Case Study Analysis

CASE 1 MINI CASE OF COST OF

CAPITAL
SUMMARY
Suman Joshi, Managing director of omega textile, was reviewing two very
diferent investment proposals. The rst one is for expanding the capacity
of the current pro!ect and the second is for diversifying into a new line of
"usiness.
#e need to nd #ACC $weighed average cost of capital% with the help of
following data.
&ia"ilities Amount Assets
Amou
nt
'(uity capital )*+ ,ixed assets -++
.reference capital /++ 0nvestment /++
1eserve and surplus 2++
Current Assets,
loans and
advances 3++
4e"entures 3*+
Current lia"ilities 5
provision /++
/2++ /2++
6mega7s target capital structure has *+ percent e(uity, /+ percent
preference, and 3+ percent de"t
6mega has 1s./++ par, /+ percent coupon, annual payment,
noncalla"le de"enture with 8 year to maturity. These de"entures are
currently selling at 1S.//2.
6mega has 1s./++ par, 9 percent, annual dividend, preference
share with residual maturity of * years. The mar:et price of these
preference shares is 1s./+;.
.age /
Case Study Analysis
6mega7s e(uity share is currently selling at 1s.8+ per share. 0ts last
dividend was 1s.2.8+ and the dividend per share is expected to
grow at a rate of /+ percent in future.
6mega7s e(uity "eta is /./, the ris: free rate is - percent, and the
mar:et ris: premium is estimated to "e - percent.
6mega7s tax rate is )+ percent.
The new "usiness that 6mega is considering has diferent nancial
characteristics than 6mega7s existing "usiness. ,irm engaged purely in
such "usiness have, on an average, the following characteristics<
$/%Their capital structure has de"t and e(uity in e(ual proportion.
$2%Their cost of de"t is // percent.
$)%Their e(uity "eta is /.*.
=uestions<
/. #hat sources of capital would you consider relevant for calculating
the #ACC>
2. #hat is 6mega7s post?tax cost of de"t>
). #hat is 6mega7s cost of preference>
3. #hat is 6mega7s estimated cost of e(uity using dividend discount
model>
*. #hat is 6mega7s estimated cost of e(uity using the capital asset
pricing model>
;. #hat is 6mega7s #ACC using CA.M for the cost of e(uity>
-. #hat would "e your estimate cost of capital for the new "usiness>
8. #hat is the diference "etween company cost of capital and pro!ect
cost of capital>
.age 2
Case Study Analysis
S6&@T06A<
/. #hat sources of capital would you consider relevant for calculating
the #ACC>
All sources other than non?interest "earing lia"ilities li:e e(uity,
preference share, de"enture and serves 5 surplus. Aon?interest
"earing lia"ility which is given over here is current lia"ility and
provision.

2. #hat is 6mega7s post?tax cost of de"t>
4enotations<
r B /+C
Dv ?/++
Do ?//2
A B 8 yrs
,ormula for nding E
d
Current value of de"enture

F interest $.G0,A
Ed, n
% Hmaturity value
$.G0,
Ed, n
%
At -C
//2 F /+$.G0,A
-C, 8
% H /++$.G0,
-C, 8
%
F /+$*.9-/% H /++$+.*82%
F*9.-/H*8.2
F//-.9/
At 8C
//2 F /+$.G0,A
8C, 8
% H /++$.G0,
8C, 8
%
F /+$*.-3-% H /++$+.*3+%
F *-.3- H *3.+
F ///.3-
0nterpolation<
Actu
al //2
4iferen
ce
.age )
Case Study Analysis
*.9/
at
-C
//-.9
/
;.33
at
8C
///.3
-
F +.+- H $+.+8?+.+-%*.9/I;.33
F7.92 C

.ost tax cost of de"t
F -.92$/?+.)+%
F 5.54 %
). #hat is 6mega7s cost of preference>
4enotations<
r B 9C
Dv ?/++
Do ?/+;
A B * yrs
,ormula for nding E
p
Current value of share

F interest $.G0,A
Ep, n
% Hmaturity value $.G0,
Ep, n
%
At -C
/+; F 9$.G0,A
-C, *
% H /++$.G0,
-C, *
%
F 9$3./++% H /++$+.-/)%
F);.9 H -/.)
F/+8.2
At 8C
/+; F 9$.G0,A
8C, *
% H /++$.G0,
8C, *
%
F 9$).99)% H /++$+.;8/%
.age 3
Case Study Analysis
F )*.9)- H ;8./
F /+3.+)
0nterpolation<
Actu
al /+;
4iferenc
e
2.2
at
-C /+8.2
3./-
at
8C
/+3.+
)
F +.+- H $+.+8?+.+-%2.2I3./-
F7.53
3. #hat is 6mega7s estimated cost of e(uity using dividend discount
model>
4iv+ F 2.8+
.+ F8+
J F/+C
E
e
F 4iv
/
I .
+
H g
F2.8+$/./+%I8+H +./+
F +.)8* H +./+8+F +./)8*
F 13.85%
*. #hat is 6mega7s estimated cost of e(uity using the capital asset
pricing model>
4enotations<
1m? -
$1m?1f%?-
K? /./
.age *
Case Study Analysis
EeF 1fH $1m?1,% K
F - H /./$-%
F 14.70%
;. #hat is 6mega7s #ACC using CA.M for the cost of e(uity>

sou!"s
o# #u$%
&o&o'
(o$ Cos'
)AC
C
'(uity +.* /3.- -.)*
.referen
ce +./ -.*) +.-*)
4e"entu
re +.3 *.*3 2.2/;

10.31
9
-. #hat would "e your estimate cost of capital for the new "usiness>

Sou!"
s o#
#u$%
Po&o'
(o$ Cos'
)AC
C
'(uity +.* /-.* 8.-*
4e"entu
re +.* -.- ).8*
12.*
E
e
F 1f H $1m?1f% K
F - H $-% /.*
F /-.*C
8. #hat is the diference "etween company cost of capital and pro!ect
cost of capital>
Company7s cost of capital is /+.)2 and pro!ect7s cost of capital is
/2.;. Thus, Company7s cost of capital is less than pro!ect7s cost of
capital so Suman Joshi, Managing director of omega textile shall
continue with its current "usiness.
.age ;
Case Study Analysis
CASE+ 2 )OR,IN- CAPITAL FINANCIN-
SUMMARY<
This case represents a dilemma of a management graduate who has "een
placed in one of the leading "an:s of 0ndia. Suresh .ai faced one client
who is in re(uirement of wor:ing capital nance. Suresh was the only one
who could deal with this pro"lem as other executives were of diferent
departments.
The demand of customer was of incremental wor:ing capital nance of 1s
;+ la:h $,rom 1s /3+ la:h and 1s 2++ la:h%. Le was approaching
predecessor of Suresh since many days "ut did not have any :ind of
feed"ac:. Le as:ed Suresh to do his "est and provided him with various
data of previous two years and also the pro!ected data for next year.
Suresh has a challenging tas: of computing all the details and compute
.age -
Case Study Analysis
the data and provide the result to the head of that "an:. Dut he nds that
lending can only "e done "y following second method of Tondon
committee. ,or this approval he has to get an approval from head oMce as
lending amount exceeds / crore.
I.&o'/$' !o$!"&'s "0/'"% 'o !/s"1
To$%o$ !o..(''""1
0n /9-3, a study group under the chairmanship of Mr. .. &. Tondon was
constituted for framing guidelines for commercial "an:s for follow?up 5
supervision of "an: credit for ensuring proper end?use of funds. The group
su"mitted its report in August /9-*, which came to "e popularly :nown as
Tondon Committee7s 1eport. 0ts main recommendations related to norms
for inventory and receiva"les, the approach to lending, style of credit,
follow ups 5 information system.
0t was a landmar: in the history of "an: lending in 0ndia. #ith acceptance
of ma!or recommendations "y 1eserve Dan: of 0ndia, a new era of lending
"egan in 0ndia.
To$%o$ !o..(''""2s "!o.."$%/'(o$s1
Drea:ing away from traditional methods of security oriented lendingN the
committee en!oyed upon the "an:s to move towards need "ased lending.
The committee pointed out that the "est security of "an: loan is a well
functioning "usiness enterprise, not the collateral.
M/3o "!o.."$%/'(o$s o# '4" !o..(''"" 5"" /s #o00o5s1
/. Assessment of need "ased credit of the "orrower on a rational "asis on
the "asis of their "usiness plans.
.age 8
Case Study Analysis
2. Dan: credit would only "e supplementary to the "orrower7s resources
and not replace them, i.e. "an:s would not nance one hundred percent of
"orrower7s wor:ing capital re(uirement.
). Dan: should ensure proper end use of "an: credit "y :eeping a closer
watch on the "orrower7s "usiness, and impose nancial discipline on
them.
3. #or:ing capital nance would "e availa"le to the "orrowers on the
"asis of industry wise norms $prescri"e rst "y the Tondon Committee and
then "y 1eserve Dan: of 0ndia% for holding diferent current assets, viO.
R/5 ./'"(/0s ($!0u%($6 s'o"s /$% o'4"s ('".s us"% ($
./$u#/!'u($6 &o!"ss.
Stoc: in .rocess.
,inished goods.
Accounts receiva"les.
*. Credit would "e made availa"le to the "orrowers in diferent
components li:e cash creditN "ills purchased and discounted wor:ing
capital, term loan, etc., depending upon nature of holding of various
current assets.
;. 0n order to facilitate a close watch under operation of "orrowers, "an:
would re(uire them to su"mit at regular intervals, data regarding their
"usiness and nancial operations, for "oth the past and the future periods
M"'4o%s o# 0"$%($61
There are ) methods of lending money to the "orrowers. The "elow
mentioned is the 2
nd
method of lending money.
0n order to ensure that the "orrowers do enhance their contri"utions to
wor:ing capital and to improve their current ratio, it is necessary to place
them under the second method of lending recommended "y the Tondon
committee which would give a minimum current ratio of /.))</. The
"orrower will have to provide a minimum of 2*C of total current assets
.age 9
Case Study Analysis
from long?term funds. Lowever, total lia"ilities inclusive of "an: nance
would never exceed -*C of gross current assets. As many of the
"orrowers may not "e immediately in a position to wor: under the second
method of lending, the excess "orrowing should "e segregated and
treated as a wor:ing capital term loan which should "e made repaya"le in
installments. To induce the "orrowers to repay this loan, it should "e
charged a higher rate of interest. ,or the present, the group recommends
that the additional interest may "e xed at 2C per annum over the rate
applica"le on the relative cash credit limits. This procedure should "e
made compulsory for all "orrowers $except sic: units% having aggregate
wor:ing capital limits of rs./+ lacs and over.
7/!8 'o !/s"1
,rom "orrowers le we nd that the limits sanctioned to him are su"!ect to
the following norms<
P0n assessing the wor:ing capital advance the "an: will follow the average
holding levels prevalent in their industry, which as updated on +/?+3?2+//
are as follows<
Maximum holding level for raw material and stores< ) months of
consumption.
#or: in process< +.* months of cost of production
,inished goods< 2 months of cost of sales
1eceiva"les< ) months of net sales
Trade credit< 2 months purchase or the actual credit period en!oyed
whichever is higher
The level of CA may "e set at ) percent of the rest of the CA.7
=</ The holding levels for raw materials, wor: in process, nished goods,
de"tors and creditors as seen from "orrowers own pro!ections.
.age /+
Case Study Analysis
=< 2 M.D, under the second method of lending as per the norms set "y
the "an:
=< ) whether to recommend any increase in the present wor:ing capital
limit of 1s. /3+ lacs or not and if the latter, how to explain the reasons to
the client and the course of action desired "y the "an:.
So0u'(o$1
A$s5" 11+
Computation of Lolding level of 1aw material
F1aw Material 0nventory91aw Material Consumption
F;+I/8+Q/2
F3 Month
Computation of Lolding level of #or: in progress
F #or: in .rogress 0nventory9 Cost of .roduction
F2+I)8+Q/2
F+.;)/* Month
Computation of Lolding level of ,inish good consumption period
F ,inish JoodI C6JS
F*+I)8+Q/2
F/.*- Month
4e"tors conversion period
F 4e"tors I Credit Sales
F23+ I -++ Q /2
F 3.// Months
Creditors 4eferral .eriod
F Creditors I Credit .urchase
F/)+ I /9+ Q /2
.age //
Case Study Analysis
F8.2/ Months
A$s5"1 2
MP7F C('"(/ :; To$%o$ !o..(''""
As per the Tondon committee M.D, $Maximum .ossi"le Dan: ,inance% the
value of the current assets must "e 2*C of the total current assets. So
this criteria is satised "y the availa"le data for pro!ected year.
S"!o$% M"'4o% o# L"$%($6
@nder this method, it was thought that the "orrower should provide for a
minimum of 2*C of total current assets out of long?term funds i.e., owned
funds plus term "orrowings. A certain level of credit for purchases and
other current lia"ilities will "e availa"le to fund the "uild up of current
assets and the "an: will provide the "alance $M.D,%. Conse(uently, total
current lia"ilities inclusive of "an: "orrowings could not exceed -*C of
current assets.
Lere current lia"ility inclusive of "an: "orrowings is not exceeding -* C of
current assets.
As "oth the conditions are satised "y the client7s data Dan: can provide
extra wor:ing capital of ;+ lacs.
Answer: 3
Here, we have two option through which we can increase in working capital or not.
As per the Companys Standard.
We can not increase in working capital.
Because we can not satisfy the criteria of companys standard. As per companys standard
holding level for raw material is 3 months of consumption But as per projection it is
months. !o it is not good for firm. Working process is ".# months of cost of production $ut as
per projection it is ".% month Which is not good for company, finished goods is & months of
cost of sales and as per projection it is '.#(.
.age /2
Case Study Analysis
Here company can get $enefit in )reditors *eferral +eriod. Because as per companys
standard credit period is & months of purchase $ut as per projection it is ,.&' -onths. !o
company can enjoy credit of , months. Which is $eneficial for the company.
As per second method of Tondon committee,
We can accept the increment.
/nder this method, it was thought that the $orrower should provide for a minimum of
&#0 of total current assets out of long1term funds i.e., owned funds plus term $orrowings.
A certain level of credit for purchases and other current lia$ilities will $e availa$le to fund
the $uild up of current assets and the $ank will provide the $alance -a2imum permissi$le
$anking finance 3-+B45. )onse6uently, total current lia$ilities inclusive of $ank
$orrowings could not e2ceed (#0 of current assets.
Here, company can fulfill all the criteria of tendon )ommittee and through which company
can increase in working capital.
.age /)