Case Study Analysis

CASE – 1 MINI CASE OF COST OF CAPITAL

SUMMARY

Suman Joshi, Managing director of omega textile, was reviewing two very different

investment proposals. The first one is for expanding the capacity of the current project and

the second is for diversifying into a new line of business.

We need to find WACC (weighed average cost of capital) with the help of following data.

Liabilities Amount Assets

Amoun

t

Equity capital 350 Fixed assets 700

Preference capital 100 Investment 100

Reserve and surplus 200

Current Assets,

loans and

advances 400

Debentures 450

Current liabilities &

provision 100

1200 1200

Omega’s target capital structure has 50 percent equity, 10 percent preference, and

40 percent debt

Omega has Rs.100 par, 10 percent coupon, annual payment, noncallable debenture

with 8 year to maturity. These debentures are currently selling at RS.112.

Omega has Rs.100 par, 9 percent, annual dividend, preference share with residual

maturity of 5 years. The market price of these preference shares is Rs.106.

Omega’s equity share is currently selling at Rs.80 per share. Its last dividend was

Rs.2.80 and the dividend per share is expected to grow at a rate of 10 percent in

future.

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Case Study Analysis

Omega’s equity beta is 1.1, the risk free rate is 7 percent, and the market risk

premium is estimated to be 7 percent.

Omega’s tax rate is 30 percent.

The new business that Omega is considering has different financial characteristics than

Omega’s existing business. Firm engaged purely in such business have, on an average, the

following characteristics:

(1) Their capital structure has debt and equity in equal proportion.

(2) Their cost of debt is 11 percent.

(3) Their equity beta is 1.5.

Questions:

1. What sources of capital would you consider relevant for calculating the WACC?

2. What is Omega’s post-tax cost of debt?

3. What is Omega’s cost of preference?

4. What is Omega’s estimated cost of equity using dividend discount model?

5. What is Omega’s estimated cost of equity using the capital asset pricing model?

6. What is Omega’s WACC using CAPM for the cost of equity?

7. What would be your estimate cost of capital for the new business?

8. What is the difference between company cost of capital and project cost of capital?

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Case Study Analysis

SOLUTION:

1. What sources of capital would you consider relevant for calculating the WACC?

All sources other than non-interest bearing liabilities like equity, preference share,

debenture and serves & surplus. Non-interest bearing liability which is given over

here is current liability and provision.

2. What is Omega’s post-tax cost of debt?

Denotations:

r – 10%

Bv -100

Bo -112

N – 8 yrs

Formula for finding Kd

Current value of debenture = interest (PVIFA Kd, n) +maturity value (PVIF Kd, n)

At 7%

112 = 10(PVIFA 7%, 8) + 100(PVIF 7%, 8)

= 10(5.971) + 100(0.582)

=59.71+58.2

=117.91

At 8%

112 = 10(PVIFA 8%, 8) + 100(PVIF 8%, 8)

= 10(5.747) + 100(0.540)

= 57.47 + 54.0

= 111.47

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Case Study Analysis

Interpolation:

Actual 112 Difference 5.91at 7% 117.91 6.44at 8% 111.47

= 0.07 + (0.08-0.07)5.91/6.44

=7.92 %

Post tax cost of debt

= 7.92(1-0.30)

= 5.54 %

3. What is Omega’s cost of preference?

Denotations:

r – 9%

Bv -100

Bo -106

N – 5 yrs

Formula for finding Kp

Current value of share = interest (PVIFA Kp, n) +maturity value (PVIF Kp, n)

At 7%

106 = 9(PVIFA 7%, 5) + 100(PVIF 7%, 5)

= 9(4.100) + 100(0.713)

=36.9 + 71.3

=108.2

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Case Study Analysis

At 8%

106 = 9(PVIFA 8%, 5) + 100(PVIF 8%, 5)

= 9(3.993) + 100(0.681)

= 35.937 + 68.1

= 104.03

Interpolation:

Actual 106

Difference

2.2at 7% 108.2 4.17at 8% 104.03

= 0.07 + (0.08-0.07)2.2/4.17

=7.53

4. What is Omega’s estimated cost of equity using dividend discount model?

Div0 = 2.80

P0 =80

G =10%

Ke = Div1 / P0 + g

=2.80(1.10)/80+ 0.10

= 0.385 + 0.1080= 0.1385

= 13.85%

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Case Study Analysis

5. What is Omega’s estimated cost of equity using the capital asset pricing model?

Denotations:

Rm- 7

(Rm-Rf)-7

β- 1.1

Ke= Rf+ (Rm-RF) β

= 7 + 1.1(7)

= 14.70%

6. What is Omega’s WACC using CAPM for the cost of equity?

sources of fund

proportion Cost WACC

Equity 0.5 14.7 7.35Preferen

ce 0.1 7.53 0.753Debentur

e 0.4 5.54 2.216

10.31

9

7. What would be your estimate cost of capital for the new business?

Sources of fund

Proportion Cost WACC

Equity 0.5 17.5 8.75Debentur

e 0.5 7.7 3.85

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Case Study Analysis

12.6

Ke = Rf + (Rm-Rf) β

= 7 + (7) 1.5

= 17.5%

8. What is the difference between company cost of capital and project cost of capital?

Company’s cost of capital is 10.32 and project’s cost of capital is 12.6. Thus,

Company’s cost of capital is less than project’s cost of capital so Suman Joshi,

Managing director of omega textile shall continue with its current business.

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Case Study Analysis

CASE- 2 WORKING CAPITAL FINANCING

SUMMARY:

This case represents a dilemma of a management graduate who has been placed in one of

the leading banks of India. Suresh Pai faced one client who is in requirement of working

capital finance. Suresh was the only one who could deal with this problem as other

executives were of different departments.

The demand of customer was of incremental working capital finance of Rs 60 lakh (From Rs

140 lakh and Rs 200 lakh). He was approaching predecessor of Suresh since many days but

did not have any kind of feedback. He asked Suresh to do his best and provided him with

various data of previous two years and also the projected data for next year. Suresh has a

challenging task of computing all the details and compute the data and provide the result to

the head of that bank. But he finds that lending can only be done by following second

method of Tondon committee. For this approval he has to get an approval from head office

as lending amount exceeds 1 crore.

Important concepts related to case:

Tondon committee:

In 1974, a study group under the chairmanship of Mr. P. L. Tondon was constituted for

framing guidelines for commercial banks for follow-up & supervision of bank credit for

ensuring proper end-use of funds. The group submitted its report in August 1975, which

came to be popularly known as Tondon Committee’s Report. Its main recommendations

related to norms for inventory and receivables, the approach to lending, style of credit,

follow ups & information system.

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Case Study Analysis

It was a landmark in the history of bank lending in India. With acceptance of major

recommendations by Reserve Bank of India, a new era of lending began in India.

Tondon committee’s recommendations:

Breaking away from traditional methods of security oriented lending; the committee

enjoyed upon the banks to move towards need based lending. The committee pointed out

that the best security of bank loan is a well functioning business enterprise, not the

collateral.

Major recommendations of the committee were as follows:

1. Assessment of need based credit of the borrower on a rational basis on the basis of their

business plans.

2. Bank credit would only be supplementary to the borrower’s resources and not replace

them, i.e. banks would not finance one hundred percent of borrower’s working capital

requirement.

3. Bank should ensure proper end use of bank credit by keeping a closer watch on the

borrower’s business, and impose financial discipline on them.

4. Working capital finance would be available to the borrowers on the basis of industry wise

norms (prescribe first by the Tondon Committee and then by Reserve Bank of India) for

holding different current assets, viz.

Raw materials including stores and others items used in manufacturing process.

Stock in Process.

Finished goods.

Accounts receivables.

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Case Study Analysis

5. Credit would be made available to the borrowers in different components like cash credit;

bills purchased and discounted working capital, term loan, etc., depending upon nature of

holding of various current assets.

6. In order to facilitate a close watch under operation of borrowers, bank would require

them to submit at regular intervals, data regarding their business and financial operations,

for both the past and the future periods

Methods of lending:

There are 3 methods of lending money to the borrowers. The below mentioned is the 2 nd

method of lending money.

In order to ensure that the borrowers do enhance their contributions to working capital and

to improve their current ratio, it is necessary to place them under the second method of

lending recommended by the Tondon committee which would give a minimum current ratio

of 1.33:1. The borrower will have to provide a minimum of 25% of total current assets from

long-term funds. However, total liabilities inclusive of bank finance would never exceed 75%

of gross current assets. As many of the borrowers may not be immediately in a position to

work under the second method of lending, the excess borrowing should be segregated and

treated as a working capital term loan which should be made repayable in installments. To

induce the borrowers to repay this loan, it should be charged a higher rate of interest. For

the present, the group recommends that the additional interest may be fixed at 2% per

annum over the rate applicable on the relative cash credit limits. This procedure should be

made compulsory for all borrowers (except sick units) having aggregate working capital

limits of rs.10 lacs and over.

Back to case:

From borrowers file we find that the limits sanctioned to him are subject to the following

norms:

‘In assessing the working capital advance the bank will follow the average holding levels

prevalent in their industry, which as updated on 01-04-2011 are as follows:

Maximum holding level for raw material and stores: 3 months of consumption.

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Case Study Analysis

Work in process: 0.5 months of cost of production

Finished goods: 2 months of cost of sales

Receivables: 3 months of net sales

Trade credit: 2 months purchase or the actual credit period enjoyed whichever is higher

The level of CA may be set at 3 percent of the rest of the CA.’

Q:1 The holding levels for raw materials, work in process, finished goods, debtors and

creditors as seen from borrowers own projections.

Q: 2 MPBF under the second method of lending as per the norms set by the bank

Q: 3 whether to recommend any increase in the present working capital limit of Rs. 140 lacs

or not and if the latter, how to explain the reasons to the client and the course of action

desired by the bank.

Solution:

Answer 1:-

Computation of Holding level of Raw material

=Raw Material Inventory/Raw Material Consumption

=60/180*12

=4 Month

Computation of Holding level of Work in progress

= Work in Progress Inventory/ Cost of Production

=20/380*12

=0.6315 Month

Computation of Holding level of Finish good consumption period

= Finish Good/ COGS

=50/380*12

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Case Study Analysis

=1.57 Month

Debtors conversion period

= Debtors / Credit Sales

=240 / 700 * 12

= 4.11 Months

Creditors Deferral Period

= Creditors / Credit Purchase

=130 / 190 * 12

=8.21 Months

Answer: 2

MPBF Criteria by Tondon committee

As per the Tondon committee MPBF (Maximum Possible Bank Finance) the value of the

current assets must be 25% of the total current assets. So this criteria is satisfied by the

available data for projected year.

Second Method of Lending

Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets.

Here current liability inclusive of bank borrowings is not exceeding 75 % of current assets.

As both the conditions are satisfied by the client’s data Bank can provide extra working

capital of 60 lacs.

Answer: 3

Here, we have two option through which we can increase in working capital or not.

As per the Company’s Standard.

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Case Study Analysis

We can not increase in working capital.

Because we can not satisfy the criteria of company’s standard. As per company’s standard

holding level for raw material is 3 months of consumption But as per projection it is 4

months. So it is not good for firm. Working process is 0.5 months of cost of production but as

per projection it is 0.6 month Which is not good for company, finished goods is 2 months of

cost of sales and as per projection it is 1.57.

Here company can get benefit in Creditors Deferral Period. Because as per company’s

standard credit period is 2 months of purchase but as per projection it is 8.21 Months. So

company can enjoy credit of 8 months. Which is beneficial for the company?

As per second method of Tondon committee,

We can accept the increment.

Under this method, it was thought that the borrower should provide for a minimum of

25% of total current assets out of long-term funds i.e., owned funds plus term borrowings.

A certain level of credit for purchases and other current liabilities will be available to

fund the build up of current assets and the bank will provide the balance Maximum

permissible banking finance (MPBF). Consequently, total current liabilities inclusive of

bank borrowings could not exceed 75% of current assets.

Here, company can fulfill all the criteria of tendon Committee and through which company

can increase in working capital.

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