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.

Amou
Liabilities Amount Assets nt

Equity capital 350 Fixed assets 700

Preference capital 100 Investment 100

Current Assets,
loans and
Reserve and surplus 200 advances 400

Debentures 450
Current liabilities &
provision 100
1200 1200

Omegas 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.

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 Case Study Analysis

Omegas 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.
Omegas equity beta is 1.1, the risk free rate is 7 percent, and the
market risk premium is estimated to be 7 percent.
Omegas tax rate is 30 percent.

The new business that Omega is considering has different financial

characteristics than Omegas 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 Omegas post-tax cost of debt?
3. What is Omegas cost of preference?
4. What is Omegas estimated cost of equity using dividend discount
model?
5. What is Omegas estimated cost of equity using the capital asset
pricing model?
6. What is Omegas 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 Omegas 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 ) +maturity value

Kd, n

(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

Interpolation:

Actu Differen
al 112 ce

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 Case Study Analysis

5.91
at 117.9
7% 1
6.44
at 111.4
8% 7

= 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 Omegas cost of preference?

Denotations:
r 9%
Bv -100
Bo -106
N 5 yrs

Formula for finding Kp

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

Kp, n

)
Kp, n

At 7%

106 = 9(PVIFA ) + 100(PVIF

7%, 5 )
7%, 5

= 9(4.100) + 100(0.713)

=36.9 + 71.3

=108.2

At 8%

106 = 9(PVIFA ) + 100(PVIF

8%, 5 )
8%, 5

= 9(3.993) + 100(0.681)

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 Case Study Analysis

= 35.937 + 68.1

= 104.03

Interpolation:

Actu Differenc
al 106 e
2.2
at
7% 108.2
4.17
at 104.0
8% 3

= 0.07 + (0.08-0.07)2.2/4.17
=7.53

4. What is Omegas 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%

5. What is Omegas estimated cost of equity using the capital asset

pricing model?
Denotations:
Rm- 7
(Rm-Rf)-7
- 1.1

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 Case Study Analysis

Ke= Rf+ (Rm-RF)

= 7 + 1.1(7)

= 14.70%

6. What is Omegas WACC using CAPM for the cost of equity?

sources proport WAC

of fund ion Cost C
Equity 0.5 14.7 7.35
Preferen
ce 0.1 7.53 0.753
Debentu
re 0.4 5.54 2.216
10.31
9

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

Source
s of Proport WAC
fund ion Cost C
Equity 0.5 17.5 8.75
Debentu
re 0.5 7.7 3.85
12.6

Ke = Rf + (Rm-Rf)
= 7 + (7) 1.5
= 17.5%

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

cost of capital?
Companys cost of capital is 10.32 and projects cost of capital is
12.6. Thus, Companys cost of capital is less than projects 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

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 Case Study Analysis

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 Committees Report. Its main recommendations related to norms
for inventory and receivables, the approach to lending, style of credit,
follow ups & information system.

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 committees 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.

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2. Bank credit would only be supplementary to the borrowers resources

and not replace them, i.e. banks would not finance one hundred percent of
borrowers working capital requirement.

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

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 2nd 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

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 Case Study Analysis

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.

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.

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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

=1.57 Month

Debtors conversion period

= Debtors / Credit Sales

=240 / 700 * 12

= 4.11 Months

Creditors Deferral Period

= Creditors / Credit Purchase

=130 / 190 * 12

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 Case Study Analysis

=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 clients 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 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 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.

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