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Question 2 (a) The following information pertain to CMC Limited: Number of Equity Shares 20,00,000 Book Value of 10% Convertible Debentures ` 1,00,00,000 Book Value of 12% Bank Term Loan ` 25,00,000 Market Price of Equity Share ` 55 Market Value of 10% Convertible Debenture ` 108 Face Value of Equity Share ` 10 Face Value of 10% Convertible Debenture ` 100 Beta coefficient of Equity shares of CMC Ltd. 1.5 Risk free rate of return 4.5% Equity risk Premium 9% Rate of taxation 30% The company expects that the share prices will rise in future at an average rate of 6% per annum. The 10% convertible debentures of 100 each will be converted in six years' time into equity shares of the company in the ratio of 1: 4 (4 equity shares for each debenture). The market value of 12% bank term loan is at par. You are required to calculate: (i) Cost of Equity Share Capital by applying Capital Asset Pricing Model (CAPM) Approach (ii) Cost of Convertible Debenture by using approximation method, (iii) Cost of Bank Term Loan (iv) Weighted Average Cost of Capital using Market Value weights (1+2+1+3=7 Marks) (b) The following information pertain to MSD Limited for the year ending 31st March, 2024: Particulars Number of days Raw material storage period 61 days Work-in -progress conversion period 20 days Finished goods storge period 30 days Debt collection period 45 days Creditors payment period 60 days The annual operating cost (including depreciation of ` 4,80,000) was ` 60,00,000. Assume 360 days in a year. You are required to calculate: (i) Operating cycle period (ii) Number of operating cycles in a year (iii) Amount of working capital required for the company (1 + 1 + 1 = 3 Marks) FINANCIAL MANAGEMENT AND STRATEGIC MANAGEMENT

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Detailed Solution & Explanation

### Solution to Question 2 #### (a) Weighted Average Cost of Capital (WACC) for CMC Limited **Working Notes:** 1. **Cost of Equity Share Capital (Ke\displaystyle K_e):** Using Capital Asset Pricing Model (CAPM) Approach: Ke=Rf+β×(Equity Risk Premium)K_e = R_f + \beta \times (\text{Equity Risk Premium}) Given: * Risk-free rate of return (Rf\displaystyle R_f) = 4.5%\displaystyle 4.5\% * Beta coefficient (β\displaystyle \beta) = 1.5\displaystyle 1.5 * Equity risk premium (Rm−Rf\displaystyle R_m - R_f) = 9%\displaystyle 9\% Ke=4.5%+1.5×9%=4.5%+13.5%=18%=0.180K_e = 4.5\% + 1.5 \times 9\% = 4.5\% + 13.5\% = 18\% = 0.180 2. **Cost of 10% Convertible Debentures (Kd\displaystyle K_d):** * Face value of each debenture = Rs. 100\displaystyle \text{Rs. } 100 * Life of debentures (n\displaystyle n) = 6 years\displaystyle 6 \text{ years} * Growth rate of share price = 6% per annum\displaystyle 6\% \text{ per annum} * Current market price of equity share = Rs. 55\displaystyle \text{Rs. } 55 * Expected share price after 6 years: Price6=55×(1+0.06)6=55×1.418519=Rs. 78.0185\text{Price}_6 = 55 \times (1 + 0.06)^6 = 55 \times 1.418519 = \text{Rs. } 78.0185 * Conversion ratio = 4 shares for each debenture. * Redemption Value of Debenture (RV\displaystyle RV) = 4×78.0185=Rs. 312.074≈Rs. 312.07\displaystyle 4 \times 78.0185 = \text{Rs. } 312.074 \approx \text{Rs. } 312.07 * Annual Interest (I\displaystyle I) = 10% of 100=Rs. 10\displaystyle 10\% \text{ of } 100 = \text{Rs. } 10 * Tax rate (t\displaystyle t) = 30%\displaystyle 30\% * Annual Interest (After Tax) = I(1−t)=10×(1−0.3)=Rs. 7\displaystyle I(1 - t) = 10 \times (1 - 0.3) = \text{Rs. } 7 * **Alternative 1: Using Market Value of Debenture as Net Proceeds (NP=Rs. 108\displaystyle NP = \text{Rs. } 108):** Kd=I(1−t)+RV−NPnRV+NP2×100K_d = \frac{I(1 - t) + \frac{RV - NP}{n}}{\frac{RV + NP}{2}} \times 100 Kd=7+312.07−1086312.07+1082×100=7+34.012210.035×100=41.012210.035×100≈19.52%K_d = \frac{7 + \frac{312.07 - 108}{6}}{\frac{312.07 + 108}{2}} \times 100 = \frac{7 + 34.012}{210.035} \times 100 = \frac{41.012}{210.035} \times 100 \approx 19.52\% * **Alternative 2: Using Face Value of Debenture as Net Proceeds (NP=Rs. 100\displaystyle NP = \text{Rs. } 100):** Kd=7+312.07−1006312.07+1002×100=7+35.345206.035×100=42.345206.035×100≈20.55%K_d = \frac{7 + \frac{312.07 - 100}{6}}{\frac{312.07 + 100}{2}} \times 100 = \frac{7 + 35.345}{206.035} \times 100 = \frac{42.345}{206.035} \times 100 \approx 20.55\% 3. **Cost of Bank Term Loan (Kl\displaystyle K_l):** * Interest rate = 12%\displaystyle 12\% * Tax rate = 30%\displaystyle 30\% * Since market value of bank term loan is at par, Net Proceeds (NP\displaystyle NP) = Book Value. * Cost of Bank Loan (Kl\displaystyle K_l) = I(1−t)=12%×(1−0.3)=8.4%=0.084\displaystyle I(1 - t) = 12\% \times (1 - 0.3) = 8.4\% = 0.084 4. **Market Values of Capital Structure Components:** * **Equity Share Capital:** Market Value=Number of Shares×Market Price per Share=20,00,000×55=Rs. 11,00,00,000 (Rs. 1,100 Lakhs)\text{Market Value} = \text{Number of Shares} \times \text{Market Price per Share} = 20,00,000 \times 55 = \text{Rs. } 11,00,00,000 \text{ (Rs. 1,100 Lakhs)} * **10% Convertible Debentures:** Number of Debentures=Book ValueFace Value=1,00,00,000100=1,00,000\text{Number of Debentures} = \frac{\text{Book Value}}{\text{Face Value}} = \frac{1,00,00,000}{100} = 1,00,000 Market Value=1,00,000×Market Price per Debenture=1,00,000×108=Rs. 1,08,00,000 (Rs. 108 Lakhs)\text{Market Value} = 1,00,000 \times \text{Market Price per Debenture} = 1,00,000 \times 108 = \text{Rs. } 1,08,00,000 \text{ (Rs. 108 Lakhs)} * **12% Bank Term Loan:** Market Value is at par=Rs. 25,00,000 (Rs. 25 Lakhs)\text{Market Value is at par} = \text{Rs. } 25,00,000 \text{ (Rs. 25 Lakhs)} * **Total Market Value of Capital Structure:** Total MV=11,00,00,000+1,08,00,000+25,00,000=Rs. 12,33,00,000 (Rs. 1,233 Lakhs)\text{Total MV} = 11,00,00,000 + 1,08,00,000 + 25,00,000 = \text{Rs. } 12,33,00,000 \text{ (Rs. 1,233 Lakhs)}
**WACC Calculations:** **Alternative 1 (Using Kd=19.52%\displaystyle K_d = 19.52\% based on Market Value of Debenture):** | Source of Capital | Market Value (Rs.) | Weight | Specific Cost (After Tax) | Weighted Cost (W×C\displaystyle W \times C) | | :--- | :---: | :---: | :---: | :---: | | Equity Share Capital | 11,00,00,000 | 0.892 | 18.00% | 16.06% | | 10% Convertible Debentures | 1,08,00,000 | 0.088 | 19.52% | 1.71% | | 12% Bank Term Loan | 25,00,000 | 0.020 | 8.40% | 0.17% | | **Total** | **12,33,00,000** | **1.000** | | **17.94%** | *Weighted Average Cost of Capital (WACC) under Alternative 1 = **17.94%***
**Alternative 2 (Using Kd=20.55%\displaystyle K_d = 20.55\% based on Face Value of Debenture):** | Source of Capital | Market Value (Rs.) | Weight | Specific Cost (After Tax) | Weighted Cost (W×C\displaystyle W \times C) | | :--- | :---: | :---: | :---: | :---: | | Equity Share Capital | 11,00,00,000 | 0.892 | 18.00% | 16.06% | | 10% Convertible Debentures | 1,08,00,000 | 0.088 | 20.55% | 1.80% | | 12% Bank Term Loan | 25,00,000 | 0.020 | 8.40% | 0.17% | | **Total** | **12,33,00,000** | **1.000** | | **18.03%** | *Weighted Average Cost of Capital (WACC) under Alternative 2 = **18.03%*** --- #### (b) Net Operating Cycle and Working Capital Requirements for MSD Limited **Calculations:** **(i) Operating Cycle Period:** Net Operating Cycle Period (in days)=R+W+F+D−C\text{Net Operating Cycle Period (in days)} = R + W + F + D - C Where: * R=Raw material storage period=61 days\displaystyle R = \text{Raw material storage period} = 61 \text{ days} * W=Work-in-progress conversion period=20 days\displaystyle W = \text{Work-in-progress conversion period} = 20 \text{ days} * F=Finished goods storage period=30 days\displaystyle F = \text{Finished goods storage period} = 30 \text{ days} * D=Debtors/Debt collection period=45 days\displaystyle D = \text{Debtors/Debt collection period} = 45 \text{ days} * C=Creditors payment period=60 days\displaystyle C = \text{Creditors payment period} = 60 \text{ days} Net Operating Cycle Period=61+20+30+45−60=96 days\text{Net Operating Cycle Period} = 61 + 20 + 30 + 45 - 60 = 96 \text{ days} **(ii) Number of Operating Cycles in a Year:** Number of Operating Cycles=Number of days in a yearOperating Cycle Period=36096=3.75 times\text{Number of Operating Cycles} = \frac{\text{Number of days in a year}}{\text{Operating Cycle Period}} = \frac{360}{96} = 3.75 \text{ times} **(iii) Amount of Working Capital Required:** * **Total Cost Basis (including depreciation):** Working Capital Required=Annual Operating CostNumber of Operating Cycles=60,00,0003.75=Rs. 16,00,000\text{Working Capital Required} = \frac{\text{Annual Operating Cost}}{\text{Number of Operating Cycles}} = \frac{60,00,000}{3.75} = \text{Rs. } 16,00,000 * **Cash Cost Basis (excluding depreciation):** Annual Cash Operating Cost=Annual Operating Cost−Depreciation=60,00,000−4,80,000=Rs. 55,20,000\text{Annual Cash Operating Cost} = \text{Annual Operating Cost} - \text{Depreciation} = 60,00,000 - 4,80,000 = \text{Rs. } 55,20,000 Working Capital Required (Cash Cost Basis)=55,20,0003.75=Rs. 14,72,000\text{Working Capital Required (Cash Cost Basis)} = \frac{55,20,000}{3.75} = \text{Rs. } 14,72,000

Key Concepts to Understand

Depreciation

Allocation of the cost of a tangible fixed asset over its useful life due to wear and tear, efflux of time, or obsolescence.

Working Capital

The excess of current assets over current liabilities, representing the short-term liquidity available to a business for its day-to-day operations. Positive working capital indicates good short-term financial health.

Debentures

Long-term debt instruments issued by a company to the public for raising loan capital, carrying a fixed rate of interest (coupon rate) payable regardless of profit. Debenture holders are creditors, not owners, of the company.

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