Financial ManagementQuestion 5568 of 217
All Questions

Question 3 (a) AB Enterprises deals in hardware materials having current turnover ` 30 Lakhs per annum. All sales are on credit and average collection period is 30 days with zero bad debts. The customers are requesting to increase the credit period. As a result of increase in credit period sales will also increase. Other information is as under: Credit policy | Increase in collection period (days) | Increase in sales (`) | Bad debts anticipated A | 15 | 3,00,000 | 1% B | 30 | 5,00,000 | 3.5% The Selling price is ` 100/- per unit. Variable cost per unit is ` 50/- and fixed cost is ` 5,00,000. Required rate of return on additional investment is 20%. Creditors for variable cost are ready to give 15 days extra credit for the additional cost incurred. Assume a 360 days year. You are required to analyse the present and proposed credit policies using the "Total Approach" method and recommend the credit policy to be adopted. (5 Marks) (b) ER Private Limited has a paid-up capital ` 2,50,000 consisting of 25,000 Equity shares of ` 10 each. The Market price per share is ` 24 with PE ratio of 8. The company is planning to purchase a plant which will cost ` 5,00,000. This plant is expected to yield earnings before interest and taxes of ` 2,00,000 per annum. It has two alternatives to finance the plant: Alternatives | Equity | Debt A | 100% | - B | 50% | 50% Other information is as under: (i) Cost of debt is 12%. (ii) Equity shares of face value of ` 10 each will be issued at a premium of ` 10 per share. (iii) PE ratio of Leveraged company will be 7. (iv) Tax rate -40%. Advise which alternative is the most suitable to raise the funds for additional capital, keeping in mind to maximize the benefit to its Shareholders. (5 Marks)

For any discrepancies in this question, email contact@cadada.in

Ad

Detailed Solution & Explanation

Part (a): Evaluation of Credit Policies — Total Approach

Background: AB Enterprises has a current annual turnover of \u20b930 Lakhs (i.e., \u20b930,00,000). Selling price = \u20b9100/unit, so current units sold = 30,00,000 \u00f7 100 = 30,000 units. Variable cost = \u20b950/unit, Fixed cost = \u20b95,00,000. Current credit period = 30 days, zero bad debts.

Step 1: Units sold under each policy
Present: 30,000 units (sales = \u20b930,00,000)
Policy A: Additional sales = \u20b93,00,000 \u00f7 \u20b9100 = 3,000 units \u2192 Total = 33,000 units (sales = \u20b933,00,000)
Policy B: Additional sales = \u20b95,00,000 \u00f7 \u20b9100 = 5,000 units \u2192 Total = 35,000 units (sales = \u20b935,00,000)

Statement Showing Evaluation of Credit Policies (Total Approach)

| Particulars | Present Policy | Policy A | Policy B |
|---|---|---|---|
| Credit Period (days) | 30 | 45 | 60 |
| Units Sold | 30,000 | 33,000 | 35,000 |
| **(A) Expected Profit:** | | | |
| (a) Credit Sales @ \u20b9100/unit | 30,00,000 | 33,00,000 | 35,00,000 |
| (b) Total Cost: | | | |
| \u2003(i) Variable Costs @ \u20b950/unit | 15,00,000 | 16,50,000 | 17,50,000 |
| \u2003(ii) Fixed Costs | 5,00,000 | 5,00,000 | 5,00,000 |
| \u2003Total Cost | 20,00,000 | 21,50,000 | 22,50,000 |
| (c) Bad Debts | — | 33,000 (1% of 33,00,000) | 1,22,500 (3.5% of 35,00,000) |
| (d) Expected Profit [(a)\u2212(b)\u2212(c)] | **10,00,000** | **11,17,000** | **11,27,500** |
| **(B) Opportunity Cost of Investment in Receivables** | 33,333 | 52,500 | 72,917 |
| **(C) Net Benefits (A \u2212 B)** | **9,66,667** | **10,64,500** | **10,54,583** |

Working Notes — Opportunity Cost of Investment in Receivables:

| Particulars | Present | Policy A | Policy B |
|---|---|---|---|
| Credit Period (days) | 30 | 45 | 60 |
| (a) Cost of Sales (VC + FC) | 20,00,000 | 21,50,000 | 22,50,000 |
| (b) Avg. Debtors = Cost \u00d7 (Days/360) | 1,66,667 | 2,68,750 | 3,75,000 |
| (c) Avg. Creditors for extra VC [Incremental VC \u00d7 15/360] | — | 6,250 | 10,417 |
| (d) Net Avg. Investment = (b) \u2212 (c) | 1,66,667 | 2,62,500 | 3,64,583 |
| (e) Opportunity Cost @ 20% | **33,333** | **52,500** | **72,917** |

Note on Creditors: Under Policy A, incremental VC = 1,50,000; Creditors = 1,50,000 \u00d7 15/360 = 6,250. Under Policy B, incremental VC = 2,50,000; Creditors = 2,50,000 \u00d7 15/360 = 10,417.

Recommendation: Proposed Policy A (collection period increased by 15 days to total 45 days) yields the highest net benefit of \u20b910,64,500 compared to \u20b99,66,667 (Present) and \u20b910,54,583 (Policy B). Policy A should be adopted.

---

Part (b): ER Private Limited — Financing Alternatives to Maximise Shareholders' Benefit

Given Data:
Existing paid-up capital = \u20b92,50,000 (25,000 equity shares of \u20b910 each).
MPS = \u20b924, PE Ratio = 8 (existing). New plant cost = \u20b95,00,000. New EBIT from plant = \u20b92,00,000 p.a. Tax rate = 40%.
Alternative A: 100% Equity (issue at \u20b910 + \u20b910 premium = \u20b920 per share), PE remains 8.
Alternative B: 50% Equity + 50% Debt @ 12% (PE ratio = 7 for leveraged company).

Step 1: Existing EPS and EBIT
EPS = MPS \u00f7 PE Ratio = 24 \u00f7 8 = \u20b93
EAT (existing) = EPS \u00d7 25,000 = \u20b975,000
EBT = EAT \u00f7 (1 \u2212 0.40) = 75,000 \u00f7 0.60 = \u20b91,25,000
Since no existing debt, Existing EBIT = EBT = \u20b91,25,000

Step 2: Number of New Equity Shares
Alt. A: Fund required = \u20b95,00,000 (100% equity); Shares issued = 5,00,000 \u00f7 20 = 25,000; Total shares = 50,000.
Alt. B: Equity portion = \u20b92,50,000; Shares issued = 2,50,000 \u00f7 20 = 12,500; Total shares = 37,500.

Step 3: EPS and MPS Calculation

| Particulars | Existing | Alternative A | Alternative B |
|---|---|---|---|
| Existing EBIT | 1,25,000 | 1,25,000 | 1,25,000 |
| EBIT from New Project | — | 2,00,000 | 2,00,000 |
| Total EBIT | 1,25,000 | 3,25,000 | 3,25,000 |
| Less: Interest on 12% Debt (50% of 5,00,000) | — | — | 30,000 |
| EBT | 1,25,000 | 3,25,000 | 2,95,000 |
| Less: Tax @ 40% | 50,000 | 1,30,000 | 1,18,000 |
| EAT | 75,000 | 1,95,000 | 1,77,000 |
| Number of Equity Shares | 25,000 | 50,000 | 37,500 |
| **EPS = EAT \u00f7 Shares** | **3.00** | **3.90** | **4.72** |
| PE Ratio | 8 | 8 | 7 |
| **MPS = EPS \u00d7 PE Ratio** | **\u20b924.00** | **\u20b931.20** | **\u20b933.04** |

Advice: Alternative B (issue of 50% equity + 50% as 12% Debentures) is most suitable as it results in the highest Market Price per Share of \u20b933.04, thereby maximising the benefit to shareholders.

More Questions from Financial Management

If A={1,2,3,4,5}\displaystyle A = \{1, 2, 3, 4, 5\}, B={2,4}\displaystyle B = \{2, 4\} and C={1,3,5}\displaystyle C = \{1, 3, 5\} then (A−C)×B\displaystyle (A - C) \times B is:

If f(x)=x2−5\displaystyle f(x)=x^2-5, evaluate f(3)\displaystyle f(3), f(−4)\displaystyle f(-4), f(5)\displaystyle f(5), and f(1)\displaystyle f(1).

Out of a group of 20\displaystyle 20 teachers in a school, 10\displaystyle 10 teach Mathematics, 9\displaystyle 9 teach Physics and 7\displaystyle 7 teach Chemistry. 4\displaystyle 4 teach Mathematics and Physics but none teach both Mathematics and Chemistry. How many teach Chemistry and Physics; how many teach only Physics?

If A={1,2,3,4,5,7,8,9}\displaystyle A = \{1, 2, 3, 4, 5, 7, 8, 9\} and B={2,4,6,7,9}\displaystyle B = \{2, 4, 6, 7, 9\} then how many proper subset of A∩B\displaystyle A \cap B can be created?

The number of subsets of the set {0,1,2,3}\displaystyle \{0, 1, 2, 3\} is:

If f(x)=x2+x−1\displaystyle f(x) = x^2+x-1 and 4f(x)=f(2x)\displaystyle 4f(x) = f(2x), then find the value of 'x'.

Ready to Master Financial Management?

Practice all 217 questions with instant feedback, earn XP, track your streaks, and ace your CA Foundation exam.

Start Practicing — It's Free