Special Studies in Finance _solution 2012-13

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SPECIAL STUDIES IN FINANCE - Solution

Section I

1. Concepts (5)

(a) Segment Reporting

The following is the text of Accounting Standard -17, “Segment Reporting” issued by the

Council of the Institute of Chartered Accountants of India. This Standard comes into effect in

respect of accounting period’s commencing on or after 1.4.2001 and is mandatory in nature,

from that date in respect of the following:

a. Enterprises whose equity or debt securities are listed on a recognized stock exchange in

India, and enterprises that are in the process of issuing equity or debt securities that will

be listed on a recognized stock exchange in India as evidenced by the board of directors’

resolution in this regard.

b. All other commercial, industrial and business reporting enterprises, whose turnover for

the accounting period exceeds `50 crore.

(b) Sweat Equity

What are sweat equity shares and under what conditions can companies issue them?

Answer: The expression “sweat equity shares” refers to equity shares issued by the

company to employees or directors at a discount or for consideration other than cash for

providing know-how or making available rights in the nature of intellectual property rights or

similar value additions to the company.

1. All the limitations, restrictions and provisions relating to equity shares are applicable to

such sweat equity shares. A company may issue sweat equity shares of a class of

shares already issued if the following conditions are fulfilled the issue of sweat equity

shares is authorised by special resolution passed by the company in the general

meeting.

2. The resolution specifies the number of shares, current market price, consideration, if

any, and the class or classes of directors or employees to whom such equity shares are

to be issued not less than one year has, at the date of the issue, elapsed since the date

on which the company was entitled to commence, business the sweat equity shares of a

company whose equity shares are listed on a recognised stock exchange are issued in

accordance with the regulations made by the Securities and Exchange Board of India in

this behalf. (In case of a company whose equity shares are not listed on any recognised

stock exchange, the sweat equity shares can be issued in accordance with such

guidelines as may be prescribed.) .

3. All these provisions are laid down in section 79 A of the Companies Act, 1956. This

section was inserted by the Companies (Amendment) Act 1999 which provided for issue

of sweat equity shares subject to fulfilment of certain conditions.

4. The Companies (Amendment) Act, 2000 laid down that the provisions of this section are

to be administered by SEBI in respect of companies already listed or companies, which

intend to get listed. In respect of other companies, the administration shall be by the

Central Government.

(c) Wealth Maximization: Wealth maximization means maximization of the wealth of the

shareholders. Wealth maximization objective is superior to profit maximization objective.

It overcomes the drawback of profit maximization criteria. Its operational feather satisfies

all the three requirements of a suitable operational objective of financial courses of action

namely, exactness, quality of benefits and the time value of money. Wealth maximization

concept is measured in terms of cash flows rather than accounting profits. Cash flows

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are calculated by taking into account the time value of money. Measurement of benefits

in terms of cash flows avoids the possibility of ambiguity associated with accounting

profits.

(d) Non-monitory items as per Accounting standard (AS) – 11.

Accounting Standard (AS) 11, The Effects of Changes in Foreign Exchange Rates (revised

2003), issued by the Council of the Institute of Chartered Accountants of India, comes into

effect in respect of accounting periods commencing on or after 1-4-2004 and is mandatory in

nature from that date. The revised Standard supersedes Accounting Standard (AS) 11,

Accounting for the Effects of Changes in Foreign Exchange Rates (1994), except that in

respect of accounting for transactions in foreign currencies entered into by the reporting

enterprise itself or through its branches before the date this Standard comes into effect, AS

11 (1994) will continue to be applicable.

Non-monetary items are assets and liabilities other than monetary items.

(e) Return on Investment.

2. (A) Case study.

Answer the following questions with the help of the following. (15)

Greenland Ltd is an extending business set up having sales turnover of Rs. 3 Crores. It

wants to double its turnover in the coming years and is very confident of achieving the same.

The company produces and sells a basic drug component, being the raw material for OTC

(over the counter) medicines.

The firm was set up 5 years ago, as partnership firm, but converted itself into a company

2 years ago. The current capital employed of the company is totally debt free at Rs. 2 crores

and hopes to raise it to Rs. 4.5 crores, the term loan applied for being Rs. 2 crores.

The term lending institution offers the loan for 5 years tenure @ rate of 10% p.a. being

advance towards purchase of additional to the primary security.

The company has its establishment at Silvasa which enjoys an 8 years tax holiday from

the date of inception. Depreciation on new machinery is estimated at Rs. 40 lacs p.a. The

average Tax applicable to a company is 30%. Expected ROI @ 18% p.a. for years 1 to 3

years after inception and 22% p.a. thereafter.

(a) Prepare a Flash Report of Greenland Ltd.

(b) Prepare Statement of Profitability and DSCR for the tenure of the loan.

(c) Comment on the viability of the project in brief.

Solution:

Flash Report: A) Facts: Name of the borrower: Greenland Ltd. Presented & Proposed Set up: Silvasa Proposed Loan: ` 2,00,00,000 I) Market Appraisal: i. Produces and sell a basic drug component.

II) Technical Appraisal: i. The product is raw material for medicines.

III) Financial Appraisal: i. The company’s sales turnover will be double every year. ii. The company enjoys 8 years tax holiday.




iii. The ROI of the company increases after 3 year.

IV) Economic Appraisal: i. The project helps the company to earn more profit.

Calculation of EBIT

For three years

ROI = EBIT / Capital Employed x 100

18% = x / 4,50,00,000

EBIT = 81,00,000

For fourth and fifth year

ROI = EBIT / Capital Employed x 100

22% = x / 4,50,00,000

EBIT = 99,00,000

Amortisation schedule for 5 years.

Year Loan at beginning

Principal installment

Interest @10%

Total Repayment

Loan at end

1 2,00,00,000 40,00,000 20,00,000 60,00,000 1,60,00,000

2 1,60,00,000 40,00,000 16,00,000 56,00,000 1,20,00,000

3 1,20,00,000 40,00,000 12,00,000 52,00,000 80,00,000

4 80,00,000 40,00,000 8,00,000 48,00,000 40,00,000

5 40,00,000 40,00,000 4,00,000 44,00,000 ----

Calculation of Debt Service Coverage Ratio

Particulars 1 2 3 4 5

EBIT 81,00,000 81,00,000 81,00,000 99,00,000 99,00,000

Less: Interest 20,00,000 16,00,000 12,00,000 8,00,000 4,00,000

EBT 61,00,000 65,00,000 69,00,000 91,00,000 95,00,000

Less: Tax (30%) -- -- -- -- --

EAT 61,00,000 65,00,000 69,00,000 91,00,000 95,00,000

EAT 61,00,000 65,00,000 69,00,000 91,00,000 95,00,000

(+) Depreciation 40,00,000 40,00,000 40,00,000 40,00,000 40,00,000

(+) Interest 20,00,000 16,00,000 12,00,000 8,00,000 4,00,000

Amount available for repayment(A) 1,21,00,000 1,21,00,000 1,21,00,000 1,39,00,000 1,39,00,000

Principal Repayment 40,00,000 40,00,000 40,00,000 40,00,000 40,00,000

(+)Interest 20,00,000 16,00,000 12,00,000 8,00,000 4,00,000

Loan Repayment (B) 60,00,000 56,00,000 52,00,000 48,00,000 44,00,000

Debt Service Coverage Ratio (A/B) 2.02 2.16 2.33 2.90 3.16

(B) Solve any 2 from the following: (10)

(i) Explain the term financial assets as per accounting standards 31.

Ans) AS – 31 will be applicable to all commercial, industrial and business entities other than

small and medium sized entities (SMEs). It will be recommendatory for initial period of two

years starting on or after 1-4-2009. It will become mandatory for the accounting period

commencing on or after 1-4-2011.

OBJECTIVE

The objective of the Standard is to establish principles for

Presenting financial instruments as liabilities or equity




Offsetting financial assets and financial liabilities

Compound financial instruments.

(1) Financial instrument: A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. (2) Financial asset: A financial asset is any asset that is: (a) cash; (b) An equity instrument of another entity; (c) A contractual right: i) To receive cash or another financial asset from another entity; or ii) To exchange financial assets or financial liabilities with another entity under conditions

that are potentially favourable to the entity; or (d) A contract that will or may be settled in the entity’s own equity instruments and is: i) A non-derivative for which the entity is or may be obliged to receive a variable number of

the entity’s own equity instruments; or ii) A derivative that will or may be settled other than by the exchange of a fixed amount of

cash or another financial asset for a fixed number of the entity’s own equity instruments. For this purpose the entity’s own equity instruments do not include instruments that are themselves contracts for the future receipt or delivery of the entity’s own equity instruments.

(ii) From the following information, compute EVA of TCS Ltd. (Assume 35% tax rate)

Equity Share Capital ` 1,000 lakhs.

12% Debentures ` 500 lakhs

Cost of equity is 20%

Financial leverage is 1.5 times.

Solution:

Interest = 12% of 500lakhs

= 60 lakhs

Financial Leverage = EBIT / EBT

= EBIT / EBIT – Interest

1.5 = x / x – 60

1.5x – 90 = x

1.5x –x = 90

0.5 x = 90

X = 90/0.5

EBIT = 180

Calculation of NOPAT:

Particulars Amount (`)

EBIT 180

(-) Tax @ 35% 63

NOPAT 117

Calculation of WACC:

Sources Amount

(Lakhs)

Proportion

(%)

Cost of Capital

(%)

Weighted cost

of capital (%)

Equity Share Capital 1,000 66.67 20 13.334

12% Debentures 500 33.33 7.8 2.6

1,500 100 15.93




Kd = I (1-t)

= 12 (1 – 0.35)

= 12 (0.65)

= 7.8%

EVA = NOPAT – (WACC x CE)

= 117 – (15.93% x 1500)

= 117 – 238.95

EVA = (121.95)

(iii) Vijay Ltd. Is considering a project with an initial outlay of ` 1,00,000 comprising of

machinery worth ` 75,000 and balance towards, working capital exclusively for this

project ` 25,000. The entire amount can be borrowed at a rate of 12% p.a. The

machinery can be used for 5 yrs at the end of which there is salvage value of ` 10,000. It

can be assumed that the machinery is depreciated on SLM basis @20% p.a. for tax

purpose. The tax rate assumes to be 35%. Evaluate whether the project is viable under

NPV method. Also calculate the pay- back period and briefly recommend for the project

given the following annual sales and expenses. Annual Sales - ` 2,00,000. Expenses

excluding depreciation ` 20,000.

Solution:

Depreciation = Original Investment x rate of Depreciation

= 75,000 x 20%

= 15,000 per year.

Calculation of Cash Inflow

Particulars Amount

Sales 2,00,000

(-) Expenses 20,000

PBDT 1,80,000

(-) Depreciation 15,000

PBT 1,65,000

(-) Tax @ 35% 57,750

PAT 1,07,250

(+) Depreciation 15,000

Cash Inflow 1,22,250

Year Cash Inflow PV Factor@12% PVCI

1 1,22,250 0.893 1,09,169

2 1,22,250 0.797 97,433

3 1,22,250 0.712 87,042

4 1,22,250 0.636 77,751

5 1,22,250 0.567 69,316

5 (wc) 25,000 0.567 14,175

5 (sv) 10,000 0.567 5,670

PV of Cash Inflow 4,60,556

(-) PV of Cash

Outflow (OI+WC)

1,00,000

Net Present Value 3,60,556




Pay Back Period = Original Investment / Annual Cash Inflow

= 75,000 / 1,22,250

= 0.613 years

Note: Since the cash inflows were same every year we will use the above formula.

Section II

3. What is Lease Financing? Write advantages and limitations of Lease Financing?

Conceptually, a lease may be defined as a contractual| arrangement/ transaction in

which a party owning an asset/equipment (lessor) provides the asset for use to another,

/transfer the right to use the equipment to the user (lessee)' over a certain/ for an agreed

period of time, for consideration in form of/in return for periodic payment (rentals), with or

without a further payment (premium). At the end of the period of contract (lease period),

the asset/equipment reverts back to the lessor unless there is a provision for the renewal

of the contract

Advantages of Leasing:

1. Conservation of working capital.

2. Income tax considerations.

3. Financial reporting implications i.e., potential to use leasing as off balance sheet

financing.

4. Leasing permits 100% financing.

5. Threat of technological obsolescence. E.g. computers.

6. Less restrictive forms of financing when compared with debentures or loans.

7. Ability to maintain flexibility by avoiding ownership commitments.

8. Provides a mechanism for enjoying the benefits of capital allowances in the form of

reduced rentals.

9. More easily accessible.

10. Cheaper than other sources of finance.

11. Permits increased capital investment.

12. Leasing is part of planned finance.

13. Makes its possible to design structured leasing arrangement.

14. Assists in prediction of future cash requirements.

15. Leasing is spill over financing i.e. it covers deficiencies or shortfalls in planning.

16. Need for the equipment in temporary

17. Flexibility in repayment.

18. Undisclosed source of financing.

19. Cheaper than purchase.

Disadvantages of Leasing:

1. Relatively high cost of lease.

2. More burden when interest rates decline in market.

3. Miscellaneous expenses are owned by lessee.

4. Problem of shifting responsibility, its obsolescence in long term lease.

5. No capital gains when asset prices are poorer.

6. Depreciation cannot be claimed.

4. PQR Ltd. has purchased a machine (cash price ` 1,09,737) on hire purchase system

from HP Ltd. on 1-1-2010. The term is that PQR Ltd. would pay ` 40,000 as down

payment on signing of the agreement and 4 annual equated instalments of ` 22,000

each including interest @10% commencing from the beginning of the next year. PQR ltd.

charged depreciation @20% p.a. on WDV method in their Hire purchase contract.




Prepare Journal Entries, Machinery account and HP Ltd. account for first 2 years in the

book of PQR Ltd.

Solution: Depreciation @ WDV

Particulars Amount (`) Cost of Machine 1,09,737 (-) Dep @ 20% year 2010 21,947 WDV 87,790 (-) Dep @ 20% year 2011 17,558 WDV 70,232 (-) Dep @ 20% year 2012 14,046

WDV 56,186

(-) Dep @ 20% year 2013 11,237

WDV 44,949

Cash Price = 1,09,737 (-) Down payment = 40,000 69,737

Year Opening

Balance

Installment Interest @

10%

Principal Closing

Balance

2011 69,737 22,000 6,974 15,026 54,711

2012 54,711 22,000 5,471 16,529 38,182

2013 38,182 22,000 3,818 18,182 20,000

2014 20,000 22,000 2,000 20,000 Nil

In the books of PQR Ltd

Journal Entries

DATE PARTICULARS DEBIT (Rs.) CREDIT (Rs.) 1/1/2010 Machine a/c Dr 1,09,737

To HP a/c 1,09,737

(Being asset purchase)

1/1/2010 HP a/c Dr 40,000 40,000 To Bank a/c (Being down payment made)

31/3/2010 Depreciation a/c Dr 21,947 To Machinery a/c 21,947

(Being depreciation charge)

31/3/2010 P&L a/c Dr 21,947

To Depreciation a/c 21,947

(Being depreciation transferred to P&L a/c)

1/1/2011 HP a/c Dr 22,000

To Bank a/c 22,000

(Being 1st installment paid)




1/1/2011 Interest a/c Dr 6,974

To HP a/c 6,974

(Being interest paid)

31/12/2011 Depreciation a/c Dr 17,558 To Machinery a/c 17,558

(Being depreciation charge)

31/12/2011 P&L a/c Dr 24,532 To Interest a/c 6,974

To Depreciation a/c 17,558

(Being interest and depreciation transferred to P&L a/c)

Machinery A/c

Date Particulars Amt Date Particulars Amt

1/1/2010 To HP a/c 1,09,737 31/12/10 By Depreciation a/c 21,947

31/12/10 By balance c/d 87,790

1,09,737 1,09,737

1/1/2011 To balance b/d 87,790 31/12/11 By Depreciation a/c 17,558

31/12/11 By balance c/d 70,232

87,790 87,790

1/1/2012 To balance b/d 70,232

HP A/c

Date Particulars Amt Date Particulars Amt

1/1/2010 To Bank a/c 40,000 1/1/2010 By Machine a/c 1,09,737

31/12/10 To Balance c/d 69,737

1,09,737 1,09,737

1/1/2011 To Bank a/c 22,000 1/1/2011 By Balance b/d 69,737

1/1/2011 By Interest 6,974

31/12/11 To Balance c/d 54,711

76,711 76, 711

1/1/2012 By Balance b/d 54,711

5. Manthan Ltd. Imported goods from Mayur company worth US$ 5 lakhs on 1 - 8 – 2009

when exchange rate was US$ 1 = ` 42.90. He agreed to pay in 5 instalments as below:

Date Instalments (US$) Rate of Exchange (`)

10-10-2009 75,000 42.75

10-12-2009 1,50,000 43.50

10-2-2010 60,000 44.80

10-4-2010 75,000 42.90

10-6-2010 Balance 43.00

The rate of exchange was ` 43.00 as on 31-3-2010. Pass journal entries (including those

for cash) in the books of Mayur in accordance with AS-11.

Solution:




In the Books of Mayur (Exporter)

Date Particulars Amt in $ ` / $ Amt. Recd Amt to be recd

Exchange Diff

1/8/09 Sales 5,00,000 42.90 2,14,50,000 2,14,50,000 ---

10/10/09 1st Installment

received

75,000 42.75 32,06,250 32,17,500 11,250 (loss)

10/12/09 2nd installment

received

1,50,000 43.50 65,25,000 64,35,000 90,000 (gain)

10/2/2010 3rd installment

received

60,000 44.80 26,88,000 25,74,000 1,14,000

(gain)

31/3/2010 Reporting 2,15,000

(5,00,000 -

75,000 -1,50,000

– 60,000)

43.00 92,45,000 92,23,500 21,500 (gain)

10/4/2010 4th Installment

received

75,000 42.90 32,17,500 32,25,000 7,500 (loss)

10/6/10 5th Installment

received

1,40,000

(2,15,000 –

75,000)

43 60,20,000 60,20,000 ----

Journal Entries

DATE PARTICULARS DEBIT (Rs.) CREDIT (Rs.) 1/8/09 Manthan a/c Dr 2,14,50,000

To Sales a/c 2,14,50,000

(Being goods sold)

10/10/09 Bank a/c Dr 32,06,250

FEF a/c (loss) Dr 11,250

To Manthan a/c 32,17,500

(Being 1st installment received)

10/12/09 Bank a/c Dr 65,25,000

To FEF a/c (profit) 90,000


(Being 2nd installment received)

10/2/2010 Bank a/c Dr 26,88,000

To FEF a/c (profit) 1,14,000


(Being 3rd installment received)

31/3/2010 Manthan a/c Dr 21,500

To FEF a/c 21,500

(Being profit reported)

31/3/2010 FEF a/c Dr 21,500

To P& L a/c 21,500

(Being profit transferred)

31/3/2010 FEF a/c Dr 2,14,250

To P& L a/c 2,14,250

(Being net profit transferred)




10/4/2010 Bank a/c Dr 32,17,500

FEF a/c (loss) Dr 7,500


(Being 4th installment received)

10/6/10 Bank a/c Dr 60,20,000


(Being 5th installment received)

31/3/10 P& L a/c Dr 7,500

To FEF a/c 7,500

(Being loss transferred)

6. (a) XYZ Ltd has provided depreciation as per accounting records ` 20 lakhs but as per

tax records ` 40 lakhs. The unamortized preliminary expenses, as per tax records are `

10, 000. There is adequate evidence of future profit sufficiency. Tax rate 30%. How

much deferred tax asset /liability should be recognised as transition adjustment as per

AS - 22? (5)

Solution:

Description Calculations Amount Excess Depreciation as per Tax (Tax Depreciation - Accounting Depreciation) Rs. 120 - Rs. 40 80 (-) Unamortized expenses 0.1 Timing Difference 79.9

As tax Expense is more than the current tax due to timing difference of Rs. 79.9 Lakhs, therefore Deferred Tax Liability = 30% x 79.9 Lakhs = Rs. 23.97 Lakhs.

P& L a/c Dr 23,97,000 To DTL a/c 23,97,000

(b) ABC Ltd. IPO opened on 6th October & closed on 8th October- Company issued 20

crore shares in the price band 1200-1300. Public applied for 200 crore shares. The

BRLM J.P. Morgan in consultation with company announced issue price ` 1250.

Average Price of application receive is ` 1270. Pass necessary journal entries in books

of coal India Ltd. Refund and Allotment of shares of face value of ` 10 were done on

20th Oct. 2011. (5)

Solution: (in cores)

No. Date Particulars Debit Credit

6/10/10 To 8/10/10

Cash/Bank a/c……………………….Dr. To share application a/c (200 x 1270)

2,54,000 2,54,000

20/10/10 Share application a/c……………….Dr. To Equity share capital a/c (20x10) To Securities premium a/c (20 x 1240) To Cash/Bank a/c (Refund amount)

2,54,000 200 24,800 2,29,000

Documents

Special Studies in Finance _solution 2012-13