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Financial Management-2-July-Dec-14

Financial Management-2-July-Dec-14

Section A (20 Marks)

Write short notes on any four of the following

1.      Leasing as a Source of Finance

2.      Portfolio Diversification and Risk

3.      Theories of capital structure

4.      Different capital budgeting appraisal methods

5.      Components of working capital

 

Section B (30 marks)

(Attempt any three)

 

1.      Define the term Economic value added. How is it calculated?

2.      Describe the basic aspects of the concept of cost of capital.

3.      Explain the concept of financial leverage and its impact on EPS.

4.      What is meant by capital rationing? What are the steps involved in capital rationing?

Section C (50 marks)

(Attempt all questions. Every question carries 10 marks)

Read the case “Economic Value Added.” and answer the following questions:

 

Case Study: Economic Value Added

 

While ‘value’ is a general term, “value added” has specific meanings. I teach Management Accounting and when I say “What is value added?” most of the students would say that it is ‘adding a feature to a product’. It may be product development but not necessarily value addition. I point to a multimedia hanging from the ceiling and say “This is presently rotated manually. Its present price is Rs.45,000. If the manufacturer introduces a feature for rotating through a remote control at an additional cost of Rs.15,000, would it be called value addition?” Most maybe inclined to say, “Yes Sir”, but it is “No Sir.”

Why, no one would pay a hefty sum of Rs.15,000 for the new feature. Even if someone is willing to pay, it still does not add any value. It is only when the manufacturer can fetch say Rs.65,000, value addition has occurred. In this way, by using a feature costing Rs.15,000, the manufacturer has realized an additional Rs.20,000 thereby increasing the bottom line by Rs.5,000.

Its Profit & Loss Accounts for the last year are given below:

 

An entity can increase Value addition by (i)bringing up new products or services which have a higher value in the eyes of a customer than the cost of inputs used such as materials, components and services used to make them, (ii) capture un-tapped market of new segments or geographical areas, (iii) improving quality and raising prices, (iv) reducing costs by switching over to cheaper raw materials, size reduction and combinations, and finally (v) reducing, as far as possible, non-value added activities such as setup, storage, transportation, wait and inspection.

In economics, the value addition is calculated by the following formula:

Value Added = Value of sales less the cost of bought-in goods and services.

In this formula, only cost of bought-in goods and services has been accounted for. It completely ignores labour cost, depreciation, mark-up etc. In fact, they are factors of production (land, labour and capital). They provide “services” which raise value of “inputs” to a much higher realized value. The difference would be shared among them.

The Valued added in our example and its distribution is shown in the below table:

 

Then what is Economic Value Added?

Economic Value Added (EVA) concentrates only on one of the factors of production i.e. Capital. It measures surplus value created by total investments which include funds provided by banks, bond-holders and share holders. It is more useful than Rate of Return (ROI) or Internal Rate of Return (IRR)in evaluating operations of an enterprise.

Accounting professor Steven Orpurt from Singapore Management University explains: “One of the primary insights from the EVA concept is recognition that growing earnings does not necessarily increase firm value or stock price. EVA focuses attention on how a firm uses its capital by asking, “Is a firm generating earnings above and beyond that expected by the market (the providers of the capital)?”

How relevant is EVA today? Responds Stern, “Some may say that EVA was a fad of the 1990s, but earning more than the cost of capital is not a fad. It is what all companies should do all of the time. That they do not is surprising. All of the talk on governance, also not a fad, never demanded this simple requirement. Until boards do, EVA will remain as relevant as it was in the 1990s.”

The relevant formula is:

EVA= (Return on Capital - Cost of Capital) x Total Capital

We need three figures:

1.      NOPAT

2.      Investment

3.      WACC

By dividing NOPAT with Investment, we get returns in percentage. From this, we deduct AWCC which is also in percentage; the difference would show %profit per rupee. By multiplying this with total capital, we capture EVA in rupee-terms.

 

Questions:

1.      Explain the term value added.

2.      How can an entity increase its value addition?

3.      Describe with formula, how is value addition calculated?

4.      How do we get returns in percentage?

5.      Read and summarise the case in about 50 words.

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