1. INTRODUCTION Anita Jewels Ltd,, a new Public Limited Company, has been promoted by Shri D.P.

Maheshwari and his son, Shri G.R. Maheshwari, to set up a plant with installed capacity of manufacturing 80 lakhs watch -jewels per annum. Shri D.R Maheshwari is an Electrical Engineer and has long experience of working in a senior position in 3 companies. At present, he is working in an engineering company and likely to retire shortly. Shri. G.R Maheshwari did his graduation in Electrical Engineering from a University in U.S.A. After doing his graduation, he worked with a highly-reputed jewel manufacturing company in Switzerland for 10 years. He has returned to India last year and is at present working as a partner in a from dealing in dading and repair of all types of watches. During his services in Switzerland he has acquired practical experience in production, maintenance, quality control, etc. The production has been estimated at 1500 lakhs javels in 1994 against the demand of 2,800 lakh jewels. While there would be no dearth of demand for watch jewels, the sales would depend upon the quality of the jewels. With the experience of Shri G.P. Maheswari company would be able to produce quality watch jewels. The company has proposed to employ most modem methods for quality control and it is importing necessary electronic equipments for the purpose. It is hoped that the company would be able to maintain high precision standard. The company will effect its sales directly to the watch manufacturers. The elf, value of imported jewels is about Rs. 38 for 100 jewels and after adding import duty at 75%, it works out to about Rs. 66.5 for 100 jewels. As compared to this, the price fixed by the company at Rs. 55 for 100 jewels will be an encouraging factor for watch
10

manufacturers to accept the company's product. It is hoped that the company may not find any difficulty in marketing its product

11

2. STATEMENT OF THE PROBLEM The main raw materials required by the company are Ruby or Sapphire stones, The Company propose to use Ruby stones for the manufacture of proposed jewels. It has estimated its requirements at 1000 kgs. of Ruby stones for the production of 75 lakhs jewels. This quantity takes into account the process loss and rejection. The company has made enquiries with a reputed firm supplying Ruby stones which has indicated its willingness to enter Into an agreement for the continuous supply of Ruby -stones. The price of Ruby stone is quoted at Rs. 515/- per kg. and the same wilt increase to Rs. 525/- per kg after including-transportation and. -other costs. The company does not envisage any difficulty in continuous - supply of raw material,

12

3. DATA ANALYSIS AND MAJOR FINDINGS The company has also made necessary arrangements for power, water and other facilities required for the production. The capital cost of the project has been estimated at Rs. 66.89 lakhs as under: (Rs. in lakhs)
Land Building Plant & Machinery Imported (c.i.f.) Indigenous Import duty @ 40% of c.i.f. Transportation & erection Other fixed assets Electrical installation Preliminary & pre-operative expenses (including Rs. 3.00 lakhs of interest during construction period) Contingencies Margin for working capital 0.86 4.50 28.00 4.00 11.20 1.00 1.20 1.00 8.20 5.90 1.03 66.89

The company proposes to finance its project by raising the resources as under: (Rs. in lakhs) Share capital Term loan State Government's Special incentive loan (Repayable in 6 installments after 12 years) 9.89 66.89 30.00 27.00

13

The Profitability estimates of the company can be prepared on the following assumptions i. The company would work for 300 days on two shifts basis during a year. On this basis, its installed capacity will be 80 lakhs jewels per annum. ii. iii. It will start commercial production after one yean It proposes to produce 30,00,000 jewels in the first year, 48,00,000 jewels in the second year and 75,00,000 jewels from third year onwards, iv. The company would be selling entire production in the domestic market. The sale price of jewels is taken at Rs. 55 for 100 jewels, v. The cost of raw materials viz., Ruby stones is taken at Rs. 525A per kg. The requirements is estimated at 1,000 kg, per annum for manufacture of 75,00,000 jewels, vi. vii. Consumable stores or spares have been taken at Rs. 4.50 lakhs from third year onwards and proportionately for previous years. The annual expenses for power and water have been taken at Rs. 1.15 lakhs from third year onwards and proportionately for previous years. viii. Expenditure on repairs and maintenance is taken at Rs. 0.45 lakh- in the first year and an increase of Rs. 0.15 lakh is provided in each subsequent year, ix. The company will be employing 9 persons during first year, 12 persons in second year and 14 persons from third year onwards. Wages and salaries are provided at Rs. 2500 per month per worker. It is presumed that emoluments of each employee will increase by 10% every year from the year of his recruitment

14

x. xi.

An amount of Rs. 0.75 lakh is provided towards rent, insurance, etc. for each year. The depreciation has been provided at the rate of 5% on building, 15% on plant and machinery and 10% on miscellaneous fixed assets. It is calculated on straight line method for the purpose of profitability estimates and on written down value method for the purpose of calculating tax liability. According to straight line method, the amount of total depreciation to be provided in profitability estimates comes to Rs. 2.92 lakhs per annum. The details of depreciation are given in Annexure I.

xii.

Administrative expenses including management remuneration are provided at Rs. 110 lakhs in the first year and an increase of Rs. 0.10 lakh is provided in each subsequent year,

xiii. xiv.

The selling expenses are assumed at Rs. 0,02 per jewel The interest liability has been worked out at 12.5 per cent per annum on term loan and at 15 per cent per annum on bank borrowings for working capital The details of working capital requirements and bank finance are given in Annexure II The interest on bank borrowings for working capital at the rate of 15 percent per annum comes to Rs. 0.45 lakhs in first year, Rs. 0.66 lakhs in second year and Rs. 0.95 lakhs from third year onwards.

xv.

The term loan will be repaid in equal half yearly instalments from second year of its production. While calculating interest on term loan at the rate of 12.5 per cent per annum, the repayment of half yearly instalments as mentioned above may be taken into consideration and interest be calculated half yearly on the balance of the outstanding loan amount. The interest of
15

two half years may be added to get annual payment of interest on term loan. The details of interest on term loan are given in Annexure III. xvi. xvii. This company proposes to pay dividend at 10 per cent from 4th year onwards. Entire capital expenditure will be incurred during construction period of one year. On the basis of above assumptions, the profitability estimates, cash flow estimates and projected balance sheet of the company are prepared and given in Annexures IV, V and VI. It is suggested that those who do not have long experience of preparing financial projections may please prepare profitability estimates, cash flow estimates and projected balance sheet on the basis of above assumptions and compare their figures with the solution given in Annexure IV, V and VI. They can take the proforma from the solution, but figures should be calculated by them on the basis of assumptions. The figures of this case are used in subsequent chapters while illustrating the calculation of ratios, break-even point, internal rate of return and domestic resources cost.

16

ANITA JEWELS LTD. Assets Valuation for the Purpose of Depreciation Under the Income Tax Act, a company is permitted to write off preliminary expenses upto a limit of 25% of the project cost In the present case, 2.5% of the project cost (excluding margin money) i.e. 2.5% of Rs. 65.86 lakhs comes to Rs. 1.65 lakhs; say Rs. 1.60 lakhs. This can be written off at 10% every year for a period, of 10 years i.c. Rs. 0,16 lakhs every year. The balance of preliminary and pre-operative expenses viz., Rs. 6.60 lakhs (Rs. 820 lakhs minus Rs. 1.60 lakhs) and contingencies of Rs. 5.90 lakhs would be capitalised proportionately as under: Assets Value for Depreciation (Rs.in lakhs)
Cost Land Building Plant & Machinery Other Assets 0.86 4.50 44.20 2.20 51.76 Share of Share of preliminary Contingencies expenses 0.11 0.10 0.57 0.54 5.64 0.28 6.60 5.04 0.25 5.90 Total Cost 1.07 5.58 54.88 2.73 64.26

Depreciation on Straight Line Method Building (1.6%) Plant and Machiner (5%) Other ssets 0.09 2.74 0.09
2.92

17

Depreciation on Written Down Value Method

Years Building Plant & Machinery Other Assets Total

I II III IV V VI VII VIII IX X 0.28 0.27 0.25 0.24 0.23 0.22 0.21 0.20 0.10 0.18 8.23 7.00 5.95 5.06 4.30 3.65 3.10 2.64 2.25 1.91 0.27 0.25 0.22 0.20 0.18 0.16 0.15 0.13 0.12 0.11 8.78 7.52 6.42 5.50 4.71 4.03 3.46 2.97 2.56 2.20 ANITA JEWELS LTD.

Calculation of Working Capital Requirements*

Norms in Months Indigenous raw material 1. 2. 3. 4. (including consumable stores) Stock-in-process Stock of finished goods Accounts receivables (book debts) Total current assets Margin for working capita1 to be brought from long term resources (25% of total Current assets) 3.10 Trade credit available from Less: Suppliers of raw materials and consumable stores Bank finance for working capital 10 days 0.11 0.17 0.27 4.57 6.64 2 3/4 1 1/2 1 0.65 0.70 1.40 1.38 4.13 1.04 0.95 1.90 2.20 6.09 1.63 1.26 2.52 3.44 8.85

I Year

II Year

III Year

Less:

1.03

1.52

2.21

2.99

4.40

6.37

Procedure adopted for calculation of above working capital requirement:

18

The level of total current assets has been ascertained on the basis of the norms of the requirement. The annual requirement of each component can be ascertained from profitability estimates (Annexure IV) and from annual requirement; the level of each current asset can be ascertained by applying the norms of working capital requirement. The cost of stock in process and stock of finished goods can be ascertained from total manufacturing expenses given in profitability estimates. The level of accounts receivables can be ascertained from sales realization. As profitability estimates give figures for one year, they can be divided by 12 to get 1 months requirement which is multiplied by number of months requirement according to norms. The working capital requirements have been assessed for three years because the utilisation of capacity is gradually increasing in first three years. The level of production or utilisation of capacity remains at the same level from third year onwards. Therefore, it is presumed that the level of current assets will also remain at the same level in future. As per second method of lending suggested by Tandon Study Group and accepted by the Reserve Bank, 25 per cent of total current assets should be financed from long-term sources which is considered as margin money for working capital and included in the cost of project while considering long term requirements of funds. As this unit is likely to achive profit before providing for depreciation in the first year itself, margin money required for the first year at Rs, 1.03 1akhs has been included in the capital. Money for working capital owing to increase in production during second year and third year will be met from internal cash generations of the unit.

19

It can be said that preparation of profitability estimates also helps in finding the level of working capital for new companies. After ascertaining working capital requirement and the level of bank finance, interest on bank finance can be easily calculated with the help of the rate of interest charged by banks. The interest amount is subsequently added to other expenses already estimated in profitability estimates. Therefore, it is suggested that in case of new companies, profitability estimates may be prepared to ascertain direct manufacturing cost. Afterwards, working capital requirement can be ascertained and interest should be calculated on it. The profitability estimates can be completed after adding interest to other expenses already estimated.

20

ANITA JEWELS LTD. Calculation of Interest on Term Loan Outstanding Outstandin at the end of g at the end 1st of half year 30.00 28.00 24.00 20.00 16.00 12.00 8.00 4.00 Nil 2nd half year 30.00 26.00 22.00 18.00 14.00 10.00 6.00 2.00 -

Year of productio n I Year II Year III Year IV Year V Year VI Year VII Year VIII Year IX Year X Year

Outstandi ng at the beginning 30.00 30.00 26.00 22.00 18.00 14.00 10.00 6.00 2.00 -

Interest for 1st half-year 1.875 1.88 1.63 1.38 1.13 0.88 0.63 0.38 0.13 -

Interest for 2nd

Total interest on

half-year term loan 1.875 1.75 1.50 1.25 1.00 0.75 0.22 3.75 3.63 3.13 2.63 2.13 1.63 1.13 0.60 0.13 -

21

ANITA JEWELS LTD. SOLUTION TO THE CASE STUDY of FINANOIAL PROJECTIONS Profitability Estimates (Estimates of Working Results) (Rs. in Lakhs) Installed Capacity (Nos) Production (Nos.) % of production to installed capacity A. Sales realization Cost of Production 1. Raw materials 2. Consumables 3 Power, Fuel, Water, etc 4. Repairs & maintenance 5. Wages & salaries 6. Rent, insurance, etc. 7. Depreciation B. Total manufacturing expense (Total of items from lto7) 8. Administrative expenses I Year II Year III Year IV Year V Year VI Year VII Year VIII Year IX Year X Year 80 80 80 80 80 80 80 80 80 80 lakhs lakhs lakhs lakhs lakhs lakhs lakhs lakhs lakhs lakhs 30 48 75 75 75 75 75 75 75 75 37.5% 60.0% 16.50 2.10 1.80 0.46 0.45 2.70 0.75 2.92 11.18 1.10 26.40 3.36 2.88 0.74 0.60 3.87 0.75 2.92 15.12 1.20 93.75% 93.75% 93.75% 93.75% 41.25 1 5.25 4.50 1.15 0.75 4.86 0.75 2.92 20.18 1.30 41.25 5.25 4.50 1.15 0.90 5.35 0.75 2.92 20.82 1.40 41.25 5.25 4.50 1.15 1.05 5.89 0.75 2.92 21.51 1.50 41.25 5.25 4.50 1.15 1.20 6.48 0.75 2.92 22.25 1.60 93.75% 41.25 5.25 4.50 1.15 1.35 7.13 0.75 2.92 23.05 1.70 93.75% 41.25 5.25 4.50 1.15 1.50 7.84 0.75 2.92 23.91 1.80 93.75% 93.75% 41.25 5.25 4.50 1.15 1.65 8.62 0.75 2.92 24.84 1.90 41.25 5.25 4.50 1.15 1.80 9.48 0.75 2.92 25.85 2.00

22

9. Selling expenses C. Total Admn. & Selling expenses (Total of item8&9) 10. Interest on term loan 11. Interest on bank borrowings D. Total financial expenses Total of item No. 10 & 11 E. Total cost of production
(B + C + D)

0.60 1.70 3.75 0.45

4.20

0.96 2.16 3.63 0.66

4.29 21.57 4.83 0.16

1.50 2.80 3.13 0.95

4.08 27.06 14.19 0.16

1.50 2.90 2.63 0.95

3.58 27.30 13.95 0.16 2.70 11.09 29.05

1.50 3.00 2.13 0.95

3.08 27.59 13.66 0.16 0.70 2.70 10.10 39.15

1.50 3.10 1.63 0.95

2.58 27.93 13.32 0.16 7.66 2.70 2.80 41.95

1.50 3.20 1.13 0.95

2.08 28.33 12.92 0.16 7.43 2.70 2.63 44.58

1.50 3.30 0.60 0.95

1.55 28.76 12.49 0.16 7.18 2.70 2.45 47.03

1.50 3.40 0.13 0.95

1.08 29.32 11.93 0.16 6.86 2.70 2.21 49.24

1.50 3.50 0.95

0.95 30.30 10.95 0.16 6.30 2.70 1.79 51.03

17.08
0.58 0.16

Net operating profit (A-E) (-) Preliminary expenses written of

Taxation Dividend C/F loss/net surplus

Cumulative surplus

(-)0.74 (-)0.74

4.67 3.93

14.03 17.96

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Anita jewels ltd. CASH FLOW ESTIMATES (Rs. in lakhs) During Construction Sources of Funds Increase in share capital Net Profit after depreciation but before interest and taxes Depreciation Preliminary expenses written off Increase in term loans Trade credits Increase in bank borrowings State Government interest free loan Disposition of Funds Increase in capital expenditure Increase in current assets 30.00 9.89 66.89 64.26 27.00

I Year

II Year

III Year

IV Year

V Year

VI Year

VII Year VIII Year IX Year

X Year

3.46 2.92 0.16 0.11 2.99 9.64 4.13

8.96 2.92 0.16 0.06 1.41 13.51 1.96

18.11 2.92 0.16 0.10 1.97 23.26 2.76

17.37 2.92 0.16

16.58 2.92 0.16 _

15.74 2.92 0.16 _ -

14.84 2.92 0.16

13.88 2.92 0.16

12.85 2.92 0.16

11.74 2.92 0.16

20.45 19.66 -

17.92 -

16.96 -

15.93 -

14.82 -

18.82 -

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(Inventories and book debts) Preliminary expenses Repayment of term loan Interest Taxation Dividend Opening Balance Net Surplus Closing balance

1.60 65.86 1.03 1.03

4.20 8.33 l.03 1.31 2.34

4.00 4.29 10.25 2.34 3.26 5.60

_ 4.00 4.08 10.84 5.60 12.42 18.02

4.00 3.58 _ 2.70 10.28 18.02 10.17 28.19

4.00 3.08 0.70 2.70 10.48 28.19 9.18 37.37

4.00 2.58 7.66 2.70 16.94 37.37 1.88 39.25

4.00 2.08 7.43 2.70 16.21 39.25 1.71 40.96

4.00 1.55 7.18 2.70 15.43 40.96 1.53 42.49

2.00 1.08 6.86 2.70 12.64 42.49 3.29 45.78

0.95 6.30 2.70 9.95 45.78 4.87 50.65

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ANITA JEWELS LTD. Projected Balance Sheets At the end of Construct on period Liabilities Increase in share capita Reserves Term Loans Bank Borrowings Sundry Creditors State Government Loan Assets Gross Fixed Assets Less: Depreciation Net Fixed Assets Current assets (inventories and book debts) Preliminary expenses Cash and bank balances Carried forward loss I Year II Year III Year IV Year V Year 27.00 27.00 30.00 30.00 2.99 0.11 9.89 9.89 66.89 69.99 64.26 64.26 2.92 64.26 61.34 4.13 1.60 1.03 1.44 2.34 0.74 66.89 69.99 27.00 3.93 26.00 4.40 0.17 9.89 71.39 64.26 5.84 58.42 6.09 1.28 5.60 71.39 27.00 17.96 22.00 6.37 0.27 9.89 83.49 64.26 8.76 55.50 8.85 1,12 18.02 83.49 27.00 29.05 18.00 6.37 0.27 9.89 90.58 64.26 11.68 52.58 8.85 0.96 28.19 90.58 27.00 39.15 14.00 6.37 0.27 9.89 96.68 64.26 14.60 49.66 8.85 0.80 37.37 96.68 VI Year 27.00 41.95 10.00 6.37 0.27 9.89 95.48 64.26 17.52 46.74 8.85 0.64 39.25 95.48 VII Year 27.00 44.58 6.00 6.37 0.27 9.89 94.11 64.26 20.44 43.82 8.85 0.48 40.96 94.11 (Rs. inlakhs) VIII Year IX Year X Year 27.00 47.03 2.00 6.37 0.27 9.89 92.56 64.26 23.36 40.90 8.85 0.32 42.49 92.56 27.00 49.24 6.37 0.27 9.89 92.77 64.26 26.28 37.98 8.85 0.16 45.78 92.77 27.00 51.03 6.37 0.27 9.89 94.56 64.26 29.20 35.06 8.85 50.65 94.56

26

Ratio Analysis Ratio indicates the relationship between two or more than two (variables). Many important items like sales, profit, net profit, debt, equity, current assets, current liabilities, etc, do not give much information if each figure is studied in isolation. If a ratio is calculated between the related items, a banker can get meaningful information about the borrowing unit Ratios are useful for comparative study of various units and also of various years working of the same unit. Ratio can be calculated for the past record as well as for the future. Past record can be studied only in case of the existing undertakings by "analysing their balance sheets. Future records can be studied for existing undertakings as well as new undertakings by analysing their financial projections; "Ratios should be calculated from the figures of balance sheets to study past record and from figures of financial projections to study the future. Many ratios can be calculated to study financial position and working of a unit by applying different formulae. In order to have comparative study of several units and also several years of the same unit, it is necessary to follow uniform formula for calculating a particular ratio. As mentioned in earlier chapter on sources of finance, all India financial institutions are having common application form and common appraisal they also have co-ordination for supervision and follow-up. Therefore, they have developed common approach for calculating various ratios used for appraisal (pre-sanction) and follow up (post-sanction). Important ratios calculated by financial institutions are as follows:

27

I. Loan Safety Ratios or Appraisal Ratios i. ii. iii. iv. v. vi. Debt-equity ratio (Term liabilities to owned funds Current ratio (Current assets to current liabilities) Debt-service coverage ratio Fixed assets coverage ratio Break-even point (Discussed in a separate chapter) Internal rate of return (Discussed in a separate chapter)

II Profitability Ratios (i) (ii) (iii) (iv) (v) (vi) Profit before interest, lease rentals and depreciation (PBILD) to total income Operating profit to total income Return on capital employed Earnings per share (EPS) Price earnings ratio Dividend payout ratio

(vii) Interest coverage ratio III. Growth Ratios (i) (ii) (iii) Increase in PBILD Increase in net manufacturing sales Increase in gross fixed assets

IV. Turnover Ratios (i) (ii) (iii) Current assets holding ratio Raw materials holding ratio Stores holding ratio

28

(iv) (v) (vi)

Work-in-process holding ratio Finished goods holding ratio Collection ratio

(vii) Total income to net fixed assets ratio (viii) Capital turnover ratio V. Operating Ratios (i) (ii) (iii) (iv) (v) (vi) Raw materials to total cost Outside purchase to total cost Consumable stores to total cost Power, fuel and water to total cost Salaries and wages to total cost Marketing and selling expenses to total cost

(vii) Interest on lease rentals to total cost (viii) Depreciation to total cost (ix) Other residuary cost to total cost

VI. Other Ratios (i) (ii) (iii) (iv) Export sales to net manufacturing sales Imported raw materials and stores to total raw materials and stores Gross value added to capital employed Break-up value of equity share

We shall now discuss various components of each ratio and also utility of each ratio to study the financial position and working of a unit. I. Debt-Equity Ratio (Term Liabilities to Owned Funds)

29

This ratio indicates the relationship between term liabilities and owned funds and helps in assessing the capital gearing. As it was explained while discussing sources of finance, debt is cheaper to finance a project as compared to equity owing to taxation policy. While dividend on shares has to be paid from net profit after payment of tax, interest on borrowings is considered as an item of expenditure for arriving at profit for calculating tax. But a certain amount of equity is necessary to have cushion for debt. Higher the debt equity ratio, lower will be the margin available to the banker for its term loans. All items of capital and liabilities can be divided into (a) current liability, or (b) long term liability, or (c) equity on the basis of the period during which the liability is repayble. The instalments of the term debt repayable within one year and preference capital redeemable within one year should be treated as current liability and excluded for the purpose of long term debt-equity ratio. Similarly, fixed deposits repayable after one . year should be treated as long term debt for the purpose of long term debt-equity ratio and excluded from current liabilities. Preference share capital, sales tax loan and other incentive loans should be treated as quasi-equity and they may be included in equity only upto the period of time when their redemption/ repayment is due after three years. Thereafter, the preference shares/sales-tax or other incentive loans should be treated as part of liabilities. The following items should be included in debt: (i) (ii) Long term loans/deposits Debentureconvertible debentures to be treated as debt (except that part of debentures which is compulsorily convertible into equity) until they are converted
30

(iii) (iv) (v) (vi)

Preference share capital redeemable within three years Sales tax loan repayable within three years Other incentive loans repayable within three years Future lease rentals payable

(vii) Working capital term loan (viii) External commercial borrowings (ix) (x) (xi) Foreign suppliers' credit Deferred interest Unsecured loans and deposits.

It may be noted that installments of all the above dues payable within one year should be deducted from the total to arrive at the figure of long term debt because any liability is considered as long term debt when it is repayable after one year and as current liability when it is repayable within one year. The following items should be included in the equity: (i) (ii) (iii) (iv) Equity share capital Preference share capital redeemable after three years Any other types of share capital Free reserve and surplus (development rebate/investment allowance reserve, capital reserve, premium on issue of shares, capital redemption reserve, dividend equalization reserve, etc. are also treated as free reserves. However reserves created out of revaluation of assets are excluded. (v) (vi) Subsidy Sales-tax loan repayable after three years

(vii) Other incentive loans repayable after three years (viii) Subordinated loans from promoters
31

(ix)

Portion of debentures to be compulsory converted into equity shares.

Accumulated losses, arrears of depreciation, preliminary expenses to the extent not written off and goodwill should be deducted from the above total to arrive at the figure of equity. The debt-equity ratio is normally allowed around 1.5:1 depending on the nature of the industry, size of the project, priority of the project, gestation period involved, profitability potential, debt-service capacity of the project, risk involved in the project etc. Higher debt-equity ratio can be allowed for large size capital intensive units. Similarly, a liberal debtequity ratio is allowed in respect of projects set up in under developed/backward areas. It can also be high for certain projects like shipping industry where gestation period is very short. In case of small and medium projects having capital cost upto Rs. 5 crores which are eligible for refinance from SIDBI/IDBI, higher debt equity ratio may be allowed. As per the norms prescribed by SIDBI, debtequity ratio may be allowed upto 3: 1 for term loans upto Rs. 10 lakhs and 2: 1 for term loans above Rs. 10 lakhs. In case of modernization/rehabilitation assistance, flexible

approach is adopted for debt equity ratio depending upon, the profitability of the individual project. It may be observed from the above that institutions have adopted flexible approach in regard to debt-equity ratio depending on various relevant factors.

32

In order to find out overall debt position and capital gearing of the unit, financial institutions have recently started calculating total debtequity ratio where the total liabilitiesboth short term and long term are compared with the equity. However, no norms have been prescribed for this ratio so far. 2. Current Ratio (Current Assets to Current Liabilities) This ratio indicates the liquidity position of a unit following items should be included in current assets: (i) (ii) Cash and bank balances Investments a. Government and other Trustee Securities (other than for long-term purposes e.g., Sinking Fund, Gratuity Fund, etc.) b. Fixed deposits with banks (iii) Receivables arising out of sales other than deferred receivables (including bills purchased and discounted by bankers) (iv) (v) (vi) Instalments of deferred receivables due within one year Raw materials and components used in the process of manufacture including those in transit Stock-in-process including semi-finished goods (vii) Finished goods including goods in transit (viii) Other consumable spares (ix) (x) (xi) Advance payment for tax Pre-paid expenses Advances for purchase of raw materials, components and consumable stores.
33

(xii) Payment to be received from contracted sale of fixed assets during the next 12 months Following items should be included in the current liabilities: (i) Short term borrowings (including bills purchased and discounted) from (a) banks, and (b) others (ii) (iii) (iv) (v) (vi) Unsecured loans Public deposits maturing within one year Sundry creditors (trade) for raw materials and consumable stores and spares Interest and other charges accrued but not due for payment Advance/Progress payment from customers deposits are payable only when the dealership/agency is terminated, they may be treated as term liabilities (viii) Installments of term loans, deferred payment credits, debentures, redeemable preference shares and long term deposits payable within one year (ix) Statutory Liabilities a. Provident fund dues b. Provision for taxation c. Sales tax, excise, etc. d. Obligations towards workers considered as statutory e. Any other statutory liability payable within one year (x) Miscellaneous Current Liabilities: a. Dividends

(vii) Deposits from dealers, selling agents, etc., However, if such

34

b. Liabilities for expenses c. Gratuity payable within one year d. Other provisions e. Any other payments due within one year. Current assets should be more than current liabilities to provide necessay margin to the banker for working capital finance. Banks are providing working capital finance according to second method of lending recommended by Tandon Study Group. As per the second method of lending, atleast 25 per cent of total current assets should be financed from long term funds (owned funds and term borrowings) and it gives a minimum current ratio of 1.3:1. Therefore, while estimating the total requirement of long term funds for new projects, margin money for working capital should be calculated at 25 per cent of the expected total current assets. The requirement of margin money for working capital should be included in the capital cost of the project and long term resources should be provided to finance it like other fixed assets. If the current ratio of any unit is less than 1.33, efforts should be made to raise the long term sources (owned funds and term borrowings) to provide sufficient margin to the banker for working capital requirements. 3. Debt-service Coverage Ratio This ratio indicates the capacity of the unit to repay term loan and interest thereon. The formula for calculating this ratio is as under: Profit after tax + Depreciation + Interest on term debt + Lease rentals, if any ______________________________________

35

Repayment of term debt + Interest on term debt + Lease rentals, if any The above ratio should be calculated during the entire repayment period separately for each year and also as an average for the entire repayment period. The average debt-service coverage ratio (DSCR) should be computed by asking the total of all values of the numbers and denominator for the entire repayment period and not by taking an average of DSCRs for each year. This ratio should be generally about two. As this ratio indicates the capacity of a unit to repay the term loan, it is a very important ratio for a term lending institution. A term loan may not be repaid if the concerned unit does not generate profit. Repayment of term loan without generating profit will lead to Reduction in working capital, tight liquidity position and further deterioration in the working of the unit. Therefore, repayment schedule should be drawn on the basis of profitability estimates. The profitability estimates of Anita jewels Ltd, (a case study given earlier to explain financial projections) can be used to illustrate the calculation of debt-service coverage ratio as under:

36

ANITA JEWELS LTD. DEBT SERVICE COVERAGE RATIO Years A. Total cash accruals 1. Net profit (after tax) 2. Depreciation term loan Total of A B. Debt-service requirements 1. Repayment of term loan 2. Interest on term loan Total of B I -0.58 2.92 3.75 6.09 II 4.83 2.92 3.63 11.38 III 14.19 2.92 3.13 20.24 IV 13.95 2.92 2.63 19.50 V 12.96 2.92 2.13 48.01 VI 5.66 2.92 1.63 10.21 VII 5.49 2.92 1.13 9.54 VIII 5.31 2.92 0.60 8.83 IX 5.07 2.92 0.13 8.12 Total

111.92

3.75 3.75

4.00 3.63 7.63

4.00 3.13 7.13

4.00 2.63 6.63

4.00 2.13 6.13

4.00 1.63 5.63

4.00 1.13 5.13

4.00 0.60 4.60

2.00 0.13 2.13

48.76

The debt service coverage ratio varies between 1.47 to 3.81 and average for the entire repayment period comes to 2.30 which can be considered satisfactory. 4. Fixed Assets Coverage Ratio Term loans are generally sanctioned against the security of fixed assets. The excess of fixed assets over term loans secured by them provides margin on security. In order to find out the available security cover, fixed assets coverage ratio may be calculated by the following formula: Net fixed assets + Capital work-in-process __________________________________ Deferred credits + Term loans + Debentures secured by first charge over fixed assets + Other loans having pari passu charge on fixed assets In case of existing units, fixed assets to be created for implementation of the project are added to the present net assets (gross
37

fixed assets less depreciation). Similarly, proposed term loans are added to existing term loans if both have pari passu charge on fixed assets. If any fixed asset is having specific charge for a particular loan, the amount of such fixed asset and the loan should be excluded. If the amount of existing fixed assets includes any addition by revaluation, it should be deducted to find out the present net fixed assets. In case of new units, proposed fixed assets will cover the proposed term loans. Proposed fixed assets will be equal to the entire capital cost of the project except those preliminary expenses which will not be capitalised. It may be clarified that provision for contingencies provided while estimating the capital cost of a project forms a part of fixed assets because the amount of the provision, will be. utilised, if necessary, for creation of fixed assets. The fixed assets coverage ratio depends on dept- equity ratio. Higher the debt equity ratio lower will be the margin available because the amount of term loans will be higher for creation of fixed assets. As now-a-days emphasis is more on purpose-oriented advances than security-oriented advances, higher emphasis is given on debt-service coverage ratio to ensure repayment of term loans. Sometimes, financial institutions and banks are asking for collateral security or personal guarantee of promoters, if they find the risk involved in the project is very high.

38

5. Other Ratios The details of other ratios are given in the Annexure to this chapter. In order to illustrate the calculation of each ratio, the financial projections of Anita Jewels Ltd., a case study given in the earlier chapter have been used. It may be observed from profitability estimates of Anita Jewels Ltd. that it is expected to utilise 37.5 percent of its capacity in first year, 60.0 per cent in the second year and 93.75 per cent from third year onwards. Therefore, the figures of third year have been taken to demonstrate the calculation of each ratio from financial projections. Similar calculations can be done for other years.

39

CALCULATION OF VARIOUS RATIOS AND THEIR UTILITY

Name of the Ratio 1. Profitability Ratios Formula for calculation Ratios for Anita Jewels Ltd. Utility The ratios mentioned at Sr. Nos. 1 and 2 provide an
Profit before interest, lease rental and depreciation X 100 Net sales + Operational Income

idea about the relationship between profit & sales. Increase in sales is not sufficient, if margin of profit declines. In such cases, detailed study should be done to find out the reasons for decline in profitability.

Operational income includes income from sale of scrap, job/processing 1. PBILD to total income (%) charges, charges for technical services,

14.19 (Profit)+ 4.08 Interest + 2.92 (Depreciation) x 100 41.25 (Net sales) = 51.37 It does not have lease rentals

duty drawbacks royalty etc. Such income and also operational income comes from operations of the unit but does not from part of sales.

Operating profit X 100 Net sales - Operational income

2. Operating profit to total income (%) 3. Return on capital employed (%)

Operating profit = PBILD - (Interest +

14.19 X 100 = 34.40 41.25

lease rentals + depreciation) 1419 Opeartin profit + non - operationa l + 4.08 100 Net fixed assets + 8.85 income + Interest + Lease rentals X 100 Net fixed assets + lease rentals payable + Investment s + Current (Current assets) -0.27 (Creditors) =

It indicates the earning capacity of the assets deployed.

40

Capita1 employed should be calculated on the basic of assetd employed instead of libilities. Capital, work-in-progress and advances against capital expenditure are not included in capital employed as these assets do no start generating returns. Future lease rentals payable is taken as part of capital employed is they represent assets employed. The noninterest bearing current liabilities i.e., Provisions and crediters are excluded. It indicates the capacity to serve the equity capital. 4. Earnings per share (EPS) (in Rs.)
Net Profit - Preference dividend - Other dividend 14.19 = 5.26 No of equity shares at the end of the year 2 .7

28.51% It does not have nonoperational income, lease rentals, investments and provisions.

The rate of equity dividend should not be more than earnings shown by this ratio. It indicates under/over

5. Price earnings ratio (times)

Market Price of equity share (current) Earning per share

The share is not quoted in the market

41

pricing of the share in the market. It indicates the profit 6 Dividend payout ratio (%)

Equity Dividend 100 Net Profit - Preference dividend - Other dividend

No dividend is proposed to be declared during this year.

distributed to equity holders and the balance retained within business for investment. It indicates the ability of

7. Interest coverage ratio (times)

PBILD - tax Interest + Lease rentals

1419 + 4.08 + 2.92 =5.19 4.08

the unit to meet interest and lease rental commitments.

2. Growth Ratios 8. Increase in PBILD (%)

PBILD of current - PBILD of previous yer 100 PBILD of previous year

It indicates the trend of

21.19 - 12.04 100 = 76.0% 12.04

improvements/deterioratio n in the earning capacity.

9. Increase in net manufacturing sales (%)

41.25 - 26.40 100 = 56.25% Figures should be annualised, if any 26.40 accounting year is not for 12 months. Both the above growth Net manufacturing sales of current year It indicates the trend of increase/decrease ratios are high because Net manufacturing sales of previous year 100 in sales. Net manufacturing sales of previous year capacity utilisation has Figures should be annualised, if any increased during this year as accountant year is not for 12 months

compared to previous year.

42

10. Increase in gross fixed assets (%)

Gross fixied assets + Capital work in progress Future lease rentals payable (all at the end of current year) Gross fixed assets + capital work - in - progress + Future lease There is no increase in gross It indicates the trend of investments rentals payable (all the end)of previous year 100 Gross fixed assets + Capital work - in - fixed assets made in fixed assets. progress + Future lease rentals payable (all at the end of previous year Figures s hould be annualised, if any accounting year is not for 12 months.

3.Turnover Ratio Stocks of raw meterials + Finished goods 11.Current assets holding ratio (Months) +Work-in -progress + Stores, spares and packing in aterials + Receivables Gross sales/12 12. Raw materials holding ratio

8.85 = 2.58 months 41.25/12

It indicates the extent to which the gross working capital is turned around in a year.

Stock of raw materials 0.88 = 2.0 months Raw matrial consumed during the year/12 5.25/12

The ratios mentioned from serial nunber 12 to 16 indicate the level of

43

13. Stores holding ratio (months)

Stock of stores 0.75 = 2.0 months Consumaile stores used during the year/12 4.50/12 Stock of work - in - process Cost of production/12 1.26 = 0.75 months 20.18/12

the holdings of various inventories and receivables. These ratios are very useful for banks providing working capital finance to judge the efficiency of the management in

14. Work-in-procef holding ratio (months)

15. Finished goods holding ratio (months)

Stock of finished goods Cost of goods sold/12

2.52 20.18/12

= 1.50 months

utilisation of inventories and recovery of receivables. If increasing trend is shown in holdings, detailed study should be done to find out the reasons.

16. Collection ratio (months)

Receivables (including contingent liability for 3.44bills discounted = 10 month Gross sales/12 41.25/12 Net sale + Other income(operatinal) 41.25 Net fixed assets Future lease rentals payable 55.50
= 0.74
The ratios mentioned at serial No. 17 and 18 indicate the relationship between total value of

17. Total income 1o net fixed assets ratio (times)

44

18. Capital turnover ratio (times)

Net sale + Other income (operational) + other income (non operational) 41.25 firm comparison of these ratios within Net fixed assets + Future lease rentals payable = 0.64 55.50 + 8.85 - 0.27 same industry may indicate the investment + currentassestsProvisions - Creditors
been used.

goods sold and funds deployed. Inter

efficiency with which capital assets have

4.Operating Ratios The ratios mentioned from Sr. No. 19 to 27 indicate the comparative cost of various inputs. While preparing profitability estimates, the appraising

19. Raw materials to total cost (%)

Raw meterial consumed 100 Total cost !

5.25 27.06

x 100 = 19.40%

It

officer should be very careful about estimating the cost of any component which has high importance to total cost. If it is not possible to estimate its cost properly, sensitivity analysis should be done for that component. The study of these ratios may also help in inter firm comparison.

does not have any outside Purthases.

45

20. Outside purchase to total cost (%)

Outside purchase 100 Total cost Consumable stores 100 Total cost Power fuel and water 100 Total cost 4.50 x 100 = 16.63% 27.06 1.15 x100 = 4.25% 27.06 4.86 Xl00 = 17.96% 27.06

21. Consumable stores to total cost (%)

22. Power, fuel and water to total cost (%)

salaries and wages 100 Total cost 23. Salaries and wages to total cost (%)

24. Marketing and selling expenses to total cost (%)

:

All the expenses relating to marketing and selling 100 1.50 x100 = 5.54o/o Total cost 27.06 Interest + lease rentals 100 Total cost

25. Interest and lease rentals to total cost

4.08 x 100 = 15.08 27.06

46

26. Depreciation to total cost (%)

Depreciation 100 Total cost other residuary cost 100 Total cost

2.92 27.06 2.80 27.06

x 100 = 10.79%

27. Other residuary cost to total cost (%) 5.Other Ratios 28. Export sales to net manufacturing sales

x 100 = 10.03%

Export sales 100 Net manufacturing sales

The ratios mentioned at serial No. 28 and It does not have any export sales 29 indicate the relative importance of the project for earning/spending foreign exchange. However, it is better to study exchange rate of the project or domestic It does not have any import resources cost (discussed in the chapter of raw materials and stores on Economic Appraisal) to know the relative importance of the Project in the international market.

29. Imported raw materials and stores to total raw materials and stores

Imported raw materials and stores 100 Total raw materials and stores

47

41.25 - (5.25 + 4.50 + 1.15 = 0.47 55.50 + 8.85 - 0.27

(Net manufacturing sales + Closing stock of finish goods aad work - in - process) No adjustment has been - (Opening stock of finished goods and work made for level of stocks in - process + Cost of raw materials + Outside purchase + Consumable stores + packingbecause projections have expenses + Power, fuel and water been made in the case stud] Net fixec assets + Lease rentals on the assumption the entire payable + Investments + Current assets production is sold and Provisioils - creditors

It indicates the requirements of capital for increasing the gross output. All direct mateirial inputs are deducted from net sales. / t

30. Gross value added to capital employed (times)

stocks are maintained at the same level. Packing material has been included in consumable stores. Equity Share capital + Reserves and surplus Intangibles/Losses. Preference dividend 27.00 + 17.96 - 1.12 = 16.24 2.7 arrears evaluation amount No of Equity shares at the end of the year

31. Break-up value of equity share (Rs.)

It indicates real value of the share as per financial position of the unit.

48

49

Break-even Point Break-even Point is the point at which the unit neither earns profit nor incurs losses. The cost of production is just recovered at the breakeven point. The cost of production can be divided into two categories, viz., Fixed Cost and Variable Cost, Division of total cost into fixed cost and variable cost is a difficult task because a few expenses can be counted under both the categories. They neither remain fixed nor change in the same proportion in which the level of production changes. Therefore, a banker should follow the uniform policy for each industry to divide the total cost into fixed and variable cost to enable him to compare the break- even point of one unit with another unit in the same industry. Following practice may be followed for dividing the cost into fixed and variable cost. Fixed Cost (Including Semi-fixed Cost) A certain amount of cost has to be incurred by a unit irrespective of level of production. It will not change with the change in the level of production. Since in the short run, the semi-fixed cost may not vary materially with the level of output, the entire semi-fixed cost is added to the fixed cost for the purpose of calculating break-even point. Cost incurred on following items may be included into fixed and semi-fixed cost: (i) Salaries and wages (ii) Repairs and maintenance (iii) Administrative and miscellaneous expenses (iv) Fixed portion of selling expenses

50

(v) Fixed royalty and know-how payments (vi) Interest on term debt (vii) Depreciation on straight line basis (not to be included for cash break-even calculation) Variable Cost or Marginal Cost Variable cost or marginal cost varies with the variation in the level of production. It is presumed that it changes in the same proportion in which the level of production changes. The cost incurred on following items mayb e included into variable cost. (i) Raw materials (ii) Outside purchases (iii) Purchase of goods for re-sale (iv) Packing materials (v) Power, fuel and water (vi) Royalty payments linked to sales (vii) Variable selling expenses (viii) Interest on working capital (ix) Other variable expenses varying directly in proportion to output. Selling Price Selling price is the price at which the unit is selling its product It should be taken after excluding excise duty. If it is taken gross and excise duty is also counted in the selling price, the excise duty should be included as an item of variable cost. It is better to take selling price (net of excise duty) and avoid excise duty as an item of expenditure. Other incomes like import entitlements, export incentives, etc. should be
51

included in selling price. In the case of units having multi-products, it is presumed that the same product mix will be continued. . Contribution and Break-even Point Difference between sale price and variable cost is called contribution. The contribution helps a unit to recover its fixed cost. The level of production at which the contribution recovers entire fixed cost is called break-even point. For example, if fixed cost is Rs. 6,000, sale price is Rs. 12 per unit and variable cost is Rs. 6 per unit, the break-even point will be at the production of 1,000 units because the contribution of Rs. 6 per unit (sale price-variable cost) will recover the entire fixed cost of Rs. 6,000 at the production of 1,000 units. It can be calculated by using the following formula:

Fixed Cost Fixed Cost Break event Point = = Sale Price Variable Cost Contribution

Break-even point can be calculated from figures of balance sheets to Study past record and from figures of profitability estimates to study future. While calculating break-even point from profitability estimates, it is better to calculate it on the basis of figures when the unit is likely to achieve the normal level of production. Break-even point can be expressed in terms of a. volume of production, or b. a percentage of installed capacity, or c. amount of sales. Example of Calculation of Break-even Point
52

The figures of profitability estimates of Anita Jewels Ltd., (a case study given earlier while explaining financial projections) can be used to illustrate the calculation of break-even point. It may be observed from financial projections of Anita Jewels Ltd., that the company proposes to utilise 37.5% of its capacity in the first year, 60,0% in the second year and 93 75% from third year onwards. As the unit is likely to achieve normal level of production in third year, the break-even point can be calculated on the basis of the estimates provided for third year. While dividing the total cost into fixed and variable cost, selling expenses have been treated as variable cost because this unit is manufacturing industrial goods and a major portion of selling expenses relates to packing charges and commission payable to selling agents which varies with sales. Wages and salaries have been treated as semi-fixed/fixed cost presuming that it may be difficult for the unit to retrench its trained staff even on reduction in the production. In order to maintain good quality, the company does not keep casual labourers. After dividing the total cost into fixed and variable cost the break-even point has been calculated as follows on the basis of estimates provided for third year when the-unit is expected to achieve normal level of production

53

Example of Break-even Point - Anita Jewels Ltd., (Rs. in lakhs)

Based on the year of normal level of Production (III year production at 93.75% of installed capacity) A. Variable Cost Raw materials Consumable stores Power, Fuel, Water, etc. Selling expenses Interest on working capital B. Fixed Cost (Including semi-fixed cost Repairs and maintenance Wages and salaries Rent, Insurance, etc. Depreciation Administrative expenses Interest on term loans C. Sales Realisation D. Contribution (C-A) Break-even point (in terms of volume of production) 5.25 4.50 1.15 1.50 0.95 13.35 0.75 4.86 0.75 2.92 1.30 3.13 13.71 41.25 27.90
= Fixed Cost 75 lakhs jewels Contribution = 13.71 75 lakhs jewels 27.90

= 36.85 lakhs jewels

In order to find the break-even point in terms of volume of production, the figures of break even point have been multiplied by 75 lakhs jewels because the production in that year has been estimated at 75 lakhs jewels. Break - even point (in terms of percentage of installed capacity)
= 13.71 9.75 27.90 = Fixed Cost 93.75 Contribution

54

= 46.07% of installed capacity In order to find the break-even point in terms of the percentage of installed capacity, the figures of break-even point have been multiplied by 93.75 because the utilisation of capacity in that year has been estimated at 93.75% of the installed capacity. Break-even point (in terms of amount of sales)
= Fixed Cost Rs. 41.25 lakhs Contribution 13.71 Rs. 41.25 lakhs 27.90

= Rs. 20.27 lakhs In order to find the break-even point in terms of amount of sales, the figures of break-even point have been multiplied by Rs. 41.25 lakhs because sales realisation in that year is estimated at Rs. 41.25 lakhs. It may be observed from the above that the figures of break-even point are coming in various terms as under: B.E.P. in terms of volume = of production = 36.85 lakhs jewels B.E.P in terms of percentage of installed capacity = 46.07% B.E.P in terms of amount of sales = Rs. 20.27 lakhs The above figures can be cross-checked as under with the help of total capacity of the unit at 80 lakhs jewels and sale price of Rs. 0.55 per jewel: Total capacity -80 lakhs jewels B.E.R in terms of installed capacity = 46.07%

55

Production at B. E. P. =80 lakhs jewels

46.07 100

= 36.85 lakhs jewels Amount of sales at B.E.P. = 36.85 lakhs jewels x sale price = 36.85 lakhs jewels x Rs. 0.55 =Rs. 20.27 lakhs. As the unit illustrated above is manufacturing watch jewels for which demand is ensured and it is not likely to face any difficulty regarding procurements of raw material and other necessary inputs, the break-even point at 46.07% of installed capacity can be considered highly satisfactory for this unit. Calculation of Break-even Point for Appraisal While appraising a project, the break-even point should be expressed in terms of the percentage of installed capacity to know the margin of safety in the capacity. The absolute volume of production or amount of sales alone does not convey much meaning unless it is expressed as percentage to total capacity. Therefore, banks and financial institutions use the following formula to know the break-even point in terms of the percentage of installed capacity:
Break-even point (in terms of percentage of installed capacity)

Fixed Cost utilisation at which total = contribution is arrived at Contribution

Percentage capacity

As the break-even point is calculated on the basis of estimates provided for the year in which the unit is likely to achieve normal level of

56

production, the figures of sales, cost, variable cost and percentage capacity utilisation of that year are taken for calculation break-even point according to above formula. Case break-even point may be calculated on the basis of same formula without taking depreciation as part of fixed cost. Utility of Break-even Point for Appraisal Break-even point indicates the level of production which is necessary to avoid losses. Break-even point can be called bread earning point because a unit earns profit from sales above break-even point. Sales above breakeven point indicate the margin of safety available to a unit. Break-even point should be low for units likely to have difficulties regarding marketing or non-availability of raw materials or shortage of power or any other difficulties in achieving utilisation of full capacity. For example, breakeven point should be low for the units manufacturing air-conditioners or television sets because their marketing may be difficult and utilsation of capacity may be low. Similarly, break-even point for a hotel should be low because all the rooms may not be fully occupied throughout the year. But a unit manufacturing cement can have high break-even point if raw material, power and market for finished product are assured. A private entrepreneur will prefer to close his plant when variable cost is more than sales price and the situation is not likely to improve in near future. He will lose only fixed cost by closing such plant, but if he runs the plant he will lose not only fixed cost but also excess of variable cost over sale price. Whenever banks or financial institutions consider any proposal for rehabilitation of a six unit, they must ensure that sale

57

price will be higher than variable cost and some contribution will be available to recover the fixed cost and unit will achieve the break even point. Break-even point can be calculated with sensitivity analysis also by assuming increase/decrease in fixed cost or variable cost or sale price. Break-even point can be used for comparative study of various proposals within the same industry. Discounted Cash Flow TechniquesNet Present Value and Internal Rate of Return A project should earn sufficient return which should be at least equal to the cost of the funds invested in it. If many alternative Proposals are available for the investment, the investor should make a comparative study of the return on various proposals. Following methods have been suggested for evaluating the profitability of industrial projects: 1. Pay-Back Method 2. Average Rate of Return Method 3. Net Present Value Method 4. Internal Rate of Return Pay Back Method The object of this method is to ascertain the period required for recovering the entire -investment made in a project. The cash inflow includes net operating profit after adding back to it the amount of depreciation on fixed assets and amortization of intangible assets, if any, less income-tax payable during the year. The cash inflow is accumulated, year by year, until it equals the original investment. The length of time

58

required for total cash inflow to recover the original investment is called the pay-back period. For example, a project needs original investment of Rs. 1000 and its estimated cash inflow (net operating profit + depreciation and other non-cash write offs added back-income tax) is as follows: Original Investment: Rs. 1000 Cash inflow of each year 100 150 250 300 300 Cumulative Cash inflow 100 250 500 800 1100

Year 1 2 3 4 5

Pay back period to recover original investment of Rs. 1000 comes to 4 years and 8 months [Rs. 800 is recovered in 4 years and to recover balance amount of Rs. 200, 8 months are required because the rate of recovery is Rs. 25/- per month (300 4 12) in fifth year]. Although the calculation of pay back period is simple, it ignores the time value of money and does not take into account the income which may be received beyond the pay back period. Sometimes, a project having higher pay back period may be better than lower pay back period owing to higher return after pay back period. For example, two projects having original investment of Rs. 1,000/- each are having cash inflow as under: Comparison of Two Projects by Pay Back Method Project A -Original Investment Project B - Original Investment

Year

59

Rs.1000 Annual Cash Inflow 200 400 300 100 -

Cumulative 200 600 900 1000 4 years

Rs. 1000 Annual Cash Inflow 100 150 200 250 300 250 250 150 100

Cumulative 100 250 450 700 1000 1250 1500 1650 1750 5 years

1 2 3 4 5 6 7 8 9

Pay Back Period

According to pay back method, project A is better because the entire investment is recovered in 4 years against 5 years required for project B. But project A recovers only original investment and it does not have earning capacity after 4 years, whereas project B earns much more than its original investment. Pay back method ignores the cash inflow received after crossing the pay back period and does not give the rate of return However, this method can be used where emphasis is on avoidance of long term risk or on the liquidity value of investment. For example, while investing in a foreign country where political stability cannot be forecasted for a long period or while investing in a plant which is likely to become obsoletes shortly, this method can be used to judge suitability of investment. Average Rate of Return Method Under this method, the entire life of a project is taken into account, unlike the payback period. An average of the annual net operating profits (after depreciation) for the entire life of the project is taken and rate of
60

return on original investment and average investment is calculated. Average investment of one year can be ascertained by taking the average of opening and closing book value of investments in the year. The grand average of such average investments of all the years is obtained to know the average investment for the project. Average profit is divided by original investment and average investment to get the rate of return on them. An example giving comparison of three projects by average rate of return method is given below:

61

Comparison of three projects by AVERAGE RATE OF RETURN METHOD (Amount in Re.) Net operating profit (after depreciation) Year I Year II Year III Year IV Year V Year VI Total profit Project 'A' 300 400 400 200 200 1500 Project 'B' 50 150 200 800 300 1500 Project 'C' 300 300 300 300 300 300 1800

Life of project 5 years Average annual profit 300 Original investment 2000 Return on Original Investment 15% Return on .Average -Investment Presuming Average investment at Rs. 30% 1000)

5 years 300 2000 15% 30%

6 years 300 2000 15% 30%

It may be observed from the above example that income received in earlier years is more for project 'A' as compared to Project 'B'. But this method does not give any importance to the time value of money. Further total income of project 'C' is more than project 'A' and 'B'. But its annual average is same because the life of the project is longer than that of the other two projects. This method does not take into account the life differential of projects. Time Value of MoneyDiscounting Technique
62

Pay back method and average rate of return method do not consider the time value of money. The initial amount incurred for acquisition of assets to implement a project and income received from the project in future is given equal importance under the above two methods. But in fact the value of money received in future is not equivalent to the value of money invested today. In other words, a rupee in hand now is more valuable than a rupee to be received in future because cash in hand can be invested elsewhere and interest can be earned on it. For example, if Rs. 100 is invested at the annual interest often per cent, it will increase as under: Rs. 100 today is equal to Rs. 110 afterone year Rs. 121 after two years (Rs. 100 + Rs. 10 of interest) (Rs. 110 + Rs. 11 of interest) (Rs. 121 + Rs. 12.1 of interest),

Rs. 133.1 after three years and so on.

The above example gives an idea of the compounding. Increase of the present value in future. The opposite of compounding is called discounting. If we want to know the present sum from the future sum, we have to discount the future sum. Taking the above example, it can be said that Rs. 110 after 1 year is equal to Rs. 100 today or Rs. 121 after two years is equal to Rs. 100 today or Rs. 133.1 after three years is equal to Rs. 100 today. It can be expressed as under: Rs. 110 alter 1 year is equal to Rs. 100 today, or Re, 1 after 1 year is equal to Rs.
100 110

= Rs. 0.909 today

63

Rs. 121 after 2 years is equal to Rs. 100 today or Re. 1 after 2 years is equal to Rs.
100 121

= Rs. 0.826 today.

Rs. 131.1 after 3 years is equal to Rs. 100 today or Re. 1 after 3 years is equal to Rs.
100 133.1

= Rs. 0.751 today.

The above example can be expressed by following figures: Relationship of Future and Present Values (Interest rate 10 per cent)

Now Compounding Discounting Discounting or Present Value factors Rs. 100 Rs. 100 Rs. 100 Rs. 100 100 110 = Rs. 0.909 100

After 1 year Rs. 110 Rs. 110

After 2 years Rs. 121 Rs. 121

After 3 years Rs. 133.1 Rs.133.1

Re. 1

Re. 1 121 = Rs. 0.826 100 Re. 1 133.1 = Rs. 0.751

If rate of return is 10 percent, 0.909, 0.826 and 0.751 are the discounting factors to know the present value of future sums after 1, 2 and 3 years respectively, If we multiply the future sum with discounting factor, we can get the present value. The discounting factors are given in discounting tables according to the different rates of return and different periods (years). An extract of discounting tables for 10 per cent to 30 per
64

cent and upto the period of 20 years is given as an annexure to this chapter. While calculating present value of future sum, take the discounting factor from discounting tables according to the period and rate of return and multiply the future sum by discounting factor to get the present value. This relationship between present and fixture values can be shown by following figure:
Present Amount Multiply by compounding factor ________________________________ ________________________________ Multiply by discounting factor Future Amount

Mathematically, future value can be calculated by using the following formula: Future value = Present value x (1 + r)n r represents rate of interest per period (per year) n represents number of period (years) Likewise, the present value of a future sum can be calculated by using the following formula:
Present value = Future sum (1 + r ) n

In practice, the tedious method of calculating present value bymeans or the above formula is avoided and discounting tables are used, The future value is multiplied by relevant discounting factor taken from discounting tables to get the present value.

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Net Present Value Method After understanding discounting technique, we shall now discuss the net present value method. Under this method, the cash flows of all the years during the expected life of the project are discounted at a predetermined cut-off rate and net present value is obtained. The cut-off rate should be either equal to or more than the cost of funds. A positive net present value at the cut-off rate indicates that the investment in the project gives profits greater than the marginal investment rate or cost of capital and hence the proposal can be accepted. If net present value is zero, it indicates that the total earnings from the project are equal to marginal investment rate. If net present value is negative, it indicates that total earnings from the project are less than the marginal investment rate or cost of capital An example showing calculation of net present value of two projects at 15% discount rate is given below:

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Comparison of Two Projects by Net Present Value Method Project A Investment in 0 year & Discountin cash inflow g factor at in other Year Year 1 Year 2 Year 3 year 4 Year 5 Total Inflow Total Outflow Net Present Value years -1000 +300 +400 +400 +300 +300 +1700 -1000 15% Present Value Project B Investment Discountin in 0 year & g - Present cash inflow in other years 0.870 0.756 0.658 0.572 0.497 -1000 +261.0 +302.4 +263.2 +171.6 +149.1 +1147.3 -1000 +147.3 +200 +300. +500 +400 +300 +1700 -1000 factor Value at 15% 0.870 0.756 0.658 0.572 0.497 -1000 +174.0 +226.8 +329.0 +228.8 +149.1 +1107.7 -1000.0 +107.7 Present Value

1. It is presumed that life of both the projects is 5 years. 2. Investment in both the projects is Rs. 1000 each. Entire investment is done in one year of construction period, The first year construction period is considered as zero year and no discounting is necessary for zero year. Therefore, present value of investment remains at Rs. 1000 each for both the projects. 3. The cash inflow has been discounted at the rate of 15% presuming that the cost of funds or cut-off rate is 15. 4. Discounting factors at 15% have been taken from discounting tables for 1st year to 5th year, 5. Present value of cash inflow has been obtained by multiplying the inflow by its respective discounting factors. 6. Although total cash inflow in 5 years is same (Rs.1700) for both the projects, project A has higher net present value because cash inflow in initial years is more in project A as compared to that
67

in project B. As discounting is just opposite of compounding, the discounting factor to find present value from future values gets reduced with the increase in years. The timing of cash flow makes all the difference in favour of project A. If investment in both the projects is same, the project with higher net present value is referred. But two projects having different investment outlay should not be compared by net present value because it indicates the excess amount in absolute terms. For example projects X and Y are having initial investment of Rs. 5,000 and Rs, 10,000 respectively. Their net present value is as under: (Amount in Rs.) Project X Present value of investments (costs) Present value of cash inflows (benefits) Net present value Project Y -10,000 +11,000 + 1,000

-5,000 +6,000 +1,000

If we see the absolute figure of net present value, project Y appears better than project X. But in fact project X is better because in project X, an investment of Rs. 5,000 provides a net present value of Rs. 1,000, whereas in project Y, an investment of twice that amount provides a net present value of only Rs. 1000. In such a situatioin, profitability index should be calculated by using the following formula to compare the two projects having different investment outlays:
Profitability Index = Present value of cash inflows Pr esent value of cash outflows

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Profitability Index of Project X

6,500 =1.20 5,000

Profitability Index of Project Y = 10,000 =1.10 As profitability index of project X is more than that of project Y, it can be concluded that 'Project X is better than project Y. Higher the Profitability index better is the project. Internal Rate of Return Net present value method indicates fhe net present value of the cash flows of a project at a predetermined interest rate, but it does not indicate the rate ol return of the project. In order to find out the rate of return of a project, estimated net cash flows of each year are discounted at various rates till a rate is obtained at which the sum of positive present values is equal to the sum of negative present values or the net present value comes to zero. Such a rate is called internal rate of return. In other words, internal rate of return is that rate of discount which would equate the present value of investments (cash outflows) to the present value of benefits (cash inflows) over the life of the project Internal rate of return cannot be determined by just looking at the cash flows. It is calculated by trial and error method. Various discounting rates are applied to the net cash flows until a rate is found that reduces the net present value to zero. Usually cut-off rate is chosen at the starting point. If net present value at the cut-off rate comes positive, the internal rate of return is further calculated by increasing the discounting rate. If net surplus comes negative, the discounting rate is reduced. The exercise is done till a rate is found when the present value of net cash flow comes to zero. As this is a tedious and time consuming process, an interpolation
69

11,000

formula can be used after arriving at a range between which the internal rate of return lies. The example of project 'A' given earlier while explaining net present value method can be used to demonstrate the calculation of internal rate of return . First the cash flows are discounted at 15% as already done in the illustration of net present value method. As net surplus comes positive at 15 per cent the cash flows are discounted at 20 per cent. As net surplus comes positive even at 20 percent the cash flows are discounted at 25 per cent as under (Amount in Rs.)
Discounting factor at 15% (2) 0,870 0.756 0.658 0.572 0.497 Present Value at 15% (1x2) (3) -1000.0 +261.0 +302.4 +263.2 +171.6 +149.1 +1473 Discountin g factor at 20% (4) 0.833 0.694 0.579 0.482 0.402 Present Value at 20% (1x4) (5) -1000.0 +249.9 +277.6 +231.6 +144.6 +120.6 +24.3 .Discounting factor at 25% (6) 0.800 0.640 3.512 0.410 0.328 Present Value at 25% (1x6) (7) -1000.0 +240.0 +256.0 +204.8 +123.0 +98.4 -77.8

Cash flow (1) Year 0 -1000 Year 1 +300 Year 2 +400 Year 3 +400 Year 4 +300 Year 5 +300 Net present value

As the net present value comes positive at 20 per cent and negative at 25 per cent, the internal rate of return should be between 20% and 25%. In order to arrive at internal rate of return, the following interpolation formula can be used:
Interpolation formula

Internal rate of return at the lower

Difference between the two

Net present value at the lower discount rate Absolute difference between the net present value at the two discount rates

70

discount rate =20 =20 =20 + + +

discount rates 5 5 1.19 x x

24.3 24.3 + 77.8 24.3 102.1

= 21.19 or say 21% To test the validity of the above formula, if we discount the cash flows as 21% the net present value will be almost negligible as under (Amount in Rs.) Discounting factor at 21% 0.826 0.683 0.564 0.467 0.386

Cash flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 -1000 +300 +400 +400 +300 +300 Net present value

Present Value -1000 +247.8 +273.2 +225.6 +140.1 + 115.8 +2.5

The present value of 2.5 is too small and can be ignored. The internal rate of return for above example comes to 21%. It may be mentioned that we should not try to interpolate between a range of more than 5 per cent. In other words, while using the interpolation formula, we should ensure that the difference between lower discount rate on which the net present value comes positive and higher discount rate on which the net present value comes negative, is not more than 5. If the difference is more than 5, it is better to use the discounting tables and reduce the difference between the two discounting rates for

71

calculating the internal rate of return with the help of interpolation formula. Information needed for Calculation of Net Present Value and Internal Rate of Return It may be observed from the earlier discussions that the following information is required for calculation of net present value or internal rate 1. Life of the project 2. Cash outflow (amount of investment for capital expenditure and working capital) 3. Cash inflow (benefits of the project) 4. Residual or terminal value of the project 5. Net cash receipt and calculation of internal rate of return 6. Pre-determined cut-off rate or minimum rate of return 7. Cost of capital. 1. Life of the Project The life of the project means the estimated period (in terms of number of years) during which it will be economically productive. It should be shortest of (a) physical life, or (b) technological life (equipment obsolescence), or (c) product market life (product obsolescence) because a project will become unproductive due to any of the above reasons. The life of a project should not be based on the rate of depreciation used in the books of accounts. Generally, life of an industrial project is taken as 12 years for most of the projects. However, in certain industries such as chemicals, petrochemicals and electronics, where the rate of technological obsolescence is faster, project life may be taken less than 12 years depending on technological progress and emerging market
72

competitiveness. In the case of hotel industry, where the major assets are in the form of building, a longer project life may be assumed. For shipping industry, life of the project can be taken equal to the balance life of the ship assumed by income tax authorities. Law agricultural projects like growing coconuts, construction of irrigation dams, etc. may have life of 40-50 years. But the present value of the future amount goes on decreasing with an increase in number of years. It we take 50 years as project life, the present value of the income recived at 50th year will be almost negligible. Therefore, while calculating internal rate of return, life of a project is generally not taken above 25 years. 2. Cash Outflow Resources are used in a project for acquisition of two kinds of assets, viz., fixed assets and current assets. Fixed assets mean project cost minus margin for working capital and interest during construction period. Any expenditure which is incurred after commencement of production for maintaining the life and productivity of fixed assets should be charged to repairs and maintenance. However, expenditures incurred on additions to fixed assets, if any, should be shown in cash outflow of the year in which they are incurred. In addition to the cost of fixed assets, the requirement of working capital (current assets minus current liabilities other than bank borrowings) are shown in cash outflow. The requirement of working capital increases with the increase in the level of production in the initial years and expected to remain at the level of normal year of operations when maximum production is achieved.

73

Implementation period or construction period of a project is considered as zero years. However, If implementation period of a project exceeds one year, the first year of the implementation should be treated as zero year, the second as first year and so on. The first year of operations may therefore become the second or the third year depending on the implementation period. The life of the project should be taken after implementation of the project. For example, if implementation of a project takes three years and life of the project is taken for twelve years, the cash flow may have to be prepared from zero year to 14 years to indicate the cash flow position of 3 years of project implementation and 12 years of the project life. 3. Cash Inflow Cash inflow includes the profit earned from operations of the project during life of the project and residual or terminal value of the project in the last year of operations. Profit should be taken before interest, lease rentals, depreciation and tax for each year during the estimated life of the project. As interest and lease rentals represent the return of funds employed, before payment of depreciation also because the amount of depreciation remains within the unit and it does not involve cash outflow. As the purpose of calculating internal rate of return is to find out the income generating capacity of the total funds invested in the project, we should avoid distortions caused by changing the pattern of financing. The amount of interest and direct tax depends on debt-equity position, If the debt-equity ratio is high, the amount of interest will also be high and direct tax may be low because interest is a deductable item of expenditure for the purpose of direct tax. The amount of interest and direct tax will
74

change with the change in debt-equity ratio. Therefore, while calculating internal rate of return for the purpose of comparative study of various projects regarding their income generating capacity, profit should be taken before payment of tax. In other words, interest, lease rentals and depreciation are added back to the profit before tax while taking cash inflow for calculating internal rate of return of various projects. If we wish to calculate internal rate of return from the point of view of equity holders, benefits of the project should be taken after deduction of the tax. Net profits (Profit after deduction of the tax) should be taken in the cash inflow. In other words, profit after tax should be taken and interest, lease rentals and depreciation should be added back to it. Financial institutions are calculating internal rate of return by taking profit before tax and also profit after tax. In other words, financial institutions are calculating two internal rates of return, one before tax and another after the tax. In both the cases, interest, lease rentals and depreciation are added back to the profit while taking cash inflow. If we want to calculate economic rate of return from the point of view of economy, we may have to recast the cash flow on the basis of shadow prices which may reflect socially desirable use of each input and output and calculate internal rate of return from the recasted cash flow, (Details of economic appraisal are discussed in the next chapter) 4. Residual or Terminal Value of the Project Assets will have some value even at the end of the estimated life of the project. The residual value of assets should be added to cash inflow of the last year of the project life. The value of land can be taken at its cost price shown in cash outflow because it does not depreciate. The salvage
75

value of other fixed assets (other than land) can be taken at 5% of cash outflow shown for them. Recovery of current assets used for working capital may be taken at the amount shown for their investment in the cash outflow, 5. Net Cash Receipt and Calculation of Internal Rate of Return The difference between cash outflow and cash inflow is called net receipt. It may show negative figures in initial years owing to high outflow-on investment in fixed assets and working capital assets. It may start showing positive figures when the level of production and profitability is increased. The net cash receipt may be discounted on various discounting rates to know the present value till a rate is ascertained on which the sum of positive present value is almost equal to the sum of negative present value or in other words, the net present value comes to almost zero. The rate of discounting on which the net present value comes to almost zero is called internal rate of return. In order to arrive at the internal rate of return, interpolation formula can be used after arriving at a range of discounting rates between which it lies. Many financial institutions are taking the help of computers to calculate internal rate of return from the cash flow estimates. 6. Pre-determined Cut-off Rate or Minimum Rate of Return Although pre-determined cut-off rate is not required to calculate internal rate of return, it is necessary to compare the internal rate of return with the pre-determined cut-off rate to take a decision regarding financing a project. A project is generally accepted if the internal rate of return is higher than the pre-determined cut-off rate. The cut-off rate is decided on the basis of Availability of capital in the economy and the desired growth

76

rate in the industrial sector. Generally, financial institutions in India take 15% as cut-off rate and may provide finance if internal rate of return (before tax) is higher than 15%. It indicates that a project should have income generating capacity of at least 15%. A relaxation in the cut-off rate can be allowed if a project is considered highly useful for the economy due to other considerations like increase in employment, distribution of income in favour of weaker sections, development of backward areas or saving/ earning of foreign exchange. 7. Cost of Capital The internal rate of return calculated on the basis of profit after tax should be higher than cost of funds employed in the project. The total cost of a project (capital cost of the project plus working capital requirement) in the year of normal operations) can be financed by various sources like equity capital, retained earnings, preference capital, subsidy, convertible debentures, term loans, bank borrowings for working capital, etc. The cost for different sources of funds may be taken as under:
(i) Equity share capital (ii) Cash accruals/ Retained earnings (iii) Subsidy/Incentive loans : : : :15% 15% To be treated free of cost Interest rate charged by the agency providing loan X (1-Average applicable tax rate). Average applicable tax rate may be different than the national prevailing tax rate because of various tax : benefits available to a unit. The average applicable tax rate can be calculated by the following formula:
Total tax liability durin the life of the project 100 Total operating profit during the life of the project

(iv)

Debt (Term loans from institutions/banks, nonconvertible debentures, bank borrowings for working capital, unsecured loans from public, etc.)

(v)

Cost of convertible debentures

The cost of non-convertible portion may be

77

calculated on the lines indicated above for the term loans. Cost of convertible portion should be the same as cost of equity, i.e. 15% The working capital requirement in the year of normal operations may be financed by banks (vi) Cost of working capital : borrowings, equity/cash accruals, term loans, etc. The cost of each source may be calculated as indicated above.

The total cost of each source can be calculated by multiplying the amount used in the project with its above rate of the cost. The cost of all the sources or the total capital used in the project can be calculated by taking the weighted average of the above cost. Example of Calculation of Internal Rate of Return The figures of profitability estimates of Anita Jewels Ltd., (the case study given earlier while explaining financial projections) can be used to illustrate the calculation of internal rate of return. The cash outflow, inflow, net receipt and present value of net receipt at various discounting rates are given in the Annexure I to this Chapter. These figures taken from the case study of Anita jewels Ltd., can be explained as under: i. Cash outflow represents capital expenditure in zero year and initial working capital requirement in the first year and increase in working capital requirement with the increase in level of production in second and third years. As the production remains at the level of third year, it is presumed that working capital requirement remains at that level in subsequent years and no additional cash is required after third year. ii. (II) Capital expenditure is worked out as under: (Rs. in lakhs}
78

Project Cost Less: (a) Margin money for working capital 1.03 (b) Interest during construction or project implementation period 3.00

66.89

4.03 62.86

It is presumed that entire construction is done and capital expenditure is incurred in one year. Therefore, it is shown against zero vear, the year of construction work. iii. The requirement of working capital in the first year and increase in it in second and third year with the increase in the level of production is worked out as under:

79

(Rs. in lakhs) First Year Second Year Third Year Total current assets 4.13 6.09 8.85 Less : Trade credit available 0.11 0.17 0.27 Requirement of working capital 4.02 5,92 8.58 Cash outflow for working capital 4.02 1.90 2.66 (5.92-4.02) (8.58 - 5.92 iv. Cash-inflow has been taken on the basis of profit before tax as well as profit after tax. In both the cases, interest and depreciation have been added back to the profit. Thus, net cash receipt has two series and we will be able to calculate two internal rates of return one before tax and another after the tax. v. The cash inflow of 12th year includes salvage value or terminal value of assets as under

80

(Rs. in lakhs)

Land Other fixed assets (other than land) (5% of cash outflow shown for other fixed) assets, viz., Rs. 62.86 0.86 = Rs. 62.00 lakhs) shown for working capital requirement, viz., Rs. 4.02 + 1.90 + 2.66 = Rs. 8.58 lakhs)

0.86 3.10

8.58 12.54 vi. The net cash receipt represents the difference between cash outflow and cash inflow. As cash inflow has been taken on the basis of profit before tax as well as profit after tax, net cash receipt also automatically comes in two series on the basis of profit before tax and profit after tax. The figures of net cash receipt are discounted at various rates to find out the internal rate of return.

vii. In case of the net cash receipts taken on the basis of profit before tax, net present value comes positive at 20 per cent discounting rate and it comes negative at 25 per cent discounting rate. Therefore, internal rate of return (before tax) lies between 20 per cent and 25 per cent. We can now find out the internal rate of return within the range of 20 to 25 per cent with the help of interpolation formula discussed earlier.
Internal Rate of Return = 20 + 5 0.57 0.57 + 11.61

= 20 + 5

0.57 12.18

81

=20+0.234 = 20.234 or20% In practice, it is sufficient if internal rate of return is expressed in nearest whole number. Therefore, internal rate of return (before tax) for the case study of Anita jewels Ltd., can be mentioned as 20 percent. viii. In case of net cash receipt taken on the basis of profit after tax, net present value comes positive at 15 per cent discounting rate and it comes negative at 20 per cent discounting rate. Therefore, internal rate of return (after tax) lies between 15 per cent to 20 per cent. Internal rate of return can be located between 15 to 20 per cent by using the interpolation formula as under
Internal Rate of Return =15 + 5 2.47 2.47 + 10.08

=15 + 5

2.47 12.55

= 15 + 0.98 =15.98 or 16% It may be observed from the above that internal rate of return on the basis of cash receipts after tax comes to 16 per cent Example of Calculation of Cost of Capital The figures of the case study of Anita jewels Ltd., can be used to illustrate the calculation of the cost of capital also. The project has been financed by equity capital of Rs. 27 lakhs, term loans of Rs. 30 lakhs and State Government's special incentive loan of Rs. 9.89 lakhs. After implementation of the project, bank borrowings have been taken for financing working capital requirements. In the first year of production, the total requirement of working capital is estimated at Rs. 4.02 lakhs

82

which has been raised to Rs. 5.92 lakhs in the second year and to Rs. 8.58 lakhs in the third year. The working capital requirement remains at the same level in future as the production also remains at the same level. The requiement of Rs. 4.02 lakhs in the first year has been financed by bank borrowings of Rs.2.99 lakhs and margin for working capital of Rs. 1.03 lakhs included in the capital cost of the project. The increased requirement of working capital in the subsequent years with the increase in production has been financed by increased bank borrowings. However, margin requirements of second year and third year have been financed from the internal generations. Various sources of financing the total cost of the project including working capital requirement can be summarised as under: ANITA JEWELS LTD. Cost of Capital Employed
Sources of financing 1. Equity and cash accruals 2. Term loan 3. Special incentive loan 4. Bank borrowings for working capital Total cost Amount (Rs. in lakhs) 28.18 30.00 9.89 6.37 74.44 Cost of funds (Rate) .15% 12.5% x (1-38.54%) =7.68% Nil 15.0% x (1-38.54%) = 9.22% Total cost of funds (Rs. in lakhs) 4.23 230 Nil 0.59 7.12

Average cost: 7.12 74.44 = 9.56% The above calculations can be further explained as under i. Equity and cash accruals of Rs. 28.18 lakhs includes equity capital of Rs 27.00 lakhs used for project implementation and remaining Rs. 1.18 lakhs represents the internal cash generations

83

used for providing margin for working candial requirements as given under: Amount (Rs. in lakhs)
Total working capital requirement in normal year of production Margin for working capital, included in capital Less (a) cost of the project Bank borrowings for working capital in the (b) normal year of production Balance amount financed from internal accruals 8.58 1.03 6.37 7.40 1.18

ii. Term loan of Rs, 30.00 lakhs and special incentive loan of Rs. 9.89 lakhs have been used for project implementation, iii. Bank borrowings of Rs. 6.37 lakhs represent the total bank borrowings taken for working capital in the normal year of the production, i.e., third year of production and thereafter. iv. It is the practice of the financial institutions to take cost of equity and cash accruals at 15 per cent. The cost of loans is taken as per the rate of interest charged by agency providing loans. It has been mentioned in the case study that interest is charged on term loan at 12.5 per cent and on bank borrowing for working capital at 15.0 per cent. No interest is charged on the special incentive loan provided by the State Government. v. As interest payable on term loan and bank borrowings is deducted from the income while calculating tax liability, the rate of interest payable to the institutions and banks has been multiplied by i average applicable tax. The average applicable tax rate has been calculated as under:
Total tax liability during the life of the project (Rs. 49.93 lakhs) Total operating profit during the life of the project (Rs. 129.56 lakhs)

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vi. The total cost of Rs. 7.12 lakhs has been divided by total capital of Rs. 74.44 lakhs employed in the project to find out the average cost of the funds in the project. Thus, the average cost of total funds employed in the project comes to 9.56 per cent. The above examples indicating the calculations of internal rate of return and cost of capital from the figures of the case study of Anita Jewels Ltd, have given an idea about the methodology followed for their calculation. The theoretical concept has been made clear by giving the example from the figures of the same case study which was used for demonstrating the financial projections. The internal rate of return for Anita Jewels Ltd. comes to 20 per cent on the basis of profit before tax and 16 per cent on the basis of profit after tax. It can be concluded that internal rate of return is an important technique used by entrepreneurs and financial institutions for evaluating the profitability of projects. With the help of internal rate of return, financial institutions can decide ranking of various projects according to their income generating capacity and select the suitable projects for financing keeping in view the other relevant factors. It can be said that internal rate of return helps the entrepreneurs and financial institutions to a great extent while taking a decision on financing a project.

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ANITA JEWELS LTD. Cash Flow for Calculation of Internal Rate of Return Year Cash out-flow Cash inflow Before After tax tax 3 1 2 3 4 5 6 7 8 9 10 11 12 Net Cash Receipt Before After tax tax (-)62.86 2.52 1014 18.53 20.45 18.96 11.16 10.49 9.78 9.07 8.12 8.12 20.66 Present value of net Present value of net cash receipt (before tax) At 25% cash receipt (after tax) At At 20% Discount -62.86 2.52 7.04 10.73 9.86 7.90 6.30 5.00 3.95 3.09 2.40 2.00 3.06 -62.86 +63.43 +0.57 20% Discount -62.86 2.10 6.49 9.49 8.38 6.45 4.93 3.76 2.85 213 1.59 1.27 1.89 -62.86 +51.25 -11.61 At 15% Discount -62-86 210 7.67 1219 11.70 9.42 4.82 3.94 3.20 2.58 2.01 1.75 3.86 -62.86 +65.33 +2.47 16% 20% Discount -62.86 210 7.04 10.73 9.86. 7.62 3.76 2.92 2.28 1.76 1.32 1.10 2.31 -62.86 +52.78 -10.08

62.86 (-)62.86 4.02 6.54 6.54 2.52 1.90 12.04 12.04 10.14 2.66 21.19 21.19 18.53 20.45 20.45 20.45 19.66 18.96 19.66 18.82 11.16 18.82 17.92 10.49 17.92 16.96 9.78 16.96 15.93 9.07 15.93 14.82 8.12 14.82 14.82 18.12 14.82 27.36 0.66 27.36 Sum of negative figures of present value Sum of positive figures of present value Net present value Internal Rate of Return

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Discounting Tables (Present Value of Re. 1 Receivables at the End of Each Year) Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 0.350 0.319 0.290 0463 0.239 0.218 0.198 0.180 0.164 0.149 11 0.901 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.353 0.317 0.286 0.258 0.232 0.209 0.188 0.170 0.153 0.138 0.124 12 0.893 Q.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0,257 0.229 0.205 0.183 0.163 0.146 0.130 0.116 0.104 13 0.885 ; 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 Percentage 14 15 0.877 0.870 0.769 0.756 0.675 0.658 0.592 0.572 0.519 0.497 0.456 0.400 0.351 0.309 0.270 0.237 0.208' 0.182 0.160 0.140 0.123 0.108 0.095 0.083 0.073 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 0.107 0.093 0.081 0.070 0.061 16 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 0.195 0.168 0.145 0.125 0.108 0.093 0.080 0.069 0.060 0.051 17 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.043 18 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.071 0.060 0.051 0.043 0.037 19 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 6.209 0.176 0.148 0.124 0.104 0.088 0.074 0.062 0.052 0.044 0.037 0.031 20 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026

|0.231 0.204 0.181 0.160 0.141 0.125 0.111 0.098 0.087

87

88

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

21 0.826 0.683 0.564 0.467 0.386 0.319 0.263 0.218 0.180 0.149 0.123 0.102 0.084 0.069 0.057

22 0.820 0.672 0.551 0.451 0.370 0.303 0.249 0.204 0.167 0.137 0.112 0.092 0.075 0.062 0.051

23 0.813 0.661 0.537

0.437

0.355 0.289 0.239 0.191 0.155 0.126 0.103 0.083 0.068 0.055 0.045

24 0.806 0.650 0.524 0.423 0.341 0.275 0.222 0.179 0.144 0.116 0.094 0.076 0.061 0.044 0.040

Percentage 25 0.800 0.640 0.512 0.410 0.328 0.262 0.210 0.168 0.134 0.107 0.086 0.069 0.055 0.044 0.035

26 0.794 0.630 0.500 0.397 0.315 0.250 0.198 0.157 0.128 0.099 0.079 0.062 0.050 0.039 0.031

27 0.787 0.620 0.488 0.384 0.303 0.238 0.188 0.148 0.116 0.092 0.072 0.057 0.045 0.035 0.028

28 0.781 0.610 0.477 0.373 0.291 0.227 0.178 0.139 0.108 0.085 0.066 0.052 0.040 0.032 0.025

29 0.775 0.601 0.466 0.361 0.280 0.217 0.168 0.130 0.101 0.078 0.061 0.047 0.037 0.028 0.022

30 0.769 0.592 0.455 0.350 0.269 0.207 0.159 0.123 0.094 0.073 0.056 0.043 0.033 0.025 0.020

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5. Conclusion It may be observed from the above that various ratios are calculated to study various aspects of a unit. However, all ratios do not have equal importance to a term lending institution. Debt-equity ratio and debt-service coverage ratio are vital for a term lending institution. Profits earned by a unit and repayment schedule of the term loan are reflected in debt-services-coverage ratio. Similarly, debt-equity ratio indicates the amount of cushion available to the term lending institution. Current ratio is very important for a bank providing working capital finance. It-may also-be mentioned that a ratio by itself does not have much significance unless it is compared with an appropriate standard. The comparison can be-done from one company to the average of the industry and also one year to other years of the same company depending on the nature of the ratio, object of the study and availability of data.

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