(b) To illustrate the relationship between EBIT (Earnings before income tax) and EPS (earnings per share) under alternative financing plans let us look at the data given below for two companies, Falcon motors and Star motors.


EBIT( Earnings before Income Tax) 2,000,000 4,000,000
Interest Expense 0 0
earnings before Tax 2,000,000 4,000,000
Tax (50%) 1,000,000 2,000,000
Profit after Tax 1,000,000 2,000,000
Number of Shares Equity Shares 2,000,000 2,000,000
Earnings per Share 0.500 1.000
• Let us take Case 1: Falcon motors wishes to raise an additional capital of Rs.10 million in order to finance an additional manufacturing CNC machine. Falcon motors has decided to go in with the option of Issue of equity shares, which come up to a million in number costing Rs.10 a share. Tax rate is constant at 50% and existing capital structure is 1 million equity shares of Rs.10 each. Let us calculate the EPS under two individual EBIT’s to better analyze the EPS value.


• Let us take case 2: Star Motors wishes to raise an additional capital of 10 million in order to finance an automatic assembling plant. Star motors decide to go ahead with the issue of debentures carrying 14% Interest. The assumptions are that there is a constant tax rate and there is an existing capital structure of 1 million equity shares of Rs.10 each. We calculate the EPS value for two capitals of 2 million and 4 million.

EBIT( Earnings before Income Tax) 2,000,000 4,000,000
Interest Expense 1,400,000 1,400,000
earnings before Tax 600,000 2,600,000
Tax (50%) 300,000 1,300,000
Profit after Tax 300,000 1,300,000
Number of Shares Equity Shares 1,000,000 1,000,000
Earnings per Share 0.300 1.300
In the above example’s if we consider the break even EBIT, it facilitates our judgment on which kind of financing to go for. Break Even EBIT is calculated using the formula,
(EBIT* - I1) (1- t) = (EBIT* - I2) (1- t)
n1 n2

Where,
EBIT* = indifference point between the two financing plans
I1 and I2 = interest expenses before taxes under case 1 and case 2
t = Income Tax rate
n1 and n2 = number of equity shares outstanding under the two financing plans.

In the above cases, if we take the case where in the EBIT stands at 2 million for the two companies, then the EBIT* will come up to about 2.8 million.

(EBIT* - 0) (1- 0.5) = (EBIT* - 1,400,000) (1- 0.5) 2,000,000 1,000,000

EBIT* = 2,800,000

Based on this figure we can come up with a few implications,
• If EBIT is below 2.8 million then equity financing is preferable to debt financing: if the EBIT exceeds 2.8 million, then the opposite holds true.
A manager will have to do a few calculations
• Compare the expected value of the EBIT with its indifference value.
• Access the probability of the EBIT value falling below its indifference value.
• Which kind of capital structure to go for minimizing the risks.
Earnings per share changes with the variance in EBIT levels. As levels of EBIT goes above the EBIT* value, there is a greater Earning per Share when there is debt financing.
In addition, when there is a lower level of EBIT there is a viable option of going in for equity financing over debt financing.

(c) The P/E ratio gives you an indication of how many times you are paying for a company's stock verse a company's earnings.
Calculated as:





For our calculations and discussions, let us take into consideration the companies TATA Motors and Maruti Suzuki Motors from India.
• TATA Motors –
Market value per share (as on march 12th 2007) = Rs.178
Earnings per share (EPS) = Rs. 49.65
Hence, the P/E ratio of TATA motors as on March 12th 2007 was 3.59.
• Maruti Suzuki Motors –
Market value per share (as on march 12th 2007) = Rs. 237.23
Earnings per share (EPS) = Rs. 54.07
Hence, the P/E ratio of Maruti Suzuki Motors as on March 12th 2007 was 4.39.

What can be observed from the above equation is that Maruti Suzuki Motors shares are more expensive as their P/E ratio is higher. Nevertheless, Tata Motors offers hope for those people who wish to buy a reasonably priced share offering a decent return. In general, a high P/E suggests that investors are expecting higher earnings growth in Maruti Suzuki in the future compared to Tata Motors with a lower P/E.
There might be different reasons for the changes in P/E ratio among companies. A few reasons that lead to a high P/E ratio are –
• The market expects the earnings to rise sharply in the near future. For Example in the above case, the company Maruti might be expected to bring out a popular car model next quarter, which will lead to a rise in sales. This causes the shareholders to buy out their shares leading to an increase in the share price hence with it the P/E ratio.
• The company just had a one-time expense and this led to a dip in earnings last quarter, but the earnings of the company is expected to come up again and retain its normal growth curve. In this case, the shareholders continue to buy the shares at the same rate and will sell at least the same rate keeping the high P/E ratio.
• Hype for the stock has created a huge demand for the shares, which causes people to buy the share at a rate higher than the market price causing a high P/E ratio. This is also known as a “Bubble Effect” in the market.
• The company has some business knowledge that will enhance the sale in the next quarter by a huge margin with minimum risk. This causes the shareholders to buy the shares frantically at a higher rate than the market quote causing the P/E ratio to increase substantially.
• A large amount of money has been inserted into the stock market, out of proportion with the growth of companies across the same period. Since there are, only limited amounts of stocks to buy, supply and demand dictate that the prices of stocks must go up.
• However, it must be noted that even though P/E ratio is a good indicator of the company’s position it might be misleading at times. There would be many factors and management decisions that might lead to variability in a company’s P/E ratio at times. Hence, the best option would be to look at 5-6 years P/E ratios and then decide on the company’s shares feasibility.











a) Dividend Policies may be analyzed as follows – let us take the examples of the companies TATA Motors and
TATA Motors
The shareholders at a general meeting have no power to declare any dividend. The shareholders at a general meeting may declare a lower, but not higher, dividend than that recommended by the Board. Dividends are generally declared as a percentage of the par value. No shareholder is entitled to a dividend while any lien in respect of unpaid calls on any of their shares is outstanding.
Tata Motors may only pay a dividend in excess of 10% of paid-up capital in respect of any year out of the profits of that year after they have transferred to their reserves a percentage of their non-consolidated Indian GAAP profits for that year. If the profit for a year is insufficient, the dividend for that year may be declared out of the non-consolidated Indian GAAP accumulated profits earned in previous years and transferred to reserves.
Over all Tata Motors follows a residual dividend policy with its dividend of at least 10% coming from its accumulated profits.

Dividend from Tata Motors over the years. (Residual Dividend Policy)
Year Month Dividend (%)
2007 May 150
2006 May 130
2005 May 125
2004 May 40
2004 Jan 40
2003 May 40
2002 Jun Figures not available
2001 Jun Figures not available
2000 May 25
1999 May 30
1998 Jun 55
1997 May 80

Even though Tata Motors follows a residual dividend policy, it is interesting to note that they have to compulsorily give out at least 10% of their accumulated profits.

Maruti Udyog on the other hand pays through a compromise dividend Policy.
Main characteristics of this type of dividend policy are -
• Avoid cutting back on positive NPV projects to pay a dividend
• Avoid dividend cut
• Avoid the need to sell equity
• Maintain a target debt/equity ratio
• Goals ranked in order of importance


Dividend given out by compromise dividend policy
Year Month Dividend (%)
2007 Apr 90
2006 Jul 70
2005 May 40
2004 May 30















{e} India Pharma Ltd.
India Pharma is engaged in the manufacture of pharmaceuticals. The company was established in 1991 and has registered a steady growth in sales since then. Presently the company manufactures 16 products and has a annual turnover of Rs 2200 million. The company is considering the manufacture of new antibiotic preparation, k-cin for which the following information has been gathered.
The equipment required for manufacturing k-cin is Rs 100 million.
The equipment will be depreciated at the rate of 25% per year for tax purposes.
K-cin is expected to have a product life cycle OF five years and thereafter it would be withdrawn from the market. The sales from this preparation are expected as follows :
Year 1: 180 million Rs
Year 2: 230 million Rs
Year 3: 290 million Rs
Year 4: 200 million Rs
Year 5: 140 million Rs
The following costs are estimated for manufacturing K-cin:
Raw material cost : 30% of sales
Labor cost : 20% of sales
Operating and maintenance cost : Rs 5 million
Overhead allocation : 10% of sales
The working capital requirement for the project is estimated to be 20% of sales. At the end of 5 years, the working capital is expected to be liquidated at par, barring an estimated loss of 5 million because of bad debt. The bad debt will be a tax-deductible expense.
The tax rate applicable to the firm is 22%.
The expected net salvage value after 5 years is Rs 20 million.
The manufacture of k-cin would also require some of the common facilities of the firm. The use of these facilities would call for the reduction in the production of other pharmaceutical preparations of the firm. This would entail a reduction of Rs 15 million of contribution margin.

Note: It is assumed that the level of working capital is adjusted at the beginning of the year in relation to the expected sales for the year.
In million (Rs)
DETAILS
YEAR 0 YEAR 1
YEAR 2
YEAR 3
YEAR 4
YEAR 5


Equipment cost
(100)

depreciation cost

(25)
(18.8)
(14.1)
(10.5)
(7.9)

sales revenue
180
230
290

200
140

raw material cost
Labor cost
Operating & maintenance cost
(30)
(20)
(5)
(45)
(30)
(5)
(60)
(40)
(5)
(45)
(30)
(5)
(30)
(20)
(5)

Level of working capital
(ending)
(20)
(30)
(40)
(30)
(20)
0

Bad debts

(5)

Recovery of working capital

15

Tax (22%)
(22)
(33)
(44)
(33)
(22)

Salvage value of equipment

20

Loss of contribution (15) (15) (15) (15) (15)

Net cash flow (∑)
(120)
33
43.20
81.90
41.50
70.10




Pay back

∑ (120) = (33) (43.20) (43.80)

Therefore 2 years+43.80 * 12 = 2years 6.5 months.
81.90

Pay back period = 2 years 6.5 months




Net present value


Year
Cash flow
Discount rate
Interest factor
present value

1
33
12%
0.893
29.47

2
43.20
12%
0.797
34.43

3
81.90
12%
0.712
58.32

4
41.50
12%
0.636
26.40

5
70.10
12%
0.567
39.75

Total = 227.98



Therefore, net present value = 227.98 – 120 = 107.97 million Rs

Net present value = 107.97 million Rs










Profitability index

Profitability index = cash inflow = 227.98= 1.90
Cash outflow 120


Profitability index= 1.90



Discounted payback

∑ (120) = (29.47) (34.43) (56.10)

Therefore 2 years+56.10 * 12 = 2years 11.65 months.
58.32

Pay back period = 2 years 11.65 months





Internal rate of return

Net present value @ 32% is – 3.42

Therefore,
IRR = A+ { a * [B-A] }
a-b

IRR = 12+ { 107.97 * [32-12] }
107.97-(-3.42)

IRR = 31.40%





• The main five non financial factors that affect decision making in businesses are –
1) Political environment – the political stability of the country that we intend to do business plays a major role in our decisions. Whether there are unnecessary, political interventions must be taken into account and our decisions must be based upon the nation’s laws and policies of trade and businesses.
2) Social environment – In some countries we must be careful not to hurt the nationalistic sentiments that people carry and our business decisions must take into account the local support structures.
3) Legal atmosphere – What’s legal in some countries might not be in some others, its as simple as that. Extra care must be taken to understand the laws of the nation thoroughly before we carry on with our decisions.
4) Market share – Our decisions must also take into consideration our present market share. Companies cannot go ahead and make some decisions, which seem to be very disharmonious with the current market share that it enjoys.
5) Geographic location and Basic Factors like resources – The location in which our company is located also plays an extremely important role in the decision making process. Decisions like how, where, when and so many other questions always arise based first on our location.

In extreme cases, neglect of non-financial aspects can cause the failure of a project despite very favorable financial components; or can even cause the failure to go-ahead with a project that may have been of great non-financial benefit due to its projected ordinary returns. Hence, non-financial aspects need careful analysis and understanding so that they can be assessed and properly managed.

(d) A working capital/total asset (WC/TA) is a ratio that is a good test for corporate distress, which is a measure of the net liquid assets of the firm relative to the total capitalization.


Ford Motor(million, USD) 2003 2004 2005 2006
Current Asset 172,168.0 210,156.0 200,142.0 182,835.0
Current Liability 82,288.0 52,676.0 95,790.0 80,220.0
Working Capital 89,880.0 157,480.0 104,352.0 102,615.0
Total Assets 315,920.0 292,654.0 269,476.0 278,554.0
WC/TA Ratio(percent) 28.45% 53.81% 38.72% 36.84%




GM(million, USD) 2003 2004 2005 2006
Current Asset 306,197.0 336,988.0 312,931.0 64,668.0
Current Liability 106,860.0 113,635.0 118,450.0 79,399.0
Working Capital 199,337.0 223,353.0 194,481.0 −14,731.0
Total Assets 448,507.0 479,603.0 476,078.0 186,192.0
WC/TA Ratio(percent) 44.44% 46.57% 40.85% −7.91%



During the year from 2003 to 2006, Ford Motor had significantly positive working capital. Accordingly, Ford’s WC/TA Ratio is showing positive and relatively mildly trend compares to GM, the average rate is around 39.455%. Therefore, Ford Motor rarely has trouble paying its bills.
For GM, in the year 2006, working capital contracted as a percentage of total assets, consistent with its continued operating losses and weak cash flow. This valuable liquidity ratio suggests that is facing a sharp decline in liquid assets. In 2006, GM has a negative working capital, which is likely to experience problems meeting its short-term obligations - because there are simply not enough current assets to cover them. It’s due to the sharply decreased in current asset, (including marketable securities, account receivable, current deferred income taxes, which are decrease the most significantly), from 306,197.0m to 64,668.0m, decreased by 78.8%.
However, based on accrued expenses and current deferred income taxes decreasing, the current liability decreased by 32.97%, the decreasing speed slower than current asset, total current liability more than total current assets. Therefore, there are showing negative working capital and WC/TA ratio. Ordinarily, GM was experiencing consistent operating losses will shrink current assets in relation to total assets.

Comment for cost of doing business:
Working Capital pays for day-to-day operating costs, high current liability will permits high level of accounts receivable, receivable, liberal credit policy, marketable securities, current deferred income taxes, etc. It basically will keep sales high, keeps customers happy, and motivate employees. The cost is high bad debt expense, and uncompetitive labor costs. On the contrast, low current liability keeps receivables low, tight credit policy (hard to get credit from them); it will keep low bad debt expense. But the cost is unhappy customers, employees, and sales drop.
For the current asset, as GE is an example, in the year 2006, GE decrease long-term debt, and starts to get short-term debt, because long-term debt usually has higher interest rate than short-term debt, pays more interest expense. Accordingly current asset also increase, it will usually carries lower interest expense.
Totally, working capital contracted as a percentage of total assets, consistent with its continued operating losses and weak cash flow.