Test 11: answer key

Question 1 · 2 marks · Management of Working Capital · medium

Scenario. Aakash Exporters has annual credit sales of Rs 90,00,000 and an average collection period of 60 days. It currently incurs credit administration cost of Rs 1,20,000 per year, of which two-fifths is avoidable if receivables are factored. Bad debts are 1.5 percent of credit sales. A factor offers non-recourse factoring with a commission of 2 percent on average receivables, a reserve of 10 percent of receivables, and an advance carrying interest at 15 percent per annum for the collection period. Assume 360 days in a year and ignore one-time costs.

What is the factoring commission charged on average receivables?

1. Rs 30,000 (correct answer)
2. Rs 1,80,000
3. Rs 15,000
4. Rs 27,000

Answer: A — Rs 30,000

Working. Average receivables = 90,00,000 x 60 / 360 = Rs 15,00,000. Factoring commission = 15,00,000 x 2 percent = Rs 30,000.

Explanation. Factoring commission is computed on average receivables because the factor purchases or administers the receivables. Average receivables are annual credit sales multiplied by collection period divided by 360. Commission at 2 percent on Rs 15,00,000 is Rs 30,000. The other options either apply the commission to annual sales or use incorrect rates.

Where it goes wrong. Applying 2 percent directly to annual credit sales of Rs 90,00,000 gives Rs 1,80,000, which is incorrect for a commission on average receivables.

Authority. Chapter 9: Management of Working Capital - Financing Receivables - Factoring

Question 2 · 2 marks · Management of Working Capital · hard

What is the net advance available to Aakash Exporters after reserve and interest?

1. Rs 13,20,000
2. Rs 15,00,000
3. Rs 12,87,000 (correct answer)
4. Rs 12,00,000

Answer: C — Rs 12,87,000

Working. Average receivables = Rs 15,00,000. Commission = Rs 30,000. Reserve = 10 percent x 15,00,000 = Rs 1,50,000. Amount available for advance = 15,00,000 - 30,000 - 1,50,000 = Rs 13,20,000. Interest = 13,20,000 x 15 percent x 60/360 = Rs 33,000. Net advance = 13,20,000 - 33,000 = Rs 12,87,000.

Explanation. The amount available for advance is average receivables less factoring commission and reserve. Interest is deducted on this amount for the collection period. The net advance is Rs 13,20,000 less interest of Rs 33,000, giving Rs 12,87,000. Options a and b ignore interest or reserve, and option d uses an arbitrary deduction.

Where it goes wrong. Deducting reserve but not commission, or deducting interest on gross receivables instead of on the amount available for advance.

Authority. Chapter 9: Management of Working Capital - Financing Receivables - Factoring

Question 3 · 2 marks · Management of Working Capital · hard

What is the effective annualised cost of factoring, ignoring savings, based on net advance?

1. 21.3 percent
2. 29.4 percent (correct answer)
3. 31.2 percent
4. 35.0 percent

Answer: B — 29.4 percent

Working. Total cost = Rs 30,000 + Rs 33,000 = Rs 63,000. Effective annualised cost = 63,000 / 12,87,000 x 360/60 x 100 = 29.37 percent, approximately 29.4 percent.

Explanation. Total factoring cost before savings is commission plus interest, namely Rs 63,000. This cost is compared with net advance and annualised by multiplying by 360 divided by 60. The result is about 29.4 percent. Option a is a rough nominal estimate, while options c and d use incorrect bases.

Where it goes wrong. Using gross receivables or amount available for advance instead of net advance as the denominator.

Authority. Chapter 9: Management of Working Capital - Financing Receivables - Factoring

Question 4 · 2 marks · Financing Decisions - Capital Structure · medium

Scenario. Zenith Ltd requires Rs 50,00,000 for expansion. Plan A is to issue equity shares of Rs 10 each for the entire amount. Plan B is to raise Rs 20,00,000 by 10 percent debt and the balance by equity shares of Rs 10 each. The corporate tax rate is 30 percent. EBIT is expected to vary across years.

What is the indifference EBIT between Plan A and Plan B?

1. Rs 3,00,000
2. Rs 4,00,000
3. Rs 5,00,000 (correct answer)
4. Rs 6,00,000

Answer: C — Rs 5,00,000

Working. Plan A shares = 50,00,000 / 10 = 5,00,000. Plan B shares = 30,00,000 / 10 = 3,00,000. Indifference: EBIT x 0.70 / 5,00,000 = (EBIT - 2,00,000) x 0.70 / 3,00,000. 3 EBIT = 5 EBIT - 10,00,000. EBIT = Rs 5,00,000.

Explanation. The indifference EBIT equates EPS under the two financing plans. Plan A has 5,00,000 shares and no interest. Plan B has 3,00,000 shares and interest of Rs 2,00,000. Solving the EPS equality gives EBIT of Rs 5,00,000. Other options arise from arithmetic errors in the equation.

Where it goes wrong. Ignoring tax in the equation is harmless because the same tax rate applies, but ignoring the lower number of shares under Plan B gives an incorrect answer.

Authority. Chapter 5: Financing Decisions - Capital Structure - EBIT-EPS Indifference Point

Question 5 · 2 marks · Financing Decisions - Capital Structure · hard

If EBIT is Rs 4,00,000, which plan gives higher EPS?

1. Plan A gives higher EPS (correct answer)
2. Plan B gives higher EPS
3. Both plans give equal EPS
4. EPS cannot be compared without dividend data

Answer: A — Plan A gives higher EPS

Working. Plan A EPS = 4,00,000 x 0.70 / 5,00,000 = Rs 0.56. Plan B EPS = (4,00,000 - 2,00,000) x 0.70 / 3,00,000 = Rs 0.47.

Explanation. At EBIT below the indifference point, the all-equity plan gives higher EPS because the fixed interest burden of debt is not fully absorbed by operating earnings. EPS under Plan A is Rs 0.56, while under Plan B it is about Rs 0.47. Dividend data is not needed for EPS.

Where it goes wrong. Assuming debt always increases EPS. Debt increases EPS only when EBIT exceeds the indifference level.

Authority. Chapter 5: Financing Decisions - Capital Structure - EBIT-EPS Analysis

Question 6 · 2 marks · Financing Decisions - Capital Structure · medium

What is the financial risk implication of Plan B when EBIT falls below the indifference point?

1. Plan B has no financial risk because interest is tax deductible
2. Plan B has lower financial leverage than Plan A
3. Plan B keeps WACC constant at all EBIT levels
4. Plan B has higher financial leverage and EPS is more sensitive to EBIT changes (correct answer)

Answer: D — Plan B has higher financial leverage and EPS is more sensitive to EBIT changes

Working. Financial leverage magnifies the effect of EBIT changes on EPS. Plan B has interest of Rs 2,00,000 and fewer shares, so EPS is more volatile.

Explanation. Plan B uses fixed-interest debt, so it has higher financial leverage. EPS becomes more sensitive to changes in EBIT, and below the indifference point the fixed interest charge reduces EPS relative to the all-equity plan. Tax deductibility of interest does not eliminate financial risk.

Where it goes wrong. Treating tax deductibility of interest as removing financial risk, or confusing operating leverage with financial leverage.

Authority. Chapter 5: Financing Decisions - Capital Structure - Financial Leverage and Risk

Question 7 · 2 marks · Management of Working Capital · medium

Scenario. Venus Retail purchases goods on credit terms of 2/10 net 45. It can borrow funds from its bank at 18 percent per annum. The financial manager is examining whether the firm should forgo the cash discount and pay on day 45. Assume 365 days in a year.

What is the effective annual cost of forgoing the cash discount, using compounding?

1. 21.28 percent
2. 23.45 percent (correct answer)
3. 18.00 percent
4. 36.50 percent

Answer: B — 23.45 percent

Working. Discount period = 10 days. Net period = 45 days. Extra credit period = 35 days. Effective cost = (100/98)^(365/35) - 1 = 23.45 percent approximately. Nominal cost = 2/98 x 365/35 = 21.28 percent.

Explanation. The effective annual cost of forgoing the discount uses the formula (100/98)^(365/35) minus 1. This gives about 23.45 percent. Option a is the nominal annual cost without compounding, and option c is the bank borrowing rate.

Where it goes wrong. Reporting the nominal cost of 21.28 percent when the question requires the effective annual cost with compounding.

Authority. Chapter 9: Management of Working Capital - Management of Payables - Cost of Trade Credit

Question 8 · 1 marks · Management of Working Capital · medium

Given that Venus Retail can borrow at 18 percent, what action is most appropriate?

1. Forgo the discount because 18 percent is lower than 23.45 percent
2. Forgo the discount because the nominal cost is 21.28 percent
3. Pay on day 45 because borrowing costs are always irrelevant
4. Borrow at 18 percent and pay within 10 days because the effective cost of forgoing the discount is about 23.45 percent (correct answer)

Answer: D — Borrow at 18 percent and pay within 10 days because the effective cost of forgoing the discount is about 23.45 percent

Working. Effective cost of forgoing discount = 23.45 percent. Borrowing cost = 18 percent. Since 18 percent is lower, borrow and take the discount.

Explanation. The effective cost of forgoing the discount is about 23.45 percent, which exceeds the 18 percent borrowing rate. Therefore, borrowing to pay within the discount period reduces financing cost. Option a reverses the comparison, and option c ignores the cost comparison.

Where it goes wrong. Comparing the discount percentage of 2 percent directly with the annual borrowing rate of 18 percent instead of annualising the cost of forgoing the discount.

Authority. Chapter 9: Management of Working Capital - Management of Payables - Cost of Trade Credit