Page 115 - DMGT409Basic Financial Management

Basic Financial Management

Notes
V (`) B A: Value of firm with no leverage
B: MM value of firm (VL = VU + TD)
C: Actual firm value
F D: Optimal debt level
E E: PV of tax shelter (TD)
F: Financial distress and agency costs

V A
U
C

D Debt (`)

Sushma Enterprises

ushma Enterprises was set up in 1950 as a public limited company to manufacture
goods used for decoration in drawing rooms. The company is situated in Calicut
Sand it distributes its products throughout the western region of the country. The
company expects to earn just over ` 30,00,000 and expects sales of ` 33,00,000 next year.

Variable costs will stay at approximately the same percentage of sales and fixed costs will
not increase next year.
Recently the management is seized with investigating the possibility of diversifying the
production activities to manufacture small metallic fountains for residential purposes and
marble statues to be placed in public gardens. Both products would be compatible with
Sushma’s existing product line and neither would require any increase in net working
capital.
Mr. Arvind, the Production Manager, has been entrusted with the task of analyzing the
new product proposals. He estimates that the company would require an investment of `
9,00,000 for the fountains and ` 11,00,000 for the statues. In either case, it would take less
than 80 days to install the equipment, so production could begin by January 1st.
Mr. Prakash the Sales Manger, estimates that the company could sell fountains, worth
` 6,00,000 and ` 9,00,000 of statues annually. The company’s cost accountant predicts
variable cost of two-thirds of sales for the fountains and 64 per cent for the statues. Fixed
cost is estimated to be around ` 90,000 and ` 1,90,000 respectively.

The management requested Mr. Sahu, the Finance manager, to find out sources of funds that

could be obtained for financing the additional requirements and the terms and conditions
of financing. Mr Sahu after investigating the capital market of the country, submitted to the

management that, the company could borrow upto ` 25,00,000 by fl oating 25 year bonds
at 6 per cent for either or both the projects. The company could also raise funds by issuing
preferred stock with 8 per cent dividend upto ` 11,00,000. He informed the management

that the common stock financing would not be currently available.
Performa Income Statement and Balance Sheet of Sushma Enterprises are shown in Exhibits
1 and 2 below.

Contd...

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