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Attempt Any Four Case Study
Case Study 1 : Structuring global companies
As the chapter illustrates, to carry out their activities in pursuit of their objectives, virtually all organisations adopt some form of organisational structure. One traditional method of organisation is to group individuals by function or purpose, using a departmental structure to allocate individuals to their specialist areas (e.g. Marketing, HRM and so on ). Another is to group activities by product or service, with each product group normally responsible for providing its own functional requirements. A third is to combine the two in the form of a matrix structure with its vertical and horizontal flows of responsibility and authority, a method of organisation much favoured in university Business Schools.
What of companies with a global reach: how do they usually organise them-
Writing in the Financial Times in November 2000 Julian Birkinshaw, Associate Professor of Strategic and International Management at London Business School, identifies four basic models of global company structure:
● The International Division – an arrangement in which the company establishes a
separate division to deal with business outside its own country. The
International Division would typically be concerned with tariff and trade issues,
foreign agents/partners and other aspects involved in selling overseas. Normally
the division does not make anything itself, it is simply responsible for interna-
tional sales. This arrangement tends to be found in medium-sized companies
with limited international sales.
The Global Product Division – a product-based structure with managers responsible
for their product line globally. The company is split into a number of global busi-
nesses arranged by product (or service) and usually overseen by their own
president. It has been a favoured structure among large global companies such as
BP, Siemens and 3M.
● The Area Division – a geographically based structure in which the major line of
authority lies with the country (e.g. Germany) or regional (e.g. Europe) manager who
is responsible for the different product offerings within her/his geographical area.
● The Global Matrix – as the name suggests a hybrid of the two previous structural
types. In the global matrix each business manager reports to two bosses, one
responsible for the global product and one for the country/region. As we indi-
cated in the previous edition of this book, this type of structure tends to come
into and go out of fashion. Ford, for example, adopted a matrix structure in the
later 1990s, while a number of other global companies were either streamlining
or dismantling theirs (e.g. Shell, BP, IBM).
As Professor Birkinshaw indicates, ultimately there is no perfect structure and organisations tend to change their approach over time according to changing circumstances, fads, the perceived needs of the senior executives or the predispositions of powerful individuals. This observation is no less true of universities than it is of traditional businesses.
Case study questions
1. Professor Birkinshaw’s article identifies the advantages and disadvantages of being a global business. What are his major arguments?
2. In your opinion what are likely to be the key factors determining how a global company will organise itself?
Case 2 : Resource prices
As we saw in Chapter 1, resources such as labour, technology and raw materials
constitute inputs into the production process that are utilised by organisations to
produce outputs. Apart from concerns over the quality, quantity and availability of
the different factors of production, businesses are also interested in the issue of
input prices since these represent costs to the organisation which ultimately have
to be met from revenues if the business is to survive. As in any other market, the
prices of economic resources can change over time for a variety of reasons, most, if
not all, of which are outside the direct control of business organisations. Such fluc-
tuations in input prices can be illustrated by the following examples:
● Rising labour costs – e.g. rises in wages or salaries and other labour-related costs
(such as pension contributions or healthcare schemes) that are not offset by
increases in productivity or changes in working practices. Labour costs could rise
for a variety of reasons including skills shortages, demographic pressures, the
introduction of a national minimum wage or workers seeking to maintain their
living standards in an inflationary period.
● Rising raw material costs – e.g. caused by increases in the demand for certain raw
materials and/or shortages (or bottlenecks) in supply. It can also be the result of
the need to switch to more expensive raw material sources because of customer
pressure, environmental considerations or lack of availability.
● Rising energy costs – e.g. caused by demand and/or supply problems as in the oil
market in recent years, with growth in India and China helping to push up
demand and coinciding with supply difficulties linked to events such as the war
in Iraq, hurricanes in the Gulf of Mexico or decisions by OPEC.
● Increases in the cost of purchasing new technology/capital equipment – e.g.
caused by the need to compete with rivals or to meet more stringent government
regulations in areas such as health and safety or the environment.
As the above examples illustrate, rising input prices can be the result of factors operating at both the micro and macro level and these can range from events which are linked to natural causes to developments of a political, social and/or economic kind. While many of these influences in the business environment are uncontrollable, there are steps business organisations can (and do) often take to address the issue of rising input prices that may threaten their competitiveness. Examples include the following:
● Seeking cheaper sources of labour (e.g. Dyson moved its production of vacuum
cleaners to the Far East).
● Abandoning salary-linked pension schemes or other fringe benefits (e.g. com-
pany cars, healthcare provisions, paid holidays).
● Outsourcing certain activities (e.g. using call centres to handle customer com-
plaints, or outsourcing services such as security, catering, cleaning, payroll, etc.). ● Switching raw materials or energy suppliers (e.g. to take advantage of discounts
by entering into longer agreements to purchase).
● Energy-saving measures (e.g. through better insulation, more regular servicing of
equipment, product and/or process redesign).
● Productivity gains (e.g. introducing incentive schemes).
In addition to measures such as these, some organisations seek cost savings through
divestment of parts of the business or alternatively through merger or takeover
activity. In the former case the aim tends to be to focus on the organisation’s core
products/services and to shed unprofitable and/or costly activities; in the latter the
objective is usually to take advantage of economies of scale, particularly those asso-
ciated with purchasing, marketing, administration and financing the business.
Case study questions
1. If a company is considering switching production to a country where wage costs
are lower, what other factors will it need to take into account before doing so?
2. Will increased environmental standards imposed by government on businesses
inevitably result in higher business costs?
Case 3 : Government and business – friend or foe?
As we have seen, governments intervene in the day-to-day working of the economy
in a variety of ways in the hope of improving the environment in which industrial
and commercial activity takes place. How far they are successful in achieving this
goal is open to question. Businesses, for example, frequently complain of over-
interference by governments and of the burdens imposed upon them by
government legislation and regulation. Ministers, in contrast, tend to stress how
they have helped to create an environment conducive to entrepreneurial activity
through the different policy initiatives and through a supportive legal and fiscal
regime. Who is right?
While there is no simple answer to this question, it is instructive to examine the
different surveys which are regularly undertaken of business attitudes and condi-
tions in different countries. One such survey by the European Commission – and
reported by Andrew Osborn in the Guardian on 20 November 2001 – claimed that
whereas countries such as Finland, Luxembourg, Portugal and the Netherlands
tended to be regarded as business-friendly, the United Kingdom was perceived as
the most difficult and complicated country to do business with in the whole of
Europe. Foreign firms evidently claimed that the UK was harder to trade with than
other countries owing to its bureaucratic procedures and its tendency to rigidly
enforce business regulations. EU officials singled out Britain’s complex tax formali-
ties, employment regulations and product conformity rules as particular problems
for foreign companies – criticisms which echo those of the CBI and other represen-
tative bodies who have been complaining of the cost of over-regulation to UK firms
over a considerable number of years.
The news, however, is not all bad. The Competitive Alternatives study (2002) by
KPMG of costs in various cities in the G7 countries, Austria and the Netherlands
indicated that Britain is the second cheapest place in which to do business in the
nine industrial countries (see www.competitivealternatives.com). The survey, which
looked at a range of business costs – especially labour costs and taxation -, placed
the UK second behind Canada world-wide and in first place within Europe. The
country’s strong showing largely reflected its competitive labour costs, with manu-
facturing costs estimated to be 12.5 per cent lower than in Germany and 20 per
cent lower than many other countries in continental Europe. Since firms frequently
use this survey to identify the best places to locate their business, the data on rela-
tive costs are likely to provide the UK with a competitive advantage in the battle for
foreign inward investment (see Mini case, above).
Case study questions
1. How would you account for the difference in perspective between firms who often
complain of government over-interference in business matters and ministers who
claim that they have the interests of business at heart when taking decisions?
2. To what extent do you think that relative costs are the critical factor in determining
inward investment decisions?
Case 4 : The end of the block exemption
As we have seen in the chapter, governments frequently use laws and regulations to promote competition within the marketplace in the belief that this has significant benefits for the consumer and for the economy generally. Such interventions occur not only at national level, but also in situations where governments work together to provide mutual benefits, as in the European Union’s attempts to set up a ‘Single Market’ across the member states of the EU.
While few would deny that competitive markets have many benefits, the search
for increased competition at national level and beyond can sometimes be
restrained by the political realities of the situation, a point underlined by a previous
decision of the EU authorities to allow a block exemption from the normal rules of
competition in the EU car market. Under this system, motor manufacturers operat-
ing within the EU were permitted to create networks of selective and exclusive dealerships and to engage in certain other activities normally outlawed under the competition provisions of the single market. It was argued that the system of selective and exclusive distribution (SED) benefited consumers by providing them with a cradle-to-grave service, alongside what was said to be a highly competitive supply situation within the heavily branded global car market.
Introduced in 1995, and extended until the end of September 2002, the block
exemption was highly criticised for its impact on the operation of the car market in
Europe. Following a critical report by the UK competition authorities in April 2000,
the EU published a review (in November 2000) of the workings of the existing
arrangement for distributing and servicing cars, highlighting its adverse conse-
quences for both consumers and retailers and signalling the need for change. Despite
intensive lobbying by the major car manufacturers, and by some national govern-
ments, to maintain the current rules largely intact, the European Commission
announced its intention of replacing the block exemption regulation when it expired
in September, subject of course to consultation with interested parties.
In essence the Commission’s proposals aimed to give dealers far more independ-
ence from suppliers by allowing them to solicit for business anywhere in the EU
and to open showrooms wherever they want; they would also be able to sell cars
supplied by different manufacturers under the same roof. The plan also sought to
open up the aftersales market by breaking the tie which existed between sales and
servicing. The proposal was that independent repairers would in future be able to
get greater access to the necessary spare parts and technology, thereby encouraging
new entrants to join the market with reduced initial investment costs.
While these proposals were broadly welcomed by groups representing consumers
(e.g. the Consumer Association in the UK), some observers felt that the planned
reforms did not go far enough to weaken the power of the suppliers over the market
(see e.g. the editorial in the Financial Times, 11 January 2002). For instance it
appeared to be the case that while manufacturers would be able to supply cars to
supermarkets and other new retailers, they would not be required by law to do so,
suggesting that a market free-for-all was highly unlikely to emerge in the foreseeable
future. Equally the Commission’s plans appeared to do little to protect dealers from
threats to terminate their franchises should there be a dispute with the supplier.
In the event the old block exemption scheme expired at the end of September
2002 and the new rules began the next day. However, the majority of the provisions
under the EC rules did not come into effect until the following October (2003) and
the ban on ‘location clauses’ – which limit the geographical scope of dealer opera-
tions – only came into effect two years later. Since October 2005 dealers have been
free to set up secondary sales outlets in other areas of the EU, as well as their own
countries. This is expected to stengthen competition between dealers across the
Single Market to the advantage of consumers (e.g. greater choice and reduced prices).
Case study questions
1. Can you suggest any reasons why the European Commission was willing to grant
the block exemption in the first place, given that it ran counter to its proposals for
a Single Market?
2. Why might the new reforms make cars cheaper for European consumers?
Case 5 : The sale of goods on the Internet
The sale of consumer goods on the Internet (particularly those between European member states) raises a number of legal issues. First, there is the issue of trust, with-
out which the consumer will not buy; they will need assurance that the seller is genuine, and that they will get the goods that they believe they have ordered.
Second, there is the issue of consumer rights with respect to the goods in question: what rights exist and do they vary across Europe? Last, the issue of enforcement: what happens should anything go wrong?
Information and trust
Europe recognises the problems of doing business across the Internet or telephone
and it has attempted to address the main stumbling blocks via Directives. The
Consumer Protection (Distance Selling) Regulations 2000 attempts to address the
issues of trust in cross-border consumer sales, which may take place over the
Internet (or telephone). In short, the consumer needs to know quite a bit of infor-
mation, which they may otherwise have easy access to if they were buying face to
face. Regulation 7 requires inter alia for the seller to identify themselves and an
address must be provided if the goods are to be paid for in advance. Moreover, a
full description of the goods and the final price (inclusive of any taxes) must also
be provided. The seller must also inform the buyer of the right of cancellation available under Regulations 10-12, where the buyer has a right to cancel the contract for seven days starting on the day after the consumer receives the goods or services. Failure to inform the consumer of this right automatically extends the period to three months. The cost of returning goods is to be borne by the buyer, and the seller is entitled to deduct the costs directly flowing from recovery as a restocking fee. All of this places a considerable obligation on the seller; however, such data should stem many misunderstandings and so greatly assist consumer faith and confidence in non-face-to-face sales.
Another concern for the consumer is fraud. The consumer who has paid by
credit card will be protected by section 83 of the Consumer Credit Act 1974, under
which a consumer/purchaser is not liable for the debt incurred, if it has been run
up by a third party not acting as the agent of the buyer. The Distance Selling
Regulations extend this to debit cards, and remove the ability of the card issuer to
charge the consumer for the first £50 of loss (Regulation 21). Moreover, section 75
of the Consumer Credit Act 1974 also gives the consumer/buyer a like claim against
the credit card company for any misrepresentation or breach of contract by the
seller. This is extremely important in a distance selling transaction, where the seller
What quality and what rights?
The next issue relates to the quality that may be expected from goods bought over
the Internet. Clearly, if goods have been bought from abroad, the levels of quality
required in other jurisdictions may vary. It is for this reason that Europe has
attempted to standardise the issue of quality and consumer rights, with the
Consumer Guarantees Directive (1999/44/EC), thus continuing the push to encour-
age cross-border consumer purchases. The implementing Sale and Supply of Goods
to Consumer Regulations 2002 came into force in 2003, which not only lays down
minimum quality standards, but also provides a series of consumer remedies which
will be common across Europe. The Regulations further amend the Sale of Goods
Act 1979. The DTI, whose job it was to incorporate the Directive into domestic law
(by way of delegated legislation) ensured that the pre-existing consumer rights were
maintained, so as not to reduce the overall level of protection available to con-
sumers. The Directive requires goods to be of ‘normal’ quality, or fit for any
purpose made known by the seller. This has been taken to be the same as our pre-
existing ‘reasonable quality’ and ‘fitness for purpose’ obligations owed under
sections 14(2) and 14(3) of the Sale of Goods Act 1979. Moreover, the pre-existing
remedy of the short-term right to reject is also retained. This right provides the
buyer a short period of time to discover whether the goods are in conformity with
the contract. In practice, it is usually a matter of weeks at most. After that time has
elapsed, the consumer now has four new remedies that did not exist before, which
are provided in two pairs. These are repair or replacement, or price reduction or
rescission. The pre-existing law only gave the consumer a right to damages, which
would rarely be exercised in practice. (However, the Small Claims Court would
ensure a speedy and cheap means of redress for almost all claims brought.) Now
there is a right to a repair or a replacement, so that the consumer is not left with an
impractical action for damages over defective goods. The seller must also bear the
cost of return of the goods for repair. So such costs must now be factored into any
business sales plan. If neither of these remedies is suitable or actioned within a ‘rea-
sonable period of time’ then the consumer may rely on the second pair of
remedies. Price reduction permits the consumer to claim back a segment of the pur-
chase price if the goods are still useable. It is effectively a discount for defective
goods. Rescission permits the consumer to reject the goods, but does not get a full
refund, as they would under the short-term right to reject. Here money is knocked
off for ‘beneficial use’. This is akin to the pre-existing treatment for breaches of
durability, where goods have not lasted as long as goods of that type ought reason-
ably be expected to last. The level of compensation would take account of the use
that the consumer has (if any) been able to put the goods to and a deduction made
off the return of the purchase price. However, the issue that must be addressed is as
to the length of time that goods may be expected to last. A supplier may state the
length of the guarantee period, so a £500 television set guaranteed for one year
would have a life expectancy of one year. On the other hand, a consumer may
expect a television set to last ten years. Clearly, if the set went wrong after six
months, the consumer would only get £250 back if the retailer’s figure was used,
but would receive £475 if their own figure was used. It remains to be seen how this
provision will work in practice.
One problem with distance sales has been that of liability for goods which arrive
damaged. The pre-existing domestic law stated that risk would pass to the buyer once
the goods were handed over to a third-party carrier. This had the major problem in
practice of who would actually be liable for the damage. Carriers would blame the
supplier and vice versa. The consumer would be able to sue for the loss, if they were
able to determine which party was responsible. In practice, consumers usually went
uncompensated and such a worry has put many consumers off buying goods over the
Internet. The Sale and Supply of Goods to Consumer Regulations also modify the
transfer of risk, so that now the risk remains with the seller until actual delivery. This
will clearly lead to a slight increase in the supply of goods to consumers, with the
goods usually now being sent by insured delivery. However, this will avoid the prob-
lem of who is actually liable and should help to boost confidence.
Enforcement for domestic sales is relatively straightforward. Small-scale consumer
claims can be dealt with expeditiously and cheaply under the Small Claims Court.
Here claims under £5000 for contract-based claims are brought in a special court
intended to keep costs down by keeping the lawyers’ out of the court room, as a vic-
torious party cannot claim for their lawyers’ expenses. The judge will conduct the
case in a more ‘informal’ manner, and will seek to discover the legal issues by ques-
tioning both parties, so no formal knowledge of the law is required. The total cost of
such a case, even if it is lost, is the cost of issuing the proceedings (approximately
10 per cent of the value claimed) and the other side’s ‘reasonable expenses’. Expenses
must be kept down, and a judge will not award value which has been deliberately run
up, such first-class rail travel and stays in five star hotels. Residents of Northampton
have hosted a trial of an online claims procedure, so that claims may now be made
via the Internet. (www.courtservice.gov.uk outlines the procedure for MCOL, or
Money Claims Online.) Cases will normally be held in the defendant’s court, unless the complainant is a consumer and the defendant a business.
Enforcement is the weak point in the European legislation, for there is, as yet, no
European-wide Small Claims Court dealing with transnational European transac-
tions. The consumer is thus forced to contemplate expensive civil action abroad in a
foreign language, perhaps where no such small claims system exists – a pointless
measure for all but the most expensive of consumer purchases. The only redress lies
in EEJ-Net, the European Extra-Judicial Network, which puts the complainant in
touch with any applicable professional or trade body in the supplier’s home member
state. It does require the existence of such a body, which is unlikely if the transac-
tion is for electrical goods, which is one of the most popular types of Internet
purchase. Therefore, until Europe provides a Euro Small Claims Court, the consumer
cross-border buyer may have many rights, but no effective means of enforcement.
Until then it would appear that section 75 of the Consumer Credit Act 1974, which
gives the buyer the same remedies against their credit card company as against the
seller, is the only effective means of redress.
Case study questions
1. Consider the checklist of data which a distance seller must provide to a consumer
purchaser. Is this putting too heavy a burden on sellers?
2. Is a consumer distance buyer any better off after the European legislation?
3. Are there any remaining issues that must be tackled to increase European cross-
border consumer trade?
Attempt Any Four Case Study
Case 1: Zip Zap Zoom Car Company
Zip Zap Zoom Company Ltd is into manufacturing cars in the small car (800 cc) segment. It was set up 15 years back and since its establishment it has seen a phenomenal growth in both its market and profitability. Its financial statements are shown in Exhibits 1 and 2 respectively.
The company enjoys the confidence of its shareholders who have been rewarded with growing dividends year after year. Last year, the company had announced 20 per cent dividend, which was the highest in the automobile sector. The company has never defaulted on its loan payments and enjoys a favorable face with its lenders, which include financial institutions, commercial banks and debenture holders.
The competition in the car industry has increased in the past few years and the company foresees further intensification of competition with the entry of several foreign car manufactures many of them being market leaders in their respective countries. The small car segment especially, will witness entry of foreign majors in the near future, with latest technology being offered to the Indian customer. The Zip Zap Zoom’s senior management realizes the need for large scale investment in up gradation of technology and improvement of manufacturing facilities to pre-empt competition.
Whereas on the one hand, the competition in the car industry has been intensifying, on the other hand, there has been a slowdown in the Indian economy, which has not only reduced the demand for cars, but has also led to adoption of price cutting strategies by various car manufactures. The industry indicators predict that the economy is gradually slipping into recession.
Exhibit 1 Balance sheet as at March 31,200 x
(Amount in Rs. Crore)
Source of Funds
Share capital 350
Reserves and surplus 250 600
Debentures (@ 14%) 50
Institutional borrowing (@ 10%) 100
Commercial loans (@ 12%) 250
Total debt 400
Current liabilities 200
Application of Funds
Gross block 1,000
Less : Depreciation 250
Net block 750
Capital WIP 190
Total Fixed Assets 940
Current assets :
Sundry debtors 40
Cash and bank balance 10
Other current assets 10
Total current assets 260
Exhibit 2 Profit and Loss Account for the year ended March 31, 200x
(Amount in Rs. Crore)
Sales revenue (80,000 units x Rs. 2,50,000) 2,000.0
Operating expenditure :
Variable cost :
Raw material and manufacturing expenses 1,300.0
Variable overheads 100.0
Fixed cost :
R & D 20.0
Marketing and advertising 25.0
Total operating expenditure 1,765.0
Operating profits (EBIT) 235.0
Financial expense :
Interest on debentures 7.7
Interest on institutional borrowings 11.0
Interest on commercial loan 33.0 51.7
Earnings before tax (EBT) 183.3
Tax (@ 35%) 64.2
Earnings after tax (EAT) 119.1
Debt redemption (sinking fund obligation)** 40.0
Contribution to reserves and surplus 9.1
* Includes the cost of inventory and work in process (W.P) which is dependent on demand (sales).
** The loans have to be retired in the next ten years and the firm redeems Rs. 40 crore every year.
The company is faced with the problem of deciding how much to invest in up
gradation of its plans and technology. Capital investment up to a maximum of Rs. 100
crore is required. The problem areas are three-fold.
• The company cannot forgo the capital investment as that could lead to reduction in its market share as technological competence in this industry is a must and customers would shift to manufactures providing latest in car technology.
• The company does not want to issue new equity shares and its retained earning are not enough for such a large investment. Thus, the only option is raising debt.
• The company wants to limit its additional debt to a level that it can service without taking undue risks. With the looming recession and uncertain market conditions, the company perceives that additional fixed obligations could become a cause of financial distress, and thus, wants to determine its additional debt capacity to meet the investment requirements.
Mr. Shortsighted, the company’s Finance Manager, is given the task of determining the additional debt that the firm can raise. He thinks that the firm can raise Rs. 100 crore worth debt and service it even in years of recession. The company can raise debt at 15 per cent from a financial institution. While working out the debt capacity. Mr. Shortsighted takes the following assumptions for the recession years.
a) A maximum of 10 percent reduction in sales volume will take place.
b) A maximum of 6 percent reduction in sales price of cars will take place.
Mr. Shorsighted prepares a projected income statement which is representative of the recession years. While doing so, he determines what he thinks are the “irreducible minimum” expenditures under
recessionary conditions. For him, risk of insolvency is the main concern while designing the capital structure. To support his view, he presents the income statement as shown in Exhibit 3.
Exhibit 3 projected Profit and Loss account
(Amount in Rs. Crore)
Sales revenue (72,000 units x Rs. 2,35,000) 1,692.0
Variable cost :
Raw material and manufacturing expenses 1,170.0
Variable overheads 90.0
Fixed cost :
R & D —
Marketing and advertising 15.0
Total operating expenditure 1,532.5
Financial expenses :
Interest on existing Debentures 7.0
Interest on existing institutional borrowings 10.0
Interest on commercial loan 30.0
Interest on additional debt 15.0 62.0
Tax (@ 35%) 34.1
Debt redemption (sinking fund obligation) 50.0*
Contribution to reserves and surplus 13.4
* Rs. 40 crore (existing debt) + Rs. 10 crore (additional debt)
Assumptions of Mr. Shorsighted
• R & D expenditure can be done away with till the economy picks up.
• Marketing and advertising expenditure can be reduced by 40 per cent.
• Keeping in mind the investor confidence that the company enjoys, he feels that the company can forgo paying dividends in the recession period.
He goes with his worked out statement to the Director Finance, Mr. Arthashatra, and advocates raising Rs. 100 crore of debt to finance the intended capital investment. Mr. Arthashatra does not feel comfortable with the statements and calls for the company’s financial analyst, Mr. Longsighted.
Mr. Longsighted carefully analyses Mr. Shortsighted’s assumptions and points out that insolvency should not be the sole criterion while determining the debt capacity of the firm. He points out the following :
• Apart from debt servicing, there are certain expenditures like those on R & D and marketing that need to be continued to ensure the long-term health of the firm.
• Certain management policies like those relating to dividend payout, send out important signals to the investors. The Zip Zap Zoom’s management has been paying regular dividends and discontinuing this practice (even though just for the recession phase) could raise serious doubts in the investor’s mind about the health of the firm. The firm should pay at least 10 per cent dividend in the recession years.
• Mr. Shortsighted has used the accounting profits to determine the amount available each year for servicing the debt obligations. This does not give the true picture. Net cash inflows should be used to determine the amount available for servicing the debt.
• Net Cash inflows are determined by an interplay of many variables and such a simplistic view should not be taken while determining the cash flows in recession. It is not possible to accurately predict the fall in any of the factors such as sales volume, sales price, marketing expenditure and so on. Probability distribution of variation of each of the factors that affect net cash inflow should be analyzed. From this analysis, the probability distribution of variation in net cash inflow should be analysed (the net cash inflows follow a normal probability distribution). This will give a true picture of how the company’s cash flows will behave in recession conditions.
The management recognizes that the alternative suggested by Mr. Longsighted rests on data, which are complex and require expenditure of time and effort to obtain and interpret. Considering the importance of capital structure design, the Finance Director asks Mr. Longsighted to carry out his analysis. Information on the behaviour of cash flows during the recession periods is taken into account.
The methodology undertaken is as follows :
(a) Important factors that affect cash flows (especially contraction of cash flows), like sales volume, sales price, raw materials expenditure, and so on, are identified and the analysis is carried out in terms of cash receipts and cash expenditures.
(b) Each factor’s behaviour (variation behaviour) in adverse conditions in the past is studied and future expectations are combined with past data, to describe limits (maximum favourable), most probable and maximum adverse) for all the factors.
(c) Once this information is generated for all the factors affecting the cash flows, Mr. Longsighted comes up with a range of estimates of the cash flow in future recession periods based on all possible combinations of the several factors. He also estimates the probability of occurrence of each estimate of cash flow.
Assuming a normal distribution of the expected behaviour, the mean expected
value of net cash inflow in adverse conditions came out to be Rs. 220.27 crore with standard deviation of Rs. 110 crore.
Keeping in mind the looming recession and the uncertainty of the recession behaviour, Mr. Arthashastra feels that the firm should factor a risk of cash inadequacy of around 5 per cent even in the most adverse industry conditions. Thus, the firm should take up only that amount of additional debt that it can service 95 per cent of the times, while maintaining cash adequacy.
To maintain an annual dividend of 10 per cent, an additional Rs. 35 crore has to be kept aside. Hence, the expected available net cash inflow is Rs. 185.27 crore (i.e. Rs. 220.27 – Rs. 35 crore)
Analyse the debt capacity of the company.
CASE – 2 GREAVES LIMITED
Started as trading firm in 1922, Greaves Limited has diversified into manufacturing and marketing of high technology engineering products and systems. The company’s mission is “manufacture and market a wide range of high quality products, services and systems of world class technology to the total satisfaction of customers in domestic and overseas market.”
Over the years Greaves has brought to India state of the art technologies in various engineering fields by setting up manufacturing units and subsidiary and associate companies. The sales of Greaves Limited has increased from Rs 214 crore in 1990 to Rs 801 crore in 1997. The sales of Greaves Limited has increased from Rs 214 crore in 1990 to Rs 801 crore in 1997. Profits before interest and tax (PBIT) of the company increased from Rs 15 crore to Rs 83 crore in 1997. The market price of the company’s share has shown ups and downs during 1990 to 1997. How has the company performed? The following question need answer to fully understand the performance of the company:
Profit and Loss Account ending on 31 March (Rupees in crore)
1990 1991 1992 1993 1994 1995 1996 1997
Raw Material and Stores
Wages and Salaries
Power and fuel
Other Mfg. Expenses
Marketing and Distribution
Change in stock 214.38
– 1.13 521.56
Total Op Expenses 202.72 239.40 268.91 291.85 338.77 493.41 672.20 731.75
PBIT 15.10 19.67 23.97 34.51 39.64 42.98 65.67 82.64
Interest 5.56 6.77 11.92 19.62 17.17 21.48 28.25 27.54
PBT 9.54 12.90 12.05 14.89 22.47 21.50 37.42 55.10
Retained Earnings 3.00
Balance Sheet (Rupees in crore)
1990 1991 1992 1993 1994 1995 1996 1997
Land and Building
Plant and Machinery
Other Fixed Assets
Gross Fixed Assets
Less: Accu. Depreciation
Net Tangible Fixed Assets
Intangible Fixed Assets
Net Fixed Assets 6.89 6.93 7.83 56.20 119.68 126.50 135.10 139.97
Cash and Bank Balance
LIABILITIES AND CAPITAL
Reserves and Surplus
Net Worth 37.66 42.63 47.48 119.39 200.60 206.52 219.81 243.19
Current Portion of LT Debt 14.81
Borrowings 38.35 57.12 73.72 84.61 130.82 158.73 183.94 203.66
Provision for tax, etc.
Current Portion of LT Dept 37.52
Current Liabilities 48.20 65.38 77.56 85.35 141.85 166.42 181.86 220.01
Share premium reserve
Bonus equity capital 124.21
Share Price Data
1990 1991 1992 1993 1994 1995 1996 1997
Closing share price (Rs)
Yearly high share price (Rs)
Yearly low share price (Rs)
Market capitalization (Rs crore
Book value (Rs) 27.19
1. How profitable are its operations? What are the trends in it? How has growth affected the profitability of the company?
2. What factors have contributed to the operating performance of Greaves Limited? What is the role of profitability margin, asset utilisation, and non-operating income?
3. How has Greaves performed in terms of return on equity? What is the contribution of return on investment, the way of the business has been financed over the period?
CASE – 3 CHOOSING BETWEEN PROJECTS IN ABC COMPANY
ABC Company, has three projects to choose from. The Finance Manager, the operations manager are discussing and they are not able to come to a proper decision. Then they are meeting a consultant to get proper advice. As a consultant, what advice you will give?
The cash flows are as follows. All amounts are in lakhs of Rupees.
Duration 5 Years
Beginning cash outflow = Rs. 100
Cash inflows (at the end of the year)
Yr. 1 – Rs 30; Yr. 2 – Rs 30; Yr. 3 – Rs 30; Yr.4 – 10; Yr.5 – 10
Duration 5 Years
Beginning Cash outflow Rs. 3763
Cash inflows (at the end of the year)
Yr. 1 – 200; Yr. 2 – 600; Yr. 3 – 1000; Yr. 4 – 1000; Yr. 5 – 2000.
Duration 15 Years
Beginning Cash Outflow – Rs. 100
Cash Inflows (at the end of the year)
Yrs. 1 to 10 – Rs. 20 (for 10 continuous years)
Yrs. 11 to 15 – Rs. 10 (For the next 5 years)
If the cost of capital is 8%, which of the 3 projects should the ABC Company accept?
CASE – 4 STAR ENGINEERING COMPANY
Star Engineering Company (SEC) produces electrical accessories like meters, transformers, switchgears, and automobile accessories like taximeters and speedometers.
SEC buys the electrical components, but manufactures all mechanical parts within its factory which is divided into four production departments Machining, Fabrication, Assembly, and Painting—and three service departments—Stores, Maintenance, and Works Office.
Though the company prepared annual budgets and monthly financial statements, it had no formal cost accounting system. Prices were fixed on the basis of what the market can bear. Inventory of finished stocks was valued at 90 per cent of the market price assuming a profit margin of 10 per cent.
In March, the company received a trial order from a government department for a sample transformer on a cost-plus-fixed-fee basis. They took up the job (numbered by the company as Job No 879) in early April and completed all manufacturing operations before the end of the month.
Since Job No 879 was very different from the type of transformers they had manufactured in the past, the company did not have a comparable market price for the product. The purchasing officer of the government department asked SEC to submit a detailed cost sheet for the job giving as much details as possible regarding material, labour and overhead costs.
SEC, as part of its routine financial accounting system, had collected the actual expenses for the month of April, by 5th of May. Some of the relevant data are given in Exhibit A.
The company tried to assign directly, as many expenses as possible to the production departments. However, It was not possible in all cases. In many cases, an overhead cost, which was common to all departments had to be allocated to the various departments using some rational basis. Some of the possible bases were collected by SEC’s accountant. These are presented in Exhibit B.
He also designed a format to allocate the overhead to all the production and service departments. It was realized that the expenses of the service departments on some rational basis. The accountant thought of distributing the service departments’ costs on the following basis:
a. Works office costs on the basis of direct labour hours.
b. Maintenance costs on the basis of book value of plant and machinery.
c. Stores department costs on the basis of direct and indirect materials used.
The accountant who had to visit the company’s banker, passed on the papers to you for the required analysis and cost computations.
Based on the data given in Exhibits A and B, you are required to:
1. Complete the attached “overhead cost distribution sheet” (Exhibit C).
Note: Wherever possible, identify the overhead costs chared directly to the production and service departments. If such direct identification is not possible, distribute the costs on some “rational basis.
2. Calculate the overhead cost (per direct labour hour) for each of the four producing departments. This should include share of the service departments’ costs.
3. Do you agree with:
a. The procedure adopted by the company for the distribution of overhead costs?
b. The choice of the base for overhead absorption, i.e. labour-hour rate?
STAR ENGINEERING COMPANY
Actual Expenses(Manufacturing Overheads) for April
Indirect Labour and Supervisions:
Indirect Materials and Supplies
Depreciation of Plant and Machinery
Building Rates and Taxes
(At 2 per cent of direct labour wages and Indirect labour and supervision)
(Maintenance—Rs 366; Works Office Rs 2,200, Balance to Producing Departments)
Works Office Salaries and Expenses
Miscellaneous Stores Department Expenses
STAR ENGINEERING COMPANY
Projected Operation Data for the Year
(sq.m) Original Book of Plant & Machinery
Rs Direct Materials
The estimates given in this exhibit are for the budgeted year January to December where as the actuals in Exhibit A are just one month—April of the budgeted year.
STAR ENGINEERING COMPANY
Actual Overhead Distribution Sheet for April
Overhead Costs Production Departments Service Departments Total Amount Actuals for April (Rs) Basis for Distribution
A. Allocation of Overhead to all departments
A.1 Indirect Labour and Supervision
A.2 Indirect materials and supplies
A.3 Factory Rent 1,68,000
A.4 Depreciation of Plant and Machinery
A.5 Building Rates and Taxes
A.6 Welfare Expenses
A.7 Power 68,586
A.8 Works Office Salaries and Expenses
A.9 Miscellaneous Stores Expenses
A. Total (A.1 to A.9) 5,96,430
B. Reallocation of Service Departments Costs to Production Departments
B.1 Distribution of Works Office Costs
B.2 Distribution of Maintenance Department’s Costs
B.3 Distribution of Stores Department’s Costs
Total Charged to Producing
C. Departments (A+B)
D. Labour Hours Actuals for April
E. Overhead Rate/Per Hour (D)
Case 5: EASTERN MACHINES COMPANY
Raj, who was in charge production felt that there are many problems to be attended to. But Quality Control was the main problem, he thought, as he found there were more complaints and litigations as compared to last year. With the demand increasing, he does not want to take any chances.
So he went down to assembly line, but was greeted by an unfamiliar face. He introduced himself.
Raj: I am in charge of checking the components, which we use, when we assemble the machines for customers. For most of the components, suppliers are very reliable and we assume that there will not be any problem. When we generally test the end product, we don’t have failures.
Namdeo: I am Namdeo. I was in another dept. and has been transferred recently to this dept.
Raj: Recently we have been having problems, and there has been some complaint or other about the machines we have supplied. I am worried and would like to check the components used. I would like to avoid lot of expensive rework.
Namdeo: But it would be very expensive to test every one of them. It will take at least half an hour for each machine. I neither have the staff nor the time. It will be rather pointless as majority of them will pass the test.
Raj: There has been more demand than supply for these machines in last 2 years. We have been buying many components from many suppliers. We have been producing more with extra shifts. We are trying to capture the market and increase our market share.
Namdeo: We order for components from different places, and sometimes we do not have time to check all. There is a time lag between order and supply of components, and we cannot wait as production will stop. We use whatever comes soon as we want to complete our orders.
Raj: Oh! Obviously we need some kind of checking. Some sampling technique to check the quality of the components. We need to get a sample from each shipment from our component suppliers. But I do not know how many we should test.
Namdeo: We should ask somebody from our statistics dept. to attend to this problem.
As a Statistician, advice what kind of Sampling schemes can we consider, and what factors will influence choice of scheme. What are the questions we should ask Mr. Namdeo, who works in the assembly line?