IIBMS – Zip Zap Zoom Car Company
Case 1: IIBMS – Zip Zap Zoom Car Company IIBMS – 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 Loans : Debentures (@ 14%) 50 Institutional borrowing (@ 10%) 100 Commercial loans (@ 12%) 250 Total debt 400 Current liabilities 200 1,200 Application of Funds Fixed Assets Gross block 1,000 Less: Depreciation 250 Net block 750 Capital WIP 190 Total Fixed Assets 940 Current assets: Inventory 200 Sundry debtors 40 Cash and bank balance 10 Other current assets 10 Total current assets 260 -1200 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 Total 1,400.0 Fixed cost: R & D 20.0 Marketing and advertising 25.0 Depreciation 250.0 Personnel 70.0 Total 365.0 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 Dividends 70.0 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 earnings 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 maximum of 10 percent reduction in sales volume will take place. A maximum of 6 percent reduction in sales price of cars will take place. Mr. Shortsighted 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 Operating expenditure Variable cost : Raw material and manufacturing expenses 1,170.0 Variable overheads 90.0 Total 1,260.0 Fixed cost: R & D — Marketing and advertising 15.0 Depreciation 187.5 Personnel 70.0 Total 272.5 Total operating expenditure 1,532.5 EBIT 159.5 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 EBT 97.5 Tax (@ 35%) 34.1 EAT 63.4 Dividends — Debt redemption (sinking fund obligation) 50.0* Contribution to reserves and surplus 13.4 * Rs. 40 crore (existing
IIBMS – Zip Zap Zoom Car Company Read More »