Seminar in Finance
BBA 8th (Morning)
Sir. Nazik Hussain
Solved by: Owais Shafique
CASE 2
CAPITAL STRUCTURE
EQUITY
DEBT (@10%)
TOTAL CAPITALIZATION
Debt to equity ratio is 50:50
CEMENT
120,000
120,000
240,000
SUGAR
80,000
80,000
160,000
CHEMICAL
30,000
30,000
60,000
RUNNING FINANCE
20,000
10,000
40,000
ROI = EBIT / Total Capitalization
(30,000/240,000) (15,000/160,000) (15,000/60,000)
12.5%
9.375%
25%
1ST decision of mr. Z is wrong. He just concentrated on the figures and paid off the loan of cement
sector which was giving us an ROI of 12.5% which is 2.5% higher then the cost of capital 10%. He
should have paid the loan of sugar sector because it is giving us an return on investment of 9.375%
which is less then the 10% cost of capital. thus we are paying more to bank then we are earning.
The 2nd decision of mr. Z was also wrong because by cutting down or removing 50% running finance
of sugar sector he is going to reduce the production of sugar sector by 50%. How? Running finance is
the lifeblood of any sector it is the finance needed to produce goods. In other words it is our variable
cost. By reducing our running finance by 50% in sugar sector we reduce the amount of money or
finance needed to produce the total number of units produced. With the remaining running finance
we can only produce 50% of the previous production thus our sales plummeted by 50% because our
production decresed by 50%. Thus we can not sell more then we produce. The fixed cost remained
the same and thus per unet cost of production rose resulting in a loss.
The 3rd decision of mr z was wrongly timed and poor. As market was losing confidence in the
company thus mr z should not have converted some of the variable cost of chemical sector to fixed
cost because it is only beneficial if sales are expected to increase in the future. As sales feel the old
system would have sustained the shock because most of the cost was variable which means that the
cost would occur only if production is done. But in new system the cost became fixed and irrelevant
of the production level the company had to bear the fixed cost. Thus a decrease in sales of 40%
resulted in a huge loss in the chemical sector.
1
The data provided by mr j is not correct.
Cement:
After rechecking his calculations we find that when we close territory z and invest the amount saved
from that sector to sector y of cement company then we get these results.
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
Division C
2820 units
28200
(9400)
18800
(600)
18200
(4000)
14200
CM Ratio = CM/Sales X 100
Territory X
600 units
6000
(2000)
4000
(500)
3500
Territory Y
(300+1920)=2220 units
22200
(7400)
14800
(100)
14700
66%
66%
When we dissolve territory z then we save 1000 running expense or variable cost and 5400 traceable
fixed cost. Thus we save a total of Rs. 6400. Now we have to invest this money in territory Y. We
were already producing 300 units in territory Y so our sale price per unit was 3000/300= Rs. 10 and
variable cost per unit was 1000/300 = Rs. 3.33333 so we divide the amount we saved from territory z
on our per unit variable cost. Thus we get 6400/3.3333 = 1920 units. Thus we can produce 1920
more units in territory Y now. Fixed cost will not change because it is fixed. It does not matter if we
invest in Territory Y or X because both have same CM Ratio. Thus they will yield the same return.
Cement
6820 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
68200
(14500)
52800
(14600)
38200
(5000)
33200
Division A
3000 units
30000
(2000)
28000
(4000)
24000
Division B
1000 units
10000
(4000)
6000
(6000)
0
Division C
2820 units
28200
(9400)
18800
(4600)
14200
2
Sugar:
After rechecking his calculations we find that when we close territory z and invest the amount saved
from that sector to sector y of sugar company then we get these results.
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
Division C
12325 units
123250
(48200)
75050
(800)
74250
(1000)
73250
CM Ratio = CM/Sales X 100
Territory X
400 units
4000
(500)
3500
(500)
3000
Territory Y
(50+11875)=11925 units
119250
(47700)
71550
(300)
171250
87.5%
40%
When we dissolve territory z then we save 300 running expense or variable cost and 47200 traceable
fixed cost. Thus we save a total of Rs. 47500. Now we have to invest this money in territory Y. We
were already producing 50 units in territory Y so our sale price per unit was 500/50= Rs. 10 and
variable cost per unit was 200/50 = Rs. 4 so we divide the amount we saved from territory z on our
per unit variable cost. Thus we get 47500/4 = 11925 units. Thus we can produce 11925 more units in
territory Y now. Fixed cost will not change because it is fixed.
sugar
16825 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
168250
(52200)
116050
(27800)
88250
(8000)
80250
Division A
3500 units
35000
(2000)
33000
(20000)
13000
Division B
1000 units
10000
(2000)
8000
(6000)
2000
Division C
12325 units
123250
(48200)
75050
(1800)
73250
The calculations on this page are not required in the case. These are just for the purpose of
understanding. The calculations on the next page are required.
3
Territory X has a grater CM Ratio then territory Y that means investment in territory X will yield more
return. Thus we should have invested in territory x. if we do so this would be the result.
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
Division C
38450 units
384500
(48200)
336300
(800)
335500
(1000)
334500
sugar
42950 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
429500
(52200)
377300
(27800)
349500
(8000)
341500
Territory X
(400+38000)= 38400 units
384000
(48000)
336000
(500)
335500
Division A
3500 units
35000
(2000)
33000
(20000)
13000
Division B
1000 units
10000
(2000)
8000
(6000)
2000
Territory Y
50 units
500
(200)
300
(300)
0
Division C
38450 units
384500
(48200)
336300
(1800)
334500
Correcting the Chemical Sector:
The data for the chemical sector is not correctly stated thus we calculate the statement again.
Chemical
6750 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
67500
(25125)
42375
(43500)
(1125)
(10875)
(12000)
Division A
2250 units
22500
(8375)
14125
(8700)
5425
Division B
2250 units
22500
(8375)
14125
(4350)
9775
Division C
2250 units
22500
(8375)
14125
(30450)
(16325)
Using the statement on top of page 8 and the data in the 1st table at page 1 we find out that variable
cost is not properly allocated in the provided segment margin statement thus we created this
statement by using the data provided on page 8. Using information from page 1 we get to know that
50% of cgs in the 1st table of page 8 is variable cost. That is Rs. 25125. There is no oter variable cost
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as it has been mentioned in page 4 that all operating variable expenses have been converted to fixed
cost. So our total variable cost = 25125. And as per data on page 8 it is equally divided in the 3
divisions. The remaining CGS, operating expenses and interest expense (because interest expense
belongs to the chemical sector) are fixed costs = Rs. 29250 and are allocated as per stated on the
same page. 80% traceable and 20% non traceable fixed cost.
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
Division C
2250 units
22500
(8376)
14124
(27405)
(13281)
(3045)
(16326)
Territory X
750 units
7500
(2792)
4708
(2741)
1967
Territory Y
750 units
7500
(2792)
4708
(1370)
3338
Territory Z
750 units
7500
(2792)
4708
(23294)
(18586)
This data has been calculated using the information on page 8.
Time to close the territory z. After rechecking his calculations we find that when we close territory z and
invest the amount saved from that sector to sector y of chemical company then we get these results.
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
CM Ratio = CM/Sales X 100
Division C
8507 units
85070
(31669)
53401
(4111)
49290
(3045)
46245
Territory X
750 units
7500
(2792)
4708
(2741)
1967
Territory Y
(750+7007)=7757 units
77570
(28877)
48693
(1370)
47323
62.77%
62.77%
When we dissolve territory z then we save 2792 running expense or variable cost and 23294
traceable fixed cost. Thus we save a total of Rs. 26086. Now we have to invest this money in territory
Y. We were already producing 750 units in territory Y so our sale price per unit was 7500/750= Rs. 10
and variable cost per unit was 2792/750 = Rs. 3.723 so we divide the amount we saved from
territory z on our per unit variable cost. Thus we get 26086/3.723 = 7007 units. Thus we can produce
7007 more units in territory Y now with the existing 750 units. Fixed cost will not change because it
is fixed. It does not matter if we invest in Territory Y or X because both have same CM Ratio. Thus
they will yield the same return.
5
Division A
2250 units
22500
(8375)
14125
(8700)
5425
Division B
2250 units
22500
(8375)
14125
(4350)
9775
Fine Grup
Cement
sugar
Chemical
13007 units
6820 units
42950 units
13007 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Net Profit/ Segment Margin
627770
(115119)
511751
(86481)
425270
68200
(14500)
52800
(19600)
33200
429500
(52200)
377300
(35800)
341500
130070
(48419)
81651
(31081)
50570
Investment
ROI
340000
125%
120000
27.7%
155000
220%
65000
77.8%
Chemical
13007 units
Sales
Variable Cost
Contribution Margin
Traceable Fixed Cost
Segment Margin
Non- Traceable Fixed Cost
Segment Margin div C
130070
(48419)
81651
(20206)
61445
(10875)
50570
Division C
8507 units
85070
(31669)
53401
(7156)
46245
The final situation becomes
ROI in sugar and chemical sector is this because investment was shifted from sugar to chemical sector.
ROI = Net Profit or Segment Margin/total investment or segment investment
6
Recommendations:
Decision to drop territory z or not will be based on either the problem in territory z is due to
managerial problems or market problems. We can control managerial problems thus we will not
shut down territory z. but incase the problem is market problem then we cannot control it. So we
will close territory z.
The working capital saved from territory z will now be invested in any territory in cement or
chemical industry as both their territories are having same segment margin percentage. While
investment in sugar company will be made in territory x because it has a very high segment margin
percentage.
1st we will check that management accountant was involved in the negligence of duties or not. If he
was involved then a charge sheet will be issued to him and he can be fired. We would also need to
see if he is a permanent employ or a contractual employ. Contractual employs can be fired after 1
month notice. While permanent employs cannot be fired without a charge sheet.
If we are expecting our sales to fall in the future then we will be more likely to convert our fixed cost
into variable cost. But in the current situation we expect sales to increase thus we do not need to
convert our fixed costs to variable cost.
Define the criteria of performance measurement. (Segment margin % is the best base)
We will calculate the ROI and segment margin as a percentage of investment to decide which
segment is profitable and then we can invest in that by taking finance from the other company
temporarily.
This is the complete solution of the case.
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