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TYBMS STRATEGIC FINANCIAL MANAGEMENT SEM V
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1|Page EDUWIZ MANAGEMENT EDUCATION

TABLE OF CONTENTS
SR. PAGE
TOPIC
NO NO.
0 SYLLABUS 3
1 DIVIDEND POLICY 4
2 EXTENSIBLE BUSINESS REPORTING LANGUAGE 25
3 CAPITAL BUDGETING (Techniques under uncertainty) 29
4 CAPITAL RATIONING 47
5 SHAREHOLDER VALUE CREATION 55
6 CORPORATE GOVERNANCE 67
7 COPORATE RESTRUCTURING 73
8 FINANCIAL MANAGEMENT IN BANKING SECTOR 97
9 WORKING CAPITAL FINANCING 108
THINK BMS…THINK EDUWIZ!!!

SYLLABUS
UNIT I : DIVIDEND DECISION AND XBRL
 Dividend Decision
Meaning and Forms of Dividend, Dividend-Modigliani and Miller‟s Approach, Walter Model, Gordon
Model, Factors determining Dividend Policy, Types of Dividend Policy
 XBRL
Introduction, Advantages and Disadvantages, Features and Users
UNIT II : CAPITAL BUDGETING AND CAPITAL RATIONING

 Capital Budgeting
Risk and Uncertainty in Capital Budgeting, Risk Adjusted Cut off Rate, Certainty Equivalent Method,
Sensitivity Technique, Probability Technique, Standard Deviation Method, Co-efficient of Variation
Method, Decision Tree Analysis, Construction of Decision Tree.
 Capital Rationing
Meaning, Advantages, Disadvantages, Practical Problems Investment Planning
UNIT III : SHAREHOLDER VALUE AND CORPORATE GOVERNANCE/ CORPORATE

RESTRUCTURING
 Shareholder Value and Corporate Governance:
Financial Goals and Strategy, Shareholder Value Creation: EVA and MVA Approach, Theories of
Corporate Governance, Practices of Corporate Governance in India
 Corporate Restructuring
Meaning, Types, Limitations of Merger, Amalgamation, Acquisition, Takeover, Determination of
Firm‟s Value, Effect of Merger on EPS and MPS, Pre Merger and Post Merger Impact.
UNIT IV : FINANCIAL MANAGEMENT IR BANKING SECTOR AND WORKING CAPITAL

FINANCING
 Financial Management in Banking Sector
An Introduction, Classification of Investments, NPA & their Provisioning, Classes of Advances,
Capital Adequacy Norms, Rebate on Bill Discounting, Treatment of Interest on Advances
 Working Capital Financing

Maximum Permissible Bank Finance (Tandon Committee), Cost of issuing Commercial Paper and
Trade Credit, Matching Approach, Aggressive Approach, Conservative

1 DIVIDEND POLICY
DIVIDEND
Dividend refers to that portion of a firm's earning which is distributed among shareholders
Earnings are the net profit of a business while dividend is nothing but the payout ratio of the
earnings. Thus we could say that earnings are a broader concept than dividend. In general,
earnings are greater than the total money declared as dividend. This is because a company
usually transfers some part of profit to its reserves. Earnings are equal to dividend when
nothing is kept as reserves. In some cases, total money declared as dividend may exceed the
total earnings for the particular year. This is possible only when the company uses the past
reserves for declaring present dividend.
FACTORS INFLUENCING DIVIDEND POLICY/DETERMINANTS OF DIVIDEND

POLICY
(1) Liquidity:
Traditional theories have postulated that a dividend decision is solely a function of the earnings
of the firm. While earnings are important determinant for the dividend decision, the role of
liquidity cannot be ignored. Dividend payout entails cash outflow for the firm. Hence the
quantum of dividends proposed to be distributed critically depends on the liquidity position of
the firm. In practice, firms often face cash crunch in spite of having good earnings. Such firms
may not be in a position to declare dividends despite their profitability.
(2) Investment Opportunities:

Another key determinant to the dividend decision is the requirement of capital by the firm.
Normally firms tend to have low payout if profitable investment opportunities exist and
conversely firms tend to resort to high payouts if profitable investment opportunities are
lacking. Generally, firms operating in industries, which are in the nascent and growth phases of
the product life cycle, are characterised by high dependence on retained earnings. On the other
hand, firms operating in industries, which are in maturity and decline stages normally,
distribute a larger proportion of their earnings as dividends.
(3) Access to Finance:

A company, which has easy access to external sources of finance, can afford to be more liberal
in its dividend payout. The dividend policy of such firms is relatively independent of its
financing decisions. Firms having little or no access to external financing have rather limited
flexibility in their dividend decisions.
(4) Floatation Costs:

Issue of securities to raise capital in lieu of retained earnings involves floatation costs. These
costs include fees payable to the merchant bankers, underwriting commission, brokerage,
listing fees, marketing expenses, etc. Moreover smaller the size of the issue, higher will be the
floatation costs as a percentage of amounts mobilised. Further there are indirect floatation costs
in the form of under pricing. Normally issue of shares is made at a discount to the prevailing
market price. The cost of external financing has an influence on the dividend policy.
(5) Corporate Control:

Further issue of shares (unless done through rights issue) results in dilution of the stake of the
existing shareholders. On the other hand, reliance on retained earnings has no impact on the
controlling interest. Hence companies vulnerable to hostile takeovers prefer retained earnings
rather than fresh issue of securities. In practice, this strategy can be a double-edged sword. The
niggardly payout policy of the company may result in low market valuation of the company
vis-a-vis its intrinsic value. Consequently the company becomes a more attractive target and is
in the danger of being acquired.
(6) Investor Preferences:

The preference of the shareholders has a strong influence on the dividend policy of the firm. A
firm tends to have a high payout ratio if the shareholders have strong preferences towards
current dividends. On the other hand, a firm resorts to retained earnings if the shareholders
exhibit a clear tilt towards capital gains.
(7) Restrictive Covenants:

The protective covenants a bond indentures or loan agreements often include restrictions
pertaining to distribution of earnings. These covenants are incorporated to preserve the ability
of the issuer/borrower to service the debt. These covenants limit the flexibility of the company
in determining its dividend policy.
(8) Taxes:
The incidence of taxation on the firm and the shareholders has a bearing on the dividend
policy. In India the tax laws levies a certain percentage of tax on the amount of distributed
profits. This tax is a strong fiscal disincentive on dividend distribution.
(9) Dividend Stability:

The earnings of a firm may fluctuate wildly between various time periods. Most firms do not
like to have an erratic dividend payout in line with their varying earnings. They try to maintain
stability in their dividend policy. Stability does not mean that the dividends do not vary over a
period of time. It only indicates that the previous dividends have a positive correlation with the
current dividends. In the long run, the dividends have to be invariably adjusted to synchronize
with the earnings. However the short-term volatility in earnings need not be fully reflected in
dividends.

(10) Returns Earned:
Returns earned by the company whether high or low influences the dividend payout ratio.
More the earnings earned, more is the amount available for dividend distribution and vice-
versa. Other factors such as investment opportunities also matters in this case.
(11) Shareholding Pattern:

Few shareholders in closely held company in high income tax bracket prefers that the firm
should retain the earnings and not to pay attractive dividends since it results into being taxed at
a higher rates since the income tax rates are higher than the taxes on capital gains.
(12) Competitive Concerns:

The dividend policy of competitive concerns should be taken into consideration while framing
the dividend policy since equity investors have an option to switch over their investments from
one company to another.
(13) Management Philosophy:

The extent to which management identifies itself with the ordinary shareholders. If the
shareholders have a strong desire to current income over capital gains then the management
should adopt such a dividend policy to satisfy the needs of its majority shareholders.
(14) Influential Shareholders:

The existence of influential shareholders with special investment objectives has an impact on
the firms dividend policy. Mutual funds invest in a company's shares with the objective of
earning dividends, etc.
DIVIDEND PRACTICES/TYPE OF DIVIDEND POLICY/FORMS OF DIVIDEND

POLICY
(1) Maintenance of Dividend Stability:
This position is in recession when many companies maintain dividends even though earnings
fall, therefore, push up the payment ratio. If the slump in income is short-lived, this policy is
logical since a reduction in a dividend rate may shaken the investors confidence and may
impair the investment status of the company in the eyes of institutional investors like insurance
companies, financial companies, investment trusts, etc.
(2) Distribute a Fixed Rupee amount of Dividend:

Treats ordinary shareholders, somewhat like preference shareholders. The danger in using this
policies is that if the distributions are too large and the dividend takes a large portion of
accumulated working capital, the company may not be able to withstand the shock of operating
losses.
(3) Minimum Rupee amount with a Step-up Feature:

This policy sets the dividend low enough so that there is little chance of a default but at the
same time it allows a great deal of flexibility for paying higher dividends and does commit the
business to adopt the larger payments as part of the future fixed dividends.
(4) Fixed Percentage of Net Profit:

The company distributes dividend as a fixed percentage of net profits. When the net profits are
more the amount available for dividends is more and vice-versa. In this policy the rate of
dividend is a fixed percentage and it is kept constant.
(5) Corporate management increases the percentages of dividends when profits decline and
decreases it as profits increases. When the profits declines the shareholders will question the
management for their inefficiency. In order to avoid such embarrassing situation the
management increases the percentage of dividends when earnings declines. And when the
earnings increases the corporate management decreases the percentage of dividend with a
justification that it is adopting a conservative dividend policy and retaining the earnings for
future requirements.
(6) Dividend as a fixed percentage of market value.

As per this policy the company declares dividend as a fixed percentage of market price of the
company's shares. A high market price means higher dividend and in turn high dividend results
in higher market price per share and vice-versa.
Company - A Company - B
Fig. : DPS as a percentage of EPS Earnings of both companies same but market prices
increases because stability of dividend of Company - B.
(7) Constant payout:

The ratio of dividend to earnings is known as payout ratio. Some companies may follow a
policy of a constant payout ratio, i.e. paying a fixed percentage of net earnings every year.
With this policy the amount of dividend will fluctuate in direct proportion to earnings. If a
company adopts a 40 percent payout ratio, then 40 percent of every rupee of net earnings will

be paid out. For example, if the company earns Rs. 2 per share, the dividend per share will be
Re. 0.80 and if it earns Rs. 1.50 per share the dividend per share will be Re. 0.60. The relation
between the earnings per share and the dividend per share under this policy can be exhibited as
in the figure below.
This policy is related to a company's ability to pay dividends. If the company incurs losses no
dividends shall be paid regardless of the desires of shareholders. Internal financing with
retained earnings is automatic when this policy is followed. At any given payout ratio, the
amount of dividends and the additions to retained earnings increase with increasing earnings
and decrease with decreasing earnings. This policy simplifies the dividend decision, and has
the advantage of protecting a company against over or tinder payment of dividend. It ensures
that dividends are paid when profits are earned, and avoided when it incurs losses.
(8) Constant Dividend per share or Dividend rate:

A number of companies follow the policy of paying a fixed amount per share or fixed rate on
paid-up capital as dividend every year, irrespective of the fluctuations in the earnings. This
policy does not imply that the dividend per share or dividend rate will never be increased.
When the company reaches new levels of earnings and expects to maintain it, the annual
dividend per share may be increased. The earnings per share and the dividend per share
relationship under this policy can be depicted as in the following figure 1.3.

It is easy to follow this policy when earnings are stable. If the earnings pattern of a company
shows wide fluctuations, it is difficult to maintain such a policy. With earnings fluctuating
from year to year, it is essential for a company, which wants to follow this policy to build up
surpluses in years of higher than average earnings to maintain dividends in years of below
average earnings. In practice, when a company retains earning in good years for this purpose, it
earmarks this surplus as reserve for dividend equalisation. Dividend Equalisation Fund or
Reserve is maintained in this case. These fluids are invested in current assets like marketable
securities, so that they may easily be converted into cash at the time of paying dividend in bad
years.
The dividend policy of paying a constant amount of dividend per year treats ordinary
shareholders somewhat like preference shareholders without taking into account the firm's or
shareholders' investment opportunities. Those investors who have dividends as the only source
of their income prefer the constant dividend policy. They are hardly concerned about the
changes in share prices. In the long run, such behaviour helps to stabilise the market price of
the share.
(9) Small constant dividend per share plus extra dividend:

Under the constant dividend per share policy, the amount of dividend is set at a high level, and
this policy is usually adopted by the companies with stable earnings. For companies with
fluctuating earnings, the policy to pay a minimum dividend per share with a step up feature is
desirable. The small amount of dividend is fixed to reduce the possibility of ever missing a
dividend payment. By paying extra dividend (a number of companies pay an interim dividend
followed by a regular final dividend) in periods of prosperity, an attempt is made to prevent
investors from expecting that the dividend represent an increase in the established dividend
amount. This type of a policy enables a company to pay constant amount of dividend regularly
without a default and allows a great deal of flexibility for supplementing the income of
shareholders only when the company's earnings are higher than the usual, without committing
itself to making larger payments as a part of the future fixed dividend. Certain shareholders
like this policy because of the certain cash flow in the form of regular dividend and the option
of earning extra dividend occasionally.
(10) Conservative dividend policy:

Build up reserves during prosperous period by low payout of dividend. In case of a
conservative dividend policy the firm adopts a policy of low dividend payout and retains the
maximum portion of earnings which it can use at a later date. Since the policy emphasis on
conserving a maximum proportion of its earnings it is known as conservative dividend policy.
(11) Stable dividend policy:

Pays consistent rate of dividend. Fixed rate of dividend is maintained in prosperity (boom) also
in depression (lean). During prosperous period the company conserves its earnings and pays
dividend at a certain rate and in the years of low profits it utilizes the retained earnings in order

to pay dividends at the same rate as in the years of prosperity and thus it maintains a dividend
stability.
TYPES OF DIVIDEND
(1) Interim Dividend:
An interim dividend is one, which is declared before the declaration of final dividend. Interim
dividend, which is declared between two annual general meetings. The Board of Directors may
from time to time pay to the members such an interim dividend as appears to it to be justified
by profits of the company. The directors must take into consideration the future prospects of
the profits e.g. orders in hand, any seasonal element in business before declaration of interim
dividend otherwise it may be considered payment out of capital. Cash resources, likelihood
profitability of the company must also be taken into consideration while deciding to declare an
interim dividend.
In March 2002 many Indian companies declared interim dividend to escape from 10% dividend
tax levied in the Annual Budget 2002- 03 on the shareholders. But SEBI did not allow this as it
did not follow the stipulated 30-42 days advance declaration.
(2) Final Dividend:

At the end of the accounting period, the accounts of the company are prepared to ascertain the
amount of profit earned by the company. The directors, taking into consideration the financial
position of the company, its future prospects, provisions for resources, etc., decide to
recommend to the shareholders at the annual general meeting the dividend to be paid to the
shareholders.
(3) Dividend on Preference Share:

The Articles of Association of a company empower the directors to declare and pay both
interim and final dividend on preference share. Holders of preference share are entitled to
receive dividend before any dividend is paid to the equity shareholders as per the terms of the
issue.
LEGAL ASPECTS OF DIVIDEND

The amount of the dividend that can be legally distributed is governed by company law,
judicial pronouncements in leading cases, and contractual restrictions. The Companies Act
prescribes certain guidelines in respect of declaration and payment of dividends. The important
provisions of company law pertaining to dividends are described below:
(1) Companies can pay only cash dividends (with the exception of issue of fully paid-up
bonus shares).
(2) (i) Dividends can be paid only of the profits earned during the financial year after
providing for depreciation in accordance with the provisions of Companies Act and after
transferring to reserve such percentage of profits as prescribed by the law. The Companies
10 | P a g e EDUWIZ MANAGEMENT EDUCATION

(Transfer to Reserves) Rules, 1975, provide that before dividend declaration a percentage of
profit as specified below should be transferred to the reserves of the company.
(a) Where the dividend proposed exceeds 10 per cent but not 12.5 percent of the paid-up
capital, the amount to be transferred to the reserves shall not be less than 2.5 per cent of the
current profits.
(b) Where the dividend proposed exceeds 12.5 percent but not 15 percent of the paid-up
capital, the amount to be transferred to the reserves shall not be less than 5 percent of the
current profits.
(c) Where the dividend proposed exceeds 15 percent but not 20 percent of the paid up
capital, the amount to be transferred to the reserves shall not be less than 7.5 percent of the
current profits; and
(d) Where the dividend proposed exceeds 20 percent of the paid-up capital, the amount to be
transferred to the.reserves shall not be less than 10 percent of the current profits.
Or
(ii) Dividend can be declared out of the remaining undistributed profits of the company for
any previous year(s) arrived at after providing for depreciation.
or
(iii) Dividend can be paid out of moneys provided by the Central Government or a State
Government for the payment of dividend in pursuance of a guarantee given by that
Government.
(3) Due to inadequacy or absence of profits in any year, dividend may be paid out of the
accumulated profits of previous years. In this context, the following conditions, as stipulated
by the Companies (Declaration of Dividend Out of Reserves) Rules, 1975, have to be satisfied.
(a) The rate of the dividend declared shall not exceed the average of the rates at which
dividend was declared by it in 5 years immediately preceding that year or 10 percent of its
paid-up capital, whichever is less;
(b) The total amount to be drawn from the accumulated profits earned in previous years and
transferred to the reserves shall not exceed an amount equal to one-tenth of the sum of its paid-
up capital and free reserves and the amount so drawn shall first be utilised to set off the losses
incurred in the financial year before any dividend in respect of preference or equity shares is
declared; and
(c) The balance of reserves after such withdrawal shall not fall below 15 percent of its paid-
up capital.
(4) Dividends cannot be declared for past years for which the accounts have been closed.
(5) The Central Government, if it thinks necessary so to do in the public interest, allow any
company to declare or pay dividend for any financial year out of the profits of the company for
that year or any previous financial year(s) without providing for depreciation.

(6) Any dividend payable in cash may be paid by cheque or warrant sent through the post
directed to the registered address of the shareholder or in case of joint shareholders to the
registered address of the first named person on the register of members.
PROCEDURAL ASPECTS OF DIVIDEND

The important events and dates in the dividend payment procedure are:
(a) Board resolution:
The dividend decision is the prerogative of the board of directors. Hence the Board of
Directors should in a formal meeting resolve to pay the dividend to the shareholders.
(b) Shareholders approval:

The resolution of the Board of Directors to pay the dividend has to be approved by the
shareholders in the annual general meeting (AGM).
(c) Record date:

The dividend is payable to shareholders whose names appear in the Register of Members as on
the record date (the cutoff date).
(d) Dividend payment:

Once a dividend declaration has been made, dividend warrants must be posted within 42 days.
Within a period of 7 days, after the expiry of 42 days, unpaid dividends must be transferred to
a special account opened with the scheduled bank. In case of default the company has to pay
interest at 12% p.a. or at the rate stated from time to time. Any money which remains unpaid or
unclaimed for three years from the date of transfer shall be transferred to General Revenue
account of the Central Government, but claims may be done by persons to whom monies are
due.
TERMINOLOGIES
While reading stock exchange quotations, one comes across various abbreviations. The
important ones are as follows:
(i) Ex-all (xa): Appearing after a share price, it means a purchaser buys without rights to
whatever thecompany is in the process of issuing - dividend, rights issue shares, scrip issue
shares, warrants, etc. likewise;
(ii) con: indicates convertible.
(iii) sl: indicates small lot.
(iv) xd: indicates ex (excluding) dividend.
(v) cd: indicates cum (with) dividend.
(vi) xr: indicates ex (excluding) rights.
(vii) cr: indicates cum (with) rights.
(viii) cb: indicates cum (with) bonus [shares].
(ix) xb: indicates ex (excluding) bonus.

CUM OR EX
Shares prices are sometimes quoted cum or ex dividend or cum or ex¬bonus or cum or ex
rights. They are written as cd, cr or cb if cum and xd, xb or xr if ex. Unless specifically
mentioned, all prices are cum which means that all future dividends, bonuses and rights will
accrue to the buyer. In cases of doubt - this could arise if the trading date is closure to
the date on which a share changes status from cum or ex. It is always advisable
to get the doubt clarified with the broker before placing the order.
If share are purchased when they are quoted cum and sent for registration before the closure of
the books, dividends and other distributions are made to the new purchaser who henceforth will
be the registered holder of the shares. However if the books are already closed, it is the
responsibility of the buyer broker to collect the distribution from the seller broker and pass
them on to the purchaser.
BOOK CLOSURE/RECORD DATE

Every company maintains a Register of its shareholders. The Register of Members contains
names, address and other particulars of each of its shareholders. As the ownership of the shares
keeps on changing due to the buying and selling activities and the consequent registration of
transfers, the list of shareholder is constantly updated with the names of the transferees added
and those of transferors deleted.
When a company declares a dividend or announces a bonus share or right issue or wants to
convene a meeting of the shareholders, it becomes necessary to freeze the list at a point of time
to take stock of the shareholders entitled to the benefit. This is known as Closure of Register of
Members or just Book Closure. During the period of Book Closure, no transfer of share is
undertaken by the company.
THEORIES OF DIVIDEND POLICIES

1. WALTER’S MODEL
Professor James E. Walterargues that the choice of dividend policies almost always affects the
value of the enterprise. His model shows clearly the importance of the relationship between the
firm‟s internal rate of return (r) and its cost of capital (k) in determining the dividend policy
that will maximise the wealth of shareholders.
Walter’s model is based on the following assumptions:

1. The firm finances all investment through retained earnings; that is debt or new equity is not
issued;
2. The firm‟s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.

4. Beginning earnings and dividends never change. The values of the earnings pershare (E),
and the divided per share (D) may be changed in the model to determine results, but any given
values of E and D are assumed to remain constant forever in determining a given value.
5. The firm has a very long or infinite life.
Walter‟s formula to determine the market price per share (P) is as follows:
P = D/K +r(E-D)/K/K
The above equation clearly reveals that the market price per share is the sum of the present
value of two sources of income:
i) The present value of an infinite stream of constant dividends, (D/K) and
ii) The present value of the infinite stream of stream gains [r (E-D)/K/K]
CRITICISM
1. Walter‟s model of share valuation mixes dividend policy with investment policy of the firm.
The model assumes that the investment opportunities of the firm are financed by retained
earnings only and no external financing debt or equity is used for the purpose when such a
situation exists either the firm‟s investment or its dividend policy or both will be sub-optimum.
The wealth of the owners will maximise only when this optimum investment in made.
2. Walter‟s model is based on the assumption that r is constant. In fact decreases as more
investment occurs. This reflects the assumption that the most profitable investments are made
first and then the poorer investments are made. The firm should step at a point where r = k.
This is clearly an erroneous policy and fall to optimise the wealth of the owners.
3. A firm‟s cost of capital or discount rate, K, does not remain constant; it changes directly
with the firm‟s risk. Thus, the present value of the firm‟s income moves inversely with the cost
of capital. By assuming that the discount rate, K is constant, Walter‟s model abstracts from the
effect of risk on the value of the firm.
2. GORDON’S MODEL
One very popular model explicitly relating the market value of the firm to dividend policy is
developed by Myron Gordon.
Gordon’s model is based on the following assumptions.

1. The firm is an all Equity firm
2. No external financing is available

3. The internal rate of return (r) of the firm is constant.
4. The appropriate discount rate (K) of the firm remains constant.
5. The firm and its stream of earnings are perpetual
6. The corporate taxes do not exist.
7. The retention ratio (b), once decided upon, is constant. Thus, the growth rate (g) = br is
constant forever.
8. K > br = g if this condition is not fulfilled, we cannot get a meaningful value for the share.
According to Gordon‟s dividend capitalisation model, the market value of a share (Pq) is equal
to the present value of an infinite stream of dividends to be received by the share. Thus:
The above equation explicitly shows the relationship of current earnings (E,), dividend policy,
(b), internal profitability (r) and the all-equity firm‟s cost of capital (k), in the determination of
the value of the share (P0).
3. MODIGLIANI AND MILLER’S HYPOTHESIS

According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it does
not affect the wealth of the shareholders. They argue that the value of the firm depends on the
firm‟s earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of earnings
between dividends and retained earnings is of no significance in determining the value of the
firm.
M – M’s hypothesis of irrelevance is based on the following assumptions.
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends with certainty and one discount rate is appropriate for all securities and all time
periods. Thus, r = K = Kt for all t.

Under M – M assumptions, r will be equal to the discount rate and identical for all shares. As a
result, the price of each share must adjust so that the rate of return, which is composed of the
rate of dividends and capital gains, on every share will be equal to the discount rate and be
identical for all shares.
Thus, the rate of return for a share held for one year may be calculated as follows:
The Rate of Return for a Share held for one year

Where P0 is the market or purchase price per share at time 0, P1, is the market price per share
at time 1 and D is dividend per share at time 1. As hypothesised by M – M, r should be equal
for all shares. If it is not so, the low-return yielding shares will be sold by investors who will
purchase the high-return yielding shares.
This process will tend to reduce the price of the low-return shares and to increase the prices of
the high-return shares. This switching will continue until the differentials in rates of return are
eliminated. This discount rate will also be equal for all firms under the M-M assumption since
there are no risk differences.
From the above M-M fundamental principle we can derive their valuation model as follows:
Multiplying both sides of equation by the number of shares outstanding (n), we obtain the
value of the firm if no new financing exists.
If the firm sells m number of new shares at time 1 at a price of P^, the value of the firm at time
0 will be
The above equation of M – M valuation allows for the issuance of new shares, unlike Walter‟s
and Gordon‟s models. Consequently, a firm can pay dividends and raise funds to undertake the
optimum investment policy. Thus, dividend and investment policies are not confounded in M –
M model, like waiter‟s and Gordon‟s models.
CRITICISM
Because of the unrealistic nature of the assumption, M-M‟s hypothesis lacks practical
relevance in the real world situation. Thus, it is being criticised on the following grounds.
1. The assumption that taxes do not exist is far from reality.

2. M-M argue that the internal and external financing are equivalent. This cannot be true if the
costs of floating new issues exist.
3. According to M-M‟s hypothesis the wealth of a shareholder will be same whether the firm
pays dividends or not. But, because of the transactions costs and inconvenience associated with
the sale of shares to realise capital gains, shareholders prefer dividends to capital gains.
4. Even under the condition of certainty it is not correct to assume that the discount rate (k)
should be same whether firm uses the external or internal financing.
If investors have desire to diversify their port folios, the discount rate for external and internal
financing will be different.
5. M-M argues that, even if the assumption of perfect certainty is dropped and uncertainty is
considered, dividend policy continues to be irrelevant. But according to number of writers,
dividends are relevant under conditions of uncertainty.

PRACTICAL PROBLEMS
1. Shalini & Co. earns Rs. 6 per share having capitalization rate of 10% and has a return on
investment @ 20%. According to Walter‟s Model, what should be the price per share at 30%
dividend payout ratio? Is this the optimum payment ratio as per Water?
2. Following are the details regarding three companies A Ltd., B Ltd. and C Ltd.
A Ltd. B Ltd. C Ltd.
Internal Rate of Return 15% 5% 10%
Cost of Equity Capital 10% 10% 10%
Earning per Share Rs. 8 Rs. 8 Rs. 8
Calculate value of an equity share of each of these companies as per Walter‟s Model when the
dividend payout ratio is :
a) 50%,
b) 75% and
c) 25%.
3. Details regarding three companies are given below :

A Ltd. B Ltd. C Ltd.
r = 15% r = 10% r = 8%
Ke = 10% Ke = 10% Ke = 10%
E = Rs. 10 E = Rs. 10 E = Rs. 10
By using Walter‟s Model, you are required to calculate the value of an equity share of each of
these companies when dividend payout ratio is :
a) 20%,
b) 50%,
c) 0% and
d) 100%
4. ABC Ltd. was started a year back with a paid-up equity capital of Rs. 40,00,000. The other
details are as under:
Earnings of the Company : Rs. 400,000
Dividend Paid Price : Rs. 320,000
Eamings Ratio : 12.5
Number of Shares : 40,000
You are required to find out whether the company‟s dividend pay out ratio is optimal, using
Walter‟s Formula.
5. The cost of capital and the rate of return on investment of WM Ltd. is 10% and 15%
respectively. The company has one million equity Shares of Rs. 10 each outstanding and its
earnings per share is Rs. 5. Calculate the value of the firm in the following situations using
Walter‟s Model: (i) 100% retention, (ii) 50% retention and (iii) No retention. Comment on
your results.

6. Calculate the market price of a share of ABC Ltd. under Walter‟s formula.
Earning Per Share Rs. 5
Dividend Per Share Rs. 3
Cost of Capital 16%
Internal Rate of Return on Investment 20%
Retention Ratio 50%
7. The dividends of Nelson Company Ltd. are expected to grow at a rate of 25% for 2 years,
after which the growth rate is expected to fall to 5%. The dividend paid last period was ? 2.
The investor desires a 12% return.
You are required to find the value of this stock. P V factor @ 12% is as under :
Year 1 2 3
Value 0.893 0.797 0.712
8. Z Ltd. is foreseeing a growth rate of 12% per annum in the next 2 years. The growth rate is
to fall to 10% for the third year and fourth year. After that, the growth rate is expected to
stabilise at 8% p.a. The last dividend paid was Rs. 1.50 per share and the investors‟ required
rate of return is 16%.
Find out interest per share of Z ltd as of date. You may use the following table.
Years 0 1 2 3 4 5
Discounting Factor at 1 0.86 0.74 0.64 0.55 0.48
16%
9. R Dotcom Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The
growth rate is likely to fall to 10% for the third year and the fourth year. After the growth rate
is expected to stabilize at 8% annum,. If the last dividend was Rs. 1.50 per share and the
investor‟s required rate of return is 16%, determine the current value of its equity share. The
PV factors at 16% are :
Years 1 2 3 4
PV Factor 0.862 0.743 0.641 0.552
10. The required rate of return of investors is 15%. ABC Ltd. declared and paid annual
dividend of 3 per share. It is expected to grow @ 20% for the next 2 years and 10% thereafter.
Compute the price at which the company‟s share should sell.
Note : P.V. Factor @ 15% for Year 1 = 0.8696 and Year 2 = 0.7561.
11. The MNC Ltd.‟s available information is :

Ke = 15%,
E = Rs. 30,
r = (i) 14%, (ii) 15% and (iii) 16%.
You are required to calculate market price of a share of the MNC Ltd. as per Gordan
Model if :
(i) b = 40%, (ii) b = 60% and (iii) b = 80%.

12. A company has a total investment of Rs. 5,00,000 in assets and 50,000 outstanding
ordinary shares at Rs. 10 per share (per value). It earns a rate of 15% on its investment and has
a policy of retaining 50% of the earnings.
If the appropriate discount rate of the firm is 10%, determine the price of its share using
Gordon‟s model. What shall happen to the price of the share, if the company has a payout of
80% or 20%?
13. D Ltd. has 10 lakhs equity shares outstanding at the beginning of the year 2002. The
current market price of the shares is Rs. 150 each. The Board of Directors of the company has
recommended ? 8 per share as dividend. The rate of capitalization, appropriate to the risk class
to which the company belongs, is 12%
i) Based on M.M. approach, calculate the market price of the share of the company when
the recommended dividend is :
a) declared and
b) not declared.
ii) How many new shares are to be issued by the company at the end of the accounting
year on the assumption that the net income for the year is Rs. 2 crores and investment
budget is Rs. 4 crores, when:
a) the above dividends are distributed and
b) dividends are not declared.
iii) Show the market value of the shares.
14. Bestbuy Auto Ltd. has outstanding 1,20,000 shares selling at Rs. 20 per share. The
company hopes to make a net income of Rs. 3,50,000 during the year ended 31st March, 2011.
The company is considering to pay a dividend of Rs. 2 per share at the end of current year. The
capitalization rate for risk class of this company has been estimated to be 15%.
Assuming no taxes, answer the questions listed below on the basis of the Modigliani and Miller
Dividend valuation model:
i) What will be the price of a share at the end of 31st March, 2010.
a) if the dividend is paid and
b) if the dividend is not paid?
ii) How many new shares must the company issue if the dividend is paid and company
needs Rs. 7,40,000 for an approved investment expenditure during the year?
15. ABC Ltd. has 50,000 outstanding shares. The current market price per shares is Rs. 100
each. It hopes to make a net income of Rs. 5,00,000 at the end of current year. The Company‟s
Board is considering a dividend of Rs. 5 per share at the end of current financial year. The
company needs to raise Rs. 10,00,000 for an approved investment expenditure. The company
belongs to a risk class for which the capitalization rate is 10%. Show, how does the M.M.
approach affect the value of firm if the dividends are paid or not paid.

16. Rama Ltd. had 1,00,000 equity shares of Rs. 10 each outstanding on 1st January, 2007. The
shares are currently being quoted at par in the market. In the wake of the removal of the
dividend restraint, the company now intends to pay a dividend of Rs. 2 per share for the current
financial year. It belongs to a risk class whose appropriate capitalization rate is 15%. Using
Modigliani - Miller Model and assuming no taxes, ascertain the price of the company‟s shares
as it is likely to prevail at the end of the year - (i) when dividend is declared and (ii) when no
dividend is declared.
Also find out the number of new equity shares that company must issue to meet its investment
needs of Rs. 4 lakh assuming that the dividend is paid and the earnings per share works out @
Rs. 2.20.
17. M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000
outstanding shares and the current market price is Rs. 100. It expects a net profit of Rs.
2,50,000 for the year and the Board is considering dividend of Rs. 5 per share.
M Ltd. requires to raise Rs. 5,00,000 for an approved investment expenditure. Show, how does
the MM approach affect the value of M Ltd. if dividends are paid or not paid.
18. ST Ltd. has capital Rs. 10,00,000 in equity shares of Rs. 100 each. The shares are currently
quoted at par. The company proposes declaration of a dividend of Rs. 10 per share. The
capitalization rate for the risk class to which the company belongs is 12%.
What will be the market price of the share at the end of the year, if - (i) no dividend is declared
and (ii) 10% dividend is declared?
Assuming that the company pays the dividend and has net profits of Rs. 5,00,000 and makes
new investments of Rs. 10,00,000 during the period, how many new shares must be issued Rs.
Use the M.M. Model.
19. (Rs. in lakhs)

Particulars Quick Slow Ltd.
Equity Share Capital (Rs. 10 face value) 200
Ltd. 250
12% Preference Shares 80 100
Profits after Tax 50 70
Proposed Dividend 35 40
Borrowed Fund 15% Debentures 300 Rs. 500 Rs.
Market Price Per Share 100 140
Calculate:
(a) Earnings per share (b) P/E ratio (c) Dividend pay-out ratio (d) Return on equity shares
(e) Debt equity ratio (f) Interest coverage ratio.
Assuming Net Profits Ratio of 10%.
Comment on the Dividend Policy of the companies.
As an analyst inform the investor which of the two companies are worth investing.

20. Excellent Enterprises furnishes the following extract from its Balance sheet for the year
ending 2004-05.
Liabilities Rs. in Lakhs
Equity Share (Rs. 10 each) 450
Accumulated Profits 255
Profit for the year 150
8% Debentures 120
Total 975
The management of the Company has been following a dividend payout of 30% constantly in
the past. However it is not sure as to whether it should continue the practice as it has enough
investment opportunities in store. It has therefore approached you for advice and needs you to
answer the following questions with reasons, if any:
(a) If it continues the earlier dividend policy what is the rate of dividend it will be declaring
and how much is the cash outflow?
(b) If it wants to give out dividends @ 30%, how muchis the cash outflow then?
(c) If it wants to give out dividends @ 45%, how muchis the cash outflow then?
(d) If the current market price of the share is Rs. 70; what would be the P/E ratio?
(e) Can it give out Bonus shares in lieu of dividend to avoid the cash outflow in the form
of dividend payment?
21. A company expects to generate the following net income and incur the following capital
expenditure in the next five years as per the following details:
Year 1 2 3 4 5
Net Profit 75 60 45 40 25
Capital 40 45 55 47 50
Expenditure
The total number of outstanding shares are 18,00,000 and current dividend is Rs. 6.5 per share;
you are required to:
(a) Determine the dividend per share, if the company follows a residual dividend policy.
(b) Determine the amount of external financing if the current dividend is maintained.
(c) Determine the amounts of external financing if the company maintains a 50% dividend
pay out ratio.
(d) Identify under which of the above three policies the aggregate dividends are maximized
and under which policy the amount of external financing is minimized.
22. Excell Enterprises is a fast growing firm in a manufacturing sector. Following is the
Balance sheet of the company for the year ending 2003-04:
Particulars Rs. (in „000)
Equity Shares of Rs. 10 each 300
Accumulated Profits 170
Profits for the year 100
6% Debentures 80

Total: 650
Fixed Assets 400
Working Capital 250
Total 650
The Management of the company has been following a dividend payout of 40% constantly in
the past. However it is not sure as to whether it should continue the practice as it has enough
investment opportunities in store. It has therefore approached you for advice and needs you to
answer the following questions with reasons if any:
(a) If it continues the earlier dividend policy what is the rate of dividend it will be declaring
and how much is the cash outflow?
(b) Can it give out bonus shares in lieu of dividend to avoid the cash outflow in the form of
dividend payment?
(c) If it wants to give out dividends @40%, how much is the cash outflow then?
(d) If the current market price of the share is Rs. 50. What would be the P/E ratio?
(e) If in the future years it incurs a loss due to incorrect investments then can it still pay out
dividends?
23. Following is the EPS record of PP Ld. Company over the past ten years:
Year ending March EPS (Rs.) Year ending March EPS (Rs.)
2005 20 2000 12
2004 19 1999 6
2003 16 1998 9
2002 15 1997 3
2001 16 1996 2
Determine the annual dividend paid each year in the following cases:
(i) If the company‟s dividend policy is based on a constant dividend pay-out policy of 50%
for all the years.
(ii) If the policy is to pay Rs. 8 per share dividend and increase it to Rs. 10 when earnings
exceed Rs. 14 per share for 2 consecutive years.
(iii) If the policy is to pay Rs. 7 per share dividend each year except when EPS exceeds Rs.
14 per share, when an extra dividend equal to 80% of earnings beyond Rs. 14 would be paid.
24. The following is the Balance Sheet of M/s. ABC Ltd. as at 31-3-2008.
Liabilities (Rs.) Assets (Rs.)
30,00,000 Equity Fixed Assets 4,56,00,000
Shares of Rs. 10 each 3,00,00,000 Investment 8,00,000
11% Pref. Shares of Rs. 50,00,000 Current Assets:

10 each Cash and Bank 59,45,980
Others 3,81,53,320 4,40,99,300

General Reserve 2,60,00,000
Profit & Loss A/c. Op. 1,22,30,400

Bal.
+ Current year‟s Profit 88,22,450 2,10,52,850
Secured Loans 44,23,000

Current Liabilities 1,12,23,450
Total 9,76,99,300 Total 9,76,99,300

The Company has a track record of paying dividend § 12% on equity shares. Two of the total
directors of the company are of the opinion that the current position of the company is not
sound enough to declare and pay dividend. Instead they propose that the Company should skip
the dividend this year and go for Bonus Issue.
Discuss with reasons whether you agree with them.
In the light of the above case, you are also required to list any five points in support of:
(a) Policy of declaring dividend.
(b) Practice of periodical bonus issue of dividend.
25. Calculate the market price of share as per Walter and Gordon Model.
Retention Ratio 50%
Internal Rate of Return 20%
Cost of Capital 16%
Dividend per share Rs. 3
Earning Per share Rs. 5

EXTENSIBLE BUSINESS REPORTING LANGUAGE
2 (XBRL)
XBRL stands for extensible Business Reporting Language, which is a language used for the
electronic communication of business and financial data. XBRL is an open international,
standard for digital business reporting. It is managed by a global not for profit consortium
named XBRL International. Today XBRL is used in more than 50 countries in the world.
Every year millions of XBRL documents are created replacing the older paper-based reports.
Such XBRL documents are more useful, more effective and more accurate digital versions.
XBRL was designed as a language to electronically communicate business and financial data
instead of the more traditional formats. XBRL assigns unique tags to different financial terms,
categorizes them, shows the relationship between them, and allows the data to be analysed by
the computer software. In the days to come XBRL is expected to revolutionize the business
and financial world.
FEATURES
(1) Clear Definitions:
XBRL allows the creation of reusable, authoritative definitions, called taxonomies.
Taxonomies are developed by the regulators, accounting standards setters, government
agencies and other groups that need to clearly define information that needs to be reported
upon. Such taxonomies capture the meaning contained in all of the reporting terms used in a
business report, as well as the relationships between all of the terms. Thus it provides a list of
definitons (taxonomies) for the financial terms used.
(2) Testable Business Rules:

XBRL allows the creation of business rules that limit what can be reported. Business rules can
be logical or mathematical, or both which can be used to stop poor quality information being
sent to the regulator or to a third party.
(3) Multi-lingual Support:

XBRL allows reports to be prepared in as many languages as necessary which means that it's
possible to display a range of reports in a different language to the one that they were prepared
in, without any additional work.
(4) Mandatory Requirement:

Vide Companies (Filing of documents and forms in Extensible Business Reporting Language)
Rules, 2011, notification issued by Ministry of Corporate Affairs, Government of India
mandated that companies falling in the following categories will have to file their Balance
Sheet and Profit & Loss Account under the provisions of relevant Section of the Companies

Act using the Extensible Business Reporting Language (XBRL) taxonomy for financial year
ending on or after 31.03.2011:
(a) All companies listed with any Stock Exchange(s) in India and their Indian subsidiaries;
or
(b) All companies having paid-up capital of Rupees Five Crore and above; or
(c) All companies having turnover of Rupees One Hundred Crore and above.
ADVANTAGES
(1) Reporting Language:
XBRL provides a language in which reporting terms can be authoritatively defined. It provides
a standardized language for all companies reporting their financial data.
(2) Flow of Information:

XBRL allows reporting information move between organisations rapidly, accurately and
digitally. Also it allows for the exchange of business information across a reporting chain.
(3) Digital Information:

XBRL also opens up a range of new capabilities because the information is clearly defined,
platform-independent, testable and digital.
(4) Sharing and Analysis:

Digital business reports, in XBRL format, simplify the way that people can use, share, analyse
and add value to the data.
(5) Accurate and Time Saving:

XBRL makes reporting more accurate and more efficient. Hence reporting becomes more
authentic. Thus it saves time in entering and reporting financial data and increases efficiency.
(6) Exchange of Reports:

Allowing the exchange of summary business reports, like financial statements, and risk and
performance reports.
(7) Benefits Stakeholders:

Allows investors and stakeholders to easily download and understand financial reports.
(S) Cost-effective:
XBRL reports are very cost-effective.
DISADVANTAGES
(1) Limited Usage:
XBRL is not used by all companies as of now.

(2) Error:
Wrong definitions (taxonomies) may be given to certain financial terms. There might be a
possibility of tags may be wrongly assigned to financial terms.
(3) Inconsistency:
There is still a lack of consistency in the use of standards.
(4) Security Risk:

It may pose security risks for companies publicly reporting their financial information.
USERS
(1) Banking Regulators:
RBI as a regulator in the Banking sector who also frames the monetary policy need significant
amount of complex performance and risk information about the institutions that they regulate.
(2) SEBI:
SEBI as securities regulator in the financial market need to analyse the performance and
compliance of listed companies and securities, and need to ensure that this information is
available to markets to consume and analyse.
(3) Stock Exchanges:

Stock exchanges also need to analyse the performance and compliance of listed companies and
securities, and they too need to ensure that this information is available to markets to consume
and analyse.
(4) Registrar of Companies:

Registrar of Companies need to receive compliance information and make publicly available a
range of corporate data about private and public companies, including annual financial
statements.
(5) Tax authorities:

Various tax authorities need financial statements from companies in order to process and
review their corporate tax affairs, both direct as well as indirect taxes.
(6) Data Providers:

Statistical authorities that need financial performance information from many different
organisations.
(7) Companies:
Companies are also major users of such information. They need to provide information to one
or more of the regulators as mentioned above. Enterprises need to accurately move information

around within a complex business group. Also supply chains need to exchange information to
help manage risk and measure activity.
(8) Government:
Government agencies that are simplifying the process of businesses reporting to government
and reducing the red tape, by either harmonising data definitions or consolidating reporting
obligations (or both).
(9) Credit Rating Agencies:

Specialist data providers that use performance and risk information published into the market
place and create comparisons, ratings and other value-added information products for other
market participants.
(10) Analysts:
Analysts need to understand relative risk and performance of several business enterprises on
the basis of such available information.
(11) Investors:
Investors need to compare potential investments and understand the underlying performance of
existing investments.
(12) Accountants:
Accountants use XBRL in support of clients reporting requirements and are often involved in
the preparation of XBRL reports.

CAPITAL BUDGETING
3
11
(Techniques under uncertainty)
"CAPITAL BUDGETING is concerned with the allocation of the firm's scarce financial
resources among the available market opportunities. The consideration of investment
opportunities involves the comparison of the expected future streams of earnings from a
project, with the immediate and subsequent streams of expenditures for it."
-
G. C. Philiphatos
"Capital budgeting consists of planning, the development of available capital for the purpose
of maximizing the long term profitability (return on investment) of the firm.”
-
SIGNIFICANCE OF CAPITAL BUDGETING
The key function of the financial management is the selection of tie most profitable assortment
of capital investment and it is the most important area of decision-making of the financial
manager because any action taken by the manager in this area affects the working and the
profitability of the firm for many years to come. The need of capital budgeting can be
emphasized taking into consideration the very nature of the capital expenditure such as heavy
investment in capital projects, long-term implications for the firm, irreversible decisions
complications of the decision making.
Significance and Importance of Capital budgeting:

(1) Indirect Forecast of Sales
The investment in fixed assets is related to future sales of the firm during the life time of the
assets purchased. It shows the possibility of expanding the production facilities to cover
additional sales shown in the sales budget. Any failure to make the sales forecast accurately
would result in investment or under investment in fixed assets and any erroneous forecast of
asset needs may lead the firm to serious economic results.
(2) Comparative Study of Alternative Projects:

Capital budgeting makes a comparative study of the alternative projects for the replacement of
assets which are wearing out or are in danger of becoming obsolete so as to make the best
possible investment in replacement of assets. For this purpose, the profitability of project is
estimated.
(3) Timing of Assets-Acquisition

Proper capital budgeting leads proper timing of assets-acquisition and improvement in
quality‟s assets purchased. It is due to the nature of demand and supply capital goods. The
demand of capital goods does not arise sales impose on productive capacity and such situation

occurs intermittently; On the other hand, supply of capital goods with availability is one of the
functions of capital budgeting.
(4) Cash Forecast

Capital investment requires substantial funds which can only be arranged by making
determined efforts to ensure availability at the right time. Thus it facilitates cash forecast.
(5) Worth-Maximization of Shareholders

The impact of long – term capital investment decisions is far reaching. It protects the in of the
shareholders and of the enterprise because it avoids over- investment and under-investment in
fixed assets. By selecting the most profitable projects, the management facilitates the wealth
maximization of equity shareholders.
(6) Irreversibility
Long term asset investment decision are not easily reversible and that too, at so much financial
loss to the firm; due to difficulties in finding out market for such capital items once they have
been used. Hence firm will incur more losses in that type of capital asset.
(7) Huge Investment

Long term asset involves more initial cash outflow which makes it imperative for the firm to
plan its investment programmes very carefully and make an advance arrangement of funds
either from internal or external source of or both the source.
(8) More Risky

Investment in long term asset increase average profit but it may lead to fluctuation in its
earning, and then firm will become more risky. Hence investment decision decides the future
of the business concern.
(9) Difficult Decision

Capital budgeting decision is very difficult because it involves decision of future years‟ cash
flow, uncertainty of future and more risk.
DISCUSS THE PHASES OF CAPITAL BUDGETING

"Capital budgeting consists of planning, the development of available capital for the purpose of
maximizing the long term profitability (return on investment) of the firm.”
Capital expenditure includes all those expenditure which are expected to produce benefits to
the firm over more than one year, and encompasses both tangible and intangible assets. But
mainly it includes expenditure on tangible fixed assets. Capital expenditure involves a huge
investments for long-term in the fixed assets.
Five Phases of Capital Expenditure Planning and Control

1. Proposal Origination

Identification or origination of investment opportunities. Potential investment proposals
originate in a variety of ways such as acquisition or additions to existing production and
marketing facilities. Ideas can be generated from production managers, marketing analysts,
etc. Large companies maintain project analysis divisions which continuously search for new
ideas, projects and ventures. A potential proposal will be considered only if it attracts
additional cash flows.
2. Development of Forecasts
Development of forecasts of benefits and costs. Widely used methods are ARR, NPV and IRR.
The benefit generated from the project is estimated. While calculating the benefits cash flows
are considered which differs from the accounting profit. While computing the cash flows non-
cash expenditure like depreciation is added back to accounting profit. Cash flow forecasting
involves:
a. Incremental Analysis.
b. Differential Analysis.
c. Cash Savings.
3. Evaluation of Net Benefits

Evaluation of the net benefits. Benefits should exceed its cost adjusted for time, value and risk.
Discounted Cash flow (DCF) and Pay back techniques are used. Accept/reject decision
involves the evaluation of capital expenditure proposal in order to determine whether they meet
the minimum acceptance level. The projects under consideration may be:
a. Independent projects.
b. Mutually exclusive projects
4. Authorization
Authorisation for progressing and spending capital expenditure after considering:
a. Business risk.
b. Capital rationing.
5. Control
Control of capital projects review and feedback.
RISK AND UNCERTAINTY IN CAPITAL BUDGETING

Risk is defined as the variability that is likely to occur in the future returns from investment.
It is the variability in the actual returns from a project from its future return at the time of the
initial capital budgeting decision.
According to Oster Young Risk refers to the set of unique outcomes for a given event which
can be assigned probabilities, while uncertainty refers to the outcomes of a given event which
are too unsure to be assigned probabilities.
Risk arises due to uncertainty in future. If there is no uncertainty there is no risk. If a person
invest Rs. 2,00,000 in 10% Government Bonds, he will certainly get Rs. 20,000 return every

year. There is no risk in it. If a person invest ? 2,00,000 in equity shares of companies there is
no guarantee of return. He may get dividend of 20% or 100% or no dividend. This is due to the
risk.
TECHNIQUES OF DEALING WITH RISK

There are number of techniques used to deal with risk. Some of the important techniques are as
follows:
1. Risk Adjusted cut off Rate Method

This is also known as Risk Adjusted Discount Rate. In the case of projects involving risk the
investor would expect a premium over and above the Risk Free Return. It means high discount
rate is considered in present value calculation. The higher the risk, the higher would be the
discount rate and lower the risk, the lower would be the discount rate.
If the rate of interest on Government securities is 10%, then the risk free interest is 10%. In
case the company is considering a project involving risk, the premium required is say 8% then
the Risk Adjusted, Discount Rate would be 10 + 8 = 18%. The rate of discount is the cost of
capital. In other words it is the rate demanded by the investors on their investments.
If the project earns less than this rate the shareholders will earn less than the rate which is
prevailing for such a risk level. In other words, the value of shares will decline.
Merits
1. It is simple to calculate and easy to understand.
2. It is more practical as it considers time value of money.
3. It should be the future cash flow which should be adjusted.
4. It incorporates risk by adding risk premium to risk free rate.
Demerits
1. It is difficult to decide Risk Adjusted Discount Rate.
2. It does not adjust the Cash Flow.
3. It involves subjectivity as different rates are used for different projects.
Procedure to Calculate NPV

1. Calculate RARD
RADR = Risk Free Rate + Risk Premium
Risk Premium = Beta (Market Rate of Return - Risk Free Rate)
2. Calculate Risky Cash Flows and outflows with the project.
3. Calculate NPV using RADR.
4. Apply Decision Rule
Technique Rule
A. If NPV technique is applied Accept if NPV > 0 Reject if NPV < 0
Management indifferent if NPV = 0

B. If IRR technique is applied Accept if IRR > RADR
Reject if IRR < RADR
Management indifferent if IRR = RADR
In case of Multiple Projects
Technique Rule
A. If NPV technique is applied Project with highest NPV should be

selected.
B. If IRR technique is applied Project with highest IRR should be selected
2. Certainty Equivalent Method

Under this method, risk is incorporated by discounting the Risk Fee Cash Flow at Risk Free
Rate. It incorporates the risk by converting the risky cash flow into riskless cash flows.
Riskless Cash Flow = Risky Cash Flow x CEC
Certainty Equivalent Co-efficient = Risk Less Cash Flow
Risky Cash Flow
Merits
1. It is simple to compute and easy to understand.
2. It considers time value of money.
3. It incorporates risk by converting uncertain cash flow into certain cash flow.
Demerits
1. It is difficult to decide certainty equivalent co-efficient.
2. It involves subjectivity.
3. It does not directly use the probability distributing of cash flows.
Procedure
1. Compute Certain Cash Flow
Certain Cash Flow = Risky Cash Flow x Certainty Equivalent Coefficient
2. Compute NPV of certain cash flow using Risk Free Discount Rate.
3. Apply Accept / Reject Rule
Technique Rule
A. NPV Technique i) Accept if NPV of certainty
equivalent cash flow is > 0.
ii) Reject if NPV of certainty
equivalent cash flow is < 0.
iii) Management indifferent if NPV = 0.
B. IRR Technique i) Accept if IRR > Risk free discount
rate.
ii) Reject if IRR < Risk Free discount
rate.
In the case of multiple projects
Technique Rule
A. NPV Technique Select the project with highest NPV.
B. IRR Technique Select the project with highest IRR.
3. Sensitivity Analysis
It is a technique of analysing the impact of changes in each of the variables viz. cash inflows
cash outflows, project life, cost of capital, NPV or IRR.
The management calculates the NPV or IRR of the project for each forecast under three
situations viz.
(a) Pessimistic,
(b) Expected and
(c) Optimistic.
Sensitivity analysis provides answers to the following questions :
i) If cash inflows are less than expected, what will be its impact on NPV?
ii) If cash outflows are more than expected, what will be its impact on NPV?
iii) If project life is less than expected, what will be its impact on NPV?
iv) If discount rate is more than expected, what will be its impact on NPV?
Sensitivity analysis plays an important role whenever there is an uncertainty. But it is not a
method of measuring or reducing risk.
Objective
The objective of sensitivity analysis is to find out the most sensitive factor. It is the factor
which causes drastic change in NPV or IRR of the project even if there is a small change.
Merits
i) It assesses risk in capital budgeting decisions.
ii) It shows sensitivity of different variables.
Demerits
i) It considers only one variable at a time. Other variables are kept constant.
ii) It does not consider the probability associated with occurrence of different value of
variables.
iii) It is not a risk reducing technique
Procedure
Sensitivity analysis involves the following steps :
1. Identify those variables which have an influence on the project‟s NPV or IRR.
2. Define the quantitative relationship among the variables.
3. Analyse the effect of changes in variables on NPV or IRR of the project.
4. Find out the sensitivity of each factor as follows :

i) Sensitivity of CFAT = Annual CFAT - Annual CFAT to Match
Cash Out Flow x 100
Annual CFAT
ii) Sensitivity of Cash Out Flow = P.V. of CFAT - P.V. of C.O. x 100
Cash Out Flow
iii) Sensitivity of Discount Rate = IRR - Discount Rate x 100
Discount Rate
iv) Sensitivity of Payback Period = Project Life - Payback Period x 100
Project Life
5. Rank the factors from most sensitive to least sensitive.
6. Identify the most sensitive factor which has least percent of sensitivity.
4. Probability Technique
Sensitivity Analysis fails to show the changes of variability of cash flow. For this purpose
probability may be assigned to each of the cash flows. Probability assignment will give some
definite measure of possibility of different cash flows. It shows the percentage chance of
occurrence of each possible cash flow. For example if the probability of occurrence of cash
flow of Rs. 40,000 is 0.6, it means the probable cash flow is ? 24,000. If the probability is 1, it
means if is certain to take place. If probability is 0, it means it is not likely to occur at all. Thus,
the probability varies from 0 to 1.
Merits
i) It gives more accurate estimate of likely cash flow.
ii) The probabilities assigned which are objective can give correct result.
Demerits
i) Probabilities which are subjective can give inaccurate results.
ii) The concept of objective probability is of little use in capital budgeting decisions.
Procedure
1. Compute cash flow after tax as usual for each year.
2. Decide the probability of occurrence of cash flow for each year.
3. Compute expected cash flow after tax for each year.
4. Decide P.V. factor.
5. Calculate NPV.
5. Standard Deviation Method

Probability assignment takes into account the risk in terms of variability in cash flows.
However it does not indicate the extent of variability or the extent of risk in cash flow
estimates. To overcome this limitation standard deviation method is used. Under this method,
we calculate the dispersion of cash flows. It is the difference between the possible cash flows
and their estimates. The dispersion of cash flow indicates the degree of risk. The project which

has higher standard deviation is considered more risky. The project which has smaller standard
deviation is considered less risky.
Procedure
The procedure involves the following steps :
1. Calculate Cash Flow after tax.
2. Find out the deviations from mean.
3. Find out the square of deviations.
4. Consider the probability assigned.
5. Find out probable deviations.
6. Calculate standard deviation.
Standard Deviation (σ) = √Ʃpf2
7. Select the project which has smaller standard deviation.
6. Co-Efficient of Variation Method

Standard Deviation is an absolute measure of variability. It cannot be used for comparison of
two projects when their sizes are different. Hence, co-efficient of variation is used. It is a
relative measure of dispersion. It indicates that higher the co-efficient, the risker is the project.
Co-efficient of variation is the standard deviation of probability distribution divided by its
expected value.
Procedure
1. Calculate Standard Deviation
2. Calculate Expected Cash Flow on the basis of probability assignments.
3. Find out co-efficient of variation = Standard Deviation
Expected Cash Flow
4. Select the project which has lesser co-efficient of variation.
7. Decision Tree Analysis

It is another quantitative technique used to evaluate risky proposals. In many cases present
investment decision may have its impact on future investment decisions. It involves a sequence
of decisions over time.
Decision tree is a graphic display of relationship between a present decision and possible future
events, future decisions and their consequences. In other words, a decision tree is a pictorial
representation in a tree form which indicates the magnitude of probability and inter relationship
of all possible outcomes.
Under decision tree approach it is possible to see a large number of decisions arising out of the
main decision. A chain of sub-divisions shows various alternatives which enables a manager to
make a choice of the best alternative. This is known as Decision Tree because just as several
branches come out of the main trunk of a tree. In the same way major decision brings out a
number of sub-decisions.

Each one of them has several alternatives. In a tree all the branches are never uniform in terms
of leaves and flowers on them. Alternative business decisions also carry different possibilities
of profits and losses. A decision tree can be represented vertically or horizontally.
Merits
i) It is quite useful in sequential decision making.
ii) It helps in visualising the different alternatives graphically.
iii) It provides lot of information to the decision maker in simple form.
Demerits
i) It requires lot of information.
ii) It becomes complicated as the number of stages increases.
iii) In certain cases it may not be possible to incorporate too.
Procedure
1. Calculate joint probability of various alternatives.
2. Calculate NPV of project for each alternative.
3. Compute expected NPV by adding the product of NPV of each alternative with their
corresponding joint probabilities.
4. Compute Standard Deviation.
5. Compute Co-efficient of Variation.

PRACTICAL PROBLEMS
1. Global Ltd. is considering one of the two mutually exclusive Project X and project Y which
require cash outlay of Rs. 50,000 and Rs. 70,000 respectively. The current yield on
Government Bonds is 5% and the risk premium is 3%. The expected cash flows are :
Year Project X Rs. Project Y Rs.
1 20,000 30,000
2 30,000 40,000
3 40,000 50,000
Which project should be accepted?
2. Determine the risk adjusted net present value of the following projects :
Particulars Project A Project B Project C
Net Cash Outlay (Rs.) 1,00,000 1,20,000 2,10,000
Project Life (Years) 5 5 5
Annual Cash Inflow (Rs.) 30,000 42,000 70,000
Coefficient of Variation 0.4 0.8 1.2
The company select the risk adjusted rate of discount on the basis of coefficient of variation :
Coefficient of Variation Risk Adjusted Rate of Discount
0.0 10%
0.4 12%
0.8 14%
1.2 16%
1.6 18%
2.0 22%
More than 2.0 25%
3. A Ltd. company is considering two mutually exclusive projects viz. Project X and Project Y
which require cash outflow of Rs. 50,000 and Rs. 70,000 respectively. The risk free return is
5% and risk premium is 3%. The expected cash flow and C.E. are as follows :
Year Project X Project Y
Cash Flow Rs. C.E. Cash Flow Rs. C.E.
1 20,000 0.9 30,000 0.8
2 30,000 0:8 40,000 0.7
3 40,000 0.7 50,000 0.6
a) Which project should be accepted?
b) Which project is riskier and why?
c) If RADR is used, which project should be appraised with a higher rate.
4. The Textile Manufacturing Company Ltd. is considering one of two mutually exclusive
proposals. Project M and N, which require cash outlay of Rs. 8,50,000 and Rs. 8,25,000
respectively. The certainty equivalent (C.E.) approach is used in incorporating risk in capital
budgeting decisions. The current yield on government bonds is 6% and this as the free rate.
The expected net cash flows and their certainty equivalents are as follows :
Year Project M Project N
Cash Flow (Rs.) C.E. Cash Flow (Rs.) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of Rs. 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890
and 0.840 respectively.
Required :
i) Which project should be accepted?
ii) If risk adjusted discount rate method is used, which project would be appraised with a
higher rate and why?
5. X Ltd. is considering a project with following cash flow :

Year Purchase of Plant Running Cost Savings
0 70,000 - -
1 - 20,000 60,000
2 - 25,000 70,000
The cost of capital is 8%. Measure the sensitivity of the project to changes in the level of
running cost, savings and plant cost. Which factor is the most sensitive?
The present values of Rs. 1 at 8% for year 1 and year 2 are respectively 0.9259 and 0.8573.
6. From the following project details calculate the sensitivity of the (a) Project Cost, (b) Annual
Cash Flow and (c) Cost of Capital. Which variable is the most sensitive?
Project Cost Rs. 12,000 Annual Cash Flow Rs. 4,500
Life of the Project 4 years Cost of Capital 14%
The annuity factor at 14% for 4 years is 2.9137 and at 18% for 4 years is 2.667.
7. The initial investment outlay for a capital investment project consists of Rs. 100 lakhs for
plant and machinery and Rs. 40 lakhs for working capital. Other details are summarized below:
Selling Price 1 lakh units of output per year for years 1 to 5
Selling Price Rs. 120 per unit of output
Variable Cost Rs. 60 per unit of output
Fixed Overheads (excluding depreciation) Rs. 15 lakhs per year for years 1 to 5.
Rate of depreciation on plant and machinery 25% on WDV method
Salvage Value of plant and machinery Equal to the WDV at the end of year 5.
Applicable Tax Rate 40%
Time Horizon 5 Years
Post-Tax Cut Off Rate 12%
Required :

a) Indicate the financial viability of the project by calculating the net present value.
b) Determine the sensitivity of the projects NPV under each of the following conditions :
i) Decrease in selling price by 5%.
ii) Increase in variable cost by 10%.
iii) Increase in cost of plant and machinery by 10%.
8. Following information relates to cash flows of Project X and Y with their associated
probabilities which project should be accepted?
Possibility Project X Project Y
Cash Flow Rs. Probability Cash Flow Rs. Probability
1 70,000 0.10 1,20,000 0.10
2 80,000 0.20 80,000 0.10
3 90,000 0.30 60,000 0.10
4 1,00,000 0.20 40,000 0.20
5 1,10,000 0.20 20,000 0.50
9. Cyber Company is considering two mutually exclusive projects. Investment outlay of both
the projects is Rs. 5,00,000 and each is expected to have a life of 5 years. Under three possible
situations their annual cash flows and probabilities are as under :
Situation Probabilities Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 per cent, which project should be accepted? Explain with workings.
10. A company is considering two mutually exclusive Projects X and Y. Project X costs Rs.
30,000 and Project Y Rs. 36,000. You are given below the net present probability :
Project X Project Y
NPV Estimate Probability NPV Estimate Probability
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
i) Compute the expected net present value of projects X and Y.
ii) Compute the risk attached to each project, i.e. standard deviation of each probability
distribution.
iii) Which project do you consider more risky and why?
iv) Compute the probability index of each project.

11. Skylark Airways is planning to acquire a light commercial aircraft for flying class clients at
an investment of Rs. 50,00,000. The expected cash flow after tax for the next three years is as
follows :
Year I Year II Year III
CFAT Probability CFAT CFAT Probability CFAT
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The company wishes to take into consideration all possible risk factors relating to an airline
operations. The company wants to know :
i) The expected NPV to this venture assuming independent probability distribution with 6
per cent risk free of interest.
ii) The possible deviation in the expected value.
12. Standard Projects Ltd. is considering accepting one out of two mutually exclusive projects
M and N. The cash flows and probabilities are as follows :
Project M Project N
Probability Cash Flow Probability Cash Flow
Rs. Rs.
0.10 6,000 0.10 4,000
0.20 7,000 0.25 6,000
0.40 8,000 0.30 8,000
0.20 8,000 0.25 10,000
0.10 10,000 0.10 12,000
Advise the company.
13. A company is trying to choose between two investment proposals A and B. Project A has a
standard deviation Rs. 6,500 while Project B has a standard deviation of Rs. 7,200. The
Finance manager wishes to know which investment to choose, given each of the following
combinations of the expected values :
i) Project A and Project B both have expected net present value of Rs. 15,000.
ii) Project A has expected NPV of? 18,000 while for Project B it is Rs. 22,000.
14. The Indian Yacht Company has developed a new cabin cruiser which they have earmarked
for the medium to large boat market. A market analysis has 30% probability of annual sales
being 5,000 boats, a 40% probability of 4,000 annual sales and a 30% probability of 3,000
annual sales. This company can go into limited production, where variable costs are Rs.
10,000 per boat and fixed costs are Rs. 8,00,000 annually. Alternatively, they can go into full
scale production, where variable costs are Rs. 9,000 per boat and fixed costs are Rs.
50,00,000 annually. If the new boat is to be sold for Rs. 11,000, should be company go into
limited or full scale production when their objective is to maximize the expected profits?
15. A business man has an option of selling a product either in domestic market or in export
market. The available relevant data are given below :
Items Export Domestic
Market Market
Probability of Selling 0.6 1.0
Probability of Keeping Delivery Schedule 0.8 0.9
Penalty for Not Meeting Delivery Schedule (Rs.) 50,000 10,000
Selling Price (Rs.) 9,00,000 8,00,000
Cost of Third Party Inspection (Rs.) 30,000 Nil
Probability of Collection of Sale Amount 0.8 0.9
If the product is not sold in foreign market, it can always be sold in domestic market. There are
no other implications like interest and time.
i) Draw the decision tree using the data given above.
ii) Should the business man go for selling the product in the foreign market? Justify your
answer.
16. A firm has an investment proposal, requiring an outlay of Rs. 40,000. The investment
proposal is expected to have 2 year‟s economic life with no salvage value. In year I, there is a
0.4 probability that cash inflow after tax will be Rs. 25,000 and 0.6 probability that cash inflow
after tax will be Rs. 30,000. The probabilities assigned to cash inflows after tax for the year II
are as follows :
Cash Inflow Year I 25,000 30,000
Cash Inflow Year II 12,000 Probability 20,000 Probability
16,000 0.2 25.000 0.4
22,000 0.3 30.000 0.5
0.5 0.1
The firm uses a 10% discount rate for this type of investment.
Required :
a) Construct a decision tree for the proposed investment project.
b) What net present value will the project yield if worst outcome is realized? What is the
probability of occurrence of this NPV?
c) What will be the best and the probability of that occurrence?
d) Will the project be accepted?
(Discount factor @ 10% 1 year - 0.909; 2 year - 0.826)
17. Calculate NPV using RADR for an investment project having the following cash flows:
Year 1 2 3 4 5
CFAT 80,000 70,000 85,000 60,000 50,000
(Rs.)
Investment Rs. 2,00,000
Risk-free rate is 7% and Risk adjusted rate is 10%.
18. MNL Ltd. is considering investment in one of the three mutually exclusive projects: AB,
BC, CD. The company‟s cost of capital is 15% and the risk free interest rate is 10%. The
income tax rate for the company is 34%. MNL has gathered the following basic cash flows and
risk index data.
Projects AB BC CD
Initial Investment 12,00,000 10,00,000 15,00,000
Cash Inflows:
Year 1 5,00,000 5,00,000 4,00,000
2 5,00,000 4,00,000 5,00,000
3 5,00,000 5,00,000 6,00,000
4 5,00,000 3,00,000 10,00,000
Risk Index 1.80 1.00 0.60
Using the Risk Adjusted Discount Rate, determine the risk adjusted NPV for each of the
project. Which project should be accepted by the company?
19. If the Risky Cash Flow is Rs. 80,000; calculate the Certainty Equivalent Coefficient in the
following situations if Risk Free Cash Flow is:
Situation 1: Rs. 52,000
Situation 2: Rs. 18,000
Draw your inferences.
20. From the following data of Shatabdi Ltd., find out which project is better using Certainty
Coefficient Approach.
Year Project K Project L
CFAT Certainty Equivalent CFAT Certainty Equivalent
(Rs.) Coefficient (Rs.) Coefficient
1 60,000 0.9 50,000 0.8
2 50,000 0.8 60,000 0.7
3 20,000 0.6 30,000 0.5
4 50,000 0.5 20,000 0.4
Each of the projects requires a cash outlay of Rs. 1,00,000. Risk free discount rate is 12% for
both the projects.
21. A project costing Rs. 1,00,000 has the following estimated cash flows and certainty
equivalent coefficients as follows:
Year 1 2 3 4
Cash Inflow 70,000 80,000 50,000 60,000
(Rs.)
CE Coefficient 0.8 0.6 0.7 0.67
If the risk free discount rate is 10%, calculate its NPV.

22. Mr. X, an entrepreneur, undertook a study which cost of him Rs. 5 lakhs. As a result of his
study he is considering to embark on a new project to manufacture a new product Y which will
involve an investment of Rs. 200 lakhs in Plant and Machinery. The project will also require an
investment of Rs. 60 lakhs in Working Capital. The other projections are:
Sales 1 lakh units in year 1,3 lakh units in year 2 and year 3,2 lakh units in year 4 and 1 lakh
units in year 5.
Selling price per unit Rs. 100.
Variable cost per unit Rs. 50.
Scrap value of the Plant and Machinery at the end of 5 year Rs. 20 lakhs.
Provide Depreciation on Straight Line Method.
Rate of tax applicable to the business 35%.
Post tax cut-off rate 12%.
Advise X about the feasibility of the project by letting him know the NPV of the project. Also
tell him what will be the payback period of the project.
X also fears that (i) the product may not be able to sell § Rs. 100 per unit in the last year of the
project and would be required to be sold at Rs. 90 per unit, (ii) the variable cost may rise by
10% in the last year, and (iii) an additional investment in Plant and Machinery of Rs. 21 lakhs
would be required in the beginning of the third year of the project with no salvage value at the
end of the project.
Please advise X about to what extent the NPV of the project will be affected by each of these
three factors separately.
23. A company has two mutually exclusive projects. The management has developed the
following estimates of the annual cash flows for each project having a life of 10 years and 12%
discount rate.
Project X (Rs.) Project Y (Rs.)
Net Investment 1,00,000 1,00,000
Annual CFAT:
Pessimistic 12,000 15,000
Most Likely 17,000 17,000
Optimistic 20,000 19,000
Calculate NPV using Sensitivity Analysis. Comment.
24. Panipat Battle Ltd. has two mutually exclusive projects. The management‟s estimates of
both the projects are given below:
Project M (Rs.) Project N (Rs.)
Net Investment 1,20,000 1,20,000
Cash Inflows:
Pessimistic 8,000 15,925
Most Likely 16,000 16,000
Optimistic 28,000 18,000

Calculate the NPV related with each estimate for both the projects. The projects have a life of
12 years each and the company‟s cost of capital is 8%. State giving reasons which project
should be selected.
25. Victoria Ltd. furnishes the following information from which you are required to compute
the PV
Year Project AL Project LA
CFAT (Rs.) Probability CFAT (Rs.) Probability
1 8,000 0.1 22,000 0.2
2 9,000 0.2 21,000 0.2
3 12,000 0.3 17,000 0.2
4 13,000 0.2 15,000 0.2
5 18,000 0.2 12,000 0.2
Company‟s cost of capital is 10%.
26. Project A
Cash Flows (Rs.) 8,000 10,000 12,000 14,000 16,000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash Flows (Rs.) 24,000 20,000 16,000 12,000 8,000
Probability 0.10 0.15 0.50 0.15 0.10
Compute Standard Deviation and Comment on riskiness of project.
27. Kurukshetra Ltd. provides the following information from which you have to ascertain
which project is more risky on the basis of standard deviation.
Project CA
Cash Inflow (Rs.) Probability
15,760 0.2
30,240 0.3
44,100 0.2
51,660 0.3
Project BD
Cash Inflow (Rs.) Probability
17,640 0.1
28,350 0.4
39,690 0.3
52,920 0.2

28. Summary data is as follows:
Project Standard Deviation Expected Value CF (Rs.)
A 2,191 12,000
B 4,195 16,000
Compute coefficient of variation and comment.
29. Arangetram Ltd. has the following estimates of cash inflows with different investment
proposals. The company wants to use a Decision Tree to get the picture of the project‟s cash
inflow. The life of the project is 2 years. The total investment of the project is Rs. 2,00,000 and
the company prefers to discount the inflows at 10% discount factor. Construct a Decision Tree
for investment proposals.
In the First Year:
Event Cash Inflows (Rs.) Probability
(i) 1,25,000 0.4
(ii) 1,50,000 0.6
In the second year, if cash inflows in the 1st year are:
Rs. 1,25,000 Rs. 1,50,000
Cash Inflow Probability Cash Inflow (Rs.) Probability
(Rs.)
60,000 0.2 1,00,000 0.2
80,000 0.6 1,25,000 0.5
1,10,000 0.2 1,50,000 0.3

4 CAPITAL RATIONING
It is a process of allocating limited funds amongst the financially viable projects which are not
mutually exclusive under consideration with a view to maximize the wealth of the
shareholders. Thus capital rationing is done when :
i) Limited funds are available for investment
ii) More than one financially viable projects which are not mutually exclusive are under
consideration.
FACTORS LEADING TO CAPITAL RATIONING

There are two types of factors leading to capital rationing :
i. Internal Factors
Internal factors include :
i) Reluctance to finance by external equities.
ii) Reluctance to broaden the equity base.
iii) Reluctance to concept same viable projects due to managerial inability.
2. External Factors
External factors include imperfections of capital market or deficiencies in market information
about availability of capital.
SITUATIONS OF CAPITAL RATIONING

Situation: I
Projects are divisible and constraint is a single period one.
Procedure:
a) Compute profitability index of each project.
b) Rank the projects on the basis of profitability index.
c) Select the optimal combination of the projects.
Situation: II
Projects are indivisible and constraint is a single period one.
Procedure:
1. Prepare a table showing the feasible combinations of the projects (whose total of
initial outlay does not exceed the available funds for investment.
2. Select the projects whose total NPV is maximum and consider it as an optimal
project mix.
Situation: III
Projects are divisional and constraint is multi period one.

This situation can be handled by linear programming. It is a mathematical programming
approach. Many assumptions used for applying Linear Programming Technique is unrealistic.
Hence its usefulness is limited.
Assumptions:
1. All cash flows have linear relationships.
2. Projects are infinitely divisible.
3. Cash flows are known with certainty.
4. Projects and constraints are independent.
5. Projects cannot be delayed.
TECHNIQUES USED UNDER THE SITUATION OF CAPITAL RATIONING

1. Profitability Index
P.I. should be used to rank the financially viable projects under the following conditions :
i) Funds are scare today and not thereafter in subsequent years.
ii) Projects are infinitely divisible.
iii) None of the projects can be delayed.
iv) None of the projects can be undertaken more than once.
v) All cash outflows are made today.
Procedure to use P.I.

1. Calculate P.I. for each of the divisible project.
2. Rank the projects in descending order of P.I.
3. Select the combination of the projects ranked in descending order of P.I. which involve:
funds upto a given limit.
2. NPV Index or Excess Present Value Index (i.e. NPV + Initial cash outflow)
This method should be used to rank the financially viable projects under the following
conditions:
i) Funds are scare today and thereafter in subsequent years.
ii) Projects are infinitely divisible.
iii) None of the projects can be delayed.
iv) None of the projects can be under taken more than once.
v) Cash outflow are made not only today but also in future.
Procedure to use
1. Calculate NPVI for each of the divisible projects as follows :
NPVI = NPV
Initial Cash outflow
2. Rank the projects in descending order of NPV.
3. Select the combination of projects ranked in descending order of NPVI which involves
funds upto a given limit.

3. NPV Method
This method should be used to rank the financially viable projects in other cases. The
combination which gives the maximum overall NPV should be selected.
Procedure
1. Calculate NPV for each of the indivisible projects.
2. Rank the projects in descending order of NPV.
3. Select the combination of projects ranked in descending order of NPV involving funds
upto a given limit.

PRACTICAL PROBLEMS
1. In a capital rationing situation (investment limit Rs. 25 lakhs), suggest the most desirable
feasible combination on the basis of the following data (indicate justification):
Project Initial outlay NPV
A 15 6
B 10 4.5
C 7.5 3.6
D 6 3
Projects B and C are mutually exclusive.
2. A Ltd. has an investment budget of Rs. 25 lakhs for next year. It has under consideration
three projects A, B and C ( B and C are mutually exclusive) and all of them can be completed
within a year. Further details are given below:
Project Investment required Net Present Value
A 14 5.6
B 12 7.2
C 10 5.0
Recommend the best policy to utilize the investment budget, supported by proper reasoning.
3. Five projects M, N, O, P and Q are available to a company for consideration. The investment
required for each project and the cash flows it yields are tabulated below. Projects N and Q are
mutually exclusive. Taking the cost of capital @ 10%, which combination of projects should
be taken up for a total capital outlay not exceeding Rs. 3 lakhs on the basis of NPV.
Project Investment Cash flow p.a. No. of years P.V. @ 10%
M 50,000 18,000 10 6.145
N 1,00,000 50,000 4 3.170
O 1,20,000 30,000 8 5.335
P 1,50,000 40,000 16 7.824
Q 2,00,000 30,000 25 9.077
4. The total available budget for a company is Rs. 20 crores and the total cost of the projects is
Rs. 25 crores. The projects listed below have been ranked in order of profitability. There is a
possibility of submitting X project where cost is assumed to be Rs. 13 crores and it has the
Profitability Index of 140.
Project Cost (Rs. crores) Profitability Index
A 6 150
B 5 125
C 7 120
D 2 115

E 5 110
25
Which projects, including X, should be acquired by the same company?
5. S Ltd. has Rs. 10,00,000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined :
Project Amount (Rs.) Profitability Index
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible
and there is no alternative use of the money allocated for capital budgeting.
6. KPR is evaluating six capital investment projects. The company has allocated Rs. 20,00,000
for capital budgeting purposes. The relevant particulars of the projects, which are independent
of one another, are as follows :
Project Investment needed Profitability Index
P1 (?)
10,00,000 1.21
P2 3,00,000 0.94
P3 7,00,000 1.20
P4 9,00,000 1.18
P5 4,00,000 1.20
P6 8,00,000 1.05
If there is strict capital rationing, which of the projects should be undertaken?
7. Vishakha Ltd. having limited funds of Rs. 4,00,000 and cost of capital 10% is evaluating the
desirability of the following project.
Project X Rs. Project Y Rs. Project X Rs.
Cash flow at 0 year (3,00,000) (2,00,000) (3,00,000)
1st year (1,00,000) (2,10,000) (3,00,000)
1 st year 6,00,000 4,00,000 2,00,000
2nd year 2,00,000 4,00,000 10,00,000
i) Rank the projects according to NPVI.
ii) Which projects should be selected as per NPVI ranking that the projects are divisible?
Note : The PV factors @ 10% discount rate at the end of year 1 and year 2 are .909 and .826
respectively.

8. Indica Chemicals Ltd. is considering the following projects:
Project Outlay NPV
(Rs.) (Rs.)
A 1,60,000 65,000
B 1,40,000 50,000
C 1,20,000 45,000
D 80,000 30,000
E 70,000 32,000
Projects B and C are mutually exclusive; so are projects D and E. The capital budget constraint
is Rs. 3,00,000.
Choose the feasible combination that has the highest NPV. Give Reason.
9. Tango Ltd. is considering the following projects:

Project Outlay (Rs.) NPV (Rs.)
A 15,00,000 5,00,000
B 10,00,000 4,50,000
C 9,00,000 4,00,000
D 8,00,000 3,50,000
E 7,00,000 2,50,000
Capital budget constraint of Rs. 25,00,000.
10. Total available fund for capital expenditure in a year in a firm is estimated at Rs. 2 lakhs.
The mutually exclusive investment proposals along with profitability index are given below:
Project A B C D E F G
Initial Outlay 25 35 25 80 20 40 20
(Rs. „000)
PI 0.94 1.16 1.14 1.25 1.05 1.09 1.19
Which of the above projects should be accepted?
11. The following investment proposals are competing for selection. The PI of each of these
proposals is also given
Proposal P Q R S
Initial Outlay (Rs. „000) 25 35 40 30
PI 1.13 1.11 1.15 1.08
If the budgeted fund is Rs. 60,000; select the most profitable projects.
12. Jack & jill Ltd. furnishes the following information: Investment limit: Rs. 7,00,000
Project Initial Outlay (Rs. in Lacs) NPV (Rs. in Lacs)
M 340 26.7
N 280 36.7
O 300 38.8
P 320 70.6
Rank them on PI and select them. Also determine the aggregate NPV for the selected projects.
All projects are DIVISIBLE, i.e. size of investment can be reduced, if necessary in relation to
the availability of funds. None of the projects can be delayed or undertaken more than once.
13. Humpty Dumpty Ltd. furnishes the following information: Investment Limit: Rs. 70 Lacs.
Project Initial Outlay (Rs. in Lacs) NPV (Rs. in Lacs)
P 50 20.0
Q 10 9.0
R 35 7.2
S 32 6.4
Q and R are mutually exclusive. None of the projects can be delayed or undertaken more than
once. Suggest the most feasible combination.
14. The total available budget for the company is Rs. 20 Lacs. The Projects have been ranked
in the order of Profitability.
Project Cost (Rs. In Lacs) Profitability Index
M 6 1.50
N 5 1.25
O 7 1.20
P 2 1.15
Q 5 1.10
R 13 1.40
Calculate -
(a) (i) Cash Inflow for each of the projects.
(ii) Net Present Value for each of the projects.
(b) Which projects should be undertaken by the company in order to maximise the Net Present
Value under Capital Rationing assuming that the each Project is indivisible?
15. Navnirman Ltd. is considering four capital projects for the year 2010 and 2011. The
company is financed by equity entirely and its cost of capital is 12%. The expected cash flows
of the projects are as below:
Year and Cash Flows (Rs. „000)
Project 2010 2011 2012 2013
A (40) (30) 45 55
B (50) (60) 70 80
C - (90) 55 65
D (60) 20 40 50
Note: Figures in brackets present cash outflows.
All projects are indivisible i.e. size of investment cannot be reduced. None of the projects can
be delayed or undertaken more than once. Calculate which project(s) Navnirman Ltd., should

undertake if the capital available for investment is limited to Rs. 1,10,000 in 2010 and with no
limitation in subsequent years. For your analysis use the following present value factors.
Year 2010 2011 2012 2013
Factor 1.00 0.89 0.80 0.71

5 SHAREHOLDER VALUE CREATION
PROFIT MAXIMISATION DECISION CRITERION

Under this approach, actions that increase profits should be undertaken and those that decrease
profits are to be avoided. The profit maximisation criterion implies that the investment,
financing and dividend policy decisions of a firm should be oriented towards the maximisation
of profits.
WHY SHOULD PROFIT MAXIMISATION BE USED IN DECISION MAKING

(a) Profit is a test of economic efficiency. It provides the yardstick by which economic
performance can be judged.
(b) It leads to efficient allocation of resources as resources tend to be directed to uses, which in
terms of profitability are the most desirable.
(c) It ensures maximum social welfare. The more effectively resources are deployed; the more
robust will be the economic growth and the rate of improvement in the standard of living.
LIMITATIONS
(a) Profit in absolute terms is not a proper guide to decision making. It has no precise
connotation. It should be expressed either on a per share basis or in relation to investment.
Also, profit can be long term or short term, before tax or after tax, it may be the return on total
capital employed or total assets or shareholders equity and so on. Therefore, a loose term like
profit cannot form the basis of operational criterion for financial management.
(b) It leaves considerations of timing and duration undefined. There is no guide for comparing
profit now with profit in future or for comparing profit streams of different durations.
(c) If a company pursues a profit maximization strategy, it creates an environment where price
is a premium and cutting costs is a primary goal. This, in turn, creates a perception of the
company that could lead to a loss of goodwill with customers and suppliers.
(d) It undermines the future for today's profit, and reduces research, promotion and other
investments, parameters of shareholders' wealth creation, viz. Earning Per Share and Share
Price in stock exchange/ market.
WEALTH MAXIMISATION DECISION CRITERION

This is also known as value maximisation or net present worth maximisation. The focus of
financial management is on the value to the owners or suppliers of equity capital. The wealth
of the owners is reflected in the market value of the shares. So wealth maximisation implies the
maximisation of the market price of shares. It has been universally accepted as an appropriate

operational decision criterion for financial management decisions as it removes the technical
limitations, which characterise the earlier profit maximisation criterion.
ADVANTAGES OF SHAREHOLDER WEALTH MAXIMISATION

(a) It is a long-term strategy which emphasises on raising the present value of the owner's
investment in a company and the implementation of projects that will increase the market value
of the firm's securities.
(b) Recognises the risk or uncertainty.

(c) Recognises the timing of returns by taking into account the trade-off between the various
returns and the associated levels of risk.
(d) Considers the shareholders return by taking into account the payment of dividend to
shareholders.
PARAMETERS OF MEASUREMENT OF PERFORMANCE OF AN ORGANISATION

Companies are using various measures and indicators for measuring the financial performance.
These indicators' help in identifying the performance and its strengths and weaknesses and
suggesting improvement in its future course of actions.
PARAMETER I - RETURN ON NET WORTH (RONW)
Return On Net Worth (RONW) = Profit After Tax X 100

Net Worth
Rationale
The profits earned by the firm has to be related to Net Worth, which is the actual shareholders
investment made in the business.
Utility
(a) It measures productivity of shareholders funds.
(b) Higher ratio signifies better utilization of shareholders funds or higher productivity of
owners' funds.
(c) It indicates to an investor in shares of a company that whether continued investment is
worthwhile or not.
(d) It enables investors to compare the earning capacity of the
company with that of other companies.
Applicability
It is used to calculate the returns available on Net Worth in terms of percentage.
PARAMETER II - RETURN ON CAPITAL EMPLOYED (ROCE)

Return on Capital Employed (ROCE) = Profit Before Interest and Tax X 100
Debt + Equity
Rationale
The earnings before interest and tax earned by the firm has to be related to the total Capital
Employed in the business.
Utility
(a) It is also termed as Return on Investment (ROI).
(b) It indicates earning capacity of business.
(c) It measures overall performance of a company vis-a-vis utilization for management of total
resources or funds available with the company.
(d) Higher ratio indicates better utilization of funds.
(e) It gives idea as to overall efficiency of company's working.
(f) It also indicates extent of utilization of total available funds by the management.
(g) It measures management's performance.
(h) The ratio is used for comparison of similar ratio of other company to make choice of
company for investment decision.
Applicability
It is used to calculate the returns available on total Capital Employed in the firm in terms of
percentage.
PARAMETER III - EARNING PER SHARE (EPS)
Earning Per Share (EPS) = Profit After Tax - Preference Dividend X 100
Number of Shares outstanding
Rationale
The total annual profits earned by the firm has to be divided by the total number of equity
shares outstanding in order to determine profit per equity share.
Utility
(a) The ratio indicates whether over a given period there has been change in the wealth per
(each) shareholder.
(b) Higher ratio increases the possibility for higher dividends and increase in the market price
of the share due to increase in the intrinsic value of the share.
(c) The ratio calculated for 5 to 6 years showing the trend line for a given company indicates
that whether the future of the company is bright or not.
Applicability

It is used to calculate annual profits earned by the firm per equity share in absolute terms
(rupees).
PARAMETER III - ECONOMIC VALUE ADDED STATEMENT (EVA)

EVA is a residual income measure that subtracts the cost of capital from the operating profit
generated by a business. In other words, EVA measures whether the operating profit is enough
compared to the total cost of capital. EVA is simply after-tax operating profit minus the total
annual cost of capital. Unlike the traditional measure of accounting profit where only a part of
the cost of capital (cost of debt) is deducted, EVA requires deduction of full cost of capital
(cost of debt as well as the cost of equity).
Stewart defined EVA as Net Operating Profit after Taxes (NOPAT) subtracted with a capital
charge.
EVA = NOPAT – WACC
Where,
NOPAT = Net Operating Profit after Tax
WACC = Weighted Average Cost of Capital.
WACC is computed by applying book value weights to individual costs of debt and equity.
Capital Asset Pricing Method (CAPM) is used to calculate the cost of equity (ke).
Ke = Rf + (Rm – Rf) x β
Where,
Rr: Risk-free rate
Rm: Expected market return
β: Beta of the security (Market Risk)
Or equivalently, if rate of return is defined as NOPAT/Capital,
EVA = (Rate of Return - Cost of Capital) x Capital
Where,
Rate of return = NOPAT/Capital
Capital = Total of balance sheet minus non-interest bearing debt in the beginning of
the year, or (Total borrowings + Net worth)
Cost of capital = Cost of equity x Proportion of equity from capital + Cost of debt x
Proportion of debt from capital x (1 - tax rate).
Cost of capital or Weighted Average Cost of Capital (WACC) is the average cost of both
equity capital and interest bearing debt.
Rationale

The returns earned has to be related to the Cost of Capital Employed while taking investment
decisions by the firm.
Utility
(a) The ratio indicates whether over a given period there has been an excess of earnings over
the Cost of Capital Employed.
(b) Higher ratio increases the possibility for higher dividends and increase in the market price
of the share due to increase in the intrinsic value of the share.
(c) The ratio calculated for 5 to 6 years showing the trend line for a given company indicates
that whether the future of the company is bright or not.
Applicability
It is used to calculate excess of the annual Net Operating Profit After Taxes over the annual
Cost of Capital Employed by the firm in absolute terms (rupees). The concept of Economic
Value Added (EVA) has revolutionized the ways in which companies are evaluated.
ADVANTAGES OF EVA
1. EVA, economic profit, and other residual income measures are clearly better than earnings
or earnings growth for measuring performance.
2. EVA is conceptually the same as the residual income measure long advocated by some
accounting scholars for its managers as well as value for shareholders.
3. EVA may also highlight parts of the business that are not performing up to scratch. If a
division is failing to earn a positive EVA, its management is likely to face some pointed
questions about whether the division's assets could be better employed elsewhere. EVA sends a
message to managers: Invest if and only if the increase in earnings is enough to cover the cost
of capital.
4. For managers who are used to tracking earnings or growth in earnings, this is a relatively
easy message to grasp. Therefore EVA can be used down deep in the organization as an
incentive compensation system.
5. It is a substitute for explicit monitoring by top management. Instead of telling plant and
divisional managers not to waste capital and then trying to figure out whether they are
complying, EVA rewards them for careful and thoughtful investment decisions.
6. EVA lets the business managers realize that even assets have a cost and hence stock won't be
lying idle. The firm will start using JIT and change the way they connect with their suppliers,
and have them deliver raw materials more often.
LIMITATIONS OF EVA
1. EVA is calculated on the basis of historical values, which are often misleading. This
drawback can be overcome by using current value of assets in place of book values.
2. The concept of EVA fails to allocate the returns of a single investment in different periods.
Straight-line method of depreciation for the long-term investments underestimates the rate of

return in the early years and overestimates in the later years. This problem can be overcome by
using the sinking fund method of depreciation.
3. Decision based on EVA can be misleading, particulars in case of companies which are in
their growth phase. Such companies may have negative EVA even though the rate of return is
good.
4. The computation of EVA involves a complex procedure. Stern & Stewart suggested 175
different assumptions and adjustments on the basic measure.
5. Accounting distortions and poor disclosure practices affects the calculation of EVA.
EVA DRIVERS: WAYS FOR IMPROVING EVA
EVA
GROW CONTROL MANAGE

SALES COSTS CASH
PARAMETER IV - MARKET VALUE-ADDED (MVA)

MVA is the difference between the market value of invested capital and book value of invested
capital. MVA is a measure of shareholders' value. MVA measures how the executives
managing the company have fared with regard to the optimal utilization of capital under their
control. That is to measure how efficiently the shareholders' funds have been utilized. If the
MVA is positive, it means value is being created for shareholders. If the MVA is negative, it
means shareholders' value is being destroyed. MVA is equal to the present value of all future
EVA. MVA and EVA move in tandem. But in situations where the EVA or MVA is negative,
the relationship may not hold good.

PRACTICAL PROBLEMS
1. The following data pertain to three division of M Incorporated. The company‟s required rate
of return on invested capital is 8%.
Particulars Division A Division B Division C
Sales Value ? 1,00,00,000 ?
Income 4,00,000 20,00,000 ?
Average Investment ? 25,00,000 ?
Sales Margin (%) 20% ? 25%
Capital Turnover (times) 1 ? ?
ROI (%) ? ? 20%
Residual Income/ Economic Value
? ? 1,20,000
Added (EVA)
2. The Income Statement and Balance Sheet of ABC Ltd are given below:
Income Statement
Particulars Rs. (in lakhs) Rs. (in lakhs)
Sales 500
Interest on Investments 10
Profit on sale of old assets 5
Total Income 515
Less:
Manufacturing cost 180
Administration Cost 60
Selling and distribution cost 50
Depreciation 30
Loss on sale of an old M/C 5 325
EBIT 190
Less: Interest 20
EBT 170
Less: Tax (30%) 51
PAT 119
EPS [119 Lakhs/ 5Lakh] Rs. 23.8
P/E ratio 2 times
Balance Sheet
Liabilities Rs. (in lakhs) Assets Rs. (in lakhs)

Equity Capital (Rs. 10 share) 50 Building 80
Retained Earnings 40 Machinery 70
Long term loan 60 Stock 10
Creditors 15 Debtors 12

Provision 13 Bank 6
Total 178 Total 178
The cost of equity and cost of debt is 10% and 12% respectively. The company pays 30%
corporate tax. From the information given you are required to calculate the EVA. Also,
calculate MVA on basis of Market Value of equity capital.
3. (M.U., BMS, Oct. 2010)

From the following date pertaining to Ojha Ltd. For the year ended 31st March 2010, your are
required to calculate the missing figures:
Sales Value Rs. 20,00,000
Income Rs. 4,00,000
Average Investment Rs. 5,00,000
Sales Margin (%) ?
Capital Turnover (times) ?
R.O.I. (%) ?
Economic Value Added (Rs.) ?
Weighted Average Cost of Capital 8%
4. (M.U., BMS, Oct. 2010)

Profit before tax of Ishant Ltd. with 1,25,000 equity shares outstanding is Rs. 5,00,000.
Further,
it has 50,000 10% Preference Shares of Rs. 10 each as a part of its share capital. The current
share price in the stock market is Rs. 18 per share. Calculate the Earnings Per Share and the
Price-Earning Ratio. Assume tax rate @ 30%
5. (M. U., BMS, Nov. 2011)

Calculate EVA from the following data for the year ended 31st March 2003.
Average Debt (Rs. Crs.) 50
Average equity (Rs. Crs.) 2766
Cost of debt (Post Tax) 7.72%
Cost of equity 16.54%
Profit after tax, before exceptional item 15.41
Interest 5
6. (M.U., BMS, April 2012)

Calculate EVA from the following data for the year ended 31st March 2010:
Average Debt Rs. 25 Crores
Average Equity Rs. 2,500 Crores
Cost of debt 8%
Cost of Equity 15 %
Profit after tax Rs. 12 crores
Interest Rs. 4 crores
7. (M.U., BMS, Oct. 12)
M/s Man India Ltd. is considering a capital project for which the following information is
available.
Investment outlay 10,000
Project life 5 years
Salvage value Zero
Annual Revenues 8,000
Annual cost (excluding depreciation, interest & taxes) 4,000
Depreciation Straight line
Tax rate 40%
Debt equity ratio 3:2
Cost of equity 20%
Cost of debt (post tax) 8%
Calculate EVA of the project over its life.
8. (M.U., BMS, April 2013)

The following data are of Cisco Ltd. The company‟s required rate of return on invested capital
is 8%. Find the missing figures:
Sales Value (?) ?
Income (?) ?
Capital employed (Investment) 6,00,000
Sales Margin (%) 25%
Capital Turnover (Times) ?
ROI (%) 20%
Economic Value Added (EVA) 1,20,000
9. (M.U., BMS, Oct. 2013)

Calculate the missing figures.
Particulars
Sales Value 20,00,000
Income 4,00,000
Average Investment 5,00,000
Sales Margin (%) ?
Capital Turnover ?
Rol ?
EVA (Rs.) ?
WACC 8%
10. Pizza Hut Ltd. has existing assets in which it has capital invested of Rs. 150 crores. The
After Tax Operating Income is Rs. 20 crores & Company has a Cost of Capital of 12%.
Estimate the Economic Value Added (EVA) of the firm.
11. The Income Statement and Balance Sheet of Alpha Company Ltd. is given below:
INCOME STATEMENT

Particulars (in Lakhs) (in Lakhs)
Sales 5,000
Interest on investments 100
Profit on sale on old assets 50
Total Income 5,150
Less
Manufacturing cost 1,800
Administration cost 600
Selling and distribution cost 500
Depreciation 300
Loss on sale of building 202 3,402
EBIT 1,748
Less: Interest 48
EBT 1,700
Less: Tax (30%) 510
PAT 1,190
EPS [1,190 Lakhs/ 50 Lakhs] Rs.23.8
P/E ratio 2.5
BALANCE SHEET
LIABILITIES Rs. ASSETS Rs.
Equity Capital ( Rs. 10 share) 500 Buildings 800
Retained profits 400 Machinery 700
Term loan 600 Stock 100
Payables 150 Debtors 120
Provisions 130 Bank 60
TOTAL 1,780 TOTAL 1,780
The cost of equity and cost of debt is 14% and 8% respectively. The company pays 30%
corporate tax.
From the information given you are required to calculate the EVA. Also, calculate MVA on the
basis of Market value of equity capital.
12. For B Ltd. Market rate of return (Rm) = 15%, Interest Rate of Treasury Bonds(Rf)=6.5%,
Beta Factor((3) = 1.20 . Calculate Equity Risk Premium & Cost of Equity (ke).
13. The following information is available of Docomo Ltd. Calculate EVA.

12% Debt Capital Rs. 2,000 crores
Equity Capital Rs. 500 crores
Reserves & Surplus 7,500 crores
Capital Employed Rs. 10,000 crores
Risk free rate 9%

Beta factor 1.05
Market rate of return 19%
Operating profit after tax 2,100 crores
Tax rate 30%
14. Compute EVA of BPCL Ltd. for 3 years from the information given
(in Rs. Lakhs)
Year 1 2 3
Average Capital Employed 3,000.00 3,500.00 4,000.00
Operating Profit before Interest 850.00 1,250.00 1,600.00
Corporate Income Taxes 80.00 70.00 120.00
Average Debt/Total Capital Employed in % 40.00 35.00 13.00
Beta variant 1.10 1.20 1.30
Risk Free Rate % 12.50 12.50 12.50
Equity Risk Premium % 10.00 10.00 10.00
Cost of Debt (Post Tax) % 19.00 19.00 20.00
15. The capital structure of BHEL Ltd is as under:

• 80,00,000 Equity shares of Rs. 10 each = Rs. 800 lakhs
• 1,00,000 12% Preference Shares of Rs. 250 each = 250 Lakhs
• 1,00,000 10% debentures of Rs. 500 each = 500 Lakhs
• 10% term loan from bank = 450 lakhs
The Company‟s Profit and Loss Account for the year showed a balance PAT of Rs. 110 Lakhs,
after appropriating Equity Dividend at 20%. The company is in the 40% tax bracket. Treasury
bonds cany 6.5% interest and beta factor for the company may be taken at 1.5. The long run
market rate of return may be taken at 16.5%. Calculate EVA.
16. From the following information, compute EVA of TCS Ltd. (Assume 35% tax rate)
• Equity Share Capital= Rs. 1,000 Lakhs
• 12% Debenture = Rs. 500 Lakhs
• Cost of Equity =20%
• Financial Leverage = 1.5 times
17. Following Details of Beckham Ltd. is given to you to calculate EVA and comment on the
performance of the org.
Amount in lacs
Equity Share Capital 13100 Fixed Assets 38900
Reserves 26000 Investments 1940
Long Term Debt 8.5% 2400 Current Assets 1320
660

Current Liabilities 42160 42160
Other Information Amt in lacs
Operating profit before interest & tax - 13240
Income Tax rate 33%
Beta of the Org 1.25
Risk free rate 9%
Market rate 13.5%

6 CORPORATE GOVERNANCE
Corporate Governance is a relationship amongst the management of the company, its directors,
the share holders, the auditor, the creditors, the bankers and other stake holders.CG is the
system through which the companies are controlled and directed for the better interest of
company‟s stakeholders and others linked to the company. In every company the board of
directors are primarily responsible for the company‟s governance. There has been many codes
and reports published in connection to CG.
Companies around the world are now realising that CG will add better value for the company
in all respects, few are as under :
• Long term goodwill amongst stake holders both internal as well as external
• It limits the liability of the management by stopping to commit mal practice
• Monitors the risk that the company may face in future
• Helps in better decision making process.
The corporate governance framework also depends on the ethical environment, the legal, the
regulatory and the institutional of the community. The 20th century might be viewed as the age
of management whereas the 21st century is seen to be more focused on governance.
Corporate governance also involves gathering together a group of smart people in the board to
make better decisions on behalf of the company and its stakeholders.
IMPORTANCE OF CORPORATE GOVERNANCE

1. Changing Ownership Structure
The ownership structure of the company has changed a lot in recent times. The Public financial
institutions, the mutual funds companies and more are the single largest shareholders in most
of the large companies and this is because they have better control on the company‟s
management. CG puts pressure on the management to become more efficient, transparent,
accountable, responsible, towards its stakeholders.
2. Social Responsibility
Social responsibility is given much importance in current century. Directors of the company
have to safeguard the rights of the customers, employees, shareholders, suppliers, creditors, the
company‟s bankers etc.
3. Number of Scams
In recent two decades many scams, frauds and corrupt practices have taken place in India.
Misuse of public money is happening everyday in India and also in other nations. In order to

avoid the scams most of the companies have started Corporate Governance.
4. Protect the Rights of Shareholders

Shareholders are inactive in the management of their companies. Share holders only attend the
Annual General Meeting and still Postal ballot is absent in our country. More over Proxies are
not allowed to vote in the meetings. The association of the shareholders is still week in India.
Due to all these reasons the directors of the company misuse their powers for their self
benefits. So, there is a need for Corporate Governance to protect all the stakeholders of the
company.
5. World-wide
Most of the companies are selling their products in international market. Due to this attracting
international buyers is necessary and also have to follow international rules and regulations.
All this requires Corporate Governance.
6. Takeovers and Mergers

We had seen many takeovers and mergers. Corporate governance is required to protect the
interest of all the persons/ companies during takeovers and mergers.
7. SEBI
Securities and Exchange Board of India has made Corporate Governance compulsory for
certain companies to protect the interest of the stakeholders.
PRINCIPLES OF GOOD CORPORATE GOVERNANCE

Commonly accepted principles of corporate Governance include :
i) Rights and Equitable Treatment of Shareholders
Business organisations should respect the rights of shareholders and help them in exercising
those rights. They can help shareholders in exercising their rights by effective communication
and participation in general meeting.
ii) Interest of Other Stakeholders

The management must recognize that it has legal obligations to all the legitimate stakeholders.
iii) Responsibility of the Board

The Board has a responsibility of dealing with various business issues and it has the ability to
review and challenge management performance. It should be of sufficient size and consist of a
proper mix of executives and non-executive directors.
iv) Integrity and Ethical Behaviour

Business organisations should develop a code of conduct for the directors and the executives
that promote ethical and responsible decision making. Business organisations establish
compliance and ethics programmes to minimise the risk.

v) Disclosure and transparency

People demand greater transparency and better disclosure of the economic and social
performance of the companies. Companies are expected to provide access to information on
impact of their operations and engage the stakeholders in a meaningful dialogue about the issue
of the organisations. In this respect, accounting standards are developed to improve corporate
reporting.
THEORIES OF CORPORATE GOVERNANCE

The theories of corporate Governance include :
1. Agency Theory
2. Stewardship Theory
3. Stakeholder Theory
4. Political Theory
1. Agency Theory
In a company ownership is separated from management. Shareholders are the owners and
managers manage the company. Separation of ownership from management is the basis of
agency theory. Managers are the agents who control the company. Shareholders wealth
maximization may not work due to the agency problem. The basic objective of finance is to
maximize wealth of the shareholders. The managers who are the agents may not work to
maximize wealth of the shareholders. The discretionary powers of the managers motivate them
to expropriate wealth to themselves. Hence they may not work to maximize wealth of the
shareholders i.e. owners. Under this theory the main concern is to develop rules and incentives
to minimize the conflict of interest between owners and managers. A company develops rules
and regulations in addition to the legal regulations in a country.
2. The Stewardship Theory

This theory views managers as stewards. It is assumed that these managers work efficiently
and honestly in the interest of the company and the owners. They are self directed and
motivated to have high achievements and discharge the duties efficiently. Managers are goal
oriented, self motivated. They feel constrained if they are controlled by the outside directors.
3. The Stakeholders Theory

This theory is based on the premise that the fundamental responsibility of managers is to
maximize total wealth of the stakeholders rather than the only shareholders wealth. Corporate
Governance efforts are intended to empower those stakeholders who contribute or control
critical resources and skills. This is to ensure that the interest of the stakeholders is aligned
with the interest of the shareholders.
4. The Political Theory

This theory states that it is the government that decides the allocation of control, rights,
responsibility, profit etc. between owners, managers, employees, and other stakeholders.
Within the structure, every stakeholder tries to enhance its bargaining power. This is to
negotiable higher allocation in its favour. The corporate governance efforts depend on the
allocated powers of the stakeholders.
CORPORATE GOVERNANCE PRACTICE

In good corporate governance, the companies are required to have policies and practices in
conformity with the requirements of clause 49 of the listing agreement.
1. Board of Directors
The board of directors constitute the top and strategic decision making body of a company. It
should comprise of executive and non-executive directors. It should represent an optimum mix
of professionalism, knowledge and expertise. ,
About half the directors on the board should be independent directors. They are expected to act
independently. The meetings of the Board of directors should be held at regular intervals.
2. Audit Committee
The appointment of audit committee is mandatory and it is very powerful instrument of
ensuring good governance in the financial matters. The committee carries out the functions in
accordance with the terms of listing agreement.
3. Shareholders / Investor’s Grievance Committee
The companies should form Grievance Committee under the chairmanship of a non-executive
independent director. The committee should monitor the grievances.
4. Remuneration Committee
The company may appoint remuneration committee to fix up the remuneration and perks of t/ie
CEO and other senior management officials.
5. Management Analysis
Management is required to make full disclosure of all material information to iiwresteyK..
should give detailed discussion
6. Communication
The quarterly, half yearly, and annual financial results must be sent to the stock exchanges
immediately after they have been taken on record by the board. Some companies post that
information on the website.
7. Auditor’s Certificate and Corporate Governance

The external auditors are required to give a certificate on the compliance of corporate
governance requirements.

PRACTICES OF CORPORATE GOVERNANCE IN INDIA
The governance structure specifies the distribution of rights and responsibilities among the
different participants in the corporation such as the board of directors, manager. Shareholders
and other stakeholders and spell out the rules and regulations for making decisions on
corporate affairs.
The board outline of mandatory and non-mandatory requirement is :
MANDATORY
1. Board of directors include composition of the board, non-executive directors,
compensation and disclosures provisions as to board and its committees, and code of conduct
for the board and management.
2. Qualified and independent audit committee.
Meetings, powers, role and mandatory review of information.
3. Subsidiary companies (unlisted subsidiary companies information).
4. Disclosure with respect to basic of related party transactions, disclosure of accounting
treatment, board disclosure, risk management, disclosure of use of funds from public issues,
rights issues, preferential issues etc. Remuneration of directors, management discussion and
analysis, disclosure to shareholders.
5. CEO / CFO certification.
6. Report on corporate governance.
7. Compliance certificate.
NON-MANDATORY
1. Chairman of the Board.
2. Remunerations Committee.
3. Shareholders Rights.
4. Audit Qualifications.
5. Training of Board Members.
6. Mechanism for evaluating non-executive board members.
7. Whistle Blower Policy.
In 2005-2006, private sector companies as ranked on average market capitalisation in a
business magazine constituted the subject of the study. 100 companies out of 500 listed in the
magazines constituted the sample. The data was collected from the Annual Reports of the
companies, their websites prowess data base of CMIE, stock exchange directories etc. to
measure the extent and quality of corporate governance.
An unweighted Corporate Governance Index was developed. It included both mandatory and
non-mandatory disclosures. After developing the index, Annual reports were thoroughly
studied to find out the disclosure extent A score of „ 1 ‟ was assigned for inclusion in the
annual report and „o‟ for non-inclusion. These scores were converted into 100. The scores
obtained were subject to various statistical analysis tools.

An index similar to corporate disclosure Index was used to calculate corporate disclosure
score. The index consists of an extensive list of 147 information items both mandatory and
non¬mandatory.
For the purpose of compliance every listed company must include a separate section captioned
as, „Report on Corporate Governance‟ in its Annual Report. The report shall provide details of
compliance with every mandatory item of corporate governance guidelines. The non-
compliance of any mandatory requirement with reasons there of must be stated in the Annual
Report.
SEBI AND CORPORATE GOVERNANCE

The Securities and Exchange Board of India (SEBI) in January 2013, had released its
„Consultative Paper on Review of Corporate Governance Norms in India' to align the existing
corporate governance norms in India with the then existing Companies Bill, 2012 and other
international practices.
Consequent to the enactment of the Companies Act, 2013 („the Act‟), the SEBI Board has on
13 February 2014, approved the proposals to amend the Corporate Governance norms for listed
companies in India. These amendments shall be applicable to all listed companies with effect
from 1 October 2014.
1. Prohibition of stock options to Independent Directors
2. Separate meeting of Independent Directors
3. At least one woman director on the Board of the company
4. Constitution of Stakeholders Relationship Committee
5. Performance evaluation of Independent Directors and the Board of Directors
6. Exclusion of nominee director from the definition of Independent Director
7. To restrict the total tenure of an Independent Director to 2 terms of 5 years. However, if
a person who has already served as an Independent Director for 5 years or more in a listed
company as on the date on which the amendment to listing agreement becomes effective, he
shall be eligible for appointment for one more term of 5 years only
8. Compulsory whistle blower mechanism

7 11
CORPORATE RESTRUCTURING
CORPORATE RESTRUCTURING is defined as “the cross-border re-deployment by a

multinational enterprise of functions, assets and/or risks (among related parties) with
consequent effects on the profit and loss potential in each country”. It is process by which a
business organisation alters its present structure in order to create a new structure in the place
of its existing structure. Business restructuring may involve change in the asset structure,
liability structure or both of them.
A corporate restructuring may involve:

1) Ownership Restructuring
A company can affect ownership restructuring through mergers and acquisitions, leveraged
buy-outs, buy back of shares, spin-offs, joint ventures and strategic alliances.
2) Business Restructuring
Business restructuring involves the reorganization of business units or divisions. It includes
diversification into new businesses, out-sourcing, divestment, brand acquisitions, etc.
3) Assets Restructuring
Asset restructuring involves the acquisition or sale of assets and their ownership structure. The
examples of asset restructuring are sale and leaseback of assets, securitization of debt,
receivable factoring, etc.
OBJECTIVES OF CORPORATE RESTRUCTURING

The objectives of business restructuring are as follows:
1) To raise efficiency and profitability of the business unit.
2) To reduce cost and to raise competitive capacity of the business unit.
3) To gear up the business unit to face the challenges of change.
4) To bring financial soundness to the company and also to take it towards
higher profitability and prosperity.
5) To use re-structuring as a tool for solving current problems and challenges faced by the
company.
6) To secure benefits of opportunities created by current environmental factors.
REASONS/IMPORTANCE FOR BUSINESS RESTRUCTURING

1) The globalization of business has compelled companies to open new export houses to
meet global competition. 'Global market concept has necessitated many companies to re-
structure, because lowest cost producers only can survive in the competitive global markets.

2) Changed fiscal and government policies like deregulation/decontrol has led many
companies to go for newer markets and customer segments.
3) Revolution in information technology has made it necessary for companies to adopt new
changes for improving corporate performance.
4) Many companies have divisionalized into smaller businesses. Wrong divisionalization

strata have led to revamp them. Product divisions which do not fit into the company's main line
of business are being divested. Fierce competition is forcing the companies to re-launch
themselves.
5) Improved productivity and cost reduction has necessitated downsizing of the workforce -
both at works and at managerial level.
6) Convertibility of rupee has attracted medium-sized companies to operate in the global

markets.
7) Competitive business necessitated to have sharp focus on core business activities, to gain
synergy benefits, to minimize the operating costs, to maximize efficiency in operation and to
tap the managerial skills to best advantage of the firm.
8) Economies of scale can be achieved by consolidating the capacities and by expansion of

activities.
9) By diversification of business activities, the minimization of business risks is possible

and it will enable the firm to achieve atleast the minimum target rate of return.
10) By re-structuring the enterprise, a sick company can be successfully revived and
rehabilitated, and can be brought back to profitable lines.
11) With the integration of sick unit into the Successful unit, the adjustment of unabsorbed
depreciation and write-off of accumulated loss is possible; there by the successful unit can
have strategic tax planning.
12) Re-structuring includes financial re-organization, by bringing the company to achieve a

desired balance of debt and equity, thereby reduce the overall cost of capital and financial
risks.
13) The re-structuring process will facilitate to have horizontal and vertical integration,
thereby the competition is eliminated and the company can have access to regular raw
materials and reaching new markets and accessibility to scientific research and technological
developments.

FINANCIAL IMPLICATIONS OF CORPORATE RESTRUCTURING
Financial implications of business restructuring are as follows:
1) Investors
i) Represent individuals, institutions and companies that have financial stake in the
company.
ii) Investors concerned about immediate future and long-term returns.
iii) Re-structuring generates severe financial implications and this creates insecurity and
uncertainty in the minds of the investors.
2) Customers
i) Re-structuring often results in reallocation of resources, introduction of new products or
withdrawal of the existing products, changes in the after¬sales policy of the company, etc.
ii) Often result in erosion of customer base and confidence and adversely affect future
business prospects.
iii) Focus on the needs and expectations of the customer by providing quality products and
reducing the lead time needed.
3) Management
i) Re-structuring results in changes in business processes, introduction of changes that suit
change in processes, changes in systems and in ensuring effective communication with all the
stakeholders.
ii) Helps release financial resources blocked in unproductive assets and low return assets
and businesses.
iii) Diverts core competencies to core areas reducing the risk of failure.
iv) Provides an opportunity to the management to prove its ability to „manage the change‟.
4) Employees
i) Re-structuring impacts them psychologically, culturally and materialistically.
ii) „Patterned Mindset‟, makes acceptance of new set of challenges difficult.
iii) Creates fears in their mind leading to psychological turmoil.
iv) Involves unlearning old skills and acquiring new skills.
5) Others Stakeholders
i) Reduction in competition as weak and inefficient players exit the market.
ii) Companies in a better position to seizp new opportunities and creating new businesses.
iii) Contributes to the growth of the national economy.
iv) Government may have to provide resources and subsidies to such companies which
imposes burden on the national exchequer.
v) Leads to lot of social discontent and can create political instability.
6) Budgets and Equipment

With regard to budgets and equipment, impact is also evaluated by comparing the current
means with future needs of the restructured departments. Also, an evaluation of the cost of re-
structuring is done and consists of:
i) The cost of re-deployment of personnel no longer needed after restructuring.
ii) The cost of putting the new structures in place, as well as that of building them.
BUSINESS RESTRUCTURING CAN BE DONE THROUGH THE FOLLOWING

METHODS
1) Merger,
2) Amalgamation,
3) Acquisition
4) Demerger
5) (Divestiture, Joint Ventures, and Strategic Alliances)
1. MERGER
A merger is a combination of two or more companies into one company. It may be in the form
of one or more companies being merged into an existing company or a new company may be
formed to merge two or more existing companies. The Income Tax Act, 1961 of India uses the
term „amalgamation‟ for merger.
Thus, merger or amalgamation may take any of the two forms:
1) Merger or amalgamation through absorption.
2) Merger or amalgamation through consolidation.
TYPES OF MERGERS
1) Horizontal Merger
When two or more concerns dealing in same product or service join together, it is known as a
horizontal merger. The idea behind this type of merger is to avoid competition between the
units. For example, two manufacturers of same type of cloth, two book sellers and two
transport companies operating on the same route - the merger in all these cases will be
horizontal merger.
Besides avoiding competition, there are economies of scale, marketing economies, elimination
of duplication of facilities, etc. For example, merger of Tata Industrial Finance Ltd. with Tata
Finance Ltd., GEC with EEC, TOMCO with HLL.
2) Vertical Merger

A vertical merger represents a merger of firms engaged at different stages of production or
distribution of the same product or service. In this case two or more companies dealing in the
same product but at different stages may join to carry out the whole process itself. A petroleum
producing company may set up its own petrol pumps for its selling. A railway company may
join with coal mining company for carrying coal to different industrial centers. Similarly, a
textile unit may merge with a transport company for carrying its products to different places.
All these are the examples of vertical merger. The idea behind this type of merger is to take up
two different stages of work to ensure speedy production or quick service. For example,
merger of Reliance Petroleum Ltd. with Reliance Industries Ltd.
3) Conglomerate Merger
When two concerns dealing in totally different activities join hands, it will be a case of
conglomerate merger. The merging concerns are neither horizontally nor vertically related to
each other. For example, a manufacturing company may merge with an insurance company; a
textile company may merge with a vegetable oil mill. There may be some common features in
merging companies, such as distribution channels, technology, etc. This type of merger is
undertaken to diversify the activities.
4) Congeneric Mergers
It occurs where two merging firms are in the same general industry, but they have no mutual
buyer/customer or supplier relationship, such as a merger between a bank and a leasing
company. For example, Prudential's acquisition of Bache & Company.
5) Reverse Merger
A unique type of merger called a reverse merger is used as a way of going public without the
expense and time required by an IPO. In case of an ordinary merger, a profit making company
takes over another company which may or may not be making a profit. The objective is to
expand or diversify the business. However, in case of a reverse merger, a healthy company
merges into a financially weak company and the former company is dissolved. The basic
philosophy of reverse merger is to take advantage of the provisions of Income Tax Act, 1961
which permits a company to carry forward its losses to set off against its future profits.
ADVANTAGES OF MERGERS
The following are the important advantages of mergers are:
1) The size of the business is increased by merging two companies.
2) It is possible to achieve the maximum operational efficiency of a concern.
3) It helps to improve cyclical and seasonal stability.
4) It helps to increase the profitability and earning capacity of a concern because of
maximum utilization of resources.
5) It helps to increase the rate of growth of a concern.
6) It facilitates security for new products.
7) It helps to improve marketing effectiveness.

8) It helps to expand the business by adaptation of methods such as modernization,
innovation, and research and development.
9) It helps to overcome the crisis of a small concern after merger and consolidation.
10) It helps in the effective utilization of excess working capital in profitable investment.
DISADVANTAGES OF MERGERS
The following are the disadvantages of mergers:
(a) Monopoly:
A merger can reduce competition and give the new firm monopoly power. With less
competition in the market and greater market share, the new firm can usually increase prices
for consumers which can be a detriment to the consumers.
(b) Job Loss:

Merging two firms that are doing similar activities may mean duplication and over capability
within the company that may need retrenchments. A merger may result in reducing the labor
force thus leading to job losses.
(c) Low Morale:

Employees may become fearful of losing their job and may lose their trust in the organization.
This can decrease employee motivation and reduce productivity.
(d) Leadership Issues:

Leadership issues could lead to corporate infighting resulting in talent drain as people leave the
company. There will be loss of experienced workers in leadership positions.
(e) Clash of Culture:

When two companies merge, it is more than just the coming together of names or brands or
products. It is the joining of two groups of people who bring along their own specific corporate
cultures. If two firms have very different cultures, conflicts are bound to arise.
(f) Diseconomies of Scale:

Sometimes when two firms merge the resulting entity being larger will actually create
diseconomies of scale, where per unit production costs increase resulting in diseconomies of
scale.
(g) Lack of Synergy:

Synergy is the magic force that allows for enhanced cost efficiencies of the new business.
Synergy takes the form of revenue enhancement and cost savings. The merging entities merge
with the objective to realize operating synergy. "1+1 = 3" sounds great but in practice or reality
every time it may not work properly and go wrong. Historical trends show that roughly two-
thirds of huge mergers tend to lose worth on the stock exchange.

(h) Unwarranted Competition:
Company will face major difficulties due to frictions and internal competition that may occur
among the staff of the merged companies. There is conjointly risk of getting surplus employees
in some departments.
(i) Cost Increase:

Increase in costs might result if the right management of merged entity and also the
implementation of the merger and acquisition dealing are delayed.
2. AMALGAMATION
Amalgamation refers to a situation where two or more existing companies are joined to form a
third company or where an existing company takes over the other existing company. Thus,
amalgamation entails two kinds of situations:
1) Two or more companies join to form a new company, or
2) One company absorbs other company.
TERMS USED IN AMALGAMATION

Accounting Standard-14 (Accounting for amalgamations), defines the following terms:
1) Amalgamation:
It means an amalgamation pursuant to the provisions of the Companies Act, 1956, or any other
statute which may be applicable to companies.
2) Transferor Company:
It means the company which is amalgamated into another company.
3) Transferee Company:
It means the company into which a transferor company is amalgamated.
4) Reserve:
It means the portion of earnings, receipts or other surplus of an enterprise (whether capital or
revenue) appropriated by the management for a general or a specific purpose other than a
provision for depreciation or diminution in the value of assets or for a known liability.
5) Purchase Consideration:
Consideration for the amalgamation means the aggregate of the shares and other securities
issued and the payment made in the form of cash or other assets by the transferee company to
the shareholders of the transferor company.
6) Pooling of Interests:
It is a method of accounting for amalgamations the object of which is to account for the
amalgamation as if the separate businesses of the amalgamating companies were intended to be

continued by the transferee company. Accordingly, only minimal changes are made in
aggregating the individual financial statements of the amalgamating companies.
TYPES OF AMALGAMATION
As per AS 14 there are two types of amalgamations as shown in figure below:
1. AMALGAMATION IN THE NATURE OF MERGER

Amalgamation in the nature of merger is an amalgamation which satisfies all the following five
conditions:
1) Transfer of All Assets and Liabilities
All the assets and liabilities of the transferor company (i.e., the company which is amalgamated
into another company) become, after amalgamation, the assets and liabilities of the transferee
company (i.e., the company into which a transferor company is amalgamated).
2) Same Equity Shareholders Holding 90%

Shareholders holding atleast 90% of the face value of the equity shares of the transferor
company (other than the equity shares already held therein, immediately before the
amalgamation, by the transferee company or its subsidiaries or their nominees) become equity
shareholders of the transferee company by virtue of the amalgamation.
3) Purchase Consideration in Equity Shares

The consideration for the amalgamation receivable by those equity shareholders of the
transferor company who agree to become equity shareholders of the transferee company is
discharged by the transferee company wholly by the issue of equity shares in the transferee
company, except that cash may be paid in respect of any fractional shares.
4) Same Business
The business of the transferor company is intended to be carried-on, after the amalgamation, by
the transferee company.
5) Recording of Assets and Liabilities at Book Values

No adjustment is intended to be made to the book values of the assets and liabilities of the
transferor company when they are incorporated in the financial statements of the transferee
company expect to ensure uniformity of accounting policies.
2. AMALGAMATION IN THE NATURE OF PURCHASE

If any one or more of the conditions specified for merger are not satisfied, the amalgamation is
in the nature of purchase. For example, A Ltd. acquires the business of B Ltd. with no intention
to continue such business; it is a purchase and not merger. Similarly, shareholders of B Ltd.
holding 90% of the share capital do not become shareholders of A Ltd.; the amalgamation is
only in the nature of purchase. Such amalgamations result in acquisition of one company by
another company. As a consequence, the equity shareholders of the transferor company
normally do not continue to have a proportionate share in the equity of the transferee company.
In this case normally there is no intention to continue the business of the company which is
acquired.
3. ACQUISITIONS
An acquisition, also known as a takeover, is the buying of one company (the „target‟) by
another. An acquisition typically has one company - the buyer - that purchases the assets or
shares of the seller, with the form of payment being cash, the securities of the buyer, or other
assets of value to the seller. In a stock purchase transaction, the seller‟s shares are not
necessarily combined with the buyer‟s existing company, but often kept separate as a new
subsidiary or operating division. In an asset purchase transaction, the assets conveyed by the
seller to the buyer become additional assets of the buyer‟s company, with the hope and
expectation that the value of the assets purchased will exceed the price paid over time, thereby
enhancing shareholder value as a result of the strategic or financial benefits of the transaction.
TYPES OF ACQUISITIONS/TAKEOVER
Takeover may be categorized in following types:
1) Hostile Takeover
A hostile takeover of a company will very likely be extremely emotional. A hostile takeover
means that the acquired company (i.e., the Board of Directors, senior management, and/or
employees) does not want to be acquired, for business reasons (valuations are opportunistic for
the acquirer, due to market factors), personal reasons (management believes that it is doing an
excellent job and does not believe the acquirer will do as well), or perhaps job security reasons.
It is a hostile takeover if the management of the company being taken over is opposed to the
deal. A hostile takeover is sometimes organized by a corporate raider. Hostile takeovers
frequently result in job losses, factory shutdowns, and downsizing for the benefit of the
acquirer or the resulting company.
2) Friendly Takeover
A friendly takeover may be the result of negotiations by senior management to assure that all
constituents of the acquired company have been fairly treated. This does not necessarily mean
that management desires the acquisition, but rather that they are meeting their fiduciary
responsibility to sell or maximize the company‟s value. A very healthy, positive merger may
have dissatisfied groups. The merger of Citicorp and Travellers Insurance Company is the
result of a friendly consolidation, where two potential rivals reached an agreement that will
have minimal impact on total employment.
BENEFITS/REASONS FOR ACQUISITIONS

1) Increased Market Power

A primary reason for acquisitions is to achieve easier greater market power. Market power
exists when a firm is able to sell its goods or services above competitive levels or when
the costs of its primary or support activities are below those of its competitors. It is also
affected by the firm‟s share of the market. Therefore, most acquisitions that are designed to
achieve greater market power entail buying a competitor, a supplier, a distributor, or a business
in a highly related industry to allow the exercise of a core competence and to gain competitive
advantage in the acquiring firm‟s primary market.
2) Overcoming Entry Barriers

Barriers to entry are factors associated with the market or with the firms currently operating in
it that increase the expense and difficulty faced by new ventures trying to enter that particular
market. Facing the entry barriers created by economies c-f scale and differentiated products, a
new entrant may find acquiring an established company to be more effective than entering the
market as a competitor offering a good or service that is unfamiliar to current buyers.
3) Cost of New Product Development and Increased Speed to Market

Developing new products internally and successfully introducing them into the marketplace
often require significant investments of a firm‟s resources, including time, making it difficult to
quickly earn a profitable return. Also of concern to firm‟s managers is achieving adequate
returns from the capital invested to develop and commercialize new products. Acquisitions are
another means a firm can use to gain access to new products and to current products that are
new to the firm.
4) Adequate and Easy Terms Working Capital

Acquisition not only secures the necessary working plant and equipment more quickly than
building up its own, but also helps the firm by making available desired amount of working
capital. It means that by making available the much needed working capital, the problems of
supply of inputs and distribution of final products are solved.
5) Access to Resourceful Management

Management or managerial competencies play important role in running the business, in
expanding it either by intensification or diversion and reaching new heights. The firms which
have failed need both financial and managerial resources to repair the existing loss and
achieving new heights of progress and prosperity. This is possible by acquisition.
6) Increased Diversification
Acquisitions are also used to diversify firms. Based on experience and the insights resulting
from it, firms typically find it easier to develop and introduce new products in markets
currently served by the firm. In contrast, it is difficult for companies to develop products that
differ from their current lines for markets in which they lack experience.

DIFFERENCE BETWEEN MERGERS AND ACQUISITIONS
Basis of Merger Acquisition
Differences
1) Nature A purchase deal will also be called When the deal is unfriendly, i.e.,
a merger when both CEOs agree when the target company does
that joining together is in the best not want to be purchased - it is
interest of both of their companies. always regarded as an
acquisition.
2) Existence In Merger companies may or may In acquisition, the target company
not lose their existence. ceases to survive. It is the buyer
who is the sole proprietor.
3) Equality Merger is referred to as a “merger Acquisition refers to two unequal
of equals”. companies becoming one, usually
strong company buying the weak
company.
4) Financing Mergers are mostly financed by a In acquisition the buyer swallows
stock swap. In a stock swap, the company and the buyer‟s
owners of stock in both companies stock continues to be traded and
receive an equivalent measure of the mode of financing may
stock in the newly formed involve cash and debt
association. Both companies combination, all cash, stocks or
surrender their stocks and stock of additional equity of the company.
the new company is issued as a
replacement. A single
administrative section, then
manages the new union.
4. DEMERGER/SPIN-OFF
A spin-off is a series of transaction through which a company divests or spin-off one or more
unit - typically a small portion of its business with some common theme by turning them into
an independent company and selling the company‟s share to the investing public.
A Spin-off or demerger is the opposite of a merger (the practice of combining several
companies under one corporate roof). A demerger hives-off parts of a company into separate
operations because in a belief that they will perform better that way. It is a corporate strategy to
sell-off subsidiaries or divisions of a company.
REASONS FOR DEMERGER

1) Restructuring the existing business, by segregating different uncommon activities into
different corporate bodies.
2) Separation of management of different undertakings.
3) Introduction of the concept of Responsibility Accounting and Accountability.

4) Protection of business from high risk activities and undertakings which are continuously
incurring cash losses.
5) Bringing clear lines of management.
6) Protection of crown jewel from the predator through hostile takeover.
7) Avoidance of frequent interference of Government and its agencies in business.
8) Division of family managed business.
9) Tapping more opportunities and counter against threats.
10) Separation of unwanted activities and to concentrate on core activities.
11) Enable management buy-out.
ADVANTAGES OF DEMERGER
Following are the advantages of demerger:
1) A demerger will result in the company being split into different segments which will
operate as separate entities. If some parts of the firm are not expected to perform well in the
future, it is sometimes better for these parts of the company to be isolated and sold. This would
mean that the shareholders could dispose of their interests in the parts of the organization
which are expected to generate lower levels of profitability.
2) It is possible that a demerger will enable the company to increase the dividends which
might also affect the price of the share.
3) Re-invest the proceeds into different activities that are expected to result in the
objectives of the company being achieved.
4) It is sometimes possible that a demerger will act as a defense against hostile takeovers.
This is likely to be of greater significance to the management of the company, but to some
extent it will also affect the shareholders.
DISADVANTAGES OF DEMERGER
Following are the disadvantages of demerger:
1) Loss of economies of scale.
2) Increase in overheads.
3) Loss of ability to raise extra finances.
4) Lower turnover and profitability.
5) Loss of benefits from synergy.
4. OTHER RESTRUCTURINGS
a. DIVESTITURES
Divestiture is the sale or disposition of an asset. One of the most common motivations for
divesture is economic. Simply put, when an asset is no longer making money for its parent
company, the company may choose to sell or otherwise dispose of it before it becomes a
liability. Likewise, companies may spin-off divisions which would be more profitable on their
own, or be encouraged to sell divisions and assets which are more valuable to potential buyers
than they are to the company.
REASONS FOR DIVESTITURES

Following are the reasons for divestitures:
1) Viable of Project
A business that had been acquired proves to be a mismatch and cannot be integrated within the
company. Similarly, a project that proves to be unviable in the long-term is divested.
2) Persistent Negative Cash Flows

Persistent negative cash flows from a particular business create financial problems for the
whole company, creating the need for divestment of that business.
3) Severity of Competition
Severity of competition and the inability of a firm to cope with it may lead to divestment.
4) Technological Up gradation
Technological up gradation is required if the business is to survive, but where it is not possible
for the firm to invest in it, a preferable option would be to divest.
5) Survival
Divestment may be done because by selling off a part of a business, the company may be in a
position to survive.
6) Choosing Better Alternative

A better alternative may be available for investment, causing a firm to divest a part of its
unprofitable business.
b. JOINT VENTURES
A joint venture (often abbreviated JV) is an entity formed between two or more parties to
undertake economic activity together. The parties agree to create a new entity by both
contributing equity, and they then share in the revenues, expenses, and control of the
enterprise. The venture can be for one specific project only, or a continuing business
relationship such as the Fuji Xerox joint venture.
For Example, GM-Toyota JV - GM hoped to gain new experience in the management

techniques of the Japanese in building high-quality, low-cost compact and sub-compact cars.
Whereas, Toyota was seeking to learn from the management traditions that had made GE the
number one auto producer in the world and in addition to learn how to operate an auto
company in the environment under the conditions in the U.S., dealing with contractors,
suppliers, and workers.
REASONS FOR FORMING A JOINT VENTURE

There are many motivations that lead to the formation of a JV. They include:
1) Risk Sharing

Risk sharing is a common reason to form a JV, particularly, in highly capital intensive
industries and in industries where the high costs of product development equal a high
likelihood of failure of any particular product.
2) Economies of Scale
If an industry has high fixed costs, a JV with a larger company can provide the economies of
scale necessary to compete globally and can be an effective way by which two companies can
pool resources and achieve critical mass.
3) Market Access
For companies that lack a basic understanding of customers and the relationship/infrastructure
to distribute their products to customers, forming a JV with the right partner can provide
instant access to established, efficient and effective distribution channels and receptive
customer bases. This is important to a company because creating new distribution channels and
identifying new customer bases can be extremely difficult, time consuming and expensive
activities.
4) Geographical Constraints
When there is an attractive business opportunity in a foreign market, partnering with a local
company is attractive to a foreign company because penetrating a foreign market can be
difficult both because of a lack of experience in such market and local barriers to foreign-
owned or foreign-controlled companies.
5) Funding Constraints
When a company is confronted with high up-front development costs, finding the right JVP
can provide necessary financing and credibility with third parties.
c. STRATEGIC ALLIANCES
A strategic alliance is a formal relationship between two or more parties to pursue a set of
agreed upon goals or to meet a critical business need while remaining independent
organizations. During the past decade, companies in all types of industries and in all parts of
the world have elected to form strategic alliances and partnerships to complement their own
strategic initiatives and strengthen their competitiveness in domestic and international markets.
REASONS FOR STRATEGIC ALLIANCES

Several reasons why strategic alliances are used:
1) Entering New Markets
A company that has a successful product or service may wish to look for new markets. Doing
so on one‟s own capabilities may seem to be difficult.
2) Reducing Manufacturing Costs

Strategic alliances are used to pool resources to gain economies of scale or make better
utilization of resources in order to reduce manufacturing costs.
3) Developing and Diffusing Technology

Strategic alliances may be used to develop technological capability by leveraging the technical
expertise of two or more firms; an act which may be difficult to perform if these firms act
independently.
4) Obtain Technology and/or Manufacturing Capabilities

Strategic alliances can be used for obtaining the new technologies. For example, Intel formed a
partnership with Hewlett-Packard to use HP‟s capabilities in RISC technology in order to
develop the successor to Intel‟s Pentium microprocessors.
5) Reduce Financial Risk

It reduces the risk of business. For example, because the costs of developing a new large jet
airplane were becoming too high for any one manufacturer, Boeing, Aerospatiale of France,
British Aerospace, Construcciones Aeronauticas of Spain and Deutsche Aerospace of Germany
planned a joint venture to design such a plane.
6) Reduce Political Risk

Strategic alliance help in creating good political condition. For example, to gain access to
Srilanka while ensuring a positive relationship with the often sensitive Srilankan government,
Indian Oil Corporation formed a MoC (Memorandum of Collaboration) with Ceylon Petroleum
Corporation for Indian Oil‟s entry into the downstream petroleum sector.
7) Achieve or Ensure Competitive Advantage

For achieving the competitive advantage. For example, General Motors and Toyota formed
Nummi Corporation as a joint venture to provide Toyota a manufacturing facility in the United
States and GM access to Toyota‟s low-cost, high-quality manufacturing expertise.
8) Vertical Integration
Vertical integration is designed to help firms enlarge the scope of their operations within a
single industry. Yet, for many firms, exapanding their set of activities within the value chain
can be an expensive and time-consuming proposition. Engaging in full vertical integration is
especially risky for companies that compete in fast-changing industries. Alliances can help
firms retain some degree of control over crucial supplies at a time when investment funds are
scarce and cannot be allocated to backward integration. Also, alliances can assist firms to
achieve the benefits of vertical integration without saddling them with higher fixed costs and
risks. This benefit is especially appealing when the core technology used in the industry is
changing quickly.

VALUATION
In mergers and acquisition both the companies decide the exchange ratio for finalisation of
purchase consideration. Hence, valuation assumes greater significance in mergers and
acquisition.
Value has the following perspectives :
1. Book Value
Book value of a company is decided on the basis of assets and liabilities obtained from the
Balance Sheet at historical cost. The liabilities are subtracted from the assets to get the book
value of a share.
Steps:
1. Find out Net Assets available to Equity Shareholders :
All Assets at Book Value xx
Less : Liabilities at Book Value xx
xx
Less : Preference Shareholder's Claim xx
xx
2. Value of a share = Net Assets Available to Equity Shareholders

No. of Equity Shares
2. Liquidation Value
In this case, it is assumed that the company will be liquidated. All the assets will be sold out
and liabilities paid for. Value of a share depends on the amount available per equity share.
Liquidation value is a more realistic method of valuation. However, it does not measure
earning power of the firm's assets.
Steps:
1. Calculate Net Assets available :
All Assets at Market Value xx
Less : Liabilities to be paid xx
xx
Less : Preference Shareholder's Claim xx
Net Assets available to Equity Shareholders xx
2. Find out value of a share :
Value of a share = Net Assets Available to Equity Shareholders
3. Fair Market Value
Fair market value is the value at which the property would change hands from the willing seller
to the willing buyer. Hence, fair value depends on the circumstances in each case
4. Economic Value
It is the value of the expected earnings from using the item discounted at an appropriate rate to
give a present day value. It is based on future estimated earnings.

5. Free Cash Flow Basis of Valuation
In this case, merger is evaluated as a capital budgeting decision. The target firm should be
valued in terms of its potential to generate incremental future cash flow. Such a cash flow
should be free cash flow. Free cash flow is equal to after tax operating income plus non-cash
expenses such as depreciation and amortisation less additional investment to be made in the
long term assets and working capital. The cash flows are to be discounted at an appropriate rate
that reflects the riskiness of target firm's business.
The present value of the expected benefits from the merger are to be compared with the cost of
acquisition of the target firm. Acquisition cost includes the payment made to the target firm's
shareholders and debentureholders and payment made to discharge the external liabilities,
liquidation expenses to be met less cash proceeds expected to be realized from disposal of the
assets of the target firm. If the NPV is positive, the decision is taken to go with the proposal.
Steps :
I. Decide Projected Free Cash Flow :
Net Operating Profit after tax xx
Add: Non Cash Expenses xx
(Depreciation and Amortisation)
xx
Less : Investment in Long-term Assets xx
xx
Less : Investment in Net Working Capital xx
xx
2. Decide Terminal Value
Terminal Value is the present value of Projected Free Cash Flow after the forecast period.
It is calculated as follows :
a) When FCFF are likely to be constant:
TV = FCFF T+1/Ko
Where, FCFF T+1 = Expected FCFF in the first year after the forecast period
b) When FCFF are likely to grow at a constant rate :
TV = FCFFT (1 + g/K0 - g)
c) When FCFF are likely to decline
TV = FCFFT (1 - g)/(K0 + g)
3. Select the appropriate Discount Rate i.e. Cost of Capital.
4- Decide Present Value of FCFF by using appropriate discount rate.
5. Decide cost of acquisition :
Payment to Equity Shareholders xx
Plus Payment to Preference Shareholders xx
Plus Payment to Debentureholders xx
Plus Payment to Other External Liabilities xx
Plus Obligations assumed to be paid in future xx
Plus Liquidation Expenses xx
Plus Unrecorded / Contingent Liability xx

xx
Less Cash Proceeds of Sale of Assets of the Target Firm xx
xx
6. Calculate NPV.
6. Earning Per Share

The value of a prospective acquisition is considered to be the function of the impact of merger
on EPS. In this case, the impact of merger on EPS is analysed. EPS is calculated as follows :
1. Find out the earnings available to Equity Shareholders :
2. Calculate EPS.
EPS = Earning available to Equity Shareholders
7. Earning Based Value

It is based on the assumption that the company is a going concern. Therefore, value of share
depends on the earnings that will be available to Equity Shareholders. It involves following
three steps:
1. Calculate FMP.
Average Profit after tax xx
Less : Preference Dividend xx
Less : Transfer to Reserve xx
xx
2. Calculate rate of earnings.
FMP x 100
Paid Up Equity Capital
3. Find out earning based value.
Rate of Earnings x Amount per Equity share
NRR

PRACTICAL PROBLEMS
1. Madhu Company wishes to take over Sudha Company. The financial details of the company
are as follows:
Liabilities Madhu Sudha Assets Madhu Sudha
Company Company Company Company
(Rs) (Rs.) (Rs.) (Rs.)
10% Debentures 1,00,000 50,000 Fixed Assets 6,00,000 2,10,000
Profit and Loss A/c 1,70,000 90,000 Current Assets 3,70,000 2,00,000
Share Premium A/c - 20,000
Equity Share of Rs. 100 per 5,00,000 2,50,000
Share
Preference Shares 2,00,000 -
9,70,000 4,10,000 9,70,000 4,10,000

Additional Information:
1) Annual profit available for equity shareholders after tax and preference dividend:
Madhu Ltd. – Rs. 1,80,000
Sudha Ltd. – Rs. 70,000
2) Market price per equity share:
Madhu Ltd. – Rs. 210
Sudha Ltd. – Rs. 270
You are required to calculate the share exchange ratio to the shareholders of Rahim Ltd. based
on Earning per Share (EPS).
2. Prapthi Ltd. is planning to acquire shares of Sahitya ltd. for exchamge ratio of 0.8 of its
share for each share of Sahitya Ltd. The relevant data is given below
Particulars Prapthi Sahitya Ltd.
EAT 16,00,000 6,00,000
Number of equioty shares 4 lac 2 lac
EPS Rs. 4 Rs. 3
PE Ratio (Time) 10 7
Market Value Per Share Rs. 40 Rs. 180
You are required to calculate:
1. EPS after merger
2. PE ratio after merger
3. Ram Ltd. wants to take over Rahim Ltd. The following details of both companies are as
follows:
Particulars Ram Rahim
PAT and Preference Dividend 4.80 lac 3 lac
Preference Share Capital 1 lac -

Equity Share Capital of Rs. 50 10 lac 5 lac
each
You are required to calculate the share exchange ratio to the shareholders of Rahim Ltd. based
on EPS.
4. Omega Ltd is intending to acquire Alpha Ltd. (by merger) and the following information is
available.
Particulars Omega Ltd. Alpha Ltd.
Number of Equity Shares 10,00,000 6,00,000
Earning after Tax (Rs.) 50,00,000 18,00,000
Market Value per Share (Rs.) 42 28
Required:
(i) What is the present EPS of both the companies?.
(ii) What is the present Price Earning Ratio. (P/E Ratio) of both the companies?
(iii) If the proposed merger takes place, what would be the new EPS for Omega Ltd. (assuming
that the merger takes place by exchange of equity shares and the exchange ratio is based on the
current market price.)
5. East Company Ltd. is studying the possible acquisition of Fost Co. Ltd. by way of merger.
The following data are available in respect of the companies.
Particulars East Co. Ltd. Fost Co. Ltd.
Earning after Tax (Rs.) 2,00,000 60,000
No. of equity shares 40,000 10,000
Market value per share (Rs.) 15 12
(i) If the merger goes through by exchange of equity share and the exchange ratio is based on
the current market price, What is the new EPS for East Co. Ltd.?
(ii) Fost Co. Ltd. wants to be sure that the earnings available to its shareholders will not be
diminished by the merger. What should be the exchange ratio in that case?
6. Solid Ltd. is intending to acquire Sound Ltd. by merger and the following information is
available in respect of the companies.
Particulars Solid Ltd. Sound Ltd.
Equity Share Capital of Rs. 10 each (Rs. Millions) 450 180
Earnings after Tax (Rs. Millions) 90 18
Market price of each Share (Rs.) 60 37
Required:
(i) What is the present EPS of both the companies?
(ii) What is the present Price Earnings Ratios (P/E Ratios) of both the companies?

(iii) If the proposed merger takes place, what would be the new EPS for Solid Ltd. (assuming
that the merger takes place by exchange of equity shares and the exchange ratio is based, on
the current market prices)?
(iv) What should be the exchange ratio if, Sound Ltd. wants to ensure the same EPS to
members as before the merger takes place?
7. Charlie Ltd. is intending to acquire Delta Ltd. by merger and the following information is
available.
Particulars Charlie Ltd. Delta Ltd.
Equity Share Capital of Rs. 10 each (Rs. Lakhs) 450 90
Earnings after Tax (Rs. Lakhs) 90 18
Market Price per share (Rs.) 60 46
Required:
1. What is the present EPS of both the companies?
2. What is the present Price Earning Ratios (P/E Ratios) of both the Companies?
3. If the proposed merger takes place, what would be the new EPS for Charlie Ltd. (assuming
that the merger takes place by exchange of equity shares and the exchange ratio is based on the
current market prices).
4. What should be the exchange ratio if, Delta Ltd. wants to ensure the same EPS to members
as before the merger takes place?
8. XYZ Ltd. is considering merger with ABC ltd. XYZ Ltd‟s, shares are currently traded at Rs.
25. It has 2,00,000 shares outstanding and its EAT amount to Rs. 4,00,000. ABC Ltd. has
1,00,000 shares outstanding; its current MPS is Rs. 12.50 and its EAT are Rs. 1,00,000. The
merger will be effected by means of a Stock Swap (exchange). ABC Ltd. has agreed to a plan
under which XYZ Ltd. will offer the current Market Value of ABC Ltd‟s Shares:
(i) What is the pre-merger EPS and P/E ratios of both the companies?
(ii) If ABC Ltd‟s P/E Ratio is 8, What is its current MPS? What is the exchange ratio? What
will XYZ Ltd‟s, post-merger EPS be?
(iii) What must be the exchange ratio for XYZ Ltd‟s so that the pre and post-merger EPS to be
the same?
9. (M.U., BMS, Oct. 2007)

The following are the Balance Sheet of X Ltd. and Y Ltd. for the year ended 31.8.2007.
Particulars X Ltd. Y Ltd.
Equity Share Capital (Rs. 10 each) 1,50,000 75,000
10% Preference Share CapN (Rs. 10 each) 30,000 Nil
Securities Premium Nil 3,000
Profit and Loss A/c. 57,000 6,000
10% Debentures 22,500 7,500
Total 2,59,500 91,500
Fixed Assets 1,83,000 52,500
Net Current Assets 76,500 39,000
Total 2,59,500 91,500
Maintainable Annual Profits After Tax 39,000 22,500
Market Price per Share 20 25
X Ltd. is planning to take over Y Ltd. Hence you are required to determine for each company
the following:
(a) Value per share under Net Assets Method.
(b) Earning Per Share.
(c) P/E Ratio.
(d) EPS if both the companies are merged
10. (M.U., BMS, Oct. 2010)

Company X is contemplating to purchase Company Y. Company X has 3,00,000 shares having
a market price of Rs. 30 per share while company Y has 2,00,000 shares selling at Rs. 20 per
share. The EPS are Rs. 4 and Rs. 2.25 for X and Y Respectively.
Management of both the companies are discussing proposal for exchange of share in
proportion to the relative earning per share of two companies.
Calculate EPS after merger if implemented.
11. (M.U., BMS, April 2011)

Star and Moon had been carrying on business independently. They agreed to amalgamate and
from a new company Neptune Ltd., with an authorized share capital of 2,00,000 divided into
40,000 equity shares of Rs. 5 each. On 31st December, 2009 the respective Balance Sheets of
Star and Moon were as follows:
Star (Rs.) Moon (Rs.)
Fixed Assets 3,17,500 1,82,500
Current Assets 1,63,500 83,875
4,81,000 2,66,375
Less: Current Liabilities 2,98,500 90,125
Representing Capital 1,82,500 1,76,250
a. Revalued figures of Fixed and Current Assets were as follows:
Fixed Assets 3,55,000 1,95,000
Current Assets 1,49,750 78,875
b. The purchase consideration is satisfied by issue of following shares and debentures:
(i) 30,000 equity shares of Neptune Ltd., to Star and Moon in proportion to the profitability of
their respective business based on the average net profit during the last three years which were
as follows:
2007 Profit 2,24,788 1,36,950

2008 (loss)/Profit (1,250) 1,71,050
2009 Profit 1,88,962 1,79,500
(ii) 15% debentures in Neptune Ltd. at par to provide an income equivalent to 8% return on
capital employed in their respective business as on 31st December, 2009 after revaluation of
assets.
You are requested to:
(1) Compute the amount of debentures and shares to be issued to Star and Moon.
(2) A Balance Sheet of Neptune Ltd., showing the position immediately after amalgamation.
12. (M.U., BMS, Nov. 2011)

Company X wishes to takeover Company Y. The financial details of the two companies are as
under:
Company X Company Y
Equity Share (? 10 per share) 1,00,000 50,000
Security Premium Account - 2,000
Profit & Loss Account 38,000 4,000
Preference Shares 20,000 -
10% Debentures 15,000 5,000
1,73,000 61,000
Fixed Assets 1,22,000 35,000
Net Current Assets 51,000 26,000
1,73,000 61,000
Maintainable Annual Profit (aftertax) for Equity 24,000 15,000
Shareholders
Market Price per equity share 24 27
Price Earninq Ratio 10 9
What offer do you think Company X could make to Company Y in terms of exchange ratio,
based on (i) Net assets value; (ii) Earning per share; and (iii) Market price per share? Which
method would you prefer from Company X‟s point of view?
13. (MU, BMS, April 2012)

Following data is available for X and Y Ltd.
Particulars X Ltd. Y Ltd.
Net Profit After Tax 1,50,000 2,50,000
Equity Share Capital (Each Share of Rs. 10 Each) 1,00,000 90,000
If the proposal is that X will absorb Y Ltd. by issuing 1 share for every two held by the
shareholders of Y ltd, than compute the following:
(i) Pre Merger EPS.
(ii) Post Merger EPS
14. (MU, BMS, Nov. 2013)

STREET Ltd. and ROAD Ltd. proposes to amalgamate. Goodwill may be taken at Rs. 96,000
for STREET Ltd. and Rs. 38,000 for ROAD Ltd. The stock of STREET Ltd. and ROAD Ltd.
to be taken at Rs. 2,04,000 and Rs. 1,42,000 respectively.
You are required to find out PURCHASE CONSIDERATION receivable by both the
companies on the basis of NET ASSETS method.
Liabilities Street Ltd. Road Assets Street Ltd. Road Ltd.
Equity Share Capital (Rs. 5,00,000 Ltd.
2,00,000 Fixed Assets 4,00,000 1,00,000
10) Investments 1,00,000 -
General Reserves 2,00,000 20,000 Stock 2,00,000 1,30,000
Profit and Loss A/c. 1,00,000 30.000 Debtors 1,70,000 60,000
Creditors 1,00,000 50.000 Cash & Bank 30,000 10,000
9,00,000 3,00,000 9,00,000 3,00,000
What offer do you think the STREET Ltd. Company could make to ROAD Ltd. Company in
terms of exchange ratio based on - “NET ASSETS VALUE”.
15. (MU, BMS, April 2014)

Jai Ho Ltd. is considering take over of Chak de Ltd. and Pee Kay Ltd. The financial data for
the three companies are as follows:
Jai Ho Ltd. Chak De Pee Kay
Equity share capital of Rs. 10 each (Rs. in 450 Ltd.
180 Ltd.
90
Crores)
Earnings (Rs. in Crores) 90 18 18
Market price per share (Rs.) 60 37 46
Calculate:
(a) Price Earnings ratios.
(b) Earnings per share of Jai Ho Ltd. after the acquisition of Chak De Ltd. and Pee Kay Ltd.
separately. Will you recommend the merger of either both of the companies? Justify your
answer.

8 FINANCIAL MANAGEMENT IN BANKING SECTOR
CLASSIFICATION OF INVESTMENTS
As per Banking Companies Act investments are classified as :
Item Schedule Coverage Notes and Instructions for compilation
Investments 8 I. Investments in
India
i) Government Includes Central and State Government
securities securities and Government treasury bills.
These securities should be shown at the
book value. However, the difference
between the book value and market value
should be given in the notes to the balance
sheet.
ii) Other approved Securities other than Government
securities securities, which according to the Banking
Regulation Act, 1949 are treated as
approved securities, should be included
here.
iii) Shares Investments in shares of companies and
corporations not included in item (ii)
should be included here.
iv) Debentures and Investments in debentures and bonds of
Bonds companies and Corporations not included
in item (ii) should be included here.
v) Investments in Investments in subsidiaries/joint ventures

subsidiaries / joint (including RRBs) should be included here.
ventures
vi) Others Includes residual investments, if any, like
gold, commercial paper and other
instruments in the nature of shares/
debentures/bonds.
II. Investments
outside India

i) Government All foreign Government securities
securities including securities issued by local
(including local authorities may be classified under this
authorities) head.
ii) Subsidiaries and All investments made in the share capital
/ or joint ventures of subsidiaries floated outside India and/or
abroad joint ventures abroad should be classified
under this head.
iii) Others All other investments outside India may be
shown under this head.
CLASSIFICATION OF INVESTMENTS FOR VALUATION PURPOSES

Banks are required to classify their investments into the following categories :
1. Held to Maturity Securities
These are the securities which are held by the bank with the intension to hold them upto
maturity.
The amount of these investments should not exceed 25% of the total investments of the banks.
They are valued as per the following guidelines :
a) When securities are acquired at cost equal to or less than the face value.
The securities should be valued at cost.
b) When securities are acquired at cost which is more than the face value.
The securities are valued at face value. The amount of premium is amortised over the
remaining period to maturity.
c) When there is any diminution in the value of investments in subsidiaries / joint
ventures.
The amount of permanent diminution should be determined and provided for each investment
individually.
2. Held to Trade Securities

These are the securities which are acquired by the bank for trading to take advantage of short
term price/movement in interest rates. These securities are required to be sold within 90 days.
Valuation of such securities should be done as follows :
a) Monthly valuation
The individual securities should be valued monthly or at more frequent intervals.
b) Recognition of Appreciation and Depreciation in Profit and Loss A/c
Any appreciation or depreciation of scrips under each category should be recognized in the
Profit and Loss A/c.
c) Recording of Appreciation and Depreciation in Individual scrip account
Any depreciation or appreciation in the value of individual scrips should be recorded in
individual scrip account.
d) Change in the Book Value

Any change in the book value of individual scrip should be changed to reflect the market value
3. Available for Sale Securities

There are the securities which do not fall in the above categories. They are valued as follows :
a) Marked to Market Valuation at the year end.
The individual securities should be marked to market quarterly or at more frequent intervals.
b) Depreciation in Profit and Loss A/c
Any depreciation of scripts under each category should be recognized and provided in th<
profit and loss A/c.
c) Ignoring Appreciation
Any net appreciation of scrips under each category should be ignored.
d) Recording of Appreciation and Depreciation
Any depreciation or appreciation in the value of an individual scrip is not recorded in the
individual scrip A/c. It is recorded in a separate account.
e) No Change in Book Value
The book value of individual scrips is not changed to reflect the marked to market valuations.
NON-PERFORMING ASSETS (NPA)

As per RBI Circular on Prudential Norms on Income Recognition, Asset Classification and
Provisioning pertaining to Advances, "An asset, including a leased asset, becomes non-
performing when it ceases to generate income for the bank".
A non -performing asset (NPA) is a loan or an advance where;
(i) interest and/ or instalment of principal remain overdue for a period of more than 90 days in
respect of a term loan,
(ii) the account remains 'out of order', in respect of an Overdraft/Cash Credit (OD/CC),
(iii) the bill remains overdue for a period of more than 90 days in the case of bills purchased
and discounted,
(iv) the instalment of principal or interest there on remains overdue for two crop seasons for
short duration crops,
(v) the instalment of principal or interest there on remains overdue for one crop season for long
duration crops,
(vi) the amount of liquidity facility remains outstanding for more than 90 days, in respect of a
securitisation transaction undertaken in terms of guidelines on securitisation.
(vii) in respect of derivative transactions, the overdue receivables representing positive mark-
to-market value of a derivative contract, if these remain unpaid for a period of 90 days from the
specified due date for payment.
Banks should, classify an account as NPA only if the interest due and charged during any
quarter is not serviced fully within 90 days from the end of the quarter. Banks are required to
classify non-performing assets further into the following three categories based on the period
for which the asset has remained non-performing and the realisability of the dues:

(a) Sub-standard Assets:
A sub-standard asset would be one, which has remained NPA for a period less than or equal to
12 months. In such cases, the current net worth of the borrower/ guarantor or the current
market value of the security charged is not enough to ensure recovery of the dues to the banks
in full. In other words, such an asset will have well defined credit weaknesses that jeopardise
the liquidation of the debt and are characterised by the distinct possibility that the banks will
sustain some loss, if deficiencies are not corrected.
(b) Doubtful Assets:

An asset would be classified as doubtful if it has remained in the sub-standard category for a
period of 12 months. A loan classified as doubtful has all the weaknesses inherent in assets that
were classified as sub-standard, with the added characteristic that the weaknesses make
collection or liquidation in full, on the basis of currently known facts, conditions and values,
highly questionable and improbable.
(c) Loss Assets:

A loss asset is one where loss has been identified by the bank or internal or external auditors or
the RBI inspection but the amount has not been written off wholly. In other words, such an
asset is considered uncollectible and of such little value that its continuance as a bankable asset
is not warranted although there may be some salvage or recovery value.
PROVISIONING NORMS FOR NPA

In conformity with the prudential norms, provisions should be made on the non-performing
assets on the basis of classification of assets into prescribed categories.
(1) Standard Assets:
The provisioning requirements for all types of standard assets are as indicted below. Banks
should make general provision for standard assets at the following rates for the funded
outstanding on global loan portfolio basis:
(a) Direct advances to agricultural and Small and Micro Enterprises (SMEs) sectors at 0.25 per
cent;
(b) Advances to Commercial Real Estate (CRE) Sector at 1.00 per cent;
(c) Housing loans extended at teaser rates and restructured advances as per mandatory
provision;
(d) All other loans and advances not included in (a), (b) and (c) above at 0.40 per cent.
(2) Doubtful Assets:

100 percent of the extent to which the advance is not covered by the realisable value of the
security to which the bank has a valid recourse and the realisable value is "estimated on a
realistic basis. In regard to the secured portion, provision may be made on the following basis,
at the rates ranging from 25 percent to 100 percent of the secured portion depending upon the
period for which the'asset has remained doubtful:

Period for which the advance has remained Provision requirement (%)
in 'doubtful' category
Up to one year 25
One to three years 40
More than three years 100
(3) Loss Assets:

Loss assets should be written off. If loss assets are permitted to remain in the books for any
reason, 100 percent of the outstanding should be provided for.
CLASSES OF ADVANCES
(1) Demand Loan:
In case of a demand loan account, the entire amount is paid to the borrower at one time, either
in cash or by transfer to his saving/current account. Only the following subsequent debit is
ordinarily allowed such as interest, incidental charges, insurance premiums, expenses incurred
for the protection of the security, etc. The repayment is provided for by periodical regular
instalment. There is usually a condition that in the event of any instalment, remaining unpaid,
the entire amount of the loan will become due. Interest is charged on the debit balance, usually
with monthly rests unless there is an arrangement to the contrary. The security may be personal
or in the form of shares, Government securities, fixed deposit receipt, life insurance policies,
goods, etc.
(2) Term Loan:

A term loan is generally granted for fixed capital requirements, such as purchase of plant and
equipment, land and building or even for setting up new projects or expansion or
modernization of the plant and equipment. Such a loan is granted for a fixed period exceeding
three years which may be extended up to 10 years and in some cases even up to 20 years. It is
repayable according to the schedule of repayment.
(3) Overdraft:
Overdraft facilities are allowed in current accounts only. An overdraft is a fluctuating account
wherein the balance sometimes may be in credit and at other times in debit. Opening of an
overdraft account requires that a current account will have to be formally opened, and the usual
account opening procedure to be completed. Whereas in a current account cheques are
honoured if the balance is in credit, the overdraft arrangement enables a customer to draw over
and above his own balance up to the extent of the limit stipulated. There is no restriction,
unlike in the case of loans, on drawing more than once. In fact, as many drawings and
repayments are permitted as the customer would des.ire, provided the total amount overdrawn,
i.e. the debit balance at any time does not exceed the sanctioned overdraft limit. This is a
satisfactory arrangement from the customer's point of view. Borrower need not hesitate to pay
into the account any moneys for fear that an amount once paid in cannot be drawn out or

borrowed again, unlike in a loan account. The security in an overdraft account may be either
personal or tangible. The tangible security may be in the form of shares, government security,
life insurance policies, fixed deposit receipts etc. A cheque book is issued in an overdraft
account.
(4) Cash Credit:

Bank credits lump sum loan amount in a separate cash credit account in the name of the
borrower and it is used in the same way as a current account in which an overdraft limit has
been sanctioned. The main advantage of a cash credit account to a borrower is that, unlike the
party borrowing on a fixed loan basis, he may operate the account within the sanctioned limit
as and when required and can save interest by reducing the debit balance whenever he is in a
position to do so. Cash credits are normally granted against the security of goods e.g. raw
materials, work-in- process, and finished goods. The borrower provides securities in
conformity with the terms of the advance.
(5) Bills Purchased:

Bills, clean or documentary, are sometimes purchased from approved customers in whose
favour regular limits are sanctioned. Before granting a limit, the creditworthiness of the drawer
of thr bill of exchange is to be ascertained. Sometimes the financial standing of the drawees of
the bills are also verified, particularly when the bills are drawn from time to time on the same
drawees and/or the amounts are large.
(6) Bills Discounted:

Bills of Exchange maturing within 90 days or so after date or sight, are discounted by banks for
approved parties. In case a bill, say for Rs. 1,00,000 due 90 days hence, is discounted today at
20% per annum, the borrower is paid Rs. 95,000, its present worth. However the full amount is
collected from the drawee on maturity. The difference amount of Rs. 5,000 represents earning
of the banker for the period for which the bill is to mature. In banking terminology this item of
income is called "discount".
CAPITAL ADEQUACY NORMS

Capital adequacy is a measure of a bank's financial strength, expressed as a ratio of capital to
risk-weighted assets. Capital acts as a buffer in times of crisis or poor performance by a bank.
Sufficiency of capital also instills depositors' confidence. As such, adequacy of capital is one of
the pre-conditions for licensing of a new bank as well as its continuance in business. The
traditional approach to sufficiency of capital does not capture the risk elements in various types
of assets in the balance sheet as well as in the off-balance sheet business and compare the
capital to the level of the assets.
The Basel Committee on Banking Supervision had published the first Basel Capital Accord
(popularly called as Basel I framework) in July, 1988 prescribing minimum capital adequacy
requirements in banks for maintaining the soundness and stability of the International Banking

System and to diminish existing source of competitive inequality among international banks.
As per RBI's Master Circular on Prudential Norms on Capital Adequacy the current norms
under Basel III require banks to maintain a minimum capital adequacy of 9% and a Tier-I ratio
of 7%.
CAPITAL FUNDS
'Capital Funds' for the purpose of capital adequacy standard consist of both Tier I and Tier II
Capital as explained below:
1. Tier I Capital
Tier I would include the following items:
(i) Paid-up share capital collected from regular members having voting rights.
(ii) Contributions received from associate / nominal members where the bye-laws permit
allotment of shares to them and provided there are restrictions on withdrawal of such shares, as
applicable to regular members.
(iii) Contribution / non-refundable admission fees collected from the nominal and associate
members which is held separately as 'reserves' under an appropriate head since these are not
refundable.
(iv) Perpetual Non-Cumulative Preference Shares (PNCPS).
(v) Free Reserves as per the audited accounts. Reserves, if any, created out of revaluation of
fixed assets or those created to meet outside liabilities should not be included in the Tier I
Capital.
(vi) Capital Reserve representing surplus arising out of sale proceeds of assets.
(vii) Innovative Perpetual Debt Instruments.
(viii) Any surplus (net) in Profit and Loss Account i.e. balance after appropriation towards
dividend payable, education fund, other funds whose utilisation is defined, asset loss, if any,
etc.
(ix) Outstanding amount in Special Reserve created as per the provisions of Income Tax Act,
1961 if the bank has created Deferred Tax Liability (DTL) on this reserve.
2. Tier II Capital
Tier II capital would include the following items:
(i) Undisclosed Reserves.
(ii) Revaluation Reserves.
(iii) General Provisions and Loss Reserves.
(iv) Additional General Provisions (Floating Provisions).
(v) Additional Provisions for NPAs at higher than prescribed rates.
(vi) Excess Provisions on Sale of NPAs.
(vii) Provisions for Diminution in Fair Value.
(viii) Investment Fluctuation Reserve.
(ix) Hybrid Debt Capital Instruments.
(x) Tier II Preference Shares. -x

(xi) Long Term (Subordinated) Deposits.
(xii) Subordinated Debt.
REBATE ON BILL DISCOUNTING

Rebate on Bills Discounted is also known as Discount Received in Advance, or, Unexpired
Discount or, Discount Received but not earned.
Its treatment is same as in the case of Interest Received in Advance. Accounting Effect:
(i) If it is given only in the Trial Balance: (Only One Effect)
The same will be shown as a liability and will appear in the liability side of the Balance Sheet.
(ii) If it is given in adjustment: (Double Entry Effect)

The same is deducted from the Income from Interest and Discount in Profit and Loss Account
and the same also will appear in the liability side of the Balance Sheet.
ACCOUNTING STEPS
(a) If it is given only in the Trial Balance:
The same will be shown as a liability and will appear in the Liabilities side of the Balance
Sheet.
(b) If it is given in adjustment:
The following entry is required to be passed:
Interest and Discount A/c Dr.
To Rebate on Bills Discounted A/c
In other words, the same is deducted from Interest and Discount Account in Profit and Loss
Account and the same will also appear in the Liability side of the Balance Sheet.
Method of Computation of Rebate on Bill Discounted
Rebate on Bills Discounted = Amount of Bill x Rate of Discount x Unexpired Period

365
TREATMENT OF INTEREST ON ADVANCES

Under accrual accounting the interest that has accrued but has not yet been received as of the
date of the balance sheet, is reported as a current asset and such as Interest Receivable or
Accrued Interest Receivable and is also reported as Interest Income in the income statement.
Interest receivable is the amount of interest that has been earned, but which has not yet been
received in cash. The usual journal entry used to record this transaction is a debit to the interest
receivable account and a credit to the interest income account. When the actual interest
payment is received, the entry is a debit to the cash/bank account and a credit to the interest
receivable account, thereby eliminating the balance in the interest receivable account. The
interest receivable account is usually classified as a current asset on the balance sheet, unless
there is no expectation to receive payment from the borrower within one year.

Journal Entries of Loan:
When loan is given, it must be recorded in books because given loan an asset. Moreover on the
basis of outstanding balance, interest is culated and it is paid by borrower to lender. So, for
knowing actual ce of loan outstanding, journal entries are passed.
Journal Entries in the Books of Lender:

(1) When loan is given by Lender:
Borrower's Loan Account Debit
To Bank Account Credit
(Accounting Effect: Borrower's Loan is our Asset. It is increase in asset, so this account will
debit. Cash though banks will go out from the business which is our asset. It is decrease of
asset in the business. So, Bank account Credit.)
(2) When Lender has right to get interest on given loan

Interest on Loan Receivable Account Debit
To Interest Account Credit
(3) When Lender receives interest from borrower

Bank Account Debit
To Interest on Loan Receivable Account Credit
(4) When Borrower repays his loan.

(a) If there is no interest receivable on loan.
Bank Account Debit
To Borrower's Loan Account Credit
(b) If there is any interest receivable on given loan.
(i) Borrower's Loan Account Debit
To Interest on Loan Receivable Account Credit
(ii) Bank Account Debit (Principal + Receivable Interest)
To Borrower's Loan Account Credit

PRACTICAL PROBLEMS
1. A customer discounts a bill of Rs. 10,000 for 3 months at 12% on 1st March 2016. Calculate
the actual income of Rebate on Bill Discounted as on 31st March, 2016.
2. In respect of the following transactions of the State Bank of Bharat Ltd., you are required to
indicate the necessary journal entries as well as their treatment in the Profit and Loss Account
and Balance Sheet in respect of the year ended 31.3.2016:
(a) The following bills were discounted at 6%:
Discounted on Amount (Rs.) Due Date inclusive
(i) 28.03.2016 1,00,000 30.04.2016
(ii) 29.10.2015 2,00,000 29.02.2016
(iii) 29.01.2016 8,00,000 30.07.2016
(iv) 31.03.2016 60,000 03.06.2016
(b) The Bank has accepted Bills on behalf of its customers amounting to Rs. 4,00,000 at
nominal commission of 2%.
(c) The Bank has advanced an amount of Rs. 10,00,000 having a covering for the same through
bills worth Rs. 4,00,000 and goods on key-loan basis Rs. 8,00,000.
3. On 31st March 2015, Maharashtra Bank Ltd. had a balance of Rs. 18 crores in “Rebate on
Bills Discounted” Account. During the year ended 31st March 2016, Maharashtra Bank Ltd.
discounted, bills of exchange of Rs. 8,000 crores charging interest @ 16% per annum, the
average period of discount being for 73 days. Of these, Bills of Exchange of Rs. 1,200 crores
were due for realization from the acceptors/customers after 31st March 2016, the average
period outstanding after 31st March 2016 being 365 days.
Maharashtra Bank Ltd. asks you to pass Journal Entries and show the ledger accounts
pertaining to:
(a) Discounting of bills of exchange; and
(b) Rebate on bills discounted
4. On 31st March 2015, Bombay Bank Ltd. had a balance of Rs. 4,000 in “Rebate on Bills
discounted” Account. During 2015-2016, Bombay Bank Ltd. discounted Bills of Exchange of
Rs. 5 lakhs. The discount rate was 18% p.a. The average period of discount was 99 days. Bills
of Rs. 2 lakhs were to mature at 49 days after 31st March 2016.
Show the Journal Entries and prepare “Interest and Discount A/c” and “Rebate on Bills
Discounted A/c” in the books of Bombay Bank Ltd.
5. The following particulars are extracted from (Trial balance) books of National Bank Ltd. for
the year ending 31st March 2016:
(i) Interest and Discount Rs. 1,96,000
(ii) Rebate on Bills Discounted (balance on 01.04.2015) Rs. 6,500
(iii) Bills Discounted and Purchased Rs. 67,000

It is ascertained that proportionate discount not yet earned on the Bills Discounted which will
mature during 2016-2017 amounted to Rs. 9,200
Pass the necessary journal entries with narration adjusting the above and show:
(a) Rebate on Bills Discounted A/c and
(b) Interest and Discount Account in the ledger of the bank.
6. The following in an extract from the Trial balance of Queens Bank Ltd. as on 31st March
2016:
Rs.
Rebate on Bills Discounted on 01.04.2015 2,04,777 (Cr.)
Discount Received 5,10,468 (Cr.)
Analysis of the bills discounted reveals:
Due Date Amt. (Rs.)
01.6.2016 8,40,000
08.6.2016 26,16,000
21.6.2016 16,92,000
01.7.2016 24,36,000
05.7.2016 18,00,000
You are required to find out the amount of discount to be credited to Profit and Loss Account
for the year ending 31st March 2016, and pass journal entries.
The rate of discount may be taken at 12% per annum.
7. From the following details of Kings Bank Ltd., prepare Bills for Collection (Assets) A/c and
Bills for Collection (Liability) A/c:
Rs.
On 1.4.2015 bills for collection were 10,20,000
During the year 2015-16 bills received for collection 15,00,000
Bills collected during the year 2015-16 19,69,400
Bills dishonoured and returned during the year 5,42,000
8. Loan sanctioned Rs. 10 lakhs

Interest @ 8% per annum
Repayment Received Rs.
First 50,000
Second and Final 10,30,00
0 of the bank.
Pass Journal entries in the books

9 WORKING CAPITAL MANAGEMENT
WORKING CAPITAL is that capital which is not fixed. It is the difference between, the
book value of the current assets and the current liabilities.
"Working capital is descriptive of that capital which is not fixed. But, the more common use of
working capital is to consider it as the difference between the book value of the current assets
and the current liabilities."
ROLE AND IMPORTANCE

(1) Working Capital Finance:
Alongwith long term finance which the financial institutions provides to the corporate houses
in order to finance purchase of fixed (capital) assets; it also provides working capital finance
for short term purpose in order to finance the working capital requirements of a firm.
(2) Bridge Finance:

Financial institutions provide bridge finance to the corporate firms on short to medium term
basis.
(3) Project Finance:

Financial institutions provides project finance to the corporate houses for medium term as well
as for long term purpose for projects such as expansion, diversification, mergers, acquisitions
as well as takeovers.
(4) Project Report:

Financial Institutions helps the corporate firms in order to select a right business proposal
(project) as well as in the preparation of the project report.
(5) Feasibility Study:

Financial institutions possess a great amount of knowledge and experiences. Due to this they
are able to help the corporate firms in connection with conducting the feasibility as well as
viability study of their proposed projects.
(6) Priority Sector Lending:

Financial institutions are mainly promoted by State or Central Governments in India. Thus they
help the government in its policies of priority sector lending.
(7) Concessional rates of interest:

Financial institutions offers loans to the corporates on concessional rates of interest depending
on the project.
(8) Supplementary Channel/Source:

Financial institutions alongwith banks acts as a supplementary source of finance for the
corporate houses in order to finance its working capital as well as fixed capital requirements.
(9) Advisory Role:

Due to the immense amount of knowledge and experience possessed by the financial
institutions they advise corporate firms with respect to selection of viable project as well as its
day to day management.
(10) Helps in implementing government policies:

In India financial institutions are mainly sponsored as wel, as promoted by the Central
Government as well as by the respective State Governments. Thus through the financial
institutions government policies such as priority sector lending, rural development is easily
possible. Thus financial institutions acts as an agent of the government in mobilizing funds to
the government as well as channelising credit to the selective areas, needed by the corporate
firms.
ELEMENTS OF WORKING CAPITAL

(1) Cash:
Cash is the most liquid item of current assets and therefore managing cash is very important in
case of working capital management. In case of cash management there must be a balance
between liquidity and profitability. If cash is more than required than such idle cash does not
earn anything and hence a firm losses an opportunity to generate some returns on such surplus
cash balances and if less cash is there than what is required it will adversely affect the firms
liquidity position and its image.
(2) Marketable Securities:

Marketable securities are temporary short term investments made out of surplus cash balances
arising out of seasonal operations of the business. Marketable securities helps to park the idle
cash balances and thus helps in increasing the profitability of the firm. Also marketable
securities ensures safety of the principal amount invested. It should be noted that, cash lying
idle earns nothing but if invested in marketable securities brings in returns which in turn
increases the firms profitability position and thus contributing towards shareholders wealth
maximisation in the long run.
(3) Receivables:
Receivables is the aggregate of Sundry debtors and bills receivables. Receivables arises due to
credit sales. A firm selling on credit alongwith cash sales would have a higher turnover. But
liberal credit policy is also associated with higher bad debts, higher collection costs, etc. On the

other hand a stringent credit policy would be to play on the safer side with low credit sales, low
bad debts but in this case the total turnover would be low. A firm has to strike a balance
between liberal and stringent credit policies.
(4) Inventories:
Inventories includes investments in stock of raw materials, work-in-progress (WIP), finished
goods, stores, spares and packaging materials. Inventory management has to take into account
fixing the minimum and maximum levels of inventory. There must be adequate inventories in
order to avoid the disadvantages of both excessive and inadequate inventories.
(5) Creditors/Payables:
Creditors/payables arises due to credit purchases. The role of the credit manager is to get
liberal credit terms. Better working capital management involves stretching the payments to the
maximum without affecting the goodwill and image of the firm adversely.
TYPES OF WORKING CAPITAL

Working capital has been classified and distinguished in a number of ways. Some of the
important classifications are as follows:
(1) Gross Working Capital
Gross working capital is equal to the total current assets only. Items of current assets are like
stock of raw materials, work-in-progress, finished goods, spares and consumable stores, sundry
debtors, bills receivable, cash and bank balance, prepaid expenses, accrued income, advance
payments, short term investments, etc.
(2) Net Working Capital

Net working capital is the excess of current assets over current liabilities. Thus,
Net working capital = Current Assets minus Current Liabilities In other words the value of the
gross working capital is reduced by current liabilities such as sundry creditors, bills payable,
bank overdraft, income received in advance, outstanding liabilities, proposed dividend,
provision for tax, etc.
(3) Positive Working Capital

When the current assets are more than the current liabilities such a situation is known as
positive working capital.
E.g. If the current assets are Rs. 5,00,000 and the current liabilities are Rs. 3,00,000, the
working capital is Rs. 2,00,000.
(4) Negative Working Capital

When the current liabilities are more than the current assets such a situation is known as
negative working capital.

E.g. If the current assets are Rs. 5,00,000 and the current liabilities are Rs. 6,50,000, the
working capital is negative to the extent of Rs. 1,50,000. A negative working capital indicates
the lack of liquidity and solvency position which is a danger signal for the business.
(5) Zero Working Capital

When the investment in current assets is exactly equal to the current liabilities in such a
situation it shows zero working capital.
E.g. If the current assets are Rs. 5,00,000 and also the current liabilities are Rs. 5,00,000; then
it is a situation of zero working capital.
(6) Permanent Working Capital/Core Working Capital
It represents the amount of capital locked up in the business on a continuous basis so long as it
continues to exist. Permanent working capital are of two types:
(a) Initial Working Capital: It is the amount of working capital required at the inception of the
business. In the initial stages on one hand it may be required to grant credit to customers and
on the other hand it may be difficult to get credit from the banks in such a case adequate
working capital is required to initiate the circulation of capital and keep it moving till
collection from debtors are more than payments.
(b) Regular Working Capital: It refers to the excess of current assets over current liabilities.
A business enterprise has to keep a minimum stock of materials, finished goods and cash in
order to meet its immediate obligations as well as to ensure its smooth working.
(7) Variable Working Capital/ Fluctuating Working Capital

Variable working capital is of three kinds and it is influenced by seasonal fluctuations.
(a) Seasonal Working Capital: It is the amount of working capital to meet the demand of
seasonal requirements. During the season more working capital is required and during the off
season less amount of working capital is required.
(b) Special Working Capital: In order to meet unforeseen eventualities such as strikes, fire,
floods, riots, sudden increase in demand, war contracts, drastic increase in taxes, severe
competition, etc. additional funds are required by an organisation. Such amount is termed as
special working capital.
(8) Peak Working Capital

The variable working capital keeps on fluctuating. Peak working capital is the highest amount
of the working capital required by a business organisation during its course of operations.

(8) Balance Sheet Working Capital
It is the difference between the current assets and current liabilities as per the Balance-sheet
prepared at the end of the financial year. The concept of balance-sheet working capital is static
in nature as it does not reveal the flow of money occurring between the two balance sheet
dates.
(9) Cash Working Capital

It refers to the working capital which is available in cash or cash resources. It is reflected by
the items contained in the income statement in between the two balance sheet dates. It reveals
the operational inflow as well as outflows of cash.
WORKING CAPITAL CYCLE

The working capital cycle is also known as operating cycle. It refers to the duration between
the firm's payment of cash for raw materials, entering into production and inflow of cash from
debtors and realization of receivables.
As there is a time lag between sales and realisation of receivables there is a need for sufficient
working capital to deal with the problem which arises due to lack of immediate realisation of
cash against goods sold. The operating cycle refers to the time taken for the conversion of cash
into raw material, raw material into work-in- progress, work-in-progress into finished goods,
finished goods into receivables, receivables into cash and this cycle repeats.
The operating cycle consists of three phases (as shown in the diagram)
PHASE I
In phase 1, cash gets converted into inventory. This would include purchase of raw materials,
conversion of raw materials, conversion of raw materials into work-in-progress, finished goods
and terminate in the transfer of goods to stock at the end of the manufacturing process, in the
case of trading organisations, this phase would be shorter as there would be no manufacturing
activity and cash will be converted into inventory directly. The phase will of course be totally
absent in the case of service organisations.

OPERATING CYCLE
PHASE II
In phase 2 of the cycle, the inventory is converted into receivable as credit sales are made to
customers. Firms, which do not sell on credit, will obviously not have phase 2 of the operating
cycle.
PHASE III
The last phase, phase 3, represents the state when receivables are collected. This phase
completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables
and to cash again.
The operating cycle consists of the following events which continue throughout the life of a
firm remaining engaged in commercial activities:
(I) Conversion of cash into raw materials.
(II) Conversion of raw materials in work-in-progress.
(III) Conversion of work-in-progress into finished goods.
(IV) Conversion of finished goods into account receivable and debtors through sales.
(V) Conversion of accounts receivable into cash.
OPERATING CYCLE CALCULATION

Calculation of Operating Cycle:
STEP I
Advance Money = (Advance/[Raw Material + Stores]) X 365 Days
Raw Material Stock Holding Period = (Raw Material/Purchases) X 365 Days
Work in Progress = (Work in Progress/Cost of Production) X 365 Days
Finished Goods = (Finished Goods/COGS) X 365 Days
Debtors = (Debtors/Credit Sales) X 365 Days
Creditors = (Creditors/Credit Purchases) X 365 Days

STEP II
OC = A + R + W + F + D - C
OC = Duration of operating cycle

A = Amount paid for purchases of raw materials in respect of Government supplies or Quota
items
R = Storage of raw materials period
W = W-I-P period/duration
F = Finished goods period
D = Debtors collection period
C = Creditors payment period
STEP III
Number of OC in a year = 365 Days/OC
STEP IV
AWCR = Total of Operating Cost/Number of OC in a year = Rs.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS (APRIL 12, 14)

A finance manager is required to estimate the working capital requirements. The amount of
working capital required by a business firm depends on the following factors
(1) Nature of Business
The nature and volume of business is an important factor in deciding the needed working
capital. Public utility service (like railway companies) as compared to manufacturing concerns
requires a lesser amount of working capital. A larger amount of working capital is required for
trading or merchandising institutions as it has to carry large inventories and allow credit to its
customers. Similarly, basic and key industries or those engaged in the manufacture of
producer's goods, usually have less proportion of working capital to fixed capital than
industries producing consumer's goods. A manufacturing concern requires more working
capital as compared to a firm engaged in trading activities.
(2) Size of Business Unit

It is an important factor for determining the proportion of working capital. The general
principal in this connection is that the bigger the size of the unit, the more will be the amount
of working capital required. But it is quite likely that the bigger sized business unit, i.e. a
consumers' goods industry may require a larger amount of fixed capital than working capital.
(3) Time Consumed for Manufacture

The longer the period of manufacture, the larger the inventory required. However, if the flow
of product is quite steady, although the value of goods in process is large, the working capital
will not vary much from time to time.

(4) Need to Stock Pile Raw Materials
Those concerns where there is the need to stock pile raw materials require larger amount of
working capital. The necessity for stock piling increases the extent of funds tied up in
inventories.
(5) Need to Store Finished Goods

In business like retail stores, where unit is required to store finished goods, (because in the
absence of adequate stocks, customer may return disappointed) naturally more working capital
is required.
(6) Cost and Time Involved in the Manufacturing Process

If the manufacturing process in an industry entails high cost because of its complex nature,
more working capital will be required to finance that process and also for other expense which
vary with the cost of production. Moreover, the longer the period of manufacture, higher the
amount of cash needed.
(7) Turnover of Circulating Capital

Turnover of circulating capital plays an important and decisive role in judging the adequacy of
working capital. The speed with which the circulating capital completes its round, i.e.,
conversion of cash into book debts or bills receivables, and book debts or bills receivables into
cash again plays an important role.
(8) Terms and Conditions of Purchase and Sale

The place given to credit by a concern in its dealings with creditors and debtors may also be
considered to assess the adequacy of working capital. A business unit, making purchase on
credit basis and selling its finished products on cash basis, will require lower amount of
working capital than a concern having no credit facilities and which may further be forced to
grant credit to its customers.
(9) Conversions of Current Assets into Cash

A company having ample stock of liquid current assets will require lesser amount of working
capital, because adequate funds can easily be procured by disposal of current assets.
(10) Impact of Cyclical and Seasonal Variation

In periods of the boom and depression, more working capital is needed than during the other
stages of cyclical fluctuations.
(11) Production Policies

The production policies adopted by a business organisation affects the requirements of working
capital. The level of production decides the investment in current assets which in turn decides
the amount of working capital required.

(12) Turnover of Inventories
A business firm having high inventory turnover would require limited working capital whereas,
a firm having low inventory turnover would require more amount of working capital.
(13) Dividend Policies

A firm following a liberal dividend policy requires high working capital to pay cash dividends,
whereas a firm following a conservative dividend policy will require less amount of working
capital resources.
(14) Inflation
During inflation a business concern requires more working capital to pay for raw materials, ‟
labour and other expenses. This may be compensated to some extent later due to possible rise
in selling price.
(15) Technology
A firm using labour oriented technology will require more working capital to pay labour wages
regularly.
(16) Taxation Policies

Government taxation policy affects the quantum of working capital requirements. High tax
rates demands more amount of working capital.
(17) Expansion
An expanding business will require increase in working capital proportionate to the rate of
expansion.
(18) Degree of Co-ordination

In the absence of co-ordination between production and distribution policies more working
capital may be needed.
MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)

In 1974, Reserve Bank of India appointed a Study Group with Shri P. L. Tandon, then
Chairman, Punjab National Bank as the Chairman for "Framing Guidelines for the follow up of
Bank Credit". A "Working Group" to review the system of cash credit was constituted in April
1979 under the chairmanship of Shri K. B. Chore, Chief Office, DBCOD, Reserve Bank of
India. Reserve Bank of India (RBI) had appointed Tandon Committee and Chore Committee
which recommended that business enterprises should improve their liquidity position and
firstly they should try to improve their current ratio to the level of 1.33 : 1 and thereafter should
try to achieve a current ratio of 2 :1.

CALCULATION OF MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)
Method 1 Method 2 Method 3

Low Risk Medium Risk High Risk
Category of Category of Category of
Borrowers Borrowers Borrowers
0.75 (CA - CL) 0.75CA - CL 0.75 (CA - CCA) - CL
where;
CA = Current Assets
CL = Current Liabilities excluding Bank Overdraft or any Short Term Bank Borrowings
CCA = Core Current Assets
WORKING CAPITAL FINANCING APPROACHES

(1) Matching Approach:
The Matching Approach to Assets Financing Under the matching approach both the fixed
assets and permanent portion of the working capital is financed from the long term funds such
as equity and long term debt, while the fluctuating working capital is financed from short term
debt. Thus, under this approach the maturity structure of the firm's liabilities is made to
correspond exactly to the life of its assets.
(2) Conservative Approach:

Under the conservative approach, fixed assets, permanent working capital and also a part of
fluctuating working capital are financed from long term funds. Hence there is less reliance on
short term debt. Since the cost of long term funds in general is relatively greater than short
term funds therefore this approach results in lower profitability. In this case the firm tries to
play safe and reduce the risk of refund of short term debt. But lower risk is also associated with
lower returns in this case.
(3) Aggressive Approach:

Under the aggressive approach only the fixed assets and part of the permanent working capital
is financed from the long term funds such as equity and long term debt while the remaining
portion of permanent working capital as well as the fluctuating working capital is financed
from short term debt. This approach is associated with higher risk but also it also generates
higher returns to the firm. The firm has to arrange funds frequently for its refunds tinder this
approach.
INTRODUCTION TO RBI
Reserve Bank of India (RBI) is the Central Bank of India. RBI is the bankers bank. The role of
RBI in providing finance to corporate firms is very vital in the present days. Traditionally in

India indigenous bankers were providing finance. In the post-independence era institutional
sources of finance is provided to the corporate houses. Such institutional sources of finance is
provided by the banking system. RBI co-ordinates the short term and medium term finance
which is provided by the commercial banks.
ROLE OF COMMERCIAL BANKS IN FINANCING CORPORATE SECTOR

In India banking system is a major source of institutional finance to the corporate sector. Banks
provide the following forms of financing to a corporate sector.
(1) Overdraft:
Overdraft is a facility provided to the current account holders. In case of overdraft the account
holders are allowed to overdraw upto a certain limit from their accounts. Overdraft is a
negative balance in the current account. Interest is calculated on daily basis on the amount
outstanding in an overdraft account. The bank pre-decides and fixes the overdraft limit.
Overdraft is a temporary/short term facility but can be renewed from time to time. The bank
sanctions the overdraft limit based on the credit appraisal and assessment of the current
account holders. Overdraft is a running account and deposits and withdrawals upto the
sanctioned limit are freely allowed by the bankers.
(2) Cash Credit:

Overdrafts are sanctioned to small businesses and proprietory concerns whereas cash credit are
sanctioned to large corporates like Reliance, M&M, Telco, etc. In case of cash credit a separate
account is opened by the banker in the name of the borrower and the cash credit limit is
sanctioned to this account. Cash credit limit is decided by the banker based on the credit
appraisal undertaken of the borrower. Cash Credit is an official arrangement with the bank
wherein the bank allows its cash credit account holders (customers) to borrow upto a certain
limit called cash credit limit. Cash credit account is a running account and deposits and
withdrawals upto the sanctioned limit are freely allowed by the bankers in this account. Interest
is calculated on daily basis on the amount outstanding in cash credit account. Cash credit
facility is given against the security of tangible assets in the form of hypothecation and pledge
and other guarantees. In cash credit there is a commitment charges on the unutilised amount
since the bank has an opportunity cost on it.
(3) Bank Loans:

Banks provide loans to the customers for various purposes. Banks provide Working Capital
Term Loans (WCTL) which is also termed as Note Lending System (NLS). Loans are
sanctioned only after a detailed credit appraisal of the proposed borrower. For this purpose a
separate loan account is opened. The borrower has to repay the loan installments as per the
repayment loans it may be of two types:
(a) Secured loans: In case of secured loans such loan amounts are secured by the tangible
assets and / or other guarantees by the borrowers. Secured loans may be secured in the form of:
(i) Mortgage (ii) Hypothecation (iii) Pledge (iv) Lien

(b) Unsecured loans: In case of unsecured loans it is raised against the personal guarantee of
the borrowers. There is no assets that form security for such loans.
(4) Discounting of Bills of Exchange:

Commercial banks provide short term finance to corporates by discounting their:
(i) Bills of Exchange;
(ii) Hundis; and
(iii) Promissory Notes.
A business firm gets ready cash against its bills receivable amount on a future date. The banks
deduct a small amount as commission for providing this service.
Discounting:
A bill of exchange is a negotiable instrument signed by the drawee (purchaser of goods on
credit) indicating therein that he will honour the bill (make the payment for such credit
transaction) on a specified later date.
Bill discounting or discounting of a bill of exchange is a process of paying the amount of the
bill of exchange less discount deducted for the time period and risk involved. Such amount is
paid to the holder of the bill by the bank or a bill discounting agency or by any cash rich
company and hold the bill till its maturity date to get it honoured or it can further re-discount it
prior to its due date. Just like banks do the discounting of bills similarly cash rich business
firms can also discount the bill of exchange.
Such a bill of exchange is then handed over to the drawer / beneficiary (the seller of the goods
on credit). A bill of exchange is a very popular instrument of credit. Alongwith bill discounting
banks also undertakes bills (of exchange) purchasing.
(5) Letter of Credit:

Letter of Credit (L/C) is the most important mode of payment for trade in international trade
throughout the world. As the buyers (importers) and sellers (exporters) are often not known to
each other and the bankers are well known for their credit standing, the bank's creditworthiness
is substituted for the importers creditworthiness. The letter of credit is an undertaking given by
the bank to pay or accept the bill provided the exporter (beneficiary) fulfill the terms and
conditions of sale as set out in the application made to the bank by the importer. A letter of
credit is issued by the importers bank guaranteeing the payment by the importer or by the
importers bank for the trade transaction.
The letter of credit is obtained by the importer from his bank and then sent to the exporter.
Based on such a letter of credit the exporter can obtain both pre-shipment and post-shipment
finance from his bank at a concessional rates of interest as notified by RBI.
Also for the exporter L/C helps in confirmed receipt of the payment even if the importer goes
bankrupt his bank (issuing Bank) will make the payment. A letter of credit helps an exporter in
arranging finance in order to meet his working capital requirements.

COMMERCIAL PAPER (CP)
Commercial Paper (CP) is an unsecured money market instrument issued in dematerialised
form (made mandatory from June 30th, 2001). II is a short term funding tool available to
highly rated corporates/Primary Dealers (PDs)/Satellite Dealers (SDs) and All India Financial
Institutions (Fis) and is typically issued by companies to raise funds for their short
term/working capital requirements.
Benefits of CP:
Commercial Paper offers substantial interest cost savings vis-a-vis traditional forms of working
capital borrowings like bank credit. Besides the savings in terms of interest costs, CP also
offers the issuer the flexibility to match cash flows and fund requirements against the loan
component of working capital.
Issuers of CP:
CP can be issued by -
(1) Corporates.
(2) Primary Dealers (PD) and Satellite Dealers (SD).
(3) All India Financial Institutions (FI).
Eligibility for issuance of CP:

For Corporates:
(1) Minimum "Tangible Net worth" of Rs. 4 crores as per the latest available audited
Balance sheet.
(2) Corporate should have sanctioned working capital limits by bank/s or all India Financial
Institution/s.
(3) Borrowal account of Corporate should be a Standard Asset in the books of bank/s or all
India Financial Institution/s.
As per the latest guidelines, RBI has done away with the requirement of a minimum current
ratio of 1.33 and working capital limits of Rs. 4 crores.
For Primary Dealer/Satellite Dealer and All India Financial Institution (AIFI):
(1) Only those PD/SD/AIFI that have been permitted to raise short term resources under
Umbrella limit fixed by RBI can issue CP not exceeding the umbrella limit fixed by RBI.
In addition to the above, the issuer would also need to satisfy the following prerequisites:
(a) Issuers should have a valid credit rating for the issue of short-term unsecured paper/CP
from CRISIL or such other Credit Rating Agency (CRA) as may be specified by RBI from
time to time. The minimum credit rating shall be P-2 of CRISIL or equivalent.
(b) The rating should be current and not due for renewal at the time of initial issue and
during the currency of CP.

(c) Borrowing under the CP cannot exceed maximum amount rated for issue of the CP by
CRA or the amount authorized under the resolution of the Board of Directors of the
Corporate/PD/SD/ AIFI whichever is lower.
In all the above cases, any other eligibility criteria prescribed by RBI from time to time will
also be applicable.
Maturity profile of CP:

CP can be issued for maturities between a minimum of 15 days and a maximum of upto 1 year
from the date of issue.
Minimum size and denomination of CP:

CP can be issued in denomination of Rs. 5 lakh or multiples thereof. NSDL accounts the CP in
terms of units. Rs. 5 Lakhs of maturity value is equal to one unit.
Primary investors in CP:
CP's can be held by following category of investors:

(1) Individuals.
(2) Banking companies.
(3) OCB's registered/incorporated in India.
(4) Unincorporated bodies.
(5) NRI's.
(6) FII's (within overall limits set by SEBI).
Limit on amount to which a CP can be issued:

Traditionally, Commercial paper was carved out of the working capital limits available to the
company. The reinstatement of the bank limit on the maturity of the commercial paper served
as an inhere liquidity support for the repayment of the instrument.
The recent guidelines of the Reserve Bank of India have de-linked the Commercial Paper from
the working capital limits of the company. This in effect, indicates that companies now have
the freedom to issue Commercial paper within or outside of their working capital limits. I
addition, RBI has allowed banks to provide "Stand-by assistance/credit back-stop facilities" for
credit enhancement of commercial paper.
Consequently, corporates could today raise CP in excess of their working capital facilities also
and their ability to do so would be entirely dependent on the limits set by the Credit Rating
Agency and the standby assistance provided by banks.

PRACTICAL PROBLEMS
1. Prepare an estimate of working capital requirement from the following details of a company
which has a paid up share capital of Rs. 10,00,000, 6% debentures of Rs. 1,00,000 and fixed
assets of Rs. 7,50,000.
(a) The monthly production and sales will be 5,000 units to be sold at Rs. 15 each.
(b) The per unit costs will be: Materials Rs. 6.00, Wages Rs. 4.50, and expenses Rs. 1.50.
(c) Raw materials and finished goods will remain in stock for 1.5 month and 2 months
respectively.
(d) The process time will be 1 month.
(e) The credit allowed to debtors and received from creditors will be 2 months and 1 month
respectively.
2. The cost sheet of PQR Ltd. gives the following data:

Particulars Cost Per Unit Rs.
Raw Material 50
Direct Labour 20
Overhead (including depreciation of Rs. 10) 40
Total Cost 110
Profit 20
Selling Price 130
Average raw material in stock is for one month. Average material in work in progress is for
half month. Credit allowed by suppliers is one month. Debtors are allowed credit of one month.
Average time lag in payment of wages is 10 days. Average time lag in payment of overheads is
30 days 25% of the sales are on cash basis. Cash balance is expected to be Rs. 1,00,000.
Finished goods lie in the warehouse for one month.
Prepare a statement of working capital needed to finance a level of activity of 54,000 units of
output. Production is carried on evenly throughout the year and wages and overhead accrue
similarly.
3. The management of Gemini Enterprises has called for a statement showing the working
capital required to finance a level of activity of 1,80,000 units of output for the year. The cost
structure for the company‟s product for the above-mentioned level of activity is detailed below:
Particulars Cost per Unit Rs.
Raw Material 20
Direct Labour 5
Overheads (including depreciation of Rs. 5 per unit) 15
Total Cost 40
Profit 10
Selling Price 50
(i) Minimum cash balance desired Rs. 20,000.
(ii) Raw materials are held, in stock, on an average, for two months.
(iii) Work in progress (assume 50% completion stage) will approximate to half a month‟s
production.
(iv) Finished goods remain in warehouse, on an average, for one month.
(v) Suppliers of raw materials extend one month‟s credit and debtors are given two month‟s
credit. Cash sales are 25% of total sales.
(vi) There is a time lag in payment of wages of one month and of half a month in the case of
overheads.
Prepare an Estimate of Working Capital requirements.
4. From the following information pertaining to Swaraj Ltd., prepare a statement showing the
working capital requirements:
Budgeted Sales Rs. 2,60,000 p.a.
Analysis of Sales (Per Unit): Rs.
Raw Materials 3
Direct Labour 4
Overhead 2
Total Cost 9
Profit 1
Sale Price 10
It is estimated that:
(i) Raw materials remain in stock for 3 weeks and finished goods for 2 weeks.
(ii) Factory processing takes 3 weeks.
(iii) Suppliers allow 6 weeks credit.
(iv) Customers are allowed 8 weeks credit.
Assume that production and overhead‟s accrue evenly throughout the year.
Also calculate MPBF as per Tandon Committee recommendation, assuming that of the current
assets 15% is Core Current Assets.
5. The management of Royal Industries has called for a statement showing the working capital
needs to finance a level of activity of 1,80,000 units of output for the year. The cost structure
for the company‟s product for the above mentioned activity level is detailed below:
Cost Per Unit (Rs.)
Raw Materials 20
Direct Labour 5
Overheads (including depreciation 15
of Rs. 5 per unit)
40
Profit 10
Selling Price 50
(a) Minimum desired cash balance is Rs. 20,000.

(b) Raw materials are held in stock, on an average for two months.
(c) Work in progress (assume 50% completion stage) will approximate to half
month's production.
(d) Finished goods remain in warehouse on an average for a month.
(e) Suppliers of materials extend a month‟s credit and debtors are provided two month‟s credit.
Cash sales are 25% of total sales.
(f) There is a time-lag in payment of wages of a month and half a month in case of overheads.
From the above facts, you are required to
(i) Prepare a statement showing working capital needs.
(ii) Determine the maximum working capital finance available under first two methods
suggested
by Tandon Committee.
6. DCM Ltd, had an annual sate of 50,000 units at Rs. 100 per unit. The company works for 50
weeks in a year.
The cost details of the company are as given below:
Cost Elements
Raw Materials 30
Labour 10
Overheads 20
Cost per unit 60
Profit per unit 40
Selling Price per unit 100
The company has the practice of storing raw material for 4 weeks‟ requirements. The wages
and other expenses are paid after a lag of 2 weeks. Further, the debtors enjoy a credit of 10
weeks and company gets a credit of 4 weeks from suppliers. The processing time is 2 weeks
and finished goods inventory is maintained for 4 weeks.
From the above information prepare a working capital estimate allowing for a 15%
contingency.
7. From the details of E Co. Ltd. calculate MPBF.

Balance Sheet (Rs. in lakhs)
Liabilities Rs. Assets Rs.
Share Capital 600 Fixed Assets 960
Reserves and Surplus 200 Current Assets 600
Debentures 400
Creditors and Other Current 360
Liabilities
1,560 1,560
Note: Of the current assets Rs. 80 lakhs is Core Current Assets.

8. The following cost percentage to sales have been extracted from the cost sheet.
%
Material 50
Labour 20
Overhead 10
Production and sales in 2004 was 1,00,000 units and it is proposed to maintain the same
production during 2005.
(i) Raw materials are expected to remain in stores for an average period for one month.
(ii) Finished goods are to stay in warehouse on an average for one month.
(iii) Credit allowed by supplier was two months.
(iv) Debtors are allowed two months credit.
(v) Each unit of production will be in process for an average of 1V2 months.
(vi) Time lag in payment of wages and overheads are one month.
(vii) Sales price per unit is Rs. 12.00/-.
(viii) Keep 10% margin of safety on net working capital.
(ix) Production and sales are spread evenly through out the year.
Prepare statement showing estimated working capital for the year 2005.
9. M/s. Jayam Ltd. sells its products on a gross profit of 20% on sales. The following
information is extracted from its annual accounts for year ended 31 st March, 2002.
Rs.
Sales (at three months credit) 40,00,000
Raw material (One month in arrears) 12,00,000
Wages paid (average time lag 15 days) 9,60,000
Manufacturing Expenses paid (One month in arrears) 12,00,000
Administrative Expenses paid (one month in arrears) 4,80,000
Sales Promotion Expenses (Payable half-yearly in 2,00,000
advance)
Cash 1,00,000
Stock of:
(A) Raw Materials (2 months inventory)
(B) Finished goods (1.5 months inventory)
(Add 10%Ltd.
10. Ram Safety Margin)
furnishes the following details and requests you to prepare a statement showing
the
requirements of working capital for the year 2006.
Particulars Budget for 2006
Production Capacity 30,000 units
Production 80%

Cost Structure:
Raw Material Rs. 40 p.u.
Other direct material Rs. 30 p.u.
Wages Rs. 20 p.u.
Overheads: Fixed Rs. 10,000 p.m.
Variable Rs. 10 p.u.
Profit 20% on sales
(a) Fixed overheads payable quarterly in advance.
(b) Raw material remains in stock for two months.
(c) Other Direct Material in stock for one month.
(d) The production process takes one month. WIP valuation to be made raw material
and other direct material at cost and 50% of wages and overheads (variable).
(e) Finished goods remain in stock for two months (to be valued at direct cost).
(f) Raw Material purchased from suppliers against advance payment of three months and other
direct material suppliers allow credit of two months.
(g) Time lag in payment of wages two months.
(h) Cash Balance to be maintained at Rs. 75,000.
(i) Credit allowed to customers as under (valued at selling price)
(1) 50% of invoice price against acceptance of Bill for three months.
(2) 25% of invoice price time lag three months.
11. X and Co. is desirous to purchase a business and has consulted you, and one point on which
you are asked to advise them is the average amount of working capital, which will be required
in the first year‟s working. You are given the following estimates and instructed to add 15 % to
your computed figure to allow for contingencies.
Figures for the
Particulars
year Rs.
a) Average amount locked up in stocks:
Stocks of finished product 25,000
Stocks of stores, material, etc. 28,000
b) Average Credit given:
Inland sales 6 weeks credit 3,12,000
Export Sales 1 ½ weeks credit 78,000
c) Lag in payment of wages and other
overheads:
Wages 1 ½ weeks 2,60,000
Rent Royalties, etc. 6 months 10,000
Clerical staff ½ month 62,400
Manager ½ month 4,800
Miscellaneous Expenses 1 ½ months 48,000
d) Payment in advance:
Sundry Expenses Quarterly advance 16,000
e) Undrawn profit on average 11,000
Also calculate MPBF as per Tandon Committee Recommendations, assuming that of the
current assets 10% are core current assets.
12. LAXMAN Ltd. manufactured and sold 1000 D.V.D. sets in the year 2005. The production
cost
per unit was as under:
Particulars Rs.
Material 1,500
Labor 750
Overheads 450
Total Cost 2,700
Profit 300
Selling Price 3,000
For the year 2006 it is estimated that:
(a) The output and sales will be 1,500 D.V.D. sets.
(b) Selling price per unit will be Rs. 3,600/-.
(c) Overheads will increase by 20%.
(d) Price of material will rise by 10%.
(e) Labour cost will rise by 20%.
It is also estimated that:
(a) Cash in hand and with bank should always be Rs. 75,000/-.
(b) Customers allowed credit as under:
(i) 50% of sales against acceptance of bill for 2 months.
(ii) 50% of sales on one month credit.
(c) 60% of Raw Material requirements will be obtained from the suppliers from China by
making 2 months advance payment and 40% of Raw Materials purchased on 1 month credit.
(d) Finished goods will remain in warehouse for one month.
(e) Raw material remain in stock for a half month before issue to production.
(f) Wages are paid one month in arrears.
(g) Material will be in process for half month. (Valued at cost of material plus 50% of
labour and overheads).
13. The Board of Directors of Alka Ltd. require you to prepare a statement showing the
working capital requirements forecast for a level of activity of 1,56,000 units of production.
The following information is available for your calculation:
Particulars (Rs. Per Unit)
Raw Materials 90
Direct Labour 40
Overheads 75
205
Profit 60

Selling Price Per Unit 265
(a) Raw materials are in stock on average one month.
(b) Materials are in process, on average two weeks.
(c) Finished goods are in stock, on average one month.
(d) Credit allowed by suppliers - one month.
(e) Time lag in payment from debtors - two months.
(f) Time lag in payment of wages -1 ½ weeks.
(g) Lag in payment of overheads - one month.
20% of the output is sold against cash. Cash in hand and at Bank is expected to be Rs. 60,000.
It is to be assumed that production is carried on evenly throughout the year. Wages and
overheads accrue similarly and a time period of 4 weeks is equivalent to a month.
14. From the following information prepare an estimate of working capital required to finance
a level of activity of 3,12,000 units p.a. (52 weeks) and how will you finance the working
capital.
Particulars Per unit
Raw Materials 90
Wages 40
Overheads:
Manufacturing 30
Administrative 40
Selling 10
210
Profit 40
Selling price 250
Other information:
(a) Raw materials are held in stock for a period of 4 weeks.
(b) Materials remain in process for 2 weeks requiring 50% wages and 40% overheads.
(c) Finished goods remain in stock for a period of 4 weeks.
(d) Credit allowed to customers is 8 weeks but 20% of the invoice price is collected
immediately.
(e) Time lag in payment of wages is 1.5 weeks and in overheads is 4 weeks.
(f) Credit available from suppliers is 4 weeks but 20% of the creditors are paid 4 weeks in
advance.
(g) Bank balance is to be maintained at Rs. 60,000.
15. The following is a cost sheet of a Company producing 48,000 similar types of products
every year.
Particulars Amount per unit in (Rs.)
Raw Materials 80
Labour 40
Factory Overheads 30

Selling and Distribution cost 20
Net Profit 30
The following further particulars are given to you:
(a) Raw materials remain in stock for 2 months while finished goods stock in carried for 3
month.
(b) Credit allowed to customers is 3 months while credit allowed by suppliers of materials is 2
months.
(c) Factory Overheads are paid at the end of the month.
(d) Company has a policy to have bank balance of at least Rs. 1,50,000 on any date and cash
holding worth 3 months factory overhead.
(e) 20% of the total sale is for cash.
You are required to prepare a statement of working capital requirements.
16. The selling price of a product is Rs. 20/- each and its break up is:
Materials 40%
Labour 20%
Other Direct Cost 10%
General Overheads 10%
Selling and Distribution Cost 10%
Profit @ 10%
A company produces 3,60,000 units of a product in a year and the following details for the year
are given for consideration:
(a) Raw materials remain in stock for 3 months, and the suppliers of Raw materials extend 2
months credit.
(b) The Work in Progress is to be valued @ 50% of the total direct cost of one months
production.
(c) The customers are given three months credit.
(d) The wgges are paid after the end of the month.
(e) 40% of the total sales are for cash and balance on credit.
(f) There is no opening and closing stock of finished goods.
(g) Cash and Bank balance is carried to the extent of 50% of a monthly profit on an average
basis.
You are required to compute Working Capital Requirement of the business.
17. From the following information available to you, on 1st January, prepare the working
capital requirement forecast for the year.
Production during the previous year was 30,000 units. It is planned that this level of activity
should be maintained during the current year. The expected ratios of the cost to selling prices
are Raw materials 60%, Direct wages 10% and Overheads 20%. Raw materials are expected to
remain in stores for an average of 2 months before issue to production. Each unit of production
is expected to be in process for 1 month, the raw materials being fed into the pipeline
immediately and the labour and overheads cost accruing evenly during the month. Finished
goods will be in the storehouse approximately for 3 months before being dispatched to

customer. Creditors allow 2 months credit from the date of delivery of raw materials. Credit
allowed to debtors is 3 months from the date of dispatch. Selling price is Rs. 10 per unit. The
cycle of production and sales is regular. Wages are paid 15 days in arrears. Cash in hand with
the company is normally Rs. 20,000. Assume 30 days to a month.
18. The Board of Directors of Maria Ltd. Requires you to prepare working capital estimation
for the coming year. The details of the company are as follows:
The number of units being produced currently are 50,000 units per annum.
The Raw material cost is Rs. 180 per unit.
The Wages are Rs. 40 per unit.
The Fixed Overheads are Rs. 100 per unit.
The Selling Price Per unit is Rs. 680.
Other Details are:
(a) Raw Material are in store on an average for 1 month along with Finished Goods.
(b) Material in Progress is on an average for 15 days.
(c) Credit allowed by suppliers is for 1 month.
(d) Time lag in collection from debtors is 4 months.
(e) Time lag in payment of Wages is 1 month and that of Overheads it is 3 months.
(f) 20% of the output is sold against credit. Cash in hand and in Bank is expected to be Rs.
3,00,000.
19. Amartax Ltd. is going to produce and sell 5,000 units per month in the year 2011. The
material required per unit is Rs. 550. The direct labour is Rs. 12,00,000 per month. The other
direct expenses are Rs. 1,26,00,000 per annum. The selling price is fixed by calculating profit
at 20% on cost price.
Calculate requirement of working capital for 2011 by taking into consideration following
information:
(a) Stock of raw material will be for two months.
(b) Process time is one month.
(c) Stock of finished goods will be for 1.5 months.
(d) Credit allowed to customer is two months.
(e) Time lag in payment of wages is one month and the direct expenses in arrear of 15 days.
(f) 20% of material is purchased on cash basis and suppliers of 80% material give 2 months
credit.
(g) Cash required is 15% of net working capital.
20. Vineeth & Co. is going to produce and sell 5,000 units per month in the year 2013. The
material
required per unit is Rs.55. Direct labour cost Rs. 1,20,000 per month. The overhead expenses
amounted to Rs. 12,60,000 p.a. The sale price is fixed by calculating profit at 20% on sale
price.
Calculate requirement of working capital for 2013 by taking into consideration the following

information:
(a) Stock of raw material will be two months.
(b) Process time is one month.
(c) Stock of finished goods will be 1.5 months.
(d) Credit allowed to 50% customers is two months and the balance 50% customers are given
one month credit.
(e) 25% of expenses are paid one month in advance and the balance 75% is paid after one
month.
(f) Time lag in payment of wages is one month.
(g) 20% material is purchased on cash basis and 80% material on 1.5 month‟s credit.
(h) Cash required is 20% of net working capital.

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TYBMS STRATEGIC FINANCIAL MANAGEMENT SEM V

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UNIT II : CAPITAL BUDGETING AND CAPITAL RATIONING

UNIT III : SHAREHOLDER VALUE AND CORPORATE GOVERNANCE/ CORPORATE

UNIT IV : FINANCIAL MANAGEMENT IR BANKING SECTOR AND WORKING CAPITAL

 Working Capital Financing

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FACTORS INFLUENCING DIVIDEND POLICY/DETERMINANTS OF DIVIDEND

(2) Investment Opportunities:

(3) Access to Finance:

(4) Floatation Costs:

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(5) Corporate Control:

(6) Investor Preferences:

(7) Restrictive Covenants:

(9) Dividend Stability:

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(11) Shareholding Pattern:

(12) Competitive Concerns:

(13) Management Philosophy:

(14) Influential Shareholders:

DIVIDEND PRACTICES/TYPE OF DIVIDEND POLICY/FORMS OF DIVIDEND

(2) Distribute a Fixed Rupee amount of Dividend:

(3) Minimum Rupee amount with a Step-up Feature:

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(4) Fixed Percentage of Net Profit:

(6) Dividend as a fixed percentage of market value.

(7) Constant payout:

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(8) Constant Dividend per share or Dividend rate:

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(9) Small constant dividend per share plus extra dividend:

(10) Conservative dividend policy:

(11) Stable dividend policy:

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(2) Final Dividend:

(3) Dividend on Preference Share:

LEGAL ASPECTS OF DIVIDEND

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PROCEDURAL ASPECTS OF DIVIDEND

(b) Shareholders approval:

(c) Record date:

(d) Dividend payment:

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BOOK CLOSURE/RECORD DATE

THEORIES OF DIVIDEND POLICIES

Walter’s model is based on the following assumptions:

3. All earnings are either distributed as dividend or reinvested internally immediately.

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5. The firm has a very long or infinite life.