Ca Inter 4-12-2019 PDF

YESHAS ACADEMY
CA INTERMEDIATE
FINANCIAL
MANAGEMENT
RAVI KANTH MIRIYALA, FCA

INDEX
1. Leverage Analysis
2. Cost of Capital
3. Capital Structure
4. Working Capital
5. Ratio Analysis
6. Capital Budgeting
7. Dividend Policy
8. Theory Question and Answer
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Ravi Kanth Miriyala

Chapter 1: LEVERAGE ANALYSIS
OPERATING LEVERAGE
Formula: (i) % change in EBIT / % change in Sales
(ii) Contribution / EBIT
High value of operating leverage means high operating risk and vice versa.
Break-even point in units = Fixed cost / Contribution per unit
BEP = Fixed cost / PV Ratio
Margin of safety (MOS) = (Sales – BEP sales) / Sales * 100
MOS = (Contribution – FC)/ Contribution = EBIT / Contribution
So, OL = 1/ MOS
Higher margin of safety indicates lower business risk and higher profit and vice versa.
FINANCIAL LEVERAGE
Formula: (a) When there is no Preference Share Capital
(i) % change in EPS / % change in EBIT

(ii) EBIT / EBT
(b) When there is Preference Share Capital
(i) % change in EPS / % change in EBIT

(ii) EBIT / EBT – (Preference Dividend / 1 – t)
High value of Financial leverage means high financial risk and vice versa.
COMBINED LEVERAGE
Formula: (a) When there is no Preference Share Capital
(i) % change in EPS / % change in Sales

(ii) Contribution / EBT
(iii) OL x FL
(b) When there is Preference Share Capital
Ravi Kanth Miriyala Page 1.1
(i) % change in EPS / % change in Sales

(ii) Contribution / EBT - (Preference Dividend / 1 – t)
(iii) OL x FL
High value of Combined leverage means high combined risk and vice versa.
CLASS ASSIGNMENT
1. Calculate operating leverage, financial leverage, and combined leverage for the
following and interpret the results.
PARTICULAR FIRM A FIRM B FIRM C

Output (Units) 60,000 15,000 1,00,000
Fixed Costs (Rs.) 7,000 14,000 1,500
Variable cost per unit (Rs.) 0.20 1.50 0.02
Interest on borrowed funds (Rs.) 4,000 8,000 --
Selling price per unit (Rs.) 0.60 5.00 0.10
2. The balance sheet of a Company is as follows:

(Rs. In Assets (Rs. In
Crore) Crore)
Equity Share Capital 10 Fixed Assets 25
(1 crore share of 10 each)
Reserve and surplus 2 Current Assets 15
15% Debentures 20
Current Liabilities 8
Total 40 Total 40
The additional information given is as under:

Fixed Costs per annum (excluding interest) Rs. 8 crore
Variable operating cost ratio 65%
Total assets turnover ratio 2.5

Income tax rate 40%
Calculate the following:

(a) Earnings per share (b) Operating Leverage (c) Financial Leverage (d)
Combined Leverage.
3. If the combined leverage and operating leverage figures of a company are 2.5
and 1.25 respectively. Find financial leverage and P / V ratio, given that the equity
dividend per share is Rs. 2, interest payable per year is Rs. 1 lakh, total fixed cost
Rs. 0.5 Lakh and sales Rs. 10 Lakhs.
4. From the following, prepare Income Statement of A, B and C.

PARTICULAR FIRM A FIRM B FIRM C
Financial Leverage 3:1 4:1 2:1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating Leverage 4:1 5:1 3:1
Variable cost as % of Sales 66.67% 75% 50%
Income tax Rate 45% 45% 45%
5. A firm has sales of Rs. 10,00,000 variable cost of Rs. 7,00,000 and fixed cost of Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,
financial and combined leverages? If the firm wants to double its Earnings before
interest and tax (EBIT), how much of a rise in sales would be needed on a
percentage basis?
6. Consider the following information for Omega Ltd.

PARTICULAR Rs. In Lakh
EBIT 15,750
EBT 7,000
Fixed Cost 1,575
Required: calculate % change in earning per share, if sales increase by 5%.
7. A firm’s sales, variable costs and fixed costs amount to Rs. 75,00,000, Rs.
42,00,000 and Rs. 6,00,000 respectively. It has borrowed Rs. 45,00,000 at 9
percent and its equity capital Rs. 55,00,000.
a. What is the firm’s ROI?
b. Does it have favorable financial leverages?
c. If the firm belongs to an industry whose assets turnover is 3, does it have a
high or low asset leverage?
d. What the operating, financial and combined leverages of the firm?
e. If the sales drop to Rs. 50,00,000 what will be the new EBIT be?
f. At what level of sales EBT of the firm will be equal to zero?
8. A textile company has EBIT of Rs. 1,60,000. Its capital structure consists of the
following securities:
PARTICULAR Rs.
10% Debentures 5,00,000
12% Preference Shares 1,00,000
Equity Shares of Rs. 100 each 4,00,000
The company is in the 35 per cent tax bracket.

a. Determine the EPS
b. Determine the % change in EPS with 30 % increase and 30 % decrease in EBIT
c. Determine the degree of financial leverage.
9. The net sales of A Ltd is Rs. 30 crores. Earnings before interest and tax of the
company as a percentage of net sales is 12%. The capital employed comprises Rs
10 crores of equity, Rs. 2 crores of 13% Cumulative Preference Share Capital and
15% Debentures of Rs. 6 crores. Income tax rate is 40%. Calculate the Operating
Leverage of the company given that combined leverage is 3.
10. The following summarizes the percentage changes in operating income,

percentage change in revenue, and betas for four pharmaceuticals firms.
Firm Change in Revenue Change in operating income Beta

PQR Ltd 27% 25% 1.00
RST Ltd 25% 32% 1.15
TUV Ltd 23% 36% 1.30

WXY Ltd 21% 40% 1.40
Required:
(a) Calculate the degree of operating leverage for each of these firms. Comment
also
(b) Use the operating leverage to explain why these firms have different beta
HOME ASSIGNMENT
11. The date relating to two Companies are as given below:

PARTICULAR COMPANY A COMPANY B
Equity Capital Rs. 6,00,000 Rs. 3,50,000
12% Debentures Rs. 4,00,000 Rs. 6,50,000
Output (unit) per annum 60,000 15,000
Selling price / unit Rs. 30 Rs. 250
Fixed Costs per annum Rs. 7,00,000 Rs. 14,00,000
Variable Cost per unit Rs. 10 Rs. 75
You are required to calculate the Operating, Financial and Combined Leverage of
two Companies.
12. A company operates at a production level of 1,000 units. The contribution is Rs. 60
per unit, operating leverage is 6, combined leverage is 24. If tax rate is 30%, what
would be its earnings, after tax? (Nov, 2008)
13. The following data relate to RT Ltd. Calculate Combined Leverage.

PARTICULAR Rs.
Earnings before interest and tax (EBIT) 10,00,000
Fixed Cost 20,00,000
Earning before tax (EBT) 8,00,000
14. A firm has sales of Rs. 40 lakhs, Variable cost of Rs. 25 Lakhs, Fixed Cost of Rs. 6
lakh; 10% debt of Rs. 30 Lakhs; and equity Capital of Rs. 45 Lakhs. Calculate
operating and financial leverage.
15. The capital structure of the Progressive Corporation Ltd. consists of an ordinary
share capital of Rs. 10,00,000 (shares of Rs. 100 per value) and Rs. 10,00,000 of
10% Debentures. The unit sales increased by 20 per cent from 1,00,000 units to
1,20,000 units, the selling price is Rs. 10 per unit, variable costs amount to Rs. 6
per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is
assumed to be 35 per cent.
a. You are required to calculate the following:
(i) The percentage increase in earnings per share
(ii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.
(iii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.
b. Comment on the behavior of operating and financial leverage in relation to
increase of production from 1,00,000 to 1,20,000 units.
16. Prepare Income Statements for A, B and C Companies.

PARTICULAR A B C
Variable expenses as a percentage of 66.67 75 50
sales
Interest expenses (Rs.) 200 300 1,000
Degree of Operating Leverage 5 6 2
Degree of Financial leverage 3 4 2
Income tax Rate 0.35 0.35 0.35
17. From the following Financial data of Company A and Company B, Prepare the
Income Statement:
PARTICULAR Company A Company B
Variable Cost (Rs. ) 56,000 60% of Sales
Fixed Cost (Rs.) 20,000 --
Interest expenses (Rs.) 12,000 9,000
Financial Leverage 5:1 --
Operating Leverage -- 4:1
Income tax rate 30% 30%
Sales -- 1,05,000
18. Calculate operating leverage and financial leverage under situations A, B and C
and financial plans 1, 2 and 3 respectively of XYZ Ltd.
PARTICULAR Amount
Installed Capacity (units) 1,200
Actual production and sales (units) 800
Selling price per unit (Rs. ) 15
Variable cost per unit (Rs.) 10
Fixed Costs (Rs.) Situation A 1,000
Situation B 2,000
Situation C 3,000
Capital Structure: Financial Plan
1 2 3
Equity Rs. 5,000 Rs. 7,500 Rs. 2,500
Debt (interest 12%) 5,000 2,500 7,500
19. (a) Find out Operating Leverage from the following data:
PARTICULAR Amount
Sales Rs. 50,000
Variable Costs 60%
Fixed Costs Rs. 12,000
(b) Find out the Financial leverage from the following data:
PARTICULAR Amount
Net worth Rs. 25,00,000
Debt / Equity 3:1
Interest Rate 12%
Operating Profit Rs. 20,00,000
20. The following details of RST Limited for the year ended 31st March, 2013 are
given below:
PARTICULAR Amount
Operating Leverage 1.4
Combined Leverage 2.8
Fixed cost (excluding Interest) Rs. 2.04 Lakhs
Sales Rs. 30.00 Lakhs
12% Debenture of Rs. 100 each Rs. 21.25 Lakhs
Equity share capital of Rs. 10 each Rs. 17.00 Lakhs
Income tax rate 30 percent
Required:
(i) Calculate financial leverage
(ii) Calculate P / v ratio and earning per share
(iii) If the company belongs to an industry, whose assets turnover ratio is 1.5,
does it have a high or low assets leverage?
(iv) At what level of sales the earning before tax (EBT) of the company will be
equal to zero?
21. The following is the income statement of XYZ Ltd for the year 2013:
PARTICULAR Amount
Sales Rs. 50 Lacs
- Variable Cost 10 lacs
- Fixed Cost 20 lacs
EBIT 20 lacs
- Interest 5 lacs
Profit before tax 15 lacs
- Tax at 40% 6 lacs
Profit after tax 9 lacs
- Preference dividend 1 lacs
Profit for equity shareholder 8 lacs
The company has 3 lacs equity shares issued to the shareholders. Find out the
degree of (i) Operating leverage, (ii) Financial Leverage, and (iii) Combined
leverage. What would be the EPS if the sales level increases by 10%.
ANSWERS
1. OL 1.41, 1.36, 1.23; FL 1.31, 1.26, 1; CL 1.85, 1.71, 1.23

2. (i) Rs. 14.4 (ii) 1.3 (iii) 1.13 (iv) 1.47
3. 2, 25%
4. Earnings after tax Rs. 55, 55, 550
5. OL 3, FL 2, CL 6, 33.33%
6. 12.375%
7. (a) 27% (b) Yes (c) 0.75, Lower (d) OL 1.22, FL 1.18, CL 1.44 (e) Rs. 16 lacs, (f)
Sales Rs. 22,84,091
8. (a) 14.875 (b) 52.44% (c) 1.74
9. Degree of Operating Leverage 1.887
10. 0.93, 1.28, 1.57, 1.90
11. OL 2.4, 2.14 ; FL 1.11, 1.07; CL 2.66, 2.29
12. Rs. 1750
13. 3.75
14. OL 1.67, FL 1.5
15. (a) (i) 80% (ii) 2, 1.56 (iii) 2, 1.71
16. EAT Rs. 65, 65, 650
17. Net profit after tax of Company A Rs. 2,100; Company B Rs. 1,050
18. DOL 1.33, 2, 4; DFL 1.25, 1.11, 1.43 Under Situation A; 1.43, 1.18, 1.82 Under
situation B; 2.5, 1.43, 10 Under situation C
19. (i) 2.5 (ii) 1.82
20. (i) 2 (ii) 23.8%, 1.05 (iii) Low (iv) Rs. 19.29 Lacs
21. OL 2; FL 1.5; CL 3. The new EPS would be 30% higher at Rs. 2.60.
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Chapter 2: COST OF CAPITAL
COST OF DEBENTURE (Kd)

Cost of Debenture (Kd)
Perpetual Debenture Redeemable Debenture
Interest (1 - t) Interest (1 - t)  (RV - NP) / N

Kd = x 100 Kd = x 100
NP RV  NP / 2
Where: - t = Tax rate

RV = Redemption value of debenture
NP = Net proceeds per debenture
N = Life of Debentures or maturity period
Notes:
1. If year of maturity is not given that it is assumed that it is perpetual
2. If redeemable value is not given than redemption is assumed on par
3. NP = issue price per debenture – Flotation Cost
4. Issue price is calculated in following order of preference.
(a) Sale price or issue price (b) Market price (c) Face Value (d) Rs. 100
5. Flotation cost is calculated on issue price
Cost of Debt using Present value method [Yield to maturity (YTM) approach)]
The cost of redeemable debt (Kd) is also calculated by discounting the relevant cash flows
using Internal rate of return (IRR). The concept of IRR is discussed in the Chapter-
Investment Decisions (Capital budgeting). You can solve those sums only after that chapter.
Amortisation of Bond
A bond may be amortised every year i.e. principal is repaid every year rather than at
maturity. In such a situation, the principal will go down with annual payments and interest
will be computed on the outstanding amount. The cash flows of the bonds will be uneven.
For this also, we can apply IRR method.
Cost of Convertible Debenture
Holders of the convertible debentures has the option to either get the debentures
redeemed into the cash or get specified numbers of companies shares in lieu of cash. The
calculation of cost of convertible debentures are very much similar to the redeemable
debentures. While determining the redemption value of the debentures, it is assumed that
Ravi Kanth Miriyala Page 2. 1
Chapter 2: Cost of Capital
all the debenture holders will choose the option which has the higher value and accordingly
it is considered to calculate cost of debt.
Example:
A company issued 10,000, 15% Convertible debentures of ₹100 each with a maturity period
of 5 years. At maturity the debenture holders will have the option to convert the
debentures into equity shares of the company in the ratio of 1:10 (10 shares for each
debenture). The current market price of the equity shares is ₹ 12 each and historically the
growth rate of the shares are 5% p.a. Compute the cost of debentures assuming 35% tax
rate.
Determination of Redemption value:
Higher of
(i) The cash value of debentures = ₹ 100
(ii) Value of equity shares = 10 shares × ₹12 (1+0.05)5 = 10 shares × 15.312 = ₹153.12
₹153.12 will be taken as redemption value as it is higher than the cash option and attractive
to the investors.
Now we can apply above discussed formula and the answer would be 16.09%s.
COST OF PREFERENCE SHARE (Kp)

Cost of Preference Share Capital
Perpetual PSC Redeemable PSC
Pref Dividend Pref Dividend  (RV - NP) / N

Kp = x 100 Kp =
NP RV  NP / 2
COST OF TERM LOAN (KL)

KL = Rate of Interest (1 - tax rate)
COST OF EQUITY SHARE CAPITAL (Ke)
(a) Capital asset pricing model (CAPM):
Risk free rate of interest + (Average market risk premium x Beta)
Or
Risk free rate of interest + Beta (Average market rate of return - Risk Free rate
of interest)
(b) D / p Ratio Approach:

Ke = Expected Dividend per share / Net proceed per share x 100
(c) E / p Ratio Approach:

Ke = Earning per share / Net proceed per share x 100
(d) D /p + g Approach / Gordon Approach:

Ke = Expected Dividend per share / Net proceed per share x 100 + Growth
rate
(e) E / P + g Approach:
Ke = Expected Earning per share / Net proceed per share x 100 + Growth rate
(f) Realised yield approach / Effective interest rate of method: Realised yield =
Internal rate of return (IRR)
Growth rate may be calculated as follows:

1. Last trend of dividend or earning
2. G = % of retained earning x ROI = b * r
COST OF RETAINED EARNINGS
Same as Ke except that flotation cost is not deducted in the calculation of net
proceed.
If personal tax is also considered then a shortcut formula may be as follows:
Kr = Ke (1-tp)(1-f)
Here tp is rate of personal tax on dividend and “f” is rate of flotation cost.
WEIGHTED AVERAGE COST OF CAPITAL
WACC= (Ke X Weight) + (Kd X Weight) + (Kp x Weight) + (Kr x Weight) + {KL x Weight)
CLASS ASSIGNMENT
1. Assuming the corporate tax rate of 35 per cent, compute the after tax cost of
capital in the following situations:
(i) Perpetual 15% Debentures of Rs. 1,000 sold at a premium of 10 per cent
with no flotation costs.
(ii) 10-year 14% Debentures of Rs. 2,000 redeemable at par, with 5 per cent
flotation costs.
(iii) 10-year 14% Preference Shares of Rs. 100, redeemable at premium of 5 per
cent with 5 per cent flotation costs.
(iv) XYZ Ltd. intends to issue new equity shares of which the current market
value is Rs. 125 per share. The flotation cost is estimated to be 3%. The
dividends paid by the company during last 5 years are Rs. 10.70, 11.45,
12.25, 13.11 and 14.03. Find out the growth rate in dividends, cost of equity
shares and the cost of retained earning given that the same growth rate
continues in future.
2. SK Limited has obtained funds from the following sources, the specific cost are
also given against them:
Sources of Fund Amount Cost of Capital

Equity Shares 30,00,000 15 percent
Preference Shares 8,00,000 8 percent
Retained earning 12,00,000 11 percent
Debentures 10,00,000 9 percent (before tax)
You are required to calculate weighted average cost of capital. Assume that the
Corporate tax rate is 30 percent.
3. PQR & Co. has the following capital structure as on Dee. 31, 2013.
Particulars Amount
Equity Share Capital (5000 shares of Rs. 100 each) Rs. 5,00,000
9% Preference Shares Rs. 2,00,000
10% Debentures Rs. 3,00,000
The equity shares of the company are quoted at Rs. 102 and the company is
expected to declare a dividend of Rs. 9 per share for the next year. The Company has
registered a dividend growth rate of 5% which is expected to be maintained.
i. Assuming the tax rate applicable to the company at 50%, calculate the
weighted average cost of capital, and
ii. Assuming that the company can raise additional term loan at 12% for Rs.
5,00,000 to finance its expansion, calculate the revised WACC. The company's
expectation is that the business risk associated with new financing may bring
down the market price from Rs. 102 to Rs. 96 per share.
4. As a financial analyst of a large electronics company, you are required to

determine the weighted average cost of capital of the company using (a) book
value weights and (b) market value weights. Following information available:
The company's present book value capital structure is :

Particulars Amount
Debentures (Rs. 100 per debenture) Rs. 8,00,000
Preference Shares (Rs. 100 per share) Rs. 2,00,000
Equity Shares (Rs. 10 per share) Rs. 10,00,000
Total Rs. 20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures, Rs. 110, Preference Share, Rs. 120, Equity shares Rs. 22
Anticipated external financing opportunities are:
(i) Rs. 100 per debentures redeemable at par; 10 year maturity, 13 per cent
coupon rate, 4 per cent flotation costs, sale price, Rs. 100.
(ii) Rs. 100 preference share redeemable at par, 10 year maturity, 14 per cent
dividend rate, 5 per cent flotation costs, sales price, Rs. 100.
(iii) Equity shares: Rs. 2 per share flotation costs, sale price Rs. 22. The dividend
expected on the equity share at the end of the year is Rs. 2 per share; the
anticipated growth rate in dividends is 7 per cent and the firm has the
practice of paying all its earnings in the form of dividends. The corporate tax
rate is 35 %.
5. Three companies A, Band C are in the same type of business and hence have
similar operating risks. However, the capital structure of each of them is
different and the following are the details:
Particulars A B C
Equity Share Capital (face value Rs. Rs. 2,50,000 Rs. 5,00,000
Rs. 10 per share) 4,00,000
Market value per share 15 20 12
Dividend per share 2.70 4 2.88
Debentures (Face value per Rs. 1,00,000 Rs.
debenture Rs. 100) 2,50,000
Market value per debenture 125 80

Interest Rate 10% 8%
Assume that the current levels of dividends are generally expected to continue
indefinitely and the income-tax rate at 50%.
Compute the WACC of each company as per market value weight.
6. International Foods Limited has the following capital structure:

Particulars Book Market
Value Value (Rs.)
(Rs.)
Equity Capital (25,000 shares of Rs. 10 each) 2,50,000 4,50,000
13% Preference Capital (500 Shares of Rs. 100 50,000 45,000
each)
Reserves and Surplus 1,50,000 -
14% Debentures (1500 debentures of Rs. 100 1,50,000 1,45,000
each)
Total 6,00,000 6,40,000
The expected dividend per share is Rs. 1.40 and the dividend per share is
expected to grow at a rate of 8 per cent forever. Preference share are
redeemable after 5 years at par whereas debentures are redeemable after 6
years at par. The tax rate is 50%.
You are required to compute the weighted average cost of capital for the existing
capital structure using market value as weights.
7. XYZ Ltd., has the following book value capital structure:

Particulars Amount
Equity Capital (in shares of Rs. 10 each fully paid up-at par) Rs. 15 crores
11% Preference Capital (in shares of Rs. 100 each, fully paid up- Rs. 1 crores
at par)
Retained Earnings Rs. 20 crores
13.5% Debentures (of Rs. 100 each) Rs. 10 crores
15% Term Loans Rs. 12.5 crores
The next expected dividend on equity shares per share is Rs. 3.60; the dividend
per share is expected to grow at the rate of 7%. The market price of equity per
share is Rs. 40. Preference Stock, redeemable after ten years; is currently selling
at Rs. 75 per share. Debentures, redeemable after six years, are selling at Rs. 80
per debentures.
The Income-tax rate for the company is 40%.
Calculate the weighted average cost of capital using:

(a) Book value proportions; and (b) market value proportions.
8. The capital structure of XYZ Co. is comprising of 12% debentures, 9% preference

shares and some-equity share of Rs. 100 each in the ratio of 3: 2 : 5 . The
company is considering to introduce additional capital to meet the needs of
expansion plans by raising 14% loan from financial institutions. As a result of this
proposal, the proportions of different above sources would go down by 1/10,
1/15 and 1/6 respectively.
In the light of the above proposal, find out the impact on the WACC of the firm
given that (i) tax rate is 50%, (ii) expected dividend of Rs. 9 at the end of the year
and (iii) the growth rate, g, may be taken at 5%. No change is expected in
dividends, growth rate, market price of the share etc. after availing the proposed
loan.
9. Aries Limited wishes to raise additional finance of Rs. 10 lacs for meeting its
investments plans. It has Rs. 2,10,000 in the form of retained earnings available
for investment purposes. The following are the further details:
1. Debt / Equity Mix 30% / 70%
2. Cost of Debt up to Rs. 1,80,000 10% (before tax)
Beyond Rs. 1,80,000 16% (before tax)
3. Earnings per share Rs. 4
4. Dividend Pay out 50% earning
5. Expected growth rate in dividend 10%
6. Current market price per share Rs. 44
7. Tax rate 50%
You are required to:

(i) determine the pattern for raising the additional finance.
(ii) determine the post-tax average cost of additional debt.
(iii) determine the cost of retained earnings and cost of equity, and
(iv) compute the overall weighted average after tax cost of additional finance.
10. ABC Limited has the following book value capital structure:
Particulars (Rs. Million)
Equity share capital (150 million shares, Rs. 10 par) 1,500
Reserve and surplus 2,250
10.5% Preference share capital (million shares; Rs 100 100
par)
9.5% Debentures (1.5 million debentures, Rs. 1,000 par) 1,500
8.5% Term Loans from Financial Institutions 500
The debentures of ABC Limited are redeemable after three years and are quoting
at Rs. 981.05 per debenture. The income tax rate for the company is 35%.
The current market price per equity share is Rs. 60. The prevailing default-risk
free interest rate on 10 year GOI Treasury Bonds is 5.5%. The average market
risk premium is 8%. The beta of the company is 1.1875.
The preferred stock of the company is redeemable after 5 years is currently
selling at Rs. 98.15 per preference shares.
Required:
(i) Calculate weighted average cost of capital of the company using market
value weights.
(ii) Define the marginal cost of capital and if the firm raises Rs. 750 million
for a new project what is the marginal cost of capital. The firm plans to
have a target debt to value ratio of 20%. The beta of new project is
1.4375. The debt capital will be raised through term loans. It will carry
interest rate of 9.5% for the first 100 million and 10% for the next Rs. 50
million.
11. The R & G company has following capital structure 31st March 2013, which is
considered to be optimum:
Particulars Amount
13% Debenture 3,60,000
11% Preference Share Capital 1,20,000
Equity Share Capital (2,00,000 shares) 19,20,000
Total 24,00,000
The company's share has a current market price of Rs. 27.75 per share. The
expected dividend per share in next year is 50% of the 2013 EPS. The EPS of last
10 years is as follows. The past trends are expected to continue:
Year 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
EPS 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
(Rs.)
The company can issue 14% new debentures. The company's debenture is
currently selling at Rs. 98. The new preference issue can be sold at a net price of
Rs. 9.80, paying a dividend of Rs. 1.20 per share. The company's marginal tax
rate is 50%.
(i) Calculate the after tax cost (a) of a new debts and new preference share
capital, (b) of ordinary equity, assuming new equity comes from retained
earnings.
(ii) Calculate the marginal cost of capital
(iii) How much can be spent for capital investment before new ordinary share
must be sold? Assuming that retained earnings available for next year's
investment are 50% of 2013 earnings.
(iv) What will be marginal cost of capital (cost of fund raised in excess of the
amount calculated in part (iii) if the company can sell new ordinary shares to
net Rs. 20 per share? The cost of debt and of preference capital is constant.
HOME ASSIGNMENT
12. A company issue Rs. 10,00,000 12% Debenture of Rs. 100 each. The debenture
are redeemable after the expiry of fixed period of 7 years. The company is in
35% tax bracket.
Required:
(i) Calculate the cost of debt after tax, if debenture are issued at (a) Par (b)
10% discount (c) 10% premium
(ii) If brokerage is paid at 2%, what will be the cost of debenture, if issue is at
par?
13. PQR Ltd. has the following capital structure on October 11, 2013 :
Particulars Rs.
Equity Share Capital (2,00,000 share of Rs. 10 each) 20,00,000
Reserve and Surplus 20,00,000
The market price of equity share is Rs. 30. It is expected that the Company will
pay next year a dividend of Rs. 3 per share, which will grow at 7% forever.
Assume 40% income tax rate. You are required to compute weighted average
cost of capital using market value weight.
14. A Limited has the following capital structure

Particulars Amount Rs.
Equity Share Capital (2,00,000 shares) 40,00,000
The market price of the company's equity share is Rs. 20. It is expected that
company will pay a dividend of Rs. 2 per share at the end of current year, which
will grow at 7 per cent forever. The tax rate may be presumed at 50 per cent.
You are required to compute the following:
a. A weighted average cost of capital based on existing capital structure.
b. The new weighted average cost of capital if the company raises an additional
Rs. 20,00,000 debt by issuing 10 per cent debentures, This would result in
increasing the expected dividend to Rs. 3 and leave the growth rate
unchanged but the price of share will fall to Rs. 15 per share.
c. The cost of capital if in (b) above, growth rate increases to 10 per cent.
15. The capital structure of MNP Ltd. is as under

Particulars Amount Rs.
9% Debentures Rs. 2,75,000
11% Preference Share Rs. 2,25,000
Equity Share (face value: Rs. 10 per share) Rs. 5,00,000
Total Rs.
10,00,000
Additional information:
(i) Rs. 100 per debenture redeemable at par has 2% flotation cost and 10
year of maturity. The market price per debenture is Rs. 105.
(ii) Rs. 100 per preference share redeemable at par has 3% flotation cost and
10 year of maturity. The market price per preference share is Rs. 106.
(iii) Equity share has Rs. 4 flotation cost and market price per share of Rs. 24.
The next year expected dividend is Rs. 2 per share with annual growth of
5%. The firm has a practice of paying all earning in the form of dividend.
(iv) Corporate income tax rate is 35%
Required: Calculate weighted average cost of Capital (WACC) using market value
weight.
16. An electric equipment manufacturing company wishes to determine the

weighted average cost of capital for evaluating capital budgeting projects. You
have been supplied with the following Information:
Balance Sheet
Liabilities Rs. Assets Rs.
Equity Share Capital 12,00,000 Fixed Assets 25,00,000
Pref. Share Capital 4,50,000 Currents assets 15,00,000
Retained Earnings 4,50,000
Debentures 9,00,000
Current Liabilities 10,00,000
Total 40,00,000 Total 40,00,000
i. 20 years 14% debentures of Rs.2,500 face value, redeemable at 5%
premium can be sold at par, 2% flotation costs.
ii. 15% preference shares: Sale price Rs. 100 per share, 2% flotation costs.
iii. Equity shares: Sale price Rs.115 per share, flotation costs, Rs. 5 per share
The corporate tax rate is 55% and the expected growth in equity dividend
is 8% per year.
The expected dividend at the end of the current financial year is Rs. 11
per share. Assume that the company is satisfied with its present capital
structure and intends to maintain it.
17. In considering the most desirable capital structure for a company, the following
estimate cost of debt capital (after tax) have been made a various levels of debt-
equity mix.
Debts as percentage of Cost of Debt Cost of Equity
Total Capital employed % %
0 7.0 15.0
10 7.0 15.0
20 7.0 15.5
30 7.5 16.0
40 8.0 17.0
50 8.5 19.0
60 9.5 20.0
You are required to find out the WACC of the firm for different proportions of
debt
18. ABC Ltd. wishes to raise additional finance of Rs. 20 lakhs for meeting its
investment plans. The company has Rs. 4,00,000 in the form of retained earning
available for investment purpose. The following are the further details:
a. Debt equity ratio 25:75
b. Cost of debt at the rate of 10% (before tax) upto Rs. 2,00,000 and 13%
(before tax) beyond that
c. Earning per share Rs. 12
d. Dividend payout 50% of earning
e. Expected growth rate in dividend 10%
f. Current market price per share Rs. 60
g. Company tax rate is 30%, and shareholder personal tax rate is 20%
Required:
(i) Calculate the post tax average cost of additional debt
(ii) Calculate the cost of retained earning and cost of equity
(iii) Calculate the overall weighted average (after tax) cost of additional debt
19. The following information is provided in respect of the specific cost of capital of
different sources along with the book value (BV) and market value (MV) weights.
Sources C/C BV MV
Equity Share Capital 18% .50 .58
Preference Share 15% .20 .17
Long term debts 7% .30 .25
i) Calculate the weighted average cost of capital, WACC, using both the BV
and MV weights
ii) Calculate the WMCC using marginal weights given that the company
intends to raise additional fund using 50% long term debts, 35%
preference shares and 15% by retaining profits.
20. You are analyzing the beta for ABC Computer Ltd. And have divided the company
into four broad business groups, with market values and betas for each group.
Business Group Market value of equity Unleveraged

(Rs. Billion) beta
Main Frames 100 1.10
Personal computer 100 1.50
Software 50 2.00
Printers 150 1.00
ABC Computers Ltd. had Rs. 50 billion in debt outstanding.

Required:
(i) Estimate the beta for ABC Computer Ltd. as a company.
(ii) If the Treasury bond rate is 7.5%, estimate the cost of equity for ABC
Computers Ltd, Estimate the cost of equity for each division. The
average market risk premium is 8.5%.
ANSWER
1. (i) 8.86% (ii) 9.85% (iii) 15% (iv) 7%, 19.38%, 19.01%
2. 11.81%
3. (i) 10.21 % (ii) 8.96%
4. 13.6%, 14.7%
5. 18%, 16.8%, 19.25%
6. Ke = 15.78%, Kp Rs. 15.79%, Kd = 7.68%, WACC = 13.93%
7. Ke= 16%; Kp= 15.43%; Kd= 12.70%; Kl = 9% - (a) 13.96%, (b) 14.61%
8. 10.60% to 9.37%
9. (a) 10% debt Rs. 180000, 16% debt Rs. 120000, Retained earning Rs. 210000,
Equity Rs. 4,90,000 (b) 6.2% (c) 15% (d) WACC 12.36%
10. 13.43% (ii) 14.85%
11. (i) 7.14%, 12.24%, 17% (ii) 15.28% (iii) Rs. 3,46,625 (iv) 16.82%
12. (i) (a)7.81% (b) 9.71% (c) 6.07% (ii) 8.17%
13. 13.02%
14. (a) 10.75% (b) 13.60% (c) 14.80%
15. Ke = 15%, Kd = 5.49%, Kp = 10.57%, WACC = 12.76%
16. Kd = 6.55%, Kp = 15.31%, Ke = 18%, Kr = 17.57%, WACC 14.11%
17. 15%, 14.2%, 13.8%, 13.45%, 13.4%, 13.75%, 13.70%
18. (i) 8.26% (ii) ke 21%, kre 16.8% (iii) 17.375%
19. (i) 14.1%, 14.74% (ii) 11.45%
20. (i) 1.275 (ii) 18;34%, 16.85%, 20.25%, 24.5%, 16%
---------------
Chapter 3: Capital Structure
INDIFFERENCE POINT
For calculating indifference point, formula for calculation of EPS have to be equaled under
both plan and EBIT is calculated as balancing figure. Formula for calculating EPS is as follows-
(EBIT - Interest) (1 - t) - Preference Dividend
EPS =
No. of Equity Shares
If Expected EBIT > Indifference point EBIT: Select the structure where fixed finance cost is
higher; or select the structure where Debn + PSC > Equity;
If Expected EBIT < Indifference point EBIT: Select the structure where fixed finance cost is
lower; or select the structure where Debn + PSC < Equity;
Alternative where amount of Interest plus preference dividend is low should be selected.
FINANCIAL BREAK EVEN POINT
Capital Structure Financial Break Even Point
Only Equity Zero
Equity & Preference Preference Dividend / 1 – t
Equity & Debenture Interest
Equity, Debenture & Preference Interest + (Preference Dividend / 1 – t)
CAPITAL STRUCTURE THEORIES

Under Net income approach:
(i) Ke remain same
(ii) Market value of firm increase as debt amount increase
(iii) Overall cost of capital decrease with increase in debt proportion
Under Net operating income and MM approach:

(i) ke increase as debt amount increase
(ii) Market value of firm remain same
(iii) Overall cost of capital remain same
Market value of firm

Value of Equity share + Value of debt
Value of Equity share

EBT / Ke (if there is no tax) or
EAT / Ke (if there is tax)
Overall cost of capital

EBIT / Market value of firm (if there is no tax)
(Kd x D/V) + (Ke x E/V) (if there is tax)
D = Value of debt
E = Value of equity
V = Market value of firm
Chapter 3. Capital Structure
Assumptions are made to understand this relationship;

• There are only two kinds of funds used by a firm i.e. debt and equity.
• The total assets of the firm are given. The degree of average can be changed by
selling debt to purchase shares or selling shares to retire debt.
• Taxes are not considered.
• The payout ratio is 100%.
• The firm’s total financing remains constant.
• Business risk is constant over time.
• The firm has perpetual life.
CLASS ASSIGNMENT
ALTERNATIVE FINANCING PLAN, INDIFFERENCE POINT & FINANCIAL BREAK EVEN
POINT
1. The Modern Chemicals Ltd. requires ₹ 25,00,000 for a new plant. This plant is
expected to yield earnings before interest and taxes of ₹ 5,00,000. While
deciding about the financial plan, the company considers the objects of
maximizing earnings per share. It has three alternatives to finance the project
- by raising debt of ₹ 2,50,000 or ₹ 10,00,000 or ₹ 15,00,000 and the balance,
in each case, by issuing equity shares. The company's share is currently selling
at ₹ 150, but is expected to decline to ₹ 125 in case the funds are borrowed in
excess of ₹ 10,00,000.
The funds can be borrowed at the rate of 10% up to ₹ 2,50,000. At 15% over ₹
2,50,000 and up to ₹ 10,00,000 and at 20% over ₹ 10,00,000. The tax rate
applicable to the company is 50%. Which form of financing should the
company choose?
2. ABC Ltd. has the following capital structure:
PARTICULAR ₹ (lakhs)
Ordinary Shares : 10 Lakh Nos. @ ₹ 10 each 100
Reserves and Surplus 40
10% debentures each of face value ₹ 100 60
The company needs ₹ 50 lakhs to execute a new project which will raise its
operating profit (EBIT) from the current level of ₹ 40 lakhs to ₹ 55 lakhs. It is
considering the following options
(i) Issue equity shares at a premium of ₹15 each for the entire amount.
(ii) Issue 12% debentures for ₹ 50 lakhs required additionally.
(iii) Issue equity shares for ₹ 25 lakhs at a premium of ₹ 20 per share and
issue 12% debentures for the balance amount.
Evaluate the three option and advise the company. Tax rate is 40%.
3. The existing capital structure of ABC Ltd. is as follows:

PARTICULAR ₹
Equity shares of ₹ 100 each 40,00,000
Retained earning 10,00,000
Company earns a return of 12% and the tax on income is 50%.

Company wants to raise ₹ 25,00,000 for its expansion project for which it is
considering following alternatives:
(i) Issue of 20,000 Equity shares at a premium of ₹ 25 per share; (ii) Issue
of 10% preference shares; (iii) Issue of 9% Debenture.
(ii) Project that the P/E ratios in the case of Equity, Preference and
Debenture financing 20, 17 and 16 respectively.
Evaluate each option and choose the best alternative. Give reason.
4. A company provides the following figures:

PARTICULAR ₹ Amount
Profit 26,00,000
Less: Interest on debentures@ 12% p.a. 6,00,000
Profit before tax 20,00,000
Less: Income- tax @ 50% 10,00,000
Profit after tax 10,00,000
Number of equity share (of ₹ 10 each) 4,00,000
Earnings per share (EPS) 2.50
Ruling price in market 25
P/E ( Price Earning) Ratio ( i.e. Price / EPS ) 10
The company has undistributed reserves of ₹ 60,00,000
The company needs ₹ 20,00,000 for expansion; this amount will earn the
same rate as funds already employed. You are informed that a debt equity
ratio [Debt / (Debt + Equity)] higher than 35% pulls the PE ratio down to 8.
Interest rate on additional amount borrowed at 14%. You are required to
ascertain the probable price of the share if –
(i) The additional funds are raised as a loans; or
(ii) The amount is raised by issuing equity shares.
5. Calculate the level of EBIT at which the indifference point between the
following financing alternative will occur assume corporate tax rate is 50% and
the price of the ordinary share is ₹ 10 in each case.
1. Ordinary share capital ₹ 10,00,000 or 15% Debenture of ₹ 5,00,000. and

ordinary share capital of ₹ 5,00,000
2. Ordinary share capital of ₹ 10,00,000 or 13%· Preference share capital of ₹
5,00,000 and ordinary share capital of ₹ 5,00,000
3. Ordinary share capital of ₹ 10,00,000 or ordinary share capital of ₹
5,00,000 13% preference share capital of ₹ 2,00,000 and 15% debenture of
₹ 3,00,000.
4. Ordinary share capital of ₹ 6,00,000 and 15% debenture of ₹ 4,00,000 Or
Ordinary share capital of ₹ 4,00,000, 13% preference share capital of ₹
2,00,000 and 15% debenture of ₹ 4,00,000
5. Ordinary share capital of ₹ 8,00,000 and 13% preference share capital of ₹
2,00,000 or ordinary share capital of ₹ 4,00,000, 13% preference share
capital of ₹ 2,00,000 and 15% debenture of ₹ 4,00,000.
6. A company needs ₹ 31,25,000 for the construction of new plant. The following
three plans are feasible:
I. The company may issue 3,12,500 equity shares at ₹ 10 per share.
II. The company may issue 1,56,250 ordinary equity shares at ₹ 10 per
share and 15,625 debentures of ₹ 100 denomination bearing a 8% rate
of interest.
III. The company may issue 1,56,250 equity shares at ₹ 10 per share &
15,625 preference shares at ₹ 100 per share bearing a 8% rate of
dividend
1. If the company earnings before interest and taxes are ₹ 62,500, ₹ 1,25,000,
₹ 2,50,000, ₹ 3,75,000 and ₹ 6,25,000, what are the earning per share
under each of the three financial plans? Income tax rate of 40%.
2. Which alternative would you recommend and why?
3. Determine the EBIT - EPS indifference points by formulae between
financing plan I and plan II and plan I and plan III.
7. The information relating to the proposed financing plans is given below:

Sources of Funds I II
Equity 15,000 shares 30,000 shares
Preference Shares 12%, 25,000 shares
of ₹ 100 each
Debentures ₹ 5,00,000 coupon ₹ 15,00,000
Rate, 10 per cent coupon Rate, 11
percent
Assuming 35 per cent tax rate,

I. Determine the (a) indifference point and (b) financial break-even point.
II. Which plan has more financial risk and why?
III. Indicate over what EBIT range, if any, one plan is better than the other.
Capital Structure APPROACHES
8. Calculate the market value of the firm under NI and NOI approach:
a. EBIT of ₹ 5,00,000
b. 10% Debt of ₹ (i) Nil (ii) 500000 (iii) 1000000 (iv) 2000000
Equity capitalisation rate of all equity firm is 20%. Ignore taxation
9. ABC Ltd. with EBIT of ₹ 3,00,000 is evaluating a number of possible capital

structures, given below. Which of the capital structure will you recommend,
any why?
Capital Structure Debt (₹) Kd% Ke%
I 3,00,000 10.0 12.0
II 4,00,000 10.0 12.5
III 5,00,000 11.0 13.5
IV 6,00,000 12.0 15.0
V 7,00,000 14.0 18.0
10. X Ltd. and Y Ltd. are identical except that the former uses debt while the
latter does not. The levered firm has issued 10% Debentures of ₹ 9,00,000.
Both the firms earn EBIT of 20% on total assets of ₹ 15,00,000. Assuming tax
rate of 50% and capitalization rate of 15% for an all- equity firm:
(i) Compute the value of the two firms using NI approach
(ii) Compute the value of the two firms using NOI approach.
(iii) Calculate the overall cost of capital using NOI approach.
11. RES Ltd. is an all equity company with a market value of ₹ 25,00,000 & Ke =
21%. The company wants to buyback equity shares worth ₹ 5,00,000 by
issuing and raising 15% perpetual debt of the same amount. Income tax rate =
30%. After the capital restructuring and applying MM Model (with taxes), you
are required to calculate:
 Market value of RES Ltd.;
 Cost of Equity Ke;
 Weighted average cost of capital and comment on it.
HOME ASSIGNMENT
ALTERNATIVE FINANCING PLAN, INDIFFERENCE POINT AND FINANCIAL BREAK EVEN
POINT
12. Paramount Produces Ltd. wants to raise ₹ 100 lakhs for a diversification
project. Current estimate of earnings before interest and taxes (EBIT) from the
new projects is ₹ 22 lakhs per annum. Cost of debt will be 15% for amounts up
to and including ₹ 40 lakhs, 16% for additional amounts up to and including ₹
50 lakhs and 18% for additional amounts above ₹ 50 lakhs. The equity shares
(face value ₹ 10) of the company have a current market value of ₹ 40.This is
expected to fall to ₹ 32 if debts exceeding ₹ 50 lakhs are raised. The following
options are under consideration of the company:
Option Equity Debt
I 50% 50%
II 60% 40%
III 40% 60%
Determine the earning per share (E.P.S.) for each option and state which
option the company should exercise. Tax rate applicable to the company is
50%.
13. Bhaskar Manufacturer Ltd. has Equity Share Capital of ₹ 5,00,000 (face value ₹
100). To meet the expenditure of an expansion program, the company wishes
to raise ₹ 3,00,000 and is having following four alternative sources to raise the
funds:
Plan A To have full money from the issue of Equity shares.

Plan B To have ₹ 1,00,000 form Equity and ₹ 2,00,000 from
borrowings from the financial institutions @10% per annum.
Plan C Full money from borrowings @ 10% per annum.
Plan D ₹ 1,00,000 in Equity and ₹ 2,00,000 from 8% Preference
Shares.
The company earnings after expansion will be ₹ 1,50,000. The
tax is 50%. Select a suitable plan out of the above four plans
to raise the required funds.
14. A company earn a profit of ₹ 3,00,000 per annum after meeting its interest
Liability of ₹ 1,20,000 on 12% Debenture. The tax rate is 50%. The number of
equity shares of ₹ 10 each are 80,000 and retained earning amount to
₹12,00,000. The company propose to take up an expansion scheme for which
a sum of ₹ 4,00,000 is required. It is anticipated that after expansion, the
company will be able to achieve the same return on investment as at present.
The fund required for expansion can be raised either through debt at the rate
of 12% or by issuing share at par.

Required:
1. Compute the earning per share (EPS) if :
- the additional funds were raised as debt
- the additional funds were raised by issue of equity shares
2. Advice the company as to which source of finance is preferable.
15. EXE Limited is considering three financing plans. The key information is as
follows:
a. Total investment to be raised ₹ 2,00,000.
b. Plans of Financial Proportion.
Plan Equity Debt Preference Share
A 100% -- --
B 50% 50% --
C 50% -- 50%
c. Cost of debt 8%. Cost of Preference 8%.

d. Tax rate 50%. (Assume no dividend tax)
e. Equity shares of face value of ₹ 10 each will be issued at a premium of ₹ 10
per share.
f. Expended EBIT is ₹ 80,000
You are required to determine for each plan:

(i) Earnings per share
(ii) The Financial breakeven point
(iii) Compute the EBIT range among the plans of indifference.
Capital Structure APPROACHES
16. Calculate the market value of three firms under NI and NOI approach
Particulars A Ltd B Ltd C Ltd
10% Debt Nil 2,50,000 5,00,000
EBIT ₹ 2,00,000 2,00,000 2,00,000
Equity capitatisation rate 20%. Ignore income tax.
17. Assuming no taxes and given the earnings before interest and taxes (EBIT),
interest (I) at 10 per cent and equity capitalisation rate (Ke) below, calculate
the total market value of each firm and WACC of each firm.
Firms EBIT i. Ke (percent)
X ₹ 2,00,000 ₹ 20,000 12
Y 3,00,000 60,000 16
Z 5,00,000 2,00,000 15
W 6,00,000 2,40,000 18
18. Manufacturing Co., has a total capitalisation of ₹ 10,00,000 and normally

earns ₹ 1,00,000 (before interest and taxes). The financial manager of the firm
wants to take a decision regarding the capital structure. After a study of the
capital market, he gathers the following data::
Amount of Debt Interest Ke%
Rate
0 -- 10.00
1,00,000 4.0 10.50
2,00,000 4.0 11.00
3,00,000 4.5 11.60
4,00,000 5.0 12.40
5,00,000 5.5 13.50
6,00,000 6.0 16.00
7,00,000 8.0 20.00
a. What amount of debt should be employed as per traditional approach

b. If the Modigliani-Miller approach is followed, what should be the equity
capitalization rate? Assume there is no income tax.
19. XYZ Ltd. has Earnings before interest and taxes (EBIT) of ₹ 4,00,000. The firm
currently has outstanding debts of ₹ 15,00,000 at an average cost, kd, of 10%.
Its cost of equity capital ke, is estimated to be 16%.
i. Determine current value of the firm using the Traditional approach.
ii. Determine the firm's overall capitalization rate, ko
iii. The firm is considering issuing capital of ₹ 5,00,000 in order to redeem ₹
5,00,000 debt. The cost of debt is expected to be unaffected. However, the
firm's cost of equity capital is to be reduced to 14% as a result of decrease
in leverage. Would you recommended the proposed action?
20. Z Ltd. operating income (before interest and tax) is ₹ 9,00,000. The firm cost
of debt is 10 Percent, and currently firm employs ₹ 30,00,000 of debt. Its
overall cost of capital is 12%. Calculate cost of equity.
21. Given (i) the EBIT of ₹ 2,00,000 (ii) the corporate tax rate of 35% and (iii) the
following data, determine the amount of debt that should be used by the firm
in its capital structure to maximize the value of the firm.
Debt Interest rate Ke (%)
(%)
Nil Nil 12
1,00,000 10 12
2,00,000 10.5 12.6

3,00,000 11 13
4,00,000 12 13.6
5,00,000 14 15.6
6,00,000 17 20
22. From the following selected data, determine the value of the firms, P and Q
belonging to the homogeneous risk class under (a) the Net Income (NI)
approach, and (b) the Net Operating Income (NOI) approach.
Particular Firm P Firm Q
EBIT ₹ 2,25,000 ₹ 2,25,000
Interest at 15% 75,000
Equity capitalization rate, ke 20%
Corporate tax rate 50%
23. There are two firms P and Q which are identical except P does not use debt in
its capital structure while Q has ₹ 8,00,000, 9% debenture in its capital
structure. Both the firm have earnings before interest and tax of ₹ 2,60,000
p.a. and the capitalization rate is 10%. Assuming the corporate tax of 30%,
calculate the value of these firms according to MM Hypothesis.
24. The following figures are made available to you:
₹
Net Profits for the year 18,00,000
Less: Interest on secured debentures at 15% p.a. 1,12,500
(debentures were issued 3 months after the
commencement of the year)
Profit before tax 16,87,500
Less: Income - tax at 50% 8,43,750
Profit after tax 8,43,750
Number of equity share ₹ 10 each ) 1,00,000
Market quotation of equity share 109.70
The company has accumulated revenue reserve of ₹ 12 lakhs. The company is

examining a project calling for an investment obligation of ₹ 10 lakhs. This
investment is expected to earn the same rate as funds already employed.
You are informed that a debt equity ratio (Debt dividend by debt plus equity)
higher than 60% will cause the price earnings ratio to come down by 25%. The
interest rate on additional borrowing will cost company 300 basis points (3%)
more than on their current borrowing in secured.
You are required to calculate the probable price of the equity share, if :
(a) the additional investment were to be raised by way loans; or
(b) the additional investment were to be raised by way of equity. Assume
issue price per share ₹100
ANSWER
1. EPS 15.833, 18.125, 16.406
2. EPS ₹ 2.45, 2.58, 2.55. Option (ii) should be adopted
3. Market Price per Share ₹ 145.80, 79.70, 130; Alternative (i)
4. (i) 20.64 (ii) 24.40
5. (1) 150000 (2) 260000 (3) 194000 (4) 216000 (5) 172000
6. (1) 0.12, -0.24, -0.56 ; 0.24, 0, -0.32 ; 0.48, 0.48, 0.16 ; 0.72, 0.96, 0.64 ; 1.20,
1.92, 1.60 (3) ₹ 2,50,000; ₹ 4,16,667
7. (i)(a) ₹ 8,58,077 (b) ₹ 5,11,538, ₹ 1,65,000 (ii) Plan I
8. (i) MV under NI approach ₹ 2500000, 2750000, 3000000, 3500000 (ii) MV ₹
2500000 under all situation. Ke = 20%, 22.5%, 26.67%, 60%
9. MV ₹ 2550000, 2480000, 2314815, 2120000, 1822222. Structure I
10. (i) ₹ 16, 10 Lacs (ii) ₹ 14.5, 10 Lacs (iii) 10.34% and 15%
11. MV of firm = ₹ 26,50,000; Ke = 22%; WACC = 19.82%;
12. EPS 5.76, 5.33, 5.04. Option I should be accepted.
13. EPS ₹ 9.38, 10.83, 12,9.83. Plan C
14. (1) 1. 925, 1.48 (2) Raised through debt.
15. (i) 4, 7.2, 6.4 (ii) 0; 8,000; 16,000 (iii) AB = 16,000; AC = 32,000; BC = N.A
16. (i) MV under NI ₹ 10,00,000; 11,25,000; 12,50,000 (ii) MV under NOI ₹ 10,00,000.
Ke = 20%, 23.33%, 30%.
17. Value = 17, 21, 40, 44 lacs. Ko = 11.76, 14.29, 12.5, 13.64
18. (a) ₹ 3,00,000 (b) 10%, 10.67%, 11.5%, 12.36%, 13.33%, 14.5%, 16%, 14.67%
19. (i) 30,62,500 (ii) 13.06% (iii) Accepted, MV 31,42,857
20. 13.33%
21. MV = 10,83,333; 11,29,167; 11,23,413; 11,35,000; 11,26,471; 10,41,667;
9,18,500; Debt 300000
22. (a) MV = 875000, 562500. WACC = 12.86%, 20% (b) MV = 812500, 562500. WACC
= 13.85, 20.
23. Value of P = ₹ 18,20,000 ; Value of Q Ltd. = ₹ 20,60,000
24. (a) 132.10 (b) 130.70
--------
Chapter 4: Working Capital Management
A. WORKING CAPITAL ESTIMATION
(1) OPERATING CYCLE METHOD
Step 1 : Calculate operating cycle period:
R+W+F+D–C
Where
R= Raw material storage period
W = Work -in- progress holding period
F= Finished goods storage period
D = Debtors collection period
C= Credit period allowed by creditor
1. R = Average stock / Material consumed per day

2. W = Average stock / Cost of production Per day
3. F = Average stock / Cost of goods sold per day
4. D = Average Debtors / Credit sales per day
5. C = Average Creditors / Credit purchases per day
Step 2: Calculate total cash expenses for the year
Step 3: Calculate working capital:

Cash expenses per day x operating cycle period
Note:
1. Material consumed:
Opening stock R.M + Purchases - Closing stock R.M
2. Cost of production:
Material consumed + Labour + Factory overhead + Opening WIP - Closing WIP
3. Cost of goods sold :

a. Cost of production + Opening F.G. - Closing F.G.
b. Sales - Gross profit

4. If opening stock and closing stock of raw material is not given separately, then
it is assumed that purchases is equal to consumption.
5. If opening and closing stock of finished goods is not given separately, then it is
assumed that cost of production is equal to cost of goods sold.
6. If credit sales is not given separately, total sales is taken as credit sales
7. If credit purchases is not given separately, total purchases is taken as credit
purchases.
(2) TRADITIONAL APPROACH

In this method, all items of current assets and current liabilities are separately
valued. If units are given then value per unit of each item is calculated as under:
COMPONENT OF VALUE PER UNIT VALUE PER UNIT (CASH
CURRENT ASSETS (TOTAL BASIS) COST BASIS)
Raw material stock Raw material per unit Raw material per unit
Work in progress Raw material + 50% Raw material + 50% wages
stock wages + 50% factory + 50% cash factory
overhead overhead
Finished goods stock Raw material + Raw material + wages +
wages + factory cash factory overhead
overhead
Debtors Selling price Selling price – profit - Dep.
Prepaid expenses Expenses per unit Expenses per unit
Creditors Raw materials per Raw material per unit
unit
Outstanding exp. Expenses per unit Expenses per unit
If units are not given then each component of working capital is calculated directly
on amount which is given below:
COMPONENT OF AMOUNT OF AMOUNT FOR
WORKING CAPITAL VALUATION (TOTAL VALUATION (CASH COST

BASIS) BASIS)
Raw material stock Raw material Raw material consumed
consumed
Work in progress Cost of production or Cash Cost of production or
stock Raw material Raw material consumed +
consumed + wages + wages + factory overhead
factory overhead
Finished goods stock Cost of goods sold or Cash Cost of goods sold or
sales – gross profit sales – G. P – Dep
Debtors Credit sales Administrative exp. +
selling expenses
Prepaid expenses Annual expenses Annual expenses
Creditors Creditors purchase Credit purchase
Outstanding exp. Annual expenses Annual expenses
Note:
1. Creditors are calculated on credit purchases. Raw material consumption may
be used if purchase cannot be calculated.
2. In newly commencing business, purchase is to be calculated for the calculation
of creditors as follows:
Raw material consumed + Stock of raw material
EFFECT OF DOUBLE SHIFT ON WORKING CAPITAL REQUIRMENT

When a firm produce goods in double shift, then its working capital will be high. Each
component is change proportionately except WIP stock
METHODS OF BANK FINANCE AS PER TANDON COMMITTEE

Method 1 = 75% (Current assets - Current Liabilities)
Method 2 = 75% of Current assets - Current liabilities
Method 3 = 75% (Current assets - Core Current Assets) - Current liabilities

CLASS ASSIGNMENT
OPERATING CYCLE METHOD

1. Calculate the operating cycle and the working capital requirements from the
following figures of Ritika Ltd.
Particulars Balance as at 1st Balance as at 31st
Jan (in ₹) Dec (in ₹)
Raw material 80,000 1,20,000
Work in progress 20,000 60,000
Finished goods 60,000 20,000
Sundry debtors 40,000 40,000
Wages and Manufacturing exp. 2,00,000
Distribution and other exp. 40,000
Purchases of material 4,00,000
Total sales 10,00,000
i. The company obtains a credit period for 60 days from its supplier
ii. All goods were sold for credit
2. From the following data, compute the duration of the operating cycle for each
of the two years assume 360 days in a year.
₹ (Thousand)
Particulars Year 1 Year 2
Stock : Raw Materials 20 27
Work in progress 14 18
Finished Goods 21 24
Purchases 96 135
Cost of goods sold 140 180
Sales 160 200
Debtors 32 50
Creditors 16 18
3. The following information is available in respect of a trading firm:

a. On an average, debtors are collected after 45 days; inventories have an

average holding period of 75 days and creditors payment period on an
average is 30 days.
b. The firm spends a total of ₹ 120 lakh annually at a constant rate
c. It can earn 10 per cent on investments.
From the above information) compute: (a) the cash cycle and cash turnover,
(b) minimum amounts of cash to be maintained to meet Payments as they
become due) (c) savings by reducing the average inventory holding period by
30 days. Assume 360 days in a year.
WORKING CAPITAL APPROACHES (TRADITIONAL & CASH COST BASIS)

4. Cost sheet of a company provides the following data:
Particulars Cost per unit (₹)
Raw material 50
Direct labour 20
Overheads (including depreciation of ₹ 10) 40
Total cost 110
Profit 20
Selling price 130
Average raw material in stock is for one month. Average material in progress is for
half month. Credit allowed by suppliers: one month; Credit allowed to debtors: One
month. Average time lag in payment of wages: 10 days; average time lag in payment
of overheads: 30 days. 25% of the sales are on cash basis. Cash balance expected to
be ₹ 1,00,000. Finished goods lie in the warehouse for one month.
You are required to prepare a statement showing the working capital needed to
finance a level of the activity of 54,000 units of output. Production is carried on
evenly throughout the year and wages and overheads accrue similarly. State your
assumptions, if any, clearly.
5. Calculate working capital requirements from the following information

Particulars ₹ (per unit)

Raw material 160
Direct labour 60
Overheads 120
Total Cost 340
Profit 60
Selling price 400
Raw materials are held in stock on an average for one month

Materials are in process on an average for half-a-month.
Finished goods are in stock on an average for one month.
Credit allowed by suppliers is one month and credit allowed to debtors is two
months. Time lag in payment at wages is 1.5 week. Time lag in payment of
overhead expenses is one month. One fourth of the finished goods is sold
against cash.
Cash in hand and at bank is expected to be ₹ 50,000; and expected level of
production amounts to 1,04,000 units for a 52 week.
You may assume that production is carried on evenly throughout the year,
wages and overheads accrue similarly and a time period of four weeks is
equivalent to a month.
6. Foods Ltd. is presently operating at 60% level producing 36,000 packets of

snack foods and proposes to increase capacity utilization in the coming year
by 33 1/3% over the existing level of production.
The following data has been supplied:
1. Unit cost structure of the product at current level:
Particulars ₹
Raw material 4
Wages (variable) 2
Overheads (variable) 2
Fixed overheads 1
Profit 3

Selling price per unit 12
2. Raw materials will remain in stores for 1 month before being issued for
production. Material will remain in process for further 1 month. Suppliers
grant 3 months credit to the company.
3. Finished goods remain in godown for 1 month
4. Debtors are allowed credit for 2 months.
5. Lag in wages and overhead payments it 1 month and these expenses
accrue evenly throughout the production cycle
6. No increase either in cost of inputs or selling price is envisaged.
Prepare a projected profitability statement and the working capital
requirement at the new level, assuming that a minimum cash balance of ₹
19,500 has to be maintained.
7. XYZ Cements Ltd. Sells its products on a gross profit of 20% on sales. The
following information is extracted from its annual accounts for the year ended
31st March, 2013 : (In ₹)
Sales At 3 months credit 40,00,000
Raw materials 12,00,000
Wages paid 15 days in arrears 9,60,000
Manufacturing expenses one month in arrears 12,00,000
paid
Administrative expenses one month in arrears 4,80,000
Sales promotion expenses payable half yearly 2,00,000
advance
The company enjoys one month credit from the suppliers of raw materials and
maintains 2 months stock of raw materials and one and half months finished
goods. Cash balance is maintained at ₹ 1,00,000 as a precautionary balance.
Assuming a 10% margin, find out the working capital requirements of XYZ
Cement Ltd.

8. X Ltd. sells goods at a gross profit of 20%. It includes depreciation as part of

cost of production. The following figures for the 12 months period ending 31st
December, 2013 are given to enable you to ascertain the requirements of
working capital of the company on a cash cost basis.
In your working, you are required to assume that:
1. a safety margin of 15% will be maintained;
2. cash is to be held to the extent of 50% of current liabilities;
3. Stocks of raw material and finished goods are kept at one month's
requirement.
Sales - at 2 months credit ₹ 27,00,000

Materials consumed (suppliers credit is for 2 months) 6,75,000
Wages ( paid at the beginning of the next month) 5,40,000
Manufacturing expenses outstanding at the end of the 60,000
year
(cash expenses are paid one month in arrear)
Total Administrative expenses (One month in arrear) 1,80,000
Sales promotion exp. (paid quarterly in advance) 90,000
9. A newly formed company has applied to the commercial bank for the first
time for financing its working capital requirements. The following information
is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000
units of work-in-progress. Based on the above activity estimated cost per unit
is :
Particulars ₹
Raw material 80
Direct Wages 30
Overheads 60
(exclusive of depreciation)
Total cost 170
Profit 30

Selling price 200

Raw material in stock: average 4 weeks consumption, Work-in-process
(assume 50% completion stage of conversion cost, material issued at the start
of processing)
Finished goods in stock 8000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 Weeks
Lag in payment of wages Average 1-1/2 weeks
Cash at banks ₹ 25000
Assume that production is carried on evenly throughout the year (52 weeks)
and wages and overhead accrue similarly. All sales are on credit basis only.

10. MN Ltd. is commencing a new project for manufacture of electric toys. The
following cost information has been ascertained for annual production of
60,000 units at full capacity.
Particulars Amount per

unit (₹)
Raw material 20
Direct Labour 15
Manufacturing overhead Variable 15
Fixed 10 25
Selling and Distribution overhead: Variable 3
Fixed 1 4
Total cost 64
Profit 16
Selling price 80
In the first year of operation, expected level of production and sales are
40,000 units and 35,000 units respectively. To assess the need of working
capital, the following additional information is available:
i. Stock of raw material 3 month consumption
ii. Credit allowed for debtors 1.5 months
iii. Credit allowed by creditors 4 months
iv. Lag in payment of wages 1 month
v. Lag in payment of overhead 0.5 month
vi. Cash in hand and bank expected to ₹ 60,000
vii. Provision for contingencies is required @ 10% of working capital
requirement including that provision.
You are required to prepare a projected statement of working capital
requirement for the first year of operation. Debtors are taken at cost.

CASH BUDGET
11. Prepare a Cash Flow Budget of Modern Garments Ltd. for the six month
ending Sept. 2013 on the basis of the following information:
A. Sale Forecast
January ₹ 2,40,000 June ₹ 1,80,000
February ₹ 2,00,000 July ₹ 2,10,000
March ₹ 2,60,000 August ₹ 2,00,000
April ₹ 1,40,000 September ₹ 2,00,000
May ₹ 1,60,000 October ₹ 1,60,000
B. Cash sales represent 20% of total sales, 60% of the credit sales are
collected in 30 days, 30% in 60 days and balance in 90 days.
C. Gross Profit margin is maintained at 20% of selling price.
D. Anticipated sales of each month is purchased and paid in cash in the
preceding month.
E. Administration and selling expenses are budgeted as follows:
April ₹ 11,000 July ₹ 14,500
May ₹ 12,000 August ₹ 14,500
June ₹ 13,500 September ₹ 15,000
F. Payment for instalment of a machine costing ₹ 80,000 is due on 1st May
2013.
G. Interest on deposit of ₹ 2 lacs @ 12% p.a. is payable quarterly in April and
July.
H. Advance tax of ₹ 24,000 is payable on 14th June 2013.
I. Interest on investment amounting to ₹ 10,000 per quarter is receivable in
June and September.
J. Balance 25% of the value of an asset sold for ₹ 1 lacs is due in August
K. The company has a cash balance of ₹ 57,500 on 31st March, 2013. If at any
time cash balance reduces below ₹ 50,000 level, short-term loan @ ₹
10,000 at a time is arranged @ 18% p.a. interest payable on monthly basis.

12. Sunrise Ltd. have given the forecast sales from March, 2013 to September
2013 and actual sales for January and February 2013. Prepare a cash budget
for five months, i.e., from March 2013 with following information.
a. Sales
₹
January, 2013 1,60,000
February, 2013 1,40,000
March, 2013 1,60,000
April, 2013 2,00,000
May, 2013 1,60,000
June, 2013 2,00,000
July, 2013 1,80,000
August, 2013 2,40,000
September, 2013 2,00,000
b. Cash sales : 20%, Credit sales 80%, received in the third month
c. Variable expenses: 5% turnover, time lag half month
d. Commission 5% on credit sales payable in the third month
e. Material is 60% of the sales and it is purchase of the third month, payment
will be made in third month from purchases.
f. Rent and other expenses ₹ 6,000 paid every month.
g. Other payments: Tax - March- ₹ 40,000; Fixed assets purchases - May ₹
1,00,000.
h. Opening cash balance - ₹ 50,000.
13. A firm maintains a separate account for cash disbursement. Total disbursement are ₹
2,62,500 per month. Administrative and transaction cost of transferring cash to
disbursement account is ₹ 25 per transfer. Marketable securities yield is 7.5% per
annum.
Determine the optimum cash balance according to William J Baumol model.

MANAGEMENT OF DEBTORS
14. Gemini Products Ltd. is considering the revision of its credit policy with a view
to increasing its sales and profits. Currently all its sales are on credit and the
customers are given one month's time to settle and dues. It has a contribution
of 40% on sales and it can raise additional funds at a cost of 20% per annum.
The marketing directors of the company has given the following options with
draft estimates for consideration:
Particulars Current Option Option Option
Position I II III
A. Sales (in Lakhs of rupees) 200 210 220 250
B. Credit period (in months) 1 1.5 2 3
C. Bad Debts (% of sales) 2 2.5 3 5
D. Cost of credit 1.20 1.30 1.50 3
Administration
( in lakhs of rupees)
Advise the company to take right decision.
15. A company currently has an annual turnover of ₹ 10,00,000 and an average

collection period of 45 days. The company wants to experiment with a more
liberal credit policy on the ground that increase in collection will generate
additional sales. From the following information, kindly indicate which of the
policies you would like the company to adopt:
Credit Policy Increase in Increase in % of Default
Credit Policy Sales
I 15 days ₹ 50,000 2%
II 30 days ₹ 80,000 3%
III 40 days ₹ 1,00,000 4%
IV 60 days ₹ 1,25,000 6%
The selling price of the product is ₹ 5, average cost per unit at current level is
₹ 4 and the variable cost per unit is ₹ 3. The current bad debts loss is 1 % and
the required rate of return on investment is 20%. A year can be taken to
comprise of 360 days.

16. The present credit terms of P company are 1/10 net 30. Its annual sales are ₹
80,00,000. Its average collection period is 20 days; Its variable cost and
average total cost to sales ₹0.85 and 0.95 respectively and its cost of capital is
10 percent. The proportion of sales on which customer currently take discount
is 0.5. P company is considering relaxing its discount terms to 2/10 net 30.
Such relaxation is expected to increase sales by ₹ 5,00,000, reduce the
average collection period to 14 days and increase the proportion of discount
sales to 0.8. What will be the effect of relaxing the discount policy on
company profit? Take year as 360 days.
17. As a part of strategy to increase sales and profit, the sales manager of a
company proposes to sell goods to a group of new customer with 10% risk of
non-payment. This group would require one and half month credit and is likely
to increase sales by ₹ 100000 per annum. Production and selling expenses
amount to 80% of sales and income tax rate is 50%. The company minimum
required rate of return (after tax) is 25%. Should the sales manager proposal
be accepted?
18. A company has sales of ₹ 25,00,000. Average collection period is 50 days, bad
debts losses are 5% of sales and collection expenses are ₹ 25,000. The cost of
fund is 15%. The company has two alternative collection programmes:
Particulars Programme I Programme II
Average collection period reduced 40 days 30 days
to
Bad debts losses reduced to 4% of sales 3% of sales
Collection expenses ₹ 50,000 ₹ 80,000
Evaluate which program is viable.
19. Easy Limited specializes in the manufacture of a computer component. The

component is currently said for ₹ 1,000 and its variable cost is ₹ 800. For the

year ended 31.12.2012 the company sold on an average 400 component per
month.
At present, the company grants onemonth credit to its customers. The
company is thinking of extending the same to two months on account of
which the following is expected:
Particulars Amount
Increase in sales 25%
Increase in stock ₹ 4,00,000
increase in creditors ₹ 3,00,000
You are required to advise the company on whether or not to extend the
credit terms if
a. Old customer avail the extended credit period of two months and
b. Existing customers do not avail the extended credit terms but only the new
customers avail the same. Assume in this case the entire increase in sales
is attributable to the new customer. The company expects a minimum
return of 40% on the investment:
FACTORING
20. A Factoring firm has credit sales of ₹360 lakhs and its average collection
period is 30 days. The financial controller estimates, bad debt losses are
around 2% of credit sales. The firm spends ₹1,40,000 annually on debtors
administration. This cost comprises of telephonic and fax bills along with
salaries of staff members. These are the avoidable costs. A Factoring firm has
offered to buy the firm’s receivables. The factor will charge 1% commission
and will pay an advance against receivables on an interest @15% p.a. after
withholding 10% as reserve. What should the firm do?
Assume 360 days in a year

21. The Megatherm Corporation has just acquired a large account. As a result, it needs
an additional ₹ 75,000 in working capital immediately. It has been determined that
there are three feasible sources of funds:

(a) Trade credit (Cash discount): The company buys about ₹ 50,000 of
materials per month on terms of 3/30, net 90. Discounts are taken.
(b) Bank loan: The firm’s bank will lend ₹ 1,00,000 at 13 per cent. A 10%
compensating balance will be required, which otherwise would not be
maintained by the company.
(c) A factor will buy the company’s receivables (₹ 1,00,000 per month), which
have a collection period of 60 days. The factor will advance up to 75 per cent
of the face value of the receivables at 12 per cent on an annual basis. The
factor will also charge a 2 per cent fee on all receivables purchased. It has
been estimated that the factor’s services will save the company a credit
department expense and bad-debt expenses of ₹ 1,500 per month.
On the basis of annual percentage cost, which alternative should the company
select?
22. The turnover of PQR Ltd. is ₹ 120 Lakhs of which 75 percent is on credit. The
variable cost ratio is 80%. The credit terms are 2/10 net 30. On the current
level of sales, the bad debts are 1 percent. The company spends ₹ 1,20,000
per annum on administrating its credit sales. The cost include salaries of staff,
who handle credit checking, collection etc. These are avoidable cost. The past
experience indicate that 60 percent of the customer avail of the cash discount,
the remaining customers pay on an average 60 days after the date of sales.
The book debts of the company are presently being finance in the ratio of 1 : 1
by a mix of bank borrowing and owned funds which cost per annum 15
percent and 14 percent respectively
A factoring firm has offered to buy the firm receivable. The main element of
such deal structured by the factor are:
(a) Factor reserve 12%

(b) Guaranteed payment 25 days.
(c) Interest charge 15%, and
(d) Commission 4% of the value of receivables

Assume 360 days in a year.

What advise would you give to PQR Ltd. - Whether to continue with the in
house management of receivables or accept the factoring firm offer?
(May, 2007)

HOME ASSIGNMENT
OPERATING CYCLE PERIOD
23. Following information is forecasted by the CS Limited for the year ending 31st
March, 2011 :
PARTICULARS Balance as at 1st Balance as at 31st
April, 2012 ₹ March, 2013 ₹
Raw material 45,000 65,356
Work in progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchase of material 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales 11,00,000
You may take one year as equal to 365 days.
You are required to calculate
(i) Net operating cycle period
(ii) Number of operating cycles in a year
(iii) Amount of working capital requirement.
TRADITIONAL APPROACH
24. A proforma cost sheet of a company provides the following particulars

Particulars Amount per unit ₹
Raw material cost 100.00
Direct Labour cost 37.50
Overheads cost 75.00
Total cost 212.50
Profit 37.50

Selling price 250.00
The company keeps raw material in stock on an average for one month; Work
in progress on an average for one week; and finished goods in stock on an
average for two weeks. The credit allowed by supplier is three weeks and
company allow four weeks credits to its debtors. The lag in payment of wages
is one week and lag in payment of overhead is two weeks
The company sells one fifth of the output against cash and maintains cash in
hand and bank put together at ₹ 37,500.
Required:
Prepare a statement showing estimate of working capital needed to finance
an activity level of 1,30,000 units of production. Assume that production is
carried on evenly throughout the year, and wages and overheads accrue
similarly. Work in progress stock is 80% complete in all respects. Assume four
week equal to one month.
Methods of lending – Tandon Committee suggestions

This concept is not given in ICAI material) Additionally provided to you. Read once –
only for understanding a new concept. Not necessary for exams.
Like many other activities of the banks, method and quantum of short-term finance
that can be granted to a corporate was mandated by the Reserve Bank of India till
1994. This control was exercised on the lines suggested by the recommendations of a
study group headed by Shri Prakash Tandon.
The study group headed by Shri Prakash Tandon, the then Chairman of Punjab
National Bank, was constituted by the RBI in July 1974 with eminent personalities
drawn from leading banks, financial institutions and a wide cross-section of the
Industry with a view to study the entire gamut of Bank's finance for working capital
and suggest ways for optimum utilisation of Bank credit. This was the first elaborate
attempt by the central bank to organise the Bank credit. The report of this group is
widely known as Tandon Committee report. Most banks in India even today
continue to look at the needs of the corporate in the light of methodology
recommended by the Group.

As per the recommendations of Tandon Committee, the corporates should be

discouraged from accumulating too much of stocks of current assets and should
move towards very lean inventories and receivable levels. The committee even
suggested the maximum levels of Raw Material, Stock-in-process and Finished Goods
which a corporate operating in an industry should be allowed to accumulate these
levels were termed as inventory and receivable norms. Depending on the size of
credit required, the funding of these current assets (working capital needs) of the
corporate could be met by one of the following methods:
First Method of Lending:

Banks can give maximum 75% working capital gap, i.e. total current assets less
current liabilities other than bank borrowings (called Maximum Permissible Bank
Finance or MPBF) and the balance should be financed by owned funds and other
ways. This approach was considered suitable only for very small borrowers i.e. where
the requirements of credit were less than ₹10 lacs.
Second Method of Lending:
This is applicable for the entities who requires more than ₹ 10 lakh.
Under this method, Maximum WC loan can be given = (75% Current assets) – Current
liabilities;
So, Total current liabilities inclusive of bank borrowings could not exceed 75% of
current assets.
Third Method of Lending:
Under this method,
Maximum WC loan can be given = 75% of (Current Assets – Core current assets) –
Current Liabilities
CORE CURRENT ASSETS are the minimum level of raw material, WIP & FG that the
company has to maintain at every point of time. (Generally, this is given in the
question)
(This method was not accepted for implementation and hence is of only academic
interest).
25. The data of ABC Ltd is as under:
Production for the year 69,000 units

Finished goods inventory 3 months

Raw materials inventory 2 months consumption
Production process 1 month
Credit allowed by Creditors 2 months
Credit given to debtors 3 months
Selling price per unit ₹ 50 each
Raw material 50% of selling price
Direct wages 10% of selling price
Overheads 20% of selling price
There is regular production and sales cycle, and wages and overheads occur
evenly. Wages are paid in the next month of accrual. Material is introduced in
the beginning of production cycle. Work-in-process involves use of full unit of
raw materials in the beginning of manufacturing process and other conversion
costs equivalent to 50%.
You are required to find out:-
1. Its working capital requirement, and
2. its permissible bank borrowing as per 1st and 2nd method of lending
under the Tandon committee norms.
26. XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicate
that material are introduced in the beginning of the production cycle. Wages
and overhead accrue evenly throughout the period of the cycle. Wages aloe
paid in the next month following the month of accrual. Work in progress
include full unit of raw materials used in the beginning. of the production
process and 50% of wages and overhead are supposed to be conversion costs.
Detail of production process and the components of working capital are as
follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw material inventory held One month
Finished goods inventory held for Two month
Credit allowed by creditors One month

Credit given to debtors Two month

Cost price of raw material ₹ 60 per unit
Direct wages ₹ 10 per unit
Overheads ₹ 20 Per unit
Selling price of finished goods ₹ 100 per unit
Required to calculate:
1. The amount of working capital required for the company
2. Its maximum permissible bank finance under all the three methods of
working capital of lending norms as suggested by the Tondon Committee
assuming the value of core current assets ₹ 1,00,00,000
27. The following information has been extracted from the record of a Company
Product Cost sheet ₹ / Unit
Raw Material 45
Direct wages 20
Overheads 40
Total 105
Profit 15
Selling price 120
- Raw material are in stock on an average of two months
- The material are in process on an average for 4 weeks. The degree of
completion is 50% for each item.
- Finished goods stock on an average is for one month.
- Time lag in payment of wages and overhead is 1.5 weeks.
- Time lag in receipts of proceeds from debtors is 2 months.
- Credit allowed by supplier is one month.
- 20% of the output is sold against cash.
- The company expects to keep cash balance of ₹ 100000.
- Take 52 weeks per annum
The company is poised for a manufacture of 1,44,000 units in the year.

You are required to prepare a statement showing the working capital

requirements of the company.
28. A proforma cost sheet of a Company provides the following data:

Particulars ₹
Raw materials per unit 117
Labour cost per unit 49
Factory overhead per unit (include ₹ 18 dep.) 98
Total cost per unit 264
Profit 36
Selling price per unit 300
Following additional information is available:
Average raw material in stock 4 weeks
Average work in progress in stock (% completion with 2 weeks
respect to material 80%, other 60%)
Finished goods in stock 3 weeks
Credit period allowed to debtors 6 weeks
Credit availed from suppliers 8 weeks
Time lag in payment of wages 1 week
Time lag in payment of overheads 2 weeks
The Company sells one fifth of the output against cash and maintains cash
balance of ₹ 2,50,000.
Required:
Prepare a statement showing the estimate of working capital needed to
finance a budgeted activity level of 78,000 units of production. You may
assume that production is carried on evenly throughout the year and wages
and overhead accrue similarly.
29. Q Ltd. sells goods at a uniform rate of gross profit of 20% on sales including
depreciation as part of cost of production. Its annual figures are as under:
Particulars ₹

Sales ( At 2 months credit) 24,00,000

Materials consumed ( Suppliers credit 2 months 6,00,000
Wages paid ( Monthly at the beginning of the subsequent 4,80,000
month)
Manufacturing expenses (cash expenses are paid - one month 6,00,000
in arrear)
Administration expenses (cash expenses are paid - one 1,50,000
month in arrear)
Sales promotion expenses ( paid quarterly in advance) 75,000
The Company keeps one month stock each of raw materials and finished
goods. A minimum cash Balance of ₹ 80,000 is always kept. The company
wants to adopt a 10% safety margin in the maintenance of working capital.
The company has no work-in-progress. Find out the requirements of working
capital of the company on cash cost basis.
CASH BUDGET
30. ABC Co. wishes to arrange overdraft facilities with its Bankers during the
period April to June 2013, when it will be manufacturing mostly for stock.
Prepare a Cash Budget for the above period from the following data,
indicating the extent of the bank facilities the company will require at the end
of each month:
A.
Month Sales (₹) Purchases (₹) Wages (₹)
February, 2013 1,80,000 1,24,800 12,000
March, 2013 1,92,000 1,44,000 14,000
April, 2013 1,08,000 2,43,000 11,000
May, 2013 1,74,000 2,46,000 10,000
June, 2013 1,26,000 2,68,000 15,000

B. 50 per cent of credit sales are realised in the month following the sales and
the remaining 50 per cent in the second month following. Creditors are
paid in the month following the month of purchase. Wages are paid in next
month.
C. Cash at Bank on 1-4-2013 (estimated) ₹ 25,000.
31. On 30th September, 2013 the balance sheet of M Ltd., (retailer) was as under:
PARTICULARS ₹ PARTICULARS ₹
Equity Shares of ( 10 each 20,000 Equipment (at 20,000
fully paid cost)
Reserves 10,000 Less: 5,000
Depreciation
Trade creditors 40,000 15,000
Proposed dividend 15,000 Stock 20,000
Trade debtors 15,000
Balance at bank 35,000
Total 85,000 Total 85,000
The company is developing a system of forward planning and on 1st, 2013 it
supplies the following information :-
PARTICULARS Sales Purchases

Credit ₹ Cash ₹ Credit ₹
September 2013 ( actual) 15,000 14,000 40,000
October 2013 ( budget) 18,000 5,000 23,000
November 2013 ( budget) 20,000 6,000 27,000
December 2013 (budget) 25,000 8,000 26,000
All trade debtors are allowed one month's credit and are expected to settle
promptly. All trade creditors are paid in the months following delivery.
On 1st October, 2013, all equipments were replaced at a cost of ₹ 30,000. ₹
14,000 was allowed in exchange for the old equipment and a net payment of ₹
16,000 was made.

The proposed dividend will be paid in Dec., 2013.

The following expenses will be paid. Wages ₹ 3,000 per month. Administration
₹ 1,500 per month. Rent ₹ 3,600 for the year up to 30th Sept. 2014 (to be paid
in Oct, 2013).
You are required to prepare a cash budget for the months of October,
November, and December, 2013.
32. ABC Company Ltd. has given the following particulars. You are required to
prepare a cash budget for the three months ending 31st December, 2013 :
(a)
Months Sales ₹ Materials ₹ Wages ₹ Overheads ₹
August 20,000 10,200 3,800 1,900
September 21,000 10,000 3,800 2,100
October 23,000 9,800 4,000 2,300
November 25,000 10,000 4,200 2,400
December 30,000 10,800 4,500 2,500
(b) Credit terms are:
(i) Sales / Debtors - 10% sales are on cash basis. 50% of the credit sales are
collected next month and the balance in the following month:
(ii) Creditors - Material 2 months
- wages 1 / 5 months
- overheads 1 / 2 months
(c) Cash balance on 1st October, 2013 is expected to be ₹ 8,000.
(d) A machinery will be installed in August, 2013 at a cost of ₹ 1,00,000. The
monthly installment of ₹ 5,000 is payable from October onwards.
(e) Dividend at 10% on preference share capital of ₹ 3,00,000 will be paid on
1st December, 2013.
(f) Advance to be received for sale of vehicle ₹ 20,000 in December.
(g) Income-tax (advance) to be paid in December ₹ 5,000.
MANAGEMENT OF DEBTORS
33. ABC & Company is making sales of ₹ 16,00,000 and it extents a credit of 90
days to its customers. However, in order to overcome the financial difficulties,

it is considering to change the credit policy. The proposed terms of credit and
expected sales are given here under: -
Policy Terms Sales ₹
I 75 days 15,00,000
II 60 days 14,50,000
III 45 days 14,25,000
IV 30 days 13,50,000
V 15 days 13,00,000
The firm has a variable cost of 80% and a fixed cost of ₹ 1,00,000. The cost of
capital is 15%. Evaluate different proposed policies and which policy should be
adopted?
(Year may be taken as 360 days)
34. Star Limited, manufacturers of Color TV sets, are considering the liberalization
of existing credit terms to three large customers A, B and C. The credit and
likely quantity of TV sets that will be lifted by the customers are as follows:
Credit Period (Quantity Lifted of TV sets)
(Days)
A B C
0 1000 1,000 --
30 1000 1,500 --
60 1000 2,000 1,000
90 1000 2,500 1,500
The selling price per TV set is ₹ 9,000. The expected contribution is 20% of the
selling price.
The cost of carrying debtors averages 20% per annum.
You are required to determine the credit period to the allowed to each
customer.
(Assume 360 days in a year for calculation purposes)
35. A company has prepared the following projections for a year:

Sales 21,000 units

Selling price per unit ₹ 40
Variable cost per unit ₹ 25
Total cost per unit ₹ 35
Credit period allowed One Month
The company propose to increase the credit period allowed to its customer
from one month to two months. It is envisaged that the change in the policy
as above will increase the sales by 8%.
The company desires a return of 25% on its investment.
You are required to examine and advise whether the proposed credit policy
should be implemented or not.
36. A firm has a current sales of ₹ 2,56,48,750. The firm has an utilized capacity. In
order to boosts its sales, It is considering the relaxation in its credit policy. The
proposed terms of the credit will be 60 days credit against the present policy
of 45 days. As a result, the bad debts increase from 1.5% to 2% of sales. The
firm sales are expected to increase by 10%. The variable operating costs are
72% of the sales. The firm corporate tax rate is 35%, and it requires an after
tax return of 15% on its investment. Should the firm change its credit period?
37. The sales manager of AB Ltd. suggests that if credit period is given for 1.5
month then sales may likely to increase by ₹ 1,20,000 per annum. Cost of
sales amounted to 90% of sales. The risk of non payment is 5%. Income tax
rate is 30%. The expected return on investment is ₹ 3,375 (after tax). Should
the company accept the suggestion of Sales manager?
38. An engineering company is considering its working capital investment for the
year 2012-13. The estimated fixed assets and current liabilities for the next
year are ₹ 6.63 crore and 5.967 crore respectively. The sales and EBIT depend
on investment in its current assets - particularly inventory and receivables.
The company is examining the following alternatives working capital policies:
Working Capital Investment In Estimated Sales EBIT (₹ I Crore)

Policy current (₹ In (₹ In crore)

crore)
Conservative 11.475 31.365 3.1365
Moderate 9.945 29.325 2.9325
Aggressive 6.630 25.500 2.5500
You are required to calculate the following for each policy:
i. Rate of return on total assets.
ii. Net working capital position
iii. Current assets to fixed assets ratio
iv. Discuss the risk return trade off of each working capital policy
Answer
(` in Crores)
Conservati Modera Aggressi

1. Current assets 11.475 9.94 6.63
2. Fixed assets 6.630 6.63 6.63
3. Total assets 18.105 16.57 13.2
4. Current liabilities 5.967 5.96 5.96
5. Estimated sales 31.365 29.32 25.5
6. Estimated EBIT 3.1365 2.932 2.5
7. Current ratio {(1) / (4)} 1.92 1.6 1.1
Computation of following for each policy:
(i) Rate of return on total assets 17.32 17.69 19.23

(in percentages):
[(6)/(3)] × 100
(ii) Net working capital 5.508 3.978 0.663
position : (in crores)
[(1)−(4)]
(iii Current assets to fixed 1.73 1.50 1.00
assets ratio: [(1) / (2)]
(iv) Risk-return trade off:

The net working capital or current ratio is a measure of risk. Rate of return on total
assets is a measure of return. The expected risk and return are minimum in the case
of conservative investment policy and maximum in the case of aggressive investment
policy. The firm can improve profitability by reducing investment in working capital.
39. Samreen Enterprises has been operating its manufacturing facilities till
31.3.2017 on a single shift working with the following cost structure:
Per unit (₹)
Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016-17 – ₹ 4,32,000.
As at 31.3.2017 the company held:
(₹)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
In view of increased market demand, it is proposed to double production by
working an extra shift. It is expected that a 10% discount will be available from
suppliers of raw materials in view of increased volume of business. Selling price
will remain the same. The credit period allowed to customers will remain
unaltered. Credit availed of from suppliers will continue to remain at the present
level i.e., 2 months. Lag in payment of wages and expenses will continue to remain
half a month.
You are required to PREPARE the additional working capital requirements, if the
policy to increase output is implemented.
Answer
This question can be solved using two approaches:

(i) To assess the impact of double shift for long term as a matter of production
policy.
(ii) To assess the impact of double shift to mitigate the immediate demand for
next year only.
The first approach is more appropriate and fulfilling the requirement of the question.
Workings:
(1) Statement of cost at single shift and double shift working
24,000 units 48,000 Units
Per unit Total Per unit Total
(₹) (₹) (₹) (₹)
Raw materials 6.00 1,44,000 5.40 2,59,200
Wages - Variable 3.00 72,000 3.00 1,44,000
Fixed 2.00 48,000 1.00 48,000
Overheads - Variable 1.00 24,000 1.00 48,000
Fixed 4.00 96,000 2.00 96,000
Total cost 16.00 3,84,000 12.40 5,95,200
Profit 2.00 48,000 5.60 2,68,800
18.00 4,32,000 18.00 8,64,000
(2) Sales in units 2016-17 = Sales / Selling price p.u. = 4,32,000 / 18 = 24,000
units
(3) Stock of Raw Materials in units on 31.3.2017 = Value of stock / Cost p.u. =
36,000 / 6 = 6,000 units
(4) Stock of work-in-progress in units on 31.3.2017 = Value of WIP / Prime cost
p.u. = 22,000 / (6+5) = 2,000 units;
(5) Stock of finished goods in units 2016-17 = Value of stock / Total cost p.u. =
72,000 / 16 = 4,5000 units
Assessment of impact of double shift for long term as a matter of production
policy:
Comparative Statement of Working Capital Requirement

Single Shift Double Shift

Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: (A) 2,26,000 3,44,000
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 8,000 5.40 43,200
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current Liabilities: (B) 34,000 57,200
Working Capital: (A) – (B) 1,92,000 2,86,800
Additional Working Capital requirement = ₹ 2,86,800 – ₹ 1,92,000 = ₹ 94,800
Assessment of the impact of double shift to mitigate the immediate demand for
next year only.
Workings:
(3) Calculation of no. of units to be sold:
No. of units to be Produced 48,000
Add: Opening stock of finished goods 4,500
Less: Closing stock of finished goods (9,000)
No. of units to be Sold 43,500
(4) Calculation of Material to be consumed and materials to be purchased in
units:
No. of units Produced 48,000
Add: Closing stock of WIP 2,000
Less: Opening stock of finished goods (2,000)
Raw Materials to be consumed in units 48,000
Add: Closing stock of Raw material 12,000
Less: Opening stock of Raw material (6,000)

Raw Materials to be purchased (in units) 54,000

Credit allowed by suppliers: (54,000 * 5.40) * 2 months / 12 months = Rs. 48,600;
Comparative Statement of Working Capital Requirement

Single Shift Double Shift
Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: (A) 2,26,000 3,44,000
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 9,000 5.40 48,600
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current Liabilities: (B) 34,000 62,600
Working Capital: (A) – (B) 1,92,000 2,81,400
Additional Working Capital requirement = ₹ 2,81,400 – ₹ 1,92,000 = ₹ 89,400
Notes:
(i) The quantity of material in process will not change due to double shift
working since work started in the first shift will be completed in the second
shift.
(ii) It is given in the question that the WIP is valued at prime cost hence, it is
assumed that the WIP is 100% complete in respect of material and labour.
(iii) In absence of any information on proportion of credit sales to total sales,
debtors quantity has been doubled for double shift.
(iv) It is assumed that all purchases are on credit.
(v) The valuation of work-in-progress based on prime cost as per the policy of
the company is as under.
Single shift Double shift
(₹) (₹)

Materials 6.00 5.40

Wages – Variable 3.00 3.00
Fixed 2.00 1.00
11.00 9.40

40. You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
₹ ₹ ₹ ₹
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
To Other Expenses 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000 - -
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000
Sales are expected to be ₹ 12,00,00,000 in year 3.

As a result, other expenses will increase by ₹ 50,00,000 besides other charges. Only
raw materials are in stock. Assume sales and purchases are in cash terms and the
closing stock is expected to go up by the same amount as between year 1 and 2. You
may assume that no dividend is being paid. The Company can use 75% of the cash
generated to service a loan. COMPUTE how much cash from operations will be
available in year 3 for the purpose? Ignore income tax.
Answer
Projected Profit and Loss Account for the year 3
Year 2 Year 3 Year 2 Year 3

Actual Projected Actual Projected
(` in (` in (` in (` in
lakhs) lakhs) lakhs) lakhs)
To Materials 350 420 By Sales 1,000 1,200
consumed
To Stores 120 144 By Misc. 10 10
Income
To Mfg. Expenses 160 192
To Other expenses 100 150
To Depreciation 100 100

To Net profit 180 204

1,010 1,210 1,010 1,210
Cash Flow:
(` in lakhs)
Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock 50
Net cash inflow 254
Available for servicing the loan: 75% of ` 2,54,00,000 or ` 1,90,50,000
Working Notes:
(i) Material consumed in year 2: 35% of sales.
Likely consumption in Year 3 = 1,200 * 35% = 420 lakh
(ii) Stores are 12% of sales, as in year 2.
(iii) Manufacturing expenses are 16% of sales.
Note: The above also shows how a projected profit and loss account is prepared.
41. Mosaic Limited has current sales of ` 15 lakhs per year. Cost of sales is 75 per
cent of sales and bad debts are one per cent of sales. Cost of sales comprises
80 per cent variable costs and 20 per cent fixed costs, while the company’s
required rate of return is 12 per cent. Mosaic Limited currently allows
customers 30 days’ credit, but is considering increasing this to 60 days’ credit
in order to increase sales.
It has been estimated that this change in policy will increase sales by 15 per
cent, while bad debts will increase from one per cent to four per cent. It is not
expected that the policy change will result in an increase in fixed costs and
creditors and stock will be unchanged.
Should Mosaic Limited introduce the proposed policy? ANALYSE (Assume a
360 days year)
Answer

New level of sales will be 15,00,000 * 1.15 = ` 17,25,000

Variable costs are 80% * 75% = 60% of sales Contribution
from sales is therefore 40% of sales
Fixed Cost are 20% × 75% = 15% of sales
Particulars ` `
Proposed investment in debtors = Variable Cost +
Fixed Cost* = (17,25,000 × 60%) + (15,00,000 ×
15%)
60 2,10,000
= (10,35,000 + 2,25,000) ×
360
Current investment in debtors = [(15,00,000 *
30
60%) + (15,00,000 × 15%)] ×
360 93,750
Increase in investment in debtors 1,16,250
Increase in contribution = 15% * 15,00,000 * 90,000
40%
New level of bad debts = (17,25,000 * 4% ) 69,000
Current level of bad debts (15,00,000 × 1%) 15,000
Increase in bad debts (54,000)
Additional financing costs = 1,16,250 * 12% = (13,950)
Savings by introducing change in policy 22,050
Fixed Cost is taken at existing level in case of proposed investment as well
Advise: Mosaic Limited should introduce the proposed policy.
42. The Dolce Company purchases raw materials on terms of 2/10, net 30. A review
of the company’s records by the owner, Mr. Gautam, revealed that payments
are usually made 15 days after purchases are made. When asked why the firm
did not take advantage of its discounts, the accountant, Mr. Rohit, replied that
it cost only 2 per cent for these funds, whereas a bank loan would cost the
company 12 per cent.
(a) ANALYSE what mistake is Rohit making?
(b) If the firm could not borrow from the bank and was forced to resort to the
use of trade credit funds, what suggestion might be made to Rohit that
would reduce the annual interest cost? IDENTIFY.

Answer
(a) Rohit’s argument of comparing 2% discount with 12% bank loan rate is not
rational as 2% discount can be earned by making payment 5 days in
advance i.e. within 10 days rather 15 days as payments are made presently.
Whereas 12% bank loan rate is for a year.
Assume that the purchase value is `100, the discount can be earned by
making payment within 10 days is `2. The interest cost on bank loan for 10
days would be `0.33 (100 × 12% × 10/365 days). The net benefit of `1.67 (2 –
0.33).
(b) If the bank loan facility could not be available then in this case the
company should resort to utilise maximum credit period as possible.
The maximum possible repayment period would be lower of two:
(i) 30 days as allowed by supplier
(ii) (No. of days / 365) * 100 * 12 % = 1.67 OR no. of days = 51 days
Therefore, payment should be made in 30 days to reduce the interest cost.

ANSWER
1. 110 days, ₹1,80,822
2. 177, 198
3. (a) 90 days (b) 30 lakh (c) 1 lakh.
4. NWC ₹ 8,91,250 (cash cost basis); ₹ 10,48,750 (Total Basis)
5. NWC ₹ 67,10,000 (cash cost basis) ; ₹ 74,30,000 (Total Basis)
6. Profit ₹ 156000, ₹ 99,000 (cash cost); ₹ 1,25,000 (Total Basis)
7. NWC ₹ 1639000 (Cash cost basis) ; ₹ 16,72,000 (Total Basis)
8. NWC ₹ 5,64,937 (Cash cost basis)
9. NWC Total basis ₹46,95,990, Cash cost basis (,42,52,913
10. ₹ 4,99,768
11. ₹ 132500, ₹74100, ₹55800, ₹ 53150, ₹ 90300, ₹ 158100
12. Balance ₹54.10, 65.50, 8.10, 65.10, 99.20
13. Optimum cash balance = ₹ 45,826
14. Option III should be accepted
15. First proposal should be accepted
16. Policy reduce the profit by ₹ 9986. Not accepted.
17. Accepted
18. Programme II is viable due to low cost.
19. Net contribution ₹ 8000, ₹ 136000
22. (i) 86 days (ii) 4.2444 (iii) ₹ 2,23,845
23. ₹ 33,06,250 (Total basis), ₹ 30,06,250 (Cash cost basis)
24. ₹ 1710625 T.B, ₹ 1538125 C.C.B, Bank loan ₹ 12,82,970, ₹ 1203906 on total
basis
25. Cash cost (i) 4,25,00,000 (ii) 3,18,75,000; 3,01,25,000; 2,26,25,000 Total Basis(i)
4,45,00,000 (ii) 3,33,75,000 ; 3,16,25,000; 2,41,25,000
26. Total basis ₹ 45,36,307, Cash cost basis ₹ 42,48,307
27. Cash cost basis ₹ 26,25,700
28. ₹ 4,44,125
29. Cash Bal. April ₹ 53,000, May ₹ - 51,000, June ₹ - 1,66,000
30. Oct ₹ (9100), Nov. ₹ (12600), Dec ₹ (31100)
31. Oct. ₹ 7390, Nov. ₹ 8180, Dec. overdraft ₹ 3910
32. Net profit ₹168250, 159375, 158500, 161750; 155250, and 152875

33. Customer A = 0 period; Customer B = 90 days; Customer C = 90 days

34. Proposed plan should be accepted
35. Proposed plan should be accepted
36. Yes, net profit ₹ 4,200
37. (i) 17.32%, 17.69%, 19.23% (ii) 5.508, 3.978, 0.663 (iii) 1.73, 1.50, 1.00
-----
Chapter 7: Ratio Analysis
LIQUIDITY RATIO
Current Assets
(1) Current Ratio =
Current Liabilities
Current Assets = Stock + Debtors + Cash + Bank + Loan &

advances + Prepaid exp. + Marketable securities
+ Accrued Income + Bills receivable
Current Liabilities = Creditors + Proposed dividend + Provision for

taxation + Cash credit + unclaimed dividend + Bank
Overdraft + Short term loan + Bills Payable +
outstanding Expenses
Quick Assets
(2) Quick Ratio =
Current Liabilitie s
Quick Assets = Current Assets - Stock - Prepaid expenses
Quick Ratio = Liquid ratio = Acid test ratio
cash  Marketable securities

(3) Cash Ratio =
Current Liabilities
Cash ratio = Absolute Liquid Ratio
Quick Assets
(4) Cash Interval Measure Ratio =
Cash expenses per day
Cash interval measure ratio = basic Defense Interval
PROFITABILITY RATIO
Gross Profit
1. GROSS PROFIT RATIO = x 100
Sales
Operating Profit
2. OPERATING PROFIT RATIO = x 100
Sales
Operating profit = Net Profit + Provision for taxation +

Interest on long term loan and
debenture + Loss on sale of fixed assets
and investment - Profit on sale of
fixed assets and investment - Income on
investment.
Net Profit
3. NET PROFIT RATIO = x 100
Sales
Sales - Operating Profit

4. OPERATING RATIO = x 100
Sales
Expenses
5. EXPENSES RATIO = x 100
Sales
6. RETURN ON INVESTMENT OR CAPITAL EMPLOYED =

Return
x 100
Capital Employed
Return = Operating Profit
Capital Employed = Equity share capital + Preference share

capital + Reserves & surplus +. Long
term loans taken + Debentures -
Investment - Misc: expo - Capital
work in progress - Loans & Advances
Or
Fixed Assets + Current assets - Current
Liabilities
Return
7. RETURN ON NET WORTH = x 100
Net Worth
Return = Net profit as per P & L A/c
Net worth = Equity share capital + Preference share

capital + Reserve and surplus – Misc. exp
Net worth = Shareholder Fund = Proprietor Fund =

Equity = Owner equity
Net Profit - PReference Dividend

8. RETURN ON EQUITY SHAREHOLDER FUND =
Equity Shareholder Fund
Equity Shareholder fund = Equity share capital + Reserve a Surplus fund - Misc.
Exp.
Net Profit - Preference Dividend

9. EARNING PER SHARE =
Number of Equity Shares
Equity Share Dividend

10. DIVIDEND PER SHARE =
Number of Equity Shares
Market Price per share

11. P.E. RATIO =
Earning per share
TURNOVER RATIO OR ACTIVITY RATIO OR EFFICIENCY RATIO

Sales
1. CAPITAL TURNOVER RATIO =
Capital Employed
Sales
2. FIXED ASSETS TURNOVER RATIO =
Net Fixed Assets
Sales
3. WORKING CAPITAL TURNOVER RATIO
Working Capital
Net Credit Sales

4. DEBTORS TURNOVER RATIO =
Average Receivables
Receivables = Debtors + Bills receivables
5. DEBTORS VELOCITY OR DEBT COLLECTION PERIOD =

365 / 52 /12
Debtors Turnover Ratio
Net Credit Purchase

6. CREDITORS TURNOVER RATIO =
Average Payable
Payable = Creditors + B/P
365 / 52 /12
7. CREDITORS VELOCITY =
Creditors Turnover Ratio
Cost of goods sold

8. INVENTORY TURNOVER RATIO (FINISHED GOODS) =
Average Inventory
365 / 52 /12
9. STOCK VELOCITY =
Inventory Turnover Ratio
Cost of Production
10. INVENTORY TURNOVER RATIO (WIP) =
Average Inventory
11. INVENTORYTURNOVER RATIO (RAW MATERIAL)=

Raw Material Consumed
Average Inventory
CAPITAL STRUCTURE RATIO

Debt Debt
1. DEBT EQUITY RATIO = or
Equity Debt  Equity
Debt = Long Term Loans + Debentures
Proprietary Fund
2. PROPRIETORY RATIO =
Totatl Assets
Note: Total assets does not include Misc. expenditure.
Shareholder Fund
3. EQUITY RATIO =
Capital Employed
Total Debt
4. DEBT RATIO =
Capital Employed
Total Debt = Debt + Current liabilities
Total Liabilities
5. TOTAL LIABILITIES TO NET WORTH RATIO =
Net Worth
Total Liabilities = Debt + Current Liabilities and Provisions.
Pr eference Share Capital  Debt

6. CAPITAL GEARING RATIO =
Equity Share Holder Fund
Owner ' s Equity

7. OWNER'S EQUITY TO TOTAL EQUITY RATIO =
Total of Liabililty Side
Net Profit  Depreciation  Interest

8. DEBT SERVICE COVERAGE RATIO =
Interest  Instalment of Loan
EBIT
9. FIXED CHARGES COVER RATIO OR INTEREST COVERAGE RATIO =
Interest
Net Profit
10. FIXED DIVIDEND OR PREF DIVIDEND COVERAGE RATIO =
Preference Dividend
Earningsavailabletoequityshareholders
11. EQUITY DIVIDEND COVERAGE RATIO =
Dividend declared
RATIO FOR INVESTMENT ANALYSTS

Equity Dividend
1. DIVIDEND (%) = x 100
Dividend per share

2. YIELD = x 100
Market Price per share
Total Dividend
3. PAY OUT RATIO = x 100
Net Profit
Market Price Per share

4. MARKET PRICE TO CASH FLOW =
Cash Flow per share
Net Profit  Non Cash Expenses

5. CASH FLOW PER SHARE =
Number of Equity Share

6. BOOK VALUE PER SHARE =
Number of Equity Share
CLASS ASSIGNMENT
1. JKL limited has the following Balance sheet as on March 31, 2013 and March 31,
2012:
Balance Sheet
Rs. In Lakhs
Particulars March 31, 2013 March 31, 2012
Sources of funds
Shareholder Funds 2377 1472
Loan funds 3570 3083
5947 4555
Application of funds
Fixed assets 3466 2900
Cash and bank 489 470
Debtors 1495 1168
Stock 2867 2407
Other current assets 1567 1404
Less: Current Liabilities (3937) (3794)
5947 4555
The Income statement of the JKL Ltd. for the year ended is as follows:
Rs. In Lakhs
Particulars March 31, 2013 March 31, 2012
Sales 22165 13882
Less : Cost of goods sold 20860 12544
Gross Profit 1305 1338
Less: Selling & Admn. Exp 1135 752
Earning before interest & tax 170 586
Interest expenses 113 105
Profit before tax 57 481
Tax 23 192
Profit after tax (PAT) 34 289
Calculate for the year 2012-13 :

a. Inventory turnover ratio
b. Financial leverage
c. Return on Investment (ROI)
d. Return On Equity (RO)

e. Average collection period
2. Calculate the amount of Opening Stock, Closing Stock, Opening Sundry Debtors
and Closing Sundry Debtors from the following information:
Average Debt Collection Period 4 Months, Stock Turnover Ratio 3 Times, Gross
Profit Ratio 25%, Cash Sales being 33 1/3% of Credit Sales, Stock at the end was
3 times that in the beginning. Receivables at the end were 3 times more than
that in the beginning. Bills Receivables in the beginning and at the end were Rs.
10,000 and Rs. 50,000 respectively. Gross Profit was Rs. 1,00,000.
3. Complete the following annual financial statements of CANIJ Ltd. on the basis of
ratios given below:
Dr. Profit and Loss Account for the year ended 31st March, 2013
Cr.
Particulars Rs. Particulars Rs.
To Cost of goods sold 6,00,000 By sales 20,00,000
To Operating Expenses ?
To EBIT ?
20,00,000 20,00,000
To Debenture Interest 10,000 By Earning before Interest ?
& Tax
To Income tax ?
To Net Profit ?
Balance Sheet as 31st March, 2013

Net Worth: Fixed Assets ?
Share Capital ? Current Assets:
Reserves & Surplus ? Cash ?
10% Debentures ? Stock ?
Sundry Creditors 60,000 Debtors 35,000
Net Profit to sales 5%, Current Ratio 1.5, Return on net worth 20%, Inventory
turnover (based on cost of goods sold) 15 times, Share capital to reserves 4 : 1,
Rate of Income-tax 50%.
4. Using the following information, complete the Balance sheet given below
(i) Total debt to net worth : 1:2
(ii) Total assets turnover : 2
(iii) Gross profit on sales : 30%
(iv) Average collection period (360 days in a year) : 40 days
(v) Inventory turnover ratio (based on closing stock) : 3
(vi) Acid test ratio : 0.75
Balance Sheet as 31st March, 2013
Equity Share Capital 4,00,000 Machinery & other fixed
assets
Reserves & Surplus 6,00,000 Current Assets:
Current Liabilities Inventory
Debtors
Cash
5. MN Ltd. gives you the following information for the year ending 31st March,
2013 :
1. Current Ratio 2.5 : 1
2. Debt Equity Ratio 1 : 1.5
3. Return on Total Assets 15%
4. Total Assets Turnover Ratio 2
5. Gross Profit Ratio 20%
6. Stock Turnover Ratio 7
7. Current Market Price per Equity Share Rs. 16
8. Net Working Capital Rs. 4,50,000
9. Fixed Assets Rs. 10,00,000
10. 60,000 Equity Shares of Rs. 10 each
11. 20,000 9% Preference Share of Rs. 10 each
12. Opening Stock Rs. 3,80,000
You are required to calculate
(i) Quick Ratio
(ii) Fixed assets turnover Ratio

(iii) Proprietary Ratio
(iv) Earning per share
(v) Price earning Ratio
6. From the following information pertaining to M/s CANIC Ltd. prepare its
Trading, Profit & Loss Account for the year ended on 31st March, 2013 and a
summarized Balance Sheet as at that date Current Ratio 2.5, Quick Ratio 1.3,
Proprietary Ratio (Fixed Assets/Proprietary Fund) 0.6, Gross profit to Sales Ratio
10%, Debtors' velocity 40 days, Sales Rs. 7,30,000, Working capital Rs. 1,20,000,
Bank overdraft Rs. 15,000, Share capital Rs. 2,50,000. Closing stock is 10% more
than Opening stock, Net Profit 10% of proprietors funds.
7. Following is the abridged Balance Sheet of the Everest Co. Ltd. as at 31st March,
2012 :

Paid up Share Capital 5,00,000 Free Hold Property 4,00,000
Profit & Loss Account 85,000 Plant & Machinery
2,50,000
Current Liabilities 2,00,000 Less: Depreciation 1,75,000
75,000
Stock 1,05,000
Debtors 1,00,000
Bank 5,000
7,85,000 7,85,000
From the following information, you are required to prepare Profit and Loss
Account and Balance Sheet as at 31st March, 2013 :
a. The composition of the total of the 'Liabilities' side of the company's Balance
Sheet as at 31st March, 2013 (the paid-up share capital remaining the same
as at 31st March, 2012) was:
Share Capital 50 percent
Profit & Loss A/c 15 percent
7 percent Debentures 10 percent
Creditors 25 percent
The Debentures were issued on 1st April, 2012, interest being paid on 30th
September, 2012 and 31st March, 2013.
b. During the year ended on 31st March, 2013, Additional Plant and Machinery
had been bought and a further Rs. 25,000 depreciation written off. Freehold
property remained unchanged. The total fixed assets then constituted 60
per cent of total fixed and current assets.
c. The current ratio was 1.6: 1. The quick assets ratio was 1: 1
d. The debtors (four-fifths of the quick assets) to sales ratio revealed a credit
period of two months.
e. Gross Profit was at the rate of 15 per cent of selling price and Return on Net
worth as at 31st March, 2013 was 10 per cent.
8. You are given the following figures worked out from the Profit and Loss Account
and Balance Sheet of Zed Ltd. relating to the year 2012-13. Prepare the Balance
Sheet.
Particulars Rs.
Fixed Assets (net, after writing off 30% ) 10,50,000
Fixed Assets Turnover Ratio (Cost of sales basis) 2
Finished Goods Turnover Ratio 6
Rate of Gross Profit to Sales 25%
Net Profit ( before interest) to sales 16%
Fixed charges cover (Debenture Interest 14%) 8
Debt Collection period 1–½
months
Materials consumed to sales 30%
Stock of raw materials (in terms of number of months 3
consumption)
Current Ratio 2.4
Quick ratio 1.0
Reserves to Capital 0.21
9. From the following information and ratios, prepare the Profit & loss A/c and
Balance Sheet of M/s Sivaprakasam & Co., an export company [Take 1 year =
360 days]
Current Assets to Stock - 3 : 2
Current Ratio - 3.00 Fixed Asset to Turnover Ratio - 1.20
Acid Test Ratio - 1.00 Total liabilities to Net Worth - 2.75
Financial Leverage - 2.20 Net Working Capital - Rs. 10 Lakhs
Earnings per share (each of Rs. 10) Net Profit to Sales - 10 %
- Rs. 10.00
Book Value per share - Rs. 40.00 Variable Cost - 60%
Average Collection Period - 30 days Long Term Loan Interest - 12%
Stock Turnover - 5.00 (based on sales Taxation – Nil
10. From the following information, prepare the projected Trading and Profit and
Loss Account for the next financial year ending March 31, 2013 and the
projected Balance Sheet as on that date
Particulars Rs.
Gross Profit Ratio 25%
Net Profit to Equity Capital 10%
Stock Turnover Ratio 5 Times
Average Debt Collection Period 2 months
Creditors Velocity 3 months
Current Ratio 2
Proprietary Ratio (Fixed Assets to Capital Employed) 80%
Capital Gearing Ratio (Preference Share And Debentures to 30%
Capital Employed)
General Reserve and Profit & Loss to Equity Share Capital) 25%
Preference Share Capital to Debentures 2
Cost of Sales consists of 40% for materials and balance for Wages and
Overheads. Gross Profit Rs. 6,00,000. Working notes should be clearly shown.
HOME ASSIGNMENT
11. From the following annual statements of Sudharshan Ltd. calculate the
following ratio: (a) GP Ratio; (b) Operating Profit Ratio; (c) Net Profit Ratio; (d)
Current Ratio; (e) Liquid Ratio; (f) Debt Equity Ratio; (g) Return on Investment
Ratio; (h) Debtors Turnover Ratio; (i) Fixed Assets Turnover Ratio.
Trading and Profit and Loss Account for the year ended 31st
March, 2013
Particulars Amount Particulars Amou
nt
To materials consumed: By Sales 85000
Opening stock 9050 By profit on sale of 600
investment
Purchases 54525 By interest on investment 300
Closing stock 49575
(14000)
To Carriage inwards 1425
To office expenses 15000
To sales expenses 3000
To Financial expenses 1500
To loss on sale of assets 400
To net profit 15000
Total 85900 85900
Balance Sheet as at 31st March, 2013

Liabilities Amount Assets Amou
nt
Share Capital : 2000 equity 20000 Building 15000
Shares of Rs. 10 each fully
paid up
Reserves 3000 Plant 8000
Profit & Loss Account 6000 Current Assets:
Secured Loans 6000 Stock In Trade 14000
Bank overdraft 3000 Debtors 7000
Sundry creditors Bills Receivable 1000
For expenses 2000 Bank Balances 3000
For others 8000

Total 48000 48000
12. The Balance Sheet of Star Ltd. as at 31 st March, 2013 is given below:
Liabilities Amount Assets Amount

Equity Shares Capital 6,00,000 Plant & Machinery 4,50,000
Reserves 1,80,000 Furniture 50,000
Creditors 1,20,000 Stock 1,80,000
Debtors 1,20,000
Cash at bank 1,00,00
Total 9,00,000 Total 9,00,000
The other details are as follows:

1. Total sales during the year have been Rs. 10,00,000 out of which cash sales
amounted to Rs. 2,00,000.
2. The Gross Profit has been earned @ 20%
3. Amounts as on 1.4.2012
Debtors Rs. 80,000
Stock Rs. 1,40,000
Creditors Rs. 30,000
4. Cash paid to creditors during the year Rs. 2,10,000.
You are required to calculate the following ratios:

[a] Debtors Turnover Ratio; [b] Creditors Turnover Ratio; [c] Stock Turnover
Ratio.
13. Following are the ratios relating to the trading activities of an organisation:
Debtors' Velocity 3 months
Stock Velocity 6 months
Creditors' Velocity 2 months
Gross Profit Ratio 20%
Gross Profit for the year ended 31st March, 2013 was Rs. 5,00,000. Stock as on
31st March, 2013 Rs. 20,000 more than it was on 1st April, 2012, Bills payable
and Bills Receivable were Rs. 36,667 and Rs. 60,000 respectively.
You are to ascertain the figures of :
[1] Sales [2] Debtors [3] Creditors; and [4] Stock
14. Using the following data, complete the Balance sheet of X Limited:
(a) Gross Profit Rs. 54,000
(b) Gross Profit ratio 20%
(c) Shareholders fund Rs. 6,00,000
(d) Credit sales to total sales 80%.
(e) Total asset turnover 0.3 time
(f) Inventory turnover 4 time
(g) Average collection period = 20 days, assume 360 days in a year
(h) Long term debt of equity 40%
(i) Current Ratio = 1.8
Balance Sheet of X Ltd

Sundry Creditors Cash
Long term debt Sundry Debtors
Shareholder fund Inventory
Fixed assets
15. With the help of the following information complete the Balance sheet of
MNOP Ltd.
Particulars Amount
Equity Share Capital 100000
The relevant ratio of the company are as follows:
Current Debt to Total debt 0.40
Total Debt to Owner Equity 0.60
Fixed assets to Owner Equity 0.60
Total assets turnover 2 times
Inventory turnover 8 times
16. From the following information, relating to a limited company, prepare Balance
sheet:
1) Current Ratio 2
2) Liquid Ratio 1.5
3) Fixed Assets / Proprietary Fund 3/4
4) Working Capital Rs. 75,000
5) Reserves and Surplus Rs. 50,000
6) Bank Overdraft Rs. 10,000
There were no long-term loans or fictitious assets.
17. Based on the following information, prepare the Balance Sheet of Star
Enterprises as at 31st December.
Current Ratio - 2.5 Cost of Goods sold to Net Fixed Assets - 2
Liquidity Ratio - 1.5 Average Debt Collection Period - 2.4
months
Net working capital - Rs 6 lakhs Fixed Assets to Net worth - 0.80
Stock Turnover Ratio - 5 Long term Debt to Capital and Reserves - 7
/25
Gross Profit to Sales - 20%
18. From the following information relating to wise Ltd. prepare is summarized
Balance Sheet.
Current Ratio - 2.5 Sales / Debtors - 6.0
Acid Test Ratio - 1.5 Reserves / Capital Ratio - 1.0
Gross Profit to Sales Ratio - 0.2 Net worth / Long term Loan Ratio –
20.0
Net Working capital to Net Worth Ratio – 0.3 Stock Velocity - 2
months
Sales / Net Fixed Assets Ratio - 2.0 Paid up Share Capital - Rs. 10
Lakhs
Sales / Net Worth Ratio - 1.5
19. From the following information, prepare the balance sheet of XYZ Co. Ltd.,
showing the details of working :-
Particulars Amount
Paid up capital Rs. 50,000
Plant and Machinery Rs. 1,25,000
Total sales annual Rs. 5,00,000
Gross Profit Margin 25%
Annual Credit Sales 80% net
sales
Current ratio 2
Inventory turnover 4
Fixed assets turnover 2
Sales return 20% of sales
Average collection period 73 days
Bank credit to trade credit 2
Cash to inventory 1 : 15
Total debt to current liabilities 3
20. The following accounting information and financial ratios of XYZ Ltd. relate to
the year ended 31.03.2013:
i. Accounting Information:
Particulars
Gross profit 15% of Sales
Net profit 8% of Sales
Raw Material consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw material 3 months usuage
Stock of finished goods 6% of works cost
Debt collection period 60 days
all sales are on credit
ii. Ratios:
Particulars
Fixed assets to Sales 1:3
Fixed Assets to current assets 13: 11

Current Ratio 2
Long term loan to current liabilities 2:1
Capital to reserves and surplus 1:4
If value of fixed assets as on 31.03.2013 amounted to Rs. 26 lakhs, prepare a
summarized profit & loss account of the company for the year ended 31.3.2013
and balance sheet as at 31.3.2013.
21. The following data relates to a company as at 31st March 2013 :
Particulars Amount
Current ratio 1.75
Quick ratio 1.25
Stock turnover ratio (Closing Stock) 6 times
G. P. Ratio 20%
Reserve to Capital Ratio 0.6
Debtors collection period 2 months
Fixed assets turnover ratio (on cost of goods 1.2
sold
Capital gearing ratio 0.625
Fixed assets to net worth 1.25
Sales for the year Rs. 15 lakh
You are required to prepare balance sheet as on 31st March, 2013.
ANSWER
1. (a) 7.91 (b) 2.98, 1.22 (c) 2.86%, 12.86% (d) 1.43%, 19.63% (e) 22
2. 50,000, 1,50,000, 30,000, 1,10,000.
3. Balance Sheet Total Rs. 660000.
4. B/s Total Rs. 15,00,000
5. (i) 1.1 (ii) 3.5 (iii) 0.6 (d) 4.075 (e) 3.926
6. Net Profit Rs. 30000, B/s Total 380000.
7. Net Profit Rs. 65000; G.P. Rs. 180000; B/s Total Rs. 1000000;
8. B/S Total Rs. 2010000
9. B/s Total Rs. 75 Lakhs
10. Net Profit Rs. 1,06,400; Balance Sheet Total Rs. 22,80,000
11. (a) 40% (b) 18.82% (c) 17.65% (d) 1.92 (e) 0.84 (f) 0.21 (g) 45.71% (h) 10.625 (i)
3.69
12. (i) 8 times; (ii) 4 times; (iii) 5 times
13. 2500000, 565000, 300000, 1010000
14. Total of Balance Sheet Rs. 9,00,000.
15. Balance sheet total Rs. 160000
16. Balance sheet total Rs. 3,75,000
17. B/s Total Rs. 20 Lakh
18. B/s Total Rs. 25 Lakh
19. B/S Total Rs. 3,44,000
20. Net Profit Rs. 6,24,000; B/s Total Rs. 48,00,000.
21. Total of B/s Rs. 1700000
22. (i) 17.32%, 17.69%, 19.23% (ii) 5.508, 3.978, 0.663 (iii) 1.73, 1.50, 1.00
------
Chapter 5: Capital Budgeting
Methods of Capital Budgeting

(1) PAYBACK PERIOD
(a) Annual cash inflow is equal = Cash outflow / Annual cash inflow
(b) Annual cash inflow is not equal = In such case, annual cash inflow are cumulated and
then a period is find out at which total cash inflow equals to cash Outflow.
(2) DISCOUNTED PAY BACK PERIOD

It is calculated same as payback period. It is calculated using present value of cash inflow
instead of-cash inflow.
(3) ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF RETURN

ARR = Average annual net profit / Average Investment x 100
Average Investment = Initial investment + Terminal value / 2
(4) NET PRESENT VALUE

NPV = Present value of cash inflow - Present value of cash outflow
(5) PROFITABILITY INDEX

Profitability Index = P.V. of Cash Inflow / P.V. of cash outflow
(6) INTERNAL RATE OF RETURN

Cash inflow are discounted by different discount rate. Rate at which present value of
inflow is equal to present value of outflow is IRR. It is trial and error approach. If IRR is
between the two rate, following formula may be used for IRR calculation:
P. V of low rate - Cash Outflow

Low Rate + x Difference of low and high rate
P. V of low rate - v P. V of high rate
NOTE:
1. Cash outflow = Investment in fixed assets + Investment in working capital
2. Annual cash inflow except last year = Cash profit
Cash profit = Net profit after tax + depreciation
3. Cash inflow last year = Cash profit + Terminal value
Terminal Value = Salvage value of fixed assets + Working capital
CONFLICT BETWEEN NPV AND IRR RANKING

1. Time difference:
Short term project have higher IRR whereas Long term project have higher NPV.
2. Size difference:
Project uses high investment have high NPV and project uses low investment have
high IRR.
3. Reinvestment rate assumption:
In IRR; it is assumed that intermediate cash inflow in a project is reinvested at IRR
itself whereas in NPV it is assumed that intermediate cash inflow is reinvested at the
rate of cost of capital. Pattern of cash inflow of two project are different.
SELECTION CRITERION IN CASE OF CONFLICT BETWEEN NPV AND IRR
IRR measures only the quality of the investment while NPV takes into account both quality
and the scale. This is because the IRR provide a relative measure of value while NPV
provides an absolute measure. lf the objective is to maximise the firms wealth, then NPV
provides the correct measure. If the objective is to maximise the rate of profitability per unit
of capital invested, then IRR would provide the correct ranking of project. The objective of
financial management is to maximise the wealth of the firm. So the NPV method is superior
than method. In case of conflict, Annual NPV is calculated. Project which have high annual
NPV is selected. Annual NPV is calculated as follows: Annual NPV = NPV / Cumulative PV
factor
CAPITAL RATIONING
(A) When Projects are divisible

1. Calculate profitability index
2. Rank the project asper profitability index
3. Invest available fund as per rank given.
(B) When Projects are not divisible

1. Prepare possible combination of projects out of available fund
2. Calculate total NPV of all possible combination of project
3. Select the combination which have high net present value.
If no information given in question whether projects are divisible or not, then it is assumed
that projects are indivisible
CAPITAL BUDGETING DECISION OF NEW PROJECT
Net present value is calculated. If NPV is positive or zero then project is accepted. If NPV is
negative then project is rejected.
CASH OUTFLOW
Cost of fixed assets xxx
Add: Working Capital xxx
Less: Subsidy if received xxx
-----
xxx
-----
Note:
1. If there is further investment in fixed assets and working capital during the life of the
project, its present value should be added in P.V. of cash outflow.
2. If any fixed assets which is proposed to be used in project, already owned by the
company should not be considered.
3. If any market research is conducted during evaluation of the project, it is not
considered.
ANNUAL CASH INFLOW EXCEPT LAST YEAR
Sales xxx
Less: Variable and Fixed Expenses xxx
Less: Depreciation xxx
Less: Income tax xxx
----
Xxx
Add: Depreciation xxx
-----
Annual cash inflow / annual cash profit xxx
-----
Note:
1. Allocated expenses should not be considered.
2. If any owned fixed assets is used in the project and such fixed assets is presently
generating annual income, then such annual income will be annual expenses for the
project.
3. If Profit before tax is negative
a. If company have other income: Tax benefit should be taken (tax in negative)
b. If company have no any other income: Provision of Carry forward of is applicable
4. Only those expenses and benefits which arise due to investment decision should be
taken in to decision making. Any expenses or 'income which remain same, should
not be considered
CASH INFLOW LAST YEAR
Cash profit of last year + Terminal value

Terminal value = Salvage value of fixed assets
(+) Realizable value of working capital
(+) Loss on sale of fixed assets x tax rate
(-) Profit on sale of fixed assets x tax rate
Note:
1. Realizable value of working capital is taken 100% if nothing given in question.
2. Loss/Profit on sale of fixed assets arise only when depreciation is calculated on
percentage basis
3. Salvage value of fixed assets is taken zero if no information given.
CAPITAL BUDGETING DECISION IN PLANT REPLACEMENT
NPY is to be calculated. If NPY is positive or zero, plant is replaced. If NPY is negative, plant is
not replaced;
CASH OUTFLOW
Cost of new plant xxx

Add: Additional working capital xxx
Less: Sale value of old plant (xxx)
Add: Capital gain on sale of old plant x Tax rate xxx
Less: Capital loss on sale of old plant x tax rate (xxx)
------
Xxx
------
ANNUAL CASH INFLOW EXCEPT LAST YEAR
increase in profit excluding depreciation xxx

Less: Additional depreciation (xxx)
-----
Xxx
Less: Income tax (xxx)
Add : Additional depreciation xxx
-----
Cash inflow each year xxx
-----
Note:
1. If PBT is negative, tax benefit should be taken
2. Allocated expenses should not be taken
CASH INFLOW LAST YEAR

Annual Cash inflow as calculated above + Terminal value
Terminal value: Salvage value of new plant xxx
(-) Salvage value of old plant (xxx)
(+) Additional working capital xxx
(+) Loss on sale of fixed assets x tax rate xxx
(-) Profit on sale of fixed assets x tax rate (xxx)
Note:
1. Salvage value of plant is taken nil if not given
2. Loss/Profit on sale of fixed assets arise only when depreciation is calculated on
percentage basis.
SELECTION OF PLANT
Equivalent annual cash outflow is to be calculated. Plant which have low equivalent annual
cash outflow should be selected.
Equivalent annual cash outflow:
Cost of assets/Cumulative PV factor xxx

(+) Annual running cost xxx
(-) Annual tax benefit (xxx)
(Annual depreciation + Annual running cost) x Tax rate
(-) Annual salvage value (xxx)
(Salvage value x PV factor of last year/Cumulative PV factor)
------
Xxx
------
CLASS ASSIGNMENT
DIFFERENT METHODS OF CAPITAL BUDGETING
1. A company is considering two Project X and Y. Following details are made available:
(Rs. In Lakhs)
Particulars Project X Project Y
Rs. Rs.
Project Cost 700 700
Cash inflows:
1 year 100 500
2 year 200 400
3 year 300 200
4 year 450 100
5 year 600 100
Total 1650 1300
Assume no residual value at the end of the fifth year. The firm's Cost of Capital is 10%.
Required in respect of each of the two Projects:
(i) Net Present Value using 10% discounting.
(ii) Internal rate of return (iii) Profitability Index.
2. The Management of a Company has two alternative proposal under consideration.

Proposal A require a capital outlay of Rs.12,00,000 and project B require Rs. 18,00,000.
Both are estimated to provide a cash flow for five years: Project A Rs. 4,00,000 per year
and Project B Rs. 5,80,000 per year. The cost of capital is 10%.
Show which of the proposal is preferable from the view point of (i) Net present value
(ii) Present value index (iii) IRR Method.
The present value factor of Rs. 1 of 10%, 18% and 20% to be received annually for 5
years being 3.791, 3.127, and 2.991 respectively.
3. Pioneer Steels Ltd., is considering two mutually exclusive projects. Both require an
initial cash outlay of Rs. 10,000 each and have a life of five years, The company's
required rate of return is 10% and pays tax at a 50% rate. The projects will be
depreciated on a straight line basis. The profit before depreciation expected to be
generated by the projects are as follows:
Year 1 2 3 4 5
Project 1 4,000 4,000 4,000 4,000 4,000
Project 2 6,000 3,000 2,000 5,000 5,000
You are required to calculate:

a. The pay back of each project.
b. Average rate of return.
c. Net present value and Profitability index
d. IRR
4. A company is considering a proposal of installing a drying equipment. The equipment

would involve a cash outlays of Rs. 6,00,000 and net working capital of Rs. 80,000. The
expected life of the project is 5 years without any salvage value. Assume that the
company is allowed to charge depreciation on straight line basis for income tax
purpose. The estimated before tax cash flows are given below:
Before tax cash in flow (Rs. ‘000)

Year 1 2 3 4 5
240 275 210 180 160
The applicable income tax rate to the company is 35%. If the company opportunity cost
of capital is 12%, calculate the equipment's discounted payback period, payback period,
net present value and internal rate of return.
5. Gama & Co. wants to replace its old machine with a new automatic machine. Two
models A and B are available at the same cost of Rs. 5,00,000 each. Salvage value of the
old machine is Rs. 1,00,000. The utilities of the existing machine can be used if the
company selects A. Additional cost of utilities to be purchased in that case are Rs.
1,00,000. If the company purchases B then all the existing utilities will have to be
replaced with new utilities costing Rs. 2,00,000. The salvage value of the old utilities will
be Rs. 20,000. The cash flows are expected to be:
Year A B
1 1,00,000 2,00,000
2 1,50,000 2,10,000
3 1,80,000 1,80,000
4 2,00,000 1,70,000
5 1,70,000 40,000
Salvage value at the end of year 5 50,000 60,000
The targeted return on capital is 15%. You are required to

(i) Compute, for the two machines separately, Net Present Value, Discounted
Payback Period and desirability factor and
(ii) Advise which of the machines is to be selected.
6. The cash flows of two mutually exclusive Projects are as under:

t0 t1 t2 t3 t4 t5 t6
Project “P” Rs. 40,000 13,000 8,000 14,000 12,000 11,000 15,000
Project “J” Rs. 20,000 7,000 13,000 12,000
Required:
(i) Estimate the net present value (NPV) of the Project "P" and "J" using 15% as the
hurdle rate.
Estimate the internal rate of return (IRR) of the Project "P" and “J".
(ii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iii) Which criteria you will use in such a situation? Estimate the value at that
criterion.
Make a project choice.
7. A Company wants to invest in a machinery that would cost Rs. 50,000 at the beginning
of the year 1. It is estimated that the net cash inflow from operations will be Rs. 18,000
per annum for 3 years, if the company opt to service a part of the machine at the end of
the year 1 at Rs. 10,000 and the scrap value at the end of the year3 will be Rs. 12,500.
However, of the company decides not to service the part, it will have to replaced at the
end of the year 2 at Rs. 15,400. But in this case, the machine will work for the 4th year
also and get operational cash inflow of Rs. 18, 000 for the 4th year. It will have to be
scrapped at the end of year 4 at Rs. 9,000. Assuming cost of capital at 10% and ignoring
tax, will you recommend the purchase of this machine based on the net present value
of its cash flow?
If the supplier gives a discount of Rs. 5,000 for purchase, what would be your decision?
8. Following are the data on a capital project being evaluated by the management of X
Ltd.
Particulars Project M
Annual cost saving 40,000
Useful life 4 years
I.RR. 15%
Profitability index (PI) 1.064
NPV ?
Cost of Capital ?
Cost of project ?
Payback ?
Salvage value 0
Find the missing value
Given the following cumulative pv factor:
Discount factor Cum. Pvf
15% 2.855
14% 2.913
13% 2.974
12% 3.038
CAPITAL RATIONING
9. XYZ Ltd. has the following proposals:

Project Cost Rs. Net Present Value Rs.
A 1,00,000 20,000
B 3,00,000 35,000
C 50,000 16,000
D 2,00,000 25,000
E 1,00,000 30,000
Total funds available are Rs. 3,00,000. Determine the optimal combination of projects
assuming that: (i) the projects are divisible, and (ii) if the projects are not divisible.
10. S Ltd. has Rs. 10,00,000 allocated for capital budgeting purposes. The following
proposal and associated profitability indexes have been determined
Project Amount 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 undertaking? Assume that projects are
indivisible and there is no alternative use of the money allocated for capital.
11. Alpha Limited is considering five capital projects. The company is financed by equity
and its cost of capital 12%. The expected cash flows of the projects are as follows:
(Figures in ‘000)
Project Year 0 Year 1 Year 2 Year 3
A -70 35 35 20
B -40 -30 45 55
C -50 -60 70 80
D -- -90 55 65
E -60 20 40 50
All project are divisible i.e., size of investment can be reduced, if necessary in relation
to available of funds. None of the projects can be delayed or undertaken more than
once.
Calculating which projects Alpha Limited should undertake if the capital funds available
for investment are limited to Rs. 1,10,000 in current year and with no limitation in
subsequent years. PVF up to two decimal.
NEW PROJECT
12. A company is engaged in evaluating an investment project which requires an initial cash
outlay of Rs. 2,50,000 on equipment. The project's economic life is 10 years and its
salvage value Rs. 30,000. It would require current assets of Rs. 50,000. An additional
investment of Rs. 60,000 would also be necessary at the end of five years to restore the
efficiency of the equipment. This would be written off completely over the last five
years. The project is expected to yield annual profit (before Dep.) of Rs. 1,00,000.
Income tax rate is assumed to be 40%. Should the project be accepted if the minimum
required rate of return is 20%. Follow Sum of digits depreciation method.
13. ABC Ltd. manufactures toys and other gift items. The research and development
department has come up with an item that would make a good promotional gift for
office equipment dealers. As a result of efforts by the sales personnel, the firm has
commitments for this product.
To produce the quantity. demanded, ABC Ltd. will need to buy additional machinery
and rent additional space. It appears that about 25,000 square feet will be needed;
12,500 square feet of presently unused space, but leased at the rate of Rs. 3 per square
foot per year, is available. There is another 12,500 square feet available at the annual
rent of Rs. 4 per square foot.
The equipment will be purchased for Rs. 9,00,000. It will require Rs. 30,000 in
modifications, Rs. 60,000 for installation and Rs. 90,000 for resting. The equipment will
have a salvage value of about Rs. 1,80,000 at the end of the third year. No additional
general overhead costs are expected to be incurred.
The estimated revenues and costs for the this product are as follows:-
Particulars Year 1 Rs. Year 2 Rs. Year 3 Rs.

Sales 10,00,000 20,00,000 8,00,000
Mat., Lab., & O/H 4,00,000 7,50,000 3,50,000
Overheads Allocated 40,000 75,000 35,000
Rent 50,000 50,000 50,000
Depreciation 3,00,000 3,00,000 3,00,000
Earnings before taxes 2,10,000 8,25,000 65,000
Taxes 1,05,000 4,12,500 32,500
Earnings after taxes 1,05,000 4,12,500 32,500
If the required of return of 20% after taxes, should project be accepted?
14. A hospital is considering to purchase a diagnostic machine costing Rs. 80,000. The
projected life of the machine is 8 years and has an expected salvage value of Rs. 6,000
at the end of 8 years. The annual operating cost of the machine is Rs. 7,500. It is
expected to generate revenue of Rs. 40,000 per year for eight years. Presently, the
hospital is outsourcing the diagnostic work and is earning commission is Rs. 12,000 per
annum net of tax.
Required:
Whether it would be profitable for the hospital to purchase the machine. Tax rate is
30%. Give your recommendation under:
(i) Net Present value method at 10% discounting rate
(ii) Profitability Index method at 10% discounting rate
15. Sagar industries, is planning to introduce a new product with a projected life of 8 years.
The project, to be set up in a backward region, qualifies for a one-time (as its starting)
tax-free subsidy from the government of Rs. 20 lakhs. Initial equipment cost will be Rs.
140 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning
of the third year. At the end of 8 years the original equipment will have no resale value,
but the supplementary equipment can be sold for Rs.1 lakh. A working capital of Rs. 15
lakhs will be needed. The sales volume over the eight year period have been forecasted
as follows.
Years Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of
sales revenue. Fixed cash operating costs will amount to Rs. 16 lakhs per year. In
addition, an extensive advertising campaign will be implemented, requiring annual
outlays as follows:
Years (Rs. In Lakhs)
1 30
2 15
3-5 10
6-8 4
The company subject to 50% tax rate and considers 12% to be an appropriate after-tax
cost of capital for this project. The company follows the straight line method of
depreciation.
Should the project be accepted?
16. Techtronics Ltd is considering a new project for manufacture of pocket Video games
involving a capital expenditure of Rs. 600 lakh and working capital of Rs.150 lakh. The
capacity of the plant is for an annual production of 12.lakh units and capacity utilization
during the 6 years working life of the project is expected to be as indicated below:
Years Capacity utilisation (per cent)
1 33.33
2 66.67
3 90
4-6 100
The average price per unit of the product is expected to be Rs. 200 netting a
contribution of 40 per cent. The annual fixed costs, excluding depreciation, are
estimated to be Rs. 480 lakh per annum from the third year onwards: for the first and
second year, it would be Rs. 240 lakh and Rs. 360 lakh respectively. The average rate of
depreciation for tax purposes is 33.33 per cent written down value method. The rate of
income tax may be taken at 35 per cent. Cost of capital is 15 %.
At the end of the third year, an additional investment of Rs.100 lakh would be required
for working capital.
Terminal value for the fixed assets may be taken at 10 per cent and for the current
assets at 100 per cent. Assume that co. have other income. Calculation in round of
lakhs.
17. SCL Limited, a highly profitable company, is engaged in the manufacturing of power
intensive products. As part of its diversification plans, the company proposes to put up
a Windmill to generate electricity. The details of the scheme are as follows:
1. Cost of Windmill Rs. 300 lacs
2. Cost of land Rs. 15 lacs
3. Subsidy from Government to be received at the end of first year Rs. 15 lacs
4. Cost of electricity will be Rs. 2.25 per unit in year 1. This will increase by Rs. 0.25 per
unit every year till year 7. After that it will increase by Rs. 0.50 per unit every year.
5. Maintenance cost will be Rs. 4 lacs in year 1 and the same will increase by Rs. 2 lacs
every year.
6. Estimated life 10 years.
7. Cost of Capital 15%.
8. Residual value of Windmill will be nil. However, land value will go up to Rs. 60 lacs,
at the end of year 10.
9. Depreciation will be 100% of the cost of the Windmill in year 1 and the same will be
allowed for tax purposes.
10. As Windmill is expected to work based on wind velocity, the efficiency. is expected
to be an average 30%. Gross electricity generated at this level will be 25 lacs units
per annum, 4% of this electricity generated will be committed free to the State
Electricity Board as per the agreement.
From the above information you are required to calculate the Net Present Value.
(Ignore tax on capital profits). Tax rate is 50%
For your exercise, use the following discount factor for year 1 to 10 :-
0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
18. A Ltd. acquired new machinery for `1,00,000 depreciable at 20% as per WDV method.
The machine has an expected life of 5 years with salvage value of `10,000. What would
be the treatment of Depreciation/ Short Term Capital Loss in the 5th year in the
following two cases:
Case 1 : There is no other asset in the Block;
Case 2 : More than one asset exists in the Block:
PLANT REPLACEMENT DECISION
19. P. Ltd. has a machine having an additional life of 5 years which costs Rs. 10,00,000 and
has a book value of Rs. 4,00,000. A new machine costing Rs. 20,00,000 is available.
Though its capacity is the same as that of the old machine, it will mean a saving in
variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5
years at the end of which it will have a scrap value of Rs. 3,00,000. The rate of income-
tax is 40% and P ltd.'s policy is not to make an investment if the yield is less than 12%
per annum. The old machine, if sold today, will realize Rs. 1,00,000; it will have no
salvage value if sold at the end of 5th year. Advise P. ltd. whether or not the old
machine should be replaced.
20. WX Ltd. has a machine which has been in operations for 3 years; its remaining
estimated useful is 8 years, with no salvage value at the end. Its current market value is
Rs. 2,00,000. The management is considering a proposal to purchase as improved
model of a machine, which gives increased output. The relevant particulars are as
follows:
Particulars Existing Machine New Machine
Purchaser Price Rs. 3,30,000 Rs. 10,00,000
Estimated life 11 year 8 year
Salvage value -- 40,000
Annual operating hours 3,000 3,000
Selling price per unit Rs. 15 Rs. 15
Output per annum 30,000 units 75,000 units
Material cost per unit Rs. 4 Rs. 4
Labour cost per hour Rs. 40 Rs. 70
Indirect cash cost per annum 50,000 65,000
The company follows the straight-line method of depreciation and is subject to 30% tax
should the existing machine be replaced? Assume that the company's required to rate
of return is 12%. Present value of annuity of Rs. 1 at 12% rate of discount for 8 years is
4.968, and for 8th year is 0.404. Ignore capital gain tax.
EQUIVALENT ANNUAL CASH OUTFLOW
21. Company UVW has to make a choice between two identical machine, in terms of
capacity, 'A' and 'B'. They have been designed differently, but do exactly the same job.
Machine 'A' cost Rs. 7,50,000 and will last for three years. It cost Rs. 2,00,000 per year
to run.
Machine 'B' is an economy model costing only Rs. 5,00,000 but will last for only two
years. It costs Rs. 3,00,000 per year to run.
The cash flow of Machine 'A' and 'B' are real cash flows. The costs are forecasted in
Rupees of, constant purchasing power. Ignore taxes. The opportunity cost of capital is
9%.
Required: Which machine the company UVW should buy?
22. Company X is forced to choose between two machine A and B. The two machines are
designed differently, but have identical capacity and do exactly the same job. Machine
A costs Rs. 1,50,000 and will last for 5 years and salvage value Rs. 30,000. It costs
Rs.40,000 per year to run. Machine is an ‘economy’ model costing only Rs. 1,00,000,
but will last only for 4 years , and Rs. 20,000 will be salvage value. It costs Rs. 60,000 per
year to run. These are real cash flows. Income tax rate is 50%. Opportunity cost of
capital is 10 percent. Which machine company X should buy?
23. D Ltd. is foreseeing a growth rate of 12% per annum in the next two years. The growth
rate is likely to be 10% for the third and fourth year. After that the growth rate is
expected to stabilize at 8% per annum. If the last dividend was Rs. 1.5 per share and the
investor required rate of return is 16%, determine the current value of equity share of
the company. (May, 2005)
Risk Analysis in Capital Budgeting
Coefficient of Variation
The Coefficient of Variation calculates the risk borne for every percent of expected return.
Hence management selects the project which has lower Coefficient of Variation.
Coefficient of Variation = Standard deviation / expected cash flows
Risk Adjusted Discount Rate
The concept that investors demands higher returns from the risky projects.
If the project is riskier than similar kind of project, discount rate is increased in order to
compensate the additional risk borne by the investors.
Advantages of Risk-adjusted discount rate
1. It is easy to understand.
2. It incorporates risk premium in the discounting factor.
Limitations of Risk-adjusted discount rate
1. Difficulty in finding risk premium and risk-adjusted discount rate.
2. Assumption that investors are risk averse is always not true.
Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new
venture is identical to the one being evaluated here and the project is to be financed by the
same method on the same terms. The effect on the company’s cost of capital of introducing
debt into the capital structure cannot be ignored.
Certainty Equivalent (CE) Method
It is a guaranteed return that the management would accept rather than accepting a higher
but uncertain return. In this approach a set of risk less cash flow is generated in place of the
original cash flows.
Steps to compute
1. Multiply the cash flows with certainty coefficient factor;
2. Discount the cash flow with RISK FREE rate; (as risk is already adjusted by the CE);
3. Compute NPV or IRR as usual;
Advantages of Certainty Equivalent Method
1. simple and easy to understand and apply.
2. It can easily be calculated for different risk levels applicable to different cash flows.
Disadvantages of Certainty Equivalent Method
1. There is no Statistical or Mathematical model available to estimate certainty

Equivalent. Assumption of risk being subjective, it varies on the perception of the risk
by the management because of bias and individual opinions involved.
2. Certainty equivalents are decided by the management based on their perception of
risk. However the risk perception of the shareholders who are the money lenders for
the project is ignored. Hence it is not used often in corporate decision making.
Sensitivity Analysis
This is used to study the impact of changes in the variables on the outcome of the project. In
a Project, several variables like Weighted average cost of capital, consumer demand, price
of the product, cost price per unit etc. operate simultaneously. The changes in these
variables impact the outcome of the project. It therefore becomes very difficult to assess
change in which variable impacts the project outcome in a significant way.
In Sensitivity Analysis, the project outcome is studied after taking into change in only one
variable. The more sensitive is the NPV, the more critical is that variable. So, Sensitivity
analysis is a way of finding impact in the project’s NPV (or IRR) for a given change in one of
the variables.
Advantages of Sensitivity Analysis:
1. Critical Issues : This analysis identifies critical factors that encroach on a project’s
success or failure.
2. Simplicity : This analysis is quite simple.
Disadvantages of Sensitivity Analysis

1. Assumption of Independence: This analysis assumes that all variables are
independent i.e. they are not related to each other, which is unlikely in real life.
2. Ignore probability: This analysis does not look to the probability of changes in the
variables.
3. Not so reliable: This analysis provides information on the basis of which decisions
can be made but does not point directly to the correct decision.
Scenario analysis
This analysis brings in the probabilities of changes in key variables and also allows us to
change more than one variable at a time. This analysis begins with base case or most likely
set of values for the input variables. Then, go for worst case scenario (low unit sales, low
sale price, high variable cost and so on) and best case scenario.
In nutshell, Scenario analysis examine the risk of investment, so as to analyse the impact of
alternative combinations of variables, on the project’s NPV (or IRR).
Monte Carlo Simulation
Advantages of Simulation Analysis:

1. It provides useful inputs for Sensitivity Analysis by helping to understand variability
in which inputs affects the outcome to the biggest extent.
2. Using this method, a judgment can be made as to the range in which the input lied
under a particular scenario. Thus using the results of Monte Carlo Simulation,
different scenarios can be studied.
3. The results produced by Monte Carlo Simulation also show the associated
probability of the results occurring. Thus it simplifies the decision making process of
the management.
4. Monte Carlo simulation, helps to understand the interdependency between input
variables. Understanding this inter dependability, enables to reduce the complexity
of decision
Limitation of Simulation Analysis
1. Difficult to model the project and specify probability distribution of various variables.
2. Simulation provides only rough approximation of probability distribution of NPV.
3. Simulation model is complex and can be constructed by management expert and not
by the decision maker.
4. Determine NPV in simulation run, risk free discount rate is used which may not give
correct picture.
Decision Tree
Advantages of using decision trees
1. The Decision nodes enable to set out the various options available thus ensuring that
no option is left out to be considered.
2. All the options available can are considered simultaneously thus allowing
comparison.
3. Risk is addressed in an objective manner by use of probabilities.
4. Decision Trees enable the evaluation of the options by considering the Cash
Outflows and the Cash Inflows. Thus it enables to evaluate the different options on
the basis of the Net benefit arising out of that project.
5. Simple to understand and apply.
Limitations of using decision trees
1. Probabilities cannot be calculated objectively.
2. Decision Trees use only that data which can be quantified. It ignores qualitative
aspects of decisions.
3. Assignment of probabilities and expected values do not have any relevant basis as it
pertains to a future outcome which is uncertain.
EXPECTED NET PRESENT VALUE-SINGLE PERIOD

25. Possible net cash flows of Projects A and B and their probabilities are given as below.
Discount rate is 10 per cent for both the project initially investment is Rs. 10,000. Calculate
the expected net present value for each project. Which project is preferable?
Project A Project B
Possible Cash Flow
Probability Cash Flow (Rs.) Probability
Event (Rs.)
A 8,000 0.10 4,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
26. Probabilities for net cash flows for 3 years a project are as follows:
Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
(Rs.) (Rs.) (Rs.)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net cash flows. Also calculate the present value of the expected cash
flow, using 10 per cent discount rate. Initial Investment is Rs. 10,000.
VARIANCE
27. Calculate Variance and Standard Deviation on the basis of figure given in Question 25.
28. Calculate Coefficient of Variation for the following numbers

Project A B
Standard deviation 2,191 4,195
Average/expected return 12,000 16,000
RISK ADJUSTED DISCOUNT RATE
29. An enterprise is investing Rs. 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.
Year Cash flows(Rs. in lakhs)

1 25
2 60
3 75
4 80
5 65
Calculate Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.
CERTAINTY EQUIVALENT (CE) METHOD FOR RISK ANALYSIS

30. If Investment Proposal is Rs. 45,00,000 and risk free rate is 5%, calculate Net present value
under certainty equivalent technique.
Certainty
Year Expected cash flow (Rs.
Equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
SENSITIVITY ANALYSIS
31. X Ltd is considering its New Product with the following details
Sr. No. Particulars Figures
1 Initial capital cost Rs. 400 Cr
2 Annual unit sales Rs. 5 Cr
3 Selling price per unit Rs. 100
4 Variable cost per unit Rs. 50
5 Fixed costs per year Rs. 50 Cr
6 Discount Rate 6%
1. Calculate the NPV of the project (life is 3 years);

2. Find the impact on the project’s NPV of a 2.5 per cent adverse variance in each variable.
Which variable is having maximum effect?
SCENARIO ANALYSIS
32. XYZ Ltd. is considering a project "A" with an initial outlay of Rs. 14,00,000 and the possible
three cash inflow attached with the project as follows :
(Rs.’000)
Particulars Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain
about the most likely result but uncertain about the third year’s cash flow, what will be the
NPV expecting worst scenario in the third year.
MONTE CARLO SIMULATION
33. Annual Net Cash Flow & Life of the project with their probability distribution are as follows:
Annual Cash Flow Project Life
Value (Rs.) Probability Value (Year) Probability
10,000 0.02 3 0.05
15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02
Risk free rate is 10%, and Initial Investment is Rs. 1,30,000.

Various Random Number generated are as follows:
53479 81115 98036 12217 59526
97344 70328 58116 91964 26240
66023 38277 74523 71118 84892
99776 75723 03172 43112 83086
30176 48979 92153 38416 42436
81874 83339 14988 99937 13213
19839 90630 71863 95053 55532
09337 33435 53869 52769 18801
31151 58295 40823 41330 21093
67619 52515 03037 81699 17106
Calculate NPV in each Run.
DECISION TREE ANALYSIS

34. A firm has an investment proposal, requiring an outlay of Rs. 80,000. The investment
proposal is expected to have two years’ economic life with no salvage value. In year 1, there
is a 0.4 probability that cash inflow after tax will be Rs. 50,000 and 0.6 probability that cash
inflow after tax will be Rs. 60,000. The probability assigned to cash inflow after tax for the
year 2 is as follows:
Year Cash Flows (Rs.) Probability Cash Flows (Rs.) Probability
Year-1 Rs. 50,000 0.4 Rs. 60,000 0.6
Year- 2
Rs. 24,000 0.2 Rs. 40,000 0.4
Rs. 32,000 0.3 Rs. 50,000 0.5
Rs. 44,000 0.5 Rs. 60,000 0.1
The firm uses a 10% discount rate for this type of investment.
Required:
(i) Construct a decision tree for the proposed investment project and calculate the
expected Net Present Value (NPV).
(ii) What net present value will the project yield, if worst outcome is realized? What is the
probability of occurrence of this NPV?
(iii) What will be the best outcome and the probability of that occurrence?
(iv) Will the project be accepted?
(Note: 10% discount factor 1 year 0.909; 2years 0.826)
MISCELLANEOUS ILLUSTRATION
35. Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs Rs.36,000
and project B Rs. 30,000. You have been given below the Net Present Value probability
distribution for each project.
Project A Project B
NPV estimates (Rs.) Probability NPV estimates (Rs.) Probability
15,000 0.2 15,000 0.1

12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
i. Compute the expected net present values of projects A and B.

ii. Compute the risk attached to each project i.e. standard deviation of each probability
distribution.
iii. Compute the profitability index of each project.
iv. Which project do you recommend? State with reasons.
Answer
Statement showing computation of expected net present value of Projects A and B:
Project A Project B
NPV Estimate Proba- Expected NPV Proba- Expected
(`) bility Value Estimate bility Value
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9,000 1.0 EV = 9,000
Computation of Standard deviation of each project
Project A
P X (X – EV) P (X- EV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 - 3,000 27,00,000
0.2 3,000 - 6,000 72,00,000
Variance = 1,98,00,000
Standard Deviation of Project A = √1,98,00,000 = Rs.4,450

Project B
P X (X - EV) P (X- EV)2
0.1 15,000 6,000 36,00,000

0.4 12,000 3,000 36,00,000
0.4 6,000 - 3,000 36,00,000
0.1 3,000 - 6,000 36,00,000
Variance = 1,44,00,000
Standard Deviation of Project B = √l,44,00,000 = Rs. 3,795

i. Computation of profitability of each project
Profitability index = Discount cash inflow / Initial outlay
, , ,
In case of Project A: PI = = = 1.25
, ,
, , ,
In case of Project B: PI = = = 1.30
, ,
ii. Measurement of risk is made by the possible variation of outcomes around the
expected value and the decision will be taken in view of the variation in the expected
value where two projects have the same expected value, the decision will be the project
which has smaller variation inexpected value. In the selection of one of the two projects
A and B, Project B is preferable because the possible profit which may occur is subject
to less variation (or dispersion). Much higher risk is lying with project A.
36. From the following details relating to a project, analyse the sensitivity of the project to
changes in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (Rs.) 1,20,000
Annual Cash Inflow (Rs.) 45,000
Project Life (Years) 4
Cost of Capital 10%
To which of the three factors, the project is most sensitive if the variable is adversely
affected by 10%? (Use annuity factors: for 10% - 3.169 and 11% - 3.103)
Answer
Calculation of NPV through Sensitivity Analysis
(Rs.)
PV of cash inflows (Rs. 45,000 x 3.169 ) 1,42,605

Initial Project Cost (1,20,000)
NPV 22,605
Situation NPV Changes in NPV

Base(present) Rs. 22,605
If initial project cost is varied (Rs.1,42,605 - Rs. 1,32,000 ) (Rs. 22,605 - Rs. 10,605) /
adversely by 10% = Rs. 10,605 Rs. 22,605 = (53.08%)
If annual cash inflow is varied [Rs. 40,500(revised cash flow) (Rs. 22,605 - Rs. 8,345) /
adversely by 10% x 3.169) - (Rs. 1,20,000)] = Rs. 22,605 = 63.08%
Rs. 8,345
If cost of capital is varied (Rs. 45,000 x 3.103) – (Rs. 22,605 - Rs. 19,635) /
adversely by 10% i.e. it Rs. 1,20,000 = Rs. 19,635 Rs. 22,605 = 13.14%
becomes 11%
Conclusion: Project is most sensitive to ‘Annual cash inflow’
HOME ASSIGNMENT
DIFFERENT METHODS
1. A Company is considering the replacement of its existing Machine which is obsolete

and unable to meet the rapidly rising demand for its Product. The Company is faced
with two alternatives: to buy Machine X which is similar to the Existing Machine or to
go in for Machine Y which is more expensive and has much greater capacity. The
Cash Flows at the Present level of operation is under the two alternatives are as
under:
Particulars Machine x Machine Y
Rs. Rs.
Cost of Machine 5,00,000 8,00,000
Cash flow (years):
1 -- 2,00,000
2 1,00,000 2,80,000
3 4,00,000 3,20,000
4 2,80,000 3,40,000
5 2,80,000 3,00,000
The Company's Cost of Capital is 10%.
The finance manager tries to appraise the Machine by calculating the following:
(1) Net Present Value; (2) Profitability Index; (3) Pay back Period; (4) Discounted Pay
back Period.
Note: Present Values of Re. 1 at 10% discount rate are as follows:-
Years 0 1 2 3 4 5
P.V 1.00 0.91 0.83 0.75 0.68 0.62
2. Surya Ltd. is purchase a machine. Two proposal are available, each costing Rs.
10,00,000. In comparing the profitability of the machines, a discounting rate of 10% is
to be used and machine is to be written off in five years by straight line method of
depreciation with nil residual value. Cash inflows after tax are expected as follows:
Years Proposal I Proposal II
Rs. Rs.
1 3,20,000 1,05,000
2 4,05,000 3,00,000
3 5,10,000 4,10,000
4 3,00,000 5,90,000
5 2,00,000 4,00,000
Indicate which machine would be profitable using the following methods of ranking
investment proposal.
1. Payback method
2. Net present value method
3. Profitability Index Method
4. Average Rate of Return Method
3. A company is considering an investment proposal to install new milling controls. The

project will cost Rs. 50,000. The facility has a life expectancy of 5 years and no salvage
value. The company tax rate is 55%. The firm uses straight line depreciation. The
estimated profit before Dep. from the proposed investment proposal are as follows:
Year Profit Rs.
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Compute the following:
a. Payback period. (b) Average rate of return. (c) Internal rate of return.
(d) Net present value at 10% discount rate. (e) Profitability index at 10% discount rate.
4. A company is considering the replacement of its existing machine which is obsolete and
unable to meet the rapidly rising demand for its product. The company is faced with
two alternatives: (i) to buy Machine A which is similar to the existing machine or (ii) to
go in for Machine B which is more expensive and has much greater capacity. The cash
flows at the present level of operations under the two alternatives are as follows:
Cash flows (in lacs of Rs.) at the end of year:
Particulars 0 1 2 3 4 5
Machine A 25 -- 5 20 14 14
Machine B 40 10 14 16 17 15
The company's cost of capital is 10%. The finance manager tries to evaluate the
machines by calculating the following:
(1) NPV (2) Profitability Index; (3) Payback period; and (4) Discounted pay back period
At the end of the calculations, however, the finance manager is unable to make up his
mind as to which machine to recommend.
You are required to make these calculation and in the light thereof to advise the
finance manager about the proposed investment.
5. A Company has to make a choice between projects namely A and B. The initial capital
outlay of two project are Rs. 135000 and 240000 respectively for A and B. There will be
no scrap value at the end of the life of both the projects. The opportunity cost of capital
of the company is 16%. The annual incomes are as under:
Years Project A Project B Project C
Rs. Rs. Rs.
1 -- 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476
You are required to calculate for each of the project:
(i) Discounted Pay back Period (ii) Profitability Index (iii) NPY
(Nov 2002)
6. A Company is considering the proposal of taking up a new project which requires an

initial investment of Rs. 400 lakhs on machinery and other assets. The project is
expected to yield the following earning (before depreciation and taxes) over the next
five years:
Years Earning (in Rs Lakh)
1 160
2 160
3 180
4 180
5 150
The cost of raising the additional capital is 12% and assets have to be depreciated at
20% on written down value basis. The scrap value at the end of the five year period
may be taken as zero. Income tax applicable to the company is 50%.
You are required to calculate the net present value of the project and advise the
management to take appropriate decision. Also calculate the Internal rate of return of
the project.
7. C Ltd. is considering investing in a project. The expected original investment in the

project will be Rs. 2,00,000, the life of the project will be 5 years with no salvage value.
The expected PBTduring the life of the project will be as follows:
year 1 2 3 4 5
Rs. 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is
subject to 30% tax rate:
Required:
(i) Calculate payback period and average rate of return
(ii) Calculate NPY and NPY Index if cost of capital is 10%
(iii) Calculate internal rate of return
(May, 2008)
8. PR Engineering Ltd. is considering the purchase of a new machine which will carry out
some operations which are at present performed by manual labour. The following
information related to the two alternative model - 'MX' and 'MY' are available:
Particulars Machine MX Machine MY
Cost of Machine Rs. 8,00,000 Rs. 10,20,000
Expected Life 6 years 6 years
Scrap value Rs. 20,000 Rs. 30,000
Estimated net income before depreciation and tax:

Year Rs. Rs.
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000
Corporate tax rate for this company is 30 percent and Company required rate of return
on investment proposal is 10 percent. Depreciation will be charged on straight line
basis.
You are required to:
(i) Calculate the pay back of each proposal.
(ii) Calculate the net present value of each proposal.
(iii) Which proposal you would recommend and why?
(Nov. 2009)
NEW PROJECT
9. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The
project is to be set up in Special Economic Zone (SEZ) qualifies for one time (at starting)
tax free subsidy from the state Government of Rs. 25,00,000 on capital investment.
Initial equipment cost will be Rs. 1.75 crore. Additional equipment cost Rs. 12,50,000
will be purchased at the end of the third year from the cash inflow of this year. At the
end of the 8 years, the original equipment will have no resale value, but additional
equipment can be sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be
needed and it will be released at the end of the eighth year. The project will be
financed with sufficient amount of equity capital.
The sales volumes over the eight years have been estimated as follows
year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sale price of Rs. 120 per unit is expected and variable expenses will amount to 60% of
sales revenue. Fixed cash operating cost will amount Rs. 18,00,000 per year. The loss of
any year will be set off from the profit of subsequent two year. The company is subject
to 30% tax rate and considered 12% to be an appropriate after tax cost of capital for
this project. The company follows straight line method of depreciation.
Required:
Calculate the net present value of the project and advise the management to take
appropriate decision.
(Nov. 2007)
REPLACEMENT DECISION
10. National Bottling Company is contemplating to replace one of its bottling machines
with a new and more efficient machine. The .old machine has a cost value of Rs. 10
lakhs and a useful life of ten years. The machine was bought five year back. The
company does not expect to realise any return from scrapping the old machine at the
end of ten years but presently if it is sold to another company in the industry, National
Bottling Company would receive Rs. 6 lakhs for it. The new machine has a purchase
price of Rs. 20 lakhs. It has an estimated salvage value of Rs. 2 lakhs and has useful life
of five years. The new machine will have a greater capacity and annual sales are
expected to increase from Rs. 10 lakhs to Rs. 12 lakhs. Operating efficiencies with the
new machine will also produce savings of Rs. 2 lakhs a year. Depreciation is on a
straight line basis over a five year life.
The cost of capital is 8% and a 50% tax-rate is applicable. The present value interest
factor for an annuity for five years, at 8% is 3.993 and present value interest factor at
the end of five years is 0.681. Capital gain is taxable. Should the company replace the
old machine?
11. A company has a machine which has been in operations for 2 years; its remaining
estimated useful is 10 years with no salvage value at the end. Its current market value is
Rs. 1,00,000. The management is considering a proposal to purchase as improved
model of a machine, which gives increased output. The relevant particulars are as
follows:
Particulars Existing Machine New Machine
Purchaser Price Rs. 2,40,000 Rs. 4,00,000
Estimated life 12 year 10 year
Salvage value -- --
Annual operating hours 2,000 2,000
Selling price per unit Rs. 10 Rs. 10
Output per hour 15 units 30 units
Material cost per unit Rs. 2 Rs. 2
Labour cost per hour Rs. 20 Rs. 40
Consumable stores per year 2,000 5,000
Repairs and maintenance per year 9,000 6,000
Working capital 25,000 40,000
The company follows the straight-line method of depreciation and is subject to 50% tax
should the existing machine be replaced? Assume that the company's required to rate
of return is 15% and that the loss on sale of assets is tax deductible.
EQUIVALENT ANNUAL CASH OUTFLOW
12. A company is required to choose between two machines A and B. The two machine are
designed differently, out have identical capacity and do exactly the same job. Machine
A cost Rs. 6,00,000 and will last for 3 years. It cost Rs. 1,20,000 per year to run.
Machine B is an economy model costing Rs. 4,00,000 but will last only for two years,
and cost Rs. 1,80,000 per year to run. These are real cash flows. The cost are forecasted
in Rupees of constant purchasing power. Opportunity cost of capital is 10%. Which
machine company should buy? Ignore tax.
(May 2009)
----
ANSWER
1. NPV Rs.461.35 Lakhs and Rs. 365.50 Lakhs, IRR 27.21% and 37.63%, PI 1.659 and 1.522
2. (i) 3,16,400; 3,98,780 (ii) 1.264; 1.222 (iii) 19.87% ; 18.35%
3. (a)3 -1/3 years, 3-3/7 years ; (b) 20%, 22% (e) NPV Rs.1373, 1767 & PI 1.137, 1.17 (d)
15.24%,16.83%
4. Payback 3.51 year, Discounted payback period 4.76 year, NPV Rs.29, 110, IRR 13.86%.
5. NPV Rs.42580, 18140; DPBP 4.61,4.64 years; PI 1.085., 1.031 (ii) A
6. (i) NPV Rs. 5381, 3814 (ii) IRR 19.73%, 25.20% (iv) Project J
7. NPV (-) 4,938 part service ; Rs.477 part replace. NPV Rs.62 service, Rs. 5477 replace in
case of discount
8. NPV Rs. 7309, Project cost Rs. 114200, Payback 2.855; cost of capital 12
9. (i) C + E + A +1/4 of D. (ii) A + C + E.
10. Project 3, 4 & 5
11. Investment in Project E, Band 1/5 of C
12. NPV Rs. (6,662) – not accepted
13. NPV Rs 61,907
14. (i) NPV Rs. (5,402) (ii) Profitability Index 0.93
15. NPV Rs.141.51 lacs
16. NPV Rs. 272 Lakhs
17. Rs. 8.26 lac
18. Case 1: STL – 30,960; tax benefit: 9,288; Case 2: STL – Tax benefit on dep: 1,858
19. NPV Rs. 2,79,120
20. NPV Rs. 7,06,560
21. Equivalent annual cash outflow of A Rs. 4,96,290 and B Rs. 5,84,236
22. Machine A Eq. Annual cash outflow Rs.42,653 ; Machine B Rs.47,245
23. Rs. 22.43
Home Assignment
1. (1) 2,47,000; 2,71,600 (2) 1.494 ; 1.3395 (3) 3 year; 3 year (4) 3.6 ; 3.6 year
2. (1) 2.54 year; 3.31 year (2) 3,37,520, 3,02,525 (3) 1.34, 1.3 (4) 29.4% ; 32.2%
3. Pay back period 4.33 years; ARR 9%; NPV Rs.- 4647; IRR 6.6% ;. PI is 0.907.
4. (1) 12.40, 13.58; (2) 1.494, 1.339; (3) 3 years, 3 years; (4) 3.614, 3.629 year.
5. (i} Payback 3.61 , 4.19, (ii) Profitability Index 1.43, 1.15 (iii) NPV Rs. 58254, 34812.
6. NPV Rs.0.81 Lakh ; IRR 12.1%
7. (i) 1.91 year, 53.9% (ii) 1,61,198 ; 1.81 (iii) 39.91%.
8. (i) 4.25 years; 3.67 years (ii) 4,807.; 1,12,092 (iii) Machine M
9. NPV 105 lacs
10. NPV Rs. 3890
11. NPV Rs. 2907950
12. Equivalent annual cash outflow machine A Rs. 3,61,273 and Machine B Rs. 4,10,481.
------
Chapter 8. Dividend Decision
These theories will be discussed under two categories
Irrelevance theory: MM approach
Relevance theories: Walter model & Gordon Model
Forms of Dividend
Cash dividend
Stock dividend (Bonus shares)
Advantages of Bonus
To Share holders
No CDT;
Fixed dividend will continue and it can increase further. (excess earnings are paid by way of bonus)
To the Company
Earnings are Invested further;
In case – imposition of lenders on cash dividend;
Limitations
No extra benefit to Share holder – it is just share split;
It is costlier to the company to administrate;
Gordon Model:
As per this model,
Value of the shares is the discounted value of the future dividend payments. It is discounted by an
appropriate risk- adjusted rate.
Intrinsic value = Sum of PV of Future cash flows
Intrinsic value = Sum of PV of Dividends + PV of Stock Sale Price
Advantages
The dividend discount model is a common sense model that relates the present stock price to the
present value of its future cash flows;
This Model is easy to understand.
Ravi Kanth Miriyala Page8. 1

Limitations
It depends on projections about company growth rate and future capitalization rates of the
remaining cash flows, which may be difficult to calculate accurately;
The true intrinsic value of a stock is unknowable;
Walter Model
This formula emphasises two factors which influence the market price of a share.
Dividend Per Share
Relationship between IRR and Ke/Market capitalization rate;
If r > Ke, the share value would be higher even if dividends are lower.
If the r < Ke, share value would be higher only when dividends are higher.
i.e. shareholders would prefer a higher dividend so that they can utilise the funds so obtained
elsewhere in more profitable opportunities.
Advantages of Walter Model
1. The formula is simple to understand and easy to compute.

2. It can explain different possible market prices in different situations and considers IRR, Ke
and dividend payout ratio in the determination of market value of shares.
Limitations of Walter Model
1. The formula does not consider all the factors affecting dividend policy and share prices.
Moreover, determination of market capitalisation rate is difficult.
2. It ignores such factors as taxation, various legal and contractual obligations, management
policy and attitude towards dividend policy and so on.
MM approach
As per this approach, value of the firm remains same- whether the firm pays dividend or not. Market
value of the shares solely on its earning power and is not influenced by its split between dividend
and retained earnings.
Assumptions of this approach
1. Perfect capital markets – all the investors are rational and have full information;
2. No taxes on dividend income and capital gains;
3. The entity has fixed investment policy i.e. it is assumed that all the investments are financed
only through equity (debt is not considered);
4. No flotation or transaction costs;

5. Risk of uncertainty does not exist – i.e. investors are able to forecast future prices and
dividend with certainty and one discount rate is appropriate for all securities and all time
periods.
Linters Model
John Linter based his model on a series of interviews which he conducted with corporate managers
in the mid 1950’s. While developing the model, he considers the following assumptions:
Firm have a long term dividend payout ratio. They maintain a fixed dividend payout over a long
term. Mature companies with stable earnings may have high payouts and growth companies usually
have low payouts.
Managers are more concerned with changes in dividends than the absolute amounts of dividends. A
manager may easily decide to pay a dividend of Rs. 2 per share if last year too it was Rs. 2 but paying
Rs. 3 dividend if last year dividend was Rs.2 is an important financial management decision.
Dividend changes follow changes in long run sustainable earnings.
Managers are reluctant to affect dividend changes that may have to be reversed.
Under Linter’s model, the current year’s dividend is dependent on current year’s earnings and last
year’s dividend.
D₁ = D0 + [(EPS ×Target payout) - D0] × Af
Where
D₁ = Dividend in year 1
D0 = Dividend in year 0 (last year dividend)
EPS = Earnings per share
Af = Adjustment factor
STOCK SPLITS
Stock split means splitting one share into many, say, one share of Rs.500 in to 5 shares of Rs.100.
Stock splits is a tool used by the companies to regulate the prices of shares i.e. if a share price
increases beyond a limit, it may become less tradable, for e.g. suppose a company’s share price
increases from Rs.50 to Rs.1000 over the years, it is possible that it might goes out of range of many
investors.

Gordon Model
Illustration 1
X ltd. is a no growth company, pays a dividend of Rs. 5 per share. If the cost of capital is
10%, what should be the current market price of the share as per Gordon Model?
Illustration 2
XYZ is company having share capital of Rs.10 lakhs of Rs.10 each. It distributed current
dividend of 20% per annum. Annual growth rate in dividend expected is 2%. The expected
rate of return on its equity capital is 15%. What should be the current market price of the
share as per Gordon Model?
Illustration 3
A firm had been paid dividend at Rs.2 per share last year. The estimated growth of the
dividends from the company is estimated to be 5% p.a. The expected rate of return on its
equity capital is 15%. Determine the estimated market price of the equity share if the
estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Given that the required
rate of return of the equity investors is 15.5% under both the circumstances. What should be
the current market price of the share as per Gordon Model under each circumstance?
Illustration 4
Based on the following information share price using Gordon model for three different firms
i.e. growth, normal and declining firm:
Factors Growth Firm Normal Firm r Declining Firm

r > Ke = Ke r < Ke
r (rate of return on retained earnings) 15% 10% 8%

Ke (Cost of Capital) 10% 10% 10%
E(Earning Per Share) Rs. 10 Rs. 10 Rs. 10
b (Retained Earnings) 0.6 0.6 0.6
1- b 0.4 0.4 0.4
What would be the new value of share if b is changed from 0.4 to 0.6;
Walter Model
Illustration 5
XYZ ltd. which earns Rs.10 per share, dividend is declared is Rs. 8 per share. Its equity
capitalisation is 12% and has a return on investment of 10%. Determine Market price of the
share and determine the optimum dividend payout ratio and the price of the share at the
payout as per Walter Model?

Illustration 6
The following figures are collected from the annual report of XYZ Ltd.
Rs.
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (ke) 16%
What should be the approximate dividend pay-out ratio so as to keep the share price at Rs.42
by using Walter model?
Illustration 7
The following information pertains to M/s XY Ltd.
Earnings of the Company Rs. 5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%
(i) What would be the market value per share as per Walter's model?
What is the optimum dividend payout ratio according to Walter's model and the market value
of Company's share at that payout ratio?
MM Model
Illustration 8
AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It
currently has outstanding 10,000 shares selling at Rs.100 each. The firm is contemplating the
declaration of a dividend of Rs.5 share at the end of the current financial year. It expects to
have a net income of Rs.1,00,000 and has a proposal for making new investments of
Rs.2,00,000.
What will be the market value of the firm, if
(i) a dividend is not declared ?
(ii) a dividend is declared ?
Illustration 9

RST Ltd. has a capital of Rs. 10,00,000 in equity shares of Rs. 100 each. The shares are
currently quoted at par. The company proposes to declare a dividend of Rs. 10 per share at
the end of the current financial year. The capitalization rate for the risk class of which the
company belongs is 12%. What will be the market price of the share at the end of the year, if
(iii) a dividend is not declared ?
(iv) a dividend is declared ?
(v) 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? Use the MM model.
Illustration 10
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 the
MM approach affects the value of M Ltd. if dividends are paid or not paid.
TRADITIONAL MODEL (GRAHAM & DODD MODEL)

Illustration 11
The following information regarding the equity shares of M ltd. is given:
Market price Rs.58.33
Dividend per share Rs.5
Multiplier 7
According to the Graham & Dodd approach to the dividend policy, compute the EPS.
LINTERS MODEL
Illustration 12
Given the last year's dividend is Rs. 9.80, speed of adjustment = 45%, target payout ratio
60% and EPS for current year Rs. 20. Calculate current year's dividend.

Chapter 9: Theory Questions and Answers
Q. 1 What is financial management?

Ans: Financial Management deals with procurement of funds and their effective
utilization in the business. Financial management comprises the forecasting,
planning, organising, directing, coordinating and controlling of all activities relating
to acquisition and application of the financial resources of an undertaking in keeping
with its financial objectives.
Q. 2 What are the objectives of financial management?

Ans: The objectives of financial management are as follows:
(1) Profit Maximization
The profit is regarded as a yardstick for the economic efficiency of any firm. If all
business firm of the society are working towards profit maximization then economic
resources of the society can be used efficiently, economically and profitably. For any
business firm, the maximization of profit is often considered as the implied objective
and therefore it is natural to retain the maximization of profit as the goat of financial
management also.
But there are many limitations with the profit maximization as the objective of
financial management. Some of these are as follows
a. Higher profit is associated with high risk which is ignored there
b. It also ignore time pattern of cash inflow.
c. It does not take into account the social welfare.
d. It does not clarify what exactly it means
(2) Wealth Maximization

Wealth here means the market value of the firm. A firm primary objective is to
maximize its value which is shown by its market price of share. The market price of
the share of a company is determined as follows:-
Market price per share = earning per share / Capitalization rate
Earning per share is based on profitability of the company and time pattern of cash
inflow. Capitalisation Rate is the normal rate of return which is ascertain after taking
risk factor into account. So market price of a share takes into account the risk; time
pattern of cash inflow and profitability (actor. If market price ·of a share increase, it
indicate the increase in value of firm. So the primary objective of financial
management is to increase the wealth of the firm. Profit rnaximisation is the
secondary objective.
Q3. Discuss the functions / role of Chief Financial Officer.
Ans. Functions of Chief Financial Officer
A. Primary functions
a. Estimation of Requirement of fund
b. Decision regarding capital structure
c. Investment decision
d. Dividend decision
B. Secondary functions
a. Supply of funds to all parts of organization
b. Evaluating financial performance
c. Financial negotiations
d. Keeping touch with stock exchange transaction.
Q4. Write short notes on evolution of Financial management.

Ans. Traditional Phase
(Financial management used only during some event like takeover, merger,
expansion liquidation etc.)
Transitional Phase
(Financial management used in day to day activities Relating to fund analysis,
planning and control)
Modern Phase
(Financial management used in decision making, Capital market Analysis, capital
budgeting, Option pricing, valuation model etc.)
Q5. Write short notes on scope of Financial management.

Ans. The scope of Financial management can be depicted as follows:
Financial Management
Wealth maximization objective
Procurement of fund Proper investment of fund Dividend Decision
Risk and Return consideration
Q6. What is the significance/importance of Financial Management?

Ans. The importance of financial management can be described as follows:
a. Best use of scarce resources namely capital fund
b. Availability of required fund at the time of requirement
c. No production stoppage due to non-availability of fund
d. No idle money so cost of capital decreases
e. Evaluate financial performance to determine the efficiency.
f. Better financial negotiation with financial institution
g. Availability of fund at minimum cost of capital
h. Increase value of firm by decreasing overall cost of capital
Q7. What is the relationship between Finance function and other functions?
Ans. The relationship of Finance function with other functions is given below
(1) Finance and Production

Production function require large amount of fund in raw material, Plant and
machinery, factory overhead etc. Production manager have to take decision after
consulting the finance manager. If production manager take decision to install a new
machinery and if fund is not available than the decision will be dismissed whatever
be the profitability of the new machinery.
(2) Finance and Marketing

All marketing decision are directly related to finance. Credit period, Discount,
Finished goods stock, Packing, Advertisement etc. all such marketing decision require
consideration of fund and timely availability of fund.
(3) Finance and Personnel

Wages of employees, training facility, perquisites, No. of employees all decision are
taken after finance consideration
(4) Finance and Accounting

Accounting provides basic information which is used in Financial management as
input. Both function are closely related for decision making purpose. But Accounting
and Financial management differ in the following points:
(a) For estimation of fund, Accounting use accrual basis but Financial management
use cash basis
(b) The main focus of Accounting is to collect data and presentation of such data.
The main focus of Financial management is to use such data for decision making
purpose
Q8. Discuss the changing scenario of financial management in India?

Ans. Finance manager occupies an important role in the business organization. The role of
finance manager in present scenario may be explained as follows:
1. Forecasting the financial requirement
2. Procurement of fund at lower cost
3. Effective utilization of fund
4. Maintaining proper liquidity
Debtors and cash management
5. Dividend decision
6. Financial negotiation with financial institutions
7. Evaluation of financial performance
Q9. What is Financial statement analysis? What are the types of Financial statement
analysis?
Ans. It is the process of identifying the financial strength and weakness of a firm from the
available accounting data and financial statement. In other words, it is the process of
selection, relating and evaluation of the accounting data/information.
Types of Financial statement analysis

1. External analysis:- Financial statement analysis by outsider
2. Internal analysis:- Financial statement analysis by the employees of the
company.
3. Horizontal analysis: - It is the comparison between the current year figure to last
year figures.
4. Vertical analysis: In such method, all figures are converted into percentage and
than comparison is made.
5. Trend analysis: In such method trend are analysis for a period of time
6. Ratio analysis
7. Fund flow analysis
8. Break Even analysis: - It mean analysis of operating data.
Q10. What is time value of money? Explain the relevance of time value of money in
financial decisions.
Ans. The time value of money means that worth of a rupee received today is different
from the worth of a rupee to be received in future.
Every person prefer that rupee should be received in present rupee than in future.
This preference for money now as compared to future is known as time preference
for money. Reasons for relevance of time value of money.
1. Risk of future
2. Preference for present consumption
3. Investment opportunity
4. Inflation
Q11. Describe the organization chart of Finance function?
Ans. Organization chart of finance function is described here under:
Chief Financial Officer
Treasurer Controller
Cash Management Financial Accounting

Credit Management Cost Accounting
Capital budgeting Manager Tax Manager
Fund Raising manager Data Processing
Portfolio Management Internal Audit
Q12. What are the various source of financing long term, medium term and short term
financing needs?
Ans. SOURCES OF FINANCE
Long Term Source Medium Term Source Short Term Source

1. Equity Share 1. Preference Share 1. Trade Credit
2. Preference Share 2. Debenture 2. Commercial Bank
3. Retained earning 3. Commercial Bank 3. Fixed Deposit
4. Debenture 4. Public Deposit 4. Advances from Customer
5. Financial institution 5. Lease Financing 5. Short Term provision
6. State Financial Corp. 6. Euro Issue
7. Commercial Bank 7. State Financial Corp.
8. Venture Capital Finance 8. Financial Institution
9. International Financing 9. Foreign Currency Bond
Q13. Write short notes on the following

1. Bridge Finance
2. Seed Capital Assistance
3. Deferred Payment Guarantee
4. Deep Discount Bond
5. Secured Premium Notes
6. Ploughing Back of profit
Ans:
1. Bridge Finance:
Sometimes company arrange short period loan from commercial bank because of
their term loan from financial institution is pending for disbursement and paid such
short period loan as term loan received from financial institution. Such short period
loan is called Bridge finance. Rate of interest on Bridge finance is generally high than
rate of interest on term loan from financial institution. Bridge finance may also be
provided by the financial institution which provide term loan also and adjust such
bridge finance amount in term loan amount.
2. Seed Capital Assistance:

Seed capital assistance scheme is designed by IDBI for assistance to a unit which is
organised by professionally or technically qualified entrepreneur. In such case IDBI
finance such unit at nil interest but charging service charge ranging 1 % p.a. up to
first five years and increase thereafter. IDBI may also charge interest if profitability of
the unit so permit. Assistance is provided to the project which cost should not
exceed Rs. 2 crore. Maximum assistance under such scheme will be restricted to 50%
of project cost or Rs. 15 lacs whichever is lower.
For project which cost exceeding Rs. 2 crore, such assistance may be obtained from
Risk and Technology Ltd. Project costing up to 5 lacs, such assistance may be
obtained from SIDBI.
3. Deferred Payment Guarantee:
When plant and machinery are purchased and payment are made in instalment over
a period of time, it is called deferred payment. It is a best source of finance. Supplier
may demand bank guarantee from the buyer.
4. Deep Discount Bond

Such bond are issued at discount price and paid after a fixed period of time at par.
No any amount of interest are paid on such bond. Investor acquire the difference of
discounted value and par value as consideration of their investment. It is also called
as Zero coupon bond.
5. Secured Premium Notes

In such note, a warrant is attached with such note. After a fixed time period, warrant
is converted in to equity shares. Such note are issued for a period of 4 to 7 years
6. Ploughing back of profit

Ploughing back of profit is an internal source of finance. lt is a phenomenon under
which the company does not distribute all the profit earned but retain a part of it,
which is reinvested in the business for its development. It is thus known as Retained
earning.
Q14. Write short notes on the following;

(1) Zero interest fully convertible debenture
(2) Double Option Bond
(3) Option Bond
(4) Inflation Bond
(5) Floating Rate Bond
Ans:
(1) Zero interest fully convertible debenture:
Such type of debenture are issued carry no interest charge and compulsorily
converted into equity share after a fixed time period. It is beneficial for the company
as company have not to pay any amount of interest. If market price of share
increases speedily than it will be beneficial to the investor as they get equity share at
low rate.
(2) Double Option Bond:

Such bond have been issued by the IDBI carrying 15% p.a. rate of interest payable
half yearly have maturity period of 10 years. Each bond is divided into two certificate
namely one for principal and other for interest of ten years. Investor can sold any
certificate at his option.
(3) Option Bond:

In these bond, investor have option to receive interest periodically or in one
installment at the time of maturity.
(4) Inflation Bond:

In such bond, rate of interest increases as rate of inflation. Interest is given to
investor after adding inflation rate in rate of interest of Bond.
(5) Floating Rate Bond:

In such bond, rate of interest fluctuate as market rate of interest fluctuate. If market
rate of interest increases or decreases than rate of interest on such bond is taken the
same increase or decrease rate.
Q15. What are the advantages and disadvantages of Equity share capital?
Ans: Advantages of Equity share capital:
(1) Permanent source of finance
(2) Additional fund can be raised through issue of right share
(3) Low risk because no legal obligation to pay dividend
(4) Company borrowing power increase
Disadvantages of Equity share capital:

(1) Cost of equity capital is higher
(2) Riskier from the point of view of investor
(3) Control diluted as number of share increase
(4) EPS decrease as number of share increase if income proportionately not
increase.
Q16. What are the advantages and disadvantages of Preference share capital?
Ans: Advantages of Preference share capital:
(1) No dilution of ownership control
(2) It can be redeemed after a fix time period
(3) Preference dividend is fixed so it does not participate in surplus profit
(4) Advantage of leverage available because it is fixed charges fund
Disadvantages of Preference share capital:

(1) Cost is high because it is not tax deductible
(2) Preference dividend, if not paid in one year has to be paid in next yea/s because
these are cumulative in nature.
Q17. What are the advantages and disadvantages of Debenture?

Ans: Advantages of Debenture:
(1) Cost of debenture is lower than other source
(2) Raising of fund from Debenture does not dilute the ownership control
(3) Interest is fixed. So it does not participate in surplus profit
Disadvantages of Debenture :
(1) Interest and capital payment are obligatory
(2) Highly risky source of finance
Q18. What is Venture capital financing? What are the characteristics of Venture capital
undertaking? What are the factors to be considered in financing any risky project?
Ans: Venture refers to an undertaking involving more than normal business risk. The
venture capital therefore refers to investment of capital in relatively high risk
enterprises. The investor may be ready to expose his funds to relatively high risk
enterprises to earn a relatively higher return not in terms of steady dividend or
interest but through capital gains at a later stage.
The investor in such a case is known as “Venture Capital Firm: or the “Venture
Capitalist”.
Characteristics of Venture Capital undertaking
(1) Entrepreneurial promoter (2) Innovative technology
(3) Longer Gestation Period (4) Highly risky proposal
The factors to be considered in financing any risky project are:

i. Quality of the management team is a very important factor to be considered.
They are required to show a high level of commitment to the project.
ii. The technical ability of the team is also vital. They should be able to develop
and produce a new product / service.
iii. Technical feasibility of the new product / service should be considered.
iv. Since the risk involved in investing in the company is quite high, venture
capitalists should ensure that the prospects for future profits compensate for
the risk.
v. A research must be carried out to ensure that there is a market for the new
product.
vi. The venture capitalist himself should have the capacity to bear risk or loss, if
the project fails.
vii. The venture capitalist should try to establish a number of exit routes.
In case of companies, venture capitalist can seek for a place on the Board of
Directors to have a say on all significant matters affecting the business.
Q19. What are the types of Venture capital financing?

Ans: Types of Venture capital financing is as follows:
(1) Equity financing

As Venture Capital undertaking have longer gestation period, it acquire most of fund
through equity. The equity contribution of Venture Capitalist does not exceed 49% of
total equity capital to the effect that ownership and controlling remain with the
entrepreneur.
(2) Conditional Loan
In Such method, interest is not paid on loan. Instead it, royalty is paid as a
percentage of sales so there is no any burden of interest on the Venture Capital firm
during gestation period.
(3) Income note
In such method, Interest and royalty both are paid on the basis of sales. Rate of
interest in case of income note is generally low.
(4) Participating Debenture
In such case, interest is charged in three phase namely in first phase, no interest is
charged, in second stage low rate of interest is charged and in third stage high rate
of interest is charged.
Q20. What factors that should be considered before financing in a venture firm or in a
risky project?
Ans. Following factors should be considered:
(1) Quality and expertise of management team of Venture firm
(2) Technical ability of the firm
(3) Product / service feasibility
(4) Future prospectus
(5) Level of competition available in the market
(6) Level of risk borne by entrepreneur
(7) Exit route
Q21. Write short notes on the following:

(1) Certificate of deposit
(2) Public Deposit
(3) Global Depository Receipt
(4) American Depository Receipt
(5) Euro Convertible bonds
(6) Indian depository receipt
Ans:
(1) Certificate of Deposit
It is same as time deposit certificate issued by the bank except that no interest rate
is prescribed on such certificate and investor can sell such certificate in the open
market as he wish.
(2) Public Deposit
A company can accept public deposit under the guideline of RBI. It can accept
deposit from public or shareholder for a period of six month to three years.
Company cannot use such deposit money in the purchase of plant or any fixed,
assets. It can be used in working capital finance. The amount of public deposit can be
maximum of 35% of shareholder fund.
(3) Global depository receipt
It is an instrument which allows Indian Corporate, Banks, Non-banking financial
companies etc. to raise funds through equity shares issued abroad to augment their
resources for domestic operation. A GDR is a dollar denominated instrument of a
company, traded in the stock exchange outside the country of the origin i.e. country
other than USA. It represents a certain number of underlying equity shares. Instead
of issuing in the names of individual shareholder, the shares are issued by the
company to an intermediary called the "Depository" usually in overseas depository
bank, in whose name the shares are registered. It is the depository, which
subsequently issues the GDR to the subscribing public. The physical possession of the
equity shares will be with the another intermediary called the "Custodian", who is an
agent of the depository. Though the GDR represent he company' shares, it has a
distinct identity and does not figure in the books of the company.
(4) American Depository Receipt
It is same as GDR. Difference is that it is used for fund collection from USA whereas
GDR is used for fund collection from European and South Asian markets .
(5) Euro convertible Bonds:
It is a Euro Bond with the characteristics of convertible attached to it. It gives the
bond holder an option to convert them into equity shares at premium. These bonds
carry a fixed rate of interest and may include a call option or a put option. Under call
option, the issuing company has the option to buy or call the bond prior to maturity
date for its redemption. Under a put option the holder has the option to sell his
bonds to the issuing company at a predetermined date and price.
(6) Indian depository receipt:
It is same as GDR. In IDR, foreign companies issue shares to an Indian Depository,
which would in turn, issue Depository Receipt to investor in India.
Q22. Write short notes on Debt securitization and its advantages

Ans. It is a method of recycling of fund. A company pooled its loan assets and then such
loan assets is transferred to a Trustee. Trustee issue securities on the security of such
pooled loan assets. It can be explained as follows:
The origination function

(Credit worthiness of borrower is assessed)
The Pooling function

(The loan/credit of similar types are pooled together)
The Transferring function

(The assets pool is then transferred to a trustee)
The securitization function

(The trustee then issue securities on the basis of assets pool)
Advantages of Debt securitization:

(1) It convert debt into securities
(2) It convert illiquid assets into liquid assets
(3) It gives the opportunity of off balance sheet funding
(4) It enhance credit rating of the company
(5) It open up new investment avenue
(6) Securities are tied up in definite assets
Q23. Write short notes on Export Finance.

Ans: Export finance can be divided into two category: -
1. Pre-shipment Finance 2. Post-shipment finance
(1) Pre-shipment Finance

It means packing credit. Packing credit means finance given by bank to the exporter
which have an export order in hand and require fund for the purpose of buying,
manufacturing, packing and supplying of goods. Packing credit may be of following
types:
1. Clean packing credit in which bank provide finance without any security and only
on the basis of export order
2. Packing credit against hypothecation of goods
3. Packing credit against pledge of goods
4. Loan given against guarantee provided by Export credit guarantee corp. Ltd
5. Forward exchange contract:- To avoid risk in fluctuation of exchange rate,
Exporter may obtain finance on the basis of export bill.
Documents to be filed in packing credit finance:

In case of partnership or proprietorship : (a) Letter of continuity (b) Letter of
authority to operate the account (c) Declaration of partnership (d) Letter of
hypothecation of bills (e) Agreement to utilise the monies drawn in terms of contract
(f) Letter of pledge or hypothecation (g) Joint and several demand promissory note
In case of limited company: (a) Letter of continuity (b) Demand promissory note (c)
Letter of pledge or hypothecation (d) General guarantee of the director (e) Certified
copy of the board of director's resolution (f) Agreement to utilies the monies drawn
in terms of contract (g) Letter of hypothecation of bills.
(2) Post shipment finance

It mean finance after shipment of goods. Such finance may be of the following type :-
1. Purchasing/discounting documentary export bill:- In such case, finance is
provided by bank by purchasing or discounting export bill. In such finance, bank
require following documents :- (a) Letter of hypothecation of export bill (b)
General guarantee of the director or partner as the case may be
2. Advance against export bill sent for collection:- In such case, finance is provided
to exporter on the basis of credit worthiness of the exporter. Bank require
following documents :- (a) Demand promissory note (b) Letter of hypothecation
of bills (c) Letter of continuity (d) General guarantee of the director or partner as
the case may be
3. Advance against duty drawback, cash subsidy etc. :- In such finance, bank require
following documents :- (a), (b, (c),and (d) Same as above (e) Undertaking from
the borrower that amount received will be used in the payment of loan.
Q24. Write short notes on instrument of International Commercial Borrowings?

Ans: Some of the financial instrument for international financing is given below:
(1) Euro issue
An Euro issue is a issue listed on a foreign stock exchange. It is an instrument which
raise foreign currency in the international market through the issue of ADR/GDR and
Foreign currency convertible bond
(2) Euro Bond
Euro bond are long term loans raised by entities enjoying an excellent credit rating.
These bond are issued for a period ranging between 3 to 20 years.
(3) Foreign Bonds
Foreign bond are debt instrument denominated in a currency which is foreign to the
borrower and is sold in the country of that currency.
(4) Fully hedged bond
Fully hedged bond are the foreign bond devoid of the risk of currency fluctuation. It
eliminate the risk by selling the entire stream of principle and interest payment in
the forward market.
(5) Floating rate bond
The floating rate notes provides foreign currency at a rate lower than foreign loans.
They are issued for a period up to 7 years. The interest rate are adjusted to reflect
the prevailing exchange rate
(6) Euro commercial paper
Euro commercial paper are promissory notes with a maturity period of less /than
one year. These are unsecured instrument issued by a corporate body. The main
investors are
(7) Foreign Currency option
Foreign currency option is a right to buy or sell a sum of foreign currency at a
predetermined rate on a future date.
(8) Foreign Currency Futures
A foreign currency future is a right to buy or sell a sum of foreign currency at a fixed
exchange rate on a specific future date. It is an alternative to forward contract for
hedging of exchange risk.
Q25. Write short notes on Commercial Paper.

Ans: It is a short term promissory note issued by the company at discounted value for its
short term finance. It is issued to the public and negotiable by endorsement. It bear
certificate from the bank verifying the signature of the executants. It can be issued
for maturities between 15 days and maximum upto one year. These can be issued in
denomination of Rs. 5 lakh or multiple thereof.
Features of Commercial paper:
1. Short term debt instrument
2. Issued at discounted value redeemable at face value
3. Contain promise by the issuer to pay at a fixed time period
4. It is an unsecured debt instrument
Advantages of Commercial paper:

1. Simple to issue 2. Cheaper cost 3. High return to investor
4. Company position is considered favourable if it issue
Eligibility criteria for issue of Commercial paper:
1. Shareholder's fund should be equal to or more than 5 crore
2. Obtain credit rating from credit rating agencies
3. Bank account of company is classified as standard assets
1. Minimum current ratio should be 1.33 : 1
2. All expenses relating to CP issue have to be borne by the company.
3. Shares should be listed in stock exchange except company in public Sector and
closely held company
Working capital management
Q26. What is working capital management?

Ans: Working capital Management may be defined as management of current assets and
current liabilities which includes :-
(1) Timely availability of funds.
(2) Optimum utilization of available fund
(3) Neglecting under and over capitalization.
Q27. What are the various kind of working capital?
Ans: Working Capital
From the point of From the point of

View of Concept view of time
Gross Net Permanent Temporary

Aggregate of Current Assets Minimum level of over and above
All current assets minus current liabilities working capital permanent
working
Capital is temporary
The requirement of working capital or the permanent and temporary working capital
may be explain by the following diagram :-
Temporary Total W C
WC
Temporary
Total W.C W.C
Amount
Permanent W.C Permanent W.C
Time Time
Q28. What is the need behind maintaining adequate working capital?

Ans: A firm should maintain adequate working capital which should not be excess or short
then requirement. Excessive working capital may result the following consequences:
(1) Unnecessary accumulation in inventories resulting in waste.
(2) High amount of debtors may result high amount of bad debts.
(3) Cost of working capital high
(4) Low ROI result in Adverse influence on the management's performance.
Other hand, Inadequate working capital situation have the following consequences
(1) The fixed assets may not be optimally used
(2) Interruption in production schedule.
(3) The firm may not be able to take benefit of on opportunity
(4) Firm goodwill in the market is affected.
Q29. What are the factor determining the working capital requirement?
Ans: Following factors determine the size of working capital:
(1) Basic Nature of business (2) Length of production process
(3) Business cycle fluctuation (4) Seasonal operation
(5) Credit Policy (6) Market Competitiveness
(7) Supply Condition (8) Dividend Policy
(9) Inflation (10) Growth and expansion
Q30. What is the Operating capital cycle?

Ans: The operating cycle or Working capital cycle refer to the length of time between the
firm paying cash for material etc., entering into production process and inflow of
cash from debtors / finished goods. Thus there is a complete cycle from cash to cash
wherein cash gets converted into raw material, Work in progress, finished goods,
debtors and finally into cash again. The cycle is known as operating cycle or working
capital cycle. Working capital cycle may be depicted in the following diagram:-
CASH
DEBTORS OPERATING CYCLE RAW MATERIALS
FINISHED STOCK WORK IN PROCESS
Operating Cycle Period :-

Operating cycle period Is the sum of the duration of each of the above event less the
credit period allowed by the suppliers. In the form of equation, the operating cycle
period is calculated as under:
Operating cycle period = R + W + F + D – C
R = Raw material storage period
W = Work -in- progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit period allowed by creditor
Q31. What are the different approaches for working capital financing?
Ans: There are three approaches for working capital financing:
(1) Hedgeing or Matching approach
Such approach states that the permanent working capital requirement of a firm
should be satisfied by long term source and temporary working capital need should
be satisfied by short term source. So it is risky approach but profitable approach. It is
explained by following diagram
Total WC
Short Term
Financing
Amount
Of WC
Long Term Sources
Time
(2) Conservative approach
Such policy states that permanent and temporary working capital should be financed
entirely by long term sources and firm should avoid short term source of finance. So
it avoid risk but less profitable approach. It can be explained by the following
diagram:-
Total WC
Amount of
WC
Long Term
Source
Financing
Time
(3) Aggressive approach
A working capital policy is called an aggressive policy if the firm decides to finance a
part of the permanent working capital and full amount of temporary working capital
by short term sources. So it is highly risky approach but highly profitable approach. It
can be explained by the following diagram:-
Total WC
Permanent WC
Amount of
WC Short term
Financing
Long Term Finance
Q32. Write short notes on the Risk Return trade off about size of working capital.
Ans: When a firm maintain large investment in working capital, it reduces the chances of
production Stoppage lost of sales and inability to pay liability. So the firm reduce the
risk of cash shortage by maintaining huge amount of working capital. But high
investment in working capital reduce the profitability of the firm because high
Investment in working capital attached with high cost of capital. As the firm
increases its investment in working capital, there is not a corresponding increase in
its expected returns: Besides investment in current assets carry some cost in term of
interest. So when a firm increases the size of working capital, it reduce the risk but
decrease profitability of the firm.
So there exist a tradeoff between profitability and liquidity with reference to
working capital. Such risk-return trade off with respect to different working capital
policies can be explained here under :-
High
Hedging
Profit Risk Return trade off

Conservative
Low
Low Risk High
In Hedgeing approach, requirement of temporary working capital is satisfied by short
term source. So it is risky approach but profitable approach.
In Conservative approach, requirement of temporary working capital is satisfied by
long term source. So it is low risk but low profitable approach.
In risk return trade off, 50% of temporary working capital is financed through long
term and 50% through short term source. So there is normal risk and normal return
which is also called risk return trade off.
Q33. What is the need to hold cash?

Ans: Motives to hold cash is given below:
(1) Transaction motive: Every firm requires cash balance to meet day to day
transaction so it hold cash.
(2) Precautionary motive: The necessity of keeping a cash balance to meet any
emergency situation or unpredictable event is known as precautionary motive
(3) Speculative motive:- Sometimes a firms, requires cash balance to take advantage
of an unexpected profitable opportunity that may suddenly appear which called
speculative motive.
Q34. What is cash budget? What are the various methods for preparing cash budget?
Ans: Cash budget is a statement which indicate the estimated cash inflow and outflow of
a company for a period. It may be prepared weekly, monthly, quarterly. There are
three methods for preparing cash budget: -
(1) Receipt and Payment method:
In this methods, estimated receipts and payment are taken in a statement and on
the basis of which, cash balance is estimated. It also show the point of time when
fund will be below the minimum balance so as to borrowed fund.
(2) Adjusted net income method:
In this method, it is assumed that net profit (adjusted) during a period is the net
increase in the cash balance. So adjusted net income is find out. Adjusted net income
is calculated as under :-
Net profit + Non expenses expense - Non cash income
(3) Pro-forma balance sheet method:
In this method, each item of Balance Sheet except cash is projected and balancing
figure of the proforma Balance Sheet is taken as cash balance. A negative cash
balance indicate a need for borrowing fund.
Q35. Write short notes on the following:

(1) Concentration banking
(2) Lock Box System
(3) Miller orr Model
(4) Baumol model
Ans:
(1) Concentration Banking
In such method, many bank account are opened in different areas of sale. Debtors
are instructed to deposit their cheque directly to firm bank account which is near
thereto. It eliminate the postal time and deposit time. The firm which have wide
spread sale, use such method for collection of amount of debtors. But concentration
banking method have some cost because many bank account have to be opened and
a minimum cash balance have to be kept in each such account which Increase cost of
capital.
(2) Lock Box System
Under this system, firm hire a post box in the post office, and customer are
instructed to send their cheque to the post box address. The firm arranges with a
local bank or some other agency to collect the cheque from post box and credit to
the firm's account as quickly as possible. It also reduce collection time. But it is also a
costly method two costs are related to such system which is given below :
(a) Hire charges of post office box
(b) Collection charges or service charges to bank or other agency.
(3) Miller orr model
The model has specified two control limit for cash balance. An upper limit, beyond
which cash balance need not be allowed to go and a lower limit, below which the
cash balance is not allowed to reduce. The cash balance should be allowed to move
within these limits. If the cash level reaches the upper control limit, then a part of
the cash should be invested in marketable securities in such a way that the cash
balance comes downs to a predetermined level called returned level. If the cash
balance reaches the lower limit, than sufficient marketable securities should be sold
to realise cash so that the cash balance reaches back to return level. No transaction
between cash and marketable securities is undertaken between the two limits. The
miller-orr model has been presented in figure:-
Amount of Cash
Upper Limit H
Buy securities
Sale Return Level R

Securities
Lower Limit L
Time
(4) BAUMOL'S MODEL
Baumol's model argue that a firm should not kept idle cash because it earn nothing.
It should invest idle cash in hand in marketable securities. As the cash deplet,
marketable securities should be converted into cash. But conversion of marketable
securities into cash incur some cost called transaction cost. So marketable securities
should be converted into cash in a fix lot size which is calculated as follows:
2FT
𝐶= 𝑅
Where: -
C= lot size of conversion of marketable securities into cash
F= Total cash required during the year
T= cost of Transaction
R= Rate of interest on marketable securities
The model is same as EOQ model in inventory management .
Assumption of Baumol Model:

a. Total cash requirement is known.
b. Transaction cost per transaction is fixed and known
c. No time lag between conversion of marketable securities into cash.
d. Holding cost or opportunity cost per unit is known and fixe
(5) Ageing Schedule

An important means to get an insight into the collection pattern of debtors is the
preparation of their Ageing Schedule. In this receivables are classified according to
their age. This classification helps the firm in its collection efforts and enables the
management to have a close control over the quality of individual accounts. The
ageing schedule provides an effective method of comparing the liquidity of
receivables with the liquidity of receivables in the past and also comparing current
liquidity of receivables of one firm with that of other firm.
(6) Collection Programme:

It include followings:
(1) Monitoring the state of receivables
(2) Intimation to customers when due date approaches
(3) Telegraphic and telephonic advice to customers on the due date
(4) Threat of legal action on overdue accounts
(5) Legal action on overdue accounts.
Q 36. What is playing the float? What are the kinds of float?
Ans: When a firm purchase goods or receive any service, then there is a time lag between
purchase of goods or timing of service and payment for there. Such period's is called
float period. A firm should make payment on the due date, making excessive use of
draft (bill of exchange) instead of cash payment so to maximize the cash balance. A
firm should estimates accurately the time when the cheques issued, will be
presented for encashment and thus utilise the float period to its advantage by
issuing more cheques but having in the bank account only so much cash balance as
will be sufficient to honour those cheques which are actually expected to be
presented on a particular date. Such technique is called playing the float.
Kind of Float
(1) Billing float: Time lag between transaction of sale and the mailing of the invoice.
(2) Mail float: This is the time when a cheque is being processed by post office
messenger service or other means of delivery.
(3) Cheque processing float : This is the time required for the seller to sort record
and deposit the cheque after it has been received by the company.
(4) Bank Processing float: This is the time from the deposit of the cheque by the
seller and crediting of fund in the seller account by the bank.
Q 37. What constitutes the cost of maintaining receivables?

Ans: Following cost are cost of debtors:
(1) Cost of capital - Interest in case of loan fund and opportunity cost in case of own
fund.
(2) Administrative cost which include record keeping, investigation of credit
worthiness etc.
(3) Collection cost.
(4) Defaulting cost - Bad debts
Q 38. What is credit analysis? What are the sources of obtaining information for credit
analysis?
Ans: An important task of the finance manager is the credit rating. It involve decision
regarding individual parties so as to ascertain how much credit can be extended and
for how long. The credit manager here has to employ a number of sources to obtain
credit information. The following are the important sources:-
1. Trade reference 2. Bank reference
3. Credit bureau reports 4. Past experience
5. Published financial statement 6. Salesman interview and reports.
Q 39. What is factoring? What is types of factoring? What are the advantages and
disadvantages of factoring?
Ans: Factoring is a agreement between firm and a third party in which third party takes
the responsibility of monitoring, follow up, collection and risk of debtors of the firm
and charge commission from the firm for such service. The third party is known as
factor. The agreement between them is called as factoring.
Types of Factoring agreement:
(1) Non-recourse factoring: In such factoring, factor purchase the debtor of the firm
paying immediately and bear the risk of bad debts. Commission in such factoring
is high.
(2) Recourse or pure factoring: In such factoring, factor does not take liability of bad
debts. In such case, commission is low.
Advantages
(1) Better cash flow (2) Better assets management (3) Better W.C.
management.
(4) Better administration (5) Better evaluation (6) Better risk management.
Limitations
(1) Substantial cost in terms of commission and fees
(2) High Rate of interest.
(3) Debtor objection not to deal with factor
(4) Factor does not take risk so sales affected.
(5) Service taking firm from factor may be considered as sick unit.
Q 40. Differentiation between Factoring and Bills Discounting The differences between
Factoring and Bills discounting are:
i. Factoring is called as “Invoice Factoring’ whereas Bills discounting is known as
‘Invoice discounting.”
ii. In Factoring, the parties are known as the client, factor and debtor whereas in Bills
discounting, they are known as drawer, drawee and payee.
iii. Factoring is a sort of management of book debts whereas bills discounting is a sort of
borrowing from commercial banks.
iv. For factoring there is no specific Act, whereas in the case of bills discounting, the
Negotiable Instruments Act is applicable.
Q 41. What is treasury Management? What are the functions of Treasury Management?
Ans: Treasury management includes:
(1) Management of cash while obtaining the optimum return from any surplus fund
(2) Management of exchange rate risk in accordance with group policy
(3) Providing both long term and short term fund for the business at minimum cost
(4) Maintaining good relationships with banks and others providers of finance
(5) Advice on corporate financing
Functions of Treasury management is as follows:
(1) Cash Management
(2) Currency Management
(3) Funding Management
(4) Banking
(5) Corporate finance
Q 42. Discuss the criteria for selection of marketable securities.

Ans: (1) Safety: Minimum risk and optimum return
(2) Maturity: Short term investment is preferable
(3) Marketability: Security should be marketable
Q42. What is Virtual banking? What are its advantages?

Ans: Virtual banking denotes the provision of banking and related services through
extensive use of information technology without direct recourse to the bank by the
customer. For example ATM facility, Electronic fund transfer technique, Internet
banking etc.
Advantages of Virtual Banking
(1) Low cost of banking transaction
(2) Low cost of operating branch transaction
(3) Speedy cash payment and receipt
(4) Increased speed of bank transaction
Ratios
Q 43. Define ratio.

Ans: Ratio represent the relationship between two variables. It is the technique of
analysis of financial statements. By comparing one variable with other variable. It
show the firm position as regard to profitability, liquidity, activity and solvency.
Q 44. What are the importance of Ratio analysis technique?

Ans: Following are the importance of ratio analysis:
(1) Inter firm comparison is possible
(2) It helps in judging the efficiency and inefficiency of a firm.
(3) It shows the short term liquidity position of a firm and also the long term
solvency position
(4) Over all profitability of a company can be judged with the help of ratio analysis
Q 45. What are the limitations-of Ratio analysis?

Ans: Following are the limitations of Ratio analysis technique ?
(1) Basic data upon which ratio is calculated should be correct. If basic data is wrong,
than ratio will gives wrongful result.
(2) In case of inter firm comparison, Ratio will be helpful only when accounting
policies adopted by different firm is same. If firm adopt different accounting
policies as regard to valuation, treatment etc. of same items, than Ratio will gives
wrongful result
(3) Ratio is greatly influenced by price level change.
(4) Many business operate a large number of product or services. In such cases, ratio
calculated on the basis of aggregate data cannot be used for inter firm
comparison.
(5) Financial ratio are inter related and not independent. So decision cannot be
taken on the basis of one or some ratio.
Q 46. What are the kind of Ratio?

Ans: Ratio are classified according to source and usage as given below:
(A) According to Source
1. Revenue Ratio :- When two variables are taken from revenue statement the ratio
so computed is known is revenue ratio.
2. Balance sheet Ratio :- When two variables are taken from the balance sheet, the
ratio so computed is .known a balance sheet ratio.
3. Mixed Ratio :- When one variable is taken from the revenue statement and other
is taken from the balance sheet the ratio so computed are known as mixed ratio.
(B) According to Usage

1. Liquidity Ratio
2. Profitability Ratio
3. Turnover Ratio or Activity Ratio or Efficiency Ratio
4. Capital Structure Ratio or Leverage Ratio or Risk Ratio
Q 47. Differentiate between Business risk and Financial risk.

Ans: Business risk refers to the risk associated with the firm’s operations. It is an
unavoidable risk because of the environment in which the firm has to operate and the
business risk is represented by the variability of earnings before interest and tax
(EBIT). The variability in turn is influenced by revenues and expenses. Revenues
and expenses are affected by demand of firm’s products, variations in prices and
proportion of fixed cost in total cost.
Whereas, Financial risk refers to the additional risk placed on firm’s shareholders as
a result of debt use in financing. Companies that issue more debt instruments would
have higher financial risk than companies financed mostly by equity. Financial risk
can be measured by ratios such as firm’s financial leverage multiplier, total debt to
assets ratio etc.
Q 48. Explain the important ratios that would be used in each of the following situations:
i. A bank is approached by a company for a loan of Rs. 50 lakh for working
capital purposes.
ii. A long term creditor interested in determining whether his claim is adequately
secured.
iii. A shareholder who is examining his portfolio and who is to decide whether he
should old or sell his holding in the company.
iv. A finance manager interested to know the effectiveness with which a firm uses
its available resources.
Important Ratios used in different situations

i. Liquidity Ratios - Here Liquidity or short – term solvency ratios would be used by the
bank to check the ability of the company to pay its short-term liabilities. A bank may
use Current ratio and Quick ratio to judge short terms solvency of the firm.
ii. Capital Structure/Leverage Ratios- Here the long-term creditor would use the capital
structure/leverage ratios to ensure the long term stability and structure of the firm. A
long term creditors interested in the determining whether his claim is adequately
secured may use Debt-service coverage and interest coverage ratio.
iii. Profitability Ratios- The shareholder would use the profitability ratios to measure the
profitability or the operational efficiency of the firm to see the final results of business
operations. A shareholder may use return on equity, earning per share and dividend
per share.
iv. Activity Ratios- The finance manager would use these ratios to evaluate the efficiency
with which the firm manages and utilises its assets. Some important ratios are (a)
Capital turnover ratio (b) Current and fixed assets turnover ratio (c) Stock, Debtors
and Creditors turnover ratio.
Leverages
Q 49. What is Leverage? What are types of Leverages?

Ans: Leverage refer to the ability of a firm in employing long term fund having a fixed
cost, to enhance returns to the owner. So leverage is the employment of fixed assets
or fund for which a firm has to meet fixed cost or fixed rate of interest obligation
irrespective of the level of activities attained or the level of operating profit earned.
The higher the leverage, higher the profit and vice versa. But higher leverage
accompanied with higher degree of risk due to existence of higher amount of fixed
operating cost and financial cost. Leverage are of three types viz Operating, Financial
and combined leverage.
Q 50. Write short notes on Operating, Financial, and Combined Leverage.

Ans:
(1) Operating Leverage
It is defined as the "firm's ability to use fixed operating costs to magnify effect of
change in sales on its earning before interest and taxes". It may also be defined as %
change in EBIT divided by % change in sales. So it shows the relationship between

Sales and EBIT (Operating Profit). Higher Operating leverage arise due to higher
proportion of fixed cost in total cost which shows that firm operating risk is high and
vice versa. If a firm have no fixed cost, its operating leverage equal to one which
show that firm have no any operating risk.
(2) Financial Leverage
Financial leverage is defined as the ability of a firm to use fixed financial charges to
magnify the effect of changes in the EBIT (operating profit) on the firm's earning per
share. It may also be defined as % change in EPS divided by the % change in EBIT.
Financial Leverage is the relationship between EBIT & EPS. Higher financial leverage
arise due to high amount of interest which show high financial risk of the firm and
vice versa. If firm fixed charges is nil, its financial leverage will be one which shows
that firm's financial risk is zero.
(3) Combined Leverage
Combined leverage is defined as the firm ability to use fixed financial and operating
cost taken together to magnify the effect of changes in sales on the firm earning per
share. It may also be defined as the % change in EPS divided by the % change in
sales. So it shows the relationship between sales and EPS. Combined leverage shows
both operating & financial risk together. Higher combined leverage shows the high
total risk of the organization and vice versa.
Q 51. What is impact of Leverage on Capital turnover ratio and Working capital ratio?
Ans: When a firm increase its sales, all of its leverage decrease. If there is no
corresponding increase in the capital fund of the organization, its capital turnover
ratio increases. When capital turnover ratio increases, its working capital ratio
decreases.
Decrease in working capital ratio is sign of less liquidity of an organization and firm
position may be risky in the market. Therefore it must be ensured that when capital
turnover ratio is sought to be increased, its effect on working capital should be
considered and working capital should be adjusted so to maintain proper current
and quick ratio.
Q 52. Discuss the impact of financial leverage on shareholder wealth by using return on
assets (ROA) and return on equity (ROE) analytic framework.
Operating profit after tax Sales
Ans: ROA  x
sales Capital employed
Net Profit for equtiy shareholder

ROE 
Equity Shareholder fund
Debt
Also ROE  ROA  (ROA – Kd)
Equity
There it is evident that when ROA is high ROE will also be high and the financial
leverage will be favourable.
However if Kd > ROA then the leverage will work in the opposite direction.
Therefore in order that equity shareholder gain wealth from debt fund the cost of
debt should be less than ROA.
COST OF CAPITAL
Q 53. What is cost of Capital?
Ans: It is Minimum rate of return that a firm must earn in order to satisfy the expectations
of the investor is called the cost of capital. It may be defined as minimum required
rate of return; a project must earn in order to cover the cost of raising funds being
used by the firm in financing of the proposal.
Q 54. Write short notes on the following:

(1) Cost of Debenture
(2) Cost of Preference Share
(3) Cost of Equity Share
(4) Cost of Reserve
(5) Weighted average cost of capital
(6) Marginal cost of capital
Ans:
(1) Cost of Debenture
Debenture carries a fixed rate of interest. So interest is the cost of debenture. When
a firm pays interest on debenture, its taxable income decreases and as a result, it
gain in income tax. So income tax benefit is deducted from rate of interest and result
is cost of debenture.
(2) Cost of Preference Shares
Preference shareholder is paid fix annual dividend each year. Such dividend is the
cost of capital for the firm. Cost of preference share is same as cost of debenture
except that there is no tax benefit but sometimes there is tax charge as corporate
dividend tax on dividend.
(3) Cost of Equity Share
The cost of equity capital may be defined as the minimum rate of return that a
company must earn on the equity financed' portion of an investment project so that
the market price of the shares remain unchanged. A shareholder invest money in the
share capital of a company in the expectation of some return. Such rate of return is
cost of equity which is also known as expectation of shareholders. Expectation of
shareholder always more than cost of Debenture and Preference share because
Equity shareholder bear risk of the company operation. So cost of equity is sum of
risk free rate of interest and risk premium.
(4) Cost of Reserve
The cost of retained earning must be considered as the opportunity cost of the
foregone dividends. From the point of view of equity shareholder, any earning
retained by the firm could have been profitably invested by the equity shareholders
themselves, had these been distributed to them. Thus there is an opportunity cost
involved in the firms retaining the earnings and an estimation of this cost can be
taken as a measure of cost of capital of retained earnings.
(5) Weighted average cost of capital
It is defined as the weighted average of the cost of different sources of fund. It may
also be defined as the rate of return that must be earned by the firm in order to
satisfy the requirement of different investors. The cost of capital is thus the
minimum required rate of return on the assets of the firm. Cost of each source is
specific cost of capital. Weighted average cost of capital is the overall cost of total
capital of the firm.
(6) Marginal Cost of Capital
Weighted average cost of capital of additional fund is called marginal cost of capital.
Its calculation is same as weighted average cost of capital.
Q 55. What are the various approaches for calculating cost of Equity Shares?
Ans: Various approaches are given below:
(1) D/p Ratio approach
As per this approach, Equity shareholder invests money in the expectation of
dividend. So dividend is the basis for calculating the cost of equity.
Ke = Expected Dividend per share / Net proceed per share x 100
It is so simple approach. But such approach takes only dividend and not the capital
appreciation into account which arise due to retained earning. It also assumed that
dividend is stable and there is no growth which is hardly true.
(2) E/p Ratio Approach
This approach take both into account viz. Dividend and retained earning. It takes into
account total earning, whether distributed or not. The argument is that investor
expects a certain amount of earning, whether distributed or not.
Ke = Earning per share / Net proceed per share x 100
(3) D/p + g Approach
It is same as D/p approach. Only difference is that it takes into account some growth
rate also in the calculation of cost of equity share capital.
Ke = Expected Dividend per share / Net proceeds per share x 100 + growth rate.
(4) E/P + g approach
It is same as E/P approach. Only difference is that it takes into account some growth
rate also in the calculation of cost of equity share capital.
Capital Budgeting / Investment decision
Q 56. What is capital budgeting decision?

Ans: Capital budgeting decision involve the entire process of decision making relating to
acquisition of long term assets whose returns are expected to arise over a period
beyond one year. In other words the capital budgeting decision denote a decision
situation where lump sum funds are invested in the initial stage of a project and the
return are expected over a long period.
Its main features are as under:
(1) Capital budgeting decision involve long time period horizon which is more than
one year
(2) It involve huge amount of fund investment in the project.
(3) Such decision carry high degree of risk and uncertainty.
(4) These decision are irreversible in the sense that these decision once taken and
implemented cannot be reversed or reversed at high loss.
Q 57. What are the types of capital budgeting decision?
Ans: Types of Capital Budgeting Decision
From the point of firm existence From the point of decision situation
Decision by Decision by Mutually Accept

Contingent
New Firm Existing Firm Exclusive Reject Decision
Replacement Expansion Cost Reduction Diversification
Mutually exclusive decision:

Two or more alternatives proposal are said to be mutually exclusive when
acceptance of one alternative result in automatic rejection of all other proposal.
Such decision occur when a firm has more than one alternative but competitive
proposal before it.
Accept-Reject decision:
An accept-reject decision occurs when a proposal is independently accepted or
rejected without regard to any other alternative proposal.
Contingent decision:
Some capital budgeting decision are taken due to acceptance of some other capital
budgeting decision. Such decision is called contingent decision.
Q 58. What difficulties arise in capital budgeting decision?

Ans: Followings difficulties arise in capital budgeting decision:
(1) As capital Budgeting decision involve long time period, estimation for such time
period is very difficult.
(2) Capital budgeting decision include future time period which is highly uncertain
and risky
(3) There are many factors relating to a decision which are related to each other. If
such relationship is not measured properly, it may dampen the result of the
project.
(4) As such decision involve huge amount of fund, so there is possibility of loss of
large amount.
Q 59. What are the various techniques of Capital budgeting technique?

Ans:
Techniques of Capital Budgeting
Traditional or Non discounting technique Discounting Technique
Pay Back Average rate Net Present Profitability Internal Rate

Discounted
Period of return Value Index of Return Pay
Back
Q 60. Write short notes on pay back period technique of budgeting.

Ans: Pay back period is defined as the number of years required for the proposal's
cumulative cash inflows to be equal to its cash outflows. In other words the payback
period is the length of time required to recover the initial cost of the project.
Its advantages are as follows:
(1) Simple and easy in concept and application
(2) It is used in case of risky proposal.
Its disadvantages are as follows :
(1) The payback period entirely ignores all cash inflows which occur after the
payback period
(2) It ignores the timing of the occurrence of the cash flows.
(3) The payback period also ignores the salvage value and the total economic life of
the project.
Q 61. Write short notes on Discounted pay back period of budgeting.

Ans: Discounted pay back period means the time period in which proposal discounted
value is equal to its cash outflow. In other words it is that period in which future
discounted cash inflow equal the initial outflow. It is calculated same as pay back
period.
The shorter the period, better it is. It takes care of the time value of money. But it
ignore post discounted payback period cash flow.
Q 62. Write short notes on Average rate of return technique of budgeting.

Ans: Accounting rate of return simply indicate the percentage of net profit over
investment.
Accounting rate of return is based on the accounting concept of return on
investment.
Its advantages are as follows:

(1) Simple to understand and calculate
(2) Data readily available
Its disadvantages are as follows:
(1) It ignore the time value of money
(2) lt consider accounting profit rather than cash flows.
(3) It ignore the life of the proposal

(4) It ignore the salvage value of the proposal
Q 63. Write short notes on Net Present Value technique of budgeting

Ans: The NPV of an investment proposal may be defined as the sum of the present value
of all the cash inflows less the sum of present values of all the cash outflows
associated with a proposal. In other words the NPV is the sum of the discounted
values of the cash flows of a proposal.
Its advantage are as follows;
(1) It recognizes the time value of money.
(2) It is based on cash flow rather than accounting profit.
Its disadvantages are as follows :

(1) Calculation is complicated.
(2) It required the predetermination of the required rate of return which itself is a
difficult job.
(3) It does not provide own rate of return. It evaluate the proposal against the
minimum rate of return.
Q 64. Write short notes on Profitability Index technique of budgeting.

Ans: This technique is a variant of the NPY technique is also known as benefit cost ratio or
present value Index. Profitability Index indicate the relationship between present
value of cash inflow to present value of cash outflow. Its advantages and
disadvantages are same as of Net present value techniques given above. It is also
known as Desirability factor.
Q 65. Write short notes on Internal rate of return technique of budgeting.

Ans: Internal rate of return is the discount rate at which the present value of cash inflows
and present value of cash outflow is equal. In other words the Internal rate of return
is defined as the discount rate which produces a zero NPY.
Its advantages are as follows :
(1) It consider time value of money
(2) All cash flow are considered
(3) It is easy to understand
Its disadvantages are as follows:

(1) Tedious calculation
(2) It is assumed in such method that all fund earn rate equals to internal rate of
return which is not correct.
Q 66. Explain the concept of multiple internal rate of return.

Ans: When in a project, there is Cash outflow after that there is cash inflow and after that
again there is cash outflow, there may be more than one internal rate of return.
Advantages:
(1) It use the concept of time value of money
(2) All cash flow in a project are considered.
Disadvantages:
(1) Its calculation is tedious
(2) Decision based on IRR may not be correct
Q 67. Discuss the need of Social Cost Benefit analysis.
Ans: It is given below:
(1) The market price which is used to measure cost and benefit analysis in a project
does not represent social value due to imperfections in the market.
(2) Monetary cost & benefit analysis fails to consider to external positive and
negative effect of a project
(3) Taxes and subsidies are transfer payments and therefore are not relevant in
national economic profitability analysis.
(4) It is essential for measuring the redistribution effect of benefit of a project, as
benefit going to be economically weaker section is more important than one
going to economically fairer section
Q 68. What is Modified internal rate of return ?

Ans: In this method, all cash inflow of a project are converted in to terminal value at the
rate of cost of capital. After that the above terminal value is converted in to present
value. The rate at which the discounted value of above converted terminal value is
equal to cash outflow is called modified internal rate of return.
Modified internal rate of return was developed due to limitation of conventional
internal rate of return. The limitations of conventional internal rate of return is as
follows:
(1) It eliminates multiple IRR
(2) It addresses to reinvestment rate issue
Q 69. Write short notes on Capital rationing.

Ans: The capital rationing situation refers to the choice of investment proposal under
financial constraints in terms of a given size of capital expenditure budget. It is refer
to a situation where a company cannot undertake all positive NPV projects it has
identified because of shortage of capital.
Capital rationing arise in the following situations.
(1) When fund available is less than the fund required to invest in all investment
proposal
(2) When perfect knowledge about market is not available
(3) Where a limit is placed by higher authority on the total amount of investment
(4)
Q 70. Distinguish between Net present value method and internal rate of return method
1. The results of NPV and IRR methods regarding the choice of an asset under certain
circumstances are mutually contradictory under two methods.
2. The NPV is expressed in financial values whereas IRR is expressed in percentage terms.
3. In the NPV, cash flows are assumed to be reinvested at cost of capital rate whereas in IRR,
reinvestment is assumed to be made at IRR rates.
4. Under IRR method, a project is selected when IRR is greater than cut-off date, whereas,
under NPV method, a project is accepted with positive NPV.
Capital Structure
Q 71. Discuss the major consideration in capital structure planning.

Ans: Factors considered in capital
structure planning
Risk Cost Control

Debt – High Risk Debt – Low Cost Debt – No dilution of
control
Equity – Low Risk Equity – High Cost Equity – Dilution of control
Q 72. List the fundamental principles governing capital structure (4 Marks, Nov 12)
The fundamental principles are:
1. Cost Principle: According to this principle, an ideal pattern or capital structure is
one that minimises cost of capital structure and maximises earnings per share
(EPS).
2. Risk Principle: According to this principle, reliance is placed more on common
equity for financing capital requirements than excessive use of debt. Use of more
and more debt means higher commitment in form of interest payout. This would
lead to erosion of shareholders value in unfavourable business situation.
3. Control Principle: While designing a capital structure, the finance manager may
also keep in mind that existing management control and ownership remains
undisturbed.
4. Flexibility Principle: It means that the management chooses such a combination
of sources of financing which it finds easier to adjust according to changes in
need of funds in future too.
5. Other Considerations: Besides above principles, other factors such as nature of
industry, timing of issue and competition in the industry should also be
considered.
Q 73. What is optimum capital structure?
Ans: Capital structure is optimum when market value of firm is maximum or when overall
cost of capital is minimum. Market value of firm is sum of value of equity and value
of debt.
If a company use debt, its overall cost of capital decreases and value of firm
increases. But use of debt increase risk which increase cost of equity. So a company
should select a proper mix of equity and debt in its capital structure after considering
risk and return so its market value increases and overall cost of capital decreases.
Q 74. What is Net Income approach?

Ans: According to this approach, a firm can increase its value or lower overall cost of
capital by increasing the proportion of debt in the capital structure. As cost of debt is
less than cost of equity, higher use of debt decreases overall cost of capital and
increases value of firm. Capital structure is optimum where debt content in total
capital is high.
Assumption of such approach: -
1. Cost of debt is less than cost of equity

2. Cost of equity constant whatever be the amount of debt.
Q 75. What is Net Operating Income approach?

Ans: As per this approach, value of firm is not affected by its capital structure. It remain
same at any capital structure. Overall cost of capital is the combination of cost of
equity and cost of debt. As a firm increases the debt content in total capital (which
have low cost), risk of business increases and as a result, the cost of equity also
increases. Cost of equity increases in such a way that it nullify the effect of increase
in debt content in total capital. As a result, overall cost of capital remain same and
also the value of firm.
Q 76. What is Traditional approach of capital structure?

Ans: As per this approach, when the company initially use debt fund in its capital, cost of
equity not increase, or increase by lower percentage than percentage increase of
debt. At a certain point, percentage increase of debt and percentage increase of cost
of equity become equal. After that point, percentage increase of cost of equity
higher than percentage increase of debt. It is such because the equity shareholder
does not increase their expectation up to a certain level of debt mixing. Up to such
mixing, overall cost of capital decreases and value of firm increases. But if debt
mixing is further increases, than Cost of equity increases at a high speed which
increase the overall cost of capital and reduce the value of firm.
Q 77. What are the propositions of MM Approach?

Ans: There are three propositions of M.M approach which are as follows:
(1) The total market value of firm and its cost of capital are independent of its
capital structure. The total market value of the firm is given by capitalising the
expected stream of operating income earning at a discount rate considered
appropriate for its risk class
(2) The cost of equity is equal to capitalisation rate of pure equity stream plus a
premium for financial risk. The financial risk increases with more debt content in
the capital structure. As a result, Ke increases in a manner to offset exactly the
use of less expensive source of funds.
(3) The cut off rate for investment purposes is completely independent of the way in
which the Investment is financed.
Assumption of M.M Approach :

(1) Capital market are assumed to be perfect and investor behave rationally.
(2) All investor have the same expectation from firm
(3) The firm can be classified into 'homogenous risk class’.
Criticism of M.M Approach: Assumption is not valid.
Lease financing
Q 78. What is lease financing? What are types of lease financing?
Ans: Lease is a contract between the owner and user of the assets over a specified period
of time.
The assets is purchased by the Lessor and assets is used by Lessee in consideration of
charges which is called lease rental. Types of lease financing are given below:
(1) Operating Lease:

A lease is classified as an operating lease if it does not secure for the Lessor the
recovery of capital outlay plus a return on the fund invested during the lease term.
Normally these are callable lease and is cancelled with proper notice.
(2) Finance Lease:
In finance lease, Lessor finance the use of assets for the major part of its useful life.
The Lessee has the right to use the assets while Lessor retain legal title. It is also
called capital Lease.
(3) Sales and lease back:
In this lease, the owner of the assets sells the assets to a buyer, who in turn lease
back the same assets to the owner in consideration of a lease rental.
(4) Leveraged Lease:
In such lease three party are involved viz. Lessor, Lessee, and a financer. Financer
finance the assets to the Lessor. Lessor paid installment to the financer out of lease
rental received from the lessee.
(5) Sales aid lease:
In such lease, Lessor enter in to an agreement with Lessee for marketing the product
of Lessee. Lessor get lease rental and also commission on sales.
(6) Close ended and Open ended lease:
In close ended Lease, Lessee transfer the assets to the Lessor after the lease period.
In Open ended lease, the Lessee has the option of purchasing the assets at the end
of the lease period.
Q 79. Differentiate between Operating lease and Finance lease.

Ans:
(1) In finance Lease, risk of assets passed to Lessee. In operating lease, risk of assets
remain with the Lessor.
(2) In finance lease, Risk of obsolescence passed to Lessee but in operating lease, it
remain with Lessor.
(3) In finance lease, Lessor is interested only in lease rent and not in assets but in
operating lease, Lessor is interested mainly in his assets.
(4) In finance lease, generally Lessee bear repair and maintenance cost of assets and
in Operating lease, generally Lessor bear the cost.
Q 80. Discuss the Advantages of Leasing.

(i) Lease may low cost alternative: Leasing is alternative to purchasing. As the
lessee is to make a series of payments for using an asset, a lease arrangement is
similar to a debt contract. The benefit of lease is based on a comparison between
leasing and buying an asset. Many lessees find lease more attractive because of
low cost.
(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning an
asset may be less than that available for lease payment
(iii) Working capital conservation: When a firm buy an equipment by borrowing from
a bank (or financial institution), they never provide 100% financing. But in case of
lease one gets normally 100% financing. This enables conservation of working
capital.
(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing
debt equity ratio. This enables the lessee to go for debt financing more easily.
The access to and ability of a firm to get debt financing is called debt capacity
(also, reserve debt capacity).
(v) Obsolescence and Disposal: After purchase of leased asset there may be
technological obsolescence of the asset. That means a technologically upgraded
asset with better capacity may come into existence after purchase. To retain
competitive advantage the lessee as user may have to go for the upgraded asset.
Q 81. Advantages of Electronic Cash Management System

Advantages of Electronic Cash Management System
i. Significant saving in time.
ii. Decrease in interest costs.
iii. Less paper work.
iv. Greater accounting accuracy.
v. More control over time and funds.
vi. Supports electronic payments.
vii. Faster transfer of funds from one location to another, where required.
viii. Speedy conversion of various instruments into cash.
ix. Making available funds wherever required, whenever required.
x. Reduction in the amount of ‘idle float’ to the maximum possible extent
xi. Ensures no idle funds are placed at any place in the organization.
xii. It makes inter-bank balancing of funds much easier.
xiii. It is a true form of centralized ‘Cash Management’.
xiv. Produces faster electronic reconciliation.
xv. Allows for detection of book-keeping errors.
xvi. Reduces the number of cheques issued.
xvii. Earns interest income or reduce interest expense.
Q 82. Operating risk is associated with cost structure, whereas financial risk is associated
with capital structure of a business concern.” Critically examine this statement.
“Operating risk is associated with cost structure whereas financial risk is associated with
capital structure of a business concern”. Operating risk refers to the risk associated with
the firm’s operations. It is represented by the variability of earnings before interest and tax
(EBIT). The variability in turn is influenced by revenues and expenses, which are affected
by demand of firm’s products, variations in prices and proportion of fixed cost in total
cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk
refers to the additional risk placed on firm’s shareholders as a result of debt and preference
shares used in the capital structure of the concern. Companies that issue more debt
instruments would have higher financial risk than companies financed mostly by equity.
Q 83. What are the forms of bank credit?

Some of the forms of bank credit are:
(i) Short Term Loans: In a loan account, the entire advance is disbursed at one time
either in cash or by transfer to the current account of the borrower. It is a single
advance and given against securities like shares, government securities, life
insurance policies and fixed deposit receipts, etc.
(ii) Overdraft: Under this facility, customers are allowed to withdraw in excess of
credit balance standing in their Current Account. A fixed limit is therefore granted
to the borrower within which the borrower is allowed to overdraw his account.
(iii) Clean Overdrafts: Request for clean advances are entertained only from parties
which are financially sound and reputed for their integrity. The bank has to rely
upon the personal security of the borrowers.
(iv) Cash Credits: Cash Credit is an arrangement under which a customer is allowed
an advance up to certain limit against credit granted by bank. Interest is not
charged on the full amount of the advance but on the amount actually availed of
by him.
(v) Advances against goods: Goods are charged to the bank either by way of pledge
or by way of hypothecation. Goods include all forms of movables which are
offered to the bank as security.
(vi) Bills Purchased/Discounted: These advances are allowed against the security of
bills which may be clean or documentary.
Usance bills maturing at a future date or sight are discounted by the banks for
approved parties. The borrower is paid the present worth and the bank collects the
full amount on maturity.
vii. Advance against documents of title to goods: A document becomes a document
of title to goods when its possession is recognised by law or business custom as
possession of the goods like bill of lading, dock warehouse keeper's certificate,
railway receipt, etc. An advance against the pledge of such documents is an
advance against the pledge of goods themselves.
viii. Advance against supply of bills: Advances against bills for supply of goods to
government or semi-government departments against firm orders after acceptance
of tender fall under this category. It is this debt that is assigned to the bank by
endorsement of supply bills and executing irrevocable power of attorney in favour
of the banks for receiving the amount of supply bills from the Government
departments.
Q 84. "Financing a business through borrowing is cheaper than using equity." Briefly
explain:
(i) Debt capital is cheaper than equity capital from the point of its cost and interest
being deductible for income tax purpose, whereas no such deduction is allowed
for dividends.
(ii) Issue of new equity dilutes existing control pattern while borrowing does not
result in dilution of control.
(iii) In a period of rising prices, borrowing is advantageous. The fixed monetary outgo
decreases in real terms as the price level increases.
Q 85. What are Masala Bonds?

Masala (means spice) bond is an Indian name used for Rupee denominated bond that
Indian corporate borrowers can sell to investors in overseas markets. These bonds are
issued outside India but denominated in Indian Rupees. NTPC raised `2,000 crore via
masala bonds for its capital expenditure in the year 2016.

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YESHAS ACADEMY

RAVI KANTH MIRIYALA, FCA

8. Theory Question and Answer

Ravi Kanth Miriyala

Formula: (i) % change in EBIT / % change in Sales

(ii) Contribution / EBIT

Break-even point in units = Fixed cost / Contribution per unit

BEP = Fixed cost / PV Ratio

Margin of safety (MOS) = (Sales – BEP sales) / Sales * 100

MOS = (Contribution – FC)/ Contribution = EBIT / Contribution

Formula: (a) When there is no Preference Share Capital

(i) % change in EPS / % change in EBIT

(b) When there is Preference Share Capital

(i) % change in EPS / % change in EBIT

Formula: (a) When there is no Preference Share Capital

(i) % change in EPS / % change in Sales

(b) When there is Preference Share Capital

(i) % change in EPS / % change in Sales

PARTICULAR FIRM A FIRM B FIRM C

2. The balance sheet of a Company is as follows:

The additional information given is as under:

Total assets turnover ratio 2.5

Calculate the following:

4. From the following, prepare Income Statement of A, B and C.

6. Consider the following information for Omega Ltd.

Required: calculate % change in earning per share, if sales increase by 5%.

The company is in the 35 per cent tax bracket.

10. The following summarizes the percentage changes in operating income,

Firm Change in Revenue Change in operating income Beta

TUV Ltd 23% 36% 1.30

11. The date relating to two Companies are as given below:

13. The following data relate to RT Ltd. Calculate Combined Leverage.

16. Prepare Income Statements for A, B and C Companies.

1. OL 1.41, 1.36, 1.23; FL 1.31, 1.26, 1; CL 1.85, 1.71, 1.23

COST OF DEBENTURE (Kd)

Perpetual Debenture Redeemable Debenture

Interest (1 - t) Interest (1 - t)  (RV - NP) / N

Where: - t = Tax rate

COST OF PREFERENCE SHARE (Kp)

Perpetual PSC Redeemable PSC

Pref Dividend Pref Dividend  (RV - NP) / N

COST OF TERM LOAN (KL)

(b) D / p Ratio Approach:

(c) E / p Ratio Approach:

(d) D /p + g Approach / Gordon Approach:

Growth rate may be calculated as follows:

COST OF RETAINED EARNINGS

WEIGHTED AVERAGE COST OF CAPITAL

Sources of Fund Amount Cost of Capital

4. As a financial analyst of a large electronics company, you are required to

The company's present book value capital structure is :

Market value per debenture 125 80

6. International Foods Limited has the following capital structure:

7. XYZ Ltd., has the following book value capital structure:

Calculate the weighted average cost of capital using:

8. The capital structure of XYZ Co. is comprising of 12% debentures, 9% preference

You are required to:

14. A Limited has the following capital structure

15. The capital structure of MNP Ltd. is as under

16. An electric equipment manufacturing company wishes to determine the

Business Group Market value of equity Unleveraged

ABC Computers Ltd. had Rs. 50 billion in debt outstanding.

CAPITAL STRUCTURE THEORIES