FM Management Notes

TYBMS SEM V
www.SCOrEeducatioN.co.in
Financial Management 1
CHAPTER: 3 RECEIVABLE MANAGEMENT

SECTION I:- ACCOUNT RECEIVABLE MANAGEMENT
Credit Sales results in Accounts Receivables (AR). Selling goods on credit results into increase in
sales and ultimately the profits also. At the same time the funds are blocked in Accounts
Receivables. Therefore more funds are required to be raised to meet the Working Capital
requirements. Moreover, it involves the risk of Bad Debts. Hence, selling goods on credit is
beneficial (return) as well as dangerous (risk). The Finance Manager has to frame proper credit
policies and take decisions regarding the sanction of credit to the customers.
Therefore, Accounts Receivable Management is the process of decision-making relating to the
investments of funds in these assets in such a manner that the return on shareholders investments is
maximized.
SECTION II:- VARIOUS COSTS ASSOCIATED WITH AR
Capital Cost: AR blocks the firms resources because of the time lag in sale of goods and collection
from the customers. The firm has to arrange for additional funds, which involves cost.
Administrative Cost: The firm has to incur additional cost for maintaining AR. Ex: salaries to the
staff, cost of conducting investigations and cost of deciding credit worthiness.
Collection Cost: Cost incurred for collection dues from the customers. Ex: monitoring state of AR,
letters, telephone and legal action.
Defaulting Cost: Inspite of making all serious efforts some customers may not pay their dues.
Hence, such debts are treated as bad debts. It cannot be realized. Hence it is written off.
SECTION III:- CREDIT MANAGEMENT PROCESS/CREDIT POLICY VARIABLES
The need of receivables management arises only when company grants credit to its customers. To
manage overall condition of receivables, company needs to frame the policy that will govern this
process and there are other aspects that are involved in managing receivables. These aspects can be
divided in three parts: (i) Credit policy, (ii) Credit analysis, and (iii) Control of receivable.
(i) Credit policy:- It generally involves decision relating to period of credit, discount (if any) and
other special items.
Period of credit:- Credit period generally depends on the demand prevailing in the market. It is
also dependent on the custom, the practice followed in the industry, credit risk, and availability
of funds and possibility of bad debts.
The credit period is generally stated in term of net days. For example, if the firms credit terms are
net 50, it is expected that customer will repay credit obligations not later than 50 days.
Discount policy:- Discounts are normally given to speed up the collection of debts. A cash
discount is means of improving the liquidity of the seller. In practice, credit terms are written as
follows. 3/15 net 60. These means that client will get 3% discount if it pays within 15 days of
sale, if he does not avail the offer he must make payment within 60 days. Credit period in this
includes three important things i.e. (a) rate of cash discount, (b) cash discount period and (c) net
credit period.
TYBMS SEM V
www.SCOrEeducatioN.co.in
Financial Management 2
(ii) Credit appraisal / analysis:- After determining credit terms, firm should test whether customer
will be able to pay debts if it grants credit to him. Here analysis regarding 5 Cs (Character,
capacity, capital, conditions and collateral) is done to know his position in the market and
depending on the analysis, final decision is taken. The credit granting decision is:
DENY
CREDI
T
GRAN
T
CREDI
T
Credit Rating:- An important task for finance manager is to rate the various debtors who seek
credit facility. These involves decisions regarding individual parties so as to ascertain how much
credit can be extended and for how long. Here finance manager has to look into creditworthiness of a
party and sanction credit limit only after he is convinced that the party is sound. This would involve
an analysis of the financial status of the party etc.
The credit manager has to employ a number of sources to obtain credit information the following are
important sources.
Trade References:- The firm can ask the customer to give trade reference of people with whom
he is doing business or has done it. The trade reference maybe contacted by the firm to get the
necessary information.
Bank references:- A firm can get credit information from the bank were his customer has
account in it. Firm can ask bank officials regarding the relationship that its customer has with
bank when it comes to exercise the obligation.
Credit Bureau Reports:- In some cases the associations for specific industries maintain a credit
bureau which provides useful and authentic credit information for their members. Credit rating
agencies in India which do the same rate CRISIL (Credit Rating Investment Services of India
Ltd), IICRA (Investment Information and Credit Rating Agency)
Past Experience:- In case of existing customers, the past experience of his account would be
valuable sources of essential data for security and interpretation.
Published Financial Statements:- Financial statements are powerful statements itself to
determine the creditworthiness of the customers. Using tools like cash flow statement & ratios
the financial position of the customer can be determined.
Once the credit-worthiness of a client is ascertained, the next question to resolve is to set a limit on
the credit. In all such enquiries, the finance manager must be discreet and should always have the
interest of company in view.
(iii) Control of receivables:
Another aspect of management of debtors is control of receivables. Merely setting of standards
through policy is not sufficient. It is, equally important to control receivables.
Collection policy: Efficient and timely collections of debtors ensure that the bad debts losses are
reduced to the minimum and the average collection period is shorter. The collection cell of a firm
has to work in a manner that it does not create too much resentment amongst the customers. On the
other hand, it has to keep the amount of outstanding on check. Hence, it has to work in a very
smooth manner and diplomatically.
It is important that clear-cut procedure regarding credit collection is set up. Such procedure must
answer questions like the following:
How long should a debtor balance be allowed to exist before collection process is started?
What should be the procedure of follow up with defaulting customer? How reminders are to be
send and how should each successive reminder be drafted?
Should their be collection machinery whereby personal calls by companys representatives are
made?
What should be the procedure for dealing with doubtful accounts? Is legal action to be instituted?
How should account be handled?
Collection effort / Collection program:
Monitoring the state of receivables
Sending letters to those whose due date is approaching fast
Telegraphic/telephone advice to customers around the due dates
Threat of legal action in case of overdue accounts
Legal action in the case of customers who are overdue
(FOR MORE DETAILS (THEORY) REFER HIMALAYA

PUBLICATION FINANCIAL MANAGEMENT PROF.
PAWAN JHABAK BOOK)
SECTION - PROBLEMS + SOLUTIONS
Problem 1
The following are the details regarding the operation of a firm during a period of 12 months:
Sales
Rs.1200000
Selling Price per unit
Rs.10
Variable Cost Price per unit
Rs.7
Total Cost per unit
Rs.9
Credit period allowed to customers 1 month
The firm is considering a proposal for a more liberal extension of credit by increasing the average
collection period from 1 month to 2 months. This relaxation is expected to increase the sales by
25%.
You are required to advise the firm regarding adopting the new credit policy, presuming that the
firms required return on investment is 25%.
Q.1 Solution
Evaluation of Credit Proposal
Particular
Credit Period
No of Units
Sales @ 10
(-) Variable cost @ 7
Present Policy
1month
120000
1200000
840000
Proposed Policy
2 months
150000
1500000
1050000
Contribution
(-) Fixed Cost (9-7) = 2x120000
Profit
(a). . . .
Receivables
VC + FC x DCP
12
Cost of AR
Capital cost (Receivables x ROI)
(b). . . .
Net Profit
(a-b) . . . .
Incremental NP
360000
240000
120000
840000 + 240000
12
x1
= 90000
450000
240000
210000
1050000 + 240000
12
x2
= 215000
= 90000 x 25%
= 22500
97500
-
= 215000 x 25%
= 53750
156250
58750
Recommendation:
The company is advised to adopt 2 months credit period since it result into incremental net profit of
Rs. 58750.
Problem 2
Arvind Mills Ltd. manufactures readymade garments and sells them on credit basis through a
network of dealers. Its present sale is Rs.60 lakhs per annum with 20 days credit period. The
Company is contemplating an increase in the credit period with a view to increasing sales. Present
variable costs are 70% of sales and the total fixed costs are Rs.8 lakhs per annum. The company
expected pre tax return on investment @ 25%. Some other details are given as under:
Proposed
Average Collection Period
Expected annual Sales (Rs.
Credit Policy
(Days)
Lakhs)
I
30
65
II
40
70
III
50
74
IV
60
75
Which credit policy should the company adopt? (Assume 360 days in a year)
Q.2 Solution
Evaluation of credit proposal
Particulars
DCP (days)
Sales
(-) Variable cost (70%)
Contribution
(-) Fixed cost
Profit (a)
Receivables
VC + FC x DCP
360
Cost of AR
Capital cost (Reci x ROI)
(b)
Net profit (a b)
Incremental NP
Present
Policy
20
60
42
18
8
10
42 + 8 x 20
360
= 2.78
= 4.46
= 6.33
= 8.31
= 10.08
2.78 x 25%
= 0.70
9.30
-
4.46 x 25%
= 1.12
10.38
1.08
= 1.58
11.42
2.12
= 2.08
12.12
2.82
= 2.52
11.98
2.68
I
30
65
45.5
19.5
8
11.5
Proposed Policy
II
III
40
50
70
74
49
51.8
21
22.2
8
8
13
14.2
IV
60
75
52.5
22.5
8
14.5
Recommendation:
Select proposed policy III since it result into highest incremental net profit. i.e. 2.82 lakhs.
Problem 3
Ponds Ltd. has present sales level of 10,000 units at Rs. 300 per unit. Variable cost is Rs.200 per unit
and the fixed cost amounts to Rs.300000 per annum. The present credit period allowed by the
company is 1 month. The company is considering a proposal to increase the credit periods to 2
months and 3 months and has made the following estimates:
Credit Policy
Increase In Sales
% Of Bad Debts
Existing
1 month
1%
Proposed
2 months 3 months
15%
30%
3%
5%
There will be increase in fixed cost by Rs.50000 on account on increase of sales beyond 25% of
present level. The company plans on a pretax return of 20% on investment in receivables. You are
required to calculate the most paying credit policy for the company.
Q.3 Solution
Particular
DCP
No of Units
Sales @ (300 p.u.)
(-) Variable cost @ 200 p.u.
Contribution
(-) Fixed Cost
Profit
(a). . . .
Receivables
VC + FC x DCP
12
Cost of AR
Capital cost (Receivables x
ROI)
Defaulting cost (1% of sales)
(b) . . . . .
Net Profit
(a-b) . . . . . .
Incremental NP
Present
Policy
1month
10000
3000000
2000000
1000000
300000
700000
Proposed Policy
I
II
2 months 3 months
11500
13000
3450000
3900000
2300000
2600000
1150000
1300000
300000
350000
850000
950000
= 191667
= 433333
=737500
38333
86667
147500
30000
68333
63166.7
-
103500
190167
659833
28166
195000
342500
607500
(24167)
Recommendation: i.e. 2 months

Select proposed policy I since it results into highest incremental net profit. i.e. Rs.28166
Problem 4
Samsung Ltd. manufacturers of Color TV sets are considering the liberalization of existing credit
terms to three of their large customers A, B and C. The credit period and likely quantity of TV sets
that will be lifted by customers are as follows:
Credit period (days)
Quantity lifted (No of TV sets)

A
B
C
0
1000
1000
30
1000
1500
60
1000
2000
1000
90
1000
2500
1500
The selling price per TV set is Rs.9000. The expected contribution is 20% of the selling price. The
cost of carrying debtors averages 20% per annum.
a. Determine the credit period to be allowed to each customer. (1year = 360 days)
b. What other problems the company might face in allowing the credit period as determined in (a)
above.
Q.4 Solution.
Evaluation of credit proposal for A
Select Credit period 0 days since Quantity remains same inspite of increase in Credit period.
Evaluation of credit proposal for B.
Particulars
DCP
No. of units
Sales @ 9000 p.u
Contribution (20%) (a)
Receivables
Sales x DCP
360
Cost of AR
Capital cost (Recv x ROI)
(b)
Net profit (a b)
1
0
1000
9000000
7200000
1800000
Proposed Policy
2
3
4
30
60
90
1500
2000
2500
13500000 18000000 22500000
10800000 14400000 18000000
2700000
3600000 4500000
1125000
3000000
5625000
1800000
225000
225000
2475000
600000
600000
3000000
1125000
1125000
3375000
Recommendation:
Select proposed policy 4 i.e. 90 days credit period as it results into highest net profit Rs.3375000.
Note: In absence of information of fixed cost, receivables have been valued at sales.
Evaluation of credit proposal for C.
Particulars
Proposed Policy
3
4
DCP
60
90
No. of units
1000
1500
Sales @ 9000 p.u
9000000 13500000
7200000 10800000
Contribution (20%) (a) 1800000 2700000
Receivables
Sales x DCP
1500000
360
Cost of AR
Capital cost (Recv x ROI) 300000
(b) 300000
Net profit (a b)
1500000
3375000
675000
675000
2025000
Recommendation:
Select proposed policy 4 i.e. 90 days credit period, as it results into highest net profit Rs.2025000
Note :- In absence of information of fixed costs, Receivable have been valued at sales.
b) The problems to be faced by the company in allowing credit period as determined in A above.
1) Customer A on discovering that B & C are allowed higher credit period 90 days at same price
will feel is treated by the company in an unfair manner, and may stop doing business with
company.
2) Customer A might also spread disinformation in market resulting into Loss at reputation /
goodwill for Samsung Ltd.
Problem 5
X & Co. whose current sales are Rs.600000 per annum and an average collection period of 30days
wants to pursue a more liberal policy to improve sales.
Credit Policy
Increase In Collection
Increase In Sales
% Default
Period (Days)
Rs.
Anticipated
A
10
30000
1.5%
B
20
48000
2%
C
30
75000
3%
D
45
90000
4%
Selling price per unit is Rs.3, average cost per unit is Rs.2.25 and variable cost per unit is Rs.2
Current Bad Debt loss is 1%. Required Return on additional Investment is 20%. Assume 360 days a
year.
Which of the above policies would you recommend for adoption?
Q.5 Solution
Particulars
DCP (days)
No. of units
Sales @3 p.u.
(-) Variable cost @ 2 p.u.
Contribution
(-) Fixed cost (2.25 2) x 200000
Profit (a)
Receivables
VC + FC x DCP
360
Present
Policy
30
200000
600000
400000
200000
50000
150000
A
40
210000
630000
420000
210000
50000
160000
Proposed Policy
B
C
50
60
216000
225000
648000
675000
432000
450000
216000
225000
50000
50000
166000
175000
D
75
230000
690000
460000
230000
50000
180000
37500
52222
66944
106250
83333
Cost of AR
Capital cost (Recv x ROI)
Defaulting cost
(b)
Net profit (a b)
Incremental NP
7500
6000
13500
136500
-
10444
9450
19894
140106
3606
13389
12960
26349
139651
3151
16667
20250
36917
138083
1583
21250
27600
48850
131150
(5350)
Recommendation:
Select proposed policy A since it results into highest incremental net profit. i.e. Rs.3606
(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

HIMALAYA PUBLICATION FINANCIAL MANAGEMENT
PROF. PAWAN JHABAK BOOK)
Extra Practise Problem
Problem 7
Many times Customers play a very smart game. They pay the bills before time in initial period and
once they get used to Companys working, they start delaying payment beyond agreed terms. It is
observed that company suffers loss not because of higher costs but slow, low and less recovery of
the outstanding from customers. And here comes the role of a Credit Manager.
You are required to prepare a list of the precautions to be taken while extending credit terms to a
new customer.
(BMS EXAM) (May 2010)
Problem 8
System Failure in USA, Economic Slowdown in Europe and Stock Market Meltdown in Asia have
their root cause in SUB PRIME CRISIS. The SUB PRIME crisis arose because of Lending without
knowing. In the light of the above enlist the issues involved in formulating a sound Credit Policy.
Problem 9
As a Marketing Executive, before extending credit facilities to the customers introduced by your
Salesman, what precaution would you take to protect the interest of the Company.
Problem 10
Construct of a Credit Rating Index (based on a 5-point rating scale)
Factor
Past Payment
Net profit Margin
Current ratio
Debt-equity ratio
Return on equity
Factor
Weight
0.25
0.25
0.15
0.15
0.20
Rating
5
3
4
2
3
Problem 11
Ageing Schedule The ageing schedule (AS) classifies outstanding accounts receivables at a given
point of time into different age brackets. An illustrative AS is given below.
Age Group ( in days ) A Ltd. B Ltd.

0 30
60
25
31 60
30
15
61 90
10
35
> 90
0
25
Comment on above ageing schedule of A Ltd. & B Ltd.
Percent of Receivables (Standard)

45
35
15
5
Problem 12
Kalpataru Ltd.
Collection Matrix
Percentage of receivables
collected during the
Month of Sales
First following month
Second following month
Third following month
Fourth following month
January
Sales
15
20
35
15
15
February
Sales
17
22
37
17
7
March
Sales
18
23
38
18
3
April
Sales
19
24
39
18
0
May
Sales
21
26
41
12
0
June
Sales
25
28
43
4
0
Comment on collection matrix.
REVIEW QUESTIONS:Q.1 Concept Testing

(a) Concept of Receivable Management.
(b) Various costs associated with Accounts Receivable.
(c) 5 cs of credit / Traditional credit Analysis.
(d) Numerical credit scoring.
(e) DSO
(f) Collection Matrix.
(g) Ageing Schedule.
Q.2 Explain Credit Management process / credit policy variables.

CHAPTER: 4 CASH MANAGEMENT
SECTION I :- CASH BUDGET MEAN ING AND OBJECTIVES

Cash is the most liquid asset. It is most important for the daily operation of the firm. Efficient
management of cash is very crucial for the solvency of the firm. Hence, it is considered as life blood
of business organization.
Cash budget represents the cash receipts and cash payments and estimated cash balance for each
month of the period for which budget is prepared. Cash budget is a device for controlling and coordaining the financial side of a business. Cash budget serves the following purposes:
a. To ensure that sufficient cash is available whenever required
b. To point out any possible shortage of cash so that necessary steps can be taken to meet the
shortage by making arrangement with the bank for overdraft or loan,
c. To point out any surplus cash so that management can invest it in interest fetching securities etc.
Distinguish between cash budget and cash forecast:
Cash Budget
Cash budget is usually prepared for short
periods ranging up to one year.
Objective is to ensure short term liquidity
an avoid default in timely discharge of
current liabilities.
Thrust is on current assets and liabilities
and maintaining cash cushion for safety.
Usually prepared by junior management
team for perusal of senior managers.
It is working capital management activity.
Cash Forecast
Cash forecast is for longer terms exceeding
one year such as 3 years, 5 years, etc.
Objective is to study sources of funds for
various future requirements.
Capital receipts and capital expenditure
investment dominate this number game.
Usually prepared by senior management for
perusal of directors owners.
It is more of investment planning activity.
Distinguish between Cash Flow Statement and Cash Budget:

Cash Flow Statement
Cash flow statement is prepared based on past
data of income statement and balance sheet.
Is historical in nature.
Analytical tool.
Is based on real data.
Cash Budget
Cash budget is prepared based on estimates
of collection and outgo of cash.
Is futuristic in nature.
Planning tool.
Is based on estimates.
SECTION II :- MOTIVES FOR HOLDING CASH

There are 3 important motives for holding cash:
Transaction Motives
Business organization needs cash for conducting business transactions. The collection of cash is not
perfectly matched with payment of cash. Hence, some cash balance is required to be maintained.
Precautionary Motive
There maybe uncertainties regarding receipt of cash and payment of cash. In order to protect against
such uncertainties, it is necessary to maintain some cash balance.
Speculative Motive
Business organization would like to tap business opportunities arising from fluctuations in
commodity prices, share prices, foreign exchange rates etc. A firm which has sufficient cash can
exploit opportunities.
SECTION III :- STRATEGIES OF CASH MANAGEMENT:
Strategies of Cash Management
The cash budget, as a cash management tool, would throw light on the net cash position of a firm.
After knowing the cash position, the management should work out the basic strategies to be
employed to manage its cash. The present section attempts to outline the basic strategies of cash
management.
The broad cash management strategies are essentially related to the cash turnover process, that is, the
cash cycle together with the cash turnover. The cash cycle refers to the process by which cash is
used to purchase material from which are produced goods, which are then sold customers, who later
pay the bills. The firm receives cash from customers and the cycle repeats itself. The cash turnover
means the number of times cash is used during each year. The cash cycle involves several steps
along the way as funds flow from the firms accounts.
Cash Cycle is the amount of time cash is tied up between payment for production inputs and receipt
of payment from the sale of resulting finished product; calculated as average age of inventory plus
average collection period minus average accounts payable period.
Cash turnover is the number of times cash is used during the year; calculated by dividing number
of days in a year by the cash cycle.
Example A firm which purchases raw materials on credit is required by the credit terms to make
payments within 30 days. On its side, the firm allows its credit buyers to pay within 60 days. Its
experience has been that it takes, on an average, 33 days to pay its accounts payable and 70 days to
collect its accounts receivable. Moreover, 85 days elapse between the purchase of raw materials and
the sale of finished goods, that is to say, the average age of inventory is 85 days. What is the firms
cash cycle? Also, estimate the cash turnover.
Solution The cash cycle of the firm can be calculated by finding the average number of days that
elapse between the cash outflows associated with paying accounts payable and the cash inflows
associated with collecting accounts receivable:
(i) Cash cycle = 85 days + 70 days 33 days = 122 days.
(ii) Cash turnover = The assumed number of days in a year divided by the cash cycle = 365 / 122 = 3
Cash management strategies are intended to minimize the operating cash balance
requirement. The basic strategies that can be employed to do the needful are as follows.
(a) Stretching Accounts Payable,
(b) Efficient Inventory-Production Management.
(c) Speedy Collection of Accounts Receivable, and
(d) Combined Cash Management Strategies.
(a) Stretching Accounts Payable

One basic strategy of efficient cash management is to stretch the accounts payable. In other words, a
firm should pay its accounts payable as late as possible without damaging its credit standing. It
should, however, take advantage of the cash discount available on prompt payment. Stretching
Accounts payable should not result into higher prices / lower quality.
(b) Efficient Inventory-Production Management
Another strategy is to increase the inventory turnover, avoiding stock-outs, that is shortage of stock.
This can be done in the following ways:
1. Increasing the raw materials turnover by using more efficient inventory control techniques.
2. Decreasing the production cycle through better production planning, scheduling and control
techniques; it will lead to an increase in the work-in-progress inventory turnover.
3. Increasing the finished goods turnover through better forecasting of demand and a better
planning of production.
(c) Speeding Collection of Accounts Receivable
Yet another strategy for efficient cash management is to collect accounts receivable as quickly as
possible without losing future sales because of high-pressure collection techniques. The average
collection period of receivables can be reduced by changes in (i) credit terms, (ii) credit standards,
and (iii) collection policies. These are elaborated in the receivable management chapter. In brief,
credit standards represent the criteria for determining to whom credit should be extended. The
collection policies determine the effort put forth to collect accounts receivable promptly. Speeding
collection will also reduce bad debts.
(d) Combined Cash Management Strategies
We have shown the effect of individual strategies on the efficiency of cash management. Each one
of them has a favourable effect on the operating cash requirement. We now recommend their
combined effect, as firms will be well advised to use a combination of these strategies.
The foregoing discussion clearly shows that the three basic strategies of cash management related to
(1) accounts payable, (2) inventory, and (3) accounts receivable, lead to a reduction in the cash
balance requirement. But, they imply certain problems for the management. First, if the accounts
payable are postponed too long, the credit standing of the firm may be adversely affected. Secondly,
a low level of inventory may lead to a stoppage of production as sufficient raw materials may not be
available for uninterrupted production or the firm may be short of enough stock to meet the demands
for its product that is, stock-out. Finally, restrictive credit standards, credit terms and collection
policies may jeoparadise sales. These implications should be constantly kept in view while working
out cash management strategies. The company needs to adopt a balanced approach.
METHODS / TOOLS / TECHNIQUES / PROCESSES OF CASH MANAGEMENT:
The following are the popular methods of cash management, required to implement cash
management strategies.
1. Cash budgets.
2. Long term cash forecasting: This involves planning for cash requirements for a period of over
a year and includes capital expenditure decisions, sale of fixed assets, issue of shares, redemption
etc.
3. Reports: Most firms used there management information system (MIS) to prepare regular and
sometimes even daily treasury reports to report the cash position.
4. Prompt billing: Invoices should be promptly sent to customers to minimize billing float.
5. Obtaining favorable credit terms of purchase: This depends on the companys bargaining
power with the suppliers.
6. Concentration banking: In concentration banking the company establishes a number of
strategic collection centers in different region instead of a single collection at the head office.
Payments received by the different collection centres are deposited with their respective local
bank which in turn transfers all surplus funds to the concentration bank of the head office. The
concentration bank with which the company has its major bank account is generally located at
the headquarters. This system reduces the period between the time a customer mails in his
remittances and time when they become spendable funds with the company. Concentration
banking is one important and popular way of reducing the size of the float. (Float is the time
taken to convert a transaction into cash.) Any where banking across nation wide Branches is
another new facility offered (SBI, ICICI, etc.)
7. Lock Box System:- Under this system, customers deposit their cheques in special boxes and the
local branch collects them and deposits them immediately. For example, the system used by
mobile phone and electric companies.
8. Playing the float:- Playing the float can maximizes availability of cash. In this, a firm estimates
accurately the time when the cheques issued will be presented for payment and thus utilizes the
float period to its advantage by issuing more cheques but having in the bank a lesser cash
balance.
The term float is used to refer to the periods that affect cash as it moves through the different stages
of the collection process. Four kinds of float with reference to management of cash are:
Billing float: An invoice is the formal document that a seller prepares and sends to the purchaser
as the payment request for goods sold or services provided. The time between the sale and the
mailing of the invoice is the billing float.
Mail float: This is the time when a cheque is being processed by the post office, courier
messenger service or other means of delivery.
Cheque processing float: This is the time required to sort, record and deposit the cheque after it
has been received by the company.
Banking processing float: This is the time from the deposit of the cheque to the crediting of
funds in the sellers account.
9. RTGS (Real Time Gross Settlement):- i.e. Online Payment to suppliers and from customers
can reduce float.

PAWAN JHABAK BOOK)
SECTION : PROBLEM AND SOLUTION
Q.1 Prepare a cash budget of a company for April, May and June 2010 in a columnar form using the
following information:
Month 2010
January (actual)
Sales Rs.
80,000
Purchase Rs.
45,000
Wages Rs.
20,000
Expenses Rs.
5,000
February (actual)
80,000
40,000
18,000
6,000
March (actual)
75,000
42,000
22,000
6,000
April (budgeted)
90,000
50,000
24,000
7,000
May (budgeted)
85,000
45,000
20,000
6,000
June (budgeted)
80,000
35,000
18,000
5,000
You are further informed that:
10% of the purchases and 20% of sales are for cash.
The average collection period of the company is 2 month and credit purchase is paid off regularly
after one month.
Wages are paid half monthly in arrears and the rent of Rs.500 included in expenses is paid monthly.
Cash and Bank balance as on April 1, was Rs.15,000 and the company wants to keep it on the end of
every month below this figure, the excess cash being put in fixed deposits.
Q.1 Solution
th
Cash budget for 3 months ending 30 June 2010.
Particulars
Opening Balance b/f
Add:- Cash Receipts
Cash Sales
Collection from debtors.
i)
ii) Cash Payment
Cash purchase
Payment to suppliers
Wages
Rent
Other expenses ii)
(iii)
Less:- Fixed deposits
*
Closing balance c/f
W.N.1) Collection from debtors.
Feb
Total Sales
80000
(-) Cash Sales 20% 16000
Credit Sales
64000
April
15000
May
15000
June
14500
18000
64000
97000
17000
60000
92000
16000
72000
102500
5000
37800
23000
500
6500
72800
24200
9200
15000
4500
45000
22000
500
5500
77500
14500
14500
3500
40500
19000
500
4500
68000
34500
19500
15000
Mar
75000
15000
60000
April
90000
18000
72000
May
June
2m
Due & received
April
W N 2) Payment to Suppliers.
Mar
Total Purchase
42000
(-) Cash Purchase 10%
4200
Credit Purchase
37800
April
50000
5000
45000
May
45000
4500
40500
May
June
1m
Due & Paid
April
W N 3) Wages
April
of Previous month 11000
of Current month 12000
23000
May
12000
10000
22000
June
10000
9000
19000
st
Q.2 From the following information prepare a monthly cash budget for the three months ending 31
December, 2009:
Sales
Materials
Wages
Production Admin. And
Months 2009
Rs.
Rs.
Rs.
Rs.
Selling Rs.
June
3,000
1,800
650
225
160
July
3,250
2,000
750
225
160
August
3,500
2,400
750
250
175
September
3,750
2,250
750
300
175
October
4,000
2,300
800
300
200
November
4,250
2,500
900
350
200
December
4,500
2,600
1,000
350
225
Credit terms are:
Sales: 4months to debtors, 10% of sales are on cash.
On an average, 50% of credit sales are paid on the due dates while the other 50% are paid in the
following month.
Creditors for material: 2months.
Lag in payment:
Wages: month
Overheads: month
st
Cash and bank balance: On 1 October it is expected to be Rs. 15,000
Other Information is:
Plant and machinery to be installed in august at a cost of Rs.24,000. It will be paid for by
st
monthly of Rs.500 each from 1 October.
st
Preference share dividend @ 5% on Rs.50,000 is to be paid 1 December.
st
Calls on 250 equity shares @ Rs.2 per share expected on 1 October.
st
Dividends from investments amounting to Rs.250 are expected to 31 December.
Income tax (advance) to be paid in December Rs.1500
Q.2 Solution
st
Cash budget for 3 months ending of 31 December, 09
Particulars
Opening Balance b/f
Add:- Cash receipts
Cash sales
Dividend from Investment.
Call on shares (250 x 2)
i)
ii) Cash Payment
Wages
OHs
Plant & Machinery
Preference dividend (5% x 50000)
Income tax advance
ii)
Closing balance (i-ii)
Oct
15000
Nov
13075
Dec
12162.5
400
1350
500
17250
425
2812.5
16312.5
450
3037.5
250
15900
2400
78750
48750
500
4175
13075
2250
875
525
500
4150
12162.5
2300
975
562.5
500
2500
1500
8337.5
7562.5
W N 1) Wages ( month)
of Previous month
of Current month
Oct
187.50
600
787.50
Nov
200
675
875
Dec
225
750
975
W N 2) Overheads (Production + A + S)
of Previous month
of Current month
Oct
237.5
250
487.50
W N 3) Collection from debtors

June
Total Sales
3000
(-) Cash Sales (10%)
300
Credit Sales
2700
Nov
250
275
525
Dec
275
287.50
562.50
July
3250
325
2950
August
3500
350
3150
Nov
1462.5
1350
2812.5
Dec
1575
1462.5
3037.5
(4 M)
Due
50% in due month
50% next month
Oct
1350
-_
1350
th
Q.3 Prepare cash budget for the three months ending 30 June 2010 from the following information:
Month
Sales Rs.
Material
Wages Rs.
Overheads
Purchase Rs.
Rs.
9,600
3,000
1,700
9,000
3,000
1,900
9,200
3,200
2,000
10,000
3,600
2,200
10,400
4,000
2,300
the remaining sales, 50% are collected in the next month and
February
14,000
March
15,000
April
16,000
May
17,000
June
18,000
Sales: 10% sales are on cash. Of
remaining balance in next month.
Creditors: materials-2 months. Wages-1/4 month. Overheads- month.
st
Cash and bank balance on the 1 April, 1990 is expected to Rs.6,000/- Other information
provided is as follows:
Plant and machinery will be installed in February 2003 at a cost Rs.96,000/-. The monthly
installment of Rs.2,000/- is payable from April onwards.
st
Dividend at 5% on preference share capital of Rs.2,00,000/- is to be paid on 1 June.
Advance to be received for sale of vehicles Rs.9,000/- in June.
Dividend on investment accounting to Rs.1,000/- is expected to be received in June.
Income tax (advance) to be paid in June is Rs.2,000/-.
(MU, BAF, April 2006)
Q.3) Solution
th
Cash budget for 3 months ending of 30 June 2010

Particulars
Opening Balance b/f
Add:- Cash Receipts
Cash Sales
Dividend on Investment
Advance to be received vehicle
i)
i) Cash Payment
Wages
OHs
Plant & Machinery
Dividend on preference share capital
Advance to be paid
ii)
Closing balance c/f (i-ii)
April
6000
May
3950
June
3000
1600
13050
20650
1700
13950
19600
1800
1000
14850
9000
29650
9600
3150
1950
2000
16700
3950
9000
3500
2100
2000
16600
3000
9200
3900
2250
2000
10000
2000
29350
300
W N 1) Collection from debtors

Feb
Total Sales
14000
(-) Cash Sales
1400
Credit Sales
12600
March
15000
1500
13500
April
16000
1600
14400
April
6300
6750
13050
May
6750
7200
13950
June
7200
7650
14850
50% of credit sale 2m

50% of credit sales 1m
May
17000
1700
15300
W N 2) Overheads
of Previous month
of Current month
April
950
1000
1950
May
1000
1100
2100
June
1100
1150
2250
th
W N 3) Wages (1/4 month)

of Previous month
of Current month
April
750
2400
3150
May
2800
2700
3500
June
900
3000
3900
th
Q.4 Prepare cash budget on Alpha Co. Ltd. for three months ended 30 June 2010 from the
following information:
Month
Sales Rs. Purchase Rs. Wages Rs. Other Expenditure Rs.
January
1,20,000
40,000
30,000
20,000
February
1,00,000
40,000
30,000
20,000
March
1,60,000
80,000
30,000
30,000
April
2,00,000
1.00,000
50,000
40,000
May
2,80,000
1,40,000
50,000
40,000
June
3,20,000
1,20,000
60,000
40,000
Additional information:
1. Sales are 20% cash and the balances are two months credit.
2. Purchases are at one month credit subject to a cash discount of 5%.
3. Wages are paid in month and other expenditure on the months interval.
4. During May, the company pays dividend of 15% on its equity capital of Rs.2,00,000 and
during June, deferred payment installment (quarterly) of Rs.50,000 will fall due.
5. It is expected that at the end of March 2003, there will be cash balance of Rs.28,000.
Q.4 Solution
Cash budget for Alpha Co. Ltd. for 3 months ending 30 June, 2010
Particulars
April
Opening Balance b/f
28000
Add:- Cash Receipts
40000
Cash Sales
80000
148000
A).
(-) Cash Payment
76000
Payment to creditors
40000
Payment of Wages (W.N.3)
30000
Payment of other expenditure
Payment equity dividend
Payment of installment
146000
B).
2000
Note:- It is assumed that company has sufficient overdraft facility.
W.N.1) Collection from debtors
Feb
March
April
Sales
100000
160000
200000
(-) Cash Sales 20000
32000
40000
Credit Sales
80000
128000
160000
(2 M)
April
May
W.N.2) Payment to supplier
March
April
80000
100000
5% discount
4000
5000
76000
95000
1 month:. April
W.N.3) Wages
Current month
June
May
140000
7000
133000
May
April
25000
June
May
25000
June
30000
May
June
2000 (29000)
56000
128000
186000
64000
160000
195000
95000 133000
50000
55000
40000
40000
30000
50000
215000 278000
(29000) (83000)
Previous month
15000
40000
25000
50000
25000
55000
th
Q.5 Prepare a cash budget for the months ended 30 September, 2010 based on the following
information:
st
Cash at bank on 1 July, 2010
25,000
Salaries and wages estimated monthly
10,000
Interest payable: August 2010
5,000
Estimated
June Rs. July Rs. August Rs. September Rs.
Cash sales
-- 1,40,000
1,52,000
1,21,000
Credit sales
1,00,000
80,000
1,40,000
1,20,000
Purchases
1,60,000 1,70,000
2,40,000
1,80,000
Other expenses
-20,000
22,000
21,000
Credit Sales are collected 50% in the month sales are made and 50% in the month following.
Collection from credit sales are subject to 5% discount, if payment is received during the month of
purchase and 2 %, if payment is received in the following month. Creditors are paid either on a
prompt or 30 days basis. It is estimated that 10% of the creditors are in the prompt category.
(M.Com, May 1988 & Oct 1986)
Q.5) Solution
Particulars
Opening Balance b/f
Add:- Cash Receipt
Cash Sales
i)
ii) Cash Payment
Salaries & wages
Interest payable
Cash - Purchases (10%)
Other expenses ii)
Closing balance (i-ii)

W. N 1) Collection from debtors
June
Credit Sales
100000
July
50% in same month
38000
50% in 1 month
48750
86750
July
80000
Aug
66500
39000
105500
July
25000
Aug
Sept
60750 104250
140000
86750
251750
152000 121000
105500 125250
318250 350500
10000
17000
144000
20000
191000
60750
10000 10000
5000
24000 18000
153000 216000
22000 21000
214000 265000
104250 85500
Aug
140000
Sept
57000
68250
125250
Sept
1,20,000
EXTRA PRACTISE PROBLEM

(Q.6) LTC Brothers have requested to prepare their cash budget for the period January 20X1 through
June 20X1. The following information is available.
a. The estimated sales for the period of January 20X1 through June 20X1 are as the follow:
1,50,000 per month from January through March and 2,00,000 per month from April
through to June.
b. The sales for the month of November & December of 20X0 have been 1,20,000 each.
c. The division of Sales between cash & credit Sales is as follows: 30% cash & 70% credit.
d. Credit collection pattern is : 40 & 60% after 1 and 2 month respectively.
e. Bad debt losses are nil.
f. Other anticipated receipt are (i) 70,000 from the sale of machine in April. (ii) 3,000
interest on securities on June.
g. The estimated purchase of material are 60,000 per month from January to March &
80,000 per month from April to June.
h. The payment for purchase are approximately a month after the purchase.
i. The purchase for the month of December, 20X0 have been 60,000 for which payment
will be made in January 20X1.
j. Miscellaneous cash purchase of 3,000 per month are planned, January through June.
k. Wage payments are expected to be 25,000 per month, January through June.
l. Manufacturing expenses are expected to be 32,000 per month, January through June.
m. General Administrative and selling expenses are expected to be 15,000 per month.
n. Dividend payment of 30,000 & Tax payment of 35,000 are scheduled in June 20X1.
o. A machine worth 80,000 is planned to purchase on Cash in March 20X1.
st
Cash Balance as on 1 January 20X1 is 28,000.
REVIEW QUESTIONS:Q.1) Concept Testing.

(a) Cash budget
(b) Motives for holding cash
(c) Marketable securities
Q.2) Explain Strategies of Cash Management.
Q.3) Explain methods / tools / techniques / processes of cash management.
Q.4) What is optimal cash balance? State options for investing surplus cash.
(FOR MORE DETAILS (P ROBLEMS AND SOLUTIONS) REFER

CHAPTER: 5 COST OF CAPITAL

SECTION I TYPES OF CAPITAL
Types of Capital, can be mainly classified as (a) owners capital & (b) Borrowed capital i.e. Debt
(a) Owners Capital can be further classified as
(i) Equity Share Capital
(ii) Preference Share Capital
(iii)Retained Earnings / Internal funds / R & S.
(b) Borrowed Capital / Borrowed funds / Debts, includes Debentures, Bank Loan, Public deposits
and other long term loan.
The above types of capital are explained in detail in chapter sources of finance.
SECTION II COST OF CAPITAL
Risk Return relationships of various securities Risk
Since the firm sells various securities to investors to raise capital for financing investment projects, it
is therefore necessary that investment projects to be undertaken by the firm should generate atleast
sufficient net cash flow to pay investors shareholders and debt holders their required rates of
return. In fact, investment projects should yield more cash flows than to just satisfy the investors
expectations in order to make net contribution to the wealth of ordinary shareholders. Viewed from
all investors point of view, the firms cost of capital is the rate of return required by them for
supplying capital for financing the firms investment projects by purchasing various securities. It
may be emphasized that the rate of return required by all investors will be an overall rate. Thus, the
firms cost of capital is the average of the opportunity costs (or required rates of return) of various
securities which have claims on the firms assets.
Cost of Equity Share Capital
Cost of Equity
Cannot be estimated accurately, as there is no legal obligation to pay equity shareholders.
Based on expectations of shareholders.
Only Net Income (N1) Approach believes in such estimation.
Commonly used three models
Model 1: Total Yield Model
Model 2: Dividend growth Model
Ke = D1 + (P1 Po) x 100
Po
Ke = (D1 x 100) + G
Po
Model 3: FPS
Model
EPS1 = PAT-Pref. Div
No. of eq. sh.
& Ke = EPS1 x 100
Po
Good Approximation
Ke =
1
P/E Ratio
Model 1 is suitable for listed & frequently traded (Liquid Shares)

Model 2 is Suitable for any security, listed or unlisted.
Model 3 is based on fundamental analysis, useful for portfolio management.
Cost of equity (Ke)
Notations: Po = Stock (share) price today
P1 = Stock after 1 year (expected)
D1 = Dividend (expected) after 1 year
G = Growth in dividend % p.a. (expected)
EPS1 = Earnings per share after 1 year (expected)
Capital Asset Pricing Model (CAPM)

Ke = Rf + (Rm Rf)
Where: Rf is Risk free rate of return.
Rm is market return (Eq. Nifty)
is Beta of a security.
Ke = + Rm [security Market Line (SML)]
is unsystematic diversifiable risk factor.
is Systematic non-diversifiable risk factor.
Equity is free source of capital. Do you agree?
Ans: Equity is perceived as free source of capital because
a) There is no legal obligation to pay dividend (or any other from of return) to equity
shareholders.
b) Equity shareholders are entitled to any benefit only if there is profit or accumulated profit
(Lenders get interest even in case of loss)
c) Equity shareholders have only residual charge on assets in case of liquidation, after paying
lenders & pref. shareholder.
Equity is however not a free source of capital because-
a) Though there is no legal obligation there is managerial obligation to give expected return to the
shareholders, they are de-facto owners of the firm.
b) If Equity is really treated as free source it will not take care of shareholders interests. This will
conflict with going concern concept of accounting, as shareholders will not continue their
investment.
Hence, Equity is the costliest source because of,
(i) High risk (ii) Residual Benefits only. (iii) Expectations matching with high risk-high return.
These factors make it costliest source of capital.
Cost of preference Share Capital

The cost of preference capital is a function of the dividend expected by investors.
The cost of preference share is not adjusted for taxes because preference dividend is paid after
the corporate taxes have been paid. Preference dividends do not save any taxes. Thus the cost of
preference shares is automatically computed on an after tax basis. Since interest is tax deductible
and preference is not, the after tax cost of preference shares is substantially higher than the after
tax cost of debt.
Generally, in absence of information
Kp = Proposed Preference dividend
For e.g. 15% preference share capital
:. Kp = 15%
Irredeemable preference shares
Kp = Preference dividend x 100
Net proceeds
Note:- Net proceeds = Face value + premium discount flotation cost.
Redeemable Preference Shares
Kp = Pref. divd + FV NP
N
FV + NP
2
x 100
Note:- N = Number of Years

Cost of Retained Earnings
The opportunity cost of the retained earnings (Internal funds) is the rate of return on dividends
foregone by equity shareholders.
There is however a difference between retained earnings and issue of equity shares from the firms
point of view. The firm may have to issue new shares at a price lower than the current market price.
Also, it may have to incur flotation costs. Thus external equity will cost more to the firm than the
internal equity / Retained earnings.
ke = D1 x 100 ++ G
G
P0
The cost of retained earnings determined by dividend valuation model implies that if the firm
would have distributed earnings to shareholders, they could have invested it in the shares of other
firms of similar risk at market price (Po) to earn a rate of return equal to Ke. Thus the firm should
earn a return on retained funds equal to Ke to ensure growth of dividends and share price. If a return
less than Ke is earned on retained earnings, the marker price of the firms share will fall.
Example:- Current market price of XYZ Ltd. is Rs.90 and expected dividend per share next year is
Rs.4.50. Dividends are expected to grow at a constant rate of 8 percent. Calculate cost of retained
earning.
Solution
ke = D1 x 100 ++ G
G
P0
= 4.5 x 100 + 8
90
= 5% + 8%
= 13%
If the company intends to retain earnings, it should at least earn a return of 13% on retained earnings
to keep the current market price unchanged.
Cost of Debt
Cost of Debt Capital : (post tax)

Owned Funds and Owed Funds are important sources of corporate capital. Owed Funds are nothing
but Borrowed Funds. A company may borrowed from different sources like FIs, CBs, other
companies and through Public Deposits which are repayable after 36 months.
The most important source of BF is by issue of debentures. A debenture is a part of the total amount
borrowed by issue of debentures.
Debentures may or may not be secured. Generally they are secured. They may be secured against
specific asset or may create a general charge on all assets.
In India, debentures are of face value of Rs.100.
Debentures may be redeemable or irredeemable. In the case of redeemable debentures the company
makes a commitment of redeeming the debentures after a specific period of time say, 5 years or 10
years after the date of issue. Debentures may be redeemed at par, at discount or at premium.
Similarly, debentures may be issued at par, or at discount or at premium. The discount offered is an
expense or loss. Further, there may be other issue expenses like cost of advertising, brokerage, etc.
1) Cost of debt if irredeemable can be calculated as follows:
Kd = I (1 t)
NP
Where,
Kd
= Cost of debt
I
= Interest on debt calculated on Face Value
t
= tax rate
NP
= Net proceeds. i.e. the net amount collected at issue
NP = FV + Premium on issue discount on issue expense on issue
2) Cost of redeemable debt : (post tax)

Kd =
I + FV NP
N
FV + NP
2
x (1t)
Where,
Kd
= Cost of debt
I
= Interest on debt calculated on Face Value
FV
= Face Value
NP
= Net proceeds
N
= No. of years after which the debt is redeemable
t
= tax rate
Note : If the problem says ignore tax or ask to calculate pretax cost of debt, ignore (1 - t).
Cost of debt is always less than Cost of Equity. Discuss.
Ans: It is borrowed capital with specified rate of interest. It is generally a secured debt.
Features:
On borrowed funds interest is paid.
Secured i.e. first charge on assets.
Interest is paid irrespective of profit or loss.
Borrower saves tax as interest is allowable deduction.
Cost of debt can be accurately estimated because of interest rate. (Which is fixed i.e.
independent of sales)
Equity: It is owners capital. It does not get any guaranteed returns.
Features:
Owners Capital, get voting rights.
Equity to any external person, dilutes control.
Low financial risk from issuers perspective.
High risk from investors point of view. (There is no guaranteed return)
Payment of equity dividend is not post-tax.
It does not save tax of the issuers.
Dividend is not taxable in the hands of receiver.
Cost of equity cannot be accurately estimated.
It is based on expectations of shareholders.
Thus equity is costlier than debt becausei. Tax: Interest on debt is pretax & dividend on equity is post tax. Debt (interest) saves tax.
ii. Estimation of cost: cost of debt is based on interest & tax cost of equity is based on expectations
of shareholder (Non-accurate). Expectations are based on risk-profile.
iii. Risk Return matching: Debt is secured, low-risk investment. Low riskLow return. Equity is
unsecured, high risk investment. High riskHigh return.
SECTION III WEIGHTED AVERAGE COST OF CAPITAL
i.
ii.
iii.
iv.
Once the component costs have been calculated, they are multiplied by weights of the various
sources of capital to obtain WACC.
The following steps are to be used in computation of the WACC.
Calculate the cost of each specific source of fund.
Assign weight of specific costs based on its proportion in the capital structure.
Multiply cost of each source by its proportion in the capital structure.
Add the weighted component cost to get the firms WACC.
Cost of Debt (Kd) is lower than Cost of Equity (Ke). As the proportion of Debt increases in capital
structure Kd increases and also Ke increases as risk increases for equity shareholders.
The firm has to select such a capital structure where the WACC is minimum. WACC is an important
tool in determining an optimum capital structure.
ko = eke + dd
Where Ko = WACC
Example
Capital Component
Equity Share Capital
Retained Earning
Preference Shares
Debt
K
11%
10%
9%
6%
W
10
25
15
50
WK
1.10%
2.50%
1.35%
3.00%
WACC 7.95%
Trading on Equity
It refers to use of borrowed funds so as to increase the return on equity (ROE). Use of borrowed
funds is also financial leverage. Features of Trading on Equity.
High Debt Equity Ratio [High Debt Proportion].
Low WACC.
High Degree of Financial leverage (DFC).
High ROE.
Demerits
High Financial Break Even point (BEP).
High Financial risk.
Low incremental borrowing power.
Points to Remember
1) Unless specified otherwise, we assume only two sources of capital: Debt and Equity.
Hence, if debt proportion is x% then equity has to be (100-x)%
For e.g:- Debt proportion 25%
:. Equity proportion will be 75%
2) Issue of bonus shares does not have any impact on WACC.
[If reserves & surplus is not given separately with different cost]

PAWAN JHABAK BOOK)
SECTION : VI - COST OF CAPITAL :- PROBLEMS + SOLUTION
(Q.1) Cost of equity 30%
Cost of debt 9%
rd
rd
Equity is 1/3 of capital and debt is 2/3
Calculate weighted average cost of capital
Q.1 Solution:W.A.C.C = 1 x 30% + 2 x 9%
3
3
= 10% + 6%
= 16%
Cost of debt 16%
th
th
Equity is 1/4 of capital and debt is 3/4
Q.2 Solution:W.A.C.C = 1 x 40% + 3 x 16%
4
4
= 10% + 12%
= 22%
Cost of debt 18%
Equity is 40% of capital and debt is 60%
Q.3 Solution:W.A.C.C = (40% x 36%) + (60 x 18%)
= 14.4% + 10.8%
= 25.2%
Cost of debt 12%
Calculate weighted average cost of capital if Debt proportion is (1) 25%, (2) 50%, (3) 75%
Q.4 Solution:- ko = eke + dkd
= (75% x 40%) + (25% x 12%)
= 30% + 3%
= 33%
ko = eke + dkd
= (50% x 40%) + (50% x 12%)
= 20% + 6%
= 26%
ko = eke + dkd
= (25% x 40%) + (75% x 12%)
= 10% + 9%
= 19%
Cost of debt 15% (If debt proportion is less than 60%)
Calculate weighted average cost of capital if debt proportion is 20%, 50%, 80%
Cost of debt 20% (If debt proportion is more than 60%)
Q.5 Solution:Ko = WeKe + WdKd
1.
2.
3.
e
80%
50%
20%
Ke
30%
30%
30%
eke
24%
15%
6%
d
20%
50%
80%
kd
15%
15%
20%
dkd
3%
7.5%
16%
Ko
27%
22.5%
22%
Q.6 In considering the most desirable capital structure for a company, the following estimates of the
cost of debt and equity capital (both after tax) have been made at various levels of financial leverage:
Debt as a percentage of
Cost of Debt
Cost of
total capital employed
equity
0
5%
12%
10
5%
12%
20
5%
12.50%
30
5.5%
13%
40
6%
14%
50
6.5%
16%
60
7%
20%
Advise the company of the optimal Debt Equity Mix on the basis of the Composite cost of capital.
(MU, BMS, May 2006 & C.A. Final May 1978)
Q.6 Solution:Ko = WeKe + WdKd
Option
1.
2.
3.
4.
5.
6.
7.
e
100%
90%
80%
70%
60%
50%
40%
Ke
12%
12%
12.50%
13%
14%
16%
20%
eke
12%
10.8%
10%
9.1%
8.4%
8%
8%
d
0%
10%
20%
30%
40%
50%
60%
kd
5%
5%
5%
5.5%
6%
6.5%
7%
dkd
0%
0.5%
1%
1.65%
2.4%
3.25%
4.2%
Ko
12%
11.3%
11%
10.75%
10.8%
11.25%
12.2%
Advise select option 4 since it results into lowest composite cost of capital (Ko)
Q.7 Weighted average cost of capital = 20%
Cost of Debt = 12%
Equity proportion = 25%
Debt proportion = 75%
Calculate cost of equity
Q.7 Solution:ko = eke + dkd
20% = (25% x ke) + (75% x 12%)
20% = 25% x ke + 9%
11% = 25% x ke
:. ke = 44%
Alternative Formula
ke = k0 + (k0-kd) x debt
Equity
Q.8
Weighted average cost of capital
Cost of Debt
Debt
Equity
Calculate ke
= 30%
= Rs.20%
= Rs.500
= Rs.250
(1) in current situation
(2) If cost of debt is reduced by 5%
(3) If debt : Equity ratio is 3
Q.8 Solution:ke = k0 + (k0-kd) x debt

Equity
= 30% + (30% - 20%) x 500
250
= 30% + 10% x 2
= 30% + 20%
= 50%
Equity
= 30% + (30% - 15%) x 500
250
= 30% + (15% x 2)
= 60%
Equity
= 30% + (30% - 20%) x 3
= 30% + 10% x 3
= 60%
Q.9 M / s. Monica Enterprises believes in Net Operating Income Approach. Its Capital Structure has
following parameters:
Overall cost of capital
16%
Cost of debt
14%
Market value of debts
Rs. 300 lacs
Value of equity
Rs. 260 lacs
Calculate:
a) Cost of equity at current level.
b) If cost of debt is reduced by 2% what will be cost of equity, if the overall cost remains
unchanged.
c) If bonus shares are issued in the ratio of 1:1 and overall cost gets reduced to 15%
d) If debt-equity ratio is adjusted to 1.8 in current situation, then what will be cost of equity?
(MU, BMS, May 2005)
Q.9 Solution:WACC = 16%
Kd
= 14%
Debt = 300 lacs
Equity = 260 lacs
(1) :. ke = k0 + (k0-kd) x debt
Equity
= 16% + (16% - 14%) x 300

260
= 16% + 2% x 1.15
= 16% + 2.3%
= 18.3%
(2) kd = 12%
Equity
= 16% + (16% - 12%) x 1.15

= 16% + (14% x 1.15)
= 16% + 4.6%
= 20.6%
(3) ko = 15%
Equity
= 15% + (15% - 14%) x 1.15

= 15% + (2% x 1.15)
= 15% + 2.3%
= 17.3%
(4) Debt Equity Ratio = 1.8
Equity
= 16% + (16% - 14%) x 1.8

= 16% + (2% x 1.8)
= 16% + 3.6%
= 19.6%
Q.10
Cost of Equity
= 30%
Cost of Debt
= 10%
Debt
= 300
Equity
= 100
Calculate Weighted average cost of capital
Q.10 Solution:ke = k0 + (k0-kd) x debt
Equity
30% = k0 + (k0 - 10%) x 3

30% = 4 k0 - 30%
:. 60% = 4k0
:. k0 = 15%
Alternative Way
Rs.
Equity
100
Debt
300
400
Q.11 Equity = Rs.440
Preference shares = Rs.165
Debt = Rs.275
Cost of equity = 30%
Pref. = 20%
Debt = 10%
Calculate WACC
25%
75%
100%
k
30%
10%
k
7.5%
7.5%
15%
Q.11 Solution:Rs.
Equity
440
Preference
165
Debt
275
880
50%
18.75%
31.25%
100%
k
30%
20%
10%
k
15%
3.75%
3.13%
21.88%
:. WACC = 21.88%
Q.12
Cost of Equity = 40%
Cost of Preference = 20%
Cost of Debt = 15%
Equity = Rs.525
Pref. = 168
Debt = 782
Calculate WACC
Q.12 Solution:Rs.
Equity
525
Preference
168
Debt
782
1475
35.59%
11.39%
53.02%
100%
k
40%
20%
15%
k
14.24%
2.28%
7.95%
24.47%
:. WACC = 24.47%
Q.13
Equity
= 500
12% of Preference
= 100
15% Debt
= 900
Tax @ 40%, Cost of equity 30%.
Calculate WACC.
Q.13 Solution:Equity
Preference
Debt
Rs.
500
100
900
1500
33.33%
6.67%
60%
100%
k
30%
12%
9%
k
10
0.80
5.4
16.20%
:. WACC = 16.20%
Cost of debt
kd
= I x (1 Tax rate %)
= 15% x (1 40%)
= 15% x (1 0.40)
= 15% x 0.6
= 9%
Cost of Preference
kd
= Proposed dividend
kp
= 15%

EXTRA PRACTISE PROBLEMS
(Q.14)
For varying levels of debt-equity mix, the estimates of the cost of debt and equity capital (after tax)
are given below:
Debt as % of Total capital
employed
0
10
20
30
40
50
60
Cost of debt
Cost of equity
7.0
7.0
7.0
8.0
9.0
10.0
11.0
15.0
15.0
16.0
17.0
18.0
21.0
24.0
You are required to decide on the optimal debt-equity mix for the company by calculating the
composite cost of capital.
ADDITIONAL IMPORTANT NOTES:-
CHAPTER: 6 CAPITAL STRUCTURE

SOURCES OF FUNDS
CAPITAL STUCTURE (The means of capital by which a firm is financed)

Capital Structure is a part of Financial Structure and is the mix of the various types of long term
sources of funds i.e. debt / equity. Ex:
Common Stock i.e. Equity Share Capital
Preferred Stock i.e. Preference Share Capital
Retained Earnings (profit the company makes, but does not give to the shareholders in the form
of dividends)
Bonds (debt)
The Target Capital Structure
Capital Structure: The combination of debt and equity used to finance a firm
Target Capital Structure: The ideal mix of debt, preferred stock, and common equity with which the
firm plans to finance its investments.
SECTION I THEORY OF CAPITAL STRUCTURE
1. Net Income (N) Approach
As per NI Approach we calculate WACC &
use it as a benchmark to compare with ROI of
Proposed investment. If ROI>WACC, we
accept, the proposal.
2. Net operating Income (NOI)

As per NOI Approach, we estimate ROI of
proposed investment. We deduct the cost of
Debt (and cost of pref. if any) from ROI to get
Ke (ROE). If Ke [ROE]> Expectation of
shareholders, we accept, the proposal.
Ke
Cost%
KO
Kd
Debt Proportion %
Equation: ko = weke + wdwd
Assumptions: Cost of debt can be calculated &
is constant.
Cost of Equity (Net income to equity
shareholders) is estimable and is calculated.
Overall cost (WACC) is weighted avg. of
Ke & Kd.
Ke & Kd are independent variables & ko is
dependent.
Cost%
Ke
Ko
Kd
Debt Proportion %
Ke = Ko + (Ko Kd) x Debt / Equity
Cost of Debt can be calculated & is
constant.
Overall Return (ROI) i.e. PBIT or Net
Operating income) is estimable & is constant.
Ke is residual value after deducting kd from
WACC
Ko & Kd are independent variables & ke is
dependent.
3. Traditional Approach: According to the traditional financial structure theory the cost of capital
is not independent of the capital structure of the firm and that there is an optimal capital
structure. There are two types of risks:
(a) Business risk: Business risks includes factors such as market fluctuations, availability of
material, etc and it will always be there more or less in the same measure.
(b) Financial risk: Financial risks keeps on increasing after a certain stage as more and more
debt capital commitments are under taken.
Debt Equity Ratio

Fig. 6.1 Traditional
Approach indicating inter
-relationshipbetween Costof Capital and Capital Structure
This theory states that there exists a correlation between the weighted average Cost of Capital and
the Debt Equity Ratio. The relation between the two when presented graphically takes the form of
an U shaped curve. Cost of Capital will be very high if the Debt Equity ratio is zero. When debt
is injected into the capital structure step by step the weighted average cost of capital will
progressively come down only upto the lowest (optimum) point and then the cost of capital will go
up with the further introduction of debt; since the debenture holders have to be offered a higher rate
of interest, to compensate higher risk.
4. Modigliani Miller Approach: The franco Modigliani and Merton H. Miller (M.M.) Approach
on cost of capital states that there is no correlation between cost of capital and debt equity
ratio. This approach states that the average cost of capital of any firm is independent of its capital
structure and equal to the capitalisation rate of pure equity stream of its class. The value of the
firm and cost of capital is the same for all the firms irrespective of the proportion of debt
included in a firms capital structure.
Ko
Fig. 6.2 Modigliani Miller Approach to Cost of Capital and Capital Structure
Assumptions:i. Perfect Capital Market.
ii. Rational Investors. & Managers
iii. Homogeneous Expectations.
iv. Equivalent Risk Classes.
v. Absence of Taxes.
The value of a firm is equal to its expected operating income divided by the discount rate
appropriate to its risk class. It is independent of its capital structure.
In symbols
V = D + E = O/r
Where V is the market value of the firm, D is the market value of debt, E is the market value of
equity, O is the expected operating income, and r is the discount rate applicable to the risk class
which the firm belongs. Hence the value of the firm will be Independent of its Capital Structure, as
per MM theory.

PAWAN JHABAK BOOK)
SECTION II :- PROBLEMS + SOLUTION
Q.1 Your friend approaches you with a proposal to setup a manufacturing unit having gestation
period of 50 to 55 months and fund requirement of around Rs.15 crores. Explain to him the various
sources to raise the fund for the project.
Q.1 Solution:
Observations:
a) Individual Promoter.
b) Manufacturing unit, good asset base.
c) Funds requirement Rs.150 million (Rs. 15 Crores)
d) Gestation period 50-55 months (4-5yrs)
Possible Sources of Capital - Equity, Debt.
Equity: It is owners capital with claim on profits after paying external liabilities.
Merits (to issuing firm) No legal obligation to pay dividend.
No charge on assets.
Improves borrowing capacity.
Improves Debt:- Equity ratio (Comfortable to lenders)
Demerits Voting Rights.
Dilution of control
Tax not saved on dividend paid.
Ways to Raise Equity.
a) Promoters: Promoters should invest to the extent possible, as it does not dilute control. Limited
fund availability with the promoters, however, should not hamper growth.
b) Private Placements: Equity can be placed with business associates, friends & other such
network. Advantage is control is diluted, but to known people. Also they not bring only money,
but also bring business contacts / community. This improves business. Disadvantage is they really
use voting rights & dilution of control is real. Nominee on board is common.
c) Public Issue: IPO offer can fetch virtually unlimited money. Advantage is that, public is not
interested in control. They do not vote. Practically no dilution of control. Disadvantage is people
are passive, they bring only funds & no other value addition. Also public issue is time consuming
& costly.
d) Venture Capital: It is a risk capital invested at very early stage of business. It is suitable for
technology / new upcoming areas of ventures.
e) Retained Earnings: Re-investment of profits is always good. It is low cost & less time
consuming. It does not dilute control of the existing shareholders / Promoters.
Debt: It is borrowed capital.
Merits-
Fixed Interest.
Saves Tax.
Offers Leverage Benefits.
No Loss of controlling stake / voting power.
Demerits-
Charge on assets.
Interest to be paid irrespective of profits / loss.
Ways to raise Debt:

i. Term Loan
:
From Banks (negotiated.)
ii. Debentures
By public issue.
Factors Determining Capital Structure in given Case:

a) Business Track Record: Appears to be a new business, so external funds will have limitation.
b) Nature of Business: Manufacturing Unit- doesnt seem to be a high technology unit. Not
Suitable for venture capital. Offers good asset backup & good for borrowing.
c) Quantum of Investment: Rs. 15 Crore - Small size. Not suitable for public issue.
Suggested Capital Structure.
Manufacturing Unit.
Rs.15 Crore
Equity (7.5 Crore)
Promoters (To extent possible)
Debt (7.5 Crore)
. Term Loan from bank with factory assets as security
Private Placements (Balance, friends & relatives)
Q.2 X Ltd. a widely held company is considering a major expansion of its production facilities and
the following alternatives are available:
(Rs. in crores)
Particulars
Share capitals (Rs.10)
14% debentures
Loan from financial institution
@ 18 p.a. Rate of Interest
Alternative
A
B
C
50 20 10
20 15
10 25
Expected rate of return before tax is 25%. The company at present has low debt. Corporate taxation
50%.
Which of alternatives you would choose?
Q.2 Solution
Evaluation of financing Alternative
Particulars
EBIT
(-) Interest
(20 x 14%) + (10 x 18) = 4.6
(15 x 14%) + (25 x 18) = 6.6
EBT
(-) Tax @ 50%
EAT
(-) Preference dividend
A
12.5
-
B
12.5
4.6
C
12.5
6.6
12.5
6.25
6.25
-
7.9
3.95
3.95
-
5.9
2.95
2.95
-
Earnings for ESH

No of Equity Shares
:. EPS (a b)
(a)
(b)
(Rs.)
6.25
5
1.25
3.95
2
1.98
2.95
1
2.95
Recommendation:- On the basis of EPS it is advised to select Alternative C.

Q.3 One-up Ltd. has equity share capital of Rs. 500000 divided into shares of Rs. 100 each. It
wishes to raise further Rs. 300000 for expansion-cum-modernization scheme. The company plans
the following financing alternatives:
By issuing equity shares only.
Rs.100000 by issuing equity shares and Rs. 200000 through debentures or term loan @ 10% per
annum.
By raising term loan only at 10%per annum.
Rs.100000 by issuing equity shares and Rs. 200000 by issuing 8% preference shares.
You are required to suggest the best alternative giving your comment assuming that the
estimated earning before interest and taxes (EBIT) after expansion is Rs.150000 and corporate of
tax is 35%.
Q.3) Solution
Evaluation of Financing Alternatives.
Particulars
EBIT
(-) Interest
1
150000
-
EBT / PBT
(-) Tax @ 35%
EAT / PAT / NPAT
(-) Preference dividend
Earnings for ESH a). . .
150000
52500
97500
97500
No of equity shares Existing

New
b). . . .
EPS (a/b)
5000
3000
8000
Rs.12.19
Alternatives
2
3
150000
150000
20000
30000
(10% x 2L) (10% x 3L)
130000
120000
45500
42000
84500
78000
84500
78000
5000
1000
6000
Rs.14.08
5000
5000
Rs.15.60
4
150000
150000
52500
97500
16000
81500
5000
1000
6000
Rs.13.58
Recommendation:The company is advised to select alternative 3 i.e. 10% term loan since it results into highest EPS i.e.
Rs.15.60
Q.4 The existing capital structure of ABC Ltd. is as follows:
Equity shares of Rs.100 each
Retained Earnings
9% Preference shares
7% Debentures
Rs.
4000000
1000000
2500000
2500000
Company earns a return of 12% and the tax on income is 50%.

Company wants to raise Rs. 2500000 for its expansion project for which it is considering following
alternatives:
Issue of 20000 Equity shares at a premium of Rs. 25 per share.
Issue of 10% Preference shares.
Issue of 9% Debentures.
Projected that the Price Earning ratios in the case of Equity, Preference and Debentures financing
Rs. 20, 17 and 16 respectively.
Which alternative would you consider to be the best? Give reason for your choice.
(MU, BMS, May 2008)
Q.4) Solution
Evaluation of Financing Alternatives.
Particulars
EBIT
(-) Interest - Existing
- New
EBT / PBT
(-) Tax @ 50%
EAT / PAT / NPAT
(-) Preference dividend Existing
New
Equity Earnings
a). . . .
No of equity shares Existing
New
b). . . .
EPS (a/b)
MPS = PE x EPS
ROI
1
1500000
(175000)
1325000
662500
662500
(225000)
437500
40000
20000
60000
7.29
Rs.145.8
(29 x 7.29)
Alternatives
2
1500000
(175000)
1325000
662500
662500
(225000)
(250000)
187500
40000
40000
4.69
Rs.79.73
(17 x 4.69)
3
1500000
(175000)
(225000)
1100000
550000
550000
(225000)
325000
40000
40000
8.13
Rs.130.08
(16 x 8.13)
PBIT
x 100
Capital employed
:. PBIT = Cap. Emp. x ROI

100
= 12500000 x 12
100
= Rs.1500000
Recommendation: - Select Alternative 1 i.e. Issue of 20000 Equity shares, since
It results into highest MPS.

PRACTISE PROBLEMS
st
Q.8 The following financial information pertains to VX Ltd. as at 31 March, 2010.

Balance Sheet
(Rs. In lacs)
Fixed Assets (at cost less depreciation)
200
Net Current Assets
60
Total Assets
260
Less: Long term debt
215
Net Assets
45
Represented by:
Equity capital
40
Retained earnings
5
45
Profit and Loss Account
(Rs. In lacs)
Net Profit before interest and tax
52
Interest paid
20
Tax paid
12
Dividends declared
18
The company has identified a profitable investment opportunity and requires funds to the tune of
Rs.20 lacs for fixed assets purchase and Rs.5 lacs for working capital.
You are required to state the sources of funds that are available to company and also discuss the
problem to choose debt to fund the new project.
ADDITIONAL IMPORTANT NOTES:-
CHAPTER: 7 LEVERAGE
LEVERAGE:Leverage refers to amplified benefit on comparatively lower level of investment or lower sales. Such
enhancement of profit is usually seen because of fixed costs. These could be operating fixed cost or
financial fixed cost. As sales volume increases fixed cost do not increase. Hence, it results in higher
level of profit.
Fixed cost however also leads to higher level of break even-point. Higher break-even point is a risk.
Thus highly leveraged firms feature high risk and high return. Leverages are also refered in the
context of optimal utilization such as asset leverage and working capital leverage.
SECTION I TYPES OF LEVERAGE
1. Operating Leverage:Operating leverage refers to enhancement of profits because of fixed operating expenses. As sales
increase fixed cost do not increase which results in proportionately higher profits. Degree of
operating leverage calculated as
DOL =
Contribution =
% change in PBIT
PBIT
% change in Sales
Higher fixed expenses indicate higher operating break-even point and hence higher business risk.
Fixed operating expenses are determined by nature of business and industry. For instance, heavy
engineering units would have higher level of fixed overheads whereas service industry would have
lower overheads. Thus DOL is dictated by these factors and managers have little liberty to adjust it
at their will.
2. Financial Leverage:Financial leverage refers to higher level of profit because of higher fixed financial expenses. These
include interest on loan & debentures as well as preference dividend. Degree of financial leverage is
calculated as:PBIT =
% Change in PBT
PBT =
% Change in PBIT
Higher financial leverage indicates higher financial break-even point & higher financial risk. Capital
structure to some extent is determined by nature of business and industry. However, finance
managers have greater flexibility in choice of capital structure. They can decide quantum of
borrowed capital and preference shares. Aggressive policies will lead to higher borrowings, higher
DFL, which will result in high risk & high return profile.
Conservative policies would lead to lower level of borrowings, and therefore low risk low return
profile.
It may be argued that capital intensive units are more likely to have higher debt to equity proportion
and hence higher financial leverage. (e.g. Power Sector Units).
3. Combined Leverage.
Combined leverage refers to higher profits because of fixed costs. These include fixed operating
expenses as well as fixed financial expenses. Degree of combined leverage is calculated as:
DCL = Contribution = % change in PBIT
PBIT
% change in Sales
Alternate Formula
DCL = DOL x DFL.
DCL is a complete indicator of leverage benefits & leverage risks. DCL also indicates overall breakeven point. While operating fixed costs are determined by nature of business & industry. Financial
fixed costs can be adjusted by appropriate choice of capital structure. Aggressive firms choose
higher level of DCL whereas conservative go for lower level of DCL.
Distinguish between Operating Leverage and Financial Leverage
The differences between the two leverages are as follows:
1. Objective
2. Relationship
3. Measurement
4. Relationship
5. Effect on income
6. Risk
7. Decision
8. Stage
9. Formula
Operating Leverage
Financial Leverage
The objective is to magnify the The objective is to magnify
effect of changes in sales on the effect of changes in
operating profit.
operating profits on earning
per share.
It establishes
relationship It establishes relationship
between operating profit and between operating profit and
sales.
return on equity
It measures a firm ability to use It measures a firm ability to
fixed cost assets to magnify the use fixed cost funds to
operating profits.
magnify the return to equity
shareholders.
It relates to the assets side of It relates to the liability side
the Balance sheet.
of the Balance sheet.
It affects the profit before It affects the profit after
interest and tax
interest and tax
It involves operating risk of It involves financial risk of
being unable to cover fixed being unable to cover fixed
operating cost.
financial cost.
It is concerned with investment It is concern with financial
decision
decision
It is described as first stage It is described as second stage
leverage.
leverage.
DOL = Contribution
DFL = PBIT
PBIT
PBIT

PAWAN JHABAK BOOK)
SECTION II:- LEVERAGE:- PROBLEMS + SOLUTION
Problem: 1
Jigna Ltd. sells 1,00,000 units of product. Selling price is Rs.10 per unit and variable cost is Rs. 3, if
the fixed cost for the year amounts to Rs. 4,00,000, find out the effect on profit, if the company sells
1,10,000 units and 80,000 units.
Q.1 Solution
Particulars
Units
Sales
(-) Variable cost
Contribution
(-) Fixed cost
Profit
Amt (Rs.) Amt (Rs.) Amt (Rs.)

100000
110000
80000
1000000
1100000
800000
300000
330000
240000
700000
770000
560000
400000
400000
400000
300000
370000
160000
Comment :The companies profit when the sales is 110000 units is Rs. 370000 and when the sales are 80000
units, the profit is Rs.160000 i.e. 10% Increase in sales Increase profit by 23.33% and 20% decrease
in sales, reduces profit by 46.67%
Problem: 2
Ambika Ltd. sells 2,000 units per annum. The selling price per unit is Rs. 300 and the variable cost
per unit is Rs. 70. The fixed operating cost is Rs. 60,000.
Calculate operating leverage.
Q.2 Solution
Particulars
Sales (2000 x 300)
(-) Variable cost (70 x 2000)
Contribution
(-) Fixed Cost
PBIT
Amt (Rs.)
600000
140000
460000
60000
400000
Operating Leverage = Contribution

PBIT
= 460000
400000
= 1.15
Problem: 3
Y Ltd. sells its product at Rs. 20 per unit. Variable cost per unit is Rs. 15. Find out the degree of
operating leverage for sale of 3,000 units, and 3,500 units. What do you understand from the degree
of operating leverage of these sales volumes? Fixed cost is Rs. 10,000.
Q.3 Solution
Particulars
Amt (Rs.) Amt (Rs.)
Units
3000
3500
Sales
60000
70000
(-) Variable cost
45000
52500
Contribution
15000
17500
(-) Fixed cost
10000
10000
PBIT
5000
7500
(3000 units)
PBIT
= 15000
5000
=3

(3500 units)
PBIT
= 17500
7500
= 2.3
Higher units / sales, results into lower operating / business risk and vice versa.
Problem: 4
Compute financial leverage from the following information:
Interest
Sales (1,000 units)
Variable Cost
Fixed Cost
Rs.
10,000
1,00,000
50,000
30,000
Q.4 Solution
Particulars
Sales
(-) Variable cost
Contribution
(-) Fixed cost
PBIT
(-) Interest
PBIT
Amt (Rs.)
100000
50000
50000
30000
20000
10000
10000
Financial Leverage = PBIT

PBT
= 20000
10000
=2
Problem: 5
Shruti Ltd. has the following structure:
Equity share capital
10% preference share capital
8% debentures
Rs.
5,00,000
5,00,000
5,50,000
The present EBIT is Rs. 2,50,000, tax rate is 50%. Calculate financial leverage.
Q.5 Solution
EBIT (Earning Before Interest Tax)
- Interest (550000 x 8%)
PBT
(-) Tax @ 50%
PAT
Rs.
250000
44000
206000
103000
103000
Financial Leverage = PBIT

PBT
= 250000
206000
= 1.21
Problem: 6
Y Ltd. has sales of Rs. 2,00,000. Variable cost is 50% of sales while the fixed operating cost
amounts to Rs. 60,000. Interest on long-term loan amounted to Rs. 20,000.
You are requested to calculate the composite leverage and analyze the impact if sales increase by
10%.
Q.6 Solution
Particulars
Sales
(-) Variable cost
Contribution
(-) Fixed cost
PBIT
(-) Interest
PBT
Rs.
Sales 10%
200000
220000
100000
110000
100000
110000
60000
60000
40000
50000
20000
20000
20000
30000
Composite Leverage = Contribution

(at present)
PBT
= 100000
20000
=5
Composite Leverage = Contribution
(at 10% )
PBT
= 110000
30000
= 3.67
Analysis
Increase in Sales reduces the combined risk and vice versa.
Problem: 7
The following information is available in respect of two firms, P Ltd. and Q Ltd.
Sales
-variable cost
Contribution
-Fixed cost
EBIT
-Interest
Profit before tax
P Ltd. Rs.
500
200
300
150
150
50
100
Q Ltd. Rs.
1,000
300
700
400
300
100
200
You are required to calculate different leverages for both the firms and also comment on their
relative risk position.
Q.7 Solution
Particulars
1) Operating Leverage ratio
= Contribution
PBIT
2) Financial Leverage ratio
= PBIT
PBT
3) Combined Leverage ratio
= Operating Leverage ratio x Financial
Leverage ratio
P Ltd.
300
150
=2
150
100
= 1.5
2 x 1.5
=3
Q Ltd.
700
300
= 2.3
300
200
= 1.5
2.3 x 1.5
= 3.45
Comment:1) Operating leverage :- Q Ltd. has comparatively higher operating risk.

2) Financial Leverage :- The financial risk of both companies is same.
3) Combined Leverage :- The combine risk is higher for Q Ltd.
Problem: 8
A simplified Income Statement of Zenith Ltd. is given below. Calculate its degree of operating
leverage, degree of financial leverage and degree of combined leverage.
Sales
Variable cost
Fixed cost
EBIT
Interest
Taxes (30%)
Net Income
?
2,00,000
75,000
2,08,000
1,10,000
29,400
68,600
Q.8 Solution
Revenue statement for year----Particulars
Sales
(-) Variable cost
Contribution
(-) Fixed cost
PBIT
(-) Interest
PBT
(-) Tax (30%)
PAT
Rs.
483000
200000
283000
75000
208000
110000
98000
29400
68600
Operating Leverage Ratio
Financial Leverage Ratio
Combined Leverage Ratio
= Contribution
PBIT
= 283000
208000
= 1.36
= PBIT
PBT
= 208000
98000
= 2.12
= Contribution
PBT
= 283000
98000
= 2.9
(F OR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

PRACTISE PROBLEMS
Q.9 Case Study: Observe the following data
Income Statement
Sales
50 L
50 L
PBIT
5L
5L
- Interest
0.4 L
1.6 L
PBT
4.6 L
3.4 L
- Tax
2.3 L
1.7 L
PAT
2.3 L
1.7 L
Sources of Funds
Equity
16 L
4L
Debt
4L
16 L
Company A has more profit than company B. So, Company A is better. Do you agree? Discuss
Q.18 Interest Rs.1200/- DFL 3, DOL 2, PV Ratio 1/3, Interest Rate @ 10%,
Debt: Equity is 2 : 1
Tax @ 50%
(A) Prepare Income Statement
(B) Calculate RoI
(C) Is financial leverage favorable?
(D) Calculate Asset Leverage
(E) If Industry Asset leverage is 1.1, is this firm efficient?
CHAPTER: 8 CAPITAL BUDGETING
SECTION I:- INTRODUCTION TO CAPITAL BUDGETING

Capital budgeting is the process of generating, evaluating, selecting, implementing and followingup on capital expenditure projects. The term Capital budgeting is used interchangeably with capital
expenditure decision, capital expenditure management & long-term investment decision.
The methods employed to evaluate the worth of capital expenditure proposals are known as capital
budgeting techniques. The popular methods are:1. Average rate of return
2. Pay back period
3. Net present value
4. Internal rate of return
5. Profitability index
The following are the basic features of capital budgeting: Potentially large anticipated benefits
A relatively high degree of risk
A relatively long time period between the initial outlay & the anticipated return
Discuss the phases of Capital Budgeting
Capital budgeting is a complex process which may be dividend into following phases:
1. Identification of potential investment opportunities
2. Assembling of proposed investments
3. Decision making
4. Preparation of capital budgeting and appropriations
5. Implementation
6. Performance review
1. Identification of potential investment opportunities
The capital budgeting process begins with the identification of potential investment opportunities.
Typically the planning body develops the estimates of future sales, which serves as the basis for
setting production target. This information in turn is helpful in identifying required investments in
plant and equipment etc.
For imaginative identification of investment ideas it is helpful to
i) Monitor external environment regularly to scout investment opportunities,
ii) Formulate a well defined corporate strategy based on a through analysis of strengths,
weaknesses, opportunities and threats,
iii) Share corporate strategy and perspective with person who are involved in the process of capital
budgeting and,
iv) Motivate employees to make suggestions.
e.g. Ratan Tata Nano, Bill gates Computer Software, Warren Buffet Insurance etc.
2. Assembling of investment proposals
Investment proposal identified by the production department and other department is usually
submitted in a standardized capital investment proposal firm. Generally, most of the proposals
before they reach the capital budgeting committee are routed through several persons. The objective
of routing a proposal through several persons is primarily to ensure that the proposal is viewed from
different angles. It also helps in creating a climate for bringing about co-ordination of interrelated
activities.
Investment proposals are usually classified into various categories for a facilitating decision
making, budgeting and control.
3. Decision making
The management does Project appraisal and arrives at a decision regarding selection of project.
Project appraisal is done regarding financial feasibility, technical feasibility, economic feasibility,
managerial competence and market appraisal. Capital budgeting techniques are used while
undertaking financial viability study of the project.
4. Preparation of capital budget and appropriation
Project involving smaller outlays and which executives at lower levels can decide are often covered
by a blanket appropriation for expeditious action. Project involving larger outlays are included in
capital budget after necessary approvals. Before undertaking such project appropriation order is
usually required. The purpose of this check is mainly to ensure that the funds position of the firm is
satisfactory at the time of implementation. Further it provides an opportunity to review the project at
the time of implementation. In this step project cost is decided, funds are raised and financial closure
of the project is achieved.
5. Implementation
Translating an investment proposal into a concrete project is a complex, time consuming and risk
fraught task. Delays in implementation, which are common, can lead to substantial cost overruns.
For expeditious implementation at reasonable cost, the following are helpful.
Adequate formulation of project: The major reason for delay is inadequate formulation of
projects. Put differently, necessary homework in terms of preliminary studies and comprehensive
and detail formulation of the projects is not done. Many surprises and shocks are likely to spring
on the way. Hence the need for adequate formulation of the project cannot be overemphasized.
E.g. Posco Ltd. and Arcelor Mittal Ltd. projects in India is facing implementation problem due to
above reasons.
Use of the principle of responsibilities accounting: Assigning specific responsibility to project

managers for a completing a project within a definite time frame and cost limit is helpful for
expeditious execution and cost control.
Use of network techniques: For project planning and control several network techniques like
PERT (Program Evaluation Review Technique) and CPM (Critical Path Method) are available.
With the help of these techniques monitoring becomes easier.
E.g. Dhirubhai Ambani (RIL) was known for faster implementation of project. Also Tata Motors
nd
Nano Plant at Sanand started in record time of 1 year on 2 June 10.
6. Performance Review
Performance review, post completion audit, is a feedback device. It is a measure for comparing
actual performance with project performance. It may be conducted, most appropriately, when the
operations of the project have established. It is useful in several ways:
a) It throws the light on how realistic were the assumptions underlying the project.
b) It provides a documented log of experience that is highly valuable for decision making;
c) It helps in uncovering judgmental biases;
d) It includes a desired caution among project sponsors. (Reward for appropriate
implementation to project manager and vice versa)
Rationale of Capital Expenditure decisions:
The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must
replace worn and obsolete plants and machinery, acquire fixed asset for current and new products
and make strategic investment decisions. This will enable the firm to achieve its objective of
maximizing profits either by way of increased revenues or by cost reductions. The quality of these
decisions is improved by capital budgeting. Capital budgeting decisions can be of two types: (i)
those which expand revenue (ii) those which reduce costs.
(i) Investment Decisions Affecting Revenue:
Such investment decisions are expected to bring in additional revenue, thereby raising the size of
the firms total revenue. They can be the result of either expansion of present operations or the
development of a new product line. Both types of investment decisions involve acquisition of new
fixed assets. Both types of investment decisions are income expansionary in nature.
(e.g. Tata steel acquisition of Corus, RIL setting Oil and Gas exploration in K.G. basin etc.)
(ii) Investment Decisions Reducing Costs:
Such decisions by reducing costs, add to the total earnings of the firm. The classic example of such
investment decisions is the replacement proposals. When an asset wears out or becomes outdated,
the firm must decide whether to continue with the existing asset or replace it. The firm evaluates
the benefit from the new machine in term of lower operating cost and the outlay that would be
needed to replace the machine. An expenditure on a new machine may be quite justifiable in the
light of the total cost savings that result.
Kinds of Capital Budgeting Decisions:
Capital budgeting refers to the total process of generating, evaluating, selecting, implementing and
following up on capital expenditure alternatives. The firm allocates or budgets financial resources to
new investment proposals. Basically the firm may be confronted with three types of capital
decisions: (i) the accept reject decision; (ii) the capital rationing decision; and (iii)the mutually
exclusive project accepted.
(i) The Accept-Reject Decision
This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it;
if the proposal is rejected, the firm does not invest in it. In general, all those proposals, which yield
a rate of return greater than a certain required rate of return or cost of capital is accepted and the
rest, are rejected. Under the accept-reject decision, all the independent projects that satisfy the
minimum investment criterion should be implemented.
(ii) Capital Rationing Decision:
In a situation where the firm has unlimited funds, capital budgeting becomes a very simple process
in that all independent investment proposals yielding return greater than some predetermined level
are accepted. However, this is not the situation prevailing in most of the business firms in the real
world. They have a fix capital budget or limitation of availability of funds at a given point of time.
A large number of investment proposals compete for these limited funds. The firm must, therefore,
ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns.
Thus, capital rationing refers to the situation in which the firm has more acceptable investments,
requiring a greater amount of finance than is available with the firm. Ranking of the investment
projects is employed in capital rationing. Projects can be ranked on the basis of some predetermined criterion such as the rate of return. The project with the highest return is ranked first
and the project with the lowest acceptable return last. The projects are ranked in the descending
order of the rate of return. It may be noted that only acceptable projects should be ranked and
higher Ranked projects till funds are available should be selected for implementation.
(iii)Mutually Excusive Project Decisions
Mutually exclusive projects are projects, which compete with other projects in such a way that the
acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually
exclusive and only one may be chosen. Suppose a company is intending to buy a new folding
machine. There are three competing brands, each with different initial investment and operating
cost. The three machines represent mutually exclusive alternatives, as only one of the three
machines can be selected. Mutually excusive investment decisions acquire significance when more
than one proposal is acceptable. Then some techniques have to be used to determine the best
one. The acceptance of this best alternative automatically eliminates the other alternatives.

PAWAN JHABAK BOOK)
SECTION II - PROBLEMS + SOLUTIONS
Q.1 A machine is available for purchase at a cost of Rs. 80000. It is expected to have a life of 5 yrs
& scrap value of Rs. 10000 at the end of 5yr period. It is estimated to generate a profit in its life as
follows:
Year Amount
1
20000
2
40000
3
30000
4
15000
5
25000
These estimates are of profits before the calculation of straight line depreciation. Ignore tax. Provide
for depreciation and calculate Accounting Rate of Return.
Q.1 Solution Depreciation =
=
=
=
Cost Scrap
Life
80,000 10,000
5
Rs.70,000
5
Rs.14,000
Year
1.
2.
3.
4.
5.
PBDT (-)
20,000
40,000
30,000
15,000
25,000
Dep =
14,000
14,000
14,000
14,000
14,000
PBT/PAT
6,000
26,000
16,000
1,000
11,000
60,000
TOTAL NPAT
Avg. NPAT =
60,000
5
=
Rs.12,000
ARR based on O.Inv =
Avg. NPAT x 100
O.Inv
=
12,000 x 100
80,000
=
15%
ARR based on Avg. Invst. =
Avg. NPAT x 100
Avg. Invst.
=
12,000 x 100
45,000
=
26.67%
Avg. Invst
=
O.C Scrap + Scrap + Net W.Cap
2
=
80,000 10,000 + 10,000 + 0
2
=
35,000 + 10,000 + 0
=
Rs.45,000
Q.2 The CFO of Infotech India Ltd. is considering the purchase of a new machine to replace an old
machine which has been in operation for the last 5 years. The details relating to available alternative
machines are as follows:
Purchase Price
Power per year
Consumable Stores Per Year
Other Changes Per Year
Wages Per Running Hour
Selling Price Per Unit
Material Cost Per Unit
Estimated Life of Machine
Machine Running Hrs. Per Year
Units Of Output Per Hour
Tax at 40% of Net Profit
Old Machine (Rs.) New Machine (Rs.)

200000
300000
10000
22500
30000
37500
40000
45000
15
26.25
6.25
6.25
2.50
2.50
10 yrs.
10 yrs.
2000 hrs.
2000 hrs.
24 units
36 units
Assuming that the above sales and cost of sales hold good for the entire economic life of the
machines, suggest which of the two alternatives should be preferred; using ARR. Depreciation has to
be charged according to Straight Line Method.
Q.2 Solution
Infotech India Ltd.
Particulars
No. of Units
:. Sales @ 6.25
(-) Variable Cost
Power
Consumable
Other Charges
Wages
Evaluation of Alternatives
Old Machine
48000
(2000 x 24)
(a)
300000
New Machine
72000
(2000 x 36)
450000
10000
30000
40000
30000
(2000 x 15)
120000
230000
70000
20000
(200000 10)
50000
20000
30000
22500
37500
45000
52500
(2000 x 26.25)
180000
337500
112500
30000
(300000 10)
82500
33000
49500
= 30000 x 100
200000
= 15%
= 49500 x 100
300000
= 16.5%
= 30000 x 100
100000
= 30%
= 49500 x 100
150000
= 33%
Material @ 2.50
(b)
(a b)
NPBDT
(-) Depreciation
NPBT
(-) Tax @ 40%
NPAT
= Avg. NPAT
:. ARR based on O.Inv.
= Avg. NPAT x 100
O. Inv.
ARR based on Avg. Inv
= Avg. NPAT x 100
Avg. Inv.
Recommendation
Based on ARR, the company should prefer new machine since it results into higher ARR.
Q.3 Calculate the average rate of return with the following data:
Year
Investment
Sales Revenue
Operating Cost
0
Rs.
90000
-
1
Rs.
2
Rs.
3
Rs.
120000
60000
100000
50000
80000
40000
Q.3 Solution
Sales
(-) Oper. Cost
PBT = NPAT
:. Avg. NPAT =
1
1,20,000
60,000
60,000
2
1,00,000
50,000
50,000
3
80,000
40,000
40,000
1,50,000
=
Rs.50,000
3
ARR based on O.Inv =
Avg. NPAT x 100
O.Inv.
=
50,000 x 100
90,000
=
55.56%
Avg. NPAT x 100
Avg. Invst.
=
50,000 x 100
45,000
=
111.11%
Avg. Invst
=
2
=
90,000 0 + 0 + 0
2
=
Rs.45,000
Q.4 Sengupta Company Ltd. wishes to buy a machine costing Rs. 2,00,000. The life of this machine
is 10 years and its scrap value would be Rs. 5000.
The following details are provided:
Average Annual NPBT
Rs.20,000
Tax Rate
35%
Depreciation (already charged)
SLM basis
1.Payback period
2.Payback profitability
3.ARR (Accounting Rate of Return Method)
Q.4 Solution
n
Dep = Cost Scrap
Life
=
2,00,000 5,000
10
=
Rs.19,500
Avg. PBT
20,000
(-) Tax @ 35%
7,000
:. Avg. NPAT
13,000
3) ARR based on O.Inv
=
Avg. NPAT x 100

O.Inv
=
13,000 x 100
2,00,000
=
6.5%
Avg. NPAT x 100
Avg. Invst.
=
13,000 x 100
1,02,500
=
12.68%
Avg. Invst
=
2 5000 + 5000 + 0
=
2,00,000
Avg. NPAT
(+) Depn
=
=
97,500 +2 5,000
1,02,500
=
=
13,000
19,500
Annual CIF
32,500
1) Payback Period
2) Payback profitability
=
=
=
=
=
=
Initial Outlay
Annual CIF
2,00,000
32,500
6.15 Years.
Annual CIF x (Life PBP)
32,500 x (10 6.15)
Rs.1,25,000
Annual CIF x Life

= 32,500 x 10 = 3,25,000
For cross check
(-) Cash outflow = 2,00,000
PB Profitability = 1,25,000
Note: Scrap is ignored in calculation of PB profitability.
Q.5 Beta Gama Ltd. is producing articles mostly on hand labor and is considering replacing it by a
new machine. There are two alternative models P and Q of the new machine. Prepare a statement of
profitability showing the pay-back period from the following information:
Machine P Machine Q
Estimated life of machine
4 years
5 years
Rs.
Rs.
Cost of machine
9000
18000
Estimated savings in scrap
500
800
Estimated savings in direct wages
6000
8000
Additional cost of Maintenance
800
1000
Additional cost of Supervision
1200
1800
Q.5 Solution
Particulars
Est. Savings in Scrap
Est. Savings in direct wages
(A) n
Add cost of maintenance
n
Add cost of Supervision
(B) NSBDT = CIF
Payback Period
Machine P
Machine Q
Machine P Machine Q
500
800
6000
8000
6500
8800
800
1000
1200
1800
2000
2800
4500
6000
Initial Outlay
Annual Cash inflow
9000 =
2 years
4500
18000 =
3 years
6000
Q.6 Shantanu Company Ltd. is proposing to expand its production. It can go in for an automatic
machine costing Rs.50,000 or an ordinary machine costing Rs.50,000
(Model 1) . The life of both these machines is 5 years. The annual sales and costs are as below:
Automatic
Rs.
50000
15000
7000
7000
Sales
Materials
Labor
Variable Overheads
Calculate payback period and payback profitability
Ordinary
(Model 1) Rs.
50000
15000
6000
6000
(MU, BMS, Oct. 1996)
Q.6 Solution
Sales
(-) V.C
Contribution
(-) F.C
PAT
Payback Period
Initial Outlay
Annual CIF
=
=
Payback profitability =
Automatic
=
=
Ordinary
=
=
Automatic
50,000
29,000
21,000
21,000
Ordinary
50,000
27,000
23,000
23,000
50,000
21,000
2.38yrs
= 50,000
23,000
= 2.17yrs

50,000 x (5 2.38)
Rs.55,000
50,000 x (5 2.17)
Rs.65,000
Q.7 From the following details of Brebone Ltd. Calculate payback period and payback profitability.
Rs.
Sales
8000
Variable Cost
3000
Fixed Cost
2000 (excluding depreciation)
Investment
10000
Life 10 years. Tax @ 50%
Q.7 Solution
Rs.
Sales
8,000
(-) V.C
3,000
Contribution
5,000
(-) F.C
2,000
PBDT
3000
(-) depr
1000
PBT
2000
(-) Tax @ 50%
1000
PAT
1000
(+) depr
1000
Annual CIF
2000
n
Dep =
O.C Scrap
Life
10,000 0
10
Rs.1,000
Payback Period
=
=
=
Initial Outlay
Annual CIF
10,000
2,000
5 Yrs
Payback Profitability
=
=
2,000 x (10 5)
=
2,000 x 5
=
Rs.10,000
Q.8 M & M Ltd. is considering the purchase of a new machine for the immediate expansion
program. There are 3 types of machines in the market for this purpose as follows:
Particulars
Cost of machine
Estimate savings in scrap per year
Estimate savings in direct wages per year
Additional Cost of Indirect Materials per year
Expected savings in Indirect Materials per annum
Additional cost of maintenance per year
Additional cost of supervision
Estimated Life of machine (Yrs)
Taxation at 40% profit
Machine A
Rs.
17500
400
2750
100
750
10
Machine B
Rs.
12500
750
6000
400
550
800
6
Machine C
Rs.
9000
250
2250
250
500
5
You are required to advise the management which type of machine should be purchase on the basis
of Payback Period.
Q.8 Solution
Particulars
Est. savings in scrap
Est. savings in direct wages
Est. savings in indirect material
(A)
n
Add cost of indirect material
n
Add cost of maintenance
n
Add cost of supervision
(B)
NSBDT
(A B)
n
(-) Dep
PBT
(-) Tax
PAT
(+) Depn
Annual Cash inflow
Payback Period =
Initial Outlay
Annual cash inflow
Machine A
= 17,500 = 7.95 Years
2200
Machine A Machine B Machine C

400
750
250
2,750
6000
2250
100
250
3250
6750
2750
400
750
550
500
800
750
1750
500
2500
5000
2250
1750
2083
1800
750
2917
450
300
1167
180
450
1750
270
1750
2083
1800
2200
3833
2070
Machine B
= 12500 = 3.26 Years

3833
Machine C
= 9000 = 4.35 Years
2070
Recommendation:On the basis of the payback period it is advisable to select machine B as it has the lowest payback
period.
Q.9 Calculate Payback period from the following information of Rama Newsprint Ltd.
Investment
Rs. 1 lakh
Estimated life
10 years
Tax Rate
50%
Profit Before
Profit After
Depreciation
Year
Depreciation
Depreciation
Tax @ 50%
Rs.
Rs.
Rs.
1
40000
10000
30000
15000
2
60000
10000
50000
25000
3
50000
10000
40000
20000
4
50000
10000
40000
20000
Q.9 Solution
Year
PAT
+ Depn
= CIF
CCIF
1
15,000
10,000
25,000
25,000
2
25,000
10,000
35,000
60,000
3
20,000
10,000
30,000
90,000
4
20,000
10,000
30,000
1,20,000
Payback Period = 3yrs + 10,000 x 12
30,000
= 3yrs 4 Months
Q.10 Your Company is considering the question of investment in a project for which the following
data are available:
Capital Outlay
Rs. 2,20,000
Depreciation Charges
20% p.a. (Straight Line Method)
Forecast of annual income before charging depreciation, but after all other charges:
Profit Before
Year
Depreciation Rs.
1
100000
2
100000
3
80000
4
80000
5
40000
From the above data, the management want you to calculate the following:
a) Pay Back Period
b) Rate of Return On Original Investment
c) Rate of Return On Average Investment
Ignore Taxation
Q.10 Solution
n
Dep =
2,20,000 x 20%
n
Year
PBDT = CIF - Dep
1
1,00,000
44,000
= Rs.44,000
= PAT
56,000
CCIF
1,00,000
2
3
4
5
1,00,000
44,000
80,000
44,000
80,000
44,000
40,000
44,000
4,00,000
NPAT
a) Payback Period = 2 Yrs + 20,000 x 12
80,000
= 2 Yrs 3 months
:. Avg. NPAT = 36,000
b) ARR based on O.Inv.
=
56,000
36,000
36,000
(4000)
1,80,000
2,00,000
2,80,000
3,60,000
4,00,000
Avg. NPAT x 100

O.Inv.
=
36,000 x 100
2,20,000
=
16.36%
c) ARR based on Avg. Invst.
=
Avg. NPAT x 100
Avg. Invst.
=
36,000 x 100
1,10,000
=
32.73%
Avg. Invst
=
2
=
2,20,000 0 + 0 + 0
2
=
Rs.1,10,000
Q.11 The existing manufacturing units have yearly fixed overheads of Rs.1,00,000. It wishes to
expand the production by purchasing one of the two types of machinery Model A and Model B each
costing Rs.5,00,000 and having an estimated life of 5 years. The estimated annual sales and costs
under both of these models are given as under:
Model A
Model B
Rs.
Rs.
Sales
2000000
2450000
Materials
920000
1112200
Labour
412450
567800
Variable Overheads 380900
495670
Compute the comparative profitability of each model of machinery under the payback period and
also calculate Payback profitability. Ignore Depreciation and taxation.
(MU, BMS, April 2004)
Q.11 Solution
Sales
(-) V.C
n
Cont .
(-) F.C
PBDT = CIF
Payback period
= Initial Outlay
Annual CIF
Model (A)
20,00,000
17,13,350
2,86,650
2,86,650
Model (B)
24,50,000
21,75,670
2,74,330
2,74,330
= 5,00,000
2,86,650
= 1.74yrs
= 5,00,000
2,74,330
= 1.82 yrs
Payback profitability = Annual CIF X (LIFE PBP)

A
= 2,86,650 X (5 1.74)
= 9,33,250
B
= 2,74,330 x (5 1.82)
= 8,71,650
Q.12 A company can make either of two investments at period to assuming a required rate of return
of 10%, determine for each project:
1.The Payback period
2.The discounted payback period
3.The profitability index
You may assume straight line depreciation.
P
Cost of investment (Rs.)
200000
Expected life (no salvage) 5 years
Projected net income
(after depreciation, interest and taxes)
Year
Rs.
1
10000
2
10000
3
20000
4
20000
5
20000
(Q.12) Solution
Project P
Cash outflow
n
Yr. PAT
Dep
1 10,000
40,000
2 10,000
40,000
3 20,000
40,000
4 20,000
40,000
5 20,000
40,000
=
Rs.200000
CIF
CCIF
50,000
50,000
50,000
1,00,000
60,000
1,60,000
60,000
2,20,000
60,000
2,80,000
Depn = Cost Scrap value

Life
= 2,00,000 0
5
= Rs.40,000
1) Payback period
= 3yrs + 40,000 x 12
60,000
= 3yrs and 8 months
2) Discounted PB period
= 4 yrs + 27210 x 12
37260
= 4yrs and 8.76 months
3) Profitability Index
= PVCIF
PVCOF
Q
280000
5 years
Rs.
24000
24000
24000
24000
24000.
PV@10%
0.909
0.826
0.751
0.683
0.621
PVCIF
45,000
41,300
45,060
40,980
37,260
2,10,050
CPVCIF
45450
86750
131810
172790
210050
= 210050
200000
= 1.05
Project Q
Cash outflow = Rs.280000
n
Yr.
PAT
+ Dep
= CIF
1
24,000
56,000
80,000
2
24,000
56,000
80,000
3
24,000
56,000
80,000
4
24,000
56,000
80,000
5
24,000
56,000
80,000
PV@10%
0.900
0.826
0.751
0.683
0.621
PVCIF
72,720
66,080
60,080
54,640
49,680
3,03,200
CCIF
72,720
1,38,800
1,98,880
2,53,520
3,03,200
1) Payback period = Initial Outlay

Annual CIF
= 2,80,000 = 3.5yrs (3yrs 6months)
80,000
2) Discounted payback period (P)
= 4yrs + 26,480 x 12
49,680
= 4yrs 6.40 months
3) Profitability Index = PVCIF
PVCOF
= 303200
280000
= 1.08
Q.13 A company whose cost of capital is 12% is considering 2 projects A and B. The following data
is available:
Project A
Project B
Rs.
Rs.
Investment
140000
140000
Cash Flows:
Year
1
20000
100000
2
40000
80000
3
60000
40000
4
100000
20000
5
110000
20000
330000
260000
Select the most suitable project by using the following methods:
a) Pay Back Period
b) Net Present Value
c) Profitability Index
The present values of Rs.1 at 12% are:
Year 1
0.9
Year 2
0.8
Year 3
0.7
Year 4
0.6
Year 5
0.55
Q.13) Solution:COF Rs.140000

Year
1
2
3
4
5
PV @ 12%
0.9
0.8
0.7
0.6
0.55
a) Payback Period
Project A
Project B
COF Rs.140000
CIF
20000
40000
60000
100000
110000
PVCIF
Project A
CCIF
20000
60000
120000
220000
330000
PVCIF
18000
32000
42000
60000
60500
212500
20000 x 12
100000
3 years 2.4 months.
1 year
CIF
100000
80000
40000
20000
20000
Project B
CCIF
100000
180000
220000
240000
260000
PVCIF
90000
64000
28000
12000
11000
205000
3 years +
40000 x 12
80000
=
1 year 6 months.
Recommendation : Select Project B since Lower PBP.
b) Net present value =
Project A
=
=
PVCIF PVCOF
212500 140000
Rs.72500
Project B
=
205000 140000
=
Rs.65000
Recommendation : Select Project A since Higher NPV
c) Profitability index =
Project A
=
=
Project B
PVCIF
PVCOF
212500
140000
1.52
205000
140000
=
1.46
Recommendation : Select Project A since Higher PI
Conclusion:- A conservative company should opt for project B [Lower Risk (PBP) and Lower
Return] whereas an aggressive company should opt for project A [Higher Risk (PBP) and Higher
Returns]
Q.14 Your Company can make either of the following two investments at the beginning of 2010.
The particulars available in this respect are:
Project I Project II
Estimated cost (to be incurred initially) Rs.
20000
28000
Estimated life in years
4
5
Scrap value at the end of estimated life
Nil
Nil
Estimated Net Cash Flows (Rs)
End of 2010
5500
5600
End of 2011
7000
9000
End of 2012
8500
9000
End of 2013
7500
9000
End of 2014
9000
It estimated that each of the alternative projects will require an additional working capital of Rs.
2000 which will be received back in full after the expiry of each project life. In estimating net cash
flow, depreciation has been provided under SLM.
Cost of finance to your company may be taken at 10% p.a. The present value of Rs. 1 to be
received at the end of each year, at 10% is given below:
Year
1
2
3
4
5
P.V. 0.91 0.83 0.75 0.68 0.62
Evaluate the investment proposals using NPV and profitability Index methods.
(Q.14) Solution Project I:
Yr.
CIF
PV@10%
1
5,500
0.91
2
7,000
0.83
3
8,500
0.75
4
7,500
0.68
5
2000
0.68
PVCOF (-)
NPV
PVCIF
5005
5810
6375
5100
1360
23,650
22,000
1,650
P.I = PVCIF
PVCOF
= 23,650 = 1.075
22,000
Project II
Yr.
CIF PV@10%
1
5,600
0.91
2
9,000
0.83
3
9,000
0.75
4
9,000
0.68
5
9,000
0.62
6
2,000
0.62
PVCIF
5096
7470
6750
6120
5580
1240
32256
PVCOF (-) 30000
NPV 2256
P.I = PVCIF = 32,256 = 1.0752
PVCOF 30,000
Evaluation: As per NPV select Project II since higher NPV
As per PI select Project II since higher PI.
Selection:- Hence project II is recommended.
Q.15 A company has an investment opportunity costing Rs. 40,000 with the following expected net
cash flow (i.e. after taxes and before depreciation)
Year Net Cash Inflows
Rs.
1
7000
2
7000
3
7000
4
7000
5
7000
6
8000
7
10000
8
15000
9
10000
10
4000
Using 10% as the cost of capital (rate of discount) determine the following:
1.Payback period and payback profitability
2.NPV at 10% discounting factor and 15% discounting factor
3.Profitability index at 10% discounting factor and 15% discounting factor
4.Internal rate of return with the help of 10% discounting factor and 15% discounting factor.
Q.15 Solution
Year
Cash inflow
1
7000
2
7000
3
7000
4
7000
5
7000
6
8000
7
10000
8
15000
9
10000
10
4000
CCIF
7000
14000
21000
28000
35000
43000
53000
68000
78000
82000
PV @ 10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
0.467
0.424
0.386
PVCIF
1) Payback Period
=
=
2) Payback profitability =
=
=
5yrs + 5000 x 12
8000
5yrs and 7.5months
Cash inflow Cash outflow
82,000 40,000
Rs.42,000
2) PV CIF
- PV COF
NPV @ 10%
=
=
Year
1
2
3
4
5
6
7
8
9
10
PV@15%
0.870
0.756
0.658
0.572
0.497
0.432
0.376
0.327
0.284
0.247
Cash inflow
7000
7000
7000
7000
7000
8000
10000
15000
10000
4000
48961
(40,000)
8961
PVCIF
6090
5292
4606
4004
3479
3456
3760
4905
2840
988
PVCIF
6363
5782
5257
4781
4347
4512
5130
7005
4240
1544
48961
2)
PV CIF
PV COF
NPV @ 15%
(-)
3) Profitability index
@ 10%
@ 15%
=
=
=
4) IRR
39420
(40000)
- 580
PVCIF
PVCOF
48961
40000
1.22
39420
40000
0.99
= D1 + PVCIF (H) PVCOF x (D2 D1)

PVCIF (H) PVCIF (L)
= 10% + 48,961 40,000 x (15% - 10%)
48,961 39,420
= 10% + 8961 x 5%
9541
= 10% + 4.69%
= 14.69%
Q.16 Runwal group has short listed two projects Karma and Dharma for final consideration. It wants
to take up only one project of the two and not both. The investment required for project Karma is Rs.
190 lakhs while that for project Dharma is Rs. 400 lakhs. The other details related to project Karma
and Dharma are given below:
Project Karma
Profit before tax Profit after tax
78
56
82
60
100
74
Project Dharma
Year Depreciation Profit before tax Profit after tax
1
78
104
82
2
64
118
92
3
54
260
186
st
nd
rd
The cost of capital of company is 10% and the PV of Re. 1 at the end of 1 , 2 and 3 year @14%
rate is 0.8772, 0.7695 and 0.6750 respectively using NPV method, which project would you
recommend.
What will be your answer under Payback period method?
Year
1
2
3
Depreciation
24
20
16
(Q.16) Solution
Project Karma
Year PAT CIF
1
56
80
2
60
80
3
74
90
CCIF
80
160
250
Payback period
PV@14%
0.8772
0.7695
0.6750
PVCIF
70.176
61.56
60.75
192.486
2yrs + 30 x 12
90
2yrs 4 months
Project Dharma
n
Year PAT Dep
1
82
78
2
92
64
3
186
54
CIF
160
156
240
CCIF
160
316
556
Payback Period
2yrs + 84 x 12
240
2yrs 4.2 months
PV@14%
0.8772
0.7695
0.6750
PVCIF
140.352
120.042
162
422.394
Recommendation:
On the basis of payback period, it is advisable to select karma as it has lower pay back period. (i.e.
2yrs 4 months)
Project Karma
P.V CIF
192.486
(-)P.V COF 190.000
NPV
2.486
Project Dharma
P.V CIF
422.394
(-) P.V COF 400.000
NPV
22.394
Recommendation:
On the basis of NPV method it is advisable to select Dharma as it has higher NPV (i.e. 22.394)
Q.17 A product is currently being manufactured on a machine that has book value of Rs. 30000. The
machine was originally purchased for Rs. 60000 ten years ago. The per unit costs of the product are:
Direct Labor Rs.8; Direct Materials Rs.10; Variable OHS Rs.5; Fixed OHS Rs.5; and total is Rs.28.
In the past year 6000 units were produced and sold for Rs. 50 per unit. It is expected that the old
machine can be used indefinitely for the future.
An equipment manufacturer has offered to accept the old machine at Rs. 20000, a trade in for a new
version. The purchase price of the new machine is Rs 100000. The projected per unit costs
associated with the new machine are: Direct Labor Rs.4; Direct Materials Rs.7; Variable OHS Rs.4;
Fixed OHS Rs.7; and total is Rs.22. The management expects that if the new machine is purchased,
the new working capital requirement of the company would be less by Rs. 10000. The fixed OH
costs are allocations from other departments plus depreciation of the equipment.
The new machine has an expected life of 10 years with no salvage value; straight line method of
depreciation is employed by the company. It is also expected that the future demand of the product
will remain at 6000 units per year. Should the new equipment be acquired?
Corporate tax is 40%. (PV of Annuity is Re.1 at 10% rate of discount for 9 years is 5.759. PV of
Re.1 at 10% rate of discount, received at end of tenth year is 0.386)
(MU, BMS, Oct. 2002)
(Q.17) Solution.
Evaluation of proposal
Old Machine
O.C
60,000
Total depn *30,000
B.V / WDV 30,000
Revenue statement for the year

Particulars
OldMac.
Sales (6,000 x 50)
3,00,000
(-) Variable cost
1,38,000
Contribution
1,62,000
(-) F.C
PBDT
1,62,000
n
(-) Dep
3,000
PBT
1,59,000
(-) Tax @ 40%
63,600
PAT
95,400
(+) Depn
3,000
CIF
98,400
Dep p.a. = 30,000 = 3,000

10
New machine
n
Dep = 1,00,000 = 10,000
10
New Mac.
3,00,000
90,000
2,10,000
.
2,10,000
10,000
2,00,000
80,000
1,20,000
10,000
1,30,000
Note:- Fixed OHs is ignored to the extent of allocation from other

department.
:. Additional cash inflow
=
=
1,30,000 98,400
Rs.31,600
Calculation of cash outflow

Particular
Purchase price
Less: Exchange price
Release of working capital
Savings in tax on loss of sale of old machine (10000 x 40%)
COF
Calculation of NPV
Yr.
C.I.F
PV@10%
PVCIF
1 10
31,600
6.145
1,94,182
(-) PVCOF
66,000
:. NPV
1,28,182
Recommendation:The company is advised to purchase new machine since NPV is positive.
Rs.
1,00,000
(20,000)
(10,000)
(4,000)
66,000
Q.18 Vijay Electronics wants to take up a new project for the manufacture of electronic device
which has good market. Further details are given below:
i) Cost of the project as estimated:
(Rs. In Lacs)
Land
2.00
Buildings
3.00
Machinery
10.00
Working Capital Margin
5.00
ii) Project will go into production immediately and will be operational for 5 years.
iii) The annual working results are estimated as follows:
(Rs. In Lacs)
Sales
21.00
(-) Variable Cost
8.00
Fixed Cost (Excluding Depreciation)

4.00
Depreciation of assets
2.00
iv) At the end of Operational period, it is expected the fixed assets can be sold for Rs.5 lakhs
(without any profit).
v) Cost of capital of the firm is 10%. Applicable tax rate is 40%.
Note: 1. The present value of an annuity of Re.1 at 10% rate of discount for 5 years is Rs.3.791.
2. The present value of Re.1 at 10% rate of discount for year 1 is Re.0.909 and for year 5 is
Re.0.61.
a) You are required to evaluate the proposal by working out the NPV and advice the firm
for taking investment decision
b) List down 5 factors that should be considered before taking the decision.
(Q.18) Solutions
Particulars
Sales
(-) V.C
Contribution
(-) F.C
PBDT
n
(-) Dep
PBT
(-) Tax
PAT
n
Dep
Cash inflow
21
8
13
4
9
2
7
2.8
4.2
2
6.2
Yr.
1.5
5
5
CIF
6.2
5
5
PV@10%
3.791
0.61
0.61
PVCIF
(-)PVCOF
NPV
PVCIF
23.5042
3.05
3.05
29.6042
20.0000
9.6042
Advice
Since NPV is positive company is advised to take investment of the new project.
(b) Factors which should be considered before taking decisions.
(1) Financial feasibility
(2) Technical feasibility
(3) Economic feasibility
(4) Market appraisal
(5) Management competence
(F OR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

PRACTISE PROBLEMS:(Q.19) One of three projects of a company is doing poorly and is being considered for replacement.
The projects (A, B and C) are expected to require Rs 2,00,000 each, have an estimated life of 5
years, 4 years and 3 years respectively and have no salvage value. The required rate of return is 10
per cent. The anticipated cash flows after taxes (CFAT) for the three projects are as follows:
CFAT
YEAR
1
2
3
4
5
A
Rs 50,000
Rs 50,000
Rs 50,000
Rs 50,000
Rs 90,000
B
Rs 80,000
Rs 80,000
Rs 80,000
Rs 30,000
C
Rs 1,00,000
Rs 1,00,000
Rs 10,000
A) Rank each project applying the methods of pay back, average rate of return, net present value,
internal rate of return and profitability index.
B) Explain why the five capital budgeting systems yield conflicting answers.
C) What would be the profitability index if the internal rate of return equals the required return on
investment? What is the significance of a profitability index of less than one?
D) Recommend the project to be adopted and give reasons.
(Q.20) Aman Limited is a leading manufacturer of automotive components. It supplies to the
original equipment manufacturers as well as the replacement market. Its projects typically have a
short life as it introduces new models periodically.
You have recently joined Aman Limited as a financial analyst reporting to Ravi Sharma, the
CFO of the company. He has provided you the following information about three projects, A, B, and
C, that are being considered by the Executive Committee of Sona Limited:
Project A is an extension of an existing line. Its cash flow will decrease over time.
Project B involves a new product. Building its market will take some time and hence its cash
flow will increase over time.
Project C is concerned with sponsoring a pavilion at a Trade Fair. It will entail a cost initially
which will be followed by a huge benefit for one year. However, in the year following that a
substantial cost will be incurred to raze the pavilior.
The expected net cash flows of the three projects are as follows:
Year
0
1
2
3
Project A
(15,000)
11,000
7,000
4,800
Project B
(15,000)
3,500
8,000
13,000
Project C
(15,000)
42,000
(4,000)
Ravi Sharma believes that all three projects have risk characteristics similar to the average risk of the
firm and hence the firms cost of capital, viz. 12 percent, will apply to them.
You are asked to evaluate the projects.
(a) What is payback period and discounted payback period? Find the payback periods and the
discounted payback periods of Projects A and B.
(b) What is the net present value (NPV)? What are the properties of NPV? Calculate the NPVs of
projects A, B and C.
(c) What is internal rate of return (IR)? What are the problems with IRR? Calculate the IRRs of
projects A, B and C.
Q.21 A choice is to be made between two competing projects which require an equal investment of
Rs. 50,000 and are expected to generate net cash flows as under:
Project I
Project II
End of year 1
Rs.25,000
Rs. 10,000
End of year 2
End of year 3
End of year 4
End of year 5
End of year 6
Tax Rate
Calculate:
Pay Back Period.
Average Ratio of Return.
Pay Back Profitability.
Rs. 15,000
Rs. 10,000
Rs. NIL
Rs. 12,000
Rs. 6,000
50%
Rs. 12,000
Rs. 18,000
Rs. 25,000
Rs. 8,000
Rs.4,000
40%
(MU, B.Com., April 2007)
CHAPTER: 9 SOURCES OF SHORT TERM & LONG TERM FINANCE

Finance is the lifeblood of an organization can exist without it. Finance is required because receipts
dont match expenditure, inflows dont match outflows. Sources of finance are categorized in 3
ways:
1. According to the period i.e. short, medium and long term
2. According to the ownership i.e. owners fund and borrowed funds
3. According to the generation i.e. internal and external sources
SECTION : I - SHORT TERM SOURCES OF FINANCE:Short terms of finance are required primarily to meet working capital requirements. The focus is on
maintaining liquidity at a reasonable cost. The various sources of short term finance are:
1. Trade Credit:- This is the credit extended by suppliers of material and other resources.
2. Cash Credits / Overdrafts:- Under this arrangement the borrower can borrow upto a fixed limit
and repay it as and when he desires. Interest is charged only running balance and not on the
sanctioned amount. A minimal charge is payable for availing this facility.
3. Loans repayable in one year:- They are either credited to the current of the borrower or given
to him in cash. A fixed rate of interest is charged and the loan amount is repayable on demand or
in periodical installments.
4. Purchase / Discount of Bills:- A bill may be discounted with the bank and when it matures on a
future date the bank collects the amount from the party who had excepted the bill. When a bank
is short of funds it can sell or rediscount the bill on the other hand the bank with surplus funds
would invest in bill. However, with discount rate at 10-11 percent for 90-day paper, bill
discounting is an expensive sources of short-term funds.
5. Letter of Credit:- A letter of credit is an instrument issued by a bank on behalf of an importer,
whereby the bank agrees to honour the draft drawn on the importer provided certain conditions
are satisfied. Through the letter of credit arrangement, the credit of the importer is substituted by
the credit of the bank. Hence, it virtually eliminates the risk of the exporter when he sells to an
unknown importer in a foreign country. When an L/C is opened by the bank in favour of the
customer it takes the responsibility of honoring the obligation in case the customer fails to do so.
In this case even though the customer provides the credit the risk is born by the bank.
6. Inter-Corporate Deposits:- A deposit made by one company with another, normally for a
period of up to 6 months is referred to as an inter-corporate deposit. Such deposit are usually of 3
types:
a) Call Deposits:- In theory, a call deposit is withdrawable by the lender on giving a days notice.
In practice however the lender has to wait for at least three days.
b) Three Month Deposits:- More popular in practice, these deposits are taken by borrowers to
tide over a short term cash inadequacy that may be caused due to one or more of the following
factors: disruption in production, excessive imports of raw material, tax payment delay in
collection, dividend payment, and unplanned capital expenditure.
c) Six Month Deposits:- Normally, lending companies do not extend deposits beyond this time
frame. Such deposits are usually made with first-class borrowers.
As inter-corporate deposits represent unsecured borrowing, the lending company must satisfy itself
about the credit worthiness of the borrowing firm.
Characteristics of the Inter-Corporate Deposit Market:
a) Lack of Regulation:- The lack of legal hassles and bureaucratic red tape makes an intercorporate deposit transaction very convenient.
b) Secrecy:- Brokers are discreet about their lists of borrowers and lenders.
c) Importance of Personal Contacts:- Lending decisions in the inter-corporate deposit markets
are based on personal contacts and market information which may sometime lack reliability.
7. Short-Term Loan From Financial Institution:- The Life Insurance Corporation of India, The
General Insurance Corporation of India. and The Unit Trust of India provide short-term loans to
manufacturing companies with an excellent track record
. Features:
a. They are totally unsecured.
b. The loan is given for the period of 1 year and can be renewed for 2 consecutive years,
provided the original eligibility criteria are satisfied.
c. After a loan is repaid, the company has to wait for at least 6 months before availing of a
fresh loan.
d. The loans carry a higher interest rate. However, there is a rebate of 1 % for prompt
payment.
8. Commercial Paper:- Large firms who are financially strong issue commercial paper. It
represents a short-term unsecured promissory note issued by firms of high credit rating.
Its important features include:
1. Maturity ranges from 90-180 days.
2. It is sold at a discount from its face value and redeemed at its face value. Thus the implicit
interest rate is a function of size of the discount and the period of maturity.
3. CP are either directly placed with investors or sold though dealers / merchant bankers.
Usually bought by investors who keep it till the maturity and hence there is no well
developed secondary market.
Who can issue CP?
Highly rated listed companies, primary dealers and All-India financial institutions have been
permitted to raise short-term resources.
Eligibility of Issuing CP
Minimum tangible net worth as per latest audited balance sheet is Rs.5 crore.
Company has been sanctioned working capital limit by bank(s) or All-India financial
institution(s) and
The company is classified as a Standard Asset by the financing bank(s) institution(s)
Minimum Credit Rating required from recognised credit rating agencies
Maturity period of CP
The CP can be issued for maturities between 15 days to 1 year from the date of its issue.
Minimum amount of investment and denomination of CP
The minimum amount required to be invested by a single investor is atleast Rs.5 lakhs. It is
issued in denominations of Rs.5 lakh or multiples thereof.
9. Factoring:- Factoring is a financial transaction whereby a business sells its accounts receivables
at discount to a factor. The three parties directly are: the seller, debtor, and the factor. The seller
is owed money (usually for worked performed or goods sold) by the second party, the debtor.
The seller than sells the debtors accounts at a discount to the third party, the factor. The debtor
than directly pays the factor the full value of invoice.
Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the
receivables, not the firms credit worthiness. Secondly, factoring is not a loan- it is the purchased of
an asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.
Features of Factoring Arrangement:
a) The factor selects the account of the client that would be bought by it.
b) The factor assumes responsibility for collecting the debt of accounts handled by it.
c) The factor advance money to the client against not-yet-collected and not-yet-due debts. Typically
the amount advanced is 70-80% of the face value of the debt and carries and interest rate, which
may be equal to or marginally higher than the lending rate of commercial banks.
d) Factoring may be on a recourse basis or non-recourse basis (full credit risk). (Presently, in India
it is done only on a recourse basis)
Forfaiting is similar to factoring. It is the purchasing of an exporters receivables (the amount
importers owe the exporter) at a discount by paying cash. The forfaiter, the purchaser of the
receivables), becomes the entity to whom the importer is obliged to pay its debt. By purchasing these
receivables- which are usually guaranteed by the importers bank- the forfaiter frees the exporter
from credit and from the risk of not receiving payment from the importer who purchased the goods
on credit.
SECTION : II - SOURCES OF LONG-TERM FINANCE
9.1 Introduction
As you are aware finance is the life blood of business. It is of vital significance for modern business
which requires huge capital. Funds required for a business may be classified as long term and short
term. You have learnt about short term finance in the previous Part Finance is required for a long
period also. It is required for purchasing fixed assets like land and building, machinery etc. Even a
portion of working capital, which is required to meet day to day expenses, is of a permanent nature.
To finance it we require long term capital. The amount of long term capital depends upon the scale
of business and nature of business. In this lesson, you will learn about various sources of long term
finance and the advantages and disadvantages of each source.
9.2 Long Term Finance Its meaning and purpose
A business requires funds to purchase fixed assets like land and building, plant and machinery,
furniture etc. These assets may be regarded as the foundation of a business. The capital required for
these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds
required for this part of the working capital and for fixed capital is called long term finance.
Purpose of long term finance:
Long term finance is required for the following purposes:
1. To Finance fixed assets:
Business requires fixed assets like machines, Building, furniture etc. Finance required to buy these
assets is for a long period, because such assets can be used for a long period and are not for resale.
2. To finance the permanent part of working capital:

Business is a continuing activity. It must have a certain amount of working capital which would be
needed again and again. This part of working capital is of a fixed or permanent nature. This
requirement is also met from long term funds.
3. To finance growth and expansion of business:
Expansion of business requires investment of a huge amount of capital permanently or for a long
period.
FACTORS DETERMINING LONG TERM FINANCIAL REQUIREMENTS:
The amount required to meet the long term capital needs of a company depend upon many factors.
These are:
(a) Nature of Business:
The nature and character of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So it has to invest a large amount of capital for a
long period. But a trading concern dealing in, say, washing machines will require a smaller amount
of long term fund because it does not have to buy building or machines.
(b) Nature of goods produced:
If a business is engaged in manufacturing small and simple articles it will require a smaller amount
of fixed capital as compared to one manufacturing heavy machines or heavy consumer items like
cars, refrigerators etc. which will require more fixed capital.
(c) Technology used:
In heavy industries like steel / cement the fixed capital investment is larger than in the case of a
business producing plastic jars using simple technology or producing goods using labour intensive
technique or service sector companies.
Lease Financing:
1) Lease: A contract of lease may be defined as A contract whereby the owner of an asset (lessor)
grants to the another party (lessee) the exclusive right to use the asset usually for an agreed period of
time in return for the payment of rent.
Important features here are:
a) Owner and User are different
b) Depreciation claim is not with the user (lessee) as he is not the owner. Lessor (owner) claim
the depreciation.
c) Lease (rent) payment is a tax-deductible expense.
d) In most transactions, asset is delivered directly to the lessee by the manufacturer / supplier.
Lessor makes payment to the supplier and receives rent from lessee in future periods.
e) Lease funded assets do not alter Debt Equity ratio.
2) Types of Leases:
Distinction between: Operating Lease and Finance Lease:
1.
Operating Lease
1) In an operating lease all the risks and
rewards incidental to ownership are not
transferred by the lessee to the lessor.
2) Operating lease is cancelable by either party
during the lease period.
2.
Finance Lease
1) In a finance lease the lessor transfers to all
the risks and rewards incidental to the
ownership of the asset to the lessee.
2) Finance lease is noncancellable and it
involves payment of lease rentals over an
obligatory non-cancellable lease period.
3) In an operating lease the lessor does not

relay on only a single lessee for recovery of his
investment since the lease period are shorter
such as even an hour, a day, a week, or a month
and so on. The lessor is ultimately interested in
the residual value of the asset.
4) An operating lease is termed as a Service
Lease
5) In an operating lease the cost of asset is not
fully amortised during the primary lease (noncancellable) period.
6) Operating lease being shorter than the
expected economic life of the asset no such
option of purchase of the asset by the lessee
exists there.
7) An operating lease is generally for a period
shorter than the economic life of the leased
asset.
8) In an operating lease the lessor other than
financing the cost of leased asset, also provides
such as repairs, maintenance and technical
advice.
9) In an operating lease the lessor bears the risk
of obsolescence of the asset leased.
10) Examples: Aircrafts, Buildings, Heavy
machinery, railway, Buses etc.
3) In a finance lease the lessor is only a

financer and usually not interested in the asset.
4) Finance lease is also termed as full-payout

leases.
5) The finance lease enable the lessor to
recover his investment in the asset lease plus to
derive a profit.
6) In a finance lease the lessee has the option to
purchase the asset at a price on a date the
option becomes exercisable or at the end of the
lease agreement period.
7) In a finance lease the lease term is for the
major part of the economic life of the asset.
8) In a finance lease the lessee is responsible
for the repairs and maintenance, insurance and
risk of obsolescence of the asset leased.
9) In a finance lease the lessee has to bear the
risk of obsolescence of the asset leased.
10) Examples: Hiring a cap, chartering of Air
crafts, Hiring of cranes etc.
3) Leveraged Lease:- Under leveraged leses there are three parties. The lessor, the lessee and
the financial institution / Bank who lends a major cost of the asset leased. The lessor
contributes 20% to 50% of the cost and the lender contributes 50% to 80% of the cost of the
asset. The periodic lease rental is being appropriately divided between the lender and the
lessor.
4) Sale and Lease Back:- In case of sale and lease back as the name suggest, the firm sells an
asset that it already owns to another firm / party and (hires) gets it on lease back from the
buyer which is usually a financial institution or a leasing company.
5) Direct Lease:- In case of direct lease the lessee acquires the equipment directly from the
manufacturer or arrange the desired equipment to be purchased by the leasing company.
6) Cross Border Lease / International Lease:- A cross border lease is also known as an
international lease or a trans-national lease. In this case lessee and the lessor are domiciled in
different countries. It is an agreement between the nationals of two countries.
7) Triple Net Lease:- In case of triple net lease is obligated to pay the following typical
executory costs in addition to and separate from the basic lease rental payments. Such
additional executory costs are:(i) Sales Tax
(ii) Property Tax
(iii) Repairs
(iv) Parts and Accessories
(v) Insurance
(vi) Maintenance and Servicing
8) Master Lease:- Master leases are structure for lessees who either will be leasing several
pieces of equipment to be received over a period of time or leasing equipment that will
require frequent substitution.
10) Hire Purchase:- In case of hire purchase transaction, the goods are delivered by the owner
to another person on the agreement that such person pays the agreed amount in the periodical
installment.
Important features here are:
(a) Ownership of the asset is transferred to the buyer only on payment of last installment.
(b) Buyer claims depreciation on the asset.
Lease
Lessor claims depreciation
On completion of contract residual
(salvage) value goes to Lessor.
In absence of specific agreement
otherwise, asset is to be returned to the
lessor after the lease period.
Lease payment is fully deductible for
tax.
Hire Purchase
Buyer claim depreciation
On completion of contract residual
(salvage) value goes to Buyer.
Asset is conclusively purchased by the
buyer at the end of the agreement
period.
Only interest portion of EMI/ Hire
value is tax deductible.
11. Venture Capital

Venture capital is money provided by professionals who invest alongside management in young,
rapidly growing companies that have a potential to develop into significant economic
contributors. Venture capital is an important sources of equity for start-up companies.
Venture capitalists generally:
Finance new and rapidly growing companies.
Purchase equity securities
Assist in the development of new product or services
Add value to the company through active participation
Take higher risk with the expectation of higher rewards
Have a long term orientation
When considering an investment, venture capitalists carefully screen the technical and business
merits of the proposed company. Venture capitalists only invest in a small percentage of the
businesses they review and have a long-term perspective. They also actively work with the
companys management, especially with contact and strategy formulation. Companies such as
Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel,
Microsoft and Genentech are famous examples of companies that received venture capital early in
their development period.
In India, these funds are governed by the Securities and Exchanged Board of India (SEBI)
guidelines. According to this, venture capital fund means a fund established in the form of the
company or trust, which raises monies through loans, donations, and issue of securities or units as
the case may be, and makes or proposes to make investments in accordance with these regulations.
The basic principal underlying venture capital-invest in high risk projects with the anticipation of
high returns. These funds are then invested in several fledging enterprises, which require funding,
but unable to access it through the conventional sources such as bank and financial institutions.
Typically first generation entrepreneurs start such enterprises. Such enterprises generally do not have
any major collateral to offer as security, hence banks and financial institution are averse to funding
them. Venture capital funding may be by way of investment in the equity of the new enterprises or a
combination of debt and equity, though equity is the most preferred route.
Since most of the venture finance is through this route are in new areas (worldwide venture capital
follows hot industries like infotech, electronic and biotechnology), the probability of success in
very low. All project financed have a potentially high return. Some projects fail and some give
moderate returns. The investment, however, is a long- term risk capital as such projects normally
take 3 to 7 years to generate substantial returns. Venture capitalists give more than money to the
venture and seek to add value to the investee unit by active participation in its management. They
monitor and evaluate project on a continuous basis.
To conclude, a venture financier is one who funds a start up company, in most cases promoted by a
first generation technocrat promoter with equity. A venture capitalist is not a lender, but an equity
partner. He is driven by maximization: wealth maximization. Venture capitalists are sources of
expertise for the companies they finance. Exit is preferably through listing on stock exchanges. This
method has been extremely successful in USA, and venture funds have been credited with the
success of technology companies in Silicon valley.

PAWAN JHABAK BOOK)
(a) Any 3 Short Term Source of Finance.
(b) Any 3 Long Term Source of Finance.
(c) Any 2 modern Long Term Source of Finance.
(d) Inter corporate deposit.
(e) Merits and Demerits of Equity Share Capital.
(f) Types of Debentures.
(g) ADR.
(h) Venture Capital.
Q.2) Differentiate Equity Shares and Preference Share Capital.
Q.3) What is Securitisation? Explain motives / Advantages of Securitisation.

CHAPTER: 10 BUSINESS RESTRUCTURING
SECTION I :- IMPORTANCE
Business restructuring refers to a broad array of activities that expand or contract a firms operations
or substantially modify its financial structure or bring about a significant change in its organizational
structure and internal functioning. Inter alia, it includes activities such as mergers, purchases of
business units, takeovers, slump sales, demergers, leveraged buyouts, and organizational
restructuring. We will refer to these activities collectively as mergers, acquisitions, and restructuring
(a widely used, though not a very accurate term) or just business restructuring. Sacrificing some
rigour, these activities may be classified as shown in Exhibit
On the Indian scene, too, corporates are seriously looking at mergers, acquisitions, and
restructuring which have indeed become the orders of the day. Most of the business groups and their
companies seem to be engaged in some kind of business restructuring or the other. From the house
of Tatas to the house of AV Birla, from an engineering giant like Larsen & Toubro to a banking
behemoth like State Bank of India, everyone seems to be singing the anthem of business
restructuring. The pace and intensity of business restructuring has increased since the beginning of
the liberalization era, thanks to greater competitive pressures and a more permissive environment.
SECTION II :- BUSINESS RESTRUCTURING
Business restructuring occurs in myriad ways. Sacrificing some rigour, important restructuring
transactions may be classified as shown in Exhibit. They are described below.
Types of Business Restructuring Activities
Corporate restricting occurs in myriad ways. Sacrificing some rigour, important restricting
transactions may be classified as shown in Exhibit. They are described below:
Exhibit 10.1 Types of Business Restructuring Activities
Acquisitions: Acquisition, a broad term, inter alia, subsumes the following transaction:
Merger: A merger refers to a combination of two or more companies into one company. It may
involve absorption or consolidation. In an absorption, one company acquires another company. For
example, Hindustan Lever Limited absorbed Tata Oil Mills Company, ICICI bank absorbed Bank of
Rajasthan, Hindustan Computers Limited, Hindustan Instruments Limited, Indian software company
Limited, and Indian Reprographics Limited combined to form HCL Limited. In India, mergers are
called amalgamations in the legal parlance (hereafter we shall use the terms and mergers and
amalgamations interchangeably) are usually of the absorption variety. The acquiring company (also
reffered to as the amalgamated company or the merged company) acquires and takes over the assets
and liabilities of the acquired company (also referred to as the amalgamating company or the
merging company or the target company)
Typically, the shareholders of the amalgamating company receive shares of the amalgamated in
exchange for their share in the amalgamating company. E.g. Shareholders of Centurion Bank of
Punjab (amalgamating co.) received shares of HDFC Bank (amalgamated co.)
Purchase of Division or Plant: A company may acquire a division or plant of another company. For
example, SRF India bought the nylon cord division of CEAT Limited. E.g. Abott bought the
healthcare division from Piramal Ltd.
Takeover: A takeover generally involves the acquisition of a certain stake in equity capital of a
company which enables the acquirer to exercise control over the affairs of the company. E.g
Mahindra Telecom takeover of Satyam, United Breweries Ltd. acquired majority stake in Deccan
Aviation Ltd. (Now Kingfisher Airlines), Daichi takeover of Ranbaxy Ltd. etc.
Divestitures: While acquisitions lead to expansion of assets or increase of control, divestitures result
in contraction of assets or relinquishment of control. The common forms of divestitures are briefly
described below:
Partial selloff A partial selloff involves the sale of a business division or plant of one company to
another. It is the mirror image of a purchase of a business division.
Demerger A demerger involves the transfer by a company of one or more of its business divisions
to another company which is newly set up. For example, the Great Eastern Shipping Company
transferred its offshore division to a new company called The Great Eastern Shipping Company. The
company whose business division is transferred is called the demerged company and the company
to which the business division is transferred is called the resultant company.
Equity Carveout: In an equity carveout, a parent company sells a portion of its equity in a wholly
owned subsidiary. The sale may be to the general investing public or a strategic investor.
Other forms of Business restructuring
Going Private: Going private means converting a company whose stock is publicly held into a
private company. (e.g. Coal India Ltd., BSNL Ltd. proposed issued).
Leveraged Buyout: A leveraged buyout involves transfer of ownership, effected substantially with
the help of debt finance. (e.g. Zain buyout by Bharati Airtel Ltd).
Privatisation: Privatisation involves transfer of ownership (represented by equity shares), partial or
total, of public enterprises from the government to individuals and non government institutions.
Organisational Restructuring: Organisational restructuring is done through initiatives like
regrouping of businesses, decentralization, and downsizing to enhance performance.
Takeovers
A takeover generally involves the acquisition of a certain block of equity capital of a company which
enables the acquirer to exercise control over the affairs of the company. In theory, the acquirer must
buy more than 50 percent of the paid-up of the acquired company to enjoy complete control. In
practice, however, effective control can be exercised with a smaller holding, usually between 20 and
40 percent, because the remaining shareholders, scattered and ill-organised, are not likely to
challenge the control of the acquirer. A takeover is friendly if the incumbent management supports
it and is hostile if it opposes it.
Takeovers have become commonplace in the Indian corporate world. Some of the prominent
transactions of recent years are the takeover of Indal by Hindalco. IPCL by Reliance Industries,
VSNL by Tatas, BALCO by sterlite Industries, and Raasi Cements by India Cements.
A takeover may be done through the following ways:
Open market purchase The acquirer buys the shares of the listed company in the stock market.
Generally, hostile takeovers are initiated in this manner.
Negotiated acquisition The acquirer buys shares of the target company from one or more existing
shareholders in a negotiated transaction.
[e.g. Daichi Sankyo Ltd. acquired promoters stake in Ranbaxy Ltd.]
Preferential allotment The acquirer buys shares of the target company through a preferential
allotment of equity shares. Obviously such an acquisition is a friendly acquisition meant to give the
acquirer a strategic stake in the company and also infuse funds into the company.
Common Forms of Business Alliances
Business alliances come in a variety of forms. The more commonly used forms are: joint ventures,
strategic alliances, equity partnerships, licensing, franchising alliances, and network alliances.
Joint Ventures A joint ventures (JV) is set up as an independent legal entity in which two or more
separate organisations participate. The JV agreement spells out how ownership, operational
responsibilities, and financial risks and rewards will be shared by the cooperating members.
Needless to add, each member preserves its own corporate identity and autonomy.
Strategic Alliances A strategic alliance is a cooperative relationship like the JV. However, it does
not, unlike a JV result in the creation of a separate legal entity. A strategic alliance may involve an
agreement to transfer technology, provide R&D service, or grant marketing rights. A strategic
alliance may be a precursor to a JV or even an acquisition.
Equity Partnership Beside having the characteristics of a strategic alliance, an equity partnership
also involves one party taking a minority equity stake in the other party.
Licensing There are two popular types of licensing. The first type involves licensing a specific
technology, product, or process; the second type involves licensing a trademark, copyright.
Franchising Alliance A firm may grant rights to sell goods and services to multiple licensees
operating in different geographical locations.
[e.g. Macdonalds Ltd., Titan Industries Ltd., Eurokids Pvt. Ltd. etc.]
Network Alliances A network alliance is a web of inter-connecting alliances among companies
that often transcend national and industrial boundaries. Under such arrangements two companies
may collaborate in one market but complete in another. Such alliances are common in multimedia,
computer, airline, and telecommunication industries.
Rationale for Business Alliances
Business alliances are motivated by a desire to share risk and again access to new markets, reduce
costs, receive favourable regulatory treatment, or acquire (or exit) a business.
Sharing Risks and Resources Developing new technologies can be a very risky and expensive
proposition. Further, such endeavours require pooling technical capabilities of different
organisations. Hence, firms in high technology industries form business alliances so that diverse
know-how can be pooled, adequate funding can be arranged, acceptable risk sharing mechanisms
can be worked out.
Access to New Markets The cost of accessing a new market may be prohibitive because huge
outlays are required on advertising, promotion, warehousing and distribution. To solve this problem,
a company may enter into an alliance to market its products or services through the sales force,
distribution outlays, or Internet site of another firm.
Cost Reduction Business alliances can help in reducing costs through sharing or combining of
facilities in joint manufacturing operations, mutually beneficial purchaser supplier relationships.
Favourable Regulatory Treatment Regulatory authorities like the Department of justice in the
US generally look upon JVs more favourable than mergers or acquisitions.
Prelude to Acquisition or Exit A JV or strategic alliance may be a prelude to acquire another
company. Alternatively, it may be used as a means for exiting a business.
What Makes a Business Alliances Succeed
The following factors are critical to the success of a business alliance:
The partners have complementary strengths.
The cost of developing a new product is exorbitant for a single firm.
The partners have the ability to cooperate with one another.
There is clarity of purpose, roles, and responsibilities.
The apportionment of risks and rewards are perceived as equitable by all parties.
The partners have similar time horizons and financial expectations.
In AGM of RIL, on 22 June 10 Chairman Mukesh Ambani articulated Asset light Partnership
heavy approach for diversification in telecom sector.
SECTION III :- REASONS FOR BUSINESS RESTRUCTURING
Mergers may be classified into several types: horizontal, vertical, conglomerate, and co-generic. A
horizontal merger represents a merger of firms engaged in the same line of business. A vertical
merger represents a merger of firms engaged at different stages of production in an industry. A
conglomerate merger represents a merger of firms engaged in unrelated lines of business. A
cogeneric merger represents a merger of firms engaged in related lines of business.
The principal economic rationale of a merger is that the value of the combined entity is expected
to be greater than the sum of the independent values of the merging entities. If firms A and B merge,
the value of the combined entity, V (AB), is expected to be greater than (VA + VB), the sum of the
independent values of A and B.
A variety of reasons like growth, diversification, economies of scale, managerial effectiveness,
utilization of tax shields, lower financing costs, strategic benefit, and so on are cited in support of
merger proposals. Some of them appear to be plausible in the sense that they create value; others
seem to be dubious as they do not create value.
Plausible Reasons / Advantages
Strategic Benefit If a firm has decided to enter or expand in a particular industry, acquisition of a
firm engaged in that industry, rather than dependence on internal expansion, may offer several
strategic advantages: (i) As a pre-emptive move it can prevent a competitor from establishing a
similar position in that industry. (ii) It offers a special timing advantage because the merger
alternative enables a firm to leap frog several stages in the process of expansion. (iii) It may entail
less risk and even less cost. (iv) In a saturated market, simultaneous expansion and replacement
(through a merger) makes more sense than creation of additional capacity through internal
expansion.
Economies of Scale When two are more firms combine, certain economies are realised due to the
larger volume of operations of the combined entity. These economies arises because of more
intensive utilization of production capacities, distribution networks, engineering services, research
and development facilities, data processing systems, so on and so forth. Economies of scale are most
prominent in the case of horizontal mergers where the scope for more intensive utilization of
resources is greater. In vertical mergers the principal sources of benefits are improved coordination
of activities, lower inventory levels, and higher market power of the combined entity. Finally, even
in conglomerate mergers there is scope for reduction or elimination of certain overhead expenses.
Can there be diseconomies of scale? Yes, if the scale of operations and the size of organization
become too large and unwieldy. Economists talk of the optimal scale of operation at which the unit
cost is minimal. Beyond this optimal point the unit cost tends to increase.
Economies of Scope A company may use a specific set of skills or assets that it possesses to
widen the scope of its activities. For example, Hindustan Unilever Ltd. can enjoy economies of
scope if it acquires a consumer product company that benefits from its highly regarded consumer
marketing skills.
Economies of Vertical Integration When companies engaged at different stages of production or

value chain merge, economies of vertical integration may be realised. For example, the merger of a
company engaged in oil exploration and production (like ONGC) with a company engaged in
refining and marketing (like HPCL) may improve coordination and control.
Vertical integration, however, is not always a good idea. If a company does everything in-house,
it may not get the benefit of outsourcing from independent suppliers who may be more efficient in
their segments of the value chain.
Complementary Resources If two firms have complementary resources, it may make sense for
them to merge. For example, a small firm with an innovative product may need the engineering
capability and marketing reach of a big firm. With the merger of the two firms it may be possible to
successfully manufacturer and market the innovative product. Thus, the two firms, thanks to their
complementary resources, are worth more together than they are separately.
Tax Shields When a firm with accumulated losses and/or unabsorbed depreciation merges with a
profit-making firm, tax shields are utilised better. The firm with accumulated losses and/or
unabsorbed depreciation may not be able to derive tax advantages for a long time. However, when it
merges with a profit-making firm, its accumulated losses and/or unabsorbed depreciation can be set
off against the profits of the profit-making form and tax benefits can be quickly realised.
Utilisation of Surplus Funds A firm in a mature industry may generate a lot of cash but may not
have opportunities for profitable investment. Such a firm ought to distribute generous dividends and
even buy back its shares, if the same is possible. However, most managements have a tendency to
make further investments, even though they may not be very profitable. In such a situation, a merger
with another firm involving cash compensation often represents a more efficient utilization of
surplus funds. (e.g. Generous dividend Infosys Ltd., Buyback of Shares HUL Ltd, Cash
compensation Mittal Steels)
Managerial Effectiveness One of the potential gains of merger is an increase in managerial

effectiveness. This may occur if the existing management team, which is performing poorly, is
replaced by a more effective management team. Often a firm, plagued with managerial inadequacies,
can gain immensely from the superior management that is likely to emerge as a sequel to the merger.
Another allied benefit of a merger may be in the form of greater congruence between the interests of
the managers and the shareholders.
(e.g. Merger of Bank of Rajasthan with ICICI Ltd)
Dubious Reasons for Mergers / Business Restructuring
Often mergers are motivated by a desire to diversify, lower financing costs, and achieve a higher rate
of earnings growth. Prima facie, these objectives look worthwhile, but they are not likely to enhance
value.
Diversification A commonly stated motive for mergers is to achieve risk reduction through
diversification. The extent to which risk is reduced, of course, depends on the correlation between
the earnings of the merging entities. While negative correlation brings greater reduction in risk,
positive correlation brings lesser reduction in risk.
Corporate diversification, however, may offer value at least in two special cases: (i) if a company
is plagued with problems which can jeopardize its existence and its merger with another company
can save it from potential bankruptcy. (ii) If investors do not have the opportunity of home-made
diversification because one of the companies is not traded in the marketplace, corporate
diversification may be the only feasible route to risk reduction.
Lower Financing Costs The consequence of larger size and greater earnings stability, many
argue, is to reduce the cost of borrowing for the merged firm. The reason for this is that the creditors
of the merged firm enjoy better protection than the creditors of the merging firms independently. If
two firms, A and B, merge, the creditors of the merged firm (call it firm AB) are protected by the
equity of both the firms. While this additional protection reduces the cost of debt, it imposes an extra
burden on the shareholders; shareholders of firm A must support the debt of firm B, and vice versa.
In an efficiently operating market, the benefit to shareholders from lower cost of debt would be
offset by the additional burden borne by them as a result there would be no net gain.
Earnings Growth A merger may create the appearance of growth in earnings. This may stimulate
a price increase if the investors are fooled. An example may be given to illustrate this phenomenon.
Financial Positions of Ace Limited and Aim Limited
Particulars
Ace Ltd. before Aim Ltd. before
Ace Ltd. after merger
merger
merger
The market
The market
Is smart
is foolish
(1)
(2)
(3)
(4)
Earnings per share
Rs.2
Rs.2
Rs.2.67
Rs.2.67
Price per share
Rs.40
Rs.20
Rs.40
Rs.53.4
Price-earning ratio
Number of shares
Total earnings
Total value
20
10 million
Rs.20 million
Rs.400 million
10
10 million
Rs.20 million
Rs.200 million
15
15 million
Rs.40 million
Rs.600 million
20
15 million
Rs.40 million
Rs.800 million
Value of Control and Value of Synergy

Value of Control Acquiring firms often are willing to pay a price that is higher than the status quo
value for the right to control the management of target firms.
The value of control stems from the changes that can be made to improve performance Investments
can be made for debottlenecking capacity, redundant assets can be liquidated, operations can be
streamlined, financing structure can be changed, managerial system and processes can be
strengthened, more competent people can be brought in, so on and so forth. The value of control can
be defined as follows:
Value of control = Value of the firm, if it is value of firm with current
Optimally managed
management
Clearly, the value of control is substantial if the firm is currently being run very inefficiency and the
scope for improvements is considerable. On the other hand, the value of control is negligible if the
firm is being managed efficiently.
(e.g. Tata Motors acquisition of Jaguar Land Rover)
Value of Synergy In most acquisitions, there is a potential for synergy which may come in one or
more of the following ways:
Lower operating costs due to economic of scale.
Savings in outlays on R & D, advertising, marketing, and various shared services
Higher growth rate because of greater market power of the combined entity.
Longer growth period from enhanced competitive advantages.
Lower cost of capital due to higher debt capacity.
Better utilisation of tax shelters
Valuing synergy may not be easy because synergy is easy to imagine but difficult to realise.
(e.g. Vodafone acquisition of Essar stake in Hutch)
SECTION IV :- LEGAL PROCEDURE OF BUSINESS RESTRUCTURING
Sections 391 to 394 of the Companies Act, 1956 contain the provisions for amalgamations. The
procedure for amalgamation normally involves the following steps:
1. Examination of Object Clauses The memorandum of association of both the companies
should be examined to check if the power to amalgamate is available. Further, the object clause
of the amalgamated company (transferee company) should permit it to carry on the business of
the amalgamating company (transferor company). If such clauses do not exists, necessary
approvals of the shareholders, boards of directors, and Company Law Board are required.
2. Intimation to Stock Exchanges The stock exchanges where the amalgamated and
amalgamating companies are listed should be informed about the amalgamation proposal. From
time to time, copies of all notices, resolutions, and orders should be mailed to the concerned
stock exchanges.
3. Approval of the Draft Amalgamation Proposal by the Respective Boards The draft
amalgamation proposal should be approved by the respective boards of directors. The board of
each company should pass a resolution authorizing its directors/executives to pursue the matter
further.
4. Application to the High Court/s Once the draft of amalgamation proposal is approved by the
respective boards, each company should make an application to the High Court of the state where
its registered office is situated so that it can convene the meetings of shareholders and creditors
for passing the amalgamation proposal.
5. Dispatch of Notice to Shareholders and Creditors In order to convene the meetings of
shareholders and creditors, a notice and an explanatory statement of the meeting, as approved by
the High Court, should be dispatched by each company to its shareholders and creditors so that
they get 21 days advance intimation. The notice of the meetings should also be published in two
newspapers (one English and one vernacular). An affidavit confirming that the notice has been
dispatched to the shareholders/creditors and that the same has been published in newspapers
should be field in the court.
6. Holding of Meetings of Shareholders and Creditors A meeting of shareholders should be
held by each company for passing the scheme of amalgamation. At least 75 percent (in value) of
shareholders, in each class, who vote either in person or by proxy, must approve the scheme of
amalgamation. Likewise, in a separate meeting, the creditors of the company must approve of the
amalgamation scheme. Here, too, at least 75 percent (in value) of the creditors who vote, either in
person or by proxy, must approve of the amalgamation scheme.
7. Petition to the High Court for Confirmation and Passing of High Court Orders Once the
amalgamation scheme is passed by the shareholders and creditors, the companies involved in the
amalgamation should present a petition to the High Court for confirming the scheme of
amalgamation. The High Court will fix a date of hearing. A notice about the same has to be
published in two newspapers. After hearing the parties concerned and ascertaining that the
amalgamation scheme is fair and reasonable, the High Court will pass an order sanctioning the
same. However, the High Court is empowered to modify the scheme and pass orders accordingly.
8. Filing the Order with the Registrar Certified true copies of the High Court order must be filed
with the Registrar of Companies within the time limit specified by the Court.
9. Transfer of Assets And Liabilities - After the final orders have been passed by both the High
Courts, all the assets and liabilities of the amalgamating company will, with effect from the
appointed date, have to be transferred to the amalgamated company.
10. Issue of Shares and Debentures The amalgamated company, after fulfilling the provisions of
the law, should issue shares and debentures of the amalgamated company. (Cash payment may
have to be arranged in some cases.) The new shares and debentures so issued will then be listed on
the stock exchange

PAWAN JHABAK BOOK)
SECTION PROBLEMS AN D SOLUTIONS

st
(Q.1) The Balance Sheet of X Co. Ltd. on 31 March, 2010 are as follows :
Balance Sheet of X Co. Ltd.
Liabilities
Rs. Assets
Share Capital :
Fixed Assets :
Authorised Capital of 10000
Goodwill
80000
shares of Rs. 100 each
1000000 Others
800000
Issued Capital :
Current Assets,
10000 shares of Rs. 100 each
Loans and Advances
fully paid
1000000
Reserves & Surplus
Capital Reserve
200000
General Reserve
70000
270000
Unsecured Loans
200000
Current Liabilities & Provisions
Sundry Creditors
310000
Total 1780000
Total
Balance Sheet of Y Co. Ltd.
Liabilities
Rs. Assets
Share Capital :
Fixed Assets :
Authorised Capital 200000 shares of
Current Assets,
Rs. 10 each
2000000 Loans and Advances:
Issued Capital :
Bank
200000
80000 shares of Rs. 10 each fully paid
660000
800000 Others
Reserves & Surplus :
General Reserve
800000
Secured Loans
500000
Current Liabilities & Provisions
Sundry Creditors
360000
Total 2460000
Total
Rs.
880000
900000
1780000
Rs.
1600000
860000
2460000
It was proposed that X Co. Ltd. should be taken over by Y Co. Ltd. The following arrangements
were accepted by both the companies.
(a) Goodwill of X Co. Ltd. is considered valueless
(b) Arrears of depreciation in X Co. Ltd. amounted to Rs.40,000
(c) The holder of every 2 shares in X Co. Ltd. was to receive.
(i) as fully paid 10 shares in Y Co. Ltd. and
(ii) so much cash as is necessary to adjust the right of shareholders of both the companies in
accordance with the intrinsic value of the shares as per their Balance Sheets subject to
necessary adjustment with regard to goodwill and depreciation in X Co. Ltd.s Balance
Sheet.
You are required to:
1. Determine the composition of purchase consideration.
2. Show the Balance Sheet after absorption.
Q.1) Solution:Computation of Intrinsic Value per Share

Particulars
Share Capital
Capital Reserve
General Reserve
Total
Less : Goodwill being valueless
80000
Arrears of Depreciation
to be provided for
40000
Tangible Net Worth = Value of Net Assets
Number of Shares
(Paid up Capital Rs. 100 Rs.10
respectively) Intrinsic Value per Share
X Co. Ltd.
Rs.
1000000
200000
70000
1270000
Y Co. Ltd.
Rs.
800000
(120000)
1150000
Nil
1600000
10000
Rs.115
80000
Rs.20
800000
1600000
Scheme of Amalgamation
Basis of Exchange : 10 shares in Y Co. Ltd.
+ Cash for every two shares in X Co. Ltd.
Rs.
Intrinsic Value of Two Shares in X Co. Ltd.
= Rs. 115 x 2
230.00
Less : Intrinsic Value of Ten Shares in Y Co. Ltd.
= Rs. 20 x 2
200.00
Balance cash to paid in respect of every 2 shares in X Co. Ltd.
30.00
Purchase Consideration will be as under
Equity Shares in Y Co. Ltd.
= (10000 2) x 10 shares x Rs.20 (Issue
1000000
Price) Cash paid to adjust the rights
= (10000 2) x Rs.30
150000
Total Purchase Consideration
1150000
Balance Sheet of Y CO. Ltd. (after absorption) as on.
Liabilities
Rs. Assets
Share Capital :
Fixed Assets :
Authorised : 2,00,000 shares of Rs.
Cost
16,00,000
10 each
20,00,000 Add : Addition on
Acquisition
8,00,000
Issued & Subscribed :
1,30,000 shares of Rs. 10 each fully
Less : Arrears of
paid (of which 50,000 shares issued
Depreciation
(40,000)
13,00,000
for consideration other than cash)
Current Assets,
Reserves and Surplus :
Loans & Advances :
Securities Premium
5,00,000 Current Assets
General Reserve (given)
(9,00,000 + 6,60,000)
8,00,000
Secured Loans
5,00,000 Cash at Bank
Unsecured Loans
(2,00,000 + 1,50,000)
2,00,000
Current Liabilities & Provisions :
Sundry Creditors
(3,10,000 + 3,60,000)
6,70,000
39,70,000
Rs.
23,60,000
15,60,000
50,000
39,70,000
(Q.2) On September 30, 2009 the Balance Sheet of Dull Past Ltd. was as follows :
Liabilities
Authorised :
10000 Ordinary shares of Rs. 10 each
1000 6% Cumulative Preference Shares
of Rs. 100 each
Issued :
6000 Ordinary Shares of Rs. 10 each,
fully paid
600, 10% Cumulative Preference
Shares of Rs. 100 each, fully paid
15% Debentures
Current Liabilities :
Trade Creditors
130000
Bank Overdraft (Secured by a
charge on the freehold property) 61000
Rs. Assets
Freehold Land & Building at cost
100000 Plant & Machinery
80000
Less : Depreciation written
100000 off to date
30000
Tools
and
Patents
200000
Current Assets :
Stock in trade
70000
30000
60000 Trade Debtors
Cash in hand
1000
60000 Profit and Loss A/c.
30000
191000
341000
Rs.
100000
50000
10000
101000
80000
341000
It was decided to reconstruct the company and for this purpose. Bright future Ltd. was registered
with a capital of Rs. 200000 divided into 8000 ordinary shares of Rs.10 each and 1200; 11.5%
preference shares of Rs. 100 each to take over the assets and liabilities of the old company.
The debenture holders of Dull Past Ltd. agreed to accept 11.5% preference share in the new
company in exchange of their debentures.
The preference shareholders were to receive one preference share in Bright Future Ltd. for every
three shares held by them in the old company and the ordinary share holders were to be allotted one
ordinary share of Rs. 8 paid in the new company for every four shares held by them in the old
company.
Bright Future Ltd. issued 3500 ordinary shares of Rs. 10 each at par and called up the Balance of Rs.
2 on the shares issued to the old shareholders in Dull Past Ltd.
The preliminary expenses of Bright Future Ltd. which have been paid were Rs. 240.
You are required to :
(1) Give the journal entries to record the above transactions in the books of the old company.
(2) Show the Balance Sheet of Bright Future Ltd. under purchase method in vertical form.
Q.2) Solution
Calculation of Purchase Consideration :
1. Preference Shareholders 1 x 600 x Rs.100
3
2. For Equity Shareholders
1,500 Equity Shares of Rs.10 each at Rs. 8 each
Total Purchase Consideration :
Rs.
20,000 11.5% Preference Shares
12,000 Equity Shares
--32,000
Journal of Dull Past Ltd.

Dr.
Rs.
2,91,000
Realisation A/c
Dr.
To Freehold Land & Building A/c
To Plant & Machinery A/c
To Tools & Patterns A/c
To Stock-in Trade A/c
To Trade Debtors A/c
To Cash in hand A/c
(Being various assets transferred to Realisation A/c)
Depreciation on Plant & Machinery A/c
Dr.
30,000
Trade Creditors A/c
Dr.
1,30,000
Bank Overdraft A/c
Dr.
61,000
15% Debentures A/c
Dr.
30,000
To Realisation A/c
(Being liabilities taken over by Bright Future Ltd. &
accumulated depreciation on Plant & Machinery transferred to
Realisation Account)
Equity Share Capital A/c
Dr.
60,000
To Equity Shareholders A/c
(Being equity share capital transferred to shareholders A/c)
Equity Shareholders A/c
Dr.
80,000
To Profit & Loss A/c
(Being accumulated loss transferred to Shareholders Account)
10% Preference Share Capital A/c
Dr.
60,000
To Preference Shareholders A/c
To Realisation A/c
(Being the amount payable to preference shareholders transfer
to their account and profit to Realisation Account)
Bright Future Ltd. A/c
Dr.
32,000
To Realisation A/c
(Being purchase consideration receivable from Bright Future
Ltd.)
11.5% Preference Shares in Bright Future Ltd. A/c
Dr.
20,000
Equity Shares In Bright Future Ltd. A/c
Dr.
12,000
To Bright Future Ltd. A/c
(Being preference & equity shares received against purchase
consideration)
Preference Shareholders A/c
Dr.
20,000
To 11.5% Preference Shares in Bright Future Ltd. A/c
(Being settled claim of preference shareholders by the issue of
11.5% preference shares)
Realisation A/c
Dr.
32,000
To Equity Shareholders A/c
(Being profit on realisation transferred to shareholders A/c)
Equity Shareholders A/c
Dr.
12,000
To Equity Shares in Bright Future Ltd. A/c
(Being equity shares in Bright Future Ltd. issued to equity
shareholders)
Cr.
Rs.
1,00,000
80,000
10,000
70,000
30,000
1,000
2,51,000
60,000
80,000
20,000
40,000
32,000
32,000
20,000
32,000
12,000
I.
II.
Bright Future Ltd.

th
Balance Sheet as at 30 September, 2009
Schedule
Rs.
No.
Sources of Funds
1. Shareholders Funds :
a) Capital
1
1,00,000
b) Reserves and Surplus
2
8,000
2. Loan Funds :
a) Secured Loans
3
61,000
b) Unsecured Loans
Nil
Total
Application of Funds
1. Fixed Assets :
a) Gross Block
b) Less : Depreciation
c) Net Block
d) Capital Work-in-Progress
2. Investments
3. Current Assets, Loans & Advances
a) Inventories
b) Sundry Debtors
c) Cash and Bank Balances
d) Other Current Assets
e) Loans and Advances
Less : Current Liabilities & Provisions
a) Liabilities
b) Provisions
Net Current Assets
4. a) Miscellaneous Expenditure to the
extent not written off or adjusted
b) Profit & Loss Account
Total
Rs.
1,08,000
61,000
1,69,000
4
-
1,60,000
Nil
Nil
70,000
30,000
38,760
10,000
Nil
1,48,760
1,30,000
Nil
1,30,000
18,760
Nil
240
1,69,000
Schedule forming part of Balance Sheet :

Schedule 1
Share Capital
Authorised :
8,000 Equity Shares of Rs.10 each
1,200 7% Preference Shares of Rs. 100 each
Issued and Subscribed :
5,000 Equity Shares of Rs. 10 each
500 11.5% Preference Shares of Rs. 100 each
(of these, 1,500 equity shares and all the preference shares
have been issued for consideration other than cash)
Rs.
80,000
1,20,000
2,00,000
50,000
50,000
-
1,00,000
Schedule 2
Reserve and Surplus

Rs.
8,000
8,000
Capital Reserve
Schedule 3
Secured Loans
Rs.
61,000
61,000
Bank Overdraft (Secured by a charge on Freehold Property)

Schedule 4
Fixed Asset
Rs.
1,00,000
50,000
1,50,000
Freehold Buildings
Plant & Machinery
Schedule 5
Current Liabilities
Rs.
1,30,000
1,30,000
Trade Creditors
W.N.1
Capital Reserve :
Assets taken over :
Freehold Land & Building
Plant and Machinery
Tools and Patterns
Current Assets
Less : Liabilities taken over :
Current Liabilities
15% Debentures
Net Assets taken over
Purchase consideration
Capital Reserve
W.N.2
Cash / Bank Balance :
Cash Balance
Add : Issue of Shares
Add : Calls of Shares
Rs.
Rs.
1,91,000
30,000
(3,500 x 10)
(1,500 x 2)
Less : Preliminary Expenses

Balance
Rs.
Rs.
Rs.
Rs.
Rs.
1,00,000
50,000
10,000
1,01,000
2,61,000
Rs.
Rs.
Rs.
Rs.
2,21,000
40,000
32,000
8,000
Rs.
Rs.
Rs.
Rs.
1,000
35,000
3,000
39,000
Rs.
Rs.
240
38,760
st
(Q.3) A Ltd. and B Ltd. were amalgamated on and from 1 April, 2010. A new company AB Ltd.
was formed to take over the business of existing companies. The balance sheets of A Ltd. and B Ltd.
st
as on 31 March, 2010 are given below:
(figures in thousands)
A Ltd.
Share Capital :
Equity share of Rs.10 each
12% Preference shares of
Rs.100 each
Reserves and Surplus
Capital Reserve
General Reserve
Profit and Loss A/c
Secured Loans
Trade Creditors
Tax Provisions
2,400
1,200
800
1,200
400
1,600
1,200
800
9600
B. Ltd
Fixed Assets
1,600 Less: Depreciation
800 Investments
Current Assets:
600 Stock
600 Debtors
200 Cash & Bank Balance
800
400
200
5200
A Ltd. B. Ltd
4,800
3,200
800
600
4,000
2,600
1,600
600
1,200
1,600
1,200
600
800
600
9,600
5,200
Other Informations:
(i) Preference shareholders of the two companies are issued equivalent number of 15% preference
shares of AB Ltd. at an issue price of Rs.125 per share.
(ii) AB Ltd. will issue one equity share of Rs.10 each for every share of A Ltd. and B Ltd. The
shares are issued at a premium of Rs.5 per share.
Prepare the balance sheet of AB Ltd. on the assumption that the amalgamation is in the nature of
merger.
Q.3 Solution
Particulars
1) 15% Preference Share for Preference Shareholders
A Ltd. (12000 shares @ 125)
B Ltd. (8000 shares @ 125)
2) ES for Equity Shareholders
A Ltd. (240000 shares @ 15)
B Ltd. (160000 shares @ 15)
Particular
Business Purchase A/c . . .
To Liquidators of A Ltd. A/c.
To Liquidators of B Ltd. A/c.
A Ltd.
B Ltd.
1500000
-
1000000
3600000
PC 5100000
2400000
3400000
l/f
Rs.
8500000
Rs.
5100000
3400000
Liquidators of A Ltd. A/c

Dr.
Liquidators of B Ltd. A/c
Dr.
To 15% Preference Shares (20000 x 100)
To Equity Share Capital (400000 x 10)
To Securities Premium
5100000
3400000
Fixed Assets A/c .

Investment A/c. . .
Stock A/c . . .
Debtors A/c . . .
Cash & Bank balance A/c
Profit & Loss A/c
6600000
2200000
1800000
2400000
1800000
2500000
Dr.
Dr.
Dr.
Dr.
Dr.
Dr.
2000000
4000000
2500000
To CR A/c.
1400000
To General Reserve A/c
1800000
To P & L A/c. . .
600000
To Secured Loans A/c . . .
2400000
To Trade Creditors
1600000
To Tax provisions A/c
1000000
To Business Purchase A/c
8500000
In balance sheet Net debit balance is P&L A/c Rs.100000 will appear on asset side.
st
Liabilities
Share Capital
Authorised capital
Called up / Issued
11% Preference Shares
Equity Share capital
Reserves & Surplus
Capital Reserve
Securities Premium
Secured Loans
Secured Loans
Unsecured Loans
Current Liabilities
Tax provisions
Trade Creditors
Balance Sheet as on 1 April 2010

Rs. Assets
Fixed Assets
?
2000000 Investment
4000000
Current Assets
1400000 Loans & Advances
2500000 Stock
Debtors
Cash & Bank balance
2400000 Miscellaneous expenditure
P & L A/c
Nil
1000000
1600000
14900000
Rs.
6600000
2200000
1800000
2400000
1800000
100000
14900000
Q.4) XYZ Ltd. is considering merger with PQR Ltd. XYZ Ltds. shares are currently traded at
Rs.25. It has 200000 shares outstanding and its EAT amount to Rs.400000. PQR Ltd. has
100000 shares outstanding; its current MPS is Rs.12.50 and its EAT are Rs.100000. The merger
will be effected by means of a Stock Swap (exchange). PQR Ltd. has agreed to a plan under
which XYZ Ltd. will offer the current Market Value of PQR Ltds Shares:
(i)
What is the pre-merger EPS and P/E ratios of both the companies?
(ii)
If PQR Ltds P/E Ratio is 8, What is its current MPS? What is the exchange ratio?
What will XYZ Ltds post-merger EPS be?
(iii) What must be the exchange ratio for XYZ Ltds so that the pre and post-merger
EPS to be the same?
(CS (Final), June 2001)
Q.4) Solution :
Given Data:
Particulars
XYZ Ltd. PQR Ltd.
MPS (Rs.)
25
12.50
No. of Equity Shares
200000
100000
Earnings after Tax (Rs.)
400000
100000
(i) a)
Pre-Merger EPS =
Earnings after Tax

No. of Equity Shares
XYZ Ltd.
= 400000
200000
= Rs.2
b)
P/E =
MPS
EPS
XYZ Ltd.
= 25
2
= 12.50 Times
(ii)
PQR Ltd.
= 100000
100000
= Re.1
If PQR Ltds P/E = 8

(a) Current MPS:
P/E = MPS
EPS
8 = MPS
1
MPS
= Rs.8
PQR Ltd.
= 12.50
1
= 12.50 Times
(b) Exchange Ratio:

XYZ
PQR
25
8
= 25
= 3.125
8
Exchange Ratio
=
=
(c) Post-Merger EPS of XYZ Ltd.

XYZ EAT
+
PQR EAT
=
Total EAT
4 lakhs
+
1 lakh
=
5 lakhs
XYZ
PQR
25
8
100000
?
100000 x 8 =
32000 Shares
25
XYZ Ltd.:
Old Shares
+
New Shares
200000
+
32000
XYZ :
3.125 :
=
=
PQR
1
Total Shares
232000 Shares
Total Earnings after Tax

Total No. of Equity Shares
= 500000
232000
= Rs.2.15
New EPS =
(iii) Desired exchange ratio for XYZ Ltd. so that Pre-Merger and Post-Merger EPS is the same.
Total No. of Shares in =
Post-Merger Earnings
Post-Merger Company
Pre-Merger EPS of XYZ Ltd.
=
500000
2
=
250000 Shares
Total No. of Shares in
Post-Merger Company
2,50,000
No of Shares in
- Pre-Merger XYZ Ltd.
- 200000
No of New Shares
= required to be issued
= 50000 Shares
Exchange Ratio:
XYZ
100000
1
= 50000 x 1
100000
Exchange Ratio
PQR
50000
?
=
0.50
0.5 : 1

(a) Business Restructuring.
(b) Exchange Ratio in a merger.
Q.2) Explain Reasons for Business Restructuring?
Q.3) Explain legal procedure of Business Restructuring?
Note:- Complete solution of all practise problems of all chapters will be uploaded on website
nd
www.SCOrEBMS.com on 2 Oct. 10
S COrE
The be st in Exams

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TYBMS SEM V

CHAPTER: 3 RECEIVABLE MANAGEMENT

(FOR MORE DETAILS (THEORY) REFER HIMALAYA

Recommendation: i.e. 2 months

Quantity lifted (No of TV sets)

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

Age Group ( in days ) A Ltd. B Ltd.

Percent of Receivables (Standard)

Comment on collection matrix.

REVIEW QUESTIONS:Q.1 Concept Testing

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

CHAPTER: 4 CASH MANAGEMENT

SECTION I :- CASH BUDGET MEAN ING AND OBJECTIVES

Distinguish between Cash Flow Statement and Cash Budget:

SECTION II :- MOTIVES FOR HOLDING CASH

(a) Stretching Accounts Payable

(FOR MORE DETAILS (THEORY) REFER HIMALAYA

W N 3) Collection from debtors

Cash budget for 3 months ending of 30 June 2010

W N 1) Collection from debtors

50% of credit sale 2m

W N 3) Wages (1/4 month)

Closing balance (i-ii)

EXTRA PRACTISE PROBLEM

Cash Balance as on 1 January 20X1 is 28,000.

REVIEW QUESTIONS:Q.1) Concept Testing.

(FOR MORE DETAILS (P ROBLEMS AND SOLUTIONS) REFER

CHAPTER: 5 COST OF CAPITAL

Cost of Equity Share Capital

Model 1 is suitable for listed & frequently traded (Liquid Shares)

Capital Asset Pricing Model (CAPM)

Cost of preference Share Capital

Note:- N = Number of Years

Cost of Debt Capital : (post tax)

2) Cost of redeemable debt : (post tax)

SECTION III WEIGHTED AVERAGE COST OF CAPITAL

(FOR MORE DETAILS (THEORY) REFER HIMALAYA

Q.8 Solution:ke = k0 + (k0-kd) x debt

= 16% + (16% - 14%) x 300

= 16% + (16% - 12%) x 1.15

= 15% + (15% - 14%) x 1.15

= 16% + (16% - 14%) x 1.8

30% = k0 + (k0 - 10%) x 3

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

ADDITIONAL IMPORTANT NOTES:-

CHAPTER: 6 CAPITAL STRUCTURE

CAPITAL STUCTURE (The means of capital by which a firm is financed)

2. Net operating Income (NOI)

Debt Equity Ratio

(FOR MORE DETAILS (THEORY) REFER HIMALAYA

Ways to raise Debt:

From Banks (negotiated.)

Factors Determining Capital Structure in given Case:

Equity (7.5 Crore)

Promoters (To extent possible)

Debt (7.5 Crore)

. Term Loan from bank with factory assets as security

Private Placements (Balance, friends & relatives)

Earnings for ESH

Recommendation:- On the basis of EPS it is advised to select Alternative C.

No of equity shares Existing

Company earns a return of 12% and the tax on income is 50%.

:. PBIT = Cap. Emp. x ROI