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Financial Management

Assignment - A
Question 1a: Should the titles of controller and treasurer be adopted under
Indian context? Would you like to modify their functions in view of the
company practice in India? Justify your opinion?
Answer to 1a:
Controller & Treasurer are independent & they have their own Perspectives & Drivers as detailed below:
Controller
Responsibilities
include,
Double
entry
accounting, financial reporting, Fraud measure,
detective controls, Financial restatement,
Compliance with statutory requirements like
Rules, Accounting standards, GAAP, IFRS etc.,
Controller works & forecasts the events for a
long term. Main focus income statement
Ex: Cash involved event
Controller looks from compliance angle (how to
record, what GAAP provides etc.,)

Treasurer
Responsible for Liquidity management (very
important function), Risk Management, More
focus on financial statements, follows leading
practices & responsible for the future
performance of company (projects cash flows)
Treasurer works/ forecasts the events regularly
(daily / weekly) focus Balance sheet & future
capital structure, capital expenditure etc.,
Treasurer concentrates more on cash availability
focus i.e. how to bring in the required cash etc,

Therefore, from the above it is clear that, controller & treasurer have different roles to play. However,
majority of the Indian companies works with Financial Controller who himself takes care of the treasury
department / Portfolio.
Therefore, as far as from Indian context, it can be concluded that, controller is also responsible for treasury
jobs & there is no separate treasurer / treasury department exists
Question 1b: firm purchases a machinery for Rs. 8, 00,000 by making a down payment of Rs.1,50,000
and remainder in equal installments of Rs. 1,50,000 for six years. What is the rate of interest to the firm?
Answer to Q1b:
Particulars
Cost of Machinery
Down Payment
made by firm
Financed through
borrowings

Ref

Year 0

(a)

800,000

(b)
c = (ab)

150,000
650,000

d=6*15
0,000

900,000

Total interest paid


over 6 year period

e=dc

250,000

Rate of Interest
= total interest
/ total
borrowings

f=e/c

38.46%

Repayment in equal
instalments every
year
(maximum of six
years)

Year 1

Year 2

Year 3
Rs.

Year 4

Year 5

Year 6

150,000

150,000

150,000

150,000

150,000

150,000

Rate of interet
per annum

g=f/6
yrs

6.41%

6:5:4:3:
2:1

21

Break of interest
cost / principal
repayment:
1) interest cost (can
be apportioned in
the ratio of
no of years
repayment - i.e.
earlier the years
more
the interest cost &
vice versa)

2) Principal
Outstanding
adjustment

Yearwise Interest
rates:
- Principal
Outstanding at year
end
(prinicpal o/s at
year beginning Principal
repayment)

RATE OF
INTEREST
EVERY YEAR

(ratio)

(6+5+4+3+2
+1)

250000

71429
(250,000
*6/21)

59524
(250,000
*5/21)

47619
(250,00
0*4/21)

35714
(250,00
0*3/21)

23810
(250,000*
2/21)

11905
(250,00
0*1/21)

i=d-h

650000

78571

90476

102381

114286

126190

138095

650000

571429

480952

378571

264286

138095

(480952
- i)

(378571
- i)

(650000i)
h/
princip
al o/s
at year
beginni
ng)

11.0%
(h /
650000)

(571429i)

10.4%
(h /
571429)

9.9%

9.4%

(h /
480952)

(h /
378571)

(264286i)

9.0%
(h /
264286)

Question 2a: Explain the mechanism of calculating the present value of


cash flows. What is annuity due? How can you calculate the present and
future values of an annuity due? Illustrate
Answer 2a:
Calculating Present Value of Cash flows:
Money has time value. For ex: Rs.1000 received today is not the same worth after a year (actually it is
less)
Present value of cash flows: It indicates the value of expected worth at current value. (Discounts the
expected cash flows at appropriate discount rate (may be 10%, 20% etc.,)
Discount rate will generally be equal to = Inflation rate + Reqd. rate of return + risk free premium rate
Details required for calculating Present Value of cash flows: Cash flows year wise, discount rate. This
technique is very useful for decision-making.

(138095
- i)

8.6%
(h /
138095)

Annuity due: Uniform/ Constant/ Equal cash flows every year


Present value of annuity
Worth of Lump sum consideration today which
is going to be received tomorrow
Computation:
Annuity * Present value annuity factor (PVAF)

Future value of annuity


Value of fixed investment every year worth
tomorrow. (i.e. corpus it grows)

PVAF is calculated as = 1-[1/(1+r) to the power


n].
Illustration:

FVAF is calculated as = [(1+r) to the power n] - 1

Mr. A would like to receive Rs.1000/- every


year for 10 years from now.

Mr.X would like to grow a corpus by investment


of Rs.10, 000 10 years from now.

It is assumed discount rate 10%, the present


value annuity factor for 10 years 10% is 6.144.

Rate of interest @10%, the future value annuity


factor for 10 years 10% is 1.594

Present value of annuity = 1000 * 6.144 =


Rs.6145/-

Future value of annuity = 10000 * 1.594=


Rs.15937/-

Annuity * Future value annuity factor (FVAF)

Question 2b: "The increase in the risk-premium of all stocks, irrespective of


their beta is the same when risk aversion increases" Comment with
practical examples
Answer 2b:
The security's beta is a function of the correlation of the security's returns with the market index returns
and the variability of the security's returns relative to the variability of the index returns.
In simple, beta measures the sensitivity of the stock with reference to broad based market index.
For instance: a beta of 1.2 for a stock would indicate that this stock is 20% riskier than the index &
similarly beta of 0.9 for a stock indicates 10% less riskier than the index.
Finally, a beta of 1.0 means, stock is as risky as the stock market index.
Therefore, the given statement is false. Expected risk-premium for stock is beta times the market risk
premium. For ex: let us assume beta = 1.2 times, market risk premium = 10%, then expected risk premium
= 10% * 1.2 times = 12%.

Question 3a: How leverage is linked with capital structure? Take example of
a MNC and analyze.
Answer to 3a:
Leverage: It is an advantage gained (it may be anything)
Leverage is linked with Capital Structure, since an organization having a optimum capital structure (where
WACC (weighted average cost of capital) is minimum) is a great leverage/ advantage both to the company
as well for the investors.
Organizations, generally have two types of risks; operating risks impact of fixed costs & variability of
EBIT & Financial risks impact of interest cost/financial charges & variability of EBT.
Example:
XYZ ltd has the following nos:
Contribution Rs.100 lacs, fixed cost Rs.25 lacs, Financial Charges/debt cost Rs.40 lacs.

Particulars

Value (Rs. In lacs)


100
25
75
35
40

Contribution
Fixed cost
EBIT
Interest cost
EBT
XYZ Ltd. has following:
Operating leverage

Financial leverage

Contribution / EBIT = 100 / 75 = 1.33

EBIT / EBT = 75 / 40 = 1.87

It is always preferable to have low operating risk & high financial risk (subject to Return on capital
employed (ROCE) > Interest cost on debt funds)
We can conclude that, XYZ ltd (MNC) is having a optimum capital structure & manageable risk.

Question 3b: The following figures relate to two companies (10)


P LTD.
Sales
Variable costs

500
200
----300
150
----150
50
----100

Contribution Fixed costs


Fixed Cost

Interest
Profit before tax

Q LTD.
(In Rs. Lakhs)
1,000
300
-------700
400
-------400
100
-------200

You are required to:


(i)
Calculate the operating, financial and combined leverages for the two companies; and
Comment on the relative risk position of them

Answer 3b:
P ltd
Particulars
Sales
Variable costs
Contibution
Fixed cost
PBIT / EBIT
Interest
Profit before Tax / EBT

Q ltd
(in Rs. Lacs)
500
200
300
150
150
50
100

1000
300
700
400
300
100
200

a) Opearting leverage:
= Contribution / EBIT

2.0

2.3

b) Financial leverage:
= EBIT / EBT

1.5

1.5

Computation:

c) Combined leverage:
= Contirbution / EBT
Comments:

3.0

3.5

Operating risk is higher


(i.e. fixed costs are high)

Operating risk is higher than 'P' ltd


(i.e. fixed costs are high)

Financial risk looks low

Financial risk looks low

Overall risk is low as compared


to 'Q' ltd.

Overall risk is high as compared


to 'P' ltd.

It is always preferable to have low Operating leverage & high Financial


leverage (provided, Return on capital employed > Interest on debt funds)

Question 4a: Define various concepts of cost of capital. Explain the


procedure of calculating weighted average cost of capital.
Answer 4a:
Concepts of Cost of Capital:
a) All source of finance have its own cost. Out of long source finance, equity mode of sourcing is costlier
than debt financing because of expectation of shareholders.
b) RISK VS. COST: Equity mode of finance will have low risk but costlier as against debt funds which will
have high risk but relatively cheaper & have tax advantage thus reducing the net cost of debt.
Organizations have to effectively trade off between risk, cost & control.
c) Optimum Capital Structure: When the firm / organization has a combination of debt and equity, such
that the wealth of the firm is maximum. At this point, cost of capital is minimum & market price of a
share is maximum.
Procedure of calculating Weighted Average Cost of Capital (WACC):
It is computed by reference to proportion of each component of capital (book value or market value as
specified) as weights.
WACC = Sum [proportion of each component of capital (weights) * individual cost of capital]
Note: Tax rates needs to be adjusted in respect of debt funds.

Question 4b: The following items have been extracted from the liabilities
side of the balance sheet of XYZ Company as on 31st December 2005.
Paid up capital:
4, 00,000 equity shares of Rs each

40,00,000

Loans:
16% non-convertible debentures
12% institutional loans

20,00,000
60,00,000

Other information about the company as relevant is given below:


31st dec
2005

Dividend
Earning
average market price
Per share
per share
per share
7.2
10.50
65
You are required to calculate the weighted average cost of capital, using book values as weights and
earnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate

Answer 4b:
Computation of Weighted Average Cost of Capital (WACC):

Nature of Capital

Value

a) Equity Capital

4,000,000

Weights
(basis of
bookvalues
O/S.)

Cost of capital

33%

Weights * Cost of
Capital

16.15

5.38

(refer W.No.1)
b) 16% non-convertible debentures

2,000,000

17%

14.53
Interest (1-taxrate) =
16% (100%-9.2%)

2.42

c) 12% institutional loans

6,000,000

50%

10.90
Interest (1-taxrate) =
12% (100%-9.2%)

5.45

Total

12,000,000

100%

13.25

Working Note: 1
Cost of equity:

Price earnings approach =

Earnings per
share /
Market price per
share
10.50 / 65 =
16.15%

Question 5a: A company has issued debentures of Rs. 50 Lakhs to be


repaid after 7 years. How much should the company invest in a sinking fund
earning 12% in order to be able to repay debentures? Show the procedure of
loan amortization and capital recovery through an example.
Answer 5a:
Debentures to be redeemed after 7 years

5,000,000

Expected rate of return - on sinking fund investment to be created


Discount rate@12%, 7 yrs
Present value of expected repayment of debentures @12% 7 yrs
therefore, company has to invest Rs.22,61,746 @ 12% earning in Sinking fund to cover
the repayment expected 7 years from now.

12%
0.452
2,261,746

Loan Amortization
A loan amortization schedule is a repayment plan that
is calculated before repayment of a loan begins.

Capital Recovery
The reciprocal of Present value annuity factor
(PVAF) is the capital recovery.

Amortization schedules are used for fixed interest long


term loans such as mortgages, expenses like R& D
expenses, Purchase of Goodwill, Voluntary Retirement
payment expenses, Amalgamation expenses etc.
Procedure with Ex:

Below example will clarify better the meaning:

M/s.XYZ ltd has incurred a Rs.50, 00,000 as lump sum


payment towards voluntary retirement separation
charges during the accounting year 2009-2010.
XYZ ltd have planned to amortize the above expenses
for a period of 10 years commencing from FY.09-10

Procedure with Ex: Mr.X plan to lend Rs.1 lac


today for a period of 5 years @ int.rate of 12%,
how much income Mr.X should receive each year
to recover investment & principal back.
The result is known as capital recovery & which
can be arrived by capital recovery factor.
Calculation:

Therefore, the schedule of amortization for 10 year


period as follows:
Rs. 500,000/- per years for 10 years

Present value = Annuity * PVAF @12%,5years


Capital Recovery
PVAF@12%,5years

Annuity

Therefore, capital recovery = 100,000 * 0.27739


= Rs.27,740 each year for 5 years.

Question 5b: A bank has offered to you an annuity of Rs. 1,800 for 10 years
if you invest Rs. 12,000 today. What is the rate of return you would earn? .
Answer 5b:
Particulars

Rs.

Return expected per annum


Fixed return/annuity for no of years
Total return expected

1800
10
18000

Investment required today

12000

Nett return expected from investment

6000

Percentage of return for 10 years


Percentage of return per annum

50%
5%

Assignment - C

Question 1: The proforma of cost-sheet of HLL provides the following data:


Cost (perunit):

Rs.

Raw materials

52.0

Direct labour

19.5

Overheads

39.0

Total cost (per unit):

110.5

Profit

19.5

Selling price

130.0

The following is the additional information available:


Average raw material in stock: one month; Average materials in process: half month; Credit allowed by
suppliers: one month; Credit allowed to debtors: two months; Time lag in payment of wages: one and half
weeks; Overheads: one month. One-fourth of sales are on cash basis. Cash balance expected to be Rs.
12,000.
You are required to prepare a statement showing the working capital needed o finance a level of activity of
70,000 units of output. You may assume that production is carried on evenly throughout the year and
wages and overheads accrue similarly.

Answer 1:
Particulars

Raw Material
Direct Labour
Prime cost
Overheads
Total cost
Profit
Sales

Cost/unit

Production = 70,000 units


cost (Rs.) for 70000 units

52
19.5

3640000
1365000
5005000
2730000
7735000
1365000
9100000

39
110.5
19.5
130

Statement of Working Capital for HLL - 70,000 units production per year:

Particulars

No of
months

Computation

Rs.

Current Assets: (A)


Raw material stock
Process stock - Work in progress (WIP)
Debtors - customers
Cash balance expected to maintain
Total of CURRENT ASSETS - (A)
Current Liabilities: (B)

1
0.5
2

36,40,000/12*1month
50,05,000/12*0.5 months
91,00,000*3/4 (credit sales)/12*2

303333
208542
1137500
12000
1661375

Creditors - suppliers

1
36,40,000/12*1month
1.5 weeks
or
13,65,000/12*0.34
0.34
month
1
27,30,000/12*1

Wages Outstanding

Overheads outstanding

303333
38675

227500

Total of CURRENT LIABILITIES - (B)

569508

NETT WORKING CAPITAL


REQUIRED

1091867

Question 2a: Through quantitative analysis prove that PI is a better


technique than NPV in Capital Budgeting.
Answer 2a:
PI Profitability Index & NPV Net Present Value both are capital budgeting techniques.
Profitability Index (PI)
PI = Present value of inflows / Present value of
outflows
Ideal = should be > 1

Net Present Value (NPV)


NPV = Present value of inflows Present
value of outflows
Ideal = NPV should be positive, it shows
absolute present value of tomorrows wealth

Quantitative analysis:
Present value of inflows = Rs. 200,000
Present value of outflows = Rs. 100,000

Present value of inflows = Rs. 200,000


Present value of outflows = Rs. 100,000

PI = 2

NPV = Rs.100,000

NPV technique is better than PI technique for capital budgeting decisions. NPV shows wealth at the end in
absolute amount, which will be helpful to make decisions clearly, whereas the same advantage is not
available with PI technique.
However, PI shows return over investment in times, which will be very useful for immediate decision
making.
Generally, over the years, organizations prefer NPV technique for capital budgeting decisions than PI
technique.

Question 2b: A company is considering the following investment projects:


Projects

Cash Flows (Rs.)


Co

C1

C2

C3

- 10,000

+ 10,000

-----

-----

-10,000

+ 7,500

+ 7,500

-----

- 10,000

+ 2,000

+ 4,000

+ 12,000

-10,000

+ 10,000

+ 3,000

+ 3,000

I. according to each of the following methods: (1.) Payback, (2.) ARR, (3.) IRR, (4.) NPV assuming
discount rates of 10 and 30 percent.
II. Assuming the project is independent, which one should be accepted? If the projects are mutually
exclusive, which project is the best?

Answer 2b:
I)

Methods
(1) Payback
@10% discount rate
@30% discount rate
(2) Accounting rate of
return (ARR)
(3) NPV
@10% discount rate
@30% discount rate

Project A

Project B

Project C

Project D

1 + years
1 + years
100%

1.13 years
1.25 years
150%

2.14 years
3 + years
180%

1.7 years
2.8 years
160%

(909)
(2308)

3017
207

4140
(633)

3824
833

0%

32%

26%

38%

(4) IRR

Independent project: Project with higher NPV needs to be selected, which shows wealth in absolute
value at the end of the project
Therefore, Project C needs to be accepted.
II) In case projects are mutually exclusive:
First disparity between projects needs to be resolved. NPV selects Project C whereas IRR selects Project
D, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for both the projects, the
disparity arisen is called as Cash flow disparity.
It can be resolved by using Incremental cash flow technique. After resolving, the right project can be
accepted.
Workings are as follows:
PROJECT A:
The following has been calculated assuming discount rates of 10%
& 30% separately:
1) Payback period: time period to recover initial investment
a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Unrecover
ed
Discount Discounted
discounte
rate *
cash flows
d cash
flows

Years

Cash
flows

@ 10%

(1)

(2)

(10,000)

(3)

1.000

(4) =
(2) * (3)

(10,000)

(5)

(10,000)

(1)

1
10,000
0.909 9,091
(909)
1
* disocunt rate computed using formule = 1 / (1+r) to the power n;
where r = disocunt rate
& n = year

(2)

Unrecove
red
Discou
Discounted
discounte
nt rate
cashflows
d cash
*
flows
@
30%

(3)

(4) = (2)
* (3)

(5)

(10,000)

1.000 (10,000)

(10,000)

10,000

0.769 7,692

(2,308)

Payback period = Base year + [(unrecovered disocunted cash flow of base year /

disocunted cash flows of next year) *12]

Payback period exceed 1 year, since unrecovered cash flows turns


positive only from IInd yr onwards
where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% & 30% discount
rate = 1 + years
=1+
years
2) Accounting rate of return: rate of return on initial investment made:
given as: Average profit after depreciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash inflows
considered as profits after depreciation & taxes
therefore (10,000 (inflow) / 10,000
=
(investment)) * 100
accounting rate of return = 100%; effectively 0% return
(whatever invested taken back)

4) NPV (net present value):


a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounte
d
cashflows

Years

Cash
flows

@ 10%

(1)

(2)

(3)

Discoun
t rate *

Discounte
d
cashflows

@ 30%
(4) =
(2) * (3)

(1)

(2)

(3)

(4) =
(2) * (3)

(10,000
)

1.000

(10,000)

(10,000)

1.000

(10,000)

10,000

0.909

9,091

10,000

0.769

7,692

(909)

NPV

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of


return at which NPV = 0
In project A , IRR is '0'% at which NPV =0
(i.e. there is no return from
the project)

(2,308)

PROJECT B:
The following has been calculated assuming discount rates of 10% &
30% separately:
1) Payback period: time period to recover initial investment
a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounte
d
cashflows

Unrecover
ed
discounte
d cash
flows

Years

Cash
flows

(2)

(3)

Unrecove
red
Discounted
discounte
cashflows
d cash
flows

@
30%

@ 10%

(1)

Discou
nt rate
*

(4) =
(2) * (3)

(5)

(1)

(2)

(3)

(4) =
(2) * (3)

(5)

(10,000)

1.000

(10,000)

(10,000)

(10,000)

1.000

(10,000)

(10,000)

7,500

0.909

6,818

(3,182)

7,500

0.769

5,769

(4,231)

7,500

0.826

6,198

3,017

7,500

0.592

4,438

207

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]
where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 1 +
[(3182/3017)*12]
=1.13
years

Payback period @ 30% discount rate=


1 + [(4231/207)*12]
=1.25
years

2) Accounting rate of return: rate of return on initial investment made:


given as: Average profit after depriciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash inflows
considered as profits after depreciation & taxes
therefor
e=

(15,000 (inflow) / 10,000


(investment)) * 100

accounting rate of return = 150%;


effectively 50% return

4) NPV (net present value):


a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounte
d
cashflows

Years

Cash
flows

@ 10%

(1)

(2)

(3)

Discoun
t rate *

Discounted
cashflows

@ 30%
(4) =
(2) * (3)

(1)

(2)

(3)

(4) = (2)
* (3)

(10,000)

1.000

(10,000)

(10,0
00)

1.000

(10,000)

7,500

0.909

6,818

7,500

0.769

5,769

7,500

0.826

6,198

7,500

0.592

4,438

3,017

NPV

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of


return at which NPV = 0
For project B , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up
Discount rate comes down

NPV falls
NPV goes
up

Let us assume L1 = 30% (why, because as could be seen at 30%


@ discount rate NPV is +ve
by applying the relationship,
increased disocunt rate)
Let us calculate L2 = 32%
Discounted @32%
(assumed rate)
Years

Cash
flows

Discoun
t rate *

Discounte
d

207

cashflows
@ 32%

(1)

(2)

(3)

(4) =
(2) * (3)

(10,000)

1.000

(10,000)

7,500

0.758

5,682

7,500

0.574

4,304

(14)

NPV

therefore, IRR for Project B = 30% + [207 /(


207+14)]*32% - 30%

IRR

30% +
1.873

31.87%

PROJECT C:
The following has been calculated assuming discount rates of 10%
& 30% separately:
1) Payback period: time period to recover initial investment
a) Discounted
@10%

Years

Cash
flows

b) Discounted
@30%

Discoun
t rate *

Discounte
d
cashflows

Unrecover
ed
discounte
d cash
flows

Years

Cash
flows

@ 10%

(1)

(2)

(3)

Discount
rate *

Disco
unted
cashf
lows

Unrecove
red
discounte
d cash
flows

@ 30%

(4) =
(2) * (3)

(5)

(1)

(2)

(3)

(4) =
(2) *
(3)

(5)

(10,000)

1.000

(10,000)

(10,000)

(10,000)

1.000

(10,0
00)

(10,000)

2,000

0.909

1,818

(8,182)

2,000

0.769

1,538

(8,462)

4,000

0.826

3,306

(4,876)

4,000

0.592

2,367

(6,095)

12,000

0.751

9,016

4,140

12,000

0.455

5,462

(633)

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted

cash flows of next year) *12]


where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 2 +
[(4876/4140)*12]
=2.14
years

Payback period @ 30% discount rate=


exceeds 3 years
=3+
years

2) Accounting rate of return: rate of return on initial investment made:


given as: Average profit after depriciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash inflows considered
as profits after depreciation & taxes
therefor
e=

(18,000 (inflow) / 10,000


(investment)) * 100

accounting rate of return = 180%;


effectively 80% return

4) NPV (net present value):

a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounted
cash flows

Years

Cash
flows

(2)

(3)

Discoun
ted
cashflo
ws

@
30%

@ 10%

(1)

Disco
unt
rate *

(4) =
(2) * (3)

(1)

(2)

(3)

(4) =
(2) * (3)

(10,000)

1.000

(10,000)

(10,000)

1.000

(10,000)

2,000

0.909

1,818

2,000

0.769

1,538

4,000

0.826

3,306

4,000

0.592

2,367

12,000

0.751

9,016

12,000

0.455

5,462

4,140

NPV

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year

(633)

3) IRR (Internal rate of return): which is the rate of


return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up
Discount rate comes down

NPV falls
NPV goes
up

Let us assume L1 = 30% (why, because as could be seen at 30% @


discount rate NPV is -ve
by applying the relationship, reduced
disocunt rate)
Let us calculate L2 = 26%
Discounted @26%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 26%

(1)

(2)

(3)

(4) =
(2) * (3)

(10,000)

1.000

(10,000)

2,000

0.794

1,587

4,000

0.630

2,520

12,000

0.500

5,999

NPV

106

therefore, IRR for Project B = 30% + [-633 /( -633106)]*26% - 30%

IRR

30% 3.43

26.57

PROJECT D:
The following has been calculated assuming discount rates of 10% &
30% separately:

1) Payback period: time period to recover initial investment


a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounte
d
cashflows

Unrecover
ed
discounte
d cash
flows

Years

Cash
flows

@ 10%

(1)

(2)

(3)

Discoun
t rate *

Discou
nted
cashflo
ws

Unrecove
red
discounte
d cash
flows

@ 30%

(4) =
(2) * (3)

(5)

(1)

(2)

(3)

(4)
= (2) *
(3)

(5)

(10,000)

1.000

(10,000)

(10,000)

(10,000)

1.000

(10,000) (10,000)

10,000

0.909

9,091

(909)

10,000

0.769

7,692

(2,308)

3,000

0.826

2,479

1,570

3,000

0.592

1,775

(533)

3,000

0.751

2,254

3,824

3,000

0.455

1,365

833

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]
where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 1 +
[(909/1570)*12]
=1.7
years

Payback period @ 30% discount rate=


2 + [(533/833)*12]
= 2.8
years

2) Accounting rate of return: rate of return on initial investment made:


given as: Average profit after depriciation & Tax / Initial
investment
Since no information on profits, depreciation & taxes, it is treated cash inflows considered as
profits after depreciation & taxes
therefor
e=

(16,000 (inflow) / 10,000


(investment)) * 100

accounting rate of return = 160%;


effectively 60% return

4) NPV (net present value):


a) Discounted @10%

Years

Cash
flows

b) Discounted @30%

Discoun
t rate *

Discounte
d cash
flows

Years

Cash
flows

@ 10%

(1)

(2)

(3)

(4) =
(2) * (3)

(1)

Disco
unt
rate *
@
30%

(2)

(3)

Discounted
cashflows

(4) = (2)
* (3)

(10,000)

1.000

(10,000)

(10,000)

1.000

(10,000)

10,000

0.909

9,091

10,000

0.769

7,692

3,000

0.826

2,479

3,000

0.592

1,775

3,000

0.751

2,254

3,000

0.455

1,365

3,824

NPV

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of


return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up
Discount rate comes down

NPV falls
NPV goes
up

Let us assume L1 = 30% (why, because as could be seen at 30% @


discount rate NPV is+ve
by applying the relationship,
increased disocunt rate)
Let us calculate L2 = 38%

833

Discounted @38%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 38%

(1)

(2)

(4) =
(2) * (3)

(3)

(10,000
)

1.000

(10,000)

10,000

0.725

7,246

3,000

0.525

1,575

3,000

0.381

1,142

NPV

(37)

therefore, IRR for Project B = 30% + [833 /(


833+37)]*38% - 30%

IRR

30% +
7.66

37.66%

1) NPV (net present value): for increments cash flows


a) Discounted @10%

Years

Increme
ntal
Cash
flows
(project
C
project
D)

b) Discounted @30%

Discou
nt rate
*

Discounted
cashflows

Years

Cash
flows

@
10%

(1)

(2)

Discou
nt rate
*

Discounte
d
cashflows

@
30%
(4) =
(2) * (3)

(3)

(1)

(2)

(4) =
(2) * (3)

(3)

1.000

1.000

(8,000)

0.909

(7,273)

(8,000)

0.769

(6,154)

1,000

0.826

826

1,000

0.592

592

9,000

0.751

6,762

9,000

0.455

4,096

NPV

316

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;


where r = disocunt rate
& n = year

(1,466)

3) IRR (Internal rate of return): which is the rate of


return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at
given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate
goes up
Discount rate comes down

NPV falls
NPV goes
up

Let us assume L1 = 10% (why, because as could be seen at 30% @


discount rate NPV is+ve
by applying the relationship,
increased disocunt rate)
Let us calculate L2 = 13%
Discounted @13%
(assumed rate)

Years

Cash
flows

Discoun
t rate *

Discounte
d
cashflows

@ 13%

(1)

(2)

(4) =
(2) * (3)

(3)

1.000

(8,000)

0.885

(7,080)

1,000

0.783

783

9,000

0.693

6,237

NPV

(59)

therefore, IRR for Project B = 10% + [316 /(


316+59)]*13% - 10%

IRR

10% +
2.5

Target return =
10%
IRR for incremental cash
flows = 12.5%

12.50%

since IRR for incremental cash flows > Target return,


select / accept Project C

Question 3a: "Firm should follow a policy of very high dividend pay-out
Taking example of two organization comment on this statement"
Answer 3a:
The statement not necessarily be true. Let us take 2 companies;
High dividend pay out company 100% payout
a) Less retained earnings
b) Slower / lower growth rate
c) Lower market price
d) Cost of equity (Ke) > IRR (r = rate of return
earned by company on its investment.
e) Indicates that company is declining.

Low dividend payout company 20% payout


a) More retained earnings
b) Accelerated/higher growth rate
c) Higher market price
d) Cost of equity (Ke) < IRR (r = rate of return
earned by company on its investment.
e) Indicates that company is growing.

It must be noted that, dividend is a trade off between retaining money for capital expenditure and issuing
new shares.

Question 3b: An investor gains nothing from bonus share "Critically analyse
the statement through some real life situation of recent past.
Answer 3b:
The statement is false. An investor gains bonus shares at zero cost, However, the market price of the
stock will come down & over the long period, the investor definitely maximizes his wealth due to bonus
shares.
From company angle, bonus issue is only an accounting entry & it doesnt change the wealth/value of the
firm.
Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained Bonus shares
at zero cost & the market have come down to the extent of bonus issue & immediately went up & investors
have cashed the bonus shares thus maximized their wealth. However, currently it is trading down due to
varied reasons.

CASE STUDY

Ques 1: You are required to make these calculations and in the light thereof,
advise the finance manager about the suitability, or otherwise, of machine A
or machine B.
Solution:
Advise to finance manager of Brown metals ltd, to select the appropriate machine:
Particulars
1) NPV
2) Profitability index
3) Pay Back period
4) Discounted pay back period

Machine A (Rs. In lacs)


12
1.48
2 years
3.18 years

Machine B (Rs. In lacs)


14
1.35
3 years
3.21 years

It is advised to go in for Machine B with enhanced capacity, which will add more value to the firm.
NPV is higher in respect of Machine B as compared to Machine A & therefore machine with higher
NPV needs to be invested.
Workings are as follows:
(a) to buy machine A which is similar to the existing machine:

Years

Cash
flows
(Rs. In
lacs)

Unrecovered
cash flows

Discount rate
*

Discounted
cashflows

Unrecovered
discounted
cash flows

@10%

(1)

(2)

0
1

(25)

(3)

(4) = (2) *
(3)

(5)

(25)
(25)

1.000
0.909

(25)
-

(25)
(25)

(20)

0.826

(21)

20

0.751

15

(6)

14

14

0.683

10

5
NPV

14

28

0.621

9
12

12

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year
1) Net Present value = Present value of inflows - Present value of outflows = 12 (as computed above)
2) Profitability Index = Present value of inflows / present value of outflows which should be >1
1.48
37 / 25
3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 2 + [(20/0)*12]

= 2 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash
flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(6/4)*12]
=3.18 years

(b) to go in for machine B which is more expensive & has much greater capacity:

Years

Cash
flows
(Rs. In
lacs)

Unrecovered
cash flows

Discount rate
*

Discounted
cashflows

Unrecovered
discounted
cash flows

@10%

(1)

(2)

(3)

(4) = (2) *
(3)

(5)

(40)

(40)

1.000

(40)

(40)

10

(30)

0.909

(31)

14

(16)

0.826

12

(19)

16

0.751

12

(7)

17

17

0.683

12

5
NPV

15

32

0.621

9
14

14

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year
1) Net Present value = Present value of inflows - Present value of outflows = 14 (as computed above)
2) Profitability Index = Present value of inflows / present value of outflows which should be
>1
1.35
54 / 40
3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(16/0)*12]

= 3 years

4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted cash
flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(7/4)*12]
=3.21 years

Assignment - C
1. The main function of a finance manager is
(a) capital budgeting
(b) capital structuring
(c) management of working capital
(d) (a),(b)and(c)
Answer (d)
2. Earning per share
(a) refers to earning of equity and preference shareholders.
(b) refers to market value per share of the company.
(c) reflects the value of the firm.
(d) refers to earnings of equity shareholders after all other obligations of the company have been met.
Answer (d)
3. If the cut off rate of a project is greater than IRR, we may
(a) accept the proposal.
(b) reject the proposal.
(c) be neutral about it.
(d) wait for the IRR to increase and match the cut off rate.
Answer (b)
4. Cost of equity share capital is
(a) equal to last dividend paid to equity shareholders.
(b) equal to rate of discount at which expected dividends are discounted to determine their PV.
(c) less than the cost of debt capital.
(d) equal to dividend expectations of equity shareholders for coming year.
Answer (b)
5. Degree of the total leverage (DTL) can be calculated by the following formula
[Given degree of operating leverage (DOL) and degree of financial leverage (DFL)]
(a) DOL + DFL
(b) DOL /DFL
(c) DFL-DOL
(d) DOL x DFL
Answer (d)
6. Risk- Return trade off implies
(a) increasing the profits of the firm through increased production
(b) not taking any loans which increase the risk of the firm
(c) taking decisions in a way which optimizes the balance between risk and return
(d) not granting credit to risky customers
Answer (c)
7. The goal of a firm should be
(a) maximization of profit
(b) maximization of earning per share
(c) maximization of value of the firm
(d) maximization of return on equity
Answer (c)

8. Current Assets minus current liabilities is equal to


(a) Gross working capital
(b) Capital employed
(c) Net worth
(d) Net working capital.
Answer (d)
9.
(a)
(b)
(c)

The indifference level of EBIT is one at which


EPS increases
EPS remains the same
EPS decreases

(d) EBIT=EPS.
Answer (d)
10. Money has time value since
(a) The value of money gets compounded as time goes by
(b) The value of money gets discounted as time goes by
(c) Money in hand today is more certain than money in future
(d) (b) and (c)
Answer (b)
11. Net working capital is
(a) excess of gross current assets over current liabilities
(b) same as net worth
(c) same as capital employed
(d) same as total assets employed
Answer (a)
12. The internal rate of return of a project is the discount rate at which NPV is
(a) positive
(b) negative
(c) zero
(d) negative minus positive
Answer (c)
13. Compounding technique is
(a) same as discounting technique
(b) slightly different from discounting technique
(c) exactly opposite of discounting technique
(d) one where interest is compounded more than once in a year.
Answer (c)
14. For determining the value of a share on the basis of P/E ratio, information is required
regarding:
(a) earning per share
(b) normal rate of return
(c) capital employed in the business
(d) contingent liabilities
Answer (a)
15. Tandon committee suggested inventory and receivable norms for
(a) 15 major industries
(b) 20 minor industries
(c) 25 major and minor industries
(d) 30 major and minor industries
Answer (c)
16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000 share of
Rs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax is Rs. 20,000. The
degree of financial leverage is

(a) 1.00
(b) 1.25
(c) 2.50
(d) 2.00
Answer (b)
17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70, Total fixed
cost- Rs. 1,00,000 Interest Charges Rs. 3,668, Output-1,00,000 units. The degree of operating leverage is

(a) 4.00
(b) 4.33
(c) 4.75
(d) 5.33
Answer (b)
18. Market price of equity share of a company is Rs. 25 and the dividend expected a year hence is Rs. 10.

The expected rate of dividend growth is 5%. The cost of equal capital to company will be
(a) 40%
(b) 45%
(c) 35%
(d) 50%
Answer (b)
19. The dilemma of "liquidity Vs profitability" arise in case of
(a) Potentially sick unit
(b) Any business organization
(c) Only public sector unites
(d) Purely trading companies
Answer (b)
20. The present value of Rs. 15000 receivable in 7 years at a discount rate of 15% is

(a) 5640
(b) 5500
(c) 5900
(d) 5940
Answer (a)
21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the required
rate of return is 10% the value of bond is
(a) 1000
(b) 1123

(c) 1140
(d) 1150
Answer (a)
22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at return rate
of 15% and dividend pay out ratio of 40% is
(a) 100
(b) 120
(c) 130
(d) 150
Answer (a)
23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of not availing
the cash discount is
(a) 22.58%
(b) 27.45%
(c) 37.75%
(d) 38.50%
Answer (a)
24. The costliest of long term sources of finance is
(a) Preference share capital
(b) Retained earnings
(c) Equity share capital
(d) Debentures
Answer (c)
25. Which of the following approaches advocates that the cost of equity capital & debit capital
remains the degree of leverages varies
(a) Net income approach
(b) Net operating income approach
(c) Traditional approach
(d) Modigliani-Miller approach
Answer (b) & (d)
26.
(a)
(b)
(c)

Which of the following is not a feature of an optimal capital structure.


Profitability
Safety
Flexibility

(d) Control
Answer (b)
27. While calculating weighted average cost of capital
(a) Retained earnings are excluded
(b) Bank borrowings for working capital are included
(c) Cost of issues are included
(d) Weights are based on market value or on book value
Answer (a)
28. Which of the following factors influence the capital structure of a business entity?
(a) Bargaining power with suppliers
(b) Demand for product of company
(c) Expected income
(d) Technology adopted
Answer (c)
29. According to the Walters model, a firm should have 100% dividend pay-out ratio when.
(a) r = ke
(b) r < ke
(c) r > ke
(d) g > ke
Answer (a)
30. Operating cycle can be delayed by
(a) Increase in WIP period
(b) Decrease in raw material storage period
(c) Decrease in credit payment period
(d) Both a & c above
Answer (d)
31. If net working capital is negative, it signifies that
(a) The liquidity position is not comfortable
(b) The current ratio is less then 1
(c) Long term uses are met out of short- term sources
(d) All of a, b and c above
Answer (d)
32. Which of the following models on dividend policy stresses on investors preference for the
current dividend
(a) Traditional model
(b) Walters model
(c) Gordon model
(d) MM model
Answer (d)
33. Which of the following is a technique for monitoring the status of receivables
(a) ageing schedule
(b) outstanding creditors
(c) selection matrix
(d) credit evaluation
Answer (a)
34. Average collection period is equal to
(a) 360/ Receivables Turnover Ratio
(b) Average Creditors / Sales per day
(c) Sales / Debtors
(d) Purchases / Debtors
Answer (a)
35.
(a)
(b)
(c)
(d)

In IRR, the cash flows are assumed to be reinvested in the project at


Internal rate of return
cost of capital
Marginal cost of capital
risk free rate

Answer (d)
36. In a capital budgeting decision, incremental cash flow mean
(a) cash flows which are increasing.
(b) cash flows occurring over a period of time
(c) cash flows directly related to the project
(d) difference between cash inflows and outflows for each and every expenditure.
Answer (d)
37. The simple EOQ model will not hold good under which of the following conditions
(a) Stochastic demand
(b) constant unit price
(c) Zero lead time
(d) Fixed ordering costs
Answer (a)
38. The opportunity cost of capital refers to the
(a) net present value of the investment.
(b) return that is foregone by investing in a project.
(c) required investment in a project.
(d) future value of the investments cash flows.
Answer (b)
39. Which of the following factors does not influence the composition of Working Capital
requirements
(a) Nature of the business
(b) seasonality of operations
(c) availability of raw materials
(d) amount of fixed assets
Answer (d)
40. The capital structure ratio measure the
(a) Financial Risk
(b) Business Risk
(c) Market Risk
(d) operating risks
Answer (a)