Financial management

Unit-ii
Capital structure decisions

Prepared
By
M.Vasudevarao
Asst. Professor,
DMS, BITS-VIZAG
 Capital Structure decisions

Capital Structure: is a combination of debt and equity capital.

Capital Structure: is the composition of a firm’s financing consists of

equity, preference, and debt.

***** CAPITAL STRUCTURE THEORIES (or)
APPROACHES:
I. Net Income (NI) Approach

II. Net Operating Income (NOI) Approach

III. Modigliani and Miller (MM) Approach

IV. Traditional Approach (TA)

I. Net Income (NI) Approach:

Net income approach suggested by the Durand David.

According to this approach, the capital structure decision is relevant to

the valuation of the firm.

Formulas:

Value of firm: V = S+B

Where,
V = Value of firm
S = Market value of equity
B = Market value of debt
Market value of equity:
NI
S=
ke
Where,
S = Market value of equity
NI = Net Income (or) Earnings available to equity shareholder
Ke = Cost of equity/equity capitalization rate
II. Net Operating Income (NOI) Approach:

Another theory of capital structure also suggested by Durand David.

According to this approach, Capital Structure decision is irrelevant to

the valuation of the firm.

Formulas:
Value of the firm:
EBIT
V=
k
Where,
EBIT= Earnings Before Interest and Taxes
K = Cost of capital
Market Value of equity:
S=V–B
Cost of equity (or) equity capitalization rate:
EBIT – I
Ke =
V -B
Where, I = Interest, V= Value of firm, B= Value of debt
III. Modigliani and Miller Approach(MM):

Modigliani and Miller approach states that the capital structure

decision of a firm does not affect the market value of a firm.

III. Modigliani and Miller Approach(MM):
Modigliani and Miller approach states that the capital structure
decision of a firm does not affect the market value of a firm.
Value of firm:
EBIT
V = ------- (1 – t)
k
t= Tax rate
IV. Traditional Approach:

It is the mix of Net Income approach and Net Operating Income

approach.

According to the traditional approach, mix of debt and equity capital

can increase the value of the firm by reducing overall cost of capital up

to certain level of debt.

Problem-1 (NI approach)

Visakha Limited is expecting an annual EBIT of Rs. 1,00,00,000.

The company has Rs.4,00,00,000 in 10% debentures.

The cost of equity capital (or) capitalization rate is 12.5%.

You are required to calculate the total value of the firm and also state
the overall cost of capital, use NI approach.
Solution:
Calculation of Value of firm:
Particulars Amounts (Rs.)
EBIT 1,00,00,000
(-) Interest on debentures 40,00,000
(10% x 4,00,00,000)
EBT 60,00,000
(-) Tax 0
EAT 60,00,000
(-) Preference dividend 0
Net Income or Earnings available to equity shareholders 60,00,000
:. Value of the firm:
V=S+B

V= Value of the firm

S= Market Value of equity
B= Market value of debt
Market Value of equity:
S= Net Income / ke
= 60,00,000 / 12.5% or 60,00,000/0.125
= 4,80,00,000

B= Debenture value = 4,00,00,000

:. Value of the firm:
V=S+B
= 4,80,00,000 + 4,00,00,000
= Rs. 8,80,00,000
Calculation of overall cost of capital (k):
𝐸𝐵𝐼𝑇
k= 𝑥 100
𝑉
EBIT = Rs. 1,00,00,000 (given)
V= Value of the firm = Rs. 8,80,00,000 (calculated)
 1,00,00,000
:. k= 𝑥 100
8,80,00,000
= 11.36%
Problem-2 (NOI approach)

XYZ expects a net operating income(EBIT) of Rs. 2,00,000. It has

8,00,000, 6% debentures. The overall capitalization rate is 10%.

Calculate the value of the firm and the equity capitalization rate (Cost

of Equity) according to the net operating income approach.

Solution :
Net operating income or (EBIT) = Rs. 2,00,000
Overall cost of capital (k)= 10%
Market value of the firm (V) =EBIT / k
= 2,00,000 / 10% = 20,00,000
(-) Market value of debentures (B)(given) = 8,00,000
Market Value of equity (s= V-B) = 12,00,000
Equity capitalization rate (or) cost of equity (Ke)
EBIT- I
= --------- x 100
V–B

I= Interest on debentures
= 6% on 8,00,000 = Rs. 48,000
 2,00,000- 48,000
= x 100
20,00,000 – 8,00,000

= 12.67%
s
1,52,000
= x 100
12,00,000

= 12.66 %
 Financial management
Unit-ii
Capital structure decisions

Problems and solutions

(mm- approach, traditional approach)
Prepared by
Mr. M.VASUDEVA RAO
Asst. Professor, DMS, BITS-VIZAG
Problem-3 (MM-approach)
Two firms A and B are identically same in all aspects except in their
capital structure.
Firm A has 10% debentures of Rs. 50,00,000.
Firm B has no debentures.
EBIT is same for both firms is of Rs.10,00,000
The equity capitalization rate for :
Firm-A is 16% and Firm-B is 12.5%
You are required to calculate the value of the firm for both firms and
also calculate the overall cost of capital.
Solution:
Calculation of Value of the firm under MM approach:
Value of the firm (V):

V= S + B
Where,
S= Market value of equity
B= Market value of debt
Income statement for firm A and B:
Particulars FIRM-A (Rs.) FIRM-B (Rs.)
Earnings Before Interest & Taxes (EBIT) 10,00,000 10,00,000
(-) Interest on debentures 5,00,000 0
(Note: only firm-A has debentures)
Firm-A: Interest= 10% on 50,00,000= 5,00,000
Firm-B: Interest=0
Earnings Before Taxes (EBT) 5,00,000 10,00,000
(-) Taxes 0 0
Earnings After Taxes (EAT) 5,00,000 10,00,000
(-) Preference dividend 0 0
Net Income 5,00,000 10,00,000
ke = Equity capitalization rate (given)
Firm-A =16% or 0.16
Firm-B= 12.5% or 0.125
Particulars FIRM-A (Rs.) FIRM-B (Rs.)
Market value of equity : 𝑆 = 5,00,000= 𝑆 = 10,00,000=
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 0.16 0.125
𝑆= 31,25,000 80,00,000
𝑘𝑒

(+) Market value of debt (B) (given) 50,00,000 0

:. Value of the firm (V)= (S+B) 81,25,000 80,00,000

Calculation of overall cost of capital:
Particulars FIRM-A FIRM-B
EBIT (Rs.) 10,00,000 10,00,000
V (Rs.) 81,25,000 80,00,000
𝐸𝐵𝐼𝑇 10,00,000 10,00,000
k= x 100 k= 81,25,000 𝑥 100 = k= 𝑥100 =
𝑉 80,00,000

12.30%
12.5%
Problem-4 (MM-approach)

There are two firms ‘X’ and ‘Y’ which are exactly identical except that X does not
use any debt in its financing, while Y has Rs. 2,50,000 , 6% Debentures in its

financing. Both the firms have Earnings Before Interest and Tax of Rs. 75,000 and

the equity capitalization rate is 10%.

Assuming the corporation tax is 50%.

calculate the value of the firm and also overall cost of capital.
Income statement for firm X and Y:
Particulars FIRM-X (Rs.) FIRM-Y (Rs.)
Earnings Before Interest & Taxes (EBIT) 75,000 75,000
(-) Interest on debentures 0 15,000
(Note: only firm-Y has debentures)
Firm-A: Interest= 0
Firm-B: Interest=6% on 2,50,000=15,000
Earnings Before Taxes (EBT) 75,000 60,000
(-) Taxes (@50% on EBT) 37,500 30,000
Earnings After Taxes (EAT) 37,500 30,000
(-) Preference dividend 0 0
Net Income 37,500 30,000
 ke = Equity capitalization rate (given) is 10% for both
Firm-X =10% or 0.10
Firm-Y= 10% or 0.10
Particulars FIRM-X (Rs.) FIRM-Y (Rs.)
Market value of equity : 𝑆 = 37500 = 3,75,000 𝑆= 30000
= 3,00,000
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 0.10 0.10
𝑆=
𝑘𝑒

(+) Market value of debt (B) (given) 0

2,50,000

:. Value of the firm (V)= (S+B) 3,75,000 5,50,000

Calculation of overall cost of capital:
Particulars FIRM-X FIRM-Y
EBIT (Rs.) 75,000 75,000
V (Rs.) 3,75,000 5,50,000
k= 𝐸𝐵𝐼𝑇 x 100 k= 75,000 𝑥 100 = k= 75,000
𝑥100 =
𝑉 3,75,000 5,50,000

20%
13.63%
Problem-5 (Traditional Approach):

In considering the most desirable capital structure for a company.

The following estimates of the cost of debt and equity capital (after tax)

has been made at various levels of debt-equity mix.

% of Debt in total capital % of equity in total capital Cost of debt (%) Cost of equity (%)
0 100 5 12
10 90 5 12
20 80 5 12.5
30 70 5.5 13
40 60 6 14
50 50 6.5 16
60 40 7 20
You are required to determine the composite cost of capital and also

determine the optimum debt-equity mix of the company.

Use Traditional approach.

Solution:
Determination of composite cost of capital (or)
overall cost of capital:
% of Cost of % of Cost of Composite or overall cost of capital (%)
Debt debt Equity equity 1 𝑋 2 + 3 𝑋 (4)
(1) (2) (3) (4) (5)=
100
0 5 100 12 (𝟎)𝑿 𝟓 + 𝟏𝟎𝟎 𝑿 (𝟏𝟐)
= 12%
𝟏𝟎𝟎

10 5 90 12 10 𝑋 5 + 90 𝑋 (12)
=11.3%
100
20 5 80 12.5 20 𝑋 5 + 80 𝑋 (12.5)
=11%
100
𝟑𝟎 𝑿 𝟓.𝟓 + 𝟕𝟎 𝑿 (𝟏𝟑)
30 5.5 70 13 = 10.75%
𝟏𝟎𝟎
40 6 60 14 40 𝑋 6 + 60 𝑋 (14)
= 10.80%
100
50 𝑋 6.5 + 50 𝑋 (16)
50 6.5 50 16 = 11.25%
100
60 7 40 20 60 𝑋 7 + 40 𝑋 (20)
= 12.20%
100
Determination of optimum cost of capital:
The least composite cost of capital should be consider as ‘optimum’.

:.The optimum cost of capital is 10.75% at

30% debt and 70% equity combination.
p

Prepared by:
Mr. M.VASUDEVARAO
ASST.PROFESSOR, DMS,BITS-VIZAG
 Cost of capital

Cost of capital:

Refers to the minimum required rate of return on

investment that the business organization expects.

*****MEASUREMENTS (OR) COMPONENTS
(OR) COMPUTATION OF COST OF CAPITAL:
COMPONENTS OR
MEASUREMENT OF
COST OF CAPITAL:

Overall cost of capital

Computation of or Weighted Average
specific cost Cost of Capital
(WACC)
I)Computation of Specific costs: consists
a. Cost of equity share capital (ke)
b. Cost of debt capital(kd)
c. Cost of preference share capital (kp)
d. Cost of retained earnings (kr)
II) Weighted Average Cost of Capital or combined cost of capital
a. Cost of equity share capital:

The approaches to measure the cost of equity capital:

i. Dividend Price approach (D/P)

ii. Dividend Price plus growth approach (D/P +g)

iii. Earning Price approach (E/P)

iv. Realized yield approach

b. Cost of preference share capital

I. Cost of irredeemable preference shares

II. Cost of redeemable preference shares

c. Cost of debt:

I. Cost of irredeemable debt (or) perpetual debt

II. Cost of redeemable debt

d. Cost of retained earnings (kr):
kr= k (1-T)(1-B)
Where
kr= cost of retained earnings
k= cost of capital
T= tax rate
B= Brokerage cost
II. Weighted Average Cost of Capital (WACC):
It is also known as ‘overall cost of capital’ or ‘composite cost of capital’.
It is calculated on the basis of Book Value weights and Market Value
weights.
 Financial Management

Cost of capital
Problems and solutions

Prepared by
Mr.M.VASUDEVARAO
Asst. Profrfessor, DMS, BITS-VIZAG
Problem:1 (ke : Dividend Price approach)

ABC company offers for public subscription equity shares of Rs.10 each

at a premium of 10%. The company pays 5% of the issue price as under

writing commission. The rate of dividend expected by the equity

shareholders is 20%.

You are required to calculate cost of equity (ke).

Solution:
ke = D/ NP
Where,
ke = cost of equity
D= Dividend Per equity share= 20% X Rs.10 = Rs.2
NP = Net proceeds or sale price of equity share
= Share price + premium - commission
ke = D/ NP
Where,
ke = cost of equity
D= Dividend Per equity share= 20% X Rs.10 = Rs.2
NP = Net proceeds or sale price of equity share
= Share price + premium - commission
= 10 + 10% premium = 11 – (5% commission on Rs.10)
= 11 – 0.50 = Rs.10.50
:. Ke = 2 / 10.50 = 0.1904 or 19.04%
Problem:2

Continue the previous problem, will your cost of capital be different if it

is to be calculated on the present market value of the equity shares,

which is Rs.15.
Solution:
ke = D/ MP
Where,
ke = cost of equity= 20%
D= Dividend Per equity share= 20% X Rs.10 = Rs.2
MP= Market Price of the equity share = Rs.15

:. Ke = 2/15 = 0.133 or 13%

ke: Dividend Price plus growth approach
(D/P + g):
Problem-3:

The current market price of the shares of A Ltd. is Rs. 90. The current

dividend per share is Rs. 4.50 and is expected to grow at a rate of 7%.

You are required to calculate the cost of equity share capital.

Solution:
D
Ke = -------- + g
MP
D= 4.5, MP= 90, g= 7% or 0.07
4.5
:. Ke = --------- + 0.07 = 0.12 or 12%
90
ke: Earning Price approach (E/P):
Problem-4:
A firm is considering an expenditure of Rs. 75 lakhs for expanding its
operations.
The relevant information is as follows :
Number of existing equity shares are 10 lakhs
Market value of existing share is Rs.100
Net earnings are Rs.100 lakhs
a) Compute the cost of existing equity share capital and
b)new equity capital, assuming that new shares will be issued at a price of
Rs. 92 per share and the costs of new issue will be Rs. 2 per share.
Solution:

Cost of equity: ke = E / NP or ke=E/MP

Where, E = Earning per share (EPS),

NP= Net proceeds or sale price

MP= Market Price

a)E = Earnings / No. of equity shares
= Rs. 100 lakhs / 10 lakhs shares = Rs.10
NP or MP = Rs.100
:. Ke = 10 / 100 = 0.10 or 10
b) E= Rs.10
NP= 92 – 2 = 90

:. Ke = 10 / 90 = 0.1111 or 11.11%
kp: Irredeemable preference shares

Problem-5: A company raised preference share capital of Rs.1,00,000

by issue of
10% preference shares @ 10/- each.
Calculate the cost of preference share capital (kp):
a) At par
b) At 10% premium
c) At 10% discount
Solution:
Calculation of cost of preference share capital:
a) At par:
kp = Dp/ NP
Dp = 10% on 1,00,000 = Rs.10,000
NP= Rs.1,00,000
:. Kp = 10000 / 100000 = 0.1 or 10%
b) At 10% premium:
𝐷𝑝
kp=
𝑁𝑃+𝑝𝑟𝑒𝑚𝑖𝑢𝑚
Dp = 10,000
NP= 1,00,000
Premium= 10% on 1,00,000 = 10,000
10,000 10,000
:. kp= = =0.0909 or 9.09%
1,00,000+10,000 1,10,000
c) At 10% discount:
𝐷𝑝
kp=
𝑁𝑃−𝑑𝑖𝑠𝑐𝑜𝑢𝑛
𝑡

Discount= 10% on 1,00,000 =10,000

10,000
:. Kp= = 0.1111 or 11.11%
1,00,000 −10,000
kp: Redeemable preference shares
Problem-6:
Star Light co., has 10% redeemable preference shares of 1,00,000/-,
Redeemable at the end of the 10th year from the year of their issue.
The under writing cost is 2%.
Calculate the cost of preference share capital.
 Solution:
𝐷𝑝+(𝑃 −𝑁𝑃)/𝑛
kp=
𝑃+𝑁𝑃 /2
Dp= 10% on 1,00,000 =10,000
P= Rs.1,00,000
NP = 1,00,000- 2%
= 100000 – 2000 = 98,000
n= 10 years
:. kp= 10000+(100000 −98000)/10
100000+98000 /2
10000+(2000)/10
=
198000 /2

10000+200 10200
kp= = = 0.1030 or 10.30%
99000 99000
c. Cost of debt:
Cost of irredeemable or perpetual debt:
Problem-7:
A company has 15% perpetual debt of Rs.1,00,000. The tax rate is 35%.
Determine the cost of debt ( before tax and also after tax).
Assuming the debt is issued:
a) at par
b) At 10% discount
c) At 10% premium
Solution:
a) Debt issued at a par:
I
Kd before tax = I= Interest = 15% 0n 1,00,000 = 15000
NP
NP= Net Proceeds = 1,00,000
15000
kd= = .015 𝑜𝑟 15%
100000
I
Kd after tax = NP
𝑋 1−𝑇 T = Tax rate
15000
= 𝑋 1 − 0.35 = 0.0975 or 9.75%
100000
b) Debt issued at 10% discount:
I
Kd before tax =
NP−discount
15000 15000
= = = 0.1667 𝑜𝑟 16.67%
100000−10% 90000
I
Kd after tax= 𝑋 1−𝑇
NP−discount
15000 15000
= 𝑋(1 − 0.35)= 𝑋0.65= 0.1083 or 10.83%
100000−10% 90000
c) Debt issued at 10% premium:
I
Kd before tax = NP+𝑝𝑟𝑒𝑚𝑖𝑢𝑚
15000 15000
= = = 0.1363 𝑜𝑟 13.63%
100000 + 10% 110000

I 15000
Kd after tax = 𝑋 1−𝑇 = 𝑋 1 − 0.35
NP+𝑝 𝑟 𝑒 𝑚 𝑖 𝑢 100000+10%
15000
= 𝑋0.65 = 0.086 𝑜𝑟 8.86%
110000
Cost of redeemable debt:
Problem-8:
A company issues Rs. 20,00,000, 10% redeemable debentures at a
discount of 5%. The costs of floatation amount to Rs. 50,000. The
debentures are redeemable after 8 years.
Calculate the cost of debt( before tax and after tax).
Assuming a tax rate of 55%.
Solution:
𝐼+(𝑃 −𝑁𝑃)
−−−
kd before tax = 𝑛
𝑃+𝑁𝑃 /2
I= Interest=10% on 20,00,000= 2,00,000
P= Par value of debenture= 20,00,000
NP=20,00,000 – 5% discount – floating charges
= 20,00,000 -1,00,000 – 50,000 = 18,50,000
n= 8 years
 200000+(20,00,000 −18,50,000)
−−−−−−−−−−−−−
= 8
20,00,000+18,50,000 /2
200000+(1,50,000)
−−−−− 200000+18750
= 8 = = 0.1136 or 11.36%
38,50,000 /2 1925000
 𝐼+(𝑃 −𝑁𝑃)
−−−
kd after tax = 𝑛 X (1-T) or Kd before tax X (1-TO
𝑃+𝑁𝑃 /2
= 0.1136 X (1-0.55)
= 0.1136 X 0.45 = 0.0511 or 5.11%
Cost of Retained earnings:

Problem-9:
A firm’s K is 10%, tax rate of shareholders is 30% and it is expected that
2% is brokerage cost that shareholders will have to pay while

investing their dividends in alternative securities.

What is the cost of retained earnings?

Solution:
kr= k (1-T)(1-B)
Where
kr= cost of retained earnings
k= cost of capital = 10% or 0.10
T= tax rate= 0.30
B= Brokerage cost= 2% or 0.02
:. Kr= 0.10 (1-0.30)(1-0.02) =0.10x 0.70x0.98= 0.0686 or 6.86%
Problem:10 Compute Weighted Average Cost of
Capital (WACC).
Source Cost of capital Book Value Market Value
(k) (%) weights (Rs.) weights (Rs.)

Equity share 20% 10,00,000 12,00,000

capital
Preference share 14% 4,00,000 4,50,000
capital
Debt 10% 6,00,000 6,50,000
Retained 15% 2,00,000 --------
Earnings
Solution: Computation of Weighted Average Cost
of Capital (WACC) at Book Value weights.
Source Book Value Cost of capital (k) (%) Total cost (Rs)
(1) weights (Rs.)
(2) (3) (4)=(2)x(3)

Equity share 10,00,000 20% 2,00,000

capital
Preference share 4,00,000 14% 56,000

capital
Debt 6,00,000 10% 60,000

Retained 2,00,000 15% 30,000

Earnings
Total 22,00,000 3,46,000
 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
:. WACC at Book Value weight= X 100
𝑇𝑜𝑡𝑎𝑙 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒

3,46,000
:. WACC at Book Value weight= X 100 = 15.72%
22,00,000
Computation of Weighted Average Cost of Capital
(WACC) at Market Value weights.
Source Market Value Cost of capital (k) (%) Total cost (Rs)
(1) weights (Rs.)
(2) (3) (4)=(2)x(3)

Equity share 12,00,000 20% 2,40,000

capital
Preference share 4,50,000 14% 63,000

capital
Debt 6,50,000 10% 65.000

Retained ------ 15% 0

Earnings
Total 23,00,000 3,68,000
 𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
:. WACC at Market Value weight= X 100
𝑇𝑜𝑡𝑎𝑙 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒

3,68,000
:. WACC at Book Value weight= X 100 = 16%
23,00,000
Financial management
UNIT-III

Investment Decision
Prepared by:
Mr. M.VASUDEVARAO,
ASST. PROFESSOR, DMS, BITS-VIZAG
 Investment
Decisions

Long-Term Short-Term
Investment Investment
decisions decisions
The long-term financial investment decision is

known as “Capital Budgeting”.

The short-term financial investment decision is

known as “Working Capital Management”.

 *****CAPITAL BUDGETING
Capital Budgeting : is the selection process of long-term financial
investment plans or proposals.

capital budgeting is a long-term planning for making and financing

proposed capital out lays. -----Charles T. Hrongreen
Need for the capital budgeting:
Capital budgeting decisions are used in the following areas:

➢ Introduction of new productions

➢ Expansion of existing business
➢ Replacement of assets or machinery
➢ Diversification of business
➢ For implementation of new technology
➢ Construction of major projects like bridges, dams, high ways etc.,
➢ Buying airlines
➢ Ship building
➢ Heavy advertising expenditure
CAPITAL BUDGETING PROCESS:
Capital budgeting process consists of the following steps:
1. Identification of various investments proposals
2. Analyzing the proposals and estimating cash flows
3. Evaluating cash flows
4. Selection of proposals based on an acceptance criteria
5. Implementing the project
6. Monitoring and review the project
 Methods or
Techniques of
capital budgeting:

Traditional Modern
methods methods

Pay Back Profitability

ARR NPV IRR Index
Period
I. Traditional methods:
These are also known as Non-Discounting Cash Flow methods (NDCF).
a) Pay Back Period method:
Pay-back period (PBP):is the period required to recover the initial
investment of a project.
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
Pay Back Period= or
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
Selection criteria:
Accept the project: when PBP < Target period
Reject the project: when PBP > Target period
a) Pay Back Period method:

Pay-back period (PBP):is the period required to recover the initial

investment of a project.

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡

Pay Back Period= or
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
Selection criteria:
Accept the project: when PBP < Target period
Reject the project: when PBP > Target period
Situation-1: When cashflows are even or
uniform:
Problem-1:
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of
the project is 5 years.
Calculate the pay-back period.
Solution:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
Pay Back Period=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠
= 30000
10000
= 3 Years
Selection: PBP of a project is 3 Years, it is less than target period
i.e., 5 year . Hence we should accept the project.
Situation-2: : When cashflows are uneven or
non-uniform:
Problem-2: Cost of the project Rs. 1,00,000,
The expected cash inflows are given below:
Years Cash Flows After Taxes (CFAT)
(Rs.)
1 20,000
2 40,000
3 50,000
4 20,000
5 25,000
You are required to calculate pay back period.
 Solution:
Year CFAT (Rs.) Cumulative CFAT (RS.)
1 20,000 20,000
2 40,000 60,000
3 50,000 1,10,000
4 20,000 1,30,000
5 25,000 1,55,000
 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐶𝐹𝐴𝑇
:. Pay Back Period in uneven situation=Base year+
𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 𝐶𝐹𝐴𝑇
b) Accounting Rate of Return( ARR):
It is also known as ‘Average Rate of Return’.
ARR refers to the ratio of annual profits after taxes to the average
investment.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠
ARR=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Average investment=
2
Selection criteria: Accept: when ARR > rate of return or Higher ARR
Reject: when ARR < rate of return or Low ARR
Problem-3:
A company is considering an investment proposal to install a new
machine. The project cost is Rs.5,00,000. The life period of the project
is 5 years. The company’s tax rate is 50%. The company uses straight
line depreciation method. The estimated Cash Flow Before Taxes (CFBT)
are as follows: YEAR CBFT(Rs.)
1 1,00,000
2 1,10,000
3 1,40,000
4 1,50,000
5 2,50,000
CALCULATE ARR FOR THIS PROJECT.
Note:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 −𝑆𝑐𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
Depreciation=
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
500000 −0 500000
= == = Rs. 1,00,000
5 𝑦𝑒𝑎𝑟𝑠 5
 Solution:
YEAR CFBT (Rs.) Depreciation Profit Before Tax @ 50% Profit After Tax
(Rs.) (note) Tax (Rs.) (Rs.)
1 1,00,000 1,00,000

2 1,10,000 1,00,000

3 1,40,000 1,00,000

4 1,50,000 1,00,000

5 2,50,000 1,00,000
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠
ARR=
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
125000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠 = = Rs.25,000
5

500000
Average investment= = Rs.2,50,000
2
Time Value of Money:

The time value of money can be classified as present value and future

value.

A rupee value of today (present) is much more valuable than a rupee

tomorrow (future).
II. Modern methods :

It is also known as ‘Discounted Cash Flow method(DCF). Here, the

future value cash flow is discounted in to present value.

Here, by using present value factors (or discounting factors) the future

value of expected cash flows are discounted in present.

 1 1 1 1
P.V.factor= + + +………+
1+100 1 1+100 2 1+100 3 1+100

r= rate of return (or) cost of capital rate

For example:
P.V. factor at 10% for a period of 10 years
Years P.V. factors @ 10%
1 1
1 = = 0.909
1+ 10 1 1+0.10 1
100

2 0.909x0.909= 0.826
3 0.826x 0.909 = 0.751
4 0.751 x 0.9096 =0.682
5 0.682 x 0.909 = 0.620
6 0.620 x 0.909 =0.563
7 0.563 x 0.909 = 0.512
8 0.512x 0.909= 0.465
9 0.465 x 0.909 = 0.422
10 0.422 x 0.909 = 0.383
a) Net Present Value (NPV):
NPV refers to the excess of present value of future cash inflows over
and above the cash outflows (or initial investment).

NPV= Cash Inflows – Cash outflows

Selection criteria:
Accept: when NPV > 1 or Positive NPV
Reject: when NPV < 1 or Negative NPV
Problem-5:
From the following information, calculate NPV of the project @10%
cost of capital. Initial investment is Rs.5,00,000, Project life is 5 years.
Years :1 2 3 4 5
CFAT (Rs.) : 100000 105000 120000 125000 175000
Solution: Calculation of NPV @ 10% cost of capital:
YEARS CFAT (Rs.) P. V. factor @ 10% Present Value (Rs.)

1 1,00,000 0.909 90,900

2 1,05,000 0.826 86730
3 1,20,000 0.751 90120
4 1,25,000 0.683 85375
5 1,75,000 0.621 108675
Present Value of Cash = 4,61,800
Inflows
Present Value of Cash = 5,00,000
Less: outflow
:. Net Present Value = ( -)38200
b) Internal Rate of Return (IRR):
IRR is the rate of discount that equates the present value of cash inflow
with present value of cash outflows.

IRR is the rate of return at which the NPV will be zero.

IRR P.V. Cash Inflows = P.V. Cash Outflows
IRR NPV = 0
Selection:
Accept: when IRR > Cost of capital
Reject : when IRR < Cost of capital
 C
IRR = A + ----------- x (B-A)
C–D
Where,
A= Rate of return at low rate
B= Rate of return at high rate
C= NPV at low rate
D= NPV at high rate
Problem :
A company considering to invest in the following project:
Particulars Project (Rs.)
Cost 22,000
CFAT (Rs.):
Year 1 12,000
Year 2 4,000
Year 3 2,000
Year 4 10,000

Calculate IRR.
Solution: Let us assume cost of capital @
10%:
Year CFAT (Rs.) Present Value factor@ 10% Present Value (Rs.)
1 12,000 0.909 10,908
2 4,000 0.826 3,304
3 2,000 0.751 1,502
4 10,000 0.683 6,830
Present Value of Cash Inflow 22,544
Less: Present Value of Cash Outflow 22,000
Net Present Value 544
Here the NPV is positive @ 10% cost of capital (i.e Rs.544).

Hence, we should try another cost of capital at high rate.

For assume take cost of capital @ 15%

Let us assume cost of capital @ 15%:
Year CFAT (Rs.) Present Value factor@ 15% Present Value (Rs.)

1 12,000 0.869 10,428

2 4,000 0.756 3,024
3 2,000 0.657 1,314
4 10,000 0.571 5,710
Present Value of Cash Inflow 20,476
Less: Present Value of Cash Outflow 22,000
Net Present Value (-1524)
 C
IRR = A + ----------- x (B-A)
C–D
Where,
A= Rate of return at low rate
B= Rate of return at high rate
C= NPV at low rate
D= NPV at high rate
C) Profitability Index (PI): refers to the ratio of present value of cash
inflows to the present value of cash outflow.
It is also known as ‘cost-benefit ratio’
 P.V. of cash inflows
PI =
P.V. of cash outflows

Selection:
Accept: PI > 1
Reject: PI < 1
Problem: (Profitability Index)
From the following information, calculate Profitability Index of the
project and give your decision.
Project cost is Rs.20,000
Cost of capital @15%
Years Cash inflows (Rs.)
1 2,000
2 2,000
3 4,000
4 20,000
Solution: Calculation of Profitability Index:
years CFAT (Rs.) P.V factor @ Present Value
15% (Rs.)
1 2000
2 2000
3 4000
4 20000
Present Value of Cash Inflows
 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
Profitability Index=
𝑷𝒓𝒆𝒔𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
 Financial management
UNIT-III
Investment decisions

Problems & solutions

on
Capital budgeting
(for practice)
Prepared by:
Mr. M.VASUDEVARAO,
ASST. PROFESSOR, DMS, BITS-VIZAG
 Methods or
Techniques of
capital budgeting:

Traditional Modern
methods methods

Pay Back Profitability

ARR NPV IRR Index
Period
Problem-1

The cost of a project is Rs. 20,00,000. The annual cash inflows for the

next 5 years are 5,00,000.

What is the pay back period for the project?

Solution:
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
Pay Back Period=
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

20,00,000
= = 4 𝑦𝑒𝑎𝑟𝑠
5,00,000

Selection:
The PBP of a project is 4 years , it is less than target period i.e 5 years.
Hence we should accept the project.
Problem-2
Two projects A and B, each worth of Rs.20,00,000.
From the following information, Calculate pay back period for each
project.
Years CFAT (Rs.) CFAT (Rs.)
Project-A Project-B
1 8,00,000 4,00,000
2 6,00,000 6,00,000
3 6,00,000 8,00,000
4 10,00,000 6,00,000
5 ---------- 9,00,000
Solution: Calculation of pay back period for
project-A:
Year CFAT (Rs.) Cumulative CFAT (RS.)
1 8,00,000 8,00,000
2 6,00,000 14,00,000
3 6,00,000 20,00,000
4 10,00,000 30,00,000
5 ---------- ------
The cost of project of project=A is Rs.20,00,000
:. The pay back period is 3 years.
Calculation of pay back period for project-B:
Year CFAT (Rs.) Cumulative CFAT (RS.)
1 4,00,000 4,00,000
2 6,00,000 10,00,000
3 8,00,000 18,00,000
4 6,00,000 24,00,000
5 9,00,000 33,00,000
 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐶𝐹𝐴𝑇
:. Pay Back Period for project-B =Base year+
𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 𝐶𝐹𝐴𝑇
 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝐶𝐹𝐴𝑇
:. Pay Back Period for project B=Base year+
𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 𝐶𝐹𝐴𝑇
20,00,000 −18,00,000
=3 years+
6,00,000
2,00,000
=3 years+ 6,00,000

=3 years+ 0.33 = 3.33 years or 3 years and 4 months

Problem-3:
Given two machines A and B. Cost of each machine @ Rs. 1,00,000 each.
Cost of capital is 15%.
Cash Flows After Taxes are as follows:
Year Machine-A (Rs.) Machine-B (Rs.)
1 25,000 35,000
2 28,000 32,000
3 32,000 28,000
4 27,000 31,000
5 20,000 33,000
Suggest, which project should be accept according to NPV method.
Solution:
Calculation of NPV of machine-A @ 15% cost ofcapital:
YEARS CFAT (Rs.) P. V. factor @ 15% Present Value (Rs.)
(1) (2) (3) (4)=(2) X (3)
1 25,000 0.869 21,725
2 28,000 0.756 21,168
3 32,000 0.657 21,024
4 27,000 0.571 15,417
5 20,000 0.497 9,940
Present Value of cash 89,274
inflow
(-) P.V. of Cash 1,00,000
Outflow
Net Present Value (-) 10,726
Calculation of NPV of machine-B @ 15% cost ofcapital:
YEARS CFAT (Rs.) P. V. factor @ 15% Present Value (Rs.)
(1) (2) (3) (4)=(2) X (3)
1 35000 0.869 30415
2 32000 0.756 24192
3 28000 0.657 18396
4 31000 0.571 17701
5 33000 0.497 16401
Present Value of cash 1,07,105
inflow
(-) P.V. of Cash 1,00,000
Outflow
Net Present Value 7,105
Decision:
NPV of machine-A is Rs. (-) 10,726.
NPV of machine-B is Rs.7,105

Therefore, select the machine-B is having highest NPV or positive NPV.

Problem-4:
A company considering to invest in the following project:
Years CFAT (Rs.)
1 100000
2 105000
3 120000
4 125000
5 175000
Cost of the project Rs. 5,00,000

Calculate IRR.
Solution: Let us assume cost of capital @
10%:
Years CFAT (Rs.) Present Value factor@ 10% Present Value (Rs.)
1 100000 0.909 90900
2 105000 0.826 86780
3 120000 0.751 90120
4 125000 0.683 85370
5 175000 0.621 108670
P.V. of cash inflow 4,61,810
(-) P.V. of cash outflow 5,00,000
Net Present Vlue (-) 38,190
Here the NPV is nagative @ 10% cost of capital (i.e Rs.- 38,190).

Hence, we should try another cost of capital at low rate.

For assume take cost of capital @ 6%

Let us assume cost of capital @ 6%:
Years CFAT (Rs.) Present Value factor@ 6% Present Value (Rs.)

1 100000 0.943 94300

2 105000 0.889 93340
3 120000 0.840 100800
4 125000 0.792 99000
5 175000 0.747 130730
P.V. Cash Inflows 5,18,170
(-) P.V. Cash outflows 5,00,000
Net Present Value 18,170
 C
IRR = A + ----------- x (B-A)
C–D
Where,
A= Rate of return at low rate
B= Rate of return at high rate
C= NPV at low rate
D= NPV at high rate
Where,
A= 6
B= 10
C= 18170
D= (-) 38190

18170 18170
IRR = 6+ ---------------------x (10-6)= 6+-------------x 4 = 6+0.322x4= 7.28% or 7%
18170+38190 56360
:. NPV will be zero at 7.28% or 7% cost of capital.
Problem-5:
From the following information, calculate Profitability Index of the project
and give your decision.
Project cost is Rs.5,00,000
Cost of capital @10%
Years Cash inflows (Rs.)
1 40,000
2 1,20,000
3 1,60,000
4 2,40,000
5 1,60,000
Solution: Calculation of Profitability Index:
years CFAT (Rs.) P.V factor @ Present Value
10% (Rs.)
1 40000 0.909 36360
2 120000 0.826 99120
3 160000 0.751 120160
4 240000 0.683 163920
5 160000 0.621 99360
Present Value of Cash inflow 5,18,920
 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
Profitability Index=
𝑷𝒓𝒆𝒔𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑰𝒏𝒇𝒍𝒐𝒘𝒔
Profitability Index=
𝑷𝒓𝒆𝒔𝒏𝒕 𝑽𝒂𝒍𝒖𝒆 𝒐𝒇 𝑪𝒂𝒔𝒉 𝑶𝒖𝒕𝒇𝒍𝒐𝒘𝒔
𝟓, 𝟏𝟖,𝟗𝟐𝟎
= = 𝟏. 𝟎𝟑
𝟓, 𝟎𝟎,𝟎𝟎𝟎
Decision: The Profitability Index is more than 1.
(i.e 1.03 > 1). Hence , we should accept the project.
Financial management
Unit-iv
Dividend decision
Prepared by
Mr.M. Vasudeva Rao
Assistant Professor,
DMS, BITS-VIZAG
 Dividend

Dividend: refers to the part of the profit of a business, which is

distributed among its shareholders.

Dividend decision: refers to the policy concerning the quantity of

profits to be distributed as dividend.

TYPES OF DIVIDEND/FORM OF DIVIDEND:
1. Cash Dividend:
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend.
2. Stock Dividend
Stock dividend is paid in the form of the company stock (shares).
3. Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient
funds to pay cash dividend, the company promises to pay the shareholder at a future
specific date with the help of issue of bond or notes.
4. Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distributed
under the exceptional circumstance. This type of dividend is not published in India.
5.Bonus dividend/ Bonus shares: Bonus shares are an additional shares issued to the
existing shareholders.
***FACTORS DETERMINING DIVIDEND
POLICY
➢Profitable Position of the Firm
➢Uncertainty of Future Income
➢Legal Constrains
➢Liquidity Position
➢Sources of Finance
➢Growth Rate of the Firm
➢Tax Policy
➢Capital Market Conditions
*****THEORIES/ APPROACHES / MODELS
OF DIVIDEND:
I.RELEVANCE THEORIES:
a. Walter’s Theory
b. Gordon’s Theory

II. IRRELEVANCE THEORIES:

a. MM Theory
b. Residual Theory
I. RELEVANCE OF THEORIES:
a. Walter’s model /approach:
Prof. James E. Walter argues that the dividend policy almost always
affects the value of the firm.
a. Walter’s approach:
According to this theory the dividend policy almost always affects the
value of the firm.
𝑟
𝐷+ 𝑘 (𝐸−𝐷)
P=
𝑘
Where,
P= Price of the share , E=EPS, D=Dividend Per Share , r= Return on
investment, k= Cost of capital
b. Gordon’s approach:
According to this theory the dividend decision is relevant to the value
of the firm.

𝐸 (1−𝑏)
P=
𝑘 −𝑔
Where
P= Price of the share, E=EPS, k=Cost of capital,
b=Retention ratio (or) (b= 1- Dividend Pay out ratio)
g=Growth rate (g=bxr)
Problem-1:

Apex Co., earns Rs.5 per share, capitalization rate is 10% and has a

return on investment is 12%.

Determine the price of the share. Use Walter’s model.

Solution:
𝑟
𝐷+ 𝑘 (𝐸−𝐷)
P=
Where,
P= Price of the share =?
E=EPS = 5
D=Dividend Per Share=0
r= Return on investment=0.12
k= Cost of capital = 0.10
 0.12
0+ (5−0)
0.10
P= = Rs.60
0.10
Problem-2:
1. r=12% k=10%(r>k)
2. r=10% k=10%(r=k)
3. r=8% k=10%(r<k)
EPS= Rs.2.00
Dividend Per Share(DPS) given in four situations:
a. Rs.0.50
b. Rs.1.00
c. Rs.1.50
d. Rs.2.00
Calculate the market price of the share. Use walter’s model.
Solution:
𝑟
𝐷+ 𝑘 (𝐸−𝐷)
P=
 a) b) c) d)
E=2.00 E=2.00 E=2.00 E=2.00
D=0.50 D=1.00 D=1.50 D=2.00
1.When 0.50+ 0.12 (2−0.50) 22 21 20
0.10
P=
r=12%, k=10% 0.10
= Rs.23
2.When 20 20 20 20
r=10%, k=10%

3.When 17 18 19 20
r=8%, k=10%
Problem-3:
The following information is available from Hyderabad Ltd.
r=12%, E=Rs.20
Determine the value of share.
Assume the following:
 D/P RATIO (%) RETENTIION RATIO (%) K (%)
a 10 90 20
b 20 80 19
c 30 70 18
d 40 60 17
e 50 50 16
f 60 40 15
g 70 30 14
Solution:
𝐸 (1−𝑏)
P=
𝑘 −𝑔
Where
P= Price of the share, E=EPS, k=Cost of capital,
b=Retention ratio
g=Growth rate
g=b X r
a. When: D/P RATIO =10, RETENTION RATIO=90
P=21.74
b. When: D/P RATIO =20, RETENTION RATIO=80 P=42.55
c. When: D/P RATIO =30, RETENTION RATIO=70 P=62.50
d. When: D/P RATIO =40, RETENTION RATIO=60 P=81.63
e. When: D/P RATIO =50, RETENTION RATIO=50 P=100
f. When: D/P RATIO =60, RETENTION RATIO=40 P=117.65
g. When: D/P RATIO =70, RETENTION RATIO=30 P=134.62
PROBLEM-4:
Compute market value per share from the given information.
Use Walter’s model and Gordon’s model.
Earnings per share Rs.20
Rate of return 12%
Cost of equity 14%
Dividend payout ratio 40%
Solution:
a) Walter’s model:

𝑟
𝐷+ 𝑘 (𝐸−𝐷)
P=
E= Earning per share = Rs.20
r=Rate of return =12%
k=Cost of equity =14%
D=Dividend per share =40% i.e 20x40%= Rs.8
 8+ 0.12 (20−8)
0.14
P=
0.14

8+0.877 (12) 18.52

P= = = Rs.130
0.14 0.14
b) Gordon’s model:
𝐸 (1−𝑏)
P=
𝑘 −𝑔
Where
P= Price of the share
E=EPS=20
k=Cost of capital=0.14
b= Retention ratio =100-Dividend payout ratio
=100- 40%= 60% or 0.60
r= Rate of return=0.12
g=Growth rate
g=b X r = 0.60 x 0.12= 0.072
 𝐸 (1−𝑏)
P=
𝑘 −𝑔

20(1−0.60)
P= = Rs.117.64
0.14 −0.072
II.IRRELEVANCE THEORIES:
a. Modigliani and Miller’s Approach (MM):

a. Modigliani and Miller’s Approach (MM):

According to this theory dividend decision is irrelevant to the value of

the firm.
Assumptions of MM theory:
1. MM approach is based on the following important assumptions:
2. Perfect capital market.
3. Investors are rational.
4. There are no tax.
5. The firm has fixed investment policy.
6. No risk or uncertainty.
For present price of the share:

P1 + D1
Po =
1 + ke
For future price of the share:

P1 = Po (1+Ke) – D1
Where,
Po = Price of the share in present (Today)
P1 = Price of the share in future.
Ke = Cost of equity capital.
D1 = Price of the Dividend
b. Residual Theory:

This theory regards dividend decision merely as a part of financing

decision because the earnings available may be retained in the

business for re-investment.

***Problem-5:
The present share capital of SUN Ltd., consists of 10000 shares,
selling at Rs.100 each. The company is contemplating a dividend of
Rs.10 per share at the end of the current financial year.
The company belongs to a risk class for which appropriate
capitalization rate is 20%.
The company expects to have a net income of Rs.2,50,000.
What will be the price of the share at the end of the year:
a) If dividend is not declared
b) If dividend is declared
You are required to use MM-model.
Solution:
Price of the share at the end of the year:

P1 = Po (1+Ke) – D1
Where,
P1 = Price of the share in future(end of the year)= ?
Po = Price of the share in present (Today)= Rs.100
Ke = Cost of equity capital= 20% or 0.20
D1 = Price of the Dividend(if not declared)= 0
D1 = Price of the Dividend(if declared)=(10% x 100)= Rs.10
a) When dividend is not declared:
P1 = Po (1+Ke) – D1
= 100 (1 + 0.20) – 0

= 100 x 1.20 = Rs.120

b) When dividend is declared:
P1 = Po (1+Ke) – D1
= 100 (1 + 0.20) – 10

= 100 x 1.20 = 120 -10 = Rs.110

*****Problem-6:
USHA company has existing 6000 equity shares each @Rs.100.
Cost of equity is 15% and dividend declared during the year is Rs.10.
During the year company introduced additional investment Rs.15,00,000
and current year income Rs.3,00,000.
Determine:
a. Firm Value and New shares are to be issued, if dividend declared and paid.
b. Firm Value and New shares are to be issued , if dividend not declared.

Use MM model.
Solution:

P1 = Po (1+Ke) – D1

Where,
Po = Price of the share in present (Today)
P1 = Price of the share in future.
Ke = Cost of equity capital.
D1 = Price of the Dividend
a) If dividend declared and paid:
P1 = Po (1+Ke) – D1

P1 = 100 (1+0.15) – 10
= 115 -10 =Rs.105
New shares to be issued:
𝐼− 𝐸−𝑛𝐷1
M=
𝑃1
Where,
M= New shares to be issued=?
I= Investment= Rs.15,00,000
E= Earnings= Rs.3,00,000
n = No. of existing shares= 6000 shares
D1 = Dividend declared = Rs.10
P1= Price of the share in future= Rs.105
 𝐼− 𝐸−𝑛𝐷1
:. M=
𝑃1
1500000− 300000−6000𝑥10
M=
105

1500000−240000
M=
105
1260000
M= = 12000 new shares
105
Value of the firm:
𝑛 + 𝑀 𝑃1 − 𝐼 − 𝐸
𝑉=
1 + 𝑘𝑒
Value of the firm:
6000 + 12000 105 − 1500000 − 300000
𝑉=
1 + 0.15

18000 105 − 1200000

𝑉=
1.15
= Rs. 6,00,000
b) If dividend is not declared:
P1 = Po (1+Ke) – D1

P1 = 100 (1+0.15) – 0
= 115 -0 =Rs.115
New shares to be issued:
𝐼− 𝐸−𝑛𝐷1
M=
𝑃1
Where,
M= New shares to be issued=?
I= Investment= Rs.15,00,000
E= Earnings= Rs.3,00,000
n = No. of existing shares= 6000 shares
D1 = Dividend declared = 0
P1= Price of the share in future= Rs.115
 𝐼− 𝐸−𝑛𝐷1
:. M=
𝑃1
1500000− 300000−6000𝑥0
M=
115

1500000−300000
M=
115
1200000
M= = 10435 new shares
115
Value of the firm:
𝑛 + 𝑀 𝑃1 − 𝐼 − 𝐸
𝑉=
1 + 𝑘𝑒
Value of the firm:
6000 + 10435 115 − 1500000 − 300000
𝑉=
1 + 0.15

16435 115 − 1200000

𝑉=
1.15
1890025 − 1200000
𝑉=
1.15
= Rs. 6,00,000
Conclusion:
According to MM model, Value of the firm is remain same irrespective
of dividend paid or not paid. (i.e. Rs.6,00,000)
FINANCIAL MANAGEMENT

Unit-v
Liquidity decision
Prepared by
Mr. M. Vasudeva Rao,
Asst. Professor, DMS
BITS-VIZAG
Liquidity decision:

The short-term of financial investment decision

is

known as “Liquidity decision”.

Working Capital: is a capital or amount required to meet day to day
expenses in one financial year.
Working capital : According to the definition of Weston and Brigham,
“Working Capital refers to a firm’s investment in short-term assets,
cash, short-term securities, accounts receivables and inventories”.
Classification of working capital

Types of working capital

Based on time period:

Based on concept: I. Permanent/ Fixed W.C
I. Gross working capital II. Temporary/ variable
II. Net working capital W.C
Based on concept:

I. Gross working capital: It refers to all total current assets .

II. Net working capital: It refers to the difference between current

assets and current liabilities. Or The excess of current assets over

current liabilities.
Gross working capital= only current assets
Net working capital = current asset – current liabilities
Current assets: are those assets which can be easily converted into
cash within one financial year.

Current liabilities: are those liabilities which can be clear or repay

within one financial year.
Based on time period:
I. Permanent / Fixed working capital:
It represents the current assets required on a continuing basis over
the entire year.
II . Temporary/ variable working capital:
It is the amount of working capital maintains on fluctuating from
time to time on the basis of business activities.
Determinants or factors of working capital:
1. Nature of business
2. Size of the business
3. Production cycle
4. Business cycle
5. Credit policy
6. Growth and expansion of business
7. Proper availability of raw materials
8. Profit level
9. Inflation
10. Operating efficiency
***Basis for working capital calculation:
I. Inventory or stock: includes raw materials, work in process (WIP),
finished goods
a. Raw materials should be calculate on storage period.
b. WIP should be calculate on total cost or cost of sales or process
time..
c. Finished goods should be calculated on total cost or cost of sales or
process time.

If only stock should be calculate on total cost or cost of sales.

2.Debtors: should be calculated on credit sales or cost of sales and

time allowed to customers.

3.Creditors: should be calculated on credit purchases or cost of sales

and time allowed by suppliers.

4.Outstanding Wages: should be calculated on direct wages for time

period.

5.Outstanding expenses: should be calculated on overheads or

expenditure and time period.

Prroblem-1:
Prepare an estimation of working capital requirement from the
following information:
Annual sales 1,00,000 units
Selling price Rs.8 per unit
Net profit on sales 25%
Average credit period allowed to customers 8 weeks
Average credit period allowed by suppliers 4 weeks
Average stock holding in terms of sales requirements 12 weeks
Allow 10% for contingencies.
Solution:
Working note:
Sales = 100000 x 8 = Rs. 8,00,000
Profit = 25% on sales = 25% x 8,00,000 = 2,00,000
Cost of sales= sales – profit = 800000 – 200000 = 600000
Net working capital = Current Assets – Current Liabilities
Statement of working capital requirements:
Current Assets: Rs.
Debtors= (cost of sales x 8 weeks/52 weeks)= 600000 x 8/52 92,307.69
Stock = (cost of sales x 12 weeks/52 weeks)= 600000 x 12/52 1,38,461.53
Total current assets (CA) 2,30,770
Current Liabilities:
Creditors = (cost of sales x 4 weeks/52 weeks)= 600000 x 4/52 46,154
Total current Liabilities (CL) 46,154
Net working capital = CA – CL =(230770-46154) 1,84,616
Add: 10% for contingencies 2,03,077.6
(10% on 184616)
Working capital required 2,03,077.6
Problem-2:
From the following information of Ravi Teja & Co.,
You are asked to prepare a statement of working capital requirement.
Production units per year 100000 units
Raw material per unit Rs 6.00
Direct Labour Rs.4.00
Overheads Rs. 5.00
Total cost Rs.15.00
Profit Rs. 5.00
Selling price Rs.20.00
Additional information:
1. Raw materials are kept in stock on average of 1 month.
2. WIP is on average of 3 weeks.
3. Finished goods are kept in store on average of 1 month
4. Credit allowed to debtors is 2 months
5. Credit allowed by creditors is 1 month
6. Lag in payment of wages to workers is 2 weeks
Solution:
Working notes: Calculation of sales: Rs.
Raw materials ( 100000x6) = 6,00,000
Direct Labour (100000x4) = 4,00,000
Overheads (100000x5) = 5,00,000
Total cost 15,00,000

Add: profit (100000x5) = 5,00,000

Sales ( 100000 x 20) = 20,00,000

Net working capital = Current Assets – Current Liabilities
Statement of working capital requirements:
Particulars Amounts (Rs.)
Current Assets:
Raw materials= Raw materials x 1/12 50,000
WIP = Total cost x 3/52 weeks 86,538
Finished good = total cost x 1/12 1,25,000
Debtors= sales x 2/12 3,33,333
Total current Assets (CA) 5,94,871
Current Liabilities:
Creditors = Raw materials x 1/12 50,000
Outstanding wages = Direct Labour x 2/52 15,384
Total Current Liabilities (CL) 65,384
Net working capital = CA - CL 5,29,487
 Inventory Management

Inventory management: is a planning of purchasing of raw material,

handling, storing and disposal of finished goods.

It is also known as “Inventory Control”.

Objectives/ importance/advantages of
inventory management/inventory control:
1. Reduction of investment on materials
2. Proper and efficient use of raw materials
3. No interruption in production
4. Avoid over stocking
5. Controlling costs
6. Reduce the wastage of materials
7. Maintain quality in production
8. Ensure against scarcity of materials in the market
9. Support the production department
*****Techniques of Inventory Management
(or) Inventory Control:
I. Economic Order Quantity (EOQ)
II. ABC analysis
III. Re-Order Level
IV. Safety stock
V. HML analysis
VI. SDE analysis
VII.VED analysis
VIII.FSN analysis
I. Economic Ordering Quantity (EOQ):
EOQ: refers to that level of inventory at which the ordering costs and
carrying costs will be minimum.
It is also known as ‘Economic Lot Size’.
 √2AO
EOQ=
C
Where, A = Annual demand or Annual consumption or Annual
requirement
O = Ordering cost
C = Carrying cost
II. ABC analysis:
It is a controlling technique that classifies inventory based on the
quantity and value.
It is a form of controlling in which the items are grouped into three
categories ( i.e A,B, and C) in order to their estimated importance.
‘A’ items are in few number having high value and are very important.
‘B’ items are in average number having moderate value and these items
are important
‘C’ items are in large number having low value and are less importance
Example:
Category No. of items(%) Items value (%) Desire degree of
control

A 15 70 Strict

B 40 20 Moderate

C 45 10 Low

Total 100 100

III. Re-Order Level (ROL):
It is the level of inventory at which the firm should place an order to
complete the inventory.
IV. Safety Stock:
It is a buffer stock to meet some unanticipated increase in usage .

Safety stock= Average usage x Period of safety stock

V. HML analysis:
It is a controlling technique that classifies inventory into unit value such
as High, Medium and Low.
H- high value
M-medium value
L- low value
VI. SDE analysis:
It is a controlling technique which is used in the case of scarcity of
supply of inventories.
S- refers to Scarcity (it is for imported materials in shortage)
D- refers to Difficult ( it is for material available difficulty)
E- refers to Easy (it is for easily available local materials)
VII. VED analysis:
According to this technique inventories are grouped based on the
effect on production.
They are: Vital, Essential and Desirable inventories.
It is especially used for spare parts.
VIII. FSN analysis:
It is a controlling technique that inventory is classified based on the
movement of inventory from stores.
‘F’ refers to Fast moving materials
‘S’ refers to Slow moving materials
‘N’ refers to Non-moving materials
The items are usually grouped for a period of 12 months.
Problem-1
Guntur manufacturing unit requires 160000 units of raw materials per
year.
Ordering cost is estimated as Rs. 40 per unit.
Carrying cost is estimated to be Rs. 5 per unit.

Calculate EOQ and also find number of orders required per year.
Solution:
Economic Order Quantity:
2AO
𝐸𝑂𝑄 =
𝐶
Where,
A= Annual demand = 160000 units
O= Ordering cost = Rs.40
C= Carrying cost= Rs. 5
√2*160000*40/5
1600
 𝐴
No .of orders required per year = 𝐸𝑂𝑄
= 160000/1600
= 100
Problem -2
An automobile manufacturing industry purchases spark plugs @ Rs.25
per piece.
Annual demand for spark plugs is estimated as 18000 pieces.
Ordering cost is Rs.250 per order
Carrying cost is 25%
Estimate EOQ and also find number of orders required per year.
Solution:
Economic Order Quantity:
2AO
𝐸𝑂𝑄 =
𝐶
Where,
A= Annual demand = 18000 pieces O= Ordering cost =
Rs.250
C= Carrying cost= Rs. 25 x25%= Rs.6.25

Ans: 1200
 𝐴
No .of orders required per year = 𝐸𝑂𝑄

= 15
Problem:3
From the following information calculate:
(1) Re-order level (2) Maximum level (3) Minimum level (4) Average
level
Normal usage: 100 units per week
Maximum usage: 150 units per week
Minimum usage: 50 units per week
Re-order quantity (EOQ) 500: units
Log in time: 5 to 7 weeks
Solution:
(1) Re-order Level = Maximum consumption × Maximum Re-order
period
= 150 x 7
= 1050
(2) Maximum Level= Re-order level + Re-order quantity –( Minimum
consumption × Minimum delivery period)

= 1050 + 500- ( 50x5)

= 1550- 250
= 1300
(3) Minimum Level= Re-order level – (Normal consumption × Average
delivery period)

= 1050 – ( 100x5+7/2)
= 1050 – 600
= 450
(4) Average Level=Maximum level + Minimum level
2

= 1300+450/2
= 875
Problem:4
From the following information, calculate re-ordering level , maximum
stock level, minimum stock level average stock level.
Maximum consumption: 200 units per day
Minimum consumption: 150 units per day
Normal consumption : 160 units per day
Re-Order Period : 10 – 15 days
Re-Order Quantity : 1600 units
Normal re-order period : 12 days
Solution :
1) Re-order Level = Maximum consumption × Maximum Re-order
period

= 200x 15
=3000
(2) Maximum Level= Re-order level + Re-order quantity –( Minimum
consumption × Minimum delivery period

= 3000+1600-(150x10)
= 4600-1500
= 3100
(3) Minimum Level= Re-order level – (Normal consumption × Average
delivery period)

= 3000-(160x10+15/2)
= 3000-2000
= 1000
(4) Average Level=Maximum level + Minimum level
2
3100+1000= 4100
Problem-5
Biscuit manufacturing company buys a lot of 10000 bags of wheat per
annum. The cost per bag is 500/- and the ordering cost is 400/-, the
inventory carrying cost is established at 10% of the price of the wheat
bag.
Determine EOQ and also the no . Of orders to be placed.
Solution:
Economic Order Quantity:
2AO
𝐸𝑂𝑄 =
𝐶
Where,
A= Annual demand = 10000 bags O= Ordering cost
= Rs.400
C= Carrying cost= Rs. 500 x10%= Rs.50
square root of 2*10000*400/50 = square root 160000
=400
 𝐴
No .of orders required per year = 𝐸𝑂𝑄

10000/400 =25
Thank you