01 FM Book Questions Main Book

CA - INTERMEDIATE
FINANCIAL MANAGEMENT
(Main Book)
BY: CA NITIN GURU

PREFACE TO THIS EDITION
Through the medium of this book, we present to you the financial management concepts in a refined and
simplified manner. Each chapter has been covered through detailed questions to help in learning by
practicing. Effort has been done to write this book in a way which makes it easy to understand and
remember.
I am grateful to my parents Shri. P. D. Guru and Smt. Suman Guru, for their support, guidance and
encouragement. They have always been a source of inspiration for me.
I am thankful to God for endowing HIS blessings always upon me.
Also, the sincere effort, persistence and determination of our associated teachers, staff members, well
wishers and students is highly appreciated.
Every effort has been taken to avoid any errors / omissions, but errors are inevitable. Any mistake may kindly
be brought to our notice and it shall be dealt with suitably.
We welcome your valuable suggestions and feedback in developing this book further.
Thank You !!
CA. Nitin Guru
ABOUT THE AUTHOR

⮚CA Nitin Guru is a Post Graduate in Commerce & a Member of The Institute of Chartered Accountants of India.
⮚ He is the lead trainer for various courses for Costing and Financial management at EDU91 and LEARN91.
⮚ He is a First Class Graduate from Delhi College of Arts and Commerce.
⮚ He is a College Topper & a Gold Medallist.
⮚ His areas of specialization are Cost & Management Accounting, Financial Management, Economics for
Finance and Strategic Financial Management.
⮚ At young age, he has amassed vast experience of teaching over 25,000 students.
⮚ His style of teaching, techniques and guidelines for preparing for examination are well accepted &
acknowledged by all the students. His friendly and interactive approach makes him popular amongst the students.
⮚ He has maintained very high passing rate. He has been a Visiting Faculty to various Professional Institutes &
MBA Colleges in the past.
CLASS ATTRACTIONS
⮚ Starts topic from the base.
⮚ Explains reasons and logic inbuilt behind concepts and has a unique method of making students understand
them.
⮚ Real life examples makes classes interesting & lively.
CLASSES AVAILABLE ON WWW.EDU91.ORG

● CA INTER - COST & MANAGEMENT ACCOUNTING (REGULAR & FAST TRACK)
● CA INTER - FINANCIAL MANAGEMENT (REGULAR & FAST TRACK)
● CA INTER - ECONOMICS FOR FINANCE
● CA FINAL - STRATEGIC FINANCIAL MANAGEMENT
FOR resolving any doubts -

CONTACT: 9211122778 (WhatsApp message)
INSTAGRAM: @nitinguruofficial
INDEX
FINANCIAL MANAGEMENT
S. No. CHAPTER
1. Scope and Objectives of Financial Management (Theory, covered from ICAI Module)
2. Types of Financing (Theory, covered from ICAI Module)
3. Ratio Analysis
4. Cost of Capital
5. Financing Decisions - Capital Structure
6. Financing Decisions – Leverages
7. Investment Decisions
8. Risk Analysis in Capital Budgeting
9. Dividend Decisions
10. Management of Working Capital

EDU91 | Where Learning Happens By CA NITIN GURU
Chapter 3
FINANCIAL ANALYSIS & PLANNING - RATIO
ANALYSIS
Question 1.
What is the significance of ratio analysis in decision making?
Solution 1:
Ratio Analysis is a useful tool in the following aspects-
1. Inter-Firm & Intra comparison: Firm’s vis-a-vis the industry can be evaluated by comparing the firm’s ratios with
the industry average. Direction of the firm’s financial policies can be indicated by Trend Analysis of ratios over
period of years.
2. Budgeting: Ratios are helpful in planning and forecasting the business activities of a firm for future periods, e.g.
estimation of working capital requirements.
3. (a) Evaluation of Liquidity: The ability of a firm to meet its short-term payment commitments is called liquidity.
Current Ratio and Quick Ratio help to assess the short-term solvency (liquidity) of the firm.
(b) Evaluation of profitability: Profitability Ratio, i.e. Gross profit Ratio, Operating profit Ratio, Net profit Ratio
are basic indicators of the profitability of the Firm. In addition, various profitability indicators like Return on
Capital Employed (ROCE), Earnings per share (EPS), Return on Assets (ROA), etc. are used to assess the financial
performance.
Question 2. [NOV 09]

What are the Limitations of Financial Ratio analysis?
Solution 2:
The limitations of Financial Ratio analysis are as follows:
1) Window Dressing:- Sometimes attempts are made to manipulate the accounts to show favourable ratio, when
they are not.
2) Seasonal factors:- These factors influence the financial data and there is no uniform pattern during the year,
therefore ratios may not indicate correct situation.
3) Lack of Standards:- There is no uniformity as to what an ‘’ideal’’ ratio is even though there are some norms like
current ratio should be 2:1.
4) Interdependence:-Decision taken on the basis of one ratio may be incorrect when a set of ratios is analysed.
5) Financial data are badly distorted by inflation:- Historical values may be substantially different from true values.
These distortions are also carried in the financial ratios.
➢ TYPES OF RATIO
I. PROFITABILITY RATIOS BASED ON SALES:
These ratios measure how efficiently a company has generated profit on sales and investment.
𝑮𝒓𝒐𝒔𝒔 𝑷𝒓𝒐𝒇𝒊𝒕
i. Gross Profit Ratio= (In %)
𝑵𝒆𝒕 𝑺𝒂𝒍𝒆𝒔
Gross Profit = Gross Profit as per Trading Account.
Sales = Sales net of returns.
Significance = Indicator of Basic Profitability.
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕
ii. Operating Profit Ratio= (In %)
Operating Profit = Sales Less Cost of Sales
[OR]
Net Profit as per P & L Account
(+) Non-Operating Expenses (e.g. Loss on sale of assets, preliminary Expenses
written off, etc.)
To get the best out of these notes visit www.edu91.org

Join Us on YouTube www.youtube.com/neerajarora
Join Us on Telegram https://t.me/neerajaroraclasses
(-) Non-Operating Income (e.g. Rent, Interest & Dividends received)

Significance = Indicator of Operating Performance of business.
𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕
iii. Net Profit Ratio= (In %)
Net Profit = Net profit as per P & L A/c (either before tax or after tax, depending upon data).
Significance= Indicator of Overall Profitability.
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
iv. Contribution Sales Ratio [or] Profit Volume Ratio=
𝑺𝒂𝒍𝒆𝒔
Contribution = Sales Less Variable Costs.
Significance = Indicator of Profitability in Marginal Costing.
II. COVERAGE RATIOS:

The soundness of firm, from the view point of long term creditors & Preference shares, lays its ability to service
their client.
𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒇𝒐𝒓 𝑫𝒆𝒃𝒕 𝑺𝒆𝒓𝒗𝒊𝒄𝒆
i. Debt Service Coverage Ratio= (𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕+𝑰𝒏𝒔𝒕𝒂𝒍𝒎𝒆𝒏𝒕)
(In Times) [MAY 07, MAY 09, MAY 14]
Earnings for Debt Service = Net Profit after Taxation
(+) Interest on Debt Funds
(+) Non-Cash Operating Expenses(e.g. depreciation & amortizations)
(+) Non-Operating Items/Adjustments (e.g. Loss on sale of Fixed Assets, etc.)
Interest + Instalment = Interest + Principal, i.e.
Interest on Debt
(+) Instalment of Loan Principal
Significance =Indicates extent of current earnings available for meeting commitments of interest and
instalment. Ideal Ratio must be between 2 to 3 times.
𝑬𝑩𝑰𝑻
ii. Interest Coverage Ratio= 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 (In Times)
EBIT = Earnings before Interest and Tax.
Interest = Interest on Debt
Significance= Indicates ability to meet interest obligations of the current year. Should be greater than 1.
𝑬𝑨𝑻
iii. Preference Dividend Coverage Ratio= 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅 (In Times)
EAT = Earnings after Tax.
Preference Dividend = Dividend on Preference Capital.
Significance= Indicates ability to pay dividend on Preference Capital. Should be greater than 1.
III. TURNOVER/ACTIVITY/ PERFORMANCE RATIOS[NOV 06]

These ratio show how efficiently a company is using its assets to generate sales, e.g. Fixed Assets Turnover
ratio, Debtor Turnover ratio etc.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒂𝒘 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍 𝑪𝒐𝒏𝒔𝒖𝒎𝒆𝒅
i. Raw Material Turnover Ratio= 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒕𝒐𝒄𝒌 𝒐𝒇 𝑹𝒂𝒘 𝑴𝒂𝒕𝒆𝒓𝒊𝒂𝒍
(In Times and Days)
Cost of Raw Material Consumed = Opening Stock of Raw Materials
(+) Purchases of Raw Materials
(-) Closing Stock of Raw Materials
(𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑹𝑴 𝑺𝒕𝒐𝒄𝒌+𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑹𝑴 𝑺𝒕𝒐𝒄𝒌)
Average Stock of Raw Material=
𝟐
Significance= Indicates how fast/regularly Raw Materials are used in production.
𝑭𝒂𝒄𝒕𝒐𝒓𝒚 𝑪𝒐𝒔𝒕
ii. WIP Turnover Ratio= 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒕𝒐𝒄𝒌 𝒐𝒇 𝑾𝑰𝑷 (In Times and Days)

Factory Cost = Materials Consumed + Wages + POH

(𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑾𝑰𝑷+𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑾𝑰𝑷)
Average Stock of WIP =
𝟐
Significance= Indicates the WIP movement/production cycle.
𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅

iii. Finished Goods or Stock Turnover Ratio= (In Times and Days)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑺𝒕𝒐𝒄𝒌 𝒐𝒇 𝑭𝒊𝒏𝒊𝒔𝒉𝒆𝒅 𝑮𝒐𝒐𝒅𝒔
Cost of Goods Sold = (a) For Manufacturers: OpeningStock of FG (+)Cost of Production (-) Closing Stock of FG.
(b) For Traders: Opening Stock of FG + Cost of Goods Purchased (-) Closing Stock
of FG.
(𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑭𝑮 𝑺𝒕𝒐𝒄𝒌+𝑪𝒍𝒐𝒔𝒊𝒏𝒈 𝑭𝑮 𝑺𝒕𝒐𝒄𝒌)
Average Stock of Finished Goods =
𝟐
Significance =Indicates how fast inventory is used/sold. High Turnover shows fast moving FG. Low
Turnover may mean dead or excessive stock.
𝑪𝒓𝒆𝒅𝒊𝒕 𝑺𝒂𝒍𝒆𝒔
iv. Debtors Turnover Ratio= (In Times and Days)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒄𝒄𝒐𝒖𝒏𝒕 𝑹𝒆𝒄𝒆𝒊𝒗𝒂𝒃𝒍𝒆
Credit Sales = Credit Sales net of returns
Average Accounts Receivable = Average Accounts Receivable (i.e. Debtors + B/R)
(𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑫𝒓𝒔 & 𝐵/𝑅 +𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐷𝑟𝑠 & 𝐵/𝑅
𝟐
Significance = Indicates the speed of collection of Credit Sales/Debtors.
𝑪𝒓𝒆𝒅𝒊𝒕 𝑷𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔
v. Creditors Turnover Ratio= (In Times and Days)
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑨𝒄𝒄𝒐𝒖𝒏𝒕𝒔 𝑷𝒂𝒚𝒂𝒃𝒍𝒆
Credit Purchases = Credit Purchases net of returns
Average Accounts Payable = Average Accounts Payable (i.e. Creditors + B/P)
(𝑶𝒑𝒆𝒏𝒊𝒏𝒈 𝑪𝒓𝒔 & 𝐵/𝑃 +𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐶𝑟𝑠 & 𝐵/𝑃)
𝟐
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓(𝑵𝒆𝒕 𝒔𝒂𝒍𝒆𝒔)
vi. Working Capital Turnover Ratio= 𝑵𝒆𝒕 𝑾𝒐𝒓𝒌𝒊𝒏𝒈 𝑪𝒂𝒑𝒊𝒕𝒂𝒍 (In Times and Days)
[Also called Operating Turnover (or) Cash Turnover Ratio]
Turnover = Sales net of returns
Net Working Capital = Current Assets Less: Current Liabilities (Average of Opening and Closing balances may be taken)
Significance= Ability to generate sales per rupee of Working Capital.
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
vii. Fixed Assets Turnover Ratio= (In Times and Days)
𝑵𝒆𝒕 𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔
Net Fixed Assets = Net Fixed Assets (Average of Opening and Closing balances may be taken)
Significance= Ability to generate sales per rupee of Fixed Assets.
𝑻𝒖𝒓𝒏𝒐𝒗𝒆𝒓
viii.Capital Turnover Ratio = (In Times and Days)
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅
Capital Employed = (Average of Opening and Closing balances may be taken)
Significance = Ability to generate sales per rupee of long-term Investment.
IV. CAPITAL STRUCTURE RATIOS

These ratios measure the extent to which a company which has been financed by long term debt obligations
like Debt equity ratio. It measures the ability of an enterprise to survive over a long period of time.
𝑫𝒆𝒃𝒕
i. Debt to Total Funds Ratio = 𝑻𝒐𝒕𝒂𝒍 𝑭𝒖𝒏𝒅𝒔
Debt = Borrowed Funds (or) Loan Funds
= Debentures + Long-Term Loans from Banks, Financial Institutions, etc.
Total Funds = Long Term Funds (or) Capital Employed (or) Investment
= Debt + Equity......Liability Route
= Fixed Assets + Net Working Capital ..........Assets Route

Significance = Indicator of use of external funds. Ideal Ratio is 67%.
𝑬𝒒𝒖𝒊𝒕𝒚
ii. Equity to Total Funds Ratio = 𝑻𝒐𝒕𝒂𝒍 𝑭𝒖𝒏𝒅𝒔
Equity = Net Worth (or) Shareholders’ Funds (or) Proprietors’ Funds (or) Owners’ Funds (or) Own Funds
= Equity Share Capital + Preference Share Capital + Reserves & Surplus Less: Miscellaneous
Expenditure (as per Balance Sheet) and Accumulated Losses.
Total Funds = Long Term Funds (or) Capital Employed (or) Investment
= Debt + Equity......Liability Route
Significance = Indicates Long Term Solvency, mode of financing and extent of own funds used in operations.
Ideal Ratio is 33%.
𝑫𝒆𝒃𝒕
iii. Debt – Equity Ratio = 𝑬𝒒𝒖𝒊𝒕𝒚
Debt = Borrowed Funds (or) Loan Funds
= Debentures + Long-Term Loans from Banks, Financial Institutions, etc.
Equity = Net Worth (or) Shareholders’ Funds (or) Proprietors’ Funds (or) Owners’ Funds (or) Own Funds
Significance= Indicates the relationship between Debt & Equity. Ideal Ratio is 2:1.
𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑪𝒂𝒑𝒊𝒕𝒂𝒍+𝑫𝒆𝒃𝒕
iv. Capital Gearing Ratio = 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒉𝒐𝒍𝒅𝒆𝒓𝒔 𝑭𝒖𝒏𝒅𝒔
Preference Capital + Debt = Preference Share Capital and Debt i.e. Debentures + Long-Term Loans from Banks,
Financial Institutions, etc.
Equity Shareholders Funds = Equity Share Capital Less Preference Share Capital i.e.
= Equity Share Capital + Reserves & Surplus Less: Miscellaneous Expenditure (as
per Balance Sheet) and Accumulated Losses.
Significance = Show proportion of Fixed Charge (Dividend or Interest) Bearing Capital to Equity Funds, and
the extent of advantage or leverage enjoyed by Equity Shareholders.
𝑷𝒓𝒐𝒑𝒓𝒊𝒆𝒕𝒂𝒓𝒚 𝑭𝒖𝒏𝒅𝒔
v. Proprietary Ratio = 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
Proprietary Funds = Net Worth (or) Shareholders’ Funds (or) Proprietors’ Funds (or) Owners’ Funds (or) Own
Funds
Total Assets = Net Tangible Fixed Assets (+) Total Current Assets
Significance = Shows extent of Owner’s Funds, i.e. Shareholders’ Funds utilised in financing the assets of the
business.
𝑭𝒊𝒙𝒆𝒅 𝑨𝒔𝒔𝒆𝒕𝒔
vi. Fixed Asset to Long Term Fund Ratio = 𝑳𝒐𝒏𝒈 𝑻𝒆𝒓𝒎 𝑭𝒖𝒏𝒅𝒔
Fixed Assets = Net Fixed Assets, i.e. Gross Block (-) Depreciation
Long Term Funds = Debt + Equity......Liability Route
Significance= Shows proportion of Fixed Assets (Long-Term Assets) financed by long-term funds. Indicates
the financing approach followed by the Firm, i.e. Conservative, Matching or Aggressive. Ideal Ratio is less than
one.
V. LIQUIDITY RATIOS
These ratios show company’s ability to meet its short term financial obligation like current ratio and quick
ratio.

𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
i. Current Ratio= 𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒆𝒔
Current Assets = Inventories/Stocks
(+) Debtors & B/R
(+) Cash & Bank
(+) Receivables
(+) Accruals
(+) Shot Term Loans
(+) Marketable Investments/Short Term Securities
Current Liabilities = Sundry Creditors
(+) Outstanding Expenses
(+) Short Term Loans & Advances (Cr.)
(+) Bank Overdraft/Cash Credit
(+) Provision for Taxation
(+) Proposed Dividend
(+) Unclaimed Dividend
Significance = Ability to repay short-term liabilities promptly. Ideal Ratio is 2:1. Very high Ratio indicates
existence of idle Current Assets.
𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
ii. Quick Ratio= 𝑸𝒖𝒊𝒄𝒌 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔 OR Quick Assets / Current Liabilities
(Also called Liquid Ratio [or] Acid Test Ratio)
Quick Assets = Current Assets
(-) Inventories
(-) Prepaid Expense
Quick Liabilities = Current Liabilities
(-) Bank Overdraft
(-) Cash Credit
Significance = Ability to meet immediate liabilities. Ideal Ratio is 1:1
𝑪𝒂𝒔𝒉+𝑴𝒂𝒓𝒌𝒆𝒕𝒂𝒃𝒍𝒆 𝑺𝒆𝒄𝒖𝒓𝒊𝒕𝒊𝒆𝒔
iii. Absolute Cash Ratio [or] Absolute Liquidity Ratio =
𝑪𝒖𝒓𝒓𝒆𝒏𝒕 𝑳𝒊𝒂𝒃𝒊𝒍𝒊𝒕𝒊𝒆𝒔
Cash + Marketable Securities = Cash in Hand
(+) Cash at Bank (Dr)
(+) Marketable Investments/Short Term Securities
Significance = Availability of cash to meet short-term commitments. No ideal ratio as such. If Ratio > 1, it
indicates very liquid resources, which are low in profitability.
𝑸𝒖𝒊𝒄𝒌 𝑨𝒔𝒔𝒆𝒕𝒔
iv. Basic Defence Interval Measure= 𝑪𝒂𝒔𝒉 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 𝒑𝒆𝒓 𝑫𝒂𝒚 (In days)
Quick Assets = Current Assets
(-) Inventories
(-) Prepaid Expenses
𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒂𝒔𝒉 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔
Cash Expenses per Day =
𝟑𝟔𝟓
Cash Expenses = Total Expenses (-) Depreciation& write-offs. (cogs +selling, admin, distribution and general exp – dep)
Significance= Ability to meet regular Cash Expenses.
VI. OVERALL RETURN RATIOS – OWNER VIEW POINT

These ratios are especially important for investor while analysing information about a company. This analysis
helps the investors to decide about a company as an investment opportunity at a point of time. These ratios
are known as Stock market ratios, investment ratios and market test ratios.
i. Return on Investment (ROI) [or] Return on Capital Employed (ROCE) =

𝑬𝑩𝑰𝑻
Pre-tax ROCE: =
𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕
𝑬𝑨𝑻+𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑬𝒃𝒊𝒕(𝟏−𝒕)
Post-tax ROCE: = or
𝑬𝒒𝒖𝒊𝒕𝒚+𝑫𝒆𝒃𝒕 𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒆𝒎𝒑𝒍𝒚𝒆𝒅

• Either pre-tax or post-tax ROCE may be computed.

• Pre-tax ROCE is generally preferred for analysis purposes.
• Capital Employed = Investment
= Equity + Debt
Significance = Overall profitability of the business of the business on the Total Funds Employed.
ii. Return on Net Worth (RONW) =

𝑬𝑩𝑻
Pre-tax RONW: = 𝑬𝒒𝒖𝒊𝒕𝒚
𝑬𝑨𝑻
Post – tax RONW: =
𝑬𝒒𝒖𝒊𝒕𝒚
• Either pre-tax or post-tax ROE may be computed.
• Post-tax ROE is generally preferred for analysis purposes.
• Equity (or) Net Worth (or) Shareholders’ Funds (or) Proprietors’ Funds (or) Owners’ Funds
(or)Own Funds
Significance = Indicates profitability of Equity Funds/Owner’s Funds invested in the business.
iii. Return on Assets (ROA) =

𝑬𝑩𝑰𝑻 (𝟏−𝑻)
Return on Net Assets : =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑵𝒆𝒕 𝑨𝒔𝒔𝒆𝒕𝒔
𝑬𝑩𝑰𝑻 (𝟏−𝑻) 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝒂𝒇𝒕𝒆𝒓 𝑻𝒂𝒙+𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
Return on Assets: = OR
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
• Either pre-tax or post-tax ROA may be computed.
• Pre-tax ROA is generally preferred for analysis purposes.
• Average, i.e. ½ of Opening & Closing Balances of any of the following items –
(a) Total Assets, (or)
(b) Tangible Assets, (or)
(c) Fixed Assets.
Significance = Indicates Net Income per rupee of Average Total Assets or Tangible or Fixed Assets.
𝑹𝒆𝒔𝒊𝒅𝒖𝒂𝒍 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔
iv. Earnings per Share (EPS)= 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔
• Residual Earnings, i.e. EAT (-) Preference Dividend
𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
• Number of Equity Shares outstanding =
𝑭𝒂𝒄𝒆 𝑽𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
Significance = Income per share, whether or not distributed as dividends.
𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

v. Dividend per share(DPS)= 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔
• Profits distributed to Equity Shareholders.
Significance= Profits distributed per Equity Share.
𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

vi. Price Earnings Ratio (PE Ratio)= 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
• Average Market price (or closing Market price) as per Stock Exchange quotations. (Market
price per share = MPS)
Significance = Indicates relationship between MPS and EPS, and Shareholders’ perception of the Company.
𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
vii. Dividend Yield (%)= 𝑴𝒂𝒓𝒌𝒆𝒕 𝒑𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆
• Dividend
• Average MPS (or Closing MPS) as per stock Exchange quotations.
Significance = True return on Investment, based on Market Value on Market Value of Shares.
𝑬𝑺𝑯𝑭
viii. Book Value per Share= 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔

• Equity (or) Net Worth

𝑬𝒒𝒖𝒊𝒕𝒚 𝑪𝒂𝒑𝒊𝒕𝒂𝒍
• Number of Equity Shares outstanding =
𝑭𝒂𝒄𝒆 𝑽𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
Significance= Basis of Valuation of Shares based on Book Values.

ix. Market Value to Book Value= 𝑩𝒐𝒐𝒌 𝑽𝒂𝒍𝒖𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
• Average MPS (or Closing MPS) as per stock Exchange quotations.
Significance= Higher ratio indicates better position for Shareholders in terms of return & capital gains.
VII. CASH GENERATING EFFICIENCY RATIOS

𝑵𝒆𝒕 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔
i. Cash Flow Yield =
𝑵𝒆𝒕 𝑰𝒏𝒄𝒐𝒎𝒆
𝑵𝒆𝒕 𝑪𝒂𝒔𝒉 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔
ii. Cash Flow to Sales =
𝑵𝒆𝒕 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒇𝒓𝒐𝒎 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒊𝒆𝒔
iii. Cash Flow to Assets =
𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝑻𝒐𝒕𝒂𝒍 𝑨𝒔𝒔𝒆𝒕𝒔
VIII. FREE CASH FLOW RATIOS

i. Price to Free Cash Flow =
𝑭𝒓𝒆𝒆 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒂𝒔𝒉 𝑭𝒍𝒐𝒘
ii. Operating Cash Flow to Profit =
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑷𝒓𝒐𝒇𝒊𝒕
𝑰𝒏𝒕𝒆𝒓𝒏𝒂𝒍 𝑭𝒖𝒏𝒅𝒊𝒏𝒈
iii. Self – Financing Investment Ratio =
𝑵𝒆𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

From the information given below calculated the amount of Fixed assets and Proprietor’s Funds
Ratio of fixed assets to Proprietors Funds 0.75
Net working capital Rs 6,00,000
Question 4. [MAY 06]

JKL Limited has the following Balance Sheets as on March 31, 2006 and March 31, 2005:
Balance Sheet(Rs. in Lakhs)
Particulars March 31,2006 March 31, 2005
Sources of Funds
Shareholders’ funds 2,377 1,472
Loan Funds 3,570 3,083
5,947 4,555
Application of Funds
Fixed Assets 3,466 2,900
Cash and Bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407

Other Current Assets 1,567 1,404
Less: Current Liabilities (3,937) (3,794)
5,947 4,555
The Income Statement of the JKL Ltd. for the year ended is as follows: (Rs. in lakhs)
Particulars March 31, 2006 March 31, 2005

Sales 22,165 13,882

Less: Cost of Goods sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative expenses 1,135 752
Earnings before Interest and Tax (EBIT) 170 586
Interest Expense 113 105
Profit before tax 57 481
Tax 23 192
Profit after tax (PAT) 34 289
Required:
(i) Calculate for the year 2005-06:
a. Inventory Turnover Ratio
b. Financial Leverage
c. Return on Investment (ROI)
d. Return on Equity (ROE)
e. Average Collection Period.
(ii) Give a brief comment on the financial position of JKL Limited.
Question 5. [RTP]
You are required to calculate the Total Current Assets of Ananya Limited from the given information:
Stock Turnover Current liabilities Rs. 2,40,000
5 times Liquidity Ratio 1.25
Sales (All credit) Rs 7,20,000 Stock at the end is Rs 30,000 more than stock in the beginning
Gross Profit Ratio
25%

MN Limited gives you the following information related for the year ending 31 st March, 2009:
1. Current Ratio 2.5 : 1
2. Debt – Equity Ratio 1: 1.5
3. Return on Total Assets 15%
4. Total Assets Turnover Ratio 2
5. Gross Profit Ratio 20%
6. Stock Turnover Ratio 7
7. Current Market Price per Equity Share Rs. 16
8. Net Working Capital Rs. 4,50,000
9. Fixed Assets Rs. 10,00,000
10. 60,000 Equity Shares of Rs. 10 each
11. 20,000, 9% Preference shares of Rs. 10 each
12. Opening Stock Rs. 3,80,000
You are required to calculate:
a. Quick Ratio
b. Fixed assets Turnover Ratio
c. Proprietary Ratio
d. Earnings per share
e. Price Earnings Ratio.
Question 7. [STUDY MATERIAL(ADAPTED), NOV 10]

MNP Ltd made plans for the next year. It is estimated that the company will employ Total Assets Rs. 25,00,000, 30% of
the Assets being financed by Debt at an interest cost of 9% p.a. The Direct Costs for the year are estimated at Rs.
15,00,000 and all other Operating Expenses are estimated at Rs. 2,40,000. The Sales revenue are estimated at Rs.
22,50,000. Tax rate is assumed to be 40%. You are required to calculate – (i) Net Profit Margin, (ii) Return on Assets, (iii)
Asset Turnover, (iv) Return on Equity.

Question 8.
FLOW Ltd. has the following Profit &Loss Account for the year ended 31st March, 2010 and the Balance Sheet as on that
date:
Profit and Loss Account (For the year ended 31st March, 2010) (Rs. In lakhs)
Particulars Amount Particulars Amount

Opening Stock 1.75 Sales: Credit 12.00
Add: Manufacturing Cost 10.75 Cash 3.00
Less: Closing Stock (1.50)
Cost of Goods Sold 11.00
Gross Profit 4.00
15.00 15.00
Administrative expenses 0.35 Gross Profits 4.00
Selling expenses 0.25 Royalty Income 0.09
Depreciation 0.50
Interest 0.47
Income-Tax 1.26
Net Profit 1.26
4.09 4.09
Balance Sheet as on 31st March, 2010
Liabilities Rs. Assets Rs.
Equity Shares of Rs. 10 3.50 Plant and Machinery 10.00
10% Preference Shares 2.00 Less: Depreciation 2.50
Reserves and Surplus 2.00 Net Plant and Machinery 7.50
Long-term loan (12%) 1.00 Goodwill 1.40
Debentures (14%) 2.50 Stock 1.50
Creditors 0.60 Debtors 1.00
Bills Payable 0.20 Prepaid expenses 0.25
Accrued expenses 0.20 Marketable securities 0.75
Provision for Tax 0.65 Cash 0.25
12.65 12.65
The market price per share of FLOW Ltd. on 31st March, 2010 is Rs. 45.
Particulars (Rs. in lakhs)

Reserves at the beginning 1.465
Net Profit during the year 1.260
2.725
Preference Dividends 0.200
Equity Dividends 0.525
Reserves at the close of the year 2.000
Compute the following Ratios.
(1)Current Ratio; (2) Quick Ratio; (3) Debt Equity Ratio; (4) Interest coverage; (5) Fixed charge coverage; (6) Stock Turnover;
(7) Debtors Turnover; (8) Average collection period; (9) Gross Profit Margin; (10) Net Profit Margin; (11) Operating Ratio;
(12) Return on Capital Employed; (13) Earnings per share; (14) Return on shareholder’s funds; (15) P/E Ratio; and (16)
Earning Yield.
Question 9.
Excellence Ltd. has the following data for projections for the next five years. It has an existing Term Loan of Rs. 360 lakhs
repayable over next five years and has got sanctions for new term loan for Rs. 500 lakhs which is also repayable in five
years. As a Finance Manager you are required to calculate:

(i) Interest Service coverage ratio and

(ii) Debt Service Coverage Ratio
Particulars Amount(Rs. in Lakhs)
Profit after tax 480
Depreciation 155
Taxation 125
Interest on Term Loans 162
Repayment of Term Loans 178
Question 10. [STUDY MATERIAL]

In a meeting held at Solan towards the end of 2009, the Directors of M/s HPCL Ltd. has taken a decision to diversify. At
present HPCL Ltd. sells all finished goods from its own warehouse. The company issued debentures on 01.01.2010 and
purchased fixed assets on the same day. The purchase prices have remained stable during the concerned period.
Following information is provided to you:
INCOME STATEMENTS
Particulars 2009 (Rs.) 2010 (Rs.)
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 14,000
Interest on Debentures 49,000 2,000 59,000
Net Profit 15,000 17,000
BALANCE SHEET
2010
Particulars 2009 (Rs.) (Rs.)
Fixed Assets (Net Block) - 30,000 - 40,000
Debtors 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Creditors 50,000 76,000
Total Current Liabilities (CL) 50,000 76,000
Working Capital (CA – CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures - 30,000
1,00,000 1,47,000
You are required to calculate the following ratios for the years 2009 and 2010.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio

(vi) Net Profit to Net Worth Ratio, and

(vii) Debtors Collection Period.
Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons for change in
the ratios for 2 years. Assume opening stock of Rs. 40,000 for the year 2009. Ignore Taxation.
Question 11.
Compute Average collection Period from the following details by adopting a 360 days year (a) Average Inventory – Rs.
3,60,000, (b) Debtors – Rs. 2,40,000 (c) Inventory Turnover – 6 Times (d) GP Ratio – 10% (e) Credit Sales to Total Sales –
80%.

The total sales (all credit) of a firm are Rs. 6,40,000. It has a gross profit margin of 15 per cent and a current ratio of 2.5.
The firm’s current liabilities are Rs. 96,000; inventories Rs. 48,000; cash Rs. 16,000.
a) Determine the average inventory to be carried by the firm, if an inventory of 5 times is expected? (Assume a 360
day year).
b) Determine the average collection period if the opening balance of debtors is intended to be of Rs. 80,000?
(Assume a 360 day year).
Question 13. [STUDY MATERIAL

VRA Limited has provided the following information for the year ending 31st March 2015
Debt Equity Ratio 2:1
14% long term debt Rs 5,00,000
Gross Profit Ratio 30%
Return on equity 50%
Income Tax Rate 35%
Capital Turnover Ratio 1.2 times
Opening Stock Rs 4,50,000
Closing stock 8% of sales
You are required to prepare Trading and Profit and Loss Account for the year ending 31 st March, 2015.
Question 14.
From the following data, compute the Debt Equity Ratio – (a) Proprietary Ratio – 0.4 (b) Current ratio – 2.5 (c) Working
Capital Turnover ratio – 6 (d) Total Assets turnover Ratio – 1.5 (e) Sales- Rs. 12,00,000.

Additional information: Equity shares 80,000 @ 10 each Rs. 8,00,000 & 9% Preference shares of Rs. 3,00,000, Profit (after
tax at 35 per cent), Rs. 2,70,000; Depreciation, Rs. 60,000; Equity dividend paid, 20 per cent; Market price of equity
shares, Rs. 40.
You are required to compute the following, showing the necessary workings:
(a) Dividend Yield on the Equity Shares
(b) Cover for the Preference and Equity Dividends
(c) Earnings per Share
(d) Price-earnings Ratio.
Question 16(a).
Following are the ratios to the trading activities of Put Ltd.
Debtors Velocity – 3 months. Gross Profit -20%, Gross Profit for the year just ended was Rs. 5 lakhs.
Stock Velocity – 6 month Stock at the end of the year was Rs. 2,00,000 more than it was at the beginning
Creditors Velocity – 2 months. Bills Payable & Receivable were Rs. 36,667 & Rs. 60,000 respectively.
From the above, compute the figures of – (a)Sales , (b) Sundry Debtors, (c) Sundry Creditors, & (d) Stock.
Question 16(b). [NOV 12]

The following accounting information and financial ratios of M Limited relate to the year ended 31stMarch,2012:
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnovers Ratio 8 Times
Current Ratio 2.4


Total sales Rs. 30, 00,000; cash sales 25% of credit sales; cash purchases Rs. 2, 30,000; working capital
Rs.2, 80,000; closing inventory is Rs.80,000 more than opening inventory.You are required to
calculate:
(i) Average inventory
(ii) Purchases
(iii) Average Debtors
(iv) Average Creditors
(v) Average Payment Period
(vi) Average Collection Period
(vii) Current Assets
(viii) Current Liabilities
Question 17.
NOOR Limited provides the following information for the year ending 31st March, 2014:
Equity share capital Rs. 25,00,000
Closing Stock Rs. 6,00,000
Stock Turnover Ratio 5 times
Net Profit / Sale 20%
Net Profit / Capital 1/4
You are required to prepare, the Trading and Profit & Loss Account for the year ending 31st March, 2014.

From the following information, prepare a summarised Balance sheet as at 31st March 2002:
Working Capital Rs. 2,40,000
Bank overdraft Rs. 40,000
Fixed Assets to Proprietary Ratio 0.75
Reserves and Surplus Rs. 1,60,000
Current ratio 2.5
Liquid Ratio 1.5
Question 19.
From the following particulars prepare the Balance Sheet of Total Ltd as on 31-3-2010:-
Net profit 5% of turnover
Fixed Assets Rs. 6 lacs
G.P. 25%
Capital gearing 1.1
Current Ratio 2
Reserve 2/3 of net profits
Working Capital Rs. 4 lakhs
Creditors velocity 2 months
Fixed Assets to turnover 4
Stock velocity 2 months
Debtors velocity 1.5 months
Question 20.
Quick Ltd. provides the following information:
Sales Rs. 16,00,000
Current Ratio 2.9 times
Average collection period 64 days

Total Liabilities to Net worth 75%

Sales to net worth 2.3 times
Sales to closing inventory 4.5 times
Current Liabilities to Net worth 42%
You are required to prepare its summarized Balance sheet
Question 21. [STUDY MATERIAL, MAY 15]
Ganpati Limited has furnished the following ratios and information relating to the year ended 31st March, 2010.
Sales Rs. 60,00,000
Return on Net Worth 25%
Rate of Income Tax 50%
Share Capital to Reserves 7:3
Current Ratio 2
Net Profit to Sales 6.25%
Inventory Turnover (based on Cost of goods sold) 12
Cost of goods sold Rs. 18,00,000
Interest on Debentures Rs. 60,000
Sundry Debtors Rs. 2,00,000
Sundry Creditors Rs. 2,00,000
You are required to:
(a) Calculate the operating expenses for the year ended 31st March, 2010.
(b) Prepare a balance sheet as on 31st March in the following format:
Balance Sheet as on 31st March, 2010
Share Capital - Fixed Assets -
Reserve and Surplus - Current Assets
15% Debentures - Stock -
Sundry Creditors - Debtors -
Cash -
Question 22 . [NOV 05]

Using the following Data, complete the balance sheet given below:
Gross Profit Rs. 54,000
Shareholders’ Funds Rs. 6,00,000
Gross Profit Margin 20%
Credit sales to total sales 80%
Total assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8
Long term debt of Equity 40%
Balance Sheet
Creditors ………. Cash ……….
Long term Debt ………. Debtors ……….
Shareholders’ funds ………. Inventory ……….
Fixed Assets ……….

Question 23.
Below is given the balance Sheet of A Ltd. as on 31st March,2001 –
Share Capital: Fixed Assets:
14% Preference Shares 1,00,000 At Cost 5,00,000
Equity Shares 2,00,000 Less: Depreciation 1,60,000 3,40,000
General Reserves 40,000 Stock in trade 60,000
12% Debentures 60,000 Sundry Debtors 80,000
Current Liabilities 1,00,000 Cash 20,000
Total 5,00,000 Total 5,00,000
The following information is available. Prepare the forecast Balance Sheet as on 31st March 2002.
1. Fixed assets costing Rs. 1,00,000 to be installed on 1st April 2001 & would become operative on that date,
payment is required to be made on 31st March2002.
2. The Fixed Assets-Turnover Ratio would be 1.5 (on the basis of cost of Fixed Assets).
3. The Stock-Turnover Ratio would be 14.4 (on the basis of the opening & closing stock).
4. The break-up of cost and Profit would be as follows: Materials – 40%, Labour – 25%, Manufacturing Expenses –
10%, Office and Selling Expenses – 10% , Depreciation – 5%, Profit – 10% and Sales – 100% .The Profit is subject
to interest & taxation at 50%.
5. Debtors would be 1/9th of Sales which Creditors would be 1/5th of Materials Cost.
6. A Dividend at 10% would be paid on Equity Shares in March 2002.
7. Rs. 50,000, 12% Debentures have been issued on 1st April 2001.

Using the following, complete the balance sheet given below:
1. Total debt to net worth 1:2
2. Total assets turnover 2
3. Gross profit on sales 30%
4. Average collection period (assume 360 days in a year) 40 days
5. Inventory turnover ratio based on cost of goods sold and year-end inventory 3
6. Acid test ratio 0.75
Balance Sheet as on March 31, 2007
Equity Shares capital 4,00,000 Plant and Machinery and other fixed assets …..
Reserves and Surplus 6,00,000 Current assets:
Total Debt: Inventory …..
Current liabilities ….. Debtors …..
Cash …..

With the help of the following information complete the Balance Sheet of MNOP LTD:
Equity share capital Rs. 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to owner’s equity 0.60
Fixed assets to owner’s equity 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times


Using the following information, complete this balance sheet:
Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 times
Average collection period* 18 days
Inventory turnover 9 times
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.

Notes and payables 1,00,000 Cash -
Long-term debt - Accounts receivable -
Common stock 1,00,000 Inventory -
Retained earnings 1,00,000 Plant and equipment -
Total liabilities and equity - Total assets -
Question 27.
From the following particulars prepare the Balance Sheet of Krishna Ltd.
Current Ratio 2
Working Capital Rs. 2,00,000
Capital Block to Current Assets 3:2
Fixed Assets to Turnover 1:3
Sales Cash/Credit 1:2
Creditors Velocity 2 months
Stock Velocity 2 months
Debtors Velocity 3 months
Capital Block:
Net profit – 10% of turnover
Reserve – 2 1/2% of turnover
Debenture/Share Capital – 1:2
Gross Profit Ratio – 25% (of sales)
Question 28. [MAY 10, NOV 14]

The following figures and ratios are related to a company:
Sales for the year (all credit) Rs. 30,00,000 Current Ratio 1.5:1
Gross Profit Ratio 25% Debtors Collection Period 2 months
Fixed assets Turnover (basis on Cost of Goods Sold) 1.5 Reserves & Surplus to Share Capital 0.6:1
Stock Turnover (basis on Cost of Goods Sold) 6 Capital Gearing Ratio 0.5
Liquid Ratio 1:1 Fixed Assets to Net Worth 1.20:1
You are required to prepare:
1. Balance Sheet of the company on the basis of above details.
2. Statement showing Working Capital Requirements, if the company wants to make a provision for
contingencies at 10% of Net Working Capital including such provision.
Question 29.[STUDY MATERIAL]

Following is the abridged Balance Sheet of Alpha Ltd.:-


Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Debtors 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000
With the help of the additional information furnished below, you are required to prepare Trading and Profit & Loss
Account and a Balance Sheet as at 31st March, 2010:
(i) The company went in for reorganization of capital structure, with share capital remaining the same as follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Trade Creditors 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought and a further Rs. 5,000
depreciation written off.(The total fixed assets then constituted 60% of total gross fixed and current assets.)
(iii) Working capital ratio was 8:5.
(iv) Quick assets ratio was 1:1.
(v) The debtors (four-fifth of the quick assets) to sales ratio revealed a credit period of 2 months. There were no cash
sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the year.
Ignore Taxation.
Question 30.
From the following information and ratios, prepare the Profit and Loss Account and Balance Sheet of M/s Check & Co. an
export company. [Take 1 year = 360 days] (Ignore taxation).
Book value per share Rs. 40.00 Stock Turnover Ratio 5.00
Variable cost 60% Total liabilities to Net worth 2.75
Average collection Period 30 Days Long term Loan interest 12%
Financial Leverage (i.e. EBIT/EBT) 2.20 Net profit to sales 10%
Earnings per share (each of Rs. 10) Rs. 10.00 Current Ratio 3.00
Current Assets to stock 3:2 Net working capital Rs. 10 Lakhs
Acid test ratio 1.00 Fixed assets Turnover Ratio 1.20
Question 31.
Rate of gross profit 25%; Net profit to Equity Capital 10%; Stock turnover ratio – 5 times; Average debt collection period
– 2 months; Creditors velocity – 3 months; Current ratio – 2; Proprietary ratio (fixed assets to capital employed) 80%;
capital gearing ratio (Preference Shares and Debentures to Capital Employed) 30%; General reserve and profit and loss
to issued equity capital 25%; Preference share capital to debentures 2.
Cost of sales consists of 40% for materials and balance for wages and overheads. Gross profit is Rs. 3,00,000.
Prepare the projected Trading and Profit and Loss A/c for the next financial year ending 31 st December, 2010 and the
projected Balance Sheet as on that date:

XYZ Company’s details are as under:
Revenue: Rs. 29,261; Net Income: Rs. 4,212; Assets: Rs. 27,987: Shareholders’ Equity: Rs. 13,572. Calculate return on
equity.

Question 33.
Particulars Amount (Rs.)
Return 80,000
Sales 3,00,000
Capital Employed 2,25,000
Compute (a) Capital Turnover Ratio, (b) Net Operating Profit ratio and (c) Applying Du Pont analysis state the
relationship between the two.
Question 34.
Compute the Return on Capital Employed from the following data relating to company A and B applying Du Pont
analysis:-
Particulars Ram Ltd Shyam Ltd
Gross Profit Margin 30% Rs. 1,80,000 (15%)
Capital Employed Nil Rs. 2,00,000
Turnover on Capital Employed 4 Times Nil
Net Sales for the year Rs. 10,00,000 Nil
Operating Profit on Sales 5% 6%
Question 35.
Masco Ltd. has furnished the following ratios and information relating to the year ended 31st March 2021 :
Sales ₨ 75,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 6:4
Current ratio 2.5
Net profit to sales ( After Income tax) 6.50%
Inventory turnover ( based on cost of goods sold) 12
Cost of goods sold ₨ 22,50,000
Interest on debentures ₨ 75,000
Receivables (includes debtors ₨ 1,25,000) ₨ 2,00,000
Payables ₨ 2,50,000
Bank overdraft ₨ 1,50,000
You are required to :
a) Calculate the operating expenses for the year ended 31st March, 2021.
b) Prepare a balance sheet as on 31st March in the following format :
Liabilities ₨ Assets ₨
Share capital Fixed Assets
Reserves & Surplus Current Assets
15% Debentures Stock
Payables Receivables
Bank Term Loan Cash
Question 36.
The profit margin of a company is 10% and the capital turnover is 3 times. What is the return on investment (ROI) of the
company? Applying du Pont analysis, state by what percentage the company’s return on investment increase will or
decrease if –
(i) The profit margin decreases by 2%?
(ii) The profit margin increases by 2%?
(iii) The capital turnover decreases by 1?
(iv) The capital turnover increases by 1?
➢ Miscellaneous Theory

Question 37.
What are the types of Financial Statement analysis?
Solution 37:
Financial Statement Analysis may be of following types-
1. Internal and External Analysis:
Internal Analysis
(a) It is done within the company, i.e. by the corporate Finance Department.
(b) It is more extensive and detailed. It looks into all aspects of functioning and performance, viz. profitability,
Liquidity, Solvency, Coverage, Leverage, Turnover, and Overall Return.
External Analysis
(a) It is done by outside parties e.g. Bankers, Investors, Suppliers, etc.
(b) It is restricted according to the requirements of the user. For example, a Trade Creditor may be interested in the
general profitability and financial standing. A Lender may be interested and financial standing. A Lender may be
interested in Debt-Service Coverage, Interest Coverage, etc.
2. Inter – Firm and Intra-Firm analysis:
Inter-Firm Analysis
It involves comparison of Financial Statements of one Firm, with other Firms in the same industry.
Intra-Firm Analysis
it involves comparison of Financial Statements of one Firm for different time periods or different divisions of the
same year.
3. Horizontal and Vertical Analysis:
Horizontal Analysis
(a) It involves comparison of Financial Statements of one year with other years.
(b) Items are compared on a one-to-one basis, e.g. sales increase, comparative net profit for 2 year, etc.
Vertical Analysis
(b) It involves analysis of relationship between various items in the Financial Statements of one year.
(c) Relationship between items i.e. ratios or percentages are considered under analysis.
❖ Return on Equity using the Du Pont Model:

A finance executive at E.I. Du Pont de Nemours and Co., of Wilmington, Delaware, created the DuPont system of
financial analysis in 1919. That system is used around the world today and serves as the basis of components that
make up return on equity. There are various components in the calculation of return on equity using the traditional
DuPont model- the net profit margin, assets turnover, and the equity multiplier. By examining each input
individually, the sources of a company’s return on equity can be discovered and compared to its competitors.
(i) Profitability/ Net Profit Margin:
The net profit margin is simple the after-tax profit a company generates for each rupee of revenue. Net profit
margin varies across industries, making it important to compare a potential investment against its
competitors. Although the general rule-of-thumb is that a higher net profit margin is preferable. It is not
uncommon for management to purposely lower the net profit margin in a bid to attract higher sales.
Profitability / Net Profit margin = Profit / Net Income ÷ Sales / Revenue
Net profit margin is a safety cushion: the lower the margin, the less room for error. A business with 1% margins
has no room for flawed execution. Small miscalculations on management’s part could lead to tremendous
losses with little or no warnings.
(ii) Investment Turnover / Assets Turnover / Capital Turnover:

The assets turnover ratio is a measure of how effectively a company converts its assets into sales. It is
calculated as follows:
Investment Turnover / Assets Turnover / Capital Turnover = Sales / Revenue ÷ Investment / Assets /
Capital

The assets turnover ratio tends to be inversely related to the net profit margin; i.e., the higher the net profit
margins, the lower the assets turnover. The result is that the investor can compare companies using different
models (low profit, high-volume vs. high-profit, low-volume) and determine which one is the more attractive
business.
(iii) Equity Multiplier:

It is possible for a company with terrible sales and margins to take on excessive debt and artificially increase its
return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what
portion of the return on equity is the result of debt. The equity multiplier is calculated as follows:
Equity Multiplier = Investment / Assets / Capital ÷ Shareholder’s Equity
❖ Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin,
assets turnover, and equity multiplier.
Return on Equity = (Profitability/Net profit margin) (Investment Turnover / Asset Turnover / Capital
Turnover) Equity Multiplier)
Example:
XYZ Company’s details are as under:
Revenue: Rs 29,261; Net income: Rs 4,212; Assets: Rs 27,987; Shareholder’s Equity: Rs 13,572. Calculate return on
equity.
Solution:
Net Profit Margin = Net Income (Rs 4,212) ÷ Revenue (Rs 29,261) = 0.14439, or 14.39%
Asset Turnover = Revenue (Rs 29,261) ÷ Assets (Rs 27,987) = 1.0455
Equity Multiplier = Assets (Rs 27,987) ÷ Shareholders’ Equity (Rs 13,572) = 2.0621
Finally, we multiply the three components together to calculate the return on equity: (Rs 27,987)
Return on Equity = Net Profit Margin x Assets Turnover x Equity Multiplier

= (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%
Analysis: A 31.02% return on equity is good in any industry. Yet, if you were to leave out the equity multiplier to see
how much company would earn if it were completely debt-free, you will see that the ROE drops to 15.04% of the
return on equity was due to profit margins and sales, while 15.96% was due to returns earned on the debt at work
in the business. If you found a company at a comparable valuation with the same return on equity yet a higher
percentage arose from internally-generated sales, it would be more attractive.

Chapter 4
COST OF CAPITAL
Question 1.
What is the meaning of term “Cost of Capital”? And explain its aspects?
Solution 1:
1. Cost of Capital: For financing its operations, a firm can raise long-term funds through a combination of – (a) Debt,
(b) Preference Capital, and (c) Equity. The company has to service the above funds by paying Interest, Preference
Dividend and Equity Dividend respectively. The payment made by the company constitutes the cost of
obtaining/utilising that source of finance.
2. Aspects: Cost of Capital has the following two aspects – (a) Explicit, and (b) Implicit, described as under:
Explicit Cost of Capital Implicit Cost of Capital
Meaning It is the Discount Rate that equals the Present It is the rate of return associated with the best
Value of Cash Inflows, that are incremental to investment opportunity for the firm and its
the taking of financing opportunity, with the shareholders, that will be foregone, if the project
Present Value of its incremental Cash Outflows. presently under consideration by the firm were
accepted.
Measure It can be measured on a comparatively realistic It is based on the opportunity cost concept, and
and quantifiable basis. arises only when there are alternatives.
Decision Useful for making Capital Budgeting Decisions. Generally not considered in making capital
Making Budgeting decisions.
Question 2.
Explain the importance of the concept of Cost of Capital?
Solution 2:
Importance of Cost of Capital:
1. Helpful in comparative analysis of various sources of Finance: Cost of capital is helpful in comparative analysis of
various alternatives sources of finance. Which sources should be chosen, can be determined on the basis of cost of
capital.
2. Helpful in capital structure decisions: Cost of Capital is helpful in capital structure decisions. When the management
of the firm is to decide the optimum capital structure for the company then cost of capital should be minimised and
the value of the firm should be maximised.
Question 3.
How is value of a Bond determined?
Solution 3:
1. Present Value of a Bond or Debenture = Total Discounted Value of all its Cash Flows.
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝟒 𝑪𝑭𝒏
So, PV of a Bond = + + + + .............+
( 𝟏+𝑹)𝟏 ( 𝟏+𝑹)𝟐 ( 𝟏+𝑹)𝟑 ( 𝟏+𝑹)𝟒 ( 𝟏+𝑹)𝒏
2. Cash Flows (denoted as CF above) consist of: (a) annual Interest Payments, & (b) repayment of Principal. If there is
no risk of default, then there will not be much difficulty in calculating the cash flows associated with a bond, since
interest rate and schedule of repayment are known in advance.
3. Discount Rate (Denoted as R above) (also called Capitalisation Rate or Expectation Rate), depends on the extent of
risk associated with the bond, example: Government Bonds have a lower risk and lower discount rate, when
compared to debentures of a company.
Question 4.
A Company sells a 4 year Bond of Rs. 20,000 at 12.5% Interest per annum. The bond will be amortised equally over its life.
What will be the Present value of the Bond for an investor who expects a minimum rate of return of 12%?


Reserve Bank of India is proposing to sell a 5-year bond of Rs. 5,000 at 8 per cent rate of interest per annum. The bond
amount will be amortised over its life. What is the bond’s present value of an inventor if he expects a minimum rate of
return of 6 per cent?
Question 6.[STUDY MATERIAL, NOV 15]

(a) A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax bracket. You are required
to calculate the cost of debt after tax. If debentures are issued at (i) par, (ii) 10% discount and (iii) 10% premium.
(b) If brokerage is paid at 2% what will be cost of debentures if issue is at par?

A Company issues Rs. 10,00,000 12% debentures of Rs. 100 each. The debentures are redeemable after the expiry of fixed
period of 7 years. The Company is in 35% tax bracket. Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
a) Par;
b) 10% Discount;
c) 10% Premium.
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?

Institutional Development Bank(IDB) issued Zero interest deep discount bonds of face value of Rs.1,00,000 each issued at
Rs.2500 & repayable after 25 years. COMPUTE the cost of debt if there is no corporate tax.
Question 9.
A Company is considering raising funds of about Rs. 100 lakhs by one of two alternative methods, viz. 14% Institutional
Term Loan and 13% Non-Convertible Debentures. The Term Loan option would attract no major incidental cost. The
Debentures would be issued at a discount of 2.5% and would involve cost of issue Rs. 1 lakh. Advice the company as to
the better option based on effective cost of capital. Assume Tax Rate of 50%.
[Debentures Kd = 6.74% Rank I, Term Loan Kd = 7.00% Rank II]

If Reliance Energy is issuing preferred stock at Rs. 100 per share, with a stated dividend of Rs. 12, and a floatation cost of
3% then, what is the cost of preference share?

XYZ & Co. issues 2,000 10% preference shares of Rs. 100 each at Rs. 95 each. Calculate the Cost of Preference Shares.

Referring to the earlier question but taking into consideration that if the company proposes to redeem the preference
shares at the end of 10th year from the date of issue. Calculate the Cost of Preference Share?
[KP = 0.107]
Question 13.[MAY 13]

A company issued 40,000, 12% Redeemable Preference Shares of Rs.100 each at a premium of Rs. 5 each, redeemable
after 10 year at a premium of ` 10 each. The floatation cost of each share is Rs. 2.
You are required to calculate cost of preference share capital ignoring dividend tax.
Question 14.
Correct Ltd. issued 30,000 15% Preference shares of Rs. 100 each, redeemable at 10% premium after 20 years. Issue
Management Expenses were Rs. 30,000. Find out the Cost of Preference Capital, if shares are issued – (a) at par, (b) at a
premium of 10%, and (c) at a discount of 10%.
⧫ Dividend Price Approach

Question 15.
Bee Ltd. has a stable income and stable dividend policy. The average annual dividend payout is Rs. 27 per share (Face
value = Rs. 100). You are required to find out:
1. Cost of Equity Capital, if market price in Year 1 is Rs. 150.
2. Expected Market price in Year 2, if cost of Equity is expected to rise to 20%.
3. Dividend payout required in year 2, if the company were to have an expected Market Price of Rs. 160 per share, at
the existing Cost of Equity.
⧫ Earnings Price Approach

Question 16.
Renowned Ltd. has a uniform income that accrues in a four year business cycle. It has an average EPS of Rs. 25 (per share
of Rs. 100) over its business cycle. You are required to find out:
1. Cost of Capital, if Market Price in Year 1 is Rs. 150.
2. Expected Market Price in Year 2, if Cost of Equity is expected to rise to 18%
3. EPS in Year 2, if the Company were to have an expected Market Price of Rs. 160 per share, at the existing Cost of Equity.
⧫ Dividend Growth Model Approach

A company has paid dividend of Re. 1 per share (of face value of Rs. 10 each) last year and it is expected to grow @ 10%
next year. Calculate the Cost of Equity if the Market Price of Share is Rs. 55.
Question 18.
A company’s current price of share is Rs. 60 and dividend per share is Rs. 4. If its capitalisation rate is 12%, what is the
Dividend growth rate?

A company’s share is quoted in market at Rs. 40 currently. A company pays a dividend of Rs. 2 per share and investors
expect a growth rate of 10% per year, compute:
(a) The company’s cost of equity capital.
(b) If anticipated growth rate is 11% p.a. calculate the indicated market price per share.
(c) If the company’s cost of capital is 16% and anticipated growth rate is 10% p.a., calculate the market price if dividend
of Rs. 2 per share is to be maintained.
Question 20.
During the past four years following dividend has been paid by Bharat Ltd. which are as follows:
Year Ended Dividend per Share (Rs.)
2002 26
2005 30
The company has issued 10,000 ordinary shares of Rs. 100 each. The current market value of each ordinary share of Bharat
Ltd. is Rs. 235 cum-dividend. The 2005 dividend of Rs. 30 per share has just been paid. You are required to estimate the
cost of capital for Bharat Ltd. ordinary share capital.
Question 21.
A company’s policy is to pay dividends at the rate of 5% on the market price of the share in the beginning of year. Find the
growth rate if Ke = 12%.
⧫ Valuation of Equity Share Capital – Present Value of Future Dividend Flows

Question 22. [Study Material]
Calculate the cost of equity from the following data using realized yield approach:
Year 1 2 3 4 5
Dividend per 1.00 1.00 1.20 1.25 1.15
share

Price per share (at 9.00 9.75 11.50 11.00 10.60

the beginning)

Mr. Mehra had purchased a share of Alpha Limited for Rs.1,000. He received dividend for a period of five years at the rate
of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for Rs.1,128. You are required to COMPUTE
the cost of equity as per realised yield approach.
⧫ Capital Asset Pricing Model (CAPM)

Calculate the Cost of Equity of H Ltd., whose risk free rate of return equals 10%. The firm’s beta equals 1.75 and the return
on the return on the market portfolio equals to 15%.
Question 25.
Compute Cost of Equity if Interest on Government Bonds is 6%, Market Return is 18%, Beta Factor for Company K is 1.10.
Question 26.
The Risk-free return is 9% and the Market return is 15%. Ram intends to invest 80% of his money in an investment having
a beta of 0.8 and 20% of this investment having a Beta of 1.4. Required:
(i) What will be the return from each investment?
(ii) What will be his overall return?
(iii) What will be the Beta Factor for his total investment?
Question 27.
A Company has estimated that overall return for the Market will be 15%, Interest rate on Treasury securities will average
10%. Management has attached the following Probabilities to possible outcome:
Probability 0.2 0.3 0.2 0.2 0.1

Beta 1.00 1.10 1.20 1.30 1.40
(a) What is the required rate of return for the project using the mode – average beta of 1.10?
(b) What is the range of required rates of return?
(c) What is the expected value of required rate of return?
⧫ Cost of Equity using CAPM and Product Wise Beta

Question 28. [NOV 04 (ADAPTED)]
You are analysing the beta for XYZ Computers Ltd. and have divided the Company into four broad business groups, with
market values and betas for each group.
Business Group Market Value of Equity Beta

Main Frames Rs. 100 Billion 1.10
Personal Computers Rs. 100 Billion 1.50
Software Rs. 50 Billion 2.00
Printers Rs. 150 Billion 1.00
XYZ Computers Ltd. has Rs. 50 billion in debt outstanding. Required:
(i) Estimate the beta for XYZ Computers Ltd. as a Company.
(ii) If the Treasury bond rate is 7.5%, estimate the Cost of Equity for XYZ Computers Ltd. Estimate the Cost of Equity
for each division. Which Cost of Equity would you use to value the printer division? The average market risk
premium is 8.5%.
⧫ Realised Yield Approach

Question 29.
An individual wishes to purchase the share of a Company for Rs. 500. At present, the Company is expected to pay a
dividend of Rs. 40 on this share at the end of the year and its Market Price after the payment of the dividend is expected
to be Rs. 520. What is the Cost of Equity in this case, using Realised Yield Approach?

Question 30. [RTP]

Jet Ltd is a Large Company with several thousand shareholders. An investor buys 100 shares of the company at the
beginning of the year at a Market price of Rs. 225. The Par value of each share is Rs. 10. During the year, the company
pays a dividend at 25%. The Price of the share at the end of the Year is Rs. 267.50. Calculate the total return on the
Investment. Suppose the investor sells the shares at the end of the year, what would be the cash Inflows at the end of the
year?
⧫ Cost of Equity – Different Approaches
➢ Cost of Retained Earnings
Question 31.
How will you compute Cost of Retained Earnings?
Solution 31:
1) Cost of Retained Earnings is the opportunity cost of dividends foregone by Shareholders.
2) Cost of Reserves is generally taken the same as Cost of Equity. This is because, if earnings are paid out as dividends
without being retained, and simultaneously a Rights Issue is made, the investors would be subscribing to the issue
based on some expected return. This is taken as the indicator of the Cost of Reserves or Retained Earnings.
3) Cost of Reserves or Retained Earnings may be measured using: (a) Dividend Price + Growth Approach, or (b) Capital
Asset Pricing Model (CAPM) Approach.
Adjustment for brokerage, commission etc.
Kre = Ke (1 – tp)(1 – B)
tp = Personal Tax
B = Brokerage
⧫ Practical Problems
Question 32.
Calculate the cost of retained earnings from the following information:
Current market price of a share Rs. 140
Cost of Flotation/brokerage per share 3% on market price
Growth in expected dividend 5%
Expected dividend per share on new shares Rs. 14
Shareholders marginal/personal income tax 22%

Y Ltd. retains Rs. 7, 50,000 out of its current earnings. The expected rate of return to the shareholders, if they had invested
the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax bracket. Calculate the cost of
retained earnings.
➢ Weighted Average Cost of Capital

Question 34. [RTP, NOV 09]
What is meant by WACC? How is it determined?
Solution 34:
WACC is Weighted Average Cost of Capital also called overall cost of capital. It is determined with reference to the
proportion of various sources of funds in capital structure called weights. It is denoted by K 0.
Component Proportion or % Individual Cost Multiplication

Debt Wd After-Tax Kd Kd × Wd
Preference Capital Wp Kp Kp × Wp
Equity Capital We Ke Ke × We

Total K0 = WACC = Total of

above
➢ Weights to Cost
Question 35.
Explain Book Value Weights and Market Value Weights. Also bring out their merits and demerits?
Solution 35:
(a) Book Value Weights: The Weights are said to be Book value if the proportions of different sources are ascertained
on the basis of the face values i.e. the accounting values based on the value proportion in the company’s balance
sheet.
MERITS:
• Information readily available from the Company’s Balance sheet.
• Does not Fluctuate unless Company changes its Capital structure.
• Reflects Actual Cost/Outflow from the company.
DEMERITS:
• Does not reflect market trends.
• Not suitable for evaluation of new investments.
(b) Market Value Weights: The weights may also be calculated on the basis of the market value of different sources i.e.
the proportion of each source at its market value.
MERITS:
• Reflects Value of a firm better than Book value weights.
• More relevant for new Projects requiring fresh inflow of Capital.
• Reflects relative cost of different sources of finance.
DEMERITS:
• Data may not be readily available in all cases.
• Fluctuating in nature.
➢ Practical Problems
⧫ Computation of WACC
SK Limited has obtained funds from the following sources, the specific cost are also given against them:
Sources of Funds Amount Cost of capital

Equity Shares Rs. 30,00,000 15%
Preference Shares Rs. 8,00,000 8%
You are required to calculate Weighted Average Cost of Capital. Assume that corporate Tax rate is 30%.

PQR Ltd. has the following Capital Structure on 31st October:
Equity Share Capital (2,00,000 Shares of Rs. 10 each) Rs. 20,00,000
Reserves and Surplus Rs. 20,00,000
12% Preference Shares Rs. 10,00,000
9% Debentures Rs. 30,00,000
Total Rs. 80,00,000
The Market Price of Equity Share is Rs. 30. It is expected that the Company will pay next year, a dividend of Rs. 3 per share,
which will grow at 7% forever. Assume 40% Income tax rate. You are required to compute the Weighted Average Cost of
Capital of the Company using Market Value Weights.

The Capital Structure of a Company as on 31st March is as follows

Equity Share Capital (6,00,000 Shares of Rs. 100 each) Rs. 6.00 Crores
Reserves and Surplus Rs. 1.20 Crores
12% Debentures of Rs. 100 each Rs. 1.80 Crores
For the year ended 31st March, the company has paid Equity Dividend at 24%. Dividend is likely to grow by 5% every year.
Market Price of Equity Share is Rs. 600 per Share. Income Tax Rate applicable to the Company is 30%.
Required:
1. Compute the Current Weighted Average Cost of Capital.
2. The Company has a plan to raise a further Rs. 3 crores by way of Long Term Loan at 18% Interest. If the Loan is raised,
the Market Price of Equity Share is expected to fall to Rs. 500 per share. What will be the new Weighted Average Cost of
Capital of the Company?

The Capital Structure of a Company consists of Equity Shares of Rs. 50 lakhs; 10 percent Preference Shares of Rs. 10 lakhs
and 12 percent Debentures of Rs. 30 lakhs. The Cost of Equity Capital for the Company is 14.7 percent and income-tax rate
for this Company is 30 percent.
You are required to calculate the Weighted Average Cost of Capital (WACC).

Gamma Limited has in issue 5,00,000 Rs. 1 ordinary shares whose current ex-dividend market price is Rs. 1.50 per share.
The company has just paid a dividend of 27 paise per share, and dividends are expected to continue at this level for some
time. If the Company has no debt, what is the Weighted Average Cost of Capital?
⧫ WACC – Using Market Value Weights

Question 41. [MAY 14(similar)]
DUO Ltd. was incorporated recently its Capital Structure is as under in Market Value terms:
12% Debentures Redeemable at par in 10 years’ time Rs. 60 Lakhs
15% Preference Shares – Irredeemable Rs. 20 Lakhs
Equity Shares (3,20,000 Shares) Rs. 80 Lakhs
The Company’s Income Tax Rate is 35%. A study group has reported that the required Return on Equity Capital is 24% for
Companies in this line of business. You are required to compute the Company’s WACC.

The Capital Structure of MNP Ltd. is as under:
9% Debenture Rs. 2,75,000
11% Preference Shares Rs. 2,25,000
Equity Shares (Face Value: Rs. 10 per share) Rs. 5,00,000
Rs. 10,00,000
Additional information:
(i) Rs. 100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market price per
debenture is Rs. 105.
(ii) Rs. 100 per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The market price per
preference share is Rs. 106.
(iii) Equity share has Rs. 4 floatation cost and market price per share of Rs. 24. The next year expected dividend is Rs. 2
per share with annual growth of 5%. The firm has a practice of paying all earnings in the form of dividends.
(iv) Corporate income-tax rate is 35%.
Calculate Weighted Average Cost of Capital (WACC) using Market Value Weights.

The following is the Capital Structure of the Company:
Source of Capital Book Value Market Value
Equity Shares at Rs. 100 each Rs. 80,00,000 Rs. 1,60,00,000
9% Cumulative Preference Shares at Rs. Rs. 20,00,000 Rs. 24,00,000
100 each
11% Debentures Rs. 60,00,000 Rs. 66,00,000
Retained Earnings Rs. 40,00,000 Nil

The Current Market Price of the Company’s Equity Share is Rs. 200. For the last year, the Company had paid Equity
Dividend at 25% and its Dividend is likely to grow 5% every year. The corporate tax rate is 30% and shareholder’s personal
income tax rate is 20%. Calculate:
(1) Cost of Capital for each Source of Capital.
(2) Weighted Average Cost of Capital on the basis of Book Value Weights.
(3) Weighted Average Cost of Capital on the basis of Market Value Weights.
⧫ Kd , Ke and WACC
Question 44. [STUDY MATERIAL(SIMILAR),MAY 08, MAY 15, MAY 18(similar), MAY 2019(similar)]
ABC Ltd. wishes to raise additional finance of Rs. 20 lakhs for meeting its Investment Plans. The company has Rs. 4,00,000
in the form of retained earnings available for investment purposes. The following are the further details:
• Debt equity ratio 25: 75.
• Cost of debt at the rate of 10 percent (before tax) upto Rs. 2,00,000 and 13% (before tax) beyond that.
• Earnings per share, Rs. 12.
• Dividend payout 50% of earnings.
• Expected growth rate in dividend 10%.
• Current market price per share, Rs. 60.
• Company’s tax rate is 30% and shareholder’s personal tax rate is 20%.
Required:
(i) Calculate the post-tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance.

Beeta Ltd. has furnished the following information:
− Earning per share (EPS) 4
− Dividend pay out ratio 25%
− Market price per share 40
− Rate of Tax 30%
− Growth rate of dividend 8%
The company wants to raise additional capital of 10 lakhs including debt of 4 lakhs. The cost of debt (before tax) is 10%
upto 2 lakhs and 15% beyond that.
Compute the after tax cost of equity and debt and the weighted average cost of capital
⧫ WACC – Book Value and Market Value Weights

Question 46. [MAY 07, MAY 2019(similar)]
You are required to determine the Weighted Average Cost of Capital of a firm using – (i) Book Value Weights, and (ii)
Market Value Weights. The following information is available for your perusal:
1. Present book value of the firm’s capital structure is – Debentures of Rs. 100 each Rs. 8,00,000, Preference Shares of Rs.
100 each Rs. 2,00,000, Equity Shares of Rs. 10 each Rs. 10,00,000.
2. All these securities are traded in the capital markets. Recent Prices are: Debentures at Rs. 110, Preference Shares at Rs.
120 and Equity Shares at Rs. 22.
3. Anticipated external financing opportunities are as follows:
• Rs. 100 per Debenture redeemable at par: 20 years maturity 8% Coupon Rate, 4% Floatation Costs, Sale Prices Rs.
100.
• Rs. 100 Preference Shares redeemable at par: 15 years maturity, 10% Dividend Rate, 5% Floatation Costs, Sale prices
Rs. 100.
• Equity Shares: Rs. 2 per Share Floatation Costs, Sale Price Rs. 22.
In addition, the dividend expected on the Equity Share at the end of the year is Rs. 2 per share, the anticipated Growth
Rate in Dividend is 5% and the Firm has the practice of paying all its earnings in the form of dividend. The Corporate Tax
Rate is 50%.
⧫ WACC – Present and New Capital Structure

Question 47. [RTP, MAY 03]

JKL Ltd. has the following book-value capital structure:

Equity Share Capital (2,00,000 shares) 40,00,000
11.5% Preference Shares 10,00,000
10% Debentures 30,00,000
80,00,000
The equity share of the company sells for Rs. 20. It is expected that the company will pay next year a dividend of Rs. 2 per
equity share, which is expected to grow at 5% p.a. forever. Assume a 35% corporate tax rate.
(i) Compute weighted average cost of capital (WACC) of the company based on the existing capital structure.
(ii) Compute the new WACC, if the company raise an additional Rs. 20 lakhs debt by issuing 12% debentures. This would
result in increasing the expected equity dividend to Rs. 2.40 and leave the growth rate unchanged, but the price of
equity share will fall to Rs. 16 per share.
Comment on the use of weights in the computation of weighted average cost of capital.
⧫ Debt – Equity Ratio using WACC

Question 48.
Aries Ltd has a WACC of 18.00%. Its Capital Structure consists of Equity and Debt only. If the PE Ratio is 4, Interest Rate on
Debt Is 15%, Tax Rate is 35%, find out the Company’s Debt-Equity Ratio.
Question 49.
Step Ltd. has a WACC of 20.00%. Preference Capital (Dividend Rate 18%) constitutes 30% of the Total Capital Employed. If
the PE Ratio is 4, Interest Rate on Debt is 15%, Tax Rate is 35%, find out the ratio between Debt and Equity Capital in the
Company.
⧫ Effect of Debt Funding on Value of Equity Shares – WACC not affected by Gearing
Question 50. [RTP]

Zeta Ltd is presently financed entirely by Equity Shares. The current Market Value is Rs. 6,00,000. A Dividend of Rs.
1,20,000 has just been paid. This level of dividend is expected to be paid indefinitely. The Company is thinking of investing
in a new project involving an outlay of Rs. 5,00,000 now and is expected to generate Net Cash Receipts of Rs. 1,05,000 per
annum indefinitely. The project would be financed by issuing Rs. 5,00,000 Debentures at 18% Interest Rate. Ignoring tax
consideration:
1. Calculate the Value of Equity Shares & the gain made by Shareholders, if the Cost of Equity rises to 21.6%.
2. Prove that the Weighted Average Cost of Capital is not affected by gearing.
➢ Marginal WACC
Question 51
What is Marginal WACC?
Solution 51:
• Marginal Cost of Capital is the cost of raising an additional rupee of capital.
• It is derived when the Average Cost of Capital is computed with marginal weights. The weights represent the
proportion of funds the firm intends to employ.
• When the funds are raised in the same proportion as at present and if the component costs remains unchanged,
there
• will be no difference between Average Cost of Capital and Marginal Cost of Capital.
• As the level of capital employed increases, the component costs may start increasing. In such a case, both the WACC
and
• Marginal Cost of Capital will increase. But Marginal Cost of Capital will rise at a faster rate.

⧫ WACC and Marginal WACC

Question 52.
On January 1, 2005 the total market value of the Octane Company was Rs. 60 million. During the year, the company plans
to raise and invest Rs. 30 million in new projects. The firm’s present market value capital structure, shown below, is
considered to be optimal.
Assume that there is no short term debt.
Debt Rs. 3,00,00,000
Common Equity Rs. 3,00,00,000
Total Capital Rs. 6,00,00,000
New bonds will have an 8% coupon rate, and they will be sold at par. Common stock, currently selling at Rs. 30 a share,
can be sold to net the company Rs. 27 a share. Stockholders required rate of return is estimated to be 12% consisting of a
dividend yield of 4% and an expected constant growth rate of 8%. (The next expected dividend is Rs. 1.20, so, Rs. 1.20/30
= 4%) Retained Earnings for the year are estimated to be Rs. 3 million. The marginal corporate tax is 40%.
a) To maintain the present capital structure, how much of the new investment must be financed by common equity?
b) How much of the needed new common equity funds must be generated internally?
c) Calculate the cost of each of common equity component?
d) At what level of capital expenditures will the firm’s WACC increase?
e) Calculate the firm’s WACC using (1) the cost of retained earnings (First breaking point) and (2) the cost of new equity
(second breaking point) (3) WACC of additional funds Rs. 30 million.
⧫ Cost of Debt, Equity WACC and Marginal WACC

The R & G Co. has following capital structure at 31st March 2010, which is considered to be optimum
13% Debentures 3,60,000
11% Preference 1,20,000
Equity Share Capital (2,00,000 Shares) 19,20,000
The Company’s Share has a current market price of Rs. 27.75 per share. The expected Dividend per share in the next year
is 50% of the 2010 EPS of last 10 years is as follows. The past trends are expected to continue:
Year 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
EPS (Rs.) 1 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14% New Debenture. The Company’s Debenture is currently selling at Rs 98. The New Preference
Issue can be sold at a net price of Rs. 9.80, paying a dividend of Rs. 1.20 per share. The Company’s Marginal Tax Rate is
50%.
Required:
1. Calculate the After Tax Cost – (a) of new Debt and new preference Share Capital, (b) of ordinary Equity, assuming
new Equity comes from Retained Earnings.
2. Calculate the marginal cost of capital.
3. How much can be spent for Capital Investment before new ordinary share must be sold? Assuming that retained
earnings available for next year’s investment are 50% of 2010 earnings.
4. What will be Marginal Cost of Capital (Cost of fund raised in excess of the amount calculated in Part (3) , if the
company can sell new Ordinary shares to net Rs. 20 per share? Cost of Debt and of Preference Capital is constant.

ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March, 2010.
14% debentures 30,000
11% preference shares 10,000
Equity (10,000 shares) 1,60,000
2,00,000

The company share has a market price of Rs. 23.60. Next year dividend per share is 50% of year 2010 EPS. The following
is the trend of EPS for the preceding 10 years which is expected to continue in future.
Year EPS (Rs.) Year EPS (Rs.)
2001 1.00 2006 1.61
2002 1.10 2007 1.77
2003 1.21 2008 1.95
2004 1.33 2009 2.15
2005 1.46 2010 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of debenture is Rs. 96.
Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) was also issued. The company is in 50% tax bracket.
(A) Calculate after tax:
(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)
(B) Calculate marginal cost of capital when no new shares are issued.
(C) How much can be spent for capital investment before new ordinary shares must be sold. Assuming that retained
earnings for next year’s investment are 50 percent of 2010.
(D) What will the marginal cost of capital when the funds exceeds the amount calculated in (C), assuming new equity is
issued at Rs. 20 per share?
⧫ Cost of Equity, PSC Debt, WACC and Marginal WACC

ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, Rs. 10 par) Rs. 1,500 million
Reserves and Surplus Rs. 2,250 million
10.5% Preference Share Capital (1 million shares, Rs. 100 par) Rs. 100 million
9.5% Debentures (1.5 million debentures, Rs. 1,000 par) Rs. 1,500 million
8.5% Term Loans from Financial Institutions Rs. 500 million
income tax rate for the company is 35%.
The current market price per equity share is Rs. 60. The prevailing default risk free interest rate on 10-year GOI Treasury
Bonds is 5.5%. The average market risk premium is 8%. The beta of the company is 1.1875.
The preferred stock of the company is redeemable after 5 years is currently selling at Rs. 98.15 per preference share.
Required:
(i) Calculate weighted average cost of capital of the company using market value weights.
(ii) Define the marginal cost of capital schedule for the firm if it raises Rs. 7.50 million for a new project. The firm plans
to have a target debt to value ratio of 20%. The beta of new project is 1.4375. The debt capital will be raised through
term loans. It will carry interest rate of 9.5% for the first 100 million and 10% for the next Rs. 50 million.
➢ Miscellaneous Practical Problems
⧫ Equilibrium Price
Question 56.
A firm has next expected dividend of Rs. 3 with a growth rate at 8%. The risk free rate, RF is 10% and market rate of return,
Rm is 14%. Presently, the firm has a β, beta factor of 1.50. However, due to a decision of finance manager, β is likely to
increase to 1.75. Find out the present as well as the likely value of the share after the decision.
[Present value = Rs. 37.5; Likely value = Rs. 33.33]
Present Situation Likely value
1. Ke = Rf + β(ERm - Rf) 1. Ke = Rf + β(ERm - Rf)
= Ke = 10% + 1.5 (14% - 10%) = Ke = 10% + 1.75 (14% - 10%)
= 10% + 6% = 16% = 10% + 7% = 17%
2. Ke = (D1 / P0) + g 2. Ke = (D1 / P0) + g
16% = (3/P0 x 100) + 8% 17% = (3/P0 x 100) + 8%
8% = 300/P0 = P0 = 37.5 9% = 300/P0 = P0 = 33.33

⧫ Financing Decision of Projects – Comparison of ROCE and WACC

Question 57. [RTP]
M/s Robert Cement Corporation has a financial structure of 30% debt and 70% equity. The company is considering various
investment proposals costing less than Rs. 30 lakhs. The corporation does not want to disturb its present capital structure.
The cost of raising the debt and equity are as follows:
Project Cost Cost of Debt Cost of Equity

Upto Rs. 5 lakhs 9% 13%
Above Rs. 5 lakhs & upto Rs. 20 lakhs 10% 14%
Above Rs. 20 lakhs & upto Rs. 40 lakhs 11% 15%
Above Rs. 40 lakhs & upto Rs. 1 crore 12% 15.5%
Assuming the tax rate of 50%, you are required to calculate:
1. Cost of capital of two projects A & B whose funds requirements are Rs. 8 Lakhs and Rs. 21 lakhs respectively; and
2. If a project is expected to give after tax return of 11% determine under what conditions it would be acceptable.
⧫ Optimal Debt Equity Mix by Computing Composite Cost of Capital

Question 58.
For varying levels of Debt-Equity mix, the estimates of the cost of debt (after tax) and equity capital are given below:
Debt as % of Total Cost of Debt Cost of Equity
Capital Employed
0 Nil 15.0
10 7.0 15.0
20 7.0 15.5
30 7.5 16.0
40 8.0 17.0
50 8.5 19.0
60 9.5 20.0
You are required to decide on the optimal debt equity mix for the company by calculating the composite cost of capital.
[Optimum Debt Equity Mix = 40 : 60]
⧫ Ke Using WACC – Reverse Working

Question 59.
Display Ltd has a Debt Equity Ratio of 2 : 1 and a WACC of 12%. Its Debentures bear interest of 15%. Find out the cost of
Equity Capital. (Assume Tax = 35%)
Write short notes on the Cut off Rate?
Solution 60:
Cut off Rate: It is the minimum rate which the management wishes to have from any project. Usually this is based upon
the cost of capital. The management gains only if a project gives return of more than the cut-off rate. Therefore, the cut-
off rate can be used as the discount rate or the opportunity cost rate.

Chapter 5
FINANCING DECISIONS - CAPITAL STRUCTURE
➢ Meaning
Question 1. [STUDY MATERIAL, NOV 07, NOV 08]

What do you understand by Capital Structure?
Solution 1:
Capital Structure refers to the mix of a firm’s long term sources of funds such as debentures, preference share capital,
equity share capital and retained earnings for meeting total capital requirement.

What do you mean by Capital Structure? State its significance in financing decision.
Solution 2:
Concept of Capital Structure & its Significance in financing decision:
Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long term sources of funds such as debentures,
preference share capital, equity share capital and retained earnings for meeting its total capital requirement.
Significance in financing decision:

The capital structure decisions are very important in financial management as they influence debt – equity mix which
ultimately affects shareholders return & risk. These decisions help in deciding the forms of financing (which sources to be
tapped), their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation.
Therefore, such a pattern of capital structure must be chosen which minimises cost of capital and maximises the owner’s
return.
Question 3. [RTP, NOV 03, MAY 06, NOV 07]

Discuss the major consideration in Capital Structure planning?
OR
Discuss any five factors relevant in determining Capital Structure?
Solution 3:
The following are the five relevant factors which should be kept in view while determining the capital structure of a
company.
1. Risk: As a firm raises more debt, its risk of cash insolvency increases. The risk is not there in the case of equity shares.
There is risk of variations in the expected earnings available to equity shareholders.
2. Cost of Capital: A business should be at least capable of earning enough revenues to meet its cost of capital and finance
its growth.
3. Control: When a company issues further equity and preference shares, it automatically dilutes the controlling interest
of the present owners.
4. Trading on Equity: The effect of each proposed method of new finance on the earnings per share has to be carefully
analysed.
5. Tax Consideration: The provisions corporate taxation plays an important role in determining the choice between
different sources of financing.
Besides the above, the following factors are also relevant in determining capital structure.
(1) Government Policy (7) Size of the Company
(2) Legal Requirements (8) Purpose of financing
(3) Marketability (9) Period of finance
(4) Manoeuvrability (10) Cash flow ability of the company and nature of enterprise
(5) Flexibility (11) Requirement of investors
(6) Timing (12) Provision for future
Question 4. [STUDY MATERIAL, NOV 07, NOV 08]

What is Optimum Capital Structure?
Solution 4:
Optimum Capital Structure deals with the issue of right mix of debt and equity in the long term capital structure of a firm.
According to this, if a company takes on debt, the value of the firm increases upto a certain point. Beyond that point if
debt continues to increase then the value of the firm will start to decrease. If the company is unable to repay the debt
within the specified period then it will affect the goodwill of the company in the market. Therefore, company should select
its appropriate capital structure with due consideration of all factors.
Question 5.
Explain the meaning of under capitalization, its causes and effects?
Solution 5:
Under capitalization is a situation, when company’s actual capitalization is lower than its proper capitalization as
warranted by its earning capacity.
Under capitalization normally occurs with firms which have insufficient capital, but large secret reserves in the form of
considerable appreciation in the values of the fixed assets not brought into the books.
Causes of Under Capitalization:

1. Raising less money through issue of shares or debentures, than what is required for the firm’s operations.
2. Increase in sales and activity levels, not adequately supported by increase in capital base (both fixed assets and net
working capital).
Effects of Under Capitalization:

1. It encourages acute competition. High profitability encourages new entrepreneurs to come into same type of
business.
2. Higher profits of the company are viewed as higher prices for the firm’s product. So, consumer may feel that they are
being exploited.
3. Real Value of shares is higher than the book value. Further, Management may resort to manipulate the share values.
4. Higher market price of shares than that of other similar companies, because this company’s earning rate is
considerably higher. Dividend Rate will be higher in comparison with other companies.
5. Higher market price of shares than that of other similar companies, because this company’s earning rate is
considerably higher. This invites more government control and regulation on the company, and higher taxation also.
The following remedies are suggested:

1. The shares of the company should be split up. This will reduce the Dividend per share, though EPS shall remain
unchanged.
2. By revising upward the par value of shares in exchange of the existing shares held by them.
3. Issue of Bonus shares will reduce both Dividend per share and the Average Rate of earning.

Explain the meaning of over capitalization, its causes and effects?
Solution 6:
Over capitalization is a situation where a firm has more capital than what it needs, i.e. Assets are worth less than its Issued
Share capital, and earnings are insufficient to pay interest and dividend.
Over capitalization mainly arises when the existing capital is not effectively utilized on account of fall in earning capacity
of the company, while the company has raised funds more than its requirements. It is mainly identified by the fall in
payment of Interest and dividend, leading to fall in value of the shares of the company.
Causes of Over Capitalization:

1. Raising more money through issue of shares or debentures, than what the company can employ profitably.
2. Wrong estimation of earnings and capitalization.
3. Excessive payment for the acquisition of fictitious assets like Goodwill etc.
4. Borrowing huge amounts at a rate higher than what the company can earn.
5. Improper Provision for depreciation and replacement of assets and distribution of dividends at a higher rate.
Effects of Over Capitalization:

1. Considerable reduction in the rate of interest and dividend payments.
2. Reduction in Market Price of shares.
3. Resorting of ‘Window-dressing’ and profit manipulation by book adjustments.

4. Need for re-organisation or re-construction, and sometimes even leading to liquidation.
The following remedies are suggested:

(i) Thorough re-organisation.
(ii) Buy back of shares.
(iii) Reduction in claims of debentures holders and creditors.
(iv) Value of share may also be reduced. This will result in sufficient funds for the company to carry out replacement
of assets. [NEED TO CHECK FOR ACCURACY]
Question 7.
What are the features of an appropriate capital structure?
OR
List the fundamental principles governing capital structure. [NOV 12]
Solution 7:
The following are the major features of an appropriate capital structure:
1. Profitability: Capital is borrowed at minimum cost.
2. Flexibility: Structure should be flexible so that company may be able to raise fund or reduce fund whenever it is
required.
3. Solvency: Excessive debt may threat the solvency of the company, as it is fixed commitment.
4. Control: It should reduce the risk of dilution of control. The decisions relating to capital structure are taken after
keeping the control factor in mind. For e.g. when equity shares are issued the company automatically dilutes its
controlling.
Practical Problems
Effects of Different Modes of Financing Leverage Effects – Maximizing EPS

Question 8. [STUDY MATERIAL, RTP]
Goodluck Charm Ltd., a profit making company, has a paid-up capital of Rs. 100 lakhs consisting of 10 lakhs ordinary shares
of Rs. 10 each. Currently, it is earning an annual pre-tax profit of Rs. 60 lakhs. The company’s shares are listed and are
quoted in the range of Rs. 50 to Rs. 80. The management wants to diversify production and has approved a project which
will cost Rs. 50 lakhs and which is expected to yield a pre-tax income of Rs. 40 lakhs per annum. To raise this additional
capital, the following options are under consideration of the management:
a) To issue equity capital for the entire additional amount. It is expected that the new shares (face value of Rs. 10) can
be sold at a premium of Rs. 15.
b) To issue 16% non-convertible debentures of Rs. 100 each for the entire amount.
c) To issue equity capital for Rs. 25 lakhs (face value of Rs. 10) and 16% non-convertible debentures for the balance
amount. In this case, the company can issue shares at a premium of Rs. 40 each.
You are required to advise the management as to how the additional capital can be raised, keeping in mind that the
management wants to maximise the earnings per share to maintain its goodwill. The company is paying income tax at
50%.
⧫ Financing Pattern – Effects on EPS

Delta Ltd. Currently has an Equity Share Capital of Rs. 10,00,000 consisting of 1,00,000 Equity Shares of Rs. 10 each. The
company is going through a major expansion plan requiring to raise finds to the tune of Rs. 6,00,000. To finance the
expansion, the management has following plans:
Plan I Issue of 60,000 Equity shares of Rs. 10 each.
Plan II Issue of 40,000 Equity shares of Rs. 10, and the balance through long term borrowing at 12% interest p.a.
Plan III Issue of 30,000 Equity shares of Rs. 10 each and 3,000 Rs. 100 9% Debentures.
Plan IV Issue of 30,000 Equity shares of Rs. 10 each and balance through 6% preference shares.
The Company’s EBIT is expected to be Rs. 4,00,000 p.a. Assume Corporate tax rate of 40%. Required:
1. Calculate EPS in each of the above plan.
2. Ascertain the degree of financial leverage in each plan.

⧫ Financing Decision and EPS Maximisation

A Company earns a profit of Rs. 3,00,000 per annum after meeting its interest liability of Rs. 1,20,000 on 12% debentures.
The tax rate is 50%. The number of Equity Shares of Rs. 10 each are 80,000 and the retained earnings amount to Rs.
12,00,000. The company proposes to take up an expansion scheme for which a sum of Rs. 4,00,000 is required. It is
anticipated that after expansion, the company will be able to achieve the same return on investment as at present. The
funds required for expansion can be raised either through debt at the rate of 12% or by issuing Equity Shares at par.
Required:
(i) Compute the Earnings Per Share (EPS), if:
➢ The additional funds were raised as debt.
➢ The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.

The following figures are made available to you:
Net profits for the year 18,00,000
Less: Interest on secured debentures at 15% p.a.
(Debentures were issued 3 months after the commencement of (1,12,500 )
the year)
Profit before tax 16,87,500
Less: Income-tax at 35% and dividend distribution tax (8,43,750)
Profit after tax 8,43,750
Number of equity shares (Rs. 10 each) 1,00,000
Market quotation of equity share Rs. 109.70
The company has accumulated revenue reserves of Rs. 12 lakhs. The company is examining a project calling for an
investment obligation of Rs. 10 lakhs. This investment is expected to earn the same rate as funds already employed.
You are informed that a debt equity ratio (Debt divided by debt plus equity) higher than 40% will cause the price earnings
ratio to come down by 25% and the interest rate on additional borrowings will cost company 300 basis points more than
on their current borrowings in secured. You are required to advise the company on the probable price of the equity share,
if
a) The additional investment were to be raised by way of loans; or
b) The additional investments were to be raised by way of equity shares issued at Rs. 100 per share.
Question 12. [STUDY MATERIAL, NOV 2018(similar)]

The Modern Chemicals Ltd. requires Rs. 25,00,000 for a new plant. This plant is expected to yield earnings before interest
and taxes of Rs. 5,00,000. While deciding about the financial plan, the company considers the objective of maximising
earnings per share. It has three alternatives to finance the project-by raising debt of Rs. 2,50,000 or Rs. 10,00,000 or Rs.
15,00,000 and the balance, in each case, by issuing equity shares. The company’s share is currently selling at Rs. 150, but
is expected to decline to Rs. 125 in case the funds are borrowed in excess of Rs. 10,00,000. The funds can be borrowed at
the rate of 10% up to Rs. 2,50,000, at 15% over Rs. 2,50,000 and up to Rs. 10,00,000 and at 20% over Rs. 10,00,000. The
tax rate applicable to the company is 50%. Which form of financing should the company choose?
Question 13. [STUDY MATERIAL, RTP-MAY 2019(SIMILAR)]

A company provides the following figures:

Profit before interest and tax 52,00,000
Less: Interest on debentures @ 12% (12,00,000)
Profit before tax 40,00,000
Less: Income-tax @ 50% (20,00,000)
Profit after tax 20,00,000
Number of equity shares (of Rs. 10 each) 8,00,000
Earning per share (EPS) 2.50
Market price per share 25
P/E (Price/Earning) Ratio 10
The company is planning to start a new project requiring a total capital outlay of Rs.40,00,000. You are informed that a
debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio to 8 and rises the interest rate
on additional amount borrowed at 14%. FIND OUT the probable price of share if:

(i) the additional funds are raised as a loan.

(ii) the amount is raised by issuing equity shares.
(Note : Retained earnings of the company is Rs.1.2 crore)
Indifference Point
Question 14. [MAY 09, NOV 10, RTP]
What is meant by EPS Indifference Point?
Solution 14:
Indifference point is that level of EBIT at which EPS of different capital structures remains unchanged. While designing a
capital structure, a firm may evaluate the effect of different financial plans on the level of EPS, for a given level of EBIT.
{(EBIT - I ) (1- t ) – PD}/N1 = {(EBIT-I ) (1- t )}/N2
Where EBIT = Earnings before Interest & Tax
I = Interest on Debentures
t = Tax rate
N1 = No. of Equity Shares in alternative-1
N2 = No. of Equity Shares in alternative-2
PD = Preference Dividend
Question 15. [MAY 10, NOV 10]

What is meant by Financial Break-even point?
Solution 15:
Financial break-even point denotes the level of earnings at which a Firm’s EBIT is just sufficient to cover Interest, tax and
preference dividend. In other words, there are no Residual Earnings available to equity shareholders.
If the firm has employed debt only (and no preference shares), the financial break-even EBIT level is:
Financial break-even EBIT= Interest Charge

If the firm has employed debt as well as Preference Share Capital, then its Financial Break even EBIT level is:
Financial break-even EBIT= Interest Charge + Preference Dividend/(1-t)
Common Assumptions
(1) Only 2 sources (D + E)
(2) RE Taxes
(3) Overall CE = Same
(4) No Losses
(5) PBT = Dividend (All Profit distributed)

EBIT – EPS Indifference Point

Question 16. [STUDY MATERIAL, MAY 11, MTP, RTP-NOV 2019(similar)]
The management of Z Ltd wants to raise its funds from market to meet out the financial demands of its long term projects.
The Company has various combinations of proposals to raise its funds. You are given the following proposals of the
company:
Proposals % of Equity % of Debt % of Preference Shares

P 100 - -
Q 50 50 -
R 50 - 50
• Cost of Debt – 10%, Cost of Preference shares – 10%.

• Tax Rate – 50%.
• Equity Shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per shares.
• Total Investment to be raised Rs. 40,00,000.
• Expected Earnings Before Interest and Tax Rs. 18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan after computing the
following – (1) Earnings Per Share, (2) Financial Break Even Point, and (3) Compute the EBIT Range among the plans for
indifference. Also indicate if any of the plans dominate.

Calculate the level of EBIT at which EPS Indifference Point between the following financing alternatives will occur:
• Equity Share capital of Rs. 6,00,000 and 12% Debentures of Rs. 4,00,000 [or]
• Equity Share capital of Rs. 4,00,000, 14% Preference Share Capital of Rs. 2,00,000 and 12% Debentures of Rs. 4,00,000.
Assume that corporate Tax Rate is 35% and par value of Equity Share is Rs. 10 in each case.

A new project is under consideration in ZIP Ltd, which requires a Capital Investment of Rs. 4.50 crores. Interest on Term
Loan is 12% and Corporate Tax Rate is 50%. If the Debt Equity Ratio insisted by the financing agencies is 2:1. Calculate the
point of indifference for the project.
Question 19. [NOV 05, MTP, MAY 2019(similar)]

A company needs Rs. 31,25,000 for the construction of a new plant. The following three plans are feasible:
Plan I: The company may issue 3,12,500 Equity Shares at Rs. 10 per share
Plan II: The company may issue 1,56,250 ordinary Equity shares at Rs. 10 per share and 15,625 Debentures of Rs. 100
denomination bearing a 8% rate of interest.
Plan III: The company may issue 1,56,250 Equity shares at Rs. 10 per shares and 15,625 Preference shares at Rs. 100 per
share bearing a 8% rate of dividend.
1. If the company’s EBIT are Rs. 62,500, Rs. 1,25,000, Rs. 2,50,000, Rs. 3,75,000 and Rs. 6,25,000, what are the Earnings
Per share under each of three financial plans? Assume a corporate Income-tax rate of 40%.
2. Which alternative would you recommend and why?
3. Determine the EBIT – EPS Indifference Points by formulae between Financing Plan I & Plan II and Plan I & Plan III.
Question 20.
A Company has the choice of raising an additional sum of Rs. 25,00,000 either (i) by issue of 8% debentures, or (ii) issue of
additional equity shares @ Rs. 10 per share. Presently, the capital structure of the firm does not consist of any debt and
the company has issued 5,00,000 equity shares only. At what level of EBIT, after the new capital funds are acquired, would
the EPS be the same under different alternative financing plans. Also determine the level of EBIT at which uncommitted
earnings per share (UEPS) would be the same, if the sinking fund obligations amounting to Rs. 2,50,000 in respect of
debenture issue is to be made every year. Tax rate may be assumed at 50% and also verify the result.
Indifference Point – Alternative Financing Approaches

Question 21. [RTP (ADAPTED), STUDY MATERIAL]
Ganesha Limited is setting up a project with a capital outlay of Rs. 60,00,000. It has two alternatives in financing the project
cost.
Alternative (a): 100% equity finance in Rs. 200 shares.
Alternative (b): Debt-equity ratio 2:1

The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%. Calculate the indifference point
between the two alternative methods of financing.
Question 22. [STUDY MATERIAL, NOV 14]

Alpha Limited requires fund amounting to Rs. 80 lakhs for its new project. To raise the funds, the company has following
two alternatives:
(i) To issue Equity shares (at par) amounting to Rs.60 lakhs and borrow the balance amount at the interest of 12% p.a., or
(ii) To issue Equity shares (at par) and 12% Debentures in equal proportion.
The income tax rate is 30%.

Find out the point of indifference between the available two modes of financing and state which option will be beneficial
in different situations.

Toyo Limited presently has Rs. 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes to finance
a Rs. 40,00,000 expansion programme and is considering three alternatives: additional debt at 12 per cent interest,
preferred stock with an 11 per cent dividend, and the sale of common stock at Rs. 16 per share. The company presently
has 8,00,000 shares of common stock outstanding and is in a 40 per cent tax bracket.
a) If earnings before interest and taxes are presently Rs. 15,00,000, what would be earnings per share for the three
alternatives, assuming no immediate increase in profitability?
b) Develop an indifference chart for these alternatives. What are the approximate indifference points? To check one of
these points, what is the indifference point mathematically between debt and common stock?
c) Which alternative do you prefer? How much would EBIT need to increase before the next alternative would be best?
Question 24. [RTP]

ABC Ltd. plans to raise Rs. 5 lakhs for expansion purposes. The funds would be raised either by the issue of Rs. 50 Equity
Shares or debentures carrying 9% Interest. At present ABC Ltd. has a total capitalization of Rs. 10 lakhs, consisting entirely
of Rs. 50 Equity Shares. The present level of EBIT is Rs. 1,40,000 and tax rate is 50%. Calculate the EBIT at which EPS would
remain the same irrespective of the modes of financing.

X Ltd. is considering the following two alternative financial plans:
Particulars Plan I (Rs.) Plan II (Rs.)

Equity shares of Rs.10 4,00,000 4,00,000
each
12% Debentures 2,00,000 -
Preference shares of - 2,00,000
Rs.100 each
6,00,000 6,00,000
The indifference point between the plans is Rs.2,40,000. Corporate tax rate is 30%. Calculate the rate of dividend on
preference Shares.
Financial BEP, EBIT, EPS Indifference Point and Interpretation

Question 26. [RTP]
ABC Ltd wants to raise Rs 5,00,000 as additional capital. It has two mutually exclusive alternative financial plans. The
current EBIT is Rs 17,00,000 which is likely to remain unchanged. Tax rate is 50%. Other relevant information is:
Present Capital Structure 3,00,000 Equity shares of Rs 10 each and 10% bonds of Rs
20,00,000
Current EBIT Rs. 17,00,000
Current EPS Rs. 2.50
Current Market price Rs. 25 per Share

Financial Plan I 20,000 Equity Shares at Rs. 25 per share

Financial Plan II 12% debentures of Rs 5,00,000
What is the Indifference Level of EBIT? Identify the Financial Break Even Levels and Plot the EBIT – EPS lines on graph
paper. Which alternative Financial Plan is better?
Theories of Capital structure
Net Income Approach

Question 27.
Explain the Net Income approach of Demand?
Solution 27:
Net Income (NI) Approach: According to this approach, a firm can increase its value, i.e., it can lower its overall cost of
capital by increasing the proportion of debt in the capital structure. Higher debt content in the capital structure will result
in decline in overall or weighted average cost of capital. This will cause increase in the value of firm. Reverse will happen
in the converse situation.
The value of the firm on the basis of NI Approach can be ascertained as follows:
Where, Vf = VE + VD
Vf = Value of Firm
VE = Market Value of equity
VE = Market Value of Debt.
Market value of equity can be ascertained as follows:
VE = NI/Ke
Where
VE = Market Value of equity
NI = Earnings available for equity shareholders.
Ke = Equity Capitalisation Rate.

Rupa Company’s EBIT is Rs. 5,00,000. The company has 10%, 20 lakhs debentures. The equity capitalization rate i.e. Ke is
16%.
(i) Market value of equity and value of firm;
(ii) Overall cost of capital.
Question 29.
The following data relates to four firms:
Firm A B C D

EBIT Rs. 2,00,000 Rs. 3,00,000 Rs. 5,00,000 Rs. 6,00,000

Interest Rs. 20,000 Rs. 60,000 Rs. 2,00,000 Rs. 2,40,000
Equity Capitalisation Rate 12.00% 16.00% 15.00% 18.00%
Assuming that there are no taxes and Interest Rate on Debt is 10%, determine the value and WACC of each Firm using the
Net Income Approach. What happens if firm A borrows Rs 2 Lakhs at 10% to repay Equity capital?
Question 30.
Bajaj Ltd. has earnings before interest and taxes (EBIT) of Rs. 20 million. The company currently has outstanding debt of
Rs. 40 million at a cost of 8%.
(a) Using the net income (NI) approach and a cost of equity of 17.5%;
(1) Compute the total value of the firm and firm’s overall weighted average cost of capital (Ko) and
(2) Determine the firm’s market debt/equity ratio.
(b) Assume that the firm issues an additional Rs. 20 million in debt and uses the proceeds to retire stock; the interest rate
and the cost of equity remain the same.
(1) Compute the new total value of firm and the firm’s overall cost of capital and
(2) Determine the firm’s market debt/equity ratio.
Question 31.
AD Ltd. pays 100% of its earnings to its shareholders as dividends. Its funds requirement is met entirely by 1,00,000 shares
of common stock selling at Rs. 50 per share. Its EBIT would be Rs. 4,00,000
1. Compute value of Firm, cost of equity and overall cost of capital using NI approach.
2. The Company has decided to redeem Rs. 1 million of common stock, replacing it with 6% long term debt. Compute
overall cost of capital and value of firm after refinancing.
Net Operating Income Approach

Question 32.
Explain NOI (Net Operating Income) Approach? [RTP, MAY 12]
OR
Explain the assumption of NOI theory of Capital Structure?
Solution 32:
Net operating Income (NOI) Approach
According to this approach the market value of the firm is not at all affected by the capital structure changes. The market
value of the firm is ascertained by capitalizing the net operating income at the overall cost of capital (KO), which is
considered to be constant. The market value of equity is ascertained by deducting the market value of the debt from the
market value of the firm. According to the NOI Approach, the value of a firm is:
VF = EBIT/Ko
Where: VF = Value of firm;
KO = Overall cost of capital
EBIT = Earnings before interest and tax.

The value of equity VE is a residual value, which is determined by deducting the total value of debt VD from the total value
of the firm VF Thus, the value of equity VE can be determined by the following equation:
VE = VF – VD
Where: VE = Value of equity;
VF = Value of firm;
VD = Value of debt.

The NOI approach makes the following assumptions:

1. The investors see the firm as a whole and thus capitalises the total earnings of the firm to find value of the firm as a
whole.
2. The overall cost of capital, Ko , of the firm is constant and depends upon the business risk which also is assumed to
be unchanged.
3. The cost of debt, Kd , is also taken as constant.
4. The use of more and more debt in the capital structure increases the risk of the shareholders and thus results in the
increase in the cost of equity capital i.e., Ke . The increase in Ke is such as to completely offset the benefits of
employing cheaper debt, and
5. There is no tax.
Practical Problems
Amita Ltd’s operating income is Rs. 5,00,000. The firm’s of debt is 10% and currently the firm employs Rs. 15,00,000 of
debt. The overall cost of capital of the firm is 15%.
You are required to determine:
(i) Total value of the firm;
(ii) Cost of equity.

Z Ltd’s Operating Income (before Interest and Tax) is Rs. 9,00,000. The Firm’s Cost of Debt is 10% and currently the Firm
employs Rs. 30,00,000 of Debt. The Overall Cost of Capital of the Firm is 12%. Calculate the Cost of Equity.
Question 35.
Financial Ltd. has EBIT Rs. 20 million. The company currently has outstanding debt of Rs. 40 million at cost of 8%
(a) Using the net operating income approach and an overall cost of capital of 12%;
(1) compute the value of stock market value of firm, and the cost of equity and
(2) determine the firm’s market debt/equity ratio.
(b) Determine the answer to (a) if the company were to sell the additional Rs. 20 million in debt.

Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent debt and 50 per cent
equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are in market-value terms). The
borrowing rate for both companies is 8 per cent in a no-tax world, and capital markets are assumed to be perfect.
a) (i) If you own 2 per cent of the shares of Alpha Ltd., DETERMINE your return if the company has net operating income
of Rs.3,60,000 and the overall capitalisation rate of the company, K0 is 18 per cent?
(ii) Calculate the implied required rate of return on equity?

b) Beta Ltd. has the same net operating income as Alpha Ltd.
(i) DETERMINE the implied required equity return of Beta Ltd.?
(ii) ANALYSE why does it differ from that of Alpha Ltd.?
Question 37.
Explain Traditional Approach of Capital Structure?
Solution 37:
Traditional Approach: The Traditional Approach is also called an intermediate approach as it takes a midway between NI
approach and NOI approach. According to this approach the firm should strive to reach the optimal capital structure and
its total valuation through a judicious use of the both debt and equity in capital structure. At the optimal capital structure
the overall cost of capital will be minimum and the value of the firm is maximum. It further states that the value of the
firm increases with financial leverage upto a certain point. Beyond this point the increase in financial leverage will increase
its overall cost of capital and hence the value of firm will decline. This is because the benefits of use of debt may be so
large that even after offsetting the effect of increase in cost of equity, the overall cost of capital may still go down.
However, if financial leverage increases beyond an acceptable limit the risk of debt investor may also increase,
consequently cost of debt also starts increasing. The increasing cost of equity owing to increased financial risk and
increasing cost of debt makes the overall cost of capital to increase
Practical Problems
Equity shares are issued by Nature Ltd. with equity capitalization rate of 16% to fulfill its whole fund requirement of Rs.
20,00,000. The company is planning to redeem a part of capital by raising of debt. It has two alternatives to do so:
Alternative 1 : Raise debt to the limit of 30% of total funds. The rate of interest will be 10% and Ke to rise to 17%.
Alternative 2 : Raise debt to the limit of 50% of total funds. The rate of interest will be 12% and Ke will be 20%.
The operating profit (EBIT) would be Rs. 3,00,000. Using Traditional approach, Compute:
(1) Value of company; (2) Overall cost of capital.
MM Approach
Question 39.
Explain briefly Modigliani and Miller Approach on Cost of Capital? [MAY 07, NOV 02, MAY 09]
OR
Explain briefly the prepositions made in Modigliani and Miller Approach on Cost of Capital? [MAY 07, MAY 09]

OR
Explain briefly the assumptions of in Modigliani and Miller theory? [MAY 07]
Solution 39:
Modigliani-Miller Approach:
The Modigliani-Miller (MM) approach is similar to the Net Operating Income (NOI) approach. However, there is a basic
difference between the two. The NOI approach is purely definitional or conceptual. It does not provide operational
justification for irrelevance of the capital structure in the valuation of the firm. While MM approach supports the NOI
approach providing behavioural justification for the independence of the total valuation and the cost of capital of the firm
from its capital structure.
Assumptions:
The MM approach is subject to the following assumptions:
1. Capital markets are perfect.
2. The investors are well informed; and behave rationally.
3. Investors are free to buy and sell securities.
4. The firms can be classified into homogeneous risk classes. All firms within the same class will have the same degree
of business risk.
5. The investors can borrow without restriction on the same terms on which the firm can borrow; and there is no
borrowing cost.
6. All investors have the same expectation of a firm’s net operating income (EBIT) with which to evaluate the value of
any firm.
7. There are no retained earnings.
8. No Corporate income tax.
Propositions:
• Constant WACC: The Total Market Value of a firm and its Cost of capital are independent of its Capital structure. The
Total Market Value of the firm is given by capitalising the expected stream of operating earnings (i.e. Net Operating
Income) at a discount rate considered appropriate for its risk class.
• Ke = Ko + Premium for Risk: The cost of equity (Ke) is equal to Capitalisation Rate of pure Equity Stream Plus a
Premium for Financial Risk. The financial risk increases with more debt content in the capital structure. As a result,
Ke increases in such a manner as to off-set exactly the use of less expensive source of debt funds.
Cost of Equity = WACC + Risk Premium So, Ke = Ko + Debt / Equity (Ko – Kd)
• Investment-Financing Decisions: The cut off rate for investment purposes is completely independent of the mode of
financing. Hence every investment proposal can be evaluated at the rate applicable for such type of firms. Debt-
Equity mix is not relevant for capital budgeting decisions.
• Leverage Adjustment: Financial Leverage has no impact on market values, which remain constant for all firms in the
same risk class. In case such firms had different market values, investors will buy and sell shares and set aside the
leverage effect. Hence, Arbitrage will substitute personal leverage for corporate leverage.

Question 40. [RTP]

What will be the effect of Taxation on the value of the firm under MM Approach?
Solution 40:
1. Tax Saving: When taxes are paid on Corporate Income, use of debt Funds is advantageous due to the tax-saving effect
of Interest Payment. Equity Dividends and Retained Earnings are not “deductible” as an expense for taxation
purposes.
2. Effects of Tax saving: When Corporate Taxation is included in the analysis:
(a) Value of Firm will increase, and (b) Overall Cost of Capital will decrease.
3. Tax Shield: The effect of Tax Saving can be identified from the following relationships:
(a) Total Earnings in Levered Firm = Total Earnings in Unlevered Firm + Interest on Debt × Tax rate. [Here Total
Earnings = EAT + Interest i.e. the earnings available for equity and debt holders].
(b) Value of the Levered Firm will be greater than that of the Unlevered Firm, to the extent of the tax shield.
Hence, value of Levered Firm = Value of unlevered firm + Debt × tax rate.
Question 41. [RTP]

Explain the concept of Arbitrage under MM Approach?
Solution 41:
Modigliani and Miller argue that there is no difference in the market values of different firms in the same risk class. They
consider that financial leverage or use of debt in capital structure has no impact on market values. Their reasoning is as
under:
1. Buying and selling effect: In the same risk category (i.e. return expectation is the same), if the market values (i.e.
MPS) of different companies were to be different, investors in the high MPS Company will sell their holding and buy
the shares of low MPS Company.
2. Arbitrage: The movement in share prices will continue till both companies share prices settle at a constant. This is
attributed to the arbitrage effect. Through the above procedure, investors will move from a Leveraged Firm to
Unleveraged Firm and vice-versa, through the process of arbitrage. This will cease only when total Market Values of
both Firms are the same.
3. Constant Market Value and WACC: For a company in a particular risk class, the total market value must be same,
irrespective of level of Debt in the Company’s capital structure.
4. Same Risk = Same K0 = Same Market Value: Companies in different industries may have different risks, which will
result in their earnings being capitalized at different rates. However, companies in the same risk category will have
the same expected earnings (EBIT). This EBIT will be capitalized at the WACC (for that risk category) and hence Market
Values of all Companies in the same risk category (i.e. same WACC) will also be the same.
5. Movement in share prices: The buying and selling spree of Inventors will lead to increase in demand of the low MPS
Company’s Shares, causing its share price to increase. Similarly, due to sale of holdings, the price of high MPS
Company’s shares will fall.
Question 42.

Discuss the criticism of MM Approach?
Solution 42:
Modigliani and Miller Theory is criticised due to following reasons:
1. The argument that arbitrage nullifies the effect of leverage is not valid. Investors do not behave in such a calculated
and rational way in switching from leveraged to unleveraged firm or vice-versa.
2. The assumption of perfect market is not practical. In the real world, various imperfections exist, such as transaction
costs for purchase and sale of securities, differential rates of interest, etc.
3. The theory presumes the availability of free and upto date information on all aspects. Dealings in shares are based
not only upon the information on hand, but on other considerations also.
Value of Levered Firm is more than Value of Unlevered Firm

There are two firms N and M, having same earnings before interest and taxes i.e. EBIT of Rs. 20,000. Firm M is levered
company having a debt of Rs. 1,00,000 @ 7% rate of interest. The cost of equity of N company is 10% and of M Company
is 11.50%
Find out how arbitrage process will be carried on?

Following data is available in respect of two companies having same business risk:
Capital employed = Rs.2,00,000 ,EBIT = Rs.30,000 Ke = 12.5%
Sources Levered company (Rs.) Unlevered company (Rs.)

Debt (@ 10%) 1,00,000 Nil
Equity 1,00,000 2,00,000
Investor is holding 15% shares in levered company. CALCULATE increase in annual earnings of investor if he switches his
holding from Levered to Unlevered company.

There are two companies U Ltd. and L Ltd., having same NOI of Rs.20,000 except that L Ltd. is a levered company having a
debt of Rs.1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and 18% respectively.
COMPUTE how arbitrage process will work.

Following data is available in respect of two companies having same business risk:
Capital employed = Rs.2,00,000 ,EBIT = Rs.30,000
Sources Levered company (Rs.) Unlevered company (Rs.)

Debt (@ 10%) 1,00,000 Nil
Equity 1,00,000 2,00,000
Ke 20% 12.5%
Investor is holding 15% shares in Unlevered company. CALCULATE increase in annual earnings of investor if he switches
his holding from Unlevered to Levered Company.
Arbitrage Process when Value of Unlevered Firms is more than Value of

Levered Firm
There are two firms U and L having same NOI of Rs. 20,000 except that the firm L is a levered firm having a debt of Rs.
1,00,000 @ 7% and cost of equity of U and L are 10% and 18% respectively. Show how arbitrage process will work.
MM Approach – Levered and Unlevered Firm – Computing WACC

Question 48. [RTP- MAY 2018(similar), NOV 14]
Companies Uma and Lata are identical in every respects in every respect except that the former does not use Debt in its
capital structure, while the latter employs Rs 6 lakhs of 15% Debt. Assume that –
(a) All the M & M assumption are met,
(b) the corporate tax rate is 35%,
(c) the EBIT is Rs 2,00,000 and

(d) the equity capitalization of the Unlevered Company is 20%.

1. What will be the value of the Firms – Uma and Lata?
2. Determine the weighted Average Cost of Capital for both the firms.
Capital Structure and Taxation

Zion Company has earnings before interest and taxes of Rs. 30,00,000 and a 40 per cent tax rate. Its required rate of return
on equity in the absence of borrowing is 18 per cent.
(a) In the absence of personal taxes, what is the value of the company in an MM world (i) With no leverage? (ii) With Rs.
40,00,000 in debt? (iii) With Rs. 70,00,000 in debt?
(b) Personal as well as corporate taxes now exist. The marginal personal tax rate on common stock income is 25 per cent,
and the marginal personal tax rate on debt income is 30 per cent. Determine the value of the company for each of the
three debt alternatives in part (a). Why do your answers differ?

There are two firms Company A and B having Net operating income of Rs. 15,00,000 each. Company B is a levered company
whereas Company A is all Equity company. Debt employed by Company B is of Rs. 7,00,000 @ 11%. The tax rate applicable
to both the companies is 25%. Calculate earnings available for equity and Debt for both the firms.
NOI and MM Approach – Computation of Ko

Question 51. [RTP]
ABC Ltd adopts Constant-WACC Approach, and believes that its cost of debt and overall cost of capital is at 9% and 12%
respectively. If the ratio of the market value Debt to market value of Equity is 0.8, what Rate of Return do equity
shareholders earn? Assume that there are no taxes.
Question 52. [RTP-NOV 2018(similar), MAY 12]

RES Ltd. is an all equity financed company with a market value of 25,00,000 and cost of equity Ke = 21%. The company
wants to buyback equity share worth 5,00,000 by issuing and raising 15% perpetual debt of the same amount. Rate of tax
may be taken as 30%. After the capital restructuring and applying MM Model (with taxed), you are required to calculate:
(i) Market value of RES Ltd.
(ii) Cost of Equity Ke
(iii) Weighted average cost of capital and comment on it.
Traditional and MM Approach

Question 53.
DETERMINE the optimal capital structure of a company from the following information:
Options Cost of debt (Kd) in % Cost of equity (Ke) in % % of debt on total
value (debt + equity)
1 11 13.0 0.0
2 11 13.0 0.1
3 11.6 14.0 0.2
4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6
Miscellaneous Theory
Write a short note on Pecking Order Theory of Capital Structure?
Solution 54:
1. Donaldson’s Approach:
a) This Approach suggests that the Firm should use low-cost funds in order to minimize WACC and maximize its value.

b) According to this theory, to minimize overall cost, the order of raising finance should be: (i) Internal Cash Accruals,
(ii) Additional Debt, and (iii) Additional Equity. This is because issue cost of internally generated funds is the least,
and the issue cost of equity is the highest.
c) Therefore, a Firm should rely as much as possible, on internally generated funds. If these funds are not sufficient, the
Firm will move to additional debt and then to additional equity.
2. Myers’ Approach:
a) Myers has suggested that a Firm follows a ‘’modified pecking order’’ in their approach to financing.
b) Heavy reliance on internally generated funds is attributed to asymmetric information relating to the capital Market,
where issue of Equity Shares is interpreted in the Market, as bad news. So, the theory argues that a Firm will be
motivated to issue Equity Shares only when share markets are undeveloped.
c) If funds over and above internal cash accruals are required, the Firm will first resort to additional borrowings. Further
issue of Equity Shares will be the last resort for financing.
3. General Points: The Pecking Order Theory of Capital Structure has the following aspects:
a) Low Dividend Payout Ratio, i.e. a sticky dividend policy;
b) Preference for using internally generated funds;
c) Aversion to the issue of Equity Shares, which will be the last resort for financing.

Explain the term ploughing Back of Profits?
Solution 55:
A Public Limited Company must plough back a reasonable amount of Profit every year to comply with the legal
requirement in this regard and its own expansion plans. Such funds carry almost no risk. Also, control of present owners
is also not lost by retaining profits.

Sun Ltd. is considering two financing plans. Details of which are as under:
(i) Fund's requirement – Rs.100 Lakhs
(ii) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%
(iii) Cost of debt – 12% p.a.
(iv) Tax Rate – 30%
(v) Equity Share Rs.10 each, issued at a premium of Rs.15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) Rs.40 Lakhs
You are required to compute:

(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iv) Indifference point between Plan I and II
The Trade-Off Theory

• The trade-off theory of capital structure refers to the idea that a company chooses how much debt finance and how
much equity finance to use by balancing the costs and benefits. Trade-off theory of capital structure basically entails
offsetting the costs of debt against the benefits of debt.
• Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress and agency
costs. An important purpose of the trade-off theory of capital structure is to explain the fact that corporations usually
are financed partly with debt and partly with equity.
• It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing
with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff
leaving, suppliers demanding disadvantageous payment terms, bondholder/ stockholder infighting, etc).
• The first element of Trade-off theory of capital structure, considered as the cost of debt is usually the financial distress
costs or bankruptcy costs of debt. The direct cost of financial distress refers to the cost of insolvency of a company.

Once the proceedings of insolvency start, the assets of the firm may be needed to be sold at distress price, which is
generally much lower than the current values of the assets.
• A huge amount of administrative and legal costs is also associated with the insolvency. Even if the company is not
insolvent, the financial distress of the company may include a number of indirect costs like - cost of employees, cost
of customers, cost of suppliers, cost of investors, cost of managers and cost of shareholders.
• The firms may often experience a dispute of interests among the management of the firm, debt holders and
shareholders. These disputes generally give birth to agency problems that in turn give rise to the agency costs. The
agency costs may affect the capital structure of a firm.
• There may be two types of conflicts - shareholders-managers conflict and shareholders-debt holders conflict. The
introduction of a dynamic Trade-off theory of capital structure makes the predictions of this theory a lot more
accurate and reflective of that in practice.
As the Debt-equity ratio (i.e. leverage) increases, there is a trade-off between the interest tax shield and bankruptcy,
causing an optimum capital structure, D/E*
Pecking Order Theory

• This theory is based on Asymmetric information, which refers to a situation in which different parties have different
information. In a firm, managers will have better information than investors. This theory states that firms prefer to
issue debt when they are positive about future earnings. Equity is issued when they are doubtful and internal finance
is insufficient.
• The pecking order theory argues that the capital structure decision is affected by manager’s choice of a source of
capital that gives higher priority to sources that reveal the least amount of information. Myres has given the name
‘PECKING ORDER’ theory as here is no well-defined debtequity target and there are two kind of equity internal and
external. Now Debt is cheaper than both internal and external equity because of interest. Further internal equity is
less than external equity particularly because of no transaction/issue cost, no tax etc.
• Pecking order theory suggests that managers may use various sources for raising of fund in the following order.
1. Managers first choice is to use internal finance

2. In absence of internal finance they can use secured debt, unsecured debt, hybrid debt etc.
3. Managers may issue new equity shares as a last option.

Chapter 6
FINANCING DECISIONS- LEVERAGES
Question 1.
What is meant by Leverage? Explain the leverage used in financial analysis?
Solution 1:
• The term Leverage in general, refers to advantage gained for any purpose.
• In financial analysis, Leverage is used by business firms to quantify the risk-return relationship of different
alternative capital structures. Leverage magnifies the effect of changes in Sales, on EBIT and EPS.
• There are three commonly used measures of leverage in financial analysis. These are:
(a) Operating Leverage – For measuring the impact of Fixed Operating Costs,
(b) Financial Leverage – For measuring the impact of Interest Expenses,
(c) Combined Leverage – For measuring the impact of both Fixed Operating Costs and Interest Costs.
Question 2. [RTP]
Explain the meaning of Operating Leverage.
Solution 2:
• Operating Leverage is defined as the Firm’s ability to use fixed operating costs to magnify effects of changes in
sales on its EBIT.
• When sales changes, variable costs will change in proportion to sales while fixed costs will remain constant. So,
a change in sales will lead to a more than proportional change in EBIT. The effect of change in sales on EBIT is
measured by Operating Leverage.
• When Sales increases, Fixed Costs will remain the same irrespective of level of output, and so, the percentage
increase in EBIT will be higher than increase in sales. This is the favourable effect of Operating Leverage.
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
Operating Leverage =
𝑬𝑩𝑰𝑻
• When there is an increase or decrease in sales level the EBIT also changes. The effect of change in sales on the
level EBIT is measured by Operating Leverage. The Operating Leverage is also calculated as:
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻/𝑬𝑩𝑰𝑻
Operating Leverage = Or
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑺𝒂𝒍𝒆𝒔/𝑺𝒂𝒍𝒆𝒔
Question 3.
Explain Break-even point.
Solution 3:
Break-even analysis is a generally used to study the Cost Volume Profit analysis. It is concerned with computing the break-
even point. At this point of production level and sales there will be no profit and loss i.e. total cost is equal to total sales
revenue.
Product X (Rs.) Product Y (Rs.)
Selling Price 40 20
Variable Cost 20 12
Contribution 20 8
Total Contribution of 1,000 units 20,000 8,000
Fixed Cost 15,000 5,000
Profit (EBIT) 5,000 3,000
Break- even point (Fixed Cost / 𝟏𝟓,𝟎𝟎𝟎 𝟓,𝟎𝟎𝟎
= 750 units = 625 units
𝟐𝟎 𝟖
Contribution
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝟐𝟎,𝟎𝟎𝟎 𝟖,𝟎𝟎𝟎
Operating Leverage = 4 = 2.67
𝐄𝐁𝐈𝐓 𝟓,𝟎𝟎𝟎 𝟑,𝟎𝟎𝟎

There is a relationship between leverage and Break-even point. Both are used for profit planning. In brief the relationship
between leverage, break-even point and fixed cost as under:
Leverage Break - even point

1. Firm with high leverage 1. Higher Break-even point
2. Firm with low leverage 2 .Lower Break-even point
Fixed cost Operating leverage
1. High fixed cost 1. High degree of operating leverage
2. Lower fixed cost 2. Lower degree of operating leverage
Question 4.
Explain relation of Margin of Safety and Operating Leverage.
Solution 4:
In cost accounting, one studies that margin of safety (MOS) may be calculated as follows:
𝐒𝐚𝐥𝐞𝐬 − 𝐁𝐄𝐏 𝐒𝐚𝐥𝐞𝐬

MOS = x 100
𝐒𝐚𝐥𝐞𝐬
Higher margin of safety indicates lower business risk and higher profit and vice versa. If we both multiply and divide above
formula with profit volume (PV) ratio then:
𝐒𝐚𝐥𝐞𝐬 − 𝐁𝐄𝐏 𝐒𝐚𝐥𝐞𝐬 𝐏𝐕 𝐑𝐚𝐭𝐢𝐨 𝐒𝐚𝐥𝐞𝐬 𝐱 𝐏𝐕−𝐁𝐄𝐏 𝐱 𝐏𝐕

MOS = x =
𝐒𝐚𝐥𝐞𝐬 𝐏𝐕 𝐑𝐚𝐭𝐢𝐨 𝐒𝐚𝐥𝐞𝐬 𝐱 𝐏𝐕
we know that:
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
PV ratio = or Sales x PV ratio = Contribution
𝐒𝐚𝐥𝐞𝐬
𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
Further, BEP = or BEP × PV ratio = Fixed Cost
𝐏𝐕 𝐫𝐚𝐭𝐢𝐨
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 − 𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭 𝐄𝐁𝐈𝐓

So, MOS = =
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧
we know that:
DOL =
𝐄𝐁𝐈𝐓
hence:
𝟏
Degree of Operating Leverage =
𝐌𝐚𝐫𝐠𝐢𝐧 𝐨𝐟 𝐒𝐚𝐟𝐞𝐭𝐲
Let us Understand through the following example:
Particulars Product X (Rs.)

Sales (50 x 1000 units) 50,000
Variable Cost (30 x 1000 units) 30,000
Contribution 20,000
Fixed Cost 15,000
Profit (EBIT) 5,000
Break- even point (Fixed Cost / PV ratio) 15000/0.40 = 37,500
Margin of Safety = (50000-37500)/50000 0.25
Operating Leverage = Contribution/EBIT = 20000/5000 4
Operating Leverage = 1/MOS = 1/0.25 4
If Margin of safety Business Risk DOL (= 1/MOS)

Rises Falls Falls
Falls Rises Rises

When DOL is more than one (1), operating leverage exists. More is the DOL higher is operating leverage. A positive DOL/
OL means that the firm is operating at higher level than the break- even level and both sales and EBIT moves in the same
direction. In case of negative DOL/ OL firm operates at lower than the break-even sales and EBIT is negative.
Situation 1: No. Fixed Cost

Particulars 20,000 units (Rs.) 30,000 units (Rs.)
Sales @ Rs.10 2,00,000 3,00,000
Variable cost @ Rs. 5 1,00,000 1,50,000
EBIT 1,00,000 1,50,000
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 𝟓𝟎%

Degree of Operative leverage (DOL) = = = 1
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐬𝐚𝐥𝐞𝐬 𝟓𝟎%
Situation 2: Positive Leverage

Particulars (Rs.) (Rs.)
Sales @ Rs.10 2,00,000 3,00,000
Variable cost @ Rs. 5 1,00,000 1,50,000
Contribution 1,00,000 1,50,000
Fixed Cost 50,000 50,000
EBIT 50,000 1,00,000
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐄𝐁𝐈𝐓 𝟏𝟎𝟎%
Degree of Operative leverage (DOL) = = = 2
𝐏𝐞𝐫𝐜𝐞𝐧𝐭𝐚𝐠𝐞 𝐜𝐡𝐚𝐧𝐠𝐞 𝐢𝐧 𝐬𝐚𝐥𝐞𝐬 𝟓𝟎%
Situation 3: When EBIT is Nil (contribution = fixed cost)
Degree of Operative leverage (DOL) = = Undefined
𝟎
Analysis and Interpretation of operating leverage
S.No Situation Result
1 No fixed cost No operating leverage
2 Higher fixed cost Higher break - even point
3 Higher than break - even level Positive operating leverage
4 Lower than break - even level Negating operating leverage
Positive and Negative Operating Leverage
Operating Leverage
and EBIT
Negative Indefinite / Positive

Undefined
Operating at Lower Operating at Operating at a Higher Level

breakeven point than break-even point
than break-even
point
EBIT = - Ve EBIT = 0 EBIT = + Ve

Note: DOL can never be between zero and one. It can be zero or less or it can be one or more.
positive
DFL
1
Financial BEP*
0
EBIT
negative
When Sales is much higher than BEP sales, DOL will be slightly more than one. With decrease in sales DOL will increase.
At BEP, DOL will be infinite. When sales is slightly less than BEP, DOL will be negative infinite. With further reduction in
sale, DOL will move towards zero. At zero sales, DOL will also be zero.
Question 5. [RTP]
Explain the meaning of Financial Leverage.
Solution 5:
• Financial Leverage is defined as the ability of a Firm to use fixed financial charges (interest) to magnify the effects
of changes in EBIT (i.e. Operating Profits), on the Firm’s Earning Per Share (EPS).
• Financial Leverage occurs when a company has debt content in its capital structure and fixed financial charges,
e.g. interest on debentures. These fixed financial charges do not vary with the EBIT. They are fixed and are to be
paid irrespective of level of EBIT.
• When EBIT increases, the interest payable on debt remains constant, and hence residual earnings available to
equity shareholders will also increase more than proportionately.
• Hence an increase in EBIT will lead to a higher percentage increase in earnings per share (EPS). This is measured
by financial leverage.
𝑬𝑩𝑰𝑻
Financial Leverage = 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅
𝑬𝑩𝑻−
(𝟏−𝒕)
• When there is an increase or decrease in the level of E.B.I.T. level of Earnings per share (EPS) also changes. The
effect of changes in operating profit or EBIT on the level of Earning per share (EPS) is measured by financial
leverage. The financial leverage is also calculated as:
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑬𝑷𝑺/𝑬𝑷𝑺
Financial Leverage = Or
% 𝒄𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 𝑰𝒏𝒄𝒓𝒆𝒂𝒔𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻/𝑬𝑩𝑰𝑻

Positive and Negative Financial Leverage
Financial Leverage
Positive Indefinite / Negative

Undefined
EBIT level is more Operating at Financial EBIT level is less than Fixed
break even point Financial Charge
than Fixed Financial
Chargepoint
EPS: will change in No Profit no Loss EPS : Negative

the same direction
as EBIT
Analysis and Interpretation of Financial leverage
S. No Situation Result
1 No Fixed Financial Cost No Financial leverage
2 Higher Fixed Financial cost Higher Financial Leverage
3 When EBIT is higher than Financial Break-even Positive Financial leverage
point
4 When EBIT is levy then Finance Break-even Negating Financial leverage
point
Financial Leverage as a ‘Double edged Sword’

On one hand when cost of ‘fixed cost fund’ is less than the return on investment financial leverage will help to increase
return on equity and EPS. The firm will also benefit from the saving of tax on interest on debts etc. However, when cost
of debt will be more than the return it will affect return of equity and EPS unfavourably and as a result firm can be under
financial distress. This is why financial leverage is known as “double edged sword”.
Effect on EPS and ROE:
When, ROI > Interest – Favourable – Advantage
When, ROI < Interest – Unfavourable – Disadvantage
When, ROI = Interest – Neutral – Neither advantage nor disadvantage.

Note: DFL can never be between zero and one. It can be zero or less or it can be one or more.
positive
DFL
1
Financial BEP*
0
EBIT
negative
*Financial BEP is the level of EBIT at which earning per share is zero. If a company has not issued preference shares then
Financial BEP is simply equal to amount of Interest.
Question 6.
Differentiate between Operating Leverage and Financial Leverage.
Solution 6:
Operating Leverage Financial Leverage

• It indicates the tendency of operating profits (i.e. • It indicates the tendency of PBT to vary
EBIT) to vary disproportionately with sales. disproportionately with operating profit (i.e. EBIT).
𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑬𝑩𝑰𝑻
• DOL = • DFL =
𝑬𝑩𝑰𝑻 𝑬𝑩𝑻
• It is related to fixed cost. • It is related to interest on debt.
• High operating leverage indicates high operating • High financial leverage indicates high financial fixed
fixed cost. cost.
• If contribution exceeds fixed cost, operating • If ROI exceeds the rate of interest on debt, financial
leverage will be favourable and vice versa. leverage will be favourable and vice versa.
• It indicates Business Risk. • It indicates Financial Risk.
DOL DFL Remarks

Low Low Conservative, defensive company
Low High Ideal combination
Question 7.
What is Combined High Low Natural combination Leverage?
High High Risky combination.
Solution 7:
• Combined leverage is used to measure the total risk of a firm i.e. Operating Risk and Financial Risk.
• Effect of fixed operating costs (i.e. Operating Risk) is measured by Operating Leverage (DOL). Effect of fixed
interest charges (i.e. Financial Risk) is measured by Financial Leverage (DFL). The combined effect of these is
measured by Combined Leverage (DCL).

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏 𝑬𝑩𝑰𝑻 𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏

DCL = [DOL × DFL] = × = 𝑬𝑩𝑰𝑻−𝑷𝒓𝒆𝒇.𝑫𝒊𝒗/ (𝟏−𝒕)
𝑬𝑩𝑰𝑻 𝑬𝑩𝑰𝑻−𝑷𝒓𝒆𝒇.𝑫𝒊𝒗/(𝟏−𝒕)
• Degree of combined Leverage (DOL) measures the sensitivity of EPS to changes in sales. The combined Leverage
is also calculation as:
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 % 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺 % 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑷𝑺
DCL = [DOL × DFL] = × % 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝑬𝑩𝑰𝑻 =
% 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒂𝒍𝒆𝒔 % 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒔𝒂𝒍𝒆𝒔
⧫ Computation of DOL and DFL

Question 8. [STUDY MATERIAL, Nov 07]
CALCULATE the operating leverage for each of the four firms A, B, C and D from the following price and cost data:
Firms
A(Rs.) B(Rs.) C(Rs.) D(Rs.)
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage result? Explain.
Assume number of units sold is 5,000.
Question 9. [STUDY MATERIAL(similar), May 11]

You are given two financial plans of a company which has two financial situations. The detailed information is as under:
Installed Capacity 10,000 units

Actual Production and Sales 60% of installed capacity
Selling Price per unit Rs. 30
Variable cost per unit Rs. 20
Fixed cost Situation A = Rs. 20,000 Situation B = Rs. 25,000
Capital Structure of the company is as follows:

Financial Plans
XY (Rs) XM (Rs)
Equity 12,000 35,000
Debt (Cost of Debt 12%) 40,000 10,000
52,000 45,000
You are required to calculate operating Leverage and Financial Leverage of both the plans.

(i) You are required to calculate the Operating leverage from the following data:
Sales Rs. 50,000
Variable Costs 60%
Fixed Costs Rs. 12,000
(ii) You are required to calculate the Financial Leverage from the following data:
Net Worth Rs. 25,00,000
Debt /Equity 3:1
Interest rate 12%
Operating Profit Rs. 20,00,000

A Company produces and sells 10,000 shirts. The selling price per shirt is Rs. 500. Variable cost is Rs. 200 per shirt and fixed
operating cost is Rs. 25,00,000.

(a) Calculate operating leverage.

(b) If sales are up by 10%, then what is the impact on EBIT?
Question12. [NOV 12]

Find Ltd. has estimated that for a new product, its operating break-even point is 2,000 units, if the item is sold for Rs. 14
per unit. The cost accounting department has currently identified variable cost of Rs. 9 per unit. Calculate the operating
leverage for sales volume of Rs. 2,500 units and 3,000 units and their difference, if any?
Question 13.
Ram Ltd. produces Mobile phones with a selling price per unit of Rs. 100. Fixed cost amount to Rs. 2,00,000. 5,000 units
are produced and sold each year. Annual profits amount to Rs. 50,000. The company’s all equity-financed assets are Rs.
5,00,000.
The company proposes to change its production process, adding Rs. 4,00,000 to investment and Rs. 50,000 to fixed
operational costs. The consequences of such a proposal are:
(i) Reduction in variable cost per unit by Rs. 10
(ii) Increase in output by 2,000 units
(iii) Reduction in selling price per unit to Rs. 95
Assuming a rate of interest on debt is 10%, examine the above proposal and advice whether or not the company should
make the change. Ignore taxation. Also measure the degree of operating leverage and overall break-even-point.
⧫ Computation of Operating Leverage and Beta Analysis

Question14. [NOV 04, MAY 15]
The following summarizes the percentage changes in operating income, percentage changes in revenues, and betas for
four pharmaceutical firms.
Firm Change in Revenue Change in Operating Income Beta
PQR Ltd. 27% 25% 1.00
RST Ltd. 25% 32% 1.15
TUV Ltd. 23% 36% 1.30
WXY Ltd. 21% 40% 1.40
Required:
(i) Calculate the degree of operating leverage for each of these firms. Comment also.
(ii) Use the operating leverage to explain why these firms have different beta.
⧫ Computation of DOL, DFL and DCL

Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the
following firms:
Particulars N S D
Production (in units) 17,500 6,700 31,800
Fixed cost (Rs.) 4,00,000 3,50,000 2,50,000
Interest on loan (Rs.) 1,25,000 75,000 Nil
Selling price per unit (Rs.) 85 130 37
Variable cost per unit (Rs.) 38.00 42.50 12.00

(i) Consider the following information for Omega Ltd.:
Particulars Rs. (In lakhs)
EBIT (Earnings before Interest and Tax) 15,750
Earnings before Tax (EBT) 7,000
Fixed Operating costs 1,575

Required:
Calculate percentage change in earnings per share, if sales increases by 5%.

Annual sales of a company is Rs. 60,00,000. Sales to variable cost ratio is 150 per cent and fixed cost other than interest is
Rs. 5,00,000 per annum.
Company has 11 percent debentures of Rs. 30,00,000.
You are required to calculate the Operating, Financial and Combined leverage of the company.

The data relating to two Companies are as given below:
Particulars Company A Company B
Equity Capital Rs. 6,00,000 Rs. 3,50,000
12% Debentures Rs. 4,00,000 Rs. 6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit Rs. 30 Rs. 250
Fixed Costs per annum Rs. 7,00,000 Rs. 14,00,000
Variable Cost per unit Rs. 10 Rs. 75
You are required to calculate the Operating leverage, Financial leverage and Combined leverage of two Companies.

A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000
at 9% and equity of Rs. 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favorable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low assets leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to Rs. 50,00,000 what will be the new EBIT?
(vi) At what level the EBT of the firm will be equal to zero?
⧫ Computation of DOL, DCL and DFL and Beta Analysis

Question 20.
The following summarizes the percentage change in E.P.S. percentage change in revenues & betas for four companies in
mobile business
Name of Companies Change in Revenues Change in EPS Beta
Nokia 10% 50% 1.40
Motorola 20% 80% 1.27
Samsung 25% 75% 1.18
Blackberry 30% 75% 1.10
(a) Calculate the Degree of Combined Leverage for each of these companies.
(b) If the Degree of operating leverage of these four companies is 2.5, 2, 2.25 & 1.2 respectively for Nokia, Motorola,
Samsung and Blackberry. Compute Degree of financial Leverage.
(c) Explain why these companies have different betas.

You are given the following information of 5 firms of the same industry:
Name of the firm Change in revenue Change in operating Change in Earning per
income share
M 28% 26% 32%
N 27% 34% 26%
P 25% 38% 23%
Q 23% 43% 27%
R 25% 40% 28%


(i) Degree of operating leverage and
(ii) Degree of combined leverage
for all firms.
Question 22.
ABC Ltd. has its assets turnover ratio equal to 2. Its variable cost ratio is 60% of sales. Consider the following three different
capital structures and calculate the operating and financial leverages for the three different fixed costs:-
(a) Rs. 4,000.
(b) Rs. 6,000.
(c) Rs. 8,000.
Capital Structure
(In Rs.)
Particulars A B C
Equity 60,000 40,000 20,000
10% Debt 20,000 40,000 60,000
Which combination has the highest & lowest DCL?
Question 23. ___________________________________________________________________[MAY 07, NOV 09, NOV 14]

Explain the risk facing equity shareholders.
Or
Distinguish between Business Risk and Financial risk.
Solution 23:
Residual Earnings: A Firm can raise funds through a combination of – (a) Debt, (b) Preference Capital, and (c) Equity
Capital. Of the three sources, Equity Shareholders are entitled to Residual Earnings, i.e. after paying
Interest on Debt, and Preference Dividend.
Basis Business Financial
Meaning It refers to the risk associated with the firm’s If refer to the additional risk placed on the firm’s
operations. It is the uncertainty about future net equity shareholders as a result of debt use.
operating income (EBIT).
Nature It is unavoidable i.e. it cannot be controlled. It is avoidable i.e. it can be controlled.
Measurement It can be measured by standard deviation of the It can be measured with the help of ratios like,
Basic Earning power i.e. (ROCE). Debt to assets, etc.
Related To It is related to economic environment. It is related to use of debt in capital structure.
Formula DOL = Contribution/ EBIT DFL = EBIT/ EBT
Question 24.__________________________________________________________________[STUDY MATERIAL, MAY 92]
The following information is available in respect of two firms, P Ltd. and Q Ltd.: (In Rs. Lacs)
Particulars P Ltd. Q Ltd.
Sales 500 1,000
Less: Variable Cost 200 300
Contribution 300 700
Less: Fixed Cost 150 400
EBIT 150 300
Less: Interest 50 100
Profit before tax 100 200
You are required to calculate different leverages for both the firms and also comment on their relative risk position.
Question 25.________________________________________________________________[STUDY MATERIAL, MAY 2019]

The capital structure of ABC Ltd. consist of an ordinary share capital of Rs. 5,00,000 (equity shares of Rs. 100 each at par
value) and Rs. 5,00,000 (10% debenture of Rs. 100 each). Sales increased from 50,000 units to 60,000 units, the selling
price is Rs. 12 per unit, variable cost amounts to Rs. 8 per unit and fixed expenses amount to Rs. 1,00,000. The income tax
rate is assumed to be 50%.
You are required to calculate the following:
(a) The percentage increase in earnings per share;
(b) The degree of financial leverage at 50,000 units and 60,000 units;
(c) The degree of operating leverage at 50,000 units and 60,000 units;
(d) Comment on the behaviour E.P.S., operating and financial leverage in relation to increases in sales from 50,000 units
to 60,000 units.
Question26. ________[Study Material(similar),NOV 06, NOV 11 (SIMILAR), MAY 14, MAY 2016, NOV 2018, NOV 2019]
A company had the following Balance Sheet as on March 31, 2006:
Liabilities and Equity Rs. (In Crores) Assets Rs. (In Crores)
Equity Share Capital (1 crore 10 Fixed Assets (Net) 25
shares of Rs. 10 each)
Reserves and Surplus 2 Current Assets 15
15% Debentures 20
20
Current Liabilities 8
40 40
The additional information given is as under:
Fixed Costs per annum (excluding interest) Rs. 8 crores

Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required: Calculate the following and comment:
(i) Earnings per share (iii) Financial Leverage (v) Current Ratio
(ii) Operating Leverage (iv) Combined Leverage
➢ Computation of Leverage, EBIT for required EPS
Question 27. _____________________________________________________________________[Study Material]

The Sale revenue of TM excellence Ltd. @ Rs.20 Per unit of output is Rs.20 lakhs and Contribution is Rs.10 lakhs. At the
present level of output the DOL of the company is 2.5. The company does not have any Preference Shares. The number of
Equity Shares are 1 lakh. Applicable corporate Income Tax rate is 50% and the rate of interest on Debt Capital is 16% p.a.
What is the EPS (At sales revenue of Rs. 20 lakhs) and amount of Debt Capital of the company if a 25% decline in Sales will
wipe out EPS.
Question 28.___________________________________________________________________________ [NOV 09]

Z Limited is considering the installation of a new project costing Rs. 80,00,000. Expected annual sales revenue from the
project is Rs. 90,00,000 and its variable costs are 60 percent of sales. Expected annual fixed cost other than interest is Rs.
10,00,000. Corporate tax rate is 30 percent. The company wants to arranges the funds through issuing 4,00,000 equity
shares of Rs. 10 each and 12 percent debentures of Rs. 40,00,000.
(i) Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
(ii) Determine the likely level of EBIT, if EPS is (1) Rs. 4, (2) Rs. 2, (3) Rs. 0.
➢ Computation of Leverage and effects of changes in Sales on EPS.

Question 29.___________________________________________________________________ [STUDY MATERIAL]
PL Forgings Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31st


Equity Capital (Rs. 10 per share) 8,00,000 Net Fixed Assets 10,00,000
10% Debt 6,00,000 Current Assets 9,00,000
Retained Earnings 3,50,000
Current Liabilities 1,50,000
19,00,000 19,00,000
Income Statement for the year ending March 31

Particulars Rs.
Sales 3,40,000
Operating expenses (including Rs. 60,000 depreciation) (1,20,000)
EBIT 2,20,000
Less: Interest (60,000)
Earnings before tax 1,60,000
Less: Taxes (56,000)
Net Earnings (EAT) 1,04,000
(a) Determine the degree of operating, financial and combined leverages at the current sales level, if all operating
expenses, other than depreciation, are variable costs.
(b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 per cent, what
will be the earnings per share at the new sales level?
Question 30. ___________________________________________________________________[STUDY MATERIAL]

The following information is available for a concern for the year ended 31.3.2011.
Total Sales (Quantity) 100,000 units
Fixed Cost Rs. 12,60,000
Variable Cost 55% of sales
Debt (@ 10%) Rs. 54,00,000
Equity (Face value of each share of Rs. 10) Rs. 50,00,000
Income tax rate 35%
Selling price per unit Rs. 80
You are required to find out –
1. Income Statement for the year ended 31.3.2011.
2. Operating and Financial Leverage
3. Company’s Return on Investment
4. How much of the Company’s sales have to come down so that earning of the company before tax comes down to
zero?
Question 31. ________________________________________________________________________[STUDY MATERIAL]

XYZ Ltd. sells 2,000 units @ Rs. 10 per unit. The variable cost of production is Rs. 7 and fixed cost is Rs. 1,000. The company
raised the required funds by issue of 100, 10% debentures @ Rs. 100 each and 2,000 equity shares @ Rs. 10 per share. The
sales of XYZ Ltd. are expected to increase by 20%. Assume tax rate of company is 50%. You are required to calculate the
impact of increase in sales on earning per share.
➢ Reverse Working with DCL
Question 32. ________________________________________________________________________[NOV 08, MAY 09]

A company operates at a production level of 1,000 units. The contribution is Rs. 60 per unit, operating leverage is 6, and
combined leverage is 24. If tax rate is 30%, what would be its earnings after tax?

➢ Reverse Working with DFL - ROE and ROI with Interest Rate and Leverage.
Question 33._______________________________________________________________________________ [MAY 07]
ABC Limited has an average cost of debt at 10 percent and tax rate is 40 per cent. The financial leverage ratio for the
company is 0.60. Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20%.
➢ Reverse Working with DCL- ROE and ROI
Question 34. _______________________________________________________________________[STUDY MATERIAL]

The net sales of Carlton Limited is Rs. 30 crores. Earnings before interest and tax of the company as a percentage of net
sales are 12%. The capital employed comprises Rs. 10 crores of equity, Rs. 2 crores of 13% Cumulative Preference Share
Capital and 15% Debentures of Rs. 6 crores. Income-tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments due to the presence of Preference Share
Capital and Borrowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that combined leverage is 3.
⧫ Reverse Working with All Leverages

Question 35._____________________________________________________________________ [MAY 07, NOV 2017]
The following details of RST Limited for the year ended 31st March, 2006 are given below:
Operating leverage 1.4 times
Combined leverage 2.8 times
Fixed cost (Excluding interest) Rs. 2.04 lakhs
Sales Rs. 30.00 lakhs
12% Debentures of Rs. 100 each Rs. 21.25 lakhs
Equity Share Capital of Rs. 10 each Rs. 17.00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial leverage.
(ii) Calculate P/V ratio and Earning per Share (EPS).
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets leverage?
(iv) At what level of sales the Earning before Tax (EBT) of the company will be equal to zero?
Question 36. ______________________________________ ___________________[STUDY MATERIAL, NOV 97, NOV 15]

From the following prepare Income statement of Company A, B and C.
Company A B C
Financial Leverage 3:1 4:1 2:1
Interest Rs. 200 Rs. 300 Rs. 1,000
Operating Leverage 4:1 5:1 3:1
𝟐
Variable cost as a percentage to sales 66 % 75% 50%
𝟑
Income tax rate 45% 45% 45%
Question 37. ________________________________________________________________________________[NOV 09]

From the following data of Company A and Company B, Prepare their Income Statement
Particulars Company A Company B
Variable cost Rs. 56,000 60% of sales
Fixed Cost Rs. 20,000 -
Interest Expense Rs. 12,000 Rs. 9,000
Financial Leverage 05:01 -

Operating Leverage - 04:01

Income tax rate 30% 30%
Sales - Rs. 1,05,000
➢ Miscellaneous Practical Problems

Question 38.
Show the effect of Trading on equity on ROE of an entity from the following information:-
Particulars (Rs. in 000's)
Total Assets 2000
Debt Equity Ratio
Case I 0:1
Case II 1:4
Case III 2:3
Tax rate – 35%, Rate of Interest – 15%, Return on Investment – 30%.
Question 39. __________________________________________________________________________[Study Material]

X Ltd. details are as under:
Sales (@ 100 per unit) Rs. 24,00,000

Variable Cost 50%
Fixed cost Rs. 10,00,000
It has borrowed Rs. 10,00,000 @ 10% p.a. and its equity share capital share capital is Rs. 10,00,000 (Rs. 100 each). The
company is in a tax bracket of 50%. Calculate:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Equity
(e) If the sales increases by Rs. 6,00,000; what will the new EBIT?
Question 40. ______________________________________________________________________[MAY 13, NOV 2016]

The following information related to XL company Ltd. For the year ended 31st March, 2013 are available to you:
Equity share capital of Rs. 10 each Rs. 25 lakh
11% Bonds of Rs. 1000 each Rs. 18.5 lakh
Sales Rs. 42 lakh
Fixed cost (Excluding Interest) Rs. 3.48 lakh
Financial leverage Rs.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%
(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earnings Per Share.
Question 41. ____________________________________________________________________________[MAY 2018]

The following data have been extracted from the books of LM Ltd:
Sales - Rs. 100 lakhs
Interest Payable per annum - Rs. 10 lakhs
Operating leverage - 1.2
Combined leverage - 2.16


(i) The financial leverage,
(ii) Fixed cost and
(iii)P/V ratio
Question 42.
What is Trading on Equity or Gearing Effect?
Solution 42:
• When ROCE > Interest Rate on Debt, the company earns at a higher rate of return on its investment and pays a
lower rate of return to the suppliers of long term debt funds.
• The difference between EBIT and the cost of debt funds would enhance the earning of Equity Shareholders.
This will maximize ROE and EPS, creating a gain to the Equity Shareholders.
• Hence, gain from DFL, arises due to –
(i) Excess of return on investment over effective cost (cost after considering taxation effect, since the interest cost
on debt is tax – deductible expenses) of Debt Funds.
(ii) Reduction in the number of Equity Share issued due to the use of Debt Funds.
• The use of low – cost Debt Funds when Basic Earning power (ROCE) of the business is higher, thereby
increasing the EPS and ROE, is called ‘’Gearing Effect’’ or ‘’Trading on Equity’’.
Question 43
Discuss the impact of Financial Leverage on Shareholders Wealth while using Return on Assets (ROA) and Return on Equity
(ROE) analytic framework.
Solution 43:
• The impact of financial leverage on ROE is positive, if cost of debt (before tax) i.e. rate of interest is less than ROI.
𝑬𝑩𝑰𝑻
ROI = × 100
𝑪𝒂𝒑𝒊𝒕𝒂𝒍 𝑬𝒎𝒑𝒍𝒐𝒚𝒆𝒅
ROE = ROI (1 – t) + D/E (ROI – I)(1 – t)
Where, EBIT = Earnings Before Interest & Tax
Capital Employed = Debt + Shareholders funds
D = Debt amount in capital structure
E = Equity capital amount in capital structure
I = Interest rate
T = Tax rate
• The impact of financial leverage on ROE is positive, if cost of debt (after-tax) is less than ROA, but it is double-
edged sword.
𝑵𝑶𝑷𝑨𝑻
ROA =
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑨𝒔𝒔𝒕𝒆𝒔
× 100
ROE = ROA + D/E (ROA – Kd)
Where, NOPAT = EBIT (1 – t)
Operating Assets = Total Assets invested in the business
D = Debt amount in capital structure
E = Equity capital amount in capital structure
Kd = Interest rate (1 – t)
• When ROCE is high, the ROE is also higher and financial leverage is favourable. However, when the after tax cost
of debt is higher ROCE, financial leverage works in the reverse manner and consequently ROE will be affected.
• Hence, equity shareholders stand to gain with use of debt funds, only if ROCE is higher than the after tax cost of
debt.
• Note: Interest (100% – tax rate) is the Cost of Debt denoted by Kd .


Chapter 7
INVESTMENT DECISIONS
⧫ Introduction
Question 1.
What is Capital Budgeting?
Solution 1:
Capital Budgeting is the process of:
• Evaluating investment project proposals that are strategic to business overall objectives.
• Estimating and evaluating post-tax incremental cash flows for each of the investment proposals.
• Selection an investment proposal that maximises the return to the investors.
Question 2. [RTP]
Explain the Process of Capital Budgeting?
Solution 2:
The Process of Capital Budgeting involves following phases:
PHASE I: Planning:
• Identification of potential investment opportunities.
• The ability of the management of the firm to exploit the opportunity is determined.
• Opportunities having little merit are rejected and promising opportunities are advanced in the form of a
proposal to enter the evaluation phase.
PHASE II: Evaluation:

• The determination of proposal and its investment, inflows and outflows.
• Investment appraisal techniques, like simple payback method, accounting rate of return, discounted cash flow
techniques are used to appraise the proposals.
PHASE III: Selection:

• Consideration of the returns and risks associated with the individual projects as well as the cost of capital to the
organisation.
• Choose among projects so as to maximise shareholder’s wealth.
PHASE IV: Implementation:

• On the final selection, the firm must acquire the necessary funds.
• Purchase the assets and begin the implementation of the project.
PHASE V: Control
• The progress of the project is monitored with the aid of feedback reports.
PHASE VI: Review

• On termination of a project the organisation should review the entire project to explain its success or failure.
• The review may produce ideas for new proposals to be undertaken in the future

ABC Ltd. is evaluating the purchase of a new project with a depreciable base of Rs. 1,00,000; expected economic life of 4
years and change in earnings before taxes and depreciation of Rs. 45,000 in year 1, Rs. 30,000 in year 2, Rs. 25,000 in year
3 and Rs. 35,000 in year 4. Assume straight line depreciation and a 20% tax rate. You are required to compute relevant
cash flows.
Question 4. [May 18]

A company is evaluating a project that requires initial investment of Rs. 60 lakhs in fixed assets and Rs. 12 lakhs towards
additional working capital. The project is expected to increase annual real cash inflow before taxes by Rs. 24,00,000 during
its life. The fixed assets would have zero residual value at the end of life of 5 years. The company follows straight line
method of depreciation which is expected for tax purposes also. Inflation is expected to be 6% per year. For evaluating

similar projects, the company uses discounting rate of 12% in real terms. Company's tax rate is 30%. Advise whether the
company should accept the project, by calculating NPV in real terms
PVIF(12%,5 YEARS) PVIF(12%, 5 YEARS)

YEAR 1 0.893 YEAR 1 0.943
YEAR 2 0.797 YEAR 2 0.890
YEAR 3 0.712 YEAR 3 0.840
YEAR 4 0.636 YEAR 4 0.792
YEAR 5 0.567 YEAR 5 0.747
⧫ Incremental Cash Flows with WDV Method of Depreciation

Question 5. [RTP]
XYZ Ltd. is interested in assessing the cash flows associated with the replacement of an Old Machine by a New Machine.
The Old Machine bought a few years ago has a Book Value of Rs. 90,000 and it can be sold for Rs. 90,000. It has a remaining
life of five years after which its Salvage Value is expected to be Nil. It is being depreciated annually at 20% (Written down
Value Method.) The New Machine costsRs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will no
longer be required. It will be depreciated annually at the rate of 33 1/3rd % (Written Down Value Method.) The New
Machine is expected to bring a saving of Rs. 1,00,000 per annum in manufacturing costs. Investment in Working Capital
would remain unaffected. The Company’s Tax Rate is 50%. Find out the relevant Incremental Cash Flow for this
replacement decision. (Ignore Tax on Capital Gain/Loss).
I. Payback Period
Question 6. _________________________________________________________________________________[RTP]
What do you mean by Payback Period? What are its advantages and disadvantages?
Solution 6:
Payback Period represents the time period required for complete recovery of the initial investment in the project. It is the
period within which the total cash inflows from the project equals the cost of investment in the project. The lower the
payback period, the better it is, since initial investment is recovered faster.
Advantages:
1. This method is simple to understand and easy to operate.
2. When funds are limited, projects having shorter payback periods should be selected, since they can be rotated more
number of times.
3. This method promotes liquidity by stressing on projects with earlier cash inflows.
Disadvantages:
1. It ignores the time value of money. This is against the basic principle of financial analysis, which states compounding
or discounting of cash flows when they arise at different points of time.
2. It stresses on capital recovery rather than profitability.
3. It becomes an inadequate measure of evaluating two projects where the cash inflows are uneven.
Question 7._______________________________________________________________________ [STUDY MATERIAL]
Suppose a project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after depreciation @ 12
% (Straight Line Method) but before tax 50%.What would be the payback period?
Question 8._______________________________________________________________________ [STUDY MATERIAL]

Consider the following cash flows from two projects.(In Rs.)
No. of years Project A Project B
1 Nil 40,000
2 Nil 50,000

3 5,000 1,20,000
4 20,000 10,000
5 50,000 10,000
6 1,50,000 Nil
7 50,000 Nil
8 40,000 Nil
Total 3,15,000 2,30,000
Both projects cost Rs. 1,50,000 each. You are required to compute the payback period for both projects. Which project
will you prefer?
Question 9.
What is Payback Reciprocal? How it is used for evaluation of Project?
Solution 9:
Definition:
Payback Reciprocal is the reciprocal of Payback Period. It is computed as Average annual cash inflows(CFAT p.a.)/Initial
investment.
Usage:
The Payback Reciprocal is considered to be an approximation of the Internal Rate of Return, if: (i) The life of the project is
at least twice the Payback Period, and (ii) The Projects generates equal amount of the annual cash inflows. Example:
A project with an Initial Investment of Rs. 50 lakhs and life of 10 years, generates CFAT of Rs. 10 lakhs per annum. Its
Payback Reciprocal will be Rs 10lakhs/50lakhs = 20%.
⧫ Computation of Payback Reciprocal

Question 10. _________________________________________________________________________[STUDY MATERIAL]
Suppose a project requires an initial investment of Rs. 20,000 and it would give annual cash inflow of Rs. 4,000. The useful
life of the project is estimated to be 5 years. What will be the Payback Reciprocal?
II. Accounting or Average Rate of Return (ARR)

Question 11.___________________________________________________________________________________ [RTP]
Briefly explain Average Rate of Return method. Bring out its advantages and disadvantages?
Solution 11:
Accounting or Average Rate of Return (ARR) means the average annual yield on the project. In this method, Profit after
Taxes (i.e. PAT, instead of CFAT) is used for evaluation. ARR= Average PAT p.a./Net initial investment
, where Average PAT p.a. = Total PAT during project life/No of years during project life
Net Initial Investment = Initial Investment –Salvage Value.
Advantages:
1. This technique uses readily available data that is routinely generated for financial reports.
2. This method may also mirror the method used to evaluate performance on the operating results of an investment
and management performance.
3. The calculation of the accounting rate of return method considers all net incomes over the entire life of the project
and provides a measure of the investment’s profitability.
Disadvantages:
1. It ignores the time value of money and considers the value of all cash flows to be equal.
2. It uses net income rather than cash flows.
3. Inclusion of only the book value of the invested asset ignores the fact that a project can require commitments of
working capital and other outlays.
Question 12. _____________________________________________________________________[STUDY MATERIAL]

Suppose a project requiring an investment of Rs. 10,00,000 yields profit after tax and depreciation as follows:
Years Profit after tax and depreciation (Rs.)
1 50,000

2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of 5 years, the plant and machinery of the project can be sold for Rs. 80,000. Calculate
Average Rate of Return?

Times Ltd. is going to invest in a project a sum of ₹ 3,00,000 having a life span of 3 years. Salvage value of machine is ₹
90,000. The profit before depreciation for each year is ₹1,50,000. The Profit after Tax and value of Investment in the
Beginning and at the End of each year shall be as follows:
Year Profit before Depreciation Profit after Value of investment
depreciation depreciation Beginning End
1 1,50,000 70,000 80,000 3,00,000 2,30,000
2 1,50,000 70,000 80,000 2,30,000 1,60,000
3 1,50,000 70,000 80,000 1,60,000 90,000
Compute ARR.
III. Net Present Value (NPV)

Question 14.________________________________________________________________________________ [NOV 15]
Write a note on Net Present Value Method or Discounted Cash Flow Technique. Give its advantages and disadvantages.
Solution 14:
The Net Present Value (NPV) of a project is the sum of the Present Values of all future Cash Inflows less the sum of the
Present Values of all Cash Outflows associated with the proposal. NPV represents the additional value created with the
cash available in hand now for the investment.
NPV = Discounted Cash Inflows – Discounted Cash Outflows
DECISION MAKING:
NPV > 0 Accept the Project NPV = 0 This constitutes an Indifference Point NPV < 0 Reject the Project NPV Method is based
on the assumption that all intermediate/future cash flows can be immediately re-invested at a rate of return equal to the
Firm’s Cost of Capital.
Advantages:
1. It considers the concept of Time Value of Money. Hence, it satisfies the basic criterion for project evaluation.
2. Since all cash flows are converted into their Present Value, different projects can be compared on NPV basis. Thus,
each project can be evaluated independent of others, on its own merit.
3. NPV constitutes addition to the wealth of Shareholders, and thus focuses on the basic objective of financial
management.
Disadvantages:
1. The difference in initial outflows, size of different proposals etc, while evaluating mutually exclusive projects is
ignored.
2. It involves complex calculations in discounting and present value computations.
3. NPV and project ranking may differ at different discount rates, causing inconsistency in decision-making.
⧫ Computation of Net Present Value

Compute the net present value for a project with a net investment of Rs. 1,00,000 and the following cash flows if the
company’s cost of capital is 10%? Net cash flows for year one is Rs. 55,000; for year two is Rs. 80,000 and for year three is
Rs. 15,000. [PVIF @ 10% for three years are 0.909, 0.826 and 0.751].
Question 16._________________________________________________________________________ [STUDY MATERIAL]

ABC Ltd. is a small company that is currently analyzing capital expenditure proposals for the purchase of equipment; the
company uses the net present value technique to evaluate projects. The capital budget is limited to Rs. 5,00,000 which
ABC Ltd. believes is the maximum capital it can raise. The initial investment and projected net cash flows for each project
are shown below. The cost of capital of ABC Ltd. is 12%.

You are required to compute the NPV of the different projects. (In Rs.)
Particulars Project A Project B Project C Project D

Initial Investment 2,00,000 1,90,000 2,50,000 2,10,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
Year 2 50,000 50,000 75,000 75,000
Year 3 50,000 70,000 60,000 60,000
Year 4 50,000 75,000 80,000 40,000
Year 5 50,000 75,000 1,00,000 20,000
Question 17. _______________________________________________________________________[STUDY MATERIAL]

Cello Limited is considering buying a new machine which would have a useful economic life of 5 years, a cost of Rs. 1,25,000
and a scrap value of Rs. 30,000, with 80 per cent of the cost being payable at the start of the project and 20 per cent at
the end of the first year. The machine would produce 50,000 units per annum of a new project with an estimated selling
price of Rs. 3 per unit. Direct costs would be Rs. 1.75 per unit and annual fixed costs, including depreciation calculated on
a straight-line basis, would be Rs. 40,000 per annum. In the first year and the second year, special sales promotion
expenditure, not included in the above costs, would be incurred, amounting to Rs. 10,000 and Rs. 15,000 respectively.
Evaluate the project using the NPV method of investment appraisal, assuming the company’s cost of capital to be 10
percent.
IV. Desirability / Profitability Index

Question 18. ___________________________________________________________________________[RTP, NOV 09]
Explain Desirability/Profitability Index.
Solution 18:
The Profitability Index (PI) technique is used where different investment proposals each involving different Initial
Investments and Cash Inflows are to be compared. PI or Desirability Factor or Benefit Cost Ratio =
Importance:
PI represents the amount obtained at the end of the project life, for every rupee invested in the project. The higher the
PI, the better it is, since the greater is the return for every rupee of investment in the project.
DECISION
PI > 1 Accept the Project PI = 1 This constitutes an Indifference Point PI < 1 Reject the Project
Advantages:
1. This method considers the Time Value of Money.
2. It focuses on maximum return per rupee of investment, and is hence useful in case of investment in divisible projects,
when funds are not fully available.
Disadvantages:
1. Situations may arise where a project with a lower profitability index selected may generate cash flows in such a way
that another project can be taken up one or two years later, the total NPV in such case being more than the one with
a project with highest PI.
2. It fails as a guide in resolving capital rationing problems, when projects are indivisible. Once a single large project
with high NPV is selected, possibility of accepting several small projects which together may have higher NPV than
the single project is excluded.
⧫ Computation of Profitability Index

There are three projects involving discounted cash outflow of Rs. 5,50,000, Rs. 75,000 and Rs. 1,00,20,000 respectively.
Suppose that the sum of discounted cash inflows for these projects are Rs. 6,50,000, Rs. 95,000 and Rs. 1,00,30,000
respectively. Calculate the desirability factors for the three projects.

V. Internal Rate Of Return

Question 20.__________________________________________________________________________ [NOV 08, NOV 14]
What is Internal Rate of Return (IRR)? State its acceptance rule?
Solution 20:
Internal Rate of Return (IRR) is the rate at which the sum total of Discounted Cash Inflows equals the Discounted Cash
Outflows. So, IRR of a project is the discount rate at which NPV of the project equal to zero. IRR refers to that discount
rate K, such that
At IRR, NPV = 0 and PI = 1 Discount Rate (i.e. Cost of capital) is assumed to be known and constant in the computation of
NPV, while in computation of IRR, the NPV is set equal to zero, and the discount rate which satisfies this condition is
calculated.
DECISION MAKING OR ACCEPTANCE RULE:
IRR >Ko Accept the Project IRR = Ko This constitutes an Indifference Point IRR <Ko Reject the Project
Advantages:
(i) Time Value of Money is taken into account.
(ii) Decisions are immediately taken by comparing IRR with the Firm’s Cost of Capital.
(iii) All Cash Inflows of the Project, arising at different points of time are considered.
Disadvantages:
1. It may conflict with NPV in case inflow/outflow patterns are different in alternatives proposals.
2. IRR is only an approximation and cannot be computed exactly always without the use of computers and spreadsheet
software.
3. The Presumption that all the future cash Inflows of a Proposals are re- invested at a rate equal to the IRR, may not
be practically valid.
Question 21.________________________________________________________________________ [STUDY MATERIAL]

Calculate the Internal Rate of Return of an Investment of Rs. 1,36,000 which yields the following cash inflows:
YEAR CASH INFLOWS(RS)

1 30000
2 40000
3 60000
4 30000
5 20000

A company proposes to install machine involving a capital cost of Rs. 3,60,000.The life of the machine is 5 years and its
salvage value at the end of the life is nil. The machine will produce the net operating income after depreciation of Rs.
68,000 per annum. The company’s tax rate is 45% The Net present value factor for 5 years are as under:
Discounting Rate 14 15 16 17 18
Cumulative 3.43 3.35 3.27 3.20 3.13
Factor
You are required to calculate the internal rate of return of the proposal.
VI. Modified Internal Rate Of Return

Question 23. _________________________________________________________________________[MAY 07, NOV 08]
Explain the concept of Multiple Internal Rate of Return?
Solution 23:
In cases where project cash flows change signs or reverse during the life of a project for example, an initial cash outflow
is followed by cash inflows and subsequently followed by a major cash outflow; there may be more than one internal rate
of return (IRR). The following graph of discount rate versus net present value (NPV) may be used as an illustration:

In such situations if the cost of capital is less than the two IRR’s, a decision can be made easily, however, otherwise the
IRR decision rule may turn out to be misleading as the project should only be invested if the cost of capital is between
IRR1 and IRR2. To understand the concept of multiple IRR’s it is necessary to understand the implicit reinvestment
assumption in both NPV and IRR techniques.
Question 24. ________________________________________________________________________________[MAY 07]

Write short note on Modified Internal Rate of Return.
Solution 24:
Modified Internal Rate of Return (MIRR):
There are several limitations attached with the concept of the conventional Internal Rate of Return. The MIRR addresses
some of these deficiencies. For example, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and
produces results, which are consistent with the Net Present Value Method. Under this method, all cash flows, apart from
the initial investment, are brought to the terminal value using an appropriate discount rate (usually the cost of capital).
This results in a single stream of cash inflow in the terminal year. The MIRR is obtained by assuming a single outflow in
the zeroth year and the terminal cash inflow as mentioned above. The discount rate which equates the present value of
the terminal cash inflow to the zeroth year outflow is called the MIRR. Modified Internal Rate of Return is computed as
under:
Step 1: Determine the total Cash Outflows & Inflows of the project and the time periods in which they occur.
Step 2: Compute Terminal Value of all Cash Flows other than the Initial Investment. For this purpose,
Terminal Value of a Cash Flow = Amount of Cash Flow × Re-investment Factor, where Reinvestment Factor = (1 + K)n where
n = number of years balance remaining in the project. Step 3: Compute Total of Terminal Values as computed under Step
2. This is taken as the ‘’Inflow’’ from the project, to be compared with the ‘’Outflow’’, i.e. the initial investment. Step 4:
Compute MIRR, i.e. Discount Rate such that PV of Terminal Value = Initial Investment. Note:
For computing MIRR, the interpolation techniques applicable to IRR may be used.
⧫ Practical Problems
Question 25.__________________________________________________________________________ [Study Material]
An investment of Rs. 1,36,000 yields the following cash inflows. Determine the MIRR if the Cost of Capital = 8%
Year 1 2 3 4 5
CFAT(RS) 30,000 40,000 60,000 30,000 20000
Question 26. _______________________________________________________________________________[MAY 09]

Explain the concept of Discounted Payback Period?
Solution 26:
Payback Period is time taken to recover the original investment from project cash flows. It is also termed as break-even
period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of money
and profitability. Discounted payback period considers present value of cash flows, discounted at company’s cost of capital
to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the initial outflow. The
shorter the period, better it is. It also ignores post discounted payback period cash flows.

⧫ Simple Payback and ARR

Question 27. ____________________________________________________________________________________[RTP]
A Ltd is considering a new 5-year project. Its investment costs and annual profits are projected as follows:
Investment Profits
Year 0 1 2 3 4 5
Amount(Rs.) (2,50,000) 40,000 30,000 20,000 10,000 10,000
Residual Value at the end of the project is expected to be Rs. 40,000 and Depreciation of the Original Investment is on
straight line basis. Using Average profits and Average Capital Employed, calculate ARR for the project and also the payback
period.

The Alpha Co. Ltd, is considering the purchase of a new machine. Two alternative machines (A & B) have been suggested,
each costing Rs. 4,00,000. Earnings after taxation but before depreciation are expected to be as follows:
YEAR CASH FLOWS
Machine A Machine B
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
Total 7,20,000 6,80,000
The company has a target rate return on capital @ 10 percent and on this basis, you are required: (a) Compare profitability
of the machines and state which alternative you consider financially preferable;
(b) Compute the payback period for each project; and (c) Compute annual rate of return for each project. [Present value
of machine B is higher than that of machine A; Payback period machine A – 3 years 4 months, machine B 2 years 7.2
months; Annual return machine A – 16%, machine B – 14%]
⧫ NPV, IRR, Payback Period, ARR

Hind lever Company is considering a new product line to supplement its range line. It is anticipated that the new product
line will involve cash investment of Rs. 7,00,000 at time 0 and Rs. 10,00,000 in year 1. After-tax cash inflows of Rs. 2,50,000
are expected in year 2, Rs. 3,00,000 in year 3, Rs. 3,50,000 in year 4 and Rs. 4,00,000 each year thereafter through year 10.
Although the product line might be viable after year 10, the company prefers to be conservation and end all calculation
at that time.
(a) If the required rate of return is 15 per cent, what is the net present value of the project? Is it acceptable?
(b) What would be the case if the required rate of return were 10 per cent?
(c) What is its internal rate of return?
(d) What is the project’s payback period?

The expected cash flows of three projects are given below. The cost of capital is 10 per cent.
(a) Calculate the payback period, net present value, internal rate of return and accounting rate of return of each project.
(b) Show the rankings of the projects by each of the four methods.
Period Project A Project B Project C
0 (5,000) (5,000) (5,000)
1 900 700 2000
2 900 800 2000
3 900 900 2000
4 900 1000 1000
5 900 1100
6 900 1200
7 900 1300
8 900 1400
9 900 1500

10 900 1600

Alpha company is considering the following investment projects:
PROJECTS CASH FLOWS
C0 C1 C2 C3
A -10,000 10,000
B -10,000 7500 7500
C -10,000 2000 4000 12000
D -10,000 10000 3000 3000
a) Rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii) IRR and (iv) NPV, assuming
discount rates of 10 and 30 per cent.
b) Assuming the projects are independent, which one should be accepted? If the projects are mutually exclusive, which
project is the best?
Question 32. _________________________________________________________________________________[NOV 09]

New Thought Company is evaluating an Investment proposal of Rs. 3,06,000 with expected cash flows as –
YEAR 1 2 3 4
CFAT(Rs) 100000 130000 150000 100000
The Company’s Cost of Capital is 10%. Compute the NPV and PI for this project.
Question 33. __________________________________________________________________________________ [RTP]

Bhilwara Co.’s cost of capital is 10% and it is subject to 50% tax rate. The Company is considering buying a new finishing
machine. The machine will cost Rs. 2 Lakhs and will reduce materials waste by an estimated amount of Rs. 50,000 a year.
The machine will last for 10 years and will have a zero salvage value. Assume straight line method of depreciation on
assets.
1. Compute the Annual Cash Inflows, Present Value, Net Present Value, and profitability Index.
2. Should the company purchase the new finishing machine?
Question 34. ________________________________________________________________________________[MAY 08]

C Ltd. is considering investing in a project. The expected original investment in the project will be Rs. 2,00,000, the life of
project will be 5 year with no salvage value. The expected net cash inflows after depreciation but before tax during the
life of the project will be as following:
YEAR 1 2 3 4
(Rs) 85000 100000 80000 40000
The project will be depreciated at the rate of 20% on original cost. The company is subjected to 30% tax rate.
Required:
(i) Calculate payback period and average rate of return (ARR).
(ii) Calculate net present value and net present value index, if cost of capital is 10%.
(iii) Calculate internal rate of return. Note:
The P.V. factors are

YEAR P.V. at 10% P.V. at 37% P.V. at 38% P.V. at 40%
1 0.909 0.730 0.725 0.714
2 0.826 0.533 0.525 0.510
3 0.751 0.389 0.381 0.364
4 0.683 0.284 0.276 0.260
5 0.621 0.207 0.200 0.186
Question 35.__________________________________________________________________________ [NOV 07, May 19]

Consider the following mutually exclusive projects:
Cash Flows (Rs.)
Projects C0 C1 C2 C3 C4
A 10,000 6,000 2,000 2,000 12,000
B 10,000 2,500 2,500 5,000 7,500

C -3,500 1,500 2,500 500 5,000

D 3,000 0 0 3,000 6,000
Required:
(i) Calculate the payback period for each project.
(ii) If the standard payback period is 2 years, which project will you select? Will your answer differ, if standard payback
period is 3 years?
(iii)If the cost of capital is 10%, compute the discounted payback period for each project. Which projects will you
recommend, if standard discounted payback period is (i) 2 years; (ii) 3 years?
(iv) Compute NPV of each project. Which project will you recommend on the NPV criterion? The cost of capital is 10%.
What will be the appropriate choice criteria in this case? The PV factors at 10% are:
YEAR 1 2 3 4
PV factor at 10% 09091 08264 0.7513 0.6830
(PV/F 0.10,t)

A sole trader installs plant and machinery in rented premises for the production of luxury article, the demand for which is
expected to last only 5 years. The total capital put in by the sole trader is as under:
Plant and machinery Rs. 2,70,500
Working capital Rs. 40,000
Rs. 3,10,500
The working capital will be fully realized at the end of 5th year. The scrap value of the plant expected to be realized at the
end of the 5th year is only Rs. 5,500. The trader’s earning are expected to be as under:
Year Cash profit (before Tax payable (`)
depreciation & tax) (`)
1 90,000 20,000
2 1,30,000 30,000
3 1,70,000 40,000
4 1,16,000 26,000
5 19,500 5,000
Present value factors of various rates of interest are given below:

Years 11% 12% 13% 14% 15%
1 0.9009 0.8929 0.8850 0.8770 0.8696
2 0.8116 0.7972 0.7831 0.7695 0.7561
3 0.7312 0.7118 0.6931 0.6750 0.6675
4 0.6587 0.6355 0.6133 0.5921 0.5718
5 0.5935 0.5674 0.5428 0.5194 0.4972
You are required to compute the present value of cash flows discounted at the various rates of interests given above and
state the return from the project.
Question 37. _________________________________________________________________________________[MAY 07]

A company is considering the proposal of taking up a new project which requires an investment of Rs. 400 lakhs on
machinery and other assets. The project is expected to yield the following earnings (before depreciation and taxes) over
the next five years:
Year Earnings (` in lakhs)
1 160
2 160
3 180
4 180
5 150
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on ‘Written Down Value’ basis.
The scrap value at the end of the five years’ period may be taken as zero. Income-tax applicable to the company is 50%.
You are required to calculate the net present value of the project and advise the management to take appropriate
decision. Also calculate the Internal Rate of Return of the Project.
Note: Present values of Re. 1 at different rates of interest are as follows:

Year 10% 12% 14% 16%

1 0.91 0.89 0.88 0.86
2 0.83 0.80 0.77 0.74
3 0.75 0.71 0.67 0.64
4 0.68 0.64 0.59 0.55
5 0.62 0.57 0.52 0.48
⧫ Computing Missing Figure with IRR, PI, NPV

Question 38. _______________________________________[NOV 98, MAY 09 (ADAPTED),MAY 12 (ADAPTED), MAY 15]
Following are the data on a Capital project being evaluated by the management of X Ltd.
Particulars Project M
Annual cost saving Rs. 40,000
Useful life 4 years
I.R.R 15%
Profitability Index (P.I) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0
Find the missing values considering the following table discount factor only:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
Question 39. ______________________________________________________________________________[NOV 09]

A Doctor is planning to buy an X-Ray machine for his hospital. He has two options – he can either purchase it by making a
cash payment of Rs. 5 lakhs or Rs. 6,15,000 are to be paid in six equal annual instalments. Which option do you suggest to
the Doctor assuming the Rate of Return is 12%? Present Value of Rs. 1 at 12% rate of discount for 6 year is 4.111.
Question 40.______________________________________________________________________________ [NOV 09]

A Doctor is planning to buy an X-Ray machine for his hospital. He has two options – he can either purchase it by making a
cash payment of Rs. 5 lakhs or Rs. 6,15,000 are to be paid in six equal annual instalments. Which option do you suggest to
the Doctor assuming the Rate of Return is 12%? Present Value of Rs. 1 at 12% rate of discount for 6 year is 4.111.
Question 41. ______________________________________________________________________[STUDY MATERIAL]

Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A and B are available at
the same cost of Rs. 5 lakhs each. Salvage value of the old machine is Rs. 1 lakh. The utilities of the existing machine can
be used if the company purchases A. Additional cost of utilities to be purchased in that case are Rs. 1 lakh. If the company
purchases B then all the existing utilities will have to be replaced with new utilities costing Rs. 2 lakhs. The salvage value
of the old utilities will be Rs. 0.20 lakhs. The earnings after taxation are expected to be:
(Cash Inflows of)

Year A (Rs.) B(Rs.) P.V. Factor @15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage value at the end of 50,000 60,000
year 5

The targeted return on capital is 15%. You are required to (i) Compute, for the two machines separately, Net present value,
Discounted payback period and Desirability factor and (ii) Advice which of the machines is to be selected?
Question 42. ________________________________________________________________________________[MAY 06]

A company is considering a proposal of installing drying equipment. The equipment would involve a cash outlay of Rs.
6,00,000 and net working capital of Rs. 80,000. The expected life of the project is 5 years without any salvage value.
Assume that the company is allowed to charge depreciation on straight-line basis for income-tax purpose. The estimated
before-tax cash inflows are given below:
Before-Tax Cash Inflows (Rs. ‘000)
Year 1 2 3 4 5
240 275 210 180 160
The applicable Income-tax rate to the company is 35%. If the company’s opportunity cost of capital is 12%, calculate the
equipment’s discounted payback period, payback period, net present value and internal rate of return.
The PV factors at 12%, 14% and 15% are:
Year 1 2 3 4 5
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194
PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972
Question 43. __________________________________________________________________________[NOV 09, MAY 14]

A Hospital is considering purchasing a Diagnostic Machine costing Rs. 80,000. The projected life of the machine is 8 years,
and it has an expected Salvage Value of Rs. 6,000 at the end of 8 years. The annual operating cost of the machine is Rs.
7,500. It is expected to generate revenues of Rs. 40,000 per year for 8 years. Presently, the Hospital is outsourcing the
diagnostic work and is earning Commission Income of Rs. 12,000 per annum, net of taxes. Required: Whether it would be
profitable for the Hospital to purchase the machine? Give your recommendation under Net Present Value and Profitability
Index Methods. PV Factors at 10% are given below:
Year 1 2 3 4 5 6 7 8
PV Factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
[Additional Cash Flow p.a. by Purchasing new Diagnostic Machine: Rs. 11,200; Net Present Value: (17,457); Profitability
Index: 0.78]
⧫ Mutually Exclusive Decisions – NPV and Simple Payback

Question 44.________________________________________________________________________________ [NOV 09]
PR Engineering Ltd. is considering the purchase of a new machine which will carry out some operations which are at
present performed by manual labour. The following related to the alternative models – ‘MX’ and ‘MY’ are available:
Particulars Machine ‘MX’ Machine ‘MY’
Cost of Machine Rs. 8,00,000 Rs. 10,20,000
Expected Life 6 year 6 year
Scrap value Rs. 20,000 Rs. 30,000
Estimated Net Income before Depreciation and Tax are as under:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Machine MX 2,50,000 2,30,000 1,80,000 2,00,000 1,80,000 1,60,000
Machine MY 2,70,000 3,60,000 3,80,000 2,80,000 2,60,000 1,85,000
Depreciation will be charged on Straight Line basis.

1. Calculate the payback period of each proposal.
2. Calculate the Net Present Value of each proposal, if the PV Factor at 10% is 0.909, 0.826, 0.751, 0.683, 0.621 and
0.564.
3. Which proposal you would recommend and why?
Question 45.__________________________________________________________________________________ [RTP]

The Director of Damon Electronics Co. has asked you analyse two proposed investment projects X and Y. Each project has
an initial investment of Rs. 10,000 at a cost of 12%. The Cash Flows are expected as under:
Year 1 2 3 4

Cash Flows of X Rs. 6,500 Rs. 3,000 Rs. 3,000 Rs. 1,000
Cash Flows of Y Rs. 3,500 Rs. 3,500 Rs. 3,500 Rs. 3,500
1. Calculate for each project – (a) Simple payback period, (b) NPV, and (c) IRR.
2. Which project(s) should be accepted if the projects were independent?
3. Which project should be accepted if they were mutually exclusive?
Question 46.________________________________________________________________________________ [MAY 10]

The Management of a company has two alternatives under consideration. Project A requires a capital outlay of Rs.
12,00,000 and Project B requires Rs. 18,00,000. Both are estimated to provide a cash flow for five years as Project A Rs.
4,00,000 per year and Project B Rs. 5,80,000 per year. Cost of Capital is 10%. Show which of the two projects is preferable
from the viewpoint of –
(i) Net Present Value Method,
(ii) Present Value Index Method, and
(iii) Internal Rate of Return Method.
Question 47. _______________________________________________________________[MAY 10, MAY 13 (ADAPTED)]

The Management of P Limited is considering to select a machine out of the mutually exclusive machines. The company’s
Cost of Capital is 12% and Corporate Tax Rate for the Company is 30%. Details of the machines are as follows
Particulars Machine – I Machine – II
Cost of Machine Rs. 10,00,000 Rs. 15,00,000
Expected life 5 years 6 years
Annual Income before Tax Depreciation Rs. 3,45,000 Rs. 4,55,000
Depreciation is to be charged on straight line basis. You are required to:

1. Calculate the Discounted Payback Period, Net Present Value and Internal Rate of Return for each machine.
2. Advise the Management of P Limited as to which Machine they should take up.
Question 48. _________________________________________________________________[NOV11,NOV12 (SIMILAR)]

A Ltd. is considering the purchase of a machine which will perform some operations which are at present performed by
workers. Machines X and Y are alternative models. The following details are available:
Particulars Machine X (`) Machine Y (`)
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material p.c. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages p.a. 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternatives according to:
(i) Average rate of return method, and
(ii) Present value index method assuming cost of capital being 10%.
Question 49.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two projects are Rs.
1,35,000 and Rs. 2,40,000 respectively for A and B. There will be no scrap value at the end of the life of both the projects.
The opportunity Cost of Capital of the company is 16%. The annual incomes are as under:
Year Project A Project B Discounting factor @ 16%
1 - Rs. 60,000 0.862
2 Rs. 30,000 Rs. 84,000 0.743
3 Rs. 1,32,000 Rs. 96,000 0.641
4 Rs. 84,000 Rs. 1,02,000 0.552
5 Rs. 84,000 Rs. 90,000 0.476
You are required to calculate for each project:

(i) Discounted Payback Period
(ii) Profitability Index
(iii) Net Present Value.

Question 50.
The Cash flows of projects C and D are reproduced below:
Project C0 C1 C2 C3 NPV at 10% IRR

C -Rs. 10,000 + 2,000 + 4,000 + 12,000 + Rs. 4,139 26.5%
D -Rs. 10,000 + 10,000 + 3,000 + 3,000 + Rs. 3,823 37.6%
(i) Why there is a conflict of ranking?

(ii) Why should you recommend project C in spite of lower internal rate of return?
Discount Rate 1 2 3
10% 0.9090 0.8264 0.7513
14% 0.8772 0.7695 0.6750
15% 0.8696 0.7561 0.6575
30% 0.7692 0.5917 0.4552
40% 0.7143 0.5102 0.3644
Question 51. _________________________________________________________________________________[MAY 08]

A Firm can make investment in either of the following two projects. The firm anticipates its cost of capital to be 10% and
the net (after taxes). Cash flows of the five years are as follows: (in Rs. ‘000)
Year 0 1 2 3 4 5
Project A (500) 85 200 240 220 70
Project B (500) 480 100 70 30 20
The discount factors are as under:

Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
PVF (20%) 1 0.83 0.69 0.58 0.48 0.41
1. Calculate the NPV and IRR of each project.

2. State with reasons which project you would recommend.
3. Explain the inconsistency in ranking of two projects.
⧫ NPV – IRR Conflict – Life Inequality – Equivalent Annual Flows

Question 52.
The Cash flows of two mutually exclusive Projects are as under:
Particulars t0 t1 t2 t3 t4 t5 t6
Project 'P' (Rs.) (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
Project 'J' (Rs.) (20,000) 7,000 13,000 12,000 - - -
Required:
(i) Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the hurdle rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by NPV and IRR criterion. Make a project choice.
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion. Make a project choice.
The present value interest factor values at different rates of discount are as under:
Rate of discount t0 t1 t2 t3 t4 t5 t6
0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704
0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499
Question 53. _____________________________________________________________________________________[RTP]

Fair Ltd. is a manufacturer of high quality running shoes. Hari, President, is considering computerizing the company’s
ordering, inventory and billing procedures. He estimates that the annual savings from computerization include a
reduction, of 10 clerical employees with annual salaries of Rs. 15,000 each, Rs. 8,000 from, reduced production delays
caused by raw materials inventory problems, Rs. 12,000 from lost sales due to inventory stock out and Rs. 3,000 associated

with timely billing procedures. The purchase price of the system is Rs. 2,00,000 and installation costs are Rs. 50,000. These
outlays will be capitalized (depreciated) on a straight-line basis to a zero book salvage value, which is also its market value
at the end of 5 years. Operation of the new system requires two computer specialists with annual salaries of Rs. 40,000
per person. Also annual maintenance and operating (cash) expenses of Rs. 12,000 are estimated to be required. The
company’s tax rate is 40% and its required rate of return (cost of capital) for this project is 12%. You are required to:
(i) Find the project’s initial net cash outlay;
(ii) Find the project’s operating and terminal value cash flows over its 5-year life;
(iii) Evaluate the project using NPV method;
(iv) Evaluate the project using PI method;
(v) Calculate the project’s payback period;
(vi) Find the project’s cash flows and NPV *parts (i) through (iii)+ assuming that the system can be sold for Rs. 25,000 at
the end of five years even though the book salvage value will be zero; and
(vii) Find the project’s cash flows and NPV *parts (i) through (iii)+ assuming that the book salvage value for depreciation
purposes is Rs. 20,000 even though the machine is worthless in terms of its resale value.
Note: Present value of annuity of Re. 1 at 12% rate of discount for 5 years is 3.605.
Present value of Re. 1 at 12% rate of discount, received at the end of 5 years is 0.567.
Question 54._________________________________________________________________________________ [NOV07]

XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be setup in Special Economic
Zone (SEZ), Qualifies for one time (at starting)tax free subsidy from the State Government of Rs. 25,00,000 on Capital
investment. Initial equipment cost will be Rs. 1.75 crores. Additional equipment cost Rs.12,50,000 will be purchased at
the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale
value, but additional equipment can be sold for Rs. 1,25,000. A Working Capital of Rs.20,00,000 will be needed and it will
be released at the end of the eight year. The project will be financed with sufficient amount of Equity Capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sales price of Rs.120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed Cash
operating costs will amount Rs. 18,00,000 per year. The loss of any year will be set off from the profits of subsequent two
years. The company is subject to 30 percent tax rate and consider 12 percent to be an appropriate after tax cost of capital
for this project. The company follows straight line method of depreciation.
Required: Calculate the net present value of the project and advise the management to take appropriate decision.
Note: The PV factors at 12% are:
Year 1 2 3 4 5 6 7 8
0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Question 55. __________________________________________________________________[STUDY MATERIAL, NOV 91]

Modern Enterprises Ltd. is considering the purchase of a new computer system for its Research and Development Division,
which would cost Rs. 35 lakhs. The operation and maintenance costs (excluding depreciation) are expected to be Rs. 7
lakhs per annum. It is estimated that the useful life of the system would be 6 years, at the end of which the disposal value
is expected to be Rs. 1 lakh.
The tangible benefits expected from the system in the form of reduction in designing costs would be Rs. 12 lakhs per
annum. Besides, the disposal of used drawing, office equipment and furniture, initially, is anticipated to net Rs. 9 lakhs.
Capital expenditure in research and development would attract 100% write-off for tax purpose. The gains arising from
disposal of used assets may be considered tax-free. The company’s effective tax rate is 50%.
The average cost of capital to the company is 12%. The present value factors at 12% discount rate are:
Year PVF
1 0.892
2 0.797
3 0.711
4 0.635
5 0.567
6 0.506
After appropriate analysis of cash flows, please advise the company of the financial viability of the proposal.

Question 56. _____________________________________________________________________[RTP, STUDY MATERIAL]

Beta Electronics is considering a proposal to replace one of its machines. The following information is available to you.
The existing machine was bought 3 years ago for Rs. 10 Lakhs. It was depreciated at 25% p.a. on reducing balance basis. It
has remaining useful life of 5 years, but its annual maintenance cost is expected to increase by Rs. 50,000 from the sixth
year of its installation. Its present realisable value is Rs. 6 Lakhs. The company has several machines, having 25%
depreciation.
The new Machine costs Rs. 15 Lakhs and is subject to the same rate of depreciation. On sale after 5 years, it is expected
to net Rs. 9 Lakhs. With the new machine, the annual operating costs (excluding depreciation) are expected to decrease
by Rs. 1 Lakh. In addition, the new machine would increase productivity on account of which Net Revenues would increase
by Rs. 1.5 Lakhs annually.
The tax-rate application to the company is 35% and cost of Capital is 10%. Advise the company, on the basis of NPV of the
proposal, whether the proposal is financially viable. .
Question 57.
ABC Ltd. manufactures toys and other gift items. The R & D Division has come up with a product that would make a good
promotional gift for office equipment dealers. As a result of efforts by the sales personnel, the Firm has commitments for
this product.
To produce the quantity demanded, the company will need to buy additional machinery and rent additional space. It
appears that about 25,000 square feet will be needed. 12,500 square feet of presently unused space, but leased at the
rate of Rs. 3 per square foot per year, is available. There is another 12,500 square feet available at an annual rent of Rs. 4
per square foot.
The Machinery will be purchased for Rs. 9,00,000. It will require Rs. 30,000 for modifications, Rs. 60,000 for installation
and Rs. 90,000 for testing. The machinery will have a salvage value of about Rs. 1,80,000 at the end of the third. No
additional General Overheads Costs are expected to be incurred.
The estimated revenues and costs for this product for the three years have been developed as follows:(Rs.)
Particulars Year I Year II Year III
Sales 10,00,000 20,00,000 8,00,000
Less: Material and Labour 4,00,000 7,50,000 3,50,000
Overheads allocated 40,000 75,000 35,000
Rent 50,000 50,000 50,000
Depreciation 3,00,000 3,00,000 3,00,000
Earnings Before Taxes 2,10,000 8,25,000 65,000
Less: Taxes 1,05,000 4,12,500 32,500
Earnings After Taxes 1,05,000 4,12,500 32,500
If the Company sets a required rate of return of 20% after taxes, should this product be manufactured?
Question 58._______________________________________________________________________________ [NOV 94]

Swastik Ltd. manufactures of special purpose machine tools, have two divisions, which are periodically assisted by visiting
terms of consultants. The management is worried about the steady increase of expenses in this regard over the years. An
analysis of last year’s expenses reveals the following:
Particulars Rs.
Consultant's Remuneration 2,50,000
Travel and Conveyance 1,50,000
Accommodation Expenses 6,00,000
Boarding charges 2,00,000
Special Allowances 50,000
12,50,000
The management estimates accommodation expenses to increase by Rs. 2,00,000 annually.

As part of a cost reduction drive, Swastik Ltd. is proposing to construct a consultancy centre to take care of the
accommodation requirements of the consultants. This centre will additionally save the company Rs. 50,000 in boarding
charges and Rs. 2,00,000 in the cost of Executive Training Programmes hither to conducted outside the company’s
premises, every year.

The following details are available regarding the construction and maintenance of the new centre:
a) Land: At a cost of Rs. 8,00,000 already owned by the company will be used.
b) Construction cost: Rs. 15,00,000 including special furnishings.
c) Cost of annual maintenance: Rs. 1,50,000.
d) Construction cost will be written off over 5 years being the useful life.
Assuming that the write-off of construction cost as aforesaid will be accepted for tax purposes, that the rate of tax will be
50% and that desired rate of return is 15%, you are required to analyse the feasibility of the proposal and make
recommendations. The relevant Present Value Factors are:
Year 1 2 3 4 5
PV Factor 0.87 0.76 0.66 0.57 0.50
Question 59. _________________________________________________________________________[MAY 97, MAY 07]

Excel Ltd. Manufacture a special chemical for sale at Rs. 30 per Kg. The variable cost of manufacture is Rs. 15 per kg. Fixed
cost excluding depreciation is Rs. 2,50,000. Excel Ltd. is currently operating at 50% capacity. It can produce a maximum of
1,00,000 kgs. at full capacity.
The production manager suggests that if the existing machines are fully replaced, the company can achieve maximum
capacity in the next five years, gradually increasing the production by 10% per year.
The finance Manager estimates that for each 10% increase in capacity, the additional increase in fixed cost will be Rs.
50,000. The existing machines with a current book value of Rs. 10,00,000 can be disposed of for Rs. 5,00,000. The Vice
President (finance) is willing to replace the existing machines provided the NPV on replacement is about Rs. 4,53,000 at
15% cost of capital after tax.
(i) You are required to compute the total value of machines necessary for replacement.
For your exercise you may assume the following:
a) The company follows the block of assets concept and all the assets are in the same block. Depreciation will be in
straight line basis and the same basis is allowed for tax purposes.
b) There will be no salvage value for the machines newly purchased. The entire cost of the assets will be depreciated
over five years period.
c) Tax rate is at 40%
d) Cash inflows will arise at the end of the year.
e) Replacement outflow will be at beginning of the year (Year 0)
Year 0 1 2 3 4 5
Discount 1 0.87 0.76 0.66 0.57 0.49
Factor at 15%
(ii) On the basis of data given above, the managing director feels that the replacement, if carried out, would at yield post
tax return of 15% in the three years provided the capacity build up is 60%, 80% and 100% respectively. Do you agree?
⧫ Repair – Replace – Conflict

Question 60.__________________________________________________________________________ [MAY 98,MAY 05]
S Engineering Company is considering to replace or repair a particular machine, which has just broken down. Last year this
machine costed Rs.20,000 to run and maintain. These costs have been increasing in real terms in recent years with the age
of the machine. A further useful life of 5 years is expected, if immediate repairs of Rs. 19,000 are carried out. If the machine
is not repaired it can be sold immediately to realise about Rs. 5,000 (Ignore loss/gain on such disposal).
Alternatively, the company can buy a new machine for Rs. 49,000 with an expected life of 10 years with no salvage value
after providing depreciation on straight line basis. In this case, running and maintenance costs will reduce to Rs. 14,000
each year and are not expected to increase much in real terms of a few years at least. S Engineering Company regards a
normal return of 10% p.a. after tax as a minimum requirement on any new investment. Considering capital budgeting
techniques, which alternative will you choose? Take corporate tax rate of 50% and assume that depreciation on straight
line basis will be accepted for tax purposes also. Given cumulative present value of Re. 1 p.a. at 10% for 5 years Rs. 3.791,
10 years Rs. 6.145.
⧫ Mutually Exclusive Decision – Retain or Replace – Incremental NPV

Question 61. ________________________________________________________________________________[NOV 08]
WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated useful life is 8 years with no
salvage value in the end. Its current market value is Rs. 2,00,000. The company is considering a proposal to purchase a
new model of machine to replace the existing machine. The relevant information’s are as follows:

Particulars Existing Machine New Machine

Cost of machine Rs. 3,30,000 Rs. 10,00,000
Estimated life 11 years 8 years
Salvage value Nil Rs. 40,000
Annual output 30,000 units 75,000 units
Selling price per unit Rs. 15 Rs. 15
Annual operating hours 3,000 3,000
Material cost per unit Rs. 4 Rs. 4
Labour cost per hour Rs. 40 Rs. 70
Indirect cash cost per Rs. 50,000 Rs. 65,000
annum
The company follows the straight line method of depreciation. The corporate tax rate is 30 percent and WX Ltd, does not
make any investment, if it yields less than 12 percent. Present value of annuity of Re. 1 at 12% rate of discount for 8 years
is 4.968. Present value of Re. 1 at 15% rate of discount, received at the end of 8th year is 0.404. Ignore capital gain tax.
Advise WX Ltd. whether the existing machine should be replaced or not.
Question 62. ______________________________________________________________________________[NOV 19]

A company has ₹ 1,00,000 available for investment and has identified the following four investments in which to invest.
Project Investment (₹) NPV (₹)
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit if:
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible
Question 63. ______________________________________________________________________________[May 19]

Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y. The particulars are as under :
Project X (₹) Project Y (₹)
Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000
The cut off rate is 14%. The discount factor at 14% are :
Year 1 2 3 4 5 6 7 8 9
Discount 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308
factor
⧫ Mutually Exclusive Project with Different Lines – EAB/EAC Model

Question 64. ______________________________________________[MAY 00, NOV 06 (ADAPTED), NOV 10 (ADAPTED)]
Company X is forced to choose between two machines A and B. The two machines are designed differently, but have
identical capacity and do exactly the same job. Machine A costs Rs. 1,50,000 and will last for 3 years. It costs Rs. 40,000
per year to run. Machine B is an ‘economy’ model costing only Rs. 1,00,000, but will last only for 2 years, and costs Rs.
60,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore
tax. Opportunity cost of capital is 10 percent. Which machine company X should buy?
Question 65.


A Company is required to choose between two machines A and B. The two machines are designed differently, but have
identical capacity to do exactly the same job. Machine A costs Rs. 6,00,000 and will last for 3 years. It costs Rs. 1,20,000
per year to run.
Machine B is an Economy Model costing Rs. 4,00,000 but will last only for two years, and cost Rs. 1,80,000 per year to run.
These are real cash flows. The costs are forecasted in rupees of constant purchasing power. Opportunity Cost of Capital is
10%. Which Machine should the Company buy? Ignore tax. Given: PVIF0.10,1= 0.9091, PVIF0.10,2 = 0.8264, PVIF0.10,3=
0.7513.
Question 67.________________________________________________________________________________ [NOV 13]

APZ Limited is considering selecting a machine between two machines ‘A’ and ‘B’. The two machines have identical
capacity, do exactly the same job, but designed differently.
Machine ‘A’ costs Rs. 8,00,000, having useful life of 3 years. It costs Rs. 1,30,000 per year to run.
Machine ‘B’ is an economy model costing Rs. 6,00,000, having useful life of 2 years. It costs Rs. 2,50,000 to run.
The cash flows of Machine ‘A’ and Machine ‘B’ are real cash flows. The costs are forecasted in rupees of constant
purchasing power. Ignore taxes. The opportunity cost of capital is 10%. Which Machine would you recommend the
company to buy?
⧫ Replacing Part or Servicing – Different Project Lines

Question 68.
A company wants to invest in machinery that would cost Rs. 50,000 at the beginning of year 1. It is estimated that the net
cash inflows from operations will be Rs. 18,000 per annum for 3 years, if the company opts to service a part of the machine
at the end of year 1 at Rs. 10,000. In such a case, the scrap value at the end of year 3 will be Rs. 12,500. However, if the
company decides not to service the part, then it will have to be replaced at the end of year 2 at Rs. 15,400. But in this case,
the machine will work for the 4th year also and get operational cash inflow of Rs. 18,000 for the 4th year. It will have to
be scrapped at the end of year 4 at Rs. 9,000. Assuming cost of capital at 10% and ignoring taxes, will you recommend the
purchase of this machine based on the net present value of its cash flows?
If the supplier gives a discount of Rs. 5,000 for purchase, what would be your decision? (The present value factors at the
end of years 0,1,2,3,4,5 and 6 are respectively 1,0.9091,0.8264,0.7513,0.6830,0.6209 and 0.5644).
⧫ Labour Savings by Utilisation of Machine

An investment in new machinery is being considered. The machine will cost Rs. 80,000 and will last for seven years. It is
expected to yield savings in raw material cost of Rs. 8,000 p.a. (due to lower wastage) and it is hoped also to achieve
labour savings of Rs. 14,000 p.a., however the arrangement have not yet been discussed with the trade union. The
company’s cost of capital is 12%.
What percentage change in the estimated labour savings will render the project not viable? Given that the present value
of an annuity for 7 years at 12% = Rs. 4.564.
Question 70. _________________________________________________________________________________[Nov 18]

PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years. Project cost will be Rs.
2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of Rs. 30,00,000 will be needed. The
100% capacity of the project is 2,00,000 units p.a. but the Production and Sales Volume is expected are as under :
Year Number of Units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units

Other Information:
(i) Selling price per unit Rs. 200
(ii) Variable cost is 40 of sales.
(iii) Fixed cost p.a. Rs. 30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:
Year 1 2 3-5 6-8
Expenditure 50,00,000 25,00,000 10,00,000 5,00,000
(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purpose.
(vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.
Present Value Table
Year 1 2 3 4 5 6 7 8
PVF @ 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
10%
Advise about the project acceptability.
⧫ Replacement Decision – Now or Later

Question 71.
Company Y is operating an elderly machine that is expected to produce a net cash inflow of Rs. 40,000 in the coming year
and Rs. 40,000 next year. Current salvage value is Rs. 80,000 and next year’s value is Rs. 70,000. The machine can be
replaced now with a new machine, which costs Rs. 1,50,000, but is much more efficient and will provide a cash inflow of
Rs. 80,000 a year for 3 years. Company Y wants to know whether it should replace the equipment now or wait a year with
the clear understanding that the new machine is the best of the available alternatives and that it turn be replaced at the
optimal point. Ignore tax. Take opportunity cost of capital as 10%. Advise with reasons.
⧫ Investment at Different Point of time – NPV Based Evaluation

Question 72.
X Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8 years. Initial
equipment cost will be Rs. 120 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning of
third year. At the end of the 8 years, the original equipment will have resale value equivalent to the cost of removal, but
the additional equivalent would be sold for Rs. 1 lakh. Working Capital of Rs. 15 lakhs will be needed. The 100% capacity
of the plant is of 4,00,000 units per annum, but the production and sales-volume expected are as under:
Year Capacity in percentage
1 20
2 30
3-5 75
6-8 50
A sale price of Rs. 100 per unit with a profit-volume ratio of 60% is likely to be obtained. Fixed Operating Cash Cost are
likely to be Rs. 16 lakhs per annum. In addition to this the advertisement expenditure will have to be incurred as under
Year 1 2 3-5 6–8
Expenditure in Rs. 30 15 10 4
lakhs each year
The company is subject to 50% tax, straight-line method of depreciation, (permissible for tax purposes also) and taking
12% as appropriate after tax cost of capital, should the project be accepted?
Question 73.
What is Capital Rationing? Describe various ways of implementing it?
Solution 73:
1. Resource Constraints: Sometimes a firm has a number of Projects that yield a positive NPV and funds are not fully
available to undertake all the projects. This is considered as a Resource Constraints situation.

2. Capital Rationing: In case of limited availability of funds, the objective of the firm is to maximise the wealth of
shareholders with the available funds. Such investment planning is called Capital Rationing. There are two possible
situations of Capital Rationing –
a. Firm fix up the maximum funds that can be invested in capital projects, during a given period of time. This budget
ceiling imposed internally is called as Soft Capital Rationing
b. There may be a market constraint on the funds available for investment during a period. This inability to obtain
funds from the market, due to external factors is called Hard Capital Rationing.
3. NPV Maximisation: Whenever capital rationing situation arises, the Firm should allocate the limited funds available in
such a way that maximises the NPV of the firm. The following principles may be applied in selecting the appropriate
investment proposals/ combinations.
INDIVISIBLE PROJECT
Investment should be made in full. Partial or Proportionate investment is not possible.
STEPS INVOLVED IN DECISION MAKING

• Determine the combination of projects to utilise amount available.
• Compute NPV of each combination.
• Select the combination with maximum NPV.
DIVISIBLE PROJECT
Partial Investment is also possible and proportionate NPV can be obtained in such projects.
STEPS INVOLVED IN DECISION MAKING

• Compute PI of various projects and rank them based on PI.
• Projects are selected based on maximum profitability Index.
Question 74.
S. Ltd. has Rs. 10,00,000 allocated for capital budgeting purposes. The following proposals and associated profitability
indexes have been determined.
Project Amount (Rs.) Profitability Index (Rs.)
1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken? Assume that projects are indivisible and there is no alternative
use of the money allocated for capital budgeting.
Question 75. ____________________________________________________________________________________[RTP]

Venture Ltd. has Rs. 30 lakhs available for investment in capital projects. It has the option of making investment in projects
1, 2, 3 and 4. Each project is entirely independent and has a useful life of 5 years. The expected present values of cash
flows from the projects are as follows:
Projects Initial outlay (Rs.) Present value of Cash
Inflows (Rs.)
1 8,00,000 10,00,000
2 15,00,000 19,00,000
3 7,00,000 11,40,000
4 13,00,000 20,00,000
Which of the above investments should be undertaken? Assume that the cost of capital is 12% and risk free interest rate
is 10% per annum. Given compounded sum of Re. 1 at 10% in 5 years is Rs. 1.611 and discount factor of Re. 1 at 12% rate
for 5th year is 0.567.
Question 76._________________________________________________________________________ [STUDY MATERIAL]

Shiva Limited is planning its capital investment programme for next year. It has five projects all of which give a positive
NPV at the company cut-off rate of 15 percent, the investment outflows and present values being as follows:
Project Investment (Rs. '000) NPV @ 15% (Rs. '000)
A (50) 15.4

B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of Rs. 1,20,000.You are required to optimize the returns from a package of
projects within the capital spending limit. The projects are independent of each other and are divisible (i.e., part-project
is possible).
⧫ Miscellaneous Theory
Question 77.
Distinguish between Net Present Value and Internal Rate of Return?
Solution 77:
NPV and IRR:NPV and IRR methods differ in the sense that the results regarding the ‘choice’ of an asset under certain
circumstances are mutually contradictory under two methods. In case of mutually exclusive investment projects, in certain
situations, they may give contradictory results such that if the NPV method finds one proposal acceptable, IRR favours
another. The different rankings given by the NPV and IRR methods could be due to size disparity problem, time disparity
problem and unequal expected lives.
The net present value is expressed in financial values whereas internal rate of return (IRR) is expressed in percentage
terms.
In net present value cash flows are assumed to be re-invested at cost of capital rate. In IRR re-investment is assumed to
be made at IRR rates.
Question 78.
“Decision tree analysis is helpful in managerial decisions”.
Solution 78:
Complex investment decisions involve a sequence of decisions over time. It is also argued that since present choices
modify future alternatives, industrial activity cannot be reduced to a single decision and must be viewed as a sequence of
decisions extending from the present time into the future. These sequential decisions are taken on the basis of decision
tree analysis. While constructing and using decision tree, some important steps to be considered are as follows:
(i) Investment proposal should be properly defined.
(ii) Decision alternatives should be clearly clarified.
(iii) The decision tree should be properly graphed indicating the decision points, chances, events and other data.
(iv) The results should be analysed and the best alternative should be selected.
Question 79.
Explain the concept of Multiple Internal Rate of Return.
Solution 79:
In cases where project cash flows change signs or reverse during the life of a project for example, an initial cash outflow
is followed by cash inflows and subsequently followed by a major cashoutflow, there may be more than one internal rate

of return (IRR). The following graph of discount rate versus net present value (NPV) may be used as an illustration:
In such situations if the cost of capital is less than the two IRRs, a decision can be made easily, however, otherwise the IRR
decision rule may turn out to be misleading as the project should only be invested if the cost of capital is between IRR1
and IRR2. To understand the concept of multiple IRRs it is necessary to understand the implicit reinvestments assumption
in both NPV and IRR techniques.

Elite Cooker Company is evaluating three investment situations: (1) Produce a new line of aluminium skillets, (2) expand
its existing cooker line to include several new sizes, and (3) develop a new, higher-quality line of cookers. If only the project
in question is undertaken, the expected present value and the amounts of investment required are:
Project Investment required Present value of Future Cash-

(Rs.) Flows (Rs.)
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the investment required and preset value will simply
be the sum of the parts. With projects 1 and 3, economies are possible in investment because one of the machines acquired
can be used in both production processes. The total investment required for projects 1 and 3 combined is Rs. 4,40,000.If
projects 2 and 3 are undertaken, there are economies to be achieved in marketing and producing the products but not in
investment. The expected present value of future cash flows for projects 2 and 3 is Rs. 6,20,000. If all three projects are
undertaken simultaneously, the economies noted will still hold. However, a Rs. 1,25,000 extension on the plant will be
necessary, as space is not available for all three projects. Which project or projects should be chosen?

Chapter 8
RISK ANALYSIS IN CAPITAL BUDGETING
Question 1. ___________________________________________________________________________[Study Material]
Possible net cash flows of Projects A and B at the end of first year and their probabilities are given as below. Discount rate
is 10 per cent. For both the project initial investment is ₹ 10,000. From the following information, CALCULATE the expected
net present value for each project. State which project is preferable?
Possible Event Project A Project B

Cash Flow (₹) Probability Cash Flow (₹) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
Question 2. ____________________________________________________________________________[Study Material]

Probabilities for net cash flows for 3 years of a project are as follows:
Year I Year II Year III
Cash Flow (₹) Probability Cash Flow (₹) Probability Cash Flow (₹) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
CALCULATE the expected net cash flows. Also calculate net present value of the project using expected cash flows using
10 per cent discount rate. Initial Investment is ₹10,000.

CALCULATE Variance and Standard Deviation on the basis of following information:
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10

CALCULATE Coefficient of Variation based on the following information:
A 10,000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10


An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by the
Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated over the life of the
project.
Year Cash Flows (₹ In Lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted discount rate.

If Investment proposal is ₹ 45,00,000 and risk free rate is 5%, CALCULATE net present value under certainty equivalent
technique.
Year Expected Cash Flows (₹) Certainty Equivalent
Coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

X Ltd is considering its New Product ‘with the following details
S. No. Particulars Figures
1 Initial capital cost ₹ 400 cr
2 Annual unit sales 5 cr
3 Selling price per unit ₹ 100
4 Variable cost per unit ₹ 50
5 Fixed costs per year ₹ 50 cr
6 Discount Rate 6%
Required:
1. CALCULATE the NPV of the project.
2. COMPUTE the impact on the project’s NPV of a 2.5 per cent adverse variance in each variable. Which variable is having
maximum effect .Consider Life of the project as 3 years.

XYZ Ltd. is considering a project “A” with an initial outlay of ₹ 14,00,000 and the possible three cash inflow attached with
the project as follows: (₹ in 000)
Particular Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most likely result but
uncertain about the third year’s cash flow, ANALYSE what will be the NPV expecting worst scenario in the third year.
Question 9. ___________________________________________________________________[Study Material, May 2009]

Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ₹ 36,000 and project B ₹ 30,000. You
have been given below the net present value probability distribution for each project.
Project A Project B
NPV estimates (₹) Probability NPV estimates (₹) Probability
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4

6,000 0.3 6,000 0.4

3,000 0.2 3,000 0.1
(i) COMPUTE the expected net present values of projects A and B.

(ii) COMPUTE the risk attached to each project i.e. standard deviation of each probability distribution.
(iii) COMPUTE the profitability index of each project.
(iv) IDENTIFY which project do you recommend? State with reasons.
Question 10. __________________________________________________________________________[Study Material]

From the following details relating to a project, analyse the sensitivity of the project to changes in initial project cost,
annual cash inflow and cost of capital:
Initial Project Cost (₹) 1,20,000
Annual Cash Flow (₹) 45,000
Project Life (Years) 4
Cost of Capital 10%
IDENTIFY which of the three factors; the project is most sensitive if the variable is adversely affected by 10%? (Use annuity
factors: for 10% 3.169 and 11% ... 3.103).
Question 11. __________________________________________________________________________[ Study Material]

The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals, Projects M and N, which
require cash outlays of ₹8,50,000 and ₹8,25,000 respectively. The certainty-equivalent (C.E) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bonds is 6% and this is used as the risk
free rate. The expected net cash flows and their certainty equivalents are as follows:
Project M Project N
Year-end Cash Flow (₹) C.E. Cash Flow (₹) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and 0.840 respectively.
Required:
(i) ANALYSE which project should be accepted?
(ii) If risk adjusted discount rate method is used, IDENTIFY which project would be appraised with a higher rate and why?

DETERMINE the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (₹) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (₹) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:
Coefficient of Variation Risk-Adjusted Rate of Return P.V. Factor 1 to 5 years At risk
adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
Question 13. ___________________________________________________________________[Nov 2018 (similar)]

From the following details relating to a project, analyze the sensitivity of the project to changes in initial project cost,

Initial Project Cost (₹) 1,20,000

Annual Cash Inflow (₹) 45,000
Cost of Capital 10%
Required:
EXAMINE which of the three factors, the project is most sensitive? (Use annuity factors: for 10% 3.169 and 11% 3.103).
Question 14. ________________________________________________________________ __[RTP New May 2019]

An enterprise is investing ₹ 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by the
Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated over the life of the
project.
Year Cash flows (₹ in lakhs)
1 25
2 60
3 75
4 80
5 65
Question 15. ____________________________________________________________________[RTP New - Nov 2018]

Gauav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following information regarding
a new project is as follows:
Year Cash flows (₹ in lakhs) Certainty equivalent quotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project should be accepted?
Question 16.____________________________________________________________________ [RTP New - Nov 2019]

SL Ltd. has invested ₹1,000 lakhs in a project. The risk-free rate of return is 5%. Risk premium expected by the Management
is 10%. The life of the project is 5 years. Following are the cash flows that are estimated over the life of the project.
Year Cash flows (₹ in lakhs)
1 125
2 300
3 375
4 400
5 325
Question 17.______________________________________________________________________________ [May 1999]

A company is considering two mutually exclusive projects X and Y. Project X costs ₹ 30,000 and Project Y costs ₹ 36,000.
You have been given the below net present value probability distribution for each project:
Project X Project Y
NPV estimate Probability NPV estimate Probability
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
(i) Compute the expected net present value of Projects X and Y.
(ii) Compute the risk attached to each project i.e., standard deviation of each probability distribution.
(iii) Which project do you consider more risky and why?
(iv) Compute the probability index of each project.
Question 18. ___________________________________________________________________[Exam - Nov 2018 (New)]

From the following details relating to a project, analyze the sensitivity of the project to changes in initial project cost,
Initial Project Cost (₹) 2,00,00,000
Annual Cash Inflow (₹) 60,00,000
Cost of Capital 10%
Required:
EXAMINE which of the three factors, the project is most sensitive? (Use annuity factors: for 10% 3.791 and 11% 3.696).
Question 19.__________________________________________________________________ [RTP May 2010 (CA Final)]

X Ltd. has under its consideration a project with an initial investment of ₹ 1,00,000. Three probable cash inflow scenarios
cash inflow scenarios with their probabilities of occurrence have been estimated as below:
Annual cash inflow (₹) 20,000 30,000 40,000
Probability 0.1 0.7 0.2
The project life is 5 years and the desired rate of return is 20%. The estimated terminal values for the project assets under
the three probability alternatives are 0, ₹ 20,000 and ₹ 30,000.

(i) Find the probable NPV;
(ii) Find the worst case NPV and the best case NPV; and
(iii) State the probability occurrence of the worst case, if the cash flows are perfectly positively correlated over time
Question 20. _______________________________________________________________________________[Nov 2019]

Door Ltd. is considering an investment of ₹ 4,00,000. This investment is expected to generate substantial cash inflows over
the next five years. Unfortunately the annual cash flows from this investment is uncertain, but the following probability
distribution has been established.
Annual cash flow (₹) Probability
50,000 0.3
1,00,000 0.3
1,50,000 0.4
At the end of its 5 years life, the investment is expected to have a residual value of ₹ 40,000. The cost of capital is 5%.
Calculate:
(i) NPV under the three different scenarios.
(ii) Calculate expected NPV
(iii) Advise Door Ltd. on whether the investment is to be undertaken.
Year DF @ 5%
1 0.952
2 0.907
3 0.864
4 0.823
5 0.784

Chapter 9
DIVIDEND DECISIONS
➢ Meaning of Dividend
Dividend is that part of profit after tax which is distributed to the shareholders of the company. In other words, the profit
earned by a company after paying taxes can be used for:
i. Distribution of dividend or
ii. Can be retained as surplus for future growth
Distributed Dividend
Profit After
Tax
Retained Retained
Earnings
➢ Significance of Dividend Policy

Dividend policy of a company is governed by:
(i) Financing Decisions:
• In order to make investments, a company needs finance and one of the source of finance available to
it is Equity Shareholders funds.
• These funds can be arranged externally by issue of new equity shares or can be generated internally
through retention of earnings.
• Retained Earnings are a less costly, as it does not involve incurrence of floatation costs.
a) Projects available with the Company:

When a company has many financially viable projects to put its money as investments, then instead of
distributing a large amount of profit as dividends amongst the shareholders, it may retain earnings and make
investment in these projects by using internally generated funds or retained earnings.
b) Requirement of Equity Funds:

The funds required from equity shareholders will be arranged by first from its retained earnings, which will affect
the amount of dividends payable to its shareholders.
(ii) Wealth Maximizing Decisions:
a) Proper balance between Dividends and Retentions:

The small and medium income class group shareholders and investors give higher value to near dividends than
future dividends and capital gains due to uncertainty in the market and economy as a whole.
b) Use of Retained Earnings affects current and future dividends:

Increased retained earnings to finance profitable investments increases future earnings per share and thus,
future dividends per share.
Management should develop a dividend policy which divides net earnings into dividends and retained earnings in an
optimum way so as to achieve the objective of wealth maximization for its equity shareholders.

➢ Forms of Dividend
(i) Cash Dividend:

• A cash dividend is in the form of money paid to stockholders out of the company’s current earnings or
accumulated profits.
• It is the most common form of dividend.
• Money here means payment in the form of cash, cheque, warrant, demand draft, pay order or directly
through Electronic Clearing Service (ECS), but NOT in kind.
(ii) Stock Dividend (Bonus Shares)

• Stock dividends are in the form of issue of Bonus shares to the existing shareholders.
• This will increase the capital and reduce the reserves and surpluses.
• The net worth is not affected by Stock dividends.
• The stock dividends have no impact on the overall wealth of the shareholders.
• It merely divides the ownership of the company into a large number of pieces.
• The bonus issue does not give any extra or special benefit to a shareholder.
➢ Advantages of stock Dividend

There are many advantages both to the shareholders and to the company. Some of the important ones are listed as under:
(1) To Share Holders:

• Tax benefit –At present there is no tax on dividend received from a domestic company.
• Policy of paying fixed dividend per share and its continuation even after declaration of stock dividend will
increase total cash dividend of the shareholders in future.
(2) To Company:
• Conservation of cash for meeting profitable investment opportunities.
• Cash deficiency and restrictions imposed by lenders to pay cash dividend.
➢ Limitations of Stock Dividend

Limitations of stock dividend to shareholders and to company are as follows:
(1) To Share Holders

• Stock dividend does not affect the wealth of shareholders and therefore it has no value for them.
• It merely divides the company's ownership into a large number of share certificates.
• Proportionate ownership in the company does not change at all.
(2) To Company:
• Stock dividends are more costly to administer than cash dividend.
• It is disadvantageous if periodic small stock dividends are declared by the company as earnings.
• This result in the measured growth in earnings per share being less than the growth based on per share for small
issues of stock dividends are not adjusted at all and only significant stock dividends are adjusted.
• Also, companies have to pay tax on distribution.
➢ Relationship between Retained Earnings and Growth

It can be illustrated with the help of the following equation:
Growth (g) = br
Where,
g = growth rate of the firm
b = retention ratio

r = rate of return on investment
➢ Determinants of Dividend Decisions

The dividend policy is affected by the following factors:
1. Availability of funds:
• If the business is in requirement of funds, then retained earnings could be a good source.
• Since it saves the floatation cost and further the control will not be diluted as in case of further issue
of share capital.
2. Cost of capital:
• If the financing requirements can be financed through debt (relatively cheaper source of finance), then
it should be preferred to distribute more dividend but if the financing is to be done through fresh issue
of equity shares, it is better to use retained earnings as much as possible.
3. Capital structure:
• An optimum Debt equity ratio should also be under consideration for the dividend decision.
4. Stock price:
• Stock price here means market price of the shares.
• Generally, higher dividends increase value of shares and low dividends decrease it.
5. Investment opportunities in hand:

• The dividend decision is also affected, if there are investment opportunities in hand, the company may
prefer to retain more from the earnings.
6. Internal rate of return:

• If the internal rate of return is more than the cost of retained earnings, it’s better to distribute the
earnings as much as possible.
7. Trend of industry:
• Few industries have been seen by investors for regular income, hence in such cases, the firm will have
to pay dividend for survival.
8. Expectation of shareholders:
• The shareholders can be categorised in two categories:
(i) those who invests for regular income, &
(ii) those who invests for growth. Generally, the investor prefers current dividend over the
future growth.
9. Legal constraints:
Section 123 of the Companies Act, 2013 came into force from 1st April, 2014 which provides for declaration of
dividend. According to this section:
(i) Dividend shall be declared or paid by a company for any financial year only:
(a) out of the profits of the company for that year arrived at after providing for depreciation, or
(b) out of the profits of the company for any previous financial year or years arrived at after providing for
depreciation, or
(c) out of both; or
(d) out of money provided by the Central Government or a State Government for the payment of dividend by
the company in pursuance of a guarantee given by that Government.
10. Taxation:
• As per Section 115-O of Income Tax Act, 1961, dividend is subject to dividend distribution tax (DDT) in
the hands of the company.

➢ Practical Considerations in Dividend Policy

Internal financing ultimately turns to practical considerations which determine the dividend policy of a company.
• whether there should be a stable pattern of dividends over the years or
• whether the company should treat each dividend decision completely independent.
(a) Financial Needs of The Company:

• Retained earnings can be a source of finance for creating profitable investment opportunities.
• Risk and financial obligations increase if a company raises capital through issue of new shares where
floatation costs are involved.
Mature Companies Growth Companies

Mature companies having few investment opportunities Growth companies, on the other hand, have low payout
will show high payout ratios. ratios. They are in need of funds to finance fast growing
fixed assets.
Share prices of such companies are sensitive to dividend Distribution of earnings reduces the funds of the
charges. company. They retain all the earnings and declare bonus
shares to offset the dividend requirements of the
shareholders.
So a small portion of the earnings are kept to meet These companies increase the amount of dividends
emergent and occasional financial needs. gradually as the profitable investment opportunities
start falling.
(b) Constraints on Paying Dividends:
(i) Legal:
Under Section 123 of the Companies Act 2013, Dividend shall be declared or paid by a company for any
financial year only:
(a) Out of the profits of the company for that year arrived at after providing for depreciation in
accordance with the provisions of section 123(2), or
(b) Out of the profits of the company for any previous financial year or years arrived at after providing
for depreciation in accordance with the provisions of that sub-section and remaining undistributed, or
(c) Out of both; or
(d) Out of money provided by the Central Government or a State Government for the payment of
dividend by the company in pursuance of a guarantee given by that Government.
(ii) Liquidity:
Payment of dividends means outflow of cash. Ability to pay dividends depends on cash and liquidity
position of the firm.
(iii) Access to the Capital Market:

By paying large dividends, cash position is affected. If new shares have to be issued to raise funds for
financing investment programmes and if the existing shareholders cannot buy additional shares,
control is diluted.
(iv) Investment Opportunities:

If investment opportunities are inadequate, it is better to pay dividends and raise external funds
whenever necessary for such opportunities.
(c) Desire of Shareholders:

• The small shareholders are concerned with regular dividend income hence select shares of companies
paying regular and liberal dividend.
• Shareholders who prefer to gain on sale of shares at times when shares command higher price in the
market. However capital gain on sale of shares attracts tax on such gain and rate vary on the basis of
holding period.

(d) Stability of Dividends:
(i) Constant Dividend Per Share:

Shareholders are given fixed amount of dividend irrespective of actual earnings. The amount of
dividend may increase or decrease later on depending upon the financial health of the company but it
will be maintained far a considerable period.
(ii) Constant Percentage of Net earnings:

The ratio of dividend to earnings is known as Payout ratio. Some companies follow a policy of constant Payout
ratio i.e. paying fixed percentage on net earnings every year. To quote from Page 74 of the annual report 2011
of Infosys Technologies Limited,
“The Dividend Policy is to distribute up to 30% of the Consolidated Profit after Tax (PAT) of the Infosys Group as
Dividend.”
(iii) Small Constant Dividend Per Share plus Extra Dividend:

The amount of dividend is set at high level and the policy is adopted for companies with stable earnings. For
companies with fluctuating earnings, the policy is to pay a minimum dividend per share with a step up feature.
➢ Theories of Dividend:

➢ Modigiliani and Miller (M.M.) hypothesis:
Modigliani – Miller theory was proposed by Franco Modigliani and Merton Miller in 1961. MM approach is in support of
the irrelevance of dividends i.e. firm’s dividend policy has no effect on either the price of a firm’s stock or its cost of capital.
➢ Assumptions of M.M. hypothesis:

MM hypothesis is based on the following assumptions:
• Perfect capital markets:

The firm operates in a market in which all investors are rational and information is freely available to all.
• No taxes or no tax discrimination between dividend income and capital appreciation (capital gain):
This assumption is necessary for the universal applicability of the theory, since, the tax rates or provisions to tax
income may be different in different countries.
• Fixed investment policy:

It is necessary to assume that all investment should be financed through equity only.
• No floatation or transaction cost:

Similarly, these costs may differ country to country or market to market.
• Risk of uncertainty does not exist:

Investors are able to forecast future prices and dividend with.
According to MM hypothesis,
• Market value of equity shares of its firm depends solely on its earning power.
• Market value of equity shares is not affected by dividend size.
• MM hypothesis is primarily based on the arbitrage argument.
𝑷𝟏+𝑫𝟏
Po = 𝟏+𝑲𝒆
Where,
Pₒ= Price in the beginning of the period.
P₁= Price at the end of the period.
D₁= Dividend at the end of the period.

Where,
Vf = Value of firm in the beginning of the period
n = number of shares in the beginning of the period
∆n = number of shares issued to raise the funds required
I = Amount required for investment
E = total earnings during the period
➢ Advantages of MM Hypothesis:
Various advantages of MM Hypothesis are as follows:
1. This model is logically consistent.
2. It provides a satisfactory framework on dividend policy with the the concept of Arbitrage process.
➢ Limitations of MM Hypothesis:
Various Limitations of MM Hypothesis are as follows:
1. Validity of various assumptions is questionable.
2. This model may not be valid under uncertainty.
➢ WALTER MODEL
Assumptions of Walter’s Model:

Walter’s approach is based on the following assumptions:
• All investment proposals of the firm are to be financed through retained earnings only
• ‘r’ rate of return & ‘Ke’ cost of capital are constant
• Perfect capital markets: The firm operates in a market in which all investors are rational and information is freely
available to all.
• No taxes or no tax discrimination between dividend income and capital appreciation (capital gain): This assumption is
necessary for the universal applicability of the theory, since, the tax rates or provisions to tax income may be different in
different countries. • No floatation or transaction cost: Similarly, these costs may differ country to country or market to
market.
• The firm has perpetual life.
The relationship between dividend and share price based on Walter’s formula is shown below:
𝑫+(𝑬−𝑫)𝒙 𝒓/𝑲𝒆
Market Price (P) =
𝑲𝒆
Where,
P = Market Price of the share.
E = Earnings per share.
D = Dividend per share.
Ke = Cost of equity/ rate of capitalization/ discount rate.
r = Internal rate of return/ return on investment
➢ IRR, Ke and Optimum Payout

As we know Walter approach consider two factors, following is the conclusion of Walter’s model
Company Condition of r vs Ke Correlation between size of Optimum Dividend Payout

Dividend and Market Price of Share Ratio

Growth R > Ke Negative Zero

Constant R = Ke No Correlation Every payout ratio is optimum
Decline R < Ke Positive 100%
➢ Advantages of Walter Model:

1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers internal rate of return, market
capitalisation rate and dividend payout ratio in the determination of market value of shares.
➢ Limitations of Walter Model:

1. The formula does not consider all the factors affecting dividend policy and share prices. Moreover, determination of
market capitalisation rate is difficult.
2. Further, the formula ignores such factors as taxation, various legal and contractual obligations, management policy
and attitude towards dividend policy and so on.
➢ GORDAN MODEL (Dividend Discount Model)

According to Gordon’s model dividend is relevant and dividend policy of a company affects its value.
➢ Assumptions of Gordon’s Model

This model is based on the following assumptions:
• Firm is an all equity firm i.e. no debt.

• IRR will remain constant, because change in IRR will change the growth rate and consequently the value will be affected.
Hence this assumption is necessary.
• Ke will remains constant, because change in discount rate will affect the present value.
• Retention ratio (b), once decide upon, is constant i.e. constant dividend payout ratio will be followed.
• Growth rate (g = br) is also constant, since retention ratio and IRR will remain unchanged and growth, which is the
function of these two variable will remain unaffected.
• Ke > g, this assumption is necessary and based on the principles of series of sum of geometric progression for ‘n’ number
of years.
• All investment proposals of the firm are to be financed through retained earnings only.
The following formula is used by Gordon to find out price per share:
Po = E1 (1 - b) / Ke - br
Where,
P0 = Price per share
E1 = Earnings per share
b = Retention ratio; (1 - b = Payout ratio)
Ke = Cost of capital
r = IRR
br = Growth rate (g)
➢ The “Bird-in-Hand Theory”

Myron Gordon revised his dividend model and considered the risk and uncertainty in his model. The Bird-in-hand theory
of Gordon has two arguments:
(i) Investors are risk averse and
(ii) Investors put a premium on certain return and discount on uncertain return.
The relationship between dividend and share price on the basis of Gordon's formula is shown as:

Where,
P0 = Market price per share (ex-dividend)
Do = Current year dividend
g = Constant annual growth rate of dividends
Ke = Cost of equity capital (expected rate of return)
➢ DIVIDEND DISCOUNT MODEL (DDM)

It is a financial model that values shares at the discounted value of the future dividend payments. Under this model, the
price of a share will be traded is calculated by the PV of all expected future dividend payment discounted by an appropriate
risk- adjusted rate. The dividend discount model price is the intrinsic value of the stock i.e.
Intrinsic value = Sum of PV of future cash flows
Intrinsic value = Sum of PV of Dividends + PV of Stock Sale Price
(a) Zero growth rates:

Assumes all dividend paid by a stock remains same. In this case the stock price would be equal to:
Stock's intrinsic Value = Annual Dividend / Requied rate of return

i.e. P0 = D / Ke
Where,
D = Annual dividend
Ke = Cost of capital
Po = Current Market price of share
(b) Constant Growth Rate (Gordon’s Growth Model):

The relationship between dividend and share price on the basis of Gordon’s formula is:
Market price per share (P) = Do (1 + g) / Ke - g

Where,
P = Market price per share
Do = current year dividend
g = growth rate of dividends
Ke = cost of equity capital/ expected rate of return
Notes:
g = b × r b = proportion of retained earnings or (1- dividend payout ratio)
(c) Variable growth rate:

• Variable-growth rate models (multi-stage growth models) can take many forms, even assuming the growth rate
is different for every year.
• The most common form is one that assumes 3 different rates of growth.
• An initial high rate of growth, a transition to slower growth, and lastly, a sustainable, steady rate of growth.
• The present values of each stage are added together to derive the intrinsic value of the stock. Sometimes, even
the capitalization rate, or the required rate of return, may be varied if changes in the rate are projected.
➢ Advantages of Gordon’s Model:

1. The dividend discount model is a useful heuristic model that relates the present stock price to the present value of its
future cash flows.
2. This Model is easy to understand.
➢ Limitations of Gordon Model:

1. The dividend discount model depends on projections about company growth rate and future capitalization rates of the
remaining cash flows, which may be difficult to calculate accurately.
2. The true intrinsic value of a stock is difficult to determine realistically.
➢ Traditional Model
1. Graham & Dodd Model:

According to the traditional position expounded by Graham & Dodd, the stock market places considerably more
weight on dividends than on retained earnings. Their view is expressed quantitatively in the following valuation
model:
P = m (D + E / 3)
Where,
P = Market price per share
D = Dividend per share
E = Earnings per share
m = a multiplier
2. Linter’s Model:
Linter’s model has two parameters:
i. The target payout ratio,
ii. The spread at which current dividends adjust to the target.
John Linter based his model on a series of interviews which he conducted with corporate managers in the mid 1950’s.While
developing the model, he considers the following assumptions:
1. Firm have a long term dividend payout ratio. They maintain a fixed dividend payout over a long term. Mature companies
with stable earnings may have high payouts and growth companies usually have low payouts.

2. Managers are more concerned with changes in dividends than the absolute amounts of dividends. A manager may easily
decide to pay a dividend of ` 2 per share if last year too it was ` 2 but paying ` 3 dividend if last year dividend was `2 is an
important financial management decision.
3. Dividend changes follow changes in long run sustainable earnings.
4. Managers are reluctant to affect dividend changes that may have to be reversed.
Under Linter’s model, the current year’s dividend is dependent on current year’s earnings and last year’s dividend.
D1 = Do + [(EPS x Target Payout) – D0] x Af
Where,
D₁ = Dividend in year 1
Dₒ = Dividend in year 0 (last year dividend)
EPS = Earnings per share
Af = Adjustment factor or Speed of adjustment
➢ STOCK SPLITS
Stock split means splitting one share into many, say, one share of `500 in to 5 shares of `100. Stock splits is a tool used by
the companies to regulate the prices of shares i.e. if a share price increases beyond a limit, it may become less tradable,
for e.g. suppose a company’s share price increases from `50 to `1000 over the years, it is possible that it might goes out of
range of many investors.
➢ Advantages of Stock Splits:

Various advantages of Stock Splits are as follows:
1. It makes the share affordable to small investors.
2. Number of shares may increase the number of shareholders; hence the potential of investment may increase.
➢ Limitations of Stock Splits:

Various limitations of Stock Splits are as follows:
1. Additional expenditure need to be incurred on the process of stock split.
2. Low share price may attract speculators or short term investors, which are generally not preferred by any company.
➢ PRACTICAL PROBLEMS

AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has outstanding 10,000
shares selling at Rs. 100 each. The firm is contemplating the declaration of a dividend of Rs. 5/ share at the end of the
current financial year. It expects to have a net income of Rs. 1,00,000 and has a proposal for making new investments of
Rs. 2,00,000. CALCULATE the value of the firms when dividends (i) are not paid (ii) are paid.

XYZ Ltd. earns Rs. 10/ share. Capitalization rate and return on investment are 10% and 12% respectively.
DETERMINE the optimum dividend payout ratio and the price of the share at the payout.

The following figures are collected from the annual report of XYZ Ltd.:
Net Profit Rs. 30 lakhs
Outstanding 12% preference shares Rs. 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
COMPUTE the approximate dividend pay-out ratio so as to keep the share price at Rs. 42 by using Walter’s
model?

Question 4. [STUDY MATERIAL, MTP, RTP(MAY 2019)]

The following figures are collected from the annual report of XYZ Ltd.:
Net Profit Rs. 30 lakhs
Outstanding 12% preference shares Rs. 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii) 100%.

X Ltd. is a no growth company, pays a dividend of Rs. 5 per share. If the cost of capital is 10%, COMPUTE the current market
price of the share?

XYZ is a company having share capital of Rs. 10 lakhs of Rs. 10 each. It distributed current dividend of 20% per annum.
Annual growth rate in dividend expected is 2%. The expected rate of return on its equity capital is 15%. CALCULATE price
of share applying Gordons growth Model.

A firm had been paid dividend at Rs. 2 per share last year. The estimated growth of the dividends from the company is
estimated to be 5% p.a. DETERMINE the estimated market price of the equity share if the estimated growth rate of
dividends (i) rises to 8%, and (ii) falls to 3%. Also FIND OUT the present market price of the share, given that the required
rate of return of the equity investors is 15%.

The earnings per share of a company is Rs. 30 and dividend payout ratio is 60%. Multiplier is 2. DETERMINE the price per
share as per Graham & Dodd model.

The following information regarding the equity shares of M Ltd. is given below:
Market price Rs. 58.33
Dividend per share Rs. 5
Multiplier 7
According to the Graham & Dodd approach to the dividend policy, COMPUTE the EPS.

Given the last year’s dividend is Rs. 9.80, speed of adjustment = 45%, target payout ratio 60% and EPS for current year
Rs. 20. COMPUTE current year’s dividend using Linter’s model.

RST Ltd. has a capital of Rs. 10,00,000 in equity shares of Rs. 100 each. The shares are currently quoted at
par. The company proposes to declare a dividend of Rs. 10 per share at the end of the current financial year.
The capitalization rate for the risk class of which the company belongs is 12%. COMPUTE market price of the
share at the end of the year, if
(i) dividend is not declared ?
(ii) dividend is declared ?
(iii) assuming that the company pays the dividend and has net profits of Rs. 5,00,000 and makes new investments of Rs.
10,00,000 during the period, how many new shares must be issued? Use the MM model.
Question 12. [STUDY MATERIAL, RTP(MAY 2018), NOV 2018(Similar), RTP(NOV 2019)]
The following information pertains to M/s XY Ltd.
Earnings of the Company 5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15
CALCULATE:
(i) What would be the market value per share as per Walter’s model?

(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of Company’s share
at that payout ratio?

Again taking an example of three different firms i.e. growth, normal and declining firm. CALCULATE the Gordon’s model
with the help of a following example:
Factors Growth Firm Normal Firm Declining Firm
r > Ke r = Ke r < Ke
r (rate of return on 15% 10% 8%
retained earnings)
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) Rs. 10 Rs. 10 Rs. 10
b (Retained Earnings) 0.6 0.6 0.6
1- b 0.4 0.4 0.4

M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares and
the current market price is Rs. 100. It expects a net profit of Rs. 2,50,000 for the year and the Board is
considering dividend of Rs. 5 per share.
M Ltd. requires to raise Rs. 5,00,000 for an approved investment expenditure. ILLUSTRATE, how the MM approach
affects the value of M Ltd. if dividends are paid or not paid.

The following information is supplied to you:
Total Earnings 2,00,000
No. of equity shares (of Rs. 100 20,000
each)
Dividend paid 1,50,000
Price/ Earnings ratio 12.5
Applying Walter’s Model
(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE

With the help of following figures CALCULATE the market price of a share of a company by using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)
Earnings per share (EPS) Rs. 10
Dividend per share (DPS) Rs. 6
Cost of capital (Ke) 20%
Internal rate of return on 25%
investment
Retention Ratio 40

The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend policy with a multiplier
of 9, COMPUTE P/E ratio.
Question 18. [RTP (NOV 2018)]

The earnings per share of a company is Rs. 10 and the rate of capitalisation applicable to it is 10 per cent. The
company has three options of paying dividend i.e. (i) 50%, (ii) 75% and (iii) 100%.
CALCULATE the market price of the share as per Walter’s model if it can earn a return of (a) 15, (b) 10 and (c) 5 per cent
on its retained earnings.

The following information is supplied to you:
Total Earning Rs. 40 lakhs

No. of Equity Shares (of Rs. 100 4,00,000

each)
Dividend Per Share Rs. 4
Cost of Capital 16%
Internal rate of return on 20%
investment
Retention ratio 60%
Calculate the market price of a share of a company by using :
(i) WaIter’s Formula
(ii) Gordon's Formula

Following figures and information Rs. 10,00,000
were extracted from the company A
Ltd. Earnings of the company
Dividend paid Rs. 6,00,000
No. of shares outstanding 2,00,000
Price earnings ratio 10
Rate of return on investment 20%
Question 21.
Sahu & Co. earns Rs.6 per share having capitalisation rate of 10 percent and has a return on investment at the rate of 20
percent. According to Walter’s model, what should be the price per share at 30 percent dividend payout ratio? Is this the
optimum payout ratio as per Walter?
Question 22.
MNP Ltd. Has declared and paid annual dividend of Rs. 4 per share. It is expected to grow @ 20% for the next
two years and 10% thereafter. The required rate of return of equity investors is 15%. Compute the current
priceat which equity shares should sell.
Note: present value interest factor (PVIF) @ 15% for
Year 1: 0.8696
Year 2: 0.7561
Question 23.
A company is currently paying a dividend of Rs. 2.00 per share. The dividend is expected to grow at a 15% annual rate
for three years, then at 10% rate for the next three years, after which it is expected to grow at a 5% rate forever. What is
the present value of the share if the capitalization rate of 9%?
Question 24.
D Ltd. Is foreseeing a growth rate of 12% per annum in the next two years. The growth rate is likely to be 10% for the third
and fourth year. After that, the growth rate is expected to stabilise at 8% per annum. If the last dividend was Rs. 1.50 per
share and the investor’s required rate of return is 16%, determine the current value of equity share of the company. The
P.V. factors at 16% are:
Year 1 2 3 4
PVF 0.862 0.743 0.641 0.552
Question 25.
Po = Rs. 120
E = Rs. 12
D = Rs. 6
Compute P/E Ratio. Also compute multiplier as per traditional theory.
Question 26.
A chemical company belongs to a risk – class for which the appropriate P/E Ratio is 10. It currently has
50,000 equity shares (outstanding) selling at Rs. 100 each. The firm is contemplating declaration of dividend
of Rs. 8 per share at the current fiscal year, which has just started. Given the assumption of MM, answer the
following questions:
(i) What will be the price of the share at the end of the year
a) If dividend is not declared, and
b) If it is declared?

(ii) Assuming that the company pays the dividend, has a net income (Y) of Rs. 5,00,000 and makes new
investments of Rs. 10,00,000 during the period, how many new shares must be issued?
Chapter 10
MANAGEMENT OF WORKING CAPITAL
PART I: Introduction to Working Capital
Management
Question 1.
Explain the meaning of Working Capital?
Solution 1:
Working Capital = Current Assets – Current Liabilities
Current Assets are those assets which are readily convertible into cash within a period of one year. Example: Inventories,
Debtors, Cash and Bank Balances.
Current Liabilities are those which fall due for payment or settlement within a short duration, i.e. generally less than one
year. Example: Trade Creditors, Outstanding Expenses, Tax Provision.
Question2. [NOV 08]

What factors are to be considered while determining the Working Capital requirement?
Solution 2:
The factors to be considered are as follows:
(1) Nature of Business (7) Availability of Credit from Suppliers
(2) Production Policies (8) Length of Manufacturing Process
(3) Market Standing (9) Business Cycle
(4) Market Conditions (10) Operating Efficiency
(5) Production Process (11) Inflationary Conditions/Price Level Changes
(6) Credit Policy (12) Inventory Policy.
Question 3
What is the importance of adequate Working Capital?
Solution 3:
1. Funds are required for day-to-day operations and transactions. These are provided by Cash and Cash Equivalents,
forming part of Current Assets.
2. Increase in activity levels and sales should be backed up by suitable investment in Working Capital. Otherwise, it will
result in under-capitalization and over-trading.
3. Working Capital is required to use Fixed Assets profitably. For example, a machine cannot be used productively
without Raw Materials.
4. Adequate Working Capital determines the short-term solvency of the Firm. Inadequate Working Capital means that
the Firm will be unable to meet its immediate payment commitments.
Question 4.
Discuss the various approaches to estimation of Working Capital Requirements?
Solution 4:
The two approaches to estimation of Working Capital Requirements are:
(a) TOTAL APPROACH: All expenses and profit margin are included.

(b) CASH COST APPROACH: Only Cash expenses (excluding depreciation) are included.
COMPONENT TOTAL APPROACH CASH COST APPROACH

Sundry Selling Price Selling Price – Profit Margin – Depreciation
Debtors
Work in Raw Materials + 50% of [Direct Labour + Direct Raw Materials + 50% of [Direct Labour + Direct
Progress Expenses + All Production Overheads] Expenses + Production Overheads excluding
Depreciation]
Finished Cost of Production Cost of Production – Depreciation
Goods
Question5.
Give the classification of Working Capital?
Solution 5:
Working Capital can be classified based on:
1) Concept
a) Gross Working Capital (i.e. Current Assets only)
b) Net Working Capital (i.e. Current Assets – Current Liabilities)
2) Time Factor
a) Permanent Working Capital
b) Temporary Working Capital.
Question 6.
Explain the difference between Permanent Working Capital and Temporary Working Capital?
Solution 6:
Permanent Working Capital Temporary Working Capital
• It represents a long-term investment. • It represents a short-term investment.
• Generally, the amount of Permanent Working Capital • The amount of Temporary Working Capital fluctuates
increases along with sales and activity levels in the (i.e. moves up and down) due to factors like peak
long-run. season, trade cycle boom, etc.
• It represents Working Capital requirements over and
• It is the minimum level of investment required in the above Permanent Working Capital.
Working Capital of the business at any point of time
and hence at all points of time. • It is also called Fluctuating (or) Variable Working
• It is also called Fixed (or) Core (or) Hard Core Working Capital.
Capital.
➢ Operating Cycle
Question7_______________________________________________________________________________ [RTP, NOV 10]
Bring out the importance of Working Capital Cycle?
Solution 7:
Working Capital Cycle (also called Cash Cycle or Operating Cycle) is the time required for conversion of cash into cash
equivalents like Raw Materials, Work-in-Progress, Finished Goods, Debtors, and thereafter back into cash.
CASH CYCLE OF MANUFACTURING FIRM
Raw
Cash Material
Work in
Debtors
Progress
Finshed
Goods
CASH CYCLE OF TRADING FIRM

Cash
Finished
Debtors
Goods
1. Phases: The operating cycle has the following phases:

(a) Conversion of Cash into Raw Materials – Lead Time.
(b) Conversion of Raw Materials, into WIP and then into Finished Goods – Production/Process
Cycle.
(c) Conversion of Finished Goods into Debtors through Sales – Stockholding Period.
(d) Conversion of Receivables into Cash – Average Collection
Period.
2. Computation: Operating Cycle or Cash Cycle or Working Capital Cycle (expressed in days) is computed as under:
Particulars Amount
Raw Material Storage Period -----
Add: Work-in-Progress holding period -----
Add: Finished Goods Storage Period -----
Add: Debtors Collection Period -----
Less: Creditors Payment Period -----
3. Importance:
(a) Surplus Generation: It represents the activity cycle of the business, i.e. purchase, manufacture, sales and
collection thereof.
(b) Funds Rotation: Operating Cycle indicates the total time required for rotation of funds. The faster the funds
rotate, the better it is for the Firm.
(c) Going Concern: Cash Cycle lends meaning to the Going Concern concept. If the cycle stops in between, the
going concern assumption may be lost.
Hence, Working Capital Cycle should be on par with the industry average. A long cycle indicates overstocking of inventories
or delayed collection of receivables and is considered unsatisfactory.
𝟑𝟔𝟓
Using the Operating Cycle, the Working Capital Turnover can be computed as . Generally, the higher the
𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝑪𝒚𝒄𝒍𝒆
Turnover Ratio, the better it is for business.
⧫ Estimation of Working Capital using Operating Cycle

Question8. [NOV 09]
Following information is forecasted by CS Limited for the year ending 31 st March:
Particulars Opening Balance (₹ ) Closing Balance (₹ )
Raw Materials 45,000 65,356
Work-in-Progress 35,000 51,300
Finished Goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Other Particulars Amount (₹ )

Annual Purchases of Raw Material (all credit) 4,00,000
Annual Cost of Production 7,50,000
Annual Operating Cost 9,50,000
Annual Sales (all credit) 11,00,000

Annual Cost of Goods Sold 9,15,000

Take 1 year = 365 days.
Calculate the following:
(1) Net Operating Cycle Period, (2) Number of Operating Cycles in a year, and (3) Amount of Working Capital
required.

From the following information of XYZ Ltd., you are required to calculate:
(a) Net Operating cycle period
(b) Number of Operating cycles in years.
Raw material inventory consumed during the year ₹ 6,00,000
Average stock of raw material ₹ 50,000
Work-in-Progress Inventory ₹ 5,00,000
Average Work-in-Progress Inventory ₹ 30,000
Finished Goods Inventory ₹ 8,00,000
Average Finished Goods stock held ₹ 40,000
Average Collection Period from Debtors 45 Days
Average Credit Period Availed 30 Days
No. of days in a year 360 Days
Question 10.
The following data are available for Gama Limited.
Particulars 1995 (₹ In Lakhs)
Opening Balance of
a) Raw materials, stores etc. 80
b) Work-in-Progress 20
c) Finished goods 90
d) Book debts 140
e) Trade Creditors 80
Closing Balance of
a) Raw materials, stores etc. 85
b) Work-in-Progress 24
c) Finished goods 100
d) Book debts 150
e) Trade Creditors 105
Purchase of Raw materials, Stores etc. 300
Consumption of Raw materials, Stores etc. 295
Manufacturing expenses 145
Depreciation 20
Excise Duty 60
Administration & Financial and Selling costs 80
Sales 800
Required: Calculate the duration of:
(i) Raw materials and stores storage period.
(ii) Work-in-Progress period.
(iii) Finished goods storage period.
(iv) Debtors collection period.

(v) Creditors payment period, and

(vi) Operating cycle.
Question 11.
The following data relating to a consumer goods manufacturing Firm is available for the year ended 31 st March.
Debtors Collection Period 30 days
Advance payment to Creditors 5 days
Total Cash Operating Expenses per annum (60% of the Total Cash Operating Expenses are due to Raw ₹ 600
Material) lakhs
Number of days Raw Materials in storage 30 days
Average Credit period from Suppliers 50 days
Conversion Process Period 12 days
Finished Goods Storage Period 45 days
Required:
1. Determine the Average Cash Working Capital needed by the Firm at any point of time during the year, assuming that
the Firm wants to carry a Cash Balance of ₹ 10 Lakhs at all the time.
2. Compute the Working Capital Turnover Rate for the year.

The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:
Particulars Amount Particulars Amount
( ) ( ) ( )
To Opening Stock: By Sales (Credit) 20,00,000
Raw materials 1,80,000 By Closing Stock:
Work-in-progress 60,000 Raw materials 2,00,000
Finished Goods 2,60,000 5,00,000 Work-in-Progress 1,00,000
To purchases (credit) 11,00,000 Finished Goods 3,00,000 6,00,000
To Wages 3,00,000
To Production 2,00,000
Expenses
To Gross Profit c/d 5,00,000
26,00,000 26,00,000
To Administration Expenses 1,75,000 By Gross Profit 5,00,000
To Selling Expenses b/s
To Net Profit 75,000
2,50,000
5,00,000 5,00,000
The opening and closing balances of debtors were 1,50,000 and 2,00,000 respectively whereas opening and closing
creditors were 2,00,000 and 2,40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.
Question 13. [MAY 13, MAY 15]

The following information is provided by the DPS Limited for the year ending 31 st March, 2013
Raw material storage period 55 days
Work-in progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditors payment period 60 days
Annual Operating cost ₹ 21,00,000
(including depreciation of ₹ 2,10,000)
[1 year = 360 days]


I. Operating Cycle period
II. Number of Operating Cycle in a year.
III. Amount of working capital required of the company on a cash cost basis.
IV. The company is a market leader in its product, there is virtually no competitor in the market.
Based on a market research it is planning to discontinue sales on credit and deliver products based
on pre-payment. Thereby, it can reduce its working capital requirement substantially.
What would be the reduction in working capital requirement due to such decision?
Question 14. [NOV 09 (similar)]

Following information is forecasted by the CS Limited for the year ending 31st March, 2010:
Particulars Balance as at 1st Balance as at 31st
April, 2009 (₹ ) March, 2010 (₹ )
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished Goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual Cost of Goods Sold 9,15,000
Annual Operating Cost 9,50,000
Annual Sales (all credit) 11,00,000
You may take one year as equal to 365 days.

(i) Net Operating Cycle Period.
(ii) Number of Operating Cycles in a year.
(iii) Amount of Working Capital Requirement using Operating Cycle method.
Question 15.
Write short note on Maximum Permissible Bank Finance.
Solution 15:
(I) Earlier Norms (Tandon Committee)
Maximum Permissible Bank Finance shall be computed under any of the following methods:
I: 75% of (Current Assets – Current Liabilities)
II: 75% of Current Assets – Current Liabilities
III: 75% of (Total Current Assets – Core Current Assets) – Current Liabilities
(II) Recent Changes/New Credit System
Credit Required Credit Scheme
Upto ₹ 25 Lakhs Credit limit will be computed after detailed discussions with the
Borrower, without going into detailed evaluation.
₹ 25 Lakhs, but upto ₹ 5 Crores Credit Limit can be offered upto 20% of the projected Gross Sales of
the Borrower.
Large Borrowers not falling in the above Cash Budget System may be used to identify the Working Capital
categories needs.
Question16. [MAY 10]

Compute ‘Maximum Permissible Bank Finance’ under Methods I, II and III of Tandon Committee norms from the following
figures and comment on each method – Assume Core Current Assets are ₹ 380 Lakhs.
₹ In ₹ In
Current Liabilities Lakhs Current Assets Lakhs

Creditors for Purchases 400 Raw Material 800

Other Current Liabilities 200 Work-in-Progress 80
600 Finished Goods 360
Bank Borrowing including Bills Discounted with Receivables (including Bills
Bankers 800 Discounted) 200
Other Current Assets 40
1,400 1,480
Question 17.
Total Current Assets required: ₹ 40,000
Current liabilities other than bank borrowings: ₹ 10,000
Core current assets: ₹ 5,000
Compute MPBF under all the three methods of lending norms as suggested by the Tandon Committee.
Question 18.
The following information has been extracted from the records of a company:
Product Cost Sheet ₹ Per Unit
Raw Materials 45
Direct Labour 20
Overheads 40
Total 105
Profit 15
Selling Price 120
• Raw materials are in stock on an average of two months.
• The materials are in process on an average for 4 weeks. The degree of completion is 50%.
• Finished goods stock on an average is for one month.
• Time lag in payment of wages and overheads is 1 ½ weeks.
• Time lag in receipt of proceeds from debtors is 2 months.
• Credit allowed by suppliers is one month.
• 20% of the output is sold against cash.
• The company expects to keep a cash balance of ₹ 1,00,000.
• Take 52 weeks per annum.
The company is poised for a manufacture of 1,44,000 units in the year.
You are required to prepare a statement showing the Working Capital Requirements of the Company.

A Performa Cost Sheet of a Company provides the following particulars:
Particulars Amount per unit (₹ )
Raw Materials Cost 100.00
Direct Labour Cost 37.50
Overheads Cost 75.00
Total Cost 212.50
Profit 37.50
Selling Price 250.00
The Company keeps raw material in stock, on an average for one month; work-in-progress, on an average for one week;
and finished goods in stock, on an average for two weeks.
The Credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors. The lag in payment
of wages is one week and lag in payment of overhead expenses is two weeks. The company sells one-fifth of the output
against cash and maintains cash-in-hand and at bank put together at ₹ 37,500.

Required: Prepare a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000 units
of production. Assume that production is carried on evenly throughout the year, and wages and overheads accrue
similarly, work-in-progress stock is 80% complete in all respects.

On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working capital that will be required
during the year. From the following information prepare the working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during
the present year. The expected ratios of the cost to selling prices are Raw Materials 60%, Direct Wages 10% and Overheads
20%. Raw materials are expected to remain in store for an average of 2 months before issue to production. Each unit is
expected to be in process for one month, the raw materials being fed into the pipeline immediately and the labour and
overhead costs are 50% complete. Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately 3 months. Credit allowed by creditors is 2 months from the date of delivery of raw materials. Credit allowed
to debtors is 3 months from the date of dispatch. Selling price is ₹ 5 per unit. There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month. The company normally keeps cash in
hand to the extent of ₹ 20,000.
⧫ Working Capital Forecast – Total Approach and MPBF
A newly formed company has applied to the Commercial Bank for the first time for financing its working capital
requirements. The following information is available about the projections for the current year:
Particulars Per unit (₹ )
Raw Material 40
Direct Labour 15
Overhead 30
Total Cost 85
Profit 15
Sales 100
Other information:
Raw material in stock: Average 4 weeks consumption, Work-in-Progress (completion stage, 50 percent), on an average
half a month. Finished goods in stock: on an average, one month. Credit allowed by suppliers is one month. Credit allowed
to debtors is two months.
Average time lag in payment of wages is 1 ½ weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at ₹ 50,000. All sales are on credit basis only.
Required:
(i) Prepare a statement showing estimate of working capital needed to finance an activity level of 96,000 units of
production. Assume that production is carried on evenly throughout the year, and wages and overhead accrue
similarly. For the calculation purpose 4 weeks may be taken as equivalent to a month and 52 weeks in a year.
(ii) From the above information calculate the Maximum Permissible Bank Finance by all the three methods for Working
Capital as per Tandon Committee norms; assume the core current assets constitute 25% of the current assets.

XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicates that materials are introduced in the beginning
of the production cycle; wages and overhead accrue evenly throughout the period of the cycle. Wages are paid in the next
month following the month of accrual. Work-in-progress includes full units of raw materials used in the beginning of the
production process and 50% of wages and overheads are supposed to be conversion costs. Details of production process
and the components of working capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw materials inventory held One month consumption
Finished goods inventory held for Two months
Credit allowed by creditors One month
Credit given to debtors Two months

Cost price of raw materials ₹ 60 per unit

Direct wages ₹ 10 per unit
Overheads ₹ 20 per unit
Selling price of finished pipes ₹ 100 per unit
(i) The amount of working capital required for the company.
(ii) Its maximum permissible bank finance under all the three methods of lending norms as suggested by the Tandon
Committee, assuming the value of core current assets: ₹ 1,00,00,000.

MNO Ltd. has furnished the following cost data relating to the year ending of 31st March, 2008:
Particulars Amount (₹ In Lakhs)

Sales 450
Material Consumed 150
Direct Wages 30
Factory Overheads (100% variable) 60
Office and Administrative Overheads (100% variable) 60
Selling Overheads 50
The company wants to make a forecast of working capital needed for the next year and anticipates that:
• Sales will go up by 100%.
• Selling expenses will be ₹ 150 Lakhs.
• Stock holdings for the next year will be – Raw material for two and half months, work-in-progress for one month,
Finished goods for half month and Book debts for one and half month.
• Lag in payment will be 3 months for creditors, 1 month for wages and half month for Factory, Office and
Administrative and Selling Overheads.
(i) Prepare statement showing Working Capital Requirements for next year, and
(ii) Calculate Maximum Permissible Bank Finance as per Tandon Committee guidelines assuming that core current
assets of the firm are estimated to be ₹ 30 Lakhs.

The management of Royal Industries has called for a statement showing the working capital needs to finance a level of
activity of 1,80,000 units of output for the year. The cost structure for the company’s product for the above mentioned
activity level is detailed below:
Particulars Cost Per Unit (₹ )
Raw Material 20
Direct Labour 5
Overheads (Including Depreciation of ₹ 5 per unit) 15
Total Cost 40
Profit 10
Selling Price 50
Additional Information:
• Minimum desired cash balance is ₹ 20,000.
• Raw Materials are held in stock on average for two months.
• Work-in-Progress (Assume 50% completion stage as regards material labour and overheads) will approximate to half
a month production.
• Finished goods remain in warehouse, on an average for a month.
• Suppliers of materials extend a month credit and debtors are provided two months credit, cash sales are 25% of
total sales.

• There is a time lag in payment of wages of a month and half a month in the case of overheads.
From the above facts, you are required to:
(i) Prepare a statement showing working capital needs; and
(ii) Determine the maximum working capital finance available under the first two methods suggested by Tandon
Committee.
⧫ Working Capital Forecast of New Company – Total Approach

Question 25. [STUDY MATERIAL, RTP, NOV 98]
A newly formed company has applied to the commercial bank for the first time for financing its working capital
requirements. The following information is available about the projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-progress. Based on the
above activity, estimated cost per unit is:
Raw Material ₹ 80 per unit
Direct Wages ₹ 30 per unit
Overheads (Exclusive of Depreciation) ₹ 60 per unit
Total Cost ₹ 170 per unit
Selling Price ₹ 200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (Assume 50% completion stage in respect of
conversion cost) (Materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1 ½ weeks
Cash at banks is expected to be ₹ 25,000
Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads accrue similarly.
All sales are on credit basis only. Find out:
(i) The Net Working Capital Required;
(ii) The Maximum Permissible Bank Finance under first and second methods of financing as per Tandon Committee
Norms.
⧫ Working Capital Forecast – Cash Cost Approach

Question 26.
Cost Sheet of the company provides the following data:
Particulars Cost Per Unit (₹)
Raw Material 50
Direct Labour 20
Overheads (Including Depreciation of ₹ 10) 40
Total Cost 110
Profit 20
Selling Price 130
Additional Information:
Average Raw Material in stock is for one month. Average material in progress is for half month. Credit allowed by
suppliers: one month; credit allowed to debtors: one month.
Average time lag in payment of wages: 10 days; Average time lag in payment of overheads: 30 days. 25% of the sales are
on cash basis. Cash balance expected to be ₹ 1,00,000. Finished goods lie in the warehouse for one month.
You are required to prepare a statement showing the cash cost of working capital needed to finance a level of the activity
of 50,000 units of output. Production is carried on evenly throughout the year and wages and overheads accrue similarly.
State your assumptions, if any, clearly.

Question 27.
A Performa Cost Sheet of a Company provides the following data:
Particulars Cost Per Unit (₹)
Raw Material 117
Direct Labour 49
Factory Overheads (Includes Depreciation of ₹ 18 per unit at budgeted level of activity) 98
Total Cost 264
Profit 36
Selling Price 300
Following additional information is available:

Average raw material in stock 4
weeks
Average work-in-progress stock 2
weeks
(% completion with respect to Materials is 80% and Labour and Overheads is 60%)
Finished goods in stock 3
weeks
Credit period allowed to debtors 6
weeks
Credit period availed from suppliers 8
weeks
Time lag in payment of wages 1
week
Time lag in payment of overheads 2
weeks
The company sells one-fifth of the output against cash and maintains cash balance of ₹ 2,50,000.
Prepare a statement showing estimate of working capital needed to finance a budgeted activity level of 78,000 units of
production. You may assume that production is carried on evenly throughout the year and wages and overheads accrue
similarly.
⧫ Working Capital Estimation – Cash Cost Approach – Hidden Depreciation

Question 28. [STUDY MATERIAL (ADAPTED]
The following annual figures relate to XYZ Company:
Amount (₹
Particulars )
Sales (at two months credit) 18,00,000
Materials Consumed (suppliers extend two months credit) 4,50,000
Wages paid (monthly in arrear) 3,60,000
Manufacturing expenses outstanding at the end of the year (Cash expenses are paid one month in
arrear) 40,000
Total administrative expenses, paid as above 1,20,000
Sales promotion expenses, paid quarterly in advance 6 0,000
The company sells its products on gross profit of 25% counting depreciation as part of the cost of production. It keeps one
month’s stock each of raw materials and finished goods, and a cash balance of ₹ 1,00,000. Assuming a 15% safety margin,
ascertain the requirements of working capital requirement of the company on cash cost basis. Ignore work-in-progress.
⧫ Working Capital Forecast – Total Approach and Cash Cost Approach

PQ Ltd., a company newly commencing business in 2019 has the following projected Profit and Loss Account:

Particulars (₹ ) (₹ )
Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less: Stock of Finished goods 17,000
(10% of goods produced not yet sold)
1,53,000
The figure given above relate only to finished goods and not to work-in-progress. Goods equal to 15% of the year’s
production (in terms of physical units) will be in process on the average requiring full materials but only 40%.
of the other expenses. The company believes in keeping materials equal to two months’ consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months credit. Sales will be 20%
for cash and the rest at two months’ credit. 70% of the Income tax will be paid in advance in quarterly installments. The
company wishes to keep ₹ 8,000 in cash. 10% has to be added to the estimated figure for unforeseen contingencies.
PREPARE an estimate of working capital.
Note: All workings should form part of the answer.
Question 30.
The Management of MNP Company Ltd is planning to expand its business and consult you to prepare an estimated
Working Capital Statement. The records of the Company reveal the following annual information:
Particulars Amount (₹ )
Sales – Domestic at one Month’s Credit 24,00,000
Export at three Month’s Credit (Sales Price 10% below Domestic Price) 10,80,000
Materials used (Suppliers extend two months credit) 9,00,000
Lag in Payment of Wages – ½ Month 7,20,000
Lag in Payment of Manufacturing Expenses (Cash) – 1 month 10,80,000
Lag in Payment of Administration Expenses – 1 month 2,40,000
Sales Promotion Expenses payable quarterly in advance 1,50,000
Income Tax payable in four instalments of which one falls in the next Financial Year 2,25,000
Rate of Gross Profit is 20%. Ignore Work-in-Progress and Depreciation.
The Company keeps one Month’s Stock of Raw Materials and Finished Goods (each) and believes in keeping ₹ 2,50,000
available to it including the Overdraft Limit of ₹ 75,000 not yet utilized by the Company. The Management is also of the
opinion to make 12% Margin for Contingencies on the computed figures.
You are required to prepare the estimated Working Capital Statement for the next year.
⧫ Working Capital Forecast – Total Approach, but Debtors at Cash

Question 31.
MN Ltd. is commencing a new project for manufacture of electric toys. The following cost information has been
ascertained for annual production of 60,000 units at full capacity:
Amount Per Unit (₹
Particulars )
Raw materials 20
Direct labour 15

Manufacturing Overheads:
Variable
15
Fixed
10 25
Selling and Distribution Overheads:
Variable
3
Fixed
1 4
Total Cost 64
Profit 16
Selling Price 80
In the first year of operations expected production and sales are 40,000 units and 35,000 units respectively. To assess the
need of working capital, the following additional information is available:
• Stock of Raw materials 3 months consumption
• Credit allowable for debtors 1 ½ months
• Credit allowable by creditors 4 months
• Lag in payment of overheads ½ month
• Cash in hand and Bank is expected to be ₹ 60,000.
• Provision for contingencies is required @ 10% of Working Capital requirement including that provision.
You are required to prepare a projected statement of working capital requirement for the first year of operations. Debtors
are taken at cost.
⧫ Profitability Statement and Working Capital Estimation

M.A. Limited is commencing a new project for manufacture of a plastic component. The following cost information has
been ascertained for annual production of 12,000 units which is the full capacity:
Costs per unit (₹ )
Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00
The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per unit, 80% of which is variable.
In the first two years of operations, production and sales are expected to be as follows:
Year Production (No. of units) Sales (No. of units)
1 6,000 5,000
2 9,000 8,500
To assess the working capital requirements, the following additional information is available:
(a) Stock of materials – 2.25 months’ average consumption
(b) Work in progress – Nil
(c) Debtors – 1 months’ average sales
(d) Cash balance - ₹ 10,000
(e) Creditors for supply of materials – 1 month’s average purchase during the year.
(f) Creditors for expenses – 1 month’s average of all expenses during the year.
Prepare, for the two years:

i. A projected statement of Profit/Loss (ignoring taxation); and
ii. A projected statement of working capital requirements.

Foods Ltd is presently operating at 60% level producing 36,000 packets of snack foods and proposes to increase capacity
𝟏
utilization in the coming year by 33 % over the existing level of production. The following data has been supplied:
𝟑
• Unit cost structure of the product at current level: ₹
Raw Material 4
Wages (Variable) 2
Variable Overheads 2
Fixed Overheads 1
Profit 3
Selling Price 12
• Raw materials will remain in stores for 1 month before being issued for production. Material will remain in process
for further 1 month. Suppliers grant 3 months credit to the company.
• Finished goods remain in godown for 1 month. Debtors are allowed credit for 2 months.
• Lag in wages and overhead payments is 1 month and these expenses accrue evenly throughout the production cycle.
• No increase either in cost of inputs or selling price is envisaged.
Prepare a Projected Profitability Statement and the Working Capital Requirement at the new level, assuming that a
minimum cash balance of ₹ 19,500 has to be maintained.
Question 34.
Prepare a working capital forecast and the projected Profit and Loss Account and the Balance Sheet from the following
information:
Issued Share Capital ₹ 50,10,000
6% Debentures ₹ 15,00,000
The Fixed Assets are valued at ₹ 30,66,667. Production during the previous year was 10 lakhs units. The same level of
activity is intended to be maintained during the current year. The expected ratios of cost to selling price are:
Raw Materials 40%
Direct Wages 20%
Overheads 20%
The raw materials ordinarily remain in stores for 3 months before production. Every unit of production remains in the
process for 2 months. Finished goods remain in the warehouse for 3 months. Credit allowed by creditors is 4 months from
the date of the delivery of raw material and credit given to debtors is 3 months from the date of dispatch. The estimated
balance of cash to be held ₹ 2,00,000.
Lag in payment of wage ½ month.
Lag in payment of expenses ½ month.
Selling price is ₹ 8 per unit. Both production and sales are in a regular cycle.
You are required to make a provision of 10% for contingency. Relevant assumptions may be made.
➢ Double Shift Working

Question 35.
Explain the impact of Double Shift Working on Working Capital Requirement?
Solution 35:
Raw Material Work-in-Progress Finished Goods
Effect Cost of production per unit will be
on Due to bulk purchasing, the Firm Due to reduction in Raw Material cost and reduced
may be able to avail quantity on account to lower cost of
Rate discounts. economies of fixed costs, the average cost materials and
Hence, average cost per unit of
Raw per unit of WIP may be reduced. economies of fixed costs per unit.
Material may be reduced.
Effect There will be no change in the quantity of Due to greater production, Finished
on Stock requirements may double WIP, Goods
Quanti since work commenced in the first shift will
ty since consumption per day will be be Stock may double in quantity.
completed in the second shift. Hence, at
twice as earlier. the end of

any day, the quantity of WIP will remain

the same
as it was in single shift working.

Samreen Enterprises has been operating its manufacturing facilities till 31.3.2010 on single shift working with the
following cost structure:
Particulars Per Unit (₹ )
Cost of Materials 6
Wages (out of which 40% fixed) 5
Overheads (out of which 80% fixed) 5
Profit 2
Selling Price 18
Sales during 2009-10 is ₹ 4,32,000. As at 31.3.2010 the company held:
Stock of raw materials (at cost) ₹ 36,000
Work-in-progress (valued at prime cost) ₹ 22,000
Finished goods (Valued at total cost) ₹ 72,000
Sundry debtors ₹ 1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift. It is expected that a
10% discount will be available from suppliers of raw materials in view of increased volume of business. Selling price will
remain the same. The credit period allowed to customers will remain unaltered. Credit availed of from suppliers will
continue to remain at the present level i.e., 2 months Lag in payment wages and expenses will continue to remain half a
month.
You are required to assess the additional working capital requirements, if the policy to increase output is implemented.
➢ Sources of Financing Working Capital

Question 37.
What are the various sources available for financing Working Capital requirements? List a few alternatives for external
financing of Receivables.
Solution 37:
Some sources of financing Working Capital are:
1. Trade Credit – Credit Period availed, use of Bills payable, Advances from Customers, etc.
2. Factoring of Receivables, Forfeiting.
3. Commercial Paper.
4. Pledging of Receivables.
5. Bank Credit – Cash Credit, Overdrafts, Supply Bills Discounting/Purchasing, Working Capital Demand Loan, Loans
against Book Debts, Loan against supply of bills to Government Departments, etc.
6. Debt Securitization.
7. Non-Bank Short-Term Borrowings Short-Term Unsecured Loans.

Discuss the risk return considerations in financing the current assets.
➢ Approaches of Financing Working Capital
Question 39.

What are the approaches of financing Working Capital Requirements? Discuss the risk-return considerations in financing
of Current Assets.
Solution 39:
The various approaches to funding are as under:
Approach Matching Approach Conservative Approach Aggressive Approach
1. Long Term Funds Fixed Assets & Fixed Assets, Permanent Fixed Assets and part of
used in Permanent Working Capital & Part of permanent Working
Working Capital. Temporary Working Capital. Capital.
Balance part of Temporary
2. Short Term Funds Temporary Working Working Capital. Balance part of Permanent
used in Capital. Working Capital and entire
High Liquidity. Temporary Working
Low Profitability & Return on Capital.
3. Effect on Liquidity Well-balanced. assets. Low Liquidity.
4. Effect on profitability Comparatively well- High return on assets but
balanced. risky.
⧫ Working Capital Funding & Long Term Financing

A company is considering its working capital investment and financial policies for the next year. Estimated fixed assets
and current liabilities for the next year are ₹ 2.60 crores and ₹ 2.34 crores respectively. Estimated Sales and EBIT depend

on current assets investment, particularly inventories and book-debts. The financial controller of the company is
examining the following alternative Working Capital
Policies: (₹ In
Crores)
Working Capital Policy Investment in Current Assets Estimated Sales EBIT
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working
capital policy. The company is now examining the use of long-term and short-term borrowings for financing its assets. The
company will use ₹ 2.50 crores of the equity funds. The corporate tax rate is 35%. The company is considering the following
debt alternatives:
Financing Policy Short-term Debt Long-term Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest Rate – Average 12% 16%
You are required to calculate the following:
(1) Working Capital Investment for each policy: (a) Net Working Capital position; (b) Rate of Return; (c) Current ratio.
(2) Financing for each policy; (a) Net Working Capital; (b) Rate of Return of Shareholders equity; (c) Current ratio.

A firm has the following data for the year ending 31st March, 2017:
(₹)
Sales (1,00,000 @ ₹ 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are ₹ 5,00,000, ₹ 4,00,000 and ₹ 3,00,000. It is assumed that fixed
assets level is constant and profits do not vary with current assets levels. ANALYSE the effect of the three alternative
current assets policies.
Question 42.
The Management of Fibroplast Limited is trying to establish a Current Assets policy. Fixed Assets are ₹ 6,00,000, and the
Company plans to maintain a 50% Debt-to-Assets ratio. It has no operating Current Liabilities. The Interest Rate is 10% on
all Debts. The Company is considering three alternative Current Asset Policies – 40%, 50% and 60% of Projected Sales. The
Company expects to earn 15% before Interest and Taxes on Sales of ₹ 30,00,000. The effective tax rate is 40%. You are
required to calculate the expected Return on Equity under each alternative.

PART II MANAGEMENT OF RECEIVABLES

Question 43.
Briefly explain Credit Policy, Credit Period and Discount Policy?
Solution 43:
The Credit Policy involves decisions relating to length of the credit period, Discount Policy, and (c) Other special items,
wherever applicable.
Role: The Credit Policy determines the investment in Sundry Debtors, average collection period and bad debt losses.
Hence, credit policy of a Firm should enable it to achieve the following objectives –
(a) Increasing profits due to higher sale and higher margins on credit sales, and
(b) Increasing sales and market share,
(c) Meeting competition.
Components: Credit Policy includes – (a) Credit Period; the period allowed for payment by customers, in the normal
course of business, & (b) Discount Policy: it involves decisions relating to:
• Percentage of Cash Discount to be offered as incentive for early settlement of invoice, and
• Period within which cash discount can be availed.
Discounts are given to speed up the collection of debts. Hence, it improves the liquidity of the Seller. It also ensures prompt
collection and reduces risk of bad debts.
Normally, credit terms are expressed in this order – (a) the rate of cash discount, (b) the cash discount period and (c) the
net credit period. For example, credit terms of “2/10 net 60” means that a cash discount of 2% will be granted if customer
pays within 10 days, if he does not avail the offer he must pay within 60 days, being the credit period. If payment is made
after 60 days, interest will be charged by the Seller, on the amount overdue.
Question 44. [ STUDY MATERIAL]

The credit manager of XYZ Ltd. is reappraising the Company’s policy. The company sells its products on terms of net 30.
Cost of goods sold is 85% of sales and fixed costs are further 5% of sales. XYZ classifies its customer on a scale of 1 to 4.
During the past five years, the experience was as under:
Classifica Default as a percentage Average collection period in days for non-
tion of sales defaulting
1 0 45
2 2 42
3 10 40
4 20 80
The average rate of interest is 15%. What conclusions do you draw about the Company’s Credit Policy? What other factors
should be taken into account before changing the present policy? Discuss.
Question 45. [NOV 99, STUDY MATERIAL]

Radiance Garments Ltd. manufactures readymade garments and sells them on credit basis through a network of dealers.
Its present sale is Rs. 60 lakh per annum with 20 days credit period. The company is contemplating an increase in the credit
period with a view to increasing sales. Present variable costs are 70% of sales and the total fixed costs Rs. 8 lakhs per
annum. The company expects pre-tax return on investment @ 25%. Some other details are given as under:
Proposed Credit Average Collection period Expected Annual Sales (Rs. In
Policy (days) Lakhs)
I 30 65
II 40 70
II 50 74
IV 60 75
Required: when credit policy should the company adopt? Present your answer in a tabular form. Assume
360 days a year. Calculation should be made upto two digits after decimal.
Question 46 [MAY 08]

The Sales Manager of AB Limited suggests that if credit period is given for 1.5 months then sales may likely to increase by

Rs. 1,20,000 per annum. Cost of sales amounted to 90% of sales. The risk of non-payment is 5%. Income tax rate is 30%.
The expected return on investment is Rs. 3375 (after tax.) Should the company accept the suggestion of Sales Manager?

A new customer has approached a firm to establish new business connection. The customer require 1.5 month of credit.
If the proposal is accepted, the sales of the firm will go up by Rs.2,40,000 per annum. The new customer is being
considered as a member of 10% risk of non-payment group.
The cost of sales amounts to 80% of sales. The tax rate is 30% and the desired rate of return is 40% (after tax).
Should the firm accept the offer? Give your opinion on the basis of calculations.

Star Limited is considering the liberalization of existing credit terms to three of their large customers A, B and C. The
credit period and likely quantity of TV Sets that will be lifted by the customers are as follows:
Quantity lifted (No. of units)
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The Selling Price per unit is Rs. 750. The expected contribution is 1/3rd of the Selling Price. The cost of carrying Debtors
averages 20% per annum.
You are required:
(a) To determine the credit period to be allowed to each customer. (Assume 360 day in a year for calculation
purposes).
(b) To list what other problems the Company might face in allowing the credit period as determined in (a) above?

A new customer with 10% risk of non-payment desires to establish business connections with you. He would require
1.5 month of credit and is likely to increase your sales by 1,20,000 p.a. Cost of sales amounted to 85% of sales. The
tax rate is 30%. Should you accept the offer if the required rate of return is 40% (after tax)?

A trader whose current sales are in the region of Rs 6 lakhs per annum and an average collection period of 30 days wants
to pursue a more liberal policy to improve sales. A study made by a management consultant reveals the following
information:-
Credit Policy Increase in Collection Period Increase in Sales Present Default anticipated
A 10 days Rs. 30,000 1.5%
B 20 days Rs. 48,000 2%
C 30 days Rs. 75,000 3%
D 45 days Rs. 90,000 4%
The selling price per unit is Rs 3. Average cost per unit is Rs 2.25 and variable costs per unit are Rs 2. The current bad debt
loss is 1%. Required return on additional investment is 20%. Assume a 360 days year. ANALYSE which of the above policies
would you recommend for adoption?
PQR Ltd. having an annual sales of Rs 30 lakhs, is re-considering its present collection policy. At present, the average
collection period is 50 days and the bad debt losses are 5% of sales. The company is incurring an expenditure of Rs 30,000
on account of collection of receivables. Cost of funds is 10 percent.
The alternative policies are as under:
Particulars Alternative I Alternative II
Average Collection Period 40 days 30 days
Bad Debt Losses 4% of sales 3% of sales
Collection Expenses Rs. 60,000 Rs. 95,000

DETERMINE the alternatives on the basis of incremental approach and state which alternative is more beneficial.

As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods to a group
of new customers with 10% risk of non-payment. This group would require one and a half months credit and is likely to
increase sales by Rs 1,00,000 p.a. Production and Selling expenses amount to 80% of sales and the income-tax rate is 50%.
The company’s minimum required rate of return (after tax) is 25%. Should the sales manager’s proposal be accepted?
ANALYSE Also COMPUTE the degree of risk of non-payment that the company should be willing to assume if the required
rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.

Slow Payers are regular customers of Goods Dealers Ltd. and have approached the sellers for extension of credit facility
for enabling them to purchase goods. On an analysis of past performance and on the basis of information supplied, the
following pattern of payment schedule emerges in regard to Slow Payers:
Pattern of Payment Schedule
At the end of 30 days 15% of the bill
Non-Recovery 1% of the bill
Slow Payers want to enter into a firm commitment for purchase of goods of Rs 15 lakhs in 20X7, deliveries to be made in
equal quantities on the first day of each quarter in the calendar year. The price per unit of commodity is Rs 150 on which
a profit of Rs 5 per unit is expected to be made. It is anticipated by Goods Dealers Ltd., that taking up of this contract
would mean an extra recurring expenditure of Rs 5,000 per annum. If the opportunity cost of funds in the hands of Goods
Dealers is 24% per annum, would you as the finance manager of the seller recommend the grant of credit to Slow Payers?
ANALYSE. Workings should form part of your answer. Assume year of 365 days.
Question54. [MAY 09]

A Company currently has an annual turnover of Rs. 50 Lakhs and an average collection period of 30 days. The Company
wants to experiment with a more liberal credit policy on the ground that increase in collection period will generate
additional sales. From the following information, kindly indicate which policy the company should adopt:
Credit Average Collection Annual Sales (Rs. in
Policy Period Lakhs)
A 45 days 56
B 60 days 60
C 75 days 62
D 90 days 63
Variable Cost is 80% of Sales.
Required (pre-tax) Return on Investment is 20%.
Fixed Cost is Rs. 6 Lakhs per annum.
A year may be taken to comprise of 360 days.

Mosaic Limited has current sales of Rs. 1.5 lakh per year. Cost of sales is 75 per cent of sales and bad debts are one per
cent of sales. Cost of sales comprises 80 per cent variable cost and 20 per cent fixed costs, while the company’s required
rate of return is 12 per cent. Mosaic Limited currently allows customers 30 days’ credit, but is considering increasing this
to 60 days’ credit in order to increase sales.
It has been estimated that this change in policy will increase sales by 15 per cent, while bad debts will increase form one
per cent to four per cent. It is not expected the policy change will result in an increase in fixed costs and creditors and
stock will be unchanged.
Should Mosaic Limited introduce the proposed policy?

Question 56. [STUDY MATERIAL (ADAPTED)]

XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two proposed policies.
Currently, the firm has annual credit sales of Rs. 50 lakhs and accounts receivable of Rs. 12,50,000. The current level of
loss due to bad debts is Rs. 1,50,000. The firm is required to give a return of 20% on the investment in new accounts
receivables. The company’s variable costs are 70% of the selling price. Given the following, which is the better option?
Particulars Present Policy Policy

Policy Option I Option II
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable 12,50,000 20,00,000 28,12,500
Bad debt losses 1,50,000 3,00,000 4,50,000
Question 57. [NOV 13, NOV 14]

PTX Limited is considering a change in its present credit policy. Currently, it is evaluating two policies. The company is
required to give a return of 20% on the investment in new accounts receivables. The company’s variable costs are 70%
of the selling price.
Information regarding present and proposed policies are as follows:
Particulars Present policy Policy option 1 Policy option 2
Annual credit sales (Rs.) 30,00,000 42,00,000 45,00,000
Debtors turnover ratio 4 times 3 times 2.4 times
Loss due to bad debts 3% of sales 5% of sales 6% of sales
Note: Return on investments in new accounts receivable is based on cost of investment in debtors. Which option would
you recommend?

The Marketing Manager of XY Ltd. is giving a proposal to the Board of Directors of the Company that an increase in
credit period allowed to customers from the present one month to two months will bring a 25% increase in Sales volume
in the next year.
The following operational data of the Company for the current year are taken from the records of the Company:
Selling Price Rs. 21 p.u.
Variable Cost Rs. 14 p.u.
Total Cost Rs. 18 p.u.
Sales Value 18,90,000
The Board, by forwarding the above proposal and data requests you to give your expert opinion on the adoption of the
new credit policy in next year subject to condition that the Company’s required rate of return on Investments is 40%.
Question 59. [RTP]

ABC Ltd is now extending 1 month credit to its selected customers. It sells its products at Rs. 100 each, and has an annual
sales volume of 60,000 units. At current level of production, which matches with sales, the product has a Total Cost of Rs.
90 per unit and a Variable Cost of Rs. 80 per unit. The Company is considering a plan to grant more liberal terms by
extending the duration of credit from 1 month to 2 months and expects the sales to the customer group to go up by 25%.
In the background of a normal expectation of a 20% return on investment, will this relaxation in credit standard justify
itself?

Misha Limited presently gives terms of net 30 days. It has Rs. 6 crores in sales, and its average collection period is 45 days.
To stimulate demand, the company may give terms of net 60 days. If it does instigate these terms, sales are expected to
increase by 15 per cent. After the change, the average collection period is expected to be 75 days, with no difference in
payment habits between old and new customers. Variable costs are Rs. 0.80 for every Re. 1.00 of sales, and the company’s
required rate of return on investment in receivables is 20 per cent. Should the company extend its credit period? (Assume
a 360 days year).


Easy Limited specializes in the manufacture of a computer component. The component is currently sold for Rs. 1,000
and its variable cost is Rs. 800. For the year ended 31-3-2010 the company sold on an average 400 components per
month.
At present the company grants one month credit to its customers. The company is thinking of extending the same to
two months on account which the following is expected:
Increase in Sales 25%
Increase in Stock Rs. 2,00,000
Increase in Creditors Rs. 1,00,000
You are required to advise the company on whether or not to extend the credit terms if:
(a) All customers avail the extended credit period of two months; and
(b) Existing customers do not avail the credit terms but only the new customers avail the same. Assume in this case
the entire increase in sales is attributable to the new customers.
The company expects a minimum return of 40% on investment

A company has prepared the following projections for a year:
Sales 21,000 units
Selling price per unit Rs. 40
Variable Costs per unit Rs. 25
Total Costs per unit Rs. 35
Credit period allowed One month
The company proposes to increases the credit period allowed to its customers from one month to two months. It is
envisaged that the change in the policy as above will increase the sales by 8%. The company desires a return of 25% on
its investment.
You are required to examine and advise whether the proposed Credit policy should be implemented or not.

A firm has a current sales of Rs. 2,56,48,750. The firm has unutilized capacity. In order to boost its sales, it sales, it is
considering the relaxation in its credit policy. The proposed terms of credit will be 60 days credit against the present policy
of 45 days. As a result, the bad debts will increase from 1.5% to 2% of sales. The firm’s sales are expected to increase by
10%. The variable costs are 72% of the sales. The firm’s corporate tax rate is 35%, and it requires and after tax return of
15% on its investment. Should the firm change its credit period?
[Net Incremental Gain Rs. 1,88,518]
Question 64
New Ltd sells on credit terms “2/15 net 45”. Its present Sales are Rs. 100 Lakhs per annum, Fixed Costs are Rs. 12 Lakhs
per annum and Variable Costs are 70% of Sales. The Company’s cost of funds is 24% and it is observed that 40% of the
customers avail the discount, while the rest pay on the due date.
The Company is considering relaxing its credit terms to “3/18 net 45’. This relaxation is expected to increase Sales by 25%
and Fixed Costs by Rs. 3 Lakhs per annum. Due to economy of operations, Variable Costs will be reduced to 68% on all
Sales. It is expected that 80% of the customers will avail the discount, the rest paying on the due date.
Advise whether the relaxation in credit terms is worthwhile.

A company is presently having credit sales of Rs 12 lakh. The existing credit terms are 1/10, net 45 days and average
collection period is 30 days. The current bad debts loss is 1.5%. In order to accelerate the collection process further as also
to increase sales, the company is contemplating liberalization of its existing credit terms to 2/10, net 45 days. It is expected
that sales are likely to increase by 1/3 of existing sales, bad debts increase to 2% of sales and average collection period to
decline to 20 days. The contribution to sales ratio of the company is 22% and opportunity cost of investment in receivables
is 15 percent (pre-tax). 50 per cent and 80 percent of customers in terms of sales revenue are expected to avail cash
discount under existing and liberalization scheme respectively. The tax rate is 30%.
Should the company change its credit terms? (Assume 360 days in a year.)


A firm is considering offering 30-day credit to its customers. The firm likes to charge them an annualized rate of 24%.
The firm wants to structure the credit in terms of a cash discount for immediate payment. How much would the
discount rate have to be?
Question 67. [MAY 98, STUDY MATERIAL]

The present credit terms of P Company are 1/10 net 30. Its annual sales are Rs. 80 lakhs, its average collection period is
20 days. Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost of capital is 10 per
cent. The proportion of sales on which customers currently take discount is 0.5. P Company is considering relaxing its
discount terms to 2/10 net 30. Such relaxation is expected to increase the sales by Rs. 5,00,000 , reduce the average
collection period to 14 days and increase the proportion of discount to sales to 0.8. What will be the effect of relaxing the
discount policy on company’s profit? Take year as360 days.
Question 68. [NOV 00, STUDY MATERIAL]

A Bank is analysing the receivables of Jackson Company in order to identity acceptable collateral for a short-term loan.
The company’s credit policy is 2/10 net 30. The bank lends 80 per cent on accounts where customers are not currently
overdue and where the average payment period does not exceed. 10 days past the net period. A schedule of Jackson’s
receivables has been prepared. How much will the bank lend on a pledge of receivables, if the bank uses a 10 per cent
allowance for cash discount and returns?
Account Amount Days Outstanding In Average Payment Period
(Rs.) days historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48
Question 69
White Traders has a contribution/sales ratio of 20% and average book debts of Rs. 10 lakhs which it collects in an average
collection period 24 days. The company reorganized its “Credit Administration” dept. recently and introduced a cash
incentive of 5% to speed up collection of outstanding. The incentive is payable to customers making payment within 10
days. When the company reviewed the position after a few months it was found that the average collection period has
actually fallen to 20 days only and the average book debts had increased to Rs. 10.50 lakhs mainly as a result of some
increase in sales. It has also noticed that only about half the total sales availed of the cash discount. The company’s cost
of raising additional funds is 20%. Do you recommend continuance of the cash incentive scheme? Show workings. (Year =
360 days).

The Dolce Company purchase raw materials on terms of 2/10, net 30. A review of the company’s records by the owner
Mr. Gupta, revealed that payments are usually made 15 days after purchase are received. When asked why the firm did
not take advantage of its discounts, the accountant, Mr. Ram, replied that it cost only 2 per cent for these funds, whereas
a bank loan would cost the company 12 per cent.
(a) What mistake is Ram making?
(b) What is the cost of not taking advantage of the discount?
(c) If the firm could not borrow the bank and was forced to resort to the use of trade credit funds,
what suggestion might be made to Ram that would reduce the annual interest cost?


Briefly explain Ageing Schedule?
Solution 71:
Meaning: In Ageing Schedule, the receivables are classified according to their age, i.e. period for which they have been
outstanding, e.g. less than 30 days. 30-45 days, above 60 days etc.
Preparation of ageing schedule helps management in the following ways:
(1) Trend Analysis of debtors.
(2) Recognition of recent increase and slump in sales.
(3) Analysis of quality of individual accounts.
(4) Supplement to average collection period of receivables/sales analysis.
(5) Intra-firm and Inter-firm comparison i.e. comparing liquidity of present receivables with the past periods and
also comparing current liquidity of receivables of one firm with that of other firms.
“Decision Tree Analysis is helpful in managerial decisions”. In the context of Debtors Management, explain this
statement with an example.
Solution 72:
Meaning: Decision Tree Analysis is one of the techniques of Cost – Benefit Analysis, as to whether credit can be granted
or not. Decision: Decisions are based on the expected profits/ losses. If there is net expected profit, credit may be
granted. However in case of net expected loss, credit should not be granted.
Example: A Company intends to make a credit sale to Ajay for a value of Rs. 40,000, the cost of goods sold being Rs.
30,000. Trade enquiries about Ajay indicate a 20% risk of non-payment. The decision-tree analysis will be as under:
Possibility Chance Benefit Expected Benefit
I – Make Credit sale Payment Received 80% Rs 10,000 Rs 8,000

Options Rs.
2,000
No payment received 20% (Rs. 30,000) (Rs. 6,000)
II – Do not sell to Ajay No Cost-No Benefit Rs.
Nil
From the above, it is advisable to make the sale to Ajay, since Expected Net Benefit is Rs. 2,000.
Question 73.
Interest Ltd. is considering offering credit to a customer. The probability that the customer would pay is 0.5 and the
probability that the customer would default is 0.5. The revenues from the sale would be Rs. 5,000 and the cost of sale
would be Rs. 2,400. Should credit be granted to the customer? Draw a decision tree.
Question 74.
What are the measures for monitoring receivables?
Solution 74:
Monitoring of Receivables involves the following:
1. Collection Programme: The procedures for collection e.g. reminding letters, direct follow-up, etc. should be
initiated based on the Company’s policies and procedures.
2. Average Age of Receivables: At periodic intervals Debtors Turnover Ratio and Average Collection Period are
worked out. These are compared with the industry norms or the standards set by the Firm. In case of high
collection period, intense collection efforts are initiated.
3. Ageing Schedule: The pattern of outstanding/ receivables is determined by preparing the Ageing Schedule. If the
receivables denote old outstanding due for longer periods, suitable action should be taken to collect them
immediately.

Question 75. [STUDY MATERIAL

The Megatherm Corporation has just acquired a large account. As a result, it needs an additional Rs. 75,000 in working
capital immediately. It has been determined that there are three feasible sources of funds:
(a) Trade credit: The company buys about Rs. 50,000 of materials per month on terms of 3/30, net 90. Discounts
are taken.
(b) Bank loan: The firm’s bank will lend Rs. 1,00,000 at 13 per cent. A 10 per cent compensating balance will be
required, which otherwise would not be maintained by the company.
(c) A factors will buy the company’s receivables (Rs. 1,00,000 per month), which have a collection period of 60 days.
The factor will advance up to 75 per cent of the face value of the receivables at 12 per cent on an annual basis.
The factors will also charges a 2 per cent fee on all receivables purchased. It has been estimated that the factor’s
services will save the company a credit department expense and bad-debt expenses of Rs. 1500 per month.
On the basis of annual percentage costs, which alternative should the company select?

RST Limited is considering relaxing its present credit policy and is in the process of evaluating two proposed policies.
Currently, the firm has annual credit sales of Rs. 225 lakhs and Accounts Receivable Turnover Ratio of 5 times a year. The
current level of loss due to bad debts is Rs. 7,50,000. The firm is required to give a return of 20% on the investment in new
accounts receivables. The company’s variable costs are 60% of the selling price. Given the following information, which is
a better option?

A company has sales of Rs. 25,00,000. Average collection period is 50 days, bad debt losses are 5% of sales and collection
expenses are Rs. 25,000 and the cost of funds is 15%. The company has two alternative collection programmes:
Particulars Programme I Programme II
Average collection period reduced to 40 days 30 days
Bad Debt losses reduced to 4% of sales 3% of sales
Collection expenses Rs. 50,000 Rs. 80,000
Evaluate which Programme is viable.

Chapter 10
WORKING CAPITAL MANAGEMENT
PART III: Treasury and Cash Management
➢ Cash Budget
Write a note on Cash Budget and its advantages and disadvantages?
Solution 78:
Cash Budgets are a tool for forecasting short-term cash requirements of an enterprise. They provide a blueprint of the
cash inflows and outflows that are expected to occur in the immediate future period. They assist the management in
determining the surplus or shortage of funds and to take suitable action.
Advantages:
(a) Complete picture of all items of expected Cash Flows.
(b) Sound tool of managing daily cash operations.
(c) Determination of Net Cash Inflow so as to arrange finance, when required.
(d) Identification of better ways to utilize funds, e.g. investing surplus cash in marketable securities and earn profits.
Disadvantages:
(a) Reliability is reduced due to uncertainty of cash forecasts. For example, collections may be delayed, or unanticipated
demands may cause large disbursements.
(b) Fails to highlight the significant movements in Working Capital items.

Prepare monthly cash budget for six months beginning from April 2010 on the basis of the following information:
(i) Estimated monthly sales are as follows:
Particulars Amount (₹) Particulars Amount (₹)
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and salaries are estimated to be payable as follows:

Particulars Amount (₹) Particulars Amount (₹)
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month and the
balance in two months. There are no bad debt losses.
(iv) Purchase amount to 80% of sales and are made and paid for in the month preceding the sales.
(v) The firm has 10% debentures of ₹ 1,20,000. Interest on these has to be paid quarterly in January, April and so on.
(vi) The firm is to make an advance payment of tax of ₹ 5,000 in July, 2010.
(vii) The firm had a cash balance of ₹ 20,000 on April 1, 2010, which is the minimum desired level of cash balance. Any
cash surplus/deficit above or below this level is made up by temporary investments /liquidation of temporary
investment or temporary borrowings at the end of each month (interest on these to be ignored).


From the following information relating to a departmental store, you are required to prepare for the three months ending
31st March, 2010:
(a) Month wise cash budget on receipts and payments basis; and
(b) Statement of Sources and use of funds for the three months period.
It is anticipated that the working capital at 1st January, 2010 will be as follows:
Particulars ₹ '000's
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade Creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Budgeted Profit Statement (₹ In '000's)

Particulars January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative Selling and Distribution
Expenses 315 270 255
Net Profit before tax 150 125 115
Budgeted balances at the end of each months (₹ In '000's)

Particulars 31st Jan. 29th Feb. 31st March
Short term investments 700 - 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade Creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividend Payable 485 - -
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550
Depreciation amount to ₹ 60,000 is included in the budgeted expenditure for each month.
Capital Expenditure amounting to ₹ 8,00,000 is expected to be incurred during February 2010 and proceeds from sale of
Plant and Equipment of ₹ 50,000 is expected in March 2010

You are given below the profit & Loss Accounts for two years for a company:
Profit and Loss Account
Particulars Year 1 (₹) Year 2 (₹) Particulars Year 1 (₹) Year 2 (₹)
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Miscellaneous Income 10,00,000 10,00,000
To Manufacturing Expenses 1,00,00,000 1,60,00,000
To Other Expenses 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000

To Net Profit 1,30,00,000 1,80,00,000

9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000
Sales are expected to be ₹ 12,00,00,000 in year 3.
As a result, other expenses will increase by ₹ 50,00,000 besides other charges. Only raw materials are in stock. Assume
sales and purchase are in cash terms and the closing stock is expected to go up by the same amount as between year 1
and 2. You may assume that no dividend is being paid. The company can use 75% of the cash generated to service a loan.
How much cash from operations will be available in year 3 for the purpose? Ignore income tax.

The selling price of a book is ₹ 15, and sales are made on credit through a book club and invoiced on the last day of the
month. Variable costs of production per book are materials (₹ 5), labour (₹ 4), and overhead (₹ 2).
The sales manager has forecasted the following volumes:
Nov Dec Jan Feb March April May June July Aug
No. of Books 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Customers are expected to pay as follows:

One month after the sale 40%
Two months after the sale 60%
The company produces the books two months before they are sold and the creditors for materials are paid two months
after production.
Variable overheads are paid in the month following production and are expected to increase by 25% in April; 75% of wages
are paid in the month of production and 25% in the following month. A wage increase of 12.5% will take place on 1 st
March.
The company is going through a restructuring and will sell one of its freehold properties in May for ₹ 25,000, but it is also
planning to buy a new printing press in May for ₹ 10,000. Depreciation is currently ₹ 1,000 per month, and will rise to ₹
1500 after the purchase of the new machine.
The company’s corporation tax (of ₹ 10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2010, of ₹ 1500.
You are required to prepare a cash budget for the six months from January to June.

From the information and the assumption that the cash balance in hand on 1st January 2010 is ₹ 72,500 prepare a cash
budget. Assume that 50 per cent of total sales are cash sales. Assets are to be acquired in the months of February and
April. Therefore, provisions should be made for the payment of ₹ 8,000 and ₹ 25,000 for the same. An application has
been made to the bank for the grant of a loan of ₹ 30,000 and it is hoped that loan amount will be received in the month
of May.
It is anticipated that a dividend of ₹ 35,000 will be paid in June. Debtors are allowed one month’s credit. Creditors for
materials purchased and overheads grant one month’s credit. Sales commission at 3 per cent on sales is paid to the
salesman each month.
Sales Material Purchases Salaries & Wages Production Overheads Office & Selling
Months (₹) (₹) (₹) (₹) Overheads (₹)
January 72,000 25,000 10,000 6,000 5,500
Februar
y 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
1,02,50
May 0 37,000 22,000 8,000 11,000
1,08,70
June 0 38,800 23,000 8,200 11,500

Consider the balance sheet of Maya Limited as on 31 December,20X8. The company has received a large order and
anticipates the need to go to its bank to increase its borrowings. As a result, it has to forecast its cash requirements for

January, February and March, 20X9. Typically, the company collects 20 per cent of its sales in the month of sale, 70 per
cent in the subsequent month, and 10 per cent in the second month after the sale. All sales are credit sales.
Equity & liabilities Amount (₹ in ‘000) Assets Amount (₹ in ‘000)
Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,439 Inventories 545
Long-term borrowings 450 Accounts receivables 530
Accounts payables 360 Cash at bank 50
Loan from banks 400
Other liabilities 212
2,961 2,961
Purchases of raw materials are made in the month prior to the sale and amounts to 60 per cent of sales. It is paid in the
subsequent month. Payments for these purchases occur in the month after the purchase. Labour costs, including
overtime, are expected to be ₹ 1,50,000 in January, ₹ 2,00,000 in February, and ₹ 1,60,000 in March. Selling,
administrative, taxes, and other cash expenses are expected to be ₹ 1,00,000 per month for January through March.
Actual sales in November and December and projected sales for January through April are as follows (in thousands):
Month ₹ Month ₹ Month ₹
November 500 January 600 March 650
December 600 February 1,000 April 750
On the basis of this information:

(a) PREPARE a cash budget for the months of January, February, and March.
(b) DETERMINE the amount of additional bank borrowings necessary to maintain a cash balance of ₹ 50,000 at all times.
(c) PREPARE a pro forma balance sheet for March 31.
Question 85
Optimum Ltd. is a Trading Company, in respect of which you are required to prepare a cash forecast statement, together
with supporting schedules, for each of the 3 months of January to March on the basis of the following information –
• Sales Department advises that sales for the current year estimated on the basis of actual sales for the previous year
of ₹ 180 Lakhs, which were as follows:
Particulars Amount (₹)
January 9.00 Lakhs
February 12.60 Lakhs
March 18.00 Lakhs
April 16.20 Lakhs
May 14.40 Lakhs
June 12.00 Lakhs
July 10.50 Lakhs
August 16.50 Lakhs
September 15.00 Lakhs
October 12.00 Lakhs
November 18.00 Lakhs
December 25.80 Lakhs
• Sundry Debtors, as at 1st January would be at ₹ 11.40 Lakhs. The pattern of sales collection is: 50% in the month of
sale, 40% in the first subsequent month, 9% in the second subsequent month and 1% bad debt.
• The Company expects that it would realize by sale of machinery ₹ 1,00,000 in February, and capital expenditure
during the month would amount to ₹ 2,00,000.
• The normal expenditure, for the replacement of equipment, is estimated at ₹ 9,000 per month. The items of
equipment have an average estimated life of five yea₹
• Ex-gratia payment to staff will be made in January ₹ 30,000 and March ₹ 45,000.
• It is anticipated that Cash Dividends of ₹ 1,20,000 will be paid in March.
• Payment in respect of fixed and variable expenses for the first three months of January ₹ 4,81,860, February ₹
3,56,400 and March ₹ 4,75,200.

• The purchase cost of goods averages to 50% of Selling Price. The cost of the stock on hand as 31 st December is ₹
25,20,000 of which ₹ 90,000 is obsolete. It is anticipated that this latter stock will be sold in March, at 75% of the
normal Selling Price. The Company wishes to maintain stock for each month at a level of 3 subsequent months’ sales
as determined by the sales forecast. All purchases are paid in the immediately subsequent month. The liability on
this account, as at 31st December would be ₹ 6,95,000.
• Income Tax and Provident Fund payments-January ₹ 50,000, February ₹ 50,000, March ₹ 1,00,000.
• As on 1st January, the Company has a bank Loan of ₹ 8,40,000 which, together with simple interest at the rate of 15%
p.a. is payable on 31st March. The interest is due for the period January to March.
• The Cash Balance on 31st December was ₹ 3,00,000.
Question 86.
The following details are forecasted by a Company for the purpose of effective utilization and management of Cash:
• Estimated Sales and Manufacturing Costs:
Year 2010 Month Sales (₹) Materials (₹) Wages (₹) Overheads (₹)
April 4,20,000 2,00,000 1,60,000 45,000
May 4,50,000 2,10,000 1,60,000 40,000
June 5,00,000 2,60,000 1,65,000 38,000
July 4,90,000 2,82,000 1,65,000 37,500
August 5,40,000 2,80,000 1,65,000 60,800
September 6,10,000 3,10,000 1,70,000 52,000
• Credit-Terms:
(a) 20% Sales are on Cash. 50% of the Credit Sales are collected next month and the balance in the following
month.
(b) Credit allowed by Suppliers is 2 months.
(c) Delay in payment of Wages is ½ (one-half) month and of Overheads is 1 (one) month.
• Interest on 12% Debentures of ₹ 5,00,000 is to be paid half-yearly in June and December.
• Dividends on Investments amounting to ₹ 25,000 are expected to be received in June.
• A New Machinery will be installed in June at a cost of ₹ 4,00,000 payable in 20 monthly instalments from July
onwards.
• Advance Income-Tax to be paid in August is ₹ 15,000.
• Cash balance on 1st June is expected to be ₹ 45,000 and the Company wants to keep it at the end of every month
around this figure, the excess cash (in multiple of thousands rupees) being put in Fixed Deposit.
You are required to prepare monthly Cash Budget on the basis of above information for four months beginning from June.
Question 87.
Current Limited is into retail business. The following information is given for your consideration:
• Purchases are 75% of Sales and Purchases are sold at Cost plus 33 1/3rd %.
• Budgeted Sales, Labour Cost and expenses incurred are:
Budgeted Sales (₹) Labour Cost (₹) Expenses incurred (₹)
January 40,000 3,000 4,000
February 60,000 3,000 6,000
March 1,60,000 5,000 7,000
April 1,20,000 4,000 7,000
• 75% Sales are for Cash. 25% of Sales are one month’s interest-free credit.
• The policy of the Management is to have sufficient stock in hand at the end of each month to meet sales demand in
the next half month.
• Creditors for Materials and Expenses are paid in the month after the Purchases are made or the expenses incurred.
Labour is paid in full by the end of each month.
• Expenses include a monthly depreciation charge of ₹ 2,000.

• The Company will buy Equipment costing ₹ 18,000 cash in February and will pay a Dividend of ₹ 20,000 in the month
of March. The opening Cash Balance on February is ₹ 1,000.
Prepare for the months of February and March: (a) Profit and Loss Account, and (b) Cash Budget.

Slide Ltd. is preparing a cash flow forecast for the three months period from January to the end of March. The following
sales volume have been forecasted:
December January February March April
Sales (units) 1800 1875 1950 2100 2250
Selling price per unit is ₹ 600. Sales are all on one month credit. Production of goods for sale takes place one month before
sales. Each unit produced requires two units of raw materials costing ₹ 150 per unit. No raw material inventory is held.
Raw material purchases are on one month credit. Variable overheads and wages equal to ₹ 100 per unit are incurred
during production and paid in the month of production. The opening cash balance on 1st January is expected to be ₹
35,000. A long term loan of ₹ 2,00,000 is expected to be received in the month of March. A machine costing ₹ 3,00,000 will
be purchased in March.
(a) Prepare a cash budget for the month of January, February and March and calculate the cash balance at the end of each
month in the three months period.
(b) Calculate the forecast current ratio at the end of the three months period.
➢ Cash Management Models

Question 89. [MAY 04, NOV 05, NOV 07, MAY 11]
Briefly explain William J. Baumal’s EOQ model for optimum cash balance?
Solution 89:
The Baumol model is as follows:
1. Assumptions: The Optimum Cash Balance model is based on the following assumptions:
(a) Uniform Cash Flows: Cash payments arise uniformly during a year.
(b) Fixed Transaction Costs: Surplus cash can be invested in short-term marketable securities. However, for every
purchase of securities (i.e. investments) and for every sale (i.e. disposal of investments), fixed transaction costs
are incurred, e.g. Brokerage, registration costs, etc.
(c) Fixed Holding Costs: Surplus cash, if held by the Firm, entails loss of interest at a fixed rate. This constitutes
the carrying costs of cash, i.e. the interest foregone on marketable securities.
(d) Free Marketability: Short-term instruments can be freely traded. The Firm can invest them at any time, and
sell off/dispose investments at any time.
2. Principle: According to Baumol Model, Optimum Investment Size is that level of investment where the total of
Transaction Costs per annum and Carrying Costs per annum are the minimum.
𝟐𝑨𝑻
3. Formula: Optimum Transfer Size of Cash = √
𝑪
Where
A = Annual (Monthly) Cash Requirement.
T = Fixed Cost per transaction
C = Opportunity cost of one rupee per annum (or Per Month)
4. (a) Average Cash Balance = ½ of Optimum Transfer Size

(b) Associated Costs of Optimum Investment Size = Transaction Costs p.a. + Interest Costs p.a. = [(No. of Transaction
X Cost per
Transaction) + (Average Cash balance × Interest Rate p.a.)]
(a) At the Optimum Investment Size level, Transaction Costs p.a. = Interest Costs p.a. = ½ of Associated Costs per
annum
Question 90.
Explain Miller – Orr Cash Management Model?
Solution 90:
1. Stochastic Cash Flow Assumption:
(b) Under this model, cash payments are presumed at different amounts on different days, i.e. variable or
stochastic, e.g. Wage and Salary payment arises in the first week etc.
(c) With this assumption, this model is designed to determine the time and size of transfers between an
Investment Account and Cash Account.
2. Theory: This model Operates as under:

(a) Upper and lower limits can be fixed for cash balances, as outflows do not exceed a certain limit on any day.
These limits are determined based on fixed transaction costs, interest foregone on marketable securities and
the degree of likely fluctuations in cash balances.
(b) During the period when Cash Balance stays between high and low limits, there are no transactions between
cash and marketable securities.
(c) When cash balance reaches the upper limit, surplus cash is invested in marketable securities, to bring down
the cash balance to the average limit or return point.
(d) Cash Outflows/Payments are not uniform during the year.
(e) When cash balance touches the lower limit, investments (marketable securities) are disposed off so that cash
balances goes up to the average limit or return point.
Question 91. [RTP, MAY 14]

Decision Ltd. estimates its Total Cash Requirement at ₹ 4 Lakhs next year. Its Opportunity Cost of Funds is 15% per annum.
The Company will incur ₹ 300 per transaction to convert its short-term securities to cash and vice-versa. Determine the
Optimum Cash Balance according to Baumol Model.
Question 92. [STUDY MATERIAL, MAY 09 (ADAPTED)]

A firm maintains a separate account for cash disbursement. Total disbursement are ₹ 1,05,000 per month or ₹ 12,60,000
per year. Administrative and transaction cost of transferring cash to disbursement account is ₹ 20 per transfer. Marketable
securities yield is 8% per annum.
Determine the optimum cash balance according to William J. Baumol model.

JPL has two dates when it receives its cash inflows, i.e., Feb. 15. On each of these dates, it expects to receive ₹ 15 crore.
Cash expenditure is expected to be steady throughout the subsequent 6 months period. Presently, the ROI in marketable
securities is 8% per annum, and the cost of transfer from securities to cash is ₹ 125 each times at a transfer occurs.
(i) What is the optimal transfer size using the EOQ model? What is the average cash balance?
(ii) What would be your answer to part (i), if the ROI were 12% per annum and the transfer costs were ₹ 75? Why do
they differ from those in part (i)?
)Question 94. [STUDY MATERIAL]
The annual cash requirement of A Ltd. is ₹ 10 lakhs. The company has marketable securities in lot sizes of ₹ 50,000, ₹
1,00,000, ₹ 2,00,000, ₹ 2,50,000 and ₹ 5,00,000. Cost of conversion of marketable securities per lot is ₹ 1,000. The company
can earn 5% annual yield on its securities.
You are required to prepare a table indicating which lot size will have to be sold by the company. Also show that the
economic lot size can be obtained by the Baumol Model.
Question 95. [RTP, NOV 09]

What is the role of Lock Box System in Reducing Float?
Solution 95:
This method of collection from customers operates as under:
(1) Identify locations or places where major customers are placed, i.e. a Company with Head Office at Chennai and
customers based in Delhi, Kolkata and Mumbai.
(2) Open a local bank Account in each of these locations, i.e. Delhi, Kolkata and Mumbai.
(3) Instruct customers to mail their payments to the Local bank, through a Post Bag Number. [For example, the invoice
may carry instructions like “Mail your payment to Corporation Bank A/c No. 157483, P.O. Box No. 7083, Andheri
Branch, Mumbai]
(4) Authorize the Bank to pick up remittances from the Post Box.
(5) Authorize the Bank to realize the cheques through local collection/ clearing.
(6) Upon realization of cheques, transfer the funds to Head Office Bank Account, through telegraphic/ electronic
transfer schemes, by arrangement with the Bank.
Question 96. [may 13, MAY 14]

State the advantages of Electronic Cash Management System.
Solution 96:
With the growth in use of computers, banks are now providing electronic fund transfer and electronic clearing transfer
securities. Dividends payments by companies, refunds of subscription money in case of OPOs and refund of tax by
Income-tax Dept. are now being made through electronic clearing facility where in the funds are transferred from one
account to another within a few moments across India. In such transfers, there is no float as such. Business houses are
also using these faculties and payments and receipts are effected through electronic clearing system. If it is so, then the
question of float management does not arise. Even where the cheques are being used for payment, float period is
reducing because of greater efficiency on the part of the banking system.
Question 97.
ABC Limited currently has a centralized billing system. It takes around 4 days for customers mailed payments to reach the
central billing location. Subsequently, it takes another 1 ½ days for processing these payments, only after which deposits
are made. ABC Limited has a daily average collection of ₹ 5,00,000. The company plans to initiate a lock box system in
which customers mailed payments would reach the receipt location 2 ½ days earlier. Further the process time would be
reduced by another 1 day, since each lock box bank would collect mailed deposits twice daily.
(i) Determine the reduction in cash balances that can be achieved through the use of a lock box system.
(ii) Determine the reduction in opportunity cost of the present system by introduction of Lock box system assuming a
5% return on short-term investments.
(iii) If the annual cost of the lock box system is ₹ 80,000, should the system be initiated?
Solution 97:
(i) Total time saving = 3 & ½ days
Time savings × Daily average collection = Reduction in cash balances achieved
3 & ½ days × ₹ 5,00,000 = ₹ 17,50,000
(ii) 5% × ₹ 17,50,000 = ₹ 87,500

(iii) Since the opportunity cost of the present system (₹ 87,500) exceeds the cost of the lock box system (₹ 80,000), the
system should be initiated.

Star Limited is manufacturer of various electronic gadgets. The annual turnover for the year 2010 was ₹ 730 lakhs. The
company has a wide network of sales outlets all over the country. The turnover is spread evenly for each of the 50 weeks
of the working year. All sales are for credit and sales with within the week are also spread evenly over each of the five
working days.
All invoicing of credit sales is carried out at the Head Office in Bombay. Sales documentation is sent by post daily from
each location to the Head Office for the past two yea₹ Delays in preparing and dispatching invoices were noticed. As a
result, only some of the invoices were dispatched in the same week and the remainder in the following week.
An analysis of the delay in invoicing (being the interval between the date of sale and the date of dispatch of the invoice
indicated the following pattern:
No. of days of delay in invoicing 3 4 5 6
% of weeks sales 20 10 40 30
A further analysis indicated that the debtors take on an average 36 days of credit before paying. This period is measured
from the day of dispatch of the invoice rather than the date of sale.
It is proposed to hire an agency for undertaking the invoicing work at various locations. The agency has assured that the
maximum delay would be reduced to three days under the following pattern:
No. of days of delay in invoicing 0 1 3
% of weeks sales 40 40 20
The agency has also offered additionally to monitor the collections which will reduce the credit period to 30 days.
Star Limited expects to save ₹ 4,000 per month in postage costs. All working funds are borrowed from a local bank at
simple interest rate of 20% p.a.
The agency has quoted a fee of ₹ 2,00,000 p.a. for the invoicing work and ₹ 2,50,000 p.a. for monitoring collections and is
willing to offer a discount of ₹ 50,000 provided both the works are given. You are required to advise Star Limited about
the acceptance of agency’s proposal. Working should form part of the answer.
Solution 98:
Computation of Savings in Interest Cost:
𝑹𝒔.𝟕,𝟑𝟎,𝟎𝟎,𝟎𝟎𝟎
Sales per week = = ₹ 14,60,000
𝟓𝟎 𝒘𝒆𝒆𝒌𝒔
Interest Cost per week for existing Bill Float

% of week's Sales Sales Amount (₹) Days delay Interest Cost per week at 20% (₹)
𝟑
20% 14,60,000 × 20% = 2,92,000 3 2,92,000 × 20% × = 480
𝟑𝟔𝟓
𝟒
10% 14,60,000 × 10% = 1,46,000 4 1,46,000 × 20% × = 320
𝟑𝟔𝟓
𝟓
40% 14,60,000 × 40% = 5,84,000 5 5,84,000 × 20% × = 1,600
𝟑𝟔𝟓
𝟔
30% 14,60,000 × 30% = 4,38,000 6 4,38,000 × 20% × = 1,440
𝟑𝟔𝟓
14,60,000 Total 3,840
Interest Cost per week after hiring the agency

% of week's Sales Sales Amount (₹) Days delay Interest Cost per week at 20% (₹)
40% 14,60,000 × 40% = 5,84,000 0 Nil
𝟏
40% 14,60,000 × 40% = 5,84,000 1 5,84,000 × 20% × = 320
𝟑𝟔𝟓
𝟑
20% 14,60,000 × 20% = 2,92,000 3 2,92,000 × 20% × = 480
𝟑𝟔𝟓

14,60,000 Total 800

Savings in Interest Cost per annum = (₹ 3,840 – ₹ 800) × 50 weeks = ₹ 1,52,000
Cost Benefit Analysis of hiring the agency

Nature of Work Invoicing Credit Collection Both
Benefits:
Interest Saved 1,52,000 - 1,52,000
Postage Expenses Saved (₹ 4,000 × 12) 48,000 - 48,000
Savings due to fast collection of Debtors 36 – 30 =
𝟔
6 days (₹ 730 Lakhs × 20% × ) - 2,40,000 2,40,000
𝟑𝟔𝟓
Total Benefits 2,00,000 2,40,000 4,40,000
Less: Cost of Hiring 2,00,000 2,50,000 4,00,000
Net Benefit Nil (10,000) 40,000
Decision Indifference Point Reject Accept
⧫ Lock Box System Vs Concentration Banking Vs Compensating Balances

Question 99.
Prachi Ltd is a manufacturing company producing and selling a range of cleaning products to wholesale customers. It has
three suppliers and two customers. Prachi Ltd relies on its cleared funds forecast to manage its cash. You are an accounting
technician for the company and have been asked to prepare a cleared funds forecast for the period Monday 7 August to
Friday 11 August 2019 inclusive. You have been provided with the following information:
(1) Receipts from customers

Credit terms Payment method 7 Aug 2019 Sales 7 July 2019 Sales
W Ltd. 1 calendar month BACS ₹ 1,50,000 ₹ 1,30,000
X Ltd. None Cheque ₹ 1,80,000 ₹ 1,60,000
a. Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.

b. X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale is made and will clear on the
third day following this (excluding day of payment).
(2) Payments to suppliers
Supplier name Credit terms Payment method 7 Aug 2019 7 July 2019 7 June 2019
Purchases Purchases Purchases
A Ltd. 1 calendar month Standing order ₹ 65,000 ₹ 55,000 ₹ 45,000
B Ltd. 2 calendar Cheque ₹ 85,000 ₹ 80,000 ₹ 75,000
months
C Ltd. None Cheque ₹ 95,000 ₹ 90,000 ₹ 85,000
a. Prachi Ltd has set up a standing order for ₹ 45,000 a month to pay for supplies from A Ltd. This will leave Prachi’s
bank account on 7 August. Every few months, an adjustment is made to reflect the actual cost of supplies purchased
(you do NOT need to make this adjustment).
b. Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August. The amounts will leave its bank account on
the second day following this (excluding the day of posting).
(3) Wages and salaries

July 2019 Aug 2019
Weekly wages ₹ 12,000 ₹ 13,000
Monthly salaries ₹ 56,000 ₹ 59,000
a. Factory workers are paid cash wages (weekly). They will be paid one week’s wages, on 11 August, for the last week’s
work done in July (i.e. they work a week in hand).
b. All the office workers are paid salaries (monthly) by BACS. Salaries for July will be paid on 7 August.

(4) Other miscellaneous payments

a. Every Monday morning, the petty cashier withdraws ₹ 200 from the company bank account for the petty cash. The
money leaves Prachi’s bank account straight away.
b. The room cleaner is paid ₹ 30 from petty cash every Wednesday morning.
c. Office stationery will be ordered by telephone on Tuesday 8 August to the value of ₹ 300. This is paid for by company
debit card. Such payments are generally seen to leave the company account on the next working day.
d. Five new softwares will be ordered over the Internet on 10 August at a total cost of ₹ 6,500. A cheque will be sent
out on the same day. The amount will leave Prachi Ltd’s bank account on the second day following this (excluding
the day of posting).
(5) Other information
The balance on Prachi’s bank account will be ₹ 200,000 on 7 August 2019. This represents both the book balance and the
cleared funds.
PREPARE a cleared funds forecast for the period Monday 7 August to Friday 7 August 2019 inclusive using the information
provided. Show clearly the uncleared funds float each day.
Solution 99:
Cleared Funds Forecast
7 Aug 2019 8 Aug 2019 9 Aug 2019 10 Aug 2019 11 Aug 2019
(Monday) (Tuesday) (Wednesday) (Thursday) (Friday)
Particulars ₹ ₹ ₹ ₹ ₹
Receipts 1,30,000 0 0 0 0
W Ltd 0 0 0 1,80,000 0
X Ltd 1,30,000 0 0 1,80,000 0
(a)
Payments
A Ltd 45,000 0 0 0 0
B Ltd 0 0 75,000 0 0
C Ltd 0 0 95,000 0 0
Wages 0 0 0 0 12,000
Salaries 56,000 0 0 0 0
Petty cash 200 0 0 0 0
Stationery 0 0 300 0 0
(b) 1,01,200 0 1,70,300 0 12,000

Cleared excess Receipts over
payments (a) – (b)
Cleared balance b/f 28,800 0 (1,70,300) 1,80,000 (12,000)
Cleared balance c/f (c) 2,00,000 2,28,800 2,28,800 58,500 2,38,500
Uncleared funds float 2,28,800 2,28,800 58,500 2,38,500 2,26,500
Receipts 1,80,000 1,80,000 1,80,000 0 0
Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)
(d) 10,000 9,700 1,80,000 (6,500) (6,500)

Total book balance c/f 2,20,000
(c + d) 2,38,800 2,38,500 2,38,500 2,32,000
Question 100.
What do you mean by Concentration Banking? Give its advantages?
Solution 100:
This method of collection from customers operates as under –
(a) Identify locations or places where major customers are placed, i.e. a Company with Head Office at Chennai and
customers based in Delhi, Kolkata and Mumbai.

(b) Open a Local Bank Account in each of these locations, i.e. Delhi, Kolkata and Mumbai.
(c) Have a local Collection Centre (or Branch or Agent) for receiving cheques from customers at the respective places.
(d) Collect remittances from customers locally, either in person or through post.
(e) Deposit the cheques received from customers in the local Bank Account for faster clearing.
(f) Upon realization of cheques, transfer the funds to Head Office Bank Account, through telegraphic/ electronic
transfer schemes, by arrangement with the Bank.
ADVANTAGES:
(a) Reduction in Cheque Processing Float: The Agent/ Branch/ Bank would prepare a list of remittances received and
forward it to the Head Office as a Credit Advice. This reduces cheque processing float at the Company’s office.
(b) Centralized Cash Management: As surplus funds are transferred to Head Office Bank Account, idle funds in various
locations are avoided. Centralized Cash Management ensures optimum use of funds available to the Company, and
enables payment planning.
(c) Reduction in Mailing Float: Since remittances from customers are collected locally either in person or by local post/
courier, Mailing Float is reduced substantially.
(d) Reduction in Banking Processing Float: Cheques are cleared locally, and the funds are made available faster. Time
for clearance of outstation cheques is avoided.

Explain four kinds of Float with reference to management of cash.
Question 102.
What is Zero Balance Account?
Solution 102:
Firms can employ an extensive policy of substituting marketable securities for cash by the use of Zero Balance Accounts
for efficient Cash Management,
Every day, the Firm totals the cheques presented for payment against the account. The Firm transfers the balance amount
of cash in the account of any, for buying marketable securities. In case of shortage of cash, the Firm sells the marketable
securities. This method seeks to ensure optimum liquidity as well as profitability.
Question 103.
What is EFT (Electronic Fund Transfer/ Cash Management System)?
Solution 103:
(a) By using information technology in Banking Services, the electronic network will be linked to the different branches
and banks. Funds and Data can be transferred electronically from one account/ place/ branch/ bank to another.
(b) The advantages of Electronic Fund Transfer System are: (i) Instant updation of accounts, (ii) Quick transfer of funds,
and (iii) Instant information about foreign exchange rates.
(c) Certain networked Electronic Cash management Systems may also provide a very limited access to third parties
having very regular dealings of receipts and payments with the Company.
Question 104.
What is Petty Cash Imprest System?
Solution 104:
The day-to-day Petty Cash Expenses are estimated taking into account past experience and future needs. Generally, a
week’s requirement of cash will be kept separately for making Petty Cash Expenses. Again, the next will commence with
the pre-determined balance. This will reduce the strain of the management in managing Petty Cash Expenses and help in
managing overall cash efficiently.
Question 105.
What are the principals involved in selection of Marketable Securities?
Solution 105:
Marketable Securities: Surplus cash can be invested in short-term instruments in order to earn interest. Such instruments
are called Marketable Securities. Some examples are Government Treasury Bills (T-Bills), Short-term Deposits with Banks
(Certificate of Deposits and Money at Call and at Short Notice).

Selection Criteria: The selection of securities for short-term investment purposes, depends on:
(a) Safety: Investment should be safe, i.e. guaranteed income and return of principal, when disposed off. Since short-
term funds are to be parked in marketable securities, minimum risk is the criterion of selection, for ensuring liquidity.
(b) Maturity: Matching maturity of investments with forecasted cash needs is essential. Prices of long term securities
fluctuate more with changes in interest rates and are therefore, more risky.
(c) Marketability: It refers to the convenience, speed and cost at which a security can be converted into cash. If the
security can be sold quickly without loss of time and price it is said to be highly liquid or marketable.
Question 106
‘Management of marketable securities is an integral part of investment of cash.’ Comment.
Solution 106:
Management of Marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity
& cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to
invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of
securities should be guided by the three principles namely, safety, maturity and marketability.
The following Information is available in respect of Sai Trading Company:
• On an average, debtors are collected after 45 days; inventories have an average holding period of 75 days and
creditor’s payment period on an average is 30 days.
• The firm spends a total of ₹ 120 lakhs annually at a constant rate.
• It can earn 10 per cent on investments.
From the above information, you are required to calculate:
(a) The cash cycle and cash turnover.
(b) Minimum amounts of cash to be maintained to meet payments as they become due.
(c) Savings by reducing the average inventory holding period by 30 days.
Solution 107:
(a) Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months)
Cash turnover = 12 months (360 days)/3 months (90 days) = 4.
(b) Minimum operating cash = Total operating annual outlay/cash turnover, that is, ₹ 120 lakhs/4 = ₹ 30 lakhs.
(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months)

Cash Turnover = 12 Months (360 days) / 2 Months (60 Days) = 6
Minimum Operating Cash = ₹ 120 lakhs/6 = ₹ 20 lakhs
Reduction in investments = ₹ 30 lakhs – ₹ 20 lakhs = Rs 10 lakhs
Saving = 0.10 x ₹ 10 lakhs = ₹ 1 lakh.

Chapter 10
PART IV: Inventory Management
The following details are available in respect of a firm:
• Annual requirement of inventory 40,000 units
• Cost per unit (other than carrying and ordering cost) ₹ 16
• Carrying cost are likely to be 15% per year
• Cost of placing order ₹ 480 per order
Determine the economic ordering quantity.
Question 109.
The demand for a certain product is random. It has been estimated that the monthly demand of the product has a normal
distribution with a mean of 390 units. The unit price of product is ₹ 25. Ordering cost is ₹ 40 per order and inventory
carrying cost is estimated to be 35 per cent per year. Calculate Economic Order Quantity (EOQ).

A publishing house purchases 72,000 rims of a special type paper per annum at cost ₹ 90 per rim. Ordering cost per order
is ₹ 500 and the carrying cost is 5 per cent per year of the inventory cost. Normal lead time is 20 days and safety stock is
Nil. Assume 300 working days in a year:
(i) Calculate the Economic Order Quantity (E.O.Q).
(ii) Calculate the Reorder Inventory Level.
(iii) If a 1 per cent quantity discount is offered by the supplier for purchases in lots of 18,000 rims or more, should the
publishing house accept the proposals?

A company’s requirements for ten days are 6,300 units. The ordering cost per order is ₹ 10 and the carrying cost per unit
is ₹ 0.26. You are required to CALCULATE the economic order quantity.

Marvel Limited uses a large quantity of salt in its production process. Annual consumption is 60,000 tonnes over a 50-
week working year. It costs ₹ 100 to initiate and process an order and delivery follow two weeks later. Storage costs for
the salt are estimated at ₹ 0.10 per tonne per annum. The current practice is to order twice a year when the stock falls to
10,000 tonnes. IDENTIFY an appropriate ordering policy for Marvel Limited, and contrast it with the cost of the current
policy.

Pureair Company is a distributor of air filters to retail stores. It buys its filters from several manufacture₹ Filters are
ordered in lot sizes of 1,000 and each order costs ₹ 40 to place. Demand from retail stores is 20,000 filters per month, and
carrying cost is ₹ 0.10 a filter per month.
a. COMPUTE the optimal order quantity with respect to so many lot sizes?
b. CALCULATE the optimal order quantity if the carrying cost were ₹ 0.05 a filter per month?
c. COMPUTE the optimal order quantity if ordering costs were ₹ 10?

Chapter 10
PART V: Management of Payables
➢ Cost and Benefits of Trade Credit
Question 114.
Bring out the costs and benefits of Trade Credit?
Solution 114:
(a) Cost of Availing Trade Credit
(i) Price
(ii) Loss of goodwill
(iii) Cost of managing
(iv) Conditions
(b) Cost of Not taking Trade Credit
(i) Impact of inflation
(ii) Interest
(iii) Inconvenience
Question 115.
How is cost of Payables Computed?
Solution 115:
The following equation can be used to calculate nominal cost, on an annual basis of not taking the discount:
𝒅 𝟑𝟔𝟓 𝒅𝒂𝒚𝒔
×
𝟏𝟎𝟎 − 𝒅 𝒕
The cost of lost cash discount can be estimated by the formula:
𝟑𝟔𝟓
𝟏𝟎𝟎 𝒕
–1
𝟏𝟎𝟎−𝒅
Where,
d = Size of discount i.e. for 6% discount, d = 6
t = The reduction in the payment period in days, necessary to obtain the early discount or Days Credit Outstanding –
Discount Period.
Suppose ABC Ltd. has been offered credit terms from its major supplier of 2/10, net 45. Hence the company has the choice
of paying ₹ 10 per ₹ 100 or to invest the ₹ 98 for an additional 35 days and eventually pay the supplier ₹ 100 per ₹ 100.
The decision as to whether the discount should be accepted depends on the opportunity cost of investing ₹ 98 for 35 days.
What should the company do?
Question 117.
XYZ Limited normally pays its Suppliers in the third month after invoicing. It is now offered a 2% discount for payment
within one month on invoicing. Payments are at ₹ 3,00,000 per month, and the Company operates on Bank Overdraft on
which interest is charged at 14.5%. Advise whether the offer should be accepted.
Would your answer differ if the Company were given 3% discount, all other conditions remaining the same as above?
Solution 117:
(a) When Discount = 2%
Particulars Amount (₹)

Benefit = Discount Received [₹ 3,00,000 × 2%] 6,000

𝟐
Cost = Opportunity Cost of funds due to early payment [₹ 3,00,000 × 14.5% × ] 7,250
𝟏𝟐
(Payment being made two months in advance, i.e. 3rd month Vs 1st month)
Net Benefit/ (Cost) per month (1,250)
Net Payment to Supplier will be ₹ 3,00,000 less 2% discount = ₹ 2,94,000.
Interest can also be calculated on ₹ 2,94,000, being the actual outflow of cash.
𝟐
So, Interest Cost = ₹ 2,94,000 × 14.5% × = ₹ 7,105
𝟏𝟐
Conclusion: As there is a Net Cost of ₹ 1,250, the discount offer is not worthwhile. The Company may pay the Supplier in
the third month after invoicing.
(b) When Discount = 3%, Benefit = Discount Received = ₹ 3,00,000 × 3% = ₹ 9,000.

Net Benefit = ₹ 9,000 – ₹ 7,250 = ₹ 1,750.
Conclusion: Since there is a Net Benefit, the 3% Discount Offer may be accepted and the payment can be made early.
Question 118
Outline the few measure of Payment Management?
Solution 118:
Quick collection of funds and effective control over payments results in faster turnover of cash. This can be done by the
following measures:
1. Utilisation of credit period to the extent permissible, i.e. making payments to creditors on the due date, except when
the cash discount offered by supplier for early payments is substantial.
2. Use of draft (Bill of Exchange) instead of cheques.
3. Playing the float-estimating accurately the time of presentation of issued cheques for encashment and thus utilising
the float period by issuing more cheques, but having only such cash balance in the Bank account as will be sufficient
to honour cheques that are actually expected to be presented on a particular date.
Question 119.
Explain briefly the Accounts Receivable Systems?
Solution 119:
Accounts Receivables System includes – (a) Credit Granting Decision, (b) Credit Period Decision, (c) Discount Rate and
Period Decision, (d) Financing against Receivable, and (e) Debtors follow up.

Chapter 10
PART VI: Financing of Working Capital
What is meant by Financing of Working Capital?
Solution 120:
After determining the amount of working capital required, the next step to be taken by the finance manager is to arrange
the funds.
1. Bifurcate - requirements between the permanent working capital and temporary working capital.
2. The permanent working capital is always needed. It should be financed by the long-term sources such as debt
and equity. The temporary working capital may be financed by the short-term sources of finance.

What are the two categories of Working Capital financing?
Solution 121:
The working capital finance may be classified between the two categories:
(i) Spontaneous sources; and
(ii) Negotiable sources.
Spontaneous Sources: Spontaneous sources of finance are those which naturally arise in the course of business operations.
Trade credit, credit from employees, etc.
Negotiated Sources: Sources which have to be specifically negotiated with lenders say, commercial banks, financial
institutions, general public etc.
The finance manager has to be very careful while selecting a particular source. Generally, the following parameters will
guide his decisions in this respect:
(i) Cost factor
(ii) Impact on credit rating
(iii) Feasibility
(iv) Reliability
(v) Restrictions
(vi) Hedging approach or matching approach i.e., Financing of assets with the same maturity as of assets.

Explain sources of finance.
Solution 122:
(I) Spontaneous Sources of Finance
(a) Trade Credit: Finance which is normally extended to the purchaser organization by the sellers or services provide₹ It
contributes to about one-third of the total short-term requirements.
• lesser cost of finance
• without completing much formality
(b) Bills Payable: The purchaser will have to give a written promise to pay the amount of the bill/invoice
• simplicity,
• easy availability
• lesser explicit cost
• dependence on this source is much more in all small or big organizations
• financing depends on the volume of purchases

(c) Accrued Expenses: The services availed by the firm, but the payment for which has yet to be made. An automatic
source of finance as most of the services like wages, salaries, taxes, duties etc., are paid at the end of the period. No
explicit or implicit cost is associated.
(II) Inter-corporate Loans and Deposits:

Organizations having surplus funds invest for short-term period with other organizations. The rate of interest will be
higher than the bank rate of interest and depends on the financial soundness of the borrower company.
(III) Commercial Papers:

• Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period.
• This is an instrument that enables highly rated corporate borrowers for short-term borrowings and provides an
additional financial instrument to investors with a freely negotiable interest rate.
• The maturity period ranges from minimum 7 days to less than 1 year from the date of issue.
• CP can be issued in denomination of ₹ 5 lakhs or multiples thereof.
Advantages of CP:
(a) CP is sold on an unsecured basis and does not contain any restrictive conditions.
(b) Maturing CP can be repaid by selling new CP and thus can provide a continuous source of funds.
(c) Maturity of CP can be tailored to suit the requirement of the issuing firm.
(d) CP can be issued as a source of fund even when money market is tight.
(e) Generally, the cost of CP to the issuing firm is lower than the cost of commercial bank loans.
Limitations:
(i) Only highly credit rating firms can use it. New and moderately rated firm generally are not in a position to issue CP.
(ii) CP can neither be redeemed before maturity nor can be extended beyond maturity.
(IV) Funds Generated from Operations

Funds generated from operations, during an accounting period, increase working capital by an equivalent amount. The
two main components of funds generated from operations are profit and depreciation.
(V) Public Deposits

Deposits from the public are one of the important sources of finance particularly for well established big companies with
huge capital base for short and medium term.
(VI) Bills Discounting

Bill discounting is recognized as an important short term Financial Instrument. Supplier of goods draws a bill of exchange
with direction to the buyer to pay a certain amount of money after a certain period, and gets its acceptance from the
buyer or drawee of the bill.
(VII) Bill Rediscounting Scheme

• The Bill rediscounting Scheme was introduced by Reserve Bank of India with effect from 1st November, 1970.
• Providing credit and the creation of a bill market in India with a facility for the rediscounting of eligible bills by
banks.
• All licensed scheduled banks are eligible to offer bills of exchange to the Reserve Bank for rediscount.
Question 123
Discuss the meaning of Commercial Paper?
Solution 123:
Commercial Paper (CP) is an unsecured promissory note issued by a firm to raise funds for a short period. This is an
instrument that enables highly rated corporate borrowers for short-term borrowings and provides an additional financial
instrument to investors with a freely negotiable interest rate. The maturity period ranges from minimum 7 days to less
than 1 year.
Question 124.
Mr. Big purchased a commercial paper of Entry Inc. issued for 6 months in the market for ₹ 9,61,000. The company issued
the CP with a face value of ₹ 10,00,000. Determine the rate of return which Mr. Big earns.

➢ Factoring
Question 125. [NOV 03, MAY 04, MAY 07, MAY 08, MAY 11]
What is Factoring? What are its advantages?
Solution 125:
1. Meaning: Factoring is an arrangement under which a Firm (called Borrower) receives advances against its
receivables, from a financial institution (called Factor). The Factor also provides certain Allied Services, e.g. Debtors
follow-up, Maintenance of Debtors Ledger, etc. on behalf of the Borrower.
The Factoring procedure is an under:
(a) The Borrower sells his Accounts Receivables (i.e. Book Debts) to the Factor.
(b) The Factor purchases the Receivables and provides advances against them, after deducting and retaining: (i) a
suitable margin/reserve, (ii) Factor’s Commission/Fees, and (c) Interest on Advance.
(c) The Borrower forwards collections from his customers/Buyers to the Factor, and thus settles the advances
received by him.
(d) The factor may also provide allied services like Credit Investigation, Sales Ledger Management, Collection of
Debts, credit protection and risk-bearing.
2. Types of Factoring:
(a) Disclosed v/s Undisclosed Factoring: In Disclosed Factoring, all parties Factor, Borrower/Seller and the Buyer,
is aware of the other’s presence in the arrangement.
In Undisclosed Factoring, the factoring arrangement is not known to the Buyer of goods.
(b) Recourse v/s Non Recourse Factoring: In Recourse Factoring, in case of default by the Customer, the risk of
Bad Debts is born by the Borrower and not the Factor.
In Non-Recourse Factoring, the risk of bed debts is born by the factor himself. The rate of commission is higher
in case of Non-Recourse Factoring, to compensate the Factor for the additional risk borne by him.
3. Conditions: Various conditions are laid down by the Factor for factoring arrangements. Some are:
(1) Standardization of invoices;
(2) Fixing Credit Limits for each borrower and each customer;
(3) Instruction to customers that the payment shall be forwarded directly to the Factor;
(4) Acknowledgement from Customer for actual supply of goods under the invoice;
(5) Exclusion of certain customers from factoring – e.g. sale to sister concerns cannot be factored,
4. Benefits:
(a) Pattern of Inflows: Supply invoices are factored immediately. Hence, Cash Inflows the sale pattern.
(b) Flexibility: The Seller may continue to finance its receivables continuously, on a more or less automatic basis.
If value of sales increase or decrease, it can vary the financing proportionately.
(c) Convertibility: Accounts receivables are easily converted into cash.
(d) Reduction in Collection and Administration Costs: There is no need for a separate credit department since
credit management may also be undertaken by the Factor.
(e) Compensating balance is not required in case of factoring, unlike Unsecured Loans. However, the Factor may
not give 100% advance, he may reduce a reserve/margin and advance only the balance.
Question 126. [NOV 09,MAY 13]

What are the differences between Bills Discounting and Factoring?
Solution 126:
Aspect Bills Discounting Factoring
1. Nature Primarily a method of borrowing from Primarily a method of management of Book
Commercial Banks. Debts/Receivables.
2. Additional The Financier (Banker) provides Factor provides financing services like
Services advance/finance against the Bill of Debtors follow up, Debtors Ledger
exchange/Invoice. Maintenance, Collection Mechanism, Credit
Reports on Debtors etc.
3. Statue Negotiable Instrument Act is applicable. There is no specific Act as such.
4. Parties Buyer of Goods = Drawee. Buyer of Goods = Debtor.

Seller of Goods = Drawer. Seller or Goods = Client.

Financier = Payee. Financier = Factor.
5. Income to Banker earns ‘Discounting Charges’ on the Factor earns ‘Interest’ for the financing
Financier transaction. service, and ‘commission’ for other services
rendered.
6. Pattern of The entire amount of the Bill of Exchange is Factor gives an advance (say 90%) at the
financing discounted and provided at the time of time of transaction, and provides the
transaction itself. balance (i.e. 10%), at the time of
settlement/end of credit period.

A Factoring firm has credit sales of ₹ 360 lakhs and its average collection period is 30 days. The financial controller
estimates, bad debt losses are around 2% of credit sales. The firm spends ₹ 1,40,000 annually on debtors administration.
This cost comprises of telephonic and fax bills along with salaries of staff members. These are the avoidable costs. A
Factoring firm has offered to buy the firm’s receivables. The factor will charge 1% commission and will pay an advance
against receivables on an interest @15% p.a. after withholding 10% as reserve. ANALYSE what should the firm do? Assume
360 days in a year.

A firm has a total sales of ₹ 12,00,000 and its Average Collection Period is 90 days. The past experience indicates that Bad
Debt losses are 1.5% on Sales. The expenditure incurred by the Firm in administering receivable collection efforts are ₹
50,000. A Factor is prepared to buy the Firm’s Receivables by charging 2% commission. The Factor will pay advance on
receivables to the Firm at an interest rate of 16% p.a. after withholding 10% as Reserve. Calculate Effective Cost of
Factoring to the Firm. Assume 360 days in a year.

A Ltd has a total sales of ₹ 3.2 Crores and its Average Collection Period is 90 days. The past experience indicates that Bad
Debt losses are 1.5% on Sales. The expenditure incurred by the Firm in administering its receivable collection efforts are
₹ 5,00,000. A Factor is prepared to buy the Firm’s receivables by charging 2% Commission. The Factor will pay advance on
receivables to the Firm at an Interest Rate of 18% p.a. after withholding 10% as Reserve. Calculate the Effective Cost of
Factoring to the Firm.
Question 130
Jaidev Ltd has total credit sales of ₹ 40 lakhs p.a. and its average collection period is 90 days. The past experience indicates
that the Bad Debt losses are around 3% of credit sales. Jaidev spends about ₹ 1,00,000 per annum on administrating its
credit sales. It is considering availing the services of a Factoring Firm. It has received offer from Uday Ltd, which agrees to
buy the receivables of Company. Uday will charge Commission of 3% and also agrees to pay advance against receivables
at an Interest Rate of 18% p.a. after withholding 10% as Reserve. Should Jaidev accept Uday’s offer if the former’s ROI is
15%? Assume 360 days in a year.

The turnover of R Ltd. is ₹ 60 lakhs of which 80% is on credit. Debtors are allowed one month to clear off the dues. A factor
is willing to advance 90% of the bills raised on credit for a fee of 2% a month plus a commission of 4% on the total amount
of debts. R Ltd. as a result of this arrangement is likely to save ₹ 21,600 annually in management costs and avoid bad debts
at 1% on the credit sales.
A scheduled bank has come forward to make an advance equal to 90% of the debts at an interest rate of 18% p.a. However,
its processing fee will be at 2% on the debts. Would you accept factoring or the offer from the bank?
Question 132.
Laxman Ltd sells on credit terms 2/10 net 30. It has an annual credit sales of ₹ 900 lakhs, with a Variable Cost of 80% and
Bad Debts of 0.75%. Past experience shows that 50% of the customers avail cash discount and the remaining customers
pay 50 days after the date of sale. Presently the Company’s investment in receivables are financed in the ratio of 2 : 1 by
a mix of Bank Borrowings and Own Funds, which cost 24% and 27% p.a. respectively. The Company also incurs ₹ 16 Lakhs
on Credit Collection Costs.
The Company is considering a “Non-Recourse Factoring” arrangement with T-Factors Ltd on the following terms – (a) 15%
Factor Reserve, (b) Guaranteed Payment date = 24 days after the date of purchase, (c) 22% Interest/ Discount, (d) 4%
Factoring Commission. Evaluate whether the factoring proposal is worthwhile, with suitable assumptions, wherever
applicable.

Question 133
A firm has a total sales of ₹ 200 lakhs of which 80% is on credit. It is offering credit terms of 2/40, net 120. Of the total,
50% of customers avail of discount & the balance pay in 120 days. Past experience indicates that bad debt losses are
around 1% of credit sales. The firm spends about ₹2,40,000 per annum to administer its credit sales. These are avoidable
as a factor is prepared to buy the firm’s receivables. He will charge 2% commission. He will pay advance against receivables
to the firm at an interest rate of 18% after withholding 10% as reserve.
(i) What is the effective cost of factoring? Consider year as 360 days.
(ii) If bank finance for working capital is available at 14% interest, should the firm avail of factoring service?
⧫ Evaluation of Factoring Proposals

The turnover of PQR Ltd. is ₹ 120 lakhs of which 75 per cent is on credit. The variable cost ratio is 80 per cent. The credit
terms are 2/10, net 30. On the current level of sales, the bad debts are 1 per cent. The company spends ₹ 1,20,000 per
annum on administering its credit sales. The cost includes salaries of staff who handle credit checking, collection etc. These
are avoidable costs. The past experience indicates that 60 per cent of the customers avail of the cash discount, the
remaining customers pay on an average 60 days after the date of sale.
The Book debts (receivable) of the company are presently being financed in the ratio of 1 : 1 by a mix of bank borrowings
and owned funds which cost per annum 15 per cent and 14 per cent respectively.
A factoring firm has offered to buy the firm’s receivables. The main elements of such deal structured by the factor are:
(i) Factor reserve, 12 per cent
(ii) Guaranteed payment, 25 days
(iii) Interest charges, 15 per cent, and
(iv) Commission 4 day cent of the value of receivables.
Assume 360 days in a year.
What advice would you give to PQR Ltd. – whether to continue with the in house management of receivables or accept
the factoring firm’s offer?

Slow Payers are regular customers of Goods Dealers Ltd. and have approached the sellers for extension of credit facility
for enabling them to purchase goods. On an analysis of past performance and on the basis of information supplied, the
following pattern of payment schedule emerges in regard to Slow Payers:
Pattern of Payment Schedule
Non - recovery 1% of the bill
Slow Payers want to enter into a firm commitment for purchase of goods of ₹ 15 lakhs in 20X7, deliveries to be made in
equal quantities on the first day of each quarter in the calendar year. The price per unit of commodity is ₹ 150 on which
a profit of ₹ 5 per unit is expected to be made. It is anticipated by Goods Dealers Ltd., that taking up of this contract would
mean an extra recurring expenditure of ₹ 5,000 per annum. If the opportunity cost of funds in the hands of Goods Dealers
is 24% per annum, would you as the finance manager of the seller recommend the grant of credit to Slow Payers?
ANALYSE. Workings should form part of your answer. Assume year of 365 days.

Explain working capital finance from banks.
Solution 136:
Banks in India today constitute the major suppliers of working capital credit to any business activity.
The two committees viz., Tandon Committee and Chore Committee have evolved definite guidelines and parameters in
working capital financing.
Instructions on Working Capital Finance by Banks

• Assessment of Working Capital - Reserve Bank of India has withdrawn the prescription, in regard to assessment
of working capital needs, based on the concept of Maximum Permissible Bank Finance, in April 1997.
• Banks are now free to evolve, with the approval of their Boards, methods for assessing the working capital
requirements of borrowers.
• Banks, however, have to take into account Reserve Bank’s instructions relating to directed credit and prohibition
of credit while formulating their lending policies.

Explain the forms Of Bank Credit?
Solution 137:
The bank credit will generally be in the following forms:
• Cash Credit: This facility will be given by the banker to the customers by giving certain amount of credit facility
on continuous basis.
• Bank Overdraft: It is a short-term borrowing facility made available to the companies in case of urgent need of
funds. When the borrowed funds are no longer required they can quickly and easily be repaid.
• Bills Discounting: The seller, here discounts the bill with his banker. The banker will generally earmark the
discounting bill limit.
• Bills Acceptance: The bank accepts the bill thereby promising to pay out the amount of the bill at some specified
future date.
• Line of Credit: Line of Credit is a commitment by a bank to lend a certain amount of funds on demand specifying
the maximum amount.
• Letter of Credit: It is an arrangement by which the issuing bank on the instructions of a customer or on its own
behalf undertakes to pay or accept or negotiate or authorizes another bank to do so against stipulated
documents subject to compliance with specified terms and conditions.
• Bank Guarantees: Bank guarantee is one of the facilities that the commercial banks extend on behalf of their
clients in favour of third parties who will be the beneficiaries of the guarantees.


01 FM Book Questions Main Book

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

01 FM Book Questions Main Book

Uploaded by

Copyright:

Available Formats

CA - INTERMEDIATE

BY: CA NITIN GURU

ABOUT THE AUTHOR

CLASSES AVAILABLE ON WWW.EDU91.ORG

FOR resolving any doubts -

2. Types of Financing (Theory, covered from ICAI Module)

5. Financing Decisions - Capital Structure

6. Financing Decisions – Leverages

8. Risk Analysis in Capital Budgeting

10. Management of Working Capital

Question 2. [NOV 09]

To get the best out of these notes visit www.edu91.org

(-) Non-Operating Income (e.g. Rent, Interest & Dividends received)

II. COVERAGE RATIOS:

III. TURNOVER/ACTIVITY/ PERFORMANCE RATIOS[NOV 06]

To get the best out of these notes visit www.edu91.org

Factory Cost = Materials Consumed + Wages + POH

𝑪𝒐𝒔𝒕 𝒐𝒇 𝑮𝒐𝒐𝒅𝒔 𝑺𝒐𝒍𝒅

IV. CAPITAL STRUCTURE RATIOS

To get the best out of these notes visit www.edu91.org

Significance = Indicator of use of external funds. Ideal Ratio is 67%.

To get the best out of these notes visit www.edu91.org

VI. OVERALL RETURN RATIOS – OWNER VIEW POINT

i. Return on Investment (ROI) [or] Return on Capital Employed (ROCE) =

To get the best out of these notes visit www.edu91.org

• Either pre-tax or post-tax ROCE may be computed.

ii. Return on Net Worth (RONW) =

iii. Return on Assets (ROA) =

Significance = Income per share, whether or not distributed as dividends.

𝑻𝒐𝒕𝒂𝒍 𝑬𝒒𝒖𝒊𝒕𝒚 𝑫𝒊𝒗𝒊𝒅𝒆𝒏𝒅

𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

To get the best out of these notes visit www.edu91.org

• Equity (or) Net Worth

𝑴𝒂𝒓𝒌𝒆𝒕 𝑷𝒓𝒊𝒄𝒆 𝒑𝒆𝒓 𝑺𝒉𝒂𝒓𝒆

VII. CASH GENERATING EFFICIENCY RATIOS

VIII. FREE CASH FLOW RATIOS

Question 3. [NOV 09]

Question 4. [MAY 06]

Stock 2,867 2,407

To get the best out of these notes visit www.edu91.org

Sales 22,165 13,882

Question 6. [NOV 09]

Question 7. [STUDY MATERIAL(ADAPTED), NOV 10]

To get the best out of these notes visit www.edu91.org

Particulars Amount Particulars Amount

Particulars (Rs. in lakhs)

To get the best out of these notes visit www.edu91.org

(i) Interest Service coverage ratio and

Question 10. [STUDY MATERIAL]

To get the best out of these notes visit www.edu91.org

(vi) Net Profit to Net Worth Ratio, and

Question 12. [STUDY MATERIAL]

Question 13. [STUDY MATERIAL

Question 15. [STUDY MATERIAL]

Question 16(b). [NOV 12]

To get the best out of these notes visit www.edu91.org

Gross Profit Ratio 25%

Question 18. [NOV 02]

To get the best out of these notes visit www.edu91.org

Total Liabilities to Net worth 75%

Question 22 . [NOV 05]

To get the best out of these notes visit www.edu91.org

Question 24. [NOV 07]