EASWARI ENGINEERING COLLEGE CHENNAI--89

DEPARTMENT OF MANAGEMENT STUDIES

QUESTION BANK

BA 5203– FINANCIAL MANAGEMENT

COMPILED BY

Dr.R.Vasudevan

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1. Name the objective of Conventional and modern approaches in financial management.

Distinguish them on two aspects. (May / June 2007), (May/June 2008),
There are two approaches of financial management:
Conventional approach – Profit maximization
Modern approach – Wealth maximization
2. A Rs.10,000 per value bond bearing a coupon rate of 12% will mature after 5 years.
What is the value of bond, if the discount rate is 15%?(May / June 2007)
V = 1200(PVIFA 15% 5 Years) + 10,000(PVIF 15%, 5)
= 1,200(3.352) + 10,000(0.497) = Rs. 8,992.
3. What is meant by Time Value of Money? (Nov/Dec 2007), (Nov/Dec 2008), (May/June
2011), (May/June 2012), (May/June 2013), (Nov/Dec 2013),
The value of money changes over time. A rupee today is more valued than a rupee a year hence;
because of inflationary tendencies money will have lost its purchasing power.
4. What is Rule of 72? (May/June 2008)
Rule 72, helps us to find, how many years principal get doubled in Years = 72/I (i= Interest rate)
5. What are the modern view(s) on financial management? (Nov/Dec 2008)
The scope of financial management is not limited to the procurement of funds. It includes efficient
utilization as well.
6. State any four functions of a finance manager in an organization(May/June 2009)
Functions of a finance manager in an organization are :
* Procurement of Funds.
* Efficient utilization of Funds
* Increasing Profitability
* Maximizing Firm’s Value
7. Return on market portfolio has a standard deviation of 20% and covariance between the
returns on the market portfolio and that of security A is 800. (May/ June 2009)
Bate of Security A
Covariance between the returns
=
2
= 800 800
= 2
(20.2 400
8. What are the goal of financial management? (Nov/Dec 2009)
The goals of financial management are :
* Profit Maximization
* Wealth Maximization

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9. Define Future Value of Money. (Nov/Dec 2009)

The amount to be invested today at a given interest rate over a specified period to equal the future
value of money.
10. How is the term finance more comprehensive than money management? (May/June
2010)
Financial management is a managerial activity, which is concerned with the planning and
controlling of the firms financial resources
11. How would you have a fresh look at the finance function in business? (May/June 2010)
a. Profit Maximization
b. Maximizing Earning Per Share
c. Shareholders Wealth Maximization
12. State and brief any two activities of the financial manager. (Nov/Dec 2010)
d. Raising Funds
e. Allocation of funds
f. Profit Planning
g. Understanding Capital Market
13. Applying CAPM , compute the expected market returns, using the following data : risk
free returns 7.75% . Beta=2, expected returns of investors=16%.
SOLUTION: To be discussed in class (Nov/Dec 2010)
14. What is meant by Yield to Maturity? (May/June 2011)
The rate of return anticipated on a bond if it is held until the maturity date. YTM is considered a
long-term bond yield expressed as an annual rate. The calculation of YTM takes into account the
current market price, par value, coupon interest rate and time to maturity. It is also assumed that
all coupons are reinvested at the same rate. Sometimes this is simply referred to as "yield" for
short.
15. Define and explain financial assets? (Nov/Dec 2011)
Financial Assets include cash and bank accounts plus securities and investment accounts that can
be readily converted into cash. Excluded are illiquid physical assets such as real estate,
automobiles, art, jewelry, furniture, collectibles, etc., which are included in calculations of Net
Worth.
16. What is effective rate of interest? (Nov/Dec 2011)
The effective interest rate is the true rate of interest earned. It could also be referred to as the
market interest rate, the yield to maturity, the discount rate, the internal rate of return, the annual
percentage rate (APR), and the targeted or required interest rate.
17. What are the basic financial decisions? (May/June 2012)
-Investment decision, -Financing decision, -Dividend decision,

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18. What is financial management? (May/June 2012), (May/June 2014)

Financial management deals with the study of procuring funds and its effective and judicious
utilization, in terms of the overall objectives of the firm, and expectations of the providers of
funds.

19. What is a bond?(May/June 2012)

 Public authorities, credit institutions, companies and supranational institutions in the
primary markets, issue bonds. The most common process for issuing bonds is through
underwriting.
 When a bond issue is underwritten, one or more securities firms or banks, forming a
syndicate, buy the entire issue of bonds from the issuer and re-sell them to investors.
20. What is the scope of Financial Management?(May/June 2013)
1. Procurement of Short term and long term funds from financial institutions.
2. Mobilization of funds through financial instruments such as equity shares, preference
shares, debentures shares, bonds, notes and so fourth.
3. Compliance with legal and regulatory provisions relating to funds procurement, use
and distribution as well as coordination of the finance function with accounting function.
21. Current normal P/E = 15/1, Current earnings per share Rs.1.20, Find out the current
intrinsic value? (May/June 2013) Answer : 1.2*15 = 18.
22. What is sweat equity?
Sweat equity refers to those shares, which are issued at discount to employees or workers who
contribute for the development of a company by providing necessary know-how using their
intellectual property.
23. What is meant by risk return tradeoff?
The relationship between risk and return, indicating that additional risk should be rewarded with
additional expected returns.
24. What is finance?
Finance refers to the management of flow of money through an organization. It concerns with the
application of skills in the manipulation, use and control of money.
25. What is portfolio return?
The return of a portfolio is equal to the weighted average of the returns of individual assets (or
securities) in the portfolio with weights being equal to the proportion of investment value in each
asset.

PART- B (5*16 = 80 MARKS)

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1. List and discuss the various functions of finance manager in an organization.

(May / June 2007), (may/June 2010), (MAY/JUNE 2012)
Functions of financial management can be broadly divided into two groups.
1. Executive functions of financial management, and
2. Routine functions of financial management.
This division of functions of financial management is depicted below.

Executive Functions of Financial Management:

The executive functions of financial management are depicted & listed below.

Eight executive functions of financial management (FM) are:-

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1. Estimating capital requirements : The company must estimate its capital requirements
(needs) very carefully. This must be done at the promotion stage. The company must
estimate its fixed capital needs and working capital need. If not, the company will
become over-capitalized or under-capitalized.
2. Determining capital structure : Capital structure is the ratio between owned capital and
borrowed capital. There must be a balance between owned capital and borrowed capital.
If the company has too much owned capital, then the shareholders will get fewer
dividends. Whereas, if the company has too much of borrowed capital, it has to pay a lot
of interest. It also has to repay the borrowed capital after some time. So the finance
managers must prepare a balanced capital structure.
3. Estimating cash flow : Cash flow refers to the cash which comes in and the cash which
goes out of the business. The cash comes in mostly from sales. The cash goes out for
business expenses. So, the finance manager must estimate the future sales of the business.
This is called Sales forecasting. He also has to estimate the future business expenses.
4. Investment Decisions : The business gets cash, mainly from sales. It also gets cash from
other sources. It gets long-term cash from equity shares, debentures, term loans from
financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer
deposits, etc. The finance manager must invest the cash properly. Long-term cash must be
used for purchasing fixed assets. Short-term cash must be used as a working capital.
5. Allocation of surplus : Surplus means profits earned by the company. When the
company has a surplus, it has three options, viz.,
1. It can pay dividend to shareholders.
2. It can save the surplus. That is, it can have retained earnings.
3. It can give bonus to the employees.
6. Deciding Additional finance : Sometimes, a company needs additional finance for
modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.
1. When the additional finance will be needed?
2. For how long will this finance be needed?
3. From which sources to collect this finance?
4. How to repay this finance?
Additional finance can be collected from shares, debentures, loans from financial
institutions, fixed deposits from public, etc.
7. Negotiating for additional finance : The finance manager has to negotiate for additional
finance. That is, he has to speak to many bank managers. He has to persuade and
convince them to give loans to his company. There are two types of loans, viz., short-term

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loans and long-term loans. It is easy to get short-term loans from banks. However, it is
very difficult to get long-term loans.
8. Checking the financial performance : The finance manager has to check the financial
performance of the company. This is a very important finance function. It must be done
regularly. This will improve the financial performance of the company. Investors will
invest their money in the company only if the financial performance is good. The finance
manager must compare the financial performance of the company with the established
standards. He must find ways for improving the financial performance of the company.
Routine Functions of Financial Management:
The routine functions are also called as incidental functions.
Routine functions are clerical functions. They help to perform the Executive functions of
financial management.
The routine functions of financial management are briefly listed below.

Six routine functions of financial management (FM) are:-

1. Supervision of cash receipts and payments.
2. Safeguarding of cash balances.
3. Safeguarding of securities, insurance policies and other valuable papers.
4. Taking proper care of mechanical details of financing.
5. Record keeping and reporting.
6. Credit Management.
2. A patent has been purchased for Rs.17,50,000 has a remaining life of 13 years ad
Rs.2,50,000 salvage value. It is estimated that the patent will generate operating revenues
Rs.3,50.000 per year through out its life. Operating cost will be Rs.80,000 per year from
year 2 to 13. Using an interest rate of 12% p.a. find the present values of this investment.
(May/June 2007)
Solution:
CIF = Revenue – cost

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3,50,000 – 80,000 = 2,70,000 (PVF for 13 years)

= 2, 70,000
Present Value of CIF = 2, 70,000 * PVF (2-13 years)
Present Value of Salvage value = 2,50,000 * PVF @12%
Net present value = Present value of CIF + Present Value of Salvage Value
= 17,50,000
3. What are the objectives of Financial Management? (Nov/Dec2007)
(May / June 2007), (Nov/Dec 2013)
Objectives of Financial Management
Profit maximization : The main objective of financial management is profit maximization. The
finance manager tries to earn maximum profits for the company in the short-term and the long-
term. He cannot guarantee profits in the long term because of business uncertainties. However, a
company can earn maximum profits even in the long-term, if:-
The Finance manager takes proper financial decisions. He uses the finance of the company
properly.
Wealth maximization : Wealth maximization (shareholders' value maximization) is also a main
objective of financial management. Wealth maximization means to earn maximum wealth for the
shareholders. So, the finance manager tries to give a maximum dividend to the shareholders. He
also tries to increase the market value of the shares. The market value of the shares is directly
related to the performance of the company. Better the performance, higher is the market value of
shares and vice-versa. So, the finance manager must try to maximize shareholder's value.
Proper estimation of total financial requirements : Proper estimation of total financial
requirements is a very important objective of financial management. The finance manager must
estimate the total financial requirements of the company. He must find out how much finance is
required to start and run the company. He must find out the fixed capital and working capital
requirements of the company. His estimation must be correct. If not, there will be shortage or
surplus of finance. Estimating the financial requirements is a very difficult job. The finance
manager must consider many factors, such as the type of technology used by company, number
of employees employed, scale of operations, legal requirements, etc.
Proper mobilization : Mobilization (collection) of finance is an important objective of financial
management. After estimating the financial requirements, the finance manager must decide about
the sources of finance. He can collect finance from many sources such as shares, debentures,
bank loans, etc. There must be a proper balance between owned finance and borrowed finance.
The company must borrow money at a low rate of interest.
Proper utilization of finance : Proper utilization of finance is an important objective of
financial management. The finance manager must make optimum utilization of finance. He must
use the finance profitable. He must not waste the finance of the company. He must not invest the

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company's finance in unprofitable projects. He must not block the company's finance in
inventories. He must have a short credit period.
Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of
financial management. The company must have a proper cash flow to pay the day-to-day
expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity bills,
etc. If the company has a good cash flow, it can take advantage of many opportunities such as
getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. A
healthy cash flow improves the chances of survival and success of the company.
Survival of company : Survival is the most important objective of financial management. The
company must survive in this competitive business world. The finance manager must be very
careful while making financial decisions. One wrong decision can make the company sick, and it
will close down.
Creating reserves : One of the objectives of financial management is to create reserves. The
company must not distribute the full profit as a dividend to the shareholders. It must keep a part
of it profit as reserves. Reserves can be used for future growth and expansion. It can also be used
to face contingencies in the future.
Proper coordination : Financial management must try to have proper coordination between the
finance department and other departments of the company.
Create goodwill : Financial management must try to create goodwill for the company. It must
improve the image and reputation of the company. Goodwill helps the company to survive in the
short-term and succeed in the long-term. It also helps the company during bad times.
Increase efficiency : Financial management also tries to increase the efficiency of all the
departments of the company. Proper distribution of finance to all the departments will increase
the efficiency of the entire company.
Financial discipline : Financial management also tries to create a financial discipline. Financial
discipline means:-
To invest finance only in productive areas. This will bring high returns (profits) to the company.
To avoid wastage and misuse of finance.
Reduce cost of capital : Financial management tries to reduce the cost of capital. That is, it tries
to borrow money at a low rate of interest. The finance manager must plan the capital structure in
such a way that the cost of capital it minimized.
Reduce operating risks : Financial management also tries to reduce the operating risks. There
are many risks and uncertainties in a business. The finance manager must take steps to reduce
these risks. He must avoid high-risk projects. He must also take proper insurance.
Prepare capital structure : Financial management also prepares the capital structure. It decides
the ratio between owned finance and borrowed finance. It brings a proper balance between the

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different sources of. capital. This balance is necessary for liquidity, economy, flexibility and
stability.
4. The required rate of return on a portfolio with beta of 1.2 is 18% and the risk-free is 6%.
According to CAPM:
1. What is the expected rate of return on the market portfolio?
2. A stock, say delta, with beta of 1.5, sells for Rs.50, one year from now it is expected to
yield a dividend income of Rs.6. What price do investors expect after one year?
(May/June 2007)
Solution
1) Expected return = Rf +β(Rm-Rf )
18% = 6% + 1.2 (Rm – 6%)
Rm = 16%
2) Expected return after one year:
= 6% + (16%-6%)
=6% + 15% = 21%
5. What are the main features of Financial Management? Explain. (Nov/Dec 2007)
 According to Solomon, “Financial management is concerned with the efficient use of an
important economic resource, namely, capital funds.”
 According to J. L. Massie, “Financial management is the operational activity of a
business that is responsible for obtaining and effectively utilizing the funds necessary for
efficient operation.”
 According to Weston & Brigham, “Financial management is an area of financial
decision making harmonizing individual motives & enterprise goals.”
 According to Howard & Upton, “Financial management is the application of the
planning & control functions of the finance function.”
 According to J. F. Bradley, “Financial management is the area of business management
devoted to the judicious use of capital & careful selection of sources of capital in order to
enable a spending unit to move in the direction of reaching its goals.”
Main features of financial management:
On the basis of the above definitions, the following are the main characteristics of the financial
management-
 Analytical Thinking-Under financial management financial problems are analyzed and
considered. Study of trend of actual figures is made and ratio analysis is done.
 Continuous Process-previously financial management was required rarely but now the
financial manager remains busy throughout the year.
 Basis of Managerial Decisions- All managerial decisions relating to finance are taken
after considering the report prepared by the finance manager. The financial management
is the base of managerial decisions.

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 Maintaining Balance between Risk and Profitability-Larger the risk in the business
larger is the expectation of profits. Financial management maintains balance between the
risk and profitability.
 Coordination between Process- There is always a coordination between various
processed of the business.
 Centralized Nature- Financial management is of a centralized nature. Other activities
can be decentralized but there is only one department for financial management.
6.On 31st December 1980, the balance sheet of a limited company disclosed the following
position: (Nov/Dec 2007)
Balance Sheet as on 31.12.1980
Equity Share Capital
(40,000 equity shares of
Rs.10 each fully paid) 4,00,000 Goodwill 40,000
Fixed Assets 5,00,000
General reserve 90,000 Current assets 2,00,000
P/L account 20,000
5% Debentures 1,00,000
Current Liabilities 1,30,000
________ _________
7,40,000 7,40,000
________ _________
st
On 31 December 1970, the fixed assets were independently valued at Rs.5,50,000 and the good
will at Rs. 50,000. The net profits for the last three years were as under
1968 Rs.51,600
1969 Rs.52,000
1970 Rs.51,650
Of which 20% was placed to reserve, this proportion being considered reasonable in the industry
in which this company is engaged and where a fair return is estimated at the rate of 10%.
Calculate the value of the company’s share by a
a) The assets method and
b) The yield method
Solution:
Assets Method:
Goodwill as revalued Rs.50,000
Tangible assets Rs. 5,50,000
Current Assets as per Balance sheet Rs. 2,00,000
__________
8,00,000
Less: 5% Debentures Rs. 1,00,000
Current Liabilities Rs. 1,30,000
___________ 2,30,000

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_________
5,70,000
_________
Value per share 5,70,000 /40,000 = Rs. 14.25
Yield Method:
Total Profit = 51,600+52,000+51,650 = 1,55,250
Average profit = 1,55,250/3 = 51,750
Less: Transfer to General reserve @ 20% 10,350
___________
41,400
Expected rate of return on Equity capital
= 41,400 /4,00,000 * 100
= 10.35%
Value per share = Expected Rate of return /Normal rate
* paid up value per share
Value per share = 10.35 /10 *10 = Rs. 10.35
7. Attempt a short on the responsibility of financial management. (Nov/Dec 2007)
The responsibilities of financial management or financial manager vary widely from one
business unit to another, depending upon the size and the nature of the business.
In the light of this wide diversity of organizational practices, it is not surprising to find that in
most of the company, financial officer is responsible for the routine finance functions. The main
responsibilities of the financial officer are as follows:
1. Financial Planning
The main responsibility of the chief financial officer in a large concern is to forecast the needs
and sources of finance and ensure the adequate supply cash at proper time for the smooth
running of the business. He is to see that cash inflow and outflow must be uninterrupted and
continuous. For this purpose, financial planning is necessary, i.e., he must decide the time when
he needs money, the sources of supply of money and the investments patters so that the company
may meet its obligations properly and maintain its goodwill in the market. The financial manager
is also to see that there is no surplus money in the business which earns nothing.
2. Raising of Necessary Funds
The second main responsibility of the financial officer is to see the nature of the need, i.e.,
whether finances are required for long-term or for short-term. He must assess the alternative
sources of supply of finance taking into view the cost of raising funds, its effect on various
concerned parties, i.e. shareholders, creditors, employees and the society, control and risk in
financing and elasticity in capital structure etc.
3. Controlling the Use of Funds
The financial manager is also responsible for the proper utilization of funds. Assets must be
used effectively so as to earn higher profits; inflow and outflow of cash must be controlled in a

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manner so as to meet the current as well as future obligations; unnecessary expenditure should be
curtailed and there should be left no possibility for misappropriation of money.
4. Disposition of profits
Appropriation of profits is one of the main responsibilities of the financial manager. He is to
advise to the top executives as how much of the profits should be retained in the business as
reserves for future expansion; how much to be used in repaying the debts; and how much to be
distributed to the shareholders as dividend. On the basis of the advice given by the financial
manage, the resolutions regarding deprecations, reserves, general reserves and distribution of
dividends are carried out in the meeting of board of directors of the company.
5. Other Responsibilities
Over and above, the responsibilities sated above, there are certain other responsibilities of the
financial manager. These are:
a) Responsibility to owners
Shareholders or stock-holders are the real owners of the concern. Financial manager has the
prime responsibility to those who have committed funds to the enterprise. He should not only
maintain the financial health of the enterprise, but should also help to produce a rate of earning
that will reward the owners adequately for the risk capital they provide.
b) Legal obligations
Financial manager is also under an obligation to consider the enterprise in the light of its
legal obligations. A host of laws, taxes and rules and regulations cover neatly every move and
policy. Good financial management help to develop a sound legal framework
c) Responsibilities of Employees
The financial management must try to produce a healthy going concern capable of
maintaining regular employment at satisfactory rate of pay under favorable working conditions.
The long term financial interests of management, employee’s, owners are common.
d) Responsibilities to customers
In order to make the payments of its customers’ bill, the effective financial management is
necessary. Sound financial management ensures the creditors continued supply of raw material
e) Wealth Maximization
Prof. Soloman of Standford University has argued that the main goal of the finance function
is wealth maximization. The other goals may be achieved automatically
In the light of the above discussion, we can conclude that the main responsibility of the
financial manager is not only to maintain the financial health of the organization but also to
increase the economic welfare of the shareholders by utilizing the funds in an effective manner.
8. Explain the scope of financial management in any organization of your choice.(Nov/Dec
2008),
Scope of Financial Management:
Financial management has a wide scope. According to Dr. S. C. Saxena, the scope of financial
management includes the following five 'A's.

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Anticipation : Financial management estimates the financial needs of the company. That is, it finds
out how much finance is required by the company.
Acquisition : It collects finance for the company from different sources.
Allocation : It uses this collected finance to purchase fixed and current assets for the company.
Appropriation : It divides the company's profits among the shareholders, debenture holders, etc. It
keeps a part of the profits as reserves.
Assessment : It also controls all the financial activities of the company. Financial management is the
most important functional area of management. All other functional areas such as production
management, marketing management, personnel management, etc. depends on Financial
management. Efficient financial management is required for survival, growth and success of the
company or firm.
9. A share is quoted is Rs.60. An investor expects the company to pay a dividend of Rs.3 per share,
one year from now. The expected price one year from now is Rs.78.50
Share price at present = Rs.60
Expected Dividend = Rs.3 per share
Expected share price one year from now = Rs.78.50
i. What is the expected dividend yield, the rate of price change and holding period yield?
PO = D1 / 1+ke+P1 / 1+ke
60 = 3 / 1+ke + 78.50 / 1+ke
60 = 81.50 / 1+ke
60 + 60 ke = 81.50
Ke = 35.83%
ii. If the beta of the share is 1.5,the risk free rate is 6 percent and the market risk premium is 10
percent, what is the required rate of return?
Risk Free Rate = Rf = 6%
Market Risk Premium = Rm = 10%
Beta of the share =?= 105
Required Rate of return =Ri= Rf + (Rm – Rf)?
= 6+(10-6) 1.5
= 6+6 = 12%
iii. What is the intrinsic value of the share? (Nov /Dec 2008)
In any fundamental analysis, the objective of the analyst would be to find out the securities which
are undervalued or low priced in the market in comparison with the intrinsic value. Graham & Dodd
have defined the intrinsic value “as that value which is justified by the facts of assets, earnings,
dividends”. These facts are reflected in the earning potential of the company. The analyst has to
project the future earnings potential of the company. The analyst has to project the future earnings
per share and value them for the present time by summing up the discounted future dividend or

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earnings. This means that all future earnings are discounted to the present value, which gives its
intrinsic value at present.
10. (i) What is security market line’? How does it differ from capital market line? (May/June
2009)
Security Market Line (SML) : A line that graphs the systematic, or market, risk versus return of the
whole market at a certain time and shows all risky marketable securities. It is also referred to as the
“characteristic line”. The SML essentially graphs the results from the capital asset pricing model
(CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return.
The market risk premium is determined from the slope of the SML. The security market line is a
useful tool in determining whether an asset being considered for a port folio offers a reasonable
expected return for risk. Individual securities are plotted on the SML graph. If the security’s risk
versus expected return is plotted above the SML, it is undervalued because the investor can expect a
greater return for the inherent risk. A security plotted below the SML is overvalued because the
investor would be accepting less return for the amount of risk assumed.
Capital Market Line – CML : A line used in the capital asset pricing model to illustrate the rates of
return for efficient portfolios depending on the risk-free rate of return and the level of risk (standard
deviation) for a particular portfolio. The CML is derived by drawing a tangent line from the
intercept point on the efficient frontier to the point where the expected return equals the risk-free
rate of return. The CML is considered to be superior to the efficient frontier since it takes into
account the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM)
demonstrates that the market portfolio is essentially the efficient frontier. This is achieved visually
through the security market line (SML).
10. (ii) Explain in detail the importance of correlation between assets returns in a Portfolio.
(May/June 2009)
ASSET RETURNS IN PORTFOLIO : There are two components of Risk – systematic (non –
diversifiable) and unsystematic (diversifiable). For diversifiable risk, the investor makes a proper
diversification to reduce the risk for the non-diversifiable portion, he uses the relevant Beta measure
to adjust to his requirement or preferences. Due to the possibility of risk free asset and lending and
borrowing at the free rate, the investor has two components of the port folio – risk free assets and the
risky market asset. His total return is summation from the above two components.
Under CAPM, the equilibrium situation arises when all frictions, like taxes, divisibility transaction
costs and different risk-free borrowing and lending rates are assumed away. Equilibrium will be
brought about by changes in prices due to changes in demand and supply.
11. Using the following details, calculate, i) expected rate of returns of portfolio in each using
capital asset pricing model, ii) average return of portfolio. (May/June 2009)
Market Price at Beta factor
Investment in Initial Price Dividends
the end of the year

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Rs. Rs. Rs.

A) Equity share of
250 20 500 0.8
L&T Ltd.
H&T Ltd 350 20 600 0.7
P&G Ltd. 450 20 1350 0.5
B) 14% GOI Bonds risk
1000 1005 0.99
free rate of return 14%
Solution:
i) Calculation of Expected Rate or returns of Portfolio using Capital Asset Pricing Mode :
= (Dividend Earned + Capital Appreciation) / Initial Investment *100
= (20+20+20+140) + (3455 – 2050) / (250+350+450+1000) *100
= (200 + 1405) / 2050 *100
= 78.29 %
By using CAPM Formula :
Ke = Rf + b (Rm – Rf)
Rf = Risk Free Rate of Return = 14%
Rm = Market Return = 78.29%
b = Beta Factor
L&T = 14% + 0.8 (78.29% - 14%) = 65.43%
H&L = 14% + 0.7 (78.29% - 14%) = 59.00%
P&G = 14% + 0.5 (78.29% - 14%) = 46.145%
14% GOI = 14% + 0.99 (78.29% - 14%) = 77.65%
ii).Average Return of Portfolio = ( 65.43 + 59 + 46.145 + 77.65) / 4 = 62.06%.
12. “The goal of profit maximization does not provide an operationally useful criterion” –
Explain. (Nov/Dec 2009)
Profit maximization refers to the maximization of income or earnings of a firm. The arguments
in favour of profit maximization as the objectives of financial management are
1. Nature Goal : Profit is the aim of any business. Naturally, the goal of financial
management should be profit maximization.
2. Measure of Efficiency : Profit is a measure of efficiency. Higher profits imply greater
efficiently. Hence, the objective of profit maximization is quite rational.
3. Internal Generation of Funds Profit lead to internal generation of funds. It helps to
finance the growth of the business.
4. Protection against Risks : Profits provide protection against risks when a company is
faced with unfavourable conditions, (such as fall in prices, increase n costs and severe
competition). Accumulated profits serve as a cushion to absorb the shocks.
5. Fulfillment of Social Obligations: Profits are essential for fulfilling social obligations of
the business. The goal or profit maximization helps to maximize social welfare.

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1. Vague : The term profit is vague. It has different meanings. For instance, profit may refer
to long-term profits or short-term profits. It may refer to profit before tax or profit after tax or
short-term profits. It may refer to profit before tax or profit after tax or even operating profits.
2. Neglects Time Value of Money : The objective of profit maximization neglects time
value of money. Profits of today are more valuable than profits to be earned after five years. But
profit maximization objective treats all profits as equal, irrespective of the timing.
3. Ignores Risk Factor. Some projects are more risky than the others though the expected
earnings may be equal. But, the risk factor is not considered by the profit maximization goal.
4. Taint of Immorality: Profit maximization implies exploitation of consumers, workers
and the society. Hence, it is regarded as immoral.
5. Invalid: Profit maximization may be a valid objective under conditions of perfect
competition. As the markets are not perfect, it cannot be a valid objective.
6. Inadequate: In company form of a organization, there is separation of ownership and
control. Share holders are the owners. But, control is in the hands of professional managers.
Creditors, financial institutions, workers, consumers and the society are concerned with the
company’s operations. The management has to reconcile the conflicting interests of these stake
holders. Profit maximization goal is inadequate for the purpose.
The variants of profit maximization goal are :
To overcome the problem of vagueness, the term profit may be defined specifically as profit
after taxes. But this objective is also not sound as it will not maximize the economic welfare of
the share holders.
For example, A Ltd has 10,000 equity and earns a profit of Rs.50,000. The earnings per share
(EPS) are Rs.5. The company issues 5000 additional shares and invests the proceeds in the
business. If profit after tax increases to Rs.60,000 the EPS will decline to Rs.4 (Rs.60,000
divided by 15,000). It is clear that maximizing profit after tax is not necessarily advantageous to
the share holders.
ii) Maximizing the EPS
The objective of maximization of earnings per share also suffers from draw backs. It ignores
time value of money and the risk element. Because of the drawbacks profit maximization, as an
objective of financial management has been rejected.
13. i). Generally individuals show a time preference for money. Give reasons for such a
preference. (May/June 2009)
The concept of time value of money is simple. According to this concept, the same amount of
cast, receivable during different time periods has different values. The value of money received
today is greater than the value of the same amount receivable after 5 to 10 years. The sooner the
money is received the better it is. If Mr. Rajesh is given the option of receiving Rs.10,000 today
or after one year he will definitely prefer to receive the amount, today itself. This is called time
preference for money. However, he may be ready to receive the money after one year. If he is

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suitable rewarded for his waiting. The reward is called interest. Mrs. Rajesh may agree to
receive Rs.10,000 after 1 year if he is paid an interest of Rs.1200. So, time preference for
money is expressed as interest rate. Hence, time value of money is to be recognized in making
financial decisions. This is done by making appropriate adjustments through discounting or
compounding of cash flows. Reasons for Time Preference for Money People prefer to receive
money, earlier than later. The reasons are :
1. Uncertainty: Future is uncertain. There is a chance of not getting the money at all.
Hence, people like to receive the money today itself rather than waiting for the future.
2. Preference for Consumption: The money may be needed to meet urgent current needs.
Therefore, people prefer to receive money as early as possible.
3. Investment Opportunities: Money has time value. If Mr.Chandran received Rs.50,000
today, he can invest the amount and earn interest. Suppose he gets an interest of 10% he will
have Rs.55,000 at the end of 1 year. Therefore, it is good fro him to receive Rs.50,000 now as it
will grow into Rs.55,000 after one year.
13. ii) Write short notes on valuation of Bonds. (May/June 2009)
Bonds are issued by the government, public sector and private sector companies to raise long
term funds. The salient features of bonds are :
Bonds are long term debt instruments. They are generally redeemable, after say 7years or 10
years. Bonds may be issued at par, at a premium or at s discount. Usually they are issued at a
face value (par value) of Rs.100 or Rs.1000.
Interest rate is fixed and known to the investors. It is paid on the face value. Interest rate is also
known as coupon rate. The expected cash inflows to a bondholder consist of annual interest
payments and repayment of principal. Payment of interest at the specified rate and repayment of
principal on the due dates is promised. But bonds are not risk free as there are chances of default
in payment of interest and the principal.
14. ‘Financial management is the appendage of the finance function’-comment, (May/June
2010),
Explain the three major decisions in financial management. “Wealth maximization is the
sole objective of financial management” – discuss. (Nov/Dec 2011), (May/June 2008)
Meaning of Financial Management
Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working capital
decisions

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2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby
3. Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
Dividend for shareholders- Dividend and the rate of it has to be decided
Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with regards
to capital requirements of the company. This will depend upon expected costs and profits and
future programmes and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis. This
will depend upon the proportion of equity capital a company is possessing and additional funds
which have to be raised from outside parties
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This
can be done in two ways
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansion, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.

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7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc.
15.What is annuity? Explain with an example explain how can future value of an annuity
be determined? (Nov/Dec 2010)
"A Rupee today is better than a Rupee tomorrow"
The earlier the money is received, greater the potential for increasing the wealth. Due to
inflation, money may lose its purchasing power overtime.
Present Value Factor (PVF) = 1 / (1 + r)ⁿ
Present value (PV) = Cash flows * PVF
Illustration
What is the present value of Rs. 10,000 to be received after 5 years when the rate of interest is
10%?
Solution:
PVF = 1 / (1 + r)ⁿ = 1 / (1 + 0.10)5 = 0.621
PV = 10,000 * 0.621 = 6,210
Illustration
A Rs. 10,000 par value bond bearing a coupon rate of 12% will mature after 5 years. What is the
value of the bond, if the discount rate is 15%?
Solution:
Interest earned p.a. = 10,000 * 12/100 = Rs. 1,200
Principal = Rs. 10,000
PVAF = (1 – [ 1 / (1 + r)ⁿ ] ) / r
PVAF = {1 – [ 1 / (1 + 0.15)5 ] / 0.15 } = 3.352
PVF = 1 / (1 + r)ⁿ = 1 / (1 + 0.15)5 = 0.497
Value of bond = (3.352 * 1,200) + (0.497 * 10,000)
= 4,022 + 4970
= Rs. 8,992
16. MM ltd ’ s share price is at present Rs.120. after 6 months; its price will be either Rs.150
with probability of 0.8 or Rs.110 with remaining probability. An European call option exists with
an exercise price of Rs.130.as a call option writer, if you intend to create a perfectly hedged
position, what will you do? What will be the value of your hedged position in each of the
possibilities stated? (Nov/Dec 2010)
SOLUTION: To be discussed in class
17.(i). With reference to bond valuation explain with examples. (Nov/Dec 2010)
1) Basic bond valuation:

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Bond refers to borrowings of company from individuals and financial institutions. Bond is
written promise given by borrower (company) to lenders (individuals/FIs) while borrowing funds
for capital of the company.
Value of Bond = (PVAF * Interest earned p.a.) + (PVF * Principal)
2) Yield to maturity
It is the measure of a bond’s rate of return that considers both the interest income and any capital
gain or loss. YTM is the bond’s internal rate of return.
A perpetual bond’s YTM = ∑ INTt + Bn
(I + Kd)t (1 + Kd)
17.(ii) The bonds of ABC Ltd., currently sell at Rs.115.they have a 11% coupon rate and 100
per value .The interest is paid annually and the bonds have 18 years to maturity. Compute the
yield to maturity. (Nov/Dec 2010)
SOLUTION: To be discussed in class
18. Rajesh purchased a bond with a face value of Rs.1,000, a 10% coupon rate and 4 years to
maturity .The bond makes annual interest payments, the first to be received one year form today.
Rajesh paid Rs.1,032.40 for the bond. Calculate 1. What is the bond’s yield to maturity? 2. If the
bond can be called two years from now at a price of Rs. 1,100. What is its yield to call? (To be
discussed in the class) (May/June 2011)
19. What is the relationship between effective rate of interest and nominal rate of interest?
(May/June 2011)
The nominal interest rate is the periodic interest rate times the number of periods per year. For
example, a nominal annual interest rate of 12% based on monthly compounding means a 1%
interest rate per month (compounded). A nominal interest rate for compounding periods less than
a year is always lower than the equivalent rate with annual compounding (this immediately
follows from elementary algebraic manipulations of the formula for compound interest). Note
that a nominal rate without the compounding frequency is not fully defined: for any interest rate,
the effective interest rate cannot be specified without knowing the compounding
frequency and the rate. Although some conventions are used where the compounding frequency
is understood, consumers in particular may fail to understand the importance of knowing the
effective rate.
Nominal interest rates are not comparable unless their compounding periods are the
same; effective interest rates correct for this by "converting" nominal rates into annual compound
interest. In many cases, depending on local regulations, interest rates as quoted by lenders and in
advertisements are based on nominal, not effective interest rates, and hence may understate the
interest rate compared to the equivalent effective annual rate.
The term should not be confused with simple interest (as opposed to compound interest) which is
not compounded.

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The effective interest rate is always calculated as if compounded annually. The effective rate is
calculated in the following way, where r is the effective rate, i the nominal rate (as a decimal, e.g.
12% = 0.12), and n the number of compounding periods per year (for example, 12 for monthly
compounding):

Monthly compounding:
Example 1: A nominal interest rate of 6%/a compounded monthly is equivalent to an effective
interest rate of 6.17%.
Example 2: 6% annually is credited as 6%/12 = 0.5% every month. After one year, the initial
capital is increased by the factor (1+0.005)12 ≈ 1.0617.
Daily compounding:
A loan with daily compounding will have a substantially higher rate in effective annual terms.
For a loan with a 10% nominal annual rate and daily compounding, the effective annual rate is
10.516%. For a loan of $10,000 (paid at the end of the year in a single lump sum), the borrower
would pay $51.56 more than one who was charged 10% interest, compounded annually.
19. What is a put option? Explain how the intrinsic and the time value of a put option are
estimated? What is meant by time value of a call option? Describe the factors influencing
the time value of an option. (May/June 2011)
Options
 An option is a contract that gives the holder a right, without any obligation, to buy or
sell an asset at an agreed price on or before a specified period of time.
 The option to buy an asset is known as a call option.
 The option to sell an asset is called a put option.
 The price at which option can be exercised is called an exercise price or a strike
price.
 The asset on which the put or call option is created is referred to as the underlying
asset.
 The option premium is price that the holder of an option has to pay for obtaining a
call or a put option.
When an Option can be exercised
 European option When an option is allowed to be exercised only on the maturity date, it
is called a European option.
 American option When the option can be exercised any time before its maturity, it is
called an American option.
Possibilities at Expiration
 In-the-money A put or a call option is said to in-the-money when it is advantageous for
the investor to exercise it.

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 Out-of-the-money A put or a call option is out-of-the-money if it is not advantageous for

the investor to exercise it.
 At-the-money When the holder of a put or a call option does not lose or gain whether or
not he exercises his option.
Call Option
Buy a call option
a. You should exercise call option when:
Share price at expiration > Exercise price.
b. Do not exercise call option when:
Share price at expiration < Exercise price.
c. The value of the call option at expiration is:
Value of call option at expiration = Maximum
[Share price – Exercise price, 0].
d. The expression above indicates that the value of a call option at expiration is the
maximum of the share price minus the exercise price or zero.
The call buyer’s gain is call seller’s loss.
Put Option
Buy a put option
o Exercise the put option when:
 Exercise price > Share price at expiration.
o Do not exercise the put option when:
 Exercise price < Share price at expiration.
o The value or payoff of a put option at expiration will be:
Value of put option at expiration = Maximum [Exercise price – Share price at expiration, 0].
The put option buyer’s gain is the seller’s loss.
Options Trading in India
i. The Security Exchange Board of India (SEBI) has announced a list of 31 shares for the
stock-based option trading from July 2002. SEBI selected these shares for option trading
on the basis of the following criteria:
ii. Shares must be among the top 200 in terms of market capitalisation and trading volume.
iii. Shares must be traded in at least 90 per cent of the trading days.
iv. The non-promoter holding should be at least 30 per cent and the market capitalisation of
free-float shares should be Rs 750 crore.
v. The six-month average trading volume in the share in the underlying cash market should
be a minimum of Rs 5 crore.
vi. The ratio of daily volatility of the share vis-à-vis the daily volatility of the index should
not be more than four times at any time during the previous six months.

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vii. The minimum size of the contract is Rs 2 lakh. For the first six months, there would be
cash settlement in options contracts and afterwards, there would be physical settlement.
The option sellers will have to pay the margin, but the buyers will have to only pay the
premium in advance. The stock exchanges can set limits on exercise price.
Index Options
i. Index options are call or put options on the stock market indices. In India, there are
options on the Bombay Stock Exchange (BSE)—Sensex and the National Stock
Exchange (NSE)—Nifty.
ii. The Sensex options are European-type options and expire on the last Thursday of the
contract month. The put and call index option contracts with 1-month, 2-month and 3-
month maturity are available. The settlement is done in cash on a T + 1 basis and the
prices are based on expiration price as may be decided by the Exchange. Option contracts
will have a multiplier of 100.
iii. The multiplier for the NSE Nifty Options is 200 with a minimum price change of Rs 10
(200 ´ 0.05).
Factors Determining Option Value
1. Exercise price and the share (underlying asset) price
2. Volatility of returns on share
3. Time to expiration
4. Interest rates
Model for Option Valuation
 Simple binomial tree approach to option valuation.
 Black-Scholes option valuation model.
Simple Binomial Tree Approach
 Sell a call option on the share. We can create a portfolio of certain number of shares (let
us call it delta, D) and one call option by going long on shares and short on options that
there is no uncertainty of the value of portfolio at the end of one year.
 Formula for determining the option delta, represented by symbol D, can be written as
follows:
 Option Delta = Difference in option Values / Difference in Share Prices.
 The value of portfolio at the end of one year remains same irrespective of the increase or
decrease in the share price.
 The value of the call option will remain the same irrespective of any probabilities of
increase or decrease in the share price. This is so because the option is valued in terms of
the price of the underlying share, and the share price already includes the probabilities of
its rise or fall.
Black and Scholes Model for Option Valuation

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 The B–S model is based on the following assumptions:

 The rates of return on a share are log normally distributed.
 The value of the share (the underlying asset) and the risk-free rate are constant during the
life of the option.
 The market is efficient and there are no transaction costs and taxes.
 There is no dividend to be paid on the share during the life of the option.
 The B–S model is as follows:
o C0 = S0 N(d1)-Ee-rft N(d2)
 where
 C0 = the current value of call option
 S0 = the current market value of the share
 E = the exercise price
 e = 2.7183, the exponential constant
 rf = the risk-free rate of interest
 t = the time to expiration (in years)
 N(d1) = the cumulative normal probability density function
20. Best Ltd has a Rs 1000 per value bond, carrying coupon rate of 12% and maturing after 7
years. The market value of this bond is Rs. 750. What is the Yield to Maturity of this bond?
What will be the yield to Maturity of this bond? What will be the Yield to Maturity if the market
price is Rs. 1050? (Nov/Dec 2011)
Solution: To be discusses in class
21. “Financial management is nothing but managerial decision making on asset mix,
capital mix and profit allocation” – Explain. (May/June 2012)
a. Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital in
those long term assets so as to get maximum yield in future. Following are the two aspects of
investment decision
 Evaluation of new investment in terms of profitability
 Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. This
risk factor plays a very significant role in calculating the expected return of the prospective
investment. Therefore while considering investment proposal it is important to take into
consideration both expected return and the risk involved.
b. Financial Decision

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Financial decision is yet another important function which a financial manger must perform.
It is important to make wise decisions about when, where and how should a business acquire
funds. Funds can be acquired through many ways and channels. Broadly speaking a correct
ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known
as a firm’s capital structure. A firm tends to benefit most when the market value of a
company’s share maximizes this not only is a sign of growth for the firm but also maximizes
shareholders wealth. On the other hand the use of debt affects the risk and return of a
shareholder. It is more risky though it may increase the return on equity funds. A sound
financial structure is said to be one which aims at maximizing shareholders return with
minimum risk. In such a scenario the market value of the firm will maximize and hence an
optimum capital structure would be achieved. Other than equity and debt there are several
other tools which are used in deciding a firm capital structure.
c. Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key
function a financial manger performs in case of profitability is to decide whether to distribute
all the profits to the shareholder or retain all the profits or distribute part of the profits to the
shareholder and retain the other half in the business. It’s the financial manager’s
responsibility to decide a optimum dividend policy which maximizes the market value of the
firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay
regular dividends in case of profitability another way is to issue bonus shares to existing
shareholders.
d. Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s
profitability, liquidity and risk all are associated with the investment in current assets. In
order to maintain a tradeoff between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets. Current assets
should properly be valued and disposed of from time to time once they become non
profitable. Currents assets must be used in times of liquidity problems and times of
insolvency
22. (i).“ Risk analysis is an essential features of investment decision making process” –
Discuss. (May/June 2012)
Investment Decision Processes:
• Knowledge About Fundamentals of Investment: Expected Return and Realized
Return
• Risk Return Trade-off
The Investment Decision Process: Two-step process

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– Security analysis and valuation: Necessary to understand security

characteristics
– Portfolio management
• Selected securities viewed as a single unit
• Efficient financial markets
• Measurement of portfolio performance
22.(ii). What are the major risk factors and how will you control them? (May/June 2012),
 Risk is the chance of financial loss, or the variability of returns associated with a given
asset.
 Assets that are having higher chances of loss are viewed as more risky, than those with
lesser chances of loss
 Risk may be used interchangeably with the term uncertainty to refer to the variability of
returns associated with a given asset.
Example: Government bond is less risky because principal amount and return (interest) are
guaranteed. On the other hand, investment on a company’s stock is risky, because of the
highly variability (0 to above) of returns.
Unique and Market Risk – 2 types of risk
 A Unique risk is a risk that affects a very small number of assets. This is sometimes
referred to as "unsystematic risk“ or diversifiable risk.
 An example would be news that is specific to either one stock or a group of companies,
such as the loss of a patent or a major natural disaster affecting the company's operation.
 In fact, most unsystematic risk is removed by holding a portfolio of about twenty-five to
thirty securities.
An example such as a sudden strike by the employees of a company you have shares in or a
new governmental regulation affecting a particular group of companies.
Examples of factors which create Unique Risk :
i. Strike by workers
ii. Entry of a powerful competitor
iii. Severe setback to the R & D efforts of the company
iv. Loss of a big contract
v. Adverse verdict in a court case involving high stakes
vi. Dispute among the members of the promoter’s family
Market Risk
 Risk which is common to an entire class of assets or liabilities.
 The value of investments may decline over a given time period simply because of
economic changes or other events that impact large portions of the market .

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 Asset allocation and diversification can protect against market risk because different
portions of the market tend to under perform at different times also called systematic risk
 The four standard market risk factors are stock prices, interest rates, foreign exchange
rates, and commodity prices. The associated market risks are:
 Examples of factors which create Market Risk :
 Political Uncertainty
 War and other calamities
 Massive cut in government spending
 Change in interest rates
 Major changes in tax rates
 Industrial recession
23. What happens to the value of perpetuity when interest rates increase? What happens
when interest rate decrease?(May/June 2013)

 Perpetuity is an annuity in which the periodic payments begin on a fixed date and
continue indefinitely. It is sometimes referred to as a perpetual annuity. Fixed coupon
payments on permanently invested (irredeemable) sums of money are prime examples of
perpetuities. Scholarships paid perpetually from an endowment fit the definition of
perpetuity.
 The value of the perpetuity is finite because receipts that are anticipated far in the future
have extremely low present value (present value of the future cash flows). Unlike a
typical bond, because the principal is never repaid, there is no present value for the
principal. Assuming that payments begin at the end of the current period, the price of
perpetuity is simply the coupon amount over the appropriate discount rate or yield that is:


 Where PV = Present Value of the Perpetuity, A = the Amount of the periodic payment,
and r = yield, discount rate or interest rate.
24. Explain the concept of time value of money, discuss its techniques. (May/June 2008)
(May/June 2012)
TECHNIQUES OF TIME VALUE OF MONEY:
There are two techniques for adjusting time value of money. They are:
1. Compounding Techniques / Future Value Techniques
2. Discounting / Present Value Techniques
The value of money at a future date with a given interest rate is called future value. Similarly, the
worth of money today that is receivable or payable at a future date is called Present Value.

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Compounding Techniques/Future Value Technique In this concept, the interest earned on the
initial principal amount becomes a part of the principal at the end of the compounding period.
FOR EXAMPLE: Suppose you invest 1000 for three years in a saving account that pays 10 per
cent interest per year. If you let your interest income be reinvested, your investment will grow as
follows:
First year : Principal at the beginning 1,000
Interest for the year (1,000 × 0.10) 100
Principal at the end 1,100
Second year : Principal at the beginning 1,100
Interest for the year ( 1,100 × 0.10) 110
Principal at the end 1210
Third year : Principal at the beginning 1210
Interest for the year ( 1210 × 0.10) 121 Principal at the end 1331 This process of compounding
will continue for an indefinite time period. The process of investing money as well as reinvesting
interest earned there on is called Compounding. But the way it has gone about calculating the
future value will prove to be cumbersome if the future value over long maturity periods of 20
years to 30 years is to be calculated.
UNIT-II
PART A(`10*2=20 MARKS)
1. What is ‘pay-back period’ method? List the two important limitations of this approach.
(May / June 2007), (Nov/Dec 2013)
The term pay back refers to the period in which the project will generate the necessary cash to
recover the initial investment. It is a traditional and simple method of evaluating the project.
Original investment
Pay back period = _________________
Average Annual cash inflows
Limitations of PB
1. It does not recognize the time value of money
2. It does not consider the profitability of economic life of the project.
3. It is based on the principle of ‘rule of thumb’
2. List the phases of capital budgeting process. (May / June 2007)
Capital budgeting process has the following steps:
-Project generation, -Project evaluation, -Project selection, -Project execution
3. Why is Capital budgeting so important to Management? (Nov / Dec 2007), (Nov/Dec
2008)
 Capital budgeting is so important because of the following:
 Involve massive investment of resources
 Are not easily reversible
 Have long-term implications for the firm

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 Involve uncertainty and risk for the firm

4. What are the merits of pay-back period method?(Nov / Dec 2007)
 The amount of time needed to recover the initial investment
 The number of years it takes including a fraction of the year to recover initial
investment is called payback period
 To compute payback period, keep adding the cash flows till the sum equals initial
investment
 Simplicity is the main benefit, but suffers from drawbacks
5. What are the components of Capital Budgeting?(May /June 2008)
i. Cash outflows ii. Cash inflows iii. Cost of capital
6. What is capital rationing? (May/June 2010), (Nov/Dec 2011), (May/June 2011),
(May/June 2012), (Nov/Dec 2013)
Capital rationing is a situation where a constraint or budget is placed on the total size of capital
expenditures during a particular period. Often firms draw up their capital budget under the
assumption that the availability of financial resources is limited.
Capital rationing refers to a situation where a company cannot take all acceptable projects it has
identified because of shortage of capital. Under this situation a decision maker is compelled to
reject some of the viable projects because of shortage of funds
Kr = (Ea(1-TR/2))/P
Were Kr = Cost of retained earnings
Ea = Anticipated earnings
P = Current market price
TR= Tax rate
9. What is internal rate of return? (Nov/Dec 2008)
It is one the important discounted cash flow technique of evaluation of capital budgeting proposals
is known as IRR technique. The IRR of a proposal is defined as the discount rate, which produces a
zero NPV i.e., the IRR is the discount rate which will quite the present value of cash inflows with
the present value of cash outflow.
10. Brief with a simple illustration, the profitability index method of capital budgeting.
(May/June 2009)
Profitability Index = Total Present Value of Cash inflows
x 100
Total Present Value of Cash outflows
The higher the profitability index, the more desirable is the investment.
11. Suppose the dividend per share of firm is expected to be Re.1 per share next year and is expected
to grow at 6% per year perpetually. Determine the cost of equity capital, assuming the market price
per share is Rs.25. (May/June 2009)
D1

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Cost of Equity Capital = ke = +g

P0
= 1
+ 6% = 10%
25

12. What is ‘NPV’? (Nov/Dec 2009)

NPV is Net Present Value. The NPV may be described as the summation of the present values of
operating cash inflows minus the summation of present values of the cash outflows. The present
value is computed using cost of capital as a discount rate. The project will be accepted in case the
NPV is positive.
13.What is risk free rate? (Nov/Dec 2009)
Risk free rate is the rate at which the future cash inflows are discounted assuming there is no risk
from the project. This implies that it takes into account only the time factor in discounting.
14. What are the components of a capital expenditure management programme?
(May/June 2010)
-Identification of potential investment opportunities, -Assembling of investment proposals,
-Decision Making, -Preparation of capital budget and appropriations, -Implementation,
-Performance review
14. State and distinguish the two ways of defining benefit-cost ratio. (Nov/Dec 2010)
Cost–benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic
process for calculating and comparing benefits and costs of a project, decision or government
policy (hereafter, "project").
CBA has two purposes:
1. To determine if it is a sound investment/decision (justification/feasibility),
2. To provide a basis for comparing projects.
It involves comparing the total expected cost of each option against the total expected benefits,
to see whether the benefits outweigh the costs, and by how much.[1]
CBA is related to, but distinct from cost-effectiveness analysis. In CBA, benefits and costs are
expressed in money terms, and are adjusted for the time value of money, so that all flows of
benefits and flows of project costs over time (which tend to occur at different points in time) are
expressed on a common basis in terms of their "net present value." Closely related, but slightly
different, formal techniques include cost-effectiveness analysis, cost–utility analysis, economic
impact analysis, fiscal impact analysis and Social return on investment(SROI) analysis
15. How the cost of a specific source of finance is calculated? Brief with an example.
(Nov/Dec 2010)

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Cost of capital is the minimum rate of return that a company must earn on its investments in
order to satisfy the various categories of investors who have made investments in the form of
shares, debentures or bonds Assuming that a firm pays tax at 50%, after tax cost of capital of a
ten-year, 8% Rs.1,000 par bond sold at Rs. 950 less 4% underwriting commission will be
Cost of debt/bond = {[C + (P-M)/N] (1-TR)} / [(M+P)/2]
Where: C- Coupon amount; P – Par value; M – Realized value; N – period TR – Tax
rate
= {[80 + (1,000 – 912)/10] (1-0.5)} / [(912 + 1,000) / 2]
= 4.6%

16. What does the probability index signify?(May/June 2011)

It is a ratio of the present value of the net cash benefits to the present value of the net cash outlay.
The higher the PI, the greater the return. Any project with a PI higher than ONE is acceptable
since benefits exceed outlay. Projects with PI less than ONE are rejected.
17. Explain operating risk and financial risk? (Nov/Dec 2011)
1) Operating Risk: It refers to the risk of the inability of the firm to cover its operating costs.
This cost is assumed to be unchanged i.e. the firm’s acceptance of a given project does not
affect its ability to meet operating costs.
2) Financial Risk: It refers to the risk of the inability of the firm to cover the required financial
obligations (interests, lease payments or preference dividend) – is assumed to be unchanged.
18. List down the objectives of cost of capital. (May/June 2012)
 It provides a financial yardstick for making capital expenditure decisions
 The cost of capital of various sources helps in designing the capital structure
 It helps to evaluate the financial performance of a company.
 It serves a basis for several other financial decisions such as leasing, hire- purchase,
working capital, dividend policy and issue of rights shares.
19. What are the objectives of capital budgeting? (May/June 2012)
(1) To ensure the selection of the possible profitable capital projects.
(2) To ensure the effective control of capital expenditure in order to achieve by forecasting
the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period and to see that the
benefits and costs may be measured in terms of cash flow.
(4) Determining the required quantum takes place as per authorization and sanctions.
(5) To facilitate co-ordination of inter-departmental project funds among the competing
capital projects.
(6) To ensure maximization of profit by allocating the available investible.
20. What do you mean by weighted average cost of capital? (May/June 2012)

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WACC is the weighted average of the costs of different sources of finance. It is also known as
composite cost of capital or overall cost of capital.
21. How do you arrive at IRR? (May/June 2008)
The IRR is the discount rate at which the NPV for a project equals zero. This rate means that the
present value of the cash inflows for the project would equal the present value of its outflows.
 The IRR is the break-even discount rate
 The IRR is found by trial and error.
n
∑ C1/ (I+r)t – I0 =0
t=1
where r = IRR
IRR of an annuity:
Q(n,r) = r0 /C
Where : (n, r) is the discount factor
I0 is the initial outlay
C is the uniform annual receipt (C1 = C2 =….Cn)
22. How do you arrive at cash flows? (May/June 2008)
Cash flows generally referred as the operating income generated by the company during a
particular period. Even in accounting principles it is considered as the income and cash flow will
be considered as cost. The difference between the two is referred as the profit. The profit so
arrived or estimated will reflect real financial strength of the organization which would be
considered as base for making capital expenditure decision.
23. In two projects selection, Project 1 is better as per IRR method: Project 2 is better as
per NPV method. How do you choose the best Project? And how do you avoid the conflict?
(May/June 2008)
NPV and IRR methods are closely related because:
i) Both are time-adjusted measures of profitability, and
ii) Their mathematical formulas are almost identical
So, which method leads to an optimal decision: IRR or NPV ?
a) NPV vs. IRR: Independent projects
Independent project: Selecting one project does not preclude the choosing of the other.
With conventional cash flows(-!+!+) no conflict in decision arises; in this case both NPV
and IRR lead to the same accept / reject decisions.
If cash flows are discounted at k1, NPV is positive and IRR >k1 : accept project
If cash flows are discounted at k2, NPV is negative and IRR <k2 : reject the project
Mathematical proof: for a project to be acceptable, the NPV must be positive, i.e.
nn
∑ Ct/(I+k)t – I0 >0 ∑ Ct/(I+k)t – I0 >0
t=1 t=1
similarly for the same project to be acceptable:
n

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∑ Ct/(I+R)t = I0
t=1
where R is the IRR
since the numerators Ct are identical and positive in both instances:
 Implicitly / intuitively R must be greater than k (R>k);
 If NPV = then R=k; the company is indifferent to such a project;
 Hence, IRR and NPV lead to the same decision in this case.
b) NPV vs IRR : Dependent projects.
NPV clashes with IRR where mutually exclusive projects exist. NPV and IRR may give
conflicting decisions where projects differ in their scale of investment
*Taking an example we can explain the conflicting solution.
24. What is capital budgeting? (Nov/Dec 2013), (Nov/Dec 2014)
Capital Budgeting is the process by which the firm decides which long-term investments
to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to
generate cash flows over several years. The decision to accept or reject a Capital Budgeting
project depends on an analysis of the cash flows generated by the project and its cost.
25. What is an investment?
Investment aims at multiplication of money at higher or lower rates depending upon whether it
is a long term or short-term investment, and whether it is risky or risk free investment.

PART- B (5*16 = 80 MARKS)

1. Discuss three DCF capital budgeting techniques . Distinguish them on two aspects.
(May/June 2007),
A valuation method used to estimate the attractiveness of an investment opportunity. Discounted
cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often
using the weighted average cost of capital) to arrive at a present value, which is used to evaluate
the potential for investment. If the value arrived at through DCF analysis is higher than the
current cost of the investment, the opportunity may be a good one.
Calculated as:
CF1 + CF2 + ……+CFn
DCF = ____ _____ _____
1 2
(1+r) (1+r) (1+r)n
CF = Cash Flow’
r = discount rate (WACC)
Discounted Cash Flow method
Discounted Cash Flow (DCF) is what someone is willing to pay today in order to receive the
anticipated cash flow in future years. DCF means converting future earnings to today’s money.
The future cash flows must be discounted in order to express their present value in order to
properly determine the value of a company or project under consideration as a whole.

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The DCF for an investment is calculated by estimating the cash you will have to pay out and the
cash you think you will receive back. The times that you expect to receive the payments must
also be estimated. Each cash transaction must then be discounted by the opportunity cost of
capital over the time between now and when you will pay or receive the cash.
The DCF method is an approach to valuation, whereby projected future cash flows are
“discounted” at an interest rate (also called:”rate of return”), that reflects the perceived riskiness
of the cash flows. The discount rate reflects two things:
1. The time value of money (investors would rather have cash immediately than having to
wait and must therefore be compensated by paying for the delay)
2. A risk premium that reflects the extra return investors demand because they want to be
compensated for the risk that the cash flow might not materialize after all
2. The shares of a chemical company are selling at Rs. 20 per share. The firm had paid dividend
at Rs.2 per share last year the estimated growth of the company is approximately 5% per year.
Determine the cost of equity capital of the company. Also determine the estimated market price
of equity shares if the anticipated growth rate of the firm (1) rises to 8% (2) falls to 3%.
(May/June 2007)
Solution:
Calculation of Cost of equity:
K = D0((1+g)/P0) +g
Calculate the value = 2(1.05)/20 + 0.05 = 15.5%
Anticipate market price, with 8% growth:
P0 = D0(1+g)/(k-g) = 2(1.08)/(0.155-0.08) = 28.8
3. What is Capital budgeting? Discuss in detail the need and importance of it. Capital
Budgeting. (May/June 2007)
 Capital budgeting addresses the issue of strategic long-term investment decisions.
 Capital budgeting can be defined as the process of analyzing, evaluating, and
deciding whether resources should be allocated to a project or not.
 Process of capital budgeting ensure optimal allocation of resources ad helps
management work towards the goal of shareholder wealth maximization.
Capital budgeting decisions
 Should we add a new product to our existing product line?
 Should we expand into a new market?
 Should we replace our existing machinery?
 Should we buy fully automatic or semiautomatic machinery?
 Where to locate manufacturing facility?
 Should we outsource components and parts?
Importance of capital budgeting:
 Involve massive investment of resources
 Are not easily reversible
 Have long-term implications for the firm

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 Involve uncertainty and risk for the firm

 Due to the above factors, capital budgeting decisions become critical and must be
evaluated very carefully
 Any firm that does not follow the capital budgeting process will not be
maximizing shareholder wealth and management will not be acting in the best
interests of shareholders
4. An asset has an initial investment of Rs. 6,00,000 with an anticipated life of 4 years. The
estimated net annual cash inflows will be Rs. 1,50,000 , Rs, 2,00,000, Rs. 3,00,000 and Rs,
2,00,000 during the year I, II, III and IV respectively. Calculate the internal rate of return.
(May/June 2007)
Solution:
Years CIF DF@10% Present Value DF @15% Present value
1 1,50,000 .909 1,36,350 .870 1,30,500
2 2,00,000 .826 1,65,200 ,756 1,51,200
3 3,00,000 .751 2,25,300 .658 1,97,400
4 2,00,000 .683 1,36,600 .572 1,14,400
6,63,450 5,93,500
Less: Initial investment 6,00,000 6,00,000
Net present value 63,450 (6,500)

IRR = MTR + NPV of the LTR * Diff in TR

__________________________
Diff between the HTR and LTR
= 10% + 63,450 * 8 5%
______
69950
IRR = 10% +4.53 = 14.52

5. From the following information, rank the projects according to their desirability under
(i) Pay back period, (ii) Accounting rate of returns and (iii) Net present Value Index method
assuming the cost of capital is 10%. (Nov/Dec 2007)
Projects Initial Annual CIF (Rs.) Life in years
Investment (Rs.)
A 60,000 12,000 15
B 88,000 22,500 22
C 2,150 1,500 3
D 20,500 4,500 10

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E 4,25,000 2,25,000 20
You may use the following table for calculation:
Period in Years 3 10 15 20 22
P.V of an annuity of
Re.1 pa payable 2.5918 6.3213 7.7688 8.6466 8.8919
for ‘n’ years at 10%
Solution:
Projects CIF DF@10% GPV Investment NPV
A 12,000 7.7688 92,225 60,000 32,225
B 22,500 8.8919 2,00,067 88,000 1,12,067
C 1,500 2.5918 3,888 2,150 1,738
D 4,500 6.3213 28,445 20,500 7,495
E 2,25,000 8.6466 19,45,485 4,25,000 15,20,485

Pay back Period Method

PB = Initial Investment / ACIF
A = 60,000 /12,000 = 5years-V
B = 88,000/22,500 = 3.9 years –III
C = 2150/1,500 = 1.43 years – I
D = 20,500/4,500 = 4.55 years –IV
E = 4,25,000/2,25,000 = 1.88 years – II
ARR = (Average Annual Income / Original Investment ) *100
A = 12,000/60,000 *100 = 20% V
B = 2,500/88,000*100 = 25.56% III
C = 1,500/2150*100 = 69.76% I
D = 4,500/20,500*100 = 21.95% IV
E = 2,25,500/4,25,00*100 = 52% II
PI = PV of cash inflows / PV of cash outlays
A = 92,225/60,000 = 1.53 –IV
B = 2,00,067/88,000 = 2.27 –II
C = 3,888/2150 = 1.80 –III
D = 28,445/20,500 = 1.38-V
E = 19,45,485/4,25,000 = 4.57
6. The following is the Capital structure of M/S Kurukshetra Earning Works Ltd., (Nov/Dec
2007)
Source of Finance Amount(Rs) Projections
Equity share Capital (45,000 shares
of Rs. 10 each fully paid) 4,50,000 45%
Retained Earnings 1,50,000 15%
Preference share capital 1,00,000 10%
Debentures 3,00,000 30%
_______________________

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10,00,000 100%
_______________________
The firm’s after tax component costs of the various sources of funds are as follows:
Equity capital 14%
Preferences share capital 10%
Retained earnings 14%
Debt 4.5%
Calculate the weighted cost of capital
i) By assigning the book-value as weight and
ii) Market values as weight. Assume the market price of equity shares is Rs. 20 per
share.

Solution:
Composite cost of capital under BOOK VALUE approach
Sources Amount (Rs.) Proportion (weights) CC WCC
Equity Capital 4,50,000 .45 .14 0.063
Retained Earnings 1,50,000 .15 .14 0.021
Preference Capital 1,00,000 .10 .10 0.010
Debt capital 3,00,000 .30 .045 0.013
Total 10,00,000 1.00 0.107 (or)
10.7%
Composite Cost of capital under MARKET VALUE approach
No of Equity shares = 4,50,000 +1,50,000 = 6,00,000 /10 =60,000
*Market Value = 60,000 *20 = 12,00,000
Sources Amount (Rs.) Proportion (weights) CC WCC

Equity Capital 12,00,000 .75 .14 0.105

Preference Capital 1,00,000 .06 .10 0.006

Debt capital 3,00,000 .19 .045 0.008

Total 16,00,000 1.00 0.119 (or)

11.9%

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7.Which Investment is a risky one from the following returns? (May/June 2008)
BHEL 12% 14% 16% 18% 20%
SBI 12% 15% 20% 16% 17%
RIL 15% 21% 23% 20% 16%
Solution:
Range = Highest return – Lowest return
BHEL 20%-12% =8%
SBI 20%-12% =8%
RIL 23%-15% =8%
Standard deviation (Risk)
BHEL = 3.16
SBI = 2.91
RIL = 3.39
Therefore RIL is Risky. Since, it has more volatile. (°=3.39)
8. Discuss the various capital budgeting techniques. (Nov / Dec 2008), (May/June 2010)
Discuss the various methods of evaluating capital expenditure proposals with merits and
demerits. (May/June 2011)
Traditional Techniques: These techniques are generally very simple and easily understandable.
But the main drawback of these techniques is that they don’t consider the time value of money.
But in many industries where an instant decision is to be taken, these methods offer the quicker
way out. There are mainly two techniques under this category of methods. They are –
Accounting rate of return and Payback period.
Accounting rate of return (ARR):
This method relies on the rate of return each project will earn over its life. It takes the help of
accounting profit while calculating the returns. There are 2 methods of calculating ARR
(i) On the basis of original investment,
ARR = average after tax annual net profit
Original investment
This method of calculation was rejected on the ground that the original outlay is gradually
recovered over the project life because of depreciation charge.
(ii) On the basis of average investment,
ARR = average annual net profit
Original investment / 2
When depreciation is to be taken on a straight line basis and no salvage value is assumed, the
average investment is always equal to one-half of the original investment, and the resulting
rate of return is always twice the rate determined on the basis of original investment.
Advantages of ARR:

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 It is easy to understand and simple to calculate

 With the help of this method, direct comparisons among proposed projected of
varying lives without a built-in-prejudice in favor of short-term ventures can be made.
Disadvantages of ARR:
 This method ignores time value of money.
 It fails to shed light on yearly rate if return of the project. It may be possible for the
project producing higher earnings in the early years to show a lower average rate of return
and be rejected in favor of other projects.
 Serious errors can occur in selection of projects if corporate managers accept projects
whose accounting rates are equal to or above some arbitrarily selected cut-off rate, and they
reject projects whose accounting rates fall short of the cut-off rate.
 Accounting information is not suitable for investment decision because if fails to
distinguish between cash flowing in and out of the company and book keeping transactions.
 There is no full agreement on the proper measure of the term investment. Thus, different
managers have different meanings when they refer to ARR.
Payback period (PBP):
This is the most popular method employed by industrial practitioners for ranking investment
projects. This is defined as the “period required for a proposal’s initial cash outlay to be
recovered by future additional cash savings generated from the proposal”. The cash flow (after
tax & depreciation) is used in calculating the payback period.
PBP = CO/CF
Where CO = cash outflow of the project and CF = cash inflow
When the cash gains generated by the project are unevenly distributed, cumulative cash gains
resulting from the project are to be calculated until the year in which the running total is equal to
the amount of investment outlay.
Accept-Reject Rule:
The decision rule is to accept the project if the computed payback period is less than the
standard. Otherwise, reject it. While ranking the projects, project with shortest payback period
is assigned the highest rank.
Advantages:
 It is easy to understand and calculate
 With the help of this method, projects can be ranked in terms of their economic
merits without much of complication.
 It indirectly considers factors like obsolescence and liquidity of investments
because project with shortest payback period is exposed to fewer risks.

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 This method is useful to the company experiencing shortage of cash because it

helps in choosing a project that will yield a quick return of cash fund regardless of
its long-term profitability.
Disadvantages:
 It does not measure the profitability of the projects.
 It fails to consider any receipts after the pay-back period, no matter how great
they might be. As a result, a project with shorter payback period may be selected
against a project with a longer pay back period but longer income producing life
and greater return on investment.
 It ignores time value of money.
A survey conducted by the Machinery and Allied Products Institute disclosed that about 2/3 rd of
the American companies employ pay back approach to appraise merit of projects. This is
because, in countries where technological changes are rapid, companies are usually exposed to
greater obsolescence risks and where uncertainty surrounding the outcome estimates is great,
prime consideration is the speed of capital investment recovery.
Modern / Discounting Cash Flow Techniques: These techniques usually are of more use to
businesses in their investment decisions. They take into account the time value of money and
adjust their cash flows accordingly before taking a decision. That is the reason why they are
considered superior to the traditional techniques. There are four techniques under this category
of methods. They are –
 Net present value (NPV)
 Internal rate of return (IRR)
 Profitability index (PI)
 Discounted Payback Period (DPBP)
Net Present Value (NPV):
In this method, future cash flows are discounted to the present and then compared with the
investment outlay. The basic discount rate is usually the cost of capital to the enterprise. For
ranking the projects according to this method, the NPVs of various alternative projects are
compared. Project with highest positive NPV or a project with highest NPV is given highest
rank.
Accept-Reject Rule:
In the case of independent projects, if the present value of cash inflows of a project is higher than
the present value of investment outlay of the project, it should be accepted. Otherwise, it should
be rejected. In the case of mutually exclusive projects, a project with highest NPV should be
accepted.
Advantages:
 It is simple to understand

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 Where a company has several mutually exclusive projects in hand, this method
helps the management to choose the most profitable one.
Disadvantages:
 It does not take into consideration the magnitude of the investment outlay and net
cash benefits together.
Internal Rate of Return (IRR):
This rate tries to find the earnings rate which equates the present value of the streams of earnings
to the investment outlay. IRR is defined as the rate of return which discounts all the future cash
inflows to exactly equal the outlay.
Accept-Reject Rule:
The project with IRR higher than the cut-off rate will be accepted. Otherwise, it will be rejected.
The management will be indifferent if the IRR = cut-off rate.
Advantages:
 It is useful and has many positive points
 It recognizes the time value of money
 It helps the management in selecting the most profitable project
Disadvantages:
 It is complicated to calculate by trial and error method
 It assumes that the funds received at the end of each year can be invested at the
same rate of return.
 It does not provide weight age of the volume of funds committed in the project.
 Under certain conditions it becomes very difficult to take any decisions like –
under conditions of irregular cash flows, IRR may give 2 or more answers.
Profitability Index (PI):
It is a ratio of the present value of the net cash benefits to the present value of the net cash outlay.
The higher the PI, the greater the return. Any project with a PI higher than ONE is acceptable
since benefits exceed outlay. Projects with PI less than ONE are rejected.
Advantages:
It places the present value of each investment project on a relative basis so that projects of
different sizes of capital outlays can be compared.
Discounted Payback Period (DPBP):
The discounted payback period is the no of periods taken in recovering the investment outlay on
the present value basis? Discounted payback period will always be higher than simple payback
period for a project because its calculation is based on the discounted cash flows. It differs from
the simple pay period in that it takes into account the time value of money. But still, it does not
account for post pay back profitability of the project.

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9. A company’s debentures with face value of Rs.100 bear an 8 percent coupon rate. Debentures of
this type currently yield 10 percent.
i) What is the market price of debentures of the company?
Given
Face Value of Debenture = Rs.100
Coupon Rate = 8%
Current Yield = 10%
Market price of debentures of the company
Market Price = INT / (1 + kg) + D / (1+ke)
= 8 / (1+10) + 100 / (1+10)
= 7.27 x 90.90
= Rs.98.17
ii) What would happen to the market price of the debentures if interest rises to 16 percent?
Market Price = INT / (1+ke) + D/(1+ke)
= 16 / (1+10) + 100 / (1+10)
= 14.55 + 90.90
= Rs.105.46
iii) What would be the market price of the debentures if it is assumed that debentures were having a
maturity period of 4 years from now (bases on situation (i)? (Nov / Dec 2008)
Market Price = INT / (1+ke) + INT / (1+ke)2 + INT /
(1+ke)3 + INT / (1+ke0 ?+D / (1+ke)?
= 8 / (1+10) + 8 / (1+10)2 + 8 / (1+10)3
= +8 / (1+10)? + 100 / (1+10)?
= 7.27 x 6.60 + 6.01 + 5.46 + 68.30
= Rs.93.65
iv) Would you pay Rs.90 to purchase debentures specified in situation (iii) above. Explain.
If market price is Rs.93.65, it is advisable to Pay Rs.90 to purchase debentures
10. A project has the following pattern of cash flows
Year 0 1 2 3 4 5
Cash flow (Rs) -40,00,000 15,00,000 8,00,000 7,50,000 -8,00,000 35,23,000
i).Calculate IRR of the project (ii) with i=8% calculate NPV of the project. (May/June 2009)
Year Cash Flow Discounting Factor @12% @ 13%
@8%
Preset Discounted P.V. Discounted P.V. DCF
Value Cash Flows Cash flows
1 1500000 0.926 1389000 0.893 1339500 0.885 1327500

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2 800000 0.857 685600 0.797 637600 0.783 626400

3 750000 0.794 595500 0.712 534000 0.693 519750

4 -800000 0.735 588000 0.636 508800 0.613 490400

5 3523000 0.681 2399163 0.568 2001064 0.543 1912989

Total Discounted cash inflows 4481263 4003364 3896239

Cash Outflow = Rs.4000000

Total Discounted Cash Inflows
at 12% = Rs.4003364
at 13% = Rs.3896239
It clearly shows that IRR lies between 12% and 13%. In order to find out the exact IRR, the following
formula can be applied.
4003364 - 4000000
IRR = 12% + x (13% - 12%)
4003364 – 3896239
3364
= 12% + x 1%
107125
= 12% + 0.03%
IRR = 12.03%
ii) Calculation of NPV at 8%
Total Discounted Cash inflows at 8% = 4481263
(-) Cash Outflows = 4000000
Net Present Value (NPV) = 481263
11. Enumerate is considering investing in a new products. The following annual information is available.
(May/June 2009)
* Cash sales Rs.25 Lakhs
* Credit sales Rs.32 lakhs
* Manufacturing cost of sales, excludes depreciation and includes Rs.75,000 of
allocated fixed cost Rs.16 lakhs
* Selling a administrative expenses (includes Rs.5,00,000 of allocated costs)
Rs.7 Lakhs

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* Loss of contribution on other products Rs.2 Lakhs

Credit sales are collected after a year with a bad debt loss of 2%. The capital equipment costs
Rs.30 lakhs and is depreciated at 33 1/3% per annum, written down value method. Working capital
investment of Rs.20 lakhs is required.
A long-term debt carrying 14% interest rate will increase by Rs.20 lakhs and a short term bank
borrowing carrying 18% rate will increase by Rs.10 lakhs. The corporate tax rate is 50%
Compute the cash flows for four years.
Ans : Particulars Years
1 2 3 4
Cash Sales 2500000 2500000 2500000 2500000
Credit Sales 3200000 3200000 3200000 3200000
Total Revenue (1) 5700000 5700000 5700000 5700000
Manufacturing Cost 1600000 1600000 1600000 1600000
Selling and Adm. Exp. 700000 700000 700000 700000
Bad Debt. Losses 64000 64000 64000 64000
Depreciation 1000000 666667 444444 296296
Total Payments (2) 3364000 3030667 2808444 26602963
Cash Flow (1-2) 2336000 2669333 2891556 3039704
(-) Tax @ 50% 1168000 1334667 1445778 1519852
Net Cash Flow 1168000 1334666 1445778 1519852
Calculation of Depreciation under WDB Method
Cost of Equipment = 3000000
(-) Dep. @ 33 1/3% = 1000000
2000000
(-) Dep. @ 33 1/3% = 666667
1333333
(-) Dep. @ 33 1/3% = 444444
8888889
(-) Dep. @ 33 1/3% = 296296
592593
(-) Dep. @ 33 1/3% = 197531
12. ABC Limited is proposing to invest in a project requiring a capital outlay of Rs.50,000. Cost for
annual income after depreciation but before tax is as follows :
Year 1 2 3 4 5
Rs.20,000 20,000 16,000 16,000 8,000
Depreciation may be taken at 20% on original cost and taxation at 50% of net income. You are
required to evaluate the project according to each of the following method. (May/June 2009)

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i) Pay-back method.
ii) Rate of return on original investment method
iii) Rate of return on average investment method
iv) Discount cash flow method taking cost of capital at 10%
v) Excess present value index.
Solution:
Calculation of Adjusted cash inflows:
Particulars 1 2 3 4 5
Cash inflow after Depreciation 20000 20000 16000 16000 8000
(-) Tax @ 50% 10000 10000 8000 8000 4000
Cash Inflow after Tax (+) 10000 10000 8000 8000 4000
Depreciation 10000 10000 10000 10000 10000
Cash Inflow after tax before dep. 20000 20000 18000 18000 14000
i) Calculation of Pay Back Method
Year Cash Inflows Cumulative
Cash Inflows
1 20000 20000
2 20000 40000
3 18000 58000
4 18000 76000
5 14000 90000
Cash Out flow = Rs.50000
10000
Pay – Back Period = 2 + = 2 Years
18000
ii) Rate of Return on Original Investment Method :
Average Annual Cash Inflows
= x 100
Original Investments
= (10000+10000+8000+8000+4000) /5
x 100
50000
8000
= x 100
50000
= 16%
iii)
Average Annual Cash Inflows
= x 100

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Average Investments
8000
= x 100
50000 / 2
= 32%
iv) Discount cash flow method taking cost of capital at 10%
Cost of Capital @
Year Cash Inflows Discounted Cash Inflows
10%
1 0.909 20000 18180
2 0.826 20000 16520
3 0.751 18000 13518
4 0.683 18000 12294
5 0.621 14000 8694
69206

Total Discounted Cash Inflows = 69206

(-) Cash Outflows = 50000
Net Present Value = 19206
v)
Discounted Cash Inflows
= x 100
Cash Outflows
69206
= x 100
50000
= 138.41%
13. From the following structure of a company, calculate the overall cost of capital, using Book
value weights, Market value weights
Equity shares (Rs.10/Share) 45,000 90,000
Retain earnings 15,000 …………..
Preference share capital 10,000 10,000
Debentures 30,000 30,000
The after tax cost of different sources of finance is as follows :
Equity : 14% Preference Share capital : 10%
Retained Earnings : 13% Debentures : 5%, (May/June 2009)
Solution:
i) Calculation of Overall Cost of Capital using Book Value Weights :
Sources Book Value Weights After-Tax Weighted
Cost Cost of Capital

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Equal shares 45000 0.45 14% 6.30

Retired Earnings 15000 0.15 13% 1.95
Pref. Shares 10000 0.10 10% 1.00
Debentures 30000 0.30 5% 1.50
Total 100000 10.75
ii) Calculation of Overall cost of Capital using Market Value Weights:
Sources Book Value Weights After-Tax Weighted
Cost Cost of Capital
Equal shares 90000 0.692 14 9.69
Pref. Shares 10000 0.077 10 0.77
Debentures 30000 0.231 5 1.16
Total 130000 11.62
14. Someshwar industries limited is considering is considering the purchase of a new machine
which would carry out some operations, at present being performed by hands, the two
alternatives models under considerations are complex and shrilex.
complex shrilex
Estimated life in years 10 12
Cost of machines Rs. 600000 Rs.1000000
Estimated savings in scrap p.a. Rs. 40000 Rs .60000
Additional cost of supervision p.a. Rs.48000 Rs. 64000
Additional cost of maintenance p.a. Rs. 28000 Rs. 44000
Cost of indirect material p.a. Rs.24000 Rs.32000
Estimated savings in wages i) Wages per workers
p.a.
Rs.2400 Rs.2500

ii) No. of workers p.a. not required

Rs. 150 Rs.200

Using method of payback period, suggest which should be purchased. Ignore tax? (May/June
2010)
Solution: To be discussed in class
15. The cash flow streams for two alternatives are shown below: (Nov/Dec 2010)
yea 0 1 2 3 4 5 6 7 8 9 10
r
Cas 30000 4000 4000 4000 4000 4000 3000 3000 2000 2000 2000
h 0 0 0 0 0 0 0 0 0 0 0

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flow
A:
Cas 21000 8000 6000 8000 6000 8000 6000 4000 4000 4000 4000
h 0 0 0 0 0 0 0 0 0 0 0
flow
B:
Calculate the:
i) Pay back period
ii) Internal rate of returns
iii) Net present value
iv) Profitability index for the two alternatives.
Solution: To be discussed in class
16. Following data is pertaining to AUOM Net operating income Rs.80 million Interest on debt
Rs.20 million. Cost of equity 18%, Cost of debt 12% Calculate the average cost of capital. (Nov /
Dec 2010)
Solution:To be discussed in class
17. A company is considering which of two mutually exclusive projects it should undertake. As
both projects have the same initial outlay and length of life. The company anticipates cost of
capital of 10% and the net after cash flows of the projects are as follows:
Investment 1 2 3 4 5
Project A 2,00,000 35,000 80,000 90,000 75,000 20,000

Project B 2,00,000 2,18,000 10,000 10,000 4,000 3,000

Discount factor @ 10% 0.91 0.83 0.75 0.68 0.62
Calculate the NPV of each project and state, with reasons, which project you would recommend.
(To be discussed in the class) (May/June 2011)
18. A company is considering two mutually exclusive projects A and B. Project A involves an
outlay of Rs.100 million which will generate an expected cash inflow of Rs. 25 million per year
for 6 years. Project B has an outlay of Ks 50 million which will produce an expected ash flow of
Rs. 13 million per year for 6 years. The company’s cost of capital is 12% calculate the NPV and
IRR of each project. Which method is better and why? (To be discussed in the class) (Nov/Dec
2011)
19. Gulch Ltd has the following book value capital structure:
Equity Capital (10 million shares @ Rs 10) Rs. 100 Million
Preference Capital, 11% (100000 shares, Rs 100) 10 Million
Retained Earnings 120 Million
Debentures, 13.5% (500000 debentures, Rs100 Par) 50 Million
Term Loans, 12% 80 Million

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TOTAL 360 Million

The next expected dividend per share is Rs. 1.50. The dividend per share is expected to grow at
7%. The current market price of a share is Rs. 20. Preference stock redeemable after 10 years, is
currently selling for Rs.75 per share. Debentures, redeemable after 6 years, are selling for Rs.80
per debenture. The tax rate for the company is 50%. Calculate the average cost of capital using
book value weights and market value weights. (Nov/Dec 2011)
Solution: (To be discussed in the class)
20. A limited company is considering investment in a project requiring a capital of Rs. 2, 00,000.
Forecast for annual income after depreciation but before tax is as follows: (MAY/JUNE 2012)
Year Rs.
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at 40% of the net income. You
are required to evaluate the project according to each of the following methods.
(i) pay-back method
(ii) Accounting rate of return on original investment
(iii) Discounted cash flow method taking cost of capital as 10%
(iv) Internal rate of return method
Solution:
(i) pay-back method
Statement of cash inflow
Year Profit Tax at 50% Profit Depreciation Cash Cumulative
after tax inflows cash
inflows
1 1,00,000 50,000 50,000 40,000 90,000 90,000
2 1,00,000 50,000 50,000 40,000 90,000 1,80,000
3 80,000 40,000 40,000 40,000 80,000 2,60,000
4 80,000 40,000 40,000 40,000 80,000 3,40,000
5 40,000 20,000 20,000 40,000 60,000 4,00,000
Payback period = Rs. 1, 80,000 is recovered in 2 years
The balance of Rs. 20,000 = 20,000/80,000*1 = 0.25 years
The Payback period is 2.25 yrs. or 2 years and 3 months.
(ii) Accounting rate of return on original investment
Year Net Profit after tax but before depreciation

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1 50,000
2 50,000
3 40,000
4 40,000
5 20,000
Total Profits Rs. 2,00,000
Average annual profits = Rs. 2, 00,000/ 5 = Rs.40, 000
Rate of return = 40,000/2, 00,000*100 = 20%
(iii) Discounted cash flow method taking cost of capital as 10%
Year Cash inflows Discount factor @ 10 % Present value in Rs.
1 90,000 0.909 81,810
2 90,000 0.826 74,340
3 80,000 0.751 60,080
4 80,000 0.683 54,640
5 60,000 0.621 37,260
Present value of cash inflows 3,08,130
Less : Initial Investment 2,00,000
Net Present Value 1, 08, 130
(iv) Internal rate of return method
= 40,000/1, 00,000*100 = 40%
21. From the following capital structure of a company, calculate the overall cost of capital, using
(i) Book weight
(ii) Market value weights
Sources Book value (Rs.) Market value (Rs.)
Equity share capital (Rs. 10 shares) 45,000 90,000
Retained earnings 15,000 ---------
Preference share capital 10,000 10,000
Debentures 30,000 30,000
The after tax cost of different sources of finance is as follows:
Equity share capital – 14%; retained earnings – 13%
Preference share capital – 10%; debentures – 5% . (May/June 2012)
Solution:
i).Calculation of Overall Cost of Capital using Book Value Weights:
Sources Book Value Weights After-Tax Weighted
Cost Cost of Capital
Equal shares 45000 0.45 14% 6.30
Retired Earnings 15000 0.15 13% 1.95
Pref. Shares 0.10 10% 1.00
Debentures 10000 0.30 5% 1.50

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30000
Total 100000 10.75
ii) .Calculation of Overall cost of Capital using Market Value Weights:
Sources Book Value Weights After-Tax Weighted
Cost Cost of Capital
Equal shares 90000 0.692 14 9.69
Pref. Shares 10000 0.077 10 0.77
Debentures 30000 0.231 5 1.16
Total 130000 11.62
22. Explain the various factors influencing capital expenditure decisions. (May/June 2012),
(May/June 2014),
1. Availability of funds
Generally, capital expenditure projects require large funds. A project, however profitable, may
not be taken for want of funds. So, projects with a lesser profitability may be sometimes
preferred due to lesser pay back period for want of liquidity.
2. Urgency
Sometimes an investment is to be made on the grounds of urgency for the firm’s survival or to
avoid heavy losses. In such circumstances, proper evaluation of proposal cannot be made
through profitability test. E.g. break down of machinery, fire accident etc.
3. Legal Compulsion
When statutory compulsion arises, investment has to be made in a project though it may not be
profitable one. For example, waste disposal plants have to be installed to satisfy environmental
laws.
4. Degree of uncertainty
Profitability is directly related to risk. Normally, higher the profits, greater is the risk or
uncertainty. Sometimes, a project with lower profitability may be selected due to constant flow
of income as compared to another project with an irregular and uncertain flow of income.
5. Intangible factors:
Sometimes, a capital expenditure has to be made due to certain emotional and intangible factors
such as safety and welfare of workers, prestigious project, social welfare, goodwill of the firm
etc., though such investments are not profitable.
6. Obsolescence:
If obsolete plant and machinery exist in a firm, their replacement becomes necessary.
7. Research and Development
It is necessary for the long term survival of the business to invest in research and development
projects though it may not loom to be a profitable investment.
8. Competitors’ activities

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When competitors perform certain activities, they may compel a firm to undertake similar
activates to withstand competition.
9. Future Earnings
A project may not be profitable today when compared to another one, but it may promise better
future earnings. In such cases, it may be preferred to increase earnings.
23. How is cost of equity capital determined under CAPM? Explain. (May/June 2012)
Cost of equity refers to a shareholder's required rate of return on an equity investment. It is the
rate of return that could have been earned by putting the same money into a different investment
with equal risk.
Example: To be discussed in the class
24. A Company is considering two mutually exclusive projects. Both require an initial cash
outlay of Rs. 10,000 each and have a life of five years. The company’s required rate of return is
10% and pays tax at 50 % rate. The projects will be depreciated on a straight line basis. The
before taxes cash flow expected to be generated by the projects are as follows:
Before tax cash flow (Rs.)
Project 1 2 3 4 5
A 4000 4000 4000 4000 4000
B 6000 3000 2000 5000 5000
Calculate for each project (i) the payback (ii) The ARR (iii) the NPV (iv) IRR. Which project
should be accepted and why? (May/June 2013)
Answer - Project A
Particulars Amount
Cash flows before tax 4,000
Less : Tax @ 50% 2,000
EAT 2,000
Add: Depreciation 2,000
Earnings after tax but before depreciation 4,000

(i) Pay back period = Investment /AACIF = 10,000/4,000 = 2.5 years

(ii) ARR = AACIF (After dep & tax) / Average investment
= 2,000/ 5,000 = 40%
(iii) NPV = CIF * Df @10% (.909+.826+.751+.683+.621)
= 4000*3.79 = 15,160 – 10,000 = 5,160
(iv) IRR = F = I/C = 10,000/4,000 = 2.5 = 28%

Answer - Project B
Depreciation = 10,000/5= 2,000
CIF ( Before Tax 50% CIF ( after CIF (Before Df @11% Present

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tax) tax) dep, after Value

tax)
6,000 3,000 3,000 5,000 .909 4545
3,000 1,500 1,500 3,500 .826 2891
2,000 1,000 1,000 3,000 .751 2253
5,000 2,500 2,500 4,500 .683 3073
5,000 2,500 2,500 4,500 .621 2794
10,500 15,556
Gross Present Value 15,556
Initial Investment 10,000
NPV 5,556
(i) Pay back period = 3 year + (311/3073) = 3.10 years
(ii) ARR = Average CIF ((After dep & tax) / Average investment
= Average CIF = 10,500/5 = 2,100
= 2,100/5000 = 42%
(iii) IRR
CIF Df @10% Present Df @20% Present Df @30% Present
(Before Value Value Value
dep, after
tax)
5000 0.909 4545 0.833 4165 0.769 3845
3500 0.826 2891 0.694 2429 0.592 2072
3000 0.751 2253 0.579 1737 0.455 1365
4500 0.683 3073 0.482 2169 0.350 1575
4500 0.621 2794 0.402 1809 0.269 1210
Gross present Value 15556 12309 8702
Initial Investment 10000 10000 10000
NPV 5556 2309 (1298)
IRR = 10% +5556 /(5556-(-1298) *20% = 26.21%
Project A Project B Decision
Payback Period 2.5 years 3.1 years Project A accepted
NPV 5160 5556 Project B accepted
ARR 40% 42% Project B accepted
IRR 28% 26.21% Project A accepted
25. Sagar Industries is planning to introduce a new product with a projected life of 8 years. The
project, to be set up in a backward region, qualifies for one time (as its starting) tax free
subsidiary from the government of Rs. 20 lakhs. Initial equipment cost will be needed at the
beginning of the third year. At the end of 8 years, the original equipment will have no resale
value, but the supplementary equipment can be sold for Rs.1 lakh. A working capital of Rs. 15

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lakhs will be needed. The sales volume over the eight years period have been forecasted as
follows:

Years Units
1 80,000
2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs. 100 per unit is expected and Variable expenses will amount to 40% of sales
revenue. Fixed cash operating costs will amount to Rs. 16 lakhs per year. In addition, an
extensive advertising campaign will be implemented, requiring annual outlays as follows:
Years Rs. (in lakhs)
1 30
2 15
3-5 10
6-8 4
The company is subject to 50% tax rate and considers 12% to be an appropriate after –Tax cost
of capital for this project. The company follows the straight line method of depreciation. Should
the project be accepted? Assume that the company has enough income from its existing products.
(May/June 2008)
Solution:
Cash outflow
Initial equipment cost 140,00,000
Less Tax free subsidiary 20,00,000
__________
120,00,000
Add: Working expenses 15,00,000
__________
135,00,000
Additional equipment in the III year
10,00,000 *0.797 = 7,79,000
Total Cash outflow = 1,35,00,000 +7,79,000
= 142,97,000
Cash inflow:(Rs. in. Thousands) 1 2 3-5 6-8

Sales A 80,000 1,20,000 3,00,000 2,00,000

Variable cost 32,000 48,000 1,20,000 80,000
Fixed cost 16,000 16,000 16,000 16,000
Advertisement 30,000 15,000 10,000 4,000
Depreciation 17,500 17,500 19,000 19,000
Total Cost B 95,500 96,500 1,65,000 1,19,000

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Profit (A-B) (15,500) 23,500 1,35,500 81,000

Tax - 4,000 67,500 40,500
PAT (15,500) 19,500 67,500 40,500
Cash inflow (PAT+ Dep.) 2,000 37,000 86,500 59,500
Rs. in Thousands
Years CIF DF @12% Present Value
1 2,000 .893 1,786
2 37,000 .797 29,489
3 86,500 .712 61,588
4 86,500 .636 55,014
5 86,500 .567 49,046
6 59,500 .507 30,167
7 59,500 .452 26,894
8 59,500 .404 24,038
WC 15,000 .404 6,060
Scrap 1,000 .404 404
Gross present value 284,28,500
Less: Initial Investment 142,97,000
Net Present Value 141,51,500
NPV is positive; therefore the project will be accepted

UNIT-III
PART A(`10*2=20 MARKS)
1. State and brief any four factors which are relevant for determining the payout ratio.
(May / June 2007)
-Fund requirement, -Liquidity, -Access to external source of financing, -Shareholders preference,
-Control etc.,
2. List out the different form of Dividend Policies? (Nov/Dec 2007), (May/June 2014)
Dividend Practices
1. Constant dividend per share, 2. Constant percentage of net earnings, 3. Small constant
dividend per share plus extra dividend, 4. Dividend as fixed percentage of market value.
Forms of dividend

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1. Scrip dividend – Transferable note with or without interest-weak form of company, 2.Bond
dividend- or Notes- long term, 3. Property dividend, 4.Cash dividend, 5.Stock dividend(Bonus
shares).
3. PQR & Co., has issued 1000 equity shares of Rs. 100 each as fully paid. It has earned a
profit of Rs. 10,000 after tax. The Market price of these shares is Rs. 160 per share. Find
out the cost of equity capital. (Nov/Dec 2007)
Cost of Equity = D/MP *100 = 10/160*100 = 6.25%
4. What is stock split? (May / June 2007), (May/June 2008), (Nov/Dec 2008), (Nov/Dec 2009),
(May/June 2009) (Nov/Dec 2010), (Nov/Dec2011), (May/June 2012)
Share split is a method to increase the number of outstanding shares through a proportional
reduction in the par value of shares. A share split affects only the par value and the number of
outstanding shares, the shareholders total funds remains unchanged.
Reasons for stock split
 To make trading in shares attractive
 To signal the possibility of higher profits in the future
 To give higher dividends to shareholders
E.G. a company with 100 shares of stock priced at Rs.50 per share. The market capitalization is
100 × Rs.50, or Rs.5000. The company splits its stock 2-for-1. There are now 200 shares of stock
and each shareholder holds twice as many shares. The price of each share is adjusted to Rs.25.
The market capitalization is 200 × Rs.25 = Rs.5000, the same as before the split
5. What is trading on equity? (May/June 2008), (Nov/Dec 2009)
Trading on equity means to raise fixed cost capital (borrowed capital and preference share capital)
on the basis of equity share capital so as to increasing the income of equity shareholders.
6. What is ‘indifference point’?(May/June 2009)
Indifference point refers to the level of EBIT at which Earnings Per Share (EPS) or return on share
capital is equal for different combinations of debt and equity. That is, at this level of EBDT,
whatever is the debt-equity mix, the EPS remains uncharged.
7. What is ‘dividend payout ratio’? Brief with a simple illustration (May/June 2009)
Dividend Payout Ratio shows that the percentage share of net earnings distributed to the share
holders as dividends. It is calculated as follows :
Dividend per share
Dividend Payout Ratio =
Earning per share
8. State the advantage of trading on equity? (May/June 2010)
It is the use of long term fixed interest bearing debt and Preference shares along with equity
share capital. The use of long-term debt increases and magnifies the EPS if the firm yields a
return higher than the cost of debt. This is positive leverage. However, if the firm yields a lower
return than the cost of debt, it is adverse leverage. EPS also increases with the use of preference

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share capital also, but due to the fact that interest is allowed to be deducted while computing the
tax, the leverage impact of debt is more.
9. What you mean by an optimal capital structure? (May/June 2010), (May/June 2011),
(May/June 2012), (Nov/Dec 2013)
The optimum capital structure may be defined as “that capital structure or combination of debt
and equity that leads to the maximum value of the firm”. Optimal capital structure maximize the
value of the company and hence the wealth of its owners and minimizes the company’s cost of
capital.
10.Distinguish debt-equity ratio and interest coverage ratio on two aspects. (Nov/Dec 2010)
a. Debt – Equity ratio
Debt ratio = (Debt / Equity)
b. Interest cover ratio
Interest cover = PBIT / Interest charges
Note: preference dividend is excluded from interest charges
11. What are the different types of Dividend policy?(May/June 2011)
a. Stable Dividend Policy, -b. Fluctuating Dividend Policy, -c. Small Constant Dividend per
Share plus Extra Dividend.
Forms of dividend:-
1. Cash dividend, 2. Bond dividend, 3. Property dividend, 4. Stock dividend
12. What is arbitrage? Give an example. (Nov/Dec 2011)
Arbitrage is the practice of taking advantage of a price difference between two or more markets:
striking a combination of matching deals that capitalize upon the imbalance, the profit being the
difference between the market prices. When used by academics, an arbitrage is a transaction that
involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in
at least one state; in simple terms, it is the possibility of a risk-free profit at zero cost
13. What do you mean by stable dividend?(May/June 2012)
The term stability of dividends means consistency in the payment of dividends. It refers to
regular payment of a certain minimum amount as dividend year after year. Even if the company's
earnings fluctuate from year to year, its dividend should not. This is because the shareholders
generally value stable dividends more than fluctuating ones.
Stable dividend can be in the form of:
1. Constant dividend per share
2. Constant percentage
3. Stable rupee dividend plus extra dividend
14. Define the concept of dividend. (May/June 2012)
Dividend refers to that part of the earnings (profits) of a company which is distributed to
shareholders.

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15. What do you mean by financial leverage? (Nov/Dec 2013)

Financial Leverage is a leverage created with the help of debt component in the capital structure
of a company. Higher the debt, higher would be the financial leverage because with higher debt
comes the higher amount of interest that needs to be paid.
16. Explain the concept of script dividend.(May /June 2013)
It is the issue of additional shares by a company to shareholders in lieu of a dividend. The shares
have an equivalent cash value to the dividend. No dealing charges or stamp duty is payable on
the issue of the new shares.
17. What is composite leverage?(May/June 2014)
18. What is reverse split? (May/June 2014)
corporate action in which a company reduces the total number of its outstanding shares. A
reverse stock split involves the company dividing its current shares by a number such as 5 or 10,
which would be called a 1-for-5 or 1-for-10 split, respectively. A reverse stock split is the
opposite of a conventional (forward) stock split, which increases the number of shares
outstanding. Similar to a forward stock split, the reverse split does not add any real value to the
company. But since the motivation for a reverse split is very different from that for a forward
split, the stock’s price moves after a reverse and forward split may be quite divergent. A reverse
stock split is also known as a stock consolidation or share rollback.
19. What is capital structure?
The composition of a firm’s long-term financing consisting of equity, preference, and long-term
debt
20. What is interest coverage ratio?
Earnings before interest and taxes divided by interest expense. Used to measure firms ability to a
pay interest.
21. What is trading on equity?
The use of the fixed-charge capital like debt with equity capital in the capital structure is
described as financial leverage or trading on equity.
22. What do you understand by capital gearing?
The term capital gearing is used to describe the relationship between equity share capital
including reserves and surplus to preference share capital and other fixed charge bearing
securities.
23. What is indifference point in EBIT-EPS analysis?
The level of EBIT that produces the same level of EPS for two (or more) alternative capital
structures.
24. Define operating leverage.
Operating leverage refers to the use of fixed costs in the operations of a firm.
25. Define financial leverage.

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The use of long-term debt and preference share capital along with the owners equity in the
capital structure is called financial leverage or trading on equity.
26. Define composite leverage.
Composite leverage is a combination of operating leverage and financial leverage

PART- B (5*16 = 80 MARKS)

1. Explain in detail the impact of financial leverage on ‘earnings –per-share’ (May/June
2007)
Operating Leverage
Operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify
the effects of changes in sales on its earnings before interest and taxes. Operating Leverage =
Contribution / Operating profit (EBIT).
Financial Leverage
Financial leverage is concerned with the effect of changes in EBIT on the earnings available to
equity shareholders. It is defined as the ability of a firm to use fixed financial charges to magnify
the effects of changes in EBIT on the earnings per share. Financial Leverage = EBIT / PBT
Combined Leverage
Operating and financial leverage together cause wide fluctuation in EPS for a given change in
sales. If a company employs a high level of operating and financial leverage even a small
change in the level of sales will have dramatic effect on EPS.
Combined Leverage = (C*EBIT)/(EBIT*PBT) (or) (C/PBT)
Operating Risk
Operating risk can be defined as the variability of EBIT (Rate of Return on Total Assets). The
environment internal and external in which a firm operates determines the variability of EBIT.
Operating risk is an unavoidable risk.
The variability of two components as EBIT
1. Variability of sales
2. Variability of expenses
Financial Risk
For a given degree of variability of EBIT. The variability of EPS(and ROE) increases with more
financial leverage. The variability of EPS caused by the use of financial leverage is called
financial risk. Financial risk is thus a avoidable risk if the firm decides not to use any debt in this
capital structure.
2. 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. Calculate
operating, financial and combined leverage of them. Also calculate the new EBIT, if the
sales drop to Rs. 50,00,000. (May/June 2007)
Solution:
Calculation of leverage
Existing New

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Sales 75,00,000 50,00,000

Less: variable cost: 42,00,000 28,00,000
___________________________
Contribution 33,00,000 22,00,000
Less: Fixed cost 6,00,000 6,00,000
___________________________
Operating profit 27,00,000 16,00,000
(EBIT)
Less: Interest; 4,50,000 4,05,000
========================
EBT 22,50,000 11,95,000
========================

Operating leverage

Contribution = 33,00,000 : 22,00,000

____________ __________ __________
EBIT 27,00,000 16,00,000
= 1.2:1 :1.375: 1
Financial leverage

EBIT = 27,00,000 : 16,00,000

______ _________ _________
EBT 22,50,000 11,95,000

= 1.2 : 1.33
Combined Leverage

Contribution = 33,00,000 : 22,00,000

____________ __________ __________
EBT 22,50,000 11,95,000
= 1.47 : 1.84
3. Explain Modigliani Miller approach on cost of capital.(May/ June 2007)
M M theory relating to the relationship between cost of capital and valuation is similar to NOI
approach
Net Operating Income Approach (NOI)
According to NOT approach is diametrically opposite to the NI approach. The essence of this
approach is that capital structure decision of a corporate does not affect its cost of capital and the
valuation, and, hence, irrelevant.
The main argument of NOI is that an increase in the proportion of debt in the capital structure
would lead to an increase in the financial risk of the equity holders. To compensate for the
increased risk , they would require a high rate of return (Ke) on their investment. As a result , the

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advantage of the lower cost of debt would exactly be neutralized by the increase in the cost of
equity. The cost of debt has two components:
i) Explicit, represents rate of interest and
ii) Implicit, represents the in the cost of equity capital
Modigliani – Miller Approach (MM)
MM theory agree with NOI and provide a behavioral justification for the irrelevance of capital
structure. They maintain the cost of capital and the value of the firm do not change with a
change in leverage.
MM hypothesis (Assumptions)
1. Perfect capital market:
a. Securities are infinitely divisible
b. Investors are free to buy / sell securities
c. Investors can borrow without restrictions on the same terms and conditions as
firms can
d. Investors are rational and behave accordingly
2. Given the assumption of perfect information and rationality
3. Same expectations of investors (EBIT or NOT) Homogeneous risk class.
4. Dividend payout ration is 100%
5. There are no taxes. (This assumption is removed later)
4. Discuss in detail the legal and procedural aspects of dividend payments. (May/ June
2007)
Information on payment of dividends
Every general meeting of shareholders sets record-date. Shareholders registered with Central
Securities Clearing Corporation as owners of shares are eligible for the payment of dividends.
The resolution, adopted at the general meeting of shareholders, sets the gross amount of the
dividend per share. The new procedure of dividend taxation was introduced by amendments of
Personal Income Tax Act, in force since January 1st, 2006.
 Shareholders – legal persons. Regarding the fact that dividends are a part of legal
persons’ income, they are the basis for corporate income tax.
The tax(15%) is deducted from the payment of dividends for both residents ad non- residents.
The latter may be exempt from paying the income tax at this rate if a different tax rate is set by
an agreement on prevention of double taxation between the Republic of Nation and the country
of the recipient. Regardless of this general legal requirement, legal persons may receive a gross
divided if they comply with the requirements of article 70, paragraph 2 of Corporate Income Tax.
Dividend payment procedure
After the General Meeting of Shareholders, all shareholders receive written notifications of the
dividend amount they are eligible for, and the date and method of dividend payment. Prior to
that, the shareholders are notified about any missing of inaccurate data on which basis the
dividends are to be paid (personal account number and tax number). To ensure on-time payment
of dividends, shareholders who receive such a notification and all those, whose data have

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changed after being submitted, must send the relevant data as soon as possible. The regulations
allow for dividends to be paid to natural persons in cash provided that the net dividend does not
exceed prescribed amount. If the net dividend exceeds the above amount, shareholders must
submit information of their personal accounts.

5. Explain the considerations involved in evolving a balanced capital structure of a

corporation. (Nov/Dec 2007), (May/June 2012)
Capital structure of a company refers to the make up of its capitalization. A company procures
funds by issuing various types of securities, i.e. ordinary shares, preferences shares, bonds and
debentures. Before issuing any of these securities, a company should decide about the kinds of
securities to be issued. In what proportion will the various kinds of securities be issued, should
also be considered. However, in broader sense, capital structure includes all the long term capital
resources including loans, bonds, share issued, reserves, etc. and the components of the total
capital. A company engaged in devising a financial plan will be faced with problem regarding the
proportion of funds to be raised by issue of its shares and the amount to be raised though
borrowings. There is an important difference between these two methods. Funds raised from
shareholders require the payments of dividend only out of profits, if there is any, a company
should maintain a fair balance between these two types of securities- (a) fixed cost bearing
securities. (debentures and preference share), and (b) Variable cost bearing securities (ordinary
shares). This security mix affects the financial stability of the company. If a company fails in its
efforts in maintaining the security mix, its capital structure will be imbalanced which may affect
its profitability.
Balanced capital structure
Capital structure or financial plan refers to the composition of long- term sources of funds such
as debentures, long term debts, preference and ordinary share capital and retained earnings
(reserves and surpluses) Companies that do not plan their capital structure may proper in the
short run, but ultimately will face serious problems in raising funds to finance their activities in
the long-run. Therefore, it is important for a company to take ad decision regarding its capital
structure. Whenever, financial manager considers the question of capital structure, it is always
the question of optimum or balanced capital structure, i.e., to decide the proportion of long term
finance to be raised through borrowings and through investments from owners. Optimum or
balanced capital structure means an ideal combination of borrowed and owned capital that may
attain the marginal, goal, i.e. maximization of market value per share or minimization of cost of
capital. The market value will be maximized or the cost of capital will be minimized when the
real cost of each source of funds is the same. It is formidable task of the financial manager to
determine the combination of the various sources of long-term finance.

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6. What are the various factors influencing Dividend Policy? Explain. (Nov/Dec 2007),
(May/June 2009), (May/June 2012)
The amount of profits of a company made available for the distribution among its share holders
is called dividend. The dividend may be a fixed annual percentage shares or it may vary
according to the prosperity of the company as in the case of ordinary shares. The decision for
distributing or paying a dividend is taken in the meeting of Board of directors and is confirmed
generally by the Annual General Meeting of the share holders. The dividend can be declared only
out of divisible profits, remained after setting of all the expenses transferring reasonable amount
of profit to reserve fund and providing for depreciations and taxation for the year. It means if in
any year, there is no profit, no dividend shall be distributed on that year. The share holder’s
cannot insist upon the company to declare the dividend. It is solely the discretion of the directors.
The dividend was an income of the owners of the corporation which they received in the capacity
of the owners, Distribution of dividend involves reduction of current assets (cash) but not always
stock dividend or bonus shares is an exception to it.
Factors affecting dividend policy:
1. Expectations of shareholders
Shareholders are the owners of the company. So the company should consider the dividend
expectations of shareholders. They may be interested in dividend or capital gains. The preference
for dividend or capital gains depends on the economic status or attitude of an individual. For
example a retired person who wants a regular income may prefer to receive dividends.
2. New investments
Availability of investment opportunities (such as expansion and diversification) is an important
factor, which influence the dividend decision. If the company has profitable investment
opportunities it may retain a substantial part of the earnings and pay out a small dividend. It the
company does not have good investment opportunities; it is better to distribute the earnings as
dividends. In other words a high payout is desirable for such companies.
3. Taxation
Taxation policy also affects the dividend policy of a firm. In India dividends are tax free in the
hands of the shareholders. Long term capital gain on listed shares sold on or after 1 st October
2004 is also not taxable if securities transitions tax has been paid. But short-term capital gain is
taxable. The shareholders may prefer dividends or capital gains depending on the effect of tax on
their incomes.
4. Liquidity
The liquidity position is important factors which influence the dividend decision. Sometimes a
company, which has good earnings, may not have sufficient liquidity. In such case it is advisable
to restrict the dividend to the available liquid resources.
5. Access to capital markets

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A company which is confident of raising resources from the capital market (for expansion and
diversification) may pay higher dividends. On the hand if the company is unable to raise
resources due to its poor image or the depressed state of the capital markets, it has to content
with a low payout.
6. Restrictions by lenders
The lenders particularly financial institutions impose restrictions on the payment of dividends to
safeguard their own interests. For example, a lender may stipulate that only up to 30 percent of
the profits may be paid as dividends. Because of these restrictions, a company may be forced to
retain earnings and have a low payout.
7. Control
The objective of maintains control by the present mang3ement may also affect the dividend
policy. Suppose a company’s is quite liberal in paying dividends, it may have to raise funds for
expansion or diversification by the issue of new shares, its control will be diluted. Hence the
management may opt for a low payout and retain earnings to maintain control over the company.
8. Legal Restrictions
The provisions of the companies act are to be adhered in the formulation of dividends policy.
According to these provisions, dividends can be paid only out of current profits or past profits,
only after providing for depreciation. There are also stipulations regarding transfer of profits to
reserve before declarations of dividends. Further dividends cannot be paid out of capital.
7. Firms X and Y are identical except that firm ‘X’ is not leveraged while firm ‘Y’ is leveraged.
The following data relate to them: (Nov/Dec 2007)
Firm ‘X’ Firm ‘Y
Assets 5,00,000 5,00,000
Debt Capital 0 2,50,000
Equity share capital (9%Interest)
(50,000 shares of Rs. 10 each) 5,00,000 2,50,000
(25,000 shares of Rs.10
each)
Rate of return on assets 20% 20%
Calculate EPS for both Firms, assuming a tax-rate of 50%. Will it be advantageous to Firm ‘y’ to
raise the level of debt capital to 75%?
Solution
Calculation of EPS
Firm –X (Equity) Firm – Y (Equity +Debt)
Earnings 1,00,000 Earnings 1,00,000
Less: Interest ____ Less: Interest @9% 22,500
_________ ___________
EBT 1,00,000 EBT 77,500
Less: tax @50% 50,000 Less: tax @50% 38,750

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________ ___________
EAT 50,000 EAT 38,750

EPS = Earnings/ No of shares EPS = 38,750/25,000 = 1.55

EPS=50,000/50,000 = 1.00
If the debt is increased to 75%
Earnings 1,00,000
Less: Interest @9% 33,750
________
EBT 66,250
Less: tax @50% 33,125
_________
EAT 33,125
EPS = 33,125/12,500 = 2.65
If the company Y raise the level of debt to 75%, will increase the EPS to Rs.2.65, therefore, it is
advantages.
8. What are the different types of Dividend Policy? (May/June 2008)
Dividend policy of a firm, thus affects the long-term financing and wealth of share holders. The
important aspect of dividend policy is to determine the amount of earnings to be distributed to
shareholders and the amount to be retained in the firm. Retained earnings are the most significant
internal sources of financing the growth of the firm. On the other hand, dividend is the right of
the shareholders to participate in the profit.
Dividend Practices
1. Constant dividend per share
2. Constant percentage of net earnings
3. Small constant dividend per share plus extra dividend
4. Dividend as fixed percentage of market value
Significance of stable dividend
1. Confidence among shareholders’
2. Investors desire for current income
3. Institutional investors requirements
4. Stability in market price of shares
5. Raising additional finance
6. Market for debentures and preference shares
7. Reducing the chances of loss of control
Forms of dividend are
1. Scrip dividend (may or may not bearing interest) – weak form of company
2. Bond dividend – or Notes – long term
3. Property dividend

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4. Cash dividend
5. Stock dividend (Bonus shares)
9. Determine the market Value of equity shares of the company from the following information
as per Walter’s model. (May/June 2008)
Earnings of the company Rs. 5, 00,000
Dividend paid Rs. 3,00,000
Number of shares outstanding Rs. 1,00,000
Price earnings ratio 8
Rate of return on investment 15%
Cost of capital 13.2%
Solution:
EPS = 5,00,000/1,00,000 =Rs.5
DPS= 3,00,000/1,00,000 =Rs.3
PE Ratio = Market Price per share / EPS
8 = Mkt Price /5
Market price = Rs.40
Dividend payout = DPS/EPS
5/3 = 1.666
Walters formula
P= (D+r(E-d))/(ke/ke) (or)
P= (D/ke) +(r(E-D)/ke/ke)
P= 0+((0.15/0.132)(5-0))/0.132 =Rs.43
10. A companies Capital structure consist of the Following: (May/June 2008)
Equity share capital of Rs. 100 each Rs. 20 Lakhs
Retained Earnings Rs. 10 Lakhs
9% Preference shares Rs. 12 Lakhs
7% Debentures Rs. 8 Lakhs
_______________
Rs. 50 lakhs
_______________
The company earns 12% on its capital. The income tax rate is 50% The company requires a sum
of Rs. 25 lakhs to finance its expansion programme for which following alternatives are
available to it.
i) Issue of 20,000 equity shares at a premium of Rs. 25 per share
ii) Issue of 10% preferences shares
iii) Issue of 8% debentures

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It is estimated that the P/E rations in the cases of equity, preference and debenture financing
would be 21.4, 17 and 15.7 respectively. Which of the three financing alternatives would you
recommend and why?
Solution:
Particulars Existing Equity Preference Debt
EBIT 6,00,000 9,00,000 9,00,000 9,00,000
Less: Interest 56,000 56,000 56,000 56,000+
2,00,000
PBT 5,44,000 8,44,000 8,44,000 6,44,000
Less: Tax@50% 2,72,000 4,22,000 4,22,000 3,22,000
PAT 2,72,000 4,22,000 4,22,000 3,22,000
Less: Pref. Dividend 1,08,000 1,08,000 1,08,000+ 1,08,000
2,50,000
Earnings to ESH 1,64,000 3,14,000 64,000 2,44,000
No. of Equity shares 20,000 40,000 20,000 20,000
EPS = (E/No. of shares) 8.20 7.85 3.20 10.7
PE Ratio - 21.4 17 15.7
Market Price - 167.99 54.40 167.99
* EPS is highest in debenture option it will be selected.
11. Why must the finance manager keep in mind the degree of financial leverage in evaluating
financing plans? When does leverage become favorable? (Nov/Dec 2008)
When leverage is used properly, a force applied at one point is transformed, or magnified, into
another, larger force or motion at some other point. In a business context, however, leverage refers
to the use of fixed costs in an attempt to increase (or lever up) profitability. There are two types of
leverages, such as, operating leverage and financial leverage. The former is due to fixed operating
costs associated with the production of goods or services, whereas the latter is due to the existence
of fixed financing cost in capital structure.
Operating leverage is present any time a firm has fixed operating cost, regardless of volume.
Fixed operating costs do not include debt interest, which is a fixed financial cost. On the other hand
it includes such as administrative costs, depreciation, selling and advertisement expenses etc.
Financial leverage is acquired by choice, but operating leverage sometimes is not. The amount of
operating leverage (the amount of fixed operating costs) employed by a firm is sometimes dictated
by the physical requirements of the firm’s operations.
For example, a steel mill by way of its heavy investment in plant and equipment will have a large
fixed operating cost component consisting of depreciation. Financial leverage, on the other hand, is
always a choice item. No firm is required to have any long-term debt or preferred stock financing.
Firms can, instead, finance operations and capital expenditures from internal sources and the
issuance of common stock. Nevertheless, it is a fare firm that has no financial leverage.

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Financial leverage is employed in the hope of increasing the return of common share holders.
Favorable or positive leverage is said to occur when the firm uses funds obtained at a fixed cost
(funds obtained by issuing debt with a fixed interest rate of preferred stock with a constant dividend
rate) to earn more that the fixed financing cost paid. Any profits left after meeting fixed financing
costs then belong to common share holders. Unfavourable or negative leverage occurs when the firm
does not earn as much as the fixed financing costs. The favour ability of financial leverage; or
“trading on the equity” as it is sometimes called, is judged in terms of the effect that it has on
earnings per share to the common share holders. In effect, financial leverage is the second step in a
two-step profit magnification process. In step one; operating leverage magnifies the effect of
changes in sales on changes in operating profit. In step two, the financial manager has the option of
using financial leverage to further magnify the effect of any resulting changes in operating profit on
changes in earnings per share. Financial Leverage may be favourable or unfavourable. If the
company is able to generate a return which is higher than the cost of borrowings, the leverage said to
be favouarble.
12. What are the practical considerations in formulating the dividend policy? (Nov/Dec 2008)
The amount of profits of a company made available for the distribution among its share holders is
called dividend. The dividend may be as fixed annual percentage of paid-up capital as in the case of
preference shares or it may vary according to the prosperity of the company as in the case of
ordinary shares. The decision for distributing or paying a dividend is taken in the meeting of Board
of directors and is confirmed generally by the Annual General Meeting of the share holders.
Dividend Policy and Practical Consideration in formulating the dividend policy.
The economic soundness of a company is generally judged by the amount of dividend declared
and paid by it to the share holders. It affects its good will among the share holders and the
prospective share holders. Dividend is a part of profits distributed among the share holders. The
basic question before the Board of Directors is how much profits should be dividend among share
holders as dividend and how much to be retained in the business as reserves to meet the future
contingencies and for expansion of business. Both future expansion and distribution of dividend are
desirable but two aims are in conflict. Hence allocation of earnings is an essential part of
management functions. It requires a sound dividend policy to be followed by the corporation.
According to Weston and Brigham “Dividend policy determines the division of earnings
between payments to share holders and retained earnings”. In this connection, the dividend declared
during previous years may be taken as a base and the same rate is followed in the coming years.
Generally, Board of Directors aims at maintaining the dividend rate which we may call a “Stable
Dividend Policy”. For this purpose a “dividend equalization fund” is crated out of profits to equalize
the profits of the coming years. There are certain basis questions which are involved in determining
the sound dividend policy such as question are:
1) Cost of capital

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2) Realization of objectives
3) Share holders Group
4) Release of corporate Earnings
i) Cost of Capital
Cost of capital is one of the consideration for taking a decision whether to distribute dividend or
not. As a decision making tool, the Board calculates the ratio of rupee profits the business expects to
earn (Ra) to the rupee profit that the share holders can expect to earn out side (Rc) i.e. Ra/Rc. If the
ratio is less than one, it is signal to distribute dividend and if it is more than one, the distribution of
dividend will be discontinued.
ii) Realization of objectives
The main objectives of the firm i.e. maximization of wealth for shareholders including the current
rate of dividend should also be aimed at in formulating the dividend policy.
iii) Share Holder’s Group
Dividend policy affects the share holder’s group. It means a company with low pay-out and heavy
reinvestment attracts share holders interested in Capital gains rather than in current income where as
a company with high dividend pay-out attracts those who are interested in current income.
iii) Release of Corporate Earnings
Dividend distribution is taken as a means of distributing unused funds. Dividend policy affects the
share holders wealth by varying its dividend pay-out ratio. In dividend policy, the financial
managers decide whether to release corporate earnings or not.
These are certain basic issues involved in formulating a dividend policy. Dividend Policy to a large
extend affects the financial structure, the flow of funds, liquidity, stock prices and in the last share
holders satisfaction. That is why management exercise a high degree of judgment in establishing a
sound dividend pattern.
13. Write short notes on forms of dividends.(Nov/Dec 2008)
The amount of profits of a company made available for the distribution among its share holders is
called dividend. The dividend may be as fixed annual percentage of paid-up capital as in the case of
preference shares or it may vary according to the prosperity of the company as in the case of
ordinary shares. The decision for distributing or paying a dividend is taken in the meeting of Board
of directors and is confirmed generally by the Annual General Meeting of the share holders. The
dividend can be declared only out of divisible profits, remained after setting of all expenses
transferring reasonable amount of profit to reserve fund and providing for depreciations and taxation
for the year. It means if in any year, there is no profit; no dividend shall be distributed on that year.
The share holder’s cannot insist upon the company to declare the dividend. It is solely the discretion
of the directors. The dividend was an income of the owners of the corporation which they received
in the capacity of the owners, Distribution of dividend involves reduction of current assets (cash) but
not always stock dividend or bonus shares is an exception to it

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Forms of dividend :
“ Cash dividend
“ Stock dividend
“ Scrip dividend
“ Bond dividend
“ Property dividend
Dividend may be different forms. The above said dividend has been classified according to the mode
of its distribution as follows :
1) Cash dividend
This is the most popular from of dividend. In cash dividend, share holders are paid dividend in cash.
Sometimes it is supplemented by bonus (stock dividend). The company must have sufficient cash
balance in its bank account otherwise it would have to arrange funds for the payment of dividend. If
the company follows the stable dividend policy, it should prepared a cash budget for the coming
period to indicate the necessary funds which would be needed to meet the regular dividend
payments of the company. But if unstable policy of dividend is followed, cash planning in
anticipation of dividend is relatively difficult. The cash dividend may take two forms : i) Regular
dividend or Final dividend, and ii) Interim dividend
i) Regular Dividend
By dividend we mean regular dividend paid annually proposed by the board of directors and
approved by the share holders in general meeting. It is also known as final dividend because it is
usually paid after the finalization of accounts. It is generally paid in cash as a percentage of paid-up
capital, say 10% or 15% of the capital. Sometimes it is paid per share. No dividend is paid on calls
in advance or calls in arrears. The company is however, authorized to make provision or calls in
arrears.
1) Interim Dividend
If articles so permit, the directors may decide to pay dividend at any time between the two Annual
General Meetings before finalizing the accounts. It is generally declared and paid when company
has earned heavy profits or abnormal profit during the year and directors wish to pay the profits to
share holders such payments of dividend in between the two Annual General Meeting before
finalizing the accounts is called Interim Dividend. No Interim Dividend can be declared or paid
unless depreciation for the full year (not proportionately) has been provided for. It is, thus, an extra
dividend paid during the year requiring no need of approval of the Annual General Meeting. It is
paid in cash.
2) Stock Dividend
Companies, not having good cash position, generally pay dividend in the form of shares by
capitalizing the profits of current year and of past year. Such shares are issued instead of paying

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dividend in cash are called “Bonus Shares”. Basically there is no charge in the equity of share
holders. Certain guidelines have been issued by the company Law Board in respect of Bonus Shares.
3) Script Dividend
Scrip dividends are used when earnings justify a dividend, but the ash position of the company is
temporarily weak. So share holders are issued shares or debentures if other companies held by the
company at investment. Such payment of dividend is called Scrip Dividend. Share holders generally
do not like such dividend because the shares or debentures so paid are worthless for the share
holders as directors would use only such investments which they found were not good. Such
dividend was allowed before passing of the companies (Amendment) Act 1960, but thereafter this
unhealthy practice was stopped.
4) Bond Dividends
In rare instance, dividends are paid in the form of debentures or bonds or notes for long-term period
baring interest at fixed rate. The effect of such dividend is the same as that of paying dividend in
scrips. The share holders become the secured creditors if the bonds have a lien on assets.
5) Property Dividend
Sometimes, dividend is paid in the form of assets instead of payment of dividend in cash. The
distribution of dividend is made whenever the asset is no longer required in the business such as
investment or stock of finished goods. But, it is, however, important to note that in India,
distribution of dividend is permissible in the form of cash or bonus shares only. Distribution of
dividend in any other form is not allowed.
14. Calculate the operating leverage for each of the four firms A,B,C and D from the following
data.
Particulars Firms
A B C D
Rs. Rs. Rs. Rs.
Sale Price / unit 20 32 50 70
Variable cost/unit 6 16 20 50
Fixed operating cost 80000 40000 200000 Nil
Calculation of Operating Leverages :
Particulars Firms
A B C D
No. of Units sold 10000 10000 10000 10000
Sales 200000 320000 500000 700000
(-) Variable Cost 60000 160000 200000 500000
Contribution 120000 160000 300000 200000
(-) Fixed Cost 80000 40000 200000 NIL
EBIT 40000 120000 100000 200000

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Operating Leverage = Contribution

EBIT

Firm A = 120000
= 3 times
40000

Firm B = 160000
= 1.33 times
120000

Firm C = 300000
= 3 times
100000
Firm D = 200000
= 1 time
200000
15. ABC Ltd. Provides following details :
Profit 3,00,000
Less : Interest on debentures 60,000
Earnings before taxes 2,40,000
Less : taxes @ 35% 84,000
Earnings after taxes 1,56,000
No. of equity shares @ Rs.10 each 40,000
Earnings per share 3.9
Market price of share (Rs) 39
P/E ratio 10
The company has undistributed reserves, Rs.6,00,000. It needs Rs.2,00,000 for expansion which will
earn the same rates as funds already employed. The debt equity ratio higher than 35% will push the
P/E Ratio down to 8 and raise the interest rate on additional amount borrowed to 14%. Calculate the
price of equity share (1) If the additional funds are raised s debt; (2) If the amount is raised by equity
shares at current market price.
Calculation of Price of Equity Shares :
Particulars Additional Funds are raised as
DEBT EQUITY SHARES
Profit 300000 300000

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(-) Interest on Debentures 88000 60000

(60000 + 28000)
Earnings before taxes 212000 240000
(-) Taxes @ 35% 74200 84000
Earnings after taxes 1378000 156000
No. of equity shares @ Rs.10 each 40000 (40000 + 5128)
Earnings Per Share 3.445 3.457
Market Price of Share 27.56 34.57

MP 8 10
P/E Ration =P/E
EPS
16. The Evergreen company has the choice in raising an additional sum of Rs.50 Lakhs either by
the sale of 10% debentures or by issue of additional equity shares Rs.50 per share. The capital
structure of the company consists of 10 lakhs ordinary shares and not debt. At what level of
EBIT after the new capital is acquired, would EPS be the same whether new funds are raised
either by issuing ordinary shares or by issuing debentures? Also determine the level of EBIT at
which uncommitted EPS (UEPS) would be the same, if sinking fund obligation amount to Rs.5
Lakhs per year. Assume a 50% tax rate. Discuss the relevance of this calculation and also verify
your results. (May/June 2009)
Solution:
i) Determination of Indifference Point :
Debt Alternative = Equity Alternative
(X-I) (l-t) (X) (l-t)
=
N1 N2
(X-Rs.500000) (1-0.50) X (1-0.50)

1000000 1100000
1100000 [0.50 X – 250000] = 1000000 [X – 0.50X]
5.5X – 2750000 = 10X – 5X
5.5X – 2750000 = 5X
0.5 X = 2750000
X = 5500000
Verification Table:
Particulars 10% Debt Equity

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EBIT Rs.5500000 Rs.5500000

(-) Interest 500000 NIL
Earnings after interest 5000000 5500000
(-)Tax @ 50% 2500000 2750000
Earnings after tax 2500000 2750000
No. of Equity Shares 10000000 1100000
EPS 2.5 2.5

(X-I) (l-t)- S (X) (l-t)

=
N1 N2
(X-Rs.500000) (1-0.50) - 500000 X (1-0.50)
=
1000000 1100000

0.50 X – 250000) – 500000 0.50X

1000000 1100000
11 (0.50X – 750000) = 10(0.50X)
5.5X – 8250000 = 5X
0.5X = 8250000
X = Rs.16500000
Particulars 10% Debt Equity
EBIT 16500000 16500000
(-) Interest 500000 NIL
Earnings after interest 16000000 16500000
(-)Tax @ 50% 8000000 8250000
Earnings after tax 8000000 8250000
(-) Sinking Fund 500000 -
Earnings for equity holders 7500000 8250000
Number of equity shares 1000000 1100000
EPS 7.5 7.5
Conclusion : The relevance of indifference level of EBIT is that it enables the management to
take better financial decisions. It is a point beyond which the leverage (use of debt) becomes
favourable in that the use of debt could be employed to enhance to EPS. Therefore, if the
estimated EBIT is more than the indifference level, debt alternative to raise finance should be
used, otherwise the equity alternative would be preferred.

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The uncommitted EPS (UEPS) approach is useful to the conservative decision makers, who look to
debt not only in terms of interest payment but also in terms of its repayment. Therefore, they want to
get an idea of earnings which, could meet both the payments. However, this approach is of short-
terms significance only as after the redemption of debentures, the sinking fund balance is transferred
to general reserves and thus forms a part of the equity share holders funds.
17. Calculate financial leverage and operating leverage under situations A and B financial plans I
and II respectively from the following relation to the operations and capital structure of ABC ltd.
(May/June 2010)
Installed capacity 1000 units
Actual production and sales 800 units
Selling price per unit Rs. 20
Variable cost per unit Rs. 15
Fixed cost: situation-A Rs.800
Situation-B Rs.1500
Capital structure:
Financial plan
I II
Equity capital Rs. 5000 Rs. 7000
Debt Rs. 5000 Rs. 2000
SOLUTION: To be discussed in class
18. Explain the approach of weighted average cost of capital and state its limitations?
(May/June 2010)
The weighted average cost of capital (WACC) is the rate that a company is expected to pay on
average to all its security holders to finance its assets. The WACC is the minimum return that a
company must earn on an existing asset base to satisfy its creditors, owners, and other providers
of capital, or they will invest elsewhere. Companies raise money from a number of
sources: common equity, preferred equity, straight debt, convertible debt, exchangeable
debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and
so on. Different securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights of each
component of the capital structure. The more complex the company's capital structure, the more
laborious it is to calculate the WACC. In general, the WACC can be calculated with the
following formula:

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where N is the number of sources of capital (securities, types of liabilities); ri is the required rate
of return for security i; MVi is the market value of all outstanding securities i.
Tax effects can be incorporated into this formula. For example, the WACC for a company
financed by one type of shares with the total market value of MVe and cost of equity Re and one
type of bonds with the total market value of MVd and cost of debt Rd, in a country with corporate
tax rate t is calculated as:

Limitations of the WACC

1. Weighting System
a. Marginal Capital Costs
b. Capital Raised in Different Proportions than WACC
2. Flotation Costs are the costs associated with issuing securities such as underwriting, legal,
listing, and printing fees.
a. Adjustment to Initial Outlay
b. Adjustment to Discount Rate
19. How to measure the degree of operating, financial leverage? Illustrate with an example.
(Nov/Dec 2010)
1. OPERATING LEVERAGE
The operating leverage takes place when a change in revenue produces a greater change in EBIT.
It indicates the impact of changes in sales on operating income. A firm with a high operating
leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in sales
may enhance profits considerably, while a small decline in sales may reduce and even wipe out
the EBIT. Naturally, no firm likes to operate under conditions of a high operating leverage
because that creates a high-risk situation. It is always safe for a firm to operate sufficiently above
the break-even point to avoid dangerous fluctuations in sales and profits. The operating leverage
is related to fixed costs. A firm with relatively high fixed costs uses much of its marginal
contribution to cover fixed costs. It is interesting to note that beyond the break-even point, the
marginal contribution is converted into EBIT. The operating leverage is the highest near the
break-even point. After a firm reaches this point, even a small increase in sales results in a big
increase in EBIT.
The extent of the operating leverage at any single sales volume is calculated as follows:

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The change in the rate of earnings is based on the operating leverage resulting from the fact that
some costs do not move proportionally with changes in production. This leverage operates both
positively and negatively, increasing profits at a rapid rate when sales are expanding and
reducing them or causing losses when operations decline. If all the costs are variable, the rate of
profit would show fewer changes at different operating levels. The operating leverage, then, is
the process by which profits are raised or lowered in greater proportion than the changes in the
volume of production because of the inflexibility of some costs. The higher the fixed costs, the
greater the leverage and the more frequent the changes in the rate of profit (or loss) with
alternations in the volume of activity.
2. FINANCIAL LEVERAGE
It is generally accepted that investors seek to maximize their return on investments, subject to
given risk constraints, and that they demand a higher return for the greater risk involved in an
investment. The proportion of debt in the capital structure of a company is limited by two
factors:
 Investors risk preference
 Business risk associated with the nature of a company’s operations.
The determination of this limit, which is known as the corporate debt capacity, is an important
aspect of the financial policy of a company to get the maximum benefit from debt financing.
While the investors’ risk preference is difficult to assess because it varies from individual to
individual, business risk can be determined objectively.
20. Firms A and B are similar except that A is unlevered, while B has Rs. 200000 of 5%
debenture outstanding. Assume that the tax rate is 40%. NOI is Rs. 40000 and the cost of equity
is 10% . (Nov/Dec 2010)
(i) Calculate the value of the firm, if the M-M assumptions are met.
(ii) Suppose VB = Rs. 3,60,000, according to M-M ado these represent
equilibrium values?
(iii) How will equilibrium be set? Explain.
SOLUTION: To be discussed in class

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21. Discuss the various factors influencing the capital structures of a company. May/June
2011), (May/June 2012)
1. Financial leverage (or) Trading on equity
It is the use of long term fixed interest bearing debt and Preference shares along with equity
share capital. The use of long-term debt increases and magnifies the EPS if the firm yields a
return higher than the cost of debt. This is positive leverage. However, if the firm yields a lower
return than the cost of debt, it is adverse leverage. EPS also increases with the use of preference
share capital also, but due to the fact that interest is allowed to be deducted while computing the
tax, the leverage impact of debt is more.
2. Growth & Stability of Sales
If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt, as the
firm may not face any difficulty in meeting its fixed commitments of interest repayment of debt.
Usually, greater the rate of growth of sales, greater can be the use of debt in the financing of a
firm.
3. Cost of Capital
The capital structure should provide for minimum overall cost of capital depending upon the risk
involved, out of the three sources of capital (equity, preference and debt capital), debt usually is a
cheaper source because of (1) fixed rate of interest (2) legal obligation to pay interest (3) priority
in payment at the time of winding up of the company and (4) tax advantage. Preference capital
is also cheaper than equity because of lesser risk involved and fixed rate of dividend.
4. Cash flow ability to service debt
A firm which can generate higher and stable cash inflows can employ more debt in its capital
structure as compared to one which has unstable and lesser ability to generate cash inflows.
5. Nature and size of firm
Public utility concerns may employ more of debt due to their regular earnings. Small companies
due to their inability to raise long-term loans at reasonable rate of interest depend on own capital.
A large company can arrange for long-term loans and also can issue equity or preference shares
to be public.
6. Control
Issue of equity shares implies dilution of control of existing equity shareholders. Hence either
debt or preference capital is issued.
7. Flexibility
Capital structure of the firm should be flexible and must be able to substitute one form of
financing by another.
8. Requirement of Investors
The risk profile of the investors – institutional as well as private (risk averse, indifferent and
adventurous investors) should be matched with the risk characteristics of the capital instruments

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i.e. issue of equity shares to adventurous investors, issue of preference shares to indifferent
investors and issue of debt to risk averse investors.
9. Capital market conditions
If the share market is depressed the company should not issue equity shares. If there is boom
period, it should issue equity shares.
10. Assets structure
If major portion of the total assets of a company comprises of fixed assets, the company can
borrow long-term debts.
24. A firm has sales of Rs. 10,00,000, variable cost of 70%, total costs Rs.9,00,000 and debt of
Rs.5,00,000 at 10% rate of interest. Tax rate is 40%. What are the operating and financial
leverage and earning after tax (EBIT), how much of a rise in sales would be needed on a
percentage basis? (To be discussed in the class) (May/June 2011)
25. A company’s present capital structure contains 15,00,00 equity shares and 5,00,000
preferences shares. The firm’s current EBIT is Rs.7.2 million. Preference shares carry a dividend
of Rs. 122 per share. The earning per share is Rs. 2. The firm is planning to raise Rs. 10 million
of external financing. Two financing alternatives are being considered:
(i) Issuing 10,00,000 equity shares for Rs.10 each Issuing debentures for
Rs.10 million carrying 15% interest.
Compute the EPS-EBIT indifference point. Which is the best alternative? Solution: (To be
discussed in the class) (Nov/Dec 2011)
26. What is the difference between a policy of stable dividend payout ratio and a policy of
stable dividends or steadily changing dividends? What are the reasons for a firm to choose
a specific dividend policy?(Nov/Dec 2011)
Stable Dividend Policy
Stabile dividends have a positive impact on the market price of shares. If dividends are stable it
reduces the chance of speculation in the market and investors desiring a fixed rate of return will
naturally be attracted towards such securities. Stability of dividend means either a constant
amount per shares or a constant percentage of net earnings.
(1) Strict or Conservative dividend Policy which envisages the retention of profits on the cost of
dividend pay-out. It helps in strengthening the financial position of the company; (2) Lenient
Dividend Policy which views the payment of dividend at the maximum rate possible taking in
view the current earning of the company. Under such policy company retains the minimum
possible earnings; (3) Stable Dividend Policy suggests a mid-way of the above two views. Under
this policy, stable or almost stable rate of dividend is maintained. Company maintains reserves in
the years of prosperity and uses them in paying dividend in lean year. If company follows stable
dividend policy, the market price of this shares shall be higher. There are reasons why investors
prefer stable dividend policy. Main reasons are:-

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1. Confidence among Shareholders. A regular and stable dividend payment may serve to
resolve uncertainty in the minds of shareholders. The company resorts not to cut the dividend
rate even if its profits are lower. It maintains the rate of dividends by appropriating the funds
from its reserves. Stable dividend presents a bright future of the company and thus gains the
confidence of the shareholders an the goodwill of the company increases in the eyes of the
general investors.
2. Income Conscious Investors. The second factor favoring stable dividend policy is that some
investors are income conscious and favor a stable rate of dividend. They too, never favor an
unstable rte of dividend. A Stable dividend policy may also satisfy such investors.
3. Stability in Market Price of Shares. Other things beings equal, the market price very with
the rate of dividend the company declares on its equity shares. The value of shares of a company
having a stable dividend policy fluctuates not widely even if the earnings of the company turn
down. Thus, this policy buffer the market price of the stock.
4. Encouragement to Institutional Investors. A stable dividend policy attracts investments
from institutional investors such institutional investors generally prepare a list of securities,
mainly incorporating the securities of the companies having stable dividend policy in which they
invest their surpluses or their long term funds such as pensions or provident funds etc.
In this way, stability and regularity of dividends not only affects the market price of shares but
also increases the general credit of the company that pays the company in the long run.
Dividends paid by the firms are viewed positively both by the investors and the firms. The firms
which do not pay dividends are rated in oppositely by investors thus affecting the share price.
The people who support relevance of dividends clearly state that regular dividends reduce
uncertainty of the shareholders i.e. the earnings of the firm is discounted at a lower rate, k e
thereby increasing the market value. However, its exactly opposite in the case of increased
uncertainty due to non-payment of dividends. Two important models supporting dividend
relevance are given by Walter and Gordon.
Walter's model
James E. Walter's model shows the relevance of dividend policy and its bearing on the value of
the share.
Assumptions of the Walter model
1. Retained earnings are the only source of financing investments in the firm, there is no
external finance involved.
2. The cost of capital, k e and the rate of return on investment, r are constant i.e. even if new
investments decisions are taken, the risks of the business remains same.
3. The firm's life is endless i.e. there is no closing down.

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Basically, the firm's decision to give or not give out dividends depends on whether it has enough
opportunities to invest the retain earnings i.e. a strong relationship between investment and
dividend decisions is considered
Dividends paid to the shareholders are re-invested by the shareholder further, to get higher
returns. This is referred to as the opportunity cost of the firm or the cost of capital, k e for the
firm. Another situation where the firms do not pay out dividends, is when they invest the profits
or retained earnings in profitable opportunities to earn returns on such investments. This rate of
return r, for the firm must at least be equal to ke. If this happens then the returns of the firm is
equal to the earnings of the shareholders if the dividends were paid. Thus, its clear that if r, is
more than the cost of capital ke, then the returns from investments is more than returns
shareholders receive from further investments.
Walter's model says that if r<ke then the firm should distribute the profits in the form of
dividends to give the shareholders higher returns. However, if r>k e then the investment
opportunities reap better returns for the firm and thus, the firm should invest the retained
earnings. The relationship between r and k are extremely important to determine the dividend
policy. It decides whether the firm should have zero payout or 100% payout.
In a nutshell :
 If r>ke, the firm should have zero payout and make investments.
 If r<ke, the firm should have 100% payouts and no investment of retained earnings.
 If r=ke, the firm is indifferent between dividends and investments.
The market price of the share comprises of the sum total of :
 the present value if an infinite stream of dividends
 the present value of an infinite stream of returns on investments made from retained
earnings.
Therefore, the market value of a share is the result of expected dividends and capital gains
according to Walter.
Criticisms
Although the model provides a simple framework to explain the relationship between the market
value of the share and the dividend policy, it has some unrealistic assumptions.
1. The assumption of no external financing apart from retained earnings, for the firm make
further investments is not really followed in the real world.
2. The constant r and ke are seldom found in real life, because as and when a firm invests
more the business risks change.
30. Explain the impact of various combinations of operating and financial leverage? Which
combination is considered to be an ideal situation for a company? (May/June 2012)
Operating Leverage

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Operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify
the effects of changes in sales on its earnings before interest and taxes. Operating Leverage =
Contribution / Operating profit (EBIT)
Financial Leverage
Financial leverage is concerned with the effect of changes in EBIT on the earnings available
to equity shareholders. It is defined as the ability of a firm to use fixed financial charges to
magnify the effects of changes in EBIT on the earnings per share.
Financial Leverage = EBIT / PBT
Examples: to be discussed in class
31. A company needs Rs.5,00,000 for construction of a new plant. The following three financial
plants are feasible:
(i) The company may issue Rs. 50,000 ordinary shares at Rs. 10 per share.
(ii) The company may issue 25,000 ordinary shares at Rs. 10 per share and 2500
debentures of Rs. 100 denomination bearing a 8% rate of interest.
(iii) The company may issue 25,000 ordinary share at Rs. 10 per share and Rs. 2,500
preference share at Rs. 100 per hare bearing a 8% rate of dividend. If the company’s earnings
before interest and taxes are Rs. 10,000, Rs. 20,000, Rs. 40,000, Rs. 60,000 and Rs. 1,00,000,
What are the earnings per share under each of the three financial plans? Which alternative would
you recommend and Why? Determine the indifference points by formulating and solving
graphically. Assume a corporate tax rate 50%. (May/June 2013)
Solution:
Particulars Equity Firm

EBIT 10,000 20,000 40,000 60,000 1,00,000

Less: Interest - - - - -
PBT 10,000 20,000 40,000 60,000 1,00,000
Less: Tax@50% 5,000 10,000 20,000 30,000 50,000
EAT 5,000 10,000 20,000 30,000 50,000
Less : Pref Div - - - - -

Earnings to equity
shareholders 5,000 10,000 20,000 30,000 50,000
No. of Equity
Shareholders 50,000 50,000 50,000 50,000 50,000
EPS (Rs.) 0.10 0.20 0.40 0.60 1.00

Particulars Equity + Debt Firm

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EBIT 10,000 20,000 40,000 60,000 1,00,000

Less: Interest 20,000 20,000 20,000 20,000 20,000
PBT -10,000 0 20,000 40,000 80,000
Less: Tax@50% - - 10,000 20,000 40,000
EAT - - 10,000 20,000 40,000
Less : Pref Div - - - - -

Earnings to equity
shareholders -10,000 - 10,000 20,000 40,000
No. of Equity
Shareholders 25,000 25,000 25,000 25,000 25,000
EPS (Rs.) -0.40 - 0.40 0.80 1.60

Particulars Equity + Preference

EBIT 10,000 20,000 40,000 60,000 1,00,000

Less: Interest - - - - -
PBT 10,000 20,000 40,000 60,000 1,00,000
Less: Tax@50% 5,000 10,000 20,000 30,000 50,000
EAT 5,000 10,000 20,000 30,000 50,000
Less : Pref Div 20,000 20,000 20,000 20,000 20,000

Earnings to equity
shareholders -15,000 -10,000 0 10,000 30,000
No. of Equity
Shareholders *25,000 25,000 25,000 25,000 25,000
EPS (Rs.) -0.60 -0.40 0.00 0.40 1.20
32. Distinguish between operating and financial leverage. Explain the scope of operating
and financial leverage analysis for a financial executive in corporate profit and financial
structure. (May/June)
Following are the main differences between operating leverage and financial leverage:
1. Relation
Operating leverage shows the relationship between sales and operating profit. Financial leverage
show the relationship between operating profit and earning per share.
2. Cause
Operating leverage arises due to the use of fixed operating cost. Financial leverage arises due to
the use of debt or cost of financing.
3. Measurement Of Risk

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Operating leverage measures the business risk. Financial leverage measures the financial risk.
How Can A Company Control the Amount of Financial Leverage?
As the ratio of debt to equity increases, the degree of financial leverage increases. Remember
that a magnification of profits occurs whenever the company's managers make decisions that add
fixed costs to the company. If these managers borrow money at a fixed interest rate, the fixed
interest payments will tend to magnify the company's changes in income.
As sales and EBIT increase, the interest payments do not change. Therefore, more of this
operating cash flow is allowed to flow through to the owners because very little is siphoned off
in the form of higher expenses.
Is the Degree of Financial Leverage Affected by the Degree of Operating Leverage?
Yes, since both types of leverage tend to increase the risk of the company. Therefore, you would
normally like to "trade off" the risk of one against the other.
The total leverage of the company is the product of operating leverage and financial leverage,
i.e.,
Total Leverage = Operating Leverage * Financial Leverage
Of these three, the desired levels are determined in the order of left to right above: total leverage
first, operating leverage second and financial leverage last.
1. Total leverage determines the overall risk level of the company; this is set by the
company's owners (through its board of directors) and is reflected in the operating and
financial policies of the company. This decision is made first.
2. The degree of operating leverage is determined next. The company's production manager
will determine how the product is to be produced. Will it be produced by using a lot of
machinery (i.e., with a high degree of operating leverage) or by using a lot of labor (i.e.,
with a low degree of operating leverage)? The production manager will make this
decision after the board has decided how much overall risk it is comfortable with and
before the financial decisions are made.
3. The degree of financial leverage is determined last. How will the company's assets be
financed: (1) with a lot of debt and little equity or (2) with very little debt and a lot of
equity?
The contribution that leverage makes to risk is:
 high degrees of leverage lead to a high risk level for the company.
 average degrees of leverage lead to an average risk level for the company.
 low degrees of leverage lead to a low risk level of the company.

UNIT – IV
PART A (`10*2=20 MARKS)

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1. What is ‘Commercial paper’? State its two features. (May / June 2007), (May/June 2009)
(Nov/Dec 2011) (May/June 2012), (Nov/Dec 2013),
An unsecured, short-term debt instrument issued by a corporation, typically for the financing of
accounts receivable, inventories, and short-term liabilities. Maturities on commercial paper
rarely are longer than 270 days, and commercial paper usually is issued at a discount to
prevailing market interest rates. To help meet their immediate needs for cash, banks and
corporations sometimes issue unsecured, short-term debt instruments known as commercial
paper. Commercial paper usually matures within a year and is an important part of what's known
as the money market.
2. Z & Co. requires 2000 units of an item per year. The purchase price per unit is Rs. 30 the
carrying cost of inventory is 25% and the fixed cost per order is Rs.1000. Determine the
economic ordering quantity. (May / June 2007)
EOQ = √2co/c =√( 2*1000*2000 )/(30*0.25) = 730 units
3. List the three popular methods available for forecasting working capital requirements.
(Nov/ Dec 2007),
 Cash forecasting method –cash position at the end of the period
 Balance sheet method-based o assets & liability position
 Profit and loss adjustment method
 % of sales method
 Operating cycle method
4. What are the specific advantages of inventory control?(Nov/Dec 2007)
1. Maximize the level of customer service by avoiding under stocking
2. Promote efficiency in production and purchasing by minimizing the cost of
providing an adequate level of customer service.
5. What is Factoring?(May/June 2008), (May/June 2011), (Nov/Dec 2011)
Factoring is defined as an agreement in which receivables arising out of sale of goods or services
are sold to their ‘factor’ as a result of which the title to the goods/services represented by the said
receivables passes on to the factor. Debt collection services are called factoring services
6. What do you understand by the term “float”?(Nov/Dec 2008)
The cash balance shown by a firm on its books is called the ledger, whereas the balance shown in its
bank account is called the available or collected balance. The difference between the available
balance and the ledger balance is referred to as the float.
7. What is meant by ABC analysis? (Nov/Dec 2008)
ABC analysis is a selective approach to inventory control which calls for a great concentration on
inventory items accounting for the bulk of usage value. This analysis classified the inventors into
three categories :
“ Category A representing the most important items, generally consists of 15 to 25
percent of inventory items and accounts for 60 and 75 percent of annual usage value

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“ Category B representing the moderate important items, generally consists of 20 to 30

percent of inventory items and accounts for 20 to 30 percent of annual usage value
“ Category C representing the least important items, generally consists of 40 to 60
percent of inventory items and accounts for 10 to 15 percent of annual usage value
8. Present the diagram showing working capital operating cycle and brief (or) cash cycle.
(May/June 2008) (May/June 2009), (Nov/Dec 2009), (Nov/Dec 2013)
Time gap between purchase of raw materials into realization of cash, is termed as operating cycle of
the business.
The term “Operating Cycle” refers to the length of time necessary to complete the following cycle of
events :-Conversion of cash into inventory, -Conversion of inventory into receivables,-Conversion
of receivable into cash.
9.Explain the nature of cash.(Nov/Dec 2009)
Cash is the important current assets for the operations of the business. Cash is the basic input needed
to keep the business running on a continuous basis. Cash is the money which a firm can disburse
immediately without any restriction.
10. State the difference types of working capital?(May/June 2010) (Nov/Dec2012)
(i)Gross working capital (ii) Net working capital (iii) permanent working capital (iv) Variable
working capital.
11. How are receivables forecasted?(May/June 2010)
-Calculate former turnovers for receivables, -2. Calculate average turnovers for receivables,
-Forecast numbers using formula,-Sales forecasting
12. State the three motives of holding cash in a firm? (Nov/Dec 2010)
-Transaction Motive, -Precautionary Motive, -Speculative motive
13. A manufacturing company is need of 50000 units of a certain types of ball bearing next year.
The company spends Rs. 200 to process an order and it incurs Rs .5/p.a/year in holding the
bearing in inventory. Calculate economic ordering quantity. (Nov/Dec 2010)
Solution: To be discussed in class
14. State the objective of cash management.(May/June 2011)
1) To make Payment According to Payment Schedule, -(2) To minimize Cash Balance
15. Define the term fixed working capital?(May/June 2012)
Fixed or (permanent) working capital is the minimum amount of working capital required to
ensure effective utilization of fixed assets and support the normal operations of the business.
16. What does cash management mean? (May/June 2012)
Cash management refers to a broad area of finance involving the collection, handling, and usage
of cash. It involves assessing market liquidity, cash flow, and investments.
17. What is the significance of factoring? (May/June 2013)

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Factoring is a financial transaction whereby a business sells its accounts receivable (i.e.,
invoices) to a third party (called a factor) at a discount in exchange for immediate money with
which to finance continued business.
 Factoring could be helpful to any organization that works using records receivables, if
they are a wholesaler, maker, merchant, or in the administration business.
Organizations that are new, have negative total assets, or are development turned will
be helped the most by factoring.
 A practice of factoring helps minor entrepreneurs to tackle their money issues as well
as assistance in expanding deals. Minor entrepreneurs can additionally focus on their
organizations instead of pursuing their clients for installments and money.
 Factoring practice helps various sorts of minor to medium entrepreneurs if they are a
little trucking organization or any makers.
18. Define working capital.
The difference between the current assets and current liability is called working capital. It is the
life of the business.
19. What are the various forms working capital?
(i)Gross working capital (ii) Net working capital (iii) permanent working capital (iv) Variable
working capital.
20. What are the determinants of working capital?
The basic determinants are nature of business, size of business, seasonal variations, time
consumed in manufacture and terms of purchase and sales.
21. What Fluctuating working capital?
Fluctuating working capital is the extra working capital needed to support the changing
production and sales activities of the firm.
22. What is commercial paper?
Commercial paper is a form of unsecured promissory note issued by the blue chip companies to
raise short-term funds.
23. What are two concepts of working capital?
i. Gross working capital concepts, ii. Net working capital concepts.
24. List the three popular methods available for forecasting working capital requirements.
a. Cash forecasting method, b. the balance sheet method, the profit and loss adjustment method.
25. What are the motives of holding cash?
-Transaction motive, precautionary motive, speculative motive.
26. What is operating cycle?
Operating cycle is the length period required to convert sales, after acquisition of the resources
such as materials, power etc, into cash.
27. What are the motives for holding stock?

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a. Speculative motive, b.transaction motive, c.precationeay motive.

28. What are the specific advantages of inventory control?
-Reduction in investment in inventory
-Proper and efficient use of raw materials
-Improvement in production and sales
-No bottleneck in production
29. List the three popular methods available for forecasting working capital requirements.
-Cash forecasting method
-The balance sheet method
-The profit and loss adjustment method
30. What is EOQ?
The quantity of an inventory item to order so that total inventory costs are minimized over the
firms planning period.

PART- B (5*16 = 80 MARKS)

1. Discuss the various techniques of control of receivables. Also explain ‘Aging Schedule’.
(May/June 2007)
The credit policy followed by a firm should be optimum, i.e. neither too liberal not too stringent.
Since the basic objectives of committing funds to account receivable is to promote sales and
profits so as to generate a large flow of operating revenues, each and every firm must evaluate its
credit policy form time to time. For analyzing and controlling the investment in receivables by a
firm, the following techniques may be adopted:
1. Computation of average age of receivable.
2. Computation of Percentage of bad debts to receivables
3. Preparation of Receivable Investment Budget
4. Aging schedule of receivables
An account receivable is the money owed to a company by a consumer for products and services
purchased on credit. This is usually treated as a current asset of accounts receivable after the
customer is sent a invoice. Accounts receivable are known by various names, such as accounts
receivable aging, accounts payable, days receivable, accounts receivable turnover and invoice
factoring.
Accounts receivable management specialists can help you in a variety ways:
 It can cut and maintain your average collection delay or DSO.
 It can lessen your direct and indirect expenses.
 It ca considerably reduce your bad debt
 It can tell you various ways to take advantage of your cash-flow
 It can help you capitalize on your internal resources
 It can maximize your interventions on sales, service and market share.

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The accounts receivable aging schedule is a listing of the customers making up your total
accounts receivable balance. Most businesses prepare an accounts receivable aging schedule at
the end of each month. Analyzing your accounts receivable aging schedule may help you identify
potential cash flow problems.
The typical accounts receivable aging schedule consists of 6 columns:
1. Column 1 lists the name of each customer with an accounts receivable balance.
2. Column 2 lists the total amount due from the customers listed in column 1.
3. Column 3 is the “current column”. Listed in this column are the amounts due
from customers for sales made during the current month
4. Column 4 shows the unpaid amount due from customers for sales made in the
previous month. These are the customers with accounts 1 to 30 days past due
5. Column 5 lists the amounts due form customers for sales made two months prior.
These are customers with accounts 31 to 60 days past due.
6. Column 6 lists the amount due from customers with accounts over 60 days past
due
2. Assuming a year of 50 weeks of 5 days each, calculate the working capital requirements, using
the following data, sales 1,50,000 units at Rs.10/piece on credit. Customers are allowed 60 days
credit. Production cost include, Rs.5/piece for raw material, Rs. 2/piece for labour and
Rs.2.5/piece for other expenses. Production cycle time 20 days. Credit allowed by suppliers 50
days. Cash requirement is one quarter of the remaining current assets. Stock levels raw material,
40 days of supply and finished goods 30 days. Ignore work-in progress. (May/June 2007)
Solution:
Sales = 1,50,000 * 10 15,00,000
Less: Cost of Labour 2*1,50,000 = 3,00,000
Raw materials 5*1,50,000 = 7,50,000
Other expenses 2.5*1,50,000 = 3,75,000
________ 14,25,000
______
Profit 75,000
______
Calculations
Current Assets 57,600
Cash requirement ¼*57,600 = 14,400
_______
Total Current Assets 72,000
Less: Current Liabilities 15,000
________
Working Capital is 57,000
3. What is ‘float’ in cash management? Explain the different kinds of float in cash
management. (May/June 2007)
Managing the collection and disbursement of cash

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Float is the difference between bank cash and book cash represents the net effect of checks in the
process of collection
Float management involves controlling the collection and disbursement of cash, the objective in
cash collection is to reduce the lag between time customer pays and the time checks clear. The
objective of cash disbursement is to slow down payments, increase time when checks are written,
and received; in other words collect early, pay late.
Types of Float
1. Mail Float- when checks are trapped in the postal system
2. In-House Processing Float-time it takes for the receiver to process the check for deposit
3. Availability float-time is takes for the check to clear in the bank
4. Accelerating collection
1. Lockbox
Special post office box set up to intercept accounts receivable payments
2. Concentration banking
Checks are deposited into local bank, by sales office, surplus funds are transferred from the
deposit bank, to the concentration bank, bank clearing time is reduced because most customer’s
check are drawn on local bank rather than the concentration bank.
3. Wire transfers
Electronic transfer over computer
Delaying Disbursement
Some are stretching the rules
1. Write check on distant bank
2. Hold payment for several days after postmarked in office
3. Call supplier to verify statement accuracy for large amounts
4. Mail from distant post office
5. Mail from post office that requires a great deal of handling
6. Playing “games” with Disbursement Float, Zero Balance Accounts, Drafts- these are all
other ways to delay the disbursement of funds, cash managers must be careful because if
they are drawing on uncollected funds many ethical and legal questions will be raised…
Money market is the market for short term financial assets.
Sweep accounts- this is when the bank will take all excess Amount at the end of the business
day and will invest it for a firm.
Firms may have temporary cash surpluses for the following reasons
1. To help finance seasonal for cyclical activity.
2. To help finance planned expenditures
3. To provide for unanticipated contingencies.
4. A company has sales of Rs.10,00,000. Average collection period is 50 days, bad debt losses
6% of sales and collection expenses Rs. 10,000. The cost of funds is 15% p.a. the company has
two alternative collection programs. (May/June 2007)
I II
Average collection period 40 days 30 days

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reduced to
Bad debt losses reduced to 4% of sales 3% of sales
Collection expenses Rs.20,000 Rs. 30,000
Evaluate which program is viable
Solution:
Existing:
Total credit sales Rs.10,00,000
Less: bad debt @6% on sales Rs.60,000
_________
Rs. 9,40,000
Less: Collection Expenses Rs. 10,000
__________
Rs.9,30,000
Less: Amount Of funds is
10,00,000 *15/100*50/365 Rs.20,547
___________
Rs.9,09,453
___________
Average Collection period = No of day in a year
________________
DTR
50 = 365/DTR = 365/50 = 7.3 times
DTR = Net Credit Sales / Average accounts receivable
i.e = 7.3 = 9,09,453 / AAR = 1,24,582.60
I- Average collection period reduced to 40 days
Sales Rs.10,00,000
Less: Bad debts @4% Rs.40,000
___________
Rs.9,60,000
10,000*15%*40/365 Rs.16,438
___________
Rs. 9,23,562
Average Collection period = 365/DTR
40 = 365/DTR = 9.12
Debtor’s turnover ratio
Average accounts receivable
9.12 = 9,23,562 / AAR = 1,01,267.76
II- Average Collection period reduced to 40 days
Sales = Rs.10,00,000
Less: Bad debts @3% Rs.30,000
______________
Rs. 9,70,000
Less: Cost of Funds

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10,00,000 *15%*30/365 Rs. 12,328

_____________
Rs. 9,27,671
Average Collection period= 365/DTR
30 = 365/DTR = 12.16
Debtor’s turnover ratio
Average accounts receivable
12.16 = 9,27,61/AAR = 76,289
Conclusion
Out of the three closing Debtors:
i.e. 1) 1,24,582.60 2) 1,01,267.76 3) 76,289
The true one is least closing debtors, therefore the III rd programme is viable (i.e. alternative II)
5. A proforma cost sheet of a company provides the following particulars:
Elements of cost Amount per unit
Raw material 80
Direct Labour 30
Overheads 60
_______
Total Cost 170
Profits 30
_______
Selling price 200
______
The following further particulars are available:
Raw materials are in stock on average one month. Materials are in process, on average ½ month.
Finished goods are in stock on average one month. Credit allowed by suppliers is one month.
Credit allowed to debtors is two months. Lag in payment of wages is 1 ½ weeks. Lag is payment
of overhead expenses is one month. One-fourth of the output is sold against cash. Cash on hand
and at bank is expected to be Rs. 25,000.
You are required to prepare a statement showing the working capital needed to finance a level of
activity of 1,04,000 units of production. You may assume that production is carried on evenly
throughout the year, wages and overheads accrue similarly and a time period of 4 weeks is
equivalent to a month. (Nov/Dec 2007)
Solution:
Statement of working capital requirement
Current Assets
Raw materials: 1,04,000 *80*4/52 = 6,40,000
WIP
Raw material 1,04,000*80*2/52 3,20,000
Labour 1,04,000*30*2/52 1,20,000
Overhead 1,04,000*60*2/52 2,40,000

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Finished stock
Raw material 1,04,000*80*4/52 6,40,000
Labour 1,04,000*30*4/52 2,40,000
Overhead 1,04,000*60*4/52 4,80,000
Debtors
Raw material 1,04,000*80*8/52*3/4 9,60,000
Labour 1,04,000*30*8/52*3/4 3,60,000
Overhead 1,04,000*60*8/52*3/4 7,20,000
Cash in hand 25,000
__________
47,45,000
Less: Current Liabilities
Sundry creditors:
Raw material 1,04,000*80*4/52 6,40,000
Wages 1,04,000*30*1.5/52 90,000
Lag in payment 1,04,000*60*4/52=4,80,000 12,10,000
of OHS
___________
Net working capital requirement 35,35,000
___________
6. What are the objectives of inventory management? Explain. (Nov /Dec 2007).
Inventory Management:
Inventories are the stocks of the product of a company, and components thereof that makeup the
product. The different forms in which inventories exist are- raw materials, work in process (or
semi finished goods) and finished goods. Raw materials are those inputs that are converted into
finished product. Work in progress inventories are semi-finished products. That requires more
work before they are ready for sale. Finished goods inventories are those which are completely
manufactured products and are ready for sale. Raw materials and semi finished goods inventories
facilitate production while finished good inventories are required for smooth marketing
operations. Thus inventories serve as a line between the production and the consumption of
goods.
Inventories constitute, in every business concern, the most significant part of working capital or
current assets. Inventories in Indian industries constitute more than 60% of the current assets.
Inventories are significant elements in cost process. It is, therefore essential to control the
inventories. Inventories control is usually used in two ways-unit or physical control and value
control. Purchase and production department officials use this work in terms of unit control
because they are concerned only with the physical control of the inventories. Where as in
accounting department official use it in terms of value control because
Objectives of Inventory Management:
1. Ensuring continuous supply of materials
2. Efficient utilization of production facilities

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3. Controlling production and purchase levels

4. Maintaining Buffer stock against Fluctuations in Demand
5. Minimizing the wastage
6. Efficient services to the customers
7. Maintaining optimum level of inventory
8. Efficient use of capital
9. Minimizing carrying costs
10. Economics of purchase
11. Minimizing risk of loss
7. Purchase manager places order each time for a lot of 500 numbers of a particular item. From
the available data, the following results are obtained. (May/June 2008)
Inventory carrying cost - 40%
Ordering Cost per order - Rs.600
Cost per unit - Rs. 50
Annual Demand - 1,000
Find out the loss to the organization due to his ordering policy.
Solution:
Ordering cost = 1000/500 = 2 *6000 = 1,200
Carrying cost = 500/2
= 250 @40% of Rs. 50 =5,000
________
6,200
________
EOQ = √2CO/C
= √2*1000*600/20 = 250 units
Ordering cost = 4*600 = 2,400
Carrying cost = 250/2 *20 = 2,500
___________
4,900
____________
Loss to the company is 6,200 – 4,900= 1,300

8. Calculate the amount of working capital requirement for jolly & Co Limited from the
following information:
(Rs. per Unit)
Raw Materials 160
Direct Labor 60

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Overheads 120
_______
Total Cost 340
Profit 60
_______
Selling Price 400
Raw materials are held in stock on average for one month. Materials are in process on an average
for half month. Finished goods are in stock on a average for one month. Credit allowed by
suppliers is one month and credit allowed to debtors is two months. Time lag in payment of
wages is 1.1/2 weeks. Time lag in payment of overhead expenses is one month. One fourth of the
finished goods are sold against cash. Cash in hand and at bank is expected to be Rs. 50,000 and
expected level of production amounted to 1,04,000 units. You may assume that production is
carried on evenly throughout the year, wages and overheads accrue similarly and time period of
four weeks is equivalent to a month. (May/June 2008)
Solution:
Statement of working capital requirement
Current Assets
Raw materials: 1,04,000 *160*4/52 = 12,80,000
WIP
Raw material 1,04,000*160*2/52 = 6,40,000
Labour 1,04,000*60*2/52 = 2,40,000
Overhead 1,04,000*120*2/52 = 4,80,000
Finished stock
Raw material 1,04,000*160*4/5 = 12,80,000
Labour 1,04,000*60*4/52 = 4,80,000
Overhead 1,04,000*120*4/52 = 9,60,000
Debtors
Raw material 1,04,000*160*8/52*3/4 = 19,20,000
Labour 1,04,000*60*8/52*3/4 = 7,20,000
Overhead 1,04,000*120*8/52*3/4 = 14,40,000
Cash in hand 50,000
__________
94,90,000
Less: Current Liabilities
Sundry creditors:
Raw materials 1,04,000*160*4/52 = 12,80,000
Wages 1,04,000*60*1.5/52 = 1,80,000

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Lag in payment of Ohs1,04,000*120*4/52 =9,60,000 24,20,000

_________
Net working capital 70,70,000
9. A proforma cost sheet of a company provides the following particulars :
Particulars Amount / Unit
Elements of Cost Rs.
Raw Materials 80
Direct Labour 30
Overheads 60
Total Cost 170
Profit 30
Selling Price 200
The following particulars available :
Raw materials in stock, on average, one month; work in progress (completion stage 50 percent); on
average, half a month; finished goods in stock, on average, one month. Credit allowed by suppliers
is one month; credit allowed to debtors is two months; average tie lag in payment of wages is 1.5
weeks and one month in overhead expenses; one fourth of the output is sold against cash; cash in
hand and at bank is desired to be maintained at Rs.365000. Prepare a statement showing the working
capital needed to finance a level of activity of 104000 units of production. You may assume that
production is carried on evenly throughout the year and wages and overheads accrue similarly. For
calculation purposes; 4 weeks may be taken as equivalent to a month. (Nov/Dec 2008)
Solution:
Particulars Amount Amount
Rs. Rs.
Current Assets 640000
1. Stock of Materials (4 weeks)
2. WIP (2 weeks)
Materials 320000
Labour 120000
Overheads 240000 680000
3. Stock of finished goods (4 weeks)
Materials 640000
Labour 240000
Overheads 480000 1360000

4. Debtors (8 weeks)

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Materials 960000
Labour 360000 2040000
Overheads 720000 25000

5. Cash in hand and at bank

Total Current Assets 4745000

Less : Current Liabilities
1. Creditors 640000
2. Outstanding wages 90000
3. Outstanding Overheads 480000 1210000
Working Capital Required 3535000
10. Krishnan and Co. requires aluminum for its factory. The probability distributes on the daily usage
rate and the lead time for procurement are given below. (The distributions are independent) (May/June
2009)
Daily usage rate
Probability Lead time (in days) Probability
(in tones)
2 0.2 25 0.2
3 0.6 35 0.5
4 0.2 45 0.3
The stock out cost of estimated at Rs.8,000 per tonne and the carrying cost is Rs.2,000 per tonne per
year. Calculate (i) optimum level of safety stock and (ii) probability of stock out .
Calculation of Normal Usage
Normal usage = Average Daily usage x Average Lead Time
Average Lead Time = 25 x 0.2 + 35 x 0.5 + 45 x 0.3
= 36
Normal Usage = 36 x 3
= 108 tonnes
Calculation of Optimum Level of Stock :
Normal Usage = 108 tonnes
Daily usage rate Tonnes
2 108 / 2 = 54
3 108 / 3 = 36
4 108 / 4 = 27

Tonners Stock out cost Carrying cost Total

@ Probability Cost
@ Rs.8000 pt Rs.2000 per tonne Cost

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54 432000 108000 540000 0.2 108000

36 288000 72000 360000 0.6 216000
27 216000 54000 270000 0.2 54000
Optimum Level of Safety Stock = 27 tonnes
ii) Probability of stock out, when the safety stock is 27 tonnes :
= 0.06 + 0.10 = 0.16
11. Vivek and Co. is a large retailer of consumer durable, 25% of its sales are for cash; the balance is
on one month’s credit, though at least 20% (of the total sales), end up being collected in the second
month following sales. Work out the cash collections expected during April, May and June, using the
following data. (May/June 2009)
Rs. in lakhs
Total sales achieved in
January 100
February 120
March 160
Total sales estimated in :
April 200
May 200
June 200
Calculation Cash & Credit Sales & Its Realization.
Month Total sales Cash sales Credit Sales I Last
Realization Realization
January 100 25 75 55 20
February 120 30 90 72 18
March 160 40 120 96 24
April 200 50 150 120 30
May 200 50 150 120 30
June 200 50 150 120 30
Statement of cash collections Expected :
(Rs. In lakhs)
Particulars April May June
Cash sales 50 50 50
Credit Sales 96 120 120
Credit Sale (Bal) 18 24 30
Total 164 194 200
13. State the significance of working capital. Also state the advantages of adequate working
capital and disadvantages of redundant working capital. (May/June 2009)

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The problem of managing working capital has got a separate entity as against different decision
making issues concerning current assets individually. Working capital has to be regarded as one of
the conditioning factors in the long run operation of a firm which is inclined to treat it as no issues of
shot term analysis and decision making. The skills for working capital management are somewhat
unique, though the goals are the same as in managing current assets individually, viz to make on
efficient use of funds for minimizing the risk of loss to attain profit objectives.
Working capital may be regarded as the life blood of a business. It is a capital which is required to
look after the day to day operation of the business. Its effective provision can do much more to
ensure the success of a business. There are two concept of working capital gross concept and net
concept.
Significance of working capital:
Modern business enterprises produce goods in anticipation of demand. Goods produced are not sold
immediately. Cash for sales is also not realized immediately. From the time of purchases of raw
materials to the time of realizations of cash for sales made, an operating cycle is involved. The
following stages are usually found in the operating cycle of a manufacturing firm :
1) Conversion of cash in to raw material
2) Conversion of raw material into work in progress
3) Conversion of work in progress into finished goods
4) Conversion of finished goods into debtors through sales
5) Conversion of debtors into cash
There are time gap between purchase or raw materials and production, production and sales and
sales and realization of cash thus the need for working capital arises due to the time gap between
purchases of raw materials and realization of cash from sales. Working capital is need for the
following purposes.
1) To purchases raw materials spares and component parts
2) To incur day to day expenses
3) To meet selling cost such as packing advertising
4) To provide credit facilities to customers
5) To maintain inventories of raw materials work in progress and finished stock
Advantages of adequate working capital :
Working capital is the life blood and never center of a business. No business can be run successfully
without adequate of working capital. The advantages of working capital are :
1) Continuous production : Adequate working capital ensures regular supply of raw materials and
continuous production
2) Solvency and good will : Adequate working capital enables promote to creditors this helps in
creating and maintaining good will.

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3) Easy Loans : A concern having sufficient working capital enjoys liquidity and good credit
standing. Hence, it can secure loans from banks and other on easy and favourable terms.
4) Cash discount : Adequate working capital enable a concern to avail cash discounts on the
purchases, leading to a reduction in costs.
5) Regular payment of expenses : A company, which has ample working capital, can make regular
payment of salaries, wages and other day to day commitments. Such prompt payments raise the
morale of employees and increase their efficiency. As a result, costs are minimized and profit
increases.
6) Exploitation of market conditions : A concern with adequate working capital can exploit
favourable market conditions. It can buy its requirements of raw materials in bulk when the market
price is lower. Similarly, it can hold stock of finished goods to realize better prices.
7) Ability to face : Adequate working capital enables a concern to face business crises such as
depression, because during such period there is much pressure on working capital.
8) High return on investment : Adequate of working capital facilities continuous production and
effective utilization of fixed assets. Because of this, the concern is able to generate more profits and
ensure higher returns on investment.
Disadvantages of redundant working capital:
 Redundant or excessive working capital means the funds which earn no profit for the
business. Hence, the business cannot earn a proper rate of return on its investments.
 Due to low rate or return on investments, the value of shares may also fall.
 Redundant working capital may lead to unnecessary purchasing and accumulation of
inventories. As a result, chances of theft, waste and losses will increase.
 Excessive working capital is an indication of excessive debtors and defective credit policy.
Consequently, there may be delay in collection and higher incidence of bad debts.
 Excessive working capital makes management co placement. It leads to overall inefficiency
in the organization.
14. NMK brothers desires to purchase a business and has consulted you and one point on
which you are asked to advise them is the average amount of working capital which will be
required in the first year. You are given the following estimates and are instructed to add
10 percent to you computed figures to allow contingencies. (May/June 2009)
Particulars Amount for the year
Average amount locked up in stocks
Stock of finished goods 5000
Stock of stores and materials 8000
Average Credit given
In land Sales – 6 Weeks 3,12,000
Export Sales – 1.5 Weeks 78,000

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Lag in Payment of wages and others

Wages 1.5 weeks 2,60,000
Stores, materials – 1.05 months 48,000
Rent, loyalties – 6 months 10,000
Clerical staff – 0.5 month 62,400
Manager – 0.5 month 4,800
Miscelalneous Expenses – 1.5 months 48,000
Payments in advance
Sundry advances (paid in quarterly in advance) 8,000
Undrawn profits on the average throughout the year 11,000
Setup your calculations for the average amount of working capital required.
Solution:
Particulars Amount (in Rs.)
Current Assets :
Stock of Finished Goods 5000
Stock of Stores and Materials 8000
Debtors – Inland Sales (312000 x 6/52) 36000
Export Sales (78000 x 1.5/52) 2250
Advance Payment of Sunday
Expenses (8000 / 4) 2000
Total Current Assets (1) 53250
Current Liabilities :
Wages (260000 x 1.5 / 52) 7500 6000
Stores, Materials (48000 x 1.5 / 52) 5000
Rent, Loyalties (1000 x 6/12) 2600
Clerical Staff (64200 x 0.5/12) 200
Manager (4800 x 0.5 / 12) 6000
Misl.Expenses (48000 x 1.5 / 12)
Total Current Liabilities (2) 27300
Network Working Capital (1-2) 25950
Add : 10% Contingency allowance 2595
28545
Converted to nearest hundred Rs.28500
Advarge Amount of Working
Capital Required is Rs.28500
15. Discuss the factors that determine working capital. (May/June2010), (May/June 2013),
(May/June 2011), (Nov/Dec 2011), (May/June 2014),

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1. Nature of business:
In the case of public utility concern like railways, electricity etc most of the transactions are on
cash basis. Further they do not require large inventories. Hence working capital requirements are
low. On the hand, manufacturing and trading concerns require more working capital since they
have to invest heavily in inventories and debtors. Example cotton or sugar mil
2. Size of business
Generally large business concerns are required to maintain huge inventories are required. Hence
bigger the size, the large will be the working capital requirements.
3. Time consumed in manufacture
To run a long production process more inventories is required. Hence the longer the period of
manufacture, the higher will the requirements of working capital and vice-versa.
4. Seasonal fluctuations
A number of industries manufacture and sell goods only during certain seasons. For example the
sugar industry produces practically all sugar between December and April. Their working capital
requirements will be higher during this session. It is reduced as the sales are made and cash is
realized.
5. Fluctuations in supply
If the supply of raw materials is irregular companies, are forced to maintain huge stocks to avoid
stoppage of production. In such case, working capital requirement will be high.
6. Speed of turnover
A concern say hotel which affects sales quickly needs comparatively low working capital. This is
because of the quick conversion of stock into cash. But if the sales are slow, more working
capital will be required.
7. Terms of sales
Liberal credit sales will result in locking up of funds in sundry debtors. Hence a company, which
allows liberal credit, will need more working capital than companies, which observe strict credit
norms.
8. Terms of purchase
Working capital requirements are also affected by the credit facilities enjoyed by the company. A
company enjoying liberal credit facilities from its suppliers will need lower amount working
capital. (For example book shops). But a company that has to purchase only for cash will need
more working capital.
9. Labour intensive Vs. Capital intensive industries
In labour intensive industries, large working capital is required because of heavy wage bill and
more time taken for production. But the capitals intensive industries require lesser amount of
working capital because of have investment in fixed assets and shorter time taken for production.
10. Growth and expansion of business

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A growing concern needs more working capital to finance its increasing activities and expansion.
But working capital requirements are low in the case static concerns.
11. Price level changes
Changes in price level also affect the working capital requirements. Generally the rising prices
will require the firm to maintain large amount of working capital. This is because more funds
will be required to maintain the same amount of working capital to maintain the same level of
activity.
16. A corporation has presently no safety stock of raw materials of orders 30000 units every
30 days .Due to recent fluctuations in usage, the company finds it necessary to establish an
optimal safety stock. The probability distribution for inventory usage is as follows:(May/June
2010)
Usage (in units) probability
27000 0.04
28000 0.07
29000 0.17
30000 0.32
31000 0.20
32000 0.10
33000 0.06
34000 0.04
It takes 2 days to place an order and receive delivery. The average monthly carrying cost is
Re.1 per unit and the stock outs are estimated to cost Rs.3 per unit. You are required to find out
the optimal safety stock. Solution: To be discussed in class
17. With an example discuss the concept of working capital cycle. (Nov / Dec 2010)
WC cycle is the length period required to convert sales, after acquisition of the resources such as
materials, power etc, into cash.
Working capital (abbreviated WC) is a financial metric which represents operating
liquidity available to a business, organization or other entity, including governmental entity.
Along with fixed assets such as plant and equipment, working capital is considered a part of
operating capital. Net working capital is calculated as current assets minus current liabilities. It is
a derivation of working capital, that is commonly used in valuation techniques such as DCFs
(Discounted cash flows). If current assets are less than current liabilities, an entity has a working
capital deficiency, also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its assets cannot
readily be converted into cash. Positive working capital is required to ensure that a firm is able to
continue its operations and that it has sufficient funds to satisfy both maturing short-term

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debt and upcoming operational expenses. The management of working capital involves
managing inventories, accounts receivable and payable, and cash.

Current assets and current liabilities include three accounts which are of special importance.
These accounts represent the areas of the business where managers have the most direct impact:
 accounts receivable (current asset)
 inventory (current assets), and
 accounts payable (current liability)
The current portion of debt (payable within 12 months) is critical, because it represents a short-
term claim to current assets and is often secured by long term assets. Common types of short-
term debt are bank loans and lines of credit.

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An increase in working capital indicates that the business has either increased current assets (that
is has increased its receivables, or other current assets) or has decreased current liabilities, for
example has paid off some short-term creditors.
Implications on M&A: The common commercial definition of working capital for the purpose
of a working capital adjustment in an M&A transaction (i.e. for a working capital adjustment
mechanism in a sale and purchase agreement) is equal to:
Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus
assets and/or deposit balances. Cash balance items often attract a one-for-one purchase price
adjustment
Working capital management
Decisions relating to working capital and short term financing are referred to as working capital
management. These involve managing the relationship between a firm's short-term assets and
its short-term liabilities. The goal of working capital management is to ensure that the firm is
able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-
term debt and upcoming operational expenses.
Decision criteria
By definition, working capital management entails short term decisions - generally, relating to
the next one year period - which are "reversible". These decisions are therefore not taken on the
same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based
on cash flows and / or profitability.
 One measure of cash flow is provided by the cash conversion cycle - the net number of
days from the outlay of cash for raw material to receiving payment from the customer. As a
management tool, this metric makes explicit the inter-relatedness of decisions relating to
inventories, accounts receivable and payable, and cash. Because this number effectively
corresponds to the time that the firm's cash is tied up in operations and unavailable for other
activities, management generally aims at a low net count.
 In this context, the most useful measure of profitability is Return on capital (ROC). The
result is shown as a percentage, determined by dividing relevant income for the 12 months
by capital employed; Return on equity (ROE) shows this result for the firm's shareholders.
Firm value is enhanced when, and if, the return on capital, which results from working
capital management, exceeds the cost of capital, which results from capital investment
decisions as above. ROC measures are therefore useful as a management tool, in that they
link short-term policy with long-term decision making. See Economic value added (EVA).
 Credit policy of the firm: Another factor affecting working capital management is credit
policy of the firm. It includes buying of raw material and selling of finished goods either in
cash or on credit. This affects the cash conversion cycle.

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Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for
the management of working capital. These policies aim at managing the current
assets (generally cash and cash equivalents, inventories and debtors) and the short term
financing, such that cash flows and returns are acceptable.
 Cash management. Identify the cash balance which allows for the business to meet day
to day expenses, but reduces cash holding costs.
 Inventory management. Identify the level of inventory which allows for uninterrupted
production but reduces the investment in raw materials - and minimizes reordering costs -
and hence increases cash flow. Besides this, the lead times in production should be lowered
to reduce Work in Progress (WIP) and similarly, the Finished Goods should be kept on as
low level as possible to avoid over production - see Supply chain management; Just In
Time (JIT); Economic order quantity (EOQ); Economic quantity
 Debtors management. Identify the appropriate credit policy, i.e. credit terms which will
attract customers, such that any impact on cash flows and the cash conversion cycle will be
offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and
allowances.
 Short term financing. Identify the appropriate source of financing, given the cash
conversion cycle: the inventory is ideally financed by credit granted by the supplier;
however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to
cash" through "factoring".
18. The proforma cost sheet of a company provides the following data:
Cost per unit Rs
Raw materials 52.0
Direct labour 19.5
Overheads 39.0
Total cost per unit 110.0
Profit 19.5
Selling price 130.0
Following additional data is available:
Average raw materials in stock: One month; Average materials in process: half a month ;credit
allowed by the suppliers: one month ;credit allowed to the suppliers :one month; credit allowed
to the debtors: two months; time lag in payment of wages: one and half weeks; over heads :one
month; one forth of the sales are on cash basis: cash balance is expected to be Rs120,000.
Prepare a statement showing the working capital needed to finance a level activity of 7000
units of output.
SOLUTION: To be discussed in class

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19. Discuss the various sources of working capital in detail. (Nov/Dec 2010)
Sources of working capital are many. There are both external and internal sources. The external
sources are both short-term and long-term. Trade credit, commercial banks, finance companies,
indigenous bankers, public deposits, advances from customers, accrual accounts, loans and
advances from directors and group companies etc. are external short-term sources. Companies
can also issue debentures and invite public deposits for working capital which re external long
term sources. Equity funds may also be used for working capital. A brief discussion of each
source is attempted below.
Trade credit is a short term credit facility extended by suppliers of raw materials and other
suppliers. It is a common source. It is an important source. Either open account credit or
acceptance credit may be adopted. In the former as per business custom credit is extended to the
buyer, the buyer is not goring any debt instrument as such. The invoice is the basic document. In
the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The
bill of exchange evidences the debt. Trade credit is an informal and readily available credit
facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period
can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account
for the loss of interest for delayed payment.
Commercial banks are the next important source of working capital finance commercial
banking system in the country is broad based and fairly developed. Straight loans, cash credits,
hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal
forms of working capital finance provided by commercial banks. Straight loans are given with or
without security. A one time lump-sum payment is made, while repayments may be periodical or
one time. Cash credit is an arrangement by which the customers (business concerns) are given
borrowing facility up to certain limit, the limit being subjected to examination and revision year
after year. Interest is charged on actual borrowings, though a commitment charge for utilization
may be charged. Hypothecation advance is granted on the hypothecation of stock or other asset.
It is a secured loan. The borrower can deal with the goods. Pledge loans are made against
physical deposit of security in the bank’s custody. Here the borrower cannot deal with the goods
until the loan is settled. Overdraft facility is given to current account holding customers
overdraw the account up to certain limit. It is a very common form of extending working capital
assistance. Bill financing by purchasing or discounting bills of exchange is another common
form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter
accepts the same. The bill is discounted per cash will the banker. This is a popular form.
Finance companies around in the country. About 50000 companies exist at present. They
provide services almost similar to banks, though not they are banks. They provide need based
loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely
assistance may be obtained.

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Indigenous bankers also abound and provide financial assistance. to small business and trades.
They change exorbitant rates of interest by very much understanding.
Public deposits are unsecured deposits raised by businesses for periods exceeding a year but not
more than 3 years by manufacturing concerns and not more than S years by non-banking finance
companies. The RB! is regulating deposit taking by these companies in order to protect the
depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits
solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest
ceiling is also fixed. This form of working capital financing is resorted to by well established
companies.
Advances from customers are normally demanded by producers of costly goods at the time of
accepting orders for supply of goods. Contractors might also demand advance from customers.
Where sellers’ market prevail advances from customers may be insisted. In certain cases to
ensure performance of contract in advance may be insisted.
Accrual accounts are simply outstanding suppliers of overhead service requirements and the
like taxes due, dividend provision, etc.
Loans from directors, loans from group companies etc. constitute another source of working
capital. Cash rich companies lend to liquidity crunch companies of the group.
Commercial papers are unsecured promissory notes negotiable by endorsement and delivery.
Since 1990 CPs came to be introduced. There are restrictive conditions as to issue of commercial
paper& CPs are privately placed after RBI’s approval with any firm, incorporated or not, any
bank or financial institution. Big and sound companies generally float CPs.
Debentures and equity fund can be issued to finance working capital so that the permanent
working capital can be Mattingly financed through long term funds.
20. ABC Co. wants to relax its credit policy on sales from the current level of 1 month to 2
months. Due to this, sales would increase to Rs.72,00,000 from the present level of Rs 60,00,000
p.a. but the % of bad debt losses is likely to go up by 2% of sales which is now @ 3% of sales.
The company’s variable cost is 75% of sales and fixed expenses are Rs.12,00,000 p.a. The firm’s
required rate of return is 10% Advice the company on the implications of revising the credit
policy. (To be discussed in the class) (May/June 2011)
21. Explain in detail the cash management models proposed by Baumol and Miller Orr with their
merits and demerits. (Nov/Dec 2011), (May/June 2012)
Baumol model of cash management helps in determining a firm's optimum cash balance under
certainty. It is extensively used and highly useful for the purpose of cash management. As per the
model, cash and inventory management problems are one and the same.
William J. Baumol developed a model (The transactions Demand for Cash: An Inventory
Theoretic Approach) which is usually used in Inventory management & cash management.
Baumol model of cash management trades off between opportunity cost or carrying cost or

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holding cost & the transaction cost. As such firm attempts to minimize the sum of the holding
cash & the cost of converting marketable securities to cash.
Relevance
At present many companies make an effort to reduce the costs incurred by owning cash. They
also strive to spend less money on changing marketable securities to cash. The Baumol model of
cash management is useful in this regard.
Use of Baumol Model
The Baumol model enables companies to find out their desirable level of cash balance under
certainty. The Baumol model of cash management theory relies on the trade off between the
liquidity provided by holding money (the ability to carry out transactions) and the interest
foregone by holding one's assets in the form of non-interest bearing money. The key variables of
the demand for money are then the nominal interest rate, the level of real income which
corresponds to the amount of desired transactions and to a fixed cost of transferring one's wealth
between liquid money and interest bearing assets.
Assumptions There are certain assumptions or ideas that are critical with respect to the Baumol
model of cash management:
 The particular company should be able to change the securities that they own into cash,
keeping the cost of transaction the same. Under normal circumstances, all such deals
have variable costs and fixed costs.
 The company is capable of predicting its cash necessities. They should be able to do this
with a level of certainty. The company should also get a fixed amount of money. They
should be getting this money at regular intervals.
 The company is aware of the opportunity cost required for holding cash. It should stay
the same for a considerable length of time.
 The company should be making its cash payments at a consistent rate over a certain
period of time. In other words, the rate of cash outflow should be regular.
Equation Representations in Baumol Model of Cash Management:
 Holding Cost = k(C/2)
 Transaction Cost = c(T/C)
 Total Cost = k(C/2) + c(T/C)
Where T is the total fund requirement, C is the cash balance, k is the opportunity cost & C is the
cost per transaction.
Limitations of the Baumol model:
1.It does not allow cash flows to fluctuate.
2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.
Miller and Orr Model of Cash Management

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The Miller and Orr model of cash management is one of the various cash management models
in operation. It is an important cash management model as well. It helps the present day
companies to manage their cash while taking into consideration the fluctuations in daily cash
flow.
Description of the Miller and Orr Model of Cash Management

As per the Miller and Orr model of cash management the companies let their cash balance move
within two limits - the upper limit and the lower limit. The companies buy or sell the marketable
securities only if the cash balance is equal to any one of these.
When the cash balances of a company touches the upper limit it purchases a certain number of
salable securities that helps them to come back to the desired level. If the cash balance of the
company reaches the lower level then the company trades its salable securities and gathers
enough cash to fix the problem.
It is normally assumed in such cases that the average value of the distribution of net cash flows is
zero. It is also understood that the distribution of net cash flows has a standard deviation. The
Miller and Orr model of cash management also assumes that distribution of cash flows is normal.
Application of Miller and Orr Model of Cash Management
The Miller and Orr model of cash management is widely used by most business entities.
However, in order for it applied properly the financial managers need to make sure that the
following procedures are followed:
 Finding out the approximate prices at which the salable securities could be sold or bought
 Deciding the minimum possible levels of desired cash balance
 Checking the rate of interest
 Calculating the SD (Standard Deviation) of regular cash flows
22. “ The average age of receivable is an important yard stick of testing the efficiency of
receivable management of a firm” – Discuss. (May/June 2012)
Managing Accounts Receivable
• Generally firms like as little money as possible tied up in receivables
• Reduces costs (firm has to borrow to support the receivable level)
• Minimizes bad debt exposure
But, having good relationships with customers is important
 Increases sales
• Firm needs to strike a balance on these issues
Trade-offs in Receivable Management
Liberal Management Strict Management
More sales and gross margin, but Less sales and gross margin, but

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 More bad debts  Less bad debts

 Higher collection costs  Lower collection costs
 More discount expenses  Less discount expenses
 Higher receivables  Lower receivables
 Longer collections  Shorter collections
 More interest expense  Less interest expense

Managing Accounts Receivable

• Policy Decisions Influencing Accounts Receivable
a. Credit Policy
• Criteria used to screen credit applications
• Controls quality of accounts to which credit is extended
b. Terms of Sale
• Terms and conditions under which credit extended must be repaid
c. Collections Policy
• Methods employed to collect payment on past due accounts
a. Credit Policy
• Must examine creditworthiness of potential credit customers
 Credit report
 Customer’s financial statements
 Bank references
 Customer’s reputation among other vendors
• Conflicts often arise between sales and credit departments
 Sales department’s job to generate sales
 Credit department may refuse credit to high risk accounts
b. Terms of Sale
 Credit sales are made according to specified terms of sale
 Example: 2/10, net 30 means customer receives 2% discount if payment
is made within 10 days, otherwise entire amount is due by 30 days
 Customers pay quickly to save money
 Firm’s terms of sale generally follow industry practice
c. Collections Policy
• Firm’s collection policy—manner and aggressiveness with which firm pursues
payment from delinquent customers
 Being overly aggressive can damage customer relations

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• Function of collections department— to follow up on overdue receivables

(called dunning)
 Mail polite letter
 Follow up with additional dunning letters
 Phone calls
 Collection agency
 Lawsuit
23. From the following information prepare a statement in columnar form showing the working
capital requirements: Budgeted sales (Rs. 10 per unit) Rs. 2, 60,000.
Analysis of one rupee of sales:
Raw materials 0.30
Direct labour 0.40
Overheads 0.20
TOTAL COST0.90
Profit 0.10
Sales 1.00
It is estimated that
(i) Raw materials are carried in stock for three weeks and finished goods for two weeks
(ii) Factory processing will take three weeks
(iii) Suppliers will give full five weeks credit
(iv) Customers will require eight weeks credit
It may be assumed that production and overheads accrue evenly throughout the year. (May/June
2012) Solution : To be discussed in class
23. What are the different methods of forecasting working capital requirement of a
business? Explain. (May/June 2012)
In order to estimate the extent of working capital requirement of a firm, several factors are to be
considered. There are several methods / techniques for estimating the working capital
requirements of a firm. They include – i) Estimation of components of working capital method,
ii) Percent of sales method and iii) Operating cycle method.

1. Estimation of components of working capital method

As the concept of net working capital refers to the difference between current assets and current
liabilities, estimation of both may give the potential working capital requirement of the firm.
2. Percent of sales method

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According to this method, based on the past data, the relationship between sales and working
capital are found out and are expressed as a ratio. The application and calculation of this ratio on
estimated future sales will give the extent of working capital needs of the firm.
3. Operating cycle method
Operating cycle is the time duration required to convert sales, after the conversion of resources
into inventories and cash. The operating cycle of a manufacturing co involves 3 phases – i)
acquisition of resources such as raw material, labor, power and fuel etc, ii) manufacture of the
product that includes conversion of raw material into work in process and into finished goods,
and iii) sales of the product either for cash or credit. Credit sales create book debts for
collection (debtors).
The length of the operating cycle of a manufacturing co is the sum of – i) inventory conversion
period (ICP) and ii) Book debts conversion period (BDCP). Together, they are sometimes called
as gross operating cycle (GOC). GOC = ICP + DCP. The Inventory conversion period is the total
time needed for producing and selling the product and includes – (a) raw material conversion
time (RMCP), (b) work in process conversion period (WIPCP) and (c) Finished good conversion
period (FGCP) ICP = RMCP + WIPCP + FGCP. The payables deferral period (PDP) is the length
of time the firm is able to defer payments on various resource purchases. The difference between
the gross operating cycle and payables deferrals period is the net operating cycle (NOC). NOC =
GOC- Payables deferral period
24. Write note on commercial paper and bank finance. (May/June 2012), (May/June2014),
Commercial paper is a short-term obligation (either secured or unsecured) of a large credit-
worthy firm (or foreign government).
 Short-term, in this case, means less than 270 days.
 Unsecured means that no collateral backs the security. About half of all commercial
paper in the U.S. is asset-backed and half is unsecured.
 Obligation means a debt that must be repaid.
 Large, credit worthy firms are the only companies that have a strong enough reputation to
persuade buyers to invest in an unsecured security.
Features of commercial paper:
1. They are negotiable by endorsement and delivery and hence they are flexible as well as liquid
instruments. Commercial paper can be issued with varying maturities as required by the issuing
company.
2. They are unsecured instruments as they are not backed by any assets of the company which is
issuing the commercial paper.
3. They can be sold either directly by the issuing company to the investors or else issuer can sell
it to the dealer who in turn will sell it into the market.

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4. It helps the highly rated company in the sense they can get cheaper funds from commercial
paper rather than borrowing from the banks.
There are three types of commercial paper:
1. Finance paper - The largest issuers of commercial paper are banks and finance
companies.
o Banks often borrow money through the sale of short-term commercial paper and
then lend the money at a higher interest rate over a longer term.
o Finance companies often use the proceeds to help customers finance the purchase
of products from the parent corporation. Examples of active issuers of commercial
paper are General Electric Capital, General Motors Acceptance Corporation
(GMAC), and Ford Motor Credit. The finance companies sell commercial paper
and lend the money to customers who, in turn, buy new products like turbines and
automobiles from the parent company.
2. Industrial paper - Industrial companies use commercial paper to finance working capital
(accounts receivable and inventory) on both a permanent or seasonal basis, to fund
operating expenses, and occasionally to finance, on a temporary basis, construction
projects.
3. Asset-backed paper - In the past, commercial paper has typically been unsecured (i.e,
has no collateral). This is rapidly changing and investors are increasing insisting that
some of the company's assets be pledged as collateral, in case the company is unable to
pay upon maturity of the commercial paper.
Cost
For high-quality issuers, the yield on commercial paper is generally cheaper than the interest rate
on comparable bank loans. In fact, it is among the cheapest of all financial instruments. The rate
on commercial paper is generally slightly above the rate that the U.S. government pays on
Treasury bills.
Sold at a Discount
Although there are exceptions, commercial paper typically is sold at a discount to its face value,
i.e., the investor buys the paper at less than face value and receives the face value upon maturity.
(It is occasionally sold as an interest-bearing note.)
Bank Finance:
The bank directly lending money to the company for new or existing projects.
25. Prepare an estimate of working capital requirement from the following information of a
trading concern:
(i) projected annual sales – 1,50,000 units
(ii) Selling price Rs. 10 per unit
(iii) Percentage of net profit as sales 30

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(iv)Average credit period allowed to customers – 10 weeks

(v) Average credit period allowed to supplies – 6 weeks
(vi) Average stock holding in terms of sales requirement – 10 weeks
(vii) Allow 15% for contingencies.
Solution:
Projected Sales 1, 50,000*10 = 15, 00,000
Less: NP on sales 30% = 4, 50,000
Cost of sales = 10, 50,000
Statement of working capital requirements
Current Assets Rs
Debtors 1050000*10/52 2,01,923
Stock 1050000*10/52 2,01,923
Total Current Assets 403846
Current Liabilities
Creditors 1050000*6/52 121154
Total current liabilities 121154
Working capital (CA-CL) 282692
Add: 15% Contingencies 42,404
Working capital required 325096

26. What are the Factors Determining Size of Investment in Receivables? (May/June2014)
Receivables represent the amounts owed to the company as a result of sales of goods and
services in normal course of business. These are the claims of the firm against customers and
form a part of current assets. Receivables are also termed as account receivables, customer
receivables, trade receivables or book debts.
Size of credit sales
The volume of credit sale is the first factor that influences receivables. Firm adhering to cash
sales would have low receivables when compared to firms allowing sales on credit. Higher the
credit allowed more will be the receivables and vice a versa
Credit Policies
Firm with conservative credit policies will have low receivables when compared with firms
following liberal credit policies. The vigour with which the concern collects the receivables also
affects the size of its receivables. Prompt collections even with liberal credit policies will help in
keeping receivables under control. Outstanding for long period may result in bad debts.
Terms of trade
The period for which the credit is allowed will decide the extent of receivables. Longer the
period of credit more would be the receivables. Again, cash purchases followed up with credit
sale is the main reason for increasing receivables.

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Expansion plans
Concerns that want to expand has to enter new markets. To attract customers it becomes
necessary for the enterprise to provide incentives in terms of credit. Once the concern gets the
permanent customers it may start reducing the period for which credit was allowed.

Credit collection efforts

A concern should always have strong and well equipped credit collection machinery. Periodical
reminders should be sent to customers in order to reduce the size of outstanding. Delayed
collection will increase receivables and will impose serious financial troubles for the company.
27. What are the Factors Affecting The Size Of Investment In Inventories Or Determinants
Of Inventories?
The size of investment in inventories is affected by a number of factors. Some of them are as
follows:
1. Level Of Safety Stock
If a firm maintains high level of safety stock because of relatively larger degree of uncertainty
associated to production and sales, the size of investment in inventories is also higher.
2. Carrying Costs
If the costs of holding inventories in stock is relatively low, the firm keeps larger stocks of
inventories.
3. Economy in Purchase
If the firm is likely to receive certain benefits in the form of cash discount for purchase made
currently, the size of investment in inventories is also likely to be larger because of larger
quantity purchase.
4. Possibility Of Price Rise
If the price of materials is likely to rise in near future, the firm makes larger quantity purchase at
present.
5. Cost And Availability Of Funds
If the cost of funds to be invested in inventories is relatively cheaper and they are conveniently
available at present, the firm makes large purchase of inventories.
6. Possibility Of Rise In Demand
If the firm has anticipated the increased demand of its products in future, it maintains larger
stocks of inventories at present.
7. Length Of Production Cycle
If the length of production cycle is relatively longer, the firm has to maintain investment in work-
in-progress inventories for longer duration of time as a result of which the size of investment in
inventories increases.
8. Availability Of Material

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If certain kind of materials are only available in a particular season only, the firm has to increase
the investment in inventories to keep larger stocks in the season.
9. Nature And Size Of Business
If the firm deals with the business of perishable products, the size of investment in inventories
become lower. For a firm with relatively larger size and wide market coverage, the investment in
inventories is larger.

UNIT – V
PART A(`10*2=20 MARKS)
1. Distinguish ‘authorized share capital’ and Paid-up share capital on two aspects.
(May / June 2007)
Authorized share capital is the amount of shares that a company is allowed to issue. The amount
of authorized capital is specified in a company’s memorandum of association and there needs to
be a shareholder meeting to change the amount. Not all of the authorized share capital has to be
issued. Authorized capital is that capital which is decided by the Registrar (recruited under
companies act, 1956) as the maximum amount that can be raised from the shareholders. Say
Rs.20 Crores.
Issued capital is that part of the authorized capital which is brought before the public for
subscription. Say Rs. 18 crores. Subscribed capital is that part of the issued capital that is
actually subscribed by the public. Say 16 crores. Paid-up capital is that part of the subscribed
capital that is collected by the company as a part payment. Say 8 cores. The due part will be
collected by the company is the immediate future.
2. What is meant by debenture? (Nov/Dec 2007)
A Debenture is a long-term Debt Instrument issued by government and big institutions for the
purpose of raising funds. The Debenture has some similarities with bonds but the terms and
conditions of securitization of Debentures are different from that of a Bond. A Debenture is
regarded as an unsecured investment because there are no pledges (guarantee) or liens available
on particular assets. Nonetheless, a Debenture is backed by all the assets which have not been
pledged other wise
3. Name the three parties in leveraged lease transactions (Nov/Dec 2007)
A leveraged lease is one that involves a third party who is a lender, in addition to the Lessor and
Lessee. Under this agreement, the lessor borrows fund from the lender and himself act as equity
participant. Normally, the amount borrowed is substantial vis-avis the funds provided by the
Lesssor himself. The third party usually involved in financing the transaction is a Financial
Institution like UTI, Insurance Company, Commercial Banks, etc.,
4. What is operating Lease? (May/June 2008)

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Operating lease is where by the lessee acquires the use of an asset on a period-to-period basis.
The main characteristics of operating lease are as follows:
 The lease can be cancelled by the lessee prior to its expiration at a short notice
 The lessee is not given any uplift to purchase the asset at the end of the lease period
 The lease is for a smaller period
 The sum of all the lease payments by the lessee does not necessarily fully provide for the
recovery of the cost of the asset.
 The lessor has the option to lease out the asset again to another party
 This type of lease is preferred by the lease when the long-term suitability of the asset is
required to for uncertain, when the asset is subject to rapid obsolescence or when the asset is
required for immediate use to tide over a temporary problem. Computers and Office Equipment
are the very common assets which form the subject matter of many operating Lease agreement.
5. Name any two venture capital firms? (May/June 2008)
ICICI Venture, Gujarat venture capital
6. Distinguish between term loan and bought out deal. (Nov/Dec 2008)
Term loans given by financial institutions and banks have been the primary source of long term debt
for private firms and most public firms. Term loans differ from Bought out deal which is employed
to finance short term working capital nee and tend to be self liquidating over a period time, usually
less than one year.
7. Name at least 4 intermediaries associates with a company’s issue of capital. (Nov/Dec 2008)
-Underwriter,-Stock Exchanges,-Merchant Banker,-Stock Brokers
8. State and brief any four rights of equity share holder.(May/June 2009)
-Right to income,-Right to dividend, -Right to control, -Pre-emptive rights, -Voting right
11. Distinguish between debenture and preference share capital. (May/June 2009)
* Debentures holders are paid interest on debentures. Preference share holders are paid
dividend on the shares.
 Payment of interest for debenture holders is a legal obligation. It is payable even if there are
no profits. Payments of dividend for preference share holder is not obligatory.
 Interest on debentures is tax deductible. Dividend on preference shares not tax deductible.
12. Define ‘Lease’. (Nov/Dec 2009)
Lease is a contract between a lessor, the owner of the asset and a lessee, the user of the asset. Under
the contract, the owner gives the right to use the asset to the user over an agreed period of time for a
consideration called the lease rental.
13. Define Hire Purchase. (Nov/Dec 2009)
Hire-Purchase is a mode of financing the price of the goods to be sold on a future data. In a hire-
purchase transaction, the goods are let on hire, the purchase price is to be paid in installments and
linear is allowed on option to purchase the goods by paying all the installments.
14. State the various features of term loans? (May/June 2010)

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-Maturity, -Negotiation, -Security, - Interest Payment And Principal Repayment

15. Define the term” venture capital”? (May/June 2010)
Venture refers to risky start-up of an enterprise or company. Venture Capital is the money and
resources made available to start firms and small businesses with exceptional growth potential.
Most Venture Capital money comes from an organized group of wealthy investors.
16. State and brief any four rights of equity share holder. (Nov/Dec 2010)
Ordinary or equity or common shares are shares which are not preferred with regard to
dividend payments. The ordinary shareholder receives dividend after fixed dividends have been
paid to preference shareholders. Ordinary dividends fluctuates. When the company is wound up,
surplus not distributed is shared between the ordinary shareholders. Ordinary shares carry voting
rights, thus ordinary shareholders are the effective owners of a company. They own the equity
and reserves of the business.
17. What is’ BOOT’ in project financing? Quote a practical example. (Nov/Dec 2010)
Build-own-operate-transfer (BOOT) or build-operate-transfer (BOT) is a form of project
financing, wherein a private entity receives a concession from the private or public sector to
finance, design, construct, and operate a facility stated in the concession contract. This enables
the project proponent to recover its investment, operating and maintenance expenses in the
project. Due to the long-term nature of the arrangement, the fees are usually raised during the
concession period. The rate of increase is often tied to a combination of internal and external
variables, allowing the proponent to reach a satisfactory internal rate of return for its investment.
18. What do you mean by private equity?(May/June 2011), (Nov/Dec 2011), (Nov/Dec 2014),
Private equity consists of investors and funds that make investments directly into private
companies or conduct buyouts of public companies that result in a delisting of public equity.
Capital for private equity is raised from retail and institutional investors, and can be used to fund
new technologies, expand working capital within an owned company, make acquisitions, or to
strengthen a balance sheet.
19. What are the advantages of debentures as a source of funds? (Nov/Dec 2011)
The Advantages of Debentures are as follows:
1) The holders of the debentures are entitled to a fixed rate of interest. It can be presented as "5%
Debenture".
2) Debentures are for those who want a safe and secure income as they are guaranteed payments
with high interest rates.
3) They have priority over other unsecured creditors when it comes to debt repayment.
20. What is NIMs?(May/June 2012)
 New Issues Market (NIM) comprises all people, institutions, method/mechanism,
services and practices involved in raising fresh capital for both new and existing
companies. This market is also called primary market.

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 NIM helps raising resources from the investors by issuing them only new or fresh
securities. Thus, NIM facilities direct conversion of savings into corporate
investment or diversion of resources from the rest of the system to the corporate
sector,
22. What are the various sources of short-term finance? (May/June 2012)
-Short term working capital loans, -Trade credit,-Credit papers, - Customers credit,
- Factoring.
23. What do you mean by venture Capital? (May/June 2012)
Venture refers to risky start-up of an enterprise or company. Venture Capital is the money and
resources made available to start firms and small businesses with exceptional growth potential.
Most Venture Capital money comes from an organized group of wealthy investors

24. Distinguish Primary and Secondary Capital markets. (Nov/Dec 2010)

SI.NO Primary Market Secondary Market
1 It deals only with new or fresh issue Deals in existing security
of security
2. No fixed geographical location Need a fixed place to house the
needed secondary market activities, viz., trading.
3. Creating long-term instrument for Providing liquidity through
borrowings. marketability to those instruments
25. Explain the role of Indian capital market.(May/June2013)
1. Growth of savings,
2. Efficient allocation of investment resources,
3. Better utilization of the existing resources.
26. What are the benefits of lease financing? May/June2013)
a. Leasing also allows businesses to upgrade assets more frequently ensuring they
have the latest equipment without having to make further capital outlays.
b. To buy a new piece of machinery or equipment can be costly and requires
substantial capital. Leasing enables businesses to preserve precious cash reserves.
c. It offers the flexibility of the repayment period being matched to the useful life of
the equipment.
d. It gives businesses certainty because asset finance agreements cannot be cancelled
by the lenders and repayments are generally fixed.
26. What is meant by capital market?

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The Capital market is a market for financial investments that are direct or indirect claims to
capital. It is wider than the Securities Market and embraces all forms of lending and borrowing,
whether or not evidenced by the creation of a negotiable financial instrument. The capital market
comprises the complex of institutions and mechanisms through which intermediate team funds
and long term funds are pooled and made available to business, government and individuals. The
capital market and in particular the stock exchange is referred to as the barometer of the
economy.
27. What do you understand by financial markets?
Markets that deal with cash flows over time where the savings of lenders are allocated to the
financing needs of borrowers.
28. What is bond?
An instrument for long-term debt.
29. What is debenture?
Bonds issued by a company bearing a fixed rate of interest usually payable half-yearly on
specific dates and principle amount repayable on particular date on redemption are known as
debentures.
30. What is spontaneous financing?
Spontaneous financing refers to the automatic source of short-term funds arising in the normal
course of a business. Trade credit and outstanding expenses are examples.

PART- B (5*16 = 80 MARKS)

1. Explain the steps involved in a lease arrangement and a hire purchase agreement.
(May/June 2007)
Leasing
Lease is a contractual arrangement by which a firm or a person acquires the right to use an asset
for a definite period, in return for rent payable at regular intervals. Leasing is an alternative
source of funds. It has certain advantages as listed below:
1. Availability of 100 per cent financing
2. Tax deduction on lease payments
3. Possibility of a faster tax write-off depending on the payments schedule
4. Flexible terms of payment
5. Borrowing capacity is not affected since it is an Off-Balance Sheet form of financing
6. Less time consuming and excludes costs such as compensating balances and indenture
Covenants.
The demerits leasing are: (i) it ca be an expensive source of funds, and (ii) there is the risk of
financial failure of the lessor, which may jeopardize the continued use of leased assets by the
lessee.
There are different types of leasing arrangements. They are:

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Types of Lease
1. Service Lease
2. Direct Lease
a. Operating Lease
b. Financial Lease
3. Sale and Leaseback
4. Leveraged Lease
Hire Purchase
Hire purchase is a kind of debt. In this method, an asset is purchased on payment of regular
installments comprising the principal and interest spread over a specified period. The asset gets
transformed only on payment of the last installment. However, the hirer can avail of depreciation
and deduction of Interest cost for computing taxable income.
Hire Purchase Act was enacted in the year 1972. It consists of legal provisions regulating the
right and obligations of the parties to the hire purchase arrangement namely, hire vendor one who
sells the assets and hire purchaser one who purchases the assets.
Hire purchase sales are made to be made in accordance with the provisions of the Hire Purchase
Act, 1972. In this method, goods are delivered to the purchaser immediately on completion of the
contract. However, right will not be transferred; only the possession is transferred. The legal
right on the property purchased is transferred only on payment of the last installment. If a hire
purchaser fails to pay the installments regularly, the hire vendor has every right to repossess the
property. The installments so far paid will be treated as the rent for the usage of property.
2. Discuss elaborately the organization and functions of Indian stock market. (May/ June
2007)
Stock market
Indian stock market marks to be one of the oldest stock market in Asia. Stock Market which is a
market where the trading of company stock, both listed company securities and unlisted take
place. It is different from stock exchange because it also puts all stock indices and stock index
movements on the same platform. For example, we use the term “the stock market was up today”
or “the stock market bubble”
Stock exchange
Stock Exchanges are an organized market place, both corporation or mutual organization, where
members of the organization gather to trade company stocks and other securities. The members
may act either as agents for their customers, or as principals for their own accounts.
Functions of Stock market
It is an open market for the buying and selling of financial assets. General public can take part in
the sale and purchase of securities of different companies. Stock exchange provides information
about the change in prices of various securities. It also provides information about the overall
economic conditions of the country. Stock exchange works as an indicator of the economy. If the

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business in stock exchange market is going well, it shows that the economic conditions of the
country are good and vice versa.
Stock exchange is a market where buyers and sellers of securities come together. Due to this
sock exchange play the role of an intermediary. It provides the facility of speculation to the
speculators. Speculation is a way by which demand and supplies of the securities are adjusted. It
provides the facility of capital formation to the listed companies, because it is a place where the
people come and invest their surplus funds.
If the management of a company wants to trade the share of the company in the stock exchange,
they will have to fulfill the requirements for the listing of company. Stock exchange has indirect
impact on the management of the company. Stock exchange protects the investors by ensuring
the fair dealing for the sale and purchase of securities. The members of the stock exchange are
bound to act within the limits set by the stock exchange.
3. Discuss in detail the rights and position of equity shareholders (May/ June 2007)
Equity finance is share capital invested in a business for the medium to long-term in return for a
share of the ownership and, sometimes, an element of control of the business.
Unlike lenders, equity finance investors don’t normally have rights to interest or to be repaid at a
particular date. Their return is usually paid in dividend payments and depends on the growth and
profitability of the business.
Because equity investors share the risks your business faces, equity finance is often referred to as
risk capital.
Equity capital generally is composed of funds that are raised by a business in exchange for an
ownership interest in your company. This interest can be in the form of owner ship of common or
preferred stock or instruments that covert into stock. In addition to taking an ownership interest
in your company, equity investors may also participate as a member of the company’s board of
directors and take an active role in managing your company. However, in comparison to debt
financing, which must be repaid overtime, equity financing does not have to be repaid.
Equity capital can be raised from family or from friends. However it is most often raised from
high-net worth individual investors commonly known as “Angel Investors” or from venture
capital or private equity firms, also known as “venture Capitalists(VC)”. Generally, both angles
and venture capital firms are looking for: early stage companies that can’t yet obtain bank
financing; a return on their investment of at least 30-40%; and a clear strategy to be able exit the
investment within 3-7 years and obtain this return.
4. What is Venture Capital and Explain its features in detail? (May/ June 2007)
Venture – Venture is often use for referring to a risky start-up or enterprise company.
Define Venture Capital
Venture Capital is the money and resources made available to startup firms and small business
with exceptional growth potential. Most venture capital money comes from an organized group
of wealthy investors.
Features of Venture Capital

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The main features of venture capital can be summarized as follows:

i. High Degrees of Risk
Venture capital represents financial investment in a highly risky project with the objective of
earning a high rate of return.
ii. Equity Participation
Venture capital financing. is, invariably, an actual or potential equity participation wherein the
objective of venture capitalist is to make capital gain by selling the shares once the firm becomes
profitable.
iii. Long Term Investment
Venture capital financing is a long term investment. It generally takes a long period to en cash
the investment in securities made by the venture capitalists.
iv. Participation in Management
In addition to providing capital, venture capital funds take an active interest in the management
of the assisted firms. Thus, the approach of venture capital firms is different from that of a
traditional lender or banker. It is also different from that of a ordinary stock market investor who
merely trades in the shares of a company without participating in their management. It has been
rightly said, “venture capital combines the qualities of banker, stock market investor and
entrepreneur in one”.
v. Achieve Social Objectives
It is different from the development capital provided by several central and state level
government bodies in that the profit objective is the motive behind the financing. But venture
capital projects generate employment, and balanced regional growth indirectly due to setting up
of successful new business.
vi. Investment is liquid
A venture capital is not subject to repayment on demand as with an overdraft or following a loan
repayment schedule. The investment is realized only when the company is sold or achieves a
stock market listing. It is lost when the company goes into liquidation
5. What are the problems of stock market in India? Explain?(Nov/Dec 2007)
Problems in Indian stock market
Apart from global trends impacting India’s capital market, which has opened itself since 1991 to
the flow of foreign institutional funds in an increasingly integrating world economy, a circular
issued by the Central Board of Direct Taxes with possible implications on taxation of market
players, domestic or foreign, caused the stock plunge, say market observers.
The market crisis coincided with the second anniversary of the UPA Government, whose ascent
to power was similarly accompanied by nervous selling and a price slump, only to be reversed
within days. Since then, the Bombay Stock Exchange’s Sensex has crossed new milestones of
successive thousands with increasing frequency.
The Reserve Bank of India(RBI) too came to the rescue of the market, allaying fears of a
liquidity crunch. “In the light of the developments in the stock exchanges, the RBI has been in

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touch with major settlement banks and both major stock exchanges to ensure that the payment
obligations on the exchanges are met smoothly. Banks can get in touch with the Reserve Bank
for any liquidity assistance.” Another significant impact of the fall is the impact on corporate
raising of funds. Market expects some pressure on valuations of Initial Public offerings (IPOs) to
adjust to the market fall, even though there is considerable interest in many good growth stories.
A longer drawn-out fall would have appeared as a bear phase and softened investor interest in
what remains a very exciting growth market.
6. Distinguish between share holders and debenture holders. (Nov/Dec 2007)
Shares Debentures
1. Shares are a part of the capital. Shareholders 1. Debentures are loan raised by the company.
are owners. Debentures holders are only lenders
2. Shareholders are paid dividend on the 2. Debentures holders are paid interest on
shares. debentures.
3. The rate of dividend is not fixed. It changes 3. Debentures interest is part at a fixed rate.
depending on the divisible profits.
4.Payment of dividend is not obligatory 4. Payment of interest is legal obligation. It is
payable even if there are no profits.
5. Dividend on shares is not tax deductable. 5. Interest on debentures is tax deductible.
6. Shareholders have voting rights. 6. Debentures holders do not have voting
rights.
7. Shares are not redeemable during the 7. Debentures are redeemed at the end of the
lifetime of the company. specified period.
8. Share capital is payable after meeting all 8. Debentures are payable before any payment
outside liabilities. is made to the shareholders.
7. What is venture capital financing ? Explain. (Nov/Dec 2007)
Define Venture Capital
Venture Capital is the money and resources made available to startup firms and small business
with exceptional growth potential. Most venture capital money comes from an organized group
of wealthy investors.
Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk, growth
startup companies. The venture capital fund makes money by owning equity in the companies it
invests in, which usually have a novel technology or business model in high technology
industries, such as biotechnology, IT and software. The typical venture capital investment occurs
after the seed funding round as the first round of institutional capital to fund growth (also
referred to as Series A round) in the interest of generating a return through an eventual realization
event, such as an IPO or trade sale of the company. Venture capital is a subset of private equity.
Therefore, all venture capital is private equity, but not all private equity is venture capital.

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In addition to angel investing and other seed funding options, venture capital is attractive for
new companies with limited operating history that are too small to raise capital in the public
markets and have not reached the point where they are able to secure a bank loan or complete a
debt offering. In exchange for the high risk that venture capitalists assume by investing in
smaller and less mature companies, venture capitalists usually get significant control over
company decisions, in addition to a significant portion of the company's ownership (and
consequently value).
Venture capital is also associated with job creation (accounting for 2% of US GDP), the
knowledge economy, and used as a proxy measure of innovation within an economic sector or
geography. Every year, there are nearly 2 million businesses created in the USA, and 600–800
get venture capital funding. According to the National Venture Capital Association, 11% of
private sector jobs come from venture backed companies and venture backed revenue accounts
for 21% of US GDP.
It is also a way in which public and private sectors can construct an institution that
systematically creates networks for the new firms and industries, so that they can progress. This
institution helps in identifying and combining pieces of companies, like finance, technical
expertise, know-hows of marketing and business models. Once integrated, these enterprises
succeed by becoming nodes in the search networks for designing and building products in their
domain.
8. In the present economic scenario, which source of financing is more advantageous?
Why? (May/June 2008)
Equity finance is share capital invested in a business for the medium to long-term in return for a
share of the ownership and, sometimes, an element of control of the business. Unlike lenders,
equity finance investors don’t normally have rights to interest or to be repaid at a particular date.
Their return is usually paid in dividend payments and depends on the growth and profitability of
the business.
Because equity investors share the risks your business faces, equity finance is often referred to as
risk capital. Equity capital generally is composed of funds that are raised by a business in
exchange for an ownership interest in your company. This interest can be in the form of owner
ship of common or preferred stock or instruments that covert into stock. In addition to taking an
ownership interest in your company, equity investors may also participate as a member of the
company’s board of directors and take an active role in managing your company. However, in
comparison to debt financing, which must be repaid overtime, equity financing does not have to
be repaid. Equity capital can be raised from family or from friends. However it is most often
raised from high-net worth individual investors commonly known as “Angel Investors” or from
venture capital or private equity firms, also known as “venture Capitalists(VC)”. Generally, both
angles and venture capital firms are looking for: early stage companies that can’t yet obtain bank

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financing; a return on their investment of at least 30-40%; and a clear strategy to be able exit the
investment within 3-7 years and obtain this return.
What makes a company attractive for equity investment?
Industry – Typical companies that receive equity investment are high-growth companies, with
the potential for a high rate of return, in the technology industry. These companies generally have
the ability to be a market leader and often to capitalize on the “first mover advantage” – being
first in a growing marketplace or industry sector.
Clear Exit Strategy – Angel investors and venture capitalists are attracted to companies that have
a clear exit strategy, allowing them to obtain the return on their investment. Often known as a
“liquidity event”, this includes an initial public offering; private placement, acquisition or merger
with another company or management-led buyout. In general, investors are looking to exit an
investment within 3-7 years.
Financial Return – Equity investors are attracted to companies that clearly demonstrate the
likelihood of significant financial returns. In general, these investors would like to see profit
margins of more than 50%
From an investor’s point of view, there is a large difference between investing in debt versus
investing in equity. Bu investing in a debt instrument such as a bond, you are guaranteed the
principal of the bond, plus any interest that owes. However, for equity investors, you become an
owner. As such , you also take on the risk of the company not being a success. Just as a small
business owner has no guarantee of success with each new venture, neither is a shareholder. If
things don’t turn out well, you get to claim the assets of the company, but only after the creditors
have been satisfied, which is usually nothing. As a share holder, if the company is successful,
you stand to make a lot of money. On the flipside, you stand to lose a lot of money if the
company is less than successful.
Risk Vs Reward
Its important to understand the risk that is inherent with investing in stocks. There are no
guarantees or obligations. Some companies will pay out a dividend, while others will not. There
is no obligation for a company to pay a dividend, or even increase a dividend. If there is no
dividend paid out, then the only way for an investor to make money is through the increase in
share price on the stock market. If the shares decrease, the shareholder value is lowered. If the
company goes bankrupt, your investment is worthless.
Risk should always be balanced out with reward. By taking on more risk, you should be
compensated with the potential for a greater return. This is why small caps have historically
outperformed large caps and why the returns on investment in stocks in general have more than
doubled that of bonds or savings account. The stock market over the last 50 years has returned
over 12% per year.

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9. ABC Company Ltd., is faced with two options as under in respect of acquisition of an asset
valued Rs. 1,00,000. Either to acquire the asset directly by taking a Bank of Rs. 100,000 of asset
value for 5 years end installments at an interest of 15% (or)
To Lease in the asset at yearly rentals of Rs. 320 per Rs. 1000 of the asset value for 5 years
payable at year end. (May/June 2008)
The following additional information’s are available
1) The rate of depreciation of the asset is 15% WDV
2) The Company has an effective tax of 50%
3) The company employs a discounting rate of 16%
You are to indicate in your report which option is more preferable to the Company.
Solution:
Leasing operation
Lease rent = 32,000
After tax = 32,000(1-50%) = 16,000
Present value after 5 year = 16,000 @16% DF for 5 years, is 3.274
16,000*3.274 = 52,387
Borrow and buy
Year Principal Interest Depreciation Tax
1 20,000 15,000 15,000 15,000
2 20,000 12,000 12,750 13,375
3 20,000 9,000 10,838 9,919
4 20,000 6,000 9,212 7,830
5 20,000 3,000 52,200 27,600
Net Cash flows
Years Cash flows DF Present value
1 20,000.00 0.862 17,240.00
2 19,625.00 0.743 14,581.38
3 19,081.00 0.64 12,211.84
4 18,394.00 0.552 10,153.49
5 0.476 -
Net cash flows 4,186.70
In leasing option, cash flow is lowest, it will be selected.
10. List the procedural formalities for a company intending to raise share capital through a
public issue. (Nov/ Dec 2008)
Any company or a listed company making a public issue or a rights issue of value of more than
Rs.50 Lakhs is required to file a draft offer document with SEBI for its observations. The company
can proceed further only after getting observations from SEBI. The company can proceed further
only after getting observations from SEBI. The company has to open its issue within three months
from the date of SEBI’s observation letter. Through public issues, SEBI has laid down eligibility
norms for entities accessing the primary market. The entry norms are only for companies making a

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public issue (IPO of FPO) and not for listed company making a rights issue. The entry norms are as
follows :
Entry Norm 1 (EN 1) : The company shall meet the following requirements
“ Net Tangible Assets of a least Rs.3 crores for 3 full years.
“ Distributable profits in at least three years
“ Net worth of at lease Rs.1 crore in three years.
“ If change in name, at least 50% revenue for preceding 1 year should be from the new activity
“ The issue size does not exceed 5 times the pre-issue not worth.
SEBI has provided two other alternative routes to company into satisfying any of the above
conditions to provide sufficient flexibility and also to ensure that genuine companies do not suffer
on account of rigidity of the parameters, for accessing the primary Market. They are as under
Entry Norm II (EN II)
“ Issue shall be through book building route, with a least 50% to be mandatory allotted to the
Qualified Institutional Buyers (QIBs)
“ The minimum post-issue face value capital shall be Rs.10 crores or there shall be a
compulsory market-making for at least 2 years.
Entry Norm III (EN III)
“ The “project” is appraised and participated to the extent cf 15% by FIs/Scheduled
Commercial Banks of which at least 10% comes from the appraiser(s).
“ The minimum post-issue face value capital shall be Rs.10 crore or there shall be a
compulsory market-making for at least 2 years.
The following are exempted from the ENs
“ Private Sector Banks
“ Public Sector Banks
“ An infrastructure company whose project has been appraised by a PRI or IDFC or IL&FS or
a bank which was earlier a PFI and not less than 5% of the project cost is financed by any of these
institutions.
“ Rights issue by a listed company.
Conclusion
The new guidelines announced by the Securities Exchange Board of India (SEBI) to speed up the
public issue of shares by eligible companies that are already listed on either the BSE or the NSE are
to be welcomed. At present companies will have to go through a fairly lengthy process. Although
over the years there has been considerable simplification, there are still some regulatory and
company law requirements whose compliance inevitably takes some time.
For instance, whether a company makes an initial public officer (IPO) or a follow-on public offer
(FPO), it will have to file it prospectus with SEBI which will give an observation letter within 30
days. The new guidelines do not dispense with the filing requirements but enable the companies to

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access the market on the basis of rationalized and simplified procedures. After obtaining the in-
principle clearances from the stock exchange, the lead managers need only to file the prospectus
with SEBI before proceeding with the share issues. A considerably shorter issue period will help in
cutting down the costs of a public offer in avoidable advertisements and publicity. Besides,
companies will be able to time the issue to their advantage. Considering the volatile nature of stock
price movements today, that would be a major gain.
In many ways, the new regulatory approach is overdue. There was always a case for distinguishing
between companies having an impressive track record on the principal exchanges and those that are
making share offers for the first time. The new guidelines take into account the fact that companies
in the former category are, by virtue of their listing agreements, meeting the disclosure standards
and redressing investors’ grievances. Hence there is no need to make them comply with all the
regulatory rules that are applicable to companies making an IPO. Investors stand to benefit in two
ways. Many of them are likely to be familiar with a listed company with a three-year track record
and a healthy market capitalization. In any case, relevant information on them will be readily
forthcoming. Secondly, taking advantage of the new guidelines, many eligible companies may prefer
to access Indian capital market rather than go abroad. Investors therefore may have access to quality
shares, as the market becomes deeper. The relaxation now made for few select companies could be
extended to a larger number without of course diluting the disclosure and other regulatory norms.
The success achieved in monitoring the booming secondary market justifies the introduction of the
fast track approach.
11. Present the features of venture capital financing. Indicate the present status in the country.
(Nov/Dec 2008)
India, Asia’s fourth largest economy, is a new market in which everyone is learning. With steady
growth of between 5% to 7% in the past several years, a pace that will likely continue. India offers
tremendous opportunities for financial service even as it transfers slowly from a planned economy to
a free market one. It has already witnessed the emergence of several innovative financial instruments
and services. Venture capital is the latest entrant in this field.
Venture capital is the capital provided by firms of professionals who invest alongside management
in young, rapidly growing or changing companies that have the potential for high growth. Venture
capital is a form of equity financing especially designed for funding high risk and high reward
project. There is common perception that venture capital is a means of financing high technology
project. However, venture capital is investment of long term finance made in :
1. Ventures promoted by technically or professionally qualified but unproven entrepreneurs,
2. Ventures seeking to harness commercially unproven technology,
3. High risk venture.
Meaning

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The term ‘venture capital’ represents financial investment in highly risky projects with the objective
of earnings a high rate of return. While the concept of venture capital is very old the recent
liberalization policy of the government appears to have ---- a fillip to the venture capital movements
in India. In the real sense, venture capital financing is one of the most recent entrants in the Indian
capital market. There is a significant scope for the venture capital companies in our country because
of increasing emergence of technocrat entrepreneurs who lack capital to be risked. These venture
capital companies provide the necessary risk capital to the entrepreneurs so as to meet the
promoter’s contribution as required by the financial institution. In addition to providing capital,
these VCF’s (venture capital firms) take an active interest in guiding the assisted firms.
A young, high tech company that is in the early stage of financing and is not yet ready to make a
public offer of securities may seek venture capital. Such a high risk capital is provided by venture
capital funds in the form of long term equity finance with the hope of earning a high rate of return
primarily in the form of capital gain. In fact, the venture capitalist acts as a partner with the
entrepreneurs.
Thus, a venture capitalist (VC) may provide the seed capital for unproven ideas, products, and
technology oriented or start up firms. The venture capitalist may also invest in a firm that is unable
to rise finance through the conventional means.
Features of Venture Capital
- Venture Capital represents financial investments in a highly risky project with the objective of
earning a high rate of return.
- Venture capital financing is an actual or potential equity participation where in the objective of
venture capitalist is to make capital gain by selling the shares once the firm becomes profitable.
- Venture Capital financing is a long term investment. It generally takes a long period to enhance
the investment in securities made by the venture capitalist.
- Venture capital fund take an active interest in the management of the assisted firms.
- Venture capital projects generate employment, and balanced regional growth indirectly due to
setting up of successful new business.
- Venture capital is not subject to repayment on demand as with an overdraft or following a loan
repayment schedule
Types of venture capital
A new venture may need several infusions of cash from venture capitalist as the business progresses
- The first round, referred to as seed capital is obtained prior to company launch
- The second round, referred to as start-up capital is for luring staff, renting office space,
purchasing servers and other IT infrastructure, purchasing inventories, equipping the production
system, and other activities involved in starting the business.

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- As sales levels increase, additional rounds could be needed to modify the site, re-equip the
production system, expand plant capacity, or purchase new facilities. These additional rounds are
sometimes called second stage financing or development capital.
- Mezzanine financing is the final round of financing before going public. Once a company’s
stock is publicity traded on stock exchange, capital is raised by issuing and selling shares.
PRESENT STATUS IN THE COUNTRY
The Indian venture capital industry, at present is at cross roads. Following are the major issues faced
by this industry.
1. Limitations on structuring of venture capital funds. (VCFs)
VCFs in India are structured in the form of a company or trust fund and are required to follow a
three-tier mechanism – investors, trustee company and AMC. A proper tax-efficient vehicle in the
forms of limited liability partnership act’, which is popular in USA, is not made applicable for
structuring investors liability towards the fund is limited to the extent of his contribution in the funds
also formalities in structuring of fund are simpler.
2. Problems in rising of funds
In USA primary sources of funds are insurance companies, pension funds, corporate bodies etc.
while in Indian domestic institutions, multilateral agencies, state government undertakings are the
main sources of funds for VCFs. Allowing pension funds, insurance companies to invest in the
VCFs would enlarge the possibility of setting up of domestic VCF. Further, it mutual funds are
allowed to invest up to 5 percent of their corpus in VCFs by SEBI, it may lead to increased
availability of fund for VCFs.
3. Lack of incentive to Investors
Presently, high net worth individuals and corporate is not provided with any investments in VCFs.
The problem of raising funds from these sources further gets aggravated with the differential tax
treatment applicable to VCFs and mutual funds. In absence of any incentive, it is extremely difficult
for domestic VCFs to raise money from this investor group that has a good potential.
4. Absence of “angel investors”
In silicon Valley, which is a nurturing ground for venture fund financed IT companies, the angel
investors provide initial / seed stage financing till the company becomes eligible for venture
funding. Thereafter, Venture capitalist through financial support and value-added inputs enables the
company to achieve better growth rate and facilitate its listing on stock exchange. Private equity
investors typically invest expansion / later stages of growth of the company with large investments.
In contrast to this phenomenon, Indian industry is marked by an absence of angel investors.
5. Limitations on investment instruments
As per the section 10(23FA) of the Income Tax Act, income from investments only in equity
instruments of venture capital undertakings is eligible for tax exemption, whereas SEBI regulations

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allow investments in the form of equity shares or equity related securities issued by company whose
shares are not listed on stock exchange.
Harmonization of SEBI regulations and income tax rules of CBDT would provide much required
flexibility to VCFs in structuring the investment instruments and also availing of the tax breaks.
Thus investments by VCFs by instruments other than equity can also be qualified for Tax
exemption.
6. Domestic VCFs vis-à-vis offshore funds
The domestic VCFs operations in the country are governed by the regulations as prescribed by SEBI
and investment restrictions as placed by CBDT for availing of the tax benefits. They pay maximum
marginal tax 35% in respect of non exempt income such as interest through Debentures etc., while
off- shore Funds which are structured in tax havens such as Mauritius are able to overcome the
investment restriction of SEBI and also get exemption from Income Tax under Tax avoidance
treaties. This denies a level playing field for the domestic investors for carrying out the similar
activity in the country.
7. Limitations on industry segments
In sharp contrast to other countries where telecom, services and software bag the largest share of
venture capital investment, in India other conventional sectors dominate venture finance. Opening
up of restrictions, in recent time, on investing in the services sectors such as telecommunication and
resting services, project constancy, design and testing services, tourism etc. would increase the
domain and growth possibilities of venture capital.
8. Anomaly between SEBI regulations and CBDT Rules
CBDT tax rules recognize investment in financially weak companies only in case of unlisted
companies as venture investment, whereas SEBI Regulations recognize investment in financially
weak companies offers an attractive opportunity to VCFs, the same may be allowed by CBDT for
availing of tax exemptions on capital gains at a later stage. Also SEBI regulations do not restrict size
of an investment in a company. However, as per Income Tax rules, maximum investment in a
company. However, as per Income Tax Rules, maximum investment in a company. However, as per
Income Tax rules, maximum investment in a company is restricted to less than 20 per cent of the
raised corpus of VCF an paid up share capital in case of Venture Capital Company. Further,
investment in Company is also restricted upto 40 percent of equity of Investee Company. VCFs may
place the investment restriction for VCFs by way of maximum equity stake in the company, which
could be up to 49 percent of equity of the Investee Company.
9. Limitations on exit mechanism
The VCF’s that have invested in various ventures have not been able to exit from their investments
due to limited exit routes and also due to unsatisfactory performance of OTCEI. The threshold limit
placed by various stock exchanges acts as deterrent for listing of companies with smaller equity
base. SEBI can consider lowering of there should limit for public issue / listing for companies

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backed by VCFs. Buy-back of equity shares by the company has been permitted for unlisted
companies, which would provide exit route to investment of venture capitalists.
10. Limitation on application of sweet equity and ESOP
In the US, an entrepreneur can declare that he has nothing much to contribute except for
“intellectual” capital and still he finds venture capitalists backing his idea with their money. And
when they come together, there is a way to structure the investment deal in such a manner that the
entrepreneur still can ensure a controlling stake in the venture. In the US, the concept of par value of
shares does not exist that allows the different par value shares. Absence of such mechanism puts
limitations in structuring the deals.
12. Discuss the features of any two long term sources of finance, in detail. (May/June 2009)
Finance is the life – blood of business. The business cannot run effectively if it does not have adequate
finance to meet its requirement. The financial requirement of business can be classified into two
categories.
1. Short term financial requirement
2. Long term financial requirement
Short term funds are required for meeting working capital needs they are usually required for a period
up to one year. They are raised from sources which can provide funds only for the short period,
quickly and at reasonable cost. The requirement of these funds is usually met by taking short term
loans or getting the bill discounted from the commercial banks.
The loan term funds are required to a great for meeting the fixed capital requirement of the business.
They are required for a period exceeding one year. They are sometimes classified as 1) Intermediate or
medium term funds and 2) long term funds. The former categories include funds required for a period
between less than 5 years, while the latter category includes funds required for a period exceeding 5
years.
These founds are raised by business from sources which provide in an uninterrupted way for a long
period, namely, shares, Debentures, Loans from financial institutions. Recently the commercial banks
have also entered into this area and they have also started providing medium term as well as long term
funds to trade and industry, either independently or sometimes in collaboration with one more
specialized financial institution, such as Industrial Finance Corporation of India, Industrial Credit
Investment Corporation of India, etc.
Equity Shares
The term shares and stock are generally used interchangeable. But a stock differs from a share in
many ways. A stock is the aggregate of fully paid up shares, consolidate and divide for the purposes of
convenient holding into different parts. Therefore, only fully paid up shares are converted into stock
and no direct issue of stock by a company is lawful. The stock can also be reconverted into fully paid
up shares.

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The holders of the stock also have similar privileges and right as that of the share holders. However,
the important point of distinction between the shares and stock can b summarized as follows :
1) A share has definite face value, where as a stock has no definite face value
2) A stock is always fully paid up, whereas a share may be either fully paid up or partly paid
up
3) Stock can be transferred into small transactions, while shares can be transferred only in
round numbers
4) All shares are of equal denominations. Stock may be of unequal amounts
5) Shares can be directly issued to the public, whereas stock cannot be issued to the public
directly.
Kinds of Shares : In the ordinary commercial practices, limited companies issue various classes of
shares, viz, preference shares, equity shares, deferred shares, etc. But according to the Indian
Companies Act, the share capital of a company limited by shares shall be of two kinds only namely (1)
Equity Shares (2) Preference shares
1) Equity Shares : According to Sec 85(2), “equity shares are those shares which are not
preference shares”. Equity shares are also called ordinary shares.
If a company has issued both preference shares and equity shares the equity holder will get dividend
after the dividend on preference shares has been paid. The dividend is not certain. The financial risks
is more with equity share capital so equity shares are also called risk capital
Advantages of equity share :
1) Non recurring fixed payments 2) No charges
3) Long-term funds, 4) Capital Formation
5) Credit formation 6) Ownership
7) Right issues
Disadvantages of equity shares :
1) Inability of refund 2) Difficult in trading on equity
3) Concentration of control 4) Not always acceptable
5) Dividend at the boards Mercy 6) Illiquid
7) Speculation
PREFERENCE SHARES
According to Sec 85 of the Act, preference shares are those on which there is preference right 1) To
claim dividend during the life time of the company and 2) To claim repayment of capital on the
winding up.
The percentage of dividend is fixed. The holders of preferences shares get the fixed dividend before
any dividend before any dividend is paid to other classes of share holders. At the time of winding up
of the company, preferences share holders can get back their capital before any other classes of share
holder can get back their money.

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There are different classes of preferences shares. They are as follows

1. Cumulative preference shares
2. Non-cumulative preference shares
3. Participating preference shares
4. Non-participating preference shares
5. Convertible preference shares
6. Non-convertible preference shares
7. Redeemable preference shares
8. Guaranteed preference shares
1) Cumulative preference shares : If in any year the company does not earn adequate profit,
dividends on preference shares may not be paid for the year. In case of cumulative preference shares,
such unpaid dividend is treated as arrear. The arrear will accumulate and they will be payable out of
the profit of the subsequent years.
2) Non-cumulative preference shares : The dividend on these shares are payable only out of the
profits of the current year. If in any year, the company does not earn adequate profit, the holders get no
dividend or partial dividend in that case the unpaid dividend will not be carried forward to subsequent
years. The holders cannot claim arrears of dividend.
3) Participating preference shares : During the life time of the company in addition to the fixed
dividend, the share holders of this kinds of shares have right participate in the surplus of profit which
remains after payment to the equity shares holders. At the time of winding up, in addition to their
shares, the share holders have a right to participate in the surplus of assets which remains after
payments to the equity shares holders. The surplus will be distributed between the participating
preference share holders and equity share holders in an agreed ratio.
4) Non-participating preferences shares : The holders of this kind of shares have no right,
either to participate in the surplus of profit which remain after payments to equity shares holders
(during the life time) or to participate in the surplus of assets, which remains after payment to equity
share holders (at the time of winding up). If the article are silent, all preference shares are treated as
non participating preference shares.
5) Convertible preference shares : The holders of this kind of shares have no right to convert
their shares into equity shares with in a specified period.
6) Non-convertible preference shares : The holders of this kind of shares have no right to
convert their preference shares in to equity shares
7) Redeemable preference shares : The preference shares which can be redeemable after a
specified period at the direction of the company are called redeemable preference shares.
8) Guaranteed preferences shares : In case of conversion of private concern into a limited
company or in case of amalgamation and absorption, the seller guarantees a particular rate of dividend

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on preference shares for certain years. These shares are called guaranteed preference shares between
the participating preference and equity share holders in an agreed ratio.
Advantages of preferences shares :
-Suitable to cautions investors,-Retention of control,-Attractive types,-Convenience,-Increase in
equity share holders income, -Conversion to satisfy legal requirement,-Economical,-Enabling
reconstruction and reorganization,-Increasing the marketability,-Good alternative for debenture
Disadvantages of preference shares :
1) Heavy dividend 2) Accumulation of dividend, 3) Costly
4) No voting rights, 5) Way to liquidation 6) Affecting the financial status,
7) time of redemption, 8) Income Tax
13. Explain the features of hire purchase with suitable examples. (May/June 2009)
Hire Purchase
Hire purchase is a mode of financing the price of the goods to be sold on a future date. In a hire
purchase transaction, the goods are let on hire, the purchase price is to be paid in installments and
hirer is allowed an option to purchase the goods by paying all the installments. Hire purchase is a
method of selling goods. In a hire purchase transaction the goods are let out on hire by a finance
company (Creditor) to the hire purchase customer (hirer). The buyer is required to pay an agreed
amount in periodical installments during a given period. The ownership of the property remains with
creditor and passes on to hirer on the payment of the last installment.
A hire purchase agreement is defined in the Hire Purchase Act, 1972 as peculiar kind of transaction in
which the goods are let on hire with an option to the hirer to purchase them, with the following
stipulations :
a. Payments to be made in installments over a specified period
b. The possession is delivered to the hirer at the time of entering into the
contract
c. The property in goods passes to the hirer on payment of the last
installment
d. Each installment is treated as hire charges so that if default is made in
payment of any installment, the seller becomes entitled to take away the goods, and
e. The hirer / purchase is free to return the goods without being required to
pay any further installments falling due after the return.
Features of Hire Purchase Agreement
Under hire purchase system, the buyer takes possession of goods immediately and agrees to pay the
total hire purchase price in installments. Each installment is treated as hire charges. The ownership of
the goods passes from the seller to the buyer on the payment of the last installment. In case the buyer
makes any default in the payment of any installment the seller has right to reposses the goods from the
buyer and forfeit the amount already received treating it as hire charges. The hirer has the right to

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terminate the agreement any time before the property passes. That is, he has the option to return the
goods in which case he need not pay installments falling due thereafter. However, he cannot recover
the sums already paid as such sums legally represent hire charges on the good in question.
14. Define a lease. How does it differ from a hire purchase? What are the cash flows
consequences of a least? Illustrate. (May/June 2009),
Lease financing is one of the methods of long term financing. Lease contract stipulates the lease
period rental payments, periodic intervals of payments, repairs and maintenance, purchase options,
taxes, insurance, risk of obsolescence, penalty for delay or non payment of rental etc. It is an
agreement under which the use and control of asset is permitted without passing on the title of the
asset. In case the agreement provides, the lessor has to do maintenance and bear the cost of
maintenance and upkeep of the equipment in some case the lessee has to bear the cost of
maintenance in any case it has to be stipulated clearly in the leasing contract about the maintenance
if the lease is not renewed the lessor takes the possession of the asset after the expiry of existing
lease period.
Leasing is an arrangement that provides a firm with the use and control over assets without buying
and owing the same. It is a form of renting assets. Lease is a contract between the owner of the asset
(lessor) and the use of the asset called the lessee whereby the lessor gives the right to use the asset to
the lessee over an agreed period of time for a consideration called the lease rental the lease contract
is regulated by the terms and conditions of the agreement, the lessee pays the lease rent periodically
to the lessor as regular fixed payments over a period of time. The rental may be payable at the
beginning or end of a month quarter, half year the lease rent can also be agreed both in terms of
amount and timing as per the profits and cash flow position of the lessee. At the expiry of the lease
period the asset reverts back to the lessor who is the legal owner of the asset. However the long term
lease contracts the lessee is generally given an option to buy or renew the lease. In the words of
Miller M.H. and CW.Uptron “leasing separates Ownership and use as two economic activities and
facilities asset use without ownership”.
The Hire purchase system is a system under which money is paid of goods by means of periodical
installments with the view of ultimate purchase. Under this system the hire purchaser acquires the
possession of goods immediately on singing the Hire purchase agreement and payments of down
payment. The goods will become the property of the buyer only when all the installments have been
paid. As the title would ultimately pass on to the buyer, depreciation and interest on finance are
allowed as a deduction for Income Tax purpose.
Lease involves the use of an asset without assuming ownership. The owner of the asset is called
lessor and ownership is retained by the lessor under leasing arrangement. Lessee has to pay rental to
the lessor. Lessee rent is allowed as a deduction for income tax purpose in the hands of lessee. As
par the latest instructions of CBDT depreciation on the equipment is allowed as a deduction in the
hands of lessor.

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DIFFERENCES BETWEEN HIRE PURCHASE AND LEASE FINANCING

HIRE PURCHASE LEASE
Under this system, Hire purchase acquires Lease involves the use of an asset without assuming
the possession of goods immediately on ownership,. No down payments in lease financing.
signing the hire purchase agreement and
payments of down payment (say 20%)
The hire purchase price consists of cash Lessee ahs to pay rental to the lessor for the use of
price and the interest payable to the hire an asset
vendor.
Depreciation and interest are debit to P&L Lessee can claim the rental as business expenditure
A/c of Hirer (Lessor will claim the amount of depreciation)
The user has the option to acquire Legal Lesser is the owner. Lessee may have the option to
title to the asset as per the terms of the buy the same at the end of lease period.
contract
The goods will become the property of the Lessee cannot become the owner even after
hirer when all installments have been paid payment of lease rentals of all the years during
Lease Period.
Maintenance cost is born by the Hirer Maintenance cost In case of operating lease it is
borne by lessor.
In case of finance lease it is borne by lessee.
Capitalization is done in the books of Hirer Capitalization is done in the books of lessor
(i.e. Leasing Company)
The risk of obsolescence is borne by Hirer Risk of obsolescence : In operating lease, it is
done by Lessor. In case of finance lease, it is
borne by lessee.
The Asset is shown in the balance of Hirer The asset is shown as a foot note in the balance
and balance installments payments as a sheet
liability
Tax benefits : hirer can claim depreciation Tax benefits : Lease can claim lease rentals
and interest only and maintenance cost in case of lease
finance
15. What is the difference between the primary and the secondary market? Discuss the
different classification of shares traded in stock exchanges. (May/June 2009)
Finance is the integral part of modern business. Financial markets refer to the institutional
arrangements for dealing in financial assets and credits instruments of different types as currency
cheques, bank deposits, bills, etc.
The main functions of the financial market are
 To facilitate creation and allocation of credit and liquidity

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 To serve as intermediaries for mobilization of savings.

 To assist the process of balanced economic growth
 To provide financial convenience
 To cater to the various credits needs of the business houses.
TYPES OF FINANCIAL MARKETS
On the basis of credit requirements for short – term and long-term purposes, financial markets are
divided into two categories.
Money Market Capital Market
MONEY MARKET
The term money market is used in a composite sense to mean financial institutions which deal with
short-term funds in the economy. It refers to the institutional arrangements facilitating borrowing
and lending of short-term funds. The money market brings together the leaders who have surplus
short term investible funds and the borrowers who are in need of short term funds. In a money
market funds can be borrowed fro a short period varying form a day, a week, a month or 3 to 6
months and against different types of instruments such as bill of exchange, bankers acceptances,
bonds, etc., called ‘near money’ thus money market has been defined by Crowther as “The collective
name given to the various firms and institutions that deal in the various grades of near money.”
The reserve bank of India describes the money market as, “the centre for dealings, mainly of a short
term character, in monetary assets : it meets the short term requirements of borrowers and provides
liquidity or cash to the lenders.” The borrowers in the money market are generally merchants,
traders, manufacturers, money market on the other hand, include the central bank of the country the
commercial banks insurance companies and financial concerns.
CAPITAL MAREKT : A good capital market is an essential pre requisite and commercial
development of a country. Credit is, generally required and supplied on short-term and long-term
basis. The money market caters to the short-term needs only. The long term capital needs are met by
the capital market, capital market is a central co-ordination and directing mechanism for free and
balanced flow of financial resources into the economic system operating in a country.
The development of a good capital market in a country is dependent upon the availability of savings,
proper organization of its constituent units and the entrepreneurship qualities of its people before
independence the capital market of India was ill-developed because of its certain defects. But in
recent years since independence the capital market of India has substantially change and has been
changing for the better.
Components of Capital Market
The following are the three main components of a capital market New issue market – Stock Market
– Financial Market
NEW ISSUE MARKET

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The new issue market represents the primary market where new securities i.e., shares or bonds that
have never been previously issued, are offered. Both the new companies and the existing ones can
raise capital on the new issue market. The prime function of the new issue market. The prime
function of the new issue market is to facilitate the transfer of funds from the willing investor to the
entrepreneurs setting up new corporate enterprises or going in for expansion, diversification growth
or modernization. Besides, helping corporate enterprises in securing their funds, the new issue
market channelizes the savings of individuals and others into investments. The two facts of this
market, i.e. supply and demand are represented by issuing companies and the investors respectively.
But then the organization of the new issue market is not complete without the specialized agencies,
intermediaries and institutions etc. which promote issues of new securities and help in selling
transferring underwriting etc., these agencies incused financial institutions under writers, brokers,
merchants bankers etc. As the new issue market directs the flow of savings into long-term
investments if is of paramount importance for the economic growth and industrial development of a
country. The availability of financial resources for corporate enterprises to a great extent depends
upon the status of the new issue market of the country.
STOCK MARKET
Stock Market represents the secondary market where existing securities are traded. Stock exchange
provides an organized mechanism for purchase and sale of existing securities. By the end of 1993-
1994 there were 23 stock exchanges in our country. The daily turnover at these stock exchanges
during 1993-1994 was to the tune of Rs.3877.8 mn.
Special financial institutions are the most active constituent of the Indian capital market. Such
organizations provide medium and long term loans on easy companies : expansion and development
of existing companies and meeting the financial requirements of companies during economic
depression. The need for establishing financial institutions was felt in many countries immediately
after the second world war in order to re-establish their war-shattered economics. In underdeveloped
countries, the need for such institutions was much more due to a large number of organizational and
financial problems inherent in the process of industrialization, after independence a number of
financial institutions have been setup all India and regional levels for accelerating the growth of
industries by providing financial and other assistance. The following are the main special financial
institutions that are most active constituents of the Indian capital market.
 The Industrial Finance Corporation of India (I.F.C.)
 The Industrial Credit and investment Corporation of India (I.C.I.C.I.)
 The Refinance Corporation of India (R.F.C.)
 State Financial Development Corporations (S.F.C.s)
 National Industrial Development Corporation (N.N.D.C.)
 State Industrial Development Corporation (S.I.D.Cs)
 National Small Industries Corporation (N.S.I.C.)

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 Industrial Development Bank of India (I.D.B.I.)

 Unit Trust of India (U.T.I.)
 Life Insurance Corporation of India (L.I.C.)
 Nationalized Commercial Bank (N.C.Bs)
 Merchant Banking Institutions (M.B.Is.)
 National Industrial Reconstruction Corporation of India (N.I.R.C.)
 The Credit Guarantee Corporation of India (C.G.C.)

DIFFERENT CLASSIFICATION OF SHARES TRDED IN STOCK EXCHANGES

The term shares and stock are generally used interchangeable. But stocks differ from a share in
many ways. A stock is the aggregate of fully paid up shares, consolidate and divided for the
purposes of convenient holding into different parts. Therefore, only fully paid up shares are
converted into stock and no direct issue of stock by a company is lawful. The stock can also be
reconverted into fully paid up shares. The holders of the stock also have similar privileges and right
as that of the share holders. However, the important point of distinction between the shares and
stock can be summarized as follows : A share has definite face value, where as a stock has no
definite face value
1) A stock is always fully paid up, whereas a share may be either fully paid up or partly paid up
2) Stock can be transferred into small transactions, while shares can be transferred only in round
numbers
3) All shares are of equal denominations. Stock may be of unequal amounts
4) Shares can be directly issued to the public, whereas stock cannot be issued to the public directly.
Kinds of shares : In the ordinary commercial practices, limited companies issue various classes of
share, viz, preference shares, equity shares, deferred shares, etc. But according to the Indian
companies act, the share capital of a company limited by shares shall be of two kinds only namely,
(1) Equity shares, (2) Preference shares
1) Equity Shares : According to Sec 85(2), “equity shares are those shares which are not
preference shares”. Equity shares are also called ordinary shares
If a company ahs issued both preference shares and equity shares the equity share holder will get
dividend after the dividend on preference shares has been paid. The dividend is not certain. The
financial risks is more with equity share capital so equity shares are also called risk capital
PREFERENCE SHARES
According to Sec 85 of act, Preference shares are those on which there is preference right 1) To
claim dividend during the life time of the company and
2) To claim repayment of capital on the winding up.
The percentage of dividend is fixed. The holders of preferences shares get the fixed dividend before
any dividend is paid to other classes of share holders. At the time of winding up of the company,

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preferences share holders can get back their capital before any other classes of share holder can get
back their money.
There are different classes of preferences shares. They are as follows
1) Cumulative preference shares
2) Non-cumulative preference shares
3) Participating preference shares
4) Non-participating preference shares
5) Convertible preference shares
6) Non-convertible preference shares
7) Redeemable preference shares
8) Guaranteed preference shares
16. Bring out the relationship of term financing with capital market. (May/June 2010)
Long term financing is a form of financing that is provided for a period of more than a year.
Long term financing services are provided to those business entities that face a shortage of
capital. It is different from short term financing which is normally used to provide money that
has to be paid back within a year. The period may be shorter than one year as well.
Examples of long-term financing include - a 30 year mortgage or a 10-year Treasury note.
Equity is another form of long-term financing, such as when a company issues stock to raise
capital for a new project.
Purpose of Long Term Finance:
 To finance fixed assets.
 Expansion of companies
 To finance the permanent part of working capital
 Increasing facilities.
 Construction projects on a big scale.
 Provide capital for funding the operations. This helps in adjusting the cash flow
Factors determining Long-term Financial Requirements:
 Nature of Business
 Nature of Goods produced
 Technology used
Types of Long Term Financing:
The kind of long term financing that is provided to a particular company depends on its type. For
example, the long term financing that is provided to a solo proprietorship is different from the
one received by a partnership firm.

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Uses of Long Term Financing:

Long term financing is used in separate ways by different types of business entities. The business
entities that are not corporations are only supposed to use long term financing for the purpose of
debt. However, the corporations can use long term financing for both debt and equity purposes.
Sources of Long Term Financing:
The various sources are as follows –
a. Shares: These are issued to the general public. The holders of shares are the owners of the
business. These may be of two types:
 Equity shares and
 Preference shares.
b. Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
c. Public Deposits: General public also likes to deposit their savings with a popular and well
established company which can pay interest periodically and pay-back the deposit when due.
d. Retained Earnings: The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.
e. Term Loans from Banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of 3-5 years.
f. Loan from Financial Institutions: There are many specialized financial institutions
established by the Central and State governments which give long term loans at reasonable rate
of interest.
CAPITAL MARKET
The Capital market is a market for financial investments that are direct or indirect claims to
capital. It is wider than the Securities Market and embraces all forms of lending and borrowing,
whether or not evidenced by the creation of a negotiable financial instrument. The capital market
comprises the complex of institutions and mechanisms through which intermediate team funds
and long term funds are pooled and made available to business, government and individuals. The
capital market and in particular the stock exchange is referred to as the barometer of the
economy.
A well functioning stock market may help the development process in an economy through the
following channels:
1. Growth of savings,
2. Efficient allocation of investment resources,
3. Better utilization of the existing resources.
In market economy like India, financial market institutions provide the avenue by which long-
term savings are mobilized and channeled into investments. Confidence of the investors in the
market is imperative for the growth and development of the market. For any stock market, the

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market Indices is the barometer of its performance and reflects the prevailing sentiments of the
entire economy. Stock index is created to provide investors with the information regarding the
average share price in the stock market. The ups and downs in the index represent the movement
of the equity market. These indices need to represent the return obtained by typical portfolios in
the country. Capital Market Instruments – some of the capital market instruments are:
• Equity
• Preference shares
• Debenture/ Bonds
• ADRs/ GDRs
• Derivatives
17. Discuss the various sources of long term finance of Indian companies. (May/June 2010)
Sources of Long Term Financing:
The various sources are as follows –
a. Shares: These are issued to the general public. The holders of shares are the owners of the
business. These may be of two types:
Equity shares and
 Preference shares.
b. Debentures: These are also issued to the general public. The holders of debentures are the
creditors of the company.
c. Public Deposits: General public also likes to deposit their savings with a popular and well
established company which can pay interest periodically and pay-back the deposit when due.
d. Retained Earnings: The company may not distribute the whole of its profits among its
shareholders. It may retain a part of the profits and utilize it as capital.
e. Term Loans from Banks: Many industrial development banks, cooperative banks and
commercial banks grant medium term loans for a period of 3-5 years.
f. Loan from Financial Institutions: There are many specialized financial institutions
established by the Central and State governments which give long term loans at reasonable rate
of interest
18. Explain the feature of a Convertible Security. (Nov/Dec 2010)
In finance, a convertible note (or, if it has a maturity of greater than 10 years, a convertible
debenture) is a type of bond that the holder can convert into shares of common stock in the
issuing company or cash of equal value, at an agreed-upon price. It is a hybrid security with
debt- and equity-like features. Although it typically has a low coupon rate, the instrument carries
additional value through the option to convert the bond to stock, and thereby participate in
further growth in the company's equity value. The investor receives the potential upside of
conversion into equity while protecting downside with cash flow from the coupon payments.

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From the issuer's perspective, the key benefit of raising money by selling convertible bonds is a
reduced cash interest payment. The advantage for companies of issuing convertible bonds is that,
if the bonds are converted to stocks, companies' debt vanishes. However, in exchange for the
benefit of reduced interest payments, the value of shareholder's equity is reduced due to the stock
dilution expected when bondholders convert their bonds into new shares
Structure and features
Like any typical bond, convertible bonds have an issue size, issue date, maturity date, maturity
value, face value and coupon. They also have the following additional features:
 Conversion price: The nominal price per share at which conversion takes place.
 Conversion ratio: The number of shares each convertible bond converts into. It may be
expressed per bond or on a per centum (per 100) basis.
 Parity (Conversion) value: Equity price × Conversion ratio.
 Conversion premium: Represent the divergence of the market value of the CB compared
to that of the parity value.
 Call features: The ability of the issuer (on some bonds) to call a bond early for redemption,
sometimes subject to certain share price performance. The intention is to encourage investors to
convert early into equity (which has now become worth more than the bond's face value), by
threatening repayment in cash for what is now a lower amount
19. Explain the steps involved in a Venture capital investment process. (Nov/Dec 2010),
(Nov/Dec 2014)
The financing of high-tech., project in the form of venture capital financing is done in several
stages. They may ‘be in the form of:

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 Early-stage financing
 Later stage financing
(1) Early-stage financing
This stage of financing is done to the new project or to the new technocrat who wishes to
commercialize his research talents. As the technocrat is well versed only with knowhow
and not with capital, going for debt at this stage increases the risk of entrepreneur and
affect the health of the business unit. In, other means of financing, the obligation to repay
the loans along with interest starts immediately with lending. Hence, it is not advisable for
young entrepreneurs to go in for such loans. They have depend mainly on equity stoke so
that the risk of repayment does not arise equity financing permits the young entrepreneurs
to commercialize and earns profits out of the investment. The main instruments used for
such financial assistance would be in the form of equity contribution, unsecured loans and
optionally convertible securities. Once the financing is done, venture capitalists assist the
firm in general administrative activities and allow the technocrat to concentrate on
production and marketing. This stage of venture capital financing consists of seed capital,
start-ups and second round financing.
(a) Seed capital:
Seed capital financing includes the implementation of research project,
starting from all initial conceptual stage. This stage requires more time to
complete the process. Because the entrepreneur made an effort to the
maximum to meet the market potentiality. Therefore external equity in
preferred. The key factors that influence equity financing at this stage are:
 The technology used in the project, possible threats of new technology in the near
future.
 Different aspects of the product life cycle.
 The total investment required commercializing the product and time required to get
suitable returns etc.
(b) Start-up stage financing:
At this stage innovator requires finance to commercialize the product. This stage is not simple
to execute, it requires more time in getting different elements ie., (patent rights, trade marks,
design and copy rights) which are very essential to bring the product in the market. All these
components are very essentially needed to launch the product effectively. Hence, time and
finance is needed. On the other hand, the research must also be done to evaluate the probable
opportunities to exploit the market. Therefore, venture capital investor evaluates the projects
carefully and negotiate the terms and conditions with the entrepreneur with regard to sharing the
management.

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(c) Second round of financing:

This type of financing is required when the project incurs loss or inability to yield sufficient
profits. The reasons could be due to internal or external factors. At this stage, if the venture
capitalists are fully aware of the genuine reasons for the loss, he should decide on second round
financing, or he may seek the support of new investor. This is a complex process as the original
investor may express his inability to further finance the project or entrepreneur must have lost
the confidence with the original investor or he may wishes to broad base the investment pattern.
Lot of bargaining has been done to coordinate the financing with original investor and with the
technocrat or promoter.
(2) Later Stage Financing
Later stage financing is considered to be the easy means of assistance. The reason being, the
product launched has not only reached the boom period but also indicator further expansion and
growth. Hence it is a easy means of financing with low risk profile. The real problem associated
at this stage is entrepreneur not be willing to give majority of his stake to the venture capitalists
but may accept for more number of executive directors in the board. This means of is also known
as expansion finance, replacement capital, management buyout and turn around capital.
(a) Expansion finance: Later stage financing is executed to expand the market, production or to
establish warehouses etc., Export trade activities may also be considered for financing the
project.
(b) Replacement capital): Under this stage, the promoter may prefer to buy the entire equity
stake of the project by approaching some other financiers. He may also wish to increase his
holding by buying more number of equity shares. Replacement capital) is normally preferred at
the time of public issues. If the company is unlisted, getting capital gains on the fresh issues
needs more time, tilt then replacement capital can be obtained in the form of convertible
preference shares from the second financier.
(c) Management Buyout (MBO): This may be offered in two ways namely. ‘Management
buyout’ or ‘Management buys int. In management buyout, venture capitalists help the
management of a company to buy or take over the ownership of the business. This would help
the management to reshuffle or reengineer the entire project.
In management buy in strategies, outsides prefer to buy the existing business. This means of
financing is less risky; it is not considered as venture capital and has wide criticism.
(d) Rescue Capital: Rescue capital is also known as turnaround capital offered with a view to
help the technocrat or the business unit to come out of difficulties. This means of financing is
risky in nature and the investor may ask for major changes in the management. In India, venture
capital financing for MBO and turnout are rarely seen, as the majority of the investor prefers to
invest only in later stages.

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20. A company is considering the lease of an Equipment which has a purchase price of Rs.
3,50,000. The equipment has an estimated economic life of 5 years. 25% written down value
Depreciation is allowed. Company’s marginal tax rate is 50%. If the before tax borrowing rate
for the company is 16%, should the company base the equipment ? Ignore tax shield on
depreciation after 5 years. (May/June 2013)
SOLUTION: To be discussed in class
21.What is debenture? Explain the features of a debenture. (May/June 2011)
Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can
borrow from the general public by issuing loan certificates called Debentures. The total amount
to be borrowed is divided into units of fixed amount say of Rs.100 each. These units are called
Debentures. These are offered to the public to subscribe in the same manner as is done in the
case of shares. A debenture is issued under the common seal of the company. It is a written
acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of
interest, time repayment, and security offered, etc.
Features of a debenture
i) Debenture holders are the creditors of the company. They are entitled to periodic payment of
interest at a fixed rate.
i i ) Debentures are repayable after a fixed period of time, say five years or seven years as per
agreed terms.
iii) Debenture holders do not carry voting rights.
iv) Ordinarily, debentures are secured. In case the company fails to pay interest on debentures or
repay the principal amount, the debenture holders can recover it from the sale of the assets of the
Company
22. Venture Capital Funds is a Non Banking Financial Company’s business – Discuss.
(May/June 2011)
Venture capital (VC) is financial capital provided to early-stage, high-potential, high risk,
growth startup companies. The venture capital fund makes money by owning equity in the
companies it invests in, which and usually have a novel technology or business model in high
technology industries, such as biotechnology, IT, software, etc. The typical venture capital
investment occurs after the seed funding round as growth funding round (also referred to as
Series A round) in the interest of generating a return through an eventual realization event, such
as an IPO or trade sale of the company. Venture capital is a subset of private equity. Therefore,
all venture capital is private equity, but not all private equity is venture capital.
In addition to angel investing and other seed funding options, venture capital is attractive for new
companies with limited operating history that are too small to raise capital in the public markets
and have not reached the point where they are able to secure a bank loan or complete a debt
offering. In exchange for the high risk that venture capitalists assume by investing in smaller and
less mature companies, venture capitalists usually get significant control over company

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decisions, in addition to a significant portion of the company's ownership (and consequently

value).
Venture capital is also associated with job creation (accounting for 2% of US GDP), the
knowledge economy, and used as a proxy measure of innovation within an economic sector or
geography. Every year, there are nearly 2 million businesses created in the USA, and only 600–
800 get venture capital funding. According to the National Venture Capital Association, 11% of
private sector jobs come from venture backed companies and venture backed revenue accounts
for 21% of US GDP.
It is also a way in which public and private actors can construct an institution that systematically
creates networks for the new firms and industries, so that they can progress. This institution helps
in identifying and combining pieces of companies, like finance, technical expertise, know-how
of marketing and business models. Once integrated, these enterprises succeed by becoming
nodes in the search networks for designing and building products in their domain.
Obtaining venture capital is substantially different from raising debt or a loan from a lender.
Lenders have a legal right to interest on a loan and repayment of the capital, irrespective of the
success or failure of a business. Venture capital is invested in exchange for an equity stake in the
business. As a shareholder, the venture capitalist's return is dependent on the growth and
profitability of the business. This return is generally earned when the venture capitalist "exits" by
selling its shareholdings when the business is sold to another owner.
Venture capitalists are typically very selective in deciding what to invest in; as a rule of thumb, a
fund may invest in one in four hundred opportunities presented to it, looking for the extremely
rare, yet sought after, qualities, such as innovative technology, potential for rapid growth, a well-
developed business model, and an impressive management team. Of these qualities, funds are
most interested in ventures with exceptionally high growth potential, as only such opportunities
are likely capable of providing the financial returns and successful exit event within the required
timeframe (typically 3–7 years) that venture capitalists expect.
Because investments are illiquid and require the extended timeframe to harvest, venture
capitalists are expected to carry out detailed due diligence prior to investment. Venture capitalists
also are expected to nurture the companies in which they invest, in order to increase the
likelihood of reaching an IPO stage when valuations are favourable. Venture capitalists typically
assist at four stages in the company's development:
 Idea generation;
 Start-up;
 Ramp up; and
 Exit
Because there are no public exchanges listing their securities, private companies meet venture
capital firms and other private equity investors in several ways, including warm referrals from

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the investors' trusted sources and other business contacts; investor conferences and symposia;
and summits where companies pitch directly to investor groups in face-to-face meetings,
including a variant known as "Speed Venturing", which is akin to speed-dating for capital, where
the investor decides within 10 minutes whether he wants a follow-up meeting. In addition, there
are some new private online networks that are emerging to provide additional opportunities to
meet investors.
This need for high returns makes venture funding an expensive capital source for companies, and
most suitable for businesses having large up-front capital requirements, which cannot be
financed by cheaper alternatives such as debt. That is most commonly the case for intangible
assets such as software, and other intellectual property, whose value is unproven. In turn, this
explains why venture capital is most prevalent in the fast-growing technology and life sciences
or biotechnology fields.
If a company does have the qualities venture capitalists seek including a solid business plan, a
good management team, investment and passion from the founders, a good potential to exit the
investment before the end of their funding cycle, and target minimum returns in excess of 40%
per year, it will find it easier to raise venture capital.
Financing stages
There are typically six stages of venture round financing offered in Venture Capital, that roughly
correspond to these stages of a company's development.
 Seed Money: Low level financing needed to prove a new idea, often provided by angel
investors. Crowd funding is also emerging as an option for seed funding.
 Start-up: Early stage firms that need funding for expenses associated with marketing and
product development
 First-Round (Series A round): Early sales and manufacturing funds
 Second-Round: Working capital for early stage companies that are selling product, but
not yet turning a profit
 Third-Round: Also called Mezzanine financing, this is expansion money for a newly
profitable company
 Fourth-Round: Also called bridge financing, 4th round is intended to finance the "going
public" process
Between the first round and the fourth round, venture-backed companies may also seek to take
venture debt.
Venture capital firms and funds
Venture capitalists
A venture capitalist is a person or investment firm that makes venture investments, and these
venture capitalists are expected to bring managerial and technical expertise as well as capital to
their investments. A venture capital fund refers to a pooled investment vehicle (often an LP or

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LLC) that primarily invests the financial capital of third-party investors in enterprises that are too
risky for the standard capital markets or bank loans. Venture capital firms typically comprise
small teams with technology backgrounds (scientists, researchers) or those with business training
or deep industry experience.
A core skill within VC is the ability to identify novel technologies that have the potential to
generate high commercial returns at an early stage. By definition, VCs also take a role in
managing entrepreneurial companies at an early stage, thus adding skills as well as capital,
thereby differentiating VC from buy-out private equity, which typically invest in companies with
proven revenue, and thereby potentially realizing much higher rates of returns. Inherent in
realizing abnormally high rates of returns is the risk of losing all of one's investment in a given
startup company. As a consequence, most venture capital investments are done in a pool format,
where several investors combine their investments into one large fund that invests in many
different startup companies. By investing in the pool format, the investors are spreading out their
risk to many different investments versus taking the chance of putting all of their money in one
start up firm.

23. Discuss the steps and parties involved in an IPO process in India. (Nov/Dec 2011)
An initial public offering (IPO) or stock market launch, is the first sale of stock by a private
company to the public. It can be used by either small or large companies to raise expansion
capital and become publicly traded enterprises. Many companies that undertake an IPO also
request the assistance of an investment banking firm acting in the capacity of an underwriter to
help them correctly assess the value of their shares, that is, the share price (IPO Initial Public
Offerings, 2011). In 1602, the Dutch East India Company was the first company in the world to
issue stocks and bonds in an initial public offering (Chambers, 2006)
Reasons for listing
When a company lists its securities on a public exchange, the money paid by investors for the
newly issued shares goes directly to the company (in contrast to a later trade of shares on the
exchange, where the money passes between investors). An IPO, therefore, allows a company to
tap a wide pool of investors to provide itself with capital for future growth, repayment of debt or
working capital. A company selling common shares is never required to repay the capital to
investors.
Once a company is listed, it is able to issue additional common shares via a secondary offering,
thereby again providing itself with capital for expansion without incurring any debt. This ability
to quickly raise large amounts of capital from the market is a key reason many companies seek to
go public.
There are several benefits to being a public company, namely:

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 Bolstering and diversifying equity base

 Enabling cheaper access to capital
 Exposure, prestige and public image
 Attracting and retaining better management and employees through liquid equity
participation
 Facilitating acquisitions
 Creating multiple financing opportunities: equity, convertible debt, cheaper bank loans,
etc.
 Increased liquidity for equity holder
Disadvantages of an IPO
There are several disadvantages to completing an initial public offering, namely:
 Significant legal, accounting and marketing costs
 Ongoing requirement to disclose financial and business information
 Meaningful time, effort and attention required of senior management
 Risk that required funding will not be raised
 Public dissemination of information which may be useful to competitors, suppliers and
customers
IPO Process
Initial public offer or IPO is a way for a company to raise capital through public and get listed in
the stock market to become a publicly traded company for first time. For a company, the cost of
borrowing money through IPO is less in comparison to other popular options available in the
market. Through IPO, company diversifies its equity base to large number of investors. When
securities of a company is listed in stock exchanges, it also gets benefited in term of brand
building as its being discussed on almost day to day basis among millions of investors and
experts.
Companies follow a complex process to raise money through IPO in India. The process begins
with hiring investment bank(s) as the Lead Manager to sell the equity shares. The Lead
Managers prepares a Draft Red Herring Prospectus (DRHP) and submit it to SEBI, the regulator
for the securities market in India, for approval (this process is called IPO Filing). Company also
hires an authorized Credit Rating Agency to grade the fundamentals of the company going public
(as IPO Grading is mandatory) and gets am in-principal approval from Stock Exchanges (BSE,
NSE) for listing of its equity shares. After receiving SEBI clearance on the public issue and
approval from stock exchanges, company begins distribution of IPO Application Forms through
its designated Syndicate Managers. The initial public issue is open for a certain number of days
and the bids are updated with the stock exchanges as they are received. Once the IPO is closed
for public subscription, in case of the Book Building IPO, the company with help from the Lead
Managers and the IPO Registrar, decides the Issue Price of IPO Share (based on the demand).

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Then the Registrar does the fair distribution of shares and publishes a report in the form of Basis
of Allotment document. The allocated shares are now deposited in to the demat accounts of the
investors and get listed in designated stock exchanges on the specified IPO Listing Date.
An India Stock Market investor can follow the complete IPO Cycle on this website. IPO tools
available on this website allows investors to analyze Forthcoming IPO's, find IPO Research,
discuss stocks with likeminded investors, analyze IPO Historic Data and follow the IPO Market
though IPO Notes which are delivered regularly via Email Newsletters, SMS Alerts and Face
book Updates.
24. Explain in detail about Venture Capital as a source of long term finance. (Nov / Dec
2011)
Stages involved in venture capital financing:
The financing of high-tech., project in the form of venture capital financing is
done in several stages. They may ‘be in the form of:
 Early-stage financing
 Later stage financing
Early-stage financing
This stage of financing is done to the new project or to the new technocrat who wishes to
commercialize his research talents. As the technocrat is well versed only with knowhow and not
with capital, going for debt at this stage increases the risk of entrepreneur and affect the health of
the business unit. In, other means of financing, the obligation to repay the loans along with
interest starts immediately with lending. Hence, it is not advisable for young entrepreneurs to go
in for such loans. They have depend mainly on equity stoke so that the risk of repayment does
not arise equity financing permits the young entrepreneurs to commercialize and earns profits out
of the investment. The main instruments used for such financial assistance would be in the form
of equity contribution, unsecured loans and optionally convertible securities. Once the financing
is done, venture capitalists assist the firm in general administrative activities and allow the
technocrat to concentrate on production and marketing. This stage of venture capital financing
consists of seed capital, start-ups and second round financing.
(a) Seed capital:
Seed capital financing includes the implementation of research project,
starting from all initial conceptual stage. This stage requires more
time to complete the process. Because the entrepreneur made an
effort to the maximum to meet the market potentiality. Therefore
external equity in preferred. The key factors that influence equity
financing at this stage are:
 The technology used in the project, possible threats of new technology in the near

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future.
 Different aspects of the product life cycle.
 The total investment required commercializing the product and time required to get
suitable returns etc.
(b) Start-up stage financing:
At this stage innovator requires finance to commercialize the product. This stage is not simple to
execute, it requires more time in getting different elements ie., (patent rights, trade marks, design
and copy rights) which are very essential to bring the product in the market. All these
components are very essentially needed to launch the product effectively. Hence, time and
finance is needed. On the other hand, the research must also be done to evaluate the probable
opportunities to exploit the market. Therefore, venture capital investor evaluates the projects
carefully and negotiate the terms and conditions with the entrepreneur with regard to sharing the
management.
(c) Second round of financing:
This type of financing is required when the project incurs loss or inability to yield sufficient
profits. The reasons could be due to internal or external factors. At this stage, if the venture
capitalists are fully aware of the genuine reasons for the loss, he should decide on second round
financing, or he may seek the support of new investor. This is a complex process as the original
investor may express his inability to further finance the project or entrepreneur must have lost
the confidence with the original investor or he may wishes to broad base the investment pattern.
Lot of bargaining has been done to coordinate the financing with original investor and with the
technocrat or promoter.
(2) Later Stage Financing
Later stage financing is considered to be the easy means of assistance. The reason being, the
product launched has not only reached the boom period but also indicator further expansion and
growth. Hence it is a easy means of financing with low risk profile. The real problem associated
at this stage is entrepreneur not be willing to give majority of his stake to the venture capitalists
but may accept for more number of executive directors in the board. This means of is also known
as expansion finance, replacement capital, management buyout and turn around capital.
(a) Expansion finance: Later stage financing is executed to expand the market, production or to
establish warehouses etc., Export trade activities may also be considered for financing the
project.
(b) Replacement capital): Under this stage, the promoter may prefer to buy the entire equity
stake of the project by approaching some other financiers. He may also wish to increase his
holding by buying more number of equity shares. Replacement capital) is normally preferred at
the time of public issues. If the company is unlisted, getting capital gains on the fresh issues

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needs more time, tilt then replacement capital can be obtained in the form of convertible
preference shares from the second financier.
(c) Management Buyout (MBO): This may be offered in two ways namely. ‘Management
buyout’ or ‘Management buys int. In management buyout, venture capitalists help the
management of a company to buy or take over the ownership of the business. This would help
the management to reshuffle or reengineer the entire project.
In management buy in strategies, outsides prefer to buy the existing business. This means of
financing is less risky; it is not considered as venture capital and has wide criticism.
(d) Rescue Capital: Rescue capital is also known as turnaround capital offered with a view to
help the technocrat or the business unit to come out of difficulties. This means of financing is
risky in nature and the investor may ask for major changes in the management. In India, venture
capital financing for MBO and turnout are rarely seen, as the majority of the investor prefers to
invest only in later stages.
25. Describe briefly the recent trends in stock exchange. (May/June 2012)
Recent trends in stock market
1) Listing of securities in foreign markets allowed.
2) Online trading system is established.
3) Trading system is changed from outcry system to onscreen based system.
4) Derivative trading started.
5) Dematerialization of shares allowed. Depositories Limited started.
6) Foreign institutional investment in securities permitted.
7) Companies are allowed to buy back their shares.
8) Emergence of Credit Rating Agencies.
9) Indian companies are allowed to raise capital from abroad.
10) Foreign companies are allowed to raise capital from Indian market.
26. Elucidate the role of new issue market. (May/June 2012)
Meaning of new issue market
• It refers to the set-up which helps the industry to raise the funds by issuing different types
of securities.
• These securities are issued directly to the investors (both individuals as well as
institutional) through the mechanism called primary market or new issue market.
• The securities take birth in this market.

Functions of new issue market

1. Origination:
It refers to the work of investigation, analysis and processing of new project proposals.
Origination starts before an issue is actually floated in the market. It includes a careful study of

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the technical, economic and financial viability to ensure the soundness of the project and
provides advisory services.
2. Underwriting:
It is an agreement whereby the underwriter promises to subscribe to a specified number of shares
or debentures in the event of public not subscribing to the issue. Thus it is a guarantee for the
marketability of shares.
Underwriters may be institutional and non-institutional.
3. Distribution:
It is the function of sale of securities to ultimate investors. Brokers and agents who maintain
regular and direct contract with the ultimate investors, perform this service.
Methods of floating new issues
The various methods which are used in the floating of securities in the new issue market are:
• Public issues
• Offer for sale
• Placement
• Right issues
a. Public issues or Initial public offering (IPO)
The issuing company directly offers to the general public/institutions a fixed number of securities
at a stated price or price band through a document called prospectus. This is the most common
method followed by companies to raise capital through issue of the securities.
b. Offer of sale
• It consists in outright sale of securities through the intermediary of issue houses or share
brokers.
• It consists of two stages: the first stage is a direct sale by the issuing company to the issue
house and brokers at an agreed price.
• In the second stage, the intermediaries resell the above securities to the ultimate
investors. The issue houses purchase the securities at a negotiated price and resell at a
higher price. The difference in the purchase and sale price is called turn or spread.
c. Private placement
• It involves sale of securities to a limited number of sophisticated investors such as
financial institutions, mutual funds, venture capital funds, banks, and so on.
• It refers to sale of equity or equity related instruments of an unlisted company or sale of
debentures of a listed or unlisted company.
d. Right Issue
When a listed company proposes to issue securities to its existing shareholders, whose names
appear in the register of members on record date, in the proportion to their existing holding,

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through an offer document, such issues are called ‘Right Issue’. This mode of raising capital is
the best suited when the dilution of controlling interest is not intended.
27. Explain briefly the different types of lease financing in India. (May/June 2012)
Meaning 0f lease financing:
A lease transaction is a commercial arrangement whereby an equipment owner or
Manufacturer conveys to the equipment user the right to use the equipment in return for a rental.
In other words, lease is a contract between the owner of an asset (the lessor) and its user (the
lessee) for the right to use the asset during a specified period in return for a mutually agreed
periodic payment (the lease rentals). The important feature of a lease contract is separation of the
ownership of the asset from its usage. Lease financing is based on the observation made by
Donald B. Grant: “Why own a cow when the milk is so cheap? All you really need is milk and
not the cow.”
Lease agreements are basically of two types.
They are (a) Financial lease and (b) Operating lease.
The other variations in lease agreements are (c) Sale and lease back , (d) Leveraged leasing and
(e) Direct leasing.
(a) Financial lease
Long-term, non-cancellable lease contracts are known as financial leases. The essential point of
financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the
title for the asset at the end of the lease period at a nominal cost. At lease it must give an option
to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the
lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of
the economic life of the asset. The lease agreement is irrevocable. Practically all the risks
incidental to the asset ownership and all the benefits arising there from are transferred to the
lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remain with the
lessor. Financial lease is also known as ‘capital lease’. In India, financial leases are very popular
with high-cost and high technology equipment.
(b) Operating lease
An operating lease stands in contrast to the financial lease in almost all aspects. This lease
agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for
the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset
at the end of the lease period. Normally the lease is for a short period and even otherwise is
revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found
suitable for operating lease because the rate of obsolescence is very high in this kind of assets.
(c) Sale and Lease back
it is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the
buyer), who in turn leases back the same asset to the owner in consideration of lease rentals.

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However, under this arrangement, the assets are not physically exchanged but it all happens in
records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable
for those assets, which are not subjected depreciation but appreciation, say land. The advantage
of this method is that the lessee can satisfy himself completely regarding the quality of the asset
and after possession of the asset convert the sale into a lease arrangement.
(d) Leveraged leasing
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The
lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender
and the asset so purchased is held as security against the loan. The lender is paid off from the
lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to
the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with
the asset.
(e) Direct leasing.
Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly. The
ownership of the asset leased out remains with the manufacturer itself. The major types of direct
lessor include manufacturers, finance companies, independent lease companies, special purpose
leasing companies etc
28. Distinguish between hire purchase and installment purchase system. (May/June 2012)
Hire Purchase – Meaning
Hire purchase system defers to the system wherein, the seller of goods delivers the goods
to the buyer without transferring the ownership of goods. The payment for the goods will be
made by the buyer in installments. If the buyer pays all the installments, the ownership of the
goods will be transferred, on payment of the last installment. However, if the buyer does not pay
for any installment, the goods will be reposed by the seller and the money paid on earlier
installments will be treated as hire charges for using the goods. So, under this system, the
transaction may result in purchasing of goods by the seller or in hiring the goods. Hence, the
system is called Hire Purchase system.
Characteristics of Hire – Purchase system
a. It is a credit purchase
b. The price under hire – purchase is paid in installments
c. The goods are delivered in the possession of the purchaser at the time of commencement of the
agreement
d. Hire vendor continues to be the owner of the goods till the payment of last installment
e. The hire – purchaser has a right to use the goods as a bailer.
f. The hire – purchaser has a right to terminate the agreement the agreement at any time in the
capacity of hirer.

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g. The hire – purchaser becomes the owner of the goods after the payment of installments as per
the agreement.
h. If there is a default in the payment of any installment, the hire vendor will take away the goods
from the possession of the purchaser without refunding him any amount.
Installment Purchase System
Meaning: Installment payment system (also called deferred installments) is a system where the
buyer is given the ownership as well as the possession of the goods at the time of signing the
contract. The buyer has the facility to pay the price in installments.
Definition: According to J. B. Batliboi, installment purchase system is a system under there is an
agreement to purchase and pay by installments, the goods which become the property of the
purchaser immediately when he receives the delivery of the same.
Features:
a. Under this system, there will be an outright sale of goods/assets.
b. The Possession as well as the ownership is passed to the buyer right at the time of signing the
contract.
c. The buyer can make the payment in installments.
d. In case of default in payment, the seller cannot repossess the goods, but he can sue the buyer
for the recovery of unpaid price.
e. The buyer cannot exercise the option of returning the goods and terminate the contract, unless
the same becomes void or voidable under the contract act.
Difference between hire purchase system and installment purchase system
S. No Hire purchase system Installment purchase system
1 It is a contract of hiring It is a contract of sale
2 It is transferred by seller to buyer only It is transferred by seller to buyer,
after payment of all installments immediately on signing the contract
3 Here, the buyer is like a bailee Here, the buyer is not in a position of a
bailee
4 Risk is on the seller Risk is on the buyer
5 On default of payment of any On default of payment of any installment by
installment by the buyer, the seller can the buyer, the seller cannot repossess the
repossess the goods. goods, but can file a suit in the court of law
against the buyer for the recovery of unpaid
price.
6 The buyer can exercise the option of The buyer cannot exercise the option of
return of goods return of goods
7 The buyer cannot dispose the goods, The buyer has the right to dispose the
until the payment of last installment. If goods, even if all installments are not yet
disposed, the third party buyer does not paid.

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get a better title.

29. Explain the various sources of long term finance. (May/June 2012)
The long-term sources are:
-Equity shares,-Preference shares,-Debentures,-Bonds,-Leasing,- Long term bank loans.
1. EQUITY SHARES: According to Sec 85(2), “equity shares are those shares which are not
preference shares”. Equity shares are also called ordinary shares.
If a company has issued both preference shares and equity shares the equity holder will get dividend
after the dividend on preference shares has been paid. The dividend is not certain. The financial risks
is more with equity share capital so equity shares are also called risk capital
Advantages of equity share:
1) Non recurring fixed payments, 2) No charges, 3) Long-term funds, 4) Capital Formation, 5)
Credit formation, 6) Ownership, 7) Right issues
Disadvantages of equity shares:
1) Inability of refund, 2) Difficult in trading on equity, 3)Concentration of control, 4) Not always
acceptable, 5) Dividend at the boards Mercy 6) Illiquid,7) Speculation
2. PREFERENCE SHARES
According to Sec 85 of the Act, preference shares are those on which there is preference right 1) To
claim dividend during the life time of the company and 2) To claim repayment of capital on the
winding up. The percentage of dividend is fixed. The holders of preferences shares get the fixed
dividend before any dividend before any dividend is paid to other classes of share holders. At the time
of winding up of the company, preferences share holders can get back their capital before any other
classes of share holder can get back their money.
Advantages of preferences shares:
-Suitable to cautions investors, -Retention of control,-Attractive types, -Convenience,-Increase in
equity share holders income,-Conversion to satisfy legal requirement, -Economical, -Enabling
reconstruction and reorganization, -Increasing the marketability, -Good alternative for debenture.
Disadvantages of preference shares:
1) Heavy dividend 2) Accumulation of dividend, 3) Costly 4) No voting rights, 5) Way to
liquidation 6) Affecting the financial status, 7) Time of redemption, 8) Income Tax
3. DEBENTURE
A Debenture is a debt security issued by a company (called the Issuer), which offers to pay
interest in lieu of the money borrowed for a certain period.
• These are long-term debt instruments Issued by Private Sector Companies.
• These are issued in denominations as low as Rs 1000 and have maturities ranging
between one and ten years.

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• Debentures enable investors to reap the Dual Benefits of Adequate Security and Good
Returns.
• Unlike other Fixed Income Instruments such as Fixed Deposits, Bank Deposits they can
be transferred from one party to another by using transfer from.
• Debentures were issued in physical form. Now corporate/PSUs have started issuing
debentures in De-mat form.
• Debentures can be listed on a stock exchange, giving you an opportunity to sell them
and exit earlier then the tenure of the debenture.
In Simple Words, A debenture is a debt instrument, just like a fixed deposit (FD), usually issued
by a company. You invest a sum, and the company pays you a fixed rate of interest for the pre-
defined period. After the period gets over, you get back your principal amount.
4. BONDS
Bonds are issued by public authorities, credit institutions, companies and supranational
institutions in the primary markets. The most common process for issuing bonds is through
underwriting. When a bond issue is underwritten, one or more securities firms or banks, forming
a syndicate, buy the entire issue of bonds from the issuer and re-sell them to investors. The
security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance
is arranged by book runners who arrange the bond issue, have direct contact with investors and
act as advisers to the bond issuer in terms of timing and price of the bond issue. The book
runners' willingness to underwrite must be discussed prior to any decision on the terms of the
bond issue as there may be limited demand for the bonds.
In contrast, government bonds are usually issued in an auction. In some cases both members of
the public and banks may bid for bonds. In other cases only market makers may bid for bonds.
The overall rate of return on the bond depends on both the terms of the bond and the price paid.
The terms of the bond, such as the coupon, are fixed in advance and the price is determined by
the market.
5. LONG TERM LOANS
Loans of less than three years are typically considered short-term while loans greater than three
years are fall into the long-term category. Long-term loans are normally for a period of 10 years
although some may be approved for up to 20 years.
Long-term loans of greater than three years require a more detailed analysis by the lending
institution. As with short-term loans the same criteria of a good credit history coupled with a
successful business balance sheet and financial statement will make the approval process quicker
and easier.
A long-term loan will be a secured loan, and sufficient collateral must exist and will definitely be
the basis for approval. Long-term loans are appropriate for large acquisitions or purchases of
equipment that has an extended life.

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Interest on short and long-term loans varies widely. Typically the interest rate will be 1-3% above
the prime lending rate and it is obvious that the shorter the period of the loan the less the interest
expense will be.
Additionally the value of any collateral that might be involved in securing the loan could affect
the interest rate that will be charged. Banks and lending institution develop their policies based
on the risk involved in approving a loan. Loans for short terms generally have less risk
associated with them than longer term loans.
6. LEASING
A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer
conveys to the equipment user the right to use the equipment in return for a rental.
In other words, lease is a contract between the owner of an asset (the lessor) and its user (the
lessee) for the right to use the asset during a specified period in return for a mutually agreed
periodic payment (the lease rentals). The important feature of a lease contract is separation of
the ownership of the asset from its usage.
Lease agreements are basically of two types. They are
(a) Financial lease and
(b) Operating lease.
The other variations in lease agreements are
(c) Sale and lease back (d) Leveraged leasing and (e) Direct leasing.
30. Discuss leasing as a best source of finance to manufacturing industries. (May/June
2012)
Leasing is an arrangement that provides a firm with the use and control over assets without
buying and owing the same. It is a form of renting assets.
Lease is a contract between the owner of the asset (lessor) and the use of the asset called the
lessee whereby the lessor gives the right to use the asset to the lessee over an agreed period of
time for a consideration called the lease rental the lease contract is regulated by the terms and
conditions of the agreement, the lessee pays the lease rent periodically to the lessor as regular
fixed payments over a period of time. The rental may be payable at the beginning or end of a
month quarter, half year the lease rent can also be agreed both in terms of amount and timing as
per the profits and cash flow position of the lessee. At the expiry of the lease period the asset
reverts back to the lessor who is the legal owner of the asset.
Many businesses lease assets as an alternative to owning them.
– Business has the use of the asset and incurs an obligation either to pay off loan or
meet monthly lease payment.
– At the end of lease term, residual value of asset belongs to lessee.
Leasing is a form of debt financing.

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• FASB 13 (governing lease accounting): defines difference between capital lease and
operating lease
• Capital leases meet any one of these four conditions:
1. Title is transferred to lessee at end of lease term.
2. Lease contains bargain purchase option (an option to buy asset at very low price).
3. Term of lease is greater than or equal to 75% of estimated economic life of asset.
4. Present value of minimum lease payment is greater than or equal to 90% of fair
value of leased property.
• Operating leases
1. More like true rentals rather than means to finance long-term use of asset
2. For substantially less than expected useful life of asset and provide for both
financing and maintenance
3. Contain cancellation clauses so that lessee is not locked into long-term agreement.
4. No asset and associated liability are created
Tax benefits are the major motivation that firms prefer leasing to owning.
1. Lessor is entitled to tax benefits from depreciation.
2. Lessor’s after-tax return is higher than it would be under straight debt arrangement.
3. Lessor prices lease payments at lower rate of return than would otherwise be charged the
lessee on straight loan arrangement.
Leasing may be attractive to firm with low credit rating.
a. Lease can be obtained more easily than loan can be arranged because lessor
retains title to asset.
b. Full recovery of asset in the event of default is much easier than if asset were
owned by lessee.
c. Down payment in purchased asset is much higher than deposit required on lease
d. Use of operating leases may increase lessee’s overall credit availability since they
do not appear on the balance sheet.
Sale and Leaseback
• Firm sells fixed asset (e.g. building) to lender/lessor and then immediately leases back the
property.
• Seller/lessee receives large inflow of cash that may be used to finance other aspects of
business and in return, enters into long-term lease obligation.
Leveraged Lease
• Involves third-party lender:
– Lessor (e.g. commercial bank) borrows 80% or less of cost of asset from third-
party lender.
– Lessor purchases asset and leases it to lessee.

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• Lessor has title to asset and is thus entitled to full depreciation benefits.
31. A firm proposes to lease on asset of Rs. 20 lakhs. The annual, end-of-the year, lease rentals
will be Rs. 5 lakh for 5 years. The firm is not in a position to pay tax for next 5 years. The
depreciation rate (WDV) is 25% p.a. The lesser’s marginal tax rate is 35%. Calculate the net
present value of lease to the lessee and lessor. How can both benefit from the deal? Show your
computations. Assume that the lessee’s post –tax borrowing rate is 14%. (May/June 2013)

Solution
Step 1: Calculation of Depreciation (WDV method)
Years Amount Depreciation @ 25%
(Rs.) (Rs.)
1 20,00,000 5,00,000
2 15,00,000 3,75,000
3 11,25,000 2,81,250
4 8,43,750 2,10,937
5 6,32,813 1,58,203

Years Lease rent Depreciation Tax @35 Net cash Discount Total PV
(Rs.) @ 25% % flows factor @
WDV 14%
1 5,00,000 5,00,000 - 5,00,000 .877 4,38,500
2 5,00,000 3,75,000 43,750 81,250 .769 62,481
3 5,00,000 2,81,250 76,562 1,42,188 .675 95,976
4 5,00,000 2,10,937 1,01,172 1,87,891 .592 1,11,231
5 5,00,000 1,58,203 1,19,628 2,22,169 .519 1,15,305
3.432 8,23,493

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167