Unit – V

CAPITAL

Capital is defined as wealth, which is created over a period of time through abstinence to
spend. There are different forms of capital- property, cash or titles to wealth. It is the aggregate
of funds used in the short run and long run. An economist views capital as the value total assets
available with the business. An accountant sees the capital as the different between the assets and
liabilities.

Significance of capital

1. To promote a business: Capital is required at the promotion stage. A large variety of

expenses have to be incurred on project reports, feasibility studies and reports,
preparation and filing of various documents, and for meeting various other expenses in
connection with the raising of capital from the public.
2. To conduct business operations smoothly: Business firms also need capital for the
purpose of conducting their business operations such as research and development,
advertising, sales promotion, distribution and operation expenses.
3. To expand and diversify: The firm requires a lot of capital for expansion and
diversification purposes. This includes development expense such as purchase of
sophisticated machinery and equipment and also payment towards sophisticated
technology.
4. To meet contingencies: A firm need funds to meet contingencies such as sudden fall in
sales, major litigation, nature calamities like fire, and so on.
5. To pay taxes: The firm has to meet its statutory commitments such as income tax and
sales tax, excise duty and so on.
6. To pay dividends and interests: The business has to make payment towards dividends
and interest to shareholders and financial institutions respectively.
7. To replace the assets: The business needs to replace its assets like plant and machinery
after a certain period of use. For this purpose the firm needs funds to make suitable
replacement of assets in place of old and worn out assets.
8. To support welfare programs: The company may also have to take up social welfare
programs such as literacy drive, and health camps. It may have to donate to charitable
trusts, educational institutions or public services organizations.
9. To wind up: At the time of winding up, the company may need funds to meet
liquidation expenses.
 Types of capital

A) Fixed capital
B) Working capital

FIXED CAPITAL

Fixed capital is that portion of capital which invested in acquiring long term assets such
as land and buildings, plant and machinery, furniture and fixtures, and so on. Fixed capital forms
the skeleton of the business. It provides the basic assets as per the business needs.

Features of fixed assets:

1. Permanent in nature: Fixed capital is more or less permanent in nature. It is generally

not withdrawn as long as the business carries on its business.
2. Profit generation: Fixed asset are the sources of profits but they can never generate
profits by themselves. They use stocks, cash and debtors to generate profits.
3. Low liquidity: The fixed assets cannot be converted into cash quickly. Liquidity refers to
conversion of assets into cash.
4. Amount of fixed capital: The amount of fixed capital of a company depends on a
number of factors such as size of the company, nature of business, method of production
and so on. A manufacturing company such as steel factory may require relatively large
finance when compared to a service organization such as a software company.
5. Utilized for promotional and expansion: The fixed capital is mostly needed at the time
of promoting the company to purchase the fixed assets or at the time of expansion. In
other words, the need for fixed capital arises less frequently.

Types of fixed assets

1. Tangible fixed assets: These are physical items which can be seen and touched. Most of
the common fixed assets are land, buildings, machinery, motor vehicles, furniture and so
on.
2. Intangible fixed assets: These do not have physical form. They cannot be seen or
touched. But these are very valuable to business. Examples are goodwill, brand names,
trademarks, patents, copy rights and so on.
3. Financial fixed assets: These are investments in shares, foreign currency deposits,
government bonds , shares held by the business in other companies and so on.
WORKING CAPITAL

Working capital is the flesh and blood of the business. It is that portion of capital that
makes a company work. It is not just possible to carry on the business with only fixed assets.
Working capital is a must. Working capital is also called circulating capital. It is used to meet
regular or recurring needs of the business. The regular needs refer to the purchase of
materials, payment of wages and salaries, expenses like rent, advertising, power and so on. In
short , working capital is the amount needed to cover the cost of operating the business.

Definition of working capital

Working capital define as a Current assets excess of Current liabilities

Its also define in mathematically as formula

Working capital = Current assets – Current liabilities

CAPITAL BUDGETING

Capital budgeting is the process of making investment decision in long-term assets or

courses of action. Capital expenditure incurred today is expected to bring its benefits over a
period of time. These expenditures are related to the acquisition & improvement of fixes assets.

Capital budgeting is the planning of expenditure and the benefit which spread over a
number of years. It is the process of deciding whether or not to invest in a particular project, as
the investment possibilities may not be rewarding. The manager has to choose a project, which
gives a rate of return, which is more than the cost of financing the project. For this the manager
has to evaluate the worth of the projects in-terms of cost and benefits. The benefits are the
expected cash inflows from the project, which are discounted against a standard, generally the
cost of capital.

Scope & Significance of capital budgeting

1. Subs t an ti al exp e n d itu re : Capi ta l b udg eti ng de ci si on in vo lve s the in ve stm ent o f s ubs tan ti al
amou nt of fun ds an d i s thu s i t is ne ces sar y for a f irm to mak e su ch dec is io n af ter a
thou ght fu l c on sid era tio n, s o a s t o re su lt in pro fi tab le us e o f s car ce res our ce s. Ha s ty an d
inc orre ct de ci sio ns w ou ld not on ly r es ul t i n h uge l os ses bu t wou ld al so a cco un t for fa il ure of
the fir m.
2. L ong tim e p e r io d : Ca pi ta l bud get in g d ec is ion ha s it s e ffe ct ov er a l ong per io d of tim e . T he y
affe ct th e f utur e b ene fi ts and al so the f irm and i n fl u enc e t he r ate an d d ire ct io n of gro wt h o f
the fir m.
3. Ir re ve rs ib i lity : Mo st of su ch dec is io ns are irr eve rs ib le . On ce ta ken , t he fir m m ay not be en in
a po si ti on to r ev erse i ts i mpac t. Thi s may be du e t o the rea so n, tha t it is di ff i cul t t o f in d a
buy er f or s ec ond - ha nd cap ita l item s.
 4. Com p l ex d eci sio n : Cap it a l i nv est men t d ec is ion i nv ol ves an a sse ss men t o f f utu re e ven ts,
wh ich i n f act ar e d iff ic ul t t o pre di ct . F ur ther , it is d iff icu lt to es ti mat e i n q uan ti t ati ve term s of
all be nef it s o r c os ts rel at i ng t o a par ti cu lar in ve stm ent de ci sio n.

Nature of capital budgeting:

1. Generating investment proposals

2. Estimating cash for the proposals
3. Evaluating cash flows
4. Selection of projects
5. Monitoring and re-evaluating

Methods of capital budgeting

The capital budgeting appraisal methods are techniques of evaluation of investment proposal
will help the company to decide upon the desirability of an investment proposal depending upon
their; relative income generating capacity and rank them in order of their desirability. These
methods provide the company a set of norms on the basis of which either it has to accept or
reject the investment proposal. The most widely accepted techniques used in estimating the cost-
returns of investment projects can be grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods

1. TRADITIONAL METHODS

These methods are based on the principles to determine the desirability of an investment project
on the basis of its useful life and expected returns. These methods depend upon the accounting
information available from the books of accounts of the company. These will not take into
account the concept of „time value of money‟, which is a significant factor to determine the
desirability of a project in terms of present value.

PAY-BACK PERIOD METHOD:

It is the most popular and widely recognized traditional method of evaluating the investment
proposals. It can be defined, as „the number of years required to recover the original cash out lay
invested in a project‟.

According to Weston & Brigham, “The pay back period is the number of years it takes the firm
to recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.

The pay back period is also called payout or payoff period. This period is calculated by
dividing the cost of the project by the annual earnings after tax but before depreciation. Under
this method the projects are ranked on the basis of the length of the payback period. A project
with the shortest payback period will be given the highest rank and taken as the best investment.
The shorter the payback period, the less risky the investment is.

Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
3. It dose not involve any cost for computation of the payback period.
4. It is one of the widely used methods in small scale industry sector.
5. It can be computed on the basis of accounting information available from the books.

Demerits:
1. This method fails to take into account the cash flows received by the company after the pay
back period.
2. It doesn‟t take into account the interest factor involved in an investment outlay..
3. It is not consistent with the objective of maximizing the market value of the company‟s share.
4. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.

Cash outlay (or) Original cost of project

Pay-back period = -------------------------------------------

Annual cash inflow

Pay back Period = Cost of the project – Accumulate annual cash inflow of

lower year

Lower year + -------------------------------------------------------------------

Accumulate annual cash - accumulate annual cash inflow

inflow of higher year of lower year

ACCOUNTING (OR) AVERAGE RATE OF RETURN METHOD (ARR):

It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determine by dividing
the average income after taxes by the average investment i.e., the average book value after
depreciation.

According to „Soloman‟, accounting rate of return on an investment can be calculated as the ratio
of accounting net income to the initial investment, i.e.,

Average rate of return= average annual profit after tax

----------------------------------------- x 100
Average investment

Average annual profit after tax = Sum of profits after tax

----------------------------------
No. of the years

Average investment = Cost – Scrap value

--------------------- + Scrap value + additional working capital
2

Merits:

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.

Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. It ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.

II: DISCOUNTED CASH FLOW METHODS:

The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of cash flows. The DCF methods are based
on the concept that a rupee earned today is more worth than a rupee earned tomorrow. These
methods take into consideration the profitability and also time value of money.
NET PRESENT VALUE METHOD (NPV)

The NPV takes into consideration the time value of money. The cash flows of different
years are valued differently and made comparable in terms of present values. For this the net
cash inflows of various period are discounted using required rate of return which is
predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the initial cost
of the project.

According the NPV technique, only one project will be selected whose NPV is positive
or above zero. If a project(s) NPV is less than „Zero‟, it gives negative NPV. Hence, it must be
rejected. If there are more than one project with positive NPV‟s, the project is selected whose
NPV is the highest.

NPV = PRESENT VALUE OF CASH INFLOW – PRESENT VALUE OF CASH OUTFLOW

Merits:

1.It recognizes the time value of money.

2.It is based on the entire cash flows generated during the useful life of the asset.
3.It is consistent with the objective of maximization of wealth of the owners.
4.The ranking of projects is independent of the discount rate used for determining the
present value.
Demerits:

1. The NPV is calculated by using the cost of capital as a discount rate. But the concept of
cost of capital if self is difficult to understood and determine.
2. It does not give solutions when the comparable projects are involved in different amounts
of investment.
3. It does not give correct answer to a question whether alternative projects or limited funds
are available with unequal lines.

PROFITABILITY INDEX (PI)

It is a capital budgeting technique to evaluate the investment projects for their viability or
profitability. Discounted cash flow technique is used in arriving at the profitability index. It is
also known as a benefit-cost ratio. Calculation of profitability index is possible with a simple
formula with inputs as – discount rate, cash inflows and outflows. PI greater than or equal to 1
is interpreted as a good and acceptable criterion.
Profitability index = Present value of cash inflow / Present value of cash outflow

INTERNAL RATE OF RETURN METHOD (IRR)

Internal Rate of Return method is also called as "Time Adjusted Rate of Return method" . It is
defined as the rate which equates the present value of each cash inflows with the present value of cash
outflows of an investment. In other words, it is the rate at which the net present value of the
investment is zero.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the present
value of expected cash inflows from a project equals the present value of expected cash outflows of the
project.
The Internal Rate of Return can be found out by Trial and Error method. First, compute the
present value of the cash flow from an investment, using an arbitrarily selected interest rate, for
example 10%. Then compare the present value so obtained with the investment cost.

Lower discount factor _ Original investment

Present value
Internal rate of return = lower discount + ------------------------------------------------------------------- (HDF – LDF)
Factor Lower discount factor – Higher discount factor
Present value present value

ADVANTAGES OF INTERNAL RATE OF RETURN:

 Time Value of Money: The first and the most important thing is that it considers the
time value of money in evaluating a project which is a big lacking in accounting rate of
return.

 Simplicity: The most attractive thing about this method is that it is very simple to
interpret after the IRR is calculated.

 Hurdle Rate: The hurdle rate is a difficult and subjective thing to decide. In IRR, the
hurdle rate or the required rate of return is not required for finding out IRR.

 Required Rate of Return is a Rough Estimate: A required rate of return is a rough

estimate being made by the managers and the method of IRR is not completely based
on required rate of return.

DISADVANTAGES OF INTERNAL RATE OF RETURN:

 Economies of Scale Ignored: One pitfall in the use of IRR method is that it ignores the
actual value of benefits.
 Impractical Implicit Assumption of Reinvestment Rate: While analyzing a project with
IRR method, it implicitly assumes that the positive future cash flows are reinvested at
IRR. If a project has low IRR, it will assume reinvestment at a low rate of return and on
the contrary if the other project has very high IRR, it will assume reinvestment rate at
the very high rate of return.

 Dependent or Contingent Projects: Many times, finance managers come across a

situation when the project under evaluation creates a compulsion of investing in other
projects.

 Mutually Exclusive Projects: Sometimes investors come across mutually exclusive

projects which mean if one is accepted other cannot be accepted. Building a hotel or a
commercial complex on a particular plot of land is an example of mutually exclusive
projects.
Meaning of ratio
A ratio is a mathematical number that is calculated as a reference to the relationship of two
or more numbers and can be expressed as a fraction, ratio, percentage, and several times.
The ratio is an arithmetical expression i.e. relationship of one number to another. It may be
defined as an indicated quotient of the mathematical expression. It is expressed as a
proportion or a fraction or in percentage or in terms of number of times.

Meaning of ratio analysis

Ratio analysis is the comparison of line items in the financial statements of a business. Ratio
analysis is used to evaluate a number of issues with an entity, such as its liquidity, efficiency
of operations, and profitability. This type of analysis is particularly useful to analysts
outside of a business, since their primary source of information about an organization is its
financial statements.

 Analysis of Financial Statements: Interpretation of the financial statements and data

is essential for all internal and external stakeholders of the firm. With the help of
ratio analysis, we interpret the numbers from the balance sheet and income
statements. Every stakeholder has different interests when it comes to the result
from the financial like the equity investors are more interested in the growth of the
dividend payments and the earnings power of the organization in the long run.
Creditors would like to ensure that they get their repayments on their dues on time.
 Helps in Understanding the Profitability of the Company: Profitability ratios help to
determine how profitable a firm is. Return on Assets and Return on Equity helps to
understand the ability of the firm to generate earnings. Return on assets is the total
net income divided by total assets. It means how many does a company earn a profit
 for every dollar of its assets. Return on equity is net income by shareholders equity.
This ratio tells us how well a company uses its investors’ money. Ratios like the Gross
profit and Net profit margin. Margins help to analyse the firm’s ability to translate
sales to profit.
 Analysis of Operational Efficiency of the Firms: Certain ratios help us to analyze the
degree of efficiency of the firms. Ratios like account receivables turnover, fixed asset
turnover, and inventory turnover ratio. These ratios can be compared with the other
peers of the same industry and will help to analyze which firms are better managed
as compared to the others. It measures a company’s capability to generate income
by using the assets. It looks at various aspects of the firm like the time it generally
takes to collect cash from debtors or the time period for the firm to convert the
inventory to cash. It is why efficiency ratios are critical, as an improvement will lead
to a growth in profitability.
 Liquidity of the Firms: Liquidity determines whether the company can pay its short-
term obligations or not. By short-term obligations, we mean the short term debts,
which can be paid off within 12 months or the operating cycle. For example, the
salaries due, sundry creditors, tax payable, outstanding expenses, etc. The current
ratio, quick ratio are used to measure the liquidity of the firms.
 Helps in Identifying the Business Risks of the Firm: One of the most important
reasons to use ratio analysis is that it helps in understanding the business risk of the
firm. Calculating the leverages (Financial Leverage and Operating Leverages) helps
the firm understand the business risk, i.e., how sensitive the profitability of the
company is with respect to its fixed cost deployment as well as debt outstanding.
 Helps in Identifying the Financial Risks of the Company: Another importance of ratio
analysis is that it helps in identifying the Financial Risks. Ratios like Leverage ratio,
interest coverage ratio, DSCR ratio, etc. help the firm understand how it is
dependent on external capital and whether they are capable of repaying the debt
using their capital.
 For Planning and Future Forecasting of the Firm: Analysts and managers can find a
trend and use the trend for future forecasting and can also be used for critical
decision making by external stakeholders like the investors. They can analyze
whether they should invest in a project or not.
 To Compare the Performance of the Firms: The main use of ratio analysis is that the
strengths and weaknesses of each firm can be compared. The ratios can also be
compared to the firm’s previous ratio and will help to analyze whether progress has
been made by the company.
Limitation of ratio analysis:

 Use of Historical Data: All the information used in ratio analysis is based on historical
numbers only. These data are drawn from historical actuals and by no means will
remain the same in the future as business performance changes with every passing
time.
 The Concept of Inflation: When we are comparing period wise numbers for trend
analysis and if in between the periods the inflationary rate has changed the
comparison makes no sense. Ratio analysis does not account for the inflation factor
at all.
 The Problem of Aggregation: The data from the financial statement for a particular
line item that we are using for our study or comparison may have been aggregated
in a different proportion in the past and thus doing a trend analysis based on this
data doesn’t give a true picture.
 Changes in Operation: A business can go drastic changes in its operations due to
certain unexpected needs and thus using the data of the past and making a
judgment based on that does not give a fruitful conclusion because pre-change and
post-change of operation numbers under no circumstances can be compared
together.
 The Policies of Accounting: When we are doing peer to peer comparison different
companies may use different accounting policies and thus it makes hard to conclude
on such cases.
 No Standard Definition of Ratios: There is no set standard definition of ratios and
numbers to be included in it. Some firms may include some items when calculating a
ratio and few may include others. Thus when it comes to a comparison of both
companies it becomes difficult.
 Ignorance of the Qualitative Aspect: Ratio analysis ignores the qualitative view of the
firm and tends to include only the monetary aspect.
 Opportunities for Window Dressing: Some firms may manipulate the numbers to
bring about changes to the ratio for displaying a better picture of the firm. Thus in
ratio analysis, there are scopes of window dressing.
 Time Effect: Some ratio pick numbers from the balance sheet which is prepared only
on the last day of the accounting period. Thus if there is any sudden shoot or decline
in the number pertaining to the last day of the accounting period it can drastically
impact the overall ratio analysis.

Types of Ratio Analysis

Types of ratios are given below:

LIQUIDITY RATIOS

This type of ratio helps in measuring the ability of a company to take care of its short-term
debt obligations. A higher liquidity ratio represents that the company is highly rich in cash.
The types of liquidity ratios are: –

1. Current Ratio: The current ratio is the ratio between the current assets and current
liabilities of a company. The current ratio is used to indicate the liquidity of an organization
in being able to meet its debt obligations in the upcoming twelve months. A higher current
ratio will indicate that the organization is highly capable of repaying its short-term debt
obligations.
Ideal ratio is 2:1

Current Ratio = Current Assets / Current Liabilities

2. Quick Ratio: The quick ratio is used to ascertain information pertaining to the capability
of a company in paying off its current liabilities on an immediate basis. Ideal ratio is 1:1

The formula used for the calculation of a quick ratio is-

Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivables)
/ Current Liabilities

3. Absolute liquidity ratio : This ratio measures the total liquidity available to the company.
This ratio only considers marketable securities and cash available to the company. This ratio
only tests short-term liquidity in terms of cash, marketable securities, and current
investment.

PROFITABILITY RATIOS

This type of ratio helps in measuring the ability of a company in earning sufficient profits.
The types of profitability ratios are: –

1. Gross Profit Ratios: Gross profit ratios are calculated in order to represent the operating
profits of an organization after making necessary adjustments pertaining to the COGS or
cost of goods sold.
The formula used for the calculation of gross profit ratio is-

Gross Profit Ratio = (Gross Profit / Net Sales) * 100

Net Sales = Gross Sales – Returns – Discounts – Allowances

Gross Profit = Sales – cost of goods sold

2. Net Profit Ratio: Net profit ratios are calculated in order to determine the overall
profitability of an organization after reducing both cash and non-cash expenditures.
The formula used for the calculation of net profit ratio is-

Net Profit Ratio = (Net Profit / Net Sales) * 100

3. Operating Profit Ratio: Operating profit ratio is used to determine the soundness of an
organization and its financial ability to repay all the short term and long term debt
obligations.
The formula used for the calculation of operating profit ratio is-

Operating Profit Ratio = (Earnings before Interest and Taxes / Net Sales) * 100

4. Operating ratio: It is calculated by dividing a property's operating expense (minus

depreciation) by its gross operating income. The OER is used for comparing the expenses of
similar properties. On the other hand, the operating ratio is the comparison of a company's
total expenses compared to the revenue or net sales generated.

Operating ratio= (operating expenses/ net sales) * 100

5. Earnings per Share (EPS): EPS signifies the earnings of an equity holder based on each
share.
The formula used for EPS is:

EPS = (Net Income – Preferred Dividends) / (Weighted Average of Outstanding Shares)

(Or)
EPS= Earnings available to equity shareholders/ No. of equity shares

6. Price Earnings Ratio: P/E ratio indicates the profit earning capacity of the company.
The formula used for the calculation of price earnings ratio is:

Price Earnings Ratio = Market Price per Share / Earning per Share

7. Return on Capital Employed (ROCE): Return on capital employed is used to determine

the profitability of an organization with respect to the capital that is invested in the
business.
The formula used for the calculation of ROCE is:

ROCE = Earnings before Interest and Taxes / Capital Employed

8. Return on Investment
There are several versions of the ROI formula. The two most commonly used are shown
below:

ROI = Net Income / Cost of Investment

9. Return on Assets: Return on Assets calculated by dividing business’s net income by total
assets.

ROA = Net Income / Total Assets

SOLVENCY RATIOS

Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company
is solvent and well capable of paying off its debt obligations or not.
The types of solvency ratios are: –

1. Debt Equity Ratio: The debt-equity ratio can be defined as a ratio between total debt and
shareholders fund. The debt-equity ratio is used to calculate the leverage of an organization.
An ideal debt-equity ratio for an organization is 2:1.

Debt Equity Ratio = Total Debts / Shareholders Fund

2. Interest Coverage Ratio: The interest coverage ratio is used to determine the solvency of
an organization in the nearing time as well as how many times the profits earned by that
very organization were capable of absorbing its interest-related expenses.

Interest Coverage Ratio = Earnings before Interest and Taxes / Interest Expense

3. Debt to total fund: Total-debt-to-total-fund is a leverage ratio that defines the total
amount of debt relative to total debt of a company.

Debt to total fund = Debt/Equity+Debt

TURNOVER RATIOS

Turnover ratios are used to determine how efficiently the financial assets and liabilities of an
organization have been used for the purpose of generating revenues.
The types of turnover ratios are: –

1. Fixed Assets Turnover Ratios: Fixed assets turnover ratio is used to determine the
efficiency of an organization in utilizing its fixed assets for the purpose of generating
revenues.
The formula used for the determination of fixed assets turnover ratio is-

Fixed Assets Turnover Ratio = Net Sales / Average Fixed Assets

2. Inventory Turnover Ratio: Inventory turnover ratio is used to determine the speed of a
company in converting its inventories into sales.
The formula used for calculating inventory turnover ratio is-
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories

3. Inventory velocity = 365 days/Inventory Turnover Ratio

4. Debtors or Receivables Turnover Ratio

It is otherwise called as Debtors Velocity. All the goods cannot be sold on cash. There may
be some credit sales. The credit sale is one of the sales promotion techniques. The volume
of credit sales is based on credit policy of the company. Each company has its own credit
policy.

Debtors Turnover Ratio = Total Sales /average Debtors

5. Debtors collection period= 365days/ Debtors Turnover Ratio

6. Creditors turnover ratio: Creditors turnover ratio is calculated by total purchases divided
with average creditors

Creditors turnover ratio = Total purchases / average creditors

7. Creditors payment period: Creditors payment period is calculating by 365 days divided by
creditors payment period.

Creditors payment period= 365days/ creditors Turnover Ratio

8. working capital turnover ratio : The working capital turnover ratio is calculated by
dividing net annual sales by the average amount of working capital—current assets minus
current liabilities—during the same 12-month period.

Working capital turnover ratio = Sales/working capital

9. Total asset turnover ratio: Asset turnover is the ratio of total sales or revenue to
average assets. This metric helps investors understand how effectively companies are using
their assets to generate sales. Investors use the asset turnover ratio to compare similar
companies in the same sector or group.

Total asset turnover ratio = Net Sales / Total Assets.

Net Sales = Gross Sales – Returns – Discounts – Allowances.

10. Capital turnover ratio: Capital Turnover Ratio indicates the efficiency of the organization
with which the capital.

Capital turnover ratio = Sales/ Capital Employed

CAPITAL BUDGETING PROBLEM
1 A company is considering the purchase of a machine for which it has 3 alternatives models
A, B and C the investment are A-46,500, B-65,300 and C-55,200. The cash inflows are given
below:

Year Machine – A Machine – B Machine – C

1 13,800 5000 18,600
2 18,200 25,000 22,900
3 20,100 30,000 31,400
4 19,700 20,000 5,000
5 11,600 10,000 1,500

You are required to suggest the best machine using NPV method. The company uses 12%
rate for such machines. The present value of Re.1 at the end of five years are:

Year 1 2 3 4 5
Dis. Factor @ 12% 0.893 0.797 0.712 0.636 0.567
2 A machine will cost Rs. 1, 00,000 and will provide annual net cash inflow of Rs. 30,000
for six years. The cost of capital is 15 per cent. Calculate the machine’s net present value
and the payback period. Should the machine be purchased?

3 XYZ Ltd. is considering two manually exclusive projects A and B whose cost of Capital
is15% the details of which are:-
Project A Project B
Investments 3,00,000 3,00,000
Estimated Cash inflow
st
1 Year 80,000 70,000
nd
2 Year 1,00,000 1,20,000
rd
3 Year 1,30,000 1,40,000
th
4 Year 1,00,000 90,000
th
5 Year 80,000 60,000

Calculate the NPV @ 15% and profitability index. Which project should be
chosen under each of these methods?

4 ABC company is planning to purchase a new machine whose cash flows are given below
Year Cash flow
Mach-A Mach-B
0 (4,00,000) (4,00,000)
1 80,000 70,000
2 1,20,000 1,40,000
3 1,30,000 1,50,000
4 80,000 65,000
5 1,60,000 1,75,000
Calculate NPV and PI at a discount rate of 10% to select the right machine.
5 Given the following information regarding cash inflow in respect of the two project
proposals, rank them by applying the criteria of:
i. Payback period
ii. ARR
If Initial investment for both the proposals are Rs.25,000
 Years Proposal I (Rs.) Proposal II (Rs.)
1 11,750 13,500
2 12,250 12,500
3 12,500 12,250
4 13,500 11,750
6 Agrotech company Ltd. Is considering two alternative machines, first machine costs Rs.
15,00,000 and estimated annual cash inflow from it amounts to Rs.5,00,000. The second
machine costs Rs.20,00,000 and its estimated cash inflow Rs.5,50,000. Both the machines
economic life is 6 years. Suggest the management with the best alternative by using
payback period.
7 The following are the details pertaining to a company which is considering to acquire a
fixed asset; Project A- Cost of the proposal Rs.42000; Life:5years; Average after tax cash
flows Rs.14000 (constant).
Project B-Cost of proposal Rs.45000; life 5yeras; Annual cash flows: 1st year Rs.28000;
2nd year Rs.12000; 3rd year Rs.10000; 4th year Rs.10000; 5th year Rs.10000; Determine IRR
Which project do you recommend?
8 Calculate the net present value and payback period for the following cash flows.
Years 0 1 2 3 4
Cash flows 11,50,000 3,00,000 4,00,000 4,50,000 3,50,000
(Rs.)
Cost of capital is 14 per cent.

10
11

12.

13 Years 0 1 2 3 4
Cash flows (Rs.) (23,00,000) 6,00,000 8,00,000 9,00,000 7,00,000

Cost of capital is 14 per cent. Find NPV