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Financial Management 1

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0% found this document useful (0 votes)
42 views181 pages

Financial Management 1

Uploaded by

RISHITA R
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Dr.Sukhjeet Matharu and Prof.

Naveen Sharma

Module 1

Financial Management
Finance is the lifeline of any business. However, finances, like most other resources,
are always limited. On the other hand, wants are always unlimited. Therefore, it is
important for a business to manage its finances efficiently. As an introduction to
financial management, in this article, we will look at the nature, scope, and
significance of financial management, along with financial decisions and planning.

Introduction to Financial Management

Define financial management as the first part of the introduction to


financial management. For any business, it is important that the finance it
procures is invested in a manner that the returns from the investment are
higher than the cost of finance. In a nutshell, financial management –

 Endeavors to reduce the cost of finance

 Ensures sufficient availability of funds

 Deals with the planning, organizing, and controlling of financial activities like
the procurement and utilization of funds

Some Definitions

“Financial management is the activity concerned with planning, raising, controlling


and administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious


use of capital and a careful selection of the source of capital in order to enable a
spending unit to move in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for


obtaining and effectively utilizing the funds necessary for efficient operations.”-
Massie
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Nature, Significance, and Scope of Financial


Management

Financial management is an organic function of any business. Any organization needs


finances to obtain physical resources, carry out the production activities and other
business operations, pay compensation to the suppliers, etc. There are many theories
around financial management:

1. Some experts believe that financial management is all about providing funds
needed by a business on terms that are most favorable, keeping its objectives in
mind. Therefore, this approach concerns primarily with the procurement of funds
which may include instruments, institutions, and practices to raise funds. It also
takes care of the legal and accounting relationship between an enterprise and its
source of funds.

2. Another set of experts believe that finance is all about cash. Since all business
transactions involve cash, directly or indirectly, finance is concerned with everything
done by the business.

3. The third and more widely accepted point of view is that financial management
includes the procurement of funds and their effective utilization. For example, in the
case of a manufacturing company, financial management must ensure that funds are
available for installing the production plant and machinery. Further, it must also
ensure that the profits adequately compensate the costs and risks borne by the
business.

In a developed market, most businesses can raise capital easily. However, the real
problem is the efficient utilization of the capital through effective financial planning
and control.

Further, the business must ensure that it deals with tasks like ensuring the availability
of funds, allocating them, managing them, investing them, controlling costs,
forecasting financial requirements, planning profits and estimating returns on
investment, assessing working capital, etc.

The scope of Financial Management


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The introduction to financial management also requires you to understand the


scope of financial management. It is important that financial decisions take care of
the shareholders interests.

Further, they are upheld by the maximization of the wealth of the shareholders,
which depends on the increase in net worth, capital invested in the business, and
plowed-back profits for the growth and prosperity of the organization.

The scope of financial management is explained in the diagram below:

Core Financial Management Decisions

In organizations, managers in an effort to minimize the costs of procuring finance and


using it in the most profitable manner, take the following decisions:

Investment Decisions: Managers need to decide on the amount of investment


available out of the existing finance, on a long-term and short-term basis. They are of
two types:

1. Long-term investment decisions or Capital Budgeting mean committing funds


for a long period of time like fixed assets. These decisions are irreversible and usually
include the ones pertaining to investing in a building and/or land, acquiring new
plants/machinery or replacing the old ones, etc. These decisions determine the
financial pursuits and performance of a business.

2. Short-term investment decisions or Working Capital Management means


committing funds for a short period of time like current assets. These involve
decisions pertaining to the investment of funds in the inventory, cash, bank deposits,
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

and other short-term investments. They directly affect the liquidity and performance
of the business.

Financing Decisions: Managers also make decisions pertaining to raising finance


from long-term sources (called Capital Structure) and short-term sources (called
Working Capital). They are of two types:

Financial Planning decisions: which relate to estimating the sources and


application of funds. It means pre-estimating financial needs of an organization to
ensure the availability of adequate finance. The primary objective of financial
planning is to plan and ensure that the funds are available as and when required.

Capital Structure decisions: which involve identifying sources of funds. They


also involve decisions with respect to choosing external sources like issuing shares,
bonds, borrowing from banks or internal sources like retained earnings for raising
funds

Dividend Decisions: These involve decisions related to the portion of profits that
will be distributed as dividend. Shareholders always demand a higher dividend, while
the management would want to retain profits for business needs. Hence, this is a
complex managerial decision.

Nature of Financial Management:

Finance management is a long term decision making process which involves lot of
planning, allocation of funds, discipline and much more. Let us understand the
nature of financial management with reference of this discipline.

1. Primary nature of financial management focus towards valuation of company.


That is the reason where all the financial decisions is directly linked with optimizing
/ maximization the value of a company. Finance functionality like investment,
distribution of profit earnings, rising of capital, etc. are the part of management
activities.

2. Nature of financial management basically involves decision where risk and return
are linked with investment. Generally high risk investment yield high returns on
investments. So, role of financial manager is to effectively calculate the level of risk
company is involve and take the appropriate decision which can satisfy
shareholders, investors or founder of the company.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3. Finance is a foundation of economic activities. The person who Manages finance


is called as financial manager. Important role of financial manager is to control
finance and implement the plans. For any company financial manager plays a
crucial role in it. Many times it happens that lack of skills or wrong decisions can
lead to heavy losses to an organization.

4. Financial Management is an important function in company’s management.


Financial factors are considered in all the company’s decisions and all the
departments of an organization. It affects success, growth and volatility of a
company. Finance is said to end up being the lifeline of a business.

5. Finance management is one of the important education which has been realized
word wide. Now a day’s people are undergoing through various specialization
courses of financial management. Many people have chosen financial management
as their profession.

6. The nature of financial management is never a separate entity. Even as an


operational manager or functional manager one has to take responsibility of
financial management.

7. Nature of financial management is multi-disciplinary. Financial management


depends upon various other factors like: accounting, banking, inflation, economy,
etc. for the better utilization of finances.

8. Approach of financial management is not limited to business functions but it is a


backbone of commerce, economic and industry.

Objectives of Financial Management

Wealth Maximization

One of the main objectives of Financial Management is to maximize shareholder’s


wealth, for which achievement of optimum capital structure and proper utilization of
funds is very necessary. Be mindful that wealth maximization is different than profit
maximization. Wealth maximization is a more holistic approach, aimed at the growth
of the organization

To Ensure Availability of Funds


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The sound financial condition of business is a must for any business to survive. The
availability of funds at the proper time of need is an important objective of business.
The organization will not be able to function without funds, and activities will come to
a halt.

Optimum Capital Structure

To maintain the optimum capital structure, a perfect combination of debentures and


shares is a requirement. The organization will not want to give away too much equity,
and also control the cost of capital. It is a delicate balance.

Effective Utilizations of Funds

Business not only needs a large number of funds but also skills to handle such large
amounts. To cut down unnecessary costs and to save funds from wasting in useless
assets is crucial for business. An example of such misuse of funds would be investing
in extra raw material, in quantities not required.

Ensuring the Safety of Funds

The vital objective of financial management is to ensure the security of its funds
through the creation of reserves. The chances of risk in investment should be
minimum possible. Some of the reserves created for this purpose are Sinking Funds,
General Reserves etc.

Importance of Financial Management Points:

There is a huge importance of financial management in business planning and


controlling for your financial stability and to keep you away from bankruptcy. Here
we will see what is the importance of financial management in points mentioned
below:

1. Financial Planning:

Financial management its importance is financial planning. It decides each


financial necessity associated with business concern. Also financial planning
associates need to take prompts and correct measures instead of worries in later
stage of financial management life-cycle of a company. Financial planning looks a
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

crucial area associated with business concern. Typically, all the credit for business
success is mostly depends on the financial planning of a company.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2. Safeguarding / Protecting Funds:

Importance of financial management include protecting finance towards achieving


business goals. One has to measure the areas where funds are required and allocate
it well in all the areas for smooth functioning of business. Overspending on one
project and impact other business operations as they may lack finance in many
cases. It is crucial to safeguard funds and invest wisely.

3. Allocation of Funds:

Importance of financial management in an organization is to allocate funds


appropriately. When making proper use of allocated finance to assets enhance the
operational proficiency for the business concern. Whenever the finance specialists
makes use of the funds appropriately and allocate it wisely, they can reduce
business expense and increase capital estimated for a company.

4. Investment Opportunities:

As a person, if you are good at managing your finance and saving then you get
opportunities to explorer investment. Investment opportunities will assist you in
creating wealth so that you can enjoy your retirement period. There are various
investment opportunities you can explorer like investing in stocks, gold, mutual
funds, property, lands, etc. You can study about investing in detail to know the risk
and return of investment. Depending upon your risk ability you can then choose the
appropriate investment options.

5. Financial Decision:

Its importance of financial management points is financial decision. Once financial


choice according to the business concern has made, it cannot be rewind. As finance
once spend will not be repaid again for any wrong decision made. Financial
selection might impact the whole business operation. Since it has an instant
relationship with all the departments of a company. For example: production,
advertising, rents, salary to human resources and so on.

6. Economic Growth and Stability:

Proper financial planning will ensure your economic growth. Gradually you will
expand your wealth creation which will help you to grow financially. Important
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

thing in someone’s life is financially stability. Only way to ensure your financial
stability is through economic growth and only option to ensure the same is through
financial management.

7. Improve Standard of Living:

Once you have learned and taken good knowledge on financial management, this
will not only provide you financial stability and peace of mind but also it will
improve your standard of living. Your economic growth will transform into better
standard of living.

Sources of Business Finance

For a businessperson or entrepreneurs, to find the sources of business finance is


the most important aspect when starting a business or a new venture. It needs the
maximum effort and dedication. The sources of business finance are categorized
based on ownership, time, period, and control, etc., evaluate, and used in different
situations.

Business Finance Meaning

Business finance is the funds required to establish, operate business activities, and
expand in the future. Funds are specifically required various purchase type of
tangible assets such as furniture, machinery, buildings, offices, factories, or
intangible assets like patents, technical expertise, and trademarks, etc.

Apart from the assets mentioned above, other things that require funding are the
day-to-day operational activities of a business. This activity includes purchasing raw
materials, paying salaries, bills, collecting money from clients, etc. It is essential to
have sufficient amount of money to survive and grow the business.

Classification of Sources of Funds

Businesses can raise capital through various sources of funds which are classified
into three categories.

1. Based on Period – The period basis is further divided into three dub-division.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Long Term Source of Finance – This long term fund is utilized for more
than five years. The fund is arranged through preference and equity shares and
debentures etc. and is accumulated from the capital market.

 Medium Term Source of Finance – These are short term funds that last
more than one year but less than five years. The source includes borrowings from a
public deposit, commercial banks, commercial paper, loans from a financial
institute, and lease financing, etc.

 Short Term Source of Finance – These are funds just required for a year.
Working Capital Loans from Commercial bank and trade credit etc. are a few
examples of these sources.

2. Based on Ownership – This sources of finance are divided into two categories.

Owner’s Fund – This fund is financed by the company owners, also known as
owner’s capital. The capital is raised by issuing preference shares, retained
earnings, equity shares, etc. These are for long term capital funds which form a base
for owners to obtain their right to control the firm’s management and operations.

Burrowed Funds – These are the funds accumulated with the help of borrowings
or loans for a particular period of time. This source of fund is the most common and
popular amongst the businesses. For example, loans from commercial banks and
other financial institutions.

3. Based on Generation – This source of income is categorized into two


divisions.

 Internal Sources – The owners generated the funds within the organization.
The example for this reference includes selling off assets and retained earnings, etc.

 External Source – The fund is arranged from outside the business. For
instance, issuance of equity shares to public, debenture, commercial banks loan, etc.

LIMITATIONS OF FINANCIAL MANAGEMENT

Financial management is a tool that managers can use to better assess the
financial implications of decisions they face. Its use should be limited to deciding
among potential courses of action that will help the pharmacy to reach its goals. In
most cases, it should not be used to decide what those goals are, nor should most
decisions be based solely on financial criteria.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Financial statements do not contain all the information, or in many cases even the
most important information, about the factors that affect the finances of a
pharmacy. Such n eces sary dat a a s t he st at e o f t he nat ional and l o c a l
eco n o my, t he dem and f or t he organization’s product or service, the extent and
nature of the competition, and the health and loyalty of key employees are not found in
financial statements. This is because financial statements deal only with those
events and factors that can be readily expressed in monetary terms. In using
and interpreting financial statements properly, managers must keep these limitations
in mind.

Module No. 2
Ratio Analysis
Ratio analysis refers to the analysis of various pieces of financial information in
the financial statements of a business. They are mainly used by external analysts to
determine various aspects of a business, such as its profitability, liquidity, and
solvency.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Analysts rely on current and past financial statements to obtain data to evaluate the
financial performance of a company. They use the data to determine if a company’s
financial health is on an upward or downward trend and to draw comparisons to
other competing firms.

Uses of Ratio Analysis :

1. Comparisons

One of the uses of ratio analysis is to compare a company’s financial performance to


similar firms in the industry to understand the company’s position in the market.
Obtaining financial ratios, such as Price/Earnings, from known competitors and
comparing it to the company’s ratios can help management identify market gaps
and examine its competitive advantages, strengths, and weaknesses. The
management can then use the information to formulate decisions that aim to
improve the company’s position in the market.

2. Trend Line
Companies can also use ratios to see if there is a trend in financial performance.
Established companies collect data from the financial statements over a large
number of reporting periods. The trend obtained can be used to predict the
direction of future financial performance, and also identify any expected financial
turbulence that would not be possible to predict using ratios for a single reporting
period.

3. Operational Efficiency
The management of a company can also use financial ratio analysis to determine the
degree of efficiency in the management of assets and liabilities. Inefficient use of
assets such as motor vehicles, land, and building results in unnecessary expenses
that ought to be eliminated. Financial ratios can also help to determine if the
financial resources are over or under-utilized.

Ratio Analysis – Categories of Financial Ratios


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

There are numerous financial ratios that are used for ratio analysis, and they are
grouped into the following categories:

1. Liquidity Ratios / Financial Ratio:

Liquidity ratios measure a company’s ability to meet its debt obligations using its
current assets. When a company is experiencing financial difficulties and is unable
to pay its debts, it can convert its assets into cash and use the money to settle any
pending debts with more ease.

Some common liquidity ratios include the quick ratio, the cash ratio, and the
current ratio. Liquidity ratios are used by banks, creditors, and suppliers to
determine if a client has the ability to honor their financial obligations as they come
due.

Current Ratio:

Current ratio is a type of liquidity ratio (the ability for the debtor to pay their debts).
It is used as a financial measure in companies that span across industries to weigh a
company's ability to match its assets to its liabilities by the end of the year. It is also
called working capital.

How to calculate current ratio

The following three steps will identify the components necessary, and how to apply
them to the formula to calculate the current ratio.

1. Identify current assets

The first step in calculating a company's current ratio is to identify the current
assets on the company's balance sheets. Assets include accounts receivable,
inventory, cash and anything else that is most likely going to be turned into cash or
liquidated within the next year.

2. Identify current liabilities

The second step in calculating a company's current ratio is to identify the current
liabilities that are listed on the company's balance sheets. Liabilities can be defined
as wages, accounts and taxes payable and the current amount of debt.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3. Compare assets to liabilities

Now that you have the total amounts of assets and liabilities, you can compare them
by completing the following equation.

Current ratio = Current assets/Current liabilities

How to interpret the results

Once the current ratio has been calculated, there are multiple ways that the
resulting figure can be interpreted to determine a company's financial standing. The
following list will review the three main categories that a company's score can fall
into.

1. If a current ratio is under 1

If a company calculates its current ratio to be under 1, that is an indication that its
current assets will not be able to cover its debts that are due at the end of the year.

2. If a current ratio is at 1

If a company calculates its current ratio to be at, or slightly above, 1 then this means
that the company's assets will be able to cover its debts that are due at the end of the
year.

3. If a current ratio is above 3

If a company calculates its current ratio at or above 3, this means that the company
might not be utilizing its assets correctly. This misuse of assets can present its own
problems to a company's financial well-being.

Quick ratio:

The quick ratio is a liquidity ratio that measures a company's ability to pay its
liabilities with quick assets. The quick assets of a company are assets that can be
converted into cash within a short-term period, typically within 90 days. Quick
assets are generally regarded as the cash, cash equivalents, short-term investments
and accounts receivable that a company currently possesses. Additionally, the quick
ratio can also be referred to as the acid test ratio.

To calculate the quick ratio, the following formula is used:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Quick ratio = (cash + cash equivalents + short-term investments + accounts


receivable) divided by (current liabilities)

In the event that the company's quick assets are not listed in corresponding balance
sheets, the following formula can also be used to calculate the quick ratio:

Quick ratio = (total current assets - inventory - prepaid expenses)


divided by (current liabilities)

Question No.1

Following is the Balance Sheet of NSH Ltd. as on 31st March, 2021:

Liabilities Rs. Assets Rs.


Equity Share Capital 2,00,000 Fixed Assets 4,00,000
Reserve & Surplus 1,00,000 Stock 20,000
10% Debentures 1,50,000 Sundry Debtors 30,000
Sundry Creditors 25,000 Cash at bank 20,000
Provision for
Taxation 5,000 Prepaid Expenses 10,000
4,80,000 4,80,000

Calculate Current Ratio and Liquid Ratio from the above.

Solution:

# Calculation of Current Ratio:

Current Assets
Current Ratio =
Current Liabilities

(a)Calculation of Current Assets and Current Liabilities:

Currents Assets = Stock + Debtors + Cash at bank + Prepaid Expenses

Currents Assets = Rs.20,000 + Rs.30,000 + Rs.20,000 + Rs.10,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Currents Assets = Rs.80,000

Current Liabilities = Creditors + Provision for Taxation

Current Liabilities = Rs.25,000 + Rs.5,000

Current Liabilities = Rs.30,000

Current Assets
Current Ratio =
Current Liabilities

Rs.80,000
Current Ratio =
Rs.30,000

Current Ratio = 2.67 :1

(b) Calculation of Liquid Ratio / Acid Test Ratio / Quick Ratio / Near Money
Ratio:

# Calculation of Quick Assets:

Quick Assets = Current Assets - Stock - Prepaid Expenses

Quick Assets = Rs.80,000 - Rs.20,000 - 10,000

Quick Assets = Rs.50,000

Quick Assets
Quick Ratio =
Current Liabilities

Quick Ratio = Rs.50,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs.30,000

Quick Ratio = 1.67:1

Question No.2

(a)X Ltd. has a Current Ratio of 4.5:1 and Acid Test Ratio of 3:1. If its inventory is
Rs.24,000, Find out its Current Liabilities.

(b)Y Ltd. has a Liquid Ratio 2:1. If its stock is Rs.20,000 and its Total current Liabilities are
Rs.50,000, Find out its Current Ratio.

(C )Z Ltd. has Current Ratio of 4:1 and Quick Ratio of 2.5:1. Assuming inventories are Rs.
22,500, Find out Total Current Assets and Total Current Liabilities.

Solution

(a)

Let Current Liabilities be Rs. X


Current Ratio 4.5:1 so Current Assets = Rs.4.5x

Acid Test Ratio 3:1 so Quick Assets = 3x

Quick Assets = Current Assets – Stock

3x = 4.5x - Rs.24,000

4.5x - 3x = Rs.24,000

1.5x = Rs.24,000 so X = Rs.24,000 / 1.5

X = Rs.16,000

Current Liabilities = Rs.16,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(b)

Liquid Ratio = Liquid Assets


Current Liabilities

Liquid Asses
2 =
Rs.50,000

Liquid Assets = 2 x Rs.50,000

Liquid Assets = Rs.1,00,000

# Calculation of Current Assets

Current Assets = Liquid Assets + Stock

Current Assets = Rs.1,00,000 + Rs.20,000

Current Assets = Rs.1,20,000

# Calculation of Current Ratio:

Current Assets
Current Ratio =
Current Liabilities

Rs.1,20,000
Current Ratio =
Rs.50,000

Current Ratio = 2.4 :1

(C )

Let Current Liabilities be Rs. X


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Current Ratio 4:1 so Current Assets = Rs.4x

Acid Test Ratio 2.5:1 so Quick Assets = 2.5x

Current Assets = Liquid Assets + Stock

4x = 2.5x + Rs.22,500

4x - 2.5x = Rs.22,500,

Rs.22,500
1.5x =
1.5

X = Rs.15,000

Current Liabilities = Rs.15,000

Current Assets = 4 x Rs.15,000

Current Assets = Rs.60,000

Question No. 3

The comparative figures of X Ltd. and Y Ltd. are given below:

X Ltd. Y Ltd.

Rs. Rs.

Total Assets 4,00,000 6,00,000

External Liabilities 80,000 2,00,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Proprietor’s Fund 3,20,000 4,00,000

Calculate Debt-Equity Ratio and proprietor’s Ratio for each company and comment.

Solution:

External Equities
Debt-Equity Ratio =
Internal Equities

Rs.80,000
Debt-Equity Ratio (X) =
Rs.3,20,000

Debt-Equity Ratio (X) = 0.25;1

Rs.2,00,000
Debt-Equity Ratio (Y) =
Rs.4,00,000

Debt-Equity Ratio (Y) = 0.50;1

Owner's
Proprietary Ratio = Equity
Total Assets

Rs.3,20,000
Proprietary Ratio (X) =
Rs.4,00,000

Proprietary Ratio (X) = 0.8 :1

Rs.4,00,000
Proprietary Ratio (Y) =
Rs.6,00,000

Proprietary Ratio (Y) = 0.667 :1


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Note: Total Assets = External Liabilities + Proprietary Fund

Question No.4

X Ltd. has employed Rs.10,00,000 in its business as under:

Rs.
Fixed Capital 6,00,000
Working Capital 4,00,000
10,00,000
This has been financed by :
Equity Shares 3,00,000
6% Debentures 4,00,000
7% Preference Shares 2,00,000
Reserves & Surplus 1,00,000

The company gained a profit of Rs.2,00,000 before interest and tax. Calculate Capital-
Gearing Ratio and test it for trading on equity. Assume tax rate to be 50%.

Solution:

Equity Share Capital +


Capital-Gearing Ratio = Raserves and surplus
Preference Shares + Debentures

Rs.3,00,000 +Rs.1,00,000
Capital-Gearing Ratio =
Rs.2,00,000 + Rs.4,00,00

Capital-Gearing Ratio = 0.67:1

Thus, it is a case of high capital-gearing. The company must have followed the policy of
trading on equity as judged by the following calculation:

Rs.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 2,00,000
Less: Interest (24,000)
EBT 1,76,000
Less: Tax @50% (88,000)
EAT 88,000
Less: Dp (14,000)
Profit available for
Eq.Shareholder 74,000

Profit available for Equity Shareholder x 100


Return on Shareholder's Fund =
Proprietors Fund

Rs.74,000 x 100
Return on Shareholder's Fund =
Rs.4,00,000

Return on Shareholder's Fund = 18.57%

2. Solvency Ratios

Solvency ratios measure a company’s long-term financial viability. These ratios


compare the debt levels of a company to its assets, equity, or annual earnings.

Important solvency ratios include the debt to capital ratio, debt ratio, interest
coverage ratio, and equity multiplier. Solvency ratios are mainly used by
governments, banks, employees, and institutional investors.

Debt to Equity Ratio

The debt to equity ratio is a financial, liquidity ratio that compares a company’s
total debt to total equity. The debt to equity ratio shows the percentage of company
financing that comes from creditors and investors. A higher debt to equity ratio
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

indicates that more creditor financing (bank loans) is used than investor financing
(shareholders).

Formula

The debt to equity ratio is calculated by dividing total liabilities by total equity. The
debt to equity ratio is considered a balance sheet ratio because all of the elements
are reported on the balance sheet.

Analysis

Each industry has different debt to equity ratio benchmarks, as some industries
tend to use more debt financing than others. A debt ratio of .5 means that there are
half as many liabilities than there is equity. In other words, the assets of the
company are funded 2-to-1 by investors to creditors. This means that investors own
66.6 cents of every Rupee of company assets while creditors only own 33.3 cents on
the Rupees.

A debt to equity ratio of 1 would mean that investors and creditors have an equal
stake in the business assets.

A lower debt to equity ratio usually implies a more financially stable business.
Companies with a higher debt to equity ratio are considered more risky to creditors
and investors than companies with a lower ratio. Unlike equity financing, debt must
be repaid to the lender. Since debt financing also requires debt servicing or regular
interest payments, debt can be a far more expensive form of financing than equity
financing. Companies leveraging large amounts of debt might not be able to make
the payments.

Creditors view a higher debt to equity ratio as risky because it shows that the
investors haven’t funded the operations as much as creditors have. In other words,
investors don’t have as much skin in the game as the creditors do. This could mean
that investors don’t want to fund the business operations because the company isn’t
performing well. Lack of performance might also be the reason why the company is
seeking out extra debt financing.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3. Profitability Ratios

Profitability ratios measure a business’ ability to earn profits, relative to their


associated expenses. Recording a higher profitability ratio than in the previous
financial reporting period shows that the business is improving financially. A
profitability ratio can also be compared to a similar firm’s ratio to determine how
profitable the business is relative to its competitors.

Some examples of important profitability ratios include the return on equity ratio,
return on assets, profit margin, gross margin, and return on capital employed.

1. Gross Profit Ratio


The GPR is a calculation that returns a value representing the percentage of profit
earned on the net sales of an organization. The net sales value of an organization is
calculated by reducing the gross sales amount by any credits issued for product
returns, discounts, or rebate programs. The costs applied to the net sales to
determine the gross profit is achieved by calculating the total direct cost of sales
(inventory change + direct costs). Simply put, the ratio indicates the true
profitability of a sales transaction after the impact of sale credits are applied. The
gross profit ratio formula is calculated like this:

((Net Sales – Cost of Goods Sold) / Net Sales)) x 100

The GPR is leveraged by users of financial statements to evaluate the true


profitability of an organization’s sales. In many cases, this ratio is used for
comparison purposes to competitor’s financial statements, as well as applicable
industry trends. The ratio is a great indicator of the organizations ability to absorb
non-product related operational expenses. The larger the GPR, the more gross
profit the organization has to fund operations.

2.

Question No.

SN Ltd. submit the following data relating sales and costs;

Year Year

2020 2021
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs. Rs.

Net Sales 6,25,000 7,80,000

Cost of Sales 4,75,000 5,91,000

Units Sold 12,500 15,000

Find out Gross Profit Ratio for each year.

Solution:

Calculation of Gross Profit for 2020 and 2021:

Year 2020 Year 2021


Rs. Rs.
Net Sales 625,000 7,80,000
Less: Cost of
Sales -475,000 -5,91,000
Gross Profit 150,000 1,89,000

Gross Profit x 100


Gross profit Ratio =
Net Sales

1,50,000 x 100
Gross profit Ratio =
625,000

Gross Profit Ratio = 24%


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Gross profit Ratio for 2021

Gross Profit x 100


Gross profit Ratio =
Net Sales

1,89,000 x 100
Gross profit Ratio =
7,80,000

Gross Profit Ratio = 24.23%

Question No.

From the following data, calculate net profit Ratio:

(a)Sales Rs.6,00,000; Net profit Rs,84,000

(b)Sales Rs.8,00,000; Profit before tax Rs.1,60,000; Income tax 50%

(c )Cash Sales Rs.2,50,000; Credit Sales 75% of total Sales; Gross profit Ratio20%
and Indirect Expenses Rs.40,000.

Solution:

(a)

Net profit x 100


Net Profit Ratio =
Net Sales
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs.84,000 x 100
Net Profit Ratio =
Rs.6,00,000

Net Profit Ratio = 14%

(b)

Calculation of Net Profit:

Rs.
Profit before Tax 160,000
Less: Tax @50% -80,000
E.A.T./ Net profit = 80,000

Net profit x 100


Net Profit Ratio =
Net Sales

Rs.80,000 x 100
Net Profit Ratio =
Rs.8,00,000

Net Profit Ratio = 10%

(C )

Calculation of net profit:

Rs.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cash Sales 2,50,000


Add: Credit Sales 7,50,000
Total Sales 10,00,000
Less: G.P @20% -2,00,000
Less: Indirect Exp. -40,000
Net Profit 1,60,000

Net profit x 100


Net Profit Ratio =
Net Sales

Rs.1,60,000 x 100
Net Profit Ratio =
Rs.10,00,000

Net Profit Ratio = 16%

Question No.

From the following information calculate Net Operating Profit Ratio:

(a)Net profit Rs.80,000; Sales Rs.5,60,000; Non-operating Expenses Rs.30,000;


Non-operating income Rs.18,000.

(b)Sales Rs.5,00,000 and Operating Ratio 70%.

(C )Net Sales Rs.7,50,000; Cost of goods sold Rs.5,00,000 and operating Expenses
Rs.60,000

Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Operating Profit x 100


Operating Profit Ratio =
Net Sales
(a)

Calculation of Operating Profit:

Rs.
Net Profit 80,000
Add: Non-Operating
Expenses 30,000
1,10,000
Less: Non-Operating
Incomes -18,000
Operating Profit 92,000

Operating Profit x 100


Operating Profit Ratio =
Net Sales

Rs.92,000 x 100
Operating Profit Ratio =
Rs.5,60,000

Operating Profit = 16.42%

(b)

Operating Profit Ratio = % of sales - % of Operating Ratio

Operating Profit Ratio = 100% -70%


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Operating Profit Ratio = 30%


(C )

Calculation of Operating Profit:

Rs.
Net Sales 7,50,000
Less: Cost of goods Sold -5,00,000
Gross Profit = 2,50,000
Less: Operating Expenses -60,000
Operating Profit = 1,90,000

Operating Profit x 100


Operating Profit Ratio =
Net Sales

Rs.1,90,000 x 100
Operating Profit Ratio =
Rs.7,50,000

Operating Profit = 25.33%

Question No.

Calculate Operating Ratio:

Rs.

Sales 7,55,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Sales Returns 35,000

Cost of goods sold 5,00,000

Operating Expenses 60,000

(b)Net Sales Rs.8,00,000; Cash Sales Rs.2,00,000; Gross Profit Rs.2,00,000 and
Office & Selling Expenses Rs.1,20,000.

Solution:

4. Efficiency Ratios or Turnover Ratio:

Efficiency ratios measure how well the business is using its assets and liabilities to
generate sales and earn profits. They calculate the use of inventory, machinery
utilization, turnover of liabilities, as well as the usage of equity. These ratios are
important because, when there is an improvement in the efficiency ratios, the
business stands to generate more revenues and profits.

Some of the important efficiency ratios include the asset turnover ratio, inventory
turnover, payables turnover, working capital turnover, fixed asset turnover, and
receivables turnover ratio.

Question No.

Given:

Credit Sales Rs.1,50,000

Cash Sales Rs.2,50,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Sales Returns Rs.25,000

Opening Stock Rs.25,000

Closing Stock Rs.35,000

Gross Profit 20%

Find out Inventory Turnover Ratio.

Solution:

Cost of Goods Sold


Inventory Turnover Ratio =
Average Stock

Calculation of Net Sales:

Rs.
Cash Sales 2,50,000
Add: Credit Sales 1,50,000
Total Sales 400,000
Less: S/R -25000
Net Sales = 3,75,000

Calculation of Cost of goods Sold:

Cost of goods sold = Net Sales - G.P.


Rs.3,75,000 - 20% of
Sales
Rs.3,75,000 - Rs.75,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cost of goods sold = Rs. 3,00,000

Calculation of Average Stock:

Op. Stock + Cl. Stock


Average Stock =
2

Rs.25,000 + Rs.35,000
Average Stock =
2
Rs.60,000
Average Stock =
2
Average Stock = Rs.30,000

Cost of Goods Sold


Inventory Turnover Ratio =
Average Stock

Rs.3,00,000
Inventory Turnover Ratio =
Rs.30,000

Inventory Turnover Ratio = 10 times

Question No.
From the following particulars find out Stock Turnover Ratio:

(a)Sales Rs.3,20,000; Gross profit Ratio 25% on sales; Opening Stock Rs.31,000;
and Closing Stock Rs.29,000.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(b)Opening Stock Rs.20,000; Closing Stock Rs.10,000; Purchases Rs.50,000;


Carriage inward Rs.5,000; Total Sales Rs.1,00,000; and Cash sales Rs.10,000.

Solution:

(a)

(i)Calculation of Cost of Goods Sold –

Sales Rs.3,20,000
Less: G.P.@ 25% on
Sales (Rs.80,000)
Cost of Goods Sold = Rs.2,40,000

(ii)Calculation of Average Stock-

Opening Stock + Closing


Average Stock = Stock
2

Rs.31,000 + Rs.29,000
Average Stock =
2
Rs.60,000
Average Stock =
2

Rs.30,000
Average Stock =

Calculation of Stock Turnover Ratio:

Cost of Goods Sold


Stock Turnover Ratio =
Average Stock

Rs.2,40,000
Stock Turnover Ratio =
Rs.30,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Stock Turnover Ratio = 8 times

(b)
Calculation of Cost of Goods Sold –

Opening Stock Rs.20,000


Add: Purchases Rs.50,000
Add; Carriage Rs.5,000
Less: Closing Stock (10,000)
Cost of Goods Sold = Rs.65,000

Calculation of Average Stock –

Opening Stock + Closing Stock


Average Stock =
2

Rs.20,000 + Rs.10,000
Average Stock =
2

Rs.30,000
Average Stock =
2

Rs.15,000
Average Stock =

Calculation of Stock Turnover Ratio:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cost of Goods Sold


Stock Turnover Ratio =
Average Stock

Rs.65,000
Stock Turnover Ratio =
Rs.15,000

Stock Turnover Ratio = 4.33 times

Question No.

Calculation Debtors Turnover Ratio from the following information’s:

Rs.

Total Sales 3,00,000

Cash Sales 50,000

Sales Returns 30,000

Opening Debtors 20,000

Closing Debtors 24,000

Solution:
Calculation of Net Credit Sales –

Net Credit Sales = Total Sales - Cash Sales - Sales Returns

Net Credit Sales = Rs.3,00,000 - Rs.50,000 - Rs.30,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Net Credit Sales = Rs.2,20,000

Calculation of Average Debtors –

Opening Receivable + Closing Receivable


Average Debtors =
2

Rs.20,000 + Rs.24,000
Average Debtors =
2

Rs.44,000
Average Debtors =
2

Average Debtors = Rs.22,000

Net Credit Sales


Debtors Turnover Ratio =
Average Receivable

Rs.2,20,000
Debtors Turnover Ratio =
Rs.22,000

Debtors Turnover Ratio = 10 times

Question No.

Calculate Debtors Turnover Ratio from the following information:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(a) Rs.

Opening Debtors 60,000

Closing Debtors 90,000

Cash received from Debtors 4,20,000

Sales Returns 30,000

(b)

Total Sales 1,50,000

Cash Sales being 25% of Credit


Sales

Excess of Closing Debtors over 20,000


Opening Debtors

Closing Debtors 40,000

Solution:

(a)

Calculation of Net Credit Sales:

Cash Received from Debtors Rs.4,20,000


Add: Sales returns Rs.30,000
Add: Closing Debtors Rs.90,000
Less: Opening Debtors (Rs.60,000
Gross credit Sales Rs,4,80,000
Less: Sales Returns (Rs.30,000)
Net Credit Sales = Rs.4,50,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Calculation of Average Debtors:

Opening Receivable + Closing Receivable


Average Debtors =
2

Rs.60,000 + Rs.90,000
Average Debtors =
2

Rs.1,50,000
Average Debtors =
2

Average Debtors = Rs.75,000

Calculation of Debtors Turnover Ratio :

Net Credit Sales


Debtors Turnover Ratio =
Average Receivable

Rs.4,50,000
Debtors Turnover Ratio =
Rs.75,000

Debtors Turnover Ratio = 6 times

(b)

Calculation of Credit Sales:

Assumed Credit Sales Rs.100


then Cash Sales Rs.25
Total Sales Rs.125

Thus Credit Sales in total Sales of Rs.1,50,000 = 100 x 1,50,000


125
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs. 1,20,000

Calculation of Opening Debtors:

Closing Debtors are Rs.40,000, which is in excess of Rs.20,000 over Opening


Debtors. Thus,

Opening Debtors = Rs.40,000 – Rs.20,000

Opening Debtors = Rs.20,000

Calculation of Average Debtors:

Opening Receivable + Closing Receivable


Average Debtors =
2

Rs.20,000 + Rs.40,000
Average Debtors =
2

Rs.60,000
Average Debtors =
2

Average Debtors = Rs.30,000

Calculation of Debtors Turnover Ratio:

Net Credit Sales


Debtors Turnover Ratio =
Average Receivable

Rs.1,20,000
Debtors Turnover Ratio =
Rs.30,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Debtors Turnover Ratio = 4 times

Question No.

Raj and Sons sell their goods on cash as well as on credit. The following particulars
extracted from their books of accounts for the year 2021:

Rs.

Total Sales 1,50,000

Cash Sales 30,000

Sales Returns 10,500

Total Debtors on 31st March,2021 13,500

Bills receivable on 31st March, 2021 3,000

Calculate Average Collection Period.

Solution:

# Calculation of Net Credit Sales:

Net Credit Sales = Total Sales - Cash Sales - Sales Returns

Net Credit Sales = Rs.1,50,000 - Rs.30,000 - Rs.10,500

Net Credit Sales = Rs.1,09,500

#Calculation of Average Account Receivable:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

In this question Opening Receivable not given. Thus, closing Receivable will be
Assume that is Average Receivable.

Average Receivable = Closing Debtors + Closing Bills Receivable

= Rs.13,500 + Rs.3000

= Rs.16,500

# Calculation of Average Collection Period:

Average Receivable x 365 days


Average Collection Period =
Net Credit Sales

Rs.16,500 x 365 days


Average Collection Period =
Rs.1,09,500

Average Collection Period = 55 Days

Question No.

Arora Bros. sell goods on cash as well as on credit. The following particulars are
taken from their books of accounts for the year ending, 31st March,2021

Rs.

Total Sales 1,00,000

Cash Sales 20,000

Sales Returns 7,000

Total Debtors on 31st march,2021 9,000

Bills Receivables on 31st March, 2021 2,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Provision for Bad Debts on 31st 1,000


March,2021

Calculate Average Collection Period.

Solution:

# Calculation of Net Credit Sales:

Net Credit Sales = Total Sales - Cash Sales - Sales Returns

Net Credit Sales = Rs.1,00,000 - Rs.20,000 - Rs.7,000

Net Credit Sales = Rs.73,000

# Calculation of Average Debtors:

Debtors = Total Debtors + Bills Receivables - Bad Debts Provision

Debtors = Rs.9,000 + Rs.2,000 - Rs.1,000

Debtors = Rs.10,000

# Calculation of Average Collection Period:

Average Receivable x 365 days


Average Collection Period =
Net Credit Sales

Rs.10,000 x 365 days


Average Collection Period =
Rs.73,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average Collection Period = 50 days

Question No.

Sharma Bros. Purchase goods both on cash and credit terms. The following
Particulars are obtained from the books:

Rs.

Total Purchases 2,00,000

Cash Purchases 20,000

Purchases Returns 34,000

Creditors at the end 70,000

Bills Payable at the end 40,000

Reserve for Discount on creditors 5,000

Calculate Average Payment Period.

Solution:

# Calculation of Total Credit Purchases:

Rs.
Total Purchases 2,00,000
Less: Cash Purchases (20,000)
Less: Purchases Returns (34,000)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Total Credit Purchases 1,46,000

# Calculation of Payables:

Rs.
Creditors at the end 70,000
Add; Bills Payable at the end 40,000
Less: Reserve for Discount on Creditors (5,000)
Payables 1,05,000

# Calculation of Average Payment Period:

Payable x 365 days


Average Payment Period =
Net Credit Purchases

Rs.1,05,000 x 365 days


Average Payment Period =
Rs.1,46,000

Average Payment Period = 263 days

Question No.

From the following information, calculate Creditors Turnover Ratio and Average
payment Period:

Rs.

Total Purchases 4,00,000

Cash Purchase (included in above) 50,000

Purchases Returns 20,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Creditors at the end 60,000

Bills Payable at the end 20,000

Reserve for discount on creditors 5,000

Solution:

# Calculation of Net Credit Purchases:

Rs.
Total Purchases 4,00,000
Less: Cash Purchases (50,000)
Less: Purchases Returns (20,000)
Total Credit Purchases 3,30,000
# Calculation of Payable:

Rs.
Creditors at the end 60,000
Add; Bills Payable at the end 20,000
Less: Reserve for Discount on Creditors (5,000)
Payables 75,000

# Calculation of Average Payable Period:


Payable x 365 days
Average Payment Period =
Net Credit Purchases

Rs.75,000 x 365 days


Average Payment Period =
Rs.3,30,000

Average Payment Period = 83 days


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

# Calculation of Creditors Turnover Ratio:

Net Credit Purchases


Creditors Turnover Ratio =
Average Payable

Rs.3,30,000
Creditors Turnover Ratio =
Rs.75,000

Creditors Turnover Ratio = 4.4 times

5. Coverage Ratios
Coverage ratios measure a business’ ability to service its debts and other
obligations. Analysts can use the coverage ratios across several reporting periods to
draw a trend that predicts the company’s financial position in the future. A higher
coverage ratio means that a business can service its debts and associated obligations
with greater ease.

Key coverage ratios include the debt coverage ratio, interest coverage, fixed charge
coverage, and EBIDTA coverage.

6. Market prospect Ratios


Market prospect ratios help investors to predict how much they will earn from
specific investments. The earnings can be in the form of higher stock value or future
dividends. Investors can use current earnings and dividends to help determine the
probable future stock price and the dividends they may expect to earn.

Key market prospect ratios include dividend yield, earnings per share, the price-to-
earnings ratio, and the dividend payout ratio.

Ratio analysis refers to the analysis of various pieces of financial information in


the financial statements of a business. They are mainly used by external analysts to
determine various aspects of a business, such as its profitability, liquidity, and
solvency.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Question No.

The following information has been obtained from the books of Himank Ltd. :

Rs.
Profit after tax (60%) 4,05,000
Depreciation 90,000
Equity Dividend Paid 20%
Market Price per Equity Share Rs.40
The Capital is as under:
1,20,000 Equity Share of Rs.10 12,00,000
9%, 45,000 Pref. Shares of
Rs.10 4,50,000
Total 16,50,000

You are required to compute (i) Earning per share, (ii) Price earning Ratio, (iii) Capitalization Ratio, (iv)
Dividend yield on equity shares and (v) Payout Ratio

Solution:

Profit available for Equity Shareholder


(i) Earning per Share (E.P.S) =
No. of Equity Shares

Rs.4,05,000 - Rs.40,500
Earning per Share (E.P.S) =
1,20,000

Rs.3,64,500
Earning per Share (E.P.S) =
1,20,000

Earning per Share (E.P.S) = Rs. 3.04

Market Price per Equity Share


(ii) Price Earning Ratio (P/E Ratio =
Earning per share
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs.40
Price Earning Ratio (P/E Ratio =
Rs.3.04

13.15 times
Price Earning Ratio (P/E Ratio =

Earning per Equity Share x 100


(iii) Capitalisation Ratio / Earning
Yield Ratio (E.Y.R) = Market Price per Equity share

Capitalisation Ratio / Earning Rs.3.04 x 100


Yield Ratio (E.Y.R) = Rs.40

Capitalisation Ratio / Earning 7.60%


Yield Ratio (E.Y.R) =

Dividend per Equity share x 100


(IV) Dividend Yield Ratio =
Market price per Equity share

Rs.2 x 100
Dividend Yield Ratio =
Rs.40

Dividend Yield Ratio = 5%

Dividend per Equity share x 100


(V) Payout Ratio =
Earning per Equity share

Rs.2 x 100
Payout Ratio =
Rs.3.04

Payout Ratio = 66%


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Miscellaneous Questions
Question No.

From the following information, make at a Statement of Proprietor’s Fund with add much detail as
possible;

(1)Current Ratio 2.5:1

(2)Liquid Ratio 1.5:1

(3)Proprietary Ratio (Fixed Assets / Proprietary Fund) 0.75:1

(4)Working Capital Rs.60,000

(5)Reserves & Surplus Rs.40,000

(6)Bank overdraft Rs.10,000

(7)There is no long-term or fictitious assets.

Solution:

Current Assets
Current Ratio =
Current Liabilities
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2.5
Current Ratio =
1

Working Capital = 2.5 – 1

Working Capital = 1.5

Working Capital 1.5 = Rs.60,000

Rs.60,000 x 1
Current Liabilities =
1.5

(1)Current Liabilities = Rs.40,000

Rs.60,000 x 2.5
Current Assets =
1.5
(2)Current Assets = Rs.1,00,000

Rs.40, 000 x 1.5


Liquid Assets =
1

(3)Liquid Assets = Rs.60,000

(4) Stock = Current Assets – Liquid Assets

= Rs.1,00,000 – Rs.60,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

= Rs.40,000

(5) Assumed that is Cash at Bank is Rs.5,000 and Debtors are Rs.55,000 in Liquid Assets.

(6)Current Liabilities of Rs.40,000 include bank overdraft of Rs.10,000. Hence, other current liabilities of
Rs.30,000. Assumed that is other current Liabilities includes Creditors Rs.25,000 and Bills Payable
Rs.5,000.

Proprietary Fund to Fixed Assets is 1:0.75. It means 0.25 of Proprietary Fund is being used in Working
Capital.

(7)So, Proprietary Fund = Rs.60,000 / 0.25

= Rs.2,40,000

(8)Since Reserves and Surplus is Rs.40,000, the paid –up capital will be Rs.2,00,000.

(9)Fixed Assets will be 75% of Rs.2,40,000 i.e. Rs.1,80,000.

On the basis of calculation, the statement of proprietary Fund can be prepared:

Statement of Proprietary Fund

Rs. Rs.
Current Assets:
Cash at bank 5,000
Debtors 55,000
Stock 40,000 1,00,000

Less: Current Liabilities:


Creditors 25,000
Bills Payable 5,000
Bank Overdraft 10,000 (40,000)
Working Capital 60,000
Add: Fixed Assets 1,80,000
Total Capital Employment 2,40,000

Net Worth:
Paid-up Capital 2,00,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Reserves & Surplus 40,000


Proprietary Fund or Total Capital
Employment 2,40,000

Question No.

From the following figures and Ratios, make out the Balance Sheet and Trading and Profit & Loss
Account:

(a) Share Capital Rs.7,20,000


(b) Working Capital Rs.2,52,000
(c ) Bank Overdraft Rs.40,000

There is no fictitious assets. In current assets there are no assets other than stock, debtors and cash.
Closing Stock is 20% higher than the Opening Stock.

(i) Current Ratio 2.5:1


(ii) Quick Ratio 1.5:1
(iii) Proprietary Ratio 0.7:1
(Fixed Assets / Proprietary Fund)
(iv) Gross Profit Ratio 20%
(v) Stock Turnover 4 times
(vi) Debtors Turnover 36.5 days
(vii) Net Profit to paid-up capital 10%

Solution:

1 Current Ratio = Current Assets / Current Liabilities


= 2.5 – 1
Working Capital = 1.5

Hence,

Rs.2,52,000 x 2.5
Current Assets =
1.5
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Current Assets = Rs.4,20,000

Rs.2,52,000 x 1
(2)Current Liabilities =
1.5

Current Liabilities = Rs.1,68,000

This includes Bank Overdraft of Rs.40,000. Therefore other current liabilities are Rs.1,28,000.

(3) Quick Assets or (Debtors and Cash):

Quick Assets
Quick Ratio =
Current Liabilities

1.5
Quick Ratio =
1

Rs.1,68,000 x 1.5
Quick Assets =
1

Quick Assets = Rs.2,52,000

(4) Proprietary Ratio discloses that 0.7 is invested in Fixed Assets and the balance 0.3 used for working
capital.

Hence,

Rs.2,52,000 x 1
Proprietary Fund =
0.3

Proprietary Fund = Rs.8,40,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Fixed Assets = 70% of Proprietary Fund

So. 70% of Rs.8,40,000

Fixed Assets = Rs.5,88,000

Cal. Of Net profit:

Net profit = 10% of paid-up capital

Net profit = 10% of Rs.7,20,000

So Net profit = Rs.72,000

Cal. Of Closing Stock:

Closing Stock = Current Assets – Quick Assets

Closing Stock = Rs.4,20,000 – Rs.2,52,000

Closing Stock = Rs.1,68,000

Cal. Of Opening Stock:

Op stock = Closing Stock x 100 / 120

Op. Stock = Rs.1,68,000 x 100 / 120

Op. Stock = Rs.1,40,000

Cal. Of Cost of goods sold:

Stock Turnover Ratio = Cost of goods sold / Average stock

Average Stock = Op.Stock + Cl. Stock / 2

Average Stock = Rs.1,40,000 + Rs.1,68,000 / 2

Average Stock = Rs.3,08,000 / 2


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average Stock = Rs.1,54,000

Stock Turnover Ratio = Cost of goods sold / Average stock

4 Times = COGS / Rs.1,54,000

COGS = 4 x Rs.1,54,000

COGS = Rs.6,16,000

Cal. Of Gross Profit:

Gross Profit is 20% of Sales

i.e.25% of Cost of goods sold

Gross Profit = 25% of Rs.6,16,000

Gross Profit = Rs.1,54,000

Cal. Of Sales:

Sales = Cost of goods sold + Gross profit

Sales = Rs.6,16,000 + Rs,1,54,000

Sales = Rs.7,70,000

Cal. Of Debtors:

Average collection Period = Receivable x 365days / Net Sales

36.5 Days = Receivable x 365 days / Rs.7,70,000

Debtors = 36.5 x 7,70,000 / 365

Debtors = Rs.77,000

Cal. Of Cash:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Current Assets = Cash + Debtors + Stock

Rs.4,20,000 = Cash + Rs.77,000 + Rs.1,68,000

Cash = Rs.4,20,000 – Rs.77,000 – Rs.1,68,000

Cash = Rs.1,75,000

Trading, Profit and Loss Account

Particulars Rs. Particulars Rs.

To, Op. Stock 1,40,000 By, Sales 7,70,000

To, Purchases (Bla. 6,44,000 By, Cl. Stock 1,68,000


Fig)

To, Gross profit 1,54,000

Total 9,38,000 9,38,000

By, Gross Profit 1,54,000

To, Indirect Exp.(Bal. 82,000


Fig)

To, Net Profit 72,000

Total 1,54,000 1,54,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Balance sheet

Liabilities Rs. Assets Rs.

Share Capital 7,20,000 Fixed Assets 5,88,000

Res.and Surplus: Current Assets:-

Surplus – 72,000 Stock 1,68,000

Reserve 48,000 Debtors 77,000

(8,40,000 – 7,20,000-
72,000)

Bank Overdraft 40,000 Cash 1,75,000

Other C.L 1,28,000

(1,68,000- 40,000)

Total 10,08,000 10,08,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Module No.3
Leverage
Meaning of Leverage

The employment of an assets or a source of fund for which the firm has to pay a fixed cost or fixed return
maybe termed as Leverage.

The term ‘Leverage’ is made of Lever which indicates the means of lifting heavy objects.

In financial management, the term ‘Leverage’ is used to describe the firm’s ability to use fixed costs or
funds to increase the return to its owners. These fixed cost can be classified as :

(i)Those elements of operating expenses which are fixed in nature, and


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(ii) Those non-operating expenses, such as interest payments, which are also relatively fixed in nature.

The fixed operating expenses determine operating leverage and fixed financial expenses determine
financial leverage of a firm. These two leverages can be jointed together to provide a measure of total or
combined leverage.

Operating Leverage

Operating leverage arises when there are fixed operating cost in the firm’s cost structure. Operating costs
such as administrative cost, depreciation, selling and advertisement expenses, etc.

The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of
costs. The fixed cost is treated as a leverage . The changes in sales are related to changes in revenue. The
fixed cost do not change with the changes in sales. The operating leverage occurs when a firm has fixed
costs which must be recovered irrespective of sales volume.

The operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the
effect to changes in sales on its earnings before interest and taxes.

The operating leverage is calculated as under:

Operating Leverage = Contribution / EBIT

Operating Leverage = C / EBIT

Operating Leverage = S –V / EBIT

Operating Leverage = EBIT + Fixed Operating Expenses / EBIT

OR

Operating Leverage = CL / FL

Degree of Operating Leverage:

Operating leverage may also be described in an another way. It can be expressed as a ratio between the
percentage change in EBIT associated with percentage change in sales revenue. It is a quantitative
measurement of the degree of operating leverage .When the percentage change in EBIT due to change in
sales revenue exceeds the percentage change in sales revenue, operating leverage is said to operate. In the
form of formula:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Degree of Operating Leverage (DOL) = % change in EBIT / % change in Sales

Significance of Operating Leverage (Due)

(i)Measurement of Business Rick:

If the degree of operating leverage is higher, the EBIT would be more sensitive for a given change in
sales. If sale decreases, there is risk of exceptional loss. Therefore, it is a measure of firm or business risk.
The business risk refers to the uncertainty or variability of the firm’s EBIT.

(ii)Production Planning:

DOL is also important in production planning. The firm may have the opportunity to change its cost
structure by introducing labour saving machinery and thereby reducing variable overheads while
increasing fixed costs. Such a situation will increase DOL.

Financial Leverage:

Financial leverage related to the financing activities of a firm. The sources from which funds can be raised
by a firm, from the point of view of the cost/ change, can be categorized into:

(i)Those which carry a fixed financial charge; and

(ii)Those which do not involve any fixed charge.

The sources of funds in the first category consist of various types of long- term debt including bonds,
debentures, and preference shares. Long- term debt carry a fixed rate of interest which is a fixed
obligation for the firm. Although, the dividend on preference shares is not a contractual obligation, it is a
fixed charge and must be paid before any payment to ordinary shareholders.

The use of the fixed charged sources of funds (on which company is required to pay return at a fixed rate)
such as debt and preference capital along which the owner’s equity/ ordinary shares in the capital structure
is described as financial leverage.

The aim of financial leverage is to earn more on the fixed charges funds than their costs. If there is
surplus, it will increase the return on owner’s equity and in case of deficit, the return will decrease.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Financial leverage is based on the assumption that the firm is to earn more on the assets which are
acquired by the use of funds on which a fixed rate of interest/ dividend is to be paid. The difference
between the earnings from the assets and the fixed cost on the use of the funds goes to the equity
shareholders. Thus, use of fixed interest source of funds provided increased return on equity without
additional requirement of funds from the shareholders. Therefore, financial leverage is also called
‘Trading on equity’.

Financial leverage may be calculated in several ways:

(i) Debt- Assets Ratio = Debt x 100 / Total Assets

(ii) Debt – Equity Ratio = Debt x 100 / Total Equity

Both the above equations are mathematically inter- related. In practice, Debt – Assets ratio is more
popular and used because Debt- Equity ratio over states the financial leverage. However, a more
scientific method of calculating financial leverage is to related EBIT with EBT and thus:

Financial Leverage = EBIT / EBT

OR

Financial Leverage = EBIT / (EBIT – I)

OR

Financial Leverage = EBIT / [EBIT – I –DPg]

OR

Financial Leverage = CL / OL

Degree of Financial Leverage

The degree of financial leverage measures the impact of a change in operating income on change in
earning per share on equity (EBIT- E.P.S. analysis)

Degree of Financial Leverage (DFL) = % change in EBT / % Change in EBIT


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Sometimes, the degree of financial leverage is defined in terms of relationship between earning per share
(EPS) and EBIT. Gitman has rather explained the Financial Leverage as the ability to magnify the EPS by
changing EBIT. From this view point, the degree of financial leverage may be obtained:

DFL = % change in EPS / % Change in EBIT

Significance of Financial Leverage

Financial leverage is used to plan the ratio between debt and equity so that earning per share is improved.
The significance of financial leverage can be explained in the following points-

(i)Planning about capital structure –

The capital structure is concerned with the raising of long-term funds from shareholders and long term
creditor. A financial manager is required to decide about the ratio between fixed cost funds and equity
share capital. Financial leverage helps in determining an idea capital structure.

(2)Planning about profit-

The degree of financial leverage affects earning per share. If the profitability of a concern increasing then
fixed cost will help increasing the availability is profit of equity shareholder. In this way, financial
leverage is important for profit planning.

Composite Leverage:

Both financial and operating leverage magnify the revenue of the firm. Operating leverage affects the
income which is the result of production. On the other hand, the financial leverage is the result of
financial decisions.

The composite leverage focuses attention on the entire income of the concern. The risk factor should
be properly assessed by the management before using the composite leverage. The high financial
leverage may be offset against low operating leverage or vice-versa.

The degree of composite leverage can be calculated as follows:

Degree of Composite Leverage (DCL) = % Change in EPS or EBT / % Change in Sales


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

OR

Composite Leverage (CL) = Operating Leverage (OL) x Financial Leverage (FL)

OR

Composite Leverage (CL) = C / EBT

Format of Income Statement


Particulars Rs.

Sales (S) *********

Less: Variable Cost (Vc) (*****)

Contribution (C) xxxxxxx

Less: operating Fixed Cost (Fc) (******)

EBIT / Operating Profit xxxxxxxx

Less: Interest on Long- term Debt (I) (******)

EBT xxxxxxx

Less: Tax (T)[ @--- ON EBT] (****)

EAT xxxxxxx

Less: Dp (***)

Profit available for equity shareholder xxxxxxx

Less: De (****)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Retained Earning (RE) xxxxxxx

EBIT = Earning before Interest and Tax

EBT = Earning before Tax

EAT = Earning after Tax

Dp = Dividend on Preference Share

De = Dividend on Equity Share

DPg = Gross Dividend on Preference Share / Dividend paid on Preference Share before tax

Question No.1

A Company has estimated that for a new product its selling price is Rs14 per unit, Variable costs
Rs.9 per unit and fixed costs Rs.10,000. Calculate Operating leverage for 3,000 units and 4,000
units.

Solution:

Income Statement

Particulars For 3,000 units For 4,000 units


(Rs.) (Rs.)

Sales (Rs.14 x 4,000) 42,000 56,000

Less: Variable costs (27,000) (36,000)


(Rs.9 x 4000)

Contribution 15,000 20,000

Less: Fixed costs (10,000) (10,000)


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 5,000 10,000

Operating Leverage = C 15,000 / 5,000 20,000 / 10,000


/ EBIT

OL = 3:1 2:1

Question No.2

From the following data, calculate operating leverage and advise which company is more riskier:

Company X Company Y

Sales Rs.25,00,000 Rs.30,00,000

Variable Costs 25% of sales 25% of sales

Fixed Costs Rs.8,00,000 Rs.2,50,000

Solution:

Income Statement
Company X Company Y

Sales Rs.25,00,000 Rs.30,00,000

Less: Variable Costs @25% (Rs.6,25,000) (Rs.7,50,000)

Contribution Rs.18,75,000 Rs.22,50,000

Less: Fixed Costs (Rs.8,00,000) (Rs.2,50,000)

EBIT Rs.10,75,000 Rs.20,00,000

Operating Leverage = C / EBIT Rs.18,75,000 Rs.22,50,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs.10,75,000 Rs.20,00,000

Operating Leverage = 1.74:1 1.125:1

Question No.3

The capital structure of a company consists of the following:

Particulars Rs.

10% Preference Shares of Rs.10 each 1,00,000

Equity Share Capital (Rs.10 each) 1,00,000

The Operating profit is Rs.60,000. The company is in 50% tax bracket. Calculate financial leverage.

What would be new financial leverage if Operating profit increases to Rs.90,000?

Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Financial Leverage = EBIT / EBIT – I – DPg

Step 1: Calculation of DPg:

Dividend paid on Preference Shares after tax = 10% of Rs.1,00,000

= Rs.10,000

DPg = Dividend paid on Preference Share after tax / 1-Tax Rate

= Rs.10,000 / 1-50%

= Rs.10,000 / 1-0.5

= Rs.10,000 / 0.5

= Rs.20,000

Financial Leverage = EBIT / EBIT - I - DPg

= Rs.60,000 / Rs.60,000 - 0 –Rs.20,000

= Rs.60,000 / Rs.40,000

Financial Leverage = 1.5:1

(B) New financial leverage if Operating profit increases to Rs.90,000

Financial Leverage = EBIT / EBIT - I - DPg

= Rs.90,000 / Rs.90,000 – 0 –Rs.20,000

= Rs.90,000 / Rs.70,000

Financial Leverage = 1.286:1

Question No.4
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The financial manager of Y Ltd. Expects that its earning before interest and taxes in current year
would be Rs.30,000. The company has issued 5% debentures of Rs.1,20,000; while 10% preference
shares amount to Rs.60,000. It has 3,000 equity shares of Rs.10 each. What would be the degree of
financial leverage assuming the EBIT (i) Rs.18,000, and (ii) Rs.42,000. The tax rate of the company
may be taken as 50%. How would EPS be affected?

Solution:

Income Statement
Particular Base Case –I Case – II

EBIT Rs.30,000 Rs.18,000 Rs.42,000

Less: Interest (I) (Rs.6,000) (Rs.6,000) (Rs.6,000)

EBT Rs.24,000 Rs.12,000 Rs.36,000

Less: Tax@50% (Rs.12,000) (Rs.6,000) (Rs.18,000)

EAT Rs.12,000 Rs.6,000 Rs.18,000

Less: DP (Rs.6,000) (Rs.6,000) (Rs.6,000)

Profit available for Rs.6,000 Nill Rs.12,000


equity shareholder
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

E.P.S = (Profit [Rs.6,000 / 3,000] = [Rs.0 / 3,000] = [Rs.12,000 / 3,000] =


available for equity
shareholder / No. of Rs.2 0 Rs.4
equity shares

Change in E.P.S. _ -100% +100%

% change in EBIT 100% -40% +40%

D.F.L _ (Negative) (Positive)

# Calculation of DPg or Dividend on Preference Share before Tax

DPg = Dividend paid on Preference Share / 1-Tax rate

= Rs,6,000 / 1-50%

= Rs.6,000 / 1- 0.5

= Rs.6000 / 0.5

= Rs.12,000

Financial Leverage (FL) = EBIT / EBIT- I - DPg

FL (in Base) = Rs.30,000 / Rs.30,000 – Rs.6,000 – Rs.12,000

= Rs.30,000 / Rs.12,000

= 2.5:1

FL (Case I) = Rs.18,000 / Rs.18,000 – Rs.6,000 – Rs.12,000

= Rs.18,000 / 0
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

= ∞
FL (in Case II) = Rs.42,000 / Rs.42,000 – Rs.6,000 – Rs.12,000

= Rs.42,000 / Rs.24,000

=1.85:1

Question No.5

The profitability statement of X Ltd. For one year is as under:

Particulars Rs.

Sales 2,40,000

Less: Variable costs (1,40,000)

Contribution 1,00,000

Less: Fixed Costs (60,000)

EBIT 40,000

Less: Interest (15,000)

EBT 25,000

On the basis of above particulars, Calculate :

(i)Operating leverage

(ii)Financial Leverage

(iii)Combined Leverage

Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(i) Operating Leverage = C / EBIT

= Rs.1,00,000 / Rs.40,000

= 2.5:1

(ii) Financial Leverage = EBIT / EBT

= Rs.40,000 / Rs.25,000

= 1.6:1

(iii) Combined Leverage[CL] = OL x FL

= 2.5 x 1.6

=4

Question No.6

Given below is the Balance Sheet of a company:

Liabilities Rs. Assets Rs.

Equity Shares Capital 1,80,000 Fixed Assets 4,50,000


( Rs.10 each)

Surplus & Reserves 60,000 Current Assets 1,50,000

14% Debentures 2,40,000

Current Liabilities 1,20,000

6,00,000 6,00,000

Addition information: (i) Total assets turnover 3 times, (ii) Variable costs 40% of Sales.(iii)Fixed
Costs Rs.3,00,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Calculate: (i) Operating Leverage, (ii) Financial Leverage and (iii) Combined Leverage

Solution:

# Calculation of Sales:

Total Assets turnover = Sales / Total Assets

3 = Sales / Rs.6,00,000

Sales = 3 x Rs.6,00,000

Sales = Rs.18,00,000

# Calculation of Variable Costs:

Vc = 40% of Sales

= 40% of Rs.18,00,000

= Rs.7,20,000

Fc = Rs.3,00,000

Income Statement

Particulars Rs.

Sales 18,00,000

Less: Variable Costs (7,20,000)

Contribution 10,80,000

Less: Fixed Costs (3,00,000)


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 7,80,000

Less: Interest@14% (33,600)


of Rs.2,40,000

EBT 7,46,400

OL = C /EBIT 10,80,000
7,80,000

1.386:1

FL = EBIT / EBT 7,80,000


7,46,400

1.045:1

CL = OL x FL 1.386 x 1.045

1.448

Question No.7

The following projections are related to firms Ajay and Bajaj:

Ajay Bajaj

Output & Sales(units) 40,000 50,000

Variable Costs per unit Rs.4 Rs.3

Fixed Costs Rs.1,20,000 Rs.1,25,000

Interest burden on Debt Rs.60,000 Rs.25,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Selling price per unit Rs.10 Rs.8

On the basis of data given above, compute –

(i) Operating leverage

(ii) Financial Leverage, and

(iii) Combined leverage

Question No.8

The following information is available in respect of a company:

Rs.

Equity Share Capital (Rs.10 each) 10,00,000

Debentures (14%) 30,00,000

Contribution per unit 20

Fixed Costs 12,00,000

The Company is producing at present 1,00,000 units. Management of the company’s plans to
increase output by 25% . The tax rate is 40%. You are required to make out the following
calculations for the existing as well as planned level of output:

(i) Operating Leverage

(ii) Financial Leverage

(iii) Earning per share


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Solution:

At Existing Level of Production:

Income Statement

Rs.

Contribution, 1,00,000 units@ Rs.20 20,00,000

Less: Fixed costs (12,00,000)

EBIT 8,00,000

Less: Interest@14% of Rs.30,00,000 (4,20,000)

EBT 3,80,000

Less: Tax @40% (1,52,000)

EAT or Profit available for Eq. 2,28,000


Shareholders

Operating Leverage (OL) = C / EBIT Rs.20,00,000


Rs.8,00,000

2.5 : 1

Financial Leverage (FL) = EBIT / EBT Rs.8,00,000


Rs.3,80,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2.1 : 1

E.P.S =Profit available for Equity Rs.2,28,000 / 1,00,000


Shareholders / No. of Equity Shares

Rs.2.28

At Planned level of Production:

Rs.

Contribution, 1,25,000 units @ Rs.20 25,00,000

Less: Fixed Costs (12,00,000)

EBIT 13,00,000

Less: Interest (4,20,000)

EBT 8,80,000

Less: Tax @ 40% (3,52,000)

EAT or Profit available for Equity 5,28,000


Shareholders

Operating Leverage (OL) = C / EBIT Rs.25,00,000 / Rs.13,00,000

1.92 :1

Financial Leverage (FL) = EBIT / EBT Rs.13,00,000 / Rs.8,80,000

1.48 : 1
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Earning per share (EPS) = Profit Rs.5,28,000 / 1,00,000


available for Equity Shareholder / No. of
Eq.Shares

Rs.5.28

Question No.9

The following estimates are given to you:

Rs.
Sales 10,00,000
Less: variable (4,00,000)
Costs
6,00,000
Contribution
Less: Fixed (4,00,000)
Costs
EBIT 2,00,000
Less: Interest (1,00,000)
EBT 1,00,000

On the basis of above estimates, answer the following questions:

(i) In case sales increase by 10%, What will be the percentage increase in EBIT as result of
Operating Leverage?

(ii) In case EBIT increase by 10%, what will be percentage increase in EBT as a result of
Financial Leverage?

(iii) In case sales increase by, 10%, what will be the percentage increase in EBT as a result of
Combined Leverage?
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Solution:

(i) Percentage increase in EBIT when sales increase by 10%:

Operating Leverage (OL) = C / EBIT

= Rs.6,00,000 / 2,00,000

=3

DOL = % Change in EBIT / % change in Sales

3 = % change in EBIT / 10%

% change in EBIT = 3 x 10%

% change in EBIT = 30%

(ii)Percentage increase in EBT when EBIT increases by 10%

Financial Leverage (FL) = EBIT / EBT

= Rs.2,00,000 / Rs.1,00,000

=2

DFL = % change in EBT / % change in EBIT

2 = % change in EBT / 10%

% change in EBT = 10% x 2

% change in EBT =20%

(iii)Percentage change in EBT when sales increase by 10%

Combined Leverage = OL x FL
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

=3x2

=6

DCL = % Change in EBT / % Change in Sales

6 = % Change in EBT / 10%

% Change in EBT = 10% x 6

% change in EBT = 60%

Question No.10

The financial data for three companies for the year ending 31st March, 2021 are as under:

Company Company Company


‘A’ ‘B’ ‘C’

Variable Costs of Sales 66.67% Or 75% Or 3/4 50% Or 1/2


2/3

Interest Expenses Rs.200 Rs.300 Rs.1,000

Operating Leverage 5:1 6:1 2:1

Financial Leverage 3:1 4:1 2:1

Tax rate 50% in each case. Prepare income statements of A, B and C companies.

Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Company ‘A’:

Financial Leverage = EBIT / EBT

OR

= EBIT / EBIT – I

3 = EBIT / EBIT – Rs.200

Or 3(EBIT -200) = EBIT

Or 3EBIT – 600 = EBIT

Or 3EBIT – EBIT = 600

Or 2EBIT = 600

EBIT = 600 / 2

EBIT = 300

Operating Leverage (OL) = C / EBIT

5 = C / 300

C = 5 x Rs.300

= Rs.1,500

Company ‘B’:

Financial Leverage (FL) = EBIT / EBT

OR

= EBIT / EBIT – I
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

4 = EBIT / EBIT – Rs.300

Or 4(EBIT – Rs.300) = EBIT

Or 4EBIT – Rs.1,200 = EBIT

Or 4EBIT – EBIT = Rs.1,200

Or 3EBIT = 1,200

EBIT = 1,200 / 3

EBIT = Rs.400

Operating Leverage (OL) = C /EBIT

6 = C / 400

C = 6 x 400

C = Rs.2,400

Company ‘C’:

Financial Leverage (FL) = EBIT / EBT

OR

= EBIT / EBIT- I

2 = EBIT / EBIT – 1,000

Or 2(EBIT – 1,000) = EBIT

Or 2EBIT – 2,000 = EBIT


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Or 2EBIT – EBIT = 2,000

Or EBIT = 2,000

Operating Leverage (OL) = C / EBIT

2 = C / 2,000

C = 2 x 2,000

C = Rs.4,000

# Calculation of Variable cost and Sales in company ‘A’

Sales = 100=3

Less: Vc @ = 66.67=2

Contribution = 33.33=1

Income Statement

For the year ended 31st March,2021

Particulars Company Company Company


‘A’ (Rs) ‘B’(Rs.) ‘C’(Rs.)

Sales (100%) =1 4,500 9,600 8,000

Less: Variable Costs 3,000 (7,200) (4,000)

Contribution (S-V) 1500 2,400 4,000

Less: Fixed Costs(C- 1,200 (2,000) (2,000)


EBIT)(1500 – 300)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 300 400 2,000

Less: Interest (200) (300) (1,000)

EBT 100 100 1,000

Less: Tax@50% (50) (50) (500)

EAT 50 50 500

Question No.11

The following data relate to ABC Ltd.

Particulars Rs.

Sales price (per unit) 100

Variable Cost (per unit) 60

Fixed operating costs 40,000

Sales Volume 1200 units

What is the financial leverage of company if 10% change in sales will bring about 90% change in
EPS?

What % increase in variable costs will result will in result in 750% in the existing leverage?

Solution:

Income Statement

Particulars Rs.

Sales (1,200 x Rs.100) 1,20,000

Less: Variable costs (1,200 x Rs.60) (72,000)

Contribution 48,000

Less: Fixed Costs (40,000)


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 8,000

Operating Leverage (OL) = C / EBIT

= 48,000 / 8,000

=6

Change in sales accompanied by EPS indicates degree of combined leverage:

Combined Leverage (CL) = % change in EPS / % Change in Sales

= 90% / 10%

=9

We know,

CL = OL x FL

9 = 6 x FL

Thus,

FL = CL / OL

= 9 /6

= 1.5

Now % increase in VC when OL increase by 750%:

750% increase in OL = 6 + (750% of 6)

= 6 + 45
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

= 51

OL = C / EBIT

OR

= S – Vc / EBIT

OR

= Q (SP –Vc) / Q (SP – Vc) –Fc

51 = 1200 (100-Vc) / 1200(100-Vc) –40,000

51 = 1,20,000-1200Vc / 1,20,000 -1200Vc – 40,000

51 = 1,20,000- 1200Vc / (1,20,000-40,000) – 1200Vc

51 = 1,20,000-1200Vc / 80,000 – 1200Vc

51(80,000 -1200Vc) = 1,20,000-1200Vc

40,80,000 -61,200Vc = 1,20,000 – 1200Vc

40,80,000 – 1,20,000 = -1200Vc + 61,200Vc

39,60,000 = 60,000Vc

Vc = 39,60,000 / 60,000

Vc = 66

Increase = New Vc – Old Vc

Increase = 66 – 60

=6
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

% increase = 6 x 100/60

= 10%

Question No.12

Calculate operating leverage and financial leverage under situation A, B & C and financial plan I, II
& III respectively. From the following information relating to the operating and capital structure
XYZ company for producing additionally 800 units.

Also, find out the combination of operating and financial leverages which give the highest value
and least value. How are these calculations useful to the company?

Rs.

Selling Price per unit 30

Variable cost per unit 20

Fixed Cost:

Situation ‘A’ 2,000

Situation ‘B’ 4,000

Situation ‘C’ 6,000

Financial Plans

I II III

Equity Capital Rs.10,000 Rs.15,000 Rs.5,000

Debt @ 12% Rs.10,000 Rs.5,000 Rs.15,000

Solution :
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Income Statement and computation of Operating Leverage

Situation Situation Situation


‘A’ ‘B’ ‘C’

(Rs.) (Rs.) ( Rs.)

Sales (800 x Rs30) 24,000 24,000 24,000

Less: Variable (16,000) (16,000) (16,000)


Costs(800xRs.20)

Contribution 8,000 8,000 8,000

Less: Fixed Costs (2,000) (4,000) (6,000)

EBIT 6,000 4,000 2,000

Operating 8,000 8,000 8,000


Leverage (OL) = C 6,000 4,000 2,000
/EBIT

1.33:1 2:1 4:1

Computation of Financial Leverage

Financial Financial Financial


Plan I Plan II Plan III

SITUATION ‘A’

EBIT 6,000 6,000 6,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Less: Interest@12% (1,200) (600) (1,800)

EBT 4,800 5,400 4,200

Financial Leverage 6,000 / 4,800 6,000 / 5,400 6,000 /4,200


(FL) = EBIT / EBT

1.25:1 1.11:1 1.43:1

SITUATION ‘B’

EBIT 4,000 4,000 4,000

Less: Interest@12% (1,200) (600) (1,800)

EBT 2,800 3,400 2,200

Financial Leverage 4,000 / 2,800 4,000 / 3,400 4,000 / 2,200


(FL) = EBIT /EBT

1.43:1 1.18:1 1.82:1

SITUATION ‘C’

EBIT 2,000 2,000 2,000

Less: Interest@12% (1,200) (600) (1,800)

EBT 800 1,400 200

Financial Leverage 2,000 / 800 2,000 / 1,400 2,000 / 200


(FL) = EBIT / EBT

2.5:1 1.43:1 10:1

Combination of Financial Leverage and Operating Leverage


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Highest value = Situation ‘C’ and Financial Plan III

CL = OL x FL

= 4 x 10

= 40

Least value = Situation ‘A’ and Financial Plan II

CL = OL x FL

= 1.33 x 1.11

= 1.4763

Question No.12

Financial Leverage of Gyanganga Institute is 2. The institute pays an annual interest of Rs.1,00,000
and Preference dividend of Rs.15,000. The tax rate for the institute is 50%. By what percentage will
there be a fall in the EPS if EBIT drops to Rs.1,30,000?

Solution:

Financial Leverage = EBIT / EBIT – I – DPg

Calculation of DPg:

DPg = Dividend Paid on Pref.Shares /1-tax rate

= Rs.15,000 / 1-50%

= Rs.15,000 / 0.5

= Rs.30,000

Financial Leverage = EBIT / EBIT – I – DPg


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2 = EBIT / EBIT(- Rs.1,00,000 – Rs.30,000)

2 = EBIT / EBIT – Rs.1,30,000

2(EBIT – Rs.1,30,000) = EBIT

2EBIT – Rs.2,60,000 = EBIT

2EBIT –EBIT = Rs.2,60,000

EBIT = Rs.2,60,000

If EBIT drops to Rs.1,30,000( i.e. EBIT fall by 50%) than EPS fall by-

FL = % change in EPS / % change in EBIT

2 = % change in EPS / 50%

2 x 50% = %Change in EPS

100% Change in EPS

Question No.13

CL and FL of Vedita Ltd. are 3 and 2 respectively. Vedita Ltd. Pays annually Rs.60,000 interest and
Rs.16,000 as dividend on Preference Shares. The total variable costs Rs. 2,00,000 and applicable
tax rate is 60%. Find out the amounts of sales revenue and fixed operating costs.

Solution:

Calculation of DPg:

DPg = Dividend paid on preference shares / 1-tax rate

= Rs.16,000 / 1-60%

= Rs.16,000 / 1-0.6
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

= Rs.16,000 / 0.4

= Rs.40,000

FL = EBIT / EBIT – I – DPg

2 = EBIT / EBIT – Rs.60,000 – Rs.40,000

2 = EBIT / EBIT – Rs.1,00,000

2(EBIT – Rs1,00,000) = EBIT

2EBIT – Rs.2,00,000 = EBIT

-Rs.2,00,000 = EBIT – 2EBIT

-Rs.2,00,000 = -EBIT

EBIT = Rs.2,00,000

CL = 3 and FL = 2

We know that

CL = OL x FL

So,

OL = CL / FL

OL = 3 / 2

OL = 1.5

OL = C / EBIT

1.5 = C /Rs.2,00,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

C = 1.5 x Rs.2,00,000

C = Rs.3,00,000

Income Statement

Rs.

Sales (C + Vc) Rs.5,00,000

Less: Variable Costs (Rs.2,00,000)

Contribution Rs.3,00,000

Less: Fixed Operating (Rs.1,00,000)


Costs (C – EBIT)

EBIT Rs.2,00,000

Question No.14

The operating and total leverage of N.S. Ltd. are 2 and 3 respectively when sales volume is 10,000
units. Selling price per unit of output is Rs.12 while its variable cost is Rs.6. The company has no
preference share capital. Corporate tax rate is 50%. The rate of interest on company’s debt is 16%.
p.a. What is the amount of debt in the capital structure of N.S. Ltd,?

Solution:

Operating Leverage (OL) = C / EBIT

2 = Q(Sp – Vc) / EBIT

2 = 10,000( Rs.12 – Rs.6) / EBIT


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2 = 10,000(Rs.6) / EBIT

2 = Rs.60,000 / EBIT

2EBIT = Rs.60,000

EBIT = Rs.60,000 / 2

EBIT = Rs.30,000

CL = C / EBT

3 = Rs.30,000 / EBT

EBT = Rs.30,000 / 3

EBT = Rs.10,000

Calculation of Debt:

We know that

I = EBIT – EBT

= Rs.30,000 – Rs.10,000

= Rs.20,000

16% = Rs.20,000

Then 100%

100 x 20,000 / 16

Debt = Rs.1,25,000

EBIT-EPS Analysis in Leverage:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and shows
ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial planning that
evaluates various alternatives of financing a project under varying levels of EBIT and suggests the best
alternative having highest EPS and determines the most profitable level of EBIT’.

Concept of EBIT-EPS Analysis:

The EBIT-EPS analysis is the method that studies the leverage, i.e. comparing alternative methods of

financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the effect of financial
leverage on the EPS with varying levels of EBIT or under alternative financial plans.

It examines the effect of financial leverage on the behavior of EPS under different financing

alternatives and with varying levels of EBIT. EBIT-EPS analysis is used for making the choice of the

combination and of the various sources. It helps select the alternative that yields the highest EPS.

We know that a firm can finance its investment from various sources such as borrowed capital or

equity capital. The proportion of various sources may also be different under various financial plans.

In every financing plan the firm’s objectives lie in maximizing EPS.

Advantages of EBIT-EPS Analysis:

We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior of EPS

under various financing plans with varying levels of EBIT. It helps a firm in determining optimum

financial planning having highest EPS.

Indifference Points:

The indifference point, often called as a breakeven point, is highly important in financial planning
because, at EBIT amounts in excess of the EBIT indifference level, the more heavily levered financing
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

plan will generate a higher EPS. On the other hand, at EBIT amounts below the EBIT indifference

points the financing plan involving less leverage will generate a higher EPS.

i. Concept:

Indifference points refer to the EBIT level at which the EPS is same for two alternative financial plans.

According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS remains the

same irrespective of debt equity mix’. The management is indifferent in choosing any of the alternative
financial plans at this level because all the financial plans are equally desirable. The indifference point

is the cut-off level of EBIT below which financial leverage is disadvantageous. Beyond the

indifference point level of EBIT the benefit of financial leverage with respect to EPS starts operating.

The indifference level of EBIT is significant because the financial planner may decide to take the debt

advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will be able to

magnify the effect of increase in EBIT on the EPS.

In other words, financial leverage will be favorable beyond the indifference level of EBIT and will

lead to an increase in the EPS. If the expected EBIT is less than the indifference point then the

financial planners will opt for equity for financing projects, because below this level, EPS will be more

for less levered firm.

ii. Computation:

We have seen that indifference point refers to the level of EBIT at which EPS is the same for two

different financial plans. So the level of that EBIT can easily be computed. There are two approaches

to calculate indifference point: Mathematical approach and graphical approach.

Mathematical Approach:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

In mathematical method the following symbols are used:

x = EBIT at indifference point

N1 = No. of equity shares when only equity shares have been issued

N2 = No. of equity shares when debt and equity shares both have been issued

N3 = No. of equity shares when preference shares and equity shares both have been issued

N4 = No. of equity shares when preference shares, debt and equity shares- all three have been issued

I = Interest on Debt

DP = Dividend on preference shares

t = Tax rate

In the case of a newly – set up company, indifference point can be computed by using any of the
following equations:

(i) Equity Shares V/s Debentures

X(1-t) / N1 = (x-I) (1-t) / N2

(ii) Equity Shares V/s Preference Shares

X (1-t) / N1 = x (1-t) – DP / N3

(iii) Equity shares V/s Preference Shares and Debentures

X (1-t) / N1 = (x – I) (1-t) – DP / N4

In the case of existing company, when some debentures have already been issued, then taking I1 as
interest on existing debentures and I2 as interest on additional debt, the following equation may be
used for indifference point:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(x-I) (1-t) / N1 = (x-I1 –I2)(1-t) / N2

Question No.15

The financial manager of a company has formulated various financial plans to finance ₹30,000,000
required to implement various capital projects. You are required to determine the indifference point
for each financial plan assuming 55% tax rate and face value of equity shares ₹100:

(a) Either equity share capital of ₹30,00,000 Or ₹15,00,000, 10% debentures and ₹15,00,000
equity share capital.

(b) Either equity share capital of ₹30,00,000 Or 12% preference shares of ₹10,00,000 and
₹20,00,000 equity share capital.

(c) Either equity share capital of ₹30,00,000 Or 12% preference shares of ₹10,00,000,
₹10,00,000, 10% debentures and ₹10,00,000 equity share capital.

(d) Either equity share capital of ₹20,00,000 and 10% debentures of ₹10,00,000 Or 12%
preference shares of ₹10,00,000, 10% debentures of ₹8,00,000 and ₹12,00,000 equity
share capital.

Also verify the results in each case.

Solution:

Case (a) :
N2
N1 = ₹30,00,000 =₹15,00,000
Rs.100 Rs.100
= 30,000 = 15,000

X (1-t) = (x-I) (1-t)


N1 N2

X (1-0.55) = (x-1,50,000) (1-0.55)


30,000 15,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

0.45x = (0.45x-Rs.67,500)
30,000 15,000

Or 0.45x = 0.90x-1,35,000

Or 0.45x-0.90x = -1,35,000
x = 1,35,000
0.45
Rs.3,00,000

Thus, financial manager will be indifference when EBIT is ₹3,00,000.

Income Statement

Total Equity Equity plus


financing Debt financing
Rs. Rs.
EBIT 3,00,000 3,00,000
Less: Interest ------ (1,50,000)
EBT 3,00,000 1,50,000
Less: Tax @55% (1,65,000) (82,500)
EAT 1,35,000 67,500

EPS = EAT / No.of


Equity shares 1,35,000/30,000 67,500/ 15,000
E.P.S. 4.5 4.5
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Case (b)

N1 = Rs.30,00,000 PD = @12% of Rs.10,00,000


Rs.100 = Rs.1,20,000

= 30,000

N3 = Rs.20,00,000
Rs.100
= 20,000

x (1-t) x (1-t) – PD
=
N1 N3

x (1-0.55) x (1-0.55) - 1,20,000


=
30,000 20,000

0.45x 0.45x - 1,20,000


=
30,000 20,000

9,000x = 13,500x - 3,60,00,00,000

4,500x = 3,60,00,00,000

3,60,00,00,000
x =
4,500

x = Rs.8,00,000
EBIT at indifference point Rs.8,00,000.

Income Statement

Equity plus
Total Equity pref.shares
financing financing
Rs. Rs.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

EBIT 8,00,000 8,00,000


Less: Interest ---- ----
EBT 8,00,000 8,00,000
Less: Tax
@55% (4,40,000) (4,40,000)
EAT 3,60,000 3,60,000
Less: PD ---- (1,20,000)
Profit available
for
Eq.shareholder 3,60,000 2,40,000

E.P.S = Profit
available for
Eq.shareholder /
No.of Eq.shares 3,60,000 / 30,000 Rs.2,40,000 / 20,000

E.P.S. = Rs.12 Rs.12

Case (C) :

N1 = Rs.30,00,000 I= Rs.1,00,000
Rs.100
PD = Rs.1,20,000
= 30,000

N4 = Rs.10,00,000
Rs.100

= 10,000

X (1-t) = (X-I) (1-t) – PD


N1 N4

X (1-0.55 (X-1,00,000) (1-0.55) - 1,20,000


=
30,000 10,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

0.45x 0.45x - 45,000 -1,20,000


=
30,000 10,000

0.45x = 1.35x - 1,35,000 - 3,60,000

0.45x = 1.35x -4,95,000

0.90x = 4,95,000

X = 4,95,000
0.9
X = Rs.5,50,000

Income Statement

Total Equity Equity plus Debt


financing and Pref.Shares
(Rs.) financing (Rs.)

EBIT 5,50,000 5,50,000

Less: Interesr ---- (1,00,000)

EBT 5,50,000 4,50,000

Less: Tax @55% (3,02,500) (2,47,500)

EAT 2,47,500 2,02,500

Less: PD ---- (1,20,000)

Profit available for 2,47,500 82,500


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Eq.shareholder

EPS = Profit available for 2,47,500 82,500 / 10,000


Eq.shareholder / No.of 30,000
Eq.shares

E.P.S. = Rs.8.25 Rs.8.25

Case (d)

₹20,00,000 ₹12,00,000
N2 = N4 =
100 100

N2 = 20,000 N4 = 12,000

(x - I) (1-t) = (x-I) (1-t) -Dp


N2 N4

(x - 1,00,000 ) (1- 0.55) = (x-80,000) (1-0.55) - 1,20,000


20,000 12,000

0.45x - 45,000 = 0.45x - 36,000 - 1,20,000


20,000 12,000

5,400x - 54,00,00,000 = 9,000x - 72,00,00,000 - 2,40,00,00,000

9,000x - 5,400x = 54,00,00,000 - 72,00,00,000 - 2,40,00,00,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3,600x = 2,58,00,00,000

2,58,00,00,000
x =
3,600

X = Rs.7,16,,667

EBIT at indifference point Rs.7,16,667

Equity + Debt +
Pref.Shares
Equity + Debt Financing Financing
Rs. Rs.
EBIT 7,16,667 7,16,667
Less: Interest (1,00,000) (80,000)
EBT 6,16,667 6,36,667
Less: Tax@55% (3,39,167) (3,50,167)
EAT 2,77,500 2,86,500
Less: Dp Nill (1,20,000)
Profit available for Equity
Shareholder 2,77,500 1,66,500

Profit available / No. of Eq.


Shares 2,77,500 / 20,000 1,66,500 / 12,000
EPS Rs.13.87 Rs.13.87
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Module - 4
Capital Budgeting
Definition: Capital budgeting is the method of determining and estimating the
potential of long-term investment options involving enormous capital expenditure. It is
all about the company’s strategic decision making, which acts as a milestone in the
business.

Features of Capital Budgeting


Capital budgeting is a crucial decision and to understand the concept in a better way, let
us go through its following features:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Huge Funds: Capital budgeting involves expenditures of high value which


makes it a crucial function for the management.

 High Degree of Risk: To take decisions which involve huge financial burden
can be risky for the company.

 Affects Future Competitive Strengths: The company’s future is based on


such capital expenditure decisions. Sensible investing can improve its
competitiveness, whereas a wrong investment may lead to business failure.

 Difficult Decision: When the future is dependent on capital budgeting


decisions, it becomes difficult for the management to grab the most appropriate
investment opportunity.

 Estimation of Large Profits: Any investment decision taken by the company


is made with the perspective of earning desirable profits in the long term.

 Long Term Effect: The effect of the decisions taken today, whether favourable
or unfavourable, will be visible in the future or the long term.

 Affects Cost Structure: The company’s cost structure changes with the capital
budgeting; for instance, it may increase the fixed cost such as insurance charges,
interest, depreciation, rent, etc.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Irreversible Decision: A decision once taken is tough to be amended since it


involves a high-value asset which may not be sold at the same price once
purchased.

Factors Affecting Capital Budgeting

The capital budgeting decisions influenced by various elements present in the internal
and external business environment. Following are some of the significant factors
affecting investment decisions:

Capital Structure: The company’s capital structure, i.e., the composition of


shareholder’s funds and borrowed funds, determines its capital budgeting decisions.

Working Capital: The availability of capital required by the company to carry out
day to day business operations influences its long-term decisions.

Capital Return: The management estimates the expected return from the
prospective capital investment while planning the company’s capital budget.

Availability of Funds: The company’s potential for capital budgeting is dependent


on its dividend policy, availability of funds and the ability to acquire funds from the other
sources.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Earnings: If the company has a stable earning, it may plan for massive investment
projects on leveraged funds, but the same is not suitable in case of irregular earnings.

Lending Policies of Financial Institutions : The terms on which financial


institutions provide loans such as interest rates, collateral, duration, etc. contributes to
capital budgeting decisions.

Management Decisions: The decision of the management to take a risk


and invest funds in high-value assets or holding some other plan, also
determines the capital budgeting of the company.

Project Needs: The company needs to consider all the essentials of a new project.
Also, the means to fulfill the requirements along with the estimate of the related expenses
should be clear.

Accounting Methods: The accounting rules , principles and methods of the


company is another factor considered while capital budgeting to frame the reporting of
such expenses and revenue to be generated in future.

Government Policy: The restrictions imposed and the exemptions allowed by the
government to the companies while investing in capital nature, impacts the company’s
capital budgeting decisions.

Taxation Policy: The taxation procedure and policy of the country also influences
the long-term investment decision of the firm since additional capital will be required for
such expenses.

Project’s Economic Value: The total cost estimated for the long-term investment
and the capacity of the company determines the capital budgeting decisions.

Objectives of Capital Budgeting


What is the need for capital budgeting? Why do companies invest so much time and
efforts in it? Capital budgeting is the long-term decision which affects the business to a
great extent.

To know more about the necessity of capital budgeting for the companies, let us go
through the following objectives:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Control of Capital Expenditure: Estimating the cost of investment provides a


base to the management for controlling and managing the required capital expenditure
accordingly.

 Selection of Profitable Projects: The company have to select the most suitable
project out of the multiple options available to it. For this, it has to keep in mind the
various factors such as availability of funds, project’s profitability, the rate of return, etc.

 Identifying the Right Source of Funds: Locating and selecting the most
appropriate source of fund required to make a long-term capital investment is the
ultimate aim of capital budgeting. The management needs to consider and compare the
cost borrowing with the expected return on investment for this purpose.

Capital Budgeting Process

Capital budgeting, as we know, is a decision making process. It involves the following six
steps:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

1.Identifying Potential Investment Opportunities: The company has


various options for capital employment on a long-term basis. In the initial stage, the
management needs to analyze the strengths and weaknesses of every project for
foreseeing the potential of each option.

2.Evaluating and Assembling Investment Proposals: In the next step,


the management assembles and compiles all the investment proposals on the grounds of
cost, risk involvement, future profits, return on investment, etc.

3. Decision Making: Now, the company needs to decide as to which investment


option it may select to suit its pocket and yield a high profit for the company in the long
run.

4. Capital Budgeting and Apportionment: The next step is to classify the


investment as per its duration. The long-term investment is generally considered under
capital budgeting. This step helps in monitoring the performance of an individual
investment.

5. Implementation: After the apportioning of the long-term investment, the


company comes into action for the execution of its decision. To avoid complications and
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

excess time-consumption, the management should lay out a detailed plan of the project
in advance.

6. Performance Review: The last but the most crucial step is the follow-up and
analysis of the project’s performance. While the company’s operations are steady, the
management needs to measure and correlate the actual performance with that of the
estimated one to figure out the deviation and take corrective actions for the same.

Capital Budgeting Decisions


The organization’s all capital budgeting decisions can be broadly categorized under the
following three types:

 Accept / Reject Decision: This type of arrangement is fundamental and mostly


applies to the independent projects which are not affected by the acceptance
possibility of other projects. The projects which generate a high rate of return or cost
of capital are accepted, and the plans which do not fulfill the criteria are rejected.

 Mutually Exclusive Project Decision: These projects compete with one


another, i.e., the possibility of accepting one project excludes the acceptance of the
other.

 Capital Rationing Decision: The term itself explains that the limitation of
capital dominates such decisions. In a situation where the firm has multiple
investment options demanding huge funds, the management rank the projects on
specific criteria; such as the rate of return of each project. Then, the projects with the
highest percentage of profit or those which fulfill the requirements most can be
selected.

Capital Budgeting Techniques


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Capital budgeting is a complicated and tedious process. It involves a lot of financial


expertise and calculations. Following are the various computations required to determine
the capital budgeting of a new project:

Payback Period Method:


The payback period method is the simplest of all. It defines the period in which the
company can recover its investment value.

The formula for calculating the payback period of a project is:

(a) When Cash Inflow is constant every year:

Initial Investment
P.B.P =
Annual Cash Inflow

(b) When Cash Inflow is not constant every year:

Balance of Initial Investment 12


P.B.P = completed year + x
Cash inflow of next year

 Note: The shorter is the payback period of the project, the more suitable it is for
the company.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Calculation of Cash inflow:

EBT ****
Less : Tax ( )
EAT ****
Add: Depreciation +
Cash inflow ****

Cash inflow = Profit after tax before depreciation

Question No.1

Tata Power Ltd. Is considering to purchase a new machine is Rs.1,50,000 and the
expected cash inflow is Rs.30,000 p.a. Life of the machine is 7 years. Calculate Pay –back
period.

Solution:

Initial Investment
P.B.P =
Annual Cash inflow
P.B.P Rs.1,50,000
= Rs.30,000

P.B.P = 5 Years

Question No.2

Amit Ltd. is considering a Machine. Two machines A and B are available at the cost of
Rs.1,20,000 each. Earning after tax before depreciation are likely to be as under:

Year Machine ‘A’ Machine ‘B’


(Rs.) (Rs.)

1 50,000 20,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2 40,000 30,000

3 30,000 50,000

4 20,000 40,000

5 20,000 40,000

Calculate Pay-Back Period.

Solution:

Machine 'A"
Year Cash inflow Cum.C.I
1 Rs.50,000 Rs.50,000
2 Rs.40,000 Rs.90,000
3 Rs.30,000 Rs.1,20,000
4 Rs.20,000
5 Rs.20,000

P.B.P = 3 Year

Machine 'B'
Year Cash inflow Cum.C.I
1 20,000 20,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2 30,000 50,000
3 50,000 1,00,000
4 40,000
5 40,000

Balance of Initial Investment x 12


P.B.P. = Completed Year +
cash inflow of next year

Rs.20,000 x 12
P.B.P. = 3 Years +
Rs.40,000

P.B.P. = 3 years + 6 Months

P.B.P. = 3 years and 6 months


Note: On the basis of Pay-back period, Machine ‘A’ is preferable.

Question No.3

Company S.S. wants to replace the manual operation by new Machine. There are two
alternative Models N and H of the new machine. Using Pay-back period, suggest the most
profitable investment. Ignore taxation.

Particulars Machine Machine


‘N’ ‘H’

Original Investment Rs.9,000 Rs.18,000

Estimated Life 4 Year 5 Year

Estimated Saving in Rs.500 Rs.800


Scrap
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Estimated Saving in Rs.6,000 Rs.8,000


Wages

Additional Cost of Rs.800 Rs.1,000


Maintenance

Additional cost of Rs.1,200 Rs.1,800


Supervision

Solution:

Statement of Annual Cash inflow

Particulars Machine ‘N’ (Rs.) Machine ‘H’(Rs.)

A. Incomes:

Estimated Saving in 500 800


Scrap

Estimated Saving in 6,000 8,000


Wages

Total Saving (A) 6,500 8,800

B. Expenses:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Additional Cost of 800 1,000


Maintenance

Additional Cost of 1,200 1,800


Supervision

Total Expenses (B) 2,000 2,800

A-B = Net Saving 4,500 6,000


(Annual Cash inflow)

Initial Investment
P.B.P =
Annual Cash inflow
Rs.9,000 Rs.18,000
Rs.4,500 Rs.6,000
P.B.P = 2 Years 3 years

Suggestion: The lowest Pay-back period is 2 years in case of Machine ‘N’. Hence, the
most profitable investment is on Machine ‘N’.

Post pay-back profitability: As pointed out earlier, the other important


limitation of traditional pay-back period is that it neglects the profitability of investment
during the excess of economic life period over the pay-back period of that investment. To
get rid of this limitation, it is suggested to calculate saving for post pay-back period of the
economic life of various projects. If other things remain equal, that project is to be
preferred which has highest Post Pay-back period profits.

Question No.4

Shobhit Ltd. Is considering to purchase a machine. Two machines A and B are available
at the cost of Rs.1,20,000 each. Earning after tax but before depreciation ( C.I ) are
likely to be as under:

Year Machine 'A' Machine'B'


Rs. Rs.
1 50,000 20,000
2 40,000 30,000
3 30,000 50,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

4 20,000 40,000
5 20,000 40,000

Evaluate the two alternatives by using:

(a) Pay-back period method;

(b) Post pay-back profitability method.

Solution:

Year Machine 'A' Machine 'B'


C.I Cum.C.I C.I Cum. C.I
1 50,000 50,000 20,000 20,000
2 40,000 90,000 30,000 50,000
3 30,000 1,20,000 50,000 1,00,000
4 20,000 40,000
5 20,000 40,000

P.B.P. Machine ‘A’ = 3 years

Balance of Initial
P.B.P = completed year + Investment x 12
Cash inflow of next year

3 years + Rs.20,000 X 12
Rs.40,000

3 years + 6 Months
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

P.B.P = 3 Years and 6 Months

Note: On the basis of Pay-back Period Machine ‘A’ is more suitable.

(B) Post Pay-back Profitability:

Year Machine 'A' Machine 'B'


C.I C.I
1 50,000 20,000
2 40,000 30,000
3 30,000 50,000
4 20,000 40,000
5 20,000 40,000
Total C.I = 1,60,000 1,80,000
less: Investment (1,20,000) (1,20,000
Post pay-back C.I 40,000 60,000

Post Pay-back C.I x 100


Index of P.B.P =
Initial Investment

Rs.40,000 x 100
Machine 'A' =
Rs.1,20,000

33.33%

Machine 'B' = Rs.60,000 x 100


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Rs.1,20,000

50%
Note : Thus, Machine ‘B’ is more suitable.

Question No.5

Zoadic Ltd. is considering three projects X, Y and Z. Following are the particulars in
respect of them:

Project ‘X’ Project ‘Y’ Project ‘Z’

Cost(Investment) Rs.1,00,000 Rs.1,40,000 Rs.1,40,000

Economic Life 10 Year 10 year 10 Year

Estimated Scrap Rs.5,000 Rs.10,000 Rs.14,000

Annual Savings Rs.16,000 Rs.25,000 Rs.20,000

Ignoring income-tax, recommend the best of three projects using:

(i) Pay-back period

(ii) Post pay-back profit

(iii) Index of post pay-back profit

Solution:

Project ’X’ Project ‘Y’ Project ‘Z’


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

1.Cost of Investment Rs.1,00,000 Rs.1,40,000 Rs.1,40,000

2.Annual cash inflow Rs.16,000 Rs.25,000 Rs.20,000

3.P.B.P = Investment / 6.25 years 5.6 Years 7 years


Annual cash inflow

Ranking II I III

4.Economic life 10 years 10 years 10 years

5.Pay-back period 6.25 years 5.6 year 7 year

6.Surplus Life 3.75 years 4.4 years 3 years


(Economic life – P.B.P)

7.Post pay-back 3.75*16,000 4.4*25,000 = 3 *20,000 =


profit(Annual C.I = Rs.60,000 Rs.1,10,000 Rs.60,000
*Surplus Life)

Ranking II I III

Index of post-pay-back 60,000*100 1,10,000*100 60,000*100


profit 1,00,000 1,40,000 1,40,000

60% 78.6% 42.9%

Ranking II I III

Thus, it appears from the above calculation that project ‘Y’ is the best of all the three by
all methods of ranking.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Accounting Rate of Return:

Or

Average Rate of Return

Or

Unadjusted Rate of Return


Average rate of return or accounting rate of return means the average annual earning on
the project. Under this method, the Earning after tax as percentage of total investment
is considered. In other word, the annual returns of a project are expressed as a
percentage of the net investment in the project.

Calculation of ARR:

The average rate of return can be calculated in the following two ways:

First:

Average profit after tax x 100


ARR =
Initial Investment

In this case, the original cost of investment and the installation expenses, if any, is taken
as the amount invested in the project. To calculate average profit after tax, total profit
after tax is divided by the number of years of the project.

Theoretically, this approach seems to be good but taking the initial investment as the
base of calculating average rate of return is not correct on logical ground.

Second:

Average profit after tax x 100


ARR =
Average Investment

In this case, the average investment of the project is taken as the base for calculating
average rate of return which is more logical ground.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

How to Calculate Average Investment:

(a) When there is no scrap value and working capital:

Initial Investment + Installation Charge


Average investment =
2

(b) When there is Scrap value

Initial Investment + Installation Charge - Scrap Scrap


Average investment = value + value
2

(c)When there is Scrap Value and working capital

[Scrap value +
Initial Investment + Installation Charge - Scrap value working
Average investment = + capital]
2

Question No.6
The cost of a project is Rs.9,80,000 and the installation charges are Rs.20,000. The estimated profit
after tax are as follows:

Years Profit after tax


Rs.
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000

Calculate average rate of return if:

(a) There is no scrap value of the project.


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(b) If the scrap value at the end of 5 years is Rs.80,000.

(c) If scrap value is Rs.80,000 and additional working capital is required Rs.1,00,000.

Solution:

Total profit after tax


No. of years
Rs.4,60,000
Average Profit after tax =
5 years

Rs.92,000

(a) Calculation of Average Investment for no scrap value in the project.

Initial Investment + Installation Charge


Average investment =
2

Rs.9,80,000 + Rs.20,000
Average investment =
2

Rs.10,00,000
Average investment =
2

= Rs.5,00,000

Average profit after tax x 100


ARR =
Average Investment

Rs.92,000 x 100
ARR =
Rs.5,00,000

ARR = 18.40%
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(b) ARR when Scrap Value is Rs.80,000


Average profit after tax x 100
ARR =
Average Investment

Initial Investment + Installation Charge - Scrap Scrap


Average investment = value + value
2

Rs.9,80,000 + Rs.20,000 - Rs.80,000 + Rs.80,000


Average investment =
2
Rs.9,20,000 + Rs.80,000
Average investment =
2
Average investment = Rs.4,60,000 +Rs.80,000
Average investment = Rs.5,40,000

Average profit after tax x 100


ARR =
Average Investment

Rs.92,000 x 100
ARR =
5,40,000

ARR = 17.04%

(c)ARR when scrap value with working capital

Initial Investment + Installation Charge - Scrap


S.V+ W.C
Average investment = value +
2

Rs.80,000 +
Rs.9,80,000 + Rs.20,000 - Rs.80,000
Average investment = + 1,00,000
2
Rs.9,20,000 + Rs.1,80,000
Average investment =
2
Average investment = Rs.4,60,000 +Rs1,80,000
Average investment = Rs.6,40,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average profit after tax x 100


ARR =
Average Investment

Rs.92,000 x 100
ARR =
Rs.6,40,000

ARR = 14.38%

Question No.7
Two projects A and B are before consideration of the management of Birla Ltd. The particulars
available are:

Project A Project B

Cost Rs.10,000 Rs.10,000

Economic Life 4 year 6 year

Profit before Dep. as below - Rs. Rs.


Year

1 5,000 1,000

2 4,000 2,000

3 3,000 3,000

4 1,000 4,000

5 5,000

6 6,000

Which project should be preferred? Use Unadjusted Return on Investment Method.


Solution:
Project A Project B
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

1. Total Profit before Dep. Rs.13,000 Rs.21,000


2. Average Profit(Total profit / No.of years) 13,000 / 4 21000 / 6
= =
Rs.3,250 Rs.3,500
3. Annual Dep.(Cost / Life) 10,000 / 4 10,000 /6
= =
Rs.2,500 Rs.1,667
4. Average Investment (Cost / 2) Rs.5,000 Rs.5,000
5. Average Profit after tax (2 -3) Rs.750 Rs.1,833

Project ‘A’ :
Average profit after tax x 100
ARR =
Average Investment

Rs.750 x 100
ARR =
Rs.5,000

ARR = 15.00%

Project ‘B’:
Average profit after tax x 100
ARR =
Average Investment

Rs.1,833 x 100
ARR =
Rs.5,000

ARR = 36.67%

Note: Project ‘B’ should be preferred because its ARR is higher than project ‘A’.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Question No.8
Determine the average rate of return from the following data of two machines A and B:
Machine 'A' Machine 'B'

Cost Rs.56,125 Rs.56,125


Life 5 years 5 years
Salvage Value Rs.3,000 Rs.3,000
Tax Rate 55% 55%
Additional working capital Rs.5,000 Rs.6,000
Earning after tax:
1st year Rs.3,375 Rs.11,375
2nd year Rs.5,375 Rs.9,375
3rd year Rs.7,375 Rs7,375
4th year Rs.9,375 Rs.5,375
5th year Rs.11,375 Rs.3,375
Total Rs.36,875 Rs.36,875

Solution:
1. Calculation of Average Investment of Machine A & B:

Average Investment of Machine A :

Initial Investment + Installation Charge - Scrap


S.V+ W.C
Average investment = value +
2

Rs.56,125 +0 - Rs.3,000 + Rs.3,000 + Rs.5,000


Average investment =
2
Rs.53,125 + Rs.8,000
Average investment =
2
Average investment = Rs.26,562 + Rs.8,000
Average investment = Rs.34,562
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average Investment of Machine ‘B’


Initial Investment + Installation Charge - Scrap
S.V+ W.C
Average investment = value +
2

Rs.56,125 +0 - Rs.3,000 + Rs.3,000 + Rs.6,000


Average investment =
2
Rs.53,125 + Rs.9,000
Average investment =
2
Average investment = Rs.26,562 + Rs.9,000
Average investment = Rs.35,562

2. Calculation of Average Profit after tax :

Average Profit after tax = Total profit after tax / No. of Years
= Rs.36,875 / 5 year
= Rs.7,375
ARR for Machine ‘A’
Average profit after tax x 100
ARR =
Average Investment
7,375 x 100
ARR =
34,562

ARR = 21.34%

ARR for Machine ‘B’

Average profit after tax x 100


ARR =
Average Investment
7,375 x 100
ARR =
35,562
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

ARR = 20.74%

Question No.9
X Ltd. is considering a proposal to purchase a machine whose particulars are given
below:

cost of Machine Rs.6,00,000


Salvage value Rs.40,000
Increase in N.W.C Rs.60,000

Expected profitability from the machine are:


Year EAT
Rs.
1 60,000
2 65,000
3 70,000
4 75,000
5 80,000

Advise using ARR method whether the machine be purchased or not, if company’s
required rate of return is 16%.
Solution:

ARR =
Average profit after tax x 100
Average Investment

Calculation of Average Profit after tax:


Years Profit after tax
Rs.
1 60,000
2 65,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3 70,000
4 75,000
5 80,000
Total 3,50,000
Average Profit after tax = Total Profit after tax / No. of Years

= Rs.3,50,000 x / 5Years

= Rs.70,000

Calculation of Average Investment:


Initial Investment + Installation Charge - Scrap
S.V+ W.C
Average investment = value +
2

Rs.40,000 +
Rs.6,00,000 +0 - Rs.40,000
Average investment = + Rs.60,000
2
Rs.5,60,000 + Rs.1,00,000
Average investment =
2
Average investment = Rs.2,80,000 + Rs.1,00,000
Average investment = Rs.3,80,000

ARR =
Average profit after tax x 100
Average Investment

70,000 x 100
ARR =
3,80,000

ARR = 18.42%

Yes, the Machine can be purchased.

Net present value method


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Net present value method (also known as discounted cash flow method) is a
popular capital budgeting technique that takes into account the time value of money. It
uses net present value of the investment project as the base to accept or reject a proposed
investment in projects like purchase of new equipment, purchase of inventory, expansion
or addition of existing plant assets and the installation of new plants etc.

First, I would explain what is net present value and then how it is used to analyze
investment projects.

Net present value (NPV):

Net present value is the difference between the present value of cash inflows and the
present value of cash outflows that occur as a result of undertaking an investment project.
It may be positive, zero or negative. These three possibilities of net present value are
briefly explained below:

Positive NPV:

If present value of cash inflows is greater than the present value of the cash outflows, the
net present value is said to be positive and the investment proposal is considered to be
acceptable.

Zero NPV:

If present value of cash inflow is equal to present value of cash outflow, the net present
value is said to be zero and the investment proposal is considered to be acceptable.

Negative NPV:

If present value of cash inflow is less than present value of cash outflow, the net present
value is said to be negative and the investment proposal is rejected.

The summary of the concept explained so far is given below:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Net Present Value Formula


Net present 1
Value = 1 + Discount Rate

If discount rate is 15% then –


NPV = 1 / 1+ (15%)
= 1 / 1+ (15 / 100)
= 1 / 1 + 0.15
= 1 / 1.15
= 0.8695 or 0.87

Question No.
The A.M Fertilizers Ltd. is considering a proposal for the investment of Rs.5,00,000 on product
development which is expected to generate net cash inflow for 6 years as under:
Year Cash inflow (Rs.)
1 0
2 1,00,000
3 1,60,000
4 2,40,000
5 3,00,000
6 6,00,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The following are the present value factor @15% p.a.


Year 1 2 3 4 5 6
Factor 0.87 0.76 0.66 0.57 0.5 0.43

Solution:
Calculation of Net Present value

1 2 3 4 (2x3)
Year Cash inflow P.V Factor Present Value
(Rs.) (Rs.)
1 0 0.87 0
2 1,00,000 0.76 76,000
3 1,60,000 0.66 1,05,600
4 2,40,000 0.57 1,36,800
5 3,00,000 0.50 1,50,000
6 6,00,000 0.43 2,58,000
Total P.V Cash inflow 7,26,400
Less: Cash outlay (5,00,000)
Net present Value
(Positive) 2,26,400

Note: As the net present value is positive, the proposal is acceptable.

Question No.

A Ltd. is considering to purchase a new machine costing Rs.5,85,000. An additional


investment will be required for the following reasons.

(i) Installation cost Rs.15,000

(ii)Working Capital Rs.1,00,000

The machine has a working life of 5 year and salvage value will be Rs.1,00,000. The
working Capital will also be released after 5 Year. Investment allowance benefit will be
available @ 20% on the cost of new machine.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The estimated cash inflows (before depreciation and tax) are estimated to be as below:

Profit before
Year Depreciation (Rs.)
1 1,00,000
2 1,80,000
3 2,50,000
4 2,00,000
5 1,50,000
You can assume straight line method for charging depreciation, cost of capital of 15%
and corporate tax rate of 50%.

Should the company purchase the machine? Use N.P.V

Solution:
# Calculation of Cash outflow:
Cost of Machine Rs.5,85,000
Add: Installation Charges Rs.15,000
Actual cost of Machine: Rs.6,00,000

Less: Tax benefit due to Investment (Rs.60,000)


Net Investment Outlay Rs.5,40,000

Add: Working Capital required Rs.1,00,000


Total Cash Outlay : Rs,6,40,000

# Calculation of Depreciation:
Cost of Machine + Installation Charges - Salvage Value
Depreciation =
Estimated Life

Rs.5,85,000 + Rs.15,000 - Rs.1,00,000


Depreciation =
5 years

Rs.5,00,000
Depreciation =
5 years
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Depreciation = Rs.1,00,000

Computation Cash inflow:

Year Profit before Less: Operating Less: Profit Add: Cash


Depreciation Depreciation profit Tax @ after tax Depreciation inflow
(2-3) 50% (4-5)=6 (6 + 7) =
8
1 2 3 4 5 6 7 8
Rs. Rs. Rs. Rs. Rs. Rs. Rs.
1 1,00,000 1,00,000 0 0 0 1,00,000 1,00,000
2 1,80,000 1,00,000 80,000 40,000 40,000 1,00,000 1,40,000
3 2,50,000 1,00,000 1,50,000 75,000 75,000 1,00,000 1,75,000
4 2,00,000 1,00,000 1,00,000 50,000 50,000 1,00,000 1,50,000
5 1,50,000 1,00,000 50,000 25,000 25,000 1,00,000 1,25,000

Computation of Net Present Value:


Year Cash inflow P.V Factor P.V. Cash inflow
Rs. @15% Rs.
1 1,00,000 0.870 87,000
2 1,40,000 0.756 1,05,840
3 1,75,000 0.658 1,15,150
4 1,50,000 0.572 85,800
5 1,25,000 0.497 62,125
4,55,915
1,00,000 x
Add: W.C
0.497 49,700
1,00,000 x
Add: Salvage Value
0.497 49,700
Total P.V Cash
inflow 5,55,315

Less: Cash Outlay : (6,40,000)


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

N.P.V (Negative) (84,685)

Decision: A NPV is negative, the Machine should not be purchased.

Question No.
The following details relate to the two Machines X and Y:
Machine ‘X’ Machine ‘ Y’
Cost Rs.56,125 Rs.56,125
Salvage Value Rs.3,000 Rs.3,000
Estimated Life 5 year 5 year
Annual Profit after tax and
Depreciation:
Year
1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375

5 11,375 3,375

Overhauling charges at the end of 3rd years Rs.25,000 in case of Machine X.


Depreciation has been charged at Straight Line Method. Discount rate is 10% for five
years are:

Year 1 2 3 4 5
Factor 0.909 0.826 0.751 0.683 0.621

Using present Value Method, Suggest which Machine should be chosen?

Solution:
Computation of Net Present Value:

Machine ‘X’
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Year Profit after Add: Cash inflow P.V.F.% 10% P.V Cash
Depreciation Depreciation inflow
1 2 3 4 5 6
Rs. Rs. Rs. Rs. Rs.
1 3,375 10,625 14,000 0.909 12,726
2 5,375 10,625 16,000 0.826 13,216
3 7,375 10,625 18,000 0.751 13,518
4 9,375 10,625 20,000 0.683 13,660
5 11,375 10,625 22,000 0.621 13,662
P.V Cash inflow 66,782
Add: Scrap Value 3000 x 0.621 1,863
Total P.V. Cash inflow 68,645
Less: Initial Investment (56125)
25,000 x
Less: Overhauling 0.751 (18,775)
NPV (Negative) (6,225)
Machine ‘Y’
Year Profit after Add: Depreciation Cash inflow P.V.F.% 10% P.V Cash
Depreciation inflow
1 2 3 4 5 6
Rs. Rs. Rs. Rs. Rs.
1 11,375 10,625 22,000 0.909 19,998
2 9,375 10,625 20,000 0.826 16,520
3 7,375 10,625 18,000 0.751 13,518
4 5,375 10,625 16,000 0.683 10,928
5 3,375 10,625 14,000 0.621 8,694
P.V Cash inflow 69,658
Add: Scrap Value 3000 x 0.621 1,863
Total P.V. Cash
inflow 71,521
Less: Initial
Investment (56,125)
Overhauling Nill
NPV (Positive) 15,396

Suggestion:
Machine ‘X’ has Negative NPV so this machine should not be purchase, but Machine
‘Y’ has Positive NPV therefor it should be purchase.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Discounted Payback Period:


The discounted payback period is a modified version of the payback period that accounts
for the time value of money. Both metrics are used to calculate the amount of time that it
will take for a project to “break even,” or to get the point where the net cash flows
generated cover the initial cost of the project. Both the payback period and the discounted
payback period can be used to evaluate the profitability and feasibility of a specific project.

The discounted payback period is used to evaluate the profitability and timing of cash
inflows of a project or investment. In this metric, future cash flows are estimated and
adjusted for the time value of money. It is the period of time that a project takes to
generate cash flows when the cumulative present value of the cash flows equals the initial
investment cost.

The shorter the discounted payback period, the quicker the project generates cash inflows
and breaks even. While comparing two mutually exclusive projects, the one with the
shorter discounted payback period should be accepted.

Discounted Payback Period Formula

There are two steps involved in calculating the discounted payback period. First, we must
discount (i.e., bring to the present value) the net cash flows that will occur during each
year of the project.

Second, we must subtract the discounted cash flows from the initial cost figure in order to
obtain the discounted payback period. Once we’ve calculated the discounted cash flows
for each period of the project, we can subtract them from the initial cost figure until we
arrive at zero.

Question No.

The cost of a project is Rs.1,00,000 and the annual cash inflows are Rs.35,000;
Rs.40,000, Rs.30,000 and Rs.50,000. Calculate discounted Pay-back period assuming
that the discount rate is 15%.

Solution:

Year Cash inflow P.V Factor Discounted C.I Cumulated


Discounted
C.I
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(Rs.) 15% (Rs.) Rs.


1 35,000 0.870 30,450 30,450
2 40,000 0.756 30,240 60,690
3 30,000 0.658 19,740 80,430
4 50,000 0.572 28,600

Discounted Completed Balance Cash inflow X 12


+
P.B.P = year
Inflow of Next year
Discounted 19570 X 12
3 Years +
P.B.P =
28,600

Discounted
3 year + 8.2 months
P.B.P

Discounted
3 years, 8 months 2 days
P.B.P =

 Internal Rate of Return (IRR)

Or

Time Adjusted Return on investment

Or

Discounted Rate of Return

The Internal Rate of Return (IRR) is the discount rate that makes the net present value
(NPV) of a project zero. In other words, it is the expected compound annual rate of return
that will be earned on a project or investment.

When calculating IRR, expected cash flows for a project or investment are given and the
NPV equals zero. Put another way, the initial cash investment for the beginning period
will be equal to the present value of the future cash flows of that investment. (Cost paid =
present value of future cash flows, and hence, the net present value = 0).
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

While using this method, the decision to accept the proposal will be when it is greater
than or equal to the cut-off rate (generally cost of capital) and to reject it if the rate (IRR)
is less than cut-off rate. Such rate of return which incidentally coincides with discounting
rate, can be ascertained in the following manner:

(a)When saving are even for all the year:

When saving are even, the present values of future saving may be found from Annuity
Table by Trial and Error Method. The procedure for this method is under:

Step 1: Divide the annual saving into the investment. By coincidence it is Pay-back
period.

Step 2: Look at Annuity Table (Table II) and pick out the line for number of years
saving will generate.

Step 3: Move across this line until a figure is found nearly equal to the amount
calculated.

Formula:

P.V. at Lower Rate – P.V.F.


I.R.R = LR + (HR -LR)
P.V. at Lower Rate - P.V. at Higher Rate

(b)When Saving are not Even:

Time Adjusted Rate of Return or D.R.R. or I.R.R. may also be found out when savings
or cash inflows are uneven. But this can be done only through Trial and Error Method.
In this method, the present values of cash inflows are calculated at varying rates. In
this process the rate on which present values of cost inflows are closest to the cost of
investment is taken to be time adjusted rate of return.

The procedure for this method is under:

Step 1: Calculate average cash inflow

Step 2: Net investment should be divided by average cash inflow


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Step 3: Look at the annuity table (Table II) and pick out the line for number of years
saving will generate

Step 4: Move across this line until a figure is found nearly equal to amount calculated
this is your first present value.

Step 5: Add or Less 2% or 5% as may be required in first present value to find second
present value.

Step 6: use formula and calculate the Actual Internal Rate of Return.

Formula:

NPVL
IRR = LR + (HR - LR)
NPVL - NPVH

Question No.

The following particulars relate to two projects:

Project ‘A’ Project ‘B’

Cost Rs.90,000 Rs.1,00,000

Estimated Savings Rs.15,000 Rs.20,000

Economic Life 10 Years 10 Years

Compute Time Adjusted Rate of Return or IRR and state which of two projects is better.

Solution:

Step 1: Calculation of Present value Factor or Pay-back period

Pay-back period or P.V. = Cost / Annual saving


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

P.V.F. for project ‘A’ = Rs.90,000 / Rs.15,000

= 6.00

P.V. F. for project ‘B’ = Rs.1,00,000 / Rs.20,000

= 5.00

Step 2: Find present value to 6.00 from cumulative P.V. Table for 10Years in case of
project ‘A’ are:

P.V. Rate

6.145 10%

5.650 12%

Thus, IRR will be between 10% and 12% so find actual IRR by use this formula

P.V. at Lower Rate – P.V.F.


I.R.R = LR + (HR -LR)
P.V. at Lower Rate - P.V. at Higher Rate

(6.145 - 6)
I.R.R = 10% + (12% -10%)
6.145 – 5.650

0.145
I.R.R = 10% + (2)
0.495

I.R.R = 10% + 0.6

IRR = 10.6%

Step 3: Find present value to 5.00 from cumulative P.V. Table for 10Years in case of
project ‘B’ are:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

P.V. Rate

5. 019 15%

4.833 16%

Thus, IRR will be between 10% and 12% so find actual IRR by use this formula

P.V. at Lower Rate


I.R.R = LR + (HR -LR)
P.V. at Lower Rate - P.V. at Higher Rate

5.019-5
I.R.R = 15% + (16% - 15%)
5.019 – 4.833

0.19
I.R.R = 15% + (1)
0.186

I.R.R = 15% + 1.02

IRR = 16.02%

Suggestion: On the basis of IRR, Project ‘B’ ranked I and it is better.

Question No.

Sarthak Ltd. is contemplating to purchase a Machine for Rs.32,400; the expected cash
inflow from this machine in the next three years are:

Year 1 2 3
C.I 16,000 14,000 12,000
Calculate Internal Rate of Return.

Solution:

The cash inflow are not uniform and hence internal rate of return will be calculated by
Trial and Error procedure. But just to have an approximate idea of about the first trial
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

rate, we shall first find out P.V. Factor by dividing net investment by average annual cash
inflow.

Thus

Rs.32,400
P.V.F.=
Rs.42,000 / 3

= 2.314

If we located this factor in Annuity table II on the line of 3rd year, we find 14% rate
closest to 2.314 P.V.F. Hence, Lower rate is 14% and Higher rate is 15%.

P.V. Cash P.V.f@15 P.V. Cash


Year Cash inflow P.V.f.@14% inflow % inflow
Rs. Rs. Rs.
1 16,000 0.877 14,032 0.87 13,920
2 14,000 0.769 10,766 0.756 10,584
3 12,000 0.675 8,100 0.658 7,896
Total P.V. Cash
inflow 32,898 32,400
Less: Machine
Cost (32,400) (32,400)
N.P.V. 498 0
Note: Present Value at 15% are just equal to initial investment so IRR is 15%.

Question No.
A company has to select one of the following two projects:
Project ‘A’ Project ‘B’
Cost Rs.11,000 Rs.10,000
Cash inflows:
Year 1 Rs.6,000 Rs.1,000
Year 2 Rs.2,000 Rs.1,000
Year 3 Rs.1,000 Rs.2,000
Year 4 Rs.5,000 Rs.10,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Using the Internal Rate of Return Method suggest which project is preferable.

Solution:

Calculation of Average Cash inflow:

Average Cash inflow = Total Cash Inflow / No. of Years

For Project ‘A’ = Rs.14,000 / 4 year

= Rs.3,500

For Project ‘B’ = Rs.14,000 / 4 year

= Rs.3,500

Calculation of P.V.F. :

P.V.F. = Cost / Average cash in flow

For Project ‘A’ = Rs.11,000 / Rs.3,500

= 3.143

For Project ‘B’ = Rs.10,000 / Rs.3,500

= 2.857

Closest Present Values to 3.143 from Annuity Table II for 4 years in the case of
Project ‘A’ are 3.170 at 10% and 3.037 at 12%. Thus, IRR can be interpolated by Trial
and Error procedure using discounting rates of 10% and 12%.

Cash P.V. Cash P.V. Cash


Year inflow P.V.f.@10% inflow P.V.f@12% inflow
Rs. Rs. Rs.
1 6,000 0.909 5,454 0.893 5,358
2 2,000 0.826 1,652 0.797 1,594
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3 1,000 0.751 751 0.712 712


4 5,000 0.683 3,415 0.636 3,180
Total 11,272 10,844
Less: cost (11,000) (11,000)
N.P.V 272 (156)

NPVL
IRR = LR + (HR - LR)
NPVL – NPVH

272
IRR = 10% + (12-10)
272-(156)

272 x 2
IRR = 10% +
428

544
IRR = 10% +
428

IRR = 10% + 1.27

IRR = 11.27%

Closest Present Values to 2.86 from Annuity Table II for 4 years in the case of
Project ‘B’ are 2.914 at 14% and 2.855 at 15%. Thus, IRR can be interpolated by Trial
and Error procedure using discounting rates of 14% and 15%.

Cash P.V. Cash P.V. Cash


Year inflow P.V.f.@15% inflow P.V.f@14% inflow
Rs. Rs. Rs.
1 1,000 0.870 870 0.877 877
2 1,000 0.756 756 0.769 769
3 2,000 0.658 1,316 0.675 1,350
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

4 10,000 0.572 5,720 0.592 5,920


Total 8,662 8,916
Less: cost (10,000) (10,000)
N.P.V (1,338) (1,084)

Since Present Value at 15% and 14% are less than investment of
Rs.10,000 a much lower rate should be used. Let us use 10% rate.

Module No.5
Working Capital Management
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

What is working capital?


Working capital is the amount used to meet the day to day operation activities of a
business. In the broad sense, the term working capital is used to denote the total
value of current assets.

Needs for working capital


An effective operation of a business is based on the proper management of working
capital. Initially, the business unit should forecast the adequate working capital. In
this context, working capital forecasting is getting more importance than the
management of working capital. Generally, each business unit requires adequate
amount of capital. The reason is that capital is required for the establishment of a
business units and its proper functioning.

Fixed assets such as Land and Building, fixtures, furniture, machinery, plant and
other fixed assets are required for the establishment of a business. A portion of
capital is used to acquire the fixed assets. Such capital is called fixed capital. After
the establishment, the business unit should function properly.

 Functioning means carrying the activities like trading, service or


manufacturing.

 Trading means buying and selling of goods without making any alteration in
the goods.

 Service means rendering of intangible things like electricity, parcel service,


courier service, telephone, lorry service and the like. Manufacturing means
conversion of raw materials into finished goods which is meant for sale.

Therefore, the business unit requires capital for its proper functioning i.e. meeting
the expenses of day to day activities. Such capital is called working capital. The
other names of working capital are Circulating Capital and Revolving Capital.

Balance sheet concept of working capital


The working capital can be classified into two types under the balance sheet
concept. They are -

1. Gross Working Capital;

2. Net Working Capital


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Gross Working Capital:

Gross working capital means an amount of funds invested in the various forms of
current assets in total. Current assets are those assets which are bought in the
ordinary course of business and converted into cash within a short period which is
normally one accounting year.

Net working capital:

Net working capital is the excess of current assets over current liabilities. Again, the
net working capital is divided into two types. They are

 Positive net working capital and

 Negative net working capital.

The positive net working capital exists, whenever the current assets exceeds
current liabilities. The negative net working capital exists whenever the current
liabilities exceeds the current assets. Current liability means a liability payable
within one accounting year in the ordinary course of business or payable out of the
current assets within a short period normally one year or payable out of the revenue
income of the business.

Why is Gross working capital preferable?

Both gross working capital and net working capital concepts are used for financial
management purposes. But, gross working capital concept is preferable to net
working capital concept due to the following reasons.

1. It helps the business concern to provide adequate amount of working capital at the
time of requirements.

2. Every business concern is interested to know the gross value of current assets
since its effective operation lies on the value of current assets rather than the source
of short term finance.

3. Every increase in current assets leads to increase in the gross working capital.

4. It is highly useful in determining the rate of return on investments in working


capital.

Why is Net working capital preferable?


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Sometimes, net working capital concept is preferable to gross working capital


concept due to the following reasons.

1. It indicates the ability of the concern to meet its operating expenses and short
term liabilities.

2. It discloses the financial soundness of the business concern.

3. It shows the margin of protection available to the short term creditors i.e. the
excess of current assets over current liabilities.

4. It suggests the need for using a part of working capital requirements out of long
term or permanent source of funds.

Net or Gross?

In nutshell, either gross working capital concept or net working capital concept is
applicable to a business concern. The net working capital concept is suitable to sole-
trade concern and partnership firm. But, gross working capital is highly suitable to
private limited company and public limited company form of business organization
where there is a distinction between ownership, management and control.
Generally, working capital refers to net working capital.

Objectives of Working Capital Management


The primary objectives of working capital management include the following:

 Smooth Operating Cycle: The key objective of working capital management


is to ensure a smooth operating cycle. It means the cycle should never stop for
the lack of liquidity whether it is for buying raw material, salaries, tax payments
etc.

 Lowest Working Capital: For achieving the smooth operating cycle, it is also
important to keep the requirement of working capital at the lowest. This may be
achieved by favorable credit terms with accounts payable and receivables both,
faster production cycle, effective inventory management etc.

 Minimize Rate of Interest or Cost of Capital: It is important to


understand that the interest cost of capital is one of the major costs in any firm.
The management of the firm should negotiate well with the financial
institutions, select the right mode of finance, maintain optimal capital
structure etc.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

 Optimal Return on Current Asset Investment: In many businesses, you


have a liquidity crunch at one point of time and excess liquidity at another. This
happens mostly with seasonal industries. At the time of excess liquidity, the
management should have good short-term investment avenues to take benefit of
the idle funds.

Advantages of Working Capital Management


 Working capital management ensures sufficient liquidity when required.

 It evades interruptions in operations.

 Profitability maximized.

 Achieves better financial health.

 Develops competitive advantage due to streamlined operations.

Disadvantages of Working Capital Management


 It only considers monetary factors. There are non-monetary factors that it
ignores like customer and employee satisfaction, government policy, market
trend etc.

 Difficult to accommodate sudden economic changes.

 Too high dependence on data is another downside. A smaller organization may


not have such data generation.

 Too many variables to keep in mind say current ratios, quick ratios, collection
periods, etc.

Forecasting methods of working capital requirements


Working capital forecasting is a difficult task. The reason is that the total current
assets requirements should be forecasted in estimating the working capital
requirements. Working capital forecasting is based on the overall financial
requirements and financial policies of the concern.

The basic objective of working capital forecasting is either to measure the


cash position of the concern or to exercise control over the liquidity position of the
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

concern. In this context, any one of the following methods can be adopted for
working capital forecasting.

Working capital forecasting methods:

1. Cash Forecasting Method.

2. Balance Sheet Method.

3. Adjusted Profit and Loss Method.

4. Estimating of current assets and current liabilities Method.

5. Operating Cycle Method.

6. Regression Analysis Method

1. Cash Forecasting Method

Total cash receipts and cash disbursement for a particular period are taken into
consideration lender cash forecasting method. Cash receipts may be estimated cash
sales, cash collected from debtors, and bills receivables, other miscellaneous cash
receipts and sale of fixed assets and investments. Delay in cash receipts is taken into
consideration.

Cash disbursement may be relating to estimated cash purchases, payment to sundry


creditors, repayment of loan, payment over bills payable, payment of wages,
salaries, bonus, advances, payable to suppliers, repayment of loans and advances
interest and principal amount and the like. The minimum cash balance designed to
be maintained is added with the required disbursements and provision is also made
for additional borrowings and the like.

Both cash receipts and cash disbursements are recorded in a format. In this way,
working capital is forecasted under cash forecasting method.

2. Balance Sheet Method

A balance sheet is prepared by adjusting the anticipated transactions for the


ensuring year in the opening balances. The closing balances of all accounts are
arrived other than cash and bank balances. The accountant has confirmed that all
the assets and liabilities are balanced and recorded in the balance sheet. Lastly,
closing cash and bank balances are arrived to find the working capital.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

3. Adjusted Profit and Loss Method

Working capital is forecasted on the basis of opening cash and bank balances.
Under this method, some of the items are added and some of the items are deducted
to arrive closing cash and bank balances i.e. working capital. The items like
depreciation, preliminary expenses written off, deferred revenue expenses, goodwill
written off, reduction in closing stock, decrease in sundry debtors and bills
receivable, decrease in investments and marketable securities, increase in sundry
creditors and other liabilities, increase in loans and accrued expenses are added
with opening cash and bank balances.

The items like accrued rent, accrued interest/Dividend/ Royalty, increase in closing
stock, increase in sundry debtors, increase in investments, increase in bills
receivables, decrease in sundry creditors, bills payable and other liabilities, payment
of expenses of last year and payment of dividend are deducted from opening cash
and bank balances. The net amount will be required working capital.

4. Estimating of Current Assets and Current Liabilities Method:

This is the traditional method of forecasting the Working Capital requirements.


Since the Working Capital is the excess of current assets over current liabilities, its
requirements can easily be forecasted by making the estimates of the amount of
each component of current assets and currents liabilities. Again, such estimates can
either be made at total value of each components may be explained as under:

The following formula may be used to express the frame work of the working
capital:

(a) Stock of Raw materials = No. of units x Cost of raw materials per unit x raw material holding period

(b) Stock of W-In-Progress = No. of units x work-in-progress cost per unit x work-in-progress period

Or

(i) For Raw material = Total Cost of Raw Material x Work-in-Progress period

(ii) For Wages = 1/2 (Total amount of Wages x Work - in -Progress period)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(iii) For Overheads = 1/2 ( Total amount of Overheads x work - in- progress period)

(c ) Stock of Finished Goods = No. of units x Cost of Finished goods per unit x Finished Goods holding period

(d) Debtors = Credit Sales in unit x Selling price per unit x Debtors collection period

(e ) Creditors = Calculate as follows:

(1) For Raw materials = No. of units x Cost of raw materials per unit x creditors payment period

(2) For outstanding Exp. = Amount of Expenses x Lag in payment period

Question No.
The following information has been submitted by a borrower:

Production 2,40,000 units

Raw Materials to remain in stock 2 months

Processing period 1 month

Finished goods stay in stock 3 months

Credit allowed to customers 3 months

Expected rate of cost of sales:

Materials 60%
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Labour 10%

Overheads 20%

Selling price per unit Rs.20

Expected margin on sale 10%

You are requested to estimate the Working Capital Requirements of the borrower.

Solution:

Calculation of Cost per unit:

Materials cost per unit = 60% of Rs.20

Materials cost per unit = Rs.12

Wages cost per unit = 10% of Rs.20

Wages cost per unit = Rs.2

Overheads cost per unit = 20% of Rs.20

Overheads cost per unit = Rs.4

Stock of Raw Materials = No. of units x Raw materials cost per unit x Raw Materials holding period

2,40,000 units x Rs.12 x 2 months


Stock of Raw Materials =
12

Stock of Raw Materials = Rs. 4,80,000

Stock of W-in-Prog. = No. of units x Cost of w-in-progress x work in progress period


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

2,40,000 x Rs.18 x 1
Stock of W-in-Prog =
12

Stock of W-in-Prog = Rs.3,60,000

Stock of Finished Goods = No.of units x Cost of finished goods x Finished goods holding period

2,40,000 x Rs.18 x 3 months


Stock of Finished Goods =
12

Stock of Finished Goods = 10,80,000

Debtors = Credit Sales in units x Cost of Sales x Debtors collection period

Debtors = 2,40,000 units x Rs.18 per units x 3 months

Debtors = Rs.10,80,000

Creditors = Not given in the Question

Statement of Working capital


Estimates

Particulars Rs. Rs.


(A) Current Assets:

Stock of Raw materials 4,80,000


Stock of W-in-prog. 3,60,000
Stock of Finished Goods 10,80,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Debtors( at cost) 10,80,000


Total (A) 30,00,000
(B) Current Liabilities: Nill
A-B = Working Capital 30,00,000
Add: Margin @ 10% of W.C 3,00,000
Working Capital Required 33,00,000

Question No.
The Board of directors of K.V. Nigam ask you to prepare a statement showing
Working Capital estimates for a level of activity of 15,600 units of production. The
following information is available for you calculation:

(A)per unit Cost and selling price:

Rs.

Raw materials 90

Labour 40

Overheads 75

Profit 60

Selling Price 265

(B)Average Periods of stock holding:

Raw Materials are in Stock 1 month = 4 Weeks

Raw Materials are in process 2 Weeks

Finished Goods are in stock 1 month

Credit allowed by Suppliers 1 month


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Credit allowed to customer 2 months = 8 Weeks

Lag in payment of wages 1.5 weeks

Lag in payment of overheads 1 month

20% of the production is sold against cash. Cash in hand is expected to be


Rs.60,000. It is to be assumed that production is carried on evenly
throughout the year, wages and overheads accrue similarly and time period of 4
week is equivalent to one month.

Solution:

Calculation of Current Assets and Current Liabilities:

(a) Stock of Raw Materials = No. of units x Raw materials cost per unit xRaw Materials holding period

Stock of Raw Materials = 15,600 units x Rs.90 x 4 weeks


52

Stock of Raw Materials = Rs. 1,08,000

(b) Stock of W-in-Prog = No. of units x Cost of w-in-progress x work in progress period

15,600 units x Rs.90 x 2 weeks


Stock of W-in-proc.(Raw) =
52

Stock of W-in-Prog = Rs.54,000

(b) Stock of W-in-Pro(W) = ½ (No. of units x Cost of Labour per unit x work in progress period)
(b) Stock of W-in-Pro(W) = ½ (15,600 x Rs.40 x 2 / 52) = Rs.12,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

(c) Stock of W-in-Pro(ov) = ½ (No. of units x Cost of overhead per unit x work in progress period)
(c) Stock of W-in-Pro(ov) = ½ (15,600 x Rs.75 x 2 / 52) = Rs.22,500

15,600 units x Rs.205 x 4 weeks


Stock of Finished Goods =
52

Stock of Finished Goods = Rs.2,46,000

(d) Debtors = Credit Sales in units x Cost of Sales x Debtors collection period

12,480 units x Rs.205 x 8 weeks


Debtors =
52

Debtors = Rs.3,93,600

(C ) Creditors =

(a) Raw Materials = No. of units x Raw Material cost per unit x Creditors payment period

15,600 units x Rs.90 x 4 weeks


Raw Materials =
52

Raw Materials = Rs.1,08,000

(b) Wages = No. of units x Labour cost per unit x Lag in payment

Wages = 15,600 units x Rs.40 x 1.5 weeks


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

52

Wages = Rs.18,000

(c ) Overheads = No. of units x Overheads cost per unit x Lag in payment

15,600 units x Rs.75 x 4 weeks


Overheads =
52

Overheads = Rs.90,000

Statement of Working Capital Estimates

Particulars Rs. Rs.


(A) Current Assets:
Stock of Raw materials 1,08,000
Stock of W-in-prog. 88,500
Stock of Finished Goods 2,46,000
Debtors (at cost) 3,93,600
Cash in hand 60,000
Total (A) 8,96,100
(B) Current Liabilities:
Creditors for Raw Materials 1,08,000
Outstanding Wages 18,000
Outstanding overheads 90,000
Total (B) 2,16,000

A-B = Working Capital = 6,80,100

5. Operating Cycle Method:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

The operating cycle refers to the period required to convert the cash back into cash.
In the case of trading concern, cash is used to buy goods, goods are sold on credit to
customers who become sundry debtors, the sundry debtors may accept bill of
exchange i.e. Bills Receivable, conversion of bills receivable into cash. At this stage,
one operating cycle is completed. Thus, a loop from cash back to cash is called the
“Operating Cycle“.

The following formula may be used to express the frame work of the operating cycle:

OCP = R+W+F+D -C
Where,

OCP = Operating Cycle Period

R = Raw Material Holding Period

W = Work-in-Progress Period

F = Finished Goods Holding Period

D = Debtors Collection Period

C = Creditors Payment Period

Calculation of Operating Cycle Period:

Average Stock of Raw Material x 365 days


(A) Raw Material holding Period =
Raw Material Consumption for the year

Average Stock of Work -in -Progress x 365 days


(B) Work-in-Progress Period =
Total Factory cost for the year

Average Stock of Finished Goods x 365 days


(C) Finished Goods holding Period
Total Cost of Sales for the year

Average Receivable x 365 days


(D) Debtors Collection Period =
Total Credit Sales for the year
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average Payable x 365 days


(E) Creditors Payment Period =
Total Credit Purchases for the year

Note: In order to calculate the duration of operating cycle in numbers of


days, add from ‘A’ to ‘D’ and deduct “E”

365 Or 360 days


(F) No. of Operating Cycle =
Duration of Operating Cycle

Total Operating Expenses


(G) Working Capital = + Desire Cash
No. of Operating Cycle

Question No.1

The following are the data of SNS Ltd. taken from the accounting records:

Rs.

Average Stock of Raw Materials during 1,80,000


the year

Average Stock of W-I-P during the 1,00,000


year

Average Stock of Finished Goods 54,000


during the year

Average Receivable 1,50,000

Average payable 1,20,000

Total Sales for the year 7,30,000


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Total Cost of Sales 6,57,000

Consumption of Raw Material during 4,38,000


the year

Average Credit Period available from 100 days


Suppliers

Factory cost for the year 6,57,000

Base on the above data, Calculate Operating Cycle Period.

Solution:

Average Stock of Raw Material * 365 days


(A) Raw Material holding Period =
Raw Material Consumption for the year

Rs. 1,80,000 *365


Raw Material holding Period =
Rs. 4,38,000

Raw Material holding Period = 150 days

Average Stock of Work -in -Progress * 365 days


(B) Work-in-Progress Period =
Total Factory cost for the year

Rs.1,00,000 * 365
(B) Work-in-Progress Period =
Rs. 6,57,000

(B) Work-in-Progress Period = 56 days


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Average Stock of Finished Goods * 365 days


(C) Finished Goods holding Period =
Total Cost of Sales for the year

Rs.54,000 * 365
(C) Finished Goods holding Period =
Rs. 6,57,000

(C) Finished Goods holding Period = 30 days

Average Receivable * 365


days
(D) Debtors Collection Period =
Total Credit Sales for the
year

Rs. 1,50,000 * 365


(D) Debtors Collection Period =
Rs. 7,30,000

(D) Debtors Collection Period = 75 days

Operating Cycle Period = R+W+F+D-C

= 150 days + 56 days + 30 days + 75 days – 100 days

= 211 days

Question No.2

From the following information extracted from the books of a manufacturing


company, compute the operating cycle and working capital:

(i)Estimated Sales 20,000 units p.a. @ Rs. 5 per unit.

(ii)Production and Sales quantities coincide and will be carried on evenly throught
the year.

(iii)Production cost is estimated as under:


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Materials Rs. 2.50 per unit

Labour Re.1 per unit

Overheads Rs. 17,500

(iv)Customers are given 60 day’s credit and 50 day’s credit availed from suppliers.

(iv)40 day’s supply of raw materials and 15 day’s supply of finished goods are kept
in store.

(vi) Production cycle is 20 days and all the materials are issued at the
commencement of each production cycle.

(vii) 1/3 of average other working capital is kept as cash balance for contingencies.

Solution:

(A)Calculation of total operating expenses for the year:

Rs.

Raw materials : 20,000 units @ Rs.250 50,000


per unit

Labour : 20,000 units @ Re.1 20,000

Overheads 17,500

Total 87,500

Calculation of Operating cycle period:

OCP = R + W + F + D – C
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

= 15 days + 20 days + 15 days + 60 days – 50 days

= 85 days

Calculation of No. of Operating Cycle in the year:

365 days
No. of Operating Cycle =
Duration of Operating Cycle

365 days
No. of Operating Cycle =
85 days

No. of Operating Cycle = 4.3

Calculation of Working Capital:

Total Operating Expenses


Working Capital = + Desire Cash
No. of Operating Cycle

Rs.87,500
Working Capital = + 1/3 of w.c
4.3

Working Capital = Rs.20,349 + 1/3 of 20,349

Working Capital = Rs.20,349 + Rs.6783

Working Capital = Rs.27,132


Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cost of Capital
Cost of capital is an important component of accounting and financial
analysis for a business. The cost of capital should be minimal for a business
that successfully manages its finances. In this article, we discuss what cost of
capital is, why it is important.
Cost of capital represents the return a company needs to achieve in order to justify the cost
of a capital project, such as purchasing new equipment or constructing a new building.

The term cost of capital is used by analysts and investors, but it is always an evaluation of
whether a projected decision can be justified by its cost. Investors may also use the term to
refer to an evaluation of an investment's potential return in relation to its cost and its risks.

Many companies use a combination of debt and equity to finance business expansion. For
such companies, the overall cost of capital is derived from the weighted average cost of all
capital sources. This is known as the weighted average cost of capital (WACC).

Cost of capital encompasses the cost of both equity and debt, weighted according to the
company's preferred or existing capital structure. This is known as the weighted average
cost of capital (WACC).
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

A company's investment decisions for new projects should always generate a return that
exceeds the firm's cost of the capital used to finance the project. Otherwise, the project will
not generate a return for investors.

Importance of Cost of Capital


The cost of capital is very important concept in the financial decision making. Cost of
capital is the measurement of the sacrifice made by investors in order to invest with a view
to get a fair return in future on his investments as a reward for the postponement of his
present needs. On the other hand from the point of view of the firm using the capital, cost
of capital is the price paid to the investor for the use of capital provided by him. Thus, cost
of capital is reward for the use of capital. The progressive management always likes to
consider the importance cost of capital while taking financial decisions as it’s very relevant
in the following spheres:

1. Designing the capital structure: The cost of capital is the significant factor in
designing a balanced and optimal capital structure of a firm. While designing it, the
management has to consider the objective of maximizing the value of the firm and
minimizing cost of capital. Comparing the various specific costs of different sources of capital,
the financial manager can select the best and the most economical source of finance and can
designed a sound and balanced capital structure.

2. Capital budgeting decisions: The cost of capital sources as a very useful tool in
the process of making capital budgeting decisions. Acceptance or rejection of any investment
proposal depends upon the cost of capital. A proposal shall not be accepted till its rate of
return is greater than the cost of capital. In various methods of discounted cash
flows of capital budgeting, cost of capital measured the financial performance and determines
acceptability of all investment proposals by discounting the cash flows.

3. Comparative study of sources of financing: There are various sources of


financing a project. Out of these, which source should be used at a particular point of time is
to be decided by comparing costs of different sources of financing. The source which bears the
minimum cost of capital would be selected. Although cost of capital is an important factor in
such decisions, but equally important are the considerations of retaining control and of
avoiding risks.

4. Evaluations of financial performance: Cost of capital can be used to evaluate


the financial performance of the capital projects. Such as evaluations can be done by
comparing actual profitability of the project undertaken with the actual cost of capital of
funds raise to finance the project. If the actual profitability of the project is more than the
actual cost of capital, the performance can be evaluated as satisfactory.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

5. Knowledge of firms expected income and inherent risks: Investors can


know the firms expected income and risks inherent there in by cost of capital. If a firms cost
of capital is high, it means the firms present rate of earnings is less, risk is more and capital
structure is imbalanced, in such situations, investors expect higher rate of return.

6. Financing and Dividend Decisions: The concept of capital can be conveniently


employed as a tool in making other important financial decisions. On the basis, decisions can
be taken regarding dividend policy, capitalization of profits and selections of sources of
working capital.

In sum, the importance of cost of capital is that it is used to evaluate new project of
company and allows the calculations to be easy so that it has minimum return that investor
expect for providing investment to the company.

Measurement of Cost of Capital


Measurement of cost of capital is totally related with the risk level of business. In above
screenshot, you can see, when the risk is very very low. We will pay low cost of capital. Our
measuring tool will show also low rate of this cost. Both cost of debt and cost of equity will
low. If we have to simplify, we may calculate the weighted average cost of capital. It will
also be very low if risk are at low level. But when the risk level of business will increase, we
have to pay more cost of capital and rate angle will move to right side in measurement tool.

Because, we have explained all the formulae for calculating cost of capital, so this content,
we will explain some examples of measuring cost of capital.

Cost of Debt Measurement

Such capital is generally obtained through the issue of debentures. The issue of debentures
may involve a number of floating charges such as printing of prospectus, advertisement,
underwriting brokerage, etc. Again, debentures can be issue at par or at sometimes below
par and at sometimes above par. These floatation costs and modes of issue have
importance bearing upon the cost of debt capital.

The cost of debt capital is very simple to calculate. The usual formula will be:

(a)Before Tax

Kd = I x100 x 100
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

NP

(b) After Tax

I(1-Tax Rate) 100


Kd = x
NP

(c) Redeemable Debt

I+(RV-NP)/N 100
kd before tax = x
(RV+NP)/2

I+ (1 - T)(RV-NP)/N x 100
kd after tax =
(RV+NP)/2

Cal. of Net Proceed


Amount
Face Value *******
Add: Premium( if any )
Less: Discount (if any) ( )
Issue Price *******

Less: Floatation Cost ( )

Net
Proceed

Question No.1
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

X Ltd. wishes to issue 1,000, 7% debentures of Rs.100 each for which the
expenses of issue would be Rs.5 per debenture. Find out the cost of debentrure
capital.
Solution:
Step 1: Calculation of Net proceed

Rs.
Face Value
100
Less: Floatation Cost -5
Net Proceed
95.00

Step 2: Calculation of Interest on per Debenture :


Interest = 7% on Face value so,
7% on Rs.100 = Rs.7

Step 3: calculation of Cost of Debt (Kd)


I x100 100
Kd = x
NP

Rs.7 x100
Kd =
Rs.95

Kd = 7.37%

Question No.3
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

A Company issues 10% irredeemable debentures of Rs.1,00,000. Ther Company


is in 55% tax bracket. Calculate the cost of debt (before and after tax). If
debentures are issued art (a) par, (b) 10% discount. (c ) 10% premium.

Solution:

Cost of Preference Share Capital Measurement


Formula

(a) After Tax

Dp x 100
Kp ( After Tax ) =
NP

(b) Before Tax

[DP/1-TAX Rate] x 100


Kp =
NP

( C) Reddeemable Pref.Share

DP+(RV-NP/N)
Kp = x 100
(RV+NP)/2

Question No.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Module – 4(Extra)
Cost of Capital
Cost of capital is a composite cost of the individual sources of funds including equity
shares, preference shares, debt and retained earnings.

The overall cost of capital depends on the cost of each source and the proportion of
each source used by the firm. It is also referred to as weighted average cost of capital.
It can be examined from the viewpoint of an enterprise as well as that of an investor.

Some of the components of cost of capital are:-

1. Cost of Debt Capital 2 Cost of Preference Capital 3. Cost of Equity Capital 4. Cost of
Retained Earnings 5.Weighted Average Cost of Capital 6. Marginal Cost of Capital
7.The Cost of Preferred Stock 8. Return on Capital.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cost of Debt Capital:

Generally, cost of debt capital refers to the total cost or the rate of interest paid by an
organization in raising debt capital. However, in a real situation, total interest paid for
raising debt capital is not considered as cost of debt because the total interest is treated
as an expense and deducted from tax. This reduces the tax liability of an organization.

Therefore, to calculate the cost of debt, the organization needs to make some
adjustments. Let us understand the calculation of cost of debt with the help of an
example.

Suppose an organization raised debt capital of Rs.10000 and paid 10% interest on it. The
organization is paying corporation tax at the rate of 50%. In this case, the total 10% of
interest rate would not be deducted from tax and the deduction would be 50% of 10%.

Therefore, the cost of debt would be only 5%. While calculating cost of debt capital,
discount allowed, underwriting commission, and cost of advertisement are also
considered.

These expenses are added to the amount of interest paid, which is considered as total cost
of debt capital. For example- when an organization increases its proportion of debt
capital more than the optimum level, then it increases its risk factor. Therefore, the
investors feel insecure and their expectations of EPS start increasing, which is the hidden
cost related to debt capital.

Formulae to calculate cost of debt are as follows:

1. When the debt is issued at par, Discount and Premium

I (1-t)
Kd =
NP
Where,
Kd = Cost of debt after tax
I= Interest on Debt
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

t= Tax Rate
Net Proceed
NP =
Calculation Of Net Proceed:

Face Value of Debenture ****


Add: Premium (if any) -----
Less: Discount( if any) ( )
Issue Price ****
Less: Floatation Cost ( )
Net Proceed *****

2.Cost of redeemable debt –

I (1-t) +( RV - NP)
Kd = N
( RV +NP)
2
Where :-

Kd = Cost of debt after tax


I= Interest on Debt
t= Tax Rate
Np = Net Proceed
RV = Redemption Value

Cost of Preference Capital:

Cost of preference capital is the sum of amount of dividend paid and expenses incurred
for raising preference shares. The dividend paid on preference shares is not deducted
from tax, as dividend is an appropriation of profit and not considered as an expense.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

Cost of preference share can be calculated by using the following


formulae:

2.Cost of irredeemable Preference Shares Capital :

Dp
Kp (after tax) =
NP

2. Cost of redeemable Preference Shares Capital –

DP + ( RV - NP)
N
Kp = ( RV +NP)
2
Where :-

Cost of Preference
Kp =
Share after tax
Dividend paid on
DP =
Preference Share
t= Tax Rate
NP = Net Proceed
RV = Redemption Value
Dr.Sukhjeet Matharu and Prof. Naveen Sharma

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