Financial Management 1
Financial Management 1
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.
Deals with the planning, organizing, and controlling of financial activities like
the procurement and utilization of funds
Some Definitions
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.
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.
and other short-term investments. They directly affect the liquidity and performance
of the business.
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.
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.
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
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.
Wealth Maximization
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.
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.
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.
1. Financial Planning:
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
3. Allocation of Funds:
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:
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.
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.
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.
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.
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.
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.
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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.
1. Comparisons
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.
There are numerous financial ratios that are used for ratio analysis, and they are
grouped into the following categories:
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.
The following three steps will identify the components necessary, and how to apply
them to the formula to calculate the current ratio.
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.
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.
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Now that you have the total amounts of assets and liabilities, you can compare them
by completing the following equation.
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.
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.
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.
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:
Question No.1
Solution:
Current Assets
Current Ratio =
Current Liabilities
Current Assets
Current Ratio =
Current Liabilities
Rs.80,000
Current Ratio =
Rs.30,000
(b) Calculation of Liquid Ratio / Acid Test Ratio / Quick Ratio / Near Money
Ratio:
Quick Assets
Quick Ratio =
Current Liabilities
Rs.30,000
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)
3x = 4.5x - Rs.24,000
4.5x - 3x = Rs.24,000
X = Rs.16,000
(b)
Liquid Asses
2 =
Rs.50,000
Current Assets
Current Ratio =
Current Liabilities
Rs.1,20,000
Current Ratio =
Rs.50,000
(C )
4x = 2.5x + Rs.22,500
4x - 2.5x = Rs.22,500,
Rs.22,500
1.5x =
1.5
X = Rs.15,000
Question No. 3
X Ltd. Y Ltd.
Rs. Rs.
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
Rs.2,00,000
Debt-Equity Ratio (Y) =
Rs.4,00,000
Owner's
Proprietary Ratio = Equity
Total Assets
Rs.3,20,000
Proprietary Ratio (X) =
Rs.4,00,000
Rs.4,00,000
Proprietary Ratio (Y) =
Rs.6,00,000
Question No.4
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:
Rs.3,00,000 +Rs.1,00,000
Capital-Gearing Ratio =
Rs.2,00,000 + Rs.4,00,00
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
Rs.74,000 x 100
Return on Shareholder's Fund =
Rs.4,00,000
2. Solvency Ratios
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.
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
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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
Some examples of important profitability ratios include the return on equity ratio,
return on assets, profit margin, gross margin, and return on capital employed.
2.
Question No.
Year Year
2020 2021
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Rs. Rs.
Solution:
1,50,000 x 100
Gross profit Ratio =
625,000
1,89,000 x 100
Gross profit Ratio =
7,80,000
Question No.
(c )Cash Sales Rs.2,50,000; Credit Sales 75% of total Sales; Gross profit Ratio20%
and Indirect Expenses Rs.40,000.
Solution:
(a)
Rs.84,000 x 100
Net Profit Ratio =
Rs.6,00,000
(b)
Rs.
Profit before Tax 160,000
Less: Tax @50% -80,000
E.A.T./ Net profit = 80,000
Rs.80,000 x 100
Net Profit Ratio =
Rs.8,00,000
(C )
Rs.
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Rs.1,60,000 x 100
Net Profit Ratio =
Rs.10,00,000
Question No.
(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
Rs.
Net Profit 80,000
Add: Non-Operating
Expenses 30,000
1,10,000
Less: Non-Operating
Incomes -18,000
Operating Profit 92,000
Rs.92,000 x 100
Operating Profit Ratio =
Rs.5,60,000
(b)
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
Rs.1,90,000 x 100
Operating Profit Ratio =
Rs.7,50,000
Question No.
Rs.
Sales 7,55,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
(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:
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:
Solution:
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
Rs.25,000 + Rs.35,000
Average Stock =
2
Rs.60,000
Average Stock =
2
Average Stock = Rs.30,000
Rs.3,00,000
Inventory Turnover Ratio =
Rs.30,000
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
Solution:
(a)
Sales Rs.3,20,000
Less: G.P.@ 25% on
Sales (Rs.80,000)
Cost of Goods Sold = Rs.2,40,000
Rs.31,000 + Rs.29,000
Average Stock =
2
Rs.60,000
Average Stock =
2
Rs.30,000
Average Stock =
Rs.2,40,000
Stock Turnover Ratio =
Rs.30,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
(b)
Calculation of Cost of Goods Sold –
Rs.20,000 + Rs.10,000
Average Stock =
2
Rs.30,000
Average Stock =
2
Rs.15,000
Average Stock =
Rs.65,000
Stock Turnover Ratio =
Rs.15,000
Question No.
Rs.
Solution:
Calculation of Net Credit Sales –
Rs.20,000 + Rs.24,000
Average Debtors =
2
Rs.44,000
Average Debtors =
2
Rs.2,20,000
Debtors Turnover Ratio =
Rs.22,000
Question No.
(a) Rs.
(b)
Solution:
(a)
Rs.60,000 + Rs.90,000
Average Debtors =
2
Rs.1,50,000
Average Debtors =
2
Rs.4,50,000
Debtors Turnover Ratio =
Rs.75,000
(b)
Rs. 1,20,000
Rs.20,000 + Rs.40,000
Average Debtors =
2
Rs.60,000
Average Debtors =
2
Rs.1,20,000
Debtors Turnover Ratio =
Rs.30,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
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.
Solution:
In this question Opening Receivable not given. Thus, closing Receivable will be
Assume that is Average Receivable.
= Rs.13,500 + Rs.3000
= Rs.16,500
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.
Solution:
Debtors = Rs.10,000
Question No.
Sharma Bros. Purchase goods both on cash and credit terms. The following
Particulars are obtained from the books:
Rs.
Solution:
Rs.
Total Purchases 2,00,000
Less: Cash Purchases (20,000)
Less: Purchases Returns (34,000)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
# 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
Question No.
From the following information, calculate Creditors Turnover Ratio and Average
payment Period:
Rs.
Solution:
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
Rs.3,30,000
Creditors Turnover Ratio =
Rs.75,000
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.
Key market prospect ratios include dividend yield, earnings per share, the price-to-
earnings ratio, and the dividend payout ratio.
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:
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
Rs.40
Price Earning Ratio (P/E Ratio =
Rs.3.04
13.15 times
Price Earning Ratio (P/E Ratio =
Rs.2 x 100
Dividend Yield Ratio =
Rs.40
Rs.2 x 100
Payout Ratio =
Rs.3.04
Miscellaneous Questions
Question No.
From the following information, make at a Statement of Proprietor’s Fund with add much detail as
possible;
Solution:
Current Assets
Current Ratio =
Current Liabilities
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2.5
Current Ratio =
1
Rs.60,000 x 1
Current Liabilities =
1.5
Rs.60,000 x 2.5
Current Assets =
1.5
(2)Current Assets = Rs.1,00,000
= 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.
= Rs.2,40,000
(8)Since Reserves and Surplus is Rs.40,000, the paid –up capital will be Rs.2,00,000.
Rs. Rs.
Current Assets:
Cash at bank 5,000
Debtors 55,000
Stock 40,000 1,00,000
Net Worth:
Paid-up Capital 2,00,000
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Question No.
From the following figures and Ratios, make out the Balance Sheet and Trading and Profit & Loss
Account:
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.
Solution:
Hence,
Rs.2,52,000 x 2.5
Current Assets =
1.5
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Rs.2,52,000 x 1
(2)Current Liabilities =
1.5
This includes Bank Overdraft of Rs.40,000. Therefore other current liabilities are Rs.1,28,000.
Quick Assets
Quick Ratio =
Current Liabilities
1.5
Quick Ratio =
1
Rs.1,68,000 x 1.5
Quick Assets =
1
(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
COGS = 4 x Rs.1,54,000
COGS = Rs.6,16,000
Cal. Of Sales:
Sales = Rs.7,70,000
Cal. Of Debtors:
Debtors = Rs.77,000
Cal. Of Cash:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Cash = Rs.1,75,000
Balance sheet
(8,40,000 – 7,20,000-
72,000)
(1,68,000- 40,000)
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 :
(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.
OR
Operating Leverage = CL / FL
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
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:
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’.
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:
OR
OR
OR
Financial Leverage = CL / OL
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)
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:
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-
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.
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.
OR
OR
EBT xxxxxxx
EAT xxxxxxx
Less: Dp (***)
Less: De (****)
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
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
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
Solution:
Income Statement
Company X Company Y
Rs.10,75,000 Rs.20,00,000
Question No.3
Particulars Rs.
The Operating profit is Rs.60,000. The company is in 50% tax bracket. Calculate financial leverage.
Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
= Rs.10,000
= Rs.10,000 / 1-50%
= Rs.10,000 / 1-0.5
= Rs.10,000 / 0.5
= Rs.20,000
= Rs.60,000 / Rs.40,000
= Rs.90,000 / Rs.70,000
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
= Rs,6,000 / 1-50%
= Rs.6,000 / 1- 0.5
= Rs.6000 / 0.5
= Rs.12,000
= Rs.30,000 / Rs.12,000
= 2.5:1
= 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
Particulars Rs.
Sales 2,40,000
Contribution 1,00,000
EBIT 40,000
EBT 25,000
(i)Operating leverage
(ii)Financial Leverage
(iii)Combined Leverage
Solution:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
= Rs.1,00,000 / Rs.40,000
= 2.5:1
= Rs.40,000 / Rs.25,000
= 1.6:1
= 2.5 x 1.6
=4
Question No.6
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:
3 = Sales / Rs.6,00,000
Sales = 3 x Rs.6,00,000
Sales = Rs.18,00,000
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
Contribution 10,80,000
EBIT 7,80,000
EBT 7,46,400
OL = C /EBIT 10,80,000
7,80,000
1.386:1
1.045:1
CL = OL x FL 1.386 x 1.045
1.448
Question No.7
Ajay Bajaj
Question No.8
Rs.
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:
Solution:
Income Statement
Rs.
EBIT 8,00,000
EBT 3,80,000
2.5 : 1
2.1 : 1
Rs.2.28
Rs.
EBIT 13,00,000
EBT 8,80,000
1.92 :1
1.48 : 1
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Rs.5.28
Question No.9
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
(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:
= Rs.6,00,000 / 2,00,000
=3
= Rs.2,00,000 / Rs.1,00,000
=2
Combined Leverage = OL x FL
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
=3x2
=6
Question No.10
The financial data for three companies for the year ending 31st March, 2021 are as under:
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’:
OR
= EBIT / EBIT – I
Or 2EBIT = 600
EBIT = 600 / 2
EBIT = 300
5 = C / 300
C = 5 x Rs.300
= Rs.1,500
Company ‘B’:
OR
= EBIT / EBIT – I
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Or 3EBIT = 1,200
EBIT = 1,200 / 3
EBIT = Rs.400
6 = C / 400
C = 6 x 400
C = Rs.2,400
Company ‘C’:
OR
= EBIT / EBIT- I
Or EBIT = 2,000
2 = C / 2,000
C = 2 x 2,000
C = Rs.4,000
Sales = 100=3
Less: Vc @ = 66.67=2
Contribution = 33.33=1
Income Statement
EAT 50 50 500
Question No.11
Particulars Rs.
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.
Contribution 48,000
EBIT 8,000
= 48,000 / 8,000
=6
= 90% / 10%
=9
We know,
CL = OL x FL
9 = 6 x FL
Thus,
FL = CL / OL
= 9 /6
= 1.5
= 6 + 45
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
= 51
OL = C / EBIT
OR
= S – Vc / EBIT
OR
39,60,000 = 60,000Vc
Vc = 39,60,000 / 60,000
Vc = 66
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.
Fixed Cost:
Financial Plans
I II III
Solution :
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
SITUATION ‘A’
SITUATION ‘B’
SITUATION ‘C’
CL = OL x FL
= 4 x 10
= 40
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:
Calculation of DPg:
= Rs.15,000 / 1-50%
= Rs.15,000 / 0.5
= Rs.30,000
EBIT = Rs.2,60,000
If EBIT drops to Rs.1,30,000( i.e. EBIT fall by 50%) than EPS fall by-
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:
= 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
-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.
Contribution Rs.3,00,000
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:
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 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’.
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.
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
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
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
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
Mathematical Approach:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
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
t = Tax rate
In the case of a newly – set up company, indifference point can be computed by using any of the
following equations:
X (1-t) / N1 = x (1-t) – DP / N3
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
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.
Solution:
Case (a) :
N2
N1 = ₹30,00,000 =₹15,00,000
Rs.100 Rs.100
= 30,000 = 15,000
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
Income Statement
Case (b)
= 30,000
N3 = Rs.20,00,000
Rs.100
= 20,000
x (1-t) x (1-t) – PD
=
N1 N3
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
E.P.S = Profit
available for
Eq.shareholder /
No.of Eq.shares 3,60,000 / 30,000 Rs.2,40,000 / 20,000
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
0.90x = 4,95,000
X = 4,95,000
0.9
X = Rs.5,50,000
Income Statement
Eq.shareholder
Case (d)
₹20,00,000 ₹12,00,000
N2 = N4 =
100 100
N2 = 20,000 N4 = 12,000
3,600x = 2,58,00,00,000
2,58,00,00,000
x =
3,600
X = 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
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.
High Degree of Risk: To take decisions which involve huge financial burden
can be risky for the company.
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
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:
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.
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.
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.
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.
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
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, as we know, is a decision making process. It involves the following six
steps:
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 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.
Initial Investment
P.B.P =
Annual Cash Inflow
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
EBT ****
Less : Tax ( )
EAT ****
Add: Depreciation +
Cash inflow ****
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:
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
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
Rs.20,000 x 12
P.B.P. = 3 Years +
Rs.40,000
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.
Solution:
A. Incomes:
B. Expenses:
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
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’.
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:
4 20,000 40,000
5 20,000 40,000
Solution:
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
Rs.40,000 x 100
Machine 'A' =
Rs.1,20,000
33.33%
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:
Solution:
Ranking II I III
Ranking II I III
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
Or
Or
Calculation of ARR:
The average rate of return can be calculated in the following two ways:
First:
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:
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
[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:
(c) If scrap value is Rs.80,000 and additional working capital is required Rs.1,00,000.
Solution:
Rs.92,000
Rs.9,80,000 + Rs.20,000
Average investment =
2
Rs.10,00,000
Average investment =
2
= Rs.5,00,000
Rs.92,000 x 100
ARR =
Rs.5,00,000
ARR = 18.40%
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Rs.92,000 x 100
ARR =
5,40,000
ARR = 17.04%
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
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
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
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'
Solution:
1. Calculation of Average Investment of Machine A & B:
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 = 20.74%
Question No.9
X Ltd. is considering a proposal to purchase a machine whose particulars are given
below:
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
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
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%
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 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.
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
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
Question No.
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%.
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
# Calculation of Depreciation:
Cost of Machine + Installation Charges - Salvage Value
Depreciation =
Estimated Life
Rs.5,00,000
Depreciation =
5 years
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Depreciation = Rs.1,00,000
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
Year 1 2 3 4 5
Factor 0.909 0.826 0.751 0.683 0.621
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
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.
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:
Discounted
3 year + 8.2 months
P.B.P
Discounted
3 years, 8 months 2 days
P.B.P =
Or
Or
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:
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:
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.
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.
Compute Time Adjusted Rate of Return or IRR and state which of two projects is better.
Solution:
= 6.00
= 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
(6.145 - 6)
I.R.R = 10% + (12% -10%)
6.145 – 5.650
0.145
I.R.R = 10% + (2)
0.495
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
5.019-5
I.R.R = 15% + (16% - 15%)
5.019 – 4.833
0.19
I.R.R = 15% + (1)
0.186
IRR = 16.02%
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%.
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:
= Rs.3,500
= Rs.3,500
Calculation of P.V.F. :
= 3.143
= 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%.
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 = 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%.
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
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.
Trading means buying and selling of goods without making any alteration in
the goods.
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.
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 is the excess of current assets over current liabilities. Again, the
net working capital is divided into two types. They are
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.
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.
1. It indicates the ability of the concern to meet its operating expenses and short
term liabilities.
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.
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.
Profitability maximized.
Too many variables to keep in mind say current ratios, quick ratios, collection
periods, etc.
concern. In this context, any one of the following methods can be adopted for
working capital forecasting.
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.
Both cash receipts and cash disbursements are recorded in a format. In this way,
working capital is forecasted under cash forecasting 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.
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
(1) For Raw materials = No. of units x Cost of raw materials per unit x creditors payment period
Question No.
The following information has been submitted by a borrower:
Materials 60%
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Labour 10%
Overheads 20%
You are requested to estimate the Working Capital Requirements of the borrower.
Solution:
Stock of Raw Materials = No. of units x Raw materials cost per unit x Raw Materials holding period
2,40,000 x Rs.18 x 1
Stock of W-in-Prog =
12
Stock of Finished Goods = No.of units x Cost of finished goods x Finished goods holding period
Debtors = Rs.10,80,000
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:
Rs.
Raw materials 90
Labour 40
Overheads 75
Profit 60
Solution:
(a) Stock of Raw Materials = No. of units x Raw materials cost per unit xRaw Materials holding period
(b) Stock of W-in-Prog = No. of units x Cost of w-in-progress x work in progress period
(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
(d) Debtors = Credit Sales in units x Cost of Sales x Debtors collection period
Debtors = Rs.3,93,600
(C ) Creditors =
(a) Raw Materials = No. of units x Raw Material cost per unit x Creditors payment period
(b) Wages = No. of units x Labour cost per unit x Lag in payment
52
Wages = Rs.18,000
Overheads = Rs.90,000
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,
W = Work-in-Progress Period
Question No.1
The following are the data of SNS Ltd. taken from the accounting records:
Rs.
Solution:
Rs.1,00,000 * 365
(B) Work-in-Progress Period =
Rs. 6,57,000
Rs.54,000 * 365
(C) Finished Goods holding Period =
Rs. 6,57,000
= 211 days
Question No.2
(ii)Production and Sales quantities coincide and will be carried on evenly throught
the year.
(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:
Rs.
Overheads 17,500
Total 87,500
OCP = R + W + F + D – C
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
= 85 days
365 days
No. of Operating Cycle =
Duration of Operating Cycle
365 days
No. of Operating Cycle =
85 days
Rs.87,500
Working Capital = + 1/3 of w.c
4.3
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.
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.
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.
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.
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
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
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
Rs.7 x100
Kd =
Rs.95
Kd = 7.37%
Question No.3
Dr.Sukhjeet Matharu and Prof. Naveen Sharma
Solution:
Dp x 100
Kp ( After Tax ) =
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.
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
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.
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:
I (1-t) +( RV - NP)
Kd = N
( RV +NP)
2
Where :-
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
Dp
Kp (after tax) =
NP
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