BY : VINIT MISHRA SIR

ALL INDIA RANK - 04 4

ARUL KUMAR
(STUDENT OF TOP-20)

10 ALL INDIA RANK -10

MEGHANA SAWAKAR
(STUDENT OF TOP-20)
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 INDEX

S.NO. CHAPTER NAME PAGE NO.

1. COST OF CAPITAL 1–9

2. LEVERAGES 10 – 20

3. CAPITAL STRUCTURE 21 – 30

4. DIVIDEND DECISION 31 – 37

5. CAPITAL BUDGETING 38 – 57

6. INTRODUCTION TO RISK ANALYSIS IN CAPITAL BUDGETING 58 – 63

7. FINANCIAL STATEMENT ANALYSIS 64 – 76

8. WORKING CAPITAL MANAGEMENT 77 – 105

 CH. 1 : COST OF CAPITAL

QUESTIONS AND ANSWERS

Question - 1
CALCULATE the WACC by using Market value weights.
The capital structure of the company is as under:

(Rs.)
Debentures (Rs.100 per debenture) 10,00,000
Preference shares (Rs.100 per share) 10,00,000
Equity shares (Rs.10 per share) 20,00,000
40,00,000

The market prices of these securities are:

Debentures Rs. 115 per debenture
Preference shares Rs. 120 per preference share
Equity shares Rs. 265 each.
Additional information:
(1) Rs.100 per debenture redeemable at par, 10% coupon rate, 2% floatation cost, 10-year
maturity.
(2) Rs.100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and
10-year maturity.
(3) Equity shares have a floatation cost of Rs. 1 per share.
The next year expected dividend is Rs. 5 with an annual growth of 15%. The firm has the
practice of paying all earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference
shares. [MTP March 21 (10 Marks)]

ANSWER:
(i) Cost of Equity (Ke)
.
= +g= + 0.15 = 0.1689 or 16.89%
. .
(ii) Cost of Debt (Kd)
Calculation of NPV at discount rate of 5% and 7%

Year Cash Discount Present Discount Present Value

flows factor @ 5% Value factor @ 7% (Rs.)
(Rs.)
0 112.7 1.000 (112.7) 1.000 (112.7)
1 to 10 7 7.722 54.05 7.024 49.17

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 10 100 0.614 61.40 0.508 50.80
NPV +2.75 -12.73

Calculation of IRR
. .
IRR = 5% + (7% - 5%) = 5% + (7% - 5%) = 5.36%
. ( . ) .

Cost of Debt (kd) = 5.36%

(iii) Cost of Preference shares (Kp)
Calculation of NPV at discount rate of 2% and 5%
Year Cash flows Discount Present Value Discount Present Value
(Rs.) factor @ factor @ (Rs.)
2% 5%
0 117.6 1.000 (117.6) 1.000 (117.6)
1 to 10 5 8.983 44.92 7.722 38.61
10 100 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

Calculation of IRR
. .
IRR = 2% + (5% - 2%) = 2% + (5% - 2%) = 3.04%
. ( . ) .

Cost of Preference Shares (kp) = 3.04%

Calculation of WACC using market value weights
Source of capital Market Value Weights After tax cost WACC (Ko)
of capital
(Rs.) (a) (b) (c) = (a)×(b)
10% Debentures (Rs.115× 10,000) 11,50,000 0.021 0.0536 0.00113
5% Preference shares (Rs.120 × 10,000) 12,00,000 0.022 0.0304 0.00067
Equity shares (Rs.265 × 2,00,000) 5,30,00,000 0.957 0.1689 0.16164
5,53,50,000 1.000 0.16344

WACC (K0) = 0.16344 or 16.344%

Question - 2
In March, 2021 Tiruv Ltd.'s share was sold for Rs. 219 per share. A long term earnings growth
rate of 11.25% is anticipated. Tiruv Ltd. is expected to pay dividend of Rs. 5.04 per share.
(i) DETERMINE the rate of return an investor can expect to earn assuming that dividends
are expected to grow along with earnings at 11.25% per year in perpetuity?
(ii) It is expected that Tiruv Ltd. will earn about 15% on book equity and shall retain 60% of
earnings. In this case, whether, there would be any change in growth rate and cost of
equity? ANALYSE. [MTP April 21 (5 Marks)]

ANSWER:
(i) According to Dividend Discount Model approach the firm’s expected or required return on equity
is computed as follows:

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 Ke = +g

Where,
Ke = Cost of equity share capital
D1 = Expected dividend at the end of year 1
P0 = Current market price of the share.
g = Expected growth rate of dividend.
.
Therefore, Ke = + 0.1125 = 13.55%

(ii) With rate of return on retained earnings (r) of 15% and retention ratio (b) of 60%, new growth
rate will be as follows:
g = br = 0.60 x 0.15 = 0.09 or 9%
Accordingly, dividend will also get changed and to calculate this, first we shall calculate previous
retention ratio (b1) and then EPS assuming that rate of return on retained earning (r) is same.
With previous Growth Rate of 11.25% and r =15%, the retention ratio comes out to be:
0.1125 = b1 x 0.15
b1 = 0.75 and payout ratio = 0.25
With 0.25 payout ratio, the EPS will be as follows:
.
EPS = = Rs. 20.16
.
With new payout ratio of 40% (1 – 0.60) the new dividend will be:
D1 = Rs. 20.16 x 0.40 = Rs. 8.064
Accordingly new Ke will be:
.
Ke = + 0.09 = 12.68%

Question - 3
Gamma Limited has in issue 5,00,000 ₹ 1 ordinary shares whose current ex-dividend market
price is ₹ 1.50 per share. The company has just paid a dividend of 27 paise per share, and
dividends are expected to continue at this level for some time. If the company has no debt
capital, COMPUTE the weighted average cost of capital?

SOLUTION:
Market value of equity, E = 5,00,000 shares x ₹ 1.50 = ₹ 7,50,000
Market value of debt, D = Nil
₹ .
Cost of equity capital, Ke = = = 0.18
₹ .

Since there is no debt capital, WACC = Ke = 18 per cent.

Question - 4
The following details are provided by the GPS Limited:
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 (₹)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000

The cost of equity capital for the company is 16.30% and income tax rate for the company is
30%.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of the
company.

SOLUTION:
Calculation of Weighted Average Cost of Capital (WACC)

Source Amount (₹) Weight Cost of Capital WACC

after tax
Equity Capital 65,00,000 0.619 0.163 0.1009
12% Preference Capital 12,00,000 0.114 0.120 0.0137
15% Redeemable Debentures 20,00,000 0.190 0.105* 0.020
10% Convertible Debentures 8,00,000 0.076 0.07** 0.0053
Total 1.05,00,000 1.0000 0.1399

* Cost of Debentures (after tax) = 15 (1 – 0.30) = 10.5% = 0.105

** Cost of Debentures (after tax) = 10 (1 – 0.30) = 7% = 0.07
Weighted Average Cost of Capital = 0.1399 = 13.99%
(Note: In the above solution, the Cost of Debentures has been computed in the above manner without
considering the impact of special features i.e. redeemability and convertibility in absence of requisite
information.)

Question – 5
ABC Company’s equity share is quoted in the market at ₹s25 per share currently. The
company pays a dividend of ₹ 2 per share and the investor’s market expects a growth rate of
6% per year.
You are required to:
(i) CALCULATE the company’s cost of equity capital.
(ii) If the company issues 10% debentures of face value of ₹ 100 each and realises ₹ 96 per
debenture while the debentures are redeemable after 12 years at a premium of 12%,
CALCULATE cost of debenture Using YTM?
Assume Tax Rate to be 50%.

SOLUTION:

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(i) Cost of Equity Capital (Ke):
( )
Ke =
( )
+ Growthrate (g)
₹ × .
= + 0.06 = 0.1448 or 14.48%
₹
(ii) Cost of Equity Capital (Kd):
Using Present Value method or YTM)
Identification of relevant cash flows

Year Cash flows

0 Current market price (P0) = ₹ 96
1 to 12 Interest net of tax [I(1 – t)] = 10% of ₹ 100 (1 – 0.5) = ₹ 5
12 Redemption value (RV) = ₹ 100 (1.12) = ₹ 112

Calculation of Net Present Values (NPV) at two discount rates

Year Cash flows Discount Present Discount Present

factor @ 5% Value factor @ Value
(L) 10% (H)
0 (96) 1.000 (96.00) 1.000 (96.00)
1 to 12 5 8.863 44.32 6.814 34.07
12 112 0.557 62.38 0.319 35.73
NPV + 10.7 - 26.2

Calculation of IRR

IRR = L + (H – L)

. .
= 5% + (10% - 5%) = 5% + = 6.45%
. ( . ) .

Therefore, Kd = 6.45%

Question - 6
Masco Limited wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans.
It has ₹ 2,10,000 in the form of retained earnings available for investment purposes. Further
details are as following:

(1) Debt / equity mix 3:7

(2) Cost of debt
Upto ₹ 1,80,000 10% (before tax)
Beyond ₹ 1,80,000 16% (before tax)
(3) Earnings per share ₹4
(4) Dividend pay out 50% of earnings

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 (5) Expected growth rate in dividend 10%
(6) Current market price per share ₹ 44
(7) Tax rate 50%

You are required:

(a) To DETERMINE the pattern for raising the additional finance.
(b) To DETERMINE the post-tax average cost of additional debt.
(c) To DETERMINE the cost of retained earnings and cost of equity, and
(d) COMPUTE the overall weighted average after tax cost of additional finance.

SOLUTION:
(a) Pattern of raising additional finance
Equity 70% of ₹ 10,00,000 = ₹ 7,00,000
Debt 30% of ₹ 10,00,000 = ₹ 3,00,000
The capital structure after raising additional finance:

(₹)
Shareholders’ funds
Equity Capital (7,00,000 – 2,10,000) 4,90,000
Retained earnings 2,10,000
Debt (interest at 10% p.a.) 1,80,000
(Interest at 16% p.a.) (3,00,000 – 1,80,000) 1,20,000
Total Funds 10,00,000

(b) Determination of Post – tax average cost of additional debt

Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax – rate
On ₹ 1,80,000 = 10% (1 – 0.5) = 5% or 0.05
On ₹ 1,20,000 = 16% (1 – 0.5) = 8% or 0.08
Average Cost of Debt
(₹ , , × . ) (₹ , , × . )
= x 100 = 6.2%
₹ , ,

(c) Determination of cost of retained earnings and cost of equity applying Dividend growth model:
Ke = +g

Where,

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 Ke = Cost of equity
D1 = D0 (1 + g )
D0 = Dividend Paid (i.e., 50% of EPS = 50% x ₹ 4 = ₹ 2)
g = Growth rate = 10%
P0 = Current market price per share = ₹ 44
₹ ( . ) ₹ .
Then, Ke = + 0.10 = + 0.10 = 0.05 + 0.10 = 0.15 = 15%
₹ ₹
(d) Computation of overall weighted average after tax cost of additional finance

Particular (₹) Weights Cost of Weighted

funds Cost (%)
Equity (including retained 7,00,000 0.70 15% 10.5
earnings)
Debt 3,00,000 0.30 6.2% 1.86
WACC 10,00,000 12.36

Question - 7
DETERMINE the cost of capital of Best Luck limited using the book value (BV) and market value
(MV) weighed from the following information:

Sources Book Value Market Value

(₹) (₹)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 --
Preference Shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000

Additional information:
I. Equity: Equity shares are quoted at ₹130 per share and a new issue priced at ₹125 per
share will be fully subscribed; flotation costs will be ₹ 5 per share.
II. Dividend: During the previous 5 years, dividends have steadily increased from ₹ 10.60 to
₹ 14.19 per share. Dividend at the end of the current year is expected to be ₹ 15 per share.
III. Preference shares: 15% Preference shares with face value of ₹ 100 would realise ₹105
per share.
IV. Debentures : The company proposes to issue 11-year 15% debentures but the yield on
debentures of similar maturity and risk class is 16% ; flotation cost is 2%.
V. Tax : Corporate tax rate is 35%. Ignore dividend tax. Floatation cost would be calculated
on face value.

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SOLUTION:
₹
(i) Cost of Equity (Ke) = +g= + 0.06 (refer to working note)
₹ ₹

Ke = 0.125 + 0.06 = 0.185

Working Note: Calculation of ‘g’
.
₹ 10.6 (1 + g)5 = ₹ 14.19 Or, (1 + g)5 = = 1.338
.

Table (FVIF) suggests that ₹1 Compounds to ₹ 1.338 in 5 years at the compound rate of 6 percent.
Therefore, g is 6 per cent.
₹
(ii) Cost of Retained Earnings (Kr) = +g= + 0.06 = 0.18
₹

₹
(iii) Cost of Preference Shares (Kp) = = = 0.1429
₹
₹ ₹ . ∗
( . )
(iv) Cost of Debentures (Kd) = ₹ ₹ . ∗

₹ × . ₹ . ₹ .
= = = 0.1095
₹ . ₹ .
*Since yield on similar type of debentures is 16 per cent, the company would be required to offer
debentures at discount.
Market price of debentures (approximation method)
= ₹ 15 ÷ 0.16 = ₹ 93.75
Sale proceeds from debentures = ₹93.75 – ₹ 2 (i.e., floatation cost) = ₹91.75

Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11 years)
P0 = ₹15 × 5.029 + ₹100 × 0.195
P0 = ₹75.435 + ₹19.5 = ₹ 94.935
Net Proceeds = ₹94.935 – 2% of ₹100 = ₹ 92.935
Accordingly, the cost of debt can be calculated

Cost of Capital (amount in lakh of rupees)

[BV weights and MV weights]

Weights Specific Total Cost

Source of Capital
BV MV Cost (K) (BV x K) (MV x K)
Equity Shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2
Preference Shares 36 33.75 0.1429 5.14 4.82

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 Debentures 9 10.4 0.1095 0.986 1.139
Total 195 244.15 33.73 42.76

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained
earnings
Weighted Average Cost of Capital (WACC):
₹ .
Using Book Value = = 0.1729 or 17.29%
₹
₹ .
Using Market Value = = 0.1751 or 17.51%
₹ .

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 CH. 2 : LEVERAGES

QUESTIONS AND ANSWERS

Question - 1
Following information has been extracted from the accounts of newly incorporated Textyl Pvt.
Ltd. for the Financial Year 2020-21:
Sales ₹ 15,00,000
P/V ratio 70%
Operating Leverage 1.4 times
Financial Leverage 1.25 times
Using the concept of leverage, find out and verify in each case:
(i) The percentage change in taxable income if sales increase by 15%.
(ii) The percentage change in EBIT if sales decrease by 10%.
(iii) The percentage change in taxable income if EBIT increase by 15%. [RTP May 21]

ANSWER:
Workings:
1. Contribution = Sales x P/V ratio
= ₹ 15,00,000 x 70% = ₹ 10,50,000

2. Operating Leverage =
( )
₹ , ,
Or, 1.4 =

EBIT = ₹ 7,50,000

3. Financial leverage =

₹ , ,
Or, 1.25 =

EBT = ₹6,00,000
4. Fixed Cost = Contribution – EBIT
= ₹ 10,50,000 – ₹ 7,50,000 = ₹ 3,00,000
5. Interest = EBIT – EBT
= ₹ 7,50,000 – ₹ 6,00,000 = ₹ 1,50,000
6. Income Statement

Particulars Amount (₹)

Sales 15,00,000

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 Less: Variable cost (30% of ₹ 15,00,000) 4,50,000
Contribution (70% of ₹ 15,00,000) 10,50,000
Less: Fixed costs 3,00,000
Earnings before interest and tax (EBIT) 7,50,000
Less: Interest 1,50,000
Earnings before tax (EBT) 6,00,000
₹ , ,
(i) Combined Leverage = = = 1.75 times
₹ , ,

Or, Combined Leverage = Operating Leverage x Financial Leverage

= 1.4 x 1.25 = 1.75 times
So, if sales is increased by 15% then taxable income (EBT) will be increased by 1.75 × 15% =
26.25%
Verification

Particulars Amount (₹)

New Sales after 15% increase (₹ 15,00,000 + 15% of ₹ 15,00,000) 17,25,000
Less: Variable cost (30% of ₹ 17,25,000) 5,17,500
Contribution (70% of ₹ 17,25,000) 12,07,500
Less: Fixed costs 3,00,000
Earnings before interest and tax (EBIT) 9,07,500
Less: Interest 1,50,000
Earnings before tax after change (EBT) 7,57,500

Increase in Earnings before tax (EBT) = ₹ 7,57,500 - ₹ 6,00,000 = ₹ 1,57,500

₹ , ,
So, percentage change in Taxable Income (EBT) = x 100 = 26.25%, hence verified
₹ , ,

(ii) Degree of Operating Leverage (Given) = 1.4 times

So, if sales is decreased by 10% then EBIT will be decreased by 1.4 × 10% = 14%
Verification

Particulars Amount (₹)

New Sales after 10% decrease (₹ 15,00,000 - 10% of ₹ 15,00,000) 13,50,000
Less: Variable cost (30% of ₹ 13,50,000) 4,05,000
Contribution (70% of ₹ 13,50,000) 9,45,000
Less: Fixed costs 3,00,000
Earnings before interest and tax after change (EBIT) 6,45,000

Decrease in Earnings before interest and tax (EBIT) = ₹ 7,50,000 - ₹ 6,45,000 = ₹ 1,05,000
₹ , ,
So, percentage change in EBIT = x 100 = 14%, hence verified
₹ , ,

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 (iii) Degree of Financial Leverage (Given) = 1.25 times
So, if EBIT increases by 15% then Taxable Income (EBT) will be increased by 1.25 ×15% =
18.75%
Verification

Particulars Amount (₹)

New EBIT after 15% increase (₹ 7,50,000 + 15% of ₹ 7,50,000) 8,62,500
Less: Interest 1,50,000
Earnings before Tax after change (EBT) 7,12,500

Increase in Earnings before Tax = ₹ 7,12,500 - ₹ 6,00,000 = ₹ 1,12,500

₹ , ,
So, percentage change in Taxable Income (EBT) = x 100 = 18.75%, hence verified
₹ , ,

Question - 2
Following information are related to four firms of the same industry:

Firm Change in Revenue Change in Operating Charge in Earnings per

Income Share
P 25% 23% 30%
Q 27% 30% 26%
R 24% 36% 20%
S 20% 30% 20%

For all the firms, FIND OUT:

(i) Degree of operating leverage, and
(ii) Degree of combined leverage. [MTP March 21]

ANSWER:
Calculation of Degree of Operating leverage and Degree of Combined leverage

Firm Degree of Operating Leverage (DOL) Degree of Combined Leverage (DCL)

% %
= =
% %
% %
P = 0.92 = 1.2
% %
% %
Q = 1.11 = 0.96
% %
% %
R = 1.50 = 0.83
% %
% %
S = 1.50 = 1.00
% %

Question - 3
Following data of MT Ltd. under Situations 1, 2 and 3 and Financial Plan A and B is given:

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Installed Capacity (units) 3,600
Actual Production and Sales (units) 2,400
Selling price per unit (Rs.) 30
Variable cost per unit (Rs.) 20
Fixed Costs (Rs.): Situation 1 3,000
Situation 2 6,000
Situation 3 9,000
Capital Structure:

Particulars Financial Plan

A B
Equity Rs. 15,000 Rs. 22,500
Debt Rs. 15,000 Rs. 7,500
Cost of Debt 12% 12%
Required:
(i) CALCULATE the operating leverage and financial leverage.
(ii) FIND out the combinations of operating and financial leverage which give the highest
value and the least value. [MTP April 21 (10 Marks)]

ANSWER:
(i) Operating Leverage

Situation 1 Situation 2 Situation 3

(Rs.) (Rs.) (Rs.)
Sales (S)
2,400 units @ Rs. 30 per unit 72,000 72,000 72,000
Less: Variable Cost (VC) @ Rs. 20 per unit 48,000 48,000 48,000
Contribution (C) 24,000 24,000 24,000
Less: Fixed Cost (FC) 3,000 6,000 9,000
EBIT 21,000 18,000 15,000
. , . , . ,
Operating Leverage =
. , . , . ,
= 1.14 = 1.33 = 1.60

Financial Leverage

Financial Plan
A (Rs.) B (Rs.)
Situation 1
EBIT 21,000 21,000

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 Less: Interest on debt 1,800 900
(Rs. 15,000 x 12%);(Rs. 7,500 x 12%)
EBT 19,200 20,100

. , . ,
Financial Leverage = = 1.09 = 1.04
. , . ,

Situation 2
EBIT 18,000 18,000
Less: Interest on debt 1,800 900
EBT 16,200 17,100

. , . ,
Financial Leverage = = 1.11 = 1.05
. , . ,

Situation 3
EBIT 15,000 15,000
Less: Interest on debt 1,800 900
EBT 13,200 14,100
. , . ,
Financial Leverage = = 1.14 = 1.06
. , . ,

(ii) Combined Leverages

CL = OL x FL

Financial Plan
A (Rs.) B (Rs.)
(a) Situation 1 1.14 x 1.09 = 1.24 1.14 x 1.04 = 1.19
(b) Situation 2 1.33 x 1.11 = 1.48 1.33 x 1.05 = 1.40
(c) Situation 3 1.60 x 1.14 = 1.82 1.60 x 1.06 = 1.70

The above calculations suggest that the highest value is in Situation 3 financed by Financial Plan A
and the lowest value is in the Situation 1 financed by Financial Plan B.

Question - 4
From the following information extracted from the books of accounts of Imax Ltd.,
CALCULATE percentage change in earnings per share, if sales increase by 10% and Fixed
Operating cost is ₹ 1,57,500:

Particulars Amount in ₹
EBIT (Earnings before Interest and Tax) 31,50,000
Earnings before Tax (EBT) 14,00,000

SOLUTION:
Operating Leverage (OL)

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 ₹ , , ₹ , ,
= = = = 1.05
₹ , ,

Financial Leverage (FL)

₹ , ,
= = = 2.25
₹ , ,

Combined Leverage (CL)

= 1.05 x 2.25 = 2.3625
Percentage Change in Earnings per share
% %
DCL = = 2.3625 =
% %

∴ % change in EPS = 23.625%.

Hence, if sale is increased by 10%, EPS will be increased by 23.625%.

Question - 5
Consider the following information for Mega Ltd:

Production level 2,500 units

Contribution per unit ₹ 150
Operating leverage 6
Combined leverage 24
Tax rate 30%

Required:
COMPUTE its earnings after tax.

SOLUTION:
Computation of Earnings after tax
Contribution = ₹ 150 x 2,500 = ₹ 3,75,000
Operating Leverage (OL) x Financial Leverage (FL) = Combined Leverage (CL)
6 x Financial Leverage = 24
∴ Financial Leverage =4
₹ , ,
Operating Leverage = = =6

₹ , ,
∴ EBIT = = ₹ 62,500

Financial Leverage = =4

,
∴ EBT = = = ₹ 15,625

Since tax rate = 30%

Earnings after Tax (EAT) = EBT (1 – 0.30) [30% is tax rate] = ₹ 15,625 (0.70)
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∴ Earnings after Tax (EAT) = ₹ 10,938

Question - 6
From the following information, prepare Income Statement of Company A & B:

Particulars Company A Company B

Margin of safety 0.20 0.25
Interest ₹ 3,000 ₹ 2,000
Profit volume ratio 25% 33.33%
Financial Leverage 4 3
Tax rate 45% 45%

SOLUTION:
Income Statement
(Amount in ₹)

Particulars Company A Company B

Sales 80,000 36,000
Less: Variable Cost 60,000 24,000
Contribution 20,000 12,000
Less: Fix Cost 16,000 9,000
EBIT 4,000 3,000
Less: Interest 3,000 2,000
EBT 1,000 1,000
Tax (45%) 450 450
550 550

Working Notes:
(i) Company A
Financial Leverage = EBIT / (EBIT – Interest)
4/1 = EBIT/ (EBIT - ₹ 3,000)
4 EBIT - ₹ 12,000 = EBIT
3 EBIT = ₹ 12,000
EBIT = ₹ 4,000
Company B
Financial Leverage = EBIT/ (EBIT – Interest)
3/1 = EBIT/ (EBIT - ₹ 2,000)
3EBIT - ₹ 6000 = EBIT
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 2 EBIT = ₹ 6,000
EBIT = ₹ 3,000
(ii) Company A
Operating Leverage = 1/ Margin of Safety
= 1/0.20 = 5
Operating Leverage = Contribution / EBIT
5 = Contribution/ ₹ 4,000
Contribution = ₹ 20,000
Company B
Operating Leverage = 1/ Margin of Safety
= 1/0.25 = 4
Operating Leverage = Contribution/EBIT
4 = Contribution/ ₹3,000
Contribution = ₹ 12,000
(iii) Company A
Profit Volume Ratio = 25% (Given)
Profit Volume Ratio = Contribution/ Sales* 100
25% = ₹ 20,000/Sales
Sales = ₹ 20,000/25%
Sales = ₹ 80,000
Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ₹ 12,000 / 33.33%
Sales = ₹ 36,000

Question - 7
The capital structure of PS Ltd. for the year ended 31st March, 2020 consisted as follows:

Particulars Amount in ₹
Equity share capital (face value ₹ 100 each) 10,00,000
10% debentures (₹ 100 each) 10,00,000

During the year 2019-20, sales decreased to 1,00,000 units as compared to 1,20,000 units in
the previous year. However, the selling price stood at ₹ 12 per unit and variable cost at ₹ 8 per
unit for both the years. The fixed expenses were at ₹ 2,00,000 p.a. and the income tax rate is
30%.
You are required to CALCULATE the following:

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(i) The degree of financial leverage at 1,20,000 units and 1,00,000 units.
(ii) The degree of operating leverage at 1,20,000 units and 1,00,000 units.
(iii) The percentage change in EPS.

SOLUTION:

Sales in units 1,20,000 (₹) 1,00,000 (₹)

Sales Value 14,40,000 12,00,000
Variable Cost (9,60,000) (8,00,000)
Contribution 4,80,000 4,00,000
Fixed expenses (2,00,000) (2,00,000)
EBIT 2,80,000 2,00,000
Debenture Interest (1,00,000) (1,00,000)
EBT 1,80,000 1,00,000
Tax @ 30% (54,000) (30,000)
Profit after tax (PAT) 1,26,000 70,000
₹ , , ₹ , ,
(i) Financial Leverage = = =
₹ , , ₹ , ,
= 1.56 =2
₹ , , ₹ , ,
(ii) Operating Leverage = = =
₹ , , ₹ , ,
= 1.71 =2
(iii) Earnings per share (EPS) =
₹ , ,
=
₹ ,
₹ , ₹ ,
= 12.6 =₹7
Decrease in EPS = ₹ 12.6 - ₹ 7 = ₹ 5.6
% decrease in EPS =
.
x 100 = 44.44%
.

Question - 8
The Sale revenue of TM excellence Ltd. @ ₹ 20 Per unit of output is ₹ 20 lakhs and Contribution
is ₹ 10 lakhs. At the present level of output the DOL of the company is 2.5. The company does
not have any Preference Shares. The number of Equity Shares are 1 lakh. Applicable
corporate Income Tax rate is 50% and the rate of interest on Debt Capital is 16% p.a. What is
the EPS (At sales revenue of ₹ 20 lakhs) and amount of Debt Capital of the company if a 25%
decline in Sales will wipe out EPS.

SOLUTION:
(i) Calculation of Fixed Cost

DOL = or 2.5 = or EBIT = ₹ 4,00,000 lakhs

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 EBIT = Contribution – Fixed Cost
4 = 10 – Fixed Cost
Fixed Cost = 10 – 4 = ₹ 6 lakhs
(ii) Calculation of Degree of total leverage (DTL)
Question says that 25% change in sales will wipe out EPS. Here wipe out means it will reduce EPS
by 100%.
%
DTL = = =4
%

(iii) Calculation of Degree of Financial Leverage (DFL)

DTL = DOL x DFL or 4 = 2.5 x DFL
So DFL = 1.6
(iv) Calculation of Interest and amount of Debt

DFL = or 1.6 = or Int = ₹ 1,50,000 lakhs

Debt x interest rate = Amount of Interest

Debt x 16% = ₹ 1,50,000
Debt =₹ 9,37,500
(v) Calculation of Interest and amount of Debt
( )( ) ( . ) .
EPS = = = ₹ 1.25

Question - 9
Betatronics Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31st 2020

Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 8,00,000 Net fixed assets 10,00,000
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Income Statement for the year ending March 31st 2020

Liabilities ₹
Sales 3,40,000
Operating expenses (including ₹ 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000

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 Earnings before tax 1,60,000
Less: Taxes 56,000
Net Earnings (EAT) 1,04,000

(a) DETERMINE the degree of operating, financial and combined leverages at the current
sales level, if all operating expenses, other than depreciation, are variable costs.
(b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii)
decrease by 20 percent, COMPUTE the earnings per share at the new sales level?

SOLUTION:
(a) Calculation of Degree of Operating (DOL), Financial (DFL) and Combined leverages
(DCL).
₹ , , ₹ ,
DOL = = 1.27
₹ , ,
₹ , ,
DFL = = 1.38
₹ , ,

DCL = DOL x DFL = 1.27 x 1.38 = 1.75

(b) Earnings per share at the new sales level

Increase by 20% Decrease by 20%

(₹) (₹)
Sales level 4,08,000 2,72,000
Less: Variable expenses 72,000 48,000
Less: Fixed cost 60,000 60,000
Earnings before interest and taxes 2,76,000 1,64,000
Less: Interest 60,000 60,000
Earnings after taxes (EAT) 1,40,400 67,600
Number of equity shares 80,000 80,000
EPS 1.76 0.85

Working Notes:
(i) Variable Costs = ₹ 60,000 (total cost − depreciation)
(ii) Variable Costs at:
(a) Sales level, ₹ 4,08,000 = ₹ 72,000 (increase by 20%)
(b) Sales level, ₹ 2,72,000 = ₹ 48,000 (decrease by 20%)

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 CH. 3 : CAPITAL STRUCTURE

QUESTIONS AND ANSWERS

Question - 1
Zordon Ltd. has net operating income of ₹ 5,00,000 and total capitalization of ₹ 50,00,000
during the current year. The company is contemplating to introduce debt financing in capital
structure and has various options for the same. The following information is available at
different levels of debt value:

Debt Value (₹) Interest rate (%) Equity capitalization rate (%)
0 - 10.00
5,00,000 6.0 10.50
10,00,000 6.0 11.00
15,00,000 6.2 11.30
20,00,000 7.0 12.40
25,00,000 7.5 13.50
30,00,000 8.0 16.00

Assuming no tax and that the firm always maintains books at book values, you are REQUIRED
to calculate:
(i) Amount of debt to be employed by firm as per traditional approach.
(ii) Equity capitalization rate, if MM approach is followed. [RTP May 21]

ANSWER:
(a) Amount of debt to be employed by firm as per traditional approach
Calculation of Equity, Wd and We

Total Capital (₹) Debt Wd Equity value (₹) We

(₹)
(a) (b) (b)/(a) (c) = (a) - (b) (c)/(a)
50,00,000 0 - 50,00,000 1.0
50,00,000 5,00,000 0.1 45,00,000 0.9
50,00,000 10,00,000 0.2 40,00,000 0.8
50,00,000 15,00,000 0.3 35,00,000 0.7
50,00,000 20,00,000 0.4 30,00,000 0.6
50,00,000 25,00,000 0.5 25,00,000 0.5
50,00,000 30,00,000 0.6 20,00,000 0.4

Statement of Weighted Average Cost of Capital (WACC)

Ke We Kd Wd Ke We KdWd Ko

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 (1) (2) (3) (4) (5) = (1) x (2) (6) = (3) x (4) (7) = (5) + (6)
0.100 1.0 - - 0.100 - 0.100
0.105 0.9 0.060 0.1 0.095 0.006 0.101
0.110 0.8 0.060 0.2 0.088 0.012 0.100
0.113 0.7 0.062 0.3 0.079 0.019 0.098
0.124 0.6 0.070 0.4 0.074 0.028 0.102
0.135 0.5 0.075 0.5 0.068 0.038 0.106
0.160 0.4 0.080 0.6 0.064 0.048 0.112

So, amount of Debt to be employed = ₹ 15,00,000 as WACC is minimum at this level of debt
i.e. 9.8%.
(b) As per MM approach, cost of the capital (K0) remains constant and cost of equity increases linearly
with debt.
( )
Value of a firm =

₹ , ,
₹ 50,00,000 =

₹ , ,
K0 = = 10%
₹ , ,

Statement of Equity Capitalization rate (ke) under MM approach

Debt Equity Debt/Equity Ko Kd Ko - Kd Ke

(₹) (₹) = Ko +
(Ko - Kd)
𝐃𝐞𝐛𝐢𝐭
𝐄𝐪𝐮𝐢𝐭𝐲

(1) (2) (3) = (1)/(2) (4) (5) (6) = (4) (7) = (4) +
-(5) (6) x (3)
0 50,00,000 0 0.10 - 0.100 0.100
5,00,000 45,00,000 0.11 0.10 0.060 0.040 0.104
10,00,000 40,00,000 0.25 0.10 0.060 0.040 0.110
15,00,000 35,00,000 0.43 0.10 0.062 0.038 0.116
20,00,000 30,00,000 0.67 0.10 0.070 0.030 0.120
25,00,000 25,00,000 1.00 0.10 0.075 0.025 0.125
30,00,000 20,00,000 1.50 0.10 0.080 0.020 0.130

Question - 2
The following information is supplied to you:

(₹)
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
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 Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the
share.
(iii) Will your decision change if the P/E ratio is 8 instead of 12.5? ANALYSE. [RTP May 21]

ANSWER:
(i) The EPS of the firm is ₹ 10 (i.e., ₹ 2,00,000/ 20,000) and r = 2,00,000/ (20,000 shares × ₹100)
= 10%. The P/E Ratio is given at 12.5 and the cost of capital, Ke, may be taken at the inverse of
P/E ratio. Therefore, Ke is 8 (i.e., 1/12.5). The firm is distributing total dividends of ₹ 1,50,000
among 20,000 shares, giving a dividend per share of ₹ 7.50. the value of the share as per Walter’s
model may be found as follows:
( ) .
. ( . )
P = == .
= ₹ 132.81
.

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total earnings of ₹ 2,00,000.
Since, the rate of return of the firm, r, is 10% and it is more than the Ke of 8%, therefore, by
distributing 75% of earnings, the firm is not following an optimal dividend policy. The optimal
dividend policy for the firm would be to pay zero dividend and in such a situation, the market
price would be-
.
( )
= .
= ₹ 156.25
.
So, theoretically the market price of the share can be increased by adopting a zero payout.
(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at
which the Ke would be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at
the P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy would have no effect on
the value of the share.
(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5 and in
such a situation ke > r and the market price, as per Walter’s model would be:
( ) .
. ( . )
P = == .
= ₹ 76
.

Question - 3
HN Limited is considering total investment of Rs. 20 lakhs. You are required to CALCULATE
the level of earnings before interest and tax (EBIT) at which the EPS indifference point
between the following financing alternatives will occur:
(i) Equity share capital of Rs. 12,00,000 and 14% debentures of Rs. 8,00,000.
Or
(ii) Equity share capital of Rs. 8,00,000, 16% preference share capital of Rs. 4,00,000 and
14% debentures of Rs. 8,00,000.
Assume the corporate tax rate is 30% and par value of equity share is Rs.10 in each case.
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 [MTP March 21 (5 Marks)]

ANSWER:
Computation of level of earnings before interest and tax (EBIT)
In case alternative (i) is accepted, then the EPS of the firm would be:
( )( ) ( . , , )( . )
EPS Alternative (i) = =
. , ,

In case the alternative (ii) is accepted, then the EPS of the firm would be
( )( )
EPS Alternative (ii) =
.
( . , , )( . ) . , ,
=
,

In order to determine the indifference level of EBIT, the EPS under the two alternative plans should be
equated as follows:
( . , , )( . ) ( . , , )( . ) . , ,
=
, , ,
. , . , ,
Or, =
, , ,

Or, 1.40 EBIT – Rs. 1,56,800 = 2.10 EBIT - Rs. 4,27,200

Or, 0.70 EBIT = Rs. 2,70,400
, ,
Or EBIT =
.
Or EBIT = Rs. 3,86,285.71 (approx.)

Question - 4
Kee Ltd. and Lee Ltd. are identical in every respect except for capital structure. Kee Ltd. does
not employ debt in its capital structure, whereas Lee Ltd. employs 12% debentures amounting
to Rs. 20 lakhs. Assuming that:
(i) All assumptions of MM model are met;
(ii) The income tax rate is 30%;
(iii) EBIT is Rs. 5,00,000 and
(iv) The equity capitalization rate of Kee Ltd. is 25%.
CALCULATE the average value of both the Companies. [MTP April 21 (5 Marks)]

ANSWER:
(a) Kee Ltd. (pure Equity) i.e. unlevered company:
EAT = EBT (1 – t)
= EBIT (1 - 0.3) = Rs. 5,00,000 × 0.7 = Rs. 3,50,000
(Here, EBIT = EBT as there is no debt)

Value of unlevered company Kee Ltd. =

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 . , ,
= = Rs. 14,00,000
%
Lee Ltd. (Equity and Debt) i.e levered company:
Value of levered company = Value of Equity + Value of Debt
= Rs. 14,00,000 + (Rs. 20,00,000 × 0.3)
= Rs. 20,00,000

Question – 5
Aaina Ltd. is considering a new project which requires a capital investment of ₹ 9 crores.
Interest on term loan is 12% and Corporate Tax rate is 30%. CALCULATE the point of
indifference for the project considering the Debt Equity ratio insisted by the financing
agencies being 2 : 1.

SOLUTION:
The capital investment can be financed in two ways i.e.
(i) By issuing equity shares only worth ₹ 9 crore or
(ii) By raising capital through taking a term loan of ₹ t crores and ₹ 3 crores through issuing equity
shares (as the company has to comply with the 2 : 1 Debt Equity ratio insisted by financing agencies).
In first option interest will be Zero and in second option the interest will be ₹ 72,00,000
Point of Indifference between the above two alternatives =
× ( ) ( ) × ( )
=
. ( ) . ( )

( . ) ₹ , , ) × ( . )
Or, =
, , , ,

Or, 0.7 EBIT = 2.1 EBIT - ₹ 1,51,20,000

EBIT = ₹1,08,00,000
EBIT at point of Indifference will be ₹ 1.08 crore.
(The face value of the equity shares is assumed as ₹ 10 per share. However, indifference point will be
same irrespective of face value per share).

Question – 6
Xylo Ltd. is considering two alternative financing plans as follows:

Particulars Plan – A (₹) Plan – B (₹)

Equity shares of ₹ 10 each 8,00,000 8,00,000
Preference Shares of ₹ 100 each - 4,00,000
12% Debentures 4,00,000 -
12,00,000 12,00,000

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The indifference point between the plans is ₹ 4,80,000. Corporate tax rate is 30%. Calculate
the rate of dividend on preference shares.

SOLUTION:
Computation of Rate of Preference Dividend
( )( ) ( )
=
. ( ) . ( )
(₹ , , ₹ , ) × ( . ) ₹ , , ( . )
=
, , , ,
₹ , , ₹ , ,
=
, , , ,

₹ 3,02,400 = ₹ 3,36,000 – Preference Dividend

Preference Dividend = ₹ 3,36,000 - ₹ 3,02,400 = ₹ 33,600

Rate of Dividend = x 100

₹ ,
= x 100 = 8.4%
, ,

Question – 7
Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two
alternatives in financing the project cost.
Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each
Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
CALCULATE the indifference point between the two alternative methods of financing.

SOLUTION:
Calculation of Indifferent point between the two alternatives of financing.

Alternative – I By issue of 6,00,000 equity shares of ₹ 10 each amounting to ₹ 60 lakhs. No

financial charges are involved.
Alternative – II By raising the funds in the following way:

Debt = ₹ 40 lakhs
Equity = ₹ 20 lakhs (2,00,000 equity shares of ₹ 10 each)

Interest payable on debt = 40,00,000 x = ₹ 7,20,000

The difference point between the two alternatives is calculated by:

( )( ) ( )( )
=

Where,

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 EBIT = Earnings before interest and taxes
I1 = Interest charges in Alternative-I
I2 = Interest charges in Alternative-II
T = Tax rate
E1 = Equity shares in Alternative-I
E2 = Equity shares in Alternative-II
Putting the values, the break-even point would be as follows:
( )( . ) ( , , )( . )
=
, , , ,
( )( . ) ( , , )( . )
=
, , , ,
( . ) . ( , , )
=

EBIT = 3EBIT – 21,60,000

-2 EBIT = -21,60,000
, ,
EBIT =

EBIT = ₹ 10,80,000
Therefore, at EBIT of ₹ 10,80,000 earnings per share for the two alternatives is equal.

Question – 8
Ganapati Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ₹ 2,00,000
(b) Plans of Financing Proportion:

Plans Equity Debt Preference Shares

A 100% - -
B 50% 50% -
C 50% - 50%

(c) Cost of debt 8%

Cost of Preference shares 8%
(d) Tax rate 50%
(e) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(f) Expected EBIT is ₹ 80,000.
You are required to DETERMINE for each plan: -
(i) Earnings per share (EPS)
(ii) The financial break-even point.

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(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for
indifference.

SOLUTION:
(i) Computation of Earnings per share (EPS)

Plans A B C
Earnings before interest and tax 80,000 80,000 80,000
(EBIT)
Less: Interest charges --- (8,000) ---
(8% x ₹ 1 Lakh)
Earnings before tax (EBT) 80,000 72,000 80,000
Less: Tax (@ 50%) (40,000) (36,000) (40,000)
Earnings after tax (EAT) 40,000 36,000 40,000
Less: Preference Dividend --- --- (8,000)
(8% x ₹ 1 lakh)
Earnings available for Equity 40,000 36,000 32,000
shareholders (A)
No. of Equity shares (B) 10,000 10,000 10,000
(₹ 2 lakhs ÷ ₹ 20) (₹ 1 lakhs ÷ ₹ 20) (₹ 1 lakhs ÷ ₹ 20)
EPS ₹ [(A) ÷ (B)] 4 7.20 6.40

(ii) Calculation of Financial Break-even point

Financial break-even point is the earnings which are equal to the fixed finance charges and
preference dividend.
Plan A : Under this plan there is no interest or preference dividend payment hence, the Financial
Break-even point will be zero.
Plan B : Under this plan there is an interest payment of ₹8,000 and no preference dividend, hence,
the Financial Break-even point will be ₹8,000 (Interest charges).
Plan C : Under this plan there is no interest payment but an after tax preference dividend of
₹8,000 is paid. Hence, the Financial Break- even point will be before tax earnings of
₹16,000 (i.e. ₹8,000 ÷ 0.5 = ₹16,000.)
(iii) Computation of indifference point between the plans.
The indifference between two alternative methods of financing is calculated by applying the
following formula.
( )( ) ( )( )
=

Where,
EBIT = Earnings before interest and tax.

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 I1 = Fixed charges (interest or pref. dividend) under Alternative
I2 = Fixed charges (interest or pref. dividend) under Alternative
T = Tax rate
E1 = No. of equity shares in Alternative 1
E2 = No. of equity shares in Alternative 2
Now, we can calculate indifference point between different plans of financing.
I. Indifference point where EBIT of Plan A and Plan B is equal.
( )( . ) ( , )( . )
=
, ,

0.5 EBIT (5,000) = (0.5 EBIT - 4,000) (10,000)

0.5 EBIT = EBIT – 8,000
0.5 EBIT = 8,000
EBIT = ₹ 16,000
II. Indifference point where EBIT of Plan A and Plan C is equal.
( )( . ) ( )( . ) ,
=
, ,
. . ,
=
, ,

0.25 EBIT = 0.5 EBIT – 8,000

0.25 EBIT = 8,000
EBIT = ₹ 32,000
III. Indifference point where EBIT of Plan B and Plan C are equal.
( , )( . ) ( )( . ) ,
=
, ,

0.5 EBIT - 4,000 = 0.5 EBIT – 8,000

There is no indifference point between the financial plans B and C.
It can be seen that Financial Plan B dominates Plan C. Since, the financial break-even point of the former
is only ₹8,000 but in case of latter it is ₹16,000. Further EPS of plant B is the highest.

Question – 9
Yoyo Limited presently has ₹ 36,00,000 in debt outstanding bearing an interest rate of 10 per
cent. It wishes to finance a ₹ 40,00,000 expansion programme and is considering three
alternatives: additional debt at 12 per cent interest, preference shares with an 11 per cent
dividend, and the issue of equity shares at ₹16 per share. The company presently has 8,00,000
shares outstanding and is in a 40 per cent tax bracket.
(a) If earnings before interest and taxes are presently ₹15,00,000, DETERMINE earnings per
share for the three alternatives, assuming no immediate increase in profitability?
(b) ANALYSE which alternative do you prefer? COMPUTE how much would EBIT need to
increase before the next alternative would be best?
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SOLUTION:
(a)

Alternatives
Particulars Alternative – I: Alternative – II: Alternative –III:
Take additional Issue 11% Issue further
Debt Preference Shares Equity shares
₹ ₹ ₹
EBIT 15,00,000 15,00,000 15,00,000
Interest on Debts:
- On existing debt @ 10% (3,60,000) (3,60,000) (3,60,000)
- On new debt @ 12% (4,80,000) --- ----
Profit before taxes 6,60,000 11,40,000 11,40,000
Taxes @ 40% (2,64,000) (4,56,000) (4,56,000)
Profit after taxes 3,96,000 6,84,000 6,84,000
Preference shares dividend --- (4,40,000) ---
Earnings available to equity 3,96,000 2,44,000 6,84,000
Shareholders
Number of shares 8,00,000 8,00,000 10,50,000
Earnings per share 0.495 0.305 0.651

(b) For the present EBIT level, equity shares are clearly preferable. EBIT would need to increase by
₹2,376 −₹1,500 = ₹876 before an indifference point with debt is reached. One would want to be
comfortably above this indifference point before a strong case for debt should be made. The lower
the probability that actual EBIT will fall below the indifference point, the stronger the case that can
be made for debt, all other things remain the same.

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 CH. 4 : DIVIDEND DECISION

QUESTIONS AND ANSWERS

Question – 1
The following information is given:

Dividend per share (DPS) Rs. 9

Cost of capital (Ke) 19%
Internal rate of return on investment 24%
Retention Ratio 25%

CALCULATE the market price per share by using:

(i) Walter’s formula
(ii) Gordon’s formula (Dividend Growth model) [MTP March 21]

ANSWER:
Working:
Calculation of Earnings per share (EPS):

EPS =

.
EPS = = Rs. 12
.
Market price per share by
(i) Walter’s model:
( ) .
. ( . . )
P = = .
= Rs. 67.31
.

(ii) Gordon’s model (Dividend Growth model):

( )
P0 =

Where,
Po = Present market price per share.
g = Growth rate (br) = 0.25 × 0.24 = 0.06
b = Retention ratio
k = Cost of Capital
r = Internal rate of return (IRR)
D0 = Dividend per share
E = Earnings per share
. ( . )
=
. .

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 . .
= = Rs. 73.38
.
Alternatively
( )
P0 =
( . )
P0 = = = Rs. 69.23
. . .

Question – 2
The following data is available in respect of N Ltd. for the year ended 31st March, 2021:

Rs. (in Crore)

Share capital (@ Rs. 10 per share) 25.00
Reserves 15.00
Profit after tax (PAT) 3.70
Dividends paid 3.00
P/E ratio 26.70
Using Walter’s Model:
(i) COMMENT on the firm’s dividend policy;
(ii) DETERMINE the optimum payout ratio and
(iii) DETERMINE the P/E ratio at which dividend payout will have no effect on share price.
[MTP April 21 (5 Marks)]

ANSWER:
Workings:
. .
1. Earnings per share (E) = = = Rs. 1.48
. .
. .
2. Return on Investment (r) = x 100 = x 100 = 9.25%
. ( )
.
3. Dividend per share (D) = = = Rs. 1.2
. .
.
Dividend payout ratio = x 100 = x 100 = 81.08%
. .
4. Current Market Price (P0) = P/E Ratio x E = 26.7 x Rs. 1.48 = Rs. 39.52
5. Growth rate (g) =bxr = (1 – 0.8108) x 0.0925 = 1.75%
( ) . . ( . )
6. Cost of Capital (Ke) = +g = + 0.0175 = 4.84 %
. .

(i) The value of the share as per Walter’s Model:

( ) .
. ( . . )
.
P= =P= = Rs. 35.85
.

The firm has a dividend payout of 81.08% (i.e., Rs. 3 crores) out of Profit after tax of

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 Rs. 3.7 crores with value of the share at Rs. 35.85. The rate of return on investment (r)
is 9.25% and it is more than the Ke of 4.84%, therefore, by distributing 81.08% of earnings,
the firm is not following an optimal dividend policy.
(ii) Under Walter’s model, when return on investment is more than cost of capital (r > Ke), the
market share price will be maximum if 100% retention policy is followed. So, the optimal
payout ratio would be to pay zero dividend and in such a situation, the market price would
be:
.
( . )
.
P= = Rs. 58.44
.
(iii) The P/E ratio at which dividend payout will have no effect on share price is at which the Ke
would be equal to the rate of return (r) of the firm i.e. 9.25%.
( )
So, Ke = +g

. . ( . )
0.0925 = + 0.0175

∴ P0 = Rs. 16.28
If P0 is Rs. 16.28, then, P/E Ratio will be:
. .
= = = 11 times
. .
Therefore, at the P/E ratio of 11, the dividend payout will have no effect on share price.

Question - 3
The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to
dividend policy with a multiplier of 9, COMPUTE P/E ratio.

SOLUTION:
The P/E ratio i.e. price earnings ratio can be computed with the help of the following formula:

P/E ratio =

Since the D/P ratio is 40%,

D = 40% of E i.e. 0.4E
Hence,
Market price per share (P) using Graham & Dodd’s model =
P0 = Market price per share
D = Dividend per share
E = Earnings per share
M = a Multiplier

P0 = 9 0.4E +
.
P0 = 9 = 3 (2.2E)

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P0 = 6.6E

= 6.6 i.e. P/E ratio is 6.6 times

Question - 4
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding
shares and the current market price is ₹ 100. It expects a net profit of ₹ 2,50,000 for the year
and the Board is considering dividend of ₹ 5 per share.
M Ltd. requires to raise ₹ 5,00,000 for an approved investment expenditure. ILLUSTRATE, how
the MM approach affects the value of M Ltd. if dividends are paid or not paid.

SOLUTION:
Given,

Cost of Equity (Ke) 10%

Number of shares in the beginning (n) 25,000
Current Market Price (P0) ₹ 100
Net Profit (E) ₹ 2,50,000
Expected Dividend ₹ 5 per share
Investment (I) ₹ 5,00,000

Case 1 – When dividends are paid Case 2 – When dividend are not paid
Step 1 Step 1

P0 = P0 =

100 = .
100 = .

P1 = 110 – 5 = 105 P1 = 110 – 0 = 110

Step 3 Step 3
No. of shares required to be issued for balance No. of shares required to be issued for balance
fund fund

No. of shares = No. of shares =

( ) ( )
, , , ,
n = n =

= 3,571.4285 = 2,272.73
Step 4 Step 4
Calculation of value of firm Calculation of value of firm
( ) ( )
Vf = Vf =
( ) ( )

Vf = Vf =
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 , , , ,
, , , , , , , , , ,
( . ) ( . )

= ₹ 25,00,000 = ₹ 25,00,000

Question - 5
The following information is supplied to you:

₹
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the
share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.

SOLUTION:
(i) The EPS of the firm is ₹ 10 (i.e., ₹ 2,00,000/ 20,000). r = 2,00,000/ (20,000 shares × ₹100) =
10%. The P/E Ratio is given at 12.5 and the cost of capital, Ke, may be taken at the inverse of P/E
ratio. Therefore, Ke is 8 (i.e., 1/12.5). The firm is distributing total dividends of ₹ 1,50,000 among
20,000 shares, giving a dividend per share of ₹ 7.50. the value of the share as per Walter’s model
may be found as follows:
( ) .
. ( . )
.
P = = = ₹ 132.81
.

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total earnings of ₹ 2,00,000. since,
the rate of return of the firm, r, is 10% and it is more than the Ke of 8%, therefore, by distributing
75% of earnings, the firm is not following an optimal dividend policy. The optimal dividend policy
for the firm would be to pay zero dividend and in such a situation, the market price would be
.
( )
.
= ₹ 156.25
.

So, theoretically the market price of the share can be increased by adopting a zero payout.
(ii) The P/E ratio at which the dividend policy will have no effect on the value of the share is such at
which the Ke would be equal to the rate of return, r, of the firm. The Ke would be 10% (= r) at the
P/E ratio of 10. Therefore, at the P/E ratio of 10, the dividend policy would have no effect on the
value of the share.
(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5 and in
such a situation Ke > r and the market price, as per Walter’s model would be:

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 . .
( ) . ( . )
.
P = = = ₹ 76
. .

Question - 6
With the help of following figures calculate the market price of a share of a company by using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)

₹
Earnings per share (EPS) ₹ 10
Dividend per share (DPS) ₹6
Cost of Capital (Ke) 20%
Internal rate of return on investment 25%
Retention Ratio 40%

SOLUTION:
(i) Walter’s model:
( ) .
( )
.
P = = = ₹ 55
.

(ii) Gordon’s model (Dividend Growth model): When the growth is incorporated in earnings and
dividend, the present value of market price per share (Po) is determined as follows
Gordon’s theory:
( )
Present market price per share (Po) =

Where,
Po = Present market price per share.
E = Earnings per share
b = Retention ratio (i.e. % of earnings retained)
r = Internal rate of return (IRR)
Hint:
Growth rate (g) = br
( . )
Po =
. ( . × . )

=₹ = ₹60
.

Question - 7
The annual report of XYZ Ltd. provides the following information for the Financial Year 2020-
21:

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 Particulars Amount (₹)
Net profit 50 lakhs
Outstanding 15% preference shares 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is-
(i) 25%;
(ii) 50%;
(iii) 100%.

SOLUTION:
Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount (₹)

Net Profit 50 lakhs

Less: Preference dividend 15 lakhs
Earnings for equity shareholders 35 lakhs
Therefore, earning per share 35 lakhs/5 lakhs = ₹ 7.00
Net Profit 50 lakhs
Price per share according to Gordon’s Model is calculated as follows:
( )
Po =

Here, E1 = 7, Ke = 16%
(i) When dividend pay-out is 25%
× . .
Po = = = 175
. ( . × . ) . ( . )

(ii) When dividend pay-out is 50%

× . .
Po = = = 58.33
. ( . × . ) . . )

(iii) When dividend pay-out is 100%

×
Po = = = 43.75
. ( × . ) .

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 CH. 5 : CAPITAL BUDGETING

QUESTIONS AND ANSWERS

Question - 1
A project requires an initial outlay of ₹ 3,00,000.
The company uses certainty equivalent method approach to evaluate the project. The risk free
rate is 7%.
Following information is available:

Year CFAT CE
(Cash Flow After Tax) ₹ (Certainty Equivalent Coefficient)
1. 1,00,000 0.90
2. 1,50,000 0.80
3. 1,15,000 0.60
4. 1,00,000 0.55
5. 50,000 0.50

PV Factor at 7%

Year 1 2 3 4 5
PV Factor 0.935 0.873 0.816 0.763 0.713

Evaluate the above. Is investment in the project beneficial? [Jan 21 (5 Marks)]

ANSWER:
Statement showing the Net Present Value of Project

Year end CFAT (₹) C.E. Adjusted Cash Present Value Total
flow (₹) factor @ 7% Present
value (₹)
(a) (b) (c) = (a) × (b) (d) (e) = (c) × (d)
1 1,00,000 0.90 90,000 0.935 84,150
2 1,50,000 0.80 1,20,000 0.873 1,04,760
3 1,15,000 0.60 69,000 0.816 56,304
4 1,00,000 0.55 55,000 0.763 41,965
5 50,000 0.50 25,000 0.713 17,825
PV of Cash Inflow 3,05,004
Less: Initial Investment (3,00,000)
Net Present value 5,0004

Since the NPV of the project is positive, it is beneficial to invest in the project.

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Question - 2
A company wants to buy a machine, and two different models namely A and B are available.
Following further particulars are available:

Particulars Machine-A Machine-B

Original Cost (₹) 8,00,000 6,00,000
Estimated Life in years 4 4
Salvage Value (₹) 0 0
The company provides depreciation under Straight Line Method. Income tax rate applicable
is 30%.
The present value of ₹ 1 at 12% discounting factor and net profit before depreciation and tax
are as under:

Year Net Profit Before Depreciation and tax PV Factor

Machine-A Machine-B
₹ ₹
1. 2,30,000 1,75,000 0.893
2. 2,40,000 2,60,000 0.797
3. 2,20,000 3,20,000 0.712
4. 5,60,000 1,50,000 0.636
Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period
method, NPV method and PI method. [Jan 21 (10 Marks)]

ANSWER:
(i) Calculation of Annual Depreciation
₹ , ,
Depreciation on Machine – A = = ₹2,00,000
₹ , ,
Depreciation on Machine – B = = ₹1,50,000

(ii) Calculation of Annual Cash Inflows

Particulars Machine-A (₹)

1 2 3 4
Net Profit before Depreciation and Tax 2,30,000 2,40,000 2,20,000 5,60,000
Less: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Profit before Tax 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% 9,000 12,000 6,000 1,08,000
Profit after Tax 21,000 28,000 14,000 2,52,000
2,00,000 2,00,000 2,00,000 2,00,000

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 Add: Depreciation 2,21,000 2,28,000 2,14,000 4,52,000
Annual Cash Inflows

Particulars Machine-B (₹)

1 2 3 4
Net Profit before Depreciation and Tax 1,75,000 2,60,000 3,20,000 1,50,000
Less: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Profit before Tax 25,000 1,10,000 1,70,000 0
Less: Tax @ 30% 7,500 33,000 51,000 0
Profit after Tax 17,500 77,000 1,19,000 0
Add: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Annual Cash Inflows 1,67,500 2,27,000 2,69,000 1,50,000
(iii) Calculation of PV of Cash Flows

Machine – A Machine - B
Year PV of Re 1 Cash PV Cumulative Cash flow PV (₹) Cumulative
@ 12% flow (₹) (₹) PV (₹) (₹) PV (₹)
1 0.893 2,21,000 1,97,353 1,97,353 1,67,500 1,49,578 1,49,578
2 0.797 2,28,000 1,81,716 3,79,069 2,27,000 1,80,919 3,30,497
3 0.712 2,14,000 1,52,368 5,31,437 2,69,000 1,91,528 5,22,025
4 0.636 4,52,000 2,87,472 8,18,909 1,50,000 95,400 6,17,425
1. NPV (Net Present Value)
Machine – A
NPV = ₹ 8,18,909 - ₹ 8,00,000 = ₹ 18,909
Machine – B
NPV = ₹ 6,17,425 – ₹ 6,00,000 = ₹ 17,425
2. Discounted Payback Period
Machine – A
₹ , , ₹ , ,
Discounted Payback Period =3+
₹ , ,

= 3 + 0.934
= 3.934 years or 3 years 11.21 months
Machine – B
₹ , , ₹ , ,
Discounted Payback Period =3+
₹ ,

= 3 + 0.817
= 3.817 years or 3 years 9.80 months
3. PI (Profitability Index)
Machine – A

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 ₹ , ,
Profitability Index = = 1.024
₹ , ,

Machine – B
₹ , ,
Profitability Index = = 1.029
₹ , ,

Suggestion:

Method Machine - A Machine - B Suggested Machine

Net Present Value ₹ 18,909 ₹ 17,425 Machine A
Discounted Payback Period 3.934 years 3.817 years Machine B
Profitability Index 1.024 1.029 Machine B

Question - 3
The General Manager of Merry Ltd. is considering the replacement of five-year-old equipment.
The company has to incur excessive maintenance cost of the equipment. The equipment has
zero written down value. It can be modernized at a cost of ₹ 1,40,000 enhancing its economic
life to 5 years. The equipment could be sold for ₹ 30,000 after 5 years. The modernization
would help in material handling and in reducing labour, maintenance & repairs costs.
The company has another alternative to buy a new machine at a cost of ₹ 3,50,000 with an
economic life of 5 years and salvage value of ₹ 60,000. The new machine is expected to be
more efficient in reducing costs of material handling, labour, maintenance & repairs, etc.
The Annual cost are as follows:

Existing Equipment Modernization (₹) New Machine (₹)

(₹)
Wages & Salaries 45,000 35,500 15,000
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
1,20,000 70,500 39,500

Assuming tax rate of 50% and required rate of return of 10%, should the company modernize
the equipment or buy a new machine?
PV factor at 10% are as follows:

Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
[RTP May 21]

ANSWER:
Workings:
Calculation of Depreciation:
₹ , ₹ ,
On Modernized Equipment = = ₹ 22,000 p.a.

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 ₹ , , ₹ ,
On New machine = = ₹ 58,000 p.a.

(i) Calculation of Incremental annual cash inflows/ savings:

Particulars Existing Modernization New Machine

Equipment
Amount Savings Amount Savings
(₹)
(₹) (₹) (₹) (₹)
(1) (2) (3)=(1)-(2) (4) (5)=(1)-(4)
Wages & Salaries 45,000 35,500 9,500 15,000 30,000
Supervision 20,000 10,000 10,000 7,000 13,000
Maintenance 25,000 5,000 20,000 2,500 22,500
Power 30,000 20,000 10,000 15,000 15,000
Total 1,20,000 70,500 49,500 39,500 80,500
Less: Depreciation 22,000 58,000
(Refer Workings)
Total Savings 27,500 22,500
Less: Tax @ 50% 13,750 11,250
After Tax Savings 13,750 11,250
Add: Depreciation 22,000 58,000
Incremental Annual 35,750 69,250
Cash Inflows
(ii) Calculate of Net Present value (NPV)

Particulars Year Modernization New Machine

(₹) (₹)
Initial Cash outflow (A) 0 1,40,000.00 3,50,000.00
Incremental Cash Inflows 1-5 1,35,492.50 2,62,457.50
(₹ 35,750 x 3.790) (₹ 69,250 x 3.790)
Salvage value 5 18,630.00 37,260.00
(₹ 30,000 x 0.621) (₹ 60,000 x 0.621)

PV of Cash inflows (B) 1,54,122.50 2,99,717.50

Net Present Value (B - A) 14,122.50 (50,282.50)

Advise: The company should modernize its existing equipment and not buy a new machine
because NPV is positive in modernization of equipment.

Question - 4
N&B Ltd. is considering one of two mutually exclusive proposals, Projects A and B, which
require cash outlays of Rs. 34,00,000 and Rs. 33,00,000 respectively. The certainty-equivalent
(C.E) approach is used in incorporating risk in capital budgeting decisions. The current yield
on government bonds is 5% and this is used as the risk free rate. The expected net cash flows
and their certainty equivalents are as follows:

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 Year-end Project A Project B
Cash Flow (Rs.) C.E. Cash Flow (Rs.) C.E.
1 16,75,000 0.8 16,75,000 0.9
2 15,00,000 0.7 15,00,000 0.8
3 15,00,000 0.5 15,00,000 0.7
4 20,00,000 0.4 10,00,000 0.8
5 21,20,000 0.6 9,00,000 0.9

PV factor at 5% are as follows:

Year 1 2 3 4 5
PV Factor 0.952 0.907 0.864 0.823 0.784

DETERMINE which project should be accepted. [MTP March 21 (8 Marks)]

ANSWER:
(a) Statement Showing the Net Present Value of Project A

Year end Cash Flow C.E. Adjusted Cash Present value Total Present
(Rs.) flow (Rs.) factor at 5% value (Rs.)
(a) (b) (c) = (a) × (b) (d) (e) = (c) × (d)
1 16,75,000 0.8 13,40,000 0.952 12,75,680
2 15,00,000 0.7 10,50,000 0.907 9,52,350
3 15,00,000 0.5 7,50,000 0.864 6,48,000
4 20,00,000 0.4 8,00,000 0.823 6,58,400
5 21,20,000 0.6 12,72,000 0.784 9,97,248
PV of total Cash Inflows 45,31,678
Less: Initial Investment 34,00,000
Net Present Value 11,31,678
Statement Showing the New Present Value of Project B

Year end Cash Flow C.E. Adjusted Cash Present Total

(Rs.) flow (Rs.) value factor Present
(a) (b) (c) = (a) × (b) at 5% (d) value (Rs.)
(e) = (c) × (d)
1 16,75,000 0.9 15,07,500 0.952 14,35,140
2 15,00,000 0.8 12,00,000 0.907 10,88,400
3 15,00,000 0.7 10,50,000 0.864 9,07,200
4 10,00,000 0.8 8,00,000 0.823 6,58,400
5 9,00,000 0.9 8,10,000 0.784 6,35,040
PV of total Cash Inflows 47,24,180
Less: Initial Investment 33,00,000
Net Present Value 14,24,180

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 Project B has NPV of Rs. 14,24,180 which is higher than the NPV of Project A. Thus, N&B Ltd.
should accept Project B.

Question - 5
SG Ltd. is considering a project “Z” with an initial outlay of Rs. 7,50,000 and life of 5 years. The
estimates of project are as follows:

Lower Estimates Base Upper Estimates

Sales (units) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Variable cost p.u. 100 125 150
Fixed Cost 50,000 75,000 1,00,000
Depreciation included in Fixed cost is Rs. 35,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, DETERMINE NPV in three scenarios i.e worst, base and
best case scenario.
PV factor for 5 years at 15% are as follows:

Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497
[MTP April 21 (7 Marks)]

ANSWER:
(i) Calculation of Yearly Cash Inflow
In worst case: High costs and Low price (Selling price) and volume (Sales units) are taken.
In best case: Low costs and High price (Selling price) and volume (Sales units) are taken.

Worst Case Base Best Case

Sales (units) (A) 4,500 5,000 5,500
(Rs.) (Rs.) (Rs.)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500
Less: Tax @ 25% 3,125 75,000 1,59,375
EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash Inflow 44,375 2,60,000 5,13,125

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(ii) Calculation of NPV in different scenarios

Worst Case Base Best Case

Initial outlay (A) (Rs.) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) (Rs.) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) (Rs.) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (Rs.) (6,01,210.62) 1,21,780 9,70,508.13

Question - 6
Development Finance Corporation issued zero interest deep discount bonds of face value of
Rs. 1,50,000 each issued at Rs. 3,750 & repayable after 25 years. COMPUTE the cost of debt
if there is no corporate tax. [MTP April 21 (3 Marks)]

ANSWER:
Here,
Redemption Value (RV)= Rs.1,50,000
Net Proceeds (NP) = Rs. 3,750
Interest = 0
Life of bond = 25 years
There is huge difference between RV and NP therefore in place of approximation method we should
use trial & error method.
FV = PV x (1 + r)n
1,50,000 = 3,750 x (1 + r)25
40 = (1 + r)25
Trial 1: r = 15%, (1.15)25 = 32.919
Trial 2: r = 16%, (1.16)25 = 40.874
Here:
L = 15%; H = 16%
NPVL = 32.919 - 40 = - 7.081
NPVH = 40.874 - 40 = + 0.874

IRR =L+ (H – L)

.
= 15% + x (16% - 15%) = 15.89%
. ( . )

Question - 7
City Clap Ltd. is in the business of providing housekeeping services. There is a proposal
before the company to purchase a mechanized cleaning system for a sum of Rs. 40 lakhs. The
present system of the company is to use manual labour for the cleaning job. You are provided
with the following information:
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Proposed Mechanized System:
Cost of the machine Rs. 40 lakhs
Life of the machine 7 years
Depreciation (on straight line basis) 15%
Operating cost of mechanized system Rs. 20 lakhs per annum
Present system (Manual):
Manual labour 350 persons
Cost of manual labour Rs. 15,000 per person per annum
The company has an after-tax cost of fund at 10% per annum.
The applicable tax rate is 50%.
PV factor for 7 years at 10% are as follows:

Years 1 2 3 4 5 6 7
P.V. factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513
You are required to DETERMINE whether it is advisable to purchase the mechanized cleaning
system. Give your recommendations with workings. [MTP April 21 (10 Marks)]

ANSWER:
Calculation of NPV

(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanised System:
Operating Cost 20,00,000
Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000
Saving per annum 26,50,000
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: Depreciation 6,00,000
Cash flow per annum 19,25,000
Cumulative PV Factor for 7 years @ 10% 4.867
Present value of cash flow for 7 years 93,68,975
Less: Cost of the Machine 40,00,000
NPV 53,68,975

The mechanized cleaning system should be purchased since NPV is positive by Rs. 53,68,975.

Question - 8
Following data has been available for a capital project:
Annual cash inflows ₹ 1,00,000
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Useful life 4 years
Salvage value 0
Internal rate of return 12%
Profitability index 1.064
You are required to CALCULATE the following for this project:
(i) Cost of project
(ii) Cost of capital
(iii) Net present value
(iv) Payback period
PV factors at different rates are given below:

Discount factor 12% 11% 10% 9%

1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708

SOLUTION:
(i) Cost of the Project
At 12% internal rate of return (IRR), the sum of total cahs inflows = cost of the project i.e.
initial cash outlay
Annual cash inflows = ₹ 1,00,000
Useful life = 4 years
Considering the discount factor table @ 12%, cumulative present value of cash inflows for 4 years
is 3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Total Cash inflows for 4 years for the Project is
₹ 1,00,000 × 3.038 = ₹ 3,03,800
Hence, Cost of the Project = ₹ 3,03,800
(ii) Cost of Capital

Profitability index =

1,064 = ₹ , ,

∴ Sum of Discounted Cash inflows = ₹ 3,23,243.20

Since, Annual Cash Inflows = ₹ 1,00,000
₹ , , .
Hence, cumulative discount factor for 4 years = ₹ , ,
= 3.232

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 From the discount factor table, at discount rate of 9%, the cumulative discount factor for 4
years is 3.239 (0.917 + 0.842 + 0.772 + 0.708)
Hence, Cost of Capital = 9% (approx.)
(iii) Net Present Value (NPV)
NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ₹ 3,23,243.20 – ₹ 3,03,800 = ₹ 19,443.20
Net Present Value = ₹ 19,443.20
(iv) Payback Period
₹ , ,
Payback period = =₹ , ,
= 3.038 years

Question - 9
Lockwood Limited wants to replace its old machine with a new automatic machine. Two
models A and B are available at the same cost of ₹ 5 lakhs each. Salvage value of the old
machine is ₹ 1 lakh. The utilities of the existing machine can be used if the company purchases
A. Additional cost of utilities to be purchased in that case are ₹ 1 lakh. If the company
purchases B then all the existing utilities will have to be replaced with new utilities costing ₹ 2
lakhs. The salvage value of the old utilities will be ₹ 0.20 lakhs. The earnings after taxation are
expected to be:

(cash in-flows of)

Year A (₹) B (₹) P.V. Factor @
15%
1 1,00,000 2,00,000 0.870
2 1,50,000 2,10,000 0.756
3 1,80,000 1,80,000 0.658
4 2,00,000 1,70,000 0.572
5 1,70,000 40,000 0.497
Salvage Value at the end of 50,000 60,000
Year 5

The targeted return on capital is 15%. You are required to (i) COMPUTE, for the two machines
separately, net present value, discounted payback period and desirability factor and (ii)
STATE which of the machines is to be selected?

SOLUTION:
Working:
Calculation on Cash – Outflow at year zero

Particulars A (₹) B (₹)

Cost of Machine 5,00,000 5,00,000

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 Cost of Utilities 1,00,000 2,00,000
Salvage value of Old Machine (1,00,000) (1,00,000)
Salvage of value Old Utilities – (20,000)
Total Expenditure (Net) 5,00,000 5,80,000

(i) (a) Calculation of NPV

Machine A Machine B
Year NPV Factor Cash Discounted Cash Discounted
@ 15% inflows value of inflows value of
inflows inflows
0 1.000 (5,00,000) (5,00,000) (5,80,000) (5,80,000)
1 0.870 1,00,000 87,000 2,00,000 1,74,000
2 0.756 1,50,000 1,13,400 2,10,000 1,58,760
3 0.658 1,80,000 1,18,440 1,80,000 1,18,440
4 0.572 2,00,000 1,14,400 1,70,000 97,240
5 0.497 1,70,000 84,490 40,000 19,880
Salvage 0.497 50,000 24,850 60,000 29,820
5,42,580 5,98,140
Net Present Value 42,580 18,140

Since the Net present value of both the machines is positive both are acceptable.
(b) Discounted Pay – back Period (Amount in
₹)

Machine A Machine B
Year Discounted cash Cumulative Discounted cash Cumulative
inflows Discounted cash inflows Discounted Cash
inflows inflows
1 87,000 87,000 1,74,000 1,74,000
2 1,13,400 2,00,400 1,58,760 3,32,760
3 1,18,440 3,18,840 1,18,440 4,51,200
4 1,14,400 4,33,240 97,240 5,48,440
5 1,09,340* 5,42,580 49,700* 5,98,140

* Includes salvages value

Discounted Payback Period (For A and B):
, , , ,
Machine A = 4 years + , ,
= 4.61 years

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 , , , ,
Machine B = 4 years + ,
= 4,63 years

(c) Desirability factor or Profitability Index:

Profitability Index (PI) =

₹ , , ₹ , ,
Machine A = ₹ , ,
= 1.08; Machine B = ₹ , ,
= 1.03

(ii) Since the absolute surplus in the case of A is more than B and also the desirability factor, it is
better to choose A.
The discounted payback period in both the cases is almost same, also the net present value is
positive in both the cases but the desirability factor (profitability index) is higher in the case of
Machine A, it is therefore better to choose Machine A.

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

SOLUTION:
(a) Computation of NPV at 15% discount rate

Year Cash flow Discount Factor (15%) Present value

(₹) (₹)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5−10 4,00,000 2.163 8,65,200
Net Present Value (1,18,200)

As the net present value is negative, the project is unacceptable.

(b) Computation of NPV if discount rate would be 10% discount rate
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 Year Cash flow Discount Factor (10%) Present value
(₹) (₹)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5−10 4,00,000 2.974 11,89,600
Net Present Value 2,51,450

Since NPV = ₹ 2,51,450 is positive, hence the project would be acceptable.

(c) Calculation of IRR:

IRR = LR + x (HR – LR)

₹ , ,
= 10% + ₹ , , ( ) , ,
x (15% – 10%)
= 10% + 3.4012 or 13.40%
(d) Computation of Pay-back period of the project:
Payback Period = 6 years:
−₹ 7,00,000−₹ 10,00,000 + ₹ 2,50,000 + ₹ 3,00,000 + ₹ 3,50,000 + ₹ 4,00,000 + ₹ 4,00,000
=0

Question - 11
Elite Cooker Company is evaluating three investment situations: (1) produce a new line of
aluminium skillets, (2) expand its existing cooker line to include several new sizes, and (3)
develop a new, higher-quality line of cookers. If only the project in question is undertaken, the
expected present values and the amounts of investment required are:

Project Investment required Present value of Future Cash-Flows

₹ ₹
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required
and present values will simply be the sum of the parts. With projects 1 and 3, economies are
possible in investment because one of the machines acquired can be used in both production
processes. The total investment required for projects 1 and 3 combined is ₹ 4,40,000. If
projects 2 and 3 are undertaken, there are economies to be achieved in marketing and
producing the products but not in investment. The expected present value of future cash flows
for projects 2 and 3 is ₹ 6,20,000. If all three projects are undertaken simultaneously, the

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economies noted will still hold. However, a ₹ 1,25,000 extension on the plant will be necessary,
as space is not available for all three projects. CALCULATE NPV of the projects and STATE
which project or projects should be chosen?

SOLUTION:

Project Investment Required Present value of Net Present value

Future Cash Flows
₹ ₹ ₹
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000
1 and 2 3,15,000 4,75,000 1,60,000
1 and 3 4,40,000 6,90,000 2,50,000
2 and 3 3,85,000 6,20,000 2,35,000
1, 2 and 3 6,80,000* 9,10,000 2,30,000
(Refer Working note)

Working Note:
(i) Total Investment required if all the three projects are undertaken simultaneously:

(₹)
Project 1& 3 4,40,000
Project 2 1,15,000
Plant extension cost 1,25,000
Total 6,80,000
Project 1& 3 4,40,000

(ii) Total of Present value of Cash flows if all the three projects are undertaken simultaneously:

(₹)
Project 2 & 3 6,20,000
Project 1 2,90,000
Total 9,10,000

Projects 1 and 3 should be chosen, as they provide the highest net present value.

Question - 12
Cello Limited is considering buying a new machine which would have a useful economic life of
five years, a cost of ₹ 1,25,000 and a scrap value of ₹ 30,000, with 80 per cent of the cost being
payable at the start of the project and 20 per cent at the end of the first year. The machine
would produce 50,000 units per annum of a new product with an estimated selling price of ₹ 3
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per unit. Direct costs would be ₹ 1.75 per unit and annual fixed costs, including depreciation
calculated on a straight- line basis, would be ₹ 40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in the
above costs, would be incurred, amounting to ₹ 10,000 and ₹ 15,000 respectively.
CALCULATE NPV of the project for investment appraisal, assuming the company’s cost of
capital is 10 percent.

SOLUTION:
Calculation of Net Cash flows
Contribution = (3.00 – 1.75) x 50,000 = ₹ 62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ₹ 21,000

Year Capital (₹) Contribution Fixed costs (₹) Adverts (₹) Net cash flow
(₹) (₹)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500

Calculation of Net Present Value

Year Net Cash flow (₹) 10% discount factor Present value (₹)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
NPV 31,712

The net present value of the project is ₹ 31.712.

Question - 13
Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a choice between
the two identical machines, in terms of Capacity, ‘X’ and ‘Y’. Despite being designed
differently, both machines do the same job. Further, details regarding both the machines are
given below:

Particulars Machine ‘X’ Machinery ‘Y’

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 Purchase Cost of the Machine (₹) 15,00,000 10,00,000
Life (years) 3 2
Running cost per year (₹) 4,00,000 6,00,000

The opportunity cost of capital is 9%.

You are required to:
IDENTIFY the machine the company should buy?
The present value (PV) factors at 9% are:
Year t1 t2 t3
PVIF0.09.t 0.917 0.842 0.772

SOLUTION:
Statement Showing the Evaluation of Two Machines

Particulars Machine ‘X’ Machine ‘Y’

(i) Purchase Cost ₹ 15,00,000 ₹ 10,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year ₹ 4,00,000 ₹ 6,00,000
(iv) PVIFA 0.09, 3 2.531
PVIFA 0.09, 2 1.759
(v) PV of Running Cost of Machine {(iii)×(iv)} ₹ 10,12,400 ₹ 10,55,400
(vi) Cash outflows of Machine {(i) + (v)} ₹ 25,12,400 ₹ 20,55,400
(vii) Equivalent PV of Annual Cash outflow (vi/iv) ₹ 9,92,651 ₹ 11,68,505

Recommendation: Ae Bee Cee Ltd. should buy Machine ‘X’ since equivalent annual cash outflow is less
than that of Machine ‘Y”.

Question - 14
Alley Pvt. Ltd. is planning to invest in a machinery that would cost ₹ 1,00,000 at the beginning
of year 1. Net cash inflows from operations have been estimated at ₹ 36,000 per annum for 3
years. The company has two options for smooth functioning of the machinery- one is service,
and another is replacement of parts. If the company opts to service a part of the machinery at
the end of year 1 at ₹ 20,000, in such a case, the scrap value at the end of year 3 will be ₹
25,000. However, if the company decides not to service the part, then it will have to be
replaced at the end of year 2 at ₹ 30,800. And in this case, the machinery will work for the 4th
year also and get operational cash inflow of ₹ 36,000 for the 4th year. It will have to be
scrapped at the end of year 4 at ₹ 18,000.
Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase of this
machinery based on the net present value of its cash flows?
If the supplier gives a discount of ₹ 10,000 for purchase, what would be your decision?
Note:
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The PV factors at 10% are:

Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

SOLUTION:
Option I: Purchase Machinery and Service Part at the end of Year 1.
Net Present value of cash Flow @ 10% per annum discount rate.
, , , , ,
NPV (in ₹) = - ₹1,00,000 + ( . )
+ ( . )
+ ( . )
+ ( . )
+ ( . )

= − 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (20,000 × 0.9091) + (25,000 ×

0.7513)
= − 1,00,000 + (36,000 × 2.4868) – 18,182 + 18,782.5
= − 1,00,000 + 89,524.8 – 18,182 + 18,782.5
NPV = − 9,874.7
Since, Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ₹ 10,000 then,
NPV (in ₹ ) = + 10,000 – 9,874.7 = + 125.3
In this case, Net Present Value is positive but very small; therefore, this option may not be advisable.
Option II: Purchase Machinery and Replace Part at the end of Year 2.
, , , , ,
NPV (in ₹) = - ₹1,00,000 + ( . )
+ ( . )
+ ( . )
+ ( . )
+ ( . )

= − 1,00,000+ 36,000 (0.9091 + 0.8264 + 0.7513) – (30,800 × 0.8264) + (54,000 ×

0.6830)
= − 1,00,000 + 36,000 (2.4868) – 25,453.12 + 36,882
= − 1,00,000 + 89,524.8 – 25,453.12 + 36,882
NPV = + 953.68
Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ₹ 10,000, then
NPV (in ₹ ) = 10,000 + 953.68 = 10,953.68
Decision: Option II is worth investing as the net present value is positive and higher as compared to
Option I.

Question - 15
NavJeevani hospital is considering to purchase a machine for medical projectional
radiography which is priced at ₹ 2,00,000. The projected life of the machine is 8 years and has
an expected salvage value of ₹ 18,000 at the end of 8th year. The annual operating cost of the
machine is ₹ 22,500. It is expected to generate revenues of ₹ 1,20,000 per year for eight years.
Presently, the hospital is outsourcing the radiography work to its neighbour Test Center and
is earning commission income of ₹ 36,000 per annum, net of taxes.
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Required:
ANALYSE whether it would be profitable for the hospital to purchase the machine? Give your
recommendation under:
(i) Net Present Value method
(ii) Profitability Index method.
Consider tax @30%. PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

SOLUTION:

Determination of Cash inflows ₹

Sales Revenue 1,20,000
Less: Operating Cost 22,500
97,500
Less: Depreciation (₹ 2,00,000 – ₹ 18,000)/8 22,750
Net Income 74,750
Tax @ 30% 22,425
Earnings after Tax (EAT) 52,325
Add: Depreciation 22,750
Cash inflow after tax per annum 75,075
Less: Loss of Commission Income 36,000
Net Cash inflow after tax per annum 39,075
In 8th Year :
New Cash inflow after tax 39,075
Add: Salvage Value of Machine 18,000
Net Cash inflow in year 8 57,075

(i) Calculation of Net Present Value (NPV)

Year CFAT (₹) PV Factor @ Present Value of Cash

10% inflows (₹)
1 to 7 39,075 4.867 1,90,178.03
8 57,075 0.467 26,654.03
2,16,832.06
Less: Cash Outflows 2,00,000.00
NPV 16,832.06

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 , , .
(ii) Profitability Index = = , ,
= 1.084

Advise: Since the net present value (NPV) is positive and profitability index is also greater than 1,
the hospital may purchase the machine.

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 CH. 6 : INTRODUCTION TO RISK ANALYSIS IN
CAPITAL BUDGETING

QUESTIONS AND ANSWERS

Question – 1
X Ltd. is considering installation of new machine with the following details:

Sr. No. Particulars Figures

1 Initial Investment ₹ 1400 Crore
2 Annual unit sales 100 Crore
3 Selling price per unit ₹ 40
4 Variable cost per unit ₹ 20
5 Annual Fixed costs ₹ 500 Crore
6 Depreciation ₹ 200 Crore
7 Discount Rate 12%
8 Tax rate 30%

Consider Life of the project as 4 years with no salvage value.

Required:
(i) CALCULATE the expected NPV of the project.
(ii) COMPUTE the impact on the project’s NPV if change in variables is as under and also
compute which variable is having maximum impact on NPV.

Sr. No. Particulars Figures

1. Unit sold per year 85 Crore
2. Selling price per unit ₹ 39
3. Variable cost per unit ₹ 22
4. Annual Fixed costs ₹ 575 Crore

PV factor at 12% are as follows:

Year 1 2 3 4
PV Factor 0.893 0.797 0.712 0.636

[RTP May 21]

ANSWER:
(i) Calculation of Net Cash Inflow per year:

Particulars Amount (₹)

A Selling Price Per Unit (A) 40
B Variable Cost Per Unit (B) 20
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 C Contribution Per Unit (C = A - B) 20
D Number of Units Sold Per Year 100 Crore
E Total Contribution (E = C × D) 2,000 Crore
F Annual Fixed costs 500 Crore
G Depreciation 200 Crore
H Net Profit before taxes (H = E - F - G) 1,300 Crore
I Tax @ 30% of H 390 Crore
J Net Cash Inflow Per Year (J = H - I + G) 910 Crore

Calculation of expected Net Present Value (NPV) of the Project:

Year Year Cash Flow PVAF @ 12% Present Value (PV)

(₹ in Crore) (₹ in Crore)
0 (1400.00) 1.000 (1400.00)
1-4 910.00 3.038 2,764.58
Net Present Value 1,364.58

(ii) Sensitivity Analysis under variable different value:

Changes in variable Base Units sold Selling Variable Annual

per year is price per cost per Fixed costs
85 unit is unit is is
Crore ₹ 39 ₹ 22 ₹ 575 Crore
Particulars (₹) (₹) (₹) (₹) (₹)
A Selling Price Per Unit 40 40 39 40 40
B Variable Cost Per Unit 20 20 20 22 20
C Contribution Per Unit 20 20 19 18 20
(C = A - B)
D Number of Units Sold Per 100 85 100 100 100
Year (in Crores)
E Total Contribution (E = C 2,000 1,700 1,900 1,800 2,000
× D)
F Annual Fixed Cost (in 500 500 500 500 575
Crores)
G Depreciation (in Crores) 200 200 200 200 200
H Net Profit before taxes 1,300 1,000 1,200 1,100 1,225
(H = E - F - G)
I Tax @ 30% of H 390 300 360 330 367.50
J Net Cash Inflow Per Year 910 700 840 770 857.50
(J = H - I + G)
K (J × 3.038) 2,764.58 2,126.60 2,551.92 2,339.26 2,605.09
L Initial Cash Flow 1400 1400 1400 1400 1400

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 M NPV (K - L) 1,364.58 726.60 1,151.92 939.26 1205.09
N Change in NPV (637.98) (212.66) (425.32) (159.49)
O Percentage Change in NPV -46.75% -15.58% -31.17% -11.69%

The above table shows that by varying one variable at a time while keeping the others constant,
the impact in percentage terms on the NPV of the project. Thus, it can be seen that the change in
units sold per year has the maximum effect on the NPV by 46.75%.

Question – 2
Gauav Ltd. is using certainty-equivalent approach in the evaluation of risky proposals. The
following information regarding a new project is as follows:

Year Expected Cash flow (₹) Certainty – equivalent quotient

0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3

Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the
project should be accepted?

SOLUTION:
Determination of Net Present Value (NPV)

Year Expected Certainty- Adjusted Cash PV factor (at Total PV (₹)

Cash flow (₹) equivalent (CE) flow (Cash flow 0.06)
x CE) (₹)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 – 4,00,000) 2,58,776

As the Net Present Value is positive the project should be accepted.

Question – 3
Following information have been retrieved from the finance department of Corp Finance Ltd.
relating to Projects X, Y and Z:

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 Particulars X Y Z
Net cash outlays (₹) 42,00,000 24,00,000 20,00,000
Project Life 5 years 5 years 5 years
Annual Cash inflow (₹) 14,00,000 8,40,000 6,00,000
Coefficient of variation 2.0 0.8 1.6

You are required to DETERMINE the risk adjusted net present value of the projects
considering that the Company selects risk-adjusted rate of discount on the basis of the
coefficient of variation:

Coefficient of Variation Risk-Adjusted Rate of Return P.V. Factor 1 or 5 years at

risk adjusted rate of discount
0.0 8% 3.992
0.4 10% 3.790
0.8 12% 3.604
1.2 14% 3.433
1.6 16% 3.274
2.0 20% 2.990
More than 2.0 22% 2.863

SOLUTION:
Statement showing the determination of the risk adjusted net present value

Projects Net cash Coefficie Risk Annual PV factor Discounte Net

outlays nt of adjusted cash 1-5 years d cash present
variation discount inflow inflow value
rate
(₹) (₹) (₹) (₹)
(i) (ii) (iii) (iv) (v) (vi) (vii) = (v) (viii) =
× (vi) (vii) −
(ii)
X 42,00,000 2.0 20% 14,00,000 2.990 41,86,000 -14,000
Y 24,00,000 0.8 12% 8,40,000 3.604 30,27,360 6,27,360
Z 20,00,000 1.6 16% 6,00,000 3.274 19,64,400 -35,600

Question – 4
The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive
proposals, Projects M and N, which require cash outlays of ₹ 8,50,000 and ₹ 8,25,000
respectively. The certainty-equivalent (C.E) approach is used in incorporating risk in capital
budgeting decisions. The current yield on government bonds is 6% and this is used as the risk
free rate. The expected net cash flows and their certainty equivalents are as follows:
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 Project M Project N
Year-end Cash Flow (₹) C.E. Cash Flow (₹) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7

Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and
0.840 respectively.
Required:
(i) ANALYSE which project should be accepted?
(ii) If risk adjusted discount rate method is used, IDENTIFY which project would be appraised
with a higher rate and why?

SOLUTION:
(i) Statement Showing the Net Present Value of Project M

Year end Cash Flow C.E. Adjusted Present Total

(₹) Cash flow (₹) value factor Present
at 6% value (₹)
(a) (b) (c) = (a) x (b) (d) (e) = (c) x (d)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
Less: Initial Investment 8,50,000
Net Present Value 10,980

Statement Showing the Net Present Value of Project N

Year end Cash Flow C.E. Adjusted Present Total

(₹) Cash flow (₹) value factor Present
value (₹)
(a) (b) (c) = (a) x (b) (d) (e) = (c) x (d)
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 4,50,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
9,96,315
Less: Initial Investment 8,25,000
Net Present Value 1,71,315

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 Decision: since the net present value of Project N is higher, so the project N should be accepted.
(ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4). This
means Project M is riskier than Project N as "higher the riskiness of a cash flow, the lower will be
the CE factor". If risk adjusted discount rate (RADR) method is used, Project M would be analysed
with a higher rate.

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 CH. 7 : FINANCIAL STATEMENT ANALYSIS

QUESTIONS AND ANSWERS

Question – 1
Given below are the estimation for the next year by Niti Ltd.

Particulars (₹ in crores)
Fixed Assets 5.20
Current Liabilities 4.68
Current Assets 7.80
Sales 23.00
EBIT 2.30
The company will issue equity funds of ₹ 5 crores in the next year. It is also considering the
debt alternatives of ₹ 3.32 crores for financing the assets. The company wants to adopt one
of the policies given below:
(₹ in crores)

Financing Policy Short term debt @ 12% Long term debt @ 16% Total
Conservative 1.08 2.24 3.32
Moderate 2.00 1.32 3.32
Aggressive 3.00 0.32 3.32
Assuming corporate tax rate at 30%, CALCULATE the following for each of the financing
policy:
(i) Return on total assets
(ii) Return on owner's equity
(iii) Net Working capital
(iv) Current Ratio
Also advise which Financing policy should be adopted if the company wants high returns.
[RTP May 21]

ANSWER:
(i) Return on total assets
( )
Return on total assets =
( )
₹ . ( . )
=
₹ . ₹ .
₹ .
= = 0.1238 or 12.38%
₹
(ii) Return on total assets
(Amount in ₹)
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 Financing policy (₹)
Conservative Moderate Aggressive
Expected EBIT 2,30,00,000 2,30,00,000 2,30,00,000
Less: Interest
Short term Debt @ 12% 12,96,000 24,00,000 36,00,000
Long term Debt @ 16% 35,84,000 21,12,000 5,12,000
Earnings before tax (EBT) 1,81,20,000 1,84,88,000 1,88,88,000
Less: Tax @ 30% 54,36,000 55,46,400 56,66,400
Earnings after Tax (EAT) 1,26,84,000 1,29,41,600 1,32,21,600
Owner's Equity 5,00,00,000 5,00,00,000 5,00,00,000
Return on owner’s equity =
, , ,
=
, , ,
=
, , ,
( ) , , , , , , , , ,
= = 0.2537 or = 0.2588 or = 0.2644 or
25.37% 25.88% 26.44%
(iii) Net Working capital
(₹ in crores)

Financing policy
Conservative Moderate Aggressive
Current Liabilities (Excluding Short Term Debt) 4.68 4.68 4.68
Short term Debt 1.08 2.00 3.00
Total Current Liabilities 5.76 6.68 7.68
Current Assets
7.80 7.80 7.80
Net Working capital 7.80 - 5.76 7.80 - 6.68 7.80 - 7.68
= Current Assets - Current Liabilities = 2.04 = 1.12 = 0.12

(iv) Current ratio

(₹ in crores)

Financing policy
Conservative Moderate Aggressive
Current Ratio . . .
= = 1.35 = = 1.17 = = 1.02
. . .
=

Advise: It is advisable to adopt aggressive financial policy, if the company wants high return as
the return on owner's equity is maximum in this policy i.e. 26.44%.

Question – 2
SN Ltd. has furnished the following ratios and information relating to the year ended 31st
March 2021:
Share Capital Rs. 6,25,000
Working Capital Rs. 2,00,000
Gross Margin 25%
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Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.7:1
Reserves & Surplus to Bank & Cash 3 times
Further, the assets of the company consist of fixed assets and current assets, while its current
liabilities comprise bank credit and others in the ratio of 3:1. Assume 360 days in a year.
You are required to PREPARE the Balance Sheet as on 31st March 2021.
(Note- Balance sheet may be prepared in traditional T Format.) [MTP March 21]

ANSWER:
Workings:
( ) .
1. Current Ratio = =
( )

∴ CA = 1.5 CL
Also, CA – CL = Rs. 2,00,000
1.5 CL – CL = Rs. 2,00,000
. , ,
CL = = Rs. 4,00,000
.
CA = 1.5 x ₹ 4,00,000 = Rs. 6,00,000
2. Bank Credit (BC) to Other Current Liabilities OCL) ratio = 3:1
( )
( )
=
BC = 3 OCL
Also, BC + OCL = CL
3 OCL + OCL = Rs. 4,00,000
. , ,
OCL = = Rs. 1,00,000

Bank Credit = 3 x Rs. 1,00,000 = Rs. 3,00,00

3. Quick Ratio =

. , ,
0.7 =
. , ,

Inventories = Rs. 6,00,000 – Rs. 2,80,000 = Rs. 3,20,000

4. Inventory Turnover = 5 times
( )
Inventory Turnover =

( )
Average Inventory =

COGS = Rs. 3,20,000 x 5 = Rs. 16,00,000

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5. Gross Margin = x 100 = 25%
, ,
Sales = = Rs. 21,33,333.33
.
6. Average Collection Period (ACP) = 1.5 Months = 45 days

Debtors Turnover = = = 8 times

Also, Debtors Turnover =

. , , .
Hence, Debtors = = Rs. 2.66,667

7. Bank & Cash = CA – (Debtors + Inventory)

= Rs. 6,00,000 - (Rs. 2,66,667 + 3,20,000) = Rs. 13,333
&
8. =3
&
Reserves & Surplus = 3 x Rs. 13,333 = Rs. 40,000
Balance Sheet of SN Ltd. as on 31st March 2021

Liabilities (Rs.) Assets (Rs.)

Share Capital 6,25,000 Fixed Assets 4,65,000
Reserves & Surplus 40,000 (Balancing Figure)
Current Liabilities: Current Assets:
Bank Credit 3,00,000 Inventories 3,20,000
Other Current Liabilities 1,00,000 Debtors 2,66,667
Bank & Cash 13,333
10,65,000 10,65,000

Question – 3
XYZ Ltd. has Owner’s equity of Rs. 2,00,000 and the ratios of the company are as follows:

Current debt to total debt 0.3

Total debt to Owner’s equity 0.5
Fixed assets to Owner’s equity 0.6
Total assets turnover 2 times
Inventory turnover 10 times
COMPLETE the following Balance Sheet from the information given above:

Liabilities (Rs.) Assets (Rs.)

Current Debt - Cash -
Long-term Debt - Inventory -
Total Debt - Total Current Assets -
Owner's Equity - Fixed Assets -

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 [MTP April 21 (5 Marks)]

ANSWER:
Balance Sheet

Liabilities (Rs.) Assets (Rs.)

Current debt 30,000 Cash (balancing figure) 1,20,000
Long term debt 70,000 Inventory 60,000
Total Debt 1,00,000 Total Current Assets 1,80,000
Owner's Equity 2,00,000 Fixed Assets 1,20,000
Total liabilities 3,00,000 Total Assets 3,00,000

Workings:
1. Total debt = 0.50 x Owner's Equity = 0.50 x Rs. 2,00,000 = Rs. 1,00,000
Further, Current debt to Total debt = 0.30
So, Current debt = 0.30 × Rs. 1,00,000 = Rs. 30,000
Long term debt = Rs. 1,00,000 - Rs. 30,000 = Rs. 70,000
2. Fixed assets = 0.60 × Owner's Equity = 0.60 × Rs. 2,00,000 = Rs. 1,20,000
3. Total Liabilities = Total Debt + Owner’s Equity
= Rs. 1,00,000 + Rs. 2,00,000 = Rs. 3,00,000
Total Assets = Total Liabilities = Rs. 3,00,000
Total assets to turnover = 2 Times; Inventory turnover = 10 Times
Hence, Inventory /Total assets = 2/10=1/5,
Therefore Inventory = Rs. 3,00,000/5 = Rs. 60,000

Question - 4
The total sales (all credit) of a firm are ₹ 6,40,000. It has a gross profit margin of 15 per cent
and a current ratio of 2.5. The firm’s current liabilities are a ₹ 96,000; inventories ₹ 48,000 and
cash ₹ 16,000.
(a) DETERMINE the average inventory to be carried by the firm, if an inventory turnover of 5
times is expected? (Assume a 360 day year).
(b) DETERMINE the average collection period if the opening balance of debtors is intended
to be of ₹ 80,000? (Assume a 360 day year).

SOLUTION:

(a) Inventory turnover =

Since gross profit margin is 15 per cent, the cost of goods sold should be 85 per cent of the sales.
Cost of goods sold = 0.85 x ₹ 6,40,000 = ₹ 5,44,000.

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 ₹ , ,
Thus, = =5

₹ , ,
Average inventory = = ₹ 1,08,800

(b) Average collection period = x 360 days

( )
Average Receivables =

Closing balance of receivables is found as follows:

Particulars ₹ ₹
Current assets (2.5 of current liabilities) 2,40,000
Less: Inventories 48,000
Cash 16,000 64,000
∴ Receivables 1,76,000
(₹ , , ₹ , )
Average Receivables =
₹ 2,56,000 ÷ 2 = ₹ 1,28,000
₹ , ,
Average collection period = x 360 = 72 days
₹ , ,

Question - 5
The capital structure of Beta Limited is as follows:

Equity share capital of ₹ 10 each 8,00,000

9% preference share capital of ₹ 10 each 3,00,000
11,00,000

Additional information: Profit (after tax at 35 per cent), ₹ 2,70,000; Depreciation, ₹ 60,000;
Equity dividend paid, 20 per cent; Market price of equity shares, ₹ 40.
You are required to COMPUTE the following, showing the necessary workings:
(b) Dividend yield on the equity shares
(c) Cover for the preference and equity dividends
(d) Earnings per shares
(e) Price-earnings ratio.

SOLUTION:
(a) Dividend yield on the equity shares
₹ ( . ×₹ )
= x 100 = x 100 = 5 per cent
₹

(b) Dividend coverage ratio

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 (ii) Preference =

₹ , ,
= = 10 times
₹ , ( . ×₹ , , )

(iii) Equity =
₹
₹ , , ₹ ,
= = 1.52 times
₹ , , ( , × ₹ )

(c) Earnings per equity share =

₹ , ,
= = ₹ 3.04 per share
,
₹
(d) Price- earning (P/E) ratio = = = 13.2 times
₹ .

Question - 6
The following accounting information and financial ratios of PQR Ltd. relate to the year ended
31st March, 2020

I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13 : 11
Current ratio 2:1
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4

If value of Fixed Assets as on 31st March, 2019 amounted to ₹ 26 lakhs, PREPARE a

summarised Profit and Loss Account of the company for the year ended 31st March, 2020 and
also the Balance Sheet as on 31st March, 2020.

SOLUTION:
(a) Working Notes:

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 (i) Calculation of Sales = =
, ,
∴ = ⇒ Sales = ₹ 78,00,000
(ii) Calculation of Current Assets

=
, ,
∴ = ⇒ Current Assets = ₹ 22,00,000
(iii) Calculation of Raw Material consumption and Direct Wages

₹
Sales 78,00,000
Less: Gross Profit 11,70,000
Works Cost 66,30,000

Raw Material Consumption (20% of Works Cost) ₹ 13,26,000

Direct Wages (10% of Works Cost) ₹ 6,63,000
(iv) Calculation of Stock of Raw Materials = (= 3 months usage)
= 13,26,000 x = ₹ 3,31,500
(v) Calculation of Stock of Finished Goods (= 6% of Works Cost)

= 66,30,000 x = ₹ 3,97,800

(vi) Calculation of Current Liabilities

=2
, ,
∴ = 2 ⇒ Current Liabilities = ₹ 11,00,000

(vii) Calculation of Receivables

Average collection period = x 365

x 365 = 60 ⇒ Receivables = ₹ 12,82,191.78 or ₹ 12,82,192

, ,

(viii) Calculation of Long term Loan

= ⇒ Long term loan = ₹ 22,00,000.

, ,

(ix) Calculation of Cash Balance

₹
Current assets 22,00,000

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 Less: Receivables
12,82,192
Raw Materials stock 3,31,500
Finished goods stock 3,97,800 20,11,492
Cash balance 1,88,508

(x) Calculation of Net worth

Fixed Assets 26,00,000

Current Assets 22,00,000
Total Assets 48,00,000
Less: Long term Loan 22,00,000
Current Liabilities 11,00,000 33,00,000
Net worth 15,00,000

Net worth = Share capital + Reserves = 15,00,000

= = ⇒ Share Capital

= 15,00,000 x = ₹ 3,00,000

Reserves and Surplus = 15,00,000 x = ₹ 12,00,000

Profit and Loss Account of PQR Ltd.

for the year ended 31st March, 2020

Particulars ₹ Particulars ₹
To Direct Materials 13,26,000 By Sales 78,00,000
To Direct Wages 6,63,000
To Works (Overhead) 46,41,000
Balancing figure
To Gross Profit c/d (15% of
Sales) 11,70,000 -
78,00,000 78,00,000
To Selling and Distribution 5,46,000 By Gross Profit b/d 11,70,000
Expenses (Balancing figure)
To Net Profit (8% of Sales) 6,24,000 -
11,70,000 11,70,000

Balance Sheet of PQR Ltd.

As at 31st March, 2020

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 Liabilities ₹ Assets ₹
Share Capital 3,00,000 Fixed Assets 26,00,000
Reserves and Surplus 12,00,000 Current Assets:
Long term loans 22,00,000 Stock of Raw Material 3,31,500
Current liabilities 11,00,000 Stock of Finished Goods 3,97,800
Receivables 12,82,192
Cash 1,88,508
48,00,000 48,00,000

Question - 7
Ganpati Limited has furnished the following ratios and information relating to the year ended
31st March, 2020.

Sales ₹ 60,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 7:3
Current ratio 2
Net profit to sales 6.25%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ₹ 18,00,000
Interest on debentures ₹ 60,000
Receivables ₹ 2,00,000
Payables ₹ 2,00,000

You are required to:

(a) CALCULATE the operating expenses for the year ended 31st March, 2020.
(b) PREPARE a balance sheet as on 31st March in the following format:
Balance Sheet as on 31st March, 2020

Liabilities (₹) Assets (₹)

Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash

SOLUTION:
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(a) Calculation of Operating Expenses for the year ended 31st March, 2020.

(₹)
Net Profit [@ 6.25% of Sales] 3,75,000
Add: Income Tax (@ 50%) 3,75,000
Profit Before Tax (PBT) 7,50,000
Add: Debenture Interest 60,000
Profit before interest and tax (PBIT) 8,10,000
Sales 60,00,000
Less: Cost of goods sold 18,00,000
PBIT 8,10,000 26,10,000
Operating Expenses 33,90,000

(b) Balance Sheet as on 31st March, 2020

Liabilities ₹ Assets ₹
Shares Capital 10,50,000 Fixed Assets 17,00,000
Reserve and Surplus 4,50,000 Current Assets:
15% Debentures 4,00,000 Stock 1,50,000
Payables 2,00,000 Receivables 2,00,000
- - Cash 50,000
21,00,000 21,00,000

Working Notes:
(i) Share Capital and Reserves
The return on net worth is 25%. Therefore, the profit after tax of ₹ 3,75,000 should be
equivalent to 25% of the net worth.

Net worth x = ₹3,75,000

₹ , ,
∴ Net Worth = = ₹ 15,00,000

The ratio of share capital to reserves is 7:3

Share Capital = 15,00,000 x = ₹ 10,50,000

Reserves = 15,00,000 x = ₹ 4,50,000

(ii) Debentures
Interest on Debentures @ 15% = ₹ 60,000
,
∴ Debentures = = ₹ 4,00,000

(iii) Current Assets

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 Current Ratio =2
Payables = ₹ 2,00,000
∴ Current Assets = 2 Current Liabilities = 2 x 2,00,000 = ₹ 4,00,000
(iv) Fixed Assets

Liabilities ₹
Share capital 10,50,000
Reserves 4,50,000
Debentures 4,00,000
Payables 2,00,000
21,00,000
Less: Current Assets 4,00,000
Fixed Assets 17,00,000

(v) Composition of Current Assets

Inventory Turnover = 12

= 12

₹ , ,
Closing stock = = Closing stock = ₹ 1,50,000

Composition ₹
Stock 1,50,000
Receivables 2,00,000
Cash (balancing figure) 50,000
Total Current Assets 4,00,000

Question - 8
Using the following information, PREPARE the balance sheet:

Long-term debt to net worth 0.5 to 1

Total asset turnover 2.5 x
Average collection period* 18 days
Inventory turnover 9x
Gross Profit margin 10%
Acid-test ratio 1 to 1

*Assume a 360-day year and all sales on credit.

₹ ₹

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 Cash ______________ Notes and payables 1,00,000
Accounts receivable ______________ Long-term debt ______________
Inventory ______________ Common Stock 1,00,000
Plant and equipment ______________ Retained earnings 1,00,000
Total assets ______________ Total liabilities and equity ______________

SOLUTION:

= 0.5 =
, ,

Long – term debt = ₹ 1,00,000

Total liabilities and net worth = ₹ 4,00,000
Total assets = ₹ 4,00,000

= 2.5 = = Sales = ₹ 10,00,000

, ,

Cost of goods sold = (0.9) (₹ 10,00,000) = ₹ 9,00,000.

, ,
= = 9 = Inventory = ₹ 1,00,000

= 18 days
, ,

Receivables = ₹ 50,000
,
=1
, ,

Cash = ₹ 50,000
Plant and equipment = ₹ 2,00,000.
Balance Sheet

₹ ₹
Cash 50,000 Notes and payables 1,00,000
Accounts receivable 50,000 Long-term debt 1,00,000
Inventory 1,00,000 Common stock 1,00,000
Plant and equipment 2,00,000 Retained earnings 1,00,000
Total assets 4,00,000 Total liabilities and equity 4,00,000

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 CH. 8 : WORKING CAPITAL MANAGEMENT

QUESTIONS AND ANSWERS

Question - 1
MT Ltd. has been operating its manufacturing facilities till 31.3.2021 on a single shift working
with the following cost structure:

(₹)
Cost of Materials 24
Wages (out of which 60% variable) 20
Overheads (out of which 20% variable) 20
64
Profit 8
Selling Price 72

As at 31.3.2021 with the sales of ₹ 17,28,000, the company held:

(₹)
Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime cost) 88,000
Finished goods (valued at total cost) 2,88,000
Sundry debtors 4,32,000

In view of increased market demand, it is proposed to double production by working an extra

shift. It is expected that a 10% discount will be available from suppliers of raw materials in
view of increased volume of business. Selling price will remain the same. The credit period
allowed to customers will remain unaltered. Credit availed from suppliers will continue to
remain at the present level i.e. 2 months. Lag in payment of wages and overheads will continue
to remain at one month.
You are required to CALCULATE the additional working capital requirements, if the policy to
increase output is implemented, to assess the impact of double shift for long term as a matter
of production policy. [RTP May 21]

ANSWER:
Workings:
(1) Statement of cost at single shift and double shift working

24,000 units 48,000 Units

Per unit (₹) Total (₹) Per unit (₹) Total (₹)
Raw materials 24 5,76,000 21.6 10,36,000
Wages:
Variable 12 2,88,000 12 5,76,000

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 Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,000 49.6 23,80,800
Profit 8 1,92,000 22.4 10,75,200
Sales 72 17,28,000 72 34,56,000
₹ , ,
(2) Sales in units 2020-21 = = = 24,000 units
₹

(3) Stock of Raw Materials in units on 31.3.2021

₹ , ,
= = = 6,000 units
₹

(4) Stock of work-in-progress in units on 31.3.2021

₹ ,
= = = 2,000 units
₹( )

(5) Stock of finished goods in units 2020-12

₹ , ,
= = = 4,500 units
₹

Comparative Statement of Working Capital Requirement

Single Shift (24,000 units) Double Shift (48,000 units)

Units Rate Amount Units Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 24 1,44,000 12,000 21.6 2,59,200
Work-in-Progress 2,000 44 88,000 2,000 37.6 75,200
Finished Goods 4,500 64 2,88,000 9,000 49.6 4,46,400
Sundry Debtors 6,000 64 3,84,000 12,000 49.6 5,95,200
Total Current Assets (A) 9,04,000 13,76,000
Current Liabilities
Creditors for Materials 4,000 24 96,000 8,000 21.6 1,72,800
Creditors for Wages 2,000 20 40,000 4,000 16 64,000
Creditors for Overheads 2,000 20 40,000 4,000 12 48,000
Total Current Liabilities (B) 1,76,000 2,84,800
Working Capital (A) – (B) 7,28,000 10,91,200

Analysis: Additional Working Capital requirement = ₹ 10,91,200 – ₹ 7,28,000 = ₹3,63,200, if the

policy to increase output is implemented.

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Question - 2
While applying for financing of working capital requirements to a commercial bank, TN
Industries Ltd. projected the following information for the next year:

Cost Element Per unit (₹) Per Unit (₹)

Raw materials
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration overheads 20
(excluding depreciation)
Depreciation 10
Selling overheads 15
113

Additional Information:
(a) Raw Materials are purchased from different suppliers leading to different credit period
allowed as follows:
X – 2 months; Y– 1 months; Z – ½ month
(b) Production cycle is of ½ month. Production process requires full unit of X and Y in the
beginning of the production. Z is required only to the extent of half unit in the beginning
and the remaining half unit is needed at a uniform rate during the production process.
(c) X is required to be stored for 2 months and other materials for 1 month.
(d) Finished goods are held for 1 month.
(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed
by debtors is 2 months.
(f) Average time lag in payment of all overheads is 1 months and ½ months for direct labour.
(g) Minimum cash balance of ₹ 8,00,000 is to be maintained.
CALCULATE the estimated working capital required by the company on cash cost basis if the
budgeted level of activity is 1,50,000 units for the next year. The company also intends to
increase the estimated working capital requirement by 10% to meet the contingencies.
(You may assume that production is carried on evenly throughout the year and direct labour
and other overheads accrue similarly.) [RTP May 21]

ANSWER:
Statement showing Working Capital Requirements of TN Industries Ltd. (on cash cost basis)

Amount in (₹) Amount in (₹)

A. Current Assets
(i) Inventories:

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 Raw Material
, , ₹
X x 2 months 7,50,000
, , ₹
Y x 1 month 87,500
, , ₹
Z x 1 month 75,000
, , ₹
WIP x 0.5 month 4,00,000
, , ₹
Finished goods x 1 month 11,00,000 24,12,500

(ii) Receivables (Debtors)

, , ₹ 19,31,250
x 2 months x 0.75

(iii) Cash and bank balance 8,00,000

Total Current Assets 51,43,750
B. Current Liabilities:
(i) Payables (Creditors) for Raw Materials
, , ₹
X x 2 months 7,50,000
, , ₹
Y x 1 month 87,500
, , ₹
Z x 0.5 month 37,500 8,75,000

(ii) Outstanding Direct Labour

, , ₹ 1,56,250
x 0.5 month

(iii) Outstanding Manufacturing and administration

overheads 2,50,000
, , ₹
x 1 month

(iv) Outstanding Selling overheads

, , ₹ 1,87,500
x 1 month

Total Current Liabilities 14,68,750

Net Working Capital Needs (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working capital requirement 40,42,500

Workings:
1.

(i) Computation of Cash Cost of Production Per unit (₹)

Raw Material consumed 43
Direct Labour 25

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 Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit (₹)
Cash cost of production as in (i) above 88
Selling overheads 15
Cash cost of sales 103

2. Calculation of Cost of WIP

Particulars Per Unit (₹)

Raw material (added at the beginning): 30
X 7
Y 3
Z (₹ 6 x 50%)
Cost during the year: 1.5
Z {(₹ 6 x 50%) x 50%}
Direct Labour (₹ 25 x 50%) 12.5
Manufacturing and administration overheads (₹ 20 x 50%) 10
64

Question - 3
PREPARE monthly cash budget for the first six months of 2021 on the basis of the following
information:
(i) Actual and estimated monthly sales are as follows:

Actual (Rs.) Estimated (Rs.)

October 2020 2,00,000 January 2021 60,000
November 2020 2,20,000 February 2021 80,000
December 2020 2,40,000 March 2021 1,00,000
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000

(ii) Operating Expenses (including salary & wages) are estimated to be payable as follows:

Actual (Rs.) Estimated (Rs.)

January 2021 22,000 April 2021 30,000
February 2021 25,000 May 2021 25,000
March 2021 30,000 June 2021 24,000

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales are collected after
one month, 30% after two months and 10% after three months.

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(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month
preceding the sales.
(v) The firm has 12% debentures of Rs.1,00,000. Interest on these has to be paid quarterly in
January, April and so on.
(vi) The firm is to make an advance payment of tax of Rs. 5,000 in April.
(vii) The firm had a cash balance of Rs. 40,000 at 31st Dec. 2020, which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level is made up
by temporary investments/liquidation of temporary investments or temporary borrowings
at the end of each month (interest on these to be ignored).
[MTP March 21 (10 Marks)]

ANSWER:
Monthly Cash Budget for first six months of 2021 (Amount in Rs.)

Particulars Jan. Feb. Mar. April May June

Opening balance 40,000 40,000 40,000 40,000 40,000 40,000
Receipts:
Cash sales 15,000 20,000 25,000 30,000 20,000 15,000
Collection from debtors 1,72,500 97,500 67,500 67,500 82,500 70,500
Total cash available (A) 2,27,500 1,57,500 1,32,500 1,37,500 1,42,500 1,25,500
Payments:
Purchases 64,000 80,000 96,000 64,000 48,000 96,000
Operating Expenses 22,000 25,000 30,000 30,000 25,000 24,000
Interest on debentures 3,000 - - 3,000 - -
Tax payment - - - 5,000 - -
Total payments (B) 89,000 1,05,000 1,26,000 1,02,000 73,000 1,20,000
Minimum cash balance desired 40,000 40,000 40,000 40,000 40,000 40,000
Total cash needed (C) 1,29,000 1,45,000 1,66,000 1,42,000 1,13,000 1,60,000
Surplus/(deficit) (A - C) 98,500 12,500 (33,500) (4,500) 29,500 (34,500)
Investment/financing
Temporary Investments (98,500) (12,500) - - (29,500) -
Liquidation of temporary 33,500 4,500
investments or temporary - 34,500
borrowings
Total effect of 4,500 (29,500) 34,500
investment/financing(D) (98,500) (12,500) 33,500
Closing cash balance (A + D - B) 40,000 40,000 40,000 40,000 40,000 40,000

Workings:
1. Collection from Debtors: (Amount in Rs.)

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 Year 2020 Year 2021
Oct. Nov. Dec. Jan. Feb. Mar. April May June
Total sales 2,00,000 2,20,000 2,40,000 60,000 80,000 1,00,000 1,20,000 80,000 60,000
Credit sales
(75% of total 1,50,000 1,65,000 1,80,000 45,000 60,000 75,000 90,000 60,000 45,000
Collections:
One month 90,000 99,000 1,08,000 27,000 36,000 45,000 54,000 36,000
Two months 45,000 49,500 54,000 13,500 18,000 22,500 27,000
Three months 15,000 16,500 18,000 4,500 6,000 7,500
Total
collections 1,72,500 97,500 67,500 67,500 82,500 70,500

2. Payment to Creditors: (Amount in Rs.)

Year 2021
Jan Feb Mar Apr May Jun Jul
Total sales 60,000 80,000 1,00,000 1,20,000 80,000 60,000 1,20,000
Purchases 96,000
(80% of total
sales) 48,000 64,000 80,000 96,000 64,000 48,000
Payment:
One month prior 64,000 80,000 96,000 64,000 48,000 96,000

Question - 4
WQ Limited is considering relaxing its present credit policy and is in the process of evaluating
two proposed polices. Currently, the firm has annual credit sales of Rs. 180 lakh and Debtors
turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs. 6 lakh. The
firm is required to give a return of 25% on the investment in new accounts receivables. The
company’s variable costs are 60% of the selling price. Given the following information,
DETERMINE which is a better Policy?
(Amount in Lakhs)

Present Proposed Policy

Policy Option I Option II
Annual credit sales (Rs.) 180 220 280
Debtors turnover ratio 4 3.2 2.4
Bad debt losses (Rs.) 6 18 38
[MTP April 21 (10 Marks)]

ANSWER:
Statement showing evaluation of Credit Policies
(Amount in lakhs)

Particulars Present Proposed Policy

(Rs.) (Rs.)
Option I Option II

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A Expected Profit:
(a) Credit Sales 180 220 280
(b) Total Cost other than Bad Debts:
Variable Costs (60%) 108 132 168
(c) Bad Debts 6 18 38
(d) Expected Profit [(a)-(b)-(c)] 66 70 74
B Opportunity Cost of Investment in Debtors (Refer 6.75 10.31 17.5
workings)
C Net Benefits [A - B] 59.25 59.69 56.5

Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy
is higher than those under other policies.
Workings:
Calculation of Opportunity Cost of Investment in Debtors
∗
Opportunity Cost = Total Cost x x
*Collection period (in months) = 12/Debtors turnover ratio
/
Present Policy = Rs. 108 x x = Rs. 6.75 lakhs
/ .
Proposed Policy I = Rs. 132 x x = Rs. 10.31 lakhs
/ .
Proposed Policy II = Rs. 168 x x = Rs. 17.5 lakhs

Question - 5
Following information is forecasted by R Limited for the ending 31st March, 2020:

Balance as at Balance as at
31st March, 2020 31st March, 2019
(₹ in lakh) (₹ in lakh)
Raw Material 65 45
Work-in-progress 51 35
Finished goods 70 60
Receivables 135 112
Payables 71 68
Annual purchase of raw material (all credit) 400
Annual cost of production 450
Annual cost of goods sold 525
Annual operating cost 325

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 Annual sales (all credit) 585

You may take one year as equal to 365 days.

You are required to CALCULATE:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.

SOLUTION:
Working Notes:
1. Raw Materials Storage Period (R)

= x 365

₹ ₹

= x 365 = 52.83 or 53 days

₹

Annual Consumption of Raw Material = Opening Stock + Purchases – Closing Stock

= ₹ 45 + ₹ 400 - ₹ 65 = ₹ 380 lakh
2. Work –in – Progress (WIP) Conversion Period (W)

WIP Conversion Period = x 365

₹ ₹

= x 365 = 34.87 or 35 days

₹
3. Finished Stock Storage Period (F)

= x 365
₹ ₹

= x 365 = 45.19 or 45 days.

₹
4. Receivables (Debtors) Collection Period (D)

= x 365
₹ ₹

= x 365 = 77.05 or 77 days

₹
5. Payables (Creditors) Payment Period (C)

= x 365

₹₹ ₹

= x 365 = 63.41 or 64 days

₹
(i) Net operating Cycle Period
=R+W+F+D–C

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 = 53 + 35 + 45 + 77 – 64
= 146 days
(ii) Number of Operating Cycles in the Year

= = = 2.5 times

(iii) Amount of Working Capital Required

₹
= = = ₹ 130 lakh
.

Question - 6
The following figures and rations are related to a company:

(i) Sales for the year (all credit) ₹ 90,00,000

(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1

You are required to Prepare:

(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a
provision for contingencies @15 percent of net working capital.

SOLUTION:
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)
= ₹ 90,00,000 – ₹ 31,50,000
= ₹ 58,50,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
= ₹ 58,50,000/6 = ₹ 9,75,000
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ₹ 58,50,000/1.5
= ₹ 39,00,000

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(iv) Current Assets :
Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
Current Assets = Amount of Inventories (Stock) × 2.5/1
= ₹ 9,75,000 × 2.5/1 = ₹ 24,37,500
Or
Current Ratio / Quick Ratio = Current Assets / Quick Assets
2.5 / 1.5 = Current Assets / (Current Assets – Inventory)
2.5/1.5 Current Assets – 2.5/1.5 x ₹ 9,75,000 = Current Assets
Hence, Current Assets = ₹ 24,37,500
(v) Liquid Assets (Receivables and Cash)
= Current Assets – Inventories (Stock)
= ₹ 24,37,500 – ₹ 9,75,000
= ₹14,62,500
(vi) Receivables (Debtors) = Sales × Debtors Collection period /12
= ₹ 90,00,000 × 1/12
= ₹ 7,50,000
(vii) Cash = Liquid Assets – Receivables (Debtors)
= ₹14,62,500 – ₹ 7,50,000 = ₹ 7,12,500
(viii) Net worth = Fixed Assets /1.3
= ₹ 39,00,000/1.3 = ₹ 30,00,000
(ix) Reserves and Surplus
Reserves and Share Capital = Net worth
Net worth = 1 + 1.5 = 2.5
Reserves and Surplus = ₹ 30,00,000 × 1/1.5
= ₹ 20,00,000
(x) Share Capital = Net worth – Reserves and Surplus
= ₹ 30,00,000 – ₹ 20,00,000
= ₹ 10,00,000
(xi) Current Liabilities = Current Assets/ Current Ratio
= ₹ 24,37,500/2.5 = ₹ 9,75,000
(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ₹30,00,000 × 0.7875 = ₹23,62,500
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(a) Balance Sheet of the Company

Particulars Figures as the end Figures as the end

of 31-03-2020 of 31-03-2019 (₹)
I. EQUITY AND LIABILITIES
Shareholders’ funds
(a) Share capital 10,00,000 --
(b) Reserves and surplus 20,00,000 --
Non-current liabilities
(a) Long-term borrowings 23,62,500 --
Current liabilities 9,75,000 --
Total 63,37,500 --
II. ASSETS
Non-current assets
Fixed assets 39,00,000 --
Current assets
Inventories 9,75,000 --
Trade receivables 7,50,000 --
Cash and cash equivalents 7,12,500 --
Total 63,37,500 --

(b) Statement Showing Working Capital Requirement

(₹) (₹)
A. Current Assets
(i) Inventories (Stocks) 9,75,000
(ii) Receivables (Debtors) 7,50,000
(iii) Cash in hand & at bank 7,12,500
Total Current Assets 24,37,500
B. Current Liabilities:
Total Current Liabilities 9,75,000
Net Working Capital (A – B) 14,62,500
Add: Provision for contingencies
(15% of Net Working Capital) 2,19,375
Working capital requirement 16,81,875

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Question - 7
PQ Ltd., a company newly commencing business in 2020 has the following projected profit
and Loss Account:

(₹) (₹)
Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provisions for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 17,000
1,53,000

The figure given above relate only to finished goods and not to work-in-progress. Goods equal
to 15% of the year’s production (in terms of physical units) will be in process on the average
requiring full materials but only 40% of the other expenses. The company believes in keeping
materials equal to two months’ consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months
credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of the Income tax
will be paid in advance in quarterly instalments. The company wishes to keep ₹ 8,000 in cash.
10% has to be added to the estimated figure for unforeseen contingencies.
PREPARE an estimate of working capital.
Note: All workings should form part of the answer.

SOLUTION:
Statement showing the requirements of Working Capital

Particulars (₹) (₹)

A. Current Assets:
Inventory:

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 Stock of Raw material (₹ 96,600 x 2/12) 16,100
Stock of Work-in-progress (As per Working Note) 16,350
Stock of Finished goods (₹ 1,46,500 x 10/100) 14,650
Receivables (Debtors) (₹ 1,27,080 x 2/12) 21,180
Cash in Hand 8,000
Prepaid Expenses:
Wages & Mfg. Expenses (₹ 66,250 x 1/12) 5,521
Administrative expenses (₹ 14,000 x 1/12) 1,167
Selling & Distribution Expenses (₹ 13,000 x 1/12) 1,083
Advance taxes paid {(70% of ₹ 10,000) x 3/12} 1,750
Gross Working Capital 85,801 85,801
B. Current Liabilities:
Payables for Raw materials (₹ 1,12,700 x 1.5/12) 14,088
Provision for Taxation (Net of Advance Tax) (₹10,000 x 3,000
30/100)
Total Current Liabilities 17,088 17,088
C. Excess of CA over CL 63,713
Add: 10% for unforeseen contingencies 6,871
Net Working Capital requirements 75,584

Working Notes:
(i) Calculation of Stock of Work-in-progress

Particulars (₹)
Raw Material (₹ 84,000 x 15%) 12,600
Wages & Mfg. Expenses (₹ 62,500 x 15% x 40%) 3,750
Total 16,350

(ii) Calculation of Stock of Finished Goods and Cost of Sales

Particulars (₹)
Direct material Cost [₹ 84,000 + ₹ 12,600] 96,600
Wages & Mfg. Expenses [₹ 62,500 + ₹ 3,750] 66,250
Depreciation 0
Gross Factory Cost 1,62,850
Less: Closing W.I.P (16,350)

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 Cost of goods produced 1,46,500
Add: Administrative Expenses 14,000
1,60,500
Less: Closing stock (14,650)
Cost of Goods Sold 1,45,850
Add: Selling and Distribution Expenses 13,000
Total Cash Cost of Sales 1,58,850
Debtors (80% of cash cost of sales) 1,27,080

(iii) Calculation of Credit Purchase

Particulars (₹)
Raw material consumed 96,600
Add: closing Stock 16,100
Less: Opening Stock -
Purchases 1,12,700

Question - 8
M.A. Limited is commencing a new project for manufacture of a Plastic component. The
following cost information has been ascertained for annual production of 12,000 units which
is the full capacity:

Costa per unit (₹)

Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00

The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per unit, 80 of
which is variable.
In the first two years of operations, production and sales are expected to be as follows:

Year Production (No. of units) Sales (No. of units)

1 6,000 5,000
2 9,000 8,500

To assess the working capital requirements, the following additional information is available:

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 (a) Stock of materials 2.25 months’ average consumption
(b) Work-in-process Nil
(c) Debtors 1 month’s average sales.
(d) Cash balance ₹ 10,000
(e) Creditors for supply of materials ₹1 month’s average purchase during the year.
(f) Creditors for expenses 1 month’s average of all expenses during the
year.

PREPARE, for the two years:

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

SOLUTION:
(i) M.A. Limited
Projected Statement of Profit / Loss
(Ignoring Taxation)

Year 1 Year 2
Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
(₹) (₹)
Sales revenue (A) 4,80,000 8,16,000
(Sales unit x ₹ 96)
Cost of Production:
Materials cost 2,40,000 3,60,000
(Units produced x ₹ 40)
Direct labour and variable expenses 1,20,000 1,80,000
(Units produced x ₹ 20)
Fixed manufacturing expenses 72,000 72,000
(Production Capacity: 12,000 units x ₹ 6)
Depreciation 1,20,000 1,20,000
(Production Capacity : 12,000 units x ₹ 10)
Fixed administration expenses 48,000 48,000
(Production Capacity : 12,000 units x ₹ 4)
Total Costs of Production 6,00,000 7,80,000
Add: Opening stock of finished goods --- 1,00,000
(Year : Nil; Year 2: 1,000 units)

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 Cost of Goods available for sale 6,00,000 8,80,000
(Year 1 : 6,000 units; Year 2: 10,000 units)
Less: Closing stock of finished goods at average cost (year 1 : 1000 (1,00,000) (1,32,000)
units, year 2 : 1500 units)
(Cost of Production x Closing stock/ units produced)
Cost of Goods Sold 5,00,000 7,48,000
Add: Selling expenses – Variable (Sales unit x ₹ 4) 20,000 34,000
Add: Selling expenses – Fixed (12,000 units x ₹ 1) 12,000 12,000
Cost of Sales: (B) 5,32,000 7,94,000
Profit (+) / Loss (-): (A – B) (-) 52,000 (+) 22,000

Working Notes:
1. Calculation of creditors for supply of materials:

Year 1 (₹) Year 2 (₹)

Materials consumed during the year 2,40,000 3,60,000
Add: Closing stock (2.25 month’s average 45,000 67,500
consumption)
2,85,000 4,27,500
Less: Opening Stock --- 45,000
Purchases during the year 2,85,000 3,82,500
Average purchases per month (Creditors) 23,750 31,875

2. Creditors for expenses:

Year 1 (₹) Year 2 (₹)

Direct labour and variable expenses 1,20,000 1,80,000
Fixed manufacturing expenses 72,000 72,000
Fixed administration expenses 48,000 48,000
Selling expenses (variable + fixed) 32,000 46,000
Total (including 2,72,000 3,46,000
Average per month 22,667 28,833

(ii) Projected Statement of Working Capital requirements

Year 1 (₹) Year 2 (₹)

Current Assets:
Inventories:

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 - Stock of materials 45,000 67,500
(2.25 month’s average consumption)
- Finished goods 1,00,000 1,32,000
Debtors (1 month’s average sales) (including profit) 40,000 68,000
Cash 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,95,000 2,77,500
Current Liabilities:
Creditors for supply of materials 23,750 31,875
(Refer to working note 1
Creditors for expenses 22,667 28,833
(Refer to working note 2)
Total Current Liabilities: (B) 46,417 60,708
Estimated Working Capital Requirements; (A – B) 1,48,583 2,16,792

Projected Statement of Working Capital Requirement

(Cash Cost Basis)

Year 1 (₹) Year 2 (₹)

(A) Current Assets
Inventories:

­ Stock of Raw Material 45,000 67,500

(6,000 units x ₹ 40 x 2.25/12);
(9,000 units x ₹ 40 x 2.25/12)

­ Finished Goods (Refer working note 3) 80,000 1,11,000

Receivables (Debtors) (Refer working note 4) 36,000 56,250

Minimum Cash balance 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,71,000 2,44,750
(B) Current Liabilities
Creditors for raw materials (Refer working note 1) 23,750 31,875
Creditors for Expenses (Refer working note 2) 22,667 28,833
Total Current Liabilities 46,417 ₹60,708
Net Working Capital (A – B) 1,24,583 1,84,042

Working Note:
3. Cash Cost of Production:

Year 1 (₹) Year 2 (₹)

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 Cost of Production as per projected Statement of P&L 6,00,000 7,80,000
Less: Depreciation 1,20,000 1,20,000
Cash Cost of Production 4,80,000 6,60,000
Add: Opening Stock at Average Cost: -- 80,000
Cash Cost of Goods Available for sale 4,80,000 7,40,000
Less: Closing Stock at Avg. Cost
₹ , , × , ₹ , , × , (80,000) (1,11,000)
,
; ,

Cash Cost of Goods Sold 4,00,000 6,29,000

4. Receivables (Debtors)

Year 1 (₹) Year 2 (₹)

Cash Cost of Goods Sold 4,00,000 6,29,000
Add: Variable Expenses @ ₹ 4 20,000 34,000
Add: Total Fixed Selling expenses (12,000 units x ₹1) 12,000 12,000
Cash Cost of Debtors 4,32,000 6,75,000
Average Debtors 36,000 56,250

Question - 9
Aneja Limited, a newly formed company, has applied to a commercial bank for the first time
for financing its working capital requirements. The following information is available about the
projections for the current year:
Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-
progress. Based on the above activity, estimated cost per unit is:
Raw material ₹ 80 per unit
Direct wages ₹ 30 per unit
Overheads (exclusive of depreciation) ₹ 60 per unit
Total cost ₹ 170 per unit
Selling price ₹ 200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50%
completion stage in respect of conversion cost) (materials issued at the start of the
processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at banks (for smooth operation) is expected to be ₹ 25,000.

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Assume that production is carried on evenly throughout the year (52 weeks) and wages and
overheads accrue similarly. All sales are on credit basis only.
You are required to CALCULATE the net working capital required.

SOLUTION:
Calculation of Net Working Capital requirement:

(₹) (₹)
A. Current Assets:
Inventories:
- Raw material stock 6,64,615
(Refer to Working note 3)
- Work in progress stock 5,00,000
(Refer to Working note 2)
- Finished goods stock 13,60,000
(Refer to Working note 4)
Receivables (Debtors) 25,10,769
(Refer to Working note 5)
Cash and Bank balance 25,000
Gross Working Capital 50,60,384 50,60,384
B. Current Liabilities:
Creditors for raw materials 7,15,740
(Refer to Working note 6)
Creditors for wages 91,731
(Refer to Working note 7)
8,07,471 8,07,471
Net Working Capital (A – B) 42,52,913

Working Notes:
1. Annual cost of production

(₹)
Raw material requirements 86,40,000
{(1,04,000 units × ₹ 80) + ₹3,20,000}
Direct wages {(1,04,000 units × ₹ 30) + ₹60,000} 31,80,000
Overheads (exclusive of depreciation) 63,60,000
{(1,04,000 × ₹ 60) + ₹1,20,000}
Gross Factory Cost 1,81,80,000
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 Less: Closing W.I.P (5,00,000)
Cost of Goods Produced 1,76,80,000
Less: Closing Stock of Finished Goods (13,60,000)
(₹1,76,80,000 × 8,000/1,04,000)
Total Cash Cost of Sales 1,63,20,000

2. Work in progress stock

(₹)
Raw material requirements (4,000 units x ₹ 80) 3,20,000
Direct wages (50% x 4,000 units x ₹ 30) 60,000
Overheads (50% x 4,000 units x ₹ 60) 1,20,000
5,00,000

3. Raw material stock

It is given that raw material in stock is average 4 weeks consumption. Since, the company is newly
formed, the raw material requirement for production and work in progress will be issued and
consumed during the year.
Hence, the raw material consumption for the year (52 weeks) is as follows:

(₹)
For Finished goods (1,04,000 x ₹ 80) 83,20,000
For Work in progress (4,000 x ₹ 80) 3,20,000
86,40,000
₹ , ,
Raw material stock x 4 weeks i.e. ₹ 6,64,615

4. Finished goods stock: 8,000 units @ ₹ 170 per unit = ₹ 13,60,000

5. Debtors for sale: 1,63,20,000 x = 25,10,769

6. Creditors for raw material:

Material Consumed (₹ 83,20,000 + ₹ 3,20,000) ₹ 86,40,000
Add: Closing stock of raw material ₹ 6,64,615
Purchases of Raw Material ₹ 93,04,615
₹ , ,
Credit allowed by suppliers = x 4 weeks = 7,15,740

7. Creditors for wage

₹ , ,
Outstanding wage payment = x 1.5 weeks = ₹ 91,731

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Question - 10
The following information relates to Zeta Limited, a publishing company:
The selling price of a book is ₹ 15, and sales are made on credit through a book club and
invoiced on the last day of the month.
Variable costs of production per book are materials (₹ 5), labour (₹ 4), and overhead (₹ 2)
The sales manager has forecasted the following volumes:

Month No. of Books

November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August

Customers are expected to pay us follows:

One month after the sale 40%

Two months after the sale 60%

The company produces the books two months before they are sold and the creditors are paid
two months after production.
Variable overheads are paid in the month following production and are expected to increase
by 25% in April; 75% of wages are paid in the month of production and 25% in the following
month. A wage increase of 12.5% will take place on 1st Mach.
The company is going through a restructuring and will sell one its freehold properties in May
for ₹ 25,000, but it is also planning to buy a new printing press in May for ₹ 10,000. Depreciation
is currently ₹ 1,000 per month, and will rise to ₹ 1,500 after the purchase of the new machine.
The company’s corporation tax (of ₹ 10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 2019, of ₹ 1,500.
You are required to PREPARE a cash budget for the six months from January to June, 2020.

SOLUTION:
Workings:
1. Sales receipts

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 Month Nov Dec Jan Feb Mar Apr May Jun
Forecast sales (S) 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
S×15 15,000 15,000 15,000 18,750 22,500 30,000 28,500 33,000
Debtors pay:
1 month 40% 6,000 6,000 6,000 7,500 9,000 12,000 11,400
2 month 60% - 9,000 9,000 9,000 11,250 13,500 18,000
- - 15,000 15,000 16,500 20,250 25,500 29,400

2. Payment for materials – books produced two months before sale

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
Materials (Q×5) 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
Paid (2 months - - 5,000 6,250 7,500 10,000 9,500 11,000
after)

3. Variable overheads

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
Var. overhead 2,000 2,500 3,000 4,000 3,800
(Q×2)
Var. overhead 5,500 5,500 5,750
(Q×2.50)
Paid one month 2,000 2,500 3,000 4,000 3,800 5,500 5,500
later

4. Variable overheads

Month Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹
Wages (Q x 4) 5,000 6,000 8,000
Wages (Q x 4.50) 8,550 9,900 9,900 10,350
75% this month 3,750 4,500 6,000 6,412 7,425 7,425 7,762
25% this month 1,250 1,500 2,000 2,137 2,475 2,475

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 5,750 7,500 8,412 9,562 9,900 10,237

Cash budget – six months ended June

Month Jan Feb Mar Apr May Jun

Receipts:
Sales receipts 15,000 15,000 16,500 20,250 25,500 29,400
Freehold property - - - - 25,000 -
15,000 15,000 16,500 20,250 50,500 29,400
Payments:
Materials 5,000 6,250 7,500 10,000 9,500 11,000
Var. overheads 2,500 3,000 4,000 3,800 5,500 5,500
Wages 5,750 7,500 8,412 9,562 9,900 10,237
Printing press - - - - 10,000 -
Corporation tax - - 10,000 - - -
13,250 16,750 29,912 23,362 34,900 26,737
Net cash flow 1,750 (1,750) (13,412) (3,112) 15,600 2,663
Balance b/f 1,500 3,250 1,500 (11,912) (15,024) 576
Cumulative cash flow 3,250 1,500 (11,912) (15,024) 576 3,239

Question - 11
From the information and the assumption that the cash balance in hand on 1st January 2020 is
₹ 72,500, PREPARE a cash budget.
Assume that 50 per cent of total sales are cash sales. Assets are to be acquired in the months
of February and April. Therefore, provisions should be made for the payment of ₹ 8,000 and ₹
25,000 for the same. An application has been made to the bank for the grant of a loan of ₹
30,000 and it is hoped that the loan amount will be received in the month of May.
It is anticipated that a dividend of ₹ 35,000 will be paid in June. Debtors are allowed one
month’s credit. Creditors for materials purchased and overheads grant one month’s credit.
Sales commission at 3 per cent on sales is paid to the salesman each month.

Month Sales Material Salaries & Production Office and

Purchases Wages Overheads Selling
Overheads
(₹) (₹) (₹) (₹) (₹)
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500

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April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500

SOLUTION:
Cash Budget

Jan Feb Mar Apr May June Total

₹ ₹ ₹ ₹ ₹ ₹ ₹
Receipts
Cash sales 36,000 48,500 43,000 44,300 51,250 54,350 2,77,400
Collections from - 36,000 48,500 43,000 44,300 51,250 2,23,050
debtors
Bank loan - - - - 30,000 - 30,000
Total 36,000 84,500 91,500 87,300 1,25,550 1,05,600 5,30,450
Payments
Materials - 25,000 31,000 25,500 30,600 37,000 1,49,100
Salaries and wages 10,000 12,100 10,600 25,000 22,000 23,000 1,02,700
Production - 6,000 6,300 6,000 6,500 8,000 32,800
overheads
Office & selling - 5,500 6,700 7,500 8,900 11,000 39,600
overheads
Sales commission 2,160 2,910 2,580 2,658 3,075 3,261 16,644
Capital - 8,000 - 25,000 - - 33,000
expenditure
Dividend - - - - - 35,000 35,000
Total 12,160 59,510 57,180 91,658 71,075 1,17,261 4,08,844
Net cash flow 23,840 24,990 34,320 (4,358) 54,475 (11,661) 1,21,606
Balance, beginning 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106
of month
Balance, end of 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106 3,15,712
month

Question - 12
Consider the balance sheet of Maya Limited as on 31 December, 2019. The company has
received a large order and anticipates the need to go to its bank to increase its borrowings.
As a result, it has to forecast its cash requirements for January, February and March, 2020.

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Typically, the company collects 20 per cent of its sales in the month of sale, 70 per cent in the
subsequent month, and 10 per cent in the second month after the sale. All sales are credit
sales.

Equity & liabilities Amount (₹ Assets Amount (₹

in ‘000) in ‘000)
Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,439 Inventories 545
Long-term borrowings 450 Accounts receivables 530
Accounts payables 360 Cash and bank 50
Loan from banks 400
Other liabilities 212
2,961 2,961

Purchases of raw materials are made in the month prior to the sale and amounts to 60 per cent
of sales. Payments for these purchases occur in the month after the purchase. Labour costs,
including overtime, are expected to be ₹ 1,50,000 in January, ₹ 2,00,000 in February, and ₹
1,60,000 in March. Selling, administrative, taxes, and other cash expenses are expected to be
₹ 1,00,000 per month for January through March. Actual sales in November and December
and projected sales for January through April are as follows (in thousands):

Month ₹ Month ₹ Month ₹

November 500 January 600 March 650
December 600 February 1,000 April 750

On the basis of this information:

(a) PREPARE a cash budget for the months of January, February, and March.
(b) DETERMINE the amount of additional bank borrowings necessary to maintain a cash
balance of ₹ 50,000 at all times.
(c) PREPARE a pro forma balance sheet for March 31.

SOLUTION:
(a) Cash Budget (in thousands)

Nov. Dec. Jan. Feb. Mar. Apr.

₹ ₹ ₹ ₹ ₹ ₹
Sales 500 600 600 1,000 650 750
Collections, current month’s sales 120 200 130
Collections, previous month’s sales 420 420 700
Collections, previous 2 month’s 50 60 60
sales

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 Total cash receipts 590 680 890
Purchases 360 600 390 450
Payment for purchases 360 600 390
Labour costs 150 200 160
Other expenses 100 100 100
Total cash disbursements 610 900 650
Receipts less disbursements (20) (220) 240

(b)

Jan. Feb. Mar.

₹ ₹ ₹
Additional borrowings 20 220 (240)
Cumulative borrowings (Opening balance of 400) 420 640 400

The amount of financing peaks in February owing to the need to pay for purchases made the
previous month and higher labour costs. In March, substantial collections are made on the prior
month’s billings, causing large net cash inflow sufficient to pay off the additional borrowings.
(c) Pro forma Balance Sheet, 31st March, 2020

Equity & Liabilities Amount Assets Amount

(₹ in ‘000) (₹ in ‘000)
Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,529 Inventories 635
Long-term borrowings 450 Accounts receivables 620
Accounts payables 450 Cash and bank 50
Loan from banks 400
Other liabilities 212
3,141 3,141

Accounts receivable = Sales in March x 0.8 + Sales in February x 0.1

Inventories = ₹ 545 + Total purchases from January to March – Total sales from
January to March x 0.6
Accounts payable = Purchases in March
Retained earnings = ₹ 1,439 + Sales – Payment for purchases – Labour costs and – Other
expenses, all for January to March

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Question - 13
PQR Ltd. having an annual sales of ₹ 30 lakhs, is re-considering its present collection policy.
At present, the average collection period is 50 days and the bad debt losses are 5% of sales.
The company is incurring an expenditure of ₹ 30,000 on account of collection of receivables.
Cost of funds is 10 percent.
The alternative policies are as under:

Alternative I Alternative II
Average Collection Period 40 days 30 days
Bad Debt Loses 4% of sales 3% of sales
Collection Expenses ₹ 60,000 ₹ 95,000

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

SOLUTION:
Evaluation of Alternative Collection Programmes

Present Policy Alternative I Alternative II

₹ ₹ ₹
Sales Revenues 30,00,000 30,00,000 30,00,000
Average Collection Period (ACP) (days) 50 40 30

Receivables (₹) Sales × 4,16,667 3,33,333 2,50,000

Reduction in Receivables from Present - 83,334 1,66,667

Level (₹)
Savings in Interest @ 10% p.a. - ₹ 8,333 ₹ 16,667
(A)
% of Bad Debt Loss 5% 4% 3%
Amount (₹) 1,50,000 1,20,000 90,000
Reduction in Bad Debts from Present - 30,000 60,000
Level
(B)
Incremental Benefits from Present Level - 38,333 76,667
(C) = (A) + (B)
Collection Expenses (₹) 30,000 60,000 95,000
Incremental Collection Expenses from
Present Level (D) - 30,000 65,000
Incremental Net Benefit (C – D) - ₹ 8,333 ₹ 11,667

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Conclusion: From the analysis it is apparent that Alternative I has a benefit of ₹ 8,333 and Alternative
II has a benefit of ₹ 11,667 over present level. Alternative II has a benefit of ₹ 3,334 more than
Alternative I. Hence Alternative II is more viable.
(Note: In absence of Cost of Sales, sales has been taken for purpose of calculating investment in
receivables. 1 year = 360 days.)

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