FINANCIAL MANAGEMENT ARIVUPRO ACADEMY

INDEX VERSION 3:

TOPIC PAGE NO
1. SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT 1.2-1.6

2. TYPES OF FINANCING 2.1-2.10

3. FINANCIAL ANALYSIS & PLANNING - RATIO ANALYSIS 3.1-3.26
4. COST OF CAPITAL 4.1-4.20
5. CAPITAL STRUCTURE 5.1-5.17
6. LEVERAGES 6.1-6.21
7. INVESTMENT DECISIONS 7.1-7.42
8. RISK ANALYSIS IN CAPITAL BUDGETING 8.1-8.15
9. DIVIDEND DECISION 9.1-9.11
10. MANAGEMENT OF WORKING CAPITAL 10.1-10.38

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Chapter 1 SCOPE & OBJECTIVES OF FINANCIAL MANAGEMENT

INTRODUCTION-

 For the purpose of starting any new business/venture, an entrepreneur goes through the following
stages of decision making:

Stage 1 Stage 2 Stage 3 Stage 4

Decide which assets Determining what is total how much cash he would The next stage is to decide
(premises, machinery, investment (since assets need to run the daily what all sources, does the
equipment etc.) to cost money) required for operations (payment for entrepreneur
buy buying assets. raw material, salaries, need to tap to finance the
wages etc.). In other total investment (assets
words this is also defined and working capital). The
as Working Capital sources could be Share
Requirement Capital (Including
Entrepreneur’s Own funds
or Bank Borrowings or
others

 Thus, financial management is concerned with efficient acquisition (financing) and allocation
(investment in assets, working capital etc.) of funds with an objective to make profit (dividend) for
owners. In other words, focus of financial management is to address three major financial decision
areas namely, investment, financing and dividend decisions.

MEANING OF FINANCIAL MANAGEMENT-

 Financial management is that managerial activity which is concerned with planning and
controlling of the firm’s financial resources.
 In other words it is concerned with acquiring, financing and managing assets to accomplish the
overall goal of a business enterprise (mainly to maximise the shareholder’s wealth).
 Financial Management can also be defined as planning for the future of a business enterprise to
ensure a positive cash flow.

ASPECTS OF FINANCIAL MANAGEMENT-

 Procurement of funds
 Effective use of these funds to achieve business objectives

PROCUREMENT OF FUNDS-
 Funds procured from different sources have different characteristics in terms of risk, cost and control.
 some of the sources of funds:
 Equity: The funds raised by the issue of equity shares are the best from the risk point of view
for the firm, since there is no question of repayment of equity capital except when the firm is
under liquidation. From the cost point of view, however, equity capital is usually the most
expensive source of funds. This is because the dividend expectations of shareholders are
normally higher than prevalent interest rate and also because dividends are an appropriation
of profit, not allowed as an expense under the Income Tax Act. Also the issue of new shares
to public may dilute the control of the existing shareholders.

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 Debentures: Debentures as a source of funds are comparatively cheaper than the shares
because of their tax advantage. However, debentures entail a high degree of risk since they
have to be repaid as per the terms of agreement. Also, the interest payment has to be made
whether or not the company makes profits
 Funding from Banks: Commercial Banks play an important role in funding of the business
enterprises. Apart from supporting businesses in their routine activities (deposits, payments
etc.) they play an important role in meeting the long term and short term needs of a business
enterprise.

EFFECTIVE UTILISATION OF FUNDS-

 Utilization for Fixed Assets:
 The funds are to be invested in the manner so that the company can produce at its optimum
level without endangering its financial solvency.
 For this, the finance manager would be required to possess sound knowledge of techniques
of capital budgeting
 Capital budgeting (or investment appraisal) is the planning process used to determine
whether a firm's long term investments such as new machinery, replacement machinery, new
plants, new products, and research development projects would provide the desired return
(profit).
 Utilization for Working Capital: The finance manager must also keep in view the need for adequate
working capital and ensure that while the firms enjoy an optimum level of working capital they do
not keep too much funds blocked in inventories, book debts, cash etc.

EVOLUTION OF FINANCIAL MANAGEMENT-

 The Traditional Phase: During this phase, financial management was considered necessary only
during occasional events such as takeovers, mergers, expansion,liquidation, etc.
 The Transitional Phase: During this phase, the day-to-day problems that financial managers faced
were given importance. The general problems related to funds analysis, planning and control were
given more attention in this phase.
 The Modern Phase: During this phase, many theories have been developed regarding efficient
markets, capital budgeting, option pricing, valuation models and also in several other important
fields in financial management.

FINANCE FUNCTIONS/ FINANCE DECISION-

 The finance functions are divided into long term and short term functions/decisions.
 Long term Finance Function Decisions.
(a) Investment decisions (I): These decisions relate to the selection of assets in which funds will
be invested by a firm. Funds procured from different sources have to be invested in various
kinds of assets. Long term funds are used in a project for various fixed assets and also for current
assets. The investment of funds in a project has to be made after careful assessment of the
various projects through capital budgeting.
(b) Financing decisions (F):
 These decisions relate to acquiring the optimum finance to meet financial objectives.
 The financial manager needs to possess a good knowledge of the sources of available
funds and their respective costs and needs to ensure that the company has a sound
capital structure, i.e. a proper balance between equity capital and debt, Risk & hedging
(someone who has a shop, takes care of the risk of the goods being destroyed by fire by
hedging it via a fire insurance contract)

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(c) Dividend decisions(D): These decisions relate to the determination as to how much and how
frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders & the amount to be retained to support the growth of the organisation
 Short- term Finance Decisions/Function- Generally short term decision are reduced to
management of current asset and current liability (i.e., working capital Management)

TASKS OF FINANCIAL MANAGEMENT-

 Taking care not to over-invest in fixed assets.
 Balancing cash-outflow with cash-inflows
 Ensuring that there is a sufficient level of short-term working capital
 Setting sales revenue targets that will deliver growth
 Tax planning that will minimize the taxes a business has to pay

OBJECTIVES OF FINANCIAL MANAGEMENT-

 Profit Maximisation
 Wealth/Value Maximisation

Profit Maximisation-
 It has traditionally been argued that the primary objective of a company is to earn profit; hence the
objective of financial management is also profit maximisation.
 This implies that the finance manager has to make his decisions in a manner so that the profits of the
concern are maximised. Each alternative, therefore, is to be seen as to whether or not it gives
maximum profit.
 If profit is given undue importance, a number of problems can arise. Some of these have been
discussed below (The profit maximization is not an operationally feasible criterion.” IDENTIFY-
RTP MAY 2020)
 The term profit is vague. It does not clarify what exactly it means. It conveys a different
meaning to different people. For example, profit may be in short term or long term period; it
may be total profit or rate of profit etc.
 Profit maximisation has to be attempted with a realisation of risks involved. There is a
direct relationship between risk and profit. Many risky propositions yield high profit. Higher
the risk, higher is the possibility of profits. If profit maximisation is the only goal, then risk
factor is altogether ignored. This implies that finance manager will accept highly risky
proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.
 Profit maximisation as an objective does not take into account the time pattern of
returns
 Profit maximisation as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society, as
well as ethical trade practices.

Wealth / Value Maximisation-

 Wealth = Present value of benefits – Present Value of Costs.
 For measuring and maximising shareholders wealth finance manager should follow:
 Cash Flow approach not Accounting Profit
 Cost benefit analysis
 Application of time value of money
 Value of a firm (V) = Number of Shares (N) ×Market price of shares (MP) OR
 V = Value of equity (Ve ) + Value of debt (Vd )

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Goal Objective Advantages Disadvantages

Profit Large i.(Easy to calculate profits i.(Emphasizes short the
Maximization amount of ii.
i Easy to determine the term
i gains
profits link
) between financial ii.) Ignores risk or
decisions and profits. uncertainty
( iii.
( Ignores the timing
i ofi returns
i i
) )
Shareholders Highest i.i.Emphasizes
E the long i. Offers no clear
Wealth market term gains.
m relationship between
Maximisation value of ii. Recognises Risks & financial decisions &
shares Uncertainty. share price.
iii. Recognised the timing ii. can lead to
of returns. management anxiety
& frustration.

1. Profit maximization does not consider risk or uncertainty, whereas wealth maximization
considers both risk and uncertainty. Suppose there are two products, X and Y, and their
projected earnings over the next 5 years are as shown below:
Year Product X (Rs) Product Y (Rs)
1. 10,000 11,000
2. 10,000 11,000
3. 10,000 11,000
4. 10,000 11,000
5. 10,000 11,000
50,000 55,000
Solution-
A profit maximization approach would favour product Y over product X. However, if product Y is more risky
than product X, then the decision is not as straightforward as the figures seem to indicate. It is important to
realize that a trade-off exists between risk and return. Stockholders expect greater returns from
investments of higher risk and vice-versa. To choose product Y, stockholders would demand a sufficiently
large return to compensate for the comparatively greater level of risk

ROLE OF FINANCE EXECUTIVE/CFO-

 Budgeting
 Managing M&As
 Pricing analysis
 Decisions about outsourcing
 Overseeing the IT function
 Overseeing the HR function
 Risk management

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FINANCIAL DISTRESS AND INSOLVENCY -

 financial distress is a position where Cash inflows of a firm are inadequate to meet all its current
obligations.
 insolvency basically means inability of a firm to repay various debts and is a result of continuous
financial distress

AGENCY PROBLEM AND AGENCY COST-

 Though in a sole proprietorship firm, partnership etc., owners participate in management but in
corporates, owners are not active in management so, there is a separation between owner/
shareholders and managers.
 In theory managers should act in the best interest of shareholders however in reality, managers may
try to maximise their individual goal like salary, perks etc.,
 so there is a principal agent relationship between managers and owners, which is known as
Agency Problem.
 In a nutshell, Agency Problem is the chances that managers may place personal goals ahead of the
goal of owners.
 Agency Problem leads to Agency Cost.
 Agency cost is the additional cost borne by the shareholders to monitor the manager and control
their behaviour so as to maximise shareholders wealth.
 Addressing the agency problem :
 The agency problem of debt lender would be addressed by imposing negative covenants i.e.
the managers cannot borrow beyond a point.
 Agency problem between the managers and shareholders can be addressed if Managerial
compensation is linked to profit of the company to some extent and also with the long term
objectives of the company

Inter relationship between investment, financing and dividend decisions-

 The finance functions are divided into three major decisions, viz., investment, financing and
dividend decisions.
 It is correct to say that these decisions are interrelated because the underlying objective of these
three decisions is the same, i.e. maximisation of shareholders’ wealth.
 Since investment, financing and dividend decisions are all interrelated, one has to consider the joint
impact of these decisions on the market price of the company’s shares and these decisions should
also be solved jointly.
 The decision to invest in a new project needs the finance for the investment. The financing decision,
in turn, is influenced by and influences dividend decision because retained earnings used in internal
financing deprive shareholders of their dividends.
 An efficient financial management can ensure optimal joint decisions. This is possible by evaluating
each decision in relation to its effect on the shareholders’ wealth.

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Chapter 2 TYPES OF FINANCING

LONG-TERM SOURCES OF FINANCE-

A) OWNERS CAPITAL OR EQUITY CAPITAL-

Characteristics-
 It is a source of permanent capital. The holders of such share capital in the company are called
equity shareholders or ordinary shareholders.
 Equity shareholders are practically owners of the company as they undertake the highest risk
 Equity shareholders are entitled to dividends after the income claims of other stakeholders are
satisfied. The dividend payable to them is an appropriation of profits and not a charge against
profits
 In the event of winding up, ordinary shareholders can exercise their claim on assets after the claims
of the other suppliers of capital have been met
 The cost of ordinary shares is usually the highest. This is due to the fact that such shareholders
expect a higher rate of return

Advantages of raising funds by issue of equity shares-

 It is a permanent source of finance. Since such shares are not redeemable, the company has no
liability for cash outflows associated with its redemption.
 The company is not obliged legally to pay dividends. Hence in times of uncertainties or when the
company is not performing well, dividend payments can be reduced or even suspended
 The company can make further issue of share capital by making a right issue

Disadvantages of raising funds by issue of equity shares are-

 The cost of ordinary shares is higher because dividends are not tax deductible
 Investors find ordinary shares riskier because of uncertain dividend payments and capital gains
 The issue of new equity shares reduces the earning per share of the existing shareholders until and
unless the profits are proportionately increased
 The issue of new equity shares can also reduce the ownership and control of the existing
shareholders and there is a risk of takeover of business.

B) PREFERENCE SHARE CAPITAL-

Characteristics-
 Such shares are normally cumulative, i.e., the dividend payable in a year of loss gets carried over to
the next year till there are adequate profits to pay the cumulative dividends.
 The rate of dividend on preference shares is normally higher than the rate of interest on debentures,
loans etc.
 Most of preference shares these days carry a stipulation of period and the funds have to be repaid at
the end of a stipulated period

Sl. No. Type of Preference Shares Salient Features

1 Cumulative Arrear Dividend will accumulative

2 Non-cumulative No right to arrear dividend

3 Redeemable Redemption should be done

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4 Participating Participate also in the surplus of

firm
5 Non- Participating Over fixed rate of Dividend
6 Convertible Option of Convert into equity
Shares
Advantages of the preference shares:-
 No dilution in EPS on issue of Preference shares
 There is no risk of takeover as the preference shareholders do not have voting rights except in case
where dividend arrears exist
Disadvantages of the preference shares:
 One of the major disadvantages of preference shares is that preference dividend is not tax
deductible. Hence a preference share is costlier to the company than debt e.g. debenture.
 Preference dividends are cumulative in nature. This means that although these dividends may be
omitted, they shall need to be paid later. Also, if these dividends are not paid, no dividend can be
paid to ordinary shareholders. The non-payment of dividend to ordinary shareholders could
seriously impair the reputation of the company concerned.
 It is a permanent source of finance and needs to be repaid after a point of time.

C) RETAINED EARNINGS (PLOUGHING BACK OF PROFITS)–

 Long-term funds may also be provided by accumulating the profits of the company and by
ploughing them back into business.
 Such funds belong to the ordinary shareholders and increase the net worth of the company.
 Such funds also entail almost no risk
 They don’t have any cost of issue.

D) DEBENTURES-
Some of the characteristics of Debentures are:-
 Debentures are either secured or unsecured.
 May or may not be listed on the stock exchange.
 The cost of capital raised through debentures is quite low since the interest payable on debentures
can be charged as an expense before tax.
 From the investors' point of view, debentures offer a more attractive prospect than the preference
shares since interest on debentures is payable whether or not the company makes profits.
 Debentures are thus instruments for raising long-term debt capital
Types of Debentures Features
Bearer Transferable like negotiable instruments
Registered Interest payable to registered person
Mortgage Secured by a charge on Assets
Naked or simple Unsecured
Redeemable Repaid after a certain period
Non-Redeemable Not repayable

Advantages of raising finance by issue of debentures are:

 The cost of debentures is much lower than the cost of preference or equity capital as the interest is
tax-deductible
 Debenture financing does not result in dilution of control

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 No dilution in EPS

The disadvantages of debenture financing are:

 Debenture interest and capital repayment are obligatory payments.
 The protective covenants associated with a debenture issue may be restrictive
 Since debentures need to be paid during maturity, a large amount of cash outflow is needed at that
time

E) BOND –
Bond is fixed income security created to raise fund. Bonds can be raised through Public Issue and through
Private Placement.
Types of Bond
 Callable bonds - A callable bond has a call option which gives the issuer the right to redeem the
bond before maturity at a predetermined price known as the call price (Generally at a premium).
 Puttable bonds: Puttable bonds give the investor a put option (i.e. the right to sell the bond) back to
the company before maturity.

Foreign Bonds-
Name of the Bond Features
Plain Vanilla Bond  The issuer would pay the principal amount along with the
interest rate
 This type of bond would not have any options
Drop Lock Bond  A Floating Rate Note with a normal floating rate
 The floating rate bond would be automatically converted into
fixed rate bond if interest rate falls below a predetermined level
 The new fixed rate stays till the drop lock bond reaches its
maturity
Yankee Bond  Bonds denominated in dollars
 Bonds issued by non- US banks and non- US corporations
 Bonds are issued in USA
 Bonds are to be registered in SEC (Securities and Exchange
Commission)
Samurai Bond  Denominated in Japanese Yen JPY
 Issued in Tokyo
 Issuer Non- Japanese Company
 Regulations : Japanese
 Purpose : Access of capital available in Japanese market
Bulldog Bond  Denominated in Bulldog Pound Sterling/Great Britain Pound
(GBP)
 Issued in London
 Issuer Non- UK Company
 Regulations: Great Britain
 Purpose: Access of capital available in UK market
Fully Hedged Bond  In Foreign Bonds, the risk of currency fluctuations exists.
 Fully Hedged Bonds eliminate the risk by selling in forward
markets the entire stream of principal and interest payments.

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Indian Bonds-
Name of the Bond Features
Masala Bond  Masala (means spice) bond is an Indian name used for Rupee
denominated bond that Indian corporate borrowers can sell to
investors in overseas markets.
 These bonds are issued outside India but denominated in Indian
Rupees
 NTPC raised Rs 2,000 crore via masala bonds for its capital
expenditure in the year 2016
Municipal Bonds  Municipal bonds are used to finance urban infrastructure are
increasingly evident in India
 Ahmedabad Municipal Corporation issued a first historical
Municipal Bond in Asia to raise 100 crore from the capital
market for part financing a water supply project
Government or Treasury Bonds Government or Treasury bonds are bonds issued by Government of
India, Reserve Bank of India, any state Government or any other
Government department

LOANS FROM COMMERCIAL BANKS –

Bridge Finance-
 Bridge finance refers to loans taken by a company normally from commercial banks for a short
period because of pending disbursement of loans sanctioned by financial institutions
 Normally, it takes time for financial institutions to disburse loans to companies. However, once the
loans are approved by the term lending institutions, companies, in order not to lose further time in
starting their projects, arrange short term loans from commercial banks.
 The bridge loans are repaid/ adjusted out of the term loans as and when disbursed by the
concerned institutions.
 Bridge loans are normally secured by hypothecating movable assets, personal guarantees and
demand promissory notes.
 Generally, the rate of interest on bridge finance is higher as compared with that on term loans.

VENTURE CAPITAL FINANCING-

The venture capital financing refers to financing of new high risky venture promoted by qualified
entrepreneurs who lack experience and funds to give shape to their ideas
Features-
 It is basically an equity finance in new companies
 It can be viewed as a long term investment in growth-oriented small/medium firms.
 Apart from providing funds, the investor also provides support in form of sales strategy, business
networking and management expertise, enabling the growth of the entrepreneur

Methods of Venture Capital Financing-

 Equity financing: The venture capital undertakings generally require funds for a longer period but
may not be able to provide returns to the investors during the initial stages. Therefore, the venture
capital finance is generally provided by way of equity share capital. The equity contribution of
venture capital firm does not exceed 49% of the total equity capital of venture capital undertakings
so that the effective control and ownership remains with the entrepreneur.
 Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to
generate sales. No interest is paid on such loans. In India venture capital financiers charge royalty
ranging between 2 and 15 per cent; actual rate depends on other factors of the venture such as

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gestation period, cash flow patterns, risk and other factors of the enterprise. Some Venture capital
financiers give a choice to the enterprise of paying a high rate of interest (which could be well above
20 per cent) instead of royalty on sales once it becomes commercially sound.
 Income note: It is a hybrid security which combines the features of both conventional loan and
conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially
low rates.
 Participating debenture: Such security carries charges in three phases — in the start up phase no
interest is charged, next stage a low rate of interest is charged up to a particular level of operation,
after that, a high rate of interest is required to be paid

DEBT SECURITISATION –
 Securitisation is a process in which illiquid assets are pooled into marketable securities that can be
sold to investors.
 These assets are generally secured by personal or real property such as automobiles, real estate, or
equipment loans but in some cases are unsecured.

Process of Debt Securitisation:

(a) The origination function – A borrower seeks a loan from a finance company or a bank. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over
the life of the loan.
(b) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for
investors.
(c) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The
securities carry a coupon and expected maturity which can be asset-based/mortgage based. These are
generally sold to investors through merchant bankers. Investors are – pension funds, mutual funds,
insurance funds.

The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is
under an obligation to pay to investors only if the cash flows are received by him from the collateral.

LEASE FINANCING-
 Leasing is a general contract between the owner and user of the asset over a specified period of
time.
 The asset is purchased initially by the lessor (leasing company) and thereafter leased to the user
(lessee company) which pays a specified rent at periodical intervals.

Types of Lease Contracts: Broadly lease contracts can be divided into following two categories:
(a) Operating Lease –
 A lease is classified as an operating lease if it does not secure for the lessor the recovery of
capital outlay plus a return on the funds invested during the lease term.
 Normally, these are callable lease and are cancelable with proper notice.
 The term of this type of lease is shorter than the asset’s economic life.

(b) Finance Lease -

 In contrast to an operating lease, a financial lease is longer term in nature and non-cancelable.
 In general term, a finance lease can be regarded as any leasing arrangement that is to finance the
use of equipment for the major parts of its useful life.
 The lessee has the right to use the equipment while the lessor retains legal title. It is also called
capital lease

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Comparison between Financial Lease and Operating Lease

Sl no Finance Lease Operating Lease
1 The risk and reward incident to ownership are The lessee is only provided the use of the asset
passed on to the lessee. The lessor only for a certain time. Risk incident to ownership
remains the legal owner of the asset. belong wholly to the lessor
2 The lessee bears the risk of obsolescence The lessor bears the risk of obsolescence
3 the lease is non-cancellable by either party As the lessor does not have difficulty in leasing
the same asset to other willing lessor, the lease is
kept cancelable by the lessor
4 Lessee bears cost of repairs, maintenance Usually Lessor bears cost of repairs, maintenance
5 The lease is usually full payout, that is, the The lease is usually non-payout, since the lessor
single lease repays the cost of the asset expects to lease the same asset over and over
together with the interest again to several users

Other Types of Leases-

 Sales and Lease Back :
 Under this type of lease, the owner of an asset sells the asset to a party (the buyer), who in
turn leases back the same asset to the owner in consideration of a lease rentals.
 Under this transaction, the seller assumes the role of lessee and the buyer assumes the role
of a lessor
 Leveraged Lease :
 Under this lease, a third party is involved beside lessor and lessee.
 The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party
i.e., lender and asset so purchased is held as security against the loan.
 The lender is paid off from the lease rentals directly by the lessee and the surplus after
meeting the claims of the lender goes to the lessor.
 The lessor is entitled to claim depreciation allowance.
 Sales-aid Lease :
 Under this lease contract, the lessor enters into a tie up with a manufacturer for marketing
the latter’s product through his own leasing operations, it is called a sales-aid lease.
 In consideration of the aid in sales, the manufacturers may grant either credit or a
commission to the lessor.
 Thus, the lessor earns from both sources i.e. from lessee as well as the manufacturer.
 Close-ended and Open-ended Leases :
 In the close-ended lease, the assets get transferred to the lessor at the end of lease, the risk
of obsolescence, residual value etc., remain with the lessor being the legal owner of the
asset.
 In the open-ended lease, the lessee has the option of purchasing the asset at the end of the
lease period

SHORT TERM SOURCES OF FINANCE-

 Trade Credit:
 It represents credit granted by suppliers of goods, etc., as an incident of sale.
 Trade credit is preferred as a source of finance because it is without any explicit cost
 Another very important characteristic of trade credit is that it enhances automatically with
the increase in the volume of business
 Accrued Expenses and Deferred Income:
 Accrued expenses represent liabilities which a company has to pay for the services which it
has already received like wages, taxes, interest and dividends.

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 Such expenses arise out of the day-to-day activities of the company and hence represent a
spontaneous source of finance.
 Advances from Customers:
 Manufacturers and contractors engaged in producing or constructing costly goods involving
considerable length of manufacturing or construction time usually demand advance money
from their customers at the time of accepting their orders for executing their contracts or
supplying the goods. This is a cost free source of finance
 Treasury Bills:
 Treasury bills are a class of Central Government Securities. Treasury bills, commonly referred
to as T-Bills are issued by Government of India to meet short term borrowing requirements
with maturities ranging between 14 to 364 days.
 Certificates of Deposit (CD):
 A certificate of deposit (CD) is basically a savings certificate with a fixed maturity date of not
less than 15 days up to a maximum of one year.

 Bank Advances-
Some of the facilities provided by banks are
(a) Short Term Loans:
 It is a single advance and given against securities like shares, government securities, life
insurance policies and fixed deposit receipts, etc.
 Repayment under the loan account may be the full amount or by way of schedule of
repayments agreed upon as in case of term loans
(b) Overdraft:
 Under this facility, customers are allowed to withdraw in excess of credit balance
standing in their Current Account.
 A fixed limit is, therefore, granted to the borrower within which the borrower is allowed
to overdraw his account.
 Though overdrafts are repayable on demand, they generally continue for long periods by
annual renewals of the limits.
 This is a convenient arrangement for the borrower as he is in a position to avail of the
limit sanctioned, according to his requirements.
 Interest is charged on daily balances

(c) Clean Overdrafts:

 The bank has to rely upon the personal security of the borrowers.
 they have no backing of any tangible security
 A clean advance is generally granted for a short period

(d) Cash Credits:

 Cash Credit is an arrangement under which a customer is allowed an advance up to
certain limit
 Under this arrangement, a customer need not borrow the entire amount of advance at
one time; he can only draw to the extent of his requirements
 Interest is not charged on the full amount of the advance but on the amount actually
availed of by him

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FINANCING OF EXPORT TRADE BY BANKS:

The advances by commercial banks for export financing are in the form of:
(i) Pre-shipment finance i.e., before shipment of goods (PACKING CREDITS)
(ii) Post-shipment finance i.e., after shipment of goods.

Packing credit is an advance extended by banks to an exporter for the purpose of buying, manufacturing,
processing, packing, shipping goods to overseas buyers.

Types of Packing Credit

(a) Clean packing credit:
 This is an advance made available to an exporter only on production of a firm export order or
a letter of credit without exercising any charge or control over raw material or finished
goods.
 A suitable margin has to be maintained
(b) Packing credit against hypothecation of goods:
 Export finance is made available on certain terms and conditions where the exporter has pledge
able interest and the goods are hypothecated to the bank as security with stipulated margin.
 At the time of utilising the advance, the exporter is required to submit, along with the firm
export order or letter of credit relative stock statements and thereafter continue submitting
them every fortnight and/or whenever there is any movement in stocks
(c) E.C.G.C. guarantee:
 Any loan given to an exporter for the manufacture, processing, purchasing, or packing of
goods meant for export against a firm order qualifies for the packing credit guarantee issued
by Export Credit Guarantee Corporation

POST-SHIPMENT FINANCE:
(a) Purchase/discounting of documentary export bills:
 Finance is provided to exporters by purchasing export bills drawn payable at sight or by
discounting usance export bills covering confirmed sales and backed by documents including
documents of the title of goods such as bill of lading, post parcel receipts, or air consignment
notes.
(b) Advance against export bills sent for collection:
 Finance is provided by banks to exporters by way of advance against export bills forwarded
through them for collection, taking into account the creditworthiness of the party, nature of
goods exported.
 Appropriate margin is kept
(c) Advance against duty draw backs, cash subsidy, etc.:
 To finance export losses sustained by exporters, bank advance against duty draw-back, cash
subsidy, etc., receivable by them against export performance.
 Such advances are of clean nature

OTHER SOURCES OF FINANCING-

(a) Seed Capital Assistance:
 The Seed capital assistance scheme is designed by IDBI for professionally or technically qualified
entrepreneurs and/or persons possessing relevant experience, skills and entrepreneurial traits but
lack adequate financial resources.
 The Seed Capital Assistance is interest free but carries a service charge of one per cent per annum
for the first five years and at increasing rate thereafter.

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 However, IDBI will have the option to charge interest at such rate as may be determined by IDBI on
the loan if the financial position and profitability of the company so permits during the currency of
the loan.
 The repayment schedule is fixed depending upon the repaying capacity of the unit with an initial
moratorium upto five years

(b) Deep Discount Bonds:

 Deep Discount Bonds is a form of zero-interest bonds. These bonds are sold at a discounted value
and on maturity face value is paid to the investors.
 In such bonds, there is no interest payout during lock in period.

(c) Zero Coupon Bonds:

 A Zero Coupon Bonds does not carry any interest but it is sold by the issuing company at a
discount.
 The difference between the discounted value and maturing or face value represents the interest
to be earned by the investor on such bonds.

(d) Inflation Bonds:

 Inflation Bonds are the bonds in which interest rate is adjusted for inflation.
 For example, if the interest rate is 11 per cent and the inflation is 5 per cent, the investor will
earn 16 per cent meaning thereby that the investor is protected against inflation

INTERNATIONAL FINANCING-
(a) Commercial Banks: Like domestic loans, commercial banks all over the world extend Foreign
Currency (FC) loans also for international operations.
(b) Discounting of Trade Bills: This is used as a short term financing method. It is used widely in Europe
and Asian countries to finance both domestic and international business
(c) External Commercial Borrowings (ECB): ECBs refer to commercial loans (in the form of bank loans ,
buyers credit) availed from non-resident lenders with minimum average maturity of 3 years.
Borrowers can raise ECBs through internationally recognised sources like (i) international banks, (ii)
international capital markets, (iii) multilateral financial institutions such as the International Finance
Corporation(IFC), Asian Development Bank(ADB) etc
(d) EURO ISSUES –
 Euro Commercial Papers (ECP): ECPs are short term money market instruments. They are for
maturities less than one year. They are usually designated in US Dollars.
 Foreign Euro Bonds/Euro Bonds: In domestic capital markets of various countries the Bonds
issues referred to above are known by different names such as Yankee Bonds in the US,
Swiss Frances in Switzerland, Samurai Bonds in Tokyo and Bulldogs in UK.
 Euro Convertible Bonds: A convertible bond is a debt instrument which gives the holders of
the bond an option to convert the bonds into a pre-determined number of equity shares of
the company. These bonds carry a fixed rate of interest and if the issuer company so desires
may also include a Call Option or a Put Option also on these bonds.
 Euro Convertible Zero Bonds: These bonds are structured as a convertible bond. No interest
is payable on the bonds. But conversion of bonds takes place on maturity at a
pre- determined price.

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(e) American Depository Receipts (ADRs):

 These are securities offered by non-US companies who want to list on any of the US
exchange
 ADRs allow US investors to buy shares of these companies without the costs of investing
directly in a foreign stock exchange.
 They are stipulated by the Security Exchange Commission USA

(f) Global Depository Receipts (GDRs):

 These are negotiable certificate held in the bank of one country representing a specific
number of shares of a stock traded on the exchange of another country.
 These financial instruments are used by companies to raise capital in either dollars or Euros.
 These are mainly traded in European countries and particularly in London.

(g) Indian Depository Receipts (IDRs):

 The concept of the depository receipt mechanism which is used to raise funds in foreign
currency has been applied in the Indian Capital Market through the issue of Indian Depository
Receipts (IDRs).
 IDRs are similar to ADRs/GDRs in the sense that foreign companies can issue IDRs to raise funds
from the Indian Capital Market in the same lines as an Indian company uses ADRs/GDRs to raise
foreign capital.

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Chapter 3 FINANCIAL ANALYSIS & PLANNING - RATIO ANALYSIS

SUMMARY OF RATIOS

Ratio Formulae Interpretation

Liquidity Ratio
Current Ratio Current Assets A simple measure that
CurrentLiabilities estimates whether the
business can pay short term
debts.
Quick Ratio Quick Assets It measures the ability to
CurrentLiabilities meet current debt
immediately. Ideal ratio is 1.

QUICK ASSETS = Current

Assets – Inventories
-Prepaid Expense
Cash Ratio CashandBankbalances + It measures absolute
 Marketable Securities 
  liquidity of the business.
Current Liabilities
Basic Defense CashandBankbalances + It measures the ability of
 
Interval Ratio Marketable Securities  the business to meet
 
regular cash expenditures.
Opearing Expenses÷ No. of days
Net Working Current Assets – Current Liabilities It is a measure of cash
Capital Ratio flow to determine the
ability of business to
survive financial crisis.
Capital Structure Ratio
Equity Ratio Shareholders' Equity It indicates owner’s fund in
CapitalEmployed companies to total fund
invested.

Debt Ratio Total outsideliabilities It is an indicator of use of

TotalDebt+Net worth outside funds.
Debt to equity TotalOutsideLiabilities It indicates the
Ratio Shareholders'Equity composition of capital
structure in terms of debt
and equity.
Debt to Total TotalOutsideLiabilities It measures how much of
Assets Ratio TotalAssets total assets is financed by
the debt.

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Capital Gearing It shows the proportion of


Preference Share Capital +Debentures 
+ OtherBorrowedfunds 
Ratio fixed interest bearing
 
 Equity Share Capital+  capital to equity
Reserves & Surplus - Losses  shareholders’ fund. It also
  signifies the advantage of
financial leverage to the
equity shareholder.
Proprietary Ratio Proprietary Fund It measures the proportion
Total Assets of total assets financed by
shareholders.

Proprietary Fund = Equity

share capital +Preference
Share capital + Reserves&
Surplus
Coverage Ratios
Debt Service Earningsavailablefor debtservices It measures the ability to
Coverage Ratio Interest+Installments meet the commitment of
(DSCR) various debt services like
interest, installment etc.
Ideal ratio is 2.
Interest EBIT It measures the ability of
Coverage Ratio Interest the business to meet
interest obligations. Ideal
ratio is > 1.
Preference NetProfit / Earning after taxes (EAT) It measures the ability to
Dividend Preference dividend pay the preference
Coverage Ratio shareholders’ dividend.
Ideal ratio is > 1.

Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio

Total Asset Sales / Costof GoodsSold A measure of total asset
Turnover Ratio Average TotalAssets utilisation. It helps to answer
the question - What sales are
being generated by each
rupee’s worth of assets
invested in the business?
Fixed Assets Sales / Costof GoodsSold This ratio is about fixed asset
Turnover Ratio Fixed Assets capacity. A reducing sales or
profit being generated from
each rupee invested in fixed
assets may indicate
overcapacity or poorer-
performing equipment.

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Capital Turnover Sales / Costof GoodsSold This indicates the firm’s

Ratio Net Assets ability to generate sales per
rupee of long term
investment.
Working Capital Sales / COGS It measures the efficiency of
Turnover Ratio WorkingCapital the firm to use working
capital.
Inventory COGS / Sales It measures the efficiency of
Turnover Ratio AverageInventory the firm to manage its
inventory.
Debtors Turnover Credit Sales It measures the efficiency at
Ratio Average Accounts Receivable which firm is managing its
receivables.
Receivables Average Accounts Receivables It measures the velocity of
(Debtors’) Average Daily Credit Sales collection of receivables.
Velocity/Collectio Or
n Period 12
Receivable Turnover Ratio
Payables Annual Net Credit Purchases It measures the velocity of
Turnover Ratio Average Accounts Payables payables payment.

Profitability Ratios based on Sales

Gross Profit Ratio GrossProfit This ratio tells us something
×100
Sales about the business's ability
consistently to control its
production costs or to
manage the margins it
makes on products it buys
and sells.
Net Profit Ratio NetProfit It measures the relationship
×100
Sales between net profit and
sales of the business.
Operating Profit Operating Profit(EBIT) It measures operating
×100
Ratio Sales performance of business.
Expenses Ratio
Cost of Goods COGS It measures portion of a
×100
Sold (COGS) Sales particular expenses in
Ratio comparison to sales.
Operating  Administrative exp.  
 . 
Expenses Ratio  Selling & Distribution Overhead  x100
 Sales 
 
 

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Financial Financial expenses

×100
Expenses Ratio Sales
Profitability Ratios related to Overall Return on Assets/ Investments
Return on Return /Profit /Earnings It measures overall return of
×100
Investment (ROI) Investments the business on investment/
equity funds/capital
employed/ assets.
Return on Assets Net Profitafter taxes It measures net profit per
(ROA) Averagetotal assets rupee of average total
assets/ average tangible
assets/ average fixed assets.
Return on Capital EBIT ×100 It measures overall earnings
Employed ROCE CapitalEmployed (either pre-tax or post tax)
(Pre-tax) on total capital employed.

Return on Capital EBIT(1- t) ×100

Employed ROCE CapitalEmployed It indicates earnings available
(Post-tax) to equity shareholders in
comparison to equity
Return on Equity shareholders’ net worth.
Preferencedividend(if any)
NetProfitafter taxes-
(ROE)   ×100
Net worth / equity shareholders'fund

Profitability Ratios Required for Analysis from Owner’s Point of View

Earnings per Netprofitavailabletoequityshareholders EPS measures the overall
Share (EPS) Numberof equitysharesoutstanding profit generated for each
share in existence over a
particular period.
Dividend per Dividendpaidtoequity shareholders Proportion of profit
Share (DPS) Number of equity sharesoutstanding distributed per equity share.

Dividend payout Dividendper equity share It shows % of EPS paid as

Ratio (DP) Earningper Share(EPS) dividend and retained
earnings.
Profitability Ratios related to market/ valuation/ Investors
Price-Earnings MarketPriceper Share(MPS) At any time, the P/E ratio is
per Share (P/E Earningper Share(EPS) an indication of how highly
Ratio) the market "rates" or
"values" a business. A P/E
ratio is best viewed in the
context of a sector or
market average to get a feel
for relative value and stock
market pricing.

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Dividend Yield Dividend per Share(DPS) ×100 It measures dividend paid

Market Price per Share(MPS) based on market price of
shares.

Earnings Yield Earnings per Share(EPS) ×100 It is the relationship of

Market Priceper Share(MPS) earning per share and
market value of shares.

Market Value Market value per share It indicates market response

/Book Value per Book value per share of the shareholders’
Share investment.

Q Ratio Market Value of equity and It measures market value of

liabilities equity as well as debt in
Estimated replacement cost of comparison to all assets at
assets their replacement cost.

1. In a meeting held at Solan towards the end of 2018, the Directors of M/s HPCL Ltd. have taken a
decision to diversify. At present HPCL Ltd. sells all finished goods from its own warehouse. The
company issued debentures on 01.01.2019 and purchased fixed assets on the same day. The
purchase prices have remained stable during the concerned period. Following information is
provided to you:

INCOME STATEMENTS
Particulars 2018 2019
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses

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Warehousing 13,000 14,000

Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 14,000
49,000 57,000

Net Profit 15,000 19,000

BALANCE SHEET
Assets & Liabilities 2018 2019
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Payables 50,000 76,000
Total Current Liabilities (CL) 50,000 76,000
Working Capital (CA - CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures  30,000
1,00,000 1,47,000

You are required to CALCULATE the following ratios for the years 2018 and 2019.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio
(vi) Net Profit to Net Worth Ratio, and
(vii) Receivables Collection Period.

Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons for
change in the ratios for 2 years. Assume opening stock of 40,000 for the year 2018. Ignore Taxation.

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Solution-

Computation of Ratios
Ratio 2018 2019
1. Gross profit ratio 64,000 100 76,000 100
=21.3% =20.3%
(Gross profit/sales) 3,00,000 3,74,000

2. Operating expense to 49,000×100 =16.3% 57,000 100

=15.2%
sales ratio (Operating exp/ 3,00,000 3,74,000
Total sales)
3. Operating profit ratio 15,000 100 19,000 100
=5% =5.08%
(Operating profit / Total sales) 3,00,000 3,74,000

4. Capital turnover ratio 3,00,000 3,74,000

3  2.54
(Sales / capital employed) 1,00,000 1,47,000

5.Stock turnover ratio (COGS 2,36,000 2,98,000

=4.72 =3.87
/ Average stock) 50,000 77,000

6. Net Profit to Net worth (Net 15,000 100 17,000 100

=15% =16.24%
profit / Net worth) 1,00,000 1,17,000

7.Receivables collection
period( Average receivables / 50,000 82,000
=67.6 days =87.5 days
Average daily credit sales) 739.73 936.99
(Refer to working note)
Working note: 2,70,000 3,42,000
=739.73 =936.99
Average daily sales = Credit 365 365
sales / 365

Analysis:
 The decline in the Gross profit ratio could be either due to a reduction in the selling price or increase
in the direct expenses (since the purchase price has remained the same).
 Similarly there is a decline in the ratio of operating expenses to sales. However since operating
expenses have little bearing with sales, a decline in this ratio cannot be necessarily interpreted as an
increase in operational efficiency.
 The operating profit ratio has remained the same in spite of a decline in the Gross profit margin
ratio. In fact the company has not benefited at all in terms of operational performance because of
the increased sales
 The company has not been able to deploy its capital efficiently. This is indicated by a decline in the
Capital turnover from 3 to 2.5 times.
 The decline in stock turnover ratio implies that the company has increased its investment in stock.
Return on Net worth has declined indicating that the additional capital employed has failed to
increase the volume of sales proportionately. The increase in the Average collection period indicates
that the company has become liberal in extending credit on sales.

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2. Following is the abridged Balance Sheet of Alpha Ltd. :-

Liabilities Assets
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivables 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000

With the help of the additional information furnished below, you are required to PREPARE Trading and Profit &
Loss Account and a Balance Sheet as at 31st March, 2019:

(i) The company went in for reorganisation of capital structure, with share capital remaining the same as
follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Payables 25%

Debentures were issued on 1st April, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been bought and a further
Rs 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8 : 5.
(iv) Quick assets ratio was 1 : 1.
(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of 2 months. There
were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the year.
Ignore Taxation.

3. X Co. has made plans for the next year. It is estimated that the company will employ total assets of
Rs 8,00,000; 50 per cent of the assets being financed by borrowed capital at an interest cost of 8 per
cent per year. The direct costs for the year are estimated at Rs4,80,000 and all other operating
expenses are estimated at Rs 80,000. the goods will be sold to customers at 150 per cent of the
direct costs. Tax rate is assumed to be 50 per cent.
You are required to CALCULATE: (i) net profit margin; (ii) return on assets; (iii) asset turnover and (iv) return
on owners’ equity.

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4. ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statements over the last 3
years are as follows:
Particular 2017 2018 2019

Cash 30,000 20,000 5,000

Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
` ` `
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5,50,000
14,30,000 15,60,000 16,95,000
` ` `
Sales 40,00,000 43,00,000 38,00,000
Cost of goods sold 32,00,000 36,00,000 33,00,000
Net profit 3,00,000 2,00,000 1,00,000
ANALYSE the company’s financial condition and performance over the last 3 years. Are there any problems?

Solution-

Ratios 2017 2018 20179

Current ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18 22 27
Inventory turnover NA* 8.2 6.1
Total debt to net worth 1.38 1.40 1.61
Gross profit margin 0.200 0.163 0.132
Net profit margin 0.075 0.047 0.026
Asset turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06

Analysis:
 The company’s profitability has declined steadily over the period. As only Rs 50,000 is added to
retained earnings, the company must be paying substantial dividends.
 Receivables are growing slower, although the average collection period is still very reasonable
relative to the terms given.
 Inventory turnover is slowing as well, indicating a relative buildup in inventories. The increase in
receivables and inventories, coupled with the fact that net worth has increased very little, has

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resulted in the total debt-to-worth ratio increasing to what would have to be regarded on an
absolute basis as a high level.
 The current and acid-test ratios have fluctuated, but the current ratio is not particularly inspiring.
 Both the gross profit and net profit margins have declined substantially. The relationship between
the two suggests that the company has reduced relative expenses in 2019 in particular

5. Following information are available for Navya Ltd. along with various ratio relevant to the particulars
industry it belongs to. APPRAISE your comments on strength and weakness of Navya Ltd. comparing
its ratios with the given industry norms.

BALANCE SHEET AS AT 31.3.2019

Liabilities Amount Assets Amount
Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current Liabilities 4,40,000 -
Total 77,00,000 Total 77,00,000
STATEMENT OF PROFITABILITY FOR THE YEAR ENDING 31.3.2019
Particulars Amount Amount
Sales 1,10,00,000
Less: Cost of goods sold: - -
Material 41,80,000 -
Wages 26,40,000 -
Factory Overhead 12,98,000 81,18,000
Gross Profit - 28,82,000
Less: Selling and Distribution Cost 11,00,000 -
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes - 5,54,000
Less: Interest Charges - 92,000
Earning before Tax - 4,62,000
Less: Taxes & 50% - 2,31,000
Net Profit (PAT) 2,31,000

INDUSTRY NORMS
Ratios Norm
Current Assets/Current Liabilities 2.5
Sales/ debtors 8.0
Sales/ Stock 9.0
Sales/ Total Assets 2.0
Net Profit/ Sales 3.5%
Net profit /Total Assets 7.0%
Net Profit/ Net Worth 10.5%
Total Debt/Total Assets 60.0%

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6. The total sales (all credit) of a firm are Rs 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 Rs 96,000; inventories Rs 48,000 and cash Rs
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 Rs
80,000? (Assume a 360 day year).

7. The capital structure of Beta Limited is as follows:

Equity share capital of Rs 10 each 8,00,000
9% preference share capital of Rs 10 each 3,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent), Rs 2,70,000; Depreciation, Rs 60,000; Equity dividend
paid, 20 per cent; Market price of equity shares, Rs 40.

You are required to COMPUTE the following, showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Price-earnings ratio.

8. The following accounting information and financial ratios of PQR Ltd. relate to the year ended 31st
December, 2018
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
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 December, 2017 amounted to Rs 26 lakhs, PREPARE a summarised Profit
and Loss Account of the company for the year ended 31st December, 2018 and also the Balance Sheet as on
31st December, 2018.

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9. Ganpati Limited has furnished the following ratios and information relating to the year ended 31st
March, 2019
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, 2019.
(b) PREPARE a balance sheet as on 31st March in the following format:

Balance Sheet as on 31st March, 2019

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

10. Using the following information, PREPARE this balance sheet:

Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 ×
Average collection period* 18 days
Inventory turnover 9×
Gross profit margin 10%
Acid-test ratio 1 to 1

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

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

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ADDITIONAL QUESTIONS

11. The accountant of Moon Ltd. has reported the following data:
Gross profit 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days

Assume 360 days in a year

You are required to complete the following:

Balance Sheet of Moon Ltd.
Liabilities Assets
Net Worth Fixed
Current Assets
Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets
(MAY 2018 – 5 MARKS)

12. Following figures and ratios are related to a company Q Ltd. :

(i) Sales for the year (all credit) Rs 30,00,000
(ii) Gross Profit ratio 25 per cent
(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 : 1
(vi) Current ratio 1. 5 : 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to share capital 0.6 : 1
(ix) Capital gearing ratio 0.5
(x) Fixed assets to net worth 1.20 : 1

You are required to calculate :

Closing stock, Fixed Assets, Current Assets, Debtors and Net worth. (MAY 2019 – 5 MARKS)

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13. The following is the information of XML Ltd. relate to the year ended 31-03-2018 :
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1 : 4
Non-Current Assets to Current Assets 1 : 2
Current Ratio 2 : 1
Non-Current Liabilities to Current Liabilities 1 : 1
Share Capital to Reserve and Surplus 4 : 1
Non-current Assets as on 31st March, 2017 Rs 50,00,000

Assume that:
(i) No change in Non-Current Assets during the year 2017-18
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) Ignoring Tax

You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018 (NOV 2018 - 5 MARKS)

14. Following figures are available in the books Tirupati Ltd.

Fixed assets turnover ratio 8 times
Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
G P Ratio 25%
Gross profit during the year amounts to Rs 8,00,000. There is no long-term loan or overdraft.
Reserve and surplus amount to Rs 2,00,000. Ending inventory of the year is
Rs 20,000 above the beginning inventory.

Required:
CALCULATE various assets and liabilities and PREPARE a Balance sheet of Tirupati Ltd (RTP MAY 2018)

15. From the following table of financial ratios of R. Textiles Limited, comment on various ratios
given at the end:

Ratios 2017 2018 Average of

Textile
Industry
Liquidity Ratios
Current ratio 2.2 2.5 2.5
Quick ratio 1.5 2 1.5
Receivable turnover ratio 6 6 6
Inventory turnover 9 10 6
Receivables collection 87 days 86 days 85 days
period

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Operating profitability
Operating income –ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing decisions
Debt ratio 49.00% 48.00% 57%
Return
Return on equity 24% 25% 15%

COMMENT on the following aspect of R. Textiles Limited

(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders (RTP MAY 2019)

Solution-

Ratios Comment
Liquidity Current ratio has improved from last year and matching the
industry average.

Quick ratio also improved than last year and above the industry average.
This may happen due to reduction in receivable collection period and
quick inventory turnover.
However, this also indicates idleness of funds.
Overall it is reasonably good. All the liquidity ratios are either better or
same in both the year compare to the Industry Average.
Operating Profits Operating Income-ROI reduced from last year but Operating Profit
Margin has been maintained. This may happen due to variability of cost
on turnover. However, both the ratio are still higher than the industry
average.
Financing The company has reduced its debt capital by 1% and saved operating
profit for equity shareholders. It also signifies that dependency on debt
compared to other industry players (57%) is low.
Return to the shareholders R’s ROE is 24 per cent in 2017 and 25 per cent in 2018 compared to an
industry average of 15 per cent. The ROE is stable and improved over the
last year.

16. MT Limited has the following Balance Sheet as on March 31, 2019 and March 31, 2020:
in lakhs
March 31, March 31,
2019 2020
Sources of Funds:
Shareholders’ Funds 2,500 2,500
Loan Funds 3,500 3,000
6,000 5,500

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Applications of Funds:
Fixed Assets 3,500 3,000
Cash and bank 450 400
Receivables 1,400 1,100
Inventories 2,500 2,000
Other Current Assets 1,500 1,000
Less: Current Liabilities (1,850) (2,000)
6,000 5,500

The Income Statement of the MT Ltd. for the year ended is as follows:
in lakhs
March 31, March 31,
2019 2020
Sales 22,500 23,800
Less: Cost of Goods sold (20,860) (21,100)
Gross Profit 1,640 2,700
Less: Selling, General and (1,100) (1,750)
Administrative expenses
Earnings before Interest and Tax (EBIT) 540 950
Less: Interest Expense (350) (300)
Earnings before Tax (EBT) 190 650
Less: Tax (57) (195)
Profits after Tax (PAT) 133 455

CALCULATE for the year 2019-20:

(a) Inventory turnover ratio
(b) Financial Leverage
(c) Return on Capital Employed (ROCE)
(d) Return on Equity (ROE)
(e) Average Collection period.
[Take 1 year = 365 days] (RTP MAY 2020)

17. Assuming the current ratio of a Company is 2, STATE in each of the following cases whether the ratio
will improve or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonoured
(v) Issue of new shares (RTP NOV 2018)

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Solution-
Current Ratio = Current Assets (CA) = 2
Current Liabilities (CL)

S. Situation Improve/ Reason

No. Decline/
No
Change
(i) Payment of Current Ratio Let us assume CA is 2 lakhs & CL is 1 lakh.
Current will improve If payment of Current Liability = 10,000
liability then, CA = 1,90,000 CL = 90,000.
1,90,000
Current Ratio =
90,000
= 2.11 : 1. When Current Ratio is 2:1
Payment of Current liability will reduce the
same amount in the numerator and
denominator. Hence, the ratio will
improve.
(ii) Purchase of Current Ratio Since the cash being a current asset
Fixed Assets will decline converted into fixed asset, current assets
by cash reduced, thus current ratio will fall.
(iii) Cash collected Current Ratio Cash will increase and Debtors will reduce.
from will not change Hence No Change in Current Asset.
Customers
(iv) Bills Receivable Current Ratio Bills Receivable will come down and
dishonoured will not change debtors will increase. Hence no change in
Current Assets.
(v) Issue of New Current Ratio As Cash will increase, Current Assets will
Shares will improve increase and current ratio will increase.

18. The following is the Profit and loss account and Balance sheet of KLM LLP.
Trading and Profit & Loss Account
Particulars Amount Particulars Amount
To Opening stock 12,46,000 By Sales 1,96,56,000
To Purchases 1,56,20,000 By Closing stock 14,28,000
To Gross profit c/d 42,18,000
2,10,84,000 2,10,84,000
By Gross profit b/d 42,18,000
To Administrative 18,40,000 By Interest on 24,600
expenses investment
To Selling & 7,56,000 By Dividend received 22,000
distribution expenses
To Interest on loan 2,60,000
To Net profit 14,08,600
42,64,600 42,64,600

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Balance Sheet as on……….

Capital & Liabilities Amount Assets Amount
Capital 20,00,000 Plant & machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General reserve 12,00,000 Furniture 12,00,000
Term loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry Payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash & Bank balance 4,22,000
1,10,00,000 1,10,00,000

You are required to COMPUTE:

(i) Gross profit ratio (ii) Net profit ratio (iii) Operating cost ratio
(iv) Operating profit ratio (v) Inventory turnover ratio (vi) Current ratio
(vii) Quick ratio (viii) Interest coverage ratio (ix) Return on capital employed
(RTP NOV 2019)

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IPCC PRACTISE MANUAL QUESTIONS ON RATIOS

19. From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
Net Working Capital 2,40,000
Bank overdraft 40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus 1,60,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5

Answer
Working notes:
1. Current assets and Current liabilities computation:
Current assets = 2.5
Current liabilities 1

Or Current assets = 2.5 Current liabilities

Now, Working capital = Current assets - Current liabilities
Or 2,40,000 = 2.5 Current liability - Current liability
Or 1.5 Current liability = 2,40,000
Current liabilities = 1,60,000
So, Current assets = 1,60,000 x 2.5 = 4,00,000

2. Computation of stock
Liquid ratio = Liquid assets
Current liabilities
Or 1.5 = Current Assets - Inventory
160,000
Or 1.5 x Rs 1, 60,000 = Rs 4,00,000 - Inventories
Or Inventories = Rs4, 00,000 – Rs 2, 40,000
Or Stock = Rs 1, 60,000

3. Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors

Fixed Asset to Proprietary ratio= Fixed assets = 0.75
Proprietary fund

Fixed assets = 0.75 Proprietary fund (PF)

PF = Fixed Assets(FA) + Net Working Capital (NWC)
PF = 0.75 PF+ NWC
NWC = 0.25 PF
CA-CL = 0.25 PF
400,000-160,000 = 0.25 PF
240,000 = 0.25 PF
PF = 960,000 (240,000 / 0.25 )

FA = 0.75 PF
FA = 720,000 (960,000 X 0.75)

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Capital = Proprietary fund - Reserves & Surplus

= Rs 9,60,000 - Rs 1,60,000 =Rs 8,00,000

Sundry creditors = (Current liabilities - Bank overdraft)

= (Rs 1,60,000 - Rs 40,000) = Rs 1,20,000

Balance Sheet
Liabilities Amount Assets Amount
Capital 8,00,000 Fixed assets 7,20,000
Reserves & Surplus 1,60,000 Stock 1,60,000
Bank overdraft 40,000 Current assets 2,40,000
Sundry creditors 1,20,000

11,20,000 11,20,000

20. MN Limited gives you the following information related for the year ending 31st March, 2016:
Current Ratio = 2.5
Debt - Equity Ratio = 1 :1.5
Net Working Capital = 4,50,000
Fixed Assets = 10,00,000.
Calculate Proprietary Ratio

Solution-

Workings Notes:
1.Current Assets
Net Working Capital(NWC) = Current Assets(CA) – Current Liabilities(CL)
450,000 = 2.5 CL-CL
450,000 = 1.5 CL
CL = 300,000 (450,000 /1.5)
CA = 2.5 CL
CA = 750,000 (300,000 X 3)

2. Total Assets
Total Assets = FA +CA
Total Assets = 10,00,000+750,000
Total Assets = 17,50,000

3. Equity(Proprietary Funds)
Debt = 1
Equity (PF) 1.5

PF = 1.5 Debt

Total Assets = PF + Debt (TOTAL DEBT INCLUDING CL)

17,50,000 = 1.5 Debt + Debt
17,50,000 = 2.5 Debt
Debt = 700,000
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PF= 10,50,000 (700,000 X 1.5)

Calculation of Proprietary Ratio

Proprietary Ratio = Proprietary fund

Total Assets
= 10,50,000 / 17,50,000
= 0.6

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21. Manan Pvt. Ltd. gives you the following information relating to the year ending 31st March,
2021:

(1) Current Ratio 2.5 : 1

(2) Debt-Equity Ratio 1 : 1.5
(3) Return on Total Assets (After Tax) 15%
(4) Total Assets Turnover Ratio 2
(5) Gross Profit Ratio 20%
(6) Stock Turnover Ratio 7
(7) Net Working Capital Rs 13,50,000
(8) Fixed Assets Rs 30,00,000
(9) 1,80,000 Equity Shares of Rs 10 each
(10) 60,000, 9% Preference Shares of Rs 10 each
(11) Opening Stock Rs 11,40,000

You are required to CALCULATE:

(a) Quick Ratio
(b) Fixed Assets Turnover Ratio
(c) Proprietary Ratio
(d) Earnings per Share

SOLUTION-
(i) Computation of Current Assets & Current Liabilities & Total Assets
Net Working Capital = Current Assets – Current Liabilities
= 2.5 – 1 = 1.5

Thus, Current Assets = Net Working Capital × 2.5 / 1.5

= Rs 13,50,000 x 25 / 1.5
= Rs 22,50,000

Current Liabilities (CL) = Rs 22,50,000 – Rs 13,50,000 = Rs 9,00,000

Total Assets = Current Assets + Fixed Assets

= Rs 22,50,000 + Rs 30,00,000 = Rs 52,50,000

(ii) Computation of Sales & Cost of Goods Sold

Sales = Total Assets Turnover × Total Assets
= 2 x (Fixed Assets + Current Assets)
= 2 × (Rs 30,00,000 + Rs 22,50,000)
= Rs 1,05,00,000

Cost of Goods Sold = (100% – 20%) of Sales = 80% of Sales

= 80% × Rs 1,05,00,000 = Rs 84,00,000

(iii) Computation of Stock & Quick Assets

Average Stock = Cost of Good Sold / Stock Turnover Ratio

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= 84,00,000 / 7
= Rs 12,00,000

Closing Stock = (Average Stock × 2) – Opening Stock

= (Rs 12,00,000 × 2) – Rs 11,40,000
= Rs 12,60,000

Quick Assets = Current Assets – Closing Stock

= Rs 22,50,000 – Rs 12,60,000 = Rs 9,90,000

(iv) Computation of Proprietary Fund

Debt-Equity Ratio = Debt / Equity
= 1 / 1.5
Or, Equity = 1.5 Debt

Total Assets = Equity + Preference capital + Debt + CL

Rs 52,50,000 = 1.5 Debt+ Rs 6,00,000 + Debt + Rs 9,00,000
Thus, Debt = Rs 37,50,0002.5 = Rs 15,00,000
Equity = Rs 15,00,000 × 1.5 = Rs 22,50,000

So, Proprietary Fund = Equity + Preference Capital

= Rs 22,50,000 + Rs 6,00,000 = Rs 28,50,000

(v) Computation of Profit after tax (PAT)

= Total Assets × Return on Total Assets
= Rs 52,50,000 × 15% = Rs 7,87,500

(a) Quick Ratio

Quick Ratio = Quick Assets / Current Liabilities
= Rs 9,90,000/ 9,00,000
= 1.1

(b) Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio = Sales / Fixed Assets Rs
= 1,05,00,000 / 30,00,000
= 3.5

(c) Proprietary Ratio

Proprietary Ratio = Proprietary fund / Total Assets
=28,50,000 / 52,50,000
= 0.54

(d) Earnings per Equity Share (EPS)

Earnings per Equity Share = PAT - Preference Share Dividend / Number of Equity Shares
=7,87,500 - 54,000 (9% of 6,00,000) / 1,80,000
= Rs 4.075 per share

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22. Gig Ltd. has furnished the following information relating to the year ended 31st March, 2020
and 31st March, 2021:
31st March, 2020 31st March, 2021
Share Capital 40,00,000 40,00,000
Reserve and Surplus 20,00,000 25,00,000
Long term loan 30,00,000 30,00,000
• Net profit ratio: 8%
• Gross profit ratio: 20%
• Long-term loan has been used to finance 40% of the fixed assets.
• Stock turnover with respect to cost of goods sold is 4.
• Debtors represent 90 days sales.
• The company holds cash equivalent to 1½ months cost of goods sold.
• Ignore taxation and assume 360 days in a year.

You are required to PREPARE Balance Sheet as on 31st March, 2021 in the following format:
Liabilities Assets
Share Capital - Fixed Assets -
Reserve and Surplus - Sundry Debtors -
Long-term loan - Closing Stock -
Sundry Creditors - Cash in hand -

SOLUTION-
(i) Change in Reserve & Surplus = Rs 25,00,000 – Rs 20,00,000 = Rs 5,00,000
So, Net profit = Rs 5,00,000
Net Profit Ratio = 8%
Sales = 5,00,000 / 8 % = 62,50,000

(ii) Cost of Goods sold

= Sales – Gross profit Margin
= Rs 62,50,000 – 20% of Rs 62,50,000
= Rs 50,00,000

(iii) Fixed Assets = 30,00,000 / 40 %

= 75,00,000

(iv) Stock = Cost of Goods Sold / Stock Turnover ratio

50,00,000 / 4
= 12,50,000

(v) Debtors = 62,50,000 × 90 / 360

= 15,62,500

(vi) Cash Equivalent = 50,00,000 × 1.5 / 12

= 6,25,000

Balance Sheet as on 31st March 2021

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Liabilities Assets
Share Capital 40,00,000 Fixed Assets 75,00,000
Reserve and Surplus 25,00,000 Sundry Debtors 15,62,500
Long-term loan 30,00,000 Closing Stock 12,50,000
Sundry Creditors 14,37,500 Cash in hand 6,25,000
(Balancing Figure)
1,09,37,500 1,09,37,500

23. Following information relates to Temer Ltd.:

Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables 25,000
Bills Payables 10,000
Gross Profit 4,00,000
Fixed Assets turnover Ratio 4
Closing stock of the period is Rs 10,000 above the opening stock.

DETERMINE:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Sundry Creditors
(iv) Closing Stock
(v) Fixed Assets

SOLUTION-

(i) Determination of Sales and Cost of goods sold:

Gross Profit Ratio = Gross Profit / Sales × 100
Or, Sales = 4,00,00,000 / 25
= Rs 16,00,000

Cost of Goods Sold = Sales – Gross Profit

= Rs 16,00,000 - Rs 4,00,000 = Rs 12,00,000

(ii) Determination of Sundry Debtors:

Debtors’ velocity is 3 months or Debtors’ collection period is 3 months,
So, Debtors’ turnover ratio= 12months / 3months
=4

Debtors’ turnover ratio = Credit Sales / Average Accounts Receivable

4 = 16,00,000 / Bills Receivable +Sundry Debtors
Or, Sundry Debtors + Bills receivable = Rs 4,00,000

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Sundry Debtors = Rs 4,00,000 – Rs 25,000 = Rs 3,75,000

(iii) Determination of Sundry Creditors:

Creditors’ velocity of 2 months or credit payment period is 2 months.
So, Creditors’ turnover ratio =12 months / 2 months
=6

Creditors turnover ratio = Credit Purchases* / Average Accounts Payables

6 = 12,10,000 / Sundry Creditors +Bills Payables
So, Sundry Creditors + Bills Payable = Rs 2,01,667
Or, Sundry Creditors + Rs 10,000 = Rs 2,01,667

Or, Sundry Creditors = Rs 2,01,667 – Rs 10,000 = Rs 1,91,667

(iv) Determination of Closing Stock

Stock Turnover Ratio = Cost of Goods Sold / Average Stock
12,00,000 / Average Stock = 1.5
So, Average Stock = Rs 8,00,000

Now Average Stock =Opening Stock +Closing Stock / 2

8,00,000 = Opening Stock+(Opening Stock+10,000) / 2

Or, Opening Stock = Rs 7,95,000

So, Closing Stock = Rs 7,95,000 + Rs 10,000 = Rs 8,05,000

(v) Determination of Fixed Assets

Fixed Assets Turnover Ratio = Cost of Goods Sold / Fixed Assets
4 = 12,00,000 / Fixed Assets
Or, Fixed Asset = Rs 3,00,000

Workings:
*Calculation of Credit purchases:
Cost of goods sold = Opening stock + Purchases – Closing stock
Rs 12,00,000 = Rs 7,95,000 + Purchases – Rs 8,05,000
Rs 12,00,000 + Rs 10,000 = Purchases
Rs 12,10,000 = Purchases (credit)

Assumption:
(i) All sales are credit sales
(ii) All purchases are credit purchase
(iii) Stock Turnover Ratio and Fixed Asset Turnover Ratio may be calculated either on Sales or on Cost of
Goods Sold.

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Chapter 4 COST OF CAPITAL

INTRODUCTION-
 Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and the
debt-holders) to the business as a compensation for their contribution to the total capital.
 Cost of capital is also known as ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of return’ etc.

SIGNIFICANCE OF THE COST OF CAPITAL-

 Evaluation of investment options: The estimated benefits (future cashflows) from available
investment opportunities (business or project) are converted into the present value of benefits by
discounting them with the relevant cost of capital.
 Financing Decision: When a finance manager has to choose one of the two sources of finance, he
can simply compare their cost and choose the source which has lower cost. Besides cost he also
considers financial risk and control.
 Designing of optimum credit policy: While appraising the credit period to be allowed to the
customers, the cost of allowing credit period is compared against the benefit/ profit earned by
providing credit to customer of segment of customers

DETERMINATION OF THE COST OF CAPITAL-

 Cost is not the amount which the company plans to pay or actually pays, rather than it is the
expectation of stakeholders. Here Stakeholders include providers of capital (shareholders,
debenture holder, money lenders etc.), intermediaries (brokers, underwriters, merchant bankers
etc.), and Government (for taxes).
 For example if the company issues 9% coupon debentures but expectation of investors is 10% then
investors will subscribe it at discount and not at par. Hence cost to the company will not be 9%,
rather than it will be 10%. Besides giving return to investors company will also have to give
commission, brokerage, fees etc. To intermediaries for issue debentures. It will increase cost of
capital above 10%. On the other hand payment of interest is a deductible expense under the Income
tax act hence it will reduce cost of capital to the company
 To calculate cost first of all we should identify various cash flows like:
 inflow of amount received at the beginning
 outflows of payment of interest, dividend, redemption amount etc.
 Inflow of tax benefit on interest or outflow of payment of dividend tax.

COST OF LONG TERM DEBT-

Long term debt includes long term loans from the financial institutions, capital from issuing debentures or
bonds etc.

Features of debentures or bonds:-

 Face Value: Debentures or Bonds are denominated with some value; this denominated value is
called face value of the debenture. Interest is calculated on the face value of the debentures. E.g. If
a company issue 9% Non- convertible debentures of 100 each, this means the face value is 100 and
the interest @ 9% will be calculated on this face value
 Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except Zero coupon
bond and Deep discount bond). Interest (coupon) rate is applied to face value of debenture to
calculate interest, which is payable to the holders of debentures periodically.
 Maturity period: Debentures or Bonds has a fixed maturity period for redemption. However, in case
of irredeemable debentures maturity period is not defined and it is taken as infinite.
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 Redemption Value: Redeemable debentures or bonds are redeemed on its specified maturity date.
Based on the debt covenants the redemption value is determined. Redemption value may vary from
the face value of the debenture
 Benefit of tax shield: The payment of interest to the debenture holders are allowed as expenses for
the purpose of corporate tax determination. Hence, interest paid to the debenture holders save the
tax liability of the company. Saving in the tax liability is also known as tax shield

Based on redemption (repayment of principal) on maturity the debts can be categorised into two types
(i) Irredeemable debts and (ii) Redeemable debts.

Cost of Irredeemable Debentures-

Kd= I (1-T)
NP
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or current market price
t = Tax rate

 Net proceeds means issue price less issue expenses.

 If issue price is not given then students can assume it to be equal to current market price.
 If issue expenses are not given simply assume it equal to zero.

1. Five years ago, Sona Limited issued 12 per cent irredeemable debentures at Rs 103, at Rs 3 premium
to their par value of Rs 100. The current market price of these debentures is Rs 94. If the company
pays corporate tax at a rate of 35 per cent CALCULATE its current cost of debenture capital?

Cost of Redeemable Debentures (using approximation method)-

Kd= I (1-T)+(RV-NP)
n
---------------------------
(RV+NP)
2
I = Interest payment
NP = Net proceeds from debentures in case of new issue of debt or Current market price in case of existing
debt.
RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Remaining life of debentures.

 The above formula to calculate cost of debt is used where only interest on debt is tax deductable.
 Sometime, debts are issued at discount and/ or redeemed at a premium.
 If discount on issue and/ or premium on redemption are tax deductible, the following formula can
be used to calculate the cost of debt –
Kd= I +(RV-NP)
N (1-T)
--------------------------------------
(RV+NP)
2

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 Above formulas give approximate value of cost of debt. In these formulas higher the difference
between RV and NP, lower the accuracy of answer.
 Therefore one should not use these formulas if difference between RV and NP is very high. Also
these formulas are not suitable in case of gradual redemption of bonds.

2. A company issued 10,000, 10% debentures of Rs 100 each at a premium of 10% on 1.4.2017 to be
matured on 1.4.2022. The debentures will be redeemed on maturity. COMPUTE the cost of
debentures assuming 35% as tax rate.

3. A company issued 10,000, 10% debentures of Rs 100 each at par on 1.4.2012 to be matured on
1.4.2022. The company wants to know the cost of its existing debt on 1.4.2017 when the market
price of the debentures is Rs 80. COMPUTE the cost of existing debentures assuming 35% tax rate.

Cost of Debt using Present value method [Yield to maturity (YTM) approach)]-
 YTM or present value method is a superior method of determining cost of debt of company to
approximation method and it is also preferred in the field of finance.

4. A company issued 10,000, 10% debentures of Rs 100 each on 1.4.2013 to be matured on 1.4.2018.
The company wants to know the current cost of its existing debt and the market price of the
debentures is Rs 80. Compute the cost of existing debentures assuming 35% tax rate.

5. Institutional Development Bank(IDB) issued Zero interest deep discount bonds of face value of Rs
1,00,000 each issued at Rs 2500 & repayable after 25 years. COMPUTE the cost of debt if there is no
corporate tax.

AMORTISATION OF BOND-
 A bond may be amortised every year i.e. principal is repaid every year rather than at maturity. In
such a situation, the principal will go down with annual payments and interest will be computed on
the outstanding amount. The cash flows of the bonds will be uneven.
 The formula for determining the Value of a bond (Vb)or debenture that is amortised every year is as
follows:

Vb = C1 + C2 + Cn
(1+Kd)1 (1+Kd)2 (1+Kd)n

C= Cash Flow (Interest +Principal)

6. RBML is proposing to sell a 5-year bond of Rs 5,000 at 8 per cent rate of interest per annum. The
bond amount will be amortised equally over its life. CALCULATE the bond’s present value for an
investor if he expects a minimum rate of return of 6 per cent?

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COST OF CONVERTIBLE DEBENTURE-

 Holders of the convertibledebentures has the option to either get the debentures redeemed into
the cash or get specified numbers of companies shares in lieu of cash.
 The calculation of cost of convertible debentures are very much similar to the redeemable
debentures.
 While determining the redemption value of the debentures, it is assumed that all the debenture
holders will choose the option which has the higher value and accordingly it is considered to
calculate cost of debt.

7. A company issued 10,000, 15% Convertible debentures of Rs100 each with a maturity period of 5
years. At maturity the debenture holders will have the option to convert the debentures into equity
shares of the company in the ratio of 1:10 (10 shares for each debenture). The current market price
of the equity shares is Rs12 each and historically the growth rate of the shares are 5% per annum.
Compute the cost of debentures assuming 35% tax rate.

COST OF PREFERENCE SHARE CAPITAL-

 The preference share capital is paid dividend at a specified rate on face value of preference shares.
 Payment of dividend to the preference shareholders are not mandatory but are given priority over
the equity shareholder.
 The payment of dividend to the preference shareholders are not charged as expenses but treated as
appropriation of after tax profit.
 Hence, dividend paid to preference shareholders does not reduce the tax liability to the company.
 Like the debentures, Preference share capital can be categorised as redeemable and irredeemable.

Cost of Redeemable Preference Shares-

 Preference shares issued by a company which are redeemed on its maturity is called redeemable
preference shares. Cost of redeemable preference share is similar to the cost of redeemable
debentures with the exception that the dividends paid to the preference shareholders are not tax
deductible. Cost of preference capital is calculated as follows:

Kp= PD +(RV-NP)
N
--------------------------------------
(RV+NP)
2
PD = Annual preference dividend
RV = Redemption value of preference shares
NP = Net proceeds on issue of preference shares
n = Remaining life of preference shares

8. XYZ Ltd. issues 2,000 10% preference shares of Rs 100 each at Rs 95 each. The company proposes to
redeem the preference shares at the end of 10th year from the date of issue. CALCULATE the cost of
preference share?

9. XYZ & Co. issues 2,000 10% preference shares of Rs 100 each at Rs 95 each. CALCULATE the cost of
preference shares.

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10. If R Energy is issuing preferred stock at Rs100 per share, with a stated dividend of Rs12, and a
floatation cost of 3% then, CALCULATE the cost of preference share?

COST OF EQUITY SHARE CAPITAL-

 Just like any other source of finance, cost of equity is expectation of equity shareholders
 Different methods for calculation of cost of equity-
 If dividend is expected to be constant then dividend price approach should be used.
 If earning per share is expected to be constant then earning price approach should be used.
 If dividend and earning are expected to grow at a constant rate then growth approach,
which is also named as Gordon’s model should be used.
 If it is difficult to forecast future then realised yield approach should be used, which looks
into past.
 the cost of equity or expectation of investors is dependent on risk. Higher the risk higher the
expectations and vice versa. Capital asset pricing model calculates cost of equity based on
risk

Dividend Price Approach –

Cost of Equity (Ke) = D
Po

Ke= Cost of equity

D = Expected dividend
P0 = Market price of equity (ex- dividend)

Earning/ Price Approach-

Cost of Equity (Ke ) = E
P
E = Current earnings per share
P = Market share price

 This approach assumes that earning per share will remain constant forever.

Growth Approach or Gordon’s Model-

 Where earnings, dividends and equity share price all grow at the same rate, the cost of equity
capital may be computed as follows:
Cost of Equity (Ke)= D1 + g
P0
D1 = [D0 (1+ g)] i.e. next expected dividend
P0 = Current Market price per share
g = Constant Growth Rate of Dividend.

Where floatation cost is incurred-

Cost of Equity (Ke)= D1 + g
P0-F
F = Flotation cost per share

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11. A company has paid dividend of Rs 1 per share (of face value of Rs 10 each) last year and it is
expected to grow @ 10% next year. CALCULATE the cost of equity if the market price of share is Rs
55.

ESTIMATION OF GROWTH RATE-

The calculation of ‘g’ (the growth rate) is an important factor in calculating cost of equity share capital
Generally two methods are used to determine the growth rate, which are discussed below:
Average Method –
Current Dividend (D0) =Dn(1+g)n
Or
Growth rate = (D0/Dn)1/n – 1

12. The current dividend (D0) is Rs16.10 and the dividend 5 year ago was Rs10. Find out the growth rate

GORDON’S GROWTH MODEL-

Growth (g) = b × r
r = rate of return on fund invested
b = earnings retention ratio/ rate*
*Proportion of earnings available to equity shareholders which is not distributed as dividend

REALIZED YIELD APPROACH-

 According to this approach, the average rate of return realized in the past few years is historically
regarded as ‘expected return’ in the future. It computes cost of equity based on the past records of
dividends actually realised by the equity shareholders.
 It has unrealistic assumptions like risks faced by the company remain same; the shareholders
continue to expect the same rate of return; and the reinvestment opportunity cost (rate) of the
shareholders is same as the realised yield. If the earnings do not remain stable, this method is not
practical.

13. Mr. Mehra had purchased a share of Alpha Limited for Rs 1,000. He received dividend for a period of
five years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for
Rs 1,128. You are required to COMPUTE the cost of equity as per realised yield approach.

CAPITAL ASSET PRICING MODEL (CAPM) APPROACH-

 CAPM model describes the risk-return trade-off for securities.
 The risks, to which a security is exposed, can be classified into two groups:
 Unsystematic Risk: This is also called company specific risk as the risk is related with the company’s
performance. This type of risk can be reduced or eliminated by diversification of the securities
portfolio. This is also known as diversifiable risk.
 Systematic Risk: It is the macro-economic or market specific risk under which a company operates.
This type of risk cannot be eliminated by the diversification hence, it is non-diversifiable. The
examples are inflation, Government policy, interest rate etc.
 As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk
is the risk which cannot be eliminated; therefore a business should be concerned as per CAPM
method, solely with non-diversifiable risk.

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 The non-diversifiable risks are assessed in terms of beta coefficient (b or β) through fitting regression
equation between return of a security and the return on a market portfolio.
 Cost of Equity (Ke)= Rf + ß (Rm − Rf)
Ke = Cost of equity capital
Rf = Risk free rate of return
ß = Beta coefficient
Rm = Rate of return on market portfolio
(Rm – Rf) = Market risk premium

14. CALCULATE the cost of equity capital of H Ltd., whose risk free rate of return equals 10%. The firm’s
beta equals 1.75 and the return on the market portfolio equals to 15%.

COST OF RETAINED EARNINGS-

 Like another source of fund, retained earnings involve cost. It is the opportunity cost of dividends
foregone by shareholders
Dividend Price method: Kr = D / P
Earning Price method: Kr= EPS / P
Growth method: Kr= (D1/ P0 )+ g

15. Face value of equity shares of a company is Rs.10, while current market price is Rs.200 per share.
Company is going to start a new project, and is planning to finance it partially by new issue and
partially by retained earnings. You are required to CALCULATE cost of equity shares as well as cost of
retained earnings if issue price will be Rs.190 per share and floatation cost will be Rs.5 per share.
Dividend at the end of first year is expected to be Rs.10 and growth rate will be 5%

If personal tax is also considered then a shortcut formula may be as follows:

Kr = Ke (1-tp)(1-f)
Here tp is rate of personal tax on dividend and “f” is rate of flotation cost.
Here personal income tax means income tax payable on dividend income by equity shareholders. Currently
dividend income is not taxable in the hands of investors. Only dividend received in excess of Rs.10 lakhs by
an Individual, HUF or firm from domestic company is taxed at the rate of 10%.

16. Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate of personal income tax is 30%.
Calculate cost of retained earnings.

FLOATATION COST:
The new issue of a security (debt or equity) involves some expenditure in the form of underwriting or
brokerage fees, legal and administrative charges, registration fees, printing expenses etc. The sum of all
these cost is known as floatation cost. This expenditure is incurred to make the securities available to the
investors. Floatation cost is adjusted to arrive at net proceeds for the calculation of cost of capital.

17. ABC Company provides the following details:

D0 = Rs 4.19, P0 = Rs 50, g = 5%
CALCULATE the cost of retained earnings.

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18. ABC Company provides the following details:

Rf = 7%, ß = 1.20, Rm - Rf = 6%
CALCULATE the cost of retained earnings based on CAPM method.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)-

 To balance financial risk, control over the company and cost of capital, a company usually does not
procure entire fund from a single source. Rather than it makes a mix of various sources of finance.
 WACC is also known as the overall cost of capital of having capitals from the different sources
 Choice of weights
 Book Value(BV): Book value weights is operationally easy and convenient. While using BV,
reserves such as share premium and retained profits are included in the BV of equity, in addition
to the nominal value of share capital.
 Market Value(MV): Market value weight is more correct and represent a firm’s capital structure.
It is preferable to use MV weights for the equity. While using MV, reserves such as share
premium and retained profits are ignored as they are in effect incorporated into the value of
equity.

19. Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000 equity
shares of Rs.10 each and retained earnings of Rs.15,00,000. Market price per equity share is Rs.50.
Calculate WACC using market value weights if there is no other sources of finance.

20. CALCULATE the WACC using the following data by using:

(a) Book value weights
(b) Market value weights

The capital structure of the company is as under:

Debentures (Rs 100 per debenture) 5,00,000
Preference shares (Rs 100 per share) 5,00,000
Equity shares (Rs 10 per share) 10,00,000
TOTAL 20,00,000

The market prices of these securities are:

Debentures Rs 105 per debenture
Preference shares Rs 110 per preference share
Equity shares Rs 24 each.

Additional information:
(1) Rs 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 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 has Rs 4 floatation cost and market price Rs 24 per share.

The next year expected dividend is Rs 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.

Corporate tax rate is 30%. USE YTM Method to calculate Kd & Kp.

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MARGINAL COST OF CAPITAL-

The marginal cost of capital may be defined as the cost of raising an additional rupee of capital. Since the
capital is raised in substantial amount in practice, marginal cost is referred to as the cost incurred in raising
new funds.

21. ABC Ltd. has the following capital structure EXAMINE which is considered to be optimum as on 31st
March, 2017

14% Debentures 30,000

11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000

The company share has a market price of Rs 23.60. Next year dividend per share is 50% of year 2017 EPS.
The following is the trend of EPS for the preceding 10 years which is expected to continue in future.

Year EPS Year EPS

(Rs) (Rs)
2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is Rs 96.
Preference share Rs 9.20 (with annual dividend of Rs 1.1 per share) were also issued. The company is in 50%
tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)

(B) CALCULATE marginal cost of capital when no new shares are issued.

(C) DETERMINE the amount that can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year’s investment are 50 percent of 2017.

(D) COMPUTE marginal cost of capital when the funds exceeds the amount calculated in (C), assuming new
equity is issued at Rs 20 per share?

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22. DETERMINE the cost of capital of Best Luck Limited using the book value (BV) and market value (MV)
weights 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 Rs 130 per share and a new issue priced at Rs 125 per share will be fully
subscribed; flotation costs will be Rs 5 per share.
II. Dividend: During the previous 5 years, dividends have steadily increased from Rs 10.60 to Rs 14.19 per
share. Dividend at the end of the current year is expected to be Rs 15 per share.
III. Preference shares: 15% Preference shares with face value of Rs 100 would realiseRs 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

23. Gamma Limited has in issue 5,00,000 Rs 1 ordinary shares whose current ex-dividend market price is
Rs 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?

24. Masco Limited wishes to raise additional finance of Rs 10 lakhs for meeting its investment plans. It
has Rs 2,10,000 in the form of retained earnings available for investment purposes. Further details are
as following:
Debt / equity mix 30%/70%
Cost of debt
Upto Rs 1,80,000 10% (before tax)
Beyond Rs 1,80,000 16% (before tax)
Earnings per share Rs 4
Dividend pay out 50% of earnings
Expected growth rate in dividend 10%
Current market price per share Rs 44
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.

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25. The following details are provided by the GPS Limited:

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.

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ADDITIONAL QUESTIONS ON COST OF CAPITAL

26. Alpha Ltd. has furnished the following information :

- Earning Per Share (EPS) Rs 4
- Dividend payout ratio 25%
- Market price per share Rs 50
- Rate of tax 30%
- Growth rate of dividend 10%

The company wants to raise additional capital of Rs 10 lakhs including debt of Rs 4 lakhs.
The cost of debt (before tax) is 10% up to Rs 2 lakhs and 15% beyond that. Compute the
after tax cost of equity and debt and also weighted average cost of capital (MAY 2019 5 MARKS)

Solution-
(a) Cost of Equity Share Capital (Ke)
Ke = {D (1+g) / P0 } + g
Ke = { 25%of 4 (1+ 0.10) / 50} +0.10 = 0.122 or 12.2%

(b) Cost of Debt (Kd) =

Kd = Interest × 100 × (1 – t)
Net Proceeds
Interest on first Rs 2,00,000 @ 10% = Rs 20,000
Interest on next Rs 2,00,000 @ 15% = Rs 30,000

Kd= 50,000 × (1 – 0.3)

4,00,000

Kd = 0.0875 or 8.75 %

(c) Weighted Average Cost of Capital (WACC)-

Source of capital Amount Weights Cost of Capital WACC (%)

(%)
Equity shares 6,00,000 0.60 12.20 7.32
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.82

27. ABC Ltd. has the following capital structure which is considered to be optimum as on 31st March,
2019
14% Debentures 30,00,000
11% Preference shares 10,00,000
Equity Shares (10,000 shares) 1,60,00,000
2,00,00,000

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The company share has a market price of Rs. 236. Next year dividend per share is 50% of year 2019
EPS. The following is the trend of EPS for the preceding 10 years which is expected to continue in
future.
Year EPS (Rs.) Year EPS (Rs.)
2010 10.00 2015 16.10
2011 11.00 2016 17.70
2012 12.10 2017 19.50
2013 13.30 2018 21.50
2014 14.60 2019 23.60

The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is Rs. 96.
Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) were also issued. The company
is in 50% tax bracket.

(A) CALCULATE after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)

(B) CALCULATE marginal cost of capital when no new shares are issued.

(C) COMPUTE the amount that can be spent for capital investment before new ordinary shares must
be sold. Assuming that retained earnings for next year’s investment are 50 percent of 2019.

(D) COMPUTE marginal cost of capital when the funds exceeds the amount calculated in (C), assuming
new equity is issued at Rs. 200 per share? (MTP 10 MARKS)

Solution-

(A) (i) Cost of new debt

Kd = Interest × (1 – t)
Net Proceeds

Kd= 16 (1 - 0.5) = 0.0833

96
(ii) Cost of new preference shares
Kp = Pd / P0
Kp = 1.1 / 9.2
Kp = 0.12

(iii) Cost of new equity shares

Ke = {D1 / P0 } + g
Ke= {11.8/236} +0.10
Ke =0.15

Calculation of D1 -
D1 = 50% of 2019 EPS = 50% of 23.60 = Rs. 11.80

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(B) Calculation of marginal cost of capital

Type of Capital (1) Proportion (2) Specific Cost (3) Product (4) = (2) x (3)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.15 0.1200
Marginal cost of capital 0.1385

(C) The company can spend the following amount without increasing marginal cost of capital and
without selling the new shares:
Retained earnings = (0.50) (23.6 × 10,000) = Rs. 1,18,000
The ordinary equity (Retained earnings in this case) is 80% of total capital
1,18,000 = 80% of Total Capital
Capital investment before issuing equity = Rs 1,18,000 / 0.80
Capital investment before issuing equity = Rs.1,47,500

(D) If the company spends in excess of Rs.1,47,500 it will have to issue new shares.
The cost of new issue will be = { 11.8 / 200} +0.10 = 0.159

The marginal cost of capital will be:

Type of Capital (1) Proportion (2) Specific Cost (3) Product (4) = (2) x (3)
Debenture 0.15 0.0833 0.0125
Preference Share 0.05 0.12 0.0060
Equity Share 0.80 0.1590 0.1272
Marginal cost of capital 0.1457

28. As a financial analyst of a large electronics company, you are required to DETERMINE the
weighted average cost of capital of the company using (a) book value weights and (b)
market value weights. The following information is available for your perusal.
T he Company’s present book value capital structure is:
Debentures (Rs100 per debenture) 8,00,000
Preference shares (Rs100 per share) 2,00,000
Equity shares (Rs10 per share) 10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures, Rs110 per debenture, Preference shares, Rs120 per share, and Equity shares, Rs 22 per share

Anticipated external financing opportunities are:

(i) Rs 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4 per cent flotation
costs, sale price =Rs 100
(ii) Rs 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5 per cent
flotation costs, sale price= Rs100.
(iii) Equity shares: Rs 2 per share flotation costs, sale price = Rs 22.

In addition, the dividend expected on the equity share at the end of the year is Rs 2 per share, the
anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings in
the form of dividends. The corporate tax rate is 35 per cent. (RTP MAY 2019)

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Solution-
Determination of specific costs:

(i) Kd= I (1-T)+(RV-NP)

n
---------------------------
(RV+NP)
2
Kd= 11(1 - 0.35) +(100-96)/10
(100+96)/2

Kd= 0.077 or 7.70%

(ii) Kp= PD +(RV-NP)

N
--------------------------------------
(RV+NP)
2
Kp = 12+ (100-95) /10
(100+95)/2
Kp= 0.1282 or 12.82%

(iii) Cost of Equity shares (Ke) = (D1 / P0) + g

Ke ={2 / (22-2) } +0.07= 0.17 or 17%

(a) Weighted Average Cost of Capital (K0) based on Book value weights

Source of capital Book Weights Specific cost (%) WACC (%)

value
Debentures 8,00,000 0.40 7.70 3.08
Preferences shares 2,00,000 0.10 12.82 1.28
Equity shares 10,00,000 0.50 17.00 8.50
20,00,000 1.00 12.86

(b) Weighted Average Cost of Capital (K0) based on market value weights:

Source of capital Book Weights Specific cost (%) WACC (%)

value
Debentures 8,80,000 0.265 7.70 2.04
(8,00,000 x 110 / 100)
Preferences shares 2,40,000 0.072 12.82 0.92
Equity shares 22,00,000 0.663 17.00 11.27
33,20,000 1.00 14.23

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29. PK Ltd. has the following book-value capital structure as on March 31, 2020.
Equity share capital (10,00,000 shares) 2,00,00,000
11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
3,60,00,000

The equity shares of the company are sold for Rs 200. It is expected that the company will pay next year a
dividend of Rs 10 per equity share, which is expected to grow by 5% p.a. forever. Assume a 35% corporate
tax rate.

Required:
(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing capital
structure.
(ii) COMPUTE the new WACC, if the company raises an additional Rs50 lakhs debt by issuing 12%
debentures. This would result in increasing the expected equity dividend to Rs12.40 and leave the growth
rate unchanged, but the price of equity share will fall to Rs 160 per share (RTP MAY 2020)

Solution-
(i) Computation of Weighted Average Cost of Capital based on existing capital structure

Source of capital Existing Weights (a) After tax cost of WACC (%)
Capital capital (%) (a) x (b)
structure (b)
Equity share capital (W.N.1) 2,00,00,000 0.555 10.00 5.55
11.5% Preference share capital 60,00,000 0.167 11.50 1.92
10% Debentures (W.N.2) 1,00,00,000 0.278 6.50 1.81
3,60,00,000 1.00 9.28

WN1 - Cost of Equity shares

(Ke) = (D1 / P0) + g
Ke ={10/ 200 } +0.05= 10%

WN2 -Cost of 10% Debentures:

Kd = I(1-T) / NP
Kd = 10,00,000 (1-0.35) / 1,00,00,000
Kd= 0.065 or 6.5%

(ii) Computation of Weighted Average Cost of Capital based on new capital structure

Source of capital Existing Weights (a) After tax cost WACC (%)
Capital of (a) x (b)
structure capital (%)(b)
Equity share capital (W.N.3) 2,00,00,000 0.488 12.75 6.10
11.5% Preference share capital 60,00,000 0.146 11.50 1.68
10% Debentures (W.N.2) 1,00,00,000 0.244 6.50 1.59
12% Debentures (W.N.4) 50,00,000 0.122 7.80 0.95
4,10,00,000 1.00 10.32

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WN3 - Cost of equity capital:

Cost of Equity shares (Ke) = (D1 / P0) + g
Ke = (12.4 /160) +0.05
Ke= 0.1275 or 12.75%

WN4- Cost of 12% Debentures

Kd= {6,00,000(1 - 0.35) } /50,00,000
Kd= 0.078 or 7.8%

30. M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company
is presently considering several alternative investment proposals costing less than Rs 20
lakhs. The corporation always raises the required funds without disturbing its present debt
equity ratio.

The cost of raising the debt and equity are as under:

Project cost Cost of debt Cost of equity

Upto Rs 2 lakhs 10% 12%
Above Rs 2 lakhs & upto to Rs 5 lakhs 11% 13%
Above Rs 5 lakhs & upto Rs10 lakhs 12% 14%
Above Rs10 lakhs & upto Rs 20 lakhs 13% 14.5%

Assuming the tax rate at 50%, CALCULATE:

(i) Cost of capital of two projects X and Y whose fund requirements are Rs 6.5 lakhs and
Rs 14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what
conditions it would be acceptable? (RTP NOV 2018)

Solution-
Statement of Weighted Average Cost of Capital
Project cost Financing Proportion of capital After tax cost Weighted
Structure (1–Tax 50%) average cost (%)
Upto Rs 2 Lakhs Debt 0.4 10% (1 – 0.5) = 5% 0.4× 5 = 2.0
Equity 0.6 12% 0.6 × 12 = 7.2
9.2%
Above Rs 2 lakhs Debt 0.4 11% (1 – 0.5) = 5.5% 0.4× 5.5 = 2.2
& upto to Rs 5 Equity 0.6 13% 0.6 × 13 = 7.8
Lakhs 10 %
Above Rs 5 lakhs Debt 0.4 12% (1 – 0.5) = 6% 0.4× 6 = 2.4
& upto to Rs 10 Equity 0.6 14% 0.6 × 14 = 8.4
Lakhs 10.8 %
Above Rs 10 lakhs Debt 0.4 13% (1 – 0.5) = 6.5% 0.4× 6.5 = 2.6
& upto to Rs 20 Equity 0.6 14.5% 0.6 × 14.5 = 8.7
Lakhs 11.3%

Project Fund requirement Cost of capital

X Rs6.5 lakhs 10.8% (from the above table)
Y Rs14 lakhs 11.3% (from the above table)

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(ii) If a Project is expected to give after tax return of 10%, it would be acceptable provided its project cost
does not exceed Rs 5 lakhs or, after tax return should be more than or at least equal to the weighted
average cost of capital.

31. KM Ltd. has the following capital structure on September 30, 2019:
Sources of capital Amount
Equity Share Capital (40,00,000 Shares of Rs 10 each) 4,00,00,000
Reserves & Surplus 4,00,00,000
12% Preference Shares 2,00,00,000
9% Debentures 6,00,00,000
16,00,00,000

The market price of equity share is Rs60. It is expected that the company will pay next year a dividend of Rs6
per share, which will grow at 10% forever. Assume 40% income tax rate.

You are required to COMPUTE weighted average cost of capital using market value weights
(RTP NOV 2019)

Solution-

Source of capital Market Value Weights (a) After tax cost WACC (%)
of capital of (a) x (b)
capital
(%)(b)
9% Debentures 6,00,00,000 0.1875 5.40 1.01
12% Preference Shares 2,00,00,000 0.0625 12.00 0.75
Equity Share Capital 24,00,00,000 0.7500 20.00 15.00
(`60 × 40,00,000 shares)
Total 32,00,00,000 1.00 16.76

WN1 - Cost of equity capital:

Cost of Equity shares (Ke) = (D1 / P0) + g
Ke = (6/60) +0.10
Ke= 0.20 or 20%

WN2- Cost of Debentures

Kd= 0.09(1 - 0.4)
Kd= 0.054 or 5.4%

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IPCC PRACTISE MANUAL QUESTIONS ON COST OF CAPITAL-

32. ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, Rs10 par) Rs 1,500 million
Reserves and Surplus Rs 2,250 million
10.5% Preference Share Capital (1 million shares, Rs 100 million
Rs100 par)
9.5% Debentures (1.5 million debentures, Rs1,000 par) Rs 1,500 million
8.5% Term Loans from Financial Institutions Rs 500 million
The current market price per equity share is Rs 60. The prevailing default-risk free interest rate on 10-
year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The beta of the company
is 1.1875. Calculate Cost of Equity shares.

Solution
Computation of cost of equity (Ke) :
Ke= Rf + ß(Rm – Rf)
Or, Ke = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.1875 x 0.08)
= 0.15 or 15%

33. ABC Company’s equity share is quoted in the market at Rss25 per share currently. The company pays
a dividend of Rs 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 Rs 100 each and realises Rs 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-
(i) Cost of Equity Capital (Ke):
Ke =D1 / NP + g
Ke = 2 x 1.06 + 0.06
25

Ke =0.1448 or 14.48%

(ii) Cost of Debenture (Kd):

Using Present Value method or YTM)
Net Proceeds (NP) = Rs 96
Interest net of tax [I(1-t)] = 10% of Rs 100 (1 – 0.5) = Rs 5
Redemption value (RV) = Rs 100 + 12% = Rs 112

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

Year Cash flows Discount Present Discount Present Value
factor @ Value factor @
5%(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

IRR= 5% + 10.7 X (10%-5%)

10.7-(-26.2)

IRR = Kd = 6.45%

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Chapter 5 CAPITAL STRUCTURE

Capital structure is the combination of capitals from different sources of finance. The capital of a company
consists of equity share holders’ fund, preference share capital and long term external debts. The source and
quantum of capital is decided keeping in mind following factors:
 Control: capital structure should be designed in such a manner that existing shareholders continue
to hold majority stack.
 Risk: capital structure should be designed in such a manner that financial risk of the company does
not increases beyond tolerable limit.
 Cost: overall cost of capital remains minimum

The objective of a company is to maximise the value of the company and it is prime objective while deciding
the optimal capital structure

Value of the firm = EBIT

Overall cost of capital / Weighted average cost of capital
Value of firm = EBIT /Ko
Or Ko= EBIT/ Value of firm

Ko = (Cost of debt × weight of debt) + (Cost of equity × weight of equity)

Ko = [{Kd × D/ (D+S)} + {Ke × S/(D+S)}]

♦ Ko is the weighted average cost of capital (WACC)

♦ Kd is the cost of debt
♦ D is the market value of debt
♦ S is the market value of equity
♦ Ke is the cost of equity

CAPITAL STRUCTURE THEORIES-

The following approaches explain the relationship between cost of capital, capital structure and value of the
firm
(a) Net Income (NI) approach
(b) Traditional approach.
(c) Net Operating Income (NOI) approach
(d) Modigliani-Miller (MM) approach

NET INCOME (NI) APPROACH-

 An increase in financial leverage will lead to decline in the weighted average cost of capital (WACC),
while the value of the firm as well as market price of ordinary share will increase.
 Conversely, a decrease in the leverage will cause an increase in the overall cost of capital and a
consequent decline in the value as well as market price of equity shares.
 Value of Firm (V) = S + D
V = Value of the firm
S = Market value of equity
D = Market value of debt

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Market value of equity (S) = NI / Ke

NI = Earnings available for equity shareholders
Ke = Equity Capitalisation rate

The significant conclusion of this approach is that it pleads for the firm to employ as much debt as possible
to maximise its value

1. Rupa Ltd.’s EBIT is Rs 5,00,000. The company has 10%,Rs 20 lakh debentures. The equity
capitalization rate i.e. Ke is 16%.
You are required to CALCULATE:
(i) Market value of equity and value of firm
(ii) Overall cost of capital

TRADITIONAL APPROACH-
 This approach favours that as a result of financial leverage up to some point, cost of capital comes
down and value of firm increases. However, beyond that point, reverse trends emerge
 The rate of interest on debt remains constant for a certain period and thereafter with an increase in
leverage, it increases
 The expected rate by equity shareholders remains constant or increase gradually. After that, the
equity shareholders starts perceiving a financial risk and then from the optimal point and the
expected rate increases speedily
 As a result of the activity of rate of interest and expected rate of return, the WACC first decreases and
then increases
 Main Highlight of Traditional Approach - The firm should strive to reach the optimal capital
structure and its total valuation through a judicious use of the both debt and equity in capital
structure

2. Indra Ltd. has EBIT of Rs 1,00,000. The company makes use of debt and equity capital. The firm has
10% debentures of Rs 5,00,000 and the firm’s equity capitalization rate is 15%.
You are required to COMPUTE:
(i) Current value of the firm
(ii) Overall cost of capital.

3. DETERMINE the optimal capital structure of a company from the following information:
Options Cost of Cost of Percentage of Debt on total
Debt(Kd) in % Equity(Ke) in % value (Debt +Equity)
1 11 13.0 0.0
2 11 13.0 0.1
3 11.6 14.0 0.2
4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6

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NET OPERATING INCOME APPROACH (NOI)

 NOI means earnings before interest and tax (EBIT).
 Any change in the leverage will not lead to any change in the total value of the firm and the market
price of shares, as the overall cost of capital is independent of the degree of leverage. As a result, the
division between debt and equity is irrelevant
 As per this approach, an increase in the use of debt which is apparently cheaper is offset by an
increase in the equity capitalisation rate. This happens because equity investors seek higher
compensation as they are opposed to greater risk due to the existence of fixed return securities in
the capital structure

4. Amita Ltd’s operating income (EBIT) is Rs 5,00,000. The firm’s cost of debt is 10% and currently the
firm employs Rs 15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to CALCULATE:
(i) Total value of the firm.
(ii) Cost of equity.

5. Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per cent
debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All
percentages are in market-value terms). The borrowing rate for both companies is 8 per cent in a no-
tax world, and capital markets are assumed to be perfect.

(a) (i) If you own 2 per cent of the shares of Alpha Ltd., DETERMINE your return if the company has net
operating income of Rs3,60,000 and the overall capitalisation rate of the company, K0 is 18 per cent?
(ii) CALCULATE the implied required rate of return on equity?

(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) DETERMINE the implied required equity
return of Beta Ltd.? (ii) ANALYSE why does it differ from that of Alpha Ltd.?

MODIGLIANI-MILLER APPROACH (MM)-

 MM Approach – 1958: without tax:
 Value of levered firm (Vg) = Value of unlevered firm (Vu)
 Value of a firm = NOI / Ko or EBIT / Ko
 MM Approach- 1963: with tax:
 Value of a levered company = Value of an unlevered company + Tax benefit
 Or Vg = Vu + TB

6. There are two company N Ltd. and M Ltd., having same earnings before interest and taxes i.e. EBIT of
Rs 20,000. M Ltd. is a levered company having a debt of Rs1,00,000 @ 7% rate of interest. The cost of
equity of N Ltd. is 10% and of M Ltd. is 11.50%.

COMPUTE how arbitrage process will be carried on? Assume Investor owns 10% shares in Levered Company

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7. Following data is available in respect of two companies having same business risk:
Capital employed = Rs 2,00,000 ,EBIT = Rs 30,000 ,Ke = 12.5%
Sources Levered Company (Rs) Unlevered Company(Rs)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Investor is holding 15% shares in levered company. CALCULATE increase in annual earnings of investor if he
switches his holding from Levered to Unlevered company

8. There are two companies U Ltd. and L Ltd., having same NOI of Rs20,000 except that L Ltd. is a
levered company having a debt of Rs1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10% and
18% respectively.

COMPUTE how arbitrage process will work. Assume Investor owns 10% shares in Unlevered Company

9. Following data is available in respect of two companies having same business risk:
Capital employed = Rs 2,00,000 ,EBIT = Rs 30,000
Sources Levered Company Unlevered
(Rs) Company(Rs)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Ke 20 % 12.5%
Investor is holding 15% shares in Unlevered company. CALCULATE increase in annual earnings of investor if
he switches his holding from Unlevered to Levered Company.

THE TRADE-OFF THEORY-

 The trade-off theory of capital structure refers to the idea that a company chooses how much debt
finance and how much equity finance to use by balancing the costs and benefits.
 Trade-off theory of capital structure basically entails offsetting the costs of debt against the benefits
of debt.
 Trade-off theory of capital structure primarily deals with the two concepts - cost of financial distress
and agency costs.
 It states that there is an advantage to financing with debt, the tax benefits of debt and there is a
cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and
non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms.
 The first element of Trade-off theory of capital structure, considered as the cost of debt is usually the
financial distress costs or bankruptcy costs of debt. The direct cost of financial distress refers to the
cost of insolvency of a company. Once the proceedings of insolvency start, the assets of the firm may
be needed to be sold at distress price, which is generally much lower than the current values of the
assets. A huge amount of administrative and legal costs is also associated with the insolvency. Even
if the company is not insolvent, the financial distress of the company may include a number of
indirect costs like - cost of employees, cost of customers, cost of suppliers, cost of investors.
 The firms may often experience a dispute of interests among the management of the firm, debt
holders and shareholders. These disputes generally give birth to agency problems that in turn give
rise to the agency costs. The agency costs may affect the capital structure of a firm. There may be
two types of conflicts - shareholders-managers conflict and shareholders-debt holders conflict.

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PECKING ORDER THEORY-

 This theory is based on Asymmetric information, which refers to a situation in which different parties
have different information. In a firm, managers will have better information than investors. This
theory states that firms prefer to issue debt when they are positive about future earnings. Equity is
issued when they are doubtful and internal finance is insufficient.
 Pecking order theory suggests that managers may use various sources for raising of fund in the
following order –
 Managers first choice is to use internal finance
 In absence of internal finance they can use secured debt, unsecured debt, hybrid debt etc
 Managers may issue new equity shares as a last option

FACTORS AFFECTING CAPITAL STRUCTURE-

 Financial leverage of Trading on Equity:
 The use of long-term fixed interest bearing debt and preference share capital along with
equity share capital is called financial leverage or trading on equity. The use of long-term
debt increases the earnings per share if the firm yields a return higher than the cost of debt.
 However, leverage can operate adversely also if the rate of interest on long-term loan is more
than the expected rate of earnings of the firm. Therefore, it needs caution to plan the capital
structure of a firm
 Growth and stability of sales: The capital structure of a firm is highly influenced by the growth and
stability of its sale. If the sales of a firm are expected to remain fairly stable, it can raise a higher level
of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed
commitments of interest repayments of debt.
 Cost Principle: According to this principle, an ideal pattern or capital structure is one that minimises
cost of capital structure and maximises earnings per share (EPS).
 Risk Principle: According to this principle, reliance is placed more on common equity for financing
capital requirements than excessive use of debt. Use of more and more debt means higher
commitment in form of interest payout.
 Control Principle: While designing a capital structure, the finance manager may also keep in mind
that existing management control and ownership remains undisturbed. Issue of new equity will dilute
existing control pattern and also it involves higher cost.
 Flexibility Principle: By flexibility it means that the management chooses such a combination of
sources of financing which it finds easier to adjust according to changes in need of funds in future
too. While debt could be interchanged (If the company is loaded with a debt of 18% and funds are
available at 15%, it can return old debt with new debt, at a lesser interest rate), but the same option
may not be available in case of equity investment.

EBIT-EPS-MPS ANALYSIS-
 The basic objective of financial management is to design an appropriate capital structure which can
provide the highest wealth, i.e., highest MPS, which in turn depends on EPS
 Given a level of EBIT, EPS will be different under different financing mix depending upon the extent
of debt financing. The effect of leverage on the EPS emerges because of the existence of fixed
financial charge i.e., interest on debt, fixed dividend on preference share capital.
 The effect of fixed financial charge on the EPS depends upon the relationship between the rate of
return on assets and the rate of fixed charge. If the rate of return on assets is higher than the cost of
financing, then the increasing use of fixed charge financing (i.e., debt and preference share capital)
will result in increase in the EPS. This situation is also known as favourable financial leverage or
Trading on Equity.

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 On the other hand, if the rate of return on assets is less than the cost of financing, then the effect
may be negative and, therefore, the increasing use of debt and preference share capital may reduce
the EPS of the firm

10. Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of Rs 10
per share. The firm wants to raise Rs 250,000 to finance its investments and is considering three
alternative methods of financing – (i) to issue 25,000 ordinary shares at Rs 10 each, (ii) to borrowRs
2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference shares of Rs 100 each at an 8 per
cent rate of dividend. If the firm’s earnings before interest and taxes after additional investment are
Rs 3,12,500 and the tax rate is 50 per cent, FIND the effect on the earnings per share under the three
financing alternatives.
{ANSWER, EPS = 1.25(EQUITY), 1.46(DEBT), 1.36(PREFERENCE SHARES)}

FINANCIAL BREAK-EVEN AND INDIFFERENCE ANALYSIS-

 Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial
charges i.e. interest and preference dividends. It denotes the level of EBIT for which the company’s
EPS equals zero
 If the EBIT is less than the financial breakeven point, then the EPS will be negative but if the expected
level of EBIT is more than the breakeven point, then more fixed costs financing instruments can be
taken in the capital structure, otherwise, equity would be preferred
 Indifference point =
(EBIT-I1)(1-t) = (EBIT-I2)(1-t)
E1 E2
E1 = Number of equity shares in Alternative 1
E2 = Number of equity shares in Alternative 2
I1 = Interest charges in Alternative 1
I2 = Interest charges in Alternative 2
T = Tax-rate

11. Best of Luck Ltd., a profit making company, has a paid-up capital of Rs 100 lakhs consisting of 10
lakhs ordinary shares of Rs 10 each. Currently, it is earning an annual pre-tax profit of Rs 60 lakhs.
The company's shares are listed and are quoted in the range of Rs 50 to Rs 80. The management
wants to diversify production and has approved a project which will cost Rs 50 lakhs and which is
expected to yield a pre-tax income of Rs 40 lakhs per annum. To raise this additional capital, the
following options are under consideration of the management:

(a) To issue equity share capital for the entire additional amount. It is expected that the new shares (face
value of Rs 10) can be sold at a premium of Rs 15.
(b) To issue 16% non-convertible debentures of Rs 100 each for the entire amount.
(c) To issue equity capital for Rs 25 lakhs (face value of Rs 10) and 16% non-convertible debentures for the
balance amount. In this case, the company can issue shares at a premium of Rs 40 each.

CALCULATE the additional capital can be raised, keeping in mind that the management wants to maximise
the earnings per share to maintain its goodwill. The company is paying income tax at 50%.

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12. Shahji Steels Limited requires Rs 25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of Rs 5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per share. It has three alternatives to finance the
project - by raising debt of Rs 2,50,000 or Rs 10,00,000or Rs 15,00,000 and the balance, in each case,
by issuing equity shares. The company's share is currently selling at Rs 150, but is expected to decline
to Rs 125 in case the funds are borrowed in excess of Rs 10,00,000. The funds can be borrowed at the
rate of 10 percent upto Rs 2,50,000, at 15 percent over Rs 2,50,000 and upto Rs 10,00,000 and at 20
percent over Rs 10,00,000. The tax rate applicable to the company is 50 percent. ANALYSE which
form of financing should the company choose?

13. The following data are presented in respect of Quality Automation Ltd.:
Amount (Rs)
Profit before interest and tax 52,00,000
Less : Interest on debentures @ 12% 12,00,000
Profit before tax 40,00,000
Less : Income tax @ 50% 20,00,000
Profit After tax 20,00,000
No. of equity shares (of Rs 10 each) 8,00,000
EPS 2.5
P/E Ratio 10
Market price per share 25
The company is planning to start a new project requiring a total capital outlay of Rs 40,00,000. You are
informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means reduce PE ratio
to 8 and rises the interest rate on additional amount borrowed at 14%. FIND OUT the probable price of
share if:
(i) the additional funds are raised as a loan.
(ii) the amount is raised by issuing equity shares.
(Note : Retained earnings of the company is Rs 1.2 crore)

OVER- CAPITALISATION-
 It is a situation where a firm has more capital than it needs or in other words assets are worth less
than its issued share capital, and earnings are insufficient to pay dividend and interest.
 This situation mainly arises when the existing capital is not effectively utilized on account of fall in
earning capacity of the company while company has raised funds more than its requirements.
 The chief sign of overcapitalisation is the fall in payment of dividend and interest leading to fall in
value of the shares of the company.
 Causes of Over-Capitalisation:
 Raising more money through issue of shares or debentures than company can employ
profitably
 Borrowing huge amount at higher rate than rate at which company can earn
 Excessive payment for the acquisition of fictitious assets such as goodwill etc
 Consequences of Over-Capitalisation:
 Considerable reduction in the rate of dividend and interest payments
 Reduction in the market price of shares
 Resorting to “window dressing”

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 Remedies for Over-Capitalisation:

 Company should go for thorough reorganization
 Buyback of shares
 Reduction in claims of debenture-holders and creditors

UNDER CAPITALISATION-
 It is just reverse of over-capitalisation. It is a state, when its actual capitalisation is lower than its
proper capitalisation as warranted by its earning capacity.
 This situation normally happens with companies which have insufficient capital but large secret
reserves in the form of considerable appreciation in the values of the fixed assets not brought into
the books.
 Consequences of Under-Capitalisation:
 The dividend rate will be higher in comparison to similarly situated companies.
 Effects of Under-Capitalisation:
 It encourages acute competition. High profitability encourages new entrepreneurs to come
into same type of business
 High rate of dividend encourages the workers’ union to demand high wages
 Remedies:
 The shares of the company should be split up. This will reduce dividend per share
 Issue of Bonus Shares is the most appropriate measure as this will reduce both dividend per
share and the average rate of earning

14. Aaina Ltd. is considering a new project which requires a capital investment of Rs 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 Rs 9 crore or
(ii) By raising capital through taking a term loan of Rs 6 crores and Rs 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 Rs 72,00,000

Point of Indifference between the above two alternatives =

(EBIT- Interest)×(1-t) = (EBIT- Interest)×(1-t)
E1 E2
(EBIT-0) (1-0.30)/90,00,000 = (EBIT-72,00,000)x (1-0.30)/30,00,000
EBIT = Rs 1,08,00,000

EBIT at point of Indifference will be Rs 1.08 crore.

(The face value of the equity shares is assumed as Rs 10 per share. However, indifference point will be
same irrespective of face value per share).

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15. Xylo Ltd. is considering two alternative financing plans as follows:

Particulars Plan – A Plan – B
Equity shares of Rs 10 each 8,00,000 8,00,000
Preference Shares of Rs 100 each - 4,00,000
12% Debentures 4,00,000 -
12,00,000 12,00,000

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

SOLUTION-
Computation of Rate of Preference Dividend
(EBIT- Interest)×(1-t) = (EBIT- Interest)×(1-t)- Preference Dividend
E1 E2

(4,80,000 - 48,000) x (1-0.30) = (4,80,000-0)x (1-0.30)- Preference Dividend

80,000 80,000

302,400 = 3,36,000 – Preference Dividend

Preference Dividend = 3,36,000 – Rs 3,02,400
Preference Dividend = Rs 33,600
Rate of Dividend = Preference Dividend x 100
Preference share capital

Rate of Dividend = 33,600 /400,000 x 100

Rate of Dividend = 8.4%

16. Ganesha Limited is setting up a project with a capital outlay of Rs 60,00,000. It has two alternatives in
financing the project cost.
Alternative-I : 100% equity finance by issuing equity shares of Rs 10 each
Alternative-II : Debt-equity ratio 2:1 (issuing equity shares of Rs 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.

17. Ganapati Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised Rs 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 Rs 10 each will be issued at a premium of Rs 10 per share.
(f) Expected EBIT is Rs 80,000.

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You are required to DETERMINE for each plan: -

(i) Earnings per share (EPS)
(ii) The financial break-even point.
(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for indifference.

18. Yoyo Limited presently has Rs36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It
wishes to finance a Rs40,00,000 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 Rs16 per share. The company presently has 8,00,000 shares outstanding and is in
a 40 per cent tax bracket.

If earnings before interest and taxes are presently Rs15,00,000, DETERMINE earnings per share for the three
alternatives, assuming no immediate increase in profitability?

19. Alpha Limited requires funds amounting to Rs80 lakh for its new project. To raise the funds, the
company has following two alternatives:
(i) To issue Equity Shares of Rs100 each (at par) amounting to Rs60 lakh and borrow the balance amount at
the interest of 12% p.a.; or
(ii) To issue Equity Shares of Rs100 each (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
IDENTIFY the point of indifference between the available two modes of financing and state which option will
be beneficial in different situations.

20. One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of
10 per cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited,
except that its capital structure is all-equity, and its cost of equity is 16 per cent. According to
Modigliani and Miller, if we ignored taxation and tax relief on debt capital, COMPUTE the cost of
equity of Sanghmani Limited?

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ADDITIONAL QUESTIONS ON CAPITAL STRUCTURE

21. Stopgo Ltd, an all equity financed company, is considering the repurchase of Rs 200 lakhs equity and
to replace it with 15% debentures of the same amount. Current market Value of the company is Rs
1140 lakhs and it's cost of capital is 20%. It's Earnings before Interest and Taxes (EBIT) are expected
to remain constant in future. It's entire earnings are distributed as dividend. Applicable tax rate is 30
per cent.
You are required to calculate the impact on the following on account of the change in the capital structure
as per Modigliani and Miller (MM) Hypothesis:
(i) The market value of the company
(ii) It's cost of capital, and
(iii) It’s cost of equity (MAY 2018- 5MARKS)

Solution-
(a) Working Note
Market Value of Equity = Net income (NI) for equity holders
Ke
1140 lacs = NI
0.20

NI = 228 lakhs (1140 Lacs * 0.20)

EBIT = 228 lakhs / 0.7 = 325.70 lakhs

Particulars All Equity ( In lakhs) Debt & Equity( In lakhs)
EBIT 325.70 325.70
Interest on Rs200 lakhs @ 15% - (30.00)
EBT 325.70 295.70
Tax @ 30 % (97.70) (88.70)
Income available to equity holders 228 207

(i) Market value of levered firm = Value of unlevered firm + Tax Advantage
= Rs 1,140 lakhs + (Rs200 lakhs x 0.3)
= Rs 1,200 lakhs
The impact is that the market value of the company has increased by Rs 60 lakhs (Rs1,200 lakhs – Rs 1,140
lakhs)

Calculation of Cost of Equity

Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %

(ii) Cost of Capital

Components Amount (In lakhs) Cost of Capital % Weight WACC %
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00
The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax relief on debt interest
payment.

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22. Sun Ltd. is considering two financing plans.

Details of which are as under:
(i) Fund's requirement – Rs 100 Lakhs
(ii) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%

(iii) Cost of debt – 12% p.a.

(iv) Tax Rate – 30%
(v) Equity Share Rs 10 each, issued at a premium of Rs 15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) Rs 40 Lakhs

You are required to compute:

(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iii) Indifference point between Plan I and II (MAY 2018 -5 MARKS)

Solution-
(i) Computation of Earnings Per Share (EPS)
Plans I II
Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of Rs75 lakh) - (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ Rs10+Rs15) 4,00,000 1,00,000
E.P.S 7.00 21.70

(ii) Computation of Financial Break-even Points

Plan ‘I’ = 0 – Under this plan there is no interest payment, hence the financial breakeven
point will be zero.
Plan ‘II’ = Rs 9,00,000 - Under this plan there is an interest payment of Rs9,00,000,
hence the financial break -even point will be Rs9 lakhs

(iii) Computation of Indifference Point between Plan I and Plan II:

Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be
calculated by applying the following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2

EBIT(1-0.3) = ( EBIT-900,000) (1-0.3)

400,000 100,000

Or 2.8 EBIT – 25,20,000 = 0.7EBIT

Or 2.1EBIT = 25,20,000
EBIT =12,00,000

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23. RM Steels Limited requires Rs 10,00,000 for construction of a new plant. It is considering three
financial plans :
(i) The company may issue 1,00,000 ordinary shares at Rs 10 per share;
(ii) The company may issue 50,000 ordinary shares at Rs 10 per share and 5000 debentures of Rs 100
denominations bearing a 8 per cent rate of interest; and
(iii) The company may issue 50,000 ordinary shares at Rs 10 per share and 5,000 preference shares at Rs 100
per share bearing a 8 per cent rate of dividend.
If RM Steels Limited's earnings before interest and taxes are Rs 20,000; Rs 40,000; Rs 80,000; Rs 1,20,000 and
Rs 2,00,000, you are required to compute the earnings per share under each of the three financial plans ?
Which alternative would you recommend for RM Steels and why? Tax rate is 50%. (MAY 2019 10 MARKS)

Solution-
(i) Computation of EPS under three-financial plans
Plan I: Equity Financing

EBIT 20,000 40,000 80,000 1,20,000 2,00,000

Interest - - - - -
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
No. of equity shares 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
EPS 0.10 0.20 0.40 0.60 1

Plan II: Debt – Equity Mix

EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Interest 40,000 40,000 40,000 40,000 40,000
EBT (20,000) - 40,000 80,000 1,60,000
Less: Tax @ 50% 10,000* - 20,000 40,000 80,000
PAT (10,000) - 20,000 40,000 80,000
No. of equity shares 50,000 50,000 50,000 50,000 50,000
EPS (0.20) 0 0.40 0.80 1.60
* The Company can set off losses against the overall business profit or may carry forward it to next financial
years.

Plan III: Preference Shares – Equity Mix

EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Interest - - - - -
EBT 20,000 40,000 80,000 120,000 2,00,000
Less: Tax @ 50% 10,000 20,000 40,000 60,000 1,00,000
PAT 10,000 20,000 40,000 60,000 1,00,000
Less: Pref. dividend 40,000* 40,000* 40,000 40,000 40,000
PAT after Pref (30,000) (20,000) 0 20,000 60,000
Dividend
No. of equity shares 50,000 50,000 50,000 50,000 50,000
EPS (0.60) (0.40) 0 0.40 1.20
* In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits.

From the above EPS computations tables under the three financial plans we can see that when EBIT is Rs
80,000 or more, Plan II: Debt-Equity mix is preferable over the Plan I and Plan III, as rate of EPS is more under
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this plan. On the other hand an EBIT of less than Rs 80,000, Plan I: Equity Financing has higher EPS than Plan
II and Plan III. Plan III Preference share Equity mix is not acceptable at any level of EBIT, as EPS under this
plan is lower.

The choice of the financing plan will depend on the performance of the company and other macro
economic conditions. If the company is expected to have higher operating profit Plan II: Debt – Equity Mix is
preferable. Moreover, debt financing gives more benefit due to availability of tax shield.

24. 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 Rs60,00,000 and 12% debentures of Rs40,00,000. Or
(ii) Equity share capital of Rs40,00,000, 14% preference share capital of Rs20,00,000 and 12% debentures of
Rs40,00,000.
Assume the corporate tax rate is 35% and par value of equity share is Rs100 in each case. (RTP MAY 2020)

Solution-

(EBIT – I1)x (1-T) = (EBIT –I2) X (1-T) – Preference Dividend

E1 E2

{EBIT – (0.12 x 40,00,000) (1-0.35)} = {EBIT- (0.12 x 40,00,000) (1- 0.35) - (0.14x 20,00,000)}
60,000 40,000

0.65 EBIT - 3,12,000 = 0.65 EBIT - 5,92,000

1.5

0.65 EBIT-312,000 = 0.975 EBIT -888,000

888,000-312,000= 0.975 EBIT-0.65EBIT
576,000 = 0.325 EBIT
EBIT = 576,000 / 0.325
EBIT = 17,72,308

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25. The following data relates to two companies belonging to the same risk class:
Particulars A Ltd B Ltd.
Expected Net Operating Income Rs 18,00,000 Rs 18,00,000
12% Debt Rs 54,00,000 -
Equity Capitalization Rate - 18

REQUIRED:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach.

SOLUTION-
(a) Assuming no tax as per MM Approach.
Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis

Market Value of ‘B Ltd’ [Unlevered(u)]

Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = Rs 1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18

Market Value of ‘A Ltd’ [Levered Firm (I)]

Total Value of Levered Firm (VL) = Vu + (Debt× Nil)
= Rs 1,00,00,000 + (54,00,000 × nil)
= Rs1,00,00,000

Computation of Equity Capitalization Rate and Weighted Average Cost of Capital (WACC)
Particulars A Ltd. B Ltd.
A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,00 1,00,00,00
0 0
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,00
0
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital 0.18 0.18
*
[WACC (ko)] ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Amount Weight Cost of WACC
Capital Capital
Equity 46,00,000 0.46 0.2504 0.1152

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Debt 54,00,000 0.54 0.12* 0.0648

Total 1,00,00,000 0.18
*Kd = 12% (since there is no tax)
WACC = 18%

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘B Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= Rs60,00,000

Ke of unlevered Firm (given) = 0.18

Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18

Market Value of ‘A Ltd’ [Levered Firm (I)]

Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= Rs 60,00,000 + (54,00,000 × 0.4)
= Rs 81,60,000

Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’

= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and Weighted Average Cost of Capital (WACC) of A Ltd
Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Amount Weight Cost of WACC
Capital Capital
Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323
*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%
WACC = 13.23%
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Chapter 6 LEVERAGES

MEANING OF LEVERAGE –
In financial analysis leverage represents the influence of one financial variable over some other related
financial variable. These financial variables may be costs, output, sales revenue, Earnings Before Interest and
Tax (EBIT), Earning per share (EPS) etc.

TYPES OF LEVERAGE-
There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicated business risk.
(ii) Financial Leverage: it is the relationship between EBIT and EPS and indicates financial risk.
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicated total risk.

OPERATING LEVERAGE (OL)-

 Operating Leverage means tendency of operating income (EBIT) to change disproportionately with
change in sale volume. This disproportionate change is caused by operating fixed cost, which does
not change with change in sales volume
 The use of assets for which a company pays a fixed cost is called operating leverage
 OL = Contribution
EBIT

 Degree of Operating Leverage (DOL) = Percentage Change in EBIT

Percentage Change in Sales

Break-Even Analysis and Operating Leverage-

 Break-even point in units = Fixed Cost Or Fixed Cost
Contribution per unit PV Ratio

Particulars Product X Product Y

Selling Price 40 40
Variable Cost 20 20
Contribution 20 20
Total Contribution of 1,000 units 20,000 20,000
Fixed Cost 15,000 10,000
Profit (EBIT) 5,000 10,000
Break- even point (Fixed Cost / 15,000 10,000
= 750 units = 500 units
Contribution 20 20
 Contribution  20,000 20,000
Operating Leverage   =4 =2
EBIT 5,000 10,000
 

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Leverage Break-even point

1. Firm with high leverage 1. Higher Break-even point
2. Firm with low leverage 2 .Lower Break-even point
Fixed cost Operating leverage
1. High fixed cost 1. High degree of operating leverage
2. Lower fixed cost 2. Lower degree of operating leverage

MARGIN OF SAFETY (MOS) AND OPERATING LEVERAGE-

MOS= Sales-BEP Sales X 100
Sales
OR

MOS = EBIT
Contribution

DOL = 1
MOS

Example-
Particulars Product X

Sales (50 x 1000 units) 50,000

Variable Cost (30 x 1000 units) 30,000
Contribution 20,000
Fixed Cost 15,000
Profit (EBIT) 5,000
Break- even point (Fixed Cost / PV ratio) 15000/0.40 = 37,500
PV RATIO = C/S x 100 (20,000 / 50,000 * 100)
Margin of Safety = (50000-37500)/50000 0.25
Operating Leverage = Contribution/EBIT = 20000/5000 4
Operating Leverage = 1/MOS = 1/0.25 4

If Margin of safety Business Risk DOL (= 1/MOS)

Rises Falls Falls
Falls Rises Rises

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1. A Company produces and sells 10,000 shirts. The selling price per shirt is Rs 500. Variable cost is Rs
200 per shirt and fixed operating cost is Rs 25,00,000. (a) CALCULATE operating leverage. (b) If sales
are up by 10%, then COMPUTE the impact on EBIT?

2. CALCULATE the operating leverage for each of the four firms A, B, C and D from the following price
and cost data:
Firms
A B C D
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage
result? Explain. Assume number of units sold is 5,000

FINANCIAL LEVERAGE-

 Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to increase
earnings per share.’
 FL = Earnings before interest and tax(EBIT)
Earnings before tax(EBT)
EBIT = Sales - (Variable cost+ Fixed cost)
EBT = EBIT – Interest

 Degree of Financial Leverage (DFL)-

Degree of financial leverage is the ratio of the percentage increase in earnings per share (EPS) to the
percentage increase in earnings before interest and taxes (EBIT).
 Degree of Financial Leverage (DFL) = Percentage change in earnings per share (EPS)
Percentage change in earnings before interest and tax (EBIT)

FINANCIAL LEVERAGE AS ‘TRADING ON EQUITY-

 Financial leverage indicates the use of funds with fixed cost like long term debts and preference share capital
along with equity share capital which is known as trading on equity.
 The basic aim of financial leverage is to increase the earnings available to equity shareholders using fixed cost
fund. A firm is known to have a positive leverage when its earnings are more than the cost of debt.
 If earnings is equal to or less than cost of debt, it will be an unfavourable leverage. When the quantity of fixed
cost fund is relatively high in comparison to equity capital it is said that the firm is ‘’trading on equity”.

FINANCIAL LEVERAGE AS A ‘DOUBLE EDGED SWORD-

 On one hand when cost of ‘fixed cost fund’ is less than the return on investment financial leverage
will help to increase return on equity and EPS.
 The firm will also benefit from the saving of tax on interest on debts etc.
 However, when cost of debt will be more than the return it will affect return of equity and EPS
unfavourably and as a result firm can be under financial distress. This is why financial leverage is
known as “double edged sword”.

 When, ROI > Interest – Favourable – Advantage

 When, ROI < Interest – Unfavourable – Disadvantage
 When, ROI = Interest – Neutral – Neither advantage nor disadvantage.

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COMBINED LEVERAGE(CL)-
 Combined Leverage (CL) = Operating Leverage (OL) × Financial Leverage (FL) OR
 CL = Contribution x EBIT OR
EBIT EBT
 CL = Contribution
EBT
Degree of Combined Leverage (DCL)-
 DCL = DOL × DFL OR
 DCL = % Change in EBIT X %Change in EPS OR
% Change in Sales % Change in EBIT
 DCL = %Change in EPS
% Change in Sales

3. A firm’s details are as under:

Sales (@100 per unit) Rs 24,00,000
Variable Cost 50%
Fixed Cost Rs 10,00,000 (Other than interest)
Tax rate=50%
It has borrowed Rs 10,00,000 @ 10% p.a. and its equity share capital is Rs 10,00,000 (Rs 100 each)

CALCULATE:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by Rs 6,00,000; what will the new EBIT?

SUMMARY-
DOL DFL DCL
Shows level of business risk. Shows level of financial Shows level of total or combined
risk. risk.
It is dependent upon fixed cost. It is dependent upon It is dependent upon fixed cost,
interest and preference interest & preference dividend.
dividend
Measures % change in EBIT Measures % change in EPS Measures % change in EPS which
which results from a 1% change which results from a 1% results from a 1% change in
in Sales. change in EBIT. Sales.
For example, if DOL is 3 & there For example, if DFL is 2 and For example, if DCL is 6 and
is 8% increase in output then there is 5% increase in EBIT there is a 8% increase in sales
EBIT will increase by 24% & if then EPS will increase by then EPS will increase by 48%.
there is a 8% decrease in output 10% and if there is a 5% And if there is a 8% decrease in
EBIT will decrease by 24%. decrease in EBIT, EPS will sales then EPS will decrease by
decrease by 10%. 48%.

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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 Rs
1,57,500:
Particulars Amount
EBIT (Earnings before Interest and Tax) 31,50,000
Earnings before Tax (EBT) 14,00,000

5. Consider the following information for Mega Ltd.:

Production level 2,500 units
Contribution per unit Rs 150
Operating leverage 6
Combined leverage 24
Tax rate 30%
COMPUTE its earnings after tax

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 Rs 3000 Rs 2000
Profit volume ratio 25% 33.33%
Financial Leverage 4 3
Tax rate 45% 45%

7. The capital structure of PS Ltd. for the year ended 31st March, 2020 consisted as follows:
Particulars Amount in Rs
Equity share capital (face value Rs 100 each) 10,00,000
10% debentures (Rs 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 Rs 12 per unit and variable cost at Rs 8 per unit for both the years.
The fixed expenses were at Rs 2,00,000 p.a. and the income tax rate is 30%.

You are required to CALCULATE the following:

(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.

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SOLUTION-
Sales in units 1,20,000 1,00,000
(Rs) (Rs)
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=

EBIT Rs 2,80,000 Rs 2,00,000
= =
EBT Rs1,80,000 Rs1,00,000
= 1.56 =2

(ii) Operating leverage =

Contribution Rs 4,80,000 Rs 4,00,000
= =
EBIT Rs 2,80,000 Rs 2,00,000
= 1.71 =2

(iii) Earnings per share (EPS) 126,000 70,000

10,000 10,000
=12.6 =7

Decrease in EPS 12.6-7= 5.6

% decrease in EPS 5.6 X 100 = 44.44%
12.6

8. The Sale revenue of TM excellence Ltd. @ Rs.20 Per unit of output is Rs.20 lakhs and Contribution is
Rs.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.

9. Betatronics Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31st 2019
Liabilities Amount Assets Amount
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

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Income Statement for the year ending March 31st 2019

Particulars Amount
Sales 3,40,000
Operating expenses (including 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
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= 340,000-60,000 = 1.27

220,000

DFL = 220,000 / 160,000 = = 1.38

DCL = DOL×DFL = 1.27×1.38 = 1.75

(b) Earnings per share at the new sales level

Increase by Decrease by
20% 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 before taxes 2,16,000 1,04,000
Less: Taxes 75,600 36,400
Earnings after taxes (EAT) 1,40,400 67,600
Number of equity shares 80,000 80,000
EPS 1.76 0.85

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Working Notes:
(i) Variable Costs = Rs 60,000 (total cost − depreciation)

(ii) Variable Costs at:

(a) Sales level, Rs 4,08,000 = Rs 72,000 (increase by 20%)
(b) Sales level, Rs 2,72,000 = Rs 48,000 (decrease by 20%)

10. A company had the following Balance Sheet as on 31stMarch, 2019:

Liabilities Amount ( In Assets Amount ( In
Crores) Crores)
Equity capital ( 10 per share) 5 Net fixed assets 12.5
Reserves and Surplus 1 Current assets 7.5
15% Debentures 10
Current liabilities 4
20 20

The additional information given is as under

 Fixed cost per annum (excluding interest) – 4 Crores
 Variable operating cost ratio – 65%
 Total assets turnover ratio – 2.5
 Income Tax rate – 30%

CALCULATE the following and comment:

(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage

SOLUTION-
Total Assets = Rs 20 crores
Total Asset Turnover Ratio = 2.5
ASSET TUROVER RATIO = SALES
TOTAL ASSETS
Hence, Total Sales = 20 × 2.5 = Rs 50 crores

Computation of Profit after Tax (PAT)

(Rs in
crores)
Sales 50.00
Less: Variable Operating Cost @ 65% 32.50
Contribution 17.50
Less: Fixed Cost (other than Interest) 4.00
EBIT 13.50
Less: Interest on Debentures (15% X 10) 1.50
EBT 12.00

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Less: Tax @ 30% 3.60

EAT 8.40

(i) Earnings per Share

EPS =8.40 crores / Number of Equity Shares
= 8.40 crores /50,00,000
= Rs 16.80

(ii) Operating Leverage

Operating Leverage = Contribution / EBIT
= 17.50 /13.50
= 1.296

(iii) Financial Leverage

Financial Leverage = EBIT /EBT
= 13.50 / 12.00
= 1.125

(iv) Combined Leverage

= Operating Leverage × Financial Leverage
= 1.296 × 1.125
= 1.458

11. CALCULATE the operating leverage, financial leverage and combined leverage from the following
data under Situation I and II and Financial Plan A and B:
 Installed Capacity - 4,000 units
 Actual Production and Sales - 75% of the capacity
 Selling Price – 30 per unit
 Variable Cost – 15 per unit
 Fixed Cost:
Under Situation I - 15,000
Under Situation II – 20,000

 Capital Structure –
Particulars Financial Plan
A B
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

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ADDITIONAL QUESTIONS ON LEVERAGES

12. The following data have been extracted from the books of LM Ltd:
Sales - Rs100 lakhs
Interest Payable per annum - Rs 10 lakhs
Operating leverage - 1.2
Combined leverage - 2.16

You are required to calculate:

(i) The financial leverage,
(ii) Fixed cost and
(iii) P/V ratio (MAY 2018- 5 MARKS)

13. The capital structure of the Shiva Ltd. consists of equity share capital of Rs 20,00,000 (Share of
Rs 100 per value) and Rs 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000
units to 2,40,000 units, the selling price is Rs 10 per unit; variable costs amount to Rs 6 per unit
and fixed expenses amount to Rs 4,00,000. The income tax rate is assumed to be 50%.
(a) You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.
(b) Comment on the behaviour of operating and Financial leverages in relation to increase in
production from 2,00,000 units to 2,40,000 units. (MAY 2019 – 10 MARKS)

Solution-

Sales in units 2,00,000 2,40,000

(Rs) (Rs)
Sales Value @ 10 Per Unit 20,00,000 24,00,000
Variable Cost @ 6 per unit (12,00,000) (14,40,000)
Contribution 8,00,000 9,60,000
Fixed expenses (4,00,000) (4,00,000)
EBIT 4,00,000 5,60,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 3,60,000
Tax @ 50% (1,00,000) (1,80,000)
Profit after tax (PAT) 1,00,000 1,80,000
No of Share 20,000 20,000
Earnings per share (EPS) 5 9
(i)The percentage Increase in EPS 4
×100 = 80%
5
EBIT 4,00,000 5,60,000
(ii) Financial Leverage = =2 =1.56
EBT 2,00,000 3,60,000

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(iii) Operating leverage= 8,00,000 9,60,000

=2 =1.71
Contribution 4,00,000 5,60,000
EBIT

(b) When production is increased from 2,00,000 units to 2,40,000 units both financial leverage and operating
leverages reduced from 2 to 1.56 and 1.71 respectively.
Reduction in financial leverage and operating leverages signifies reduction in business risk and financial risk.

14. The following information is related to YZ Company Ltd. for the year ended 31st March, 2020:
 Equity share capital (of Rs 10 each) Rs 50 lakhs
 12% Bonds of Rs 1,000 each Rs 37 lakhs
 Sales Rs 84 lakhs
 Fixed cost (excluding interest) Rs 6.96 lakhs
 Financial leverage 1.49
 Profit-volume Ratio 27.55%
 Income Tax Applicable 40%

You are required to CALCULATE:

(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations up-to two decimal points (RTP MAY 2020)

Solution-
Computation of Profits after Tax (PAT) -
Particulars Amount (Rs)
Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12%  Rs37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)
EBT (Earnings before tax) 10,86,040*
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624

(i) Operating Leverage = Contribution

EBIT
= 23,14,200 / 16,18,200
= 1.43

(ii) Combined Leverage (CL) = Operating Leverage × Financial Leverage

CL= 2.13 ( 1.43 X 1.49)

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* Financial Leverage (FL)= EBIT

EBT
1.49 = 16,18,200
EBT
EBT = 10,86,040 (16,18,200 / 1.49)

Accordingly, other fixed interest = = 16,18,200 - Rs 10,86,040 - Rs 4,44,000 = Rs 88,160

(iii) Earnings per share (EPS) = PAT

No.of shares outstanding

EPS = 1.30 (6,51,624 / 500,000)

15. A firm has sales of Rs 75,00,000 variable cost is 56% and fixed cost isRs 6,00,000. It has a
debt of Rs 45,00,000 at 9% and equity of Rs 55,00,000. You are required to INTERPRET:
(i) The firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or
low capital turnover?
(iv) The operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase? (RTP NOV 2018)

SOLUTION-
Income Statement

Particulars Amount (Rs)

Sales 75,00,000
Less: Variable cost (56% of 75,00,000) (42,00,000)
Contribution 33,00,000
Less: Fixed costs (6,00,000)
Earnings before interest and tax (EBIT) 27,00,000
Less: Interest on debt (@ 9% on 45 lakhs) (4,05,000)
Earnings before tax (EBT) 22,95,000

(i) ROI = EBIT X 100

Capital employed

ROI = 27,00,000 X 100

55,00,000 + 45,00,000

ROI = 27%

(ROI is calculated on Capital Employed)

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(ii) ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage

(iii) Capital Turnover = Net Sales

Capital
= 0.75 (75,00,000 / 1,00,00,000)

Which is very low as compared to industry average of 3.

(iv) Calculation of Operating, Financial and Combined leverages

Operating Leverage = Contribution

EBIT
OL = 1.22 (33,00,000 / 27,00,000)

Financial Leverage (FL)= EBIT

EBT
FL= 1.18 (27,00,000 / 22,95,000)

Combined Leverage = Operating Leverage × Financial Leverage

CL = 1.44 (1.22 × 1.18 )

(v) Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased by 1.22 × 10 i.e. 12.20%
(approx)
(vi) Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to bring EBT to Zero

Accordingly, New Sales = Rs 75,00,000 × (1-0.6944)

= Rs 75,00,000 × 0.3056
= Rs 22,92,000 (approx)

Hence at Rs22,92,000 sales level EBT of the firm will be equal to Zero.

(vii) Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by 1.18 × 20 = 23.6%

16. The following summarises the percentage changes in operating income, percentage changes in
revenues, and betas for four listed firms.

Firm Change in Change in operating Beta

revenue income
A Ltd. 35% 22% 1.00
B Ltd. 24% 35% 1.65
C Ltd. 29% 26% 1.15
D Ltd. 32% 30% 1.20
Required:
(i) CALCULATE the degree of operating leverage for each of these firms. Comment also.
(ii) Use the operating leverage to EXPLAIN why these firms have different beta. (RTP NOV 2019)

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Solution-

(i) Degree of operating leverage = % Change in Operating income

% Change in Revenues

A Ltd. = 0.22 / 0.35 = 0.63

B Ltd. = 0.35 / 0.24 = 1.46
C Ltd. = 0.26 / 0.29 = 0.90
D Ltd. = 0.30 / 0.32 = 0.94

(ii) High operating leverage leads to high beta. So when operating leverage is lowest i.e. 0.63, Beta is
minimum (1) and when operating leverage is maximum i.e. 1.46, beta is highest i.e. 1.65

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IPCC PRACTISE MANUAL QUESTIONS ON LEVERAGES

17. The Capital structure of RST Ltd. is as follows:

Equity Share of Rs 10 each 8,00,000
10% Preference Share of Rs 100 each 5,00,000
12% Debentures of Rs 100 each 7,00,000
20,00,000
Additional Information:
 Profit after tax (Tax Rate 30%) are Rs 2,80,000
 Operating Expenses (including Depreciation Rs 96,800) are 1.5 times of EBIT
 Equity Dividend paid is 15%
 Market price of Equity Share is Rs 23

Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio

SOLUTION

Working Note
Net Profit after Tax (Given) 2,80,000
Tax @ 30% 1,20,000
EBT 400,000
Interest on Debentures 84,000
EBIT 4,84,000
Operating Expense ( 1.5 times of EBIT 7,26,000
(484,000 X 1.5)
Sales 12,10,000
Sales – Operating Expense = EBIT
Sales = EBIT + Operating Expense
Sales = 484,000+726,000
Contribution 580,800
( Sales – Operating Expense + Depreciation)
Contribution = 12,10,000- 726,000 +96,800

(i) Operating Leverage (OL) = Contribution / EBIT

OL= 580,800 /484,000
OL= 1.2 Times

Financial leverage(FL) = EBIT /EBT

FL = 1.21 Times ( 484,000/400,000)

(ii) Cover for Preference Dividend

= PAT / Preference Share Dividend
= 280,000 / 50,000
=5.6 Times

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Cover for Equity Dividend

=(PAT - Preference Dividend) / Equity Share Dividend
= (2,80,000 - 50,000) / 1,20,000
=1.92 times

(iii) Earning Yield Ratio

= EPS / MPS X 100
EPS = 230,000 / 80,000
EPS= 2.875

Earning Yield Ratio

= 2.875 / 23 x 100
= 12.5%

Price Earnings Ratio (PE Ratio)

PE Ratio = MPS / EPS
PE Ratio = 23 /2.875
PE Ratio = 8 Times

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18. Following are the selected financial information of A Ltd. and B Ltd. for the year ended March 31st,
2021:
A Ltd. B Ltd.
Variable Cost Ratio 60% 50%
Interest Rs 20,000 Rs 1,00,000
Operating Leverage 5 2
Financial Leverage 3 2
Tax Rate 30% 30%
You are required to FIND out:
(i) EBIT
(ii) Sales
(iii) Fixed Cost
(iv) Identify the company which is better placed with reasons based on leverages

SOLUTION-
Company A
(i) Financial Leverage = EBIT / EBIT - Interest
So, 3 = EBIT / EBIT-20,000
EBIT = 30,000

(ii) Operating Leverage = Contribution / EBIT

5 = Contribution / 30,000Rs
Contribution = Rs 1, 50,000

Sales = Contribution / P/V Ratio

= 3,75,000

(iii) Fixed Cost = Contribution – EBIT

= Rs 1, 50,000 – 30,000
Fixed cost = Rs 1,20,000

Company B
(i) Financial Leverage = EBIT / EBIT - Interest
2 = EBIT / EBIT-1,00,000
EBIT = Rs 2,00,000

(ii) Operating Leverage = Contribution / EBIT

Or, 2 = Contribution / 2,00,000Rs
Contribution = Rs 4,00,000

Sales = Contribution / P/V Ratio

Sales = 8,00,000
(iii) Fixed Cost = Contribution – EBIT
= Rs 4, 00,000 – Rs 2,00,000
Or, Fixed cost = Rs 2,00,000

Income Statements of Company A and Company B

Company A (Rs) Company B
(Rs)

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Sales 3,75,000 8,00,000

Less: Variable cost 2,25,000 4,00,000
Contribution 1,50,000 4,00,000
Less: Fixed Cost 1,20,000 2,00,000
Earnings before interest and 30,000 2,00,000
tax(EBIT)
Less: Interest 20,000 1,00,000
Earnings before tax (EBT) 10,000 1,00,000
Less: Tax @ 30% 3,000 30,000
Earnings after tax (EAT) 7,000 70,000

Comment based on Leverage

Company B has the least financial risk as the total risk (business and financial) of company B is lower
(combined leverage of Company A – 15 and Company B- 4)

19. The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given:
Output 1,00,000 units at normal capacity

Selling price per unit ₹ 40

Variable cost per unit ₹ 20

Fixed cost ₹ 10,00,000

The capital structure of the company as on 31st March, 2021 is as follows:

Particulars ₹
Equity share capital (1,00,000 shares of ₹ 10 each) 10,00,000
Reserves and surplus 5,00,000
7% debentures 10,00,000

Current liabilities 5,00,000

Total 30,00,000

Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve ₹ 10
lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by ₹ 5,00,000 and
variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling
price without any adverse impact on the market.

The following alternative schemes for financing the proposed expansion programme are planned:
(i) Entirely by equity shares of ₹ 10 each at par.
(ii) ₹ 5 lakh by issue of equity shares of ₹ 10 each and the balance by issue of 6% debentures of ₹ 100 each
at par.
(iii) Entirely by 6% debentures of ₹ 100 each at par.

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FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference
to the risk and return involved, assuming a corporate tax of 40%.

SOLUTION-
Statement showing Profitability of Alternative Schemes for Financing
(₹ in Lacs)
Particulars Existing Alternative Schemes
(i) (ii) (iii)
Equity Share capital 10 10 10 10
(existing)
New issues - 10 5 -
10 20 15 10
7% debentures 10 10 10 10
6% debentures - - 5 10
20 30 30 30

Debenture interest (7%) 0.7 0.7 0.7 0.7

Debenture interest (6%) - - 0.3 0.6

0.7 0.7 1.0 1.3

Output (units in lakh) 1 1.5 1.5 1.5

Contribution per. unit 20 22 22 22
(₹) (Selling price -
Variable Cost)

Contribution (₹ lakh) 20 33 33 33

Less: Fixed cost 10 15 15 15

EBIT 10 18 18 18
Less: Interest (as 0.7 0.7 1.0 1.3
calculated above)

EBT 9.3 17.3 17 16.7

Less: Tax (40%) 3.72 6.92 6.8 6.68
EAT 5.58 10.38 10.20 10.02

Operating Leverage 2.00 1.83 1.83 1.83

(Contribution /EBIT)

Financial Leverage 1.08 1.04 1.06 1.08

(EBIT/EBT)

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Combined Leverage 2.15 1.91 1.94 1.98

(Contribution/EBT)
EPS (EAT/No. of shares) 5.58 5.19 6.80 10.02
(₹)
Risk - Lowest Lower Highest
than
option (3)
Return - Lowest Lower Highest
than
option (3)

Conclusion-
If Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In case of
opting for less risk, alternative (ii) is the next best option with a reduced EPS of Rs 6.80 per share. In case of
alternative (i), EPS is even lower than the existing option, hence not recommended.

20. The following details of a company for the year ended 31st March, 2021 are given below:
Operating leverage 2:1
Combined leverage 2.5:1
Fixed Cost excluding interest Rs 3.4 lakhs
Sales Rs 50 lakhs
8% Debentures of Rs 100 each Rs 30.25 lakhs
Equity Share Capital of Rs 10 each 34 lakhs
Income Tax Rate 30%

CALCULATE:
(i) Financial Leverage
(ii) P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets
turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?

SOLUTION-
(i) Financial leverage
Combined Leverage = Operating Leverage (OL) × Financial Leverage (FL)
2.5 = 2 × FL
Or, FL = 1.25
Financial Leverage = 1.25

(ii) P/V Ratio and Earning per share (EPS)

Operating leverage =Contribution(C) / Contribution - Fixed Cost (FC)
2 = C / C - 3,40,000
Contribution = Rs 6,80,000

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Now, P/V ratio =Contribution (C)/ Sales (S) × 100

=6,80,000 / 50,00,000 × 100
Therefore, P/V Ratio = 13.6%

EBT = Sales – Variable Cost – Fixed Cost – Interest

= Rs50,00,000 – Rs50,00,000 (1-0.136) – Rs3,40,000 – (8% × Rs30,25,000)
= Rs 50,00,000 – Rs 43,20,000 – Rs 3,40,000 – Rs 2,42,000
= Rs 98,000

PAT = EBT(1-T)= Rs 98,000(1-0.3) = Rs 68,600

EPS = Profit after tax / No. of equity shares

EPS = 68,600 / 3,40,000shares
EPS = 0.202

(iii) Assets turnover

Assets turnover = Sales / Total Assets
= 50,00,000 / 34,00,000 + 30,25,000
=0 .78 *
0.78 < 1.5 means lower than industry turnover.
*Total Asset = Equity share capital + 8% Debentures

(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.5, sales have to be dropped by
100/2.5 = 40%. Hence new sales will be Rs 50,00,000 × (100 – 40) % = Rs 30,00,000.

Therefore, at Rs 30,00,000 level of sales, the Earnings before Tax (EBT) of the company will be zero.

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Chapter 7 INVESTMENT DECISION

 Investment decision is concerned with optimum utilization of fund to maximize the wealth of the
organization and in turn the wealth of its shareholders.
 Investment decisions are very popularly known as Capital Budgeting, which means applying the
principles of budgeting for capital investment.

PURPOSE OF CAPITAL BUDGTETING-

 Substantial expenditure: Due to huge capital investments and associated costs, it is therefore
necessary for an entity to make such decisions after a thorough study and planning.
 Long time period: The capital budgeting decision has its effect over a long period of time. These
decisions not only affect the future benefits and costs of the firm but also influence the rate and
direction of growth of the firm.
 Irreversibility: Most of the investment decisions are irreversible. Once the decision implemented it is
very difficult and reasonably and economically not possible to reverse the decision.
 Complex decisions: The capital investment decision involves an assessment of future events like
future benefits, future costs etc which in fact is difficult to predict.

CAPITAL BUDGETING PROCESS-

 Planning: The capital budgeting process begins with the identification of potential investment
opportunities.
 Evaluation: This phase involves the determination of proposal and its investments, inflows and
outflows.
 Selection: Considering the returns and risks associated with the individual projects as well as the
cost of capital to the organisation, the organisation will choose among projects so as to maximise
shareholders’ wealth.
 Implementation: When the final selection has been made, the firm must acquire the necessary
funds, purchase the assets, and begin the implementation of the project
 Control: The progress of the project is monitored with the aid of feedback reports.
 Review: When a project terminates, or even before, the organisation should review the entire
project to explain its success or failure

TYPES OF CAPITAL INVESTMENT DECISIONS-

 Generally capital investment decisions are classified in two ways. One way is to classify them on the
basis of firm’s existence. Another way is to classify them on the basis of decision situation.

On the basis of firm’s existence-

 Replacement and Modernisation decisions: The replacement and modernisation decisions aim
at to improve operating efficiency and to reduce cost. Generally, all types of plant and machinery
require replacement either because of the economic life of the plant or machinery is over or
because it has become technologically outdated. The former decision is known as replacement
decisions and latter is known as modernisation decisions. Both replacement and modernisation
decisions are called cost reduction decisions.
 Expansion decisions: Existing successful firms may experience growth in demand of their
product line. If such firms experience shortage or delay in the delivery of their products due to
inadequate production facilities, they may consider proposal to add capacity to existing product
line

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 Diversification decisions: These decisions require evaluation of proposals to diversify into new
product lines, new markets etc. for reducing the risk of failure by dealing in different products or
by operating in several markets.
On the basis of decision situation-
 Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more
alternative proposals are such that the acceptance of one proposal will exclude the acceptance of
the other alternative proposals. For instance, a firm may be considering proposal to install a semi-
automatic or highly automatic machine. If the firm installs a semi-automatic machine it excludes the
acceptance of proposal to install highly automatic machine.
 Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do
not compete with each other. The firm may accept or reject a proposal on the basis of a minimum
return on the required investment. All those proposals which give a higher return than certain
desired rate of return are accepted and the rest are rejected.
 Contingent decisions: The contingent decisions are dependable proposals. The investment in one
proposal requires investment in one or more other proposals. For example, if a company accepts a
proposal to set up a factory in remote area it may have to invest in infrastructure also e.g. building of
roads, houses for employees etc.

ESTIMATION OF PROJECT CASH FLOWS-

Calculating Cash Flows: Before, we analyze how cash flow is computed in capital budgeting decision,
following items need consideration:
 Depreciation: As mentioned earlier depreciation is a non-cash item and itself does not affect the
cash flow. However, we must consider tax shield or benefit from depreciation in our analysis. Since
this benefit reduces cash outflow for taxes, it is considered as cash inflow.
 Opportunity Cost: Opportunity cost is foregoing of a benefit due to choosing of an alternative
investment option. For example, if a company owns a piece of land acquired 10 years ago for Rs1
crore can be sold for Rs10 crore. If the company uses this piece of land for a project then its sale
value i.e. Rs10 crore forms the part of initial outlay as by using the land the company has foregone
Rs10 crore which could be earned by selling it. This opportunity cost can occur both at the time of
initial outlay and during the tenure of the project.
 Sunk Cost: Sunk cost is an outlay of cash that has already been incurred and cannot be reversed in
present. Therefore, these costs do not have any impact on decision making, hence should be
excluded from capital budgeting analysis. For example, if a company has paid a sum of Rs1,00,000
for consultancy fees to a firm to prepare a Project Report for analysing a particular project. The
consultancy fee is irrelevant and not considered for estimating cash flows as it has already been paid
and shall not affect our decision whether project should be undertaken or not
 Working Capital: Every big project requires working capital because, for every business, investment
in working capital is must. Therefore, while evaluating the projects initial working capital
requirement should be treated as cash outflow and at the end of the project its release should be
treated as cash inflow.

1. ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of Rs1,00,000;
expected economic life of 4 years and change in earnings before taxes and depreciation of Rs45,000
in year 1, Rs30,000 in year 2, Rs25,000 in year 3 and Rs35,000 in year 4. Assume straight-line
depreciation and a 20% tax rate. You are required to COMPUTE relevant cash flows.

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CAPITAL BUDGETING TECHNIQUES-

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES –

 PAYBACK PERIOD –
 Time required to recover the initial cash-outflow is called pay-back period.
 Packback Period = Total initial capital investment
Annual expected after-tax net cash flow

2. A project costs Rs 20,00,000 and yields annually a profit of Rs3,00,000 after depreciation @ 12½%
(straight line method) but before tax 50%. Calculate Payback Period.

3. XYZ Ltd. is analyzing a project requiring an initial cash outlay of Rs2,00,000 and expected to generate
cash inflows as follows:
Year Annual Cash Inflows
1 80,000
2 60,000
3 60,000
4 20,000
Calculate Payback Period

Advantages of Payback period-

 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed for the organization to
recoup the cash invested.

Limitations of Payback period-

 It ignores the time value of money.
 It ignores cash flows after the payback period

PAYBACK RECIPROCAL- (RTP NOV 2019)

 As the name indicates it is the reciprocal of payback period
 Payback Reciprocal = Average annual cash in flow
Initial investment
 Payback would be a close approximation of the Internal Rate of Return if the life of the project is at
least twice the payback period
 Payback reciprocal is a helpful tool for quick estimation of rate of return of a project provided its life
is at least twice the payback period

4. A project requires an initial investment of 20,000 and it would give annual cash inflow of 4,000. The
useful life of the project is estimated to be 5 years. Calculate payback reciprocal

SOLUTION-

Payback Reciprocal = 4,000×100

20,000

=20%

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ACCOUNTING (BOOK) RATE OF RETURN (ARR) OR AVERAGE RATE OF RETURN (ARR)-

 ARR = Average annual net income
Investment

5. Times Ltd. is going to invest in a project a sum of Rs 3,00,000 having a life span of 3 years. Salvage
value of machine is Rs90,000. The profit before depreciation for each year is Rs1,50,000. Calculate
ARR

6. A project requiring an investment of Rs10,00,000 and it yields profit after tax and depreciation which
is as follows:
Years Profit after tax and depreciation
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project can be sold for
80,000. DETERMINE Average Rate of Return.

DISCOUNTING TECHNIQUES-
 Net Present Value Technique (NPV) –
 The net present value technique is a discounted cash flow method that considers the time
value of money in evaluating capital investments. An investment has cash flows throughout
its life, and it is assumed that an amount of cash flow in the early years of an investment is
worth more than an amount of cash flow in a later year.
 Decision Rule:
If NPV ≥ 0 , Accept the Proposal
If NPV ≤ 0, Reject the Proposal
 The NPV method can be used to select between mutually exclusive projects; the one with the
higher NPV should be selected

7. COMPUTE the net present value for a project with a net investment of Rs1,00,000 and net cash flows
year one is Rs55,000; for year two is Rs80,000 and for year three is Rs 15,000. Further, the company’s
cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

8. ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the purchase
of equipment; the company uses the net present value technique to evaluate projects. The capital
budget is limited to Rs 500,000 which ABC Ltd believes is the maximum capital it can raise. The initial
investment and projected net cash flows for each project are shown below. The cost of capital of ABC
Ltd is 12%.

You are required to COMPUTE the NPV of the different projects.

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Project A Project B Project C Project D

Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000

Advantages of NPV -
NPV method takes into account the time value of money.
The whole stream of cash flows is considered.

Limitations of NPV -
It involves difficult calculations.
The application of this method necessitates forecasting cash flows and the discount rate. Thus accuracy
of NPV depends on accurate estimation of these two factors which may be quite difficult in practice

PROFITABILITY INDEX /DESIRABILITY FACTOR/PRESENT VALUE INDEX METHOD (PI)-

 PI= PV of Cash Inflow
PV Of Cash Outflow
 Decision Rule:
If PI ≥ 1 , Accept the Proposal
If PI ≤ 1 , Reject the Proposal

 In case of mutually exclusive projects; project with higher PI should be selected

9. Suppose we have three projects involving discounted cash outflow of Rs5,50,000, Rs 75,000 and
Rs1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for these
projects are Rs6,50,000, Rs95,000 and Rs1,00,30,000 respectively. CALCULATE the desirability factors
for the three projects.

INTERNAL RATE OF RETURN METHOD (IRR)-

 IRR Definition: Internal rate of return for an investment proposal is the discount rate that equates
the present value of the expected cash inflows with the initial cash outflow
Use following Interpolation Formula ,
IRR = LR+ NPV at LRR X (HR-LR)
NPV at LR - NPV at HR

10. A Ltd. is evaluating a project involving an outlay of Rs10,00,000 resulting in an annual cash inflow of
Rs 2,50,000 for 6 years. Assuming salvage value of the project is zero; DETERMINE the IRR of the
project.

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11. CALCULATE the internal rate of return of an investment of Rs1,36,000 which yields the following cash
inflows:
Year Cash Inflows
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

12. A company proposes to install machine involving a capital cost of Rs3,60,000. The life of the machine
is 5 years and its salvage value at the end of the life is nil. The machine will produce the net
operating income after depreciation of Rs68,000 per annum. The company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:

Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to CALCULATE the internal rate of return of the proposal.

DECISION RULE FOR IRR-

If IRR ≥ Cut-off Rate or WACC , Accept the Proposal
If IRR ≤ Cut-off Rate or WACC , Reject the Proposal

DISCOUNTED PAYBACK PERIOD METHOD-

 Payback period is time taken to recover the original investment from project cash flows. It is also
termed as break even period.
 The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value
of money and profitability.
 Discounted payback period considers present value of cash flows, discounted at company’s cost of
capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal
the initial outflow.
 The shorter the period, better it is. It also ignores post discounted payback period cash flows.

13. For example, a Rs30,000 cash outlay for a project with annual cash inflows of Rs6,000 would have a
payback of 5 years (Rs30,000 / Rs6,000).Discount Factor is 15%. Calculate Discounted payback
period.

MULTIPLE INTERNAL RATE OF RETURN-

In cases where project cash flows change signs or reverse during the life of a project e.g. an initial cash
outflow is followed by cash inflows and subsequently followed by a major cash outflow, there may be more
than one IRR.

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Advantages of IRR -
 This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.

Limitations of IRR -
 The calculation process is tedious if there are more than one cash outflows interspersed between the
cash inflows, there can be multiple IRR, the interpretation of which is difficult.
 If mutually exclusive projects are considered as investment options which have considerably
different cash outlays. A project with a larger fund commitment but lower IRR contributes more in
terms of absolute NPV and increases the shareholders’ wealth. In such situation decisions based only
on IRR criterion may not be correct.

MODIFIED INTERNAL RATE OF RETURN (MIRR)-

 It eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results which
are consistent with the Net Present Value method. This method is also called Terminal Value method.
 Under this method, all cash flows, apart from the initial investment, are brought to the terminal value
using an appropriate discount rate (usually the Cost of Capital). This results in a single stream of cash
inflow in the terminal year. The MIRR is obtained by assuming a single outflow in the zeroth
year and the terminal cash inflow as mentioned above. The discount rate which equates the
present value of the terminal cash inflow to the zeroth year outflow is called the MIRR.

14. An investment of Rs1,36,000 yields the following cash inflows (profits before depreciation but after
tax). DETERMINE MIRR considering 8% as cost of capital.

Year Rs
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

15. Suppose there are two Project A and Project B are under consideration. The cash flows associated
with these projects are as follows:
Year Project A Project B
0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
Assuming Cost of Capital equal to 10% IDENTIFY which project should be accepted as per NPV Method and
IRR Method.

16. Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash flows
associated with these projects are as follows:
Year Project X Project Y
0 (2,50,000) (3,00,000)
1 2,00,000 50,000

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2 1,00,000 1,00,000
3 50,000 3,00,000

Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted as per NPV Method and IRR
Method.

17. Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash flows
associated with these projects are as follows:

Year Project A Project B

0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000
Assuming Cost of Capital equal to 12%, ANALYSE which project should be accepted as per NPV Method and IRR
Method?

SUMMARY OF DECISION CRITERIA OF CAPITAL BUDGETING TECHNIQUES-

Techniques For Independent Project For Mutually
Exclusive
Projects
Non- Pay Back (i) When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period
Payback period: Accepted should be
(ii) When Payback period ≥ selected
Maximum Acceptable
Payback period: Rejected
Accounting (i) When ARR≥ Minimum Project with the
Rate of Acceptable Rate of Return: maximum ARR
Return(ARR) Accepted should be
(ii) When ARR ≤ Minimum selected.
Acceptable Rate of Return:
Rejected
Discounted Net Present (i) When NPV > 0: Accepted Project with the
Value (NPV) (ii) When NPV < 0: Rejected highest positive
NPV should be
selected

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Profitability (i) When PI > 1: Accepted When Net Present

Index(PI) (ii) When PI<1:Rejected Value is same
project with
Highest PI should
be selected

Internal Rate (i) When IRR >K: Accepted Project with the
of Return (ii) When IRR <K: Rejected maximum IRR
(IRR) should be
selected

SPECIAL CASES-

Capital Budgeting under Capital Rationing-

Project has positive NPV it should be accepted with an objective of maximisation of wealth of shareholders. However,
there may be a situation due to resource (capital) constraints (rationing) a firm may have to select some projects
among various projects, all having positive NPVs.

Broadly two scenarios may influence the method of evaluation to be adopted -

(i) If projects are independent of each other and are divisible in nature: In such situation NPV Rule should be modified
and accordingly projects should be ranked on the basis of ‘NPV per rupee of Capital ’method.
(ii) If projects are not divisible: In such situation projects shall be ranked on the basis of absolute NPV and should be
mixed up to the point available resources are exhausted.

18. Shiva Limited is planning its capital investment programme for next year. It has five projects all of
which give a positive NPV at the company cut-off rate of 15 percent, the investment outflows and
present values being as follows:
Project Investment NPV @ 15%
000 000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3

The company is limited to a capital spending of 1,20,000.

You are required to ILLUSTRATE the returns from a package of projects within the capital spending limit. The
projects are independent of each other and are divisible (i.e., part-project is possible).

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19. R plc is considering modernizing its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as per
discounting rate of 12% and IRR is as follows:
Year Cash Flow
Project A Project B
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%
IDENTIFY which project should R plc accept?

20. The expected cash flows of three projects are given below. The cost of capital is 10 per cent.

(a) CALCULATE the payback period, net present value, internal rate of return and accounting rate of
return of each project.
(b) IDENTIFY the rankings of the projects by each of the four methods.

Period Project A Project B Project C

0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600

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Solution-

Payback Period Method:

A = 5 + (500/900) = 5.56 years
B = 5 + (500/1,200) = 5.42 years
C = 2 + (1,000/2,000) = 2.5 years

Net Present Value Method:

NPVA = (− 5,000) + (900×6.145) = (5,000) + 5,530.5 = 530.5

NPV(B) is calculated as follows:

Year Cash flow 10% discount factor Present value
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 800 0.826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591

NPV(c) is calculated as follows:

Year Cash flow 10% discount factor Present value
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655

Internal Rate of Return -

NPV at 12% = (5,000) + 900×5.650
= (5,000) + 5085= 85
NPV at 13% = (5,000) + 900×5.426
= (5,000) + 4,883.40= -116.60
IRRA =12+ { 85 / (85+116.6)} x (13-12)
IRRA = 12.42%.

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IRRB
Year Cash 10% Present 20% Present
flow discount value discount value
factor factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.833 583
2 800 0.826 661 0.694 555
3 900 0.751 676 0.579 521
4 1,000 0.683 683 0.482 482
5 1,100 0.621 683 0.402 442
6 1,200 0.564 677 0.335 402
7 1,300 0.513 667 0.279 363
8 1,400 0.467 654 0.233 326
9 1,500 0.424 636 0.194 291
10 1,600 0.386 618 0.162 259
1,591 (776)

Interpolating: IRRB= 10%+ 1591 / (1591+776) x (20%-10%)

IRRB= 10%+6.72% = 16.72%

IRRC -
Year Cash flow 15% Present 18% Present
discount value discount value
factor factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 2,000 0.870 1,740 0.847 1,694
2 2,000 0.756 1,512 0.718 1,436
3 2,000 0.658 1,316 0.609 1,218
4 1,000 0.572 572 0.516 516
140 (136)

Interpolating: IRRC = 15% +140 /(140+136) x (18%-15%)= 16.52%

Accounting Rate of Return:

ARRA: Average capital employed = 5000/2 = 2500
Average accounting profit = (9,000- 5,000) / 10 = 400
ARRA = 400/2500 x 100 = 16%

ARRB: Average accounting profit = (11,500-5,000)/10 = 650

ARRB = 650/2500 x 100 =26%

ARRC: Average accounting profit = (7,000- 5,000) / 4 =500

ARRC = 500/2500 x 100 = 20%

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(b) Summary of Results

Project A B C
Payback (years) 5.5 5.4 2.5
ARR (%) 16 26 20
IRR (%) 12.42 16.72 16.52
NPV 530.50 1,591 655

Comparison of Rankings
Method Payback ARR IRR NPV
1 C B B B
2 B C C C
3 A A A A

21. 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 Rs5 lakhs each. Salvage value of the old machine is Rs1 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 Rs1 lakh. If the company purchases B then all the existing
utilities will have to be replaced with new utilities costing Rs2 lakhs. The salvage value of the old
utilities will be Rs0.20 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 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
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) ADVICE which of the machines is to
be selected?

Solution-
(i) Expenditure at year zero (Rs In lacs)
Particulars A B
Cost of Machine 5 5
Cost of Utilities 1 2
Salvage of Old Machine (1) (1)
Salvage of Old Utilities - (0.2)
Total Expenditure (Net) 5 5.8

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(ii) Discounted Value of Cash inflows (Rs In lacs)

Machine A Machine B
Year NPV Cash Discounted Cash Discounted
Factor inflows value of Flows value of
@ 15% inflows inflows
0 1.00 (5.00) (5.00) (5.80) (5.80)
1 0.87 1.00 0.87 2.00 1.74
2 0.76 1.50 1.14 2.10 1.60
3 0.66 1.80 1.19 1.80 1.19
4 0.57 2.00 1.14 1.70 0.97
5 0.50 1.70 0.85 0.40 0.20
Salvage 0.50 0.50 0.25 0.60 0.30
Net Present +0.44 +0.20
Value (5.44-5) (6-5.80)

Since the Net present Value of both the machines is positive both are acceptable.

(iii) Discounted Pay-back Period (Rs in Lacs)

Year Machine A Machine B
Discounted cash Cumulative Discounted cash Cumulative
inflows Discounted cash inflows Discounted cash
inflows inflows
1 0.87 0.87 1.74 1.74
2 1.14 2.01 1.60 3.34
3 1.19 3.20 1.19 4.53
4 1.14 4.34 0.97 5.50
5 1.10* 5.44 0.50 6.00
* Includes salvage value

Discounted Payback Period (For A and B):

Machine A = 4 years +(0.66/1.1) = 4.6 years
Machine B = 4 years + (0.30/0.50) = 4.6 years

Profitability Index (PI) = Sum of present value of net cash flow

Initial Cash Outlay

Machine A = 5.44 lacs /5 lacs = 1.088

Machine B = 6 lacs /5.80 lacs = 1.034

(iv)Since the absolute surplus in the case of A is more than B and also the desirabilityfactor, it is better to
choose A.

The discounted payback period in both the cases is same, also the net presentvalue 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.

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22. 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 Rs7,00,000 at time 0 and
Rs10,00,000 in year 1. After-tax cash inflows of Rs2,50,000 are expected in year 2, Rs3,00,000 in
year 3, Rs3,50,000 in year 4 and Rs4,00,000 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)
Year Cash flow Discount Factor (15%) Present value
0 (7,00,000) 1.00 (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)Similarly, NPV at 10% discount rate can be computed as follows:

Year Cash flow Discount Factor Present
(10%) 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)IRR = LR + NPV AT LR / (NPV at LR-NPV at HR) X (HR-LR)

IRR= 10%+ 2,51,450 / (2,51,450-1,18,200) X (15%-10%)
IRR= 13.40%

(d)Payback Period = 6 years:

−Rs7,00,000−Rs10,00,000 + Rs2,50,000 + Rs3,00,000 + Rs3,50,000 + Rs4,00,000 +Rs4,00,000 = 0

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23. 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 Present value of Future Cash-
required 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 Rs4,40,000. 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 Rs6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a Rs1,25,000 extension on the plant will be
necessary, as space is not available for all three projects. ANALYSE which project or projects should be
chosen?

Solution-

Project Investment Required Present value of Future Net Present value

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

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(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

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

24. Cello Limited is considering buying a new machine which would have a useful economic life of five
years, a cost of Rs1,25,000 and a scrap value of Rs30,000, with80 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 Rs3 per unit. Direct costs
would be Rs1.75 per unit and annual fixed costs, including depreciation calculated on a straight- line
basis, would be Rs40,000 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 Rs10,000 andRs15,000 respectively.

ANALYSE the project using the NPV method of investment appraisal, assuming the company’s cost of capital
to be 10 percent.

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

Year Capital Contribution Fixed costs Advertisement 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 10% discount Present
flow factor 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
31,712

The net present value of the project is 31,712.

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ADDITIONAL QUESTIONS ON INVESTMENT DECISIONS

25. A company is evaluating a project that requires initial investment of Rs 60 lakhs in fixed assets andRs
12 lakhs towards additional working capital.

The project is expected to increase annual real cash inflow before taxes by Rs 24,00,000 during its life. The
fixed assets would have zero residual value at the end of life of 5 years.

The company follows straight line method of depreciation which is expected for tax purposes also. Inflation
is expected to be 6% per year. For evaluating similar projects, the company uses discounting rate of 12% in
real terms. Company's tax rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms.
PVIF (12%, 5 years)
Year 1 0.893
Year 2 0.797
Year 3 0.712
Year 4 0.636
Year 5 0.567
(MAY 2018 – 10 MARKS)

Solution-
(i) Equipment’s initial cost = Rs 60,00,000 + Rs 12,00,000
= Rs 72,00,000
(ii) Annual straight line depreciation = Rs 12,00,000 (60,00,000/5)
(iii) Net Annual cash flows can be calculated as follows:
Earnings before Depreciation & Tax 24,00,000
Less – Depreciation (12,00,000)
EBT 12,00,000
Tax at 30% (3,60,000)
EAT 840,000
+ Depreciation 12,00,000
Cash Flow 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (Rs 20,40,000 × PVIF 12%, 5 years) + (Rs 12,00,000 × 0.567)
= (Rs 20,40,000 × 3.605) + Rs 6,80,400
= Rs 73,54,200 + Rs 6,80,400
= Rs 80,34,600
So NPV = PV of Inflows – Initial Cost
= Rs 80,34,600 – Rs 72,00,000
= Rs 8,34,600
Advice: Company should accept the project as the NPV is Positive

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26. Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
The particulars are as under :
Project X Project Y
Initial Investment 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut off rate is 14%. The discount factor at 14% are :
Year 1 2 3 4 5 6 7 8 9
Discount 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308
factor
Advise management about the acceptability of projects X and Y (MAY 2019 – 5MARKS)

Solution-

The possible outcomes of Project x and Project y are as follows

Estimates Project X Project Y
Estimated PVF PV of NPV Estimated PVF PV of NPV
Annual @ 14% Cash Annual @ Cash
Cash for 8 flow Cash 14% flow
inflows years inflows for 8
years
Pessimistic 26,000 4.639 1,20,614 614 12,000 4.639 55,668 (-64,332)
Most likely 28,000 4.639 1,29,892 9,892 28,000 4.639 1,29,892 9,892
Optimistic 36,000 4.639 1,67,004 47,004 52,000 4.639 2,41,228 1,21,228

In pessimistic situation project X will be better as it gives low but positive NPV whereas Project Y yield highly
negative NPV under this situation. In most likely situation both the project will give same result. However, in
optimistic situation Project Y will be better as it will gives very high NPV. So, project X is a risk less project as
it gives positive NPV in all the situation whereas Y is a risky project as it will result into negative NPV in
pessimistic situation and highly positive NPV in optimistic situation. So acceptability of project will largely
depend on the risk taking capacity (Risk seeking/ Risk aversion) of
the management.

27. AT Limited is considering three projects A, B and C. The cash flows associated with the
projects are given below:
Cash flows associated with the Three Projects

Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
You are required to :
(a) Calculate the payback period of each of the three projects.

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(b) If the cut-off period is two years, then which projects should be accepted?
(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
(d) "Payback gives too much weight to cash flows that occur after the cut-off date". True or
false?
(e) "If a firm used a single cut-off period for all projects, it is likely to accept too many short
lived projects." True or false? (MAY 2019 – 10 MARKS)

Solution-

(a) Payback Period of Projects

Projects C0 C1 C2 C3 Payback
A (10,000) 2000 2000 6,000 2,000+2,000+6,000 =10,000 i.e 3
years
B (2,000) 0 2,000 NA 0+2,000 = 2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000+2,000+6,000 = 10,000 i.e 3
years

(b) If standard payback period is 2 years, Project B is the only acceptable project.

(c) Calculation of NPV

Year PVF Project A Project B Project C

@ Cash PV of Cash PV of Cash PV of cash
10% Flows cash Flows cash Flows flows
flows flows

0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)

1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806

So, Projects with positive NPV are Project B and Project C

(d) False. Payback gives no weightage to cash flows after the cut-off date.

(e) True. The payback rule ignores all cash flows after the cutoff date, meaning that future years’ cash
inflows are not considered. Thus, payback is biased towards short-term projects.

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28. PD Ltd. an existing company, is planning to introduce a new product with projected life of 8
years. Project cost will be Rs 2,40,00,000. At the end of 8 years no residual value will be
realized. Working capital of Rs 30,00,000 will be needed. The 100% capacity of the project is
2,00,000 units p.a. but the Production and Sales Volume is expected are as under :

Year Number of Units

1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units

Other Information:
(i) Selling price per unit Rs 200
(ii) Variable cost is 40 % of sales.
(iii) Fixed cost p.a. Rs 30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure 50,00,000 25,00,000 10,00,000 5,00,000

(v)Income Tax is 25%.

(vi) Straight line method of depreciation is permissible for tax purpose.
(vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.

Present Value Table

Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Advise about the project acceptability (NOV 2018)

Solution-
Computation of initial cash outlay(COF)
( in lakhs)
Project Cost 240
Working Capital 30
270

Calculation of Cash Inflows(CIF):

Yeas 1 2 3-5 6-8
Sales in units 60,000 80,000 1,40,000 1,20,000

Contribution ( 200 x 60% x

72,00,000 96,00,000 1,68,00,000 1,44,00,000
No. of Unit)
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation
30,00,000 30,00,000 30,00,000 30,00,000
(24000000/8)

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= 30,00,000

Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000

Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)

Computation of PV of CIF
CIF PV Factor
Year
@ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 1,19,25,000
Working Capital (89,25,000+30,00,000) 0.467 55,68,975
PV of Cash Inflow 3,88,82,700
PV of COF 2,70,00,000
1,18,82,700
Recommendation: Accept the project in view of positive NPV

29. BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives.
Following new X-ray machines are of two different brands with same features are available for the
purchase.

Cost of Life of Maintenance Cost Rate of

Brand Year 1-5 Year 6-10 Year 11-15
Machine Machine Depreciation
XYZ 6,00,000 15 years 20,000 28,000 39,000 4%
ABC 4,50,000 10 years 31,000 53,000 -- 6%

Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year and
thereafter shall be depreciated at the rate mentioned above.

Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after
use on the following terms and conditions:
 Annual Rent shall be paid in the beginning of each year and for first year it shall be 1,02,000.
 Annual Rent for the subsequent 4 years shall be Rs 1,02,500.
 Annual Rent for the final 5 years shall be Rs 1,09,950.
 The Rent Agreement can be terminated by BT Labs by making a payment of Rs 1,00,000as penalty.
This penalty would be reduced by Rs 10,000 each year of the period of rental agreement.

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You are required to:

(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine shall be
continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5 years?

The cost of capital of BT Labs is 12%. (RTP MAY 2019)

Solution-

Since the life span of each machine is different and time span exceeds the useful lives of each
model, we shall use Equivalent Annual Cost method to decide which brand should be chosen.

(i) If machine is used for 20 years

Present Value (PV) of cost if machine of Brand XYZ is purchased
Period Cash Outflow PVF@12 Present Value
%
0 6,00,000 1.000 6,00,000
1-5 20,000 3.605 72,100
6-10 28,000 2.045 57,260
11-15 39,000 1.161 45,279
15 (64,000)* 0.183 (11,712)
7,62,927

*64,000 = 600,000 – (600,000 * 1/3) – (600,000 * 4% * 14 yrs)

PVAF for 1-15 years = 6.811

Equivalent Annual Cost = 1,12,014 (7,62,927 / 6.811)

Present Value (PV) of cost if machine of Brand ABC is purchased-

Period Cash Outflow PVF@12 Present Value

%
0 4,50,000 1.000 4,50,000
1-5 31,000 3.605 1,11,755
6 -10 53,000 2.045 1,08,385
10 (57,000) 0.322 (18,354)
6,51,786

PVAF for 1-10 years = 5.65

Equivalent Annual Cost = 1,15,360 (6,51,786/5.65)

Present Value (PV) of cost if machine of Brand ABC is taken on Rent-

Period Cash Outflow PVF@12 Present Value

%
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5-9 1,09,950 2.291 2,51,895
6,65,188

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PVAF for 1-10 years = 5.65

Equivalent Annual Cost = 1,17,732 (6,65,188 /5.65)

Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of brand XYZ the
same should be purchased.

(ii) If machine is used for 5 years

(a) Scrap Value of Machine of Brand XYZ

= Rs 6,00,000 – Rs 2,00,000 – Rs 6,00,000 × 0.04 × 4 = Rs 3,04,000
(b) Scrap Value of Machine of Brand ABC
= Rs 4,50,000 – Rs 1,50,000 – Rs 4,50,000 × 0.06 × 4 = Rs 1,92,000

Present Value (PV) of cost if machine of Brand XYZ is purchased-

Period Cash Outflow PVF@12 Present Value
%
0 6,00,000 1.000 6,00,000
1–5 20,000 3.605 72,100
5 (3,04,000) 0.567 (1,72,368)
4,99,732

Present Value (PV) of cost if machine of Brand ABC is purchased-

Period Cash Outflow PVF@12 Present Value
%
0 4,50,000 1.000 4,50,000
1- 31,000 3.605 1,11,755
5
5 (1,92,000) 0.567 (1,08,864)
4,52,891

Present Value (PV) of cost if machine of Brand ABC is taken on Rent-

Period Cash Outflow PVF@12 Present Value
%
0 1,02,000 1.000 1,02,000
1-4 1,02,500 3.037 3,11,293
5 50,000 0.567 28,350
4,41,643

Decision: Since Cash Outflow is least in case of lease of Machine of brand ABC the same should be taken on
rent

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30. A company is considering the proposal of taking up a new project which requires an investment of
Rs800 lakhs on machinery and other assets. The project is expected to yield the following earnings
(before depreciation and taxes) over the next five years:

Year Earnings ( in lakhs)

1 320
2 320
3 360
4 360
5 300

The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on written down
value basis. The scrap value at the end of the five year period may be taken as zero. Income-tax applicable
to the company is 40%.

You are required to CALCULATE the net present value of the project and advise the management to take
appropriate decision. Also CALCULATE the Internal Rate of Return of the Project.

Note: Present values of Re. 1 at different rates of interest are as follows:

Year 10% 12% 14% 16% 20%
1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40
(RTP MAY 2020)
Solution-

(i) Calculation of Net Cash Flow

( in lakhs)
Year Profit Depreciation PBT PAT Net cash
before (20% on flow
dep. and WDV)
tax
(1) (2) (3) (4) (5) (3) + (5)
1 320 800  20% = 160 160 96 256
2 320 (800  160) 20% = 128 192 115.20 243.20
3 360 (640  128) 20% = 257.6 154.56 256.96
102.4
4 360 (512  102.4) 20% = 278.08 166.85 248.77
81.92
5 300 (409.6  81.92) = 27.68 16.61 311.07
327.68*
*this is treated as a short term capital loss

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(ii) Calculation of Net Present Value (NPV)-

Year Net Cash 12 16 20
Flow % % %
D.F P.V D.F P.V D.F P.V
1 256 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.03
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
941.36 850.71 773.16
Less: Initial Investment 800.00 800.00 800.00
NPV 141.36 50.71 -26.84

(iii) Advise: Since Net Present Value of the project at 12% = 141.36 lakhs, therefore the
project should be implemented

(iv) Calculation of Internal Rate of Return (IRR)

IRR = 16% + 50.71 / (50.71+26.84) x (20%-16%)
IRR= 18.62%.

31. Shiv Limited is thinking of replacing its existing machine by a new machine which would cost Rs 60
lakhs. The company’s current production is 80,000 units, and is expected to increase to 1,00,000
units, if the new machine is bought. The selling price of the product would remain unchanged at Rs
200 per unit. The following is the cost of producing one unit of product using both the existing and
new machine:

Unit cost
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate 10.0 12.50 2.50
Overheads
183.25 165.50 (17.75)

The existing machine has an accounting book value of Rs 1,00,000, and it has been fully depreciated for tax
purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine has offered
to accept the old machine for Rs 2,50,000.

However, the market price of old machine today is Rs 1,50,000 and it is expected to be Rs 35,000 after 5
years. The new machine has a life of 5 years and a salvage value of Rs 2,50,000 at the end of its economic
life. Assume corporate Income tax rate at 40%, and depreciation is charged on straight line basis for Income-
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tax purposes. Further assume that book profit is treated as ordinary income for tax purpose. The opportunity
cost of capital of the Company is 15%.

Required:
(i) ESTIMATE net present value of the replacement decision.
(ii) CALCULATE the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? ANALYSE.

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

(RTP NOV 2018)

SOLUTION-
(i) Net Cash Outlay of New Machine
Purchase Price 60,00,000
Less: Exchange value of old machine [2,50,000 – 0.4(2,50,000 – 0)] 1,50,000
58,50,000
Market Value of Old Machine: The old machine could be sold for Rs 1,50,000 in the market. Since the
exchange value is more than the market value, this option is not attractive. This opportunity will be lost
whether the old machine is retained or replaced. Thus, on incremental basis, it has no impact.

Depreciation base: Old machine has been fully depreciated for tax purpose. Thus, the depreciation base of
the new machine will be its original cost i.e. Rs 60,00,000.

Net Cash Flows: Unit cost includes depreciation and allocated overheads. Allocated overheads are allocated
from corporate office therefore they are irrelevant. The depreciation tax shield may be computed separately.
Excluding depreciation and allocated overheads, unit costs can be calculated. The company will obtain
additional revenue from additional 20,000 units sold.

Thus, after-tax saving, excluding depreciation, tax shield, would be

= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)
= {52,00,000 – 21,60,000} × 0.60
= 18,24,000

After adjusting depreciation tax shield and salvage value, net cash flows and net present value are estimated

Calculation of Cash flows and Project Profitability-

(‘000)
0 1 2 3 4 5
1 After-tax savings - 1824 1824 1824 1824 1824
2 Depreciation - 1150 1150 1150 1150 1150
( 60,00,000 – 2,50,000)/5

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3 Tax shield on depreciation - 460 460 460 460 460

(Depreciation × Tax rate)
4 Net cash flows from - 2284 2284 2284 2284 2284
operations (1 + 3)*
5 Initial cost (5850)

6 Net Salvage Value - - - - - 215

(2,50,000 – 35,000)

7 Net Cash Flows (4+5+6) (5850) 2284 2284 2284 2284 2499

8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972

9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50

10 NPV 1913.32

* Alternately Net Cash flows from operation can be calculated as follows:

Profit before depreciation and tax = Rs 1,00,000 (200 -148) - 80,000 (200 -173)
= Rs 52,00,000 – 21,60,000
= Rs 30,40,000

So profit after depreciation and tax is Rs (30,40,000 -11,50,000) × (1 - .40)

= Rs 11,34,000
So profit before depreciation and after tax is :
Rs 11,34,000 + Rs 11,50,000 (Depreciation added back) = Rs 22,84,000

(ii)

(‘000)
0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12

IRR = 20% + (1066.94 / 1296.82 ) X (30%-20%)

IRR =28.23%

(iii) Advise: The Company should go ahead with replacement project, since it is positive NPV decision

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IPCC PRACTISE MANUAL QUESTIONS ON INVESTMENT DECISION

32. A company wants to invest in a machinery that would cost Rs 50,000 at the beginning of year 1. It is
estimated that the net cash inflows from operations will be Rs 18,000 per annum for 3 years, if the
company opts to service a part of the machine at the end of year 1 at Rs 10,000. In such a case, the
scrap value at the end of year 3 will be Rs 12,500. However, if the company decides not to service
the part, then it will have to be replaced at the end of year 2 at Rs 15,400. But in this case, the
machine will work for the 4th year also and get operational cash inflow of Rs 18,000 for the 4th
year. It will have to be scrapped at the end of year 4 at Rs 9,000. Assuming cost of capital at 10% and
ignoring taxes, will you recommend the purchase of this machine based on the net present value of
its cash flows?

If the supplier gives a discount of Rs 5,000 for purchase, what would be your decision? (The present value
factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6209
and 0.5644).

Answer

Option I : Purchase Machinery and Service Part at the end of Year 1.

Net Present value of cash flow @ 10% per annum discount rate.
Year Cash Flows Discount Rate at 10% Discounted Cash Flows
0 (50,000) 1 (50,000)
1 8,000 0.9091 7,273
(18,000-10,000)
2 18,000 0.8264 14,875
3 30,500 0.7513 22,915
(18,000+12,500)
NPV (4,937)

Since, Net Present Value is negative; therefore, this option is not to be considered.

If Supplier gives a discount of Rs 5,000 then,

NPV = +5,000 – 4,937 = + 63
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.

Net Present value of cash flow @ 10% per annum discount rate.
Year Cash Flows Discount Rate at 10% Discounted Cash Flows
0 (50,000) 1 (50,000)
1 18,000 0.9091 16,364
2 2,600 0.8264 2,148
(18,000-15,400)
3 18,000 0.7513 13,523
4 27,000 0.6830 18,441
(18,000+9000)
NPV 476

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Net Present Value is positive, but very low as compared to the investment
If the Supplier gives a discount of Rs 5,000, then
NPV = 5,000 + 476 = 5,476

Decision:
Option II is worth investing as the net present value is positive and higher as compared to Option I.

33. Given below are the data on a capital project 'M'.

Annual cash inflows Rs 60,000
Useful life 4 years
Internal rate of return 15%
Profitability index 1.064
Salvage value 0

You are required to calculate for this project M :

(i) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value

PV factors at different rates are given below:

Discount 15% 14% 13% 12%
factor
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636

Answer
(i) Cost of Project ‘M’
At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project i.e initial cash outlay
Annual cash inflows = Rs 60,000
Useful life = 4 years

Considering the discount factor table @ 15%, cumulative present value of cash inflows for 4 years is 2.855
(0.869 + 0.756 + 0.658 + 0.572)

Hence, Total Cash inflows for 4 years for Project M is

Rs 60,000 × 2.855 = Rs 1,71,300

Hence, Cost of the Project = Rs 1,71,300

(ii) Payback Period

Payback period (PP) = Cost of the Project
Annual Cash Inflows

PP= 171,300 / 60,000

PP = 2.855 years

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(iii) Cost of Capital

Profitability Index(PI)= PV of Cash Inflows

PV Of Cash Outflows

1.064 = PV of Cash Inflows

171,300
PV of Cash Inflows = 1,82,263.20
Since, Annual Cash Inflows = Rs 60,000
Hence, cumulative discount factor for 4 years = 1,82,263.20
60,000
= 3.038
From the discount factor table, at discount rate of 12%, the cumulative discount factor for 4 years is 3.038
(0.893 + 0.797 + 0.712 + 0.636)

Hence, Cost of Capital = 12%

(iv) Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= Rs 1,82,263.20 – Rs 1,71,300 = Rs 10,963.20
Net Present Value = Rs10,963.20

34. WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated useful life is
8 years with no salvage value in the end. Its current market value is Rs 2,00,000. The company is
considering a proposal to purchase a new model of machine to replace the existing machine. The
relevant information is as follows:

Particulars Existing Machine New Machine

Cost of machine Rs 3,30,000 Rs 10,00,000
Estimated life 11 years 8 years
Salvage value Nil Rs 40,000
Annual output 30,000 units 75,000 units
Selling price per unit Rs 15 Rs 15
Annual operating hours 3,000 3,000
Material cost per unit Rs 4 Rs 4
Labour cost per hour Rs 40 Rs 70
Indirect cash cost per Rs 50,000 Rs 65,000
annum
The company follow the straight line method of depreciation. The corporate tax rate is 30 per cent and WX
Ltd. does not make any investment, if it yields less than 12 per cent. Present value of annuity of Re. 1 at
12% rate of discount for 8 years is 4.968. Present value of Rs 1 at 12% rate of discount, received at the end
of 8th year is 0.404. Ignore capital gain tax.

Advise WX Ltd. whether the existing machine should be replaced or not.

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Answer
(i) Calculation of Net Initial Cash Outflows:

Cost of new machine 10,00,000

Less: Sale proceeds of existing 2,00,000
machine
Net initial cash outflows 8,00,000

(ii) Calculation of annual depreciation:

On old machine = 30,000 Per annum ( 330,000 / 11 years)
On new machine = 120,000 Per annum ( 10,00,000 - 40,000 / 8 years)

(iii) Calculation of annual cash inflows from operation:

Particulars Existing New Machine Differential

Machine
(1) (2) (3) (4) = (3) – (2)
Annual output 30,000 units 75,000 units 45,000 units
(A) Sales revenue @ Rs 15 per unit 4,50,000 11,25,000 6,75,000
(B) Less: Cost of Operation
Material @ Rs 4 per unit 1,20,000 3,00,000 1,80,000
Labour
Old = 3,000 x Rs 40 1,20,000 90,000
New = 3,000 x Rs 70 2,10,000
Indirect cash cost 50,000 65,000 15,000
Depreciation 30,000 1,20,000 90,000
Total Cost (B) 3,20,000 6,95,000 3,75,000
Profit Before Tax (A – B) 1,30,000 4,30,000 3,00,000
Less: Tax @ 30% 39,000 1,29,000 90,000
Profit After Tax 91,000 3,01,000 2,10,000
Add: Depreciation 30,000 1,20,000 90,000
Annual Cash Inflows 1,21,000 4,21,000 3,00,000

(iv) Calculation of Net Present Value:

Rs
Present value of annual net cash
Inflows: 1 – 8 years = Rs 3,00,000 x 4.968 14,90,400
Add: Present value of salvage value of new machine at
the end of 8th year (Rs 40,000 x 0.404) 16,160
Total present value 15,06,560
Less: Net Initial Cash Outflows 8,00,000
NPV 7,06,560
Advise: Hence, existing machine should be replaced because NPV is positive.

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35. A Ltd. is considering the purchase of a machine which will perform some operations which are at
present performed by workers. Machines X and Y are alternative models. The following details are
available:

Machine X Machine Y
Cost of machine 1,50,000 2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance p.a. 7,000 11,000
Estimated cost of indirect material, p.a. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages pa. 90,000 1,20,000

Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternatives On
(i) Average rate of return method, and
(ii) Present value index method assuming cost of capital being 10%.
(The present value of 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)

Answer
Working Notes:
Depreciation on Machine X = 30,000 (150,000 / 5)
Depreciation on Machine Y = 40,000 (240,000 / 6)

Particulars Machine X Machine Y

Annual Savings:
Wages 90,000 1,20,000
Scrap 10,000 15,000
Total Savings (A) 1,00,000 1,35,000
Annual Estimated Cash Cost :
Indirect Material 6,000 8,000
Supervision 12,000 16,000
Maintenance 7,000 11,000
Total Cash Cost (B) 25,000 35,000
Annual Cash Savings (A-B) 75,000 1,00,000
Less : Depreciation 30,000 40,000
Annual Savings Before Tax 45,000 60,000
Less : Tax @ 30% 13,500 18,000
Annual Savings/Profit (After Tax) 31,500 42,000
Add : Depreciation 30,000 40,000
Annual Cash Inflows 61,500 82,000

Evaluation of Alternatives
(i) Average Rate of Return Method (ARR)
ARR = Average Annual Net Savings
Average Investment
Machine X = 42 % ( 31,500 / 75, 000 x 100)
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Machine Y = 35 % ( 42,000 / 120, 000 x 100)

Decision : Machine X is better.

[Note: ARR can be computed alternatively taking initial investment as the basis for computation (ARR =
Average Annual Net Income/Initial Investment). The value of ARR for Machines X and Y would then change
accordingly as 21% and 17.5% respectively]

(ii) Present Value Index Method

Present Value of Cash Inflow = Annual Cash Inflow x P.V. Factor @ 10%
Machine X = 2,33,085 (61,500 x 3.79)
Machine Y = 3,57,028 (82,000 x 4.354)

P.V. Index = PV of Cash Inflow / PV of Cash Outflow

Machine X = 1.5539 (2,33,085 / 1,50,000 )
Machine Y = 1.4876 (3,57,028 / 2,40,000 )

Decision : Machine X is better.

36. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be set
up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State
Government of Rs 25,00,000 on capital investment. Initial equipment cost will be Rs 1.75 crores.
Additional equipment costing Rs 12,50,000 will be purchased at the end of the third year from the
cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but
additional equipment can be sold for Rs 1,25,000. A working capital of Rs 20,00,000 will be needed
and it will be released at the end of eighth year. The project will be financed with sufficient amount
of equity capital.

The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 108,000 260,000 270,000 180,000

A sales price of Rs 120 per unit is expected and variable expenses will amount to 60% of sales revenue.
Fixed cash operating costs will amount Rs 18,00,000 per year. The loss of any year will be set off from the
profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent
to be an appropriate after tax cost of capital for this project. The company follows straight line method of
depreciation.

Required:
Calculate the net present value of the project and advise the management to take appropriate decision.

Note:
The PV factors at 12% are
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

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Answer- (Amount in Lacs)

Year Sales VC FC Dep. Profit Tax PAT Dep. Cash
inflow
1 86.40 51.84 18 21.875 (5.315)  (5.315) 21.875 16.56
2 129.60 77.76 18 21.875 11.965 1.995* 9.97 21.875 31.845
3 312.00 187.20 18 21.875 84.925 25.4775 59.4475 21.875 81.3225
45 324.00 194.40 18 24.125 87.475 26.2425 61.2325 24.125 85.3575
68 216.00 129.60 18 24.125 44.275 13.2825 30.9925 24.125 55.1175
* (30% of 11.965 – 30% of 5.315) = 3.5895 – 1.5945 = 1.995)

Cost of New Equipment 1,75,00,000

Less: Subsidy 25,00,000
Add: Working Capital 20,00,000
Outflow 1,70,00,000

Calculation of NPV
Yea Cash inflows PV factor NPV
r
1 16,56,000 .893 14,78,808
2 31,84,500 .797 25,38,047
3 81,32,250  12,50,000 = 68,82,250 .712 49,00,162
4 85,35,750 .636 54,28,737
5 85,35,750 .567 48,39,770
6 55,11,750 .507 27,94,457
7 55,11,750 .452 24,91,311
8 55,11,750 + 20,00,000 + 1,25,000 = .404 30,85,247
76,36,750
Present Value of Cash Inflows (A) 2,75,56,539
Present Value of Cash Outflows (B) 1,70,00,000
NPV (C = (A) – (B) ) 1,05,56,539

Advise: Since the project has a positive NPV, therefore, it should be accepted.

37. A hospital is considering to purchase a diagnostic machine costing Rs 80,000. The projected life of
the machine is 8 years and has an expected salvage value of Rs 6,000 at the end of 8 years.

The annual operating cost of the machine is Rs 7,500. It is expected to generate revenues of Rs 40,000 per
year for eight years. Presently, the hospital is outsourcing the diagnostic work and is earning commission
income of Rs 12,000 per annum; net of taxes.

Required:
Whether it would be profitable for the hospital to purchase the machine? Give your recommendation
under:
(i) Net Present Value method

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(ii) Profitability Index method.

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

Advise to the Hospital Management. Tax Rate is 30%

Answer-
Determination of Cash inflows
Sales Revenue 40,000
Less: Operating Cost 7,500
32,500
Less: Depreciation (80,000 – 6,000)/8 9,250
Net Income 23,250
Tax @ 30% 6,975
Earnings after Tax (EAT) 16,275
Add: Depreciation 9,250
Cash inflow after tax per annum 25,525
Less: Loss of Commission Income 12,000
Net Cash inflow after tax per annum 13,525

In 8th Year :
New Cash inflow after tax 13,525
Add: Salvage Value of Machine 6,000
Net Cash inflow in year 8 19,525

Calculation of Net Present Value (NPV)

Year CFAT PV Factor @10% Present Value of Cash inflows

1 to 7 13,525 4.867 65,826.18
8 19,525 0.467 9,118.18
74,944.36
Less: Cash Outflows 80,000.00
NPV (5,055.64)

Profitability Index = PV of Cash Inflow / PV of Cash Outflow

PI = 0.937 (74,944.36 / 80,000 )

Advise: Since the net present value is negative and profitability index is also less than 1, therefore, the
hospital should not purchase the diagnostic machine.

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38. SS Limited is considering the purchase of a new automatic machine which will carry out some
operations which are at present performed by manual labour. NM-A1 and NM-A2, two alternative
models are available in the market. The following details are collected :

Machine
NM-A1 NM-A2
Cost of Machine 20,00,000 25,00,000
Estimated working life 5 Years 5 Years
Estimated saving in direct wages per annum 7,00,000 9,00,000
Estimated saving in scrap per annum 60,000 1,00,000
Estimated additional cost of indirect material per 30,000 90,000
annum
Estimated additional cost of indirect labour per 40,000 50,000
annum
Estimated additional cost of repairs and 45,000 85,000
maintenance per annum

Depreciation will be charged on a straight line method. Corporate tax rate is 30 percent and expected rate
of return may be 12 percent.

You are required to evaluate the alternatives by calculating the:

(i) Pay-back Period
(ii) Accounting (Average) Rate of Return; and
(iii) Profitability Index or P.V. Index (P.V. factor for Rs 1 @ 12% 0.893; 0.797; 0.712; 0.636; 0.567; 0.507)

Answer

Evaluation of Alternatives
Working Notes:

Depreciation on Machine NM-A1 = 4,00,000 ( 20,00,000 / 5)

Depreciation on Machine NM-A2 = 5,00,000 (25,00,000 / 5)

Particulars Machine NM- Machine NM-

A1 A2
Annual Savings:
Direct Wages 7,00,000 9,00,000
Scraps 60,000 1,00,000
Total Savings (A) 7,60,000 10,00,000
Annual Estimated Cash Cost :
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs and Maintenance 45,000 85,000
Total Cost (B) 1,15,000 2,25,000
Annual Cash Savings (A-B) 6,45,000 7,75,000
Less: Depreciation 4,00,000 5,00,000

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Annual Savings before Tax 2,45,000 2,75,000

Less: Tax @ 30% 73,500 82,500
Annual Savings /Profits after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
Annual Cash Inflows 5,71,500 6,92,500

(i) Payback Period(PP)

PP= Total Initial Capital Investment

Annual expected after tax net cashflow

Machine NM – A1 = 3.50 Years (20,00,000 / 5,71,500)

Machine NM – A2 = 3.61 Years (25,00,000 / 6,92,500)

Decision: Machine NM-A1 is better.

(ii) Accounting (Average) Rate of Return (ARR)

ARR= Average Annual Net Savings X 100

Average investment

Machine NM – A1 = 17.15% (1,71,500 / 10,00,000 X 100)

Machine NM – A2 = 15.4% (1,92,500 / 12,50,000 X 100)

Decision: Machine NM-A1 is better.

(Note: ARR may be computed alternatively by taking initial investment in the denominator.)

(iii) Profitability Index or P V Index

Present Value Cash Inflow = Annual Cash Inflow x PV factor at 12%
Machine NM-A1 = 5, 71,500 x 3.605 = Rs 20, 60,258
Machine NM-A2 = 6, 92,500 x 3.605 = Rs 24, 96,463

PV Index = Present Value of Cash Inflow

PV of Cash Outlfow

Machine NM-A1 = 1.03 (20,60,258 /20,00,000 )

Machine NM-A2 = 0.998 (24,96,463 /25,00,000 )

Decision: Machine NM-A1 is better.

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39. APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two machines
have identical capacity, do exactly the same job, but designed differently.

Machine 'A' costs Rs 8,00,000, having useful life of three years. It costs Rs 1,30,000 per year to run.
Machine 'B' is an economy model costing Rs 6,00,000, having useful life of two years. It costs Rs 2,50,000
per year to run.

The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupees of constant
purchasing power. Ignore taxes.

The opportunity cost of capital is 10%.

The present value factors at 10% are :

Year t1 t2 t3
PVIF0.10,t 0.9091 0.8264 0.7513
PVIFA0.10,2 = 1.7355
PVIFA0.10,3 = 2.4868

Which machine would you recommend the company to buy?

Answer

Statement Showing Evaluation of Two Machines

Particulars Machine A Machine B
Purchase Cost (i) 8,00,000 6,00,000
Life of Machines (in years) 3 2
Running Cost of Machine per year (ii) 1,30,000 2,50,000
Cumulative PVF for 1-3 years @ 10% : (iii) 2.4868 -
Cumulative PVF for 1-2 years @ 10% : (iv) - 1.7355
Present Value of Running Cost of Machines 3,23,284 4,33,875
(v) = [(ii) x (iii)]
Cash Outflow of Machines (vi) = (i) + (v) 11,23,284 10,33,875
Equivalent Present Value of Annual Cash 4,51,698.57 5,95,721.69
Outflow
[(vi) / (iii)] Or 4,51,699 Or 5,95,722

Recommendation: APZ Limited should consider buying Machine A since its equivalent Cash outflow is less
than Machine B.

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40. A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product. At
present, the waste is removed by a contractor for disposal on payment by the company of Rs 150
lakh per annum for the next four years. The contract can be terminated upon installation of the
aforesaid machine on payment of a compensation of Rs 90 lakh before the processing operation
starts. This compensation is not allowed as deduction for tax purposes.

The machine required for carrying out the processing will cost Rs 600 lakh to be financed by a loan
repayable in 4 equal instalments commencing from end of the year- 1. The interest rate is 14% per annum.
At the end of the 4th year, the machine can be sold for Rs 60 lakh and the cost of dismantling and removal
will be Rs 45 lakh.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:
(Rs In Lacs)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing operations is Rs 60 lakh at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs 165 lakh
and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would
otherwise have been rented out for Rs 30 lakh per annum. Labour costs include wages of 40 workers, whose
transfer to this process will reduce idle time payments of Rs 45 lakh in the year- 1 and Rs 30 lakh in the
year- 2.

Factory overheads include apportionment of general factory overheads except to the extent of insurance
charges of Rs 90 lakh per annum payable on this venture. The company’s tax rate is 30%.

Present value factors for four years are as under:

Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.

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SOLUTION-
WN1- CASH FLOWS (In lakh)
Year 0 1 2 3 4

Sales - 966 966 1,254 1,254

Contract payment saved(GIVEN) 150 150 150 150
TOTAL(A) 1116 1116 1404 1404

Material consumption - 90 120 255 255

Wages - 180 195 255 300
Other expenses - 120 135 162 210
Factory overheads (insurance only) - 90 90 90 90
Loss of rent on storage space (opportunity cost) - 30 30 30 30
Interest @14% (WN2) - 84 63 42 21
Depreciation (as per income tax rules) - 150 114 84 63
Total cost: (B) - 744 747 918 969
EBT (C)=(A)-(B) - 372 369 486 435
Tax (30%) 111.6 110.7 145.8 130.5
Profit after Tax (PAT) 260.4 258.3 340.2 304.5
Depreciation added back 150 114 84 63
Cash Inflow (D) 410.4 372.3 424.2 367.5
Cash outflow – Loan Repayment (E) (150) (150) (150) (150)
Working Capital- Material stock(F) (60) (105) - - 165
Compensation for contract(G) (90) - - - -
Salvage value of machine (WN 3) - - - - 15
NET CASH FLOW(H) = D+E+F+G (150) 155.4 222.3 274.2 397.5
Discount factor at 14% 1 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32

NPV = Present value of cash inflow – Present value of cash outflows

NPV = 136.28+170.95+184.81+235.32 – 150
NPV = 577.36

Advice: Since the net present value of cash flows is Rs 577.36 lakh which is positive the management should
install the machine for processing the waste.

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WN2 – Interest: (In Lacs)

Particulars Yr1 Yr2 Yr3 Yr4

Interest 600 *14% (600-150)*14% (600-150-150)*14% (600-150-150-150)*14%
= 84 =63 =42 =21

WN3 –Salvage Value :

Sale value =60 lacs
cost of dismantling =(45 lacs)
Net Proceeds =15 lacs

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41. A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling
it. A & Co. currently pays no taxes. The replacement machine costs Rs 90,000 now and requires
maintenance of Rs 10,000 at the end of every year for eight years. At the end of eight years it would
have a salvage value of Rs 20,000 and would be sold. The existing machine requires increasing
amounts of maintenance each year and its salvage value falls each year as follows:
Year Maintenance (Rs) Salvage (Rs)
Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%.

REQUIRED:
When should the company replace the machine?
(Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% : 4.4873; present
value of Re. 1 to be received after 8 years at interest rate of 15% : 0.3269).

SOLUTION-
A & Co.
Equivalent cost of (EAC) of new machine

(i) Cost of new machine now 90,000

Add: PV of annual repairs @ 10,000 per annum for 8
years (10,000  4.4873) 44,873
1,34,873
Less: PV of salvage value at the end of 8 years 6,538
(20,0000.3269)
1,28,335
Equivalent annual cost (EAC) (1,28,335/4.4873) 28,600

PV of cost of replacing the old machine in each of 4 years with new machine
Scenario Year Cash PV @ 15% PV
Flow

Replace Immediately 0 (28,600) 1.00 (28,600)

40,000 1.00 40,000
11,400
Replace in one year 1 (28,600) 0.870 (24,882)
1 (10,000) 0.870 (8,700)
1 25,0000 0.870 21,750
(11,832)
Replace in two years 1 (10,000) 0.870 (8,700)
2 (28,600) 0.756 (21,622)
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2 (20,000) 0.756 (15,120)

2 15,000 0.756 11,340
(34,102)
Replace in three years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (28,600) 0.658 (18,819)
3 (30,000) 0.658 (19,740)
3 10,000 0.658 6,580
(55,799)
Replace in four years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (30,000) 0.658 (19,740)
4 (28,600) 0.572 (16,359)
4 (40,000) 0.572 (22,880)
(82,799)
Advice: The company should replace the old machine immediately because the PV of cost of replacing the
old machine with new machine is least.

42. A chemical company is presently paying an outside firm Rs 1 per gallon to dispose off the waste
resulting from its manufacturing operations. At normal operating capacity, the waste is about
50,000 gallons per year.

After spending Rs 60,000 on research, the company discovered that the waste could be sold for Rs 10 per
gallon if it was processed further. Additional processing would, however, require an investment of Rs
6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.

Except for the costs incurred in advertising Rs 20,000 per year, no change in the present selling and
administrative expenses is expected, if the new product is sold. The details of additional processing costs
are as follows:
Variable : Rs 5 per gallon of waste put into process.
Fixed : (Excluding Depreciation) Rs 30,000 per year.

There will be no losses in processing, and it is assumed that the total waste processed in a given year will be
sold in the same year. Estimates indicate that 50,000 gallons of the product could be sold each year.

The management when confronted with the choice of disposing off the waste or processing it further and
selling it, seeks your ADVICE. Which alternative would you recommend? Assume that the firm's cost of
capital is 15% and it pays on an average 50% Tax on its income.

You should consider Present value of Annuity of Rs 1 per year @ 15% p.a. for 10 years as 5.019.

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SOLUTION-
Evaluation of Alternatives:
Savings in disposing off the waste
Particulars
Outflow (50,000 × 1) 50,000
Less: tax savings @ 50% 25,000
Net Outflow per year 25,000

Calculation of Annual Cash inflows in Processing of waste Material

Particulars Amount Amount

Sale value of waste 5,00,000

(10 × 50,000 gallon)
Less: Variable processing cost 2,50,000
(5 × 50,000 gallon)
Less: Fixed processing cost 30,000
Less: Advertisement cost 20,000
Less: Depreciation 60,000 (3,60,000)
Earnings before tax (EBT) 1,40,000
Less: Tax @ 50% (70,000)
Earnings after tax (EAT) 70,000
Add: Depreciation 60,000
Annual Cash inflows 1,30,000
Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in disposal cost
= Rs 1,30,000 + Rs 25,000 = Rs 1,55,000
Calculation of Net Present Value
Year Particulars Amount
0 Investment in new equipment (6,00,000)
1 to 10 Total Annual benefits × PVAF (10 years, 15%)
1,55,000 × 5.019 7,77,945
Net Present Value 1,77,945

Recommendation: Processing of waste is a better option as it gives a positive Net Present Value.

Note- Research cost of 60,000 is not relevant for decision making as it is sunk cost.

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Chapter 8 RISK ANALYSIS IN CAPITAL BUDGETING

RISK AND UNCERTAINTY-

 Risk is the variability in terms of actual returns comparing with the estimated returns. Most common
techniques of risk measurement are Standard Deviation and Coefficient of variations. There is a thin
difference between risk and uncertainty.
 In case of risk, probability distribution of cash flow is known.
 When no information is known to formulate probability distribution of cash flows, the situation is
referred as uncertainty. However, these two terms are used interchangeably

REASONS FOR ADJUSTMENT OF RISK IN CAPITAL BUDGETING DECISIONS (NOV 2018)

 There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of
risk is necessary to help make the decision as to whether the returns out of the project are
proportionate with the risks borne and whether it is worth investing in the project over the other
investment options available.
 Risk adjustment is required to know the real value of the Cash Inflows.

SOURCES OF RISK-
 Project-specific risk- Risks which are related to a particular project and affects the project’s cash
flows, it includes completion of the project in scheduled time, error of estimation in resources and
allocation, estimation of cash flows etc. For example, a nuclear power project of a power generation
company has different risks than hydel projects.
 Company specific risk- Risk which arise due to company specific factors like downgrading of credit
rating, changes in key managerial persons, dispute with workers etc
 Industry-specific risk- These are the risks which effect the whole industry in which the company
operates. The risks include regulatory restrictions on industry, changes in technologies etc.
 Market risk – The risk which arise due to market related conditions like entry of substitute, changes
in demand conditions
 Competition risk- These are risks related with competition in the market in which a company
operates.

TECHNIQUES OF RISK ANALYSIS IN CAPITAL BUDGETING-

Statistical Techniques Conventional techniques Others techniques
Probability Risk-adjusted discount rate Sensitivity analysis
Variance or Standard Deviation Certainty equivalents Scenario analysis
Coefficient of Variation

PROBABILITY-
Probability is a measure about the chances that an event will occur. When an event is certain to occur,
probability will be 1 and when there is no chance of happening an event probability will be 0.

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1. Possible net cash flows of Projects A and B at the end of first year and their probabilities are given as
below. Discount rate is 10 per cent. For both the project initial investment is Rs 10,000. From the
following information, CALCULATE the expected net present value for each project. State which
project is preferable?
Possible Project A Project B
Event Cash Flow Probability Cash Flow Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8 ,000 0.10

2. Probabilities for net cash flows for 3 years of a project are as follows:
Year 1 Year 2 Year 3
Cash Probability Cash Probability Cash Probability
Flow Flow Flow

2,000 0.1 2,000 0.2 2,000 0.3

4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
CALCULATE the expected net cash flows. Also calculate net present value of the project using expected cash
flows using 10 per cent discount rate. Initial Investment is Rs 10,000

VARIANCE-
 Variance measures the uncertainty of a value from its average. Thus, variance helps an organization
to understand the level of risk it might face on investing in a project.
 A variance value of zero would indicate that the cash flows that would be generated over the life of
the project would be same. This might happen in a case where the company has entered into a
contract of providing services in return of a specific sum.
 A large variance indicates that there will be a large variability between the cash flows of the different
years. This can happen in a case where the project being undertaken is very innovative and would
require a certain time frame to market the product and enable to develop a customer base and
generate revenues.
 A small variance would indicate that the cash flows would be somewhat stable throughout the life of
the project. This is possible in case of products which already have an established market

STANDARD DEVIATION-
The square root of variance is called Standard Deviation. For Capital Budgeting decisions, Standard
Deviation is used to calculate the risk associated with the estimated cash flows from the project

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3. CALCULATE Variance and Standard Deviation on the basis of following information:

Possible Project A Project B

Event Cash Flow Probability Cash Flow Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10

THE COEFFICIENT OF VARIATION-

 The Coefficient of Variation calculates the risk borne for every percent of expected return.
 When a selection has to be made between two projects, the management would select a project
which has a lower Coefficient of Variation.

4. CALCULATE Coefficient of Variation based on the following information:

Possible Project A Project B
Event Probability Probability
Cash Flow Cash Flow

A 10000 0.10 26,000 0.10

B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10

RISK ADJUSTED DISCOUNT RATE-

 The use of risk adjusted discount rate (RADR) is based on the concept that investors demands higher
returns from the risky projects.
 If the risk associated with any investment project is higher than risk involved in a similar kind of
project, discount rate is adjusted upward in order to compensate this additional risk borne.
 Risks adjusted discount rate = Risk free rate+ Risk premium
 Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g., Government
securities yield a return of 6 % and bear no risk. In such case, 6 % is the risk-free rate
 Risk Premium: It is the rate of return over and above the risk-free rate, expected by the Investors as
a reward for bearing extra risk. For high risk project, the risk premium will be high and for low risk
projects, the risk premium would be lower

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5. An enterprise is investing Rs 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows
that are estimated over the life of the project.

Year Cash flows ( in lakhs)

1 25
2 60
3 75
4 80
5 65

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted
discount rate.

Advantages of Risk-adjusted discount rate-

1) It is easy to understand.
2) It incorporates risk premium in the discounting factor.

Limitations of Risk-adjusted discount rate -

1) Difficulty in finding risk premium and risk-adjusted discount rate.
2) Though NPV can be calculated but it is not possible to calculate Standard Deviation of a given project.

CERTAINTY EQUIVALENT (CE) METHOD FOR RISK ANALYSIS-

 The certainty equivalent is a guaranteed return that the management would accept rather than
accepting a higher but uncertain return.
 In this approach a set of risk less cash flow is generated in place of the original cash flows.
 Steps in the Certainty Equivalent (CE) approach –
 Remove risks by substituting equivalent certain cash flows from risky cash flows. This can be
done by multiplying each risky cash flow by the appropriate CE coefficient
 Discounted value of cash flow is obtained by applying risk less rate of interest. Since you have
already accounted for risk in the numerator using CE coefficient, using the cost of capital to
discount cash flows will tantamount to double counting of risk
 After that normal capital budgeting method is applied

6. If Investment proposal is Rs 45,00,000 and risk free rate is 5%, CALCULATE net present value under
certainty equivalent technique.
Year Expected cash flow Certainty Equivalent
coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

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Advantages of Certainty Equivalent Method -

 The certainty equivalent method is simple and easy to understand and apply

Disadvantages of Certainty Equivalent Method-

 There is no objective or mathematical method to estimate certainty equivalents. Certainty
Equivalents are subjective and vary as per each individual’s estimate
 Certainty equivalents are decided by the management based on their perception of risk. However,
the risk perception of the shareholders who are the money lenders for the project is ignored

SENSITIVITY ANALYSIS-
 In a project, several variables like weighted average cost of capital, consumer demand, price of the
product, cost price per unit etc. operate simultaneously. The changes in these variables impact the
outcome of the project. It therefore becomes very difficult to assess change in which variable
impacts the project outcome in a significant way.
 Sensitivity analysis is a way of finding impact in the project’s NPV (or IRR) for a given change in one
of the variables
 Steps involved in Sensitivity Analysis (MAY 2019)-
1. Finding variables, which have an influence on the NPV (or IRR) of the project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.

7. X Ltd is considering its New Product ‘with the following details

Sr. No. Particulars Figures
1 Initial capital cost 400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit 100
4 Variable cost per unit 50
5 Fixed costs per year 50 Cr
6 Discount Rate 6%
Required:
 CALCULATE the NPV of the project.
 COMPUTE the impact on the project’s NPV of a 2.5 per cent adverse variance in each variable. Which
variable is having maximum effect .Consider Life of the project as 3 years.

Advantages of Sensitivity Analysis:

 Critical Issues: This analysis identifies critical factors that impacts project’s success or failure
 Simplicity: It is a simple technique

Disadvantage of Sensitivity Analysis:

 Assumption of Independence: This analysis assumes that all variables are independent i.e. they are
not related to each other, which is unlikely in real life

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SCENARIO ANALYSIS-
 Sensitivity Analysis considers change in one variable and finds out the impact of that variable change
on NPV(Or IRR) it would be useful to vary more than one variable at a time so we could see the
combined effects of changes in the variables.
 Scenario analysis provides answer to these situations of extensions. This analysis brings in the
probabilities of changes in key variables and also allows us to change more than one variable at a
time.

8. XYZ Ltd. is considering a project “A” with an initial outlay of 14,00,000 and the possible three cash
inflow attached with the project as follows:
(Rs in ‘000)
Particular Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most
likely result but uncertain about the third year’s cash flow, ANALYSE what will be the NPV expecting worst
scenario in the third year.

SCENARIO ANALYSIS VS SENSITIVITY ANALYSIS-

 Sensitivity analysis calculates the impact of the change of a single input variable on the outcome of
the project viz., NPV or IRR.
 Scenario analysis, on the other hand, is based on a scenario. The scenario may be recession or a
boom wherein depending on the scenario, all input variables change. Scenario Analysis calculates the
outcome of the project considering this scenario where the variables have changed simultaneously.

9. Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs Rs 36,000 and
project B Rs 30,000. You have been given below the net present value probability distribution for
each project.
Project A Project B
NPV estimates Probability NPV estimates Probability

15,000 0.2 15,000 0.1

12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1

(i) COMPUTE the expected net present values of projects A and B.

(ii) COMPUTE the risk attached to each project i.e. standard deviation of each probability distribution.
(iii) COMPUTE the profitability index of each project.
(iv) IDENTIFY which project do you recommend? State with reasons.

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10. From the following details relating to a project, analyse the sensitivity of the project to changes in
initial project cost, annual cash inflow and cost of capital:

Initial Project Cost 1,20,000

Annual Cash Inflow 45,000
Project Life (Years) 4
Cost of Capital 10%

IDENTIFY which of the three factors, the project is most sensitive if the variable is adversely affected by 10%?
(Use annuity factors: for 10% =3.169 and 11% = 3.103).

11. PNR Ltd. is considering a project with the following Cash flows:
Years Cost of Plant Running Cost Savings
0 12,00,00,000
1 4,00,00,000 12,00,00,000
2 5,00,00,000 14,00,00,000
3 6,00,00,000 11,00,00,000

The cost of capital is 12%. Measure the sensitivity of the project to changes in the levels of plant cost,
running cost and savings (considering each factor at a time) such that the NPV becomes zero. The P.V.
factors at 12% are as under:
Year 0 1 2 3
PV factor @12% 1 0.892 0.797 0.711

DETERMINE the factor which is the most sensitive to affect the acceptability of the project?

SOLUTION
Present value (PV) of Cash Flows
Year 0 1 2 3 Total
Cost of (12,00,00,000)
Plant
Running 0 (4,00,00,000) (5,00,00,000) (6,00,00,000)
cost
Savings 0 12,00,00,000 14,00,00,000 11,00,00,000
Net cash (12,00,00,000) 8,00,00,000 9,00,00,000 5,00,00,000
inflow
PV factor 1 0.892 0.797 0.711
NPV (12,00,00,000) 7,13,60,000 7,17,30,000 3,55,50,000 5,86,40,000

Determination of the most Sensitive factor:

(i) Sensitivity Analysis w.r.t. Plant cost:
NPV of the project would be zero when the cost of the plant is increased by `5,86,40,000
∴ Percentage change in the cost = 586,40,000 / 12,00,00,000 x 100
= 48.87%

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(ii) Sensitivity Analysis w.r.t. Running cost:

NPV of the project would be zero when the Running cost is increased by `5,86,40,000
∴ Percentage change in the cost
= 586,40,000 x 100
(0.892 x 4,00,00,000)+(0.797 x 5,00,00,000)+(0.711 x 6,00,00,000)
=49.61%

(iii) Sensitivity Analysis w.r.t. Savings:

NPV of the project would be zero when the savings decreased by `5,86,40,000
∴ Percentage change in the savings
586,40,000 x 100
(0.892 x 12,00,00,000)+(0.797 x 14,00,00,000)+(0.711 x 11,00,00,000)
=19.75%

The Savings factor is the most sensitive as only a change beyond 19.75% in savings makes the project
unacceptable.

12. Gaurav 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 Total PV
Cash flow equivalent flow (Cash flow (at 0.06)
(CE) × 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.

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

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 Risk-Adjusted P.V. Factor 1 to 5 years at
Variation Rate of Return 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 Coefficient Risk Annual PV Discounted Net
outlays of adjusted cash factor cash present
variation discount inflow 1-5 inflow value
rate years

(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

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14. The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals,
Projects M and N, which require cash outlays of Rs 8,50,000 and Rs 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:

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 Rs 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 Cash C.E. Adjusted Present Total
end Flow Cash flow (c) value Present
(a) (b) = (a)  (b) factor at value
6%(d) (e) = (c)
(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 Cash Flow (a) C.E (b) Adjusted Cash flow Present value Total Present
end (c) = (a) * (b) factor (d) value
(e) = (c) × (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 4,50,000 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

Decision : Since the net present value of Project N is higher, so the project N should be accepted

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(iii) Certainty - Equivalent (C.E.) Co-efficient of Project M {2.0 (0.8+0.7+0.5)} is lower than Project N {2.4
(0.9+0.8+0.7)}. 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

15. DETERMINE the risk adjusted net present value of the following projects:

Particulars X Y Z
Net cash outlays 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4

The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:

Coefficient of Risk-Adjusted Rate P.V. Factor 1 to 5 years At

Variation of Return risk adjusted rate of
Discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

Solution-

Statement showing the determination of the risk adjusted net present value

Projects (a) Net cash Coefficient Risk Annual PV Discounted Net

outlays (b) of adjusted cash factor cash inflow present
variation discount inflow (e) 1-5 (g) = (e) * value
(c) rate (d) years (f) (h) = g-b
(f)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

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16. A&R Ltd. has under its consideration a project with an initial investment of Rs 90,00,000. Three
probable cash inflow scenarios with their probabilities of occurrence have been estimated as below:

Annual cash inflow (Rs) 20,00,000 30,00,000 40,00,000

Probability 0.2 0.7 0.1

The project life is 5 years and the desired rate of return is 18%. The estimated terminal values for the project
assets under the three probability alternatives, respectively, are Rs 0, Rs 20,00,000 and Rs 30,00,000

You are required to:

(i) CALCULATE the probable NPV;
(ii) CALCULATE the worst-case NPV and the best-case NPV; and
(iii) STATE the probability occurrence of the worst case, if the cash flows are perfectly positively correlated
over time.

SOLUTION-
(i) Calculation of Net Present Value (NPV)
Year Prob. = 0.2 Prob. = 0.7 Prob. = 0.1

Cash Probable Cash flow Probable Cash flow Probable Total Cash PVF@ PV of
flow cash flow cash flow cash flow flow 18% Total cash
flow

0 (90,00,000) 1.000 (90,00,000)

1 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.847 24,56,300

2 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.718 20,82,200

3 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.608 17,63,200

4 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.515 14,93,500

5 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.437 12,67,300

5 0 0 20,00,000 14,00,000 30,00,000 3,00,000 17,00,000 0.437 7,42,900

Net Present Value (NPV) 8,05,400

(ii) Worst and Best case is the case where expected annual cash inflows are minimum and maximum
respectively.
Calculation of Worst Case and Best Case NPV:
Year PVF@ Worst case Best Case
18% Cash flows PV of Cash Cash flows PV of Cash
flows flows
0 1.000 (90,00,000) (90,00,000) (90,00,000) (90,00,000)
1 0.847 20,00,000 16,94,000 40,00,000 33,88,000
2 0.718 20,00,000 14,36,000 40,00,000 28,72,000
3 0.608 20,00,000 12,16,000 40,00,000 24,32,000
4 0.515 20,00,000 10,30,000 40,00,000 20,60,000
5 0.437 20,00,000 8,74,000 40,00,000 17,48,000
5 0.437 0 0 30,00,000 13,11,000
NPV (27,50,000) 48,11,000
Worst case NPV = Rs (27,50,000)
Best Case NPV = Rs 48,11,000
(iii) The cash flows are perfectly positively correlated over time means cash flow in first year will be cash
flows in subsequent years. The cash flow of Rs20,00,000 is the worst case cash flow and its probability is
20%, thus, possibility of worst case is 20% or 0.2.

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17. SG Ltd. is considering a project “Z” with an initial outlay of 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
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 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

SOLUTION-
(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

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

(ii) Calculation of NPV in different scenarios

Worst Case Base Best Case

Initial outlay (A) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) 44,375 5,13,125
2,60,000

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Cumulative PVF @ 15% (d) 3.353 3.353 3.353

PV of Cash Inflow (B = c x d) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (6,01,210.62) 1,21,780 9,70,508.13

18. New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available in
respect of these projects:
P-I P-II P-III
Cost 15,00,000 11,00,000 19,00,000
Inflows-Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free interest rate
is 10%.

REQUIRED:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?

SOLUTION-
(i) The risk free rate of interest and risk factor for each of the projects are given. The risk adjusted discount
rate (RADR) for different projects can be found on the basis of CAPM as follows:
Required Rate of Return = IRf + (ke-IRF ) Risk Factor
For P-I : RADR = 0.10 + (0.15 – 0.10 ) 1.80 = 19%
For P-II : RADR = 0.10 + (0.15 – 0.10 ) 1.00 = 15 %
For P-III : RADR = 0.10 + (0.15 – 0.10) 0.60 = 13 %

(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows:
Project P-I Annual Inflows Rs 6,00,000
PVAF (19 %, 4) 2.639
PV of Inflows (Rs 6,00,000 x 2.639 ) Rs 15,83,400
Less: Cost of Investment Rs 15,00,000
Net Present Value Rs 83,400

Project P-II
Year Cash Inflow PVF (15%,n) PV
1 6,00,000 0.870 5,22,000
2 4,00,000 0.756 3,02,400

3 5,00,000 0.658 3,29,000

4 2,00,000 0.572 1,14,400

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Total Present Value 12,67,800

Less: Cost of 11,00,000
Investment
Net Present Value 1,67,800

Project P-III
Year Cash Inflow PVF (13%,n) PV
1 4,00,000 0.885 3,54,000
2 6,00,000 0.783 4,69,800
3 8,00,000 0.693 5,54,400
4 12,00,000 0.613 7,35,600
Total Present Value 21,13,800
Less: Cost of 19,00,000
Investment
Net Present Value 2,13,800

Project P-III has highest NPV. So, it should be accepted by the firm.

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Chapter 9 DIVIDEND DECISION

MEANING OF DIVIDEND-
Dividend is that part of profit after tax which is distributed to the shareholders of the company. In other
words, the profit earned by a company after paying taxes can be used for:
i. Distribution of dividend or
ii. Can be retained as surplus for future growth

FORMS OF DIVIDEND-
1. Cash dividend: It is the most common form of dividend. Cash here means cash, cheque, warrant,
demand draft,
2. Stock dividend (Bonus Shares): It is a distribution of shares in lieu of cash dividend to existing
shareholders. When the company issues further shares to its existing shareholders without consideration it is
called bonus shares.

Advantages of Stock Dividend-

 Tax benefit –At present there is no tax on dividend received from a domestic company for the
shareholders.
 Company can Conserve cash for meeting profitable investment opportunities

RELATIONSHIP BETWEEN RETAINED EARNINGS AND GROWTH-

Growth (g) = br
Where, g = growth rate of the firm
b = retention ratio
r = rate of return on investment

Example -Suppose, there are two companies, A Ltd & B Ltd, having a capital employed of Rs 50,00,000 in
terms of Equity shares of Rs100 each are earning @ 20%. Both have same capital structure and same ROI but
different dividend policy.
A Ltd. distributes 100% of its earnings whereas B Ltd only 50%. Now, considering the other things remain
same, the position of both the companies during the next year will be:

A Ltd B Ltd
Previous year Previous year
Earnings 10,00,000 Earnings 10,00,000
Dividend 10,00,000 Dividend 5,00,000
Retained Earnings Nil Retained Earnings 5,00,000

Current year Current year

Existing capital 50,00,000 Existing capital 50,00,000
Retained Earnings Nil Retained Earnings 5,00,000
Total capital employed 50,00,000 Total capital 55,00,000
employed
Earnings@ 20% 10,00,000 Earnings@ 20% 11,00,000

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DETERMINANTS OF DIVIDEND DECISIONS-

1. Availability of funds: If the business is in requirement of funds, then retained earnings could be a good
source. Since it saves the floatation cost and further the control will not be diluted as in case of further issue
of share capital.
2. Cost of capital: If the financing requirements can be financed through debt (relatively cheaper source of
finance), then it should be preferred to distribute more dividend but if the financing is to be done through
fresh issue of equity shares, it is better to use retained earnings as much as possible
3. Capital structure: An optimum Debt equity ratio should also be under consideration for the dividend
decision.
4. Stock price: Stock price here means market price of the shares. Generally, higher dividends increase value
of shares and low dividends decrease it.
5. Investment opportunities in hand: The dividend decision is also affected, if there are investment
opportunities in hand, the company may prefer to retain more from the earnings
6. Trend of industry: Few industries have been seen by investors for regular income, hence in such cases,
the firm will have to pay dividend for survival.
7. Expectation of shareholders: The shareholders can be categorised in two categories: (i) those who
invests for regular income, & (ii) those who invests for growth. Generally, the investor prefers current
dividend over the future growth.

STABILITY OF DIVIDENDS:
Stability in dividend can be maintaining either fixing amount or rate of dividend irrespective of earnings of
the company. The stable dividend policies may include:
(i) Constant Dividend per Share: Shareholders are given fixed amount of dividend irrespective of
actual earnings. To maintain a constant dividend amount, it is necessary to create a reserve like
Dividend Equalisation Reserve Fund earmarked by marketable securities for accumulation of surplus
earnings and to use for paying dividends in bad years
(ii) Constant Percentage of Net Earnings: The ratio of dividend to earnings is known as Payout
ratio. Some companies follow a policy of constant Payout ratio i.e. paying fixed percentage on net
earnings every year.
(iii) Small Constant Dividend per Share plus Extra Dividend: For companies with fluctuating
earnings, the policy is to pay a minimum dividend per share with a step up feature. The small amount
of dividend is fixed to reduce the possibility of missing dividend payment & pay extra dividend in
period of prosperity.

THEORIES OF DIVIDEND –
Irrelevance Theory (Dividend is Irrelevant) - M.M. Approach
Relevance Theory (Dividend is relevant) - Walter Model & Gordon Model

MODIGLIANI and MILLER (M.M) HYPOTHESIS-

 MM approach is in support of the irrelevance of dividends i.e. firm’s dividend policy has no effect on
either the price of a firm’s stock or its cost of capital.
 Market value of equity shares of its firm depends solely on its earning power and is not influence by
the manner in which its earnings are split between dividends and retained earnings

Assumptions of M.M Hypothesis-

 Perfect capital markets: The firm operates in a market in which all investors are rational and
information is freely available to all.

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 No taxes or no tax discrimination between dividend income and capital appreciation (capital gain):
This assumption is necessary for the universal applicability of the theory, since, the tax rates or
provisions to tax income may be different in different countries.
 No floatation or transaction cost: Similarly, these costs may differ country to country or market to
market

Pₒ = P1+ D1
1+Ke
Where,
Pₒ= Price in the beginning of the period.
P₁= Price at the end of the period.
D₁= Dividend at the end of the period.

Vf or nP₀ = (n +Δn)P1- I + E
1+Ke
Where,
Vf = Value of firm in the beginning of the period
n = number of shares in the beginning of the period
Δn = number of shares issued to raise the funds required
I = Amount required for investment
E = total earnings during the period

1. AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has
outstanding 10,000 shares selling at Rs 100 each. The firm is contemplating the declaration of a
dividend of Rs 5/ share at the end of the current financial year. It expects to have a net income of Rs
1,00,000 and has a proposal for making new investments of Rs 2,00,000. CALCULATE the value of the
firms when dividends (i) are not paid (ii) are paid

WALTER’S MODEL-
Walter’s approach is based on the following assumptions:
 All investment proposals of the firm are to be financed through retained earnings only
 ‘r’ rate of return & ‘Ke’ cost of capital are constant
 No taxes or no tax discrimination between dividend income and capital appreciation (capital gain):
This assumption is necessary for the universal applicability of the theory, since, the tax rates or
provisions to tax income may be different in different countries
 No floatation or transaction cost: Similarly, these costs may differ country to country or market to
market
Market Price (P) = D+ r (E-D)
Ke
Ke

Where,
P = Market Price of the share.
E = Earnings per share.
D = Dividend per share.
Ke = Cost of equity/ rate of capitalization/ discount rate.
r = Internal rate of return/ return on investment

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Company Condition Correlation between Optimum dividend

of r vs Ke Size of Dividend and payout ratio
Market Price of share
Growth r > Ke Negative Zero
Constant r = Ke No correlation Every payout ratio is
optimum
Decline r < Ke Positive 100%

2. XYZ Ltd. earns Rs 10/ share. Capitalization rate and return on investment are 10% and 12%
respectively.
DETERMINE the optimum dividend payout ratio and the price of the share at the payout.

3. The following figures are collected from the annual report of XYZ Ltd.:

Net Profit 30 lakhs

Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
COMPUTE the approximate dividend pay-out ratio so as to keep the share price at Rs 42 by using Walter’s
model?

GORDON’S MODEL-
This model is based on the following assumptions:
• Firm is an all equity firm i.e. no debt.
• IRR will remain constant, because change in IRR will change the growth rate and consequently the value
will be affected. Hence this assumption is necessary.
• Ke will remains constant, because change in discount rate will affect the present value.
•Growth rate (g = br) is also constant

P0 = E1 (1-b)
Ke-br

P0 = Price per share

E1 = Earnings per share
b = Retention ratio; (1 - b = Payout ratio)
Ke = Cost of capital
r = IRR
br = Growth rate (g)

Company Condition of r vs Optimum dividend payout ratio

Ke
Growth r > Ke Zero
Constant r = Ke There is no optimum ratio
Declining r < Ke 100%

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4. The following figures are collected from the annual report of XYZ Ltd.:

Net Profit 30 lakhs

Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 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% and (iii) 100%.

THE BIRD-IN-HAND THEORY-

The Bird-in-hand theory of Gordon has two arguments:
(i) Investors are risk averse and
(ii) Investors put a premium on certain return and discount on uncertain return.

Investors would prefer to pay a higher price for shares on which current dividends are paid. Conversely, they
would discount the value of shares of a firm which postpones dividends. The discount rate would vary with
the retention rate.

The relationship between dividend and share price on the basis of Gordon's formula is shown as:

Po = D (1+g)
Ke-g

Where,
P0 = Market price per share (ex-dividend)
Do = Current year dividend
g = Constant annual growth rate of dividends
Ke = Cost of equity capital (expected rate of return).

Zero growth rates: assumes all dividend paid by a stock remains same. In this case the stock price would be
equal to:

P0 = D
Ke

D = Annual dividend
Ke = Cost of capital
P0 = Current Market price of share

5. X Ltd. is a no growth company, pays a dividend of Rs 5 per share. If the cost of capital is 10%,
COMPUTE the current market price of the share?

6. XYZ is a company having share capital of Rs10 lakhs of Rs10 each. It distributed current dividend of
20% per annum. Annual growth rate in dividend expected is 2%. The expected rate of return on its
equity capital is 15%. CALCULATE price of share applying Gordons growth Model.

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7. A firm had been paid dividend at Rs2 per share last year. The estimated growth of the dividends from
the company is estimated to be 5% p.a. DETERMINE the estimated market price of the equity share if
the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also FIND OUT the present
market price of the share, given that the required rate of return of the equity investors is 15%.

GRAHAM & DODD MODEL-

P = m ( D+ E/3)

P = Market price per share

D = Dividend per share
E = Earnings per share
m = a multiplier

8. The earnings per share of a company is Rs 30 and dividend payout ratio is 60%. Multiplier is 2.
DETERMINE the price per share as per Graham & Dodd model.

9. The following information regarding the equity shares of M Ltd. is given below:

Market price 58.33

Dividend per share 5
Multiplier 7
According to the Graham & Dodd approach to the dividend policy, COMPUTE the EPS.

LINTER’S MODEL-
D₁ = Dₒ + [(EPS ×Target payout) - Dₒ] × Af

D₁ = Dividend in year 1
Dₒ = Dividend in year 0 (last year dividend)
EPS = Earnings per share
Af = Adjustment factor or Speed of adjustment

10. Given the last year’s dividend is Rs 9.80, speed of adjustment = 45%, target payout ratio 60% and
EPS for current year Rs 20. COMPUTE current year’s dividend using Linter’s model.

STOCK SPLITS-
Stock split means splitting one share into many, say, one share of `500 in to 5 shares of `100. Stock splits is
a tool used by the companies to regulate the prices of shares i.e. if a share price increases beyond a limit, it
may become less tradable, for e.g. suppose a company’s share price increases from `50 to `1000 over the
years, it is possible that it might goes out of range of many investors.

Advantages-
 It makes the share affordable to small investors.
 Number of shares may increase the number of shareholders; hence the potential of investment
may increase.

Limitation -Additional expenditure need to be incurred on the process of stock split.

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11. RST Ltd. has a capital of Rs 10,00,000 in equity shares of Rs 100 each. The shares are currently quoted
at par. The company proposes to declare a dividend of Rs 10 per share at the end of the current
financial year. The capitalization rate for the risk class of which the company belongs is 12%.
COMPUTE market price of the share at the end of the year, if
(i) dividend is not declared ?
(ii) dividend is declared ?
(iii) assuming that the company pays the dividend and has net profits of Rs5,00,000 and makes new
investments of Rs10,00,000 during the period, how many new shares must be issued? Use the MM model.

12. The following information pertains to M/s XY Ltd.

Earnings of the Company 5,00,000
Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

CALCULATE:
(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value of
Company’s share at that payout ratio?

13. CALCULATE price of the share from Gordon’s model with the help of a following example:
Factors Growth Normal Declining
Firm Firm Firm
r > Ke r = Ke r < Ke
r (rate of return on retained earnings) 15% 10% 8%
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) 10 10 10
b (Retained Earnings) 0.6 0.6 0.6
1- b 0.4 0.4 0.4
What would be your answer if retention ratio is changed to 0.4

14. The following information is given below in case of Aditya Ltd.:

Earnings per share - Rs 60
Capitalisation rate -15%
Return on investment- 25% per cent
Dividend payout ratio- 30%

(i) COMPUTE price per share using Walter’s Model

(Ii) WHAT would be optimum dividend payout ratio per share under Gordon’s Model.

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SOLUTION
(i) As per Walter’s Model, Price per share is computed by using the following formula:
Market Price (P) = D+ r (E-D)
Ke
Ke

P = 18+ 0.25 (60-18)

0.15
0.15

P = 586.67

(ii) As per Gordon’s model, when r > Ke, optimum dividend payout ratio is ‘Zero’.

15. 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 Rs 100. It expects a net profit of Rs 2,50,000 for the year and
the Board is considering dividend of Rs 5 per share.

M Ltd. requires to raise Rs 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.

16. 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

17. 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.

18. The following information is supplied to you :

Total Earning 40 Lakhs
No. of Equity Shares (of 100 each) 4,00,000
Dividend Per Share 4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%
Calculate the market price of a share of a company by using :
(i) WaIter’s Formula
(ii) Gordon's Formula (MAY 2019 – 5MARKS)

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SOLUTION-
EPS = 40,00,000/400,000
EPS =10

(I) WALTER’S MODEL-

Market Price (P) = D+ r (E-D)
Ke
Ke
P= 4+ 0.2 (10-4)
0.16
0.16

P= 71.88

(II) GORDON’S APPROACH

P0 = E1 (1-b)
Ke-br

Po= 10(1-0.60)
0.16-(0.6 x 0.2)

P0=100

19. The earnings per share of a company is Rs 10 and the rate of capitalisation applicable to it
is 10 per cent. The company has three options of paying dividend i.e. (i) 50%, (ii) 75% and
(iii) 100%.
CALCULATE the market price of the share as per Walter’s model if it can earn a return of
(a) 15, (b) 10 and (c) 5 per cent on its retained earnings. (RTP NOV 2018)

Solution-
Market Price (P) per share as per Walter’s Model is:

Market Price (P) = D+ r (E-D)

Ke
Ke
P = Price of Share , r = Return on investment or rate of earning
Ke = Rate of Capitalisation or Cost of Equity

Calculation of Market Price (P) under the following dividend payout ratio and earning rates:
Rate of (i)DP ratio 50% (ii)DP ratio 75% (iii) DP ratio 100%
Earning (r)
(a) 15% 5 + (0.15/0.10) (10-5) 7.5 + (0.15/0.10) (10-7.5) 10 + (0.15/0.10) (10-10)
0.10 0.10 0.10
=12.5/0.10 =11.25/0.10 =10/0.10
= 125 = 112.5 = 100
(b) 10% 5 + (0.10/0.10) (10-5) 7.5 + (0.10/0.10) (10-7.5) 10 + (0.10/0.10) (10-10)
0.10 0.10 0.10
=10/0.10 =10/0.10 =10/0.10
= 100 = 100 = 100
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(c) 5% 5 + (0.05/0.10) (10-5) 7.5 + (0.05/0.10) (10-7.5) 10 + (0.05/0.10) (10-10)

0.10 0.10 0.10
=7.5/0.10 =8.75/0.10 =10/0.10
= 75 = 87.5 = 100

20. In May, 2020 shares of RT Ltd. was sold for Rs 1,460 per share. A long term earnings growth rate of
7.5% is anticipated. RT Ltd. is expected to pay dividend of Rs 20 per share.

(i) CALCULATE rate of return an investor can expect to earn assuming that dividends are expected to grow
along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of earnings. In
this case, STATE whether, there would be any change in growth rate and cost of Equity?

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

Ke = D1/P0 + g
Ke = 8.97%

(ii) With rate of return on retained earnings (r) 10% and retention ratio (b) 60%, new growth rate will be as
follows:
g = br i.e.
= 0.10 × 0.60 = 0.06

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 earnings (r) is same.

With previous Growth Rate of 7.5% and r =10%, the retention ratio comes out to be:
0.075 = b1 × 0.10
b1 = 0.75 and payout ratio = 0.25

With 0.25 payout ratio the EPS will be as follows:

=20/0.25
=80

With new 0.40 (1 – 0.60) payout ratio, the new dividend will be
D1 = Rs 80 × 0.40 = Rs 32

Accordingly, new Ke will be

Ke = 32/1460+ 6.0%
or, Ke = 8.19%

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21. A&R Ltd. is a large-cap multinational company listed in BSE in India with a face value of 100 per
share. The company is expected to grow @ 15% p.a. for next four years then 5% for an indefinite
period. The shareholders expect 20% return on their share investments. Company paid 120 as
dividend per share for the FY 2020-21. The shares of the company traded at an average price of
3,122 on last day.
FIND out the intrinsic value of per share and state whether shares are overpriced or underpriced.

SOLUTION-
As per Dividend discount model, the price of share is calculated as follows:
P= D1 / (1+Ke)1+D2 / (1+Ke)2+D3 / (1+Ke)3+D4/ (1+Ke)4+D5/ (Ke-g)×1(1+Ke)4

P = Price per share

Ke = Required rate of return on equity
g = Growth rate

P= 120×1.15 /(1+0.2)1+ 138×1.15/ (1+0.2)2+ 158.7×1.15/ (1+0.2)3+ 182.5×1.15/ (1+0.2)4

+ 209.88 ×1.05 / (0.2-0.05)×1(1+0.2)4
P= 115 + 110.2 + 105.6 + 101.2 + 708.50 = 1,140.50

Intrinsic value of share is 1,140.50 as compared to latest market price of 3,122.

Market price of a share is overpriced by 1,981.50

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Chapter 10 MANAGEMENT OF WORKING CAPITAL

Current Assets: An asset is classified as current when: (i) It is expected to be realised or intends to be sold or
consumed in normal operating cycle of the entity; (ii) The asset is held primarily for the purpose of trading;
(iii) It is expected to be realised within twelve months after the reporting period; (iv) It is non- restricted cash
or cash equivalent.

Current Liabilities: A liability is classified as current when: (i) It is expected to be settled in normal operating
cycle of the entity. (ii) The liability is held primarily for the purpose of trading (iii) It is expected to be settled
within twelve months after the reporting period

THE CONCEPT OF WORKING CAPITAL CAN ALSO BE EXPLAINED THROUGH TWO ANGLES.
 On the basis of Value –
 From the value point of view, Working Capital can be defined as Gross Working Capital or
Net Working Capital
 Gross working capital refers to the firm’s investment in current assets.
 Net working capital refers to the difference between current assets and current liabilities.
 A positive working capital indicates the company’s ability to pay its short-term liabilities. On
the other hand a negative working capital shows inability of an entity to meet its short-term
liabilities
 On the basis of Time-
 From the point of view of time, working capital can be divided into two categories viz.,
Permanent and Fluctuating (temporary).
 Permanent working capital refers to the base working capital, which is the minimum level of
investment in the current assets that is carried by the entity at all times to carry its day to day
activities.
 Temporary working capital refers to that part of total working capital, which is required by an
entity in addition to the permanent working capital. It is also called variable working capital

OVER CAPITALIZATION-
It implies that a company has too large funds for its requirements, resulting in a low rate of return, a
situation which implies a less than optimal use of resources.

DETERMINANTS OF WORKING CAPITAL-

1. Cash – Identify the cash balance which allows for the business to meet day-to-day expenses, but
reduces cash holding costs.
2. Inventory – Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials and hence increases cash flow; the techniques like Just in Time (JIT) and
Economic order quantity (EOQ) are used for this.
3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased revenue
4. Short-term Financing Options – Inventory is ideally financed by credit granted by the supplier;
dependent on the cash conversion cycle, it may however, be necessary to utilize a bank loan (or overdraft),
or to “convert debtors to cash” through “factoring”
5. Nature of Business - For e.g. in a business of restaurant, most of the sales are in Cash. Therefore, need
for working capital is very less.

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6. Market and Demand Conditions - For e.g. if an item’s demand far exceeds its production, the working
capital requirement would be less as investment in finished goods inventory would be very less.
7. Operating Efficiency – A company can reduce the working capital requirement by eliminating waste,
improving coordination etc

SCOPE OF WORKING CAPITAL MANAGEMENT-

The scope of working capital management can be grouped into two broad areas
(i) Profitability and Liquidity and
(ii) Investment and Financing Decision.

LIQUIDITY AND PROFITABILITY -

For uninterrupted and smooth functioning of the day to day business of an entity it is important to maintain
liquidity of funds evenly. As we have already learnt in previous chapters that each rupee of capital bears
some cost. So, while maintaining liquidity the cost aspect needs to be borne in mind. Unnecessary tying up
of funds in idle assets not only reduces the liquidity but also reducing the opportunity to earn better return
from a productive asset.

Component Advantages of Trade-off Advantages of

of Working higher side (between lower side
Capital (Profitability) Profitability and (Liquidity)
Liquidity)
Inventory Fewer stock-outs Use techniques Lower inventory
increase the like EOQ, JIT etc. requires less capital
profitability. to carry optimum but endangered
level of inventory. stock-out and loss of
goodwill.
Receivables Higher Credit Evaluate the Cash sales provide
period attract credit policy; use liquidity but fails to
customers and the services of boost sales and
increase revenue debt revenue
management
(factoring)
agencies.
Pre- Reduces uncertainty Cost-benefit Improves or
payment of and profitable in analysis required maintains liquidity.
expenses inflationary
environment.
Cash and Payables are Cash budgets and Cash can be invested
Cash honoured in time, other cash in some other
equivalents improves the management investment avenues
goodwill and helpful techniques can be
in getting future used
discounts.
Payables Capital can be used Evaluate the Payables are
and in some other credit policy and honoured in time,
Expenses investment avenues related cost. improves the
goodwill and helpful
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FINANCIAL MANAGEMENT ARIVUPRO ACADEMY

in getting future
discounts.

INVESTMENT AND FINANCING-

Working capital policy is a function of two decisions, first, investment in working capital and the second is
financing of the investment. Investment in working capital is concerned with the level of investment in the
current assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organisation objectives
(i.e. Effectiveness of fund). Financing decision concerned with the arrangement of funds to finance the
working capital. It gives the answer ‘Where from’ fund to be sourced’ at lowest cost as possible

INVESTMENT OF WORKING CAPITAL:

How much to be invested in current assets as working capital is a matter of policy decision by an entity. It
has to be decided in the light of organisational objectives, trade policies and financial (cost-benefit)
considerations.
Hence, level of investment depends on the various factors listed below:

(a) Nature of Industry: Construction companies, breweries etc. requires large investment in working capital
due long gestation period.
(b) Types of products: Consumer durable has large inventory as compared to perishable products.
(c) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three levels of inventory
i.e. raw material, work-in-process and finished goods whereas a trading and a service entity has to maintain
inventory only in the form of trading stock and consumables respectively
(d) Volume of sales: Where the sales are high, there is a possibility of high receivables as well

APPROACHES OF WORKING CAPITAL INVESTMENT-

(a) Aggressive: Here investment in working capital is kept at minimal investment in current assets which
means the entity does hold lower level of inventory, follow strict credit policy, keeps less cash balance etc.
The advantage of this approach is that lower level of fund is tied in the working capital which results in lower
financial costs but the flip side could be that the organisation could not grow which leads to lower utilisation
of fixed assets and long term debts. In the long run firm stay behind the competitors.
(b) Conservative: In this approach of organisation use to invest high capital in current assets. Organisations
use to keep inventory level higher, follows liberal credit policies, and cash balance as high as to meet any
current liabilities immediately. The advantage of this approach are higher sales volume, increased demand
due to liberal credit policy and increase goodwill among the suppliers due to payment in short time. The
disadvantages are increase cost of capital, higher risk of bad debts
(c) Moderate: This approach is in between the above two approaches. Under this approach a balance
between the risk and return is maintained to gain more by using the funds in very efficient manner.

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1. A firm has the following data for the year ending 31st March, 2017:
Sales (1,00,000 @ 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000

The three possible current assets holdings of the firm are Rs 5,00,000, Rs 4,00,000 and Rs 3,00,000. It is
assumed that fixed assets level is constant and profits do not vary with current assets levels. ANALYSE the
effect of the three alternative current assets policies.

OPERATING OR WORKING CAPITAL CYCLE-

 Working Capital cycle indicates the length of time between a company’s paying for materials,
entering into stock and receiving the cash from sales of finished goods.
 It can be determined by adding the number of days required for each stage in the cycle.
 For example, a company holds raw materials on an average for 60 days, it gets credit from the
supplier for 15 days, production process needs 15 days, finished goods are held for 30 days and 30
days credit is extended to debtors. The total of all these, 120 days, i.e., 60 – 15 + 15 + 30 + 30 days is
the total working capital cycle.
 Operating Cycle = R + W + F + D – C

R = Raw material storage period

W = Work-in-progress holding period
F = Finished goods storage period
D = Receivables (Debtors) collection period.
C = Credit period allowed by suppliers (Creditors).

2. From the following information of XYZ Ltd., you are required to CALCULATE:
(a) Net operating cycle period.
(b) Number of operating cycles in a year.

Raw material inventory consumed during the year 6,00,000

Average stock of raw material 50,000
Work-in-progress inventory 5,00,000
Average work-in-progress inventory 30,000
Finished goods inventory 8,00,000
Average finished goods stock held 40,000
Average collection period from debtors 45 days
Average credit period availed 30 days
No. of days in a year 360 days

3. On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working
capital that will be required during the year. From the following information PREPARE the working
capital requirements forecast.

Production during the previous year was 60,000 units. It is planned that this level of activity would be
maintained during the present year.

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The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and Overheads
20%.

Raw materials are expected to remain in store for an average of 2 months before issue to production.

Each unit is expected to be in process for one month, the raw materials being fed into the pipeline
immediately and the labour and overhead costs accruing evenly during the month.

Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3 months.

Credit allowed by creditors is 2 months from the date of delivery of raw material.
Credit allowed to debtors is 3 months from the date of dispatch.
Selling price is Rs 5 per unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month.

The company normally keeps cash in hand to the extent of Rs 20,000.

WORKING CAPITAL REQUIREMENT ESTIMATION BASED ON CASH COST-

funds blocked in sundry debtors is Rs 75,000 the cost of sundry debtors, the rest (Rs 25,000) is profit.
-cash costs; depreciation is a non-cash cost item. Suppose out
of Rs 75,000, Rs 5,000 is depreciation; then it is obvious that the actual funds blocked in terms of sundry
debtors totalling Rs 1 lakh is only Rs 70,000. In other words, Rs 70,000 is the amount of funds required to
finance sundry debtors worth Rs 1 lakh

goods and sundry debtors. Under this approach, the debtors are calculated not as a percentage of sales
value but as a percentage of cash costs. Similarly, finished goods are valued according to cash costs

4. The following annual figures relate to XYZ Co.,

Sales (at two months’ credit) 36,00,000

Materials consumed (suppliers extend two months’ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses (expenses are paid one month in 9,60,000
arrear)
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000

The company sells its products on gross profit of 25%. Depreciation is considered as a part of the cost of
production. It keeps one month’s stock each of raw materials and finished goods, and a cash balance of `
1,00,000.

Assuming a 20% safety margin, COMPUTE the working capital requirements of the company on cash cost
basis. Ignore work-in-process.

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5. Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a single shift
working with the following cost structure:
Per unit
Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016-17 – 4,32,000.

As at 31.3.2017 the company held:

Stock of raw materials (at cost) 36,000

Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
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 of from suppliers will continue to remain at the present level i.e., 2 months. Lag in payment of
wages and expenses will continue to remain half a month.

You are required to PREPARE the additional working capital requirements, if the policy to increase output is
implemented.

TREASURY MANAGEMENT-
The key goals of treasury management are:
Maximize the return on the available cash;
Minimize interest cost on borrowings;
Mobilise as much cash as possible for corporate ventures (in case of need)

FUNCTIONS OF TREASURY DEPARTMENT-

 Cash Management: It involves efficient cash collection process and managing payment of cash both
inside the organisation and to third parties.
 Currency Management: The treasury department manages the foreign currency risk exposure of the
company. If risks are to be minimized then forward contracts can be used either to buy or sell
currency forward
 Fund Management: Treasury department is responsible for planning and sourcing the company’s
short, medium and long-term cash needs.
 Banking: It is important that a company maintains a good relationship with its bankers. Treasury
department carry out negotiations with bankers and act as the initial point of contact with them.

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THE NEED FOR CASH-

 Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt payments
 Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may
present themselves and which may be lost for want of ready cash/settlement
 Precautionary needs: Cash may be held to act as for providing safety against unexpected events.

CASH BUDGET-
Cash Budget is the most significant device to plan for and control cash receipts and payments.
The various purposes of cash budgets are:-
Coordinate the timings of cash needs. It identifies the period(s) when there might either be a shortage
of cash or an abnormally large cash requirement;
It also helps to pinpoint period(s) when there is likely to be excess cash;
It enables firm which has sufficient cash to take advantage like cash discounts on its accounts payable;
Lastly it helps to plan/arrange adequately needed funds (avoiding excess/shortage of cash) on favorable
terms

METHODS OF CASH FLOW BUDGETING-

 Receipts and Payments Method: In this method all the expected receipts and payments for budget
period are considered. All the cash inflow and outflow of all functional budgets including capital
expenditure budgets are considered.
 Adjusted Income Method: In this method the annual cash flows are calculated by adjusting the
sales revenues and cost figures for delays in receipts and payments (change in debtors and creditors)
and eliminating non-cash items such as depreciation
 Adjusted Balance Sheet Method: In this method, the budgeted balance sheet is predicted by
expressing each type of asset and short-term liabilities as percentage of the expected sales. The
profit is also calculated as a percentage of sales, so that the increase in owner’s equity can be
forecasted. Known adjustments, may be made to long-term liabilities and the balance sheet will then
show if additional finance is needed

6. PREPARE monthly cash budget for six months beginning from April 2017 on the basis of the
following information:-
(i) Estimated monthly sales are as follows:-

January 1,00,000 June 80,000

February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

(ii) Wages and salaries are estimated to be payable as follows:-

April 9,000 July 10,000

May 8,000 August 9,000
June 10,000 September 9,000

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(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses.
(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 10% debentures of Rs 1,20,000. 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 July, 2017.
(vii) The firm had a cash balance of Rs 20,000 on April 1, 2017, 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).

7. From the following information relating to a departmental store, you are required to PREPARE for the
three months ending 31st March, 2019:-
(a) Month-wise cash budget on receipts and payments basis; and
(b) Statement of Sources and uses of funds for the three months period.
It is anticipated that the working capital at 1st January, 2019 will be as follows:-

Cash in hand and at bank 545

Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
Budgeted Profit Statement: in ‘000’s
January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, Selling and Distribution
Expenses 315 270 255
Net Profit before tax 150 125 115

Budgeted balances at the end of in ‘000’s

each months:
31st Jan. 28th Feb. 31st March
Short term investments 700 --- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200

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Dividends payable 485 -- --

Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550

Depreciation amount to 60,000 is included in the budgeted expenditure for each month

8. You are given below the Profit & Loss Accounts for two years for a company:
Profit and Loss Account
Year 1 Year 2 Year 1 Year 2
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
To Other Expenses 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000 - -
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000

Sales are expected to be Rs 12,00,00,000 in year 3.

As a result, other expenses will increase by Rs 50,00,000 besides other charges. Only raw materials are in
stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same
amount as between year 1 and 2. You may assume that no dividend is being paid. The Company can use
75% of the cash generated to service a loan. COMPUTE how much cash from operations will be available in
year 3 for the purpose? Ignore income tax.

SOLUTION
Projected Profit and Loss Account for the year 3
Year 2 Year 3 Year 2Actual Year 3
Actual Projected ( in lakhs) Projected(in
( in ( in lakhs)
lakhs) lakhs)
To Materials 350 420 By Sales 1,000 1,200
consumed
To Stores 120 144 By Misc.Income 10 10

To Mfg. Expenses 160 192

To Other expenses 100 150
To Depreciation 100 100
To Net profit 180 204
1,010 1,210 1,010 1,210

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Cash Flow:
(in lakhs)
Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock 50
Net cash inflow 254
Available for servicing the loan: 75% of Rs 2,54,00,000 or Rs 1,90,50,000

Working Notes:
(i) Material consumed in year 2: 35% of sales.
Likely consumption in year 3: RsRs351,200 ×or 420 (lakhs)100
(ii) Stores are 12% of sales, as in year 2.
(iii) Manufacturing expenses are 16% of sales.

ACCELERATING CASH COLLECTIONS-

(i) Concentration Banking: In concentration banking the company establishes a number of strategic
collection centres in different regions instead of a single collection centre at the head office. This system
reduces the period between the time a customer mails in his remittances and the time when they become
spendable funds with the company. Payments received by the different collection centers are deposited with
their respective local banks which in turn transfer all surplus funds to the concentration bank of head office.

(ii) Lock Box System: Under this arrangement, the company rents the local post-office box and authorizes
its bank at each of the locations to pick up remittances in the boxes. Customers are billed with instructions
to mail their remittances to the lock boxes. The bank picks up the mail several times a day and deposits the
cheques in the company’s account. The cheques may be micro-filmed for record purposes and cleared for
collection. The company receives a deposit slip and lists all payments together with any other material in the
envelope. This procedure frees the company from handling and depositing the cheques.

DIFFERENT KINDS OF FLOAT WITH REFERENCE TO MANAGEMENT OF CASH:-

Billing float: The time between the sale and the mailing of the invoice is the billing float.
Mail float: This is the time when a cheque is being processed by post office, messenger service or other
means of delivery.
Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque
after it has been received by the company.
Banking processing float: This is the time from the deposit of the cheque to the crediting of funds in
the sellers account.

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9. Prachi Ltd is a manufacturing company producing and selling a range of cleaning products to
wholesale customers. It has three suppliers and two customers. Prachi Ltd relies on its cleared funds
forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare a cleared funds forecast
for the period Monday 7 August to Friday 11 August 2019 inclusive. You have been provided with the
following information:
(1) Receipts from customers

Credit terms Payment 7 Aug 7 Jul 2019

method 2019 sales sales
W Ltd 1 calendar month BACS 150,000 130,000
X Ltd None Cheque 180,000 160,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale is made and will
clear on the third day following this (excluding day of payment).

(2) Payments to suppliers

Supplier Credit Payment 7 Aug 7 Jul 7 Jun
name terms method 2019 2019 2019
purchases purchases purchases
A Ltd 1 calendar Standing 65,000 55,000 45,000
month order
B Ltd 2 calendar Cheque 85,000 80,000 75,000
months
C Ltd None Cheque 95,000 90,000 85,000

(a) Prachi Ltd has set up a standing order for 45,000 a month to pay for supplies from A Ltd. This will leave
Prachi’s bank account on 7 August. Every few months, an adjustment is made to reflect the actual cost of
supplies purchased (you do NOT need to make this adjustment).
(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August. The amounts will leave its bank
account on the second day following this (excluding the day of posting).

(3) Wages and salaries

July 2019 August 2019
Weekly wages 12,000 13,000
Monthly salaries 56,000 59,000
(a) Factory workers are paid cash wages (weekly). They will be paid one week’s wages, on 11 August, for the
last week’s work done in July (i.e. they work a week in hand).
(b) All the office workers are paid salaries (monthly) by BACS. Salaries for July will be paid on 7 August.

(4) Other miscellaneous payments

(a) Every Monday morning, the petty cashier withdraws Rs 200 from the company bank account for the petty
cash. The money leaves Prachi’s bank account straight away.
(b) The room cleaner is paid Rs 30 from petty cash every Wednesday morning.
(c) Office stationery will be ordered by telephone on Tuesday 8 August to the value of Rs 300. This is paid for
by company debit card. Such payments are generally seen to leave the company account on the next
working day.

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(d) Five new softwares will be ordered over the Internet on 10 August at a total cost of Rs 6,500. A cheque
will be sent out on the same day. The amount will leave Prachi Ltd’s bank account on the second day
following this (excluding the day of posting).

(5) Other information

The balance on Prachi’s bank account will be Rs 200,000 on 7 August 2019. This represents both the book
balance and the cleared funds.

PREPARE a cleared funds forecast for the period Monday 7 August to Friday 7 August 2019 inclusive using
the information provided. Show clearly the uncleared funds float each day.

Solution-
Cleared Funds Forecast

7 Aug 19 8 Aug 19 9 Aug 19 10 Aug 19 11 Aug 19

(Monday) (Tuesday)(Wednesday) (Thursday) (Friday)

Receipts
W Ltd 1,30,000 0 0 0 0
X Ltd 0 0 0 1,80,000 0
(a) 1,30,000 0 0 1,80,000 0
Payments
A Ltd 45,000 0 0 0 0
B Ltd 0 0 75,000 0 0
C Ltd 0 0 95,000 0 0
Wages 0 0 0 0 12,000
Salaries 56,000 0 0 0 0
Petty Cash 200 0 0 0 0
Stationery 0 0 300 0 0
(b) 1,01,200 0 1,70,300 0 12,000
Cleared excess Receipts
over payments (a) – (b) 28,800 0 (1,70,300) 1,80,000 (12,000)
Cleared balance b/f 2,00,000 2,28,800 2,28,800 58,500 2,38,500
Cleared balance c/f (c) 2,28,800 2,28,800 58,500 2,38,500 2,26,500
Uncleared funds float
Receipts 1,80,000 1,80,000 1,80,000 0 0
Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)
(d) 10,000 9,700 180,000 (6,500) (6,500)
Total book balance c/f 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000
(c) + (d)

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CASH MANAGEMENT MODELS-

William J. Baumol’s Economic Order Quantity Model-
According to this model, optimum cash level is that level of cash where the carrying costs and
transactions costs are the minimum.

C= Square Root of (2U * P)/S

C = Optimum cash balance

U = Annual (or monthly) cash disbursement
P = Fixed cost per transaction.
S = Opportunity cost of one rupee p.a. (or p.m.)

10. A firm maintains a separate account for cash disbursement. Total disbursement are Rs 1,05,000 per
month or Rs 12,60,000 per year. Administrative and transaction cost of transferring cash to
disbursement account is Rs 20 per transfer. Marketable securities yield is 8% per annum.
DETERMINE the optimum cash balance according to William J. Baumol model.

MILLER-ORR CASH MANAGEMENT MODEL (1966)-

In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the
return point; and zero as the lower limit.
– z is invested in
marketable securities account.
ash account is made

VIRTUAL BANKING-
 Broadly virtual banking denotes the provision of banking and related services through extensive use
of information technology without direct recourse to the bank by the customer.
 Advantages of Virtual Banking-
 Lower cost of handling a transaction
 The increased speed of response to customer requirements
 The lower cost of operating branch network along with reduced staff costs

11. The following information is available in respect of Sai trading company:

(i) On an average, debtors are collected after 45 days; inventories have an average holding period of 75 days
and creditor’s payment period on an average is 30 days.
(ii) The firm spends a total of Rs 120 lakhs annually at a constant rate.
(iii) It can earn 10 per cent on investments.

From the above information, you are required to CALCULATE:

(a) The cash cycle and cash turnover,
(b) Minimum amounts of cash to be maintained to meet payments as they become due,
(c) Savings by reducing the average inventory holding period by 30 days.

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INVENTORY MANAGEMENT-

12. A company’s requirements for ten days are 6,300 units. The ordering cost per order is Rs 10 and the
carrying cost per unit is Rs 0.26. You are required to CALCULATE the economic order quantity.

MANAGEMENT OF RECEIVABLES-
The basic objective of management of receivables (debtors) is to optimise the return on investment on these
assets.

ASPECTS OF MANAGEMENT OF DEBTORS-

 Credit Policy:
 This seeks to decide credit period, cash discount and other relevant matters.
 It involves a trade-off between the profits on additional sales that arise due to credit being
extended on the one hand and the cost of carrying those debtors and bad debt losses on the
other.
 The credit period is generally stated in terms of net days. For example if the firm’s credit terms
are “net 50”. It is expected that customers will repay credit obligations not later than 50 days.
 Credit Analysis: This requires the finance manager to determine as to how risky it is to advance
credit to a particular party
 Control of Receivable: This requires finance manager to follow up debtors and decide about a
suitable credit collection policy. It involves both laying down of credit policies and execution of such
policies
There is always cost of maintaining receivables which comprises of following costs:
(i) The company requires additional funds as resources are blocked in receivables which involves a
cost in the form of interest (loan funds) or opportunity cost (own funds)
(ii) Administrative costs which include record keeping, investigation of credit worthiness etc.
(iii) Collection costs. (iv) Defaulting costs

APPROACHES TO EVALUATION OF CREDIT POLICIES-

There are basically two methods of evaluating the credit policies to be adopted by a Company –
 Total Approach and
 Incremental Approach.

(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] × No. of units sold on credit under
Present Policy

(ii) Opportunity Cost = Total Cost of Credit Sales x Collection period (Days x Required Rate of Return
365 or 360 100

13. A trader whose current sales are in the region of Rs 6 lakhs per annum and an average collection
period of 30 days wants to pursue a more liberal policy to improve sales. A study made by a
management consultant reveals the following information:-

Credit Policy Increase in Increase in sales Present default

collection period anticipated
A 10 days 30,000 1.5%
B 20 days 48,000 2%

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C 30 days 75,000 3%
D 45 days 90,000 4%
The selling price per unit is Rs 3. Average cost per unit is Rs 2.25 and variable costs per unit are Rs 2. The
current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.
ANALYSE which of the above policies would you recommend for adoption?

14. XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating
two proposed policies. Currently, the firm has annual credit sales of Rs 50 lakhs and accounts
receivable turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs 1,50,000.
The firm is required to give a return of 25% on the investment in new accounts receivables. The
company’s variable costs are 70% of the selling price. Given the following information, IDENTIFY
which is the better option?
Present Policy Policy
Policy Option I Option I
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover ratio 4 times 3 times 2.4 times
Bad debt losses 1,50,000 3,00,000 4,50,000

FINANCING RECEIVABLES-
(i) Pledging: This refers to the use of a firm’s receivable to secure a short term loan. A firm’s receivables can
be termed as its most liquid assets and this serve as prime collateral for a secured loan. The lender
scrutinizes the quality of the accounts receivables, selects acceptable accounts, creates a lien on the
collateral and fixes the percentage of financing receivables which ranges around 50 to 90%. The major
advantage of pledging accounts receivables is the ease and flexibility it provides to the borrower. Moreover,
financing is done regularly. This, however, suffers on account of high cost of financing.
(ii) Factoring:
 This refers to outright sale of accounts receivables to a factor or a financial agency. A factor is a firm
that acquires the receivables of other firms. The factoring lays down the conditions of the sale in a
factoring agreement. The factoring agency bears the right of collection and services the accounts for
a fee.
 Normally, factoring is the arrangement on a non-recourse basis where in the event of default the loss
is borne by the factor. However, in a factoring arrangement with recourse, in such situation, the
accounts receivables will be turned back to the firm by the factor for resolution
 The biggest advantages of factoring are the immediate conversion of receivables into cash

15. A Factoring firm has credit sales of Rs 360 lakhs and its average collection period is 30 days. The
financial controller estimates, bad debt losses are around 2% of credit sales. The firm spends Rs
1,40,000 annually on debtors administration. This cost comprises of telephonic and fax bills along
with salaries of staff members. These are the avoidable costs. A Factoring firm has offered to buy the
firm’s receivables. The factor will charge 1% commission and will pay an advance against receivables
on an interest @15% p.a. after withholding 10% as reserve. ANALYSE what should the firm do?
Assume 360 days in a year.

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FORFAITING-
 Forfaiting is an arrangement of bill discounting in which a financial institution or bank buys the trade
bills (invoices) or trade receivables from exporters of goods or services
 The exporter relinquish his right to receive payment from importer.
 Financial Institutions or banks provides immediate finance to exporter ‘without recourse’ basis in
which risk and rewards related with the bills/ receivables transferred to the financial institutions/
banks.
 The overseas buyers i.e. the importer on the basis trade bills and import documents draws a letter of
credit through its bank (Importer’s Bank)
 The exporter on receiving the letter of credit approaches to its bank (known as exporter’s bank).
 The exporter’s bank buys the letter of credit under ‘without recourse basis’ and provides the exporter
the payment for the bill.

INNOVATIONS IN RECEIVABLE MANAGEMENT-

(a) Centralisation: Centralisation of high nature transactions of accounts receivables and payable is one of
the practice for better efficiency.
(b) Alternative Payment Strategies: The following alternative modes of payment may also be used
alongwith traditional methods like Cheque Book etc., for making timely payment
(i) Direct debit: I.e., authorization for the transfer of funds from the purchaser’s bank account.
(ii) Integrated Voice Response (IVR): This system uses human operators and a computer based
system to allow customers to make payment over phone.
(iii) Collection by a third party: The payment can be collected by an authorized external firm. The
payments can be made by cash, cheque, credit card or Electronic fund transfer. Banks may also be
acting as collecting agents of their customers and directly depositing the collections in customers’
bank accounts.
(v) Payments via Internet using fund transfer methods like RTGS, NEFT, UPIs, App based payment
like PayTm, Phone Pe, etc.

MONITORING OF RECEIVABLES-
 Ageing Schedule: When receivables are analysed according to their age, the process is known as
preparing the ageing schedules of receivables. The computation of average age of receivables is a
quick and effective method of comparing the liquidity of receivables with the liquidity of receivables
in the past and also comparing liquidity of one firm with the liquidity of the other competitive firm. It
also helps the firm to predict collection pattern of receivables in future. This comparison can be
made periodically. The purpose of classifying receivables by age groups is to have a closer control
over the quality of individual accounts.

16. Mosaic Limited has current sales of Rs 15 lakhs per year. Cost of sales is 75 per cent of sales and bad
debts are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent
fixed costs, while the company’s required rate of return is 12 per cent. Mosaic Limited currently
allows customers 30 days’ credit, but is considering increasing this to 60 days’ credit in order to
increase sales.

It has been estimated that this change in policy will increase sales by 15 per cent, while bad debts will
increase from one per cent to four per cent. It is not expected that the policy change will result in an
increase in fixed costs and creditors and stock will be unchanged.

Should Mosaic Limited introduce the proposed policy? ANALYSE (Assume a 360 days year)

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MANAGEMENT OF PAYABLES (CREDITORS)-

Trade creditor is a spontaneous source of finance in the sense that it arises from ordinary business
transaction. But it is also important to look after your creditors - slow payment by you may create ill-feeling
and your supplies could be disrupted and also create a bad image for your company.

Cost of Availing Trade Credit-

(i) Price: There is often a discount on the price that the firm undergoes when it uses trade credit, since it can
take advantage of the discount only if it pays immediately. This discount can translate into a high implicit
cost.
(ii) Loss of goodwill: If the credit is overstepped, suppliers may discriminate against delinquent customers if
supplies become short. As with the effect of any loss of goodwill, it depends very much on the relative
market strengths of the parties involved.
(iii) Cost of managing: Management of creditors involves administrative and accounting costs that would
otherwise be incurred.
(iv) Conditions: Sometimes most of the suppliers insist that for availing the credit facility the order should
be of some minimum size or even on regular basis.

COST OF PAYABLES = d x 365

100-d t

17. The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s
records by the owner, Mr. Gautam, revealed that payments are usually made 15 days after purchases
are made. When asked why the firm did not take advantage of its discounts, the accountant, Mr.
Rohit, replied that it cost only 2 per cent for these funds, whereas a bank loan would cost the
company 12 per cent.
(a) ANALYSE what mistake is Rohit making?
(b) If the firm could not borrow from the bank and was forced to resort to the use of trade credit funds, what
suggestion might be made to Rohit that would reduce the annual interest cost? IDENTIFY.

SOLUTION -
(a) Rohit’s argument of comparing 2% discount with 12% bank loan rate is not rational as 2% discount can
be earned by making payment 5 days in advance i.e. within 10 days rather 15 days as payments are made
presently. Whereas 12% bank loan rate is for a year.
Assume that the purchase value is Rs100, the discount can be earned by making payment within 10 days is
Rs2. The interest cost on bank loan for 10 days would be Rs0.33 (100 × 12% × 10/365 days). The net benefit
of Rs1.67 (2 – 0.33).

(b) If the bank loan facility could not be available then in this case the company should resort to utilise
maximum credit period as possible.
The maximum possible repayment period would be lower of two:
(i) 30 days as allowed by supplier Or
(ii) No. of days x 100 x 12% = 1.67
365
= 50.79 or 51 days
Therefore, payment should be made in 30 days to reduce the interest cost.

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FINANCING OF WORKING CAPITAL-

 Finance manager bifurcate the working capital requirements between the permanent working capital
and temporary working capital.
 The permanent working capital is always needed irrespective of sales fluctuation, hence it should be
financed by the long-term sources such as debt and equity. On the contrary the temporary working
capital may be financed by the short-term sources of finance. Broadly speaking, the working capital
finance may be classified between the two categories:
(i) Spontaneous sources; and
(ii) Negotiable sources.

Spontaneous Sources: Spontaneous sources of finance are those which naturally arise in the course of
business operations. Trade credit, credit from employees, credit from suppliers of services

Negotiated Sources: On the other hand the negotiated sources, as the name implies, are those which have
to be specifically negotiated with lenders say, commercial banks, financial institutions, general public etc

SOURCES OF FINANCE-
(a) Trade Credit
(b) Bills Payable
(c) Accrued Expenses
(d) Public Deposits
(e) Bills Discounting
(f) Factoring
(g) Cash Credit
(h) Bills Discounting
(i) Letter of Credit
(j) Bank Guarantees

MAXIMUM PERMISSIBLE BANK FINANCE (MPBF)- TANDON COMMITTEE-

Recommendations of the Committee-
 A proper fund discipline has to be observed by the borrowers. They should supply to the banker
information regarding his operational plans well in advance
 The bank should know the end use of bank credit so that it is used only for purposes for which it was
made available

I. The borrower has to contribute a minimum of 25% of working capital gap from long term funds.
MPBF = 75% of [Current Assets Less Current Liabilities] i.e. 75% of Net Working Capital
II. The borrower has to contribute a minimum of 25% of the total current assets from long term funds.
MPBF = [75% of Current Assets] Less Current Liabilities
III. The borrower has to contribute the entire hard core current assets and a minimum of 25% of the balance
of the current assets from long term funds.
MPBF = [75% of Soft Core Current Assets] Less Current Liabilities

Core current assets is permanent component of current assets which are required throughout the year for a
company to run continuously and to stay viable. The term “Core Current Assets” was framed by Tandon
Committee while explaining the amount of stock a company can hold in its current assets. Generally, such
assets are financed by long term funds. Sometimes core current assets are also referred to as “Hardcore
Working Capital”.

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These assets are not liquid and so when companies are in need of money, they initially sell off non-core
assets (assets which are not important for continuous functioning of a business) to raise money. If a
company is ready to raise cash by selling its core current assets, then this implies that the company is in dire
situation or close to bankruptcy.

Examples of Core Current Assets are Raw materials, Work in Progress, Finished Goods, Cash in Hand and at
Bank etc.

18. From the following data, calculate the maximum permissible bank finance under the three methods
suggested by the Tandon Committee:
Liabilities in lakhs
Creditors 120
Other current liabilities 40
Bank borrowing 250
Total 410
Current Assets in lakhs
Raw material 180
Work-in-progress 60
Finished goods 100
Receivables 150
Other current assets 20
Total current assets 510
The total Core Current Assets (CCA) are ` 200 lakhs

Solution
The maximum permissible bank finance for the firm, under three methods may be ascertained as follows:
Method I: = 0.75 (CA – CL)
= 0.75 (510 – 160)
= Rs 262.50 lakhs

Method II: = 0.75 CA – CL

= 0.75 × 510 – 160
= Rs 222.50 lakhs
Method III: = 0.75 (CA – CCA) – CL
= 0.75 (510 – 200) – 160
Rs 72.50 lakhs

 As the firm, has already availed the bank loan of 250 lakhs, it can still avail a loan of Rs 12.50
lakhs as per the first method.
 However, as per the second and third method, it is not eligible for additional financing as
maximum financing allowed is for Rs 222.50 lakhs and Rs 72.50 lakhs only whereas its present
bank borrowings are already Rs 250 lakhs.

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19. PQ Ltd., a company newly commencing business in 2019 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
Provision 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 17,000
(10% of goods produced not yet sold)
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 installments. The company wishes to keep Rs 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)

20. 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 Rs 80 per unit
Direct wages Rs 30 per unit
Overheads (exclusive of depreciation) Rs 60 per unit
Total cost Rs 170 per unit
Selling price Rs 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 Average 8 weeks
debtors/receivables
Lag in payment of wages Average 1.5 weeks

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Cash at banks (for smooth operation) is expected to be Rs 25,000.

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.

21. 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 2,300

Customers are expected to pay as 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 for materials 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 March.
The company is going through a restructuring and will sell one of its freehold properties in May for
Rs25,000, but it is also planning to buy a new printing press in May for Rs10,000. Depreciation is currently
Rs1,000 per month, and will rise to Rs1,500 after the purchase of the new machine.

The company’s corporation tax (of Rs10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 20X3, of Rs1,500.
You are required to PREPARE a cash budget for the six months from January to June, 20X4.

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Solution-
Workings:
1. Sale receipts
Month Nov Dec Jan Feb Mar Apr May Jun
Forecast 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
sales (S)
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 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(Q)
Materials 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
(Q×5)
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 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(Q)
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. Wages payments-
Month Dec Jan Feb Mar Apr May Jun
Qty produced 1,250 1,500 2,000 1,900 2,200 2,200 2,300
(Q)
` ` ` ` ` ` `
Wages (Q × 4) 5,000 6,000 8,000
Wages (Q × 8,550 9,900 9,900 10,350
4.50)
75% this 3,750 4,500 6,000 6,412 7,425 7,425 7,762
month
25% this 1,250 1,500 2,000 2,137 2,475 2,475
month
5,750 7,500 8,412 9,562 9,900 10,237

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Cash budget – six months ended June-

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

22. From the information and the assumption that the cash balance in hand on 1st January 2017 is Rs
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 Rs 8,000 and Rs 25,000 for the same. An
application has been made to the bank for the grant of a loan of Rs 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 Rs 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 Materials 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
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

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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 10,000 12,100 10,600 25,000 22,000 23,000 1,02,700
wages
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 2,160 2,910 2,580 2,658 3,075 3,261 16,644
commission
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, 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106

beginning 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

23. Consider the balance sheet of Maya Limited as on 31 December,20X8. 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, 20X9. 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

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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. It is
paid in the subsequent month. Payments for these purchases occur in the month after the purchase. Labour
costs, including overtime, are expected to be Rs 1,50,000 in January, Rs 2,00,000 in February, and Rs 1,60,000
in March. Selling, administrative, taxes, and other cash expenses are expected to be Rs 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 Amount Month Amount Month Amount
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)
Particulars Nov Dec Jan Feb Mar Apr
Sales 500 600 600 1000 650 750
Collections, - - 120 200 130 -
current
month’s sales
(20%)
Collections, - - 420 420 700 -
previous
month’s sales
(70%)
Collections, - - 50 60 60 -
previous 2
month’s sales
(10%)
Total cash - - 590 680 890 -
receipts (A)
Purchases - 360 600 390 450 -
Payment for - - 360 600 390 -
purchases
Labour costs - - 150 200 160 -
Other expenses - - 100 100 100 -
Total cash - - 610 900 650 -
disbursements
(B)
Receipts less - - (20) (220) 240
disbursements
(A-B)
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(b)
Particulars Jan Feb Mar
Additional borrowings 20 220 (240)
Cumulative borrowings 420 640 400

(c) Pro forma Balance Sheet, 31st March, 20X9 (Amount in ‘000)

Equity & liabilities Amount Assets Amount

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 × 0.8 + Sales in February × 0.1

Inventories = Rs545 + Total purchases from January to March − Total sales from January to March × 0.6

Accounts payable = Purchases in March

Retained earnings = Rs 1,439 + Sales – Payment for purchases – Labour costs and – Other expenses, all for
January to March

24. PQR Ltd. having an annual sales of Rs 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 Rs 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 Losses 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 Alternative Alternative
Policy I II

Sales Revenues 30,00,000 30,00,000 30,00,000

Average Collection Period (ACP) 50 40 30
(days)
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Receivables (Sales x ACP / 360) 4,16,667 3,33,333 2,50,000

Reduction in Receivables from - 83,334 1,66,667
Present Level
Savings in Interest @ 10% p.a. (A) - 8,333 16,667
% of Bad Debt Loss 5% 4% 3%
Amount of Bad Debts 1,50,000 1,20,000 90,000
Reduction in Bad Debts from Present - 30,000 60,000
Level (B)
Incremental Benefits from Present - 38,333 76,667
Level (C) = (A) + (B)
Collection Expenses 30,000 60,000 95,000
Incremental Collection Expenses - 30,000 65,000
from Present Level (D)
Incremental Net Benefit (C – D) - 8,333 11,667

Conclusion: From the analysis it is apparent that Alternative I has a benefit of Rs 8,333 and Alternative II has
a benefit of Rs 11,667 over present level. Alternative II has a benefit of Rs 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.)

25. As a part of the strategy to increase sales and profits, the sales manager of a company proposes to
sell goods to a group of new customers with 10% risk of non-payment. This group would require one
and a half months credit and is likely to increase sales by Rs 1,00,000 p.a. Production and Selling
expenses amount to 80% of sales and the income-tax rate is 50%. The company’s minimum required
rate of return (after tax) is 25%.
Should the sales manager’s proposal be accepted? ANALYSE
Also COMPUTE the degree of risk of non-payment that the company should be willing to assume if the
required rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.

26. Slow Payers are regular customers of Goods Dealers Ltd. and have approached the sellers for
extension of credit facility for enabling them to purchase goods. On an analysis of past performance
and on the basis of information supplied, the following pattern of payment schedule emerges in
regard to Slow Payers:

Pattern of Payment Schedule

At the end of 30 days 15% of the bill
At the end of 60 days 34% of the bill.
At the end of 90 days 30% of the bill.
At the end of 100 days 20% of the bill.
Non-recovery 1% of the bill.
Slow Payers want to enter into a firm commitment for purchase of goods of Rs 15 lakhs in 20X7, deliveries to
be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is Rs 150 on which a profit of Rs 5 per unit is expected to be made.

It is anticipated by Goods Dealers Ltd., that taking up of this contract would mean an extra recurring
expenditure of Rs 5,000 per annum. If the opportunity cost of funds in the hands of Goods Dealers is 24%
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per annum, would you as the finance manager of the seller recommend the grant of credit to Slow Payers?
ANALYSE. Workings should form part of your answer. Assume year of 365 days.

Solution-
Statement showing the Evaluation of Debtors Policies

Particulars Proposed
Policy
A. Expected Profit:
(a) Credit Sales 15,00,000
(b) Total Cost
(i) Variable Costs 14,50,000
(ii) Recurring Costs 5,000
14,55,000
(c) Bad Debts 15,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investments in Receivables 68,787
C. Net Benefits (A – B) (38,787)

Recommendation: The Proposed Policy should not be adopted since the net benefits under this policy are
negative

Working Note: Calculation of Opportunity Cost of Average Investments

Opportunity Cost = Total Cost x Collection period x Rate of Return

365 100

Particulars 15% 34% 30% 20% TOTAL

A. Total Cost 2,18,250 4,94,700 4,36,500 2,91,000 14,40,450
B. Collection Period 30/365 60/365 90/365 100/365
C. Required Rate of Return 24% 24% 24% 24%
D. Oppurtunity Cost (A x B x C) 4,305 19,517 25,831 19,134 68,787

27. Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's
Working Capital Requirements. The following informations are available about the projections for the
current year:

Estimated Level of Activity Completed Units of Production 31200 plus unit of

work in progress 12000
Raw Material Cost 40 per unit
Direct Wages Cost 15 per unit
Overhead 40 per unit (inclusive of Depreciation 10 per unit)
Selling Price 130 per unit
Raw Material in Stock Average 30 days consumption

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Work in Progress Stock Material 100% and Conversion Cost 50%

Finished Goods Stock 24000 Units
Credit Allowed by the 30 days
supplier
Credit Allowed to 60 days
Purchasers
Direct Wages (Lag in 15 days
payment)
Expected Cash Balance 2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and
overheads accrue similarly. All sales are on the credit basis. You are required to calculate the
Net Working Capital Requirement on Cash Cost Basis (MAY 2018 – 10 Marks)

28. Bita Limited manufactures used in the steel industry. The following information regarding the
company is given for your consideration:

(i) Expected level of production 9000 units per annum.

(ii) Raw materials are expected to remain in store for an average of two months before issue
to production.
(iii) Work-in-progress (50 percent complete as to conversion cost) will approximate to 1/2
month’s production.
(iv) Finished goods remain in warehouse on an average for one month.
(v) Credit allowed by suppliers is one month.·
(vi) Two month's credit is normally allowed to debtors.
(vii) A minimum cash balance of Rs 67,500 is expected to be maintained.
(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.
(xi) The cost structure for Bita Limited's product is as follows:

Raw Materials -80 per unit

Direct Labour -20 per unit
Overheads (including depreciation Rs 20) 80 per unit
Total Cost -180 per unit
Profit -20 per unit
Selling Price -200 per unit

You are required to estimate the working capital requirement of Bita limited (MAY 2019: 10 MARKS)

29. A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular
basis. As per the terms of agreement the payment must be made within 40 days of
purchase. However, A Ltd. has a choice of paying Rs 98.50 per Rs 100 it owes to X Ltd. on
or before 10th day of purchase.
Required:
EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of
A Ltd. with X Ltd. is Rs 10,00,000 and an alternative investment yield a return of 15% and
company pays the invoice (RTP MAY 2018)

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30. Following information is forecasted by the R Limited for the year ending 31st March, 20X8:

Balance as Balance as
at 1st April, at 31st
20X7 March, 20X8
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469

Annual purchases of raw material (all 4,00,000

credit)
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.

Required:
CALCULATE
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement using operating cycles (RTP MAY 2018)

Solution-

Working Notes:
1. Raw Material Storage Period (R) -

R= Average Stock of Raw Material X 365

Annual Consumption of Raw Material
R= (45,000+65,356)/2 x 365
3,79,644
R= 53 days

2. Work-in-Progress (WIP) Conversion Period (W)-

W= Average Stock of WIP x 365
Annual Cost of Production
W= (35,000+ 51,300)/2 x 365
7,50,000
W= 21 days

3. Finished Stock Storage Period (F)

F= Average Stock of Finished Goods x 365
Cost of Goods Sold
F= ( 60,181 + 70,175)/2 x 365
9,15,000
F= 26 days

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4. Debtors Collection Period (D)

D= Average Debtors x 365
Annual Credit Sales
D= (1,12,123+ 1,35,000)/2 x 365
11,00,000
D= 41 days

5. Creditors Payment Period (C)

C= Average Creditors X 365
Annual Net Credit Purchases
C= (50,079+ 70,469)/2 x 365
4,00,000
C= 55 days

(i) Operating Cycle Period

= R + W + F+ D – C
= 53 + 21 + 26 + 41 – 55
= 86 days

(ii) Number of Operating Cycles in the Year

= 365
Operating Cycle Period
=365
86
=4.244

(iii) Amount of Working Capital Required

= AnnualOperating Cost
Number of Operating Cycles
= 9,50,000
4.244
=2,23,845.42

31. A company is considering its working capital investment and financial policies for the next year.
Estimated fixed assets and current liabilities for the next year are Rs 2.60 crores and Rs 2.34 crores
respectively. Estimated Sales and EBIT depend on current assets investment, particularly inventories
and book-debts. The Financial Controller of the company is examining the following alternative
Working Capital Policies:
(In Crores)
Working Capital Investment in Estimated EBIT
Policy Current Assets Sales
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00

After evaluating the working capital policy, the Financial Controller has advised the adoption of the
moderate working capital policy. The company is now examining the use of long-term and short-term
borrowings for financing its assets. The company will use Rs 2.50 crores of the equity funds. The corporate
tax rate is 35%. The company is considering the following debt alternatives.
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(In Crores)
Financing Policy Short-term Long-term
Debt Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%

You are required to CALCULATE the following:

(i) Working Capital Investment for each policy:

(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio

(ii) Financing for each policy:

(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio (RTP MAY 2019)

Solution-
(i) Statement showing Working Capital Investment for each policy
(In Crores)
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v) = (iii) - (iv) 4.76 4.16 2.86
Total liabilities: (iv) + (v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: 2.16 1.56 0.26
(i) - (iv)
(b) Rate of return: (vii) /(iii) 17.32% 17.69% 19.23%
(c) Current ratio: (i)/ (iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy

(Rs In Crores)
Financing Policy Conservative Moderate Aggressive
Current Assets (i) 3.90 3.90 3.90
Fixed Assets (ii) 2.60 2.60 2.60
Total Assets (iii) 6.50 6.50 6.50
Current Liabilities (iv) 2.34 2.34 2.34
Short term Debt (v) 0.54 1.00 1.50

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Total current liabilities 2.88 3.34 3.84

(vi) = (iv) + (v)
Long term Debt (vii) 1.12 0.66 0.16
Equity Capital (viii) 2.50 2.50 2.50
Total liabilities (ix) = 6.50 6.50 6.50
(vi)+(vii)+(viii)
Forecasted Sales 11.50 11.50 11.50
EBIT (x) 1.15 1.15 1.15
Less: Interest on short-term 0.06 0.12 0.18
debt (12% of 0.54) (12% of 1) (12% of 1.5)
Interest on long term 0.18 0.11 0.03
debt (16% of 1.12) (16% of 0.66) (16% of 0.16)
Earnings before tax (EBT) (xi) 0.91 0.92 0.94
Taxes @ 35% (xii) 0.32 0.32 0.33
Earnings after tax: (xiii) = (xi) 0.59 0.60 0.61
– (xii)
(a) Net Working
Capital Position: (i) 1.02 0.56 0.06
- [(iv) + (v)]
(b) Rate of return on
shareholders Equity 23.6% 24.0% 24.4%
capital : (xiii)/ (viii)
(c) Current Ratio (i) / (vi) 1.35 1.17 1.02

32. A proforma cost sheet of a company provides the following particulars:

Amount per unit

Raw materials cost 100.00

Direct labour cost 37.50
Overheads cost 75.00
Total cost 212.50
Profit 37.50
Selling Price 250.00
The Company keeps raw material in stock, on an average for one month; work-in-progress,
on an average for one week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to its
debtors. The lag in payment of wages is one week and lag in payment of overhead
expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at
bank put together at Rs37,500.

Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000
units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects (RTP MAY 2019)

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33. Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing
credit terms to three of their large customers A, B and C. The credit period and likely
quantity of TV sets that will be sold to the customers in addition to other sales are as
follows:

Quantity sold (No. of TV Sets)

Credit Period A B C
(Days)
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500

The selling price per TV set is Rs 9,000. The expected contribution is 20% of the selling
price. The cost of carrying receivable averages 20% per annum.

You are required:

(a) COMPUTE the credit period to be allowed to each customer. (Assume 360 days in a year for calculation
purposes).
(b) DEMONSTRATE the other problems the company might face in allowing the credit
period as determined in (a) above? (RTP NOV 2018)

Solution-
(a) In case of customer A, there is no increase in sales even if the credit is given. Hence comparative
statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period 0 30 60 90 0 30 60 90
(days)
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
in lakhs in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 18 27 36 45 - - 18 27
20% (A)
5. Receivables:
Credit Period × - 11.25 30 56.25 - - 15 33.75
Sales 360
6. Debtors at cost - 9 24 45 - - 12 27
i.e. 80% of 11.25
7. Cost of - 1.8 4.8 9 - - 2.4 5.4
carrying
debtors at 20%
(B)
8. Excess of 18 25.2 31.2 36 - - 15.6 21.6
contributions
over cost of
carrying
debtors (A – B)

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FINANCIAL MANAGEMENT ARIVUPRO ACADEMY

The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90 days in
respect of both the customers B and C. Hence, credit period of 90 days should be allowed to B and C.

(b) Problem:
(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C is taking 1000 TV sets at
credit for 60 days. Hence A also may demand credit for 60 days compulsorily.

(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets only. In such case B will
demand further relaxation in credit period i.e. B may ask for 120 days credit.

34. 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:
Costs 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:
(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.

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SOLUTION-
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 × 96)
Cost of production:
Materials cost 2,40,000 3,60,000
(Units produced × 40)
Direct labour and variable expenses 1,20,000 1,80,000
(Units produced × 20)
Fixed manufacturing expenses 72,000 72,000

(Production Capacity: 12,000 units × 6)

Depreciation 1,20,000 1,20,000
(Production Capacity : 12,000 units × 10)
Fixed administration expenses 48,000 48,000
(Production Capacity : 12,000 units × 4)
Total Costs of Production 6,00,000 7,80,000
Add: Opening stock of finished goods --- 1,00,000
(Year 1 : Nil; Year 2 : 1,000 units)
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 (1,00,000) (1,32,000)
average cost (year 1: 1000 units, year 2 :
1500 units)
(Cost of Production × Closing stock/ units
produced)
Cost of Goods Sold 5,00,000 7,48,000
Add: Selling expenses – Variable (Sales 20,000 34,000
unit × 4)
Add: Selling expenses -Fixed (12,000 units 12,000 12,000
× 1)
Cost of Sales : (B) 5,32,000 7,94,000
Profit (+) / Loss (-): (A - B) (-) 52,000 (+) 22,000

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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 45,000 67,500
average 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 23,750 31,875
(Creditors)

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:
- 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 40,000 68,000
profit)
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

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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  40  2.25/12);
(9,000 units  40  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 material (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
Cost of Production as per projected 6,00,000 7,80,000
Statement of P&L
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
4, 80, 000×1, 000 7, 40, 000×1,500  (80,000) (1,11,000)
6, 000 & 10, 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 12,000
(12,000 units × 1)
Cash Cost of Debtors 4,32,000 6,75,000
Average Debtors 36,000 56,250

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