Compilation of Problems by Dr.

Abida Khan

Mahatma Education Society’s

Pillai College of Arts, Commerce and Science (Autonomous)

Affiliated to University of Mumbai

New Panvel

T.Y.B.COM.ACCOUNTING AND FINANCE

V SEMESTER

FINANCIAL MANAGEMENT I
 Compilation of Problems by Dr. Abida Khan

Unit 1: Strategic Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.
Definitions
“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal
“Financial management is that area of business management devoted to a judicious use of
capital and a careful selection of the source of capital in order to enable a spending unit to
move in the direction of reaching the goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie

Importance of Financial Management

 Helps organisations in financial planning;
 Assists organisations in the planning and acquisition of funds;
 Helps organisations in effectively utilising and allocating the funds received or
acquired;
 Assists organisations in making critical financial decisions;
 Helps in improving the profitability of organisations;
 Increases the overall value of the firms or organisations;
 Provides economic stability;
 Encourages employees to save money, which helps them in personal financial
planning.

Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital
budgeting). Investment in current assets are also a part of investment decisions called
as working capital decisions.
2. Financial/Capital Structure decisions - They relate to the raising of finance from
various resources which will depend upon decision on type of source, period of
financing, cost of financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
 Compilation of Problems by Dr. Abida Khan

5. To plan a sound capital structure-There should be sound and fair composition of

capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with
regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period
of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current
liabilities, maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Qualities of Good finance manager

Analytical Skills
Taking financial decisions without any kind of analysis is throwing a stone in a dark hole, but
an effective financial decision must not be this kind. For effective financial decisions, there
must be a proper analysis of historical data and all existing privately and publicly available
information. So that finance manager actually can assume something about a financial outcome
that may happen.
Proper Understanding of Time Value of Money
Time value of money is one of the important concepts that must be considered when making
investment or financing decisions for the company. Because by using this concept we can
calculate the present value and future value of an amount. That’s why every finance manager
has to have a clear understanding of the time value of money concept for adapting the right
investment or financing alternatives.
Efficient Operator of Modern Technology
 Compilation of Problems by Dr. Abida Khan

Now a day’s technology made it easy to do analysis with the help of computer-based software.
Popular software used for analysis are Microsoft Excel, SPSS, STATA, etc. so financial analyst
or financial manager must need to know how to operate this software and how to interpret the
result generated by this software.
Communication Skills
Whenever a finance manager wants to analyze the financial performance of the company,
he/she will be required to have financial information about the company, so through
communicating with the respected department manager collect information. Also what kinds
of information managers are asking must be conveyed clearly to the respected parties.
Numerical Proficiency
Another important qualification of a financial manager or analyst is proficiency in numerical
calculation. For financial decisions making most of the cases we mainly use quantitative data
which is a numerical number. The ability to calculate and understand numerical variables is
required to make the right financial decision.
Ability to Diversify Investment
One of the main tasks of a financial manager or portfolio manager or financial analysis is to
find out the optimal portfolio for the company from the existing investment opportunities. You
know that diversification is the only way through which we can minimize our unsystematic
portion of the risk, that’s why managers always try to diversify their investment to maximize
the return of the company. A person who has the ability to analyze the market and identify the
optimal portfolio through diversification is to be the best financial manager or financial analyst
for the company.
Ability to Forecast
One of the important things that a financial analyst has to do is forecasting the future. Forecast
about financing requirements and investment decisions considering the future economic
prospects or recession. Another thing is the forecast about the growth of the overall industry
and the company.
Quick Decision Making
Sometimes there may have the opportunity of making huge money through investing risky
projects short-term basis and these types of opportunities mainly chosen by the aggressive
financial managers. Successful financial managers are quick decision-makers and their
decision is most of the time is an effective one. So quick decision making is the ability of a
person which helps to become a financial analyst.
Ability to Analyze Quantitative Factors
Although most of the cases finance manager deals with quantitative data but in some cases,
they also use qualitative data also, because there may have some non-monetary factors which
have a great impact on the investment and financing alternatives. So both quantitative and
qualitative analytical proficiency is required to have a financial analyst to take the right
decision for the company.
Educational Qualification Required to Become a Finance Manager
Not every people become the financial manager because to become a financial manager you
have to understand all the necessary concept and ideas about financing and investment.
Graduated from the background of economics, finance, or from accounting may become a
finance manager. But now a day’s finance background people are getting more preference
because of understanding of proper understanding of what finance is all about. If you dreaming
to become a finance manager or analyst then you should study finance first and get BBA, MBA
in finance and finally try to become CFA.
Leadership qualities
Along with all above, he must also possess all the leadership qualities
 Compilation of Problems by Dr. Abida Khan

Profit Maximisation V/s Wealth Maximisation

BASIS FOR
PROFIT MAXIMIZATION WEALTH MAXIMIZATION
COMPARISON

Concept The main objective of a concern The ultimate goal of the concern is
is to earn a larger amount of to improve the market value of its
profit. shares.

Emphasizes on Achieving short term objectives. Achieving long term objectives.

Consideration of Risks No Yes

and Uncertainty

Advantage Acts as a yardstick for computing Gaining a large market share.

the operational efficiency of the
entity.

Recognition of Time No Yes

Pattern of Returns
 Compilation of Problems by Dr. Abida Khan

` Unit 2
Capital Budgeting – Project Planning and Risk Analysis

Meaning of Capital Budgeting:

The Capital Budgeting process includes identifying and evaluating capital projects for
the company. This process can be used to examine future earnings decisions like buying
of machine, expanding operations at another geographic location, replacing the old
asset. These decisions have the power to impact the future success of the company.

Aspects of Capital Budgeting:

Capital Budgeting process has the following four aspects:

1) Generation of Ideas:
Generation of good quality project ideas is the most important capital budgeting
aspect. Ideas can be generated at management or employees level or even from
outside the company.
2) Analysis of Proposals:
The basics of accepting or rejecting a proposal is expected cash flows in the
future to determine expected profitability of project.
3) Creating the Corporate Capital Budget:
Once the profitable projects are shortlisted, they are prioritized according to the
available company resources. Some projects may be attractive, but may not be a
fit to the company’s overall strategy.
4) Monitoring and Post-Audit:
A follow up on the decision is equally important in the capital budgeting process.
The analysis compares the actual results of the projects to the budgeted ones and
the project manager is responsible if the projections match or do not match with
the actual results.

Stages of Capital Budgeting:

1) Cash Outflow
Cost of Fixed Assets + Installation Exp - Sales of Old Fixed Assets + Payment
of tax on capital gain - Saving of tax on capital loss + Working Capital.

2) Cash Inflow
A) Sales - Variable Cost - Fixed Cost = Net Profit before tax – Depreciation –
Tax = Net profit after tax + Depreciation

B) Net Profit before tax – Tax = Net profit after tax + Depreciation

C) Net Profit after tax + Depreciation

3) Terminal Cash Inflow
Scrap Value of New Fixed Asset – Payment of tax on capital gain + Savings of
tax on capital loss + Recovery of Working Capital
 Compilation of Problems by Dr. Abida Khan

Techniques of Capital Budgeting Evaluation:

Traditional or a) Average Rate of Return

Technique 1 Non-Discounting
Technique b) Payback Period

a) Net Present Value

Time Adjusted or b) Profitability Index
Technique 2 Discounted
c) Discounted Payback
Technique
d) Internal Rate of Return

Technique 1- Traditional or Non-Discounting Technique:

This technique does not discount the cash flows to find out present worth or present
value. Methods as below-
a) Payback Period
The payback is defined as the number of years required for the proposal’s
cumulative cash inflow to be equal to its cash outflow. In other words, the
payback period is the length of time required to recover the initial investment
of the project. It is calculated in different situations-
Situation 1- when annual cash inflows are uniform
When cash inflows are uniform or equal, the payback period is calculated by
dividing the cash outflow with annual cash inflow. For example a project
requires an initial investment of Rs. 1,00,000 which could generate an annual
cash inflow of Rs. 20,000 in a year, hence the project would take five years to
recover the amount of Rs. 1,00,000
Payback Period = 1,00,000
20,000
= 5 years
Situation 2- when the annual cash inflows are not uniform
In case the cash inflows from the proposal are not same, cumulative cash
inflows are used to compute the payback period.

b) Average Rate of Return (ARR)

It is also known as Accounting Rate of Return. It is defined as the annualized
net income earned on the average investment of a project. It is expressed in
percentage.

ARR = Average Annual Net Profit after Tax * 100

Average Investment

Average Annual Net Profit after Tax = Total Profit after Tax
No. of Years

Average Investment =
 Compilation of Problems by Dr. Abida Khan

Initial Investment (Cost of Fixed Asset) + Install. Exp.

– Scrap Value of Fixed Asset + Working Capital + Scrap Value of
F.A.
2
Technique 2- Time Adjusted or Discounted Technique:
Money has time value. Cash flows occur earlier in time are worth more than cash flows
that occur later. Differences are considered as inflation. Time adjusted or discounted
technique involves time value of money, more accurately reflect the true economic
value of returns. This technique is also called the present values technique and fulfils
all the requisite of good evaluation technique. Methods as below.
a) Net Present Value (NPV)
The NPV is defined as the sum of present values of all cash inflows less the sum
of present values of all the cash outflows associated with a proposal.

NPV= Present Value of Cash Inflows – Present Value of Cash Outflows

b) Profitability Index (PI)

PI is defined as the benefits-cost ratio. It is ascertained by comparing the present
value of the future cash inflows with the present value of the future cash
outflows.

PI = Present value of the future cash inflows

Present value of the future cash outflows

c) Discounted Payback Period

This method is a combination of the original payback method and the discounted
cash flow technique.

d) Internal Rate of Return (IRR)

= L+ A (H – L)
(A-B)
Where, L = Lower discount rate at which NPV is positive
H = Higher discount rate at which NPV is negative
A = NPV at lower discount rate, L
B = NPV at higher discount rate, H

Problem 1:
Honda Ltd. provides the following information.
Particulars

Purchase price of each equipment Rs. 14,00,000

Working Capital Rs. 60,000

Life of Machine 5 Years

 Compilation of Problems by Dr. Abida Khan

Method of Depreciation Straight Line Method

Tax Rate 40%

Cost of Capital 10%

Earnings before depreciation and tax as below.

Year Equipment A Equipment B P.V. Factors @ 10%

1 7,00,000 2,00,000 0.909

2 7,00,000 3,00,000 0.826

3 7,00,000 5,00,000 0.751

4 7,00,000 6,00,000 0.683

5 7,00,000 2,80,000 0.621

Evaluate and suggest the management the most profitable equipment under
discounted technique.

Problem 2
A company can make either of two investments details of which given below.
Particulars X Y
Cost of Investment Rs. 2,00,000 2,40,000
Expected life 5 years 5 years
Projected Net Income (after tax) Rs. Rs.
Year 1 40,000 56,000
2 50,000 56,000
3 60,000 56,000
4 60,000 56,000
5 40,000 56,000
Calculate Payback Period and Discounted Payback Period at 10% P. V. Factors.

Problem No. 3
Venus manufacturing company wants to replace manual operations by new machine.
There are two alternative machines, Machine X and Machine Y of the new machine.
Using Average Rate of Return and Payback Period, suggest the most profitable
investment. Tax rate 40%. Depreciation to be charged straight line method.

Particulars Machine X Machine Y

Original Investment 18,00,000 36,000,000
Estimated life of the 4 Years 5 Years
machine
Estimated saving in cost 1,00,000 1,60,000
Estimated saving in wages 12,00,000 16,00,000
 Compilation of Problems by Dr. Abida Khan

Additional cost of 1,60,000 2,00,000

maintenance
Additional cost of 2,40,000 3,60,000
supervision

Problem 4
The Cash Flow for two alternative investments X and Y are:
Year Investment X Investment Y

Cost of Investment 8,00,000 8,40,000

Working Capital 40,000 20,000

Cash Inflow 1 2,00,000 3,20,000

2 3,20,000 2,40,000

3 4,00,000 3,20,000

4 3,20,000 2,40,000

5 2,40,000 3,20,000
Calculate Discounted Payback Period, Net Present Value using 11% discount rate. Which
would you choose? Why?

Problem 5
Finman Construction Company is interested in the computerization of its office work.
For this purpose two models have been shortlisted, for which information is given
below.
Particulars Model I Model II
Cost 1,50,000 2,50,000
Working Capital Required 50,000 70,000
Savings in Expenses 1,00,000 1,50,000
Life 5 Years 5 Years
Depreciation 25% W.D.V. 25% W.D.V.
Tax Rate 35% 35%
Required Rate of Return 13% 13%
Find out which model is better on the basis of N.P.V method.
Problem No 6
ABC Ltd is considering an expansion of the installed capacity of one of its plant at a
cost of Rs. 35,00,000. The firm has a minimum required rate of return of 12%. The
following are the expected cash inflows over next 6 years after which the plant will be
scrapped away for nil value.
Year Cash Inflows (Rs.)
1 10,00,000
2 10,00,000
3 10,00,000
 Compilation of Problems by Dr. Abida Khan

4 10,00,000
5 5,00,000
6 5,00,000
Evaluate the above proposal on the basis of Internal Rate Return (IRR)

Problem 7
A Company has to consider the following project:
Cost – Rs. 20,000
Cash Inflows:
Year 1 2,000
Year 2 2,000
Year 3 4,000
Year 4 20,000
Compute the Internal Rate of Return. Cost of Capital is 11%.

Problem 8
The cash flows from two project S and R as under:
Year Project S Project R
0 Rs. (-) 66,000 Rs. (-) 81,000
1-7 (annually) Rs. 18,000 Rs. 21,000
Project life 7 years 7 years
1. Calculate NPV of the proposals at different discount rates of 15%. 16%, 17%,
18%, 19% and 20%.
2. Advice on the projects on the basis of IRR method.

Problem 9
Manoj Ltd. decided to purchase a machine to augment the company’s installed capacity
to meet growing demand for its product. There are two machines under consideration.
The relevant details including estimated yearly expenditures and sales are given below.
Income tax rate is 40%.
Particular Machine 1 Machine 2

Initial Investment 6,00,000 6,00,000

required
Estimated sales annual 10,00,000 8,00,000

Cost of Production
(estimated):
Direct Material 80,000 1,00,000

Direct Labour 1,00,000 60,000

Factory overheads 1,20,000 1,00,000

Administration 40,000 20,000

overheads
 Compilation of Problems by Dr. Abida Khan

Selling and Dist. Oh. 20,000 20,000

The economic life of Machine 1 is 2 years and Machine 2 is 3 years. The scrap
value of machine 1 is Rs. 80,000 and Machine 2 is Rs. 50,000. Calculate Average
Rate of Return and Payback Period.

Problem 10
A Company is considering a new project for which the investment data is given below:
Capital Expenditure Rs. 4,00,000
Depreciation = 10%
Annual Profit before depreciation and tax as follows.
Year Profit Rs.

1 2,00,000

2 2,00,000

3 1,60,000

4 1,60,000

5 80,000

Tax Rate 30%. Calculate Profitability of the project under each method.

Problem 11
PQR Ltd., has a capital budget of Rs. 20,00,000 for the year. It has before the following
6 proposals for which necessary information is provided hereunder:

Proposal Outlay Rs. NPV Rs.

A 14,00,000 6,00,000
B 5,00,000 3,20,000
C 10,00,000 4,00,000
D 4,00,000 2,00,000
E 11,00,000 9,00,000
F 15,00,000 -5,00,000

Find out the ranking of the proposals and final selection on the basis of maximum
NPV from the proposals, given that.
1) The projects are indivisible
2) The projects are divisible
Problem No. 12
XYZ Ltd. is considering following projects for investment. You are asked to choose the optimal
project if capital constraint is Rs. 16,25,000 if projects are a) Divisible b) Indivisible
Project Initial Outlay NPV (Rs.)
 Compilation of Problems by Dr. Abida Khan

A 12,75,000 4,25,000

B 3,00,000 76,250

C 50,000 (10,000)

D 5,00,000 1,31,250

E 2,50,000 57,500

Problem 13
Sushila Ltd. has Rs. 5,00,000 allocated for capital budgeting purposes. The following
proposals and associated Profitability Index have been given.

Project Initial Outlay Profitability Index

1 1,50,000 1.22

2 75,000 0.95

3 1,75,000 1.20

4 2,25,000 1.18

5 1,00,000 1.20

6 2,00,000 1.05
Which of the above investments should be undertaken in order to maximize NPV, assume that
the projects are a) Divisible b) Indivisible.

Problem 14
Initial Project Cost Rs. 1,20,000
Annual Cash Inflow Rs. 45,000
Project Life 4 years
Cost of Capital 10%
Annuity Factors
10% 3.169
11% 3.103
Calculate sensitivity of project cost, cash inflow and annuity factors at 11%. Apply
Shock Approach.

Problem 15
From the following project details calculate the sensitivity of a) project cost b) Annual
Cash Inflow. Which variable is the most sensitive.
Project Cost – Rs. 12,000
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Annual Cash Inflow – Rs. 4,500 Life of the project 4 Years. Cost of Capital 14%. The
annuity factor at 14% for 4 years is 2.9137. Apply MOS Approach.

Problem 16
A glass factors that specializes in crystal is developing a substantial backlog and for this the
firm’s management is considering three courses of action; the correct choice depends largely
upon future demand which may be low, medium or high. Show this decision in the form of
decision tree and indicate the most preferred decision with corresponding expected value.
Demand Probability Course of action
S1 S2 S3
Low 0.10 10 -20 -150
Medium 0.50 50 60 20
High 0.40 50 100 200

Course of actions are S1- Sub contracting, S2-Being overtime and S3-Construct new facility.

Problem 17
Pay offs of three acts A, B and C and the states of nature P, Q and R given below
States of Nature Acts
A B C
P -35 120 -100
Q 250 -350 200
R 550 650 700
The probabilities of states of nature are 0.5, 0.4 and 0.1 respectively. State which act can be
chosen as best act.

Problem 18
The following table presents the proposed cash flows for projects M and N with their
associate probabilities. Which project has a higher preference for acceptance?
Possibilities Project M Project N
Cash flow (Rs. In Probability Cash flow (Rs. Probability
lakhs) In lakhs)
1 7,000 0.10 12,000 0.10
2 8,000 0.20 8,000 0.10
3 9,000 0.30 6,000 0.10
4 10,000 0.20 4,000 0.20
5 11,000 0.20 2,000 0.50
 Compilation of Problems by Dr. Abida Khan

Unit 3 Capital Structure Theories

Introduction:
1) Impact of capital structure on the value of the firm
2) It affect total value of the firm
3) The different types of approaches – a) Net Income Approach b) Net Operating
Income Approach c) Traditional Approach (MM Approach)
Assumptions:
1) There are only two sources of funds used by a firm : Equity and Debt
2) There are no corporate Taxes (This assumption is removed later)
3) The dividend payout ratio is 100%. Total earnings are paid as dividend to the
shareholders and there are no retained earnings
4) The total asset are given and do not change. The investment decision are assumed
to be constant.
5) Total financing remains constant. The firm can change its degree of leverage
(capital Structure) either by selling shares and use the proceed to retire
debentures or by raising more debts and reduce the equity capital
6) The operating profit (EBIT) remains constant.
7) Business risk is constant.
8) Perpetual life of the firm.
Calculation of the Value of the Firm under different approaches:
a) Net Income Approach
Value of Equity (E) = Net Income / Cost of Equity (ke) E = 15/0.15 = 100
Value of Debt (D) = Interest / Cost of Debt (kd) D = 10/0.10 = 100
Value of the Firm (V) = E + D
Weighted Average Cost of Capital (ko) = EBIT / V
b) Net Operating Income Approach
Value of Firm (V) = EBIT / ko
Value of Debt (D) = Interest / kd
Value of Equity (E) = V – D
Cost of Equity (ke) = Net Income / E

c) Traditional Approach / MM Approach

All formulas same as Net Income Approach
 Compilation of Problems by Dr. Abida Khan

Example-
Profit & Loss Account
Particulars Amount
Sales
-Variable Cost
Contribution
-Fixed Cost
EBIT (Net Operating Income) 25
-Interest 10
PBT ( Net Income) 15

Balance sheet
Liabilities amount Assets Amount
Equity Capital 100
Debt 100
200 200
Cost of Equity 15%
Cost of Debt 10%
1.Net Income Approach
Debt 8,00,000 10% 5,00,000 10% 2,00,000 10%
Equity 2,00,000 15% 5,00,000 15% 8,00,000 15%
Ko 12.5% 10% 9%

ke
ko kd
 Compilation of Problems by Dr. Abida Khan

2.Net operating Income approach

Debt 8,00,000 10% 5,00,000 10% 2,00,000 10%
Equity 2,00,000 15% 5,00,000 17% 8,00,000 19%
Ko 12.5% ke 12.5% 12.5%

ko
kd

3.Traditional or MM Approach
Debt 8,00,000 10% 5,00,000 10% 2,00,000 12%
Equity 2,00,000 15% 5,00,000 15% 8,00,000 17%
Ko 12.5% 11% 14%

Problem 1:
Assuming no taxes and given the earnings before interest and tax (EBIT), interest 10%
and equity capitalization rate below, calculate the market value of each firm.
Firms EBIIT (Rs.) Interest (I) Rs. Ke %
X 4,00,000 40,000 10
Y 6,00,000 1,20,000 15
Z 10,00,000 4,00,000 16
W 12,00,000 4,80,000 18
Also determine weighted average cost of capital.
Problem No 2:
Company X and Company Y are in the same risk class and are identical in every
aspect except that company X uses debt, while company Y does not. The levered firm
has Rs. 18,00,000 debentures carrying 10% rate of interest. Both the firms earn 20%
operating profit on their total assets of Rs. 30,00,000. Assume perfect capital market ,
rational investors and so on, a tax rate of 35% and capitalization rate of 15%.
Calculate the value of firms x and y using NI Approach.
 Compilation of Problems by Dr. Abida Khan

Problem 3:
Operating Income Rs. 50,000, cost of Debt 10%. Outstanding debt Rs. 2,00,000. If the
overall capitalization rate is 12.5% , What would be the value of the firm and equity
capitalization rate?
Problem 4:
Tata Ltd. has an EBIT of Rs. 6,00,000 and 10% debentures of Rs. 10,00,000. The overall
capitalisation rate is 10% based on which you are required to compute the present value of Tata
Ltd. and equity capitalisation rate. The company decides to further raise Rs. 2,00,000 through
10% debentures and use the same to pay off the equity shareholders. Compute the proposed
total value of the company and proposed equity capitalisation rate based on Net Operating
Income Approach.

Problem 5:
In considering the most desirable capital structure of a company, the following estimates of the
cost of debt and equity capital have been made at various levels of debt-equity mix.
Debt as % of total capital Cost of Debt (kd) % Cost of Equity (ke) %
employed
0 5 12
10 5 12
20 5 12.5
30 5.5 13
40 6 14
50 6.5 16
60 7 20

Problem 6:
A company wishes to determine the optimal capital structure. From the following selected
information supplied to you, determine the optimal capital structure of the company.
Situation Debt (Rs.) Equity (Rs.) Kd % Ke %
1 8,00,000 2,00,000 9 10
2 5,00,000 5,00,000 6 11
3 2,00,000 8,00,000 5 14

Problem 7:
A company’s current net operating income (EBIT) is Rs. 8,00,000. The company has Rs. 20
lakhs of 10% debt outstanding. Its equity capitalisation rate is 15%. The company is
considering to increase its debt by raising additional Rs. 10 lakhs and to utilise these funds to
retire the amount of equity. However, due to increased financial risk, the cost of entire debt is
likely to increase to 12% and the cost of equity it 18%.
You are required to compute the market value of the company using traditional model and also
make recommendations regarding the proposal.
 Compilation of Problems by Dr. Abida Khan

Problem 8:
Reliance Ltd. has an EBIT of Rs. 8,00,000 and 10% debentures of Rs. 20,00,000. Equity
capitalization rate is 10% based on which you are required to compute the present value of
Reliance Ltd. and Overall Cost of Capital. The company decides to further raise Rs. 4,00,000
through 10% debentures and use the same to pay off the equity shareholders. Compute the
proposed total value of the company and proposed Overall Cost of Capital based on Net Income
Approach.
 Compilation of Problems by Dr. Abida Khan

Unit 4 Cost of Capital

1.Introduction:
The cost of capital is the minimum rate of return required on the investment projects to keep
the market value per share unchanged.
In other words, the cost of capital is simply the rate of return the funds used should produce to
justify their use within the firm in the light of the wealth maximisation objective.

2.The objectives of this unit are to:

• discuss the concept and importance of cost of capital
• distinguish among various classes of cost of capital
• illustrate the computation of cost of long-term debt, preferences shares, equity shares and
retained earnings
• discuss and illustrate the various weighting approaches and the weighted average cost of
capital (WACC).
• Narrate misconceptions about cost of capital.

3.Significance/Importance
 Capital Budgeting Decision
 Designing Capital Structure
 Evaluating Financial Performance
 Basis for Decision Making

4.Classification of Costs
Future cost and Historical cost:
It is commonly known that, in decision-making, the relevant costs are future costs are not the
historical costs. The financial decision-making is no exception. It is future cost of capital which
is significant in making financial decisions. Historic / Sunk / Past costs are irrelevant in the
decision-making process. Only future costs to be considered while making investment
decisions.
Specific cost and combined cost:
The cost of each component of capital (ex-common shares, debt etc.,) is known as specific cost
of capital. The combined or composite cost of capital is an inclusive: cost of capital from all
sources. It is, thus, the weighted average cost of capital.
Explicit cost and implicit cost:
The explicit cost of capital is the internal rate of return of the financial opportunity and arises
when the capital is raised. The implicit of capital arises when the firm considers alternative
uses of the funds rained. The methods of calculating the specific costs of different sources of
funds are discussed.
Project A Project B
Returns 10% 4%
Explicit Cost 10%
Implicit Cost 14% (10% + 4%)

1. Cost of debt:
It is relatively easy to calculate cost of debt, it is rate of return or the rate of interest specified
at the time of debt issue. When a bond or debenture is issued at full face value and to be
redeemed after some period, then the before tax cost of debt is simply the normal rate of
interest.
 Compilation of Problems by Dr. Abida Khan

1.1 Cost of Irredeemable Debt

Cost of Debt = Interest (1-Tax Rate) / Net Proceeds from Issue of Debts
Kd = I (1-t) / NP
Where,
Kd = Cost of Debt
I = Interest
t = Corporate Tax Rate
NP = Net Proceeds
NP means if debt issued at
Par Face value – Flotation cost
Premium Face value + Premium on issue – Flotation Cost
Discount Face Value – Discount on issue – Flotation Cost

Problem 1: (Par + No flotation)

Company issued Rs 100 Lakhs 14% Debentures of Rs100 each. Tax rate is 40%. Calculate Kd.

Problem 2: (Par + Flotation)

Company issued Rs 100 Lakhs 14% Debentures of Rs100 each. Tax rate is 40%. Calculate Kd
if issued at par with flotation cost of 5%.

Problem 3: (Premium + Flotation)

Company issued Rs 100 Lakhs 14% Debentures of Rs100 each. Tax rate is 40%. Calculate Kd
if issued 10% premium with flotation cost of 5%.

Problem 4: (Discount + Flotation)

Company issued Rs 100 Lakhs 14% Debentures of Rs100 each. Tax rate is 40%. Calculate Kd
if issued 10% discount with flotation cost of 5%.

1.2 Cost of Redeemable Debentures

Kd = Interest (1- t) + (Redeemable Value – Net Proceeds) N
(Redeemable Value + Net Proceeds) / 2

Kd = I (1-t) + (RV – NP) / N

(RV + NP) / 2
Problem 1: Company issued Rs 100 Lakhs 14% debentures of Rs 100 each redeemable at par
after 5 years. Debentures are issued at par with no flotation cost. Tax Rate 40%

Problem 2: Company issued Rs 100 Lakhs 14% debentures of Rs 100 each redeemable at par
after 5 years. Debentures are issued at par with 5% flotation cost. Tax Rate 40%

Problem 3: Company issued Rs 100 Lakhs 14% debentures of Rs 100 each redeemable at par
after 5 years. Debentures are issued at 10% premium with 5% flotation cost. Tax Rate 40%

Problem 4: Company issued Rs 100 Lakhs 14% debentures of Rs 100 each redeemable at par
after 5 years. Debentures are issued at 10% discount with 5% flotation cost. Tax Rate 40%
 Compilation of Problems by Dr. Abida Khan

2. Cost of preference capital:

The measurement of the cost of preference capital poses some conceptual difficulty. In the case
of debt, there is a binding legal obligation on the firm to pay interest and the interest constitutes
the basis to calculate the cost of debt.
However, when reference to the preference capital, it may be stated that the payment of
dividends on preference capital is not legally binding on the firm and even if the dividends are
paid, it is not a charge on earnings, rather it is a distribution or appropriation of earnings to a
class of owners. It may, therefore, be concluded, that the dividends on preference capital do
not constitute cost. This is not true.
The cost of preference capital is a function of the dividend expected by investors; preference
capital is never issued with an intention not to pay dividends. Although it is not legally binding
upon the firm to pay dividends on preference capital, yet it is generally paid when the firm
makes sufficient profits.

Formula
1) Cost of Irredeemable Preference shares
Kp = D (1+Dt) / NP

Problem 1) 12% Preference share of 100 each. DDT 10%. Calculate Kp

2. Cost of Redeemable Preference Shares

Kp = D0 (1+Dt) + (RV – NP) / N
(RV + NP)/2
Where,
Kp = Cost of Preference share capital
D0= Current year dividend
Dt = Dividend Tax or Dividend Distribution Tax (DDT)
RV = Redeemable Value
NP = Net proceeds
N = Number of years

Problem 1) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Calculate Kp

Problem 2) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Shares issued at par with 10% flotation cost. Calculate Kp

Problem 3) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Shares issued at 10% premium with 5% flotation cost.
Calculate Kp

Problem 4) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Shares issued at 10% discount with 5% flotation cost.
Calculate Kp

Problem 5) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Shares redeemable at 10% premium. Calculate Kp
 Compilation of Problems by Dr. Abida Khan

Problem 6) Company issued Rs 100 lakhs 14% preference shares of Rs 100 each. Redeemable
after 5 years. Dividend Tax 20 %. Shares redeemable at 10% premium with 10% flotation cost.
Calculate Kp

3. Cost of equity capital:

It is sometimes argued that equity capital is free of cost. This is not true. The reason for
advancing such an argument is that it is not legally binding on the company to pay dividends
to the common shareholders. Also, unlike the interest rate on debt or the rate of dividend on
preference capital, the dividend rate to the common shareholders is not fixed. However, the
shareholders invest their money in common shares with an expectation of receiving dividends.
The market value of the share depends on the dividends expected by the shareholders.
Therefore, the required rate of return which equates the present value of the expected dividends
with the market value of share is the equity capita).
For the purpose of measuring the cost of equity, the equity capital will be divided into two parts
a) external equity b) retained earnings.

A) Dividend Yield method with share price

Formula
Ke = D / NP
Ke = D + G
Np

Where,
D = Expected Dividend
NP = Net Proceeds
G = Growth Rate

Problem 1: On the basis of Net Proceeds

Company issued 5000 equity shares of 100 each at 10% premium. Company is paying 20%
dividend and its continue to pay the same.

Problem 2: On the basis of market value

Company issued 5000 equity shares of 100 each at 10% premium. Company is paying 20%
dividend and its continue to pay the same. Market value of share is Rs 160

B) Dividend yield method plus growth rate

When dividends are expected to grow at a constant rate and the dividend pay out ratio is
constant this method may be used to compute cost of capital
Ke= D/Np + G
Where,
D = Expected Dividend
NP = Net Proceeds
G = Growth Rate

Problem 3: Company planning to issue 2000 equity shares of Rs 100 each at par. Flotation cost
5%. Company pays dividend Rs 10 per share. And it is expected to grow at 5%. Compute Ke.
 Compilation of Problems by Dr. Abida Khan

Problem 4: Company planning to issue 2000 equity shares of Rs 100 each at par. Flotation cost
5%. Company pays dividend Rs 10 per share. And it is expected to grow at 5%. Compute Ke
on the basis of market value of share which is Rs 160.
C) Earning yield method
Under this method the Ke is calculated discount rate that equates the present value of expected
future earnings per shares with the net proceeds of the share

Ke = EPS / NP or Ke = EPS / MP
Where,
EPS = earnings per share
NP =Net proceeds
MP = Market Price

Problem 5: Company is considering an expenditure of Rs 60 lakhs.

No of existing equity shares = Rs 10 Lakhs
Market price of the shares = Rs 60 per share
Net earnings = Rs 90 Lakhs
Calculate Ke and new equity capital assuming the new shares will be issued at a price of Rs 52
per share and the cost of new issue will be Rs 2 per share.

4. Cost of retained earnings

Retained earnings represent a business firm's cumulative earnings since its inception, that it has
not paid out as dividends to common shareholders. Retained earnings instead get ploughed
back into the firm for growth and use as part of the firm's capital structure. Companies
typically calculate the opportunity cost of retaining these earnings by averaging the results of
three separate calculations.
Retained earnings belong to the shareholders since they're effectively owners of the company.
If put back into the company, the retained earnings serve as a further investment in the firm on
behalf of the shareholders.
The cost of those retained earnings equals the return shareholders should expect on their
investment. It is called an opportunity cost because the shareholders sacrifice an opportunity
to invest that money for a return elsewhere and instead allow the firm to build capital.

Weighted Average Cost

Problem 1
B Ltd. Has the following capital structure-
Equity shares Rs. 60 lakhs
12% Preference shares Rs. 10 lakhs
14% Debentures Rs. 30 lakhs
Total 100 lakhs
The market price of the company’s share is Rs. 20. It is expected that the company will pay
next year a dividend of Rs. 2 per share which will grow 8% for ever. Assume tax rate 40%.
You are required to compute weighted average cost of capital based in existing capital
structure. Also compute new weighted average cost of capital if the company raises additional
debt of Rs. 20 lakhs at 15% interest. This would result in increasing the expected dividend of
Rs. 3 per share and leave the growth rate unchanged but the price of the share will fall to Rs.
16.
 Compilation of Problems by Dr. Abida Khan

Unit 5 - Credit Management

Problem 1:
A company has prepared the following projections for a year.
Sales 21000 units
Selling price per unit Rs. 40
Variable cost per unit Rs. 25
Total cost per unit Rs. 35
Credit period allowed 1 month
The company proposes to increase the credit period allowed to its customers from one month
to two month. It is envisaged that the change in the policy as above will increase the sales by
8%. The company desires a return of 25% on its investment. You are required to examine and
advise whether the proposed credit policy should be implemented or not.

Problem 2:
In order to increase sales from its present level of Rs. 2.4 lakhs p.a. Your marketing manager
submits proposal for liberalizing the credit policy as shown below:
Present sales - Rs. 2,40,000
Credit period - 30 days
Proposed increase in credit beyond 30days – Increase in sales over Rs. 2,40,000
15 days – Rs. 12,000
30 days – Rs. 18,000
45 days – Rs. 21,000
60 days – Rs. 24,000
The P/V ratio of the company is 33 1/3%. The company expects a pre-tax return on investment
of 20%. Evaluate the above alternatives and advise the management (assume a 360 days a
year).

Problem 3:
Super Manufacturers Ltd. sells their product in cash. Now they desire to sell their products on
credit in order to increase the volume of sales. It wants to grant credit to its customers in the
following two alternatives forms from which you are asked to find out the better one.
1 month credit policy 2 month credit policy
Increase in the volume of sales by 50% 75%
Increase in fixed expenses Rs. 4,000 8,000
Cost of collection Rs. 10,000 15,000
Bad debts - 1% on sales
Opportunity cost of capital 10% 10%
Present level of activity:
Sales Rs. 4,00,000
Stock Rs. 80,000
Profit 25% on sales

Problem 4:
Company X furnished the following particulars:
Credit sales – Rs. 50,00,000
Variable cost to sales ratio – 50%
Fixed cost – Rs. 11,00,000
Present credit policy is 2 months.
Cash discount scheme of ‘2/10, net 60’ is to be introduced.
 Compilation of Problems by Dr. Abida Khan

It is estimated that 50% of the debtors will enjoy the discount scheme. As a result, the average
age of debtors would be reduced to 1 month. Required rate of return on investment in debtors
may be taken at 20% before tax. Evaluate the proposal.

Problem 5:
Reliance Ltd. manufactures readymade garments and sells them on credit bases through a
network of dealers. Its present sale is Rs. 60 lakhs p.a.with 20 days credit period. The company
is contemplating an increase in the period of credit with a view to increasing sales. Present
variable costs are 70% of sales and the total fixed costs Rs. 8 lakhs p.a. The company expects
pre-tax return on investment @ 25%. Some other details are given as under:
Proposed Credit Policy Average Collection Period (days) Expected Annual Sales (Rs. lakh)
I 30 65
II 40 70
III 50 74
IV 60 75
Required: Which credit policy should the company adopt? Present your solution in a tabular
form. Assume 360 days in a year. Calculations should be made up to two digits after decimals

Problem 6:
Himalaya Ltd. has a present annual sales level of 10,000 units at Rs. 300 per unit. The variable
cost is Rs. 200 per unit and the fixed costs amount to Rs. 3,00,000 p.a. The present credit period
allowed by the company is 1 month. The company is considering a proposal to increase the
credit period to 2 months and 3 months and has made the following estimates.
Particulars Existing Proposed
Credit policy 1 month 2 months 3 months
Increase in sales - 15% 30%
% of bad debts 1% 3% 5%
There will be increase in fixed cost by Rs. 50,000 on account of increase of sales beyond 25%
of present level. The company plans on a pre-tax return of 20% on investment in receivables
(based on total cost). You are required to calculate the most profitable credit policy for the
company.

Problem 7:
Honda Ltd. is considering relaxing its present credit policy and is in the process of evaluating
two proposed policies. Currently, the company has annual credit sales of Rs. 60 lakhs and
accounts receivable turnover ratio of 5 times a year. The current level of loss due to bad debts
is Rs. 1,00,000. The company is required to give a return of is 25% on the investment in new
accounts receivables (based on cost). The company’s variables cost are 60% of the selling
price. Given the following information, which is policy option should be adopted?
Particulars Present policy Policy I Policy II
Annual credit sales Rs. 60,00,000 65,00,000 70,00,000
Accounts receivable 5 times 3 times 2 times
turnover ratio
Bad debts losses Rs. 1,00,000 1,20,000 1,50,000

Problem 8: TYBAF, OCT 2016

Jack Ltd has at present annual turnover of Rs. 39,00,000 and the company grants one month
credit to its customers. Company’s selling price is Rs. 10 per unit. Bad debt loss is 1% of sales
and contribution is Rs. 3 per unit. Company’s new marketing manager has given three different
 Compilation of Problems by Dr. Abida Khan

proposals to make credit policy more liberal to increase company’s sales and profit. These
proposals are as follows:
Proposal I: To grant one and half month’s credit to customers which will increase sales to Rs.
44 lakhs with anticipated increase in bad debt loss of 1% of sales.
Proposal II: To grant two months credit to customers this will increase sales to Rs. 45 lakhs
with anticipated bad debt loss of 3% of sales.
Proposal III: To grant three months credit to customers which will increase sale to Rs. 50 lakhs
with anticipated increase in bad debt loss of 4% of sales.
Company expects a return of 20% on the additional investment in account receivables. Which
of the above proposal would you recommend to the company to accept?

Problem 9: TYBAF, OCT 2015

Sunshine Ltd has a present annual sales level of 20,000 units at Rs. 300 per unit. The variable
cost is 662/3% of sales while administration overheads amount to Rs. 5,00,000 p.a. and
depreciation Rs. 1,00,000 p.a. The present credit period allowed is 1 month. The company
wishes to consider the proposal of liberal credit policy and has the following estimates:
Particulars Existing Proposal A Proposal B
Credit period 1 month 2 months 3 months
Increase in sales - 15% 30%
% of bad debts 1 3 5
As the sales exceeds beyond 25% of current sales, the administrative overheads increase by
Rs. 1,00,000. The expected rate of return on investment before tax is 20% p.a. You are asked
to advise the company which policy shall be best suited.

Problem 10:
Seashell Ltd. has classified its customers into five risks categories as follows:
Category % of bad debts Average Collection period
A 2 30 days
B 3 45 days
C 4 60 days
D 15 100 days
E 20 150 days
At present the company allows unlimited credit to customers in categories A, B and C, limited
credit to customers in category D, and no credit to customers in category E. Due to this policy,
the company rejects orders of Rs. 4,00,000 from customers in category D and Rs. 6,00,000
from customers in category E. The variable cost to sales ratio for Seashell Ltd. is 70% and the
opportunity cost of funds is 20% Should company grant credit to all customers in categories D
& E as well? Assume 360 days in a year.
 Compilation of Problems by Dr. Abida Khan

Case Study 1-

Ashoka Ltd. is engaged in the business of Heavy Vehicles. Company wants to upgrade its
machinery with latest technology to improve past performance and customers demand. For
this, the finance manager Mr. Harish estimated the amount of funds required and the timings.
This will help the company in linking the investment and financing decisions on a continuous
basis. Mr. Harish therefore began with the preparation of a sales forecast and profitability for
the next four years. He also collected the relevant data about the profit estimates in the coming
years. By doing this, he wanted to be sure about the availability of funds from internal sources
of the business. For the remaining funds he is trying to find alternative sources. Mr. Harish also
analyse existing capital structure and the impact of additional funds on revised capital structure.
from outside.

Questions:
1. Identify and explain the financial concept discussed in the above case study.
2. State objectives to be achieved by the use of financial concept, so identified.

Case Study 2-

Hopscotch company has the following receivable management policy.

a. All customers buy on credit and pay cash in the following year if they are not bankrupt.
b. Any uncollected receivables are then written off.
c. Based on its experience company books 5% of its receivables outstanding at the end of
the period as an allowance for bad debts
d. cost of goods sold (COGS) is zero.
Following details of sales and actual collections are given.
Particulars Amount
Sales 10,00,000
Actual Collections 9,00,000

Questions:
1. Create Income Statement and Balance sheet at the end of Year.

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