Financial Management

Super 100 Questions - Lecture1

CHAPTER 1: SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Question 1
State Agency Cost. DISCUSS The Ways to Reduce the Effect of It.
OR
DISCUSS Agency Problem and Agency Cost.
(MTP Aug 18, MTP Oct 20, MTP Mar 23, MTP Apr 20, MTP Apr 23, RTP Nov 20, RTP May
22, RTP Nov 23)
Solution:
Agency Cost: In a sole proprietorship firm, partnership etc., owners participate in management but in
corporate, 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
maximize 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 behavior so as to maximize shareholder’s wealth.
Generally, Agency Costs are of four types
(i) monitoring; (ii) bonding; (iii) opportunity; (iv) structuring

Addressing the agency problem

The agency problem arises if manager’s interests are not aligned to the interests of the debt lender and
equity investors. The agency problem of debt lender would be addressed by imposing negative covenants i.e.
the managers cannot borrow beyond a point. This is one of the most important concepts of modern-day
finance and the application of this would be applied in the Credit Risk Management of Bank, Fund Raising,
Valuing distressed companies.
Agency problem between the managers and shareholders can be addressed if the interests of the managers
are aligned to the interests of the share− holders. It is easier said than done.

However, following efforts have been made to address these issues:

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(A) Managerial compensation is linked to profit of the company to some extent and also with the long-term
objectives of the company.
(B) Employee is also designed to address the issue with the underlying assumption that maximization of the
stock price is the objective of the investors.
(C) Effecting monitoring can be done.

Question 2
Functions of Finance Manager. (RTP May’19)
Solution:
Functions of Finance Manager
The Finance Manager’s main objective is to manage funds in such a way so as to ensure their optimum
utilization and their procurement in a manner that the risk, cost and control considerations are properly
balanced in a given situation.
To achieve these objectives the Finance Manager performs the following functions:
(i) Estim a ting the requirem ent of Funds: Both for long-term purposes i.e. investment in fixed assets
and for short-term i.e. for working capital. Forecasting the requirements of funds involves the use of
techniques of budgetary control and long-range planning.
(ii) Decision rega rding Ca pita l Structure : Once the requirement of funds has been estimated, a
decision regarding various sources from which these funds would be raised has to be taken. A proper
balance has to be made between the loan funds and own funds. He has to ensure that he raises sufficient
long-term funds to finance fixed assets and other long-term investments and to provide for the needs of
working capital.
(iii) Investm ent Decision: The investment of funds, in a project has to be made after careful assessment
of various projects through capital budgeting. Assets management policies are to be laid down regarding
various items of current assets. For e.g. receivable in coordination with sales manager, inventory in
coordination with production manager.
(iv) Dividend decision : The finance manager is concerned with the decision as to how much to retain
and what portion to pay as dividend depending on the company’s policy. Trend of earnings, trend of share
market prices, requirement of funds for future growth, cash flow situation etc., are to be considered.
(v) Eva lua ting financia l perform ance: A finance manager has to constantly review the financial
performance of the various units of organization generally in terms of ROI. Such a review helps the
management in seeing how the funds have been utilized in various divisions and what can be done to
improve it.
(vi) F ina ncial negotia tion : The finance manager plays a very important role in carrying out negotiations
with the financial institutions, banks and public depositors for raising of funds on favorable terms.
(vii) Ca sh m ana gem ent: The finance manager lays down the cash management and cash disbursement
policies with a view to supply adequate funds to all units of organization and to ensure that there is no
excessive cash.

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 (viii) Keeping touch with stock exchange : Finance manager is required to analyses major trends in
stock market and their impact on the price of the company share.

Question 3
DISCUSS the points that demonstrates the Importance of good financial management.
(PYQ Jan’21, RTP Nov’21)
Solution:
Points that demonstrate the "Importance of good financial management":
 Ta k ing ca re not to over-invest in fixed assets
 B a la ncing cash-outflow with cash-inflows
 Ensuring that there is a sufficient level of short-term working capital
 Setting sa les revenue targets that will deliver growth
 Increa sing gross profit by setting the correct pricing for products or services
 Controlling the level of general and administrative expenses by finding more cost- efficient ways of
running the day-to-day business operations, and
 Ta x pla nning that will minimize the taxes a business has to pay.

Question 3
DISCUSS the two main aspects of the finance function?
OR
DISCUSS the Inter relationship between investment, financing and dividend decisions.
OR
DISCUSS the three major decisions taken by a finance manager to maximize the wealth of
shareholders.
OR
BRIEFLY explain the three finance function decisions.
(Study Material, Mtp Nov 2018, Mtp Nov 2019, Mtp Nov 2021, RTP Nov 2019, RTP May 2019,
PYQ May 2018, PYQ Nov 2019, Mtp2 May 24)
Solution:
The finance functions are divided into long term and short-term functions/decisions
Long term Finance Function Decisions:
Investment These decisions relate to the selection of assets in which funds will be invested by a firm.
decisions (I) 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.

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 A part of long-term funds is also to be kept for financing the working capital
requirements. Asset management policies are to be laid down regarding various items of
current assets.
The inventory policy would be determined by the production manager and the finance
manager keeping in view the requirement of production and the future price estimates
of raw materials and the availability of funds.
Financing These decisions relate to acquiring the optimum finance to meet financial objectives and
decisions (F) seeing that fixed and working capital are effectively managed. 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.
Such managers also need to have a very clear understanding as to the difference between
profit and cash flow, bearing in mind that profit is of little avail unless the organisation is
adequately supported by cash to pay for assets and sustain the working capital cycle.
Financing decisions also call for a good knowledge of evaluation of risk, e.g. excessive
debt carried high risk for an organization’s equity because of the priority rights of the
lenders. A major area for risk-related decisions is in overseas trading, where an
organisation is vulnerable to currency fluctuations, and the manager must be well aware
of the various protective procedures such as hedging (it is a strategy designed to
minimize, reduce or cancel out the risk in another investment) available to him.
For example, 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.
Dividend These decisions relate to the determination as to how much and how frequently cash
decisions(D) can be paid out of the profits of an organisation as income for its owners/shareholders.
The owner of any profit- making organization looks for reward for his investment in two
ways, the growth of the capital invested and the cash paid out as income; for a sole trader
this income would be termed as drawings and for a limited liability company the term is
dividends.
The dividend decision thus ha s two elem ents – the amount to be paid out and
the amount to be retained to support the growth of the organisation, the latter being
also a financing decision; the level and regular growth of dividends represent a significant
factor in determining a profit-making company’s market value, i.e. the value placed on its
shares by the stock market.
All three types of decisions are interrelated, the first two pertaining to any kind of
organisation while the third relates only to profit-making organisations, thus it can be
seen that financial management is of vital importance at every level of business activity,
from a sole trader to the largest multinational corporation.

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Short- term Finance Decisions/Function:
Working capital Generally short-term decision is reduced to management of current asset and
Management (WCM) current liability (i.e., working capital Management)

Question 4
“The profit maximization is not an operationally feasible criterion. DISCUSS.
(Rtp May’18, Nov’18, May’20)
Solution:
“The profit maximization is not an operationally feasible criterion.” This statement is true
because Profit maximization can be a short-term objective for any organization and cannot be its sole
objective. Profit maximization fails to serve as an operational criterion for maximizing the owner's economic
welfare. It fails to provide an operationally feasible measure for ranking alternative courses of action in terms
of their economic efficiency.
It suffers from the following limitations:
(a) Vague term: The definition of the term profit is ambiguous. Does it mean short term or long-term
profit? Does it refer to profit before or after tax? Total profit or profit per share?
(b) Timing of Return: The profit maximization objective does not make distinction between returns
received in different time periods. It gives no consideration to the time value of money, and values benefits
received today and benefits received after a period as the same.
(c) It ignores the risk factor.
(d) The term maximization is also vague.

Question 5
List out the role of Chief Fina ncia l Officer in toda y 's World.
OR
Wha t a re the roles of F inance Executive in M odem World? (P YQ Nov ’20, P YQ M a y ’18)
Solution:
Role of Chief Fina ncia l Officer (CF O) in Toda y ’s World: Today, the role of chief financial officer, or
CFO, is no longer confined to accounting, financial reporting and risk management. It’s about being a strategic
business partner of the chief executive officer, or CEO.
Some of the role of a CFO in today’s world are as follows-
Budgeting
Forecasting
Managing M&As
Profitability analysis (for example, by customer or product)
Decisions about outsourcing
Overseeing the IT function.
Overseeing the HR function.
Pricing analysis
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 Risk management
Regulatory compliance.
Strategic planning (sometimes overseeing this function).

Question 6
Explain in brief the phases of the evolution of financial management. (PYQ Dec’21)
Solution:
Evolution of Financial Management: Financial management evolved gradually over the past 50 years.
The evolution of financial management is divided into three phases. Financial Management evolved as a
separate field of study at the beginning of the century.
The three stages of its evolution are:
The During this phase, financial management was considered necessary only during occasional
Traditional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial
Phase: decisions in the organization, the needs of outsiders (investment bankers, people who
lend money to the business and other such people) to the business was kept in mind.
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 Modern phase is still going on. The scope of financial management has greatly increased
Phase: now. It is important to carry out financial analysis for a company.
This analysis helps in decision making. 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.
Here, financial management is viewed as a supportive and facilitative function, not only
for top management but for all levels of management.

Question 7
EXPLAIN Financial Distress and explain its relationship with Insolvency.
OR
‘Financial distress is a position where Cash inflows of a firm are inadequate to meet all its
current obligations.’ Based on above mentioned context, EXPLAIN Financial Distress along
with Insolvency. (Mtp May’18, Mtp May’22)
Solution:
There are various factors like price of the product/ service, demand, price of inputs e.g. raw material, Labour
etc., which is to be managed by an organization on a continuous basis. Proportion of debt also needs to be
managed by an organization very delicately.
Higher debt requires higher interest and if the cash inflow is not sufficient then it will put lot of pressure to
the organization. Both short term and long-term creditors will put stress to the firm.

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If all the above factors are not well managed by the firm, it can create situation known as distress, so financial
distress is a position where Cash inflows of a firm are inadequate to meet all its current obligations.
Now if distress continues for a long period of time, firm may have to sell its asset, even many times at a
lower price. Further when revenue is inadequate to revive the situation, firm will not be able to meet its
obligations and become insolvent.
So, insolvency basically means inability of a firm to repay various debts and is a result of continuous financial
distress.

Question 5
EX P LA IN “Wea lth m a xim isa tion” and “P rofit m a xim isation” objectives of fina ncia l
m a na gem ent.
OR
DISTINGUISH between P rofit m a xim isa tion vis - a - vis wea lth m a xim iza tion.
OR
“P rofit m a xim isa tion is not the sole objective of a com pany . It is a t best a lim ited objective.
If profit is given undue im porta nce, a num ber of problem s ca n a rise. ”
DISCUSS four of such problem s. (Study Ma teria l, Rtp M ay ’21, Rtp M a y ’22, M tp M a y ’23)
Solution:
P rofit M a xim iza tion : It has traditionally been argued that the primary objective of a company is to earn
profit; hence the objective of financial management is also profiting 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.
However, profit maximisation cannot be the sole objective of a company. It is at best a limited objective. If
profit is given undue importance, a number of problems can arise.

Som e of these ha ve been discussed below:

(i) The term profit is va gue. It does not cla rify wha t exa ctly it m ea ns. 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.

(ii) P rofit m a xim isa tion ha s to be a ttem pted with a realisa tion of risk s 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.

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(iii) P rofit m a xim isa tion a s a n objective does not ta k e into a ccount the tim e pattern of
returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if the returns of
proposal A begin to flow say 10 years later, proposal B may be preferred which may have lower overall profit
but the returns flow is earlier and quicker.

(iv) P rofit m a xim isa tion a s an objective is too na rrow. 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. If these factors are ignored, a company cannot survive for long. Profit maximization at the
cost of social and moral obligations is a short-sighted policy.

Wea lth M a xim iza tion : We will first like to define what is Wealth / Value Maximization Model.
Shareholders wealth is the result of cost benefit analysis adjusted with their timing and risk i.e. time value of
money.
So,
Wea lth = P resent va lue of benefits – P resent Va lue of Costs
It is important that benefits measured by the finance manager are in terms of cash flow. Finance manager
should emphasis on Cash flow for investment or financing decisions not on accounting profit.
The shareholder value maximization model holds that the primary goal of the firm is to maximize its market
value and implies that business decisions should seek to increase the net present value of the economic
profits of the firm.
So, 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.

Question 9
EXPLAIN as to how the wealth maximization objective is superior to the profit maximization
objective What is the cost of these sources? (Mtp May 2019)
Solution:
A firm’s financial management may often have the following as their objectives:
(i) The maximization of firm’s profit.
(ii) The maximization of firm’s value / wealth.
The maximization of profit is often considered as an implied objective of a firm. To achieve the aforesaid
objective various type of financing decisions may be taken. Options resulting into maximization of profit may
be selected by the firm’s decision makers.

They even sometime may adopt policies yielding exorbitant profits in short run which may prove to be
unhealthy for the growth, survival and overall interests of the firm. The profit of the firm in this case is

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measured in terms of its total accounting profit available to its shareholders.

The value/wealth of a firm is defined as the market price of the firm’s stock. The market price of a firm’s
stock represents the focal judgment of all market participants as to what the value of the particular firm is.
It takes into account present and prospective future earnings per share, the timing and risk of these earnings,
the dividend policy of the firm and many other factors that bear upon the market price of the stock.

The value maximization objective of a firm is superior to its profit maximization objective due to following
reasons.
1. The value maximization objective of a firm considers all future cash flows, dividends, earning per share,
risk of a decision etc. whereas profit maximization objective does not consider the effect of EPS, dividend
paid or any other returns to shareholders or the wealth of the shareholder.
2. A firm that wishes to maximize the shareholder’s wealth may pay regular dividends whereas a firm with
the objective of profit maximization may refrain from dividend payment to its shareholders.
3. Shareholders would prefer an increase in the firm’s wealth against its generation of
increasing flow of profits.
4. The market price of a share reflects the shareholders expected return, considering the long- term
prospects of the firm, reflects the differences in timings of the returns, considers risk and recognizes the
importance of distribution of returns.
The maximization of a firm’s value as reflected in the market price of a share is viewed as a proper goal of a
firm. The profit maximization can be considered as a part of the wealth maximization strategy.

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 CHAPTER 2: TYPES OF FINANCING

Question 1
Briefly describe any four sources of short-term finance.
OR
What are the sources of short-term financial requirement of the company?
(PYQ Nov 19, PYQ May 18)
Solution:
Sources of Short-Term Finance: There are various sources available to meet short- term needs of
finance. The different sources are discussed below-
(i)Tra de Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The usual
duration of such credit is 15 to 90 days. It generates automatically in the course of business and is common
to almost all business operations. It can be in the form of an 'open account' or 'bills payable'.

(ii)A ccrued Expenses a nd Deferred Incom e: Accrued expenses represent liabilities which a company
has to pay for the services which it has already received like wages, taxes, interest and dividends. Such
expenses arise out of the day-to-day activities of the company and hence represent a spontaneous source
of finance.
Deferred Incom e: These are the amounts received by a company in lieu of goods and services to be
provided in the future. Since these receipts increases a company’s liquidity, they are also considered to be
an important source of short- term finance.

(iii)A dva nces from Custom ers: 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 and really useful.

(iv)Com m ercia l Pa per: A Commercial Paper is an unsecured money market instrument issued in the
form of a promissory note. The Reserve Bank of India instrument issued in the form of a promissory note.
The Reserve Bank of India introduced the commercial paper scheme in the year 1989 with a view to enabling
highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an
additional instrument to investors.

(v)Trea sury B ills: 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.

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(vi)Certifica tes 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.

(vii)B ank A dva nces: Banks receive deposits from public for different periods at varying rates of interest.
These funds are invested and lent in such a manner that when required, they may be called back. Lending
results in gross revenues out of which costs, such as interest on deposits, administrative costs, etc., are met
and a reasonable profit is made.
A bank's lending policy is not merely profit motivated but has to also keep in mind the socio- economic
development of the country. Some of the facilities provided by banks are Short Term Loans, Overdraft, Cash
Credits, Advances against goods, Bills Purchased/Discounted.

(viii)F inancing of Export Tra de by B a nk s: Exports play an important role in accelerating the economic
growth of developing countries like India. Of the several factors influencing export growth, credit is a very
important factor which enables exporters in efficiently executing their export orders. The commercial banks
provide short-term export finance mainly by way of pre- and post-shipment credit. Export finance is granted
in Rupees as well as in foreign currency.

(ix)Inter Corpora te Deposits: The companies can borrow funds for a short period say 6 months from
other companies which have surplus liquidity. The rate of interest on inter corporate deposits varies
depending upon the amount involved and time period.

(x)Certifica te of Deposit (CD): The certificate of deposit is a document of title similar to a time deposit
receipt issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encase the deposit before maturity period and
the investor is assured of liquidity because he can sell the CD in secondary market.

(xi)P ublic Deposits: Public deposits are very important source of short-term and medium-term finances
particularly due to credit squeeze by the Reserve Bank of India. A company can accept public deposits subject
to the stipulations of Reserve Bank of India from time to time maximum up to 35 per cent of its paid-up
capital and reserves, from the public and shareholders.
These deposits may be accepted for a period of six months to three years. Public deposits are unsecured
loans; they should not be used for acquiring fixed assets since they are to be repaid within a period of 3
years. These are mainly used to finance working capital requirements.

Question 2
Under financial lease, lessee bears the risk of obsolescence; while under operating lease,
lessor bears the risk of obsolescence. In view of this, you are required to COMPARE the
financial lease and operating lease.

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 OR
EXPLAIN the difference between Financial Lease and Operating Lease.
(Rtp Nov’22, Rtp Nov’18, Rtp Nov’20)
Solution:
Difference between Financial Lease and Operating Lease
Financial Lease Operating Lease
The risk and reward incident to ownership are passed The lessee is only provided the use of the asset
on to the lessee. The lessor only remains the legal for a certain time. Risk incident to ownership
owner of the asset. belong wholly to the lessor.
The lessee bears the risk of obsolescence. The lessor bears the risk of obsolescence.
The lessor is interested in his rentals and not in the As the lessor does not have difficulty in leasing the
asset. He must get his principal back along with same asset to another willing lessor, the lease is
interest. Therefore, the lease is non-cancellable by kept cancelable by the lessor.
either party.
The lessor enters into the transaction only as Usually, the lessor bears cost of repairs,
financier. He does not bear the cost of repairs, maintenance or operations.
maintenance or operations.
The lease is usually full payout, that is, the single lease The lease is usually non-payout, since the lessor
repays the cost of the asset together with the expects to lease the same asset over and over
interest. again to several users.

Question 3
STA TE in brief four fea tures of Sa m ura i B ond.
OR
HIGHLIGHT the sim ila rities a nd differences between Sa m ura i B ond a nd B ull Dog B ond.
(Rtp Nov ’22, M tp M ay ’22, Rtp M a y ’23)
Solution:
F ea tures of Sa m ura i B ond:
• Samurai bonds are denominated in Japanese Yen JPY
• Issued in Tokyo
• Issuer Non- Japanese Company
• Regulations: Japanese
• Purpose: Access of capital available in Japanese market
• Issue proceeds can be used to fund Japanese operation
• Issue proceeds can be used to fund a company’s local opportunities.
• It can also be used to hedge foreign exchange risk

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B ulldog B ond
• It is 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
• Issue proceeds can be used to fund UK operation
• Issue proceeds can be used to fund a company’s local opportunities

Question 4
DISCUSS in briefly any two long term sources of finance for a partnership firm. (Mtp May’22)
Solution:
The two sources of long-term finance for a partnership firm are as follows:
Loans from Commercial Banks: Commercial banks provide long term loans for the purpose of
expansion or setting up of new units. Their repayment is usually scheduled over a long period of time. The
liquidity of such loans is said to depend on the anticipated income of the borrowers.
As part of the long-term funding for a partnership firm, the banks also fund the long-term working capital
requirement (it is also called WCTL i.e. working capital term loan).

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 firm) which pays a specified rent at periodical intervals.
Thus, leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease
finance can be arranged much faster as compared to term loans from financial institutions.

Question 5
BRIEF out any four types of Preference shares along with its feature. (Mtp Nov’21)
Solution:
Type of Preference Shares Salient Features
Cumulative Arrear Dividend will accumulate.
Non-cumulative No right to arrear dividend.
Redeemable Redemption should be done.
Participating Can participate in the surplus which remains
after payment to equity shareholders.
Non- Participating Cannot participate in the surplus after payment of fixed rate of
Dividend.
Convertible Option of converting into equity Shares.

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Question 6
DESCRIBE the different types of Packing Credit.
(Study Material MTP Nov’21, Mar’22 & Oct ’23, PYQ Dec ’21)
Solution:
Types of Packing Credit
Clea n pack ing 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. It is a clean type of export advance.
Each proposal is weighed according to particular requirements of the trade and credit worthiness of the
exporter. A suitable margin has to be maintained. Also, Export Credit Guarantee Corporation (ECGC)
cover should be obtained by the bank.
P a ck ing credit a gainst hy potheca tion of goods: Export finance is made available on certain terms
and conditions where the exporter has pledged able interest and the goods are hypothecated to the bank
as security with stipulated margin.
At the time of utilizing 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.
P a ck ing credit a ga inst pledge of goods: Export finance is made available on certain terms and
conditions where the exportable finished goods are pledged to the banks with approved clearing agents
who will ship the same from time to time as required by the exporter. The possession of the goods so
pledged lies with the bank and is kept under its lock and key.
E.C.G.C. gua ra ntee: 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.
F orwa rd excha nge contra ct: Another requirement of packing credit facility is that if the export bill is
to be drawn in a foreign currency, the exporter should enter into a forward exchange contact with the
bank, thereby avoiding risk involved in a possible change in the rate of exchange.

Question 7
EXPLAIN the limitations of Leasing? (Mtp May’19, PYQ May’19)
Solution:
Limitations are:
The lease rentals become payable soon after the acquisition of assets and no moratorium period is
permissible as in case of term loans from financial institutions. The lease arrangement may, therefore, not
be suitable for setting up of the new projects as it would entail cash outflows even before the project comes
into operation.
1) The leased assets are purchased by the lessor who is the owner of equipment. The seller’s warranties
for satisfactory operation of the leased assets may sometimes not be available to lessee.

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2) Lessor generally obtains credit facilities from banks etc. to purchase the leased equipment which are
subject to hypothecation charge in favor of the bank. Default in payment by the lessor may sometimes
result in seizure of assets by banks causing loss to the lessee.
3) Lease financing has a very high cost of interest as compared to interest charged on term loans by financial
institutions/banks.
Despite all these disadvantages, the flexibility and simplicity offered by lease finance is bound to make it
popular. Lease operations will find increasing use in the near future.

Question 8
What is debt securitization? EXPLAIN the basics of debt securitization process.
(Rtp May’20, Rtp May’23, PYQ May’19, Mtp Nov’19 & May’23, Rtp Nov’23)
Solution:
Debt Securitization: It is a method of recycling of funds. It is especially beneficial to financial intermediaries
to support the lending volumes. Assets generating steady cash flows are packaged together and against this
asset pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.
Process of Debt Securitization
The origina tion function – A borrower seeks a loan from a finance company bank HDFC. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured
over the life of the loan.
The pooling function – Similar loans on receivables are clubbed together to create an underlying pool
of assets. The pool is transferred in favor of Special Purpose Vehicle (SPV) which acts as a trustee for
investors.
The securitiza tion 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. The benefits to the originator are that assets are shifted off the balance sheet thus giving
the originator recourse to off-balance sheet funding.

Question 9
Explain in brief following Financial Instruments:
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial paper
(iv) Fully Hedged Bond (PYQ Nov’18)
Solution:

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 Euro bonds: Euro bonds are debt instruments which are not denominated in the currency of the country
in which they are issued. E.g. a Yen note floated in Germany.
F loa ting Ra te Notes: are issued up to seven years’ maturity. Interest rates are adjusted to reflect the
prevailing exchange rates. They provide cheaper money than foreign loans.
Euro Com m ercial P aper (ECP ): ECPs are short term money market instruments. They are for
maturities less than one year. They are usually designated in US Dollars.
F ully Hedged B ond : 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.

Question 10
Discuss the Advantages of Leasing. (PYQ Nov’18)
Solution:
Lea se m a y low- cost a lterna tive: Leasing is alternative to purchasing. As the lessee is to make a series
of payments for using an asset, a lease arrangement is similar to a debt contract. The benefit of lease is
based on a comparison between leasing and buying an asset. Many lessees find lease more attractive
because of low cost.
Ta x benefit: In certain cases, tax benefit of depreciation available for owning an asset may be less than
that available for lease payment.
Work ing ca pita l conserva tion : When a firm buy an equipment by borrowing from a bank (or financial
institution), they never provide 100% financing. But in case of lease, one gets normally 100% financing.
This enables conservation of working capital.
P reserva tion of Debt Ca pa city: So, operating lease does not matter in computing debt equity ratio.
This enables the lessee to go for debt financing more easily. The access to and ability of a firm to get debt
financing is called debt capacity (also, reserve debt capacity).
Obsolescence a nd Disposa l: After purchase of leased asset there may be technological obsolescence
of the asset. That means a technologically upgraded asset with better capacity may come into existence
after purchase. To retain competitive advantage, the lessee as user may have to go for the upgraded asset.

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 CHA P TER 3: FINA NCIA L A NA LYSIS A ND P LA NNING – RA T IO

Question 1
Following are the data in respect of ABC Industries for the year 31st March
Debt to Total Asset Ratio 0.40
Long term debt to Equity Ratio 30%
Gross profit margin on sales 20%
Accounts Receivable Period 36 days
Quick Ratio 0.9
Inventory Holding Period 55 days
Cost of Goods sold Rs 64,00,000
Assume 360 days a year
Complete the following balance sheet (PYQ Dec’21)
Lia bilities ₹ A ssets ₹
Equity Sha re Ca pita l 20,00,000 F ixed a ssets
Reserves & surplus Inventories
Long- term debts A ccounts receiva ble
A ccounts pay a ble Ca sh
Tota l 50,00,000 Tota l 50,00,000
Solution:
(1) Total liability = Total Assets =
𝐷𝑒𝑏𝑡
50,00,000 Debt to Total Asset Ratio = 0.40 = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = 0.40
𝐷𝑒𝑏𝑡
= = 0.40
50,00,000
So, Debt = 20,00,000

(2) Total Liabilities = Rs. 50,00,000

Equity share Capital + Reserves + Debt = Rs. 50,00,000
So, Reserves =Rs. 50,00,000 – Rs. 20,00,000’; So, Reserves & Surplus = Rs. 10,00,000

𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

3. 𝐸𝑞𝑢𝑖𝑡𝑦 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐹𝑢𝑛𝑑 = 30% ∗ = 30% ∗
(20,00,000 + 10,00,000)
Long Term Debt = Rs. 9,00,000

(4) So, Accounts Payable = Rs. 20,00,000 - Rs. 9,00,000

Accounts Payable = Rs. 11,00,000

(5) Gross Profit to sales = 20%

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Cost of Goods Sold = 80% of Sales = Rs. 64,00,000
Sales = 100/80 X 64,00,000 = 80,00,000

360 𝐶𝑂𝐺𝑆 360 64,00,000 360

6. 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = = 𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
55 55 55
Closing inventory = 9,77,778

(7) Accounts Receivable period = 36 days

𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
𝑥360 = 36
𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
Accounts Receivable = 36/360 × credit sales
= 36 / 360 × 80,00,000 (assumed all sales are on credit)
Accounts Receivable = Rs. 8,00,000

(8) Quick Ratio = 0.9

𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠 𝐶𝑎𝑠ℎ+𝐷𝑒𝑏𝑡𝑜𝑟𝑠
= 0.9 = = 0.9
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 11,00,000

(9) Fixed Assets = Total Assets- Current Assets = 50,00,000 - (9,77,778+8,00,000+1,90,000)

= 30,32,222
B a la nce Sheet of A B C Industries a s on 31st M a rch 2021
Lia bilities (₹) A ssets (₹)
Share Capital 20,00,000 Fixed Assets 30,32,222
Reserved surplus 10,00,000 Current Assets:
Long Term Debt 9,00,000 Inventory 9,77,778
Accounts Payable 11,00,000 Accounts Receivables 8,00,000
Cash 1,90,000
Tota l 50,00,000 Tota l 50,00,000
(*Note: Equity shareholders’ fund represent equity in ‘Long term debts to equity ratio’. The question can
be solved assuming only share capital as ‘equity’).

Question 2
The following figures are related to the trading activities of M Ltd.
Total Assets Rs 10,00,000
Debt to Total Assets 50%
Interest Cost 10% per year
Direct Cost 10 times of Interest cost
Operating Expenses Rs 1,00,000
The goods are sold to customers at a margin of 50% on the direct cost.

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Tax rate is 30%
You are required to calculate
1. Net profit Margin
2. Net Operating Profit Margin
3. Return on Assets
4. Return on Owners Equity (PYQ Nov’22)
Solution:
(i) Computation of Net Profit Margin
Debt = (10,00,000 x 50%) = Rs. 5,00,000
10
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡 = 5,00,000𝑥 (100) = 50,000
Direct cost = 50,000 x 10 = Rs. 5,00,000
Sales = 5,00,000 x 150% = Rs. 7,50,000
Rs.
Gross profit = 7,50,000 3 5,00,000 = 2,50,000
Less: Operating expenses = 1,00,000
∴ EBIT = 1,50,000
Less: Interest = 50,000
∴ EBT = 1,00,000
Less: Tax @ 30% = 30,000
∴ PAT = 70,000
70,000
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = (7,50,000) 𝑥100 = 9.33%

(ii) Net Operating Profit margin

𝐸𝐵𝐼𝑇
𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = (𝑆𝑎𝑙𝑒𝑠) 𝑥100
1,50,000
[7,50,000] 𝑥100 = 20%

(iii) Return on A ssets

𝑃𝐴𝑇+𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 1,20,000
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = [( 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 )] 𝑥100 = [10,00,000] 𝑥100 = 12% OR
𝐸𝐵𝐼𝑇 1,50,000
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐴𝑠𝑠𝑒𝑡𝑠 𝑥100 = [10,00,000] 𝑥100 = 15% OR
70,000
𝑥100 = 7% OR
10,00,000
1,50,000(1−0.3
[ ] 𝑥100 = 10.5%
10,00,000

(iv) Return on owner’s equity

𝑃𝐴𝑇 70,000
𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑂𝑤𝑛𝑒𝑟𝑠′ 𝐸𝑞𝑢𝑖𝑡𝑦 𝑥100 = 5,00,000 𝑥100 = 14%

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Question 3
From the following information and ratios, PREPARE the Balance sheet as at 31st March,
2023 and income Statement for the year ended on that date for M/s Ganguly & Co –
Average Stock ₹10 lakh
Current Ratio 3:1
Acid Test Ratio 1:1
PBIT to PBT 2.2:1
Average Collection period (Assume 360 days in a year) 30 days
Stock Turnover Ratio (Use sales as turnover) 5 times
Fixed assets turnover ratio 0.8 times
Working Capital ₹10 lakh
Net profit Ratio 10%
Gross profit Ratio 40%
Operating expenses (excluding interest) ₹ 9 lakh
Long term loan interest 12%
Tax Nil
(Study Material, Mtp Nov 22)
Solution:
1. Current Ra tio = 3:1
Current Assets (CA)/Current Liability (CL) = 3:1
CA = 3CL
WC = 10,00,000
CA – CL = 10,00,000; 3CL – CL = 10,00,000
2CL = 10,00,000; CL= 10,00,000/2
CL = ₹5,00,000
CA = 3 x 5,00,000 CA = ₹15,00,000

2. A cid Test Ra tio = CA – Stock / CL = 1:1

15,00,000 – Stock/5,00,000=1
15,00,000 – stock = 5,00,000
Stock = ₹10,00,000

3. Stock Turnover ratio (on sa les) = 5

Sales/Avg stock =5
Sales/10,00,000=5
Sa les = ₹50,00,000

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4. Gross P rofit = 50,00,000 x 40% =20,00,000
Net profit (PBT) = 50,00,000 x 10% = 5,00,000

5. P B IT/P B T = 2.2
PBIT = 2.2 x 5,00,000
PBIT= 11,00,000
Interest = 11,00,000 – 5,00,000 =6,00,000
6,00,000
Long term loan = = ₹50,00,000
0.12

6. A vera ge collection period = 30 da y s

Receivables = 30/360 x 50.00.000 = 4,16,667

7. F ixed A ssets Turnover Ra tio = 0.8

50,00,000/ Fixed Assets = 0.8
Fixed Assets = ₹62,50,000

Incom e Sta tem ent

(₹)
Sales 50,00,000
Less: Cost of Goods Sold 30,00,000
Gross Profit 20,00,000
Less: Operating Expenses 9,00,000
Less: Interest. 6,00,000
Net Profit 5,00,000

B a la nce sheet
Lia bilities (₹) A ssets (₹)
Equity share capital 22,50,000 Fixed asset 62,50,000
Long term debt 50,00,000 Current assets:
Current liability 5,00,000 Stock 10,00,000
Receivables 4,16,667
Other 83,333 15,00,000
77,50,000 77,50,000

Question 4
PI Limited has the following Balance Sheet as on March 31, 2020 and March 31, 2021:
Balance Sheet

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 Particulars March 31, 2020 March 31, 2021
Sources of Funds:
Shareholders’ Funds 87,500 87,500
Loan Funds 1,22,500 1,05,000
2,10,000 1,92,500
Applications of Funds:
Fixed Assets 87,500 1,05,000
Cash and bank 15,750 14,000
Receivables 49,000 38,500
Inventories 87,500 70,000
Other Current Assets 35,000 35,000
Less: Current Liabilities (64,750) (70,000)
2,10,000 1,92,500

The Income Statement of the PI Ltd. for the year ended is as follows:
Particulars March 31, 2020 March 31, 2021
Sales 7,87,500 8,33,000
Less: Cost of Goods sold (7,30,100) (7,38,500)
Gross Profit 57,400 94,500
Less: Selling, General and Administrative expenses (38,500) (61,250)
Earnings before Interest and Tax (EBIT) 18,900 33,250
Less: Interest Expense (12,250) (10,500)
Earnings before Tax (EBT) 6,650 22,750
Less: Tax (1,995) (6,825)
Profits after Tax (PAT) 4,655 15,925
You are required to CALCULATE for the year 2020-21:
(i) Inventory turnover ratio
(ii) Financial Leverage
(iii) Return on Capital Employed (after tax) (MTP Sep’22)
Solution:
Ra tios for the y ea r 2020- 21
(i) Inventory turnover ra tio
𝐶𝑂𝐺𝑆 7,38,500
= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 = (87,500+70,000) = 9.4
2
(ii) F ina ncial levera ge
𝐸𝐵𝐼𝑇 33,250
= 𝐸𝐵𝐼𝑇 = 22,750 = 1.46
(iii) ROCE

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 𝐸𝐵𝐼𝑇(1−𝑡) 33,250(1−0.3) 23,275
= 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐸𝑚𝑝𝑙𝑜𝑦𝑒𝑑 = 2,10,000+1,92,500 = 2,01,250 𝑥100 = 11.56%
( )
2

Question 5
ABC Ltd. has total sales of 10,00,000 all of which are credit sales. It has a gross profit ratio
of 25% and a current ratio of 2. The company’s current liabilities are RS.2,00,000. Further, it
has inventories of Rs. 80,000, marketable securities of 50,000 and cash of RS. 30,000. From
the above information:
CALCULATE the average inventory, if the expected inventory turnover ratio is three times?
Also CALCULATE the average collection period if the opening balance of debtors is expected
to be RS.1,50,000. Assume 360 days a year. (MTPOct’21 & Oct’23)
Solution:
(i) Calculation of Average Inventory
Since gross profit is 25% of sales, the cost of goods sold should be 75% of the sales.
75 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 = 10,00,000 𝑥 100 = 7,50,000 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
7,50,000
3 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
7,50,000
Average Inventory = = 2,50,000
3

(ii) Ca lcula tion of A vera ge Collection P eriod

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑥360
𝐶𝑟𝑒𝑑𝑖𝑡 𝑆𝑎𝑙𝑒𝑠
𝑂𝑝𝑒𝑛𝑖𝑛𝑔 𝐷𝑒𝑏𝑡𝑜𝑟𝑠+𝐶𝑙𝑜𝑠𝑖𝑛𝑔 𝐷𝑒𝑏𝑡𝑜𝑟𝑠
𝑊ℎ𝑒𝑟𝑒, 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 = 2

Ca lcula tion of Closing ba la nce of debtors

₹ ₹
Current Assets (2 x 2,00,000) 4,00,000
Less: Inventories 80,000
Marketable Securities 50,000
Cash 30,000 1,60,000
Debtors Closing Balance 2,40,000
1,50,000+ 2,40,000
𝑁𝑜𝑤, 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 = = 1,95,000
2
1,95,000
So, Average Collection Period = 𝑥360 = 70.2 𝑜𝑟 70 𝑑𝑎𝑦𝑠
10,00,000

Question 6
Using the following information, PREPARE and complete the Balance Sheet given below:
(i) Total debt to net worth 1: 2
(ii) Total assets turnover 2

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 (iii) Gross profit on sales 30%
(iv) Average collection period 40 days
(Assume 360 days in a year)
(v) Inventory turnover ratio based on cost of goods sold and 3
year-end inventory
(vi) Acid test ratio 0.75

Balance Sheet as on
Liabilities Rs. Assets Rs.
Equity Shares Capital 4,00,000 Plant and Machinery and other -
Reserves and Surplus 6,00,000 Fixed Assets
Total Debt: - Current Assets: -
Current Liabilities - Inventory -
Debtors -
Cash -
(MTP May’19)
Solution:
Net worth = Capital + Reserves and surplus
= 4,00,000 + 6,00,000 = Rs.10,00,000
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 1
=2
𝑁𝑒𝑡 𝑤𝑜𝑟𝑡ℎ
 Total debt = Rs. 5,00,000
Total Liability side = Rs. 4,00,000 + Rs. 6,00,000 + Rs. 5,00,000 = Rs. 15,00,000
= Total Assets
𝑆𝑎𝑙𝑒𝑠 𝑆𝑎𝑙𝑒𝑠
Total Assets Turnover = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 2 = 𝑅𝑠.15,00,000
 Sales = Rs. 30,00,000

Gross Profit on Sales: 30% i.e. Rs. 9,00,000

 Cost of Goods Sold (COGS) = Rs. 30,00,000 – Rs. 9,00,000 = Rs. 21,00,000
𝐶𝑂𝐺𝑆 𝑅𝑠.21,00,000
Inventory turnover = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 3 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

 Inventory = Rs. 7,00,000

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑑𝑒𝑏𝑡𝑜𝑟𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 𝑆𝑎𝑙𝑒𝑠 / 𝑑𝑎𝑦
𝐷𝑒𝑏𝑡𝑜𝑟𝑠
40 = 𝑅𝑠.30,00,000 / 360

 Debtors = Rs.3,33,333.

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 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑆𝑡𝑜𝑐𝑘 (𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡) 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝑅𝑠.7,00,000
Acid test ratio = 0.75 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑅𝑠.5,00,000

 Current Assets = Rs.10,75,000.

 Fixed Assets = Total Assets – Current Assets = Rs.15,00,000 – Rs.10,75,000 = Rs.4,25,000
Cash and Bank balance = Current Assets – Inventory – Debtors = Rs.10,75,000 – Rs.7,00,000 – Rs.3,33,333
= Rs.41,667

Balance Sheet as on March 31, 20X8

Lia bilities Rs. A ssets Rs.
Equity Shares Capital 4,00,000 Plant and Machinery and other 4,25,000
Reserves and Surplus 6,00,000 Fixed Assets
Total Debt: Current Assets:
Current Liabilities 5,00,000 Inventory 7,00,000
Debtors 3,33,333
- Cash 41,667
15,00,000 15,00,000

Question 7
Following information has been provided from the books of Laxmi Pvt. Ltd. for the year
ending on 31st March, 2021:
Net Working Capital ₹ 4,80,000
Bank overdraft ₹ 80,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ₹ 3,20,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5
You are required to PREPARE a summarized Balance Sheet as at 31st March, 2021 assuming
that there is no long-term debt. (Study Material)
Solution:
Working notes:
(i) Computation of Current Assets and Current Liabilities
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
= 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 = 2.5
Current assets = 2.5 Current liabilities

Now, Working capital = Current assets − Current liabilities

4,80,000 = 2.5 Current liability − Current liability
Or, 1.5 Current liability = ₹4,80,000

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Current Liabilities = ₹3,20,000
So, Current Assets = ₹3,20,000 x 2.5 = ₹8,00,000

(ii) Com puta tion of Inventories

𝐿𝑖𝑞𝑢𝑖𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐿𝑖𝑞𝑢𝑖𝑑 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Current assets − Inventories

1.5 = ₹3,20,000
1.5x ₹3, 20,000 = ₹8,00,000 − Inventories
Inventories = ₹8,00,000 – ₹4, 80,000 = ₹3,20,000

(iii) Com puta tion of P roprieta ry fund; F ixed a ssets; Ca pita l a nd Sundry creditors
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
𝐹𝑖𝑥𝑒𝑑 𝐴𝑠𝑠𝑒𝑡 𝑡𝑜 𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑎𝑟𝑦 𝑟𝑎𝑡𝑖𝑜 𝑃𝑟𝑜𝑝𝑟𝑖𝑒𝑡𝑎𝑟𝑦 𝑓𝑢𝑛𝑑 = 0.75
Fixed assets = 0.75 Proprietary fund
Proprietary fund Proprietary fund = Fixed Assets + Net Working Capital – Long Term Debt
= 0.75 Proprietary fund + ₹4,80,000 – 0

Proprietary fund = ₹19,20,000 and

Fixed Assets = 0.75 proprietary fund
= 0.75x₹19,20,000 = ₹14,40,000

Capital = Proprietary fund − Reserves & Surplus = ₹19,20,000 − ₹3,20,000 = ₹16,00,000

Sundry Creditors = Current liabilities − Bank overdraft = ₹3,20,000 − ₹80,000 = ₹2,40,000

Balance Sheet as on 31st March, 2023

Lia bilities ₹ A ssets ₹
Capital 16,00,000 Fixed Assets 14,40,000
Reserves & Surplus 3,20,000 Inventories 3,20,000
Bank overdraft 80,000 Other Current Assets 4,80,000
Sundry creditors 2,40,000 (Balancing figure)
22,40,000 22,40,000

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 Chapter 4: Cost of Capital

Question 1
ABC Ltd. has the following capital structure which is considered to be optimum as on 31st
March, 2019
(Rs.)
14% Debentures 30,00,000
11% Preference shares 10,00,000
Equity Shares (10,000 shares) 1,60,00,000
2,00,00,000
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 year9s investment are 50
percent of 2019.
D. COMPUTE marginal cost of capital when the funds exceed the amount calculated in (C),
assuming new equity is issued at Rs. 200 per share? (Mtp Oct’19, Rtp May’19)
Solution:
(A ) (i) Cost of new debt
1(1−𝑡) 16(1−0.5)
𝐾𝑑 = = =0.0833
𝑃𝑜 96
(ii) Cost of new preference sha res

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 𝑃𝐷 1.1
𝐾𝑝 = = 9.2 = 0.12
𝑃𝑜

(iii) Cost of new equity sha res

𝐷1 11.80
𝐾𝑒 = 𝑃𝑜 + 𝑔 = + 0.10 = 0.05 + 0.10 = 0.15
236
Ca lcula tion of D1
D1 = 50% of 2019 EPS = 50% of 23.60 = Rs. 11.80

(B) Calculation of marginal cost of capital

Ty pe of Ca pital P roportion Specific Cost P roduct
(1) (2) (3) (2) × (3) = (4)
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) (236 × 10,000) = Rs. 11,80,000
The ordinary equity (Retained earnings in this case) is 80% of total capital 11,80,000 =
80% of Total Capital
Capital investment before issuing equity
11,80,000
= 𝑅𝑠. 14,75,000
0.80

(D) If the company spends in excess of Rs.14,75,000 it will have to issue new shares.
11.80
𝑇ℎ𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑛𝑒𝑤 𝑖𝑠𝑠𝑢𝑒 𝑤𝑖𝑙𝑙 𝑏𝑒 = + 0.10 = 0.159
200
The marginal cost of capital will be:
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference Shares 0.05 0.1200 0.0060
Equity Shares (New) 0.80 0.1590 0.1272
0.1457

Question 2
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

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 value weights. The following information is available for your perusal.
The Company’s present book value capital structure is:
(Rs)
Debentures (Rs 100 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, Rs100
ii. Rs100 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’19)
Solution:
Determination of specific costs:
(𝑅𝑉−𝑁𝑃) (𝑅𝑠100−𝑅𝑠 96)
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡(1−𝑡)+ 𝑅𝑠 .11(120.35)+
𝑁 10 𝑌𝑒𝑎𝑟𝑠
(𝒊)𝑪𝒐𝒔𝒕 𝑫𝒆𝒃𝒕(𝑲𝒅 ) = (𝑅𝑉+𝑁𝑃) = (𝑅𝑠100+𝑅𝑠 96)
2 2

(𝑅𝑉−𝑁𝑃) (𝑅𝑠100−𝑅𝑠95)
𝑃𝐷+ 𝑅𝑠 12+
𝑁 10 𝑌𝑒𝑎𝑟𝑠
(𝒊𝒊)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑺𝒉𝒂𝒓𝒆𝒔(𝑲𝒑) = (𝑅𝑉+𝑁𝑃) = (𝑅𝑠100−𝑅𝑠 95)
2 2
𝑅𝑠 12+𝑅𝑠 0.5
= 0.1282 𝑜𝑟 12.82%
𝑅𝑠 97.5

𝐷1 2
(𝒊𝒊𝒊)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 𝑺𝒉𝒂𝒓𝒆𝒔 (𝑲𝒆) = + 𝐺 = 22−2 + 0.07 = 0.17 𝑂𝑅 17%
𝑃0

I - Interest, t - Tax, RV- Redeemable value, NP- Net proceeds, N- No. of years, PD- Preference dividend,
D1- Expected Dividend, P0- Price of share (net)
Using these specific costs, we can calculate WACC on the basis of book value and market value weights as
follows:

(a) Weighted Average Cost of Capital (K0) based on Book value weights
Source of capital Book value (Rs) Weights Specific cost (%) WACC (%)

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 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 Market value (Rs) Weights Specific cost (%) WACC (%)
Debentures 8,80,000 0.265 7.70 2.04
𝑅𝑠 8,00,000
( 𝑥𝑅𝑠. 110)
𝑅𝑠. 100
Preferences shares 2,40,000 0.072 12.82 0.92
𝑅𝑠 2,00,000
( 𝑥𝑅𝑠. 120)
𝑅𝑠. 100
Equity shares 22,00,000 0.663 17.00 11.27
𝑅𝑠 10,00,000
( )
𝑅𝑠. 10
33,20,000 1.000 14.23

Question 3
The information relating to book value (BV) and market value (MV) weights of Ex Limited is
given below: (Rtp May’22)
Sources Book Value Market Value
Equity shares 2,40,00,000 4,00,00,000
Retained earnings 60,00,000 -
Preference shares 72,00,000 67,50,000
Debentures 18,00,000 20,80,000
Additional information:
i. 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 on face value.
ii. During the previous 5 years, dividends have steadily increased from Rs.10 to Rs16.105
per share. Dividend at the end of the current year is expected to be Rs.17.716 per
share.
iii. 15% Preference shares with face value of Rs.100 would realize Rs. 105 per share.
iv. 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% on face value.
v. Corporate tax rate is 30%.
You are required to DETERMINE the weighted average cost of capital of Ex Limited using
both the weights.

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Solution:
𝐷1 𝑅𝑠.17.716
(𝒊)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑬𝒒𝒖𝒊𝒕𝒚 (𝑲𝒆) = + 𝑔 = 𝑅𝑠.125−𝑅𝑠.5 + 0.10
𝑃0−𝐹
Ke = 0.2476

Calculation of g:
Rs.10(1 + 𝑔)5= Rs.16.105
16.105
𝑂𝑟, (1 = 𝑔)5 = = 1.6105
10

Table (FVIF) Suggests that Rs. 1 Compounds to Rs. 1.6105 in years at the Compound rate
10 percent. Therefore, g is 10 per cent.
𝐷1 𝑅𝑠.17716
(𝒊𝒊)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑹𝒆𝒕𝒂𝒊𝒏𝒆𝒅 𝑬𝒂𝒓𝒏𝒊𝒏𝒈𝒔 (𝑲𝒓) = +𝑔 = + 0.10 = 0.2363
𝑃0 𝑅𝑠.130

𝑃𝐷 𝑅𝑠.15
(𝒊𝒊𝒊)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑷𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝑺𝒉𝒂𝒓𝒆𝒔 (𝑲𝒑) = = 𝑅𝑠.105 = 0.1429
𝑃0

(𝑅𝑉−𝑁𝑃)
(1−𝑡)+ 𝑅𝑠15×0.70+𝑅𝑠.0.75 11.25
𝑛
(𝒊𝒗)𝑪𝒐𝒔𝒕 𝒐𝒇 𝑫𝒆𝒃𝒆𝒏𝒕𝒖𝒓𝒆𝒔 (𝑲𝒅) = (𝑅𝑉+𝑁𝑃) = = .95.875 = 0.1173
95.875
2

*Since yield on similar type of debentures is 16 per cent, the company would be required to offer debentures
at discount.
Market price of debentures (approximation method) = Rs.15 ÷ 0.16 = Rs.93.75

Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%, 11 years)
P0 = Rs. 15 × 5.0287 + Rs.100 × 0.1954 P0 = Rs.75.4305 + Rs19.54 = Rs. 94.9705
Net Proceeds = Rs 94.9705 3 2% of Rs.100 = Rs.92.9705 Accordingly, the cost of debt can be
calculated
Sale proceeds from debentures = Rs.93.75 3 –RS. 2 (i.e., floatation cost) = Rs91.75

Total Cost of capital [BV weights and MV weights] (Amount in Rs lakh)

Source of capital Weights Specific Total cost
BV MV Cost (K) (BV × K) (MV × K)
Equity Shares 240 320** 0.2476 59.4240 79.2320
Retained Earnings 60 80** 0.2363 14.1780 18.9040
Preference Shares 72 67.50 0.1429 10.2888 9.6458
Debentures 18 20.80 0.1173 2.1114 2.4398
Total 390 488.30 86.0022 110.2216

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Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings i.e.,
240:60 or 4:1.

Weighted Average Cost of Capital (WACC):

𝑅𝑠.86.0022
𝑈𝑠𝑖𝑛𝑔 𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = = 0.2205%
𝑅𝑠.390
𝑅𝑠. 110.2216
𝑈𝑠𝑖𝑛𝑔 𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = = 0.2257 𝑂𝑟 22.57%
𝑅𝑠. 488.30

Question 4
Explain the significance of Cost of Capital. (PYQ Nov'19)
Solution:
Significance of the Cost of Capital: The cost of capital is important to arrive at correct amount and
helps the management or an investor to take an appropriate decision. The correct cost of capital helps in
the following decision making:
(i) Evaluation of investment options: The estimated benefits (future cash flows) from available
investment opportunities (business or project) are converted into the present value of benefits by
discounting them with the relevant cost of capital. Here it is pertinent to mention that every investment
option may have different cost of capital hence it is very important to use the cost of capital which is relevant
to the options available. Here Internal Rate of Return (IRR) is treated as cost of capital for evaluation of two
options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars project
or business. The performance of a project or business in compared against the cost of capital which is known
here as cut-off rate or hurdle rate.
(ili) 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. Here cost of capital is used to arrive at the present value of
cost and benefits received.

Question 5
Alpha Ltd has furnished the following information (PYQ May’19)
- Earnings 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

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Solution:
(i) Cost of Equity Share Capital (Ke)
𝐷0(1+𝑔) 25% 𝑜𝑓 𝑅𝑠.4(1+0.10)
𝐾𝑒 = +𝑔 = + 0.10 = 0.122 𝑂𝑟 12.2%
𝑃0 𝑅𝑠.50

(ii) Cost of Debt (Kd)

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝐾𝑑 = 𝑁𝑒𝑡 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠 𝑥100𝑥(1 − 𝑡)
Interest on First Rs. 2,00,000 @10% = Rs. 20,000
Interest on next Rs. 2,00,000 @15% = Rs. 30,000
50,000
𝐾𝑑 = + (1 − 0.3) = 0.0875 𝑂𝑟 8.75%
4,00,000

(iii) Weighted Average Cost of Capital (WACC)

Source of capital Amount (Rs) Weights Cost of Capital (%) WACC (%)
Equity Shares 6,00,000 0.60 12.20 7.32
Debt 4,000,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.82
A lterna tively Cost of Equity Sha re Ca pital (K e ) can be ca lcula ted a s
𝐷0 25% 𝑜𝑓 𝑅𝑠. 4 1.00
𝐾𝑒 = +𝑔 = + 0.10 = 0.120 𝑂𝑟 12.00%
𝑃0 𝑅𝑠. 50 50
Accordingly
Weighted Average Cost of Capital (WACC)
Source of capital Amount (Rs) Weights Cost of Capital (%) WACC (%)
Equity Shares 6,00,000 0.60 12.20 7.20
Debt 4,000,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.70

Question 6
MR Ltd is having the following capital structure, which is considered to be optimum as on
31.03.2022
Equity share capital (50,000 shares) Rs. 8,00,000
12% Preference share capital Rs. 50,000
15% Debentures Rs. 1,50,000
Rs. 10,00,000
The earnings per share (EPS) of the company were Rs. 2.50 in 2021 and the expected growth
in equity dividend is 10% per year. The next year’s dividend per share (DPS) is 50% of EPS of
the year 2021. The current market price per share (MPS) is Rs. 25.00. The 15% new
debentures can be issued by the company. The company’s debentures are currently selling
at Rs. 96 per debenture.

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The new 12% Preference share can be sold at net price of Rs. 91.50 (face value Rs. 100 each).
The applicable tax rate is 30%.
You are required to calculate
(a) After tax cost of
i. New debt
ii. New preference share capital an
iii. Equity shares assuming that new equity shares come from retained earnings.
(b) Marginal cost of capital
How much can be spent for capital investment before sale of new equity shares assuming
that retained earnings for next year investment is 50% of 2021? (PYQ Nov’22)
Solution:
(a) (i) After tax cost of new Debt:
(1−𝑡) (1−0.3)
𝐾𝑑 = 𝐼 = 15 = 0.1094 (or) 10.94%
𝑃1 96

(ii) After tax cost of New Preference share capital:

𝑃𝐷 12
𝐾𝑝 = = [91.5] = 0.1311 𝑜𝑟 13.11%
𝑃0

(iii) After tax cost of Equity shares:

𝐷1 (2.50𝑥50%)
𝐾𝑒 = [𝑃0] + 𝑔 = [ ] + 0.10 = 0.15 or 15%
25

(b) Marginal Cost of Capital

Type of capital Proportions Specific cost Product
Equity Shares 0.80 0.15 0.12
Preference Shares 0.05 0.1311 0.0066
Debentures 0.15 0.1094 0.0164
∴ Marginal cost of capital 0.1430

(c) Amount that can be spend for capital investment

Retained earnings = 50% of EPS x No. of outstanding Equity shares
= 1.25 x 50,000 = Rs. 62,500
Proportion of equity (Retained earnings here) capital is 80% of total capital. Therefore, Rs. 62,500 is 80% of
total capital
62,500
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = = 𝑅𝑠. 78,125
0.80

Question 7
JKL Ltd. has the following book-value capital structure as on March 31, 2018.
(Rs.)

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 Equity shares capital (2,00,000 shares) 40,00,000
11.5% Preference shares 10,00,000
10% Debentures 30,00,000
80,00,000
The equity shares of the company are sold at Rs. 20. It is expected that the company will pay
next year a dividend of Rs. 2 per equity share, which is expected to grow by 5% p.a. forever.
Assume a 35% Corporate tax rate.
Required:
1. COMPUTE weighted average cost of capital (WACC) of the company based on the
existing capital structure.
2. COMPUTE the new WACC, if the company raises an additional Rs. 20 lakhs debt by
issuing 12% debentures. This would result in increasing the expected equity dividend to
Rs. 2.40 and leave the growth rate unchanged, but the price of equity share will fall to
Rs.16 per share. (Mtp Oct’18, Rtp May’20)
Solution:
i. Computation of Weighted Average Cost of Capital based on existing capital structure
Source of Capital Existing Capital Weights After tax cost WACC
structure (Rs.) of capital (%) (%)

(a ) (b) (a ) × (b)
Equity share capital (W.N.1) 40,00,000 0.500 15.00 7.500
11.5% Preference share capital 10,00,000 0.125 11.50 1.437
(W.N.2)
10% Debentures (W.N.3) 30,00,000 0.375 6.50 2.438
80,00,000 1.000 11.375
Working Notes (W.N.)
1. Cost of equity capital:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝐷1)
𝐾𝑒 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒(𝑃0) + 𝐺𝑟𝑜𝑤𝑡ℎ (𝑔)
2
= 𝑅𝑠.20 + 0.05 = 0.15 𝑂𝑟 15%

𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 (𝑃𝐷)

𝟐. 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒑𝒓𝒆𝒇𝒆𝒓𝒆𝒏𝒄𝒆 𝒔𝒉𝒂𝒓𝒆 𝒄𝒂𝒑𝒊𝒕𝒂𝒍: 𝑁𝑒𝑡 𝑝𝑟𝑜𝑐𝑒𝑠𝑑𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑖𝑠𝑠𝑢𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒(𝑁𝑃)

𝑅𝑠 1,15,000
= 𝑅𝑠 1,00,000

1(1−𝑡)𝑅𝑠 3,00,000(1−0.35)
𝟑. 𝑪𝒐𝒔𝒕 𝒐𝒇 𝟏𝟎% 𝑫𝒆𝒃𝒆𝒏𝒕𝒖𝒓𝒆𝒔: = 0.065 𝑜𝑟 6.5%
𝑁𝑃−𝑅𝑠 3,00,000

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

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 Source of Capital New Capital Weights After tax cost of WACC (%)
structure (Rs.) capital (%)
(b) (a ) (a ) × (b)
Equity share capital (W.N. 4) 40,00,000 0.40 20.00 8.00
Preference share (W.N. 2) 10,00,000 0.10 11.50 1.15
10% Debentures (W.N. 3) 30,00,000 0.30 6.50 1.95
12% Debentures (W.N.5) 20,00,000 0.20 7.80 1.56
1,00,00,000 1.00 12.66
Working Notes (W.N.):
4. Cost of equity capital:
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑(𝐷1) 𝑅𝑠 2.40
𝐾𝑒 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒(𝑃0 ) + 𝐺𝑟𝑜𝑤𝑡ℎ(𝑔) = + 5% = 20%
𝑅𝑠 16

5. Cost of 12% Debentures:

2,40,000(1−0.35)
𝐾𝑑 = 𝑅𝑠 20,00,000
= 0.078 𝑜𝑟 7.8%

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 Chapter 5: Financing Decisions-Capital Structure

Question 1
Sophisticated Limited is considering three financing plans. The key information is as follows:
a) Total investment amount to be raised Rs.4,00,000
b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%
c) Cost of debt 10%
Cost of preference shares 10%
(d) Tax rate 30%
(e) Equity shares of the face value of 10 each will be issued at a premium of 10 per share.
(f) Expected EBIT is 10,00,000.
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. (Study Material, MTP Oct’21, MTP Mar 18 & Oct 18, RTP Nov’19, PYP Nov’20)
Solution:
(i) Computation of Earnings per share (EPS)
Plans A B C
Earnings before interest and tax 10,00,000 10,00,000 10,00,000
(EBIT)
Less: Interest charges −−− (20,000) −−−
(10% × 32 lakh)
Earnings before tax (EBT) 10,00,000 9,80,000 10,00,000
Less: Tax (@ 30%) (3,00,000) (2,94,000) (3,00,000)
Earnings after tax (EAT) 7,00,000 6,86,000 7,00,000
Less: Preference Dividend −−− −−− (20,000)
(10% × 32lakh)
Earnings available for Equity 7,00,000 6,86,000 6,80,000
shareholders (A)
No. of Equity shares (B) 20,000 10,000 10,000
(Rs.4 lakh ÷Rs.20) (Rs.2 lakh ÷Rs.20) (Rs.2 lakh ÷Rs.20)
EPS 3 [(A) ÷ (B)] 35 68.6 68

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ii. Calculation of Financial Break−even point
Financial break−even point is the earnings which are equal to the fixed finance charges and preference
dividend.
P la n A : Under this, plan there is no interest or preference dividend payment. Hence, the Financial
Break−even point will be zero.
P la n B : Under this plan, there is an interest payment of Rs.20,000 and no preference dividend. Hence, the
Financial Break−even point will be Rs.20,000 (Interest charges).
P la n C: Under this plan, there is no interest payment but an after-tax preference dividend of Rs.20,000 is
paid. Hence, the Financial Break− even point will be before tax earnings of Rs.28,571 (i.e. Rs.20,000 ÷ 0.7)

iii. Computation of indifference point between the plans.

The indifference between two alternative methods of financing is calculated by applying the following formula.
(𝐸𝐵𝐼𝑇−𝑙1)(1−𝑇) (𝐸𝐵𝐼𝑇−𝑙2)(1−𝑇)
=
𝐸1 𝐸2
Where, EBIT = Earnings before interest and tax.
L1 = Fixed charges (interest or pref. dividend) under Alternative 1
L2 = Fixed charges (interest or pref. dividend) under Alternative 2
T = Tax rate
E1 = No. of equity shares in Alternative 1
E2 = No. of equity shares in Alternative 2
Now, we can calculate indifference point between different plans of financing.

(a) Indifference points where EBIT of Plan A and Plan B is equal.

(𝐸𝐵𝐼𝑇−0)(1−0.3) (𝐸𝐵𝐼𝑇−20,000)(1−0.3)
=
20000 10,000
0.7 EBIT (10,000) = (0.7 EBIT – 14,000) (20,000)
7,000 EBIT = 14,000 EBIT – 28 crores
EBIT = 40,000

(b) Indifference points where EBIT of Plan A and Plan C is equal

(𝐸𝐵𝐼𝑇−0)(1−0.3) (𝐸𝐵𝐼𝑇−0)(1−0.3)−20,000
=
20000 10,000
0.7 EBIT (10,000) = (0.7 EBIT – 20,000) (20,000)
7000 EBIT = 14,000 EBIT – 40 crores
EBIT = 57,142.86

(c) Indifference points where EBIT of Plan B and Plan C are equal
(𝐸𝐵𝐼𝑇−20,000)(1−0.3) (𝐸𝐵𝐼𝑇−0)(1−0.3)−20,000
=
10000 10,000
(0.7 EBIT – 14,000) (10,000) = (0.7 EBIT – 20,000) (10,000)
7,000 EBIT – 14 crore = 7,000 EBIT - 20 crore

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There is no indifference point between the financial plans B and C.

Question 2
PRI Ltd. and SHA Ltd. are identical; however, their capital structure (in market-value terms)
differs as follows:
Company Debt Equity
PRI Ltd. 60% 40%
SHA Ltd. 20% 80%
The borrowing rate for both companies is 8% in a no-tax world and capital markets are
assumed to be perfect.
(a) (i) If Mr. Rhi, owns 6% of the equity shares of PRI Ltd., DETERMINE his return if the
Company has net operating income of 9,00,000 and the overall capitalization rate of the
company (Ko) is 18%.
(ii) CALCULATE the implied required rate of return on equity of PRI Ltd.
(b) SHA Ltd. has the same net operating income as PRI Ltd.
(i) CALCULATE the implied required equity return of SHA Ltd.
(ii) ANALYSE why does it differ from that of PRI Ltd. (MTP May’22)
Solution:
𝑁𝑂𝐼 9,00,000
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑃𝑅𝐼 𝐿𝑡𝑑. = = ₹50,00,000
𝐾𝑒 18%
(a ) (i) Return on Sha res of M r. Rhi on P RI Ltd .
P a rticula rs A m ount (₹)
Value of the company 50,00,000
Market value of debt (60% x 3 50,00,000) 30,00,000
Market value of shares (40% x 3 50,00,000) 20,00,000
P a rticula rs A m ount (₹)
Net operating income 9,00,000
Interest on debt (8% × 3 30,00,000) 2,40,000
Earnings available to shareholders 6,60,000
Return on 6% shares (6% × 3 6,60,000) 39,600
6,60,000
(𝒊𝒊)𝑰𝒎𝒑𝒍𝒊𝒆𝒅 𝒓𝒆𝒒𝒖𝒊𝒓𝒆𝒅 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒆𝒒𝒖𝒊𝒕𝒚 𝒐𝒇 𝑷𝑹𝑰 𝑳𝒕𝒅. = = 33%
20,00,000

(b) i. Ca lcula tion of Im plied ra te of return of SHA Ltd.

P a rticula rs A m ount (₹)
Total value of company 50,00,000
Market value of debt (20% × 3 50,00,000) 10,00,000
Market value of equity (80% × 3 50,00,000) 40,00,000

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 P a rticula rs A m ount (₹)
Net operating income 9,00,000
Interest on debt (8% × 3 10,00,000) 80,000
Earnings available to shareholders 8,20,000
8,20,000
𝑖𝑚𝑝𝑙𝑖𝑒𝑑 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦 = 40,00,000 = 20.5%
(ii) Implied required rate of return on equity of SHA Ltd. is lower than that of PRI Ltd. because SHA Ltd.
uses less debt in its capital structure. As the equity capitalisation is a linear function of the debt-to-equity
ratio when we use the net operating income approach, the decline in required equity return offsets exactly
the disadvantage of not employing so much in the way of “cheaper” debt funds.

Question 3
Axar Ltd. has a Sales of 68,00,000 with a Variable cost Ratio of 60%.
The company has fixed cost of 16,32,000. The capital of the company comprises of 12% long
term debt, 1,00,000 Preference Shares of 10 each carrying dividend rate of 10% and 1,50,000
equity shares.
The tax rate applicable for the company is 30%.
At current sales level, DETERMINE the Interest, EPS and amount of debt for the firm if a
25% decline in Sales will wipe out all the EPS. (Study Material, Mtp Oct’22)
Solution:
Break Even Sales = 68,00,000×0.75 = 51,00,000
Incom e Sta tem ent
Origina l ₹ Ca lcula tion of Interest Now a t P resent
at B EP (B a ck ward Level ₹
ca lcula tion) ₹
Sales 68,00,000 51,00,000 68,00,000
Less: Variable Cost 40,80,000 30,60,000 40,80,000
Contribution 27,20,000 20,40,000 27,20,000
Less: Fixed Cost 16,32,000 16,32,000 16,32,000
EBIT 10,88,000 4,08,000 10,88,000
Less: Interest (EBIT-PBT) ? 3,93,714 3,93,714
PBT ? 14,286(10,000/70%) 6,94,286
Less: Tax @ 30% (or PBT-PAT) ? 4,286 2,08,286
PAT ? 10,000(Nil+10,000) 4,86,000
Less: Preference Dividend 10,000 10,000 10,000
Earnings for Equity share holders ? Nil (a t B EP ) 4,76,000
Number of Equity Shares 1,50,000 1,50,000 1,50,0000
EPS ? - 3.1733

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So, Interest = 3,93,714, EPS = 3.1733, Amount of debt = 3,93,714/12% = 32,80,950

Question 4
Aeron We Ltd.is considering two alternative financing plans as follows:
Plans A (₹) B (₹)
Equity shares of 100 each 90,00,000 90,00,000
Preference Shares of 100 each - 20,00,000
9% Debentures 20,00,000 -
1,10,00,000 1,10,00,000
The indifference point between the plans is 7,60,000. Corporate tax rate is 25%. CALCULATE
the rate of dividend on preference shares.
(Study Material, MTP March’23, RTP Nov’20)
Solution:
Computation of Rate of Preference Dividend
(𝐸𝐵𝐼𝑇 − 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡) (1 − 𝑡) 𝐸𝐵𝐼𝑇 (1 − 𝑡) − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
=
𝑁𝑜. 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦𝑠ℎ𝑎𝑟𝑒𝑠(𝑁1 ) 𝑁𝑜. 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦𝑠ℎ𝑎𝑟𝑒𝑠(𝑁2)

( 7,60,000 − 1,80,000) 𝑥 (1 − 0.25) 7,60,000 (1 − 0.25) − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

=
90,00,000 𝑠ℎ𝑎𝑟𝑒𝑠 90,00,000 𝑠ℎ𝑎𝑟𝑒𝑠

4,35,000 5,70,000 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑

=
90,00,000 𝑠ℎ𝑎𝑟𝑒𝑠 90,00,000 𝑠ℎ𝑎𝑟𝑒𝑠

₹4,35,000 = 5,70,000 – Preference Dividend

Preference Dividend =5,70,000 – 4,35,000 = 1,35,000
𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑅𝑎𝑡𝑒 𝑜𝑓 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 = 𝑥100
𝑃𝑟𝑒𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑠ℎ𝑎𝑟𝑒 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

1,35,000
= 𝑥100 = 6.75%
20,00,000

Question 5
Following data is available in respect of two companies having same business risk: Capital
employed = ₹12,00,000, EBIT = ₹2,40,000 and Ke = 15%
Sources Dumbo Ltd (₹) Jumbo Ltd (₹)
Debt (@12%) 4,00,000 Nil
Equity 8,00,000 12,00,000
An investor is holding 20% shares in the levered company. CALCULATE the increase in
annual earnings of investor if arbitrage process is undertaken.

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Also EXPLAIN the arbitrage process if Ke = 20% for Dumbo Ltd instead of 15%.
(MTP April’23)
Solution:
(i). Valuation of firms
P a rticula rs Dum bo Ltd (₹) Jum bo Ltd (₹)
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × 3 4,00,000) 48,000 Nil
Earnings available to Equity shareholders 1,92,000 2,40,000
Ke 15% 15%
Value of Equity (S) 12,80,000 16,00,000
(Earnings available to Equity shareholders/Ke)
Debt (D) 4,00,000 Nil
Value of Firm (V) = S + D 16,80,000 16,00,000
Value of Levered company is more than that of unlevered company. Therefore, investor will sell his shares
in levered company and buy shares in unlevered company. To maintain the level of risk he will borrow
proportionate amount and invest that amount also in shares of unlevered company

(ii). Investm ent & B orrowings ₹

Sell shares in Levered company (12,80,000 x 20%) 2,56,000
Borrow money (4,00,000 x 20%) 80,000
Buy shares in Unlevered company 3,36,000

(III). Cha nge in Return ₹

Income from shares in Unlevered company
(2,40,000 x 3,36,000/16,00,000) 50,400
Less: Interest on loan (80,000 x 12%) 9,600
Net Income from unlevered firm 40,800
Less: Income from Levered firm (1,92,000 x 20%) 38,400
Incremental Income due to arbitrage 2,400
A rbitra ge process if Ke = 20%

(I). Valua tion of firm s

P a rticula rs Dum bo Ltd (₹) Jum bo Ltd (₹)
EBIT 2,40,000 2,40,000
Less: Interest on debt (12% × 3 4,00,000) 48,000 Nil
Earnings available to Equity shareholders 1,92,000 2,40,000
Ke 20% 15%

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 Value of Equity (S) 9,60,000 16,00,000
(Earnings available to Equity shareholders/Ke)
Debt (D) 4,00,000 Nil
Value of Firm (V) = S + D 13,80,000 16,00,000
Value of unlevered company is more than that of levered company. Therefore, investor will sell his shares in
unlevered company and buy proportionate shares and debt in levered company i.e. 20% share.

(II). Investm ent & B orrowings ₹

Sell shares in unlevered company (16,00,000 x 20%) 3,20,000
Buy shares in levered company (9,60,000 x 20%) 1,92,000
Buy Debt of levered company 1,28,000

(III). Cha nge in Return ₹

Income from shares in levered company (1,92,000 x 20%) 38,400
Add: Interest on debt of levered (1,28,000 x 12%) 15,360
Net Income from levered firm 53,760
Less: Income from unlevered firm (2,40,000 x 20%) 48,000
Incremental Income due to arbitrage 5,760

Question 6
RML Limited needs 36,50,00,000 for the Expansion purposes. The following three plans are
feasible:
I. The Company may issue 6,50,000 equity shares at 100 per share.
II. The Company may issue 4,00,000 equity shares at 100 per share and 2,50,000
debentures of 100 denomination bearing a 9% rate of interest.
III. The Company may issue 4,00,000 equity shares at 3100 per share and 2,50,000
cumulative preference shares at 100 per share bearing a 9% rate of dividend.
(i) If the Company's earnings before interest and taxes are 15,62,500, 22,50,000, 62,50,000,
93,75,000 and 1,56,25,000, CALCULATE the earnings per share under each of three
financial plans? Assume a Corporate Income tax rate of 25%.
(ii) WHICH alternative would you recommend and why?
(MTP March’23, March’19 & Sep’23)
Solution:
Computation of EPS under three-financial plans.
Plan I: Equity Financing
(₹) (₹) (₹) (₹) (₹)
EBIT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Interest 0 0 0 0 0

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 EBT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less: Tax @ 25% 3,90,625 5,62,500 15,62,500 23,43,750 39,06,250
PAT 11,71,875 16,87,500 46,87,500 70,31,250 1,17,18,750
No. of equity shares 6,50,000 6,50,000 6,50,000 6,50,000 6,50,000
EPS 1.80 2.60 7.21 10.82 18.03

Plan II: Debt 3 Equity Mix

(₹) (₹) (₹) (₹) (₹)
EBIT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less: Interest 22,50,000 22,50,000 22,50,000 22,50,000 22,50,000
EBT (6,87,500) 0 40,00,000 71,25,000 1,33,75,000
Less: Tax @ 25% 1,71,875* 0 10,00,000 17,81,250 33,43,750
PAT (5,15,625) 0 30,00,000 53,43,750 1,00,31,250
No. of equity shares 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000
EPS (3) (1.29) 0.00 7.50 13.36 25.08
* The Company can set off losses against the overall business profit or may carry forward it to next financial
years.

Plan III: Preference Shares 3 Equity Mix

(₹) (₹) (₹) (₹) (₹)
EBIT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less: Interest 0 0 0 0 0
EBT 15,62,500 22,50,000 62,50,000 93,75,000 1,56,25,000
Less: Tax @ 25% 3,90,625 5,62,500 15,62,500 23,43,750 39,06,250
PAT 11,71,875 16,87,500 46,87,500 70,31,250 1,17,18,750
Less: Pref. dividend * 22,50,000 22,50,000 22,50,000 22,50,000 22,50,000
PAT after Pref. dividend. (10,78,125) (5,62,500) 24,37,500 47,81,250 94,68,750
No. of Equity shares 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000
EPS (2.70) (1.41) 6.09 11.95 23.67
* In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders.
(ii) In case of lower EBIT Plan I i.e Equity Financing is better however in case of higher EBIT Plan II i.e
Debt=Equity Mix is best.

Question 7
Akash Limited provides you the following information:
₹

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 Profit (EBIT) 2,80,000
Less: Interest on Debenture @ 10% (40,000)
EBT 2,40,000
Less Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity Shares (3 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10
The company has reserves and surplus of 3 7,00,000 and required 4,00,000 further for
modernization. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity)
Ratio higher than 40% will bring the P/E Ratio down to 8 and increase the interest rate on
additional debts to 12%. You are required to ASCERTAIN the probable price of the share.
I. If the additional capital is raised as debt; and
II. If the amount is raised by issuing equity shares at ruling market price.
(RTP May’19 & Nov’23)
Solution:
i. Ascertainment of probable price of shares of Akash limited
Particulars Plan-I Plan-II
If 4,00,000 If 4,00,000 is
is raised as debt raised by issuing
(₹) equity shares (₹)
Earnings Before Interest and Tax (EBIT)
{20% of new capital i.e. 20% of (14,00,000 + 4,00,000)} (Refer 3,60,000 3,60,000
working note1)
Less: Interest on old debentures (40,000) (40,000)
(10% of 4,00,000)
Less: Interest on new debt
(12% of 4,00,000) (48,000) −−
Earnings Before Tax (EBT) 2,72,000 3,20,000
Less: Tax @ 50% (1,36,000) (1,60,000)
Earnings for equity shareholders (EAT) 1,36,000 1,60,000
No. of Equity Shares (refer working note 2) 30,000 40,000
Earnings per Share (EPS) 4.53 4.00
Price/ Earnings (P/E) Ratio (refer working note 3) 8 10
Probable Price Per Share (PE Ratio × EPS) 36.24 40

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Working Notes:
Calculation of existing Return of Capital Employed (ROCE):
(₹)
Equity Share capital (30,000 shares × 10) 3,00,000
10% Debentures 40,000𝑥
100
4,00,000
10
Reserves and Surplus 7,00,000
Total Capital Employed 14,00,000
Earnings before interest and tax (EBIT) (given) 2,80,000
2,80,000 20%
𝑅𝑂𝐶𝐸𝑥 𝑥100
14,00,000
2. Num ber of Equity Sha res to be issued in P la n - II:
4,00,000
= = 10,000 𝑠ℎ𝑎𝑟𝑒𝑠
40
Thus, after the issue total number of shares = 30,000+ 10,000 = 40,000 shares

3. Debt/Equity Ra tio if 4,00,000 is ra ised a s debt:

8,00,000
= 𝑥100 = 44.44%
18,00,000
As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in Plan-I.

Question 8
Blue Ltd., an all equity financed company is considering the repurchase of 3 275 lakhs equity
shares and to replace it with 15% debentures of the same amount. Current market value of
the company is 3 1,750 lakhs with its cost of capital of 20%. The company's Earnings before
Interest and Taxes (EBIT) are expected to remain constant in future years. The company
also has a policy of distributing its entire earnings as dividend.
Assuming the corporate tax rate as 30%, 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) Approach:
(i) Market value of the company
(ii) Overall Cost of capital
(iii) Cost of equity (RTP Nov’21)
Solution:
Workings:
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 (𝑁𝐼) 𝑓𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 ℎ𝑜𝑙𝑑𝑒𝑟𝑠
𝑀𝑎𝑟𝑘𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦 = 𝐾𝑒

𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 (𝑁𝐼) 𝑓𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 ℎ𝑜𝑙𝑑𝑒𝑟𝑠

1,750 𝐿𝑎𝑘ℎ𝑠 = 0.20
Net Income to equity holders/EAT = ₹350 lakhs

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 𝐸𝐴𝑇 ₹350 𝐿𝑎𝑘ℎ𝑠
𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝐸𝐵𝐼𝑇 = (1−𝑡) = = ₹500 𝐿𝑎𝑘𝑠
(1−0.3)

Income Statement
All Equity Equity & Debt
(₹ In lakhs) (₹ In lakhs)
EBIT (as calculated above) 500 500
Interest on 3 275 lakhs @ 15% − 41.25
EBT − 458.75
Tax @ 30% 500 137.63
Income available to equity holders 150 321.12
350

(i) Market value of the company

Market value of levered firm = Value of unlevered firm + Tax Advantage
= 1,750 lakhs + (275 lakhs x 0.3)
= 1,832.5 lakhs
Change in market value of the company = 1,832.5 lakhs – 1,750 lakhs = 82.50 lakhs
The impact is that the market value of the company has increased by 82.50 lakhs due to replacement of
equity with debt.

(ii) Overall Cost of Capital

Market Value of Equity = Market value of levered firm - Equity repurchased
= 1,832.50 lakhs – 275 lakhs = 1,557.50 lakhs
Cost of Equity (Ke) = (Net Income to equity holders / Market value of equity)  100
= (321.12 lakhs / 1,557.50 lakhs)  100 = 20.62%
Cost of debt (Kd) = I (1 - t) = 15 (1 - 0.3) = 10.50%
Com ponent A m ount Cost of Ca pita l % Weight WA CC (Ko) %
s (₹ In la k hs)
Equity 1,557.50 20.62 0.85 17.53
Debt 275.00 10.50 0.15 1.58
1,832.50 1 19.11
The impact is that the Overall Cost of Capital or Ko has fallen by 0.89% (20% - 19.11%) due to the benefit
of tax relief on debt interest payment.

(iii) Cost of Equity

The impact is that cost of equity has risen by 0.62% (20.62% - 20%) due to the presence of financial risk i.e.
introduction of debt in capital structure.

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Note: Cost of Capital and Cost of equity can also be calculated with the help of following formulas, though
there will be no change in the final answers.
Cost of Capital (Ko) = Keu [1 – (t x L)]
Where,
Keu = Cost of equity in an unlevered company t = Tax rate
𝐷𝑒𝑏𝑡
𝐿=
𝐷𝑒𝑏𝑡 + 𝐸𝑞𝑢𝑖𝑡𝑦

275 𝐿𝑎𝑘ℎ𝑠
𝐾𝑜 = 0.20 [1 − (0.3𝑥 )] = 0.191 𝑜𝑟 19.10% 𝐴𝑝𝑝𝑟𝑜𝑥
1832.5 𝐿𝑎𝑘ℎ𝑠

𝐷𝑒𝑏𝑡(1 − 𝑡)
𝑐𝑜𝑠𝑡 𝑜𝑓 𝐸𝑞𝑢𝑖𝑡𝑦(𝐾𝑒) = 𝐾𝑒𝑢 + (𝐾𝑒𝑢 − 𝐾𝑑)
𝐸𝑞𝑢𝑖𝑡𝑦
Where,
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
t = Tax rate
275 𝐿𝑎𝑘ℎ𝑠 (1 − 0.3)
𝐾𝑒 = 0.20 + (0.20 − 0.15)𝑥 [ ] = 0.2062 𝑜𝑟 20.62%
1,557.5 𝐿𝑎𝑘𝑠

Question 9
Earnings before interest and tax of a company are 4,50,000. Currently the company has
80,000 Equity shares of 10 each, retained earnings of 12,00,000. It pays annual interest of
1,20,000 on 12% Debentures. The company proposes to take up an expansion scheme for
which it needs additional fund of 6,00,000. It is anticipated that after expansion, the company
will be able to achieve the same return on investment as at present.
It can raise fund either through debts at rate of 12% p.a. or by issuing Equity shares at par.
Tax rate is 40%.
Required: Compute the earning per share if:
(i) The additional funds were raised through debts.
(ii) The additional funds were raised by issue of Equity shares.
Advise whether the company should go for expansion plan and which sources of finance
should be preferred. (PYP May’18)
Solution:
Working Notes:
(1) Capital employed before expansion plan:
(₹)
Equity shares (3 10 × 80,000 shares) 8,00,000
Debentures {(3 1,20,000/12) X 100} 10,00,000

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 Retained earnings 12,00,000
Total capital employed 30,00,000
(2) Ea rnings before interest a nd ta x (EB IT) = 4,50,000
(3) Return on Ca pita l Em ploy ed (ROCE)
𝐸𝐵𝐼𝑇 4,50,000
𝑅𝑂𝐶𝐸 = 𝑥100 = 𝑥100 = 15%
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 30,00,000
(4) Ea rnings before interest a nd ta x (EB IT) a fter expa nsion schem e:
After expansion, capital employed = 30,00,000 + 6,00,000 = 36,00,000
Desired EBIT = 15% 36,00,000 = 5,40,000

(i) & (ii) Com puta tion of Ea rnings P er Sha re (EP S) under the following options:
P resent Expa nsion schem e A dditiona l
situa tion funds raised a s
Debt (i) Equity (ii)
(₹) (₹) (₹)
Earnings before Interest and Tax 4,50,000 5,40,000 5,40,000
(EBIT)
Less: Interest − Old Debt 1,20,000 1,20,000 1,20,000
− New Debt −− 72,000 −−
(3 6,00,000 X 12%)
Earnings before Tax (EBT) 3,30,000 3,48,000 4,20,000
Less: Tax (40% of EBT) 1,32,000 1,39,200 1,68,000
PAT/EAT 1,98,000 2,08,800 2,52,000
No. of shares outstanding 80,000 80,000 1,40,000
Earnings per Share (EPS) 2.475 2.610 1.800
1,98,000 2,08,800 2,52,000
= = =
80,000 80,000 1,40,000
A dvise to the Com pa ny : When the expansion scheme is financed by additional debt, the EPS is higher.
Hence, the company should finance the expansion scheme by raising debt.

Question 10
The following information pertains to CIZA Ltd.:
₹
Capital Structure:
Equity shares capital (10 each) 8,00,000
Retained earnings 20,00,000
9% Preference share capital (100 each) 12,00,000

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 12% Long-term loan 10,00,000
Interest coverage ratio 8
Income tax rate 30%
Price 3 earnings ratio 25
The company is proposed to take up an expansion plan, which requires an additional
investment of 34,50,000. Due to this proposed expansion, earnings before interest and taxes
of the company will increase by 6,15,000 per annum. The additional fund can be raised in
following manner:
• By issue of equity shares at present market price, or
• By borrowing 16% Long-term loans from bank.
You are informed that Debt-equity ratio (Debt/ Shareholders' fund) in the range of 50% to
80% will bring down the price-earnings ratio to 22 whereas; Debt-equity ratio over 80% will
bring down the price-earnings ratio to 18.
Required:
Advise which option is most suitable to raise additional capital so that the Market Price per
Share (MPS) is maximized. (PYP May’23)
Solution:
Working notes:
(i) Interest Coverage ratio = 8
𝐸𝐵𝐼𝑇 𝐸𝐵𝐼𝑇
=8= =8
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 1,20,000
So, EBIT = 9,60,000
(ii) Proposed Earnings Before Interest & Tax = 9,60,000 + 6,15,000 = 15,75,000
Option 1: Equity option
Debt=10,00,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000+34,50,000 = 74,50,000
10,00,000
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜(𝐷𝑒𝑏𝑡/𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑) = = 13.42%
74,50,000
P/E ratio in this case will be 25 times
Option 2: Debt option
Debt = 10,00,000+34,50,000 = 44,50,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000 = 40,00,000
44,50,000
𝐷𝑒𝑏𝑡 𝐸𝑞𝑢𝑖𝑡𝑦 𝑟𝑎𝑡𝑖𝑜(𝐷𝑒𝑏𝑡/𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑) = = 111.25%
40,00,000
Debt equity ratio has crossed the limit of 80% hence PE ratio in this case will remain at 18 times.
Num ber of Equity Sha res to be issued = 34,50,000/ 150 = 23,000
(i) Ca lcula tion of Ea rnings per Sha re a nd M a rk et P rice per sha re
P a rticula rs ₹

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 Current Earnings Before Interest & Tax 9,60,000
Less: Interest 1,20,000
Earnings Before Tax 8,40,000
Less: Taxes 2,52,000
Earnings After Tax 5,88,000
Less: Preference Dividend (@9%) 1,08,000
Net earnings for Equity shareholders 4,80,000
Number of equity shares 80,000
Ea rnings P er Sha re 6
Price−earnings ratio 25
M a rk et P rice per share 150

Ca lcula tion of EP S a nd M P S under two financial options

F ina ncia l Options
Option I Option II
P a rticula rs Equity Sha res 16% Long Term
Issued (₹) Debt Ra ised (₹)
Earnings before interest and Tax (EBIT) 15,75,000 15,75,000
Less: Interest on old debentures @ 12% 1,20,000 1,20,000
Less: Interest on additional loan (new) @ 16% on 34,50,000 NIL 5,52,000

Earnings before tax 14,55,000 9,03,000

Less: Taxes @ 30% 4,36,500 2,70,900
(EAT/Profit after tax) 10,18,500 6,32,100
Less: Preference Dividend (@9%) 1,08,000 1,08,000
Net Earnings available to Equity shareholders 9,10,500 5,24,100
Number of Equity Shares 1,03,000 80,000
Earnings per Share (EPS) 8.84 6.55
Price/ Earnings ratio 25 18
Market price per share (MPS) 221 117.9
A dvise: Equity option has higher Market Price per Share therefore company should raise additional fund
through equity option.

Question 11
The particulars relating to Raj Ltd. for the year ended 31st March, 2022 are given as follows:
Output (units at normal capacity) 1,00,000
Selling price per unit 40

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 Variable cost per unit 20
Fixed cost 10,00,000
The capital structure of the company as on 31st March, 2022 is as follows:
Particulars Amount in ₹
Equity shares capital (1,00,000 shares of 10 each) 10,00,000
Reserves and surplus 5,00,000
Current liabilities 5,00,000
Total 20,00,000
Raj Ltd. has decided to undertake an expansion project to use the market potential that will
involve 20 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 15%. 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 program are
planned:
(Amount in ₹)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance
Current market price per share is 200.
Slab wise interest rate for fund borrowed is as follows:
Fund limit Applicable interest rate
Up-to 5,00,000 10%
Over 5,00,000 and up-to 15%
10,00,000
Over 10,00,000 20%
Find out which of the above-mentioned alternatives would you recommend for Raj Ltd. with
reference to the EPS, assuming a corporate tax rate is 40%? (PYP May’22)
Solution:
Alternative 1 = Raising Debt of 5 lakh + Equity of 15 lakh
Alternative 2 = Raising Debt of 10 lakh + Equity of 10 lakh
Alternative 3 = Raising Debt of 14 lakh + Equity of 6 lakh

Calculation of Earnings per share (EPS)

FINANCIAL ALTERNATIVES
Particulars Alternative 1 Alternative 2 Alternative 3

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 (₹) (₹) (₹)
Expected EBIT [W. N. (a)] 19,50,000 19,50,000 19,50,000
Less: Interest [W. N. (b)] (50,000) (1,25,000) (2,05,000)
Earnings before taxes (EBT) 19,00,000 18,25,000 17,45,000
Less: Taxes @ 40% 7,60,000 7,30,000 6,98,000
Earnings after taxes (EAT) 11,40,000 10,95,000 10,47,000
Number of shares [W. N. (d)] 1,07,500 1,05,000 1,03,000
Earnings per share (EPS) 10.60 10.43 10.17
Conclusion: Alternative 1 (i.e. Raising Debt of 5 lakh and Equity of 15 lakh) is recommended which
maximises the earnings per share.

Work ing Notes (W.N.):

(a ) Calcula tion of Ea rnings before Interest a nd Ta x (EB IT)
P a rticula rs

Output (1,00,000 + 50%) (A) 1,50,000

Selling price per unit 40
Less: Variable cost per unit (₹20 -15%) 17
Contribution per unit (B) 23
Tota l contribution (A x B ) 34,50,000
Less: Fixed Cost (10,00,000 + 5,00,000) 15,00,000
EB IT 19,50,000

(b) Ca lcula tion of interest on Debt

A lterna tive (₹) Tota l (₹)
1 (5,00,000 x 10%) 50,000
2 (5,00,000 x 10%) 50,000
(5,00,000 x 15%) 75,000 1,25,000
3 (5,00,000 x 10%) 50,000
(5,00,000 x 15%) 75,000
(4,00,000 x 20%) 80,000 2,05,000

(c) Num ber of equity sha res to be issued

₹(20,00,000−5,00,000) 15,00,000
𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 1 = ₹200(𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒) = = 7,500 𝑠ℎ𝑎𝑟𝑒𝑠
200

₹(20,00,000−10,00,000) 10,00,000
𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 2 = ₹200(𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒) = = 5,000 𝑠ℎ𝑎𝑟𝑒𝑠
200

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 ₹(20,00,000−14,00,000) 6,00,000
𝐴𝑙𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑣𝑒 3 = ₹200(𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑆ℎ𝑎𝑟𝑒) = = 3,000 𝑠ℎ𝑎𝑟𝑒𝑠
200

(d) Calculation of total equity shares after expansion program

A lterna tive 1 A lterna tive 2 A lterna tive 3
Existing no. of shares 1,00,000 1,00,000 1,00,000
Add: issued under expansion program 7,500 5,000 3,000
Tota l no. of equity sha res 1,07,500 1,05,000 1,03,000

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