Chapter 1 Scope and Objective of Financial Management Page No.1.

1
Exam M12 N12 M14 M15 N16 M17 N17 M18 M19 N19
Marks 4 4 4 4 4 4 4 4 2 3

Q1.Explain two Basic aspects/ Q3. What is the interrelation 4. Ignores time pattern of return
functions of Financial Management. between Financing, Investment and 5. Too narrow
[Nov 09,19] Dividend decision? [Nov 2017]
1. Procurement of fund 1. Financing decision Q7. What is Wealth Maximization?
(Least cost, Risk and Control) 2. Investment decision
The value/wealth of a firm is defined
2. Effective utilisation of fund 3. Dividend decision
as the market price of the firm’s
(invest properly and profitably, no stock.
Q4. The two objectives of Financial
fund to be kept idle, return must be Management
greater than cost) a) Profit Maximisation ( Short term)
Q8. Wealth Maximization
b) Wealth maximisation (Long term)
Advantages
1. Considers all future cash flows,
Q2. What are the three Phases of Q5. Profit Maximisation - dividends, earning per share, risk of
Evolution of Financial Management? Advantages a decision etc.
[Nov 02, 09] 1. Primary objective 2. Pay regular dividends
1. Traditional Phase 2. Implied objective 3. Considers risk and recognizes the
Merger, acquisition, takeovers, 3. Growth and development importance of distribution of
liquidations 4. Impact on society returns.
2. Transitional Phase 5. Only profit making firms
day-to-day problems
3. Modern Phase Q9. Wealth Maximization
efficient market, capital budgeting, Disadvantages
Q6. Profit Maximisation –
option pricing, valuation models 1. No clear relationship
Dis-advantages
1. Not an operationally feasible 2. anxiety and frustration
2. Term profit is ‘Vague’
3. Ignores the risk factor.

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 Chapter 1 Scope and Objective of Financial Management Page No.1.2
Q10. . Distinguish between Financial Q12. Explain the role of Finance provision for refund when money is
management and financial accounting Manager in the changing scenario of not required in the business----
[Nov 09] financial management in India deciding most profitable investment
 Occupies key position, in the business----managing the
FM FA  responsible for shaping fortune of fund raised------paying the
Cash flow Accrual system an organisation, returns to the provider of the fund
Future oriented Past oriented  earlier role and new roles,
a. Procurement a. Measurement,  New era brings new challenges, Q15. Financial distress
 role is bigger due to liberalization, 1. There are various factors like –
of fund b. Recognition
deregulation and globalization a. price of the product/service,
b. Effective c. Disclosure
demand, price
utilisation Q13. Emerging issues affecting the b. Proportion of debt
role of CFO [ May 2014, Nov 2016] c. short term and long term
Q11. Functions of Finance Manager MT- RT RT RT GSS creditors
or CFO 1. Regulation- 2. If all the above factors are not
[ May 10, Nov 11] 2. Technology managed by the firm, it can create
[Hint- our index of FM syllabus] 3. Risk- situation like distress,
1. Estimating requirement of the 4. Transformation 3. Financial distress is a position where
fund 5. Reporting- the cash inflows of a firm are
2. Financial negotiation 6. Talent and capabilities- inadequate to meet all its current
3. Performance evaluation 7. Globalisation- obligations.
4. Capital structure decision 8. Stakeholder management-
5. Investment decision 9. Strategy- Q16. Insolvency-
6. Risk management 1. Now if the distress continues for
7. Dividend decision the long time,
8. Cash Management Q14. What do you understand by 2. Revenue is inadequate to revive
9. Market impact analysis Finance Function the situation firm
raising of fund----deciding the 3. Inability of a firm to repay
cheapest source of finance---- various debts
utilisation of fund-------

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 Chapter 1 Scope and Objective of Financial Management Page No.1.3
Q17. Agency problem Self-Notes :-
1. Separation between
owner/shareholders and
managers
2. Managers may try to maximise
their individual goals like salary,
perks etc.

Q18. Agency cost

1. Agency cost is the addition cost
borne by the shareholders to
monitor the manager and control
their behaviour
a. Monitoring
b. Bonding
c. Opportunity
d. Structuring

Q19. Solution to agency problem

1. Compensation is linked to profit
2. Aligning with objective of
shareholders

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 Chapter 2 Types of Financing Page No. 2.1
Q1.Features of equity shares 1. Long-term funds may also be 5. Low admin cost
1. Permanent capital provided by accumulating the
2. No liability for cash outflows profits
3. Right to elect board of directors 2. Increase the net worth Q6. What do you understand by
4. Redeemed only in case of 3. Increases the debt borrowing Bonds? What are the different types
liquidation capacity of Bond
5. Provides a security to other 4. This is a form of internal cash Bond is fixed income security created
suppliers accrual. to raise fund.
6. Costliest but least risky 5. A public limited company must Types of Bond-
7. Not obliged legally to pay plough back a reasonable keeping in 1. Callable bonds: A callable bond has
dividends view the legal requirements a call option which gives the issuer
8. Cost of ordinary shares is higher the right to redeem the bond
9. Increases company’s financial base before maturity at a predetermined
Q4. Salient features of term loan
1. Issued for Long term price known as the call price
Q2. Features of preference share 2. Puttable bonds: Puttable bonds give
2. Low cost
capital the investor a put option (i.e. the
1. Hybrid security because it has 3. Tax deductible
right to sell the bond) back to the
features of both ordinary share 4. Low admin cost company before maturity
capital and bonds. 5. Interest depend on credit rating
2. No dilution in EPS Q7. Masala Bond
6. Can put nominee director
3. There is leveraging advantage 1. It is an Indian name used for Rupee
4. The preference dividends are fixed denominated bond that Indian
Q5. What are the features of
and pre-decided corporate borrowers can sell to
Debentures? Or,
5. There are no voting rights investors in overseas markets
Financing a business through
2. Issued outside India but
borrowing is cheaper than using
equity denominated in Indian Rupees
Q3. Retained earnings/ explain the 1. Low cost 3. First issued by NTPC for 2000
term ‘Ploughing back of Profits’. 2. Tax deductible crore.
What do you understand by internal 3. No control dilution
cash accruals 4. Finance leverage
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 Chapter 2 Types of Financing Page No. 2.2
Q8. Municipal Bonds Equity or Debt securities of highly 7. Exist routes
used to finance urban infrastructure risky ventures with a potential of 8. place on the Board of Director
are increasingly evident in India success.
Q14. What is debt securitization?
Q9.Government bond or treasury bond Q12. Method of venture capital Explain the basics of debt
These bonds issued by Government of financing securitisation process ?
India, Reserve Bank of India, any state 1. Equity Financing (does not exceed 1. Debt securitization is a process of
potential of success 49%) transformation of illiquid assets
Government or any other Government 2. Conditional loan (No interest, only 2 into security, which may be
department and 15 per cent Royalty) traded later in open market
3. Income note: (features of both 2. It is a method of recycling of funds
conventional loan and conditional 3. Assets generating steady cash flows
Q10. Explain Bridge Finance
loan.) are packaged together and against
1. Short term financing, because of
4. Participating debenture this asset pool, market securities
pending disbursement,
a. In the start-up phase no interest can be issued, e.g. housing finance,
2. Hypotication against movable assets
is charged auto loans, and credit card
3. High interest cost
b. Next stage a low rate of interest receivables. e.g. housing finance,
4. Repaid out once proceed is received
c. After that, a high rate of auto loans, and credit card
interest receivables
Q11. What do you understand by
Venture capital financing? What are Q15. Process of securitization
Q13. Discuss the factors that a
1. The origination function – A
the methods of venture capital venture capitalist should consider
borrower seeks a loan from a
financing? [Nov 2002, 08, May before financing any risky project.
finance company
2005,13] 1. Quality of the management team
2. The pooling function – Similar loans
2. Technical ability of the team
1. The venture capital financing refers on receivables are clubbed together
3. Technical feasibility of the new
to financing of new high risky to create an underlying pool of
product.
venture promoted by qualified assets
4. Risk involved
entrepreneurs who lack experience 3. The securitization function – SPV
5. Market for the new product.
and Fund. will structure and issue securities
6. Capacity to bear risk or loss
2. VC make investment to purchase on the basis of asset pool
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 Chapter 2 Types of Financing Page No. 2.3
Q16. Advantages of Debt 3. Maturity may range from 7days- 1 or Irrevocable Letter of Credit
Securitization year. 3. liquidated within 180 days from
1. Method of recycling of funds 4. Issued in multiple of 5 lakh the date of its commencement by
2. The asset is shifted off the Balance 5. Only high rated corporate negotiation of export bills or
Sheet borrowers can issue Commercial receipt of export
3. Converts illiquid assets to liquid paper
Q21. What are the different types
portfolio
Q19. Conditions are eligible to issue of packing credits
4. Better balance sheet management
commercial paper. a. Clean packing credit -advance
5. Credit rating enhances
1. tangible net worth of the company made available to firm export order
is Rs. 5 crores or more
Short term sources 2. Working capital limit is not less
or a letter of credit without
exercising any charge
of finance than Rs. 5 crores b. Packing credit against
3. Necessary credit rating hypothecation of goods -
Q17. Name few instruments of Short
4. Minimum current ratio of 1.33:1 pledgeable interest and the goods
term finance
5. Listed on one or more stock are hypothecated to the bank as
1. Trade Credit
exchanges security
2. Advances from Customers
6. All issue expenses shall be borne by c. Packing credit against pledge of
3. Bank Advances:
the company goods
4. Accrued Expenses and Deferred
d. E.C.G.C. guarantee
Income
Finance related to e. Forward exchange contract –

Q18. What is Commercial Paper?

Export- f. exporter should enter into a
forward exchange contact with the
What are its features? Explain the Pre-Shipment bank,
eligibility criteria for issue of
commercial paper
Finance Q22. Post shipment packing credits
1. It is an Unsecured money market Q20. What do you understand by Banks provide finance to exporters by
instrument packing credits purchasing export bills drawn payable
2. Vaghul working group 1990 made 1. Advance for buying goods and at sight or by discounting usance
recommendation for criteria of capital equipment to the exporter export bill covering confirmed sales
issue 2. Advance given against Export order and backed by documents including

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 Chapter 2 Types of Financing Page No. 2.4
documents of title of goods such as Q26. Secured Premium Notes Q29. International Financing
bill of lading, post parcel receipt, or 1. Secured Premium Notes is issued 1. External commercial Borrowings
air consignment notes. along with a detachable warrant (ECB)
2. Redeemable after a notified period 2. Euro Bonds:
Q23. Certificate of Deposit (CD)
of say 4 to 7 years. 3. Foreign Bonds:
1. Document of title similar to a time
3. Tradable instrument whereby 4. Medium Term Notes
deposit receipt
investor gets right to apply for 5. Euro Convertible bond
2. No prescribed interest rate on such
equity share 6. Fully Hedged Bonds
funds
7. Euro Commercial paper
3. Banker is not required to encash the Q27. Deep discount bonds (DDB) 8. Foreign currency Options:
deposit before maturity 1. It is issued by IDBI 9. Foreign Currency Futures
4. He can sell the CD in secondary 2. Deeply discounted
10. Floating Rate Notes (FRN):
market. 3. No interest is paid during lock-in
period Q30. American Depository Receipts
Q24. Public Deposits
4. IDBI was first to issue DDB in (ADR)
1. Deposit from public
January 1992 with maturity period 1. These are securities offered by
2. Max 35% of paid up share capital &
of 25 years. The bond was issued non-US companies who want to list
reserves
for 2,700 with face value of on any of the US exchange
3. Accepter for 6M to 3 Years
1,00,000. 2. ADR represents a certain number of
4. Raised mainly for working capital
a non US company’s regular shares
Q28. Zero Coupon Bonds 3. ADRs are issued by an approved
Q25. Seed capital assistance’
1. No interest is paid till maturity. New York bank or trust company..
1. Scheme of IDBI
2. It is deeply discounted 4. ADRs goes through US brokers,
2. Professionally qualified
3. Difference between issue price and Helsinki Exchanges and DTC as well
entrepreneurs
redemption value represents as Deutsche Bank
3. Max 2cr project cost
interest 5. The most onerous aspect of a US
4. Max loan is 50% of owner’s
4. Indexation and concessional tax listing for the companies is to
contribution or 15 Lakh which is low
rate provide full, half yearly & quarterly
5. Initially no interest but service
5. Lesser lock-in compared to DDB accounts to Security Exchange
charge of 1%, moratorium period 5
Years. Commission USA.

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 Chapter 2 Types of Financing Page No. 2.5
Q31. Global Depository Receipts Factoring involves provision of payment
(GDR) specialized services relating to credit 5. Notified factoring- Debtor is
1. Represents the share of Non- US investigation, sales ledger management informed about arrangement
based company purchase and collection of debts, 6. Non-Notified factoring- Debtor is
2. GRDs are created when local credit protection as well as provision of not informed about arrangement
currency share of Indian company finance against receivables and risk
are delivered to the depository’s bearing.
local custodian bank, against which
depository receipts are created in Q34. Advantages and Limitations of
US$. factoring
3. GDRs may be freely traded like any Advantages:
other dollar denominated security 1. Firm can convert accounts
4. Advantage over debt as there is no receivables into cash
repayment of principal 2. Steady pattern of cash inflows.
5. Indian companies have preferred 3. Virtually eliminates the need for the
the GDRs to ADRs credit department
4. Relieving the borrowing firm of
Q32. Indian Depository Receipts (IDR) substantially credit and collection
1. The concept of the depository costs.
receipt mechanism which is used to Limitations: Cost of factoring is
raise funds in foreign currency has generally higher
been applied in the Indian Capital
Market through the issue of Indian Q35. What are the types of Factoring
Depository Receipts (IDRs). 1. With recourse- Bad debt borne by
2. IDRs are similar to ADRs/GDRs the client
3. The IDRs are listed and traded in 2. Non-recourse/ full factoring- Bad
India in the same way as other debt borne by Factor
Indian securities are traded. 3. Maturity factoring- factor pays to
the client on guaranteed date
Q33. What is factoring 4. Advance factoring- 80% per-

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 Chapter 2 Types of Financing Page No. 2.6
5. It is nothing but a loan in disguise Q5. Sale Aid Lease
Lease Financing 1. Lessor enters into a tie up with a
Most Important Q4. DIFFERENCE BETWEEN manufacturer for marketing the
FINANCIAL LEASE AND OPERATING latter’s product through his own
LEASE leasing operations, it is called a
Q1. What is lease
Ownership- sales-aid lease
Leasing is a general contract between
Financial Lease- The risk and reward 2. The manufacturers may grant either
the owner and user of the asset over a
incident to ownership are passed on to credit or a commission to the lessor
specified period of time.
the lessee 3. Lessor earns from both sources
Operating Lease- Risk incident to
Q2. Significant Features of Operating
ownership belong wholly to the lessor. Q6. Leveraged Lease
Lease
Risk of Obsolescence- 1. Under this lease, a third party is
1. Does not secure for the lessor the
Financial Lease-Lessee bears the involved beside lessor and lessee.
recovery of capital outlay plus a
risk 2. The lessor borrows a part of the
return on the funds
Operating Lease-lessor bears the risk purchase cost (say 80%) of the
2. Cancellable with proper notice
Cancellable- asset from the third party.
3. Shorter than the asset’s economic
Financial Lease- non-cancellable by 3. The lender is paid off from the
life
either party lease rentals directly by the lessee
4. Lessee is obliged to make payment
Operating Lease- the lease is kept and the surplus after meeting the
until the lease expiration
cancellable by the lessor claims of the lender goes to the
Repairs and Maintenance- lessor.
Q3. Finance Lease (Capital Lease)
Financial Lease- Lessee bear the cost 4. The lessor is entitled to claim
Meaning and Significance
of repairs maintenance or operations. depreciation allowance.
1. A financial lease is longer term
Operating Lease- lessor bears cost of
2. It is generally non-cancellable or
repairs, maintenance or operations. Q7. Sale and Lease back
cancellable at high penalty
Covering cost of asset- 1. The owner of an asset sells the
3. Equipment is leased for the major
Financial Lease- Covers cost + Return asset to a party (the buyer), who in
part of its useful life.
Operating Lease- Does not cover full turn leases back the same asset to
4. Lessee has the right to use the
cost the owner in consideration of a
equipment while the lessor retains
legal title lease rentals.

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 Chapter 2 Types of Financing Page No. 2.7
2. The asset is not physically (5) Obsolescence and Disposal:
exchanged but it all happen in (6) Restrictive Conditions for Debt
records only. Financing:
3. Also, Lessee can satisfy himself
completely regarding the quality of
an asset. Q10. Limitations of Leasing
4. Under this transaction, the seller 1. The lease rentals become payable
assumes the role of lessee and the immediately and no moratorium
buyer assumes the role of a lessor. period is permissible
2. Default in payment by the lessor
leads in seizure of assets by banks
Q8. Close-ended and Open-ended causing loss to the lessee.
Leases 3. Lease financing has a very high cost
In the close-ended lease, the assets
get transferred to the lessor at the
end of lease, the risk of obsolescence,
residual value etc., remain with the
lessor being the legal owner of the
asset.
In the open-ended lease, the lessee
has the option of purchasing the asset
at the end of the lease period.

Q9. Advantages of Leasing- Exam

November 2018
(1) Lease may be low cost
alternative:
(2) Tax benefit:
(3) Working capital conservation:
(4) Preservation of Debt Capacity:
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 Chapter 2 Types of Financing Page No. 2.8
Q3. Various purposes of cash budgets collection centres are deposited
Cash Management- 1. Plan for and control cash receipts with their respective local banks ,
Theory from Chapter 10 and payments. which in turn transfer to head
(WCM) 2. Identifies the period(s) of shortage office.
of cash or an abnormally large cash
Q1. What is the meaning of Treasury
3. To take advantage like cash Q16. Lock Box System
management and key Goals
discounts 1. A lock box arrangement usually is on
Treasury management is defined as ‘the
4. Plan/arrange adequately needed regional basis which a company
corporate handling of all financial
funds chooses according to its billing
matters’
patterns.
key goals of treasury management
Q4. Different Kinds of Float with 2. Eliminate the time between the
are:-
Reference to Management of Cash receipts of remittances by the
a. Maximize the return on the
1. Billing Float- The time between the company and deposited in the bank.
available cash;
sale and the mailing of the invoice
b. Minimize interest cost on Q17. Virtual Banking & its advantages
2. Mail Float- time when a cheque is
borrowings; Virtual banking refers to the provision
being processed by post office
c. Mobilise cash for corporate of banking and related services through
3. Cheque processing float- time
ventures the use of information technology
required for the seller to sort,
d. Reduce the risk of currency Advantages:
record and deposit the cheque
fluctuation a. Lower cost of handling a
4. Bank processing float-time from
the deposit of cheque to crediting transaction.
Q2. Functions of Treasury Department
of funds in the seller’s account b. Increased speed
a. Cash Management: c. Lower cost of operating branch
b. Currency Management: d. Improved and a range of services
Q15. What is Concentration Banking?
c. Fund Management e. Rapid, accurate and convenient.
1. Establishes a number of strategic
d. Banking:
collection centres in different
e. Corporate Finance Q18. Three principles relating to
regions instead of a single collection
2. Reduces the period between the selection of marketable securities
time a customer mails in his a. Safety:
remittances b. Maturity:
3. Payments received by the different c. Marketability:
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 Chapter 2 Types of Financing Page No. 2.9
Q19. Advantages of Electronic Cash 3. Holding cost is known and it is Q22. MAXIMUM PERMISSIBLE BANK
Management System constant. FINANCE (MPBF)- TANDON
a. Significant saving in time. 4. Transaction cost also remains COMMITTEE
b. Decrease in interest costs. constant. The Tandon Committee set by RBI
c. Less paper work. C= (2AT/H)1/2 suggested three lending norms which
d. Greater accounting accuracy. are as follows:
e. Supports electronic payments. Q21. Miller – Orr Cash Management Lending Norms
f. Faster transfer of funds from one Model I. MPBF = 75% of [Current Assets
location to another, where required. 1. According to this model the net Less Current Liabilities] i.e. 75%
g. Speedy conversion of various cash flow is completely stochastic. of Net Working Capital
instruments into cash. 2. When changes in cash balance occur II. MPBF = [75% of Current Assets]
h. Produces faster electronic randomly, the application of control Less Current Liabilities
reconciliation. theory serves a useful purpose. III. MPBF = [75% of Soft Core
3. When the cash balance reaches the Current Assets] Less Current
Q20. Baumol’s Model of Cash upper limit, the transfer of cash Liabilities
Management and also write its equal to ‘h – z’ is invested in
assumptions marketable securities account The salient features of new credit
a. Developed a model for optimum cash 4. When it touches the lower limit, a system were:
balance which is used in inventory transfer from marketable securities a. For borrowers with requirements of
management account to cash account is made. upto Rs. 25 lakhs -without going into
b. Trade-off between cost of holding During the period when cash balance detailed evaluation.
cash stays between (h, z) and (z, 0) b. For borrowers with requirements
c. The two opposing costs are equal 5. These limits satisfy the demands above Rs. 25 lakhs, but upto Rs. 5
and where the total cost is minimum. for cash at the lowest possible total crore- 20% of the projected gross
The model is based on the following costs. sales of the borrower.
assumptions: c. For borrowers not falling in the
1. Cash needs of the firm are known above categories, the cash budget
with certainty. systems may be used to identify the
2. Cash is used uniformly and it is also working capital needs.
known with certainty.

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Chapter 6 Leverage Page No. 6.1
Chapter 6- Leverage
Particular Operating leverage Finance leverage Combined leverage
Or Or Or
Degree of Operating Degree of Finance leverage Degree of Combined
leverage or leverage
or DFL or
DOL DCL
Advantage of Taking The Advantage of Taking The Advantage of Taking The Advantage of
What? Operational Fixed Cost Fixed Financial Obligation both Operational Fixed
(Fixed cost) (Interest and Preference Cost and Fixed Financial
dividend) Obligation
What does it Signifies that for every 1% Signifies that for every 1% Signifies that for every
signifies change in sale there will be change in EBIT there will be 1% change in sale there
(1x OL)% change in EBIT (1x FL)% change in EPS will be
(1x CL)% change in EPS
Formula No. 1 DOL = Contribution DFL = EBIT DCL = Contribution
EBIT EBT- PD EBT- PD
(1-t) (1-t)

When to use the When Data is given for Single years

formula?
Formula No. 2 DOL = % Change in EBIT DFL = % Change in EPS DCL = % Change in EPP
% Change in Sales % Change in EBIT % Change in Sales
When to use the When Data of two years is Given
formula?
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Chapter 6 Leverage Page No. 6.2

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Chapter 6 Leverage Page No. 6.3
Class room Key Notes
1 Operating leverage- ‘‘firm’s ability to use fixed operating costs to magnify the effect
of changes in sales on its earnings before interest and tax.’’

2 It implies that 1% change in Sales will lead to (1x OL %) change in EBIT. And decrease
in EBIT by 1% will lead to fall in EBIT by (1x OL %)

3 Financial leverage ‘ability of the firm to use fixed financial charges (like
interest) to magnify the effect of changes in EBIT/ Operating profits, on the firms
EPS.’

4 It implies that 1% change in EBIT will lead to (1x FL %) change in EPS. And decrease
in EBIT by 1% will lead to fall in EPS by (1x FL %)

5 It shall be noted that in case of preference dividend it shall be treated as fixed

financial Obligation before tax

4 DOL measures the impact of change in sales on EBIT. DFL measures the impact of
change in EBIT on EPS. DCL measures the combined impact.
It measures the impact of Sales on EPS. If DCL is 2 times, it implies that a 10%
increase in sales would lead to 20% increase in EPS

5 If in the question two Variables are missing. For example Interest is given and FL is
given but both EBIT and EBT are missing, convert two missing variable into one by
Converting EBT as EBIT- Interest. This will give you EBIT and accordingly you will
calculate EBT (Refer question 2 of Self-Practice) and (Question 3 of Class work)

6 DOL, DFL and DCL can not be less than 1, if it is less than one then take reciprocal of it
(Q.7 of Self practice).( the point is not correct logically, but we will do this if this
typicality appears in question)

7 Positive Finance means where ROI > Kd

8 When the company is able to increase its output substantially then leverage acts as
Advantage, but when if output gets lowered it acts as Risk

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Chapter 6 Leverage Page No. 6.4
Theory Questions
Trading When ROCE is greater than interest rate-
on DFL is said to be favourable when the firms earns more on its total investment
Equity compared to what it has to pay towards debt capital. In other words, when ROCE > rate
of interest on debt.
This is because shareholders gain in situation when the company earns higher return
and pays a lower return to suppliers. Financial leverage in such case is called as trading
on equity.
The gain enjoyed by shareholders is due to
 Return on investment is more than the effective (post- tax) cost of debt.
 Reduction in number of shares issued due to use of debt funds.
When ROCE is less than interest rate-
If the return on investment is less than the rate of interest, shareholders will suffer.
This is because their earnings fall more sharply than fall in return on investment. This
is because fixed interest cost is to be met irrespective of level of EBIT. In such case
high DLF will be dangerous.
Double edged Sword’
IF ROCE> interest cost then DFL should be kept high, other lower DLF is
justifiable.

IMP Practical Questions

Q1. Alpha limited has the following Balance sheet and income statement
Balance sheet
Liabilities Amount Assets Amount
Equity capital (10/share) 8,00,000 Net fixed assets 10,00,000
10% debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Income statement
Particulars Amount
Sales 3,40,000
Operating expense ( including depreciation 60,000) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
EBT 1,60,000
Less: Tax 56,000
EAT 104,000

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Chapter 6 Leverage Page No. 6.5
a) Determine the degree of operating leverage, Degree of Finance leverage, Degree of
combined leverage at the current level of sales, if all the expense other than depreciation is
variable.
b). If total assets remains same but sales increases by 1) 20% and 2) decreases by 20%, what
will be EPS at new sales level
Quick Revision
Q2. Z Limited is considering the installation of a new project costing Rs. 80,00,000. Expected
annual sales revenue from the project is Rs. 90,00,000 and its variable costs are 60 percent of
sales. Expected annual fixed cost other than interest is Rs. 10,00,000. Corporate tax rate is 30
percent. The company wants to arrange the funds through issuing 4,00,000 equity shares of Rs.
10 each and 12 percent debentures of Rs. 40,00,000. You are required to:
(ii) Determine the likely level of EBIT, if EPS is Rs. 4, or Rs. 2, or Zero.
Quick Revision
Q3. A firm has sales of 75,00,000 variable cost 56% and Fc 6,00,000. It has debt of 45,00,000 at
9% and equity of 55,00,000
Your are required to calculate:
a) ROI of the firm
b) Does it have the positive financial leverage
c) If the firm belongs to an industry whose capital T/O ratio is 3, does it have high or low
capital T/O ratio?
d) What are the OL, FL and CL of the firm?
e) If sales if increased by 10%, by what % will EBIT increase?
f) At what level of sales EBIT will be equal to zero?
g) If EBIT is increased by 20%, by what % EBT will increase?

Q4 The following summarizes the % change in Sales and % Change in Operating income and Betas so
four Pharma companies.
Firm % change in revenue % change in Income Beta
A 27% 25% 1
B 25% 32% 1.15
C 23% 36% 1.3
D 21% 40% 1.4
Calculate the DOL of each firm and comment why the betas of the firms are different.
Solution
DOL= % Change in Income / % Change in Sales

Firm % change in revenue % change in Income Beta DOL

A 27% 25% 1 0.9259
B 25% 32% 1.15 1.28
C 23% 36% 1.3 1.5652
D 21% 40% 1.4 1.9048

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Chapter 6 Leverage Page No. 6.6

Beta Signifies the risk and DOL also signifies the risk, hence Higher the Beta Higher is The
DOL. Since the OL is high in D Ltd., its β is also ↑

Q5 Calculate the OL and FL under situation A, B and C in each of the given situation I, II and II.
Also find out the combination of OL and FL which gives highest and lowest value
Installed capacity 1,200
Actual production and sales 8,00
SP/unit 15
VC 10
FC situation 1 1000
FC situation 2 2000
FC situation 3 3000

Particulars Financial plan

Capital structure I II III
Equity 5000 7500 2500
Debt ( 12% Kd) 5000 2500 7500

Solution
Sales = SP * Unit = 15 * 800 = Rs. 12,000
VC = VC/unit * Units = 10 * 800 = Rs. 8,000

Statement showing Calculation of DOL and DFL

Particular SAP I SAP II SAP III SBP I SBP II SBP III SCP I SCP II SCP III
Sales 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000 12,000
- V.C 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000 8,000
Contri. 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000
FC 1,000 1,000 1,000 2,000 2,000 2,000 3,000 3,000 3,000
EBIT 3,000 3,000 3,000 2,000 2,000 2,000 1,000 1,000 1,000
Int. 600 300 900 600 300 900 600 300 900
EBT 2,400 2,700 2,100 1,400 1,700 1,100 400 700 100
OL 1.33 1.33 1.33 2 2 2 4 4 4
FL 1.25 1.11 1.42 1.42 1.17 1.818 2.5 1.428 10

Conclusion:
Situation A: Plan II gives lowest OL & FL
While Situation C, Plan III gives highest OL & FL

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Chapter 4 Cost Of Capital Page No. 4.1
Particular Formula Equity Share capital
Debt and term loan As per Dividend Ke = D
Cost of Interest (1-tax) + (RV- NP)/n Price Approach- P0
redeemable debt (RV+NP)/2 with Zero Growth
Cost of Interest (1-tax) As per Dividend Ke = D1 + g
Irredeemable Net proceed of the issue Price Approach- P0
debt with Growth
Cost Of Term Interest (1-t) As per Dividend Ke = D1 +g
Loan Price Approach- P-F
Cost of Interest (1-tax) + (RV- NP)/n (1-t) with Growth and
redeemable debt (RV+NP)/2 Flotation cost
With Capital Gain tax As per Dividend Ke= D1 +g
– Special case Price Approach- P0 (1-f)
CMP is to be used when question mentions the word with Growth and
current Market price Flotation cost in %
As per Earning Price Ke = E
Preference Share Approach- with NO P0
Cost of Preference Dividend + (RV- NP)/n Growth
redeemable (RV+NP)/2 As per Earning Price Ke = E1 + g
Preference Share Approach- with P0
Cost of Preference dividend Growth
Irredeemable Net proceed of the issue CAPM Ke= Rf + (Rm-Rf) β.
Preference Share Where, Rf = Risk Free rate
CMP is to be used when question mentions the word Rm= Market risk
current Market price (Rm-Rf) = risk premium
Special Note:- In the above formulas, it is the
amount of interest and not the percentage of Retained Earnings
interest Cost of Retained Ks= Ke
earnings

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Chapter 4 Cost Of Capital Page No. 4.2
Cost of Retained Ks= Ke-tp value of equity share
earnings- under Or capital.
personal tax Ke x (1-t) x (1-tp) 4. Thus we need to divide
the value of Equity in two
Growth formula Steps to be followed: parts- Share capital and
1. Take the number on your calculator reserve and surplus using
2. Press the root button 12 times book value as weight
3. Subtract 1 from it
4. Divide by the root you wanted. If 5. No of share x price
suppose u wanted 5th root divide it
by 5 Equity Retained earnings
5. Add 1 (Ke) (ks/Kr)
6. Press ‘x’ ‘=’ 12 times Using Book value as weight
7. Subtract 1 and press 100
Growth formula- Growth (g) = b x r Calculation of WACC using Book value
Only for Gordon r = rate of return on the fund
b = earnings retention ratio/ rate or Market Value as weight
Particular Cost Capital Weight WACC
Equity Ke Xx W1 Ke x W1
Weighted Average Cost of capital
Pref. sh. Kp Xx W2 Kp x W2
Book Value Weight Market Value Weight Ret. Eng. Kr or Ks Xx W3 Ks x W3
1. Derived From Book 1. Derived From values in Debt Kd xx W4 Kd x W4
value the market. Ko = WACC
2. Retained earnings are 2. Can be calculated by
Available at Book value multiplying Note:
3. Data is Available from number of securities x 1. capital May be book value or Market value but will be
Balance sheet price per security specified in question
3. Retained earnings are not 2. Also, Note that a single table with 3 additional column
available directly. Rather can be used to solve question with both Book value and
they are hidden in the Market Value as weight

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Chapter 4 COST OF CAPITAL Page No. 4.3
Class room Key Notes
1 Generally Ke= Ks. However if there is new issue of equity then the issue will involve
Flotation cost. This flotation cost is not involved in case of retained earnings thus the
effective cost of retained earnings is generally less than cost of equity share capital.

2 When the question does not mentions anything about redemption then assume the
security to be irredeemable.

3 Value of the debenture = (coupon / rate in market ). This is used to find market
Price of debenture

4 Whenever there two prices given then make use of the price which is more realistic
and precise in its meaning. For example if it is said that the equity is quoted at 130 in
market however the fresh issue will can be brought at 125 per share and 5 as flotation
cost, use 125 as price to calculate the cost after taking into account the effect of
Flotation cost.

5 While using MV as weight, divide the market capital between equity capital and
Retained earnings in the ration of BV. Generally Ke= Ks. However if there is new issue
of equity then the issue will involve flotation cost. This flotation cost is not involved in
case of retained earnings thus the effective cost of retained earnings is generally less
than the cost of equity share capital. And thus for different cost different weights
are to be assigned. As in MV there is no weights available for RE the best way to
apportion weight is using the base of BV.

6 Cost of retained earnings = Ke x (1-tp) x (1-b) [b= brokerage/other costs]

7 If the Question mentions about Marginal cost they are talking about the extra capital
only and not total capital. Which means if question asks only about marginal cost of
capital, ignore previous capital and consider new cost and new weights.
If question mentions about additional capital and does not say Marginal cost, then
consider entire capital (NEW+ OLD)

8 In the questions where flotation cost is given and Both MP and Par value is given,
institute has considered par value and flotation cost.

9 The marginal cost of capital may be defined as the cost of raising an additional rupee

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Chapter 4 COST OF CAPITAL Page No. 4.4
of capital

10 Net proceeds means the price which we will get after issuing the security in the market
Generally it is the CMP prevailing in the Market

11 In the formula of Int (1-t ), it is the amount of interest and not the % (Q5 of self
practice

12 Institute calculated flotation cost always on face value. We need to follow same
practice unless mentioned otherwise. ( See Que 2 of solved section, for exception)

13 The question may be asked to calculate WACC using BV as weight or MV as weight

in both the cases COST OF EACH SCOURCE OF FINANCE (Kd, Ke, Kr, Kp) will
remain Constant. Only weight changes. COST will remain same unless there is any
change given in question

14 If the question (in remotest case) asks about capital gain tax on redemption of
Debenture or preference share capital, then use the formula 4 given in chart.

15 g= b x r
[ b= retention ratio; r = rate of return] [ this formula is mostly used in Ch. 9]

Self-Notes

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Chapter 4 COST OF CAPITAL Page No. 4.5
IMP Practical Questions

Q1. XYZ Ltd. is currently earning a profit after tax of Rs.25,00,000 and its shares are quoted in
the market at Rs.450 per share. The company has 1,00,000 shares outstanding and has no
debt in its capital structure. It is expected that the same level of earnings will be maintained
for future years also. The company has 100 per cent pay-out policy.
Required:
1. Calculated the Cost of equity
2. If the company’s pay-out ratio is assumed to be 70% and it earns 20% rate of return on
its investment, then what would be the firm’s cost of equity?
Quick Revision:

Q2. Determine the WACC of Best luck limited using Book value and Market value as weights
Source of capital Book value Market Value
Equity share capital 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference share 36,00,000 33,75,000
Debentures 9,00,000 10,40,000
Additional information
a Equity shares are quoted at Rs. 130 and a new issue is priced at Rs. 125/ share; flotation
costs are 5 per share.
B Dividend during the previous 5 years has steadily increased from 10.6 to 14.9 per share.
Dividend at the end of C.Y is expected to be 15.
C 15% preference share with FV of 100 would realize 105 per share.
D The company proposes to issue 11 years 15% debentures but the yield on similar maturity and
risk class is 16%. Flotation cost 2%.
e Tax rate 35%
Quick Revision:

Q3 The capital structure of Modi limited is given below.

9 % debenture 2,75,000
11% preference share 2,25,000
Equity share ( FV 10 per share) 5,00,000
Additional information
a Rs. 100 per debenture redeemable at par has 2% flotation cost and 10 years maturity. Market
price of debenture is 105
b Rs. 100 preference share redeemable at par has 3% flotation cost and 10 years maturity.
Market price of debenture is 106
c Equity share has flotation cost of 4 and MV of the share is 24. Expected dividend next year is

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Chapter 4 COST OF CAPITAL Page No. 4.6
2 and the annual growth rate is 5%. Firm has practice of paying all the earnings in the form of
dividends.
d Corporate rate of tax is 35%.
You are required to calculate the WACC using MV as the weights.
Solution
Statement of WACC of Modi Limited
Particulars Cost MV Weight WACC
Equity Shares 15% 12,00,000 0.6947 10.42
11% Pref. shares 11.47% 2,38,500 0.1381 1.58
9% 6.11 2,88,750 0.1672 1.02
Total 13.02

a WN for Calculation of Cost of Equity:

Ke = D1/PO + g
= ( 2/ 24-4) + 5%
= 15%
b WN for Calculation of Cost of Debt:
Cost of Debt (Kd) = I (1-t) +(RV – NP)/ n
(RV + NP)/2
= 9 ( 1- 0.35) + (100 – 98)/ 10
( 100 + 98)/ 2
= 6.11%

C WN for Calculation of Cost of Preference share:

Cost of Pref. Share (Kp) = PD + (RV – NP)/n
(RV + NP)/ 2
= 11 + ( 100- 97)/ 10
( 100 + 97)/ 2
= 11.47 %
Quick revision

Q4. A Ltd. wishes to raise additional finance of Rs. 30 lakhs for meeting its investment plans. The
company has Rs. 6,00,000 in the form of retained earnings available for investment purposes
The following are the further details:
a Debt equity ratio - 30 : 70
b Cost of debt - at the rate of 11 % (before tax) upto Rs. 3,00,000 and 14% (before tax)
beyond that.
c Earnings per share - Rs. 15.
d Dividend payout - 70% of earnings.

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Chapter 4 COST OF CAPITAL Page No. 4.7
e Expected growth rate in dividend - 10%.
f Current market price per share - Rs. 90.
Company's tax rate is 30% and shareholder's Personal tax rate is 20%.
You are required to :
a) Calculate the post-tax average cost of additional debt.
b) Calculate the cost of retained earnings and cost of equity.
c) Calculate the overall weighted average (after tax) cost of additional finance
Solution

a Calculation of Debt, equity and Retained earnings

Total Capital = 30,00,000
Debt: Equity ratio = 30:70
Therefore Debt = 9,00,000
Of which 3,00,000 is raised at 11%
And remaining 6,00,000 is raised at 14%
Equity = 21,00,000
Retained earnings = 6,00,000 And Fresh issue = 15,00,000
b Calculation of cost of Equity, Retained Earnings, 11% debt and 14% debt

E = 15, Payout ratio = 70%

i WN for Calculation of Cost of Equity: Do = 10.5
Ke = D1/PO + g D1 = Do (1+g)
D1= 10.5 (1+0.1)
Ke = 11.55 /90 + 10%
D1 = 11.55
= 22.83%

ii WN for Calculation of Cost of retained earnings

Kr or Ks = Ke (1-tp)
= 22.83 x (1-0.2)
= 18.264

iii WN for Calculation of Cost of 11% Debt:

Cost of 11% Debt (Kd) = I (1-t) / Np
= [3,00,000 x11% (1-0.3) ]/3,00,000
= 7.7%

vi WN for Calculation of Cost of 14% Debt:

Cost of 14% Debt (Kd) = I (1-t) / Np
= [6,00,000 x14% (1-0.3) ]/6,00,000
= 9.8%

V Calculate the post-tax average cost of additional debt.

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Chapter 4 COST OF CAPITAL Page No. 4.8
[7.7% x 3/9] + [9.8 x 6/9]
= 9.1%

Particular Cost Book Value Weight WACC

Equity Share Capital 22.83% 15,00,000 0.5 11.415 %
Retained earnings 18.264% 6,00,000 0.2 3.6528 %
11% Debt 7.7% 3,00,000 0.1 0.77 %
14% Debt 9.8% 6,00,000 0.2 1.96 %
30,00,000 17.797%
Quick Revision
Consider it as D0 (current dividend) and write a note

Q5. R&GLtd has the following capital structure as at 31 December 2015, which is consider
Optimum.
13 % debenture 3,60,000
11% preference share capital 1,20,000
Equity share capital ( 2,00,000 shares) 19,20,000
24,00,000

CMP of the share is 27.75. Expected dividend of next year is 50% of EPS of the year 2015.
The past trend is expected to continue
Year 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015
EPS 1 1.12 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
The company can issue 14% debenture. The company’s debenture is selling at 98. Preference
share can be sold at 9.8 per share paying the dividend of 1.2 per share. Tax rate is 50%

a Calculate the after tax cost of new debt and preference share capital and equity capital
assuming the equity is issued from retained earnings.
b Calculate the marginal cost of capital
c How much can be spent for capital investment before new ordinary shares are sold?
d What will be the marginal cost of capital? If the company can sell additional shares for 20
Solution
i Cost of New debt = Int.(1 – t)/ MP
= 14 (1- 0.5)/ 98
= 7.14% ---------- (1)

ii Cost of New Preference Share = Preference dividend/ MP ÷ NP

= 1.2/ 9.8
= 12.24% ---------- (2)

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Chapter 4 COST OF CAPITAL Page No. 4.9

iii Cost of Equity = (D1/ Po) + g

= (2.773x0.5) / 27.75 + 12% Growth is calculated using CAGR
= 17% ------------ (3) EPS 9 = EPS 1 (1+g) 9

Calculation of Marginal WACC of R&G Limited (MWACC)

Particulars Cost Weight WACC

Equity share Capital 17% 16/ 20 13.59 %
Preference share capital 12.24 1/ 20 0.612
Debentures 7.14% 3/ 20 1.071%
15.28%

iv Also since the company does not want to change, Capital Mix 80% will be financed by
Retained Earnings and remaining 20% by debt and preference share capital.

c) Retained Earning with Company = (EPS – DPS ) * Number of Shares

= (2.773- 1.3865 ) * 2,00,000
= 2,77,200

This 2,77,300 is 80% of new finance. So, Total Capital before issuing new Equity will be
= 2,77,300 / 80%
= Rs. 3,46,625

v Cost of New Equity (Ke) = D1/Po + g

= 1.3865/20 + 12%
=18.9325%
Similarly New Marginal Cost will be 16.827%
Quick Revision

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Chapter 5 Capital Structure Page No. 5.1
Very Important Formulas Capital Structure Theories
Formula  Value of debt x Cost of debt = Coupon 1. Net Income Approach (NI) Approach-
for Value (interest) (Crux- WACC is affected by cap. Structure. Both Ke
of Debt Or and Kd remains constant)
 Value of debt = Interest / cost of debt a) Kd = cost of debt
Value of  Value of Equity x cost of equity = EBT b) Ke is cost of equity
equity (since under this assumption there is no c) Cost of debt Kd is always less than Ke.
tax rate). d) Kd and Ke remains constant at all the levels of debt- equity
mix.
Or
e) This Theory suggests maximum use of cheaper fund, Debt
 Value of equity = EBT/ cost of equity
Value of  Value of the firm = Value of debt +
Traditional Approach
Firm Value of equity
(Crux- WACC is affected by cap. Structure. Both Ke and Kd
Or
changes, with steeper rise in Ke, and thus WACC changes)
 Value of the firm = EBIT/WACC
a) Cost of Debt Kd is always less than cost of equity Ke
These Formulas are used to find value of b) Kd and Ke varies with the change in debt equity mix
the firm. All these 4 Formulas are to be c) Increase in cost of equity is steeper and higher that
used simultaneously increase in cost of debt
EBIT EBIT- I1 (1-t) –PD1 = EBIT- I2 (1-t) – PD2 d) Thus the WACC is affected by change in capital structure
Indifference E1 E2
Where I= Interest Indifference Approach
PD = Preference dividend Net Operating Income Approach
E1 and E2 are no of equity shares (Crux- WACC is not affected by cap. Structure. Both
Financial Interest + PD Ke and Kd changes but in opp. direction and thus
BEP (1-t) WACC remains constant)
Or, a. The market capitalizes the value of the firm as whole.
(x- Int.) (1-t) - PD b. Thus the split between debt and equity is not important.
c. advantage of low cost debt is set off exactly by increase in
Optimum Where EPS under given plans is maximum
equity capitalization rate.
Capital
d. overall cost of capital (Ko) remains constant
Structure

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Chapter 5 Capital Structure Page No. 5.2
Modigliani- Miller Approach (MM) MM approach – 1958 without tax
(Crux- WACC is not affected by cap. Structure. Both Ke Propositions were derived by MM approach
and Kd changes but in opp. direction and thus WACC 1. Value of levered firm (Vg) = Value of unlevered firm (Vu).
remains constant) 2. Value of a firm = Net operating income (NOI)/ Ko
MM Approach is refinement of Net operating income approach. 3. Ke = K0 + (K0 – Kd)x Debt/Equity
The theory is same with some additional propositions.

7 Steps in Calculation of MM Problems under 7 Steps in Calculation of MM Problems under

NO TAX approach WITH TAX approach
Step 1 Calculate/ Find EBIT Calculate/ Find EBIT
Step 2 Find the Value of Equity of Unlevered firm. Find the Value of Equity of Unlevered firm.
Veu= EAT ………...(EBT or EBIT, since no int and tax) Veu= EAT …………………….[ (where EAT= EBIT-int.) –tax]
Ke Ke
Step 3 Value of Equity of Unlevered firm =Value of Value of Equity of Unlevered firm =Value of unlevered firm =
unlevered firm = Value of Levered firm Veu = Vfu
Ve = Vu Since in Ungeared firm there in no debt
Since in Ungeared firm there in no debt Vf= Ve+Vd ……………(since no debt)
Vf= Ve+Vd ……………(since no debt)
Step 4 Find the value of geared firm Find the value of geared firm
Vu = Vg …………………. As per NOI approach Vg = Vu + Tb …………………. As per NOI approach
Tb = tax benefit = amount of debt x rate of tax
Step 5 Vg= Vd+ Veg Vg= Vd+ Veg
Step 6 Keg = EAT or EBT Keg = EAT
Veg Veg
Step 7 Calculation of WACC Calculation of WACC
Kog = (Kd x Weight of debt) + (Ke x Weight of equity) Kog = (Kd x Weight of debt) + (Ke x Weight of equity)

Note Be careful while calculating WACC under tax approach .You may mistakenly take Kd = Interest instead of
Kd= Interest (1-tax)

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Chapter 5 Capital Structure Page No. 5.3
Class room Key Notes
Self-Notes:
1 Financial BEP means an EBIT where EPS is 0

2 Indifference Point :- Indifference means the firm is indifferent to choose any of the
plan. Indifference is to be calculated by taking ONLY 2 plans at a time.

3 Calculation of value of firm value of equity and value of deb.

A It is assumed that there is no preference share that means there is no preference
Dividend
B There exist no corporate tax , however institute consider sometimes tax too

4 Equity capitalisation rate means Ke.

5 Debt capitalisation rate means Kd.

6 Overall capital rate means (Ko) = WACC = Cut off rate

7 Important Terminologies
A 100% equity firm = Unlevered or Ungeared Firm
b Debt : equity mix firm = levered or geared firm
Under NI Approach :- Use 4 formulas of Values of firm, value of debt and value of
equity
 Vd x Kd = Coupon
 Ve x Ke = EAT
 Vf x Ko = EBIT
 Vf = Vd + Ve
•
8 NOI Approach:- MM Approach
Capital structure does not offer WACC ie Ko will remain constant at any level of debt
equity mix
Also if two forms are identical then EBIT will remain constant
Therefore Vf = EBIT/Ko will also remain constant at any level of debt equity mix

9 Some final conclusion (MM approach)

1. Vu = Vg. ..... ( Because EBIT and Ko will remain constant) [NOI Vf = EBIT/Ko]
2. Vu = Veu + Vdu.....( We know that )

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Chapter 5 Capital Structure Page No. 5.4
3. Therefore Vu = Veu.... (No debt )
4. Vg = Veg + Vdg......(we know that)
5. Kou = Keg...... ( NOI Approach )
6. Kou = Keu...... (Because in Ungeared there is no Kd)
7. Therefore Ko= Ke

10 Additional Capital Brings additional Earnings. Unless otherwise mentioned

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Chapter 5 Capital Structure Page No. 5.5
IMP Practical Questions

Q1 A company needs Rs.31,25,000 for the construction of a new plant. The following three plans
are feasible:
a The company may issue 3,12,500 equity shares at Rs. 10 per share.
b The company may issue 1,56,250 equity shares at Rs. 10 per share and 15,625 debentures
of Rs. 100 denomination bearing a 8% rate of interest.
c The company may issue 1,56,250 equity shares at Rs. 10 per share and 15,625 cumulative
preference shares at Rs. 100 per share bearing a 8% rate of dividend.

I if the company's earnings before interest and taxes are Rs. 62,500, Rs.
1,25,000, Rs. 2,50,000, Rs. 3,75,000 and Rs. 6,25,000, DETERMINE earnings per share under
each of three financial plans? Assume a corporate income tax rate of 40%.
II IDENTIFY which alternative would you recommend and why?
III DETERMINE the EBIT-EPS indifference points by formulae between Financing Plan I and
Plan II and Plan I and Plan III
IV Calculate the Financial BEP of Each Plan
Solution
Computation of EPS under three-financial plans.

A Plan I: Equity Financing

EBIT Level 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Taxes 40% (25,000) (50,000) (1,00,000) (1,50,000) (2,50,000)
PAT 37,500 75,000 1,50,000 2,25,000 3,75,000
No. of eq. shares 3,12,500 3,12,500 3,12,500 3,12,500 3,12,500
EPS 0.12 0.24 0.48 0.72 1.20

B Plan II: Debt – Equity Mix

EBIT Level 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Interest (1,25,000) (1,25,000) (1,25,000) (1,25,000) (1,25,000)
EBT (62,500) 0 1,25,000 2,50,000 5,00,000
Less: Taxes 40% 25,000* 0 (50,000) (1,00,000) (2,00,000)
PAT (37,500) 0 75,000 1,50,000 3,00,000
No. of eq. shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.24) 0 0.48 0.96 1.92
The Company will be able to set off losses against other profits. If the Company has no profits from

operations, losses will be carried forward.

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Chapter 5 Capital Structure Page No. 5.6
C Plan III: Preference share – Equity Mix
EBIT Level 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Taxes (40%) (25,000) (50,000) (1,00,000) (1,50,000) (2,50,000)
PAT 37,500 75,000 1,50,000 2,25,000 3,75,000
Less: Pref. dividend (1,25,000)* (1,25,000)* (1,25,000) (1,25,000) (1,25,000)
Net income (87,500) (50,000) 25,000 1,00,000 2,50,000
No. of Equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.56) (0.32) 0.16 0.64 1.60

*In case of cumulative preference shares, the dividend gets accumulated if there is insufficient
profit to pay dividend. If we assume it as non-cumulative preference shares, then in this case
dividend amount will be lower of PAT and amount of preference dividend.
ii The choice of the financing plan will depend on the state of economic conditions. If the
company’s sales are increasing, the EPS will be maximum under Plan II: Debt – Equity Mix.
Under favourable economic conditions, debt financing gives more benefit due to tax shield
availability than equity or preference financing.

b EBIT – EPS Indifference Point- Plan I and Plan II:

(EBIT) x (1- TC ) (EBIT - Interest) x (1- TC )

=
N1 N2

(EBIT) x (1- 0.4 ) (EBIT – 1,25,000) x (1- 0.4 )

=
3,12,500 1,56,250
Therefore EBIT = 2,50,000

EBIT – EPS Indifference Point- Plan I and Plan III:

(EBIT) x (1- TC ) (EBIT) x (1- TC ) – Pref. div

=
N1 N2

(EBIT) x (1- 0.4 ) (EBIT) x (1- 0.4 ) -1,25,000

=
3,12,500 1,56,250
Therefore EBIT = 4,16,666.67
Quick Revision

Q2 Atlantis limited has an EBIT of 1,00,000. The company make the use of debt in its capital. The
firm has 10% debenture of 5,00,000 and the firm’s equity capitalisation rate is 15%
You are required to calculate the cost of the firm and overall cost of capital
Solution

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Chapter 5 Capital Structure Page No. 5.7
a Value of Equity = (EBIT – Interest)/ Ke
= (1,00,000 – 50,000)/ 15%
= 3,33,333

b Value of Firm = Value of Debt + Value of Equity

= 5,00,000 + 3,33,333
= 8,33,333

c Overall Cost of Capital = EBIT/Value of Firm

= 1,00,000/8,33,333
= 12%
Quick Revision:

Q3 Akash Limited provides you the following information:

Particulars (Rs.)
Profit (EBIT) 2,80,000
Less: Interest on Debenture @ 10% 40,000
EBT 2,40,000
Less Income Tax @ 50% 1,20,000
PAT 1,20,000
No. of Equity Shares ( Rs. 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10

The company has reserves and surplus of Rs. 7,00,000 and required Rs. 4,00,000 further for
modernisation. 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 are raised as debt; and
(i) If the amount is raised by issuing equity shares at ruling market price.
Quick Revision:

Q4 The following data relate to two companies belonging to the same risk class :

Particulars A Ltd. B Ltd.

Expected Net Operating Income Rs. 18,00,000 Rs. 18,00,000
12% Debt Rs. 54,00,000 -
Equity Capitalization Rate ? 18 %
Required:

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Chapter 5 Capital Structure Page No. 5.8
(a) Determine the total market value, Equity capitalization rate and weighted average cost of
capital for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of
capital for each company assuming 40% taxes as per M.M. Approach.
Quick Revision:

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Chapter 7 Capital Budgeting Page No 7.1
Particulars Payback period ARR or Average rate of return Reciprocal payback
or, Accounting rate of return
Whether Discounting Non Discounting Non Discounting Non Discounting
or Non Discounting
What does it signifies It is the time required to recover back This method gives rate of return The reciprocal of the
the principal amount invested of the project without payback would be a
considering time value of Money. close approximation
This method use Profit after tax of the Internal Rate
and not cash flow for analysis of Return
Formula Max year of Insufficient recovery + ARR= Average PAT x 100 Reciprocal payback=
Balance Recovery Average Investment 1/ Payback Period
recovery in next year Or,
ARR= Average PAT x 100
Original Investment
Where average PAT =
Total PAT ÷ No. of years
Steps Make table of- Calculate Average PAT
1. Year, Cash Flow, Cumulative cash Calculate Average investment or
flow. original Investment ( as the case
2. Select the year till when the may be)
investment is not recovered fully. Apply the formula
3. Then apply the formula
Criteria of selection Project with lower payback is beneficial Higher ARR is Preferable Higher Reciprocal
Payback gives Higher
approximate Payback.
Precaution None ARR is to be calculated on PAT None
and not cash flow
Reference with table Refer Column – A,B and E Refer Cash Flow Format
below

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Chapter 7 Capital Budgeting Page No 7.2

Particulars Discounted Payback NPV Profitability Index

Whether Discounting Discounting Discounting Discounting
or Non Discounting
What does it signifies It is the time required to recover back Signifies that how Signifies how much is earned
the principal amount invested much is the gain or loss for every rupee invested
considering the impact of Discounting on the project after
considering TVM
Formula Max year of Insufficient recovery + PV of Inflow – PV of = PV of Inflow
Balance Recovery outflow PV of Outflow
Discounted recovery in next year
Steps Make table of- Make Table- Make Table-
1. Year, Cash Flow, PV factor, DCF, 1. Year, Cashflow, 1. Year, Cashflow, PV
CDCF Cumulative discounted cash PV factor, DCF factor, DCF
flow. 2. Make sum total 2. Make sum total of PV
2. Select the year till when the of PV of Inflows of Inflows
investment is not recovered fully. 3. Then apply the 3. Take PV of Outflow
3. Then apply the formula formula 4. Then apply the formula
Criteria of selection Project with lower Discounted payback is Higher or Zero NPV will Higher PI is selected
beneficial lead to project
selection
Precaution While applying the formula, consider None None
discounted cashflow column and not
cashflow column
Reference with table Refer Column – A,B, C, D and F Refer Column – A,B, C, Refer Column – A,B, C, and D
below and D
What about project Equated annual Value
with unequal life NPV ÷ PVAF ( of
two projects)
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Chapter 7 Capital Budgeting Page No 7.3
Particulars Internal Rate of Return (IRR) or Internal rate of return (ERR)
Whether Discounting Discounting
or Non Discounting When the project is
What does it signifies Signifies that how much the PROJECT IS ACTUALLY EARNING
discounted using Ko,
What happens at IRR 1. NPV= 0
2. Therefore, at IRR PV of Inflow = PV of Outflow it gives PV of inflow.
3. At IRR, Profitability Index (PI) = 1
Formula Lower rate + NPV of lower rate x (difference in rate)
When the project is
Difference in NPV
Steps Make table of- discounted using
1. Year, Cash Flow, PV factor at 1st rate, DCF at 1st rate IRR rate it gives PV
and then PV factor at 2nd rate DCF using 2nd rate. of Outflow.
2. Then apply the formula
Criteria of selection Higher IRR
PV of outflow is also
Precaution None
Reference with table A, B, C, D and H known as cost the
below project

Table 1- calculation of Payback, Discounted Payback, NPV, IRR

Year Cash flow PV factor @10 % DCF CCF CDCF PV factor DCF @ y%
@ y rate
A B C D E F G H
0 (xxxxx) 1 BxC 1 BxE
1 xxxxx 0.909 BxC Sum B Sum D 0.869 BxE
2 xxxxx 0.826 BxC Sum B Sum D 0.756 BxE
3 xxxxx 0.751 BxC Sum B Sum D 0.657 BxE
4 xxxxx 0.683 BxC Sum B Sum D 0.571 BxE
NPV XXXXXX NPV XXXXX

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Chapter 7 Capital Budgeting Page No 6.4
Class room Key Notes
I Calculation of cash Flow - In Capital Budgeting we are concerned with the cash
flow and not the Profit. Thus we need to calculate cash flow from financial data
Draft format is given below

II Depreciation-Straight line method

A Depreciation is same each year and also there is no Remaining WDV so no terminal
Gain or loss

B Treatment of Salvage value

Salvage value represents cash inflow and thus it shall be treated as cash inflow in year
of sale.

C Example of SLM
Depreciation in case of SLM
Cost of project = 1,00,000
Life = 4 years
Depreciation = 1,00,000 – 0 / 4 = 25,000 per year
Tax Rate = 20%

Particular Year 1 Year2 Year3 Year 4

Earning 45,000 30,000 25,000 35,000
(-) Depreciation (25,000) (25,000) (25,000) (25,000)
EBT 20,000 5,000 0 10,000
(-) TAX @20% (4,000) (1,000) 0 (2,000)
EAT 16,000 4,000 0 8,000
(+) Depreciation 25,000 25,000 25,000 25,000
Cash flows 41,000 29,000 25,000 33,000

III Depreciation-WDV Method

A Example of WDV
Let the sale be 300, 300, 320 in year 1 2, and 3 respectively with Cash cost 140,140,
140 in each year. Calculate the Cash flow with tax =30% and depreciation at WDV at
30% with initial cost of 400 lakhs. And,
Case 1- Sale price after 3 years = 100 Lakhs
Case 2- Sale price after 3 years = 200 Lakhs

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Chapter 7 Capital Budgeting Page No 6.5
Particular Year 1 Year 2 Year 3 Refer Note
Sales 300 300 320
Less: Cash cost 140 140 140 Refer Note
Earnings Before Depreciation and tax 160 160 180
Less Depreciation (120) (84) (58.8) Refer Note
EBIT 40 76 121.2
Less Interest xx xx xx Refer Note
EBT 40 76 121.2
Less: tax @ 30% (12) (22.8) (36.36)
This is used
EAT 28 53.2 84.84 for ARR
Add: Depreciation 120 84 58.8
CFAT – For evaluation of project 148 137.2 143.64

B WDV Depreciation Schedule –

Case 1- Sale value < WDV
Fixed assets cost = 400 Lakhs, Depreciation rate 30%, Sale price at Y3 = 100 L
Tax rate = 30%

Particular Amount Treatment

Opening WDV 400 Initial cash Outflow
Depreciation of 1st year (120) In First year depreciation
Closing WDV at Y1 280
Depreciation of 2nd year (84) In second year depreciation
Closing WDV at Y2 196
Depreciation of 3 year (58.8) In Third year depreciation
Closing WDV at Y3 137.2
Sale price 100 Cash inflow in terminal year
Loss 37.2 Terminal depreciation
Tax benefit (loss x tax rate)
37.2 x 30% 11.16 Cash inflow in Terminal Year

C WDV Depreciation Schedule –

Case 2- Sale value > WDV
Fixed assets cost = 400 Lakhs, Depreciation rate 30%, Sale price at Y3 = 200 L
Tax rate = 30%

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Chapter 7 Capital Budgeting Page No 6.6
Particular Amount Treatment
Opening WDV 400 Initial cash Outflow
st
Depreciation of 1 year (120) In First year depreciation
Closing WDV at Y1 280
Depreciation of 2nd year (84) In second year depreciation
Closing WDV at Y2 196
Depreciation of 3 year (58.8) In Third year depreciation
Closing WDV at Y3 137.2
Sale price 200 Cash inflow in terminal year
Gain 62.8 Terminal depreciation
Tax loss (Gain x tax rate)
62.8 x 30% 18.84 Cash Outflow in Terminal Year

IV Treatment of sunk cost- cost which is incurred in the past and is irrelevant for
decision Making
Example :- You made a project report costing 1,00,000 to see the acceptability of
project . Now this 1,00,000 is already paid and cannot be recovered by any force .
Therefore it is sunk cost

V Allocated Overheads :- Allocated Overhead shall be ignored .However ,incremental

overhead shall be considered

VI Working Capital :- Working Capital means raw material which is required to run the
project . This raw material needs to be purchased by company and it is treated as cash
outflow. It may also happen that additional working capital is infused in subsequent
year (say year 3). This additional working capital will be treated as cash outflow (in year 3)

Case 1- Question silent about treatment of working capital at the end of project.
If nothing is mentioned in question the amount of working capital which was put
initially will be recovered at the end of life which will be treated as Cash Inflow.

Case 2- if question specifically mentions the amount of working capital at the end of life
then that amount shall be taken as cash inflow

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Chapter 7 Capital Budgeting Page No 6.7
h Interest Exclusion :-
While discounting cashflow using “WACC or r” the cashflow gets smaller and
difference in present value and future value is paid to fund providers (ie Investors)
(ie Debt, Equity , Preference Shareholders )
Therefore, When we discount future cashflow using WACC return is
already received and thus ignore interest and all financial charges

Part B – Capital Budgeting Techniques

a If future cash flows are discounted at Ko, it gives PV of Inflow.

b If future cash flows are discounted at IRR, it gives PV of Outflow
c PV of outflow = cost of project
d At IRR NPV =0

e Projects with unequal life are evaluated using equalised criteria

NPV of proj A / PVAF(life, rate)
NPV of proj B / PVAF(life, rate)

f Sometimes in question ICAI does not mentions about cash inflow, but tells about
Savings. Thus we must remember MONEY SAVED= MONEY EARNED
And thus savings shall be treated as cash inflow

g If the question mentions only about cost of two projects and nothing is said about
Cash inflow, consider that project which gives Least cost

h Make suitable assumptions wherever necessary

i If question mentions EBIT then depreciation is already deducted, do not deduct it

Again. But it must be added back after tax adjustment

J Modified internal rate of return and multiple internal rate of return are not asked in
exam

k In Capital Rationing, we have to evaluate projects. Which means not a single but many
Projects are evaluated. We can invest in as many projects which are in our budget
(Budget is given in question)

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Chapter 7 Capital Budgeting Page No 6.8
Capital Rationing

Indivisible Project (NPV) Divisible Project (PI)

Projects cannot be taken in parts. Projects can be taken in part
Either take full project or leave it Which means even fraction of project can
be taken

If Projects are Indivisible the evaluation If Projects are Divisible the evaluation
shall
shall be made using NPV criterion be made using PI criterion

Project with highest NPV will be taken Project with highest PI will be taken
first followed by second highest and so on first followed by second highest and so on
till the available fund gets exhausted till the available fund gets exhausted

Incremental Approach Questions

1. Consider Incremental cash Outflow,
2. Consider Incremental cash Inflow,
3. Consider Incremental Depreciation
4. Consider Incremental Salvage Value

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Chapter 7 Capital Budgeting Page No 6.9
Class Works
Q1.(3) A company is considering the proposal of taking up a new project which requires an investment
of Rs. 400 lakhs on machinery and other assets. The project is expected to yield the following
earnings (before depreciation and taxes) over the next five years:

Before-tax Cash inflows (Rs. in lakhs)

Years 1 2 3 4 5
160 160 180 180 150

The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on
„Written Down Value’basis. The scrap value at the end of the five years‟ period may be taken
as zero. Income-tax applicable to the company is 50%.
You are required to calculate the net present valueof the project and advise the management
to take appropriate decision. Also calculate the Internal Rate of Return of the Project.
Quick Revision:
Q2.(4) Consider the following mutually exclusive projects:
Co C1 C2 C3 C4
A (10,000) 6,000 2,000 2,000 12,000
B (3,500) 1,500 2,500 500 5,000

Required:
a Calculate the payback period for each project.
b If the standard payback period is 2 years, which project will you select? Will your
answer differ, if standard payback period is 3 years?
c If the cost of capital is 10%, compute the discounted payback period for each project.
Which projects will you recommend, if standard discounted payback period is (i) 2 years;(ii) 3
years?
d Compute NPV of each project. Which project will you recommend on the NPV criterion?
e Also Calculate PI
The cost of capital is 10%. What will be the appropriate choice criteria in this case
Solution
Project A
Year Cash Flow PVF @10% DCF CCF CDCF
0 (10,000) 1 (10,000)
1 6,000 0.909 5,454 6,000 5454
2 2,000 0.826 1,652 8,000 7106
3 2,000 0.751 1,500 10,000 8606
4 12,000 0.683 8,196 22,000 16,802
NPV 6,802

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Chapter 7 Capital Budgeting Page No 6.10

a Payback Period = 3 Years

b Discounted payback= 3 years +1,394/8,196

= 3.17 Years

c NPV = PV of inflow – PV of Outflow

=16,802-10,000
=6,802

d Profitability Index (PI) = NPV = PV of inflow / PV of Outflow

= 16,802/ 10,000
= 1.6802
Project B
Year Cash Flow PVF @10% DCF CCF CDCF
0 (3,500) 1 (3,500)
1 1,500 0.909 1,363 1,500 1,363
2 2,500 0.826 2,066 4,000 3,429
3 500 0.751 375 4,500 3,804
4 5,000 0.683 3,415 9,500 7,219
NPV 3,719

a Payback Period = 1 Years +Balance recovery/ Next years recovers

= 1 +2,000/2,500
= 1.8 Years
b Discounted payback = 2 years +71/375
= 2.18 Years

c NPV = PV of inflow – PV of Outflow

=7,219-3,500
= 3,719

d Profitability Index (PI) = NPV = PV of inflow / PV of Outflow

= 7,219/ 3,500
= 2.06
Conclusion:
a If standard payback period= 2 yrs. Project B will will be selected.
& If Standard payback period = 3 yrs. Both Projects will be selected.
b If standard discounted payback period = 2 yrs. No project will be selected.
& If Standard discounted payback period = 3 yrs. Project B will be selected.
c As per NPV Criterion Project A will be preferred.

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Chapter 7 Capital Budgeting Page No 6.11
d As per PI criteria project B will be selected

Quick Revision
Q.3 (7) Given below are the data on a capital project 'M'.

Annual cash inflows 96,000

Useful life 5 years
IRR 15%
Profitability index 1.05
Salvage value 0

You are required to calculate for this project M :

(i) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value
PV factors at different rates are given below:

Discount factor 15% 14% 13%

1 year 0.869 0.877 0.885
2 year 0.756 0.769 0.783
3 year 0.658 0.675 0.693
4 year 0.572 0.592 0.614
5 year 0.497 0.519 0.544
Total 3.353 3.432 3.52
Solution
a Cost of project
PV of Cash Inflow = PV of cash outflow
PV Of Cash Inflow= C/F x PVAF @ IRR
= 96,000 x PVAF (15%, 5)
= 96,000 x 3.352
= 3,21,807

b Payback period = 3 years +33,807/ 96,000

= 3.35 years

c PI= PV of Cash Inflow/ PV of Cash O/f

1.05 = PV of cash Inflow/ 3,21,807
PV of Cash Inflow = 3,37,897
Therefore, NPV = 16,090 (3,37,897 – 3,21,807 )

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Chapter 7 Capital Budgeting Page No 6.12
d Cost of Capital:
Let the cost of capital be „x‟
3,37,897 = 96,000 * PVAF (r, 5 years)
3.519 = PVAF * (r, 5 year)
x = 13%
Cost of capital (WACC) =13%

Q4. (15) APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two
machines have identical capacity, do exactly the same job, but designed differently.
a) Machine 'A' costs Rs. 8,00,000, having useful life of three years. It costs Rs. 1,30,000
per year to run.
b) Machine 'B' is an economy model costing Rs. 6,00,000, having useful life of two years.
It costs Rs. 2,50,000 per year to run.
c) Ignore taxes.
d) The opportunity cost of capital is 10%.
e) The present value factors at 10% are :
Year t1 t2 t3
PVIF0.10,t 0.9091 0.8264 0.7513
PVIFA0.10,2 = 1.7355
PVIFA0.10,3 = 2.4868
Solution
Statement showing calculation of evaluation of two machine under equalised criteria

Particular Project A Project B

a Cost of Machine 8,00,000 6,00,000
b Annual Running cost 1,30,000 2,50,000
c Life 3 Years 2 Years
d PVAF (3,10%) & PVAF (2,10%) 2.4868 1.7355
E PV of annual Cash flow(b x d) 3,23,284 4,33,875
F Total PV of cash Outflow(a+e) 11,23,284 10,33,875
g Equalised annual yield 4,51,699 5,95,722
Machine A will be selected. Since its equalised cost is less

Q5.(18) A company wants to invest in a machinery that would cost Rs. 50,000 at the beginning of year 1.
It is estimated that the net cash inflows from operations will be Rs. 18,000 per annum for 3
years, if the company opts to service a part of the machine at the end of year 1 at Rs. 10,000.
In such a case, the scrap value at the end of year 3 will be Rs. 12,500. However, if the company
decides not to service the part, then it will have to be replaced at the end of year 2 at Rs.
15,400. But in this case, the machine will work for the 4th year also and get operational cash
inflow of Rs. 18,000 for the 4th year. It will have to be scrapped at the end of year 4 at Rs.

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Chapter 7 Capital Budgeting Page No 6.13
9,000. Assuming cost of capital at 10% and ignoring taxes, will you recommend the purchase of
this machine based on the net present value of its cash flows?
If the supplier gives a discount of Rs. 5,000 for purchase, what would be your decision? (The
present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091,
0.8264, 0.7513, 0.6830, 0.6209 and 0.5644).
Solution
Cost of Machine = 50,000
x = 10%

a For Machine where it is serviced at the end of Year 1 at 10,000

Scrap Value = 12,500
Year CF PVF@10% DCF
0 (50,000) 1 (50,000)
1 18,000-10,000 0.909 7272
2 18,000 0.863 14,875
3 18,000+12500 0.751 22,905
NPV NPV (4948)

b For Machine where part is replaced at the end of Year 2 at 15,400

Scrap Value = 9,000
Year CF PVF@10% DCF
0 (50,000) 1 (50,000)
1 18,000 0.909 16,363
2 18,000 – 15,400 0.863 2,148
3 18,000 0.751 13,523
4 18,000+9000 0.863 18,441
NPV NPV 475

Conclusion: when no discount is given Replacement decision shall be taken

As NPV is (4,948) and 475 respectively

If supplier expends the discount of 5000 then PV of outfow will fall to 45,000
Thus New NPV will rise by 5000
NPV ( Service) = 52 rs.
NPV (Replace) = 5475
Again Replacement will be accepted
Quick Revision:

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 Chapter 8 Risk Analysis in Capital Budegting Page No. 1

The Chapter is based on the concept that projects are prone to risks and thus the project may fail if
adverse business circumstances occur. Thus in this chapter we will study various techniques to evaluate
the project under adverse situations and if the project still gets selected it will be Taken
Probability based risk analysis Risk Adjusted Certainty Equivalent
Discounted rate
Calculate Expected value It is the rate where the Expected cash flows are multiplied
by Multiplying each cash flow with assigned risk free rate is with certainty equivalent αt to
probability. coupled with Risk make them certain.
You will get expected value
premium to adjust the
Calculate Variance by taking
uncertainties.
sum of (Expected value- each possible
event) 2 x Probablity
Calculate Standard deviation by by taking Now this uncertain cash flows are
Square root of the value derived converted into certain cashflow and
now you need to discount them with
Standard deviation means expected deviation from mean value.
Higher the Standard deviation, higher is the risk.
risk free rate
Calculate Coefficient of variation by Note: While discounting take risk
Standard deviation/ Expected Value free rate of return and not the risk
associated rate of return
Higher The coefficient of Variation denotes higher
risk.
If there are two projects one with lower
coefficient of Variation and Other with Higher
coefficient of Variation. Select project with lower
coefficient of Variation as it denotes lower risk

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 Chapter 8 Risk Analysis in Capital Budegting Page No. 2
Sensitivity Analysis Scenario Analysis
Project is affected by various factors such as Cost of Capital, All input variables change
Initial Cash outflow, Annual cash inflows, Life of the project, etc
simultaneously
In Sensitivity analysis we take into consideration the impact of Here the project will be given and we
change in each Factor, and calculate Revised NPV need to evaluate project as per their
instruction
The NPV which is derived from above calculation is then compared Generally, In the question we are given
and the Factor which leads to least NPV is the most sensitive three outcomes,
factor. Best Outcome
The Identified sensitive factor is generally then considered most Most Likely
critical by management and thus taken care Worst Outcome
Note: In sensitive analysis we consider changing ONE VARAIBLE
at a time and not all the variables at the time
Also some times we are asked to
Factors and When they become adverse or favorable calculate the answer with different
out comes in different years
Particulars Adverse Favorable
Sale price When it decrease When it increase
No. of Units When it decrease When it increase
Cost of production When it increase When it decrease
Fixed cost When it increase When it decrease
Initial proj. cost When it increase When it decrease
Annual Cash inflow When it decrease When it increase
Life of project When it decrease When it increase
Discount rate When it increase When it decrease

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Chapter 8 Risk Analysis In capital Budgeting Page No. 8.3
Q1. Calculate the Standard deviation and variance using the given data - Statistics
Possible Project A
Events Cash Flow Probability
A 8,000 0.10
B 10,000 0.20
C 12,000 0.40
D 14,000 0.20
E 16,000 0.10
Solution
Expected value = (8000x0.1) + (10,000x 0.2) + (12,000 x 0.4) + (14,000 x0.2)
+ (16,000 x 0.1) = 12,000

I For project A
a Variance ( 2) = (8,000 – 12,000)2 x (0.1) + (10,000 -12,000)2 x (0.2) + (12,000 – 12000)2 x
(0.4) + (14,000 – 12,000)2 x (0.2) + (16000 – 12,000)2 x (0.1) = 48,00,000

b Standard deviation= (48,00,000) 1/2 =2190.90

c Coefficient of variation = 2190.90/12000 = 0.1836

Q2. If Investment Proposal is Rs. 45,00,000 and risk free rate is 5%, calculate Net
present value under certainty equivalent technique. – Certainty Equivalent

Year Expected cash flow (Rs.) at

1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
Solution
Calculation of NPV using certainty equivalent
Year Expected cash at Certain PVF DCF
flow (Rs.) Cash flow
1 10,00,000 0.90 9,00,000 0.952 8,57,142
2 15,00,000 0.85 12,75,000 0.907 11,56,462
3 20,00,000 0.82 16,40,000 0.863 14,16,693
4 25,00,000 0.78 19,50,000 0.822 16,04,269
50,34,566
NPV = PV of Inflow – PV of Outflow
= 50,34,566 – 45,00,000
= 5,34,566

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Chapter 8 Risk Analysis In capital Budgeting Page No. 8.4
Q3 From the following details relating to a project, analyse the sensitivity of the project to
changes in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (Rs.) 1,20,000
Annual Cash Inflow (Rs.) 45,000
Project Life (Years) 4
Cost of Capital 10%
To which of the three factors, the project is most sensitive if the variable is adversely
affected by 10%? (Use annuity factors: for 10% 3.169 and 11% ... 3.103).
Solution
Since the cost of Capital raised from 10% to 11% this means there is adverse variance
of 10%

Present Cost of Project Annual cash I/F Cost of Capital

Situation adverse by 10% adverse by 10% adverse by 10%
Annual Cash Inflow 45,000 45,000 40,500 45,000
Life 4 Yrs 4 yrs 4 yrs 4 yrs
Discounting rate 10% 10% 10% 11%
PVAF 3.169 3.169 3.169 3.103
PV of Inflow 1,42,605 1,42,605 1,28,344 1,39,635
Cost of Project 1,20,000 1,32,000 1,20,000 1,20,000
NPV 22,605 12,605 8,344 19,635
Sensitivity ranking II I III

Conclusion: Project is most sensitive to ‘annual cash inflow’

Quick Revision:

Q4 Virushka Ltd. is considering the proposal of two mutually exclusive projects for increasing
plants capacity. The management has developed pessimistic, most likely and optimistic
estimates of annual cash flows associated with each project. The estimates are as follow
Particulars A B
CFAT Estimates
Pessimistic 1200 3700
Most likely 4000 4000
Optimistic 7000 4500
Determine the NPV associated with each projects. Life of the project is 20 years and cost of
capital is 10. Which project you will consider and why?

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Chapter 8 Risk Analysis In capital Budgeting Page No. 8.5
Solution
Calculation of CFAT under different Scenario
Particulars Project A Project B
Estimated CFAT under
Pessimistic 1200 3700
Most likely 4000 4000
Optimistic 7000 4500
Life 20 yrs 20 yrs
Discounting rate 10% 10%
PVAF (10%,20) 8.5135 8.5135
PV of Cash inflow
Pessimistic 10,216 31,500
Most likely 34,054 34,054
Optimistic 59,594 38,311

Under Pessimistic approach Project B is more suitable

Under Optimistic approach project A is Suitable.
Company will be indifferent to choose either of the projects at Most likely level
Quick Revision

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Chapter 9 Dividend Decision Page No. 9.1
Particular Formula MM Model – Most Important
Basic Formulas Approach says that the value of the firm is independent
Earnings per share Net income (EATESH) of Dividend payout ratio.
No. of Shares Thus if the company pays 100% dividend or 0%, value of
the firm remains constant
Payout Ratio Dividend per share Step 1 calculate the share price, assuming no
Earning per share
dividend is paid
Retention ratio 1 - Payout ratio P0 = (P1+D1)
Or Retained earnings (1+Ke)
Total Earnings Step 2- Calculate the number of shares required
Dividend per share Total equity Dividend = I-(E-D)n
No. of Share
(1+Ke)
Dividend rate Dividend per share Step 3- Calculate the value of the firm
Face Value per share
Vf= (∆n+n) P1 –I+E
Dividend Yield Dividend per share (1+Ke)
Market Value per share
1. Po = Current market price
Growth (g) bxr 2. P1= Expected market Price
Where b = retention ratio and 3. D1= Expected dividend
r = rate of return on investment 4. Ke= Cost of equity
5. E= Earnings
********* 1/ PE ratio = Ke 6. N= original number of shares
7. ∆= additional ni. Of shares
8. I= Fixed investment
Repeat the same procedure when divided is paid

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Chapter 9 Dividend Decision Page No. 9.2
Equity Share capital MODEL
Walter D1 + (E-D) r Where,
1. D₁ = Dividend in year 1
Model ke 2. D0 = Dividend in year 0 (last year
dividend)
Ke
3. EPS = Earnings per share
Where 4. Af = Adjustment factor/ speed of
1. D1= Dividend adjustment
2. E= earnings
3. Ke= cost of equity
4. R= rate of return

Gordon Do (1+g)
(Ke-g)
Model

1. IRR>K, Payout should be low or Zero.

2. IRR<K, maximum or 100% payout
3. IRR= K, Any payout is optimum
Conclusion is valid for both – Gordon and Walter

GRAHM P = m (D+E/3)
AND DODD
Where,
1. P = Market price per share
2. D = Dividend per share
3. E = Earnings per share
4. m = a multiplier

LINTNER’S D1
= D0+ [(EPS x target ratio) – D0}x AF

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Chapter 9 Dividend Decision Page No. 9.3
IMP Practice Question
Q1 With the help of following figures calculate the market price of a share of a company by using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)

EPS 10
DPS 6
Cost of capital 20%
Internal rate of return on investment 25%
Retention Ratio 40%

Q2 The dividend payout ratio of H ltd. is 40%. If the company follows traditional approach to
dividend policy with a multiplier of 9, what will be the P/E ratio

Q3 AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It currently
has outstanding 10,000 shares selling at Rs.100 each. The firm is contemplating the declaration
of a dividend of Rs.5/share at the end of the current financial year. It expects to have a net
income of Rs.1,00,000 and has a proposal for making new investments of Rs.2,00,000. Show,
how the MM approach affects the value of M Ltd. if dividends are paid or not paid.
Solution
No dividend is paid at all.
Step 1: calculation of Price of share
Po = P1 + D1
1 + Ke
100 = P1 + 0
1.1
 P1= 110

Step 2: Addition no. of shares

∆n = I – (E –nD1)
P1
= 2,00,000 – ( 1,00,000 – 0)
110
= 909 shares

Step 3: value of the firm

Vf = (∆n + n) P1 + E –I
(1 + Ke)
= ( 10909 x 110) + ( 100000-200000)
1.1

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Chapter 9 Dividend Decision Page No. 9.4
= 10,00,000

b 5 rs. dividend is paid at all.

Step 1: calculation of Price of share
Po = P1 + D1
1 + Ke
100 = P1 + 5
1.1
 P1= 105

Step 2: Addition no. of shares

∆n = I – (E –nD1)
P1
= 2,00,000 – ( 1,00,000 – 50,000)/ 150
= 1428 shares

Step 3: value of the firm

Vf = (∆n + n) P1 + E –I
(1 + Ke)
= ( 10,000+1428 ) x 105 + ( 100000-200000)
1.1
= 10,00,000

Hence the value of the firm is unaffected by Dividend payout amount

Q4 Dividend of the previous year is 19.6. Adjustment factor is 45%. Target payout ratio is 60%
and the EPS for the current year is 40. Using Lintner’s model calculate current years dividend.
What will be your answer if the speed of adjustment is 20%?
Solution
a As per Lintner:
D1 = D0+ [(EPS x target ratio) – D0}x AF
D1 = 19.6 + [(40*0.6)-19.6] 45%
= 21.58

b If the speed of adjustment is 20%?

D1 = 19.6 + [(40*0.6)-19.6] 20%
= 20.48

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Chapter 3 Ratio Analysis Page No. 3.1
1 a. Current ratio Current Assets 11 DEBT TO TOTAL ASSETS Total long Term debt
b. Working capital ratio Current liabilities RATIO Total Assets
c. Solvency ratio 12 CAPITAL GEARING RATIO Preference share capital+
2 a. Quick ratio Quick Assets Debentures+ other borrowed funds
b. Acid ratio Current Liabilities Equity share capital+ R&S – Losses
c. Liquid ratio 13 PROPRIETARY RATIO Proprietary Assets
3 Net Working Capital ratio Current assets- Current liabilities Total Assets

4 a. Absolute cash Ratio Cash and Bank Balance + 1) Shareholder’s equity = Equity share capital + preference share

b. Absolute Liquidity ratio Marketable securities capital+ Reserves and surplus- Fictitious assets

Current liabilities 2) Shareholder’s equity is also known as NET WORTH or NET

Assets
5 a. Basic defense Cash and Bank Balance +
3) Proprietary assets = Eq. share capital+ pref. share cap+ R&S-
b. Interval measure Marketable securities
losses- Fictitious assets
Operating expense/ Number of
4) Total Long term fund = Total Assets- Current liability
days
5) Net Worth= Total Assets- Current liability- Long Term Liablity
Current Assets- Inventories + Sundry Debtors + Cash and Bank
14 Total Assets turnover ratio Sales
Balances + Receivables/ Accruals + Loans and Advances + Disposable
Total assets
Investments + Any other current assets.
15 Fixed asset Turnover ratio Sales
Current Liabilities- Creditors for goods and services + Short-term
Fixed assets
Loans +Bank Overdraft + Cash Credit + Outstanding Expenses +
Provision for Taxation + Proposed Dividend + Unclaimed Dividend + 16 Capital T/O ratio Sales

Any other current liabilities Net assets

Quick Assets -Current Assets - Inventories – Prepaid expenses 17 Current Asset T/O ratio Sales
Current assets
6 Interest coverage ratio EBIT
Interest 18 Working capital turnover Sales
ratio Working capital
7 Preference dividend Earnings after tax or Net profit
coverage ratio Preference dividend liability 19 Inventory T/O ratio COGS
Average Inventory
8 EQUITY RATIO Shareholder’s equity
Average inventory =
Capital employed
9 DEBT RATIO Total long term liability (Op. stock + Cl. Stock)/2
Total Capital Or
10 DEBT TO EQUITY RATIO Total long term liability Sales
Share Holder’s Equity Average Inventory
Chapter 3 Ratio Analysis Page No. 3.2
20 Debtor T/O ratio Credit sales 32 Return on assets (ROA) EBIT (1- tax)
Average Account receivable Average Total assets
21 Debtor velocity ratio Average account receivables 33 Return on capital employed EBIT
Average daily credit sales (ROCE) – pre tax Capital employed
or 34 Return on capital employed EBIT (1-tax)
360days/52 weeks/ 12 months (ROCE) – post tax Capital employed
Debtor turnover ratio 35 Return on Equity EAT- Preference dividend
Net worth/ Equity shareholder’s
22 Payable T/O ratio Annual Credit purchase fund
Average Account payable 36 Earnings Per share Net profit available to equity
shareholders
23 Creditor/ payable velocity Average account payable Number of equity shares
ratio Average daily credit purchase outstanding
or 37 Dividend per share Dividend paid to equity
360days/52 weeks/ 12 months shareholders
Creditor turnover ratio Number of equity shares
24 Gross Profit ratio Gross Profit outstanding
Sales 38 Dividend payout ratio Dividend per share
25 Net Profit ratio Net Profit Earnings per share
Sales 39 Price Earnings Ratio = Market Price per Share(MPS)
26 Operating profit ratio Operating Profit / Sales P/E ratio Earnings per Share(EPS)

27 Expense ratio- Cost of goods sold 40 Dividend Yield Dividend

Cost of goods sold ratio Sales Market price per share

28 Expense ratio- admin + Selling and distribution 41 Earnings Yield Earnings per share (EPS)

Operating EXPENSE ratio OHDS Market price per share (MPS)

Sales RETURN ON EQUITY USING DU- PONT MODEL

= NET PROFIT MARGIN x ASSET TURNOVER RATIO x EQUITY
29 Expense ratio- COGS+ Operating. Expense
MULTIPLIER
Operating ratio Sales
Net Profit x Revenue x Total Assets
30 Expense ratio- Financial expense Revenue Total assets Net worth
Financial expense ratio Sales Equity multiplier adds the leverage effects.
31 Return on investment (ROI) Return/ Profit/ Earnings
Investment
Chapter 3 Ratio Analysis Page No. 3.3
Class room Key Notes
1 Though the word ‘shareholder’s equity’ has equity in it, it always contains preference
share capital, unless mentioned otherwise. Similarly Net worth also has preference
share capital in it.

2 While net profit Margin use either EBIT (1-tax) or EAT, but mention in the
assumption.

3 Always calculate Inventory ratios on COGS, unless otherwise mentioned.

4 a. Make clear assumption of 360 or 365 days in calculation.

b. If Question specifically mentions about 360 days consider the same.
c. If question is silent and you take 365 days no assumption is required
d. but if you make 360 days as assumption please specify with note

5 Only Admin + selling & distribution expenses differentiate Cost of Goods Sold (COGS)
and Cost of Sales (COS) in absence of it, COGS will be equal to Sales
COGS+ admin exp. + Selling and distribution exp. = COS

6 We can consider Cost of Goods Sold/ Cost of Sales to calculate turnover ratios
eliminating profit part.

7 Average of Total Assets/ Fixed Assets/ Current Assets/ Net Assets/ Working Capita/
also can be taken in calculating the above ratios. Infact when average figures of total
assets, net assets, capital employed, shareholders’ fund etc. are available , it may be
preferred to calculate ratios by using this information.

9 If the question mentions many ratios and you are confused where to start with
Start from the
a). Working capital and Current ratio and Quick ratio
b). Start with the value which is not a ratio but in number

10 We are not required to draft the balance sheet in SCH III format.

11 If question does not give opening figures but the formula contains the average value
then assume opening to be same as closing

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Chapter 3 Ratio Analysis Page No. 3.4
12 Operating Profit = EBIT
EBIT= GP – all operating expenditure ( means all expenditure except Interest
and tax)

13 Operating Expense ratio = operating expense / Sales

14 Net profit (NP) = Earnings after tax (EAT)

15 Net Income = Earnings available to Equity share holders = EAT - PD

Self-Notes:

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Chapter 3 Ratio Analysis Page No. 3.5
Q1. (24) Net income = 3,60,000; Shareholder’s equity= 4,00,000; Asset T/O ratio = 2.5 Net profit

margin= 12%. Using DuPont Model calculate return on equity. Also Calculate Equity Multiplier.

Q2.(2) The following is the Profit and loss account and Balance sheet of KLM LLP
Trading and Profit & Loss Account

Particulars Amount (Rs.) Particulars Amount (Rs.)

To Opening stock 12,46,000 By Sales 1,96,56,000

To Purchases 1,56,20,000 By Closing stock 14,28,000

To Gross profit c/d 42,18,000

2,10,84,000 2,10,84,000

To Administrative exp. 18,40,000 By Gross profit b/d 42,18,000

To S&D Expense 7,56,000 By Interest on investment 24,600

To Interest on loan 2,60,000 By Dividend received 22,000

To Net profit 14,08,600

42,64,600 42,64,600

Balance Sheet as on……….

Capital & Liabilities Amount (Rs.) Assets Amount (Rs.)

Capital 20,00,000 Plant & machinery 24,00,000

Retained earnings 42,00,000 Building 42,00,000

General reserve 12,00,000 Furniture 12,00,000

Term loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry Payables 7,20,000 Inventory 14,28,000

Other liabilities 2,80,000 Cash & Bank balance 4,22,000

1,10,00,000 1,10,00,000

You are required to COMPUTE

GP Ratio NP Ratio Operating Cost Ratio Operating Inventory T/O

Profit ratio ratio

Current ratio Quick ratio Interest Coverage ratio ROCE Debt to Asset
ratio

Solution
(i) Gross profit Ratio = Gross profit/ Sales x 100
=42,18,000/1,96,56,000 x 100
=21.46%

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Chapter 3 Ratio Analysis Page No. 3.6
(ii) Net profit Ratio = Net profit/ Sales x 100
=14,08,600 / 1,96,56,000 x 100
=7.17%

(iii) Operating Ratio = Operating cost/ Sales x 100

Operating cost = COGS+ Operating Expense
COGS = Sales – Gross Profit = 1,96,56,000 - 42,18,000 = 1,54,38,000
Operating expenses = Administrative expenses + Selling & distribution expenses
= 18,40,000 + 7,56,000 = 25,96,000
Therefore, Operating ratio = (1,54,38,000 + 25,96,000) x 100
1,96,56,000
=91.75%

(iv) Operating profit ratio = 100 – Operating cost ratio

=100 – 91.75%
= 8.25%

(v) Inventory turnover ratio = Cost of goods sold / Average Stock

= 1,54,38,000
(14,28,000 + 12,46,000) / 2
= 11.55 times

(vi) Current ratio = Current assets/ Current Liability

Current assets = Sundry receivables + Inventory + Cash & Bank balance
= 13,50,000 + 14,28,000 + 4,22,000 = 32,00,000
Current liabilities = Sundry Payables + Other liabilities
= 7,20,000 + 2,80,000 = 10,00,000
Current ratio = 32,00,000/ 10,00,000
= 3.2 times

(vii) Quick Ratio = (Current assets –Inventories) / Current Liability

= (32,00,000 -14,28,000)/ 10,00,000
= 1.77 times

(viii) Interest coverage ratio= EBIT/ Interest

= NP + Interest / Interest
= (14,08,600 + 2,60,000 )/ 2,60,000
= 6.42 Times

(ix) Return on capital employed (ROCE) = EBIT / Capital Employed x 100

Capital employed = Capital + Retained earnings + General reserve + Term loan

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Chapter 3 Ratio Analysis Page No. 3.7
= 20,00,000 + 42,00,000 + 12,00,000 + 26,00,000 = 1,00,00,000
Therefor ROCE = 16,68,600/ 1,00,00,000
= 16.68%

(x) Debt To Asset ratio = Debt / Total Assets x 100

= 26,00,000/ 1,10,00,000 x100
= 23.64%
Quick Note

Q3. (25) The following figures and ratios are related to a company:
i. Sales for the year (all credit) Rs. 30,00,000
ii. Gross Profit ratio 25 percent
iii. Fixed assets turnover (based on cost of goods sold) 1.5
iv. Stock turnover (based on cost of goods sold) 6
v. Liquid ratio 1:1
vi. Current ratio 1.5 : 1
vii. Debtors collection period 2 months
viii. Reserves and surplus to Share capital 0.6 : 1
ix. Capital gearing ratio 0.5
x. Fixed assets to net worth 1.20 : 1
You are required to prepare:
1. Balance Sheet of the company on the basis of above details.
2. The statement showing working capital requirement, if the company wants to make a
provision for contingencies @ 10 percent of net working capital including such provision
Solution
(i) Sales = 30,00,000
Gross Profit = 25%
Cost of Goods sold = 22,50,000

(ii) Fixed asset Turnover ratio = Cost of Goods Sold / Fixed Assets
1.5 = 22,50,000 / Fixed Assets
Therefore, Fixed Assets = 15,00,000

(iii) Fixed Assets / Net worth = 1.2

Therefore Net worth = 12,50,000
Net worth

Equity reserve and surplus

1 0.6
Therefore Equity = 7,81,250 and reserve = 4,68,750

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Chapter 3 Ratio Analysis Page No. 3.8
(iv) Stock Turnover ratio = Cost of Goods Sold / Average Inventory
6= 22,50,000 / Average Inventory
Average Inventory = 3,75,000

(v) Liquid ratio = Quick assets / current liability

Quick assets = (Current Assets – Inventory ) / current liability
1 = (Current Assets – Inventory ) / current liability
Therefore , current liability = Current Assets – Inventory

Current ratio = 1.5 = Current Assets/ Current Liability

Therefore, 1.5 = Current Assets/ Current Assets – Inventory
1.5 = Current Assets/ Current Assets – 3,75,000
Current Assets = 11,25,000 and Current Liability = 7,50,000

(vi) Capital Gearing ratio = Debt + Preference share capital

Equity Share capital + reserve and surplus
0.5 = Debt + Preference share capital
= 12,50,000
Debt + Preference share capital = 6,25,000

(vii) Debtors Velocity ratio = 12 months / Debtors turnover ratio

2 months = 12 / Debtors turnover ratio
Debtors turnover ratio = 6
Therefore , Credit sales / Average Debtors =6
Therefore , Average Debtors = 30,00,000/6 = 5,00,000

(viii) Balance Sheet

Liability Amount Assets Amount
Equity Share Capital 7,81,250 Fixed Assets 15,00,000
Reserve and Surplus 4,68,750 Current Assets
Long term Debt 6,25,000 Debtors 5,00,000
Other current Liability 7,50,000 Inventory 3,75,000
Cash (bal. fig.) 2,50,000
26,25,000 26,25,000

(ix) The statement showing working capital requirement,

Current Assets = 11,25,000
Current Liability = 7,50,000
Net Working Capital = 3,75,000
Provision =41,666 0.1 x
Total Working capital = 4,16,666 x
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Chapter 3 Ratio Analysis Page No. 3.9
Q4. (29) VRA Limited has provided the following information for the year ending 31st March, 2015.
Debt Equity Ratio 2: 1
14% long term debt Rs. 50,00,000
Gross Profit Ratio 30%
Return on equity 50%
Income Tax Rate 35%
Capital Turnover Ratio 1.2 times
Opening Stock Rs. 4,50,000
Closing Stock 8% of sales
You are required to prepare Trading and Profit and Loss Account for the year ending 31/3/15
Solution
(i) Debt Equity Ratio = Long term Debt / Equity = 2:1
Therefore, Equity = 50,00,000 /2
= 25,00,000

(ii) Return on Equity = Net profit / Equity Share Capital

50% = Net profit / 25,00,000
Therefore, Net Profit = 12,50,000

(iii) Tax Rate = 35%

Therefore, Profit before tax x (1-t ) = Net profit
Therefore, Profit before tax = 19,23,077
Tax = 6,73,077

(iv) Capital Turnover Ratio = Sales / Capital

1.2 = Sales / ( Equity + Long term debt)
1.2 = Sales / ( 25,00,000 + 50,00,000)
Sales = 90,00,000

(v) Closing Stock = 8% x Sales

= 8% x 90,00,000
= 7,20,000
Gross profit = 90,00,000 x 30% = 27,00,000
Cost of goods sold = 63,00,000

Trading A/c for the year ending 31st March, 2015

Particular Amount Particular Amount
To Opening Stock 4,50,000 By Sales 90,00,000
To Purchases (Bal. figure) 65,70,000 By Closing Stock 7,20,000
To Gross Profit c/f to P&L A/c 27,00,000
97,20,000 97,20,000
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Chapter 3 Ratio Analysis Page No. 3.10
Profit and & Loss A/c for the year ending 31st March, 2015
Liability Amount Assets Amount
To Interest on long term debt @14% 7,00,000 By Gross Profit b/f 27,00,000
To Miscellaneous Exp. (bal. fig) 76,923
To Income Tax 6,73,077
To Net Profit 12,50,000

27,00,000 27,00,000
Quick Revision:
Q5. (20)
RTP May 18 Old and New- RTP Nov 15, MTP 2019

Based on the following particulars List out various assets and liabilities and prepare a Balance

sheet of Tirupati Ltd.

Fixed assets turnover ratio 8 times

Capital turnover ratio 2 times
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
GP Ratio 25%
Gross profit during the year amounts to Rs. 8,00,000. There is no long-term loan or
overdraft. Reserve and surplus amount to Rs. 2,00,000. Ending inventory of the year is Rs.
20,000 above the beginning inventory.
Solution
(i) GP Ratio = Gross profit/ Sales
25% = 8,00,000 / Sales
Sales = 32,00,000

(ii) Cost of Goods Sold = Sales – Gross profit

32,00,000 -8,00,000 = 24,00,000

(iii) Receivable turnover = Sales / Receivable

4 = 32,00,000 / Receivable
Receivable = 8,00,000

(iv) Fixed assets turnover = Sales / Fixed Assets

8= 32,00,000 / Fixed Asset
Therefore, Fixed Assets = 4,00,000

(v) Inventory turnover = Cost of goods sold / Average inventory

8= 24,00,000 / Average inventory

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Chapter 3 Ratio Analysis Page No. 3.11
Average inventory = 3,00,000

Average Stock = (Opening Stock + Closing Stock)/2

3,00,000 = (Opening Stock + Opening Stock + 20,000) /2
Opening Stock = 2,90,000 and closing stock = 3,10,000

Opening Stock
(vi) Payable Turnover ratio = Credit Purchase/ Average Creditors + Purchase
6= (24,00,000 + 3,10,000 -2,90,000 )/ Average Creditors - Closing Stock
= COGS
Average Creditors = 4,03,000

(vii) Capital turnover = Sales / Total Capital

2= 32,00,000/ Total capital
Total Capital = 16,00,000

(viii) Share Capital = Capital Employed – Reserves & Surplus

16,00,000 – 2,00,000 = 14,00,000

Balance Sheet of Tirupati Ltd as on

Liability Amount Assets Amount
Share Capital 14,00,000 Fixed Assets 4,00,000
Reserve & Surplus 2,00,000 Closing Inventories 3,10,000
Payables 4,03,333 Receivables 8,00,000
Other Current Assets 4,93,333
Total 20,03,333 Total 20,03,333

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Chapter 10 Working Capital Management Page No. 10.1
Working Capital (WC) Formula for Calculation of Holding period
Gross Working Current asset Raw material Average cost of stock of raw material
Capital storage Average cost of raw material per day
Net Working Current Assets- Current Liabilities period
capital
365/ raw material turnover ratio

Part A
Management of Working capital WIP holding Average cost of stock of Work in progress

Method 1- Operating Cycle Method period Average cost production per day
What it 1. It signifies the time required for
signifies? conversion of RM into WIP into FG into 365/ WIP turnover ratio
Debtor and then back into cash
2. It gives the time required for
completion of one cycle and thus the FG holding Average cost of stock of Finished goods
fund required for Working capital period Average cost of goods sold per day

Formula RM storage Period + WIP Holding

365/ FG turnover ratio
period+ FG storage period+ Debtors
collection period – Creditors credit
period allowed Debtors Average accounts receivable
Holding Average credit sales per day
R+W+F+D –C period

How to 1. Calculate Operating cycle 365/ Debtor turnover ratio

Calculate WC 2. Calculate no. of cycle in one year
requirement 3. Divide annual operating expenditure . Creditors Average accounts payable
. No of operating cycles
payment Average credit purchase per day
period

365/ Creditors turnover ratio

Chapter 10 Working Capital Management Page No. 10.2
COST SHEET Steps in this type of Questions
Step 1 Determine the elements of current assets and
For calculation of various wc requirement
current liabilities
Opening stock of Raw material
Step 2 Determine the holding period and the units
Add: purchase
Step 3 Determine the rate at which it should be value
Less Closing Stock
– Refer table below
Raw Material consumed (Used for calculation of
Step 4 Find out the amount of each item
RM requirement)
Step 5 Ascertain the net working capital considering
Add opening WIP
cash balance, loans and advances etc.
Direct manufacturing expense
Direct wages Statement of WC requirement
Less closing WIP Current Assets Lead/lag Amount Total
Cost of production (Used for Calculation of Inventory
WIP requirement) - Raw Material
- Work in progress
Add opening Stock of FG - Finished goods
Less Closing stock of FG Receivable
COGS (used for calculation of - Trade debtors
FG) - Bills
Minimum Cash balance
Add Admin expense
Gross Working capital
Add S&D expense
Current Liabilities:
Cost of sales - Trade Payables/
bills payable
Method 2 - Wages Payables
- Payables for
Estimating WC requirement through overheads
estimation of each individual element Excess of Current Assets
over Current Liabilities
What does it signifies Requirement of WCM for each
Add: Safety Margin
individual element
Net Working Capital
[III + IV]
Chapter 10 Working Capital Management Page No. 10.3
Raw Materials Inventory: Estimated production in units x Estimated cost of RM per unit x RM holding period
USE RM CONSUMED 12 months or 365 days

Work-in-Progress Inventory: Estimated production in units x Estimated WIP cost per unit x WIP holding period
USE COST OF PRODUCTION 12 months or 365 days
Finished Goods: Estimated production in units X Estimated COGS x FG Holding period
USE COST OF GOODS SOLD (ex. Depreciation/ unit) 12 months or 365 days

Receivables (Debtors): Estimated credit sales in units x cost of sales x Average debtor collection period
USE COST OF SALES (ex. depreciation per unit ) 12 months or 365 days
Trade Payables: Estimated production in units x RM purchased per unit x Avg. creditor payment period
RM PURCHASED 12 months or 365 days
Direct Wages payable: Estimated production in units x Direct labour cost/ unit x Average time lag in payment
ANNUAL WAGES PAYABLE 12 months or 365 days of wages
Overheads: Estimated production in units x Ohds per unit x Average time lag in payment of ohds.
ANNUAL OHDS. PAYABLE 12 months or 365 days
360 days may be taken in many cases instead of 365 days in absence of information. However
assumption shall be written

RATE OF VALUATION UNDER DIFFERENT APPROACHES

Component Total Approach Cash cost approach
Raw Material Purchase price net of discount Purchase price net of discount
Work in Progress Raw material + 50%[ direct labour + direct expenses+ Raw material + 50%[ direct labour + direct expenses+ all
all production overheads] production overheads excluding depreciation]
Finished goods Cost of production Cost of production- depreciation
Debtors Selling price SP- profit margin- depreciation
Sundry creditors Purchase price net of discount Purchase price net of discount
Chapter 10 Working Capital Management Page No 10.4
Cash Management Format
These Variety ofQuestions
Receipts: M1 M2 M3 M4 Mn are not generally asked in
1. Opening balance exam
2. Collection from
debtors
3. Cash sales Boumol Model
4. Loans from banks Boumoul Model (2AT/H) 1/2
5. Share capital A = Annual Cash requirement
6. Miscellaneous receipts T= Transaction cost per
7. Other items transaction
Total H= holding cost in %
Payments:
Calculation of Interest Op bal +Cl. Bal x Interest rate
1. Payments to creditors
forgone 2
2. Wages
Calculation of Conversion No. of Transaction x cost per
3. Overheads
cost transaction
4. Interest
Total cost Transaction cost + interest cost
5. Dividend
6. Corporate tax
7. Capital expenditure
8. Other items
Total
Closing balance
[Surplus (+)/Shortfall (-)]
Chapter 10 Working Capital management - Receivable Page No. 10.5
Evaluation of Credit Policy Format of Factoring
Particulars Present Proposed Proposed Proposed Particulars Amount
Policy Policy I Policy II Policy
I Cost of In-house Debtors Management
III
a Administration cost (avoidable)
(Rs.) (Rs.) (Rs.) (Rs.)
b Bad Debt
A. Expected Profit:
c Holding period (Refer note)
(a) Credit Sales
(b) Total Cost other than
Total Cost (a+b + c ) XXX

Bad Debts
II Cost of Factoring
(i) Variable Costs a Total Annual Sales
(ii) Fixed Costs b No of Debtors Cycle
(c) Bad Debts 360/ Drs holding period
(d) Cash discount c Credit sales/ cycle (a/b)
(e) Expected Net Profit d Commission (% of c )
before Tax (a-b-c-d) e Factor reserve (% of c)
f Amount forwarded [ c-d-e]
(f) Less: Tax
g Interest (% on f)
(g) Expected EAT
h Total cost per cycle (d+g)
B. Opportunity Cost
i Total annual cost of Factoring (b x h) YYY
of Investments in
Receivables locked up Total annual cost of Factoring YYY
in Collection Period Less Total In house management cost XXX
Net Benefits (A – B) Additional cost of factoring ZZZ
Ranking
Effective cost of factoring = Additional factoring
Opportunity cost Total cost of Debtors x Interest x HP cost x amount forwarded per cycle x 100
. 365
For calculation of opp. Cost take cost of Drs. And not
sales unless data of sales in not is given

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Chapter 10 Working Capital Management Page No10.6
Class room Key Notes
1 WIP quantity does not change with change in shift. It remains constant. However
the rate of WIP may change due to purchasing power effect. (Ref. Q6 of class work)

2 For calculation of Raw material requirement use denominators as raw material

CONSUMED and not purchase.

3 Similarly, for calculation of Creditors use PURCHASE and not consumption.

4 When the question mentions about difference in Op. and Cl. Stock then care
must be taken for calculation of purchase and consumption.

5 Again if Production is not equal to sales this will create impact on sales ( see que. 8)

6 Similarly whenever the question mentions that the company is newly started then
opening stock will be zero and then in that case follow point no. 4

7 Use sales less GP for calculation of FG and Drs when cash cost basis is not mentioned

8 FG doesn’t include Admin expenses and S&D expenses.

9 If the question mentions about GP + depreciation and ask to calculate the WC

requirement do not use GP here, rather calculate all the costs given.

10 Again if the question does not mentions about cash cost the use GP directly for
FG (same as point 7)

11 If the question asks to calculate the WC requirement using Operating cycle

method, it is advised to prepare and use cost sheet.

12 Debtors are calculated on cost of sales and not on Sales amount

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Chapter 10 Working Capital Management Page No10.7
Important Marathon Question
Q1 On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working
capital that will be required during the year. From the following information prepare the
working capital requirements forecast.
a Production during the previous year was 60,000 units. It is planned that this level of
activity would be maintained during the present year.
b he expected ratios of the cost to selling prices are Raw materials 60%, direct wages
10% and Overheads 20%.
c Raw materials are expected to remain in store for an average of 2 months before issue
to production.
d Each unit is expected to be in process for one month, the raw materials being fed into the.
pipeline immediately and the labor and overhead costs accruing evenly during the month
e Finished goods will stay in the warehouse awaiting dispatch to customers for Approx. 3 months.
f Credit allowed by creditors is 2 months from the date of delivery of raw material.
g Credit allowed to debtors is 3 months from the date of dispatch.
h Selling price is Rs. 5 per unit.
i There is a regular production and sales cycle.
j Wages and overheads are paid on the 1st of each month for the previous month. The
company normally keeps cash in hand to the extent of Rs. 20,000.

Q2 The following information has been extracted from the records of a Company:
Product Cost Sheet Rs/unit
Raw Material 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
 Raw materials are in stock on an average of two months.
 The materials are in process on an average for 4 weeks. The degree of completion is 50%.
 Finished goods stock on an average is for one month.
 Time lag in payment of wages and overheads is 1½ weeks.
 Time lag in receipt of proceeds from debtors is 2 months.
 Credit allowed by suppliers is one month.
 20% of the output is sold against cash.
 The company expects to keep a Cash balance of Rs. 1,00,000.
 Take 52 weeks per annum.
The Company is poised for a manufacture of 1,44,000 units in the year.
You are required to prepare a statement showing the Working Capital requirements of the
Company.

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Chapter 10 Working Capital Management Page No10.8

Q3 Following information is forecasted by the CS Limited for the year ending 31/3/2010:
Particulars Balance as at Balance as at
1/4/2009 -Rs. 31/3/2010- Rs.
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.
You are required to calculate:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.

Solution
Statement Showing calculation of Holding period
Component Calculation Days
Raw Material Average cost of stock of RM 53 days
holding Period Average cost of RM per day

= (45,000+65,356/ 2)
(45,000+4,00,000-65,356)/365

WIP Holding = Average Cost of Stock of WIP = 21 Days

Period Average Cost of Production Per day

= 365 * ( 35,000+51,300/ 2) ÷ 7,50,000

FG Holding = Average Cost of Stock of FG = 26 Days

Period Average Cost of Goods Sold

= 365 * (60,181+70,175/2) ÷ 9,15,000

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Chapter 10 Working Capital Management Page No10.9
Debtors Average Debtors = 41 days
Velocity Ratio Average Credit Sales

= (1,12,123+1,35,000/2) * 365 ÷ 11,00,000

Creditor = Average Creditor = 55 days

Velocity Average Credit purchase

= 365 (50,079+70,469/2) ÷ 4,00,000

Net operating = R+W+F+D-C 86 Days

cycle period = 53+21+26+41-55

Operating = 365/ 86 4.244

cycle per year

Amount of = Annual operating expense =2,23,845

working capital operating cycles per year
requirement.
= 9,50,000/4.244

Q4 The following annual figures relate to MNP Limited:

Sales (at three months credit) Rs. 90,00,000
Materials consumed (suppliers extend one and half month’s credit) Rs. 22,50,000
Wages paid (one month in arrear) Rs. 18,00,000
Manufacturing expense O/S at the end of the year ( cash Rs.2,00,000
expenses
are Paid in one month lag)
Total Administrative expenses for the year (cash expenses are Rs. 6,00,000
paid one month in arrear)
Sales Promotion expenses for the year (paid quarterly in advance) Rs. 12,00,000
The company sells its products on gross-profit of 25% assuming depreciation as a part of cost
of production. It keeps two month’s stock of finished goods and one month’s stock of raw
materials as inventory. It keeps cash balance of Rs. 2,50,000.
Assume a 5% safety margin, work out the working capital requirements of the company on
Cash cost basis. Ignore work-in-progress

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Chapter 10 Working Capital Management Page No10.10
Solution
Statement showing holding period of various elements of CA & CL
Particulars Month Rs.
1. Raw Materials 1 1,87,500
2. Finished Goods 2 10,75,000
(RM Consumption + Wages+ Manufacturing Expenses)
3. Debtors 3 20,62,500
4. Sales promotion expenses paid in advance 3 3,00,000
5. Cash balance 2,50,000
Total Current assets 38,75,000
6. Creditors 1.5 2,81,500
7. Wages 1 1,50,000
8. Manufacturing expenses 1 2,00,000
9. Admin Expenses 1 50,000
Total Current liability 6,81,250
Working capital requirement 31,93,750
Margin of Safety @5% 1,59,688
Net Working capital requirement 33,53,438

Working notes for calculation of Cost of Working Capital:

1 Raw Material = RM Consumed x RM Holding Period/ 12
= 22,50,000/ 12
= Rs. 1,87,500
2 Finished Goods = Cost of production x FG Holding period/ 12
= 64,50,000 x 2/12
= Rs. 10,75,000
3 Debtors = Cost of goods sold x Debtors Holding period/ 12
= 82,50,000 x 3/12
= 20.62,500
4 Sales promotion = SP Expenses x Average Holding period/ 12
expenses = Rs. 3,00,000

5 Creditor = RM Purchased x Creditor holidng period/ 12

= 22,50,000 x 1.5/ 12
= Rs. 2,81,250
6 Wages = Wages x Average lag in wage payment/ 12
= Rs. 1,50,000
Quick Revision

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Chapter 10 Working Capital Management Page No10.11
Q5. XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicates that materials
Are introduced in the beginning of the production cycle; wages and overhead accrue evenly
throughout the period of the cycle. Wages are paid in the next month following the month of
accrual. Work in process includes full units of raw materials used in the beginning of the
production process and 50% of wages and overheads are supposed to be conversion costs.
Details of production process and the components of working capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw materials inventory held One month consumption
Finished goods inventory held for Two months
Credit allowed by creditors One month
Credit given to debtors Two months
Cost price of raw materials Rs. 60 per unit
Direct wages Rs. 10 per unit
Overheads Rs. 20 per unit
Selling price of finished pipes Rs. 100 per unit
You are required to calculate the amount of working capital required for the company
Solution
Particulars Lag period Calculations Amount
/lead /HP
Raw 1 Month Production in units x RM Cost per unit 60,00,000
Material x RM Holding period /12
= 12,00,000 x 60 x1/12
WIP 1 Month Production per unit x WIP Cost x HP/ 12 75,00,000
= 12,00,000 x {60+ 10/2 +20/2} x1/12
FG 2 Month Cost of production x FG Holding period /12 1,80,00,000
Debtors 2 Month Cost of goods sold x Debtors Holding period/ 12 1,80,00,000
= 12,00,000 x 90 x2/12
Total CA 4,95,00,000

Trade 1 Month RM Purchased * Creditor holiding period/ 12 60,00,000

payable = 12,00,000 x 60 x1/12
Wages 1 Month = Wages * Average lag in wage payment/ 12 10,00,000
= 12,00,000 x 10 x1 /12
Total CL 70,00,000
Net WC 4,25,00,000
Quick Revision

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Chapter 10 Working Capital Management Page No10.12
Q6 A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average
collection period of 30 days wants to pursue a more liberal policy to improve sales. A study
made by a management consultant reveals the following information:-
Credit Policy Increase in Increase in sales Present default
collection period Anticipated
A 10 days Rs. 30,000 1.5%
B 20 days Rs. 48,000 2%
C 30 days Rs. 75,000 3%
D 45 days Rs. 90,000 4%

The selling price per unit is Rs. 3. Average cost per unit is Rs. 2.25 and variable costs per unit
are Rs. 2. The current bad debt loss is 1%. Required return on additional investment is 20%.
Assume a 360 days year.
Which of the above policies would you recommend for adoption?
Solution
Statement showing calculation of Various credit policies
Particulars Present policy A B C D
Sales 600000 630000 648000 675000 690000
Fixed cost 50000 50000 50000 50000 50000
Variable cost 400000 420000 432000 450000 460000
Bad debts (1%) 6000 9450 12960 20250 27600
Cash discount 0 0 0 0 0
Net benefit- A 144000 150550 153,040 154750 152400
Opportunity cost of
trade receivable B 7500 10444 13388 16667 21250
Net Benefits 136500 140106 139652 138083 131150

A WN: Calculation of Fixed cost

Current level of sales = 6,00,000
SP per unit = 3
Sales unit = 2,00,000
Total cost = 2.25 and Variable cost = 2
Fixed cost 0.25 (at this level of operation)
Total Fixed cost at this level = 0.25 x 2,00,000
Fixed cost = 50,000

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Chapter 10 Working Capital Management Page No10.13
B WN for calculation of opportunity cost
Particular Present P A B C D
Total cost 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
Holding days 30 40 50 60 75
Interest % 20% 20% 20% 20% 20%
I =total cost x interest
rate x Holding
days/No. of days 7,500 10,444 13,388 16,667 21,250

Conclusion: Since policy A gives maximum benefit, it shall be selected

Quick Revision
Same can be solved by incremental approach

Q7 A firm has a total sales of Rs. 12,00,000 and its average collection period is 90 days. The past
experience indicates that bad debt losses are 1.5% on sales. The expenditure incurred by the
firm in administering receivable collection efforts are Rs. 50,000. Opportunity cost of fund
invested elsewhere is 16% A factor is prepared to buy the firm’s receivables by charging 2%
commission. The factor will pay advance on receivables to the firm at an interest rate of 16%
p.a. after withholding 10% as reserve. Calculate effective cost of factoring to the firm.
Assume 360 days in a year.- Hw [ hint cost of factoring 66240 and cost of in-house
management of receivable= 1,16,000]
Solution
Statement showing evaluation of In House relievable vs. factoring

I Cost of In house Receivable management

Credit Sales 12,00,000
A Bad debt cost (1.5%) 18,000
B Admin cost 50,000
C Opportunity cost (12,00,000 x 16% x90/360 48,000
Total cost 68,000

II Cost of Factoring
A Total Annual Sales 12,00,000
B Average collection period 90 days
C No of Debtors Cycle [360/ Drs holding period] 4
d Credit sales/ cycle (a/c) 3,00,000
E Commission (2 % of d ) 6000
F Factor reserve (10 % of d) 30,000
g Amount forwarded [ d-e-f] 2,64,000
h Interest (16% on g) 10,560

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Chapter 10 Working Capital Management Page No10.14
i Total cost per cycle (e+h) 16,560
Total annual cost of Factoring (c x i) 66,240

Total annual cost of Factoring 66,240

Total In house management cost 68,000
Additional cost of factoring (1,760)

Effective cost of factoring = Additional factoring cost x amount forwarded per cycle x 100
Quick Revision:
**** Institute did not consider opportunity cost of investment

CA Aditya Sharma 74 1013 4858