Module III

Investment Decisions- Capital Budgeting and

Working Capital Decision
Weightage 25%

1
 Topics
I. Capital Budgeting
• Estimation of Cash Flows,
• Criteria for Capital Budgeting Decisions
❑ Pay back,
❑ Discounted. Payback ,
❑ Accounting Rate of Return
❑ Net Present Value
❑ Internal Rate of Return
❑ Profitability Index
• Issues Involved in Capital Budgeting,
• Risk analysis in Capital Budgeting –
II. An Introduction Working Capital Management
• Factors Influencing Working Capital Policy,
• Operating Cycle Analysis,
• Management of Inventory,
• Management of Receivables,
• Management of Cash and Marketable Securities,
• Financing of Working Capital
 Capital Budgeting
Acquisition of Fixed Assets
Land Long term Assets Survival
Building (What & When to Buy)
Machines
& Growth
Intangibles

Investment decisions pertain to selection of the most productive avenues with a view to
maximize the returns on investment and consequently, the shareholders wealth.

Investment decisions which are alternatively referred to as capital Budgeting decisions are
crucial for survival and growth of any Firm as they involve large capital outlay.
 Significance of Capital Budgeting

• It involves substantially higher amounts than for other routine expenses.

• The decision is irreversible, i.e. it is not possible to withdraw your steps

easily, once you have taken few steps in this regard.

• It has long term impact on the affairs of a company and it, hence
determines the future of a company.
 Cash Flow Pattern

Conventional: Conventional cash flow

pattern is an initial outflow followed by
only a series of inflows

Non-conventional: Alternating inflows and

outflows and an inflow followed by
outflows are examples of non-conventional
cash flow patterns.
 Types of Capital Budgeting Decisions

From the point of view of firm’s existence From the point of view of Decision Situation

❑ New Firm ❑Mutually Exclusive Decisions

❑ Existing Firm ❑Independent Projects / Accept-Reject
• Replacement and Modernization
Decisions
Decision
• Expansion ❑Contingent Decisions
• Diversification
Capital Budgeting Process

• Generation of Investment Ideas

• Estimating Cash Flows

• Evaluating Cash Flows

• Selecting Projects

• Execution and Monitoring

 Principles of Cash-flow Estimation

➢ Accrual principle is considered better for the purpose of accounting (Probably because it
calculates profit or loss for a given period), but for a long-term investment decision making, cash
principle will be better.
➢ Every payment of cash, for whatever purpose is an outflow,
➢ While every receipt of cash, for whatever reason is an inflow.
➢ Any Non cash expenditure (like depreciation) will not be accounted for because it does not
involve any cash flows.
➢ Cash flow should be taken on ‘ After–Tax’ basis. One should calculate Cash Flow After Tax
(CFATs)
➢ Sunk Costs should be ignored. The cost which have already been incurred should not be taken in to
account while calculating cash outflows for a period.
 Treatment of Depreciation
For taxation purposes, depreciation is charged (on the basis of written down value method)
on a “block of assets” and not on an individual asset.
A “block of assets” is a group of assets (say, of plant and machinery) in respect of which the
same rate of depreciation is prescribed by the Income-Tax Act.

Block of assets as per the Income Tax Act

For the 4 Classes of Assets, we have 12 “Block of Assets”

Buildings – 3 Blocks Plant & Machinery – 7 Blocks Intangible assets – 1 Block

❖5% Depreciation ❖20% Depreciation ❖25% Depreciation
❖10% Depreciation ❖25% Depreciation
❖100% Depreciation ❖40% Depreciation
Furniture – 1 Block ❖50% Depreciation
❖60% Depreciation
❖15% Depreciation ❖80% Depreciation
❖100% Depreciation
 Treatment of Working Capital in Project Evaluation

❑ Almost every Investment proposal requires an additional investment in Working Capital (in some
form or the other).

❑ The proposal, if accepted would require increase in minimum Cash Balance , higher inventory
levels or more receivables.

❑ Any additional investment in working capital cannot be used elsewhere and is similar to an
investment made in building, plant. Machinery etc. It has to be viewed as a cash outflow, when it
is made.

❑ At the end of the proposal , this additional working capital being invested now will be released .
Thus, any decrease in working capital can be treated as a release of working capital or cash
inflow.
 CAPITAL BUDGETING DECISION

Steps

1.Estimation of costs and benefits of a proposal or of each alternative

(determination of Cash Flows)
2.Estimation of the required rate of return, i.e., the cost of capital
3.Selection and applying the decision criterion.

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 ESTIMATION OF CASH FLOWS

The costs and benefits for a capital budgeting decision situation are measured in terms of
cash flows.
An important point is that all cash flows are considered on after tax basis.
The cash flow from the project are compared with the cost of acquiring the project.

Calculation of different cash flows

INITIAL CASH OUTFLOW:

Cost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital
Tax liability on account
- {Salvage value ( Scrap Value)
of old plant -
of capital gain on sale of
old plant (if any).
}
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 SUBSEQUENT ANNUAL INFLOWS:

Profit after tax (PAT)

+ Depreciation
– Repairs (if any)
– Capital Expenditure (if any).

TERMINAL CASH INFLOW:

Annual cash inflow
+ Working capital released
+{ Salvage value ( Scrap Tax liability on account }
Value) of capital gain on sale of
of new asset - new asset (if any).
Numerical

Q1. A company desires to make an investment of Rs. 1,00,000 in a new machinery.

Additional installation and transportation cost is Rs. 20,000. The Machine has a life of 5
years after which it is expected to fetch Rs. 10,000 as scrap value. The machine is expected
to generate an output of 2000 units p.a. in the first 2 years and 3000 units p.a. for the last 3
years. The Product is expected to fetch Rs. 15 in the first 3 years and Rs. 18 in the last 2
years. The additional cost of operating a machine is expected to be Rs.5,000 p.a. for the first
3 years and Rs. 8,000 p.a. thereafter.

Calculate Cash Flow After Tax (CFATs) for the above proposal on the assumption of
Straight-line depreciation and tax rate 30%.
INITIAL CASH OUTFLOW:
Cost of new machinery 1,00,000
Add : Installation expenses 20,000
1,20,000

Calculation of Depreciation

Cost of Machinery 1,00,000

Add: Transportation & Installation Cost 20,000
1,20,000
Less: Scrap Value 10,000
Total Amount to be depreciated 1,10,000
Annual Depreciation = 22,000
1,10,000/5
 SUBSEQUENT ANNUAL INFLOWS TERMINAL CASH INFLOW:

Year 1 2 3 4 5 38,800
Annual cash inflow
a. Output (Units) 2,000 2,000 3,000 3,000 3,000
15 15 15 18 18 Scrap Value 10,000
b. Price (Rs.)
c. Revenue [ a x b] 30,000 30,000 45,000 54,000 54,000 (in Rs.) 48,800
Less :Operating Exp. 5,000 5,000 5,000 8,000 8,000
Less: Depreciation 22,000 22,000 22,000 22,000 22,000
Total Cash Inflow
d. Profit Before Tax (PBT) 3,000 3,000 18,000 24,000 24,000
= 24100
Less : Tax @ 30% 900 900 5,400 7,200 7,200 +24100
e. Profit After Tax (PAT) 2,100 2,100 12,600 16,800 16,800 +34600
+38800
Add Back : 22,000 22,000 22,000 22,000 22,000
+48800
Depreciation
CFAT (PAT + Dep.) 24,100 24,100 34,600 38,800 38,800 170400
 TECHNIQUES
OF
EVALUATION

Non-Discounting Discounting

Discounting
Pay Back Period ARR NPV IRR PI
Payback

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 Payback Period

The payback period is the time duration required to recover the initial cash outflows. This
method is based on cash flows and not on accounting data.
(a) When there is uniform annual cashflow
Initial cash outflow
Payback Period=
Annual cash inflow

(b) When there is un-even cash flow

Cash Flow yet to be recovered
Payback Period = Completed Years +
Cash flow for the next year
Q2. A company is considering a proposal to spend Rs. 1,00,000 on a new proposal. The cash
inflows are expected as follows, year I Rs. 20,000, year II Rs. 30,000, year III Rs. 30,000,
year IV Rs. 40,000, year V Rs. 40,000,
Calculate Payback period for the above proposal
Year Cash Cumulative
inflows Cash inflows Cash Flow yet to be recovered
Payback Period = Completed Years +
(Rs.) (Rs.) Cash flow for the next year
I 20,000 20,000

II 30,000 50,000 20,000

Payback Period = 3+
40,000
III 30,000 80,000 = 3.5 years

IV 40,000 1,20,000

V 40,000 1,60,000
 Average Rate of Return
This Method considers the earnings expected from the investment over their whole life. It is known
as Accounting Rate of Returns Method because under this method, the Accounting concept of profit
(Net profit after depreciation and tax) is used instead of Cashflow.
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
Accounting Rate of Return = x 100
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Q3. A project requires an investment of Rs 5,00,000 and has a scrap value of Rs20,000 after five year.
It is expected to yield profits after depreciation and taxes during the five years amounting to
Rs40,000, Rs 60,000, Rs 70,000, Rs 50,000 and Rs 20,000. Calculate Average Rate of Return.
Total Profits = Rs40,000+ Rs 60,000+Rs 70,000 + Rs 50,000 +Rs 20,000 = Rs 2,40,000
2,40,000
Average Profit = = Rs 48,000
5
Net Investment in project = Rs5,00,000 – Rs 20,000 = Rs 4,80,000
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
Average Rate of Return= x100
𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
48,000
Average Rate of Return = x100 = 10 percent
4,80,000
 Discounted Payback Period
Q4. A company is considering a project with initial outflow of Rs. 1,00,000. The Cash inflows from
the project are expected to be as follows. Find out the payback period by the traditional method as well
as by discounted method @ 10% discount. Cash inflows from year 1 to year 5 are as follows:
Rs 20,000, Rs 30,000, Rs 30,000, Rs 40,000 & Rs 30,000
Solution
Discounted Payback period
Year Cash Discount Cumulative Discounte Discounted
Flows @10 Cash flows d Cash Cumulative Discounted Payback Period =
Cash Flow yet to be recovered
flows Cash flows Completed Years +
Cash flow for the next year
@ 10%
1 20,000 .909 20,000 18,182 18,182 7165
Discounted Payback Period = 4+18626 = 4.38 years
2 30,000 .826 50,000 24,793 42,975
3 30,000 .751 80,000 22,539 65,514
Payback period
4 40,000 .683 1,20,000 27,321 92,835
20,000
5 30,000 .621 1,50,000 18,628 1,11,463 Payback Period = 3+ = 3.5 Years
40,000
6 20,000 .564 1,70,000 11,289 1,22,752
 Net Present Value
Net Present Value = Present Value of Cash inflows less Present Value of Cash outflow
▪ Accept if Present value of Cash inflow is > Present value of cash outflow
▪ Reject if Present Value of cash inflow is < Present Value of cash outflow
▪ Indifferent if Present Value of cash inflow = Present value of cash outflow
Q5. A company is considering a project with initial outflow of Rs. 1,00,000. The Cash inflows from
the project are expected to be as follows. Find out the payback period by the traditional method as
well as by discounted method @ 10% discount. Cash inflows from year 1 to year 5 are as follows:
Rs 20,000, Rs 30,000, Rs 30,000, Rs 40,000 & Rs 30,000
Year Cash Flows PV of Rs1@10% PV of cash inflow Net Present Value
1 20,000 .909 18,182
Present Value of Cash inflow = Rs1,22,752
2 30,000 .826 24,793
Less Present Value of Outflow= Rs 1,00,000
3 30,000 .751 22,539
4 40,000 .683 27,321 Net Present Value = Rs 22752
5 30,000 .621 18,628
6 20,000 .564 11,289
 Internal Rate of Return

Internal Rate of Return is the Rate of return where the Net Present Value is zero. If NPV is
positive, Increase the Rate of Interest and If NPV is negative then decrease the Rate of
Interest to move towards Zero
The Internal Rate of Return IRR can be calculated by use of log or by a scientific calculator
or by computer instantly. However, the following method can be used for the purpose.
𝑋
IRR = r +
𝑋−𝑌

Where r = the closest rate at which NPV is positive

x = value of positive NPV at that level
y = value of negative NPV at next higher rate

Profitability Index (PI) or Benefit- Cost (B-C) Ratio

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability Index or PI =
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡 𝑓𝑙𝑜𝑤
 Acceptance and Ranking Rule for IRR

❑ The IRR should be greater than the given discount rate (cost of capital) to make a project acceptable.
❑ If IRR is less than the cost of capital then, the proposal can not be accepted as it will lead to a negative
NPV.
❑ Since, IRR is a rate of return, the project with a higher IRR should be ranked higher than the other
project which has a lower IRR.

Numerical Question

Q6. A company is considering, purchase of machinery which costs Rs.8,00,000 & has an estimated life of 10 yrs.
This machine will generate a sales of Rs.4,00,000 per year while costs and maintenance will be Rs.1,00,000 per
Year. The cost of the machine is depreciated on a straight line and has no salvage value At the end of its 10 yrs
life. The company has a cost of capital of 10% and a corporate Tax rate of 40%.
calculate;
i. Annual cash flow
ii. Pay back period
iii. The NPV
iv. Profitability Index
v. IRR 24
Q7. From the following information calculate the NPV and PI of the two projects and suggest, which of the
two project should be accepted assuming discount rate of 10%.
project X Project Y
Initial investment Rs. 20,000 Rs.30,000
Estimated life 5 yrs 5 yrs
Scrap value Rs.1000 Rs.2000

cash flow after taxes are as follows;

year1 year2 year3 year4 year5

Project X 5000 10000 10000 3000 2000
Project Y 20,000 10,000 5000 3000 2000
Q8. The Cash inflows as well as the Cash outflow of a project of ABCL Ltd is given as follows;
Year outflow inflow
0 1,50,000 -
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000
Salvage value at the end of the 5th year is Rs 40,000. The project will be accepted if the yield is 10% Calculate
the NPV.
Q9. Calculate the Cash flow after tax from the following information:
Purchase price of machine is Rs.600000 and the life of the Machine is 5 years
Working capital required is Rs.300000
Estimated salvage value at the end of the useful life is Rs 100000
Actual salvage value realized at the end was Rs. 150000.
Method of depreciation is straight line
Tax rate is 30% Tax on capital gain is 40%
Earning before depreciation & taxes are Rs.300000.
Replacement Questions
Q10. Question.
Zapak is considering a new automatic blender. The new blender would last for 10 yrs and would be depreciated
to zero over 10 year period. The old blender would also last for 10 more years and would be depreciated to
zero over the same 10 year period. The old blender has a book value of Rs. 20,000 but could be sold for Rs.
30,000. The new blender would cost Rs. 1, 00,000. It would reduce Lab our expenses by Rs. 48000 a year. The
company is subject to a 50% tax rate on regular income as well as on capital gain. The cost of capital is 10%.
You are required to calculate the NPV and find out whether to go for automatic blender or not.

Q11. Rocks Ltd has a machine having an additional life of 5 yrs which costs Rs.10,00000 and has a book value
of Rs.400000. A new machine costing Rs.20,00000 is available. Though its capacity is the same as that of the
old machine, It will mean a saving in variable cost to the extent of Rs.700000 per annum. The life of the
machine will be 5 yrs at the end of which it will have a scrap value of Rs.300000. The rate of income tax is
40%. The cut off rate of the company 12%. The old machine, if sold today, will realize Rs.100000. it will have
no salvage value, If sold at the end of 5 yrs. Advise Rocks Ltd whether or not the old machine should be
replaced. The Capital Gain tax rate is 50%.
If the cut off rate is 18% than will your decision remain same to replace the machine.
Q12. The Relevant information relating to the existing plant as well a a proposed New plant is given below:

Existing Plant Proposed Plant

Book Value of the Project Rs 24,000 Rs54,000
Remaining Life of the Project Rs 6 years 6 years
Depreciation Per Annum Rs 4,000 Rs 9,000
Salvage Value if Sold Today Rs 20,000 Nil
Profit Before Dep & Taxes Rs 8,000 Rs 15,000
Evaluate the proposal using NPV method and give suggestion whether to replace the plan or not.
The Tax Rate is 30 percent, and the Required Rate of Return is 10 percent

Q13. Walt ltd , plans to undertake a project for placing a new product in the market. The Company’s cut off rate is 12%. It
was estimated that the project would cost Rs.40,00,000 In plant and machinery in addition to working capital of Rs.
10,00,000. which will be Recovered in full when the project’s 5 year life is over. The scrap value of plant & Machinery at
the end of 5 yrs was estimated at Rs. 5,00,000.
After providing for Depreciation on straight line basis, profit after tax are as follows.
Rs 300,000, Rs 8,00,000, Rs 13,00,000, Rs 5,00,000 and Rs 4,00,000
Evaluate the project under i. Payback method ii. NPV method iii. Profitability Index
Q14. From the following information analyse the two machines and suggest which
Machine should be purchase based on NPV Method of Evaluation.

Machine X Machine Y
Purchase price Rs.500000 Rs.800000
Life of the machine 5 yrs 8 yrs
Salvage value nil nil
Method of depreciation straight line straight line
Tax rate 30% 30%
Annual sales Rs.10,00000 Rs.10,00000
Variable cost 40% of sales 30% of sales
Fixed cost other than depreciation Rs.100000 Rs.200000
Annuity factor for 5yrs and 8 yrs @ 10% 3.791 5.335
Q15. Gopal Industries limited is considering the purchase of a new which would carry out some operations at
present being performed by hands. Two alternate Models are under consideration. Alpha and Max Pro. The
following information is available in respect of two models.

Particular Alpha Max Pro

Cost of Machine Rs 10,00,000 Rs 15,00,000
Estimated Life 10 Years 15 Years
Estimated Savings in Scrap (p.a.) Rs 60,000 Rs 80,000
Additional cost of Supervision p.a. Rs 65,000 Rs85,000
Additional Cost of Maintenance p.a. Rs 35,000 Rs 50,000
Cost of Indirect Material P.a. Rs 30,000 Rs 40,000
Estimated Savings in Wages
(i) Wages per worker Rs 3000 Rs 3000
(ii) No of workers not Required 200 workers 250 Workers

Using Pay back Period method, suggest which Machine should be purchased. Tax Rate is 50 percent
Q16.A machine is purchased six years back for Rs. 1,50000 has been depreciated to a
Book value of Rs.90, 000. It originally had a projected life of 15 years. There is a
proposal to replace this machine.
A new machine will cost Rs. 2, 50,000 and result in reduction of operating cost by
Rs.30, 000 Per annum for next 9 years. The existing machine can be scrapped away for
Rs. 50,000. The new machine will also be depreciated over 9 year’s period with salvage
value of Rs.25000. The tax rate is 50 percent, and the cost of capital is 10 percent.
Determine whether this existing machine should be replaced or not
Working Capital Management
 Meaning of Working Capital

Working Capital refers to that part of the firm’s capital, which is required for financing
short-term or current assets such a cash marketable securities, debtors and inventories.
Funds thus, invested in current assets keep revolving fast and are constantly converted
into cash and this cash flow out again in exchange for other current assets.

Working Capital is also known as revolving or circulating capital or short-term capital.

“circulating capital means current assets of a company that are changed in the ordinary
course of business from one form to another”.
e.g., from cash to inventories, inventories to receivables, receivable to cash
 Concept of working capital
There are two possible interpretations of working capital concept:

❑ Balance sheet concept

❑ Operating cycle concept

Balance sheet concept

There are two interpretations of working capital under the balance sheet concept.

❑ Gross Working Capital

❑ Net Working Capital.

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 Operating cycle concept
A company’s operating cycle typically consists of three primary activities:
➢ Purchasing resources,
➢ Producing the product and
➢ Distributing (selling) the product.

These activities create funds flows that are both unsynchronized and uncertain.

✓ Unsynchronized because cash disbursements (for example, payments for resource

purchases) usually take place before cash receipts (for example collection of
receivables).
✓ They are uncertain because future sales and costs, which generate the respective
receipts and disbursements, cannot be forecasted with complete accuracy.

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 FACTORS DETERMINING WORKING CAPITAL

➢ Nature of the Business

➢ Size of the Business
➢ Availability of raw material
➢ Manufacturing time
➢ Inventory Turnover Ratio
➢ Business Cycle
➢ Credit Policy
Estimating the Net Working Capital Requirement
Estimating Working Capital Requirement

Cash
Stock of Raw Material
Work in Progress
Finished Goods
Debtors

Creditors
Outstanding Expenses [Lag in
payments]

Net Working Capital

Q1. Estimate the net working capital requirement for loop ltd.
Add 20% to your computed figure to allow contingencies.
Estimated cost per unit of production Amount per unit (Rs)
Raw Material 100
Direct Wages 40
Overheads (inclusive of depreciation Rs 10) 70
Selling Expenses 20
Additional information
Total output 100000 units
Raw material in stock, average 8 weeks
Work in progress average 6 weeks
Finished goods in stock, average 6 weeks
Credit allowed by supplier, average 4 weeks
Credit allowed to debtors, average 2 weeks
Lag in payment of wages, average 1.5 weeks Selling Expenses 2 weeks
Cash at bank expected to Rs.40, 000.Consider 52 weeks in a year.
Q2. Forecast the working capital Requirement of X Ltd with the following information:
Particulars Amount Per Unit
Raw Material
Alpha Rs. 50
Beta Rs.30
Direct Lab our Rs 40
Factory Overheads (inclusive of Depreciation 10) Rs 30
Office Expenses Rs 10
Selling Expenses Rs10
Additional Information
Selling Price is Rs 200 per unit. Level of Production is 200000 units
Raw Material Alpha in stock for 6 weeks & Beta is for 4 weeks.
Work in Progress take Average time of 5 weeks( assume 50% completion stage in respect
Of conversion cost and 100% completion in respect of material.
Finished Goods in stock for 4 weeks; Credit allowed to debtors average 8 weeks
Credit allowed by the supplier is 4 weeks: Lag in payment of Wages is 2 weeks
Cash in hand is Rs. 50000. Add 10 % contingencies to your calculations
All sales are credit Sales.
Calculation of Operating Cycle
Gross Operating Cycle = RMCP+WIPHP+FGHP+RCP
RMCP = Raw Material Conversion Period
WIPHP= Work in Progress Holding Period
FGHP = Finished Good Holding Period
RCP = Receivable Conversion Period

Cash operating Cycle = Gross operating Cycle Less Average payment period
1. Raw Material Conversion Period Average Stock of RM
x 360
RM Consume
2. Work in progress conversion period Average Stock of WIP
𝑥 360
Total cost of Production
3. Finishing Goods Conversion Period Average Stock of FG
𝑥 360
Total cost of Goods Sold
4. Receivable Conversion Period Average Account Recievables
𝑥 360
Net Credit Sales
5. Creditors’ payment period Average Payables
𝑥 360
Net Credit Purchases
Gross Operating Cycle 1+2+3+4

Net Operating Cycle = Gross Operating Cycle Less Creditor payable period
Q3. From the following data compute the duration of the operating cycle for each of the two years and
comment on increase or decrease.
Particulars Year1 (in Rs) Year 2(in Rs)

Stock
Raw Material 20000 27000
Work in progress 14000 18000
Finished goods 21000 24000
Purchase of raw materials 96000 135000
Cost of goods sold 140000 180000
Sales 160000 200000
Debtors 32000 50000
Creditors 16000 18000
 A B

RMCP RMCP= (360∗Stock of RM)/(Cost of RM consumed) 75 72

WIP HP WIP HP= (360∗Stock of WIP)/(Cost of goods manufactured) 36 36

FG HP FG HP= (360∗Stock of FG)/(Cost of goods sold (COGS)) 54 48

DCP DCP= (360∗Debtors)/(Credit Sales) 72 90

CPP CPP= (360∗Creditors)/Purchases 60 48

OC RMCP+ WIP HP+ FG HP+ DCP-CPP 177 198

 Yr 1 Yr 2 Change

RMCP RMCP= (360∗Stock of RM)/(Cost of RM consumed) 75 72 3-day decrease

WIP HP= (360∗Stock of WIP)/(Cost of goods
WIP HP manufactured) 36 36 no change
FG HP= (360∗Stock of FG)/(Cost of goods sold
FG HP (COGS)) 54 48 6 days decrease

DCP DCP= (360∗Debtors)/(Credit Sales) 72 90 18days increase

CPP CPP= (360∗Creditors)/Purchases 60 48 12 days decrease

OC RMCP+ WIP HP+ FG HP+ DCP-CPP 177 198 21 days increase

Q4. Calculate the operating cycle period and cash cycle period
Period covered is 365 days
Average period of credit allowed by the supplier is 16 days
(Rs’ 000)
Total debtor outstanding 480
Raw material Consumption 4400
Total cost of production 10000
Total cost of goods sold 10500
Sales for the year 16000
Stock of Raw Material 320
Stock of WIP 350
Stock of Finished Good 260
Inventory Management and
Cash Management Model
 Economic Order Quantity
The Inventory Management basically focus on maintaining an optimum level of inventory
in order to minimize the costs attached with different inventory levels.

Average level of inventory to a great extend, depends upon the number of units procured in
one lot and then the speed at which these units are used or sold

The Average level can be optimized by careful analysis of quantity ordered, carrying cost
of each unit and the annual requirement of different items.

Economic Order Quantity model attempts to determine the orders size that will minimize
the total inventory costs. It is assumed that total inventory cost = Total carrying Cost
+Total ordering cost

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The EOQ Model as a technique of inventory management defines three parameters for any
inventory item:

❑ Minimum level of inventory of that item depending upon the usage rate of that item,
time lag in procuring that item and unforeseen circumstance, if any

❑ The re-order level of that item, at which next order for that item must be placed to avoid
any chance of a stock out and

❑ The re-order Quantity for which each order must be placed.

The EOQ Model attempts to determine quantity to be ordered at the time so as to optimize
the cost of carrying and holding inventory and also ensuring availability of the item
whenever needed.
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 EOQ = Economic Order Quantity
𝐸𝑂𝑄 = 2𝐴𝑂 A = Total Annual requirement for the item
𝐶 O = Ordering Cost per order of the item
C = Carrying Cost per unit per annum

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Question1: Annual Consumption of a particular raw material is 2,00,000 units costing ₹ 3 each.
Average cost of placing an order is ₹200 and Annual cost of storage is 50 paise per unit.
(i) Find out Economic order Quantity.
(ii) What would be the EOQ if order cost is ₹100

Question 2: The following information is available in respect of an item:

Annual Usage is 20,000 units
Ordering Cost (O) is ₹1,875 and Carrying Cost (C) is ₹ 3 Per unit.
Find out the Economic Order Quantity.

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 Cash Management
Baumol Model
Suggested by W J Baumol (1952), this model is same as economic order quantity model of
inventory management.
This model attempts to balance the income foregone on cash held by the firm against the
transaction cost of converting cash into marketable securities or vice versa.

This model is based on the proposition that in order to reduce the holding cost, a firm keeps the
least amount of cash in hand. However, as the cash level depletes, the firm can acquire cash by
selling some of its marketable securities.
Each time the firm transacts in this way, it bears a transaction cost, so it would like to transact as
occasionally as possibly. This could be done by maintaining a higher cash level involving a high
holding cost. Thus, the firm has to deal with the holding cost as well as the transaction cost.

The optimum cash balance is founded by controlling the holding cost and the transaction cost
so as to minimize the total cost of holding cash.
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The cash is recovered by selling marketable securities in such a way that the transaction cost is
optimally balanced with the holding cost of cash

C Cash Required each time to restore balance to

2𝐹𝑇 minimum cash.
𝐶=
𝑟 F = Total cash required during the year
T = Cost of each transaction between cash and
marketable securities.
r = Rate of interest on Marketable Securities

The total cash need of the firm is ₹ 5,00,000 per annum. It’s rate of interest is 15% and every
time it has to pay ₹ 25 to enter into a transaction or marketable securities, calculate minimum or
optimum cash level of the firm
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 The annual Cash requirement of A limited is ₹10 lakhs. The company has marketable securities in lot sizes of ₹
50,000, ₹1,00,000, ₹ 2,00,000, ₹2,50,000 and ₹5,00,000. Cost of conversion of marketable securities per lot is
₹1000. The company can earn 5% annual yield on its securities. (i) Calculate the economic lot size can be
obtained by the Baumol Model (ii) You are required to prepare a table indicating which lot size will have to be
sold by the company
Solution 2𝐹𝑇 2𝑥 1000000 𝑥1000 = ₹2,00,000
(i) 𝐶 =
𝑟 𝐶= 0.5
(ii)
Table indicating Lot Size
(a) Annual Requirement of cash (₹) 10,00,000 10,00,000 10,00,000 10,00,000 10,00,000
(b) Lot Size of securities (₹) 50,000 1,00,000 2,00,000 2,50,000 5,00,000
(c) Number of Lot size (a) ÷ (b) 20 10 5 4 2
(d) Average Holding of cash (₹) (b) ÷2 25,000 50,000 1,00,000 1,25,000 2,50,000
(e) Opportunity Holding cost of cash (₹) (d) x 5% 1250 2500 5000 6250 12500
(f) Fixed Conversion Cost per transaction (₹) 1000 1000 1000 1000 1000
(g) Total Conversion Cost (₹) [(C) x (f)] 20,000 10,000 5000 4000 2000
(h) Total Cost (₹) [(e) + (g)] 21250 12500 10,000 10,250 14,500

The above table clearly indicates that the total cost is minimum ₹10,000 when the Lot size of
securities is ₹2,00,000 and thus it is the economic lot size of selling securities