CA Test series

Notes

Important Question

CA Inter
Financial Management &
Economics for Finance
 FM & Eco
IMPORTANT QUES – ANS

1. TOPIC - EBIT & EPS ANALYSIS

Q-1. The Modern Chemicals Ltd. requires Rs.25,00,000 for a new plant. This plant is expected to
yield earnings before interest and taxes of Rs.5,00,000. While deciding about the financial plan,
the company considers the objective of maximizing earnings per share.
It has three alternatives to finance the projects by raising debt of Rs.2,50,000 or Rs.10,00,000 or
Rs.15,00,000 and the balance in each case, by issuing equity shares. The company’s share is
currently selling at Rs.150, but is expected to decline to Rs.125 in case the funds are borrowed
in excess of Rs.10,00,000. The funds can be borrowed at the rate of 10% up to Rs.2,50,000 at
15% over Rs.2,50,000 and upto Rs.10,00,000 and at 20% over Rs.10,00,000. The tax rate
applicable to the company is 50%.
Which form of financing should the company choose?
A-1. Statement of EPS

Particulars Alternatives

1 2 3
Earnings before interest and tax 5,00,000 5,00,000 5,00,000
Less: Interest:
@ 10% on first Rs.2,50,000 25,000 25,000
@ 15% on Rs.2,50,001 to Rs.10,00,000 - 1,12,500 1,12,500
@ 20% on above Rs.10,00,000 - - 1,00,000
EBT 4,75,000 3,62,500 2,62,500
Less: Tax @ 50% 2,37,500 1,81,250 1,31,250
EAT 2,37,500 1,81,250 1,31,250
÷ No. of Equity shares 15,000 10,000 8,000
(22,50,000/150) (15,00,000/150) (10,00,000/125)
EPS Rs.15.833 Rs.18.125 Rs.16.406
Decision:
The earnings per share is higher in alternative II i.e. if the company finance the project by
raising debt of Rs.10,00,000 & issue equity shares of Rs.15,00,000. Therefore, the company
should choose this alternative to finance the project.

Q-2. A Company earns a profit of Rs.3,00,000 per annum after meeting its interest liability of
Rs.1,20,000 on 12% debentures. The Tax rate is 50%. The number of Equity Shares of Rs.10 each
are 80,000 and the retained earnings amount to Rs.12,00,000. The company proposes to take
up an expansion scheme for which a sum of Rs.4,00,000 is required.
It is anticipated that after expansion, the company will be able to achieve the same return on
investment as at present. The funds required for expansion can be raised either through debt at
the rate of 12% or by issuing Equity Shares at par.
Required:
(i) Compute the Earnings Per Share (EPS), if:
(a) The additional funds were raised as debt
(b) The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable.
A-2.
(i) Statement of EPS

Particulars Alternatives

Debt Plan Equity Plan

Earnings before interest and tax @ 14% of Rs.34,00,000 4,76,000 4,76,000
Less: Interest:
Existing 1,20,000 1,20,000
New (12% on Rs.4,00,000) 48,000 -
EBT 3,08,000 3,56,000
Less: Tax @ 50% 1,54,000 1,78,000
EAT 1,54,000 1,78,000
÷ No. of Equity shares
Existing 80,000 80,000
New - 40,000
EPS Rs.1.925 Rs.1.483

Working notes:
1. Calculation of capital employed before expansion plan:
Equity share capital Rs.8,00,000
Retained earnings Rs.12,00,000
Debentures (1,20,000/12%) Rs.10,00,000
Total capital employed Rs.30,00,000
2. Earnings before the payment of Interest and tax (EBIT):
Profit before tax Rs.3,00,000
Interest Rs.1,20,000
EBIT Rs.4,20,000

3. Return on Capital Employed (ROCE):

ROCE = × 100 = × 100 = 14% Employed Capital EBIT 000 ,00,30000 ,20,4
4. After expansion capital employed = Rs.34,00,000 (Rs.30,00,000 + Rs.4,00,000)
(ii) Advise to the company: Since EPS is greater in the case when company arranges additional
funds as debt. Therefore, the company should finance the expansion scheme by raising debt.
Q-3. Yoyo Limited presently has Rs.36,00,000 in debt outstanding bearing an interest rate of 10
per cent. It wishes to finance a Rs.40,00,000 expansion programme and is considering three
alternatives: additional debt at 12 per cent interest, preference shares with an 11 per cent
dividend, and the issue of equity shares at Rs.16 per share. The company presently has 8,00,000
shares outstanding and is in a 40 per cent tax bracket.
(a) If earnings before interest and taxes are presently Rs.15,00,000, what would be earnings per
share for the three alternatives, assuming no immediate increase in profitability?
(b) Analyze which alternative do you prefer? Compute how much would EBIT need to increase
before the next alternative would be best?
A-3.
(a) Statement of EPS

Particulars Alternatives

Debt Preference Equity

Earnings before interest and tax 15,00,000 15,00,000 15,00,000
Less: Interest:

Existing @ 10% on Rs.36,00,000 3,60,000 3,60,000 3,60,000

New 12% on Rs.40,00,000 4,80,000 - -

EBT 6,60,000 11,40,000 11,40,000
Less: Tax @ 40% 2,64,000 4,56,000 4,56,000
EAT 3,96,000 6,84,000 6,84,000
Less: Preference Dividend - 4,40,000 -
Earnings Available for Equity Shareholders 3,96,000 2,44,000 6,84,000
÷ No. of Equity shares 8,00,000 8,00,000 10,50,000
EPS Rs.0.495 Rs.0.305 Rs.0.651
(b) For the present EBIT level, equity share is clearly preferable. EBIT would need to increase by
Rs.23,76,000 − Rs.15,00,000 = Rs.8,76,000 before an indifference point with debt is reached.
One would want to be comfortably above this indifference point before a strong case for debt
should be made. The lower the probability that actual EBIT will fall below the indifference
point, the stronger the case that can be made for debt, all other things remain the same.
Working Note:
Indifference Point between Equity and Debt plan:
(EBIT−I) (1−T)/NE = (EBIT−I) (1−T)/ND
(EBIT−3,60,000) (1−0.40)/10,50,000 = (EBIT−8,40,000) (1−0.40)/8,00,000
EBIT = Rs.23,76,000

2. TOPIC - LEVERAGE

Q-4. 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:
(i) Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
(ii) Determine the likely level of EBIT, if EPS is Rs.4, or Rs.2, or Zero.

A-4 (i) Operating Leverage =Contribution / EBIT = 90 Lacs 60% / 36 Lacs 10 Lacs = 1.38
Financial Leverage =EBIT / EBT = 26 Lacs / 26 Lacs 12%of 40 Lacs = 1.23
Combined Leverage = OL × FL = 1.38 × 1.23 = 1.70
Earnings Per Share = PAT / Equity shares = 21,20,000 (1-.30) / 4,00,000 = Rs.3.71

(ii) Calculation of likely level of EBIT:

Earnings Per Share = PAT / Equity shares = (EBIT-I)(1-t) / Equity shares
Case I: Rs. 4.00 = (EBIT - 4,80,000) (1 - 0.30) / 4,00,000 or EBIT = Rs.27,65,714
Case II: Rs.2.00 = (EBIT - 4,80,000) (1 - 0.30) / 4,00,000 or EBIT = Rs.16,22,857
Case III: Rs.0.00 = (EBIT - 4,80,000) (1 - 0.30) / 4,00,000 or EBIT = Rs.4,80,000

Q-5. The capital structure of the Progressive Corporation consists of an ordinary share capital of
Rs.1,00,00,000 (share of Rs.100 par value) and Rs.10,00,000 of 10% debentures.
Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs.10 per unit;
variable cost amounts to Rs.6 per unit and fixed expenses amount to Rs.2,00,000.
The income tax rate is assumed to be 50%.
You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) The degree of operating leverage at 1,00,000 units and 1,20,000 units.
(iii) The degree of financial leverage at 1,00,000 units and 1,20,000 units.
(iv) Comment on the behavior of operating and financial leverages in relation to increase in
production from 1,00,000 units to 1,20,000 units.
A- 5.
(i) Calculation of % increase in EPS
Particulars 1,00,000 units 1,20,000 units
Sales @ Rs.10 per unit 10,00,000 12,00,000
Less: Variable cost 6,00,000 7,20,000
Contribution 4,00,000 4,80,000
Less: Fixed cost 2,00,000 2,00,000
Profit before interest and tax 2,00,000 2,80,000
Less: Interest @ 10% of Rs.10 lacs 1,00,000 1,00,000
Profit before tax 1,00,000 1,80,000
Less: Tax @ 50% 50,000 90,000
Profit after tax 50,000 90,000

÷ No. of shares 1,00,000 1,00,000

Earnings per share Rs.0.50 Rs.0.90

% increase in EPS = 0.90 - 0.50 × 100 = 80%
(ii) Degree of Operating Leverage = Contribution / EBIT
At 1,00,000 units = 4,00,000 / 2,00,000 = 2 times
At 1,20,000 units = 4,80,000 / 2,80,000 = 1.71 times
(iii) Degree of Financial Leverage = EBT EBIT
At 1,00,000 units = 2,00,000 / 1,00,000 = 2 times
At 1,20,000 units = 2,80,000 / 1,80,000 = 1.56 times
(iv) Increase in production and sales will result in decrease in risk.
Q-6. On the basis of following information calculate Operating leverage with the help of Margin
of Safety:
Particulars Product X
Number of Unit Sold 1,000
Sale Price per unit Rs.50
Variable Cost per unit Rs.30
Fixed Cost Rs.15,000

A-6. Statement Showing Operating Leverage

Particulars Product X
Sale 50,000
Less: Variable Cost per unit 30,000
Contribution 20,000
Less: Fixed cost 15,000
Earning before interest and tax 5,000
Break-even point (Fixed Cost ÷ Contribution per unit) or (15,000 ÷ 20) 750 units
Margin of Safety (1,000 units – 750 units) 250 units
Margin of Safety to Sales (250 units ÷ 1,000 units) 0.25
Operating Leverage (1 ÷ MOS to sales ratio) or (1 ÷ 0.25) 4 times
Q-7. A firm has sales of Rs.75,00,000 variable cost is 56% and fixed cost is Rs.6,00,000. It has a
debt of Rs.45,00,000 at 9% and equity of Rs.55,00,000.

(i) What is the firm’s ROI?

(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low
capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?

A-7. Income Statement

Particulars Rs.
Sales 75,00,000
Less: Variable cost @ of 56% of sales 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
EBIT 27,00,000
Less: Interest @ 9% of 45,00,000 4,05,000
EBT 22,95,000
(i) ROI = EBIT / Capital Employed × 100 = 27,00,000 / 45,00,000+55,00,000 × 100 = 27%
(ii) ROI is 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.
(iii) Capital Turnover = Net Sales / Capital = 75,00,000 / 1,00,00,000 = 0.75
Firm has very low capital turnover as compared to industry average of 3.
(iv) Calculation of Operating, Financial and Combined leverages:
Operating Leverage =Contribution / EBIT = 33,00,000 / 27,00,000 = 1.222
Financial Leverage = EBIT/ EBT = 27,00,000 / 22,95,000 = 1.176
Combined Leverage = OL × FL = 1.222 × 1.176 = 1.437
(v) Operating leverage is 1.22. So if sales is increased by 10% then EBIT will be increased by
1.222 × 10 i.e. 12.22% (approx)
(vi) EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 56% sales – 6,00,000 – 4,05,000
44% of sales = 10,05,000
Sales = 22,84,091
Hence at Rs.22,84,091 sales level EBT of the firm will be equal to Zero.
(vii) Financial leverage is 1.176. So, if EBIT increases by 20% then EBT will increase by 1.18 ×
20% = 23.52% (approx)

Q-8. You are given the following information of 5 firms of the same industry:
Firm Change in Revenue Change in Operating Income Change in EPS
M 28% 26% 32%
N 27% 34% 26%
P 25% 38% 23%
Q 23% 43% 27%
R 25% 40% 28%
Find out:
(a) Degree of operating leverage , and
(b) Degree of combined leverage of all the firms
A-8.
(a) Degree of Operating Leverage = %Change in operating income / % Change in revenue
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
 Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60

(b) Degree of Combined Leverage = % Change in EPS / %Change in revenue

M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12

3. TOPIC - MANAGEMENT OF RECEIVABLES

Q-9. A firm has total sales as Rs.200 lakhs of which 80% is on credit. It is offering credit term of
2/40, net 120. Of the total, 50% of customers avail of discount and the balance pay in 120 days.
Past experience indicates that bad debt losses are around 1% of credit sales. The firm spends
about Rs.2,40,000 per annum to administer its credit sales. These are avoidable as a factor is
prepared to buy the firm’s receivables. He will charge 2% commission. He will pay advance
against receivables to the firm at an interest rate of 18% after withholding 10% as reserve.
(i) What is the effective cost of factoring? Consider year as 360 days.
(ii) If bank finance for working capital is available at 14% interest, should the firm avail of
factoring service?
A-9.
(i) Statement of Effective Cost of Factoring to the Firm
Particulars Rs.
(A) Cost of factoring:
Factoring commission (Rs.71,111 × 360 Days/80 Days) 3,20,000
Interest charges (Rs.31,28,889 × 18%) 5,63,200
Total (A) 8,83,200

(B) Savings:

Saving in credit administration cost 2,40,000

Saving in bad debts (1% × 80% × Rs.2,00 Lakhs) 1,60,000

Total (B) 4,00,000

Effective cost of factoring (A - B) 4,83,200

Rate of effective cost 16.09%
Alternatively:
If cost of factoring is calculated on the basis of total amount available for advance, then, it will
be
Rate of effective cost = = 15.44%
(ii) If bank finance for working capital is available at 14%, firm will not avail factoring services as
14% is less than 16.08% (or 15.44%).
Working Notes:
1. Calculation of advance:
Particulars Rs.
Average receivables (Rs.200 Lakhs × 80% × 80/360) 35,55,556
Less: Factor reserve @ 10% of Rs.35,55,556 3,55,556
Maximum possible advance 32,00,000
Less: Commission @ 2% of Rs.35,55,556 71,111
Amount available for advance 31,28,889
Less: Interest (Rs.31,28,889 × 18% × 80/360) 1,25,156
 Amount of advance 30,03,733
2. Average collection period = 40 Days × ½ + 120 Days × ½ = 80 Days

Q-10. PQR Ltd. having annual sales of Rs.30,00,000, is re considering its present collection
policy. At present the average collection period is 50 days, bad debt losses are 5% of sales. The
company is incurring an expenditure of Rs.30,000 on account of collection of receivables. Cost
of funds is 10 percent.
The alternative policies are:
Alternative I Alternative II
Average collection period reduced to 40 days 30 days
Bad debt losses 4% of sales 3% of sales
Collection expenses Rs.60,000 Rs.95,000
Evaluate the alternatives on the basis of incremental approach and state which alternative is
more beneficial.

A-10.
Statement of Evaluation

Particulars Current Alternate 1 Alternate 2

Sales 30,00,000 30,00,000 30,00,000
Cost of investment in Debtors 41,096 32,877 24,658
1. Saving in cost in Debtors - 8,219 16,438
Bad debt losses 1,50,000 1,20,000 90,000
2. Saving in Bad debt losses - 30,000 60,000
Collection expenses 30,000 60,000 95,000
3. Increase in collection expenses - 30,000 65,000
Incremental Benefit (1 + 2 - 3) - 8,219 11,438
Analysis: Since incremental benefit over present policy is higher in case of alternative II, select
Alternative II. It is suggested to reduce the collection period from existing 50 days to 30 days.
Working Notes:
Calculation of cost of investment in debtors:
Existing = 30,00,000 × 50/365 × 10% = 41,096
Alternative I = 30,00,000 × 40/365 × 10% = 32,877
Alternative II = 30,00,000 × 30/365 × 10% = 24,658

Q-11. The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the
company’s records by the owner, Mr. Gautam, revealed that payments are usually made 15
days after purchases are made. When asked why the firm did not take advantage of its
discounts, the accountant, Mr. Rohit, replied that it cost only 2 per cent for these funds,
whereas a bank loan would cost the company 12 per cent.
(a) Analyze, what mistake is Rohit making?
(b) If the firm could not borrow from the bank and was forced to resort to the use of trade
credit funds, what suggestion might be made to Rohit that would reduce the annual interest
cost? Identify.
A-11.
(a) Rohit is confusing the percentage cost of using funds for 5 days with the cost of using funds
for a year. These costs are clearly not comparable. One must be converted to the time scale of
the other.
Real cost of not taking advantage of discount is:
2 / 98 ×365 / 5 × 100 = 148.98%
(b) Assuming that the firm has made the decision not to take the cash discount, it makes no
sense to pay before the due date. In this case payment should be made after 30 days rather
than 15 days and it would reduce the annual interest cost to 37.24 per cent:
2 / 98 ×365 / 20 × 100
= 37.24%

Q-12. Slow Payers are regular customer of Goods Dealers Ltd., Calcutta and have approached
the sellers of extension of a credit facility for enabling them to purchase goods from Goods
Dealer Ltd. On an analysis of past performance and on the basis of information supplied, the
following pattern of payment schedule is regard to Slow Payers:
Pattern of Payment Schedule
At the end of 30 Days 15% of the bills
At the end of 60 Days 34% of the bills
At the end of 90 Days 30% of the bills
At the end of 100 Days 20% of the bills
Non-recovery 1% of the bills
Slow Payers want to enter into a firm commitment for purchase of goods of Rs.15 Lacs in 2017,
deliveries to be made in equal quantities on the first day of each quarter in the calendar year.
The price per unit of commodity is Rs.150 on which a profit of Rs.5 per unit is expected to be
made. It is anticipated by Goods Dealers Ltd. that taking up of this contract would mean an
extra recurring expenditure of Rs.5,000 per annum.
If the opportunity cost of funds in the hands of Goods dealers is 24% per annum, would you
as the finance manager of the seller recommend the grant of credit to Slow Payers? Workings
should form part of your answer. Assume year of 365 days.
A-12
Statement of Evaluation of Credit Policy
Particulars Proposed
Sales in units 10,000
Sales value @ Rs.150 per unit 15,00,000
Less: Variable cost @ Rs.145 per unit 14,50,000
Less: Extra recurring expenditure 5,000
Profit before bad debt 45,000
Less: Bad debts @ 1% 15,000
Expected Profit 30,000
Less: Opportunity cost of investment in receivables (WN) 68,788
Net Benefit (38,788)
Recommendation: The proposed policy should not be adopted since the net benefit under this
policy is negative.
Working notes:
Calculation of Opportunity cost of average investment:
Opportunity cost = Total cost × Average Collection / 365 × Rate
= 14,55,000 × 71.90/365 × 24% = 68,788
Calculation of Average collection period:
Average collection period = 30 days × 15% + 60 days × 34% + 90 days × 30% + 100 days × 20%
= 71.90 Days

Q-13. A current credit sales of a firm is Rs.15,00,000 and the firm still has an unutilized
capacity. In order to boost its sales, the firm is willing to relax its credit policy.
The firm proposes a new credit policy of 2/10 net 60 days as against the present policy of 1/10
net 45days. The firm expects an increase in the sales by 12%. However, it is also expected that
bad debts will go upto 2% of sales from 1.5%.
The contribution to sales ratio of the firm is 28%. The firm's tax rate is 30% and firm requires an
after tax return of 15% on its investment. 50 percent and 80 percent of customers in term of
sales revenue are expected to avail cash discount under existing and liberalization scheme
respectively.
Should the firm change its credit period?
A-13.
Statement of Evaluation

Particulars Policies

Present Proposed

Sales value 15,00,000 16,80,000

Less: Variable cost @ 72% of sales 10,80,000 12,09,600
Profit before cost of credit 4,20,000 4,70,400
Less: Bad debts @ 1.5% / 2% 22,500 33,600
Less: Cash Discount ‘WN’ 7,500 26,880
Expected PBT 3,90,000 4,09,920
Less: Tax @ 30% 1,17,000 1,22,976
Expected PAT 2,73,000 2,86,944
Less: Cost of investment in debtors ‘WN’ 12,205 9,942
Net benefit after tax 2,60,795 2,77,002
Yes, the firm should change its credit period.
Working notes:
1. Calculation of opportunity cost of investment in receivables:
Existing = 10,80,000 × 15% × 27.5 (.5×10+.5×45)/365 = 12,205
Proposed = 12,09,600 × 15% × 20 (.8×10+.2×60)/365 = 9,942

2. Calculation of cash discount:

 Existing = 15,00,000 × 50% × 1% = 7,500
Proposed = 16,80,000 × 80% × 2% =26,880

TOPIC - 4. - TREASURY AND CASH MANAGEMENT

Q-14. The following details are forecasted by a company for the purpose of effective utilization
and management of cash:
(i) Estimated sales and manufacturing costs:
Month Sales Rs. Materials Rs. Wages Rs.
April 4,20,000 2,00,000 1,60,000
May 4,50,000 2,10,000 1,60,000
June 5,00,000 2,60,000 1,65,000
July 4,90,000 2,82,000 1,65,000
August 5,40,000 2,80,000 1,65,000
September 6,10,000 3,10,000 1,70,000

(ii) Credit terms:

20% sales are on cash, 50% of the credit sales are collected next month and the balance in the
following month.
Credit allowed by suppliers is 2 months and delay in payment of wages is 1/2 month and of
overheads is 1 month.
(iii) Interest on 12 percent debentures of Rs.5,00,000 is to be paid half yearly in June and
December.
(iv) Dividends on investments amounting to Rs.25,000 are expected to be received in June,
2010.
(v) A new machinery will be installed in June, 2010 at a cost of Rs.4,00,000 which is payable in
20 monthly installments from July, 2010 onwards.
(vi) Advance income-tax to be paid in August, 2010 is Rs.15,000.
(vii) Cash balance on 1st June, 2010 is expected to be Rs.45,000 and the company wants to
keep it at the end of every month around this figure, the excess cash (in multiple of thousand
rupees) being put in fixed deposit.
You are required to prepare monthly cash budget on the basis of above information for four
months beginning from June, 2010.

A-14.
Cash Budget
(From July to September)

Particulars June July August September

Opening Balance 45,000 45,500 45,500 45,000
Cash Sales & Debtors Collection 4,48,000 4,78,000 5,04,000 5,34,000
Dividend 25,000 - - -
Total A 5,18,000 5,23,500 5,49,500 5,79,000
Payments to creditors 2,00,000 2,10,000 2,60,000 2,82,000
Wages 1,62,500 1,65,000 1,65,000 1,67,500
Overheads 40,000 38,000 37,500 60,800
Interest 30,000 - - -
Machine installments - 20,000 20,000 20,000
Advance tax - - 15,000 -
Total B 4,32,500 4,33,000 4,97,500 5,30,300
Balance (A – B) 85,500 90,500 52,000 48,700
Less: Fixed deposit 40,000 45,000 7,000 3,000
Closing balance 45,500 45,500 45,000 45,700
Working Note 1: Cash Sales and Collection from Debtors
 From Debtors Total Collection
Month Sales Cash Sales 20%
50% 50%
April 4,20,000 - - - -
May 4,50,000 - - - -
June 5,00,000 1,00,000 1,80,000 1,68,000 4,48,000
July 4,90,000 98,000 2,00,000 1,80,000 4,78,000
August 5,40,000 1,08,000 1,96,000 2,00,000 5,04,000
September 6,10,000 1,22,000 2,16,000 1,96,000 5,34,000
Working Note 2: Payment of wages:

Payment Total Payment

Month Wages
50% 50%
May 1,60,000 - - -
June 1,65,000 80,000 82,500 1,62,500
July 1,65,000 82,500 82,500 1,65,000
August 1,65,000 82,500 82,000 1,65,000
September 1,70,000 82,500 85,000 1,67,500

Q-15. You are given below the Profit & Loss Accounts for two years for a company:
Particulars Year 1 Year 2 Particulars Year 1 Year 2
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
By Closing
To Raw materials 3,00,00,000 4,00,00,000 1,00,00,000 1,50,00,000
stock
 By Misc.
To Stores 1,00,00,000 1,20,00,000 10,00,000 10,00,000
Income
To Manufacturing
1,00,00,000 1,60,00,000
exps

To Other expenses 1,00,00,000 1,00,00,000

To Depreciation 1,00,00,000 1,00,00,000

To Net Profit 1,30,00,000 1,80,00,000

9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000

Sales are expected to be Rs.12,00,00,000 in year 3.
As a result, other expenses will increase by Rs.50,00,000 besides other charges. Only raw
materials are in stock. Assume sales and purchases are in cash terms and the closing stock is
expected to go up by the same amount as between year 1 and 2. You may assume that no
dividend is being paid. The Company can use 75% of the cash generated to service a loan.
Compute how much cash from operations will be available in year 3 for the purpose? Ignore
income tax.

A-15.
Working Notes:
(a) Material consumed in year 2 = Rs.350 Lakhs ÷ Rs.1,000 lakhs = 35% of sales
Likely consumption in year 3 = Rs.1,200 Lakhs × 35% = Rs.420 Lakhs
(b) Stores are 12% of sales, as in year 2
(c) Manufacturing expenses are 16% of sales
Projected Profit and Loss Account for the year 3 (Rs. in Lakhs)
Year 2 Year 3 (Actual) (Projected)
Particulars Particulars
(Actual) (Projected) Year 2 Year 3
To Raw Materials Consumed 350 420 By Sales 1,000 1,200
To Stores 120 144 By Misc. Income 10 10
To Manufacturing Expenses 160 192
To Other Expenses 100 150
To Depreciation 100 100
To Net Profit 180 204
1,010 1,210 1,010 1,210

Cash Flow:
(Rs. in
Particulars
Lakhs)
Net Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock (50 Lakhs same as between year 1 and 2) (50)
Net Cash Inflow 254
Available for servicing the loan: 75% of Rs.2,54,00,000 or Rs.1,90,50,000
Note: The above also shows how a projected profit and loss account is prepared

Q-16. Tarus Ltd. has an estimated cash payments of Rs.8,00,000 for a one month period and the
payments are expected to steady over the period. The fixed cost per transaction is Rs.250 and
the interest rate on marketable securities is 12% p.a.
Calculate the optimal transaction size, average cash and number of transactions during one
month.

A-16.
2×8,00,000×12×250
Optimal transaction size =√ 0.12
= Rs.2,00,000
Number of transactions p.m. = Monthly cash requirement ÷ Transaction size
= Rs.8,00,000 ÷ Rs.2,00,000 = 4 transactions

TOPIC – 5. MANAGEMENT OF WORKING CAPITAL

Q-17. The following information is provided by the DPS Limited for the year ending 31st
March, 2013
Raw material storage period 55 days
Work-in progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditor’s payment period 60 days
Annual Operating cost (including depreciation of Rs.2,10,000) Rs.21,00,000
1 year 360 days

You are required to calculate:

I. Operating Cycle period.
II. Number of Operating Cycle in a year.
III. Amount of working capital required of the company on a cash cost basis.
IV. The company is a market leader in its product, there is virtually no competitor in the market.
Based on a market research it is planning to discontinue sales on credit and deliver products
based on pre-payment. Thereby, it can reduce its working capital requirement substantially.
What would be the reduction in working capital requirement due to such decision?
A-17.
I. Operating cycle = R + W + F + D – C = 55 + 18 + 22 + 45 – 60
= 80 Days
II. No. of operating cycle = 360 / 80 = 4.5 times

III. Working Capital = Annual cash operating cost × Operating cycle / 360 Days
= (Rs.21,00,000 – Rs.2,10,000) × = Rs.4,20,000 Days 360 Days 80
IV. In case of cash sales operating cycle period will reduce by 45 Days (Debt collection period).
Revised operating cycle period = 55 + 18 + 22 – 60 = 35 Days
Revised working capital = (Rs.21,00,000 – Rs.2,10,000) × 35/360 Days = Rs.1,83,750 Days
Reduction in working capital = Rs.4,20,000 - Rs.1,83,750 = Rs.2,36,250

Q-18. The following annual figures relate to XYZ Co.

Sales (at 2 months' credit) Rs.36,00,000
Materials consumed (suppliers extend two months’ credit) Rs.9,00,000
Wages paid (1 month lag in payment) Rs.7,20,000
Cash Manufacturing expenses (1 month lag in payment) Rs.9,60,000
Administrative expenses (cash 1 month lag in payment) Rs.2,40,000
Sales promotion expenses (paid quarterly in advance) Rs.1,20,000
The company sells its products on gross profit 25%. Depreciation is considered as a part of the
cost of production. It keeps one month’s stock each of raw materials and finished goods and a
cash balance of Rs.1,00,000. Assuming a 20% safety margin, ignore work-in-process.
Find out the requirements of working capital of the company on cash cost basis.

A-18.
Statement of Working Capital Requirement (Cash Cost Basis)
 Particulars Rs.
(A) Current Assets:
Raw Materials (9,00,000 × 1/12) 75,000
Finished Goods (25,80,000 × 1/12) 2,15,000
Debtors (29,40,000 × 2/12) 4,90,000
Cash 1,00,000
Prepaid Sales Promotion Expenses (1,20,000 × 1/4) 30,000
Total (A) 9,10,000

(B) Current Liabilities:

Creditors (9,00,000 × 2/12) 1,50,000

Outstanding labour (7,20,000 × 1/12) 60,000
Outstanding Manufacturing Expenses (9,60,000 × 1/12) 80,000
Outstanding Administrative Expenses (2,40,000 × 1/12) 20,000
Total (B) 3,10,000
Working Capital Before Provision (A - B) 6,00,000
Add : Safety Margin @ 20% of 6,00,000 1,20,000
Working Capital 7,20,000
Working Notes:
Projected Income Statement (Cash Cost Basis)
Particulars Rs.
Raw Materials 9,00,000
Wages 7,20,000
Manufacturing Expenses (in cash) 9,60,000
Cash Cost of Goods Sold 25,80,000
Administration Expenses (in cash) 2,40,000
Sales Promotion Expenses (in cash) 1,20,000
Cash Cost of Sales 29,40,000
Q-19.
A newly formed company has applied to the commercial bank for the first time for financing its
working capital requirements.
The following information is available about the projections for the current year:
Estimated level of activity is 2,08,000 completed units of production plus 8,000 units of work-in-
progress.
Based on the above activity, estimated cost per unit is:
Raw material Rs.16
Direct wages Rs.6
Overheads (exclusive of depreciation) Rs.12
Total cost Rs.34
Selling price Rs.40
Raw materials in stock: average 4 weeks consumption, work-in-progress (assume 50%
completion stage in respect of conversion cost and materials issued at the start of the
processing).
Finished goods in stock 16,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Lag in payment of overheads Average 4 weeks
Cash at banks (for smooth operation) Rs.50,000
Assume that production is carried on evenly throughout the year (52 weeks) and wages and
overheads accrue similarly. All sales are on credit basis only.
You are required to estimate net working capital.

A-19. Statement of Working Capital Requirement

Particulars Rs.
(1) Current Assets:
Raw materials (34,56,000 × 4/52) 2,65,846
Work in progress 2,00,000
Finished goods 5,44,000
Debtors (65,28,000 × 8/52) 10,04,308
Cash 50,000
Total (1) 20,64,154
(2) Current Liabilities:
Creditors (34,56,000 + 2,65,846) × 4/52 2,86,296
Outstanding labour (12,72,000 × 1.5/52) 36,692
Outstanding overheads (25,44,000 × 4/52) 1,95,692
Total (2) 5,18,680
Working Capital (1 - 2) 15,45,474
Working Notes: Projected Income Statement
Particulars Rs.
Raw materials (2,16,000 × 16) 34,56,000
Direct labour (2,08,000 + ½ × 8,000) × 6 12,72,000
Overheads (2,08,000 + ½ × 8,000) × 12 25,44,000
Cost Upto Factory 72,72,000
Less: Closing WIP 8,000 units × (16 + 3 + 6) (2,00,000)
Cost of Production (2,08,000 units) 70,72,000
Less: Closing FG 16,000 units × 34 (5,44,000)
Cost of Goods Sold (1,92,000 units) 65,28,000
Profit 11,52,000
Sales (1,92,000 × 40) 76,80,000
Q-20. Samreen Enterprises has been operating its manufacturing facilities till 31.03.2020 on a
single shift working with the following cost structure: Per unit
Rs.6.00
Wages (out of which 40% fixed) Rs.5.00
Overheads (out of which 80% fixed) Rs.5.00
Profit Rs.2.00
Selling price Rs.18.00
Sales during 2019-2020 Rs.4,32,000

As at 31.03.20 the company held:

Stock of raw materials (at cost) Rs.36,000
Work-in-progress (valued at prime cost) Rs.22,000
Finished goods (valued at total cost) Rs.72,000
Sundry debtors Rs.1,08,000
In view of increased market demand, it is proposed to double production by working an extra
shift. It is expected that a 10% discount will be available from suppliers of raw materials in view
of increased volume of business. Selling price will remain the same. The credit period allowed
to customers will remain unaltered. Credit availed of from suppliers will continue to remain at
the present level i.e. 2 months. Lag in payment of wages and expenses will continue to remain
half a month.
You are required to assess the additional working capital requirement, if the policy to
increase output is implemented.

A-20.
Statement of Cost at Single Shift and Double Shift Working
 Particulars Single Shift (24,000) Double Shift (48,000)

P. U. Total P. U. Total
Raw Materials 6.00 1,44,000 5.40 2,59,200
Wages Variable 3.00 72,000 3.00 1,44,000
Wages Fixed 2.00 48,000 1.00 48,000
Prime Cost 11.00 2,64,000 9.40 4,51,200
Overhead Variable 1.00 24,000 1.00 48,000
Overhead Fixed 4.00 96,000 2.00 96,000
Total Cost 16.00 3,84,000 12.40 5,95,200
Profit 2.00 48,000 5.60 2,68,800
Sales Value 18.00 4,32,000 18.00 8,64,000

Statement of Working Capital for Single Shift and Double Shift Working

Particulars Single Shift (24,000) Double Shift (48,000)

P. U. Units Total P. U. Units Total

(A)Current Assets:
Raw Materials Stock 6.00 6,000 36,000 5.40 12,000 64,800
WIP Stock 11.00 2,000 22,000 9.40 2,000 18,800
FG Stock 16.00 4,500 72,000 12.40 9,000 1,11,600
Debtors 16.00 6,000 96,000 12.40 12,000 1,48,800
Total (A) - - 2,26,000 - - 344,000
(B) Current Liabilities:
Creditors 6.00 4,000 24,000 5.40 8,000 43,200

Outstanding Wages 5.00 1,000 5,000 4.00 2,000 8,000

Outstanding Overheads 5.00 1,000 5,000 3.00 2,000 6,000

Total (B) - - 34,000 - - 57,200
Working Capital (A - B) - - 1,92,000 - - 2,86,800

Increase in working capital requirement is Rs.94,800 (Rs.2,86,800 - Rs.1,92,000).

Notes:
1. The quantity of material in process will not change due to double shift working since work
started in the first shift will be completed in the second shift.
2. It is given in the question that the WIP is valued at prime cost hence, it is assumed that the
WIP is 100% complete in respect of material and labour.
3. In absence of any information on proportion of credit sales to total sales, debtors quantity
has been doubled for double shift.
4. It is assumed that all purchases are on credit.
5. The valuation of work-in-progress based on prime cost as per the policy of the company

Q-21. Following information is forecasted by the CS Limited for the year ending 31st March
2020:
Bal as at 01.04.19 Bal as at 31.03.20
Raw Material 45,000 65,356
Work-in-process 35,000 51,300
Finished goods 60,161 70,175
Receivables 1,12,123 1,35,000
Payables 50,079 70,469

Annual purchases of raw materials (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
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.

A-21.
(i) Operating cycle =R+W+F+D–C
= 53 + 21 + 26 + 41 – 55 = 86 Days
Calculations:
Raw materials storage period (R) = Average stock of raw materials / Average cost of raw
materials consumption per day
=55,178 /3,79,444÷365 = 53 days
Raw materials consumption = Opening RM + Purchases – Closing RM
= 45,000 + 4,00,000 – 65,356 = 3,79,644
WIP holding period = Average stock of WIP / Average cost of production per day
= 43,150 / 7,50,000 ÷ 365 = 21 days
Finished Goods storage period = Average stock of FG / Average cost of goods sold per day
= 65,178 / 9,15,000 ÷ 365 = 26 days
Debtors collection period = Average book debts / Average credit sales per day
= 1,23,562 / 11,00,000 ÷ 365 = 41 days
Credit period availed = Average trade creditors / Average credit purchases per day
= 60,274 / 4,00,000 ÷ 365 = 55 days
 Calculation of averages:
1. Average stock of raw materials = (45,000 + 65,356) ÷ 2 = 55,178
2. Average stock of WIP = (35,000 + 51,300) ÷ 2 = 43,150
3. Average stock of FG = (60,181 + 70,175) ÷ 2 = 65,178
4. Average receivables = (1,12,123 + 1,35,000) ÷ 2 = 1,23,562
5. Average payables = (50,079 + 70,469) ÷ 2 = 60,274
(ii) Number of operating cycles in the year:
= 365 / Operating cycle period = 365 / 86 = 4.244 times
(iii) Amount of working capital required:
= Annual operating cost / Number of operating cycles = 9,50,000/ 4.244 = Rs.2,23,845
Or
Annual operating cost /365 × Operating cycle period= 9,50,000/365 = Rs.2,23,836

Q - 3,5,7,8

TOPIC – 6. CAPITAL BUDGETING/INVESTMENT DECISION

Q-21.
XYZ Ltd is planning to introduce a new product with a projected life of 8 years. The project to be
set up in a backward region, qualifies for a one time (as its starting) tax free subsidy from the
government of Rs.20,00,000 equipment cost will be Rs.140 lakhs and additional equipment
costing Rs.10,00,000 will be needed at the beginning of the third year. At the end of 8 years the
original equipment will have no resale value but the supplementary equipment can be sold for
Rs.1,00,000. A working capital of Rs.15,00,000 will be needed. The sales volume over the eight
years period has been forecasted as follows:
Year Units
1 80,000
 2 1,20,000
3-5 3,00,000
6-8 2,00,000
A sale price of Rs.100 per unit is expected and variable expenses will amount to 40% of sales
revenue. Fixed cash operating costs will amount to Rs.16,00,000 per year. In addition an
extensive advertising campaign will be implemented requiring annual outlays as follows:

Year (Rs. in lakhs)

1 30
2 15
3-5 10
6-8 4
The company is subject to 50% tax rate and considers 12% to be an appropriate after tax cost of
capital for this project. The company follows the straight line method of depreciation.
Should the project be accepted?

A-21.
Net Present Value
Year Particulars Rs. DF @ 12% PV
Initial outflows
0 (1,35,00,000) 1.000 (1,35,00,000)
(140 – 20 + 15) Lakhs
1 CFAT 2,00,000 0.893 1,78,600
CFAT less Additional Equipment
2 24,50,000 0.797 19,52,650
(34,50,000 – 10,00,000)
3-5 CFAT 85,25,000 1.915 1,63,25,375
6–8 CFAT 58,25,000 1.363 79,39,475
Working Capital and Salvage
8 16,00,000 0.404 6,46,400
(15,00,000 + 1,00,000)
 NPV 1,35,42,500
Company should accept the proposal having positive NPV of the project.
Working Notes:
1. Statement of CFAT
Particulars 1 2 3–5 6–8
Units sold 80,000 1,20,000 3,00,000 2,00,000
Sales @ Rs.100 p.u. 80,00,000 1,20,00,000 3,00,00,000 2,00,00,000

Less: VC @ 40% 32,00,000 48,00,000 1,20,00,000 80,00,000

Contribution 48,00,000 72,00,000 1,80,00,000 1,20,00,000

Less: Advertisement expenses (30,00,000) (15,00,000) (10,00,000) (4,00,000)

Less: Cash fixed cost (16,00,000) (16,00,000) (16,00,000) (16,00,000)

Less: Depreciation (15,00,000) (15,00,000) (16,50,000) (16,50,000)

PBT (13,00,000) 26,00,000 1,37,50,000 83,50,000
Less: Tax @ 50% - (6,50,000) (68,75,000) (41,75,000)
PAT (13,00,000) 19,50,000 68,75,000 41,75,000
Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000
CFAT 2,00,000 34,50,000 85,25,000 58,25,000
2. Depreciation:

Main equipment (t0 - t8) = = Original Cost- Subsidy - Salvage/ Life of Equipment = 1,20,00,000
/ 8 Years = 15,00,000

Additional equipment (t3 - t8) = Original Cost - Salvage / Life of Equipment= 9 00 000/ 6Years
= 1, 50,000
3. Tax for year 2 = 50% of (26, 00,000 – 13,00,000) = 6,50,000

Note: As per section 32 of Income Tax Act “Depreciation is not allowed on subsidized part of
asset”
Q-22. A Ltd. Is considering the purchase of a machine which will perform some operations
which are at present preformed by workers. Machines X and Y are alternative models. The
following details are available:
Particulars Machine X Machine Y
Cost of machine Rs.1,50,000 Rs.2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance per annum Rs.7,000 Rs.11,000
Estimated cost of indirect materials per annum Rs.6,000 Rs.8,000
Estimated savings in scrap per annum Rs.10,000 Rs.15,000
Estimated cost of supervision per annum Rs.12,000 Rs.16,000
Estimated saving in wages per annum Rs.90,000 Rs.1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternation
according to:
(a) Average rate of return method, and
(b) Present value index method assuming cost of capital being 10%.
(The present value of Rs.1.00 @ p.a. for 5 years is 3.79 and for 6 years is 4.354)
A-22.
(a) Statement Showing Evaluation of Two Machines (ARR)
Particulars Machine X Machine Y
A. Savings:
Saving in scrap (materials) 10,000 15,000
Savings in wages 90,000 1,20,000
Total savings (A) 1,00,000. 1,35,000
B. Cost:
Cost of maintenance 7,000 11,000

Cost of indirect materials 6,000 8,000

Cost of supervision 12,000 16,000
Depreciation (Cost of machine ÷ Life of
30,000 40,000
machine)
Total cost (B) 55,000 75,000
Profit (A – B) 45,000 60,000
Less: Tax @ 30% 13,500 18,000
Profit after tax 31,500 42,000
𝟑𝟏, 𝟓𝟎𝟎 𝟒𝟐, 𝟎𝟎𝟎
𝐏𝐀𝐓 ( × 𝟏𝟎𝟎) ( 𝟏𝟎𝟎 )
ARR (𝐈𝐍𝐕𝐄𝐒𝐓𝐌𝐄𝐍𝐓 × 𝟏𝟎𝟎) 𝟏, 𝟓𝟎, 𝟎𝟎𝟎 𝟐, 𝟒𝟎, 𝟎𝟎𝟎
21% 17.50%
Selection as per ARR Yes No
 (b) Statement Showing Evaluation of Two Machines (PI)
Particulars Machine X Machine Y
Profit after tax 31,500 42,000
Add: Depreciation 30,000 40,000
CFAT 61,500 82,000
Annuity factor for 5 years and 6 years 3.79 4.354
PV of Inflows 2,33,085 3,57,028
PV of outflows (Initial outflows × 1.000) 1,50,000 2,40,000
𝐏𝐕 𝐨𝐟 𝐈𝐧𝐟𝐥𝐨𝐰 𝟐, 𝟑𝟑, 𝟎𝟖𝟓 𝟑, 𝟓𝟕, 𝟎𝟐𝟖
PI (𝐏𝐕 𝐨𝐟 𝐎𝐧𝐟𝐥𝐨𝐰) ( ) ( )
𝟏, 𝟓𝟎, 𝟎𝟎𝟎 𝟐, 𝟒𝟎, 𝟎𝟎𝟎
1.5539 1.4876
Selection as per PI Yes No

Q-23. Elite Cooker Company is evaluating three investment situations: (1) produce a new line of
aluminum skillets, (2) expand its existing cooker line to include several new sizes, and (3)
develop a new, higher-quality line of cookers. If only the project in question is undertaken, the
expected present values and the amounts of investment required are:
Present value of future
Project Investment required
cash flows
123 Rs.2,00,000 Rs.2,90,000
 Rs.1,15,000 Rs.1,85,000
Rs.2,70,000 Rs.4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required
and present values will simply be the sum of the parts. With projects 1 and 3, economies are
possible in investment because one of the machines acquired can be used in both production
processes. The total investment required for projects 1 and 3 combined is Rs.4,40,000. If
projects 2 and 3 are undertaken, there are economies to be achieved in marketing and
producing the products but not in investment. The expected present value of future cash flows
for projects 2 and 3 is Rs.6,20,000. If all three projects are undertaken simultaneously, the
economies noted will still hold. However, a Rs.1,25,000 extension on the plant will be
necessary, as space is not available for all three projects.
Which project or projects should be chosen?
Answer
Statement of Cumulative NPV of Different Combinations
Project Investment required PV of future cash flows Net Present Value
1 Rs.2,00,000 Rs.2,90,000 Rs.90,000
2 Rs.1,15,000 Rs.1,85,000 Rs.70,000
3 Rs.2,70,000 Rs.4,00,000 Rs.1,30,000
1 and 2 Rs.3,15,000 Rs.4,75,000 Rs.1,60,000
1 and 3 Rs.4,40,000 Rs.6,90,000 Rs.2,50,000
2 and 3 Rs.3,85,000 Rs.6,20,000 Rs.2,35,000

1, 2 and 3 Rs.6,80,000* Rs.9,10,000 Rs.2,30,000

(Refer working note)

Calculation of total investment required if all the three projects are undertaken
simultaneously:
Total investment = Investment in project 1 & 3 + Investment in project 2 + Plant extension cost
= 4,40,000 + 1,15,000 + 1,25,000
= Rs.6,80,000
Advise: Projects 1 and 3 should be chosen, as they provide the highest net present value.
Q-24. Alpha Company is considering the following investment projects:

Projects Cash Flows (Rs.)

C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

(a) Rank the projects according to each of the following methods: (i) Payback, (ii) ARR, (iii) IRR
and (iv) NPV, assuming discount rates of 10 and 30 per cent.
(b) Assuming the projects are independent, which one should be accepted? If the projects are
mutually exclusive, which project is the best?

A-24.
(a) Calculation of Payback, ARR, IRR and NPV:
(i) Payback Period:
Project A = 10,000÷10,000 = 1 year
Project B = 7,500 + 2,500÷7,500 = 1.33 years
Project C = 2,000 + 4,000 + 4,000÷12,000 = 2.33 years
Project D = 10,000÷10,000 = 1 year
(ii) ARR using average investment base:
(10,000−10,000)
Project A = ( × 100) =0%
10,000 × ½
(15,000−10,000)÷2
Project B = ( × 100) =50%
10,000 × ½
(18,000−10,000÷3)
Project C = ( × 100) =53.33%
10,000 × ½
(10,000−10,000÷3)
Project D = ( × 100) = 40%
10,000 × ½

Note: Average book profit is found by deducting initial investment, otherwise student may
deduct depreciation year wise.
(iii) IRR:
Project A (The net cash proceeds in year 1 are just equal to investment):
IRR = 0%
Project B (Uniform cash inflow, so we can calculate IRR by PVAF):
PVAF for 2 years = 10,000÷7,500 = 1.33 (This factor is found under 32%)
IRR = 32%
Project C (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):
NPV at 20% = 2,000 × 0.833 + 4,000 × 0.694 + 12,000 × 0.579 - 10,000
= +1,390
NPV at 30% = 2,000 × 0.769 + 4,000 × 0.592 + 12,000 × 0.455 - 10,000
= -634
IRR = L + NPVL/ NPVL- NPVH ×(H-L) = 20% + 1,390/1,390-(-634)×(30% - 20%)
=26.87%
Project D (Unequal cash inflow, so we can calculate IRR by computing NPV using random rates):
NPV at 20% = 10,000 × 0.833 + 3,000 × 0.694 + 3,000 × 0.579 - 10,000
= +2,149
NPV at 30% = 10,000 × 0.769 + 3,000 × 0.592 + 3,000 × 0.455 - 10,000
= +831
NPV at 40% = 10,000 × 0.714 + 3,000 × 0.510 + 3,000 × 0.364 - 10,000
= -238
IRR = L + NPVL/ NPVL- NPVH ×(H-L) = 30% + 831/831-(-238) × (40% - 30%)
 =37.77%
(iv) NPV:
Project A:
NPV at 10% = 10,000 × 0.909 – 10,000 = - 910
NPV at 30% = 10,000 × 0.769 = -2,310
Project B:
NPV at 10% = 7,500 × (0.909 + 0.826) – 10,000 = +3,013
NPV at 30% = 7,500 × (0.769 + 0.592) – 10,000 = +208
Project C:
NPV at 10% = 2,000 × 0.909 + 4,000 × 0.826 +12,000 × 0.751 – 10,000
= +4,134
NPV at 30% = 2,000 × 0.769 + 4,000 × 0.592 + 12,000 × 0.455 – 10,000
= -633
Project D:
NPV at 10% = 10,000 × 0.909 + 3,000 × (0.826 + 0.751) – 10,000 = +3,821
NPV at 30% = 10,000 × 0.769 + 3,000 × (0.592 + 0.455) – 10,000 = +831
The projects are ranked as follows according to the various methods:
Ranks

Projects PBP ARR IRR NPV 10% NPV 30%

A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1

(b) Payback and ARR are theoretically unsound method for choosing between the investment
projects. Between the two time-adjusted (DCF) investment criteria, NPV and IRR, NPV gives
consistent results. If the projects are independent (and there is no capital rationing), either IRR
or NPV can be used since the same set of projects will be accepted by any of the methods. In
the present case, except Project A all the three projects should be accepted if the discount rate
is 10%. Only Projects B and D should be undertaken if the discount rate is 30%.

If it is assumed that the projects are mutually exclusive, then under the assumption of 30%
discount rate, the choice is between B and D (A and C are unprofitable). Both criteria IRR and
NPV give the same results – D is the best. Under the assumption of 10% discount rate, ranking
according to IRR and NPV conflict (except for Project A). If the IRR rule is followed, Project D
should be accepted. But the NPV rule tells that Project C is the best. The NPV rule generally
gives consistent results in conformity with the wealth maximization principle. Therefore,
Project C should be accepted following the NPV rule.

Q-25. APZ limited is considering selecting a machine between two machines ‘A’ and ‘B’. The
two machines have identical capacity, do exactly the same job, but designed differently.

Machine A costs Rs.8,00,000, having useful life of three years. It costs Rs.1,30,000 per year to
run. Machine B is an economic model costing Rs.6,00,000, having useful life of two years. It
costs Rs.2,50,000 per year to run.

The cash flows of machine ‘A’ and ‘B’ are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore taxes. The opportunity cost of capital is 10%.

The present value factors at 10% are:

Years t1 t2 t3
PVIF0.10t 0.9091 0.8264 0.7513
PVIFA0.10.2 = 1.7355
PVIFA0.10.3 = 2.4868
Which machine would you recommend the company to buy?
A-25.
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B
Initial outflow/ Purchase cost of machines 8,00,000 6,00,000
Annual running cost 1,30,000 2,50,000
Life of machines 3 years 2 years
PV of annual running cost 3,23,284 4,33,875

(2,50,000 × 1.7355)
(Annual running cost × PVIFA) (1,30,000 × 2.4868)

Present value of total outflow

11,23,284 10,33,875
(Initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.4868 ÷ 1.7355
Equivalent Annual outflow 4,51,699 5,95,722
Select the Machine A having lower equivalent annualized outflow
TOPIC – 7. RISK ANALYSIS IN CAPITAL BUDGETING

Q-26. Probabilities for net cash flows for 3 years a project are as follows:

Year 1 Year 2 Year 3

Cash Flow Cash Flow Cash Flow

Probability Probability Probability
(Rs.) (Rs.) (Rs.)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2

8,000 0.4 8,000 0.1 8,000 0.1

Calculate the expected net cash flows. Also calculate the net present value of the expected
cash flow, using 10 per cent discount rate. Initial Investment is Rs.10,000.
A-26.
Year 1 Year 2 Year 3
Expecte Expecte Expecte
Cash Cash Cash
Probabilit d Probabilit d Probabilit d
Flow Flow Flow
y Value y Value y Value
(Rs.) (Rs.) (Rs.)
(Rs.) (Rs.) (Rs.)
2,00 2,00 2,00
0.1 200 0.2 400 0.3 600
0 0 0
4,00 0.2 800 4,00 0.3 1,200 4,00 0.4 1,600
 0 0 0
6,00 6,00 6,00
0.3 1,800 0.4 2,400 0.2 1,200
0 0 0
8,00 8,00 8,00
0.4 3,200 0.1 800 0.1 800
0 0 0
ENCF 6,000 4,800 4,200
The net present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:
Expected NPV = 6,000 × 0.909 + 4,800 × 0.826 + 4,200 × 0.751 – 10,000
= Rs.2,573

Q-27. Gaurav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The
following information regarding a new project is as follows:
Year Expected cash flow (Rs.) Certainty Equivalent coefficient
0 (4,00,000) 1.0
1 +3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of return on the government securities is 6%. Determine whether the project
should be accepted.
A-27.
Statement Showing the Net Present Value of Project
Cash Flow C.E. Adjusted Cash flow (Rs.) PVF at 6% PV (Rs.)
Year
(Rs.) (b) (c) = (a) × (b) (d) (e) = (c) ×(d)
 (a)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032

5 1,60,000 0.3 48,000 0.747 35,856

Net Present Value 2,58,776

Yes accept the proposal having positive NPV.

Q-28. X Ltd is considering its New Product ‘with the following details of three years project:
Sr. No. Particulars Figures
1 Initial capital cost Rs.400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit Rs.100
4 Variable cost per unit Rs.50
5 Fixed costs per year Rs.50 Cr
6 Discount Rate 6%
1. Calculate the NPV of the project.
2. Find the impact on the project’s NPV of a 2.5 per cent adverse variance in each variable.
Which variable is having maximum effect.
A-28.
1. Calculation of Net Cash Inflow per year:
Variables Particulars Figures
A Selling Price Per Unit (A) Rs.100
 B Variable Cost Per Unit (B) Rs.50
C Contribution Per Unit (C = A - B) Rs.50
D Number of Units Sold Per Year (D) 5 Cr.
E Total Contribution (E = C × D) Rs.250 Cr.
F Fixed Cost Per Year (F) Rs.50 Cr.
G Net Cash Inflow Per Year (G = E - F) Rs.200 Cr.
Calculation of Net Present Value (NPV) of the Project:
Year Cash Flow (Rs. in Present Value (Rs. in
Year Discounting @ 6%
Cr.) Cr.)
0 -400 1.000 -400
1 200 0.943 188.60
2 200 0.890 178
3 200 0.840 168
Net Present Value 134.60
Here NPV represent the most likely outcomes and not the actual outcomes. The actual outcome
can be lower or higher than the expected outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable
Initial
Cash Selling Variable Units sold
Fixed Cost
Flow Price per Cost Per per year
Per Unit
S. increase Unit Unit reduced
Change in variable Base increased
No. d Reduced increased to
to
to to to Rs.4.875
Rs.51.25
Rs.410 Rs.97.5 Rs.51.25 crore
crore
Selling Price Per
A 100 100 97.5 100 100 100
Unit (A)
Variable Cost Per
B 50 50 50 51.25 50 50
Unit (B)
 Contribution Per
C 50 50 47.5 48.75 50 50
Unit (C = A - B)
Number of Units
D Sold Per Year (in 5 5 5 5 5 4.875
Crores)
Total Contribution
E 250 250 237.5 243.75 250 243.75
(E = C× D)
Fixed Cost Per
F 50 50 50 50 51.25 50
Year (in Crores)
Net Cash Inflow
G 200 200 187.5 193.75 198.75 193.75
Per Year (G = E-F)
H (G × 2.673) 543.60 543.60 501.19 517.89 531.26 517.89
I Initial Cash Flow 400 410 400 400 400 400
J NPV 134.60 124.60 101.19 117.89 131.26 117.89
Percentage
K - -7.43% -24.82% -12.41% -2.48% -12.41%
Change in NPV
The above table shows that the by varying one variable at a time by 2.5% while keeping the
others constant, the impact in percentage terms on the NPV of the project. Thus it can be seen
that the change in selling price has the maximum effect on the NPV by 24.82 %.

Q-29. XYZ Ltd. is considering a project “A” with an initial outlay of Rs.14,00,000 and the possible
three cash inflow attached with the project as follows:
Particular Year 1 Year 2 Year 3
Worst Case 4,50,000 4,00,000 7,00,000
Most Likely 5,50,000 4,50,000 8,00,000

Best Case 6,50,000 5,00,000 9,00,000

Cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most
likely result but uncertain about the third year’s cash flow, what will be the NPV expecting
worst scenario in the third year.
A-29.
The possible outcomes will be as follows:

Year PVF @ 9% Worst Case Most Likely Best Case

Cash Flow PV Cash Flow PV Cash Flow PV

(Rs. 000) (Rs. 000) (Rs. 000) (Rs. 000) (Rs. 000) (Rs. 000)
0 1.000 (1,400) (1,400) (1,400) (1,400) (1,400) (1,400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85
NPV with most likely but expecting worst scenario in the third year:
NPV = 5,50,000 / (1+0.09)+4,50,000 / (1+0.09)2+7,00,000 / (1+0.09)3 - - Rs.14,00,000 =
Rs.23,872

TOPIC -8 COST OF CAPITAL

Q-30. A company issued 10,000, 15% Convertible debentures of Rs.100 each with a maturity
period of 5 years. At maturity the debenture holders will have the option to convert the
debentures into equity shares of the company in the ratio of 1:10 (10 shares for each
debenture). The current market price of the equity shares is Rs.12 each and historically the
growth rate of the shares are 5% per annum.
Compute the cost of debentures assuming 35% tax rate.
A-30.
Determination of Redemption value:
Higher of
(i) The cash value of debentures = Rs.100
(ii) Value of equity shares = 10 shares × Rs.12(1 + 0.05)5
= 10 shares × 15.312 = Rs.153.12
Rs.153.12 will be taken as redemption value as it is higher than the cash option and attractive
to the investors.
Calculation of Cost of Convertible debenture:
Alternative 1: Using approximation method:
RV−NP RV−NP
Kd = I (1 − t) + ( )/ × 100 = 15 (1−0.35) + 153.12−100/ 5
n 2

153.12 + 100/2
= 16.09%
Alternative 2: Using present value method:
Calculation of NPV at two discount rates:

Present Value Present Value

Year Cash Flow
10% DCF 20% DCF
0 100 1.000 (100) 1.000 (100)
1-5 9.75 3.352 32.68 2.991 29.16
5 153.12 0.497 76.10 0.402 61.55
NPV +8.78 -9.29
IRR/Kd = LR + NPVL / NPVL – NPVH × (H - L) = 15% + 8.78/8.78-(-9.29) × (20% - 15%)
= 17.43%
Q-31. RBML is proposing to sell a 5-year bond of Rs. 5,000 at 8 per cent rate of interest per
annum. The bond amount will be amortised equally over its life.
What is the bond’s present value for an investor if he expects a minimum rate of return of 6
per cent?
A-31.
The amount of interest will go on declining as the outstanding amount of bond will be reducing
due to amortization. The amount of interest for five years will be:
First year : Rs.5,000 × 0.08 = Rs.400
Second year : (Rs.5,000 – Rs.1,000) × 0.08 = Rs.320
Third year : (Rs.4,000 – Rs.1,000) × 0.08 = Rs.240
Rs.160;
Fourth year : (Rs.3,000 – Rs.1,000) × 0.08 =
and
Fifth year : (Rs.2,000 – Rs.1,000) × 0.08 = Rs.80.

The outstanding amount of bond will be zero at the end of fifth year. Since RBML will have to
return Rs.1,000 every year, the outflows every year will consist of interest payment and
repayment of principal:

First year : Rs.1,000 + Rs.400 = Rs.1,400

Second year : Rs.1,000 + Rs.320 = Rs.1,320
Third year : Rs.1,000 + Rs.240 = Rs.1,240
Rs.1,160;
Fourth year : Rs.1,000 + Rs.160 =
and
Fifth year : Rs.1,000 + Rs.80 = Rs.1,080.
The above cash flows of all five years will be discounted with the cost of capital. Here the
expected rate i.e. 6% will be used. Value of the bond is calculated as follows:
VB = 1400/(1.06)1+1320/(1.06)2+1240/(1.06)3+1160/(1.06)4+1080/(1.06)4
Q-32. Mr. Mehra had purchased a share of Alpha Limited for Rs.1,000. He received dividend for
a period of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of
Alpha Limited for Rs.1,128.
You are required to compute the cost of equity as per realized yield approach.
A-32.
Calculation of IRR/Ke
Ke = LR + NPVL / NPVL – NPVH × (H - L) = 11% + 38.50 / 38.50-(-35.80) × (13% - 11%)
= 12.04% or 12%
Calculation of NPV at two discount rates:

Present Value Present Value

Year Cash Flow
11% DCF 13% DCF
0 1,000 1.000 (1,000) 1.000 (1,000)
1-5 100 3.696 369.60 3.517 351.70
5 1,128 0.593 668.90 0.543 612.50
NPV +38.50 -35.80

Q-33.Calculate the WACC using the following data by using:

(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:
Debentures (Rs.100 per debenture) Rs.5,00,000
Preference shares (Rs.100 per share) Rs.5,00,000
Equity shares (Rs.10 per share) Rs.10,00,000
Debentures Rs.105 per debenture
Preference shares Rs.110 per share
Equity shares Rs.24 each
Additional information:
(i) Rs.100 per debenture redeemable at par, 10% coupon rate, 4% floatation cost, 10 years of
maturity. The market price per debenture is Rs.105.
(ii) Rs.100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost, 10
years of maturity.
(iii) Equity share has Rs.4 floatation cost and market price per share of Rs.24.
The next year expected dividend is Rs.1 per share with annual growth of 5%. The firm has a
practice of paying all earnings in the form of dividends. Corporate Income-tax rate is 50%.
A-33.
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particular Book Value Weight Cost (K) Weighted cost
10% Debenture 5,00,000 0.25 5.51% 1.38%
5% Preference share 5,00,000 0.25 5.25% 1.31%
Equity Share Capital 10,00,000 0.50 10.00% 5.00%
Total 20,00,000 1.00 WACC 7.69%
(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost Weighted cost
10% Debenture 5,25,000 0.151 5.51% 0.83%
5% Preference share 5,50,000 0.158 5.25% 0.83%
Equity Share Capital 24,00,000 0.691 10.00% 6.90%
Total 34,75,000 1.0000 WACC 8.56%
Working notes:
Ke = D1 / P0 – F +g = 1/ 24 +0.05 = 10%
Kd = I(1-t) +(RV-NP/n)/ RV+NP/2 = 109(1-0.05)+(100-96/10) / 100+96/2 ×100
= 5.51%
Kp = PD++(RV-NP/n) / RV+NP/2 ×100 = 5+(100-98/10) / 100+98/2 ×100 = 5.25%

Q-34. Determine the cost of capital of Best Luck Limited using the book value (BV) and market
value (MV) weights from the following information:
Sources of Fund Book Value Market Value
Equity Shares Rs.1,20,00,000 Rs.2,00,00,000
Retained Earnings Rs.30,00,000 Nil
Preference Shares Rs.36,00,000 Rs.33,75,000
Debentures Rs.9,00,000 Rs.10,40,000
Additional Information:
1. Equity: Equity shares are quoted at Rs.130 per share and a new issue priced at Rs.125 per
share will be fully subscribed; flotation costs will be Rs.5 per share.

2. Dividend: During the previous 5 years, dividends have steadily increased from Rs.10.60 to
Rs.14.19 per share. Dividend at the end of the current year is expected to be Rs.15 per share.
3. Preference Shares: 15% Preference shares with face value of Rs.100 would realize Rs.105 per
share.
4. Debentures: The company proposes to issue 11 year 15% debentures but the yield on
debentures of similar maturity and risk class is 16%; flotation cost is 2%.
5. Tax: Corporate tax rate is 35%. Ignore dividend tax.

A-34.
(a) Calculation of Weighted Average Cost of Capital by Using Book Value Weight
Particulars Book Value Weight (W) Cost (K) Weighted cost
Equity Shares Rs.1,20,00,000 0.615 0.1850 0.1138
Retained Earnings Rs.30,00,000 0.154 0.1800 0.0277
Preference Shares Rs.36,00,000 0.185 0.1429 0.0264
Debentures Rs.9,00,000 0.046 0.1095 0.0050
Total Rs.1,95,00,000 1.000 WACC 0.1729

WACC (Ko) = 0.1729 or 17.29%

(b) Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particulars Market Value Weight (W) Cost (K) Weighted cost
*Equity Shares Rs.1,60,00,000 0.655 0.1850 0.1212
*Retained Earnings Rs.40,00,000 0.164 0.1800 0.0296
Preference Shares Rs.33,75,000 0.138 0.1429 0.0197
Debentures Rs.10,40,000 0.043 0.1095 0.0047
Total Rs.2,44,15,000 1.000 WACC 0.1752
WACC (Ko) = 0.1752 or 17.52%
Working notes:
Ke = D1/P0-F + g = 15/125-5 + 6% = 18.50%
5 14.19
g = √ = 6%
10.60

Kr = D1/P0 + g = 15/125 + 6% = 18.00%

Kd =I (1−t) + (RV−NP/n)/(RV + NP/2) × 100 = 15 (1−0.35) + (100−91.75/11)/(100 + 91.75/2)

× 100 = 10.95%
Kp = PD/NP × 100 = 15/105 × 100 = 14.29%
MV of Debenture = Interest / Market rate of Interest = 15% of 100 / 16% × 100 = Rs.93.75
NP of Debenture = MV of Debenture – Floatation Cost
= Rs.93.75 - Rs.2 (2% of Rs.100) = Rs.91.75
*Since yield on similar type of debentures is 16 per cent, the company would be required to
offer debentures at discount.
Market value of Equity Shares = Rs.2,00,00,000 × 120/150 = Rs. 1,60,00,000
Market value of Retained Earnings = Rs.2,00,00,000 × 30/150 = Rs. 40,00,000
*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained
earnings.

TOPIC – 9 , CAPITAL STRUCTURE

Q-35. X Ltd. and Y Ltd. are identical except that the former uses debt while the latter does not.
Thus levered firm has issued 10% Debentures of Rs.9,00,000. Both the firms earn EBIT of 20%
on total assets of Rs.15,00,000. Assuming tax rate is 50% and capitalization rate is 15% for an all
equity firm.
(i) Compute the value of the two firms using NI approach.
(ii) Compute the value of the two firms using NOI approach.
(iii) Calculate the overall cost of capital, Ko for both the firms using NOI approach.

A-35.
(i) Calculation of Value of firms by NI Approach:
Particulars X Ltd (Rs.) Y Ltd (Rs.)
EBIT (20% of Rs.15,00,000) 3,00,000 3,00,000
Less: Interest on Debt 90,000 -
Profit Before Tax 2,10,000 3,00,000
Less: Tax @ 50% 1,05,000 1,50,000
Profit After Tax 1,05,000 1,50,000
Equity Capitalization rate 15% 15%
Market Value of Equity (PAT  Ke) 7,00,000 10,00,000
Value of debt 9,00,000 -
Total Value of the Firm 16,00,000 10,00,000
(ii) Values of the firm as per NOI Approach:
Value of unlevered firm = EBIT(1-t)/Ko = 3,00,000(1-0.30)
= Rs.10,00,000
Value of levered firm (X Ltd) = Value of unlevered firm + Debt × tax
= Rs.10,00,000 + 9,00,000 × 50% = Rs.14,50,000
This value of Rs.14,50,000 can be bifurcated into Debt of Rs.9,00,000 and Equity of Rs.5,50,000.

(iii) Calculation of Ko under NOI Approach:

Y Ltd (Ko) = Ke = 15%
X Ltd (Ko) = KeWe + KdWd
= 19.1% × + 5% × = 10.34% 000 50 14 000 50 5 , , , , 000 ,50,14000 ,00,9
Or
X Ltd (Ko) = × 100 V ) t(EBIT1
= × 100 = 10.34% 000 ,50,14) 50
Working Notes:
Calculation of Ke of X Ltd:
Ke = Earning for Equity Market value of Equity × 100
= (3,00,000−90,000) (1−0.50) 5,50,000 × 100 = 19.10%
Q-36. RES Ltd. is an all equity financed company with a market value of Rs.25,00,000 and cost of
equity Ke 21%. The company wants to buyback equity shares worth Rs.5,00,000 by issuing and
raising 15% perpetual amount (Debt).
Rate of tax may be taken as 30%. After the capital restructuring and applying MM model with
taxes.
You are required to calculate:
(a) Market value of RES Ltd.
(b) Cost of Equity Ke.
(c) Weighted average cost of capital and comment on it.

A- 36.
(a) Market Value (MV) of RES Ltd:
MV before restructuring (VUL) = 25,00,000
MV after restructuring (VL) = VUL + Debt × Tax
= 25,00,000 + 5,00,000 × 30% = 26,50,000
(b) Cost of Equity:
Ke = Ko + (Ko – Kd) × E ) D(1-t)/E
= .21 + (.21 - .15) × 5,00,000(1-.30)/21,50,000 = 21.97%
Here,
Kd = before tax cost of debt
Ko = Ko of unlevered firm
Ko of unlevered firm = Ke of unlevered firm = 21%
E = Value of Equity
E = Value of firm – Value of Debt
 = 26,50,000 – 5,00,000 = 21,50,000
(c) Weighted average cost of capital:
WACC = KeWe + KdWd
= 21.97% × 21,50,000/26,50,000+ 10.50% × 5,00,000/26,50,000
= 19.806 %
Here,
Kd = I (1-t) = 15% (1- .30) = 10.50%
Comment: WACC after restructuring is lower than before restructuring. Hence, company should
restructure the firm.

Q-37. Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has
50 per cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per
cent equity. (All percentages are in market value terms). The borrowing rate for both
companies is 8 per cent in a no-tax world, and capital markets are assumed to be perfect.
(a) (i) If you own 2 per cent of the shares of Alpha Ltd., determine your return if the company
has net operating income of Rs.3,60,000 and the overall capitalisation rate of the company, Ko
is 18 per cent?
(ii) Calculate the implied required rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd.
(i) Determine the implied required equity return of Beta Ltd.?
(ii) Analyze why does it differ from that of Alpha Ltd.?

A-37.
(a) Value of the Alpha Ltd. = NOI / Ko = 3,60,000 / 18% = Rs.20,00,000
Value of Shares of Alpha Ltd. = 50% of Rs.20,00,000 = Rs.10,00,000
(i) Return on Shares on Alpha Ltd
Particulars Rs.
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on Rs.10,00,0,00 (50% of Rs.20,00,000) 80,000
Earnings for Equity Investors 2,80,000
Return on 2% Shares (2% of Rs.2,80,000) 5,600
(ii) Implied required rate of return on Equity = 2,80,000 / 10,00,000 × 100 = 28%

(b) (i) Return on Shares on Beta Ltd

Particulars Rs.
Net Operating income 3,60,000
Less: Interest on Debt @ 8% on Rs.4,00,0,00 (20% of Rs.20,00,000) 32,000
Earnings for Equity Investors 3,28,000
Value of Shares of Beta Ltd. = 80% of Rs.20,00,000 = Rs.16,00,000
Implied required rate of return on Equity = 3,28,000 / 16,00,000 × 100 = 20.50%
(ii) It is lower than the Alpha Ltd. because Beta Ltd. uses less debt in its capital structure. As the
equity capitalization is a linear function of the debt-to-equity ratio when we use the net
operating income approach, the decline in required equity return offsets exactly the
disadvantage of not employing so much in the way of “cheaper” debt funds.

Q-38. Following data is available in respect of two companies having same business risk:
Capital employed = Rs.2,00,000
EBIT = Rs.30,000
Sources Levered Company (Rs.) Unlevered Company (Rs.)
 Debt (@ 10%) 1,00,000 -
Equity 1,00,000 2,00,000
Ke 20% 12.5%
Investor is holding 15% shares in Unlevered company.
Calculate increase in annual earnings of investor if he switches his holding from unlevered to
levered company.
Answer
1. Calculation of Value of firms:
Particulars Levered (Rs.) Unlevered (Rs.)
EBIT 30,000 30,000
Less: Interest @ 10% 10,000 -
Earning available to Equity Shareholders 20,000 30,000
Equity Capitalization rate 20% 12.5%
Market Value of Equity (Earning for Equity  Ke) 1,00,000 2,40,000
Value of Debt 1,00,000 -
Value of the Firm 2,00,000 2,40,000
Value of Unlevered company is more than that of Levered company therefore investor will sell
his shares in unlevered company and buy shares in levered company. Market value of Debt and
Equity of Levered company are in the ratio of Rs.1,00,000 : Rs.1,00,000, i.e., 1:1. To maintain
the level of risk he will lend proportionate amount (50%) and invest balance amount (50%) in
shares of Levered company.
2. Investment:
Sell shares in Unlevered company (2,40,000 × 15%) 36,000
Lend money (36,000 × 50%) 18,000
Buy shares in Levered company 18,000
Total investment 36,000

3. Change in Return:
Income from shares in Levered company (18,000 × 20%) 3,600

Add: Interest on money lent (18,000 × 10%) 1,800

Total income after switch over 5,400
Income from Unlevered firm (36,000 × 12.5%) 4,500
Incremental Income due to arbitrage 900

TOPIC – 10 , DIVIDEND DECISIONS

Q-39. 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 per 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.
Required:
1. Calculate value of firm when dividends are not paid.
2. Calculate value of firm when dividends are paid.

A-39.
1. Value of the firm when dividends are not paid:
Step 1: Calculate price at the end of the period:
Ke = 10%, P₀ = Rs.100, D₁ = 0
Pₒ = P1 +D1 / 1+Ke
Rs.100 = P1+0 / 1+0.10 or P1 = Rs.110
Step 2: No. of shares required to be issued:
No. of shares Δn = Funds required−(E−D) / Price at end(P₁) = 2,00,000−(1,00,000−0) / 110
= 909.09 shares
Step 3: Calculation of value of firm:
nPo = (n+ Δn)P1− I+E1+Ke
nPo = (10,000+909.09)110−2,00,000+1,00,000 / (1+.10) = Rs.10,00,000

2. Value of the firm when dividends are paid:

Step 1: Calculate price at the end of the period:
Ke = 10%, P₀ = Rs.100, D₁ = Rs.5
Pₒ = P1 +D1 / 1+Ke
Rs.100 = P1+51+0.10 or P1 = Rs.105

Step 2: No. of shares required to be issued:

No. of shares Δn = Funds required−(E−D) / Price at end(P₁) = 2,00,000−(1,00,000−50,000) / 105
= 1,428.57 shares

Step 3: Calculation of value of firm:

nPo = (n+ Δn)P1− I+E1+Ke
nPo = (10,000+1,428.57)105−2,00,000+1,00,000(1+.10) = Rs.10,00,000
Thus, it can be seen that the value of the firm remains the same in either case.

Q-40.The following information is supplied to you:

Total Earnings Rs.2,00,000

No. of equity shares (of Rs.100 each) 20,000
Dividend paid Rs.1,50,000
Price/Earnings ratio 12.5
Applying Walter’s Model:
1. Ascertain whether the company is following an optimal dividend policy.
2. Find out what should be the P/E ratio at which the dividend policy will have no effect on the
value of the share.
3. Will your decision change, if the P/E ratio is 8 instead of 12.5?
A-40.
1. Ke = 1 / PE = 1 / 12.5 = 8%
r = Total Earnings / Total Funds × 100 = 2,00,000 / 20,000 Shares ×100 per share × 100 = 10%
r > Ke, Therefore as per Walter model optimum dividend payout is Nil and company is paying
dividend to shareholders means company is not following optimum dividend policy.
2. The P/E ratio at which the dividend policy will have no effect on the value of the share is such
at which the ke would be equal to the rate of return (r) of the firm.
Ke =r = 10%
PE = 1 / Ke = 1 / .10 = 10 times
3. If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be 12.5:
Ke = 1 / PE =1/8 = 12.5%
In such a situation Ke > r and optimum dividend payout will be 100%.

Question 41.
A N Ltd. gives you the following information:
The appropriate market rate of discount is 8% and that the company is expected to enjoy an
above-average performance for eight years with dividends growing at say 10% per annum.

After that time, because of competition and the company losing its present technological or
marketing lead, the growth in dividends will revert to the average for all companies-say 4%.

The present dividend is Rs.0.10 per share.

Compute the current value of equity share of the company.

A- 41.
Calculation of Present Value or Current Market Value of Share
 Year Expected benefits PVF @ 8% DCF
1 0.10 + 10% = Rs.0.11 0.926 0.101
2 0.11 + 10% = Rs.0.121 0.857 0.103
3 0.121 + 10% = Rs.0.133 0.794 0.106
4 0.133 + 10% = Rs.0.146 0.735 0.107
5 0.146 + 10% = Rs.0.161 0.681 0.110
6 0.161 + 10% = Rs.0.177 0.630 0.112
7 0.177 + 10% = Rs.0.195 0.583 0.114
8 0.195 + 10% = Rs.0.214 0.540 0.116
(9 to ꚙ ) P8 = Rs.5.55 0.540 3.00
Present value of all future benefits of Current market value of Share Rs.3.87
P8 = D9/ Ke - g = .214+4% / 8% - 4% = Rs.5.55

Q- 42.
Given the last year’s dividend is Rs.9.80, speed of adjustment = 45%, target payout ratio 60%
and EPS for current year Rs.20.
Calculate current year’s dividend using Linter’s model.
A – 42.
D₁ = D0 + [(EPS × Target payout) – D0] × Af
= 9.80 + [(20 × 60%) – 9.80] × 0.45 = Rs.10.79
TOPIC – 11, RATIO ANALYSIS

Question 43.
The following figures and ratios are related to a company:
(a) Sales for the year (all credit) Rs.30,00,000
(b) Gross profit ratio 25 percent
(c) Fixed assets turnover (basis on cost of goods sold) 1.5
(d) Stock turnover (basis on cost of goods sold) 6
(e) Liquid ratio 1:1
(f) Current ratio 1.5 : 1
(g) Debtors collection period 2 months
(h) Reserve and surplus to Share capital 0.6 : 1
(i) Capital gearing ratio 0.5
(j) 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% of net working capital including such provision.

A-43.
(1) Projected Balance Sheet Balance Sheet
Liabilities Rs. Assets Rs.
Share Capital 7,81,250 Fixed Assets 15,00,000
Reserve & Surplus 4,68,750 Stock 3,75,000
Debt 6,25,000 Debtors 5,00,000
Current Liabilities 7,50,000 Cash 2,50,000
26,25,000 26,25,000
Working Notes:
a. Cost of Goods Sold = 30,00,000 - 25% = 22,50,000
b. Fixed Assets Turnover Ratio = COGS / Fixed Assets = 1.5 times
Fixed Assets = 22,50,000 / 1.5 = Rs.15,00,000
c. Fixed Assets to Net Worth = Fixed Assets / Net Worth = 1.2 times
Net Worth = 15,00,000 / 1.2= Rs.12,50,000
d. Capital Gearing = Debt+ preference / Equity = Debt + Nil / 12,50,000
Debt = 0.5 × Rs.12,50,000 = Rs.6,25,000
Assumption: Preference Share capital is zero.
e. Reserves & Surplus = 12,50,000 × 0.6/1.6 = Rs.4,68,750
f. Share Capital = 12,50,000 × 1/1.6 = Rs.7,81,250
g. Stock Turnover = COGS / Stock = 6 times
Stock = 22,50,000 / 6 = Rs.3,75,000
h. Debtors = Sales × Collection Period / 12
= 30,00,000 × = Rs.5,00,000 12 2
i. Stock = CL (Current ratio – Liquid ratio)

Current Liabilities = Stock / CR - LR

= 3,75,500 / 1.5 – 1 = Rs.7,50,000
j. Current Ratio = CA / CL = 1.5 times
Current Assets = 1.5 × 7,50,000 = Rs.11,25,000
k. Cash in Hand = 11,25,000 - 3,75,000 - 5,00,000
= Rs.2,50,000
(2) Statement of Working Capital Requirement
Particulars Rs.
Current Assets: Stock 3,75,000
Debtors 5,00,000
 Cash 2,50,000
11,25,000
Less: Current Liabilities (7,50,000)
Working Capital Before Provision (A - B) 3,75,000
Add: Provision for Contingencies @ 10% of WC (Including provision) 41,667
𝟏𝟎𝟎
Working Capital Including Provision(𝟑, 𝟕𝟓, 𝟎𝟎𝟎 × ) 4,16,667
𝟗𝟎

Q- 44.
MNP Limited has made plans for the next year 2010-11. It is estimated that the company will
employ total assets of Rs.25,00,000; 30% of assets being financed by debt at an interest cost of
9% p.a. the direct costs for the year are estimated at Rs.15,00,000 and all other operating
expenses are estimated at Rs.2,40,000. The sales revenue are estimated at Rs.22,50,000. Tax
rate is assumed to be 40%.
You are required to calculate: (i) Net profit margin, (ii) Return on Assets, (iii) Assets turnover,
(iv) Return on equity

A-44.
(i) Net Profit Margin = EAT / Sales × 100 = 2,65,000 / 22,50,000 × 100 = 11.80%

(ii) Return on Assets = EBIT (1−t) / Assets = 5,10,000 (1−.40) / 25,00,000 = 12.24%

(iii) Assets turnover = = Assets Total Sales 000 ,00,25000 ,50,22 = 0.90

(iv) Return on Equity = EAT / Share holder’s Fund × 100 =2,65,000 / 17,50,000 × 100 = 15.171%
Working Notes:
 Particulars Rs.
Sales Revenue 22,50,000
Less: Direct Cost 15,00,000
Gross Profit 7,50,000
Less: Other operating expenses 2,40,000
EBIT 5,10,000
Less: Interest on 9% Debt (2500000 × 30% × 9%) 67,500
EBT 4,42,500
Less: Taxes @ 40% 1,77,000
EAT 2,65,500

Q- 45.
With the following ratios and further information given below prepare a Trading Account,
Profit and Loss Account and Balance Sheet of ABC Company.
Fixed Assets Rs.40,00,000
Closing Stock Rs.4,00,000
Stock turnover ratio 10 times
Gross Profit Ratio 25%
Net Profit Ratio 20%
Net profit to capital 1/5
Capital to total liabilities 1/2
Fixed assets to capital 5/4
Fixed assets / Total current assets 5/7
Answer
Trading and Profit & Loss Account
Particulars Rs. Particulars Rs.
To Opening Stock 80,000 By Sales 32,00,000
To Purchase & Conversion Cost (b.f.) 27,20,000 By Closing Stock 4,00,000
To Gross Profit c/d (25% of 32 Lacs) 8,00,000
36,00,000 36,00,000
To Operating Expenses (b.f.) 1,60,000 By Gross Profit b/d 8,00,000
To Net Profit 6,40,000
8,00,000 8,00,000

Balance Sheet
Liabilities Rs. Assets Rs.
Capital 32,00,000 Fixed Assets 40,00,000
Other Liabilities 64,00,000 Current Assets:
Stock 4,00,000
56,00,000
Other CA (b.f.) 52,00,000
96,00,000 96,00,000
Working Notes:
(i) Calculation of Capital:

= Fixed Assets / Capital = 5/4 or Capital = 40,00,000 × 4/5

= Rs.32,00,000
(ii) Calculation of Other Liabilities:
= Capital / Other Liabilities = 1/2 or Other Liabilities = 32,00,000 × 2
= Rs.64,00,000
(iii) Calculation of Current Assets:
= Fixed Assets / Current Assets = 5/7 or Current Assets = 40,00,000 × 7/5
= Rs.56,00,000
(iv) Calculation of Net Profit:
= Net Profit / Capital = 1/5 or = 32,00,000 × 1/5
= Rs.6,40,000
(v) Calculation of Sales:
= Net Profit / Sales =20% or Sales = 6,40,000 ÷ 20%
= Rs.32,00,000
(vi) Calculation of Opening Stock:
COGS = 75% of Sales = 75% of 32,00,000
= 24,00,000
= COGS / Average Stock = 10 or Average Stock = 24,00,000 ÷ 10
= 2,40,000
Average stock = (Opening Stock + Closing Stock) ÷ 2 = 2,40,000
Opening Stock = (2,40,000 × 2) – 4,00,000 = Rs.80,000

Question 46.
The following accounting information and financial ratios of PQR Ltd. relate to the year ended
31st December, 2019:
Accounting Information:

Gross profit 15% of sales

Net profit 8% of sales
Raw material consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
Financial Ratios:
Fixed assets to Sales 1:3
Fixed assets to Current assets 13 : 11
Current ratio 2:1
Long term loan to Current liabilities 2:1
Capital to Reserve and Surplus 1:4
If value of fixed assets as on 31st December, 2019 amounted to Rs.26 lakhs, prepare a
summarised profit and loss account of the company for the year ended 31st December, 2019
and also the balance sheet as on 31st December, 2019.

A- 46.
Profit and Loss account for the year ended 31.12.2019
Particulars Rs. Particulars Rs.
To Direct Materials 13,26,000 By Sales 78,00,000
To Direct Wages 6,63,000
To Works Overheads (b.f.) 46,41,000

To Gross profit (15% of Rs.78,00,000) 11,70,000

78,00,000 78,00,000
To Administration and Selling expenses (b.f.) 5,46,000 By Gross Profit 11,70,000
To Net Profit (8% of Rs.78,00,000) 6,24,000
11,70,000 11,70,000
Balance Sheet as at 31st December, 2019
Liabilities Rs. Assets Rs.
Share Capital 3,00,000 Fixed Assets 26,00,000
Reserves and Surplus 12,00,000 Current Assets:
Long term loans 22,00,000 Raw Material Stock 3,31,500
Current Liabilities 11,00,000 Finished Goods Stock 3,97,800
Receivables 12,82,192
Cash 1,88,508
48,00,000 48,00,000
Working Notes:
(a) Calculation of Sales:
Fixed Assets / Sales = 1/3 or Sales = 3 × Rs.26,00,000
Sales = Rs.78,00,000
(b) Calculation of Current Assets:
Fixed Assets / Current Assets = 13/11 or Current Assets = Rs.26,00,000 × 11/13
Current Assets = Rs.22,00,000

(c) Calculation of Raw Material Consumption and Direct Wages:

Works Cost = Sales – Gross Profit
= 78,00,000 – 15% of Sales = Rs.66,30,000
Raw Material Consumption = 20% of Rs.66,30,000 = Rs.13,26,000
Direct Wages = 10% of Rs.66,30,000 = Rs.6,63,000
(d) Calculation of Finished Goods Stock:
Finished Goods Stock = 6% of Rs.66,30,000 = Rs.3,97,800
(e) Calculation of Raw Material Stock:
Raw Material Stock = Raw Material Consumption × 3/12
= Rs.13,26,000 × 3/12 = Rs.3,31,500
(f) Calculation of Current Liabilities:
Current Ratio = Current Assets / Current Liabilities =2
Current Liabilities = Rs.22,00,000 ÷ 2 = Rs.11,00,000
(g) Calculation of Receivables:
Receivables = Credit Sales × ACP / 365
= Rs.78,00,000 × 60 / 365 = Rs.12,82,192
(h) Calculation of Long Term Loan:
Long Term Loan / Current Liabilities =2
Long Term Loan = 2 × Rs.11,00,000 = Rs.22,00,000
(i) Calculation of Cash Balance:
Current Assets = Cash + Stock + Receivables
Cash Balance = Rs.22,00,000 – (Rs.3,97,800 + Rs.3,31,500 + Rs.12,82,192)
= Rs.1,88,508
(j) Calculation of Net Worth:
Total Liabilities = Total Assets (Fixed Assets + Current Assets)
= Rs.22,00,000 + Rs.26,00,000 = Rs.48,00,000
Net Worth = Total Liabilities – Long Term Loan – Current Liabilities
= Rs.48,00,000 - Rs.22,00,000 - Rs.11,00,000
= Rs.15,00,000
(k) Calculation of Capital, Reserve and Surplus:
Net Worth = Share Capital + Reserve and surplus
Capital to Reserve and Surplus =1:4
Share Capital = Rs.15,00,000 × 1/5 = Rs.3,00,000
Reserve and Surplus = Rs.15,00,000 × 4/5 = Rs.12,00,000
Q- 47.
The Balance Sheets of A Ltd. and B Ltd. as on 31st March 2020 are as follows:
Particulars A Ltd B Ltd
Liabilities:

Share Capital 40,00,000 40,00,000

Reserve and surplus 32,30,000 25,00,000

Secured Loans 25,25,000 32,50,000

Current Liabilities and provisions:
Sundry Creditors 15,00,000 14,00,000
Outstanding Expenses 2,00,000 3,00,000
Provision for Tax 3,00,000 3,00,000
Proposed Dividend 6,00,000 -
Unclaimed Dividend 15,000 -
Assets: 1,23,70,000 1,17,50,000

Fixed Assets (Net) 80,00,000 50,00,000

Investments 15,00,000 -
Inventory at Cost 23,00,000 45,00,000
Sundry Debtors - 17,00,000
Cash & Bank 5,70,000 5,50,000
1,23,70,000 1,17,50,000
Additional information available:
(i) 75% of the Inventory in A Ltd. readily saleable at cost plus 20%,
(ii) 50% of Sundry Debtors of B Ltd. are due from C Ltd. which is not in a position to repay the
amount B Ltd. agreed to accept 15% debentures of C Ltd.
(iii) B Ltd. had also proposed 15% dividend but that was not shown in the accounts.

(iv) At the year end, B Ltd. sold investments amounting to Rs.1,20,000 and repaid Sundry
Creditors.
On the basis of the given Balance Sheet and the additional information, you are required to
evaluate liquidity of the companies. All working should form part of the answer.
A- 47.
Particulars A B
Current Assets and Liquid Assets:
Stock (23,00,000 × 75%) + 20% 20,70,000 -
Debtor (17,00,000 × 50%) - 8,50,000
Cash & Bank 5,70,000 5,50,000
Liquid Assets 26,40,000 14,00,000
Add: Stock (23,00,000 × 25%) 5,75,000 45,00,000
Total Current Assets 32,15,000 59,00,000
Current Liabilities: 6,00,000 6,00,000
Proposed Dividend 15,00,000 15,20,000
Creditor 2,00,000 3,00,000
Out Expenses 3,00,000 3,00,000
Provision for tax 15,000 -
Unclaimed Dividend 26,15,000 27,20,000
Evaluation of Liquidity
RATIO A B

1. Current Ratio = CA / CL 32,15,000 / 26,15,000 = 1.23 59,00,000/27,20,000= 2.17

2. Liquid Ratio = LA / CL 26,40,000 / 26,15,000 = 1.009 14,00,000 /27,20,000 = .51

 THEORY QUESTIONS – ANSWER

TOPIC - 1. , Basic Concepts

Q-1. Differentiate between Financial Management and Financial Accounting.

A-1.Though financial management and financial accounting are closely related, still they differ
in the treatment of funds and also with regards to decision - making.
Basis Financial Accounting Financial Management
In accounting, the measurement of The treatment of funds, in financial
funds is based on the accrual management is based on cash flows.
principle. The accrual based The revenues are recognised only
accounting data does not reflect when cash is actually received (i.e. cash
fully the financial conditions of the inflow) and expenses are recognised
Treatment of organization. An organization on actual payment (i.e. cash outflow).
Funds which has earned profit (sales less Thus, cash flow based returns help
expenses) may said to be profitable financial managers to avoid insolvency
in the accounting sense but it may and achieve desired financial goals.
not be able to meet its current
obligations due to shortage of
liquidity.
Financial manager’s primary
Decision The chief focus of an accountant is responsibility relates to financial
making to collect and present the data. planning, controlling and decision
making.
Q-2. Explain the two basic functions of Financial Management.

A-2.

Procurement ✓ Funds can be obtained from different sources having different

of
Funds characteristics in terms of risk, cost and control.
✓ The funds raised from the issue of equity shares are the best from the risk
point of view since repayment is required only at the time of liquidation.
✓ However, it is also the most costly source of finance due to dividend
expectations of shareholders.
✓ On the other hand, debentures are cheaper than equity shares due to their
tax advantage.
✓ However, they are usually riskier than equity shares.
✓ There are thus risk, cost and control considerations which a finance
manager must consider while procuring funds.
✓ The cost of funds should be at the minimum level for that a proper
balancing of risk and control factors must be carried out.
Effective ✓ The Finance Manager has to ensure that funds are not kept idle or there is
Utilization of
Funds no improper use of funds.
✓ The funds are to be invested in a manner such that they generate returns
higher than the cost of capital to the firm.
✓ Besides this, decisions to invest in fixed assets are to be taken only after
sound analysis using capital budgeting techniques.
✓ Similarly, adequate working capital should be maintained so as to avoid
the risk of insolvency.
Q-3. State the role of a Chief Financial Officer.

A-3.

✓ Determining the proper amount of funds to employ in the

Financial analysis and
firm, i.e. designating the size of the firm and its rate of
planning
growth.
Investment decisions ✓ The efficient allocation of funds to specific assets.

Financing and capital ✓ Raising funds on favourable terms as possible i.e.

structure decisions determining the composition of liabilities.
Management of financial
✓ Judicious mix of Current Assets and liabilities.
resources
Risk management ✓ Protecting assets
Decision regarding stock ✓ Increasing shareholders wealth by bonus shares, right
market shares & stock split decisions etc.
Financial Negotiations ✓ Negotiations with financial institutions, bank, public
depositors, shareholders, investors etc.

Q-4. Distinguish between Profit maximization vs. Wealth maximization objective of

the firm.
A-4.

✓ Profit maximization is a short-term objective and cannot be the sole

objective of a company.
✓ It is at best a limited objective.
Profit
✓ If profit is given undue importance, a number of problems can arise like the
maximization
term profit is vague, profit maximization has to be attempted with a realization of
risks involved, it does not take into account the time pattern of returns and as an
objective it is too narrow.
 ✓ Wealth maximization, as an objective, means that the company is using its
resources in a good manner.
Wealth ✓ If the share value is to stay high, the company has to reduce its costs and use the
maximization resources properly.
✓ If the company follows the goal of wealth maximization, it means that the
company will promote only those policies that will lead to an efficient allocation of
resources.

Q-5. "The profit maximization is not an operationally feasible criterion." Comment on

it.
A-5.
✓ “The profit maximization is not an operationally feasible criterion.” This
statement is true because Profit maximization can be a short-term objective for
any organization and cannot be its sole objective.
Validity of
✓ Profit maximization fails to serve as an operational criterion for maximizing
statement
the owner's economic welfare.
✓ It fails to provide an operationally feasible measure for ranking alternative
courses of action in terms of their economic efficiency.
✓ The definition of the term profit is ambiguous. Does it mean short term or
long term profit? Does it refer to profit before or after tax? Total profit or profit
per share?
Limitations ✓ The profit maximization objective does not make distinction between
returns received in different time periods. It gives no consideration to the time
value of money, and values benefits received today and benefits received after a
period as the same.
 ✓ It ignores the risk factor.
✓ The term maximization is also vague.

Q-6. Discuss emerging issues affecting the future role of Chief Financial Officer (CFO).
A-6.
✓ Regulation requirements are increasing and CFOs have an increasingly
Regulation
personal stake in regulatory adherence.
✓ The challenges of globalization are creating a need for finance leaders to
Globalization develop a finance function that works effectively on the global stage and that
embraces diversity.
✓ Technology is evolving very quickly, providing the potential for CFOs to
Technology reconfigure finance processes and drive business insight through ‘big data’
and analytics.
✓ The nature of the risks that organizations face is changing, requiring more
Risk effective risk management approaches and increasingly CFOs have a role to
play in ensuring an appropriate corporate ethos.
✓ There will be more pressure on CFOs to transform their finance functions
Transformation
to drive a better service to the business at zero cost impact.
Stakeholder ✓ Stakeholder management and relationships will become important as
Management increasingly CFOs become the face of the corporate brand.
✓ There will be a greater role to play in strategy validation and execution,
Strategy because the environment is more complex and quick changing, calling on the
analytical skills CFOs can bring.
✓ Reporting requirements will broaden and continue to be burdensome for
Reporting
CFOs.
Talent and ✓ A brighter spotlight will shine on talent, capability and behaviors in the
Capability top finance role.
Q-7. Explain 'Finance Function'.
A-7. The finance function is most important for all business enterprises. It remains a focus of all
activities. It starts with the setting up of an enterprise. It is concerned with raising of funds,
deciding the cheapest source of finance, utilization of funds raised, making provision for refund
when money is not required in the business, deciding the most profitable investment,
managing the funds raised and paying returns to the providers of funds in proportion to the
risks undertaken by them.
Therefore, it aims at acquiring sufficient funds, utilizing them properly, increasing the
profitability of the organization and maximizing the value of the organization and ultimately the
shareholder’s wealth.

Q-8. What are the roles of Finance Executive in Modem World?

A-8. Today, the role of Financial Executive, is no longer confined to accounting, financial
reporting and risk management. Some of the key activities that highlight the changing role of a
Finance Executive are as follows :
 Budgeting
 Forecasting
 Managing M & As
 Profitability analysis relating to customers or products
 Pricing Analysis
 Decisions about outsourcing
 Overseeing the IT function.
 Overseeing the HR function.
 Strategic planning (sometimes overseeing this function).
 Regulatory compliance.
 Risk management.
Q-9. What are the two main aspects of the Finance Function?

A-9. Long term Finance Function Decisions

✓ These decisions relate to the selection of assets in which funds will be
Investment invested by a firm. Funds procured from different sources have to be invested
Decisions in various kinds of assets. Long term funds are used in a project for various
fixed assets and also for current assets.
Financing ✓ These decisions relate to acquiring the optimum finance to meet financial
decisions objectives and seeing that fixed and working capital are effectively managed.
✓ These decisions relate to the determination as to how much and how
frequently cash can be paid out of the profits of an organization as income
for its owners/ shareholders. The owner of any profit-making organization
Dividend
looks for reward for his investment in two ways, the growth of the capital
decisions
invested and the cash paid out as income; for a sole trader this income would
be termed as drawings and for a limited liability company the term is
dividends.
Short term Finance Function Decisions
Generally short-term decisions are reduced to management of current asset and current
liability (i.e., working capital Management).

TOPIC – 2, Sources of Finance

Q-10. Explain the term Ploughing back of profits.

A- 10.
✓ Ploughing back of Profits or Retained earnings means retention of profit.
Meaning ✓ In other words, that part of surplus profit which is not distributed as dividend
are termed as Retained Profit or Ploughing back of Profits.
 ✓ Retained Earnings are an internal source of long term financing and are treated
as long term funds.
✓ Such funds belong to the ordinary shareholders and increase the net worth of the
company.
Features ✓ A public limited company must plough back a reasonable amount of profit every
year keeping in view the legal requirements in this regard and its own expansion
plans.
✓ Such funds also entail almost no risk.
✓ Further, control of present owners is also not diluted by retaining profits.

Q-11. Briefly discuss the concept of seed capital assistance.

A-11. ✓ The seed capital assistance has been designed by IDBI for professionally or technically

qualified entrepreneurs.
✓ All the projects eligible for financial assistance from IDBI, directly or indirectly through
refinance are eligible under the scheme.
✓ The project cost should not exceed Rs. 2 crores and the maximum assistance under the
project will
be restricted to 50% of the required promoters contribution or Rs. 15 lacs whichever is lower.
✓ The seed capital assistance is interest free but carries a security charge of one percent per
annum for the first five years and an increasing rate thereafter.

Q- 12.Distinguish between Global Depository Receipts and American Depository Receipts.

A-12.
Basis GDR ADR
The depository receipts in world market is The depository receipts in US
Meaning
GDR. market is ADR.
Compliance It need not comply with any of the condition of It is issued in accordance with
with SEC SEC (Securities Exchange Commission) of USA. the provisions of SEC.
Disclosure Disclosure requirement is
Disclosure requirement is less stringent.
requirement very strict.
Cost of issuing GDR is less in comparison to Cost of issuing ADR is more in
Cost
ADR. comparison to GDR.
GDRs are listed in any foreign stock
ADRs are listed only in
exchange other than the American Stock
Listing American Stock
Exchange. Example: London Stock
Exchange.
Exchange, Luxemburg Stock Exchanges etc.

Q-13. What is debt securitization? Explain the basic debt securitization process.
A-13.

✓ It is a method of recycling of funds.

✓ It is especially beneficial to financial intermediaries to support the lending
Meaning of volumes.
✓ Assets generating steady cash flows are packaged together and against
Debt
this asset
Securitization pool, market securities can be issued, e.g. housing finance, auto loans, and
credit
card receivables.

✓ A borrower seeks a loan from a finance company, bank,

Process of The HDFC.
Debt origination ✓ The credit worthiness of borrower is evaluated and
Securitization function contract is entered into with repayment schedule structured
over the life of the loan.

The pooling ✓ Similar loans on receivables are clubbed together to create

an underlying pool of assets.
function
✓ The pool is transferred in favour of Special purpose Vehicle
 (SPV), which acts as a trustee for investors.

✓ SPV will structure and issue securities on the basis of asset

pool.
The ✓ The securities carry a coupon and expected maturity which
securitization can be asset based/ mortgage based.
✓ These are generally sold to investors through merchant
function
bankers.
✓ Investors are pension funds, mutual funds, insurance funds.

Q-14. Distinguish between Operating lease and financial lease.

A-14.

Basis Finance Lease Operating Lease

The risk and reward incident to The lessee is only provided the use of
Risk and ownership are passed on the lessee. the asset for a certain time. Risk
reward The lessor only remains the legal incident to ownership belongs only
owner of the asset. to the lessor.
Risk of The lessee bears the risk of The lessor bears the risk of
obsolescence obsolescence. obsolescence.
The lease is non-cancellable by either The lease is kept cancellable by the
Cancellation
party under it. lessor.
The lessor does not bear the cost of Usually, the lessor bears the cost of
Cost of repairs
repairs, maintenance or operations. repairs, maintenance or operations.
Life of Life of contract approximates the Life of contract is shorter than the
contract economic life of the asset. economic life of the asset.
Q-15. Explain Bridge finance.
A-15. ✓ Bridge finance refers, normally, to loans taken by the business, usually from
commercial banks for a short period, pending disbursement of term loans by financial
institutions, normally it takes time for the financial institution to finalize procedures of creation
of security, tie-up participation with other institutions etc. even though a positive appraisal of
the project has been made.
✓ However, once the loans are approved in principle, firms in order not to lose further time in
starting their projects arrange for bridge finance.
✓ Such temporary loan is normally repaid out of the proceeds of the principal term loans.
✓ It is secured by hypothecation of moveable assets, personal guarantees and demand
promissory notes.
✓ Generally, rate of interest on bridge finance is higher as compared with that on term loans.

Q-16. Discuss factors that a venture capitalist should consider before financing any risky project.
A-16.✓ Quality of the management team is a very important factor to be considered. They are
required to show a high level of commitment to the project.
✓ The technical ability of the team is also vital. They should be able to develop and produce a
new product/ service.
✓ Technical feasibility of the new product/ service should be considered.
✓ Since the risk involved in investing in the company is quite high, venture capitalists should
ensure that the prospects for future profits compensate for the risk.
✓ A research must be carried out to ensure that there is a market for the new product.
✓ The venture capitalist himself should have the capacity to bear risk or loss, if the project
fails.
✓ The venture capitalist should try to establish a number of exist routes.
✓ In case of companies, venture capitalist can seek for a place on the Board of Directors to
have a say on all significant matters affecting the business.
Q-17. Write short note on Deep Discount Bonds.
A-17. ✓ Deep Discount Bonds is a form of zero-interest bonds.

✓ These bonds are sold at a discounted value and on maturity face value is paid to the
investors.
✓ In such bonds, there is no interest payout during lock in period.
✓ IDBI was the first to issue a deep discount bond in India in January, 1992. The investor could
hold the bond for 26 years or seek redemption at the end of every five years with a specified
maturity value.

Q- 18.What is debt securitization? And also state its advantages.

A-18.

✓ It is a method of recycling of funds.

✓ It is especially beneficial to financial intermediaries to support the lending
Meaning of volumes.
Debt ✓ Assets generating steady cash flows are packaged together and against
Securitization this asset pool, market securities can be issued, e.g. housing finance, auto
loans, and credit card receivables.
✓ The asset is shifted off the Balance Sheet, thus giving the originator
recourse to off balance sheet funding.
Advantages to ✓ It converts illiquid assets to liquid portfolio.
Originator ✓ It facilitates better balance sheet management; assets are transferred off
balance sheet facilitating satisfaction of capital adequacy norms.
✓ The originator’s credit rating enhances.
Advantages to ✓ For the investor, securitization opens up new investment avenues.
Investor ✓ Though the investor bears the credit risk, the securities are tied up to
definite assets.
✓ Securitization helps to convert a stream of cash receivables into a source
of long term finance.
✓ Securities are rated by Credit Rating Agencies and it becomes easier for
an investor to compare risk return profile and make an informed choice.

Q-19. What is venture capital financing? State the factors which are to be considered in financing any
risky project.
The pooling
function
A-19.

Meaning of ✓ The Venture Capital Financing refers to financing of new high risky
Venture Capital ventures promoted by qualified entrepreneurs who lack experience &
Financing funds to give shape to their ideas.

Factors to be
considered in
✓ Please refer answer to Question 7.
financing risky
project

Q-20. State the main elements of leveraged lease.

A-20.✓ Under this lease, a third party is involved beside lessor and lessee.
✓ The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party
i.e., lender.
✓ The asset so purchased is held as security against the loan.
✓ The lender is paid off from the lease rentals directly by the lessee and the surplus after
meeting the claims of the lender goes to the lessor.
✓ The lessor is entitled to claim depreciation allowance.

Q- 21. State the main features of Global Depository Receipts (GDRs) and American Depository Receipts
(ADRs).
A-21.

✓ Global Depository Receipts (GDRs) are basically negotiable certificates

denominated in US dollars that represent a non-US company’s publicly
Global
traded local currency equity shares.
Depository
✓ These are created when the local currency shares of Indian company are
Receipts
delivered to the depository’s local custodian bank, against which the
depository bank issues Depository Receipts in US dollars.
✓American Depository Receipts (ADRs) are securities offered by non-US
companies who want to list on any of the US exchange.
✓Each ADR represents a certain number of a company's regular shares.
American
✓ADRs allow US investors to buy shares of these companies without the costs
Depository
of investing directly in a foreign stock exchange.
Receipts
✓ADRs are issued by an approved New York bank or trust company against
the deposit of the original shares.
✓These are deposited in a custodial account in the US.
 ✓Such receipts have to be issued in accordance with the provisions
stipulated by the SEC USA which are very stringent.

Q-22. Name any four financial instruments, which are related to international financial
market.
A-22.
✓Euro Bonds
✓Foreign Bonds
✓Fully Hedged Bonds
✓Medium Term Notes
✓Floating Rate Notes
✓External Commercial Borrowings
✓Foreign Currency Futures
✓Foreign Currency Option
✓Euro Commercial Papers

Q- 23.State the different types of Packing Credit.

A-23.
✓This is an advance made available to an exporter only on production of a
firm export order or a letter of credit without exercising any charge or control
over raw material or finished goods.
✓It is a clean type of export advance.
Clean Packing
✓Each proposal is weighted according to particular requirements of the trade
credit
and credit worthiness of the exporter.
✓A suitable margin has to be maintained.
✓Also, Export Credit Guarantee Corporation (ECGC) cover should be obtained
by the bank.
Packing credit ✓Export finance is made available on certain terms and conditions where the
against exporter has pledge able interest and the goods are hypothecated to the
hypothecation bank as security with stipulated margin.
of goods ✓At the time of utilizing the advance, the exporter is required to submit along
with the firm export order or letter of credit, relative stock statements and
thereafter continue submitting them every fortnight and whenever there is
any movement in
stocks.
✓Export finance is made available on certain terms and conditions where the
Packing credit
exportable finished goods are pledged to the banks with approved clearing
against
agents who will ship the same from time to time as required by the exporter.
pledge of
✓The possession of the goods so pledged lies with the bank and is kept under
goods
its lock and key.
✓Any loan given to an exporter for the manufacture, processing, purchasing,
E.C.G.C.
or packing of goods meant for export against a firm order qualifies for the
guarantee
packing credit guarantee issued by Export Credit Guarantee Corporation.
✓Another requirement of packing credit facility is that if the export bill is to be
Forward
drawn in a foreign currency, the exporter should enter into a forward
exchange
exchange contact with the bank, thereby avoiding risk involved in a possible
contract
change in the rate of exchange.

Q- 24.Explain 'Sales and Lease Back'.

A-24.
✓Under this type of lease, the owner of an asset sells the asset to a party (the buyer), who in
turn leases back the same asset to the owner in consideration of a lease rentals.
✓Under this arrangement, the asset are not physically exchanged but it all happen in records
only.
✓The main advantage of this method is that the lessee can satisfy himself completely regarding
the quality of an asset and after possession of the asset convert the sale into a lease
agreement.
✓Under this transaction, the seller assumes the role of lessee and the buyer assumes the role
of a lessor.
✓The seller gets the agreed selling price and the buyer gels the lease rentals.

Q-25. What is meant by venture capital financing? State its various methods.
A-25.
Meaning
of ✓The venture capital financing refers to financing and funding of the small scale
Venture enterprises, high technology and risky ventures.

Capital
Methods ✓The venture capital undertakings generally requires funds for a
of longer period but may not be able to provide returns to the
Equity
Venture investors during the initial stages.
financing
Capital ✓Therefore, the venture capital finance is generally provided by
financing way of equity share capital.
✓ A conditional loan is repayable in the form of a royalty after the
venture is able to generate sales.
Conditional
✓ No interest is paid on such loans.
Loan
✓ In India, Venture Capital Financers charge royalty ranging
between 2 to 15 per cent; actual rate depends on other factors of
 the venture such as
❖ gestation period,
❖ cash flow patterns,
❖ riskiness and
❖ other factors of the enterprise.

✓ It is a hybrid security which combines the features of both

conventional loan and conditional loan.
Income Note
✓ The entrepreneur has to pay both interest and royalty on sales
but at substantially low rates.
✓ Such security carries charges in three phases :
❖ in the startup phase, no interest is charged,
Participating
❖ next stage a low rate of interest is charged upto a particular
Debenture
level of operations,
❖ after that, a high rate of interest is required to be paid.

Q-26. Distinguish between the Preference Shares and Debentures.

A-26.
Basis Preference Share Debenture
Preference Share Capital is a special kind Debenture is a type of loan which
Ownership
of share i.e. part of ownership. can be raised from the public.
Dividend/ It carries fixed percentage of
It carries fixed percentage of dividend.
Interest interest.
Charge or Dividend on preference share is Interest on debentures is charge
appropriation appropriation against profits. against profits.
Preference shares are a hybrid form of
Debentures are instrument for
financing with some characteristic of
Nature raising long term capital with a
equity shares and some attributes of
period of maturity.
Debt Capital.
Q- 27. What are Masala Bonds?
A-27. Masala (means spice) bond is an Indian name used for Rupee denominated bond that
Indian corporate borrowers can sell to investors in overseas markets. These bonds are issued
outside India but denominated in Indian Rupees. NTPC raised Rs.2,000 crore via masala bonds
for its capital expenditure in the year 2016

Q- 28.Explain in brief following financial instruments :

A-28.
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial Paper
(iv) Fully Hedged Bond
Euro Bonds -
These are the Bonds issued or traded in a country using a currency other than the one in which
the bond is denominated. These are issued by multinational corporations, for example, a British
company may issue a Eurobond in Germany, denominating it in U.S. dollars.
Floating Rate Notes -
These are issued up to seven years maturity. Interest rates are adjusted to reflect the prevailing
exchange rates. They provide cheaper money than foreign loans.
Euro Commercial Paper -
These are short term money market instruments. They are for maturities less than one year.
They are usually designated in US Dollars.
Fully Hedged Bond -
Usually in foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds eliminate
the risk by selling in forward markets the entire stream of principal and interest payments.

TOPIC – 3, Cost of Capital

Q-29. What do you understand by Weighted Average Cost of Capital?
A-29. 

✓ The composite or overall cost of capital of a firm is the weighted average of
the costs of the various sources of funds.
✓ Weights are taken to be in the proportion of each source of fund in the capital
structure.
✓ While making financial decisions, this overall or weighted cost is used.
Meaning
✓ Each investment is financed from a pool of funds which represents the various
sources from which funds have been raised.
✓ Any decision of investment, therefore, has to be made with reference to the
overall cost of capital and not with reference to the cost of a specific source of
fund used in the investment decision.
The weighted average cost of capital is calculated by :
Calculation ✓ Calculating the cost of specific source of fund e.g. cost of debt, equity etc;
✓ Multiplying the cost of each source by its proportion in capital structure; and
 ✓ Adding the weighted component cost to get the firm’s WACC represented by
k0.
k0 = k1 w1 + k2 w2 + ………..
Where,
k1, k2 are component costs and w1, w2 are weights.


Q-30. "Financing a business through borrowing is cheaper than using equity." Briefly
explain.
A-30. ✓ Debt capital is cheaper than equity capital from the point of its cost and interest being

deductible for income tax purpose, whereas no such deduction is allowed for dividends.
✓ Issue of new equity dilutes existing control pattern while borrowing does not result in
dilution of control.
✓ In a period of rising prices, borrowing is advantageous. The fixed monetary outgo decreases
in real terms as the price level increases.

TOPIC – 4, Leverage

Q-31. What do you understand by Business Risk and Financial Risk?

A-31.
✓ Business risk refers to the risk associated with the firm’s operations.
✓ It is an unavoidable risk because of the environment in which the firm has
to operate and the business risk is represented by the variability of earnings
Business Risk before interest and tax (EBIT).
✓ The variability in turn is influenced by revenues and expenses.
✓ Revenues and expenses are affected by demand of firm’s products,
variations in prices and proportion of fixed cost in total cost.
 ✓ Financial risk refers to the additional risk placed on firm’s shareholders as
a result of debt use in financing.
✓ Companies that issue more debt instruments would have higher financial
Financial Risk
risk than companies financed mostly by equity.
✓ Financial risk can be measured by ratios such as firm’s financial leverage
multiplier, total debt to assets ratio etc.

Q-32. Distinguish between business risk and financial risk.

A-32.

Basis Business Risk Financial Risk

Business Risk refers to the risk
Financial Risk refers to the additional
associated with the firm's operations.
Meaning risk placed on the firm's shareholders
In other words, Business Risk is defined
as a result of use of debt.
as the risk of running a business.
Type of cost It occurs due to fixed operating cost. It occurs due to fixed financing cost.
Financial Risk can be avoided by not
Avoidable or
Business Risk is generally unavoidable. using the source of finance involving
Unavoidable
fixed payment.
Companies that issue more debt
Higher the fixed operating cost, higher instruments would have higher
Higher Risk
the Business Risk. financial risk than companies financed
mostly or entirely by equity.
Q-33. “Operating risk is associated with cost structure, whereas financial risk is associated with
capital structure of a business concern.” Critically examine this statement.

A-33.

Validity of ✓ The statement is valid that “Operating risk is associated with cost structure
statement whereas financial risk is associated with capital structure of a business concern”.
✓ Operating risk refers to the risk associated with the firm’s operations.
✓ It is represented by the variability of earnings before interest and tax (EBIT).
✓ The variability in turn is influenced by revenues and expenses, which are
affected by demand of firm’s products, variations in prices and proportion of
fixed cost in total cost.
Explanation ✓ If there is no fixed cost, there would be no operating risk.

✓ Whereas financial risk refers to the additional risk placed on firm’s

shareholders as a result of debt and preference shares used in the capital
structure of the concern.
✓ Companies that issue more debt instruments would have higher financial risk
than companies financed mostly by equity.
TOPIC – 5, Capital Structure

Q-34. What do you understand by Capital structure? How does it differ from Financial
structure?
A-34.

✓ Capital Structure refers to the combination of debt and equity which a

Meaning of
company uses to finance its long-term operations.
Capital
✓ It is the permanent financing of the company representing long-term sources
Structure
of capital i.e. owner’s equity and long-term debts but excludes current liabilities.
✓ On the other hand, Financial Structure is the entire left-hand side of the
Financial balance sheet which represents all the long-term and short-term sources of
Structure capital.
✓ Thus, capital structure is only a part of financial structure.

Q- 35. Discuss financial break–even and EBIT–EPS indifference analysis.

A-35.
 ✓ Financial break-even point is the minimum level of EBIT needed to satisfy all
the fixed financial charges i.e. interest and preference dividend.
✓ It denotes the level of EBIT for which firm’s EPS equals zero.
Financial
✓ If the EBIT is less than the financial breakeven point, then the EPS will be
Break Even
negative but if the expected level of EBIT is more than the breakeven point,
then more fixed costs financing instruments can be taken in the capital
structure, otherwise, equity would be preferred.
✓ EBIT-EPS analysis is a vital tool for designing the optimal capital structure of
EBIT–EPS
a firm.
indifference
✓ The objective of this analysis is to find the EBIT level that will equate EPS
analysis
regardless of the financing plan chosen.
(𝐄𝐁𝐈𝐓 - 11) (𝟏 - 𝐭)/ 𝐧𝟏 = (𝐄𝐁𝐈𝐓 - 𝐈𝟐)(𝟏 - 𝐭)/ 𝐧𝟐
Where
EBIT = Indifference point
n1 = Number of equity shares in Alternative 1
n2 = Number of equity shares in Alternative 2
Computation
I1 = Interest charges in Alternative 1
I2 = Interest charges in Alternative 2
t = Tax Rate
Alternative 1 = All equity finance
Alternative 2 = Debt-equity finance.

Q-36. List the fundamental principles governing capital structure.

A-36.
✓ According to this principle, an ideal pattern or capital structure is one that
Cost Principle ❖ minimizes cost of capital structure and
❖ maximizes earnings per share (EPS).
 ✓ According to this principle, reliance is placed more on common equity for
financing capital requirements than excessive use of debt.
✓ Use of more and more debt means higher commitment in form of interest
Risk Principle
payout.
✓ This would lead to erosion of shareholders value in unfavorable business
situation.
Control ✓ While designing a capital structure, the finance manager may also keep in
Principle mind that existing management control and ownership remains undisturbed.
✓ It means that the management chooses such a combination of sources of
Flexibility
financing which it finds easier to adjust according to changes in need of funds
Principle
in future too.
Other ✓ Besides above principles, other factors such as nature of industry, timing
Considerations of issue and competition in the industry should also be considered.

Q-37. What is Over capitalisation? State its causes and consequences.

A-37.
Meaning of ✓ It is a situation where a firm has more capital than it needs or in other
Over words assets are worth less than its issued share capital, and earnings are
Capitalisation insufficient to pay dividend and interest.
✓ Raising more money through issue of shares or debentures than company
can employ profitably.
✓ Borrowing huge amount at higher rate than rate at which company can
Causes earn.
✓ Excessive payment for the acquisition of fictitious assets such as goodwill
etc.
✓ Improper provision for depreciation, replacement of assets and
 distribution of dividends at a higher rate.
✓ Wrong estimation of earnings and capitalization.
✓ Considerable reduction in the rate of dividend and interest payments.
✓ Reduction in the market price of shares.
Consequences ✓ Resorting to “window dressing”.

✓ Some companies may opt for reorganization. However, sometimes the

matter gets worse and the company may go into liquidation.

Q-38. What do you mean by capital structure? State its significance in financing decision.
A-38.
Meaning of ✓ Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-
Capital term sources of funds such as debentures, preference share capital, equity
Structure share capital and retained earnings for meeting its total capital requirement.
✓ The capital structure decisions are very important in financial management
as they influence debt – equity mix which ultimately affects shareholders
return and risk.
✓ These decisions help in deciding
Significance in
❖ the forms of financing (which sources to be tapped),
Financing
❖ their actual requirements (amount to be funded) and
Decision
❖ their relative proportions (mix) in total capitalisation.
✓ Therefore, such a pattern of capital structure must be chosen which
❖ minimizes cost of capital and
❖ maximizes the owners’ return.
TOPIC – 6, Theories of Capital Structure
Q-39. What is Net Operating income theory of capital structure? Explain the assumptions on
which the NOI theory is based.
A-39.
✓ According to this approach, there is no relationship between the cost of
Meaning capital and value of the firm.
✓ The value of the firm is independent of the capital structure of the firm.
✓ There are no taxes.
✓ The market capitalizes the value of the firm as a whole. Thus, the split
between debt and equity is not important.
Assumptions ✓ The increase in proportion of debt in capital structure leads to change in risk
perception of the shareholders i.e. increase in cost of equity (Ke). The increase
in cost of equity is such as completely offset the benefits of using cheaper debt.
✓ The overall cost of capital remains same for all degrees of debt equity mix.

TOPIC – 7, Investment Decisions (Capital Budgeting)

Q-40. Explain the term Desirability factor.
A-40.
✓ In certain cases, we have to compare a number of proposals each involving different
amount of cash inflows.
✓ One of the methods of comparing such proposals is to work out what is known as the
‘Desirability factor’ or ‘Profitability index’.

𝐒𝐮𝐦 𝐨𝐟 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰𝐬

Formula
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲 𝐨𝐫 𝐓𝐨𝐭𝐚𝐥 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰
Acceptance
✓ A project is acceptable if its profitability index value is greater than 1.
Criteria

Q-41. Distinguish between Net present value method and Internal Rate of Return method.
A-41.
✓ NPV and IRR methods differ in the sense that the results regarding the
choice of an asset under certain circumstances are mutually contradictory
under two methods.
Introduction ✓ In case of mutually exclusive investment projects, in certain situations,
they may give contradictory results such that if the NPV method finds one
proposal
acceptable, IRR favours another.
✓ The different rankings given by the NPV and IRR methods could be due to

Causes of ❖ Size disparity problem,

difference ❖ time disparity problem and
❖ unequal expected lives.
Absolute value ✓ The net present value is expressed in financial values whereas internal
or percentage rate of return (IRR) is expressed in percentage terms.
Reinvestment ✓ In the net present value, cash flows are assumed to be re-invested at cost
of cash flows of capital rate.
✓ In IRR, reinvestment is assumed to be made at IRR rates.

Q-42. What is 'Internal Rate of Return'? Explain.

A-42.
✓ It is that rate at which discounted cash inflows are equal to the
Meaning
discounted cash outflows.
✓ This rate is to be found by trial and error method.
Computation ✓ This rate is used in the evaluation of investment proposals.
✓ In this method, the discount rate is not known but the cash outflows
and cash inflows are known.
✓ In evaluating investment proposals, internal rate of return is
compared with a required rate of return, known as cut-off rate.
Relevance
✓ If it is more than cut-off rate the project is treated as acceptable;
otherwise project is rejected.

Q-43. Which method of comparing a number of investment proposals is most suited if each
proposal involves different amount of cash inflows? Explain and state its limitations.
A-43.
✓ Profitability Index (PI) method is best suited if each investment proposal involves different
amount of cash inflows. PI considers both present value of cash inflows and present value of
cash outflows.

𝐒𝐮𝐦 𝐨𝐟 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐢𝐧𝐟𝐥𝐨𝐰𝐬

Formula
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐥𝐚𝐲 𝐨𝐫 𝐓𝐨𝐭𝐚𝐥 𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐨𝐮𝐭𝐟𝐥𝐨𝐰
Acceptance
✓ A project is acceptable if its profitability index value is greater than 1.
Criteria
✓ PI is known as a superior method of comparing a number of investment
Superiority
proposal than Net present value method (NPV).
 ✓ Profitability index fails as a guide in resolving capital rationing where projects
are indivisible.
✓ Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single
Limitations project is excluded.
✓ Also, situations may arise where a project with a lower profitability index
selected may generate cash flows in such a way that another project can be
taken up one or two years later, the total NPV in such case being more than the
one with a project with highest Profitability Index.

TOPIC – 8, Estimation of Working Capital

Q-44. Discuss the estimation of working capital need based on operating cycle process.
A-44.
✓ One of the methods for forecasting working capital requirement is based on
the concept of operating cycle.
✓ The determination of operating capital cycle helps in the forecast, control and
Meaning
management of working capital.
✓ The duration of working capital cycle may vary depending on the nature of the
business.
✓ The length of operating cycle is the indicator of performance of management.
✓ The net operating cycle represents the time interval for which the firm has to
Relevance negotiate for Working Capital from its Bankers.
✓ It enables to determine accurately the amount of working capital needed for
the continuous operation of business activities.
✓ In the form of an equation, the operating cycle process can be expressed as
Formula
follows:
 Operating Cycle = R + W + F +D – C
✓ Where,
R = Raw material storage period
W = Work-in-progress holding period
F = Finished goods storage period
D = Debtors collection period
C = Credit period availed

TOPIC – 9, Debtor’s Management

Q-45. Differentiate between Factoring and Bills discounting.
A-45.
Basis Factoring Bill Discounting
Factoring is called as “Invoice Bills discounting is known as ‘Invoice
Other name
Factoring”. discounting.”
In Factoring, the parties are
In Bills discounting, they are known
Parties known as the client, factor and
as drawer, drawee and payee.
debtor.
Factoring is a sort of management Bills discounting is a sort of
Purpose
of book debts. borrowing from commercial banks.
In the case of bills discounting, the
Relevant For factoring, there is no specific
Negotiable Instruments Act is
statute act.
applicable.

Q- 46. Explain briefly the accounts receivable systems.

A-46. ✓ Manual systems of recording the transactions and managing receivables are
cumbersome and costly.
✓ The automated receivable management systems automatically update all the accounting
records affected by a transaction.
✓ This system allows the application and tracking of receivables and collections to store
important information for an unlimited number of customers and transactions, and
accommodate efficient processing of customer payments and adjustments.

Q-47. What is factoring? Enumerate the main advantages of factoring.

A-47.
✓ In factoring, accounts receivables are generally sold to a financial institution
(a subsidiary of commercial bank-called “Factor”), who charges commission and
bears the credit risks associated with the accounts receivables purchased by it.
✓ Its operation is very simple.
Meaning ✓ Clients enter into an agreement with the “factor” working out a factoring
arrangement according to his requirements.
✓ The factor then takes the responsibility of monitoring, follow-up, collection
and risk-taking and provision of advance.
✓ The factor generally fixes up a limit customer-wise for the client (seller).

✓ The biggest advantages of factoring are the immediate

Advantages Convertibility
conversion of receivables into cash.

Certainty ✓ Factoring ensures a definite pattern of cash inflows.

✓ There is no debt repayment, no compromise to balance sheet,

No feature of
no long term agreements or delays associated with other
loan methods of raising capital.
TOPIC – 10, Treasury & Cash Management
Q-48. Write short note on William J. Baumal Vs. Miller–Orr cash management model.
A-48.
 According to this model, the net cash flow is completely stochastic.
 When changes in cash balance occur randomly, the application of control theory serves a
useful purpose.
 The Miller – Orr model is one of such control limit models.
 This model is designed to determine the time and size of transfers between an investment
account and cash account.
 In this model control limits are set for cash balances.
 These limits may consist of ‘h’ as upper limit, ‘z’ as the return point and zero as the lower
limit.


 When the cash balance reaches the upper limit, the transfer of cash equal to ‘h – z’ is invested
in marketable securities account. 
 When it touches the lower limit, a transfer from marketable securities account to cash account
is made. 
 During the period, when cash balance stays between (h, z) and (z, 0) i.e. high and low limits, no
transactions between cash and marketable securities account is made. 
 The high and low limits of cash balance are set up on the basis of fixed cost associated with the
securities transaction, the opportunities cost of holding cash and degree of likely fluctuations in
cash balances. 
 These limits satisfy the demands for cash at the lowest possible total costs. 

Q-49. State the advantage of Electronic Cash Management System.

A-49.
✓Significant saving in time.
✓Decrease in interest costs.
✓Less paper work.
✓Greater accounting accuracy.
✓More control over time and funds.
✓Supports electronic payments.
✓Faster transfer of funds from one location to another, where required.
✓Speedy conversion of various instruments into cash.
✓Making available funds wherever required, whenever required.
✓Reduction in the amount of ‘idle float’ to the maximum possible extent.
✓Ensures no idle funds are placed at any place in the organization.
✓It makes inter-bank balancing of funds much easier.
✓It is a true form of centralized ‘Cash Management’.
✓Produces faster electronic reconciliation.
✓Allows for detection of book-keeping errors.
✓Reduces the number of cheques issued.
✓Earns interest income or reduce interest expense.

Q-50. What is Virtual Banking? State its advantages.

A-50.
✓ Virtual banking refers to the provision of banking and related services
Meaning
through the use of information technology without direct recourse to the
 bank by the customer.
✓ Lower cost of handling a transaction.
✓ The increased speed of response to customer requirements.
✓ The lower cost of operating branch network along with reduced staff costs
Advantages
leads to cost efficiency.
✓ Possibility of improved and a range of services being made available to the
customer rapidly, accurately and at his convenience.

Q-51. 'Management of marketable securities is an integral part of investment of cash.'

Comment.
A-51. 
 Management of marketable securities is an integral part of investment of cash as it serves
both the purposes of liquidity and cash, provided choice of investment is made correctly.
 As the working capital needs are fluctuating, it is possible to invest excess funds in some
short term securities, which can be liquidated when need for cash is felt.
 The selection of securities should be guided by three principles namely
 safety,
 maturity and
 marketability.

Q-52. Explain the following :

(i) Concentration Banking
(ii) Lock Box System
A-52.
✓ In concentration banking, the company establishes a number of strategic
collection centers in different regions instead of a single collection centre at
Concentration
the head office.
Banking
✓ This system reduces the period between the time a customer mails in his
remittances and the time when they become spendable funds with the
 company.
✓ Payments received by the different collection centers are deposited with
their respective local banks which in turn transfer all surplus funds to the
concentration bank of head office.
✓ Another means to accelerate the flow of funds is a lock box system.
✓ The purpose of lock box system is to eliminate the time between the
Lock Box
receipts of remittances by the company and deposited in the bank.
System
✓ A lock box arrangement usually is on regional basis which a company
chooses according to its billing patterns.

Q-53. Explain four kinds of float with reference to management of cash.

A-53.
✓ The time between the sale and the mailing of the invoice is the billing
Billing Float
float.
✓ This is the time when a cheque is being processed by post office,
Mail Float
messenger service or other means of delivery.
Cheque ✓ This is the time required for the seller to sort, record and deposit the
processing float cheque after it has been received by the company.
Bank ✓ This is the time from the deposit of the cheque to the crediting of funds
processing float in the seller’s account.

Q-54. Evaluate the role of cash budget in effective cash management system.

 Cash Budget is the most significant device to plan for and control cash receipts and
payments.
 It plays a very significant role in effective Cash Management System.
 This represents cash requirements of business during the budget period.
 The various roles of cash budgets in Cash Management System are :
 Coordinate the timings of cash needs. It identifies the period(s) when there might either be
a shortage of cash or an abnormally large cash requirement.
 It also helps to pinpoint period(s) when there is likely to be excess cash.
 It enables firm which has sufficient cash to take advantage like cash discounts on its
accounts payable. and
 Lastly, it helps to plan/ arrange adequately needed funds (avoiding excess/ shortage of
cash) on favorable terms.

Q-55. Describe the three principles relating to selection of marketable securities.

A-55.
✓ Return and risks go hand in hand.
Safety ✓ As the objective in this investment is ensuring liquidity, minimum
risk is the criterion of selection.
✓ Matching of maturity and forecasted cash needs is essential.
Maturity ✓ Prices of long term securities fluctuate more with changes in
interest rates and are therefore, more risky.
✓ It refers to the convenience, speed and cost at which a security
can be converted into cash.
Marketability
✓ If the security can be sold quickly without loss of time and price, it
is highly liquid or marketable.

Q-56.. Explain briefly the functions of Treasury Department.

A-56.
The functions of treasury department management are to ensure proper usage, storage and
risk management of liquid funds so as to ensure that the organization is able to meet its
obligations, collect its receivables and also maximize the return on its investments.
Towards this end, the treasury function may be divided into the following :
✓ The efficient collection and payment of cash both inside the organization
Cash
and to third parties is the function of treasury department.
Management
✓ Treasury normally manages surplus funds in an investment portfolio.
 ✓ The treasury department manages the foreign currency risk exposure of the
company.
Currency
✓ It advises on the currency to be used when invoicing overseas sales.
Management
✓ It also manages any net exchange exposures in accordance with the
company policy.
✓ Treasury department is responsible for planning and sourcing the
Fund company’s short, medium and long-term cash needs.
Management ✓ It also participates in the decision on capital structure and forecasts future
interest and foreign currency rates.
✓ Since short-term finance can come in the form of bank loans or through the
sale of commercial paper in the money market, therefore, treasury department
Banking
carries out negotiations with bankers and acts as the initial point of contact
with them.
✓ Treasury department is involved with both acquisition and disinvestment
Corporate
activities within the group.
Finance
✓ In addition, it is often responsible for investor relations.

TOPIC – 11, Working Capital Finance

Q-58. Enumerate the various forms of bank credit in financing working capital of a business
organization.
A-58.
✓ In a loan account, the entire advance is disbursed at one time either in cash
Short Term or by transfer to the current account of the borrower.
Loans ✓ It is a single advance and given against securities like shares, government
securities, life insurance policies and fixed deposit receipts, etc.
✓ Under this facility, customers are allowed to withdraw in excess of credit
balance standing in their Current Account.
Overdraft
✓ A fixed limit is therefore granted to the borrower within which the borrower is
allowed to overdraw his account.
 ✓ Request for clean advances are entertained only from parties which are
Clean
financially sound and reputed for their integrity.
Overdrafts
✓ The bank has to rely upon the personal security of the borrowers.
✓ Cash Credit is an arrangement under which a customer is allowed an advance
Cash up to certain limit against credit granted by bank.
Credits ✓ Interest is not charged on the full amount of the advance but on the amount
actually availed of by him.
Advances ✓ Goods are charged to the bank either by way of pledge or by way of
against hypothecation.
goods ✓ Goods include all forms of movables which are offered to the bank as security.
✓ These advances are allowed against the security of bills which may be clean or
documentary.
Bills
✓ Usance bills maturing at a future date or sight are discounted by the banks for
Purchased/
approved parties.
Discounted
✓ The borrower is paid the present worth and the bank collects the full amount
on maturity.
Advance
✓ A document becomes a document of title to goods when its possession is
against
recognised by law or business custom as possession of the goods like bill of
documents
lading, dock warehouse keeper's certificate, railway receipt, etc.
of
✓ An advance against the pledge of such documents is an advance against the
title to
pledge of goods themselves.
goods
✓ Advances against bills for supply of goods to government or semi-government
Advance departments against firm orders after acceptance of tender fall under this
against category.
supply ✓ It is this debt that is assigned to the bank by endorsement of supply bills and
of bills executing irrevocable power of attorney in favour of the banks for receiving the
amount of supply bills from the Government departments.
Q-59. Discuss the liquidity vs. profitability issue in management of working capital.
A-59. 
 Working capital management entails the control and monitoring of all components of working
capital i.e. cash, marketable securities, debtors, creditors etc. 
 Finance manager has to pay particular attention to the levels of current assets and their
financing. 
 To decide the level of financing of current assets, the risk return trade off must be taken into
account. 
 The level of current assets can be measured by creating a relationship between current assets
and fixed assets. 
 A firm may follow a conservative, aggressive or moderate policy. 



✓A conservative policy means lower return and risk while an aggressive policy produces higher
return and risk.
✓The two important aims of the working capital management are profitability and solvency.
✓A liquid firm has less risk of insolvency i.e. it will hardly experience a cash shortage or a stock
out situation.
✓However, there is a cost associated with maintaining a sound liquidity position.
✓ So, to have a higher profitability the firm may have to sacrifice solvency and maintain a
relatively low level of current assets.

Q-60. Discuss the risk-return considerations in financing current assets.

A-60.
✓ The financing of current assets involves a tradeoff between risk and return.
✓ A firm can choose from short or long term sources of finance.
✓ Short term financing is less expensive than long term financing but at the
Introduction same time, short term financing involves greater risk than long term financing.
✓ Depending on the mix of short term and long term financing, the approach
followed by a company may be referred as matching approach, conservative
approach and aggressive approach.
Matching ✓ In matching approach, long-term finance is used to finance fixed assets and
Permanent current assets and short term financing to finance temporary or
Approach
variable current assets.
✓ Under the conservative plan, the firm finances its permanent assets and also
Conservative
a part of temporary current assets with long term financing and hence less risk
Approach
of facing the problem of shortage of funds.
✓ An aggressive policy is said to be followed by the firm when it uses more
Aggressive
short term financing than warranted by the matching plan and finances a part
Approach
of its permanent current assets with short term financing.

TOPIC – 12, Ratio Analysis

Q-62. Explain briefly the limitations of Financial ratios.
A-62.
 ✓ Many businesses operate a large number of divisions in quite different
Diversified industries.
product lines ✓ In such cases, ratios calculated on the basis of aggregate data cannot be
used for inter-firm comparisons.
Financial data
badly ✓ Historical cost values may be substantially different from true values.
distorted by ✓ Such distortions of financial data are also carried in the financial ratios.
inflation
Seasonal
✓ Seasonal factors may also influence financial data.
factors
✓ To give a good shape to the popularly used financial ratios (like current
ratio, debt equity ratios, etc.), the business may make some year-end
Biased ratios adjustments.
✓ Such window dressing can change the character of financial ratios which
would be different had there been no such change.
Differences in
accounting
✓ It can make the accounting data of two firms non-comparable as also the
policies and
accounting ratios.
accounting
period
✓ Sometimes, a firm’s ratios are compared with the industry average.
✓ But, if a firm desires to be above the average, then industry average
No standard
becomes a low standard.
set of ratios
✓ On the other hand, for a below average firm, industry averages become too
high a standard to achieve.

Q- 63. Explain the following ratios :

a. Operating ratio
b. Price earnings ratio
A-63.
Operating ✓ This is the test of the operational efficiency with which the
Meaning
Ratio business is being carried.
✓ The operating ratio should be low enough to leave a portion of
Relevance
sales to give a fair return to the investors.
Formula 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐠𝐨𝐨𝐝𝐬 𝐬𝐨𝐥𝐝 + 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐄𝐱𝐩𝐞𝐧𝐬𝐞𝐬 / 𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬 × 𝟏𝟎𝟎
Price-
✓ This ratio indicates the number of times the earnings per share is
Earnings Meaning
covered by its market price.
ratio
✓ It indicates the expectation of equity investors about the earnings
Relevance
of the firm.
𝐌𝐚𝐫𝐤𝐞𝐭 𝐩𝐫𝐢𝐜𝐞 𝐩𝐞𝐫 𝐞𝐪𝐮𝐢𝐭𝐲 𝐬𝐡𝐚𝐫𝐞
Formula
𝐄𝐚𝐫𝐧𝐢𝐧𝐠 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
Q- 64. Explain the important ratios that would be used in each of the following situations :
a. A bank is approached by a company for a loan of 50 lakh for working capital purposes.
b. A long term creditors interested in determining whether his claim is adequately secured.
c. A shareholder who is examining his portfolio and who is to decide whether he should hold or
sell his holding in the company.
d. A finance manager interested to know effectiveness with which a firm uses its available
resources.
A-64.
✓ Here Liquidity or short-term solvency ratios would be used by the bank to
Liquidity check the ability of the company to pay its short-term liabilities.
a
Ratios ✓ A bank may use Current ratio and Quick ratio to judge short terms
solvency of the firm.
Capital ✓ Here the long-term creditor would use the capital structure/ leverage
b Structure/ ratios to ensure the long term stability and structure of the firm.
Leverage ✓ A long term creditors interested in the determining whether his claim is
 Ratios adequately secured may use Debt-service coverage and interest coverage
ratio.
✓ The shareholder would use the profitability ratios to measure the
profitability or the operational efficiency of the firm to see the final results of
Profitability
c business operations.
Ratios
✓ A shareholder may use return on equity, earning per share and dividend
per share.
✓ The finance manager would use these ratios to evaluate the efficiency
with which the firm manages and utilizes its assets.

Activity ✓ Some important ratios are :

d
Ratios ❖ Capital turnover ratio
❖ Current and fixed assets turnover ratio
❖ Stock, Debtors and Creditors turnover ratio.

Q-65. Comment on the Debt Service Coverage Ratio.

A-65.

✓ Debt service coverage ratio indicates the capacity of a firm to service a

Meaning
particular level of debt i.e. repayment of principal and interest.
✓ High credit rating firms target Debt service coverage ratio to be greater than 2
in its entire loan life.
✓ High Debt service coverage ratio facilitates the firm to borrow at the most
Relevance
competitive rates.
✓ Lenders are interested in this ratio to judge the firm’s ability to pay off current
interest and installments.
𝐄𝐚𝐫𝐧𝐢𝐧𝐠𝐬 𝐚𝐯𝐚𝐢𝐥𝐚𝐛𝐥𝐞 𝐟𝐨𝐫 𝐝𝐞𝐛𝐭 𝐬𝐞𝐫𝐯𝐢𝐜𝐞
Formula
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 + 𝐈𝐧𝐬𝐭𝐚𝐥𝐥𝐦𝐞𝐧𝐭𝐬
TOPIC – 13, Risk Analysis in Capital Budgeting

Q-66. What is certainty equivalent.

A-66.

✓ As per CIMA terminology, “An approach to dealing with risk in a capital

budgeting context.
✓ It involves expressing risky future cash flows in terms of the certain cash
Definition
flow which would be considered, by the decision maker, as their equivalent,
that is the decision maker would be indifferent between the risky amount and
the (lower) riskless amount considered to be its equivalent.”
✓ The certainty equivalent is a guaranteed return that the management
would accept rather than accepting a higher but uncertain return.
✓ This approach allows the decision maker to incorporate his or her utility
Mechanism
function into the analysis.
✓ In this approach, a set of risk less cash flow is generated in place of the
original cash flows.
✓ It is simple and easy to understand and apply.
Advantages ✓ It can easily be calculated for different risk levels applicable to different
cash flows.
✓ There is no Statistical or Mathematical model available to estimate
certainty Equivalent.
Disadvantages
✓ Certainty Equivalent are subjective and vary as per each individual’s
estimate.
Q-67. Write two main reasons for considering risk in Capital Budgeting decisions.
A-67.
✓ There is an opportunity cost involved while investing in a project for the level
of risk. Adjustment of risk is necessary to help make the decision as to whether
Opportunity
the returns out of the project are proportionate with the risks borne and
Cost
whether it is worth investing in the project over the other investment options
available.
Real Value ✓ Risk adjustment is required to know the real value of the Cash Inflows.

TOPIC – 14, Leasing Decisions

Q- 68. Discuss the advantages of leasing.
A-68.
✓ Leasing is alternative to purchasing.

Lease may ✓ As the lessee is to make a series of payments for using an asset, a lease
be arrangement is similar to a debt contract.
low cost ✓ The benefit of lease is based on a comparison between leasing and buying an
alternative asset.
✓ Many lessees find lease more attractive because of low cost.

Tax benefit ✓ Lease Rent is tax deductible.

Working ✓ In case of purchase of asset, bank doesn’t provide 100% finance usually and
capital the difference is to be paid from own funds.
conservation ✓ In case of lease, there is no requirement of large amount of funds initially.

Preservation ✓ Operating lease payment is treated as expenditure in the profit and loss

of Debt account.

Capacity ✓ Neither the asset taken on lease appears as asset nor does the liability
representing present value of future lease payment (cost of leased asset)
appear as liability in the balance sheet.
✓ That is, operating lease doesn’t have any balance sheet impact.
✓ So, operating lease does not matter in computing debt equity ratio.
✓ This enables the lessee to go for debt financing more easily.