FINANCIAL MANAGEMENT

QUESTIONS
Ratio Analysis
1. From the following table of financial ratios of Prabhu Chemicals Limited, comment on
various ratios given at the end:
Ratios 2021 2022 Average of
Chemical Industry
Liquidity Ratios
Current ratio 2.1 2.3 2.4
Quick ratio 1.4 1.8 1.4
Receivable turnover ratio 8 9 8
Inventory turnover 8 9 5
Receivables collection period 46 days 41 days 46 days
Operating profitability
Operating income –ROI 24% 21% 18%
Operating profit margin 18% 18% 12%
Financing decisions
Debt ratio 45% 44% 60%
Return
Return on equity 26% 28% 18%
COMMENT on the following aspect of Prabhu Chemicals Limited
(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders
Cost of Capital
2. Jason Limited is planning to raise additional finance of ` 20 lakhs for meeting its new
project plans. It has ` 4,20,000 in the form of retained earnings available for investment
purposes. Further details are as following:
 Debt / Equity Mix 30 / 70
Cost of Debt
Upto ` 3,60,000 8 % (before tax)
Beyond ` 3,60,000 12 % (before tax)
Earnings per share `4
Dividend pay-out 50% of earnings
Current Market Price per share ` 44
Expected Growth rate in Dividend 10 %
Tax 40%
You are required:
(a) To determine the cost of retained earnings and cost of equity.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the pattern for raising the additional finance, and
(d) Compute the overall weighted average after tax cost of additional finance.
Capital Structure
3. Prakash Limited provides you the following information:
(`)
Profit (EBIT) 3,00,000
Less: Interest on Debenture @ 10% (50,000)
EBT 2,50,000
Less Income Tax @ 50% (1,25,000)
1,25,000
No. of Equity Shares (` 10 each) 25,000
Earnings per share (EPS) 5
Price /EPS (PE) Ratio 10
The company has reserves and surplus of ` 7,50,000 and required ` 5,00,000 further for
modernisation. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt +
Equity) Ratio higher than 40% will bring the P/E Ratio down to 8 and increase the interest
rate on additional debts to 12%. You are required to ASCERTAIN the probable price of the share.
(i) If the additional capital is raised as debt; and
(ii) If the amount is raised by issuing equity shares at ruling market price
Leverage
4. The capital structure of ABC Ltd. for the year ended 31st March 2022 consisted as follows:
Particulars Amount in `
Equity share capital (face value ` 100 each) 20,00,000
10% debentures (` 100 each) 20,00,000

During the year 2021-22, sales decreased to 1,00,000 units as compared to 1,20,000 units
in the previous year. However, the selling price stood at ` 15 per unit and variable cost at
` 10 per unit for both the years. The fixed expenses were at ` 2,00,000 p.a. and the income
tax rate is 30%.
You are required to CALCULATE the following:
(a) The degree of financial leverage at 1,20,000 units and 1,00,000 units.
(b) The degree of operating leverage at 1,20,000 units and 1,00,000 units.
(c) The percentage change in EPS.
Investment Decisions
5. PQR Limited is considering buying a new machine which would have a useful economic life
of five years, at a cost of ` 40,00,000 and a scrap value of ` 5,00,000, with 80 per cent of
the cost being payable at the start of the project and 20 per cent at the end of the first year.
The machine would produce 80,000 units per annum of a new product with an
estimated selling price of ` 400 per unit. Direct costs would be ` 375 per unit and annual
fixed costs, including depreciation calculated on a straight- line basis, would be
` 10,40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in
the above costs, would be incurred, amounting to ` 1,25,000 and ` 1,75,000 respectively.
EVALUATE the project using the NPV method of investment appraisal, assuming the
company’s cost of capital to be 12 percent.
Management of Receivables (Debtors)
6. A regular customer of your company has approached to you for extension of credit facility
for purchasing of goods. On analysis of past performance and on the basis of information
supplied, the following pattern of payment schedule emerges:
Pattern of Payment Schedule
At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.
 At the end of 90 days 30% of the bill
At the end of 100 days 18% of the bill
Non-recovery 2% of the bill

The customer wants to enter into a firm commitment for purchase of goods of ` 40 lakhs in
2022, 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 ` 400 on which a profit of ` 20 per unit is
expected to be made. It is anticipated that taking up of this contract would mean an extra recurring
expenditure of ` 20,000 per annum. If the opportunity cost is 18% per annum, would you as
the finance manager of the company RECOMMEND the grant of credit to the customer?
Assume 1 year = 360 days.
Risk Analysis in Capital Budgeting
7. An enterprise is investing ` 200 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.
Year Cash flows (` In lakhs)
1 50
2 120
3 150
4 160
5 130
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis
of Risks adjusted discount rate.
Dividend Decisions
8. HM Ltd. is listed on Bombay Stock Exchange which is currently been evaluated by Mr. A on
certain parameters.
Mr. A collated following information:
(a) The company generally gives a quarterly interim dividend. ` 2.5 per share is the last
dividend declared.
(b) The company’s sales are growing by 20% on a 5-year Compounded Annual Growth
Rate (CAGR) basis, however the company expects following retention amounts
against probabilities mentioned as contention is dependent upon cash requirements
for the company. Rate of return is 10% generated by the company.
 Situation Prob. Retention Ratio
A 30% 50%
B 40% 60%
C 30% 50%
(c) The current risk-free rate is 3.75% and with a beta of 1.2 company is having a risk
premium of 4.25%.
You are required to help Mr. A in calculating the current market price using Gordon’s
formula.
Management of working Capital
9. Consider the following figures and ratios:
(i) Sales for the year (all credit) ` 1,05,00,000
(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1

You are required to PREPARE:

(a) Balance Sheet as on 31/3/2022 based on above details.
(b) The statement showing working capital requirement if the company wants to make a
provision for contingencies @ 14 percent of net working capital.
Miscellaneous
10. (a) EXPLAIN agency problem and agency cost. How to address the issues of the same.
(b) DESCRIBE the inter relationship between investing, financing, and dividend
decisions.
(c) STATE the meaning of debt securitization.
 SUGGESTED HINTS/ANSWERS

1.
Ratios Comment
Liquidity Current ratio has improved from last year and matching the
industry average.
Quick ratio also improved than last year and above the
industry average.
The reduced inventory levels (evidenced by higher
inventory turnover ratio) have led to better quick ratio in
FY 2022 compared to FY 2021.
Further the decrease in current liabilities is greater than the
collective decrease in inventory and debtors as the current
ratio have increase from FY2021 to FY 2022.
Operating Profits Operating Income-ROI reduced from last year, but
Operating Profit Margin has been maintained. This may
happen due to decrease in operating cost. However,
both the ratios are still higher than the industry
average.
Financing The company has reduced its debt capital by 1% and
saved earnings for equity shareholders. It also signifies that
dependency on debt compared to other industry
players (60%) is low.
Return to the shareholders Prabhu’s ROE is 26 per cent in 2021 and 28 per cent in
2022 compared to an industry average of 18 per
cent. The ROE is stable and improved over the last
year.
2. (a) Cost of Equity / Retained Earnings (using dividend growth model)
D1
Ke =
P0
where D1 = Do (1 + g) = 2 (1 + .10) = 2.2
2.2
Ke = + 0.10 = 0.15 or 15 %
44
(b) Cost of Debt (Post Tax)
Kd = I (1-t)
Upto 3,60,000 Kd = .08 (1-0.4) = 0.048
 Beyond 3,60,000 = .12 (1-0.4) = 0.072
Thus, post-tax cost of additional debt = 0.048 x 3,60,000 / 6,00,000 + 0.072 x
2,40,000/ 6,00,000 = 0.0288 + 0.0288 = 0.0576 or 5.76%
(c) Pattern for Raising Additional Finance
Debt = 20,00,000 x 30% = 6,00,000
Equity = 20,00,000 x 70 % = 14,00,000
Out of this total equity amount of ` 14,00,000 -
Equity Shares = 14,00,000 – 4,20,000
= 9,80,000
And Retained Earnings = 4,20,000
(d) Overall Weighted Average after tax cost of additional finance
WACC = Kd x Debt Mix + Ke x Equity Mix = 0.0576 x 30% + 0.15 x 70% = 0.01728 +
0.105 = 0.1223 or 12.23% (approx.)
3. Ascertainment of probable price of shares of Prakash limited
Plan-I Plan-II
If ` 5,00,000 is If ` 5,00,000 is
Particulars raised as debt raised by
issuing equity
shares
(`) (`)
Earnings Before Interest and Tax (EBIT)
{20% of new capital i.e., 20% of (`15,00,000 +
4,00,000 4,00,000
` 5,00,000)}
(Refer working note1)
Less: Interest on old debentures
(50,000) (50,000)
(10% of `5,00,000)
Less: Interest on new debt
(60,000) --
(12% of `5,00,000)
Earnings Before Tax (EBT) 2,90,000 3,50,000
Less: Tax @ 50% (1,45,000) (1,75,000)
Earnings for equity shareholders (EAT) 1,45,000 1,75,000
 No. of Equity Shares (refer working note 2) 25,000 35,000
Earnings per Share (EPS) ` 5.80 ` 5.00
Price/ Earnings (P/E) Ratio (refer working note
8 10
3)
Probable Price Per Share (PE Ratio × EPS) ` 46.40 ` 50
Working Notes:
1. Calculation of existing Return of Capital Employed (ROCE):
(`)
Equity Share capital (25,000 shares × `10) 2,50,000
10% Debentures  ` 50,000
100 

  5,00,000
 10 
Reserves and Surplus 7,50,000
Total Capital Employed 15,00,000
Earnings before interest and tax (EBIT) (given) 3,00,000
` 3,00,000
ROCE = 100 20%
` 15,00,000

2. Number of Equity Shares to be issued in Plan-II:

`5,00,000
=  10,000 Shares
`50
Thus, after the issue total number of shares = 25,000+ 10,000 = 35,000 shares
3. Debt/Equity Ratio if ` 5,00,000 is raised as debt:
`10,00,000
= 100 = 50%
` 20,00,000

As the debt equity ratio is more than 40% the P/E ratio will be brought down to 8 in
Plan-I
4.

Sales in units 1,20,000 1,00,000

(`) (`)
Sales Value 18,00,000 15,00,000
Variable Cost (12,00,000) (10,00,000)
Contribution 6,00,000 5,00,000
 Fixed expenses (2,00,000) (2,00,000)
EBIT 4,00,000 3,00,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 1,00,000
Tax @ 30% (60,000) (30,000)
Profit after tax (PAT) 1,40,000 70,000
EBIT 4,00,000 3,00,000
(i) Financial Leverage= = =2 = =3
EBT 2,00,000 1,00,000
Contribution 6,00,000 5,00,000
(ii) Operating leverage = = 1.50 = = 1.67
EBIT 4,00,000 3,00,000
(iii) Earnings per share (EPS) 1, 40,000 70,000
=`7 = ` 3.5
20,000 20,000
Decrease in EPS = ` 7 – ` 3.5 = ` 3.5
% decrease in EPS 3.5
= x 100 = 50%
7
5. Calculation of Net Cash flows
Contribution = (400 – 375)  80,000 = ` 20,00,000
Fixed costs = 10,40,000 – [(40,00,000 – 5,00,000)/5] = ` 3,40,000
Year Capital Contribution Fixed costs Promotion Net cash flow
(`) (`) (`) (`) (`)
0 (32,00,000) (32,00,000)
1 (8,00,000) 20,00,000 (3,40,000) (1,25,000) 7,35,000
2 20,00,000 (3,40,000) (1,75,000) 14,85,000
3 20,00,000 (3,40,000) 16,60,000
4 20,00,000 (3,40,000) 16,60,000
5 5,00,000 20,00,000 (3,40,000) 21,60,000
Calculation of Net Present Value
Year Net cash flow (`) 12% discount factor Present value (`)
0 (32,00,000) 1.000 (32,00,000)
1 7,35,000 0.893 6,56,355
2 14,85,000 0.797 11,83,545
 3 16,60,000 0.712 11,81,920
4 16,60,000 0.636 10,55,760
5 21,60,000 0.567 12,24,720
21,02,300
The net present value of the project is `21,02,300.
6. Statement showing the Evaluation of credit Policies
Particulars Proposed Policy `
A. Expected Profit:
(a) Credit Sales 40,00,000
(b) Total Cost
(i) Variable Costs (` 380 x 10000 units) 38,00,000
(ii) Recurring Costs 20,000
38,20,000
(c) Bad Debts 80,000
(d) Expected Profit [(a) – (b) – (c)] 1,00,000
B. Opportunity Cost of Investments in Receivables 1,31,790
C. Net Benefits (A – B) (31,790)

Recommendation: The Proposed Policy should not be adopted since the net benefits
under this policy are negative.
Working Note: Calculation of Opportunity Cost of Average Investments
Collection period Rate of Return
Opportunity Cost = Total Cost × x
360 100

Particulars 20% 30% 30% 18% Total

A. Total Cost 7,64,000 11,46,000 11,46,000 6,87,600 37,43,600
B. Collection period 30/360 60/360 90/360 100/360
C. Required Rate of 18% 18% 18% 18%
Return
D. Opportunity Cost 11,460 34,380 51,570 34,380 1,31,790
(A × B × C)
7. The Present Value of the Cash Flows for all the years by discounting the cash flow at 7%
is calculated as below:
Year Cash flows Discounting Present value of Cash
`In lakhs Factor@7% Flows ` In Lakhs
1 50 0.935 46.75
2 120 0.873 104.76
3 150 0.816 122.40
4 160 0.763 122.08
5 130 0.713 92.69
Total of present value of Cash flow 488.68
Less: Initial investment (200.00)
Net Present Value (NPV) 288.68
Now, the risk-free rate is 7 % and the risk premium expected by the Management is 7 %.
So, the risk adjusted discount rate is 7 % + 7 % =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below:
Year Cash flows Discounting Present Value of Cash Flows
` in Lakhs Factor@14% ` in lakhs
1 50 0.877 43.85
2 120 0.769 92.28
3 150 0.675 101.25
4 160 0.592 94.72
5 130 0.519 67.47
Total of present value of Cash flow 399.57
Initial investment (200.00)
Net present value (NPV) 199.79
8. Market price using Gordon’s formula
D0 1 g
P0 =
ke  g

D0 = 2.5×4 = 10 per share (annual)

g = br or retention ratio x rate of return
Calculation of expected retention ratio
 Situation Prob. Retention Ratio Expected Retention Ratio
A 30% 50% 0.15
B 40% 60% 0.24
C 30% 50% 0.15
Total 0.54
g = 0.54 × 0.10= 0.054 or 5.4%
D0 1 g
P0 =
Ke  g

101 0.054 10.54

P0 = = = 305.51
0.0885  0.054 0.0345

Ke = Risk free rate + (Beta x Risk Premium)

= 3.75% + (1.2 x 4.25%) = 8.85%
9. Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)
= ` 1,05,00,000 – ` 36,75,000
= ` 68,25,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
` 68, 25, 000
= ` = ` 11,37,500
6
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
` 68, 25, 000
= `
1.5
= ` 45,50,000
(iv) Current Assets:
Current Ratio = 2.5 and Liquid Ratio = 1.5
Inventories (Stock) = 2.5 – 1.5 = 1
2.5
Current Assets = Amount of Inventories Stock x
1
 2.5
= `11, 37, 500 x = ` 28,43,750
1
(v) Liquid Assets (Receivables and Cash)

= Current Assets – Inventories (Stock)

= ` 28,43,750 – ` 11,37,500
= ` 17,06,250
Debtors Collection period
(vi) Receivables (Debtors) = Sales x
12
1
= `1, 05, 00, 000 ×
12
= ` 8,75,000
(vii) Cash = Liquid Assets – Receivables (Debtors)
= ` 17,06,250 – ` 8,75,000 = ` 8,31,250
Fixed Assets
(viii) Net worth =
1.3
`45,50, 000
= = ` 35,00,000
1.3
(ix) Reserves and Surplus

Reserves and Share Capital = Net worth

Net worth = 1 + 1.5 = 2.5
1
Reserves and Surplus = `35, 00, 000 x
2.5
= ` 14,00,000
(x) Share Capital = Net worth – Reserves and Surplus
= ` 35,00,000 – ` 14,00,000
= ` 21,00,000
(xi) Current Liabilities = Current Assets/ Current Ratio
`28, 43, 750
= = ` 11,37,500
2.5
(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ` 35,00,000 × 0.7875 = ` 27,56,250
(a) Balance Sheet

Particulars Figures as at Figures as at

31-03-2022 (`) 31-03-2021 (`)
I. EQUITY AND LIABILITIES
Shareholders’ funds
(a) Share capital 21,00,000 -
(b) Reserves and surplus 14,00,000 -
Non-current liabilities
(a) Long-term borrowings 27,56,250 -
Current liabilities 11,37,500 -
TOTAL 73,93,750 -
II. ASSETS
Non-current assets
Fixed assets 45,50,000 -
Current assets
Inventories 11,37,500 -
Trade receivables 8,75,000 -
Cash and cash equivalents 8,31,250 -
TOTAL 73,93,750 -

(b) Statement Showing Working Capital Requirement

Particulars (`) (`)
A. Current Assets
(i) Inventories (Stocks) 11,37,500
(ii) Receivables (Debtors) 8,75,000
(iii) Cash in hand & at bank 8,31,250
Total Current Assets 28,43,750
 B. Current Liabilities:
Total Current Liabilities 11,37,500
Net Working Capital (A – B) 17,06,250
Add: Provision for contingencies
2,38,875
(14% of Net Working Capital)
Working capital requirement 19,45,125
10. (a) Though in a sole proprietorship firm, partnership etc., owners participate in
management but in corporates, owners are not active in management so, there is a
separation between owner/ shareholders and managers. In theory managers should
act in the best interest of shareholders, however, in reality, managers may try to
maximise their individual goal like salary, perks etc., so there is a principal agent
relationship between managers and owners, which is known as Agency
Problem. In a nutshell, Agency Problem means that there is a chance that managers may
place personal goals ahead of the goal of owners. Agency Problem leads to Agency
Cost. Agency cost is the additional cost borne by the shareholders to monitor the manager
and control their behaviour so as to maximise shareholders wealth. Generally, Agency
Costs are of four types (i) monitoring (ii) bonding (iii) opportunity
(iv) structuring.
Addressing the agency problem
The agency problem arises if manager’s interests are not aligned to the interests of
the debt lender and equity investors. The agency problem of debt lender would be
addressed by imposing negative covenants i.e. the managers cannot borrow beyond
a point. This is one of the most important concepts of modern day finance and the
application of this would be applied in the Credit Risk Management of Bank, Fund
Raising, Valuing distressed companies.
Agency problem between the managers and shareholders can be addressed if the
interests of the managers are aligned to the interests of the shareholders. It is easier said
than done.
However, following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and
also with the long term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption
that maximisation of the stock price is the objective of the investors.
 Effecting monitoring can be done.
(b) Inter-relationship between Investment, Financing and Dividend Decisions
The finance functions are divided into three major decisions, viz., investment,
financing, and dividend decisions. It is correct to say that these decisions are inter -
related because the underlying objective of these three decisions is the same, i.e.,
maximisation of shareholders’ wealth. Since investment, financing and dividend
decisions are all interrelated, one must consider the joint impact of these decisions on
the market price of the company’s shares and these decisions should also be solved
jointly. The decision to invest in a new project needs the finance for the investment.
The financing decision, in turn, is influenced by and influences dividend decision
because retained earnings used in internal financing deprive shareholders of their
dividends. An efficient financial management can ensure optimal joint decisions.
This is possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter -
relationship and to see how they can help in maximising the shareholders’ wealth i.e.,
market price of the company’s shares.
Investment decision: The investment of long-term funds is made after a careful
assessment of the various projects through capital budgeting and uncertainty
analysis. However, only that investment proposal is to be accepted which is expected
to yield at least so much return as is adequate to meet its cost of financing. This has
an influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds
involves different issues. The finance manager must maintain a proper balance
between long-term and short-term funds. With the total volume of long-term funds, he must
ensure a proper mix of loan funds and owner’s funds. The optimum f inancing mix will
increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or
declare dividend. He assists the top management in deciding as to what portion of the
profit should be paid to the shareholders by way of dividends and what portion should
be retained in the business. An optimal dividend pay-out ratio maximises
shareholders’ wealth.
The above discussion makes it clear that investment, financing, and dividend
decisions are interrelated and are to be taken jointly keeping in view their joint effect
on the shareholders’ wealth.
(c) Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to
financial intermediaries to support the lending volumes. Assets generating steady cash
flows are packaged together and against this asset pool, market securities can be
issued, e.g., housing finance, auto loans, and credit card receivables.
Process of Debt Securitisation
(i) The origination function – A borrower seeks a loan from a finance company, bank.
The credit worthiness of borrower is evaluated, and contract is entered into with
repayment schedule structured over the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to
create an underlying pool of assets. The pool is transferred in favour of Special
purpose Vehicle (SPV), which acts as a trustee for investors.
(iii) The securitisation function – SPV will structure, and issue securities based on
asset pool. The securities carry a coupon and expected maturity which can be
asset-based/mortgage based. These are generally sold to investors through
merchant bankers. Investors are – pension funds, mutual funds, insurance
funds.