Inter FM Concept Book 2024-2025

BASICS
Income Statement
Sales ₹ 1000
Less: Variable cost 400
Contribution 600
Less: Fixed Cost 150
EBIT or Operating income 450
Less: Interest on Debt 75

Reverse calculation
EBT 375
Less: Taxes @ 40 % 150

EAT 1000
EAT 225
Tax R ate 30%
Less: Preference dividend 25 EBT ?
EAES 200
Ans:
÷ No. of Eq Shares 40
EPS 5
Less: DPS 2
Retained earnings per share 3
Dividend % Vs. Dividend Payout ratio Vs. Dividend yield %

DPS DPS DPS
= = =
Face value EPS MP
₹2 ₹2 ₹2
= = =
₹ 100 ₹5 ₹ 500 (say)
= 2% = 40% = 0.40%
PV Ratio [Profit Volume Ratio] aka Contribution Ratio

Contribution
PV Ratio = x 100
Sales
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India 1
LEVERAGES
Breakeven Point [BEP] is a level of sales at which there is no profit no loss. In other words,
Contribution is just sufficient to meet Fixed cost
Fixed Cost
BEP (in units) = Practice Q
Contribution pu
SP 1000
₹ 35000 VC 300
=
₹ 700 Cpu 700
= 50 units FC 35000
BEP ( in Value ) = BEP units x SP pu

= 50 units x ₹ 1000
= ₹ 50000
or
Fixed Cost ₹ 35000
= = = ₹ 50000
PV Ratio 70 %
Margin Of Safety [MOS] is a level of sales over & above BE sales.
Suppose actual sales qty = 80 units ASQ = 80

P
MOS = Actual Sales Quantity - Breakeven sales Qty r
(in units) = 80 - 50
30 o
= 30 units f
i
t
MOS = Actual Sales - Breakeven sales BEP = 50
( in Value) = ₹ 80000 - ₹ 50000 L
= ₹ 30000 o
s
s
ASQ - BEQ 80 - 50
MOS = = = 37.5%
ASQ 80
( in % )
or
Actual Sales - Breakeven sales ₹ 80000 - ₹ 50000
= = = 37.5%
Actual Sales ₹ 80000
LEVERAGES
Types of Leverage
Operating Financial Combined

Leverage Leverage Leverage
Operating Leverage
माँ के िलए साड़ी खरीदना है, बहन ादा Fixed Cost के

की शादी करनी है, म Fixed Aal Izz Well
िलए अ ू नही ं मानगे
Cost का बोझ नही ं उठा सकता
Situation 1: Situation 2: Situation 3:

FC=₹0, VC= ₹25pu FC=₹10000, VC=₹15pu FC= ₹20000, VC= ₹5pu
Proposal with No FC Proposal with Lower FC Proposal with Higher FC but Lower
but Higher VC VC
20% 20% 25% 20%
1000 1200 1000 1200 BEP=800 1000 1200
16.67% 16.67%
Sales @ ₹ 30 30000 36000 30000 36000 24000 30000 36000
Less :VC 25000 30000 15000 18000 4000 5000 6000

@ ₹25 or 15
or 5pu
20% 20% 25% 20%
Contribution 5000 6000 15000 16.67%18000 20000 2500016.67%30000
@ ₹ 5 or 15
or 25pu
Less: Fixed 0 0 10000 10000 20000 20000 20000

cost
20% 60% ∞% 100%
EBIT or 5000 6000 5000 37.5% 8000 0 5000 50% 10000
Operating
income
DOL 1 times 1 times 3 times 2.25 times ∞ times 5 times 3 times
Degree of Operating Leverage
% ∆ in EBIT 60%
DOL = = = 3 times
% ∆ in Sales 20%
Contribution 15000
DOL = = = 3 times (Preferred formula)
EBIT 5000
1 1
DOL = = = 3 times
MOS % 33.33 %
MOS% calculation explained

FC
BEP in situation 1 = ∴MOS = 1000 - 666.67
Cpu
= 333.33
= 10000/15 ∴MOS = 333.33
1000
= 666.67 units = 33.33%
Definition:
Operating Leverage is magnification of EBIT or Operating Income that results from having fixed cost in the.
Company's Cost Structure.
Operating Leverage is a measure of Business risk .
Observations :
1. If there is No Fixed cost then there is No Operating Leverage [DOL = 1]. It means there will be no
magnification of Operating Income.
2 Higher the Proportion of Fixed cost in the cost Structure , higher will be DOL & vice-versa.
3. At BEP, DOL = ∞
4. As we move beyond BEP i.e as our sales starts rising above BEP, then DOL starts falling.
This is so because DOL is a measure of Business risk. At BEP, Business risk is highest (because any fall in
sales will lead to Losses). However as we move above BEP , our MOS , Business Risk and hence, DOL
being a measure of Business Risk also
5 If sales are expected to increase then higher DOL is preferred so that Operating Income rises by a
higher %.
6. If we expect decrease in sales eg in times of Recession then lowér DOL is preferred
7. A positive DOL means the firm is operating above BEP. A Negative DOL means the firm is o p e r a t i n g
below BEP.
LEVERAGES
D
O 1
L
BEP
Contribution
DOL = Sales
EBIT
5000 5000
(-) 100 (-) 1000
= - 50 =-5
Contribution
Derivation of DOL =
EBIT
% ∆ in EBIT
DOL =
% ∆ in Sales
we know that % Δ in Sales = % Δ in Contribution (it’s a fact)
% ∆ in EBIT
=
% ∆ in Contribution
Here EBIT & Contribution means
New EBIT - EBIT
= Existing EBIT & Contribution
EBIT
New Contr - Contr Since Increase / Decrease in EBIT ₹ = Inc/Dec in

Contr Contribution ₹, ∴ they will cancel each other in the formula .
Contribution
∴ DOL =
EBIT
LEVERAGES
Derivation of DOL = 1/ MOS %
Actual Sales - Break even Sales

MOS % =
Actual Sales
Multiply & Divide RHS by PV Ratio
Actual Sales - Break even Sales PV Ratio

MOS % = x
Actual Sales PV Ratio
Actual Sales x PV Ratio - BES x PV Ratio

=
Actual Sales x PV Ratio FC
BES =
Contribution - Fixed Cost PVR
=
Contribution
EBIT
MOS % =
Contribution
∴
MOS % is inverse of DOL ∴ DOL = 1/MOS %
Financial Leverage
Eg. Let’s say, Total capital Requirement = ₹ 10,00,000
there are three ways to finance the same

Situation 1 : Situation 2 : Situation 3 :
Equity : ₹ 10 lakhs Equity : ₹ 5 lakhs Equity : ₹ 4 lakhs
Debt : ₹ 5 lakhs Preference : ₹ 4 lakhs
Debt : ₹ 2 lakhs
Let's say , EBIT is ₹ 1,00,000 under all three Situation

Intt on Debt is 10 %
Preference Dividend is 12 %
Face Value of Eq Sh is ₹ 100
Tax Rate = 30 %
LEVERAGES
Income Statement
Situation 1: Situation 2: Situation 3
Particulars Base Case Case (ii) Base Case Case (ii) Base Case Case (ii)
(i) (i) (i)
20% 20% 20%
EBIT / Op Inc 100000 120000 100000 120000 100000 120000
16.67% 16.67% 16.67%
Less: Intt on Debt - - 50000 50000 20000 20000
EBT 1,00,000 120000 50000 70000 80000 100000
Less: Taxes @30% 30000 36000 15000 21000 24000 30000
EAT 70000 84000 35000 49000 56000 70000
Less: Pref. Div - - - - 48000 48000

20% 40% 175%
EAES 70000 84000 35000 49000 8000 22000
16.67% 28.57% 63.64%
÷ No. of Sh. 10000 10000 5000 5000 4000 4000
20% 40% 175%
EPS 7 8.4 7 9.8 2 5.5
16.67% 28.57% 63.64%
DFL 1 times 1 times 2 times 1.71 times 8.75 times 3.82 times
Degree of Financial Leverage

DFL = % Δ in EAES or % Δ in EPS 40% 175 %
= =
% Δ in EBIT 20% 20 %
= 2 times = 8.75 times
If only Debt exists & there is No preference share capital
EBIT 100000
DFL = =
EBT 50000
= 2 times
If both Debt & Preference exists
EBIT 100000
DFL = (Preferred Formula) =
EBIT - I - Dp 100000 - 20000 - 48000
1-t 1-0.3
= 8.75 times
Alternatively,
EBIT (1-t) 100000 (1-0.3)
= =
(EBIT - I) (1-t) - Dp (100000 - 20000) (1-0.3) - 48000
= 8.75 times
LEVERAGES
Definition of Financial leverage :

Financial leverage is magnification of EAES (or EPS) due to the presence of fixed intt & dividend bearing
liabilities in the Capital structure
Observations :
1. If there is no Debt & No Preference Capital then there is No financial leverage. DFL= 1 times [refer
Situation 1 in our example]
2. Higher the Debt & Preference higher would be the financial leverage & vice - versa
3. If Company expects Operating Income will increase in the future then higher DFL is preferred.
4. If Co. expects bad times ahead eg. Recession or downward business cycle etc then Lower DFL is
preferred.
5. At Financial BEP , DFL = ∞
Above financial BEP, as firms EBIT increases, DFL starts falling
Operating BEP Vs. Financial BEP
Operating BEP is a level of sales Financial BEP is a level of EBIT at which

at which EBIT = 0 EAES (or EPS) = 0
Pref. Div
FC FC Financial BEP = Interest on debt +
Operating BEP = or 1-t
Cpu PV Ratio
Financial BEP for Situation 3
48000
= 20000 +
1- 0.30
= ₹ 88571
Combined Leverage
Income Statement
Particulars Amount
DCL = DOL x DFL
Sales
DOL = 1.5 % Δ in EAES

DCL =
EBIT / Op Inc DCL % Δ in Sales
DFL = 2 Contribution
DCL =
EAES EBIT - I - DP
1-t
EPS
DOL x DFL
DCL
Contribution EBIT
x
EBIT EBIT - I - DP
1-t
LEVERAGES
Ratios
ROCE (Return on Capital Employed) Vs. ROE (Return on Equity)

aka ROI
Eg. Total Capital Requirement is ₹ 10 lakhs to start a new business.
Equity ₹ 6,00,000
12 % Debt ₹ 4,00,000
₹ 10,00,000
EBIT (Say) ₹ 1,50,000
Prepare Income Statement & Calculate ROCE & ROE
Solve:
Income Statement
Particulars Amount
EBIT 1,50,000
Less : Intt on Debt [12% x ₹ 4,00,000] 48,000
EBT 1,02,000
Less : Taxes @ 30 % (say) 30,600
EAT or EAES 71,400
Caution Note:
Do not make the mistake of calculating Intt % on EBIT. Intt % should be applied on Debt amount.
EBIT 1,50,000
ROCE i.e Return on capital employed = = x 100 = 15%
Capital Employed 10,00,000
EAES 71,400
Return on Equity i.e. ROE = = = 11.9%
Equity Sh. hl. fund 6,00,000
Eq Sh capital + R & S
Tutorial Note
By Default, ROE always means Post - tax ROE
LEVERAGES
Q. Calculate After - tax ROCE in the above case ?

EBIT (1-t)
After- tax ROCE = Pretax ROCE (1-t) After- tax ROCE =
Cap Employed
= 15% (1 - 0.3) 1,50,000 (1- 0.3)
=
10,00,000
= 10.5 %
= 10.5%
Debt - Equity Ratio Vs. Debt to Total capital Ratio
aka Debt Ratio
Debt Debt
DE Ratio = =
Equity Debt + Equity
Eg.
B/S
Equity 150
Debt 60
D 60 D 60
Solve : DE Ratio = = = 0.40 Debt Ratio = = = 0.2857
E 150 D+E 60 + 150
Asset Turnover Ratio

Total Assets Turnover
Asset Turnover Ratio = Asset Turnover Ratio =
Turnover Assets
It shows how well we have utilized our Assets in
generating the Turnover. Generally, higher assets T/o
ratio vs industry is considered better.
LEVERAGES
PE Ratio i.e. Price to earnings Ratio

Eg. Infy Local software Co.
MP = ₹ 1250 MP ₹ 150
EPS = ₹ 50 EPS ₹ 10
Market Price
PE Ratio = Co.
EPS re
twa
sy s l sof
Info ₹ 1250 Loca
= = ₹ 150
₹ 50 ₹ 10
= 25 Times = 15 Times
Observations:
PE Ratio tells us how much Price we have to pay for every ₹ 1 of earnings.
1. A Company having higher Goodwill, Brand- name , Reputation etc will have higher PE Ratio.
2. A Co. having lower risk level will command higher PE Ratio.
3. A Co. having higher future growth expectations will have higher PE Ratio.
4, Other things being Constant, a Company having higher PE Ratio is Overvalued & a Company having lower
PE Ratio is Undervalued.
Remember, MP = PE Ratio x EPS
Capital Gearing Ratio
Debt + Preference By showing Eq Shhl funds, how much Debt & Pref funds Co. is
=
Equity Sh hl Fund able to raise. This ratio shows the level of gearing or leveraging
Operating Income ratio Vs. Operating Cost Ratio

aka Operating Profit Ratio aka Operating Ratio
EBIT or Operating income Total Operating Cost

= =
Sales Sales
= 1 - Operating Profit Ratio
450
= {Using Eg 1 of Basics Data}
1000
= 1- 0.45
= 45% = 0.55 or 55 %
LEVERAGES
Financial Leverage as a ‘Double Edged sword’ or Should we employ debt ?

When should company borrow debt ?
If Pre-tax ROCE or ROI % Favourable leverage Since. Co. is earning
> Interest rate % i.e Company should employ Debt higher on Amt
If Pre-tax ROCE or ROI % Unfavourable leverage borrowed than what
< Interest rate % i.e Company should NOT employ Debt Co. has to pay in the
form of Interest.
If Pre-tax ROCE or ROI % Neutral i.e. Neither Advantage Nor
= Interest rate % Disadvantage
When should company employ preference share capital ?

Then favourable leverage
If Post-tax ROCE > Preference Div %
i.e Company should raise money from Preference
Then Unfavorable leverage

If Post-tax ROCE < Preference Div %
i.e Company should NOT raise Preference Sh. Capital
If Post-tax ROCE = Preference Div % The neutral i.e. Neither Advantage Nor Disadvantage
Selection of Financing Plans
In this topic, we will be presented with two or more Financing Alternatives (Eg. Alt 1: Eq= ₹ 5 lakhs &
Debt = ₹ 5 lakhs; Alt 2: Eq = ₹ 8 lakhs & Debt = ₹ 2 lakhs) & now we have to DECIDE which alternative to
select ?
Two ways to select Financing Alternatives
Profit Maximization Wealth Maximization
Compare EPS under both the financing Compare MP i.e. Market Price & select
Plans & Select one having Higher EPS one having Higher MP per share
Caution Note :
Always compare earnings per share or market price per share. Do not make the mistake of
Comparing total earnings i.e. EAES or Total Market Value because other things being constant a
financing plan with higher equity Investment will always have Higher Total Earnings or Total MV
LEVERAGES
Segmentation of ROE
(due to the presence of Debt & Preference in the capital structure)
or
Reconciliation of ROE & ROCE
Situation 1: 100 % funding by Equity

Total capital requirment = ₹ 10 lakhs
EBIT or Operating income = ₹ 1.20 lakhs
Tax rate = 30 %
Calculate ROCE & ROE ?
Solve:
Income Statement
EBIT 120000 EBIT

ROCE =
Less : Intt on Debt Capital Employed
EBT 120000 120000

=
1000000
Less : Taxes @ 30% 36000
= 12%
EAT or EAES 84000
EAES
Why ROCE% & ROE% are different despite the fact ROE =
that 100% of Capital has been provided by Equity ? Eq Sh hi fund
Ans: ROCE is Pre-tax whereas ROE is Post-tax 84000
=
1000000
= 8.40 %
If we calculate Post- tax ROCE then it would tally with ROE (∴ 100% funding is done by Eq Shhl)
Post-tax ROCE = Pre-tax ROCE (1-t)
= 12% (1 - 0.30)
= 8.40% (which is same as ROE]
LEVERAGES
Situation 2: When Debt - Equity mix is used
Equity 6,00,000
EBIT = ₹ 120000
10 % Debt 4,00,000
Tax rate = 30 %
10,00,000
Calculate ROCE & ROE ?
Solve:
Income Statement
EBIT 120000 120000
ROCE = = 12%
Less : Intt on Debt 40000 1000000
EBT 80000 56000

ROE = = 9.33%
Less : Taxes @ 30% 24000 600000
EAT or EAES 56000
Equity Eq = ₹
6000
00
Investment
= ₹ 10 lakhs
000
bt = ₹ 400 ₹ 120000
10% De
ROCE = 12 % (Pre tax)
Total Capital or
Debt ROCE = 8.4 % (Post-tax)
= ₹ 10,00,000
Present Segmentation of ROE ? D

ROE = Post tax ROCE + (Pre tax ROCE - Intt rate %) (1-t) x
E
400000
= 8.4 % + (12% - 10% )( 1-0.3) x
= 8.4 % + 0.93 % 600000
= 9.33 %
Situation 3: When both Debt & preference are used along with equity
Equity 2,50,000
10 % Debt 3,50,000 EBIT = ₹ 120000
6 % Pref 4,00,000 Tax rate = 30 %
10,00,000
Calculate ROCE & ROE. Reconcile ROCE with ROE ?

LEVERAGES
Solve :
Income Statement
EBIT 120000 120000
ROCE = = 12%
Less : Intt on Debt 35000 1000000
(Pretax)
EBT 85000
ROCE = 12 % (1-0.3) = 8.4%
Less : Taxes @ 30% 25500
(After tax)
EAT 59500
Less : Dp 24000 35500
ROE = = 14.2%
EAES 35500 250000
Equity
Eq =
₹ 25
0000
Investment
6% Pref = ₹ 400000 = ₹ 10 lakhs
Preference 0 ₹ 120000
000
35
=₹ ROCE = 12 % (Pre tax)
bt
De or
10% Total Capital
= ₹ 10,00,000 ROCE = 8.4 % (Post-tax)
Debt
Aftertax Debt Pref

ROE = + (Pretax ROCE - Intt Rate) (1 - t) x + (Posttax ROCE - Pref div%) x
ROCE Equity Equity
on own equity on Debt amount employed on Pref amt employed
350000 400000
= 8.4% + (12% - 10%) (1 - 0.3) x + (8.4% - 6%) x
250000 250000
= 8.4% + 1.96% + 3.84%
= 14.2%
Meaning of Beta
Beta measures sensitivity of a particular stock with respect to changes in the Overall Stock Market
Stock Mkt Infosys Share
falls by 10% falls by 15%
∴Beta of Infosys = 1.5 times

Generally Speaking Higher DOL & DFL leads to Higher Beta & vice- versa
COST OF
CAPITAL
“Cost of Capital” is the return expected by the providers of capital.
Significance of ‘Cost of Capital’

Three areas where ‘Cost of Capital’ concept is used
BS
2. Evaluation of Investment Options
Equity in
ere to vest ?
1. Financial wh
Decisions
- Selecting among
various sources
Preference of Finance
3. Desig
ning of
Optimu
m Credit
Policy Debtors
Debt
Various sources of Finance
Retained
Debt
Earnings
i.e. Kd
i.e. Kr
Equity Preference
i.e. Ke i.e. Kp
Overall Cost of capital

i.e. Ko
COST OF CAPITAL
Time Value of Money

Future Value of a Single Sum
n
FV = PV (1 + r)
Q. You have ₹ 10,000 today. You can invest it @ 10 % р.а. in a Bank's fixed deposit for 3 Years. Calc
Future Value at the end of 3 Yrs
Solve :
@ 10% @ 10% @ 10%
₹ 10,000 11000 12100 13310
₹ 1000 ₹ 1100 1210
= ₹ 10000 (1 + 0.10)3
= ₹ 13310
Present Value of a Single Sum

FV
PV = n
(1 + r)
Q. You have been promised by your parents to give you ₹ 100000 gift on becoming CA after 4 years. If
rate of interest is 12%, Calc PV ?
Solve :
0 1 2 3 4
₹ 63551 ₹ 100000
100000
=
1.124
COST OF CAPITAL
Present value of an Annuity
Annuity is a series of Cash flow

ü having same amount every time
ü having equal time gap between any two consecutive amounts
n n means No. of Annuity Payments

1
PVA = A x
( 1- ( (( 1+r
r
Eg. You will receive ₹ 100000 per year from a client for next 5 year. calculate PV if rate of intt is 10% ?
Solve:
0 1 2 3 4 5
₹ 100000 ₹ 100000 ₹ 100000 ₹ 100000 ₹ 100000

100000
1
1.10 100000
90909 2
PVF1 = 0.909 1.10 100000
82644
PVF2 = 0.826 1.103
100000
75131
PVF3 = 0.751 1.104
68301 100000
PVF4 = 0.683 1.10
5
62092
PVF5 = 0.621
₹ 379078
OR
n
1
PVA = A x
( ( ((
1-
1+r
r
5
1
= 100000 x
(( ((
1-
1.10
0.10
= 379078
OR
PVA = A x PVAF (@ 6%, n yrs)
= 100000 x PVAF (@ 10%, 5 yrs)
= 100000 x 3.79078
= 379078
COST OF CAPITAL
Present Value of Perpetuity
Perpetual + Annuity
0 1 2 3 ∞
₹ 10000 ₹ 10000 ₹ 10000
@ 10%
A
PVP = 10000
r = = ₹100000
0.10
n=∞ this portion

1
1- will become
1+r irrelevant
PVA = A x
r
PV of Uneven Cash Flows

0 1 2 3 4 5
Eg.
₹ 100000 ₹ 120000 ₹ 125000 ₹ 140000 ₹ 150000

Rate of Intt = 10%
Calc PV
Solution :
Year Cashflow PVF @10% Present Value
1 100000 0.909 90909
2 120000 0.826 99173
3 125000 0.751 93914
4 140000 0.683 95621
5 150000 0.621 93138
PV of Cash flows = 472755
COST OF CAPITAL
Loan Amortization Schedule | Equated monthly installments (EMI)

Car Loan Sanctioned = ₹ 500000
Tenure = 5 Yrs
Rate of Intt = 7%
Loan Repayment Style = EAI
Equated Annual Installment

Initial Yrs Interest Principal = EAI
Interest Principal = EAI

= EAI
Interest Principal
= EAI
Interest Principal = EAI
Later Yrs Interest Principal = EAI
Calculate EAI ?
Solution Intt Rate = 7%
0 1 2 3 4 5
? ? ? ? ?
Loan Amount Annuity Annuity
= ₹ 500000
n
1
1- ( (
1+r
PVA = A x PVAF(@r%, n yrs)
PVA = A x
r 500000 = A x PVAF(@7%, 5 yrs)
5
1
1- ( ( 1.07 500000 = A x 4.1002
500000 = A x
0.07
500000 = A x 4.1002
∴ A = 121945
Loan amortization schedule
Year Opening Add: Interest Installments Closing
Balance @ 7% Interest payment Principal Repayment Balance
1 500000 35000 35000 86945 413055

2 413055 28914 28914 93031 320021
3 320021 22402 22402 99543 220481
4 220481 15434 15434 106511 113970
5 113970 7975 (b/f) 7975 113970 0
COST OF CAPITAL
Calculation of Cost of Capital
Cost of Debt [Kd]
Irredeemable Redeemable Convertible

Debt Debt Debt
I (1 - t)
Kd =
NP Same formulas as
here, taught earlier for
Kd = Cost of Debt after tax Redemption in Redemption in Redeemable Debt
I = Annual Interest Lumpsum Installments but use RV or CV
t = Tax Rate (Conversion
NP or MP = Net Proceeds or (i) Approximation Method value) whichever
Use
Market Price or Shortcut formula is higher in place
IRR
of RV in the
Technique
formula
RV - NP
I (1 - t) +
n
Kd = (Preferred) Use either
RV + NP
ü Approx Method
2 or
Tutorial Note: ü IRR Technique
This formula assumes
Ÿ Tax benefit is available only on Intt
Ÿ Rate of Intt is constant
Net Proceeds = Gross Isssue Proceeds
or
less Flotation Cost
RV - NP
I+
n
here, Flotation Cost includes Kd = (1 - t)
Ÿ Brokerage RV + NP
Ÿ Legal & Admin Charges 2
Ÿ Listing fees Tutorial Note:
Ÿ Brochure printing This formula assumes that Tax benefit is
Ÿ Advertisements etc. available on all viz Intt, Floatation Cost &
Premium paid
(ii) Accurate Method

Use IRR Technique
COST OF CAPITAL
Eg. How to calculate of cost Debt - Irredeemable Debt
Situation 1: If there is No Floatation Cost
0 1 2 ∞
pany pays Regular

: Com In t ₹ 100000 ₹ 7200 ₹ 7200
p 2 ere
e st
St inflow
Interest ₹ 12000
Less : Tax
(4800)
Benefit @ 40%
₹ 7200
₹ 7200
Cost of Debt i.e. Kd =
Company Step 1: Investor gives ₹ 100000
money to company,
say, ₹ 100000 Investor
= 7.2%
12% Debt
Situation 2: If Floatation Cost exists

Q. What if in above case, Co. has incurred floatation cost of 3%.
Solve 0 1 2 ∞
Inflow ₹ 100000 ₹ 7200 ₹ 7200

Less: Fl. C ₹ 3000
pany pays Regular Net Proceeds ₹ 97000
: Com In t
2 ere
t ep st
S
Interest ₹ 12000
Less : Tax
(4800)
Benefit @ 40%
₹ 7200 ₹ 7200
Cost of Debt i.e. Kd =
₹ 100000 - ₹ 3000
Company Step 1: Investor gives
money to company, = 7.426%
say, ₹ 100000 Investor
Less: Flotation Cost ₹ 3000 12% Debt
Net Proceeds = ₹ 97000
COST OF CAPITAL
Eg 2: How to calc cost of Debt - Redeemable Debt

0 1 2 3 4 5
Net Proceeds Intt 10000 7000 7000 7000 7000

= ₹ 98000 (-) Tax benefit 3000 105000
₹ 7000
Rate of Intt Tax Rate = 30%

Net Proceeds = 10%
= ₹ 98000 Floatation
Investor
Cost = ₹2000
₹ 100000
Bond Life = 5 Yrs
Redeemable @ 5%
premium
RV - NP 105000 - 98000
I (1 - t) + 10000 (1 - 0.3) +
n 5 Years
Kd = = = 8.275 %
RV + NP 105000 + 98000
2 2
-n
Cal of cost of Debt - Accurate Method
0 1 2 3 4 5
Debt Raised
i.e. Inflow 100000
10000 10000 10000 10000 10000
100000
10000
1
1.10 10000
9091 2
1.10 10000
8264 3
1.10
10000
7513
1.104 110000
6830
5
1.10
68301
₹ 100000
Tutorial Note:
Future Outflows against any Loan are reflection of “Principal Repayment + Intt on loan”. Hence,
Future Outflows are equal to loan Amount + interest Rate compounded (i.e. Added in the Loan
Amount.) Accordingly, if we think other way round, then ‘Discounting Future Cash Outflows @ Kd
will equate to the PV of Loan Amount” This rate is found by Trial & Error.
COST OF CAPITAL
Let’s apply the concept in another example :
0 1 2 3 4 5
Debt Raised 15000 16000 18000 20000

25000
i.e. Inflow 100000 Outflows Outflows Outflows Outflows
100000
Outflows
Solve: Using interest Rate of Return Method [IRR Method] aka Present Value Method OR Yield Method To
Maturity
Calculation of Kd using Trial & Error Method
Year Cashflows PV @ 18% PV @ 19%
PVF PV PVF PV
1 15000 0.847 12712 0.840 12605
2 16000 0.718 11491 0.706 11299
3 18000 0.608 10955 0.593 10681
4 20000 0.515 10316 0.498 9973
5 125000 0.437 54639 0.419 52381
PV of Outflows = 100113 PVO = 96939
PV of Inflows = 100000 PVI = 100000
Net Present Value (113) NPV = + 3061
Using Interpolation :
NPVL Tutorial Note:
=L+ (H - L)
NPVL - NPVH 1. Interpolation can be applied only when one NPV is -
ve & another is +ve
here, 2. Prefer using Formula in Exam instead of doing it
L means Lower Rate logically
H means Higher Rate
NPVL means NPV at Lower Rate
NPVH means NPV at Higher Rate
- 113
= 18% + (19% - 18%)
- 113 - 3061
113
= 18% + (19% - 18%)
3174
= 18% + 0.035%
= 18.035%
or
COST OF CAPITAL
Disc rate 1%
Logically
? = 0.035%
Disc Rate: @ 18% ?? @ 19%
0 + 3061
NPV : (113)
113
NPV
NPV 3174
NPV by when Disc R by

∴
3174 1%
∴ 113 113 x 1%
?= = 0.035%
3174
∴New Disc Rate = 18% + 0.035%
= 18.035%
How to calculate Fair Value of the Bond ?

‘Fair Value of the Bond’ is the Present Value of future Cash flows (in the form of Interest + Redemption
Value) discounted @ Required/Expected Rate of return (or prevailing rate of return)
Example: IMC has an outstanding Bond having Face Value of ₹ 1000, offering 10% Coupon Rate & remaining 4
years of maturity.
If prevailing rate of Intt in the market is 12%, Calc Fair Value of the Bond ?
Solve : 0 1 2 3 4
Reqd
Return
= 12% ₹ 100 ₹ 100 ₹ 100 100
1000
100
1.121 100
89.28
2
1.12 100
79.72 3
1.12 1100
71.18
4
1.12
699.07
Fair Value = 939.25
or
Present Value
of the Bond
COST OF CAPITAL
Q. If Actual Market Price of the Bond is ₹ 900. Would you buy this Bond ?
Solution: Since Actual MP (₹ 900) < Fair Price (₹ 939.25), therefore, Bond is Undervalued. Hence, we should
buy this Bond.
Exam Tip:
While calculating Kd - When to use NP & When to use MP ?
Issue Date Today
0 1 2 10
Use Market Price

MP RV
RV - MP
I(1 - t) I (1 - t) +
Kd = n Remaining
MP Kd =
RV + MP life of the
2 Bond
Use Net
Proceeds
Issue Price RV - NP
I(1 - t) I (1 - t) +
(-) Flotation Cost Kd = n Life of
OR Kd =
Net Proceeds NP the Bond
RV + NP
2
Convertible Debt
Issue Date 5
8% Coupon Convertible
Debt into 5 Eq. Sh.
Life = 5 Yrs
OR
If Redeemed If Converted into eq sh

say, Redeemable @ 5 Eq. shares x ₹ 27, Say
RV* - NP 10% Premium = ₹ 110 [Estimated Shares
I (1 - t) +
n is Redemption Value Price] Vs. = ₹ 135 is
Kd = Conversion Value
RV* + NP
2 * whichever is higher would be opted by
Debenture holder & hence
Higher of these two Numbers is taken as RV
COST OF CAPITAL
Cost of Preference Shares
Ÿ Unlike Debt where we pay Interest, in case of Preference shares we pay preference Dividend
Ÿ Interest is an Expense but Preference Dividend is an Appropriation of Profits. Hence, ‘Interest' attracts
Tax benefit but there is no such Tax benefit on payment of Preference Dividend.
Cost of Preference Shares [Kp]
Irredeemable Redeemable Convertible

Preference Preference Preference
PD Use either
KP =
NP or MP ü Approximation Method
Lumpsum Installments ü IRR Technique
Approximation Method Use Note : Use RV or CV

or Shortcut formula IRR whichever is higher
RV - NP Technique
KP = PD +
n
RV + NP
2
Accurate Method
Use IRR Technique
here,
PD means Preference Dividend [may also be denoted by Dp]
Cost of Equity [Ke]
1. Dividend Price (D/P) Approach
2. Earning Price (E/P) Approach
3. Dividend plus Growth Approach
4. Realized Yield Approach
5. Capital Assets Pricing Model [CAPM]
COST OF CAPITAL
1. Dividend Price Approach

D here
Ke =
P0 D means Dividend
P0 means Market Price as of today
2. Earning Price Approach

EPS
Ke =
P0
3. Dividend plus Growth Approach aka Gordon’s growth Model aka Discounted Cash Flow [DCF technique]
D1
Ke = +g
P0
here,
D1 means Expected Dividend in the Next Yr i.e. Do(1 + g)
‘g’ means Growth Rate

How to find out growth rate ?
Average Method Formula Method

(i) Symmetric Growth g=bxr
or
Year 2016 2017 2018 2019
g = RR x ROE
DPS 5 5.5 6.05 6.655
10% 10% 10% here,
b means Retention Ratio
∴ growth in dividends = 10% in the above case r means Return on Equity
(ii) Asymmetric Growth
Year 2016 2017 2018 2019 2020
DPS 5 5.75 6 8 10
4% %
15% 4 .3 3 .33 25
%
g= g= g=
3 g=
Solve: Use Geometric Mean
G.M = n (1 + r1) (1 + r2)..........(1 + rn) - 1
= 4 (1.15) (1.0434) (1.3333) (1.25) - 1
= 0.1892 or 18.92%
COST OF CAPITAL
OR
Use FV PV Formula
n
Do = Dn (1 + r) just like FV = PV (1 + r)n
here, r = n D0
-1
Dn
Do means Current Dividend
Dn means Dividend n yrs ago
4
10 = 5 (1 + r)
4
2 = (1 + r)
42 =1+r
1.1892 = 1 + r
∴r = 18.92 %
Existing Equity Vs New Equity
D1 D1
Ke = +g Ke = +g
P0 P0 - F
here,
If Q. has given a separate F means Flotation Cost
Issue Price then ‘Use Issue Note : If Flotation Cost is given in % terms then either
Price in place of Po ü Calc Flotation Cost amount by multiplying Fl. cost %
with Po
ü & Rewrite the formula as
D1
Ke = +g
P0 (1 - F%)
4. Realized Yield Approach
Single Period
here,
D1 + P1 - P0
Y1 = Y1 means Yield during Yr 1
Po D1 means Dividend at the end of Yr 1
P0 & P1 Price of the Share at the end of Yr 0 & Yr 1.
Multiple Period
- Situation I : when only beginning & ending share price are available
0 1 2 3 4
₹ 200 Dividend 18 20 25 inflow

Outflow = ₹ 15 Infl. Infl. P4 = ₹ 300 inflow
inflow
Calculate Return earned by an Investor over 4 yrs period ?
COST OF CAPITAL
Solve: Hint : Use IRR Technique
PV @ 18% PV @ 20%
Year Cashflow PVF PV PVF PV
1 15 .
2 18 .
3 20 .
4 25 + 300 = 325 .
PVI = 205.44 193.31
Pv0 = 200 200
NPV 5.44 (6.69)
Using Interpolation : -
=
= 18.9%
Situation II : When Share Prices at the end of each yr are given ?

0 1 2 3 4
₹ 200 Dividend 18 20 25 inflow

Outflow = ₹ 15 Infl. Infl. P4 = ₹ 300 inflow
inflow P2 = 250 P3 = 275
P1 = 220
Calculate Realized Yield ?
Solve: Two steps are involved :
Step 1: Treat each 1 year period as a ‘Single Period’ & calculate yield using :
D1 + P1 - P0
Y1 =
P0
Now we’ll have yield for each of the 4 years
Step 2: Find Geometric Mean
Step 1: Calculate Yield for each year

D1 + P1 - P0
Yield % =
P0
Year 1
15 + 220 - 200
= = 17.5 %
200
COST OF CAPITAL
Year 2
18 + 250 - 220
= = 21.82 %
220
Year 3
20 + 275 - 250
= = 18 %
250
Year 4
25 + 300 - 275
= = 18.18 %
275
Step 2: Calc Geometric Mean

= 4 (1 + Y1) (1 + Y2) (1 + Y3) (1 + Y4) - 1
= 4 (1.175) (1.2182) (1.18) (1.1818) - 1
= 18.87% Same answer as situation I. In fact both the situations are effectively the same.
Tutorial Note:
Which Approach shall we use in Exam ?
If Share Prices at the end of each yr are given then use ‘Geometric Mean’ else 'Use IRR"
5. CAPITAL ASSET PRICING MODEL [CAPM]
Ke = Rf + β (Rm - Rf)
‘Rm - Rf’ means Market Risk Premium
here,
Rf means Risk-free Rate of Return
Rm means Return from Market
β means Sensitivity of a particular stock w.r.t. Market. β is a measure of Systematic Risk
Eg. Rf = 6% , Rm = 15% , β = 1.5 times

Calc Ke ?
Rm = 15%
Solve : Ke = Rf + β (Rm - Rf) Market
= 6% + 1.5 (15% - 6%) Risk
= 19.5% Prem
= 9%
Rf = 6%
COST OF CAPITAL
Cost of Retained Earnings [Kr]
Investment
B/S
in the Project
Eq sh Capital ₹ 100000 Investment in Project 100000

Return earned + 20000
Eq sh hl
Less : Dividend Paid - 8000 Project
R & S i.e.
112000
Retained Earnings 12000 Return earned
on the Project
Concept: Since both Eq Sh Capital as well as Retained Earning belong to the same person & carries the same
risk, therefore,
Kr = Ke
So the formulas we have learned for Ke, applies equally to Kr
Exceptions:
1. Kr = Keif Flotation Cost is given in the Question.
-n
For Cal of Ke: ‘P’ Could be ‘PO - f’ i.e. (i) issue price less Flotation cost or (ii) Market Price
For Cal-n of Kr: ‘P’ will always be Po i.e. Current Mkt Price
because No Flotation
Cost is incurred
for Retained Earnings
2. If Personal tax rates is also given in the question then Kr = Ke

Kr = Ke (1 - tp)
here,
tp means Personal Tax Rate on dividend
3. If both Flotation Cost & Personal Tax Rates are given

Kr = Ke (1 - tp) (1 - f)
here,
‘f’ means flotation cost%
COST OF CAPITAL
Cost of Capital or Weighted Average (WACC) or KO Cost of Capital
Equity B/S
Ke = 20%
600 x 20 %
600
= 120
Kd = 10%
400
400 x 10 %
Debt = 40
Calculate K0 ?
Alternative 1:
Sources of finance Cost% Amount Cost ₹
Eq 20% 600 120
Debt 10% 400 40
∴KO = 160/1000
1000 160
= 16%
Alternative 2:
Sources of finance Cost% Amount Weights Cost% x weights
Eq 20% 600 0.60 12%
Debt 10% 400 0.40 4%
1000 1 16%
Ko = Ke x We + Kr x Wr + Kp x Wp + Kd x Wd
Book Value Weights Market Value Weights
Simply pick up values of Eq. We use Market Prices

Debt etc. from Balance sheet of Equity Shares, Preference
Shares & Debentures
to calc Market Values.
COST OF CAPITAL
Key Points to Remember : -

1. While writing MV Weights, use Market Values (Not Market Price). MP is per share/ debenture
whereas MV = MP x n,
2. When using MV Weights approach, MP of Eq Shares represents both Eq Sh Capital + R & s'. Hence
MV of Equity represents combined position of ‘Eq Sh Capital + R & S'
3. If Ke & Kr are different and we are using MV weights then Split MV between Eq & Reserves Surplus
in the ratio of Book value of Eq Sh Capital : R & S.
4. If Q is silent about choice of weights - Prefer MV Weights because MV represents true &
updated picture of the business.
5. If Such words “Co. is satisfied with its present capital Structure" are written then it means we
have to use BV Weights
Weighted Marginal Cost of Capital [WMCC]/ Marginal Average Cost of Capital [MACC]
Existing B/S Additional Equity

Eq
Pref Additional Pref.
Debt
Additional Debt
WACC
WMCC
means Ko for Existing

means Ko for Addl. funds
Capital structure
Cal-n of WMCC Others Information
Income Statement Proposed Capital Investment = ₹ 800000
Sales 10,00,000 D E Ratio 3:2
Contribution 4,00,000 Intt Rate:
EBIT 2,50,000 Upto ₹ 200000 8%
EAES 1,50,000 Beyond ₹ 200000 9%
÷n 10000 shares MP ₹ 63
EPS 15 Expected growth 7%
DPR 40% Flotation Cost of Eq. ₹3
Tax Rate 30%

Calculate WMCC ? (or MACC)
COST OF CAPITAL
Solve : Total Fund Requirement

= ₹ 800000
Equity [2/5] Debt [3/5]

= ₹ 320000 = ₹ 480000
Out of Retained Fresh Issue First ₹ 200000 Next ₹ 280000

Earnings = 230000 Intt Rate @ 8% Intt Rate @ 9%
= ₹ 90000 (b/f)
EAES x RR
150000 x 60%
Caln of Cost of various source of finance
1. Debt
Alternatively
First ₹ 200000 : Kd = I% (1 - t)
= 8% (1 - 0.3) I(1 - t)
= 5.6% Kd =
NP
16000 (1 - 0.3)
=
200000
= 5.6%
Next ₹ 280000 : Kd = 9% (1 - 0.3)
= 6.3%
2. Equity
New Equity: Retained Earnings
D1 D1
Ke = +g Kr = +g
PO - F PO
₹ 6 x 1.07
₹ 6 x 1.07 = + 0.07
= + 0.07 63
63 - 3
= 17.19%
= 17.7%
COST OF CAPITAL
Caln of WMCC
Sources of funds Cost Amount Weights Cost x W
Equity 17.7% 230000 23/80
Retained earnings 17.19% 90000 9/80
Debt upto ₹ 200000 5.6% 200000 20/80
Beyond ₹ 200000 6.3% 280000 28/80
800000 10.63%
Exam Tip
What's special in WMCC vs WACC ?
Also take into account availability of funds through Retained Earnings of the latest year
Caution Note
Do not make the mistake of taking entire ‘R & S’ Balance from Balance Sheet because it pertains
not just to last year but it could be accumulation of past so many years which must have been
invested in the past years projects
Q. Calculate Maximum Investment Amount that can be done

ü without raising fresh equity
ü while maintaining DE Ratio
Solve: Retained Earnings Available = ₹ 90000

We know that DE Ratio is 3:2
Which means that if Total Cap Req is ₹ 5, then ₹ 3 will be raised from Debt
& ₹ 2 will be raised from Equity
5
∴ Maximum Cap Inv = ₹ 90000 x
2
= ₹ 225000
FINANCING DECISIONS
CAPITAL STRUCTURE
Learning Objective: To learn how to design optimal capital structure
Below table is from the view point of company
Type Risk Cost Control
Equity Low Risk Most Expensive Dilution of Control
Pref Slightly Higher Risk Slightly Cheaper than Equity No Dilution
Debt High Risk Cheapest No Dilution
The ultimate objective is ‘Wealth Maximization’

0 1 2
Performance
Value =
Expectations
It’s a reflection Value Performance Performance
of PVP formula expectations depends

discounted by
A upon risk level
i.e. PVP = expectations
r If low Risk If High Risk
then Return Expectations then Return Expectations
are also low are also high
Formula to calc Value

Net Income
Value of Equity [S] =
Ke
+
Interest
Value of Debt [D] =
Kd
=
EBIT
Value of Firm [F or V] =
Ko
Value of Firm [F or V] = Value of Equity [S] + Value of Debt [D]
i.e., VF or VO = VE + VD
Example
Income Statement Value

Equity Ke = 18% ?
EBIT 100000
Less: Interest 10000 10% Debt 100000

??
EBT or Net Income 90000
Calculate value of Equity, Value of Debt, Value of firm and Reconcile them ?
FINANCING DECISIONS - CAPITAL STRUCTURE
Solve:
Net Income 90000
Value of Equity [S] = = = 500000
Ke 18%
Interest 10000
Value of Debt [D] = = = 100000
Kd 10%
Value of Firm = Value of Equity + Value of Debt
= 500000 + 100000
= 600000
Alternatively,
EBIT
Value of Firm =
Ko*
100000
=
16.6667%
= 600000
*Ko = Ke x We + Kd x Wd
500000 100000
= 18% x + 10% x
600000 600000
= 16.6667%
Tutorial Note: Conclusion: To maximize Value of Firm we have to design a capital structure that
minimizes Ko
Capital Structure Theories
Capital Structure Relevance Theory Capital Structure Irrelevance Theory
1. Net Income (NI) Approach 2. Net Operating Income (NOI) Approach
3. Traditional Approach 4. Modigliani & Miller Approach - without Tax
5. Modigliani & Miller Approach - with Tax
Other Capital Structure Theories

6. The Trade-off Theory
7. Pecking order Theory
Net Income [NI] Approach
Ke
Cost Ko
of
Capital
Kd
(%)
Leverage
According to this Theory :-

1. Ke and Kd are assumed to be constant. They do not change with the leverage.
2. As Debt increases, Ko decreases.
3. As Ko decreases, Value of firm increases
4. Optimum Capital Structure - This theory suggests maximum possible debt financing (theoretically,
100% debt financing) to minimize Ko and hence to maximize value of firm.
Practical steps involved under NI approach
Step 1: Calc market value of Equity [S]

Net Income
=
Ke
Step 2: Calc market value of Debt [D]

Interest
=
Kd
Step 3: Calc market value of Firm [V]

V=S+D
Step 4: Calc Overall cost of capital [Ko]

EBIT
Ko =
V i.e. value of firm
Net Operating Income [NOI] approach

Ke
Ko
Cost
of
Capital
(%)
Kd
Leverage
According to this theory :-
1. Kd and Ko remains constant irrespective of Debt: Eq. mix
2. As we increase leverage, risk of Eq Sh hl starts rising. The increase in risk leads to an increase in Ke [i.e.
return expectations of Eq Sh hl]. Ke increases in such a manner so that overall cost of capital i.e. Ko
finally remains same.
Practical steps involved under NOI approach
Step 1: Calculate Value of Firm

EBIT
V=
Ko
Step 2: Calc Value of Debt

Interest
D=
Kd
Step 3: Calc Value of Equity

S=V-D
i.e. Value of Equity = Value of Firm - Value of Debt
Step 4: Calc Cost of Equity

Net Income NI
Ke = i.e.
Value of Equity S
Traditional Approach Ke
Phase III
Phase II
Ko
Phase I
Cost
of
Kd
Capital
(%)
Leverage Optimum Capital Structure
Phase I II III
Equity i.e. Ke Constant Increasing Increasing at a faster rate
Debt i.e. Kd Constant Constant Increasing
Overall i.e. Ko Declines Constant Increasing
Can we have an optimal capital structure ?

Yes, it is found where Ko is minimum
Explanation of each phase of theory
Phase I: Initially the ratio of Debt is very small (between 0% to 20%) due to which neither Equity nor Debt
feels the risk. Hence both Ke & Kd remains constant. Consequently, Ko declines as leverage
increases.
Phase II: As the ratio of Debt increases further, the fixed financial burden is now felt by Equity and hence
Ke starts increasing gradually. Consequently, Ko declines but upto certain point only beyond which
it start increasing.
Phase II: Beyond certain leverage level (say more than 60% ratio of Debt) both Eq as well as Debt stand at
risk leading to an increase in Kd & Ke
Resultantly, Ko increases sharply
Somewhere in the middle of phase II we come across “Optimum capital structure”
Modigliani & Miller approach - without tax

Ke
Risk Premium
Ko
Cost Tutorial Note: Yes, you got it

of right. MM approach - W/o tax is
Capital all the same as NOI Approach !
(%) Kd
Leverage
Ke = Ko + Risk Premium
Debt
Ke = Ko + (Ko - Kd) x
Equity
here, Ke means Ke of a levered firm
Modigliani & Miller Approach - With Tax
A levered firm having Debt in its capital structure will be able to claim tax benefit on intt & hence VL > VU to
the extent of tax advantage. Therefore, capital structure (i.e. debt equity mix) becomes relevant.
Value of a levered firm = Value of an Unlevered firm + Tax benefit

VL = VU + (D x t)
here,
D means Debt amount
t means corporate tax rate
Steps to calc Value of Firm, Equity & Cost of Capital & Equity
Steps will remain the same as under NOI approach (although formulas are relevant but can’t be applied due
to lack of info)
Step 1: (a) Calc value of Unlevered firm

EBIT (1 - t) or EAT
VU =
Overall capitalization Ke of an
or
rate of an unlevered firm unlevered firm
(b) Calc value of a Levered firm

EBIT VL = VU + D x t
VF =
Ko
Since Ko is changing hence not available
Step 2: Calc value of equity

= Value of firm (-) value of debt
Step 3: Calc cost of equity

Net income i.e. EAT
Ke =
Value of equity
Step 4: Calc cost of capital

Ko = Ke x we + Kd x wd
Step 3 E D
I% (1 - t)
E+D E+D
Arbitrage process under M-M approach
Assumptions: 1. There are NO taxes

2. 100% of earnings are distributed as dividends i.e. 100% dividend payout ratio
An investor is
holding 15% equity
Infosys TCS
Same ₹ Revenue Same ₹
Same ₹ Op. Inc. ie. EBIT Same ₹
Same Business Risk Level Same
Unlevered Leverage Level Levered
Overall value of both the firms must be the same irrespective of capital structure
Example 1: When Unlevered firm is Overvalued

Infosys TCS
₹ 1,00,000 Operating Income ₹ 1,00,000
- Debt @8% ₹ 3,00,000
10% Equity capitalization rate i.e. Ke 16%
Solve:
Infosys i.e. unlevered firm TCS i.e. levered firm
Operating income ₹ 1,00,000 ₹ 1,00,000
Less: Interest - 24,000
EBT i.e. Net income ₹ 1,00,000 ₹ 76,000
Ke 10% 16%
NI
Value of Equity ( (
Ke
10,00,000 4,75,000
Value of Debt - 3,00,000
Value of Firm 10,00,000 7,75,000
Valuation status Overvalued Undervalued
Comment: Ideally, Overall value of both the firms must be the same under MM approach (w/o taxes). If
there is a difference then arbitrage process will start where investors in an overvalued firm will sell their
holdings & buy holdings in an undervalued firm.
Steps under arbitrage process when unlevered firm is overvalued
Particulars Amoumt
Step 1: Investor’s present position in overvalued firm
(a) Market value of investment [₹ 10,00,000 x 15% shareholding] ₹ 150000
(b) Dividend income [₹ 1,00,000 x 15% shareholding] ₹ 15000
Step 2: Investor sells his present stake
(a) Proceeds from selling stake ₹ 150000
Step 3: He purchases same % stake* in undervalued firm
(a) Investment in Equity [₹ 475000 x 15%] ₹ 71250
(b) Investment in Debt [₹ 300000 x 15%] ₹ 45000
₹ 116250
Step 4: His income after switching process
(a) Dividend income [₹ 76000 x 15%] 11400
(b) Interest income [₹ 24000 x 15%] 3600
(c) Total income 15000
It may be observed that investor is able to maintain his same earnings of ₹ 15000 but reduced outlay by ₹
33750.
Step 5: The amount by which investor could reduce his outlay [₹ 150000 - ₹ 116250]
*Alternatively he could have invested whole proceeds of ₹ 150000 to buy 19.35% [₹ 150000 / ₹ 775000] and
earn additional income of ₹ 4350 [₹ 100000 x 19.35% - ₹ 15000]
New Earnings Present Earnings

Example 2: When Levered firm is Overvalued
Infy i.e. Unlevered TCS i.e. Levered
Operating Inc. ₹ 100000 ₹ 100000
8% Debt ₹ 300000
Eq. Cap rate ie Ke 15% 16%
How arbitrage process can be carried by an investor holding 15% equity stake in Overvalued firm ?
Solve:
Infosys TCS
Operating Income 100000 100000
Less: Intt - 24000
PBT or Net income 100000 76000
Ke 15% 16%
Value of Eq [NI / Ke] 666667 475000
Value of Debt - 300000
Value of Firm 666667 775000
Valuation status Undervalued Overvalued
Ideally, Value of both the firms must be the same. In case of difference, on investor will switch from an
overvalued firm to an undervalued firm.
Steps under arbitrage process when levered firm is overvalued

Particulars Amoumt
Step 1: Investor’s present positions in overvalued firm
(a) Market value of investment [₹ 475000 x 15%] 71250
(b) Dividend income [₹ 76000 x 15%] 11400
Step 2: Investor sells his present stock
(a) Proceeds from selling stoke 71250
(b) He borrows proportionate to his share of debt [300000 x 15%] 45000
(c) Total amount available 116250
Step 3: He purchases same % *of equity holding of an undervalued firm [₹ 666667x15%] 100000
Step 4: His net income after switching process
(a) Dividend income [₹ 10000 x 15%] 15000
(b) Less: Interest on personal borrowings [₹ 45000 x 8%] 3600
(c) Net income 11400
Step 5: The amount by which investor could reduce his outlay through the use of ₹ 16250
arbitrage process
It may be observed that investor is able to maintain his earnings of ₹ 11400 but reduced outlay by ₹ 16250.
*Alternatively, he could have invested whole proceeds of ₹ 116250 to buy 17.44% [₹ 116250 / ₹ 666667] and
earn additional income of ₹ 2437 [₹ 100000 x 17.44% - 45000 @ 8% intt - ₹ 11400]
New Earnings Present Earnings
Alternative ways to decide optimum capital structure
EBIT - EPS - MPS analrsis Indifference Financial BEP

{exactly same as leverage chapter} Point {exactly same as leverage chapter}
Various financing alternatives or capital For various financing alternatives, we have

structures would be given. We have to to calc Financial BEP & select the
prepare I/s to find out EPS (or MPS) for Alternative having least Financial BEP.
each alternative and select the Alternative
that results in highest EPS (or MPS)
Indifference point | EBIT - EPS Indifference Point | Debt - Equity Indifference Point
is a level of EBIT at which EPS under both the financing alternatives is same.
I/S
Particulars Alt I Debt financing Alt II Equity financing
EBIT ? ?
. . .
. . .
EPS Same EPS = Same EPS
Example:
Capital requirement = ₹ 10,00,000
Alt I Alt II
10% Debt 200000 500000
Equity (Face Value = ₹ 10) 800000 500000
Tax rate = 30%

Calc Indifference Point ?
Solve:
There are two ways to salve
Statement Approach
Formula Approach
Statement Approach
Let the EBIT be x at which EPS under both the alternatives is same.
Income Statement
Alt 1 Alt 2
EBIT x x
Less: Interest on Debt 20000 50000
EBT x - 20000 x - 50000
Less: Taxes @30% 0.3x - 6000 0.3x - 15000
EAT 0.7x - 14000 0.7x - 35000
Less: Dp - -
EAES 0.7x - 14000 0.7x - 35000
÷ No. of shares 80000 50000
EPS 0.7 - 14000 0.7x - 35000
80000 50000
Equating EPS under both the alternatives

0.7x - 14000 0.7x - 35000
=> =
80000 50000
1.6
=> 0.7x - 14000 = 1.12x - 56000

=> 56000 - 14000 = 1.12x - 0.7x
=> 42000 = 0.42x
∴ x = 42000/0.42 = 100000
Formula Approach here,
(EBIT - I1) (1 - t) - Dp (EBIT - I2) (1 - t) - Dp I1 & I2 means Interest amount under Alt 1 & 2
=
E1 E2 E1 & E2 means No. of equity shares under Alt 1 & 2
Conclusion
Level of EBIT Reference Comment
EBIT < Indiff Prfer an option having Since our EBIT would be less therefore it is NOT
Point more equity financially prudent to have fixed Intt commitment on Debt.
EBIT = Indiff Either Alterative can

Since EPS would be same under both the Alt
Point be selected
EBIT > Indiff Prefer an option having Since Co. is now capable to meet fixed intt obligation &
Point more amt of Debt hence using more Debt will result in less dilution of EPS.
Investment
Decisions
B/S
Ke --> Equity Fixed Assets ?
Kp --> Pref
Kd --> Debt Current Assets ?
Financing Decisions Investment Decisions

1. Leverages
2. Cost of capital
3. Capital Structure
Learning Objective: How to take Investment Decisions ? How to analyze financial viability of Investment
/ capital expenditure ?
Eg. Force Motors - Traveller vehicle
Equity Ke = 15 % We 0.4
Debt Kd = 10% 0.6
Ko = 12%
Investment = ₹ 15 lakhs
Life = 5 yrs.
Revenue = ₹ 25 per km x 250 kms per day x 20 days per month x 12 months
Cost = Diesel = 15 kmpl , ₹ 100 per liter of diesel
Driver’s Sal. = ₹ 15000 per month
Other Op Cost (Repairs, Maintenance etc) = ₹ 300000 per annum
Depn. = 25 % WDV Tax Rate = 30 %
Scrap value = ₹ 300000
Solve:
0 1 2 3 4 5
15,00,000 ₹ 5.47 ₹ 5.18 ₹ 4.97 ₹ 4.81 ₹ 4.70

₹ Outflow inflow ₹ 3.17
₹ 7.87
A. Initial Investment
Cost of Vehicle = ₹ 15,00,000 [Outflow]
INVESTMENT DECISIONS
B. Annual Cash Flows [₹ in lakhs]
Particulars 1 2 3 4 5
Revenue [ ₹25 per km x 250kms x 20 days 15 15 15 15 15

x 12 m]
Less: Cash Operating Cost
60000 kms 4 4 4 4 4
- Diesel x ₹ 100 per litre
15 kmpl
- Driver 1.8 1.8 1.8 1.8 1.8
- Other Op Cost 3 3 3 3 3
CFBT 6.2 6.2 6.2 6.2 6.2
Less : Depn 3.75 2.8125 2.1 1.58 1.19
PBT 2.45 3.39 4.10 4.62 5.01
Less ; Taxes @ 30 % 0.73 1.02 1.23 1.39 1.50
PAT 1.72 2.37 2.87 3.23 3.51
Add back : Depn 3.75 2.81 2.1 1.58 1.19
CFAT 5.47 5.18 4.97 4.81 4.70
PVF @ 12 % 0.892 0.797 0.712 0.635 0.567
PV of annual CF’s 4.87 4.13 3.54 3.05 2.66
18.25 lakhs
C. Terminal Value
Proceeds on sale of Asset 300000
Tax benefit on capital loss [(355957 - 300000) x 30 % tax benefit] 16787
316787
th
PVF (@ 12%, 5 yr) 0.567
PV of terminal Cf’s 1.80 lakhs
NPV = PVI - PVO

= 18.25 lakhs + 1.80 lakhs - 15 lakhs
= + 5.05 lakhs Since NPV is +ve therefore, Accept the project
WN # 1 Cal of WDV
5
= 1500000 x (1 - 0.25)
= ₹ 355959
Important Points to remember :-

1. Why we add back Depn ?
Since we have already deducted full amount of Initial Investment there fore, deducting Depn once
again from Annual CFS would tantamount to double consideration of the Same Expenditure.
Still we deduct Depn from cash flows. The purpose is to ascertain the correct amount of Tax ( i . e .
to take Tax benefit on Depn) and there after we add back Depn to nullify the effect of deducting Depn.
2. Why we don't deduct Interest while calc. Annual Cf’s ?

Interest Expenses are already incorporated when discounting @ Ko
3. Since we are not deducting Intt on Debt, are we loosing the Tax benefit ?
No, we are not loosing the Tax benefit. In fact, it has already, been considered while calc Kd
(Remember that Kd is based on aftertax intt Rates) & hence when we use Kd we have already taken
into account tax benefit on interest exps.
4. Where are we paying back Principal amount of Debt ?

When we deduct initial outflow of ₹ 15 lakhs from PVI (i.e. from ₹ 20.05 lakhs) then it is effectively just
like paying back principal amount raised from Debt (₹ 9 lakhs) and equity (₹ 6 lakhs). Hence NPV of ₹
5.05 lakhs is the met addition to the company’s wealth after paying back to both Eq. & Debt.
Techniques of Evaluation of Capital Budgeting Proposals
Based on Profits Based on Cash Flows
Accounting Rate
of Return [ARR]
Non - Discounted Discounted
cash flows CF’s
Pay back Period Pay back Reciprocal
Discounted Net Present Internal Rate of Modified IRR Profitability

Pay back Period value [NPV] return [IRR] Index [PI]
Accounting Rate of Return / Average Rate of Return

Average Profits
ARR = x 100
Initial or Average Investment
Eg.
Initial Investment = ₹ 15 lakhs
Salvage Value at the end = ₹ 3 lakhs
Depn on SLM basis
Profit after tax is as below:- (₹ lakhs)
Year 1 2 3 4 5
PAT ₹4 ₹3 ₹ 2.5 ₹2 ₹1
Calc ARR using 3 Different Ways
(i) Total Investment basis
(ii) Annual basis
(iii) Average Investment basis
Solve: Working Note
PAT Valve of Investment

Year
Beginning End
1 4 15 12.6
2 3 12.6 10.2
3 2.5 10.2 7.8
4 2 7.8 5.4
5 1 5.4 3
(i) Total Investment basis ( aka initial investment basis)
Average Annual PAT

ARR = x 100
Investment in the beginning
= (4+3+2.5+2+1) /5 Yrs x 100
15
= 16.67 %
(ii) Annual basis (i.e. calc profit % for each year by dividing PAT by investment value at the beginning of
that yr)
Year Computation Rate of Return
1 4 / 15 26.67 %
2 3 / 12.6 23.80 %
3 2.5 / 10.2 24.51 %
4 2 / 7.8 25.64 %
5 1 / 5.4 18.5 %
26.67 % + 23.80 % + 24.51 % + 25.64 % + 18.5%

Average ARR =
5
= 23.83 %
(iii) Average Investment basis

Initial Inv + Salv value
Average Investment =
2
15 lakhs + 3 lakhs
=
2
= 9 lakhs
or
= 1/2 (Initial Inv - Salvage Value) + Salvage Value
= 1/2 (15 lakhs - 3 lakhs) + 3 lakhs
= 9 lakhs
4 + 3 + 2.5 + 2 + 1
Average Annual Profit =
5 Yrs
= 2.5 lakhs
Avg Ann Profit

ARR = x 100
Avg Inv
2.5 lakhs
= x 100
9 lakhs
= 27.78 %
Tutorial Note: If Q is silent about which version of ARR to be used in exam then prefer either (i)
or (iii) method & write the corresponding assumption
Decision Rule :
ARR Vs. Minimum Acceptable rate of return
If ARR > Minimum Acceptable If ARR < Minimum Acceptable
Accept Reject
Pay - Back Period
is the time required to recover the initial Investmeat back
If uniform Cash flow over the life
Total Initial Investment
Pay back =
Annual CFAT
If Not uniform Cash flows

There is no formula as such. The Simple trick is to cumulate the Cash flows and stop at that point of time
where cumulative CF’s = Initial investment
Example: Initial investment = ₹ 10 lakhs

Uniform Annual Cf’s = ₹ 1 lakhs
calc payback period ?
Initial investment 10,00,000

Solve : Pay - back period = = = 10 yrs
Annual CFAT 1,00,000
Q. What if in above Q , CF pattern is not uniform as indicated below :-
Year CF
1 100000
2 150000
3 200000
4 250000
5 400000
6 500000
Solve : Use Cumulative CF Technique
Year CF Cumulative CF
1 100000 100000
2 150000 250000
3 200000 450000
4 250000 700000
5 400000 1100000
6 500000 1600000
3,00,000 Unrecovered remaining portion of ini. inv.

Pay back Period = 4 Years +
4,00,000
Total CF in the next yr
= 4.75 years
or 4 years & 9 months 0.75 Yr x 12 M
Decision Rule :
Pay back period Vs. Maximum Acceptable pay back period
If Pay back period < Maximum Acceptable If Pay back > Maximum Acceptable
Accept Reject
Pay - back Reciprocal

1
Pay back Reciprocal =
Pay back Period
Pay back reciprocal is a close approximation of the ‘rate of return’ on the project.
Eg. Calc pay back reciprocal for above example
Solve :
1
=
4.75 Years
= 21.05 %
Discounted Pay back Period
Instead of cumulating CF’s (as we used to do under ‘Payback Period Method’), we will cumulate PV of CF’s to
calc Disc pay back period.
Eg. In above eg, Say Discounting Rate is 10 %
Solve:
Year CF PV of CF @ 10 % Cumulative PV of CF’s
1 100000 90909 90909
2 150000 123967 214876
3 200000 150263 365139
4 250000 170753 535892
5 400000 248369 784261
6 500000 282237 10,66,498
5 ₹10,00,000 6
Cumulative PV
282237
of Cf’s 784261 1066498
215739 Shortfall i.e. Unrecovered remaining amount

Discounted Pay back Period = 5 Years +
282237
Amount if we work for the entire year
= 5.76 years
or 5 years 9 month 4 days
Net Present Valve Method [NPV Method]
NPV = PV of Inflows - PV of Out flows

(aka Initial Inv.)
PV of Annual CF’s PV of Terminal Cf’s
Generally, it is a 4 - step process :-

Step 1: Calc PVo, i.e Initial Investment
Step 2: Calc CFAT & its PV of Annual Cf’s
Step 3: Calc Terminal CF’s & its PV of Terminal Cf’s
Step 4: NPV = PV of Annual Cf’s + PV of Terminal Cf’s - Ini. Inv
Format for solving Question :-

Purchase Cost of Asset xxx
Investment in Working Cap xxx
xxx
B. Pv of Annual CF’s
Year
Particulars 1 2 3
Sales Revenue xxx
Less : Variable Cost xxx
Contibution xxx
Less : Cash Fixed Cost xx
CFBT xxx
Less : Depn xx
PBT
Less : Taxes
PAT
Add back : Depn
CFAT xxx
Less : Additional cap Expenditure xx
Less : Incremental W/c Investment xx
Net CF’s xx
C. PV of Terminal Cf’s
Proceeds on sale of asset xxx

Tax (Payment)/ Benefit on Capital
gain / loss on sale of Asset xx
Realization of Working Capital xxx
Total xxx
Decision Rule
If NPV > O If NPV = O If NPV < O

i.e +ve Indifferent. Mngt. will take i.e. -ve
Accept the decision based on other Reject
qualitative factors
Points to Remember :
1. In case of Replacement Decisions, Purchase cost of New Asset is an Outflow (as usual) but sale
proceeds of old asset along with tax treatment on Cap Gain / loss (if any) is considered as an inflow
4. Sunk cost is an outlay that has already been incurred and hence becomes irrelevant in decision -
making. Ignore such costs eg. consultancy fees already paid.
2. Opportunity Cost - Opportunity Cost is the benefit foregone due to accepting the project Eg.
Rental Income lost due to using Rented premises for own use in the project.
Opp costs are deducted from annual Cf’s.
If Q has given ‘Opp cost after taxes amount’ then deduct from CFAT.
If Q has given ‘Opp cost pre tax amount’ then deduct before calculating PBT
3. Allocated Overheads - Allocated Overheads represents a fair share of Expenditure already been
incurred. Either, we Accept or Reject the project the Overall Expenditure is going to remain same
hence such Allocated cost should be ignored while taking decision.
6. Don't forget to consider recapture of W/c. W/c to be recaptured should include initial W/c Inv
as well as Incremental Inv in W/c (if any) during the project period.
7. Don’t forget to calc PV of Terminal CF’s
5. Block of assets & depn
Q is Silent about which method of If Q gives WDV Rate of depn and

Depn. (SLM or WDV) to be used ? Block of Assets concept needs
to be followed
Use SLM Method
Scenario 1: Scenario 2:
When it is the Only When more than one
Asset in the Block Asset in the block
Case 1 : Salvage value < Case 2: Case 3: Case 4:

WDV at the beginning Salvage value > WDV Salvage value < WDV Salvage value > WDV
Two Cf’s Two Cf’s Two Cf’s One CF
ü Sale Proceeds on sale of Asset ü Sale Proceeds ü Sale Proceeds ü Sale Proceeds
ü Tax benefit on Remaining WDV ü Tax payment ü Tax Benefit on Depn
(after deducting sale proceeds) on cap gain on remaining WDV
Common Note for case 1 & 2: Note : We cannot write-off

No Depreciation will be charged the block since there
for the Year in which Asset is sold. are other Assets in it.
1. # Subsidy
Suppose cost of Machine is ₹ 100 lakhs
& subsidy is ₹ 25 lakhs
If Subsidy is taxfree If Subsidy is taxable*
ü Subsidy of ₹ 25 lakhs is an Inflow ü Subsidy of ₹ 25 lakhs is an Inflow

ü Depn in the following years shall be Charged on ü Instead of Paying tax on Subsidy Income of
full amount of ₹ 100 lakhs ₹ 25 lakhs, Simply adjust it against cost of
Asset of ₹ 100 lakhs & then claim Depn on
only ₹ 75 lakhs in the following years.
*This is the default assumption if Q is silent.
4. # Carry - Forward of loss
If Q says “Losses can be carried If Q is completely silent If Q says “Assume that loss
forward to subsequent years” cannot be carried forward”
{Refer Q28} {Refer Q29}
Same Year: Tax benefit CANNOT be Same Year: Claim Tax Same Year: Tax benefit CANNOT
claimed benefit in be claimed
Next Year: C/f losses will be adjusted the same Next Year: Again Tax benefit
against Profits (on calculator) year CANNOT be claimed
to determine Net Taxable
Income & Taxes thereon
Example : Purchase Cost of Asset = ₹ 100000

Life = 5 Years
WDV Rate = 25 %
Tutorial Note: Irrespective of any case / any scenario, calculation of depn for first 4 Years under
WDV method will remain the same.
Solve: Calculation of Depn & WDV

Year Opening WDV Less: Depn @ 25 % Closing WDV
1 100000 25000 75000
2 75000 18750 56250
3 56250 14063 42187
4 42187 10547 31640
5 31640 ?
Scenario 1: When it is the only Asset in the block
Case 1 : When Asset Case 2 : When Asset

is sold @ ₹ 10000 is sold @ ₹ 40000
ü Depn for 5th Year ie. Year in which Asset is ü Depn for 5th Year i.e. Year in which Asset
sold is NOT Claimed is sold is NOT Claimed
ü ü
Cal. of Short term capital loss Cal. of Short term capital gain
WDV at the beginning of WDV at the beginning of

5 th Year 31640 5 th Year 31640
Less : Sale Proceeds 10000 Sale Proceeds 40000
Remaining Block value 21460 Short Term Capital gain 8360
This amount of ₹ 21640 is treated as capital On above amount of ₹ 8360 we have to pay tax
loss on which Tax benefit (₹ 21610 x 30 % tax
rate, say) is claimed
Conclusion: Cash flow Position Conclusion: Cash flow Position
Sale Proceeds ₹ 10000 inflow Sale Proceeds ₹ 40000 inflow
Tax benefit on Capital ₹ 6492 inflow Tax payment on cap ₹ 2508 outflow
Loss [21640 x 30 %] gain [8360 x 30%]
Scenario 2: When more than one Asset in the block
Case 1 : When Asset Case 2 : When Asset

is sold @ ₹ 10000 is sold @ ₹ 40000
ü Amount of ₹ 10000 is considered as sale ü Amount of ₹ 40000 is considered as an inflow

proceeds and hence deducted from the ü No Treatment of capital gain/ (loss) needs to
beginning value of block be done.
ü Remaining value of the block is used to charge
Depn for 5th Year Tutorial Note: Why No Treatment of
Block at the beginning 31640 cap gain ?
Because ₹ 40000 would be deducted
(-) Sale Proceeds 10000
from Gross value of block ( which might
Remaining Block value 21640 be, say, ₹ 25 lakhs since block
comprises of other Assets as well )
Depn @ 25 % 5410
hence block will still exist with
Tax benefit @ 30 % 1623 substantial amount & hence there
would be no capital gain
Conclusion: Cash flow Position Conclusion: Cash Flow position
Sale Proceeds 10000 inflow Sale Proceeds 40000 inflow
Tax benefit on Depn 1623 inflow* No CG tax treatment since x
block still exists
Internal Rate of Return Method [IRR]

A rate at which NPV = 0 or in other words, PVI = PVO
Eg. Let us consider our first example i.e Traveller vehicle and Cale IRR for those CF’s
Solve:
0 1 2 3 4 5
15,00,000 ₹ 5.17 ₹ 5.18 ₹ 4.97 ₹ 4.81 ₹ 4.70

₹ Outflow inflow ₹ 3.17
₹ 7.87
By Trial & Error

Cash
Year @15% @ 24%
Flows @ 25%
PVF PV PVF PV
1 5.47 . 4.76 . 4.41
2 5.18 . 3.92 .
3 4.97 . 3.27 .
4 4.81 . 2.75 .
5 7.87 . 3.91 .
PVI 18.6 15.11 14.78
PVO 15 15 15
NPV 3.6 +0.11 (0.22)
Using interpolation :-
lly Disc rate 1%

ca
Logi
@ 24% @ 25%
Dise rate
NPV = 0
NPV + 0.11 - 0.22
0.11 NPV
0.33
NPV by When Disc rate

∴
0.33 1%
∴ 0.11 ?
0.11 x 1 %
= = 0.33 %
0.33
∴ Disc Rate i.e. IRR = 24 % + 0.33 %
= 24.33 %
Formula
NPVLR
= LR + (HR - LR)
NPVLR - NPVHR
= 24 % + 0.11 (25% - 24%)
0.11 - (- 0.22)
= 24.33 %
Decision Rule:
If IRR > WACC i.e Ko If IRR = WACC i.e. Ko If IRR < WACC i.e. Ko
Accept Indifferent Reject
Comparative Analysis of NPV & IRR

In most of the cases both NPV & IRR gives same Accept / Reject signals. However, in certain cases
NPV & IRR may give conflicling results . In such cases NPV method is considered superior to IRR
method because .
1. NPV method gives answer in Absolute terms whereas IRR method gives answer in % age terms .
Answer in Absolute terms is better for decision making since it is in conformity with basic
objective of financial mngt i.e. wealth Maximization.
IRR= 20% Although Proj B gives

Project A ₹ 100000
NPV = ₹ 20000 higher return in %
Vs. terms but think which
projects adds More
IRR= 50%
Project B ₹ 10000 wealth for the Co. ?
NPV = ₹ 5000
2. Reinvestment Assumption: NPV Method assumes reinvestment of intermediate CF’s @ Ko where

as IRR method assumes reinvestment of intermediate Cf’s @ IRR itself .
It is relatively easy to reinvest CF’s @ ko as compared to reinvesting @ higher IRR. hence, reinv.
assumption of NPV method is better (i.e. more realistic) than that of IRR method.
3. In case of mutually exclusive projects, in certain situations, NPV & IRR methods may give
contradictory results the different rankings given by NPV & IRR methods could be due to:
(i) Size Disparity

I II
100 Proj A 200 IRR = 100 % NPV = 100
I
100000 II
Proj B 120000 IRR = 20 % NPV = 20000
(ii) Time Disparity

0 1 2 3 4
Proj A
Ini Inv. Big CF
Proj B
Ini Inv. Big CF
Other things being constant if a big chunk of CF is recd. in initial yrs itself in proj B then it will
command higher IRR despite having lower NPV.
Modified Internal Rate of Return [ MIRR]

The inherent assumption of IRR method is that intermediate CF’s are reinvested at the same rate as
IRR itself which may not be a realistic assumption. On the contrary, MIRR provides the flexibility of
using a different reinvestment & hence addresses the issue of unrealistic assumption in IRR.
0 1 2 3 4
PV = (1000) 300 400 500 600
500 x 1.24891
624.45
2
400 x 1.2489
623.9
300 x 1.24893
584.39
n
FV = PV (1 + r)
FV = 2432.74
4
2432.74 = 1000 (1 + r)
∴ r = 24.89 %
Disclaimer: Above calculated IRR of 24.89% can be Rough work - cal. of IRR
earned only when Co. is able to reinvest
Year CF PV @ 24% PV @ 25%
inter mediate Cf’s @ 24.89% again .
1 300
Q. What if I could not reinvest @ 24.89% instead I
2 400
could reinvest only @ 12 % ?
Answer: Then your real rate of return went be 3 500
24.89% In fact, it would be definitely less
4 600
than 24.89%.
Q. Then how much would be my actual / Real rate of 1081.1 997.76
return ?
(1000) (1000)
Ans: The. answer lies in MIRR as calc below :-
NPV 18.1 (2.24)
Using interpolation :
= 24 % + 18.1
= 24.89 %
18.1 - (-2.24)
Q. Then how much would be my Actual / Real Rate of return ?

Ans: The answer lies in MIRR as calc below :-
0 1 2 3 n=4
PV = (1000) 300 400 500 600
1
500 x 1.12
560
400 x 1.122
501.76
300 x 1.123
FV = PV (1 + r)n 421.15
2083.23 = 1000 (1 + r)4 FV = 2083.23

∴ r = 20.14 %
Note1: It is not essential to calc IRR before calc MIRR. Infact MIRR can be calc even without knowing IRR.
Note 2: To calc MIRR, Q has to provide reinvestment rate. If not given in the Q then Simply assume
reinvestment rate to be same as Ko.
Profitability Index Method/Desirability Factor-Useful in Situations of Capital Rationing
Eg. Investment Amount Available = ₹ 200000
Educational Institute Hostel Cafe Hotel

Initial Inv./ PV of Outflows 1,00,000 60,000 40,000 80,000
PV of inflows 1,25,000 70,000 45,000 94,000
Case 1: Case 2:
When Projects are Divisible When Projects are
in nature Indivisible in nature
Step 1: Calculate Profitability Index Step 1: Calculate Profitability Index
PV of inflows PV of inflows
= =
Initial Inv Initial Inv
Step 2: Rankings in the decreasing order of PI. Step 2: Rankings in the decreasing order of PI.
Note: But do not make allocation of Capital
based on rankings
Step3: Allocation of Capital based on Rankings
Step3: Make various Alternatives using permutations
/combinations that are feasible within the
Step4 : Cale Aggregate NPV.
limit of Capital available.
Step4 : Calc Aggregate NPV for each alternatives &

select Alt that has highest NPV.
Solve: Case 1: When Projects are DIVISIBLE

Particulars Educational Institute Hostel Cafe Hotel
PV of inflows 1,25,000 70,000 45,000 94,000
Ini inv. 1,00,000 60,000 40,000 80,000
NPV 25,000 10,000 5,000 14,000

PVI
PI 1.25 1.167 1.125 1.175
Ini Inv
Rankings I III IV II
Allocation of 100000 20000 - 80000

capital (bal. flg)
NPV 25000 3333 - 14000

20000
10000 x
60000
Case 2: When Projects are INDIVISIBLE 42333
Particulars Educational Institute Hostel Cafe Hotel
PV of inflows 1,25,000 70,000 45,000 94,000
Initial Inv. 1,00,000 60,000 40,000 80,000
NPV 25,000 10,000 5,000 14,000

PVI
PI 1.25 1.167 1.125 1.175
Ini Inv
Rankings I III IV II
Alternatives
I
NPV 25000 14000
39000
II
NPV 25000 10000 14000
40000
III
NPV 10000 5000 14000
29000
Decision: Co. should select Alternative II ( i.e. implement Project - Ed Inst, hostel & Cafe) since it results in
highest NPV of ₹ 40000.
Note: If in exam, instead of PVI, Q has directly given NPV we may simply calc Profitability Index by using
NPV
= (Refer Q 18 & Q 19)
Ini Inv
Projects with Unequal life
Made in China machine Made in Japan machine

[Mach - A] [Mach - B]
Cost of machine 1,00,000 1,80,000
Life 2 Years 3 Years
Salvage value 15,000 18,000
Net CFAT
Year 1 70,000 90,000
2 60,000 80,000
3 - 70,000
Ko 10%
Solve :
Made in China machine
0 1 2 Since life of both the Machines is Unequal,

therefore, we cannot Compare NPVs
PV0 = (100000) 70000 60000
PVI = 125620 + 15000 We have to calc ENPV & then Compare ENPV
NPV = 25620 75000
NPV
@Ko = 10% ENPV =
PVAF (@ r%, life yrs)
25620 25620
= = = 14762
PVAF (@ 10%, 2 yrs) 1.735
Made in Japan machine

0 1 2 3
NPV
ENPV =
PVO = (180000) 90000 80000 70000 PVAF (@ r% life yrs)
PVI = 214050 18000
34050 34050
NPV = 34050 88000 = = = 13692
@Ko = 10% PVAF (@ 10%, 3 yrs) 2.486
Decision: We should select ‘Made in China’ machine since it results in higher ENPV
To deal with situation of Projects with Unequal Life, there are 2 methods :-
1. Equivalent NPV (ENPV) / Equivalent Annual criterion (EAC)
2. Replacement chain method / Common life / Time Horizon method
Replacement chain Method / Common Life Method / Common time Horizon method
Made in China (will be repeated 3 times)
0 1 2 3 4 5 6
(100000) 70000 75000 70000 75000 70000 75000

(100000) (100000)
(25000) (25000)
63636
(20661)
52592
Discounting @ Ko = 10 %
(17075)
43464
42335
NPV = 64292
0 1 2 3 4 5 6
(180000) 90000 80000 88000 90000 80000 88000

(180000)
NPV = 59632
Now, we can simply compare NPVs of both the proposals and take decision based on NPV since Life of both
the projects is same.
#Two Approaches to evaluate capital budgeting decisions
Vs.
Project Approach Equity Approach
Revenue
₹4 - Op cost ₹4 Revenue
00 00
00 00 - Op cost
10% Debt 10% Debt - Intt on Debt
Interest PBT
Tax benefit - Tax payment
0 0 0
on Intt
00 00 Cash inflows
60 ₹
6
- Loan principal
₹
Intt on Debt & Repayment
Cash inflows Net CF’s
TB thereon are
15% Equity 15% Equity
not considered
in Cf’s since
Ke = 15%
Total Inv. ₹ 100000 Disc rate of Ko isc @
D
WACC i.e. Ko = 13% takes care of Suppose PVI = 95000
this aspect %
= 13 Less: Ini Inv (-) 60000
Ko NPV = 35000
Suppose PVI = 125000 @ Since we have already
sc
NPV = 25000 Di deducted loan
principal repayment
while calc net Cf’s
therefore only amount
that remains to be
paid out is investment
by equity
Summary of above
Project Approach Equity Approach

Discount Rate : Ko Ke
Intt on Debt : Not considered in Cf’s Yes, deducted while calc CF’s
{but intt indirectly gets
considered in Ko}
Tax benefit on Intt : Not considered in Cf’s Yes, Considered while calc Cf’s since PBT is calc
{but intt indirectly gets after deducting intt.
considered in Ko}
loan Principal Repayment : Not deducted from Cf’s Yes. deducted while calculating CF’s
{but Since we deduct
Total initial investment
from PVI, these fore, it
indirectly gets
considered}
Replacement Decisions
Use ‘Incremental’ Approach i.e (i) Incremental Ini Inv (ii) Incremental Annual Cf’s (ii) Incremental
Terminal CF’s
Eg. Old Machine New Machine
Cost of New Machine 25,00,000
500000 Sale Proceeds on sale of old Machine today
5 Years Remaining Life / Life 5 Years
50,000 Salvage value at the end of life 3,00,000
90000 units Production Capacity 100000 units
₹ 120 Selling Price pu ₹ 120
55 VC pu ₹ 50
600000 p.a. Repairs & Maint 200000 p.a.
42 lakhs Other Op Fixed cost 40 lakhs
40% Tax Rate 40%
15% Ko 15%
Solve: Evaluation of replacement decision Prefer in Exam
Particulars Old Machine New Machine Incremental Approach
Cost of new Machine (25,00,000) (25,00,000)
Proceeds on sale of old (5,00,000) 5,00,000

machine being Opp loss
Incremental Initial Investment (20,00,000)
B. Annual CF’s
No. of units 90000 100000
Sales Revenue ₹ 108 lakhs ₹ 120 lakhs ₹ 12 lakhs
Less : Variable Cost ₹ 49.5 lakhs ₹ 50 lakhs ₹ 0.5 lakhs
Contri 58.5 lakhs ₹ 70 lakhs 11.5
Less : Repairs & Maint 6 2 Savings 4
: Other Op. cost 42 40 Savings 2
CFBT 10.5 lakhs ₹ 28 lakhs ₹ 17.5 lakhs
Less : Depn 0.90 lakhs 4.4 ₹ 3.5 lakhs

500000 - 50000 ₹ 25 lakhs - 3 lakhs Incremental
5 yrs 5 yrs Depn
PBT 9.60 lakhs ₹ 23.6 lakhs 14 lakhs
Less : Taxes @ 40 %
PAT
Add back : Depn

Incremental
CFAT 6.66 lakhs 18.56 lakhs CFAT 11.90 lakhs
PVAF (@15%,5 yrs) 3. _ _ _ 3. _ _ _ 3. _ _ _
PV of Annual CF’s 22.32 lakhs 62. _ lakhs 39.89 lakhs
C. Terminal CF’s
Salvage Value 0.50 lakhs 3 lakhs 2.5 lakhs
PVAF (@15%,5th yrs) 0. _ _ _ 0. _ _ _ 0. _ _ _
PV of Terminal CF 0.25 lakhs 1.49 lakhs 1.24 lakhs

Incremental
NPV 17.57 lakhs Vs. 38.71 lakhs NPV 21.13 lakhs
Decision Rule: If Incremental NPV is
Positive Negative
Replace Old machine with New machine Continue with Old machine
Caution Note:
Old Asset New Asset Incremental

Sale value of Old Asset Sale value of New Asset Incremental Sale value
+/- Tax Treatment on CG/CL +/- Tax Treatment on CG/CL Incremental Tax Treatment
After tax salv of old After tax salv of New = Incremental After tax salv value
Not Recommended
Recommended Approach in Exams in exams
So as to avoid any kind of
calculation +/- mistake
CFBT 1000
CFAT = CFBT (1 - t) + Depn x t
- Depn 200 or = 1000 (1-0.3) + 200 x 30 %
PBT 800 = 700 + 60
= 760
- Taxes @ 30 % 240
PAT 560
+ Depn 200
CFAT 760
Dividend
Decisions
Learning Objective: How to frame dividend policies so as to maximize shareholder’s wealth
Price per share x No. of shares

Relevance of dividend
Yes, Relevant No, Irrelevant
1. Dividend capitalization model 6. Earnings capitalization model

2. Gordon’s model 7. Modigliani & Miller model
3. Walter’s model
4. Graham & Dodd model
5. Lintner’s model
Basic Valuation Principle

0 1 2 25
Annual Rental income

480000 480000 480000
Read Return = 15% Sale of asset = ₹ 1.5 Crores

disc @ 15%
31,02,790
4,55,665 @ 15%
disc
PV = 35,58,455
i.e. Fair value of asset
“Value of any asset today is the present value of Future cash flows generated from such asset
discounted @ ”Required rate of return”
Dividend Capitalization Model
D here. D means Dividend
Po =
Ke Po means Price at year 0 i.e. Price today
0 1 2 3 ∞
Reqd Return ₹8 ₹8 ₹8 ₹8
= 12.5%
A
PVP =
r
₹8
=
0.125
Fair value per share = ₹ 64

DIVIDEND DECISIONS
Tutorial Note:
Assumption of dividend capitalization model: Dividend amount will remain constant forever. /
Dividend growth model / Dividend discount model / Constant growth model / Dividend valuation
model / DCF technique
Gordon’s Model
idends = 8%
Growth in div ∞
3 4
1 2
0
Required D4
D2 D3
Return D1 = 13.604
D0 = ₹ 10 = 11.664 = 12.597
= 10% = 1080
D1
Po = A1
Ke - g
PVGP =
r-g
10.80
=
0.10 - 0.08
= ₹ 540
What if there is a variable growth rate in dividends instead of constant growth rate ?
Answer: Use ‘Variable growth rate Gordon’s Model’ / Two stage growth model / Three stage growth model.
Q. Rjio has paid a dividend of ₹ 10 per share in the last year. growth rate is estimated to be 30% for first 3
years, there after it will fall to 20% for next 2 years and it will then stabilize to 8% forever.
Calc Po if investors reqd rate of return is 12% ?
DIVIDEND DECISIONS
Solve:
g = 30% g = 20% g = 8%
0 1 2 3 4 5 6 ∞
D0 = 10 D1 = 13 D2 = 16.9 D3 = 21.97 D4 = 26.36 D5 = 31.64 D6 = 34.17

13
1
1.12 16.9
11.61
1.122 21.97 D6 34.17
13.47 P5 = =
1.123 Ke - g 0.12 - 0.08
26.36
15.64
1.12
4 = 854.12
16.75 31.64
1.125
17.95
484.7
P0 = 560.12 854.2
1.125
Exam Presentation
Year Cash flows / Dividend PVF @ 12% PV
1 D1 = 10 x 1.30 = 13
2 D2 = 13 x 1.30 = 16.9
3 D3 = 16.9 x 1.30 = 21.97
4 D4 = 21.97 x 1.20 = 26.364
5 D5 = 26.364 x 1.20 = 31.6368
D6 31.6368 x 1.08
5 P5 = =
Ke - g 0.12 - 0.08
= 854.20
P0 = 560
Q. If stock R Jio is available @ ₹ 700 Should you buy the stock ?

Answer: Since actual price (₹ 700) > Fair price (₹ 560) therefore stock of Rjio is overvalued. Hence we should
not buy the stock.
Q. Let’s say you still decide to buy the shares of Rjio @ ₹ 700 today. How much return will you earn ?
DIVIDEND DECISIONS
Use IRR
@ 10% @ 11% @ 12%
Year CF’s
PVF PV PVF PV PV
1 13
2 16.9
3 21.97
4 26.364
5 31.6368
34.17
5 P5 = 1061.__
Ke - 0.08
Caution Note:
Don’t make the mistake of using P5 = 854
directly bcoz it has been calc @ Ke = 12%
34.17
P5 = 1708
Ke - 0.08
1708 is P5. Remember, we don’t

have to write P5 in this column.
Instead we have to write PV of P5
PVI 1140.79 753 560
PV0 700 700 700
NPV + 440.79 + 53 140
Using Interpolation:
NPVLR
= LR + (HR - LR)
NPVLR - NPVHR
53
= 11% + x (12% - 11%)
53 - (- 140)
= 11.276% ~ 11.28%
Rate of return an investor will earn on his investment in Rjio stock is 11.28%
Above rate of 11.28% is return for an Investor & Cost of equity (Ke) for the company.
DIVIDEND DECISIONS
How to calc growth rate - formula method
g = RR x ROE or g=bxr
= 0.40 x 20%
= 8%
Note: ‘g’ in earnings = ‘g’ in dividends provided both RR & ROE remains constant
Eg. Price per share today = ₹ 540

Growth rate = 8%
Expected dividend = ₹ 10.80
Calc Ke ?
Solve:
D1
Ke = +g
P0
10.80
= + 0.08
540
= 10%
ROE = 20%
Q. If Co. earns 20% on retained earnings and shall retain 30% of its earnings.
(i) whether growth rate will change ?
(ii) Calc Ke ?
Solve:
(i) g = RR x ROE
= 0.30 x 20%
= 6%
Yes, growth rate is changing
D1
(ii) Ke = +g
P0
DIVIDEND DECISIONS
Tutorial Note: As per ICAI CA Only make adjustment for change in DPR’s and hence dont adjust
for change in growth rate
70% New DPR

= ₹ 10.80 x
60% Old DPR
= ₹ 12.6
D1
Ke = +9
P0
12.6
= + 0.06
540
= 8.33%
CA inter study mat has adopted this alternative in one of the Q’s hence prefer this alt 2 in exam.
Alternative 2: Assuming 0th yr div has already been paid & retention for 0th yr has already been done
Under this alternative the growth rate for yr 1 will remain same at 8% because we have already retained 40%
earnings in 0th yr
Therefore, D1 will be impacted just because of change in DPR and will not be impacted due to Δ in growth rate
Earlier Expended D1 = 10.80
Old DPR = 60%

New DPR = 80%
80%
Now Expected D1 = 10.80 x
60%
= 14.44
D1
∴Ke = +g
P0
14.4
= + 0.04
540
= 6.67%
DIVIDEND DECISIONS
How to calc growth rate - formula method

g = RR x ROE or g = b x r
Eg. Dividend payout ratio = 70%
ROE = 15%
Calc g ?
Solve:
g = RR x ROE
= 0.30 x 15%
= 4.5%
Proof
At Yr 0 ie Yr 1 beginning
B/s
Equity ₹ 1000 Assets ₹ 1000

ROE = 15%
Earnings ₹ 150
growth
Less: Div
At Yr 1 ie Yr 2 beginning rate
@ DPR = 70% (105)
in Earnings
Equity ₹ 1045 ₹ 1045 growth
= 4.5%
ROE = 15% rate
Earnings ₹ 156.75 in Dividend
Less: Div = 4.5%
@ DPR = 70% (109.725)
Note: ‘g’ in earnings = ‘g’ in dividends. But it will be true only when DPR (or RR) are constant over the yrs. If
DPR is changed then result of above formula will only tell you ‘g’ in earnings. In such case, ‘g’ in dividends would
be at a different rate for that particular year.
Walter’s Model
r
D+ (E -D)
Ke
P0 =
Ke
here,
D means Dividend per share
E means Earnings per share
r means Rate of return on retained earnings or Return on equity or Return on investment
Ke means Cost of equity
Tutorial Note: Assumption is that

100% inv. is done by Eq hence ROI
= ROE will be the same
DIVIDEND DECISIONS
Derivation of the formula:

D + P1 Since there is NO such concept
P0 =
1 + Ke of growth in dividends hence no
need to write D1. Simply write ‘D’
D + P1
1 + Ke =
P0
D + P1
Ke = -1
P0
D + P1 - P0
Ke =
P0
D + ΔP ΔP denotes change in price

Ke =
P0
r Change in share price takes place due
D+ (E - D)
Ke to retained earnings. The amount of
Ke =
P0 change in price will be equivalent to
PV of return on inv. of such retained
r
D+ (E - D) earnings disc @ Ke.
Ke
P0 =
Ke
Eg 1
Situation I II III
EPS = ₹ 10 EPS = ₹ 10 RR = 90%
RR = 40% RR = 70%
RORE = 15% RORE = 15%
Ke = 12% Ke = 12%
Calc P0 using walter’s model ?
Solve:
r
D+ (E - D)
Ke
P0 =
Ke
0.15 0.15 0.15

6+ (10 - 6) 3+ (10 - 3) 1+ (10 - 1)
0.12 0.12 0.12
= = =
0.12 0.12 0.12
= ₹ 91.67 = ₹ 97._ _ = ₹ 102._ _
DIVIDEND DECISIONS
Observation: As we increase the retention ratio, share price increases.
Tutorial Note: But remember that’s an

incomplete observation. See Example 2 below
Eg 2
Situation I II III
EPS = ₹ 10 EPS = ₹ 10 RR = 90%
RR = 40% RR = 70%
r = 10% r = 10%
Ke = 12% Ke = 12%
Calc P0 using walter’s model ?
Solve:
0.10 0.10 0.10
6+ (10 - 6) 3+ (10 - 3) 1+ (10 - 1)
0.12 0.12 0.12
P0 = = =
0.12 0.12 0.12
= ₹ 77.78 = ₹ 73.61 = ₹ 70.83
Complete Observation
(i) When r > Ke (i.e. Co. can earn more return% that what shhl expectations are)
then share prices increases when RR increases.
(ii) When r < Ke (i.e. Co. can earn less return% than what shhl expectations are)
then share prices decreases when RR increases.
Tutorial Note: This conclusion opplies
to both i.e. walter’s as well as gordon’s
Optimum Dividend Policy
Optimum dividend
Condition Comment
payout ratio
r > Ke 0%
Since Co. can earn returns which are above
say 15% > 12%
sh hi expectations
[Generally growth companies]
r < Ke 100%
say 10% < 12%
Since Co. cannot meet sh hi expectations.
[Generally Maturity companies
or declining]
Any payout ratio is

r = Ke Since Co. can earn returns that exactly
optimum
say 12% = 12% equals Sh hi expectations hence shhi will be
[Constant businesses] indifferent as regards Co’s dividend policy
DIVIDEND DECISIONS
Relationship between Ke & PE ratio
MP EPS
PE ratio = & Ke = (this is one of the formulas)
EPS MP
In p
ve hi
rs e Relations
1
i.e. Ke =
PER
Exam Tip: If Q asks comment about “Whether co. is following optimum div policy” then make it a
habit to also calc P0 at both - the actual DPR as well as optimum DPR.
Graham & Dodd Model [Traditional Model]

E
P0 = m x D +
3
here,
m means multiplier
Lintner’s Model [Traditional Model]
D4
D4
D3
D1
Dividend Dividend D2
amount D1
amount
D3
D0 D2 D0
0 1 2 3 4
0 1 2 3 4
Time (in yrs)
Time (in yrs)
D1 = D0 + [(EPS1 x Target payout ratio) - D0] x AF
here,
AF means adjustment factor [always range between 0 to 1]
DIVIDEND DECISIONS
Target DPR = 60%
EPS = 25 here,
AF means Adjustment Factor [always range between 0 to 1]
DPS = 15 EPS = 18
Dividend without
DPS = 6.99 DPS = 10.8 --> lintner’s
EPS = 10
DPS = 8.3 --> Dividend as per
DPS = 8.7 lintner’s model
EPS = 5
DPS = 6
DPS = 3
0 1 2 3
Time (in years)
D1 = D0 + [(EPS1 x Target payout ratio) - D0] x AF
Year 1
= 6 + [(25 x 0.6) - 6] x 0.30
= 6 + 2.7
= 8.7
Year 2
= 8.7 + [(5 x 0.6) - 8.7] x 0.30
= 6.99
Year 3
= 6.99 + [(18 x 0.6) - 6.99] x 0.30
= 8.13
Tutorial Note: Note on adjustment factor: In exams, AF will always be given in the Questions
In real life, adjustment factor depends on how stable or fluctuating companies earnings are
? If Co. is expected to have stable earnings then keep AF between 0.60 to 0.90. If Co. is expected
to experience high fluctuations in earnings then keep AF low (between 0.10 to 0.50). What would
be the exact number of AF is a subjective matter.
DIVIDEND DECISIONS
Irrelevance of Dividend
Earnings Capitalization Model
Assumption of this model: Earnings will remain constant forever.
E
P0 =
Ke
Modigliani & Miller Model
(n - Δn) P1 - I + E
nP0 =
1 + Ke
here,
n means No. of shares outstanding today
Δn means no. of shares to be issued at the end of year 1
P0 & P1 means price of the share at Yr 0 & Yr 1
I means Investments to be made i.e. capital expenditure
E means Earnings
Derivation:
D1 + P1
P0 =
1 + Ke
Multiply both the sides by ‘n’

nD1 + nP1
nP0 =
1 + Ke
Add & subtract ΔnP1 to the RHS numerator

nD1 + nP1 + ΔnP1 - ΔnP1
nP0 =
1 + Ke
here,
ΔnP1 means additional capital raised
ΔnP1 = I - (E - nD1)
Suppose, Capex to be done at Yr 1 end = ₹ 100 cr.
Earnings for the next yr = ₹ 30 cr.
Total dividends to be paid in the next yr [nD1] = ₹ 10 cr.
∴ Additional capital to be raised at yr 1 = 100 cr. - (₹ 30 cr - ₹ 10 cr)

= 80 crores
DIVIDEND DECISIONS
Δn P1 = I - (E - nD1)
Addl. shares at P1 Retained

to be issued price earnings
Additional capital Additional capital

to be raised to be raised
Replace ΔnP1 by I - (E - nD1)

nD1 + nP1 + ΔnP1 - [I - (E - nD1)]
nP0 =
1 + Ke
nD1 + (n + Δn) P1 - I + E - nD1

nP0 =
1 + Ke
(n + Δn) P1 - I + E
nP0 =
1 + Ke
Since dividends are not present anywhere in the above formula, hence dividends are irrelevant in
determining value of the firm.
Eg. Proof of irrelevance of dividend

No. of share outstanding today = 100000
Planned capex for the next yr = ₹ 30 lakhs
Earnings for the next yr = ₹ 12 lakhs
P0 = ₹ 150
Ke = 8%
Calc value of firm today under following situations:-
(i) If dividends @7 per share are paid
(ii) If dividends are not paid
DIVIDEND DECISIONS
Solve:
Proof of irrelevance of dividend
Particulars If dividends are paid If Dividends are not paid
Step1: Calculate Price = ₹ 150 (1.08) - 7 = ₹ 150 (1.08) - 0

at the end of yr 1 i.e. P1 = ₹ 155 = ₹ 162
P1 = P0 (1 + Ke) - D1
Step2: Calculate addl

no. of shares to be
issued at yr 1 end i.e. Δn
=
₹ 30
lakhs
-
)₹ 12
lakhs
1 lakh
- shares
x₹7
) =
₹ 30
lakhs
-
)₹ 12
lakhs
1 lakh
- shares
x0
)
I - (E - nD1) ₹ 155 ₹ 162
Δn =
P1
= 16129.03 shares = 11111.11 shares
Step3: Calc value of

firm
nP0 =
(n + Δn) P1 - I + E) =
) 100000
+ 16129.03 ) 155 -
1.08
₹ 30
lakhs
+
₹ 12
lakh
=
) )100000
+ 11111.11
Shares
162 -
₹ 30
lakhs
+
₹ 12
lakh
1 + Ke
1.08
= ₹ 150 lakhs = ₹ 150 lakhs
Q. In the above case, prove that value of firm at the end of yr1 is also same under both the situations.
Solve
Step4: Value firm at yr1 = (100000 shares + 16129.03 shares) = (100000 shares + 11111.11 sh)
end x ₹ 155 x ₹ 162
= (n + Δn) P1 = ₹ 180 lakh = ₹ 180 lakh
Stock Split & Stock Dividends
Face value (before split) = ₹ 100 When cos. share price increases sharply such that it
goes out of the reach of a normal investor, then Co. goes
for stock split to make it affordable for investors.
Face value (after stock split) = ₹ 25 each

vs
Reverse stock split When share prices falls sharply then investors might
Face value = ₹ 25 each consider such a Co. as a penny stock company. To save
the face, Co. goes for reverse stock split.
Consolidate to 1 share of FV = ₹ 100

DIVIDEND DECISIONS
Q. Current MP of MRF = ₹ 82000

Face value = ₹ 100
n = 1 crore
If co. goes for 4:1 stock split
Don’t read: as ‘is to’

Read it as ‘for’
then calc new MP ?
Solve
RF
M
At present the total wealth is divided

Total Shhi
among 1 cr sh. But now, after split, the
wealth = ₹
same wealth will get divided among 4 cr. sh.
82000 x 1 cr Sh
= ₹ 82000
crores
P0 x n
New MP = here, n + Δn means Total no. of shares O/s
n + Δn
₹ 82000 x 1 cr. sh
= = ₹ 20500
4 cr. sh
If stock split info is given in % terms instead of ratio
25% Stock split 50% Stock split 10% Stock split

it means put a cut means means
at every 25% means 2:1 Stock split 10:1 Stock split
4:1 Stock split
‘Stock dividends’ simply means issue of bonus shares
Eg. No. of Sh o/s before bonus issue = 1 crore sh.
Co. declares bonus in the ratio of 4:1 find new total no. of shares o/s after bonus issue.
Solve:
₹ 82000 x 1 cr
= = ₹ 16400
1 cr + 4 cr
Q. If co. declares 100% bonus issue then it simply means that total no. of shares will now double after bonus
issue [i.e. 1:1 bonus issue]. Similarly if co. declares 20% bonus then what will be the ratio ?
Solve:
1:5 [1 share for every 5 shares will be issued as bonus]
for
MANAGEMENT OF
WORKING CAPITAL
Unit 1: Estimating Working Capital Requirements

four approaches to estimate W/c Requirement
Approach 1 : Approach 2 : Approach 3 : Approach 4 :

Operating Cycle Components of Ratio of Ratio of
Approach Working Capital Sales Fixed
Method Investments
Operating Cycle Approach
Cash
Debtors
RM
FG
WIP
Steps under ‘Operating Cycle Approach ‘
Step 1: Calculate Length of Operating Cycle
RM Conversion FG Debtors Credit period

= holding + Period or + holding + collection - allowed
Period WIP Period period Period by Creditors
MANAGEMENT OF WORKING CAPITAL
Step 2: Calc No. of Operating cycles in a Year
360 or 365 days Use ‘12' in Numerator if

=
Operating Cycle Period OC period is given in months
Step 3: Calc ‘Working Capital Requirement’

Annual Operating Cost
=
No. of Operating Cycles in a Year
How to calculate Holding Period for each of the elements of Op cycle
COST SHEET
Credit Period Average Creditors
Opening RM xxx allowed by =
Avg RM Credit purchases
+ RM Purchases xxxx suppliers
per day
- Closing RM (xx)
RM
Average RM Stock
RM Consumption xxx Storage =
Period Avg RM Consumption
+ Direct labour & Direct Fxps xxx per day
+ Factory Overheads xx
+ Opening WIP xx
Caution: Do not make the mistake
- Closing WIP (xx)
of directly using RM Purchase here
FACTORY COST xxx RM Consumption ≠ RM Purchases
+ Admin [Factory Admin Exps xx

here] Average WIP
WIP Holding
-n
=
COST OF PROD xxx Period Avg COP per day
+ Opening FG xx
- Closing FG (xx)
FG Average Stock of FG
COGS xxx =
Holding Period Avg COGS per day
+ Admin [General Admin Exps] xx
+ Selling & Distr-n xx
COS xxx
Debtors Average Debtors
+ Profit xx =
Collection Avg Credit Sales
Sales xxxx Period per day
Alternatively, Holding Periods may also be calculated with the help of Respective Turnover Ratios
la
Fo rmu 360 or 365
eric Holding Period =
Gen Respective T/O Ratio
360 or 365
RM Holding Period = Annual RM Consumption
RM Turnover Ratio RM T/O Ratio =
Avg RM Stock
360 or 365
WIP Conversion Period = Annual COP
WIP T/O Ratio WIP T/O Ratio =
Avg WIP
360 or 365
FG Holding Period = Annual COGS
FG T/O Ratio FG T/O Ratio =
Avg FG Stock
360 or 365
Debtors Collection Period = Annual Credit Sales
Debtors T/O Ratio Debtors T/O Ratio =
Avg Debtors
360 or 365
Creditors Payment Period = Annual Credit Purchase
Creditors T/O Ratio Creditors T/O Ratio =
Avg Creditors
Components of Working Capital Method
4:40AM Tue July 08 100%
Estimation of Working Capital Requirements

Amount Amount Amount
I. Current Assets:
Inventories:
- Raw Materials ----
- Work-in-process ----
- Finished goods ---- ----
Receivables:
- Trade debtors ----
- Bills ---- ----
Minimum Cash Balance ----
Gross Working Capital ---- ----
II. Current Liabili es:
Trade Payables ----
Bills Payables ----
Wages Payables ----
Payables for overheads ---- ----
III. Excess of Current Assets over Current Liabili es [I – II] ----
IV. Add: Safety Margin ----
V. Net Working Capital [III + IV] ----
There are 3 ways to calculate ‘Amounts‘ for above statement
Way 1: Way 2: Way 3:

Total Approach Total Cost Approach Cash Cost Approach
includes element of excludes Profits but values
excludes both Profit as well as
Profit as well wherever components at Total Cost
Depn.
required (including Depn).
is valued @ Cost of is valued @ COP including is valued @ Cash COP excluding
WIP
Prod-n including depn. Depn. Depn
is valued @ Total Cost is valued @ Total Cost is valued @ Cash Total Cost
FG
Pr including depn. including depn. excluding depn.
is valued @ Total SP is valued @ Total Cost
is valued @ Cash Cost excluding
Debtors including depn & including depn but excluding
depn & excluding Profit
including Profits Profit
Note: Rest of the Components of W/C viz. RM, Creditors, Wages O/S, Cash balance etc. remains exactly
same under all 3 ways.
Example Cost Sheet per unit

RM ₹300
DL ₹ 100
Factory OH (inclusive of Depn = ₹ 25) ₹ 150
Total Cost ₹ 550
Profit 150
Garments Manf. co. Selling Price ₹ 700
Planned Prod-n level = 180000 Units
Co. will keep RM in stock, on an average for 15 days requirement.
Similarly, Conversion period is 7 days
FG remain in FG store for an average of 45 days
Debtors credit period averages to 60 days.
Creditors allow 30 days credit period.
Wages: Lag in payment of wages by 10 days
Lag in payment of Manf. overheads by 15 days
Cash & Bank balances to be kept = ₹25,00,000
Safety Margin @ 10% is desired.
Compute W/C Requirement as per ‘Components of W/C Approach’ under all 3 ways ?
Assume 360 days in a year.
Solve : Statement showing Estimation of W/c Req. [Total Amount in ₹ Lakhs]
Total Approach Total Cost Approach Cash Cost Approach

Particulars Units Amount Total Amount Total Amount Total
Per Unit Per Unit Per Unit
A. CURRENT ASSETS .
Inventories 7500
- RM [180000x15/360] 300 22.5 300 22.5 300 22.5
- WIP 3500 425 14.875 425 14.875 412.5 14.4375

[180000 x 7/360] [300x100%] [300x100%] [300x100%]
[+100x50%] [+100x50%] [+100x50%]
[+150x50%] [+150x50%] [+125x50%]
- FG 22500 550 123.75 550 123.75 525 118.125

[180000x45/360]
Debtors 30000 700 210 550 165 525 157.5

[180000x60/360]
Cash & Bank Balance 25 25 25
Total CA or Gross 396.125 351.125 337.5625

Working Capital
B. CURRENT
LIABILITIES
Creditors 15000 300 45 300 45 300 45
30
180000x
360
Wages Pybl 5000 100 5 100 5 100 5

10
180000x
360
Manf OH 7500 125 9.375 125 9.375 125 9.375

15
180000x
360
TOTAL CURRENT 59.375 59.375 59.375

LIAB
C. Excess of CA over 336.75 291.75 278.1875

CL
D. Add : Safety Margin 33.675 29.175 27.81875

@ 10%
E. NET WORKING 370.425 320.925 306.00625

CAPITAL ~ 370 ~ 321 ~ 306
Things to Remember
1. If Q is silent then WIP is assumed to be 50% complete regarding Conversion cost. As regards RM
component there are 2 choices
Labour & Manf OH
Assume that RM is Assume that RM is

issued at the start of issued evenly throughout the
Prod-n process Prod-n process
then RM will be taken then RM will

as 100% complete in WIP be taken as
50% complete
2. Whether under ‘Total Approach‘ or ‘Total Cost Approach‘, Manf OH Outstanding Amount will always be
Excluding Depn. Amount ( because Depn . Amt cannot be O/S)
3. If Q is silent whether Company is an Existing Co. or Newly commencing business, then default
assumption is that it's an Existing Co .
Existing Co . Co - Newly
commencing business
Unless otherwise specified, simply Then Opening Stock must be

assume that co. is operating at a assumed as ‘O’ & hence RM
constant levels over the years & hence, Consumption ≠ RM Purchase
ü Op stock = Closing Stock
ü RM Consumption = RM Purchase Similarly, Prod-n ≠ sales [because RM Purchases now
-n
ü Prod = Sales needs to be sufficient to support both (i)
-n
Consumption & (ii) Closing stock and Prod also needs
to be sufficient to support both i) Sales & ii) Cl. FG]
How to calc RM Purchase when Co. is newly commencing business ?
Supplier RM Store Factory FG Stock Customer
How much
RM Purchase ??
RM Stock to support 1 WIP Conversion Cl Fg Stock Demand

month prod-n should be Period = 1/2 month equivalent to 1 ½ units =
kept in Stock months sales should 100000
be kept
Solve :
Sales 100000 Units
1.5
+ Closing FG 100000 x 12500 Units
12
-n
Total Completed Units of Prod 112500 Units
0.5
+ WIP 112500 x 4687.5 Units
12 [assuming 100% of RM is issued at the start
of the Prod process]
Total RM Consumption 117187.5 Units
1
+ Closing RM Stock 117187.5 x 9765.625 Units
12
126953125
Total RM Purchase from supplier ~ 126953 Units
4. If I didn't define whether "Overheads" are Factory OH or Admin OH or selling Ovhs then just the word
‘Overheads' implies that these are ‘Factory Ovhs’ .
5. When reading WCM - Unit I Question in exam, pay special attention to whether Co . is (i) an existing co,
or (ii) newly commencing business. Because this info makes a HUGE difference in the way we calc W/C
Requirement.
6. Which way i.e. Way 1 or way 2 or way 3 to follow in exams if Q is silent ?
If Depn info is given If Depn info is

in the Q not given
Use "Cash Cost Approach” Use "Total Cost Approach "
# Effect of Double shift working on W/C Req .
Component No.of Units Amount Comment
Raw Material Double Little less than Since RM Purchased Qty from Supplier will
Stock Double double - up, we might get Bulk-Qty. discounts
WIP Double Same or little bit Due to concept of ‘Pipeline Theory’ the No. of
[RM + Lab + SAME less or little bit Units of WIP will remain same (because 2nd
Factory Ovhs] more shift workers will start work where 1st shift
workers have left).
If RM Purchase price has reduced (due to bulk
Qty discount) OR Fixed Factory Cost (eg.
Factory Rent) has reduced due to producing
double no. of units then WIP Val-n will decrease.
Alternatively, if 2nd shift workers are paid a
higher wage rate then WIP Value will increase.
Finished Double Little bit Same reason as written above.

goods stock. more/less than
‘Exact Double Am’
Debtors Double Little bit more/ Same reason as written above.

less than ‘Exact
Double Amt’
Creditors Double Little bit Amount Depends on new RM Purchase price (eg
more/less than Bulk Qty Discounts offered )
‘Exact Double Amt’
Two ways to look @ Double shift W/C Req.
To assess the Impact of To assess the impact of

Double shift FOR LONG TERM Double shift TO MITIGATE
as a matter of prod-n policy IMMEDIATE DEMAND FOR NEXT
YEAR ONLY
here Double Prod-n means Double here, Double Prod-n does Not translate
sales into Double sales [because some of the
increased Prod-n is kept in FG stock to
meet increased level of FG]
doubled to
-n
eg. Prod 25000 50000
FG 2000 4000
Sales 25000 50000
48000
Out of 50000 units we will keep 2000 addll. units

to meet increased req. of FG stock .
To conclude. we don't have to To conclude.

∴
think about Differences in Op FG ≠ Cl FG
Op Stock & ∴ Prod-n ≠ Sales
Closing Stock levels.
Simply assume that Similarly,
∴
Op Stk = Cl Stock. Op RM ≠ Cl RM
∴ RM Cons ≠ Rm Purch.
But Remember that

Just like Op WIP = Cl WIP
Existing Co. case (in terms of units)
Exam Tip:
Prefer this approach in exam Just like
‘Newly commencing business’
Exam Tip:
Always first prepare Cost sheet for both Single shift & Double shift before estimating W/C Req.
Unit II: Treasury & Cash Management

Learning Objective: Management of Cash
How will you manage cash?

Cash Planning
Tool for Cash Planning is
Cash Budget
Methods of preparing Cash Budget
(a) (b) (c)

Receipts & Payments Adjusted Adjusted
Method Income Method Balance sheet Method
is as good as ‘Cash is as good as Prepare Forecasted B/S

A/c’ or as good as ‘Indirect Method i.e. forecast All liabilities &
‘Direct Method of of preparing Cash All FA & CA except Cash
preparing Cash flow flow St’ bal.
Statement ' Cash balance simply
Preferred for becomes a balancing figure.
Preferred Method Long - term Cash
for short - term Budgets
Cash Budgets
4:40AM Tue July 08 100%
FORMAT OF CASH BUDGET (SHORT PERIOD)

Co. Ltd.
Cash Budget
Period………………
Month Month Month Month
1 2 3 12
Opening Balance
Receipts:
1. Collection from debtors
2. Cash sales
3. Loans from banks
4. Share capital
5. Miscellaneous receipts
6. Other items
Total Cash Available [A]
Payments:
1. Payments to creditors
2. Wages
3. Overheads
4. Interest
5. Dividend
6. Corporate tax
7. Capital expenditure
8. Other items
Total Payments [B]
Closing balance
[Surplus (+)/Shortfall (-)]
Fund Flow Statement
Sources of Funds Application of Funds

ü Issue of shares (for cash) ü Buyback of Shares/Payment of Div
ü Issue of Debentures/ long - term Debt ü Repayment of LT Debt
ü Sale proceeds of fixed Assets ü Purchase of FA
ü Liquidation of Investments ü Purchase of Investments
ü Non-Operating Income ü Non Operating Exps (eg Payment of
(eg. Dividend/lntt on Inv.) under - writing Comm./Preliminary Exps)
ü Funds from Operations ü Funds used in Operations
ü Decrease in Working Cap ü Increase in W/C.
How to calc Inc / Decrease in W/C

Amounts Changes in W/C
Particulars
Prev. Yr Current Yr Increase Decrease
A. Current Assets
Debtors 100000 120000 20000
Cash & Balance
B. Current liabilities
Creditors 50000 55000 5000
How to calc FFO ?

Net Profit for the Year xxxx
Less: Gain on sale of Assets / Non - Op Inc . xxx
Add: Depn / Non- Cash Expenses xxx
Loss on sale of Assets / Non - op Exps xxx
FUNDS FR0M OPERATIONS xxx
FORMAT of Fund Flow Statement
A. Sources
. of Funds
d
one xx
.
m enti
s xx
. items a ove
a b xx
.
. TOTAL of Sources of funds xxx
B. Application of Funds
. d
tione The Totals
. a s men xx
s will match
. item above xx
. xx
. TOTAL of Application of Funds xxx
Determining Optimum Cash Balance
Use CASH MANAGEMENT MODELS
Inventory type Models Stochastic Models

i.e. William J. Baumol’s i.e . Miller - Orr Model
Economic Order Qty Model
Purchase of securities
Optimum Cash Upper Limit ₹16000
2UP
balance i.e. C = (denoted by ‘h’) S
S p
r
here, Return Point = ₹10000 e
U = Annual Cash Requirement (denoted by ‘z’) a
P = Fixed Cost per transaction d
Sale of Securities
S = Opportunity Cost per rupee per annum
Lower Limit ₹ 7000
i.e. Rate of Intt on Short term Securities
(denoted by 0 i.e. Zero)
If ‘U’ is Annual then ‘S’ should be per annum.
If ‘U’ is Monthly then ‘S’ should be per month
Time 1
r 3
h ove x Transaction Cost x Variance of Daily CF’s 3
cas e Spread = 3 x 4
the im
i n g oft Interest Rate per day
Amount
Ut
ilis riod
ap
e
) )
If variance of Cf’s is per day then rate of intt must
Co. should
also be per day
arrange this
much amount of Upper limit = Lower limit + Spread
or
CA, CFA (USA), CPA (USA) PRAVEEN KHATOD - Leaders in Advanced Financial Education Across India
cash every time
2
Time Return Point + Spread
3
Spread
Return Point = Lower limit +
101
3
or
2
Upper limit - x Spread
3
Unit III: Management of Inventory
Excess level of inventory leads to Very high

Excess levels carrying cost in terms of
of Inventory (i) Opp cost of funds blocked in inventory
(ii) Operating cost of godown etc. needs to be
incurred
follow the Optimum levels
concept of Inventory
of EOQ
Low levels are is not advisable because
2AO (i) there would be frequent stock-out
EOQ = Low levels
C situation
of Inventory
(ii) No. of orders to be placed will increase
here,
leading to high ordering cost
A means Annual Requirement of RM
O means Ordering Cost per Order
C means Carrying Cost per unit per annum
Exam Tip:
If in Q, Monthly Req. of RM (instead of Annual req) is given then use ‘C’ as carrying cost per unit per month
(instead of per annum)
Unit IV: Management of Receivables

three functions comes under mngt of Receivables
Deciding credit policy Credit Analysis Collection of Rcbls/Monitoring

Receivables
we evaluate various credit means evaluating whether credit Mainly two ways to monitor
policies by preparing ‘Statement should be given to a particular Rcbls Collection progress
showing evaln of credit policies’ customer or not ? (i) Calculate Avg Collection
ü Credit Ratings period - & watch for the
two types of ü Decision-tree trend
formats Analysis of granting credit (ii) Ageing schedule
Under ‘Total Under Example given after some pages

Approach’ ‘Incremental
Approach’
i.e. evaluate each credit

policy separately /
individually and don’t
make any incremental
calculations Refer Format on Next page
4:40AM Tue July 08 100%
APPROACHES TO EVALUATION OF CREDIT POLICIES

There are basically two methods of evalua ng the credit policies to be adopted by a Company – Total
Approach and Incremental Approach. The formats for the two approaches are given as under:
Statement showing the Evalua on of Credit Policies (based on Total Approach)
Present Proposed Proposed Proposed
Par culars
Policy Policy I Policy II Policy III
(₹) (₹) (₹) (₹)
A. Expected Profit:
(a) Credit Sales ……… ……… ……… ………
(b) Total Cost other than Bad Debts
(i) Variable Costs ……… ……… ……… ………
(ii) Fixed Costs ……… ……… ……… ………
……… ……… ……… ………
(c) Bad Debts ……… ……… ……… ………
(d) Cash discount
(e) Expected Net Profit before Tax ……… ……… ……… ………
(a-b-c-d)
(f) Less: Tax ……… ……… ……… ………
(g) Expected Profit a er Tax ……… ……… ……… ………
B. Opportunity Cost of Investments in ……… ……… ……… ………

Receivables locked up in Collec on Period
Net Benefits (A – B) ……… ……… ……… ………
Advise: The Policy……. should be adopted since the net benefits under this policy are higher as
compared to other policies.
Here
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] x No. of units sold on credit under
Present Policy
(ii) Opportunity Cost
Collec on period (Days) Required Rate of Return
= Total Cost Of Credit Sales x x
365 (or 360) 100
4:40AM Tue July 08 100%
Statement showing the Evalua on of Credit Policies (based on Incremental Approach)
Present Proposed Proposed Proposed
Par culars Policy Policy I Policy II Policy III
days days days days
(₹) (₹) (₹) (₹)
A. Incremental Expected Profit:
Credit Sales ......... .......... ......... .........
(a) Incremental Credit Sales ......... .......... ......... .........
(b) Less: Incremental Costs of Credit Sales
(i) Variable Costs ......... .......... ......... .........
(ii) Fixed Costs ......... ......... ......... .........
(c) Incremental Bad Debt Losses ........ ......... ......... .........
(d) Incremental Cash Discount ........ ......... ........ .........
(e) Incremental Expected Profit (a-b-c-d) ........ ......... ........ .........
(f) Less: Tax ........ ......... ........ .........
(g) Incremental Expected Profit a er Tax ........ ......... ........ .........
........ ......... ........ .........
B. Required Return on Incremental
Investments:
(a) Cost of Credit Sales ........ ........ ........ ........
(b) Collec on Period (in days) ........ ........ ........ ........
(c) Investment in Receivable (a x b/365 or ........ ........ ........ ........
360)
(d) Incremental Investment in Receivables ........ ........ ........ ........
(e) Required Rate of Return (in %) ........ ........ ........ ........
(f) Required Return on Incremental ........ ........ ........ ........
Investments (d x e)
Incremental Net Benefits (A – B) ........ ........ ........ ........
Advise: The Policy ……….should be adopted since net benefits under this policy are higher as compared
to other policies
Here:
(i) Total Fixed Cost = [Average Cost per unit – Variable Cost per unit] x No. of units sold on
credit under Present Policy
Collec on period (Days) Required Rate of Return
(ii) Opportunity Cost = Total Cost of Credit Sales x x
365 (or 360) 100
Credit Sales Say, ₹ 100000

Debtors Turnover Ratio = = = 10 times
Avg. Debtors ₹ 10,000
360 or 365 Say, 360 days

Average Collection Period = = = 36 days
Debtors T/o Ratio 10 times
Point to Remember:
While calculating “Opportunity cost of funds blocked in debtors” use “Total cost of credit sales other
than bad debts & cash disc”.
However if info related to cost is not given in the Q then use “Full credit sales value” for calculation
purposes”
Format of Credit Analysis - Decision Tree diagram
Pay Probability (0.9) ₹ 1,00,000
Grant
Credit Does not Pay
₹ 4,00,000
Evaluation Probability (0.1)
DO not Grant
Format of Ageing Schedule
As on 30th June, 2020

Age
Classes (Days) Month Balance of Percentage
of Sale Receivables to total
(₹)
1 - 30 June 41,500 11.9
31 - 60 May 74,200 21.4
61 - 90 April 1,85,600 53.4
91 - 120 March 35,300 10.2
121 and more Earlier 10,800 3.1
3,47,400 100
Financing of Receivables
Pledging Factoring Forfeiting
Using receivables as a security is same as factoring but is done

to arrange short term finance in case of international trade
from bank. St
n ts ep
m e m 4:
cu r ak On
d o c t o e s du
s Factor pa
e nd o Fa y m
ed
ate
s l t e
l i er b il nt cu
pp ay ys to sto
S u - w p a t h me
2 : , E o r r e fa r
e p c e c t l i e cto
St v oi F a u p p
Step 1: Supplier sells r
In 3: to
s
eg t ep *
S ce goods to the customer
d van Customer
a
*Amount of accounts receivables xxxx
Less: Factor reserve @10% (say) (xxxx)
xxxx
Supplier
Less: Factoring commission xx
Amount available for advance xxx
Less: Interest to the factor xxx
Net Advance paid xxx
Two types of Q’s in case of Factoring
Q asks for ADVISE or DECIDE Q asks for calculate ‘Effective

cost of Factoring’
Answer is usually given in absolute terms by
either comparing the Two Alternatives (eg Answer is given in % age terms
In-house management of receivables vs
Factoring) or solving on incremental basis
Example:
Factor Comm = 1%
₹ Factor Reserve = 15%
Intt to factor on advance = 11%
Bank
Bank loan @10% interest Annual Sales = ₹ 36 lakhs
Supplier Credit Period = 60 days

Customers
If inhouse mngt of receivables
Cost of credit administration = ₹ 1.25 lakhs
Bad debts = 1.5%
Case (i)
Advise or decide whether supplier should go for factoring proposal or not ? Assume that bank finance 80% of
receivables & for balance amount own funds are arranged @18% ?
Solve: Evaluation of both the proposals

In-House management of receivables Factoring Proposal
1. Cost of credit admin = ₹ 125000 1. Cost of credit admin x
2. Bad debts = ₹ 36 lakhs x 1.5% = ₹ 54000
Since ₹ 125000 cost is already charged
as a cost under proposal 1 ∴ it would be
3. Cost of bank funds
60 wrong to write ₹ 125000 as savings
Avg Inv in debtors = ₹ 36 lakhs x here. It will amount to double
360
consideration of the same amount
= ₹ 6 lakhs
Out of above :-
2. Bad debts x
- Bank finance [80%] = ₹ 4.8 lakhs
- Own funds [20%] = ₹ 1.2 lakhs If Q is silent then it is assumed that
factoring proposal is on Non-recourse
Intt on bank loan @10% = ₹ 4.8 lakhs x 10% basis
= ₹ 48000
3. Factoring Comm
4. Cost of own funds = ₹ 36 lakhs x 1% = ₹ 36000
= ₹ 1.2 lakhs x 18% = ₹ 21600
4. Interest to factor
Total cost of Inhouse Mngt of Receivables
Avg Inv in Debtors ₹ 6 lakhs
₹ 248600
Less: Factor reserve @15% 0.90 lakhs
Less: Commission
[1% x ₹ 6 lakhs] 0.06 lakhs
Amt available for advance ₹ 504000
Less: Intt to factor 9240
[₹ 504000 x 11% p.a. x 60/360]
Net advance to be paid by ₹ 494760
Factor to Supplier
∴ Annual intt to factor ₹ 55440
360
₹ 9240 x
60
5. Cost of own funds
Own funds to be arranged = ₹ 6 lakhs - ₹
494760
= ₹ 105240
∴ Intt on own funds = ₹ 105240 x 18%
= ₹ 18943
Total cost of factoring proposal = ₹ 110383

Advise:
Co. should select factoring proposal since it results in Net benefit of ₹ 138217 [₹ 248600 - ₹ 110383]
Case (ii):
Calculate effective cost of factoring arrangement in the above example assuming :-
(a) No info regarding own funds is given
(b) Cost of credit administration is only ₹ 25000
(c) Factoring comm @4%
Solve:
Statement showing evaluation of factoring proposal
A. Annual savings on taking factoring services
Cost of credit admin saved ₹ 25000
Bad debts avoided ₹ 54000
₹ 79000
B. Annual cost of factoring services

Factoring commission [4% x ₹ 36 lakhs] ₹ 144000
Interest to factor [₹ 486000 x 11%] ₹ 53460
₹ 197460
C. Net annual cost of factoring services ₹ 118460
∴ Effective cost of factoring = Net annual cost of factoring x 100

Net advance paid [WN#1]
or
Total amt available for advance
₹ 118460 ₹ 118460
= x 100 or = x 100
486000 ₹ 477090
= 24.37% = 24.83%
Advice:
Since effective cost of factoring [24.37% or 24.87%] > Cost of bank finance [10%], therefore, Co. should
reject the factoring proposal.
WN#1
60 ₹ 600000
Avg inv in receivables ₹ 36 lakhs x
360
Less: Factor reserve [15% x ₹ 600000] ₹ 90000
Less: Commission [4% x ₹ 600000] ₹ 24000
Amount available for advance ₹ 486000
60
Less: Interest to factor ₹ 4860000 x 11% x 8910
360
Net advance paid ₹ 477090
Decision tree analysis of granting credit

Eg.
Probability of recovery = 95%
hence, Risk of default = 5%
Sales revenue = ₹ 300000
Profit margin = 8%
Evaluate whether credit should be granted or not ?
Solve:
If he pays
₹ 24000
Prob = 0.95
Grant
Credit
Evaluation If he doesn’t pays
(₹ 276000)
Prob = 0.05
Do Not
Grant
If we grant credit
= 0.95 x ₹ 24000 + 0.05 x (₹ 276000)
= ₹ 9000 net benefit
If we donot grant credit:

=₹0
Advice: Co. should grant credit since net benefit is positive.
Unit V: Management of Payables

Creditors are generally seen as free of cost sources of finance. However, the reality could be that supplier is
indirectly charging us inflated price / not offering cash discount if we wish to avail credit period.
Learning Objective: How to calc cost of trade credit ?
Example:
Purchase goods worth

₹ 10 lakhs on credit
terms 2/10 net 60
We, The customer Supplier
Calc Cost of Trade credit ?

Solve: Pay in Pay in

0 10 Days 60 Days
Credit ₹ 10 Alt I Alt II

Purchases: lakhs eligible for 2% discount No Discount
∴ Discount = ₹ 20000 & Simply pay = ₹ 10,00,000
payment to be made
= ₹ 980000
There are 2 ways to calculate Cost of Trade Credit / Cost of Cash Disc Lost
(i) Ignoring compounding effect i.e. simple rate of intt
(ii) Take in to account compounding effect
Way 1: Simple Interest Rate

d 365
= x
100 - d t
here,
d means Rate of Cash Discount
t means no. of credit days after cash disc period is over / Total credit days -Cash disc period
2 365
= x
100 -2 50 60 days - 10 days
= 14.90%
Way 2:
365 If you are earning 2% per month. How much is your
= ) d
100 - d
) t
-1
effective annual income ?
12
Solve: 3
365
2 2% pm 824
₹ 1.26
= ) 2
100 - 2
) 50
-1 0 2% pm
1 2% pm
= 1.1589 - 1
₹1
= 0.1589 or 15.89%
Note: ICAI always assumes 365 days in a year for this unit V
RATIO
ANALYSIS
Sources of Financial Data for Analysis
The sources of informa on for financial statement analysis are:
1. Annual Reports 4. Statement of cash flows
2. Interim financial statements 5. Business periodicals
3. Notes to Accounts 6. Credit and investment advisory services
Types of Ra os
Ac vity Ra os/
Efficiency Ra os/
Performance
Leverage Ra os/ Ra os/ Turnover Ra os*
Long term Solvency
Ra os
Profitability Ra os
Capitel Structure Ra os
Related to Sales
Coverage Ra os
Required for analysis

from Owner's point of
view
Liquidity Ra os/
Short-term Solvency
Related to overall Return
Ra os
on lnvertment (Assets/
Capital Employed/ Equity)
Related to Market/
Valua on/ Investors
RATIO ANALYSIS
SUMMARY OF RATIOS
Ra o Formulae Interpreta on
Liquidity Ra o
Current Current Assets A simple measure that es mates whether

Ra o Current Liabili es the business can pay short term debts.
Quick Quick Assets It measures the ability to meet current

Ra o Current Liabili es debt immediately. Ideal ra o is 1
(Cash and Bank balaces +

Cash Marketable securi es)
It measures absolute liquidity of the
Ra o business.
Current Liabili es
Basic Cash and Bank balaces + Net

Defense ( Receivables + Marketable securi es
) It measures the ability of the business to
Interval meet regular cash expenditures.
Opera ng Expenses ÷ No.of days
Ra o
Net It is a measure of cash flow to determine
Working Current Assets – Current Liabili es the ability of business to survive financial
Capital crisis.
Ra o
Capital Structure Ra o
Equity Shareholder's Equity It indicates owner's fund in companies to

Ra o Net Assets total fund invested.
RATIO ANALYSIS
Debt Total Debt

It is an indicator of use of outside funds.
Ra o Net Assets
Debt to Total Outside Liabili es It indicates the composi on of capital

equity Shareholders Equity structure in terms of debt and equity.
Ra o
Debt to
Total Total Outside Liabili es It measures how much of total assets is
Assets Total Assets financed by the debt.
Ra o
Share Capital + Debentures It shows the propor on of fixed interest
Capital (Preference
+ Other Borrowed funds ) bearing capital to equity shareholders'
Gearing Equity Share Cap tal +
fund. It also signifies the advantage of
Ra o (Reseves and Surplus - Losses ) shareholder.
fi nancial leverage to the equity
Proprietary Proprietary Fund It measures the propor on of total assets

Ra o Total Assets financed by shareholders.
Coverage Ra os
Debt Service It measures the ability to meet the

Earnings available for debt services commitment of various debt services like
Coverage
Ra o Interest + Instalments interest, instalment etc.
(DSCR) Ideal ra o is 2.
Interest It measures the ability of the business to

EBIT
Coverage Interest
meet interest obliga ons.
Ideal ra o is > 1.
Ra o
RATIO ANALYSIS
Preference It measures the ability to pay the

Dividend Net Profit / Earnings a er taxes (EAT)
preference shareholders' dividend.
Coverage Preferences divident liability
Ideal ra o is > 1.
Ra o
Fixed This ra o shows how many mes the cash
Charges EBIT + Deprecia on flow before interest and taxes covers all
Coverage Interest + Repayment of loan fixed financing charges.
Ra o Ideal ra o is > 1.
Ac vity Ra o/ Efficiency Ra o/ Performance Ra o/ Turnover Ra o
Total A measure of total asset u lisa on. It helps

Asset Sales / Cost of Goods Sold to answer the ques on - What sales are
Turnover Average Total Assets being generated by each rupee's worth of
Ra o assets invested in the business?
Fixed This ra o is about fixed asset capacity. A

reducing sales or profit being generated
Assets Sales / Cost of Goods Sold
from each rupee invested in fixed assets
Turnover Fixed Assets may indicate overcapacity or poorer
Ra o performing equipment.
Capital This indicates the firm's ability to generate

Sales / Cost of Goods Sold
Turnover sales per rupee of long term investment.
Ra o Net Assets
Working
Capital Sales / COGS It measures the efficiency of the firm to use
Turnover Working Capital working capital.
Ra o
Inventory COGS / Sales It measures the efficiency of the firm to

Turnover Average Inventory manage its inventory.
Ra o
RATIO ANALYSIS
Debtors
Credit Sales It measures the efficiency at which firm is
Turnover Average Accounts Receivables managing its receivables
Ra o
Receivables Average Accounts Receivables It measures the velocity of collec on of

(Debtors') Average Daily Credit Sales receivables
Velocity
Payables Annual Net Credit Purchases It measures the velocity of payables

Turnover Average Accounts Payables payment.
Ra o
Profitability Ra os based on Sales
This ra o tells us something about the

Gross Gross Profit business's ability consistently to control its
Profit Sales
x 100
produc on costs or to manage the margins
Ra o it makes on products it buys and sells.
Net
Net Profit It measures the rela onship between net
Profit x 100
profit and sales of the business.
Sales
Ra o
Opera ng Opera ng Profit It measures opera ng performance of

Profit Sales
x 100 business.
Ra o
RATIO ANALYSIS
Expenses Ra o
Cost of
Goods Sold COGS
x 100
(COGS) Sales
Ra o
Opera ng Administra ve exp. +

Expenses
Ra o
( )
Selling and Distribu on Overhead x 100
Sales
It measures por on of a par cular
expenses in comparison to sales.
Opera ng COGS + Opera ng expenses
x 100
Ra o Sales
Financial Financial expenses

Expenses Sales
x 100
Ra o
Profitability Ra os related to Overall Return on Assets/ Investments
Return on Return / Profit / Earnings

It measures overall return of the business
Investment x 100 on investment/ equity funds/capital
Investments employed/ assets.
(ROI)
Return on Net Profit a er taxes It measures net profit per rupee of average
Assets Average total assets
total assets/ average tangible assets/
(ROA) average fixed assets.
Return on
Capital EBIT
Employed x 100
ROCE Capital Employed
(Pre-tax) It measures overall earnings (either pre-tax
Return on or post tax) on total capital employed.
Capital EBIT (1 - t)
Employed x 100
ROCE Capital Employed
(Post-tax)
RATIO ANALYSIS
Net Profit a er taxes

Return on Preferences dividend (if any)
It indicates earnings available to equity
Equity x 100 shareholders in comparison to equity
(ROE) Net worth / Equity shareholders' net worth.
shareholders' fund
Profitability Ra os Required for Analysis from Owner's Point of View
Earnings Net profit available to equity

per EPS measures the overall profit generated
shareholders for each share in existence over a par cular
Share Number of equity shares outstanding period.
(EPS)
Dividend
per Dividend paid to equity shareholders Propor on of profit distributed per equity
Share Number of equity shares outstanding share.
(DPS)
Dividend Dividend per equity share It shows % of EPS paid as dividend and
payout retained earnings.
Ra o (DP) Earning per share (EPS)
Profitability Ra os related to market/ valua on/ Investors
At any me, the P/E ra o is an indica on of

Price- how highly the market "rates" or "values" a
Earnings Market Price per Share (MPS) business. A P/E ra o is best viewed in the
per Share Earning per share (EPS) context of a sector or market average to get
(P/E Ra o) a feel for rela ve value and stock market
pricing.
Dividend ± Change in share price

x 100
Ini al share price
Dividend It measures dividend paid based on market
OR
Yield price of shares.
Dividend per Share (DPS)
x 100
Market Price per Share (MPS)
Earnings Earnings per Share (DPS) It is the rela onship of earning per share
x 100
Yield Market Price per Share (MPS) and market value of shares
RATIO ANALYSIS
Market
Value / Market value per share It indicates market response of the
Book Value Book value per share shareholders' investment.
per Share
It measures market value of equity as well

Market Value of equity and liabili es
Q Ra o Es mated replacement cost of assets
as debt in comparison to all assets at their
replacement cost.
Students are requested to refer Alpha Academy Booklets/ Notes for Ratios, formulas and interpretation.
Point to remember :-
1. EBIT = Operating income [usually]
But, if Non-Operating items are given, then EBIT ≠ Op Inc.
Sales
-VC
Contribution
-FC
Operating Income
+ Non-operating income eg. intt on FD/dividend income on Non-trade investment

- Non-operating cost eg loss on sale of asset
EBIT
2. While calc ROA, ROCE & ROE if sufficient info is available to calc avg assets/avg cap emp/avg equity
then average must be taken in denominator.
If averages are not available then 2nd preference is to use opening assets/CE/Equity
3. While writing comments on ‘Ratio analysis’ type questions - prefer to write numeric values of the ratios
as well instead of just using a generic language.

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BASICS

Less: Variable cost 400

Less: Fixed Cost 150

EBIT or Operating income 450

Less: Interest on Debt 75

Less: Taxes @ 40 % 150

Retained earnings per share 3

Dividend % Vs. Dividend Payout ratio Vs. Dividend yield %

PV Ratio [Proﬁt Volume Ratio] aka Contribution Ratio

BEP ( in Value ) = BEP units x SP pu

Suppose actual sales qty = 80 units ASQ = 80

Operating Financial Combined

माँ के िलए साड़ी खरीदना है, बहन ादा Fixed Cost के

Situation 1: Situation 2: Situation 3:

Less :VC 25000 30000 15000 18000 4000 5000 6000

Less: Fixed 0 0 10000 10000 20000 20000 20000

DOL 1 times 1 times 3 times 2.25 times ∞ times 5 times 3 times

MOS% calculation explained

we know that % Δ in Sales = % Δ in Contribution (it’s a fact)

New Contr - Contr Since Increase / Decrease in EBIT ₹ = Inc/Dec in

Derivation of DOL = 1/ MOS %

Actual Sales - Break even Sales

Actual Sales - Break even Sales PV Ratio

Actual Sales x PV Ratio - BES x PV Ratio

Eg. Let’s say, Total capital Requirement = ₹ 10,00,000

there are three ways to ﬁnance the same

Let's say , EBIT is ₹ 1,00,000 under all three Situation

EBT 1,00,000 120000 50000 70000 80000 100000

Less: Taxes @30% 30000 36000 15000 21000 24000 30000

EAT 70000 84000 35000 49000 56000 70000

Less: Pref. Div - - - - 48000 48000

Degree of Financial Leverage

If both Debt & Preference exists

Deﬁnition of Financial leverage :

Operating BEP Vs. Financial BEP

Operating BEP is a level of sales Financial BEP is a level of EBIT at which

DOL = 1.5 % Δ in EAES

ROCE (Return on Capital Employed) Vs. ROE (Return on Equity)

Prepare Income Statement & Calculate ROCE & ROE

Less : Intt on Debt [12% x ₹ 4,00,000] 48,000

Less : Taxes @ 30 % (say) 30,600

EAT or EAES 71,400

Q. Calculate After - tax ROCE in the above case ?

Asset Turnover Ratio

PE Ratio i.e. Price to earnings Ratio

Remember, MP = PE Ratio x EPS

Capital Gearing Ratio

Operating Income ratio Vs. Operating Cost Ratio

EBIT or Operating income Total Operating Cost

Financial Leverage as a ‘Double Edged sword’ or Should we employ debt ?

When should company employ preference share capital ?

Then Unfavorable leverage

Selection of Financing Plans

Two ways to select Financing Alternatives

Proﬁt Maximization Wealth Maximization

Situation 1: 100 % funding by Equity

EBIT 120000 EBIT

EBT 120000 120000

Situation 2: When Debt - Equity mix is used

EBT 80000 56000