Paper 20

RTP_Final_Syllabus 2012_Dec‘2014
Paper – 20: Financial Analysis & Business Valuation
SN – 1 [Financial Modeling for Project Appraisal]
Question 1.
(a) A company is considering the following investment projects:
Projects Cash Flows (`)
C0 C1 C2 C3
W (-10,000) +10,000
X (-10,000) +7,500 +7,500
Y (-10,000) +2,000 +4,000 +12,000
Z (-10,000) +10,000 +3,000 +3,000
(i) Rank the projects according to each of the following methods: (I) Payback, (II) ARR, (III)
IRR and (IV) NPV, assuming discount rates of 20 and 30 percent.
(ii) Assuming the projects are independent, which one should be accepted? If the projects
are mutually exclusive, which project is the best?
Answer:
(i) (I) Project Cumulative Cash Inflows:
Amount in (`)
Years W X Y Z
1 10,000 7,500 2,000 10,000
2 15,000 6,000 13,000
3 18,000 16,000
Cash Outflows:
W X Y Z
Cash Outflows (`) (10,000) (10,000) (10,000) (10,000)
Computation of Payback Period:

W X Y Z
Pay Back Period 2,500 4,000
= 1 year 1 years + 7,500 2 years + 12,000 = 1 year

= 1.33 years = 2.33 years
(II)
(CFAT - Depreciation) x 1/ No. of years
ARR =
Average investment
(` 10,000 - ` 10,000)1/1
Project W: 1
= 0%
(` 10,000)
2
(` 15, 000 - ` 10, 000)1/ 2 ` 2, 500
Project X : 1
=  50%
(` 10, 000) ` 5, 000
2
Academics, The Institute of Cost Accountants of India (Statutory Body under an Act of Parliament) Page 1
(` 18, 000 - ` 10, 000)1/ 3 ` 2,667

Project Y : 1
 = 53%
(` 10, 000) ` 5, 000
2
(` 16, 000 - ` 10, 000)1/ 3 ` 2, 000
Project Z : 1
 = 40%
(` 10, 000) ` 5, 000
2
(III) IRR
Project W: The net cash proceeds in year 1 are just equal to investment. Therefore, r = 0%
Project X: This project produces an annuity of ` 7,500 for two years. Therefore, the
required PVAF is: `10,000/`7,500 = 1.33
This factor is found under 32% column. Therefore, r = 32%
Project Y: Since cash flows are uneven, the trial and error method will be followed. Using
20% rate of discount the NPV is + ` 1,390. At 30% rate of discount, the NPV is – ` 634. The
true rate of return should be less than 30%. At 27% rate of discount it is found that the NPV
is – ` 90 and at 26% + ` 108. Through interpolation, we find r = 26.5%.
Project Z: In this case also by using the trial and error method, it is found that at 37.6% rate
of discount NPV becomes almost zero. Therefore, r = 37.3%.
(IV) NPV
Project W:
At 20% - `10,000 + `10,000 x 0.833 = - ` 1,670
At 30% - `10,000 + `10,000 x 0.769 = - ` 2,310
Project X:
At 20% - `10,000 + `7,500 (0.833 + 0.694) = + ` 1,453
At 30% - `10,000 + `7,500 (0.769 + 0.592) = + ` 208
Project Y:
At 20% - `10,000 + ` 2,000 x ` 0.833 + ` 4,000 x 0.694 + `12,000 x 0.579 = + ` 1,390
At 30% - `10,000 + ` 2,000 x ` 0.769 + ` 4,000 x 0.592 + `12,000 x 0.455 = - ` 634
Project Z:
At 20% - `10,000 + `10,000 x 0.833 + ` 3,000 (0.694 + 0.579) = +` 2,149
At 30% - `10,000 + `10,000 x 0.769 + ` 3,000 (0.592 + 0.455) = + ` 831
The projects are ranked as follows according to the various methods:
Ranks
Project PBP ARR IRR NPV (20%) NPV (30%)
W 1 4 4 4 4
X 2 2 2 2 2
Y 3 1 3 3 3
Z 1 3 1 1 1
(ii) Payback and ARR are unsound methods for choosing between the investment projects.
Between the two DCF investment criteria, NPV and IRR, NPV gives consistent results. In the
present case, except Project W all the three projects should be accepted if the discount rate
is 20%. Only Projects X and Z should be undertaken if the discount rate is 30%.
If it is assumed that the projects are mutually exclusive, then under the assumption of 30%
discount rate, the choice is between X and Z (W and Y are unprofitable). Both criteria IRR
and NPV give the same results Z is the best. Again under the assumption of 20% discount
rate, ranking according to IRR and NPV is same. In the both cases, project Z should be
accepted.
(b) ―A typical financial model comprises of the Income statement, Balance Sheet and Cash
Flow.‖ — Describe the need and importance of the financial models in this respect.
Answer:
Financial Model – Need and Importance:
• Financial modeling supports management in making important business decisions.

• It involves the quantification of the potential impact of decisions on the profit and loss
account, balance sheet and cash flow statements.
• Through financial models, managers can determine the outcome of a proposal before even
its execution and rely on a rational and comprehensive justification for their decisions.
 Moreover, these models enable managers to study different options and scenarios without
imposing any risk on the business.
 To avoid the common pitfalls related to financial modeling, designers should follow five basic
principles. They should make sure that the model satisfies its objectives, maintain model
flexibility, take inflation into consideration, present the model clearly and interestingly, and
measure outcome.
Question 2.
(a) Lily Ltd. purchased a machine five years ago. A proposal is under consideration to replace it
by a new machine. The life of the machine is estimated to be 10 years. The existing machine
can be sold at its written – down value.
As a Cost Accountant of the company you are required to submit your recommendation
based on the following information:
Existing Machine New Machine

Initial Cost (`) 25,000 50,000
Machine hours p.a. 2,000 2,000
Wages per running hour (`) 1.25 1.25
Power per hour 0.50 2.00
Indirect Material p. a. (`) 3,000 4,500
Other expenses p. a. (`) 12,000 15,000
Cost of materials per unit (`) 1 1
Number of units produced per hour 12 18

Selling price per unit (`) 2 2
Interest to be paid at 10% on fresh capital
invested.
Answer:
Comparative Profitability Statement
Existing Machine New Machine
` ` ` `
Sales
(2,000 × 12) × `2 48,000 -
(2,000 × 18) × `2 - 72,000
48,000 72,000
Less: Cost of Materials (2,000 × 12) × ` 1 24,000
(2,000 × 18) × ` 1 36,000
Wages ( 2,000 × 1.25) 2,500 2,500
Power (2,000 × 0.50) 1,000
(2,000 × 2) 4,000
Indirect materials 3,000 4,500
Other Expenses 12,000 15,000
Depreciation 2,500 5,000
Interest on Capital @ 10% on (` 50,000 – ` 12,500) - 3,750
45,000 70,750
Profit 3,000 1,250
Selling Price per unit 2.00 2.00
Cost Price per unit (` 45,000 ÷ 24,000) 1.88
(` 71,250 ÷ 36,000) 1.97
0.12 0.03
Hence, the existing machine should be continued since its per unit profit is more than the new
machine.
(b) Financial Modelling follows a step-by-step procedure on which it is build up. State the
process.
Answer:
Generally following process is used for preparing Financial Model:
(i) Gather historic financial statements and analyze it.
(ii) Compute Ratios from Historic Financial Statements to develop some of the mechanical
assumptions about revenue, fixed & variable cost, working capital.
(iii) Need detailed discussions with all the departments of the organization. i.e. Productions,
Sales, Commercial & Logistics, Finance.
(iv) Develop Revenue, Expense, working capital and capital expenditures by working
through value drivers.
(v) Work through the Income Statement, then the Balance Sheet, then the Cash Flow
Statement and finalize Balance sheet to check, for forecast years.
(vi) Valuation, sensitivity analysis and presentation.
SN – 2 [The Analysis of the Statement of Shareholders‘ Equity]
Question 3.
(a) On the basis of the following figures derived from the Accounts of Gold Ltd., prepare a report
on the level of efficiency of financial and operational management of the company:
Years Capital Turnover Ratio Net Profit on Sales (%) ROI (%) Current Ratio
1 1.0 8 8 6.0
2 2.0 10 20 4.0
3 3.0 11.5 34.5 2.0
4 4.5 14 63 0.5
Answer:
Year 1:
1. Company's Capital Turnover ratio is one, which indicates that the Company is able to
generate sales just one time in relation to its capital employed.
2. The Net Profit ratio is a modest 8%, which reflects a low level of profitability.
3. Since the Company's Net Profit ratio is only 8% & it is able to generate sales equal to just 1
time that of capital employed, consequently its ROI is also a meager 8%.
4. The Current Ratio is far away from being ideal, indicating the underutilization & ineffective
management of current assets.
Year 2:
1. The Company has now able to double its sales in relation to its capital employed, which is
worth notice.
2. Even, its Net Profit ratio has increased slightly by 2%, which is due to increase in sales as
mention in point (1).
3. The combined effect of increase in Capital Turnover Ratio & Net Profit ratio has magnified
the Company's ROI from 8% to 20%, thus fostering Company's investment avenue.
4. The Current Ratio has improved in relation to the past year but still there is ineffective
utilization of Current Assets.
Year 3:
1. The Company is on a good path leading towards development, which is clearly reflective
from its Capital Turnover Ratio, as it has been able to increase its sales, equal to thrice of its
capital employed as compared to twice in the past year.
2. Increase in sales & operating efficiency for proper utilization of current assets has had a
positive effect/impact on Net Profit Ratio, which is gradually improving.

3. ROI of the Company has magnified manifold due to dual effect of sharp increase in Capital
Turnover Ratio & Net Profit Ratio.
4. The short-term solvency position of Company is now ideal (2:1). Current assets are being
effectively managed & utilised & there is a good amount of cover for the current debts.
Year 4:
1. The utilisation of Capital to generate turnover has improved from 3 times in the last year to
4.5 times in the current year. This shows high efficiency of management in utilization of its
long term funds.
2. The Net Profit Ratio is improving step by step & now it has reached upto the level of 14%.
3. ROI of the Company has almost doubled its self in comparison to last year. This is due to
better utilisation of Capital employed by the management.
4. The short-term solvency position is alarming. It is quite surprising to see that the company is
using Current Liabilities to finance its Fixed Assets as can be seen from the ratio that Current
Assets are only half of that of Current Liabilities. It demands immediate attention at the
company which is short of working capital and the Company is not in a position to pay its
current liabilities from its Current Assets. If the short-term creditors are to be paid immediately,
the Company may have to sell its long-term investments.
(b) Compute the Liquid Ratio from the following information for the year ended 31 st March 2014
and also interpret the result:
Particulars `
Land and Building 55,000
Plant and Machinery 40,000
Stock 30,000
Debtors 42,000
Bills receivable 25,000
Prepaid Expense 5,000
Cash at bank 15,000
Cash in hand 10,000
Creditors 25,000
Outstanding Salary 5,000
Bank Overdraft 3,000
Bills payable 4,000
Proposed Dividend 6,000
Long – Term Liabilities 46,000
Provision for Bad debts 2,000
Answer:
Components of Liquid Assets and Liquid Liabilities
Liquid Assets ` `
Debtors 42,000
Less: Provision for Bad Debts 2,000 40,000
Bills receivable 25,000
Cash at bank 15,000
Cash in hand 10,000
90,000
Liquid Liability ` `
Creditors 25,000
Outstanding Salary 5,000
Bills payable 4,000
Proposed dividend 6,000
40,000
Liquid Assets `90,000

Liquid ratio =  = 2.25: 1.
Liquid Liabilities ` 40,000
Interpretation and Significance:
It can be stated that liquid ratio is, practically, the true test of liquidity. It measures the capacity
of the firm to pay-off its liabilities as soon as they become mature for payment. Thus, a high liquid
ratio indicates that the firm is quite able to pay-off its current obligations without difficulty,
whereas, a low liquid ratio will create an opposite situation i.e. it is not possible for the firm to
pay-off its current obligations, which indicates the liquidity position is not sound at all.
Although it is stated that a 1:1 ratio is considered as good but the same cannot safely be
concluded since if percentage of debtors is more than other liquid assets, and if the same is not
realised (if the debtors do not pay), it indicates that problem will arise to liquidate current
obligations although the normal liquid ratio is maintained. Similarly, a low liquid ratio does not
ensure a bad liquidity position since stocks are not absolutely non-liquid in character. Thus, a
high liquid ratio does not always prove a satisfactory liquidity position if the firm has slow—paying
customers, and vice versa in the opposite case i.e. a low liquid ratio may ensure a sound liquidity
position if the firm has fast-moving stocks.
Question 4.
(a) The Balance Sheets (Extracts) of Centak Ltd. for the last 3 years read as below:
Sources ` in lakhs
31.03.12 31.03.13 31.03.14
Shareholders‘ Fund:
Share Capital (shares of ` 10) 2,000 2,000 3,000
Securities Premium 1,500 1,500 500
Reserves (after 10% dividend) 1,500 1,700 1,800
Non-current Liabilities:
Long Term Loan 1,000 800 800
6,000 6,000 6,100
Represented by:
Non-current Assets:
Fixed Assets 2,000 2,500 3,000
Less: Depreciation (700) (950) (1,250)
1,300 1,550 1,750

Capital Work-in-progress 800 900 700
Investments 200 200 200
2,300 2,650 2,650
Current Assets:
Debtors 1,700 1,800 1,850
Stocks 1,800 1,900 2,400
Cash and Bank 500 500 500
Others Current Assets 400 600 1,400
4,400 4,800 6,150
Current Liabilities (700) (1,450) (2,700)
3,700 3,350 3,450
Sales 3,900 4,000 5,000
Required: Calculate for the year 2012-13 and 2013-14:

(i) Fixed Assets Turnover Ratio, (ii) Stock Turnover Ratio, (iii) Debtors Turnover Ratio in terms of
number of days' sales assuming 360 days in a year, (iv) Earnings per share.
Briefly comment on the performance of the company.
Answer:
Calculation of Ratios
(` in lakh)
2012-13 2013-14
(i) Fixed Assets Turnover ratio
Sales ` 4,000 ` 5,000
= 2.81 = 3.03
Average Fixed Assets ` 1,425 ` 1,650
(ii) Stock Turnover Ratio
Sales ` 4,000 ` 5,000
= 2.16 = 2.33
Average Inventory ` 1,850 ` 2,150
(iii) Debtors Turnover Ratio in terms of number of
day‘s sales
Average Receivable
Opening Debtors  closing Debtors ` 1,700  ` 1,800 ` 1,800  ` 1,850
=
2 2 2
= ` 1,750 = ` 1,825
Average Receivables ` 1,750 ` 1,850
 No.ofday sina year  360  360
Credit Sales ` 4,000 ` 5,000
= 157.5 = 133.2
(iv) Earnings Per share
Increase in reserves during the year ` 200 ` 100
Add: Dividends ` 200 ` 300
Total Earnings for the year (after tax) ` 400 ` 400

Earnings attributable to equity shareholders ` 400 lakhs ` 400 lakhs
= =2 = = 1.33
Number of Equity Shares 200 lakhs 300 lakhs
Comments:
Fixed Assets turnover ratio is a measure of the efficiency or use of fixed assets—a high ratio
indicates a high degree of efficiency in asset utilisation and a low ratio reflects inefficiency in the
use of assets. In 2013-14, the ratio has increased from 2.81 to 3.03 showing better efficiency in the
utilisation of fixed assets.
Similarly better turnover ratios in 2013-14 as compared to 2012-13, relating to current assets —
inventory and receivables indicate improved management of current assets. However inventory
holding period is very high; its comparison with the industry average may actually reveal the
degree of efficiency in inventory management.
EPS has declined; perhaps one of the reasons is increase in number of shares on account of
utilisation of securities premium account for issuing fully paid bonus shares. While the net profit
ratio has declined, the dividend payout ratio on share capital has remained the same in 2013-14
as compared to 2012-13.
Note:
(i) In the absence of information about the cost of sales, stock turnover ratio has been
calculated on the basis of sales.
(ii) For the purpose of calculating debtors‘ turnover ratio, the entire sales have been assumed to
be made on credit.
(b) The capital of E. Ltd. is as follows:

`
9% Preference shares, ` 10 each 3,00,000
Equity shares of ` 10 each 8,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent), ` 2,70,000; Depreciation, ` 60,000;
Equity dividend paid, 20 per cent; Market price of equity shares, ` 40.
You are required to compute the following, showing the necessary workings:
(i) Dividend yield on the equity shares.
(ii) Cover for the equity dividends.
(iii) Earnings per shares.
(iv) Price-earnings ratio.
Answer:
Dividend per share ` 2 [0.20 x ` 10]
(i) Dividend yield on the equity shares: = x 100 = x 100
Market price per share ` 40
= 5 per cent
(ii) Cover for the equity dividends =

Profit after taxes - Preference share dividend
Dividend payable to equity shareholders at current rate of ` 2 per share
` 2,70,000 - ` 27,000
= = 1.52 times
` 1,60,000 [80,000 shares x ` 2]
Earnings available to equity shareholders ` 2,43,000

(iii) Earnings per equity share: = =
Number of equity shares outstanding 80,000
= ` 3.04 per share
Market price per share ` 40

(iv) Price-earning (P/E) ratio = = = 13.2 times
Earnings per share ` 3.04
Question 5.
(a) The current assets and working capital of a firm are ` 40,000 and ` 25,000 respectively. How
much can the firm borrow on a short-term basis to maintain its current ratio of 1.50?
Answer:
Current Assets (CA) ` 40,000
Working Capital (WC) ` 25,000
Therefore, Current Liabilities (CA – WC) ` 15,000
Let x = Amount to be borrowed to keep the current ratio at 1.50.

Then,
40,000  x
 1.50
15,000  x
Solving the equation, we get x = ` 35,000. Hence the amount of short-term loan would be `
35,000.
(b) Rowdy Company‘s equity shares are being traded in the market at ` 54 per share with a
price-earnings ratio of 9. The Company‘s dividend payout is 75%. It has 1,00,000 equity
shares of ` 10 each and no preference shares. Book value per share is ` 47.
Calculate: (i) Earnings per share, (ii) net income, (iii) Dividend yield, and (iv) return on equity.
Answer:
The calculation of ratios of Rowdy Company as follows:
(i) Earnings per Share:
Price/ Earnings Ratio (given) = 9
M arketPr ice
P/E ratio =
EPS
` 54
9=
EPS
9 x EPS = `54
EPS = `54/9 = `6
(ii) Net Income = EPS x No. of shares

= EPS x No. shares
= ` 6 x 1,00,000 Equity shares = `6,00,000
Dividend per share

(iii) Dividend Yield =
M arketprice per share
Net income x Dividend payout
Dividend per share =
No. of equityshares
= `6,00,000 x 0.75 = `4.50
1,00,000 Equity shares
Dividend yield = ` 4.50 x100 = 8.33%
` 54
net Income
(iv) Return on Equity =
Equity
= ` 6, 00, 000
x100 = 11.11% (based on market price)
` 54 x1, 00, 000 Equity shares
= `6,00,000
x100 = 12.77% (based on book value)
` 47 x 1,00,000Equity shares
SN – 3 [The Analysis of the Balance Sheet and Income Statement]
Question 6.
(a) The summarized results of operations of Big Ltd. are given below:
For the year ended 31st March,

2013 2014
(` in lakh) (` in lakh)
Sales 120 129.6
Material Cost of sales 80 91.1
Variable overheads 20 24.0
Fixed Expenses 14 18.5
During 2013-14, average prices increased over the previous year by:
(i) 20% in the case of sales.
(ii) 15% in the case of materials.
(iii) 10% in overheads
Analyse the reasons for variations in profit.
Answer:
Statement showing net profit for the year ended 31st March, 2013 and 2014
(` in lakh)
2012-13 2013-14
` ` ` `
Sales 120.0 129.6
Less: Material Cost 80.0 91.1
Variable overheads 20.0 100.0 24.0 115.1
Gross Profit 20.0 14.5
Fixed Expenses 14.0 18.5
Net Profit/(Net Loss) 6.0 (4.0)
20 2
Percentage of gross profit in 2012-13 = x100 = 16 %
120 3
Statement showing Factor wise contribution to increase in Profit in 2013-14 over 2012-13
(` in Lakh)
(`) (`)
(i) Increase in profit due to increase in selling price:
Actual Sales of 2013-14 129.6
100 
Less: Sales of 2013-14 at 2012-13 price
120 x129.6 108.0
21.6
(ii) Decrease in profit due to decrease in volume:
Sales in 2013-14 at 2012-13 price 108.0
Less: Sales in 2012-13 120.0
Decrease in sales due to volume decrease 12.0
12.0 
Percentage of volume decrease =
 120 x100 = 10% 
2
Loss of Gross profit at 16 % on ` 12.0 lakh
3 (2.0)
(iii) Decrease in profit due to increase in usage of material:
Cost of material in 2012-13 80.00
Less: Decrease in volume (10%) 8.00
Permitted material cost of 2013-14 at 2012-13 price 72.00
100  (7.22)
Actual material cost of 2013-14 at 2012-13 price
115 x91.1 79.22
(iv) Decrease in profit due to increase in material price:

Actual material cost of 2013-14 at 2012-13 price 79.22
Less: Actual material cost of 2013-14 91.10 (11.88)
(v) Effect on profit due to variable overhead efficiency variance:
Variable overhead in 2012-13 20.00
Expected decrease due to volume decrease by 10% in 2013-14 2.00
Permitted variable overhead in 2013-14 at 2012-13 price 18.00
100 
Actual variable overhead in 2013-14 at 2012-13 price
110 x 24.00 21.82 (3.82)
(vi) Effect on profit due to variable overhead price variance:

Actual variable overhead in 2013-14 at 2012-13 price 21.82
Actual variable overhead in 2013-14 24.00 (2.18)
(vii) Effect on profit due to Fixed overhead volume variance:
Fixed overhead in 2012-13 14.00
100 
Actual fixed overhead in 2013-14 at 2012-13 rate
110 x 18.5 16.82 (2.82)
(viii) Effect on profit due to fixed overhead price variance:

Fixed overhead in 2013-14 at 2012-13 price 16.82
Actual fixed overhead in 2013-14 18.50 (1.68)
Decrease in Net Profit in 2013-14 over 2012-13 ` (-4.00 – 6.00) (10.00)
(b) Calculate the trend percentage from the following figures of Tenta Ltd. and interpret them.
Year Sales Revenue (` ‗000) Inventory (` ‗000) Earnings before Tax (` ‗000)
2009-10 1,995 820 325
2010-11 2,390 910 422
2011-12 2,805 940 478
2012-13 3,140 1,055 549
2013-14 3,650 1,368 699
Answer:
The trend value of an accounting number of current years will be calculated as below:
Tenta Ltd.
Trend Percentage
(Base year: 2009-10)
Year Sales Revenue Inventory Earnings before Tax
Amount (` in Trend Amount (` in ‗000) Trend Amount (` in ‗000) Trend Value
‗000) Value Value
2009-10 1,995 100.0 820 100.0 325 100.0
2010-11 2,390 119.8 910 111.0 422 129.8
2011-12 2,805 140.6 940 114.6 478 147.1
2012-13 3,140 157.4 1,055 128.7 549 168.9
2013-14 3,650 183.0 1,368 166.8 699 215.1
Interpretation:
1. The sales increased in all the years over the period of study. Particularly, in the last year of the
period of the study, the increase in sales was quite satisfactory. While comparing to 100 in
the base year 2009-10, the percentage jumped from 157.4 in 2012-13 to 183.0 in 2013-14.
2. It is being noted that over the first four years of the period of study inventory increased more
or less consistently along with sales. But in the last year, inventory jumped to 166.8% from
128.7% of just previous year as compared to 100 in the base year 2009-10. Excessive inventory
is not desirable from the profitability point of view. So further investigation is required to see
whether the purchase of material was more than what was required in the last year of the
period of study or whether slow moving items got accumulated.
3. Profit before tax has increased very satisfactorily over the period of study. It was more than
doubled just in five years period. Particularly in the last year the comparative increase was
very impressive as compared to others years.
The analysis of trend percentages of sales revenue, inventory and earnings before tax reveals
that Tenta Ltd. expanded in all directions in just five years time. It should be further noted that
the profit increased more than the sales revenue in all the years. It indicates that the company
exercised proper control over cost of goods sold. So it can be concluded that the performance
of the company was satisfactory.
Question 7.
(a) The following informations are available from the book of MP Ltd. as on 31st March 2014:
Balance Sheet (Extracts)

as at 31st March, 2014
Equities & Liabilities ` Assets `
Shareholders‘ Fund: Non-current Assets:
Equity Share Capital @ ` 10 each 1,00,000 Land & Building (Net) 3,50,000
Reserves & Surplus 50,000 Other Fixed Assets (Net) 1,80,000
Non-current Liabilities: Current Assets:
10% Debentures 3,00,000 Stock 60,000
12% Long Term Loan 1,00,000 Debtors 40,000
Current Liabilities: Cash & Bank 20,000
Creditors 50,000
Bank overdraft 50,000
6,50,000 6,50,000
Additional Information:
(i) Income Tax rate is 30%.
(ii) Net Sales of MP Ltd. during 2013-2014 is ` 7,80,000.
(iii) EPS as on 31st March, 2014 is ` 0.975.
(iv) Price Earnings Ratio is 9.
Using Altman‘s function, calculate Z score of MP Ltd. and interpret the result.
Answer:
The Z score of multivariate model as developed by Altman is —
Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5
Where, Z = Overall discriminant score
Working Capital
X1 =
Total Assets
Working Capital = Current Assets – Current Liabilities
= ` (60,000 + 40,000 + 20,000) – ` (50,000 + 50,000)
= ` 20,000
Total Assets = Fixed Assets + Current Assets
= ` 6,50,000
` 20,000
 X1 = = 0.03077, i.e., 3.077%
`6,50,000
Retained Earnings ` 50,000

X2 = = = 0.07692,i.e.,7.692%
Total Assets 6,50,000
Earnings before Interest and Tax (EBIT)

X3 =
Total Assets
Computation of EBIT:
`
Total earnings available to Equity Shareholders 9,750
[EPS x No. of Equity Shares, i.e., ` 0.975 x 10,000]
0.30
Tax added back: @ 30%, i.e., x 9,750 4,179
(1- 0.30)
13,929
Earnings Before Tax (EBT)
Interest added back:
10
Debenture Interest = ` 3,00,000 x = ` 30,000
(100)
12
Long Term Loan Interest = ` 1,00,000 x =` 12,000
(100) 42,000
EBIT 55,929
` 55,929
 X3 = = 0.0860, i.e., 8.60%
`6,50,000
Market Value of Equity

X4 =
Book Value of Total Debt
Market value of each equity share = Price Earnings Ratio x EPS
= 9 x 0.975 = ` 8.775
So, total market value of equity = ` 8.775 x 10,000 = ` 87,750
` 87,750
X4 = = 0.1755, i.e.17.55%
`(3,00,000 + 1,00,000 + 50,000 + 50,000)
Sales `7,80,000
X5 =  = 1.2 times
Total Assets ` 6,50,000)
Putting the values of all variables as above in the discriminant function, we get —
Z = (1.2 x 0.03077) + (1.4 x 0.07692) + (3.3 x 0.0860) + (0.6 x 0.1755) + (1 x 1.2)
Or, Z = 0.0369 + 0.1077 + 0.2838 + 0.1053 + 1.2000
Or Z = 1.7337
According to Altman, if a firm‘s Z score is less than 1.81, it would be a bankrupt firm. So, MP Ltd.
may be considered as bankrupt as its Z score is 1.7337.
(b) A ` 1,000 par value bond bears a coupon rate of 14 percent and matures after 5 years.
Interest is payable semi-annually. Compute the value of the bond if the required rate of
return is 16 percent. Given PVIFA8%, 10 years = 6.710 and PVIF8%, 10 years = 0.463.
Answer:
In this case the number of half yearly period is 10, the half-yearly interest payment is ` 7, and the
discount rate applicable to a half-yearly period is 8 percent. Hence the value of the bond is:
10
7 1000
V t

t 1 (1.08 ) (1 .08)10
= 7 (PVIFA8%, 10 years) + 1,000 (PVIF8%, 10 years)
= 7 (6.710) + 1,000 (0.463)
= 46.97 + 463
= ` 509.97
Question 8.
The following are the Balance Sheet of Maharaj Ltd. as on 31.03.13 and 31.03.14:-
31.03.13 31.03.14
(`) (`)
Current Assets:
Cash and Bank Balance 23,600 2,000
Debtors 41,800 38,000
Inventory 32,000 26,000
Other Current Assets 6,400 2,600
(A) 1,03,800 68,600
Non-current Assets:
Fixed Assets:
Land and Building 54,000 34,000
Plant and Machinery 62,000 1,57,200
Furniture 5,800 9,600
(B) 1,21,800 2,00,800
Non-current investment (C) 9,200 11,800
Total assets (A + B + C) 2,34,800 2,81,200
Current Liabilities (D) 52,400 25,400

Non-current Liabilities:
Long-term debt (E) 40,000 65,000
Shareholders‘ Fund :
Equity share capital 80,000 1,20,000
Reserve and surplus 62,400 70,800
(F) 1,42,400 1,90,800
Total equities & liabilities (D+E+ F) 2,34,800 2,81,200
Prepare Comparative Balance Sheet and study its financial position.
Answer:
Comparative Balance Sheet of Maharaj Ltd. as on 31.03.2012 and 31.03.2013

31.03.12 31.03.13 Amount of Percentage
(`) (`) increase (+) increase (+)
or decrease or decrease
(-) (-)
(`)
Current Assets :
Cash and Bank Balance 23,600 2,000 (–) 21,600 (–) 91.5
Debtors 41,800 38,000 (–) 3,800 (–) 9.1
Inventory 32,000 26,000 (–) 6,000 (–) 18.8
Other Current Assets 6,400 2,600 (–) 3,800 (–) 59.4
(A) 1,03,800 68,600 (–) 35,200 (–) 33.9
Non-current Assets:
Fixed Assets :
Land and Building 54,000 34,000 (–) 20,000 (–) 37
Plant and Machinery 62,000 1,57,200 (+) 95,200 (+) 153.5
Furniture 5,800 9,600 (+) 3,800 (+) 65.5
(B) 1,21,800 2,00,800 (+) 79,000 64.9
Non-current investment (C) 9,200 11,800 (+) 2,600 (+) 28.3
Total assets (A + B + C) 2,34,800 2,81,200 (+) 46,400 (+) 19.8
Current Liabilities (D) 52,400 25,400 (–) 27,000 (–) 51.5

Non-current Assets:
Long-term debt (E) 40,000 65,000 (+) 25,000 (+) 62.5
Shareholders‘ Fund:
Equity share capital 80,000 1,20,000 (+) 40,000 (+) 50.0
Reserve and surplus 62,400 70,800 (+) 8,400 (+) 13.5
(F) 1,42,400 1,90,800 (+) 48,400 (+) 34
Total liabilities and capital (D + E + F) 2,34,800 2,81,200 (+) 46,400 (+) 19.8
Comparative balance sheet shows the balance of different assets and liabilities of two different
periods of same company and shows absolute increase / decrease of each item in 31.03.2014
over 31.03.2013 and also shows the percentage change. Interpretations of these changes are as
follows:-
(i) The current assets of Maharaj Ltd. have decreased by `35,200 in the year 2013-14 over
2012-13, whereas current liabilities have decrease by `27,000 only. But it has no adverse
effect on short term liquidity or on current ratio because current assets have decreased
by 33.9% and current liabilities have decreased by 51.5%.
(ii) Cash at Bank have decreased by 91.5%. It implies an adverse cash position of the
company. The company may face problem in meeting its short-term obligations.
(iii) The long-term debt of the company has increased by 62.5%, whereas its owners‘ equity
has improved by 34% only. It implies that the financial risk (in terms of dependency on
outsiders and in terms of contractual obligation) associated with the company has
increased significantly during the period under study.
(iv) There has been a substantial increase in the fixed assets by the company. The fixed
assets have increased by ` 79,000 (64.9%). This is mainly due to significant increase in
the plant and machinery of the company. The plant and machinery have increased
by ` 95,200 (153.5%). It indicates a remarkable improvement in the production
capacity of the company during the study period. Such cost of assets have financed
by proprietors fund and long term loan raised. It indicates the long term stability of the
business.
Question 9.
(a) The following are the Profit and Loss Accounts (Extracts) of X Ltd. and Y Ltd., who are
engaged in the same line of business:
(` lakhs)
Particulars X Ltd. for the Y Ltd. for the
year ended year ended
31st March, 31st
2014 December,
2013
Sales 32.00 28.00
Add: Excess of closing stocks over opening stocks 5.00 4.00
37.00 32.00
Less: Raw materials consumed 8.30 7.80
Wages 4.15 3.90
Direct manufacturing expenses 0.90 0.60
Indirect manufacturing expenses 0.30 0.18
Administrative expenses 1.00 0.90
Selling and distribution expenses 0.90 0.90
Depreciation 2.50 2.00
Interest 2.00 0.92
20.05 17.20
Profits before tax 16.95 14.80
Other information:
(i) There was an increase of 10% in the price of products with effect from 1st January,
2014.
(ii) Cost of raw materials was increased by 15% from 1st January, 2014.
(iii) X Ltd. follows FIFO method of valuation of its finished goods, whilst Y Ltd. follows Simple
Average method. If X were to accept Simple Average method, its closing inventory
valuation will come down by ` 20,000.
(iv) Y Ltd. follows straight line method of depreciation whilst X Ltd. follows the WDV method.
The difference in depreciation between the two methods in the case of X Ltd. will be `
50,000 excess provision in its books.
(v) Production and sales of the two companies are evenly spread throughout the year.
Prepare a common size statement and interpret the results with appropriate reasons and
working notes.
Answer:
Working Notes:
(1) Smoothening of increase in Sales due to 10% increase in price of products from 1st January
2014.
Let monthly sales of X Ltd. be ‗x‘
9 months sales of X Ltd. = 9x
110
Next 3 months sales X Ltd. = 3 x
100
33x
12 months sales = 9x +
10
33x
9x  = ` 32,00,000
10
99x  33x
= ` 32,00,000
10
123x = ` 32,00,000 × 10
x = ` 3,20,00,000/123
x = ` 2,60,163
Sales before the effect of 10% price increased (`)

Total sales 32,00,000
Less: Sales prior to effect of 10% price increase (12 months × ` 31,21,956
2,60,163)
78,044
say ` 0.78 lakhs
(2) Smoothening of increases in Raw material cost due to 15% increase in cost from 1st January,
2014.
Let monthly Raw material cost of X Ltd. be ‘y’
9 months cost of raw material = 9y
115
3 months cost of raw material = 3 y
110
11.5y
9y + 3 ×
10
34.5y
9y + = ` 8,30,000
10
90y  34.5y
= ` 8,30,000
10
124.5y = ` 8,30,000 × 10
Y = ` 83,00,000/124.5
Y = ` 66,667
Raw Material Cost Before the effect of 15% increase (`)

Total raw material cost 8,30,000
Less: Raw material cost prior to effect of 10% increase (12 months × ` 66,667) 8,00,000
30,000
say ` 0.30 lakhs
Revised Figures of X Ltd. (` lakhs)
(i) Sales = 32-0.78 = 31.22
(ii) Excess of closing stock over opening stock = 5 - 0.20 (Simple Average adjustment)
= 4.80
(iii) Raw material consumption = 8.30 - 0.30 = 8
(iv) Depreciation = 2.50 - 0.50 (SLM adjustment) = 2
Common Size Income Statement as on 31.12.2013

X Ltd. Y Ltd. Variance %
(Y Ltd. - X Ltd.)
` lakhs % ` lakhs %
Sales 31.22 86.67 28.00 87.50
Stock adjustment 4.80 13.33 4.00 12.50
(i) 36.02 100.00 32.00 100.00
Costs:
Raw material consumption 8.00 22.21 7.80 24.38 + 2.17
Wages 4.15 11.52 3.90 12.19 + 0.67
Direct manufacturing expenses 0.90 2.50 0.60 1.88 -0.62
Indirect manufacturing expenses 0.30 0.83 0.18 0.56 -0.27
Administration expenses 1.00 2.78 0.90 2.81 + 0.03
Selling and distribution expenses 0.90 2.50 0.90 2.81 + 0.31
Depreciation 2.00 5.55 2.00 6.25 + 0.70
Interest 2.00 5.55 0.92 2.88 -2.67
(ii) 19.25 53.44 17.20 53.75 + 0.31
Profit before tax (i) - (ii) 16.77 46.56 14.80 46.25 -0.31
Comments:
(1) X Ltd. shows favourable result over Y Ltd. in respect of raw material consumption. This may
be due to liberal credit terms, discounts, favourable material usage variance etc.
(2) X Ltd. shows savings over Y Ltd. in Wages, Administrative expenses and Selling and
distribution expenses.
(3) It appears that X Ltd. expended more on direct and indirect manufacturing expenses, as
compared to Y Ltd.
(4) Higher depreciation charge in respect of Y Ltd. may be due to higher investment in fixed
assets by Y Ltd. X Ltd. is in advantageous position than Y Ltd. as regards investment in Fixed
Assets.
(5) Interest charges of X Ltd. are much higher over Y Ltd. X Ltd. appears to be highly geared
and is subject to leverage risk.
(b) Describe Off-Balance-Sheet Financing.
Answer:
Off-Balance-Sheet Financing:
A form of financing in which large capital expenditure are kept off of a company‘s balance
sheet through various classification methods. Companies will often use off-balance-sheet
financing to keep their debt to equity (D/E) and leverage ratio low, especially if the inclusion of
a large expenditure would break negative debt covenants.
Contrast to loans, debt and equity, which do appear on the balance sheet. Examples of Off-
balance – sheet financing includes joint ventures, research and development partnerships, and
operating leases (rather than purchases of capital equipment).
Operating lease are one of the most common forms of off-balance-sheet financing. In these
cases, the asset itself is kept on the lessor‘s balance sheet and the lessee reports only the
required rental expenses for use of the asset.
This term came into popular use during the Enron bankruptcy. Many of the energy traders‘
problems stemmed from setting up inappropriate off-balance-sheet entities.
SN – 4 [The Analysis of the Cash Flow Statement]
Question 10.
The Balance Sheet (Extracts) of A Ltd. as on 31st March, 2014 is as follows:
Equities & Liabilities ` (‗000) Assets ` (‗000)

Equity Share Capital 6,000 Fixed Assets (at cost) 16,250
8% Preference Share Less: Depreciation written off 5,200 11,050
Capital 3,250 Current Assets:
Reserve & Surplus 1,400 Stock 1,950
Non-current Liabilities: Sundry Debtors 2,600
10% Debentures 1,950 Cash 250
Current Liabilities:
Sundry Creditors 3,250
Total 15,850 Total 15,850
The following additional information is available:

(i) The Stock Turnover Ratio based on cost of goods sold would be 6 times.
(ii) The Cost of Fixed Assets to sales ratio would be 1.4.
(iii) Fixed Assets costing ` 30,00,000 to be installed on 1st April, 2014, payment would be
made on March 31, 2015.
(iv) In March, 2015, a dividend of 7% on equity capital would be paid.
(v) ` 5,50,000, 11% Debentures would be issued on 1st April, 2014.
(vi) ` 30,00,000, Equity shares would be issued on 31st march, 2015.
(vii) Creditors would be 25% of materials consumed.
(viii) Debtors would be 10% of sales.
(ix) The cost of goods sold would be 90% of sales include material 40% and depreciation
5% of sales.
(x) The profit is subject to debenture interest and taxation @ 30%.
Required:
(i) Prepare the projected Balance Sheet as on 31st March, 2015.
(ii) Prepare projected Cash Flow Statement in accordance with AS-3.
Answer:
(1) Working Notes:
` (‗000)
(1) Cost of Fixed Assets b/d on 1.4.14 16,250
(+) Cost of Fixed Assets installed on 1.4.14 3,000
Cost of Fixed Assets used during the year 2014-15 19,250
Cost of Fixed Assets

(2) Cost of Fixed Assets to Sales = 1.4 = Sales
19,250
1.4 = Sales (` ‗000)
Sales = 13,750 (` ‗000)
(3) Debtors = 10% x 13,750 = 1,375 (` ‗000)
(4) Cost of Goods Sold = 90% x 13,750 = 12,375 (` ‗000)
COGS
(5) Stock Turnover Ratio =

Average Stock
12,375
6=
Average Stock(` ‗000)
Average Stock = 2,062.5 (` ‗000)
Opening Stock + Closing Stock
Average Stock = 2
1,950 + Closing Stock

2,062.5 = 2 (` ‗000)
Closing Stock = 4,125 – 1,950 = 2,175 (` ‗000)
(6)
(` ‗000)
Interest on 10% Debentures = 1,950 x 10% = 195
Interest on 11% Debentures = 550 x 11% = 60.5
Total Interest 255.5
(7) Raw Material Consumed = 13,750 x 40% = 5,500 (` '000) Depreciation = 5% x 13,750 = 687.5 (`
'000)
(8) Creditors = 25% × 5,500 = 1,375 (` ‗000)
(9)
GP (10% x 13,750) 1,375
Less: Interest (255.5)
EBT 1,119.50
Less: Income Tax (30%) (335.85)
EAT 783.65
Less: Preference dividends (8% x 3,250) (260)
Earnings Available for Equity Shareholders 523.65
Less: Equity Dividends (420.00)
Retained Earnings 103.65
Note: It is being assumed that tax has been paid.

(i)
Projected Balance Sheet (31st March 2015) (` ‗000)
Equities & Liabilities (` ‗000) Assets (` ‗000)
Equity Share Capital 9,000 Fixed Assess (at cost) 19,250
8% Preference Share Capital 3,250 Less: Depreciation Written off (5,887.5)
Reserves & Surplus 1,503.65 Fixed Assets (Net) 13,362.5
Non-current Liabilities: Current Assets:
10% Debentures 1,950 Stock 2,175
11% Debentures 550 Sundry Debtors 1,375
Current Liabilities: Cash 716.15
Sundry Creditors 1,375
17,628,65 17,628.65
(ii) Cash Flow Statement

(` ‗000)
(A) Cash Flows from Operating Activities:
Net Profit Before Tax 1,119.50
Add: Interest 255.50
Add: Depreciation 687.50
Operating Profits before Working Capital changes 2,062.50

Less: Reduction in Sundry Creditors (1,875)
Less: Increase in Stock (225)
Add: Reduction in Sundry Debtors 1225
Cash Flows from Operating Activity before Tax 1187.50
Less: Tax Paid (335.85) 851.65
(B) Cash Flows from Investing Activities:
Less: Purchase of Fixed Assets (3,000) (3,000)
(C) Cash Flows from Financing Activities
Issue of Equity Share Capital 3,000
Add: Issue of 11% Debentures 550
Less: Interest Paid (255.5)
Less: Dividends Paid (680) 2614.5
Net Increase in Cash & Cash Equipments 466.15
Add: Opening Cash & Cash Equipments 250
Closing Cash & Cash Equipments 716.15
Question 11.
Pawan Ltd.
The summarized Balance Sheets of the company as on 31st March 2013 and 2014 were:
Equities & Liabilities 2013 2014 Assets 2013 2014
` ` ` `
Issued Share Freehold Property at
Capital 1,00,000 1,50,000 cost 1,10,000 1,30,000
Securities Premium 15,000 35,000 Plant & Machinery at
Profit & Loss A/c 28,000 70,000 cost 1,20,000 1,51,000
Non-current Less: Provision for
Liabilities: Depreciation 45,000 54,000
Debentures 70,000 30,000 75,000 97,000
Current Liabilities: Furniture & Fixture at
Bank Overdraft 14,000 --- cost 24,000 29,000
Creditors 34,000 48,000 Less: Provision for
Proposed Depreciation 13,000 15,000
Dividends 15,000 20,000 11,000 14,000
Current Assets:
Stocks 43,000 44,000
Debtors 37,000 51,000
Bank --- 16,000
Premium on
Redemption of
debentures --- 1,000
2,76,000 3,53,000 2,76,000 3,53,000
The following additional information is relevant:
(i) There had been no disposal of freehold property in the year.

(ii) The Machine tool which has cost ` 8,000 and in respect of which ` 6,000 depreciation
has been provided, was sold for ` 3,000, and fixtures, which had cost ` 5,000 in respect
of which depreciation of ` 2,000 has been provided, were sold for ` 1,000. The Profit and
losses on these transactions had been dealt with through the Profit and Loss Account.
(iii) The actual premium of the redemption of debentures was ` 2,000 of which ` 1,000 had
been written-off to the Profit and Loss A/c.
(iv) No interim dividend has been paid.
(v) Interest paid on debentures amounted to ` 4,500.
After reading the above financial statements and informations, answer the following
questions:
I. Calculate the cash flows from the operating activities. Necessary workings should be part
of the answer.
II. Find out those ratios which are essential to analyse the financial position of the company,
based on cash flows. Provided —
Net cash flows from Investing Activities: (-) ` 65,000
Net cash flows from Financing Activities: ` 8,500
Interpret and comment on the financial position of the company, based on the data
obtained from above point (I).
Answer:
I. Calculation of Cash Flows from Operating Activities
For the year ended 31st March 2014
` ` `
Net Profit during the year:
Net Profit for the year 2013-14 70,000
Less: Net Profit for the year 2012-13 28,000
42,000
Add: Non-Operating Expenses
Depreciation (` 15,000 + ` 4,000) 19,000
Loss on Sale of Fixtures 2,000
Discount on Debenture 1,000
Proposed Dividend 20,000
Debenture Interest 4,500
46,500
88,500
Less: Non-Operating Income
Profit on Sale of Plant 1,000
87,500
Add: Decrease in Current Assets or Increase in
Decrease in Current Assets Nil
Increase in Current Liabilities:
Increase in Creditors 14,000
14,000
1,01,500
Less: Increase in Current Assets or Decrease in
Increase in Current Assets:
Increase in Stock 1,000
Increase in Debtors 14,000
15,000
Net Cash Flows from Operating Activities 86,500
Workings:
Plant & Machinery A/c
Dr. Cr.
` `
To Balance b/d 1,20,000 By Bank Account – Sale 3,000
`` Profit & Loss Account – Profit `` Provision for Depreciation 6,000
on Sale 1,000 `` Balance c/d 1,51,000
`` Bank A/c – Purchase 39,000
1,60,000 1,60,000
Fixtures & Fittings A/c

Dr. Cr.
` `
To Balance b/d 24,000 By Bank Account – Sale 1,000
`` Bank Account – Purchase 10,000 `` Profit & Loss Account –
Loss on Sale 2,000
`` Provision for Depreciation 2,000
`` Balance c/d 29,000
34,000 34,000
Provision for Depreciation on Plant & Machinery A/c

Dr. Cr.
` `
To Plant & Machinery Account 6,000 By Balance b/d 45,000
`` Balance c/d 54,000 `` Profit & Loss Account 15,000
60,000 60,000
Provision for Depreciation on Fixtures & Fittings A/c

Dr. Cr.
` `
To Furniture & Fixture 2,000 By Balance b/d 13,000
`` Balance c/d 15,000 `` Profit & Loss Account 4,000
17,000 17,000
II. Ratios required to analyse financial position:

(i) Ratio of Dividend to Operating Cash Flow (OCF)
Dividend `15, 000
= x 100 = x 100 = 17.34%
Operating Cash Flows (OCF) ` 86, 500
(ii) Depreciation to Cash Flow

`19,000
= x 100 = 21.97%
` 86,500
(iii) Debts Coverage Ratio

OCF - Interest - Dividend ` 86,500 - `4,500 - `15,000 `67,000
= = = = 2.23 times
Debts ` 30,000 ` 30,000
(iv) Interest Coverage Ratio

Operating Cash Flow (OCF) ` 86,500
= = = 19.22 times
Interest ` 4,500
(v) Return of Cash to Total Assets

Operating Cash Flow ` 86, 500
= x 100 = x 100 = 20.55%
Total Assets ` 4, 21, 000
(vi) Dependence of Capital Investment on Internal Fund

Operating Cash Flow - Increase in Cash Balance ` 86, 500 - ` 30, 000
= = x 100 = 86.92%
Investing Cash Flow `65, 000
(vii) Return of Cash on Net Worth

Operating Cash Flow - Interest ` 86,500 - ` 4,500
= x 100 =
Net Worth (`1,50,000 + ` 35,000 + `70,000 - `1,000)
` 82,000
= x 100 = 32.28%
` 2,54,000
(viii) Dependence of Extra Funds for Capital Expenditure Ratio

Financing Cash Flow ` 8, 500
= x 100 = x 100 = 13.08%
Investing Cash Flow `65, 000
III. Comments and Interpretation:
Rate of Dividend to Operating Cash Flow is found to be 17.34% which indicates that
percentage of cash generated through operational activities which may be considered as
good. But if it is found to be ‗good‘, more cash will be required for paying dividend.
Similarly, Rate of Depreciation of Operating Cash Flow ratio is computed as only 21.96%
which reveals percentage of cash used to replace fixed assets. It may be considered as
normal. But Debt Coverage Ratio is found to be 2.23 times which is very poor and the same is
used to redeem the existing debts by the amount of net cash generated from operation.
Interest Coverage Ratio, on the other hand, is found to be 19.22 times. It means ability of the
firm to repay interest and also indicates the proportion of interest of ‗cash generated from
operation‘. This ratio is high which invites obstruction to take the benefit of trading on equity.
Return of cash to total assets ratio is found to be satisfactory, i.e., percentage of OCF to total
assets is 20.55% which is considered as good. Similarly, dependence of capital investments
on internal funds ratio is taken as 86.93% which reveals that percentage of OCF to Investing
Cash Flow is 86.93% i.e., 86.93%, of capital expenditure has been founded out of cash to be
generated from internal funds.
Return of Cash to Net worth ratio is found to be 32.28% which may be considered as good,
and it indicates that shareholder‘s fund is efficiently used. Dependence of External Funds to
Capital Expenditure Ratio is found to be 13.08% which reveals that external funds are used
only a little portion and the rest is used as Working Capital.
From the discussion made so far, it may be concluded that the overall position to be
measured in terms of Cash Flow Statement may be considered as sound. But whether such
ratios are satisfactory or not can be measured by making proper comparison with the
industry average ratio.
SN – 5 [The Analysis of Profitability]
Question 12.
(a) The following data relate of Anik Ltd.:
Sales ` 2,00,000
Less: Variable expenses (30%) ` 60,000
Contribution ` 1,40,000
Fixed operating expenses ` 1,00,000
EBIT (Earnings before Interest & Taxes) ` 40,000
Less: Interest ` 5,000
Taxable income ` 35,000
1. Using the concept of leverage, by what percentage will taxable income increase if sales
increase by 6 per cent?
2. Using the concept of operating leverage by what percentage will EBIT increase if there is
a 20 per cent increase in sales?
3. Using the concept of financial leverage, by what percentage will taxable income
increase if EBIT increases by 6 per cent?
Answer:
(1) Degree of composite leverage on sales level of ` 2,00,000:
Contribution 1,40,000
= =4
Taxable income 35,000
If sales increase by 6 per cent, taxable income will increase by 4 × 6 = 24 per cent:
8,400  100
= 24%
35,000
Workings:
Sales ` 2,12,000
Less: Variable expenses (30%) ` 63,600
Less: Fixed expenses ` 1,00,000
EBIT ` 48,400
Increase in taxable Income `8,400 i.e. 24% over `35,000.
(2) Degree of operating leverage on sales level of `2,00,000:
= = 3.5
EBIT 40,000
If sales increase by 20 per cent, EBIT will increase 3.5 × 20 = 70 per cent:
Working:
Sales ` 2,40,000
Less: Variable expenses ` 72,000
Less: Fixed expenses ` 1,00,000
EBIT ` 68,000
28,000  100
Increase is ` 68,000 – ` 40,000 or = 70%
40,000
(3) Degree of financial leverage on sales level of `2,00,000:

EBIT 40,000
= = 1.15
Taxable Income 35,000
If EBIT increase by 6 per cent, taxable income will increase by 1.15 ×6 = 6.9 %
Workings:
EBIT `40,000
Add: 6% ` 2,400
` 42,400
2,400  100
Increase is `37,400 – 35,000 or = 6.9%
35,000
(b) Firm X and Firm Y manufacture the same product and their cost sheets are given below:
(`/unit)
Firm X Firm Y
Units manufactured and sold 30,000 30,000
Direct material 10 10
Direct labour 5 5
Variable overheads 5 5
20 20
Contribution 10 10
Selling price 30 30
The fixed overheads of Firm X and Firm Y are ` 1,50,000 and ` 2,25,000 respectively. You are
required to calculate the operating leverage for both the firms and comment on them.
Answer:
Calculation of Operating Leverage:
Particulars Firm X Firm Y
Contribution for 30,000 units 3,00,000 3,00,000
Less: Fixed overheads 1,50,000 2,25,000
EBIT 1,50,000 75,000
Operating leverage (Contribution/EBIT) (3,00,000/1,50,000) (3,00,000/75,000)
=2 =4
Comment – Firm Y‘s operating leverage is twice of Firm X, as the fixed overheads are higher. The
higher the operating leverage ratio the situation is more risky. While a low ratio indicates a large
absorption capacity of a firm in times of adversity.
Question 13.
(a) Madona Ltd. had budgeted the following sales for the month of August, 2014 :
Product X: 800 units @ ` 100 per unit.

Product Y: 700 units @ ` 200 per unit.
The actual sales for month were as follows :

Product X: 900 units @ ` 110 per unit.
Product Y: 800 units @ ` 180 per unit.
The costs per unit of products X and Y were ` 80 and ` 170 respectively.
You are required to compute the Profit Value Variance, Profit Price Variance and Profit
Volume Variance to explain the difference between the budgeted and actual profits.
Answer:
Calculation budgeted and Actual sales, Cost and Profit
Product Sales Data Cost Data Profit Data
Units Selling Price Amount Cost p.u. Amount Profit p.u. Total
p.u. ` ` ` ` `
`
I Budgeted data
X 800 100 80,000 80 64,000 20 16,000
Y 700 200 1,40,000 170 1,19,000 30 21,000
Total 1,500 2,20,000 1,83,000 37,000
II Actual Data
X 900 110 99,000 80 72,000 30 27,000
Y 800 180 1,44,000 170 1,36,000 10 8,000
Total 1,700 2,43,000 2,08,000 35,000
Calculation of Profit variance:

(1) Profit Value Variance
Budgeted Profit - Actual Profit =
= `37,000 – `35,000 = `2,000 (A)
(2) Profit Price Variance

Actual Qty. (Std. rate of Profit – Actual rate of Profit)
X = 900 (20 – 30) = `9,000(F)
Y = 800 (30 – 10) = `16,000 (A) = `7,000 (A)
(3) Profit Volume Variance

Std. rate of Profit (Budgeted Qty. – Actual Qty.)
X = 20 (800 – 900) = `2,000 (F)
Y = 30 (700 – 800) = `3,000 (F) = `5,000 (F)
Summary of Profit variances (`)

Price Variance 7,000 (A)
Volume variance 5,000 (F)
Profit Value Variance 2,000 (A)
Statement showing variation of Budgeted and Actual Profit (`)

Budgeted Profit 37,000
Add: Volume Variance 5,000 (F)
42,000
Less: Price Variance 7,000 (A)
Actual Profit 35,000
(b) From the following Profit and Loss Account (Extracts) of Taj Ltd., prepare a Gross Value
Added Statement. Show also the reconciliation between gross value added and profit
before taxation:
Profit and Loss Account (Extracts) for the year ended 31st March, 2014
Particulars Notes ` Lakhs
Income
Sales 206.42
Other income 10.20
216.62
Expenditure
Production and operational expenses 1 166.57
Administration expenses 2 6.12
Interest and other charges 3 8.00
Depreciation 5.69 186.38
Profit before tax 30.24
Provision for tax 3.00
27.24
Investment allowance reserve written back 0.46
Balance as per last Balance Sheet 1.35
29.05
Transferred to:
General reserve 24.30
Proposed dividend 3.00 27.30
Surplus carried to Balance Sheet 1.75
29.05
Notes:
(1) Production and Operational Expenses
(` lakhs)
Increase in stock 30.50
Consumption of raw materials 80.57
Consumption of stores 5.30
Salaries, wages, bonus and other benefits 11.80
Cess and local taxes 4.20
Other manufacturing expenses 34.20
166.57
(2) Administration expenses include inter alia audit fees of ` 1 lakh, salaries and commission
to directors ` 2.20 lakhs and provision for doubtful debts ` 2.50 lakhs.
(3) Interest and Other charges

(` lakhs)
On fixed loans from financial institutions 3.90
On debentures 1.80
On working capital loans from bank 2.30
8.00
Answer:
Value Added Statement of Taj Ltd. for the year ended 31st March, 2014
Particulars ` lakhs %
Sales 206.42
Less: Cost of bought –in materials and services
Production and operational expenses 150.57
Administration expenses 3.92
Interest on working capital loans 2.30 156.79
Value added by manufacturing and trading activities 49.63
Add: Other income 10.20
Total Value Added 59.83
Application of Value Added:

To Employees
Salaries, wages, bonus and other benefits 11.80 19.72
To Directors
Salaries and commission 2.20 3.68
To Government
Income-tax 3.00 7.20 12.03
To Providers of Capital
Interest on debentures 1.80
Interest on fixed loans 3.90
Dividend 3.00 8.70 14.54
To provide for Maintenance and expansion
Depreciation 5.69
General reserve (24.30 – 0.46) 23.84
Retained profit (1.75 – 1.35) 0.40 29.93 50.03
59.83 100.0
Reconciliation between Total Value Added and Profit before Taxation

(` lakhs)
Profit before tax 30.24
Add back:
Depreciation 5.69
Salaries, wages, bonus and other benefits 11.80
Directors‘ remuneration 2.20
Interest on debentures 1.80
Interest on fixed loans 3.90 29.59
Total Value Added 59.83
Question 14.
(a) A firm has sales of `75,00,000, variable cost of `42,00,000 and fixed cost of `6,00,000. It has a
debt of ` 45,00,000 at 10% and equity of ` 55,00,000.
(i) What is the firm's Return on Investment (ROl)?

(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low
asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to ` 50,00,000, what will be the new EBIT?
(vi) At what level the EBT of the firm will be equal to zero?
Answer:
Basic Calculations
`
Sales 75,00,000
Less: Variable 42,00,000
Les: Fixed Cost 6,00,000

Earnings before Interest and Taxes (EBIT) 27,00,000
Less: Interest at 9% on Debt `45,00,000 4,50,000
Earnings before Taxes (EBT) 22,50,000
EBIT 27,00,000
(i) ROI   100 = ` x100 = 27%
Capital Employed 1,00,00,000
(ii) The return on investment at 27% is higher than the interest payable on debt at 10%. The firm
has a favourable financial leverage.
Net Sales
(iii) Asset Turnover =
Total Assets
75,00,000
Firm‘s Assets Turnover is = ` = 0.75
1,00,00,000
The industry average is 3. Hence, the firm has a low asset leverage.
(iv) Operating leverage = =` = 1.2222
EBIT 27,00,000
EBIT
Financial leverage = = ` 27,00,000 = 1.2
EBT 22,50,000
Contribution
Combined Leverage = = ` 33,00,000
EBT 22,50,000
Combined Leverage = Operating Leverage x Financial leverage
= 1.2222 x 1.2 = 1.46664
(v) If the sales drop to ` 50,00,000 from ` 75,00,000, the fall is by 33.33%. Hence, EBIT will drop by
40.73% (% Fall In Sales x Operating Leverage) Hence, the new EBIT will be ` 27,00,000 x (1 -
40.73%) = ` 16,00,290 or rounded to ` 16,00,000.
(vi) EBT to become zero means 100% reduction in EBT. The combined leverage is1.438, hence,
sales have to drop by 100/1.438 i.e. 68.18%. The new sales will therefore, be `75,00,000 x (1 –
68.18%) = ` 23,86,500 (approx.)
(b) The financial statements of Square Infotech Ltd. are as follows:
Balance Sheet as at: 31.03.14

(` in crores)
Ref Particulars Note As at As at
No. No. 31.03.14 31.03.13
(`) (`)
I EQUITY AND LIABILITIES
1 Shareholders‘ fund
(a) Share capital 1,121 931

(b) Reserves and surplus 8,950 7,999
(c) Money received against share
warrants
2 Share application money pending
allotment
3 Non-current liabilities
(a) Long-term borrowings 1 245 374
(b)Deferred tax liabilities (Net) 320 —
(c)Other Long term liabilities
(d) Long-term provisions
4 Current Liabilities
(a) Short-term borrowings
(b) Trade payables
(c)Other current liabilities 513 572
(d) Short-term provisions 10,109 7,902
Total 21,258 17,778
II ASSETS
1 Non-current assets
(a) Fixed assets
(i) Tangible assets 2 3,517 3,186
(ii) Intangible assets
(iii) Capital work-in-progress 27 28
(iv) Intangible assets under
development
(b) Non-current investments 288 222
(c)Deferred tax assets (Net)
(d) Long-term loans and advances
(e) Other non-current assets
2 Current assets
(a)Current investments
(b) Inventories 2,709 2,540
(c) Trade receivables 9,468 9,428
(d) Cash and cash equivalents 3,206 662
(e)Short-term loans and advances 2,043 1,712
(f) Other current assets
Total 21,258 17,778
Workings:
(` in crores)
1. Long Term Borrowings 31.03.14 31.03.13
Secured loans — 259
Unsecured loans 74 —
Finance Lease Obligations 171 115
Total 245 374
(` in crores)
2. Tangible Assets 31.03.14 31.03.13
Gross Block 6,667 5,747
Less: Accumulated Depreciation 3,150 2,561
Total 3,517 3,186
Profit & Loss Account (Extracts)

For the year ended 31.03.14
(` in crores)
2013-14 2012-13
1. Income
Sales 23,436 17,849
Other income 320 306
23,756 18,155
2. Expenditure
Cost of materials 15,179 10,996
Personnel expenses 2,543 2,293
Other expenses 3,546 2,815
Depreciation 419 383
Less: Transfer from Revaluation Reserve 7 412 6 377
Interest 164 88
21,844 16,569
3. Profit before Tax [1-2] 1,912 1,586
4. Provision for tax:
Current tax 450 371
Deferred tax (6) —
5. Profit after tax [3-4] 1,468 1,215
You are required to:

(i) Compute and analyse the return on capital employed (ROCE) with the help of Du-
Pont analysis.
(ii) Compute and analyse the average inventory holding period and average collection
period.
(iii) Compute and analyse the return on equity (ROE) by bringing out clearly the impact
of financial leverage.
Answer:
(i) As per Du-Pont analysis,
Return on Capital Employed (ROCE) = Net Profit ratio × Capital Turnover ratio
Operating profit before interest and tax Sales
 
Sales Capital employed
In the year 2012-13,

Operating profit before interest and tax = ` 1,368 crores
Sales = ` 17,849 crores
Capital employed = ` (3,186 + 12,630 – 8,474) crores = ` 7,342 crores
Net Profit ratio = 7.66%
Capital Turnover ratio = 2.43 times
Therefore, ROCE = 18.61%
Operating profit before interest and tax = ` 1,756 crores

Sales = ` 23,436 crores
Capital employed = ` (3,517 + 15,383 – 10,622) crores = ` 8,278 crores
Net Profit ratio = 7.49%
Capital Turnover ratio = 2.83 times
Therefore, ROCE = 21.20%
Return on Capital Employed (ROCE) has increased in the year 2013-14 as compared to 2012-
13 because capital turnover ratio has increased. This indicates better sales effort or effective
use of capital by the firm. Capital turnover ratio has increased because sales with respect to
capital employed in the firm have comparatively increased.
(ii) Average Inventory Holding Period  12

Inventory Turnover Rtaio
Cost of goods sold
Inventory Turnover Ratio 
Clo sing stock

10,996 = 4.329 times
Inventory Turnover Ratio 
2,540
12
Average Inventory Holding Period   2.77 months or 83 days
4.329

15,179
Inventory Turnover Ratio   5.603 times
2,709
12
Average Inventory Holding Period   2.14 months or 64 days
5.603
The average inventory holding period has got reduced in the year 2013-14 as compared to
the year 2012-13. This shows that the company has been in a position to improve its turnover
with lower inventory.
12  Debtors
Average Collection Period 
Annual credit Sales

12  9,428
Average Collection Period   6.34 month or 190 days
17,849

12  9,468
Average Collection Period   4.85 month or 145 days
23,436
The average collection period has reduced in the year 2013-14 as compared to the year
2012-13. The shorter the average collection period, the better is the quality of debtors as it
implies quick payment by debtors.
(iii) Return on equity (ROE)  Earnings available to equity shareholders  100

Equity shareholders fund

1,215
Re turn on equity   100  13.61%
(931 7,999)

1,468
Return on equity   100  14.58%
(1,121 8,950)
Return on equity has increased in the year 2013-14 as compared to the year 2012-13. This
indicates high profitability of the firm. The higher the ROE, the better it is for the firm as it
attracts prospective investors.
Impact of Financial Leverage:

Year 2012-13 2013-14
Return on equity (ROE) 13.61% 14.58%
Return on Capital Employed 18.61% 21.2%
Loan funds / total funds 4.02% 2.37%
Shareholders fund / total funds 95.98% 97.63%
Since financial leverage is also increased in the year 2013-14 as compared to the year 2012-
13, hence there is increase of return on equity in the year 2013-14 over that in the year 2012-
13. This is good since due to increase in return to the equity shareholders, prospective
investors will be attracted to invest money in the company.
SN – 6 [The Analysis of Growth and Sustainable Earnings]
Question 15.
(a) From the following details, compute Internal Growth Rate and Sustainable Growth Rate of a
firm:
Sales - ` 100 lakhs

Cost of sale - 70% of sales
Taxation - 35%
Retained Earnings ratio - 66.67%
Total Assets - ` 100 lakhs
Equity share capital - ` 76 Lakhs
Borrowings - ` 24 Lakhs
Verify your computation of growth rates.
Answer:
Computation of Internal Growth Rate (IGR)
(` in lakhs)
Sales 100.00
Less: cost of sales 70.00
Earnings Before tax (EBT) 30.00
Less: Tax 10.50
Earnings after tax (EAT) 19.50
Less: Dividend payout (33.3%) 6.50
Total Assets 100.00
EAT  100
Return on Assets (ROA) =
Total Assets
19.5  100
=
100
= 19.50%
ROA  b
IGR =
1(ROA  b)
19.5%  2 / 3
=
1 (19.5%  2 / 3)
13%
=
1  0.13
13%
=
0.87
IGR = 14.94%
Verification of Internal Growth Rate (IGR)

(` in lakhs)
Income Statement
Sales Revenue (100 lakhs ×114.94/100) 114.94
Less: Cost of Sales (70%) 80.46
Earnings Before Tax (EBT) 34.48
Less: Taxes (35%) 12.07
Earnings After Tax (EAT) 22.41
Dividends paid (1/3 × ` 22.41 Lakhs) 07.47
Retained Earnings (2/3 × ` 22.41 Lakhs) 14.94
Balance Sheet
Total Assets (Assets/Sales Ratio 1 : 1)
i.e., Assets = Sales] 114.94
Equity Share Capital ` 76 lakhs + Retained earnings 90.94
` 14.94 lakhs
Debt 24.00
Total Liabilities 114.94

Return on Assets: (` 22.41 Lakhs/`114.94 lakhs) (%) 19.50
(IGR will therefore be calculated above) 14.94%
` in lakhs
Earnings after Tax = 19.5
Shareholders‘ Funds = 76.0
19.5  100
Return on Equity =
76.0
= 25.7%
25.66%  2 / 3
SGR =
1 (26%  2 / 3)
17.11%
=
1  17.11%
17.11%
=
0.829
= 20.64%
The above computation shows that the company can grow at a maximum rate of 20.64%
without equity financing and maintain the present debt equity ratio and return on equity. This
can be confirmed by the following calculations:
Verification of SGR
Income Statement
Sales Revenue (100 lakhs ×120.64/100) 120.64
Less: Cost of Sales (70%) 84.49
Earnings Before Tax (EBT) 36.19
Less: Taxes (35%) 12.67
Earnings After Tax (EAT) 23.52
Less: Dividends paid (1/3 × EAT) 07.84
Balance Sheet
Total Assets (Assets/Sales Ratio 1 : 1) 120.64
Equity ( ` 76 lakhs + `15.68, retained earnings) 91.68
Debt (Total Assets `120.64 lakhs – `91.68 lakh) 28.96
Return on Equity: (` 23.52 Lakhs/`91.68 lakhs) (%) 25.7%
SGR will therefore be calculated above) 20.64%
(b) Explain Price Earnings Ratio (P/E Ratio) and Price-Book Value Ratio (P/BV ratio).
Answer:
Price Earnings Ratio (P/E Ratio):

The ratio indicates the market price of an equity share to the earnings per share. It measures the
number of times the earnings per share discounts the market price of an equity share.
Current Market Price of Equity Share

Price Earnings Ratio 
Earnings per Share
The ratio indicates how much an investor is prepared to pay per rupee of earnings. The ratio
helps to ascertain the value of equity share, if the EPS and probable price-earnings ratio of the
industry to which the company belongs. The intrinsic value of share may be more or less than the
market value which is influenced by company's track record and dividend distribution policy,
speculative trading, state of economy, efficiency of management, capital gearing etc. Price-
earning approach to share valuation is simple and more popular. This ratio reflects the market's
assessment of the future earnings potential of the company. A ratio reflects high earnings
potential and a low ratio reflects the low earnings potential. The ratio reflects the market's
confidence on company's equity.
Market Price to Book Value Ratio (P/BV ratio)

This ratio measures the relationship between the accounting value of the firm's assets and the
market price of its stock. The ratio is calculated by dividing the stock price per share by the book
value of share.
Market Price per Share

Price  Book Value Ratio 
Book Value per Share
Generally, the higher the rate of return a firm is earning on its common equity the higher will be
the P/BV ratio. In case of growth firms i.e. firms with high growth of sales and earnings will have
this ratio higher than 1, for the reason that the potential future growth in earnings is reflected in
the current stock price. Whereas the book value of equity share is based on historical costs and it
does not consider the potential growth.
SN – 7 [Valuation Basics]
Question 16.
(a) What do you mean by valuation bias? Explain the different sources of valuation bias?
(b) How do you minimize valuation bias?
Answer to 16 (a):
Valuation bias: We start valuing a firm with certain assumptions and preconceived conditions. All
too often, our views on a company are formed before we start inserting the numbers into the
financial/econometric model models that we use and not surprisingly, our conclusions tend to
reflect our biases. We will begin by considering the sources of bias in valuation and then move
on to evaluate how bias manifests itself in most valuations. We close with a discussion of how
best to minimize or at least deal with bias in valuations.
Sources of valuation bias:

The bias in valuation starts with the companies we choose to value. These choices are almost
never random, and how we make them can start laying the foundation for bias. It may be that
we have read something in the press (good or bad) about the company or heard from an
expert that it was under or overvalued. Thus, we already begin with a perception about the
company that we are about to value. We add to the bias when we collect the information we
need to value the firm. The annual report and other financial statements include not only the
accounting numbers but also management discussions of performance, often putting the best
possible spin on the numbers. With many larger companies, it is easy to access what other
analysts following the stock think about these companies.
In many valuations, there are institutional factors that add to this already substantial bias. For
instance, it is an acknowledged fact that equity research analysts are more likely to issue buy
rather than sell recommendations, i.e., that they are more likely to find firms to be undervalued
than overvalued. This can be traced partly to the difficulties analysts face in obtaining access
and collecting information on firms that they have issued sell recommendations on, and partly to
pressure that they face from portfolio managers, some of whom might have large positions in
the stock, and from their own firm investment banking arms which have other profitable
relationships with the firms in question.
The reward and punishment structure associated with finding companies to be under and
overvalued is also a contributor to bias. An analyst whose compensation is dependent upon
whether she finds a firm is under or overvalued will be biased in her conclusions. This should
explain why acquisition valuations are so often biased upwards. The analysis of the deal, which is
usually done by the acquiring firm‘s investment banker, who also happens to be responsible for
carrying the deal to its successful conclusion, can come to one of two conclusions. One is to find
that the deal is seriously over priced and recommends rejection, in which case the analyst
receives the eternal gratitude of the stockholders of the acquiring firm but little else. The other is
to find that the deal makes sense (no matter what the price) and to reap the ample financial
windfall from getting the deal done.
Answer to 16 (b):
Bias cannot be regulated or legislated out of existence. Analysts are human and bring their
biases to the table. However, there are ways in which we can mitigate the effects of bias on
valuation:
Reduce institutional pressures: A significant portion of bias can be attributed to institutional

factors. Equity research analysts in the 1990s, for instance, in addition to dealing with all of the
standard sources of bias had to grapple with the demand from their employers that they bring in
investment banking business. Institutions that want honest sell-side equity research should protect
their equity research analysts who issue sell recommendations on companies, not only from irate
companies but also from their own sales people and portfolio managers.
De-link valuations from reward/punishment: Any valuation process where the reward or
punishment is conditioned on the outcome of the valuation will result in biased valuations. In
other words, if we want acquisition valuations to be unbiased, we have to separate the deal
analysis from the deal making to reduce bias.
No pre-commitments: Decision makers should avoid taking strong public positions on the value
of a firm before the valuation is complete. An acquiring firm that comes up with a price prior to
the valuation of a target firm has put analysts in an untenable position, where they are called
upon to justify this price. In far too many cases, the decision on whether a firm is under or
overvalued precedes the actual valuation, leading to seriously biased analyses.
Self-Awareness: The best antidote to bias is awareness. An analyst who is aware of the biases he
or she brings to the valuation process can either actively try to confront these biases when
making input choices or open the process up to more objective points of view about a
company‘s future.
Honest reporting: In Bayesian statistics, analysts are required to reveal their priors (biases) before
they present their results from an analysis. Thus, an environmentalist will have to reveal that he or
she strongly believes that there is a hole in the ozone layer before presenting empirical evidence
to that effect. The person reviewing the study can then factor that bias in while looking at the
conclusions. Valuations would be much more useful if analysts revealed their biases up front.
While we cannot eliminate bias in valuations, we can try to minimize its impact by designing
valuation processes that are more protected from overt outside influences and by report our
biases with our estimated values.
Question 17.
(a) Explain the Sources of Uncertainties?
(b) How do you react to various uncertainties during the process of business valuation?
Answer to 17 (a):
Sources of Uncertainties: Uncertainty is part and parcel of the valuation process, both at the
point in time that we value a business and in how that value evolves over time as we get new
information that impacts the valuation. That information can be specific to the firm being
valued, more generally about the sector in which the firm operates or even be general market
information (about interest rates and the economy).
When valuing an asset at any point in time, we make forecasts for the future. Since none of us
possess crystal balls, we have to make our best estimates, given the information that we have at
the time of the valuation. Our estimates of value can be wrong for a number of reasons, and we
can categorize these reasons into three groups.
Estimation Uncertainty: Even if our information sources are impeccable, we have to convert raw
information into inputs and use these inputs in models. Any mistakes or mis-assessments that we
make at either stage of this process will cause estimation error.
Firm-specific Uncertainty: The path that we envision for a firm can prove to be hopelessly wrong.
The firm may do much better or much worse than we expected it to perform, and the resulting
earnings and cash flows will be very different from our estimates.
Macroeconomic Uncertainty: Even if a firm evolves exactly the way we expected it to, the
macroeconomic environment can change in unpredictable ways. Interest rates can go up or
down and the economy can do much better or worse than expected. These macroeconomic
changes will affect value.
The contribution of each type of uncertainty to the overall uncertainty associated with a
valuation can vary across companies. When valuing a mature cyclical or commodity company,
it may be macroeconomic uncertainty that is the biggest factor causing actual numbers to
deviate from expectations. Valuing a young technology company can expose analysts to far
more estimation and firm-specific uncertainty. Note that the only source of uncertainty that can
be clearly laid at the feet of the analyst is estimation uncertainty. Even if we feel comfortable
with our estimates of an asset‘s values at any point in time, that value itself will change over
time, as a consequence of new information that comes out both about the firm and about the
overall market. Given the constant flow of information into financial markets, a valuation done
on a firm ages quickly, and has to be updated to reflect current information.
Answer to 17 (b):
The advantage of breaking uncertainty down into estimation uncertainty, firm-specific and
macroeconomic uncertainty is that it gives us a window on what we can manage, what we can
control and what we should just let pass through into the valuation.
Building better models and accessing superior information will reduce estimation uncertainty but
will do little to reduce exposure to firm-specific or macro-economic risk. Even the best-
constructed model will be susceptible to these uncertainties.
In general, analysts should try to focus on making their best estimates of firm-specific information
– how long will the firm are able to maintain high growth? How fast will earnings grow during that
period? What type of excess returns will the firm earn? – and steer away from bringing in their
views on macro economic variables. To see why, assume that you believe that interest rates
today are too low and that they will go up by about 1.5% over the next year. If you build in the
expected rise in interest rates into your discounted cash flow valuations, they will all yield low
values for the companies that you are analyzing. A person using these valuations will be faced
with a conundrum because she will have no way of knowing how much of this over valuation is
attributable to your macroeconomic views and how much to your views of the company.
In summary, analysts should concentrate on building the best models they can with as much
information as they can legally access, trying to make their best estimates of firm-specific
components and being as neutral as they can on macro economic variables. As new
information comes in, they should update their valuations to reflect the new information. There is
no place for false pride in this process. Valuations can change dramatically over time and they
should if the information warrants such a change.
SN – 8 [Valuation Models]
Question 18.
(a) The Directors of a Public Limited Company are considering the acquisition of the entire Share
Capital of an existing Company Subham Ltd engaged in a line of business suited to them.
The Directors feel that acquisition of Subham Ltd will not create any further risk to their
business interest. The following is the Balance Sheet of Subham Ltd as at 31.3.2013 –
Equity and Liability ` Assets `
(1) Shareholders Fund: (1) Non-Current Assets:
(a) Share Capital (a) Fixed Assets
4,000 Equity Share Capital of ` 100 4,00,000 (i) Tangible Assets:
each (Cost Less Depreciation) 6,00,000
(b) Reserve & Surplus
─ General Reserve 3,00,000 (2) Current Assets:
(a) Inventories (Stock & WIP) 2,00,000
(2) Current Liabilities: (b) Trade Receivables
(a) Short Term Borrowings – Bank O/D 2,40,000 ─ Sundry Debtors 3,40,000
(b) Trade Payables (c) Cash & Cash Equivalents 1,00,000
─ Sundry Creditors 3,00,000
Total 12,40,000 Total 12,40,000
Subham Ltd‘s financial records for the past five years were as under — (`)
Particulars 2012-13 2011-12 2010-11 2009-10 2008-09
Profits before Extra-ordinary items 80,000 74,000 70,000 60,000 62,000
Adj: Extra Ordinary Item 3,500 4,000 (6,000) (8,000) 1,000
Profit after Extra – Ordinary Items 83,500 78,000 64,000 52,000 61,000
Less: Dividends 48,000 40,000 40,000 32,000 32,000
Net balance 35,500 38,000 24,000 20,000 29,000
The following additional information is available:

(i) There were no changes in the Issued Share Capital of Subham Ltd during this period.
(ii) The estimated values of Subham Ltd‘s assets on 31.3.2013 are – (`)
Particulars Replacement Cost Realizable Value
Fixed Assets 8,00,000 5,40,000
Stock and WIP 3,00,000 3,20,000
(iii) It is anticipated that 1% of the may prove difficult to be realized.

(iv) The cost of capital of Chandra Ltd is 10%.
(v) The current Return on Investment of Public Limited Co. is 10% Quoted Companies with
business activities and activities as Subham Ltd have a PE ratio approximating to 8,
although these companies tend to be larger than Subham.
Required: Estimate the value of the total Equity Capital of Subham Ltd as on 31.3.2013 using
each of the following bases – (a) Balance Sheet Value (b) Replacement Cost; (c ) Realizable
Value; (d) Gordon‘s Dividend Growth Model and (e) PE Ratio Model.
(b) XM Ltd had earning per share of ` 11.04 in 2012-13 and paid a dividend of ` 7 per share.
The growth rate in earnings and dividends in the long term is expected to be 5%. The
return on equity at XM Ltd is expected to be 13.66%. The beta of XM Ltd is 0.80 and the
risk free Treasury bond is 6% while risk premium is 4%. Based on the information,
calculate Price to Book Value Ratio.
Answer to 18 (a):
Valuation of Equity Capital of Subham Ltd under various methods
1. Balance Sheet Value Capital `4,00,000 + Reserves `3,00,000 = `7,00,000
2. Replacement Value Capital + Reserves + Appreciation in Fixed Assets and = `10,00,000

Stock
= 4,00,000 + 3,00,000 + (8,00,000 – 6,00,000)+(3,00,000 -
2,00,000)
3. Realizable value = Capital + Reserves + Change in Fixed Assets, Stock and Debtors
Particulars `
Capital 4,00,000
Reserve 3,00,000
Appreciation in Stock (3,20,000 – 2,00,000) 1,20,000
Less: Reduction in Fixed Assets (6,00,000 – 5,40,000) (60,000)
Less: Reduction Debtors (3,40,000 X 1%) (3,400)
Total Value 7,56,600
Note: It is assumed that the estimated Bad Debts are not relevant to Balance Sheet Value and
Replacement Value.
4. Gordon‘s Dividend Growth Model is given by the rule: P = [Ex (1 - b)] ÷ [(k-br)] ,
Where,
P = Price Per Share; E = Earnings Per Share; b= retention Ratio; k = Cost of Capital ;
br= g= Growth rate and r= Rate of Return on Investment.
The calculation is made as under –

Step 1: Average Profit Retained and Profit earned:
Profit Retained: 35,500 + 38,000 +24,000 +20,000 +29,00 = `1,46,500
Profit Earned: 83,500 + 78,000 +64,000 +52,000 + 61,000 = `3,38,500
Step 2: Calculation of b = `1,46,500 ÷ 3,38,500 = 0.433 (approx)
Step 3: Calculation of r = year ended 31.3.2013
Where, Avg. Investment = (Capital + Reserve – ½ of Profit Retained)
Pr ofit before extra ordinary items

Or, r   100
1
Capital  Re serve  of profit retained
2
80,000
r   100
1
4,00,000  3,00,000   35,500
2
80,000
  100  11.73%
6,82,250
Step 4: Calculation of b×r = g = Return x Retention Ratio

= 11.73% x 0.433
= 5.08%
Step 5: Avg Profit = `(3,38,500 ÷ 5) = `67,700
E 1 b  67,700 1 0.433 

Step 6 : Market Value  
Ke  b.r 0.10  0.0508
38,385.90
 ` 7,80,201.22
0.0492
Step 7: P/E Ratio Model: Comparable companies have P/E Ratio of 8, but Subham Ltd is much
smaller.
If P/E Ratio is taken at 6, the valuation will be 80,000 x 6 = ` 4,80,000
If P/E Ratio is taken at 8, maximum possible value will be (` 80,000 × 8) = `6,40,000
Answer to 18 (b):
Current dividend payout ratio = 7/11.04 × 100 = 63.41%

Expected growth rate in earnings and dividends = 5%
Return on equity = 13.66%
Cost of equity = 6% + 0.80 × 4% = 6% + 3.2% = 9.20%
PBV Ratio= ROE × Payout Ratio/(Cost of equity - Growth rate)
= 0.1366 × 0.6341/(0.092-0.05) = 2.06.
Question 19.
(a) Describe the situations when FCFE models and dividend discount valuation models provide
similar as well as dissimilar results?
(b) SMT Air Ltd is a telecommunications firm that generates ` 300 lakh in pretax operating
income and reinvested ` 60 lacs in most recent financial year. As a result of tax deferrals
the firm has an effective tax rate of 20% while its marginal tax rate is 40%. Both the
operating income and the reinvestment are expected to grow 10% a year for 5 years and
5% thereafter. The firm‘s cost of capital is 9% and is expected to remain unchanged over
time.
Estimate the value of SMT Air Ltd. using the different assumptions about tax rates:
(i) The effective tax rate---------------20% to be considered.
(ii) The marginal tax rate--------------40% to be considered.
Answer to 19 (a):
FCFE model is alternative to dividend discounting model. But at times both provide similar results:
When result obtained from FCFE and Dividend discount model may be same:
(i) Where dividends are equal to FCFE.
(ii) Where FCFE is greater than dividends but excess cash (FCFE- dividends) is invested in projects
with NPV = 0 (Investments are fairly priced)
When results from FCFE and Dividend discounting models are different:
(i) When FCFE is greater than dividends and excess cash earns below market interest rates or is
invested in negative NPV – value projects, the value from FCFE will be greater than the value
from discount model.
(ii) When dividends are greater than FCFE, the firm will have to issue either new stock or new
debt to pay their dividends- with attendant costs.
(iii) Paying too much of dividend can lead to capital rationing constraints when good projects
are rejected, resulting in loss of wealth.
Conclusion:
The dividend model uses a strict definition of cash flows to equity, i.e. expected dividends on
stock, while FCFE model uses an expensive definition of cash flows to equity as the residual cash
flows after meeting all financial obligations and investment needs.
When the firms have dividends that are different from FCFE, the values from two models will be
different.
In valuing firms for takeover or where there is reasonable chance of changing corporate control,
the value from the FCFE provides the better value.
Answer to 19 (b):
(i) Computation of the value of SMT Air Ltd assuming the effective tax rate (T) to be 20%
` in lacs
Year Terminal Total
Current 1 2 3 4 5
EBIT 300 330 363 399 439 483 507
EBIT(1-T) 240 264 290 319 351 386 406
Reinvestment 60 66 73 80 88 97 102
FCFF 180 198 217 239 263 289 304
Terminal value
PV factor at 9% 1.00 0.917 0.842 0.773 0.708 0.649 7600*
PV 182 183 185 186 188 4932 5856
The value of SMT Air Ltd as per effective tax rate of 20% is ` 924 lacs +` 4932 lacs= ` 5856 lacs.
(ii)Value of SMT Air Ltd. assuming marginal tax rate (T) of 40%
` In lacs
Year Terminal Total
Current 1 2 3 4 5
EBIT 300 330 363 399 439 483 507
EBIT(1-T) 180 198 218 239 263 290 304
Reinvestment 60 66 73 80 88 97 102
FCFF 120 132 145 159 175 193 202
Terminal value 5050**
PV factor at 9% 1.00 0.917 0.842 0.773 0.708 0.649 0.649
PV - 121 122 123 124 125 3277 3892
Value of SMT Air Ltd as per marginal tax rate of 40%is ` 615 lacs +` 3277 lacs=` 3892 lacs.
*304/(9%-5%)
**202/ (9%-5%)
Question 20.
(a) The directors of True Value Fund are keen on acquiring the business of Gem Ltd. They have
approached you given your valuation expertise for mergers and acquisitions for help. Gem
Ltd. has an invested capital of ` 50 million. Its return on invested capital (ROIC) is 12% and its
weighted average cost of capital (WACC) is 11%. The expected growth rate in Gem Ltd.'s
invested capital will be 20% for the first three years, 12% for the following two years and 8%
thereafter forever. The forecast of G Ltd's free cash flows is given below:
(` in Million)
Year 1 2 3 4 5 6 7
Invested Capital 50 60 72 86.40 96.77 108.38 117.05
Net operating profit less adjusted tax 6 7.20 8.64 10.37 11.61 13.00 14.05
Net investment 10 12.00 14.40 10.37 11.61 8.67 9.36
Free cash flow (-)4.00 (-)4.80 (-)5.76 - - 4.33 4.69
Cost of Capital (%) 11 11 11 11 11 11 11

Capital charge 5.50 6.60 7.92 9.50 10.64 11.92 12.88
Economic Profit .50 .60 .72 .87 .97 1.08 1.17
Growth rate (%) 20 20 20 12 12 8 8
Value Gem Ltd. under:

(i) Discounted cash flow method and
(ii) Present value of economic profit method.
Can the consideration paid for the shares exceed the valuation, if so, under what
circumstances?
(b) The following information is available of a concern; calculate E.V.A.:

Debt capital 12% ` 2,000 crores
Equity capital ` 500 crores
Reserve and surplus ` 7,500 crores
Capital employed ` 10,000 crores
Risk-free rate 9%
Beta factor 1.05
Market rate of return 19%
Equity (market) risk premium 10%
Operating profit after tax `2,100 crores
Tax rate 30%
Answer to 20 (a):
The present value of free cash flow (FCF) during the planning period is:
-4.00 -4.80 -5.76 0 0 4.33
PV FCF  + + + + +  - 9.4 million.
2 3 4 5 6
1.11 1.11 1.11 1.11 1.11 1.11
The horizon value at the end of six years, applying constant growth model, is
FCF H +1 4.68
V+1 = = = 156.0 million
WACC - g 0.11- 0.08
The present value of VH is
156.0
= 83.4 million.
6
1.11
Adding the present value of free cash flow during the planning period and present value of
horizon value, gives the enterprise DCF value
Vo = -9.4 + 83.4 = 74.0 million.
The present value of Economic profit stream is

0.50 0.60 0.72 0.87 0.97 1.08 1.17 1
+
2
+
3
+
4
+
5
+ +
6  0.11- .08 
x
6
 24.0 million.
1.11 1.11 1.11 1.11 1.11 1.11 1.11
Adding the invested capital to the present value of EP stream given the enterprise value:
Vo= 50+24 = 74 million.
Thus, the two models lead to identical valuation.

In the case of Mergers and Acquisitions the actual consideration paid for the shares can exceed
the valuation of shares under the DCF method and /or under the Present Value of Economic
Profit method in situations where the merger /acquisition is likely to result in synergy providing
additional benefits arising out of the M&A. Examples are where the target company has patents
or other key facilities/factors like access to resources, raw material, location, markets etc. which
can be better utilized by the existing acquirer company, thereby enhancing its profitability. This
can also arise where the target company is a key competitor. In such situations the
consideration paid can exceed the valuation based on present value using DCF or PV of
economic profit.
Answer to 20 (b):
E.V.A. = NOPAT – COCE

NOPAT = Net Operating Profit after Tax
COCE = Cost of Capital Employed
COCE = Weighted Average Cost of Capital  Average Capital Employed
= WACC  Capital Employed
Debt Capital `2,000 crores

Equity capital 500 + 7,500 `8,000 crores
=
Capital employed 2,000+8,000 = `10,000 crores
=
Debt to capital employed =
2,000
=0.20
10,000
Equity to Capital = 8,000
 0.80
employed 10,000
Debt cost before Tax 12%
Less: Tax (30% of 12%) 3.6%
Debt cost after Tax 8.4%
According to Capital Asset Pricing Model (CAPM)
Cost of Equity Capital = Risk Free Rate + Beta  Equity Risk Premium
Or
= Risk Free Rate + Beta (Market Rate – Risk Free Rate)
= 9 + 1.05  (19-9)
= 9 + 1.05  10 = 19.5%
WACC = Equity to CE x Cost of Equity capital + Debt to CE x Cost of debt

= 0.8 19.5% + 0.20 8.40%
= 15.60% + 1.68% = 17.28%
COCE = WACC  Capital employed

= 17.28%  10,000 crores = 1728 crores
E.V.A. = NOPAT – COCE

= ` 2,100 – ` 1,728 = ` 372 crores
SN – 9 [Mergers and Acquisitions: Valuation]
Question 21.
(a) K Ltd. processes raw material M to make product A. Contribution per unit of A is ` 32. Each
unit of A requires two units of M. The company can process maximum 20,000 units of M to
produce 10,000 units of A. Demand for product is unlimited at present selling price but annual
production is restricted to 6,000 units due to restricted supply of raw materials. B Ltd is the
only supplier of the raw material.
K Ltd. wishes to acquire controlling interest in B Ltd. to ensure supply of raw material M. B Ltd.
makes two products M and N using same production facilities. Machine hour required for
each unit of M and N are 4 and 5 respectively. Total machine hour available in a year is
75,000. Contribution per unit of M is ` 8 and that per unit of N is ` 15. Demand for N is
restricted to 5,400 units.
Share capital of B Ltd. consists of 50,000 ordinary shares of ` 10 each. Tax rate is 40%and cost
of capital is 10%.
Determine (i) maximum price K Ltd. Can offer for 51% interest in B Ltd; (ii) Likely change in
value of B Ltd. if the acquisition is successful.
(b) Explain the term ‗Demerger‘?
Answer to 21 (a):
Product M Product N
Contribution per unit 8.00 15.00
Machine hours required per unit 4 5
Contribution per machine hour 2.00 3.00
Since availability of machine hour is restricted and N gives higher contribution per machine hour,
presumably, B Ltd. prefers to produce N to satisfy the entire demand of 5,400 units. This takes
27,000 (5,400 units x 5 machine hours per unit) machine hours, leaving 48,000 machine hours for
production of M. The available machine hour permits B Ltd. to produce 12,000 units of M (48,000
machine hours / 4 machine hours per unit), which it supplies to K Ltd.
If the acquisition is successful, K Ltd. will require B Ltd. to use whole of 75,000 hours for production
of M. This means, B Ltd. will lose Re 1 per hour (` 3.00 – ` 2.00) for each of 27,000 hours currently
used for production of N.
If acquisition is successful, the PAT of B Ltd. is expected to fall by ` 16,200 annually [` 27,000 (1-
0.40)]. Since cost of capital is 10%, value of B Ltd. is expected to fall by ` 1,62,000 (` 16,200 / 0.10)
after acquisition. In 75,000 machine hours, B Ltd. will make 18,750 units of M allowing K Ltd. to
produce 9,375 units of A. If acquisition is successful, K Ltd. can expect to produce and sell 9,375
units of A instead of current 6,000 units. The additional contribution expected from additional
sale of 3,375 units is ` 1,08,000 (3375 units × ` 32 per unit).
If acquisition is successful, K Ltd can expect its PAT to increase by ` 64,800 annually [` 1,08,000 (1-
0.40)]. Since cost of capital is 10%, value of K Ltd. is expected to rise by ` 6,48,000 [` 16,200 / 0.10)
after acquisition. The maximum consideration, that K Ltd. can offer for controlling interest in B Ltd.
is ` 6,48,000.
B Ltd. has 50,000 shares outstanding, 51% interest in this share capital consists of 25,500 shares.
Maximum price per share = ` 25.41 (` 6,48,000 / 25,500)
Answer to 21 (b):
It has been defined as a split or division. As the same suggests, it denotes a situation opposite to
that of merger. Demerger or spin-off, as called in US involves splitting up of conglomerate (multi-
division) of company into separate companies. This occurs in cases where dissimilar business are
carried on within the same company, thus becoming unwieldy and cyclical almost resulting in a
loss situation. Corporate restructuring in such situation in the form of demerger becomes
inevitable. Merger of SG chemical and Dyes Ltd. with Ambalal Sarabhai enterprises Ltd. (ASE)
has made ASE big conglomerate which had become unwieldy and cyclic, so demerger of ASE
was done. A part from core competencies being main reason for demerging companies
according to their nature of business, in some cases, restructuring in the form of demerger was
undertaken for splitting up the family owned large business empires into smaller companies. The
historical demerger of DCM group where it split into four companies (DCM Ltd., DCM Shriram
industries Ltd., Shriram Industrial Enterprise Ltd. and DCM Shriram consolidated Ltd.) is one
example of family units splitting through demergers. Such demergers are accordingly, more in
the nature of family settlements and are affected through the courts order. Thus, demerger also
occur due to reasons almost the same as mergers i.e. the desire to perform better and
strengthen efficiency, business interest and longevity and to curb losses, wastage and
competition. Undertakings demerge to delineate businesses and fix responsibility, liability and
management so as to ensure improved results from each of the demerged unit. Demerged
Company, according to Section (19AA) of Income Tax Act, 1961 means the company whose
undertaking is transferred, pursuant to a demerger to a resulting company. Resulting company,
according to Section2(47A) of Income Tax Act,1961 means one or more company, (including a
wholly owned subsidiary thereof) to which the undertaking of the demerged company is
transferred in a demerger, and the resulting company in consideration of such transfer of
undertaking issues shares to the shareholders of the demerged company and include any
authority or body or local authority or public sector company or a company established,
constituted or formed as a result of demerger.
Question 22.
(a) Alpha Ltd. is investigating the acquisition of Gama Ltd. Gama Ltd.'s balance sheet is given
below:
Gama Ltd: Balance Sheet (` in crore)
10% Cumulative preference shares 100
Ordinary share capital (30 crore shares @ ` 10 per share) 300
Reserves & Surplus 150
14% Debentures 80
Current Liabilities 100
Total 730
Net fixed assets 275

Investments 50
Current assets
Stock 190
Book debts 150
Cash & Bank 65 405
Total 730
Alpha Ltd. proposed to offer the following to Gama Ltd.

(i) 10% cumulative preference shares of ` 100 crore in Alpha Ltd. for paying 10% cumulative
preference capital of Gama Ltd.
(ii) 12% convertible debentures of ` 84 crore in Alpha Ltd. to redeem 14% debentures of
Gama Ltd.
(iii) One ordinary share of Alpha Ltd. for every three shares held by Gama Ltd.'s shareholders,
the market price being ` 42 for Alpha Ltd.' s shares and ` 20 for Gama Ltd.'s shares.
After acquisition, Alpha Ltd. is expected to dispose of Gama Ltd.'s stock for ` 150 crore, book
debts for ` 102 crore and investments for ` 55 crore. It would pay entire current liabilities.
What is the cost of acquisition to Alpha Ltd.? If Alpha Ltd.' s required rate of return is 20% how
much should be the annual after tax cash flows from Gama Ltd.' s acquisition assuming a
time horizon of 8 years and a zero salvage value? Would your answer change if there is a
salvage value of ` 30 crore after 8 years?
Given, Present Value of ` 1 discounted @ 20% cumulative for 1 to 8 years = 3.837 and Present
Value of ` 1 in 8th year discounted @ 20% = 0.233.
(b) Define Business Strategy? What are the different strategies for entering to a new business?
Answer to 22 (a):
Cost of Acquisition
` in Crore
10% Cumulative Preference share 100
12% Convertible debentures 84
Ordinary share capital ` (30/3x42) 420
Payment of current liabilities 100
Gross payment (A) 704
Less realization from
Investment 55
Stock 150
Book debts 102
Cash & Bank (B) 65 372
Net Cost (A-B) 332
Computation of annual after-tax cash flows.

332 = A x PVAF (0.20, 8)
332 = A x 3.837 or A = ` 86.53 crore (Annual Cash Flows)
Computation of annual after-tax cash flows with salvage value.

332 = A x PVAF (0.20, 8) + 30 x PVF (0.20, 8)
332 = 3.837A +0.233x30
332 = 3.837A +6.99
A = ` 84.70 Crores (Annual cash flows with salvage value of ` 30 crore after 8 years.)
Answer to 22 (b):
A business strategy typically is a document that clearly articulates the direction that a
business will pursue and the steps it will take to achieve its goals. In a standard business plan,
the business strategy results from goals established to support the stated mission of the
business. A typical business strategy is developed in three steps: analysis, integration and
implementation.
An organization can enter into a new or unrelated business in any of the following three
forms:
(i) Acquisition
(ii) Internal start-up
(iii) Joint Ventures or strategic partnerships
Question 23.
(a) Q Ltd. wants to acquire R Ltd. and has offered a swap ratio of 1:2 (0.5 shares for every one
share of T Ltd.). Following information is provided:
Q Ltd. R Ltd.
Profit after tax `18,00,000 `3,60,000
Equity shares outstanding (Nos.) 6,00,000 1,80,000
EPS `3 `2
PE Ratio 10 times 7 times
Market price per share `30 `14
Required:
(i) The number of equity shares to be issued by Q Ltd. for acquisition of R Ltd.
(ii) What is the EPS of Q Ltd. after the acquisition?
(iii) Determine the equivalent earnings per share of R Ltd.
(iv) What is the expected market price per share of Q Ltd. after the acquisition, assuming
its PE multiple remains unchanged?
(v) Determine the market value of the merged firm.
(b) What are the Strategic Imperatives behind successful mergers acquisitions?
Answer to 23 (a):
(i) The number of shares to be issued by Q Ltd.:

The Exchange ratio is 0.5
So, new Shares = 1,80,000 x .5 = 90,000 shares.
(ii) EPS of Q Ltd. after acquisition:

Total Earnings (18,00,000+3,60,000) `21,60,000
No. of Shares (6,00,000 + 90,000) 6,90,000
EPS (21,60,000)/6,90,000) `3.13
(iii) Equivalent EPS of R Ltd.:

No. of new Shares 0.5
EPS `3.13
Equivalent EPS (3.13 x .5) `1.57
(iv) New Market Price of Q Ltd. (P/E remaining

unchanged):
Present P/E Ratio of QLtd. 10 times
Expected EPS after merger `3.13
Expected Market Price (3.13 x 10) `31.30
(v) Market Value of merged firm:

Total number of Shares 6,90,000
Expected Market Price `31.30
Total value (6,90,000 x 31.30) `2,15,97,000
Answer to 23 (b):
The first priority for successful acquisition implementation is to know precisely what you are
buying and what are you going to do if and when the deal is completed.
• Valid strategy for successful acquisition policy:
(i) To obtain presence for core business.
(ii) To leverage marketing: Applying a massive marketing capability to a good product line
is an excellent base for an acquisition strategy.
(iii) To build an enlarged base
(iv) To reposition the business
• Drucker‘s five commandments for successful acquisitions
(i) The acquirer must contribute something to the acquired company
(ii) Common ore of unity is required.
(iii) Acquirer must respect the business of acquired company
(iv) Within a year or so, acquiring company must be able to provide top management to the
acquired company.
(v) Within the first year of merger, management‘s in both companies should receive
promotions across the entities.
• Weston‘s Commentary on Drucker‘s Pentalegue
(i) Relatedness is a necessary requirement, but complimentary is an even greater virtue.
e.g., combining a company, strong in research but weak in marketing with a company
strong in marketing but weak in research may bring blessings to both.
(ii) Relatedness or complementarities apply to general management functions such as
research, plants control and financial manager as well as firm specific operations of
production and marketing.
(iii) Thus companies with cash flows or managerial capabilities in excess of investment
opportunities could effectively combine with companies lacking in financial or
managerial resources to make the most of the prospects for growth and profits in their
industries.
(iv) An acquiring firm will experience negative results if it pays too much. It is difficult to
accurately evaluate another organization. There can be great surprises on both sides
after marriage. Expectation that a firm can improve average risk return relationship in an
unfamiliar market or industries is likely to be disappointed.
• Golden Rules of Integration
(i) Plan First: If you don‘t know what you are going to do, don‘t do it.
(ii) Implement quickly: If you are going to do it, do it immediately.
(iii) Communicate frankly: Cost of error is always on the side of inadequate communication.
A change of plan can always be explained or admitted, with less adverse effect on
morale and hence productivity, than a policy of silence.
(iv) Sensitivity in the treatment of people, recognition of long service and proper and
generous separation arrangements all count here.
Question 24.
(a) Frontier Company Limited (FCL) is in negotiation for taking over Back Moving Company
Limited (BMCL). The management of FCL is seeing strong strategic fit in taking over BMCL
provided it is a profitable proposition. Mr. Amit, GM (Finance) has been asked to look into the
viability of the probable takeover of BMCL. He has collected the following necessary
information.
Summarized Balance Sheet of Back Moving Company Limited (BMCL) as on March 31, 2014
LIABILITIES Amount (` in crores)
Shareholders' Fund:
Equity Share Capital (`10 par) 200.00
12% Preference Capital (`100 par) 75.00
Reserves and Surplus 125.00
400.00
Non-Current Liabilities:
10% Debentures 40.00
Long Term Loans 25.00
65.00
Current Liabilities 24.75
ASSETS
Non-Current Assets
Net Fixed Assets 332.75
Investments 125.00
457.75
Current Assets:
Inventories 10.00
Debtors 15.00
Cash in Hand and at Bank 4.25
Loans and Advances 1.75
31.00
Miscellaneous Expenses to the extent not written off 1.00
Total Assets 489.75
Proposed Purchase Consideration:

 10.50% Debentures of FCL for redeeming 10% Debentures of BMCL – `44 crores.
 11% Convertible Preference Shares of FCL for the payment of Preference Shareholders
BMCL-`100 crores.
 12.50 crores of Equity Shares of FCL would be issued to the shareholders of BMCL at the
prevailing market price of ` 20 each.
 FCL would meet all dissolution expenses of `0.50 crores.
The management of FCL would dispose any asset and liability which may not be required
after takeover:
 Investments `150 crores
 Debtors ` 15 crores
 Inventories ` 9.75 crores
 Payment of Current Liabilities ` 25 crores
 All intangible assets will be written off
The management of FCL would like to run the taken over company, BMCL, for next 7 years
and after that, it would discontinue with it. It is expected that for the next 7 years, the taken
over company would generate the following yearly operating cash flows after tax:
1 2 3 4 5 6 7
Operating Cash Flows After Tax 70 75 85 90 100 125 140
(` In crores)
It is estimated that the terminal cash flows of BMCL would be ` 50 crores at the end of 7th
year.
If the cost of capital of FCL is 16%, then you are required to find out whether the decision to
takeover BMCL at the terms and conditions mentioned above will be a profitable decision:
Year 1 2 3 4 5 6 7
Discounting Factor @ 16% 0.8621 0.7432 0.6407 0.5523 0.4761 0.4104 0.3538
(b) Discuss the major theories of Mergers & Acquisitions.
Answer to 24 (a):
Cost of Acquisition:
Proposed Payments:
Dissolution Expenses 0.50
Current Liabilities 25.00
10.50% debentures 44.00
11% Convertible Preference Shares 100.00
Equity Shares 250.00
419.50
Less:
Sales proceeds from-
Investments 150.00
Debtors 15.00
Inventories 9.75
174.75
Cash and Bank Balance 4.25 179.00
Net cost of Acquisition 240.50
Year Cash Flows (in ` crores) Discounting factor Present Value
1 70 0.8621 60.34
2 75 0.7432 55.74
3 85 0.6407 54.46
4 90 0.5523 49.71
5 100 0.4761 47.61
6 125 0.4104 51.31
7 140 0.3538 49.54
7 50 0.3538 17.69
Total 386.39
Since the present Value of the future cash flows is more than the cost of acquisition, it will be a
profitable proposition to take over the said company, BMCL.
Answer to 24 (b):
The following theories of mergers and acquisitions are discussed below:
(i) Synergy or Efficiency: In this theory, the total value from the combination is greater than
the sum of the values of the component companies operating independently.
(ii) Hubris: The result of the winner‘s curse, causing bidders to overpay. It is possible that
value is unchanged.
(iii) Agency: The total value here is decreased as a result of mistakes or managers who put
their own preferences above the well-being of the company.
While the target company always gains, the acquirer gains when synergy accrues from
combined operations, and loses under the other two theories. The total value becomes
positive under synergy, becomes zero under the second, and becomes negative under the
third.
SN – 10 [Valuation of Assets and Liabilities]
Question 25.
(a) SB Finance Ltd. is a non-banking finance company. It makes available to you the costs
and market price of various investments held by it as on 31.3.2014.
(` Lakhs)
Scripts: Cost Market Price
I. Equity Shares-
E-1 60.00 61.20
E-2 31.50 24.00
E-3 60.00 36.00
E-4 60.00 120.00
E-5 90.00 105.00
E-6 75.00 90.00
E-7 30.00 6.00
II. Mutual funds-
MF-1 39.00 24.00
MF-2 30.00 21.00
MF-3 6.00 9.00
III. Government securities-
GV-1 60.00 66.00
GV-2 75.00 72.00
(i) Can the company adjust depreciation of a particular item of investment within a
category?
(ii) What should be the value of investments as on 31.3.2014?
(iii) Is it possible to off-set depreciation in investment in mutual funds against
appreciation of the value of investment in equity shares and government securities?
(b) From the following details, compute the total value of human resources of skilled and
unskilled group of employees according to Lev and Schwartz (1971) model.
Particulars Skilled Unskilled
Annual average earning of an employee till the retirement age `1,20,000 `80,000
Age of retirement 65 years 62 years
Discount rate 18% 18%
No of employees in the group 25 35
Average age 62 years 60 years
(c) A share of GHB Ltd. is currently quoted at, a price earning ratio of 7.5 times. The retained
earning per share being 37.5% is ` 3 per share. Compute:
(i) The company‘s cost of equity, if investors expect annual growth rate of 12%.
(ii) If anticipated growth rate is 13% p.a., calculate the indicated market price, with
same cost of capital.
Answer to 25 (a):
(i) Quoted current investments for each category shall be valued at cost or market value,
whichever is lower. For this purpose, the investments in each category shall be
considered scrip-wise and the cost and market value aggregated for all investments in
each category. If the aggregate market value for the category is less than the
aggregate cost for that category, the net depreciation shall be provided for or charged
to the profit and loss account. If the aggregate market value for the category exceeds
the aggregate cost for the category, the net appreciation shall be ignored. Therefore,
depreciation of a particular item of investments can be adjusted within the same
category of investments.
(ii) Value of Investments as on 31.3.2014

Type of Investment Valuation Principle Value
`in lakhs
Equity Shares (Aggregated) Lower of cost or market Value 406.50
Mutual Funds NAV (Market value, assumed) 54.00
Government securities Cost 135.00
595.50
As per para 14 of AS 13 ―Accounting for Investments‖, the carrying amount for current
investments is the lower of cost and market price. Sometimes, the concern of an
enterprise may be with the value of a category of related current investments and not
with each individual investment, and accordingly, the investments may be computed at
the lower of cost and market value computed category wise.
(iii) Inter category adjustments of appreciation and depreciation in values of investments

cannot be done. It is not possible to offset depreciation in investment in mutual funds
against appreciation of the value of investments in equity shares and Government
securities.
Answer to 25 (b):
Particulars Skilled Unskilled

1. Average Age 62 years 60 years
2. Age of retirement 65 years 62 years
3. Remaining period of employment 3 years 2 years
4. Annual earnings/Employee 1,20,000 80,000
5. Annuity factor at 18% for 3 & 2 years 2.1743 1.5656
6. Value of employees= PV of Future Earnings of Employees =
Annual Earnings x Annuity factor
(a) Skilled(1,20,000 x annuity factor at 18% for 3 years) `2,60,916
(b) Unskilled(80,000 x annuity factor at 18% for 2 years) `1,25,248
7. No of employees 25 35
8. Therefore total value of Human Resources `65,22,900 `43,83,680
Total value of Human Resources

Skilled `65,22,900
Unskilled `43,83,680
Total `1,09,06,580
Answer to 25 (c):
(i) Calculation of cost of capital
Retained earnings 37.5% ` 3 per share
Dividend* 62.5% ` 5 per share
EPS 100.0% ` 8 per share
P/E ratio 7.5 times
Market price is ` 7.5  8 = ` 60 per share
Cost of equity capital = (Dividend*/price  100) + growth %
= (5/60  100) + 12% = 20.33%.
(ii) Market price = Dividend/(cost of equity capital %  growth rate %)
= 5/(20.33%  13%)
= 5/7.33%
= ` 68.21 per share.
*Dividend = `(3/37.5)×62.5=` 5
Question 26.
(a) Given below is the Balance Sheet of Sandip Ltd as on 31.03.2014
Equity and Liability ` in Assets ` in
lakhs lakhs
(1) Shareholders Fund: (1) Non-Current Assets:
(a) Share Capital (a) Fixed Assets - Tangible Assets 72.00
Equity Share Capital of ` 10 each 50.00 (b) Non-Current Investments (Non Trade) 12.00
(b) Reserve & Surplus
(i) Reserve (2) Current Assets:
32.00
(ii) P & L Account (a) Inventories
3.00 (b) Trade Receivables - Sundry Debtors 7.80
(c) Cash and Cash Equivalents 6.20
(2) Current Liabilities:
(a) Trade Payables – Sundry Creditors 5.20
(b) Short Term Provision - Proposed 8.20
Dividend 10.00
Total 103.20 Total 103.20
Other Information:
1. Profit Before Tax and Other relevant information: (` Lakhs)
Year Profit Before Tax Provision for Gratuity Gratuity Paid Loss of uninsured stock
required
2010 42.00 2.20 - -
2011 39.00 2.30 1.67 0.62
2012 44.00 2.50 0.32 -
2013 42.00 2.60 1.42 -
2014 37.00 2.70 0.12 -
2. Past Tax rate is 51% while Expected Tax Rate is 45%.

3. The Company wants to switch over towards maintaining gratuity provision on actuarial
calculation rather than accounting on payment basis. The Company‘s Non- Trade
Investments fetched 11%.
Find out value of Goodwill. It may be assumed that Super Profit, if any, is maintainable for 5
years. 18% should be the appropriate discount factor. Normal Rate of Return may be taken
as 15%.
(b) State the features of Credit Derivative.
(c) Calculate the price of 3 months ABC futures, if ABC (FV `10) quotes `220 on NSE and the
three months future price quotes at `230 and the one month borrowing rate is given as 15
percent and the expected annual dividend yield is 25 percent per annum payable before
expiry.
Answer to 26 (a):
1. Computation of Future Maintainable Profits (` Lakhs)
Particulars 2010 2011 2012 2013 2014
Profit Before Tax 42.00 39.00 44.00 42.00 37.00
Less: Provision for Gratuity (2.20) (2.30) (2.50) (2.60) (2.70)
Add: Gratuity Paid — 1.67 0.32 1.42 0.12
Add: Abnormal Loss — 0.62 — — —
Adjusted Profits 39.80 38.99 41.82 40.82 34.42
Simple Average Profit (See Note below) (39.80 + 38.99 + 41.82 + 40.82 + 34.42)÷5 39.17
Less : Income from Non-Trade Investments at 11% of `12 Lakhs (1.32)
Adjusted Profit Before Tax = Future Maintainable PBT 37.85
Less : Tax Expense at 45% (17.03)
Adjusted Profit After Tax = Future Maintainable PAT 20.82
Note: Since Profits show an oscillating trend, Simple Average Profit shall be more appropriate
than Weighted Average or Trend Equation Methods.
2. Computation of Average Capital Employed
Particulars ` Lakhs
Total of Assets as per Balance Sheet 103.20
Less: Non- Trade Investments and Sundry Creditors (12.00 +8.20) (20.20)
Closing Capital Employed 83.00
Less: 50% of Profit After Tax earned in 2014 as per Books
PAT = PBT less Tax at 51% = 37.00 Less 51% thereon = `18.13 Lakhs 18.13
50% of the above PAT for the year (9.07)
Average Capital Employed 73.93
3. Computation of Goodwill (` Lakhs)

(a) Capitalization Method:
Expected Capital (Future Maintainable Profit ÷ NRR) =`20.82 Lakhs ÷ 15% 138.80
Less: Closing Capital Employed Less Proposed Dividend = 83.00-10.00 73.00
Goodwill using Capitalization Method 65.80
(b) Super Profit Method:
Future Maintainable Profit 20.82
Less: Normal Profit at 15% Average Capital Employed (15% of `73.93 Lakhs) 11.09
Super Profits 9.73
Goodwill at 5 years‘ purchase of Super Profits 48.65
Note: Alternatively Normal Profit can be computed based on Closing Capital Employed
(c) Annuity Method:
Super Profits 9.73
Annuity Factor for 5 years at 18% 3.127
Goodwill using Annuity Method 30.43
Note and Assumptions:

1. Under Capitalization Method, Closing Capital is considered, whereas under Super Profit
Method, Average Capital Employed is considered for calculating Normal Profits.
2. Discount Rate and Normal Rate of Return given above are after tax rates.
Answer to 26 (b):
In general, credit derivative products have following features;

• It is a contract between two counterparties protection buyer and protection seller
• The contract is based on reference asset. It could be bank loan, corporate loan, corporate
bond and debenture or trade receivables.
• Protection buyer pays premium for exchanging /transferring credit risk to protection seller
• The credit event for which protection is bought and sold is also predefined. It could be
bankruptcy, insolvency, payment default, price decline etc.
• The settlement between protection buyer and protection seller on the credit event can be
cash settled.
Answer to 26 (c):
Future‘s Price = Spot + cost of carry – Dividend

F = 220 + 220 × 0.15 × 0.25 – 0.025** × 10
= 225.75
** Entire 25% dividend is payable before expiry, which is `2.50.
Thus we see that futures price by calculation is `225.75 which is quoted at `230 in the
exchange.
Analysis:
Fair value of Futures less than Actual futures Price: Futures Overvalued .Hence it is advised to
sell.
Question 27.
(a) J Ltd. purchased machinery from K Ltd. on 30.09.2013. The price was ` 370.44 lakhs after
charging 8% Sales-tax and giving a trade discount of 2% on the quoted price. Transport
charges were 0.25% on the quoted price and installation charges come to 1% on the quoted
price.
A loan of ` 300 lakhs was taken from the bank on which interest at 15% per annum was to
be paid.
Expenditure incurred on the trial run was Materials ` 35,000, Wages ` 25,000 and
Overheads ` 15,000.
Machinery was ready for use on 1.12.2013. However, it was actually put to use only on
1.5.2014. Find out the cost of the machine and suggest the accounting treatment for the
expenses incurred in the interval between the dates 1.12.2013 to 1.5.2014. The entire loan
amount remained unpaid on 1.5.2014.
(b) The following abridged Balance Sheet as at 31.03.2013 pertains to Jupiter Ltd. (`Lakhs)
Equity & Liabilities `

(1) Shareholders' Funds:
(a) Share Capital - Equity Share Capital
(i) 180 Lakhs Shares of `10, fully paid up 1,800
(ii) 90 Lakhs Shares of `10, `8 paid up 720
(iii) 150 Lakhs Shares of `5, fully paid up
750
(b) Reserves & Surplus
5,628
(2) Non-Current Liabilities:
Long Term Borrowings - Secured Loans
4,500
(3) Current Liabilities:
(a) Other Current Liabilities
1,242
(b) Short Term Provisions
960
Total 15,600
Assets
(1) Non-Current Assets:
(a) Fixed Assets:
(i) Tangible Assets 11,166
(ii) Intangible Assets - Goodwill 420
(b) Other Non-Current Assets
- Miscellaneous Expenditure 171
(2) Current Assets:
(a) Short Term Loans & Advances 943
(b) Other Current Assets 2,900
Total 15,600
You are required to calculate the following for each one of three categories of Equity Shares
appearing in the above mentioned Balance Sheet -
 Intrinsic Value on the basis of Book Values of Assets and Liabilities including Goodwill,
 Value per Share on the basis of Dividend Yield. Normal Rate of Dividend in the concerned
Industry is 15%, whereas Jupiter Ltd has been paying 20% Dividend for the last four years
and is expected to maintain it in the next few years, and
 Value per Share on the basis of EPS, For the year ended 31st March, 2013 the Company has
earned `1,371 Lakhs as Profit after tax, which can be considered to be normal for the
Company. Average EPS for a fully paid Share of `10 of a Company in the same Industry is
`2.
Answer to 27 (a):
` (in Lacs) (` in Lacs)
Quoted price (refer to working note) 350.00
Less: 2% Trade Discount 7.00
343.00
Add: 8% Sales tax (8% × ` 343 lacs) 27.44 370.44
Transport charges (0.25% × ` 350 lacs) 0.88 (approx.)
Installation charges (1% × ` 350 lacs) 3.50
Financing cost (15% on `300 Lacs) for the period
30.9.2013 to 1.12.2013 7.50
Trial Run Expenses
Material 0.35
Wages 0.25
Overheads 0.15 0.75
Total cost 383.07
15 5
Interest on loan for the period 1.12.2013 to 1.05.2014 is ` 300 lakhs   = `18.75 lacs
100 12
This expenditure may be charged to Profit and Loss Account or deferred for amortization
between say three to five years. Assumed that no other expenses are incurred on the
machine during this period.
Working Note:
Let the quoted price ‗X‘
Less: Trade Discount 0.02X.
Actual Price = 0.98X.
Sale Tax @8% = 1.08 × 0.98X
` 370.44 lakhs
or X   ` 350 lakhs
1.08  0.98
Answer to 27 (b):
A. Computation of Capital employed (` in Lakhs)

Particulars Amount Amount
Goodwill at Cost 420
Other fixed assets 11,166
Current Assets 2,900
Loans and advances 943
Total assets Less: Outside liabilities 15,429
Secured loans .' 4,500
Current liabilities 1,242
Provisions 960 6,702
Capital employed attributable to Equity Share Holders 8,727
B. Computation of Value per Share under Intrinsic Value Method (` in Lakhs)

C. Particulars Amount
Capital employed as on valuation Date i.e. Balance Sheet Date 8,727
Add: Notional call on shares partly paid up (90 Lakhs shares × ` 2 per share) 180
Net assets available to equity shareholders [A] 8,907
Equivalent value of equity share capital (at par value)
180 + 90 Lakhs Shares of ` 10 2,700
150 Lakhs Shares of ` 5 750
Face value of equity share capital [B] 3,450
A ` 8,907 `2.58
Value per share of `1 = =
B ` 3,450
Value per Share
` 10 Share, fully paid-up = ` 10 × ` 2.58 ` 25.80
` 10 Share, × 8 paid-up = ` 25.80 Less × 2 Unpaid ` 23.80
` 5 Share, fully paid-up = ` 5 × ` 2.58 ` 12.90
Note: Unpaid amount on partly paid up shares is assumed to be called up in the immediate
future.
C. Computation of Value per Share under Dividend Yield Method (` in lakhs)

Particulars
Company's Dividend rate 20%
Normal industry dividend 15%
Value
rate per share
`10  20%
` 10 Shares, fully paid up =
15% ` 13.33
` 8  20%
` 10 Shares, ` 8 paid up = ` 10.67
15%
` 5  20%
` 5 Shares, Fully paid up = `6.67
15%
Note: Dividend is payable only on the paid up value. Hence under dividend - yield Method, the
value per share for different Categories of shares, should be taken on pro- rata basis, as
indicated above.
Particulars ` in Lakhs
Profit after Tax for the year 1,371
Paid up Equity share capital [1,800+720+750] 15%
`1,371 0.42
Company‘s EPS for a share of `1 =
` 3,270
Face Value  Company EPS per `1
Value per share =
Market EPS
`10  0.42 ` 21.00
0.20
` 8  0.42 ` 16..80
` 10 Shares, ` 8 paid up =
0.20
` 5  0.42 `10.50
0.20
Summary of value per under different methods

Particulars Intrinsic value Dividend yield EPS method
method method
` 10 Shares, fully paid up `25.80 `13.33 `21.00
` 10 Shares, ` 8 paid up `23.80 `10.67 `16.80
` 5 Shares, fully paid up `12.90 `6.67 `10.50
Note: Under Intrinsic Value / Net Assets Method, the difference between fully and partly paid up
share will reflect the uncalled amount. However, under Dividend and EPS methods, the
difference between the fully and partly paid up shares will be proportional to the paid up value.
Question 28.
(a) A Company is in the process of setting up a production line for manufacturing a new
product. Based on trial runs conducted by the company, it was noticed that the production
lines output was not of the desired quality. However, company has taken a decision to
manufacture and sell the sub-standard product over the next one year due to the huge
investment involved.
In the background of the relevant accounting standard, advice the company on the cut -
off date for capitalization of the project cost.
(b) In view of the provisions of Accounting Standard 25 on Interim Financial Reporting, on what
basis will you calculate, for an interim period, the provision in respect of defined benefit
schemes like pension, gratuity etc. for the employees?
(c) In May, 2013 Q Ltd. took a bank loan to be used specifically for the construction of a new
factory building. The construction was completed in January, 2014 and the building was
put to its use immediately thereafter. Interest on the actual amount used for construction
of the building till its completion was ` 24 lacs, whereas the total interest payable to the
bank on the loan for the period till 31st March, 2014 amounted to ` 31 lacs.
Can ` 31 lacs be treated as part of the cost of factory building and thus be capitalized on
the plea that the loan was specifically taken for the construction of factory building?
(d) TT Limited has set up its business in a designated backward area which entitles the
company to receive from the Government of India a subsidy of 20% of the cost of
investment. Having fulfilled all the conditions under the scheme, the company on its
investment of ` 50 crore in capital assets, received ` 10 crore from the Government in
January, 2014 (accounting period being 2013-2014). The company wants to treat this
receipt as an item of revenue and thereby reduce the losses on profit and loss account
for the year ended 31st March, 2014.
Keeping in view the relevant Accounting Standard, discuss whether this action is justified
or not.
Answer to 28 (a):
As per provisions of AS 10 ‗Accounting for Fixed Assets‘, expenditure incurred on start -up
and commissioning of the project, including the expenditure incurred on test runs and
experimental production, is usually capitalized as an indirect element of the c onstruction
cost. However, the expenditure incurred after the plant has begun commercial
production i.e., production intended for sale or captive consumption, is not capitalized
and is treated as revenue expenditure even though the contract may stipulate that the
plant will not be finally taken over until after the satisfactory completion of the guarantee
period. In the present case, the company did stop production even if the output was not
of the desired quality, and continued the sub-standard production due to huge
investment involved in the project. Capitalization should cease at the end of the trial run,
since the cut-off date would be the date when the trial run was completed.
Answer to 28 (b):
Accounting Standard 25 suggests that provision in respect of defined benefit schemes

like pension and gratuity for an interim period should be calculated based on the year -
to-date basis by using the actuarially determined rates at the end of the prior financial
year, adjusted for significant market fluctuations since that time and for significant
curtailments, settlements or other significant one-time events.
Answer to 28 (c):
AS 16 clearly states that capitalization of borrowing costs should cease when

substantially all the activities necessary to prepare the qualifying asset for its intended
use are completed. Therefore, interest on the amount that has been used for the
construction of the building upto the date of completion (January, 2014) i.e. ` 24 lac
alone can be capitalized. It cannot be extended to ` 31 lacs.
Answer to 28 (d):
As per para 10 of AS 12 ‗Accounting for Government Grants‘, where the government

grants are of the nature of promoters‘ contribution, i.e. they are given with reference to
the total investment in an undertaking or by way of contribution towards its total capital
outlay (for example, central investment subsidy scheme) and no repayment is ordinarily
expected in respect thereof, the grants are treated as capital reserve which can be
neither distributed as dividend nor considered as deferred income.
In the given case, the subsidy received is neither in relation to specific fixed asset nor in
relation to revenue. Thus it inappropriate to recognise government grants in the profit
and loss statement, since they are not earned but represent an incentive provided by
government without related costs. The correct treatment is to credit the subsidy to
capital reserve. Therefore, the accounting treatment followed by the company is not
proper.
Question 29.
(a) How do you classify different types of real estate? What are the Advantages of Real Estate
investing?
(b) Estimate the brand value of ABC Tech Ltd with help of following information:
` in crores
Year ended 31st March 2014 2013 2012
PBIT 696.03 325.65 155.86
Non branded income 53.43 35.23 3.46
Inflation compound factor@8% 1.000 1.087 1.181
Remuneration of Capital(5% of Average Capital 55.57
Employed)
Tax@30%
Multiple applied 22.18
(c) LM Pvt Ltd. is negotiating to sell their business to a public limited company. The following
is a summarized extract from Balance Sheet as on 31 st March, 2014 of LM Pvt Ltd.
(`)
Share Capital(1000 shares of `1000 each) 10,00,000
Free reserve 2,00,000
12,00,000
Fixed Assets at depreciated cost 6,40,000
Current assets 7,20,000
Less: Current Liabilities 1,60,000 5,60,000
12,00,000
The profits of LM Pvt. Ltd. for the last 5 years has been in existence after eliminating any
extraneous or non-recurring debits and credits were ` 90,000; ` 1,30,000; ` 1,15,000;
`2,40,000; and ` 2,75,000. A return on capital employed at 10% is considered to be
reasonable and it is expected that future requirements as to capital will not materially
vary from capital employed as on 31 st March.
Ignoring extraneous factors that may affect the position, suggest the amount that should
reasonably be paid to the company for goodwill for acquiring the company. You may
make necessary assumptions.
Answer to 29 (a):
Types of real estate:

(1) Raw land: Undeveloped land may be purchased by an investor who hopes that its
market price will rise in the coming years. If the investor is energetic and the location
desirable, the land can be developed by subdividing it and installing roads and sewers
and other amenities. Then parcels of the developed land can be sold.
(2) Rental residences: Investors may purchase residential space to generate rental income.
The owner or hired manager must collect rents, maintain the premises, and keep the
premises rented.
(3) Office buildings: Rental income from a commercial office building can be tax-sheltered.
Keeping the building well maintained and rented to compatible tenants usually requires
professional management.
(4) Warehouses: A building that is to be leased as storage space does not require much
active management with a responsible tenant that will sign a long-term lease.
(5) Neighborhood shopping centres: A profitable shopping centre can be wonderful source
money so long as the neighborhood remains attractive and competing shopping
centres are scarce.
(6) Travel accommodations: A hotel or motel located near a heavily traveled route can be
profitable, but such an asset generally requires professional management.
(7) Private residences: The single-family residence remains the most popular investment in
the United States now a day in India also. In fact, the psychic income associated with
home ownership clouds the rational economic thinking of many prospective buyers.
The advantages are:

(1) Financial Leverage: Financial leverage can be defined as the use of borrowed money to
buy an investment with a larger value than what the buyer could have afforded without
any borrowed money. When an individual can invest borrowed money and earn a rate
of return higher than the rate of interest payable on the loan, the financial leverage is
profitable. Traditionally, real estate investors borrow from 60 to 80 percent of the value
of the properties they acquire, which is a much higher leverage ratio (of loan to asset
value) than is available on most other forms of investment.
(2) Tax Shelter: Real estate investors benefit from tax; laws that encourage real estate
ownership. Rental property can be depreciated, and this depreciation is a tax-
deductible expense that will reduce taxes on the rental income.
(3) Control: Real estate owners can control all physical aspects of their properties-the color
their house is painted, how often the grass is cut, how soon leaking plumbing is repaired,
and other factors, all of which may give them psychic income.
Answer to 29 (b):
The Computation of Brand Value for ABC Tech Ltd is as follows:

(`in crores)
Year ended 31st March 2014 2013 2012
PBIT 696.03 325.65 155.86
Less: Non branded income 53.43 35.23 3.46
Adjusted profits 642.60 29.42 152.40
Inflation compound factor@8% 1.000 1.087 1.181
Present value of profits for the brand 642.60 315.69 179.98
Weightage factor 3 2 1
Weightage profits 1927.80 631.38 179.98
Three years average weighted profits 456.53 - -
Remuneration of Capital(5% of Average Capital 55.57
Employed)
Brand related profits 400.96
Tax at 30% 120.29
Brand earnings 280.67
Multiple applied 22.18
Brand value 6225.26
Answer to 29 (c):
Calculation of average profit of last 5 years = ` (90,000+130,000+115,000+240,000+275,000)/5

= `850000/5 = `170000
Expected return on capital employed = `1200000 ×10/100 = ` 120000
Super profit = `170000 - ` 120000 = ` 50000
Goodwill (assumed to be 3 years super profit) = `50000 ×3 = ` 150000.

Alternatively,
As per Capitalisation method, Goodwill is = (`170000/.10) - ` 1200000
= `1700000-`1200000
= `500000/-
Question 30.
(a) 14 years ago a man took a 21 years lease of a premises on payment of salami and rent
which was equivalent to a net rent of ` 3000/- per month. The net Rack Rent of the
property is ` 5000/- per month. He now wishes to cancel his existing lease and to take a
new lease for 21 years at the existing rental. What should be the value of fair premium or
salami for him to pay? Assume interest on capital is required at 9 % and sinking fund of
3%.
(b) Discuss the financial aspect of valuation of farm house.
(c) KBC Bank had issued a tax saving bond carrying an interest of 8% on face value of `10000/-
per bond with 6 years to maturity and interest payable each year. BB Finance had also
issued a tax saving bond of ` 10000 each with 8 years to maturity and carrying a coupon
rate of 6%.
As on date, i.e two years after the issue date, when a new bond with 6 years to maturity
carries a coupon rate of 7% and bonds with 8 years to maturity carries 5%, and both
these bonds are priced correctly , which is cheaper to buy and how many bonds can be
bought for ` 5 lacs (assume part of a bond can also be bought)?
Answer to 30 (a):
Net Rack rent = ` 5000 p.m

Less: Rent reserved on lease = ` 3000 p.m
` 2000 p.m
Profit on rental = ` 2000 × 12 = ` 24000p.a

Multiplying by years‘ purchase (Y.P) at 9% and 3% for 14 years
= 1/(i+S)
= 1/[i+{r(1+r)n -1}]
Where, i= interest on capital

r=interest on sinking fund
n= years.
Substituting,
= 1/[.09 + P{0.03/(1 + 0.03)14 -1
=6.7328126
And present value of Re. 1 @ 9% for 7 years=1/(1+i) n =1/(1+.0.09) 7

=0.5470342
Y.P dual rate 9% and 3% for 14 years deferred by 7 years

= 6.7328126 × 0.5470342 × `24000
= 3.6830791 × `24000
= ` 88393.898
Or, = ` 88394/-
Amount of premium to be paid = ` 88394/-
Answer to 30 (b):
The Farm building happens to be part of the whole farm. General modes of valuation of
farm houses are as follows:
(i) Land and Building method: This method is used for farm houses located within 8 km from
municipal limit. Capital gains tax is applicable to transfer of such properties.
(ii) Comparative Sales method: The sales comparison approach in farm house valuation is
based primarily on the principle of substitution. This approach assumes a prudent
individual will pay no more for a property than it would cost to purchase a comparable
substitute property. The approach recognizes that a typical buyer will compare asking
prices and seek to purchase the property that meets his or her wants and needs for the
lowest cost. In developing the sales comparison approach, the appraiser attempts to
interpret and measure the actions of parties involved in the marketplace, including
buyers, sellers, and investors. This method may be applied if sale values of comparable
farm houses are available from Revenue Authorities.
(iii) The income capitalization approach (often referred to simply as the "income approach") is
used to value resorts in and around cities/towns. It should be remembered that the
appurtenant land and the land for amenities with building do not give additional agricultural
income. Because it is intended to directly reflect or model the expectations and behaviors of
typical market participants, this approach is generally considered the most applicable
valuation technique for income-producing properties, where sufficient market data exists.
In a commercial income-producing property this approach capitalizes an income stream
into a value indication. This can be done using revenue multipliers or capitalization rates
applied to a Net Operating Income (NOI). Usually, an NOI has been stabilized so as not to
place too much weight on a very recent event. An example of this is an unleased building
which, technically, has no NOI. A stabilized NOI would assume that the building is leased at a
normal rate, and to usual occupancy levels. The Net Operating Income (NOI) is gross
potential income (GPI), less vacancy and collection loss (= Effective Gross Income) less
operating expenses (but excluding debt service, income taxes, and/or depreciation charges
applied by accountants).
(iv) Replacement Cost less depreciation method: Farm houses generally have constraints of free
access and hence lack ability or marketability of the buildings thereon as separate units. This
then rules out capitalization mode of valuation. Hence replacement cost less depreciation is
the prominent method used for valuation of farm house buildings.
Answer to 30 (c):
Value of Bonds based on expected yields:

Particulars KBC BB
(i) Desired Yield 7% 5%
(ii) Face Value ` 10000 ` 10000
(iii) Annual Coupon Rate 8% 6%
(iv) Period of maturity 4 years 6 years
(v) Annual cash flows(Interest)(i×ii) ` 800 ` 600
(vi) PV of Interest Factor for Annuity for period to 3.387 5.076
maturity at the rate of yield
(vii) Present Value of Interest Payments (iv×v) ` 2710 ` 3046
(viii) Maturity Value ` 10000 ` 10000
(ix) PV at Yield Rate at the time of maturity(4 th year and 0.763 0.746
6th year)
(x) Present Value of maturity proceeds(viii×ix) ` 7630 ` 7460
(xi) Value of Bond today(vii+x) ` 10340 ` 10506
Evaluation:
Cheaper Bond is that issued by KBC Bank.
Bonds that can be bought: ` 500000/Market price of Bond = `500000/10340= 48.35 Bonds.

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RTP_Final_Syllabus 2012_Dec‘2014

Paper – 20: Financial Analysis & Business Valuation

SN – 1 [Financial Modeling for Project Appraisal]

Computation of Payback Period:

= 1 year 1 years + 7,500 2 years + 12,000 = 1 year

(` 18, 000 - ` 10, 000)1/ 3 ` 2,667

The projects are ranked as follows according to the various methods:

• Financial modeling supports management in making important business decisions.

Existing Machine New Machine

Number of units produced per hour 12 18

SN – 2 [The Analysis of the Statement of Shareholders‘ Equity]

positive effect/impact on Net Profit Ratio, which is gradually improving.

Liquid Assets `90,000

Interpretation and Significance:

1,300 1,550 1,750

Required: Calculate for the year 2012-13 and 2013-14:

Total Earnings for the year (after tax) ` 400 ` 400

(b) The capital of E. Ltd. is as follows:

(ii) Cover for the equity dividends =

Earnings available to equity shareholders ` 2,43,000

Market price per share ` 40

Let x = Amount to be borrowed to keep the current ratio at 1.50.

(ii) Net Income = EPS x No. of shares

Dividend per share

SN – 3 [The Analysis of the Balance Sheet and Income Statement]

For the year ended 31st March,

Analyse the reasons for variations in profit.

(iv) Decrease in profit due to increase in material price:

(vi) Effect on profit due to variable overhead price variance:

(viii) Effect on profit due to fixed overhead price variance:

Balance Sheet (Extracts)

Retained Earnings ` 50,000

Earnings before Interest and Tax (EBIT)

Market Value of Equity

Current Liabilities (D) 52,400 25,400

Prepare Comparative Balance Sheet and study its financial position.

Comparative Balance Sheet of Maharaj Ltd. as on 31.03.2012 and 31.03.2013

Current Liabilities (D) 52,400 25,400 (–) 27,000 (–) 51.5

Sales 32.00 28.00

Add: Excess of closing stocks over opening stocks 5.00 4.00

Less: Raw materials consumed 8.30 7.80

Wages 4.15 3.90

Direct manufacturing expenses 0.90 0.60

Indirect manufacturing expenses 0.30 0.18

Administrative expenses 1.00 0.90

Selling and distribution expenses 0.90 0.90

Depreciation 2.50 2.00

Interest 2.00 0.92

Profits before tax 16.95 14.80

Sales before the effect of 10% price increased (`)

Raw Material Cost Before the effect of 15% increase (`)

Common Size Income Statement as on 31.12.2013

Sales 31.22 86.67 28.00 87.50

Stock adjustment 4.80 13.33 4.00 12.50

(i) 36.02 100.00 32.00 100.00

(b) Describe Off-Balance-Sheet Financing.

SN – 4 [The Analysis of the Cash Flow Statement]

Equities & Liabilities ` (‗000) Assets ` (‗000)