[Link]. Name of the Chapter Page No.

1 Introduction 1–9

2 Time Value Of Money 10 – 15

3 Capital Budgeting 16 – 31

4 Cost Of Capital 32 – 38

5 Capital Structure And Capital Structure 39 – 45

Theories

6 Debtors Management 46 – 51

7 Cash Management 52 – 58

8 Management Of Working Capital 59 – 69

9 Ratio Analysis 70 – 86

10 Leverage 87 – 89

11 Dividend Policy And Equity Valuation 90 – 98

VIDHYODAY EDUCATION – AUDICHYA BHAWAN Behind High Court, South Tukoganj, Indore [M.P.] | 8181815951
VIDHYODAY EDUCATION – AUDICHYA BHAWAN Behind High Court, South Tukoganj, Indore [M.P.] | 8181815951
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INTRODUCTION

Definition of Financial Management

“Financial management is procurement of fund and its effective utilization”

“Financial Management comprises of forecasting, planning, organizing, directing, co-ordinating and
controlling of all activities relating to acquisition and application of the financial resources of an
undertaking in keeping with its financial objective.
Another very elaborate definition given by Phillippatus is: “Financial Management is concerned with
the managerial decisions that result in the acquisition and financing of short term and long term
credits for the firm.”

Two Aspect of F.M.

Procurement of fund Effective Utilization

EVOLUTION OF FINANCIAL MANAGEMENT

The evolution of Financial Management is divided into three phases :

The Traditional Phase: During this phase, Financial Management was considered necessary only
during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking
financial decisions in the organisation, the needs of outsiders (investment bankers, people who lend
money to the business and other such people) to the business was kept in mind.
The Transitional Phase: During this phase, the day-to-day problems that financial managers faced
were given importance. The general problems related to funds analysis, planning and control were
given more attention in this phase.
The Modern Phase: Modern phase is still going on. The scope of Financial Management has greatly
increased now. It is important to carry out financial analysis for a company. This analysis helps in

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decision making. During this phase, many theories have been developed regarding efficient markets,
capital budgeting, option pricing, valuation models and also in several other important fields in
financial management.

FINANCE FUNCTIONS /
FINANCE DECISION

Long Term Short Term

Working
Investment Financing Dividend
Capital
Decision Decision Decision
Decision

IMPORTANCE OF FINANCIAL MANAGEMENT

Without proper administration of finance, no business enterprise can reach at its full potentials for
growth and success.
The best way to demonstrate the importance of good financial management is to describe some of the
tasks that it involves:-
 Taking care not to over-invest in fixed assets
 Balancing cash-outflow with cash-inflows
 Ensuring that there is a sufficient level of short-term working capital
 Setting sales revenue targets that will deliver growth

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INTRODUCTION
 Increasing gross profit by setting the correct pricing for products or services
 Controlling the level of general and administrative expenses by finding more cost-efficient ways of
running the day-to-day business operations, and
 Tax planning that will minimize the taxes a business has to pay.

SCOPE OF FINANCIAL MANAGEMENT

As an integral part of the overall management, financial management is mainly concerned with
acquisition and use of funds by an organization. Based on financial management guru Ezra Solomon’s
concept of financial management, following aspects are taken up in detail under the study of financial
management:
a) Determination of size of the enterprise and determination of rate of growth.
b) Determining the composition of assets of the enterprise.
c) Determining the mix of enterprise’s financing i.e. consideration of level of debt to equity, etc.
d) Analysis, planning and control of financial affairs of the enterprise.

ROLE OF FINANCIAL CONTROLLER

Financial Controller

Maximisation of Share Value

Financial Decision
Financial Decisions Investment Decisions Dividend Decisions

Trade off
Return Risk

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INTRODUCTION

OBJECTIVES OF FINANCIAL MANAGEMENT

Profit Maximization Wealth / Value Maximization

Wealth of Shareholders

No. of Shares × MPS

Limitations / Disadvantages of profit Maximization :

1. It is not beneficial in long term

2. It leads to decrease in goodwill
3. It leads to decrease in MPS
4. It does not consider risk factor
5. It does not consider time value of money
6. It is too narrow concept
7. Word profit is not clear.

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Advantages of profit maximization

1. It is beneficial in short term

2. It is easy to calculate
3. Directly linked with financial decisions

Advantages of wealth maximization

1.
2.
3.
4.
5.

Disadvantages of Wealth maximization

1. Difficult to calculate
2. No clear relationship between financial decisions
3. Can lead to management anxietyand frustration.

ROLE OF FINANCE EXECUTIVE

the finance executive of an organisation plays an important role in the company’s goals, policies, and
financial success. His responsibilities include:
a) Financial analysis and planning: Determining the proper amount of funds to employ in the firm, i.e.
designating the size of the firm and its rate of growth.
b) Investment decisions: The efficient allocation of funds to specific assets.
c) Financing and capital structure decisions: Raising funds on favourable terms as possible i.e.
determining the composition of liabilities.
d) Management of financial resources (such as working capital).
e) Risk management: Protecting assets.

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INTRODUCTION

Chief Financial Officer / Finance Executive

Treasurer Controller

Cash Credit Financial Accounting Cost Accounting

Manager Manager Manager Manager

Capital Budgeting Fund Raising Tax Data Processing

Manager Manager Manager Manager

Portfolio Manager Internal Auditor

ORGANISATION OF FINANCE FUNCTION

What a CFO used to do? What a CFO now does?

Budgeting Budgeting

Forecasting Forecasting

Treasury (cash management) Profiability analysis (for exmaple, by customer or

product)

Preparing internal financial reports for Pricing analysis

management

Preparing quarterly, annual filings for investors Decisions about outsourcing

Tax filing Overseeing the IT Function

Tracking accounts payalbe and accounts Overseeing the HR function

receivable

Travel and entertainment expense management Stratetic planning ( sometimes overseeing this
function)

Regulatory compliance

Risk management

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FINANCIAL DISTRESS AND INSOLVENCY

There are various factors like price of the product/ service, demand, price of inputs e.g. raw material,
labour etc., which is to be managed by an organisation on a continuous basis. Proportion of debt also
need to be managed by an organisation very delicately. Higher debt requires higher interest and if the
cash inflow is not sufficient then it will put lot of pressure to the organisation. Both short term and
long term creditors will put stress to the firm. If all the above factors are not well managed by the firm,
it can create situation known as distress, so financial distress is a position where Cash inflows of a
firm are inadequate to meet all its current obligations. Now if distress continues for a long period of
time, firm may have to sell its asset, even many times at a lower price. Further when revenue is
inadequate to revive the situation, firm will not be able to meet its obligations and become insolvent.
So, insolvency basically means inability of a firm to repay various debts and is a result of continuous
financial distress.

Financial Management and Accounting

The relationship between financial management and accounting are closely related to the extent that
accounting is an important input in financial decision making. In other words, accounting is a
necessary input into the financial management function.
The outcome of accounting is the financial statements such as balance sheet, income statement, and
the statement of changes in financial position. The information contained in these statements and
reports helps the financial managers to understand the past performance and future directions of the
organisation.
Though financial management and accounting are closely related, still they differ in the treatment of
funds and also with regards to decision making. Some of the differences are:-

Treatment of fund :

Account : Accrual Concept

FM : Cash Basis

Decision Making

The chief focus of an accountant is to collect data and present the data while the financial manager’s
primary responsibility relates to financial planning, controlling and decision making. Thus, in a way it
can be stated that financial management begins where accounting ends.

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INTRODUCTION
Financial Management and Other Related Disciplines

Financial Decision Areas

1. Investment analysis
2. Working capital management Support Primary Discipline
3. Sources and cost of funds 1. Accounting
4. Determination of capital structure
5. Dividend policy
6. Analysis of risks and return Support Other Related Disciplines
1. Marketing
2. Production
Resulting in 3. Quantitative methods

Shareholder’s wealth maximisation

Impact of Other Disciplines on Financial Management

AGENCY PROBLEM AND AGENCY COST

Though in a sole proprietorship firm, partnership etc., owners participate in management but in
corporates, owners are not active in management so, there is a separation between owner/
shareholders and managers. In theory managers should act in the best interest of shareholders
however in reality, managers may try to maximise their individual goal like salary, perks etc., so there
is a principal agent relationship between managers and owners, which is known as Agency Problem. In
a nutshell, Agency Problem is the chances that managers may place personal goals ahead of the goal of
owners. Agency Problem leads to Agency Cost. Agency cost is the additional cost borne by the
shareholders to monitor the manager and control their behaviour so as to maximise shareholders
wealth. Generally, Agency Costs are of four types
(i) monitoring
(ii) bonding
(iii) opportunity
(iv) structuring.

Addressing the agency problem

Agency problem between the managers and shareholders can be addressed if the interests of the
managers are aligned to the interests of the share- holders.
following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and also with the long
term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption that maximisation
of the stock price is the objective of the investors.
 Effecting monitoring can be done.

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 CA INTER CHAPTER 1
TIME VALUE OF MONEY

Let’s start a discussion on Time Value of Money by taking a very simple scenario. If you are offered the
choice between having Rs. 1,00,000 today or having Rs. 1,00,000 at a future date, you will usually
prefer to have Rs. 1,00,000 now. Similarly if you have a choice between paying Rs. 1,00,000 now or
paying the same Rs. 1,00,000 at future date, you will usually prefer to pay Rs. 1,00,000 later. It is
simple common sense. In the first case by accepting Rs 1,00,000 early, you can simply put the money
in Bank and earn some interest. Similarly in the second case by deferring the payment, you can earn
interest by keeping the money in the bank.
Therefore the time gap allowed helps us to make some money. This incremental gain is Time Value of
Money.
Time value of money results from the concept of interest. So it now time to discuss Interest.

Simple Interest:-

It may be defined as Interest that is calculated as a simple percentage of the ORIGINAL PRINCIPAL
AMOUNT.
SI = Po (i)(n)
Where,
S I= Simple Interest
Po= Original Principal
i = Interest rate per time period
n = No. of time period
FV = Po + SI
Where,
FV = Future Value

Compound Interest:-

Interest that is calculated on total of previously earned interest and the original principal amount.

Future Value of Single Cash Flow:-

FV = PV (1+r)n
Where,
PV = present value
r = rate of interest per period
(1+r)n= future value interest factor / future value factor

Future Value of an Annuity:-

An annuity is a stream of constant cash flows occurring at a regular interval of time. Examples- RD,
Pension etc.
A (1  r)n  1
r
Where,
FVA = future value of annuity

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TIME VALUE OF MONEY

A = constant periodic amount

r = rate of interest per period
n = duration of annuity
[(1+r)n – 1 = future value annuity factor

Present Value of Single Cash Flow:-

PV = FV x 1/(1+r)n

Present Value of Annuity:-

PVA = A [ 1 – 1/(1+r)n ]
-----------------
r

Deferred Annuity:-

Deferred Annuity is an annuity which begins late.

 1 
A 1 
(1  r)n  1
  
r (1  r)n
Where,
m= deferment period

Annuity Due:-

Annuity due means an annuity in which installments accrue at the beginning of the period.
PV of Annuity Due
 1 
A 1 
(1  r)n 
  1  r 
r

Effective Interest Rate:-

ER = [ 1 + NR/m ]m – 1
Where,
ER= effective rate
NR= nominal rate
m = no. of times interest is compounded in a year.

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TIME VALUE OF MONEY

PRACTICAL QUESTIONS

Simple Interest

Question 1: If you invest Rs. 10,000 in a bank at a simple interest of 7% p.a. what will be the amount
at the end of three years ?

Question 2: Find the rate of interest, if the amount owed after 6 months is Rs. 1,050, borrowed
amount being Rs. 1,000.

Future Value of a Single Cash Flow

Question 3: If you invest Rs.10,000 today at a compound interest rate of 10%, what will be its future
value after 5 years ?

Question 4: How much time will it take to double the fixed deposit of Rs. 50,000, if the rate of
interest is 12 % p.a.

Question 5: Determine the compound interest for an investment of Rs. 7,500 at 6% compounded
half yearly for 5 years.
Given that (1+r)n for i=0.03 and n=12 is 1.42576

Question 6: Rs. 2,000 is invested at annual rate of interest of 10%. What is the amount after two year
if the compounding is done :
(a) Annually (b) Semi Annually (c) Monthly (d) Daily

Question 7: What annual rate of interest compounded annually doubles an investment in 7 years ?
Given that 21/7 = 1.104090

Question 8: SRK has deposited Rs. 55,650 in a bank, which is paying 15 percent rate of interest on a
ten year time deposit. Calculate the amount at the end of ten years?

Present Value of Single Cash Flow

Question 9: Find out the present value of Rs. 10,000 to be required after five years if the interest rate
be 9%.

Question 10: (Capital Budgeting Basic) What is the total present value of the following earnings
(discounting rate = 12 %):-
Year Earnings
0 1000
1 2000
2 3000
3 4000

Question 11: A company offers a fixed deposit scheme whereby Rs. 10,000 matures to 12,625 after
two years, on a half-yearly compounding basis. If the company wishes to amend the
scheme by compounding interest every quarter. What will be the revised maturity
value?

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TIME VALUE OF MONEY

Future Value of Annuity

Question 12: Find out the amount of an annuity if payment of Rs. 500 is made annually for 7 years at
interest rate of 14% compounded annually.

Question 13: Rs. 200 is invested at the end of each month in an account paying interest 6% per year
compounded monthly. What is the amount of this annuity after 10th payment? Given
that (1.005)10 = 1.0511

Question 14: If you are investing Rs. 80,000 every year at rate of interest 14% p.a. How long it will
take time to become Rs.10,00,000?

Question 15: Your annual saving is Rs.5,000 and you want Rs. 40,000 after five year. At what rate of
interest you should invest your saving to achieve your desired amount?

Present Value of Annuity

Question 16: Find out the present value of a 4 year annuity of Rs. 20,000 discounted at 10 percent?

Question 17: Y bought a TV costing Rs.3,000 and agreeing to make equal annual payment for 4 years.
How much would be each payment if the interest on unpaid amount be 14%
compounded annually?

Question 18: M.S. Dhoni has taken a 20 months car loan of Rs. 6,00,[Link] rate of interest is 12
percent p.a. What will be the amount of monthly loan amortization?

Question 19: Find the missing figures of the following annuity:-

1. (a) Amount= 10,000, (b) i= 10% (c) n=5years (d) PVA = ?
2. (a) Amount= 15,000 (b) i= ? (c) n=5years (d) PVA= 54,072
3. (a) Amount = 20,000 (b) i= 15% (c) n=? (d) PVA= 45,665
4. (a) Amount =? (b) i= 8% (c) n=7years (d) PVA= 26,032

Perpetuity

Question 20: Find out the present value of perpetuity of Rs. 3,000 @ 10 % p.a.

Question 21: Assuming that the discount rate is 7% p.a., how much would you pay to receive Rs. 50,
growing at 5% annually, forever?

Deferred Annuity

Question 22: Find out the present value of 5 annual installment of Rs. 5,000, beginning from the end
of year 3, if the rate of interest is 13 percent.

Annuity Due

Question 23: A Private Finance Co. is giving a machinery on rental basis @ 50,000 p.a., payable in
advance for upcoming 10 years. Company is charging interest @ 18%, what is the
present value of the offer?

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TIME VALUE OF MONEY

Effective Rate of Return

Question 24: Find the effective rate of interest in the following cases:-
a) Nominal rate of interest is 15%, compounded quarterly.
b) Nominal rate of interest is 12%, compounded half yearly.
c) Nominal rate of interest is 10%, compounded Monthly.

Advanced

Question 25: Mr. X has made a real estate investment for Rs. 12,000 which he expects will have a
maturity value equivalent to interest at 12% compounded monthly for 5 years. If most
saving institutions currently pay 8% compounded quarterly on a five year term, what is
the least amount for which Mr. X should sell his property ?
Given that (1+i)n = 1.81669670 for i=1% and n=60, (1+i)-n= 0.67297133 for i=2%
and n= 20

Question 26: Z plans to receive an annuity of Rs. 5,000 semi-annually for 10 years after he retires in
18 years. Money is worth 9% compounded semi-annually.
a) How much amount is required to finance the annuity?
b) What amount of single deposit made now would provide the funds for the annuity?
c) How much will Mr. Z receive from the annuity?

Question 27: A person opened an account on April,2009 with a deposit of Rs. 800. The account paid
6% interest compounded quarterly. On October 1, 2009, he closed the account and
added enough additional money to invest in a 6-month time deposit for Rs. 1,000
earning 6% compounded monthly.
a) How much additional amount did the person invest on October 1?
b) What was the maturity value of his time deposit on April 1, 2010?
c) How much total interest was earned?

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 CA INTER CHAPTER 2
CAPITAL BUDGETING

Question 1: ABC Ltd. is evaluating the purchase of a new project with a depreciable base of Rs.
1,00,000; expected economic life of 4 years and change in earnings before taxes and
depreciation of Rs. 45,000 in year 1, Rs.30,000 in year 2, Rs. 25,000 in year 3 and Rs.
35,000 in year 4. Assume strait-line depreciation and 20% tax rate. You are required to
compute relevant cash flows.

Accounting/Average Rate of Return (ARR)

Question 2: ABC Ltd. provide you the following information:

Purchase price of Machine Rs.80,000
Installation Charges Rs.20,000
Estimated salvage value at the end of useful life Rs.40,000
Useful Life 4 years
Working capital required Rs.10,000
Annual Earnings before Dep. & Tax Rs.65,000
Tax Rate 30%
Calculate ARR if the method of Dep. Is (a) SLM (b) WDV (WDV rate 20% ).

Question 3: XYZ Ltd. provides you the following information:

Purchase price of each Machine Rs.6,00,000
Working Capital Rs.3,00,000
Useful Life 5 Years
Estimated Salvage Value Rs.1,00,000
Method of Dep. SLM
Tax Rate 30%
Earning before Dep. & tax:

Machine Year 1 Year 2 Year 3 Year 4 Year 5

Machine X 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000

Machine Y - 1,00,000 2,00,000 3,00,000 12,00,000
Machine Z 5,00,000 4,00,000 3,00,000 2,00,000 -

Which of the above Machines should be purchased on the basis of ARR Method?

Payback Period

Question 4: Calculate pay-back period in the following cases:

Particulars Project A Project B Project C
Initial cash outflow Rs. 4,00,000 Rs. 3,50,000 Rs. 2,80,000
Annual CFAT Rs.1,00,000 Rs.1,00,000 Rs.1,00,000
Life of Project 5 Years 5 Years 5 Years

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CAPITAL BUDGETING

Question 5: Calculate Payback period from the following information:-

 Initial outflow is Rs.1,00,000
 Annual CFAT:

Year 1 Year 2 Year 3 Year 4 Year 5

40,000 30,000 50,000 40,000 45,000

Discounted Payback Period

Question 6: Calculate discounted payback period from the following information:

 Initial Outflow is Rs. 1,50,000
 Annual CFAT is Rs. 50,000 for 5 years
 Discounting rate 10%

Question 7: Calculate discounted payback period from the information provided in Question 5;
Discounting rate is 10%.

Net Present Value

Question 8: Mr. Santa purchased a Machine of Rs.12,00,000. Expected Earning from the machine is
as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

3,00,000 3,25,000 3,50,000 4,00,000 5,00,000

Find out Net Present Value. (discounting rate 10% )

a) What if, when the tax rate is 30% in Question no. 8.
b) What if in Q.8, when the tax rate is 30% ; Salvage value 2,00,000; Useful life is 5
years; Dep. Method SLM.
c) What if in Q.8, when the tax rate is 30%; Estimated salvage value 2,00,000, Actual
salvage value 1,00,000; useful life is 5 years; SLM Dep.
d) What if in Q.8, when the tax rate is 30%; Estimated salvage value 2,00,000, Actual
salvage value 1,00,000; useful life is 5 years; SLM Dep.; working capital required
1,00,000 at the beginning of the year.

Question 9: A large profit making company is considering the installation of a machine to process
the waste produced by one of its existing manufacturing process to be converted into a
marketable product. At present, the waste is removed by a contractor for disposal on
payment by the company of Rs.50lacs per annum for the next four years. The contract
can be terminated upon installation of the aforesaid machine on payment of a
compensation of Rs.30lacs before the processing operation starts. This compensation is
not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost Rs.200lacs to be financed
by a loan repayable in four equal installments commencing from the end of year 1. The
interest is 16% per annum. At the end of the 4th year, the machine can be sold for
Rs.20lacs and the cost of dismantling and removal will be Rs.15lacs.

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CAPITAL BUDGETING

Sales and direct costs of the product emerging from waste processing for 4 years are
estimated as under:
(Rs. in lacs)

Year 1 2 3 4

-Sales 322 322 418 418

-Material consumption 30 40 85 85
-Wages 75 75 85 100
-Other expenses 40 45 54 70
-Factory overheads 55 60 110 145
-Depreciation(as per income tax rules) 50 38 28 21

Initial stock of material required before commencement of the processing operations is

Rs.20lacs at the start of year 1. The stock levels of materials to be maintained at the end
of year 1, 2 and 3 will be Rs.55lacs and the stock at the end of year 4 will be nil. The
storage of materials will utilize space which would otherwise have been rented out for
Rs.10lacs per annum. Labour costs include wages of 40 workers, whose transfer to the
process will reduce idle time payments of Rs.15lacs in the year 1 and Rs.10lacs in the
year 2. Factory overheads include apportionment of general factory overheads except to
the extent of insurance charges of Rs.30lacs per annum payable on this venture. The
company’s tax rate is 50%.
Present value factors for four years are as under:

Year 1 2 3 4

Present value factors 0.870 0.756 0.658 0.572

Advise the management on the desirability of installing the machine for processing the
waste. All calculations should form part of the answer.

Question 10: X Ltd. an existing profit making company, is planning to introduce a new product with a
projected life of 8 years. Initial equipment cost will be Rs,120lacs and additional
equipment costing Rs. 10lacs will be needed at the beginning of third year. At the end of
the 8th year, the original equipment will have resale value equivalent to the cost of
removal, but the additional equipment will be sold for Rs.1lac. Working capital of
Rs.15lacs will be needed. The 100% capacity of the plant is of 400000 units per annum,
but the production and sale volume expected are as under:

Year Capacity in percentage

1 20

2 30

3-5 75

6-8 50

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A sale price of Rs.100 per unit with a profit volume ratio of 60% is likely to be obtained.
Fixed operating cash cost are likely to be Rs.16lacs per annum. In addition to this the
advertisement expenditure will have to be incurred as under:

Year 1 2 3-5 6-8

Expenditure(in lacs, each year) 30 15 10 4

The company is subject to 50% tax, straight line method of depreciation, (permissible
for tax purposes also) and taking 12% as appropriate after tax cost of capital, should the
project be accepted?

Question 11: A Company is considering the proposal taking up a new project which requires an
investment of Rs.400lacs on machinery and other assets. The project is expected to yield
the following earnings (before depreciation and taxes) over the next five years:

Year Earnings(in lacs)

1 160

2 160

3 180

4 180

5 150

The cost of raising the additional capital is 12% and assets have to be depreciated at
20% on ‘Written Down Value’ basis. The scrap value at the end of the five years’ period
may be taken as zero. Income tax applicable to the company is 50%.
You are required to calculate the net present value of the project and advise the
management to take appropriate decision. Also calculate the internal rate of return of
the project.
Note: Present value of Rs.1 at different rates of interest are as under:

Year PVF@10% PVF@12% PVF@14% PVF@16%

1 0.91 0.89 0.88 0.86

2 0.83 0.80 0.77 0.74

3 0.75 0.71 0.67 0.64

4 0.68 0.64 0.59 0.55

5 0.62 0.57 0.52 0.48

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Question 12: ABC Company Ltd. has been producing a chemical product by using machine Z for the
last two years. Now the management of the company is thinking to replace this machine
either by X or Y machine. The following details are furnished to you:
(in Rs.)

Z X Y

-Book value 1,00,000 - -

-Resale value now 1,10,000 - -
-Purchase price 1,80,000 2,00,000
-Annual fixed cost (including depreciation) 92,000 1,08,000 1,32,000
-Variable running cost(including labour)per unit 3 1.5 2.5
-Production per hour 8 8 12

You are also provided the following details:

-Selling price per unit 20
-Cost of materials per unit 10
-Annual operating hours 2000

Working life of each of the three machines (as from now)

Salvage value of machine Z is Rs.10,000, X is Rs.15,000 and Y is 18,000
The company charges depreciation using straight line method. It is anticipated that an
additional cost of Rs.8,000 per annum would be incurred on special advertising to sell
the extra output of machine Y. Assume tax rate of 50% and cost of capital 10%. The
present value of Rs.1 to be received at the end of the year at 10% is as under:

Year 1 2 3 4 5

Present 0.909 0.826 0.751 0.683 0.621

value

Required: Using NPV method, you are required to analyse the feasibility of the proposal
and make recommendations.

Question 13:
a) Company X is forced to choose between two machines A and B. The two machines are
designed differently, but have identical capacity and do exactly the same job. Machine A
costs Rs.150000 and will last for 3 years. It costs Rs.40000 per year to run. Machine B is
an ‘economy’ model costing only Rs.100000 but will last only 2 years and costs
Rs.60000 per year to run. These are real cash flows. The costs are forecasted in rupees
of constant purchasing power. Ignore tax. Opportunity cost of capital is 10%. Which
machine company X should buy?

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CAPITAL BUDGETING

b) Company Y is operating an elderly machine that is expected to produce a net cash inflow
of Rs.40000 in the coming year and Rs.40000 next year. Current salvage value is
Rs.80000 and next year’s value is Rs.70000. The machine can be replaced now with a
new machine, which costs Rs.150000, but is much more efficient and will provide a cash
inflow of Rs.80000 a year for 3 years. Company Y wants to know whether it should
replace the equipment now or wait a year with the clear understanding that the new
machine is the best of the available alternatives and that it in turn be replaced at the
optimal point. Ignore tax. Take opportunity cost of capital as 10%. Advice with reasons.

Question 14: MNP limited is thinking of replacing its existing machine by a new machine which would
cost Rs.60lacs. The company’s current production is 80000 units, and is expected to
increase to 100000 units, if the new machine is bought. The selling price of the product
would remain unchanged at Rs.200 per unit. The following is the cost of producing one
unit of product using both the existing and new machine:
Unit cost(in Rs.)

Existing machine New machine

Difference
(80000 units) (100000 units)

Material 75.0 63.75 (11.25)

Wages & 51.25 37.50 (13.75)

salaries

Supervision 20.0 25.0 5.0

Repair & 11.25 7.50 (3.75)

maintenance

Power & Fuel 15.50 14.25 (1.25)

Depreciation 0.25 5.0 4.75

Allocated 10.0 12.50 2.50

Corporate
Overhead

The existing machine has an accounting book value of Rs.100000, and it has been fully
depreciated for tax purpose. It is estimated that machine will be useful for 5 years. The
supplier of the new machine has offered to accept the old machine for Rs.250000.
However, the market price of old machine today is Rs.150000 and it is expected to be
Rs.35000 after 5 years. The new machine has a life of 5 years and a salvage value of
Rs.250000 at the end of its economic life. Assume corporate income tax rate at 40%, and
depreciation is charged on straight line basis for income tax purpose. Further assume
that book profit is treated as ordinary income for tax purpose. The opportunity cost of
capital of the company is 15%.
Required:
1. Estimate the net present value of the replacement decision.
2. Estimate the internal rate of return of the replacement decision.
3. Should company go ahead with the replacement decision? Suggest.

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 CA INTER CHAPTER 2
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Year 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.8000 0.6400 0.5120 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

Question 15: WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated
useful life is 8 years with no salvage value in the end. Its current market value is
Rs.200000. The company is considering a proposal to purchase a new model of machine
to replace the existing machine. The relevant informations are as follows:

Existing Machine New Machine

Cost of machine Rs.330000 Rs.1000000

Estimated life 11 Years 8 Years

Salvage value Nil Rs.40000

Annual output 30000 units 75000 units

Selling price per unit Rs.15 Rs.15

Annual operating hours 3000 3000

Material cost per unit Rs.4 Rs.4

Labour cost per hour Rs.40 Rs.70

Indirect cash cost per annum Rs.50000 Rs.65000

The company follow the straight line method of depreciation. The corporate tax rate is
30% and WX Ltd. does not make any investment, if it yields less than 12%. Present value
of annuity of Rs.1 at 12% rate of discount for 8 years is 4.968. present value of Rs.1 at
12% rate of discount, received at the end of 8th year is 0.404. Ignore capital gain tax.
Advise WX Ltd. whether the existing machine should be replaced or not.

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Project with Unequal Life

Question 16: As Finance adviser, advise the company about selection of the following mutually
exclusive projects by:
a) Common Time Horizon Method
b) Equivalent Net Present Value Method

Particulars Project A Project B

Initial outflow 1,00,000 1,50,000
Life of the project 6 years 3 years
Annual Cash Inflow
Year 1 20,000 60,000
Year 2 30,000 75,000
Year 3 25,000 60,000
Year 4 40,000 -
Year 5 20,000 -
Year 6 25,000 -

( discounting rate = 10% )

The cash flows of two mutually exclusive projects are as under:
(in Rs.)

Time T0 T1 T2 T3 T4 T5 T6

Project‘P’ (-)40000 13000 8000 14000 12000 11000 15000

Project ‘J’ (-)20000 7000 13000 12000 - - -

Required:
1. Estimate the net present value of the project ‘P’ and ‘J’ using 15% as the hurdle
rate.
2. Estimate the internal rate of return of the Project ‘P’ and ‘J’.
3. Why there is a conflict in the project choice by using NPV and IRR criterion?
4. Which criteria you will use in such situation ? Estimate the value at that criterion.
Make a project choice.
The present value interest factor values at different rates of discount are as under:
Rate of
T0 T1 T2 T3 T4 T5 T6
discount
0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704
0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499

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 CA INTER CHAPTER 2
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Internal Rate of Return

Question 17: A company processes to install a machine involving a capital cost of Rs.360000. The life
of the machine is 5 years and its salvage value at the end of the life is nil. The machine
will produce the net operating income after depreciation of Rs.68000 per annum. The
company’s tax rate is 45%.
The net present value factors for 5 years are as under:

Discounted rate 14 15 16 17 18

Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to calculate the internal rate of return of the proposal.

Profitability Index

Question 18: A company has to make a choice between two projects namely A and B. The initial
capital outlay of two projects are Rs.135000 and Rs.240000 respectively for A and B.
There will be no scrap value at the end of the life of both the projects. The opportunity
cost of capital of the company is 16%. The annual income are as under:
Year Project A Project B Discounting factor @16%
1 - 60000 0.862
2 30000 84000 0.743
3 132000 96000 0.641
4 84000 102000 0.552
5 84000 90000 0.476
You are required to calculate for each project:
1. Discounted payback period
2. Profitability index
3. Net present value

Question 19: S Ltd. has Rs.1000000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined:
Project Amount Profitability index
1 300000 1.22
2 150000 0.95
3 350000 1.20
4 450000 1.18
5 200000 1.20
6 400000 1.05
Which of the above investments should be undertaken? Assume that projects are
divisible and there is no alternative use of the money allocated for capital budgeting.

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Question 20: S Ltd. has Rs.1000000 allocated for capital budgeting purposes. The following proposals
and associated profitability indexes have been determined:
Project Amount Profitability index
1 300000 1.22
2 150000 0.95
3 350000 1.20
4 450000 1.18
5 200000 1.20
6 400000 1.05
Which of the above investments should be undertaken? Assume that projects are
indivisible and there is no alternative use of the money allocated for capital budgeting.

Project NPV Vs. Equity NPV

Question 21: Ad-hoc Ltd. provides you the following information:

 Total cost of plant (life 4 years) Rs.300 Lakhs.
 Plant is to be financed by 12% Debts and Equity so as to maintain Debt-Equity Ratiio
of 2:[Link] is to be repaid in four equal installments beginning from the end of first
year.
 Annual earnings before interest, Dep. And tax: Rs.200 lakhs
 Tax rate 50%
 Cost of capital 9%
 Method of Dep. : SLM
Calculate
a) Project NPV;
b) Equity NPV

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PRACTICE QUESTIONS

Question 1: Consider the following mutually exclusive projects:

Cash flows
Project
C0 C1 C2 C3 C4

A (-)10000 6000 2000 2000 12000

B (-)10000 2500 2500 5000 7500
C (-)3500 1500 2500 500 5000
D (-)3000 0 0 3000 6000

Required:
1. Calculate the payback period for each project.
2. If the standard payback period is 2 years, which project will you select? Will your
answer differ, if standard payback period is 3 years?
3. If the cost of capital is 10%, compute the discounted payback period for each
project. Which projects will you recommend, if standard discounted payback
period is (a) 2 years; (b) 3 years?
4. Compute NPV of each project. Which project will you recommend on the NPV
criterion? The cost of capital is 10%. What will be the appropriate choice criteria in
this case? The PV factor at 10% are:

Year 1 2 3 4

PVF@10% 0.9091 0.8264 0.7513 0.6830

Question 2: Given below are the data on a capital project ‘M’:

Annual cost saving : Rs.60000
Useful life : 4 Years
Internal rate of return : 15%
Profitability index : 1.064
Salvage value : 0
You are required to calculate for this project ‘M’:
1. Cost of capital
2. Payback period
3. Cost of project
4. Net present value

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Question 3: A Ltd. is considering the purchase of a machine which will perform some operations
which are at present performed by workers. Machines X and Y are alternatives models.
The following details are available:
(in Rs.)
Machine X Machine Y
Cost of machine 150000 240000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance (p.a.) 7000 11000
Estimated cost of indirect material (p.a.) 6000 8000
Estimated savings in scrap (p.a.) 10000 15000
Estimated cost of supervision (p.a.) 12000 16000
Estimated savings in wages (p.a.) 90000 120000

Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the
alternatives according to:
1. Average of return method, and
2. Present value index method assuming cost of capital being 10%.
(The present value of Rs.1 @10%p.a. for 5 years is 3.79 and for 6 years is 4.354)

Question 4: An investment of Rs.136000 yields the following cash inflows (profits before
depreciation but after tax). Determine internal rate of return and modified internal rate
of return.

Year 1 2 3 4 5

Cash inflows 30000 40000 60000 30000 20000

Question 5: XYZ Ltd. is considering a new investment project about which the following information
is available:
1. The total outlay on the project will be Rs.100lacs. This consists of Rs.60lacs on
plant and equipment and Rs.40lacs on gross working capital. The entire outlay will
be incurred at the beginning of the project.
2. The project will be financed with Rs.40lacs of equity capital; Rs.30lacs of long term
debt (in the form of debenture); Rs.20lacs short term borrowings, and Rs.10lacs of
trade credit. This means that Rs.70lacs of long term finds (equity + long term
debt) will be applied towards plant and equipment (Rs.60lacs) and working
capital margin (Rs.10lacs) – working capital margin is defined as the contribution
of long term funds towards working capital. The interest rate on debentures will
be 15% and the interest rate on short term borrowings will be 18%.
3. The life of the project is expected to be five years and the plant and equipment
would fetch a salvage value of Rs.20lacs. The liquidation value of working capital
will be equal to Rs.10lacs.
4. The project will increase the revenues of the firm by Rs.80lacs per year. The
increase in operating expenses on account of the project will be Rs.35lacs per year.

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 CA INTER CHAPTER 2
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(this includes all items of expenses other than depreciation, interest and taxes).
The effective tax rate will be 50%.
5. Plant and equipment will be depreciated at the rate of 331/3% per year as per the
written down value method. So, the depreciation charges will be:
(Rs. in lacs)

1st year 20.0

2nd year 13.3

3rd year 8.9

4th year 5.9

5th year 4.0

Given the above details, you are required to work out the post tax, incremental cash
flows relating to long term funds.

Question 6: Happy Singh Taxiwala is a long established tour operator providing high quality
transport to their clients. It currently owns and runs 250 cars and has turnover of
Rs.100lacs p.a.
The current system of allocating jobs to drivers is very insufficient. Happy Singh is
considering the implementation of a new computerized tracking system called ‘Banta’.
This will make the allocation of jobs far more efficient.
You are as accounting technician, for an accounting firm, has been appointed to advice
Happy Singh to decide whether ‘Banta’ should be implemented. The project is being
appraised over five years.
The costs and benefits of the new system are as follows:
1. The Central Tracking System costs Rs.2100000 to implement. This amount will be
payable in three equal installments-One immediately, the second in one years’ time
and third in two years’ time.
2. Depreciation on the new system will be provided at Rs.420000 p.a.
3. Staff will need to be trained how to use the new system. This will cost Happy Singh
Rs.425000 in the first year.
4. If ‘Banta’ is implemented, revenues will rise to an estimate Rs.110lacs this year,
thereafter increasing by 5% per annum (Compounded). Even if ‘Banta’ is not
implemented, revenue will increase by an estimate Rs.200000 per annum, from
their current level of Rs.100lacs per annum.
5. Despite increased revenues, ‘Banta’ will still make overall savings in terms of
vehicle running cost. These costs are estimated at 1% of the post ‘Banta’ revenues
each year (i.e. the Rs.110lacs revenue rising by 5% thereafter, as referred to in (4)
above.
6. Six new staff operatives will be recruited to manage the ‘Banta’ system. Their
wages will cost the company Rs.120000 per annum in the first year, Rs.200000 in
the second year, thereafter increasing by 5% per annum (i.e. compounded).
7. Happy Singh will have to take out an annual maintenance contract for ‘Banta’
system. This will cost Rs.75000 per annum.

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8. Interest on money borrowed to finance the project will cost Rs.150000 per annum.
9. Happy Singh Taxiwala’s cost of capital is 10% per annum.
Required:
a) Calculate the Net Present Value of the new ‘Banta’ system nearest to Rs.’000.
b) Calculate the simple payback period of the project and interpret the result.
c) Calculate the discounted payback period for the project and interpret the result.

Question 7: Lockwood limited wants to replace its old machine with a new automatic machine. Two
models A and B are available at the same cost of Rs.5lacs each. Salvage value of the old
machine is Rs.1lac. The utilities of the existing machine can be used if the company
purchases A. additional cost of utilities to be purchased in that case are Rs.1lac. if the
company purchases B then all the existing utilities will have to be replaced with new
utilities costing Rs.2lacs. The salvage value of the old utilities will be Rs.0.20lac. The
earnings after taxation are expected to be:
Cash inflows of A Cash inflows of B
Year PVF@15%
(in Rs.) (in Rs.)
1 100000 200000 0.87
2 150000 210000 0.76
3 180000 180000 0.66
4 200000 170000 0.57
5 170000 40000 0.50
Salvage value at the 50000 60000
end of year 5

The targeted return on capital is 15%. You are required to (1) Compute, for the two
machines separately, net present value, discounted payback period and desirability
factor and (2) Advice which of the machines is to be selected?

Question 8: Elite Cooker Company is evaluating three investment situations: (1) produce a new line
of aluminum skillets, (2) expand its existing cooker line to include several new sizes,
and (3) develop a new, higher-quality line of cookers. If only the project in question is
undertaken, the expected present values and the amounts of investment required are:
(in Rs.)
Present value of future cash
Project Investment required
flows
1 200000 290000
2 115000 185000
3 270000 400000

if projects 1 and 2 are jointly undertaken, there will be no economies; the investments
required and present values will simply be the sum of the parts. With project 1 and 3,
economies are possible in investment because one of the machines acquired can be used
in both production processes. The total investment required for projects 1 and 3
combined is Rs.440000. If projects 2 and 3 are undertaken, there are economies to be
achieved in marketing and producing the products but not in investment. The expected
present value of future cash flows for projects 2 and 3 is Rs.620000. If all three projects

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 CA INTER CHAPTER 2
CAPITAL BUDGETING

are undertaken simultaneously, the economies noted will still hold. However, a
Rs.125000 extension on the plant will be necessary, as space is not available for all three
projects. Which project or projects should be chosen?

Question 9: Cello limited is considering buying a new machine which would have a useful economic
life of five years, a cost of Rs.125000 and a scrap value of Rs.30000, with 80% of the cost
being payable at the start of the project and 20% at the end of the first year. The
machine would produce 50000 units per annum of a new project with an estimated
selling price of Rs.3 per unit. Direct costs will be Rs.1.75 per unit and annual fixed costs,
including depreciation calculated on a straight line basis, would be Rs.40000 per annum.
In the first year and second year, special sales promotion expenditure, not included in
the above costs, would be incurred, amounting to Rs.10000 and Rs.15000 respectively.
Evaluate the projects using the NPV method of investment appraisal, assuming the
company’s cost of capital to be 10%.

Question 10: YoYo Honey Singh Company purchased a machine 3 years ago at a cost of Rs. 10,000.
The machine has a life of 8 years at the time of purchase. It has been depreciated at 15%
on declining balance. The company is thinking of replacing it with a new machine
costing Rs.20,000 with an expected 5 year life. The profit before depreciation is
estimated to increase by Rs.4445 a year. Now the new as well as old machine will be
depreciated at 25% on decline balance. The salvage value of the new machine is
anticipated as Rs.500. The market value of old machine today is Rs.11,500. It is
estimated to have zero salvage value after 5 years. The income tax rate may be assumed
as 55%. Find out the cash flow of replacement decision given that the two machines
belongs to same block of assets and there is no other asset in the same block of asset.
Discounting rate is 10%

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 CA INTER CHAPTER 3
COST OF CAPITAL

Cost of Debt

Question 1: Five years ago, Sona Limited issued 12 per cent irredeemable debentures atRs.103, a Rs.
3 premium to their par value of Rs. 100. The current market price of these debentures is
Rs. 94. If the company pays corporate tax at a rate of 35 per cent what is its current cost
of debenture capital

Question 2: A company issued 10,000, 10% debentures ofRs.100 each on 1.4.2010 to bematured on
1.4.2015. The company wants to know the current cost of its existing debt and the
market price of the debentures is Rs. 80. Compute the cost of existing debentures.

Question 3: A Company issues Rs. 10,00,000 12% debentures of Rs. 100 each. The debentures are
redeemable after the expiry of fixed period of 7 years. The Company is in 35% tax
bracket.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
a) Par
b) 10% Discount
c) 10% Premium.
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
(May 2006)

Question 4: AD-HOC Ltd. has issued special type of debt instrument of Rs.100 each. It is repayable in
two equal annual installments of Rs.53 each at the end of year 1 and year 2. Interest rate
is 12%p.a. corporate tax is 35% and surcharge@10%. Find out the cost of debt.

Cost of Preference Shares

Question 5: If Reliance Energy is issuing preferred stock atRs.100 per share, with a stateddividend of
Rs.12, and a floatation cost of 3% then, what is the cost of preference share?

Question 6: XYZ Z & Co. issues 2,000 10% preference shares ofRs.100 each atRs.95 [Link]
the cost of preference shares if shares are to be redeemed at the end of 10th year.

Cost of Equity

Question 7: A company has paid dividend of Re. 1 per share (of face value ofRs.10 each)last year.
Calculate the cost of equity if the market price of share is Rs. 55.
What if, when dividend is expected to grow @ 10% next year.

Question 8: Find out the cost of equity in the following cases:

1. Earning per share Rs. 8, Market price per share Rs.60.
2. Earning available to equity shareholders Rs.15,00,000, Market capitalization
Rs.90,00,000

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Question 9: Calculate the cost of equity from the following data using realized yield approach:
Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share ( at the beginning) 9.00 9.75 11.50 11.00 10.60

Question 10: Calculate the cost of equity capital of H Ltd., whose risk free rate of returnequals 10%.
The firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.

Cost of Retained Earnings

Question 11: ABC Company provides the following details:

D0 = Rs. 4.19 P0 = Rs. 50 G = 5%
Calculate the cost of retained earnings based on DCF method.

Question 12: ABC Company provides the following details:

Rf = 7% b = 1.20 RM - Rf = 6%
Calculate the cost of retained earnings based on CAPM method.

Weighted Average Cost of Capital (WACC)

Question 13: Calculate weighted average cost of capital from the following information:-

Source Proportion After-tax cost

Equity Capital 0.50 18%

Retained Earning 0.20 18%
Debt 0.30 6.5%

Question 14: Calculate WACC from the following information:-

 10% Debt- 100 lakhs
 Equity capital- 150 lakhs ( Ke= 15%)
 Preference Capital-50 lakhs (kp=12%)
 Tax rate-30%

Question 15: Calculate the WACC using the following data by using:
a) Book value weights
b) Market value weights

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COST OF CAPITAL

The capital structure of the company is as under:

Rs.
Debentures (Rs. 100 per debenture) 5,00,000
Preference shares (Rs. 100 per share) 5,00,000
Equity shares (Rs. 10 per share) 10,00,000
20,00,000
The market prices of these securities are:
Debenture Rs. 105 per debenture
Preference Rs. 110 per preference share
Equity Rs. 24 each.
Additional information:
1. Rs. 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs,
10 year maturity.
2. Rs. 100 per preference share redeemable at par, 5% coupon rate, 2% floatation
cost and10 year maturity.
3. Equity shares has Rs. 4 floatation cost and market price Rs. 24 per share.
The next year expected dividend is Rs. 1 with annual growth of 5%. The firm has
practice of paying all earnings in the form of dividend.
Corporate tax 50%.

Question 16: Determine the cost of capital of BestLuck Limited using the book value (BV)and market
value (MV) weights from the following information:

Sources Book Value Market Value

(Rs.) (Rs.)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 —
Preference shares 9,00,000 10,40,000
Debentures 36,00,000 33,75,000
Additional information :
(i) Equity : Equity shares are quoted at Rs. 130 per share and a new issue priced at
125 per share will be fully subscribed; flotation costs will be Rs. 5 per share.
(ii) Dividend : During the previous 5 years, dividends have steadily increased from
10.60 to Rs. 14.19 per share. Dividend at the end of the current year is expected to
be Rs. 15 per share.
(iii) Preference shares : 15% Preference shares with face value of Rs. 100 would
realiseRs. 105 per share.
(iv) Debentures : The company proposes to issue 11- year 15% debentures but the
yield on debentures of similar maturity and risk class is 16% ; flotation cost is 2%.
(v) Tax : Corporate tax rate is 35%. Ignore dividend tax..
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Marginal Cost of Capital

Question 17: The following is the capital structure of Simons Company Ltd. as on 31.12.1998:

Rs.

Equity shares : 10,000 shares (of Rs. 100 each) 10,00,000

10% Preference Shares (of Rs. 100 each) 4,00,000

12% Debentures 6,00,000

20,00,000

The market price of the company’s share is Rs. 110 and it is expected that a dividend of
Rs. 10 per share would be declared for the year 1998. The dividend growth rate is 6%:
(i) If the company is in the 50% tax bracket, compute the weighted average cost of
capital.
(ii) Assuming that in order to finance an expansion plan, the company intends to
borrow a fund of Rs.10 lakhs bearing 14% rate of interest, what will be the
company’s received weighted average cost of capital? This financing decision is
expected to increase dividend from Rs. 10 to 12 per share. However, The market
price of equity share is expected to decline from Rs. 110 to Rs.105 per share.

Question 18: JKL Ltd. has the following book-value capital structure as on March 31, 2003.

Rs.

Equity share capital (2,00,000 shares) 40,00,000

11.5% preference shares 10,00,000

10% debentures 30,00,000

80,00,000

The equity share of the company sells for Rs. 20. It is expected that the company will pay
next year a dividend of Rs. 2 per equity share, which is expected to grow at 5% p.a.
forever. Assume a 35% corporate tax rate.
Required:
(i) Compute weighted average cost of capital (WACC) of the company based on the
existing capital structure.
(ii) Compute the new WACC, if the company raises an additional Rs. 20 lakhs debt by
issuing 12% debentures. This would result in increasing the expected equity
dividend to Rs. 2.40 and leave the growth rate unchanged, but the price of equity
share will fall to Rs. 16 per share.

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Question 19: ABC Ltd. has the following capital structure which is considered to beoptimum as on
31st March, 2010.

Rs.

14% debentures 30,000

11% Preference shares 10,000

Equity (10,000 shares) 1,60,000

2,00,000

The company share has a market price of Rs. 23.60. Next year dividend per share is 50%
of year 2010 EPS. The following is the trend of EPS for the preceding 10 years which is
expected to continue in future.

Year EPS (Rs.) Year EPS Rs.)

2001 1.00 2006 1.61

2002 1.10 2007 1.77

2003 1.21 2008 1.95

2004 1.33 2009 2.15

2005 1.46 2010 2.36

The company issued new debentures carrying 16% rate of interest and the current
market price of debenture is Rs. 96.
Preference share Rs. 9.20 (with annual dividend of Rs. 1.1 per share) were also issued.
The company is in 50% tax bracket.
a) Calculate after tax:
(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (consuming new equity from retained earnings)
b) Calculate marginal cost of capital when no new shares are issued.
c) How much can be spent for capital investment before new ordinary shares must be
sold. Assuming that retained earnings for next year’s investment are 50 percent of
2010.
d) What will the marginal cost of capital when the funds exceeds the amount calculated
in (c), assuming new equity is issued at Rs. 20 per share?

Question 20: Gamma Limited has in issue 5,00,000Rs.1 ordinary shares whose current ex-dividend
market price is Rs. 1.50 per share. The company has just paid a dividend of 27 paise per
share, and dividends are expected to continue at this level for some time. If the company
has no debt capital, what is the weighted average cost of capital?

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Question 21: Masco Limited wishes to raise additional finance ofRs.10 lakhs for meeting
itsinvestment plans. It has Rs. 2,10,000 in the form of retained earnings available for
investment purposes. Further details are as following:
(1) Debt / equity mix 30%/70%
(2) Cost of debt
UptoRs. 1,80,000 10% (before tax)
Beyond Rs. 1,80,000 16% (before tax)
(3) Earnings per share Rs. 4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate in dividend 10%
(6) Current market price per share Rs. 44
(7) Tax rate 50%
You are required:
a) To determine the pattern for raising the additional finance.
b) To determine the post-tax average cost of additional debt.
c) To determine the cost of retained earnings and cost of equity, and
d) Compute the overall weighted average after tax cost of additional finance.

Question 22: XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of Rs. 10 each, fully paid up- at par) Rs. 15 crores
11% Preference Capital (in shares of Rs. 100 each, fully paid up- at par) Rs. 1 crore
Retained Earnings Rs.20 crores
13.5% Debentures (of Rs. 100 each) Rs. 10 crores
15% Term Loans Rs. 12.5 crores
The next expected dividend on equity shares per share is Rs. 3.60; the dividend per
share is expected to grow at the rate of 7%. The market price per share is Rs. 40.
Preference stock, redeemable after ten years, is currently selling at Rs. 75 per share.
Debentures, redeemable after six years, are selling at Rs. 80 per debenture.
The Income tax rate for the company is 40%.
Required
a) book value proportions; and
b) market value proportions.
c) Define the weighted marginal cost of capital schedule for the company, if it raises Rs.
10 crores next year, given the following information:
(i) the amount will be raised by equity and debt in equal proportions;
(ii) the company expects to retain Rs. 1.5 crores earnings next year;
(iii) the additional issue of equity shares will result in the net price per share being
fixed at Rs. 32;
(iv) the debt capital raised by way of term loans will cost 15% for the first Rs. 2.5
crores and 16% for the next Rs. 2.5 crores

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COST OF CAPITAL

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CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Question 1: Best of Luck Ltd., a profit making company, has a paid-up capital ofRs.100
lakhsconsisting of 10 lakhs ordinary shares of Rs. 10 each. Currently, it is earning an
annual pre- tax profit of Rs. 60 lakhs. The company's shares are listed and are quoted in
the range of Rs. 50 to Rs. 80. The management wants to diversify production and has
approved a project which will cost Rs. 50 lakhs and which is expected to yield a pre-tax
income of Rs. 40 lakhs per annum. To raise this additional capital, the following options
are under consideration of the management:
a) To issue equity capital for the entire additional amount. It is expected that the new
shares (face value of Rs. 10) can be sold at a premium of Rs. 15.
b) To issue 16% non-convertible debentures of Rs. 100 each for the entire amount.
c) To issue equity capital for Rs. 25 lakhs (face value of Rs. 10) and 16% non-
convertible debentures for the balance amount. In this case, the company can issue
shares at a premium of Rs. 40 each.
You are required to advise the management as to how the additional capital can be
raised, keeping in mind that the management wants to maximise the earnings per share
to maintain its goodwill. The company is paying income tax at 50%.

Question 2: Shahji Steels Limited requiresRs.25,00,000 for a new plant. This plant is expectedto
yield earnings before interest and taxes of Rs. 5,00,000. While deciding about the
financial plan, the company considers the objective of maximizing earnings per share. It
has three alternatives to finance the project - by raising debt of Rs. 2,50,000 or Rs.
10,00,000 or Rs. 15,00,000 and the balance, in each case, by issuing equity shares. The
company's share is currently selling at Rs. 150, but is expected to decline to Rs. 125 in
case the funds are borrowed in excess of Rs. 10,00,000. The funds can be borrowed at
the rate of 10 percent uptoRs. 2,50,000, at 15 percent over Rs. 2,50,000 and uptoRs.
10,00,000 and at 20 percent over Rs. 10,00,000. The tax rate applicable to the company
is 50percent. Which form of financing should the company choose?

Question 3: two alternatives in financing the project cost.

Alternative (a): 100% equity finance
Alternative (b): Debt-equity ratio 2:1
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
Calculate the indifference point between the two alternative methods of financing.

Question 4: Ganpati Limited is considering three financing plans. The key information is asfollows:
a) Total investment to be raised Rs. 2,00,000
b) Plans of Financing Proportion:

Plans Equity Debt Preference Shares

A 100% - -
B 50% 50% -
C 50% - 50%
c) Cost of debt 8%
Cost of preference shares 8%
d) Tax rate 50%

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 CA INTER CHAPTER 4
CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per
share.
Expected EBIT is Rs. 80,000.
You are required to determine for each plan: -
Earnings per share (EPS)
The financial break-even point.
Indicate if any of the plans dominate and compute the EBIT range among the plans for
indifference.

Question 5: Touchscreen Limited needsRs.10,00,000 for expansion. The expansion isexpected to

yield an annual EBIT of Rs. 1,60,000. In choosing a financial plan, Touchscreen Limited
has an objective of maximizing earnings per share. It is considering the possibility of
issuing equity shares and raising debt of Rs. 1,00,000 or Rs. 4,00,000 or Rs. 6,00,000.
The current market price per share is Rs. 25 and is expected to drop to Rs. 20 if the
funds are borrowed in excess of Rs. 5,00,000. Funds can be borrowed at the rates
indicated below:
a) uptoRs. 1,00,000 at 8%;
b) over Rs. 1,00,000 up to Rs. 5,00,000 at 12%;
c) over Rs. 5,00,000 at 18%.
Assume a tax rate of 50 per cent. Determine the EPS for the three financing alternatives.

Question 6: Yoyo Limited presently hasRs.36,00,000 in debt outstanding bearing an interestrate of

10 per cent. It wishes to finance a Rs. 40,00,000 expansion programme and is
considering three alternatives: additional debt at 12 per cent interest, preferred stock
with an 11 per cent dividend, and the sale of common stock at Rs. 16 per share. The
company presently has 8,00,000 shares of common stock outstanding and is in a 40 per
cent tax bracket.
a) If earnings before interest and taxes are presently Rs. 15,00,000, what would be
earnings per share for the three alternatives, assuming no immediate increase in
profitability?
b) Develop an indifference chart for these alternatives. What are the approximate
indifference points? To check one of these points, what is the indifference point
mathematically between debt and common?
Which alternative do you prefer? How much would EBIT need to increase before the
next alternative would be best

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CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Capital Structure Theories

Net Income Approach (NI)

Question 1: From the following data, determine the total market value and overall cost f capital of
the companies, ABC Ltd . & XYZ Ltd. belonging to the same equivalent risk class under
the Net Income Approach.
ABC Ltd. XYZ Ltd.
EBIT 225000 225000
Interest @ 15% 75000
Equity capitalization rate for purely equity company is 20%.

Question 2: A Ltd. is going to start a new project of Rs.200 crores. It has the following options to
raise money :
1. 14% Debt of Rs. 150 crores
2. 14% Debt of Rs. 100 crores
3. 14% Debt of Rs. 50 crores
And the rest of the capital by issuing equity shares of Rs.10 each at par. Expected EBIT is
Rs.36 crores and expectation of equity share holders is 20%p.a. you are required to
calculate total market value of the company in all the above situations. Which one is the
optimal capital structure ?

Net Operating Income Approach (NOI)

Question 3: From the following information find out the total market value and ke under Net
Operating Income approach :
Company L Company U
EBIT 650000 650000
Interest (15%) 270000 Nil
Equity capitalization rate of pure equity stream company is 18%. Which of the above
companies have an optimal capital structure under NOI approach.

Question 4: ( NI& NOI with tax ) Company X and Company Y are in the same risk class and are
identical in every respect except that company x uses debt, while company Y does not.
The levered firm has Rs.18,00,000 debentures, carrying10% rate of interest . ROI is 20%
for both the firms. Total assets are Rs.30,00,000. Income tax rate is 35%. Capitalization
rate for pure equity stream company is 15%. You are required to
Compute the value and overall cost of capital of Company X and Company Y using NI
approach :
a) With no corporate tax assumption
b) With corporate tax
Compute the value and cost of equity of Co. X and Co. Y using NOI approach:
a) With no corporate tax assumption
b) With corporate tax

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CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Modigliani & Miller Approach ( M& M)

Question 5: the following data regarding two companies belo0nging to the same equivalent risk class:
Company A Company B
No. of Equity shares 180000 270000
FV of Equity shares 10 10
Equity capitalization rate 10% 10%
6% Debentures 9,00,000 NIL
Profit before interest 324000 324000
Dividend payout ratio is 100%. You are required to explain how under M & M Approach,
an investor holding 15% of shares in Co. A will be better off in switching his holding to
Co. B.

Question 6: The following is the data regarding two Company X and Company Y belonging to the
same equivalent risk class:

Number of ordinary shares 90000 150000

Market price per share 1.2 1.0

6% Debenture 60000 Nil

Profit Before interest 18000 18000

All profit after debenture interest are distributed as dividends.

Explain how under M & M approach, an investor holding 10% of shares in Company X
will be better off in switching his holding to Company Y.

Question 7: The following particulars are available for two companies operating identical business:
Co. U Co. L
EBIT 2,50,000 2,50,000
Less: interest (12%) NIL 36,000
EAESH 2,50,000 2,14,000
Value of firm:
Value of Equity 10,00,000 6,00,000
Value of Debt NIL 3,00,000
Total Value 10,00,000 9,00,000
Show arbitrage process explained under M & M Approach.

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CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Traditional Approach

Question 8: In considering the most desirable capital structure of a company, the following
estimates of the cost of debt and equity capital (before tax) has been made at various
levels of Debt-Equity mix.

Case Debt Amount Equity Amount Cost of Debt Cost of Equity

1 - 5,00,000 10 12
2 50,000 4,50,000 10 12
3 1,00,000 4,00,000 10 12.5
4 1,50,000 3,50,000 11 13
5 2,00,000 3,00,000 12 14
6 2,50,000 2,50,000 13 16
7 3,00,000 2,00,000 14 20

Required: Suggest the optimal Debt-Equity Mix for the company assuming tax rate of
40%.

Practice Questions

Question 1: Rupa Company’s EBIT isRs.5,00,000. The company has 10%, 20 lakhdebentures. The
equity capitalization rate i.e. Ke is 16%.
You are required to calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital

Question 2: Amita Ltd’s operating income isRs.5,00,000. The firm’s cost of debt is 10% andcurrently
the firm employs Rs. 15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to determine:
(i) Total value of the firm.
(ii) Cost of equity.

Question 3: There are two firms N and M, having same earnings before interest and taxes i.e. EBIT of
Rs. 20,000. Firm M is levered company having a debt of Rs. 1,00,000 @ 7% rate of
interest. The cost of equity of N company is 10% and of M company is 11.50%.
Find out how arbitrage process will be carried on?

Question 4: There are two firms U and L having same NOI of Rs. 20,000 except that the firm L is a
levered firm having a debt of Rs. 1,00,000 @ 7% and cost of equity of U & L are 10% and
18% respectively.
Show how arbitrage process will work.

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 CA INTER CHAPTER 4
CAPITAL STRUCTURE AND CAPITAL STRUCTURE THEORIES

Question 5: One-third of the total market value of Sanghmani Limited consists of loanstock, which
has a cost of 10 per cent. Another company, Samsui Limited, is identical in every respect
to Sanghmani Limited, except that its capital structure is all-equity, and its cost of equity
is 16 per cent. According to Modigliani and Miller, if we ignored taxation and tax relief
on debt capital, what would be the cost of equity of Sanghmani Limited?

Question 6: Alpha Limited and Beta Limited are identical except for capital [Link] has 50
per cent debt and 50 per cent equity, whereas Beta has 20 per cent debt and 80 per cent
equity. (All percentages are in market-value terms). The borrowing rate for both
companies is 8 per cent in a no-tax world, and capital markets are assumed to be
perfect.
a)
(i) If you own 2 per cent of the stock of Alpha, what is your return if the company
has net operating income of Rs. 3,60,000 and the overall capitalisation rate of
the company, K0 is 18 per cent?
(ii) What is the implied required rate of return on equity?
b) Beta has the same net operating income as Alpha.
(i) What is the implied required equity return of Beta?
(ii) Why does it differ from that of Alpha?

Question 7: Zion Company has earnings before interest and taxes ofRs.30,00,000 and a 40 percent
tax rate. Its required rate of return on equity in the absence of borrowing is 18 per
cent.
a) In the absence of personal taxes, what is the value of the company in an MM world
(i) with no leverage?
(ii) with Rs. 40,00,000 in debt?
(iii) with Rs. 70,00,000 in debt?
b) Personal as well as corporate taxes now exist. The marginal personal tax rate on
common stock income is 25 per cent, and the marginal personal tax rate on debt
income is 30 per cent. Determine the value of the company for each of the three debt
alternatives in part (a). Why do your answers differ?

Question 8: There are two firms Company A and B having net operating income ofRs.15,00,000 each.
Company B is a levered company whereas Company A is all equity company. Debt
employed by Company B is of Rs. 7,00,000 @ 11%. The tax rate applicable to both the
companies is 25%. Calculate earnings available for equity and debt for both the firms

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 CA INTER CHAPTER 5
DEBTORS MANAGEMENT

Question 1: Calculate the Average Collection Period in each of the following cases:

Credit Policy Customers avails cash discount

2/10, net 30 days 25%

3/15, net 40 days 20%
1/20, net 50 days 30%

Question 2: Calculate Debtors turnover ratio in each of the following cases:

a) Credit sales 50 lakhs p.a., Current level of receivables(debtors) is 5 lakhs.
b) Average collection period is 45 days.
c) Average collection period is 2 months.

Question 3: Calculate average collection period in each of the following alternative cases: (assume
360 days in year)
Case A: Debtors turnover ratio is 6.
Case B: Current level of receivables Rs.60 crores, current annual credit sales Rs. 600
crores.
Case C: Average level of receivables Rs. 1,00,000, Average net credit sales per day Rs.
2,500.
Case D: Credit terms are 2/10, net 30, 25% of the credit customers avails cash discount
facility.

Question 4: Calculate the opportunity cost of investment in receivable in each of the following
alternative cases: (assume 360 days in a year )
Case A: Total sales Rs. 62,50,000, cash sales 20% of the total sales, variable cost 85% of
sales, fixed cost Rs. 3,12,000, bad debts 5 %, Average collection period 90 days, required
rate of return 12%.
Case B: Total sales Rs. 125 lakhs, cash sales 25% of credit sales, bad debts 5%, selling
price per unit Rs. 500, average cost per unit Rs. 450, Debtors turnover ratio 4, required
rate of return 12%.

Question 5: A trader whose current sales are in the region of 6 lakhs per annum and an average
collection period of 30 days wants to pursue a more liberal policy to improve sales. A
study made by a management consultant reveals the following information:-

Increase in Present default

Credit policy Increase in sales
collection period anticipated

A 10 Days Rs. 30,000 1.5%

B 20 Days Rs. 48,000 2%
C 30 Days Rs. 75,000 3%
D 45 Days Rs. 90,000 4%

The selling price per unitis Rs. 3. Average cost per unit is Rs. 2.25 and variable cost per
unit is Rs. 2.

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The current bad debts loss is 1%. Required return on additional investment is 20%.
Assume a 360 days year.
Which of the above policies would you recommend for adoption?

Question 6: XYZ Corporation is considering relaxing its present credit policy and is in the process of
evaluating two proposed policies. Currently, the firm has annual credit sales of Rs. 50
lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss
due to bad debts is Rs. 1,50,000. The firm is required to give a return of 25% on the
investment in new accounts receivables. The company’s variable cost are 70% of the
selling price. Given the following information, which is the better option?

Present Policy Policy

Policy Option I Option II

Annual credit sales 50,00,000 60,00,000 67,50,000

Accounts Receivable turnover ratio 4 times 3 times 2.4 times
Bad debts losses 1,50,000 3,00,000 4,50,000

Question 7: As a part of the strategy to increase sales and profits, the sales manager of a company
proposes to sell goods to group of new customers with 10% risk of non-payment. This
group would require one and a half months credit and is likely to increase sales by Rs.
1,00,000 p.a. Production and selling exp. amount to 80% of sales and the income tax rate
is 50%. The company’s minimum required rate of return (after tax) is 25%.
Should the sales manager’s proposal be accepted?
Also find the degree of risk of non-payment that the company should be willing to
assume if the required rate of return (after tax) were (i) 30% (ii) 40% and (iii) 60%

Question 8: Slow Payers are regular customer of Goods Dealers Ltd, Calcutta and have approached
the seller for execution of a credit facility for enabling them to purchase goods from
Goods Dealers Ltd. On an analysis of past performance and on the basis of information
supplied, the following pattern of payment schedule emerges in regard to Slow Payers:
Pattern
At the end of 30 day 15% of the bill
At the end of 60 days 34% of the bill
At the end of 90 days 30% of the bill
At the end of 100 days 20% of the bill
Non-recovery 1% of the bill
Slow Payers want to enter into a firm commitment for purchase of goods of Rs. 15 lakhs
in 2005, deliveries to be made in equal quantities on the first day of each quarter in the
calendar year. The price per unit of commodity is Rs. 150 on which a profit of Rs. 5 per
unit is expected to be made. It is anticipated by Goods dealers Ltd. that taking up of this
contract would mean an extra recurring expenditure of Rs. 5,000 p.a. If the opportunity
cost of fund in the hands of Goods Dealers Ltd. is 24% p.a., would you as the finance
manager of the seller recommend the grant of credit to Slow Payers? Working should be
part of your answer. Assume year of 360 days.

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 CA INTER CHAPTER 5
DEBTORS MANAGEMENT

Question 9: A Factoring firm has credit sales of Rs. 360 lakhs and its average collection period is 30
days. The financial controller estimates, bad debts losses are around 2% of credit
[Link] firm spends Rs. 1,40,000 annually on debtors administration. This cost
comprises of telephonic and fax bills along with salaries of staff members. These are the
avoidable costs. A Factoring firm has offered to buy the firm’s receivables. The factor
will charge 1% commission and will pay and advance against receivables on an interest
@15% p.a. after withholding 10% as reserve. What should the firm do?

Question 10: Mosaic Limited has current sales of Rs. 1.5 Lakh per year. Cost of sales is 75 percent of
sales and bad debts are one percent of the sales. Cost of sale comprises 80 percent
variable costs and 20 percent fixed cost, while the company’s required rate od return is
12 percent. Mosaic Limited currently allows customers 30 days credit, but is considering
increasing this to 60 days credit in order to increase sales.
It has been estimated that this change in policy will increase sales by 15 percent, while
bad debts will increase from one percent to four percent. It is not expected that the
policy change will result in an increase in fixed costs and creditors and stock will be
unchanged.
Should Mosaic Limited introduce the proposed policy?

Question 11: The Megatherm Corporation has just acquired a large account. As a result, it needs an
additional Rs. 70,000 in working capital immediately. It has been determined that there
are three feasible sources of fund:
a) Trade credit: The company buys about Rs. 50,000 of materials per month on terms of
3/30 net 90. Discounts are taken.
b) Bank loan: The firm’s bank will lend Rs. 1,00,000 at 13%. A 10 per cent
compensating balance will be required, which otherwise would not be maintained by
the company.
c) A factor will buy the company’s receivables (Rs. 1,00,000 per month ), which have a
collection period of 60 days. The factor will advance up to 75% of the face value of
the receivables at 12% on an annual basis. The factor will also charge a 2 per cent fee
on all receivables purchased. It has been estimated that the factor’s services will
save the company a credit department expense and bad-debt expenses of Rs. 1,500
per month.
On the basis of annual percentage cost, which alternative should the company select?

Question 12: The Dolce Company purchases raw materials on terms of 2/10 net 30. A review of the
company’s records by the owner, Mr. Gupta, revealed that payments are usually made
15 days after purchases are received. When asked why the firm did not take advantage
of its discounts, the accountant, Mr. Ram, replied that its cost only 2 per cent for these
fund, whereas bank loan would cost the company 12 per cent.
a) What mistake is Ram making?
b) What is the real cost of not taking advantage of the discount?
c) If the firm could not borrow from the bank and was forced to resort to use of trade
credit funds, what suggestion might be made to Ram that would reduce the annual
interest cost?

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Question 13: The credit manager of XYZ Ltd is reappraising the company’s credit policy. The company
sells the products on terms of net 30. Cost of goods sold is 85% of sales and fixed cost
are further 5% of sales. XYZ classifies its customers on a scale of 1 to 4. During the past
five years, the experience was as under:

Average collection period

Default as a percentage of
Classification in days for non-defaulting
sales
accounts

1 0 45
2 2 42
3 10 40
4 20 80

The average rate of interest is 15%. What conclusions do you draw about the company’s
credit policy? What other factors should be taken into account before changing the
present policy? Discuss.

Question 14: A firm is considering offering 30-days credit to its customers. The firm likes to charge
them an annualized rate of 24%. The firm wants to structure the credit in terms of a
cash discount for immediate payment. How much would the discount rate have to be?

Question 15: PTC Ltd. received on order for supply of a product from X Ltd. for Rs. 10 lakhs. Cost of
sales is 80% of sales. It has been estimated that the probability of non-recovery in case X
Ltd. is bankrupt is:
a) 25%,
b) 15 %,
c) 20%
On the basis of above information determine whether PCT Ltd. should accept the order

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DEBTORS MANAGEMENT

Practice Questions

Question 1: The present credit terms of Creation Ltd. are 1/10, net 30. Its annual sales are Rs.80
lakhs, its average collection period is 20 days, its variable cost and average total costs to
sales are 0.85 and 0.95 respectively and its cost of capital is 10%. The proportion of
sales on which customers currently take discount is 0.5. Creation Ltd. is considering
relaxing its discount terms to 2/10,net 30. Such relaxation is expected to increase sales
by Rs.5 lakhs, reduce the average collection period to 14 days and increase the
proportion of discount sale to 0.8. What will be the effect of relaxing the discount policy
on company’s profit? Take an year as of 360 days.

Question 2: Gel Corporation presently gives credit terms of ‘net 30 days’. It has Rs.600 lakhs in
credit sales and its average collection period is 45 days. To stimulate sales, the company
may give credit terms of ‘net 60 days’ with sales expected to increase by 15%. After the
change, the average collection period is expected to be 75 days with no difference in
payment habits between old and net of customers. Variable costs are Rs.0.8 for every
Re.1 of sales; and the company’s before tax required rate of return on investment in
receivable is 20%. Assume 360 days in a year. Should the company extend its credit
period?

Question 3: Peacock Ltd. has been engaged in manufacturing of textiles. It has a current sale of Rs.30
lakhs p.a. The cost of sale is 75% of sales and bad debts are 1% of sales. The cost of sales
comprises 80% variable and 20% fixed cost, while the company’s required rate of
return is 12%. The company currently allows customers 30 days credit, but is now
considering increasing this to 60 days credit in order to attract more customers.
It has been estimated that this change in policy will increase sales by 15%, while bad
debts will increase from 1% to 4%. It is expected that the policy change will not result in
any increase fixed cost, creditors and stock level.
Should Peacock Ltd. introduce proposed policy?

Question 4: ABC Ltd. currently has sales of Rs.30,00,000 with an average collection period of two
months. At present, no discounts are offered to the customers. The management of the
company is thinking to allow a discount of 2% on cash sales which will result as under:
(i) The average collection period would reduce to one month.
(ii) 50% of customers would take advantage of 2% discount.
The company would normally require a 25% return on its investment.
Advise the management whether to extend the discount on cash sales.

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 CA INTER CHAPTER 6
CASH MANAGEMENT

Question 1: From the following information, find out the amount paid to creditors:-
Opening balance of creditors:- Rs. 1,25,000
Purchases during the period:- Rs. 10,75,000
Closing balance of the creditors:- Rs. 2,45,000

Question 2: From the following information, find out the amount received from debtors:-
Opening balance of debtors:- Rs. 5,00,000
Total Sales during the period:- Rs.25,00,000
Closing balance of debtors:- Rs.7,00,000
Credit sales is 80% of the total sale.

Question 3: Find out the amount received from sales for the three months ( January-March):-

November December January February March

Total Sales 1,00,000 80,000 1,05,000 1,20,000 90,000

Other information:-
(i) 20% of total sales are in cash.
(ii) 50% of the total credit sales will be received in 1 month from the month of sales
and balance in next month.

Question 4: Find the amount paid to creditors in January, February and March, if materials are
purchased 2 months before the sale and payment is made 1 month after the purchases.
Purchases are 80% of the sale amount and sales amount is same as in Question No. 3.

Question 5:

Sales Purchases Expenses

April 25,000 18,750 2,500
May 30,000 22,500 3,000
June 45,000 33,750 4,500
July 40,000 30,000 4,000
August 50,000 37,500 5,000
September 45,000 33,750 4,500
Other information:-
(i) All sales and purchases are on credit basis.
(ii) Debtors are given two months credit period.
(iii) Company have taken one month credit period from the suppliers.
(iv) Expenses are paid in ½ month from the occurrence.
Prepare a cash budget for the month of July, August and September. Opening cash
balance on 1st July is to be taken as Rs. 20,000.

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CASH MANAGEMENT

Question 6: Prepare monthly cash budget for six months beginning from April 2010 on the basis of
the following information:-
(i) Estimated monthly sales are as follows:-
Rs. Rs.
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages & salaries are estimated to be payable as follows:-
Rs. Rs.
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
(iii) Of the sale, 80% is on credit and 20% for cash, 75% of the credit sales are collected
within one month and the balance in two months. There are no bad debts.
(iv) Purchases amount to 80% of sales and are made and paid for in the month
preceding the sale.
(v) The firm has 10% debenture of Rs. 1,20,000. Interest on these has to be paid
quarterly in January, April and so on.
(vi) The firm is to make an advance payment of tax of Rs.5,000 in July,2010.
(vii) The firm has a cash balance of Rs. 20,000 on April 1,2010, which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level is
made up by temporary investment/liquidation of temporary investment or
temporary borrowing at the end of each month (interest on these to be ignored).

Question 7: From the following information relating to a departmental store, you are required to
prepare Month-wise cash budget on receipt and payments basis for the three months
ending 31st March, 2010:-
It is anticipated that the working capital at 1st January, 2010 will be as follows:-

Rs. In ‘000’s
Cash in hand and at bank 545
Short term investment 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800

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Budgeted Profit Statement: Rs. In ‘000’s

January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administration, Selling and Distribution Expenses 315 270 255
Net Profit before tax
150 125 115

Budgeted balances at the end of each month:- Rs. In ‘000’s

31st Jan. 28th Feb. 31st March
Short term investment 700 --- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade Creditors 2,000 1,950 1,900
Other Creditors 200 200 200
Dividend payables 485 --- ---
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550
Depreciation amount to Rs.60,000 is included in the budgeted expenditure for each month.

Question 8: You are given below the Profit & Loss Accounts for two years for a company:

Year 1 Year 2 Year 1 Year 2

Rs. Rs. Rs. Rs.

To Opening Stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000

To Raw Materials 3,00,00,000 4,00,00,000 By Closing Stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To ManufacturingExp. 1,00,00,000 1,60,00,000
To Other Exp. 1,00,00,000 1,00,00,000
To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000

Sales are expected to be Rs. 12,00,00,000 in year 3.

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

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Question 9: A new manufacturing company is to be incorporated from January 1, 2000. Its

authorized capital will be Rs. 2 crores divided into 20 lakh equity shares of Rs. 10 each.
It intends to raise capital by issuing equity shares of Rs. 1 cr. (fully paid ) on 1 st January.
Besides, a loan of Rs. 13 lakhs @ 12% per annum will be obtained from a financial
institution on 1st January and further borrowing will be made at the same rate of
interest on the first day of month in which borrowing is required. All borrowings will be
repaid alongwith interest on the expiry of one year. The company will make payment for
the following assets in January.
Rs. ( in Lakhs )
Plant & Machinery 20
Land & Building 40
Furniture 10
Motor Vehicle 10
Stock of Raw Materials 10
The following further details are available:
1. Projected Sales ( January-June ):
(Rs. In lakhs ) (Rs. In lakhs )
January 30 April 40

February 35 May 40
March 35 June 45
2. Gross profit margin will be 25% on sales.
3. The company will make credit sales only and these will be collected in the second
month following sales.
4. Creditors will be paid in the first month following credit purchases. There will be
credit purchases only.
5. The company will keep minimum stock of raw materials of Rs. 10 Lakhs.
6. Depreciation will be charged @ 10% p.a. on cost on all fixed assets.
7. Payment of preliminary exp. of Rs. 1 lakh will be made in January.
8. Wages and salaries will be Rs. 2 lakhs each month and will be paid on the first day
of next month.
9. Administrative expenses of Rs. 1 lakh per month will be paid in the month of their
incurrence.
Assume no minimum required cash balance.
You are required to prepare the monthly cash budget ( Jan.-June), the projected Income
statement for the 6 months and the projected Balance Sheet as on 30th June, 2000.

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Question 10: Alcobex Metal Company (AMC) does business in three products P1, P2 and P3. Products
P1 and P2 are manufactured in the company, while product P3 is procured from outside
and resold as a combination with either Product P1 or P2. The sales volume budgeted
for the three products for the year 2000-2001 (April-March) are as under:
Products Rs. In Lakhs
P1 1,200
P2 500
P3 400 [ Dec.1999 to May 2000= 20 lakhs per month
April 2000 to July 2000= 25 lakhs per month
Aug. 2000 to Nov 2000= 30 lakhs per month
Dec. 2000 to Mar. 2001= 45 lakhs per month]
Based on the budgeted sales value, the cash flow forecast for the company is prepared
based on the following assumption:
1. Sales realization is considered at:
50% Current month
25% Second month
25% Third month
2. Production Programme for each month is based on the sales value of the next
month.
3. Raw material consumption of the company is kept at 59% of the month’s
production.
4. 81% of the raw materials consumed are components.
5. Raw material and components to the extent, at 25% are procured through import.
6. The purchases budget is as follows:
(i) Indigenous raw materials are purchased two months before the actual
consumption.
(ii) Components are procured in the month of consumption.
(iii) Imported raw materials and components are bought three months prior to
the month of consumption.
7. The company avails following credit terms from suppliers:
(i) Raw materials are paid in the month of purchases;
(ii) Company gets one month’s credit for its components;
(iii) For imported raw material and components payments are made one month
prior to the dates of purchases.
8. Currently the company has a cash credit facility of Rs. 140.88 lakhs.
9. Expenses are given below and are expected to be constant throughout the year:
Wages and salaries Rs.312 lakhs
Administrative Exp. Rs. 322 lakhs
Selling & Distribution Exp. Rs. 53 lakhs

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10. Dividends of Rs. 58.03 lakhs is to be paid in October.

11. Tax of Rs. 23.92 lakhs will be paid in equal installments in four-quarters: i.e.,
January, April, July and October.
12. The term loan of Rs. 237.32 lakhs is repayable in two equal installments half-
yearly. i.e., June/December.
13. Capital expenditure of Rs. 292.44 lakhs for the year is expected to be spread
equally during the 12 months period.
You are required to prepare a Cash Budget for the period of June-November, 2000.

Question 11: A firm maintains a separate account for cash disbursement. Total disbursement are Rs,
1,05,000 per month or 12,60,000 per year. Administrative and transaction cost of
transferring cash to disbursement account is Rs. 20 per transfer. Marketable securities
yield is 8% p.a.
Determine the optimum cash balance ACCORDING TO William J. Baumol model

Question 12: M/s ABC Ltd. provides following information:

The company maintains a minimum cash balance of Rs. 1000. The standard deviation of
the company’s daily cash flow is Rs. 1200. The annual interest rate is 0.01%. The
transaction cost of buying & selling securities is Rs. 20 per transaction. ( Assume 360
days in a year ).
Required: Calculate upper limit, return point, and average cash balance as per the
Miller-Orr model.

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Question 1: From the following information of XYZ Ltd., you are required to calculate:
a) Net operating cycle period.
b) Number of operating cycles in a year.

Rs.

(i) Raw material inventory consumed during the year 6,00,000

(ii) Average stock of raw material 50,000
(iii) Work-in-progress inventory 5,00,000
(iv) Average work-in-progress inventory 30,000
(v) Finished goods inventory 8,00,000
(vi) Average finished goods stock held 40,000
(vii) Average collection period from debtors 45 days
(viii) Average credit period availed 30 days
(ix) No. of days in a year 360 days

Question 2: Discuss the liquidity vs. profitability issue in management of working capital.

Question 3: Discuss the estimation of working capital need based on operating cycle process.

Question 4: Q Ltd. sells good at a uniform rate of gross profit of 20% on sales including depreciation
as part of cost of production. Its annual figures are as under:

Rs.

Sales (At 2 month’s credit) 24,00,000

Materials consumed (Suppliers credit 2 months) 6,00,000
Wages paid (Monthly at the beginning of the subsequent month) 4,80,000
Manufacturing expenses (Cash expenses are paid – one month in arrear) 6,00,000
Administration expenses (Cash expenses are paid – one month in arrear) 1,50,000
Sales promotion expenses (Paid quarterly in advance) 75,000

The company keeps one month stock each of raw materials and finished goods. A
minimum cash balance of Rs. 80,000 is always kept. The company wants to adopt a 10%
safety margin in the maintenance of working capital.
The company has no work in progress
Find out the requirements of working capital of the company on cash cost basis.

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Question 5: A company is considering its working capital investment and financial policies for the
next year. Estimated fixed assets and current liabilities for the next year are Rs. 2.60
crores and Rs. 2.34 crores respectively. Estimated Sales and EBIT depend on current
assets investment, particularly inventories and book-debts. The financial controller of
the company is examining the following alternative Working Capital Policies:
(Rs. Crores)

Investment
Working
in Current Estimated Sales EBIT
Capital Policy
Assets
1.23
Conservative 4.50 12.30 1.15
Moderate 3.90 11.50 1.00
Aggressive 2.60 10.00

After evaluating the working capital policy, the Financial Controller has advised the
adoption of the moderate working capital policy. The company is now examining the use
of long-term and short-term
borrowings for financing its assets. The company will use Rs. 2.50 crores of the equity
funds. The corporate tax rate is 35%. The company is considering the following debt
alternatives.
(Rs. Crores)

Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12

Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%

You are required to calculate the following:

1. Working Capital Investment for each policy:
a) Net Working Capital position
b) Rate of Return
c) Current ratio
2. Financing for each policy:
d) Net Working Capital position.
e) Rate of Return on Shareholders equity.
f) Current ratio.

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Question 6: The following information has been extracted from the records of a Company:
Product Cost Sheet Rs./unit
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
 Raw materials are in stock on an average of two months.
 The materials are in process on an average for 4 weeks. The degree of completion is
50%.
 Finished goods stock on an average is for one month.
 Time lag in payment of wages and overheads is 1½ weeks.
 Time lag in receipt of proceeds from debtors is 2 months.
 Credit allowed by suppliers is one month.
 20% of the output is sold against cash.
 The company expects to keep a Cash balances of Rs. 1,00,000.
 Take 52 weeks per annum.
The Company is poised for a manufacture of 1,44,000 units in the year.
You are required to prepare a statement showing the Working Capital requirements of
the Company.

Question 7: An engineering company is considering its working capital investment for the year
2003-04. The estimated fixed assets and current liabilities for the next year are Rs. 6.63
crore and Rs. 5.967 crore respectively. The sales and earnings before interest and taxes
(EBIT) depend on investment in its current assets – particularly inventory and
receivables. The company is examing the following alternative working capital policies:

Investment in
Working Capital Estimated Sales EBIT
Current Assets
Policy (Rs. Crores) (Rs. Crore)
(Rs. Crores)

Conservative 11.475 31.365 3.1365

Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55

You are required to calculate the following for each policy:

(i) Rate of return on total assets.
(ii) Net working capital position.
(iii) Current assets to fixed assets ratio.
(iv) Discuss the risk-return trade off of each working capital policy.

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Question 8: XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicates that
materials are introduced in the beginning of the production cycle; wages and overhead
accrue evenly throughout the period of the cycle. Wages are paid in the next month
following the month of accrual. Work in process includes full units of raw materials used
in the beginning of the production process and 50% wages and overheads are supposed
to be conversion costs. Details of production process and the components of working
capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw materials inventory held One month consumption
Finished goods inventory held for Two months
Credit allowed by creditors One month
Credit given to debtors Two months
Cost price of raw materials Rs. 60 per unit
Direct wages Rs. 10 per unit
Overheads Rs. 20 per unit
Selling price of finished pipes Rs. 100 per unit
Required to calculate the amount of working capital required for the company.

Question 9: The following annual figures relates to MNP Limited:

Sales (at three months credit) Rs. 90,00,000
Materials consumed (suppliers extend one and half month’s credit) Rs. 22,50,000
Wages paid (one month in arrear) Rs. 18,00,000
Manufacturing expenses outstanding at the end of the year (cash expenses
Rs. 2,00,000 are paid one month in arrear)
Total Administrative expenses for the year (cash expenses are paid one
Rs.6,00,000 month in arrear)
Sales Promotion expenses for the year (paid quarterly in advance) Rs. 12,00,000
The company sells its products on gross-profit of 25% assuming depreciation as a part
of cost of production. It keeps two month’s stock of finished goods and one month’s
stock of raw materials as inventory. It keeps cash balance of Rs. 2,50,000.
Assume a 5% safety margin, work out the working capital requirement of the company
on cash cost basis. Ignore work-in-progress.

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Question 10: A proforma cost sheet of a Company provides the following particulars:

Amount per unit

(Rs.)

Raw materials cost 100

Direct labour cost 37.50
Overheads cost 75
Total cost 212.50
Profit 37.50
Selling Price 250

The Company keeps raw material in stock, on an average for one month; work-in-
progress, on an average for one week; and finished goods in stock, on an average for two
weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to
its debtors. The lag in payment of wages is one week and lag payment of overhead
expenses is two weeks.
The company sells one-fifth of the output against cash and maintains cash-in-hand and
at bank put together at Rs. 37,500.
Required:
Prepare a statement showing estimate of Working Capital needed to finance an activity
level of 1,30,000 units of production. Assume that production is carried on evenly
throughout the year, and wages and overheads accrue similarly. Work-in-progress stock
is 80% complete in all respects.

Question 11: A proforma cost sheet of a Company provides the following data:

Rs.

Raw material cost per unit 117

Direct Labour cost per unit 49
Factory overheads cost per unit
(include depreciation of Rs. 18 per unit at budgeted level of activity) 98
Total cost per unit 264
Profit 36
Selling price per unit 300

Following additional information is available:

Average raw material in stock : 4 weeks
Average work-in-process stock : 2 weeks
(% completion with respect to

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Materials : 80%
Labour and Overheads : 60%)
Finished goods in stock : 3 weeks
Credit period allowed to debtors : 6 weeks
Credit period availed from suppliers : 8 weeks
Time lag in payment of wages : 1 week
Time lag in payment of overheads : 2 weeks
The company sells one-fifth of the output against cash and maintains cash balance of Rs.
2,50,000.
Required:
Prepare a statement showing estimate of working capital needed to finance a budgeted
activity level of 78,000 units of production. You may assume that production is carried
on evenly throughout the year wages and overheads accrue similarly.

Question 12: MNO Ltd. has furnished the following cost data relating to the year ending on 31st March,
2008.
Rs. (in Lakhs)
Sales 450
Material consumed 150
Direct wages 30
Factory overheads (100% variable) 60
Office and Administrative overheads (100% variable) 60
Selling overheads 50
The company wants to make a forecast of working capital needed for the next year and
anticipates that:
 Sales will go up by 100%.
 Selling expenses will be Rs. 150 lakhs,
 Stock holding for the next year will be-Raw material for two and half months, Work-
in-progress for one month, Finished goods for half month and Book debts for one
and half months,
 Lags in payment will be of 3 months for creditors, 1 month for wages and half month
for Factory, Office and Administrative and Selling overheads.
You are required to prepare statement showing working capital requirements for next year.

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Question 13: Following information is forecasted by the CS Limited for the year ending 31st March,
2010:
Balances as at1st Balances as at
April, 2009 31st March, 2010
Rs. Rs.
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.
You are required to calculate:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.

Question 14: A newly formed company has applied to the Commercial Bank for the first time for
financing its working capital requirements. The following information is available about
the projections for the current year:
Per unit
Elements of Cost: Rs.
Raw material 40
Direct labour 15
Overhead 30
Total cost 85
Profit 15
Sales 100
Other information:
Raw material in stock : average 4 weeks consumption, work – in progress (completion stage, 50
per cent), on an average half a month. Finished goods in stock : on an average, one month.
Credit allowed by suppliers is one month.
Credit allowed to debtors is two months.
Average time lag in payment of wages is 1 ½ weeks and 4 weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at Rs. 50,000.
All Sales are on credit basis only.
Required:
Prepare statement showing estimate of working of working capital needed to finance an
activity level of 96,000 units of production. Assume that production is carried on evenly
throughout the year, and wages and overhead accrue similarly. For the calculation
purpose 4 weeks may be taken as equivalent to a month and 52 weeks in a year.

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Question 15: MN Ltd. is commencing a new project for manufacture of electronic toys. The following
cost information has been ascertained for annual production of 60,000 units at full
capacity:

Amout per unit

Rs.

Raw materials 20

Direct labour 15

Manufacturing overheads: Rs.

Variable 15

Fixed 10

25

Selling and distribution overheads: Rs

Variable 3

Fixed 1

Total cost 64

Profit 16

Selling price 80

In the first year of operations expected production and sales are 4,000 units and 35,000
units respectively. To assess the need of working capital, the following additional
information is available:
(i) Stock of Raw materials 3 months consumption.
(ii) Credit allowable for debtors 1 ½ months.
(iii) Credit allowable by creditors 4 months.
(iv) Lag in payment of wages 1 month.
(v) Lag in payment of overheads ½ month.
(vi) Cash in hand and Bank is expected to be Rs. 60,000.
(vii) Provision for contingencies is required @ 10% of working capital requirement
including that provision.
You are required to prepare a projected statement of working capital requirement for
the first year of operations. Debtors are taken at cost.

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Question 16: Samreen Enterprises has been operating its manufacturing facilities till 31.3.2010 on a
single shift working with the following cost structure:

Rs.

Cost of Material 6.00

Wages (out of which 40% fixed ) 5.00
Overheads ( 80 % fixed ) 5.00
Profit 2.00
Selling price 18.00
Sales during 2009-10 –Rs. 4,32,000. As at 31.3.2010 the company held:

Rs.

Stock of raw materials (at cost) 36,000

WIP ( valued at prime cost ) 22,000
Finished goods ( valued at total cost ) 72,000
Sundry debtors 1,08,000

In view of increased market demand, it is proposed to double production by working an

extra shift. It is expected that a 10% discount will be available from suppliers of raw
materials in view of increased volume of business. Selling price will remain the same.
The credit period allowed to customers will remain unaltered. Credit availed of from
suppliers will continue to remain at the present level i.e., 2 months. Lag in payment of
wages and exp. will continue to remain half a month.
You are required to assess the additional working capital requirements, if the policy to
increase output is implemented.

Question 17: The management of MNP Company Ltd. is planning to expand its business and consults
you to prepare an estimated working capital statement. The records of the company
reveal the following annual information:
Rs.
Sales –Domestic at one month’s credit 24,00,000
Export at three month’s credit (sales price 10% below domestic price) 10,80,000
Materials used (suppliers extend two months credit) 9,00,000
Lag n payment of wages – ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four instalments of which one falls in the next 2,25,000
financial year
Rate of gross profit is 20%.
Ignore work-in-progress and depreciation.

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The company keeps one month’s stock of raw materials and finished goods (each) and
believes in keeping Rs. 2,50,000 available to it including the overdraft limit of Rs. 75,000
not yet utilized by the company.
The management is also of the opinion to make 12% margin for contingencies on
computed figure.
You are required to prepare the estimated working capital statement for the next year.

Question 18: The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March,
2011 is given below:

Amount Particulars Amount

Particulars
(Rs.) (Rs.) (Rs.)

To Opening Stock: By Sales (Credit) 2,00,000 20,00,000

Raw Materials 1,80,000 By Closing Stock: 1,00,000
Work- in- progress 60,000 Raw Materials 3,00,000
Finished Goods 2,60,000 5,00,000 Work-in-progress
To Purchases (credit) 11,00,000 Finished Goods
To wages 3,00,000
To production 2,00,000 6,00,000
Expenses 5,00,000
To Gross Profit c/d 26,00,000 By Gross Profit 26,00,000
To Administration Expenses 1,75,000 b/s 5,00,000
To Selling Expenses 75,000
To Net Profit 2,50,000
5,00,000 5,00,000

The opening and closing balances of debtors were Rs. 1,50,000 and Rs. 2,00,000 respectively whereas
opening and closing creditors were Rs. 2,00,000 and Rs. 2,40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.

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Liquidity Ratio:

Ratios Formulae Explanation

Current Assets: Assets

which are expected to
1. Current Ratio Current Assets/ Current Liabilities
be realizable within one
year.
2. Quick Ratio / Acid test Ratio Quick Assets
Quick Liabilities or Current Liabilities Current Liabilities:
Liabilities which are
payable within one year.

3. Absolute Cash Ratio Cash Reservoir

Quick Assets: realizable
Or Current Liabilities Cash + Bank + within 3 months. It can
Super Quick ratio Marketable non be calculated by
trade Investment following ways, unless
otherwise stated : (
Current Assets – stock –
prepaid exps.)

Non Trade: Held for the purpose of Quick Liabilities:

investment. Payable within 3
months. Quick liabilities
are equal to current
Marketable: which can be easily liabilities unless
convertible into cash. Usually otherwise stated.
investments that are quoted into
recognized stock exchange.

4. Interval Measure Ratio Cash Reservoir

Avg. daily cash Exp.
Cost of goods sold +
Administration exp +
Selling and distribution
exp. 360

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Profitability Ratio

Ratio Formulae Explanation

1. Gross Profit Ratio G.P. G.P.= sales – Cost og goods sold

 100
Sales Sales = Gross sales – sales
return

2. Operating Profit Ratio OperatingProfit Operating Profit = Net profit –

 100
Sales non operating income + non
operating exp.

3. Operating Exp. Ratio Cost of goods sold + Other

Or Operating Exp.
 100
Operating Ratio Sales

4. Net Profit Ratio N.P. Return= N.P. + interest on long

 100
Sales term fund + provision for tax
(in case of pre taxROI )

5. Return on Investment (ROI) Return Average Inv.= Op. + Cl. / 2

 100
[Link] EAESH = EBIT – interest – tax –
preference dividend.

6. Return on Equity (ROE) EAESH Equity Share Holder’s Fund =

 100
Equity SHFund refer Annexure I

Capital Structure Ratios

Ratios Formulae Explanation

1. Debt- Equity Ratio Debt / Equity Debt = all long term borrowings
whether secured or not.
Equity = refer Annexure I

2. Proprietary Ratio Proprietary Fund / Total Assets Proprietary Fund = refer

Annexure I

3. Capital Gearing Ratio (Preference Share Capital  Debt)

Equity ShareHoldersfund

4. Fixed Assets Ratio Fixed Assets / Capital Employed

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Coverage Ratios
Ratios Formulae Explanation
1. Interest Coverage Ratio EBIT / Interest
2. Dividend Coverage Ratio PAT / Dividend on Pref. Shares
3. Debt Service Coverage Ratio Profit available for debt Profit available for debt
(DSCR) servicing servicing = PAT + Non cash
Principal + Interest Exp. + Interest on long term
borrowing

Turnover Ratio / Activity Ratio

Ratios Formulae Explanation
1. Capital Employed Turnover Ratio Turnover ( Net Sales ) Capital Employed = refer
Capital Employed Annexure I
2. Fixed Assets Turnover Ratio Turnover / Net Fixed Assets
3. Working Capital Turnover Ratio Turnover / Working Capital
4. Finished Goods Turnover Ratio Credit Purchase COGS = Sales – G/p
Average Creditors
Avg. stock = Op. + Cl. / 2
5. Work-in-progress Turnover Ratio Cost of Production
Avg. stock of WIP

6. Raw Material Turnover Ratio Raw MaterialConsumed RM Consumed

[Link] of Raw Material = Op. + purchases - Closing
7. Debtors Turnover Ratio Credit Sales Avg. Debtors
AverageDebtors = Op. + Cl. / 2
8. Creditors Turnover Ratio Credit Purchase Avg. Creditors
Average Creditors = Op. + Cl. / 2

Annexure - I : Calculation of Capital Employed

Particulars Amount
Equity Share Capital XXX
+ Reserves & Surplus XXX
Equity Share holder’s Fund XXX
+ Preference Share Capital XXX
Share Holder’s Fund / Equity / Proprietary Fund XXX
+ Long Term Debt XXX
Capital Employed XXX

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Question 1: (master question).

Following are the Income Statement and Balance Sheet of Master Blaster Ltd. for the accounting year
2013.
INCOME STATEMENT
For the year ending Dec. 31st, 2013

Particulars Amount

Credit Sales 61,48,000

Less: Cost of Goods Sold 41,76,000

G.P. 19,72,000

Less: Adm. Exp. 4,58,000

Selling Exp. 2,00,000

Dep. 4,78,000

Operating Profit (EBIT) 8,36,000

Less: Interest charges 1,76,000

PBT 6,60,000

Less: Provision for tax (30%) 1,98,000

PAT 4,62,000

Less: Preference Dividend 20,000

EARNING FOR EQUITY SHAREHOLDER 4,42,000

Less: Dividend paid 1,96,000

Retained Earning 2,46,000

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BALANCE SHEET OF MASTER BLASTER LTD.

As on 31st Dec.2013
Amount
5% Pref. Share ( of Rs. 100 each ) 4,00,000
ESC ( 38,200 shares of Rs.10 each ) 3,82,000
Total Share Capital 7,82,000
Add:- Security Premium 8,56,000
P&L 22,70,000
Shareholder’s Fund 39,08,000
Add: Long term loan 20,46,000
Capital Employed 59,54,000
Represented by :

Fixed Assets 93,38,000

Less: Dep. 45,90,000
Net Block (1) 47,48,000

Working Capital

Cash and bank 7,26,000

Receivables 10,06,000
Marketable securities 1,36,000
Liquid assets 18,68,000
Add: Inventories 5,78,000
Total Current Assets(2) 24,46,000
Less:Trade Creditors 7,64,000
Bills payable 1,58,000
o/s exp. 1,20,000
Provision for tax 1,98,000
Total Current Liabilities(3) 12,40,000
Net Working Capital (4) (2-3) 12,06,000
Total Assets ( 1 + 4) 59,54,000

Additional Information:
a) No final dividend has been proposed
b) Loan of Rs. 1,42,000 is to be repaid every year
c) Market price of the share on Dec.31,2012 was Rs.80
d) The firm extends a credit of 50 days to its customer but receives a credit of 90 days from its
supplier.
Calculate various financial ratios to analyze different aspects of the operations and financial position
of the company.

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Question 2: The balance sheet of AD-HOC LTD is given below:

Liabilities Amount Assets Amount

ESC 250 Fixed Assets 400

Gen. Res. 280 Investment 50
P & L (current ) 30 Stock 460
Secured Loan ( long term) 300 Debtors 460
Secured Loan (short term) 360 Cash 10
Creditors 150 Misc Exp. ( not written off ) 20
Other Liabilities 30

1400 1400

Additional Information:
a) From the P & L a/c 90 lakhs are transferred to general reserve during the year.
b) Interest cost = 120 lakhs
c) Tax 40%)
You are required to calculate (i) Debt Equity Ratio (ii) Current Ratio (iii) Interest
coverage Ratio

Question 3: In a meeting held at Solan towards the end of 2009, the Directors of M/s HPCLLtd. have
taken a decision to diversify. At present HPCL Ltd. sells all finished goods from its own
warehouse. The company issued debentures on 01.01.2010 and purchased fixed assets
on the same day. The purchase prices have remained stable during the concerned
period. Following information is provided to you:
INCOME STATEMENTS

2009 (Rs. ) 2010 (Rs. )

Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 14,000
Interest on Debenture 49,000 2,000 59,000
Net Profit 15,000 17,000

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BALANCE SHEET

2009 2010
(Rs. ) (Rs. )

Fixed Assets (Net Block) - 30,000 - 40,000

Debtors 50,000 82,000

Cash at Bank 10,000 7,000

Stock 60,000 94,000

Total Current Assets (CA) 1,20,000 1,83,000

Creditors 50,000 76,000

Total Current Liabilities (CL) 50,000 76,000

Working Capital (CA - CL) 70,000 1,07,000

Total Assets 1,00,000 1,47,000

Represented by:

Share Capital 75,000 75,000

Reserve and Surplus 25,000 42,000

Debentures − 30,000

1,00,000 1,47,000

You are required to calculate the following ratios for the years 2009 and 2010.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio
(vi) Net Profit to Net Worth Ratio, and
(vii) Debtors Collection Period.
(viii) Ratio relating to capital employed should be based on the capital at the end of the
year. Give the reasons for change in the ratios for 2 years. Assume opening stock of
Rs. 40,000 for the year 2009. Ignore Taxation.

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Question 4: Following is the abridged Balance Sheet of Alpha Ltd. :-

Liabilities Rs. Assets Rs.

Share Capital 1,00,000 Land and Buildings 80,000

Profit and Loss Account 17,000 Plant and Machineries 50,000

Current Liabilities 40,000 Less: Depreciation 15,000 35,000

1,15,000

Stock 21,000

Debtors 20,000

Bank 1,000 42,000

Total 1,57,000 Total 1,57,000

With the help of the additional information furnished below, you are required to
prepare Trading and Profit & Loss Account and a Balance Sheet as at 31st March, 2010:
(i) The company went in for reorganisation of capital structure, with share capital
remaining the same as follows:

Share capital 50%

Other Shareholders’ funds 15%

5% Debentures 10%

Trade Creditors 25%

Debentures were issued on 1stApril, interest being paid annually on 31st March.
(ii) Land and Buildings remained unchanged. Additional plant and machinery has been
bought and a further Rs. 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total gross fixed and current
assets.)
(iii) Working capital ratio was 8 : 5.
(iv) Quick assets ratio was 1 : 1.
(v) The debtors (four-fifth of the quick assets) to sales ratio revealed a credit period of
2 months. There were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the year.
Ignore Taxation

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Question 5: Equity Shares (80000 @ Rs.10 )

9% Preference Shares (Rs.3,00,000)
Additional information:
Profit (after tax at 35 per cent),Rs.2,70,000;Depreciation, Rs. 60,000; Equity dividend
paid, 20 per cent; Market price of equity shares, Rs. 40.
You are required to compute the following, showing the necessary workings:
a) Dividend yield on the equity shares
b) Cover for the preference and equity dividends
c) Earnings per shares
d) Price-earnings ratio

Question 6: The total sales (all credit) of a firm areRs.6,40,000. It has a gross profit marginof 15 per
cent and a current ratio of 2.5. The firm’s current liabilities are Rs. 96,000; inventories
Rs. 48,000 and cash Rs. 16,000. (a) Determine the average inventory to be carried by the
firm, ifan inventory turnover of 5 times is expected? (Assume a 360 day year). (b)
Determine the average collection period if the opening balance of debtors is intended to
be of Rs. 80,000? (Assume a 360 day year).

Question 7: The following accounting information and financial ratios of PQR Ltd. relate tothe year
ended 31st December, 2009:
2009
I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13:11
Current ratio 2:1
Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
If value of fixed assets as on 31st December, 2008 amounted to Rs. 26 lakhs, prepare a
summarised Profit and Loss Account of the company for the year ended 31st December,
2009 and also the Balance Sheet as on 31st December, 2009.

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Question 8: Ganpati Limited has furnished the following ratios and information relating tothe year
ended 31st March, 2010.

Sales Rs. 60,00,000

Return on net worth 25%

Rate of income tax 50%

Share capital to reserves 7:3

Current ratio 2

Net profit to sales 6.25%

Inventory turnover (based on cost of goods sold) 12

Cost of goods sold Rs. 18,00,000

Interest on debentures Rs. 60,000

Sundry debtors Rs. 2,00,000

Sundry creditors Rs. 2,00,000

You are required to:

a) Calculate the operating expenses for the year ended 31st March, 2010.
b) Prepare a balance sheet as on 31st March in the following format:

Liabilities Amount Assets Amount

Share Capital Fixed Assets

Reserve and Surplus Current Assets
15% Debenture Stock
Sundry Creditors Debtors
Cash

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Question 9: ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financialstatements
over the last 3 years are as follows:
2007 2008 2009
Rs. Rs. Rs.
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
Rs. Rs. Rs.
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5,50,000
14,30,000 15,60,000 16,95,000
Rs. Rs. Rs.
Sales 40,00,000 43,00,000 38,00,000
Cost of goods sold 32,00,000 36,00,000 33,00,000
Net profit 3,00,000 2,00,000 1,00,000
Analyse the company’s financial condition and performance over the last 3 years. Are
there any problems

Question 10: Using the following information, complete this balance sheet:
Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5
Average collection period* 18 days
Inventory turnover 9
Gross profit margin 10%
Acid-test ratio 1 to 1

Assume 360 days-year and all sales on credit.

Cash Payables 1,00,000

Accounts Receivable Long Term Debt
Inventories Common Stock 1,00,000
Plant and Equipment Retained Earning 1,00,000
Total Assets Total Liabilities

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Practice Questions

Question 1: Using the following data, complete the Balance Sheet given below:

Gross Profit Rs. 54,000

Shareholders’ Funds Rs. 6,00,000

Gross Profit margin 20%

Credit sales to Total sales 80%

Total Assets turnover 0.3 times

Inventory turnover 4 times

Average collection period (a 360 days year) 20 days

Current ratio 1.8

Long-term Debt to Equity 40%

Balance Sheet

Rs. Rs.

Creditors Fixed Assets

Long term Debt Cash
Share Holder’s Fund Debtors
Inventories

Question 2: From the following information, prepare a summarised Balance Sheet as at 31st March,
2002:

Working Capital Rs. 2,40,000

Bank overdraft Rs. 40,000

Fixed Assets to Proprietary ratio 0.75

Reserves and Surplus Rs. 1,60,000

Current ratio 2.5

Liquid ratio 1.5

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Question 3: JKL Limited has the following Balance Sheets as on March 31, 2006 and March 31, 2005:
Balance Sheet
Rs. in lakhs
March 31, 2006 March 31, 2005
Sources of Funds:
Shareholders Funds 2,377 1,472
Loan Funds 3,570 3,083
5,947 4,555
Applications of Funds:
Fixed Assets 3,466 2,900
Cash and bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407
Other Current Assets 1,567 1,404
Less: Current Liabilities (3,937) (3,794)
5,947 4,555
The Income Statement of the JKL Ltd. for the year ended is as follows:
Rs. in lakhs
March 31, 2006 March 31, 2005
Sales 22,165 13,882
Less: Cost of Goods sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative expenses 1,135 752
Earnings before Interest and Tax (EBIT) 170 586
Interest Expense 113 105
Profits before Tax 57 481
Tax 23 192
Profits after Tax (PAT) 34 289
Require:
(i) Calculate for the year 2005-06
a) Inventory turnover ratio
b) Financial Leverage
c) Return on Investment (ROI)
d) Return on Equity (ROE)
e) Average Collection period.

(ii) Give a brief comment on the Financial Position of JKL Limited.

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Question 4: With the help of the following information complete the Balance Sheet of MNOP Ltd.:

Equity share capital Rs. 1,00,000

The relevant ratios of the company are as follows:

Current debt to total debt .40

Total debt to owner’s equity .60

Fixed assets to owner’s equity .60

Total assets turnover 2 Times

Inventory turnover 8 Times

Question 5: Using the following information, complete the Balance Sheet given below:

(i) Total debt to net worth: 1:2

(ii) Total assets turnover: 2

(iii) Gross profit on sales: 30%

(iv) Average collection period: 40 days

(Assume 360 days in a year)

Inventory turnover ratio based on cost of goods sold and year-end

inventory :3

Acid test ratio :0.75

ESC 4,00,000 Plant and Machinery

Reserve & surplus 6,00,000 Current Assets:
Total Debt: Inventory
Current Liability Debtors
Cash

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Question 6: Honey Sing’s Financial Statement contain the following info. :-

Year 1 Year 2

Cash 200000 160000

Sundry Debtors 320000 400000
Temporary Investment 200000 320000
Stock 1840000 2160000
Prepaid exp. 28000 12000

Total CA 2588000 3052000

Total Assets 5600000 6400000

Current Liabilities 640000 800000

Loan 1600000 1600000
Capital 2000000 2000000
Retained Earning 468000 812000

STATEMENT OF PROFIT FOR THE CURRENT YEAR

Rs.

Sales 40,00,000

Less: Cost of goods sold 28,00,000

Less Interest 1,60,000

Net Profit 10,40,000

Less: Tax @ 50% 5,20,000

PAT 5,20,000

Profit distributed 2,20,000

From the above, appraise the financial position of the company from the point of view
of:
(i) Liquidity
(ii) Profitability
(iii) Activity.

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LEVERAGE

Question 1: A Company produces and sells 10,000 shirts. The selling price per shirt is Rs. 500.
Variable cost is Rs. 200 per shirt and fixed operating cost is Rs. 25,00,000.
a) Calculate operating leverage.
b) If sales are up by 10%, then what is the impact on EBIT?

Question 2: Calculate the operating leverage for each of the four firms A, B, C and D fromthe
following price and cost data.

Firms
A B C D
Rs. Rs. Rs. Rs.
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 80,000 40,000 2,00,000 Nil

What calculations can you draw with respect to levels of fixed cost and the degree of
operating leverage result? Explain. Assume number of units sold is 5,000.

Question 3: A firm’s details are as under:

Sales (@100 per unit) Rs. 24,00,000

Variable Cost 50%

Fixed Cost Rs. 10,00,000

It has borrowed Rs. 10,00,000 @ 10% p.a. and its equity share capital is Rs. 10,00,000
(Rs. 100 each) Calculate:
a) Operating Leverage
b) Financial Leverage
c) Combined Leverage
d) Return on Investment
e) If the sales increases by Rs. 6,00,000; what will the new EBIT?

Question 4: Betatronics Ltd. has the following balance sheet and income statement information:
Balance Sheet as on March 31st

Liabilities (Rs.) Assets (Rs.)

Equity capital (Rs. 10 per share) 8,00,000 Net fixed assets 10,00,000

10% Debt 6,00,000 Current assets 9,00,000

Retained earnings 3,50,000

Current liabilities 1,50,000

19,00,000 19,00,000

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Income Statement for the year ending March 31

(Rs.)

Sales 3,40,000

Operating expenses (including Rs. 60,000 depreciation) 1,20,000

EBIT 2,20,000

Less: Interest 60,000

Earnings before tax 1,60,000

Less: Taxes 56,000

Net Earnings (EAT) 1,04,000

a) Determine the degree of operating, financial and combined leverages at the current
sales level, if all operating expenses, other than depreciation, are variable costs.
b) If total assets remain at the same level, but sales
(i) increase by 20 percent and
(ii) decrease by 20 percent, what will be the earnings per share at the new sales level?

Question 5: Calculate the operating leverage, financial leverage and combined leveragefrom the
following data under Situation I and II and Financial Plan A and B:

Installed Capacity 4,000 units

Actual Production and Sales 75% of the Capacity

Selling Price Rs. 30 Per Unit

Variable Cost Rs. 15 Per Unit

Fixed Cost:

Under Situation I Rs. 15,000

Under Situation-II Rs.20,000

Capital Structure:
Financial Plan
A B
Rs. Rs.
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000

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Question 6: Prepare the income statement and Balance-sheet from the following data:

Price Earning ratio 3 time

Market price per equity share Rs. 18
No. of equity share of Rs. 10 each 10,000
1,000
No. of 12% pref. shares of Rs. 100 each
2-1
Degree of financial leverage
2-1
Degree of operating leverage
40%
Income-tax rate
60%
Variable cost as % of sales revenue
10%
Rate of interest

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DIVIDEND POLICY AND EQUITY VALUATION

Question 1: (Valuation based on dividend.)

The following information are available for XYZ CO.
 No of shares outstanding is 1 lakh
 EPS is Rs. 4
 DPS is Rs. 2.4
 Equity capitalization rate: 12%
 Rate of return on investment: 15%
(i) As per Walter’s model, what will be Market value per Share?
(ii) To keep Share price at Rs. 40, what should be payout ratio?
(iii) As per Walter’s model, what is optimum payout ratio?
(iv) Market Value at that payout ratio?

Question 2: ABC Ltd has 10 lakhs equity shares outstanding at the beginning of the year. The current
market price of is Rs. 150 and the directors have recommended a dividend of Rs. 8 per
share. The shareholders expect a return of 12%.
(i) Applying MM Model calculate the fair price of the shares when a) dividend is
declared and b) dividend is not declared.
(ii) If the investment budget is Rs. 500 lakhs and anticipated profit is Rs. 180 lakhs,
compute how many shares are to be issued if
a) dividend is declared and
b) dividend is not declared.

Question 3: The following figures are collected from the annual report of PQR Ltd.:

Rs.

Net Profit 300 lakhs

Outstanding 12% preference shares 1000 lakhs
No. of equity shares 30 lakhs
Return on Investment 20%

What should be the approximate dividend pay-out ratio so as to keep the share price at
Rs. 42 by using Walter model?

Question 4: ABC Ltd. was started a year back with a paid-up equity capital of Rs. 40,00,000. The
other details are as under:

Earnings of the company Rs. 4,00,000

Dividend paid Rs. 3,20,000
Price-earnings ratio 12.5
Number of shares 40,000

You are requiredto find out whether the company’s dividend payout ratio is optimist,
using Walter’s formula.

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Question 5: A large sized chemical company has been expected to grow at 14% per year for the next
4 years and then to grow indefinitely at the same rate as the national economy, i.e., 5%.
The required rate of return on the equity shares is 12%. Assume that the company paid
a dividend of Rs. 2 per share last year (D0 = 2). Determine the market price of the share
today.

Question 6: The EPS of a company is Rs. 16. The market capitalization rate applicable to the
company is 12.5%. Retained earnings can be employed to yield a return of 10%. The
company is considering a payout of 25%, 50% and 75%. Which of these, if any, would
maximise the wealth of shareholders as per the Walter’s Model?

Question 7: Exponent Ltd. had 50,000 equity shares of Rs. 10 each outstanding on 1st April. The
shares are being quoted at par in the market. The company intends to pay a dividend of
Rs. 2 per share for current financial year. It belongs to a risk class whose appropriate
capitalization rate is 15%.
Using Modigliani-Miller Model and assuming to taxes, ascertain the price of company’s
share as it is likely to prevail at the end of the year when (i) dividend is declared; and
(ii) no dividend is declared.
Also find out number of new equity shares that the company must issue to meet its
investment needs of Rs. 2,00,000 assuming net income of Rs. 1,10,000 and assuming
that the dividend is paid.

Question 8: Import Replacement Ltd. specializes in producing goods to substitute imports from the
USA. The managing director of the company Ajay is seriously concerned about the
dividend payout policy of the company. He has asked you as a company secretary-cum-
finance director to suggest dividend payout under each of the following alternative
policies:
Policy-I: A dividend payout of Rs. 2.00 per share, increasing by Rs. 0.20 per share over
the previous year whenever the dividend payout falls below 50% for the two
consecutive years.
Policy-II: A dividend payout of Rs. 1.00 per share for each period except when earnings
per share exceed Rs. 6.00 when an extra dividend equal to 80% of earning beyond Rs.
6.00 would be paid.
The earnings per share of the company over the last 10 years is shown in the following table:
Year Earnings per Share
Rs.
2001 8.00
2000 7.60
1999 6.40
1998 5.60
1997 6.40
1996 4.80
1995 2.40
1994 3.60
1993 -1.00
1992 0.50
You are also requiredto discuss the pros and cons of each of the dividend policies
mentioned above.

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Question 9: The required rate of return of investors is 15%. ABC Ltd. declared and paid annual
dividend of Rs. 4 per share. It is expected to grow @ 20% for the next 2 years and 10%
thereafter. Compute the price at which the shares should sell.
NOTE: PV factor @ 15% for Year 1 = 0.8696 and Year 2 = 0.7561.

Question 10: Bestbuy Auto Ltd. had outstanding 1,20,000 shares selling at Rs. 20 per share. The
company hopes to make a net income of Rs. 3,50,000 during the year ended 31 st March,
2003. The company is considering to pay a dividend of Rs. 2 per share at the end of
current year. The capitalization rate for risk class of this company has been estimated to
be 15%.
Assuming no taxes, answer the questions listed below on the basis of the Modigliani
Miller Dividend Valuation Model:
(i) What will be the price of a share at the end of 31st March, 2003-
 If the dividend is paid; and
 If the dividend is not paid?
(ii) How many new shares must the company issue if the dividend is paid and
company needs Rs. 7,40,000 for an approved investment expenditure during the
year?

Question 11: The earnings per share (EPS) of a company is Rs. 10. It has an internal rate of return of
15% and the capitalization rate of its risk class is 12.5%. If Walter’s Model is used.
(i) What should be the optimum payout ratio of the company?
(ii) What should be the price of the share at this payout?
(iii) How shall the price of the shares be affected, if a different payout were employed?

Question 12: Following information is available in respect of DPS and PPS of Intelligent Ltd. for the
last five years:

Year 2004 2003 2002 2001 2000

EPS (Rs.) 14.10 13.60 13.10 12.70 12.20

DPS (Rs.) 8.20 8.10 7.90 7.80 7.70

Dividends for a particular year are paid in the same calendar year. If the same dividend
policy is maintained, it is expected that the annual growth rate of earnings will be no
better than the average of last four years. The risk free rate is 6% and the market risk
premium is 4%. With reference to the market rate of return, the equity shares of the
company have a β of 1.5 and is not expected to change in near future.
The company has received a proposal from Smart Ltd. to acquire its operations by
paying the value of shares.
You are required
to value the equity shares of the company using
(i) dividend growth model;
(ii) earnings growth model; and
(iii) capital asset pricing model (CAPM).

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Question 13: A closely-held toys manufacturing company has been following a dividend policy, which
can maximise the market value of the company as per Walter’s Model. Accordingly, each
year at dividend time, the capital budget is reviewed in conjunction with the earnings
for the period and alternatives investment opportunities for the shareholders. In the
current year, the company can earn Rs. 2,50,000 if such profits are retained. The
investors have alternative investment opportunities that will yield them 12%. The
company has 1,00,000 shares outstanding. What would be the dividend payout ratio of
the company, if it wishes to maximise the wealth of the shareholders?

Question 14: From the following information, ascertain whether the firm is following an optimal
dividend policy as per Walter’s model:
Total earnings (RS.) 6,00,000
Number of equity shares of Rs. 100 each 40,000
Dividend paid (Rs.) 1,60,000
Prices-Earnings (P/E) ratio 10
The firm is expected to maintain its rate of return on fresh investment.
What should be the P/E ratio at which dividend policy will have no effect in the value of
the share?
Will your decision change if the P/E ratio is 5 instead of 10?

Question 15: The following financial data relates to XYZ Ltd.:

Earnings Dividend
Share Price
Year Per Share Per Share
(RS.)
(Rs.) (RS.)

2004 42 17 252
2005 46 18 184
2006 51 20 255
2007 55 22 275
2008 62 25 372

A firm of market analysts which specializes in the industry in which XYZ Ltd. operates
has recently re-evaluated the company’s future prospects. The analysts estimate that
XYZ Ltd.‘s earnings and dividend will grow a 25% for the next three years. Thereafter,
earnings are likely to increase at a lower rate of 10%. If this reduction in earnings
growth occurs, the analysts consider that the dividend payout ratio will be increased to
50%.
XYZ Ltd. is all equity financed and has 10 lakh ordinary shares in issue. The tax rate of
33% is not expected to change in the foreseeable future. Calculate the estimated share
price; and the P/E ratio by using dividend valuation model. For this purpose, you can
assume a constant post-tax cost of capital of 18%.

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Question 16: Rosa Chemicals Ltd. has outstanding 1,20,000 shares selling at Rs. 20 per share. The
company hopes to make a net income of Rs. 3,50,000 during the year ending 31st March,
2009. The company is thinking of paying a dividend of Rs. 2 per share at the end of
current year. The capitalization rate for risk class of this firm has been estimated to be
15%. Assuming no taxes, answer the questions listed below on the basis of the
Modigliani Miller dividend valuation model:
(i) What will be the price of share at the end of 31st March, 2009, if –
a) the dividend is paid; and
b) the dividend is not paid?
(ii) How many new shares the company must issue if the dividend is paid and
company needs Rs. 9,50,000 for an approved investment expenditure during the
year?

Question 17: From the following information, determine the market value of equity shares of the
company:
Earnings of the company Rs. 5,00,000
Dividend paid Rs. 3,00,000
Number of shares outstanding 1,00,000
Price-earnings ratio 8
Rate of return on investment 15%
Are you satisfied with the current dividend policy of the company? If not, what should
be the optimal dividend payment ratio? Use Walter’s Model.

Question 18: Zebra Ltd. was started a year back with paid-up equity capital of Rs. 40 lakh. Other
details are as under:
Earnings of the year : Rs. 4,00,000
Dividend paid : Rs. 3,20,000
Price-earnings ratio : 12.5
Number of shares : 40,000
You are required
to find out whether company’s dividend payout ratio is optimal using Walter’s Model,
giving reasons.

Question 19: Rani has invested in a share whose dividend is expected to growth at 15% for 5 years
and thereafter at 5% till life of the company. Find out value of the share, if current
dividend is Rs. 4 and investor’s required rate of return is 6%.

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Question 20: The following data relate to Intel Projects (India) Ltd.:

Year ending 31st March Net Earnings Per Share Net Dividend Per Share
(Rs.) (Rs.)

2006 32 17.50
2007 28 18.50
2008 26 20.00
2009 26 21.00
2010 24 22.00

There are 10 lakh equity shares issued and majority of these shares are owned by
private investors. There is no debt in the capital structure of the company.
The company has been experiencing difficult trading conditions over the past few years.
In the current year, net earnings are likely to be Rs. 2.20 crore, which will be just
sufficient to pay a maintained dividend of Rs. 22 per share.
You are required to comment on the company’s dividend policy between 2005-06 to
2009-10; and on its possible consequences for earnings.

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