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Financial Managemant

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Financial Managemant

Rahul B. Chauhan
Andino Maseleno

Penerbit:

i
inancial Management
@ Rahul B. Chauhan, Dr. Andino Maseleno

ISBN 978-623-7491-24-8

Layout:
Heri Bojes

Desain Cover:
Gunawan

Penerbit :
CV. Sadari

Cetakan pertama, Mei 2020

Hak cipta dilindungi undang-undang

Dilarang memperbanyak karya tulis ini dalam bentuk apapun tanpa ijin tertulis
dari penerbit

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 Financial Management

Level of knowledge : Basic

Aim :To assess whether students have acquired basic
knowledge about what is financial
management, what are the various tools of
financial management and methods of
financial management f

Detailed contents :

1. Meaning, Importance and objectives of financial management and

functions of Finance Manager
2. Finance planning and forecasting cash budgets
3. Operating and financial leverage, cost volume profit analysis
4. Management of working capital - cash management, receivables
management, Inventory management and financing of working capital
5. Sources of long term and short term finance – Term borrowings,
commercial papers, Equity Shares, Preference shares, debentures etc.
6. Cost of Capital and capital structure theories – cost of different sources
of finance
7. Dividend policies
8. Capital budgeting – Basics of capital budgeting and various techniques
of capital budgeting

iii
 Index

Chapter 1 : Financial Management – an overview

Topic Page no.
1.1 Introduction
1.2 Meaning of Financial Management
1.3 Importance of Financial Management
1.4 Objectives of Financial Management
1.5 Functions of finance manager
1.6 Financial management and organisational structure
1.7 Financial management in India
1.8 Self examination questions

Chapter 2 : Finance planning and forecasting

Topic Page no.
2.1 Introduction
2.2 What is financial planning
2.3 Need and Importance of Financial planning
2.4 Factors to be considered in a financial plans
2.5 Essential characteristics of financial plan
2.6 Budgets
2.7 Solved problems
2.8 Self examination questions

Chapter 3 : Operating and financial leverage, cost volume profit analysis

Topic Page no.
3.1 Introduction
3.2 Types of leverages
3.3 Solved problems on leverages
3.4 Cost volume profit analysis
3.5 Solved problems on break-even point
3.6 Self examination questions

Chapter 4 : Management of working capital

Topic Page no.
4.1 Introduction
4.2 Meaning of the term working capital
4.3 Importance of adequate working capital
4.4 How to determine optimum working capital
4.5 Working capital cycle
4.6 Solved problems on working capital cycle
4.7 Estimation of working capital requirements
4.8 Solved problems on working capital estimation

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4.9 Factors affecting the working capital requirements
4.10 Management of Working capital
4.11 Cash Management
4.12 Debtors management
4.13 Inventories management
4.14 Working capital financing in India
4.15 Self examination questions

Chapter 5 : Sources of long term and short term finances

Topic Page no.
5.1 Introduction
5.2 Types of Requirement of funds
5.3 Various sources of finance
5.4 Long term sources of finance
5.5 Short term sources of finance
5.6 Modes of charges against a loan
5.7 Self examination questions

Chapter 6 : Cost of capital and capital structure theories

Topic Page no.
6.1 Introduction
6.2 Considerations in Capital structure planning
6.3 Determination of cost of various sources of capital
6.4 Weighted average cost of capital
6.5 Theories of cost of capital
6.6 Self examination questions

Chapter 7 : Dividend policies

Topic Page no.
7.1 Introduction
7.2 Walter model
7.3 Gordon model
7.4 Irrelevance approach
7.5 Self examination questions

Chapter 8 : Capital Budgeting

Topic Page no.
8.1 Introduction
8.2 What is capital budgeting ?
8.3 Methods and techniques of capital budgeting
8.4 Solved problems

v
8.5 Self examination questions

Chapter 9 : Assorted questions

Biodata

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vii
 Financial Management

1 Financial Management – an overview

1.1 Introduction

Management of funds is one of the most important functions of any organisation, be it

a profit oriented organisation or social organisation like CRY. In this Chapter, we shall
try to understand the basic concepts of financial management i.e. management of
money matters.
In our day-to-day life also we face many finance related problems which we try
to solve on our own judgement or with the help of friends and relatives examples of
such problems can be –
1. Mr A is willing to buy a car but is not sure from which bank he shall take loan.
2. Ms X is having Rs 5 lakhs that she is willing to invest profitably and without
much risk.

If we analyse carefully we can elaborate the problems as follows –

1. Which bank offers the cheapest interest rates? What will be the repayment
period ? What will be the instalment per month? How much instalment Mr A
can afford, considering his all other expenses? and so on
2. Whether to invest in government securities, Provident fund, Mutual funds,
Debentures, Shares, gold or real estate ?

To put it simply we can say that Mr A is facing a problem about procurement of funds
whereas Ms X is facing problem as to investment of funds. Financial Management
provides guidelines , tools and methods of solving the problems of procurement of
funds and problems of investment of funds and is helpful for every organisation as well
as individual.

1.2 Meaning of Financial management

Various authors have defined the term financial management differently. The most
acceptable definition of financial management deals with procurement of funds and
their effective utilisation. There are, thus, two basic aspects of financial management –
procurement of funds and their effective utilisation.

1.2.1 Procurement of funds – Procurement of funds or raising the funds is complex

problem as funds can be obtained from indefinite sources, each having different
characteristic in terms of risk, cost and control. E.g - let us evaluate some sources of
funds (For detailed discussion of sources of funds refer following topics - cost of
capital and sources of funds)

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 Financial Management

Risk High
Cost Low
R (Bank loan)
I
S
K Cost High
Risk Low
(Equity shares)

COST
Again Control risk is least for bank loan where as it is highest for Equity shares. One
more constraint for procurement of funds is availability of funds e.g for a small
business house only availability may be bank loan and the business may not be able to
raise funds from public by way of equity shares.

Procurement of funds inter alia includes –

 Identification of sources of finance
 Determination of finance mix from such sources
 Raising of funds
 Allocation of profits between dividends and retention of profits i.e internal
fund generation

In the current global scenario it is not enough to scout for available ways of raising
finance but resource mobilisation has to be undertaken through innovative financial
products which understand the business as well as investors needs an example can be
convertible debentures which gets converted from debentures to equity shares after a
predefined date.

1.2.2 Utilisation of Funds - A finance manager is also responsible for effective

utilisation of funds. He is responsible to ensure that the funds are not kept idle and are
invested properly. Utilisation of funds can be directly linked with the procurement of
funds, if the funds are not utilised to generate income higher than the cost of procuring
it then there is no point in running the business, say, for example if a bank is offering
5% interest on deposits then the banker must ensure that the amount of deposit is
utilised to generate an income which is higher than 5%.
The funds have to be so invested that the company can optimise its profitability
without harming its solvency and liquidity. The finance manager has to invest in fixed
assets and current assets in a right proportion so as to reap maximum yield.

Utilisation of funds inter alia includes –

 Identification of area of investments
 Determination of finance mix for the utilisation

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 Financial Management

 Assessing the risk level of the investment

 Maximising the return on such investment

In present day scenario utilisation of funds can be done in indefinite ways making the
job of finance manager more complicated and demanding. Following chart indicates
the decision-making options available to a finance manager for utilisation of its funds.

Risk High
Returns high
R (Equity market)
I
S
K Risk Low
Return Low
(Government
Security)

RETURN

1.3 Importance of Financial Management

The importance of finance manager cannot be over-emphasised. There is an ordinary

belief that a finance manager is needed only in private organisations. However, sound
finance manager is essential in all organisations – whether profit or non profit where
funds are involved. Financial management is so essential as he plays a crucial role in
making best use of resources. Commercial history is full of examples where firms have
been liquidated not because their technology was obsolete or it lacked demand for its
products but because of financial mismanagement, a recent example of ENRON INC can
be very elaborative about this point.
Financial management essentially optimises the output from the given input of funds.
It attempts to use the funds in most productive manner. In underdeveloped countries
like India where resources are scare and demands on funds are many, the need for
finance manager is enormous.
Finance management can be very effective in case of non-profit making organisations
as which hardly pay proper attention to financial management. Very frequently we
read about such organisations closing down because of lack of finance, in fact, many
times, it is not lack of finance but it is lack of proper financial management. Many times
these organisations keep their funds idle which has cost. Though motive of such
organisations is not to make profits but it can certainly cut down its costs in order to
have sound financial position.
An example - Following extract is taken from board report of a company emphasising
the turnaround in company’s financial position achieved due to sound financial
management –

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 Financial Management

“Better cash management and control over capital employed and working capital has
helped the company in reducing its loans from Rs 580 crores to Rs 200 crores resulting
into interest saving of approx Rs 30 crores, this has improved profit position of the
company substantially. We hope to continue with similar performance in current year
by undertaking further cost cutting and strict control over cash flows.”

1.4 Objectives of Financial Management – A basic understanding of objectives of

financial management would help us in appreciating how a finance manager makes his
decisions. Decisions can be made only when objectives are clear. Following are the
fundamental objectives of finance manger –

1.4.1 Profit Maximisation – It cannot, however, be the sole objective of the company,
but it is certainly one of the most important objectives. If a company is run with sole
object of profit making then it can create certain problems like –
i. Profit maximisation has to be attempted with a realisation of risks
involved. Risk and profit is directly relates and motive of profit
maximisation may lead to risk maximisation also. A finance manager with
sole objective of profit maximisation may end up taking excessive risk,
which may lead to failure of organisation. In practice, risk is given almost
equal importance as that of profit and profit is maximised only till it
reaches the acceptable risk level.
ii. Profit maximisation may or may not take into account the time pattern of
return i.e even if Project A is having more profit than Project B, project A
may start giving return at the end of year 5 and Project B at the end of year
1. In such scenario finance manager has to consider both the things time
and profit and not only profit.
iii. Profit maximisation is a very narrow object and does not take into
consideration social aspects, which can be very harmful to the society.

1.4.2 Wealth Maximisation –The policy of profit maximisation is considered as short-

term policy as it may give exorbitant benefits in short term but may end up affecting
growth and survival of the company in the long run. Thus a company may start buying
inferior raw materials in order to maximise profit, which it may actually get for some
period, but will end up losing its goodwill and may have to close down.
Hence, it is commonly agreed that the objective of a firm is to maximise its value or
wealth. According to Van Horne – “Value is represented by the market price of the
company’s common stock ………… The market price of a firm’s stock represents the
focal judgement of all market participants as to what the market value of the particular
firm is. It takes into consideration present and expected future earnings per share, the
timing and the risk associated to the earning, company’s dividend policy etc.. The
market price serves as performance indicator of the firm; it indicates how well
management is doing on behalf of the stockholders.”
Though market value of the firm depends upon various factors, it normally depends
upon two
Factors –

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 Financial Management

a. The likely rate of earnings per share of the company (EPS)

b. The Capitalisation rate

Let us see one example. If for a company A ltd the market expectation of returns is
25% and it’s Earnings per share is Rs 5 (EPS = Earnings available to equity share
holders/ no of equity shares outstanding) then the market price per share will be –

5/25*100 = Rs 20 per share. If we calculate in reverse way we can see that the return
on every Rs 20 invested the shareholder will be getting Rs 5 i.e 25% which is as per his
expectations. The expected return varies form company to company and industry to
industry (which is 25% for A ltd), the logic for expected returns is simple - more the
risk more will be the expected returns.

The finance manager has to ensure that his decisions are such that the market value of
the shares of the company is maximum in the long run. It is, therefore, duty of the
finance manager to optimise the earning of the company so that its value is maximum.
Wealth maximisation can thus be considered a better objective as it considers both
risk and return of the company.

It must be clearly understood that financial decision-making is related to the objective

of business and objective of business over shadows the objective of wealth
maximisation. To support the statement the following example can be taken – suppose
a Public sector under taking, which is in business of steel pipes, is planning to
undertake a research and development programme on fertility of baron lands for
public welfare, then the finance manager cannot deny funds stating that this is wastage
of funds and it wouldn’t maximise the company’s wealth.

1.5 Functions of Finance Manager

The main function of finance manager revolves around procurement of funds and its
effective utilisation. Thus all the decisions concerning management of funds are
subject matter of finance function. This function involves a number of important
decisions; some of these have been listed below –

1.5.1 Estimating the requirements of funds - In any business requirement of funds

have to be carefully estimated. Certain funds are required for long term purposes i.e
investment in fixed assets etc. Not only a careful estimation of such funds is required
but also estimation of timing of its requirement is essential. Finance Manager also has
to estimate the requirement of the working capital and how much funding will be
required for funding its current assets. Forecasting these requirements require
budgetary controls and techniques. To forecast the funds requirement all the physical
activities of the organisation has to be forecasted like sales, requirement of fixaed
assets, debtors etc.

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 Financial Management

1.5.2 Decision regarding the capital structure – After estimating the quantum of
funds required the finance manager has to plan for the sources from where the funds
should and can be raised. An optimum mix of the various sources has to be worked out
for this purpose. As discussed earlier each source of finance has different cost, risk and
control risk, a finance manager has to take into consideration all these factors and find
out an optimum capital structure which will be best for the organisation. Finance
manager has to maintain a proper proportion of outside borrowings and own funds.
Again as every other decision this decision should also aim at wealth maximisation,
which can be achieved by keeping the cost of capital (borrowed from outside as well as
own funds) minimum. This is a golden rule of capital structure theories that lesser the
cost of capital higher will be the market value of the business.

1.5.3 Investment decision – Funds procured should be invested in various kinds of

assets. Long term loans / funds should be invested in Fixed assets and short term
funds should be invested in current assets. The investment in any asset should be
made after through examination of all the options, the technique for examining various
capital projects is termed as capital budgeting. One thing a finance manager should
always keep in mind is that money should never be kept idle as idle money always has
a cost.

1.5.4 Dividend decision – The finance manager is concerned with the decision to the
decision to declare and pay the dividends periodically, so that the equity investors get
return on their investments. He has to help the top management in identifying how
much amount can be distributed as dividends, keeping in mind organisations cash
needs, expansion plans etc.. There are many other factors on which this decision
depends like trend of earnings, the trend of market price of the shares, the tax
implications etc.

1.5.5 Supply of funds to all departments and cash management – Though not a
primary function, cash management and funds allocation is an important function of a
finance manager. It is more than likely in any organisation that one branch or
department is having excess cash and other may be having a shortage, this may
hamper company’s day to day functioning as adequate funds is a necessity for smooth
running of any business. Finance manager should ensure that cash is not kept idle as it
may cost the organisation heavily.

1.5.6 Evaluating financial performances – Finance manager is always required to

do the job of performance evaluator of the company. He has to supply top management
information with financial analysis. Analysis of financial performance helps the
management in seeing how the funds have been utilised in various divisions and what
can be done to improve it.

1.5.7 Financial negotiations – A major responsibility of finance manager is to

negotiate with bankers, financial institutions providing loans, debenture investors etc.
Negotiation for finance is considered as a specialised job and involves lots of expertise.

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 Financial Management

1.5.8 Maintaining the share price of the company – stability in market price of the
shares is extremely essential for every organisation as it maintains the company’s
goodwill amongst the investors. It is responsibility of Finance manager to see that the
prices of shares do not fluctuate extremely.

1.6 Financial management and organisational structure –

The chief financial executive (his designation may vary from company to company)
works directly under the president or Managing director of the company. Besides
routine work, he keeps the Board of directors informed about all the phases of
business activity, including economic, social and political developments affecting the
business behaviour. He also furnishes information about the financial status of the
company by analysing it from time to time. The chief financial executive may have
many officers under him to carry out his functions. Broadly, his functions are divided
into two channels –
A. Treasury functions
B. Control functions

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 Financial Management

1.6.1 Relationship of finance manager with other managers

Finance function can never be an independent function and is closely related with
other management functions like production, marketing, personnel etc. we’ll take a
close look at how these functions are co related, in order to understand position of
finance manger in the organisation. Finance is blood of an organisation. It is the
common thread which binds all the organisational functions as each function when
carried out creates financial implications. The interface between finance and other
functions can be described as follows –

 Production – Finance – Production Function necessitates a large investment.

Productive uses of resources ensure a cost advantage for the firm. Optimum
investment in inventories improves profit margins. Many parameters of the
production function having effect on production cost or possible to be controlled
through internal management, thus improving profits. One of the important
decisions taken by Finance – Production departments together is the make or buy
decision. In current scenario this decision has lead to heavy outsourcing to low
cost countries.

 Marketing – Finance – Many aspects of marketing management have direct

financial impact. How much inventory shall be hold so that prompt delivery can be
guaranteed to the customer, has a direct impact on inventory holding cost of the
company. Similarly credit period granted to customers by the marketing
department directly affects the liquidity position of the company. Marketing
campaigns and advertisements have huge cost and should always co-related with
the revenue which it generates.

 Personnel – Finance – In the globalised competitive scenario business firms are

moving to leaner and flat organisations. Investments in human resource
development are also bound to increase. Restructuring of remuneration structure,
Voluntary retirement schemes, stock options etc. have become major financial
decisions in the areas of human resources management.

1.7 Changing face of financial management in India

India has witnessed tremendous change in the concept of financial management ever
since a the last decade. Ever since the Indian market opened up, Indian corporate
sector has access to global financial markets. Currently there are unlimited
opportunities available to the corporate sector in India to invest as well as borrow
from foreign markets and to maximise the benefit by considering these increased
options. Financial products like options, swaps, American depositary receipts (ADRs),
Global depositary receipts (GDRs) etc. were totally unheard a few years ago. Some of
the key indicators of changing era and reasons for this changing era are -

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 Financial Management

a. Rupee has become fully convertible on current account

b. Industrial licensing has been abolished
c. Allowing foreign institutional investors (FII) to invest in Indian market
d. Allowing Foreign direct investment (FDI), though upto certain extent
e. Allowing abroad listing of Indian companies e.g ICICI is listed in New york
stock exchange.
f. Share prices of new share issue are no longer regulated by the government
g. ECB- External commercial borrowing is allowed.
h. NRIs and OCBs are allowed to invest in unlisted companies.
Though the changing financial market is outcome of several factors, the above
mentioned factors are landmarks.

1.8 Self-examination questions

Write notes on –

1. The objectives of financial management

2. Distinguish between “Profit maximisation” and “Wealth maximisation”
3. Draw and explain organisational chart of a finance manager and his
relationship with other departments
4. Discuss Functions of a Finance manager
5. Discuss how financial management is changing in Indian scenario
6. What are the important aspects of procurement of funds and its utilisation

Select the correct options –

1. Which of the following are the functions of a Finance Manager

a. Negotiating loans with bankers

b. Internal audit
c. Deciding the advertiser
d. Deciding company’s recruitment policies
e. Cash management

2. The primary objective of a finance manager is

a. Wealth maximisation
b. Profit maximisation
c. Both of the above
d. None of the above

3. Financial management is essential for –

a. Private sector enterprises

b. Public sector enterprises

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 Financial Management

c. Social organisations
d. All of them
e. None of them

4. The value of a company is reflected by –

a. Profit of the company

b. Number of employees
c. Total assets of the company
d. Market value of the shares of the company

5. What are the key aspects a finance manager must think before procuring the
funds

a. Risk
b. Cost of the funds
c. Control risk
d. All of the above
e. None

6. To maximise the value of the company; cost of capital should be –

a. minimum
b. maximum
c. company value doesn’t depend upon cost of capital

7. The cost of capital for a high risk project will be –

a. high
b. low
c. zero
d. cannot say

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 Financial Management

2 Financial planning and forecasting

2.1 Introduction

Estimation of requirement of finance is essential before deciding the amount of funds

that needs to be raised. Financial management provides various tools for this
estimation commonly known as ‘Budgeting’. A finance manager has to prepare budgets
periodically and accurately as inaccurate budgets may lead to either under financing or
excess financing, both of which are detrimental to the interests of the organisation. The
term accurate does not imply accuracy to last rupee but indicates a fairly accurate
estimate. Timely preparation of budgets is necessary as with the help of budgets funds
can be raised timely and smooth flow of operations can be ensured.

2.2 What is financial planning and nature of financial planning

[Link] defined financial planning as “ the financial planning of a corporation

has a two fold aspects, it refers not only to the capital structure of corporation but also
to the financial policies which the corporation has adopted or intends to adopt.”

According to Solomon and Pringle “narrowly conceived, financial planning may refer
to the process of determining the financial requirements and financial structure
necessary to support a given set of plans in the other areas”

Above two definitions highlight following aspects of Financial management –

1. It determines the requirement of finance

2. Financial planning is a process and not just a one time activity
3. It invariably includes plans of other areas like production, marketing etc.
4. It covers both capital structure and financial policies

Financial planning should always be bifurcated between long term planning and short
term planning. Long term financial planning includes designing of the capital structure
of the company, estimating requirements for long term funds, planning amount of
investment in long term assets etc. Short term planning mainly includes planning and
estimating working capital requirements and cash budgeting. Long term planning may
be for up-to 5 to 20 years, whereas generally short term plans are for 1 to 2 years. The
budgeting process covers estimates of almost all departments like Marketing,
Production, Human resources, administration etc. The starting point of all the budgets
is always the sales figure. Almost all the figures can be derived based on estimated
sales. It should be noted that the sales figure and most of the other incomes and
expenses are not only estimated in terms of money but also in terms of quantity for
budgeting purposes.
Estimation of requirement of investment for expansion of production capacities from
sales figure can be determined as follows –

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 Financial Management

Sales (Rs.)

Sales (Units)

Estimated production required for estimated sales

Currently available production capacity

Estimated Production capacity required to cover the shortfall

Estimated expenditure involved to set-up such production facility*

*- Please note that it is not necessary that the organisation will go for expansion based
on the estimated requirement. Before expansion it will have to consider various
factors and take various decisions like whether the increased demand is seasonal or
permanent, whether to make or buy the product, whether demand is sufficiently high
to cover the additional expenditure.

It is imperative to note that planning is not only useful for predicting the requirement
of funds but also it is an important control device for the management. Every
department is answerable for spending more than the budgeted figures and earning
lesser than the budgets.

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 Financial Management

2.3 Need and importance of financial planning

The need and importance of financial management can never be over emphasised.
Following points briefly highlight the need and importance of financial management –

a. Ensuring enough liquidity i.e sufficient availability of cash balance

b. Determining the timing and extent of borrowings
c. To anticipate requirements of funds
d. To minimise the cost of funds by looking for opportunities to invest idle
funds
e. To maintain company’s solvency

2.4 Factors to be considered in a financial plan

Following factors needs to be considered before making a financial plan –

Nature and seasonality of business – Nature of business plays a decisive role in

financial planning. The requirement of funds, its timing and type wholly depends upon
the business in which the organisation operates. Capital intensive industry requires
heavy investment in long term finance like cement industry, aviation industry steel
industry etc. whereas labour intensive organisations require comparatively higher
funds for short term funding like Information technology. Financial plan must consider
these requirements of the industry before forecasting the results. Again seasonality of
business is certainly a dominating factor. For example If the finance manager is making
finance plan for a air conditioner manufacturing company based the estimates that
sales for the year will be Rs 360 lacs and so per month will be Rs 30 lacs and hence the
working capital requirement will be Rs xxxxxx . Here it is more than likely that his
estimation is wrong as ACs are sold more in summers i.e from March to May and is
sold lesser in winters, so the basic estimate of sales per month itself is wrong as failed
to appreciate seasonality of his business. This will obviously lead to over financing in
winters and under financing in summers.
It may be noted here that almost all the businesses have some sort of
seasonality that the finance manager should be aware of before preparing
the finance plans.

Contingencies - A Finance manager should always make room for contingencies

while making a finance plan. He should make some provisions for unforeseen risks
otherwise he may fail to give a good finance plan.

Management perceptions - Before deciding the sources of funds in a finance plan

a finance manager must take into consideration management perceptions about risk,
cost and control risk involved in raising finance. For example if management is not
interested in diluting the control of existing shareholders then it may reject any

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 Financial Management

proposal of raising funds through equity shares. If management is not prone to taking
risks then perhaps large bank loans may never be raised by the organisation.

Analysis of all the available alternatives – A finance manager must consider all
the available alternatives, analyse its advantages and disadvantages, before deciding
upon the mix that will be best for the interest of the organisation.

Government policies – In preparing a financial plan, finance manager has to

invariably take into account various government policies and controls. He must take
full advantage of the government subsidies and other benefits made available by the
government.

Expansion plans – Expansion plans must be considered before deciding upon any
finance plan as generally expansion plans require huge investments and may affect
significantly all the other estimates.
Inflation - A finance plan made by individuals also take into account inflation, so it
is almost unnecessary to mention inflation as a major consideration for a fiancé plan. It
is not necessary that inflation will only inflate the projected expense figures and will
reduce the estimated profit figures, on the contrary inflation may increase the sales
figures more than the expenses and may result into more profit (estimated).

Uniqueness of the organisation – All the companies cannot have a similar finance
plan as each unit is unique in itself and will require different finance mix to suit its
needs. Again its not possible that all the units have access to all kinds of finances and
then the finance plan should only consider whatever options are available to the
particular units.

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 Financial Management

2.5 Essential characteristics of financial plan

Though finance plan of every organisation is unique it invariably should have following
characteristics in common –

2.5.1 Simplicity – Simplicity is a requirement for every plan let alone financial plan.
All the financial plans should be simple and self content , so that it is more
understandable even to non finance members of the management.

2.5.2 Flexibility – Rigid financial plans can never be successful all financial plans
needs some sort of flexibility. It can be noted that what we have discussed till
now about financial plan is that it is an estimation, and its nearly impossible to
estimate with 100% accuracy. To cope up with this drawback in the estimates
financial plans should be kept open for any unseen material changes that may
occur in future.

2.5.3 Completeness – Completeness implies that whether all the estimates are
considered in the financial plan or not. It should never happen that some
department or some major expenses are completely missed out from the
financial plans. Ensuring completeness is perhaps one of the most difficult task
which a finance manager faces.

2.5.4 Vision – Vision and foresight is an absolute essential characteristic of any

financial plan. Financial plan is not merely mathematical job but it involves
thinking and foresight

2.5.5Control - Financial plans or budgets should be able to serve as a control tool by

the management. The budgeted figures should be compared with the actual
performance so that inefficiencies in the organisation can be controlled.

2.6 Budgeting

Budgeting is a process comprising of designing, preparation, implementing and

operating financial plans. Budget is an estimation as well as target. One of the most
significant aspect of budgeting is that it helps in establishing responsibilities at various
levels, as budgets are prepared department / branch / cost centre wise and each
department head is responsible for following that budget. The ultimate budget
encompassing most of the operations of the firm is known as ‘Master Budget’ and may
comprise of the following –

1. Capital budgeting
2. Financial budgets – Cash budgets and projected financial statements (profit
and balance sheet budgets)
3. Operating budgets – sales budget, production budget purchae budget etc.

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 Financial Management

2.6.1 Cash Budgets- Cash budgets are prepared periodically to identify cash inflows
and outflows, as cash flows determine the requirement of funds and helps identifying
investible funds. Cash budgets are nothing but cash flow statements. One must note
that cash flow is different from profit or loss, to identify cash flow one must adjust all
non cash items to the profit / loss. Other popular way for preparing cash budgets is to
prepare estimated receipts and payments account.

2.6.2 Projected financial statements - The projected financial statement means

projected Balance sheet and Profit and loss account. The requirement for preparing
this budgets is financial statements of earlier periods and operating budgets.

2.7 Solved problems on Budgeting

Problem 2.7.1

From the following information prepare balance sheet of A ltd. for the year ending on
31.3.2005

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 Financial Management

Solution –

Projected Balance Sheet as at 31/3/2005

Rs. 000’s
Liabilities Amount Assets Amount
Share Capital 7,50 Fixed Assets (net) 10,00
Reserves 12,00 Investments 2,00
Bank Loan 2,00 Debtors 3,00
Current Liabilities 2,50 Inventories 6,00
Cash Balance 3,00

Total 24,00 Total 24,00

Working Notes –

1. Debtors = Opening Debtors + Credit sales – Collections = 5,00,000 + 20,00,000 -

22,00,000

2. Projected Income statement

Projected Profit & Loss Account for the year ended 31/3/2005
Rs. 000’s Rs. 000’s
Opening stocks 3,00 Sales 20,00
Cost of Production 17,00 Closing stock 6,00
Depreciation 1,00
Selling and distribution costs 2,00
Net profit 3,00

Total 26,00 26,00

3. Profit transferred to reserves

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 Financial Management

Net profit for the year ended 31/3/2005

Rs.3,00,000
(-) Dividend declared and paid
1,00,000

Transfer to reserves 2,00,000

4. Fixed assets = Opening balance – Depreciation = 11,00,000 – 1,00,000 = 10,00,000

5. Projected cash balance

a. Opening Cash balance 1,00,000
b. Collection from debtors
22,00,000
c. Increase in current liabilities
50,000

Total receipts
23,50,000

Less :
a. Cost of production
17,00,000
b. Variable cost
2,00,000
c. Debentures repaid
50,000
d. Payment of dividend
100,000

Total Payments
20,50,000

Net Cash balance

3,00,000

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 Financial Management

Problem 2.7.2

Following is the summerised Balance sheet of the Progressive Corporation Ltd. as on

31st December, 1998

Liabilities Rs. Assets Rs.

Share Capital 8,00,000 Fixed assets 4,48,000
Reserves 11,84,000 Stocks 11,52,000
Bank overdraft 5,76,000 Debtors 16,00,000
Creditors 6,40,000

32,00,000 32,00,000

Other Information

1. Trade creditors are equal to last months purchases and debtors are equal to last
two months sales (for both the years)
2. For the half year ended on 31.12.1998 sales amounted to Rs 50,42,000 and gross
profit earned at an uniform rate was Rs 10,08,000
3. With effect from 1.1.1999 goods purchased will cost 25% higher and sales price
will be increased by 20%
4. Sales and purchases are spread evenly throughout the year
5. Value of closing stock on 30.6.1999 is expected to be 10% higher than on
31.12.1998
6. Expenses other than purchases amounts to Rs 64,000 per month
7. No fixed assets are proposed to be sold or acquired during the period

You are required to prepare Projected Balance sheet and Profit & loss account for half
year ending 30.6.1999.

(CS Final Dec)

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 Financial Management

Solution

Projected Balance sheet as at June 30, 1999

Liabilities Rs Assets Rs
Share capital 8,00,000 Fixed assets 4,48,000
Reserves 21,65,000 Stocks 12,67,200
(including profit for the
year)
Trade creditors 8,00,000 Debtors 20,16,800
Cash 33,600

37,65,600 37,65,600

Working notes –

1. Debtors = 2 months sales = (50,42,000*120%) / 6*2 = 60,50,400/3 =20,16,800

2. Creditors = 125% (last years creditors) = 125% * 640,000 = 8,00,000

3. Cash figure is balancing figure

4. Creditors have been increased by same percentage as that of purchases.

Projected Profit & loss Account

Rs Rs
To opening stock 11,52,000 By sales 60,50,400
To Purchases 48,00,000 By Closing stock 12,67,200
To gross profit 13,65,600

73,17,600 73,17,600
To other expenses 3,84,000 By Gross profit 3,65,600

To net profit 9,81,600

37,65,600 37,65,600

Working notes –

1. Purchases = 6 months creditors (as creditors are one months purchases) = 6 *

8,00,000 = 48,00,000
2. Sales = 120% (last years sales) = 120% (50,42,000) = 60,50,400

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 Financial Management

3. Other expenses = 64,000 * 6 = 3,84,000

Problem 2.7.3

You are required to make a projected income statement and projected balance sheet
for the year 1995-96 on the basis of following information available for 1994-95

Sales Rs 10
Crores
Expected growth rate 40%
Net profit margin
20%
Dividend paid (as % of net profit)
40%
Tax rate
50%

Balance sheet as on 31.3.95

Liabilities Rs. lakhs Assets Rs lakhs

Share capital 175 Fixed assets 400
Retained earnings 150 Current assets 470
Current liabilities 545

870 870
You may make necessary assumptions
(CWA final Dec 95)

Solution :

Projected Income statement for 1995-96

Rs. Lakhs

Sales (40% increase) 1400

Profit before tax 560
Less : Tax @ 50% 280
Profit after tax (20% of sales) 280
Less : Dividend (@ 40 % of above) 112
Retained earnings 168

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 Financial Management

Working notes

1. Sales are 40 % above previous years sales of Rs 1000 lakhs = 140% (Rs. 1000
lakhs) = Rs 14 crores

2. Net profit margin is stated to be 20% of the sales i.e Profit after tax = 20%
(Rs1400 lakhs) = Rs 280 lakhs

3. As Net profit is after deducting tax of 50%, profit before tax is double of profit
after tax i.e Profit before tax = Rs 280 lakhs * 2 = Rs 560 lakhs

4. It is assumed that the 40% increase in sales is also reflacted in increse in

current assets and liabilities

Projected Balance sheet as on 31.3.96

Liabilities Rs. Lakhs Assets Rs lakhs

Share capital 175 Fixed assets 400
Retained earnings 318 Current assets 658
Current liabilities 763 Cash 310
Proposed dividend 112

1368 1368

Working notes

1. Current liabilities and current assets is taken as 40% above previous years
figures i.e Current liabilities = 545 * 140% =Rs 763 lakhs, Current assets = 470
* 140% = Rs. 658 lakhs
2. Cash is balancing figure
3. It is assumed that there is no increase in share capital and Fixed assets.

Problem 2.7.4 (Cash budgeting)

R ltd. has decided to raise Rs 80 lakhs for a proposed new project. The management
has decided to raise half of the required funds through equity shares and half through
bank loan.
The estimated cash flows are as follows –

Initial outlay (In April 2004)

Land Rs 30,00,000
Machinery Rs 20,00,000

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 Financial Management

Stocks Rs 10,00,000
Other assets Rs 6,00,000

Estimated sales and purchases for the period April to September 2004 is as follows

April – Sales (S) = Rs 14 lakhs, Purchases (P)= Rs 10.40 lakhs

May – S = Rs 15 lakhs, P = Rs 11.20 lakhs
June– S = Rs 18.5 lakhs, P = Rs 14 lakhs
July – S = Rs 25 lakhs, P = Rs 19.05 lakhs
August – S = Rs 26.5 lakhs, P= Rs 20.25 lakhs

September – S = Rs 28 lakhs, P = Rs 21.45 lakhs

Other information –

1. Debtors are given 2 months credit period and creditors give 1 months credit
period.
2. Preliminary expenses Rs 50,000 payable in May
3. General expense paid in each month Rs 50,000
4. Monthly salaries payable next month – Rs 80,000 for three months and Rs
95,000 there after
Prepare a cash budget for the six months and calculate estimated cash balance as at
each month end

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 Financial Management

Solution :

Rs lakhs
April May June July August September
Opening cash balance - 13.5 1.30 2.80 2.50 0.50
0
Receipts:
Issue of shares 40.00 - - - -- -
Issue of debentures 40.00 - - - - --
Collection from Debtors - - 14.00 15.00 18.50 25.00

Total receipts (i) 80.00 13.5 15.30 17.80 21.00 25.50

0

Payments :
Purchase of land 30.00 - - - - -
Purchase of Machinery 20.00 - - - - -
Purchase of other assets 6.00 - - - - -
Preliminary expenses - 0.50 - - - -
Paid to creditors 10.00 10.4 11.20 14.00 19.05 20.25
0
Salaries - 0.80 0.80 0.80 0.95 0.95
General expenses 0.50 0.50 0.50 0.50 0.50 0.50

Total payments (ii) 66.50 12.2 12.50 15.30 20.50 21.70

0

Net cash balance (i-ii) 13.50 1.30 2.80 2.50 0.50 3.80

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 Financial Management

Problem 2.7.5

B Ltd. has following balance sheet for the year ended on 30th June 2000

Liabilities Rs. Assets Rs.

Share capital 1,00,000 Fixed assets 1,26,000
Profit & loss 44,600 Stocks 25,000
Trade creditors 25,000 Bank 3,000
Other creditors 9,000 Debtors 24,600

1,78,600 1,78,600
The budget committee has given following forecast for the six months ended 31 st
December 2000:

Month Sales in Purchases Salaries Overheads Purchase Issue of

units of Fixed shares
assets
May 4000 12,000 8,000 7,000
June 4200 13,000 8,000 7,000
July 4500 14,000 8,000 7,000
August 4600 18,000 10,000 7,000
September 4800 16,000 10,000 7,000 20,000
October 5000 14,000 10,000 8,000
November 3800 12,000 12,000 8,000 30,000
December 3000 12,000 12,000 8,000

You are given the following information

1. The selling price in May 2000 was Rs. 6 per unit and this is to be increased to
Rs 8 per unit in October 50% of sales are for cash and 50% on credit to be paid
2 months later
2. Purchases are to be paid 2 months after purchases
3. Wages are to be paid 75% in the month incurred and 25% in the following
month
4. Overheads are to be paid for in the month after they are incurred
5. Fixed assets are to be paid in three equal monthly instalments starting from
the month of purchase
6. Other income received in the month of August Rs 2,600 and December Rs
2,500

Prepare a cash budget from the following information

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 Financial Management

Solution:

Monthly Cash budget for the period ended Dec. 31,2000

July August September October November December

Opening 3,000 1500 1,000 17,900 16,700 10,800
Balance
Receipts:
Cash sales 13,500 13,800 14,400 20,000 15,200 12,000
Collection from 12,000 12,600 13,500 13,800 14,400 20,000
debtors
Issue of capital - - 20,000 - - -
Other income - 2,600 - - - 2,500

Total 28,500 30,500 48,900 51,700 46,300 45,300

Payments :
Creditors 12,000 13,000 14,000 18,000 16,000 14,000
Salaries
– Current 6,000 7,500 7,500 7,500 9,000 9,000
month
- Previous 2,000 2,000 2,500 2,500 2,500 3,000
month
Overheads 7,000 7,000 7,000 7,000 8,000 8,000
Fixed assets - - - - - 10,000

Total 27,000 29,500 31,000 35,000 35,500 44,000

Closing balance 1,500 1,000 17,900 16,700 10,800 1,300

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 Financial Management

2.8 Self examination Questions

1. What do you understand by financial planning ? explain the characteristics of a

sound financial plan ?
2. You are requested to do financial planning for a newly manufacturing company
to be set up. What important considerations you take into account in doing so?
3. What is budgeting ? discuss various types of budgeting and its importance ?
4. MA Limited is commencing a new project for manufacture of a plastic
component The following cost information has been ascertained for annual
production of 12,000 units which is full capacity.
Cost Per unit (Rs.)
Materials 40
Direct labour and variable expenses 20
Fixed manufacturing expenses 6
Depreciation 10
Admin expenses (fixed) 4
Total 80

The selling price per unit is expected to be Rs 96 and selling expenses Rs 5 per
unit 80% of which is variable

In first two years production and sales are expected to be –

Year 1 – sales = 5000 units, Production = 6000 units
Year 2 – Sales = 8500 units, Production = 9000 units

You are required to prepare projected profit & loss account for both the years

5. X ltd. has decided to raise Rs 160 lakhs for a proposed new project. The
management has decided to raise 2/3rd of the required funds through equity
shares and remaining through Debentures.
The estimated cash flows are as follows –

Initial outlay (In April 2004)

Building Rs 60,00,000
Machinery Rs 40,00,000
Stocks Rs 20,00,000
Cars Rs 12,00,000

Estimated sales and purchases for the period April to September 2004 is as follows

April – Sales (S) = Rs 42 lakhs, Purchases (P)= Rs 32 lakhs

May – S = Rs 45 lakhs, P = Rs 36 lakhs
June– S = Rs 50 lakhs, P = Rs 42lakhs
July – S = Rs 52 lakhs, P = Rs 45 lakhs

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 Financial Management

August – S = Rs 52 lakhs, P= Rs 47 lakhs

September – S = Rs 54 lakhs, P = Rs 47 lakhs

Other information –

1. 50% sales are on credit and Debtors are given 2 months credit period and
creditors give 1 months credit period.
2. Preliminary expenses Rs 150,000 payable in May
5. General expense paid in each month Rs 85,000
6. Monthly wages payable next month – Rs 1,80,000 for three months and Rs
125,000 there after
Prepare a cash budget for the six months and calculate estimated cash balance as
at each month end

6. D Ltd. has following balance sheet for the year ended on 30th June 2000

Liabilities Rs. Assets Rs.

Share capital 1,20,000 Fixed assets 26,000
Profit & loss 24,600 Stocks 1,25,000
Trade creditors 5,000 Bank 13,000
Other creditors 29,000 Debtors 14,600

1,78,600 1,78,600

The budget committee has given following forecast for the six months ended 31 st
December 2000:

Month Sales in Purchases Salaries Overheads Purchase Issue of

units of Fixed shares
assets
May 14,000 82,000 18,000 7,000
June 14,200 83,000 18,000 7,000
July 14,500 84,000 18,000 7,000
August 14,600 88,000 20,000 7,000
September 14,800 86,000 20,000 7,000 30,000
October 15,000 84,000 20,000 8,000
November 13,800 82,000 22,000 8,000 58,000
December 13,000 82,000 22,000 8,000

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 Financial Management

You are given the following information

7. The selling price in May 2000 was Rs. 16 per unit and this is to be increased to
Rs 18 per unit in October 50% of sales are for cash and 50% on credit to be
paid 2 months later
8. Purchases are to be paid 2 months after purchases
9. Wages are to be paid 75% in the month incurred and 25% in the following
month
10. Overheads are to be paid for in the month after they are incurred
11. Fixed assets are to be paid in three equal monthly instalments starting from
the month of purchase
12. Other income received in the month of August Rs 2,600 and December Rs
2,500

Prepare a cash budget from the following information

2.8.1 Objective questions

1. -------------------- involves planning for cash inflows and out flows

2. The most important function of financial planning is anticipating ----------------.

3. Financial plan should have following characteristics

a. Simplicity
b. Flexibility
c. Foresight
d. Completeness
e. All of the above

4. Choose the considerations which a Finance manager has to follow while

making a financial plan

a. Nature of business
b. Inflation
c. Seasonality of business
d. Attitude of management
e. All of the above
f. None of the above

5. The uses of preparing a budget are –

a. Estimating the requirements of funds

b. Control
c. Deciding capital structure

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 Financial Management

d. Preparation of Balance sheets

e. Ascertaining the true profits of the enterprise
f. All of the above
g. Options a, b and c
h. Options b,c,d and e
6. Do you agree with the following statements –

a. It determines the requirement of finance

b. Financial planning is a process and not just a one time activity
c. It invariably includes plans of other areas like production, marketing
etc.
d. It covers both capital structure and financial policies

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 Financial Management

3 Operating and financial leverage, cost volume profit analysis

3.1 Introduction

After ascertaining the financial requirements through a financial plan a manager has to
ascertain the source of finance from where he should raise the funds. This decision
depends upon how each type of funds affects the risk and returns of shareholders.
Leverage analysis is one of the technique used to ascertain and quantify the firms risk
return relationship of different alternative capital structures.

3.2 Types of leverages

Leverage represents the ratio of one financial variable to some other related financial
variable. In short it quantifies the expected change in one financial variable with
respect to other related financial variable. There are three common types of leverages
used in financial management –
1. Operating leverage
2. Financial leverage
3. Combined leverage

Operating leverage [OL] – This ratio quantify the change in Earnings before
interest and tax (EBIT) on account of change in contribution. All the costs can be
bifurcated between two parts
i. Variable costs
ii. Fixed costs
Variable costs is the cost which varies with the production whereas fixed cost
remains constant. An example can be taken to elaborate this statement –
consumption of raw materials varies with the production i.e if a component x
requires y units of raw material then for production 2x quantity required will be
2y. Whereas some expenses like rent remains the same even if there is no
production or production is 100%. It can be appreciated here that as the
production goes up variable cost will also go up, but fixed cost is bound to
remain same, increasing the profits of the company.

Illustration –

Company A manufactures plastic components, its cost structure is a s follows –

Selling price per unit Rs 5, Cost of materials per unit Rs 3, Rent paid by the
company Rs 1000 p.m
Company A sold 1000 units in month of march and 2000 units in month of April
calculate its contribution and EBIT for both the months

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 Financial Management

Solution –

Rs.
March April
Sales (No of units * selling price) 5,000 10,000
Less :
Variable costs – Materials 3,000 6,000
Contribution 2,000 4,000
Less :
Fixed costs – rent 1,000 1,000
EBIT 1,000 3,000

It is clearly evident from above solution that though contribution as percentage

of sales remains same i.e. 40%, EBIT as percentage of sales has gone up from
20% to 30%. This is because what we can call spreading of fixed expenses over a
lager amount of sales.

Operating leverage = contribution = % Change in

EBIT

EBIT % Change in
sales

In current problem = 100% / 200% i.e. 2

So we can state from this that for every 1% change in contribution there will be
2% change in EBIT. Extending this statement, as sales and contribution varies
proportionately. We can say that for every 1% increase / decrease in sales there
will be 2% increase / decrease in EBIT.
It is important to note here that it is risky to have a high operating leverage since
a slight fall in sales will result in a disproportionately higher fall in profit.

3.2.2 Financial Leverage [FL] – Capital structure of a company plays a vital role in
determining the return to the equity shareholders. Financial leverage is an
indicator of impact of capital structure on the returns to the shareholders. Kohler
defines financial Leverage as “the tendency of residual net income to vary
disproportionately with net income”. The concept of financial leverage is very
similar to that of Operating leverage in respect to fixed charge. In operating
leverage we saw that fixed expenses result in disproportionate rise or fall in
EBIT as compared to sales, in FL the same criterion applies about fixed interest
which results into disproportionate rise or fall in Earnings Before Tax (EBT).

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 Financial Management

Illustration –

Continuing with the illustration given above (Company A ltd ) let us assume that
the company pays fixed interest of Rs 500 p.m, then the profit will be as follows

Rs.
March April
Sales (No of units * selling price) 5,000 10,000
Less :
Variable costs – Materials 3,000 6,000
Contribution 2,000 4,000
Less :
Fixed costs – rent 1,000 1,000
EBIT 1,000 3,000
Less :
Interest 600 600
Earnings before tax; after interest 400 2,400

It is clearly evident from above solution that EBIT as percentage sales has gone
up from 20% to 30%, whereas EBT as percentage of sales has gone up from 8%
to 24%.

Operating leverage = EBIT = % Change

in EBT

EBT % Change
in EBIT

In current problem = % change in EBT is 500% (I.e Rs 400 to Rs 2400 ) and %

change in EBT is 200% (i.e Rs 1000 to Rs 3000) = 500% / 200% = 2.5

Excessive financial leverage is always considered as very risky for any company.
As when company is in profits it gives very good results but in case of losses it
can be hazardous and may put company’s existence at stake.

3.2.3 Combined Leverage [CL] – As the name suggests combined leverage is simply
combined effect of both operating leverage and financial leverage. It can simply
be calculated as -
Combined leverage = Operating leverage * financial leverage = contribution
EBT

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 Financial Management

The ratio of contribution to earnings before tax shows the combined effect of
financial and operating leverage. A high operating and high financial leverage is
considered to be very risky. If these leverages are very high then at a high level of
production and selling company will earn high profits but a slight fall in sales will
result in tremendous losses. A company must therefore maintain a proper
balance between these two leverages. Let us consider various leverage situations
and its implications –

Operating Financial Implications

leverage Leverage
Low Low It indicates that management is too conservative and
is not willing to take risk. Though the company is in a
low risk situation, it is losing on opportunities to earn
higher income.

High Low It can be considered as an ideal mix. Management is

willing to take some risk on operations to earn higher
profits, but is not taking undue risk on financial
leverage.

Low High This situation can be more profitable than the above
situation. As operating leverage is low, the company
reaches its breakeven earlier

High High It is very risky situation and though it will give

exceptional returns when company is in profits, in
case falling sales losses will be tremendous.

3.3 Solved problems

Problem 3.3.1
A Ltd. B Ltd.
Sales 500 1,000
Less :
Variable costs 200 300
Contribution 300 700
Less :
Fixed costs 150 400
EBIT 150 300
Less :
Interest 50 100
Profit before tax (PBT) 100 200

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 Financial Management

Please Calculate Operating, Financial and combined leverages and comment on

the same

Solution –
Operating leverage (OL) = Contribution / EBIT
For A Ltd = Rs 300 lakhs / Rs 150 lakhs = 2
For B Ltd = Rs 700 lakhs / Rs 300 lakhs = 2.33
Financial Leverage (FL) = EBIT / PBT
For A Ltd. = Rs 150 lakhs / Rs 100 lakhs = 1.5
For B Ltd. = Rs 300 lakhs / Rs 200 lakhs = 1.5

Combined Leverage (CL) = Contribution / PBT = OL * FL

For A Ltd. = Rs 300 lakhs / Rs 100 lakhs = 3
For B Ltd. = Rs 700 lakhs / Rs 200 lakhs = 3.5
Comments –

e. Operating leverage – it is higher for B ltd. than for A ltd. That means
management B ltd is taking more business risk.
ii. Financial leverage – Financial leverage for both the companies have the
same degree of financial risk. It means that both the managements have
similar perceptions about financial risks
iii. Combined leverage – B ltd has combined leverage more than A ltd. i.e B
ltd is riskier but profitable than A ltd.

Problem 3.3.2
Calculate degree of operating, Financial and combined leverage for the following
firms –

Firm A Firm B
Output (Units) 6,000 1,500
Fixed costs (Rs) 700 1,400
Variable cost per unit (Rs) 0.20 1.50
Interest on borrowed funds (Rs) 400 800
Selling price per unit (Rs) 0.60 5.00

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 Financial Management

Solution –
Firm A Firm B
Sales (units * selling price) 3,600 7,500
Less :
Variable costs 1,200 2,250
Contribution 2,400 5,250
Less:
Fixed costs 700 1,400
EBIT 1,700 3,850
Less :
Interest 400 800
Profit before tax 1,300 3,050

Operating leverage = Contribution / EBIT 1.41 1.36

Financial leverage = EBIT / PBT 1.31 1.26

Combined leverage = Contribution / PBT 1.85 1.72

Problem 3.3.2

A simplified income statement of Zenith Ltd. is given below. Calculate and

interpret its degree of operating leverage, Financial leverage and combined
leverage.

Income statement for the year ending 31st March 1998

Rs
Sales 10,50,000
Variable costs 7,67,000

Fixed costs 75,000

EBIT 2,08,000
Interest 1,10,000
Taxes 29,400
Net income 68,600
(CWA final, June 1998)

Solution –

i. Contribution = Sales – Variable cost = Rs. 10,50,000 – 7,67,000 = Rs. 2,83,000

ii. Earnings before interest and taxes (EBIT) = contribution – fixed costs =
2,83,000 – 75,000 = Rs.2,08,000

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 Financial Management

iii. Earnings before tax (EBT) = EBIT – Interest = Rs 2,08,000 – 1,10,000 = Rs

98,000
iv. Operating leverage = Contribution / EBIT = 2,83,000 / 2,08,000 = 1.36
The above ratio indicates that for every 1% change in sales it is expected that
EBIT will change by 1.36%

V. Financial leverage = EBIT / EBT = 2,08,000 / 98,000 = 2.12

The above ratio indicates that for every 1% change in EBIT it is expected that
EBT will change by 2.12%

vi. Combined leverage = Operating leverage * financial leverage = 1.36 * 2.12 =

2.88

The above ratio indicates that for every 1% change in sales it is expected that
EBT will change by 2.88%

Problem 3.3.3

A firm has sales of Rs 2,00,000, variable cost of Rs 1,40,000, fixed cost of Rs

30,000 and interest of Rs 10,000. Calculate the leverages and ascertain the
amount of sales required to double its Earnings before interest tax (EBIT).

Solution –

Rs.
Sales 2,00,000
Less :
Variable cost 1,40,000
Contribution 60,000
Less :
Fixed costs 30,000
EBIT 30,000
Less:
Interest 10,000
Profit before tax 20,000

Operating Leverage = Contribution / EBIT = 6,00,000 / 3,00,000 = 2

Financial leverage = EBIT / EBT = 3,00,000 / 2,00,000 = 1.5

Combined leverage = Operating leverage * Financial leverage = 2 * 1.5 = 3

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 Financial Management

Operating leverage indicates that for every 1% change in sales there will be 2%
change in EBIT.

Hence, for EBIT to get doubled i.e increase of 100%, sales should increase by
(100/2)% = 50% . This can be elaborated as follows –

Rs.
Sales (increased by 50%) 3,00,000
Less :
Variable cost 2,10,000
Contribution 90,000
Less :
Fixed costs 30,000
EBIT 60,000
3.3.4 Problem

From the following prepare income statement of A,B and C

Firm A Firm B Firm C

Financial Leverage 3 4 2
Interest Rs 200 300 1,000
Operating leverage 4 5 3
Variable cost as a % sales 66.67% 75% 50%
Income tax 45% 45% 45%

(CA final, Nov 97)

Solution –

Firm A

Financial leverage = EBIT / EBT = 3 i.e EBIT = 3 EBT

Again EBIT – interest = EBT

Therefore 3 EBT – Interest = EBT

Considering both the equations 3EBT – 200 = EBT ; 2EBT = 200

i.e. EBT = 100 and EBIT = 3*100 = 300

Now operating leverage = 4 = Contribution / EBIT = contribution / 300

Therefore Contribution = 4*300 = 1,200

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 Financial Management

As variable cost is 66.67% of sales that means contribution is 33.33% of sales or

sales is 3 times the contribution i.e. sales = 3*1200 = 3,600

Firm B

Financial leverage = EBIT / EBT = 3 i.e EBIT = 3 EBT

Again EBIT – interest = EBT

Therefore 4 EBT – Interest = EBT

Considering both the equations 4EBT – 300 = EBT ; 3EBT = 300

i.e. EBT = 100 and EBIT = 4*100 = 400

Now operating leverage = 5 = Contribution / EBIT = contribution / 400

Therefore Contribution = 5*400 = 2,000

As variable cost is 75% of sales that means contribution is 25% of sales or sales
is 4 times the contribution i.e. sales = 4*2,000 = 8,000

Firm C

Financial leverage = EBIT / EBT = 2 i.e EBIT = 2 EBT

Again EBIT – interest = EBT

Therefore 2 EBT – Interest = EBT

Considering both the equations 2EBT – 1,000 = EBT ; EBT = 1,000

i.e. EBT = 1,000 and EBIT = 2*1,000 = 2,000

Now operating leverage = 3 = Contribution / EBIT = contribution / 2,000

Therefore Contribution = 3*2,000 = 6,000

As variable cost is 50% of sales that means contribution is 50% of sales or sales
is 2 times the contribution i.e. sales = 2*6,000 = 12,000

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 Financial Management

Income statement of Firms A,B and C can be drawn as follows –

Firm A Firm B Firm C

Sales 3,600 8,000 12,000
Less : Variable cost 2,400 6,000 6,000
Contribution 1,200 2,000 6,000

Less : Fixed cost 900 1,600 4,000

EBIT 300 400 2,000

Less : interest 200 300 1,000

EBT 100 100 1,000

Less : Taxes @ 45% 45 45 450

Profit after tax 55 55 550

3.4 Cost - Volume - profit analysis

The analytical tools and techniques available to finance managers for studying
the behaviour of profit in relation to changes in volume, cost and prices is known
as the “Cost-Volume-Profit (CVP) analysis”. It is a tool used to determine the
minimum quantity of sales for avoiding the losses and the quantity of sales at
which the desired profit can be achieved. CVP analysis can be used to predict and
evaluate the implications of its short run decisions about fixed costs, variable
costs, sales volume and selling price for its profit plans on a continuous basis.
Thus CVP technique seeks to establish –

a. The minimum amount of sales to avoid losses

b. The level of sales to earn the targeted profit
c. The effect of change in prices, costs and volumes on profits
d. The effect on profits of various sales mix.
e. The breakeven in terms of value and units under different conditions

3.4.1 Break-even point – The technique of calculation of breakeven point is used to

calculate the quantity or amount of sales required to at least recover all the costs
i.e a no profit no loss situation. Each unit sold covers up the whole variable cost
and a part of fixed cost. The amount left over above the variable cost is termed as
contribution per unit. Break-even point is the quantity of sales where the total
contribution equals the total fixed cost.

Break-even point (in units) = Total fixed cost / contribution per unit

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 Financial Management

Contribution per unit = Sales price per unit – variable cost per unit

Illustration 1 – Company x manufactures watches and has a capacity of 1,000

watches per year. Selling price per watch is Rs 2,500 and its variable cost per
watch is Rs 1,500. The company has fixed costs to the extent of Rs 2,00,000.
Calculate the company’s break-even point

Solution –
Rs.
Selling price per unit 2,500
Less : Variable cost 1,500

Contribution per unit 1,000

Total fixed cost 2,00,000

Break even point = fixed cost / contribution per unit = 2,00,000 / 1,000 = 200
watches

Thus the company must sell at least 200 watches per year to avoid losses. These
can be elaborated as follows –
Sales (200 watches sold) Rs 5,00,000
Variable cost 3,00,000

Contribution 2,00,000
Fixed cost 2,00,000

Net profit / loss Nil

Illustration 2 – Consider the above problem and calculate the quantity of
watches company x must sell to achieve desired profitability of Rs 4,00,000

Solution –

Quantity to be sold = (Fixed costs + desired profit) / contribution per unit

= (2,00,000 + 4,00,000) / 1,000

= 600 units

Thus the company must sell at least 600 watches per year to earn desired profits.
These can be elaborated as follows –

Sales (600 watches sold) Rs 15,00,000

Variable cost 9,00,000

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 Financial Management

Contribution 6,00,000
Fixed cost 2,00,000

Net profit 4,00,000

3.4.2 Limitations of break-even analysis – Though a very effective pricing and

control tool break-even analysis has its own limitations. The basic assumption
about the selling price and cost is practically difficult to achieve. It is highly
impossible that contribution varies with the sales price, as with increased
volumes sales price generally goes down, which may or may not result into
proportionate decrease in costs. Cost is influenced by several factors including
the production process, plant and machinery needed, raw material used, wages
paid etc. which are sure to vary with higher scale of production and may lead to
wrong break-even analysis.

3.5 Solved problems

Problem

Company A ltd manufactures cars and has a capacity of 5,000 cars per year.
Selling price per car is Rs 2,00,000 and its variable cost per car is Rs 150,000.
The company has fixed costs to the extent of Rs 500,00,000. Calculate the
company’s break-even point and also calculate the quantity of cars that must be
sold to achieve profitability of Rs 14,00,00,000

Solution -
Rs.
Selling price per unit 2,00,000
Less : Variable cost 1,50,000

Contribution per car 50,000

Total fixed cost 500,00,000

Break even point = fixed cost / contribution per car = 5,00,00,000 / 50,000 =
1,000 cars

Thus the company must sell at least 1000 cars per year to avoid losses. These can
be elaborated as follows –

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 Financial Management

Sales (1,000 cars sold) Rs 20,00,00,000

Variable cost 15,00,00,000

Contribution 5,00,00,000
Fixed cost 5,00,00,000

Net profit / loss Nil

To earn a profit of Rs 14,00,00,000 -

Quantity to be sold = (Fixed costs + desired profit) / contribution per unit

= (5,00,00,000 + 14,00,00,000) / 50,000

= 3,800 cars

Thus the company must sell at least 3,800 cars per year to earn desired profits.
These can be elaborated as follows –

Sales (3,800 cars sold) Rs 76,00,00,000

Variable cost 57,00,00,000

Contribution 19,00,00,000

Fixed cost 5,00,00,000

Net profit 14,00,00,000

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 Financial Management

3.6 Self examination questions

1. Define the concept leverages, explain types of leverages and how to measure
it

2. Explain the term break even point with examples

3. What are the limitations of break-even analysis

4. From the following prepare income statement of A,B and C

Firm A Firm B Firm C

Financial Leverage 2 4 3
Interest Rs 2,50,000 36,500 1,20,000
Operating leverage 2.2 1.5 3
Contribution as a % sales 25% 35% 22.5%
Income tax 50% 50% 50%

5. Calculate the operating leverage from the following data

Sales – Rs 50,000
Variable cost per unit = Rs 5
Fixed cost = Rs 2,000
Number of units sold = 5,000

6. Company B ltd manufactures steel and has a capacity of 25,000 tonnes per
year. Selling price per ton is Rs 14,000 and its Cost of iron and labour
(variable) is Rs 8,000. The company has fixed costs to the extent of Rs
8,00,00,000. Calculate the company’s break-even point and also calculate the
quantity of cars that must be sold to achieve profitability of Rs 5,00,00,000

7. Operating leverage =

a. EBT / Profit after tax

b. EBIT / EBT
c. Contribution / EBIT
d. None of the above

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 Financial Management

8. Financial Leverage =

a. EBT / Profit after tax

b. EBIT / EBT
c. Contribution / EBIT
d. None of the above

9. If operating leverage of a firm is 6, then

a. With every 1% increase in sales its contribution will increase by 1%

b. With every 6% increase in sales its contribution will increase by 1%
c. With every 1% increase in sales its contribution will increase by 6%
d. With every 6% increase in sales its contribution will increase by 16%

10. If combined leverage of a firm is 6, then

e. With every 1% increase in sales its EBT will increase by 1%

f. With every 6% increase in sales its EBT will increase by 1%
g. With every 1% increase in sales its contribution will increase by 6%
h. With every 1% increase in sales its EBT will increase by 6%

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 Financial Management

4 Management of Working Capital

4.1 Introduction

One of the most important day to day function of finance manager is to manage the
working capital. In first chapter we studied that there are two major functions of a
finance manager, one of them being procurement of funds. The function of
procurement of funds can be bifurcated between – Procurement of long term funds to
purchase fixed assets etc. and procurement of funds for short term purposes like
funding for working capital. In this chapter we are going to study the methods of
estimating, raising and controlling the working capital.

4.2 Meaning of the term working capital

Working capital refers to the funds that are invested in current assets net of current
liabilities. Current assets include Cash, inventory (stock), debtors, advances and other
current assets. Current assets are required to use fixed assets profitably, for example If
company is not maintaining stock of raw materials, which is a current asset, then there
can be breakdown in production and result into losses. Similarly granting credit period
to customers (resulting into debtors) is absolutely essential to generate higher sales. It
is obvious that certain amount of funds will always be invested in the debtors, raw
materials, work in progress, finished goods and day to day cash requirements. On the
other hand the business will also receive some credit period from its suppliers
resulting into reduction in the funds requirement. However, generally the requirement
of funds in current assets is more than availability of funds from current liabilities.
The term working capital is defined in two different ways –

a. Gross working capital – The gross working capital refers to investment in all
current assets taken together

b. Net Working capital – The term net working capital refers to excess of current
assets over current liabilities.

From the view point of time working capital can be defined as –

a. Permanent working capital – It also refers to hard core working capital. It is

the minimum level of investment in working capital required at all times by the
business to carry out minimum level of activities.

b. Temporary working capital – It is the requirement of investment in working

capital over and above permanent working capital. This investment varies
from time to time and changes as per seasonal requirements. As the volume of
temporary working capital varies from time to time it can funded by very short
term sources of finance.

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 Financial Management

Permanent and temporary working capital can be elaborated with the help of
diagrams as follows –

A
m
o
u
n
t Permanent
of
WC

Time

Or

A
m
o
u
n
t Permanent
of
WC

Time

WC – working capital in Rs.

4.3 Importance of adequate working capital

Every Business need funds for its day to day operations. Adequacy of funds will ensure
smooth running of such day to day operations. A Finance manager has to ensure the
smooth running of such operations by arranging adequate funds to the business and
simultaneously ensuring that the funds arranged are not excessive and is not resulting
to excessive cost. A very big amount of working capital would mean that the company
has idle funds. Since funds have a cost, the company has to pay large amount as
interest on such funds. Having excess funds, known as over capitalisation, has been a
big reason for sick companies in India

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 Financial Management

If the firm has inadequate working capital it is termed as under capitalised. Such firms
always have risk of insolvency. This is because shortage of funds may lead to a
situation where the firm may not be able to meet its liabilities. It is interesting to note
that many firms which are otherwise prosperous may fail because of lack of liquidity.

4.4 How to determine optimum working capital

Current ratio (with acid test ratio to support it) has traditionally been considered best
indicator of the working capital situation; current ratio = Current assets / current
liabilities. Academically it is believed that a current ratio of 2 for a manufacturing firm
is ideal ratio i.e current assets = 2 * current liabilities (approx) is considered as ideal.
Another indicator for ideal working capital mix is quick ratio = quick current assets /
current liabilities. Academically it is believed that a quick ratio of 1 for a manufacturing
firm is ideal ratio. The reason to mention it as academic is that practically ideal ratios
vary from industry to industry and should be decided by finance manager for his own
company considering the production process, normal credit terms, location of the
company and customers etc.. An example can be taken of Hero Honda Motors Ltd, a
two wheeler manufacturing company. The company has current ration less than 1 as
company is already utilising its full capacities and due to excessive demand for its
products does not offer any credit period, eliminating debtors and huge turnover of its
products also result into very less finished goods inventory. Here it won’t be correct to
say that company is not investing in current assets and hence is losing on profitability,
as the company is able to sell to its full capacity without pilling up stocks and debtors
so for Hero Honda current ratio less than 1 can be considered as ideal. On the other
hand a company who deals in a high credit period industry may have a current ratio of
above 3. Here also we can’t say that the company is over capitalised and is investing
excessively in its current assets, as the company is just following trend of the industry
in which it is operating. Hence ideal ratio should be determined on basis of facts of
each company and should be compared with the average of the industry in which it
operates.

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4.5 Working capital cycle

The working capital cycle refers to the length of time between the firms paying cash
for materials, etc., entering into production process and inflow of cash from debtors.

For example – Company A buys material worth Rs 5,000 on 1st January 2004, keeps it
in stock upto 15th January 2004 and then start processing, the material is in process till
31st January 2004. After completing the production it takes one month to sell the
product i.e Finished goods stock is maintained for 1 month and is sold on 2 nd March
2004, it offers its customer 1 months credit and so recovers the cash only on 31 st
March 2004. Now it is clearly evident here that the investment of Rs 5,000 in materials
gets recovered only after three months and in between it takes various forms of
current assets viz. Cash, Raw materials, work in progress, finished goods, debtors and
again cash. Important point here is that we have only considered material cost and
ignored labour and overheads cost other wise the invested amount will go up. Now
consider a situation where Company A is getting credit period of 1 month, it can be
noticed that though material is purchased on 1st January 2004, amount of Rs 5,000 is
invested only from 31st of January and now the period of investment is reduced to 2
months.

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 Financial Management

The above example can be elaborated diagrammatically as –

Cash

Debtors Raw Materials,

Labour & overheads

Work in progress

Finished goods

The working capital cycle consists of the following events for a manufacturing
company which keeps on repeating –

a. Conversion of cash into raw materials

b. Conversion of Raw materials into work-in-progress
c. Conversion of work in progress into finished goods
d. Conversion of Finished goods into debtors
e. Conversion of debtors into cash again.

Working capital is always measured in terms of days, as follows -

Working capital cycle / operating cycle [in number of days] = R + W + F + D

–C

R - Raw materials storage period in number of days

W - Number of days of work in progress
F - Number of days of finished goods in stock
D – Debtors collection period
C – Credit period availed

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 Financial Management

In the current example –

R = 15 days (1st January – 15th January)

W = 15 days (16th January – 31st January)
F = 30 days (1st February – 2nd March)
D = 30 days (2nd March to 31st March)
C = 30 days (1st January – 31st January)
Working capital cycle or operating cycle (in days) = 15+15+30+30 –30 = 60 days

The various components of operating cycle can be calculated as follows -

1. Raw material storage period [R] = Average stock of raw materials

Average cost of consumption per day

2. Work in progress holding period [W]= Average work-in-progress inventory

Average cost of production per day

3. Finished goods storage period [F ]= Average Finished goods inventory

Average cost of goods sold per day

4. Debtors collection period [D] = Average book debts

Average credit sales per day

5. Credit period availed [C] = Average creditors

Average credit purchases per day

The above formulas are applied to forecast the working capital cycle and can be
compared with other companies in the same industry. The deviation with
industry average shows the efficiencies or inefficiencies of the organisation. For
example let us assume that the average debtors collection period for competitors
of company A is 15 days and company is offering a credit period of 30 days, then
it can be said that the company A higher risk and is locking excessive funds in
current assets.

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4.6 Solved problems on calculation of working capital cycle

Problem 4.6.1

From the following information calculate the period of operating cycle of A Ltd. :

Rs.

Raw material consumed during the year 7,20,000

Average stock of raw materials 50,000

Cost of production 6,00,000

Average work in progress inventory 30,000
Cost of goods sold 7,20,000
Average finished goods inventory 40,000

Average collection period from debtors 35 days

Average credit period availed 25 days
Assume 360 days in a year

Solution –

1. Raw material storage period [R] = Average stock of raw materials

Average cost of consumption per day

= 50,000 / (7,20,000 / 360)

= 50000 / 2000
= 25 days.
2. WIP holding period [W] = Average work-in-progress inventory

Average cost of production per day

= 30,000 / (6,00,000 / 360)

= 30,000 / 1667
= 18 days (approx)

3. Finished goods storage period [F]= Average Finished goods inventory

Average cost of goods sold per day

= 40,000 / (7,20,000/360)
= 40,000/2,000
= 20 days

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 Financial Management

4. Debtors collection period [D] = 35 days

5. Credit period availed [C] = 25 days

Operating / working capital cycle = R + W +F+ D –C

= 25 + 18 + 20 +35 –25
= 73 days

Number of operating cycles in a year = 360 / 73 = 4.93

Problem 4.6.2

A ltd. has obtained the following data concerning the average working capital
cycle for other companies in the same industry:

Raw material stock turnover 25 days

Credit received -35 days
Work in progress turnover 10 days
Finished goods 32 days
Debtor’s collection period 55 days
87 days

Using the following data, calculate the current working capital cycle for A ltd. and
briefly comment on it.

(Rs. In ‘000)
Sales 500
Cost of production (also cost of goods sold) 210
Average Raw material inventory 8
Average work in progress 9
Average finished goods stock 18
Average debtors 35

Other information -

Out of cost of production Rs 60,000 is consumption of raw materials.60% of the

sales is on credit, credit period availed is 55 days. Assume 360 days of a year.

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 Financial Management

Solution –
Days (approx.)
1. R = 8 / (60 /360) = 48 days

2. W = 9 / (210 /360) = 15 days

3. F = 18 / (210 /360) = 31 days

4. D = 35 / (300 /360) = 43 days

5. C = 55 days

Operating cycle = R + W + F + D – C

Operating cycle = 48 + 15 + 31 + 43 – 55 = 82 days.

Comments –

Company Industry Comments

A average
R 48 25 The raw material storage period is
considerably higher than industry
average, so the company must try and
reduce its raw material stocks
W 15 10 Higher number of days in work in
progress indicates inefficiencies in
production.
F 31 32 Almost at par with the industry
D 43 55 Debtors are offered lesser credit period
than average, the company can perhaps
increase the credit period in order to
achieve higher sales
C -55 -35 Credit period availed is higher than
average indicating availability of more
funds. Though it may result in higher
cost of raw materials or loss of goodwill
amongst the creditors.

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 Financial Management

Problem 4.6.3

From the following data, compute the duration of the operating cycle for each of
the two years –
Year 1 Year 2
Stock :
Raw Materials 20,000 27,000
Work in progress 14,000 18,000
Finished goods 21,000 24,000
Purchases 96,000 1,35,000
Cost of goods sold 1,40,000 1,80,000
Sales 1,60,000 2,00,000
Debtors 32,000 50,000
Creditors 16,000 18,000

Assume 360 days per year for computation purpose

Solution –

Year 1 Year 2
Days Days

Raw material stock holding period [R]:

Year 1 – 20,000 / (96,000 /360) 75
Year 2 – 27,000 / (1,35,000 /360) 72

Work in progress [W]:

Year 1 – 14,000 / (1,40,000 /360) 36
Year 2 – 18,000 / (1,80,000 /360) 36
(As cost of production is not given calculation is done on
the basis of cost of goods sold)

Finished goods [F]:

Year 1 – 21,000 / (1,40,000 /360) 54
Year 2 – 24,000 / (1,80,000 /360) 48

Debtors [D]:
Year 1 – 32,000 / (1,60,000 /360) 72
Year 2 – 50,000 / (2,00,000 /360) 90

Creditors [C]:
Year 1 – 16,000 / (96,000 /360) 60
Year 2 – 18,000 / (1,35,000 /360) 48

Operating cycle = R + W + F + D - C 177 198

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 Financial Management

4.7 Estimation of working capital requirements

In practice working capital cycle is mainly used for comparison with previous periods
and competitors, so that inefficiencies in operations can be pointed out and rectified.
Hence the main purpose of working capital cycle is control. But more essential thing is
perhaps funding for the working capital requirements, which can be done only when
working capital requirements is estimated in terms of money and not days. Banks
providing working capital and short term loans always demand such estimations and
give loan on the basis of such estimations. Such estimations can be done on the basis of
operating cycle. The formulas for estimation of current assets is given below

Formulas for Estimation of various current assets

i. Funds invested in Raw materials inventory can be calculated as follows –

The funds invested in raw materials inventory can be estimated on the
basis of production budget, cost per unit and the estimated holding period
as follows –
The following formula can be used for this purpose –

Estimated production in units * estimated cost of raw material per unit *

average raw materials holding period (in months / days)

12 months / 365 (or 360) days

ii. Funds invested in work in progress can be calculated as follows

The following formula can be used for this purpose –

Estimated production in units * estimated cost of production per unit *

average WIP holding period (in months / days)

12 months / 365 (or 360) days

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 Financial Management

iii. Funds invested in finished goods inventory can be calculated as follows

The following formula can be used for this purpose –

Estimated production in units * estimated cost of goods sold per unit *

average Finished goods holding period (in months / days)

12 months / 365 (or 360) days

iv. Funds tied up in debtors can be calculated as follows

The following formula can be used for this purpose –

Estimated credit sales in units * estimated cost of sales per unit (excluding
depreciation) * average debtors collection period (in months / days)

12 months / 365 (or 360) days

Formulas for Estimation of various current liabilities

i. Calculation of estimated amount of trade creditors:

The following formula can be used for this purpose –

Estimated yearly credit purchases in units * estimated cost of raw

materials per unit * average credit period granted by creditors (in months
/ days)

12 months / 365 (or 360) days

ii. Calculation of estimated amount of direct wages:

The following formula can be used for this purpose –

Estimated production in units * estimated direct labour cost per unit *

average time lag in payment of wages (in months / days)

12 months / 365 (or 360) days

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 Financial Management

iii. Calculation of estimated amount of overheads (other than depreciation and

amortisation):

The following formula can be used for this purpose –

Estimated yearly production in units * estimated overheads cost per unit *

average time lag in payment of overheads (in months / days)

12 months / 365 (or 360) days

Note - The amount of overheads may be separately calculated for different

types of overheads. In case of sales overheads, the relevant item would be
sales volume instead of production volume.

Some important points

i. Effect of shift working – A company may operate in more than 1 shift in

that case the production is substantially higher. Let us say that for a 2 shift
working production is approx double that of 1 shift working, in such case
current assets like stocks should also get doubled, as daily requirement will
be twice. But in reality it hardly happens and though the stock levels go up
it, it is never in proportion with the production. Though in examination
students should assume the stock levels going up in same proportion as
that of production unless otherwise stated.

ii. Measurement of working capital in terms of Cash outflows – Working

capital requirement should be estimated as accurately as possible so that
funds can be raised accordingly. Excess funds result into additional interest
expenditure. Hence in practice amount of debtors and finished goods etc
are adjusted for non-cash items, which are not required to be funded. Let
us see one example – Company A has debtors worth Rs 25,000, but the
total cost of the goods sold to these debtors is Rs 20,000 which includes Rs
5,000 depreciation. Now here we can see that actual cash out flow on the
goods sold to these debtors is just Rs 15,000 (selling price – profit –
depreciation), or it can be said that only Rs 15,000 is blocked with the
debtors and this is the amount which needs to be funded. If the company A
takes loan based on debtors amount of Rs 25,000 then the company is
unnecessary taking excess loan to the extent of Rs 10,000 on which it will
be bearing interest. To avoid this current asset figures are estimated
excluding all the non cash items.

iii. Work in progress – Work in progress is half completed production. As the

product can be in any stage for estimating working capital WIP is always
assumed to be 50% complete. Important point here is WIP is always

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assumed to be 100% material and 50% labour and overheads unless

otherwise stated.

4.8 Solved problems

Problem 4.8.1

The Cost sheet of A ltd. is as follows –

Cost per unit (Rs)
Raw Materials 50
Labour 20
Overheads 30
Depreciation 10
Profit 10
Selling price 120

Average holding/realisation period is as follows –

Raw materials – 1 month, Finished goods – 1 month, creditors – 2 month,
Debtors 2 months. Assume that there is no working capital.

Other information – Expected output is 54,000 units per year.

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 Financial Management

Solution -

Rs.

A Current assets
1. Raw materials = (Cost per unit * production * estimated
period of
stock in months) / 12 months
= (50*54,000*1) / 12 2,25,000

2. Finished goods = (Cost of production per unit * production

* estimated period of stock in
months) / 12 months
= (100 * 54000*1) / 12 4,50,000

3. Debtors = (sales in units * cost of sales per unit (excluding

depreciation) * average debtors collection
period (in months) / 12 months
= (100* 54000 *2 ) / 12 9,00,000

Total current assets 15,75,000

4. Creditors = (purchases in units * purchase cost per unit *

average credit period availed (in months)
/ 12 months
= (50*54000 *2) / 12 4,50,000

Total current liabilities 4,50,000

Net working capital 11,25,000

Working notes –

1. Calculation of cost of production for the purpose of calculation of Finished

goods stock
Rs.
Raw Materials 50
Labour 20
Overheads 30
Total 100

2. Debtors are also valued at same rate as selling expenses are not given.

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 Financial Management

3. Debtors and finished goods exclude depreciation and profit as they are non-
cash items

4. Work in progress is assumed to be nil

Problem 4.8.2

The cost sheet of Hi-Tech Ltd. provides the following data:

Rs
Raw Material 30
Direct labour 20
Overheads (including depreciation of Rs.10) 20
------
Total Cost 70
Profit 10
------
Selling price 80
------

1) Average Raw material in stock is for 1 month

2) Work-in-progress (assume 50 % completion stage for Raw materials,
wages and overheads) will approximate to 1/2 month’s production
3) Finished goods lie in the warehouse for 1 month
4) Credit allowed to Debtors is 1 month. 25 % of Sales are on cash basis.
5) Cash balance expected to be Rs.2,00,000.00
6) Credit allowed by suppliers is 1 month
7) Average time lag in payment of wages is 2 months
8) Average time lag in payment of overheads is 1 month
9) Assume a 10 % margin
You are required to prepare a statement of the working capital needed to
finance a level of the activity of 60,000 units of output per year.

Solution:
As the annual level of activity is given at 60,000 units, it means that the monthly
turnover would be 60,000 / 12 = 5,000 units

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 Financial Management

Estimation of Working Capital Requirement

I Current Assets: Amount (Rs.)

Minimum Cash Balance 2,00,000
Raw Material Stock (5000 x 30) 1,50,000
Work-in-progress [(5000 x 60) / 2] x 50 % 75,000
Finished Goods (5000 x 60) 3,00,000
Debtors (5000 x 60 x 75%) 2,25,000
Gross Working Capital 9,50,000

=======

II Current Liabilities:
Creditors for materials (5000 x 30) 1,50,000
Creditors for Wages (5000 x 20 x 2) 2,00,000
Creditors for Overheads (5000 x 10) 50,000
-------------
Total Current Liabilities 4,00,000
========

Excess of Current Assets over Current Liabilities (I – II) 5,50,000

Add :- 10 % margin 55,000

Net working capital requirement 6,05,000

Problem 4.8.3

The management of Royal Industries has called for a statement showing the
working capital to finance a level of activity of 1,80,000 units of output for the
year. The cost structure for the company’s product for the above mentioned
activity level is detailed below –

Rs
Raw Material 20
Direct labour 5
Overheads (including depreciation of Rs.5) 15
------
Total Cost 40
Profit 10
------
Selling price 50
------

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Additional information –

a. Minimum desired cash balance is Rs 20,000

b. Raw materials are held in stock for average period of 2 months
c. Work in progress (assume 50% completion stage for all labour, material and
overheads) will approximate to half months production.
d. Finished goods remain in warehouse, on an average for a month
e. Supplier for materials extend 1 month’s credit and debtors are given 2
months credit period. Cash sales are 25% of total sales
f. There is a time lag in payment of wages of a month and half a month in case
of overheads
g. You are required to prepare a statement showing working capital
requirements.
(CS final, Dec 90)

Solution -

Statement of working capital requirements

I Current Assets: Amount (Rs.)

Minimum Cash Balance 20,000

Raw Material Stock (15,000 x 20x2) 6,00,000

Work-in-progress [(15,000 x 35) / 2] x 50 % 1,31,250

Finished Goods (15,000 x 35) 5,25,000

Debtors (15,000 x 35 x 2 x 75%) 7,87,500

Gross Working Capital 20,63,750

=======

II Current Liabilities:

Creditors for materials (15,000 x 20) 3,00,000

Creditors for Wages (15,000 x 5) 75,000

Creditors for Overheads (15,000 x 10) / 2 75,000

-------------
Total Current Liabilities 4,50,000
========

Excess of Current Assets over Current Liabilities (I – II) 16,12,750

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Notes –

1. Work in progress, finished goods and debtors exclude depreciation

being non cash items.

2. production is assumed to be equal in all months i.e Production per

month = 1,80,000 / 12 = 15,000 units

Problem 4.8.4

H ltd plans to sell 30,000 units next year. The expected cost of goods sold is as
follows –
Rs. (per unit)
Raw materials 100
Manufacturing expenses 30
Selling, administration and financial expenses 20
Selling price 200

The duration at various stages of operating cycle is expected to be as follows :

Raw material stage 2 months
Work in progress stage 1 month
Finished goods ½ month
Debtors 1 month

Assuming monthly sales level of 2,500 units, estimate the gross working capital
requirement if desired cash balance is 5% of the gross working capital
requirement, and work in progress is 25% complete with respect to
manufacturing expenses.

Solution:
Statement of working capital requirements

I Current Assets: Amount (Rs.) Amount

(Rs.)

Raw Material Stock (2,500 x 100 x2) 5,00,000

Work-in-progress :
Raw materials in WIP ( 2500 x 100) 2,50,000
Manufacturing expenses 25% (2,500x30) 18,750
2,68,750
Finished Goods :
Raw materials in WIP ( 2500 x 100 x1/2) 2,50,000
Manufacturing expenses (2,500x30x1/2) 37,500
1,62,500

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 Financial Management

Debtors (2,500 x 150 x 1) 3,75,000

13,06,250

Cash balance (13,06,250 *5/95) 68,750

Working Capital requirement 13,75,000

=========

Note – Selling and distribution expenses never for part of finished goods and
WIP but is always included in Debtors

Problem 4.8.4

Happy Family is a small trading company whose balance sheet as at 31st March
1998 was as under :

Liabilities Rs Assets Rs
Capital 50,500 Building 50,000
General reserve 7,000 Furniture 10,000
Bank loan 40,000 Cash 9,500
Creditors 11,300 Motor car 15,000
Liability for income tax 9,700 Stock in trade 12,000
Debtors 22,000

1,18,500 1,18,500

On the basis of following information pertaining to the year ended 31.3.1999,

you are required to prepare a statement of changes in working capital:

a. Sold motor car on 30.9.1998 for Rs 18,000 and on the same date purchased
100 equity shares of Rs 10 each in X ltd.
b. Sales for the year were 20% higher than that in the last year. Purchase of
materials increased by 10%. Customers were allowed 2 months credit and
suppliers allowed 1 month credit. Debtors on 31st March 1998 represented
sales of February and march ( to be evenly allocated) and creditors also
represented purchases for March (monthly average)
c. Business expenditure for the year amounted to Rs 1,800 per month (paid in
each month). There were no other receipts and payments during the year.
Gross profit rate was 30% on turnover.
d. Provide for interest on bank loan at 6% p.a and for income tax liability Rs
5,000
( ICWA final, June 1999)

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Solution –
Statement showing changes in working capital –

31.3.98 31.3.99 Increase Decrease

Current Assets
Stock 12,000 50,280 38,280
Debtors 22,000 26,400 4,400
Cash & Bank balance 9,500 1,170 8,330
42,680 8,330
Current liabilities
Creditors 11,300 12,430 1,130
Interest on bank loan 2,400 2,400
Liability for taxes 9,700 5,000 4,700
4,700 3,530
Net Increase in Working capital 35,520

Working notes –

1. As sales are going up by 20%, debtors will also go up by 20%, as debtors are
equal to last 2 months sales (which is going up by 20%). Debtors as on
31.3.1999 = 22,000 + 20%(22,000) = 26,400

2. As purchases are going up by 10%, creditors will go up by 10%. Creditors =

11,300 + 10%(11,300) = 12,430

3. Amount of sales for 1999 = Debtors / 2 *12 = 26,400/ 2 * 12 = 1,58,400 (As

debtors = 2 months sales)

4. Amount of purchases for 1999 = creditors *12 = 12,430 *12 = 1,49,160 (As
creditors = 1 months purchases)

5. Stock in trade for 31.3.99 can be calculated as follows :

Trading Account for the year ended 31.3.1999

Rs Rs
To Opening stock 12,000 By sales 1,58,400
To purchases 1,49,160

To gross profit (30% of 47,520 By closing stock 50,280

sales)

2,08,680 2,08,680

6. Calculation of Cash balance as on 31.3.99

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Trading Account for the year ended 31.3.1999

Rs Rs
To Opening balance 9,500 By payment to creditors 1,48,030
To collection from debtors 1,54,000 By purchase of investment 1,000
To Sale of motor car 18,000 By other expenses 21,600
By income tax for last year 9,700
By closing balance 1,170

1,81,500 1,81,500

7. Collection from debtors = opening balance + sales during the year – closing
balance = 22,000 + 158,400 – 26,400 = 154,000

8. Payment to creditors = opening balance + purchases during the year – closing

balance = 11,300 + 149,160 – 12,430 = 1,48,030

4.9 Factors affecting the working capital requirement

[Link] of business – Seasonality of industry would obviously affect the

working capital requirements. Unlike we have seen in earlier problems, it
is difficult to predict working capital on the basis of assumptions like sales
accrue evenly throughout the period. Let us take an example of Air
condition manufacturing company, if we assume that sales are even
throughout the year then perhaps the company will be short of funds in
summers when demand (and so the working capital) is higher and
company may carry unnecessary funds in winter season. Thus a finance
manager should estimate working capital according to seasonality of
business.

[Link] of business and production process – Service industry and trading

activities require very less working capital whereas manufacturing
concerns always have huge working capital requirement. Companies
having shorter production process require lesser working capital as
compared to companies having lengthy production process.

[Link] policies of the company – The credit policies of the company plays a
major role in determining the requirement of working capital. Company
allowing liberal credit may end up having lesser finished goods stock but
will have large investment in the debtors. A company having strict credit
policies and efficient debt collection system will have lesser investment in
debtors. Credit policy of the company also depends upon the company’s
reputation and demand for its products in the market, a well established
company may not offer any credit to its customers whereas a new company
having same product may offer few months credit.

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[Link] policy – The inventory policy of a company also has a impact on

the working capital requirements since a large amount of funds is normally
locked up in the inventories. An efficient firm stock raw material for a
smaller period and may require lesser amount of working capital

[Link] – Contingencies play an important role in working capital

requirements, unpredicted shortage of raw materials, heavy rise in demand
for products, strikes etc. may shatter the estimates.

[Link] – Working capital requirements are affected by degree of

competition. Large inventory is essential to assure timely delivery and
credit period may be higher to cope up with high level of competition in
buyers market

[Link] and taxation policies - Level of working capital requirements

vary according to dividend and taxation policies.

4.10 Management of Working capital

Estimation of working capital requirements is just par of the finance manager. An

equally important job is management of working capital. We have already discussed
that operating cycle and working capital estimation are control tools as well, i.e. it
gives the management an idea whether the company is having an adequate level
working capital or it is carrying excess / lower working capital. Excess working capital
leads to increase in interest costs whereas lower working capital carries the risk of
insolvency. It is acumen of the finance manager to strike a balance between the risk
and profitability. In current Indian scenario especially after depression in industry
since year 2000 the concept of working capital management has gained significant
importance. It will not be wrong to say that many companies could recover from heavy
losses and were able to turnaround to profits only because of excellent working capital
management. In last few years companies have consistently taken efforts on reduction
of unnecessary inventories by following Just in time purchase techniques, improving
delivery systems, improving communications and co-ordination between marketing,
production and purchase departments. The companies also have taken special efforts
to reduce their debtors’ collection period and recovery of bad debts. Banking industry
has paid a keen role in cash management of companies by providing facilities like
collection centres etc. Though academically current ratio of 2 is considered to be ideal,
currently most of the companies are eying for a substantially lesser ratio. We’ll now
discuss various aspects of working capital management bifurcating between
management of each aspect of current assets and current liabilities.

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4.11 Management of cash - Management of cash has always been one of the
important functions of a finance manager, though now a days it appears to be a bit
simpler job as compared to earlier days thanks to technological advancement of
banking industry. The term management of cash includes management of actual cash
and cash equivalents like liquid bank balances and other liquid investments. A major
problem in cash management has always been the geographical diversity of business.
Let us see one example of a Pune based two-wheeler manufacturing company. The
company has it’s dealers network spread all over India and abroad but has its
production facilities and most of the suppliers in and around Pune. Now let us discuss
a case where the company has a receivable of an amount from a dealer in Assam, say
on 1.1.2004 of Rs 10,00,000 and on the same day (or in 2-3 days time) has a payment
due to a Pune based supplier, Say Rs 5,00,000 then though company has a
receivablefrom its dealer in Assam, cannot use the same amount to settle the dues of
the Pune based supplier. Now the company has no option but to borrow from the
banks till the time the cheque gets cleared in the company’s account (the payment may
take a long time to reach the company and even longer time to clear cheque from
remote place). A similar problem is faced when one department of the company has
excess cash, whereas another is short of cash. To summarise the requirement of
proper cash management can be highlighted as under –

1. An effective cash management ensures that there is no shortage of funds as

well as there are no idle funds
2. Cash is required for meeting day to day expenses like – petty expense,
payment to creditors, payment of wages, payment of various government
dues etc.

3. Liquidity can always be used for taking profitable opportunities which

requires liquidity. For example a sudden fall in share market may become
right time for investment in share market and company having enough liquid
cash / bank balance can only take shares and take the speculative
advantages.

4. Cash balance is absolutely necessary to cope up with unforeseen

contingencies.

4.11.1 Estimation of cash requirements – The first step of cash management is cash
estimation. These estimations are done with the help of cash budgets. Cash
budgets are prepared periodically to identify cash inflows and outflows, as cash
flows determine the requirement of funds and helps identifying investible funds.
Cash budgets are nothing but cash flow statements. One must note that cash flow
is different from profit or loss, to identify cash flow one must adjust all non cash
items to the profit / loss. Other popular way for preparing cash budgets is to
prepare estimated receipts and payments account. The preparation of cash
budgets offers following advantages –

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 Financial Management

1. It gives information about timing and quantum of liquid funds required to be

raised

2. It shows the amount of internal accruals; management can assess how much
is needed fro day to day operations and how much is available for purchase
of long term assets.]

3. It shows the need for additional amount of cash required so that loans can be
raised accordingly.

Format of cash budget –

XYZ Ltd.
Cash budget
Period

Month 1 Month 2 Month 3 Month 4 Month.. Month..

Opening Balance

Receipts:
1. Cash sales
2. Collection from
debtors
3. Issue of capital
[Link] income
(Scrap etc.)
5. Loans taken
[Link]
receipts
(dividend,
interest etc.)

Total

Payments :

Creditors
Salaries
Wages
Interest
Overheads
- Fixed overheads
- Variable over heads
- selling overheads
Dividend
Fixed assets
Taxes
Other items

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Total

Closing balance
Minimum desired
balance
Surplus / (shortfall)

4.11.2 System of Cash Management – The next step of cash management is proper
allocation of funds amongst various departments / locations and maintaining
appropriate balance / liquidity at each place. The collection mechanism can be
made efficient by –
a. Speeding up the mailing time of payments from the customers
b. Reducing the time lag between collection of cheques and its deposition with
the banks.

Two important methods to speed up collection process are – 1. concentration

banking and 2. lock box system

1. Concentration banking – In concentration banking the company establishes

number of collection centres according to locations of its customers. Instead
of mailing the payments the customers deposits the money in the collection
centres, which it deposits immediately in the local branch of the main bank,
and the collection centres transfer the funds to the Head office of the
company. The importance of this can be elaborated as follows –
Continuing with the example of the two-wheeler company discussed above, let
us see how concentration banking will help the company –

a. The collection process (mailing time of the dealer + clearing time for the
cheque) will be very high as the place is quite far and mailing will take
time, again outstation cheques take long time to get cleared, where as
under concentration banking the time of mailing is completely avoided as
the dealer will deposit the cheque in the collection centre near to his
dealership place and clearing will also take lesser time as the dealer will
obviously give cheque drawn on a local bank.
b. let us assume that total such collections in a year are Rs 3,65,00,000 in a
year (365 days) and the collection process is expected to be reduced by 5
days by using the concentration banking, also the rate of interest on
working capital loan is 10% p.a. Now we can see that the total interest
saving will be 5 days collection * 10% = (3,65,00,000 / 365 * 5 * 10%) = Rs
5,00,000 p.a. . Even if the company incurs Rs 1,00,000 as charges for
availing collection bank facility, it will stand to gain Rs 4,00,000.

An extension of concentration banking has been introduced by the bankers,

where they allow same day clearing i.e. when the dealer deposits the cheque,

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bank gives immediate credit in the company’s account, saving the days of
clearing also, of course the cheque is reversed if the dealer’s bank does not
honour the cheque.

2. Lock box facility – The purpose of lock box system is to eliminate the time
between the receipt of remittance by the company and depositing it in the
bank. Under this system the company rents local post office boxes and
authorise banks at each location to collect the remittances in the box. After
collecting the remittances the bank deposits it in the company’s account. This
also relieves the company from handling of the cheques.

3. Reducing the floats – Float here means the time periods that affect the cash
movements in various stages of collection process. Floats can be bifurcated
as follows –
a. Billing float – An invoice is the formal document that a seller prepares
and sends to the purchaser as the payment request for goods sold or
services provided. The time between the sale and the mailing of invoice is
the billing float

b. Mail float – This is the time when a cheque is being processed by post
office or currior

c. Cheque processing float – This is the time required for the seller to sort,
record and deposit the cheque after it has been received by the company

d. Bank processing float – This is the time from the deposit of the cheque to
the crediting of funds in the sellers account

Lesser the float faster will be the collection process. To achieve this aim finance
manager must ensure that some basic procedures are followed, like – cheques
are deposited on time, timely delivery of invoices, regular analysis of uncleared
cheques etc.

4.12 System of debtors Management –

The basic difference between cash management and management of other

current assets is that the system of cash management can be solely designed by finance
manager and he need not take consent of other departments and that makes the task
bit easier. Whereas in case of debtors and inventory management a finance manager
has to take into consideration decisions of other departments like Marketing
department and production department. Say for example – if a finance manager,
considering the serious position of working capital, decides to grant no credit to
debtors then the marketing department will certainly object this decision as it won’t be
able to achieve the sales targets without appropriate credit period and perhaps in a
competitive market will substantially lose it’s market share. Similarly if a finance

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manager decided to keep Raw material inventory to the extent of 30 days

consumption, which is equal to the industry average, Production manager may argue
against it as reduction in raw material stock may hamper the production. Selling goods
on credit has a cost, the cost includes –
a. Interest on the amount of loans raised to fund the investment in debtors
b. Administrative cost like cost of maintaining records
c. Collection cost
d. Bad debts – debts which cannot be recovered

Some of the important determinants of the investment in working capital are –

a. Credit policy of the company
b. Discount policy of the company
c. Collection policy
d. Credit analysis

1. Credit policy – Credit policy determines the period of credit to be granted to

debtors, decides as to which types of debtors should be given credit period and
how much. Granting credit is absolutely essential as –
a. It helps in increasing sales and market share
b. Credit sales generally has higher margins, thus it adds to profitability of
the company
c. In case of intense competition it is absolutely essential to grant credit
period
Credit policy plays a very important role in debtors management and hence it
should be decided carefully after considering various marketing and financial
aspects. It is necessary to keep on revising the credit policies with changing
market situations.

2. Discount policy – Practically every business offers cash discount for speedy
collection of debts. It helps the seller to improve his liquidity. Cash discount is
generally granted in slabs like say discount of 2% for payment in 0-15 days
from sales, 1% for payment in 16-30 days and so on. Let us take an example to
elaborate the importance of the cash discount – Trader A has an annual sale of
Rs 600 lakhs and has average credit period of 3 months. Trader A has decided
to offer 2% discount on cash sales, now suppose 50% of the customers avail
this discount, reducing the debtors from Rs 150 lakhs (3/12 *600) to Rs 75
lakhs. Now suppose Trader A pays interest @ 18% p.a on working capital
loans, then he is saving Rs 75 lakhs * 18% p.a = Rs 13.5 lakhs against the cost of
discount = Rs 300 lakhs * 2% = Rs 6 lakhs.

3. Collection policy – Efficient and timely collection of debtors is absolutely

essential for avoiding bad debts and reducing the unnecessary investment in
the debtors. Delay in collection period unnecessary adds up to investment in
the debtors, i.e. if credit period of 60 days is necessary to make a good sale then
investment in debtors for these 60 days is only essential, additional recovery

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period (say of 10 days) adds only to the investment without adding anything to
the sales. It is important that clear-cut procedures regarding credit collection
are set up. The procedures shall include guidelines regarding the time period of
dues after which the collection procedures should be initiated, what should be
the format of initial letters and legal letters, which cases of defaulters should be
taken to courts (this basically involves assessment of cost of legal action and
actual dues) etc. One important analytical tool used by the collection
department is aging analysis. Ageing analysis bifurcates the dues between
various periods throwing out dues that are outstanding beyond the credit
period. It also highlights dues outstanding for abnormally long period, which is
generally provided for in the accounts.

4. Credit analysis - Having determined the credit terms, the firm has to evaluate
credit worthiness of individual customers. It is an absolute essential procedure
as it helps the company in substantially reducing its bad debts. This procedure
includes credit rating, in which each and every customer (except for cash
customers) are rated according to their creditworthiness and their credit
period etc are determined according to their ratings. The credit rating depends
upon analysis of various factors like –

a. Past experience of the company with the customer

b. Latest financial performance of the customer like Balance sheet
c. Trade references etc.

4.12.1 Factoring

Factoring is the debt collection service provided by the bankers. Bankers provide
like buying the debtors of a company and extending credit upto 70-80% of the
invoice value. It is nothing but financing the sundry debtors and is a type of
working capital finance. Operation of factoring is very simple, clients enter into
an agreement with the ‘factor’ working out an factoring agreement according to
his requirements. The Factor then takes the responsibility of monitoring, follow
up, collection and risk taking and provision of advance. The factors generally
fixes up a limit customer wise for the seller. Some of the benefits and limitations
of factoring are –

a. The company can convert directly its debtors into cash ( after deducting the
factoring commission)
b. Factoring ensures a definite pattern of cash inflows
c. Factoring eliminates the need of a credit and collection department in the
company saving on administration and staff costs. This is particularly very
useful for seasonal businesses where firms can’t afford to maintain such
department for whole year, as work for such department is only for a season.

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d. Collection and recovery has been considered as a big problem by almost all
businesses and factoring reduces or nullifies this problem.

The limitations of factoring are –

a. It is costlier source of finance as the cost includes both factoring fees and
interest on the advance till the amount is recovered from the debtors
b. Bad debts can still be the responsibility of the company and not the factor. If
factor agrees to take the risk as to the bad debts then the factoring fees are
even higher

Thus before availing the services of a Factor the finance manager must consider
the costs and benefits associated with factoring and should appraise its utility to
his company.
Some other popular ways of management of debtors are Debt securitisation, Invoice
discounting etc. Debt securitisation is used by financial concerns like banks NBFCs etc.
A detailed study of these tools will be done in next semester.

4.13 System of Inventory Management

In case of any manufacturing industry inventories is perhaps the biggest element of

working capital and hence maximum funds are blocked in the inventories (stocks).
Keeping inventories at its optimum level is always a tough task as excess or shortage of
inventories may create tremendous problems, like –

1. Shortage of raw materials may lead to interruptions in production schedule

resulting in under utilisation of capacity. Interruption in production increases the
cost of production as wages and overheads are incurred even when production is
halted.

2. Reduction in Finished goods may lead to excessive delay in deliveries to customers,

resulting into reduction in sales

3. Excessive stock blocks up funds which has a cost

4. Inventories are non liquid assets and can’t be converted in cash easily.

Therefore inventory control should be done carefully. There are various techniques
developed for inventory control which are discussed in brief –

1. Minimum and Maximum levels – This is perhaps the simplest form of inventory
management, under his method management simply decides what should be the
minimum and maximum level of various items in inventory. These levels are
decided after considering the availability and importance of various items. It also

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takes into consideration cost of purchases and lead time (time period between
ordering of material and actual receiving the material). Cost of procurement is an
important point especially for imported items as carriage costs are heavy for
imports and the cost can be spread over only bulk quantity.

2. Re order quantity – The re-ordering quantity is the level of stock where new
procurement orders are required to be placed without delay.

3. Economic order quantity [E.O.Q.] – It is an important concept in the purchase of

raw materials and in the storage of finished goods and in-transit inventories. EOQ
techniques gives a formula to determine the optimum quantity to be ordered.

EOQ = 2AO/ C
A = Total usage in units for a period
O = ordering cost per order
C = Carrying cost per unit

4. Just in time purchase – This is a relatively new concept and is far easier to
implement if stock records are maintained on computers. Under this method high
value inventories are procured only when it is required in production, suppliers
are specially developed so that they can arrange these items very promptly

This was just a brief introduction to the tools of inventories, as a detailed study is part
of subject of costing and not financial management.

4.14 Working capital financing in India

Indian banks have been traditionally been extending credit to industry and trade
solely on the basis of securities like hypothecation of stocks etc. The organisation’s
ability to repay these loans and actual usage of these loans were never checked. This
resulted into heavy losses to bankers and defalcation of funds by the promoters. To
cure this problem Reserve Bank of India has set up various committees to study the
matter and provide appropriate guidelines, analysis some of the committees are
discussed below –

1. The Dahejia committee report – In 1969 Dahejia committee pointed out that
there was no relationship between optimum requirements for production and the
bank loans. It was general tendency of the businessmen to take short term loans
and use it for other than production purposes. It was also pointed out that there
are multiple hypothecations on the same stocks. The Dahejia committee suggested
that the bank should make appraisal of credit applications with reference to the
total financial situation of the client. It also suggested that all the Cash credit bank

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accounts should be bifurcated between the hard core which would cover the
permanent working capital and a strictly short term component which should be
fluctuating part of the account.

2. The Tandon committee report – The Tandon committee was set up by the RBI in
1974. Along with the suggestions regarding to whom working capital loans should
be granted, how much loan should be granted, the committee gave three different
methods for calculation of working capital. Though earlier these methods were
mandatory for the bankers now it is only recommendatory in nature. The three
methods are as follows –

Method I –
Bank finance to be granted = 75% (Current Assets – Current liabilities [excluding
bank borrowings])

Method II –
Bank finance to be granted = 75% (Current Assets) – Current liabilities [excluding
bank borrowings]

Method III –
Bank finance to be granted = 75% (Current Assets – Core current assets) – Current
liabilities [excluding bank borrowings]

3. Chore committee – In 1979 chore committee was formed by RBI to analyse

funding of working capital the committee gave certain major suggestions regarding
enhancement of borrower’s contribution in the working capital, compulsory
periodic review of cash credit accounts by bankers etc.

4.15 Self examination questions

4.15.1 Problems

1. M/s A ltd. have approached bankers for their working capital requirements.
The bankers agreed to finance but decided to keep some margins as under (i.e
agreed to finance excluding the margins) –

Raw materials 20%

Work in progress 40%
Finished goods 15%
Debtors 30%

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Following are the estimates for the year 2002-03

Rs. 000’s
Annual Sales 14,40
Cost of Production 12,00
Raw Materials purchased 7,05
Opening stock of Raw materials 1,40
Opening stock of Raw materials 1,25

Other information – Raw material is in stock for 2 months, WIP 15 days and FG 1
month. Debtors get 1 months credit and creditors give 15 days credit. Company
has received an advance of Rs. 15,000

1. Estimate the amount of working capital requirement

2. Estimate the amount of loan likely to be approved by the bankers.

Note - Margin is the amount which is not funded by the bankers e.g. if
bankers decide to fund debtors excluding 30% margin that means if
company estimates debtors to be Rs 100 then bank will fund only Rs 70

2. M/s B ltd. have approached bankers for their working capital requirements.
The bankers agreed to finance but decided to keep some margins as under (i.e
agreed to finance excluding the margins) –

Raw materials 30%

Work in progress 35%
Finished goods 12.5%
Debtors 42%
Cash 0%

Estimated annual production is 60,000 units and break-up of selling price is as

under –

Raw Materials 60%

Direct wages 10%
Overheads (includes depreciation 10%) 20%
Profit 10%
Selling price 100%

Other information – Raw material is in stock for 2 months, work in progress

(WIP) 1 month and FG 3 month. Debtors get 3 months credit and creditors give 2
months credit, wages are paid after one month. Calculate WIP considering 100%
RM + 50% wages and overheads. Selling price is estimated @ 5 Rs per unit. Cash
requirement is Rs 20,000

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1. Estimate the amount of working capital requirement

2. Estimate the amount of loan likely to be approved by the bankers.

3. M/s C ltd. have approached bankers for their working capital requirements.
The bankers agreed to finance but decided to keep 30% margins on all current
assets excluding Cash balance (i.e agreed to finance excluding the margins) other
information is as follows -

Cost per unit

Raw Materials 40
Labour 10
Overheads 60
(Depreciation included in overheads Rs 20)
Selling price 120

Average holding/realisation period is as follows –

Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads
50%) – 1½ month,
Debtors – 2 month, Creditors – 1 month, wages – 1/2 month, overheads – 30
days, Finished goods – 2 month.
80 % of sales is on credit, Expected cash balance is 75,000

1. Estimate the amount of working capital requirement

2. Estimate the amount of loan likely to be approved by the bankers.

4. Explain in details what is working capital, with its definitions

5. Write short notes on

1. Reducing the floats in collection system

2. Factoring
3. Working capital cycle
4. Concentration banking

6. Discuss various formulas given by Tandon committee

7. How each item of current assets can be managed

8. Consider the following financial facts of Company A ltd. –

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Current assets
a. Inventory Rs. 140 lacs
b. Debtors Rs. 200 lacs
c. Other current assets Rs. 20 lacs
Current liabilities
a. Creditors Rs. 100 lacs
b. Other liabilities Rs. 20 lacs

Calculate the permissible bank finance according to methods given by Tandon

committee

9. The Cost sheet of A ltd. is as follows –

Cost per unit
Raw Materials 50
Labour 18
Overheads 35
(Depreciation included in overheads Rs 10)
Selling price 125

Average holding/realisation period is as follows –

Raw materials – 11/2 month, WIP (Completion - Material 50%, labour &
overheads 50%) – 1 month, Debtors – 2 month, Creditors – 1 month, wages – 1/2
month, overheads – 1/3rd month, Finished goods – 1 month.

Other information – 1. 75 % of sales is on credit

2. Expected cash balance is 55,000

Expected output is 60,000 units per annum. Calculate the amount of working
capital required.

1. T ltd is a trading company whose balance sheet as at 31 st March 2004 was as

under :

Liabilities Rs Assets Rs
Capital 1,50,500 Building 1,10,000
General reserve 17,000 Furniture 70,000
Bank loan 34,000 Cash 19,500
Creditors 17,300 Motor car 12,000
Liability for income tax 19,700 Stock in trade 15,000
Debtors 12,000

2,38,500 2,38,500

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On the basis of following information pertaining to the year ended 31.3.2005,

you are required to prepare a statement of changes in working capital:

a. Furniture on 30.6.2004 for Rs 18,000 and on the same date purchased

100 units of UTI at Rs 100 each.

b. Sales for the year were 30% higher than that in the last year. Purchase of
materials increased by 15%. Customers were allowed 1.5 months credit
and suppliers allowed 1 month credit (Policy was same for 2004)

c. Overheads for the year amounted to Rs 3,500 per month (paid in next
month). There were no other receipts and payments during the year.
Gross profit rate was 40% on turnover.

d. Provide for interest on bank loan at 9% p.a and for income tax liability Rs
7,500

10. Compute the amount of working capital from the following balance sheet

Balance sheet as at 31.3.2004

Liabilities Rs Assets Rs

Capital 50,000 Building 40,000

Long term loans 40,000 Furniture 20,000
Expenses payable 12,000 Cash 15,000
Creditors 10,000 Motor car 10,000
Liability for income tax 10,000 Stock in trade 30,000
Bills payable 5,000 Debtors 20,000
Proposed dividend 8,000
1,35,000 135,000

[Link] are given below the Profit & loss account for two years for a company –

Profit & loss Account

Year 1 Year 2 Year 1 Year 2

Opening stock 80,000 1,00,000 Sales 8,00,000 10,00,000

Raw materials 3,00,000 4,00,000 Closing stock 1,00,000 1,50,000
Stores 1,00,000 1,20,000 Misc. income 10,000 10,000
Other expense 2,00,000 2,60,000
Depreciation 1,00,000 1,00,000

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Net profit 1,30,000 1,80,000

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

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

As a result, other expenses will increase by Rs 50,000 besides other charges.

Only raw materials are in stock. Assume sales and purchases are in cash terms
and closing stock is expected to go up by the same amount as between year 1 and
year 2. You may assume that no dividend is being paid. Estimate the cash
generated from operations in year 3.

12. Prepare a working capital forecast from the following information :

Production during the previous year was 10,00,000 units. The same level of
activity is intended to be maintained during the current year.

The expected ratios of cost to selling are :

Raw materials 40%

Direct wages 20%
Overheads 20%

The raw materials ordinarily remain in stores for 3 months, WIP for 2
months and finished goods for 3 months. Credit period given by creditors is 4
months and given to debtors is 2 months. Wages and overheads are overdue for
½ months and minimum cash balance should be Rs 2,00,000. selling price is 8
per unit you are required to make a 10% provision for contingencies ( except
cash).

4.15.2 Objective questions / problems

1. state whether following statements are true or false, giving reasons

e. A company should have large balances of cash in hand so that it can meet
all contingencies

f. A finance manager must aim at reducing inventories without considering

production requirements

g. A company should never sale on credit to avoid investment in debtors.

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h. Working capital cycle is useful for analyzing efficiency of the

organization

i. Higher the credit period, the greater are the chances of recovery of a
debt

j. Factoring is not recommended for companies having lesser collection

periods

[Link] D ltd. –

Current assets
a. Inventory Rs. 330 lacs
b. Debtors Rs. 150 lacs
c. Other current assets Rs. 20 lacs
Current liabilities
a. Creditors Rs. 120 lacs
b. Other liabilities Rs. 30 lacs

Core current assets are Rs. 200 lacs

Q1. The maximum permissible bank finance as per Tandon committee

recommendations is –
a. Rs. 180 lacs
b. Rs. 262.5 lacs
c. Rs. 250.75 lacs
d. Rs. 120 lacs

[Link] minimum permissible bank finance as per Tandon committee

recommendations is –
k. Rs. 180 lacs
l. Rs. 20 lacs
m. Rs. 75 lacs
n. Rs. 175 lacs

Q 3. Calculate the maximum permissible bank finance as per Tandon

committee recommendations if Core current assets are Rs. 170 lacs –
a. Rs. 180 lacs
b. Rs. 20 lacs
c. Rs. 15 lacs
d. Rs. 262.5 lacs

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3. The Cost sheet of A ltd. is as follows –

Cost per unit
Raw Materials 500
Labour 200
Overheads 300
Depreciation 100
Selling price 1100

Average holding/realisation period is as follows –

Raw materials – 1 month, Finished goods – 1 month, creditors – 1 month

Other information – Expected output is 4500 units per month.

O 1. The estimated figure of raw materials for calculation of working capital is –

a. 33,75,000
b. 22,50,000
c. 12,50,000
d. none of the above.

Q 2. The estimated figure of Finished goods is –

a. 22,50,000
b. 58,00,000
c. 43,55,000
d. 45,00,000

Q3. Which other figure is same as the estimated figure of raw materials –
a. Creditors for materials
b. Creditors for overheads
c. Work in progress
d. None of the above

4. state whether following statements are true or false, giving reasons

1. Increasing the sales should be the only criterion before giving credit to the
customers

2. Credit rating refers to ranking the various debtors who seek credit.

3. Inventories constitute very small portion of working capital

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4. Collection floats can never be reduced

5. ----------------- is the method of granting loans against collection debtors

6. The cash investment in working capital is lower because ----------------- and ------------
---- includes non cash items

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5 Sources of long term and short term finances

5.1 Introduction

One of the most important function of a finance manager is procurement of funds.

Number of such sources are available to a finance manager and he has to make a
decision as to which will suit him the best. The procurement of funds is not a easy task
considering the fact that it is governed by various factors which we will be seeing
ahead. Funds are required by an enterprise for various purposes like for implementing
a new project, undertaking an expansion, diversification, modernisation, day to day
working, retiring old dues etc.
Estimation of cost of the new project and exact requirement of funds is a critical step
for raising the funds. The aggregate cost indicates the quantum of funds needed for
bringing the project into existence. Therefore great care should be taken while
estimating such costs. The cost of project usually comprises of the following items –

a. Purchase of land and land development charges

b. Construction or purchase of building
c. Plant and machinery especially for manufacturing concerns.
d. Other fixed assets
e. Technical know how and royalty charges
f. Preliminary expense
g. Interest during construction period
h. Other expenses

After estimation of cost of the project the issue to be decided is from which source
finance should be raised and how much from each source. A detailed study of capital
mix is done in topic on capital structure theories, here we will be analysing pros and
cons of various available resource.

5.2Types of requirement of funds

Any enterprise has requirement of funds having varied repayment schedules. Financial
needs can be classified under three groups according to time of repayment as follows –

1. Long term Finance – Funds required for acquiring long term assets, starting of
new project etc. are classified under long term loans. Such funds are generally
raised for a period ranging from 5-20 years. Funds required to finance permanent
working capital also raised form long term sources of finance

2. Medium term finance – Loans which are raised for a period of 1-5 years are
termed as medium term finance. These kind of funds are raised for the purpose
company’s medium term requirements like small projects or projects where long
term finance can’t be raised etc. It may be noted that this term is mainly a

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theoretical term and practically finances are bifurcated between only two
categories – long term and short term.

3. Short term financial needs – These funds are raised for a short period of time;
up-to maybe 1 year. Short terms loans are used for financing company’s current
assets, These funds are of utmost importance as investment in working capital is
essential to use fixed assets profitabaly.

5.3 Various sources of finance

I. Long term sources – Some example of long term sources of finance are as follows

1. Equity and preference shares

2. Retained earnings – reserves like Profit & loss account, general reserves etc.
3. Debentures
4. long term loans from banks
5. Loans from financial institutions
6. Leases and hire purchases
7. Government subsidies
8. International instruments like American depositary receipts, Global depositary
receipts, euro issue et.

II. Medium term sources – Some example of medium term sources of finance are as
follows

1. Public deposits
2. Loans from banks
3. Medium term leases and hire purchase agreements
4. Medium term venture funds

III. Short term sources - Some example of Short term sources of finance are as follows

1. Working capital loans from banks

2. Commercial papers
3. Certificate of deposits
4. Advances from customers
5. Inter corporate deposits
6. Trade creditors

There are other ways of classification of business –

1. According to ownership – a. Owned share capital

b. Retained earnings

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2. According to source of generation – a. Internal sources e.g retained earnings

b. External sources e.g debentures, loans

5.4 Long term sources of finance -

Ordinary or equity shares – A public limited company may raise funds from
promoters or from the investing public by way of ordinary shares. Ordinary
shareholders are owners of the company and share risks of the business. Equity shares
can only be paid back on liquidation (except for buy back of shares) and hence there is
no risk as to repayment. Being the owners they elect directors of the company to run
the company. The concept of equity shares is applicable only for companies and not for
small businesses. The remuneration for equity shareholders is called dividend. As
dividends can be declared only when company is in profits (except for exceptional
cases) the risk is minimum, in case of loans interest has to be paid even when the
company is in huge losses. Cost of equity shares is maximum as the risk borne by the
shareholders is also maximum. The advantages and drawbacks of raising equity are as
follows –

Advantages –

a. It is a permanent source of finance i.e not repayable.

b. Dividends is not a mandatory payment.
c. Company can raise further capital from shareholders, if required, by
way of right shares.

Disadvantages –

a. it is the costliest source of finance

b. It may dilute the control. As equity shareholders are owners of the
company new shares issued to other investors dilutes the ownership
of existing shareholders
c. Dividend is not tax deductible.

Preference share capital – These are special kind of shares in which the
shareholder enjoys priority over equity shareholders in case of repayment of capital
on winding up of the company, Preference shareholders also enjoy priority in respect
of payment of dividend. Preference shares are a mixture of both equity shares and
debt. There are various types of preference shares –
1. Redeemable preference shares – In India only redeemable
preference shares are allowed to be issued. This preference
shares are redeemable on a predefined date.
2. Cumulative preference shares – These type of preference
shares stipulate mandatory payment of dividend, if in an year
of loss dividend is not paid then the same gets accumulated
till the time the accumulated amount is paid.

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3. Convertible preference shares – On a predefined date

investors are given an option to convert their preference
shares into equity shares
4. Cumulative convertible preference shares – it’s a hybrid type
having features of shares mentioned in point no 3 & 4 above.
5. Partly convertible preference shares - On a predefined date
investors are given an option to convert a part of their
preference shares into equity shares, remaining part (or
unconverted part) is redeemed on that date.

The advantages and disadvantages of preference shares are as follows –

Advantages –

a. As dividend on preference share is affixed charge it has a leverage

advantage
b. It does not dilute the shareholders control, There is no risk of
takeover.
c. Preference shares can be redeemed after certain period

Disadvantages –

a. It is very high cost source of finance

b. It is repayable
c. Dividend is not tax deductible.
d. If dividend is not paid on cumulative preference shares for three
consecutive years then they get rights of equity shareholders

Debentures or bonds – Debentures or bonds are the instruments used for raising
funds from public. It is basically a loan instrument and does not carry any ownership
rights. Debentures have varying face values generally varying from Rs 100 to Rs 1,000
and carry different rates of interest. Debentures are generally floated on the basis of
debenture trust deed. Debentures are secured against the property of the company. It
is a safer option for prospective investors than that of equity shares. Debenture
holders are paid fixed or floating interest every year, immaterial of whether the
company is in profits or losses. In last one or two decades variants of debentures are
gaining increasing popularity. The more popular variants are –

1. Partly convertible debentures – Investors are given an option

to convert a part of their debentures, on an predefined date,
into equity shares and remaining amount is repaid
2. Fully convertible debentures - Investors are given an option
to convert their debentures, on an predefined date, fully into
equity shares and remaining amount is repaid

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There are certain advanced versions like bonds with coupons,

debentures or bonds with floating rate notes etc. a detailed study of these
advanced instruments will be done in the next term.

Advantages of issuing debentures –

1. The cost of debentures is substantially lower than that of cost of
equity and preference shares, as, not being the owners of the
company, debenture holders carry lesser risk
2. Debenture financing does not result in dilution of control
3. It has a leverage advantage as interest on debentures is a fixed
charge.
4. The cost of raising funds by debentures is cheaper also because of tax
deductibility of debenture interest

Disadvantages –

1. Debenture interest and capital repayment are obligatory repayments

and in a situation of cash losses the company may suffer more
because of this burden
2. Debenture issue increases the financial risk associated with the firm
as it has a leveraging effect
3. Issue of debenture to public requires to berated by CRISIL or other
recognised credit rating institutes, this makes debenture issue
difficult for small companies.

Loans From Financial Institution – In India certain specialised institutes provide

long term loans to industry. This institutions are called financial institutes, examples of
which are – Industrial finance corporation of India (IFCI), The life insurance
corporation of India ( LIC), Industrial credit and investment corporation of India
(ICICI) [ ICICI is merged with ICICI bank in year 2002 and hence it is no more a
financial institution], The state financial corporation (SFC) etc. Financial institutions
are specialised in giving long-term loans and huge loans. The company asking loan has
to convince the institution about Economical, technical, managerial, financial and
commercial ability of the project for which the loan is required. The institutions grant
long term loans with interest varying for each company. These loans are generally
repayable over a period of 6 – 10 years in annual, semi-annual or quarterly
instalments.

Advantages of raising funds from financial institutions (FIs)–

1. FIs can provide huge loans, required especially for infrastructure

projects. It is difficult to raise such huge loans from any other source
2. Interest being tax deductible cost of such funds is comparatively
lower.

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3. Repayment period is quite high and it is ideal for projects having big
gestation period.

4. FIs generally appoint nominee directors on the boards of the

companies financed by them, these directors are experts in their field
and provides useful guidance to the company.

Disadvantages of raising funds from financial institutions –

1. It is impossible for small organisations to get funds from FIs

2. The procedure for raising funds from FIs is very complicated and it
takes very long time.

Term lending by Banks – The primary role of the commercial banks is to cater
the borrowing requirements of industry. Banks in India are specialised in short term
lending and avoid giving large and very long term finances to industry. Banks are
specialised in giving short term finances ( or what we can call medium term finances )
for buying fixed assets and working capital loans. The discussion on bank loans
exclude retail loans as the primary motive of this subject is not personal financing.
Though it is said that working capital loans are short term, they are
actually more permanent than a term loan. This is because term loans are
always repayable on a fixed date and the account gets settled on that
date. Whereas working capital loans are only reviewed periodically but
never repaid, though it is repayable on demand. Let us take an example of
Cash credit account, in this account a borrower is allowed to overdraw
upto a certain sanctioned limit say Rs 50,000, then throughout the life
time of that loan the borrower ensure that the overdrawn balance is
nearer to Rs 50,000 and bank does not get its funds back. Bankers always
provide loans on the basis some security like fixed assets or current
assets.

Advantages of term lending from banks –

1. The procedure of raising funds from banks is perhaps the simplest

2. Bank offers lot of flexibility in providing loans and offer variety of

lending instruments to suit every business necessity

3. Interest on loan being a tax deductible item, cost of bank borrowings

is lesser.

4. Bank borrowing does not dilute the control of the management

Disadvantages of term lending from banks –

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1. Bank borrowings increases risk associated with the organisation.

2. Bank borrowing requires hypothecation of firm’s assets.

Retained earnings – Long term funds may also be provided by accumulating the
profits of the company by ploughing them back into the business. Such funds belong to
the ordinary shareholders and increases the net worth of the company. It is mandatory
for a public limited company to set aside certain amount as reserves. Companies keep
aside certain funds over and above the legal requirements for its own expansion plans.
Dividends are always declared after considering such plans and cash flow position of
the company.

Venture capital financing – The venture capital financing refers to financing of

new high risk ventures promoted by qualified entrepreneurs who lack experience and
funds to give shape to their ideas. The concept of venture capital is investment in high
risk proposals where chances of success can also be high and profits can be huge e.g an
email portal or a website. Some common methods of venture capital financing are –

a. Equity financing – The venture capital undertaking usually requires

funds for a longer period but may not be able to give returns in initial
stages. In such cases the venture capitalists provide funds by way of
investment in equity shares. The venture capital can earn his profits
by selling the equity shares once the market value of the company is
up.

b. Conditional loan – a conditional loan is repayable in the form of a

royalty after the venture is able to generate sales. No interest is paid
on such loans.

c. Participating debentures – Such security carries charges in three

phases in very initial stage no interest is charged, after some period
(predefined) low interest is charged and in the last stage heavy
interest is levied.

d. Income note – Under this method of financing the undertaking has to

pay the venture capitalist both interest and royalty on sales. This
gives the venture capital investor a fixed as well as a variable income.

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5.5 Short term sources of finance

There are various sources of short term finances available some of them are discussed
below –

5.5.1 Bank advances – Bankers are more interested in more liquid advance ai.e the
advances which can be called back easily. Banks provide numerous types of short term
finances to meet almost every business demand. Some important types are discussed
below –

1. Bank overdraft – Under this facility customers are allowed to withdraw in

excess of credit balance standing in their current deposit account. A fixed limit is
granted to the borrower within which the borrower is to overdraw his account.
Borrower has to formally open an current account with the bank. The customer
can borrow at any time within his limits. Interest is charged on daily balances.
Bankers take security for overdrafts like LIC receipts, FD receipts, shares etc.
Bankers revive the limits granted every year according to the performance of the
borrower.

2. Clean overdrafts – Request for clean advances are entertained only from parties
which are financially sound and reputed. The bank provides this facility only on
the basis of goodwill and past experience of the borrower. The term clean
overdraft means overdraft which is not backed by any security. A clean advance
is granted only for a short period.

3. Cash credit – Cash credit is an arrangement under which a customer is allowed

an advance upto certain limit. The bank lends (approves) a certain amount to a
borrower, who as per his need can borrow the amount at any time and to any
extent subject to maximum limit sanctioned by the banks. The remaining amount
remains in his account. Interest is charged only on the amount actually borrowed
by him. Though these accounts are repayable on demand, banks generally do not
recall such advances and keep on reviving the maximum limit periodically. Cash
credit limit is generally sanctioned against hypothecation of stocks etc.

4. Bill discounting – These advances are against security of bills. The mechanism
works as follows –
Mr A sells goods to Mr B on 6 months credit and is in need of cash urgently. Then
Mr A draws a bill of exchange (also called hundi) on Mr B and Mr B, undertakes
to pay the amount mentioned in that bill ( equal to the sales amount) 6 months
further. Now Mr A discounts / endorses the bill with the bank and bank pays him
the amount mentioned in the bill less interest for 6 months. At the end of 6
months bankers present the bill to Mr B which he honours. It is very good source
of short term finance.
It’s a very effective alternative for overdraft or Cash credit. In recent times many
big companies have started this scheme for their suppliers, as rates of bill

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discounting are lesser than normal bank loans. Of course the rates are lesser for
bigger companies, ordinarily bill discounting charges are higher than normal
loans.

5. Packing credit - Packing credit is an advance extended by bank to an exporter

for the purpose of buying, manufacturing, processing, packing and shipping
goods to overseas buyers. The exporter must have a firm export order in order to
avail this facility. The packing credit has to be repaid within 180 days from the
date of its commencement, by negotiating the export bill or from the receipt of
export proceeds. There are various sub types of packing credit like clean packing
credit, packing credit against hypothecation of goods etc.

5.5.2 Commercial paper - The commercial paper is nothing but a “Promissory

note” issued by a company, approved by RBI, negotiable by endorsement and delivery.
The commercial paper is issued at face value less discount and is honoured at the face
value. E.g Company ABC ltd may issue a 6 months commercial paper carrying face
value of Rs 1,00,00,000 at Rs 96,00,000. At the end of 6 months it has to honour the
commercial paper by paying the whole amount of Rs 1,00,00,000. Being a negotiable
instrument Commercial paper can change hands till the time of maturity. There are
certain restrictions of commercial paper as it does not carry any security. These
eligibility norms are as follows –

a. The issuing company must have a tangible net worth of Rs 4 crores are more as per
latest balance sheet

b. The company must have a working capital limit not less than Rs 4 crores

c. The current ratio should be minimum 1.33 : 1 as per latest balance sheet

d. The company must have some specified ratings from institutions like CRISIL etc

e. The borrowal account of the company should be classified as standard asset by the
company’s bankers

f. No commercial paper should be issued for a period less than 15 days and a period
more 1 year.

g. As per guidelines issued by RBI, a company has to issue commercial paper only
through the same bank from where it has taken any loan.

5.5.3 Trade creditor - Creditor is a source of short term finance as creditors supply
goods on credit which is required to be paid only after certain period of time. Credit
periods offered in India generally do not extend beyond 6 months. This finance is
without ant explicit cost, except may be the amount of cash discount forgone. It
generates automatically in the course and is common to all businesses.

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5.5.4 Advances from customers – Most of the Manufacturers or constructors of big

projects prefer taking periodically advances from customers. Example of this can be
bridge contractors who take advances from government at regular intervals. This is a
useful source of finance and is cost free.

5.5.5 Certificate of deposit – The certificate of deposit is similar to that of a fixed

deposit except for the fact that it is liquidated not on demand but only on maturity. The
holder can liquidate it at any time by just selling it in secondary market.

5.5.5 Inter-corporate deposit – The companies use this option to borrow from
another company when it is in urgent need of funds and does not have time to go
through bank formalities. The rate of Inter-corporate deposits is usually higher than
bank borrowings and varies with the company’s reputation, amount and time involved.
It is good source of investment for companies wishing to park their idle money for a
short period of time.

5.5.6 Lease and hire purchase agreements – Under a lease contract the lessor
purchases an asset and then gives it on rent to the lessee. In most of the cases the
lessee uses the asset throughout its life. Lease is a very good source of finance as it is
easy to get an asset on lease and it’s a smart alternative to term loans against assets. It
is not correct to say that lease is a short term loan, it can be best classified as a medium
term loan. Some leases, like in case of land, are for a very long period, say 99 years.
Hire purchase is a simple agreement between two parties where one party purchases
the asset and transfers it to another party, the buyer party pays the dues in
instalments over a period of time.

There are many other sources of specialised finance like seed financing, bridge loans,
debt securatisation etc..

5.6 Modes of charges against a loan

As we have seen in most of the cases any loan, be it debentures or bank loan, requires
certain charges against assets of the company. These charges work as security for the
lenders / investors. The term charge basically means that the assets under charge
cannot be sold / disposed off without the permission of person holding that charge and
the sale proceeds are first adjusted against the dues of charge holder. The various
types of charges are as follows –

1. Pledge – a charge against goods (stocks) and movable assets

2. Hypothecation – a charge against goods (stocks) and movable assets

3. Mortgage – a charge against immovable properties like building, land etc.

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4. Negotiation – A charge against negotiable instruments

5. Assignment – a charge against Life Insurance policy, NSC certificates etc.

Different types of securities are given in the following paragraphs –

1. Personal and tangible security – The bank can always take action against the
borrower, though prefers to take some kind of promissory note or a bond from
the borrower. Many times bankers demand guarantee from a third party. This
kind of security is termed as personal security.
Under tangible security bankers prefer to take security of tangible assets which
can be sold or transferred in case of default by the buyer. A good tangible
security should be readily marketable. The most liquid form of such security is
Fixed deposit with the bankers.

2. Primary and collateral security – Primary security is the principal security

and is furnished to secure the repayment of advance. It is deposited by the
borrower himself. The term collateral security is applied when a supporting
security is given along with the primary security. Example – A gives his stock as
primary security and his friend Y deposits his shares as collateral security for
the loan taken by A.

3. Margin – A bank keeps certain margin on any security hypothecated or

mortgaged to it. The difference between value of security and the amount upto,
which the borrower can withdraw, is known as margin. The margin is
necessary since in case of default by the borrower the bank may not be able to
realise the full value of such security. The percentage of margin depends on the
creditworthiness of the borrower and of the security i.e the margin may be
higher in case of hypothecation of shares than that of gold.

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5.7 Self examination questions

objective type ( a question can have more than one option as correct answer)

1. Which of the following conditions should be satisfied for issuing Commercial

paper –

a. The issuing company must have a tangible net worth of Rs 4 crores are
more as per latest balance sheet
b. The company should be having profit above Rs 10 crores in last
financial year
c. The company must have a working capital limit not less than Rs 4
crores
d. The current ratio should be minimum 1.33 : 1 as per latest balance
sheet
e. The company must have some specified ratings from institutions like
CRISIL etc
f. The borrowal account of the company should be classified as standard
asset by the company’s bankers
g. Company must not have any debentures outstanding.

2. What are the advantages of raising funds through equity shares –

a. It is a very low cost option of raising funds

b. Issue of equity shares carry lesser risk as they are not repayable
c. There is no security required for raising equity capital
d. Dividend is allowed as a deduction for taxation purposes
e. All of the above
f. None of the above

3. A company wishes to raise a short term loan without undertaking heavy

documentation, which source it shall prefer –

a. Commercial paper or inter-corporate deposit

b. Cash credit
c. Overdraft
d. Public deposit
e. Debentures

4. A supplier of goods wants to encash his outstanding bills to fund his expenses,
he should use –

a. Bill discounting
b. Bank overdraft
c. Cash credit

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d. None of the above

5. Venture capital funding is more recommended to –

a. Inexperienced and highly qualified entrepreneurs

b. Unskilled businessmen
c. Government
d. Corporate sector

Detail questions

1. Write a detailed note on various factors a finance manger need to consider

before raising funds from any source

2. What are the various modes of raising short term funding from banks

3. Distinguish between equity funding and debenture funding, specifically stating

its advantages and disadvantages

4. Write a note on commercial paper

5. Explain various types of charges against the assets

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6 Cost of capital and capital structure theories

6.1 Introductions

As we have already discussed in the first chapter; the basic function of a finance
manager is procurement of funds. We have also seen the basic problems faced in
procurement of funds is availability of funds, cost of procurement, risk involved,
management perceptions etc. It is a big task for a finance manager to optimise the mix
of procurement of funds (i.e. deciding a right capital structure), which will take care of
all the factors mentioned above. Though theoretically calculation of capital structure
depends solely upon one factor that is wealth maximisation. For achieving this goal the
finance manager has to ensure that the cost of capital is minimum, as lower the cost of
capital higher will be the firms wealth at any given level of profitability. In this chapter
we’ll be seeing the methods of calculating cost of each source of capital and overall cost
of capital.

6.2 Considerations in Capital structure planning

The term capital structure simply means the mix of sources from which an
organisation raises it’s long term funds. To take an example – A ltd. wants to start a
new business and the estimated requirement of funds is Rs 10,00,000. The company
has options of contributing the money from it’s reserves, issue fresh equity, raise bank
loan or issue preference shares. Now the finance manager of A ltd faces 2 questions –

1. Which sources to be used; and

2. How much to borrow from each source.

Answers to this 2 questions is nothing but planning the capital structure of the
company

In planning the capital structure one must consider following points –

1. There is no definite model of capital structure i.e. it is not fix that a capital
structure having ……% of equity and ……% debt is ideal. Each and every
organisation has to decide on it’s own mix of capital structure considering it’s
preferences and objectives. It is therefore important to note that different
types of capital structure will be required for different types of undertakings

2. Government policy – It is a major factor in planning capital structure.

Example can be taken of bank loans and public deposits, The interest rates and
other requirements of these two sources are continuously monitored by
Reserve bank of India and one major change in it may affect the organisation
heavily.

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3. Taxation laws – Taxation laws always play a decisive role in determination of

capital structure. Example –Preference dividend is not tax deductible and
therefore it is costlier source of finance. If in future it is made tax deductible,
then it will be a much more attractive source of finance.

4. Cost of funds – as discussed earlier the ideal capital structure must have
minimum cost, so that the wealth can be maximum

5. Flexibility – The company should be able to raise further funds quickly, also
company should be able to repay some of the capital

6. Solvency – The capital structure should not have high risk of insolvency. This
can be achieved by raising certain amount by way of non refundable funds.

7. Lesser Risk – Though loan funds are cheaper the company should not take
100% funds as loan, as the risk factor associated with the company increases
substantially

8. Control – An ideal capital structure always ensure minimum loss of control

over the company.

9. Earnings per share – Capital structure affects the earnings per share of a
company and thus the returns to the shareholders. The finance manager must
take this into consideration before deciding the capital structure.

10. Legal requirements – Legal requirements must be taken into consideration

while deciding upon the capital structure, like, in India, Public deposits can be
raised only by limited companies and not by private companies

11. Availability of funds – It is not possible that all the organisations can raise
finance from all the sources of funds and therefore a finance manager has to
consider the availability of sources of funds for his organisation before
deciding the capital structure. In India only companies are allowed to raise
debentures or raise equity capital carrying limited liability.

12. Purpose of finance - The purpose of raising the finance is essential for
determining the capital structure of the company. Finance manager should not
raise long term funds when the company requires short term financing, say for
funding its working capital requirements.

13. Period of finance – This is again an important constraint, a company requiring

funds only for 5-6 years may not go for a fresh equity issue but may prefer
going for bank loans or debentures.

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14. Investors perceptions – The finance manager has to consider the

requirements of proposed investors before raising the funds

6.3 Determination of cost of various sources of finance

We have already seen that cost of capital is a significant factor in determining the
capital mix. The basic aim of running an undertaking is to earn a return at least equal
to it’s cost of capital. The first step, after estimation of financial requirements, in
determining capital structure is perhaps determination of cost of various sources of
capital available to the company. The various sources of finance, methods of
determination cost those sources of capital can be determined as follows –

a. Cost of debt - Determination of cost of debt is a very easy task as compared to

determination of cost of equity. Ideally cost of debt should be simply the rate of
interest agreed, but in practice this is hardly the case. There are two major factors
which determines the cost of debt –
1. Taxation
2. Actual inflow of funds

Let us take one example to clarify further – Company A issues 15% debentures
having face value of Rs 100 each (students should note that interest / dividend is
always payable on face value) if the company issues the debentures @ Rs 100 and
if there is no taxation then the cost of debt is 15%. But now let us assume that the
company issues this debentures @ Rs 120 each (this is a regular practice to issue
debentures at a premium or discount) and the company pays it’s taxes @ 40%.
Now the cost to company is per debenture issued =
Interest – tax saved on interest / amount received
= 15-(15*40%) / 120
= 15-6 / 120
= 7.5%

Now it can be clearly seen that though apparently the cost of raising funds is 15%,
due to taxation and premium it is coming top half i.e. 7.5%. To put it as a formula –

Kd = I * (1-T) / P

Where,
Kd = Cost of debt
I = Interest
T = Taxes
P = Net proceeds to the company

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Illustration 6.3.1

company issues Rs 10,00,000 12% debentures of face value Rs 100 each. The
company pays income tax @ 40%. Calculate the cost of capital of the company
considering that the issue is @ 10 % premium, 10% discount. Also consider a case
where the company pays a brokerage for issue of debentures 2% and issues it at
par.

Solution -

1. Cost of debentures, when company issues debentures @ 10% premium, can be

calculated as follows

Kd = I (1 – T) / P
= 1,20,000 (1 - 0.4) / 11,00,000
= 72,000 / 11,00,000
= 6.54%

2. Cost of debentures, when company issues debentures @ 10% discount , can be

calculated as follows

Kd = I (1 – T) / P
= 1,20,000 (1 - 0.4) / 9,00,000
= 72,000 / 9,00,000
= 8%

3. Cost of debentures, when company issues debentures par and pays the
brokerage, can be calculated as follows

Kd = I (1 – T) / P
= 1,20,000 (1 - 0.4) / 10,00,000 –2%(10,00,000)
= 72,000 / 9,80,000
= 7.35%

b. Cost of preference shares – In the case of preference shares, the dividend cannot
be taken as cost; the reasons are same as that of debt fund. The proceeds from
issue of preference shares vary because of issue price and other charges, similarly
taxes may be payable on preference dividend which increases its cost. Let us see
one example -

Illustration 6.3.2

Suppose a company issues 1000 12% preference shares of face value Rs 100 at Rs
105 each. The company pays Rs 5,000 as underwriting commission. The company

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is required to pay a dividend tax of 10% on the dividend paid by the company.
Calculate the cost of preference share capital to the company.
Solution –

cost of preference shares = (Dividend + tax on dividend) / net

proceeds
= 12,000 + 10%(12,000) / (1,05,000 – 5,000)
= (12,000 + 1,200) / 1,00,000
= 13,200 / 1,00,000
= 13.20 %

Here, we can note that the cost has gone up because of the dividend tax, which the
company is required to bear.

Illustration 6.3.3

A company issues Rs 10,00,000 12% preference shares of face value Rs 100 each.
The company pays dividend tax @ 10%. Calculate the cost of capital of the
company considering that the issue is @ 10 % premium, 10% discount. Also
consider a case where the company pays a brokerage for issue of debentures 2%
and issues it at par.

Solution -

1. Cost of Preference shares, when company issues @ 10% premium, can be

calculated as follows

Kp = 1,20,000 + (1,20,000 * 10%) / 11,00,000

= 1,32,000 / 11,00,000
= 12 %

2. Cost of Preference shares, when company issues @ 10% discount , can be

calculated as follows

Kp = 1,20,000 (1,20,000 * 10%) / 9,00,000

= 1,32,000 / 9,00,000
= 14.67%

3. Cost of Preference shares, when company issues par and pays the brokerage,
can be calculated as follows

Kp = 1,20,000 (1,20,000 * 10%) / 10,00,000 –2%(10,00,000)

= 1,32,000 / 9,80,000
= 13.47 %

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It can also be noticed that the cost of 12% debentures is substantially cheaper than
the cost of preference shares. This is because Dividend do not have any tax benefit,
in fact it adds to the cost to company.

c. Cost of equity shares – Calculation of the cost of ordinary shares is a complex

procedure, as the dividend rate is not fixed as in the case of preference shares.
Thus the calculation of cost of equity shares is not just mathematics but it requires
analysis of investors’ perceptions and price movement of shares. There are four
main approaches for determining the cost of equity shares, those are –

1. Dividend price approach (D/P)

2. Price earning approach (E/P)
3. Dividend and growth approach (D/P + growth)
4. Realised yield approach

The above mentioned approaches are discussed below :

1. Dividend price approach – According to this approach the amount of

dividend is what is expected by the equity shareholder and hence the dividend
is the cost of equity shares. The cost of equity shares can be determined with
the help of the dividend amount and the market price of the shares. Let us
assume that Mr A wants to invest in company B on the expectation that the
company will pay @20% dividend on face value of Rs 100, now let us suppose
that the company declares dividend of Rs 10 per share (10%), now as Mr A
wants 20% returns on his investment he will be ready to invest Rs 50 (10
/20%) so that he’ll get 20% return on his investment. Hence the market price
varies according to the dividend as the cost of capital (dividend rate expected)
remains the same. Let us take one more example –

Illustration 6.3.4

Market price of equity shares of A ltd (face value Rs 10) is Rs 15. If the
company is paying dividends to its shareholders consistently @20% and is
expected to maintain it’s rate of dividend, calculate the cost of equity shares of
the company. Also calculate the market price of the company, if, due to some
reasons the investors start expecting 12% returns from the company.

Solution –

Cost of equity shares = Dividend / Price *100 = 2/15 *100 = 13.33%

It can be said that to maintain the current market price (i.e. Rs. 15) the
company should declare dividend @ 20% every year.
Now if the investors start expecting 12% returns from the company then the
market price of the company will be –
Dividend / price = cost of capital

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2/ price = 12%
Price = 2/12% = Rs. 16.67

The approach is very simple to apply but is based on an unpractical

assumption that investors only look forward to dividend as the source of
return. Though dividend plays a key role in determining the market price, and
thus the cost of equity capital, it is not the sole determinant of the market price.
This approach fails to take into account other factors, the most important being
the capital appreciation in the value of shares. Now consider a practical case of
Infosys technologies Ltd. –
The market price of the shares of the company is say Rs 4000 ( face value Rs 5
per share), the company is consistently declaring dividend @ 200%, now let us
calculate the cost of capital of the company ( which is nothing but the investors
expected returns from the company) as per the D/P approach –

Cost of equity share capital = Dividend / Price *100

= (5*200%) /4000 *100
= 10 /4000 * 100 = 0.25%

Now as per D/P approach the cost of capital of the company is 0.25% per
annum, which is highly impossible as the investor can simply invest in Fixed
Deposit of a nationalised bank @ 6% without any risk. The term risk is
important as if the investor invests Rs 4000 in shares the share value may
come down drastically in even one day, whereas the amount of fixed deposit
remains the same.
Thus day by day this approach is losing significance (especially for listed
companies), as today’s investors are more keen on capital appreciation of the
share price rather than the amount of dividend.

2. Price Earning approach – According to this approach the market price of

shares of a company depends upon the earnings of accompany and not
dividend. To simplify it can be said that the cost of equity shares is based on
the expected rate of earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed or not, from the
company in whose shares he invests.

Illustration 6.3.5

An investor expects a return in terms of earnings @ 20% from a company and

face value of the company is Rs 100. Calculate the market value of the shares of
the company if the company is earning @ 50% ( i.e. earnings per share = Rs 50)

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Solution –

Cost of equity capital = Earnings / Price

20% = 50 / Price
Price = 50 /20% = Rs 250 per share

This approach seems to nullify the effect of dividend on the share price.
Though practically it is more acceptable, this approach also does not seem to
solve the problem of calculation of cost of equity capital.
3. Dividend and growth approach (D/P + growth) – This approach advocates
that investors expect not only dividend but also growth in the earnings
expected from the retained reserves. This growth rate in dividend (g) is taken
to be equal to the compound growth rate in the earnings per share.

Illustration 6.3.6

Calculate the cost of capital of company A if expected dividend from company A

is Rs 5 and the market price of the company is Rs 50, the growth expected in
the dividends and earnings is 5% per annum.

Solution –

Ke = D / P*100 + G
= 5 / 50 * 100 + 5%
= 15%

Where,

Ke = Cost of equity capital

D = Expected dividend
P = Current market price
G = expected growth in the earnings and dividend

Though this approach is a more realistic approach, it does not answer how to
quantify the expected dividend and the growth rate.

4. Realised yield approach – This approach advocates that the past experience
about the yield is the best estimate of the cost of capital as the same trend can
be expected to continue. The formula used is just the same as that of dividend +
growth approach, the only difference is instead of expected dividend and
growth, past dividend and growth is considered. This approach is quite useful
for stagnant companies or companies having a moderate estimable growth
rate. New age companies growing at unexpected rate can not use this model to
determine their cost of capital.

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It can be seen that all the four approaches are based on different factors and may
give totally different answers. Which approach should be used by a particular
company remains a question. A finance manager has to consider circumstances
peculiar to his company before using a particular approach. For example
companies following steady dividend policy may use dividend price approach.

d. Cost of reserves – It is commonly believed that the reserves do not have cost,
which is not correct. Reserves are part of earnings which belongs to shareholders
and should be rightfully distributed to the shareholders. It is like reinvestment by
shareholders of their funds. Thus the cost of reserves can be said to be the cost of
ordinary equity shares.

Illustration 6.3.7

A company’s share is quoted in market at Rs 60 (face value Rs 10). The company

pays Rs 3 as dividend and expected growth rate by the investor is 12%. Please
compute

a. The company’s cost of equity capital using all possible methods.

b. If expected growth rate is 13% per annum calculate the market price per
share under dividend growth approach.
c. If the company’s cost of capital is 16% and anticipated growth rate is 11%
per annum

Solution –

The relationship among cost of capital, dividend, price and expected growth rate is
given by formula:

I Dividend price model

Cost of equity capital = Dividend / Price * 100

= 3 / 60 *100
= 5%

I Dividend and growth model

a. Cost of equity capital = Dividend / Price * 100 + growth

= 3/60*100% + 10%
= 5% + 10%
= 15%

b. Market price = Dividend / (cost of equity capital – growth

rate)
= Rs 3 / (15% -13%)

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= 3 / 2%
= Rs 150

c. Market price = Dividend / (cost of equity capital – growth

rate)
= 3 / (16% - 11%)
= 3 / 5%
= Rs 60.

6.4 Weighted average cost of capital

The overall or composite cost of all the sources put together is called weighted average
cost of capital. While making important financial decisions weighted average cost of
capital is used. Each investment is financed from a pool of funds which represents
various sources from which the funds have been raised. Any decision of investment
therefore has to be made with reference to the overall cost of capital and not with
reference to a specific source of fund. The weighted average cost of capital can be
calculated as follows –

Ko = K1*W1+K2*W2……….+ Kn + Wn

Where,
K0 = Weighted average cost of capital
K1,2………n = cost of sources 1,2….n
W1,2,……..n = Weight of sources 1,2…….n

Illustration 6.4.1

Consider the following capital structure of A ltd.:

Rs.
Equity capital 4,00,000
Reserves 1,00,000
Preference shares 1,00,000
Long term loans 2,00,000
Total 8,00,000

The cost of various sources are – Equity capital = 20%, Preference shares = 12%, Loans
= 10%
Calculate the weighted average cost of capital and make suitable assumptions.

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Solution –

Assumptions –
a. Cost of retained earnings is taken to be same as cost of equity
b. There are no taxes, as taxes will reduce cost of loan.

Computation of weighted average cost of capital (WACC)

Source Proportion Cost Weighted
a B cost
a*b
Equity capital 0.50 20% 10%
Reserves 0.125 20% 2.50%
Preference shares 0.125 12% 1.50%
Loan 0.25 10% 2.50%
Overall cost of capital 1.00 16.5%
Illustration 6.4.2

Consider the following capital structure of A ltd.:

Rs.
Equity capital 5,00,000
Reserves 1,00,000
Preference shares 2,00,000
Long term loans 7,00,000
Total 15,00,000

The cost of various sources are – Equity capital = 20%, Preference shares (before
taxes) = 12%, Loans (before taxes) = 15%. Tax rate on income is 40%, company is
required to pay 10% tax on preference dividend.

Calculate the weighted average cost of capital and make suitable assumptions.

Solution –

Assumptions –
a. Cost of retained earnings is taken to be same as cost of equity
b. The cost of equity shares is calculated after considering taxation.

Cost of capital after taxes are –

1. Preference shares = Dividend rate + tax on dividend
= 12% + 1.2%
= 13.2%
2. Loan = Interest – tax on interest
= 15% - 40%(15)
= 9%

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Computation of weighted average cost of capital (WACC)

Source Proportion Cost Weighted
A B cost
a*b
Equity capital 0.33 20% 6.67%
Reserves 0.07 20% 1.40%
Preference shares 0.13 13.2% 1.72%
Loan 0.47 9% 4.23%
Overall cost of capital 1.00 14.02%

6.5 Theories of cost of capital

Though there are many methods suggested and books written on this subject, there
are two popular approaches followed for determination of cost of capital viz. the
traditional approach and Modigliani and Miller approach.

6.5.1 Traditional approach – The traditional theorists argue that a firms overall
cost of capital changes with the change in mix of its of debt and equity i.e. by
increasing the amount of loan content in the total capital or by decreasing the
same. Loans are cheaper than equity, because interest rates of loans are lesser
than rates of equity and interest is tax deductible. Traditional approach says
that as the proportion of debt increases in the company the weighted average
cost of capital goes down and vice versa. Increase in debt increases the risk
associated with the firm and high proportion of debt again increases the cost
of capital. This phenomenon can be illustrated with the following diagram –

DEBT
WACC – Weighted average cost of capital

Thus, a company should strive to reach the optimal capital structure and
increase the debt mix only till the WACC is reducing. Reaching this optimal

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level, practically, is a difficult task but a finance manager should starve for this
level.

Illustration 6.5.1 (self examination question)

Company A wants to raise Rs 1,00,000 from debt and equity source. The cost of
equity capital is expected to be 20% and that of debt is 10% (net of tax). The
company expects the cost of equity to go up by 1% with every 10% (10% of
total Rs 1,00,000) increase in debt mix (i.e. if debt goes above Rs 10,000 then
the cost will go up to 21%) similarly the debt cost is also likely to go up by
1.5% with every 10% increase in the debt share of total amount.

You are required to calculate the optimal level of debt and equity mix of the
company where the WACC will be minimum.
6.5.2 Modigliani and Miller approach [MM] – The other approach is that of
Modigliani and Miller. They argue that the total cost of capital any given
organisation is independent of its method and level of financing. In other
words they advocated that the change in debt equity mix does not affect the
cost of capital at all and the total cost of capital of an enterprise remains the
same. They make the following proposition –

1. The total market value of a firm and its cost of capital are independent of
its capital structure. The total market value of the firm is given by
capitalising the expected stream of operating earnings at a discounted rate
considered appropriate for its risk class

2. The cut off rate for investment purposes is completely independent of the
way in which the investment is financed

Modigliani and Miller takes an example of arbitrage to prove the hypothesis.

Some of the assumptions made by Modigliani and Miller like no taxes, existence
of capital market are totally impracticable. In current scenario their statement
that the debt mix does not affect the cost of capital seems to be not applicable,
as debt mix is taken into consideration by the investors before investing in a
company. The following formula elaborates the theory of Modigliani and Miller
–

Ke = Ko + (Ko – Kd) * Debt / equity

Where,

Ke = Cost of equity
Ko = Overall cost of capital
Kd = Cost of debt

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Illustration 6.5.2

Company A has a capital of Rs 2,50,000 and has earnings before interest and
taxes of Rs 50,000. The finance manager wants to take a decision regarding
how its capital structure should be based on the following information –

Amount of debt Interest rate (%) (after Equity capitalisation rate

Rs. tax) (cost of equity) %
0 0 10
50,000 8 10.5
1,00,000 8 11.0
1,50,000 9 11.5
2,00,000 9.5 12.3

You are required to determine the WACC and the optimum capital structure by
traditional approach. Also determine the equity capitalisation rate (cost of
equity) by MM approach

Solution –

1. Calculation of optimum capital mix as per the traditional approach – The

optimum capital mix is the stage at which the WACC is minimum

Cost of Weight of Cost of Weight of Ke * We Kd*Wd Ko

equity equity debt debt
(Ke) (We) (Kd) (Wd)
0.10 2,50,000 0 0 25,000 0 25,000
0.105 2,00,000 0.08 50,000 21,000 4,000 25,000
0.110 1,50,000 0.08 1,00,000 16,500 8,000 24,500
0.115 1,00,000 0.09 1,50,000 11,500 13,500 25,000
0.123 50,000 0.095 2,00,000 6,150 19,000 25,150

The optimum capital mix is debt of Rs 1,00,000 and equity of Rs 1,50,000 as the
WACC is minimum at this level ( Rs 24,500)

2. According to MM approach the overall cost of capital remains unchanged

and the cost equity rises linearly with cost of debt. The cost equilibrium of
of capital is equal to equity capitalisation rate which is 10% in present
problem. The equity capitalisation rate can be capitalised as follows –
Ke = Ko + (Ko – Kd) * Debt / equity

Where,

Ke = Cost of equity
Ko = Overall cost of capital

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Kd = Cost of debt

Debt (Rs.) Kd (%) Ko (%) Ko+(Ko-Kd) Debt / Ke (%)

equity
0 0 10 10+(10-0) 0 10
50,000 8 10 10+(10-8) 1/4 10.5
1,00,000 8 10 10+(10-8) 2/3 11.3
1,50,00 9 10 10+(10-9) 3/2 11.5
2,00,000 9.5 10 10+(10-9.5) 4 12

6.6 Self examination questions

6.6.1 Objective questions

1. State whether following statements are true or false, giving reasons

a. Increase in debt funds increases the risk associated with the company -

b. MM argues that the cost of capital of a firm remains unchanged though the debt
equity mix in the capital structure is changed

c. Excessive debt may affect the solvency position of a company

d. Taxation policies do not have any effect on the cost of capital

e. Preference shares is the cheapest source of finance

f. A company should never opt for debt option as it increases the risk of
insolvency

g. Reserves do not have any cost

h. Equity share issue has a risk of losing control.

i. A finance manager has to consider various government policies before deciding

the capital structure of the company

2. A finance manager has to consider risk, ……… and ……….. before deciding the capital
structure of the company.

3. Cost of debt is ………………. Than cost of share capital

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4. The cost of reserves can be taken to be same as …………….

5. …………… Source of finance is cheapest because of it’s tax advantage

6. Dividend tax increase cost of both ……………. and …………

7. ………….., ………….., …………, ……………. are the four approaches followed for valuation
of cost of equity shares.

8. quantification of cost of equity shares is a difficult task because it does not carry
………..

9. As per MM approach the cost of capital …………………. Even if the debt equity mix is
altered.

6.6.2 subjective questions

1. Explain the major considerations of capital structure planning

2. What is weighted average cost of capital ? and how it is calculated ?

3. Explain the risk, cost and control risk associated with each source of finance.

4. Explain the traditional approach of cost of capital with the help of suitable
graph.

5. What is Modigliani and Miller approach of cost of capital

Problems

6. A company issues Rs 5,00,00,000 14.5% debentures of face value Rs 100 each.

The company pays income tax @ 32.5 %. Calculate the cost of capital of the
company considering that the issue is @ 12 % premium, 12% discount. Also
consider a case where the company pays a brokerage for issue of debentures
2.25% and issues it at par.

7. Company A has a capital of Rs 3,85,000 and has earnings before interest and
taxes of Rs 78,000. The finance manager wants to take a decision regarding
how its capital structure should be based on the following information –

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Amount of debt Interest rate (%) (after Equity capitalisation rate

Rs. tax) (cost of equity) %
0 0 11
35,000 8.5 11.25
1,00,000 8.75 11.50
1,50,000 9.25 12.50
2,00,000 10 12.75
3,00,000 10.75 12.75

You are required to determine –

1. The WACC and the optimum capital structure by traditional approach.
2. Also determine the equity capitalisation rate (cost of equity) by MM
approach

8. Consider the following capital structure of A ltd.:

Rs.
Equity capital 15,00,000
Reserves 12,00,000
Preference shares 12,00,000
Long term loans 27,00,000
Total 66,00,000

The cost of various sources are – Equity capital = 22.5%, Preference shares
(before taxes) = 13%, Loans (before taxes) = 16%. Tax rate on income is 40%,
company is required to pay 10% tax on preference dividend.

Calculate the weighted average cost of capital and make suitable assumptions.

9. A company’s share is quoted in market at Rs 160 (face value Rs 10). The

company pays Rs 8 as dividend and its earnings per share is Rs 12. The
expected growth rate by the investor is 15%. Please compute

a. The company’s cost of equity capital using all possible methods.

b. If expected growth rate is 17% per annum calculate the market price
per share under dividend growth approach.

c. If the company’s cost of capital is 17% and anticipated growth rate is

12% per annum

10 Suppose a company issues 5000 13% preference shares of face value Rs 100 at
Rs 90 each. The company pays Rs 3,000 as underwriting commission. The

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company is required to pay a dividend tax of 12.5% on the dividend paid by the
company. Calculate the cost of preference share capital to the company.

11. Calculate cost of each source of capital and the WACC

Rs.
Equity capital 22,00,000
Reserves 8,00,000
Preference shares (15%) 15,50,000
18% debentures 14,28,000
Total 59,78,000

Additional information –

1. Cost of Equity capital is 28%

2. Preference shares are issued at Rs 110 per share (face value Rs 100)

3. Debentures are issued at Rs 105 per debenture (face value Rs 100).

4. Tax rate on income is 33.5%, company is required to pay 12% tax on

preference dividend.
11 An investor expects a return in terms of earnings @ 25% from a company and
face value of the company is Rs 100. Calculate the market value of the shares of
the company if the company is earning @ 60% ( i.e. earnings per share = Rs 50)

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7 Dividend policies

7.1 Introduction

Dividend is amount paid to shareholders / owners for their investment in the

company. Dividend is distribution of profits and the amount of profits left out after
paying dividend is known as reserves. Dividend is of utmost importance in case
unlisted companies at it is the only source of revenue available to shareholders for
getting returns on their investment. In case of listed (listed on stock exchanges)
companies also dividend is important, but the shareholders can get their returns also
from appreciation in the share value. Deciding the dividend policy is an important
function of the finance manager and is decided based on the primary aim of
maximisation of shareholders wealth. Various approaches are followed for
determining what should be ideal dividend policy; some of them are reproduced in this
chapter. The factors, which affect the dividend policy of a company, can be discussed as
below –

a. Cash flows - Dividend payment automatically results in a cash outflow. The

finance manager has to consider the cash flow position of the company before
deciding the dividend policy of the company. Though a company may borrow funds
to pay the dividend, it is not a prudent policy.

b. Company’s expansion plans – As mentioned in the irrelevance approach below in

this chapter, dividend decision can be dependant on the capital budgeting of the
company. To make it simple it can be said that the dividend decisions depend
heavily on the companies plans to invest in expansion etc. Companies having heavy
growth may decide to keep dividends on hold, or declare lesser dividends even in
year of huge profits to fund its expansion plans. Whereas stagnant companies may
declare huge dividends as they may not have any expansion plans.

c. Legal aspects - In many countries dividend cannot be declared without

transferring a certain amount to reserves. Also dividend cannot be declared
without providing for depreciation in the accounts of the company. Hence a finance
manager has to take into account all the legal restrictions before declaring
dividend.

d. Effect on market price of the company – This is one of the most important factor
that determines the company’s dividend policy. Undoubtedly dividend declaration
affects the market price of the company. The effect of dividend mainly depends
upon the perceptions of the investors, their preference to liquidity and the reason
for investment.

e. Tax considerations – Dividend policy depends a lot on tax considerations. It is

because the taxability affects both the company as well as the shareholders. The

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amount of dividend is decided after taking into consideration the structure of

individual taxation and the dividend taxes.

f. Level of inflation – The dividend decision is also linked up with the level of
inflation in the economy. Increasing inflation inflates the net profit figures,
whereas the value in real terms may remain constant. The prices of assets go up
and the firm may require resources in excess of depreciation fund to replace its
existing assets. This may result in lesser funds available for paying the dividends.
Similarly the investors requirements also goes up with the increasing inflation and
they may expect higher dividends, so that its value remains the same in real terms.

g. Other factors – There are several other factors which affects the dividend policy of
the company like Management perceptions, rate of inflation in the economy,
industry practices, special occasions etc.

7.2 Walter approach

Prof. James Walter argues that in the long run, share price reflect only the present
value of expected dividends. Retentions influence stock prices only through their effect
on further dividends. It can be used to calculate different possible market prices and
considers the increase in dividend on account of internal returns on retained earnings.
The formula is simple to understand and easy to compute. Walter gives the following
formula –

D + Ra (E-D)
P = Ke

Ke

Where,

P = Market value of equity shares of the company

Ra = Return on retained earnings ( return on reserves)
E = Earnings per share
D = Dividend per share
Ke = cost of equity i.e. equity capitalisation rate.

Though this formula takes into consideration the internal rate of returns and cost of
equity, the formula has certain shortcomings –

h. The formula does not take into account taxation

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i. It ignores management policies and shareholders attitude towards the dividend

j. It ignores legal restrictions on declaration of dividends.

One important point in the Walter model is that it says –

1. if internal rate of return is more than the capitalisation rate then the company
must retain as much as possible to maximise the share price i.e. 0% dividend
and 100% retention will maximise the shareholders wealth.

2. If internal rate of return is lesser than the capitalisation rate then the company
must declare maximum dividend to maximise the share price i.e. 100%
dividend and 0% retention will maximise the shareholders wealth
The above statements can be elaborated with the help of following illustration –

Illustration 7.2.1

Consider the following data related to three companies A ltd., B ltd. and C Ltd

A Ltd. (%) B Ltd. (%) C Ltd. (%)

Internal rate of return (Ra) 15 20 10

Cost of equity capital (Ke) 10 15 15
Earnings per share (E) Rs 8 Rs 10 Rs 8

Calculate the value of an equity share for each of these companies applying Walter’s
formula, when Dividend payment ratio (i.e % dividend paid out of the earnings) is
50%, 25% and 90%. Also calculate the % of dividend at which the share price of each
company will be maximum.

Solution –

D + Ra (E-D)
1. P = Ke

Ke

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A Ltd. B Ltd. C Ltd.

When D/P ratio is 50% = (4 + 15% * ( 8-4) = (5 + 20% (10- = (4 + 10%(8-
/ 10%) / 10% 5)/ 15%)/ 15% 4)/15%) /15%

= Rs 100 = Rs 77.78 = Rs 44.44

When D/P ratio is 25% =(2 + 15% (8-2) / =(2.5 + 20%(10- = (2+10%(8-
10%) / 10% 2.5)/15%) / 2)/15%)/ 15%
15%
= Rs 110 = Rs 40
= Rs 83.33

When D/P ratio is 90% =(7.2+15%(8- =(9-20%(10- =(7.2+10%(8-

7.2)/10%)/10% 9)/15%)/15% 7.2)/15%)/15%

= Rs 84 = Rs 68.89 = Rs 51.52

2. As it can be seen in case of company A and company B the returns on retained

earnings (Ra) is more than Cost of equity capital (Ke) when Ra > Ke, 0% dividend and
100% retention will maximise the share price -

Share price of Company A at 0% dividend payout ratio –

Ra = 15
Ke = 10

P = (0+15%(8-0)/10%)/10%
= Rs 90

Share price of Company B at 0% dividend payout ratio –

Ra = 20
Ke = 15

P = (0+20%(10-0) / 15%) / 15%

= Rs 88.89

3. As it can be seen in case of company C the returns on retained earnings (Ra) is lesser
than Cost of equity capital (Ke) when Ra < Ke, 100% dividend and 0% retention will
maximise the share price -

Share price of Company C at 100% dividend payout ratio –

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Ra = 10
Ke = 15

P = (8+10%(8-8)/15%)/15%
= Rs 54

Hence it can be concluded that when Ra > Ke, Share price is maximum at 0% dividend
and when Ra < Ke, share price is maximum when dividend is 100%.

7.3 Gordon approach

Prof. Gordon asserts that investor prefers current dividend to the future capital gains,
as future capital gain is uncertain. The dividend policy affects the market value of the
shares. Under Gordon model the market price can be determined as follows –

P= E(1-Rr)

Ke – (Rr*Ra)

Where,

E = Earnings per share (EPS)

Rr = Retention ratio (E – D)
Ke = Cost of equity
Ra = Internal rate of returns

Thus the Gordon formula suggests that the market price of shares depend upon the
dividend paid by the company and the expected growth rate.

Illustration 7.3.1

Consider the following information of A ltd

EPS Rs 10
Rate of return 20%
Equity capitalisation rate (Ke) 17%

Find out the market price of share under Gordon model if the dividend payout is 50%,
25% , 75%

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Solution –

P= E(1-Rr)

Ke – (Rr*Ra)

1. At 50% dividend payout –

E = Rs 10
Rr = 50% (or 0.50)
Ra = 20%(or 0.20)
Ke = 17%

P = 10(1-0.5) /0.17-(0.50*0.20)
= 5 / 0.07
= Rs 71.43

2. At 25% dividend payout –

E = Rs 10
Rr = 75% (or 0.75)
Ra = 20%(or 0.20)
Ke = 17%

P = 10(1-0.75) /0.17-(0.75*0.20)
= 2.5 / 0.02
= Rs 500

3. At 75% dividend payout –

E = Rs 10
Rr = 25% (or 0.25)
Ra = 20%(or 0.20)
Ke = 17%

P = 10(1-0.25) /0.17-(0.25*0.20)
= 7.5 / 0.12
= Rs 62.5

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7.4 Irrelevance approach

The irrelevance approach suggests that dividend policy has no effect on the market
price of the company. In short the market price is immaterial of that of dividend.
According to this school of thought the value of firm depends upon the earning and not
dividends. There are two models which advocates this approach, they are as follows –

Residuals theory – As the name indicates this theory believes that the dividend is
residual part of the earnings; the first decision taken is how much shall be
reinvested. This theory is based on an assumption that investment proposals are
financed by retained earnings. Thus dividends can not be maintained at a
particular level year after year as it depends upon the company’s investment
decision.

Modigliani – Miller approach - The MM approach also is based on the concept

that the market price depends upon the earnings and not the dividend. MM used
the concept of arbitrage to elaborate this approach. The formuls given by MM is
as follows –

Po = (Di + Pi)

(1+Ke)

Where,

Po = Current market price

Di = Expected dividend at the end of period
Pi = Expected market price at the end of period
Ke = Cost of equity capital

Similar to the MM approach on cost of capital, this approach also is more or less a
theoretical approach as the assumptions are quite impracticable e.g.
Assumptions like no corporate tax, existence of perfect capital market hardly
stands correct in practice.

To sum up though some approaches believe that dividend is irrelevant, in practice

dividend is certainly a relevant factor for determining the market price, especially in
Indian scenario it is a very important factor as Indians usually prefer liquidity.

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Illustration 7.4.1

Diamond engineering company has 10,00,000 equity shares outstanding at the start of
the accounting year 1997. The ruling market price per share is Rs 150. The board of
Directors of the company contemplates declaring Rs 8 per share as dividend at the end
of the current year. The rate of capitalisation appropriate to risk class to which
company belongs is 12% (Ke)

a. Based on MM approach, calculate the market price per share of the company
when the contemplated dividend is i. Declared and ii. Not declared

b. How many new shares are to be issued by the company at the end of the
accounting year on the assumption that the Net income for the year is Rs 2
crores? Investment budget is Rs 4 crores and i. The above dividends are
distributed and ii. They are not distributed.

c. Show that the total market value of the shares at the end of the accounting year
will remain the same whether dividends are either distributed or not
distributed. Also find out the current market value of the firm under both
situations.

(ICWA, Final, Dec 97)

Solution –

a. The formula given by MM is as follows –

Po = (Di + Pi)

1 + Ke
Where,
Po = Rs 150
Ke = 12%
Di = 8

i. If dividend is declared

150 = (8 + Pi) / (1+0.12)

Pi = (150 * 1.12) –8
Pi = Rs 160

ii. If dividend is not declared

150 = (0 + Pi) / (1+0.12)

Pi = (150 * 1.12) –0
Pi = Rs 168

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b. Calculation of number of shares to be issued

Rs lakhs
Dividends Dividends not
distributed distributed
Net income 200 200
Total dividend (10,00,000 * 8 ) 80 -
Retained earnings 120 200

Investment budget 400 400

Amount to be raised by new issues (a) 280 200

Relevant market price (Rs per share) 160 168

(b)
No of new shares issued 1,75,000 1,19,050
(a) / (b)

c. Total number of shares at the end of the year

Dividends Dividends not

distributed distributed

Existing shares 10,00,000 10,00,000

New issue 1,75,000 1,19,048

Total no of shares (a) 11,75,000 11,19,048

Market price per share (b) 160 168

Market value of shares (a) * (b) 18,80,00,000 18,80,00,064

To conclude total value of shares remains almost unaltered whether dividends are
distributed or not.

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7.5 Self examination questions

7.5.1 Detailed questions –

1. Consider the following data related to three companies Z ltd., X ltd. and Y Ltd

Z Ltd. (%) X Ltd. (%) Y Ltd. (%)

Internal rate of return (Ra) 12 21 19

Cost of equity capital (Ke) 18 13 14
Earnings per share (E) Rs 10.5 Rs 15 Rs 12

Calculate the value of an equity share for each of these companies applying Walter’s
formula, when Dividend payment ratio (i.e % dividend paid out of the earnings) is
25%, 50% and 100%. Also calculate the % of dividend at which the share price of each
company will be maximum.

2. Consider the following information of A ltd

EPS Rs 15
Rate of return 25%
Equity capitalisation rate (Ke) 15%

Find out the market price of share under Gordon model if the dividend payout is 50%,
25%, 75%

3. Company A has 55,000 equity shares outstanding at the start of the accounting year.
The ruling market price per share is Rs 125. The board of Directors of the company
contemplates declaring Rs 5 per share as dividend at the end of the current year. The
rate of capitalisation appropriate to risk class to which company belongs is 15% (Ke)

d. Based on MM approach, calculate the market price per share of the company
when the contemplated dividend is i. Declared and ii. Not declared

e. How many new shares are to be issued by the company at the end of the
accounting year on the assumption that the Net income for the year is Rs
25,00,000? Investment budget is Rs 35,00,000 and i. The above dividends are
distributed and ii. They are not distributed.

f. Show that the total market value of the shares at the end of the accounting year
will remain the same whether dividends are either distributed or not
distributed. Also find out the current market value of the firm under both
situations.

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4. Write pros and cons of Walter model of dividend policy

[Link] in details what are the factors a finance manager should consider before
deciding the dividend policy of the company

7.5.2 objective questions –

1. Some of the key assumptions of Modigliani and Miller approach are –

a. No corporate taxes
b. Existence of perfect capital market
c. No transaction costs
d. No government control

2. Gordon’s model asserts that –

a. Dividend policy is irrelevant for market price

b. Investors prefer dividend rather than future appreciation in price
c. Both
d. None

3. Walter model argues that –

a. Share price reflect only the present value of expected dividends

b. Dividend policy is a residual decision and is a by-product of capital
budgeting decision
c. Investor only considers present dividend
d. None of the above

4. Which one of the following is not a factor determining the dividend policy of the
company –

a. Taxation
b. Legal requirements
c. Company’s labour policies
d. Market expectations
e. Cash flows
f. Policy followed by the competitors
g. Company’s expected returns on it’s investment
h. Level of inflation in the economy

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5. Which of the following is not a part of Walters formula –

a. P = Market value of equity shares of the company

b. Ra = Return on retained earnings (return on reserves)
c. E = Earnings per share
d. Pi = Expected market price at the end of period
e. D = Dividend per share

6. According to Modigliani and Miller –

a. Dividend affects the market price

b. Share price depends upon the earnings and not the dividend
c. Inflation affects the dividend
d. Bonus shares affect the market price

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8 Capital budgeting

8.1 Introduction

After studying sources of finance, estimation of financial requirements and cost

analysis, we will now discuss the application of the finances raised. This investment of
funds is also termed as capital budgeting. Capital budgeting decisions are necessary to
decide where to invest, how much should be invested and which investment will be
most beneficial to the company.

8.2 What is capital budgeting?

The term capital budgeting indicates budgeting for capital assets. The capital
budgeting mainly involves decisions as to setting up of new plant, expansion of
existing facilities, make or buy decisions etc. It includes a financial analysis of various
proposals regarding capital expenditure, mainly analysing the benefits arising from the
project and choosing the best alternative. The capital budgeting decisions involve
extensive use of various capital budgeting techniques.

8.2.1 Factors affecting the capital budgeting decisions - The reasons why these
decisions are of utmost importance, and why it needs to be taken carefully can be
summerised as follows –

a. Generally capital budgeting decisions involve huge investment and loss of such
investment may lead to bankruptcy of the company

b. The decisions like purchase of land, plant, building, patents etc. cannot be
reversed easily and it becomes a sunk cost.

c. Capital budgeting decisions involve long term and permanent commitments

and has an effect over the company’s future earnings.

d. Capital budgeting decisions are necessarily backed by huge funding decisions

and failure in the implementation of the project may lead to problem of excess
funding.

e. Capital budgeting decisions are tough to take as it is difficult to forecast he

future cash inflows from the assets with accuracy.

A businessman always has a number of opportunities to invest his money. A company

manufacturing two wheelers may have numerous options of either buying a spare part
say a spark plug or manufacture it by itself. Such kind of decisions involves various

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aspects like analysis of cost and benefit, opportunity costs, gestation period etc.
Though our study of all these factors and techniques will be aiming to maximise the
monetary profits, in real life there may be other factors that may affect the capital
budgeting decisions. Some of the examples of such factors can be –

- Social aspects – a company may decide to undertake a social project even

though it may not be economically viable
- Business aspect – A company maybe able to buy a product cheaper than
manufacture it but still it may manufacture it for utilising its labour effectively,
or to maintain the secrecy of the ingredients of the company’s products.
- Legal and political aspect – A project may be started at a particular location
due to some legal or political aspects, even though the same project can be
operated cheaper from some other location.
- Risk involved – A business man prefer investing in a low return low risk
project, even though he may have an option to invest in some high risk and
high return project.

8.3 Methods and techniques of capital budgeting

The capital budgeting techniques are bifurcated between 2 broad approaches –

a. Traditional techniques–
1. Payback period method
2. Accounting rate of returns method

b. Discounted cash flow techniques –

1. Profitability index
2. Net present value method
3. Terminal value method; and
4. Internal rate of return (IRR) method

Following are the traditional techniques of capital budgeting

8.3.1 Pay back period – This method is used to simply calculate the period within
which the cost of the project will be completely recovered. The calculation is done on
the basis of cash flows. The period of payback is the period within which the total cost
of the project is recovered. Cash inflow is nothing but profit after tax but before
depreciation

Merits of the payback period method -

1. The method is very simple to understand and apply. It clearly states the period
till which no profit can be expected from the project. Knowing the payback
period is essential for every investment as most of the businessman are
interested in knowing when are they going to get their money back.

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2. The method aims at selecting projects generating liquidity in earlier years, this
is important for decision making when cash availability is a constraint and / or
cost of capital is very high.

3. The payback period method is also used to analyse the risk associated with the
project, lesser the payback period lesser the risk and vice versa.

Demerits of the payback period method

1. The payback period method totally ignores profitability aspect and talks only
about the capital recovery. Suppose A ltd wants to invest in a project having a
payback period of 3 years and expects a return of 15% on its investment. If the
payback period of project Z is 2.5 years and the return is 10% on the
investment then A ltd will choose the project if the payback period method is
followed, and end up getting lesser returns than what is expected.

2. It is not necessary that every businessman is interested in choosing a project

with lesser payback period and he may be interested in choosing a project with
higher profitability.

3. The method doers not take into consideration the time value of money and tha
opportunity cost, which is considered under the net present value method.

Illustration 8.3.1

Company A wishes to invest Rs 10,00,000 in a project. The estimated profit before

depreciation and taxes is Rs 6,00,000 per year. The depreciation is to be provided @
20% straight line on the project cost. The tax rate is @ 50%, calculate the payback
period for the project.

Solution –

The cash flow from the project can be estimated as follows (i.e. Profit after tax +
depreciation) –
Rs.
Profit before depreciation and tax 6,00,000
Less : depreciation @20% on 10,00,000 2,00,000

Profit before tax 4,00,000

Less : Tax @ 50% 2,00,000

Profit after tax 2,00,000

Add : depreciation 2,00,000

Net cash flow 4,00,000

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* Students are requested to note that the cash flow should be calculated in this
way only and do not reduce taxes directly from profit before depreciation and
tax.

Depreciation has been added back as it is non-cash expenditure

The payback period = Rs 10,00,000

4,00,000

= 2.5 years or 2 years and 6 months.

If the finance manager is required to choose amongst two or more projects he will
obviously choose the project having lesser payback period. Again before appraising a
project the finance manager should also decide the maximum payback period which
his company is willing to accept, so if he is appraising three projects having 5,6 and 7
years payback period

Illustration 8.3.2

Company A is willing to invest in a project costing Rs 50,000. The company provides

depreciation @ 20% on the project cost ( SLM method). The estimated profit after tax
for 5 years is as follows –

Year Amount
Rs.
1 0
2 550
3 1,700
4 3,250
5 6,750

Compute the payback period of the project

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Solution –

As the payback period can be calculated only on the basis of cash inflows, first step will
be to identify the cash inflows –

Year Profit after + depreciation = Cash flow

tax

1 0 10,000 10,000
2 550 10,000 10,550
3 1,700 10,000 11,700
4 3,250 10,000 13,250
5 6,750 10,000 16,750

As the cash flows are uneven we cannot simply divide the total cash out flow. Instead a
total of cash flow after each year should be taken –

Year Cash flow Cumulative Cash flow

1 10,000 10,000
2 10,550 20,550
3 11,700 32,250
4 13,250 45,500
5 16,750 62,250

It can be clearly seen that the payback period lies somewhere between year 4 and 5

It can be calculated as follows –

Last years revenue = 16,750
Assuming that the revenue accrues evenly throughout the year, revenue per month =
16,750 / 12 = 1396. Now up-to year 4 we have recovered 45,500 that means Rs 4,500
remains to be recovered in year 5. Thus the no of months of year 5 required = 4500 /
1396 = 3.22 = nearly 4 months

Hence the payback period = 4 years and 4 months.

8.3.2 Accounting rate of return method (ARR) – Accounting or average rate of

return means the average annual yield on the project. The average rate of return is
Profit after tax as a percentage of the total amount invested. It is simple mathematics
like if A is getting Rs 12 on Investment of Rs 120 means he is getting 10% return on his
investment (12/120). It is important to note here that this method does not take into
consideration cash flows but considers profits

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Merits of the accounting rate of return method –

1. This method is easy to understand and apply

2. It covers the major aspect of profitability and helps the investor in knowing his
rate of return.

Demerits of the accounting rate of return method –

1. It ignores the time value of money

2. It does not take into consideration the uneven flow of cash and does not calculate
the returns on year to year basis

3. It is not a good comparing technique i.e. project chosen by using this method can
be less profitable than the project rejected by using this technique.

Illustration 8.3.3

A ltd is wishing to start a new project requiring a capital investment of Rs 15,00,000

and expected profit after tax as follows –

Year Profit after tax

Rs.
1 75,000
2 1,00,000

3 1,87,500
4 1,95,000
5 1,20,000

6,77,500

Assuming that the project has only 5 years life and there will be no salvage value at the
end of the 5th year calculate the ARR of the project.

Solution –

The ARR can be calculated with the help of following formula –

ARR (in%) = Total profits * 100

Net investment in the project * no of years of profit

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In current problem –

Total profit = Rs 6,77,500

Total investment = Rs 15,00,000
Number of years =5

ARR = 6,77,500*100

15,00,000 * 5

= 9.03%

Now consider the company has an option to invest the same amount @ 12% pa. Then
it is quite clear that the company will not go for the project but will select to invest in
the fixed deposit.

Illustration 8.3.4

Let us consider that the same company does not have an option to invest in fixed
deposit but has an option to choose one out of two projects having Profit after tax as
follows (investment amount is same ) –

Year Project A Project B

1 75,000 0
2 1,00,000 0
3 1,87,500 0
4 1,95,000 3,00,000
5 1,20,000 3,77,500

6,77,500 6,77,500

Assuming that the projects have only 5 years life and there will be no salvage value at
the end of the 5th year calculate the ARR of both the projects.

Solution –

ARR of project A is already calculated in illustration 8.3.3, which is 9.03%

ARR of project B = Total profits * 100

Net investment in the project * no of years of profit

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In current problem –

Total profit = Rs 6,77,500

Total investment = Rs 15,00,000
Number of years =5

ARR = 6,77,500*100

15,00,000 * 5

= 9.03%

It can be clearly inferred from the ARR technique that both the projects are equal,
though there is no revenue for three years in case of project B. This problem highlights
the main limitation of this method. It can be clearly seen that choosing project A is
better as the revenue starts in earlier years, though the ARR method is unable to pick
project A as a better project

Following are the discounted cash flow techniques of capital budgeting

8.3.4 Net present value technique (NPV) or discounted cash flow technique – This
is the most popular method for evaluation of a capital project. This method is designed
to take into account the time value of money. Net present value of a project is nothing
but the present value of all the cash flows spread over a period of time.

Net Present Value (NPV) = CF0 + CF1 +…………………….+ CFn

(1+K)^0 (1+K) ^1
(1+K)^n

Where,

CF 0 to n = Cash flow at the end of year 0 to n. It includes both a cash inflow and a cash
outflow.

n = Life of the project

K = Cost of capital used as discounting rate.

This method of capital budgeting is based on determination of amount and timing of

the cash flows. The cash flows include both cash inflows and cash outflows. The cash
inflows can be calculated by simply adding depreciation and non-cash items to profit
after tax.

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Merits of the Net present value method –

1. NPV method takes into account the time value of money

2. NPV is nothing but the value of money as on today, when it is received at a later
date. This eliminates the drawbacks of ARR method as it considers timing of
cash flow as well as uneven cash flows.

3. The whole stream of cash flows is considered

4. It is the best way to analyse a project when the company has multiple choices
as it is a very effective comparative analysis

5. It gives due weight-age to timing of cash flow, due to discounting the cash flows
at a later date gets reduced more than the cash flows at earlier dates. It is
obvious that the following 2 projects are not same even though their total cash
flow is same -

Year Project A Project B

1 5,00,000 3,00,000
2 4,00,000 4,00,000
3 3,00,000 5,00,000
Assuming that the cash outflow of both the projects is same, Project A is better than
projects B even though both projects have same total cash inflow.

Calculation of net present value –

Illustration 8.3.5

Let us assume that the initial cash out flow of project A is Rs 5,00,[Link] project is
expected to generate a cash inflow as follows –

Year Cash inflow

Rs.

1 1,15,000
2 1,14,000
3 1,34,000
4 1,40,000
5 2,50,000

Total 7,53,000

Now assume that the discounting rate or the expected rate of return from project A is
10%. Calculate the net present value of project A and write your conclusions.

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Solution –

1. The concept of NPV requires calculating what Rs 1,15,000 is worth today when
it is going to be received at the end of the year. To put it simply if a person can
invest Rs 1,00,000 @ 10% for a year then he’ll receive Rs 1,10,000 at the end of
the year or if he is receiving Rs 1,10,000 then it is worth Rs 1,00,000 today.
This what is net present value. Now let us calculate the Present Value for Rs
1,15,000 @ 10% -

If a person invests Rs 100 today gets Rs 110 after 1 year, if he is getting Rs

1,15,000 after 1 year how much he is investing –
1,15,000 / 110 *100 = Rs 1,04,545
We can counter check it by – 1,04,545 + 104,545 * 10% = 1,15,000

2. In other word the multiplying factor @ 10% discounting rate for year 1 is
100/110 = 0.909 (which is present value of Re 1 received after 1 year).
Similarly for year 2 it will be – 100 / 121 = 0.826.
121 is calculated as follows –
100*10%+100 = 110 + 110*10% = 121 (discounting rate is always calculated
considering compounding interest)

3. The table of discounting @10% for 6 years is –

Year Discount factor
@ 10%
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6 0.564

4. Calculation of NPV for the given project –

Year Cash inflows / (outflow) Discounting factor Present value

@ 10% Rs.
0 (5,00,000) 1 (5,00,000)
1 1,15,000 0.909 1,04,545
2 1,14,000 0.826 94,164
3 1,34,000 0.751 1,00,634
4 1,40,000 0.683 95,620
5 2,50,000 0.621 1,55,250
NPV 50,231

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5. To conclude we can say that @ 10%, effectively the company is getting Rs

5,50,231 as on today against the investment of Rs 5,00,000 and hence company
is having a positive net present value of Rs 50,231.

6. A proposal can be acceptable (from financial viewpoint) only when its’ net
present value = or > 0.

[Link] Discounting table at various discounting percentages (upto 10 years)

Year 5% 8% 10% 12% 15% 16%

1 0.952 0.926 0.909 0.893 0.870 0.862
2 0.907 0.857 0.826 0.797 0.756 0.743
3 0.863 0.794 0.751 0.712 0.658 0.641
4 0.822 0.735 0.683 0.636 0.572 0.552
5 0.783 0.681 0.621 0.567 0.497 0.476
6 0.746 0.630 0.564 0.507 0.432 0.410
7 0.710 0.583 0.513 0.452 0.376 0.354
8 0.676 0.540 0.467 0.404 0.327 0.305
9 0.644 0.500 0.424 0.361 0.284 0.263
10 0.614 0.463 0.386 0.322 0.247 0.227

Year 20% 22% 25% 30%

1 0.833 0.820 0.800 0.769
2 0.694 0.672 0.640 0.592
3 0.579 0.551 0.512 0.455
4 0.482 0.451 0.410 0.350
5 0.402 0.370 0.328 0.269
6 0.335 0.303 0.262 0.207
7 0.279 0.249 0.210 0.159
8 0.233 0.204 0.168 0.123
9 0.194 0.167 0.134 0.094
10 0.162 0.137 0.107 0.073

Students should note that this table is not exclusive and in examination some other
factor may also be asked (say 7% or 26%), students should master the art of
calculation of these factors.

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Illustration 8.3.6

Company A is willing to invest in a project costing Rs 50,000. The estimated Cash flows
for 5 years is as follows –

Year Amount
Rs.

1 10,000
2 10,550
3 11,700
4 13,250
5 16,750

Calculate the NPV of the project @ 10% and 5% and comment on its viability

Solution –

Calculation of the Net present value @ 10% discounting factor

Year Cash inflows / (outflow) Discounting factor Present value

@ 10% Rs.
0 (50,000) 1 (50,000)
1 10,000 0.909 9,090
2 10,550 0.826 8,714
3 11,700 0.751 8,787
4 13,250 0.683 9,050
5 16,750 0.621 10,402
NPV (3957)
Calculation of the Net present value @ 5% discounting factor

Year Cash inflows / (outflow) Discounting factor Present value

@ 5% Rs.
0 (50,000) 1 (50,000)
1 10,000 0.952 9,520
2 10,550 0.907 9,569
3 11,700 0.863 10,097
4 13,250 0.822 10,892
5 16,750 0.783 13115
NPV 3193

Comment – The proposal is unacceptable at 10% discounting factor as the NPV is

negative, whereas the same proposal is acceptable at 5% discounting rate as the NPV is
positive.

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Note - a positive NPV means a more than expected returns, if a company is considering
two projects and wishing to continue only with the one which is more profitable then
the projects are compared at the same discounting rate and the project with higher net
present value is selected even if NPVs of both the project are positive.

Illustration 8.3.7

Please evaluate the following two projects with Net present value technique –

Year Project X Project Y

0 Cost (80,000) (80,000)
1 20,000 50,000
2 10,000 40,000
3 35,000 20,000
4 40,000 15,000
5 50,000 15,000

Consider the project at 15% discounting rate and chose the better alternative.

Solution –

Evaluation of project X @ 15% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (80,000) 1 (80,000)
1 20,000 0.870 17,400
2 10,000 0.756 7,560
3 35,000 0.658 23,030
4 40,000 0.572 22,880
5 50,000 0.497 24,850
NPV 15,720

Evaluation of project y @ 15% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (80,000) 1 (80,000)
1 50,000 0.870 43,500
2 40,000 0.756 30,240
3 20,000 0.658 13,160
4 15,000 0.572 8,580

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5 15,000 0.497 7,455

NPV 23,235

Comments – As NPV of project Y is higher than that of project X it is better to accept

project Y. It can be also noticed that the total cash inflow of project X is Rs 1,55,000
whereas total cash inflow of project Y is Rs 1,40,000 and still project Y is showing more
returns under the NPV technique. This because of the time value of money, it highlights
the point that the question when? is equally important as that of How much?

Illustration 8.3.8

Company A ltd. is considering 2 projects –

Project A costs Rs 95,000 and project B costs Rs 1,10,000, the cash outflow is split in 2
parts for project B half amount has to be paid immediately and half to be paid at the
end of year 2. The expected cash inflows are as follows –

Year Project A Project B

1 20,000 -
2 50,000 75,000
3 35,000 60,000
4 20,000 50,000
5 25,000 -

Evaluate the two projects with the NPV technique at 8% discounting rate.

Solution –

Evaluation of project A @ 8% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (95,000) 1 (95,000)
1 20,000 0.926 18,520
2 50,000 0.857 42,850
3 35,000 0.794 27,790
4 20,000 0.735 14,700
5 25,000 0.681 17,025
NPV 25,885

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Evaluation of project B @ 8% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (55,000) 1 (55,000)
1 - 0.926 -
2 20,000* 0.857 17,140
3 60,000 0.794 47,640
4 50,000 0.735 36,750
5 - 0.681 -
NPV 46,530

* - Inflow – outflow = 75,000-55,000 = 20,000

Comments – Project B is better than project A as the NPV of project B is much more
than project A.

Illustration 8.3.9

Company A is considering a project with expected life of 5 years. The initial cash
outflow is expected to be as follows –

Machinery purchased Rs 2,72,000

Working Capital Rs. 60,000

Rs. 3,32,000

The working capital will be fully realised at the end of the 5th year. The estimated scrap
value of the plant is Rs 10,000

The expected cash flow is as follows -

Year Rs.
1 70,000
2 1,00,000
3 1,30,000
4 90,000
5 5,000
You are required to evaluate the project considering the rate of discounting to be 11%
and 15%

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Solution –

Evaluation of the project @ 12% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 12% Rs.
0 (3,32,000) 1 (3,32,000)
1 70,000 0.893 62,510
2 100,000 0.797 79,700
3 130,000 0.712 92,560
4 90,000 0.636 57,240
5 5,000 0.567 2,835
5 60,000 0.567 34,020
5 10,000 0.567 5,670
NPV 2,535

In the year 5 the realised current assets and scrap are taken as cash inflows. At 12%
present value the project is acceptable as the NPV is positive.

Evaluation of the project @ 15% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (3,32,000) 1 (3,32,000)
1 70,000 0.870 60,900
2 100,000 0.756 75,600
3 130,000 0.658 85,540
4 90,000 0.572 51,480
5 5,000 0.497 2,485
5 60,000 0.497 29,820
5 10,000 0.497 4,970
NPV -21,205

Comment – Though the project is acceptable at 12% discounting factor, it is not

acceptable at 15% discounting factor as the NPV is negative

8.3.5 Profitability index method (PI) – This is a part of discounted cash flow
technique and it explains the cost benefit relations between the inflows and the
outflows of a proposal. The PI shows that how much inflows are expected for every
one rupee of outflows. PI can be calculated as -

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PI = Present value of inflows

Present value of inflows

Illustration 8.3.10

Please evaluate the following two projects with Net present value technique –

Year Project X Project Y

0 Cost (70,000) (75,000)
1 30,000 50,000
2 20,000 40,000
3 35,000 20,000
4 40,000 25,000
5 50,000 5,000

Consider the project at 8% discounting rate and calculate the Profitability index of
both the projects.

Solution -

Calculation of PI of project x @ 8% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (70,000) 1 (70,000)
1 30,000 0.926 27,780
2 20,000 0.857 17,140
3 35,000 0.794 27,790
4 40,000 0.735 29,400
5 50,000 0.681 34,050
Total cash outflows (70,000)
Total cash inflows 1,36,160

PI = Present value of inflows

Present value of inflows

= 1,36,160

70,000

= 1.95

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Calculation of PI of project Y @ 8% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (75,000) 1 (75,000)
1 50,000 0.926 46,300
2 40,000 0.857 34,280
3 20,000 0.794 15,880
4 25,000 0.735 18,375
5 5,000 0.681 3,405
Total cash outflows (75,000)
Total cash inflows 118,240

PI = Present value of inflows

Present value of inflows

= 1,18,240

75,000

= 1.58

8.3.6 Internal rate of return (IRR) – Internal rate of return is the rate at which the
discounted cash inflows are equal to discounted cash outflows. The internal rate of
return of a project is the discount rate at which the net present value of a project is nil.
The IRR is compared with the minimum rate of return expected by the firm for its
investment.

The merits of IRR method can be summarised as follows –

1. Its takes into account the time value of money

2. It gives the exact amount of returns which the project is offering, unlike NPV
method where positive NPV only denotes that the returns are more than the
minimum desired returns and it never outlines the exact amount of returns

3. This method is independent of that of NPV method and may give different
results from the NPV method.

Demerits of the IRR method –

1. The calculation process is difficult and tedious

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2. As it may give different results from that of NPV method, it is difficult to form a
decision just on the basis of IRR method.
Illustration 8.3.11

An investment of Rs 1,36,000 yields the following cash inflows –

Year Rs.
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

1,80,000

Calculate the internal rate of return of the above proposal

Solution –

Calculation of present value of project @ 8% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (1,36,000) 1 (1,36,000)
1 30,000 0.926 27,780
2 40,000 0.857 34,280
3 60,000 0.794 47,640
4 30,000 0.735 22,050
5 20,000 0.681 13,620
NPV 9,370

Calculation of present value of project @ 10% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 10% Rs.
0 (1,36,000) 1 (1,36,000)
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
2,280

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Note – It can be noted that the NPV declines with the increase in the discounting rate
as we are required to reach 0 we have to further increase the rate. Let us assume it to
be 10.7%

Calculation of present value of project @ 10.7% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 10.7% Rs.
0 (1,36,000) 1 (1,36,000)
1 30,000 0.903 27,090
2 40,000 0.816 32,640
3 60,000 0.737 44,220
4 30,000 0.665 19,950
5 20,000 0.602 12,040
-60

The NPV @ 10.7% is –60 or almost nil. Many times it is impracticable to calculate the
exact IRR and therefore the IRR at which the net present value closes to zero can also
be taken as IRR.

Note – though the IRR can be calculated by interpolation method, students can
calculate by trial and error. The golden rule for trial and error method is – if IRR is
negative at any given discounting rate use a lesser rate and if IRR is positive use higher
rate.

Illustration 8.3.12

Please evaluate the following two projects by IRR technique –

Year Project X Project Y

0 Cost (1,01,600) (85,000)
1 30,000 55,000
2 10,000 35,000
3 35,000 20,000
4 40,000 25,000
5 50,000 15,000

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Solution -

1. Calculation of present value of project X @ 15% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (1,01,600) 1 (1,01,600)
1 30,000 0.870 26,100
2 10,000 0.756 7,560
3 35,000 0.658 23,030
4 40,000 0.572 22,880
5 50,000 0.497 24,850
NPV 2,820

As NPV is positive NPV should be calculated at a higher rate – say 20%

Calculation of present value of project X @ 20% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 20% Rs.
0 (1,01,600) 1 (1,01,600)
1 30,000 0.833 24,990
2 10,000 0.694 6,940
3 35,000 0.579 20,265
4 40,000 0.482 19,280
5 50,000 0.402 20,100
NPV -10,025

As NPV is negative NPV should be calculated at a lesser rate – say 16% (16% as NPV is
closer to zero for 15%)

Calculation of present value of project X @ 16% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 16% Rs.
0 (1,01,600) 1 (1,01,600)
1 30,000 0.862 25,860
2 10,000 0.743 7,430
3 35,000 0.641 22,435
4 40,000 0.552 22,080
5 50,000 0.476 23,800
NPV 5

As NPV is 5 i.e almost zero, it can be said that the IRR of project X is 16%

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2. Calculation of present value of project Y @ 15% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (85,000) 1 (85,000)
1 55,000 0.870 47,850
2 35,000 0.756 26,460
3 20,000 0.658 13,160
4 25,000 0.572 14,300
5 15,000 0.497 7,455
NPV 24,225

As NPV is positive, NPV should be calculated at a higher rate – say 30%

Calculation of present value of project Y @ 30% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 30% Rs.
0 (85,000) 1 (85,000)
1 55,000 0.769 42,295
2 35,000 0.592 20,720
3 20,000 0.455 9,100
4 25,000 0.350 8,750
5 15,000 0.269 4,035
NPV -100

As NPV is –100, IRR is slightly lesser than 30% say 29.95%. In such case IRR can be
taken as 30%.

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8.4 Solved problems

Problem 8.4.1

A ltd is evaluating a project having an initial investment of Rs 40,000 and the following
cash inflows –

Year Rs.
1 5,000
2 7,000
3 7,000
4 6,000
5 12,000
6 15,000
7 10,000

The company’s opportunity cost is 12% and the company is wishing to evaluate the
project on the basis of NPV method and profitability index (PI) method.

Solution –

Calculation of present value of the project @ 12% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 12% Rs.
0 (40,000) 1 (40,000)
1 5,000 0.893 4,465
2 7,000 0.797 5,579
3 7,000 0.712 4,984
4 6,000 0.636 3,816
5 12,000 0.567 6,804
6 15,000 0.507 7,605
7 10,000 0.452 4,520
NPV -2,227

As NPV @12% discounting rate is negative the proposal should be rejected.

Profitability Index = Present value of cash inflows

Present value of cash outflows

PI = 37773 / 40000
= 0.94

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Problem 8.4.2

A company proposes to undertake two mutually exclusive projects AXE and BXE :

AXE BXE
Initial capital outlay Rs 22,50,000 Rs. 30,00,000
Economic life (years) 4 7
After tax annual cash inflows
Year
1 6,00,000 5,00,000

2 12,50,000 7,50,000
3 10,00,000 7,50,000
4 7,50,000 12,00,000
5 - 12,50,000
6 - 10,00,000
7 - 8,00,000

The company’s cost of capital is 16%. Please calculate the net present value and IRR
for both the projects

Solution -

1. Calculation of NPV of both the projects

Calculation of present value of the project AXE @ 16% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 16% Rs.
0 (22,50,000) 1 (22,50,000)
1 6,00,000 0.862 5,17,200
2 12,50,000 0.743 9,28,750
3 10,00,000 0.641 6,41,000
4 7,50,000 0.552 4,14,000
NPV 2,50,950

Calculation of present value of the project BXE @ 16% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 16% Rs.
0 (30,00,000) 1 (30,00,000)
1 5,00,000 0.862 4,31,000
2 7,50,000 0.743 5,57,250

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3 7,50,000 0.641 4,80,750

4 12,00,000 0.552 6,90,000
5 12,50,000 0.476 5,93,750
6 10,00,000 0.410 4,10,000
7 8,00,000 0.354 2,83,200
NPV 4,46,350

As NPV of project BXE is substantially higher than project AXE project BXE is more
profitable.

2. Calculation of IRR of both the projects

Calculation of present value of the project AXE @ 20% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 20% Rs.
0 (22,50,000) 1 (22,50,000)
1 6,00,000 0.833 4,99,800
2 12,50,000 0.694 8,67,500
3 10,00,000 0.579 5,79,000
4 7,50,000 0.482 3,61,500
NPV 57,800

Calculation of present value of the project AXE @ 21% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 21% Rs.
0 (22,50,000) 1 (22,50,000)
1 6,00,000 0.826 4,95,600
2 12,50,000 0.683 8,53,650
3 10,00,000 0.564 5,64,000
4 7,50,000 0.467 3,50,250
NPV 13,500

The IRR of AXE appears to be slightly higher than 21%

Calculation of present value of the project BXE @ 20% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 20% Rs.
0 (30,00,000) 1 (30,00,000)
1 5,00,000 0.833 4,16,500

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2 7,50,000 0.694 5,20,500

3 7,50,000 0.579 4,34,250
4 12,00,000 0.482 5,78,400
5 12,50,000 0.402 5,02,500
6 10,00,000 0.335 3,35,000
7 8,00,000 0.279 2,23,200
NPV 10,350

Calculation of present value of the project BXE @ 21% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 21% Rs.
0 (30,00,000) 1 (30,00,000)
1 5,00,000 0.826 4,13,000
2 7,50,000 0.683 5,12,250
3 7,50,000 0.564 4,23,000
4 12,00,000 0.467 5,60,400
5 12,50,000 0.386 4,82,500
6 10,00,000 0.319 3,19,000
7 8,00,000 0.263 2,10,400
NPV -79,450

IRR of project AXE is slightly higher than 21% and in case of BXE it is slightly higher
than 20%.

Problem 8.4.3

Precision instruments is considering two mutually exclusive projects X and Y.

Following details are made available to you :
Rs. In lacs
Project X Project Y

Project cost 700 700

Cash inflows
Year
1 100 500
2 200 400
3 300 200
4 450 100
5 600 100

Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects :

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i. NPV using 10% discounting rate

ii. IRR and
iii. Profitability index
(ICWA inter, June 1995)

Solution -

1. Calculation of Net present value

Calculation of present value of the project X @ 10% discounting rate

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (700) 1 (700)
1 100 0.909 90.90
2 200 0.826 165.20
3 300 0.751 225.30
4 450 0.683 307.35
5 600 0.621 372.60
Present value of inflows 1,161.35
NPV 461.35

Calculation of present value of the project Y @ 10% discounting rate

Year Cash inflows / (outflow) Discounting factor Present value

@ 10% Rs.
0 (700) 1 (700)
1 500 0.909 454.50
2 400 0.826 330.40
3 200 0.751 150.20
4 100 0.683 68.30
5 100 0.621 62.10
Present value of inflows 1,065.50
NPV 365.50

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2. Profitability index

PI = Total present value of all cash inflows

Total present value of cash outflows

PI of project X = 1,161.35
700
= 1.659

PI of project Y = 1,065.50
700
= 1.522

3. Internal rate of return (IRR)

Calculation of present value of the project X @ 27% discounting rate

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 27% Rs.
0 (700) 1 (700)
1 100 0.787 78.70
2 200 0.620 124
3 300 0.488 146.40
4 450 0.384 172.80
5 600 0.303 181.80
NPV 3.70

Calculation of present value of the project X @ 28% discounting rate

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 28% Rs.
0 (700) 1 (700)
1 100 0.781 78.10
2 200 0.610 122.00
3 300 0.477 143.10
4 450 0.373 167.65
5 600 0.291 174.60
NPV -14.35

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 Financial Management

By interpolation formula IRR = 27 + 3.70 *1

3.70+14.35
= 27.21%
IRRR of project X = 27.21%

Calculation of present value of the project Y @ 37% discounting rate

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 37% Rs.
0 (700) 1 (700)
1 500 0.73 365
2 400 0.533 213.20
3 200 0.389 77.80
4 100 0.284 28.40
5 100 0.207 20.70
NPV 5.10

Calculation of present value of the project Y @ 38% discounting rate

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 38% Rs.
0 (700) 1 (700)
1 500 0.725 362.50
2 400 0.525 210
3 200 0.381 76.20
4 100 0.276 27.60
5 100 0.200 20.70
NPV -3.00

By interpolation formula IRR = 37 + 5.10 *1

5.10+3
= 37.63%
IRR of project Y = 37.63%

Summary of both the projects

Project X Project y
Profitability index 1.659 1.522
Net present value 461.35 365.50
Internal rate of return 27.21% 37.63%

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Problem 8.4.4

National electronics ltd., an electric goods manufacturing company, is producing a

large range of electronic goods. It has under consideration 2 projects “X” and “Y”, each
costing Rs 120 lacs.
The projects are mutually exclusive and the company is considering the
question of selecting one of the two. Cash flows have been worked out for both the
projects and the details are given below. “X” has a life of 8 years and “Y” has a life of 6
years. Both will have zero salvage value at the end of their operational lives. The
company is already making profits and its tax rate is 50%. The cost of capital of the
company is 15%. The profit before depreciation and taxes are as follows -
Rs lakhs
Year Project “X” Project “Y”
1 25 40
2 35 60
3 45 80
4 65 50
5 65 30
6 55 20
7 35 -
8 15 -

1. The company follows straight line method of depreciation. Find out NPV of both
project
[ICWA Inter, June 1996]

2. Also calculate Profitability index of both the projects

Solution -

Calculation of cash flows of project X

Year Profit Depreciation PBT Tax PAT Cash flow

(PAT +
depreciation)
1 25 15 10 5 5 20
2 35 15 20 10 10 25
3 45 15 30 15 15 30
4 65 15 50 25 25 40
5 65 15 50 25 25 40
6 55 15 40 20 20 35
7 35 15 20 10 10 25
8 15 15 0 0 0 15

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 Financial Management

Calculation of present value of the project X @ 15% discounting rate

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
0 (120) 1 (120)
1 20 0.870 17.40
2 25 0.756 18.90
3 30 0.658 19.74
4 40 0.572 22.88
5 40 0.497 19.88
6 35 0.432 15.12
7 25 0.376 9.40
8 15 0.327 4.91
NPV 8.23

Calculation of cash flows of project Y

Year Profit Depreciation PBT Tax PAT Cash flow

(PAT +
depreciation)
1 40 20 20 10 10 30
2 60 20 40 20 20 40
3 80 20 60 30 30 50
4 50 20 30 15 15 35
5 30 20 10 5 5 25
6 20 20 0 0 0 20

Calculation of present value of the project Y @ 15% discounting rate

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
0 (120) 1 (120)
1 30 0.870 26.10
2 40 0.756 30.24
3 50 0.658 32.90
4 35 0.572 20.02
5 25 0.497 12.43
6 20 0.432 8.64
7 - 0.376 -
8 - 0.327 -
NPV 10.33

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Comment – based on NPV technique project Y is better than project x .

PI = Present value of all cash inflows

Present value of cash outflows

PI of X = 128.23
120.00

= 1.07

PI of Y = 130.33
120.00

= 1.09

Summary of both the projects

Project X Project y
Profitability index 1.07 1.09
Net present value (Rs. 8.23 10.33
Lakhs)

Problem 8.4.5

AP Udyog is considering a new automatic blender. The new blender would last for 10
years and would be depreciated to zero over the 10 year period. The old blender will
also last for 10 more years and would be depreciated to zero over the same 10 year
period. The old blender has a book value of Rs 20,000 but could be sold for Rs 30,000
(The original cost was Rs 40,000). The new blender would cost Rs 1,00,000.
It would reduce labour expenses by Rs 12,000 a year. The company is subject
to a 50% tax rate on regular income as well as capital gains. Their cost of capital is 8%.
There is no investment tax credit in effect.

You are required to –

a. Identify all the relevant cash flows this replacement decision.
b. Compute the present value, net present value and profitability index
c. Find out whether this is an attractive project.

(CS final June 97)

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Solution –

i. Calculation on the sale of the old machine Rs.

Sale price
30,000
Book value
20,000
Profit on sale 10,000
Tax on sale @ 50% 5,000

After-tax cash receipts from sale of old machine 25,000

(30,000 – 5,000)

ii. Cash outflow to replace old machine with new :

Cost of new machine 1,00,000

Cash flow from sale of old machine 25,000

Net cash flow 75,000

iii. Depreciation on new machine = 1,00,000 / 10 = Rs 10,000

Depreciation on old machine = 20,000 / 10 = Rs 2,000

iv. Total increase in cash inflows (annual) -

Cash flow
Annual labour savings 12,000
Less: depreciation (incremental) 8,000
Increased profit before tax 4,000

Tax on increased profits @50% 2,000

Profit after tax 2,000
Add: Depreciation (non cash item) 8,000
Increased cash inflow 10,000

v. Calculation of net present value of the incremental cash inflows and cash out flows
@ 8%

Year Cash inflows / (outflow) Discounting factor Present value

@ 8% Rs.
0 (75,000) 1 (75,000)
1 10,000 0.926 9,260
2 10,000 0.857 8,570

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 Financial Management

3 10,000 0.794 7,940

4 10,000 0.735 7,350
5 10,000 0.681 6,810
6 10,000 0.630 6,300
7 10,000 0.583 5,830
8 10,000 0.540 5,400
9 10,000 0.500 5,000
10 10,000 0.463 4,630
NPV -7,900

Note – Students may note here that when cash flows are same for a particular period,
as we can see in the current example, the calculation can also be done as follows –

10,000 x (Total of pv factors from year 1 to 10 i.e 6.710) = 67,100

Students should note that this method can be followed only when cash flow is same
every year.

vi. Profitability index = 67,100

75,000
= 0.895

Comments – As the net present value of the project is negative and PI is < 1, the
project is not financially viable at the given cost of capital of the company (8
%)

Problem 8.4.6

Swastik Ltd. manufacturers of special purpose machine tools, have two divisions which
are periodically assisted by visiting teams of consultants. The management is worried
about the steady increase of expense in this regard over the years. An analysis of last
years expenses reveals the following –
Rs.
Consultants remuneration 2,50,000
Travel and conveyance 1,50,000
Accommodation expenses 6,00,000
Boarding charges 2,00,000
Special allowance 50,000

12,50,000

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 Financial Management

The management estimates accommodation expenses to increase by Rs 2,00,000

annually.
As part of the cost reduction drive, Swastik Ltd. are proposing to construct centre to
take care of the accommodation requirements of the consultants. This centre will
additionally save the company Rs 50,000 in boarding charges and Rs 2,00,000 in the
cost of executive training programmes hitherto conducted outside the company
premises every year.
The following details are available regarding the construction and maintenance
of the new centre:

a. Land: at a cost of Rs 8,00,000 already owned by the company, will be used.

b. Construction cost: Rs 15,00,000 including special furnishings
c. Cost of annual maintenance : Rs 1,50,000
d. Construction cost will be written off over 5 years being the useful life.

Assuming that the write off of construction cost as aforesaid will be available for tax
purposes, the rate of tax will be 50% and that the desired rate of return is 15%. You
are required to analyse the feasibility of proposal and make recommendations.

[CA Nov 94]

Solution –

1. Calculation of net cash flow if the company decides to construct new centre :
Rs. lakhs
Year 1 Year 2 Year 3 Year 4 Year 5
a. Saving in cost
i. Accommodation 8.00 10.00 12.00 14.00 16.00
ii. Boarding 0.50 0.50 0.50 0.50 0.50
iii. Training 2.00 2.00 2.00 2.00 2.00
Total savings 10.50 12.50 14.50 16.50 18.50

b. Incremental costs
i. Maintenance cost 1.50 1.50 1.50 1.50 1.50
ii. Depreciation 3.00 3.00 3.00 3.00 3.00
Total cost 4.50 4.50 4.50 4.50 4.50

Net savings 6.00 8.00 10.00 12.00 14.00

Less : tax @ 50% 3.00 4.00 5.00 6.00 7.00

Net savings after tax 3.00 4.00 5.00 6.00 7.00

Add : depreciation 3.00 3.00 3.00 3.00 3.00

Net cash flow 6.00 7.00 8.00 9.00 10.00

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 Financial Management

2. Calculation of NPV @ 15%

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
0 (15) 1 (15)
1 6.00 0.870 5.22
2 7.00 0.756 5.29
3 8.00 0.658 5.26
4 9.00 0.572 5.15
5 10.00 0.497 4.97

NPV 10.89

As the NPV is positive Rs 10.89 lakhs , the proposal of building a new guest house
should be accepted.

Notes –
1. The cost of land is a sunk cost and hence is not considered for calculation
purposes.
2. All expenses other than accommodation and boarding of consultants remains
even if guest house is built.

Problem 8.4.7

Jolly company has an investment opportunity costing Rs 40,000 with the following
expected cash inflow:

Year Inflows
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000

Using 10% as the cost of capital (rate of discounting) determine the i. Net present
value and ii. Profitability index
(CS final June 92)

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Solution –

Calculation of the net present value of the investment opportunity @ 10%

Year Cash inflows / (outflow) Discounting factor Present value

@ 10% Rs.
0 (40,000) 1 (40,000)
1 7,000 0.909 6,363
2 7,000 0.826 5,782
3 7,000 0.751 5,117
4 7,000 0.683 4,571
5 7,000 0.621 4,347
6 8,000 0.564 4,512
7 10,000 0.513 5,130
8 15,000 0.467 7,005
9 10,000 0.424 4,240
10 4,000 0.386 1,544
NPV 8,611

Profitability Index = PV of cash inflows

PV of cash outflows

= 48,611
40,000
= 1.215

Problem 8.4.8

A ltd. installed a machine with an estimated life of 5 years and used it for 3 years. The
initial cost including installation charges amounted to Rs 80 lakhs. According to
current assessment, the machine can be used for another 4 years. The company has
just received an offer of Rs 50 lakhs for the machine. It is unlikely that a similar offer
will be received in near future. The machine is used for manufacturing of a product
which has a falling demand. Losses are anticipated over the next 2 years. Details of
profitability projections for the next four years are as follows –
Rs
lakhs
Year 1 Year 2 Year 3 Year 4
Sales 50.00 45.00 40.00 35.00
Less : variable cost 27.00 24.50 23.00 18.00
Fixed cost allocated 8.00 7.50 6.50 6.00
Depreciation 16.00 16.00 - -

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 Financial Management

Net profit / (loss) -1.00 -3.00 10.50 11.00

As the estimated working results are not very good and as the company has got a very
good offer for the machinery, MD feels that the machine should be sold immediately.
What is your advice to the MD ? Cost of capital of the company is 15%, ignore taxation.

(ICWA Inter Dec 1998)

Solution -

1. Calculation of cash flows for 4 years –

Rs lakhs
Year 1 Year 2 Year 3 Year 4
Net Profit / (loss) -1.00 -3.00 10.50 11.00
Add : Depreciation 16.00 16.00 - -
Add : Fixed cost 8.00 7.50 6.50 6.00

Total cash inflow 23.00 20.50 17.00 17.00

It is assumed that the fixed cost will remain fixed even if the machine is sold and
hence it is not considered as an outflow when production is continued.

2. Net present value of the project @ 15% discounting rate -

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
1 23.00 0.870 20.01
2 20.50 0.756 15.498
3 17.00 0.658 11.186
4 17.00 0.572 9.724
PV 56.418

Comments – It can be observed that @ 15% discounting rate the present value of cash
inflows by continuing the production is 56.41 lakhs as against the realisable sale price
of Rs 50 lakhs. Thus it is advisable to continue with the production rather than selling
the machinery.

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 Financial Management

Problem 8.4.9

Satya corporation is toying with the idea of replacing its existing machine. The
following are the relevant data –

1. Existing Machine

Purchased 2 years ago

Remaining life – 6 years
Salvage value – Rs 500
Current book value – Rs 2,600 and its realisable market value – Rs 3,000
Annual depreciation – Rs 350

2. New machine

Capital cost of Rs 8,000

Estimated useful life – 6 years
Estimated salvage value – Rs 800

The replaced machine would permit an output expansion. As a result, sales is expected
to rise by Rs 1,000 per year, operating expenses would decline by Rs 1,500 per year. It
would require an additional inventory of Rs 2,000 and would cause an increase in
accounts payable by Rs 500.
Assuming corporate tax rate of 40% and cost of capital of 15%, advice the company
[ ICWA Dec 1998]
Solution –

1. Calculation of incremental cash flows from purchase of new machinery –

Rs.
1. Incremental cash outflow (Year 1)
Cost of new machinery 8,000
Add : Addition to working capital
a. Inventory 2,000
b. Increase in account payable (500)
Total 9,500
Less : Net sale price (3,000 – tax on profit @ 40% of Rs 400) 2,840
Net cash outflow of year 1 6,660

2. Subsequent cash inflows

Increase in sales 1,000
Add : savings in cost 1,500
Less : increase in depreciation (Rs 1,200 – 350) 850

Increase in profit before tax 1,650

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 Financial Management

Less : tax @ 40% 660

Net profit 990

Add : depreciation 850

Net cash flow 1840

2. Calculation of net present value @ 15% discounting factor.

Year Cash inflows / (outflow) Discounting factor Present value

@ 15% Rs.
0 (6,600) 1 (6,600)
1 1,840 0.870 1,601
2 1,840 0.756 1,391
3 1,840 0.658 1,211
4 1,840 0.572 1,052
5 1,840 0.497 915
6 1,840 0.432 795
6 1,500 0.432 648
6 480 0.432 207
NPV 1,220

In year 6 additional cash inflows will be –

Recovery of working capital Rs 1,500

Sale proceeds of machinery Rs 800
Less : tax on sale @40% Rs 320
Rs 480

Since the NPV of the project is positive the company should go for replacement of old
machinery.

Problem 8.4.10

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 50 lacs per annum for next 4 years. The contract can be
terminated on installation of the aforesaid machine on payment of a compensation of
Rs 30 lakhs 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 200 lakhs to be
financed by a loan repayable in 4 equal instalments commencing from the end of year
1. The interest rate is 16% p.a At the end of 4th year, the machine can be sold for Rs 20
lakhs and the cost for dismantling and removal will be Rs 15 lakhs.

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 Financial Management

Sales and direct cost of the product emerging from waste processing for 4 years are
estimated as under:

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) 50 38 28 21

Initial stock required before commencement of the processing operations is Rs 20 lacs

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 55 lacs and the stock at the end of year 4 will be nil. The storage of
material will utilise the space which otherwise would have been rented out for Rs 10
lakhs per annum. Labour cost includes wages of 40 workers, whose transfer to this
process will reduce idle time payments of Rs 15 lacs in year 1 and Rs 10 lacs in year 2.
Factory overheads include apportionment of general factory overheads except to the
extent of insurance charges of Rs 30 lakhs per annum attributable to this [Link]
company’s tax rate is 50% for revenue incomes.

Advice the management on the desirability of installing the machinery for processing
the waste. All calculation should form part of the answer. Required rate of return is
15%.
(CA final, May 1999)

Solution -

1. Statement of incremental cash flows from operations -

Rs
lakhs
1 2 3 4
Sales 322 322 418 418

Less :
Material consumption 30 40 85 85
Wages 60 65 85 100
Other expenses 40 45 54 70
Factory overheads (Insurance) 30 30 30 30
Loss of rent 10 10 10 10
Interest 32 24 16 8
Depreciation 50 38 28 21
Total cost 252 252 308 324

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 Financial Management

Incremental profits before tax 70 70 110 94

Less: Tax @ 50% 35 35 55 47
Net profit 35 35 55 47

Add : depreciation 50 38 28 21
Net cash flow 85 73 83 68

Overheads other than insurance is not considered as they remain unchanged even
though the project is not executed

2. Statement of incremental cash flows (net)

Rs
lakhs
1 2 3 4
Net cash flow from operations 85 73 83 68
(Increase) / realisation of (35) - - 55
inventories
Contract payment saved 25 25 25 25
(Net of tax saving @ 50%)
Loan repayment (50) (50) (50) (50)
Profit on sale of machine - - - 5

Total incremental cash flows 25 48 58 103

3. Net present value of all cash flows @ 15%-

Rs
lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
0 (50) 1 (50)
1 25 0.870 21.75
2 48 0.756 36.29
3 58 0.658 38.16
4 103 0.572 58.92

NPV 105.12

Cash outflow of year 1 is – Compensation for contract + increase in inventory

level
- Rs 30 lakhs + Rs 20 lakhs = Rs 50 lakhs.

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 Financial Management

Comment - It is advisable to implement the proposal as the net present value is

positive.

Problem 8.4.11

A company is setting up a plant at a cost of Rs 300 lakhs of investment in fixed assets. It

has to decide whether to locate the plant in a forward area (FA) or backward are (BA).
Locating in backward area means a cash subsidy of Rs 15 lakhs from the central
government. Besides the taxable profit to the extent of 20% is exempt for 10 years. The
project envisages a borrowing of RS 200 lakhs in either case. The cost of borrowing
will be 12% in forward area and 10% in backward area. However the revenue costs
are bound to be higher in the BA. The borrowing principle has to be repaid in 4 equal
annual instalments beginning from the end of year 4. With the help of following
information and by using Discounted Cash Flow technique you are required to suggest
proper location for the project. Assume straight-line depreciation with no residual
value.

Earning before interest and tax (Rs in lakhs)

Year FA BA
1 -6 -50
2 34 -20
3 54 10
4 74 20
5 108 45
6 142 100
7 156 155
8 230 190
9 330 230
10 430 330

Assume –
1. Discounting rate to be 15%
2. Rate of Income tax to be 50%
3. Central subsidy is not to affect depreciation or tax.
4. No other relief and rebates will be available to the company other than those
mentioned above.
[CA final May 1991]

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Solution -

1. Calculation of cash flows from the operation for Forward area

Year EBIT Interest Depreciation PBT Tax PAT Inflow

1 -6 24 30 -60 - -60 -30
2 34 24 30 -20 - -20 10
3 54 24 30 - - - 30
4 74 24 30 20 - 20 50
5 108 18 30 60 - 60 90
6 142 12 30 100 50 50 80
7 156 6 30 120 60 60 90
8 230 - 30 200 100 100 130
9 330 - 30 300 150 150 180
10 430 - 30 400 200 200 230

2. Calculation of cash flows from the operation for Backward area

Year EBIT Interest Depreciation PBT Tax PAT Inflow

1 -50 20 30 -100 - -100 -70
2 -20 20 30 -70 - -70 -40
3 10 20 30 -40 - -40 -10
4 20 20 30 -30 - -30 -
5 45 15 30 - - - 30
6 100 10 30 60 - 60 90
7 155 5 30 120 - 120 150
8 190 - 30 160 40 120 150
9 230 - 30 200 80 120 150
10 330 - 30 300 120 180 210

3. Calculation of net present value of project in forward area @ 15% discounting factor
Rs lakhs
Year Cash inflows / Cash Net cash Discounting Present
(outflow) outflows flows factor value
@ 15% Rs.
0 (100) - (100) 1 (100)
1 -30 - -30 0.870 (26.10)
2 10 - 10 0.756 7.56
3 30 - 30 0.658 19.74
4 50 50 0 0.572 0
5 90 50 40 0.497 19.88
6 80 50 30 0.432 12.96
7 90 50 40 0.376 15.04

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8 130 - - 0.327 42.51

9 180 - - 0.284 51.12
10 230 - - 0.247 56.81
NPV 99.52

Cash outflow of year 1 = Total cash outflow – loan amount = Rs 300 lakhs – Rs 200
lakhs = Rs 100 lakhs.

4. Calculation of net present value of project in backward area @ 15% discounting

factor
Rs
lakhs
Year Cash inflows / Cash Net cash Discounting Present
(outflow) outflows flows factor value
@ 15% Rs.
0 (85) - (85) 1 (85)
1 -70 - -70 0.870 -60.9
2 -40 - -40 0.756 -30.24
3 -10 - -10 0.658 -6.58
4 - 50 -50 0.572 -28.60
5 30 50 -20 0.497 -9.94
6 90 50 40 0.432 17.28
7 150 50 100 0.376 37.6
8 150 - 150 0.327 49.05
9 150 - 150 0.284 42.60
10 210 - 210 0.247 51.87
NPV 22.86

Cash outflow of year 1 = Total cash outflow – loan amount – subsidy = Rs 300 lakhs –
Rs 200 lakhs – Rs 15 lakhs = Rs 85 lakhs.

Working notes –

1. Taxability of backward area starts only from year 8 th as in year 6 and 7 the
losses of year 1 to 5 are adjusted against the profits.
2. For year 8,9 and 10 tax is levied only on 80% of the profits as 20% profit is
exempt.
3. Ideally the discounting factor shall be 12% and 10%, which is cost of capital at
FA and BA respectively, in that case interest should be ignored. But as the
problem states the cost of capital to be 15%, calculations done considering
interest as cash out flow

Comment – As NPV of FA is positive and NPV of BA is negative project should be

located in FA.

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 Financial Management

Problem 8.4.12

X ltd. is considering two mutually exclusive projects X and Y. Following details are
made available to you :
Rs. In lacs

Project X Project Y

Project cost 1,000 1,000

Cash inflows
Year
1 200 200
2 150 600
3 320 250
4 450 100
5 500 150

Assume no residual value at the end of fifth year. The firms cost of capital is 10%.
Required, in respect of each of the two projects:

i. NPV using 10% discounting rate

ii. IRR and
iii. Profitability index
iv. Payback period

Solution –

1. Net present value of cash flows of project X @ 10%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (1,000) 1 (1,000)
1 200 0.909 181.80
2 150 0.826 123.90
3 320 0.751 240.32
4 450 0.683 307.35
5 500 0.621 310.5

NPV 163.87

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2. Net present value of cash flows of project Y @ 10%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (1,000) 1 (1,000)
1 200 0.909 181.80
2 600 0.826 495.60
3 250 0.751 187.75
4 100 0.683 68.30
5 150 0.621 93.15

NPV 26.60

4. i. Profitability index of project X = 1163.8

1000

= 1.164

ii. Profitability index of project Y = 1026.60

1000

= 1.027

5. Calculation of internal rate of return for project X -

a. Net present value of cash flows of project X @ 15%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 15% Rs.
0 (1,000) 1 (1,000)
1 200 0.870 174.00
2 150 0.756 113.40
3 320 0.658 210.56
4 450 0.572 257.40
5 500 0.497 248.5

NPV 3.86

AS net present value Rs 3.86 lacs (almost nil), it can be said that the IRR of the project
is slightly higher than 15%

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 Financial Management

b. Net present value of cash flows of project Y @ 12%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 12% Rs.
0 (1,000) 1 (1,000)
1 200 0.893 178.6
2 600 0.797 478.20
3 250 0.712 178.00
4 100 0.636 63.60
5 150 0.567 85.05

NPV -16.55

As net present value Rs 16.55 lacs, it can be said that the IRR of the project is higher
than 10% but lesser than 12%. The IRR can be calculated by interpolation method.

IRR = 10 + (26.60 / 16.55+26.60) *2

= 10+1.24
= 11.25 %

IRR of project Y is 11.25%

6. Calculation of Payback period

a. Project X = cumulative cash flow up to year 4 = 200+150+320+450 =1,120

i.e the payback period is somewhere in between year 3 and year 4.
Total cash flow till year 3 = 670, remaining cash flow = 1,000-670 = 330
Monthly returns in year 4 = 450/12 = 37.5
Number of months to recover Rs 330 = 330/37.5 = 8.8 or 9 months
Payback period = 3 years and 9 months

b. Project Y = cumulative cash flow for 3 years = 200+600+250 = 1050

i.e payback period is higher than 3 years the cash flow for year 4 is Rs 100 the
amount remains to be recovered is Rs 50 (i.e half of Rs 100), hence payback
period is 3 years and 6 months.

Summary of both the projects –

Project X Project Y
Net present value 163.87 26.60
IRR 15% 11.25%
Profitability index 1.164 1.027
Payback period 3 years and 9 months 3 years and 6 months

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In light of first three methods project X is better than project Y, while under payback
period method project Y is better than project X

Problem 8.4.13

A company is considering as to which of two mutually exclusive projects it should

undertake. The finance directors thinks that the project with the higher NPV should be
chosen whereas the managing director thinks that the one with higher IRR should be
undertaken especially as both the projects have the same initial outlay and length of
life. The company anticipates a cost of capital of 10% and the net after tax cash flows of
the project are as follows –
Year Project X Project Y
0 (200) (200)
1 35 218
2 80 10
3 90 10
4 75 4
5 20 3

Required –

1. Calculate the NPV and IRR of each project

2. state with reasons which project you would recommened

The discounting factors are as follows –

Year 10% 20%

1 0.91 0.83
2 0.83 0.69
3 0.75 0.58
4 0.68 0.48
5 0.62 0.41

[ CA final May 1995]

Solution –

1. Analysis of project x

a. Net present value of cash flows of project X @ 10%-

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Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (200) 1 (200)
1 35 0.91 31.85
2 80 0.83 66.40
3 90 0.75 67.50
4 75 0.68 51.00
5 20 0.62 12.40

NPV 29.15

b. Net present value of cash flows of project X @ 20%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 20% Rs.
0 (200) 1 (200)
1 35 0.83 29.05
2 80 0.69 55.20
3 90 0.58 52.20
4 75 0.48 36.00
5 20 0.41 8.20

NPV -19.35

IRR for project X can be calculated by interpolation method as follows –

IRR = 10 + (29.15 / 29.15+19.35)*10

= 16%

a. Net present value of cash flows of project X @ 10%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (200) 1 (200)
1 35 0.91 31.85
2 80 0.83 66.40
3 90 0.75 67.50
4 75 0.68 51.00
5 20 0.62 12.40

NPV 29.15

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2. Analysis of project Y -

a. Net present value of cash flows of project Y @ 10%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (200) 1 (200)
1 218 0.91 198.38
2 10 0.83 8.30
3 10 0.75 7.50
4 4 0.68 2.72
5 3 0.62 1.86

NPV 18.76

b. Net present value of cash flows of project Y @ 20%-

Rs lakhs
Year Cash inflows / (outflow) Discounting factor Present value
@ 10% Rs.
0 (200) 1 (200)
1 218 0.83 180.94
2 10 0.69 6.90
3 10 0.58 5.80
4 4 0.48 1.92
5 3 0.41 1.23

NPV -3.21

IRR for project Y can be calculated by interpolation method as follows –

IRR = 10 + (18.76 / 18.76+3.21)*10

= 18.54%

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8.5 Self examination questions

Problems –

Problem 8.5.1

Company Z wishes to invest Rs 150,000 in a project. The estimated profit before

depreciation and taxes is Rs 55,000 per year. The depreciation is to be provided @
15% WDV on the project cost. The tax rate is @ 35%, calculate the payback period for
the project.

Problem 8.5.2

Company C is willing to invest in a project costing Rs 2,50,000. The company provides

depreciation @ 25% on the project cost ( SLM method). The estimated profit before
tax (but after depreciation) for 7 years is as follows –

Year Amount
Rs.
1 –10,000
2 55,000
3 72,000
4 97,000
5 67,500
6 25,000
7 95,000

Compute the payback period of the project, assuming tax rate of 40%.

Problem 8.5.3

A ltd is wishing to start a new project with a capital investment of Rs 1,20,00,000 and
expected profit before tax and depreciation as follows –
Year Profit
before tax
Rs.
1 7,25,000
2 12,00,000

3 37,87,500
4 19,95,000
5 41,20,000
6 17,50,000

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Assuming that the project has only 6 years life and there will be no salvage value at the
end of the 6th year calculate the ARR of the project. Assume tax to be 25%

Problem 8.5.4

Choose the better project by using payback period method and ARR method –

Assume investment in each project to be Rs 5,00,000 and profit after tax as follows

Year Project A Project B

1 55,000 0
2 1,20,000 0
3 1,75,000 0
4 2,00,000 3,00,000
5 1,00,000 4,50,000

6,50,000 7,50,000

Assume straight-line method of depreciation

Problem 8.5.5

Company A is considering a project with initial cash out flow of Rs 3,50,[Link]

project is expected to generate a cash inflow as follows –

Year Cash inflow

Rs.
1 25,000
2 1,25,000
3 75,000
4 1,50,000
5 1,25,000
6 50,000
7 50,000

Total 6,00,000

Now assume that the discounting rate or the expected rate of return from the project is
10%, 15% and 25%. Calculate the net present value of project A and write your
conclusions.

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The discounting table for 10%,15% and 25% is as follows

Year 10% 25% 15%
1 0.909 0.800 0.870
2 0.826 0.640 0.756
3 0.751 0.512 0.658
4 0.683 0.410 0.572
5 0.621 0.328 0.497
6 0.564 0.262 0.432

Problem 8.5.6

Please evaluate the following two projects with Net present value technique –

Year Project X Project Y

0 Cost (120,000) (120,000)
1 25,000 56,000
2 10,000 48,000
3 45,000 22,000
4 50,000 15,000
5 55,000 25,000

The amounts are after tax and depreciation. Consider the project at 10%, 15% and
20% discounting rate and chose the better alternative. Make suitable assumptions.

The discounting table for 10%,15% and 20% is as follows

Year 10% 15% 20%
1 0.909 0.870 0.833
2 0.826 0.756 0.694
3 0.751 0.658 0.579
4 0.683 0.572 0.482
5 0.621 0.497 0.402

Problem 8.5.7

Company A is considering a project with expected life of 7 years. The initial cash
outflow is expected to be as follows –

Land purchased (not depreciable) Rs 5,00,000

Plant Rs 7,50,000
Working Capital Rs. 60,000

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The working capital will be fully realised at the end of the 5th year. The estimated
scrap value of the plant is Rs 25,000. The company has received the land under
special scheme and the same is not sellable.

The expected Profit before tax is as follows -

Year Rs.
1 1,50,000
2 1,20,000
3 1,00,000
4 2,90,000
5 2 55,000
6 1,50,000
7 1,15,000

Tax rate is 35%

You are required to evaluate the project considering –

1. NPV technique using rate of discounting to be 12% and 15% .

2. Payback period method
3. Profitability index method and
4. IRR method

The discounting table for 12% and 15%

Year 12% 15%

1 0.893 0.870
2 0.797 0.756
3 0.712 0.658
4 0.636 0.572
5 0.567 0.497
6 0.507 0.432
7 0.452 0.376

Problem 8.5.8

AQ ltd is considering the installation of a machine to process a new produced by one of

its existing manufacturing process, which is currently outsourced. At present, the
product is manufactured by a contractor for on payment by the company of Rs 10
lakhs per quarter for next 3 years. The contract can be terminated on installation of the

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aforesaid machine on payment of a compensation of Rs 50 lakhs before the processing

operation starts, same is deductible for tax purposes.

The machine required for carrying out the processing will cost Rs 150 lakhs, the
machine can be sold for Rs 10 lakhs at the end of its useful life.

Sales and direct cost of the product emerging from the new product for 3 years are
estimated as under:
Rs lakhs
1 2 3
Sales 250 315 320
Total cost 150 190 195
Depreciation ( As per income tax) 50 50 50

Initial working capital required before commencement of the processing operations is

Rs 15 lakhs at the start of year [Link] working capital will get realised to the extent of
95% at the end year [Link] amount of expenses include Rs 15 lakhs as fixed cost which
is immaterial of the implementation of the project .The company’s tax rate is 50% for
revenue incomes.

Advice the management on the desirability of installing the machinery for processing
the waste. All calculation should form part of the answer. Required rate of return is
12%.
Discounting table @ 12% is as follows –

Year 12%
1 0.893
2 0.797
3 0.712

Problem 8.5.8

A ltd is evaluating a project having an initial investment of Rs 1,25,000 and the

following cash inflows –

Year Rs.
1 15,000
2 9,000
3 9,000
4 22,000
5 33,000
6 45,000
7 35,000
8 –3,000

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9 15,000
10 –12,000

The company is estimating maintenance expenses at the end of year 3 and 5 of Rs

5,000 and 6,000 respectively payable in the same year.

The company’s opportunity cost is 16% and the company is wishing to evaluate the
project on the basis of NPV method and profitability index (PI) method and also
calculate the IRR of the project. The discounting table @ 16% is as follows –

Year 16%
1 0.862
2 0.743
3 0.641
4 0.572
5 0.476
6 0.410
7 0.354
8 0.305
9 0.263
10 0.227

Objective questions -

1. Which of the following techniques use discounting methods –

a. Net present value method

b. Accounting rate of return method
c. Payback period method
d. Profitability index method
e. Internal rate of return

2. Internal rate of return is the rate at which –

a. The present value of all the cash inflows is nil

b. Rate desired by the company
c. Net present value of all cash inflows and outflows is nil.
d. A proposal is acceptable.
e. None of the above

3. The major disadvantage of payback period method is –

a. It is simple
b. It ignores rate of return

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c. It does not consider all the cash flows

d. All of the above
e. None of the above

4. The discounting factor applied to cash flows of a particular project is not –

a. Rate of opportunity cost

b. Cost of capital
c. The desired rate of return
d. Rate of interest on government securities

5. State whether the following statements are true or false –

a. Generally capital budgeting decisions involve huge investment and loss

of such investment may lead to bankruptcy of the company

b. The decisions like purchase of land, plant, building, patents etc. cannot
be reversed easily and it becomes a sunk cost.

c. Capital budgeting decisions involve long term and permanent

commitments and has an effect over the company’s future earnings.

d. Capital budgeting decisions are necessarily backed by huge funding

decisions and failure in the implementation of the project may lead to
problem of excess funding.

e. Capital budgeting decisions are tough to take as it is difficult to forecast

he future cash inflows from the assets with accuracy.

f. Payback period method is the best method of capital budgeting

g. NPV method and IRR method always gives preference to same project

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9 Some assorted questions

Problem 9.1

Company – A Ltd.
Rs. Lacs.
Sales (All credit) 1,000
Cost of goods sold 90%

Other information Rs. Lacs

Balances As on As on
1-1-99 31-12-99
Inventory 100 105
Debtors 85 90
Creditors 55 65

Please answer the following questions assuming 360 days in a year.

1. The inventory cycle of A Ltd. is -

a. 41
b. 45
c. 102
d. Data insufficient

2. Debtors cycle of A ltd. , ignoring the profit portion, is

a. 31.5
b. 35
c. 38
d. Can’t be calculated

3. Creditors cycle of A ltd. is (rounded off to nearest rupee)

a. 24
b. 28
c. 32
d. 22

[Link] the figure of purchases, based on cost of sales –

a. 900
b. 895
c. 1205
d. 905

5. Debtors cycle of A ltd. , including the profit portion, is

a. 31.5
b. 35

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c. 38
d. Can’t be calculated

Problem 9.2

The Cost sheet of A ltd. is as follows –

Cost per unit
Raw Materials 50
Labour 20
Overheads 30
Depreciation 10
Selling price 110

Average holding/realisation period is as follows –

Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%)
– ½ month, Debtors – 1 month, Creditors – 1 month, wages – 1/3rd month, overheads –
30 days, Finished goods – 1 month.

Other information – 1. 75 % of sales is on credit

2. Expected cash balance is 1,00,000
3. Expected output is 4500 units per month.

Please answer the following questions –

1. The estimated figure of raw materials for calculation of working capital is –

a. 3,37,500
b. 2,25,000
c. 1,25,000
d. none of the above.

2. The figure of estimated outstanding wages is –

a. 30,000
b. 45,000
c. 33,500
d. 25,000

3. The estimated figure of Finished goods is –

a. 2,25,000
b. 5,80,000
c. 4,35,500
d. 4,50,000

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4. The estimated figures of debtors for calculation of working capital

requirement and actual debtors respectively are –

a. 3,37,500 and 4,38,750

b. 2,55,000 and 5,00,000
c. 3,37,500 and 5,00,000
d. none of the above

5. Which other figure is same as the estimated figure of raw materials

a. Creditors for materials

b. Creditors for overheads
c. Work in progress
d. None of the above

Problem 9.3

The Net operating profit of Company A ltd. is 2,10,000 and the total market
value of its 12 % debt is Rs. 3,00,000. The equity capitalisation rate of an
unlevered firm of same risk class is 16%. use Modiglian Miller approach

1. The value of unlevered firm, when tax rate is 30% is –

a. 10,00,000
b. 9,18,750
c. 5,35,000
d. 7,00,000

2. The value of levered firm, when tax rate is 30%, is –

a. 12,50,000
b. 10,08,750
c. 6,50,000
d. 8,35,000

Problem 9.4

Company – A ltd.
Earnings per share – Rs.10
Dividend pay out ratio – 50%
Rate of return – 15%
The capitalisation rate – 12.5%

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Use Walter model for dividend decision and answer the following queations

1. The market price (p) of A ltd shares at current dividend pay out ratio is –

a. 80
b. 78
c. 88
d. 95

2. What should be optimum pay out ratio of the firm A ltd, in order to maximise
the share price –

a. 100%
b. 50%
c. 55%
d. 0%

3. What will be the share price at the pay out ration mentioned in Q.2

a. 96
b. 100
c. 125
d. Data insufficient

Problem 9.5

Company A ltd. –
Current assets
d. Inventory Rs. 340 lacs
e. Other current assets Rs. 20 lacs
Current liabilities
c. Creditors Rs. 100 lacs
d. Other liabilities Rs. 20 lacs
e. Bank borrowings Rs. 180 lacs

Core current assets are Rs. 180 lacs

1. The maximum permissible bank finance as per Tandon committee

recommendations is –
a. Rs. 180 lacs
b. Rs. 200 lacs
c. Rs. 250 lacs
d. Rs. 120 lacs

2. The minimum permissible bank finance as per Tandon committee

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recommendations is –

a. Rs. 180 lacs

b. Rs. 15 lacs
c. Rs. 120 lacs
d. Rs 20 lakhs

3.. Calculate the maximum permissible bank finance as per Tandon committee
recommendations if Core current assets are Rs. 170 lacs –
a. Rs. 180 lacs
b. Rs. 20 lacs
c. Rs. 15 lacs
d. Rs. 120 lacs

Problem 9.6

Please write the formulas of Value of the firm, Cost of equity under Modigiani
and Miller approach of capital structure theories, without corporate taxes and
with corporate taxes

Problem 9.7

A Ltd. sells goods in the domestic market on a gross profit of 25%. Its annual figures
are as follows :
1. Domestic sales on 1 month credit Rs. 12,00,000
2. Export at 3 months credit, selling price 10 % below domestic price Rs. 5,40,000
3. Material with two months credit Rs. 4,50,000
4. Wages paid ½ month in arrears Rs. 3,60,000
5. Manufacturing expense paid 1 month in arrears Rs. 5,40,000
6. Depreciation Rs. 60,000
7. Administration expense paid 1 month in arrears Rs. 1,20,000, not to be
considered for Finished goods valuation
8. Sales expenses payable quarterly in advance Rs. 60,000

Stock of Raw materials and FG are kept for 1 month. Cash requirement Rs. 1,00,000.
Please ascertain the working capital requirement for A Ltd.

Problem 9.8

1. Write a detailed note on working capital cycle with all the formulas

2. Write in details at least 3 sources of long term capital

3. Commercial Paper

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4 .Tandon Committee recommendations on Working Capital funding with

formulas

5. Explain what is working capital cycle with all its formulas

Problem 9.9

The Cost sheet of A ltd. is as follows –

Cost per unit
Raw Materials 40
Labour 20
Overheads 40
(Depreciation included in overheads Rs 10)
Selling price 110

Average holding/realisation period is as follows –

Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%)
– ½ month,
Debtors – 1 month, Creditors – 1 month, wages – 1/3rd month, overheads – 30 days,
Finished goods – 1 month.

Other information – 1. 80 % of sales is on credit

2. Expected cash balance is 75,000

Expected output is 5500 units per month. Calculate the amount of working capital
required

Problem 9.10

1. Which one of the following is not a factor determining the dividend policy of a
Company

a. Cash flow
b. Tax on dividends for company
c. Profit reinvestment opportunities
d. Future viability of the companies major project

2. The Cost sheet of A ltd. is as follows –

Cost per unit
Raw Materials 50
Labour 20
Overheads 30
Depreciation 10
Selling price 110

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Average holding/realisation period is as follows –

Raw materials – 1 month, Finished goods – 1 month, creditors – 1 month

Other information – Expected output is 4500 units per month.

O 1. The estimated figure of raw materials for calculation of working capital is

–
a. 3,37,500
b. 2,25,000
c. 1,25,000
d. None of the above.

Q 2. The estimated figure of Finished goods is –

a. 2,25,000
b. 5,80,000
c. 4,35,500
d. 4,50,000

Q3. Which other figure is same as the estimated figure of raw materials –
a. Creditors for materials
b. Creditors for overheads
c. Work in progress
d. None of the above

3 Please consider the following cash flow from a project

Year Cash Flow (Rs)
(50,000)
1 10,000
2 10,450
3 11,800
4 12,250
5 16,750

Q1. The IRR ( Internal rate of return for the above project) is approx:
a. 6.6%
b. 13%
c. 14.5%
d. 10.7%

Q2. The Profitability index of the project @ 10% discounting rate is :

a. 0.850
b. 0.907
c. 1.000
d. Data insufficient

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Q3. The Net present value of the project @ 10% is approx –

a. –4650
b. 2500
c. 2236
d. -8250

Q4. The payback period of the above project is –

a. 4 years 4 months
b. 5 years
c. 2 years
e. Data insufficient

Q5. Company expects a minimum return of 13% on every project it

undertakes. State whether the company will accept the above proposal or
not –
a. It will reject
b. It will accept

4. To maximize the Company’s value, cost of capital should be –

a. Maximum
b. Company value does not depend on Cost of Capital
c. Minimum
d. Can’t say

Problem 9.11

1. The cost sheet of Hi-Tech Ltd. provides the following data:

Cost per unit (Rs.)

Raw Material 30
Direct labour 20
Overheads (including depreciation of Rs.10) 20
------
Total Cost 70
Profit 10
------
Selling price 80
------

10) Average Raw material in stock is for 1 month

11) Work-in-progress (assume 50 % completion stage for Raw materials, wages
and overheads) will approximate to 1/2 month’s production
12) Finished goods lie in the warehouse for 1 month
13) Credit allowed to Debtors is 1 month. 25 % of Sales are on cash basis.

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14) Cash balance expected to be Rs.2,00,000.00

15) Credit allowed by suppliers is 1 month
16) Average time lag in payment of wages is 2 months
17) Average time lag in payment of overheads is 1 month
18) Assume a 10 % margin
You are required to prepare a statement of the working capital needed to finance a
level of the activity of 60,000 units of output per year.

2. Write note on working capital cycle and explain how each component of working
capital cycle is calculated.

Problem 9.12

1. M/s A ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep some margins as under (i.e agreed to
finance excluding the margins) –

Raw materials 20%

Work in progress 40%
Finished goods 15%
Debtors 30%

Following are the estimates for the year 2002-03

Rs. 000’s
Annual Sales 14,40
Cost of Production 12,00
Raw Materials purchased 7,05
Opening stock of Raw materials 1,40
Opening stock of Raw materials 1,25

Other information – Raw material is in stock for 2 months, WIP 15 days and FG 1
month. Debtors get 1 months credit and creditors give 15 days credit. Company has
received an advance of Rs. 15,000

3. Estimate the amount of working capital requirement

4. Estimate the amount of loan likely to be approved by the bankers.

2. M/s B ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep some margins as under (i.e agreed to
finance excluding the margins) –

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Raw materials 30%

Work in progress 35%
Finished goods 12.5%
Debtors 42%
Cash 0%
Estimated annual production is 60,000 units and break-up of selling price is as under –

Raw Materials 60%

Direct wages 10%
Overheads (includes depreciation 10%) 20%
Profit 10%
Selling price 100%

Other information – Raw material is in stock for 2 months, work in progress (WIP) 1
month and FG 3 month. Debtors get 3 months credit and creditors give 2 months
credit, wages are paid after one month. Calculate WIP considering 100% RM + 50%
wages and overheads. Selling price is estimated @ 5 Rs per unit. Cash requirement is
Rs 20,000

3. Estimate the amount of working capital requirement

4. Estimate the amount of loan likely to be approved by the bankers.

3 M/s C ltd. have approached bankers for their working capital requirements. The
bankers agreed to finance but decided to keep 30% margins on all current assets
excluding Cash balance (i.e agreed to finance excluding the margins) other information
is as follows -

Cost per unit

Raw Materials 40
Labour 10
Overheads 60
(Depreciation included in overheads Rs 20)
Selling price 120

Average holding/realisation period is as follows –

Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%)
– 1½ month,
Debtors – 2 month, Creditors – 1 month, wages – 1/2 month, overheads – 30 days,
Finished goods – 2 month.
80 % of sales is on credit, Expected cash balance is 75,000

3. Estimate the amount of working capital requirement

4. Estimate the amount of loan likely to be approved by the bankers.

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AUTHOR PROFILE

MR RAHUL B. CHAUHAN (1993)

[Link], M.B.A, [Link]., Ph.D. (Pursuing)

Assistant Professor,
Parul Institute of Business Administration,
Parul University, Baroda, Gujarat.

He has done his MBA in finance from the Parul

Institute of management and research, Baroda in
June 2015 and also has done [Link] in Finance
from Saurashtra University, Rajkot. Currently he is
Pursuing Doctoral of Philosophy from Gujarat
Technological University, on the topic Related to
Assets Allocation and Portfolio Management. He is
having total 6 years teaching experience. He is Editorial Board member in 16
International journal including Scopus and UGC Care Listed. He wrote More than
30 research papers as an author/co-author and also presented in national and
international conference and his 24 research paper published in various national and
international journals, out of it 5 paper published in Scopus indexed Journal. He is
Co-author in two books, subject of “Forms of Business Organization”, of FY BBA
Sem. 1 in Saurashtra University and in “IT Tools Of Business” FY BBA Sem. 2 also
his one book published in Lambert Publication, Germany related to the subject of
Marketing Management. His research interests are focused on financial
management, banking, education, economics, financial system, financial services,
with the current situation. Mr R. Chauhan was also awarded the best paper
presentation in the conference at Udaipur, Rajasthan in the year 2016 and Received
Best Academic Performance Award-2019 from Parul Institute of Business
Administration, Parul University and he has received 11 more national and
international awards from other government recognised bodies. He was invited as a
technical Session chairman in national conference in Netaji Subhas University-
Jamshedpur, Jharkhand on 21st September, 2019. He was invited as a resource
person in national conference on the topic of Recent & innovation practice in higher
education, organised by Ashoka International Foundation- Nasik, Maharashtra, on
14th December, 2019. He was also invited as a guest of honour in international
conference at Mumbai on 3rd and 4th February, 2020.

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 Financial Management

Dr. Andino Maseleno is a lecturer at STMIK Pringsewu,

Lampung, Indonesia. He was postdoctoral researcher at the
Institute of Informatics and Computing Energy, Universiti
Tenaga Nasional, Malaysia, in 2018-2019. He was a visiting
fellow in Centre for lifelong learning, Universiti Brunei
Darussalam, Brunei Darussalam, in July 2016 till March 2017.
He received the B.S. in Informatics Engineering from UPN
'Veteran” Yogyakarta, Indonesia in 2005, [Link]. in Electrical Engineering from
Gadjah Mada University, Indonesia in 2009, and Ph.D. in Computer Science from
Universiti Brunei Darussalam, Brunei Darussalam in 2015.

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