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CHAPTER1

FINANCIAL ANALYSIS AND PLANNINGRATIO ANALYSIS

INTRODUCTION

¾ Ratio Means any logical comparison between two number and financial ratio means any logical
comparisonbetweentwonumberorgroupof numbersfromfinancialstatements.
¾ Ratioanalysisisbasedonfactthatisolated.Numberfromfinancialstatementcan’tprovidesufficient
information for financial planning and decision making; but financial statements when co related
logically will provide before information.
¾ Financial statement of company are used by various stakeholder like management, shareholders,
government, banker, creditors etc. for different purpose & based on different purpose following are
maintypeofRatios:
1) Profitability Ratio
2) Liquidity Ratio
3) Coverage Ratio
4) TurnoverRatio/EfficiencyRatio
5) CapitalStructureRatio/LeverageRatio
6) Cash Position Ratio
7) Miscellaneous Ratio
o Financial Statement :
Particulars Amounts
1. Sales
2. COGS
DirectMaterialConsumed
(+)DirectLabour
(+)DirectExpense
(+)FOH
xxx
(+)opg.StockofWIP
()clo.StockofWIP
FactoryCost/WorkCost/COP xxx

Chapter1   Financial Analysisand Planningratio Analysis 3


(+)opg.StockofFG
()clo.StockofFG
GrossProfit(12) xxx

Less:AdminOH
S&DOH
OperatingProfit xxx
Add : NonOperating Income
Less:NonOperatingExpenses
EBIT xxx
()Interest
EBT xxx
()Tax
PAT xxx
()Pref.Dividend
EquityEarning xxx
()No.ofShare
EarningPerShares xxx
Balance Sheet as on
Particulars Amount Particulars Amount
1. CapitalEmployed 1. FixedAsset
A) ShareHolder'sFunds
1. EquityShareCap.xxx 2. investments
Reserve&Surplusxxx 2. TradeInvestment xxx
3. Pref.ShareCap. Xxx 4. NontradeInvestment xxx
B) LongTermDebt xxx xxx
3. CurrentAsset
2. CurrentLiability 5. Debtorsxxx
6. BankO.Dxxx 7. Stockxxx
8. Otherxxx 9. Cash/Bankxxx
xxx 10. Otherxxx
xxx.
4. Misc.Exp.NotW/Off xxx
Xxx xxx

NonOperating Income :
¾ Income arising from normal business activities areknown as NonOperating Income.
¾ Examples :
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 4
¾ Profit On Saleof Investment
¾ ProfitOnSaleofFixedAsset
¾ Interest, Dividend etc from NonTrade Investment
NonOperating Expenses :
¾ Expensesincurred forPurpose otherthanbusiness activitiesof organizationisKnown as
NonOperating Expenses.
¾ Examples :
¾ LossOnSaleOfAsset
¾ LossOnSaleOfInvestmentetc.
Trade Investment :
¾ Investment made in relation to business purpose is known as Trade Investment.
¾ Investment in shares of subsidiary company, Joint Ventures, Associates, Sinking Fund Investment,
Provident Fund Investment etc.
NonTrade Investment :
¾ Investmentmadeinotherthanbusinessactivitiesorinvestmentmadewiththeintentiontoearnextra
revenue from other than business activities are known as NonTrade Investment.
¾ Examples :
¾ Investmentin share of Reliance Ltd
¾ InvestmentinshareofTCSLtd
¾ Investmentin GovernmentofIndiaBondsetc.
1. Profitability Ratio :
TheseRatioaregenerallyusedbyshareholders&Govt.toestimateprofitabilityorganizationfollowing
ratioaregenerallycalculated:

GrossProfit
i) GPRatio: ×100
Sales

NetProfit(PAT)
ii) NetProfitRatio: × 100
Sales

Operating Profit (PAT)


iii) OperatingProfitRatio: ×100
Sales

 OperatingProfit=GrossProfitAdminOHS&DOH
OR
 OperatingProfit=EBIT +NonOperatingExpenses NonOperatingIncomes

OperatingProfit
iv) ReturnOnCapitalEmployed= × 100
CapitalEmployed

Chapter1   Financial Analysis and Planningratio Analysis 5


CapitalEmployed=EquityShareCapital+Pref.ShareCap.+Res.&Surplus+Long
TermDebt+P&LA/C(DrBal.)MiscellaneousExpensesNot
w/offNonTradeInvestment
Return ShareholderFunds=
ShareholderfundsorOwnerFundsorProprietorsFundsorNetWorthorEquity=EquityShare
Capital+Pref.ShareCapital+Res.&SurplusP&LA/C(DrBal.)MiscellaneousExpensesNotw/off
v) Return On Equity

Equity Earning (PAT  Pref.Dividend)


ShareholderFunds= × 100
Equity Shareholder Funds
Equity Shareholder Funds = Equity Share Capital + Res&Surplus  P&L A/C (Dr Bal.)  Miscellaneous
Expenses Not w/off

PAT
vi) ReturnOnTotalAssets= × 100
Total Asset

Total Asset=Fixed Asset+CurrentAsset +TradeInvestment+ NonTradeInvestment


OR
TotalAsset=TotalofBalanceSheetMiscellaneousExpensesP&LA/C(DrBal.)
Example 1 :
Cogs: 700000
GPRatio: 30%
CalculateSale&GP?
Ÿ SalesCogs =
GP
10070 = 30
(?) 70,00,000 = 30,00,000
1,00,00,000
Example 2 :
Cogs : 35,00,00
GPRatio : 30%
Net Profit Ratio : 10%
Total Asset : 25,00,000

CalculateReturnOnTotalAsset?
Ÿ SalesCogs= GP
10070 = 30
(?)25,00,000= 25,00,000
50,00,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 6
NP (PAT)
NPRatio= × 100
Sales

x
10%= × 100
50, 00, 000
PAT=5,00,000
? ReturnOnTotalAsset=

5, 00, 000
= × 100
25, 00, 000
=20%
Example 3 :
Sales : 1,00,00,000
Operating profit Ratio : 20%
Net Profit Ratio : 10%
Return On Capital Employed : 25%
LongTermDebt : 20,00,000
Calculate Return Onshareholder Funds ?

PAT
è ReturnOnShareholder= × 100
Shareholder Funds

10, 00, 000


= × 100
60, 00, 000
=16.667%
Working Notes :

operating Profit
1) OperatingprofitRatio: × 100
Sales

x
20: × 100
1, 00, 00, 000
OperatingProfit:20,00,000
2) ReturnOn

Operating Profit
CapitalEmployed: ×100
Capital Employed

20, 00, 000


25%: × 100
x

Chapter1   Financial Analysis and Planningratio Analysis 7


CapitalEmployed:80,00,000

LongTermDebtShareholderFunds
20,00,00060,00,000

NP(PAT)
3) NPRatio: × 100
Sales

x
10: × 100
1, 00, 00, 000
NP:10,00,000

2. Liquidity Ratio :
¾ This type of Ratio are Calculated Generally by Creditors & providers of Short term Capital to
estimate companies Ability to repay its Current Liabilities.
¾ Following Ratio are generally Calculated :

Current Asset
i) CurrentRatio= CurrentLiabilities

IdealCurrentRatiois2:1
Current Asset  Stock
ii) LiquidRatio/QuickRatio/ AcidRatio= CurrentLiabilities

IdealQuickRatiois1:1
Example 1 :
Current Ratio : 2:1
QuickRatio : 1:1
Working Capital : 10,00,000
CalculateClosingStock?
Example 2 :
Current Ratio : 3:1
QuickRatio : 2:1
Closing Stock : 10,00,000
Calculate WorkingCapital ?
Solution 1 :
CA CL=WC
2  1=1
(?) = 10,00,000
20,00,00010,00,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 8
CA  Stock
QR=
CL

20, 00, 000  x


=
1, 00, 00, 000

CA  Stock
QR = Stock=10,00,000
CL
Solution 2 :
CA  Stock
QR =
CL

2 3y 10, 00, 000


=
1 y
2y=3y10,00,000
10,00,000=3y2y
Y=10,00,000
CACL=WC
31=2
10,00,000=(?)=20,00,000

3. Coverage Ratio :
¾ ThisratioareCalculatedtoestimateearnings availableforpaymentoffixedcharge.
¾ Following Ratio are generally Calculated :

EBIT
i) Interest Coverage Ratio :
Interest

PAT
ii) Pref. Dividend Coverage Ratio :
Pref.Dividend

PAT + NonCashExpenses + Int.


iii) Debt Service Coverage Ratio :
Principle + Interest

Example 1 :
Interest : 1,00,000
Interest Coverage Ratio : 4times
Operating Profit Ratio : 20%
NPRatio : 10%
ROCE : 25%

Chapter1   Financial Analysis and Planningratio Analysis 9


LongTermDebt : 5,00,000
Calculate ReturnOn Shareholder Fund ?
Ÿ ReturnOnShareholderFund=
2, 00, 000
= × 100
11, 00, 000
=18.18%

Working Notes :
i) InterestCoverageRatio=

x
4= × 100
1, 00, 000
EBIT=4,00,000

Operating Profit
OperatingProfit= × 100
Sales

4, 00, 000
20 = × 100
x
Sales = 20,00,000

PAT
ii) NPRatio= × 100
Sales

x
10 = × 100 PAT=2,00,000
20, 00, 000

OperatingProfit
iii) ROCE= × 100
CapitalEmployed

4, 00, 000
25% = × 100
x
CapitalEmployed=16,00,000
LongTermDebtShareholderFund
5,00,00011,00,000
Example 2 :
EBT : 6,00,000
Interest Coverage Ratio : 4times
Operating Profit Ratio : 25%
NPRatio : 10%
Total Asset : 50,00,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 10
CalculateReturnOnTotalAsset?

PAT
Ÿ ReturnOnTotalAsset= Total Assets × 100

Working Notes :
EBIT
InterestCoverageRatio=
Interest

EBT+ Interest
4=
Interest

6, 00, 000 + x
4=
x
4xx = 6,00,000
Interest = 2,00,000
EBIT = 8,00,000

4. Turnover Ratio/ Efficiency Ratio :


¾ TheseratioareCalculatedtoestimateefficiencyofcompanytoutilize,ifresourceshigherTurnover
Ratio indicate higher efficiency.
¾ Following Ratio are generally Calculated :

Sales
i) Fixed Asset Turnover Ratio :
Fixed Asset

Sales
ii) Total Asset Turnover Ratio :
Total Asset

Sales
iii) Capital Turnover Ratio :
CapitalEmployed

Sales
iv) Working Capital Turnover Ratio :
Working Capital

Credit Sales
v) Debtors Turnover Ratio :
Debtors + B / R

Debtors + B / R 12
vi) Debtors Ratio / Average Collection Ratio : ×
Credit Sales 365

CreditPurchase
vii) Creditors Ratio :
Creditors + B / P

Chapter1   Financial Analysis and Planningratio Analysis 11


Creditors + B / P 12
viii) Creditors Ratio / Average Payment Ratio : ×
CreditPurchase 365

COGS
ix) Stock Turnover Ratio :
Average Stock
Note :
o IncasedataaboutCOGSisnotavailable,saleshouldbeconsidered.
o IncaseofNewcompanyinsteadofAverageStock,ClosingStockshouldbeconsidered.

Question :
ClosingStock: 10,00,000
CurrentRatio: 2:1
QuickRatio: 1:1
W.C.TurnoverRatio: 5times
NetprofitRatio: 10%
TotalAssets: 50,00,000
CalculateReturnOnTotalAsset?
Answer :
PAT
Ÿ ReturnOnTotalAssetRatio= Total Asset × 100

5, 00, 000
= × 100 =10%
50, 00, 000

CA  Stock
Ÿ QuickRatio=
CL

2y  10, 00, 000


1=
y
Y=10,00,000
CACL=WC
21=1
10,00,000(?)
10,00,000

Sales
Ÿ W.C.TurnoverRatio=
Working Capital

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 12
x
5times=
10, 00, 000
Sales=50,00,000

NP(PAT)
Ÿ NPRatio= × 100
Sales

x
10 = × 100
50, 00, 000
=5,00,000

5. Capital Structure Ratio / Leverage Ratio :


¾ These RatioareCalculated toestimate efficiency &riskinvolvedin companiescapital structure.
¾ Capital Structure canbe definedasproportionof varioussource of capitalin companiesoverall
capital.
1. DebtEquity

Debt
Ratio=
Equity
2. Capital Gearing Ratio =
OR

ª Debt+ Preference º
«EquityShareHolder »
¬ ¼
¾ These ratio Calculate Proportion Of Capital With Fixed Commitment
(Debt+Preference)Compared to capital Without any fixed commitment.

Proprietor Fund
3. ProprietorRatio/ProprietorFundRatio= × 100
Total Assets
¾ These Ratio Calculated proportion of total asset financed By Proprietor Fund.
Question :
Sales : 1,00,00,000
Operating Profit Ratio : 20%
Return On Capital Employed : 25%
DebtEquityRatio : 1:3
ShareCapitalToReserve&Surplus : 1:1
EquityShare CapitaltoPref. ShareCapital : 1:1
Calculate :
1. Equity Capital
2. Preference Capital

Chapter1   Financial Analysis and Planningratio Analysis 13


3. Reserve & surplus
4. LongTermDebt
Answer :

Operating Profit
1. OperatingProfitRatio= × 100
Sales

x
20 = × 100
1, 00, 00, 000
Operating Profit = 20,00,000

OperatingProfit
2. ReturnOnCapitalEmployed= × 100
CapitalEmployed

20, 00, 000


25 = × 100
x
CapitalEmployed=80,00,000

Debt Equity
1 : 3
20,00,000 : 60,00,0
ShareCapital Reserve & Surplus
1 : 1
3,00,000 3,00,000
EquityShare Pref. Share
1 :` 1
1,50,000 1,50,000
6. CashPositionRatio:
¾ TheseRatioarecalculatedtoestimatecompaniesabsoluteactualposition&ProportionofTotal
Asset held in cash convertible form.
¾ Following Ratio are generally Calculated :
i) Super Quick Ratio / Absolute Cash Ratio :

Cash / Bank + short TermMarketable sequirities


CurrentLiabilities
ii) Cash Position to Total Asset :

Cash / Bank + short TermMarketable sequirities


Total Asset

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 14
iii) Defence Interval Ratio / Cash Interval Ratio :

Cash / Bank + ShortTermMarketableSecurities + Debtors


Daily Operating Exps

¾ These ratio calculated proportion of total assets held in cash convertible form.

Notes :
¾ Foralltheabove3ratiomarketvalueofshorttermmarketablesecuritiesshouldbeconsideredandnot
book value.
¾ Forcashpositiontototalassetratio
TotalAsset=FixedAsset+currentAsset+TradeInvestment(BookValue)+NonTrade
Investment(MarketValueif)
OR
TotalAsset=TotalofBalanceSheetShortTermMarketSecurities(BookValue)+ShortTerm
MarketSecurities(MarketValue)MiscellaneousExpensesNotw/offP&LA/C(DrBalance)

Chapter1   Financial Analysisand Planningratio Analysis 15


CLASS WORK

CALCULATION OF RATIOS

Q1 Thefollowing extractsof financialinformation relatetoCuriousLtd.


` lakhs
BalanceSheetasat31stDecember 2004 2003
Share Capital 10 10
Reserves and Surplus 30 10
LoansFunds 60 70
100 90
Fixed Assets (Net) 30 30
CurrentAssets:
Stocks 30 20
Debtors 30 30
CashandBankBalances 10 20
Other Current Assets 30 10
100 80
Less :Current Liabilities 30 20
Net 70 60
Total Assets 100 90
Sales (`lakhs) 270 300

(i) Calculate,for the two years DebtEquity Ratio, Quick Ratio, and Working capital Turnover
Ratio;and
(ii) Findthesalesvolumethatshouldhavebeengeneratedin2004ifthecompanyweretohave
maintained its Working Capital Turnover Ratio.
Q2 Fromthefinala.countsof PrudentLtd.givenbelow, calculatethe following:
(a) Grossprofitratio(b)Currentratio(c)Liquidratio,and(d)Returnoninvestmentratio.
TraringandProfitandLossAccountfortheyearended31stMarch.2006

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 16
` `
To Material conurned BySales 85,000
Opening stock 9,050 ByProfit on sale investment 600
Purchases 54,525 By Interest On investment 300
63,575
Less: Closing stock 14,000 49,575
To Carriage inwards 1,425
To Office expenses 15,000
To Sales expenses 3,000
To Financial expenses 1500
ToLossonsalesofassets 400
To Net profit 15,000
85,900 85,900
Balance sheet as on 31st March, 2006
Liabilities ` Assets `
Sharecapital2000equityshares 20.000 Fixed Assets:
of`10each,fullypaid Buildings15,000
General reserve 9,000 Plant8,000 23,000
Profitandlossacount 6,000 Current Assets:
Bank overdraft 3,000 Stockintrade14,000
Sundry creditor Debtors7,000
For’expenses2,000 Billsreceivable1,000
Forothers8,000 10,000 Bankbalance3,000 25,000
48,000 48,000

Q3 Acompanyiscapitalisedasfollows: (`)


7%Preferenceshares,Re.1each 6,00,000
Ordinaryshares,Re.1.each 16,00,000
22,00,000
Thefollowing informationisrelevant astoitsfinancialyear justended
Profitaftertaxatianat50% `5,42,000
Marketpriceofordinaryshares `4
Ordinary divideni paid 20%
Depreciation `1,20,000
You are required state the following showing the iecessary workings (a) Dividend yield on ordinary
shares (b) Earnings yield (c) Priceearnings (P/E) ratio.

Chapter1   Financial Analysis and Planningratio Analysis 17


Q4 You have beenfurnished withthefinancial information ofAditya Mills Limited as under.
Balance sheet as on 31st December
Liabilities Assets
(` ) (` )
Equity share capital 10,00,000 Plant and equipment 6,40,000
(`100each) Land and building 80,000
Retained earnings 3,68,000 Cash 1,60,000
Sundry creditors 1,04,000 Sundry
Bills payable 2,00,000 debtors ` 3,60,000
Other current liabilities 20,000 LessBDR 40,000 3,20,000
Stock 4,80,000
________ Prepaid insurance 12,000
16,92,000 16,92,000
Statement of profit for the year ended December 31
`
Sales 40,00,000
Lesscostofgoodssold 30,80,000
Grossprofitonsales 9,20,000
Less operating expenses 6,80,000
Net profit 2,40,000
Lesstaxes@50% 1,20,000
Net profit after taxes 1,20,000
Sundrydebtorsandstockatthebeginningoftheyearwere`3,00,000and`4,00,000,respectively.
DeterminethefollowingratiosofAdityaMillsLtd:
(a) Current ratio (b) Acidtest ratio
(c) Stock turnover (d) Debtors turnover
(e) Grossprofitratio (f) Net profit ratio
(g) Operating ratio (h) Earnings pershares(EPS)
(i) Rateofreturnonequity
(j) Marketvalueoftheshareifpriceearnings(P/E)ratiois10times.
Q5 MNPLimitedhasmadeplansforthenextyear201516.Itisestimatedthatthecompanywillemploy
totalassetsof`25,00,000;30%ofassetsbeingfinancedbydebtataninterestcostof9%p.a.Thedirect
costs for the year are estimated at `15,00,000 and all other operating expenses are estimated at
`2,40,000.Thesalesrevenueareestimatedat`22,50,000.Taxrateisassumedtobe40%.Requiredto
calculate:
(i) Netprofitmargin(After tax);
(ii) ReturnonAssets(Aftertax);
(iii) Asset turnover; and
(iv) Returnon Equity

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 18
Q6 GivenbelowBalancesheetof ALtd. (‘000`)
As on As on As on
31.12.02 31.12.03 31.12.04
Assets:
GrossBlock 80,00 100,00 120,00
Less Accumulated Depreciation (20,00) (26,00) (34,00)
60,00 74,00 86,00
InvestmentatCost:
Trade 5,00 6,00 6,50
NonTrade (quoted) 4,00 7,00 6,00
NonTrade (unquoted) 2,00 2,00 2,00
Inventories 10,00 12,00 14,00
Debtors 8,00 10,00 8,50
CashatBank 2,00 2,50 3,00
Advances toemployees due by 1,00 1,20 1,40
12months
Others 4,00 4,50 5,00
96,00 119,20 132,40
Liabilities :
Share Capital 40,00 40,00 40,00
Reserves & Surplus 10,00 15,00 20,00
Termloan 30,00 40,00 52,00
Sundry Creditors 7,00 14,70 10,40
Taxprovisionsnetofadvancetax 1,00 1,50 2,00
Proposed Dividend 8,00 8,00 8,00
96,00 119,20 132,40

Other information :
(i) Marketvalueofquotednontradeinvestmentsason31.12.02`3,80thousand,ason31.12.03`7,20
thousandandason31.12.04`5,50thousand.
(ii) Operatingexpensesfortheyearended31.12.02were`62,80thousand,fortheyearended31.12.03
`75,02 thousand and the year ended 31.12.04 `80,00 thousand excluding depreciation. Find out
three cash positionratios.

Chapter1   Financial Analysis and Planningratio Analysis 19


Q7 TheBalanceSheetofYLtd.stoodasfollowsareason:
Liabilities 31.3.04 31.3.03 Assets 31.3.04 31.3.03
Capital 250 250 Fixed Assets 400 300
Reserves 116 100 Less Depreciation 140 100
Loans 100 120 260 200
Creditors and other Investment 40 30
Current Liabilities 129 25 Stock 120 100
Debtors 70 50
Cash/Bank 20 20
Other Current Assets 25 25
Misc. Expenditure 60 70
595 495 595 495

Youaregiventhefollowinginformationfortheyear200304:
Sales 600
PBIT 220
Interest 94
Provision for Tax 60
Proposed Dividend 50
Allthe figuresgiven above are rupeesin lakhs.
Fromtheaboveparticularscalculatefortheyear200304:
(a) ReturnoncapitalEmployedRatio.
(b) Stock Turnover Ratio.
(c) ReturnonNetWorth.
(d) Current Ratio.
(e) Proprietary Ratio.

MISSING FIGURES

(a) Balance sheet


Q8 Fromthefollowinginformation,relatingalimitedcompanyprepareaStatementofProprietorsFunds :
(i) Current Ratio 2
(ii) Liquid Ratio 1.5
(iii) Fixed Assets/Proprietary Fund ¾
(iv) Working Capital `75,000
(v) Reserves and Surplus `50,000
(vi) Bank Overdraft `10,000
Therewerenolongtermloansorfictitiousassets.Allworkingsmustformpartofyouranswer.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 20
Q9 FromthefollowinginformationrelatingtowiseLimited/ youarerequiredtoprepareitssummarised
Balance Sheet.
(a) Current ratio 2.5
(b) Acid Test Ratio 1.5
(c) Gross Profit/Sales Ratio 0.2
(d) Net working capital/Net worth Ratio 0.3
(e) Sales/Net Fixed Assets Ratio 2.0
(f) Sales/Net worth ratio 1.5
(g) Sales/Debtors Ratio 6.0
(h) Reserves/Capital ratio 1.0
(i) Networth/longtermloanratio 20.0
(j) Stock Velocity 2months
(k) Paidupsharecapital `10 lakhs.
Q10 Workingcapitalofacompanyis`1,35,000andcurrentratiois2.5.Liquidratiois1.5andtheproprietary
ratio0.75.BankOverdraftis`30,000.Therearenolongtermloansandfictitiousassets.Reservesand
surplusamountto`90,000andthegearingratio(EquityCapital/PreferenceCapital)is2.
Fromtheabove, please ascertain
(i) Current assets (ii) Current Liabilities
(iii) Net block (iv) Proprietary fund
(v) Quick Liabilities (vi) Quick assets
(vii) Stockand (viii) Preference and equity capital.
AlsodrawtheStatement of ProprietaryFund.
Q11 FromthefollowinginformationpertainingtoM/sSukanya&Co.Ltd.prepareitsTrading,Profit&Loss
Accountfortheyearendedon31stMarch,05andasummarisedBalanceSheetasatthatdate:
Current Ratio 2.5
QuickRatio 1.3
Proprietary Ratio (Fixed Assets/Proprietary Fund) 0.6
GrossProfittoSalesRatio 10%
Debtor’s velocity 40days
Sales `7,30,000
Working capital `1,20,000
Bank overdraft `15,000
Share capital `2,50,000

ClosingStockis10%morethanOpeningStock
NetProfit10%ofproprietaryfunds.

Chapter1   Financial Analysisand Planningratio Analysis 21


Q12 Fromthefollowinginformation,drawtheBalanceSheetofM/sRavi&Co.ason31stMarch,04:
Current ratio =2:1
Liquid Ratio =1:1
Return on capital employed =10%
Fixed assets turnover ratio =8:5
Closingstockwas12.5%ofsales
Owner’s equity to fixed assets =8:15
Debtors turnover =1month
Debt equity ratio =5:4
Fortheyearended31stMarch,2004,M/sRavi&Co.madeaprofitof`1,00,000afterpayinginterestof
`80,000ontermloanbutbeforetax.Taxpaidfortheyearwas`40,000.Bankbalancestoodat`1,00,000
besidesstockanddebtorsoftheconcern.
Q13 WiththehelpofthefollowinginformationcompletetheBalanceSheetofMNOPLtd.
Equity shareholders fund: ` 1,00,000

Therelevantratiosofthecompanyareasfollows:
Currentdebttototaldebt .40
Total debt to owner’s equity .60
Fixed assets to owner’s equity .60
Total assets turnover 2 Times
Inventory turnover 8 Times
Q14 NOORLimitedprovidesthefollowinginformationfortheyearending31stMarch,2014:
Equity Share Capital `25,00,000
Closing Stock `6,00,000
StockTurnoverRatio 5times
GrossProfitRatio 25%
NetProfit /Sale 20%

1
NetProfit/Capital
4
Youarerequiredtoprepare:
TradingandProfit&LossAccountfortheyearending31stMarch,2014.
Q15 Fromthefollowinginformation,prepareasummarisedBalanceSheetasat31stMarch,2002:
Net Working Capital `2,40,000
Bank overdraft `40,000
Fixed Assets toProprietary ratio 0.75
Reserves and Surplus `1,60,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 22
Q16 Using the following information, complete the Balance Sheet given below:
(i) Totaldebttonetworth: 1:2
(ii) Totalassetsturnover: 2
(iii) Grossprofitonsales: 30%
(iv) Average collection period : 40days
(Assume360daysinayear)
(v) Inventoryturnoverratiobasedoncostofgoodssoldandyearendinventory: 3
(vi) Acidtestratio: 0.75
Balance Sheet
as on March 31, 2016
Liabilities ` Assets `
Equity Shares Capital 4,00,000 Plant and Machinery
Reserves and Surplus 6,00,000 and other Fixed Assets
TotalDebt: Current Assets:
Current Liabilities  Inventory
Debtors
Cash
_______ _______
______ ______

(b) Trading, P & L A/c


Q17 TheassetsofSONALtd.consistoffixedassetsandcurrentassets,whileitscurrentliabilitiescomprise
bankcreditintheratioof2:1.YouarerequiredtopreparetheBalanceSheetofthecompanyason31st
March2016withthehelpoffollowinginformation:
Share Capital `5,75,000
Working Capital (CACL) `1,50,000
GrossMargin 25%
Inventory Turnover 5times
Average Collection Period 1.5months
Current Ratio 1.5:1
QuickRatio 0.8:1
Reserves&SurplustoBank&Cash 4times
Assume360daysinayear

(c) Balance Sheet & Trading P & L a/c

Chapter1   Financial Analysis and Planningratio Analysis 23


Q18 ThefollowingaccountinginformationandfinancialratiosofPQRLtd.relatetotheyearended
31stDecember,2016
2016
I AccountingInformation:
GrossProfit 15%ofSales
Netprofit 8%ofsales
Rawmaterialsconsumed 20%ofworkscost
Directwages 10%ofworkscost
Stockofrawmaterials 3months’usage
Stockoffinishedgoods 6%ofworkscost
Debtcollectionperiod 60days
Allsalesareoncredit
II FinancialRatios:
Fixedassetstosales 1:3
FixedassetstoCurrentassets 13:11
Currentratio 2:1
LongtermloanstoCurrentliabilities 2:1
CapitaltoReservesandSurplus 1:4

Ifvalueoffixedassetsason31stDecember,2015amountedto`26lakhs,prepareasummarised
ProfitandLossAccountofthecompanyfortheyearended31stDecember,2016andalsotheBalance
Sheetason31stDecember,2016.
Q19 Complete thefollowing annual financial statement on the basisof ratios given below:
Profit and Loss Account for the year ended 30th June,04
Dr. ` Cr. `
Tocostofgoodssold 6,00,000 BySales 20,00,000
“ Operating expenses _ “
“EarningsbeforeIntt. _
andTax.

To Debenture Interest 10,000 By Earnings before

“IncomeTax _ Interest and Tax


“NetProfit _

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 24
Balance Sheet as at 30th June,2004
` `
Networth: Fixed Assets
Share capital _ Current Assets:
Reserve and Cash _
Surplus _ Stock _
10% Debentures _ Debtors 35,000
Sundry Creditors 60,000

(i) NetProfittosales 5%
(ii) Current Ratio 1.5
(iii) Returnonnetworth 20%
(iv) Inventory turnover 15times
(basedoncostofgoodssold)
(v) Sharecapitaltoreserves 4:1
(vi) Rate of Incometax 50%

Q20 Fromthe following ratiosand further information given below, prepare a Tradingand Profit andLoss
AccountandaBalanceSheetofMr.Green:
(i) Fixed Assets/Capital = 5/4
(ii) FixedAssets `5,00,000
(iii) Capital/Liabilities = 1/2
(iv) NetProfit/Capital=1/5
(v) Grossprofitratio=25%
(vi) Stockturnoverratio=10
(vii) Fixed Assets/Total Current Assets = 5/7
(viii) NetprofittoSales=20%
(ix) ClosingStock`50,000
OutofcurrentAssets,SundryDebtorsare`6,00,000.ThebalancerepresentsCashandClosingStock.
MISCELLANEOUS
Q21 Calculatetheaveragecollectionperiodfromthefollowingdetailsbyadopting360daystoanyear:

Average inventory `3,60,000


Debtors `2,30,000
Inventory Turnover Ratio 6
GrossProfitRatio 10%
Creditsalestototalsales 20%

Chapter1   Financial Analysis and Planningratio Analysis 25


Q22 Prepare working capital requirement from following information :
Average collection period 60days
Average payment period 75days
Inventory holding period 90days
(Calculatedwithreferencetocostofgoodssold)
Cashandbankbalance2.5%ofsales
Sales`20,00,000grossprofit25%
Creditpurchases1/3ofcostofgoodssold
Thecompanyexpects50%salesincrementduringthenextyear.
(Assume1year=360days)
COMMENTS
Q23 InameetingheldatSolantowardstheendof2016,theDirectorsofM/sHPCLLtd.havetakenadecision
todiversify.AtpresentHPCLLtd.sellsallfinishedgoodsfromitsownwarehouse.Thecompanyissued
debentures on 01.01.2017 and purchased fixed assets on the same day. The purchase prices have
remained stable during the concerned period. Following information is provided to you:
Income Statements
Particulars 2016 ( `) 2017 ( `)
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less:Costofgoodssold 2,36,000 2,98,000
Grossprofit 64,000 76,000
Less:Operating Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 49,000 14,000
2,000 59,000
NetProfit` 15,000 17,000
Assets & Liabilities 2016 ` 2017 `
Fixed Assets (Net Block)  30,000  40,000
Receivables 50,000 82,000
CashatBank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Payables50,00076,000
Total Current Liabilities (CL) 50,000 76,000
WorkingCapital(CACL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by: Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures  30,000
1,00,000 1,47,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 26
Youarerequiredtocalculatethefollowingratiosfortheyears2016/2017.
(i) GrossProfitRatio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock TurnoverRatio
(vi) NetProfittoNetWorthRatio,and
(vii) Receivables Collection Period.
Ratiorelatingtocapitalemployedshouldbebasedonthecapitalattheendoftheyear.Givethereasonsfor
changeintheratiosfor2years.Assumeopeningstockof`40,000fortheyear2017.
Ignore Taxation.

Chapter1   Financial Analysis and Planningratio Analysis 27


LAST MINUTE REVISION (LMR)

BASIC CONCEPTS AND FORMULAE


1. Financial Financial AnalysisandPlanningiscarriedout forthepurposeofobtaining
Analysis material and relevant information necessary for ascertaining the financial
and Planning strengthsandweaknessesofanenterpriseandisnecessarytoanalyzethedata
depictedinthefinancialstatements.Themain toolsareRatioAnalysisand
CashFlow andFunds FlowAnalysis.
2. Ratio Ratioanalysisisbasedonthefactthatasingleaccountingfigurebyitselfmay
Analysis notcommunicateanymeaningfulinformationbutwhenexpressedasarelative
to some other figure, it may definitely provide some significant information.
Ratio analysisiscomparisonofdifferent numbers fromthe balance sheet,
incomestatement,andcashflowstatement againstthefiguresofprevious
years,othercompanies, theindustry, oreven theeconomyingeneralforthe
purpose of financial analysis.
3. Importance Theimportanceofratioanalysisliesinthefactthatitpresentsfactsona
ofRatio comparative basisandenables drawingof inferencesregarding theq
Analysis performanceofafirm.Itisrelevantinassessingtheperformanceofafirmin
respect of following aspects:
• Liquidity Position
• Longterm Solvency
• Operating Efficiency
• Overall Profitability
• Interfirm Comparison
• Financial Ratios for Supporting Budgeting.
4. Cash Flow Cashflowstatementisastatementwhichdisclosesthechangesincashposition
Statement betweenthetwoperiods.Alongwithchangesinthecashpositiontheash
flowstatementalsooutlinesthereasonsforsuchinflowsoroutflowsofcash
which inturnhelpsto analyze thefunctioningofabusiness.
5. Classification Thecashflowstatementshouldreportcashflowsduringtheperiodofclassified
Cash flow into following categories:
Activities • Operating Activities:These arethe principalrevenueproducing activities
oftheenterpriseandotheractivities thatarenotinvestingorfinancing
activities.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 28
• Investing Activities: Theseactivitiesrelatetotheacquisitionanddisposal
oflongtermassets and otherinvestmentsnotincludedincash
equivalents. Cash equivalents are short term highly liquid investments
thatarereadilyconvertibleintoknownamountsofcashandwhichare
subjecttoaninsignificant riskof changesin value.
• Financing Activities: Theseareactivitiesthatresultinchangesinthesize
andcompositionoftheowners’capital(includingpreferencesharecapital
inthecaseofacompany)andborrowingsoftheenterprise.
6. Procedure • Calculation of net increase or decrease in cash and cash equivalents: The
in Preparation differencebetween cash and cashequivalents for the period may be
ofCashFlow computedbycomparingtheseaccountsgiveninthecomparativebalance
Statement sheets.Theresultswillbecashreceiptsandpaymentsduringtheperiod
responsiblefortheincreaseordecreaseincashandcashequivalentitems.
• Calculation of the net cash provided or used by operating activities: Itis
bytheanalysisofProfitandLossAccount,ComparativeBalanceSheet
and selected additional information.
• Calculation of the net cash provided or used by investing and financing
activities:AllotherchangesintheBalancesheetitemsmustbeanalysed
takingintoaccounttheadditionalinformationandeffectoncashmaybe
grouped under the investing and financing activities.
• Final Preparation of a Cash Flow Statement: Itmaybepreparedby
classifying all cash inflowsand outflows in terms ofoperating, investing
andfinancingactivities.Thenetcashflowprovidedorusedineachof
these threeactivities maybehighlighted. Ensure thattheaggregateof
net cash flows from operating,investingand financing activities isequal
tonetincreaseordecreaseincashandcashequivalents.
7. Reporting Therearetwomethodsofconvertingnetprofitintonetcashflowsfrom
ofCashFlow operating activities
from • andactualcashpayments(foraperiod)foroperatingexpensesare
Activities arranged and presentedin the cashflowstatement.The difference
betweencashreceiptsandcashpaymentsisthenetcashflowfrom
operating activities.
• Indirect Method: Inthismethodthenetprofit(loss)isusedasthebase
thenadjustedforitemsthataffectednetprofitbutdidnotaffectcash.
8. Funds Itascertainsthechangesinfinancialpositionofafirmbetweentwo
Flow accountingperiods.Itanalysesthereasonsforchangeinfinancialposition
Statement betweentwobalancesheets.It showstheinflowandoutflow offunds
i.e., sourcesandapplicationoffundsduringaparticularperiod.
? Sources of Funds
(a) Longtermfundraisedbyissueofshares,debenturesorsaleoffixed
assets and
(b) Fundgeneratedfromoperationswhichmaybetakenasagross
beforepaymentofdividendandtaxesornetafterpaymentof
dividend and taxes.

Chapter1   Financial Analysis and Planningratio Analysis 29


? Applications of Funds
(a) Investment in Fixed Assets
(b) Repayment of Capital
9. Funds Cash flow statement Funds flow statement
Flow (i) Itascertainsthechangesin (i) Itascertainsthechangesin
Statement vs. balanceofcashinhandand financial position between
Cash Flow bank. two accounting periods.
Statement (ii) Itanalysesthereasonsfor (ii) Itanalysesthereasonsfor
changesinbalanceofcashin change in financial
handand bank. position between two
balance sheets.
(iii) Itshowstheinflowsand (iii) Itrevealsthesourcesand
outflows of cash. application of funds.
(iv) Itisanimportanttoolfor (iv) Ithelpstotestwhether
short term analysis. working capital has been
effectively used or not.
(v) Thetwosignificantareasof
analysisare cash generating
efficiency and free cash flow.

SUMMARY OF RATIOS

Liquidity Ratio

Current Assets
Current Ratio A simple measure that estimates
CurrentLiabilities
whetherthebusiness canpay
shorttermdebts.Idealratiois2:1.

QuickAssets
QuickRatio Itmeasurestheabilitytomeetcurrent debt immediately.
CurrentLiabilities
Idealratiois1:1.

CashRatio It measures absolute liquidity of the

business
Basic Defense

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 30
Interval Ratio Itmeasuresthe ability of the business

to meet regular cash expenditures.


NetWorking Current Assets – Current Liabilities Itisameasureofcashflowto
Capital Ratio determine the ability of business to survive financial crisis
Capital Structure Ratio

Equity Ratio

It indicatesowner’s fund in companies to total fund invested.

Debt Ratio

Itisanindicatorofuseofoutsidefunds.

Debt to equity Ratio

Itindicatesthecompositionofcapitalstructure intermsofdebtandequity.

Debt to Total assets Ratio

Itmeasureshowmuchoftotalassetsisfinancedbythedebt.

Capital Gearing Ratio

It shows the proportion of fixed interest bearing capital to equity shareholders’ fund.It also signifies the
advantage of financial leverage to the equity shareholder.

Proprietary Ratio

Itmeasurestheproportionof total assets financedbyshareholders.


Coverage Ratios

Debt Service Coverage Ratio (DSCR)

Itmeasurestheabilitytomeetthecommitmentofvariousdebtserviceslikeinterest,installmentetc.Ideal

Chapter1   Financial Analysisand Planningratio Analysis 31


ratiois2.

Interest Coverage Ratio

Itmeasurestheabilityofthebusinesstomeetinterest.Idealratiois>1.

Preference Dividend Coverage Ratio

Itmeasurestheability topaythepreferenceshareholders’dividend.Idealratiois>1

Fixed Charges Coverage Ratio

Thisratioshowshowmanytimesthecashflowbeforeinterestandtaxescoversallfixedfinancingcharges.
Theidealratiois>1.
Activity Ratio/ Efficiency Ratio/ Performance Ratio/ Turnover Ratio

Total Asset Turnover Ratio

Ameasureoftotalassetutilisation.IthelpstoanswerthequestionWhatsalesarebeinggeneratedbyeach
rupee’s worth of assets invested in the business?

Fixed Assets Turnover Ratio

Thisratioisaboutfixedassetcapacity.Areducingsalesorprofitbeinggeneratedfromeachrupeeinvested
in fixed assets may indicate overcapacity or poorerperforming equipment.

Capital Turnover Ratio

This indicatesthe firm’s ability to generate sales per rupee of long term investment.

Working Capital Turnover Ratio

Itmeasurestheefficiencyofthefirmtouseworkingcapital.

Inventory Turnover Ratio

Itmeasurestheefficiencyofthefirmtomanageitsinventory

Debtors Turnover Ratio

Itmeasurestheefficiency atwhich firmis managingits receivables.

Receivables (Debtors’) Velocity

It measures the velocity of collection of receivables.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 32
Payables Turnover Ratio

Itmeasuresthevelocity of payables payment.


Profitability Ratios based on Sales

Gross Profit Ratio

This ratio tells us something about the business’s ability consistently to control its production costs or to
managethemarginsitmakesonproductsitbuysandsells.

Net Profit Ratio

Itmeasuresthe relationship between net profit and sales of the business.

Operating Profit Ratio

It measures operating performance of business.


Expenses Ratio

Cost of Goods Sold (COGS) Ratio

Operating Expenses Ratio

Operating Ratio

Financial Expenses Ratio

Itmeasuresportionofaparticularexpensesincomparisontosales.
Profitability Ratios related to Overall Return on Assets/ Investments

Return on Investment (ROI)

It measures overall returnof the business on investment/ equity funds/ capital employed/ assets

Return on Assets (ROA)

Itmeasuresnet profit perrupee of average totalassets/average tangible assets/average fixed assets.

Return on Capital Employed ROCE (Pretax)

Chapter1   Financial Analysis and Planningratio Analysis 33


Itmeasures overall earnings(either pretaxor post tax) on total capital employed.

Return on Capital Employed

Return on Equity (ROE)

it indicates earnings available to equity shareholders in comparison to equit shareholders’ networth.
Profitability Ratios Required for Analysis from Owner’s Point of View

Earnings per Share (EPS)

EPSmeasurestheoverallprofitgeneratedforeachshareinexistenceoveraparticularperiod.

Dividend per Share (DPS)

Proportion of profit distributed per equity share

Dividend payout Ratio (DP)

Itshows%ofEPSpaidasdividendandretainedearning
Profitability Ratios related to market/ valuation/ Investors

PriceEarnings per Share (P/E Ratio)

Atanytime,theP/Eratioisanindicationofhowhighlythemarket“rates”or“values”abusiness.AP/Eratio
isbestviewedinthecontextofasectorormarketaveragetogetafeelforrelativevalueand
stock market pricing.

Dividend Yield

Itmeasuresdividendpaidbasedonmarketpriceofshares

Earnings Yield

Itistherelationshipofearningpershareandmarketvalueofshares.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 34
Market Value /Book Value per Share

Itistherelationshipofearningpershareandmarketvalueofshares.

Market Value /Book Value per Share

It indicates market response of the shareholders’ investment

Q Ratio

It measures market value of equity as well as debt in comparison to all assets at their replacement cost

Chapter1   Financial Analysisand Planningratio Analysis 35


MULTIPLE CHOICE QUESTIONS

1. RatioofNetsalestoNetworkingcapitalisa:
(a) Profitability ratio (b) Liquidity ratio
(c) Current ratio (d) Working capital turnover ratio
2. Longtermsolvencyisindicatedby:
(a) Debt/ equity ratio (b) Current Ratio
(c) Operating ratio (d) Net profit ratio
3. Ratioofnetprofitbeforeinterestandtaxtosalesis:
(a) Grossprofitratio (b) Net profit ratio
(c) Operating profit ratio (d) Interest coverage ratio.
4. Observingchangesinthefinancialvariablesacrosstheyearsis:
(a) Vertical analysis (b) Horizontal Analysis
(c) Peerfirm Analysis (d) Industry Analysis.
5. TheReceivableTurnoverratiohelpsmanagementto:
(a) Managing resources (b) Managing inventory
(c) Managing customer relationship (d) Managing working capital

THEORETICAL QUESTIONS

1. Discussanythreeratioscomputedfor
2. Discussthefinancialratiosforevaluatingcompanyperformanceonoperatingefficiencyandliquidity
positionaspects.
3. WhatdoyoumeanbyStockTurnoverratioandGearingratio?
4. DiscussthecompositionofReturnonEquity(ROE)usingtheDuPontmodel.
5. ExplainbrieflythelimitationsofFinancialratios.
6. DiscussDuPontModel.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 36
HOME WORK

CALCULATION OF RATIOS

Q24 Thetotalsales(allcredit)ofafirmare`6,40,000.Ithasagrossprofitmarginof15percentandacurrent
ratioof2.5.Thefirm’scurrentliabilitiesare`96,000;inventories`48,000andcash`16,000.(a)Determine
the average inventory to be carried by the firm, if an inventory turnover of 5 times is expected?
(Assumea360dayyear).(b)Determinetheaveragecollectionperiodiftheopeningbalanceofdebtors
isintendedtobeof`80,000?(Assumea360dayyear).(b)Determinetheaveragecollectionperiodif
theopeningbalanceofdebtorsisintendedtobeof`80,000?(Assumea360dayyear).
Hints
(a) `1,08,000
(b) 72days
Q25 ThecapitalstructureofBetaLimitedisasfollows:
Equitysharecapitalof`10each 8,00,000
9%preferencesharecapitalof`10each 3,00,000
11,00,000
Additionalinformation:Profit(aftertaxat35percent),`2,70,000;Depreciation,`60,000;Equitydividend
paid, 20 per cent; Market price of equity shares, `40. You are required to compute the following,
showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Priceearnings ratio
Hints
(a) Dividendyieldontheequityshares=5percent
(b) Dividendcoverageratio=
(1) Preference=10times
(2) Equity=1.52times
(c) Earningsperequityshare= `3.04per share

(d) Price  earning(P/E)ratio = 13.2times

Chapter1   Financial Analysis and Planningratio Analysis 37


MISSING FIGURES
Q26 Using the following information, complete this balance sheet:
Longtermdebttonetworth 0.5to1
Total asset turnover 2.5x
Average collection period* 18days
Inventory turnover 9×
Grossprofit margin 10%
Acidtest ratio 1to1
*Assumea360dayyearandallsalesoncredit.
` `
Cash — Notesandpayables
1,00,000
Accountsreceivable — Longtermdebt —
Inventory — Commonstock 1,00,000
Plantandequipment — Retainedearnings 1,00,000
Total assets — Totalliabilitiesandequity —

Hints :
Balance Sheet
` `
Cash 50,000 Notesandpayables 1,00,000
Accountsreceivable 50,000 Longtermdebt 1,00,000
Inventory 1,00,000 Commonstock 1,00,000
Plantandequipment 2,00,000 Retainedearnings 1,00,000
Total assets 4,00,000 Totalliabilitiesandequity 4,00,000
MISCELLANEOUS
Q27 FollowinginformationsareavailableforNavyaLtd.alongwithvariousratiorelevanttotheparticulars
industry it belongs to. Gives your comments on strength and weakness of Navya Ltd. comparing its
ratioswith thegiven industry norms.
Navya Ltd. Balance Sheet as at 31.3.2017
Liabilities Amount (`) Assets Amount (`)
Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,0000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current Liabilities 4,40,000 
Total 77,00,000 Total 77,00,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 38
Statement of Profitability For the year ending 31.3.2017
Particulars Amount (`) Amount (`)
Sales 1,10,00,000
Less:Costofgoodssold:  
Material 41,80,000 
Wages 26,40,000 
Factory Overhead 12,98,000 81,18,000
GrossProfit  28,82,000
Less: Selling and Distribution Cost 11,00,000 
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes  5,54,000
Less: Interest Charges  92,000
Earningbefore Tax  4,62,000
Less:Taxes&50%  2,31,000
Net Profit (PAT) 2,31,000

Industry Norms Ratios Norm


Current Assets/Current Liabilities 2.5
Sales/ debtors 8.0
Sales/ Stock 9.0
Sales/ Total Assets 2.0
Net Profit/ Sales 3.5%
Net profit /Total Assets 7.0%
NetProfit/NetWorth 10.5%
Total Debt/Total Assets 60.0%

Hints :
1. ThepositionofNavyaLtd.isbetterthantheindustrynormwithrespecttoCurrentRatiosandtheSales
toDebtorsRatio.
2. However,thepositionofsalestostockandsalestototalassetsispoorcomparingtoindustrynorm.
3. Thefirmalsohasitsnetprofitratios,netprofittototalassetsandnetprofittototalworthratiomuch
lowerthantheindustrynorm.
4. Totaldebttototalassetsratiosuggestthat,thefirmisgearedatlowerlevelanddebtareusedtoAsset.

Chapter1   Financial Analysis and Planningratio Analysis 39


NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 40
CHAPTER 2
COST OF CAPITAL

INTRODUCTION

Thecostofcapitali.e.costofhavingcapitalforlongperiodfromdifferentsourcesoffinance.Generallythe
sourcesoffinancefornoncorporateentitycouldbeeitherinternal(savings,investmentsincurrentandnon
current assets etc.)or externalborrowings (loan from financial institutions,local borrowingsetc.).
SIGNIFICANCE OF THE COST OF CAPITAL
Thecostofcapitalisimportanttoarriveatcorrectamountandhelpsthemanagementoraninvestortotake
anappropriatedecision.Thecorrectcostofcapitalhelpsinthefollowingdecisionmaking:
(i) Evaluationofinvestmentoptions:Theestimatedbenefits(futurecashflows)fromavailableinvestment
opportunities (business or project) are converted into the present value of benefits by discounting
them with the relevant cost of capital. Here it is pertinent to mention that every investment option
mayhavedifferentcostofcapitalhenceitisveryimportanttousethecostofcapitalwhichisrelevant
totheoptionsavailable.HereInternalRateofReturn(IRR)istreatedascostofcapitalforevaluationof
two options (projects).

Chapter2CostofCapital 43
(ii) Performance Appraisal:Cost of capital isusedto appraise theperformance of a particularsproject or
business. The performance of a project or business in compared against the cost of capital which is
knownhereascutoffrateorhurdlerate.
(iii) Designingofoptimumcreditpolicy:Whileappraisingthecreditperiodtobeallowedtothecustomers,
thecostofallowingcreditperiodiscomparedagainstthebenefit/profitearnedbyprovidingcreditto
customerofsegmentofcustomers.Herecostofcapitalisusedtoarriveatthepresentvalueofcostand
benefits received.

o Sources opf capital


Capital

Debt Pref. Eq. share holder fund

Eq. share R&S


capital
o Cost of Debt [kd]

Irrecdemble Reedemble

I T I  T + RV  NP
kd = I × 100 kd = I × 100
NP N

RV + NP
2
I = Intrest
T = Taxrate
NP = Netproceeds
= Issuepriceflotationcost

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 44
RV = Reedemablevalue
N = Noofyears
Cost of Equity (Ke)
* Earlieritwasbelivedthatequitycapitalisfreeofcostastheirisnofixedcommittedregardingpayment
ofintrest&dividinghoweverwiththedevlopmentofmodelfinancialmanagementitwasagreedthat
every capital hasa cost and Heance cost of equity capital is also there which can becalculated with
reference to expectation of equity share holder & Board on different Expectation following models
are generally Developed.
Cost of Equity

Dividend Model Earning Model Dividend + Growth Model

D E § D ·
Ke = × 100 Ke = × 100 Ke = ¨ × 100 ¸ + G
p0 p0 ¨p ¸
© 0 ¹
D = ExpectedDividend
E = Earningpershare
P0 = CurrentMarketPrice
G = Growthrate
G = BxR
B = Retentionratio
R = Rateofreturn

Chapter2CostofCapital 45
CLASS WORK

COST OF DEBT

Q1 Fiveyearsago,SonaLimitedissued12percentirredeemabledebenturesat`103,at`3premiumto
their par value of ` 100. The current market price of these debentures is ` 94. If the company pays
corporatetaxatarateof35percentwhatisitscurrentcostofdebenturecapital?
Q2 Acompanyissued10,000,10%debenturesof`100eachatapremiumof10%on1.4.2017tobematured
on1.4.2022.The debentureswillberedeemedonmaturity.
Computethecostofdebenturesassuming35%astaxrate.
Q3 Acompanyissued10,000,10%debenturesof`100eachon1.4.2017tobematuredon1.4.2022.The
companywantstoknowthecurrentcostofitsexistingdebtandthemarketpriceofthedebenturesis
`80.Computethecostofexistingdebenturesassuming35%taxrate.

COST OF PREFERENCE
Q4 XYZ Ltd. issues 2,000 10% preference shares of ` 100 each at ` 95 each. The company proposes to
redeemthepreferencesharesattheendof10thyearfromthedateofissue.
Calculate the costofpreference share?
Q5 XYZ&Co.issues2,00010%preferencesharesof`100eachat`95each.Calculatethecostofpreference
shares.
Q6 IfREnergyisissuingpreferredstockat`100pershare,withastateddividendof`12,andafloatation
costof3%then,whatisthecostofpreferenceshare?

COST OF EQUITY
Q7 Acompanyhaspaiddividendof`1pershare(offacevalueof`10each)lastyearanditisexpectedto
grow@10%nextyear.Calculatethecostofequityifthemarketpriceofshareis`55.

Q8 ABC Company provides the following details:


D0=`4.19P0=`50g=5%
Calculate the cost of retained earnings.
WACC
Q9 Calculate the WACCusingthefollowingdatabyusing:
(a) Book value weights

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 46
(b) Market value weights
Thecapitalstructureofthecompanyisasunder:

(`)
Debentures (` 100 per debenture) 5,00,000
Preferenceshares(`100pershare) 5,00,000
Equityshares(`10pershare) 10,00,000
20,00,000

Themarketpricesofthesesecuritiesare:
Debentures `105perdebenture
Preference shares `110perpreferenceshare
Equity shares `24each.
Additional information:
(1) `100perdebentureredeemableatpar,10%couponrate,4%ûoatationcosts,10yearmaturity.
(2) `100perpreferenceshareredeemableatpar,5%couponrate,2%ûoatationcostand10yearmaturity.
(3) Equityshareshas`4ûoatationcostandmarketprice`24pershare.
Thenext yearexpected dividend is ` 1 with annual growthof 5%. The frmhas practice of paying all
earnings in theformof dividend.
Corporatetaxrateis50%.
Q10 ABCLtd.hasthefollowingcapitalstructurewhichisconsideredtobeoptimumason31stMarch,2017.

(`)
14% Debentures 30,000
11% Preference shares 10,000
EquityShares(10,000shares) 1,60,000
2,00,000

Thecompanysharehasamarketpriceof`23.60.Nextyeardividendpershareis50%ofyear2017EPS.
ThefollowingisthetrendofEPSforthepreceding10yearswhichisexpectedtocontinueinfuture

Year EPS (`) Year EPS (`)


2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36

The company issued new debentures carrying 16% rate of interest and the current market price of
debentureis`96.

Chapter2CostofCapital 47
Preferenceshare`9.20(withannualdividendof`1.1pershare)werealsoissued.Thecompanyisin
50%taxbracket.
(A) Calculate after tax:
(i) Costofnewdebt
(ii) Costof newpreference shares
(iii) New equity share (consuming new equity from retained earnings)
(B) Calculatemarginalcostofcapitalwhennonewsharesareissued.
(C) Howmuchcanbespentforcapitalinvestmentbeforenewordinarysharesmustbesold.Assumingthat
retainedearningsfornextyear’sinvestmentare50percentof2017.
(D) Whatwillthemarginalcostofcapitalwhenthefundsexceedstheamountcalculatedin(C),assuming
newequityisissuedat`20pershare?
Q11 Determinethe cost of capitalof Best Luck Limited using the book value (BV)and market value (MV)
weights from the following information:
Sources Book Value Market Value
(`) (`)
Equity shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 —
Preference shares 36,00,000 33,75,000
Debentures 9,00,000 10,40,000
Additional information :
I. Equity:Equitysharesarequotedat`130pershareandanewissuepricedat`125persharewillbe
fullysubscribed;ûotationcostswillbe`5pershare.
II. Dividend:Duringtheprevious5years,dividendshavesteadilyincreasedfrom `10.60to`14.19per
share.Dividendattheendofthecurrentyearisexpectedtobe`15pershare.
III. Preferenceshares:15%Preferenceshareswithfacevalueof`100wouldrealise`105pershare.
IV. Debentures:Thecompanyproposestoissue11year15%debenturesbuttheyieldondebenturesof
similarmaturityandriskclassis16%;ûotationcostis2%.
V. Tax:Corporatetaxrateis35%.Ignoredividendtax.
Q12 MascoLimitedwishestoraiseadditionalfnanceof`10lakhsformeetingitsinvestmentplans.Ithas`
2,10,000 in the form of retained earnings available for investment purposes. Further details are as
following:
(1) Debt/ equitymix 30%/70%
(2) Costofdebt
Upto`1,80,000 10% (beforetax)
Beyond`1,80,000 16% (beforetax)
(3) Earningspershare `4
(4) Dividend pay out 50%ofearnings
(5) Expected growth rate in dividend 10%
(6) Currentmarketpricepershare `44
(7) Taxrate 50%

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 48
You are required:
(a) To determine the pattern for raising the additional fnance.
(b) To determine the posttax average cost of additional debt.
(c) Todeterminethecostofretainedearningsandcostofequity,and
(d) Computetheoverallweightedaverageafter taxcostof additionalfnance.
Q13 Apapercompanyhasthefollowingspecificcostofcapitalalongwiththeindicatedboolandmarket
value weights:
Type of capital Cost Book value Market
weights value weight
Equity 18% 0.50 0.58
Preference shares 15% 0.20 0.17
Longterm debt 7% 0.30 0.25
1 Calculatetheweightedcostof capital,usingbookandmarketvalueweights.
2 Calculatetheweightedaveragecostof capital,usingmarginal weights,ifthecompany intended to
raisetheneededfundsusing50%longtermdebt,35%preferencesharesand15%retainedearnings.
Q14 Atransportcompanyisinterestedinmeasuringitscostofspecifictypesofcapital,aswellasitsoverall
cost.Thefinancedepartmentofthecompanyindicatesthatthefollowingcostswouldbeassociated
withthesaleofdebentures,preferencesharesandequityshares.Thecorporatetaxrateis35%.The
shareholdersareinthe30%marginaltaxbracket.
Debentures:Thecompanycansell15year14%debenturesofthefacevalueof`1,000for`970.In
addition,anunderwritingfeeof1.5%offacevaluewouldbeincurredinthisprocess.
Preferenceshares:15%preferenceshares,havingafacevalueof `100,canbesoldatapremiumof
10%.Anunderwritingfeeof`2pershareistobepaidtotheunderwriters.
Equityshares:Thecompany’sequitysharesarecurrentlysellingfor`125pershare.Thefirmexpects
topay`15pershareattheendofcomingyear.Itsdividendpaymentsoverthepast6yearspershare
aregiven below:
Year Dividend (`)
1 10.60
2 11.24
3 11.91
4 12.62
5 13.38
6 14.19
Itisexpectedthatthenewequitysharescanbesoldat`123pershare.Thecompanymustalsopay`
3pershareasunderwritingfee.
Marketandbookvaluesforeachtypeofcapitalareasfollows:

Chapter2CostofCapital 49
Book value Market Value
(` ) (` )
Longterm debt 18,00,000 19,30,000
Preference shares 4,50,000 5,20,000
Equity shares 60,00,000
Retained earnings 15,00,000 1,00,00,000
97,50,000 1,24,50,000
1 Calculatethespecificcostofeachsourceoffinancing.
2 Determinetheweightedaveragecostofcapitalusing(a)bookvalueweights,and(b)marketvalue
weights.
Q15 An electric equipment manufacturing company wishes to determine the weighted average cost of
capitalforevaluatingcapitalbudgetingprojects.Youhavebeensuppliedwiththefollowinginformation.
BALANCE SHEET
LIABILITIES ` ASSETS `
Equityshares capital (F.V.100) 12,00,000 Fixed assets 25,00,000
Preference share capital 4,50,000 Current assets 15,00,000
Debentures 9,00,000
Retained earnings 4,50,000
Current liabilities 10,00,000 ________
40,00,000 40,00,000

Anticipated external financing information.


1 20years14%debenturesof`2,500facevalue,redeemableat5%premium,soldatpar,2%flotation
costs.
2 15%preferenceshares:Saleprice`115pershare,flotationcost,`5pershare(facevalue`100).
The corporate tax is 35% and the expected growth in equity dividend is 8% per year.  The expected
dividendattheendofthecurrentfinancialyearis`11pershare.Assumethatthecompanyissatisfied
withitspresentcapitalstructureandintendstomaintainit.
Q16 Fromthefollowinginformation,determinetheappropriateweightedaveragecostofcapital,relevant
for evaluating longterm investment projects of the company.

Cost of equity 18%


Aftertaxcostoflongtermdebt 8%
Aftertaxcostofshorttermloans 9%
Source of capital Book value (`) Market value (`)
Equity 5,00,000 7,50,000
Longterm debt 4,00,000 3,75,000
Shortterm debt 1,00,000 1,00,000
10,00,000 12,25,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 50
Q17 TheR&GCompanyhavingcapitalstructureat31stMarch,2004,whichisconsideredtobeoptimum:

`
13debenture 3,60,000
11%preferencesharecapital 1,20,000
Equity(2,00,000shares) 19,20,000

Thecompany’ssharehasacurrentmarketpriceof`27.75pershare.Theexpecteddividendpershare
innextyearis50percentofthe2004EPS.TheEPSoflast10yearsisasfollows.Thepasttrendsare
expected to continue:
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS
(` ) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773
Thecompanycanissue 14 percentnew debenture.The company’s debentureis currently sellingat `
98.Thenewpreferenceissuecanbesoldatanetpriceof`9.80,hayingadividendof`1.20pershare.
Thecompany’smarginaltaxrateis50%.
(i) Calculatethaftertaxcost(a)ofanewdebtsandnewpreferencesharecapital,(b)ofordinaryequity,
assuming equity comes rom retained earnings.
(ii) Calculatethe marginalcostofcapital.
(iii) Howmuchcianbespentforcapitalinvestmentbeforenewordinarysharemustbesold?Assumiig
thatretainedearningavailable forrtextyear’sinvestmentare50% of2004earnings.
(iv) Whatwillbemarginalcostofcapital(costoffundraisedinexcessoftheamountcalculatedinpart
(iii)ifthecompanycansellnewordinarysharestonet`20pershare?Thecostofdebtofpreference
capital;is constant.
Q18 Using the following information, complete the Balance Sheet given below:
(i) Totaldebttonetworth: 1:2
(ii) Totalassetsturnover: 2
(iii) Grossprofitonsales: 30%
(iv) Average collection period : 40days
(Assume360daysinayear)
(v) Inventoryturnoverratiobasedoncostofgoodssoldandyearendinventory: 3
(vi) Acidtestratio: 0.75
Balance Sheet
as on March 31, 2016
Liabilities ` Assets `
Equity Shares Capital 4,00,000 Plant and Machinery
Reserves and Surplus 6,00,000 and other Fixed Assets
TotalDebt: Current Assets:
Current Liabilities  Inventory
Debtors
Cash
_______ _______
______ ______

Chapter2CostofCapital 51
Q19 NOORLimitedprovidesthefollowinginformationfortheyearending31stMarch,2014:
Equity Share Capital `25,00,000
Closing Stock `6,00,000
StockTurnoverRatio 5times
GrossProfitRatio 25%
NetProfit /Sale 20%

1
NetProfit/Capital
4

Youarerequiredtoprepare:
TradingandProfit&LossAccountfortheyearending31stMarch,2014.
CAPM MODEL
Q20 CalculatethecostofequitycapitalofHLtd.,whoseriskfreerateofreturnequals10%.Thefirm’sbeta
equals1.75andthereturnonthemarketportfolioequalsto15%.
Q21 Thebetacoefficiantis1.4withgrowthrateof8%.Lastdividendpaidwas`4.Thereturnongovernment
securitiesis10%andthatonmarketportfoliois15%.Thepresentmarketvalueis36.
(a) Calculate equilibrium market value of equity shares.
(b) Isitworthpurchasingshare@36pershares.
Q22 WhileanalysingBetaoftheXYZcompanyfollowingdataareextructedforitsdifferentGroup.
Group Market Value Unlevereged Beta
A 100Billian 1.1
B 100Billian 1.5
C 50Billian 2
D 150 1
(a) EstimateBetaforXYZcompany.ItthisBetagoingtobeequaltothatprevaluinginmarket,
(b) IfGOIBondrateis7.5%andmarketriskpremiumis8.5%.CalculatecostofequityofXYZcompany
anditsgroup.
Q23 Followingarethedetailsregardingthecapitalstructureofacompany:
Type of Capital Book Value Market Value Specific Cost
Debentures 40,000 38,000 5%
Preference Capital 10,000 11,000 8%
Equity Capital 60,000 1,20,000 13%
Retained Earnings 20,000 — 9%
1,30,000 1,69,000
Youarerequiredtodeterminetheweightedaveragecostofcapitalusing:(i)bookvalueasweights,(ii)
marketvalueasweights.Doyouthink,therecanbesituationwhereweightedaveragecostofcapital
would be the sameirrespective of the weights used.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 52
Q24 As an investment manager you are given the following information
Investment in equity Initial puce Dividends Yearend market Beta risk
shares of price factor
A Cement Ltd `25 `2 `50 0.80
Steel Ltd 35 2 60 0.70
LiquorLtd 45 2 135 0.50

B Government ofIndiaBonds 1,000 140 1,005 0.99


Riskfreereturn,14percent
Youarerequired tocalculate(i)expected rateofreturnsof market portfolio,and(ii) expected return
in eachsecurity,using capital assetpricing model.
Q25 Calculatethe expected return on portfolio ‘A’ with thefollowing data:
(i) Riskfree rate of return 8%
(ii) Expected return on market portfolio 12%
(iii) Market Sensitivity Index 0.75
Q26 Fromthe followinginformation,calculatetheexpectedrateofreturnofaportfolio:
 Riskfree rate of interest 12%
Expected return of market portfolio 18%
Standarddeviationofanasset 2.8%
Market Standard deviation 2.3%
Correlation coefficient of portfolio with market 0.8%

Q27 Theriskfreeinterestrateis8 percentandtheexpectedreturnonthemarketportfoliois16percent.


Calculate the expected return on the following securities:
Security Beta
A 0.4
B 1.0
C 2.6
D 2.0
Q28 You are required to determine the weighted average cost of capital(Ko)of the KC. Ltd. using (i) book
valueweights;and..(ii)marketvalueweights.Thefollowinginformationisavailableforyourperusal.
TheKC.Ltd,’sPresentbookvaluecapitalstructureis:
(` )
Debentures (`100 perdebenture) 8,00,000
Preference shares (`100pershare) 2.00,000
Equity shares (`10pershare) 10.00,000
20,00000

Chapter2CostofCapital 53
Allthesesecuritiesaretradedinthecapitalmarkets.Recentpricesaredebentures@`110,preference
shares@`120andequityshares`22.Anticipatedexternalfinancingopportunitiesare
(i) `100perdebentureredeemableatpar20yearmaturity,8%couponrate.4%flotationcosts,sale
price`100.
(ii) ` 100 preference share redeemable at par: 15year maturity. 10% dividend rate, 5% flotation
costs,saleprice`100.
(iii) Equityshares`2pershareflotationcosts,saleprice`22.
In addition, the dividend expected on the equity share at the cad of the year ` 2 per share, the
anticipatedgrowth.ateindividendsis5%andthecompanyhasthepracticeofpayingallitsearningin
theformofdividends.Thecorporatetaxrateis50%.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 54
MULTIPLE CHOICE QUESTIONS

1. Whichofthefollowingisnotanassumptionofthecapitalassetpricingmodel(CAPM)?
(a) ThecapitalMarketisefficient
(b) Investorslendorborrowatariskfreerateofreturn
(c) Investors do not have the same expectations about the risk and return
(d) Investor’s decisions are based on a singletime period
2. Given:riskfreerateofreturn=5%marketreturn=10%,costofequity=15%valueofbeta(B)is:
(a) 1.9 (b) 1.8
(c) 2.0 (d) 2.2
3. WhichofthefollowingsourcesoffundsisrelatedtoImplicitCostofCapital?
(a) Equity Share Capital (b) Preference Share Capital
(c) Debentures, (d) Retained earnings.
4. Whichofthefollowingcostofcapitalrequiretoadjusttax?
(a) CostofEquityShares (b) Cost of Preference Shares
(c) Cost of Debentures (d) Costof RetainedEarnings
5. MarginalCostofcapitalisthecostof:
(a) Additional Revenue (b) Additional Funds
(c) Additional Interests (d) None ofthe above.
6. Inorder tocalculateWeighted AverageCostofCapital, weightsmaybe basedon:
(a) Market Values (b) Target Values
(c) Book Values (d) Anyone
7. Firm’s Cost of Capital is the average cost of :
(a) All sources of finance (b) All Borrowings
(c) All share capital (d) All Bonds & Debentures

THEORETICAL BASED QUESTIONS


1. Whatismeantbyweightedaveragecostofcapital?Illustratewithanexample.
2. Discussthedividendpriceapproach,andearningspriceapproach toestimatecostofequitycapital.
3. Whatis the difference between Book Value and Market Value?
4. WhatisMarginalCostofCapital?
5. ExplainYTMapproachofcalculatingCostofDebt.
6. WhatisthemeaningofAmortisationofBond?
Chapter2CostofCapital 55
HOME WORK

Q29 ThecurrentmarketpriceofthesharesofALtd.is`95.Thefloatationcostsare`5pershare.Dividend
pershareamountsto`4.50andisexpectedtogrowatarateof7%.Youarerequiredtocalculatecost
of equity share capital.
Hints :
Ke=12%
Q30 TheXavierCorporation,adynamicgrowthfirmwhichpaysnodividends,anticipatesalongrunlevelof
futureearningof`7pershare.ThecurrentpriceofXavier’ssharesis`55.45floatationcostsforthe
sales of equity shares would average about 10% of the price of the shares. What is the cost of new
equitycapital to Xavier?
Hints :
Ke=14%
Q31 AriesLimitedwishestoraiseadditionalfinanceof`10lakhsformeetingitsinvestmentplans.Ithas`
2,10,000 in the form of retained earnings available for investment purposes. The following are the
further details:
(1) Debtequity Mix 30%/70%
(2) CostofDebtupto `1,80,000 10% (before tax)
beyond `1,80,000 16% (before tax)
(3) Earnings pershare `4
(4) Dividend pay out 50%ofearnings
(5) Expected growth rate in dividend 10%
(6) Currentmarketpricepershare `44
(7) TaxRate 50%
You are required:
(a) To determine the pattern for raising the additional finance,
(b) To determine the posttax average cost of additional debt,
(c) Todeterminethecostofretainedearningsandcostofequity,and
(d) Compute theoverallweightedaverageaftertax cost ofadditional finance.
Hints :

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 56
Source Amount Portion After Tax Weighted
Average Cost
Equity Capital (including retained earnings) 7,00,000 .7 145% 10.15%
Debt 3,00,000 .3 6.2% 1.86%
Total 12.01%
Q32 ThreecompaniesA,B&Careinthesametypeofbusinessandhencehavesimilaroperatingrisks.
However,the capitalstructureofeachofthemisdifferent andthefollowingare thedetails:
A B C
Equity Share Capital ` 4,00,000 250,000 5,00,000
[Facevalue`10pershare]
Marketvaluepershare ` 15 20 12
Dividendper share ` 2.70 4 2.88
Debentures ` Nil 1,00,000 250,000
[Facevalueperdebenture`100]
Market value per debenture ` 125 80
Interest rate — 10% 8%
Assume that the current levels of dividends are generally expected to continue indefinitely and the
incometarrateat50%.
Youarerequiredtocomputetheweightedaveragecostofcapitalofeachcompanybymarketvalue
weights.
Hints :
A B C
` ` `
Weighted average cost of Capital 18% 16.8% 19.25%

Q33 JKLLtd.hasthefollowingbookvaluecapitalstructureasonMarch31,2004.
`
Equitysharecapital(2,00,000shares) 40,00,000
11.5% preference shares 10,00,000
10% debentures 30,00,000
80,00,000
The equity share of the company sells for ` 20. It is expected that the company will pay next year a
dividendof`2perequitysham,whichisexpectedtogrowat5%pa.forever.Assumea35%corporatetax
rate.
Required:
(i) Compute weighted average cost of capital (WACC) of the company based on the existing capital
structure.

Chapter2CostofCapital 57
(ii) Compute the new WACC, if the company raises an additional ` 20 lakhs debt by issuing 12%
debentures. This would result in increasing the expected equity dividend to ` 2.40 and leave the
growthrateunchanged,butthepriceofequitysharewillfallto`16pershare.
Hints :
(i) Weightedaveragecostofcapital=11.375%
(ii) Weightedaveragecostofcapital=12.66%
Q34 ABCLtd.hasthefollowingcapitalstructurewhichisconsideredtobeoptimumason31stMarch,2006.
`
14% debentures 30,000
11% Preference shares 10,000
Equity(10,000shares) 1,60,000
2,00,000
Thecompanysharehasamarketpriceof`23.60.Nextyeardividendpershareis50%ofyear2006EPS.
ThefollowingisthetrendofEPSforthepreceding10yearswhichisexpectedtocontinueinfuture.
Year EPS (`) Year EPS (`)
1997 1.00 2002 1.61
1998 1.10 2003 137
1999 1.21 2004 1.95
2000 1.33 2005 2.15
2001 1.46 2006 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of
debentureis`96.
Preferenceshare`9.20(withannualdividendof`1.1pershare)werealsoissued.Thecompanyisin
50%taxbracket,
(A) Calculate after tax:
(i) Costofnewdebt
(ii) Costof newpreference shares
(iii) New equity share (consuming new equity from retained earnings)
(B) Calculatemarginalcostofcapitalwhennonewsharesareissued.
(C) Howmuchneedstobespentforcapitalinvestmentbeforeissuingnewshares?50%ofthe2006
earningsare available asretained earnings forthe purpose of capital investment.
(D) What will the marginal cost of capital when the funds exceeds the amount calculated in (c),
assumingnewequityisissuedat`20pershare?
Hints :
(A) (i) Costofnewdebt=8.33%
(ii) Costofnewpreferenceshares=12%
(iii) Costofnewequityshares=15%
(B) Marginalcostofcapital=13.85%
(C) 14,750
(D) 14.57%

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 58
Q35 Afastgrowingforeigncompanywantstoexpanditstotalassetsby50percentbytheendofthecurrent
year. Givenbelow are the company’s capital structure which it considersto be optimal.There are no
shortterm debts.
8% Debentures `4,00,000
9% Preference shares 1,00,000
Equityshares(facevalue100) 5,00,000
10,00,000
Newdebentureswouldbesoldat14percentcouponrateandwillbesoldatpar.Preferenceshareswill
havea15percentrateandwillalsobesoldatpar.Equitysharescurrentlysellingat`100canbesoldto
netthe company ` 95. The shareholders’required rate of return is tobe 17 per cent consisting of a
dividendyieldof10percentandanexpectedgrowthrateof7percent.Retainedearningsfortheyear
areestimatedtobe`50,000(ignoredepreciation).Thecorporatetaxis35percent.Youarerequiredto
calculate the following values:
(a) Assuming all asset expansion (gross expenditure for fixed assets plus related working capital) is
includedinthecapital budget,whatistherequiredamountofcapitalbudget?
(b) Howmuchofthecapitalbudgetmustbefinancedbyexternalequity(thatis,issueofnewequity
shares)tomaintaintheoptimalcapitalstructure?
(c) Calculate thecostof(i) newissuesofequity sharesand(ii)retainedearnings.
(d) Calculate the weighted average costof capitalusing marginalweights.
Hints :
(a) Requiredamountofcapitalbudget=5,00,000
(b) `2,00,000
(c) (i) Ke=17.5%
(ii) kr=17%
(d) WACC=13.84%
Q36 ABCLimited hasthe followingbook valuecapital structure:
EquityShareCapital(150millionshares,`10par) `1,500million
Reserves and Surplus `2,250million
10.5%PreferenceShareCapital(1millionshares, `100million
`100par)
9.5%Debentures(1.5milliondebentures,`1000par) `1,500million
8.5%TermLoansfromFinancialInstitutions `500million
The debentures of ABC Limited are redeemable after three years and are quoting at ` 981.05 per
debenture.Theapplicableincometaxrateforthecompanyis35%.
Thecurrentmarketpriceperequityshareis`60.Theprevailingdefaultriskfreeinterestrateon10
yearGOITreasuryBondsis5.5%.Theaveragemarketriskpremiumis8%.Thebetaofthecompanyis
1.1875.
The preferred stock of the company is redeemable after 5 years is currently selling at ` 98.15 per
preference share.

Chapter2CostofCapital 59
Required :
(i) Calculate weightedaveragecost of capitalof the companyusingmarketvalueweights.
(ii) Definethemarginalcostofcapitalscheduleforthefirmifitraises`750millionforanewproject.
Thefirmplanstohaveatargetdebttovalueratioof20%.Thebetaofnewprojectis1,4375.Thedebt
capitalwillberaisedthroughtermloans.Itwillcarryinterestrateof9.5%forthefirst100millionand
10%forthenext`50million.
Hints :
(i) Weighted Average cost of capital (WACC) : (Using market value weights) = 13.41%
(ii) Marginalcostofcapital(MCC)schedule:= 14.86%
Q37 XYZ Co. has a capital structure of 30% debt and 70% of equity. The company is considering various
investmentproposalscostingless than`30lakhs.
Thecompany does not wanttodisturb itspresentcapital structure. The cost ofraisingthe debt and
equity areas follows:

Project Cost Cost of Cost of


debt equity
Upto`5Iakhs 9% 13%
Above`5lakhsandupto`20lakhs 10% 14%
Above`20lakhsandupto`40lakhs 11% 15%
Above`40lakhsandupto`1crore 12% 15.5%

Assuming the tax rate is 50%, compute the cost of capital of two projects ABC and XYZ whose fund
requirementsare `8 lakhs and ` 21 Iakhs respectively and if a project isexpected to yield after tax
returnof 11%,determineunderwhatconditionsitwouldbeacceptable.
Hints :
The funds requirement of Project ABC is ` 8 Lakhs and it is coming under the category of investment
above`5lakhsandupto`20lakhsanditsconcernedWACCis1130%.AsregardsProjectXYZ,itrequires
total funds of ` 21 Lakhs falling under the category, above ` 20 lakhs upto ` 40 Lakhs and its WACC is
12.15%.Ifaprojectisexpectedtoyieldafterlaxreturnof11%,thenthecompanycannotundertakeboth
projects, sincethe WACCof boththeprojects exceedsthe expected rateof returnoninvestments.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 60
CHAPTER3
FINANCING DECISIONS  CAPITAL STRUCTURE

INTRODUCTION

InanorganizationfinanceManagerhastwoimportantfunctions.
1. Procuremental of Funds
2. Effective utilisation of fund
1. Procurementoffunds;
FundsareNecessaryforgrowth&survival&anybusiness,organisationfundscanbedivided
betweenshortterm&Longtermbasedonrequirementsandfinancemanagerhastobecarefull
whileselectingsourceoffundBecauseeverysourceoffundhasthereowncostandriskAspect
andproportionofvarioussourcesofcapitalwillutilmatelydecideCompaniesoverallcapitalwhich
eventualydecidewhetheranybusinessproposalisAcceptableorNot.
2. Effectiveutilisationoffund
FundraisealwayscarrycostasHenceItisNecesarrythatfundsareemplyedinmostprofittable
way.
CapitalBudgetingtechniquecanhelpindecidingmostprofitableproject.

Indesigncapitalstructureisoneofthecriticalfunctionforfinancemanagerbecauseeverysourceofcapital
hasitsowncostandriskaspects.Capitalstructurecanbedefinedasproportionofvarioussourcesofcapital
incompany’soverallcapital.Asmentionearliereverysourceofcapitalhasdifferentcostandriskwhichcan
bediscussedasfollow:
Capital
p p p
Debt Preference Equity shareholders fund (eq + Res.)
p p p
Highest Risk Moderate Risk Least Risk
LeastCost ModerateCost Highest Cost

Chapter3FinancingDecisionsCapitalStructure 63
ItisimportantforthefinancialmanagegertostockManagementb/wcost&riskandalsotoacheveultimate
objective of wealth maximum & accordingly financial plan with highest earning per share should be se
lected.
Note:
Incasepriceearningratioisgiventhenplanwithhigestmarketpricepershareshouldbeselectinsteadof
highest EPS.

Indifference point;
Itisthat levelofEBITWhere equityshareholderareindifferentamongvariousalternative financialplanit
canbecalculatedasfollows.
EPS = Plant 1 = EPS = Plant=2

EBIT  Int I  T  Pref. EBIT  Int. I  T Pref.


=
No.of share No.ofshare
EBIT = Plan
Indifference o AnyPlan
>Indiferencepoint o Plan withmoredebt
<Indifferencepoint o Planwithlessdebt

Financial Break Even Point :


ItisthatlevelofEBITWhereprofitforeq.shareholderisNil.ItisanIndicatorofriskandhigher
financialbreakevenpointindicatehigherrisk.Itcanbecalculatedasfollows.
Prof.dividend
FBEP=INTEREST+ I T

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 64
CLASS WORK

Q1 RupaLtd.’sEBITis`5,00,000.Thecompanyhas10%,20lakhdebentures.Theequitycapitalizationrate
i.e.Keis16%.
Youarerequired tocalculate:
(i)Marketvalueofequityandvalueoffrm
(ii)Overall costof capital.
Q2 IndraLtd.hasEBITof`1,00,000.Thecompanymakesuseofdebtandequitycapital.Thefrmhas10%
debenturesof`5,00,000andthefrm’sequitycapitalizationrateis15%.Youarerequiredtocompute:
(i)Currentvalueofthefrm
(ii)Overall costof capital.
Q3 AmitaLtd’soperatingincomeis`5,00,000.Thefrm’scostofdebtis10%andcurrentlythefrmemploys
`15,00,000ofdebt.Theoverallcostofcapitalofthefrmis15%.
You are required to determine:
(i)Totalvalueofthefrm.
(ii) Cost of equity
Q4 AlphaLimitedandBetaLimited are identicalexceptfor capital structures.Alpha Ltd.has50percent
debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All
percentagesareinmarketvalueterms).Theborrowingrateforbothcompaniesis8percentinano
taxworld,andcapitalmarketsareassumedtobeperfect.(a)(i)Ifyouown2percentofthesharesof
AlphaLtd.,whatisyourreturnifthecompanyhasnetoperatingincomeof `3,60,000andtheoverall
capitalisationrateofthecompany,K0is18percent?(ii)Whatistheimpliedrequiredrateofreturnon
equity?(b)BetaLtd.hasthesamenetoperatingincomeasAlphaLtd.(i)Whatistheimpliedrequired
equityreturnofBetaLtd.?(ii)WhydoesitdifferfromthatofAlphaLtd.?
Q5 TherearetwocompanyNLtd.andMLtd.,havingsameearningsbeforeinterestandtaxesi.e.EBITof`
20,000.MLtd.isaleveredcompanyhavingadebtof`1,00,000@7%rateofinterest.Thecostofequity
ofNLtd.is10%andofMLtd.is11.50%.Findouthowarbitrageprocesswillbecarriedon?
Q6 TherearetwocompaniesULtd.andLLtd.,havingsameNOIof`20,000exceptthatLLtd.isalevered
companyhavingadebtof`1,00,000@7%andcostofequityofULtd.&LLtd.are10%and18%respectively.
Showhowarbitrage processwill work.
Q7 GaneshaLimitedissettingupaprojectwithacapitaloutlayof `60,00,000.Ithastwoalternativesin
financing the project cost. AlternativeI : 100% equity finance by issuing equity shares of ` 10 each
AlternativeII:Debtequityratio2:1(issuingequitysharesof`10each)Therateofinterestpayableon
thedebtsis18%p.a.Thecorporatetaxrateis40%.Calculatetheindifferencepointbetweenthetwo
alternative methods of financing.

Chapter3FinancingDecisionsCapitalStructure 65
Q8 OnethirdofthetotalmarketvalueofSanghmaniLimitedconsistsofloanstock,whichhasacostof10
percent.Anothercompany,SamsuiLimited,isidenticalineveryrespecttoSanghmaniLimited,except
thatitscapitalstructureisallequity,anditscostofequityis16percent.AccordingtoModiglianiand
Miller, if we ignored taxation and tax relief on debt capital, what would be the cost of equity of
Sanghmani Limited?
Q9 Agrowingcompanyisconfrontedwithachoicebetween15%debtissuesandequityissuestofinance
its new investments. The firm’s preexpansion income statement is as follows:
`
Sales(productioncapacityof`60,00,000 45,00,000
atcurrentsalesprice)
Fixed cost 5,00,000
Variablecost(662/3% 30,00,000
EBIT 10,00,000
Interestat12.5% 1,00,000
Earnings before taxes 9,00,000
Incometax(at50%) 4,50,000
Net income 4,50,000
Earningspershare(EPS) 9
Theexpansionprogrammeisestimatedtocost` 5,00,000.Ifthisisfinancedthroughdebt,therateon
newdebtwillbe15%andtheP/Eratiowillbe10times.Ifexpansionprogrammeisfinancedthrough
equity, new shares can be sold at ` 100 pershare, and the P/E ratio willbe 12times. Expansionwill
generate additional sales of ` 12,75,000. No additional fixed costs would be needed to meet the
expansionoperation.Ifthecompanyistofollowapolicyofmaximisingthemarketvalueofitsshares,
whichformoffinancingshouldbeemployedbythecompany?
Q10 Key information pertaining to the proposed two new financing plans of a company is given below:
(assumetaxrate:50%)
Financial plans
Sources of Funds 1 2
Equity 15,000sharesof`100each 30,000sharesof`100each
Preference shares 12%25,000
sharesof`100each
Debentures `5,00,000
couponrateis10% 15,00,000coupon
rateis11%
(i) Determine the (a) indifferent point, and (b) financial breakeven point for each financial plan.
(ii) Whichplanhasmorefinancialriskandwhy?
(iii) IndicateoverwhatEBITrange,ifany,oneplanisbetterthantheother.
(iv) IfthefirmisfairlycertainthatitsEBITwillexceed`12,00,000,whichplanwouldyourecommend,
andwhy?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 66
Q11 A company gives you the following figures:
Profit (before interest and tax) `24,00,000
Less interest on debentures (12.5%) `2,00,000
LessinterestonLongtermloans(16%) 2,00,000 `4,00,000
20,00,000
Lessincometax@50% 10,00,000
Profit after tax 10,00,000
Numberofequityshares(of`10each) 4,00,000
Earningpershare 2.50
Ruling market price 20.00
P/Eratio 8
The company hasundistributed reserves and profits of ` 81,50,000.  The company needs to raise `
36,00,000forrepaymentofdebenturesandmodernizationofitsplants.Itseeksyouropiniononthe
advisability of taking recourse to one of the following modes of raising the required funds, on the
considerationof the probablepriceofthe sharetoruleonimplementation.
(a) Raisingtheentireamount:Interest@16%
Bytermloansfrombank.
(b) Raisingpartlybyissueof1,00,000equityshares,
Estimatedprice`18pershare,andtherestbytermloanfrombank@16%.
The company expects that the rate of return, i.e., before tax and interest on funds employed will
improve by 4% because of modernization and that if the debt equity ratio(i.e. debt/debt plus
shareholders’fund)exceeds25%,theP/Eratiowillgodownto6.
Q12 ABCCorporationplanstoexpandassetsby50%;tofinancetheexpansion,itischoosingbetweena
straight12%debtissueandordinaryshares.Itsbalancesheetandprofitandlossaccountareshown
below.
Balance sheet as on 31st December of ABC Corporation
Liabilities (` ) Assets (` )
11% Debentures 40,00,000 Total assets 2,00,00,000
Ordinary share capital
(10,00,000sharesof
`10each) 1,00,00,000
Retained earnings 60,00,000
2,00,00,000 2,00,00,000

ProfitandlossaccountfortheyearendedDecember31

Chapter3FinancingDecisionsCapitalStructure 67
Sales `6,00,00,000
Total costs (excluding interest) 5,40,00,000
Netincomebeforetax (EBIT) 60,00,000
Interestondebentures@11% 4,40,000
Income before taxes 55,60,000
Taxes@50% 27,80,000
Profit after taxes 27,80,000
Earningpershare(`27,80,000÷10,00,000) 2.78
P/Eratio 7.5times
Marketprice(7.5*`2.78)pershare 20.85
IfABCCorporationfinance`1croreexpansionwithdebt,therateoftheincrementaldebtwillbe12%
and the price/earnings ratio of the ordinary shares will be 5 times.  If the expansion, is financed by
equity, the new sharescan be sold at ` 12 per share, and the price/earnings ratio will remain at 7.5
times.
1 Assuming that net income before interest and taxes (EBIT), is 10% of sales, calculate earnings per
sharesatsaleslevelsof`4croresand`8croresand`10croreswhenfinancingiswith(a)ordinary
shares, and (b) debt,
2 At what level of earnings before interest and taxes (EBIT) after the new capital is acquired, would
earnings per share (EPS) be the same, whether new funds are raised by issuing ordinary shares or
raising debt?
3 Also determine the level of EBIT at which uncommitted earnings per share would be the same, if
sinkingfund obligationsamountto`5lakhsperyear.
4 UsingtheP/Eratio,calculatethemarketvaluepershareforeachsaleslevelforboththedebtandthe
equity financing.
Q13 Afirmisconsideringmethodstofinanceitsinvestmentproposal.Itisestimatedthatinitially`4,00,000
willbeneeded.Twoalternativemethodsofraisingfundsareavailabletothefirm:(a)Issueof15%loan
amountingto`2,00,000andissueof2,000equitysharesof`100each;and(b)Issueof4,000equity
sharesof`100each.Theappropriatetaxrateis50%.
1 Assumingoperatingprofits(EBIT)of:(a)`70,000and(b)`80,000whichfinancingproposalwould
yourecommend,andwhy?
2 Compute the indifference point of the two financial plans.
Q14 SalesandearningbeforeinterestandtaxesfortheABCLtd.,duringcurrentyearwere`17,50,000and
`4,50,000,respectively.Duringtheyearinterestexpensewas`4,000,andpreferreddividendswere
`10,000.Thesefixedchargesareexpectedtocontinueforthenextyear.
Anexpansionisplanned,whichwillrequire`1,75,000andisexpectedtoincreaseEBITby`1,00,000to
`5,50,000.
The firm is considering the following financing alternatives:
1 Issue5,000sharesofcommonstocktonetfirm`35pershare.Thefirmcurrentlyhas40,000sharesof
common stock outstanding.
2 Issue`1,75,000offifteenyearbondsat15%.Sinkingfundpaymentsonthesebondswillcommence
after15years.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 68
3 Issue`1,75,000of14%preferredstock.
Assumea50%incometaxrate.
A CalculatetheEPSattheexpectedearningsbeforeinterestandtaxeslevelof`5,5,000foreach
financing alternative.
B Calculate the equivalency level of earnings before interest and taxes between the debt and
common stock alternatives.
C Calculatetheequivalencylevelofearningbeforeinterestandtaxesbetweenthepreferredstock
andcommon stock alternatives.
Q15 Mr.Gupta,thefinanceadviserofM/sAggrawalIndustries,isconfrontedwithtwoalternativefinancial
plansforraising`10lakhsthatneededforplantexpansionandmodernization.Onechoiceis12%debt
issue.Theotheristoissue8,000equitysharesatthecurrentmarketpriceof`125pershare.
The modernization and expansion programme is expected to increase the firm’s operating profits
(EBIT)by ` 2,00,000 annually.  The firm’s condensed financial statements for current year are given
below.
Balance sheet as on 31 December, Current year
Liabilities Amount (`) Assets Amount (`)
Current liabilities 5,00,000 Current assets 16,00,000
Reserves & Surplus 10,00,000
10%longtermloan 15,00,000 Plant and Equipment 34,00,000
Equity capital (net)
(ofsharesof`100each) 20,00,000
50,00,000 50,00,000
Incomestatementforthecurrentyear
`
Operating profits 8,00,000
Lessinterestexpenses(10%of`15,00,000) 1,50,000
Income before taxes 6,50,000
Less income taxes 3,25,000
Net income 3,25,000
Earningpershare 16.25
Dividendper share 8.125
Mr.Guptaisconcernedabouttheeffectthatissuingdebtmighthaveonthefirm.Theaveragedebt
ratio(totaldebt/totalassets)forfirmsinindustryis45%.Hebelievesthatifthisratioisexceeded,the
priceearningsratiowillfallto7becauseofthepotentiallygreaterrisk.Ifthefirmincreasesitsequity
capital,heexpectsthepriceearningsratiotoincreaseto8.5.Healsowondersastowhatwillhappen
tothedividendyieldundereachplan.Thefollowsthepracticeofpayingdividendsequalto50%ofnet
income.
1 Determine the debt ratio, under eachfinancing plan, afterthe securitiesare issued,.
2 Determinetheexpectednetincomeinthenextyear,expectedearningspershareandtheexpected
marketpriceoftheequityshares.

Chapter3FinancingDecisionsCapitalStructure 69
3 Determine the dividend yield.
4 Whichformoffinancingshouldbeemployedbythecompany,ifthecompanyistofollowapolicyof
maximising market value of its shares.
Q16 ThecapitalstructureofBLtd.isextractedbelow:
(` lakhs)
Equitycapital;10lakhsharesof`10eachfullypaidup 100
Reservesand surplus 120
12%preferenceshares30,000sharesof`100eachfullypaidtip 30
14%debenturesof`100each;30,000Nos. 30
Longtermloanfromfinancialinstitutionat12%pa 20
Total 300
The company is also availing.a bank overdraftof ` 20 lakhs carrying interest at 15% per annum. The
company is now drawing up its profit plan for the year 2001. It wants to pay dividend to equity
shareholdersat15%anckeepthetotaldividendpayout(equityandpreference)at60%.Whatlevelof
earnings(EBIT’)shouldhecompanytrytoachievetomeetitscommitments?Thetaxrateapplicable
tothecompanyis50%.
Q17 Determinetheindifferencepointatwhichmarketpriceofequitysharesofacorporatefirmwillbethe
samefromthefollowingdata:
1. Fundsrequired,`50,000.
2. Existingnumberofequitysharesoutstanding,5,000@`10pershare.
3. Existing10%debt,`20,000
4. Fundsrequiredcanberaisedeitherby(a)issueof2,000equityshares,netting`25pershareor
(b)new15percentdebt.
5. TheP/Eratiowillbe7timesinequityalternativeand6timesindebtalternative.
6. Corporatetaxrate,35percent.
Q18 Assuming no taxes and given the earnings before interest and taxes (EBIT), interest (1) at 10% and
equitycapitalisationrate (ke) below, calculatethe totalmarket valueof each firm
Firms EBIT I ke
` `
X 2,00,000 20,000 12.0%
Y 3,00,000 60,000 16.0%
Z 5,00,000 2,00,000 15.0%
W 6,00,000 2,40,000 18.0%
Alsodeterminetheweighted averagecostofcapitalforeachfrim.
Q19 Company, X and Company Y are in the same risk class, and are identical in very fashion except that
companyXusesdebtwhilecompanyYdoesnot.Thefirmhas`9,00,000debentures,carrying10%rate
ofinterest.Boththefirmsearn20%beforeinterestandtaxesontheirtotalassetsof`15lakhs.
Assumeperfectcapitalmarkets,rationalinvestorsandsoon;ataxrateof50%andcapitalisationrateof
15%foranallequitycompany.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 70
(i) ComputethevalueoffirmsXandYusingthenetincome(NI)approach.
(ii) Computethevalueofeachfirmusingthenetoperatingincome(NOI)approach.
(iii) UsingtheNOIapproach,calculatetheoverallcostofcapital(ko)forfirmsXandY.
WhichoftheseoftwofirmshadanoptimalcapitalstructureaccordingtotheNOIapproach?Why?
Q20 Inconsideringthemostdesirablecapitalstructureofatcompany,thefollowingestimatesofthecotof
debtand(Aftertax)andequitycapitalhavebeenmadeatvariouslevelsofdebtequitymix:
Debt as percentage Cost of debt Cost of equity
of total capital
employed % %
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
Youarerequiredtodeterminetheoptimaldebtequitymixforthecompanybycalculatingcomposite
costofcapital.
00

Chapter3FinancingDecisionsCapitalStructure 71
MULTIPLE CHOICE QUESTIONS

1. Whichofthefollowingstatementsisfalseinthecontextofexplainingtheconceptofcapitalstructure
ofafirm:
(a) Itresemblesthearrangementsofthevariouspartsofabuilding
(b) It represents the relation between fixed assets and current assets
(c) Combinations of various longterms sources
(d) The relation between equity and debt
2. TheassumptionsofMMhypothesisofcapitalstructuredonotincludethefollowing;
(a) Capital markets are imperfect
(b) Investors have homogeneous expectations
(c) All firms can be classified into homogeneous risk classes
(d) Thedividendpayoutratioiscentpercent,andthereisnocorporatetax
3. Whichof the followingisirrelevantforoptimal capital structure?
(a) Flexibility (b) Solvency
(c) Liquidity (d) Control
4. Financial Structure refer to
(a) All Financial resources (b) Shortterm funds
(c) Longterm funds (d) None of these
5. AnEBITEPS indifference analysis chart is used for
(a) EvaluatingtheeffectsofbusinessriskonEPS
(b) Examining EPS results for alternative financial plans at varying EBIT levels
(c) DeterminingtheimpactofachangeinsalesonEBIT
(d) ShowingthechangesinEPSquality overtime
6. Theterm“capitalstructure”means
(a) Longterm debt, preferred stock, and equity shares.
(b) Current assets and current liabilities.
(c) Net working capital
(d) Shareholders’ equity.
7. Thecostofmonitoringmanagementisconsideredtobea(an):
(a) Bankruptcy cost. (b) Transaction cost.
(c) Agency cost. (d) Institutional cost.
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 72
8. Thetraditionalapproachtowardsthevaluationofafirmassumes:
(a) That the overall capitalization rate changes in financial leverage.
(b) That there is an optimum capital structure.
(c) Thattotalriskisnotchangedwiththechangesinthecapitalstructure.
(d) Thatmarketsareperfect.
9. Marketvaluesareoftenusedincomputingtheweightedaveragecostofcapitalbecause
(a) Thisisthesimplestwaytodothecalculation.
(b) This is consistent with the goal of maximizing shareholder value.
(c) ThisisrequiredbySEBI.
(d) Thisisaverycommonmistake.
10. A firm’s optimal capital structure:
(a) Is the debtequity ratio that results in the minimum possible weighted average cost of capital.
(b) 40percentdebtand60percentequity.
(c) Whenthedebtequityratiois.50.
(d) WhenCost ofequity isminimum

THEORETICAL BASED QUESTIONS

1. WhatisCapitalStructure’?
2. Explain in brief the assumptions of ModiglianiMiller theory
3. What is Net Operating Income (NOI) theory of capital structure? Explain the assumptions of Net
OperatingIncomeapproachtheoryofcapitalstructure.
4. Explain the principles of “Trading on equity”.
5. Discuss the concept of DebtEquity or EBITEPS indifference point, while determining the capital
structureofacompany.
6. Discuss financial breakeven and EBITEPS indifference analysis.

Chapter3FinancingDecisionsCapitalStructure 73
HOME WORK

Q21 Supposethatafirmhasanallequitycapitalstructureconsistingof100,000ordinarysharesof`10per
share.Thefirmwantstoraise`250,000tofinanceitsinvestmentsandisconsideringthreealternative
methodsoffinancing–(i)toissue25,000ordinarysharesat`10each,(ii)toborrow`2,50,000at8per
centrateofinterest,(iii)toissue2,500preferencesharesof`100eachatan8percentrateofdividend.
If the firm’searnings before interest and taxes after additional investment are `3,12,500 and the tax
rateis50percent,theeffectontheearningspershareunderthethreefinancingalternativeswillbe
as follows: Table: EPS under alternative financing favorable EBIT:
Particulars Equity Debt Preference
Financing (`) Financing (`) Financing (`)
EBIT 3,12,000 3,12,550 3,12,550
Less: Interest 0 20,000 0
PBT 3,12,500 2,92,500 3,12,500
Less: Taxes 1,56,250 1,46,250 1,56,250
PAT 1,56,250 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary shareholders 1,56,250 1,46,250 1,36,250
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 1.25 1.46 1.36
The firm is able to maximize the earnings per share when it uses debt financing. Though the rate of
preferencedividendisequaltotherateofinterest,EPSishighincaseofdebtfinancingbecauseinterest
charges are tax deductible while preference dividends are not. With increasing levels of EBIT, EPS will
increaseatafasterratewithahighdegreeofleverage.
However,ifacompanyisnotabletoearnarateofreturnonitsassetshigherthantheinterestrate(orthe
preference dividend rate), debt (or preference financing) will have an adverse impact on EPS. Suppose
the firm in illustration above has an EBIT of `75,000/, then EPS under different methods will be as
follows: Table: EPS under alternative financing methods: Unfavourable EBIT:
Particulars Equity Debt Preference
Financing (`) Financing (`) Financing (`)
EBIT 75,000 75,000 75,000
Less: Interest 0 20,000 0
PBT 75,000 55,000 75,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 74
Less: Taxes 37,000 27,500 37,500
PAT 37,500 1,46,250 1,56,250
Less: Preference dividend 0 0 20,000
Earning available to ordinary shareholders 1,56,250 27,500 17,500
Shares outstanding 1,25,000 1,00,000 1,00,000
EPS 0.30 0.27 0.17
Itis obvious that underunfavourable conditions, i.e.when the rate of return on the total assetsisless
thanthecostofdebt,theearningspersharewillfallwiththedegreeofleverage.
Q22 BestofLuck Ltd.,aprofitmakingcompany,hasapaidupcapitalof `100lakhsconsistingof10lakhs
ordinarysharesof`10each.Currently,itisearninganannualpretaxprofitof`60lakhs.Thecompany’s
shares are listed and are quoted in the range of ` 50 to ` 80. The management wants to diversify
productionandhasapprovedaprojectwhichwillcost`50lakhsandwhichisexpectedtoyieldapre
tax income of ` 40 lakhs per annum. To raise this additional capital, the following options are under
consideration of the management:
(a) Toissueequitysharecapitalfortheentireadditionalamount.Itisexpectedthatthenewshares
(facevalueof`10)canbesoldatapremiumof`15.
(b) Toissue16%nonconvertibledebenturesof`100eachfortheentireamount.
(c) Toissueequitycapitalfor`25lakhs(facevalueof`10)and16%nonconvertibledebenturesfor
thebalanceamount.Inthiscase,thecompanycanissuesharesatapremiumof`40each.Youare
required to advise the management as to how the additional capital can be raised, keeping in
mind that themanagement wants to maximise the earnings per share to maintain its goodwill.
Thecompanyispayingincometaxat50%.
Hints
Particulars Options
Option I: Option II: Option III:
Issue Equity Issue 16% Issue Equity
shares Debentures Shares
only only and 16%
Debentures of
equal amount
EarningsPerShare(EPS) 4.17 4.60 4.57
Advise:OptionIIi.e.issueof16%Debenturesis mostsuitabletomaximizetheearningspershare.
Q23 Shahji Steels Limited requires ` 25,00,000 for a new plant. This plant is expected to yield earnings
beforeinterestandtaxesof`5,00,000.Whiledecidingaboutthefinancialplan,thecompanyconsiders
the objective of maximizing earnings per share. It has three alternatives to finance the project  by
raisingdebtof`2,50,000or`10,00,000or`15,00,000andthebalance,ineachcase,byissuingequity
shares.Thecompany’sshareiscurrentlysellingat`150,butisexpectedtodeclineto`125incasethe
fundsareborrowedinexcessof`10,00,000.Thefundscanbeborrowedattherateof10percentupto
`2,50,000,at15percentover`2,50,000andupto`10,00,000andat20percentover`10,00,000.Thetax
rateapplicabletothecompanyis50percent.Whichformoffinancingshouldthecompanychoose?

Chapter3FinancingDecisionsCapitalStructure 75
Hints
Particulars
Earningspershare(EPS) 15.83 18.13 16.41
Financing Plan II (i.e. Raising debt of `10 lakh and issue of equity share capital of `15 lakh) is the option
which maximises the earnings per share.
Q24 GanapatiLimited is considering threefinancingplans. The key information isasfollows:
(a) Totalinvestmenttoberaised`2,00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100%  
B 50% 50% 
C 50%  50%
(c) Costofdebt 8%
Cost of preference shares 8%
(d) Taxrate 50%
(e) Equitysharesofthefacevalueof`10eachwillbeissuedatapremiumof`10pershare.
(f) ExpectedEBITis`80,000.Youarerequiredtodetermineforeachplan:
(i) Earningspershare(EPS)
(ii) The financial breakeven point.
(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for
indifference.
Hints
Plans A B C
EPS` 4 7.20 6.40

(ii) PlanA:Underthisplanthereisnointerestorpreferencedividendpaymenthence, theFinancial


Breakeven point will be zero.
PlanB: =`8,000
PlanC:`16,000
(iii) Indifference point :
PlanA&B=16,000
PlanA&C=32,000
ThereisnoindifferencepointbetweenthefinancialplansBandC.ItcanbeseenthatFinancialPlanB
dominatesPlanC.Since,thefinancialbreakevenpointoftheformerisonly`8,000butincaseoflatter
itis`16,000.
Q25 Yoyo Limitedpresently has `36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It
wishestofinancea`40,00,000expansionprogrammeandisconsideringthreealternatives:additional
debtat12percent interest,preferenceshareswithan 11 per centdividend,andtheissue of equity

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 76
sharesat`16pershare.Thecompanypresentlyhas8,00,000sharesoutstandingandisina40percent
taxbracket.
(a) Ifearningsbeforeinterestandtaxesarepresently`15,00,000,whatwouldbeearningspershare
for the three alternatives, assuming no immediate increase in profitability?
(b) Develop an indifference chart for these alternatives. What are the approximate indifference
points? To check one of these points, what is the indifference point mathematically between
debtandcommon?
(c) Which alternative do you prefer? How much would EBIT need to increase before the next
alternative would be best?
Hints
(a)
Particulars Alternatives
Alternative–I : Alternative II: Alternative III:
Take additional Issue11% Issue fur ther Equity
Debt Preference
Shares Shares
(`) (`) (`)
Earningspershare 0.495 0.305 0.651

(b) Approximateindiûerencepoints:Debtandequityshares,`24lakhs,preferenceandequityshares,`33
lakhsinEBIT;Debtdominatespreferredbythesamemarginthroughout,thereisnodiûerence point.
Mathematically, the indiûerence point between debt and equity shares is (in thousands):

EBIT*–840 EBIT*–360
=
800 1,050
Chapter3FinancingDecisionsCapitalStructure 77
EBIT*(1,050)–`840(1,050)=EBIT*(800)–`360(800)
250EBIT*=`5,94,000
EBIT*=`2,376
Notethatforthedebtalternative,thetotalbeforetaxinterestis`840,and
thisistheinterceptonthehorizontalaxis.Forthepreferredstockalternative,
wedivide`440by(10.40)toget`733.Whenthisisaddedto`360ininterest
onexistingdebt,theinterceptbecomes `1,093.
(c) ForthepresentEBITlevel,equitysharesareclearlypreferable.EBITwouldneedtoincreaseby`2,376
`1,500=`876beforeanindiûerencepointwithdebtisreached.Onewouldwanttobecomfortably
abovethisindiûerencepointbeforeastrongcasefordebtshouldbemade.Thelowertheprobability
thatactualEBITwillfallbelowtheindiûerencepoint,thestrongerthecasethatcanbemadefordebt,
allotherthingsremainthesame.
Q26 AlphaLimitedrequiresfundsamountingto`80lakhforitsnewproject.Toraisethefunds,thecompany
has following two alternatives:
(i) ToissueEquitySharesof`100each(atpar)amountingto`60lakhandborrowthebalanceamount
attheinterestof12%p.a.;or
(ii) ToissueEquitySharesof`100each(atpar)and12%Debenturesinequalproportion.
TheIncometaxrateis30%.
Findoutthepointofindifferencebetweentheavailabletwomodesoffinancingandstatewhich
option will be beneficial in different situations.
Hints :
(i) IndifferencePoint=9,60,000
(ii)

EBIT Plan
=9,60,000 Any Plan
>9,60,000 PlanB
<9,60,000 PlanA
Q27 TheModernChemicalsLtd.requires`25,00,000foranewplant.Thisplantisexpectedtoyieldearnings
beforeinterestandtaxesof`5,00,000.Whiledecidingaboutthefinancialplan,thecompanyconsiders
the objective of maximising earnings per share. It has three alternatives to finance the project—by
raisingdebtof`2,50,000or`10,00,000or`15,00,000andthebalance,ineachcase,byissuingequity
shares.Thecompany’sshareiscurrentlysellingat`150,butisexpectedtodeclineto`125incasethe
funds are borrowed in excess of ` 10,00,000. The funds can be borrowed at the rate of 10% upto `
2,50,000,at15%over`2,50,000andupto`10,00,000andat20%over`10,00,000.Thetaxrateapplicable
tothecompanyis50%.Whichformoffinancingshouldthecompanychoose?
Hints :
Alternatives
I II III
Earning per share: (A)/(B) 15.833 18.125 16.406

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 78
Q28 A company provides the following figures:
`
Profit 26,00,000
Less:Interestondebentures@12% 6,00,000
Profit before tax 20,00,000
Less:Incometax@50% 10,00,000
Profit after tax 10,00,000
Numberofequityshares4,00,000
(of`10each)
Earningpershare(EPS) 2.50
Rulingprice in market 25
P/E (Price/Earning) Ratio (i.e. Price EPS) 10
Thecornpanyhasundistributedreservesof`60,00,000.
Thecompanyneeds`20,00,000forexpansion;thisamountwill earnthesame rateasfundsalready
employed.Youareinformedthatadebtequityratio[Debt÷(Debt+Equity)]higherthan35%pullsthe
PEratiodownto8andraisestheinterestrateonadditionalamountborrowedat14%.Youarerequired
toascertaintheprobablepriceoftheshareif
(i) theadditionalfundsareraisedasaloans;or
(ii) the amount is raised by issuing equityshares.
Hints :
Probable Price of Shares of Ltd.
(i)`20,00,000 (ii)`20,00,000
is raised israisedby
asloan issue u/
equity shares
` `
MPS 20.64 24.44
Q29 AB Limited provides you with following figures:
(` )
Profit 3,00,000
LessInterestonDebentures@12% 60,000
2,40,000
Incometax@50% 1,20,000
1,20,000
NumberofEquityShares(`10each) 40,000
EP.S:(EarningPerShare) 3
Rulingpriceinmarket 30
P.E.ratio(Price/EPS) 10

Chapter3FinancingDecisionsCapitalStructure 79
Thecompanyhasundistributedreservesof`6,00,000.Thecompanyneeds`2,00,000forexpansion.
Thisamountwillearnatthesamerateasfundsalreadyemployed.Youareinformedthatadebtequity
ratio [Debt/(debt + equity)] higher than 35% will push the P/E ratio down to 8. The interest rate on
additional amount borrowed will be14%.
Youarerequiredtoascertaintheprobablepriceoftheshare:
(i) Iftheadditionalfundsareraisedasdebt;and
(ii) Iftheamountisraisedbyissuingequityshares.
Hints :
ProposalI Proposal2
Marketprcepershare `25.20 `30.00
Q30 TheexistingcapitalstructureofABCLtd.isasfollows: (` )
Equitysharesof`100each 40,00,000
Retained earnings 10,00,000
9% Preference shares 25,00,000
7% Debentures 25,00,000
Companyearnsareturnof12%andthetaxonincomeis50%.
Company warts to raise ` : 25,00,000 for its expansion project for which t is considering following
alternatives: .
(i) Issue20,000Equitysharesatapremiunmof`25pershare;(ii)Issueof10%preferenceshares;
(iii) Issue of 9% Debentures.
(ii) Projected  P/E ratios in the case of equity, preference and debenture financing 20, 17 and 16
respectively.
Whichalternativewouldyouconsidertobethebest.Givereasonsforyourchoice.
Hints :
Alternatives
Particulars Existing I II III
Expectedmarketpricepershare(BPSxP/Eratio)  145.80 79.73 129.92

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 80
CHAPTER 4
FINANCING DECISIONS  LEVERAGES

INTRODUCTION
Leverage means risk and Risk always rises due to presence of fixed cost  fixed cost can be classified in
following two types.
1. Operating fixed cost : Fixedcost rising dueto Opening activity of organisation isknown asoperating
fixed cost.
Eg:Rent,Salaries,depreciationetc.
2. Financialfixedcost:Fixedcostarisingduetocapitalstructureorfinancingpatternisknownasfinancial
fixed cost if generally included interest & preference dividend
Types of leverages:
Operating leverage : operating leverage calculate companies efficenncy to utilise its operating fixed cost.

%  inEBIT
operating leverage =
%  inSale / Contn

Contn
=
EBIT
 Operatingleveragemeanifsalesincreaseby1%EBITWILLINCREASEBY%TIMESOPERATINGLEVERAGES
2. Financial leverage :
 Financial leverage calculate companies efficency to utilised if financial fixed cost

­ %  inEBT / EPS ½
®Financialleverage = ¾
¯ %  inEBIT ¿

­ EBIT ½
®Financialleverage = ¾
¯ EBT ¿
 fINANCIALLEVERAGEMEANSIFebitINCREASEBY1%ePSwillincreaseby%Timesfinancial/leverage
3. Combined leverage : If calculate companies overall efficiency to utilise its fixed cost

operating  financial
combinedleverage =
leverage leverage

Chapter4 FinancingDecisions Leverages 83


% inEBIT %  inEBT / EPS
Combinedleverage = ×
%  insales / Contn %  IinEbIT

ª %  inEBT / EPS º
? « % inSales / contn »
¬ ¼
OR
= OLxEL

Contn EBIT
= ×
EBIT EBT

ª Contn º
?= « »
¬ EBT ¼
Combined leverage means if sales increase by % Times combined leverage

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 84
FINANCING DECISIONS  LEVERAGES

CLASS WORK

Q1 ACompanyproducesandsells10,000shirts.Thesellingpricepershirtis`500.Variablecostis`200per
shirtandfixedoperatingcostis`25,00,000.
(a) Calculate operating leverage.
(b) Ifsalesareupby10%,thenwhatistheimpactonEBIT?
Q2 CalculatetheoperatingleverageforeachofthefourfrmsA,B,CandDfromthefollowingpriceand
costdata:
Firms
A (`) B (`) C (`) D (`)
Saleprice perunit 20 32 50 70
Variable costperunit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
Whatcalculationscanyoudrawwithrespecttolevelsoffxedcostandthedegreeofoperatingleverage
result?Explain.Assumenumberofunitssoldis5,000.
Q3 Afrm’sdetailsareasunder:
Sales(@100perunit) `24,00,000
Variable Cost 50%
Fixed Cost `10,00,000
Ithasborrowed`10,00,000@10%p.a.anditsequitysharecapitalis`10,00,000(`100each)Calculate:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) Ifthesalesincreasesby`6,00,000;whatwillthenewEBIT?
Q4 BetatronicsLtd. hasthefollowingbalance sheet and income statement information:]
Balance Sheet as on March 31st
Liabilities (`) Assets (`)
Equitycapital(`10pershare) 8,00,000 Net fxed assets 10,00,000
10%Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Chapter4 FinancingDecisions Leverages 85


Income Statement for the year ending March 31
(`)
Sales 3,40,000
Operating expenses (including ` 60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
Earnings before tax 1,60,000
Less: Taxes 56,000
Net Earnings (EAT) 1,04,000
(a) Determinethedegreeofoperating,fnancialandcombinedleveragesatthecurrentsaleslevel,if
all operating expenses, other than depreciation, are variable costs.
(b) Iftotalassetsremainatthesamelevel,butsales(i)increaseby20percentand(ii)decreaseby20
percent,whatwillbetheearningspershareatthenewsaleslevel?
Q5 AcompanyhadthefollowingBalanceSheetason31stMarch,2014:
Liabilities (` incrores) Assets (` incrores)
EquityShareCapital(50lakhs 5
sharesof`10each)
Reserves and Surplus 1 Fixed Assets (Net) 12.5
15% Debentures 10 Current Assets 7.5
Current Liabilities 4
20 20
Theadditional information given isas under:
Fixed cost per annum (excluding interest) `4crores
Variable operating cost ratio 65%
Total assetsturnoverratio 2.5
Income Tax rate 30%
 Required:
Calculate the following and comment:
(i) EarningsPerShare
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 86
Q6 Calculate the operating leverage, fnancial leverage and combined leverage from the following data
underSituationIandIIandFinancialPlanAandB:
Installed Capacity 4,000units
ActualProductionand Sales 75%oftheCapacity
Selling Price `30PerUnit
Variable Cost `15PerUnit

Fixed Cost:
UnderSituationI `15,000
Under SituationII `20,000
Capital Structure:
Financial Plan
A (`) B (`)

Equity 10,000 15,000


Debt(RateofInterestat20%) 10,000 5,000
20,000 20,000
Q7 Theoperatingincomeofatextilefirmamountsto`2,00,000.Itpays50%taxonitsincome.Itscapital
structure consists of the following:
14% Debentures `5,00,000
15% Preference shares `1,00,000
Equityshares(`100each) `4,00,000
(i) Determine the firm’s EPS.
(ii) DeterminethepercentagechangeinEPSassociatedwith30%change(bothincreaseanddecrease)in
EBIT.
(iii) Determinethedegreeof financial leverageatthecurrentlevelofEBIT.
(iv) Whatadditionaldatadoyouneedtocomputeoperatingaswellascombinedleverage?
Q8 Calculatethedegreeofoperatingleverage,financialleverageandcombinedleverageforthefollowing
firms and interpret the results, given the following data.
P Q R
Output (units) 3,00,000 75,000 5,00,000
Fixed costs (`) 3,50,000 7,00,000 75,000
Unitvariable cost (`) 1.00 7.50 0.10
Interest expenses (`) 25,000 40,000 Nil
Unit selling price (`) 3.00 25.00 0.50

Chapter4 FinancingDecisions Leverages 87


Q9 Fromthefollowingfinancialdataofcompanies X and Y,prepare theirincomestatements.
Company X Company Y
Variablecostsas%ofsales 50 60
Interest expense `20,000 6,000
Degree of operating leverage 31 5l
Degree of financial leverage 21 31
Incometax rate 55% 55%

Q10 Calculate operating, financial and combined leverages under situations when fixed Costs are (a) `
5,000(b)`10,000andfinancialplans1and2,fromthefollowinginformationpertainingtotheoperation
andcapitalstructureofaleathermanufacturingcompany.
Total assets `30,000
Total assets turnover based on sales 2
Variablecostas%ofsales 60
Capital structure Financial plans
1 2
Equity `30,000 `10,000
10% debentures 10,000 30,000
Q11 ThecapitalstructureoftheProgressiveCorporationconsistsofanordinarysharecapitalof`10,00,000
(sharesof`100pervalue)and`10,00,000of10%debentures.Salesincreasedby20%from1,00,000
unitsto1,20,000units,thesellingpriceis`10perunit,variablecostsamountto`6perunitandfixed
expensesamountsto`2,00,000.Theincometaxrateisassumedtobe50%.
(a) You are to required calculate the following:
( i ) Thepercentageincreaseinearnings per share.
(ii) ThedegreeofFinancialleverageat1,00,000unitsand1,20,000units.
(iii) Thedegreeofoperatingleverageat1,00,000unitsand1,20,000units.
(b) Commentonthebehaviorofoperatingandfinancialleverageinrelationtoincreaseofproduction
from1,00,000unitsto1,20,000units.
Q12 TheABCCo.hasthefollowingbalancesheetandincomestatementinformation:
Balance sheet of the company as on 31st December
Liabilities ` Assets `
Equity capital
(`10 per share) 8,00,000 Net fixed assets 10,00,000
10%Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
`19,00,000 ` 19,00,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 88
`
Sales 3,40,000
Operating expenses
(including `60,000 depreciation) 1,20,000
EBIT 2,20,000
Interest 60,000
Earnings before tax 1,60,000
Taxesat50% 80,000
Net earnings (EAT) 80,000
(i)Debermine the degreeofoperating, financialandcombinedleveragesat thecurrentsales levels, if
all operating expenses, other than depreciation, are variable costs.
(ii)Iftotalassetsremainatthesamelevel,butsales(a)increaseby20%and(b)decreaseby20%what
willbetheearningspershareinthenewsituation?
Q.13 Findthe financialleverage from thefollowing data:
Networth `25,00,000
Debt/ Equity 3/1
Interest rate 12%
Operting profit `20,00,000
Q14 AFirm'sdetailsareasunder:
Sales(@100perunit) `24,00,000
Variable Cost 50%
Fixed Cost `1000,000
Ithasborrowed`10,00,000at10%p.a.anditsequitysharecapitalis`10,00000(`100each)
Calculate:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) Ifthesalesincreasesby`6,00,000;whatwillthenewEBIT?
Q15 ThefollowingdatarelatetoRTLtd:
`
Earningbeforeinterestand tax(EBIT) 10,00,000
Fixed cost 20,00,000
Earning Before Tax(EBT) 8,00,000
Required : Calculate combined leverage

Chapter4 FinancingDecisions Leverages 89


Q16 Acompanyoperatesataproductionlevelof1,000units.The contributionis ` 60perunit,operating
leverageis6,combinedleverageis24,Iftaxrateis30%,whatwouldbeitsearningsaftertax?
Q17 Thecombinedleverageandoperatingleveragefiguresofacompanyare2.5and1.25respectively,find
thefinancialleverageandP/Vratiogiventhattheequitydividendpershareis`2,interestpayableper
yearis`1lakh,totalfixedcost`0.5lakhaadsales`10lakhs.
Q18 Afirmhassalesof`75,00,000variablecostof`42,00,000andfixedcostof`6,00,000.Ithasadebtof
`45,00,000at9%andequityof`55,00,000.
(i) Whatisthefirm'sROI?
(ii) Does it hatefavourable financialleverage ?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have a high or low asset
leverage ?
(iv) Whataretheoperating,financialandcouibinedleveragesofthetirm?
(v) Ifthesalesdropto`50,00,000,whatwillbethenewEBIT?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 90
LAST MINUTE REVISION (LMR)

Leverages
Infinancialanalysis,leveragerepresentstheinfluenceofonefinancialvariableoversomeotherrelated
financialvariable.
Thesefinancialvariablesmaybecosts,output,salesrevenue,EarningsBeforeInterestandTax(EBIT),
Earningpershare(EPS)etc.
Operating Leverage
Operatingleverage(OL)maybedefinedastheemploymentofanassetwithafixedcostinthehope
thatsufficientrevenuewillbegeneratedtocoverallthefixedandvariablecosts.
Theuseofassetsforwhichacompanypaysafixedcostiscalledoperatingleverage.

OperatingLeverage=

Degree of Operating Leverage


Theoperatingleveragemayalsobedefinedas“thefirm’sabilitytousefixedoperatingcosttomagnifythe
effectsofchangesinsalesonitsearningsbeforeinterestandtaxes.”

Degree of Operating Leverage (DOL) =

Financial Leverage
Financialleverage(FL)maybedefinedas‘theuseoffundswithafixedcostinordertoincreaseearningsper
share.’ In other words, it is the use of company funds on which it pays a limited return. Financial leverage
involvestheuseoffundsobtainedatafixedcostinthehopeofincreasingthereturntocommonstockholders.

FinancialLeverage=

Degree of Financial Leverage = Degreeoffinancialleverageistheratioofthepercentageincreaseinearnings


per share (EPS) to the percentage increase in earnings before interest and taxes (EBIT). Financial Leverage
(FL)isalsodefinedas“theabilityofafirmtousefixedfinancialchargestomagnifytheeffectofchangesin
EBITonEPS.

DegreeofFinancialLeverage(DFL)=

Chapter4 FinancingDecisions Leverages 91


Combined Leverage = Combinedleveragemaybedefinedasthepotentialuseoffixedcosts,bothoperating
andfinancial,whichmagnifiestheeffectofsalesvolumechangeontheearningpershareofthefirm.
DegreeofCombinedLeverage=DOL×DFL
Degree of Combined Leverage = Degree of combined leverage (DCL) is the ratio of percentage change in
earningpersharetothepercentagechangeinsales.ItindicatestheeffectthesaleschangeswillhaveonEPS.

DegreeofCombinedLeverage(DCL)=

MULTIPLE CHOICE QUESTIONS

1. Given
Operating fixed costs ?20,000
Sales ?1,00,000
P/V ratio 40%
The operating leverage is:
(a) 2.00 (b) 2.50 (c) 2.67 (d) 2.47
2. IfEBITis?15,00,000,interestis?2,50,000,corporatetaxis40%,degreeoffinancialleverageis
(a) 1:11 (b) 1.20 (c) 1.31 (d) 1.41
3. IfDOLis1.24andDFLis1.99,DCLwouldbe:
(a) 2.14 (b) 2.18 (c) 2.31 (d) 2.47
4. Operating Leverageis calculated as:
(a) Contribution f EBIT (b) EBIT f PBT
(c) EBITfInterest (d) EBITfTax
5. FinancialLeverage is calculated as:
(a) EBIT fContribution (b) EBIT f EBT
(c) EBITfSales (d) EBITfVariablesCost
6. Whichofthefollowingiscorrect?
(a) CL=OL+FL (b) CL=OLFL
(c) OL = OLx FL (d) OL=OLfFL

THEORETICAL BASED QUESTIONS


1. DifferentiatebetweenBusinessriskandFinancialrisk.
2. “Operatingriskisassociatedwithcoststructure,whereasfinancialriskisassociatedwithcapital
structureofabusinessconcern.”Criticallyexaminethisstatement.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 92
HOME WORK

Q19 TheoperatingandcostdataofABCLtdare:
Sales `20,00,000
Variable costs 14,00,000
Fixed costs 4,00,000 (including 15% interest
on`10,00,000)
(i) Calculate its operating, financial and combined leverages.
(ii) Determinetheadditionalsalesto double its EBIT.
Hints :
(i)
Operatingleverage=1.71
Financialleverage=1.75
Combinedleverage=2.99
(ii) Additionalsalesrequired=`11,66,667(`31,66,667Re20,00,000).
Q20 ThedatarelatingtotwoCompaniesareasgivenbelow:
Company A Company B
Equity Capital `6,00,000 ` 3,50,000
12% Debentures `4,00,000 `6,50,000
Output (units) per annum 60,000 15,000
Selling price/ unit `30 `250
Fixed Costs per annum `7,00,000 `14,00,000
Variable Cost per unit `10 `75
You are required to calculate the Operating leverage, Financial leverage and Combined leverage of
two Companies.

Hints :
Company A Company B
Operating Leverage 2.4 2.14
Financial Leverage 1.11 1.07
Combined Leverage 2.66 2.29

Chapter4 FinancingDecisions Leverages 93


Q21 Thefollowingsummarisesthepercentagechangesinoperatingincome,percentagechangesinrevenues,
andbetasforfourpharmaceuticalfirms.
Firm Change in Change in Beta
revenue operating income
PQRLtd. 27% 25% 1.00
RSTLtd. 25% 32% 1.15
TUVLtd. 23% 36% 1.30
WXYLtd. 21% 40% 1.40
Required:
(i) Calculate thedegree of operating leverage foreach of thesefirms.Comment also.
(ii) Use the operating leverage to explain why these firms have different beta.
Hints :
(i)
PQRLtd =0.9259
RSTLtd. =1.28
TUVLtd. =1.5652
WXYLtd. =1.9048
(ii) Highoperatingleverageleadstohighbeta.Thesourcesofriskarecyclecalityofrevenues,operating
risk and financial risk.
Q22 ConsiderthefollowinginformationforStrongLtd.:
EBIT `1,120 lakhs
PBT `320 lakhs
Fixed cost `700 lakhs
Calculatethepercentageofchangeinearningspershare,ifsalesincreasedby5%.
Hints :
%changeinEPS=5.687x5=28.44%
Q23 ACompanyproducesandsells10,000shins.Theseflingpricepershirtis`500.Variablecostis`200per
shirtandfixedoperatingcostis`25,00,000.
(a) Calculate operating leverage.
(b) Ifsalesareupby10%,thenwhatistheimpactonEBIT?
Hints :
(a) Operating Leverage=6Times
(b) ' EBIT=30,000/5,00,000=60%.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 94
Q24 ThefollowingdetailsofRSTLimitedfortheyearended31March,2006aregivenbelow:
Operating leverage 1.4
Combined leverage 2.8
Fixed Cost (Excluding interest) `2.04lakhs
Sales `30.00lakhs
12%Debenturesof`100each `21.25lakhs
EquityShareCapitalof`10each `17.00lakhs
Incometaxrate 30percent
Required:
(i) Calculate Financial leverage
(ii) CalculateP/VratioandEarningperShare(EPS)
(iii) If the company belongs to an industry, whose assetsturnover is 1.5, does it have a high or low
assets leverage?
(iv) AtwhatlevelofsalestheEarningbeforeTax(EBT)ofthecompanywillbeequaltozero?
Hints :
(i) Financialleverage=2times
(ii) P/VRatioandEPS=23.8%and1.05resepctively
(iii) Assetsturnover=0.784times
(iv) At19,28,700levelofsales,theEarningsbeforeTaxofthecompanywillbeequaltozero.
Q25 Variable expenses as a % of sales662/375 50
Interest expense ` 200 ` 300 ` 1,000
Degree of operating leverage 5 6 2
Degree of financial leverage 3 4 2
Incometax rate 0.50 0.50 0.50
(a) PrepareincomestatementsforA,BandCcompanies.
(b) Commentonthefinancial positionand structureof thesecompanies.
Hints :

Chapter4 FinancingDecisions Leverages 95


Comment: CompanyBcanbeconsideredascompanywithhigherriskindicatedbyhigherDCL.Itismainly
duetohigherlevelofop.risk&financialrisk.Here,with1%changeinsales,EPSwillchangeby24%.
CompanyCcanbeconsideredaslowerriskasindicatedbylowerDCL.Itismainlyduetolowerdegreeof
operatingrisk&financialrisk.Here,with1%changeinsales,EPswillChange4%.
   Company A can be considered as moderate risk which tries to maintain balance between risk& return.
Here,with1%changeinsales,EPSwillchangeby15%.

Q26 CalculateoperatingleverageandfinancialleverageundersituationsA,BandCandfinancialplans1,2
and3.Fromthefollowing information relatingtotheoperationandcapitalstructure ofXYZCo.Also
find out the combinations of operating and financial leverage which give the highest value and the
leastvalue.Howarethesecalculationusefultothefinancialmanagerofacompany?
Installed capacity 1,200 units
Actualproduction andsales 800 units
Selling price per unit ` 15
Variable costperunit 10
Fixed cost : Situation A 1,000
Situation B 2,000
Situation C 3,000
Financial plan
1 2 3
` ` `
Equity 5,000 7,500 2,500
Debt 5,000 2,500 7,500

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 96
Costofdebt(forallplans)12 %
Hints :

The combination of Operating & financial leverage which will give highest value & least value are as
under:
Highest value: 40(SituationC, PIII)
Least Value: 1.48(Situation A, PII)
‰

Chapter4 FinancingDecisions Leverages 97


NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 98
CHAPTER5
INVESTMENT DECISIONS (CAPITAL BUDGETING)

MEANING AND OBJECTIVES


Decisionsrelatingtolongtermassets/capitalassets/fixedassets/longtermprojectsareknownasCapital
Budgetingdecisions.Fore.g.settingupanewbranch,purchaseofmachinery,manufacturinganewproduct,
etc.Theunique partofthesedecisions isthattheoutflowsassociatedwiththeproject areimmediateand
the inflows are spread over a number of years. Most of the capital budgeting decisions are irreversible
decisionsshouldbetakenonlyafterconsideringandevaluatingeachandeveryminutedetailoftheproject
else the financial consequences will have far reaching effects.
This chapter revolves around two things, comparing the cash outflows to that of the cash inflows. Cash
outflowswillalwaysbegiveninthequestionforthatmatterevencashinflowswillbegiven,ifnotthenthe
samecanbecalculatedasfollows:
Sales XX
Less: Variable cost XX
Fixed cost XX
Cash flow before tax (CFBT/NPBDT) XX
Less: Depreciation XX
Net profit before tax(NPBT) XX
Less: Tax XX
Net profit after tax (NPAT) XX
Add: Depreciation XX
Cash flows after tax (CFAT/CI) XX
Scope:
Thischapterwillteachusvariousmethodsforevaluatinglongtermproposal.
Methods for evaluation
a. PayBackPeriodApproach(PBP)
b. Net Present Value (NPV)
c. Profitability Index (PI)
d. InternalRateofReturn(IRR)
e. Discounted Payback period (Discounted PBP)
f. Average/AccountingRateofReturn(ARR)
g. Modified IRR
h. Payback reciprocal.
Chapter5  Investment Decisions (Capital Budgeting) 101
PAY BACK PERIOD:
The length of time taken to recover the original investment is the pay back period. For e.g. if the project
requiredacashoutflowof‘10lacswhichgetsrecoveredsaywithin4yearsthenthepaybackperiodis4years.
Decision Rule:
Selecttheprojectwhose paybackperiod isless.
Limitations:
(a) Itignores Timevalue ofmoney
(b) PostPayback periodcash inflowsarecompletelyignoredi.e.allcashinflowsarenotconsidered.
Eg1 :
XLtdisconsideringselectionofoneofthefollowingthreeprojectseachcostingRs.9000.
Following cash inflowsare expected from the projects
Year A B C
1 200030003000
2 300020003000
3 200020003000
4 200050003000
5 300050003000
CalculatePaybackperiodforeachoftheprojectandadvisethecompany.
NET PRESENT VALUE
This method takes into consideration all the cash inflows related to the project and also incorporates the
conceptoftimevalueofmoney.
NPV=PVCI–PVCO
Inthismethod,alltherelatedcashflowsassociatedwiththeprojectarediscountedandarebroughttoits
presentvaluebyusingadiscountingfactorratewhichisthecostofcapitalorminimumrequiredrateforthe
company.
Decision Rule:
a. If there is only one project and it is to be decided whether it should be selected or not then the
criterionisverysimple.AccepttheprojectifithasapositiveNPV,RejectiftheNPVisnegativeandif
NPV is zero then we are indifferent.
b. If the management has to select between two mutually exclusive projects, then the project with
highest NPV istobe selected.
Eg2:
XLtdisconsideringaprojectcostingRs10,000.Followingcashinflowsareexpected
Year Cash inflows
1 5000
2 4000
3 4000
4 3000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 102
Costofcapital16%.CalculateNPVandadvisewhethertheprojectshouldbeacceptedornot.
PROFITABILITY INDEX OR DESIRABILITY FACTOR OR COST BENEFIT RATIO
PVCI(atcoc)
PI=
PVCO
ItisanextendedversionofNPV.Itindicatesthatagainstevery1rupeeofoutflowhowmuchcashinflowthe
project generates in present value terms. PI technique is useful in capital rationing situation (money is in
short supply.)
Decision Rule:
a. IfPI>1,selecttheproject
b. IfP<1,rejecttheproject
c. IfPI=1,indifferent
Eg 3:
For example 2 calculate Profitability Index.
INTERNAL RATE OF RETURN:
IRRistheratewhichtheprojectisexpectedtoearnfortheCo.MathematicallyIRRisthediscountratewhich
willequatethepresentvalueofthecashinflowswiththepresentvalueofcashoutflows,i.e.atIRR,PVCI–
PVCO=0
Decision Rule:
a. IfIRR>CostofCapital,accepttheproject
b. IfIRR>CostofCapital,rejecttheproject
c. IfIRR=CostofCapital,indifferent.
Eg 4 :
Forexample2calculateIRR
DISCOUNTED PAYBACK PERIOD
Paybackperiodhas2limitations;timevalueofmoneyisignoredandpostpaybackprofitabilityisignored.
Discountedpaybackperiodisanattempttoremoveonesuchlimitation.Whentimevalueisintroducedto
thepaybackperiod,itisknownasDiscountedPaybackperiod.
Eg5 :
Forexample2calculate DiscountedPaybackperiod.
AVERAGE RATE OF RETURN/ACCOUNTING RATE OF RETURN
AverageProfitaftertax
1) ARR= × 100
OriginalInvestment

AverageProfitaftertax
2)  ARR= × 100
AverageInvestment

OriginalInvestment+scrapvalue
Whereaverageinvestment=
2

Chapter5  Investment Decisions (Capital Budgeting) 103


Itshowsbookprofitabilityoftheproject.ItindicatesAverageNPATearnedbytheprojectduringitslifetime.
Limitations:
(a) Ignores time value of money.
(b) Basedonaccountingprofit&notoncashprofit.
Eg 6 :
YLtdisconsideringaprojectcostingRs100000havingalifeof5yrs.ScrapvalueRs.5000.
FollowingNPATare expected in its5 yrslife
Year NPAT
1 10000
2 12000
3 14500
4 18000
5 20000
Calculate ARR.
MODIFIED IRR
MIRRis superior to the regular IRR, MIRR assumes that project cash flows are reinvested at a certain re
investmentrate,whereastheregularIRRassumesthatprojectcashflowsarereinvestedattheproject’sown
IRR.SincereinvestmentatcostofcapitalismorerealisticthanreinvestmentatIRR,MIRRreflectsbettertrue
profitability of a project.
Eg7
An investment of  Rs. 1,36,000 yields the following cash inflows (profits before depreciationbut aftertax).
DetermineMIRRconsidering8%ascostofcapital.
Year Cash inflows
1 30000
2 40000
3 60000
4 30000
5 20000
PAYBACK RECIPROCAL
Asthenameindicatesitisthereciprocalofpaybackperiod.Amajordrawbackofthepaybackperiod
methodofcapitalbudgetingisthatitdoesnotindicateanycutoffperiodforthepurposeofinvestment
decision.Inpractice,thepaybackreciprocalisahelpfultoolforquicklyestimatingtherateofreturnof
aprojectprovideditslifeisatleasttwicethepaybackperiod.
Thepaybackreciprocalcanbecalculatedasfollows:
Averageannualcashinflow
PaybackReciprocal=
Averageannualcashinflow

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 104
Eg8 :
AprojectrequiresaninitialinvestmentofRs.20,000anditwouldgiveannualcashinflowofRs.4,000.
Theusefullifeoftheprojectisestimatedtobe5years.CalculatePaybackreciprocal.
CAPITAL RATIONING
Itreferstomakingrationaloralogicalallocationofcapitalwhenitisinshortsupply.Supposeacompanyhas
variousalternativeprojectsunderconsiderationbutcannotacceptallofthemduetoinsufficientfunds.In
thistypeofsituationcompanyhastoallocatefundsinsuchawaythatNPVismaximized.
Capitalrationingdependsonwhethertheprojectsaredivisibleorindivisible.Aprojectissaidtobedivisible
ifitcanbeacceptedinpartsandindivisibleifitcannotbeacceptedinparts.
Eg9:
XLtdhasRs.30lakhsavailableforinvestmentincapitalprojects.Ithastheoptionofmakinginvestmentin
projects 1, 2, 3 and 4. Each project is entirely independent and has a useful life of 5 years. The expected
presentvalueofcashflowsfromtheprojectsareasfollows:

Projects Initial Outlay (`) Present value of Cash flows `


1 8,00,000 10,00,000
2 15,00,000 19,00,000
3 7,00,000 11,40,000
4 13,00,000 20,00,000

Which of the above investmentshould be undertaken.

BLOCK OF ASSETS AND DEPRECIATION


Tax shield/benefit from depreciation is considered while calculating cash flows from the project. Taxable
income is calculated as per the provisions of Income Tax. The treatment of deprecation is based on the
conceptof”BlockofAssets”,whichmeansagroupofassetsfallingwithinaparticularclassofassets.Thisclass
of assets can be building, machinery, furniture etc. in respect of which depreciation is charged at same
rate.Thetreatmentoftaxdependsonthefactwhetherblockofassetconsistofoneassetorseveralassets.To
understandtheconceptofblockofassetletusdiscussanexample.
Eg10:
XLtdhasacquireda newmachineryfor Rs.100000 depreciableat 20%on WDV method.Life5yearsand
salvageRs.10000.Explainthetreatmentofdepreciationandprofit/lossinthe5thYearassuming
a) Thereisnootherassetintheblock.
b) Therearemanyotherassetsintheblock.
Assumetaxrate30%.

Chapter5  Investment Decisions (Capital Budgeting) 105


CLASS WORK

Q1 XYZCo.Ltdisconsideringthepurchaseofoneofthefollowingmachines,whoserelevantdataare
given below :
Machine X Machine Y
Estimated life 3years 3years
Capitalcost `90,000 `90,000
Earnings(aftertax):
Year 1 40,000 20,000
2 50,000 70,000
3 40,000 50,000
The company follows the straight line method of depreciation; the estimated salvage value of both the
typesofmachinesiszero.
Showthemostprofitableinvestmentbasedon(i)paybackperiod,(ii)accountingrateofreturn,and(iii)net
presentvalueassuminga10%costofcapital.(iv)Profitability Indexassuming10%costofcapital.
Q2 ALtd.Co.isconsideringinvestinginaprojectrequiringacapitaloutlayof`2,00,000.Forecastedannual
incomeafterdepreciationbutbeforetaxisasfollows:
Year `
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciationmaybetakenas20%onoriginalcostoftheassetandtaxationat35%ofnetincome.
Youarerequired toevaluatetheprojectaccordingtoeachofthefollowingmethods.
(a) Payback methods.
(b) Rate of returnonoriginal investment method.
(c) Rateofreturnon averageinvestmentmethods.
(d) Netpresentvalueindexmethods.(costofcapital :10%)
(e) Profiabilty index
(f) Discounted payback method.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 106
Q3 ACompanyisthinkingofinstallingaplanttoimprovetheefficiencyofitsprocess.Theestimatedcost
oftheplant`20,000withinexpectedlifeof5years.Itisanticipatedthatprofitsbeforedepreciation
willbe`6,000p.a.fromtheplant.Itisexpectedtobesoldatapriceof`2,000attheendof5years.The
companyhas a40% tax rate & uses declining balance methods of depreciation. Rate ofdepreciation
20%.
Calculatethenetpresentvalueoftheplantifrequiredrateofreturnis13%.
Q4 Acompanyisconsideringtwomutuallyexclusiveproposals,X andY.
ProposalXwillrequiretheinitialcostof`1,40,000withnosalvagevalue,andwillalsorequirean
increaseinthelevelofinventoriesandreceivablesof `60,000overitslife.Theprojectwill
generateadditionalsalesof`1,30,000,andwillrequirecashexpensesof`40,000ineachofits5
yearlife. Itwill bedepreciated onstraight line method.
ProposalYwillrequireaninitialcapitalof`2,00,000withnosalvagevalue,andwillbedepreciated
onstraightline basis.Theearningsbeforedepreciationandtaxesduring its5yearlifeare:
Year 1 Year 2 Year 3 Year 4 Year 5
`70,000 `76,000 `80,000 `90,000 `92,000
Thecompanyhastopaycorporateincometaxattherateof30%,andisevaluatingprojectswith10%
asthecostofcapital.
(i) Whichoftheprojectisacceptableunderthenetpresentvaluemethod?
(ii) Will it make any difference to the above decision if profitability index is employed?

Q5 AT Limited is considering three projects A, B and C. The cash flows associated with the projects are
given below :
Cashflowsassociatedwiththe ThreeProjects (`)

Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
Youarerequiredto:
(a) Calculatethepaybackperiodofeachofthethreeproject.
(b) Ifthecutoffperiodistwoyears,thenwhichprojectsshouldbeaccepted?
(c) ProjectswithpositiveNPVsiftheopportunitycostofcapitalis10percent.
(d) “Paybackgivestoomuchweighttocashflowsthatoccurafterthecutoffdate”.Trueorfalse?
(e) “If a firm used a single cutoff period for all projects, it is likely to accept too many short lived
projects.”Trueorfalse?
P.V.Factor@10%
Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

Chapter5  Investment Decisions (Capital Budgeting) 107


Q6 A company is considering which of two mutually exclusive projects it should undertake. The Finance
DirectorthinksthattheprojectwiththehigherNPVshouldbechosenwhereastheManagingDirector
thinksthattheonewiththehigherIRRshouldbeundertakenespeciallyasbothprojectshavethesame
initialoutlayandlengthoflife.Thecompanyanticipatesacostofcapitalof10%andthenetaftertax
cashflowsoftheprojectsasfollows:
Year 0 1 2 3 4 5
(CashFlowsFigs.`000)
Project X (200) 35 80 90 75 20
Project Y (200) 218 10 10 4 3
Required :
(a) CalculatetheNPVandIRRofeachproject.
(b) State,with reasons,whichproject you wouldrecommend.
(c) Explaintheinconsistencyintheranking ofthe two projects.
Thediscountfactorsareasfollows:
Year 0 1 2 3 4 5
Discount Factors
(10%) 1 0.91 0.83 0.75 0.68 0.62
(20%) 1 0.83 0.69 0.58 0.48 0.41
Q7
Original outlay `8,000 Cash inflows `4,000p.a.for3years
Lifeoftheproject 3years Costofcapital 10%p.a.
Expectedinterestrates atwhichthecashinflows willbe reinvested:
Year end %
1 12
2 12
3 12
Evaluate as per Terminal value Method of capital budgeting.
Q8 FollowingarethedataonacapitalprojectbeingevaluatedbytheManagementofXLtd:
Project M
Annual cost saving `40,000
Useful life 4years
I.R.R. 15%
Profitability Index (PI) 1.064
NPV ?
Costofcapital ?
Costofproject ?
Payback ?
Salvage value 0

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 108
Find themissing values consideringthe following tableof discount factor only:
Discount factor 15% 14% 13% 12%
1year 0.869 0.877 0.885 0.893
2years 0.756 0.769 0.783 0.797
3years 0.658 0.675 0.693 0.712
4years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
Q9 C Ltd.is considering investing in a project. The expected original investment in the project will be `
2,00,000,thelifeofprojectwillbe5yearwith nosalvagevalue.The expectednetcashinflowsafter
depreciation but before taxduring thelifeofthe projectwillbe asfollowing:
Year 1 2 3 4 5
` 85,000 1,00,000 80,000 80,000 40,000
Theprojectwillbedepreciatedattherateof20%onoriginalcost.Thecompanyissubjectedto30%tax
rate.
Required :
(i) Calculatepaybackperiodandaveragerateofreturn(ARR)
(ii) Calculatenetpresentvalueandnetpresentvalueindex,ifcostofcapitalis10%
(iii) Calculate internalrateofreturn.
Note:TheP.V.factorsare:
Year P.V. at 10% P.V. at 37% P.V. at 38% P.V. at 40%
1 .909 .730 .725 .714
2 .826 .533 .525 .510
3 .751 .389 .381 .364
4 .683 .284 .276 .260
5 .621 .207 .200 .186
Q10 XYZLtd.isplanningtointroduceanewproductwithaprojectlifeof8years.Theprojectistobesetup
in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State
Governmentof`25,00,000oncapitalinvestment.Initialequipmentcostwillbe`1.75crores.Additional
equipmentcosting`12,50,000willbepurchasedattheendofthethirdyearfromthecashinflowof
this year. At the end of 8 years, the original equipment will have no resale value, but additional
equipment can be soldfor`1,25,000.A working capitalof `20,00,000 willbeneeded andit willbe
released at the end of eighth year. The project will be financed with sufficient amount of equity
capital.
Thesalesvolumes over eightyears have been estimatedasfollows:
Year 1 2 3 45 68
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
Asalespriceof`120perunitisexpectedandvariableexpenseswillamountto60%ofsalesrevenue.
Fixedcashoperatingcostswillamount`18,00,000peryear.Thelossofanyyearwillbesetofffromthe
profitsofsubsequenttwoyears.Thecompanyissubjectto30percenttaxrateandconsiders12per
Chapter5  Investment Decisions (Capital Budgeting) 109
centtobe an appropriate aftertax cost of capital for this project.The company follows straight line
method of depreciation.
Required:
Calculatethenetpresentvalueoftheprojectandadvisethemanagementtotakeappropriatedecision.
Note:
ThePVfactorsat12%are
Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404
Q11 ACompanyissettingupaprojectatacostof`300lakhs.Ithastodecidewhethertolocatetheplantin
a ForwardArea(FA)or BackwardArea (BA).Locating inBackwardAreameansa cashsubsidyof ` 15
lakhsfromtheCentralGovt.Besides,thetaxableprofitstotheextentof20%isexemptfor10years.
The project envisages a borrowing of ` 200 lakhs in either case. The cost of borrow will be 12% in
Forward, Area and 10% in Backward Area. However, the revenue are bound to be higher in forward
area.Theborrowinghavetoberepaidin4equalannualinstillmentsbeginningfromtheendofthe4th
year.WiththehelpoffollowinginformationandbyusingDCFTechniques,youarerequiredtosuggest
theproperlocationfortheproject:
Year Profit (loss) Before Present Value
Interest & Depreciation Factor (at 15%)
(` in Lakhs)
FA BA
1 (6.00) (50.00) 0.87
2 34.00 (20.00) 0.76
3 54.00 10.00 0.66
4 74.00 20.00 0.57
5 108.00 45.00 0.50
6 142.00 100.00 0.43
7 156.00 155.00 0.38
8 230.00 190.00 0.33
9 330.00 230.00 0.28
10 430.00 330.00 0.25
Theannualdepreciationmaybetakenat`30lakhs.Interestonborrowingmaybeworkedoutatthe
respectiverates.AverageRateofTaxmaybetakenas30%.
Q12 A Chemical Company is presently paying an outside firm Re 1 per gallon to dispose off the waste
materialresultingfromitsmanufacturingoperations.Atnormaloperatingcapacity,thewasteisabout
40,000gallonsperyear.
Afterspending`40,000onresearch,thecompanydiscoveredthatthewastecouldbesoldforRe10per
gallon if it was processed further. Additional processing would, however, require an investment of `
6,00,000 in new equipment, which would have an estimated life of 10 years and no salvage value.
Depreciation would becomputed by the straight line method.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 110
Except for the costs incurred in advertising, ` 20,000 per year, no change in the present selling and
administrative expenses is expected if the new product is sold. The details of additional processing
costsareasfollows:Variable:`5pergallonofwasteputintoprocess.Fixed(excludingdepreciation):
`30,000peryear.
Incostingthenewproductforinventorypurposes,generalfactoryoverheadswillbeallocatedatthe
rateofRe1pergallon.
Therewillbenolossesinprocessing,anditisassumedthatallofthewasteprocessedinagivenyear
will besold in that veryyear. Waste that is not processed further will have tobe disposed off at the
presentrateofRe1pergallon.Estimatesindicatethat30,000gallonsofthenewproductcouldbesold
eachyear.
Themanagement,confrontedwiththechoiceofdisposingoffthewaste,orprocessingitfurtherand
sellingit,seeksyouradvice.Whichalternativewouldyourecommend?Assumethatthefirms’costof
capitalis15%anditpays,onanaverage,30%taxonitsincome.
Q13 TechtronicsLtd.anexistingcompany,areconsideringanewprojectformanufacturingofpocketvideo
gamesinvolvingacapitalexpenditureof`600lakhsand`200lakhsincurrentassets.Projectwillhave
capacityofproductionof12lakhsunitsperannumandcapacityutilizationduringthe6yearsworkslife
oftheprojectisexpectedtobeasindicatedbelow:
Year Capacity utilization %
1 331/3%
2 662/3%
3 90%
46 100%
Theaveragepriceperunitoftheproductisexpectedtobe`200nettingacontributionof40%.Annual
fixed costs, excluding depreciation, are estimated to be ` 480 lakhs per annum from the third year
onwards;forthefirstandsecondyearitwouldbe`240lakhsand`360lakhsrespectively.Theaverage
rateofdepreciationfortaxpurposeis331/3%onthecapitalassets.Noothertaxreliefareanticipated.
Therateofincometaxmaybetakenat35%.
At the end of the third year an additional investment of ` 100 lakhs would be required for working
capital.
Thecompany,hastargetedforarateofreturnof15%.
Youarerequired toindicatewhethertheproposal isviablegivingyour workingsnotes andanalysis.
Thepresentvaluefactorsat15%Discountratewise,areextractedbelow:
0.869, 0.756 0.657, 0.571, 0.497, 0.432
Terminalvalueofthefixedassetsmaybetakenat10%andforthecurrentassetsat100%.Calculation
mayroundedofftolakhsofrupees.
Q14 Indo Plastics Ltd. is a manufacturer of high quality plastic products. Rasik, President, is considering
computerisingthecompany'sordering,inventoryandbillingprocedures.Heestimatesthattheannual
savings from computerisation include a reduction of 4 clerical employees with annual salaries of `
50,000each,`30,000fromreducedproductiondelayscausedbyrawmaterialsinventoryproblems,`
25,000fromlostsalesduetoinventorystockoutsand`18,000associatedwithtimelybfflingprocedures.
Thepurchasepriceofthesystemis`2,50,000andinstallationcostsare`50,000.Theseoutlayswillbe
capitalised(depreciated)onastraightlinebasistoazerobookssalvagevaluewhichisalsoitsmarket

Chapter5  Investment Decisions (Capital Budgeting) 111


value at the end of five years. Operation of the new system requires two computer specialists with
annualsalaries of `40,000 per person.Also annual maintenance and operating(cash) expenses of `
22,000areestimatedtoberequired.Thecompany'staxrateis40%anditsrequiredrateofreturn(cost
ofcapital)forthisprojectis12%.
Yourarerequiredto:
(i) evaluate the project usingNPV method,
(ii) evaluate the project using PI method,
(iii) calculate the Project's payback period.
Notes :
(a) PresentvalueofannuityofRe.1at12%rateofdiscountfor5yearsis3.605.
(b) PresentvalueofRe.1at12%rateofdiscount,receivedattheendof5yearsis0.567.
REPLACEMENT DECISION
Q15 Thecostbreakupofaproductofacompanyisasfollows:
Unit cost (`)
Direct labour 80.00
Direct material 60.00
Other variable expenses 50.00
Fixed overheads 40.00
230.00
Theaboveproductiscurrentlybeingproducedonamachinethathasabookvalueof`1,00,000.Itwas
purchasedfor`1,50,000fiveyearsago.Themachineoriginallyhadaprojectedlifeof15years,andwas
tobedepreciatedstraightlinetothezerosalvagevalue.Themachinehasacapacityofproducing1,000
units.Themachineatpresentisworkingatitsfull capacity.The unitsproduced aresoldat `300per
unit.Theoriginalmanufacturerhasofferedtoaccepttheoldmachineasatradeinforanewversion.
Thenewmachinewouldcost`1,80,000afterallowing`60,000fortheoldequipment.Theselleralso
agreestoallowoneyearcreditformakingthepaymentofthebalanceamount.Thecostingdepartment
ofthecompanyhasfurnishedthefollowingprojected costsassociatedwiththenewmachine:
Unit cost (`)
Direct labour 50.00
Direct material 60.00
Other variable expenses 40.00
Fixed overheads 48.00
198.00
The fixed overhead costs are allocations from other departments plus the depreciation of the
equipment.Maintenance expenses forboth the machines are the same.
Theoldmachineisingoodworkingcondition,andcanbeusedforitsremaininglifeof 10years.The
newmachinehasanexpectedlifeof10yearswithnosalvagevalue.
Thecompany’sordinarytaxrateis35%.Itscostofcapitalis10%.
The management of the company seeks your advice whether, the new machine should be acquired?
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 112
Themanagementexpectsthatthefutureproductionandsalesoftheproductwillremainat1,000units
peryear.
CAPITAL RATIONING
Q16 AlphaLimitedisconsideringfivecapitalprojectsfortheyear2004and2005.Thecompanyisfinanced
byequityentirelyanditscostofcapitalis12%Theexpectedcashflowsoftheprojectsareasfollows:
Year and Cash flows (` ’000)
Project 2004 2005 2006 2007
A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D — (90) 55 65
E (60) 20 40 50
Note :Figuresinbracketsrepresentcashoutflows.
Allprojects are divisiblei.e. size of investment can bereduced, if necessary in relation to availability
offunds.Noneoftheprojectscanbedelayedorundertakenmorethanonce.
CalculatewhichprojectAlphaLimitedshouldundertakeifthecapitalavailableforinvestmentislimited
to`1,00,000in2004and withnolimitationinsubsequent years.For youranalysis,use thefollowing
presentvaluefactors:
Year 2004 2005 2006 2007
Factor 1.00 0.89 0.80 0.71
Q17 EliteCookerCompanyis evaluatingthreeinvestmentsituations:(1) produceanewlineofaluminium
skillets,(2)expanditsexistingcookerlinetoincludeseveralnewsizes,and(3)developanew,higher
qualitylineofcookers.Ifonlytheprojectinquestionisundertaken,theexpectedpresentvaluesand
the amounts of investment required are:
Project Investment required Present value of Future CashFlows
` `
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
Ifprojects1and 2are jointly undertaken, there willbeno economies;the investmentsrequired and
present valueswillsimply be the sum of theparts.With projects 1 and 3, economiesare possible in
investmentbecauseoneofthemachinesacquiredcanbeusedinbothproductionprocesses.Thetotal
investment required for projects1 and3 combined is `4,40,000. If projects 2 and 3 are undertaken,
there are economiesto beachievedin marketingand producingtheproductsbutnot ininvestment.
Theexpectedpresentvalueoffuturecashûowsforprojects2and3is`6,20,000.Ifallthreeprojectsare
undertaken simultaneously, the economies noted will still hold. However, a `1,25,000 extension on
the plant will be necessary, as space is not available for all three projects. Which project or projects
should be chosen?

Chapter5  Investment Decisions (Capital Budgeting) 113


UNEQUAL LIFE
Q18 AFirmis consideringtoinstalleitherofthe twomachineswhicharemutuallyexclusive.Thedetails
oftheirpurchasepriceandoperatingcostare:
Year MachineX Machine  Y
` `
Purchase Cost 0 10,000 8,000
Operating Cost 1 2,000 2,500
“ 2 2,000 2,500
“ 3 2,000 2,500
“ 4 2,500 3,800
“ 5 2,500 3,800
“ 6 2,500 3,800
“ 7 3,000 —
“ 8 3,000 —
“ 9 3,000 —
“ 10 3,000 —
MachineXwillrecoversalvagevalueof`1,500intheyear10,whileMachineYwillrecover`1,000inthe
year6.Determinewhichmachineischeaperat10percentcostofcapital.
Q19 Determine which of the following two mutually exclusive projects should be selected if they are (i)
Oneoff investments, or (ii) If they can be repeated indefinitely:
(` )
Particulars Project A Project B
Investment 40,000 60,000
Life 4years 7years
Annual net cash inflows 15,000 16,000
Scrap value 5,000 3,000
Costofcapitalis15%.Ignoretaxation.Thepresentvalueofannuityfor4yearsand7yearsat15%are
respectively2.8550and 4.1604 and thediscountingfactorsat4 years/7 years respectively0.5718and
0.3759.
Q20 SellWellLtd.isconsideringtoinstallalargestampingmachine.Twomachinesbeingconsideredareas
follows:
MachineA:Itcosts`50,000andwillrequirecashrunningexpensesof`15,000perannum.Ithasa
usefullifeof6 yearsand,thereafter,itisexpectedtoyield`2,000assalvage value.
MachineB:Itcosts` 65,000anditscashrunningexpensesare`12,000perannum.Ithasausefullife
of10yearsand,thereafter,salvagevalueof`5,000.
Bothmachineswouldbedepreciatedonstraightlinebasis.Corporatetaxrateis30%.Costofcapitalis
10%.
Which machine should bebought bythe SellWellLtd.?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 114
Q21 Company X is forced to choose between two machines A and B. The two machines are designed
differently,buthaveidenticalcapacityanddoexactlythesamejob.MachineAcosts`1,50,000andwill
last for 3 years. It costs ` 40,000 per year to run. Machine B is an ‘economy’ model costing only `
1,00,000,butwilllastonlyfor2years,andcosts`60,000peryeartorun.Thesearerealcashflows.The
costsareforecasted inrupeesofconstantpurchasingpower.Ignoretax.Opportunitycost ofcapitalis
10percent.WhichmachinecompanyXshouldbuy?
MULTIPLE IRR
Q22 CalculatetheIRRforaprojectwiththefollowingpatternofCashFlows:
Year Cash Flow (`)
0 1,600
1 10,000
2 10,000
Commentonthevalueobtainedbyyou.
MODIFIED IRR
Q23 PentagonLtd.isevaluatingaprojectthathasthefollowingcashflowstreamassociatedwithit:
Year 0 1 2 3 4 5 6
Cash
Flow
(` in million) 120 80 20 60 100 140 150
ThecostofcapitalforPentagonis15%calculatetheModifiedIRR.

DIFFERENT DISCOUNTING RATES


Q24 A 5 year project involving software development. You believe that the technological uncertainty
associatedwiththisindustryleadstohigherdiscountratesinfutureasunder:
Year 0 1 2 3 4 5
Discount Rate 14% 15% 16% 18% 20%
Investment
Cash Flow 12,000 4,000 5,000 7,000 6,000 5,000
CalculatetheNPVoftheProject.

Capital Budgeting with inflation


InthenormalanalysisofCapitalBudgeting,wegenerallyuseasinglesetofcashflowswithasingleDiscount
Rate.Actually, we are assuming that we are inflationneutralin this exercise.
Buttherealityisthatourcashflowsaresubjecttoinflationandfurtherinflows&outflowsmaybesubjectto
different inflation rates. So we must be aware of the following issues in a capital budgeting exercise with
inflation.

Chapter5  Investment Decisions (Capital Budgeting) 115


The three key areas under consideration are:
(i) Discount Rate:
Real Discount Rate ItisaratewhichiswithouttheEFFECT OF INFLATION
Nominal Discount Rate/Money ItisadiscountwhichINCLUDES EFFECT OF INFLATION.
Discount Rate/Inflation (1+RR)(1+IR)=(1+NR),
Adjusted Discount Rate WhereRR=RealRate,IR=InflationRate,NR=NominalRate

(ii) Cash Flows:


Real Cash Flows Theyarecashflowswhichareexpressedintermsofprices/
pricelevelsofYear0i.e.theyarecashflowswhichareWITHOUT
EFFECT OF INFLATION.
Nominal Value Cash Flows/ ThesearecashflowswhichINCORPORATE THE
Money Value Cash Flows INFLATION EFFECT.

(iii) Present Value:


Real Cash Flows Nominal Value Cash Flows/Money Value Cash Flows
REALcashflowsshouldbe MONEYCFsshouldbediscountedwith NOMINAL
discountedwithREAL DISCOUNT DISCOUNT
RATES RATES.

Q25 ABC & Co. has the following information relating to an investment proposal: The initial outlay of
Rs.24,00,000isexpectedatyear0withalifeof4years.Thefirmhasanannualprofitbeforetaxand
depreciationofRs.10,00,000andpaystax@40%.Theannualcashinflows(i.e.profitaftertax+Dep.)of
Rs.8,40,000isexpected.Assumingthattherealdiscountrateis5%,Calculate
1. TheNPVoftheprojectgiventhatthereisnoinflation.
2. TheNPVgiventhatthereisaninflationof5%andtheannualprofitskeeppacewiththeinflation.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 116
LAST MINUTE REVISION (LMR)

BASIC CONCEPTS AND FORMULAE


1. Capital ? Capital budgeting isthe process of evaluatingand selecting longterm
Budgeting investments that are in line with the goal of investor’s wealth
maximization. The capital budgeting decisions are important, crucial
and critical business decisions due to substantial expenditure
involved; long period for the recovery of benefits; irreversibility of
decisions and the complexity involved in capital investment decisions.
? Oneofthemostimportanttasksincapitalbudgetingisestimating
futurecashflowsforaproject.Thefinaldecisionwemakeattheend
ofthecapitalbudgetingprocessisnobetterthantheaccuracyofour
cashflow estimates.
? Tax payments like other payments must be properly deducted in
derivingthecashflows.Thatis,cashflowsmustbedefinedinpost
taxterms.
2. Calculating
Cash Flows Itishelpfultoplaceprojectcashflowsintothreecategories:
a) Initial Cash Outflow
Theinitialcashoutflowforaprojectiscalculatedasfollows:
Cost of New Asset(s)
+ Installation/SetUp Costs
+() Increase (Decrease) in Net Working Capital Level
 NetProceedsfromsaleofOldAsset(If it is a
replacement situation)
+() Taxes(taxsaving)duetosaleofOldAsset(If it is a
replacement situation)
= Initial Cash Outflow
b) Interim Incremental Cash Flows
Aftermakingtheinitialcashoutflowthatisnecessarytobegin
implementing aproject, thefirm hopesto benefitfrom the
futurecashinflowsgeneratedbytheproject.Itiscalculatedas
follows:

Chapter5  Investment Decisions (Capital Budgeting) 117


Net increase (decrease) in Operating Revenue
(+) Net increase (decrease) in Operating Expenses excluding
depreciation
= Netchangeinincomebeforetaxes
(+) Net increase (decrease) in taxes
= Netchangeinincomeaftertaxes
+() Net increase (decrease) in tax depreciation charges
= Incrementalnetcashflowfortheperiod
c) TerminalYear Incremental Net Cash Flow
ForthepurposeofTerminal Yearwewillfirstcalculatethe
incrementalnetcashflowfortheperiodascalculatedinpoint
b)aboveandfurthertoitwewillmakeadjustmentsinorderto
arrive at TerminalYear Incremental Net Cash flow as follows:
Incrementalnetcashflowforthe period
+() Final salvage value (disposal costs) of asset
(+) Taxes(taxsaving)duetosaleordisposalofasset
+() Decreased (increased) level of Net Working Capital
= Terminal Year incremental net cash flow
3. Techniques of (a) Traditional (nondiscounted)
Capital Budgeting Themost common traditional capital budgeting techniques are
PaybackPeriodandAccounting(Book)RateofReturn.
(b) Timeadjusted (discounted)
The most common timeadjusted capital budgeting techniques
are Net Present Value Technique, Profitability Index, Internal
RateofReturnMethod,ModifiedInternalRateofReturnand
Discounted Payback period.
4. Payback Thepaybackperiodofaninvestmentisthelengthof timerequired
Period forthecumulativetotalnetcashflowsfromtheinvestmenttoequal
thetotal initial cashoutlays.

Total initial capital investment


Payback period =
Annualexpectedafter  tax net cash flow
Payback Reciprocal: Itisthereciprocalofpaybackperiod.

Average annualcash in flow


PaybackReciprocal =
Initial investment
5. Accounting Theaccountingrateofreturnofaninvestmentmeasuresthe
(Book) Rate averageannualnetincomeof theproject(incremental income) as
of Return: a percentageof the investment.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 118
Average annualnet income
Accountingrateofreturn=
Investment
6. Net Present Thenetpresentvaluemethodusesaspecifieddiscountratetobring
Value all subsequent net cash inflowsafter the initial investmentto their
Technique: presentvalues(the timeoftheinitialinvestmentoryear0).
Netpresentvalue=PresentvalueofnetcashflowTotalnetinitial
investment
7. Desirability Incertaincaseswehavetocompareanumberofproposalseach
Factor/Profit involving different amounts of cash inflows, then we use
ability Index ‘Desirability factor’, or ‘Profitability index’.
Thedesirability factor iscalculated asbelow

Sum of discountedcash in flows


Initialcashoutlay Or Totaldiscounted cash outflow (as the cashmay)
8. Internal Rate Internalrateofreturnforaninvestmentproposalisthediscount
of Return ratethatequatesthepresentvalueoftheexpectednetcashflows
Method with the initial cash outflow.
9. Multiple Incaseswhereprojectcashflowschangesignsorreverseduring
Internal Rate thelifeofaprojecte.g.aninitialcashoutflowisfollowedbycash
of Return inflows and subsequently followed by a major cash outflow, there
maybemorethanoneIRR.
10. Modified Under thismethod, allcash flows, apartfromtheinitial investment,
Internal Rate arebroughttotheterminalvalueusinganappropriatediscountrate
ofReturn(usuallytheCostofCapital).Thisresultsinasinglestreamof
cash(MIRR)inflowintheterminalyear.TheMIRRisobtainedbyassuming
asingleoutflowinthezerothyearandtheterminalcashinflowas
mentionedabove. Thediscount rate which equatesthe presentvalue of
theterminalcashinflowtothezerothyearoutflowiscalledtheMIRR.

Chapter5  Investment Decisions (Capital Budgeting) 119


MULTIPLE CHOICE QUESTIONS

1. A capitalbudgetingtechniquewhichdoesnotrequire the computationof costof capitalfordecision


making purposes is,
(a) Net Present Value method
(b) InternalRateof Returnmethod
(c) ModifiedInternal Rate of Return method
(d) Pay back
2. If two alternative proposals are such that the acceptance of one shall exclude the possibility of the
acceptanceofanotherthensuchdecisionmakingwillleadto,
(a) Mutually exclusive decisions
(b) Accept reject decisions
(c) Contingent decisions
(d) Noneof theabove
3. Incaseacompanyconsidersadiscountingfactorhigherthanthecostofcapitalforarrivingatpresent
values, the present values of cash inflows will be
(a) Less than those computed on the basis of cost of capital
(b) Morethanthosecomputedonthebasisofcostofcapital
(c) Equaltothosecomputedonthebasisofthecostofcapital
(d) Noneof theabove
4. Thepayback techniqueisspecially useful during times
(a) When the value of money is turbulent
(b) Whenthere is no inflation
(c) Whentheeconomyisgrowingatasteadyratecoupledwithminimalinflation.
(d) Noneof theabove
5. Whileevaluating capitalinvestmentproposals,timevalueof moneyisusedinwhichof thefollowing
techniques,
(a) Payback method (b) Accountingrateofreturn
(c) Net present value (d) Noneof theabove
6. IRRwouldfavourproject proposalswhichhave,
(a) Heavy cash inflows in the early stages of the project.
(b) Evenly distributed cash inflows throughout the project.
(c) Heavycashinflowsatthelaterstagesoftheproject
(d) None ofthe above.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 120
7. ThereinvestmentassumptioninthecaseoftheIRRtechniqueassumesthat,
(a) Cash flows can be re invested at the projects IRR
(b) Cashflowscanbereinvestedattheweightedcostofcapital
(c) Cashflowscanbereinvestedatthemarginalcostofcapital
(d) Noneof theabove
8. Multiple IRRsare obtained when,
(a) Cashflowsintheearlystagesoftheprojectexceedcashflowsduringthelaterstages.
(b) Cash flows reverse their signs during the project
(c) Cashflowsareuneven
(d) None ofthe above.
9. Depreciation isincludedasacostin whichofthefollowingtechniques,
(a) Accounting rate of return (b) Net present value
(c) Internalrateofreturn (d) Noneof theabove
10. Managementisconsideringa`1,00,000investmentinaprojectwitha5yearlifeandnoresidualvalue.
Ifthetotalincomefromtheprojectisexpectedtobe`60,000andrecognitionisgiventotheeffectof
straightlinedepreciationontheinvestment,theaveragerateofreturnis:
(a) 12% (b) 24% (c) 60% (d) 75%
11. Assumecashoutflowequals`1,20,000followedbycashinflowsof`25,000peryearfor8yearsanda
costofcapitalof11%.WhatistheNetpresentvalue?
(a) (`38,214) (b) `9,653 (c) `8,653 (d) `38,214
12. WhatistheInternalrateofreturnforaprojecthavingcashflowsof`40,000peryearfor10yearsanda
costof`2,26,009?
(a) 8% (b) 9% (c) 10% (d) 12%
13. Whileevaluating investments,thereleaseofworkingcapitalat theendoftheprojectslifeshouldbe
considered as,
(a) Cash in flow (b) Cashout flow
(c) Havingnoeffect upon the capital budgetingdecision
(d) None oftheabove.
14. Capital rationingrefers to asituation where,
(a) Funds are restricted and the management has to choose from amongst available alternative
investments.
(b) Fundsareunlimitedandthemanagementhastodecidehowtoallocatethemtosuitableprojects.
(c) Very few feasible investment proposals are available with the management.
(d) Noneof theabove
15. Capital budgetingisdone for
(a) Evaluating short term investment decisions.
(b) Evaluating medium term investment decisions.
(c) Evaluating long term investment decisions.
(d) Noneof theabove

Chapter5  Investment Decisions (Capital Budgeting) 121


THEORETICAL QUESTIONS

1. Whatarethevarioustechniqueofcapitalbudgeting?
2. WhatisNPV.Howitiscalculated?
3. Discuss in detail the ‘Capital Budgeting Process’
4. WhatarethevarioustypesofCapitalInvestmentdecisionsknowntoyou?
5. Whatistheadvantageanddisadvantageofprofitabilityofindex?
6. WhatisMIRR.?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 122
HOME WORK

Q26 ABCLtdisevaluatingthepurchase of anewproject witha depreciable baseof `1,00,000; expected


economiclifeof 4 yearsand changein earnings beforetaxes and depreciation of `45,000 inyear 1,
`30,000inyear2,`25,000inyear3and`35,000inyear4.Assumestraightlinedepreciationanda20%
taxrate.You arerequired tocompute relevantcash flows.
Hints : NetCashflow:41,000;29,000;25,000;33,000.
Q27 Aprojectrequiringaninvestmentof `10,00,000andityieldsproftaftertaxanddepreciation
whichisasfollows:
Years Proft after tax and depreciation (`)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Supposefurtherthatattheendofthe5thyear,theplantandmachineryoftheprojectcanbesoldfor
`80,000.DetermineAverageRateofReturn.
Hints : AverageInvestment=5,40,000
Q28 Computethenetpresentvalueforaprojectwithanetinvestmentof`1,00,000andnetcashflowsyear
oneis`55,000;foryeartwois`80,000andforyearthreeis`15,000.Further,thecompany’scostof
capitalis10%?
[PVIF@10%forthreeyearsare0.909,0.826and0.751]
Hints : Netpresentvalue=27,340.
Q29 ABCLtdisasmallcompanythatiscurrentlyanalyzingcapitalexpenditureproposalsforthepurchaseof
equipment;thecompanyusesthenetpresentvaluetechniquetoevaluate projects. The capital budget
is limited to ` 500,000 which ABC Ltd believes is themaximumcapitalitcanraise.Theinitialinvestment
andprojectednetcashflowsforeachprojectareshownbelow.ThecostofcapitalofABCLtdis12%.You

Chapter5  Investment Decisions (Capital Budgeting) 123


arerequired tocompute theNPVofthedifferent projects.
Project A Project B Project C Project D
Initial Investment 200,000 190,000 250,000 210,000
ProjectCashInflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000
Hints :
Net present value = Project A Project B Project C Project D
(19,750) 25,635 27,050 (3,750)
Q30 Suppose we have three projects involving discounted cash outflows of ` 5,50,000, ` 75,000 and `
1,00,20,000respectively. Suppose further that thesumof discountedcash in flowsfor theseprojects
are`6,50,000,`95,000and`1,00,30,000respectively.Calculatethedesirabilityfactorsforthethree
projects.
Hints : Desirabilityfactorsforthethreeprojects=1.18;1.27and1.001.
Q31 ALtd.isevaluatingaprojectinvolvinganoutlayof`10,00,000resultinginanannualcashinflow
of`2,50,000for6years.AssumingsalvagevalueoftheprojectiszerodeterminetheIRRoftheproject.
Hints : IRR=12.98%
Q32 Calculatetheinternalrateofreturnofaninvestmentof`1,36,000whichyieldsthefollowingcash
inflows:
Year Cash In flows (in `)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Hints : IRR=10.70%
Q33 Acompanyproposestoinstallmachineinvolvingacapitalcostof`3,60,000.Thelifeofthemachineis
5yearsanditssalvage valueattheendofthelife isnil.Themachinewillproduce the netoperating
incomeafterdepreciationof`68,000perannum.Thecompany’staxrateis45%.
TheNetPresentValuefactorsfor5yearsareasunder:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 124
Youarerequiredtocalculatetheinternalrateofreturnoftheproposal.
Hints : IRR=15.74%
Q34 SupposetherearetwoProjectAandProjectBareunderconsideration.Thecashûowsassociatedwith
theseprojectsareasfollows:
Year Project A Project B
0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
AssumingCostofCapitalequalto10%whichprojectshouldbeacceptedasperNPVMethodandIRR
Method.
Hints :
Project A Project B
NPV@10% 25,050 59,300
IRR 24.26% 21.48%
Q35 SupposeABCLtd.isconsideringtwoProjectXandProjectYforinvestment.Thecashûowsassociated
withtheseprojectsareasfollows:
Year Project X Project Y
0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000
AssumingCostofCapitalbe10%,whichprojectshouldbeacceptedasperNPVMethodandIRRMethod.
Hints : IRRX=24.87%;IRRB=17.60%.
Q36 SupposeMVALtd.isconsideringtwoProjectAandProjectBforinvestment.Thecashflowsassociated
withthese projectsareas follows:
Year Project A Project B
0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 2,00,000
3 7,00,000
AssumingCostofCapitalequalto12%,whichprojectshouldbeacceptedasperNPVMethodandIRR
Method?

Chapter5  Investment Decisions (Capital Budgeting) 125


Hints :
Project A
Project B
NPV@10% 1,69,750
3,36,400
IRR 50.00%
43.07%
Q37 ShivaLimitedisplanningitscapitalinvestmentprogrammefornextyear.Ithasfiveprojectsallof
whichgiveapositiveNPVatthecompanycutoffrateof15percent,theinvestmentoutflowsand
present values being as follows:
Project Investment NPV @ 15%
`000 `000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
Thecompanyislimitedtoacapitalspendingof`1,20,000.
You arerequired to optimise thereturns from a packageof projectswithin thecapital spending
limit.Theprojectsareindependentofeachotherandaredivisible(i.e.,partprojectispossible).
Hints :
Investment ` 000 NPV @ 15%`000
E+B+C 100 48.1
E+B+D 105 49.2
Q38 R plc is considering to modernize its production facilities and it has two proposals under
consideration. The expected cash ûows associated with these projects and their NPV as per
discountingrateof12%andIRRisasfollows:
Year Cash Flow
Project A (`) Project B (`)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000
5 11,00,000
6 10,00,000
NPV@12% 6,49,094 5,15,488
IRR 17.47% 25.20%
WhichprojectshouldRplcaccept?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 126
Hints :

Project A Project B
NPV@12% `6,49,094 `5,15,488
PVAF@12% 4.112 2.402
Equivalent Annualized Criterion `1,57,854 `2,14,608
Project should R should be selected.
Q39 Alpha Company is considering the following investment projects :
Projects Cash Flows (`)
C0 C1 C2 C3
A 10,000 +10,000
B 10,000 +7,500 +7,500
C 10,000 +2,000 +4,000 +12,000
D 10,000 +10,000 +3,000 +3,000
(a) Rankthe projectsaccordingto eachof thefollowing methods:(i)Payback, (ii)ARR, (iii)IRRand
(iv)NPV,assumingdiscountratesof10and30percent.
(b) Assumingtheprojectsareindependent,whichoneshouldbeaccepted?Iftheprojectsaremutually
exclusive, which project is the best?
Hints :
(i) Payback Period
ProjectA:10,000/10,000=1year
ProjectB:10,000/7,500=11/3years.
10, 000  6,000 1
Project C : 2 years + = 2 years
12,000 3
ProjectD:1year.
(ii) ARR

10,000  10,000 1 / 2
ProjectA: =0
10, 000 1 / 2

15,000 10,000 1 / 2 2,500


ProjectB: = = 50%
10,000 1 / 2 5,000

18,000 10,000 1 / 3 2,667


ProjectC: = = 53%
10,000 1 / 2 5, 000

16,000 10,000 1 / 3 2,000


ProjectD: = = 40%
10,000 1 / 2 5, 000

Chapter5  Investment Decisions (Capital Budgeting) 127


Note: This net cash proceed includes recovery of investment also. Therefore, net cash earnings are
found by deducting initial investment.
(iii) IRR
Project A: Thenetcashproceedsinyear1arejustequaltoinvestment.Therefore,r=0%.
Project B: Thisprojectproducesanannuityof`7,500fortwoyears.Therefore,therequiredPVAF
is:10,000/7,500=1.33.Thisfactorisfoundunder32%column.Therefore,r=32%
Project C: Sincecashflowsareuneven,thetrialanderrormethodwillbefollowed.Using20%
rateofdiscounttheNPVis+`1,389.At30%rateofdiscount,theNPVis`633.The
truerateofreturnshouldbelessthan30%.At27%rateofdiscountitisfoundthatthe
NPVis`86andat26%+`105.Throughinterpolation,wefindr=26.5%
Project D: Inthiscasealsobyusingthetrialanderrormethod,itisfoundthatat37.6%rateof
discountNPVbecomesalmostzero.Therefore,r=37.6%.
(iv) NPV
Project A :
at10% 10,000+10,000× 0.909=910
at30% 10,000+10,000× 0.769=2,310
Project B:
at10% 10,000+7,500(0.909+0.826)=3,013
at30% 10,000+7,500(0.769+0.592)=+208
Project C:
at10% 10,000+2,000× 0.909+4,000× 0.826+12,000× 0.751=+4,134
at30% 10,000+2,000× 0.769+4,000× 0.592+12,000× 0.455=633
Project D:
at10% 10,000+10,000× 0.909+3,000× (0.826+0.751)=+3,821
at30% 10,000+10,000× 0.769+3,000× (0.592+0.455)=+831
Theprojectsarerankedasfollowsaccordingtothevariousmethods:
Ranks
Projects PBP ARR IRR NPV NPV
(10%) (30%)
A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1
(b) Payback and ARR are theoretically unsound method for choosing between the investment projects.
Betweenthetwotimeadjusted(DCF)investmentcriteria, NPVandIRR,NPV givesconsistentresults.
Iftheprojectsareindependent(andthereisnocapitalrationing),eitherIRRorNPVcanbeusedsince
thesamesetofprojectswillbeacceptedbyanyofthemethods.Inthepresentcase,exceptProjectA
allthethreeprojectsshouldbeacceptedifthediscountrateis10%.OnlyProjectsBandDshouldbe
undertakenifthediscountrateis30%.
Ifit isassumed that the projectsare mutually exclusive,then underthe assumptionof30% discount

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 128
rate,thechoiceisbetweenBandD(AandCareunprofitable).BothcriteriaIRRandNPVgivethesame
results–Disthebest.Undertheassumptionof10%discountrate,rankingaccordingtoIRRandNPV
conflict(except for ProjectA).If theIRRruleis followed, Project D should be accepted.But the NPV
ruletellsthatProjectCisthebest.TheNPVrulegenerallygivesconsistentresultsinconformitywith
the wealth maximization principle. Therefore, Project C should be accepted following the NPV rule.

Q40 Theexpectedcashflowsofthreeprojectsaregivenbelow.Thecostofcapitalis10percent.
(a) Calculate the payback period, net present value, internal rate of return and accounting rate of
returnofeachproject.
(b) Showtherankingsoftheprojectsbyeachofthefourmethods.
Period Project A (`) Project B (`) Project C (`)
0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600
Hints :
(a) Payback Period Method
A=5+(500/900)=5.56years
B=5+(500/1,200)=5.42years
C=2+(1,000/2,000)=2.5years
Net Present Value
NPVA=(5,000)+(900×6.145)=(5,000)+5,530.5=`530.5
NPVB is calculated as follows:
Year Cash flow (`) 10% Present value (`) discount
factor
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 8000. 826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683

Chapter5  Investment Decisions (Capital Budgeting) 129


6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591
NPVCis calculated asfollows:
Year Cash flow (`) 10% discount factor Present value (`)
0 (5000) 1.000 (5,000)
1 2000 0.909 1,818
2 2000 0.826 1,652
3 2000 0.751 1,502
4 1000 0.683 683
655
InternalRateof Return
NPVat12%=(5,000)+900×5.650
=(5,000)+5085=85
NPVat13%=(5,000)+900×5.426
=(5,000)+4,883.40=116.60

ª 85 º
IRR A =12 + « × 13  12 = 12 + 0.42
¬ 85 + 116.60 »¼
IRRA=12.42%.
IRRB
Year Cash In 10 Discount Present Value 20% Present Value
flows factor (`) Discount (`)
(` )
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.833 583
2 800 0.826 661 0.694 555
3 900 0.751 676 0.579 521
4 1,000 0.683 683 0.482 482
5 1,100 0.621 683 0.402 442
6 1,200 0.564 677 0.335 402
7 1,300 0.513 667 0.279 363
8 1,400 0.467 654 0.233 326
9 1,500 0.424 636 0.194 291
10 1,600 0.386 618 0.162 259
1,591 (776)

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 130
1,591
Interpolating :IRRB = 10% + × 20%  10% = 10% + 6.72% = 16.72%
1,591 + 776
IRRC
Year Cash In 15 Discount Present Value 18% Present Value
flows factor (`) Discount (`)
(` )
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 2,000 0.870 1,740 0.847 1,694
2 2,000 0.756 1,512 0.718 1,436
3 2,000 0.658 1,316 0.609 1,218
4 1,000 0.572 572 0.516 516
140 (136)

140
Interpolating :IRRC = 15% + × 18% 15% = 15% + 1.52% = 16.52%
140 + 136
AccountingRateofReturn

5,000
ARRA :Averagecapitalemployed= = `2,500
2

9,000  5, 000
Averageaccountingproft= = `400
10

400 × 100
ARRA = = 16percent
2,500

11,500  5, 000
ARRB :Averageaccountingproft= = `650
10

650 ×100
ARRB = = 26per cent
2,500

7000  5000
ARRC : Averageaccountingproft= = `500
4

500  100
ARRC = =20percent
2,500

Chapter5  Investment Decisions (Capital Budgeting) 131


(b) Summary of Results
Project A B C
Payback (years) 5.5 5.4 2.5
ARR(%) 16 26 20
IRR(%) 12.42 16.72 16.52
NPV (`) 530.50 1,591 655
Comparison of Rankings
Method Payback ARR IRR NPV
1 C B B B
2 B C C C
3 A A A A

Q41 ABCLimitedisconsideringanewfiveyearproject.Itsinvestmentcostsandannualprofitsareprojected
as follows:
Year `
Investment 0 (2,50,000)
Profits 1 40,000
2 30,000
3 20,000
4 10,000
5 10,000
Theresidualvalueattheendoftheprojectisexpectedtobe`40000anddepreciationoftheoriginal
investmentis.onstraight linebasis. Usingaverage profits andaverage capitalemployed calculatethe
ARRfortheprojectandthepaybackperiod.
Solution
Accounting rate of return :
Averageprofits=`1,10,000/5years=`22,000

` 2,50,000  ` 40,000
Averageinvestment = =`1,45,000
2
ARR==15.2%

Payback
Annual depreciation tobe added back
=`42,000perannum

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 132
Profits Depreciation Cash flow Cumulative
` ` ` `
(1) (2) (1)+(2)=(3) (4)
0 (2,50,000) (2,50,000)
1 40,000 42,000 82,000 1,68,000
2 30,000 42,000 72,000 96,000
3 20,000 42,000 62,000 34,000
4 10,000 42,000 52,000 (18,000)*
5 10,000 42,000 52,000
*=paybackyear=3years8months.
Note: Residual value of the investment has been added to the investment before the average
investmentisobtained.Thishastheeffectof loweringtheARRwherearesidual value exists
Q42 ANP Ltd. is providing the following information:
Annualcostofsaving `96,000
Useful life 5years
Salvage value zero
Internalrateofreturn 15%
Profitability index 1.05
Tableof discountfactor:
Discount Years
factor 1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52
Youarerequired tocalculate:
(i) Costoftheproject
(ii) Payback period
(iii) Net present valueof cash inflow
(iv) Costofcapital
Solution
(i) Cost of Project
At15%internalrateofreturn(IRR),thesumoftotalcashinflows=costoftheprojecti.einitialcash
outlayAnnualcostsavings=`96,000
Usefullife=5years
Considering thediscount factor table @ 15%,cumulative present valueof cash inflows for 5 years is
3.353
Hence,TotalCashinflowsfor5yearsfortheProjectis

Chapter5  Investment Decisions (Capital Budgeting) 133


96,000x3.353=`3,21,888
Hence,CostoftheProject=`3,21,888
(ii) Payback Period
Paybackperiod=
PaybackPeriod=3.353years
(iii) Net Present Value (NPV)
NPV=SumofPresentValuesofCashinflows–CostoftheProject
=`3,37,982.40–3,21,888=`16,094.40
Net Present Value = ` 16,094.40
(iv) Cost of Capital
Profitability index =
1.05=
SumofDiscountedCashinflows=`3,37,982.40
Since,AnnualCostSaving=`96,000
Hence,cumulativediscountfactorfor5years=
Fromthediscountfactortable,atdiscountrateof13%,thecumulativediscountfactorfor5yearsis3.52
Hence,Cost of Capital = 13%.
Q43 SSLimitedisconsideringthepurchaseofanewautomaticmachinewhichwillcarryoutsomeoperations
which are at present performed by manual labour. NMA1 and NMA2, two alternative models are
availablein the market. Thefollowingdetails are collected :
Machine
NMA1 NMA2
CostofMachine (`) 20,00,000 25,00,000
Estimated working life 5Years 5Years
Estimatedsavingindirectwagesperannum(`) 7,00,000 9,00,000
Estimatedsavinginscrapperannum(`) 60,000 1,00,000
Estimatedadditionalcostofindirectmaterialper annum(`) 30,000 90,000
Estimatedadditionalcostofindirectlabourperannum(`) 40,000 50,000
Estimatedadditionalcostof repairs and maintenance
per annum(`) 45,000 85,000
Depreciationwillbechargedonastraightlinemethod.Corporatetaxrateis30percentandexpected
rateofreturnmaybe12percent.
You are required to evaluate thealternativesby calculating the:
(i) Payback Period
(ii) Accounting(Average)RateofReturn;and
Solution
Evaluation of Alternatives

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 134
Working Notes:
DepreciationonMachineNMA1==4,00,000
DepreciationonMachineNMA2==5,00,000
Particulars Machine NMA1 (`) Machine NMA2 (`)
Annual Savings:
DirectWages 7,00,000 9,00,000
Scraps 60,000 1,00,000
Total Savings (A) 7,60,000 10,00,000
AnnualEstimatedCashCost:
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs and Maintenance 45,000 85,000
TotalCost(B) 1,15,000 2,25,000
Annual Cash Savings (AB) 6,45,000 7,75,000
Less: Depreciation 4,00,000 5,00,000
Annual Savings before Tax 2,45,000 2,75,000
Less:Tax@30% 73,500 82,500
Annual Savings/Profits after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
Annual Cash Inflows 5,71,500 6,92,500
(i) Payback Period
MachineNMA1=  Total Initial Capital Investment
Annual expected after tax net cashflow
=
MachineNMA2==3.61Years
Decision:Machine NMA1 is better.
(ii) Accounting (Average) Rate of Return (ARR)
ARR=
MachineNMA1=
MachineNMA2=
Decision:Machine NMA1 is better.
(Note: ARR may be computed alternatively by taking initial investment in the denominator.)
(iii) Profitability Index or P V Index
PresentValueCashInflow=AnnualCashInflowxPVfactorat12%
MachineNMA1=5,71,500x3.605=`20,60,258
MachineNMA2=6,92,500x3.605=`24,96,463
PVIndex=

Chapter5  Investment Decisions (Capital Budgeting) 135


MachineNMA1=
MachineNMA2=
Decision:Machine NMA1 is better.
(iii) Profitability Index or P V Index
PresentValueCashInflow=AnnualCashInflowxPVfactorat12%
MachineNMA1=5,71,500x3.605=`20,60,258
MachineNMA2=6,92,500x3.605=`24,96,463
PVIndex=
MachineNMA1=
MachineNMA2=
Decision:MachineNMA1isbetter.
Q44 PQR Company Ltd. Is considering to select a machine out of two mutually exclusive machines. The
company’scostofcapitalis12percentandcorporatetaxrateis30percent.Otherinformationrelating
tobothmachinesisasfollows:
Machine – I Machine – II
CostofMachine `15,00,000 `20,00,000
Expected Life 5Yrs. 5Yrs.
Annual Income (Before Tax and Depreciation) `6,25,000 `8,75,000
Depreciationistobechargedonstraightlinebasis:
Youarerequired tocalculate:
(i) DiscountedPayBack Period
(ii) Net Present Value
(iii) Profitability Index
Thepresentvaluefactorsof`1@12%areasfollows:
Year 01 02 03 04 05
PVfactor@12% 0.893 0.797 0.712 0.636 0.567
Solution
Working Notes:
DepreciationonMachine–I==`3,00,000
DepreciationonMachine–II==`4,00,000
Particulars MachineI (`) Machine – II (`)
Annual Income (before Tax and Depreciation) 6,25,000 8,75,000
Less: Depreciation 3,00,000 4,00,000
Annual Income (before Tax) 3,25,000 4,75,000
Less:Tax@30% 97,500 1,42,500
Annual Income (after Tax) 2,27,500 3,32,500
Add: Depreciation 3,00,000 4,00,000
Annual Cash Inflows 5,27,500 7,32,50

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 136
(i) Discounted Payback Period
Machine – I
DiscountedPaybackPeriod=3+
=3+
=3+0.6943
=3.69yearsor3years8.28months
Machine – II
DiscountedPaybackPeriod=
=
=3+0.5163
= 3.52 years or 3 years 6.24 months
(ii) Net Present Value (NPV)
Machine – I
NPV=19,01,63915,00,000=` 4,01,639
Machine – II
NPV=26,40,664–20,00,000= ` 6,40,664
(iii) Profitability Index
Machine – I
Profitability Index =
Machine – II
Profitability Index =
Conclusion:
Method Machine  I Machine  II Rank
Discounted Payback Period 3.69years 3.52years II
Net Present Value `4,01,639 `6,40,664 II
Profitability Index 1.268 1.320 II
Q45 APZLimitedisconsideringtoselecta machinebetweentwomachines ‘A’and‘B’. Thetwomachines
have identical capacity, do exactly the same job, but designed differently.
Machine‘A’costs`8,00,000,havingusefullifeofthreeyears.Itcosts`1,30,000peryeartorun.
Machine‘B’isaneconomymodelcosting`6,00,000,havingusefullifeoftwoyears.Itcosts`2,50,000
peryeartorun.
Thecashflowsofmachine‘A’and‘B’arerealcashflows.Thecostsareforecastedinrupeesofconstant
purchasing power. Ignore taxes.
Theopportunitycostofcapitalis10%.
Thepresentvaluefactorsat10%are:

Chapter5  Investment Decisions (Capital Budgeting) 137


Statement Showing Evaluation of Two Machines
Particulars Machine A Machine B
PurchaseCost(`):(i) 8,00,000 6,00,000
LifeofMachines(inyears) 3 2
RunningCostofMachineperyear(`):(ii) 1,30,000 2,50,000
CumulativePVFfor13years@10%:(iii) 2.4868 
CumulativePVFfor12years@10%:(iv)  1.7355
PresentValueofRunningCostofMachines(`):(v)=[(ii)x(iii)] 3,23,284 4,33,875
CashOutflowofMachines(`):(vi)=(i)+(v) 11,23,284 10,33,875
Equivalent Present Value of Annual Cash Outflow
[(vi) ÷ (iii)] 4,51,698.57 5,95,721.69
Or4,51,699 Or5,95,722
Recommendation: APZLimitedshouldconsiderbuyingMachineAsinceitsequivalentCashoutflowis
lessthanMachineB.
Q46 FHHospitalisconsideringtopurchaseaCTScanmachine.PresentlythehospitalisoutsourcingtheCT
ScanMachineandisearningcommissionof`15,000permonth(netoftax).Thefollowingdetailsare
given regarding the machine:
`
CostofCTScanmachine 15,00,000
Operating cost per annum (excluding Depreciation) 2,25,000
Expected revenue per annum 7,90,000
Salvagevalueofthemachine(after5years) 3,00,000
Expected life of the machine 5years
Assumingtaxrate@30%,whetheritwouldbeprofitableforthehospitaltopurchasethemachine?
Give your recommendation under:
(i) Net Present Value Method, and
(ii) Profitability Index Method.
PVfactorsat12%aregivenbelow:
Year 1 2 3 4 5
PVfactor 0.893 0.797 0.712 0.636 0.567
Solution
AdvisetotheHospital Management
Determination of Cash inflows `
Sales Revenue 7,90,000
Less: OperatingCost 2,25,000
5,65,000
Less: Depreciation(15,00,000–3,00,000)/5 2,40,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 138
Net Income 3,25,000
Tax@30% 97,500
Earningsafter Tax(EAT) 2,27,500
Add: Depreciation 2,40,000
Cashinflowaftertaxperannum 4,67,500
Less: LossofCommissionIncome 1,80,000
NetCashinflowaftertaxperannum 2,87,500
In 5th Year :
NewCashinflow aftertax 2,87,500
Add: SalvageValue of Machine 3,00,000
NetCashinflowinyear5 5,87,500
Profitability Index =
Advise: Sincethenetpresentvalueisnegativeandprofitabilityindexisalsolessthan1,therefore,the
hospitalshouldnot purchase the CTScan machine.
Q47 A company (profile summarised below) with a 12% cost of funds and limited investment funds of `
4,00,000 is evaluating the desirability of several investment proposals.
Project Initial Investment Life in years Yearend cash Inflow
A `3,00,000 2 `187,600
B 2,00,000 5 66,000
C 2,00,000 3 100,000
D 1,00,000 9 20,000
E 3,00,000 10 66,000
(i) Rankthe projectsaccordingtotheprofitabilityindex, andNPVmethods.
(ii) Determine the optimal investment package.
(iii) Whatprojectsshouldbeselected,ifthecompanyhas`5,00,000asthesizeofitscapitalbudget?
(iv) Determine the optimal investment package in the above situations, assuming that the projects
are divisible.
Q48 Acompanyproposestoinstallmachineinvolvingacapitalcostof`3,60,000.Thelifeofthemachineis
5yearsand itssalvage valueatthe endofthelife is nil.Themachinewillproduce the netoperating
incomeafterdepreciationof`68,000perannum.Thecompany’staxrateis45%.
TheNetPresentValuefactorsfor5yearsareasunder:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
Youarerequiredtocalculatetheinternalrateofreturnoftheproposal.

Chapter5  Investment Decisions (Capital Budgeting) 139


Solution
Computation of Cash in flow per annum (`)
Netoperatingincome perannum 68,000
Less:Tax@45% 30,600
Proftaftertax 37,400
Add:Depreciation(`3,60,000/5years) 72,000
Cashinflow 1,09,400
TheIRRoftheinvestmentcanbefoundasfollows:
NPV=“`3,60,000+`1,09,400(PVAF5,r)=0

`3,60, 000
orPVAF5,r Cumulativefactor = = 3.29
` 1,09, 400
Computation of Internal Rate of Return
Discounting Rate 15% 16%
Cumulative factor 3.35 3.27
PVofIn flows 3,66,490 3,57,738
(`1,09,400×3.35)
(`1,09,400×3.27)
Initial outlay (`) 3,60,000 3,60,000
NPV (`) 6,490 (2,262)

ª 6,490 º
IRR = 15 + « » = 15 + 0.74 = 15.74%
¬ 6,490 + 2,262 ¼
Q49 Hind lever Company is considering a new product line to supplement its range of products. It is
anticipatedthatthenewproductlinewillinvolvecashinvestmentsof`7,00,000attime0and`10,00,000
inyear1.Aftertaxcashinflowsof`2,50,000areexpectedinyear2,`3,00,000inyear3,`3,50,000in
year4and`4,00,000eachyearthereafterthroughyear10.Althoughtheproductlinemightbeviable
afteryear10,thecompanypreferstobeconservativeandendallcalculationsatthattime.
(a) If the required rate of return is 15 per cent, what is the net present value of the project? Is it
acceptable?
(b) Whatwouldbethecaseiftherequiredrateofreturnwere10percent?
(c) Whatisitsinternalrateofreturn?
(d) Whatis theproject’spaybackperiod?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 140
Solution
(a) Year Cash flow Discount Factor(15%) Present value
(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
510 4,00,000 2.163 8,65,200
Net Present Value (1,18,200)
Asthenetpresentvalueis negative, theproject isunacceptable.
(b) Similarly,NPVat10%discountratecanbecomputedasfollows:
Year Cash ûow Discount Factor(10%) Present value
(`) (`)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
510 4,00,000 2.974 11,89,600
Net Present Value 2,51,450
SinceNPV=`2,51,450ispositive,hencetheprojectwouldbeacceptable.

NPVatLR
(c) IRR = LR + × HRLR
NPVatLR NPVatHR

`2,51,450
= 10% + × 15% 10%
`2,51,450   1,18,200
= 10% + 3.4012 or 13.40%
(d) PaybackPeriod=6years:
“`7,00,000“ `10,00,000+`2,50,000+`3,00,000+`3,50,000+`4,00,000+`4,00,
Q50 Cello Limited is considering buying a new machine which would have a useful economic life of five
years,acostof`1,25,000andascrapvalueof`30,000,with80percentofthecostbeingpayableatthe
startoftheprojectand20percentattheendofthefirstyear.Themachinewouldproduce50,000units
perannumofanewproductwithanestimatedsellingpriceof`3perunit.Directcostswouldbe`1.75
per unit and annual fixed costs, including depreciation calculated on a straight line basis, would be
`40,000perannum.
In the first year and thesecond year, specialsalespromotion expenditure, not includedin the above
costs,wouldbeincurred,amountingto`10,000and`15,000respectively.

Chapter5  Investment Decisions (Capital Budgeting) 141


Evaluate the project using the NPV method of investment appraisal, assuming the company’s cost of
capitaltobe10percent.
Solution
Calculationof NetCashflows
Contribution=(3.00–1.75)×50,000=`62,500
Fixedcosts=40,000–[(1,25,000–30,000)/5]=`21,000
Year Capital (`) Contribution(`) Fixed costs(`) Adverts (`) Net cash flow (`)
0 (1,00,000) (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 62,500 (21,000) (15,000) 26,500
3 62,500 (21,000) 41,500
4 62,500 (21,000) 41,500
5 30,000 62,500 (21,000) 71,500
Calculation of Net Present Value
Year Net cash flow (`) 10% discount factor Present value (`)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
31,712
Thenetpresentvalueoftheprojectis`31,712.
Q51 LockwoodLimitedwantstoreplaceitsoldmachinewithanewautomaticmachine.TwomodelsAand
B are available at the same cost of ` 5 lakhs each.Salvage value of the old machineis ` 1 lakh.The
utilitiesoftheexistingmachinecanbeusedifthecompanypurchasesA.Additionalcostofutilitiesto
bepurchasedinthatcaseare`1lakh.IfthecompanypurchasesBthenalltheexistingutilitieswillhave
tobereplacedwithnewutilitiescosting`2lakhs.Thesalvagevalueoftheoldutilitieswillbe`0.20
lakhs.Theearningsaftertaxationareexpectedtobe:
(cash inflows of)
Year A` B` P.V. Factor@
15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
SalvageValueattheendofYear5 50,000 60,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement
142
Thetargetedreturnoncapitalis15%.Youarerequiredto(i)Compute,forthetwomachinesseparately,
net present value, discounted payback period and desirability factor and (ii) Advice which of the
machinesistobe selected?
Solution
(i) Expenditure atyear zero (` in lakhs)
Particulars A B
CostofMachine 5.00 5.00
Cost of Utilities 1.00 2.00
SalvageofOldMachine (1.00) (1.00)
Salvage of Old Utilities – (0.20)
Total Expenditure (Net) 5.00 5.80
(ii) Discounted Value of Cash in flows (`in lakhs)
Machine A Machine B
Year NPV Cash In Discounted Value Cash flows Discounted Value
factor flows of inflows of inflows
@
15%
0 1.00 (5.00) (5.00) (5.80) (5.80)
1 0.87 1.00 0.87 2.00 1.74
2 0.76 1.50 1.14 2.10 1.60
3 0.66 1.80 1.19 1.80 1.19
4 0.57 2.00 1.14 1.70 0.97
5 0.50 1.70 0.85 0.40 0.20
Salvage 0.50 0.50 0.25 0.60 0.30
Net
Present 5.44 6.00
Value (+)0.44 (+)0.20
SincetheNetpresentValueofboththemachinesispositivebothareacceptable.
(iii) Discounted Payback Period (`in lakhs)
Machine A Machine B
Year Discounted cash Cumulative Discounted Cumulative
inflows Discounted cash inflows Discounted
cash inflows cash inflows
1 0.87 0.87 1.74 1.74
2 1.14 2.01 1.60 3.34
3 1.19 3.20 1.19 4.53
4 1.14 4.34 0.97 5.50
5 1.10* 5.44 0.50 6.00

Chapter5  Investment Decisions (Capital Budgeting) 143


* Includessalvage value
DiscountedPaybackPeriod(ForAandB):

§ 0.66 ·
MachineA=4years+ ¨ ¸ = 4.6 years
© 1.10 ¹

§ 0.30 ·
MachineB =4years+ ¨ ¸ = 4.6 years
© 0.50 ¹

Sumof present value of net cashinflow


ProftabilityIndex PI =
Initialcashoutlay

` 5.44lakhs ` 6.00lakhs
MachineA= = 1.088MachineB = = 1.034
` 5.00lakhs ` 5.80lakhs
(iv) SincetheabsolutesurplusinthecaseofAismorethanBandalsothedesirabilityfactor,itisbetterto
choose A.
Thediscountedpaybackperiodinboththecasesissame,alsothenetpresentvalueispositiveinboth
thecasesbutthedesirabilityfactor(profitabilityindex)ishigherinthecaseofMachineA,itistherefore
bettertochooseMachineA.
‰

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 144
CHAPTER  6
RISK ANALYSIS IN CAPITAL BUDGETING

INTRODUCTION
Varioustypesofrisk
Î PoliticalÎ Competitive
Î EconomicalÎ Exchange rate
Î IndustrySpecificÎ International
Incapitalbudgetinganalysisthecashflowsofaprojectareaffectedbyabovementionedrisk.
In this chapter we try to incorporate risk in our analysis and make the projects risk free and acceptable
Following techniques can be used:
1. Risk Adjusted Discounted Rate (RADR)
2. Certainty Equivalent Approach
3. Sensitivity Analysis
4. Scenario Analysis
5. ProbabilityDistribution Approach
6. Decision Tree Approach
7. Simulation

RADR – Risk Adjusted Discounted Rate


Inthismethod,wetrytoincorporateriskbyusingahigherdiscountrate.Thelogicisthat,iftheprojectis
moreriskythenweshouldearnahigherreturnandhencediscountthecashflowsatahigherrateandvice
versa.Risk can be determined by calculating standard deviation and coefficient of variation.
Ariskadjusteddiscountrateisasumofriskfreerateandriskpremium.TheRiskPremiumdependsonthe
perceptionofriskbytheinvestorofa particularinvestmentandriskaversionoftheInvestor.
SoRisksadjusteddiscountrate=Riskfreerate+Riskpremium
Risk Free Rate :ItistherateofreturnonInvestmentsthatbearnorisk.Fore.g.,Governmentsecuritiesyield
areturnof6%andbearnorisk.Insuchcase,6%istheriskfreerate.
Risk Premium :Itistherateofreturnoverandabovetheriskfreerate,expectedbytheInvestorsasareward
forbearingextrarisk.Forhighriskproject,theriskpremiumwillbehighandforlowriskprojects,therisk
premium would be lower.

Chapter6Risk AnalysisinCapitalBudgeting 147


CLASS WORK

Q1 Determine the Risk Adjusted Net Present Value of the following projects:
Net cash outlays (Rs.)Project lifeAnnual cash inflow (Rs.)Coefficient of Variation
A B C
Netcashoutlays(Rs.) 1,00,000 1,20,000 2,10,000
Project life 5years 5years 5years
Annual cash inflow (Rs.) 30,0000 42,000 70,000
Coefficient of Variation 0.4 0.8 1.2
Thecompanyselectsthe risk adjustedrateofdiscounton the basisoftheCoefficientof Variation:
Coefficient of Variation Risk adjusted rate of discount Present value factor 1 to 5
years at risk adjusted
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
Morethan2.0 25% 2.689
Q2 An enterprise is investing Rs.100 lakhs in a project. The riskfree rate of return is 7%. Risk premium
expectedbytheManagementis7%.Thelifeoftheprojectis5years.Followingarethecashflowthat
areestimatedoverthelifeoftheproject.
Year Cash flow (Rs.in Lakhs)
1 25
2 60
3 75
4 80
5 65
Calculate Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 148
Q3 NewProjectsLtd.isevaluating3projects,PI,PII,PIII.Followinginformationisavailableinrespectof
these projects :
PI PII PIII
Cost `15,00,000 `11,00,000 `19,00,000
InflowsYear 1 6,00,000 6,00,000 4,00,000
Year2 6,00,000 4,00,000 6,00,000
Year3 6,00,000 5,00,000 8,00,000
Year4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimumrequiredrateofreturnofthefirmis15%andapplicabletaxrateis40%.Theriskfreeinterest
rateis10%.
Required :
(i) Find out the riskadjusted discount rate (RADR)for these projects.
(ii) Whichprojectisthebest?

CERTAINTY EQUIVALENT APPROACH


Inthismethodtheuncertainsetofcashflowsaresubstitutedbyacertainsetofcashflowswhicharethen
discountedwithanormalrateofdiscount.
Supposeforaprojectyear1cashinflowisexpectedtobeRs.1,00,000butwithlittleuncertainty
CapitalbudgetingteamdoesananalysisandestimatesacertaincashflowofRs.80,000.
Inthiscasethecertaintyequivalentfactorcanbedeterminedas0.8
AhigherCEFindicateslowriskandviceversa.
CertainCashFlows
CertaintyEq.factor(CEF)=
TotalCashFlows
Q4 ABC and Co. is considering two mutually exclusive machines X and Y. The company uses a Certainty
Equivalentapproachtoevaluatetheproposals.Theestimatedcashflowandcertaintyequivalentsfor
bothmachinesareasfollows:
Yr Machine X Machine Y
Cash flow Certainty Cash flow Certainty
Equivalent Equivalent
0 30,000 1.00 40,000 1.00
1 15,000 0.95 25,000 0.90
2 15,000 0.85 20,000 0.80
3 10,000 0.70 15,000 0.70
4 10,000 0.65 10,000 0.60
Whichmachineshouldbebought,iftheriskfreediscountrateis5percent?

Chapter6RISKANALYSISINCAPITALBUDGETING 149
Q5 IfInvestmentProposalis`45,00,000andriskfreerateis5%,calculateNetpresentvalueundercertainty
equivalent technique.
Year Expected cash flow (`) Certainty Equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
Note :
InQ4certaintyequivalentsofMachineYarelesswhichmeansthatriskishigherinthisproject.Ifwewant
touseRADRtechniqueintheQno.4thencashflowsofMachineYshouldbediscountedatahigherrate.
BetweentheabovetwomethodscertaintyequivalentapproachissuperiorthanRADRtechniquebecausein
the formerwe incorporaterisk yearwise and analysis for each year is done separately whereas in case of
RADRmethodwediscountcashflowsusingsamediscountratethusassuminguniformriskineachyear.
Despitethesoundness,ofcertaintyequivalentapproachitisnotpreferablelikeRiskAdjustedDiscountRate
Method.It is difficult to specify a series of Certainty Equivalent Coefficients but simple to adjust discount
rates.
SENSITIVITY ANALYSIS
Therearevariousfactorswhichaffectthecashflowsoftheprojectlikesellingprice(S.P),costp.u.,volume,
life, etc. Change in these factors affects the profitability of the project. However the effect of change of
thesefactorsontheprojectisnotuniform.Therefore,effectofchangeinthesefactoronNPViscalculated.
Thiswillenablethecompanytodecideastowhichfactoraffectstheprojectmosti.ewecometoknowthat
projectismostsensitivetowhichfactorfollowedbywhichone.Ifthecompanyinitiatestheprojectthenit
canconcentratemoreonthatfactorwhichismostriskyforthatproject.
Q6 XYZLtd.isconsideringaprojectforwhichthefollowingestimatesare available:
(Rs.)
InitialCostoftheproject 10,00,000
Salesprice/unit 60
cost/unit 40
Sales Volumes
Year1 20000units
Year2 30000units
Year3 30000units
Discountrate10%p.a.
Youarerequiredtomeasurethesensitivityoftheprojectinrelationtoeachofthefollowingparameters:
(a)SalesPrice/Unit (b)UnitCost
(c)SalesVolume (d)InitialOutlayand
(e)ProjectLifetime
Taxation may be ignored.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 150
Q7 XLtd. isconsideringitsNew Productwith the followingdetails
Sr. no Particular Figures
1 Initial capital cost Rs.400Cr.
2 Annual unit sales 5Cr.
3 Selling price per unit Rs.100
4 Variable costper unit Rs.50
5 Fixed costsperyear Rs.50Cr
6 Lifetime 3yrs
7 Discount Rate 6%.
1. CalculatetheNPVoftheproject.
2. Findtheimpactonthe project’sNPVofa 2.5 percentadverse variancein eachvariable.Which
variable is having maximum effect?
Q8 The Easygoing Company Limited is considering a new project with initial investment, for a product
“Survival”.ItisestimatedthatIRRoftheprojectis16%havinganestimatedlifeof5years.
FinancialManagerhasstudiedthatprojectwithsensitivityanalysisandinformedthatannualfixedcost
sensitivityis7.8416%,whereascostofcapital(discountrate)sensitivityis60%.
Other Informationavailableare :
ProfitVolumeRatio(P/V)is70%;
Variablecost`60/perunit
AnnualCashFlow`57,500/
Ignore Depreciation on initialinvestment and impact of taxation.
Calculate
(i) Initial Investment of the Project
(ii) NetPresent Valueof theProject
(iii) Annual Fixed Cost
(iv) Estimatedannual unitof sales
(v) Break Even Units
CumulativeDiscountingFactorfor5years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127
Q9 RedLtd.isconsideringaprojectwiththefollowingCashFlows:
Years Cost of Plant Recurring Cost Savings
0 10,000
1 4,000 12,000
2 5,000 14,000
Thecostofcapitalis9%.Measurethesensitivityoftheprojecttochangesinthelevelsofplantvalue,
runningcostandsavings(considering eachfactoratatime)suchthatthe NPVbecomeszero.TheP.V.

Chapter6RISKANALYSISINCAPITALBUDGETING 151
factorat9%areasunder:
Year Factor
0 1
1 0.917
2 0.842
Whichfactoristhemostsensitivetoaffecttheacceptabilityoftheproject?

SCENARIO ANALYSIS
Sensitivityanalysisisprobablythemostwidely usedriskanalysistechnique, butitdoeshave limitations.It
considerstheeffectofonlyonefactorontheprojectatatime.However,morethanonefactorcanaffectthe
project simultaneously.
Scenarioanalysisprovidesanswertothese situationsofextensions. Thisanalysisbringsin theprobabilities
ofchangesinkeyvariablesandalsoallowsustochangemorethanonevariableatatime.
Thisanalysisbeginswithbasecaseormostlikelysetofvaluesfortheinputvariables.Then,goforworstcase
scenario(lowunitsales,lowsaleprice,highvariablecostandsoon)andbestcasescenario.
So,inanutshellScenarioanalysisexaminetheriskofinvestment,soastoanalysetheimpactofalternative
combinations of variables, on the project’s NPV.
Q10 XYZLtd.isconsideringaproject“A”withan initialoutlayofRs.14,00,000andthepossiblethreecash
inflowattached withthe project asfollows:
Particular Year 1 Year 2 Year 3
Worstcase 450 400 700
Most likely 550 450 800
Bestcase 650 500 900
Assumingthecostofcapitalas9%determineNPVineachscenario.IfXYZLtdiscertain.Aboutthemost
likely result but uncertain about the third years cash flow, what will be the NPV expecting worst
scenariointhethirdyear.
Notes :
(i) Probability : Probabilityisameasureaboutthechancesthataneventwilloccur.Whenaneventiscertain
tooccur,probabilitywillbe1andwhenthereisnochanceofhappeninganeventprobabilitywillbe0.
(ii) Standard Deviation : It isadegree of variation of individual items of aset of datafrom its average.The
squareroot of varianceis called StandardDeviation.For Capital Budgetingdecisions, Standard Deviation is
usedtocalculatetheriskassociatedwiththeestimatedcashflowsfromtheproject.
(iii) Coefficient of Variation : The standard deviation is a useful measure of calculating the risk associated
withtheestimatedcashinflowsfromanInvestment.HoweverinCapitalBudgetingdecisions,themanagement
inseveraltimesfacedwithchoosingbetweenmanyinvestmentsavenues.Undersuchsituations,itbecomes
difficultforthemanagementtocomparetheriskassociatedwithdifferentprojectsusingStandardDeviationas
each project has different estimated cash flow values. In such cases, the Coefficient of Variation become
useful.
TheCoefficientofVariationcalculatestheriskborneforeverypercentofexpectedreturn.Itiscalculatedas:

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 152
Standard Deviation
Coefficient of variation =
Expected Return/Expected Cash Flow

(iv) Normal distribution curve : Normalcurveisasymmetricalcurvedividedequallyoneithersidewithan


areaof0.5each.Thetotalareaonthiscurveis1.Thecurveisusedtocalculatetheprobabilityofoccurrence
ofaparticularevent.Inthenextmethodwewillusenormalcurvetocalculateprobabilityofgettingdifferent
valuesofNPVeg:veNPV,+veNPV,NPV>20,000etc.
Eg:Avg.MarksinSFMoftheclassroomis60withaSDof5marks.
Calculateprob.ofastudentgetting70marksormore?
Q11 FollowingaretheestimatesofthenetcashflowsandprobabilityofanewprojectofM/sXLtd.:
Year P = 0.3 P= 0.5 P = 0.2
Initial Investment 0 4,00,000 4,00,000 4,00,000
Estimagednetaftertaxcashinflowsperyear 1to5 1,00,000 1,10,000 1,20,000
Estimaged salvage value (after tax) 5 20,000 50,000 60,000
Requiredrateofreturnfromtheprojectis10%.Find:
(i) Theexpected NPVoftheproject.
(ii) ThebestcaseandtheworstcaseNPVs.
(iii) Theprobabilityofoccurrenceoftheworstcaseifthecashflowsareperfectlydependentovertime
and independent overtime.
(iv) Standarddeviationandcoefficientofvariationassumingthatthereareonlythreestreamsofcash
flow, which are represented by each column of the table with the given probabilities.
(v) CoefficientofvariationofXLtd.onitsaverageprojectwhichisintherangeof0.95to1.0.Ifthe
coefficientofvariationoftheprojectisfoundtobelessriskythanaverage,100basispointsare
deducted from theCompany’scost ofCapital.
ShouldtheprojecttheacceptedbyXLtd.?
Q12 ABC Ltd. is evaluating two equal size mutually exclusive proposals P and Q for which the respective
cash flows together with associated probabilities are as follows:
Project P Project Q
Cash Flows (Rs.) Probabilities Cash Flows (Rs.) Probabilities
2,000 0.3 1,000 0.1
4,000 0.4 3,000 0.1
6,000 0.3 5,000 0.4
7,000 0.3
9,000 0.1
Findouttherisksoftheproposalsintermsofthestandarddeviationandcoefficientofvariation.

PROBABILITY DISTRIBUTION APPROACH


Inthisapproachweestimatevariouspossiblecashflowsforoneyearalongwiththeirassociatedprobabilities.
Thesecashflowsaremultiplewiththeirrespectiveprobabilitiestogetasinglecashflowwhichiscalledas
EVCF (Expected Value of Cash flow)

Chapter6RISKANALYSISINCAPITALBUDGETING 153
Steps
1. CalculateyearwiseEVCFandS.D()
2. Calculate NPV oftheproject
3. CalculateSDoftheproject
4. Calculate probabilities of getting various NPVs as mentioned in the question.
Dependent and Independent cashflows
Cash flows

DependentIndependent
V NPV=
[(V ]1xDF1 )+[(V ]2xDF2 )+[(V ]3 xDF3 ]
(V 1xDF1 )2 +(V 2 xDF2 ) +(V 3 xDF3 )
2 2

Ifanyoftheyear’scashflowsaredependentorcorelatedtoanyofthepreviousyear’scashflowsthenthey
are called dependent cashflows.
Ifanyyear’scashflowsarenotdependentornotcorelatedtopreviousyearscashflowsthentheyarecalled
Independent.
Q13 PossiblenetcashflowsofProjectsAandBandtheirprobabilitiesaregivenasbelow.Discountrateis10
percentforboth theprojectinitiallyinvestmentis Rs.10,000.
Calculate:
a. Theexpected netpresentvalue foreach project.Which projectispreferable?
b. Calculate Variance and Standard Deviation.
c. Calculate Coefficient of Variation.
Project A Project B
PossibleEvent CashFlow(Rs.) Probability CashFlow(Rs.) Probability
A 8,000 0.10 4,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 80,000 0.10
Q14 XLtd.isevaluatingaprojectwhichrequiresaoutlayofRs.20,000andpossibleCI’sfor3years
YearOne
CI Probability
6000 0.3
10,000 0.4
14000 0.3
YearTwo
CI Probability
4000 0.2
8000 0.6
12000 0.2
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 154
Year Three
CI Probability
6000 0.3
10,000 0.4
14000 0.3
Required:
1.Evaluatetheproposalusingdiscountingfactor@6%
2.WhatistheprobabilitythatNPVwillbe?
(a)–ve (b)+ve (c) between4000and5500
Q15 Acompanyisconsideringinvestinginanewproductwithanexpectedlifeofthreeyears.Itisestimated
thatifthedemandfortheproductisfavourableinthefirstyear,thenitiscertaintobefavourablein
thesubsequentyears.Andifitislowinthefirstyear,itwouldremainlowinyears2and3.Thecompany
feelsthatcashflowsovertimeareperfectly correlated.Thecostoftheproject isRs.50,000andthe
possiblecashflowsforthreeyearsare:
Year 1 Year 2 Year 3
Cash flow Probability Cash flow Probability Cash flow Probability
0 0.10 5,000 0.15 0 0.15
10,000 0.20 20,000 0.20 7,500 0.20
20,000 0.40 35,000 0.30 15,000 0.30
30,000 0.20 50,000 0.20 22,500 0.20
40,000 0.10 65,000 0.15 30,000 0.15
Assumeariskfreediscountrateof5percent.Calculatetheexpectedvalueandstandarddeviationof
theprobabilitydistributionofpossiblenetpresentvalues.Assuminganormaldistribution,whatisthe
probabilityoftheprojectprovidinganetpresentvalueof(i)zeroorless(ii)Rs.15,000ormore?
Q16 AcompanyisconsideringtwomutuallyexclusiveProjectsXandY.ProjectXcostsRs.30,000andProject
YRs.36,000.YouhavebeengivenbelowtheNPVprobabilitydistributionforeachproject:
Project X Project Y
NPV Estimate Probability NPV Estimate Probability
Rs. Rs.
3,000 0.1 3,000 0.2
6,000 0.4 6,000 0.3
12,000 0.4 12,000 0.3
15,000 0.1 15,000 0.2
(i)ComputetheExpectedNetPresentValueofProjectsXandY.
(ii) Computetheriskattachedtoeachprojecti.e.,StandardDeviationofeachprobabilitydistribution.
(iii) Whichprojectdoyouconsidermoreriskyandwhy?
(iv) Compute the Profitability Index of each project.

Chapter6RISKANALYSISINCAPITALBUDGETING 155
MULTIPLE CHOICE QUESTIONS

1. ProjectAnalysis can be done using:


(a) Sensitivity Analysis (b) Scenario Analysis
(c) Monte Carlo Simulation (d) All of the Above
2. WhichfromthefollowingisnotapartofMonteCarloSimulation
(a) Modeling the Project (b) Simulating Results
(c) Calculating NPV (d) Specifying Probabilities
3. Variance Measures
(a) How far each number in the set is from the mean
(b) Themeanofagivendataset
(c) Return on Investment
(d) levelofriskbornefor everypercentofexpected return
4. Certainty Equivalent
(a) Is a guaranteed return from an Investment after adjusting for risk
(b) Isthereturnthatisexpectedoverthelifetimeofaproject
(c) Is equivalent to Net Present Value
(d) Isan importantcomponent inDecision TreeAnalysis
5. Foraproject,wherethecashflowsare?90,00,000,rateofreturnis15%,riskfreerateis4%andrisk
premiumis 9%,the CertaintyEquivalent is
(a) 78,26,087 (b) 86,53,846
(c) 82,56,881 (d) 81,08,108
6. Risk Premium
(a) is the extra rate of return expected by the Investors as a reward for bearing extra risk
(b) is equivalentto therateofGovernment Securities
(c) is the returnprovided to equity shareholders
(d) isoverandaboveexpectedrateofreturn
7. InDecisionTree Analysis,theProblem / decision isthe
(a) Decision Node (b) Root Node
(c) Event Node (d) End Node
8. Scenario Analysisis consideredunder scenariossuch as
(a) Worst CaseScenario (b) BaseCase Scenario
(c) BestCase Scenario (d) All of the above

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 156
9. Sensitivity analysis is useful in decision making because
(a) It showsthe probabilitiesassociated witheach outcome
(b) It tells the user how much critical each input is for the Output value
(c) It allows to calculatethe probable results under different scenarios
(d) The results of Sensitivity Analysis are reliable
10. Monte Carlo Simulation involves
(a) Identification of key variables on which outcome of the experiment would depend.
(b) Fixingoftherangeofvalueswithinwhichtheresultsareexpectedtovary
(c) Assigning ProbabilityDistribution after a large number of random samples is performed.
(d) All of the above

THEORETICAL QUESTIONS
1. Explain Certainty Equivalent.
2. WhatisRisk AdjustedDiscountrate?
3. Briefly explain the steps involved in Decision Tree Analysis.
4. WhatarethedrawbacksofusingDecisionTrees?
5. WhataretheBenefits of usingDecision Trees?
6. Explain Scenario Analysis.
7. Explain the different scenarios under which Scenario Analysis is considered.
8. Whatarethetwo approachesto SensitivityAnalysis?
9. What is Sensitivity Analysis used for?
10. Distinguish between Scenario Analysis & Sensitivity Analysis.

00

Chapter6RISKANALYSISINCAPITALBUDGETING 157
HOME WORK

Q17 PossiblenetcashflowsofProjectsAandBandtheirprobabilitiesaregivenasbelow.Discountrateis
10 per cent for both the project initially investment is ` 10,000. Calculate the expected net present
value foreachproject. Whichprojectispreferable?
Project A Project B
Possible Cash flow (`) Probability Cash flow(`) Probability
Event
A 8,000 0.10 4,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,0,000 0.10
Hints :
ThenetpresentvalueforProjectAis(0.909×`12,000–`10,000)=`908
ThenetpresentvalueforProjectBis(0.909×`16,000–`10,000)=`4,544.
Q18 Probabilitiesfornetcashflowsfor3yearsaprojectareasfollows:
Year 1 Year 2 Year 3
Cash Flow(`) Probability Cash Flow(`) Probability Cash Flow(`) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net cash flows. Also calculate the present value of the expected cash flow,
using10percentdiscountrate.InitialInvestmentis`10,000.
Hints :
Expected Net Present value= Present Value ofcash flow Initial Investment
=`12,573–`10,000=`2,573.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 158
Q19 ShivamLtd.isconsideringtwomutuallyexclusiveprojectsAandB.ProjectAcosts`36,000andproject
B`30,000.Youhavebeengivenbelowthenetpresentvalueprobabilitydistributionforeachproject.
Project A Project B
NPV Estimates Probability NPV estimates Probability
(`) (`)
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
(i) ComputetheexpectednetpresentvaluesofprojectsAandB.
(ii) Computetherisk attachedtoeachprojecti.e.standarddeviationofeachprobabilitydistribution.
(iii) Compute the profitability index of each project.
(iv) Whichprojectdoyourecommend?Statewithreasons.
Solution
(i) Statement showing computation of expected net present value of Projects A and B:
Project A Project B
NPV Estimate Proba Expected NPV Proba Expected
(`) bility Value Estimate bility Value
15,000 0.2 3,000 15,000 0.1 1500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV=9,000 1.0 EV=9,000
(ii) Computation of Standard deviation of each project
Project A
P X (X–EV) P(XEV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 3,000 27,00,000
0.2 3,000 6,000 72,00,000
Variance=1,98,00,000

StandardDeviationofProjectA= 1,98,00, 000 =` 4,450

Chapter6RISKANALYSISINCAPITALBUDGETING 159
Project B
P X (X–EV) P(XEV)²
0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000
0.4 6,000 3,000 36,00,000
0.1 3,000 6,000 36,00,000
Variance=1,44,00,000

StandardDeviationofProjectB= 1, 44, 00,000 =` 3,795


(iii) Computation of profitability of each project
Profitabilityindex =Discountcash in flow/ Initial outlay

9,000 + 36,000 45, 000


IncaseofProjectA:PI= = = 1.25
36,000 36,000

9, 000 + 30,000 39, 000


IncaseofProjectB:PI= = = 1.30
30,000 30, 000
(iv) Measurementofriskismadebythepossiblevariationofoutcomesaroundtheexpectedvalueandthe
decisionwillbetakeninviewofthevariationintheexpectedvaluewheretwoprojectshavethesame
expectedvalue,the decisionwillbetheproject which hassmaller variationinexpected value. Inthe
selectionofoneofthetwoprojectsAandB,ProjectBispreferablebecausethepossibleproftwhich
mayoccurissubjecttolessvariation(ordispersion).MuchhigherriskislyingwithprojectA
Q20 From the following details relating to a project, analyse the sensitivity of the project to changes in
initialprojectcost,annualcashinflowandcostofcapital:
Initial Project Cost (`) 1,20,000
AnnualCash Inflow (`) 45,000
Project Life (Years) 4
Costof Capital 10%
Towhichofthethreefactors,theprojectismostsensitiveifthevariableisadverselyaffectedby10%?
(Useannuityfactors:for10%3.169and11%...3.103)

Solution
Calculation of NPV through Sensitivity Analysis
(`)
PVofcashinflows(`45,000×3.169) 1,42,605
Initial Project Cost (1,20,000)
NPV 22,605

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 160
Situation NPV Changes in NPV
Base (present) `22,605 (`22,605–`10,605)/`
Ifinitialprojectcostis (`1,42,605`1,32,000)= `22,605=(53.08%)
variedadversely by10% `10,605
Ifannualcashinflowis [`40,500(revisedcashflow) (`22,605–`8,345)/
variedadversely by10% ×3.169)–(`1,20,000)]= `22,605=63.08%
`8,345
Ifcostofcapitalisvaried (`45,000×3.103)– (`22,605–`19,635)/
adverselyby10%i.e.it `1,20,000=`19,635 `22,605=13.14%
becomes11%
Conclusion : Projectismostsensitiveto‘annualcashinflow’.
Q21 The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive proposals,
ProjectsMandN,whichrequirecashoutlaysof`8,50,000and`8,25,000respectively.Thecertainty
equivalent(C.E)approachisusedinincorporatingriskincapitalbudgetingdecisions.Thecurrentyield
ongovernmentbondsis6%andthisisusedastheriskfreerate.Theexpectednetcashflowsandtheir
certainty equivalents are as follows:
Project M Project N
Yearend Cash Flow (`) C.E. Cash Flow (`) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Presentvaluefactorsof`1discountedat6%attheendofyear1,2and3are
0.943,0.890and0.840respectively.
Required :
(i) Whichprojectshouldbe accepted?
(ii) Ifriskadjusteddiscountratemethodisused,whichprojectwouldbeappraisedwithahigherrateand
why?
Q22 The probability distribution of two Projects NPVs are given below.
Project X Project Y
NPV Probability NPV Probability
` 5,000 0.2 `0 0.1
7,500 0.7 7,500 0.7
10,000 0.1 15,000 0.2
Calculate the expected NPV, the standard deviation and the coefficient of variation for each project.
Which of these mutually exclusive projects do you prefer,and why?

Chapter6RISKANALYSISINCAPITALBUDGETING 161
Q23 Aprojectinvolvinganoutlayof`10lakhshasthefollowingbenefitsassociatedwithit.
Year 1 Year 2 Year 3
Cash Flow Prob.. Cash Flow Prob Cash Flow
(`in lakhs) (` inlakhs) (`inlakhs) Prob.
4 0.4 5 0.4 3 0.3
5 0.5 6 0.4 4 0.5
6 0.1 7 0.2 5 0.2
Assume that the cash flows are independent. Calculate the expected net present value and the
standarddeviationofnetpresentvalueassumingthati=10%.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 162
CHAPTER  7
DIVIDEND DECISIONS

INTRODUCTION

1. Initially we will understand objective of learning the chapter.


2. Before we discuss learning point of this chapter, we are discussing that what is objective is financial
management.Objectiveoffinancialmanagementistomaximizewealthofshareholders.Anydecision
taken byfinance manager should increase wealth of shareholders.
3. As per financial management, wealth of shareholders is measured by way of current market price of
equity share.
4. Wheneveracompanyisraisingfunds,itmayobtainthroughdebentures,loan,preferencesharesand
equityshares.Forallsourcesoffinance,exceptforequityshares,itisclarifiedthatwhatreturnwillbe
giventofundproviders.Now,ifthereisaprofit,thencompanyhastodecidethatwhethertopayequity
dividendornot,ifcompanywillpaydividend,thenitisrequiredtodecidethatwhatamountofdividend
istobepaidtoequityshareholders.
5. Thisdecisionofequitydividendpaymentwillhavetobetakeninsuchawaysothatwealthofshareholder
ismaximized,ismeanscurrentmarket priceofequityshareshouldincrease.

Chapter7  Dividend Decisions 165


CLASS WORK

GORDON MODEL
1. It is adividend policymodel, based on following assumptions:
A. 100%equityfinance.
B. Rateofearningofthecompany(r);costofequity(ke),dividendpolicyandgrowthrate(g)ofthe
companyisgoingtoremainconstant.
C. Costofequity(ke)exceedsgrowthrate(g).
D. All investment proposals are to be financed with retained earning only.

2. Distribution ofearning in form of dividendwill beas under:


Company should
Rateofearningofthecompany(r) > Cost of equity (ke) RetainEarningsofarpossible
Rateofearningofthecompany(r) < Cost of equity (ke) Distribute Earning sofar possible
Rateofearningofthecompany(r) = Cost of equity (ke) Whatevermaybedividendpayour
ratio,CurrentmarketPriceofEquity
Share will remain same.
Q1 XLtd.hasissuedequityshare@`300.Rateofearningofthecompanyis20%[r=20%],whilecompany
hasdividendpayoutratioof30%[1b],i.eRetentionratiois70%,[b].
Youarerequiredtofind
(1) DPSattheendofyear1
(2) DPSattheendofyear3
(3) Growthratein earningand Dividend.
Q2 The following information is available in respect of the rate of return on investment (r), the equity
capitalizationrate(ke)andearningpershare(E)ofmanufacturingcompany:
ke=0.25
E1=`20
r=0.20
Determine the value of its share as per Gordon’s model (under conditions of certainty) in each
alternative, assuming the following.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 166
D/P ration (1 b) Retention Ratio (b)
A 20 80
B 50 50
C 90 10
Q3 The following information is available in respect of the rate of return on investment r, the equity
capitalisationrate(ke)andearningspershare(E)ofmanufacturingcompany:
r=0.30
ke=.0.25
E1=`20
Determine the value of its share as per Gordon’s model (under conditions of certainty) in each
alternative, assuming the following.
D/P ration (1 b) Retention Ratio (b)
A 20 80
B 50 50
C 90 10
Q4 The following information is available in respect of the rate of return on investment (r), the equity
capitalisationrate(ke)andEarningsPerShare(E)ofmanufacturingcompany:
r=0.25
ke=0.25
E1=`20
Determine the value of its share as per Gordon’s model (under conditions of certainty) in each
alternative, assuming the following.
D/P ration (1 b) Retention Ratio (b)
A 20 80
B 50 50
C 90 10
Q5 IsitpossibletoadjustDividendPayoutratioasperGordonModelandMaximizeCurrentMarketPrice
per Share?
Q6 WhatisoptimumdividendpayoutratioasperGordonModel.

WALTER MODEL
1. Assumptions
A. Rateofearningofthecompany(r)willremainsame.
B. Capitalmarketisperfect,itmeansfreeinformationaboutallsecuritiesareavailabletoallinvestors
andallinvestorsarerational.
C. Notaxornotaxdifferencesbetweendividendincomeandcapitalgain.
D. Nofloatationcost;notransactioncost.

Chapter7  Dividend Decisions 167


E. Life of the business is forinfinite period.
2. Distributionof earningin formofdividend willbe asunder:
Company should
Rateofearningofthecompany(r) > Cost of equity (ke) Retain100%Earning
Rateofearningofthecompany(r) < Cost of equity (ke) Distribute100%Earning
Rateofearningofthecompany(r) = Cost of equity (ke) Whatevermaybedividendpayour
ratio,CurrentmarketPriceofEquity
Share will remain same.
Q7 The following information is available in respect of the rate of return on investment (r), the equity
capitalizationrate(ke)andearningpershare(E)ofmanufacturingcompany:
ke=0.25
E1=`20
r=0.30
Determinethe valueof itsshare in each alternativeas perWalter model,assumingthefollowing.
D/P ration (1 b) Retention Ratio (b)
A 0.00 1.00
B 0.50 0.50
C 1.00 0.00
FORMULA:

D + E  D × r / ke
P0 =
ke
D1=ExpectedDividendpershare
ke=CostofEquity
P0 =Currentmarketpriceofshare
E1=Expectedearningpershare
r=RateofEarning
Q8 The following information is available in respect of the rate of return on investment (r), the equity
capitalizationrate(ke)andearningpershare(E)ofmanufacturingcompany:
ke=0.25
E1=`20
r=0.20
Determinethe valueof itsshare in each alternativeas perWalter model,assumingthefollowing.
D/P ration (1 b) Retention Ratio (b)
A 0.00 1.00
B 0.50 0.50
C 1.00 0.00

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 168
Q9 The following information is available in respect of the rate of return on investment (r), the equity
capitalizationrate(ke)andearningpershare(E)ofmanufacturingcompany:
ke= 0.25
E1=`20
r=0.25
Determinethe valueof itsshare in each alternativeas perWalter model,assumingthefollowing.
D/P ration (1 b) Retention Ratio (b)
A 0.00 1.00
B 0.50 0.50
C 1.00 0.00
Q10 IsitpossibletoadjustDividendPayoutratioasperWalterModelandmaximiseCurrentMarketPrice
PerShare?
Q11 WhatisoptimumdividendpayoutratioasperWalterModel.
NOTE:
WALTER MODEL :
1. WhateverconclusionGordonModelhasdrawn,thesameitselfistheconclusiondrawnbyWalter
Model also.
2. Dependingupon rand ke,decision willbe takenfor optimum dividend policyby thecompany.
Q12 ThefollowingfiguresarecollectedfromtheannualreportofXYZLtd:
Particulars `
Net Profit (Earning After Taxes) 30lakhs
Outstanding 12% preference shares 100lakhs
No.ofequity shares 3lakhs
Return on Investment 20%
keofXYZLtd.is16%,whatshouldbetheapproximatedividendpayoutratiosoastokeeptheshare
priceat`42byusingWaltermodel?
Source Month Year Q. No. Page No.
Study Material July2019 3 9.21
FORMULA:

EATESH
EPS=
n
EPS=Earningpershare
EATESH=EarningavailabletoEquityShareHolders
n=Numberofequityshares

Chapter7  Dividend Decisions 169


Q13 Afirmwasstartedayearagowithanequitycapitalof`20lacks.Inrespectthisfirmfollowinginformation
is available.
Particulars
EarningsoftheFirm `2,00,000
Dividend Paid `1,50,000
P/ERatio 12.50Times
Numberofsharesoutstanding,20,000@`100each.Thefirmisexpectedtomaintainitscurrentrateof
earning on investment.
(1) WhethercurrentDividend payoutratioisoptimalasperWalter?
(2) WhatshouldbetheP/ERatioatwhichthedividendpayoutratiowillhavenoeffectonthevalue
of the share?
(3) WillyourdecisionaboutdividendpayoutratiowillchangeiftheP/Eratiois8,insteadof12.50?
[Page No.9.38; Q.N.2]
NOTE:
1. WithPriceearningRatio,kewillbecalculated,furtherconsideringinvestmentatthebeginningofeach
of the year and Earning at the end of year, rate of earning of the company (r) will be calculated.
Comparisonwillbemade between`r’and`ke’,for decidingwhethercurrentdividendpayoutratiois
optimalaccordingtoWalter.
2. If there is a situation that ‘r ’itself is ke,then in that case whatever is dividend payoutratio of the
companyP0,willremainsame.WithchangeinP/ERatio,kechanges,sokeshouldchangeinsuchaway
sothatkeequalsto‘r’.Hence,taking‘r’istakenasbaseandwiththatP/E.ratioiscalculated.
FORMULA:

1
ke =
P / E.Ratio

Q14 Withthehelpoffollowingfigurescalculatethemarketpriceofashareofacompanybyusing:
(i) Walter’s formula.
(ii) Dividend growth model (Gordon’s formula)
EarningperShare(EPS) Rs.10
Dividend per share (DPS) Rs.6
Costofcapital(k) 20%
Internal rateof returnon investment 25%
Retention Ratio 60%
[Page No.9.39; Q.N.3]
MODIGLIANI MILLER APPROACH (MM APPROACH)
1. MMapproachhasmadefollowingassumptions.
A. Capital market is perfect. All investors are rational and information is available to all investors
freely.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 170
B. Notaxes, or notaxdiscriminationbetweendividend income and capitalgain.
C. Fixed investment policy.
D. 100% equityfinancing.Nodebtfinancing.
E. Nofloatationcost,transactioncost.
F. One discounting rate, no risk of uncertainty. Investors are able to forecast futures prices and
dividend.
2. AsperMMApproach,withchangeindividendpayment,wealthofshareholdersdonotchange.
Q15 Consider following information:
Aninvestorpurchasedasecurityinformofequityshare@Rs.600,hereceiveddividendofRs.10atthe
endofyear,furthermarketpriceofsecurityattheendofyearisRs.650.
Calculate return toinvestorforholdingsecurity forone year.
Q16 Consider following information:
CurrentMarketPriceofEquityshare: Rs.500
CostofEquity(ke 20%
Expected Dividend Per Share Rs.20
CalculatePriceofequityshareattheendofyearsothatinvestorgetsreturnequalstocostofequity.
Q17 XLtd.has10,000EquityShares,currentMarketPriceofEquityShareis`200,itskeis25%itsexpected
Earning(E)attheendofyearisexpectedtobe`5,00,000,companyislikelytomakeInvestment(I)at
theendofyear`7,50,000.
You are required to answer following Questions.
1. ExpectedMarketPricePerShareattheendoftheyear(P1)ifCompanyisDeclaringDividendper
share
a. `0
b. `20
c. `50
2. If company is going to issuenew equity shares to finance requirement balance funds, calculate
newequitysharesrequiredtobeissuedineachcase.
NOTE:
1. Ineachofthecasewewillcalculate,amountoftotaldividendtobepaidtoequityshareholders,
fromtotalearning,paymentofDividendwillbededucted.So,fromtotalinvestmenttobemade,
a part of finance will be by way of retained earning and remaining is amount of new issue of
equity share capital.
2. Newequityshareswillbeissuedattheendofyear,atapriceprevailingattheendofyear.
3. ConsideringthatInvestorisreadytopayapriceequaltoPresentValueCashInflow,P0 iscalculated,
consideringthat formula only P1 will be calculated.
FORMULA:
Retained Earning =E–nD1
nD 1 =Totaldividenddeclaredtoshareholdersattheendofyear.
DnP 1 =I–(EnD1)
DnP 1 =Requiredamountofissueofequitysharecapital.

Chapter7  Dividend Decisions 171


Q18 StateimportantassumptionsofMMApproach.
Q19 AsperMMapproachhowvalueoffirmcanbecalculated?
Q20 XLtd.has10,000EquityShares,currentMarketPriceofEquityShareis`200,itskeis25%itsexpected
Earning(E)attheendofyearisexpectedtobe`5,00,000,companyislikelytomakeInvestment(I)at
theendofyear`7,50,000.
YouarerequiredtocalculatevalueofFirmasperMM(ModiglianiMiller)approachifcompanyisgoing
todeclare dividend per share.
a.`0 b. `20 c. `50
NOTE:
MMMODEL{ModiglianiMillerApproach}
1. By adopting Modigliani Miller Approach, we are required to calculate Value of Firm. In that case we
havetoadoptfollowing steps:
A ValueofFirmasperMMApproachisrequiredtobecalculatedasperfollowingformula
nP0=(n+Dn)P1–I+E
1+ke
A. ForeachoftheDividendpaymentaboveformulaistobeapplied.Fromaboverequiredvariables;
we already have following variables.
i. n(ExistingNumberofEquitysharesofthecompany).
ii. ke
iii. D1
So,nowwearerequiredtocalculate
i. Dn
ii. P1
B. Dn, will be calculated considering.
i. RetainedEarning{(E)Earning–nD1},
ii. New Investment (I).
2. WewillfindthatValueofFirm(nP0)inallcaseswillbesame,thesamecanbecrossverifiedas(n´P 0).
Henceconclusionof MMApproachisalsofulfilled.
Q21 AtextilecompanybelongstoariskclassforwhichtheappropriateP/Eratio10.Itcurrentlyhas50,000
outstanding shares selling at `100 each. The firm is contemplating the declaration of `8 per share
dividend atthe end of the current fiscal year which has just started. Given the assumption of MM,
answer the following questions.
(1) Whatwillthepriceofthesharebeattheendoftheyear:
(a) if dividend is not declared?
(b) if it is declared?
(2) Assumingthatthefirmpaysthedividend,hasanetincomeof`5,00,000andmakesnewinvestment
of`10,00,000duringtheperiod,howmanynewsharesmustbeissued?
(3) Whatwillthevalueofthefirmbe(itmeanstoday):
(a) if dividend is not declared?
(b) if it is declared?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 172
FORMULA:
nP0=
nP0=Valueoffirmtoday
n=Numberofoutstandingsharesatthebeginningoftheyear
P0 =CurrentMarketPricepershare
Dn=AdditionalEquitysharesissuedattheendofyear.
P1 =MarketpriceofEquityshareattheendofyear.
I=Investmenttobemadeattheendofyear.
E=Earningattheendofyear.
Q22 WhetherasperMMapproachvalueoffirmcanbeincreasedbyadjustingDividendpayment?
Q23 AB Engineering ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has
outstanding10,000sharessellingat` 100each.Thefirmiscontemplatingthedeclarationofadividend
of`5/shareattheendofthecurrentfinancialyear.Itexpectstohaveanetincomeof`1,00,000andhas
a proposalformakingnewinvestmentsof `2,00,000.Calculatevalueoffirm,if dividendispaid,not
paid. [Page No.9.15; Q.No.1]
Q24 RSTLtd.hasacapitalof`10,00,000inequitysharesof`100each.Thesharesarecurrentlyquotedatpar.
Thecompanyproposestodeclareadividendof`10pershareattheendofthecurrentfinancialyear.
Thecapitalizationratefortheriskclassofwhichthecompanybelongsis12%.Whatwillbethemarket
priceoftheshareattheendoftheyear,if(i)adividendisnotdeclared?(ii)adividendisdeclared?(iii)
assuming that the company pays the dividend and has net profits of ` 5,00,000 and makes new
investments of ` 10,00,000 during the period, how many new shares must be issued? Use the MM
model. [Page No.9.32; Q.No.11]
Q25 MLtd.belongstoariskclassforwhichthecapitalizationrateis10%.Ithas25,000outstandingshares
andthecurrentmarketpriceis`100.Itexpectsanetproftof`2,50,000fortheyearandtheBoardis
consideringdividendof `5 pershare.
MLtd.requirestoraise`5,00,000foranapprovedinvestmentexpenditure.Show,howtheMMapproach
affectsthevalueofMLtd.ifdividendsarepaidornotpaid. [Page No.9.38; Q.No.1]
GRAHAM AND DODD MODEL
1. As per this dividend policy theory, more importance is given to dividend by share holders and not to
earning.
2. Withmoreandmoredividendpaymentbythecompany,marketpriceofequitysharewillincreaseand
vice versa.

Q26 Theearningspershareofacompanyis`30andthedividendpayoutratiois60%.Ifthesharepriceof
thecompanyis`56whatisthemultiplierapplicabletothecompany(approx)accordingtotheGraham
and Dodd model? [Page No.9.29; Q.No.8]
FORMULA:
­ § EPS · ½
P = m× ®DPS + ¨ ¸¾
¯ © 3 ¹¿

P=Currentmarketpricepershare

Chapter7  Dividend Decisions 173


D=Dividendpershare
E=Earningpershare
m = multiplier
Q27 ThefollowinginformationregardingtheequitysharesofMLtd.isgiven:
MarketPrice Rs.58.33
Dividend per share Rs.5
Multiplier 7
AccordingtotheGraham&Doddapproachtothedividendpolicy,computetheEPS.
[Page No.9.29; Q.No.9]

Q28 As perGraham and Dodd Model by adjusting dividend payment market price of equity share can be
increased?
Q29 AsperGrahamandDoddModelwhatisoptimumdividendpayoutratio?
Q30 The dividend payout ratio of H Ltd. is 40%. If the company follows traditional approach to dividend
policywithamultiplierof9,whatwillbetheP/Eratio.
[Page No.9.39; Q.No.4]
STOCK SPLIT
1. Itmeanssplittingoneshareintomorethanoneshare.
2. Stocksplitiswithanintensiontoreducepersharepriceofthesecurity.
3. Advantages :
a. Itmakesshareaffordableto smallinvestors.
b. Number of shares and shareholders increase, so potential of investment increase.
4. Disadvantages
a. Additional Expenditure incurred by the company.
b. Chancesofspeculationandshortterminvestmentincrease,whichcompanymaynotlike.
Q31 King Co. has the following shareholders’ equity account.
Share Capital(FaceValue `10) `25lakhs
Reserves `100lakhs
Shareholders equity `125lakhs
CurrentMarketPriceis`75pershare.Whatwillbe
1. Thenumberofsharesoutstandingand
2. Change in reserves
3. Trendinsharepriceifthecompanyisenteringinstocksplit2:1.
LINTNER MODEL
1. Thisdividendpolicytheoryisbasedonseriesofinterviewsconductedwithcorporatemanagersinmid
1950’.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 174
2. Asper this model, amount of dividend payment is important, dividend payout ratiois not important.
Everytimemanagerisconcernedaboutamountofdividendpershare.
3. Ifthereisdecreaseindividendpershare,itisconsideredtobepoorsignoffinancialperformanceand
with that priceof equity sharewillbe adversely affected.
4. Dividendadjustmentrate(C)meanspaceatwhichdividendpersharewillincrease.Ifthecompanyis
confidenttomaintainitsearninginfuture,itwillkeepadjustmentratehighandviceversa.
5. Acompanymaintainslongtermdividendpayoutratio.Maturecompanieskeephighpayoutratioand
growing company keeps low dividend payout ratio.
Q32 Given last year’s dividend is `9.80, speed of Adjustment = 45%, target payout Ratio 60% and EPS for
currentyear`20.
(i) Calculate current years dividend using Lintner’s Approach.  [Page No.9.31, Q.No.10]
(ii) If speed of Adjustment is considered20% calculaterevised dividend per share.
Q33 What will be the dividend per share of Rohan Industries for the year 2018 given the  following
information aboutthe company?
EPSof2018 `3
DPSfor2017 `1.20
Target payout ratio 0.60
Adjustment rate 0.70
Apply the Lintner Model.

Chapter7  Dividend Decisions 175


MULTIPLE CHOICE QUESTIONS

1. WhichoneofthefollowingistheassumptionofGordonModel?
(a) Ke>g
(b) Retentionratio (b),oncedecideupon,isconstant
(c) Firmisanallequityfirm
(d) All of the above
2. WhatshouldbetheoptimumDividendpayoutratio,whenr=15%&Ke=12%?
(a) 100% (b)50% (c) Zero (d)Noneof theabove
3. Which of the following is the irrelevance theory?
(a) Walter model (b) Gordon model
(c) M.M.hypothesis (d) Linter’s model
4. Ifthecompany’sD/Pratiois60%&ROIis16%,whatshouldbethegrowthrate?
(a) 5% (b)7% (c) 6.4% (d)9.6%
5. If the shareholdersprefer regularincome, how doesthis affect the dividend decision:
(a) It will lead to payment of dividend
(b) Itistheindicatortoretainmoreearnings
(c) Ithasnoimpact ondividenddecision
(d) Can’tsay
6. Maturecompanies havingfew investment opportunities will show high payout ratios, thisstatement
is
(a) False (b) True (c)Partial true (d) None of these
7. Which of the following is the limitation of Linter’s model?
(a) Thismodeldoesnotofferamarketpricefortheshares
(b) Theadjustmentfactorisanarbitrarynumberandnotbasedonanyscientificcriterionormethods
(c) Both (a) & (b)
(d) Noneof theabove

THEORETICAL BASED QUESTIONS


1. Whatdoyouunderstandbydividenddecision?Brieflexplainthefactorswhichgovernthisdecision.
2. Brieflexplaintheadvantagesanddisadvantagesofthestockdividend?
3. Whatarethepracticalconsiderationsindividendpolicy?
4. Listouttheassumptionsofirrelevancetheory.
5. BrieflexplaintheparametersLinter’smodelof dividend policy.Alsoexplain thereasonsof its
criticism.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 176
FORMULA
D
1
1. P0 =
ke - g
D1=ExpectedDividendpershare
ke=CostofEquity
g=Growthrate
P0 =Currentmarketpriceofshare

D + E -D ×r / k e
2. P0 =
ke
D1=ExpectedDividendpershare
ke=CostofEquity
P0 =Currentmarketpriceofshare
E1=Expectedearningpershare
r=RateofEarning
3. g=b´r
g=Growthrate%
b=Retentionratio
r=RateofEarningofthecompany
4. Dt=EPS´C´r+D(t1)´(1C)
Dt =Dividendpershare
EPS=Earningpershare
C =DividendAdjustmentratio
r=Targetpayoutratio
D(t1)=Dividendpersharelastyear

­ § EPS · ½
5. P= m× ®DPS + ¨ ¸¾
¯ © 3 ¹¿
P=Currentmarketpricepershare
D=Dividendpershare
E=Earningpershare
m = multiplier

D +P
1 1
6. P0=
1+ke
P1 =Expectedmarketpricepershare
ke=Costofequity
Chapter7  Dividend Decisions 177
n + n P - I+ E
1
7. nP0=
1+ k e

nP0=Valueoffirmtoday
n=Numberofoutstandingsharesatthebeginningoftheyear
P0 =CurrentMarketPricepershare
Dn=AdditionalEquitysharesissuedattheendofyear.
P1 =MarketpriceofEquityshareattheendofyear.
I=Investmenttobemadeattheendofyear.
E=Earningattheendofyear.
8. RetainedEarning=E–nD1
nD1=Totaldividenddeclaredtoshareholdersattheendofyear.
9. DnP1=I–(EnD1)
DnP1 =Requiredamountofissue ofequitysharecapital.
10. EPS=Investment´r

1
11. ke=
P / E.Ratio

1
12. P/ERatio= k
e

D + P -P
1 1 0 ×100
13. Rt=
P
0
Rt = Return for time period
D1=Dividendpershare
P1 =Marketpricepershareattheendofyear
P0 =Currentmarketpricepershare

EATESH
14. EPS=
n
EPS=Earningpershare
EATESH= Earning Available To Shareholders
n=Numberofequityshares

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 178
HOME WORK

GORDON MODEL
Q34 XLtd.isanogrowthcompany,paysadividendof`5pershare.Ifthecostofcapitalis10%,whatshould
bethecurrentmarketpriceoftheshare? [Page No.9.26, Q.No.5]
Hints

D 5
P0 = = = ` 50
Ke 0.10
Q35 XYZiscompanyhavingsharecapitalof`10lakhsof`10each.Itdistributedcurrentdividendof20%per
annum. Annual growth rate in dividend expected is 2%. The expected rate of return on its equity
capitalis15%. [Page No.9.27, Q.No.6]
Hints

D (1 + g)
P= 0
Ke  g
D0=10×20%=`2
g=2%or0.02
Ke=15%or0.15

2(1 + 0.02)
P=
0.150.02
=`15.69
Q36 Afirmhadbeenpaiddividendat`2persharelastyear.Theestimatedgrowthofthedividendsfromthe
companyisestimatedto be 5%p.a.Determinethe estimatedmarketpriceoftheequityshare ifthe
estimatedgrowthrateofdividends(i)risesto8%,and(ii)fallsto3%.Alsofindoutthepresentmarket
priceoftheshare,giventhattherequiredrateofreturnoftheequityinvestorsis15.5%.
[Page No.9.28, Q.No.7]
Hints
Inthepresentsituation,thecurrentMPSisasfollows:
(i) Theimpactofchangesingrowthrateto8%onMPSwillbeasfollows:

D0 1 + g
P =
Ke  g
Chapter7  Dividend Decisions 179
2 × 1.05
P =
0.1550  0.05
= `20
(i) Theimpactofchangesingrowthrateto8%onMPSwillbeasfollows:

2×1.08
P =
0.1550  0.08
= `28.80
(ii) Theimpactofchangesingrowthrateto3%onMPSwillbeasfollows:

2 ×1.03
P =
1550  0.03
= `16.48
So,themarketpriceoftheshareisexpectedtovaryinresponsetochangeinexpectedgrowthrateis
dividends
Q37 Again taking an example of three different firms i.e. growth, normal and declining firm, the Gordon
model can be appliedwiththehelp of afollowing example:
Factors Growth Firm r > Ke Normal Firm r = Ke Declining Firm r < Ke
r (rate of return
on retained earnings) 15% 10% 8%
Ke(CostofCapital) 10% 10% 10%
E(Earning Per Share) `10 `10 `10
b (Retained Earnings) 0.6 0.6 0.6
1b 0.4 0.4 0.4
[Page No.9.34, Q.No.13]
Hints
r 0.15 0.10 0.08
EPS Rs.10 Rs.10 Rs.10
1b 0.40 0.40 0.40
b 0.60 0.60 0.60
DPS Rs.4 Rs.4 Rs.4
Growthrate(g) 0.09 0.06 0.048
(bxr) (0.60x0.15) (0.60x0.10) (0.60x0.08)
P0 Rs.400 Rs.100 Rs.76.92

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 180
D1 4 4 4
ke  g 0.10  0.09 0.10  0.06 0.10  0.048

Q38 The following particulars are furnished to you for calculating the present value of market price per
share (PO),byusing Gordon’s growth model if retention ratio(b)is:
1.1
2.5
3.7
4.9
Growth firm Normal firm Declining firm
r>k r=k r<k
r=.15 r=.11 r=.08
k=.10 k=.11 k=.10
E=Rs.15 E=Rs.11 E=s.10
Commentontheresultsofyourworkings.
Solution

E Ib
GordonModel= 1
k b
Where
E1 = Earningpershare
b = retention ratio
k = Costof Capital
br = growth (g)
P0 =
MarketPricepershare.
When retention ratio
(b)=,1Paymentratio
G=br=.1x.15=0.015 br=.1x.11=.011 br=.1x.08= .008
GrowthFirm Normal Firm Declining Firm

Rs.15 1.1 Rs.11 1.1 Rs.10 1.1


P0 = P0 = P0 =
10  015 11  011 08  008

Rs.13.5 Rs.9.9 Rs.9


P0 = = Rs.158.82i.eRs.159 /  P0 = = Rs.100 P0 = = Rs.125
085 099 072
When reletion ratio Paymentratioisalso.5
i.e.,b=.5
g=br=.5x.15=0.075 br=.5x.11=0.055 br=.5x.08
=0.04
Chapter7  Dividend Decisions 181
Rs.15 1  5 Rs.11 1  5 Rs.10 1  5
P0 = = P0 = = P0 =
.10  .075 .11  .055 .08  .04

7.5 5.5 5
= Rs.300 = = Rs.100 = = Rs.125
0.025 .055 .04
When retention ratio Payoutratiois0.3
b=.7
g=.7x.15=.105 g=.7x.11=.077 g=.7x.08=
0.056

Rs.15 1  7 Rs.11 1  7 Rs.10 1  7


P0 = P0 = P0 =
10  .105 .11  .077 .08  .056

4.5 3.3 3
P0 =  =  Rs.900 /  P0 = Rs.100 P0 = Rs.125
.005 .033 0.024
When retention ratio
b=.9
g=.9x.15=0.135 g=.9x.11=.099 g=.08x.9=
.072

15 1  9 Rs.11 1  9 Rs.10 1  9
P0 = P0 = P0 =
10  0.135 11  0.099 08  .072

Rs.1.5 Rs.1.1 1
P0 =  =  Rs.43 /  P0 =  = Rs.100 P0 = = Rs.125 / 
.035 .011 .008
Comments:
(i) Inthecaseofgrowthfirms,highertheretentionratio,higheristhemarketvalueofsharesexcept
whenk–brisnegative.OneoftheassumptionofGordonisthatkshouldbemorethanbr.Ifk–br
isnegative,theabsurdresultswillbeobtained.Thisisevidentincaseofgrowthfirmwherethe
retention ratio is .7 and .9 in the above table. The market price of the share became negative
which is an absurd result. The market value of the share may be zero but it will never become
negative.
(i) Thereisnoimpactofretentionratiointhecaseofnormalfirmsanddecliningfirms.
WALTER MODEL
Q39 XYZLtd.whichearns`10/shareiscapitalizedat10%andhasareturnoninvestmentof12%.Determine
theoptimumdividendpayoutratioandthepriceoftheshareatthepayout.[Page No.9.20, Q.No.2]
Solution
Theoptimumdividendpayoutratiois‘Zero’,sincer>Ke

D + E D ×r / Ke
p=
Ke

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 182
0 + 10  0 × 0.12/0.10
P=
0.10
=`100
Q40 ThefollowinginformationpertainstoM/sXYLtd
EarningsoftheCompany `5,00,000
Dividend Payout ratio 60%
No.ofsharesoutstanding 1,00,000
Equity capitalization rate 12%
Rateofreturnoninvestment 15%
(i) WhatwouldbethemarketvaluepershareasperWalter’smodel?
(ii) WhatistheoptimumdividendpayoutratioaccordingtoWalter’smodelandthemarketvalueof
Company’sshareatthatpayoutratio?
Solution
M/sXYLtd.
(i) Walter’s modelisgiven by

D + E  D r / ke
p=
Ke

Where,
P = Market pricepershare.
E = Earningspershare=`5(`5,00,000/1,00,000)
D = Dividendpershare=`3(0.60x`5)
r = Returnearnedoninvestment=15%
Ke = Costofequitycapital=12%

0.15 0.15
3+ 53 × 3+2×
p= 0.12 = 0.12 = ` 45.83
0.12 0.12
(i) According to Walter’s model when the return on investment is more than the cost of equity
capital,thepricepershareincreasesasthedividendpayoutratiodecreases.Hence,theoptimum
dividendpayoutratio inthiscaseisnil.
So,atapayoutratioofzero,themarketvalueofthecompany’ssharewillbe:

0.15
0 + 5 0
(ii) 0.12 y `52.08
0.12

Chapter7  Dividend Decisions 183


NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 184
CHAPTER8
MANAGEMENT OF WORKING CAPITAL
UNIT I : INTRODUCTION TO WORKING CAPITAL

INTRODUCTION :
Inaccountingtermworkingcapitalisthedifferencebetweenthecurrentassetsandcurrentliabilities.Ifwe
breakdownthecomponentsofworkingcapitalwewillfoundworkingcapitalasfollows:
Working Capital = Current Assets – Current Liabilities
(a) Value : Fromthevalue pointofview,Working Capitalcanbedefined asGrossWorkingCapital orNet
Working Capital. Gross working capital refers to the firm’s investment in current assets. Net working
capitalreferstothedifferencebetweencurrentassetsandcurrentliabilities.Apositiveworkingcapital
indicates the company’s ability to pay its shortterm liabilities. On the other hand a negative working
capital showsinability of an entity tomeet itsshortterm liabilities.
(b) Time: From the point of view of time, workingcapital can be divided intotwocategories viz., Perma
nentandFluctuating(temporary).Permanentworkingcapitalreferstothebaseworkingcapital,which
istheminimumlevelofinvestmentinthecurrentassetsthatiscarriedbytheentityatalltimestocarry
itsdaytodayactivities.Temporaryworkingcapitalreferstothatpartoftotalworkingcapital,whichis
required by an entity in addition to the permanent working capital. It is also called variable working
capitalwhichisusedtofinancetheshorttermworkingcapitalrequirementswhicharisesduetofluc
tuation in sales volume.

DETERMINANTS OF WORKING CAPITAL


1. Cash – Identify the cash balance which allows for the business to meet daytoday expenses, but
reducescashholding costs.
2. Inventory–Identifythelevelofinventorywhichallowsforuninterruptedproductionbutreducesthe
investment in rawmaterialsandhence increasescashflow; the techniques like Just in Time (JIT) and
Economicorderquantity(EOQ)areusedforthis.
3. Receivables – Identify the appropriate credit policy, i.e., credit terms which will attract customers,
suchthatanyimpactoncashflowsandthecashconversioncyclewillbeoffsetbyincreasedrevenue
andhenceReturnonCapital(orviceversa).ThetoolslikeDiscountsandallowancesareusedforthis.
4. ShorttermFinancingOptions–Inventoryisideallyfinancedbycreditgrantedbythesupplier;dependent
onthecashconversioncycle,itmayhowever,benecessarytoutilizeabankloan(oroverdraft),orto
“convertdebtorsto cash”through“factoring”in ordertofinanceworkingcapitalrequirements.
5. NatureofBusinessFore.g.inabusinessofrestaurant,mostofthesalesareinCash.Thereforeneed
for working capital is very less. 6. Market and Demand Conditions  For e.g. if an item’s demand far
exceeds its production, the working capital requirement would be less as investment in finished
goods inventory would be very less.

Chapter8ManagementofWorkingCapital 187
7. TechnologyandManufacturingPoliciesFore.g.insomebusinessesthedemandforgoodsisseasonal,
inthatcaseabusinessmayfollowapolicyforsteadyproductionthroughoutoverthewholeyearor
instead may choosepolicy ofproduction only duringthe demand season. 8. OperatingEfficiency–A
company can reduce the working capital requirement by eliminating waste, improving coordination
etc.9.PriceLevelChanges–Fore.g.risingpricesnecessitatetheuseofmorefundsformaintainingan
existinglevelofactivity.Forthesamelevelofcurrentassets,highercashoutlaysarerequired.Therefore
theeffectofrisingpricesisthatahigheramountofworkingcapitalisrequired.

MANAGEMENT OF WORKING CAPITAL

Liquidity and Profitability


Foruninterruptedandsmoothfunctioningofthedaytodaybusinessofanentityitisimportanttomaintain
liquidity of funds evenly. As we have already learnt in previous chapters that each rupee of capital bears
somecost.So,whilemaintainingliquiditythecostaspectneedstobeborneinmind.Unnecessarytyingupof
funds in idleassets not  onlyreduces the liquidity but also reducing the opportunity toearn better return
from a productive asset. Hence, a tradeoff is required between the liquidity and profitability which in
creasestheprofitabilitywithoutdisturbingthedaytodayfunctioning.Thisrequires3Esasdiscussedabove
i.e. economy in financing, efficiency in utilisation and effectiveness in achieving the intended objectives.

Investment of working capital: Howmuchtobeinvestedincurrentassetsasworkingcapitalisamatterof


policydecisionbyanentity.Ithastobedecidedinthe lightoforganisationalobjectives,tradepoliciesand
financial (costbenefit) considerations.
Thereisnotsetrulesfordecidingthelevelofinvestmentinworkingcapital.Someorganisationsduetoits
peculiarity require more investment than others. For example, an infrastructure development company
requires more investment in its working capital as there may be huge inventory in the form of work in
process on the other hand a company which is engaged in fast food business, comparatively requires less
investment. Hence, level of investment depends on the various factors listed below:
(a) Nature of Industry: Constructioncompanies,breweriesetc.requireslargeinvestmentinworkingcapi
tal due long gestation period.
(b) Types of products: Consumerdurablehaslargeinventoryascomparedtoperishableproducts.
(c) Manufacturing Vs Trading Vs Service:Amanufacturingentityhastomaintainthreelevelsofinventory
i.e. raw material, workinprocess and finished goods whereas a trading and a service entity has to
maintain inventory only in the form of trading stock and consumables respectively.
(d) Volume of sales: Wherethesalesarehigh,thereisapossibilityofhighreceivablesaswell.
(e) Credit policy: Anentitywhosecreditpolicyisliberalhasnotonlyhighlevelofreceivablesbutrequires
morecapitaltofundrawmaterialpurchases.
Approaches of working capital investment
(a) Aggressive :Hereinvestmentinworkingcapitaliskeptatminimalinvestmentincurrentassetswhich

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 188
meanstheentitydoesholdlowerlevelofinventory,followstrictcreditpolicy,keepslesscashbalance
etc. The advantage of this approach is that lower level of fund is tied in the working capital which
results in lower financial costs but the flip side could be that the organisation couldnot grow which
leads to lower utilisation of fixed assets and long term debts. In the long run firm stay behind the
competitors.
(b) Conservative:Inthisapproachoforganisationusetoinvesthighcapitalincurrentassets.Organisations
usetokeep inventorylevel higher,followsliberalcreditpolicies,andcashbalanceashigh astomeet
any current liabilities immediately.
Theadvantageofthisapproacharehighersalesvolume,increaseddemandduetoliberalcreditpolicy
andincreasegoodwillamongthesuppliersduetopaymentinshorttime.Thedisadvantagesareincrease
costofcapital,higherriskofbaddebts,shortageofliquidityinlongruntolongeroperatingcycles.
(c) Moderate: This approach is in between the above two approaches. Under this approach a balance
betweentheriskandreturnismaintained togain morebyusingthefundsinvery efficientmanner.

Chapter8ManagementofWorkingCapital 189
CLASS WORK

Q1 ThefollowingannualfiguresrelatetoXYZCo.,
(`)
Sales(attwomonths’credit) 36,00,000
Materials consumed (suppliers extend two months’ credit) 9,00,000
Wagespaid(1monthlaginpayment) 7,20,000
Cashmanufacturing expenses (expenses are paidone month inarrear) 9,60,000
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000
Thecompanysellsitsproductsongrossproftof25%.Depreciationisconsideredasapartofthecostof
production.Itkeepsonemonth’sstockeachofrawmaterialsandfinishedgoods,andacashbalanceof
`1,00,000.
Assuminga20%safetymargin,workouttheworkingcapitalrequirementsofthecompanyoncashcost
basis. Ignore workinprocess.
Q2 Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a single shift
working with the followingcost structure:
Per unit (`)
CostofMaterials 6.00
Wages(outofwhich40%fixed) 5.00
Overheads (outofwhich80% fixed) 5.00
Proft 2.00
Selling Price 18.00
Salesduring201617–`4,32,000.
Asat31.3.2017thecompanyheld:

(`)
Stockofrawmaterials(atcost) 36,000
Workinprogress (valued at prime cost) 22,000
Finished goods (valuedattotalcost) 72,000
Sundry debtors 1,08,000
Inviewofincreasedmarketdemand,itisproposedtodoubleproductionbyworkinganextrashift.Itis
expected that a 10% discount will be available from suppliers of raw materials in view of increased
volume of business. Selling price will remain the same. The credit period allowed to customers will
remain unaltered. Credit availed of from suppliers will continue to remain at the present level i.e., 2
months.Laginpaymentofwagesandexpenseswillcontinuetoremainhalfamonth.
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 190
Youarerequiredtoassesstheadditionalworkingcapitalrequirements,ifthepolicytoincreaseoutputis
implemented.
Q3 X Ltd. sell goods at a gross profit of 20%. It includes depreciation as part of cost of production. The
following figures for the 12 months period ending 31st December, 2004 are given to enable you to
ascertaintherequirementsofworkingcapitalofthecompanyonacashcostbasis.
Inyourworking,youarerequiredtoassumethat:
(i) Asafetymarginof15%willbemaintained;
(ii) Cashistobeheldtotheextentof50%ofcurrentliabilities;
(iii) There will be no workinprogress;
(iv) Taxistobeignored.
Stocks ofrawmaterialsand finishedgoodare keptat onemonth’s requirements.
Allworkingsnotesaretoformpartofyouranswer.
`
Salesat2months’credit 27,00,000
Materialsconsumed(Suppliers,creditisfor2months) 6,75,000
Wages(paidatthebeginningofthenextmonth) 5,40,000
Manufacturingexpensesoutstandingattheendoftheyear
(Cashexpensesarepaidonemonthinarrear) 60,000
Total Administrative expenses (paid as above) 1,80,000
Sales promotion expenses (paid quarterly and in advance) 90,000
Q4 FollowingisthebalancesheetofXYZLtd.Calculatetheamountofmaximumpermissiblebankfinance
by all the three methods for working capital as per Tandon Committee norms. You are required to
assumethelevelofcorecurrentassetstobe`30lakhs.
Youarealsorequiredtocalculatethecurrentratiosundereachmethodandcomparethesamewiththe
currentratiosasrecommendedbytheCommittee,assumingthatthebankhasgrantedMPBF.
Balance sheet of XYZ Ltd.,
as on 31st March, 2004
(` in lakhs)
Liabilities Assets
EquityShares`10each 200 Fixed Assets 500
Retained earnings 200 Current Assets
11% Debentures 300 Inventory :
Public deposits 100 Raw Materials 100
Trade Creditors 80 W.I.P. 150
Bills Payable 100 Finished goods 75 225
Debtors 100
____ Cash/Bank 55 480
980 980

Chapter8ManagementofWorkingCapital 191
Q5 MarksLimitedislaunchinganewprojectforthemanufacturesofauniquecomponent.At100%capacity
24,000units,thecostwillbeasfollows:
Cost per unit `
Material 80
Labour and Variable Expenses 40
Fixed Manufacturing and Administrative Expenses 20
Depreciation 10
150
Thesellingpriceperisexpectedat`200andthesellingexpensesperunitwillbe`10,80%ofwhich
is variable.
Inthefirsttwoyearsproductionandsalesareexpectedtobeasfollows:
Year Production Sales
1 15,000units 14,000units
2 20,000units 18,000units
To assess working capital requirement, the following additional information is given:
(a) Stockofrawmaterial3month’sconsumption.
(b) WorkinprogressNil.
(c) Debtors1monthsales.
(d) Creditorsforsupplyofmaterials2monthspurchasesoftheyear.
(e) Creditorsforexpenses1month ofallexpensesduring theyear.
(f) Cashbalance`20,000.
Stockoffinishedgoodsistakenataveragecost.
Youarerequiredtoprepareforthetwoyears:
(1) A projected statement of profit/loss.
(2) A projected statement of working capital requirements.
Q6 BSLtd.hasbeenoperatingitsmanufacturingfacilitiestill31.3.2004onasingleshiftworkingwiththe
followingcoststructure:
Per unit
`
CostofMaterials 6.00
Wages (40% fixed) 5.00
Overheads (80% fixed) 5.00
Profit 2.00
Selling Price 18.00

Salesduring20032004`4,32,000.Asat31.3.04thecompanyheld:

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 192
`
Stockofrawmaterials(atcost) 36,000
Workinprogress (valued at prime cost) 22,000
Finished goods(valued attotalcost) 72,000
Sundry debtors 1,08,000
Inviewofincreasedmarketdemand,itisproposedtodoubleproductionbyworkinganextrashift.It
isexpectedthata10%discountwillbeavailablefromsuppliersofrawmaterialsinviewofincreased
volume of business. Selling price will remain the same. The credit period allowed to customers will
remain unaltered. Credit availed of from suppliers will continue to remain at the present level i.e. 2
months.Laginpaymentofwagesandexpenseswillcontinuetoremainhalfamonth.
Youarerequiredtoassesstheadditionalworkingcapitalrequirement,ifthepolicytoincreaseoutput
is implemented.
Q7 XYZ Co. Ltd. is a pipe manu facturing ring company. Its production cycle indicates that materials, are
introducedinthebeginningoftheproductioncycle;wagesandoverheadaccrueevenlythroughout
the period of the cycle. Wages are paid in the next month following the month of accrual. Work in
processincludesfullunitsofrawmaterialsusedinthebeginningoftheproductiorprocessand50%of
wages and overheads are supposed to be conversion costs Details of production process next the
componentsofworkingcapitalareasfollows:
Productionofpipes 12,00,000units
Durationoftheproductioncyclea One month
Raw materials inventory held One month consumption
Finished goods inventory held for Twomonths
Credit allowed lV creditors One month
Credit given to debtors Twoonths
Costpriceofrawmaterials `60perunit
Direct wages `10perunit
Overheads `20perUnit
Selling price of finished pipes `100perunit
Required to calculate :
(i) Theamountofworkingcapitalrequiredforthecompany.
(ii) Itsmaximum permissible bankfinanceunderallthethreemethodsoflending norms as
suggestedbytheTondonCornmtee,assumingthevalueofcorecurrentassets:`1,00,00,000.

Chapter8ManagementofWorkingCapital 193
Q8 Followingis the positionCurrentAssets andCurrent Liabilitiesof XLtd.
Current Assets
Stock
R.M. 200
 Workinprogress 20
 F.G. 90 310
Debtors 50
Other C.A. 10 370
Current Liabilities
Creditors (purchase) 110
Bank Borrowings 100
OtherC.L. 40 250
CalculateM.P.B.F.asperTandoncommitteenorms.(corecurrentassets:20)
Q9 The management of Gemini Ltd has called for a statement showing the working capital needed to
financealevelofactivityof3,00,000unitsofoutputfortheyear.Thecoststructureforthecompany’s
product, for the above mentioned activity level, is detailed below:
Cost per unit (`)
Raw materials 20
Direct labour 5
Overheads 15
Totalcost 40
Profit 10
Selling price 50
Pasttrendsindicatethattherawmaterialsareheldinstock,onanaverage,fortwomonths.
Workinprocess (50% complete) will approximate to halfamonth’s production.
Finishedgoodsremaininwarehouse,onanaverage,foramonth.
Suppliers of materialsextend amonth’s credit.Two month’scredit isnormally allowed to debtors.A
minimumcashbalanceof`25,000isexpectedtobemaintained.
Theproductionpatternisassumedtobeevenduringtheyear.
Prepare the statement of workingcapital determination.
Q10 Acompanyplanstomanufactureandsell400unitsofadomesticappliancepermonthatapriceof`
600each.Theratioofcoststosellingpriceareasfollows:(%ofsellingprice)
Raw materials 30%
Packing material 10%
Direct labour 15%
Direct expense 5%
Fixedoverheadsreestimatedat`4,32,000perannum.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 194
The Following are maintained for inventory management
Raw materials 30days
Packing material 15days
Finished goods 200units
Workinprogress 7days
Other particulars aregivenbelow:
(a) Creditsalesrepresent80%oftotalsalesandthedealersenjoy30workingdayscredit.
Balance20%arecashsales.
(b) Creditorsallow21workingdayscreditforpayment.
(c) Laginpaymentofoverheadsanddirectexpenseis15workingdays.
(d) Safetyrequirementstohe12%ofnetworkingcapital.
(e) Workingdaysinayeararetakenas300forbudgetingpurpose.
Preparea working capitalrequirement forecast forthe budgetyear.
Q11 Prepare a working capital forecast and the Projected Profit and Loss Account and the Balance Sheet
from the following information:
Issued share capital `50,10,000
6% Debenture `15,00,000
ThefixedAssetsarevaluedat`30,66,667.Productionduringthepreviousyearwas10lathunits.
Thesamelevdofactivityisintended tobemaintained duringthecurrentyear.
Theexpectedratiosofcosttosellingpriceare: (%)
Raw material 40
DirectWages 20
Overheads 20
Therawmaterialsordinarilyremaininstoresfor3monthsbeforeproduction.Everyunitofproduction
remains in the process for2 months. Finished goods remain in the warehouse for 3 months Credit
allowed by creditors is 4 months from the date of the delivery of raw material and ctedit given to
debtorsis3monthsfromthedateofdespatch.
Theestimatedbalanceofcashtobeheld`2,00,000Laginpaymentofwages½month
Laginpaymentofexpenses½month
Sellingpriceis`8perunit.Bothproductionandsalesareinaregularcycle.
You are required to make a provision o 10% for contingency. Relevant assumptions may be
made.[Units:10,00,000]
Q12 MNLtd.iscommencinganewprojectformanufactureofelectrictoys.Thefollowingcostinformation
hasbeenascertainedforannualproductionof60,000unitsatfullcapacity:

Chapter8ManagementofWorkingCapital 195
Ampount per unt
`
Raw materials 20
Direct labour 15
Manufacturing overheads :
`
Variable 15
Fixed 10 25

Selling and Distribution overheads :


`
Variable 3
Fixed 1 4
TotalCost 64
Profit 16
Selling 80
Inthefirstyearofoperationsexpectionsexpectedproductionandsalesare40,000unitsand35,000
units respectively. To assess the need of Working capital, the following additional information is
available :
(i) Stock of Raw materials.........................3 months consumption.
1
(ii) Credit allowable for debtors.......................1   months.
2
(iii) Credit allowable by creditors ...............4 months.
(iv) Lag in payment of wages ......................1 months.
1
(v) Lag in payment of overheads...................  months.
2
(vi) CashinhandandBankisexpectedto`60,000
(vii) Provision forcontingencies is projected @ 10% of Workingcapital requirement including that
provisions.
YouarerequiredtoprepareaprojectedstatementofWorkingcapitalrequirementforthefirstyear
ofoperations.Debtorsaretakenatcost.
Q13 AnewlyformedcompanyhasappliedtotheCommercialBankforthefirsttimeforfinancingitsworking
capital requirements. The following information is available about the projections for the current
year:
Per unit
Elements of cost: (`)
Raw material 40
Direct labour 15
Overhead 30
Totalcost 85
Profit 15
Sales 100

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 196
Other information:
Raw material in stock: average 4 weeks consumption, Work – in progress (completion stage, 50 per
cent),onanaveragehalfamonth.Finishedgoodsinstock:onanaverage,onemonth.
Credit allowed by suppliers is one month.
Creditallowedtodebtorsistwomonths.
Averagetimelaginpaymentofwagesis1½weeksand4weeksinoverheadexpenses.
Cashinhandandatbankisdesiredtobemaintainedat`50,000.
AllSales are oncreditbasisonly.
Required:
Prepare statementshowingestimate of working capital neededto finance an activitylevelof 96,000
unitsofproduction.Assume thatproductioniscarriedonevenlythroughouttheyear,andwagesand
overheadaccruesimilarly.Forthecalculationpurpose4weeksmaybetakenasequivalenttoamonth
and52weeksinayear
Q14 PQLtd.,acompanynewlycommencingbusinessin2013hastheundermentionedprojectedProfitand
Loss Account:
` `
Sales 2,10,000
Costofgoodssold 1,53,000
GrossProfit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit aftertax 20,000
Thecostofgoodssoldhasbeenarrivedatasunder:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less:StockofFinishedgoods
(10%ofgoodsproducednotyetsold) 17,000
1,53,000
Thefiguregivenaboverelateonlytofinishedgoodsandnottoworkinprogress.Goodsequalto15%
of the year’s production (in terms of physical units) will be in process on the average requiring full
materialsbutonly40%oftheotherexpenses.Thecompanybelievesinkeepingmaterialsequaltotwo
months’ consumption in stock.
Average timelag in payment of all expenses is I month. Suppliers of materials will extend 1 1/2
monthscredit.Saleswillbe20%forcashandtherestattwomonths’credit.70%oftheIncometaxwill
bepaidinadvanceinquarterlyinstalments.Thecompanywishestokeep`8,000incash.10%hastobe
added to the estimated figure for unforeseen contingencies. Prepare an estimate of workingcapital.
Note: Allworkingsshouldformpartoftheanswer.
Chapter8ManagementofWorkingCapital 197
LAST MINUTE REVISION (LMR)

1. Working • WorkingCapital Management involves managing the balance


Capital between firm’s shortterm assets and its shortterm liabilities.
Management • Fromthevaluepointofview,WorkingCapitalcanbedefinedas:
Gross Working Capital: Itreferstothefirm’sinvestmentincurrentassets.
Net Working Capital: Itreferstothedifferencebetweencurrentassetsand
current liabilities.
• Fromthepointofviewoftime,workingcapitalcanbedividedinto:
Permanent Working Capital: Itis thatminimumlevelofinvestmentinthe
currentassetsthatiscarriedbythebusinessatalltimestocarryoutminimum
level of its activities.
Temporary Working Capital: Itreferstothatpartoftotalworkingcapital,
whichisrequiredbyabusinessoverandabovepermanentworkingcapital.
2. FactorsToBe • Nature of business
Considered • Market conditions
While • Demand conditions
Planning For • Operating efficiency
Working • Credit policy
Capital
Requirement
3. Financemanagerhastopayparticularattentiontothelevelsofcurrentassets
andtheirfinancing.Todecidethelevelsandfinancingofcurrentassets,therisk
returntradeoffmustbetakenintoaccount.Indeterminingtheoptimumlevel
ofcurrentassets,thefirmshould balancetheprofitability–
Solvency tangle by minimizing total costs.
4. Working WorkingCapitalCycleindicatesthelengthoftimebetweenacompany’spaying
Capital Cycle formaterials,enteringintostock andreceivingthe cashfrom salesoffinished
goods.Itcanbedeterminedbyaddingthenumberofdaysrequiredforeach
stageinthecycle.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 198
5. Computation OperatingCycle=R+W+F+D–C
of Operating Where,
Cycle R=Rawmaterialstorageperiod
W = Workinprogress holding period
F=Finishedgoodsstorageperiod
D=Debtorscollectionperiod.
C=Creditperiodavailed.
Thevariouscomponentsofoperatingcyclemaybecalculatedasshownbelow:
• Raw materialstorage period

Averagestockofraw material
=
Averagecostofraw materialconsumptionperday

• Workinprogressholdingperiod

Averageworkinprogressinventory
=
Averagecostofproductionperday
• Finished goods storage period

Averagestockoffinishedgoods
=
Averagecostofgoodssoldperday

Averagebookdebts
• Debtorscollectionperiod=
AverageCreditSalesperday

Averagetradecreditors
• Creditperiodavailed=
Averagecreditpurchasesperday
6. Treasury Treasury management is defined as ‘the corporate handling of all financial
Management matters, the generation of externaland internal funds for business,the
managementofcurrenciesandcashflowsandthecomplex,strategies,policies
andprocedures ofcorporate finance”.
7. Management Itinvolvesefficientcashcollectionprocessandmanagingpaymentofcashboth
ofCash insidethe organisation and tothird parties.
Themainobjectivesofcashmanagementforabusinessare:
i. Provideadequatecashtoeachofitsunits;
ii. Nofundsareblockedinidlecash;and
Thesurpluscash(ifany)shouldbeinvestedinordertomaximizereturnsforthe
business.
8. Cash Budget CashBudgetisthemostsignificantdevicetoplanforandcontrolcashreceipts
andpayments.Thisrepresentscashrequirementsofbusinessduringthebudget
period.Thevariouspurposesofcashbudgetsare:
i. Coordinatethetimingsofcashneeds.Itidentifiestheperiod(s)whenthere
mighteitherbeshortageofcashoranabnormallylargecashrequirement;

Chapter8ManagementofWorkingCapital 199
ii. Italsohelpstopinpointperiod(s)whenthereislikelytobeexcesscash;
iii. Itenablesfirmwhichhassufficientcashtotakeadvantagelikecashdiscounts
on its accounts payable;
iv. Lastly it helps to plan/arrange adequately needed funds (avoiding excess/
shortageofcash)on favourableterms.
9. Preparation of TheCashBudgetcanbepreparedforshortperiodorforlongTheCashBudget
CashBudget canbepreparedforshortperiodorforlongperiod.
Cash budget for short period: Preparationofcashbudgetmonthbymonthwould
require the following estimates:
(a) As regards receipts:
• Receipts from debtors;
• CashSales; and
• Anyothersourceofreceiptsofcash(say,dividendfromasubsidiary
company)
(b) As regards payments:
• Paymentstobemadeforpurchases;
• Payments tobemade for expenses;
• Paymentsthataremadeperiodicallybutnoteverymonth;
(i) Debenture interest;
(ii) Incometaxpaidinadvance;
(iii) Salestax etc.
• Specialpaymentstobemadeinaparticularmonthforexample,
dividends to shareholders, redemption of debentures, repayments of
loan, payment of assets acquired,etc.
Cash Budget for long period: Longrangecashforecastoftenresemblethe
projected sources and application of funds statement. The following
proceduremaybeadoptedtopreparelongrangecashforecasts:
(i) Takethecashatbankandinthebeginningoftheyear:
(ii) Add:
(a) Trading profit (before tax) expected to be earned;
(b) Depreciation and other development expenses incurred to be
written off;
(c) Sale proceedsof assets’;
(d) Proceedsoffreshissueofsharesordebentures;and
(e) Reductioninworkingcapitalthatiscurrentassets(exceptcash)
less current liabilities.
(iii) Deduct:
(a) Dividends to be paid.
(b) Costofassetstobepurchased.
(c) Taxes to be paid.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 200
(d) Debentures or shares to be redeemed.
(e) Increase in working capital.
10. Cash Cash Management Models
Management WilliamJ.Baumol’sEconomicOrderQuantityModel,(1952): Accordingto
Models thismodel,optimumcashlevelisthatlevelofcashwherethecarryingcosts
andtransactionscostsaretheminimum.
Theformulafordeterminingoptimumcashbalanceis:

2U×P
C=
S
MillerOrr Cash Management Model (1966): Accordingtothismodelthenet
cash flow is completely stochastic.
Whenchangesincashbalanceoccurrandomlytheapplicationofcontroltheory
servesausefulpurpose.TheMillerOrrmodelisoneofsuchcontrollimitmodels.
11. Management of Managementofmarketablesecuritiesisanintegralpart ofinvestment of
Marketable cashasthismayserveboththepurposesofliquidityandcash,provided
Securities choiceofinvestmentismadecorrectly.Astheworkingcapital needsare
fluctuating,it ispossibletoparkexcessfundsin someshort termsecurities,
which canbe liquidated when need for cashis felt. Theselection ofsecurities
should be guided by three principles.
• Safety:Returnandrisksgohandinhand.Astheobjectiveinthisinvestment
is ensuring liquidity, minimum risk is the criterion of selection.
• Maturity: Matchingofmaturityandforecastedcashneedsisessential.Prices
oflongtermsecuritiesfluctuatemorewithchangesininterestratesandare
therefore, more risky.
• Marketability: Itreferstotheconvenience,speedandcostatwhicha
securitycanbeconvertedintocash.Ifthesecuritycanbesoldquickly
withoutloss oftimeandprice itishighlyliquidormarketable.
12. Inventory Inventory management covers a large number of problemsincluding fixation
Management ofminimumandmaximumlevels,determiningthesizeofinventorytobecarried,
deciding about theissues,receiptsand inspectionprocedures, determining the
economic order quantity, proper storage facilities, keeping check over
obsolescence and ensuring control over movement of inventories.
13. Management • Thebasicobjectiveofmanagementofsundrydebtorsistooptimisethe
of Receivables return on investment on these assets known as receivables.
• Largeamountsaretiedupinsundrydebtors,therearechancesofbaddebts
andtherewillbecostofcollectionofdebts.Onthecontrary,ifthe
investmentin sundry debtorsis low,the sales maybe restricted, since the
competitorsmayoffermoreliberalterms.Therefore,managementofsundry
debtorsisanimportantissueandrequires properpoliciesandtheir
implementation.
• Therearebasically threeaspectsofmanagementofsundrydebtors:

Chapter8ManagementofWorkingCapital 201
(i) Credit policy: Thecreditpolicyistobedetermined.Itinvolvesatrade
offbetweentheprofitsonadditionalsalesthatariseduetocredit
beingextendedontheonehandandthecostofcarryingthosedebtors
andbaddebtlossesontheother.Thisseekstodecidecreditperiod,
cashdiscountandother relevantmatters.
(ii) Credit Analysis: Thisrequiresthefinancemanagertodetermineasto
howriskyitistoadvancecredittoaparticularparty.
(iii) Control of Receivables: Thisrequiresfinancemanagertofollowup
debtorsanddecideaboutasuitablecreditcollectionpolicy.Itinvolves
both layingdown of creditpolicies and execution ofsuch policies.
• Important Sources of Financing of Receivables
(i) Pledging: Thisreferstotheuseofafirm’sreceivabletosecureashort
term loan.
(ii) Factoring: Infactoring,accountsreceivablesaregenerallysoldtoa
financialinstitution(asubsidiary ofcommercialbankcalled“Factor”),
whochargescommissionandbearsthecreditrisksassociatedwiththe
accounts receivables purchased by it.
14. Management • ManagementofPayablesinvolvesmanagementof creditors and suppliers.
of Payables • Tradecreditorisaspontaneoussourceoffinanceinthesensethatitarises
fromordinarybusinesstransaction.Butitisalsoimportanttolookafter
yourcreditorsslowpaymentbyyoumaycreateillfeelingandyoursupplies
couldbedisruptedandalsocreateabadimageforyourcompany.
• Creditorsareavitalpartofeffectivecashmanagementandshouldbe
managedcarefullytoenhance thecash position.
15. Financing of • Itis advisablethatthefinancemanagerbifurcatestheworkingcapital
Working requirementsbetweenpermanentworkingcapitalandtemporaryworking
Capital capital.
• The permanent working capital is always needed irrespective of sales
fluctuations,henceshouldbefinanced bythelongtermsourcessuch as
debtandequity.Onthecontrary,temporaryworkingcapitalmaybefinanced
bytheshortterm sourcesoffinance.
• Broadly speaking, the working capital finance may be classified between
the two categories:
(i) Spontaneous Sources: Spontaneoussourcesoffinancearethosewhich
naturallyariseinthecourseofbusinessoperations.Tradecredit,credit
fromemployees,creditfrom suppliersof services,etc.aresome of
theexampleswhichmaybequotedin thisrespect.
(ii) Negotiable Sources:Ontheotherhandthenegotiatedsources,asthe
nameimplies,arethosewhichhavetobespecificallynegotiatedwith
lenders say, commercial banks, financial institutions, general public
etc
‰

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 202
MULTIPLE CHOICE QUESTIONS

1. Thecredittermsmaybeexpressedas“3/15net60”.Thismeansthata3%discountwillbegrantedifthe
customerpayswithin15days,ifhedoesnotavailtheofferhemustmakepaymentwithin60days.
(a) I agree with the statement (b) Idonotagreewiththestatement
(c) Icannotsay.
2. Theterm‘net50’impliesthatthecustomerwillmakepayment.
(a) Exactlyon50thday (b) Before50thday
(c) Not later than 50th day (d) None ofthe above.
3. Tradecreditisasourceof:
(a) Longterm finance (b) Medium term finance
(c) Spontaneous source of finance (d) None ofthe above.
4. Thetermfloatisusedin
(a) Inventory Management (b) Receivable Management
(c) Cash Management (d) Marketable securities.
5. William J Baumol’s model of Cash Management determines optimum cash level where the carrying
costandtransactioncostare:
(a) Maximum (b) Minimum
(c) Medium (d) None ofthe above.
6. InMillerORRModelofCashManagement:
(a) The lower, upper limit, and return point of Cash Balances are set out
(b) Onlyupperlimit and return pointaredecided
(c) Onlylowerlimit and return point aredecided
(d) Noneoftheabovearedecided.
7. WorkingCapital isdefined as
(a) Excess of current assets over current liabilities
(b) Excess of current liabilities over current assets
(c) Excess of Fixed Assets over longterm liabilities
(d) None oftheabove.
8. Working Capital is also known as “Circulating Capital, fluctuating Capital and revolving capital”. The
aforesaidstatement is;
(a) Correct (b) Incorrect
(c) Cannotsay.

Chapter8ManagementofWorkingCapital 203
9. ThebasicobjectivesofWorkingCapitalManagementare:
(a) Optimum utilization of resources for profitability
(b) To meet daytoday current obligations
(c) Ensuringmarginalreturnoncurrentassetsisalwaysmorethancostofcapital
(d) Selectanyoneoftheabove statement.
10. ThetermGrossWorkingCapitalisknownas:
(a) The investment in current liabilities
(b) The investment in longterm liability
(c) The investment in current assets
(d) None ofthe above.
11. The term net working capital refers to the difference between the current assets minus current
liabilities.
(a) The statement is correct (b) Thestatementisincorrect
(c) Icannotsay.
12. Theterm“Corecurrentassets’wascoinedby
(a) Chore Committee (b) Tandon Committee
(c) Jilani Committee (d) None ofthe above.
13. Theconceptoperatingcyclereferstotheaveragetimewhichelapsesbetweentheacquisitionofraw
materials andthe finalcash realization. Thisstatement is
(a) Correct (b) Incorrect
(c) Partially True (d) Icannotsay.
14. Asamatterofselfimposedfinancialdisciplinecantherebeasituationofzeroworking capital now-
a-days in some of the professionally managed organizations.
(a) Yes (b) No
(c) Impossible (d) Cannotsay.
15. Overtradingariseswhen abusiness expandsbeyondthe level offundsavailable. Thestatement is
(a) Incorrect (b) Correct
(c) Partially correct (d) Icannotsay.
16. A ConservativeWorkingCapitalstrategycalls forhigh levelsof current assetsinrelation to sales.
(a) I agree (b) Donotagree
(c) Icannotsay.
17. The term Working Capital leverage refer to the impact of level of working capital on company’s
profitability. This measures the responsiveness of ROCE for changes in current assets.
(a) I agree (b) Donotagree
(c) Thestatement ispartially true.
18. The term spontaneous source of finance refers to the finance which naturally arise in the course of
business operations. The statement is
(a) Correct (b) Incorrect
(c) Partially Correct (d) Icannotsay.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 204
19. Under hedging approach to financing of working capital requirements of a firm, each asset in the
balancesheetassetssidewouldbeoffsetwithafinancinginstrumentofthesameapproximatematurity.
This statement is
(a) Incorrect (b) Correct
(c) Partially correct (d) Icannotsay.
20. Tradecreditisa
(a) Negotiated source of finance (b) Hybrid source of finance
(c) Spontaneous source of finance (d) None ofthe above.
21. Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial
institution. The statement is
(a) Correct (b) Incorrect
(c) Partially correct (d) Icannotsay.
22. Afactoringarrangementcanbebothwithrecourseaswellaswithoutrecourse:
(a) True (b) False
(c) Partially correct (d) Cannotsay.
23. TheBank financingof workingcapital will generally be in the following form.Cash Credit, Overdraft,
bills discounting, billsacceptance, lineof credit;Letter ofcredit andbank guarantee.
(a) I agree (b) I do not agree
(c) Icannotsay.
24. Whentheitemsofinventoryareclassifiedaccordingtovalueofusage,thetechniqueisknownas:
(a) XYZ Analysis (b) ABC Analysis
(c) DEF Analysis (d) None ofthe above.
25. WhenafirmadvisesitscustomerstomailtheirpaymentstospecialPostOfficecollectioncenters,the
systemisknownas.
(a) Concentration banking (b) Lock Box system
(c) Playing the float (d) None ofthe above.

THEORETICAL QUESTIONS
1. Discuss the factors to be taken into consideration while determining the requirement of working
capital.
2. Discuss the liquidityvs. profitability issue in management of working capital.
3. Discusstheestimationofworkingcapital needbased on operatingcycleprocess.
4. Explain briefly the functions of Treasury Department.
5. ExplainBaumol’s Model of CashManagement.
6. Statethe advantageofElectronicCashManagementSystem.
7. Explainwith example the formulaused for determining optimumcash balance accordingtoBaumol’s
cash management model.
8. Discuss MillerOrr Cash Management model.
9. Explain briefly the accounts receivable systems.
10. WriteshortnoteonFactoring.
11. Enumeratethevariousformsofbankcreditinfinancingtheworkingcapitalofabusinessorganization.

Chapter8ManagementofWorkingCapital 205
HOME WORK

Q15 Afrmhasthefollowingdatafortheyearending31stMarch,2017:
(`)
Sales(1,00,000@`20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000
Thethree possiblecurrent assetsholdingsof the frm are `5,00,000, `4,00,000 and ` 3,00,000.It is
assumedthat fixedassets levelisconstant andprofits donot varywithcurrent assetslevels.So,the
effect of the three alternative current assets policies.
Hints :
Effect of Alternative Working Capital Policies
Working Capital Policy Conservative(`) Moderate(`) Aggressive(`)
Sales 20,00,000 20,00,000 20,00,000
Earnings before Interest and Taxes (EBIT) 2,00,000 2,00,000 2,00,000
Current Assets 5,00,000 4,00,000 3,00,000
Fixed Assets 5,00,000 5,00,000 5,00,000
Total Assets 10,00,000 9,00,000 8,00,000
ReturnonTotalAssets(EBIT÷TotalAssets) 20% 22.22% 25%
Current Assets/Fixed Assets 1.00 0.80 0.60
The aforesaid calculation shows that the conservative policy provides greater liquidity (solvency)
to the frm, but lower return on total assets.On the other hand,the aggressive policy gives higher
return, but low liquidity and thus is very risky. The moderate policy generates return higher than
Conservative policy but lower than aggressive policy.
Thisisless riskythan aggressivepolicybut riskier than conservative policy.
Indeterminingtheoptimumlevelofcurrentassets,thefirmshouldbalancetheprofitability–solvency
tanglebyminimizingtotalcosts– Costofliquidity and costofilliquidity.
Q16 FromthefollowinginformationofXYZLtd.,youarerequiredtocalculate:
(a) Net operating cycle period.
(b) Numberofoperatingcyclesinayear.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 206
(`)
(i) Rawmaterial inventoryconsumedduringtheyear 6,00,000
(ii) Averagestockofrawmaterial 50,000
(iii) Workinprogress inventory 5,00,000
(iv) Average workinprogress inventory 30,000
(v) Finished goods inventory 8,00,000
(vi) Average finished goods stock held 40,000
(vii) Average collection period from debtors 45days
(viii) Average credit period availed 30days
(ix) No.ofdaysinayear 360days
Hints :
NetOperatingCycle=R+W+F+D–C=30+22+18+45–30=85days

Q17 Whilepreparingaprojectreportonbehalfofaclientyouhavecollectedthefollowingfacts.
Estimatethenetworkingcapitalrequiredfortheproject.Add10%toyourcomputedfiguretoallow
for contingencies.
Amount per unit
(` )
Estimatedcostperunitofproduction
Raw material 80
Direct labour 30
Overheads (including depreciation ` 5) 65
Total cost 175
Additional information
Selling price `200perunit
Level of activity 1,04,000unitsofproductionperannum
Rawmaterialinstock average 4 weeks
Workinprogress(assumefullunitofraw
material required in the beginning
ofmanufacturing;otherconversioncostsare50%) average 2weeks
Finishing goods in stock average 4 weeks
Credit allowed by suppliers average 4 weeks
Credit allowed to debtors average 8 weeks
Laginpaymentofwages average1.5 weeks
Cashin bank (desired to be maintained) `25,000
Youmayassumethattheproductioniscarriedonevenlythroughouttheyear(52weeks)andwages/
overheadsaccruesimilarly.Allsalesareon acreditbasisonly.

Chapter8ManagementofWorkingCapital 207
Hints :
Current assets=53,25,000; Current Liabilities= 7,30,000; Networking capital= 45,95,000;Totalworking
capital = 50,45,500.
Q18 PrepareanestimateofnetworkingcapitalrequirementfortheWCMLtd.adding10%for
contingencies from the information given below:
Estimatedcostperunitofproduction`170includesrawmaterials`80,directlabour`30andoverheads
(exclusiveof depreciation) ` 60. Selling price is ` 200 per unit. Level of activity per annum 1,04,000
units. Raw material in stock : Average 4 weeks ; workinprogress (assume 50% completion stage) :
average2 weeks ; finished goods in stock: average4weeks ; credit allowed by suppliers ; average 4
weeks;creditallowedtodebtors:average8weeks;laginpaymentofwages:average1.5weeks,and
cashatbankisexpectedtobe`25,000.Youmayassumethatproductioniscarriedonevenlythroughout
the year (52 weeks) and wages and overheads accrue similarly. As sales are on credit basis only. You
may state your assumptions, if any.

Hints :
CurrentAssets=55,65,000;CurrentLiabilities=7,30,000;NetWorkingCapital48,35,000;TotalWorking
Capital=53,18,500
Q19 Determine the working capital requirements from the following particulars. Annual budget figures
for:
` lakhs
Raw Materials 360
Suppliers and Components 120
Manpower 240
Factory Expenses 60
Administration 90
Sales 1,190
 You are given the followingadditional information:
(1) Stocklevels planned:
Raw Materials 30days
Supplies and components 90days
(2) 50%ofthesalesisforcash;fortheremaining,20dayscreditisnormal.
(3) Finishedgoodsareheldinstockforaperiodofsevendaysbeforetheyreleasedforsale.
(4) Goodsremaininprocessfor5days.
(5) Thecompanyenjoys30dayscreditfacilitieson20%ofthepurchase.
(6) Cash/Bankbalanceshadbeen plannedtobe keptat therateofhalfmonthsbudgetedexpenses.
(1yr=360Days)
Hints :
Net Amount of Working Capital required 125.12

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 208
Q20 From the following details, prepare the working capital requirement forecast:
Productionduringthepreviousyearwas1,20,000units.Itisplannedthatthislevelofactivitywouldbe
maintained during the present year. The expected ratios of the cost to selling prices are, raw materials
60%,directwages10%,overheads20%.Rawmaterialsareexpectedtoremaininstoreforanaverageof
2 months before issueto production.Each unit is expected to beinprocess forone month, the raw
materials beingfedintothepipelineimmediatelyandthelabourandoverheadcostsaccruingevenly
during the month. Finished goods will stay in the warehouse awaiting despatch to customers for
approximately 3 months. Credit allowed by creditors is 2 months from the date of delivery of raw
materials. Credit allowed to debtors is 3 months from the date of despatch. Selling price is ` 5/ per
unit. Thereis a regularproductionand salescycle.Wagesandoverheads arepaidon the1stofeach
monthforthepreviousmonth.Thecompanynormallykeepscashinhandtotheextentof`40,000.
Hints :
CurrentAssets=4,22,500;Current Liabilities =75,000;WorkingCapitalRequirement=3,47,500
Q21 FoodsLtd.ispresentlyoperatingat60%levelproducing36,000packetsofsnackfoodsandproposes
toincreasecapacityutilizationinthecomingyearby331/3%overtheexistinglevelofproduction.
The following data has been supplied:
(i) Unitcoststructureoftheproductatcurrentlevel:
`
RawMaterial 4
Wages (Variable) 2
Overheads (Variable) 2
Fixed Overheads 1
Profit 3
Selling Price 12

(ii) Rawmaterialswillremaininstoresfor1monthbeforebeingissuedforproduction.Materialwill
remaininprocessforfurther1month.Suppliersgrant3monthscredittothecompany.
(iii) Finishedgoodsremainingodownfor1month.
(iv) Debtorsareallowedcreditfor2months.
(v) Lag in wages and overhead payments is I month and these expenses accrue evenly throughout
the production cycle.
(vi) Noincreaseeitherincostofinputsorsellingprice isenvisaged.
Prepare a projected profitability statement and the working capital requirement at the new level,
assumingthataminimumcashbalanceof`19,500hastobemaintained.
Hints :

Chapter8ManagementofWorkingCapital 209
Foods Limited
PROJECFEDPROFITABILITYSTATEMENTAT80%CAPACITY
Output 80x36,000/60 =48,000packets
A. Cost of Sales: `
RawMaterial `4x48,000 =1,92,000
Wages `2x48,000 =96,000
Overhead (Variable)`2x48,000 =96,000
Overhead Fixed `1x36,000 =36,000
4,20,000
B. Profit `3.25x48,000 =1,56,000
C. Sales Value `12x48,000 =5,76,000
PROJECTED STATEMENT OF WORKING CAPITAL AT 80% CAPACITY.
Current Assets: ` `
RawMaterial (4x48,000/12) 16,000
Worki nprocess
Materials (48,000x4x1/12) 16,000
Wages (48,000x2x1/24) 4,000
VariableOverheads (48,000x2x1/24) 4,000
FixedOverheads (48,000x0.75x1/24) 1,500 25,500
Finished Goods (48,000x8.75x1/12) 35,000
76,500
Sundry Debtors 96,000
1,72,500
CashBalance 19,500 1,92,000(A)
Less: Current Liabilities:
CreditorsforGoods (48,000x4x3/12) 48,000
CreditorsforExpenses (48,000x4.75x1/12) 19,000 67,000(B)
NetWorkingCapital(A)(B) 1,25,000
Working Notes :
(1) STATEMENTOFCOSTOFSALES
Particulars Per annum Per month
` `
RawMaterial 1,92,000 16,000
Wages 96,000 8,000
Overhead (Variable) 96,000 8,000
Overhead (Fixed) 36,000 3,000
4,20,000 35,000
Profit 1,56,000 13,000
Sales Value 5,76,000 48,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 210
(2) Thewages andoverheads paymentsaccrueevenly.Henceitisassumedthattheywill beinprocess
forhalfamonthonanaverage.
(3) FixedOverheadsperunitamountto=`36,000/48,000=Re.075.
Q22 FromthefollowinginformationofXYZLtd.
Calculate:
(i) Net operating cycle period.
(ii) Numberofoperatingcyclesinayear.
`
1. Rawmaterial inventoryconsumedduringtheyear 6,00,000
2. Averagestockofrawmaterial 50,000
3. Workinprogress inventory 5,00,000
4. Average workinprogress inventory 30,000
5. Finished goods inventory 8,00,000
6. Average finished goods stock held 40,000
7. Average collection period from debtors 45days
8. Average credit period availed 30days
9. Noofdaysinayear 360days
Solution
Calculation of Net Operating Cycle period of XYZ Ltd.
Days
Rawmaterialstorageperiod:(a)30
Averagestockofrawmaterial
Averagecostofrawmaterialconsumptionperday
(`50,000/1667*)
*(`6,00,000/360days)
W.I.Pholdingperiod:(b) 22
(Averagework in progressinventory
Averagecostofproductionperday
(`30,000/1,388)**
**(`5,00,000/360days)
Finished goods storageperiod : (c) 18
Averagestockoffinishedgoods
Averagecostofgoodssoldperday
(`40,000/2,222)*** ***(`)
8,00,000/360days)
Debtors collection period: (d) 45
Total operating cycle period: 115
[(a)+(b)+(c)+(d)]
Less: Average credit period availed 30
(i) Net operating cycle period 85
(ii)Numberofoperatingcyclesinayear 4.2
(360days/85days)

Chapter8ManagementofWorkingCapital 211
Q23 TheCalgaryCompanyisattemptingtoestablishacurrentassetspolicy.Fixedassetsare`6lakhsand
the firm plans to maintain a 50% debttoassets ratio. The interest rate is 10% on all debts. Three
alternativecurrentassetspoliciesareunderconsideration40%,50%and60%ofprojectedsales.The
company expectstoearn 15% before interest and taxeson salesof ` 30lakhs. Calgary’s effective tax
rateis40%.Whatistheexpectedreturnonequityundereachalternative?
Solution
The Calgary Company
Alternative Balance Sheets
 (`)
Particulars Restricted Policy Moderate Policy Relaxed Policy
(40% of sales) (50% of sales) (60% of sales)
Current assets 12,00,000 15,00,000 18,00,000
Fixed Assets 6,00,000 6,00,000 6,00,000
Total assets 18,00,000 21,00,000 24,00,000
10%Debt(50%oftotalassets) 9,00,000 10,50,000 12,00,000
Equity 9,00,000 10,50,000 12,00,000
Total claims 18,00,000 21,00,000 24,00,000
Alternative Income Statement
(` )
Particulars Restricted Policy Moderate Policy Relaxed Policy
(Aggressive) (Conservative)
Sales 30,00,000 30,00,000 30,00,000
EBIT(15%ofsales) 4,50,000 4,50,000 4,50,000
Interest (10%)
Earnings Before 90,000 1,05,000 1,20,000
Taxes ` 3,60,000 3,45,000 3,30,000
Taxes (40%) 1,44,000 1,38,000 1,32,000
Net Income 2,16,000 2,07,000 1,98,000
Returnonequity(ROE)

` 2,16, 000
=` x100 24% 19.71% 16.5%
` 9, 00,000

Q24 On April 1 of the current year, the board of directors of Dowell Ltd wishes to know the amount of
workingcapitalthatwillberequiredtomeettheprogrammeofactivitytheyhaveplannedfortheyear.
The following information is available:
(i) Issuedandpaidupcapital,`2,00,000.
(ii) 5%Debentures(securedonassets),`50,000.
(iii) Fixedassetsvaluedat`1,25,000onMarch31ofthepreviousyear.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 212
(iv) Productionduringthepreviousyearwas60,000units;itisplannedthatthislevelofactivityshould
be maintained during the present year.
(v) Theexpectedratiosofcosttosellingpricearerawmaterials60percent,directwages10percent
andoverheads20percent.
(vi) Rawmaterialsareexpectedtoremaininstoreforanaverageoftwomonthsbeforetheseareissued
for production.
(vii) Each unit of production is expected to be in process for one month. Full unit of raw materials is
required in the beginning of production.
(viii) Finished goods will stay in warehouse for approximately three months.
(ix) Creditorsallowcreditfor2monthsfromthedateofdeliveryofrawmaterials.
(x) Creditallowedtodebtorsis3monthsfromthedateofdispatch.
(xi) Sellingpriceperunitis`5.
(xii) Thereisaregularproductionandsalescycle.
Prepare:
(a) working capital requirement forecast; and
(b) anestimatedprofitandlossaccountandbalancesheetattheendoftheyear.
Solution
(a) ForecastofworkingcapitalofDowellLtd
(A) Current assets:
(i) Rawmaterials(60,000x`3x2/12) `30,000
(ii) Workinprocess(60,000x`3.75x1/12) 18,750
(`3materialcost+50percentofwagesand
overheads i.e., ` 1.5)
 (iii) Finishedgoods(60,000x`4.5x3/12) 67,500
(iv) Debtors(60,000x`5x3/12) 75,000
Totalcurrentassets 1,91,250
(B) Currentliabilities:Creditors(60,000x`3x2/12) 30,000
(C) Networkingcapital(AB) 1,61,250

(b) Projectedprofitandlossaccountofthecurrentyear
Salesrevenue(60,000x`5)
`3,00,000
Lesscostofsales:
Rawmaterial(0.60x`3,00,000) ` 1,80,000
Directwages(0.10x`3,00,000) 30,000
Overheads(0.20x`3,00,000) 60,000
2,70,000
Lessinterest(`50,000x0.05) 2,500
Profit 27,500

Chapter8ManagementofWorkingCapital 213
Projected balance sheet at the end of March 31, current year
Liabilities Assets
Share capital `2,00,000 Fixed assets `1,25,000
Reserves & surplus: Current assets:
Profitofthecurrentyear 27,500 Raw material 30,000
Profit & lossA/c(balancing figure) 8,750 Workinprogress 18,750
5% Debentures 50,000 Finished goods 67,500
Creditors 30,000 Debtors at selling price
________ (15,000unitsx`5) 75,000
3,16,250 3,16,250
Q25 ThefollowinginformationhasbeenextractedfromtherecordsofaCompany:
Productcastsheet `/unit
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
— Rawmaterialsareinstockonanaverageoftwomonths.
— Thematerialsareinprocessonanaveragefor4weeks.Thedegreeofcompletionis50%.
— Finishedgoodsstockonanaverageisforonemonth.
— Timelaginpaymentofwagesandoverheadsis11/2weeks.
— Timelaginreceiptofproceedsfromdebtorsis2months.
— Credit allowed by suppliers is one month.
— 20%oftheoutputissoldagainstcash.
— ThecompanyexpectstokeepaCashbalanceof`1,00,000.
— Take52weeksperannum.
TheCompanyispoisedforamanufactureof1,44,000unitsintheyear.
Youarerequired topreparea statementshowingthe WorkingCapitalrequirementsof theCompany.
[Adapted C.A.  Nov.02]

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 214
Solution
Statement showing the Working Capital
requirement of the Company
A. Current Assets : `
Stockofrawmaterials 10,80,000
(`64,80,000/12months)x2months
Workinprogress 5,81,538
[(`1,51,20,000x4)/52months]x50%
Finished goods 12,60,000
(`1,51,20,000/12months)
Debtors 23,04,000
(`28,80,000x80%)
(Refertoworkingnote2)
Cash balances 1,00,000
53,25,538
Current Liabilities :
Creditorsof raw materials 5,40,000
(`64,80,000/12months)
Creditorsforwages&overheads 2,49,231
(`86,40,000x1.5weeks) 7,89,231
weeks ________
NetWorkingCapital (C.A—C.L) 45,36,307
Working notes :
1. Annual raw materials requirements (`) 64,80,000
1,44,000unitsx`45
Annual direct labour cost (`) 28,80,000
1,44,000unitsx`20
Annual overhead costs (`) 57,60,000
1,44,000unitsx`40 _________
Total cost (`) 1,51,20,000
2. Total sales: 1,72,80,000
1,44,000unitsx`120
Two months sales 28,80,000
(`1,72,80,000/6months)

Chapter8ManagementofWorkingCapital 215
Q26 Thefollowing annualfiguresrelate toMNPLimited:
Sales (at threemonthscredit) `90,00,000
Materials consumed (suppliers extend one `22,50,000
and half month’s credit)
Wages(paidonemonthinarrear) `18,00,000
Manufacturingexpensesoutstandingatthe endoftheyear(cash `2,00,000
expensesarepaidonemonthinarrear)
Total Administrative expenses for the year `6,00,000
(cashexpensesarepaidonemonthinarrear)
Sales Promotion expenses for the year `12,00,000
(paid quarterly in advance)
The company sells its products on grossprofit of 25% assuming depreciation as a part of cost of
production. It keeps two month’s stock of finished goods and one month’s stock of raw materials as
inventory.Itkeepscashbalanceof`2,50,000.
Assumea5%safetymargin,workouttheworkingcapitalrequirementsofthecompanyoncashcost
basis. Ignore workinprogress.
[May04]
Solution
Computationoftotalcashcost:
` `
Sales 90,00,000
Less:Grossprofit 22,50,000
(25%x salesrevenue)
Total manufacturing cost (A) 67,50,000
Less: Material consumedcost 22,50,000
Less: Wages paid 18,00,000 40,50,000
Manufacturing expenses 27,00,000
Less: Cash manufacturing expenses 24,00,000
(`2,00,000x12)
Depreciation: (B) 3,00,000
Totalmanufacturingcost:(C)=(A)—(B) 64,50,000
Add: Administrative expenses 6,00,000
Add: Sales promotion expenses 12,00,000
Totalcashcostofmanufacturingandsales 82,50,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 216
Estimation of Current Assets
`
Debtors 20,62,500
(Totalcashcostx3/12)or
(`82,50,000x3/12)
Cashbalance 2,50,000
Prepaid sales promotion expenses 3,00,000
Rawmaterialsstock 1,87,500
(Materialconsumed!12)or
(`22,50,000/12)
Finished goods stock 10,75,000
(Totalcashcostx2/12)or
(`67,50,000x2/12) ________
Total Current Assets 38,75,000
Estimation of Current Liabilities:
Sundry creditors 2,81,250
Material cost
(`22,50,000x1.5months/12months)
Manufacturing expenses outstanding 2,00,000
Wages outstanding 1,50,000
(`18,00,000x1/12months)
Administrative expenses outstanding 50,000
(`6,00,000x1month/12months) ______
Total Current Liabilities 6,81,250
Workingcapitalrequirements:(CA—CL) 31,93,750
(Oncashcostbasis)
Q27 Anengineeringcompanyisconsideringitsworkingcapitalinvestmentfortheyear200304.
Theestimatedfixedassetsandcurrentliabilitiesforthenext yearare `6.63croreand`5.967crore
respectively. The sales and earnings before interest and taxes (EBIT) depend  on investment in its
current assets panticularly inventoiy and receivables. The company is  examining the following
alternative working capital policies:
Working Capital Investment in Estimated EBIT
Policy Current Assets Sales
(` Crore) (` Crore) (` Crore)
Conservative 11.475 31.365 3.1365
Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55

Chapter8ManagementofWorkingCapital 217
You arerequired to calculatethefollowing foreach policy:
(i) Rateofreturnontotalassets.
(ii) Net working capital position.
(iii) Currentassetsto fixed assets ratio.
(iv) Discusstheriskreturn tradeoffofeachworkingcapitalpolicy.
Solution
Basic data :
(`inCrores)
Working Capital Investment Policy
Conservative Moderate Aggressive
1. Current assets 11.475 9.945 6.630
2. Fixed assets 6.630 6.630 6.630
3. Total assets 18.105 16.575 13.26
4. Current liabilities 5.967 5.967 5967
5. Estimated sales 31.365 29325 25.50
6. Estimated EBIT 3.1365 2.9325 2.55
7. Currentratio[(1)/(4)] 1.92 1.67 1.11
Computation of following for each policy :
(i) Rateofreturnontotalassets(in 17.32 1769 19.23
percentages):
[(6)/(3)]x100
(ii) Networkingcapitalposition:(incrores) 5.508 3.978 0.663
[(1)—(4)]
(iii) Currentassetstofixed assetsratio: 1.73 1.50 1.00
[(1)/(2)]
(iv) Risk return trade off.

Thenetworkingcapitalorcurrentratioisameasureofrisk.Rateofreturnontotalassetsisa

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 218
UNIT II : CASH MANAGEMENT

INTRODUCTION

Inthischapterwearegoingtolearn:
A. PreparationofCash Budget.
B. ConceptofFloatperiod,LockBoxSystemandConcentrationBanking.
C. CashManagementModels;viz.Baumol’sModelandMillerOrrModel.

UNITII:CASHMANAGEMENT 219
CLASS WORK
CASH BUDGET
 Asapartofshorttermplanning,usuallyonmonthlybasis,cashbudgetispreparedbasedonexpected
receipt and payment basis.
 Suppose cash budget is prepared on monthly basis, from January to June, in that expected closing
balanceisnegativeforthemonthofMarch.ItindicatesthatexpectedopeningbalanceofMarchand
receiptofMarchareinsufficienttomakepaymentswhicharebecomingdueinMarchmonth.Inthis
situation, thecompany can prepone anyreceiptor postpone any payment,if possible. If neither of
adjustmentispossiblethenitmayborrowfundstomeetwithexpectedshortfall.Forplannedborrowing
thecompanycangetlowerrateofinterest.
 Whencashbudgetispreparedthenitmayhaveexcesscashbalanceincomparisontorequirementof
funds in the business. In that case the company can invest excess funds to earn interest income or
otherwisethecompanycanmakeearlypaymenttosupplerinordertogetadvantageofcashdiscount.
 Forcashbudgetpreparation,wewilltakeintoaccount,alltransactionsaffectingcash.Itincludes
 CashSales,CashPurchase
 Collection from Debtors, Payment to creditors
 Paymentof salary,Wages andsuch otherexpenses.
 Purchase, Sale of Fixed Assets.
 Issue, redemption of securities.
So,wecansaythatalltransactionsaffectingcashwillhavetobeconsidered.Wewillignore
 Depreciation
 Lossorgainonsaleofanyasset.
 Preliminaryexpenseswrittenoffandsuchitemswhichdonotaffectcash.
 Usuallyworkingnotesarerequiredtobepreparedforanyinformationprovidedindirectly.Cashbudget
ispreparedforinternalplanningofthecompany,sonoformatisrequiredtobefollowedinpreparation
ofcashbudget.Simplyitwillbeinatabularformat,inwhichreceiptsandpaymentswillbeshown.
Q1 The following information relates to Zeta Limited, a publishing company:
Thesellingpriceofabookis`15,andsalesaremadeoncreditthroughabookclubandinvoicedonthe
lastdayofthemonth.
Variable costs of production per book are materials (` 5), labour (` 4), and overhead (` 2) The sales
manager has forecasted the following volumes:
Month No. of Books
Dec 1,000
Jan 1,000
Feb 1,250
Mar 1,500
Apr 2,000
May 1,900
Jun 2,200
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 220
Customersareexpectedtopayasfollows:
Onemonthafterthesale 40%
Twomonthafterthesale 60%
TheCompanyproducesthebooktwomonthsbeforetheyaresoldandthecreditorsformaterialsare
paidtwomonthsafterproduction.
Variableoverheadsarepaidinthemonthfollowingproductionandareexpectedtoincreaseby25%in
April; 75% of wages are paid in the month of production and 25% in the following month. A wage
increaseof12.5%willtakeplaceon1stMarch.
Thecompany’scoporatetaxofRs.10,000isdueforPaymentinMarch.
The company is going through a restructuring and will sell one of it’s freehold properties in April for
`25,000,butitisalsoplanningtobuyanewprintingpressinAprilforRs.10,000.
Depreciationiscurrently`1,000permonth,andwillriseto`1,500afterthepurchaseofmachinery.
CashBalanceofthecompanyisRs.3,200onFirstFeb.
YouarerequiredtoprepareacashbudgetforthethreemonthsfromFebruarytoApril.
Q2 ConsiderthebalancesheetofMayaLimitedatDecember31(inthousands).
The company has received a large order and anticipates the need to go to its bank to increase its
borrowings.Asaresult,ithastoforecastitscashrequirementsforJanuary,FebruaryandMarch.Typically,
thecompanycollects20percentofitssalesinthemonthofsale,70percentinthesubsequentmonth,
and10percentinthesecondmonthafterthesale.Allsalesarecreditsales.
` `
Cash 50  Accountspayable 360
Accounts receivable 530 Bankloan 400
Inventories 545 Accruals 212
Net fixed assets 1,836 Longtermdebt 450
Commonstock 100
_____ Retained earnings 1,439
Total assets 2,961 Total liabilities and equity 2,961
Purchasesofrawmaterialsaremadeinthemonthpriortothesaleandamountto60percentofsales
inthesubsequentmonth.Paymentsforthesepurchasesoccurinthemonthafterthepurchase.Labour
costs,includingovertime,areexpectedtobe`1,50,000inJanuary,`2,00,000inFebruary,and`1,60,000
in March. Selling, administrative, taxes, and other cash expenses are expected to be ` 1,00,000 per
month for January through March. Actual sales in November and December and projected sales for
JanuarythroughAprilareasfollows(inthousands):
` ` `
November 500 January 600 March 650
December 600 February 1,000 April 750
Onthebasisofthisinformation:
(a) PrepareacashbudgetforthemonthsofJanuary,February,andMarch.
(b) Determinetheamountofadditionalbankborrowingsnecessary tomaintainacashbalanceof `
50,000atalltimes.

UNITII:CASHMANAGEMENT 221
(c)PrepareaproformabalancesheetforMarch31.
Q3 Fromthefollowinginformationrelatingtoadepartmentalstore,youarerequiredtoprepareforthe
three months ending 31st March, 2020 :
Monthwisecashbudgetonreceiptsandpaymentsbasis;and
Itisanticipatedthattheworkingcapitalat1stJanuary,2020willbeasfollows:
`in'000's
Cashinhandandatbank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Taxdue 320
Plant 800
Budgeted Profit Statement: `in'000's
January February March
Sales 2,100 1,800 1,700
Cost ofsales 1,635 1,405 1,330
GrossProfit 465 395 370
Administrative, Selling and Distribution Expenses
315 270 255
Net Profit beforetax 150 125 115

Budgetedbalancesattheendofeachmonths: `in'000's
31st Jan. 28th Feb. 31st March
Short term investments 700  200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485  
Taxdue 320 320 320
Plant (depreciation ignored) 800 1,600 1,550

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 222
Depreciationamountto`60,000isincludedinthebudgetedexpenditureforeachmonth. [10.40,07]
Q4 PrachiLtdisamanufacturingcompanyproducingandsellingarangeofcleaningproductsto
wholesale customers. It has three suppliers and two customers. Prachi Ltd relies on its cleared funds
forecasttomanageitscash.
You are an accounting technician for the company and have been asked to prepare a cleared funds
forecastfortheperiodMonday7JanuarytoFriday11January2020inclusive.Youhavebeenprovided
with the following information:
(1) Receipts from customers
Customername Credit Payment 7Jan2020 7Dec2019sales
terms method sales
WLtd 1calendarmonth BACS `150,000 `130,000
XLtd None Cheque `180,000 `160,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.
(b) XLtd’schequewillbepaidintoPrachiLtd’sbankaccountonthesamedayasthesaleismadeand
will clearonthethird dayfollowing this(excluding dayof payment).
(2) Payments to suppliers
Supplier Credit Payment 7 Jan 2020 7 Dec 2019 7 Nov 2019
name terms method purchases purchases purchases
ALtd 1calendarmonth Standing order `65,000 `55,000 `45,000
BLtd 2calendarmonths Cheque `85,000 `80,000 `75,000
CLtd None Cheque `95,000 `90,000 `85,000
(a) PrachiLtdhassetupastandingorderfor`45,000amonthtopayforsuppliesfromALtd.Thiswillleave
Prachi’sbankaccounton7January.Everyfewmonths,anadjustmentismadetoreflecttheactualcost
ofsuppliespurchased(youdoNOTneed tomakethisadjustment).
(b) PrachiLtdwillsendout,bypost,chequestoBLtdandCLtdon7January.Theamountswillleaveitsbank
accountontheseconddayfollowingthis(excludingthe dayof posting).
(3) Wages and salaries
December 2019 January 2020
Weekly wages `12,000 `13,000
Monthly salaries `56,000 `59,000
(a) Factoryworkersarepaidcashwages(weekly).Theywillbepaidoneweek’swages,on11January,
forthelastweek’sworkdoneinDecember(i.e.theyworkaweekinhand).Cashiswithdrawnon
thesamedaytopaywages.
(b) Alltheofficeworkersarepaidsalaries(monthly)byBACS.SalariesforDecemberwillbepaidon
7January.
(4) Other miscellaneous payments
(a) EveryMondaymorning,thepettycashierwithdraws`200fromthecompanybankaccountforthe
petty cash.ThemoneyleavesPrachi’s bankaccountstraightaway.
(b) Theroomcleanerispaid`30frompettycasheveryWednesdaymorning.

UNITII:CASHMANAGEMENT 223
(c) OfficestationerywillbeorderedbytelephoneonTuesday8Januarytothevalueof`300.Thisis
paidforbycompanydebitcard.Suchpaymentsaregenerallyseentoleavethecompanyaccount
onthenextworkingday.
(d) Five newsoftwareswill beorderedover the Interneton10 Januaryat a total costof ` 6,500. A
chequewillbesentoutonthesameday.TheamountwillleavePrachiLtd’sbankaccountonthe
second day following this (excluding the day of posting).
(5) Other information : The balance on Prachi’s bank account will be ` 200,000 on 7 January 2020. This
representsboththebookbalanceandtheclearedfunds.
Required:
1. PrepareaclearedfundsforecastfortheperiodMonday7JanuarytoFriday11January2020inclusive
using the information provided.
2. Showclearly the uncleared funds float each day. [Page No.10.49,Q9]
FLOAT PERIOD, LOCK BOX SYSTEM, CONCENTRATION BANKING
It means time gap between two number of days. There are two types of float period; (i) Receipt Float and (ii)
Payment float. Receipt float is indicating time gap due to which there is a delay in getting the payment
becoming actual available for the purpose of spending with the company. Always a company will try to
reducefloatperiodsofarpossiblesothatblockageoffundsreduceandalsocarryingcost.Forreductionof
float period,companycanimplement LockBoxSystem,concentrationbanking.
Q5 Consider following information:
ABCLimitedisacompanybasedinMumbai,ithassoldgoodstoXYZLimitedacompanybasedinDelhi.
Goodsaresoldon1stApril,invoicewasreceivedbyXYZLimitedon5thApril.Creditperiodis3months.
On5thJuly,XYZLimited,sentpaymentbychequethroughpost.ABCLimitedreceivedchequeon7 thJuly.
Chequewasprocessedthroughitsinternalcontrolsystemanditwasdepositedon 9th July.
AmountofchequewasactuallycreditedinaccountofABCLimitedon12thJuly.
Fromaboveinformation, you are required to explain:
1. Billing Float
2. Postage/MailFloat
3. Internal Control Processing Float / ChequeProcessing Float
4. Bank Processing Float.
Q6 Explain
1. LockBoxSystem
2. Concentration Banking

CASH MANAGEMENT MODELS


TreasureDepartmentisresponsibleforeffectivecashmanagement.Inordertomakesurethatthecompany
is utilizing the available funds properly, experts have developed cash management models. It includes :
· Baumol’s Model
· Miller Orr Model.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 224
Q7 Consider following information:
Particular Information
Annual Expenses Rs.3,60,000
Numberofdaysinayear 360
Cost per Transfer Rs.500
Rate of Interest 10%
Calculatetotalcost,iftransfersizeis
1. Rs.10,000
2. Rs.90,000
Q8 Consider following information:
Particular Information
Annual Expenses Rs.3,60,000
Numberofdaysinayear 360
Cost per Transfer Rs.500
Rate of Interest 10%
From above information,
(1) CalculateOptimumtransfersizeoffunds/EconomicLotsizeoffunds/Transfersizeoffundsas
per Baumol’s Model.
(2) Calculatetotalcostiflotsizeequalstoeconomiclotsizecalculatedasabove.
Q9 TheannualcashrequirementofALtd.is`10lakhs.Thecompanyhasmarketablesecuritiesinlotsizes
of`50,000,`1,00,000,`2,00,000,`2,50,000and`5,00,000.Costofconversionofmarketablesecurities
perlotis`1,000.Thecompanycanearn5%annualyieldonitssecurities.
You are required
1. Toprepareatableindicatingwhichlotsizewillhavetobesoldbythecompany.
2. AlsoshowthattheEconomiclotsizecanbeobtainedbytheBaumolModel.
Q10 ExplainMillerOrrModelofCashManagement.

00

UNITII:CASHMANAGEMENT 225
HOME WORK

CASH BUDGET

Q11 Prepare monthlycashbudgetforsixmonthsbeginning from April2017 onthe basis of the following
information:
(i) Estimated monthly sales are as follows:
(` ) (` )
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and salaries are estimated to be payable as follows:
` `
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
(iii) Ofthesales,80%isoncreditand20%forcash.75%ofthecreditsalesarecollectedwithinonemonth
andthebalanceintwomonths.Therearenobaddebtlosses.
(iv) Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the
sales.
(v) Thefrmhas10%debenturesof`1,20,000.InterestonthesehastobepaidquarterlyinJanuary,April
andsoon.
(vi) Thefrmistomakeanadvancepaymentoftaxof`5,000inJuly,2017.
(vii) Thefrmhadacashbalanceof`20,000onApril1,2017,whichistheminimumdesiredlevelofcash
balance. Any cash surplus/defcit above/below this level is made up by temporary investments/
liquidationoftemporaryinvestmentsortemporaryborrowingsattheendofeachmonth(intereston
these to be ignored). [P.No. 10.38; Q.No.6]
Ans.
Month April May June July Aug Sept
Balancce 20,000 20,000 20,000 20,000 20,000 20,000

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 226
Q12 PreparecashbudgetforJulyDecemberfromthefollowinginformation:
(i) Theestimatedsales,expensesetc.areas follows: (` lakhs)
June July Aug. Sept. Oct. Nov. Dec.
Sales 35 40 40 50 50 60 65
Purchases 14 16 17 20 20 25 28
Wages and Salaries 12 14 14 18 18 20 22
Misc.Expenses 5 6 6 6 7 7 7
Interest Received 2   2   2
Sale of Shares   20    
(ii) 20%ofthesalesareoncashandthebalancecredit.
(iii) 1%ofthecreditsalesarereturnedbythecustomers.2%ofthetotalaccountsreceivableconstitute
baddebtlosses.50%ofthegoodaccountsreceivablearecollectedinthemonthofthesales,arethe
restinthenextmonth.
(iv) Thetimelaginthepaymentofmisc.expensesandpurchasesisonemonth,WagesandSalariesare
paidfortnightlywithatimelafof15days.
(v) Thecompanykeepsaminimumcashbalanceof`5lakhs.Cashinexcessof`7lakhsinvestedinGovt.
securities in the multiple of ` 1 lakh. Shortfalls in the minimum cash balance are made good by
borrowings from banks. Ignore interest received and paid.
Ans.
W.N.1CalculationofGoodDebtorsfromJulytoDecember.
Par\month J A S O N D

Sales 40L 50L 60L 65L


Cr. Sales 32L 32L 40L 40L 48L 52L
Sales return (0.32)L (0.32)L (0.40)L (0.40)L (0.48)L (0.50)L

B.D. (0.64)L (0.64)L (0.80)L (0.80)L (0.96)L (1)L


Good debtors 31.04L 31.04L 38.80L 38.80L 46.56L 50.44L

Collection from debtors.


Month J A S O N D
1/2 15.52L 15.52L 19.40L 19.40L 23.28L 25.22L

§ 31.04L · § 38.80L · § 38.80L · § 38.80L · § 46.56L · § 50.44L ·


¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸
© ¹ © ¹ © ¹ © ¹ © ¹ © ¹
1/2 13.58L 15.52L 15.52L 19.40L 19.40L 23.28L

§ 27.16L · § 31.04L · § 31.04L · § 38.80L · § 38.80L · § 46.56L ·


¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸
© ¹ © ¹ © ¹ © ¹ © ¹ © ¹
Collection 29.10L 31.04L 34.92L 38.80L 42.68L 48.50L

UNITII:CASHMANAGEMENT 227
W.N.  for calculating good Debtors of June month.
Cr. Sales 28L
(35L×80%)
Sales return (1%) (0.28)L
B. Debts (2%) (0.56)L
Good Debtors 27.16L
PreparationofMonthlyCashBudget,fromJulytoDecember.(Loss)
Month J A S O N D
Par.
Op. Bal 5 7.10 7.14 7.06 7.86 7.54
Coll. from 29.10 31.04 34.92 38.80 42.68 48.50
Debtors
Cash Sales 8 8 10 10 12 13
{40L×20%} {50L×20%} {60L×20%}
Pay of Misc.
Expen (5) (6) (6) (6) (7) (7)
Pay for (14) (16) (17) (20) (20) (25)
purchase
Payment of
wages & Salary
1/2 (7) (7) (9) (9) (10) (11)

§ 14 · § 14 · § 18 · 18 20 22
¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ 2 2 2
© ¹ © ¹ © ¹
1/2 (6) (7) (7) (9) (9) (10)

12 § 14 · § 14 · § 18 · 18 20
2 ¨ 2 ¸ ¨ 2 ¸ ¨ 2 ¸ 2 2
© ¹ © ¹ © ¹
Interest
Received 2 2
Sales of Shares 20
Bal. before 5th 10.10 30.14 15.06 11.86 16.54 18.04
Adjustement
Investment (3) (23) (8) (4) (9) (11)
Cl. Bal. 7.10 7.14 7.06 7.86 7.54 7.04

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 228
Q13 The sales forecast for January to May, 2006 and actual sales for November and December, 2005 for
PlysalesCo.aregivenasunder:
Month Sales (`)
Actual
November,2005 80,000
December 70,000
Forecast
January,2006 80,000
February 1,00,000
March 80,000
April 1,00,000
May 90,000
20% of sales is in cash and rest is on credit, payment of which is realised in the third month. The
following other information are also available:
(i) Amount of purchase is budgeted at 60%of the sales turnover of a month and paid in the third
month of purchase.
(ii) Variableexpensesis 5% ofturnovertimelagofpaymenthalf month.
(iii) Commissiononcreditsales@5%ispayableinthethirdmonth.
(iv) Rentandotherexpensesamounting`3,000paideverymonth.
(v) Paymentforpurchaseoffixedassets`50,000inMarch,2006.
(vi) PaymentfortaxesinApril,2006`20,000.
(vii)Therewillbeanopeningcashbalanceof`25,000.
YouarerequiredtoprepareaCashBudgetforfivemonthsfromJanuarytoMay,2006.
Solution
Working notes
Collection from Sundry Debtors and Commissionon Credit Sales (`)
2005 (Actual) 2006 (Forecast)
Particulars Nov. Dec. Jan. Feb. Mar. Apr. May
Sales 80,000 70,000 80,000 1,00,000 80,000 1,00,000 90,000
Cashsales20% 16,000 14,000 16,000 20,000 16,000 20,000 18,000
Creditsales80% 64,000 56,000 64,000 80,000 64,000 80,000 72,000
Collection of Debtors  64,000 56,000 64,000 80,000 64,000
Commissiononcredit sales(5%) 3,200 2,800 3,200 4,000 3,200 4,000 3,600
Payment of commission 3,200 2,800 3,200 4,000 3,200

Calculation ofPayment to Creditors (`)


2005 2006
Particulars Nov. Dec. Jan. Feb. Mar. Apr. May
Purchases(60%ofsales) 48,000 42,000 48,000 60,000 48,000 60,000 54,000
Paymenttosundrycreditors   48,000 42,000 48,000 60,000 48,000
(3rdmonthofpurchase)

UNITII:CASHMANAGEMENT 229
Cash Budget of Plysales Co. for the Months January to May, 2006 (` )
Jan. Feb. Mar. Apr. May Total
Opening balance 25,000 47,050 70,750 42,050 50,550 25,000
Receipts:
Cashsales 16,000 20,000 16,000 20,000 18,000 90,000
Collectionfromsundrydebtors 64,000 56,000 64,000 80,000 64,000 3,28,000
1,05,000 1,23,050 1,50,750 1,42,050 1,32,550 4,43,000
Payments:
Paymenttosundrycreditors 48,000 42,000 48,000 60,000 48,000 2,46,000
  Variable expenses 3,750 4,500 4,500 4,500 4,750 22,000
Commission 3,200 2,800 3,200 4,000 3,200 16,400
Rent 3,000 3,000 3,000 3,000 3,000 15,000
Fixedassets   50,000   50,000
Taxes    20,000 20,000
57,950 52,300 1,08,700 91,500 58,950 3,69,400
Closing balance 47,050 70,750 42,050 50,550 73,600 73,600
Q14 Fromtheinformationandtheassumptionthatthecashbalanceinhandon1stJanuary2017is`72,500
prepareacashbudget.Assumethat50percentoftotalsalesarecashsales.Assetsaretobeacquired
inthemonthsofFebruaryandApril.Therefore,provisionsshouldbemadeforthepaymentof`8,000
and`25,000forthesame.Anapplicationhasbeenmadetothebankforthegrantofaloanof`30,000
and it is hoped that the loan amount will be received in the month of May. It is anticipated that a
dividendof`35,000willbepaidinJune.Debtorsareallowedonemonth’scredit.Creditorsformaterials
purchasedandoverheadsgrantonemonth’scredit.Salescommissionat3percentonsalesispaidto
thesalesmaneach month.
Month Sales Materials Salaries & Production Office and
(` ) Purchases Wages Overheads (`) Selling Over
(`) (`) heads (`)
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500
[P.No. 10.109; Q.No.5]
Ans.
Month J F M A M J
Balancce 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 230
CASH MANAGEMENT MODELS
Q15 A firm maintains a separate account for cash disbursement. Total disbursement are `1,05,000 per
monthor`12,60,000peryear.Administrativeandtransactioncostoftransferringcashtodisbursement
accountis`20pertransfer.Marketablesecuritiesyieldis8%perannum.
DeterminetheoptimumcashbalanceaccordingtoWilliamJ.Baumolmodel.
[P.No. 10.53, Q.No.10]
Ans.
TheoptimumcashbalanceC=`25,100
Q16 Advani Chemical Limited estimates its total cash requirement as ` 2 crore next year. The company’s
opportunitycostoffundsis15%perannum.Thecompanywillhavetoincur`150pertransactionwhen
itconvertsitsshorttermsecuritiestocash.Determinetheoptimumcash balance.Howmuch isthe
totalannualcostofthedemandfortheoptimumcashbalance?
Howmanydepositswillhavetobemadeduringtheyear?
Ans.

C 2cT  k

2(150)(2, 00, 00, 000)


C* =`2,00,000
0.15
Theannualcostwillbe:
Totalcost=150(2,00,00,000/2,00,000)+0.15(2,00,000/2)
= 150(100)+0.15(1,00,000)=15,000+15,000=`30,000
During the year, the company will have to make 100 deposits, i.e. converting marketable securities to
cash.
Q17 JPLhastwodateswhenitreceivesitscashinflows.i.e.,Feb.15,andAug.15.Oneachofthesedates,it
expectstoreceive`15crore.Cashexpenditureareexpectedtobesteadythroughoutthesubsequent
6monthperiod Presently,theROIinmarketablesecurities is8% perannum, andthe costoftransfer
fromsecuritiestocashis`125eachtimeatransferoccurs.
(i) WhatistheoptimaltransfersizeusingtheEOQmodel?Whatistheaveragecashbalance?
(ii) Whatwouldbeyouranswertopart(i)jftheROlwere12%perannumandthetransfercostswere`
75?Whydotheydifferfromthoseinpart(i)?
Solution
(i) Optimaltransfer sizebyusingthe EOQmodel
AccordingtoE.O.Qmodel,

2FT
C=
r
Where,C=Cashrequiredeachtimetorestorebalancetominimumcash.
F=Totalcashrequiredduringtheyear
T=Costofeachtransactionbetweencashandsecurities

UNITII:CASHMANAGEMENT 231
r=Rateofinterestonsecurities
Now,F=`30,00,00,000,1=`125,r=8%perannum

2 u` 30, 00, 00, 000 u`125


Therefore,C=
0.08
=`9,68,245
Averagecashbalance=C/2=`9,68,245=`4,84,123
(ii) OptimaltransfersizeusingE.O.Q.modelifr=0.12andT=`75isasfollows

2 u` 30, 00, 00, 000 u` 75


C
0.12
=`6,12,372

`6,12, 372
Averagecashbalance= =`3,06,186
0.12
Alternative Solution:
SinceitisgiveninthequestionsthatJ.P.Lhastwodateswhenitreceivesitscashinflowi.e.February15and
August 15. On each of these dates, it expects to receive ` 15 crores.
AccordingtoE.O.Q.modelCwillbeworkedoutasfollows:
Now,F=`15,00,00,000,T=`125,r=0.04i.e.(0.08/2)

2 u Rs1500000 u Rs125
(i) C=
004
=`9,68,245

2 u` 15, 00, 00, 000 u` 75


(ii) C=
0.06
=`6,12,372

FLOAT PERIOD, LOCK BOX SYSTEM, CONCENTRATION BANKING


Q18 TheDivyaPaints Ltd.iscurrently followingacentralisedcollectionsystem.Mostof its customersare
located in the cities of Northern India. The remittances mailed by customers to the central location
take four days to reach. Before depositing the remittances in the bank, the firm loses two days in
processingthem.Thedailyaveragecollectionofthefirmis`1,00,000.K=18%
Thecompanyisthinkingofestablishingalockboxsystem.Itisexpectedthatsuchasystemwillreduce
mailingtimebyonedayandprocessingtimebyoneday.
(i) Find out the reduction in cash balances expected to result from the adoption of the lockbox
system.
(ii) Calculate annualised savingsincarrying cost,if Lock BoxSystemis implemented.
(iii) Shouldthelockboxsystembeestablishedifitsannualcostis`24,500?

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 232
Solution
(1) The total time saved by the firm by establishing the lockbox system is 2 days Reduction in cash
balances = Times saved x daily average collection
2x`1,00,000=`2,00,000
(2) Opportunitycost=18%x`2,00,000=`36,000
(3) The lockbox system should be established because the opportunity cost of the present system (`
36,000)ishigherthanthecostofthelockboxsystem(`24,500).

UNITII:CASHMANAGEMENT 233
UNIT III : RECEIVABLE MANAGEMENT

INTRODUCTION
1. Inthischapterwearegoingtolearnfollowingpoints;
A. Determination of Credit period to be offered tocustomers.
B. Offer ofCashDiscount.
C. Factoring Services.
2. Receivable/Debtorsmeanscreditsalesuncollected.Incompetitivebusinessconditions,itisnecessary
foracompanytooffercreditperiodtocustomers.Withincreaseincreditperiod,salesofthecompany
increasesandviceversa,howeverprofitofthecompanymaynotchangeinsamedirectioneverytime.
So,itisnecessaryforacompanytodecidethatwhatcreditperiodshouldbeofferedtocustomerssoas
toincreaseprofitofthecompany.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 234
CLASS WORK

CARRYING COST
1. For any commercial venture, always there is an intention to make profit. However only profit is not
sufficient, business should generate some amount of minimum profit, based on Investment made in
businessandcostofcapitalofthecompany.
2. Fromdecisionmakingpointofview,ifactualprofitofthecompanyislessthanminimumprofit,then
inthatcaseitisbettertoclosedownthebusiness.Simplycarryingcostcanbeconsideredasopportunity
cost for investing funds somewhere else.

Q1 Consider following information:


Particulars Information
Annual Credit Sales (Rs.) 401.50Lacs.
Annual Variable Cost (Rs.) 300.00Lacs.
Annual Fixed Cost (Rs.) 65.00Lacs.
Average Collection Period 60Days
Costofcapitalofthecompany 20%
CalculateAnnualizedCarryingcost.
DECISION MAKING ABOUT CREDIT PERIOD
Withchangeincreditperiod,salesofthecompanychanges,atthesametimebaddebts,carryingcostetc.
change.Inordertodecideaboutoptimumcreditperiodtobeofferedtocustomers,wehavetofindprofitor
lossforeachcreditperiodandcreditperiodatwhichthereisamaximumprofitwillbeofferedtocustomers.
Q2 Acompanycurrentlyhasanannualturnoverof`10lakhsandaveragecollectionperiodof45days.The
companywantstoexperimentwithamoreliberalcreditpolicyonthegroundthatincreaseincollection
period will increases sales.
Fromfollowinginformation,kindlyindicatewhichofthepolicyyouwouldlikethecompanytoadopt:
Credit Increase in Increase in Percentage
Policy Collection period Sale (`) of Default
1 15days 50,000 2%
2 30days 80,000 3%
Thesellingpriceoftheproductis`5,averagecostperunitatcurrentlevelis`4andthevariablecost
perunitis`3.
Thecurrentbaddebtlossis1%andtherequired rateoninvestmentis20 %.Ayearcanbetaken to
compriseof360days.

UNITIII:RECEIVABLEMANAGEMENT 235
OFFER OF CASH DISCOUNT TO BE GIVEN TO CUSTOMERS
1. Ascreditperiodofferedtocustomersandsalesofthecompanyhavepositiverelations,similarlyoffer
ofcashdiscountcanbringchangeinsalesandalsochangeinAverageCollectionPeriod.
2. Againfordifferentcashdiscountterm,wehavetodecidethatwhatisoptimumcashdiscountpolicyto
offered to customers.
Q3 The present credit terms of P Company are 1/10 net 30. Its annual sales are ` 80 lakhs, its average
collectionperiodis20days.Itsvariablecostsandaveragetotalcoststosalesare0.85and0.95respectively
anditscostofcapitalis10percent.Theproportionofsalesonwhichcustomerscurrentlytakediscount
is0.50.PCompanyisconsideringrelaxingitsdiscounttermsto2/10net30.Suchrelaxationisexpected
toincreasesalesby`5lakhs,reducetheaveragecollectionperiodto14daysandincreasetheproportion
ofdiscountsalesto0.80.Whatwillbetheeffect ofrelaxingthediscountpolicyofcompany’sprofit?
Takeyearas360days.
INCREMENTAL APPROACH : SINGLE CUSTOMER; PARTIAL PAYMENTS
1. If information have been given about only increase sales and entire present information have not
beengiven,theninthatcasewehavetoadoptincrementalapproach.TotalProfit/(Loss)Approachcan
not be followed for decision making.
2. If customer is making partial payment, then in that case weighted average collection period can be
foundforcarryingcost.

Q4 SlowPayersareregularcustomersofGoodsDealersLtd.,Calcuttaandhaveapproachedthesellersfor
extension of a credit facility for enabling them to purchase goods from Goods Dealers Ltd. On an
analysisofpastperformanceandonthebasisofinformationsupplied,thefollowingpatternofpayment
scheduleemerges inregard toSlow Payers:
Pattern of Payment Schedule
Attheendof30days 15%ofthebill
Attheendof100days 84%ofthebill
Nonrecovery 1%ofthebill
SlowPayerswanttoenterintoafirmcommitmentforpurchaseofgoodsof`15lakhsin2020,deliveries
tobemadeinequalquantitiesonthefirstdayofeachquarterinthecalendaryear.Thepriceperunit
ofcommodityis`150onwhichaprofitof`5perunitisexpectedtobemade.ItisanticipatedbyGoods
DealersLtd.,thattakingupofthiscontractwouldmeananextrarecurringexpenditureof`5,000per
annum.IftheopportunitycostoffundsinthehandsofGoodsDealersis24%perannum,wouldyouas
the finance manager of the seller recommend the grant of credit to Slow Payers?  Workings should
formpartofyouranswer.
Assumeyearof360days.
DEBTORS TURNOVER RATIO
Itisindicatingnumberoftimes,debtorsofthecompanyisrotatedinayear.Itishelpfultocomputeaverage
collection period of the company.
Q5 Ifacompanyhascurrentdebtorsturnoverratioof6times,anditislikelytochangeto4times,Calculate:
1. Present collection period.
2. Proposed collection period.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 236
INCREASE IN WORKING CAPITAL DUE TO CHANGE IN CREDIT PERIOD
It may happen that apart from debtors, there is a change in other working capital.Any change in working
capital,isneveraprofitorloss,howeveritscarryingcostifrequiredtobeconsideredindecisionmaking.

Q6 Easy limitedspecialises in the manufactures of a computer component. The component is currently
sold  for ` 1,000 and its variable cost is ` 800. For the year ended 31320 the company sold on an
average400componentspermonth.Atpresentthecompanygrantsonemonthcredittoitscustomers
the management ofcompany is thinking of extendingthe same to two months on account of which
following is expected :
Increase in Sales 25%
Increase in Stock `2,00,000
Increase in Creditors `50,000
Youarerequired:Toadvicethecompanyonwhetherornottoextendthecreditterms ifallcustomers
avail the extendedcredit periodof twomonths
Thecompanyexpectsaminimumreturnof40%ontheinvestments.
TAX
Incaseofincometaxrateinformationisgiven,thenwehavetoseecarefullythatwhethercostofcapitalis
givenpretax/beforetaxorposttax/aftertax.
Q7 Asapartofthestrategytoincreasesalesandprofits,thesalesmanagerofacompanyproposestosell
goodstoagroupofnewcustomerswith10%riskofnonpayment.
Thisgroupwouldrequireoneandahalfmonthscreditandislikelytoincreasesalesby`1,00,000p.a.
ProductionandSellingexpensesamountto80%ofsalesandtheincometaxrateis40%.Thecompany’s
minimumrequiredrateofreturn(aftertax)is25%.
(a) Shouldthe sales manager’s proposal be accepted?
(b) Alsofindthedegreeofriskofnonpaymentthatthecompanyshouldbewillingtoassumeifthe
requiredrateofreturn(aftertax)were(i)30%,(ii)40%.
NO VARIABLE COST AND FIXED COST INFORMATION HAVE BEEN GIVEN
1. Inthiscase,carryingcostisrequiredtobefoundbyusingcreditsalesinformation.
2. This type of question can be solved either by using incremental approach or by using relevant cost
approach.
Q8 PQRLtd.havinganannualsalesof`30lakhs,isreconsideringitspresentcollectionpolicy.Atpresent,
the average collection period is 50 days and the bad debt losses are 5% of sales. The company is
incurringanexpenditureof`30,000onaccountofcollectionofreceivables.Costoffundsis10percent.
The alternative policies areas under:
Alternative I Alternative II
Average Collection Period 40days 30days
BadDebtLosses 4%ofsales 3%ofsales
Collection Expenses `60,000 `95,000
Evaluate the alternatives on the basis of incremental approach and state which alternative is more
beneficial.Take360daysinayear.

UNITIII:RECEIVABLEMANAGEMENT 237
LAST MINUTE REVISION
Assumptions :
1. Sales of the company isoncreditbasis, unless specified otherwise.
2. Activitylevel of the company is evenlyspread throughouttheyear.
3. Variablecosttosalesratioandintotalfixedcost willremainsame.
4. Company will carryonbusiness for infinite time period.
FORMULAS
1. Contribution : Contribution means profit calculation ignoring fixed cost. It is indicating difference
betweensalesandvariablecost. Itis calculatedas under.
C = SV.C.
C = Contribution
S = Sales
V.C. = Variablecost
2. Contribution to sales ratio or Profit Volume ratio ( P/V ratio)
Thisratioisindicatingamountofcontributionforevery100`ofthesales.Itiscalculatedasunder

Contribution
P.V.ratio= × 100
Sales
3. Variable cost to sales ratio
Thisratioisindicatingvariablecostofcompanyforevery100`ofthesales.Itiscalculatedasunder

Variablecost
= × 100
Sales
Or
100contributiontosalesratioorP.V.ratio
4. Totalcost=TVC+TFC
5. Total cost to Sales ratio or Average Cost to Sales ratio
Itisindicatingtotalcostofthecompanyforevery100`ofthesales.Itiscalculatedaswithfollowing
formula:

Total cost
× 100
Sales
6. Total cost per unit or Average Cost Per Unit
Itiscalculatingtakingintoaccountandtotalcostofthecompanyandnumberofunitsproducedand
soldby thecompany.
It will calculated using following formula

Total cost
Units

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 238
MULTIPLE CHOICE QUESTIONS

1. Thecredittermsmaybeexpressedas“3/15net60”.Thismeansthata3%discountwillbegrantedifthe
customerpayswithin15days,ifhedoesnotavailtheofferhemustmakepaymentwithin60days.
(a) I agree with the statement
(b) Idonotagreewiththestatement
(c) Icannotsay.
2. Theterm‘net50’impliesthatthecustomerwillmakepayment.
(a) Exactlyon50thday (b) Before50thday
(c) Not later than 50th day (d) None ofthe above.
3. Tradecreditisasourceof:
(a) Longterm finance (b) Medium term finance
(c) Spontaneous source of finance (d) Noneoftheabove
4. Factoring is a method of financing whereby a firm sells its trade debts at a discount to a financial
institution. The statement is
(a) Correct (b) Incorrect (c)Partiallycorrect (d) Icannotsay.
5. Afactoringarrangementcanbebothwithrecourseaswellaswithoutrecourse:
(a) True (b) False (c)Partiallycorrect (d) Cannotsay.

UNITIII:RECEIVABLEMANAGEMENT 239
HOME WORK

DECISION MAKING ABOUT CREDIT PERIOD

Q9 Atraderwhosecurrentsalesareintheregionof`6lakhsperannumandanaveragecollectionperiod
of 30 days wants to pursue a more liberal policy to improve sales. A study made by a management
consultant reveals the following information:
Credit Policy Increase in Increase in sales Present default
collection period anticipated
A 10days `30,000 1.5%
B 20days `48,000 2%
C 30days `75,000 3%
D 45days `90,000 4%
Thesellingpriceperunitis`3.Averagecostperunitis`2.25andvariablecostsperunitare`2.The
currentbaddebtlossis1%.Requiredreturnonadditionalinvestmentis20%.
Assumea360daysyear.
Which of the abovepolicieswould you recommend for adoption? [P.No.10.69; Q.No15]
Ans.
Credit Period (Days) 30 40 50 60 75
Profit/(loss) 1,36,500 1,40,106 1,39,651 1,38,083 1,31,150
Q10 XYZCorporationisconsideringrelaxingitspresentcreditpolicyandisintheprocessofevaluatingtwo
proposed policies. Currently, the firm has annual credit sales of ` 50 lakhs and accounts receivable
turnover ratio of 4 times a year. The current level of loss due to bad debts is ` 1,50,000. The firm is
requiredtogiveareturnof25%ontheinvestmentinnewaccountsreceivables.Thecompany’svariable
costsare70%ofthesellingprice.Giventhefollowinginformation,whichisthebetteroption?
(Amount in ` )
Present Policy Policy
Policy Option I Option I
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover ratio 4times 3times 2.4times
Bad debt losses 1,50,000 3,00,000 4,50,000
[P.No.10.72; Q.No 16]
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 240
Ans.
Net Benefits (A – B) 11,31,250;11,50,000;10,82,812
PresentPolicy= ` 2,18,750
ProposedPolicyI=` 3,50,000
ProposedPolicyII=` 4,92,188
Q11 MosaicLimitedhascurrentsalesof`15lakhsperyear.Costofsalesis75percentofsalesandbaddebts
areonepercentofsales.Costofsalescomprises80percentvariablecostsand20percentfixedcosts,
whilethecompany’srequiredrateofreturnis12percent.MosaicLimitedcurrentlyallowscustomers30
days’credit,butisconsideringincreasingthisto60days’creditinordertoincreasesales.
Ithasbeenestimatedthatthis changeinpolicywillincreasesalesby15percent,while baddebts
willincreasefromonepercenttofourpercent.Itisnotexpectedthatthepolicychangewillresult
inanincreaseinfixedcostsandcreditorsandstockwillbeunchanged.
ShouldMosaicLimitedintroducetheproposedpolicy?(Assumea360daysyear)
Solution :
AnnualCr.salesofCo=15,00,000
BDO(1%)
Costofsales(75%) 11,25,000
80%20% 9,00,000 2,25,000
COC=12%
ACP=30days Inc.to 60days
Sales 17,25,000
BD 4%
In this question we are required to decide what Cr. period should be offered to customers for this
decisionmakingtotalprofitorlossforeachofthecr.periodwillbefoundasunder.
(i) TFC=2,25,000
(ii) VCtosales=9,00,000/15Lx100=60%
(iii) Cr.Period 30 days 60 days
Sales 1500000 1725000
VC(60%) (900000) (1035000)
FC (225000) (225000)
Carrying cost (11096) (24855)
BD (15000) (69000)
348904 371145
Ans. TheCo.isadvisedtoofferCr.periodof60daystocustomers.
Q12 HypotheticalLtdhascurrentlyanannualcreditsalesof`8,00,000.Itsaverageageofaccountsreceivables
is 60 days. It is contemplating a change in its credit policy that is expected to increase sales to `
10,00,000,andincreasetheaverageageofaccountsreceivableto72days.
Thefirm’ssalepriceis`25perunit,thevariablecostperunitis`12andtheaveragecostperunitat
`8,00,000salesvolumeis`17.Assumea360dayyear,andcalculatethefollowing.

UNITIII:RECEIVABLEMANAGEMENT 241
(1) Whatistheaveragecostperunitwiththeproposedplan?
(2) Whatarethe marginalinvestmentsinaccountsreceivable resultingfromtheproposedchange?
(3) Whatisthecostofmarginalinvestment,iftheassumedrateofreturnis15%?
Solution
W.N. 1 Calculation of number of units, the company produces and sell with present and proposed credit
policy.

Sales Rs.
Sales units =
S.P.P.U
Present Proposed

Rs.8, 00, 000 Rs.10, 00, 000


25Rs./unit 25Rs./unit
=32,000unit =40,000units
W.N. 2 Calculation of Total fixed cost
Total Cost = Total variable cost + Total fixed cost
Total fixed cost = TotalCost – Total variable cost
=(17×32,000units)–(12×32,000units)
=Rs.5,44,000–Rs.3,84,000
=Rs.1,60,000
Answer for the questions.
(1) Calculation of average cost per unit/total cost per unit with proposed plan

Totalvariablecost + Total fixedcost


=
Number of units

12Rs./Unit×40,000units+ Rs.1,60, 000


=
40,000units

Rs.4,80, 000 + Rs.1,60, 000


=
40, 000 Units

Rs.6, 40, 000


=
40, 000 Units

= 16Rs./Unit
(2) Calculation of marginal Investment in debtors by the company.
Marginal Investment in Debtors means ,additional / Incremental/ differential Investment
in Debtors.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 242
Annual variable cost + AnnualFixedCost
= × ACP
360 Days

= Present Proposed

32, 000 × 12 + 1,60, 000 40, 000 × 12 +1, 60, 000


= × 60 × 72
360 360
= Rs.90,667 = Rs. 1,28,000
MarginalInvestment in Dubtors Rs.37,333
(Rs.1,28,000Rs.90,667
(3) Cost of Marginal Investment
= Rs.37.333x15%
= Rs.5,600
Q13 Afirmhascreditsalesamountingto`32,00,000.Thesalepriceperunitis`40,thevariablecostis`
25perunitwhiletheaveragecostperunitis`32.Theaverageageofaccountsreceivableofthefirm
is72days.
Thefirmisconsideringtotightenthecreditstandards.Itwillresultinafallinthesalesvolumeto`
28,00,000,andtheaverageageofaccountsreceivableto45days.
Assume20%rateofreturn.Istheproposalunderconsiderationfeasible?(1year=360days)
Solution
Step No.1 : Calculation of Total Fixed Cost
W.N. 1 Calculation of number of units, the company produces and sells, with present and pro
posed credit policy.

Sales Rs.
Sales units =
S.P.P.U
Present Proposed

Rs.32, 00, 000 Rs.28, 00, 000


40Rs. / Unit 40Rs. / Unit

=80,000units =70,000units
Calculation of Total fixed cost
Total Cost = Total variable cost + Total fixed cost
32×80,000 =25×80,000+TotalF.C.
Total Fixed Cost =(32×80,000)–(25×80,000)
=Rs.5,60,000
Step No.2 : Calculation of variable cost to sales ratio.
Company is adviced not be change its credit policy.
= VariableCost x100
Selling Price

UNITIII:RECEIVABLEMANAGEMENT 243
=25/40x100
= 62.50%
Step No. 3 : Calculation of Profit/(Loss) with Present and Proposed credit policy.
Par. Cr. Policy Present Proposed
Sales 32,00,000 28,00,000
Variable Cost (20,00,000) (17,50,000)
(62.50% of Sales {80,000×25} {70,000×25}
Fixed Cost (5,60,000) (5,60,000)
Carrying cost (1,02,400) (57,750)

­ 17, 50,000  5, 60,000 ½ ­ 17, 50,000  5, 60,000 ½


® u 72 u 20%¾ ® u 45u 20%¾
¯ 360 ¿ ¯ 360 ¿
Profit/(Loss) 5,37,600 4,32,250
Q14 ThecreditmanagerofABCcompanyhadtodecideonaproposalforliberalextensionofcreditwhich
would result in a slowing process of the average collection period from one to two months. The
company’sproductwassoldfor`20.perunit,ofwhich`15representedvariablecost(includingcredit
department cost). The current actual sales amounted to & 24 lakhs, represented entirely by credit
sales.Theaveragetotalcostperunitwas`18.Therelaxationincreditpolicywasexpectedtoresultin
a25%increaseinsales,i.e.,`30lakhsannually.Thecorporatemanagementaimedatareturnof25%on
additional investment. You are required to make relevant calculations to help the credit manager in
examining the financial implications of liberalising the credit policy.
Solution
Step No.1 : Calculation of Total Fixed Cost
W.N. 1 Calculation of production and sales with present credit policy.

Sales(Rs.)
=
S.P.P.U.
Rs.24,000
=
20Rs./unit
Calculation of Total fixed cost
Total Cost = Total variable cost + Total fixed cost
Total fixed cost =Total cost–Total variable cost
=18Rs./Unit×1,20,000Units–15Rs./unit×1,20,000Units
=21,60,000–18,00,000
=3,60,000
Step No. 2 : Calculation of variable cost to sales ratio
Variable Cost x100
Selling price
15/20x100=75%

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 244
Step No. 3 : Calculation of Profit/(Loss) with Present and Proposed credity policy.
Particluars Cr. Policy Present Proposed
Sales 24,00,000 30,00,000
Variable Cost (18,00,000) (22,50,000)
[75% of Sales] [1,20,000×15] {1,50,000×15}
{1,20,000+25%}
Fixed Cost (3,60,000) (3,60,000)
Carrying cost (45,000) (1,08,750)

ª 18L  3.60L º ª 22.50L  3.60L º


«¬ u 1u 25%» «¬ u 2 u 25%»
12 ¼ 12 ¼
Profit/(Loss) 1,95,000 2,81,250
Company is suggested to change credit period to 2 months.
Q15 Acompanyisnowextendingonemonth’scredittoitsselectedcustomers.Itsellsitsproductat `100
each and has an annual salesvolume of60,000 units. At current level of production, which matches
withsales,theproducthasatotalcostof`90perunitandavariablecostof`80perunit.Thecompany
isconsideringaplantograntmoreliberaltermsbyextendingthedurationofcreditfromonemonthto
twomonthsandexpectsthesalestothecustomergrouptogoupby25%.Inthebackgroundofanormal
expectationofa20%returnoninvestment,willthis relaxationincreditstandardjustifyitself?
Solution
Step No. 1 : Calculation of Total Fixed Cost
Total Cost = Total Variable cost + Total Fixed Cost
Total Fixed Cost = Total cost – Total Variable Cost
=60,000units×90Rs./unit–60,000units×80Rs./unit
=54,00,000–48,00,000
=6,00,000

Step No. 2 : Calculation of variable Costto Sales ratio :


VariableCostx100
Selling Price
=80/100x100
=80%

UNITIII:RECEIVABLEMANAGEMENT 245
Step No. 3 : Calculation of profit/(Loss) for Present and Proposed credit policy.
Particluars Cr. Policy Present Proposed
Sales 60L 75L
(60,000units (75,000units
×100Rs./unit) ×100Rs/unit)
{60,000+25%}
Variable Cost [80% of sales] (48)L (60)L
Carrying cost (90,000) (2,20,000)

­ 48 L  6L ½ ­ 60 L  6L ½
® 12 u 1u 20%¾ ® 12 u 2 u 20%¾
¯ ¿ ¯ ¿
Profit/(Loss) 5,10,000 6,80,000
The Company is advised to offer credit period of 2 months.
Q16 Acompany’spresentcreditsalesamountto`50lakhs.Itsvariablecostratiois60%ofsalesandfixed
costsamountto`10lakhsperannum.Thecompanyproposestorelaxitspresentcreditpolicyof1
monthtoeither2monthsor3monthsasthecasemaybe.
The following information are also available:
Present Policy 1 Policy 2
Policy
AverageAgeof Debtors 1month 2months 3months
Increase in Sales — 20% 30%
percentageofBadDebts 1.0 2.5 5.0
Ifthecompanyrequiresareturnoninvestmentof20%beforetax,evaluatetheproposals.
Solution
Step No.1 : Calculation of Fixed cost
ItisanamountofRs.10,00,000
(Given in the question)
Step No.2 : Calculation of variable cost to sales ratio.
It is 60% (it is given in the question)

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 246
Step No. 3 : Calculation of Profit /(Loss), for Present and Proposed credit period.
Particular Cr. period 1 Month 2 Months 3 Months
Sales 50L 60L 65L

{50L+20%} {50L+30%}
Variable cost (30)L (36)L (39)L
(60%)
Fixed Cost (10)L (10)L (10)L
Carryingcost (66,667) (1,53,333) (2.45)L

­ 30L  10L ½ ­ 36L  10L ½ ­ 39L  10L ½


® u 1 u 20%¾ ® u 2 u 20%¾ ® u 3 u 20%¾
¯ 12 ¿ ¯ 12 ¿ ¯ 12 ¿
Bad Debts (50,000) (1,50,000) (3,25,000)
{50L×1%} {60L×2.50%} {65L×5%}
Profit / (Loss) 8,83,333 10,96,667 10,30,000
 Company should offer credit of 2 months to customers
Q17 In order to increase sales from the normal level of ` 2.4 lakhs per annum, the marketing manager
submitsa proposal for liberalising creditpolicyas under:
Normal Sales `2.4lakhs
Normal Credit Period 30days
Proposed increase in Relevant increase
credit period beyond over normal sales
normal30days
`
15days 12,000
30days 18,000
45days 21,000
60days 24,000
TheP.V.Ratioofthecompanyis331/3%.
Thecompanyexpectsapretaxreturnof20%oninvestment.Evaluatetheabovefouralternativesad
advisethemanagement.(assume360daysinayear.)
Solution
Step No. 1 : Calculation of Fixed cost : Directly or Indirectly no information is given about fixed cost,
so calculation of fixed cost is ignored.
Step No.2 : Calculation of variable cost to sales ratio.
It is provided that P.V. Ratio of the company is 331/3%, it means contribution to sales ratio is 33
1/3%andvariablecosttosalesratiois662/3%{100–331/3}

UNITIII:RECEIVABLEMANAGEMENT 247
Step 3 : Calculation of profit/(Loss) for each credit period.
Creditperiod 30 45 60 75 90
(30+15) (30+30) (30+45) (30+60)
Sales 2,40,000 2,52,000 2,58,000 2,61,000 2,64,000
{2,40,000 {2,40,000 {2,40,000 {2,40,000
+12,000} +18,000} +21000} +24,000}
Variable cost (1,60,000) (1,68,000) (1,72,000) (1,74,000) (1,76,000)
(662/3%)
Carrying cost (2,667) (4,200) (5,733) (7,250) (8,800)

­ 1.60L ½ ­ 1.68L ½
® 360 u 30 u 20%¾ ® 360 u 45 u 20%¾
¯ ¿¯ ¿

­ 1.72 L ½ ­ 1.76L ½ ­ 1.74000 ½


® 360 u 60 u 20%¾ ® 360 u 90 u 20%¾ ® 360 u 75 u 20%¾
¯ ¿¯ ¿ ¯ ¿
P/(L) 77,333 79,800 80,267 79,750 79,200
Company should offer credit of 60 Days.
Q18 ABCfirmisconsideringtomakecertainrelaxationinitscreditpolicy.TheABCmanagementhasevaluated
two new policies. From the following details advise the ABC management which policy has to be
adopted:
(i) Annual CreditSales at Present `87.5lakhs
(ii) Proposed Credit Sales:
UnderAlternativeI Under AlternativeII
`105lakhs `118lakhs
(iii) Accounts receivable turnover ratio
andbaddebtslosses:
Existing I II
7times 5.25times 4.2times
BadDebts `2.63lakhs, `5.25lakhs, `7.88laths.
(iv) TheABCisrequiredtogiveareturnover30%ontheinvestmentinnewaccountsreceivable.
(v) ItsPVratiois30%.
Solution
Step No. 1 : Calculation of Fixed cost :
Directly or Indirectly no information is given about fixed cost, so calculation of fixed cost is ignored.
Step No.2 : Calculation of variable cost to sales ratio.
As Profit Volume Ratio (PV Ratio/contribution to sales ratio is 30%) it means variable cost to sales
ratiois70%(100–30)
Step 3 : Calculation of profit/(Loss) for each credit period.
W.N. 1 Calculation of Average collection period for existing and proposed credit policies.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 248
12Months
ACP=
Debtorsturnoverratio

Existing Proposal I Proposal II

12Months 12Months 12Months


= = =
7times 5.25times 4.20times
12 12 12
= Months = Months = Months
7 5.25 4.20
Calculation of profit/(Loss) for each credit period
12 12 12
Par.Cr.Period Months  Months Months
7 5.25 4.20
Sales 87.50L 105L 118L
Variable cost (61.25)L (73.50)L (82.60)L
(70%)
Carrying cost (2,62,500) (4,20,000) (5,90,000)

V.C. 61.25L 12 73.50L 12 82.60 L 12


u ACP u k% u u 30% u u 30% u u 30%
12 12 7 12 5.25 12 4.2

B.D. (2.63)L (5.25)L (7.88)L


P/(Loss) 20,99,500 22,05,000 21,62,000
   Company is advised to offer credit period of 12/5.25 months.
Q19 AgroProductsLtd.isconsideringthe followingcreditpolicyalternatives2
Existing Option Option
Policy I II
(a) Credit Period (days) 30 14 60
(b) Sales (` lakhs) 10.0 9.60 12.00
(c) BadDebts(%ofsales) 5 3.33 6
(d) Cost of Credit Administration (` lakh) 0.20 0.12 0.25
(e) Average Effective Collection Period (days) 45 21 75
The average effective collection period differs from the credit period as all debtors do not strictly
adheretotheconditionstipulated.Thecompanyachievesacontributionof40%onsalesandthefirm
requires a 20% p.a. return on investment. You are required to suggest which credit period is more
suitable to the company. Do you have any further suggestion to make to the Management in the
context of your finding?
Solution
Step No. 1 : Calculation of Fixed cost :
Directly or Indirectly no information is given about fixed cost, so calculation of fixed cost is ignored.
Step No.2 : Calculation of variable cost to Sales ratio.

UNITIII:RECEIVABLEMANAGEMENT 249
It is providedthat contribution to sales ratio is 40%. So variable cost to sales ratio is60%.(10040)
Step No. 3 : Calculation of Profit/(Loss) for each credit policy.
Particulars\
Credit policy Exisitng Option I Option II
Sales 10L 9.60L 12L
Variable cost (6)L (5.76)L (7.20)L
(60%)
Carrying cost (14,794) (6,628) (29,589)

6L 5.76L 7.20L
u 45 u 20% u 21 u 20% u 75 u 20%
365 365 365
B.D. (50,000) (31,968) (72,000)
{10L×5%} {9.60L×3.33%} {12L×6%}
Collection cost (20,000) (12,000) (25,000)
Profit/(Loss) 3,15,206 3,33,404 3,53,411
Company should offer credit period of 75 Days.
Q20 Apollo Traders Ltd. sells its products through a widely distributed dealer network, allowing a credit
periodof15daysonly.Theaveragevariablecostis60%ofsalesvalueandcurrentsalesamountto` 100
lakhs.To meet growing competition the firm is trying to revamp its marketing strategy. This entails
changingthecreditperiodsuitablyandalsoincreasingthesalespromotionexpenseswhichwillincrease
the fixed costs. The marketing department has given the following estimates for various options,
along withcurrentresults:
Particulars Current Option Option II Option Ill
Credit period (months) ½ 1 1½ 2
Sales (lakhs ofrupees) perannum 100 120 135 150
Fixed costs (lakhs of rupees)
perannum 15 18 20 24
Baddebts(%ofsales) 1 1½ 2 3
Youarerequiredtoanalysetheabovedetailsinasuitableformatandsuggestthebeststrategyfor
thefirm.Additionalifrequired,canberaisedbythefirmatacostof16%p.a.
Solution
Step No. 1 : Calculation of fixed cost.
It is given in the question, for each credit period.
Step No. 2 : Calculation of variable cost of sales ratio.
It is 60% of sales, as given in the question.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 250
Step No. 3 :Calculation of Profit/(Loss) for each credit period.
Par. Credit Period 1/2 Months 1 Month 11/2 Months 2 Months
Sales 100L 120L 135L 150L
Variable (60)L (72)L (81)L (90)L
cost(60%)
Fixed Cost (15)L (18)L (20)L (24)L
Carrying cost (0.50)L (1.20)L (2.02)L (3.04)L

­ 60 L  15L ½ ­ 72 L  18L ½
® u 0.50 u 16%¾ ® u 1 u 16%¾
¯ 12 ¿¯ 12 ¿

­ 90 L  24L ½ ­ 81 L  20L ½
® u 1 u 16%¾ ® u 1.5 u 16%¾
¯ 12 ¿¯ 12 ¿
B.D. (1)L (1.80)L (2.70)L (4.50)L
{100L×1%} {120L×1.50%} {135L×2%} {150L×3%}
Profit/(Loss) 23.50L 27L 29.28L 28.46L
Company should offer Credit period of 1.50 month.
Q21 HLtd.hasapresentannualsaleslevelof10,000unitsat`300perunit.Thevariablecostis`200per
unit and the fixed costs amountto ` 3,00,000 per annum. The present credit period allowed by the
companyis1month.Thecompanyisconsideringaproposaltoincreasethecreditperiodto2months
and3monthsandhasmadethefollowingestimates:
Existing Proposed
Credit Policy 1Month 2Month 3Month
Increase in Sales – 15% 30%
%ofBadDebts 1% 3% 5%
Therewillbeincreaseinfixedcostby`50,000onaccountofincreaseofsalesbeyond25%ofpresent
level.
Thecompanyplansonapretaxreturnof20%oninvestmentinreceivables.
Youarerequiredtocalculatethemostpayingcreditpolicyforthecompany.
Solution
Step:1 Fixed cost
PresentFixedcost+increase Rs3,00,000 (Ifsalesincreasedbymorethan
25%)
Rs.50,000
Rs.3,50,000
Step:2Variablecosttosalesratio.

Variable cost
= x 100
sales

UNITIII:RECEIVABLEMANAGEMENT 251
200
= x100 =66.67%
300
Step3:Calculationofprofitorlossforeachcreditperiod
Credit period 1 months 2 months 3 months
Sales 30,00,000 34,50,000 39,00,000
(10,000x300) (11,500x300) (13,000x300)
() variable cost (29,00,000) (27,00,000) (26,00,000)
() fixed cost (3,00,000) (3,00,000) (3,50,000)
()carryingcost (38,333) (43,333)x2 (1,47,500)

ª Variable cost + fixed cost º


«¬ x1 / 32x 20% » (86,667)
12 ¼
() Bad debit (30,000) (1,03,500) (1,95,000)
(30,00,000x1%) (34,50,000x3%) (39,00,000x5%)
6,31,667 6,59,833 6,07,500
2 1 3
Thecompanyisadvisedtooffercreaditperiodof2months.
Aboveanswer canbecalculatedbyusingincrementalmethod:
In thiscase willcalculate incremental profitasloss due tochange in creditperiod. Itis calculated as
under:
Step 1 : willbesameasofthefirstmethodi.e.totalfixedcostcalculationandvariable
Step 2 costofsalesratiocalculation.
Step 3: Calculation of incremental carrying cost.
Incrementalcarryingcostiscalculatedasincarryingcostduetoproposedcreditpolicyoverthepresent
one.
Overhereitiscalculatedasunder:
Credit Period 1 month 2 months 3 months
Sales units 10,000 11,500 13,000
(10,000+15%) (10,000+30%)
Total Variable cost 20,00,000 23,00,000 26,00,000
(10,000x200) (11,550x200) (13,000x200)
Total Fixed cost 3,00,000 3,00,000 3,50,000
Carrying cost. 38,333 86,667 1,47,500

§ VC + FC ·
¨ x ACP x 20% ¸
© 12 ¹
(23,38,333)x (26,86,667)x48,335 1,09,167
Incremental Carrying cost

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 252
Step : 4 Incrementalprofitorlossiscalculatedwhatischangeinprofitforproposed
creditpolicyoverthepresent.Itiscalculated asunder.
Credit Period 2 months 3 months
Sales 4,50,000 9,00,000
(10,000+15%x300) (10,000x30%x300)
(3,00,000) (6,00,000)
(10,000x15%x200) (10,000x30%x200)
() Fixed cost Nil (50,000)
()Carryingcost (48,333) (1,09,167)
() Bad debts (73,500) (1,65,000)
[10,000x15%x300x3%)
[10,000x300x1%]=
[1,03,40030,000]
Profit 28,167 (24,167)
Thecompanyisadvisedtooffercreditperiodoftwomonths.
Ifareproposedcreditpolicieshavechangeinprofitnegative,thenitthatcasecompanywillbeadvised
to continue with present credit policy.
Q22 SuperSportsCompanydealinginsportsgoods,hasanannualsaleof`50lakhandiscurrentlyextending
30day'scredittothedealers.Itisfeltthatsalescanpickupconsiderablyifthedealersarewillingto
carryincreasedstocks,butthedealershavedifficultyinfinancingtheirinventory.SuperSportsCompany
is, therefore, considering shifts in credit policy. The following information is available.
Theaveragecollectionperiodnowis30days.(1year=360days)
Costs.Variablecosts80%onsales.
Fixedcosts,`6lakhsperannum.
Required(pretax)returnoninvestment:20%
Credit policy Average collection period Annual sales (` lakhs)
A 45days 56
B 60days 60
C 75days 62
D 90days 63
Determine which policy the company should adopt.
Solution
Step:1 TotalfixedcostRs.6,00,000
Step:2 Variablecosttosalesratioi.e.80%
Step:3 Calculationofprofitorlossforeachcreaditperiod

UNITIII:RECEIVABLEMANAGEMENT 253
Creadit period 30 days 45 days 60 days 75 days 90 days
Sales 50,00,000 56,00,000 60,00,000 62,00,000 63,00,000
()Variablecost (40,00,000) (44,80,000) (48,00,000) 49,00,000) (50,00,000)
()Fixedcost (6,00,000) (6,00,000) (6,00,000) (6,00,000) (6,00,000)
()Carryingcost (76,667) (1,27,000) (1,80,000) (2,31,667) (2,82,000)

ª variable cost + fixedcost º


«¬ x Acp x20% »
360 ¼
Profit 3,23,333 3,93,000 4,20,000 4,08,3333, 3,78,000
5 3 1 2 4
Thecompanyisadvisedtooffercreaditperiodof60daystocustomers.

Q23 Household Appliances Ltd. deals with consumer durables, having an annual turnover of ` 60 lakhs.
Normalcreditallowedis30days.Thecompanyproposestoexpanditsbusinesssubstantiallyandthere
is good demand as well. However, the marketing manager finds that the dealers have difficulty in
holdingmorestocksduetofinancialproblems.He,therefore,proposesachangeinthecreditpolicyas
follows:
Proposal Credit period Anticipated credit sales
(` lakhs)
PlanI 60days 70
Plan II 90days 75
Theproductsyieldanaveragecontributionof25%onsales.Fixedcostsamountto`5lakhsperannum.
Thecompanyexpectsapretaxreturnof20%oncapitalemployed.Thefinancemanagerafterareview
oftheproposalhasrecommendedincreasingtheprovisionforbaddebtsfromthecurrent1%to1½%
for PlanI and to 2% for Plan II. Evaluate the merits of the new proposals and recommend the best
policy.
Ans.
Solution
Evaluation of different credit policy :
Step1:Fixedcosti.e.Rs.5lacs
Step2:Variablecosttosalesratioi.e.100%25%contribution=75%
Step3:*Calculationofprofitorlossforeachcreditperiod*
Particulars Present Option1 Option2
Sales 60,00,000 79,00,000 75,00,000
()Variable cost(75%) (45,00,000) (52,50,000) (56,25,000)
Contribution 15,00,000 17,50,000 18,75,000
() fixed cost (5,00,000) (5,00,000) (5,00,000)
()carryingcost (82,192) (1,89,041) (3,02,055)

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 254
ª Variable cost + fixed cost º
«¬ x Acp x20% »
365 ¼
() Bad debits (60,000) (1,50,000) (1,50,000)
Profit 8,57,808 9,55,959 9,22,945
3 1 2
Thecompanyisadvisedtooffercreditperiodof60daystocustomers.
TAX
Q24 As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell
goodstoagroupofnewcustomerswith10%riskofnonpayment.Thisgroupwouldrequireoneanda
half months credit and is likely to increase sales by ` 1,00,000 p.a. Production and Selling expenses
amount to 80% of sales and the incometax rate is 50%. The company’s minimum required rate of
return(aftertax)is25%.
Should the sales manager’s proposal be accepted?
Also find the degree of risk of nonpayment that the company should be willing to assume if the
requiredrateofreturn(aftertax)were(i)30%,(ii)40%and(iii)60%. [Page No. 10.111, Q8]
Ans.
(1) Profit=2,500
(2) AcceptableDegreeofriskofnonpaymentis14%,12%and8%ifrequiredrateofreturn(aftertax)is
30%,40%and60%respectively.
Q25 TheSalesManagerofABLimitedsuggeststhatifcreditperiodisgivenfor1.5monthsthensalesmay
likelytoincrease by`1,20,000 perannum.Costof sales amountedto90% ofsales.Therisk ofnon
paymentis5%.Incometaxrateis30%.
Theexpectedreturnoninvestmentis`3,375(aftertax).Shouldthecompanyacceptthesuggestion
ofSalesManager?
Solution
In this question we have been given information that increase in sales will be
Rs.1,20,000sotakingincrementalsales,wewillcalculateanswer.
WN for calculating earning after taxes, with credit period of 1.50 month.
Particulars Amount
Sales 1,20,000
Cost of Sales (90%) (1,08,000)
B.D. (5%) (6,000)
EBT 6,000
Tax (30%) (1,800)
EAT 4,200
Conclusion :
As actual Earning After Taxes is exceeding required earning after taxes Rs.3,375 so company
should offer credit of 1.50 month to customer.

UNITIII:RECEIVABLEMANAGEMENT 255
INCREMENTAL APPROCH SINGLE CUSTOMER AND PARTIAL PAYMENT
Q26 SlowPayersareregularcustomersofGoodsDealersLtd.,Calcuttaandhaveapproachedthesellersfor
extension of a credit facility for enabling them to purchase goods from Goods Dealers Ltd. On an
analysisofpastperformanceandonthebasisofinformationsupplied,thefollowingpatternofpayment
scheduleemergesinregard toSlow Payers:
Pattern of Payment Schedule
Attheendof30days 15%ofthebill
Attheendof60days 34%ofthebill
Attheendof90days 30%ofthebill
Attheendof100days 20%ofthebill
Nonrecovery 1%ofthebill
SlowPayerswanttoenterintoafirmcommitmentforpurchaseofgoodsof`15lakhsin2017,deliveries
tobemadeinequalquantitiesonthefirstdayofeachquarterinthecalendaryear.Thepriceperunit
ofcommodityis`150onwhichaprofitof`5perunitisexpectedtobemade.ItisanticipatedbyGoods
DealersLtd.,thattakingupofthiscontractwouldmeananextrarecurringexpenditureof`5,000per
annum.IftheopportunitycostoffundsinthehandsofGoodsDealersis24%perannum,wouldyouas
thefinancemanagerofthesellerrecommendthegrantofcredittoSlowPayers?Workingsshouldform
partofyouranswer.Assumeyearof360days. [Page No. 10.111, Q9]
Ans.
NetBenefits=39,743

OFFER OF CASH DISCOUNT TO BE GIVEN TO CUSTOMERS


Q27 AakashLtdsellsoncreditterms"2/15net45".ltspresentsalesare`100Lakhsperannum,Variable
Costsare70%ofSalesandFixedCostsare`12Lakhsperannum.TheCompany'scostoffundsis24%
anditisobservedthat40%ofthecustomersavailthediscount,whiletherestpayontheduedate.
The Company is considering relaxing its credit terms to "3/18 net 45". This relaxation is expected to
increasesalesby25%andfixedcostsby`3Lakhsperannum.Duetoeconomyofoperations,variable
costswillbereducedto68%onallsales.Itisexpectedthat80%ofthecustomerswillavailthediscount,
therestpayingontheduedate.
Advise whether the relaxation in credit terms is worthwhile. Show workings clearly.
Solution
Step No. 1 :Calculationoftotalfixedcost.
It is Rs. 12 L presently and it will increase the Rs.15 L with proposed credit policy.
Step No. 2 : Calculation of variable cost to sales ratio.
Presently it is 70% of sales, it will reduce to 68% of sales, with proposed credit policy.
Step No. 3 : CalculationofProfit/(Loss)forpresentandproposedcreditterm:
W N1: Calculation of Weighted AverageCollectionPeriod for Present credit term.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 256
Customers % of customers Days % of Customers
× No. of Days
Availing Cash Discount Facility 0.40 15Days 6
Not Availing Cash Discount Facility 0.60 45Days 27
Weighted Average Collection Period 33
W N2:Calculation of Weighted Average Collection Periodfor Proposed creditterm.

Customers % of customers Days % of Customers ×


No. of Days
Availing Cash Discount Facility 0.80 18Days 14.40
Not Availing Cash Discount Facility 0.20 45Days 9.00
Weighted Average Collection Period 23.40

Particulars Present Proposed


Sales 1,00,00,000 1,25,00,000
{1Crore+25%}
Variable Cost ()70,00,000 ()85,00,000
(70% ofsales) (68% ofsales)
Fixed Cost ()12,00,000 ()15,00,000
Carrying Cost ()1,77,929 ()1,53,863

­ 70 L + 12 L ½ ­ 85 L + 15 L ½
® x 33 x 24%¾ ® x 23.40 x 24%¾
¯ 365 ¿ ¯ 365 ¿
Discount Allowed ()80,000 ()3,00,000
(100Lakhsx40%x2%) (125Lakhsx80%x3%)
Profit / (Loss) 15,42,071 20,46,137
Decision : Since thereisadditionalnetbenefit,therelaxationincredit termsisworthwhile.
Q28 Acompanyispresentlyhavingcreditsalesof`12lakh.Theexistingcredittermsare1/10,net45days
andaveragecollectionperiodis30days.Thecurrentbaddebtslossis1.5%.Inordertoacceleratethe
collectionprocessfurtherasalso toincreasesales, the companyis contemplatingliberalization ofits
existingcredittermsto2/10,net45days.Itisexpectedthatsalesarelikelytoincreaseby1/3ofexisting
sales, bad debts increase to 2% of sales and average collection period to decline to 20 days. The
contributiontosalesratioofthecompanyis22%andopportunitycostofinvestmentinreceivablesis
15percent(pretax).50percentand80percentofcustomersintermsofsalesrevenueareexpectedto
avail cash discount under existing and liberalization scheme respectively. The tax rate is 30%.
Shouldthecompanychangeitscreditterms?(Assume360daysinayear).

UNITIII:RECEIVABLEMANAGEMENT 257
Solution
FixedCostNotGiven
VCtosales=10022=78%
Cr.Period 30 20
1/10net 2/10net
Sales 12,00,000 16,00,000
()VC (9,36,000) (12,48,000)
() Carrying (1700)
()BD (18,000) (32,000)
()DTSC (6,000) (25,600)
________ __________
BTD 2,28,300 2,84,000
() Tax
(30%) (68490) (85200)
1,59,810 1,98,800
TheCo.isadvisedtoofferaCr.periodbasedODproposedCr.policy.
NO VARIABLE COST AND FIXED COST INFORMATION HAVE BEEN GIVEN
Q29 ThePQRCompany’sannualcreditsalesare`60crore.Thecompany’sexistingcredittermsare1/15,net
40.Generally60percentofthecustomersavailthecashdiscountfacility.Theaveragecollectionperiod
is 45 days. The percentage default rate is 1.50 per cent. The company is thinking of two alternative
changesincreditterms:
Credit Percentage Taking Average Collection Default (%)
Terms Discount Period

2/10,net35 80 20 1.0
3/10,net25 95 14 0.5
What strategy should be followed by the PQR company if sales are expected to remain stable and the
requiredrateofreturnis18percent?
Solution
In thisquestion we are required toevaluate that which credit policy should be offerred to customer in
this question information about cost is not given so we have to adopt total relevant cost approach for
decisionmakingtotalrelevantcostiscalculatedtakingintoaccount
(i) Amount of bad debits
(ii) Amountofcashdiscount
(iii) Amountofcarryingcost
Foralltheoptionssalesissame,soforalloptionsvariablecostisalsosame,sooptionhavinglowest
relevant cost will be selected.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 258
*Totalrelevantcostforeachofthecreditterm*
Particulars present 1/ 5 net 40 2/10 net 35 3/10 net25
Bad debits 0.9 0.6 0.3
[60x1.5%] [60x1%] [60x0.5%]
Cash discount 0.36 0.96 1.71
[60x60%x1%] [60%80%x2%] [60x95%x3%]
Carrying cost 1.3315 0.5918 0.4142

ª 45 º ª 20 º ª 14 º
«¬60x 365 x18% »¼ «¬60x 365 x18% »¼ «¬60x 365 x20% »¼

ª Acp º
«¬ Sales x 365 x18% »¼ 205915 2.1518 2.4242

3 1 2
Thecompanyisadvisedtooffercreditterm2/10net35.

UNITIII:RECEIVABLEMANAGEMENT 259
UNIT IV : PAYABLE MANAGEMENT

CLASS WORK

Q1 XYZLtd.isofferedbyitssuppliercashdiscount@2%ifitismakingpaymentwithin10days,presently
XYZLtd.ismakingpaymentafter70days.
Ifcostofcapitalofthecompanyis12%.YouarerequiredtoanswerthatwhetherXYZLtd.should
avail suchcashdiscount advantage?
Q2 The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s
recordsbytheowner,Mr.Gupta,revealedthatpaymentsareusuallymade15daysafterpurchasesare
received.Whenaskedwhythefirmdidnottakeadvantage ofitsdiscounts, theaccountant,Mr.Ram,
repliedthatitcostonly2percentforthesefunds,whereasabankloanwouldcostthecompany12per
cent.
(a) WhatmistakeisRammaking?
(b) Whatistherealcostofnottakingadvantageofthediscount?
(c) If the firm could not borrow from the bank andwas forced to resort to the use of trade credit
funds,whatsuggestionmightbemadetoRamthatwouldreducetheannualinterestcost?
Q3 Suppose ABC Ltd. has been offered credit terms from its major supplier of 2/10, net 45. Hence the
companyhasthechoiceofpaying`98per`100ortoinvest`98foranadditional35daysandeventually
paythesupplier`100per`100.Thedecisionastowhetherthediscountshouldbeaccepteddepends
ontheopportunitycostofinvesting`98for35days.Whatshouldthecompanydo?
[10.87; Q.No.20]
FACTORING
1. Factoringmeansaprofessionalagencyappointedbythecompanywhogivescollectionservicetothe
company.
2. Usually subsidiary of a bank is a factor. Apart from collection services, factor will advance funds to
company against uncollected debtors.
3. Factormaybearriskofbaddebts,itmaynot;dependingupontypeoffactoringagreement.
Q4 A company is considering to engage a factor.The followinginformation is available:
• Thecurrentaveragecollectionperiodforthecompany’sdebtorsis90daysand0.50% ofdebtors
default.Thefactorhasagreedtopaymoneydueafter60daysandwilltaketheresponsibilityof
anylossonaccountofbaddebts.
• The annual charge for factoring is 2% of turnover. Administration cost saving is likely to be  Rs.
1,00,000perannum.

NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 260
• AnnualcreditsalesareRs.1,20,00,000.Variablecostis80%ofsalesprice.Thecompany’scostof
borrowingis15%perannum.Assume360daysinayear.
Shouldthecompanyenterintoafactoringagreement?
Q5 ALtd.hastotalsalesof`3.2croresanditsaveragecollectionperiodis90days.Thepastexperience
indicatesthatbaddebtlossesare1.5%onsales.Theexpenditureincurredbythefirminadministering
its receivable collection efforts are ` 5,00,000. A factor is prepared to buy the firm’s receivables by
charging2%commission.Thefactorwillpayadvanceonreceivablestothefirmataninterestrateof
18%p.a.afterwithholding10%asreserve.Takeoneyearequalsto360Day.
IfcostofCapitalofcompanyis10%,whetherFactorshouldbeappointed.
Q6 ALtd.hastotalsalesof`3.2croresanditsaveragecollectionperiodis90days.Thepastexperience
indicatesthatbaddebtlossesare1.5%onsales.Theexpenditureincurredbythefirminadministering
its receivable collection efforts are ` 5,00,000. A factor is prepared to buy the firm’s receivables by
charging2%commission.Thefactorwillpayadvanceonreceivablestothefirmataninterestrateof
18%p.a.afterwithholding10%asreserve.Takeoneyearequalsto 360Days.Ifcaseofcapital ofthe
companyis15%Whetherfactorshouldbeappointed?
Q7 ALtd.hastotalsalesof`3.2croresanditsaveragecollectionperiodis90days.Thepastexperience
indicatesthatbaddebtlossesare1.5%onsales.Theexpenditureincurredbythefirminadministering
its receivable collection efforts are ` 5,00,000. A factor is prepared to buy the firm’s receivables by
charging2%commission.Thefactorwillpayadvanceonreceivablestothefirmataninterestrateof
18%p.a.afterwithholding10%asreserve.Takeoneyearequalsto360Days.
CalculatetheeffectivecostoffactoringtotheFirm.

UNITIV:PAYABLEMANAGEMENT 261
HOME WORK

Q8 AFactoringfirmhascreditsalesof`360lakhsanditsaveragecollectionperiodis30days.Thefinancial
controllerestimates,baddebtlossesarearound2%ofcreditsales.Thefirmspends`1,40,000annually
on debtorsadministration. This cost comprises of telephonic and fax bills along with salariesof staff
members.Thesearetheavoidablecosts.AFactoringfirmhasofferedtobuythefirm’sreceivables.The
factorwillcharge1%commissionandwillpayanadvanceagainstreceivablesonaninterest@15%p.a.
afterwithholding10%asreserve.Whatshouldthefirmdo?Assume360daysinayear.
[Page 10.76, Q17]
Solution
Wheneverthereisaquestionofdecisionmakingthenitthatcasewecanmakecanoftotalcostforeach
oftheoption.Evenwecouldhavecalculatedeffectivecostofthefactoringwhichwillbecomparedwith
costofcapitalofthecompanyfordecisionmaking.
Inthisquestions wearerequiredtodecide whethertoappointfactooror not.Howeverfor thisdecision
makingwehavenotbeengivencostofcapitalofthecompany.So,wewillcalculateeffectivecostofthe
factoring.Itmaybepositiveanditmaybenegative.Ifitispositivewewillgivearangeofcostofcapital
forwhichfactoreshouldbeappointed&nottobeappointed.
If it is negative then definately factore should be appointed.
OPTION:1. CONTINUE WITH IN HOUSE MANAGE RECEIVABLE
Particulars Amt.
BadDebts 7,20,000
[360,00,000X2%]
Collection cost 1,40,000
Carringcost 30,00,000x

ª360L º
x30ux
«¬ 360 »¼
TotalCost 8,60,000+30,00,000x
OPTION:2. APPOINMENT OF FACTOR
STEP:1.
Calculation of Debtors
Annual credit sales
xACP
360

360,00,000x 30
=
360
= `30,00,000

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STEP:2. CALCULATION OF AMOUNT LENT BY FACTOR:
Particulars Amt.
Debitors30,00,000
F.Res.(10%) (3,00,000)
F.Comm.(1%) (30,000)
AmtonwhichInt.iscalculated 26,70,000
Int. collected in advance (33,375)
[26,70,000x0.15x30/360]
Amt lent 26,36,625
STEP:3. CALCULATION OF TOTAL COST
Factoring Commission 3,60,000
[360,00,000X1%]
Interestpaymenttofactor 4,00,500
[26,70,000x15%]
Carringcost[30,00,00026,36,625]xx 363,375x
TotalCost 7,60,000+3,63,375x
CALCULATION OF X
T.C.FOROPTIONI T.C. FOR OPTIONII

8,60,000+30,00,000xx 7,60,000+3,63,375x
(30L3,63,375)x 7,60,5008,60,000
99500
x  26,36,625 x100

()3.77%
Aseffectivecostofthefactoryisnegative.So,companyshouldappointfactorewhatevermaybecost
ofcapitalofthecompany.
With appointment of thefactor the company isableto save expense andat thesame timefactor is
lending fundsto the company.
Q9 Afirmhasatotalsalesof`12,00,000anditsaveragecollectionperiodis90days.Thepastexperience
indicatesthatbaddebtlossesare1.5%onsales.Theexpenditureincurredbythefirminadministering
receivablecollectioneffortsare`50,000.Afactorispreparedtobuythefirm’sreceivablesbycharging
2%commission.Thefactorwillpayadvanceonreceivablestothefirmataninterestrateof16%p.a.
afterwithholding10%asreserve.Calculateeffectivecostoffactoringtothefirm.Assume360daysin
ayear.

UNITIV:PAYABLEMANAGEMENT 263
Solution
OPTION NO.1 CONTINUE WITH INHOUSE MANAGEMENT OF RECEIVABLE
Particulars Amt.
Baddebts
(12,00,000x1.5%) 18000
Collection cost 50,000
Carryingcostofownfunds 3,00,000x
ª 12,00,000 º
«¬ 360 ×90× x »¼

Totalcost 68000+3,00,000x
Option No.2 Appoint Factor
Step:1.
Collection of Debtors
Annualcreditsales×ACP
=
360

12, 00, 000


= × 90
360
`3,00,000
Step:2.
Collection amount lent to factor
Particulars Amt.
Debtors 3,00,000
factoring reserve (10%) (30,000)
Factoringcommision(3,00,000x2%) (6000)
Amount on whichint collectionin adv. (10,560)

ª2, 64, 000 × 90 × 0.16º


¬ 360 ¼
Amount lent 2,53,440

Step:3. Collection of Total cost


Particulars Amt.
Factoring Commission 24,000
[12,00,000x2%]
Intpaytofactor 42,240
[2,64,000x0.16]
Carryingcostofownfunds 46,560x

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[3,00,0002,53,440]x x
TotalCost 66,240+46560x
Calculation of x
T.CFOR T.CFOR
Option I Option II
68000+ 3,00,000x 66240+46,560x
(3L46560)x 6624068000
x () 0.69%

Effectivecostofcapitalwithcompanycostofcapitalofthecompanyfordecisionmaking.Thecompany
isrequiredtotakedecisionasunder:
Cost of Capital Cost of Factoring Appoint Factor
> Yes
= Indiff
< No
Ifatalleffectivecostofcapitalisnegativeinthatcasewhatevermaybecostofcapitalofthecompany
should appoint factor. Effective cost of the factoring negative means the company has advantage in
formofreducingofexpensewithappointmentoffactorandalsothecompanyisabletogetfundsfrom
factor.
Q10 Afirmhasatotalsalesof`200lakhsofwhich80%isoncredit.Itisofferingcredittermsof2/40,net120.
Of the total, 50% of customers avail of discount and the balance pay in 120 days. Past experience
indicates that bad debt losses are around 1% of credit sales. The firm spends about ` 2,40,000 per
annum to administer its credit sales. These areavoidable as a factor is prepared to buy the firm’s
receivables. He willcharge 2% commission.He willpayadvance againstreceivablesto thefirmat an
interestrateof18%afterwithholding10%asreserve.
Incoverd even after appoinment of factor.
(i) Whatistheeffectivecostoffactoring?Consideryearas360days.
(ii) Ifbankfinanceforworkingcapitalisavailableat14%interest,shouldthefirmavailoffactoring
service?
Solution :
Option:1. CONTINUE WITH INHOUSE RECEIVABLE MANAGEMENT
WN.1 CALCULATIONOFCREDITSALE:
= 200LX80%
= 160L
WN.2 Calculation of Avrage collection period:
Customer % Days %xDays
Availing cash discount 0.50 40 60
Notavailingcash discount 0.50 120 20
80
AssumingthatcostofcapitalofthecompanyxTotalcostiscaculated

UNITIV:PAYABLEMANAGEMENT 265
Particulars Amt.
Cash discount 160,000
[160Lx0.50x2%]
B.D 1,60,000
(160Lx1%)
Collection cost 8,40,000
Carringcost

ª 160L
« × 80× x º» 35,55,556x
¬ 360 ¼

Totalcost 5,60,000+35,55,556x
Option:2. Appoinment of factor
Calculation of amount of Debtors:
Inthisquestionwehavenotbeengivenanyguaranteedpaymentdate.So,weassumethatthereisno
changeinthecredittermhencecollectionperiodwillbe80daysandCashdiscountwillbeasperIn
house management of receivable.
Annualcreditsales
Debtors × Acp
360
160L
×80
360
35,55,556
Step:2. Calculation of amount lent by factor:
Particulars Amt.
Cashdiscout 35,55,556
F.Res(10 %) ()3,55,556
F.comm(2%) ()71,121
AmountonwhichInt.iscalculated 31,28,889
Int collection in Adv. (1,25,156)
Amount Advanced 30,03,733
Step:3. Calculation of T.C
Particulars Amt.
Interestpaytofactor 5,63,200
(31,28,889x0.18)
Factoring Commission 3,20,000
(160Lx2%)
Carryingcostofownfinance 5,51,823x
(35,55,55630,03,733)x

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Cash discount 1,60,000
(160Lx0.50x2%)
TotalCost 10,43,200+5,51,823x

4 Calculation of value of x
TotalcostforoptionI TotalcostforoptionII
5,60,000+35,55,556x 10,43,200+5,51,823x
4,83,200
x ×100
30,03,733
16.08%

(II) I 10,57,778 {5,60,000+(35,55,556x4.14)}


II 11,20,455 {10,43,200+(5,51,823x0.14)}
OR
So,thecompanyisadvisedtocontinuewithInhousemanagementofreceivable.Atthesametimewe
could have given answer that 14 % is thethan 16.0.8% .so, company should continue with Inhouse
receivable management.

UNITIV:PAYABLEMANAGEMENT 267
NavkarInstitute|CAIntermediate|Paper8A:FinancialManagement 268

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