Financial Analysis & Planning Ratio Analysis | 3.

1
CHAPTER – 3 Financial Analysis & Planning Ratio Analysis
Chapter – 3
Types of Financing
Question & Answer
Question 1
RTP /NOV. 2018/Q. 1/
Assuming the current ratio of a Company is 2, STATE in each of the following cases whether the
ratio will improve or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonoured
(v) Issue of new shares
Answer:
Current Ratio = 2 i.e. 2:1

S. Situation Improve/ Reason

No. Decline/ No
Change
(i) Payment of Current Ratio will Let us assume CA is ` 2 lakhs & CL is
Current liability improve ` 1 lakh. If payment of Current Liability
= `10,000 then, CA = 1, 90,000 CL
= 90,000.
Current Ratio =

= 2.11 : 1. When Current Ratio is 2:1

Payment of Current liability will reducethe
same amount in the numerator and
denominator. Hence, the ratio will improve.
(ii) Purchase of Fixed Current Ratio will Since the cash being a current asset
Assets by cash decline converted into fixed asset, current assets
reduced, thus current ratio will fall.
(iii) Cash collected Current Ratio willnot Cash will increase and Debtors will reduce.
from Customers change Hence No Change in CurrentAsset.

(iv) Bills Receivable Current Ratio willnot Bills Receivable will come down and
dishonoured change debtors will increase. Hence no change in
Current Assets.
(v) Issue of New Current Ratio will As Cash will increase, Current Assets will
Shares improve increase and current ratio will increase.
 Financial Analysis & Planning Ratio Analysis | 3.2
Question: 2
RTP /May-2019/Q. 1 /
From the following table of financial ratios of R. Textiles Limited, comment on various ratios
given at the end:

Ratios 2017 2018 Average of

Textile Industry
Liquidity Ratios
Current ratio 2.2 2.5 2.5
Quick ratio 1.5 2 1.5
Receivable turnover ratio 6 6 6
Inventory turnover 9 10 6
Receivables collection period 87 days 86 days 85 days
Operating profitability
Operating income –ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing decisions
Debt ratio 49.00% 48.00% 57%
Return
Return on equity 24% 25% 15%

COMMENT on the following aspect of R. Textiles Limited

(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders

Answer:
Ratios Comment
Liquidity Current ratio has improved from last year and matching the industry average.
Quick ratio also improved than last year and above the industry average. This
may happen due to reduction in receivable collection period and quick inventory
turnover. However, this also indicates idleness of funds.
Overall it is reasonably good. All the liquidity ratios are either better or same in
both the year compare to the Industry Average.
Operating Profits Operating Income-ROI reduced from last year but Operating Profit Margin has
been maintained. This may happen due to variability of cost on turnover.
However, both the ratio are still higher than the industry average.

Financing The company has reduced its debt capital by 1% and saved operating profit for
equity shareholders. It also signifies that dependency on debt compared to other
industry players (57%) is low.

Return to the R’s ROE is 24 per cent in 2017 and 25 per cent in 2018 compared to an industry
shareholders average of 15 per cent. The ROE is stable and improved over the last year.
 Financial Analysis & Planning Ratio Analysis | 3.3
Question: 3
RTP /May-2020/ Q. 1/
MT Limited has the following Balance Sheet as on March 31, 2019 and March 31, 2020:
Balance Sheet
` in lakhs
March 31, 2019 March 31, 2020
Sources of Funds:
Shareholders’ Funds 2,500 2,500
Loan Funds 3,500 3,000
6,000 5,500
Applications of Funds:
Fixed Assets 3,500 3,000
Cash and bank 450 400
Receivables 1,400 1,100
Inventories 2,500 2,000
Other Current Assets 1,500 1,000
Less: Current Liabilities (1,850) (2,000)
6,000 5,500

The Income Statement of the MT Ltd. for the year ended is as follows:
` in lakhs
March 31, 2019 March 31, 2020
Sales 22,500 23,800
Less: Cost of Goods sold (20,860) (21,100)
Gross Profit 1,640 2,700
Less: Selling, General and Administrative (1,100) (1,750)
expenses
Earnings before Interest and Tax (EBIT) 540 950
Less: Interest Expense (350) (300)
Earnings before Tax (EBT) 190 650
Less: Tax (57) (195)
Profits after Tax (PAT) 133 455
Required:
CALCULATE for the year 2019-20-
(a) Inventory turnover ratio
(b) Financial Leverage
(c) Return on Capital Employed (ROCE)
(d) Return on Equity (ROE)
(e) Average Collection period. [Take 1 year = 365 days]
Answer:
Ratios for the year 2019 – 2020

(a) Inventory turnover ratio

= 9.4
 Financial Analysis & Planning Ratio Analysis | 3.4
(b) Financial leverage

= = 1.46

(c) ROCE

= = 11.56%
( )

[Here Return on Capital Employed (ROCE) is calculated after Tax]

(d) ROE

(e) Average Collection Period

Average Sales per day = `65.20 lakhs

Average collection Period =

Question: 4
RTP /May-2021/Q. 1 /
Given below are the estimations for the next year by Niti Ltd.:
Particulars (` in crores)
Fixed Assets 5.20
Current Liabilities 4.68
Current Assets 7.80
Sales 23.00
EBIT 2.30
The company will issue equity funds of ` 5 crores in the next year. It is also considering the debt
alternatives of ` 3.32 crores for financing the assets. The company wants to adopt one of the
policies given below:
(` in crores)
Financing Policy Short term debt @ 12% Long term debt @ 16% Total
Conservative 1.08 2.24 3.32
Moderate 2.00 1.32 3.32
Aggressive 3.00 0.32 3.32
Assuming corporate tax rate at 30%, CALCULATE the following for each of the financing policy:
(i) Return on total assets
(ii) Return on owner's equity
(iii) Net Working capital
(iv) Current Ratio
Also advise which Financing policy should be adopted if the company wants high returns.
 Financial Analysis & Planning Ratio Analysis | 3.5
Answer:
(i) Return on total assets =

=
= = 0.1238 or 12.38%
(ii) Return on owner’s equity
Financing policy (`)
Conservative Moderate Aggressive
Expected EBIT 2,30,00,000 2,30,00,000 2,30,00,000
Less: Interest
Short term Debt @ 12% 12,96,000 24,00,000 36,00,000
Long term Debt @ 16% 35,84,000 21,12,000 5,12,000
Earnings before tax (EBT) 1,81,20,000 1,84,88,000 1,88,88,000
Less: Tax @ 30% 54,36,000 55,46,400 56,66,400
Earnings after Tax (EAT) 1,26,84,000 1,29,41,600 1,32,21,600
Owner's Equity 5,00,00,000 5,00,00,000 5,00,00,000
Return on owner's equity
=
= 0.2537 or = 0.2588 or = 0.2644 or
25.37% 25.88% 26.44%
(iii) Net Working capital
(` in crores)
Financing policy
Conservative Moderate Aggressive
Current Liabilities (Excluding 4.68 4.68 4.68
Short Term Debt)
Short term Debt 1.08 2.00 3.00
Total Current Liabilities 5.76 6.68 7.68
Current Assets 7.80 7.80 7.80
Net Working capital 7.80 - 5.76 7.80 - 6.68 7.80 - 7.68
= Current Assets - CurrentLiabilities = 2.04 = 1.12 = 0.12

(iv) Net Working capital

(` in crores)
Financing policy
Conservative Moderate Aggressive
Current Ratio
=

Advice: It is advisable to adopt aggressive financial policy, if the company wants high return as
the return on owner's equity is maximum in this policy i.e. 26.44%.
 Financial Analysis & Planning Ratio Analysis | 3.6
Question: 5
MTP /OCT - 2019/Q. 1(C)/ 5 MARKS
MNP Limited has made plans for the year 2019 -20. It is estimated that the company will employ
total assets of Rs.50,00,000; 30% of assets being financed by debt at an interest cost of 9% p.a.
The direct costs for the year are estimated at Rs. 30,00,000 and all other operating expenses are
estimated at Rs. 4,80,000. The sales revenue are estimated at Rs. 45,00,000. Tax rate is assumed
to be 40%. CALCULATE:
(i) Net profit margin (After tax);
(ii) Return on Assets (After tax);
(iii) Asset turnover; and
(iv) Return on Equity.
Answer:
The net profit is calculated as follows:
Rs.
Sales Revenue 45,00,000
Less: Direct Costs 30,00,000
Gross Profits 15,00,000
Less: Operating Expense 4,80,000
Earnings before Interest and tax (EBIT) 10,20,000
Less: Interest on debt (9% × 15,00,000) 1,35,000
Earnings before Tax) (EBT) 8,85,000
Less: Taxes (@ 40%) 3,54,000
Profit after Tax (PAT) 5,31,000
(i) Net Profit Martin (After Tax)
Net Profit Margin = 13.6%
(ii) Return on Assets (ROA) (After tax)
ROA =

=
= 0.1224 = 12.24%
(iii) Asset Turnover
Asset Turnover =
Asset Turnover = 0.9 times
(iv) Return on Equity (ROE)
ROE =
ROE = 15.17%

Question: 6
MTP /Nov. 2021/Q. 2/10 Marks
Jensen and spencer pharmaceutical is in the business of manufacturing pharmaceutical drugs
including the newly invented Covid vaccine. Due to increase in demand of Covid vaccines, the
production had increased at all time high level and the company urgently needs a loan to meet
the cash and investment requirements. It had already submitted a detailed loan proposal and
project report to Expo-Impo bank, along with the financial statements of previous three years as
follows:
 Financial Analysis & Planning Ratio Analysis | 3.7
Statement of Profit and Loss (In ` ‘000)
2018–19 2019–20 2020–21
Sales
Cash 400 960 1,600
Credit 3,600 8,640 14,400
Total sales 4,000 9,600 16,000
Cost of goods sold 2,480 5,664 9,600
Gross profit 1,520 3,936 6,400
Operating expenses:
General, administration, and selling expenses 160 900 2,000
Depreciation 200 800 1,320
Interest expenses (on borrowings) 120 316 680
Profit before tax (PBT) 1,040 1,920 2,400
Tax @ 30% 312 576 720
Profit after tax (PAT) 728 1,344 1,680
BALANCE SHEET (In ` ‘000)
2018–19 2019–20 2020–21
Assets
Non-Current Assets
Fixed assets (net of depreciation) 3,800 5,000 9,400
Current Assets
Cash and cash equivalents 80 200 212
Accounts receivable 600 3,000 4,200
Inventories 640 3,000 4,500
Total 5,120 11,200 18,312
Equity & Liabilities
Equity share capital (shares of ₹10 each) 2,400 3,200 4,000
Other Equity 728 2,072 3,752
Non-Current borrowings 1,472 2,472 5,000
Current liabilities 520 3,456 5,560
Total 5,120 11,200 18,312

INDUSTRY AVERAGE OF KEY RATIOS

Ratio Sector Average
Current ratio 2.30:1
Acid test ratio (quick ratio) 1.20:1
Receivable turnover ratio 7 times
Inventory turnover ratio 4.85 times
Long-term debt to total debt 24%
Debt-to-equity ratio 35%
Net profit ratio 18%
Return on total assets 10%
Interest coverage ratio (times interest earned) 10
As a loan officer of Expo-Impo Bank, you are REQUIRED to apprise the loan proposal on the
basis of comparison with industry average of key ratios considering closing balance for accounts
receivable of ` 6,00,000 and inventories of ` 6,40,000 respectively as on 31st March, 2018.
 Financial Analysis & Planning Ratio Analysis | 3.8
Answer:
Ratio Formula 2018–19 2019–20 2020–21 Industry
Average
Current 1,320 6,200 8,912 2.30:1
ratio 520 3,456 5,560
= 2.54 = 1.80 = 1.60

Conclusion:
In the last two years, the current ratio and quick ratio are less than the ideal ratio (2:1 and 1:1
respectively) indicating that the company is not having enough resources to meet its current
obligations. Receivables are growing slower. Inventory turnover is slowing down as well,
indicating a relative build-up in inventories or increased investment in stock. High Long-term
debt to total debt ratio and Debt to equity ratio compared to that of industry average indicates
high dependency on long term debt by the company.
 Financial Analysis & Planning Ratio Analysis | 3.9
The net profit ratio is declining substantially and is much lower than the industry norm.
Additionally, though the Return on Total Asset (ROTA) is near to industry average, it is declining
as well. The interest coverage ratio measures how many times a company can cover its current
interest payment with its available earnings. A high interest coverage ratio means that an
enterprise can easily meet its interest obligations, however, it is declining in the case of Jensen &
Spencer and is also below the industry average indicating excessive use of debt or inefficient
operations.
On overall comparison of the industry average of key ratios than that of Jensen & Spencer, the
company is in deterioration position. The company’s profitability has declined steadily over the
period. However, before jumping to the conclusion relying only on the key ratios, it is pertinent
to keep in mind the industry, the company dealing in with i.e. manufacturing of pharmaceutical
drugs. The pharmaceutical industry is one of the major contributors to the economy and is
expected to grow further. After the covid situation, people are more cautious towards their
health and are going to spend relatively more on health medicines. Thus, while analysing the
loan proposal, both the factors, financial and non-financial, needs to be kept in mind.

Question: 6
MTP /October- 2022/Q. 3 /10 Marks
From the following information and ratios, PREPARE the Balance sheet as at 31st March 2022
and lncome statement for the year ended on that date for M/s Ganguly & Co –
Average Stock `10 lakh
Current Ratio 3:1
Acid Test Ratio 1:1
PBIT to PBT 2.2:1
Average Collection period (Assume 360 days in a year) 30 days
Stock Turnover Ratio (Use sales as turnover) 5 times
Fixed assets turnover ratio 0.8 times
Working Capital `10 lakh
Net profit Ratio 10%
Gross profit Ratio 40%
Operating expenses (excluding interest) ` 9 lakh
Long term loan interest 12%
Tax Nil
Answer:
1. Current Ratio = 3:1
Current Assets (CA)/Current Liability (CL) = 3:1
CA = 3CL
WC = 10,00,000
CA – CL = 10,00,000
3CL – CL = 10,00,000
2CL = 10,00,000
CL =
CL = `5,00,000
CA = 3 × 5,00,000
CA = `15,00,000
2. Acid Test Ratio = CA – Stock / CL = 1:1
=
 Financial Analysis & Planning Ratio Analysis | 3.10
15,00,000 – stock = 5,00,000
Stock = `10,00,000
3. Stock Turnover ratio (on sales) = 5

Sales = `50,00,000
4. Gross Profit = 50,00,000 × 40% = `20,00,000
Net profit (PBT) = 50,00,000 × 10% = `5,00,000
5. PBIT/PBT = 2.2
PBIT = 2.2 × 5,00,000
PBIT = 11,00,000
Interest = 11,00,000 – 5,00,000 = `6,00,000
Long term loan =
6. Average collection period = 30 days
Receivables = 50,00,000 = 4,16,667
7. Fixed Assets Turnover Ratio = 0.8
50,00,000 / Fixed Assets = 0.8
Fixed Assets = `62,50,000
Income Statement
Amount (`)
Sales 50,00,000
Less: Cost of Goods Sold 30,00,000
Gross Profit 20,00,000
Less: Operating Expenses 9,00,000
Less: Interest. 6,00,000
Net Profit 5,00,000
Balance sheet

Liabilities Amount (`) Assets Amount (`)

Equity share capital 22,50,000 Fixed asset 62,50,000
Long term debt 50,00,000 Current assets:
Current liability 5,00,000 Stock 10,00,000
Receivables 4,16,667
Other 83,333 15,00,000
77,50,000 77,50,000
Question: 7
MTP /March. 2023/Q. 1(c) /
Based on the following particulars SHOW various assets and liabilities of Raina Ltd.
Fixed assets turnover ratio 10 times
(Based on Cost of sales)
Capital turnover ratio (Based on Cost of sales) 3 times
 Financial Analysis & Planning Ratio Analysis | 3.11
Inventory Turnover 10 times
Receivable turnover 5 times
Payable turnover 5 times
GP Ratio 40%
Gross profit during the year amounts to Rs.15,00,000. There is no long-term loan or overdraft.
Reserve and surplus amount to Rs.5,00,000. Ending inventory of the year is Rs. 40,000 above
the beginning inventory.
Answer:
G.P. ratio = 40

(a) Sales =
= 37,50,000
(b) Cost of Sales = Sales Gross Profit = `37,50,000 - `15,00,000
= `22,50,000
(c) Receivable turnover =
= Receivables =
= `7,50,000
(d) Fixed assets turnover =
= `2,25,000
(e) Inventory turnover =

Average Stock = = `2,25,000

Average stock =
Average Stock = Opening + `20,000
Opening Stock = Average Stock = `20,000
Average Stock = `2,25,000 - `20,000
Opening Stock = `2,05,000
Closing Stock = Opening Stock + `40,000
Closing Stock = `2,05,000 + `40,000 = `2,45,000
(f) Payable turnover =
Purchases = Cost of Sales + Increase in Stock
Purchases = `22,50,000 + `40,000 = `22,90,000
Payables =

(h) Capital Employed =

= `7,50,000
Equity share Capital = Capital Employed – Reserves & Surplus
= `7,50,000 - `5,00,000 = `2,50,000
Balance Sheet of T Ltd. as on……….
Liabilities ` Assets `
Capital 2,50,000 Fixed Assets 2,25,000
Reserve & Surplus 5,00,000 Stock 2,45,000
Payables 4,58,000 Receivables 7,50,000
 Financial Analysis & Planning Ratio Analysis | 3.12
Other Current Assets (balancing figure) 2,38,000
14,58,000 14,58,000

Question: 8
SUGGESTED /Nov. 2022 /Q. 1(b)/5 Marks
The following figures are related to the trading activities of M Ltd.
Total assets ` 10,00,000
Debt to total assets 50%
Interest cost 10% per year
Direct Cost 10 times of the interest cost
Operating Exp. ` 1,00,000
The goods are sold to customers at a margin of 50% on the direct cost Tax Rate is 30%
You are required to calculate
(i) Net profit margin
(ii) Net operating profit margin
(iii) Return on assets
(iv) Return on owner’s equity
Answer:
(i) Computation of Net Profit Margin
Debt = (10,00,000 × 50%) = ` 5,00,000
Interest cost = 5,00,000 × ( ) = `50,000
Direct cost = 50,000 × 10 = `5,00,000
Sales = 5,00,000 × 150% = `7,50,000
(`)
Gross profit = 7,50,000 – 5,00,000 = 2,50,000
Less: Operating expenses = 1,00,000
∴ EBIT = 1,50,000
Less: Interest =50,000
∴ EBT = 1,00,000
Less: Tax @ 30% =30,000
∴PAT =70,000
Net profit margin =( ) = 9.33%
(ii) Net Operating Profit margin
Net operating profit margin =( )

=( )
(iii) Return Assets
Return on Assets = ⌊( )⌋

= ⌊( )⌋ 12%
OR
Return on Assets =
= = 15%
 Financial Analysis & Planning Ratio Analysis | 3.13
OR
(iv) Return on owner’s equity
Return =( )

=( ) = 14%

Question: 9
SUGGESTED /Nov. 2019 /Q. 1(a)/5 Marks
Following information has been gathered from the books of Tram Ltd. the equity shares of
which is trading in the stock market at ` 14.
Particulars Amount (`)
Equity Share Capital (face value ` 10) 10,00,000
10% Preference Shares 2,00,000
Reserves 8,00,000
10% Debentures 6,00,000
Profit before Interest and Tax for the year 4,00,000
Interest 60,000
Profit after Tax for the year 2,40,000
Calculate the following:
(i) Return on Capital Employed
(ii) Earnings per share
(iii) PE ratio
Answer:
(i) Calculation of Return on capital employed (ROCE)
Capital employed = Equity Shareholders’ funds + Debenture + Preference
shares
= ` (10,00,000 + 8,00,000 + 6,00,000 + 2,00,000)
= ` 26,00,000
Return on capital employed [ROCE-(Pre-tax)] =

=
= 15.38% (approx.)
Return on capital employed [ROCE – (Post –tax)]] = 100

= 100
= 9.23% (approx.)
(ii) Calculation of Earnings per share
Earnings per share =

=
= `2.20
(iii) Calculation of PE ratio
PE =
 Financial Analysis & Planning Ratio Analysis | 3.14

= = 6.364 (approx.)

Question: 10
SUGGESTED /Nov. 2019 /Q. 3/10 Marks
Slide Ltd. is preparing a cash flow forecast for the three months period from January to
the end of March. The following sales volumes have been forecasted:
Months December January February March April
Sales (units) 1,800 1,875 1,950 2,100 2,250
Selling price per unit is ` 600. Sales are all on one month credit. Production of goods for sale
takes place one month before sales. Each unit produced requires two units of raw materials
costing ` 150 per unit. No raw material inventory is held. Raw materials purchases are on one
month credit. Variable overheads and wages equal to ` 100 per unit are incurred during
production and paid in the month of production. The opening cash balance on 1st January is
expected to be ` 35,000. A long term loan of ` 2,00,000 is expected to be received in the month
of March. A machine costing ` 3,00,000 will be purchased in March.
(a) Prepare a cash budget for the months of January, February and March and calculate the
cash balance at the end of each month in the three months period.
(b) Calculate the forecast current ratio at the end of the three months period.
Answer:
Working Notes:
(1) Calculation of Collection from Trade Receivables:
Particulars December January February March
Sales (units) 1,800 1,875 1,950 2,100
Sales (@ ` 600 per unit) / 10,80,000 11,25,000 11,70,000 12,60,000
TradeReceivables (Debtors) (`)
Collection from Trade 10,80,000 11,25,000 11,70,000
Receivables (Debtors) (`)
2. Calculation of Payment to Trade Payables:

Particulars December January Februar March

y
Output (units) 1,875 1,950 2,100 2,250
Raw Material (2 units per output) 3,750 3,900 4,200 4,500
(units)
Raw Material (@ ` 150 per unit) / 5,62,500 5,85,000 6,30,000 6,75,000
Trade Payables (Creditors) (`)
Payment to Trade Payables 5,62,500 5,85,000 6,30,000
(Creditors) (`)

3. Calculation of Variable Overheads and Wages:

Particulars January February March
Output (units) 1,950 2,100 2,250
Payment in the same month @ ` 100 per unit(`) 1,95,000 2,10,000 2,25,000
 Financial Analysis & Planning Ratio Analysis | 3.15

(a) Preparation of Cash Budget

January February March
Particulars
(`) (`) (`)
Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade Receivables 10,80,000 11,25,000 11,70,000
(Debtors)
Receipt of Long-Term Loan 2,00,000
Total (A) 11,15,000 14,82,500 20,57,500
Payments:
Trade Payables (Creditors) for Materials 5,62,500 5,85,000 6,30,000
Variable Overheads and Wages 1,95,000 2,10,000 2,25,000
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,000
Closing Balance (A – B) 3,57,500 6,87,500 9,02,500
(b) Calculation of Current Ratio
Particulars March (`)
Output Inventory (i.e. units produced in March)
[(2,250 units x 2 units of raw material per unit of output x ` 150 per 9,00,000
unit of raw material) + 2,250 units x ` 100 for variable overheads and
wages] or, [6,75,000 + 2,25,000] from Working Notes 2 and 3

Trade Receivables (Debtors) 12,60,000

Cash Balance 9,02,500
Current Assets 30,62,500
Trade Payables (Creditors) 6,75,000
Current Liabilities 6,75,000
Current Ratio (Current Assets / Current Liabilities) 4.537 approx.
Question: 11
SUGGESTED /Nov. 2018 /Q. 1(c)/5 Marks
The following is the information of XML Ltd. relate to the year ended 31-03-2018 :
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1:4
Non-Current Assets to Current Assets 1:2
Current Ratio 2:1
Non-Current Liabilities to Current Liabilities 1:1
Share Capital to Reserve and Surplus 4:1
Non-current Assets as on 31st March, 2017 `
50,00,000
Assume that:
(i) No change in Non-Current Assets during the year 2017-18
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
 Financial Analysis & Planning Ratio Analysis | 3.16
(iii) Ignoring Tax
You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables and Cash for
the year ended on 31st March, 2018
Answer:
Workings

Or

So, Current Assets = `1,00,00,000

Now further,

Or

So, Sales = `2,00,00,000

Calculation of Cost of Goods sold, Net profit, Inventory, Receivables and Cash:

(i) Cost of Goods Sold (COGS):

Cost of Goods Sold = Sales – Gross Profit
= `2,00,00,000 – 20% of `2,00,00,000
= `1,60,00,000
(ii) Net Profit = 10% of Sales = 10% of `2,00,000
= `20,00,000
(iii) Inventory:
Inventory Holding Period =
Inventory Turnover Ratio = 12/3 = 4
4=

4=
Average or Closing Inventory = `40,00,000

(iv) Receivable Collection Period =

Or Receivables Turnover Ratio = 12/3 = 4 =

Or 4 =

So, Average Accounts Receivables/Receivables = `50,00,000/-

(v) Cash:
Cash* = Current Assets* - Inventory – Receivables
Cash = `1,00,00,000 - `40,00,000 - `50,00,000
=`10,00,000
(It is assumed that no other current assets are included in the Current Asset)
 Financial Analysis & Planning Ratio Analysis | 3.17

QUESTION 12 SUGGESTED MAY 2024

Theme Ltd provides you the following information:

12.5 % Debt ` 45,00,000

Debt to Equity ratio 1.5 : 1

Return on Shareholder's fund 54%

Operating Ratio 85%

Ratio of operating expenses to Cost of Goods sold 2:6

Tax rate 25%

Fixed Assets ` 39,00,000

Current Ratio 1.8 : 1

You are required to calculate:

(i) Interest Coverage Ratio

(ii) Gross Profit Ratio

(iii) Current Assets

ANSWER

Working Notes:

Debt = `45,00,000

Interest = ` 45,00,000 x 12.5%= 5,62,500

Debt to Equity = 1.5:1

Equity = `30,00,000

Return of Shareholder’s funds = 54% ×100

Profit after tax (PAT) = 54% × Equity = ``16,20,000

Profit before tax (PBT)(1-25%) = Profit after tax

= `16,20,000/75% = `21,60,000

Earning before interest and tax (EBIT) = PBT + Interest

= `21,60,000 + ` 5,62,500

= `27,22,500
 Financial Analysis & Planning Ratio Analysis | 3.18
(i) Interest Coverage Ratio = EBIT/Interest

= `27,22,500/`5,62,500

= 4.84 Times

(ii) Operating Profit Ratio = 1 - Operating Ratio

= 1 – 0.85 = 0.15 or 15%

0.15 = ×100

Sales = EBIT or Operating Profit /0.15

= ` 27,22,500 / 0.15

= ` 1,81,50,000

Operating ratio = 2 : 6 = 1: 3

Operating expenses = 1/3 COGS

Operating cost = Sales – Operating profit

= ` 1,81,50,000 - ` 27,22,500

= ` 1,54,27,500

` 1,54,27,500 = COGS + Operating expenses

` 1,54,27,500 = COGS + 1/3COGS

COGS = ` 1,15,70,625

Gross profit = Sales – COGS

= 1,81,50,000 – 1,15,70,625

= ` 65,79,375

Gross profit ratio ×100

= 65,79,375/1,81,50,000

= 0.3625 or 36.25%

Gross profit and sales can be calculated in alternative way also. However, there will be no
change in GP ratio i.e 36.25%

(iii) Current Ratio

= 1.8

Current Assets = 1.8 Current Liabilities

 Financial Analysis & Planning Ratio Analysis | 3.19
Total of Balance sheet liability = Equity + Debt + Current Liabilities

=30,00,000+45,00,000+CL (2)

Total Balance sheet asset = Fixed Assets + Current Assets

= 39 lakhs + CA= 39 + 1.8CL (3)

Equating 2 and 3,

75,00,000 + CL = 39,00,000 + 1.8CL

0.8CL = 36,00,000

CL =` 45,00,000

Current Assets = 1.8 CL = 1.8 x 45 lakhs= ` 81,00,000

 Cost of Capital | 4.1
CHAPTER – 4 Cost of Capital
Chapter – 4
Cost of Capital
Question & Answer
Question 1
RTP /Nov. 2018/2/
M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company is
presently considering several alternative investment proposals costing less than ` 20 lakhs. The
corporation always raises the required funds without disturbing its present debt equity ratio.
The cost of raising the debt and equity are as under:
Project cost Cost of debt Cost of equity
Upto ` 2 lakhs 10% 12%
Above ` 2 lakhs & upto to ` 5 lakhs 11% 13%
Above ` 5 lakhs & upto `10 lakhs 12% 14%
Above `10 lakhs & upto ` 20 lakhs 13% 14.5%
Assuming the tax rate at 50%, CALCULATE:
(i) Cost of capital of two projects X and Y whose fund requirements are ` 6.5 lakhs and ` 14
lakhs respectively?
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what conditions
it would be acceptable?
Answer:
(i) Statement of Weighted Average Cost of Capital

Project cost Financing Proportion of After tax cost Weighted average

capital (1–Tax 50%) cost (%)
Structure
Upto ` 2 Lakhs Debt 0.4 10% (1 – 0.5) 0.4 × 5 = 2.0
= 5%
Equity 0.6 12% 0.6 × 12 = 7.2
9.2%
Above ` 2 lakhs Debt 0.4 11% (1 – 0.5) 0.4 × 5.5 = 2.2
& upto to ` 5 Lakhs = 5.5%
Equity 0.6 13% 0.6 × 13 = 7.8
10.0%
Above ` 5 lakhs Debt 0.4 12% (1 – 0.5) 0.4 × 6 = 2.4
& upto ` 10 lakhs = 6%
Equity 0.6 14% 0.6 × 14 = 8.4
10.8%
Above ` 10 lakhs Debt 0.4 13% (1 – 0.5) 0.4 × 6.5 = 2.6
& upto ` 20 lakhs = 6.5%
Equity 0.6 14.5% 0.6 × 14.5 = 8.7
11.3%
 Cost of Capital | 4.2

Project Fund requirement Cost of capital

X `6.5 lakhs 10.8% (from the above table)
Y `14 lakhs 11.3% (from the above table)
(ii) If a Project is expected to give after tax return of 10%, it would be acceptable provided its
project cost does not exceed ` 5 lakhs or, after tax return should be more than or at least
equal to the weighted average cost of capital.

Question: 2
RTP /May-2022/ Q. 2 /
The information relating to book value (BV) and market value (MV) weights of Ex Limited is
given below:
Sources Book Value (`) Market Value (`)
Equity shares 2,40,00,000 4,00,00,000
Retained earnings 60,00,000 -
Preference shares 72,00,000 67,50,000
Debentures 18,00,000 20,80,000

Additional information:
I. Equity shares are quoted at ` 130 per share and a new issue priced at ` 125 per share will
be fully subscribed; flotation costs will be ` 5 per share on face value.
II. During the previous 5 years, dividends have steadily increased from ` 10 to ` 16.105 per
share. Dividend at the end of the current year is expected to be ` 17.716 per share.
III. 15% Preference shares with face value of ` 100 would realise ` 105 per share.
IV. The company proposes to issue 11-year 15% debentures but the yield on debentures of
similar maturity and risk class is 16%; flotation cost is 2% on face value.
V. Corporate tax rate is 30%.
You are required to DETERMINE the weighted average cost of capital of Ex Limited using both
the weights.

Answer:
(i) Cost of Equity (Ke) =

Ke = 0.2476
*Calculation of g:
`10 (1 +g)5 = `16.105
Or, (1+g)5 =
Table (FVIF) suggests that `1 compounds to `1.6105 in 5 years at the compound rate of
10 percent. Therefore, g is 10 per cent.
(ii) Cost of Retained Earning (Kr) =

(iii) Cost of Preference Shares (Kp) =

( ) ( )
(iv) Cost of Debentures (Kd) =

( ) ( )
=
 Cost of Capital | 4.3

*Since yield on similar type of debentures is 16 per cent, the company would be required to
offer debentures at discount.

Market price of debentures (approximation method)

= `15 + 0.16 = `93.75

Sale proceeds from debentures = `93.75 - `2 (i.e., floatation cost) = `91.75

Market value (P0) of debentures can also be found out using the present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF (16%,
11 years)
P0 = ` 15 × 5.0287 + ` 100 × 0.1954
P0 = ` 75.4305 + ` 19.54 = ` 94.9705
Net Proceeds = ` 94.9705 – 2% of ` 100 = ` 92.9705
Accordingly, the cost of debt can be calculated

Total Cost of capital [BV weights and MV weights]

(Amount in (`) lakh)

Weights Specific Total cost

Source of capital Cost (K)
BV MV (BV × K) (MV × K)
Equity Shares 240 320** 0.2476 59.4240 79.2320
Retained Earnings 60 80** 0.2363 14.1780 18.9040
Preference Shares 72 67.50 0.1429 10.2888 9.6458
Debentures 18 20.80 0.1173 2.1114 2.4398
Total 390 488.30 86.0022 110.2216
**Market Value of equity has been apportioned in the ratio of Book Value of equity and retained
earnings i.e., 240:60 or 4:1.

Weighted Average Cost of Capital (WACC):

Using Book Value =

Using Market Value =

Question: 3
MTP /April - 2019/Q. 1(b) /5 Marks
Annova Ltd is considering raising of funds of about Rs.250 lakhs by any of two alternative
methods, viz., 14% institutional term loan and 13% non-convertible debentures. The term loan
option would attract no major incidental cost and can be ignored. The debentures would have to
be issued at a discount of 2.5% and would involve cost of issue of 2% on face value.
ADVISE the company as to the better option based on the effective cost of capital in each case.
Assume a tax rate of 50%.
 Cost of Capital | 4.4
Answer:
Calculation of Effective Cost of Capital
Particulars Option 1 Option 2
14% institutional 13% Non-convertible
Term loan Debentures
(Rs. in Lakhs) (Rs. in lakhs)
(A) Effective capital to be raised Face value 250.00 250.00
Less: Discount Nil (6.25)
250.00 243.75
Less: Cost of issue Nil 5.00
Effective amount of capital 250.00 238.75
(B) Annual interest charges on face value of
Rs. 250 lakhs 35.0 32.50
Less: Tax benefit on interest @ 50% 17.5 16.25
17.5 16.25
(C) Effective cost of capital after tax

= 7.0%
= 6.81% (approx..)
So, the better option is raising of funds of Rs.250 lakhs by issue of 13% Non-convertible
Debenture
Question: 4
MTP /March - 2018/Q. 4/10 Marks
G Limited has the following capital structure, which it considers to be optimal:
Capital Structure Weightage (in %)
Debt 25
Preference Shares 15
Equity Shares 60
100
G Limited’s expected net income this year is ` 34,285.72, its established dividend pay-out ratio
is 30 per cent, its tax rate is 40 per cent, and investors expect earnings and dividends to grow at
a constant rate of 9 per cent in the future. It paid a dividend of ` 3.60 per share last year, and its
shares currently sells at a price of ` 54 per share.
G Limited requires additional funds which it can obtain in the following ways:
• Preference Shares: New preference shares with a dividend of ` 11 can be sold to the
public at a price of `95 per share.
• Debt: Debt can be sold at an interest rate of 12 per cent. You are required to:
(i) DETERMINE the cost of each capital structure component; and
(ii) COMPUTE the weighted average cost of capital (WACC) of G Limited.
Answer:
(i) Computation of Cost of Different Components of Capital:
(a) Equity Shares:
( )

( )
= = 0.0727 + 0.09 = 16.27%
 Cost of Capital | 4.5
(b) Preference Shares:

(c) Debt at 12%

Kd (1-t) = 12% (1 –0.4) = 12% × 0.6 = 7.20%
(ii) Weighted Average Cost of Capital (WACC)
WACC = WdKd + WpKp + WeKe
WACC = 0.25 (7.2%) + 0.15 (11.58%) + 0.60 (16.27%)
=1.8 + 1.737 + 9.762 = 13.30%

QUESTION 5 SUGGESTED MAY 2024

The capital structure of Shine Ltd. as on 31.03.2024 is as under:
Particulars Amount (`)
Equity share capital off 10 each 45,00,000
15% Preference share capital of f 100 each 36,00,000
Retained earnings 32,00,000
13% Convertible Debenture off 100 each 67,00,000
11 % Term Loan 20,00,000
Total 2,00,00,000

Additional information:
(A) Company issued 13% Convertible Debentures of ` 100 each on 01.04.2023 with a maturity
period of 6 years. At maturity, the debenture holders will have an option to convert the
debentures into equity shares of the company in the ratio of 1 : 4 (4 shares for each
debenture). The market price of the equity share is ` 25 each as on 31.03.2024 and the
growth rate of the share is 6% per annum.
(B) Preference stock, redeemable after eight years, is currently selling at ` 150 per share.
(C) The prevailing default-risk free interest rate on 10-year GOI treasury bonds is 6%. The

Corporate tax rate is 25% and rate of personal income tax is 20%.
You are required to calculate the cost of:
(i) Equity Share Capital
(ii) Preference Share Capital
(iii) Convertible Debenture
(iv) Retained Earnings
(v) Term Loan
ANSWER

(i) Cost of Equity Share capital

 Cost of Capital | 4.6
As per CAPM Model Ke = Rf + ß (Rm − Rf)

Rf = 6%
B = 1.54
Rm-Rf = 8%
Ke = 6% + 1.54(8%)
Ke = 18.32%
(ii) Cost of Preference Share capital
n = 8
Net Proceeds (NP) = 150
Redemption Value (RV) = 100
Preference Dividend (PD) = 15
( )

Kp = ( )

–
( )
Kp =
( )

Kp= 7%
Alternatively, if we take NP as 100 and RV as 100, then solution can be done in the
following way:
Cost of Preference Share capital
n = 8
Net Proceeds (NP) = 100
Redemption Value (RV) = 150
Preference Dividend (PD) = 15
( )

( )

( )
( )

KP = 17%

(iii) Cost of convertible debenture

Cash Redemption Value (RV) = 100

Share Redemption Value (RV):

Value of share after 5 years = 25 x (1.06)5 = 33.46

Share Redemption Value (RV) = 33.46 X 4=133.82

Therefore, investor will choose share redemption.

Redemption Value (RV) = 133.82
 Cost of Capital | 4.7
Net Proceeds (NP) = 100
n =5
Interest (I) = 13
Tax (t) = 25%
( )
( )
( )

( )
( )
( )

Kd = 14.13%
(iv) Cost of Retained Earnings
Kr = Ke (1-tp)= 18.32 % x (1-0.20) = 14.66%
We can also take cost of equity as cost of retained earnings, Accordingly, Kr = Ke = 18.32%
(v) Cost of Term Loan
= 11% x (1-0.25) = 8.25%

Question 6
Following data is available in respect of Levered and Unlevered companies having same
business risk:
Capital employed = ` 2,00,000, EBIT = ` 25,000 and Ke = 12.5%
Sources Levered Company (f) Unlevered Company (`)

Debt (@8%) 75,000 Nil

1,25,000
Equity 2,00,000
An investor is holding 12% shares in levered company. Calculate the increase in annual
earnings of investor if he switches over his holding from Levered to Unlevered company.
ANSWER
1. Valuation of firms

Particulars Levered Unlevered

Firm (`) Firm (`)
EBIT 25,000 25,000
Less: Interest on debt (8% × ` 75,000) 6,000 Nil
Earnings available to Equity shareholders 19,000 25,000
Ke 12.5% 12.5%
Value of Equity (S) 1,52,000 2,00,000
(Earnings available to Equity shareholders/
Ke)
 Cost of Capital | 4.8

Debt (D) 75,000 Nil

Value of Firm (V) = S + D 2,27,000 2,00,000

Value of Levered company is more than that of unlevered company. Therefore, investor will
sell his shares in levered company and buy shares in unlevered company. To maintain the
level of risk he will borrow proportionate amount and invest that amount also in shares of
unlevered company.
2. Investment & Borrowings `

Sell shares in Levered company (` 1,52,000 x 12%) 18,240

Borrow money (` 75,000 x 12%) 9,000

Buy shares in Unlevered company 27,240

3. Change in Return `

Income from shares in Unlevered company

(` 27,240 x 12.5%) 3,405

Less: Interest on loan (` 9,000 x 8%) 720

Net Income from unlevered firm 2,685

Less: Income from Levered firm (` 18,240 x 12.5%) 2,280

Incremental Income due to arbitrage 405

Solution can also be done in the following way:Valuation of firms
Particulars Levered Unlevered
Firm (`) Firm (`)

EBIT 25,000 25,000

Less: Interest on debt (8% × ` 75,000) 6,000 Nil
Earnings available to Equity shareholders 19,000 25,000
Ke 12.5% 12.5%
Value of Equity (S) 1,52,000 2,00,000
(Earnings available to Equity shareholders/
Ke)
Debt (D) 75,000 Nil
Value of Firm (V) = S + D 2,27,000 2,00,000

Value of Levered company is more than that of unlevered company. Therefore, investor will
sell his shares in levered company and buy shares in unlevered company.
Arbitrage Process:
If investor have 12% shares of levered company, value of investment in equity shares is 12%
of ` 1,52,000 i.e. ` 18,240 and return will be 12% of `19,000 = ` 2,280.
Alternate Strategy will be:
Sell 12% shares of levered firm for ` 18,240 and borrow 12% of levered firm's debt i.e. ` 9,000
(12% of ` 75,000) and invest the money i.e. 12% in unlevered firm's stock:
Total resources /Money investor have = ` 18,240 + ` 9,000 = ` 27,240 and investor invest 12%
 Cost of Capital | 4.9
of ` 2,00,000 = ` 24,000
Surplus cash available with investor is = ` 27,240 – ` 24,000 = ` 3,240
Investor return = 12% EBIT of unlevered firm – Interest to be paid on borrowed funds
i.e. = 12% of ` 25,000 – 8% of ` 9,000 = ` 3,000 – ` 720 = ` 2,280
Now, return remains the same i.e. ` 2,280 which investor is getting from levered company
before investing in unlevered company but still have ` 3,240 excess money available with
investor. Hence, investor is better off by doing arbitrage.
 Financing Decisions – Capital Structure | 5.1

CHAPTER – 5 Capital Structure

Chapter – 5
Financing Decisions – Capital Structure
Question & Answer
Question: 1
RTP /May-2021/Q. 3 /
Zordon Ltd. has net operating income of ` 5,00,000 and total capitalization of ` 50,00,000
during the current year. The company is contemplating to introduce debt financing in capital
structure and has various options for the same. The following information is available at
different levels of debt value:
Debt value(`) Interest rate(%) Equity capitalization rate
(%)
0 - 10.00
5,00,000 6.0 10.50
10,00,000 6.0 11.00
15,00,000 6.2 11.30
20,00,000 7.0 12.40
25,00,000 7.5 13.50
30,00,000 8.0 16.00
Assuming no tax and that the firm always maintains books at book values, you are REQUIRED to
calculate:
(i) Amount of debt to be employed by firm as per traditional approach.
(ii) Equity capitalization rate, if MM approach is followed.

ANSWER
Amount of debt to be employed by firm as per traditional approach
Calculation of Equity, Wd and We
Total Capital(`) Debt(`) Wd Equity value(`) We
(a) (b) (b)/(a) (c) = (a) - (b) (c)/(a)
50,00,000 0 - 50,00,000 1.0
50,00,000 5,00,000 0.1 45,00,000 0.9
50,00,000 10,00,000 0.2 40,00,000 0.8
50,00,000 15,00,000 0.3 35,00,000 0.7
50,00,000 20,00,000 0.4 30,00,000 0.6
50,00,000 25,00,000 0.5 25,00,000 0.5
50,00,000 30,00,000 0.6 20,00,000 0.4
Statement of Weighted Average Cost of Capital (WACC)
Ke We Kd Wd Ke We Kd W d Ko
(1) (2) (3) (4) (5) = (1) x (2) (6) = (3) x (4) (7) = (5) + (6)
0.100 1.0 - - 0.100 - 0.100
0.105 0.9 0.060 0.1 0.095 0.006 0.101
0.110 0.8 0.060 0.2 0.088 0.012 0.100
0.113 0.7 0.062 0.3 0.079 0.019 0.098
0.124 0.6 0.070 0.4 0.074 0.028 0.102
 Financing Decisions – Capital Structure | 5.2

0.135 0.5 0.075 0.5 0.068 0.038 0.106

0.160 0.4 0.080 0.6 0.064 0.048 0.112
So, amount of Debt to be employed = ` 15,00,000 as WACC is minimum at this level of
debt i.e. 9.8%.
(b) As per MM approach, cost of the capital (Ko) remains constant and cost of equity
increases linearly with debt.
Value of a firm =

`50,00,000 =

Statement of Equity Capitalization rate (ke) under MM approach

Debt(`) Equity(`) Debt/Equity Ko Kd Ko - Kd Ke
= Ko +
(Ko - Kd)
Debt
Equity
(1) (2) (3) = (1)/(2) (4) (5) (6) = (4) (7) = (4) +
-(5) (6) x (3)
0 50,00,000 0 0.10 - 0.100 0.100
5,00,000 45,00,000 0.11 0.10 0.060 0.040 0.104
10,00,000 40,00,000 0.25 0.10 0.060 0.040 0.110
15,00,000 35,00,000 0.43 0.10 0.062 0.038 0.116
20,00,000 30,00,000 0.67 0.10 0.070 0.030 0.120
25,00,000 25,00,000 1.00 0.10 0.075 0.025 0.125
30,00,000 20,00,000 1.50 0.10 0.080 0.020 0.130

Question: 2
RTP /May-2023/Q. 3 /
Current Capital Structure of XYZ Ltd is as follows:
Equity Share Capital of 7 lakh shares of face value ` 20 each
Reserves of ` 10,00,000
9% bonds of ` 3,00,00,000
11% preference capital: 3,00,000 shares of face value ` 50 each
Additional Funds required for XYZ Ltd are ` 5,00,00,000.

XYZ Ltd is evaluating the following alternatives:

I. Proposed alternative I: Raise the funds via 25% equity capital and 75% debt at 10%. PE
ratio in such scenario would be 12.
II. Proposed alternative II: Raise the funds via 50% equity capital and rest from 12%
Preference capital .PE ratio in such scenario would be 11.
Any new equity capital would be issued at a face value of ` 20 each. Any new preferential capital
would be issued at a face value of ` 20 each. Tax rate is 34%

DETERMINE the indifference point under both the alternatives.

 Financing Decisions – Capital Structure | 5.3

Answer:
Current Capital Structure
Equity Share Capital ` 20 x 7 lakhs ` 1,40,00,000
Reserves ` 10,00,000
9% Bonds ` 3,00,00,000
11% Preference Share Capital ` 50 x 3 lakhs ` 1,50,00,000
Total Capital Employed ` 6,00,00,000

Proposed Capital Structure

Capital Working Proposal I Proposal II

Capital to be raised `5,00,00,000 `5,00,00,000
Equity 50000000 x ` 1,25,00,000 -
50000000
25% x - ` 2,50,00,000
Debt @ 10% 50%
50000000 x ` 3,75,00,000 -
Preference Shares @ 75%
50000000 x - ` 2,50,00,000
12% 50%
Combined Capital Amount Amount
(proposal (proposal 2)
Equity 1)` 2,65,00,000 ` 3,90,00,000
Reserves ` 10,00,000 ` 10,00,000
9% Bond ` 3,00,00,000 ` 3,00,00,000
10% Debt ` 3,75,00,000 -
11% Preference Shares ` 1,50,00,000 ` 1,50,00,000
12% Preference Shares - ` 2,50,00,000
` 11,00,00,000 ` 11,00,00,000

Interest for Proposal I = ` 3,00,00,000 x 9% + ` 3,75,00,000 x 10%

= ` 27,00,000 + ` 37,50,000
= ` 64,50,000
Preference Dividend for Proposal I = ` 1,50,00,000 x 11% = ` 16,50,000 Interest for
Proposal II = ` 3,00,00,000 x 9% = ` 27,00,000
Preference Dividend for Proposal II = ` 1,50,00,000 x 11% + ` 2,50,00,000 x 12%
= ` 16,50,000 + ` 30,00,000 = ` 46,50,000
Let the indifference point be ` X
For Proposal I
)
EPS = (1)
For Proposal II,
)
EPS =
Equating (1) and (2),
) )
EPS =

-
`51.48X - `46,07,46,000 = `37.98X - `34,08,96,000
 Financing Decisions – Capital Structure | 5.4

`16.5X =`11,98,50,000
Indifference Point = X = `72,63,636.36

Question: 3
RTP /May-2023/Q. 9 /
Kalyan limited has provided you the following information for the year 2021-22:
By working at 60% of its capacity the company was able to generate sales of ` 72,00,000. Direct
labour cost per unit amounted to ` 20 per unit. Direct material cost per unit was 40% of the
selling price per unit. Selling price was 3 times the direct labour cost per unit. Profit margin was
25% on the total cost.
For the year 2022-23, the company makes the following estimates:
Production and sales will increase to 90% of its capacity. Raw material per unit price will
remain unchanged. Direct expense per unit will increase by 50%. Direct labour per unit will
increase by 10%. Despite the fluctuations in the cost structure, the company wants to maintain
the same profit margin on sales.
Raw materials will be in stock for one month whereas finished goods will remain in stock for
two months. Production cycle is for 2 months. Credit period allowed by suppliers is 2 months.
Sales are made to three zones:
Zone Percentage of sale Mode of Credit
A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash Sales

There are no cash purchases and cash balance will be ` 1,11,000

The company plans to apply for a working capital financing from bank for the year 2022-
23. ESTIMATE Net Working Capital of the Company receivables to be taken on sales and also
COMPUTE the maximum permissible bank finance for the company using 3 criteria of Tandon
Committee Norms. (Assume stock of finished goods to be a core current asset)
Answer:
Cost Structure
2021-22 2022-23
 Financing Decisions – Capital Structure | 5.5

Particulars Calculations P.U. Amount Calculations P.U. Amount

(p.u. X (p.u. X units)
units)
Direct 40% of SP `24 `28,80,000 Same as PY `24 `43,20,000
Material
Direct Given `20 `24,00,000 20*1.1 `22 `39,60,000
labour
Direct bal. fig. `4 `4,80,000 4*1.5 `6 `10,80,000
Expenses
Total SP - Profit `48 `57,60,000 `52 `93,60,000
`12 `14,40,000 `13 `23,40,000
Cost (SP/125x25)
`60 `72,00,000 52*25% `65 `1,17,00,000
Profit 3 x Direct
Sales Labour p.u. `72,00,000/`60 1,20,000/60 x
=1,20,000 90=1,80,000
*units=
Operating Cycle
Raw material holding period Finished 1 month
Goods holding period WIP conversion 2 months
period Creditor Payment Period 2 months
Receivables Collection Period 2 months 2/3 months

Estimation of Working Capital

Particulars Calculation Amount
Current Assets
Stock of Raw Material 43,20,000 x 1/12 `3,60,000
Stock of WIP
RM cost `43,20,000
Labour cost `19,80,000
Direct Exp cost `5,40,000
Total WIP Cost `68,40,000
Stock of WIP 68,40,000 x 2/12 `11,40,000
Stock of Finished Goods 93,60,000 x 2/12 `15,60,000
Receivables (on sales)
A 1,17,00,000 x 50% x 2/12 `9,75,000
BC 1,17,00,000 x 30% x `8,77,500
Cash Balance 3/12 NIL -
Total Current Assets Given `1,11,000
Current Liabilities ` 50,23,500
Payables
Net Working Capital `7,40,000
*`44,40,000 x 2/12

` 42,83,500
 Financing Decisions – Capital Structure | 5.6

Opening RM stock = 28,80,000 x 1/12= `2,40,000

* RM purchased = RM consumed – Opening Stock + Closing Stock
= `43,20,000 – `2,40,000 + `3,60,000
= `44,40,000
Computation of Maximum Permissible Bank Finance

Method Formula Calculation `

I II III 75% x (Current Assets- 75% x (`50,23,500 - `7,40,000) `32,12,625
Current Liabilities)
75% x Current Assets- 75% x `50,23,500 - `7,40,000 `30,27,625
Current Liabilities
75% x (Current Assets-Core 75% x (`50,23,500- `15,60,000) - `18,57,625
CA)- Current Liabilities `7,40,000

Question: 4
MTP /April. 2021/Q. 1(a) /5 Marks
Kee Ltd. and Lee Ltd. are identical in every respect except for capital structure. Kee Ltd. does not
employ debt in its capital structure, whereas Lee Ltd. employs 12% debentures amounting to
Rs. 20 lakhs. Assuming that:
(i) All assumptions of MM model are met;
(ii) The income tax rate is 30%;
(iii) EBIT is Rs. 5,00,000 and
(iv) The equity capitalization rate of Kee Ltd. is 25%.
CALCULATE the average value of both the Companies.
Answer:
Kee Ltd. (pure Equity) i.e. unlevered company:
EAT = EBT (1 –t)
= EBIT (1 – 0.3) = Rs. 5,00,000 × 0.7 = Rs. 3,50,000
(Here, EBIT = EBT as three is not debt)
Value of unlevered company Kee Ltd. =

=
Lee Ltd. (Equity and Debt) i.e. levered company:
Value of levered company = Value of Equity + Value of Debt
= Rs. 14,00,000 + (Rs. 20,00,000 × 0.3)
= Rs. 20,00,000

Question: 5
MTP /October- 2022/Q. 2 /10 Marks
The financial advisor of Sun Ltd is confronted with following two alternative financing plans for
raising ` 10 lakhs that is needed for plant expansion and modernization
Alternative I: Issue 80% of funds with 14% Debenture [Face value (FV) ` 100] at par and
redeem at a premium of 10% after 10 years and balance by issuing equity shares at 33 %
premium.
Alternative II: Raise 10% of funds required by issuing 8% Irredeemable Debentures [Face
value (FV) ` 100] at par and the remaining by issuing equity shares at current market price of
`125.
Currently, the firm has an Earnings per share (EPS) of ` 21
 Financing Decisions – Capital Structure | 5.7

The modernization and expansion programme is expected to increase the firm’s Earnings before
Interest and Taxation (EBIT) by ` 200,000 annually.
The firm’s condensed Balance Sheet for the current year is given below:

Balance Sheet as on 31.3.2022

Liabilities Amount (`) Assets Amount
(`)
Current Liabilities 5,00,000 Current Assets 16,00,000
10% Long Term Loan 15,00,000 Plant & Equipment 34,00,000
(Net)
Reserves & Surplus 10,00,000
Equity Share Capital (FV: ` 100 each) 20,00,000
TOTAL 50,00,000 TOTAL 50,00,000
However, the finance advisor is concerned about the effect that issuing of debt might have on
the firm. The average debt ratio for firms in industry is 35%.He believes if this ratio is exceeded,
the P/E ratio of the company will be 7 because of the potentially greater risk.
If the firm increases its equity capital by more than 10 %, he expects the P/E ratio of the
company will increase to 8.5 irrespective of the debt ratio.
Assume Tax Rate of 25%. Assume target dividend pay-out under each alternative to be 60% for
the next year and growth rate to be 10% for the purpose of calculating Cost of Equity SUGGEST
with reason which alternative is better on the basis of each of the below given criteria:
I. Earnings per share (EPS) & Market Price per share (MPS)
II. Financial Leverage
III. Weighted Average Cost of Capital & Marginal Cost of Capital (using Book Value weights)
Answer:
Calculation of Equity Share capital and Reserve and surplus:
Alternative 1:
Equity Share capital = ` 20,00,000 + = `21,50,000
Reserve = `10,00,000 + `10,50,000
Alternative 2:
Equity Share Capital = `20,00,000 + = `27,20,000
Reserves = `10,00,000 + = `11,80,000
Capital Structure Plans
Amount in `
Capital Alternative 1 Alternative 2
Equity Share capital 21,50,000 27,20,000
Reserves and surplus 10,50,000 11,80,000
10% long term debt 15,00,000 15,00,000
14% Debentures 8,00,000 -
8% Irredeemable Debentures - 1,00,000
Total Capital Employed 55,00,000 55,00,000
Computation of Present Earnings before interest and tax (EBIT)
EPS (`) 21
No. of equity shares 20,000
Earnings for equity shareholders (I x II) (`) 4,20,000
 Financing Decisions – Capital Structure | 5.8

Profit Before Tax (III/75%) (`) 5,60,000

Interest on long term loan (1500000 x 10%) (`) 1,50,000
EBIT (IV + V) (`) 7,10,000
EBIT after expansion = `7,10,000 +` 2,00,000 = `9,10,000
Evaluation of Financial Plans on the basis of EPS, MPS and Financial Leverage
Amount in `
Particulars Alternative I Alternate II
EBIT 9,10,000 9,10,000
Less: Interest: 10% on long term loan (1,50,000) (1,50,000)
14% on Debentures (1,12,000) Nil
8% on Irredeemable Debentures Nil. (8000)
PBT 6,48,000 7,52,000
Less: Tax @25% (1,62,000) (1,88,000)
PAT 4,86,000 5,64,000
No. of equity shares 21,500 27,200
EPS 22.60 20.74
Applicable P/E ratio (Working Note 1) 7 8.5
MPS (EPS X P/E ratio) 158.2 176.29
Financial Leverage EBIT/PBT 1.40 1.21
Working Note 1
Alternative I Alternative II
Debt:
`15,00,000 +`8,00,000 23,00,000 -
`15,00,000 +`1,00,000 - 16,00,000
Total capital Employed (`) 55,00,000 55,00,000
Debt Ratio (Debt/Capital employed) =0.4182 =0.2909
=41.82% =29.09%
Change in Equity: `21,50,000-`20,00,000 1,50,000
`27,20,000-`20,00,000 7,20,000
Percentage change in equity 7.5% 36%
Applicable P/E ratio 7 8.5

Calculation of Cost of equity and various type of debt

Alternative I Alternative II
A) Cost of equity
EPS 22.60 20.74
DPS (EPS X 60%) 13.56 12.44
Growth (g) 10% 10%
Po (MPS) 158.2 176.29
 Financing Decisions – Capital Structure | 5.9

Ke= Do (1 + g)/ Po 13.56 (1.1) 12.44 (1.1)

158.2 176.29
=9.43% =7.76%
B) Cost of Debt:
10% long term debt 10% + (1-0.25) 10% +(1-0.25)
= 7.5% = 7.5%
14% redeemable debentures 14(1-0.25) + (110- nil
100/10)
110+100/2
= 10.5 + 1 / 10.5
= 10.95%
8% irredeemable debenture NA 8000(1-0.25)/1,00,00= 6%
Calculation of Weighted Average cost of capital (WACC)
Alternative 1 Alternative 2
Cost WACC Weights Cost WACC
Capital Weights (%) (%)
Equity Share Capital 0.3909 9.43 3.69% 0.4945 7.76 3.84%
Reserves and Surplus 0.1909 9.43 1.80% 0.2145 7.76 1.66%
10% Long term Debt 0.2727 7.50 2.05% 0.2727 7.50 2.05%
14% Debenture 0.1455 10.95 1.59%
8% Irredeemable Debentures - 0.0182 6 0.11%
9.12% 7.66%
Calculation Marginal Cost of Capital (MACC)
Alternative 1 Alternative 2
Amount(weight) Cost Amount Cost MACC
Capital (%) MACC (weight) (%)
Equity Share Capital ` 9.43 1.41% `7,20,000(0.72) 7.76 5.59%
1,50,000(0.15)
Reserves and Surplus ` 50,000(0.05) 9.43 0.47% `1,80,000(0.18) 7.76 1.40%
14% Debenture ` 10.95 8.76% - 0.00%
8,00,000(0.80)
8% Irredeemable
Debentures - `1,00,000(0.10) 6 0.60%
Total Capital Employed `10,00,000 10.65% `10,00,000 7.58%
Summary of solution:
Alternate I Alternate II
Earning per share (EPS) 22.60 20.74
Market price per share (MPS) 158.20 176.29
Financial leverage 1.4043 1.2101
Weighted Average cost of capital (WACC) 9.12% 7.66%
Marginal cost of capital (MACC) 10.65% 7.58%
 Financing Decisions – Capital Structure | 5.10

Alternative 1 of financing will be preferred under the criteria of EPS, whereas Alternative II of
financing will be preferred under the criteria of MPS, Financial leverage, WACC and marginal
cost of capital.
Question: 6
SUGGESTED /Nov. 2022 /Q. 5(a)/ 4 Marks
The following are the costs and values for the firms A and B according to the traditional
approach.
Firm A Firm B
Total value of firm, V (in `) 50,000 60,000
Market value of debt, D (in `) 0 30,000
Market value of equity, E (in `) 50,000 30,000
Expected net operating income (in `) 5,000 5,000
Cost of debt (in `) 0 1,800
Net Income (in `) 5,000 3,200
Cost of equity, Ke = NI/V 10.00% 10.70%
(i) Compute the Equilibrium value for Firm A and B in accordance with the M-M approach.
Assume that (a) taxes do not exist and (b) the equilibrium value of Ke is 9.09%.
(ii) Compute Value of Equity and Cost of Equity for both the firms.
Answer:
(i) Computation of Equilibrium value of Firms A & B under MM Approach:
As per MM approach KO is equal to Keu
 KO = Keu (1 – t) = 9.09 (1 – 0) = 9.09

Particulars A B
EBIT (NOI) (`) 5000 5000
KO (%) 9.09 9.09
Equilibrium value (`) (NOI/Ko) X 55005. 55005.
100 5 5

(ii) Computation of value of equity and cost of equity of Firms A & B

Particulars A B
Equilibrium value (`) 55,005.5 55,005.
Less: Value of Debt - 530,000
Value of Equity 55,005.5 25,005.
5
Cost of Equity of Firm A (unlevered) = 9.09
Cost of Debt of Firm B (Kd) (levered) = (1800/30000) × 100 = 6%
Cost of Equity of Firm B (Levered) = K0 + (K0 – Kd) × (Debt /Equity)
= 9.09 + (9.09 – 6) × (30000/25005.5)
=9.09 + 3.09 × 1.2 = 9.09 + 3.71 = 12.80%
(OR)
Cost of Equity of Firm B (Levered) = ( )

=( ) = 12.8%
 Financing Decisions – Capital Structure | 5.11

Question: 7
SUGGESTED /May- 2023 /Q. 3/10 Marks
The following information pertains to CIZA Ltd.:

`
Capital Structure:
Equity share capital (` 10 each) 8,00,000
Retained earnings 20,00,000
9% Preference share capital (` 100 each) 12,00,000
12% Long-term loan 10,00,000
Interest coverage ratio 8
Income tax rate 30%
Price – earnings ratio 25
The company is proposed to take up an expansion plan, which requires an additional
investment of ` 34,50,000. Due to this proposed expansion, earnings before interest and
taxes of the company will increase by ` 6,15,000 per annum. The additional fund can be raised
in following manner:

 By issue of equity shares at present market price, or

 By borrowing 16% Long-term loans from bank.
You are informed that Debt-equity ratio (Debt/ Shareholders' fund) in the range of 50% to
80% will bring down the price-earnings ratio to 22 whereas; Debt-equity ratio over 80% will
bring down the price-earnings ratio to 18.
Required:
Advise which option is most suitable to raise additional capital so that the Market Price per
Share (MPS) is maximized.
Answer:
Working notes:

(i) Interest Coverage ratio = 8

So, EBIT = ` 9,60,000

(ii) Proposed Earnings Before Interest & Tax = 9,60,000 + 6,15,000 = ` 15,75,000
Option 1: Equity option
Debt = ` 10,00,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000+34,50,000 = ` 74,50,000
Debt Equity ratio(Debt/Shareholders fund) = = 13.42%
P/E ratio in this case will be 25 times
Option 2: Debt option
Debt = 10,00,000 + 34,50,000 = `44,50,000
Shareholders Fund = 8,00,000+20,00,000+12,00,000 +`40,00,000
Debt Equity ratio(Debt/Shareholders fund) = = 111.25%
 Financing Decisions – Capital Structure | 5.12

Debt equity ratio has crossed the limit of 80% hence PE ratio in this case will remain at 18
times.
Number of Equity Shares to be issued = ` 34,50,000/ ` 150 = 23,000
(iii) Calculation of Earnings per Share and Market Price per share
Particulars `
Current Earnings Before Interest & Tax 9,60,000
Less: Interest 1,20,000
Earnings Before Tax 8,40,000
Less: Taxes 2,52,000
Earnings After Tax 5,88,000
Less: Preference Dividend (@9%) 1,08,000
Net earnings for Equity shareholders 4,80,000
Number of equity shares 80,000
Earnings Per Share 6
Price-earnings ratio 25
Market Price per share 150
Calculation of EPS and MPS under two financial options

Financial Options
Option I Option II
Particulars
Equity Shares 16% Long Term
Issued (`) Debt Raised (`)
Earnings before interest and Tax (EBIT) 15,75,000 15,75,000
Less: Interest on old debentures @ 12% 1,20,000 1,20,000
Less: Interest on additional loan (new) @ 16% on ` NIL 5,52,000
34,50,000
Earnings before tax 14,55,000 9,03,000
Less: Taxes @ 30% 4,36,500 2,70,900
(EAT/Profit after tax) 10,18,500 6,32,100
Less: Preference Dividend (@9%) 1,08,000 1,08,000
Net Earnings available to Equity 9,10,500 5,24,100
shareholders
Number of Equity Shares 1,03,000 80,000
Earnings per Share (EPS) 8.84 6.55
Price/ Earnings ratio 25 18
Market price per share (MPS) 221 117.9
Advise: Equity option has higher Market Price per Share therefore company should raise
additional fund through equity option.
Question: 8
SUGGESTED /May- 2022 /Q. 5 /10 Marks
The particulars relating to Raj Ltd. for the year ended 31 st March, 2022 are given as follows:
Output (units at normal capacity) 1,00,000
Selling price per unit ` 40
 Financing Decisions – Capital Structure | 5.13

Variable cost per unit ` 20

Fixed cost ` 10,00,000
The capital structure of the company as on 31st March, 2022 is as follows:
Particulars Amount in `
Equity share capital (1,00,000 shares of ` 10 each) 10,00,000
Reserves and surplus 5,00,000
Current liabilities 5,00,000
Total 20,00,000
Raj Ltd. has decided to undertake an expansion project to use the market potential that will
involve ` 20 lakhs. The company expects an increase in output by 50%. Fixed cost will be
increased by ` 5,00,000 and variable cost per unit will be decreased by 15%. The additional
output can be sold at the existing selling price without any adverse impact on the market.
The following alternative schemes for financing the proposed expansion program are planned:
(Amount in `)
Alternative Debt Equity Shares
1 5,00,000 Balance
2 10,00,000 Balance
3 14,00,000 Balance
Current market price per share is ` 200.
Slab wise interest rate for fund borrowed is as follows:
Fund limit Applicable interest rate
Up-to ` 5,00,000 10%
Over` 5,00,000 and up-to ` 10,00,000 15%
Over ` 10,00,000 20%
Find out which of the above-mentioned alternatives would you recommend for Raj Ltd. with
reference to the EPS, assuming a corporate tax rate is 40%?
Answer:
Alternative 1 = Raising Debt of ` 5 lakh + Equity of ` 15 lakh

Alternative 2 = Raising Debt of ` 10 lakh + Equity of ` 10 lakh

Alternative 3 = Raising Debt of ` 14 lakh + Equity of ` 6 lakh

Calculation of Earnings per share (EPS)

FINANCIAL ALTERNATIVES
Particulars Alternative 1 Alternative 2 Alternative 3
(`) (`) (`)
Expected EBIT [W. N. (a)] 19,50,000 19,50,000 19,50,000
Less: Interest [W. N. (b)] (50,000) (1,25,000) (2,05,000)
Earnings before taxes (EBT) 19,00,000 18,25,000 17,45,000
Less: Taxes @ 40% 7,60,000 7,30,000 6,98,000
Earnings after taxes (EAT) 11,40,000 10,95,000 10,47,000
Number of shares [W. N. (d)] 1,07,500 1,05,000 1,03,000
Earnings per share (EPS) 10.60 10.43 10.17
 Financing Decisions – Capital Structure | 5.14

Conclusion: Alternative 1 (i.e. Raising Debt of ` 5 lakh and Equity of ` 15 lakh) is recommended
which maximises the earnings per share.
Working Notes (W.N.):
(a) Calculation of Earnings before Interest and Tax (EBIT)
Particulars
Output (1,00,000 + 50%) (A) 1,50,000
Selling price per unit ` 40
Less: Variable cost per unit (` 20 – 15%) ` 17
Contribution per unit (B) ` 23
Total contribution (A x B) `
34,50,000
Less: Fixed Cost (` 10,00,000 + ` 5,00,000) ` 15,00,000
EBIT `
19,50,000
(b) Calculation of interest on Debt
Alternative (`) Total (`)
1 (` 5,00,000 x 10%) 50,000
2 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000 1,25,000
3 (` 5,00,000 x 10%) 50,000
(` 5,00,000 x 15%) 75,000
(` 4,00,000 x 20%) 80,000 2,05,000
(c) Number of equity shares to be issued
)
Alternative 1 = )
)
Alternative 2 = )
shares
)
Alternative 3 = )

(d) Calculation of total equity shares after expansion program

Alternative 1 Alternative 2 Alternative 3

Existing no. of shares 1,00,000 1,00,000 1,00,000
Add: issued under expansion 7,500 5,000 3,000
program
Total no. of equity shares 1,07,500 1,05,000 1,03,000
 Financing Decisions - Leverages | 6.1
CHAPTER – 6 Financing Decisions - Leverages
Chapter – 6
Financing Decisions - Leverages
Question & Answer
Question 1
RTP /May-22/ Q. 4 /
Company P and Q are having same earnings before tax. However, the margin of safety of
Company P is 0.20 and, for Company Q, is 1.25 times than that of Company P. The interest
expense of Company P is ` 1,50,000 and, for Company Q, is 1/3rd less than that of Company P.
Further, the financial leverage of Company P is 4 and, for Company Q, is 75% of Company P.
Other information is given as below:
Particulars Company P Company Q
Profit volume ratio 25% 33.33%
Tax rate 45% 45%
You are required to PREPARE Income Statement for both the companies.
Answer:
Income Statement
Particulars Company P (`) Company Q (`)
Sales 40,00,000 18,00,000
Less: Variable Cost 30,00,000 12,00,000
Contribution 10,00,000 6,00,000
Less: Fixed Cost 8,00,000 4,50,000
EBIT 2,00,000 1,50,000
Less: Interest 1,50,000 1,00,000
EBT 50,000 50,000
Tax (45%) 22,500 22,500
EAT 27,500 27,500
Workings:
(i) Margin of Safety
For Company P = 0.20
For Company Q = 0.20 x 1.25 = 0.25
(ii) Interest Expenses
For Company P = ` 1,50,000
For Company Q = ` 1,50,000 (1-1/3) = ` 1,00,000
(iii) Financial Leverage
For Company P = 4
For Company Q = 4 x 75% = 3
(iv) EBIT
For Company A
Financial Leverage = EBIT/(EBIT- Interest)
4 = EBIT/(EBIT- ` 1,50,000)
4EBIT – ` 6,00,000 = EBIT
3EBIT = ` 6,00,000
EBIT = ` 2,00,000
For Company B
Financial Leverage = EBIT/(EBIT - Interest)
3 = EBIT/(EBIT – ` 1,00,000)
 Financing Decisions - Leverages | 6.2
3EBIT – ` 3,00,000 = EBIT
2EBIT = ` 3,00,000
EBIT = ` 1,50,000
(v) Contribution For
Company A
Operating Leverage = 1/Margin of Safety
= 1/0.20 = 5
Operating Leverage = Contribution/EBIT
5 = Contribution/` 2,00,000
Contribution = ` 10,00,000
For Company B
Operating Leverage = 1/Margin of Safety
= 1/0.25 = 4
Operating Leverage = Contribution/EBIT
4 = Contribution/` 1,50,000
Contribution = ` 6,00,000
(vi) Sales
For Company A
Profit Volume Ratio = 25%
Profit Volume Ratio = Contribution/Sales  100
25% = ` 10,00,000/Sales
Sales = ` 10,00,000/25%
Sales = ` 40,00,000
For Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ` 6,00,000/33.33%
Sales = ` 18,00,000

Question: 2
MTP /April- 2022/Q. 1(b) /5 Marks
From the given details, PREPARE Income Statement for Alpha Ltd. and Beta Ltd.
Particulars Alpha Ltd. Beta Ltd.
Operating Leverage 1.875 1.800
Financial Leverage 1.600 1.250
PV Ratio 60% 50%
Profit after tax ` 3,00,000 ` 2,40,000
Tax rate 40% 40%
Answer:
Particulars Alpha Ltd. (`) Beta Ltd. (`)
Sales 25,00,000 18,00,000
Less: Variable Cost 10,00,000 9,00,000 (Bal. fig.)
Contribution 15,00,000 9,00,000
Less: Fixed Cost 7,00,000 4,00,000 (Bal. fig.)
EBIT 8,00,000 5,00,000
Less: Interest 3,00,000 1,00,000 (Bal. fig.)
 Financing Decisions - Leverages | 6.3

PBT 5,00,000 4,00,000

Less: Tax (40%) 2,00,000 1,60,000
PAT 3,00,000 2,40,000
Working Note:
Particulars Alpha Ltd. Beta Ltd.
PAT ` 3,00,000 ` 2,40,000
Tax Rate (t) 40% 40%
 PBT = PAT/(I-t) 5,00,000

Finance Leverage 1.60 1.25

 EBIT = PBT × FL 5,00,000 × 1.6 4,00,000 × 1.25
= 8,00,000 = 5,00,000
Operating Leverage 1.875 1.800
Contribution = EBIT × OL 8,00,000 × 1.875 5,00,000 × 1.8
= 15,00,000 = 9,00,000
PV ratio 60% 50%

∴ Sales =

Question: 3
SUGGESTED /May- 2023 /Q. 1(d)/5 Marks
Following information is given for X Ltd.:
Total contribution (`) 4,25,000
Operating leverage 3.125
15% Preference shares (` 100 each) 1,000
Number of equity shares 2,500
Tax rate 50%
Calculate EPS of X Ltd., if 40% decrease in sales will result EPS to zero.
Answer:
(i) Operating Leverage (OL) = Or, 3.125 = Or EBIT
= `1,36,000
(ii) Degree of Combined Leverage (CL) =
(iii) Combined Leverage = OL × FL = 3.125 × FL
So, Financial Leverage = 2.5 / 3.125 = 0.8
(iv) Financial Leverage =
So, EBT = `70,000
Calculation of EPS of X Ltd.
Particulars (`)
EBT 1,70,000
Less: Tax (50%) 85,000
EAT 85,000
Preference Dividend 15,000
Net Earnings for Equity Shareholders 70,000
 Financing Decisions - Leverages | 6.4
Number of equity shares 2,500
EPS 28
 Investment Decisions | 7.1
CHAPTER – 7 Investment Decisions
Chapter – 7
Investment Decisions
Question & Answer
Question: 1
MTP /MAY - 2020/Q. 3/10 Marks
A&R Ltd. has undertaken a project which has an initial investment of Rs.2,000 lakhs in plant &
machinery and Rs.800 lakhs for working capital. The plant & machinery would have a salvage
value of Rs. 474.61 lakhs at the end of the fifth year. The plant & machinery would depreciate at
the rate of 25% p.a. on WDV method. The other details of the project for the five year period are
as follows:
Sales 10,00,000 units p.a.
Selling price per unit Rs.500
Variable cost 50% of selling price
Fixed overheads (excluding depreciation) Rs.300 lakh p.a.
Corporate tax rate 35%
Rate of interest on bank loan 12%
After tax required rate of return 15%
Required:
(i) CACULATE net present value (NPV) of the project and DETERMINE the viability of the
project.
(ii) DETERMINE the sensitivity of project’s NPV under each of the following condition:
a. Decrease in selling price by 10%;
b. Increase in cost of plant & machinery by 10%.

PV factor Year-1 Year-2 Year-3 Year-4 Year-5

12% 0.892 0.797 0.711 0.635 0.567
15% 0.869 0.756 0.657 0.571 0.497
Answer:
(i) Calculation of Net Present Value (NPV):
Year-1 Year-2 Year-3 Year-4 Year-5
Sales volume (Qty. in lakh) 10 10 10 10 10
Contribution per unit (Rs.) 250 250 250 250 250
(Selling price – variable cost)
Total contribution (Rs.in lakh) 2,500 2,500 2,500 2,500 2,500
Less: Fixed overheads (Rs. Inlakh) 300 300 300 300 300
PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (Rs. in lakh) 500 375 281.25 210.94 158.20
(Working note-1)
PBT 1,700 1,825 1,918.75 1,989.06 2,041.80
Less: Tax @ 35% 595 638.75 671.56 696.17 714.63
PAT 1,105 1,186.25 1,247.19 1,292.89 1,327.17
Add: Depreciation 500 375 281.25 210.94 158.20
 Investment Decisions | 7.2

Add: Salvage value of plant & - - - - 474.61

machinery
Add: Working capital - - - - 800
Net Cash inflow 1,605 1,561.25 1,528.44 1,503.83 2,759.98
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,394.74 1,180.31 1,004.18 858.68 1,371.71
Net Present Value = P.V of cash inflows – P.V of cash outflows
= Rs. (1,394.74+1,180.31+1,004.18+858.68+1,371.71) – (Rs.2,000 + Rs. 800)
= Rs.3,009.62 lakh
The NPV of the project is positive, hence, the project is viable.
Working note-1:
Year-1 Year-2 Year-3 Year-4 Year-5
Opening balance 2,000 1,500 1,125 843.75 632.81
Depreciation @25% 500 375 281.25 210.94 158.20
Closing WDV 1,500 1,125 843.75 632.81 474.61
(ii) Determination of Sensitivity of NPV w.r.t.
a. Decrease in selling price by 10%
Year-1 Year-2 Year-3 Year-4 Year-5
Sales volume (Qty. in lakh) 10 10 10 10 10
New Selling price 450 450 450 450 450
Variable cost 250 250 250 250 250
Contribution per unit (Rs.) (Selling 200 200 200 200 200
price – variable cost)
Total contribution (Rs.in lakh) 2,000 2,000 2,000 2,000 2,000
Less: Fixed overheads (Rs. Inlakh) 300 300 300 300 300

PBDT 1,700 1,700 1,700 1,700 1,700

Less: Depreciation (Rs. inlakh) 500 375 281.25 210.94 158.20
(Working note-1)
PBT 1,200 1,325 1,418.75 1,489.06 1,541.80
Less: Tax @ 35% 420 463.75 496.56 521.17 539.63
PAT 780 861.25 922.19 967.89 1,002.17
Add: Depreciation 500 375 281.25 210.94 158.20
Add: Salvage value of plant & - - - - 474.61
machinery
Add: Working capital - - - - 800
Net Cash inflow 1,280 1,236.25 1,203.44 1,178.83 2,434.98
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,112.32 934.61 790.66 673.11 1,210.18
 Investment Decisions | 7.3
NPV = Rs. (1,112.32+934.61+790.66+673.11+1,210.18) – (Rs. 2,000 + Rs. 800)
= Rs. 4,720.88 – Rs. 2,800 = 1,920.88 lakh
10% reduction in selling price reduces the NPV by 36.18% (3,009.62-1,920.88/3,009.62)
b. Increase in project cost by 10%
Year-1 Year-2 Year-3 Year-4 Year-5
PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (Rs. in 550 412.5 309.37 232.03 174.03
lakh) (Working note-2)
PBT 1,650 1,787.50 1,890.63 1,967.97 2,025.97
Less: Tax @ 35% 577.50 625.63 661.72 688.79 709.09
PAT 1072.50 1,161.87 1,228.91 1,279.18 1,316.88
Add: Depreciation 550 412.5 309.37 232.03 174.03
Add: Salvage value ofplant - - - - 474.61
& machinery
Add: Working capital - - - - 800
Net Cash inflow 1,622.50 1,574.37 1,538.28 1,511.21 2,765.52
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,409.95 1,190.22 1,010.65 862.90 1,374.46
NPV = Rs. (1,409.95+1,190.22+1,010.65+862.90+1,374.46) – (Rs. 2,200 + Rs. 800)
= Rs. 5,848.18 – Rs. 3,000 = 2,848.18 lakh
10% increase in project cost reduces the NPV only by 5.36% (3,009.62 -
2,848.18/3,009.62)
Working note-2:
Year-1 Year-2 Year-3 Year-4 Year-5
Opening balance 2,200 1,650 1,237.50 928.13 696.10
Depreciation @25% 550 412.5 309.37 232.03 174.03
Closing WDV 1,650 1,237.50 928.13 696.10 522.07

Question: 2
MTP /Nov. 2021/Q. 3/10 Marks
Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The
parts are constructed in eight locations (including the central headquarter) around the world.
The Finance Director, Ms. Kuthrapali, chooses to implement video conferencing to speed up the
budget process and save travel costs. She finds that, in earlier years, the company sent two
officers from each location to the central headquarter to discuss the budget twice a year. The
average travel cost per person, including air fare, hotels and meals, is ` 27,000 per trip. The cost
of using video conferencing is ` 8,25,000 to set up a system at each location plus ` 300 per hour
average cost of telephone time to transmit signals. A total 48 hours of transmission time will be
needed to complete the budget each year. The company depreciates this type of equipment over
five years by using straight line method. An alternative approach is to travel to local rented
video conferencing facilities, which can be rented for ` 1,500 per hour plus ` 400 per hour
averge cost for telephone charges. You are Senior Officer of Finance Department. You have been
asked by Ms. Kuthrapali to EVALUATE the proposal and SUGGEST if it would be worthwhile for
the company to implement video conferencing.
 Investment Decisions | 7.4
Answer:
Option I : Cost of travel, in case Video Conferencing facility is not provided
Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7×2×2 = 28 Trips
Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips × ` 27,000
per trip) = ` 7,56,000
Option II : Video Conferencing Facility is provided by Installation of Own Equipment at
Different Locations
Cost of Equipment at each location (` 8,25,000 × 8 locations) = ` 66,00,000 Economic life of
Machines (5 years). Annual depreciation (66,00,000/5) = ` 13,20,000
Annual transmission cost (48 hrs. transmission × 8 locations × ` 300 per hour) = ` 1,15,200
Annual cost of operation (13,20,000 + 1,15,200) = ` 14,35,200
Option III : Engaging Video Conferencing Facility on Rental Basis Rental cost (48 hrs. ×
8 location × ` 1,500 per hr) = ` 5,76,000 Telephone cost (48 hrs.× 8 locations × ` 400 per hr.) =
` 1,53,600 Total rental cost of equipment (5,76,000 + 1,53,600) = ` 7,29,600
Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged
on rentalbasis. Therefore, Option III is suggested.

Question: 3
MTP /March. 2021/Q. 5/10 Marks
GG Pathology Lab Ltd. is using 2D sonography machine which has reached the end of its useful
life. The lab is intending to upgrade along with the technology by investing in 3D sonography
machine as per the choices preferred by the patients. Following new 3D sonography machine of
two different brands with same features is available in the market:
Brand Cost of Life of Maintenance Cost (Rs.) SLM
machine machine Depreciation
rate
(Rs.) (Rs.) Year 1-5 Year 6-10 Year 11- (%)
15
X 15,00,000 15 50,000 70,000 98,000 6
Y 10,00,000 10 70,000 1,15,000 - 6
Residual Value of machines shall be dropped by 10% and 40% of Purchase price for Brand X
and Y respectively in the first year and thereafter shall be depreciated at the rate mentioned
above on the original cost.
Alternatively, the machine of Brand Y can also be taken on rent to be returned back to the owner
after use on the following terms and conditions:
• Annual Rent shall be paid in the beginning of each year and for first year it shall be Rs.
2,24,000. Annual Rent for the subsequent 4 years shall be Rs. 2,25,000.
• Annual Rent for the final 5 years shall be Rs. 2,70,000.
• The Rent/Agreement can be terminated by GG Labs by making a payment of Rs. 2,20,000
as penalty. This penalty would be reduced by Rs. 22,000 each year of the period of rental
agreement.
You are required to:
(i) ADVISE which brand of 3D sonography machine should be acquired assuming that the use
of machine shall be continued for a period of 20 years.
(ii) STATE which of the option is most economical if machine is likely to be used for a period
of 5 years?
The cost of capital of GG Labs is 12%.
 Investment Decisions | 7.5
The present value factor of Rs. 1 @ 12% for different years is given as under:
Year PVF Year PVF
1 0.893 9 0.361
2 0.797 10 0.322
3 0.712 11 0.287
4 0.636 12 0.257
5 0.567 13 0.229
6 0.507 14 0.205
7 0.452 15 0.183
8 0.404 16 0.163

Answer:
Since the life span of each machine is different and time span exceeds the useful lives of each
modeI, we shall use Equivalent Annual Cost method to decide which brand should be chosen.
(i) If machine is used for 20 years
(a) Residual value of machine of brand X
= [Rs. 15,00,000 – (1 - 0.10)] - (Rs. 15,00,000 × 0.06 × 14) = Rs. 90,000
(b) Residual value of machine of brand Y
= [Rs. 10,00,000 – (1 - 0.40)] - (Rs. 10,00,000 × 0.06 × 9) = Rs. 60,000
Present Value (PV) of cost if machine of brand X is purchased

Period Cash Outflow PVF @ PV (Rs.)

(Rs.) 12%
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
6-10 70,000 2.046 1,43,220
11-15 98,000 1.161 1,13,778
15 (90,000) 0.183 (16,470)
19,20,778
PVAF for 1 – 15 years = 6.812
Equivalent Annual Cost =

Present Value (PV) of cost if machine of brand Y is purchased

Period Cash Outflow PVF @ PV (Rs.)

(Rs.) 12%
0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
6-10 1,15,000 2.046 2,35,290
10 (60,000) 0.322 (19,320)
14,68,320
PVAF for 1 – 10 years = 5.651
 Investment Decisions | 7.6

Equivalent Annual Cost =

Present Value (PV) of cost if machine of brand Y is taken on rent
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5-9 2,70,000 2.291 6,18,570
15,26,120
PVAF for 1-10 years = 5.651
Equivalent Annual Cost =
Decision: Since Equivalent Annual Cash Outflow is least in case of purchase of Machine of
brand Y the same should be purchased.
(ii) If Machine is used for 5 years
(a) Scrap value of machine of brand X
=[Rs. 15,00,000 – (1-0.10)] – (Rs. 15,00,000 × 0.6 × 4) = Rs. 9,90,000
(b) Scrap value of machine of brand Y
=[Rs. 10,00,000 – (1 -0.40)] – (Rs. 10,00,000 × 0.06 × 4) = Rs. 3,60,000
Present Value (PV) of cost if machine of Brand X is purchased
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
5 (9,90,000) 0.567 (5,61,330)
11,18,920
Present Value (PV) of cost if machine of brand Y is purchased

Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)

0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
5 (3,60,000) 0.567 (2,04,120)
10,48,230
Present Value (PV) of cost if machine of brand Y is taken on rent
Period Cash Outflow (Rs.) PVF @ 12% PV (Rs.)
0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5 1,10,000* 0.567 62,370
9,69,920
* [Rs. 2,20,000 - (Rs. 22,000 × 5) = Rs. 1,10,000]
Decision: Since Cash Outflow is least in case of rent of Machine of brand Y the same should be
taken on rent.
 Investment Decisions | 7.7
Question: 4
MTP /April. 2021/Q. 4 /10 Marks
City Clap Ltd. is in the business of providing housekeeping services. There is a proposal before
the company to purchase a mechanized cleaning system for a sum of Rs. 40 lakhs. The present
system of the company is to use manual labour for the cleaning job. You are provided with the
following information:
Proposed Mechanized System:
Cost of the machine Rs. 40 lakhs
Life of the machine 7 years
Depreciation (on straight line basis) 15%
Operating cost of mechanized system Rs. 20 lakhs per annum
Present system (Manual):
Manual labour 350 persons
Cost of manual labour Rs. 15,000 per person per annum
The company has an after-tax cost of fund at 10% per annum.
The applicable tax rate is 50%.
PV factor for 7 years at 10% are as follows:
Years 1 2 3 4 5 6 7
P.V. factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513
You are required to DETERMINE whether it is advisable to purchase the mechanized cleaning
system. Give your recommendations with workings.
Answer:
Calculation of NPV
(Rs.) (Rs.)
Cost of Manual System (Rs. 15,000 x 350) 52,50,000
Less: Cost of Mechanized System:
Operating Cost 20,00,000

Depreciation (Rs. 40,00,000 x 0.15) 6,00,000 26,00,000

Saving per annum 26,50,000
Less: Tax (50%) 13,25,000
Saving after tax 13,25,000
Add: Depreciation 6,00,000
Cash flow per annum 19,25,000
Cumulative PV Factor for 7 years @ 10% 4.867
Present value of cash flow for 7 years 93,68,975
Less: Cost of the Machine 40,00,000
NPV 53,68,975
The mechanized cleaning system should be purchased since NPV is positive by
Rs. 53,68,975.

Question: 5
MTP /March- 2022/Q. 4 /10 Marks
A manufacturing company is presently paying a garbage disposer company ` 0.50 per kilogram
to dispose-off the waste resulting from its manufacturing operations. At normal operating
capacity, the waste is about 2,00,000 kilograms per year.
After spending ` 1,20,000 on research, the company discovered that the waste could be sold for
` 5 per kilogram if it was processed further. Additional processing would, however, require an
 Investment Decisions | 7.8
investment of ` 12,00,000 in new equipment, which would have an estimated life of 10 years
with no salvage value. Depreciation would be calculated by straight line method.
No change in the present selling and administrative expenses is expected except for the costs
incurred in advertising ` 40,000 per year, if the new product is sold. Additional processing costs
would include variable cost of ` 2.50 per kilogram of waste put into process along with fixed
cost of ` 60,000 per year (excluding Depreciation).
There will be no losses in processing, and it is assumed that the total waste processed in a given
year will be sold in the same year. Estimates indicate that 2,00,000 kilograms of the product
could be sold each year.
The management when confronted with the choice of disposing off the waste or processing it
further and selling it, seeks your ADVICE. Which alternative would you RECOMMEND? Assume
that the firm's cost of capital is 15% and it pays on an average 50% Tax on its income.
Consider Present value of Annuity of ` 1 per year @ 15% p.a. for 10 years as 5.019.
Answer:
Evaluation of Alternatives:
Saving in disposing off the waste
Particulars (`)
Outflow (2,00,000 × ` 0.50) 1,00,000
Less: tax savings @ 50% 50,000
Net Outflow per year 50,000
Calculation of Annual Cash inflows in Processing of waste Material
Particulars Amount (`) Amount (`)
Sale value of waste (` 5 × 2,00,000 kilograms) 10,00,000
Less: Variable processing cost (` 2.50 × 2,00,000 kilograms) 5,00,000
Less: Fixed processing cost 60,000
Less: Advertisement cost 40,000
Less: Depreciation 1,20,000 (7,20,000)
Earnings before tax (EBT) 2,80,000
Less: Tax @ 50% (1,40,000)
Earnings after tax (EAT) 1,40,000
Add: Depreciation 1,20,000
Annual Cash inflows 2,60,000
Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in
disposal cost
= ` 2,60,000 + ` 50,000 = ` 3,10,000
Calculation of Net Present Value
Year Particulars Amount (`)
0 Investment in new equipment (12,00,000)
1 to 10 Total Annual benefits × PVAF(10 years, 15%)
15,55,890
` 3,10,000 × 5.019
Net Present Value 3,55,890
Recommendation: Processing of waste is a better option as it gives a positive Net Present
Value.
Note- Research cost of ` 1,20,000 is not relevant for decision making as it is sunk cost.
 Investment Decisions | 7.9
Question: 6
MTP /Sep. 2023/Q. 5 /10 Marks/
A firm can make investment in either of the following two projects. The firm anticipates its cost
of capital to be 10%. The pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (`) (3,00,000) 55,000 1,20,000 1,30,000 1,05,000 40,000
Project 8 (`) (3,00,000) 3,18,000 20,000 20,000 8,000 6,000

Ignore Taxation.
An amount of ` 45,000 will be spent on account of sales promotion in year 3 in case of Project A.
This has not been considered in calculation of pre-tax cash flows.
The discount factors are as under:
Year 0 1 2 3 4 5
PVF (10%) 1 0.91 0.83 0.75 0.68 0.62
You are required to calculate for each project:
(i) The payback period
(ii) The discounted payback period
(iii) Desirability factor
(iv) Net Present Value

Answer:
Calculation of Present Value of cash flows
Year PV factor @ Project A Project B
10% Cash flows (`) Discounted Cash flows Discounted
Cash flows (`) Cash flows
0 1.00 (3,00,000) (3,00,000) (3,00,000) (3,00,000)
1 0.91 55,000 50,050 3,18,000 2,89,380
2 0.83 1,20,000 99,600 20,000 16,600
3 0.75 85,000(1,30,000-45,000) 63,750 20,000 15,000
4 0.68 1,05,000 71,400 8,000 5,440
5 0.62 40,000 24,800 6,000 3,720
Net Present Value 9,600 30,140
(i) The Payback period of the projects:
Project-A: The cumulative cash inflows up-to year 3 is `2,60,000 and remaining amount
required to equate the cash outflow is ` 40,000 i.e. (` 3,00,000 – ` 2,60,000) which will be
recovered from year-4 cash inflow. Hence, Payback period will be calculated as below:
3 years + 3.381 years or 3 years, 4 months, 9 days (approx..)
Project-B: The cash inflow in year-1 is ` 3,18,000 and the amount required to equate the
cash outflow is ` 3,00,000, which can be recovered in a period less than a year. Hence,
Payback period will be calculated as below:
= 0943 years or 11 months
(ii) Discounted Payback period for the projects:
Project-A: The cumulative discounted cash inflows up-to year 4 is ` 2,84,800 and
remaining amount required to equate the cash outflow is ` 15,200 i.e. (` 3,00,000 – `
2,84,800) which will be recovered from year-5 cash inflow. Hence, Payback period will be
calculated as below:
 Investment Decisions | 7.10

4 years + = 4,613 years, 2 months, and 11 days

Project - B : The cash inflow in year-1 is `2,89,380 and remaining required to equate the
cash outflow is `10,620 i.e. (`3,00,000 - `2,89,380) which will be recovered from year – 2
cash inflow. Hence, Payback period will be calculated as below:
1 year + 1,640 years or 1 Year, 7 Months and 23 days
(iii) Desirability factor of the projects
Desirability Factor (Profitability Index) =
Project A =
Project B =
(iv) Net Present Value (NPV) of the projects:
Please refer the above table.
Project A - `9,600
Project B - `30,140
Question: 7
MTP /APRIL. 2023/Q. 1(a) /5 Marks
Rambow Ltd. is contemplating purchasing machinery that would cost ` 10,00,000 plus GST @
18% at the beginning of year 1. Cash inflows after tax from operations have been estimated at `
2,56,000 per annum for 5 years. The company has two options for the smooth functioning of the
machinery - one is service, and another is replacement of parts. The company has the option to
service a part of the machinery at the end of each of the years 2 and 4 at ` 1,00,000 plus GST @
18% for each year. In such a case, the scrap value at the end of year 5 will be ` 76,000. However,
if the company decides not to service the part, then it will have to be replaced at the end of year
3 at ` 3,00,000 plus GST@ 18% and in this case, the machinery will work for the 6th year also
and get operational cash inflow of ` 1,86,000 for the 6th year. It will have to be scrapped at the
end of year 6 at ` 1,36,000.
Assume cost of capital at 12% and GST paid on all inputs including capital goods are eligible for
input tax credit in the same month as and when incurred.
(i) DECIDE whether the machinery should be purchased under option 1 or under option 2 or
it shouldn’t be purchased at all.
(ii) If the supplier gives a discount of ` 90,000 for purchase, WHAT would be your decision?
Note: The PV factors at 12% are:
Year 0 1 2 3 4 5 6
PV Factor 1 0.8928 0.7972 0.7118 0.6355 0.5674 0.5066
Answer:
Option I: Purchase Machinery and Service Part at the end of Year 2 and 4.
Net Present value of cash flow @ 12% per annum discount rate.
NPV (in`) = - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (1,00,000 x
0.7972+1,00,000 x 0.6355) + (76,000 x 0.5674)
= - 10,00,000 + (2,56,000 x 3.6047) – 1,43,270+43,122.4
= - 10,00,000 + 9,22,803.2 – 1,43,270+ 43,122.4
NPV = - 1,77,344.4
Since Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ` 90,000, then:
NPV (in `) = + 90,000 - 1,77,344.4 = -87,344.4
In this case, Net Present Value is still negative; therefore, this option may not be advisable
Option II: Purchase Machinery and Replace Part at the end of Year 2.
NPV (in `)= - 10,00,000 + 2,56,000 x (0.8928+0.7972+0.7118+0.6355+0.5674) – (3,00,000
x
 Investment Decisions | 7.11
0.7118) + (1,86,000 x 0.5066+1,36,000 x 0.5066)
= - 10,00,000 + (2,56,000 x 3.6047) – 2,13,540+1,63,125.2
= - 10,00,000 + 9,22,803.2 – 2,13,540+1,63,125.2
NPV = - 1,27,611.6
Net Present Value is negative, the machinery should not be purchased.
If the Supplier gives a discount of ` 90,000, then:
NPV (in `) = 90,000 - 1,27,611.6 = - 37,611.6
In this case, Net Present Value is still negative; therefore, this option may not be advisable.
Decision: The Machinery should not be purchased as it will earn a negative NPV in
bothoptions of repair and replacement.

Question: 8
MTP /APRIL. 2023/Q. 5 /10 Marks
Genzy Ltd. is planning to introduce a new product with a project life of 10 years. The initial
equipment cost will be ` 2.5 crores. At the end of 10 years, the equipment will have a resale
value of 50 lakhs. A working capital of ` 30,00,000 will be needed and it will be released at the
end of the tenth year. The project will be financed with the following capital sources.
Particulars Amount (`) Issue Price
(Market price)
Equity Share Capital of Face value ` 10 each 1,50,00,000 `30
Debentures of face value ` 100 each with a maturity of 10 90,00,000 `90
years
Preference shares of ` 100 each with a maturity of 10 years 60,00,000 `96

The existing yield on T-bills is averaging 8% p.a. The systematic risk measure for the proposed
project is 1.6. NSE NIFTY is expected to yield 14% p.a. on average for the foreseeable future.
Debenture holders have been promised a coupon of 12% and preference shareholders have
been committed a dividend of 15%.
The sales volumes over 10 years have been estimated as follows:
Year 1 2 3-5 6-8 9-10
Units per year 70,000 98,000 2,10,000 2,50,000 1,20,000

A sales price of ` 300 per unit is expected and variable expenses will amount to 60% of sales
revenue. Fixed cash operating costs will amount to ` 40,00,000 per year. The loss of any year
will be set off from the profits of subsequent years.
The company is subject to a 30 per cent tax rate. The company follows straight line method of
depreciation which is to be assumed to be admissible for tax purpose also.
CALCULATE the net present value of the project for the company and advise the management to
take appropriate decision.
The PV factors are to be taken as rounded figures upto 2 decimals. Use market value weights to
COMPUTE overall cost of capital.
Answer:
Cost of Equity
Ke = Rf + Beta * (Rm – Rf) Ke = 8% + 1.6 * (14% - 8%)
Ke = 8% + (1.6 * 6%)
Ke = 17.6%
1. Cost of Redeemable Debentures (Post-Tax)
 Investment Decisions | 7.12

Kd = Int (1 –t) +

Kd =

Kd = 9.89%

2. Cost of Redeemable Preference Shares

Kp = PD +

Kp =

Kp =

Kp = 15.71%

3. Weighted Average Cost of Capital (WACC) – Book Value Method

Source of Capital Market Value Weights After Tax WACC

Cost
of Capital
Equity Share Capital 1,50,00,000 0.5 17.6% 0.088
Debentures 90,00,000 0.3 9.89% 0.030
Preference Share Capital 60,00,000 0.2 15.71% 0.031
3,00,00,000 1.000 0.149
WACC = 17.9%

4. Computation of CFAT

(year 1 to year 4)
Sr. Particulars / Year 1 2 3-5 6-8 9-10
No.
A Sale Price p.u. 300 300 300 300 300
Sale units 70,000 98,000 2,10,000 2,50,000 1,20,000
C Sales (A x B) 2,10,00,000 2,94,00,000 6,30,00,000 7,50,00,000 3,60,00,000
D Variable Cost p.u. 180 180 180 180 180
E Variable Cost (B x D) 1,26,00,000 1,76,40,000 3,78,00,000 4,50,00,000 2,16,00,000
F Contribution (C - E) 84,00,000 1,17,60,000 2,52,00,000 3,00,00,000 1,44,00,000
G Less: Fixed Cost 40,00,000 40,00,000 40,00,000 40,00,000 40,00,000
H PBDT (F-G) 44,00,000 77,60,000 2,12,00,000 2,60,00,000 1,04,00,000
I Less: Depreciation 20,00,000 20,00,000 20,00,000 20,00,000 20,00,000
(2,50,00,000-
50,00,000) / 10
J PBT 24,00,000 57,60,000 1,92,00,000 2,40,00,000 84,00,000
K Less: Taxes @ 30% 7,20,000 17,28,000 57,60,000 72,00,000 25,20,000
L PAT 16,80,000 40,32,000 1,34,40,000 1,68,00,000 58,80,000
 Investment Decisions | 7.13
M Add: Depreciation 20,00,000 20,00,000 20,00,000 20,00,000 20,00,000
N CFAT 36,80,000 60,32,000 1,54,40,000 1,88,00,000 78,80,000
5. Computation of NPV

Sr. Particulars / 1 2 3-5 6-8 9-10

No. Year
I CFAT 36,80,000 60,32,000 1,54,40,000 1,88,00,000 78,80,000
II PVAF @ 14.9% 0.87 0.76 (0.66+0.57+ (0.43+0.38+0.33) (0.29+0.25)
0.50) = 1.73 = 1.14 = 0.54
III PV of CFATs (I 32,01,600 45,84,320 2,67,11,200 2,14,32,000 42,55,200
x II)
IV Salvage + 80,00,000
Release ofWC
V PVF @ 14.9% 0.25
VI PV of Salvage 20,00,000
(IV xV)
PV of Inflows = 32,01,600 + 45,84,320 + 2,67,11,200 + 2,14,32,000 + 42,55,200 + 20,00,000
PV of Inflows = 6,21,84,320
PV of Outflows = Investment + Introduction of Working Capital PV of Outflows = 2,50,00,000 +
30,00,000
PV of Outflows = 2,80,00,000
NPV = PV of Inflows – PV of Outflows NPV = 6,21,84,320 - 2,80,00,000
NPV = 3,41,84,320
The management should consider taking up the project as the Net Present Value of the
Project is Positive.
Question: 9
SUGGESTED /Nov. 2022 /Q. 4 /10 Marks/
A hospital is considering to purchase a diagnostic machine costing ` 80,000. The projected life
of the machine is 8 years and has an expected salvage value of ` 6,000 at the end of 8 years. The
annual operating cost of the machine is ` 7,500. It is expected to generate revenues of ` 40,000
per year for eight years. Presently, the hospital is outsourcing the diagnostic work and is
earning commission income of ` 12,000 per annum.
Consider tax rate of 30% and Discounting Rate as 10%. Advise:
Whether it would be profitable for the hospital to purchase the machine?
Give your recommendation as per Net Present Value method and Present Value Index method
under below mentioned two situations:
(i) If Commission income of ` 12,000 p.a. is before taxes.
(ii) If Commission income of ` 12,000 p.a. is net of taxes.
Given:
t 1 2 3 4 5 6 7 8
PVIF (t, 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
10%)
Answer:
Analysis of Investment Decisions

Determination of Cash inflows Situation- Situation-

(i) (ii)
Commission Commissi
Income on Income
before after taxes
taxes
 Investment Decisions | 7.14
Cash flow up-to 7th year:
Sales Revenue 40,00 40,00
Less: Operating Cost (7,500
0 (7,500
0
)32,50 )32,50
Less: Depreciation (80,000 – 6,000) ÷ 8 0
(9,250 0
(9,250
Net Income )23,25 )23,25
Tax @ 30% 0
(6,975 0
(6,975
Earnings after Tax (EAT) )16,27 )16,27
Add: Depreciation 59,25 59,250
Cash inflow after tax per annum 0
25,52 25,52
Less: Loss of Commission Income 5
(8,400 5
(12,000
Net Cash inflow after tax per annum )17,12 ) 13,52
In 8th Year: 5 5
Net Cash inflow after tax 17,12 13,52
Add: Salvage Value of Machine 56,00 56,000
Net Cash inflow in year 8 0
23,12 19,52
5 5
Calculation of Net Present Value (NPV) and Profitability Index (PI)
Particulars PV factor Situation-(i) Situation-(ii)
@10% [Commission [Commission
Income before Income after
taxes] taxes]
A Present value of cash inflows (1st 4.867 83,347.38 65,826.18
to 7th year) (17,125 × 4.867) (13,525 × 4.867)
.

B Present value of cash inflow 0.467 10,799.38 9,118.18

at 8 th (23,125 × (19,525 ×
C year
PV of cash inflows 0.467)
94,146.76 0.467)
74,944.36
D Less: Cash Outflow 1.00 (80,000) (80,000)
E Net Present Value (NPV) 14,146.76 (5,055.64)
F PI = (C÷D) 1.18 0.94
Recommendation: The hospital may consider purchasing of diagnostic machine in situation

(i) where commission income is 12,000 before tax as NPV is positive and PI is also greater than
1. Contrary to situation (i), in situation (ii) where the commission income is net of tax, the
recommendation is reversed to not purchase the machine as NPV is negative and PI is also less
than 1.

Question: 10
SUGGESTED /Nov. 2018 /Q. 3 / 10 Marks
PD Ltd. an existing company, is planning to introduce a new product with projected life of 8
years. Project cost will be ` 2,40,00,000. At the end of 8 years no residual value will be realized.
Working capital of ` 30,00,000 will be needed. The 100% capacity of the project is 2,00,000
units p.a. but the Production and Sales Volume is expected are as under :
Year Number of Units
1 60,000 units
2. 80,000 units
3-5 1,40,000 units
 Investment Decisions | 7.15
6-8 1,20,000 units
Other Information:
(i) Selling price per unit ` 200
(ii) Variable cost is 40 of sales.
(iii) Fixed cost p.a. ` 30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:
Year 1 2 3-5 6-8
Expenditure (`) 50,00,000 25,00,000 10,00,000 5,00,000
(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purpose.
(vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.
Present Value Table
Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Advice about the project acceptability.

Answer:
Computation of initial cash outlay(COF)

(` in lakhs)
Project Cost 240
Working Capital 30
270
Calculation of Cash Inflows(CIF):

Years 1 2 3-5 6-8

Sales in units 60,000 80,000 1,40,000 1,20,000
` ` ` `
Contribution (` 200 x 60% x No. of
72,00,000 96,00,000 1,68,00,000 1,44,00,000
Unit)
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8)
30,00,000 30,00,000 30,00,000 30,00,000
= 30,00,000
Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)
Computation of PV of CIF
CIF PV Factor
Year `
` @ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
 Investment Decisions | 7.16
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000
Working Capital 30,00,000 0.467 55,68,975
3,88,82,700
PV of COF 2,70,00,000
NPV 1,18,82,700
Recommendation: Accept the project in view of positive NPV.

Question: 11
SUGGESTED /May- 2023 /Q. 5/
Four years ago, Z Ltd. had purchased a machine of ` 4,80,000 having estimated useful life of 8
years with zero salvage value. Depreciation is charged using SLM method over the useful life.
The company want to replace this machine with a new machine. Details of new machine are as
below:
• Cost of new machine is ` 12,00,000, Vendor of this machine is agreed to take old machine
at a value of ` 2,40,000. Cost of dismantling and removal of old machine will be ` 40,000.
80% of net purchase price will be paid on spot and remaining will be paid at the end of
one year.
• Depreciation will be charged @ 20% p.a. under WDV method.
• Estimated useful life of new machine is four years and it has salvage value of ` 1,00,000 at
the end of year four.
• Incremental annual sales revenue is ` 12,25,000.
• Contribution margin is 50%.
• Incremental indirect cost (excluding depreciation) is ` 1,18,750 per year.
• Additional working capital of ` 2,50,000 is required at the beginning of year and `
3,00,000 at the beginning of year three. Working capital at the end of year four will be nil.
• Tax rate is 30%.
• Ignore tax on capital gain.
Z Ltd. will not make any additional investment, if it yields less than 12% Advice, whether
existing machine should be replaced or not.
Year 1 2 3 4 5
PVIF0.12, t 0.893 0.797 0.712 0.636 0.567
Answer:
Working Notes:

(i) Calculation of Net Initial Cash Outflow

Particulars `
Cost of New Machine 12,00,000
Less: Sale proceeds of existing machine 2,00,000
Net Purchase Price 10,00,000
Paid in year 0 8,00,000
Paid in year 1 2,00,000
(ii) Calculation of Additional Depreciation

1 2 3 4
Year
` ` ` `
 Investment Decisions | 7.17

Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000

Depreciation on new machine 2,00,000 1,60,000 1,28,000 1,02,400
@ 20%
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old 60,000 60,000 60,000 60,000
machine
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400
(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values

(`)
Sales 12,25,000
Contribution 6,12,500
Less: Indirect Cost 1,18,750
Profit before Depreciation and Tax (PBDT) 4,93,750
Calculation of Incremental NPV

Year PVF @ PBTD Incremental PBT Tax @ Cash Inflows (`) PV of Cash
12% Depreciation (`) 30% Inflows
(`) (`) (`) (`)
(1) (2) (3) (4) (5) = (4) x (6) = (4) – (5) (7) = (6) x (1)
0.30 + (3)
1 0.893 4,93,750 1,40,000 3,53,750 106,125 3,87,625 3,46,149.125
2 0.797 4,93,750 1,00,000 3,93,750 1,18,125 3,75,625 2,99,373.125
3 0.712 4,93,750 68,000 4,25,750 1,27,725 3,66,025 2,60,609.800
4 0.636 4,93,750 42,400 4,51,350 1,35,405 3,58,345 2,27,907.420
* * 11,34,039.470
Add: PV of Salvage (` 1,00,000 x 0.636) 63,600
Less: Initial Cash Outflow - Year 0 8,00,000
Year 1 (` 2,00,000 × 0.893) 1,78,600

Less: Working Capital - Year 0 2,50,000

Year 2 (` 3,00,000 × 0.797) 2,39,100
Add: Working Capital released - Year 4 (` 5,50,000 × 0.636) 3,49,800
Incremental Net Present Value 79,739.470
Since the incremental NPV is positive, existing machine should be replaced.
Alternative Presentation
Computation of Outflow for new Machine:
`
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
 Investment Decisions | 7.18
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000
Computation of additional deprecation

Year 1 2 3 4
` ` ` `
Opening WDV of machine 10,00,000 8,00,000 6,40,000 5,12,000
Depreciation on new machine @ 20% 2,00,000 1,60,000 1,28,000 1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depreciation on old machine 60,000 60,000 60,000 60,000
(4,80,000/8)
Incremental depreciation 1,40,000 1,00,000 68,000 42,400
Computation of NPV

0 1 2 3 4
Year
` ` ` ` `
1. Increase in sales revenue 12,25,000 12,25,000 12,25,000 12,25,000
2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500
3. Increase in fixed cost 1,18,750 1,18,750 1,18,750 1,18,750
4. Incremental Depreciation 1,40,000 1,00,000 68,000 42,400
5. Net profit before tax [1- 3,53,750 3,93,750 4,25,750 4,51,350
(2+3+4)]
6. Net Profit after tax (5 x 2,47,625 2,75,625 2,98,025 3,15,945
70%)
7. Add: Incremental 1,40,000 1,00,000 68,000 42,400
depreciation
8. Net Annual cash inflows (6 3,87,625 3,75,625 3,66,025 3,58,345
+ 7)
9. Release of salvage value 1,00,000
10. (investment)/disinvestment (2,50,000) (3,00,000) 5,50,000
in working capital
11. Initial cost (8,00,000) (2,00,000)
12. Total net cash flows (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345
13. Discounting Factor 1 0.893 0.797 0.712 0.636
14. Discounted cash flows (12 (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420
x 13)

NPV = (1,67,549 + 60,273 + 2,60,610 + 6,41,307) - 10,50,000 = ` 79,739

Since the NPV is positive, existing machine should be replaced.

Question: 12
SUGGESTED /May- 2019 /Q. /
AT Limited is considering three projects A, B and C. The cash flows associated with the
projects are given below:
Cash flows associated with the Three Projects (`)
Project C0 C1 C2 C3 C4
 Investment Decisions | 7.19

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
You are required to:
(a) Calculate the payback period of each of the three projects.
(b) If the cut-off period is two years, then which projects should be accepted?
(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
(d) "Payback gives too much weight to cash flows that occur after the cut-off date". True or
false?
(e) "If a firm used a single cut-off period for all projects, it is likely to accept too many short
lived projects." True or false?
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
Answer:
(a) Payback Period of Projects
(b) If standard payback period is 2 years, Project B is the only acceptable project
(c) Calculation of NPV
Year PVF Project A Project B Project C
@ Cash PV of cash Cash PV of cash Cash PV of cash
10% Flows flows Flows flows Flows flows
(` ) (` ) (` ) (` ) (` ) (` )
0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)
1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806

So, Projects with positive NPV are Project B and Project C

(d) False. Payback gives no weightage to cash flows after the cut-off date.

(e) True. The payback rule ignores all cash flows after the cut-off date, meaning that future
years’ cash inflows are not considered. Thus, payback is biased towards short-term
projects.

QUESTION13 SUGGESTED MAY 2024

HCP Ltd. is a leading manufacturer of railway parts for passenger coaches and freight wagons.
Due to high wastage of material and quality issues in production, the General Manager of the
company is considering the replacement of machine A with a new CNC machine B. Machine A
has a book value of ` 4,80,000 and remaining economic life is 6 years. It could be sold now at `
1,80,000 and zero salvage value at the end of sixth year. The purchase price of Machine B is `
24,00,000 with economic life of 6 years. It will require ` 1,40,000 for installation and ` 60,000 for
 Investment Decisions | 7.20
testing. Subsidy of 15% on the purchase price of the machine B will be received from
Government at the end of 1st year. Salvage value at the end of sixth year will be ` 3,20,000.

The General manager estimates that the annual savings due to installation of machine B include
a reduction of three skilled workers with annual salaries of ` 1,68,000 each, ` 4,80,000 from
reduced wastage of materials and defectives and ` 3,50,000 from loss in sales due to delay in
execution of purchase orders. Operation of Machine B will require the services of a trained
technician with annual salary of t 3,90,000 and annual operation and maintenance cost will
increase by ` 1,54,000. The company's tax rate is 30% and it's required rate of return is 14%.
The company follows straight line method of depreciation. Ignore tax savings on loss due to sale
of existing machine.

The present value factors at 14% are:

Years 0 1 2 3 4 5 6
PV Factor 1 0.877 0.769 0.675 0.592 0.519 0.456
Required:

(i) Calculate the Net Present Value and Profitability Index and advise the company for
replacement decision.

(ii) Also calculate the discounted pay-back period.

ANSWER

Calculation of Net Initial Cash Outflows:

Particulars `
Cost of new machine 24,00,000
Less: Sale proceeds of existing machine (1,80,000)
Add: Installation 1,40,000
Add: Testing 60,000
Less: Subsidy from government (15% of 24,00,000) x0.877 (3,15,720)

Net initial cash outflows 21,04,280

Calculation of Incremental Depreciation

Particulars `
Depreciation on existing machine (4,80,000/6) (i) 80,000
Depreciation base of New Machine
Cost of new machine 24,00,000
Add: Installation 1,40,000
Add: Testing 60,000
Less: Subsidy from government (3,60,000)
Less: Salvage value at the end of 6th year (3,20,000)
 Investment Decisions | 7.21

Depreciation base of New Machine 19,20,000

Depreciation on New Machine (19,20,000/6) (ii) 3,20,000
Incremental depreciation [(ii) – (i)] 2,40,000

Computation of Annual Operating Cash flow after tax (CFAT)

Particulars Amount Amount
(`) (`)
Savings in cost
Cost of 3 skilled workers (`1,68,000 x 3) 5,04,000
Reduced wastage of material 4,80,000
Saving in loss of sales 3,50,000
Total 13,34,000
Less: Increase in cost
Salary to trained technician 3,90,000
Increase in annual operation and maintenancecost 1,54,000

Total (5,44,000)
Incremental Saving before tax and 7,90,000
depreciation
Less: Incremental Depreciation (2,40,000)
Incremental PBT 5,50,000
Less: Tax @30% (1,65,000)
PAT 3,85,000
Add: Depreciation 2,40,000
Incremental CFAT 6,25,000

Calculation of NPV
Particulars Year Net PVF @ PV (`)
Cashflow (`) 14%
Net initial cash 0 (24,20,000) 1 (21,04,280)
outflows
Incremental CFAT 1 to 6 6,25,000 3.888 24,30,000
Salvage Value of New 6 3,20,000 0.456 1,45,920
Machine
PV of inflows 25,75,920
Net Present Value 4,71,640

Profitability Index =

= 25,75,920/21,04,280= 1.224
Advise: Since the NPV is positive and PI is greater than 1, the company should replace the
machine
 Investment Decisions | 7.22
Computation of Discounted Payback Period
Year Cashflow PVF @ 14% PV of CFs (`) Cumulative PV (`)
1 6,25,000 0.877 5,48,125 5,48,125
2 6,25,000 0.769 4,80,625 10,28,750
3 6,25,000 0.675 4,21,875 14,50,625
4 6,25,000 0.592 3,70,000 18,20,625
5 6,25,000 0.519 3,24,375 21,45,000
6 9,45,000 0.456 4,30,920 25,75,920
Discounted Payback Period

= 4.87 years
If we take subsidy in cash inflow of 1st year, then solution can also be done in the following way:
Calculation of Net Initial Cash Outflows:
Particulars `
Cost of new machine 24,00,000
Less: Sale proceeds of existing machine (1,80,000)
Add: Installation 1,40,000
Add: Testing 60,000
Net initial cash outflows 24,20,000
Note: However, Incremental Depreciation and CFAT will remain same.
Calculation of NPV

Particulars Year Net PVF @ PV (`)

Cashflow 14%
(`)
Net initial cash outflows 0 (24,20,000) 1 (24,20,000)
Subsidy 1 3,60,000 0.877 3,15,720
Incremental CFAT 1 to 6 6,25,000 3.888 24,30,000
Salvage Value of New 6 3,20,000 0.456 1,45,920
Machine
PV of inflows 28,91,640
Net Present Value 4,71,640

Profitability Index
= 28,91,640 /24,20,000 = 1.195
Advise: Since the NPV is positive and PI is greater than 1, the company should replace
the machine
Computation of Discounted Payback Period
 Investment Decisions | 7.23

Year Cashflow PVF @ 14% PV of CFs (`) Cumulative PV (`)

1 9,85,000 0.877 8,63,845 8,63,845
2 6,25,000 0.769 4,80,625 13,44,470
3 6,25,000 0.675 4,21,875 17,66,345
4 6,25,000 0.592 3,70,000 21,36,345
5 6,25,000 0.519 3,24,375 24,60,720
6 9,45,000 0.456 4,30,920 28,91,640

Discounted Payback Period

= 4.87 years
 Dividend Decision | 8.1
CHAPTER – 8 Dividend Decision
Chapter – 8
Dividend Decision
Question & Answer
Question: 1
SUGGESTED /May- 2023 /Q. 1(a)/ 5 Marks
Following information are given for a company:
Earnings per share ` 10
P/E ratio 12.5
Rate of return on investment 12%
Market price per share as per Walter’s Model ` 130
You are required to calculate:
(i) Dividend pay-out ratio.
(ii) Market price of share at optimum dividend pay-out ratio.
(iii) P/E ratio, at which the dividend policy will have no effect on the price of share.
(iv) Market price of share at this P/E ratio.
(v) Market price of share using Dividend growth model.
Answer:
(i) The EPS of the firm is ` 10, r =12%. The P/E Ratio is given at 12.5 and the cost of capital
(Ke) may be taken as the inverse of P/E ratio. Therefore, Ke is 8% (i.e., 1/12.5). The value
of the share is ` 130 which may be equated with Walter Model as follows:
( ) ( )

or [D+1.5(10-D)]/0.08=130
or D+15-1.5D=10.4
or -0.5D=-4.6 So, D = ` 9.2
The firm has a dividend pay-out of 92% (i.e., 9.2/10).
(ii) Since the rate of return of the firm (r) is 12% and it is more than the Ke of 8%, therefore,
by distributing 92% of earnings, the firm is not following an optimal dividend policy. The
optimal dividend policy for the firm would be to pay zero dividend and in such a situation,
the market price would be:
( )
P = `187.5
So, theoretically to the market price of the share can be increased by adoption a zero pay-
out.
(iii) The P/E ratio at which the dividend policy will have no effect on the value of the share is
such at which the Ke would be equal to the rate of return (r) or the firm. The Ke would be
12% (=r) at the P/E ratio of 1/12% = 8.33. Therefore, at the P/E ratio of 8.33, the dividend
policy would have no effect on the value of the share.
(iv) If the P/E is 8.33 instead of 12.5, then the Ke which is the inverse of P/E ratio, would be
12% and in such a situation ke= r and the market price, as per Walter’s model would be:

( ) ( )
= `8.33

(v) Dividend Growth Model applying growth on dividend

Ke = 8%, r = 12%, D0 = 9.2, b = 0.08
g = b.r
g = 0.08 x 0.12=0.96%
D1 = D0 (1+g) = 9.2 (1+0.0096) = ` 9.2883
 Dividend Decision | 8.2

P=( )
= 9.2883 / (0.08 – 0.0096) = 9.2883/0.0704 = `131.936
Alternatively, without applying growth on dividend
( ) (
P= `130.68
( )

Question: 2
SUGGESTED /January- 2021 /Q. 1(b) /5 Marks
The following information is taken from ABC Ltd.
Net Profit for the year ` 30,00,000
12% Preference share capital `
1,00,00,000
Equity share capital (Share of ` 10 each) ` 60,00,000
Internal rate of return on investment 22%
Cost of Equity Capital 18%
Retention Ratio 75%
Calculate the market price of the share using:
(1) Gordon's Model
(2) Walter's Model
Answer:
Market price per share by –
(1) Gordon’s Model:
( )
Present market price per share ( )
OR
Present market price per share ( )
Where,
P0 = Present market price per share.
g = Growth rate (br) = 0.75 × 0.22 = 0.165
b = Retention ratio (i.e., % of earnings retained)
r = internal rate of return (IRR)
D0 = E × (1 – b) = 3 × ( 1 – 0.75) = 0.75
E = Earnings per share
( )
` 58.27 approx.
*Alternatively,
( )
P0 can be calculated as `50.
(2) Walter’s Model:
( )

( )
= `19.44
Workings:
1. Calculation of Earnings per share
Particulars Amount (`)
Net Profit for the year 30,00,000
Less: Preference dividend (12% of ` 1,00,00,000) (12,00,000)
Earnings for equity shareholders 18,00,000
No. of equity shares (` 60,00,000/`10) 6,00,000
Therefore, Earnings per share `
18,00,000/6,00,000
= ` 3.00
 Dividend Decision | 8.3

( )
2. Calculation of Dividend per share

Particulars
Earnings per share `3
Retention Ratio (b) 75%
Dividend pay-out ratio (1-b) 25%
Dividend per share ` 3 x 0.25 = `
(Earnings per share x Dividend pay-out ratio) 0.75
 Management of Receivables | 9.1.1
CHAPTER – 9 (Unit- I) Management of Receivables
Chapter – 9 (Unit – I)
Management of Receivables
Question & Answer
Question 1
RTP /May-2020/ Q. 9 /
Day Ltd., a newly formed company has applied to the Private Bank for the first time for
financing it's Working Capital Requirements. The following information is available about the
projections for the current year:
Estimated Level of Activity Completed Units of Production 31,200 plus unit of work
in progress 12,000
Raw Material Cost ` 40 per unit
Direct Wages Cost ` 15 per unit
Overhead ` 40 per unit (inclusive of Depreciation `10 per unit)
Selling Price ` 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24,000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance `2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and
overheads accrue similarly. All sales are on the credit basis. You are required to CALCULATE the
Net Working Capital Requirement on Cash Cost Basis.
Answer:
Calculation of Net Working Capital requirement:
(`) (`)
A. Current Assets:
Inventories:
Stock of Raw material (Refer to Working note (iii) 1,44,000
Stock of Work in progress (Refer to Working note (ii) 7,50,000
Stock of Finished goods (Refer to Working note (iv) 20,40,000
Debtors for Sales(Refer to Working note (v) 1,02,000
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases (Refer to Working note (vi) 1,56,000
Creditors for wages (Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
 Management of Receivables | 9.1.2
Working Notes:
(i) Annual cost of production
(`)
Raw material requirements
{(31,200 × ` 40) + (12,000 x ` 40)} 17,28,000
Direct wages {(31,200 ×` 15) +(12,000 X ` 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × ` 30) + (12,000 x ` 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (` 40 + ` 7.5 + `15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
(`26,52,000 × 24,000/31,200) (20,40,000)
Total Cash Cost of Sales* 6,12,000

[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000 units) x (` 40
+ ` 15 + ` 30) = ` 6,12,000]
(ii) Work in progress stock
(`)
Raw material requirements (12,000 units × `40) 4,80,000
Direct wages (50% × 12,000 units × ` 15) 90,000
Overheads (50% × 12,000 units × ` 30) 1,80,000
7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption. Since, the company
is newly formed; the raw material requirement for production and work in progress will
be issued and consumed during the year. Hence, the raw material consumption for the
year (360 days) is as follows:

(`)
For Finished goods (31,200 × ` 40) 12,48,000
For Work in progress (12,000 × ` 40) 4,80,000
17,28,000

Raw material stock = `1,44,000

(iv) Finished goods stock:

24,000 units @ `(40 + 15+30) per unit = `20,40,000
(v) Debtors for sale: `6,12,000 × = `1,02,000

(vi) Creditors for raw material Purchases [Working Note (iii)]:

Annual Material Consumed (`12,48,000 + `4,80,000) `17,28,000
Add: Closing stock of raw material [(`17,28,000 x 30 days) / 360 ` 1,44,000
days]
`18,72,000
 Management of Receivables | 9.1.3

Credit allowed by suppliers = 30 days = `1,56,000

(vii) Creditors for wages:

Outstanding wage payment = [(31,200 unit × `15) + (12,000 units × `15 × .50)] × 15 days
/ 360 days

= = `23,250

Question: 2
RTP /May-2021/Q. 8 /
MT Ltd. has been operating its manufacturing facilities till 31.3.2021 on a single shift working
with the following cost structure:
Per unit (`)
Cost of Materials 24
Wages (out of which 60% variable) 20
Overheads (out of which 20% variable) 20
64
Profit 8
Selling Price 72
As at 31.3.2021 with the sales of ` 17,28,000, the company held:
(`)
Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime cost) 88,000
Finished goods (valued at total cost) 2,88,000
Sundry debtors 4,32,000

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

shift. It is expected that a 10% discount will be available from suppliers of raw materials in view
of increased volume of business. Selling price will remain the same. The credit period allowed to
customers will remain unaltered. Credit availed from suppliers will continue to remain at the
present level i.e. 2 months. Lag in payment of wages and overheads will continue to remain at
one month.
You are required to CALCULATE the additional working capital requirements, if the policy to
increase output is implemented, to assess the impact of double shift for long term as a matter of
production policy.
Answer:
(1) Statement of cost at single shift and double shift working
24,000 units 48,000 Units
Per unit Total Per unit Total
(`) (`) (`) (`)
Raw materials 24 5,76,000 21.6 10,36,000
Wages:
Variable 12 2,88,000 12 5,76,000
Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,000 49.6 23,80,800
 Management of Receivables | 9.1.4
Profit 8 1,92,000 22.4 10,75,200
Sales 72 17,28,000 72 34,56,000

(2) Sales in units 2020 – 21 =

(3) Stock of Raw Materials in units on 31.3.2021

= = 6,000 units

(4) Stock of work-in-progress in units on 31.3.2021

= 2,000 units

(5) Stock of finished goods in units 2020 – 21

= 4,500 units.

Comparative Statement of Working Capital Requirement

Single Shift (24,000 units) Double Shift (48,000 units)
Units Rate Amount Units Rate Amount
(`) (`) (`) (`)
Current Assets
Inventories:
Raw Materials 6,000 24 1,44,000 12,000 21.6 2,59,200
Work-in-Progress 2,000 44 88,000 2,000 37.6 75,200
Finished Goods 4,500 64 2,88,000 9,000 49.6 4,46,400
Sundry Debtors 6,000 64 3,84,000 12,000 49.6 5,95,200
Total Current Assets (A) 9,04,000 13,76,000
Current Liabilities
Creditors for Materials 4,000 24 96,000 8,000 21.6 1,72,800
Creditors for Wages 2,000 20 40,000 4,000 16 64,000
Creditors for Overheads 2,000 20 40,000 4,000 12 48,000
Total Current Liabilities (B) 1,76,000 2,84,800
Working Capital (A) – (B) 7,28,000 10,91,200
Analysis: Additional Working Capital requirement = ` 10,91,200 – ` 7,28,000 = `3,63,200, if the
policy to increase output is implemented.
Question: 3
RTP /May-2021/Q. 9 /
While applying for financing of working capital requirements to a commercial bank, TN
Industries Ltd. projected the following information for the next year:
Cost Element Per unit Per unit
(`) (`)
Raw materials
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration overheads 20
(excludingdepreciation)
 Management of Receivables | 9.1.5
Depreciation 10
Selling overheads 15
113
Additional Information:
(a) Raw Materials are purchased from different suppliers leading to different credit period
allowed as follows:
X – 2 months; Y– 1 months; Z – ½ month
(b) Production cycle is of ½ month. Production process requires full unit of X and Y in the
beginning of the production. Z is required only to the extent of half unit in the beginning
and the remaining half unit is needed at a uniform rate during the production process.
(c) X is required to be stored for 2 months and other materials for 1 month.
(d) Finished goods are held for 1 month.
(e) 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed
by debtors is 2 months.
(f) Average time lag in payment of all overheads is 1 months and ½ months for direct labour.
(g) Minimum cash balance of ` 8,00,000 is to be maintained.
CALCULATE the estimated working capital required by the company on cash cost basis if the
budgeted level of activity is 1,50,000 units for the next year. The company also intends to
increase the estimated working capital requirement by 10% to meet the contingencies. (You
may assume that production is carried on evenly throughout the year and direct labour and
other overheads accrue similarly.)
Answer:
Statement showing Working Capital Requirements of TN Industries Ltd.
(on cash cost basis)
Amount in Amount in
(`) (`)
A. Current Assets
(i) Inventories:
Raw material
X( ) 7,50,000

Y( ) 87,500

Z( ) 75,000

WIP ( ) 4,00,000

Finished goods ( ) 11,00,000 24,12,500

(ii) Receivables (Debtors)

X( ) 19,31,250

(iii) Cash and bank balance 8,00,000

 Management of Receivables | 9.1.6
Total Current Assets 51,43,750
B. Current Liabilities:
(i) Payables (Creditors) for Raw materials
X( ) 7,50,000

Y( ) 87,500

Z( ) 37,500 8,75,000

(ii) Outstanding Direct Labour 1,56,250

(iii) Outstanding Manufacturing and administrationoverheads

2,50,000
(iv) Outstanding Selling overheads
1,87,500
Total Current Liabilities 14,68,750
Net Working Capital Needs (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working capital requirement 40,42,500
Workings:
1.
(i) Computation of Cash Cost of Production Per unit (`)
Raw Material consumed 43
Direct Labour 25
Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Computation of Cash Cost of Sales Per unit (`)
Cash cost of production as in (i) above 88
Selling overheads 15
Cash cost of sales 103
2. Calculation of cost of WIP
Particulars Per unit (`)
Raw material (added at the beginning):
X 30
Y 7
Z (` 6 x 50%) 3
Cost during the year:
Z {(` 6 x 50%) x 50%} 1.5
Direct Labour (` 25 x 50%) 12.5
Manufacturing and administration overheads (` 20 x 50%) 10
64
 Management of Receivables | 9.1.7
Question: 4
MTP /October- 2022/Q. 1(a) /
PREPARE a working capital estimate to finance an activity level of 52,000 units a year (52
weeks) based on the following data:
Raw Materials - ` 400 per unit Direct Wages - ` 150 per unit
Overheads (Manufacturing) - `200 per unit Overheads (Selling & Distribution) - `100perunit
Selling Price - ` 1,000 per unit, Raw materials & Finished Goods remain in stock for 4 weeks,
Work in process takes 4 weeks. Debtors are allowed 8 weeks for payment whereas creditors
allow us 4 weeks.
Minimum cash balance expected is `50,000. Receivables are valued at Selling Price.
Answer:
Cost Structure for 52000 units
Particulars Amount (`)
Raw Material @ ` 400 2,08,00,000
Direct Wages @ ` 150 78,00,000
Manufacturing Overheads@ ` 200 1,04,00,000
Selling and Distribution OH@ ` 100 52,00,000
Total Cost 4,42,00,000
Sales@`1000 5,20,00,000

Particulars Calculation Amount (`)

A. Current Assets:

Raw Material Stock 2,08,00,000 × 16,00,000

Work in Progress 2,08,00,000 +

(WIP) Stock 23,00,000

Finished Goods 4,42,00,000 × 34,00,000

Stock

Receivables 5,20,00,000 × 80,00,000

Cash 50,000

Total Current Assets 1,53,50,000

B. Current Liabilities:

20800000 ×
Creditors 16,00,000
C. Working Capital
Estimates(A-B) 1,37,50,000
 Management of Receivables | 9.1.8
Question: 5
MTP /April- 2022/Q. 3 /10 Marks
The following annual figures relate to manufacturing entity:
A. Sales at one month credit 84,00,000
B. Material consumption 60% of sales value
C. Wages (paid in a lag of 15 days) 12,00,000
D. Cash Manufacturing Expenses 3,00,000
E. Administrative Expenses 2,40,000
F. Creditors extend 3 months credit for payment
G. Cash manufacturing and administrative expenses are
paid 1 months in arrear.
The company maintains stock of raw material equal to economic order quantity. The company
incurs ` 100 as per ordering cost per order and opportunity cost of capital is 15% p.a. The
optimum cash balance is determined using Baumol’s model. The bank charges ` 10 for each
cash withdrawal. Finished goods are held in stock for 1 month. The company maintains a bank
balance of `12,00,000 on an average. Creditors are paid through net banking and all other
expenses are incurred in cash which is withdrawn from bank.
Assuming a 20% safety margin, you are required to ESTIMATE the amount of working capital
that needs to be invested by the Company.
Answer:
Statement of working capital Requirement
Particular (`) (`)
A. Current Assets
Stock of Raw Material (W.N. 2) 81,975
Stock of finished Goods ( ) 5,45,000

Average Receivables (at Cost) ( ) 5,65,000

Bank Balance 12,00,000
Cash Balance (W.N. 3) 15,232
Gross Working Capital 24,07,207
B. Current Liabilities
Average Creditor for materials 12,60,000

Outstanding Wages ( ) 50,000

Outstanding Cash Manufacturing Expenses ( ) 25,000

Outstanding administrative Expenses ( ) 20,000

13,55,000
Net Working Capital (A-B) 10,52,207
Add: Safety Margin @ 20% 2,10,441
Total Working Capital Requirement 12,62,648
 Management of Receivables | 9.1.9
Working Notes:
1. Computation of annual cash Cost of Production & Sales

Material Consumed (84,00,000 × 60%) 50,40,000

Wages 12,00,000
Manufacturing expenses 3,00,000
Cash Cost of production 65,40,000
(+) Administrative Expenses 2,40,000
Cash Cost of Sales 67,80,000
2. Computation of stock of Raw Material
A = 50,40,000
B = 100
C = 0.15

∴ EOQ = √ √ = `81,975

3. Calculation of Cash Balance

A = 12, 00,000 + 3,00,000 + 2,40,000
A = 17,40,000
B = 10
C = 0.15

Optimal Cash Balance = √ √ = `15,232

Question: 6
MTP /APRIL. 2023/Q. 1(b) /5 Marks
Sundaram limited a plastic manufacturing company had invested enormous amount of money in
a new expansion project. Due to such a great amount of capital investment, Company needs an
additional ` 2,00,00,000 in working capital immediately. The CFO has determined the following
three feasible sources of working capital funds:
Bank Loan: The company's bank will lend `2,30,00,000 at 12% per annum. However, the bank
will require 15% of the loan granted to be kept in a current account as the minimum average
balance which otherwise would have been just ` 50,000.
Trade Credit: A major supplier with 2/20 net 80 credit terms has approached for supply of raw
material worth `1,90,00,000 p.m.
Factoring: factoring firm will buy the companies receivables of ` 2,50,00,000 per month, which
have a collection period of 60 days. factor will advance up to 75% of the face value of the
receivables at 14 percent per annum. Factor Commission will amount to 2% on all receivables
purchased. Factoring will save credit department expense and bad debts of ` 1,75,000 p.m. and
` 2,25,000 p.m.
Based on annual percentage cost, ADVISE which alternative should the company select. Assume
360 days a year
Answer:
(i) Bank Loan: As the minimum average balance more than ` 50,000 need not be kept if loan
is not undertaken, the incremental money made available by bank through bank loan is `
2,30,00,000- (15% x ` 2,30,00,000-` 50,000) = ` 1,96,00,000. Real annual cost of bank
loan = (` 2.3 crores x 12%) / ` 1.96 crores = 14.08%.
 Management of Receivables | 9.1.10
(ii) Trade Credit: The real annual cost of trade credit will be 2/98 x 360/60 x 100 = 12.24%.
(iii) Factoring:
Commission charges per year = 2% x 2.5 crores x 12 = ` 60,00,000
Savings per year = (1,75,000+2,25,000) x 12 = ` 48,00,000
Net Factoring cost per year = ` 60,00,000 – ` 48,00,000 = `12,00,000
Annual cost of borrowing ` 2.5 crores x 75% i.e. ` 1,87,50,000 will be
Conclusion: The company should select trade credit as a preferred mode of financing the
working capital requirement as it results in lowest cost on an annual basis.

Question: 7
SUGGESTED /Nov. 2020 /Q. 2/10 Marks/
PK Ltd., a manufacturing company, provides the following information:

( `)
Sales 1,08,00,000
Raw Material Consumed 27,00,000
Labour Paid 21,60,000
Manufacturing Overhead (Including Depreciation for the year ` 32,40,000
3,60,000)
Administrative & Selling Overhead 10,80,000
Additional Information:
(a) Receivables are allowed 3 months' credit.
(b) Raw Material Supplier extends 3 months' credit.
(c) Lag in payment of Labour is 1 month.
(d) Manufacturing Overhead are paid one month in arrear.
(e) Administrative & Selling Overhead is paid 1 month advance.
(f) Inventory holding period of Raw Material & Finished Goods are of 3 months.
(g) Work-in-Progress is Nil.
(h) PK Ltd. sells goods at Cost plus 33⅓%.
(i) Cash Balance ` 3,00,000.
(j) Safety Margin 10%.
You are required to compute the Working Capital Requirements of PK Ltd. on Cash Cost basis.
Answer:
Statement showing the requirements of Working Capital (Cash Cost basis)
Particulars (`) (`)
A. Current Assets:
Inventory:
Stock of Raw material (` 27,00,000 × 3/12) 6,75,000
Stock of Finished goods (` 77,40,000 × 3/12) 19,35,00
Receivables (` 88,20,000 × 3/12) 0
22,05,00
Administrative and Selling Overhead (` 10,80,000 × 0 90,000
1/12)
Cash in Hand 3,00,000
 Management of Receivables | 9.1.11

Gross Working Capital 52,05,00 52,05,00

B. Current Liabilities: 0 0
Payables for Raw materials* (` 27,00,000 × 3/12) 6,75,000
Outstanding Expenses:
Wages Expenses (` 21,60,000 × 1/12) 1,80,000
Manufacturing Overhead (` 28,80,000 × 1/12) 2,40,000
Total Current Liabilities 10,95,00 10,95,00
Net Working Capital (A-B) 0 0
41,10,00
Add: Safety margin @ 10% 04,11,00
Total Working Capital requirements 0
45,21,00
0
Working Notes:
(i)
(A) Computation of Annual Cash Cost of Production (`)
Raw Material consumed 27,00,000
Wages (Labour paid) 21,60,000
Manufacturing overhead (` 32,40,000 - ` 3,60,000) 28,80,000
Total cash cost of production 77,40,000
(B) Computation of Annual Cash Cost of Sales (`)
Cash cost of production as in (A) above 77,40,000
Administrative & Selling overhead 10,80,000
Total cash cost of sales 88,20,000
*Purchase of Raw material can also be calculated by adjusting Closing Stock and Opening Stock
(assumed nil). In that case Purchase will be Raw material consumed +Closing Stock-Opening
Stock i.e `27,00,000 + `6,75,000 - Nil = `33,75,000. Accordingly, Total Working Capital
requirements (` 43,35,375) can be calculated.

Question: 8
SUGGESTED /May- 2019 /Q. 5 /10 Marks
Bita Limited manufactures used in the steel industry. The following information regarding
the company is given for your consideration:
(i) Expected level of production 9000 units per annum.
(ii) Raw materials are expected to remain in store for an average of two months before issue
to production.
(iii) Work-in-progress (50 percent complete as to conversion cost) will approximate to
1/2 month’s production.
(iv) Finished goods remain in warehouse on an average for one month.
(v) Credit allowed by suppliers is one month.·
(vi) Two month's credit is normally allowed to debtors.
(vii) A minimum cash balance of ` 67,500 is expected to be maintained.
(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.
(xi) The cost structure for Bita Limited's product is as follows:
`
Raw Materials 80 per unit
Direct Labour 20 per unit
Overheads (including depreciation ` 20) 80 per unit
 Management of Receivables | 9.1.12
Total Cost 180 per unit
Profit 20 per unit
Selling Price 200 per unit
You are required to estimate the working capital requirement of Bita limited.
Answer:
Statement showing Estimate of Working Capital Requirement
(Amount in `) (Amount in `)
A. Current Assets
(i) Inventories:
1,20,000
- Raw material inventory ( )

- Work in Progress:
Raw material ( )
30,000

Wages ( )
3,750

Overheads ( )
11,250 45,000

Finished goods (inventory held for 1 months)

1,20,000
( )

(ii) Debtors (for 2 months)

( )
1,92,000
or ( )

(iii) Cash balance expected 67,500

Total Current assets 5,44,500
B. Current Liabilities
(i) Creditors for Raw material (1 month)
60,000
( )

Total current liabilities 60,000

Net working capital (A – B) 4,84,500
Add: Safety margin of 20 percent 96,900
Working capital Requirement 5,81,400
Working Notes:
1. If Credit sales is x then cash sales is x-75% of x i.e. x/4.
Or x+0.25x = ` 18,00,000
Or x=` 14,40,000
So, credit Sales is ` 14,40,000
 Management of Receivables | 9.1.13

Hence, Cash cost of credit sales ( ) = `11,52,000

2. It is assumed that safety margin of 20% is on net working capital.
3. No information is given regarding lag in payment of wages, hence ignored assuming it is
paid regularly.
4. Debtors/Receivables is calculated based on total cost.
[If Debtors/Receivables is calculated based on sales, then debtors will be
( ) ( ) `2,40,000
Then Total Current assets will be ` 5,92,500 and accordingly Net working capital and Working
capital requirement will be ` 5,32,500 and ` 6,39,000 respectively].
 Management of Receivables | 9.2.1
CHAPTER – 9 (Unit- II) Management of Receivables
Chapter – 9 (Unit – II)
Management of Receivables
Question & Answer
Question 1
RTP /MAY-2018/Q. 6/
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular
basis. As per the terms of agreement the payment must be made within 40 days of purchase.
However, A Ltd. has a choice of paying ` 98.50 per ` 100 it owes to X Ltd. on or before 10th day
of purchase.

Required:

EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd.
with X Ltd. is ` 10,00,000 and an alternative investment yield a return of 15% and company
pays the invoice.
Answer:
Annual Benefit of accepting the Discount

Annual Cost = Opportunity Cost of foregoing interest on investment = 15%

If average invoice amount is `10,00,000

If discount is
Accepted(`) Not Accepted(`)
Payment to Supplier (`) 9,85000 10,00,000
Return on investment of `9,85,000 for 30 days (12,144)
{` 9,85,000 × (30/365) × 15%}
9,85,000 9,87,856
Thus, from above table it can be seen that it is cheaper to accept the discount.

Question 2
RTP /Nov.-2018/Q. 6/
Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing credit
terms to three of their large customers A, B and C. The credit period and likely quantity of TV
sets that will be sold to the customers in addition to other sales are as follows:
Quantity sold (No. of TV Sets)
Credit A B C
Period
(Days)
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
 Management of Receivables | 9.2.2
The selling price per TV set is ` 9,000. The expected contribution is 20% of the selling price. The
cost of carrying receivable averages 20% per annum.
You are required:
(a) COMPUTE the credit period to be allowed to each customer.
(Assume 360 days in a year for calculation purpose).
(b) DEMONSTRATE the other problems the company might face in allowing the credit period
as determined in (a) above?
Answer:
In case of customer A, there is no increase in sales even if the credit is given. Hence comparative
statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
` in lakhs `in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 20%(A) 18 27 36 45 - - 18 27
5. Receivables:
- 11.25 30 56.25 - - 15 33.75

6. Debtors at cost i.e.80% of - 9 24 45 - - 12 27

11.25
7. Cost of carrying debtors - 1.8 4.8 9 - - 2.4 5.4
at 20% (B)
8. Excess of contributions 18 25.2 31.2 36 - - 15.6 21.6
overcost of carrying
debtors (A – B)

The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90
days in respect of both the customers B and C. Hence, credit period of 90 days should be allowed
to B and C.
(b) Problem:
(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C is
taking 1000 TV sets at credit for 60 days. Hence A also may demand credit for 60
days compulsorily.
(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets only. In
such case B will demand further relaxation in credit period i.e. B may ask for 120
days credit.
Question: 3
MTP /October - 2019/Q. 3 /10 Marks
You are given the following information:
(i) Estimated monthly Sales are as follows:
Rs. Rs.
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
2
 Management of Receivables | 9.2.3

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:

Rs. Rs.
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

(iii) Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected
within one month and the balance in two months. There are no bad debt losses.
(iv) Purchases amount to 80% of sales and are made and paid for in the month preceding the
sales.
(v) The firm has taken a loan of Rs.1,20,000. Interest @ 10% p.a. has to be paid quarterly in
January, April and so on.
(vi) The firm is to make payment of tax of Rs. 5,000 in July, 2019.
(vii) The firm had a cash balance of Rs. 20,000 on 1St April, 2019 which is the minimum
desired level of cash balance. Any cash surplus/deficit above/below this level is made up
by temporary investments/liquidation of temporary investments or temporary
borrowings at the end of each month (interest on these to be ignored).
Required
PREPARE monthly cash budgets for six months beginning from April, 2019 on the basis of the
above information.
Answer:
Computation – Collections from Debtors
Particulars Feb Mar Apr May Jun Jul Aug Sep
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Total Sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit
Sales (80% 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
of total
Sales)
Collection
(within one month) 72,000 84,000 48,000 36,000 48,000 60,000 48,000

Collection
24,000 28,000 16,000 12,000 16,000 20,000
(within two months)
Total Collections 1,08,000 76,000 52,000 60,000 76,000 68,000

Monthly Cash Budget for Six Months: April to September, 2019

Particulars April May June July August Sept.
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
Receipts:
Opening Balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash Sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections fr om 1,08,000 76,000 52,000 60,000 76,000 68,000
Debtors
 Management of Receivables | 9.2.4
Total Receipts (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000

Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000
Wages and Salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on Loan 3,000 ----- ----- 3,000 ----- -----
Tax Payment ----- ----- ----- 5,000 ----- -----
Total Payment (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum Cash Balance 20,000 20,000 20,000 20,000 20,000 20,000
Total Cash Required (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus/ (Deficit) (A)- 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
(C)
Investment/Financing:
Total effect of
(Invest)/ Financing (D)
(64,000) (16,000) 22,000 2,000 (35,000) 9,000
Closing Cash Balance(A) 20,000 20,000 20,000 20,000 20,000 20,000
+ (D) - (B)

Question: 4
SUGGESTED /Nov. 2022 /Q. 1(a)/5 Marks/
K Ltd. has a Quarterly cash outflow of ` 9,00,000 arising uniformly during the Quarter. The
company has an Investment portfolio of Marketable Securities. It plans to meet the demands for
cash by periodically selling marketable securities. The marketable securities are generating a
return of 12% p.a. Transaction cost of converting investments to cash is ` 60. The company
uses Baumol model to find out the optimal transaction size for converting marketable
securities into cash.
Consider 360 days in a year.
You are required to calculate
(i) Company's average cash balance,
(ii) Number of conversions each year and
(iii) Time interval between two conversions.
Answer:
(i) Computation of Average Cash balance:
Annual cash outflow (U) = 9,00,000 × 4 ’36,00,000
Fixed cost per transaction (P) = `60
Opportunity cost of one rupee p.a. (S) =

Optimum cash balance (C) = √ √ `60,000

∴Average cash balance = = `30,000

(ii) Number of conversions p.a.
Annual cash outflow = `36,00,000
Optimum cash balance = `60,000
∴ No. of conversions p.a. = = 60
(iii) Time interval between two conversions

No. of days in a year = 360

No. of conversions p.a. = 60

∴ Time interval = 6 days

 Management of Receivables | 9.2.5
Question: 5
SUGGESTED /Dec. - 2021 /Q. 1(d)/ 5 Marks
A garment trader is preparing cash forecast for first three months of calendar year 2021. His
estimated sales for the forecasted periods are as below:
January (` '000) February (` '000) March (` '000)
Total sales 600 600 800
(i) The trader sells directly to public against cash payments and to other entities on credit.
Credit sales are expected to be four times the value of direct sales to public. He expects
15% customers to pay in the month in which credit sales are made, 25% to pay in the next
month and 58% to pay in the next to next month. The outstanding balance is expected to
be written off.
(ii) Purchases of goods are made in the month prior to sales and it amounts to 90% of sales
and are made on credit. Payments of these occur in the month after the purchase. No
inventories of goods are held.
(iii) Cash balance as on 1st January, 2021 is ` 50,000.
(iv) Actual sales for the last two months of calendar year 2020 are as below:
November (` '000) December (` '000)
Total sales 640 880
You are required to prepare a monthly cash, budget for the three months from January to
March, 2021.
Answer:
Working Notes:
(1) Calculation of cash and credit sales (` in thousands)
Nov. Dec. Jan. Feb. Mar.
Total Sales 640 880 600 600 800
Cash Sales (1/5th of total sales) 128 176 120 120 160
Credit Sales (4/5th of total sales) 512 704 480 480 640

(2) Calculation of Credit Sales Receipts (` in thousands)

Month Nov. Dec. Jan. Feb. Mar.
Forecast Credit sales (Working note 1) 512.00 704.00 480.00 480.00 640.00

Receipts:
15% in the month of sales 72.00 72.00 96.00
25% in next month 176.00 120.00 120.00
58% in next to next month 296.96 408.32 278.40
Total 544.96 600.32 494.40
Cash Budget (`in thousands)

Nov. Dec. Jan. Feb. Mar.

Opening Balance (A) 50.00 174.96 355.28
Sales 640.00 880.00 600.00 600.00 800.00
Receipts:
Cash Collection (Working note 1) 120.00 120.00 160.00
Credit Collections (Working note 2) 544.96 600.32 494.40
Total (B) 664.96 720.32 654.40
Purchases (90% of sales in the month prior 540 540 720
to sales)
 Management of Receivables | 9.2.6

Payments:
Payment for purchases (next month) 540 540 720
Total (C) 540 540 720
Closing balance(D) = (A + B – C) 174.96 355.28 289.68
 Management of Receivables | 9.3.1
CHAPTER – 9 (Unit- III) Management of Receivables
Chapter – 9 (Unit – III)
Management of Receivables
Question & Answer
Question 1
RTP /MAY-2018/Q. 6/
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular
basis. As per the terms of agreement the payment must be made within 40 days of purchase.
However, A Ltd. has a choice of paying ` 98.50 per ` 100 it owes to X Ltd. on or before 10th day
of purchase.

Required:

EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd.
with X Ltd. is ` 10,00,000 and an alternative investment yield a return of 15% and company
pays the invoice.
Answer:
Annual Benefit of accepting the Discount

Annual Cost = Opportunity Cost of foregoing interest on investment = 15%

If average invoice amount is `10,00,000

If discount is
Accepted(`) Not Accepted(`)
Payment to Supplier (`) 9,85000 10,00,000
Return on investment of `9,85,000 for 30 days (12,144)
{` 9,85,000 × (30/365) × 15%}
9,85,000 9,87,856
Thus, from above table it can be seen that it is cheaper to accept the discount.

Question 2
RTP /Nov.-2018/Q. 6/
Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing credit
terms to three of their large customers A, B and C. The credit period and likely quantity of TV
sets that will be sold to the customers in addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
 Management of Receivables | 9.3.2
The selling price per TV set is ` 9,000. The expected contribution is 20% of the selling price. The
cost of carrying receivable averages 20% per annum.

You are required:

(a) COMPUTE the credit period to be allowed to each customer.

(Assume 360 days in a year for calculation purposes).

(b) DEMONSTRATE the other problems the company might face in allowing the credit
period as determined in (a) above?

Answer:

In case of customer A, there is no increase in sales even if the credit is given. Hence comparative
statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
` in lakhs `in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 20%(A) 18 27 36 45 - - 18 27

5. Receivables:
Credit Period × Sales360 - 11.25 30 56.25 - - 15 33.75

6. Debtors at cost i.e.80% - 9 24 45 - - 12 27

of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20% (B)
8. Excess of contributions 18 25.2 31.2 36 - - 15.6 21.6
overcost of carrying
debtors (A – B)

The excess of contribution over cost of carrying Debtors is highest in case of credit period of 90
days in respect of both the customers B and C. Hence, credit period of 90 days should be allowed
to B and C.

(b) Problem:

(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C is taking
1000 TV sets at credit for 60 days. Hence A also may demand credit for 60 days
compulsorily.

(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets only. In such
case B will demand further relaxation in credit period i.e. B may ask for 120 days credit.
 Management of Receivables | 9.4.1
CHAPTER – 9 (Unit- IV) Management of Receivables
Chapter – 9 (Unit – IV)
Management of Receivables
Question & Answer
Question 1
RTP /MAY-2018/Q. 6/
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular
basis. As per the terms of agreement the payment must be made within 40 days of purchase.
However, A Ltd. has a choice of paying ` 98.50 per ` 100 it owes to X Ltd. on or before 10th day
of purchase.

Required:

EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd.
with X Ltd. is ` 10,00,000 and an alternative investment yield a return of 15% and company
pays the invoice.
Answer:
Annual Benefit of accepting the Discount

Annual Cost = Opportunity Cost of foregoing interest on investment = 15%

If average invoice amount is `10,00,000

If discount is
Accepted(`) Not Accepted(`)
Payment to Supplier (`) 9,85000 10,00,000
Return on investment of `9,85,000 for 30 days (12,144)
{` 9,85,000 × (30/365) × 15%}
9,85,000 9,87,856
Thus, from above table it can be seen that it is cheaper to accept the discount.

Question 2
RTP /Nov.-2018/Q. 6/
Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing credit
terms to three of their large customers A, B and C. The credit period and likely quantity of TV
sets that will be sold to the customers in addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
 Management of Receivables | 9.4.2
The selling price per TV set is ` 9,000. The expected contribution is 20% of the selling price. The
cost of carrying receivable averages 20% per annum.

You are required:

(a) COMPUTE the credit period to be allowed to each customer.

(Assume 360 days in a year for calculation purposes).
(b) DEMONSTRATE the other problems the company might fact in allowing the credit period
as determined in (a) above?

Answer:

(a) In case of customer A, there is no increase in sales even if the credit is given. Hence
comparative statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period (days) 0 30 60 90 0 30 60 90
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
` in lakhs `in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 20%(A) 18 27 36 45 - - 18 27

5. Receivables:
Credit Period × Sales360 - 11.25 30 56.25 - - 15 33.75

6. Debtors at cost i.e.80% - 9 24 45 - - 12 27

of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20% (B)
8. Excess of contributions 18 25.2 31.2 36 - - 15.6 21.6
overcost of carrying
debtors (A – B)

The excess of contribution over cost of carrying Debtors is highest in case of credit period
of 90 days in respect of both the customers B and C. Hence, credit period of 90 days
should be allowed to B and C.
(b) Problem:
(i) Customer A is taking 1000 TV sets whether credit is given or not. Customer C is
taking 1000 TV sets at credit for 60 days. Hence A also may demand credit for 60
days compulsorily.
(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift 1500 sets only. In
such case B will demand further relaxation in credit period i.e. B may ask for 120
days credit.
 Management of Receivables | 9.4.3
Question: 3
MTP /April - 2019/Q. 3(a)/6 Marks
Navya Ltd has annual credit sales of Rs. 45 lakhs. Credit terms are 30 days, but its management
of receivables has been poor and the average collection period is 50 days, Bad debt is 0.4 per
cent of sales. A factor has offered to take over the task of debt administration and credit
checking, at an annual fee of 1 per cent of credit sales. Navya Ltd. estimates that it would save
Rs. 35,000 per year in administration costs as a result. Due to the efficiency of the factor, the
average collection period would reduce to 30 days and bad debts would be zero. The factor
would advance 80 per cent of invoiced debts at an annual interest rate of 11 per cent. Navya Ltd.
is currently financing receivables from an overdraft costing 10 per cent per year.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services
should be accepted or rejected. Assume 365 days in a year.
Answer:
Rs.

Present level of receivables is 45 lakh× 50/365 6,16,438

In case of factor, receivables would reduce to 45 lakhs× 30/365 3,69,863

The costs of the existing policy are as follows:

Cost of financing existing receivables: 6,16,438×10% 61,644
Cost of bad debts: 45 lakhs × 0.4% 18,000
Cost of current policy 79,644
The cost under the factor are as follows:
Cost of financing new receivable through factor:
(Rs. 3,69,863 × 0.8 × 0.11) + (Rs. 3,69,863 × 0.2 × 0.10) 39,945
= (32,548 + 7,397)
Factor’s annual fee: 45 Lakhs × 0.01 45,000
Administration costs saved: (35,000)
Net cost under factor: 49,945
From the above analysis it is clear that the factor’s services are cheaper than Existing policy by
Rs. 29,699 (Rs. 79,644 - Rs.49,945) per year. Hence, the services of the factor should be
accepted.

Question: 4
SUGGESTED /Dec. - 2021 /Q. 1(a)/5 Marks
A factoring firm has offered a company to buy its accounts receivables. The relevant information
is given below:
(i) The current average collection period for the company's debt is 80 days and ½% of
debtors default. The factor has agreed to pay over money due to the company after 60
days and it will suffer all the losses of bad debts also.
(ii) Factor will charge commission @2%.
(iii) The company spends ` 1,00,000 p.a. on administration of debtor. These are avoidable
cost.
(iv) Annual credit sales are ` 90 lakhs. Total variable costs is 80% of sales. The company's cost
of borrowing is 15% per annum. Assume 365 days in a year.
Should the company enter into agreement with factoring firm?
Answer:
Particulars (`)
A. Annual Savings (Benefit) on taking Factoring Service
 Management of Receivables | 9.4.4
Cost of credit administration saved 1,00,000
Bad debts avoided (` 90 lakh x ½%) 45,000
Interest saved due to reduction in average collection period [` 90 lakh x 59,178
0.80 × 0.15 × (80 days – 60 days)/365 days]
Total 2,04,178
B. Annual Cost of Factoring to the Firm:
Factoring Commission [` 90 lakh × 2%] 1,80,000
Total 1,80,000
C. Net Annual Benefit of Factoring to the Firm (A – B) 24,178
Advice: Since savings to the firm exceeds the cost to the firm on account of factoring, therefore,
the company should enter into agreement with the factoring firm.

Question 5 SUGGESTED MAY 2024

Following is the sales information in respect of Bright Ltd:

Annual Sales (90 % on credit) ` 7,50,00,000

Credit period 45 days

Average Collection period 70 days

Bad debts 0.75%

Credit administration cost (out of which 2/5th is avoidable) ` 18,60,000

A factor firm has offered to manage the company's debtors on a non- recourse basis at a service
charge of 2%. Factor agrees to grant advance against debtors at in interest rate of 14% after
withholding 20% as reserve. Payment period guaranteed by factor is 45 days. The cost of capital
of the company is 12.5%. One time redundancy payment of ` 50,000 is required to be made to
factor.

Calculate the effective cost of factoring to the company. (Assume 360 days in a year)

Answer

Evaluation of Factoring Proposal

Particulars ` `

A. Savings due to factoring

Bad Debts saved 0.75% x 7.5 crores ` 5,06,250

x 90%

Administration cost saved 18.6 lakhs x 2/5 ` 7,44,000

 Management of Receivables | 9.4.5

Interest saved due to 7.5 crores x 90% ` 5,85,937.5

reduction in average x (70-45)/ 360 x
collection period 12.5%

Total ` 18,36,187.5

B. Costs of factoring:

Service charge 7.5 crores x 90% x 2% ` 13,50,000

Interest cost ` 1,15,171.875 ` 9,21,375

x 360/45

Redundancy Payment ` 50,000

Total ` 23.21,375

C. Net Annual cost to the ` 4,85,187.5

Firm: (A-B)

Rate of effective cost of ` 4,85,187.5/ 7.504%

factoring
` 64,66,078.125 x 100

Advice: Since the rate of effective cost of factoring is less than the existing cost of capital,
therefore, the proposal is acceptable.

Credit Sales = ` 7.5 crores x 90% = `6,75,00,000

Average level of receivables = ` 6.75 crores x 45/360 = ` 84,37,500

Service charge = 2% of ` 84,37,500 ` 1,68,750

Reserve = 20% of ` 84,37,500 ` 16,87,500

Total (i) ` 18,56,250

Thus, the amount available for advance is

Average level of receivables ` 84,37,500

Less: Total (i) from above ` 18,56,250

(ii) ` 65,81,250

Less: Interest @ 14% p.a. for 45 days ` 1,15,171.875

Net Amount of Advance available. ` 64,66,078.125

 Management of Receivables | 9.4.6
Note: Alternatively, if redundancy cost is taken as irrelevant for decision making, then Net
Annual cost to the Firm will be ` 4,35,187.5 and Rate of effective cost of factoring will be `
4,35,187.5/` 64,66,078.125 x 100 = 6.730%

If average level of receivables is considered for 70 days then the calculation can be
done in following way:

Evaluation of Factoring Proposal

Credit Sales = ` 7.5 crores X 90% = ` 6,75,00,000

Average level of receivables = ` 6.75 crores x 70/360 = ` 1,31,25,000
Service charge = 2% of ` 1,31,25,000 ` 2,62,500

Reserve = 20% of ` 1,31,25,000 ` 26,25,000

Total (i) ` 28,87,500

Thus, the amount available for advance is

Average level of receivables ` 1,31,25,000

Less: Total (i) from above ` 28,87,500

(ii) ` 1,02,37,500

Less: Interest @ 14% p.a. for 45 days ` 1,79,156.25

Net Amount of Advance available. ` 1,00,58,343.75

Note 1: Accordingly, interest cost will be ` 14,33,250 cost of factoring will be ` 28,33,250.

Therefore, Rate of effective cost of factoring is 9.913%

Note 2: Alternatively, if redundancy cost is taken as irrelevant for decision making, then Net
Annual cost to the Firm will be ` 9,47,062.5 and Rate of effective cost of factoring will be `
9,47,062.5/ ` 1,00,58,343.75 x 100 = 9.416%.

Advice: Since the rate of effective cost of factoring is less than the existing cost of capital,
therefore, the proposal is acceptable.
 Management of Receivables | 9.5.1
CHAPTER – 9 (Unit- V) Management of Receivables
Chapter – 9 (Unit – V)
Management of Receivables
Question & Answer
Question 1
RTP /MAY-2018/Q. 6/
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular
basis. As per the terms of agreement the payment must be made within 40 days of purchase.
However, A Ltd. has a choice of paying ` 98.50 per ` 100 it owes to X Ltd. on or before 10th day
of purchase.

Required:

EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd.
with X Ltd. is ` 10,00,000 and an alternative investment yield a return of 15% and company
pays the invoice.
Answer:
Annual Benefit of accepting the Discount

Annual Cost = Opportunity Cost of foregoing interest on investment = 15%

If average invoice amount is `10,00,000

If discount is
Accepted(`) Not Accepted(`)
Payment to Supplier (`) 9,85000 10,00,000
Return on investment of `9,85,000 for 30 days (12,144)
{` 9,85,000 × (30/365) × 15%}
9,85,000 9,87,856
Thus, from above table it can be seen that it is cheaper to accept the discount.

Question 2
RTP /Nov.-2018/Q. 6/
Tony Limited, manufacturer of Colour TV sets is considering the liberalization of existing credit
terms to three of their large customers A, B and C. The credit period and likely quantity of TV
sets that will be sold to the customers in addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
 Management of Receivables | 9.5.2
The selling price per TV set is ` 9,000. The expected contribution is 20% of the selling price. The
cost of carrying receivable averages 20% per annum.

You are required:

(a) COMPUTE the credit period to be allowed to each customer.

 Financing of Working Capital | 9.6.1
CHAPTER – 9 (Unit- VI) Financing of Working Capital
Chapter – 9 (Unit – VI)
Financing of Working Capital
Question & Answer
Question 1
RTP /November-2018/Q. 7/
A company is considering its working capital investment and financial policies for the next year.
Estimated fixed assets and current liabilities for the next year are ` 2.60 crores and ` 2.34
crores respectively. Estimated Sales and EBIT depend on current assets investment, particularly
inventories and book-debts. The financial controller of the company is examining the following
alternative Working Capital Policies:
(` Crores)
Working Capital Policy Investment in Current Estimated Sales EBIT
Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the adoption of
the moderate working capital policy. The company is now examining the use of long-term and
short-term borrowings for financing its assets. The company will use ` 2.50 crores of the equity
funds. The corporate tax rate is 35%. The company is considering the following debt
alternatives.
(` Crores)
Financing Policy Short-term Debt Long-term Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%
You are required to CALCULATE the following:
(i) Working Capital Investment for each policy:
(a) Net Working Capital position
(b) Rate of Return
(c) Current ratio
(ii) Financing for each policy:
(a) Net Working Capital position.
(b) Rate of Return on Shareholders’ equity.
(c) Current ratio.
Answer:
(i) Statement showing Working Capital for each policy
(`in crores)
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
 Financing of Working Capital | 9.6.2
(a) Net working capital position: (i)-(iv) 2.16 1.56 0.26
(b) Rate of return: (vii)/(iii) 17.3% 17.7% 19.2%
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11
(ii) Statement Showing Effect of Alternative Financing Policy

(`in crores)
Financing Policy Conservative Moderate Aggressive
Current Assets: (i) 3.90 3.90 3.90
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 6.50 6.50 6.50
Current Liabilities: (iv) 2.34 2.34 2.34
Short term Debt: (v) 0.54 1.00 1.50
Long term Debt: (vi) 1.12 0.66 0.16
Equity Capital (vii) 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT: (viii) 1.15 1.15 1.15
Less: Interest short-term debt:(ix) 0.06 0.12 0.18
(12% of ` 0.54) (12% of ` 1.00) (12% of ` 1.50)
Long term debt: (x) 0.18 0.11 0.03
(16% of ` 1.12) (16% of ` 0.66) (16% of ` 0.16)
Earning before tax: 0.91 0.92 0.94
(xi) - (ix + x)
Tax @ 35% (0.32) (0.32) (0.33)
Earning after tax: (xii) 0.59 0.60 0.61
(a) Net Working Capital 0.06
Position: (i) - [(iv)+(v)] 1.02 0.56
(b) Rate of return on Equity 23.6% 24% 24.4%
shareholders’
capital : (xii)/(vii)
(c) Current Ratio: 1.35 1.17 1.02
[(i)/(iv)+(v)]