Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Chapter- 1: Financial Analysis & Planning -

Ratio Analysis
A. QUESTION FROM STUDY MATERIAL
Illustration 1
In a meeting held at Solan towards the end of 2018, the Directors of M/s HPCL Ltd. have taken a
decision to diversify. At present HPCL Ltd. sells all finished goods from its own warehouse. The
company issued debentures on 01.01.2019 and purchased fixed assets on the same day. The purchase
prices have remained stable during the concerned period. Following information is provided to you:
INCOME STATEMENTS
Particulars 2018 (₹) 2019 (₹)
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses
Warehousing 13,000 14,000
Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 14,000
49,000 57,000

Net Profit 15,000 19,000

BALANCE SHEET
Assets & Liabilities 2018 (₹) 2019 (₹)
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000
Payables 50,000 76,000
Total Current Liabilities (CL) 50,000 76,000
Working Capital (CA - CL) 70,000 1,07,000
Total Assets 1,00,000 1,47,000
Represented by:
75,000 75,000
Share Capital

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Reserve and Surplus 25,000 42,000

Debentures - 30,000
1,00,000 1,47,000
You are required to CALCULATE the following ratios for the years 2018 and 2019.
(i) Gross Profit Ratio
(ii) Operating Expenses to Sales Ratio.
(iii) Operating Profit Ratio
(iv) Capital Turnover Ratio
(v) Stock Turnover Ratio
(vi) Net Profit to Net Worth Ratio, and
(vii) Receivables Collection Period.
Ratio relating to capital employed should be based on the capital at the end of the year. Give the
reasons for change in the ratios for 2 years. Assume opening stock of ₹ 40,000 for the year 2019.
Ignore Taxation.
Hints:
(i) 21.3%, 20.3%
(ii) 16.3%, 15.2%
(iii) 5%, 5.08%
(iv) 3 times, 2.54 times
(v) 4.72 times, 3.87 times
(vi) 15%, 14.5%
(vii) 67.6 days, 87.5 days

Illustration 2
Following is the abridged Balance Sheet of Alpha Ltd. :-
Liabilities ₹ Assets ₹ ₹
Share Capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machineries 50,000
Current Liabilities 40,000 Less: Depreciation 15,000 35,000
1,15,000
Stock 21,000
Receivables 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000
With the help of the additional information furnished below, you are required to PREPARE Trading
and Profit & Loss Account and a Balance Sheet as at 31st March, 2019:
(i) The company went in for reorganisation of capital structure, with share capital remaining
the same as follows:
Share capital 50%
Other Shareholders’ funds 15%
5% Debentures 10%
Payables 25%
Debentures were issued on 1st April, interest being paid annually on 31st March.
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

(ii) Land and Buildings remained unchanged. Additional plant and machinery has been
bought and a further ₹ 5,000 depreciation written off.
(The total fixed assets then constituted 60% of total fixed and current assets.)
(iii) Working capital ratio was 8 : 5.
(iv) Quick assets ratio was 1 : 1.
(v) The receivables (four-fifth of the quick assets) to sales ratio revealed a credit period of 2
months. There were no cash sales.
(vi) Return on net worth was 10%.
(vii) Gross profit was at the rate of 15% of selling price.
(viii) Stock turnover was eight times for the year. Ignore Taxation.
Hints:
Net Profit = ₹13,000, Assets & Liabilities = ₹2,00,000

Illustration 3
X Co. has made plans for the next year. It is estimated that the company will employ total assets
of ₹ 8,00,000; 50 per cent of the assets being financed by borrowed capital at an interest cost of 8
per cent per year. The direct costs for the year are estimated at ₹4,80,000 and all other operating
expenses are estimated at ₹ 80,000. the goods will be sold to customers at 150 per cent of the direct
costs. Tax rate is assumed to be 50 per cent.
You are required to CALCULATE: (i) net profit margin; (ii) return on assets; (iii) asset turnover
and (iv) return on owners’ equity.
Hints:
(i) 8.3% or 11.1%
(ii) 10%
(iii) 0.9 times
(iv) 16%

Illustration 4
ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statements over the
last 3 years are as follows:
Particular 2017 2018 2019
₹ ₹ ₹
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
14,30,000 15,60,000 16,95,000
₹ ₹ ₹
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long-term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Retained earnings 5,00,000 5,50,000 5,50,000

14,30,000 15,60,000 16,95,000
₹ ₹ ₹
Sales 40,00,000 43,00,000 38,00,000
Cost of goods sold 32,00,000 36,00,000 33,00,000
Net profit 3,00,000 2,00,000 1,00,000
ANALYSE the company’s financial condition and performance over the last 3 years. Are there any
problems?
Hints: Calculate financial ratios & profitability ratios for all 3 years & give conclusion.

Illustration 5
Following information are available for Navya Ltd. along with various ratio relevant to the
particulars industry it belongs to. APPRAISE your comments on strength and weakness of Navya
Ltd. comparing its ratios with the given industry norms.

Navya Ltd.
BALANCE SHEET AS AT 31.3.2019
Liabilities Amount (₹) Assets Amount (₹)
Equity Share Capital 48,00,000 Fixed Assets 24,20,000
10% Debentures 9,20,0000 Cash 8,80,000
Sundry Creditors 6,60,000 Sundry debtors 11,00,000
Bills Payable 8,80,000 Stock 33,00,000
Other current Liabilities 4,40,000 -
Total 77,00,000 Total 77,00,000

STATEMENT OF PROFITABILITY
FOR THE YEAR ENDING 31.3.2019
Particulars Amount (₹) Amount (₹)
Sales 1,10,00,000
Less: Cost of goods sold: - -
Material 41,80,000 -
Wages 26,40,000 -
Factory Overhead 12,98,000 81,18,000
Gross Profit - 28,82,000
Less: Selling and Distribution Cost 11,00,000 -
Administrative Cost 12,28,000 23,28,000
Earnings before Interest and Taxes - 5,54,000
Less: Interest Charges - 92,000
Earning before Tax - 4,62,000
Less: Taxes & 50% - 2,31,000
Net Profit (PAT) 2,31,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

INDUSTRY NORMS
Ratios Norm
Current Assets/Current Liabilities 2.5
Sales/ debtors 8.0
Sales/ Stock 9.0
Sales/ Total Assets 2.0
Net Profit/ Sales 3.5%
Net profit /Total Assets 7.0%
Net Profit/ Net Worth 10.5%
Total Debt/Total Assets 60.0%
Hints:
(i) 2.67
(ii) 10
(iii) 3.33
(iv) 1.43
(v) 2.10%
(vi) 3%
(vii) 4.81%
(viii) 37.66%

Illustration 6
From the following ratios and information given below, PREPARE Trading Account, Profit and
Loss Account and Balance Sheet of Aebece Company:
Fixed Assets ₹ 40,00,000
Closing Stock ₹ 4,00,000
Stock turnover ratio 10
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Fixed assets to capital 5/4
Fixed assets/Total current assets 5/7

Hints:
(i) Gross Profit: 8,00,000
(ii) Net Profit: 6,40,000
(iii) Balance Sheet Total: 96,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

TEST YOUR KNOWLEDGE

Question-1
The total sales (all credit) of a firm are ₹ 6,40,000. It has a gross profit margin of 15 per cent and a
current ratio of 2.5. The firm’s current liabilities are ₹ 96,000; inventories ₹ 48,000 and cash 16,000.
(a) DETERMINE the average inventory to be carried by the firm, if an inventory turnover
of 5 times is expected? (Assume a 360 day year).
(b) DETERMINE the average collection period if the opening balance of debtors is intended
to be of ₹ 80,000? (Assume a 360 day year).
Hints:
(a) ₹1,08,800
(b) 72 days

Question-2
The capital structure of Beta Limited is as follows:

Equity share capital of ₹ 10 each 8,00,000

9% preference share capital of ₹ 10 each 3,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent), ₹ 2,70,000; Depreciation, ₹ 60,000; Equity
dividend paid, 20 per cent; Market price of equity shares, ₹ 40.
You are required to COMPUTE the following, showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Price-earnings ratio.

Hints:
(a) 5%
(b) 10, 1.52
(c) 3.04 per share
(d) 13.2 times

Question-3
The following accounting information and financial ratios of PQR Ltd. relate to the year ended 31st
December, 2018
2016
I Accounting Information:
Gross Profit 15% of Sales
Net profit 8% of sales
Raw materials consumed 20% of works cost
Direct wages 10% of works cost
Stock of raw materials 3 months’ usage
Stock of finished goods 6% of works cost
Debt collection period 60 days
All sales are on credit
II Financial Ratios:
Fixed assets to sales 1:3
Fixed assets to Current assets 13 : 11

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Current ratio 2:1

Long-term loans to Current liabilities 2:1
Capital to Reserves and Surplus 1:4
If value of fixed assets as on 31st December, 2017 amounted to ₹ 26 lakhs, Prepare a summarized
Profit and Loss Account of the company for the year ended 31 st Dec, 2018 and also the Balance
Sheet as on 31st December, 2018.
Hints:
P/L – Selling & Distribution expense = ₹5,45,000
Balance Sheet Total = ₹48,00,000

Question-4
Ganpati Limited has furnished the following ratios and information relating to the year ended 31st
March, 2019.
Sales ₹ 60,00,000
Return on net worth 25%
Rate of income tax 50%
Share capital to reserves 7:3
Current ratio 2
Net profit to sales 6.25%
Inventory turnover (based on cost of goods sold) 12
Cost of goods sold ₹ 18,00,000
Interest on debentures ₹ 60,000
Receivables ₹ 2,00,000
Payables ₹ 2,00,000
You are required to:
(a) CALCULATE the operating expenses for the year ended 31st March, 2019.
(b) PREPARE a balance sheet as on 31st March in the following format:

Balance Sheet as on 31st March, 2019

Liabilities ₹ Assets ₹
Share Capital Fixed Assets
Reserve and Surplus Current Assets
15% Debentures Stock
Payables Receivables
Cash
Hints:
(a) ₹33,90,000
(b) Balance Sheet total = ₹21,00,000

Question-5
Using the following information, Prepare this Balance sheet:
Long-term debt to net worth 0.5 to 1
Total asset turnover 2.5 x
Average collection period* 18 days
Inventory turnover 9x
Gross profit margin 10%
Acid-test ratio 1 to 1
*Assume a 360-day year and all sales on credit.
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Cash Notes and payables 1,00,000

Account Receivables Long-term debt
Inventory Common Stock 1,00,000
Plant and equipment Retained earnings 1,00,000
Total Assets Total Liabilities and
equity

Hints:
Balance Sheet total = ₹4,00,000
Cash = ₹50,000
Inventory = ₹1,00,000
Receivables = ₹50,000

Question-6
Following information has been provided from the books of Laxmi Pvt. Ltd. for the year ending on
31st March, 2021:
Net Working Capital ₹ 4,80,000
Bank overdraft ₹ 80,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ₹ 3,20,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5
You are required to PREPARE a summarised Balance Sheet as at 31st March, 2021 assuming that
there is no long term debt.

Hints:
Balance Sheet Total: 22,40,000

Question-7
Manan Pvt. Ltd. gives you the following information relating to the year ending 31st March, 2021:
(1) Current Ratio 2.5 : 1
(2) Debt-Equity Ratio 1 : 1.5
(3) Return on Total Assets (After Tax) 15%
(4) Total Assets Turnover Ratio 2
(5) Gross Profit Ratio 20%
(6) Stock Turnover Ratio 7
(7) Net Working Capital ₹ 13,50,000
(8) Fixed Assets ₹ 30,00,000
(9) 1,80,000 Equity Shares of ₹ 10 each
(10) 60,000, 9% Preference Shares of ₹ 10 each
(11) Opening Stock ₹ 11,40,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

You are required to CALCULATE:

(a) Quick Ratio
(b) Fixed Assets Turnover Ratio
(c) Proprietary Ratio
(d) Earnings per Share

Hints:
(a) Quick Ratio: 1.1
(b) Fixed Assets Turnover Ratio: 3.5
(c) Proprietary Ratio: 0.54
(d) Earnings per Share: ₹4.075 per share

Question-8
Gig Ltd. has furnished the following information relating to the year ended 31st March, 2020 and
31st March, 2021: (₹)
st st
31 March, 2020 31 March, 2021
Share Capital 40,00,000 40,00,000
Reserve and Surplus 20,00,000 25,00,000
Long term loan 30,00,000 30,00,000
• Net profit ratio: 8%
• Gross profit ratio: 20%
• Long-term loan has been used to finance 40% of the fixed assets.
• Stock turnover with respect to cost of goods sold is 4.
• Debtors represent 90 days sales.
• The company holds cash equivalent to 1½ months cost of goods sold.
• Ignore taxation and assume 360 days in a year.
You are required to PREPARE Balance Sheet as on 31st March, 2021 in the following format:
Liabilities (₹) Assets (₹)
Share Capital - Fixed Assets -
Reserve and Surplus - Sundry Debtors -
Long-term loan - Closing Stock -
Sundry Creditors - Cash in hand -
Hints:
Balance Sheet Total: 1,09,37,500

Question-9
Following information relates to Temer Ltd.:
Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio 1.5
Gross Profit Ratio 25%
Bills Receivables ₹ 25,000
Bills Payables ₹ 10,000
Gross Profit ₹ 4,00,000
Fixed Assets turnover Ratio 4
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Closing stock of the period is ₹ 10,000 above the opening stock. DETERMINE:
(i) Sales and cost of goods sold
(ii) Sundry Debtors
(iii) Sundry Creditors
(iv) Closing Stock
(v) Fixed Assets

Hints:
(i) Sales and cost of goods sold: ₹12,00,000
(ii) Sundry Debtors: ₹3,75,000
(iii) Sundry Creditors: ₹1,91,667
(iv) Closing Stock: ₹8,05,000
(v) Fixed Assets: ₹3,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

B. PAST YEAR QUESTION

May 23 Q-2 (10 Marks)

Following information and ratios are given in respect of AQUA Ltd. for the year
ended 31st March, 2023:
Current ratio 4.0
Acid test ratio 2.5
Inventory turnover ratio (based on sales) 6
Average collection period (days) 70
Earnings per share ₹ 3.5
Current liabilities ₹ 3,10,000
Total assets turnover ratio (based on sales) 0.96
Cash ratio 0.43
Proprietary ratio 0.48
Total equity dividend ₹ 1,75,000
Equity dividend coverage ratio 1.60
Assume 360 days in a year.
You are required to complete Balance Sheet as on 31stMarch, 2023.
Balance Sheet as on 31stMarch, 2023.
Liabilities ₹ Assets ₹
Equity share capital (₹10 per share) XXX Fixed assets XXX
Reserves & surplus XXX Inventory XXX
Long-term debt XXX Debtors XXX
Current liabilities 3,10,000 Loans & advances XXX
Cash & bank XXX
Total XXX Total XXX
Solution:
(i) Current Ratio = 4
Current Ratio = 4
Current Liabilities
Current Ratio = 4
3,10,000
Current Assets = ₹ 12,40,000
(ii) Acid Test Ratio = 2.5
Current Assets - Inventory = 2.5
Current Liabilities
12,40,000 - Inventory = 2.5
3,10,000
12,40,000 – Inventory = ₹ 7,75,000
Inventory = ₹ 4,65,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

(iii) Inventory Turnover Ratio (on Sales) = 6

Sales = 6
Inventory
Sales = 6
4,65,000
Sales = ₹ 27,90,000

(iv) Debtors Collection Period = 70 days

(Debtors / sales) x 360 = 70
(Debtors / 27,90,000) x 360 = 70 Debtors = ₹ 5,42,500

(v) Total Assets Turnover Ratio (on Sales) = 0.96

Sales = 0.96
Total Assets
27,90,000 = 0.96
Total Assets
Total Assets = ₹ 29,06,250
(vi) Fixed Assets (FA) = Total Assets – Current Assets
= 29,06,250 – 12,40,000
Fixed Assets = ₹ 16,66,250

(vii) Cash Ratio = Cash = 0.43

Current Liabilities
= Cash = 0.43
3,10,000
Cash = ₹ 1,33,300

(viii) Proprietary Ratio = Proprietary Fund = 0.48

Total Assets
= Proprietary Fund = 0.48
29,06,250
Proprietary Fund = ₹ 13,95,000
(ix) Equity Dividend Coverage Ratio = 1.6
Or EPS = 3.5
DPS DPS
DPS = ₹ 2.1875
DPS = Total Dividend
Number of Equity Shares
2.1875 = 1,75,000
Number of Equity Shares
Number of Equity Shares = 80,000
Equity Share Capital = 80,000 x 10 = ₹ 8,00,000
Reserves &Surplus = 13,95,000 - 8,00,000 = ₹ 5,95,000

(x) Loans and Advances = Current Assets - (Inventory + Receivables + Cash & Bank)
= ₹ 12,40,000 - (₹ 4,65,000 + 5,42,500 + 1,33,300) = ₹ 99,200
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Balance Sheet as on 31st March 2023

Liabilities ₹ Assets ₹
Equity Share Capital (₹ 10 per share) 8,00,000 Fixed Assets 16,66,250
Reserves & Surplus 5,95,000 Inventory 4,65,000
Long-term debt *(B/F) 12,01,250 Receivables 5,42,500
Current Liabilities 3,10,000 Loans & Advances 99,200
Cash & Bank 1,33,300
Total 29,06,250 Total 29,06,250

Nov 22 Q-1(b) (05 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
Solution:
(xi) Computation of Net Profit Margin
Debt = (10,00,000 x 50%) = ₹ 5,00,000
Interest cost = 5,00,000 x (10/100) = ₹50,000
Direct cost = 50,000 x 10 = ₹ 5,00,000
Sales = 5,00,000 x 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
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

PAT = 70,000
Net profit margin 70,000 x 100 = 9.33%
7,50,000

(xii) Net Operating Profit margin

Net operating profit margin = EBIT x 100
Sales
= 1,50,000 x 100 = 20%
7,50,000

(xiii) Return on Assets

Return on Assets = (PAT + Interest) x 100
Total Assets
= (1,20,000) x 100
10,00,000
(OR)
Return on Assets = EBIT ×100
Assets
= 1,50,000 x 100 = 15%
10,00,000
(OR)
= 70,000 x 100 = 7%
10,00,000
(OR)
= 1,50,000 (1- 0.3) x 100 = 10.5%
10,00,000
(xiv) Return on owner’s equity
Return = PAT x 100
Owner’s Equity
= 70,000 x 100
5,00,000
= 14%

May 22 Q-1(a) (05 Marks)

Following information and ratios are given for W Limited for the year ended 31 st
March, 2022:
Equity Share Capital of ₹ 10 each ₹ 10 lakhs
Reserves & Surplus to Shareholders’ Fund 0.50

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Sales / Shareholders’ Fund 1.50

Current Ratio 2.50
Debtors Turnover Ratio 6.00
Stock Velocity 2 Months
Gross Profit Ratio 20%
Net Working Capital Turnover Ratio 2.50
You are required to calculate:
(i) Shareholders' Fund
(ii) Stock
(iii) Debtors
(iv) Current liabilities
(v) Cash Balance.
Solution:
(i) Calculation of Shareholders’ Fund:
Reserve & Surplus = 0.5
Shareholders' Funds
Reserve & Surplus = 0.5
Equity Share Capital + Reserve & Surplus
Reserve & Surplus = 0.5
10,00,000 + Reserve & Surplus
Reserve & Surplus = 5,00,000 + 0.5 Reserve & Surplus
0.5 Reserve & Surplus = 5,00,000 Reserve & Surplus = 10,00,000
Shareholders’ funds = 10,00,000 +10,00,000
Shareholders’ funds = ₹ 20,00,000

(ii) Calculation of Value of Stock:

Sales = 1.5
Shareholders' Funds
Sales = 1.5 × 20,00,000
Sales = 30,00,000
Gross Profit = 30,00,000 × 20% = 6,00,000
Cost of Goods Sold = 30,00,000 – 6,00,000
= ₹ 24,00,000
Stock velocity = 2 months
Average Stock x 12 = 2
Cost of Goods Sold
Average Stock = 24,00,000 x 2/12
Average stock = ₹ 4,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

(iii) Calculation of Debtors:

Debtors Turnover Ratio = 6
Sales =6
Average Debtors
30,00,0000 =6
Average Debtors
Average Debtors = ₹ 5,00,000

(iv) Calculation of Current Liabilities:

Net Working Capital Turnover ratio = 2.5
Sales = 2.5
Current Assets - Current Liabilites
30,00,000 = 2.5
Current Assets - Current Liabilites
Current Assets – Current Liabilities = 12,00,000 (1)
Current Ratio = 2.5
Current Assets = 2.5
Current Liabilities
Current Assets = 2.5 Current Liabilities (2)
From (1) & (2),
2.5 Current Liabilities – Current Liabilities = 12,00,000
1.5 Current Liabilities = 12,00,000
Current Liabilities = ₹ 8,00,000

(v) Calculation of Cash Balance:

Current Assets = 2.5 Current Liabilities
Current Assets = 2.5 (8,00,000) = 20,00,000
(-) Debtors (5,00,000)
(-) Stock (4,00,000)
Cash Balance ₹ 11,00,000

Dec 21 Q-2 (10 Marks)

Following are the data in respect of ABC Industries for the year ended 31 st March,
2021:
Debt to Total assets ratio : 0.40
Long-term debts to equity ratio : 30%
Gross profit margin on sales : 20%
Accounts receivables period : 36 days
Quick ratio : 0.9
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Inventory holding period : 55 days

Cost of goods sold : ₹ 64,00,000

Liabilities ₹ Assets ₹
Equity Share Capital 20,00,000 Fixed assets
Reserves & surplus Inventories
Long-term debts Accounts receivable
Accounts payable Cash
Total Total
Required:
Complete the Balance Sheet of ABC Industries as on 31st March, 2021. All
calculations should be in nearest Rupee. Assume 360 days in a year.

Solution:
Working Notes:
(1) Total liability = Total Assets = ₹ 50,00,000
Debt to Total Asset Ratio = 0.40
Debt = 0.40
Total Assets
Or, Debt = 0.40
50,00,000
So, Debt = 20,00,000

(2) Total Liabilities = ₹ 50,00,000

Equity share Capital + Reserves + Debt = ₹ 50,00,000
So, Reserves =₹ 50,00,000 - ₹ 20,00,000 - ₹ 20,00,000
So, Reserves & Surplus = ₹ 10,00,000

(3) Long term Debt = 30%*

Equity Shareholders' Fund
Long term Debt = 30%
(20,00,000 + 10,00,000)
Long Term Debt = ₹ 9,00,000
(4) So, Accounts Payable = ₹ 20,00,000 – ₹ 9,00,000
Accounts Payable = ₹ 11,00,000
(5) Gross Profit to sales = 20%
Cost of Goods Sold = 80% of Sales = ₹ 64,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Sales = 100 x 64,00,000 = 80,00,000

80
(6) Inventory Turnover = 360/55
COGS = 360/55
Closing Inventory
64,00,000 = 360/55
Closing Inventory
Closing inventory = 9,77,778
(7) Accounts Receivable period = 36 days
Accounts Receivable ×360 = 36
Credit Sales
Accounts Receivable =36 x credit sales
360
= 36 × 80,00,000 (assumed all sales are on credit)
360
Accounts Receivable = ₹ 8,00,000
(8) Quick Ratio = 0.9
Quick Assets = 0.9
Current liabilities
Cash + Debtors = 0.9
11,00,000
Cash + 8,00,000 = ₹ 9,90,000
Cash = ₹ 1,90,000
(9) Fixed Assets = Total Assets- Current Assets = 50,00,000 –
(9,77,778+8,00,000+1,90,000) = 30,32,222

Balance Sheet of ABC Industries as on 31st March 2021

Liabilities (₹) Assets (₹)
Share Capital 20,00,000 Fixed Assets 30,32,222
Reserved surplus 10,00,000 Current Assets:
Long Term Debt 9,00,000 Inventory 9,77,778
Accounts Payable 11,00,000 Accounts Receivables 8,00,000
Cash 1,90,000
Total 50,00,000 Total 50,00,000
(*Note: Equity shareholders’ fund represent equity in ‘Long term debts to equity
ratio’. The question can be solved assuming only share capital as ‘equity’)

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Jan 21 Q-1(a) (05 Marks)

From the following information, complete the Balance Sheet given below:
(i) Equity Share Capital : ₹ 2,00,000
(ii) Total debt to owner's equity : 0.75
(iii) Total Assets turnover : 2 times
(iv) Inventory turnover : 8 times
(v) Fixed Assets to owner's equity : 0.60
(vi) Current debt to total debt : 0.40
Balance Sheet of XYZ Co. as on March 31, 2020
Liabilities Amount Assets Amount
(₹) (₹)
Equity Shares 2,00,000 Fixed Assets ?
Capital ? Current Assets:
Long term Debt ? Inventory ?
Current Debt Cash ?
Solution:
Balance Sheet of XYZ Co. as on March 31, 2020
Liabilities Amount (₹) Assets Amount (₹)
Equity Share Capital 2,00,000 Fixed Assets 1,20,000
Long-term Debt 90,000 Current Assets:
Current Debt 60,000 Inventory 87,500
Cash (balancing 1,42,500
3,50,000 figure) 3,50,000

Working Notes
1. Total Debt = 0.75 x Equity Share Capital = 0.75 x ₹ 2,00,000 = ₹ 1,50,000
Further, Current Debt to Total Debt = 0.40.
So, Current Debt = 0.40 x ₹ 1,50,000 = ₹ 60,000
Long term Debt = ₹ 1,50,000 - ₹ 60,000 = ₹ 90,000
2. Fixed Assets = 0.60 x Equity Share Capital = 0.60 x ₹ 2,00,000 = ₹ 1,20,000
3. Total Assets to Turnover = 2 times; Inventory Turnover = 8 times
Hence, Inventory /Total Assets = 2/8 =1/4
Further, Total Assets = ₹ 2,00,000 + ₹ 1,50,000 = ₹ 3,50,000
Therefore, Inventory = ₹ 3,50,000/4 = ₹ 87,500
Cash in Hand = Total Assets – Fixed Assets – Inventory
= ₹ 3,50,000 - ₹ 1,20,000 - ₹ 87,500 = ₹ 1,42,500
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Nov 20 Q-1(a) (05 Marks)

Following information relates to RM Co. Ltd.
Total Assets employed 10,00,000
Direct Cost 5,50,000
Other Operating Cost 90,000
Goods are sold to the customers at 150% of direct costs.
50% of the assets being financed by borrowed capital at an interest cost of 8% per annum. Tax rate
is 30%.

You are required to calculate :

(i) Net profit margin
(ii) Return on Assets
(iii) Asset turnover
(iv) Return on owners' equity
Solution:
Computation of net profit:
Particulars (₹)
Sales (150% of ₹ 5,50,000) 8,25,000
Direct Costs 5,50,000
Gross profit 2,75,000
Other Operating Costs 90,000
Operating profit (EBIT) 1,85,000
Interest changes (8% of ₹ 5,00,000) 40,000
Profit before taxes (EBT) 1,45,000
Taxes (@ 30%) 43,500
Net profit after taxes (EAT) 1,01,500
(i) Net profit margin (After tax) = Profit after taxes = ₹ 1,01,500 = 0.12303 or 12.303%
Sales ₹ 8,25,000
Net profit margin (Before tax) = Profit before taxes = ₹ 1,45,500 = 0.17576 or 17.576%
Sales ₹ 8,25,000
(ii) Return on assets = EBIT (1 –T) = ₹ 1,85,000 (1 - 0.3) = 0.1295 or 12.95%
Total Assets ₹ 10,00,000
(iii) Asset turnover = Sales = ₹8,25,000 = 0.825 times
Assets ₹10,00,000
(iv) Return on owner's equity = Profit after taxes = ₹ 1,01,500 = 0.203 or 20.3%
Owners equity 50% × ₹ 10,00,000

Nov 19 Q-1(a) (05 Marks)

Following information has been gathered from the books of Tram Ltd. the equity
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

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

Solution:
(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)] = PBIT x 100
Capital Employed
= ₹4,00,000 x 100
26,00,000
= 15.38% (approx.)

Return on capital employed [ROCE-(Post-tax)] = Profit after tax x 100

Capital Employed
= ₹2,40,000 x 100
26,00,000
= 09.23% (approx.)

(ii) Calculation of Earnings per share

Earnings per share = Earnings available to equity shareholders
No. of equity share
= Profit after tax-preference Dividend
No. of equity share
= ₹(2,40,000 – 20,000) = ₹2.20
1,00,000

(iii) Calculation of PE ratio

PE = MPS/EPS = ₹14/2.20 = 6.364 (approx.)

May 19 Q-1(a) (05 Marks)

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Following figures and ratios are related to a company Q Ltd. :

(i) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 per cent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1:1
(vi) Current ratio 1. 5 : 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to share capital 0.6 : 1
(ix) Capital gearing ratio 0.5
(x) Fixed assets to net worth 1.20 : 1
You are required to calculate :
Closing stock, Fixed Assets, Current Assets, Debtors and Net worth.

Solution:
1. Calculation of Closing Stock:
Cost of Goods Sold = Sales – Gross Profit (25% of Sales)
= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000
Closing Stock = Cost of Goods Sold / Stock Turnover
= ₹ 22,50,000/6 = ₹ 3,75,000
2. Calculation of Fixed Assets:
Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ₹ 22,50,000/1.5
= ₹ 15,00,000
3. Calculation of Current Assets:
Current Ratio = 1.5 and Liquid Ratio = 1
Stock = 1.5 – 1 = 0.5
Current Assets= Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5 = ₹ 11,25,000
4. Calculation of Debtors:
Debtors = Sales × Debtors Collection period /12
= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000
5. Calculation of Net Worth:
Net worth = Fixed Assets /1.2
= ₹ 15,00,000/1.2 = ₹ 12,50,000

Nov 18 Q-1(c) (05 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

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

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.
(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
Solution:
Workings:
Non current assets = 1
Current assets 2
Or, 50,00,000 = 1
Current assets 2
So, Current Assets = ₹ 1,00,00,000

Now further,
Non current assets = 1
Sales 4
Or, 50,00,000 = 1
Sales 4
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 ₹ 2,00,00,000
= ₹ 20,00,000
(iii) Inventory:
Inventory Holding Period = 12 Months
Inventory turnover ratio
Inventory Turnover Ratio = 12/ 3 = 4
4= COGS
Avg. Inventory
4 = 1,60,00,000
Avg. Inventory
Average or Closing Inventory =₹ 40,00,000
(iv) Receivables :
Receivable Collection Period = 12 Months
Receivables Turnover ratio
Or Receivables Turnover Ratio = 12/ 3 = 4 = Credit Sales
Avg. Accounts Receivables
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Or 4 = 2,00,00,000
Avg. Accounts Receivables
So, Average Accounts Receivable/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)
May 18 Q-1(c) (05 Marks)
The accountant of Moon Ltd. has reported the following data:
Gross profit ₹ 60,000
Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days
Assume 360 days in a year
You are required to complete the following:

Balance Sheet of Moon Ltd.

Liabilities ₹ Assets ₹
Net Worth Fixed Assets
Current Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets

Solution:
Preparation of Balance Sheet
Working Notes:
Sales = Gross Profit / Gross Profit Margin
= 60,000 / 0.2 = ₹ 3,00,000
Total Assets = Sales / Total Asset Turnover
= 3,00,000 / 0.3 = ₹ 10,00,000
Net Worth = 0.9 X Total Assets.
= 0.9 X ₹ 10,00,000 = ₹ 9,00,000
Current Liability = Total Assets – Net Worth
= ₹ 10,00,000 – ₹ 9,00,000
= ₹ 1,00,000
Current Assets= 1.5 x Current Liability
= 1.5 x ₹ 1,00,000 = ₹ 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets / Current Liabilities =1)
= 1,50,000 – (LA / 1,00,000 = 1) = ₹ 50,000
Debtors = Average Collection Period X Credit Sales / 360
= 60 x 0.8 x 3,00,000 / 360 = ₹ 40,000
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Cash = Current Assets – Debtors – Stock

= ₹ 1,50,000 – ₹ 40,000 – ₹ 50,000
=₹ 60,000
Fixed Assets = Total Assets – Current Assets
= ₹ 10,00,000 – ₹ 1,50,000
= ₹ 8,50,000

Balance Sheet
Liabilities ₹ Assets ₹
Net Worth 9,00,000 Fixed Assets 8,50,000
Current 1,00,000 Stock Debtors 50,000
Liabilities Cash 40,000
60,000
Total liabilities 10,00,000 Total Assets 10,00,000
May 19 Q-3(b) (08 Marks) (Old Course)
Using the information given below, complete the Balance Sheet of PQR Private Limited:
(i) Current ratio 1.6 :1
(ii) Cash and Bank balance 15% of total current assets
(iii) Debtors turnover ratio 12 times
(iv) Stock turnover (cost of goods sold) ratio 16 times
(v) Creditors turnover (cost of goods sold) ratio 10 times
(vi) Gross Profit ratio 20%
(vii) Capital Gearing ratio 0.6
(viii) Depreciation rate 15% on W.D.V.
(ix) Net Fixed Assets 20% of total assets
(Assume all purchase and sales are on credit)

Balance Sheet of PQR Private Limited as at 31.03.2019

Liabilities ₹ Assets ₹
Share Capital 25,00,000 Fixed Assets
Reserve & surplus ? Opening WDV ?
12% Long term debt ? Less: Depreciation ? ?
Current Liabilities
Creditors ? Current Assets
Provisions & outstanding
Stock ?
expenses ? 68,50,000
Debtors ?
Cash and bank balance ? ?
Total ? Total ?

Solution:
Balance Sheet of PQR Private Limited as at 31.03.2019
Liabilities ₹ Assets ₹
Share Capital 25,00,000 Fixed assets
Reserve & Surplus 17,81,250 Opening WDV 32,23,529
12% Long term debt 25,68,750 Less: 4,83,529 27,40,000
Depreciation
Current Liabilities Current Assets

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Creditors 55,89,600 Stock 34,93,500

Provisions & Debtors 58,22,500
outstanding expenses 12,60,400 68,50,000
Cash and bank balance 16,44,000 1,09,60,000
Total 1,37,00,000 1,37,00,000

Working Notes:
1. Computation of Current Assets and Cash & Bank Balance
Current Ratio = Current Assets (CA) = 1.6
Current Liabilities (CL)
Current Assets = 1.6 Current Liabilities = 1.6 × ₹ 68,50,000 = ₹ 1,09,60,000/-
So, Cash and Bank Balance=15% of Current Assets=₹ 16,44,000/-

2. Computation of Total Assets, Fixed Assets and Depreciation

Total Assets = Net Fixed Assets+ Current Asset
Or Total Assets = 20% of Total Asset + ₹ 1,09,60,000/-
Or Total Assets = ₹ 1,37,00,000
So, Net Fixed Assets = 20% of Total Asset = ₹ 27,40,000
Depreciation = 27,40,000 x 15% =₹4,83,529
85%
Fixed Assets = ₹ 27,40,000 + ₹ ₹ 4,83,529 = ₹ 32,23,529

3. Calculation of Stock, Debtors and Creditors

Stock + Debtors = Current Assets – Cash & Bank
= ₹ 1,09,60,000 – 16,44,000
= ₹ 93,16,000
Now let Sales be x
So, Debtors (Credit Sales) = Credit Sales =x
Debtors turnover ratio 12
Further, Stock (on Cost of Goods Sold) = Sales - 20% of Sales
16
= x – 20% of x
16
= x – x/5 = 4x/5
16 16
= x/20
So,
x + x =₹93,16,000
12 20
Or, 10x + 6x = ₹93,16,000
120
Or x = ₹ 6,98,70,000
So, Sales = ₹ 6,98,70,000
Cash of Goods Sold (COGS) = ₹ 5,58,96,000 Stock (COGS/16) = ₹ 34,93,500
Debtors(Sales/12) = ₹ 58,22,500
Creditors(COGS/10) = ₹ 55,89,600

4. Calculation of Provision of outstanding Expenses

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

= ₹ 68,50,000 – ₹ 55,89,600
= ₹ 12,60,400

5. Share Capital + Reserve & surplus + long term debt = Total Asset or total liability –
Current liability
Or, Reserve & surplus + long term debt = ₹ 1,37,00,000 – ₹ 68,50,000 – ₹ 25,00,000
= ₹ 43,50,000
Calculation of long term Debt and Reserve & Surplus
Now, Capital Earning ratio = 0.6
So, 12% long term Debt = 0.6
Equity Share Capital + Reserve & Surplus
Or, 43,50,000 - Reserve & Surplus = .6
25,00,000 + Reserve & Surplus
Or, Reserve & Surplus = ₹ 17,81,2501
So, 12% long term debt = ₹ 25,68,750

Nov 17 Q-6(b) (08 Marks) (Old Course)

XY Ltd. provides the following information for the year ending 31st March, 2017:
Equity Share Capital ₹ 8,00,000
Closing Stock ₹ 1,50,000
Stock Turnover Ratio 5 times
Gross profit ratio 20%
Net profit/Sales 16%
Net profit/Capital 25%
Equity Share Capital ₹ 8,00,000
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March, 2017.
Solution:
Working Note:
1. Calculation of Net Profit:
Net Profit/Capital = 25%
Or,
Net Profit/₹8,00,000 = 25% Or, Net Profit = ₹2,00,000
2. Calculation of Sales:
Net Profit/Sales = 16%
Or,
₹2,00,000/Sales = 16% Or, Sales = ₹12,50,000
3. Calculation of Gross Profit
Gross profit = ₹ 12,50,000 × 20%
= ₹ 2,50,000
4. Calculation of Opening Stock
Stock Turnover Ratio = Cost of Sales = 5 times
Avg. Stock
Or,
₹ 12,50,000 x (1- 0.2) = 5
Avg, Stock
Or, Average Stock = ₹ 10,00,000/5 = ₹ 2,00,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Average Stock = 1,50,000 + Opening Stock = 2,00,000

2
Or, Opening Stock = 4,00,000 – 1,50,000 = ₹ 2,50,000

Trading and Profit & Loss Account

Particulars (₹) Particulars (₹)
To Opening Stock 2,50,000 By Sales 12,50,000
To Purchases 9,00,000 By Closing Stock 1,50,000
(Balancing figure)
To Gross Profit (Balance c/d) 2,50,000
14,00,000 14,00,000
To Miscellaneous expenses 50,000 By Gross Profit (Balance b/d) 2,50,000
(Balancing figure)
To Net Profit 2,00,000
2,50,000 2,50,000
Nov 15 Q-2(b) (08 Marks) (Old Course)
VRA Limited has provided the following information for the year ending 31st March, 2015.
Debt Equity Ratio 2: 1
14% long term debt ₹ 50,00,000
Gross Profit Ratio 30%
Return on equity 50%
Income Tax Rate 35%
Capital Turnover Ratio 1.2 times
Opening Stock ₹ 4,50,000
Closing Stock 8% of sales
You are required to prepare Trading and Profit and Loss Account for the year ending 31st March,
2015.

Solution:
Debt Equity Ratio = 2 :1; Debt = 2
Equity 1
Equity = ₹50,00,000/2 = ₹25,00,000
Return of Equity = Net Profit after tax (PAT) = 50%
Equity
Or, Net Profit after tax (PAT) = ₹ 25,00,000 × 50% = ₹ 12,50,000
Net Profit before tax = ₹12,50,000 × 100 = ₹19,23,077
65
Tax = ₹ 19,23,077 – ₹12,50,000 = ₹ 6,73,077
Capital Turnover Ratio = Sales = 1.2 Or, Sales = 1.2
Capital (₹ 25,00,000 + ₹ 50,00,000)
So, Sales = ₹ 75,00,000 × 1.2 = ₹ 90,00,000
Closing Stock = ₹ 90,00,000 × 8% = ₹ 7,20,000
Gross Profit = ₹ 90,00,000 × 30% = ₹ 27,00,000

Trading A/c for the year ending 31st March, 2015

Dr. Cr.
Amount (₹) Amount (₹)

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

To Opening Stock 4,50,000 By Sales 90,00,000

To Purchases (Balancing figure) 65,70,000 By Closing Stock 7,20,000
To Gross Profit c/f to P&L A/c 27,00,000

97,20,000 97,20,000

Profit & Loss A/c for the year ending 31st March, 2015
Amount Amount (₹)
(₹)
To Interest on long term debt 7,00,000 By Gross Profit 27,00,000
@14% b/f from
To Miscellaneous Exp. (balancing 76,923 Trading A/c
figure)
To Income Tax 6,73,077
To Net Profit 12,50,000

27,00,000 27,00,000

Nov 16 Q-2(b) (08 Marks) (Old Course)

The following figures and ratios pertain to ABG Company Limited for the year ending 31st March,
2016:
Annual Sales (credit) ₹ 50,00,000
Gross Profit Ratio 28%
Fixed assets turnover ratio (based on cost of goods sold) 1.5
Stock turnover ratio (based on cost of goods sold) 6
Quick ratio 1:1
Current ratio 1.5
Debtors collection period 45 days
Reserves and surplus to Share Capital 0.60 : 1
Capital gearing ratio 0.5
Fixed Assets to net worth 1.2 : 1
You are required to prepare the Balance Sheet as at 31st March, 2016 based on the above
information. Assume 360 days in a year.
Solution:
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (28% of Sales)
= ₹ 50,00,000 – ₹ 14,00,000
= ₹ 36,00,000
(ii) Closing Stock = Cost of Goods Sold / Stock Turnover
= ₹ 36,00,000/6 = ₹ 6,00,000
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ₹ 36,00,000/1.5 = ₹ 24,00,000
(iv) Current Assets : Current Ratio
= 1.5 and Liquid Ratio = 1
Stock = 1.5 – 1 = 0.5
Current Assets= Amount of Stock × 1.5/0.5
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

= ₹ 6,00,000 × 1.5/ 0.5 = ₹ 18,00,000

(v) Liquid Assets (Debtors and Cash & Cash equivalents)
= Current Assets – Stock
= ₹18,00,000 – ₹ 6,00,000
= ₹12,00,000
(vi) Debtors = Sales × Debtors Collection Period(days) /360 days
= ₹50,00,000 x 45 = ₹6,25,000
360
(vii) Cash & Cash equivalents
= Liquid Assets – Debtors
= ₹12,00,000 – ₹ 6,25,000 = ₹ 5,75,000
(viii) Net worth = Fixed Assets / 1.2
= ₹ 24,00,000/1.2 = ₹ 20,00,000
(ix) Reserves and Surplus
Reserves & Surplus and Share Capital = 0.6 + 1 = 1.6
Reserves and Surplus = ₹ 20,00,000 × 0.6/1.6 = ₹ 7,50,000
(x) Share Capital = Net worth – Reserves and Surplus
= ₹ 20,00,000 – ₹ 7,50,000
= ₹12,50,000
(xi) Current Liabilities = Current Assets / Current Ratio
= ₹18,00,000/1.5 = ₹12,00,000
(xii) Long- term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund (Net worth)
Or, Long-term Debts = ₹ 20,00,000 × 0.5 = ₹10,00,000

Balance Sheet as at 31st March, 2016

Liabilities Amount Assets Amount (₹)
(₹)
Equity Share Capital 12,50,000 Fixed Assets 24,00,000
Reserves and Surplus 7,50,000 Current Assets:
Long-term Debts 10,00,000 Stock 6,00,000
Current Liabilities 12,00,000 Debtors 6,25,000
Cash & Cash eq. 5,75,000 18,00,000
42,00,000 42,00,000

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
Net Working Capital ₹ 2,40,000
Bank overdraft ₹ 40,000
Fixed Assets to Proprietary ratio 0.75
Reserves and Surplus ₹ 1,60,000
Current ratio 2.5
Liquid ratio (Quick Ratio) 1.5

Solution:
Working notes:

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

1. Current assets and Current liabilities computation:

Current assets = 2.5
Current liabilities 1
Or Current assets = 2.5 Current liabilities
Now, Working capital = Current assets - Current liabilities
Or ₹ 2,40,000 = 2.5 Current liability - Current liability
Or 1.5 Current liability = ₹ 2,40,000
Current liabilities = ₹ 1,60,000
So, Current assets = ₹ 1,60,000 x 2.5 = ₹ 4,00,000

2. Computation of stock
Liquid ratio = Liquid assets
Current liabilities
Or, 1.5 = Current assets – inventory
₹1,60,000
Or 1.5 x ₹ 1, 60,000 = ₹ 4,00,000 - Inventories
Or Inventories = ₹4, 00,000 – ₹ 2, 40,000
Or Stock = ₹ 1, 60,000

3. Computation of Proprietary fund; Fixed assets; Capital and Sundry creditors

Fixed Asset to Proprietary ratio = Fixed assets = 0.75
Proprietary fund
Fixed assets = 0.75 Proprietary fund (PF) [FA + NWC = PF
or NWC = PF- FA (i.e. .75 PF)]
and Net working capital (NWC) = 0.25 Proprietary fund
Or ₹ 2,40,000/0.25 = Proprietary fund
Or Proprietary fund = ₹ 9,60,000
and Fixed assets = 0.75 proprietary fund
= 0.75 x ₹ 9,60,000
= ₹ 7,20,000
Capital = Proprietary fund - Reserves & Surplus
= ₹ 9,60,000 - ₹ 1,60,000 =₹ 8,00,000
Sundry creditors = (Current liabilities - Bank overdraft)
= (₹ 1,60,000 - ₹ 40,000) = ₹ 1,20,000

Balance Sheet
Liabilities ₹ Assets ₹
Capital 8,00,000 Fixed assets 7,20,000
Reserves & Surplus 1,60,000 Stock 1,60,000
Bank overdraft 40,000 Current assets 2,40,000
Sundry creditors 1,20,000
11,20,000 11,20,000

Question-2
With the help of the following information complete the Balance Sheet of MNOP Ltd.:
Equity share capital ₹ 1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Fixed assets to Equity share capital 0.60

Total assets turnover 2 Times
Inventory turnover 8 Times
Solution:
MNOP Ltd
Balance Sheet
Liabilities ₹ Assets ₹
Equity share capital 1,00,000 Fixed assets 60,000
Current debt 24,000 Cash (balancing figure) 60,000
Long term debt 36,000 Inventory 40,000
1,60,000 1,60,000
Working Notes:
1. Total debt = 0.60 x Equity share capital = 0.60 ´ ₹ 1,00,000 = ₹ 60,000
Further, Current debt to total debt = 0.40. So, current debt = 0.40 × ₹60,000 = ₹24,000,
Long term debt = ₹60,000 - ₹24,000= ₹ 36,000
2. Fixed assets = 0.60 × Equity share Capital = 0.60 × ₹ 1,00,000 = ₹ 60,000
3. Total assets to turnover = 2 Times : Inventory turnover = 8 Times
Hence, Inventory /Total assets = 2/8=1/4, Total assets = ₹ 1,60,000
Therefore Inventory = ₹ 1,60,000/4 = ₹ 40,000

Question-3
JKL Limited has the following Balance Sheets as on March 31, 2015 and March 31, 2016:

Balance Sheet
₹ in lakhs
March 31, 2015 March 31, 2016
Sources of Funds:
Shareholders Funds 2,377 1,472
Loan Funds 3,570 3,083
5,947 4,555
Applications of Funds:
Fixed Assets 3,466 2,900
Cash and bank 489 470
Debtors 1,495 1,168
Stock 2,867 2,407
Other Current Assets 1,567 1,404
Less: Current Liabilities (3,937) (3,794)
5,947 4,555

The Income Statement of the JKL Ltd. for the year ended is as follows:
₹ in lakhs
March 31, 2015 March 31, 2016
Sales 22,165 13,882
Less: Cost of Goods sold 20,860 12,544
Gross Profit 1,305 1,338
Less: Selling, General and Administrative 1,135 752
expenses
Earnings before Interest and Tax (EBIT) 170 586
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Interest Expense 113 105

Profits before Tax 57 481
Tax 23 192
Profits after Tax (PAT) 34 289

Required:
(i) Calculate for the year 2015-16:
(a) Inventory turnover ratio
(b) Financial Leverage
(c) Return on Capital Employed (ROCE)
(d) Return on Equity (ROE)
(e) Average Collection period.
(ii) Give a brief comment on the Financial Position of JKL Limited.

Solution:
Ratios for the year 2015-2016
(i) (a) Inventory turnover ratio
= COGS = 20,860 = 7.91
Average Inventory (2,867 + 2,407)
2
(b) Financial leverage
2015-16 2014-15
EBIT 170 586
= = =
EBIT - I 57 481
= 2.98 = 1.22

(c) ROCE
= EBIT (1-t) = 57 (1-0.4) = 34.2 x 100 = 0.651%
Average Capital Employed ( 5,947 + 4,535 ) 5251
2
[Here Return on Capital Employed (ROCE) is calculated after Tax]

(d) ROE
= Profits after tax = 34 = 34 = 1.77%
Average shareholders' funds (2,377 + 1,472) 1924.5
2

(e) Average Collection Period*

Average Sales per day = 22,165 = ₹ 60.73 lakhs
365
Average collection period = Average Debtors = (1,495 + 1,168)
Average sales per day 2
60.73
= 1331.5 = 22 days
60.73
*Note: In the above solution, 1 year = 365 days has been assumed. Alternatively, it
may be solved on the basis of 1 year = 360 days.

(ii) Brief Comment on the financial position of JKL Ltd.

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

The profitability of operations of the company are showing sharp decline due to increase in
operating expenses. The financial and operating leverages are becoming adverse.
The liquidity of the company is under great stress.

Question-4
Using the following information, complete the Balance Sheet given below:
(i) Total debt to net worth : 1:2
(ii) Total assets turnover : 2
(iii) Gross profit on sales : 30%
(iv) Average collection period : 40 days
(Assume 360 days in a year)
(v) Inventory turnover ratio based on cost of goods sold and year-end inventory: 3
(vi) Acid test ratio : 0.75

Balance Sheet
as on March 31, 2016
Liabilities ₹ Assets ₹
Equity Shares Capital 4,00,000 Plant and Machinery -
Reserves and Surplus 6,00,000 and other Fixed Assets
Total Debt: Current Assets:
Current Liabilities - Inventory -
Debtors
-
Cash
-

Solution:
Net worth = Capital + Reserves and surplus
= 4,00,000 + 6,00,000 = ₹10,00,000
Total debt =1
Net worth 2
Total debt = ₹ 5,00,000
Total Liability side = ₹ 4,00,000 + ₹ 6,00,000 + ₹ 5,00,000
= ₹ 15,00,000
= Total Assets
Total Assets Turnover = Sales
Total assets
2= Sales
₹15,00,000
Sales = ₹ 30,00,000
Gross Profit on Sales : 30% i.e. ₹ 9,00,000
Cost of Goods Sold (COGS) = ₹ 30,00,000 – ₹ 9,00,000
= ₹ 21,00,000
Inventory turnover = COGS
Inventory
3 = ₹21,00,000
Inventory
Inventory = ₹ 7,00,000
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Average collection period = Average debtors

Sales/day
40 = Debtors
₹30,00,000/360
Debtors = ₹ 3,33,333.
Acid test ratio = Current Assets - Stock (Quick Asset)
Current liabilities
0.75 = Current Assets - ₹7,00,000
₹5,00,000
Current Assets = ₹10,75,000
Fixed Assets = Total Assets – Current Assets
= ₹ 15,00,000 – ₹ 10,75,000 = ₹ 4,25,000
Cash and Bank balance = Current Assets – Inventory – Debtors
= ₹ 10,75,000 – ₹ 7,00,000 – ₹ 3,33,333 = ₹ 41,667.

Balance Sheet as on March 31, 2016

Liabilities ₹ Assets ₹
Equity Share Capital 4,00,000 Plant and Machinery and other
Reserves & Surplus 6,00,000 Fixed Assets 4,25,000
Total Debt: Current Assets:
Current liabilities 5,00,000 Inventory 7,00,000
Debtors 3,33,333
Cash 41,667
15,00,000 15,00,000

Question-5
MN Limited gives you the following information related for the year ending 31st March, 2016:
(1) Current Ratio 2.5 : 1
(2) Debt-Equity Ratio 1 : 1.5
(3) Return on Total Assets (After Tax) 15%
(4) Total Assets Turnover Ratio 2
(5) Gross Profit Ratio 20%
(6) Stock Turnover Ratio 7
(7) Current Market Price per Equity Share ₹ 16
(8) Net Working Capital ₹ 4,50,000
(9) Fixed Assets ₹ 10,00,000
(10) 60,000 Equity Shares of ₹ 10 each
(11) 20,000, 9% Preference Shares of ₹ 10 each
(12) Opening Stock ₹ 3,80,000
You are required to calculate:
(i) Quick Ratio
(ii) Fixed Assets Turnover Ratio
(iii) Proprietary Ratio
(iv) Earnings per Share
(v) Price-Earning Ratio.

Solution:
(a) Workings Notes:

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

1. Net Working Capital = Current Assets – Current Liabilities

= 2.5 – 1=1.5
Thus, Current Assets = Net Working Capital × 2.5
1.5

= ₹ 4,50,000 × 2.5 = ₹7,50,000

1.5
Current Liabilities = ₹ 7,50,000 – ₹ 4,50,000 = ₹ 3,00,000

2. Sales = Total Assets Turnover × Total Assets

= 2 x (Fixed Assets + Current Assets)
= 2 × (₹ 10,00,000 + ₹ 7,50,000) = ₹ 35,00,000

3. Cost of Goods Sold = 100% – 20%= 80% of Sales

= 80% of ₹ 35,00,000 = ₹ 28,00,000

4. Average Stock = Cost of goods sold

Stock turnover ratio
= ₹28,00,000 = ₹4,00,000
7
Closing Stock = (Average Stock ×2) – Opening Stock
= (₹ 4,00,000 × 2) – ₹ 3,80,000 = ₹ 4,20,000
Quick Assets = Current Assets – Closing Stock
= ₹ 7,50,000 – ₹ 4,20,000 = ₹ 3,30,000
Debt =1 , Or Proprietary fund = 1.5 Debt.
Equity (here Proprietary fund)

Total Asset = Proprietary Fund (Equity) + Debt

Or 17,50,000 = 1.5 Debt + Debt

Or Debt = ₹ 17,50,000 = ₹ 7,00,000

2.5
Proprietary fund = 7,00,000 x 1.5 = ₹ 10,50,000
= ₹17,50,000 x 1.5 = ₹10,50,000
2.5

5. Profit after tax (PAT) = Total Assets × Return on Total Assets

= ₹ 17,50,000 × 15% = ₹ 2,62,500
(i) Calculation of Quick Ratio
Quick Ratio = Quick Assets = ₹3,30,000 =1:1.1
Current Liabilities

(ii) Calculation of Fixed Assets Turnover Ratio

Fixed Assets Turnover Ratio = Sales = ₹35,00,000 = 3.5
Fixed Assets ₹10,00,000

(iii) Calculation of Proprietary Ratio

Proprietary Ratio = Proprietary fund
Total Assets
= ₹10,50,000 = 0.6:1
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

₹17,50,000

(iv) Calculation of Earnings per Equity Share (EPS)

Earnings per Equity Share (EPS) = PAT - Preference Share Dividend
No. of Equity Shares
= ₹ 2,62,500 - ₹ 18,000 (9% of 2,00,000)
60,000
= ₹4.075 per share

(v) Calculation of Price-Earnings Ratio (P/E Ratio)

P/E Ratio = Market Price of Equity Share = ₹16 = 3.926
EPS ₹4.075

Question-6
Using the following data, complete the Balance Sheet given below:
Gross Profit ₹ 54,000
Shareholders’ Funds ₹ 6,00,000
Gross Profit margin 20%
Credit sales to Total sales 80%
Total Assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8
Long-term Debt to Equity 40%
Balance Sheet
Creditors ……………… Cash ………
….. …..
Long-term debt ……………… Debtors …………
….. ..
Shareholders’ funds ……………… Inventory ………
….. …..
Fixed assets ………
…..

Solution:
Gross Profit ₹ 54,000
Gross Profit Margin 20%
Sales = Gross Profit =₹54,000/0.20 = ₹2,70,000
Gross Profit Margin

Credit Sales to Total Sales = 80%

Credit Sales = ₹ 2,70,000×0.80 = ₹ 2,16,000
Total Assets Turnover= 0.3 times
Total assets = Sales
Total Assets Turnover
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

= ₹2,70,000 = ₹9,00,000
0.3
Sales – Gross Profit = COGS
 COGS = ₹ 2, 70,000 – 54,000 = ₹ 2, 16,000
Inventory turnover = 4 times
Inventory = COGS = ₹2,16,000 =₹54,000
Inventory turnover 4
Average Collection Period = 20 days
Debtors turnover = 360 = 360/20 = 18
Average Collection Period
Debtors = Credit Sales = ₹2,16,000 =₹12,000
Debtor turnover 18
Current ratio = 1.8
1.8 = Debtors + Inventory + Cash (Current Assets)
Creditors (Current Liabilities)
1.8 Creditors = (₹ 12,000 + ₹ 54,000 + Cash)
1.8 Creditors = ₹ 66,000 + Cash (i)
Long-term Debt to Equity = 40%
Shareholders’ Funds (Equity)= ₹ 6, 00,000
Long-term Debt = ₹ 6, 00,000 × 40% = ₹ 2, 40,000
Creditors = ₹ 9, 00,000 – (6, 00,000 + 2, 40,000) = ₹ 60,000
Cash = (₹ 60,000×1.8) – ₹ 66,000 = ₹ 42,000 [From equation (i)]

Balance Sheet
Liabilities ₹ Assets ₹
Creditors 60,000 Cash 42,000
Debtors 12,000
Long- term debt 2,40,000 Inventory 54,000
Shareholders’ funds 6,00,000 Fixed Assets (Balancing 7,92,000
figure)
9,00,000 9,00,000

Question-7
MNP Limited has made plans for the next year 2015 -16. It is estimated that the company will
employ total assets of ₹ 25,00,000; 30% of assets being financed by debt at an interest cost of 9%
p.a. The direct costs for the year are estimated at ₹ 15,00,000 and all other operating expenses are
estimated at ₹ 2,40,000. The sales revenue are estimated at ₹ 22,50,000. Tax rate is assumed to be
40%. Required to calculate:
(i) Net profit margin (After tax);
(ii) Return on Assets (After tax);
(iii) Asset turnover; and
(iv) Return on Equity.

Solution:
The net profit is calculated as follows:
₹
Sales Revenue 22,50,000
Less: Direct Costs 15,00,000
Gross Profits 7,50,000

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Less: Operating Expense 2,40,000

Earnings before Interest and tax( EBIT) 5,10,000
Less: Interest on debt [9% × 7,50,000 (i.e. 30 % of 67,500
25,00,000 )]
Earnings before Tax)(EBT) 4,42,500
Less: Taxes (@ 40%) 1,77,000
Profit after Tax (PAT) 2,65,500
(i) Net Profit Margin (After Tax)
Net Profit Margin = EBIT (1 - t) ×100 = ₹ 5,10,000×(1-0.4) = 13.6%
Sales ₹22,50,000

(ii) Return on Assets (ROA)( After tax)

ROA = EBIT (1-t)
Total Assets

= ₹5,10,000 (1-0.4) = ₹3,06,000

₹25,00,000 ₹25,00,000
= 0.1224 = 12.24 %

(iii) Asset Turnover

Asset Turnover = Sales = ₹22,50,000 = 0.9
Assets ₹25,00,000
Asset Turnover = 0.9

(iv) Return on Equity (ROE)

ROE = PAT = ₹2,65,500 = 15.17%
Equity ₹17,50,000
ROE = 15.17%

Question-8
The following accounting information and financial ratios of M Limited relate to the year ended
31st March, 2016 :
Inventory Turnover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4
Gross Profit Ratio 25%

Total sales ₹ 30,00,000; cash sales 25% of credit sales; cash purchases ₹ 2,30,000; working capital
₹ 2,80,000; closing inventory is ₹ 80,000 more than opening inventory.
You are required to calculate:
(i) Average Inventory
(ii) Purchases
(iii) Average Debtors
(iv) Average Creditors
(v) Average Payment Period
(vi) Average Collection Period
(vii) Current Assets
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

(viii) Current Liabilities.

Solution:
(i) Computation of Average Inventory
Gross Profit = 25% of ₹ 30, 00,000= ₹ 7,50,000
Cost of goods sold (COGS) = Sales - Gross Profit = ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000
Inventory Turnover Ratio = COGS
Average Inventory

6 = ₹22,50,000
Average Inventory
Average inventory = ₹ 3,75,000

(ii) Computation of Purchases

Purchases = COGS + (Closing Stock – Opening Stock) = ₹ 22,50,000 + 80,000*
Purchases = ₹ 23,30,000
* Increase in Stock = Closing Stock – Opening Stock = ₹ 80,000

(iii) Computation of Average Debtors

Let Credit Sales be ₹ 100, Cash sales = 25 x 100 =₹25
100
Total Sales = 100 + 25= ₹ 125
Total sales is ₹ 125 credit sales is ₹ 100
If total sales is ₹ 30,00,000, then credit sales is = ₹3,00,000 x 100
125
Credit Sales = ₹ 24,00,000
Cash Sales = (₹ 30,00,000 – ₹ 24,00,000) = ₹ 6,00,000
Debtors Turnover Ratio = Net Credit Sales = 8 = ₹ 24,00,000 = 8
Average debtors Average debtors
Average debtors = ₹24,00,000/8
Average debtors = ₹3,00,000

(iv) Computation of Average Creditors

Credit Purchases = Purchases – Cash Purchases
= ₹ 23,30,000 – ₹ 2,30,000 = ₹ 21,00,000
Creditors Turnover Ratio = Credit Purchases
Avg. creditor
10 = 21,00,000
Avg. creditor
Average Creditors = ₹ 2,10,000

(v) Computation of Average Payment Period

Average Payment Period = Average Creditors
Average Daily Credit Purchases
= ₹2,10,000 = ₹2,10,000
Credit Purchases ₹21,00,000
365 365
= ₹2,10,000 x 365 = 36.5 days
₹21,00,000
Alternatively,
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Average Payment Period = 365/Creditors Turnover Ratio

= 365* = 36.5 days
10

(vi) Computation of Average Collection Period

Average Collection Period = Average Debtors × 365 * = ₹3,00,000 x 365 = 45.625 days
Net Credit Sales ₹24,00,000
Alternatively
Average collection period = 365*
Debtors Turnover Ratio
= 365 = 45.625 days
8
* 1 year is taken as 365 days.

(vii) Computation of Current Assets

Current Ratio = Current Assets = 2.4
Current Liabilities
2.4 Current Liabilities= Current Assets or CL = CA/2.4
Further, Working capital = Current Assets – Current liabilities
So, ₹ 2,80,000 = CA-CA/2.4
₹ 2,80,000 = 1.4 CA/2.4 Or, 1.4 CA = ₹ 16,72,000
CA = ₹ 4,80,000

(viii) Computation of Current Liabilities

Current liabilities = 4,80,000 = ₹2,00,000
2.4

Question-9
The assets of SONA Ltd. consist of fixed assets and current assets, while its current liabilities
comprise bank credit in the ratio of 2 : 1. You are required to prepare the Balance Sheet of the
company as on 31st March 2016 with the help of following information:
Share Capital ₹ 5,75,000
Working Capital (CA-CL) ₹ 1,50,000
Gross Margin 25%
Inventory Turnover 5 times
Average Collection Period 1.5 months
Current Ratio 1.5:1
Quick Ratio 0.8: 1
Reserves & Surplus to Bank & Cash 4 times
Assume 360 days in a year

Solution:
Working Notes:
1. Computation of Current Assets (CA) and Current Liabilities (CL)
Current Ratio = Current Assets
Current Liabilities
CA = 1.5
CL 1
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

CA = 1.5 CL
CA - CL = ₹ 1,50,000
1.5 CL- CL = ₹ 1,50,000
0.5 CL = ₹ 1,50,000
CL = 1,50,000/0.5 = ₹3,00,000
CA = 1.5 x 3,00,000 = ₹ 4,50,000

2. Computation of Bank Credit (BC) and Other Current Liabilities (OCL)

Bank Credit = 2
Other CL 1
BC = 2 OCL
BC + OCL = CL
2 OCL + OCL = ₹ 3,00,000
3 OCL = ₹ 3,00,000
OCL = ₹ 1,00,000
Bank Credit = 2 × 1,00,000 = ₹ 2,00,000
3. Computation of Inventory
Quick Ratio = Quick Assets
Current Liabilities
= Current Assets – Inventories
Current Liabilities
0.8 = ₹4,50,000 – Inventories
₹3,00,000
0.8 × ₹ 3,00,000 = ₹ 4,50,000 – Inventories
Inventories = ₹ 4,50,000 – ₹ 2,40,000 = ₹ 2,10,000
4. Computation of Debtors
Inventory Turnover = 5 times
Average Inventory = Cost of goods sold (COGS)
Inventory Turnover
COGS = ₹ 2,10,000 × 5 = ₹ 10,50,000
Average Collection Period (ACP) = 1.5 months = 45 days
Debtor Turnover = 360 = 360 = 8
ACP 45
Gross Margin = Sales - COGS ×100 = 25%
Sales
Sales-COGS = 25 x sales
100
Sales – 0.25 Sales = COGS
0.75 Sales = ₹ 10,50,000
Sales = ₹10,50,000/0.75 =₹ 14,00,000
Debtors = Sales
Debtor turnover
= ₹14,00,000 = ₹1,75,000
8
5. Computation of Bank and Cash

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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Bank & Cash = CA - (Debtors + Inventory)

= ₹ 4,50,000 - (₹ 1,75,000 + 2,10,000)= ₹ 4,50,000 - 3,85,000 = ₹ 65,000
6. Computation of Reserves & Surplus
Reserves & Surplus = 4
Bank & Cash
Reserves & Surplus = 4 × ₹ 65,000 = ₹ 2,60,000
Balance Sheet of SONA Ltd. as on March 31, 2016
Liabilities ₹ Assets ₹
Share Capital 5,75,000 Fixed Assets 6,85,000
Reserves & Surplus 2,60,000 Current Assets:
Current Liabilities: Inventories 2,10,000
2,00,000 Debtors 1,75,000
Bank Credit
Other Current Liabilities 1,00,000 Bank & Cash 65,000
11,35,000 11,35,000
Question-10
NOOR Limited provides the following information for the year ending 31st March, 2014:
Equity Share Capital ₹ 25,00,000
Closing Stock ₹ 6,00,000
Stock Turnover Ratio 5 times
Gross Profit Ratio 25%
Net Profit / Sale 20%
Net Profit / Capital 1
4
You are required to prepare:
Trading and Profit & Loss Account for the year ending 31st March, 2014.

Solution:
Working Notes:
(i) Net Profit =1
Capital 4
Net Profit =1
25,00,000 4
Net Profit = 6,25,000

(ii) Net Profit/Sales = 20%

Sales = 6,25,000/0.20 = 31,25,000

(iii) Gross Profit Ratio = Gross Profit × 100

Sales
25 = Gross Profit x 100
31,25,000
Gross Profit = 31,25,000 × 25
100
= 7,81,250
(iv) Stock turnover = COGS
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Financial Analysis & Planning - Ratio Analysis By: CA PRAKASH PATEL

Average stock
= 31,25,000 – 7,81,250
Average stock
Average Stock = 23,43,750/5 = 4,68,750

(v) Average Stock = Closing Stock + Opening Stock

2
4,68,750 = 6,00,000 + Opening Stock
2
Opening Stock = 9,37,500 – 6,00,000 = 3,37,500

Trading A/c for the year ending 31st March, 2014

₹ ₹
To Opening Stock 3,37,500 By Sales 31,25,000

To Purchases (Balancing 26,06,250 By Closing Stock 6,00,000

figure)
To Gross Profit c/f to P&L A/c 7,81,250 -
37,25,000 37,25,000

Profit & Loss A/c for the year ending 31st March, 2014
₹ ₹
To Miscellaneous Expenses 1,56,250 By Gross Profit b/f 7,81,250
(balancing figure) from Trading A/c
To Net Profit 6,25,000 -
7,81,250 7,81,250

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Chapter- 2: Financial Decisions

Unit- I Leverage
A. QUESTION FROM STUDY MATERIAL
ILLUSTRATION 1
A Company produces and sells 10,000 shirts. The selling price per shirt is ₹ 500. Variable cost is ₹
200 per shirt and fixed operating cost is ₹ 25,00,000.
(a) CALCULATE operating leverage.
(b) If sales are up by 10%, then COMPUTE the impact on EBIT?
Hints:
(a) 6 times
(b) 60%
ILLUSTRATION 2
CALCULATE the operating leverage for each of the four firms A, B, C and D from the following
price and cost data:
Firms
Particulars
A (₹) B(₹) C(₹) D(₹)
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of operating
leverage result? Explain. Assume number of units sold is 5,000.
Hints:
DOL(A) = 7 times
DOL(B) = 2 times
DOL(C) = 3 times
DOL(D) = 1 times
ILLUSTRATION 3
A firm’s details are as under:
Sales (@100 per unit) ₹ 24,00,000
Variable Cost 50%
Fixed Cost ₹ 10,00,000
It has borrowed ₹ 10,00,000 @ 10% p.a. and its equity share capital is ₹ 10,00,000 (₹ 100 each)
CALCULATE:
(a) Operating Leverage
(b) Financial Leverage
(c) Combined Leverage
(d) Return on Investment
(e) If the sales increases by ₹ 6,00,000; what will the new EBIT?
Hints:
(a) 6 times
(b) 2 times

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

(c) 12 times.
(d) 5%
(e) ₹5,00,000
ILLUSTRATION 4
The following information is related to Yizi Company Ltd. for the year ended 31st March, 2021:
Equity share capital (of ₹ 10 each) ₹ 50 lakhs
12% Bonds of ₹ 1,000 each ₹ 37 lakhs
Sales ₹ 84 lakhs
Fixed cost (excluding interest) ₹ 6.96 lakhs
Financial leverage 1.49
Profit-volume Ratio 27.55%
Income Tax Applicable 40%
You are required to CALCULATE:
(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations up-to two decimal points.
Hints:
(i) Operating Leverage: 1.43
(ii) Combined leverage: ₹88,160
(iii) Earnings per share: ₹1.30

ILLUSTRATION 5
Following are the selected financial information of A Ltd. and B Ltd. for the year ended March
31st, 2021:

A Ltd. B Ltd.
Variable Cost Ratio 60% 50%
Interest ₹ 20,000 ₹ 1,00,000
Operating Leverage 5 2
Financial Leverage 3 2
Tax Rate 30% 30%
You are required to FIND out:
(i) EBIT
(ii) Sales
(iii) Fixed Cost
(iv) Identify the company which is better placed with reasons based on leverages.
Hints:
Company A (₹) Company B (₹)
Sales 3,75,000 8,00,000
Fixed Cost 1,20,000 2,00,000
Earnings before interest and tax(EBIT) 30,000 2,00,000
Comment based on leverage – Company B is better than company A

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

TEST YOUR KNOWLEDGE

Question-1
The Sale revenue of TM excellence Ltd. @ Rs.20 Per unit of output is Rs.20 lakhs and Contribution
is Rs.10 lakhs. At the present level of output the DOL of the company is 2.5. The company does
not have any Preference Shares. The number of Equity Shares are 1 lakh. Applicable corporate
Income Tax rate is 50% and the rate of interest on Debt Capital is 16% p.a. What is the EPS (At
sales revenue of ₹ 20 lakhs) and amount of Debt Capital of the company if a 25% decline in Sales
will wipe out EPS.
Hints:
EPS = ₹1.25, Debt = ₹9,37,500

Question-2
Betatronics Ltd. has the following balance sheet and income statement information:

Balance Sheet as on March 31st 2019

Liabilities ₹ Assets ₹
Equity capital (₹ 10 per share) 8,00,000 Net fixed assets 10,00,000
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000
Income Statement for the year ending March 31st 2019
Particulars ₹
Sales 3,40,000
Operating expenses (including ₹ 60,000 depreciation) (1,20,000)
EBIT 2,20,000
Less: Interest (60,000)
Earnings before tax 1,60,000
Less: Tax (56,000)
Net Earnings (EAT) 1,04,000
(a) DETERMINE the degree of operating, financial and combined leverages at the current sales
level, if all operating expenses, other than depreciation, are variable costs.
(b) If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease
by 20 percent, COMPUTE the earnings per share at the new sales level?
Hints:
(a) 1.27, 1.38, 1.75
(b) ₹1.76, ₹0.85

Question-3
A company had the following Balance Sheet as on 31stMarch, 2019:

Liabilities (₹in crores) Assets (₹ in crores)

Equity Share Capital (50 lakhs 5 Fixed Assets (Net) 12.5

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

shares of ₹ 10 each)
Reserves and Surplus 1
15% Debentures 10
Current Assets 7.5
Current Liabilities 4
20 20
The additional information given is as under:
Fixed cost per annum (excluding interest) ₹ 4 Crores
Variable operating cost ratio 65%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:
CALCULATE the following and comment:
(i) Earnings Per Share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
Hints:
(i) ₹16.8
(ii) 1.296 times
(iii) 1.125 times
(iv) 1.458 times

Question- 4
CALCULATE the operating leverage, financial leverage and combined leverage from the following
data under Situation I and II and Financial Plan A and B:

Installed Capacity 4,000 units

Actual Production and Sales 75% of the Capacity
Selling Price ₹ 30 Per Unit
Variable Cost ₹ 15 Per Unit
Fixed Cost:
Under Situation I ₹ 15,000
Under Situation-II ₹20,000
Capital Structure:
Financial Plan
A (₹) B (₹)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
Hints:
I II
OL 1.5 1.8
FL 1.07, 1.034 1.09, 1.04
CL 1.61, 1.55 1.96, 1.872

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Question- 5
From the following information extracted from the books of accounts of Imax Ltd., CALCULATE
percentage change in earnings per share, if sales increase by 10% and Fixed Operating cost is ₹
1,57,500.
Particulars Amount in (₹)
EBIT (Earnings before Interest and Tax) 31,50,000
Earnings before Tax (EBT) 14,00,000
Hints: % change in EPS = 23.625%
Question- 6
Consider the following information for Mega Ltd.:
Production level 2,500 units
Contribution per unit ₹ 150
Operating leverage 6
Combined leverage 24
Tax rate 30%
Required:
Compute its earnings after tax.
Hints: Earnings after Tax (EAT) = ₹ 10,938
Question- 7
From the following information, prepare Income Statement of Company A & B:
Particulars Company A Company B
Margin of safety 0.20 0.25
Interest ₹ 3,000 ₹ 2,000
Profit volume ratio 25% 33.33%
Financial Leverage 4 3
Tax rate 45% 45%
Hints:
Particulars Company A (₹) Company B (₹)
Sales 80,000 36,000
Less: Variable Cost 60,000 24,000
Contribution 20,000 12,000
Less: Fixed Cost 16,000 9,000
EBIT 4,000 3,000
Less: Interest 3,000 2,000
EBT 1,000 1,000
Tax (45%) 450 450
EAT 550 550

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Question- 8
The capital structure of PS Ltd. for the year ended 31st March 2021 consisted as follows:
Particulars Amount in (₹)
Equity share capital (face value ₹ 100 each) 10,00,000
10% debentures (₹ 100 each) 10,00,000
During the year 2020-21, sales decreased to 1,00,000 units as compared to 1,20,000
units in the previous year. However, the selling price stood at ₹ 12 per unit and variable
cost at ₹ 8 per unit for both the years. The fixed expenses were at ₹ 2,00,000 p.a. and
the income tax rate is 30%.
You are required to CALCULATE the following:
(i) The degree of financial leverage at 1,20,000 units and 1,00,000 units.
(ii) The degree of operating leverage at 1,20,000 units and 1,00,000 units.
(iii) The percentage change in EPS.
Hints:
Particulars (₹) (₹)
Sales in units 1,20,000 1,00,000
(i) Financial Leverage ₹ 2,80,000 ₹ 2,00,000
= =
EBIT ₹1,80,000 ₹1,00,000
=
EBT = 1.56 =2
(ii) Operating leverage ₹ 4,80,000 ₹ 4,00,000
= =
Contribution ₹ 2,80,000 ₹ 2,00,000
=
EBIT = 1.71 =2
(iii) Earnings per share (EPS) ₹ 1, 26, 000 ₹ 70, 000
= =
PAT 10, 000 10, 000
=
No. of shares = ₹ 12.6 =₹7
Decrease in EPS = ₹ 12.6 – ₹ 7 = ₹ 5.6
5.6
% decrease in EPS = x 100
12.6
= 44.44%

Question- 9
The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is
given:
Output 1,00,000 units at normal capacity

Selling price per unit ₹ 40

Variable cost per unit ₹ 20

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Fixed cost ₹ 10,00,000

The capital structure of the company as on 31st March, 2021 is as follows:

Particulars ₹
Equity share capital (1,00,000 shares of ₹ 10 each) 10,00,000
Reserves and surplus 5,00,000
7% debentures 10,00,000
Current liabilities 5,00,000
Total 30,00,000

Navya Ltd. has decided to undertake an expansion project to use the market potential,
that will involve ₹ 10 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 10%.
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 programme are
planned:
(i) Entirely by equity shares of ₹ 10 each at par.
(ii) ₹ 5 lakh by issue of equity shares of ₹ 10 each and the balance by issue of 6%
debentures of ₹ 100 each at par.
(iii) Entirely by 6% debentures of ₹ 100 each at par.
FIND out which of the above-mentioned alternatives would you recommend for Navya
Ltd. with reference to the risk and return involved, assuming a corporate tax of 40%.
Hints:
From the above figures, we can see that the Operating Leverage is same in all
alternatives though Financial Leverage differs. Alternative (iii) uses the maximum
amount of debt and result into the highest degree of financial leverage, followed by
alternative (ii). Accordingly, risk of the company will be maximum in these options.
Corresponding to this scheme, however, maximum EPS (i.e., ₹ 10.02 per share) will
be also in option (iii).
So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is
strongly recommended. In case of opting for less risk, alternative (ii) is the next best
option with a reduced EPS of ₹ 6.80 per share. In case of alternative (i), EPS is even
lower than the existing option, hence not recommended.

Question- 10
The following details of a company for the year ended 31st March, 2021 are given
below:
Operating leverage 2:1

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Combined leverage 2.5:1

Fixed Cost excluding interest ₹ 3.4 lakhs
Sales ₹ 50 lakhs
8% Debentures of ₹ 100 each ₹ 30.25 lakhs
Equity Share Capital of ₹ 10 each 34 lakhs
Income Tax Rate 30%
CALCULATE:
(i) Financial Leverage
(ii) P/V ratio and Earning per Share (EPS)
(iii) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or
low assets turnover?
(iv) At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?
Hints:
(i) Financial Leverage: 1.25
(ii) P/V ratio and Earning per Share (EPS): ₹0.202
(iii) 0.78 < 1.5 means lower than industry turnover.
(iv) ₹ 42,79,412
Question- 11
You are given the following information of 5 firms of the same industry:
Name of the Change in Change in Change in
Firm Revenue Operating Income Earning per
share
M 28% 26% 32%
N 27% 34% 26%
P 25% 38% 23%
Q 23% 43% 27%
R 25% 40% 28%
You are required to CALCULATE for all firms:
(i) Degree of operating leverage and
(ii) Degree of combined leverage.
Hints:
Firm Degree of OperatingLeverage (DOL) Degree of CombinedLeverage (DCL)
% change in Operating Income % change in EPS
= =
% change in Revenue % change in Revenue

26% 32%
M = 0.929 = 1.143
28% 28%
34% 26%
N = 1.259 = 0.963
27% 27%

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

38% 23%
P = 1.520 = 0.920
25% 25%
43% 27%
Q = 1.870 = 1.174
23% 23%
40% 28%
R = 1.60 = 1.120
25% 25%

B. PAST YEAR QUESTION

May 23 Q-1(d) (05 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.
Solution:
1. Operating Leverage (OL) = Contribution / EBIT Or,
3.125 = ₹4,25,000/EBIT Or,
EBIT = ₹1,36,000

2. Degree of Combined Leverage (CL) = % Change in EPS = 100 = 2.5

% Change in Sales 40
3. Combined Leverage = OL × FL = 3.125 × FL
So, Financial Leverage = 2.5 /3.125 = 0.8

4. Financial Leverage = EBIT = 1,36,000 = 0.8

EBT EBT
So, EBT = 1,36,000 = ₹1,70,000
0.80

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
Number of equity shares 2,500
EPS 28

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Nov 22 Q-2 (10 Marks)

The following information is available for SS Ltd.
Profit volume (PV) ratio 30%
Operating leverage 2.00
Financial leverage 1.50
Loan ₹ 1,25,000
Post-tax interest rate 5.6%
Tax rate 30%
Market Price per share (MPS) ₹ 140
Price Earnings Ratio (PER) 10
You are required to:

(1) Prepare the Profit-Loss statement of SS Ltd. and

(2) Find out the number of equity shares.
Solution:
Preparation of Profit – Loss Statement
Working Notes:
1. Post tax interest 5.60%
Tax rate 30%
Pre tax interest rate = (5.6/70) x 100 8%
Loan amount ₹ 1,25,000
Interest amount = 1,25,000 x 8% ₹ 10,000
Financial Leverage (FL) = (EBIT/EBT)
= (EBTIT/ EBIT – Interest)
= (EBIT / EBIT – 10,000)
1.5 EBIT -15000 = EBIT
1.5 EBIT – EBIT = 15,000
0.5 EBIT = 15,000
EBIT = ₹ 30,000
EBT = EBIT – Interest = 30,000 – 10,000 = ₹ 20,000

2. Operating Leverage (OL) = Contribution/EBIT

2 = Contribution/EBIT
Contribution = ₹ 60,000
3. Fixed cost = Contribution – Profit
= 60,000 – 30,000 = ₹ 30,000
4. Sales = Contribution/PV Ratio
= 60,000/30% = ₹ 2,00,000
5. If PV ratio is 30%, then the variable cost is 70% on sales.
Variable cost = 2,00,000 x 70% = ₹ 1,40,000

Profit – Loss Statement

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Particulars ₹
Sales 2,00,000
Less: Variable cost 1,40,000
Contribution 60000
Less: Fixed cost 30,000
EBIT 30,000
Less: Interest 10,000
EBT 20,000
Less: Tax @ 30% 6,000
EAT 14,000

(2) Calculation of no. of Equity shares

Market Price per Share (MPS) = ₹140
Price Earnings Ratio (PER) = 10 WKT,
EPS = MPS = 140 = ₹14
PER 10
Total earnings (EAT) = ₹ 14,000
No. of Equity Shares = 14,000 / 14 = 1000

May 22 Q-2 (10 Marks)

Details of a company for the year ended 31st March, 2022 are given below:
Sales ₹ 86 lakhs
Profit Volume (P/V) Ratio 35%
Fixed Cost excluding interest expenses ₹ 10 lakhs
10% Debt ₹ 55 lakhs
Equity Share Capital of ₹ 10 each ₹ 75 lakhs
Income Tax Rate 40%

Required:
(i) Determine company's Return on Capital Employed (Pre-tax) and EPS.
(ii) Does the company have a favourable financial leverage?
(iii) Calculate operating and combined leverages of the company.
(iv) Calculate percentage change in EBIT, if sales increases by 10%.
(v)At what level of sales, the Earning before Tax (EBT) of the company will be equal to zero?
Solution:
Income Statement
Particulars Amount (₹)
Sales 86,00,000
Less: Variable cost (65% of 86,00,000) 55,90,000
Contribution (35% of 86,00,000) 30,10,000
Less: Fixed costs 10,00,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Earnings before interest and tax (EBIT) 20,10,000

Less: Interest on debt (@ 10% on ₹ 55 lakhs) 5,50,000
Earnings before tax (EBT) 14,60,000
Tax (40%) 5,84,000
PAT 8,76,000

(i) ROCE (Pre-tax) = EBIT x 100 = EBIT x 100

Capital employed Equity + Debt
₹ 20,10,000 ×100 = 15.46%
₹ (75,00,000+55,00,000)
EPS (PAT/No. of equity shares) 1.168 or ₹ 1.17

(ii) ROCE is 15.46% and Interest on debt is 10%. Hence, it has a favourable financial
leverage.
(iii) Calculation of Operating, Financial and Combined leverages:
Operating Leverage = Contribution = ₹30,10,000 = 1.497 (approx.)
EBIT ₹ 20,10,000
Financial Leverage = EBIT = ₹ 20,10,000 = 1.377 (approx.)
EBT ₹ 14,60,000
Combined Leverage = Contribution = ₹ 30,10,000 = 2.062 (approx.)
EBT ₹ 14,60,000
Or, = Operating Leverage × Financial Leverage = 1.497 × 1.377 = 2.06 (approx.)

(iv) Operating leverage is 1.497. So, if sales are increased by 10%.

EBIT will be increased by 1.497 × 10% i.e. 14.97% (approx.)

(v) Since the combined Leverage is 2.062, sales have to drop by 100/2.062 i.e.
48.50% to bring EBT to Zero.
Accordingly, New Sales = ₹ 86,00,000 × (1 - 0.4850)
= ₹ 86,00,000 × 0.515
= ₹ 44,29,000 (approx.)
Hence, at ₹ 44,29,000 sales level, EBT of the firm will be equal to Zero.

Dec 21 Q-5 (10 Marks)

Information of A Ltd. is given below:
• Earnings after tax: 5% on sales
• Income tax rate: 50%
• Degree of Operating Leverage: 4 times
• 10% Debenture in capital structure: ₹ 3 lakhs
• Variable costs: ₹ 6 lakhs
Required:
(i) From the given data complete following statement:
Sales XXXX

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Less: Variable costs ₹ 6,00,000

Contribution XXXX
Less: Fixed costs XXXX
EBIT XXXX
Less: Interest expenses XXXX
EBT XXXX
Less: Income tax XXXX
EAT XXXX
(ii) Calculate Financial Leverage and Combined Leverage.
(iii) Calculate the percentage change in earning per share, if sales increased by 5%.
Solution:
(i) Working Notes
Earning after tax (EAT) is 5% of sales Income tax is 50%
So, EBT is 10% of Sales
Since Interest Expenses is ₹ 30,000
EBIT = 10% of Sales + ₹30,000 (Equation i)
Now Degree of operating leverage = 4
So, Contribution/EBIT = 4
Or, Contribution = 4 EBIT
Or, Sales – Variable Cost = 4 EBIT
Or, Sales – ₹ 6,00,000 = 4 EBIT (Equation ii)
Replacing the value of EBIT of equation (i) in Equation (ii)
We get, Sales – ₹ 6,00,000 = 4 (10% of Sales + ₹ 30,000)
Or, Sales – ₹ 6,00,000 = 40% of Sales + ₹ 1,20,000
Or, 60% of Sales = ₹ 7,20,000
So, Sales = ₹7,20,000/60% = ₹12,00,000
Contribution = Sales – Variable Cost = ₹ 12,00,000 – ₹ 6,00,000 =₹ 6,00,000
EBIT = ₹6,00,000/4 = ₹1,50,000
Fixed Cost = Contribution – EBIT = ₹ 6,00,000 – ₹ 1,50,000 = ₹ 4,50,000
EBT = EBIT – Interest = ₹ 1,50,000 – ₹ 30,000 = ₹ 1,20,000
EAT = 50% of ₹ 1,20,000 = ₹ 60,000

Income Statement
Particulars (₹)
Sales 12,00,000
Less: Variable cost 6,00,000
Contribution 6,00,000
Less: Fixed cost 4,50,000
EBIT 1,50,000
Less: Interest 30,000
EBT 1,20,000
Less: Tax (50%) 60,000
EAT 60,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

(ii) Financial Leverage= EBIT/EBT = 1,50,000/1,20,000 = 1.25 times

Combined Leverage = Operating Leverage × Financial Leverage
= 4x1.25 = 5 times
Or,
Combined Leverage = Contribution/EBIT × EBIT/EBT
Combined Leverage = Contribution/EBT = ₹ 6,00,000/₹1,20,000 = 5 times

(iii) Percentage Change in Earnings per share

Combined Leverage = % Change in EPS = 5 = % change in EPS
% change in Sales 5%
% Change in EPS = 25%
Hence, if sales increased by 5 %, EPS will be increased by 25 %.

Jan 21 Q-2 (10 Marks)

The information related to XYZ Company Ltd. for the year ended 31st March, 2020

Equity Share Capital of ₹ 100 each ₹ 50 Lakhs

12% Bonds of ₹ 1000 each ₹ 30 Lakhs
Sales ₹ 84 Lakhs
Fixed Cost (Excluding Interest) ₹ 7.5 Lakhs
Financial Leverage 1.39
Profit-Volume Ratio 25%
Market Price per Equity Share ₹ 200
Income Tax Rate Applicable 30%
You are required to compute the
following:
(i) Operating Leverage
(ii) Combined Leverage
(iii) Earning per share
(iv) Earning Yield

Solution:
Workings:

1. Profit Volume Ratio = Contribution x 100

Sales
So, 25 = Contribution x 100
₹ 84,00,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

are as follows:
Contribution = ₹84,00,000 x 25 = ₹21,00,000
100

2. Financial leverage = EBIT

EBT
Or, 1.39 = ₹13,50,000 (as calculated above)
EBT
EBT = ₹ 9,71,223

3. Income Statement
Particulars (₹)
Sales 84,00,000
Less: Variable Cost (Sales - Contribution) (63,00,000)
Contribution 21,00,000
Less: Fixed Cost (7,50,000)
EBIT 13,50,000
Less: Interest (EBIT - EBT) (3,78,777)
EBT 9,71,223
Less: Tax @ 30% (2,91,367)
Profit after Tax (PAT) 6,79,856

(i) Operating Leverage = Contribution

Earnings before interest and tax (EBIT)
= ₹21,00,000 = 1.556 (approx.)
₹13,50,000

(ii) Combined Leverage = Operating Leverage x Financial Leverage

= 1.556 x 1.39 = 2.163 (approx.)
Or, Contribution = ₹21,00,000 = 2.162 (approx.)
EBT 9,71,223

(iii) Earnings per Share (EPS)

EPS = PAT = ₹6,79,856 = ₹13.597
No. of shares 50,000

(iv) Earning Yield

= EPS x 100 = ₹13.597 x 100 = 6.80% (approx.)
Market Price ₹200

Note: The question has been solved considering Financial Leverage given in the question as the

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

base for calculating total interest expense including the interest of 12% Bonds of ₹ 30 Lakhs. The
question can also be solved in other alternative ways.

Nov 20 Q-5 (10 Marks)

The following data is available for Stone Ltd. :

(₹)
Sales 5,00,000
(-) Variable cost @ 40% 2,00,000
Contribution 3,00,000
(-) Fixed cost 2,00,000
EBIT 1,00,000
(-) Interest 25,000
Profit before tax 75,000

Using the concept of leverage, find out

(i) The percentage change in taxable income if EBIT increases by 10%.
(ii) The percentage change in EBIT if sales increases by 10%.
(iii) The percentage change in taxable income if sales increases by 10%.
Also verify the results in each of the above case.

Solution:
(i) Degree of Financial Leverage = EBIT = ₹1,00,000 = 1.333 times
EBT 75,000
So, If EBIT increases by 10% then Taxable Income (EBT) will be increased by 1.333 × 10
= 13.33% (approx.)

Verification

Particulars Amount (₹)

New EBIT after 10% increase (₹ 1,00,000 + 10%) 1,10,000
Less: Interest 25,000
Earnings before Tax after change (EBT) 85,000

Increase in Earnings before Tax = ₹ 85,000 - ₹ 75,000 = ₹ 10,000

So, percentage change in Taxable Income (EBT) = ₹10,000 x 100 = 13.33% hence verified
75,000

(ii) Degree of Operating Leverage = Contribution = ₹ 3,00,000 = 3 times

EBIT ₹ 1,00,000
So, if sale is increased by 10% then EBIT will be increased by 3 × 10 = 30%

Verification

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Particulars Amount (₹)

New Sales after 10% increase (₹ 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ₹ 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax after change (EBIT) 1,30,000

Increase in Earnings before interest and tax (EBIT) = ₹ 1,30,000 - ₹ 1,00,000 = ₹ 30,000
So, percentage change in EBIT = ₹ 30,000 x 100 = 30% hence verified.
₹ 1,00,000

(iii) Degree of Combined Leverage = Contribution = ₹ 3,00,000 = 4 times

EBT 75,000
So, if sale is increased by 10% then Taxable Income (EBT) will be increased by 4 × 10
= 40%

Verification
Particulars Amount (₹)
New Sales after 10% increase (₹ 5,00,000 + 10%) 5,50,000
Less: Variable cost (40% of ₹ 5,50,000) 2,20,000
Contribution 3,30,000
Less: Fixed costs 2,00,000
Earnings before interest and tax (EBIT) 1,30,000
Less: Interest 25,000
Earnings before tax after change (EBT) 1,05,000

Increase in Earnings before tax (EBT) = ₹ 1,05,000 - ₹ 75,000 = ₹ 30,000

₹30,000
So, percentage change in Taxable Income (EBT) = ₹30,000 x 100 = 40% hence verified
75,000
Nov 19 Q-2 (10 Marks)
The Balance Sheet of Gitashree Ltd. is given below:
Liabilities (₹ )
Shareholders’ fund
Equity share capital of ₹ 10 each ₹ 1,80,000
Retained earnings ₹ 60,000 2,40,000
Non-current liabilities 10% debt 2,40,000
Current liabilities 1,20,000
6,00,000
Assets
Fixed Assets 4,50,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Current Assets 1,50,000

6,00,000
The company's total asset turnover ratio is 4. Its fixed operating cost is ₹ 2,00,000 and its variable
operating cost ratio is 60%. The income tax rate is 30%.
Calculate:
(i) (a) Degree of Operating leverage.
(b) Degree of Financial leverage.
(c) Degree of Combined leverage.
(ii) Find out EBIT if EPS is (a) ₹ 1 (b) ₹ 2 and (c) ₹ 0.

Solution:
Working Note:
Total Assets = ₹6,00,000
Total Asset Turnover Ratio i.e. = Total Sales =4
Total Assets
Hence, Total Sales = ₹6,00,000 x 4 = ₹24,00,000

Computation of Profits after Tax (PAT)

Particulars (₹)
Sales 24,00,000
Less: Variable operating cost @ 60% 14,40,000
Contribution 9,60,000
Less: Fixed operating cost (other than Interest) 2,00,000
EBIT (Earning before interest and tax) 7,60,000
Less: Interest on debt (10% 2,40,000) 24,000
EBT (Earning before tax) 7,36,000
Less: Tax 30% 2,20,800
EAT (Earning after tax) 5,15,200

i. (a) Degree of Operating Leverage

Degree of Operating leverage = Contribution = ₹9,60,000 = 1.263 (approx.)
EBIT ₹7,60,000
(b) Degree of Financial Leverage
Degree of Financial leverage = EBIT = ₹7,60,000 = 1.033 (approx.)
EBT ₹7,36,000
(c) Degree of Combined Leverage
Degree of Combined leverage = OL x FL = ₹9,60,000 = 1.304 (approx.)
₹7,60,000
Or,
= 1.263 x 1.033 = 1.304 (approx.)
ii. (a) If EPS is Re. 1
EPS = (EBIT – Interest) (1-tax)
No. of Equity Share

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Or, 1 = (EBIT - ₹24,000) (1-0.3)

18,000
Or, EBIT = ₹49,714 (approx.)

(b) If EPS is ₹ 2
2 = (EBIT - ₹24,000) (1-0.3)
18,000
Or, EBIT = ₹75,429 (approx.)

(c) If EPS is ₹ 0
0 = (EBIT - ₹24,000) (1-0.3)
18,000
Or, EBIT = ₹24,000 (approx.)
Alternatively, if EPS is 0 (zero), EBIT will be equal to interest on debt i.e. ₹ 24,000.
May 19 Q-4 (10 Marks)
The capital structure of the Shiva Ltd. consists of equity share capital of ₹ 20,00,000 (Share of
₹ 100 per value) and ₹ 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to
2,40,000 units, the selling price is ₹ 10 per unit; variable costs amount to ₹ 6 per unit and fixed
expenses amount to ₹ 4,00,000. The income tax rate is assumed to be 50%.

(a) You are required to calculate the following:

(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.

(b) Comment on the behaviour of operating and Financial leverages in relation to increase in
production from 2,00,000 units to 2,40,000 units.
Solution:
(a)
2,00,000 2,40,000
Sales in units
(₹) (₹)
Sales Value @ ₹ 10 Per Unit 20,00,000 24,00,000
Variable Cost @ ₹ 6 per unit (12,00,000) (14,40,000)
Contribution 8,00,000 9,60,000
Fixed expenses (4,00,000) (4,00,000)
EBIT 4,00,000 5,60,000
Debenture Interest (2,00,000) (2,00,000)
EBT 2,00,000 3,60,000
Tax @ 50% (1,00,000) (1,80,000)
Profit after tax (PAT) 1,00,000 1,80,000
No of Share 20,000 20,000
Earnings per share (EPS) 5 9
(i)The percentage Increase in EPS 4
×100 = 80%
5

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

EBIT ₹ 4,00,000 ₹ 5,60,000

(ii) Financial Leverage = =2 =1.56
EBT ₹ 2,00,000 ₹ 3,60,000
Contribution ₹ 8,00,000 ₹ 9,60,000
(iii) Operating leverage= =2 =1.71
EBIT ₹ 4,00,000 ₹ 5,60,000

(b) When production is increased from 2,00,000 units to 2,40,000 units both financial leverage
and operating leverages reduced from 2 to 1.56 and 1.71 respectively. Reduction in financial
leverage and operating leverages signifies reduction in business risk and financial risk.
Nov 18 Q-2 (10 Marks)
Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018 :
Liabilities Amount in ₹
Shareholder's Fund
Equity Share Capital (₹ 10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12 Debentures) 50,00,000
Current Liabilities 20,00,000
Total 1,00,00,000
Assets Amount in ₹
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000
Additional Information:
(i) Variable Cost is 60% of Sales.
(ii) Fixed Cost p.a. excluding interest ₹ 20,00,000.
(iii) Total Asset Turnover Ratio is 5 times.
(iv) Income Tax Rate 25%
You are required to:
(1) Prepare Income Statement
(2) Calculate the following and comment:
a. Operating Leverage
b. Financial Leverage
c. Combined Leverage
Solution:
Working:
Total Assets = 1 Crore
Total Asset Turnover Ratio i.e. Total Sales = 5
Total Assets
Hence, Total Sales = ₹ 1 Crore x 5 = ₹ 5 crore

(1) Income Statement

Particulars (₹ in crore)
Sales 5
Less: Variable cost @ 60% 3

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Contribution 2
Less: Fixed cost (other than Interest) 0 .2
EBIT (Earnings before interest and tax) 1.8
Less: Interest on debentures (12% x 50 lakhs) 0 .06
EBT (Earning before tax) 1.74
Less: Tax 25% 0.435
EAT (Earning after tax) 1.305

(2) (a) Operating Leverage

Operating leverage = Contribution = 2 = 1.11
EBIT 1.8
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before
interest and tax (EBIT) to change in sales at a particular level.

(b) Financial Leverage

Financial leverage = EBIT = 1.8 = 1.03
EBT 1.74
The financial leverage is very comfortable since the debt service obligation is small
vis-à-vis EBIT.

(a) Combined Leverage

Combined leverage = Contribution x EBIT = 1.11 x 1.03 = 1.15
EBIT EBT
Or,
Contribution = 2 = 1.15
EBT 1.74
The combined leverage studies the choice of fixed cost in cost structure and choice of
debt in capital structure. It studies how sensitive the change in EPS is vis-à-vis
change in sales.
The leverages- operating, financial and combined are measures of risk.

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question- 1
Consider the following information for Omega Ltd.:
₹ in lakhs
EBIT (Earnings before Interest and Tax) 15,750
Earnings before Tax (EBT): 7,000
Fixed Operating costs: 1,575

Required:
Calculate percentage change in earnings per share, if sales increase by 5%.

Solution:

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Operating Leverage (OL)

= Contribution = EBIT + Fixed Cost = ₹15,750 + ₹1,575 = 1.1
EBIT EBIT 15,750

Financial Leverage (FL)

= EBIT = 15,750 = 2.25
EBT 7,000

Combined Leverage (CL)

= 1.1 x 2.25 = 2.475

Percentage Change in Earnings per share

DCL = % Change in EPS
% Change in Sales
2.475 = % Change in EPS
5%
% change in EPS = 12.375%.
Hence if sales is increased by 5%, EPS will be increased by 12.375%.

Question-2
A company operates at a production level of 5,000 units. The contribution is ₹ 60 per unit, operating
leverage is 6, combined leverage is 24. If tax rate is 30%, what would be its earnings after tax?
Solution:
Computation of Earnings after tax (EAT) or Profit after tax (PAT)
Total contribution = 5,000 units x ₹ 60/unit = ₹ 3,00,000
Operating leverage (OL) x Financial leverage (FL) = Combined leverage (CL)
  x FL = 24  FL = 4
 OL = Contribution  6 = ₹3,00,000  EBIT = ₹50,000
EBIT EBIT
FL = EBIT  4 = ₹50,000  EBT = ₹12,500
EBT EBT
Since tax rate is 30%, therefore, Earnings after tax = 12,500 x 0.70 = ₹ 8,750
Earnings after tax (EAT) = ₹ 8,750.

Question-3
The net sales of A Ltd. is ₹ 30 crores. Earnings before interest and tax of the company as a
percentage of net sales is 12%. The capital employed comprises ₹ 10 crores of equity,
₹ 2 crores of 13% Cumulative Preference Share Capital and 15% Debentures of ₹ 6 crores. Income-
tax rate is 40%.
(i) Calculate the Return-on-equity for the company and indicate its segments due to the
presence of Preference Share Capital and Borrowing (Debentures).
(ii) Calculate the Operating Leverage of the Company given that combined leverage is 3.

Solution:
(i) Net Sales : ₹ 30 crores
EBIT = 12% on sales = ₹ 3.6 crores
Return on Capital Employed (pre-tax) = EBIT = 3.6 x 100 = 20%
Capital Employed 10+2+6
After tax it will be = 20% (1 - 0.4)= 12 %.

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Particulars ₹ in crores
EBIT 3.6
Less: Interest on Debt (15% of 6 crores) 0.9
EBT 2.7
Less : Tax @ 40% 1.08
EAT 1.62
Less : Preference dividend 0.26
Earnings available for Equity Shareholders 1.36
Return on equity = 1.36/10 × 100 = 13.6%
Segments due to the presence of Preference Share capital and Borrowing (Debentures)
Segment of ROE due to preference capital : (12% - 13%) × ₹ 2 Crore = - 2%
Segment of ROE due to Debentures: (12% - 9%) × ₹ 6 Crores = 18 %
Total= -2 % +18 % = 16 %
Cost of debenture (after tax) = 15% (1- 0.4) = 9 %
The weighted average cost of capital is as follows:
Source Proportion Cost (%) WACC
(%)
(i) Equity 10/18 13.60 7.56

(ii) Preference shares 2/18 13.00 1.44

(iii) Debt 6/18 9.00 3.00

Total 12.00

(ii) Financial Leverage = EBIT = 3.6 = 1.33

EBT 2.7
Combined Leverage = FL x OL
3 = 1.33 x OL Or, OL = 3 Or, Operating Leverage = 2.26
1.33

Question-4
The following summarises the percentage changes in operating income, percentage changes in
revenues, and betas for four pharmaceutical firms.
Firm Change in revenue Change in operating income Beta
PQR Ltd. 27% 25% 1.00

RST Ltd. 25% 32% 1.15

TUV Ltd. 23% 36% 1.30

WXY Ltd. 21% 40% 1.40

Required:
(i) Calculate the degree of operating leverage for each of these firms. Comment also.
(ii) Use the operating leverage to explain why these firms have different beta.
Solution:
(i) Degree of operating leverage = % Change in Operating Income

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

% Change in Revenue

PQR Ltd. = 25% / 27% = 0.9259

RST Ltd. = 0.32 / 0.25 = 1.28
TUV Ltd. = 0.36 / 0.23 = 1.5652
WXY Ltd. = 0.40 / 0.21 = 1.9048
It is level specific.
(ii) High operating leverage leads to high beta. So when operating leverage is lowest i.e. 0.9259,
Beta is minimum (1) and when operating leverage is maximum i.e. 1.9048, beta is highest i.e.
1.40

Question-5
Z Limited is considering the installation of a new project costing ₹ 80,00,000. Expected annual
sales revenue from the project is ₹ 90,00,000 and its variable costs are 60 percent of sales.
Expected annual fixed cost other than interest is ₹ 10,00,000. Corporate tax rate is 30 percent.
The company wants to arrange the funds through issuing 4,00,000 equity shares of ₹ 10 each and
12 percent debentures of ₹ 40,00,000.
You are required to:
(i) Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
(ii) Determine the likely level of EBIT, if EPS is ₹ 4, or ₹ 2, or Zero.

Solution:
(i) Calculation of Leverages and Earnings per Share (EPS)

Income Statement
Particulars (₹)
Sales Revenue 90,00,000
Less: Variable Cost @ 60% 54,00,000
Contribution 36,00,000
Less: Fixed Cost other than Interest 10,00,000
Earnings before Interest and Tax (EBIT) 26,00,000
Less: Interest (12% on ₹ 40,00,000) 4,80,000
Earnings before tax (EBT) 21,20,000
Less: Tax @ 30% 6,36,000
Earnings after tax (EAT)/ Profit after tax (PAT) 14,84,000

1. Calculation of Operating Leverage (OL)

Operating Leverage = Contribution = ₹36,00,000 = 1.3846
EBIT 26,00,000
2. Calculation of Financial Leverage (FL)
Financial leverage = EBIT = ₹26,00,000 = 1.2264
EBT ₹21,20,000

3. Calculation of Combined Leverage (CL)

Combined Leverage = OL × FL = 1.3846 × 1.2264 = 1.6981

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Or, Contribution = ₹36,00,000 ₹= 1.6981

EBT ₹21,20,000

4. Calculation of Earnings per Share (EPS)

EPS = EAT/PAT = ₹14,84,000 = 3.71
No. of Equity Shares 4,00,000

(ii) Calculation of likely levels of EBIT at Different EPS

EPS = (EBIT) (1-T)
Number of Equity Shares

(1) If EPS is ₹ 4
4 = (EBIT- 4,80,000)(1-0.3) Or, EBIT-4,80,000 = ₹16,00,000
4,00,000 0.7
EBIT – ₹ 4,80,000 = ₹ 22,85,714 Or, EBIT = ₹ 27, 65,714

(2) If EPS is ₹ 2
2 = (EBIT- 4,80,000)(1-0.3) Or, EBIT-4,80,000 = ₹8,00,000
4,00,000 0.7
EBIT – ₹ 4,80,000 = ₹ 11,42,857 Or, EBIT = ₹ 16,22,857

(3) If EPS is ₹ 0
0 = (EBIT- 4,80,000)(1-0.3) Or, EBIT = 4,80,000
4,00,000
Question-6
The following details of RST Limited for the year ended 31st March, 2015 are given below:

Operating leverage 1.4

Combined leverage 2.8
Fixed Cost (Excluding interest) ₹2.04 lakhs
Sales ₹30.00 lakhs
12% Debentures of ₹ 100 each ₹21.25 lakhs
Equity Share Capital of ₹ 10 each ₹17.00 lakhs
Income tax rate 30%
Required:
1. Calculate Financial leverage
2. Calculate P/V ratio and Earning per Share (EPS)
3. If the company belongs to an industry, whose assets turnover is 1.5, does it have a
high or low assets turnover?
4. At what level of sales the Earning before Tax (EBT) of the company will be equal to
zero?

Solution:
(i) Financial leverage
Combined Leverage= Operating Leverage (OL) x Financial Leverage (FL)
2.8 = 1.4 x FL Or, FL = 2
Financial Leverage =2

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

(ii) P/V Ratio and EPS

Operating Leverage = Contribution (C ) x 100
C – Fixed Cost (FC)
1.4 = C Or, 1.4 (C – 2,04,000) = C
C – 2,85,600
Or, 1.4 C – 2,85,600 = C Or, C = ₹2,85,000 = C = 7,14,000
0.4
Now, P/V Ratio = Contribution x 100 = ₹7,14,000 x 100 = 23.8%
Sales (S) ₹30,00,000
Therefore, P/V Ratio = 23.8%
EPS = PAT
No. of Equity Shares
EBT = Sales – V – FC – Interest
= ₹ 30,00,000 – ₹ 22,86,000 – ₹ 2,04,000 – ₹ 2,55,000
= ₹ 2,55,000
PAT = EBT – Tax
= ₹ 2,55,000 – ₹ 76,500 = ₹ 1,78,500
EPS = ₹1,78,500 = 1.05
₹1,70,000
(iii) Assets Turnover
Assets Turnover = Sales = ₹30,00,000 = 0.784
Total Assets ₹38,25,000
0.784 < 1.5 means lower than industry turnover.
(iv) EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to
be dropped by 100/2.8 = 35.71%. Hence new sales will be
₹ 30,00,000 x (100 – 35.71) = ₹19,28,700.
Therefore, at ₹19,28,700 level of sales, the Earnings before Tax of the company will be
equal to zero.
Question-7
From the following financial data of Company A and Company B: Prepare their Income
Statements.
Company A (₹) Company B (₹)
Variable Cost 56,000 60% of sales
Fixed Cost 20,000 -
Interest Expenses 12,000 9,000
Financial Leverage 5:1 -
Operating Leverage - 4:1
Income Tax Rate 30% 30%
Sales - 1,05,000

Solution:
Income Statements of Company A and Company B
Company A (₹) Company B (₹)

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Sales 91,000 1,05,000

Less: Variable cost 56,000 63,000
Contribution 35,000 42,000
Less: Fixed Cost 20,000 31,500
Earnings before interest and tax (EBIT) 15,000 10,500
Less: Interest 12,000 9,000
Earnings before tax (EBT) 3,000 1,500
Less: Tax @ 30% 900 450
Earnings after tax (EAT) 2,100 1,050
Working Notes:
Company A
1. Financial Leverage = EBIT
EBT i.e. EBIT – Interest
So, 5= EBIT
EBIT – 12,000
Or, 5 (EBIT – 12,000) = EBIT Or, 4 EBIT = 60,000
Or, EBIT = ₹15,000

2. Contribution = EBIT + Fixed Cost

= ₹ 15,000 + ₹ 20,000 = ₹ 35,000

3. Sales = Contribution + Variable cost

= ₹ 35,000 + ₹ 56,000
= ₹ 91,000
Company B
1. Contribution = 40% of Sales (as Variable Cost is 60% of Sales)
= 40% of 1,05,000 = ₹ 42,000
2. Operating Leverage = Contribution Or, 4 = ₹42,000
EBIT EBIT
EBIT = ₹42,000 = ₹10,500
4
3. Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = ₹ 31,500

Question-8
The following information related to XL Company Ltd. for the year ended 31st March, 2016 are
available to you:
Equity share capital of ₹ 10 each ₹ 25 lakh
11% Bonds of ₹ 1000 each ₹ 18.5 lakh
Sales ₹ 42 lakh
Fixed cost (Excluding Interest) ₹ 3.48 lakh
Financial leverage 1.39
Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage; and

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

(iii) Earning per Share.

Solution:
Profit Volume Ratio = Contribution x 100
Sales
So, 25.55 = Contribution x 100
₹42,00,000
Contribution = ₹10,73,100
Income Statement
Particulars (₹)
Sales 42,00,000
Variable Cost (Sales - Contribution) 31,26,900
Contribution 10,73,100
Fixed Cost 3,48,000
EBIT 7,25,000
Interest 2,03,500
EBT(EBIT – Interest) 5,21,600
Tax 1,82,500
Profit after Tax (EBT – Tax) 3,39,040

1. Operating Leverage = Contribution

EBIT
Or, Contribution = ₹10,73,100
Contribution – Fixed Cost ₹10,73,100 - ₹3,48,000
= ₹10,73,100 = 1.48
₹7,25,100
2. Combined Leverage = Operating Leverage x Financial Leverage
= 1.48 x 1.39 = 2.06
Or, Contribution i.e. ₹10,73,100 = 2.06
EBT ₹5,21,600
3. Earnings per Share (EPS)
EPS = PAT = ₹3,39,040 = 1.3561
No. of Share ₹2,50,000
EPS = 1.36

Question-9
The Capital structure of RST Ltd. is as follows:
(₹)
Equity Share of ₹ 10 each 8,00,000
10% Preference Share of ₹ 100 each 5,00,000
12% Debentures of ₹ 100 each 7,00,000
20,00,000
Additional Information:
- Profit after tax (Tax Rate 30%) are ₹ 2,80,000
- Operating Expenses (including Depreciation ₹ 96,800) are 1.5 times of EBIT
- Equity Dividend paid is 15%
- Market price of Equity Share is ₹ 23
Calculate:

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

(i) Operating and Financial Leverage

(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(v) The Net Fund Flow

Solution:
Working Notes:
Particulars (₹)
Net Profit after Tax 2,80,000
Tax @ 30% 1,20,000
EBT 4,00,000
Interest on Debentures 84,000
EBIT 4,84,000
Operating Expenses (1.5 times of EBIT) 7,26,000
Sales 12,10,000

1. Operating Leverage
= Contribution = (₹12,00,000 - ₹6,29,200) = ₹5,80,800 = 1.2 times
EBIT ₹4,84,000 ₹4,84,000
Financial leverage = EBIT = 4,84,000 = 1.21 times
EBT 4,00,000

2. Cover for Preference Dividend

= PAT
Pref. Share Dividend
= ₹2,80,000 = 5.6 times
₹ 50,000
Cover for Equity Dividend
= (PAT – Pref. Dividend) = (₹2,80,000 – 50,000)
Equity Share Dividend ₹1,20,000
= ₹2,30,000 = 1.92 times
₹1,20,000

3. Earning Yield Ratio

= EPS x 100
Market Price
= (2,30,000/80,000) x 100
23
= 2.875 x 100 = 12.5%
23

Price – Earnings Ratio (PE Ratio)

= Market Price = 23
EPS 2.875
= 8 times

4. Net Funds Flow

= Net PAT + Depreciation-Total Dividend
= ₹ 2,80,000 + ₹ 96,800 – ₹ (50,000 + 1,20,000)
= ₹ 3,76,800 – ₹ 1,70,000
Net Funds Flow = ₹ 2,06,800

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Question-10
A firm has sales of ₹ 75,00,000 variable cost is 56% and fixed cost is ₹ 6,00,000. It has a debt of
₹ 45,00,000 at 9% and equity of ₹ 55,00,000.
(i) What is the firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or
low capital turnover?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase?

Solution:
Income Statement
Particulars Amount (₹)
Sales 75,00,000
Less: Variable cost (56% of 75,00,000) 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000
Earnings before interest and tax (EBIT) 27,00,000
Less: Interest on debt (@ 9% on ₹ 45 lakhs) 4,05,000
Earnings before tax (EBT) 22,95,000

1. ROI = EBIT x 100 = EBIT x 100

Capital Employed Equity + Debt

= ₹27,00,000 x 100 = 27%

(₹55,00,000 + 45,00,000)
(ROI is calculated on Capital Employed)

2. ROI = 27% and Interest on debt is 9%, hence, it has a favourable financial leverage.

3. Capital Turnover = Net Sales

Capital
Or, Net Sales = ₹75,00,000 =0.75
Capital ₹1,00,00,000
Which is very low as compared to industry average of 3.

4. Calculation of Operating, Financial and Combined leverages.

a. Operating Leverage = Contribution = ₹33,00,000 = 1.22 (Approx.)
EBIT ₹27,00,000
b. Financial Leverage = EBIT = ₹27,00,000 = 1.18 (Approx.)
EBT ₹22,95,000
c. Combined Leverage = Contribution = ₹33,00,000 = 1.44 (Approx.)
EBT ₹22,95,000

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Financial Decisions - Leverage By: CA PRAKSAH PATEL

Or = Operating Leverage × Financial Leverage = 1.22 × 1.18 = 1.44 (approx)

5. Operating leverage is 1.22. So if sales is increased by 10%. EBIT will be increased

by 1.22 × 10 i.e. 12.20% (approx)

6. Since the combined Leverage is 1.44, sales have to drop by 100/1.44 i.e. 69.44% to
bring EBT to Zero
Accordingly, New Sales = ₹ 75,00,000 × (1 - 0.6944)
= ₹ 75,00,000 × 0.3056
= ₹ 22,92,000 (approx)
Hence at ₹ 22,92,000 sales level EBT of the firm will be equal to Zero.

7. Financial leverage is 1.18. So, if EBIT increases by 20% then EBT will increase by
1.18 × 20 = 23.6% (approx)

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Chapter- 2: Financial Decisions

Unit-II Cost of Capital
1. SPECIFIC COST
A. QUESTION FROM STUDY MATERIAL

LONG TERM DEBT

Illustration 1
Five years ago, Sona Limited issued 12 per cent irredeemable debentures at ₹ 103, at ₹ 3 premium
to their par value of ₹ 100. The current market price of these debentures is ₹ 94. If the company pays
corporate tax at a rate of 35 per cent CALCULATE its current cost of debenture capital?
Hints: 8.3%

Illustration 2
A company issued 10,000, 10% debentures of ₹ 100 each at a premium of 10% on 1.4.2017 to be
matured on 1.4.2022. The debentures will be redeemed on maturity. COMPUTE the cost of
debentures assuming 35% as tax rate.
Hints: 4.28%

Illustration 3
A company issued 10,000, 10% debentures of ₹ 100 each at par on 1.4.2012 to be matured on
1.4.2022. The company wants to know the cost of its existing debt on 1.4.2017 when the market
price of the debentures is ₹ 80. COMPUTE the cost of existing debentures assuming 35% tax rate.
Hints: 11.67%

Illustration 4
Institutional Development Bank(IDB) issued Zero interest deep discount bonds of face value of ₹
1,00,000 each issued at ₹ 2500 & repayable after 25 years. COMPUTE the cost of debt if there is
no corporate tax.
Hints: 15.89%

Illustration 5
RBML is proposing to sell a 5-year bond of ₹ 5,000 at 8 per cent rate of interest per annum. The
bond amount will be amortised equally over its life. CALCULATE the bond’s present value for an
investor if he expects a minimum rate of return of 6 per cent?
Hints: ₹5262.62

PREFERENCE SHARE CAPITAL

Illustration 6
XYZ Ltd. issues 2,000 10% preference shares of ₹ 100 each at ₹ 95 each. The company proposes to
redeem the preference shares at the end of 10th year from the date of issue. CALCULATE the cost
of preference share?
Hints: 10.77%

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Illustration 7
XYZ & Co. issues 2,000 10% preference shares of ₹ 100 each at ₹ 95 each. CALCULATE the cost
of preference shares.
Hints: 10.53%

Illustration 8
If R Energy is issuing preferred stock at ₹100 per share, with a stated dividend of ₹12, and a
floatation cost of 3% then, CALCULATE the cost of preference share?
Hints: 12.37%

EQUITY SHARE CAPITAL

Illustration 9
A company has paid dividend of ₹ 1 per share (of face value of ₹ 10 each) last year and it is expected
to grow @ 10% next year. CALCULATE the cost of equity if the market price of share is ₹ 55.
Hints: 12%

Illustration 10
Mr. Mehra had purchased a share of Alpha Limited for ₹ 1,000. He received dividend for a period
of five years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited
for ₹ 1,128. You are required to COMPUTE the cost of equity as per realised yield approach.
Hints: 12%

Illustration 11
Calculate the cost of equity from the following data using realized yield approach:

Year 1 2 3 4 5
Dividend per share 1.00 1.00 1.20 1.25 1.15
Price per share (at the beginning) 9.00 9.75 11.50 11.00 10.60
Hints: 15%

Illustration 12
CALCULATE the cost of equity capital of H Ltd., whose risk free rate of return equals 10%. The
firm’s beta equals 1.75 and the return on the market portfolio equals to 15%.
Hints: 18.75%

RETAINED EARNING
Illustration 13
Face value of equity shares of a company is Rs.10, while current market price is Rs.200 per share.
Company is going to start a new project, and is planning to finance it partially by new issue and
partially by retained earnings. You are required to CALCULATE cost of equity shares as well as
cost of retained earnings if issue price will be Rs.190 per share and floatation cost will be Rs.5 per
share. Dividend at the end of first year is expected to be Rs.10 and growth rate will be 5%.
Hints: 10.41%

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Illustration 14
ABC Company provides the following details:
D0 = ₹ 4.19 P0 = ₹ 50 g = 5%
CALCULATE the cost of retained earnings.
Hints: 13.8%

Illustration 15
ABC Company provides the following details:
Rf = 7% ß = 1.20 Rm - Rf = 6%
CALCULATE the cost of retained earnings based on CAPM method.
Hints: 14.2%

B. PAST YEAR QUESTION

May 22 Q-5 (10 Marks)

A company issues:
• 15% convertible debentures of ₹ 100 each at par with a maturity period of 6 years. On
maturity, each debenture will be converted into 2 equity shares of the company. The risk -
free rate of return is 10%, market risk premium is 18% and beta of the company is 1.25.
The company has paid dividend of ₹ 12.76 per share. Five year ago, it paid dividend of
₹ 10 per share. Flotation cost is 5% of issue amount.
• 5% preference shares of ₹ 100 each at premium of 10%. These shares are redeemable after
10 years at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%.
(i) Calculate the cost of convertible debentures using the approximation method.
(ii) Use YTM method to calculate cost of preference shares.
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.03, t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05, t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA 0.03, 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
t
PVIFA 0.05, 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722
t

Interest rate 1% 2% 3% 4% 5% 6% 7% 8% 9%
FVIF i, 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539
FVIF i, 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677
FVIF i, 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828

Solution:
(i) Calculation of Cost of Convertible Debentures:
Given that, RF = 10%
Rm – Rf = 18%
Β = 1.25
D0 = 12.76
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

D-5 = 10
Flotation Cost = 5%

Using CAPM,
Ke = Rf + β (Rm – Rf)
= 10%+1.25 (18%)
= 32.50%

Calculation of growth rate in dividend 12.76 = 10 (1+g)5

1.276 = (1+g)5
(1+5%)5 = 1.276…….from FV Table
g = 5%

Price of share after 6 years = D7 = 12.76(1.05)7

ke – g 0.325 - 0.05
P6 = 12.76 x1.407
0.275
P6 = 65.28
Redemption Value of Debenture (RV) = 65.28 × 2 = 130.56 (RV)
NP = 95
n =6

Kd = INT (1-t) + (RV – NP)

n x 100
(RV - NP)
2
= 15 (1-.04) + (130.56 - 95)
6 x 100
(130.56 + 95)
2
= 9 + 5.93 x100
112.78
Kd = 13.24%

(ii) Calculation of Cost of Preference Shares:

Net Proceeds = 100 (1.1) - 6% of 100 (1.1)
= 110 - 6.60
= 103.40
Redemption Value = 100

Year Cash Flows (₹) PVF @ 3% PV (₹) PVF @ 5% PV (₹)

0 103.40 1 103.40 1 103.40
1-10 -5 8.530 -42.65 7.722 -38.61
10 -100 0.744 -74.40 0.614 -61.40
-13.65 3.39

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Kp = 3% + 5% - 3% x 13.65
[3.39 - (-13.65)]

= 3% + 2% x 13.65
17.04
Kp = 4.6021%

Nov 20 Q-1(d) (05 Marks)

TT Ltd. issued 20,000, 10% convertible debenture of ₹ 100 each with a maturity period of 5 years.
At maturity the debenture holders will have the option to convert debentures into equity shares of
the company in ratio of 1:5 (5 shares for each debenture). The current market price of the equity
share is ₹ 20 each and historically the growth rate of the share is 4% per annum. Assuming tax rate
is 25%. Compute the cost of 10% convertible debenture using Approximation Method and Internal
Rate of Return Method.

PV Factor are as under:

Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497

Solution:
Determination of Redemption value:

Higher of-
(i) The cash value of debentures = ₹100
(ii) Value of equity shares = 5 shares × ₹ 20 (1+0.04)5
= 5 shares × ₹ 24.333
= ₹121.665 rounded to ₹121.67

₹121.67 will be taken as redemption value as it is higher than the cash option and attractive to the
investors.

Calculation of Cost of 10% Convertible debenture

(i) Using Approximation Method:

Kd = I(1- t ) + (RV –NP)/n - 10(1-.025) + (121.67 – 100) /5 = 7.5 + 4.334

(RV + NP)/2 (121.67 + 100) /2 110.835
= 10.676%
(ii) Using Internal Rate of Return Method

Year Cash Discount Present Discount Present

flows factor @ 10% Value factor @ 15% Value
(₹) (₹)
0 100 1.000 (100.00) 1.000 (100.00)

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

1 to 5 7.5 3.790 28.425 3.353 25.148

5 121.67 0.621 75.557 0.497 60.470
NPV +3.982 -14.382

IRR = L + NPVL (H – L) = 10% + 3.982 (15% -10%)

NPVL -NPVH 3.982-(-14.382)

= 0.11084 or 11.084% (approx.)

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
A Company issues ₹ 10,00,000 , 12% debentures of ₹ 100 each. The debentures are redeemable
after the expiry of fixed period of 7 years. The Company is in 35% tax bracket.
Required:
(i) Calculate the cost of debt after tax, if debentures are issued at
(a) Par ; (b) 10% Discount; (c) 10% Premium.
(ii) If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
Solution:
1. Calculation of Cost of Debt after tax:
RV −NP
I(1− t) +
Cost of Debt (Kd) = n
RV + NP
2
Where,
I = Annual Interest Payment
NP = Net proceeds of debentures
RV = Redemption value of debentures
t = Income tax rate
n = Life of debentures

(a) Cost of 12% Debentures, if issued at par:

Kd = ₹1,20,000(1- 0.35) + ₹10,00,000 - ₹10,00,000

7 years
₹10,00,000 + ₹10,00,000
2
= ₹78,000 = 0.078 or 7.8%
₹10,00,000

(b) Cost of 12% Debentures, if issued at 10% discount:

Kd = ₹1,20,000(1- 0.35) + ₹10,00,000 - ₹9,00,000

7 years
₹10,00,000 + ₹9,00,000
2
= ₹78,000 + ₹14,286 = 0.0971 or 9.71%
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

₹9,50,000

(c) Cost of 12% Debentures, if issued at 10% Premium:

Kd = ₹1,20,000(1- 0.35) + ₹10,00,000 - ₹11,00,000

7 years
₹10,00,000 + ₹11,00,000
2
= ₹78,000 - ₹14,286 = 0.0607 or 6.07%
₹10,50,000
2. Cost of 12% Debentures, if brokerage is paid at 2% and debentures are issued at
par:
Kd = ₹1,20,000(1- 0.35) + ₹10,00,000 - ₹9,80,000*
7 years
₹10,00,000 + ₹9,80,000*
2
= ₹80,857 = 0.0817 or 8.17%
₹9,90,000

* Net Proceeds = Par value of shares – 2% Brokerage of par value

= ₹10,00,000 – 2% of ₹10,00,000 = ₹9,80,000

Question-2
Y Ltd. retains ₹ 7,50,000 out of its current earnings. The expected rate of return to the shareholders,
if they had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in
30% tax bracket. Calculate the cost of retained earnings.

Solution:
Computation of Cost of Retained Earnings (Kr)
Ks = k (1 - tp) - Brokerage
Where, k = Opportunity cost; tp = Shareholders’ personal tax
Ks = 0.10 (1- 0.30) - 0.03 = 0.04 or 4%
Alternatively,
Cost of Retained earnings is equal to opportunity cost for benefits forgone by the shareholders
Particulars (₹)
Earnings before tax (10% of ₹7,50,000) 75,000
Less: Tax (30% of ₹75,000) (22,500)
After tax earnings 52,500
Less: Brokerage (3% of ₹7,50,000)
Net earnings (22,500)
Total Investment 30,000
7,50,000
Effective Rate of earnings (30,000 x 100) 4%
7,50,000

Question-3
A company issued 40,000, 12% Redeemable Preference Share of ₹ 100 each at a premium of ₹ 5
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

each, redeemable after 10 years at a premium of ₹ 10 each. The floatation cost of each share is ₹ 2.
You are required to calculate cost of preference share capital ignoring dividend tax.

Solution:
Calculation of Cost of Preference Shares (Kp)
Preference Dividend (PD) = ₹100 × 40,000 shares × 0.12 = ₹4,80,000
Floatation Cost = 40,000 shares × ₹ 2 = ₹ 80,000
Net Proceeds (NP) = ₹105 × 40,000 shares – ₹ 80,000 = ₹ 41,20,000
Redemption Value (RV) = 40,000 shares × ₹110 = ₹ 44,00,000

Cost of Redeemable Preference Shares = PD + (RV – NP)/N

RV + NP
2
= ₹4,80,000 + (₹44,00,000 - ₹41,20,000)/10 Years
₹44,00,000 + ₹41,20,000
2
= ₹4,80,000 + ₹2,80,000 / 10 Years
₹85,20,000/2
= ₹4,80,000 + ₹28,000 = ₹5,08,000
₹42,60,000 ₹42,60,000
= 0.1192 or 11.92%
2. WEIGHTED AVERAGE COST OF CAPITAL

A. QUESTION FROM STUDY MATERIAL

Illustration 16
Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000
equity shares of Rs.10 each and retained earnings of Rs.15,00,000. Market price per equity share is
Rs.50. Calculate WACC using market value weights if there is no other sources of finance.
Hints: 10.10%

Illustration 17
CALCULATE the WACC using the following data by using:
(a) Book value weights
(b) Market value weights
The capital structure of the company is as under:
(₹)
Debentures (₹ 100 per debenture) 5,00,000
Preference shares (₹ 100 per share) 5,00,000
Equity shares (₹ 10 per share) 10,00,000
20,00,000
The market prices of these securities are:
Debentures ₹ 105 per debenture
Preference shares ₹ 110 per preference share
Equity shares ₹ 24 each.

Additional information:
1. ₹ 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10 year maturity.
Page |2- 26-
Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

2. ₹ 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 year
maturity.
3. Equity shares has ₹ 4 floatation cost and market price ₹ 24 per share.
The next year expected dividend is ₹ 1 with annual growth of 5%. The firm has practice of paying
all earnings in the form of dividend.
Corporate tax rate is 50%. Assume that floatation cost is to be calculated on face value.
Hints: 7.69%, 8.5%

TEST YOUR KNOWLEDGE

Question-1
Determine the cost of capital of Best Luck Limited using the book value (BV) and market value
(MV) weights from the following information:

Sources Book Value Market Value

(₹) (₹)

Equity shares 1,20,00,000 2,00,00,000

Retained earnings 30,00,000 —
Preference shares 36,00,000 33,75,000

Debentures 9,00,000 10,40,000

Additional information:
I. Equity: 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.
II. Dividend: During the previous 5 years, dividends have steadily increased from ₹ 10.60 to ₹
14.19 per share. Dividend at the end of the current year is expected to be ₹ 15 per share.
III. Preference shares: 15% Preference shares with face value of ₹ 100 would realise₹ 105 per
share.
IV. Debentures: The company proposes to issue 11-year 15% debentures but the yield on
debentures of similar maturity and risk class is 16% ; flotation cost is 2%.
V. Tax: Corporate tax rate is 35%. Ignore dividend tax.
Hints: 17.29%, 17.51%

Question-2
Gamma Limited has in issue 5,00,000 ₹ 1 ordinary shares whose current ex- dividend market price
is ₹ 1.50 per share. The company has just paid a dividend of 27 paise per share, and dividends are
expected to continue at this level for some time. If the company has no debt capital, COMPUTE the
weighted average cost of capital?
Hints: Ke = 18%, Kc = 18%

Question-3
Masco Limited wishes to raise additional finance of ₹ 10 lakhs for meeting its investment plans. It
has ₹ 2,10,000 in the form of retained earnings available for investment purposes. Further details
are as following:
(1) Debt / equity mix 30%/70%
(2) Cost of debt

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Upto₹ 1,80,000 10% (before tax)

Beyond ₹ 1,80,000 16% (before tax)
(3) Earnings per share ₹4
(4) Dividend pay out 50% of earnings
(5) Expected growth rate i n dividend 10%
(6) Current market price per share ₹ 44
(7) Tax rate 50%
You are required:
(a) To DETERMINE the pattern for raising the additional finance.
(b) To DETERMINE the post-tax average cost of additional debt.
(c) To DETERMINE the cost of retained earnings and cost of equity, and
(d) COMPUTE the overall weighted average after tax cost of additional finance.
Hints:
(a) Equity = ₹4,90,000
(b) Average Kd= 6.2%
(c) Ke = 15%
(d) Kc = 12.36%

Question-4
The following details are provided by the GPS Limited:
Particulars (₹)
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000
The cost of equity capital for the company is 16.30% and Income Tax rate for the company is 30%.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of the company.
Hints: 13.99%

Question-5
ABC Company’s equity share is quoted in the market at ₹ 25 per share currently. The company pays
a dividend of ₹ 2 per share and the investor’s market expects a growth rate of 6% per year.
You are required to:
(i) CALCULATE the company’s cost of equity capital.
(ii) If the company issues 10% debentures of face value of ₹ 100 each and realises ₹ 96 per
debenture while the debentures are redeemable after 12 years at a premium of 12%, CALCULATE
cost of debenture using YTM?
Assume Tax Rate to be 50%.
Hints:
(i) Cost of equity capital: 14.48%
(ii) Cost of debenture using YTM : 6.45%

Question-6
Kalyanam Ltd. has an operating profit of ₹ 34,50,000 and has employed Debt which gives total
Interest Charge of ₹ 7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and
8% respectively. The firm has a new proposal before it, which requires funds of ₹ 75 Lakhs and is
expected to bring an additional profit of ₹ 14,25,000. To finance the proposal, the firm is expecting
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

to issue an additional debt at 8% and will not be issuing any new equity shares in the market. Assume
no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam
Ltd.:
(i) Before the new Proposal
(ii) After the new Proposal.
Hints:
(i) Before the new Proposal: 13.15%
(ii) After the new Proposal: 14.45%

B. PAST YEAR QUESTION

May 23 Q-4 (05 Marks)

Capital structure of D Ltd. as on 31stMarch, 2023 is given below:
Particulars ₹
Equity share capital (₹ 10 each) 30,00,000
8% Preference share capital (₹ 100 each)12% 10,00,000
Debentures (₹ 100 each) 10,00,000
• Current market price of equity share is ₹ 80 per share. The company has paid
dividend of ₹ 14.07 per share. Seven years ago, it paid dividend of ₹ 10 per
share. Expected dividend is ₹ 16 per share.
• 8% Preference shares are redeemable at 6% premium after five years. Current
market price per preference share is ₹ 104.
• 12% debentures are redeemable at 20% premium after 10 years. Flotation cost
is ₹ 5 per debenture.
• The company is in 40% tax bracket.
• In order to finance an expansion plan, the company intends to borrow 15%
Long-term loan of ₹ 30,00,000 from bank. This financial decision is expected
to increase dividend on equity share from ₹ 16 per share to ₹ 18 per share.
However, the market price of equity share is expected to decline from ₹ 80 to
₹ 72 per share, because investors' required rate of return is based on current
market conditions.
Required:
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking
book value weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion
plan taking book value weights.
Interest Rate 1% 2% 3% 4% 5% 6% 7%
FVIFi,5 1.051 1.104 1.159 1.217 1.276 1.338 1.403
FVIFi,6 1.062 1.126 1.194 1.265 1.340 1.419 1.501
FVIFi,7 1.072 1.149 1.230 1.316 1.407 1.504 1.606
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Solution:
a) Growth rate in Dividends
14.07 = 10 x FVIF (i,7 years) FVIF (i,7 years) = 1.407 FVIF (5%, 7 years) = 1.407
i = 5%
Growth rate in dividend= 5%
(b) Cost of Equity
Ke = D1 + g
P0
Ke = 16 + 0.05
80
Ke = 25%
(c) Cost of Preference Shares
Kp = PD+ (RV-NP)
n
(RV+NP)
2
Kp = 8+ (106 - 104)
5
(RV+NP)
2
Kp = 8.4/105
Kp = 8%

(d) Cost of Debt

Kd = I(1-t )+ (RV – NP)
n
(RV + NP)
2
Kd = 12(1-0.4 )+ (120 – 95)
10
(120 + 95)
2
Kd = (7.2+2.5)/107.5 = 9.02%
Kd = 9.02%
Calculation of existing Weighted Average Cost of Capital (WACC)
Capital Amount (₹) Weights Cost WACC
Equity Share Capital 30,00,000 0.6 25% 15.00%
Preference Share Capital 10,00,000 0.2 8% 1.60%
Debenture 10,00,000 0.2 9.02% 1.80%
50,00,000 1 18.40%

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Alternative presentation
(i) Computation of existing WACC on book value weights
Source Book value Weight Cost of Product
(1) (₹) (2) (3) capital (%) (2) x (4)
(4)
Equity share capital 30,00,000 0.60 25 7,50,000
Preference share capital 10,00,000 0.20 8 80,000
Debentures 10,00,000 0.20 9.02 90,200
Total 50,00,000 1.00 9,20,200

WACC = (Product / Total book value) x 100 = (9,20,200 /50,00,000) x 100

= 18.4%
(ii) Cost of Long Term Debt = 15% (1-0.4) = 9%
Revised Ke = 18 + 0.05 = 30%
72
Calculation of WACC after expansion taking book value weights
Capital Amount Weights Cost W.C
Equity Share Capital 30,00,000 0.3750 30% 11.25%
Preference Share Capital 10,00,000 0.1250 8% 1.00%
Debenture 10,00,000 0.1250 9.02% 1.13%
Long Term Debt 30,00,000 0.3750 9.00% 3.38%
80,00,000 1.0000 16.76%

Alternative presentation
(i) Computation of WACC on book value weights after expansion
Source Book value Weight Cost of capital Product
(1) (₹) (2) (3) (%) (4) (2) x (4)
Equity share capital 30,00,000 0.375 30 9,00,000
Preference share capital 10,00,000 0.125 8 80,000
Debentures 10,00,000 0.125 9.02 90,200
Long term loan 30,00,000 0.375 9 2,70,000
Total 80,00,000 1.00 13,40,200
WACC = (Product / Total book value) x 100 = (13,40,200 / 80,00,000) x 100
= 16.76%

Nov 22 Q-1(c) (05 Marks)

The following is the extract of the Balance Sheet of M/s KD Ltd.:
Particulars Amount (₹)
Ordinary shares (Face Value ₹ 10/- per share) 5,00,000

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Share Premium 1,00,000

Retained Profits 6,00,000
8% Preference Shares (Face Value ₹ 25/- per share) 4,00,000
12% Debentures (Face value ₹ 100/- each) 6,00,000
22,00,000
The ordinary shares are currently priced at ₹ 39 ex-dividend and preference share is
priced at ₹ 18 cum-dividend. The debentures are selling at 120 percent ex-interest.
The applicable tax rate to KD Ltd. is 30 percent. KD Ltd.'s cost of equity has been
estimated at 19 percent. Calculate the WACC (weighted average cost of capital) of
KD Ltd. on the basis of market value.
Solution:
Computation of WACC on the basis of market value

W.N. 1
Cum-dividend price of Preference shares = ₹ 18
Less: Dividend (8/100) x 25 = ₹ 2
Market Price of Preference shares = ₹ 16
Kp = 2 = 0.125 (or) 12.5%
16
No. of Preference shares = (4,00,000/25 ) = 16,000

W.N. 2
Market price of Debentures = (120) x 100 = ₹120
100
K = 12 (1 – 0.3) = 0.07 (or) 7%
120
No. of Debentures = ( 6,00,000 / 100 ) = 6000

W.N.3
Market Price of Equity shares = ₹39
Ke (given) = 19% or 0.19
No. of Equity shares = 5,00,000 / 10 = 50,000
Sources Market Nos. Total Weight Cost of Product
Value Market Capital
(₹) value (₹)
Equity Shares 39 50,000 19,50,000 0.6664 0.19 0.1266
Preference Shares 16 16,000 2,56,000 0.0875 0.125 0.0109
Debentures 120 6,000 7,20,000 0.2461 0.07 0.0172
WACC = 0.1547
WACC = 0.1547 or 15.47%

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Dec 21 Q-1(b) (05 Marks)

Book value of capital structure of B Ltd. is as follows:
Sources Amount
12%, 6,000 Debentures @ ₹ 100 each ₹ 6,00,000
Retained earnings ₹ 4,50,000
4,500 Equity shares @ ₹ 100 each ₹ 4,50,000
₹ 15,00,000
Currently, the market value of debenture is ₹ 110 per debenture and equity share is ₹ 180 per
share. The expected rate of return to equity shareholder is 24% p.a. Company is paying tax @
30%.
Calculate WACC on the basis of market value weights.
Solution:
Calculation of Cost of Capital of debentures ignoring market value:
Cost of Debentures (Kd)= 12 (1 - .30) = 8.40%
Computation of Weighted Average Cost of Capital based on Market Value Weights
Source of Capital Market Weights to After tax Cost WACC
Value Total Capital of capital (%) (%)
(₹)
Debentures (6,000 nos. × 6,60,000 0.45(approx.) 8.40 3.78
₹ 110)
Equity Shares (4,500 nos. × 8,10,000 0.55(approx.) 24.00 13.20
₹180)
14,70,000 1.00 16.98
Note: Cost of Debenture and Cost of equity considered as given without considering
market value. Cost of sources of capital can be computed based on the Market price
and accordingly Weighted Average Cost of Capital can be calculated as below:
Calculation of Cost of Capital for each source of capital considering market value of
capital:
(1) Cost of Equity share capital:
Ke = Earnings = 24% x ₹100 = 13.333%
Market Price per share

(2) Cost of Debentures (Kd) = I(1-t) = ₹ 12(1 - 0.3) = 7.636%

NP ₹110
Computation of Weighted Average Cost of Capital based on Market Value Weights
Source of Capital Market Weights to After tax WACC (%)
Value Total Cost of
(₹) Capital capital
(%)
Debentures (6,000 nos. × 6,60,000 0.45(approx.) 7.636 3.44 (approx.)
₹ 110)

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Equity Shares (4,500 nos. × 8,10,000 0.55(approx.) 13.333 7.33 (approx.)

₹ 180)
14,70,000 1.00 10.77 (approx.)

July 21 Q-2 (10 Marks)

Following are the information of TT Ltd.:
Particulars
Earnings per share ₹ 10
Dividend per share ₹6
Expected growth rate in Dividend 6%
Current market price per share ₹ 120
Tax Rate 30%
Requirement of Additional Finance ₹ 30 lakhs
Debt Equity Ratio (For additional finance) 2:1
Cost of Debt
0-5,00,000 10%
5,00,001 - 10,00,000 9%
Above 10,00,000 8%
Assuming that there is no Reserve and Surplus available in TT Ltd. You are required
to:
(a) Find the pattern of finance for additional requirement
(b) Calculate post tax average cost of additional debt
(c) Calculate cost of equity
(d) Calculate the overall weighted average after tax cost of additional finance.

Solution:
(a) Pattern of raising additional finance
Equity 1/3 of ₹ 30,00,000 = ₹ 10,00,000
Debt 2/3 of ₹ 30,00,000 = ₹ 20,00,000
The capital structure after raising additional finance:
Particulars (₹)
Shareholder’s Funds
Equity Capital 10,00,000
Debt (Interest at 10% p.a.) 5,00,000
(Interest at 9% p.a.) 5,00,000
(Interest at 8% p.a.) (20,00,000–10,00,000) 10,00,000
Total Funds 30,00,000
(b) Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate
On First ₹ 5,00,000 = 10% (1 – 0.3) = 7% or 0.07

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

On Next ₹ 5,00,000 = 9% (1 – 0.3) = 6.3% or 0.063

On Next ₹ 10,00,000 = 8% (1 – 0.3) = 5.6% or 0.056
Average Cost of Debt
= (₹ 5,00,000 x 0.07) + (₹ 5,00,000 x 0.063) + (₹ 10,00,000 x 0.056) x 100
₹20,00,000
= 6.125%
(c) Determination of cost of equity applying Dividend growth model:
Ke = D1 + g
P0
Where,
Ke = Cost of equity
D1 = D0 (1+ g)
D0 = Dividend paid
g = Growth rate = 6%
P0 = Current market price per share = ₹ 120
Ke = ₹6 (1+0.6) + 0.06 = ₹ 6.36 + 0.06 = 0.113 or 11.3%
₹ 120 ₹ 120
(d) Computation of overall weighted average after tax cost of additional finance
Particulars (₹) Weights Cost of funds Weighted Cost (%)
Equity 10,00,000 1/3 11.3% 3.767
Debt 20,00,000 2/3 % 4.083
WACC 30,00,000 7.85
(Note: In the above solution different interest rate have been considered for
different slab of Debt)
Alternative Solution
(a) Pattern of raising additional finance
Equity 1/3 of ₹ 30,00,000 = ₹ 10,00,000
Debt 2/3 of ₹ 30,00,000 = ₹ 20,00,000
The capital structure after raising additional finance:
Particulars (₹)
Shareholders’ Funds
Equity Capital 10,00,000
Debt (Interest at 8% p.a.) 20,00,000
Total Funds 30,00,000

(b) Determination of post-tax average cost of additional debt Kd = I (1 – t)

Where,
I = Interest Rate
t = Corporate tax-rate
Kd = 8% (1 – 0.3) = 5.6%

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

(c) Determination of cost of equity applying Dividend growth model:

Ke = D1 + g
P0
Where,
Ke = Cost of equity D1 = D0 (1+ g)
D0 = Dividend paid
g = Growth rate =6%
P0 = Current market price per share = ₹ 120
Ke = ₹6 (1+0.6) + 0.06 = ₹ 6.36 + 0.06 = 0.113 or 11.3%
₹ 120 ₹ 120
(d) Computation of overall weighted average after tax cost of additional
finance
Particulars (₹) Weights Cost of funds Weighted Cost (%)
Equity 10,00,000 1/3 11.3% 3.767
Debt 20,00,000 2/3 5.6% 3.733
WACC 30,00,000 7.50
(Note: In the above solution single interest rate have been considered for
Debt)

Jan 21 Q-4 (10 Marks)

The Capital structure of PQR Ltd. is as follows:
₹
10% Debenture 3,00,000
12% Preference Shares 2,50,000
Equity Share (face value ₹ 10 per share) 5,00,000
10,50,000
Additional Information:
(i) ₹ 100 per debenture redeemable at par has 2% floatation cost & 10 years of maturity. The
market price per debenture is ₹ 110.
(ii) ₹ 100 per preference share redeemable at par has 3% floatation cost & 10
years of maturity. The market price per preference share is ₹ 108.
(iii) Equity share has ₹ 4 floatation cost and market price per share of ₹ 25. The
next year expected dividend is ₹ 2 per share with annual growth of 5%. The
firm has a practice of paying all earnings in the form of dividends.

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

(iv) Corporate Income Tax rate is 30%.

Required:
Calculate Weighted Average Cost of Capital (WACC) using market value weights.
Solution:
Workings:
1. Cost of Equity (Ke) = D1 +g = ₹2 + 0.05 = 0.145 (approx.)
Po – F ₹25 - ₹4
2. Cost of Debt (Kd) = I (1-t) + (RV – NP)
n
(RV + NP)
2
= 10 (1-0.3) + (100 – 98)
10 = 7 + 0.2 = 0.073 (approx.)
(100 + 98) 99
2
3. Cost of Preference Shares (Kp) = PD + (RV – NP)
n
(RV + NP)
2
= 12 + (100 – 97)
10
(100 + 97)
2
= 12 + 0.3 = 0.125 (approx.)
98.5
Calculation of WACC using market value weights
Source of capital Market Weights After tax cost WACC (Ko)
Value of capital
(₹) (a) (b) (c) = (a) × (b)
10% Debentures (₹ 110 × 3,000) 3,30,000 0.178 0.073 0.013
12% Preference shares (₹ 108 × 2,70,000 0.146 0.125 0.018
2,500)
Equity shares (₹ 25 × 50,000) 12,50,000 0.676 0.145 0.098
18,50,000 1.00 0.129
WACC (Ko) = 0.129 or 12.9% (approx.)

Nov 19 Q-5 (10 Marks)

A Company wants to raise additional finance of ₹ 5 crore in the next year. The company expects to
retain ₹ 1 crore earning next year. Further details are as follows:
(i) The amount will be raised by equity and debt in the ratio of 3: 1.
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

(ii) The additional issue of equity shares will result in price per share being fixed at ₹ 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first ₹ 75 lakh and 12%
for the next ₹ 50 lakh.
(iv) The net expected dividend on equity shares is ₹ 2.00 per share. The dividend is expected
to grow at the rate of 5%.
(v) Income tax rate is 25%.
You are required:
(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax.

Solution:
(a) Determination of the amount of equity and debt for raising additional finance:

Pattern of raising additional finance

Equity 3/4 of ₹ 5 Crore = ₹ 3.75 Crore
Debt 1/4 of ₹ 5 Crore = ₹ 1.25 Crore

The capital structure after raising additional finance:

Particulars (₹ In crore)
Shareholders’ Funds
Equity Capital (3.75 – 1.00) 2.75
Retained earnings 1.00
Debt (Interest at 10% p.a.) 0.75
(Interest at 12% p.a.) (1.25-0.75) 0.50
Total Funds 5.00
(b) Determination of post-tax average cost of additional debt
Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate

On ₹ 75,00,000 = 10% (1 – 7.5% or

0.25) = 0.075
On ₹ 50,00,000 = 12% (1 – 9% or 0.09
0.25) =
Average Cost of Debt

= (₹75,00,000 x 0.075) + (₹50,00,000 x 0.09) x 100

1,25,00,000
= ₹5,62,500 + ₹4,50,000 x 100 = 8.10%
1,25,00,000

(c) Determination of cost of retained earnings and cost of equity (Applying Dividend
growth model):
Ke = D1 + g
Po
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Where,
Ke = Cost of equity D1 = DO (1+ g)
Do = Dividend paid (i.e = ₹ 2) g = Growth rate
Po = Current market price per share
Then,
Ke = ₹2 (1.05) + 0.05 = ₹2.1 + 0.05 = 0.084 + 0.05 = 0.134 = 13.4%
₹25 ₹25
Cost of retained earnings equals to cost of Equity i.e. 13.4%

(d) Computation of overall weighted average after tax cost of additional finance
Cost of Weighted
Particular (₹) Weights
funds Cost (%)
Equity (including retained 3,75,00,000 3/4 13.4% 10.05
earnings)
Debt 1,25,00,000 1/4 8.1% 2.025
WACC 5,00,00,000 12.075

May 19 Q-1(b) (5 Marks)

Alpha Ltd. has furnished the following information :
- Earning Per Share (EPS) ₹4
- Dividend payout ratio 25%
- Market price per share ₹ 50
- Rate of tax 30%
- Growth rate of dividend 10%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost
of debt (before tax) is 10% up to ₹ 2 lakhs and 15% beyond that. Compute the after tax cost of
equity and debt and also weighted average cost of capital.
Solution:
(i) Cost of Equity Share Capital (Ke)
Ke = Do + (1+g) + g = 25% of ₹4(1+0.1) + 0.10 = ₹1.10 + 0.10 = 0.122 or 12.2%
Po ₹50 ₹50
(ii) Cost of Debt (Kd)
Kd = Interest x 100 x (1-t)
Net Proceeds
Interest on first ₹ 2,00,000 @ 10% = ₹ 20,000
Interest on next ₹ 2,00,000 @ 15% = ₹ 30,000
Kd = 50,000 x (1-0.3) = 0.0875 or 8.75%
4,00,000

(iii) Weighted Average Cost of Capital (WACC)

Source of Amount Weights Cost of Capital WACC
capital (₹) (%) (%)
Equity shares 6,00,000 0.60 12.20 7.32
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.82

Alternatively Cost of Equity Share Capital (Ke) can be calculated as

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Ke = D + g = 25% of ₹4 + 0.10 = ₹1.00 + 0.10 = 0.120 or 12.00%

Po ₹50 ₹50
Accordingly,
Weighted Average Cost of Capital (WACC)
Source of Amount Weights Cost of WACC
capital (₹) Capital (%) (%)
Equity shares 6,00,000 0.60 12.00 7.20
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 10.70

D. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
PQR Ltd. has the following capital structure on October 31, 2015:
Sources of capital (₹)
Equity Share Capital (2,00,000 Shares of ₹ 10 20,00,000
each)
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
9% Debentures 30,00,000
80,00,000
The market price of equity share is ₹ 30. It is expected that the company will pay next year a dividend
of ₹ 3 per share, which will grow at 7% forever. Assume 40% income tax rate.
You are required to compute weighted average cost of capital using market value weights.
Solution:
Workings:
(i) Cost of Equity (ke) = D1 + g = ₹3 + 0.07 = 0.1 + 0.07 = 0.17 = 17%
Po ₹30
(ii) Cost of Debenture (Kd) = I (1-t) = 0.09 (1-0.4) = 0.054 or 5.4%
Computation of Weighted Average Cost of Capital (WACC using market value weights)
Source of capital Market Value Weight Cost of WACC
of capital (₹) capital (%) (%)
9% Debentures 30,00,000 0.30 5.40 1.62
12% Preference Shares 10,00,000 0.10 12.00 1.20
Equity Share Capital 60,00,000 0.60 17.00 10.20
(₹30 × 2,00,000 shares)

Total 1,00,00,000 1.00 13.02

Question-2
The following is the capital structure of Simons Company Ltd. as on 31.12.20X5:
(₹)
Equity shares : 10,000 shares (of ₹ 100 each) 10,00,000
10% Preference Shares (of ₹ 100 each) 4,00,000
12% Debentures 6,00,000
20,00,000
The market price of the company’s share is ₹ 110 and it is expected that a dividend of ₹ 10 per share
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

would be declared for the year 20X6. The dividend growth rate is 6%:
(i) If the company is in the 50% tax bracket, compute the weighted average cost of
capital.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow
a fund of ₹ 10 lakhs bearing 14% rate of interest, what will be the company’s revised
weighted average cost of capital? This financing decision is expected to increase
dividend from ₹ 10 to ₹ 12 per share. However, the market price of equity share is
expected to decline from ₹ 110 to ₹ 105 per share.

Solution:
1. Computation of the weighted average cost of capital (using market value weights*)
Source of finance Market Weight After tax WACC (%)
Value of Cost of
capital (₹) capital (%)
(a) (b) (c) (d) = (b) × (c)
Equity share (Working note 1) [₹110 11,00,000 0.5238 15.09 7.9041
× 10,000 shares]
10% Preference share 4,00,000 0.1905 10.00 1.9050
12% Debentures 6,00,000 0.2857 6.00 1.7142
21,00,000 1.0000 11.5233

2. Computation of Revised Weighted Average Cost of Capital (using market value

weights*)
Source of finance Market Weight After tax WACC (%)
Value of Cost of
capital capital
(%)
(₹)
(a) (b) (c) (d) = (b) × (c)
Equity shares (Working note 2) 10,50,000 0.3443 17.43 6.0011
[₹105 × 10,000 shares]
10% Preference shares 4,00,000 0.1311 10.00 1.3110
12% Debentures 6,00,000 0.1967 6.00 1.1802
14% Loan 10,00,000 0.3279 7.00 2.2953
30,50,000 1.0000 10.7876
(* This can also be calculated using book value weights.)
Working Notes:
1. Cost of Equity Shares (ke)
Ke = Dividend per Share (D1) + Growth Rate (g)
Market Price per Share
= ₹10 + 0.06 = 0.1509 or 15.09%
₹110
2. Revised cost of equity shares (Ke)
Revised Ke = ₹12 + 0.06 = .01742 or 17.43%
₹105

Question-3
The following is the capital structure of a Company:
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Source of capital Book value (₹) Market value (₹)

Equity shares @ ₹ 100 each 80,00,000 1,60,00,000
9% Cumulative preference
shares @ ₹ 100 each 20,00,000 24,00,000
11% Debentures 60,00,000 66,00,000
Retained earnings 40,00,000 -
2,00,00,000 2,50,00,000
The current market price of the company’s equity share is ₹ 200. For the last year the company had
paid equity dividend at 25 per cent and its dividend is likely to grow 5 per cent every year. The
corporate tax rate is 30 per cent and shareholders personal income tax rate is 20 per cent.
You are required to calculate:
(i) Cost of capital for each source of capital.
(ii) Weighted average cost of capital on the basis of book value weights.
(iii) Weighted average cost of capital on the basis of market value weights.
Solution:
(i) Calculation of Cost of Capital for each source of capital:
(a) Cost of Equity share capital:
Ke = Do (1+g) + g = 25% x ₹100(1+0.05) + 0.05
Market Price per Share (po) ₹200
= ₹26.25 + 0.05 = 0.18125 or 18.125%
₹200
(b) Cost of Preference share capital (Kp) = 9%
(c) Cost of Debentures (Kd) = r (1 – t)
= 11% (1 – 0.3) = 7.7%.
(d) Cost of Retained Earnings :Ks = Ke (1 – tp) = 18.125 (1 – 0.2) = 14.5%.
(ii) Weighted Average Cost of Capital on the basis of book value weights
Source Amount (₹) Weights After tax Cost WACC (%)
of Capital (%)
(a) (b) (c) = (a) x (b)
Equity share 80,00,000 0.40 18.125 7.25
9% Preference share 20,00,000 0.10 9.000 0.90
11% Debentures 60,00,000 0.30 7.700 2.31
Retained earnings 40,00,000 0.20 14.500 2.90
2,00,00,000 1.00 13.36
(iii) Weighted Average Cost of Capital on the basis of market value weights
Source Amount (₹) Weights After tax Cost WACC (%)
of Capital (%)
(a) (b) (c) = (a) x (b)
Equity share 1,60,00,000 0.640 18.125 11.60
9% Preference share 24,00,000 0.096 9.000 0.864
11% Debentures 66,00,000 0.264 7.700 2.033
2,50,00,000 1.000 14.497

Question-4

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Beeta Ltd. has furnished the following information:

- Earning per share (ESP) ₹4
- Dividend payout ratio 25%
- Market price per share ₹ 40
- Rate of tax 30%
- Growth rate of dividend 8%
The company wants to raise additional capital of ₹ 10 lakhs including debt of ₹ 4 lakhs. The cost of
debt (before tax) is 10% upto ₹ 2 lakhs and 15% beyond that.
Compute the after tax cost of equity and debt and the weighted average cost of capital.
Solution:
1. Cost of Equity Share Capital (Ke)
Ke = Do (1+g) + g = 25% of ₹4(1+0.08) + 0.08 = ₹1.08 + 0.08 = 0.107 or 10.7%
Po ₹40 ₹40
2. Cost of Debt (Kd)
Kd = Interest x 100 x (1-t)
Net Proceeds
Interest on first ₹ 2,00,000 @ 10% = 20,000
Interest on next ₹ 2,00,000 @ 15% = 30,000
Kd = 50,000 x (1-0.3) = 0.0875 or 8.75%
4,00,000
3. Weighted Average Cost of Capital (WACC)
Source of capital Amount (₹) Weights Cost of WACC
Capital (%) (%)
Equity shares 6,00,000 0.60 10.70 6.42
Debt 4,00,000 0.40 8.75 3.50
Total 10,00,000 1.00 9.92

3. MARGINAL COST OF CAPITAL

A. QUESTION FROM STUDY MATERIAL

Illustration 18
ABC Ltd. has the following capital structure EXAMINE which is considered to be optimum as on
31st March, 2017.
Particulars (₹)
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ₹ 23.60. Next year dividend per share is 50% of year
2017 EPS. The following is the trend of EPS for the preceding 10 years which is expected to
continue in future.
Year EPS Year EPS
(₹) (₹)
2008 1.00 2013 1.61

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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

2009 1.10 2014 1.77

2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is ₹ 96.
Preference share ₹ 9.20 (with annual dividend of ₹ 1.1 per share) were also issued. The company is
in 50% tax bracket.
(A) Calculate after tax:
(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)
(B) Calculate marginal cost of capital when no new shares are issued.
(C) Determine the amount that can be spent for capital investment before new ordinary shares
must be sold. Assuming that retained earnings for next year’s investment are 50 percent of 2017.
(D) Compute marginal cost of capital when the funds exceeds the amount calculated in (C),
assuming new equity is issued at ₹ 20 per share?
Hints:
(a) 8.33%, 12%, 15%
(b) 13.85%
(c) ₹14,750
(d) 14.57%

B. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
ABC Limited has the following book value capital structure:
Equity Share Capital (150 million shares, ₹10 par) ₹ 1,500 million
Reserves and Surplus ₹ 2,250 million
10.5% Preference Share Capital (1 million shares, ₹100 par) ₹ 100 million
9.5% Debentures (1.5 million debentures, ₹1,000 par) ₹ 1,500 million
8.5% Term Loans from Financial Institutions ₹ 500 million

The debentures of ABC Limited are redeemable after three years and are quoting at ₹ 981.05 per
debenture. The applicable income tax rate for the company is 35%.
The current market price per equity share is ₹ 60. The prevailing default-risk free interest rate on
10- year GOI Treasury Bonds is 5.5%. The average market risk premium is 8%. The beta of the
company is 1.1875.
The preferred stock of the company is redeemable after 5 years is currently selling at ₹ 98.15 per
preference share.
Required:
(i) Calculate weighted average cost of capital of the company using market value weights.
(ii) Define the marginal cost of capital schedule for the firm if it raises ₹ 750 million for a new
project. The firm plans to have a debt of 20% of the newly raised capital. The beta of new
project is 1.4375. The debt capital will be raised through term loans, it will carry interest rate
of 9.5% for the first ₹100 million and 10% for the next ₹ 50 million.

Solution:
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Financial Decisions- Cost of Capital By: CA PRAKASH PATEL

Working Notes:
1. Computation of cost of debentures (Kd) :
Kd = 95 (1-0.35) + (1,000 – 981.05)/3 = 6.872%
(1,000 + 981.05)/2

2. Computation of cost of term loans (KT) :

= r ( 1 t)
= 0.085 ( 1 0.35) = 0.05525 or 5.525%
3. Computation of cost of preference capital (KP) :
Kp = Preference Dividend + (RV – NP)/n
(RV + NP)/2
= 10.5 + (100 – 98.15)/5 = 0.1097 or 10.97%
(100 + 98.15)/2
4. Computation of cost of equity (Ke) :
= Rf + ß(Rm - Rf)
Or, = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.1875 0.08) = 0.15 or 15%

(i) Calculation of Weighted Average cost of capital Using market value weights
Market value of After tax
Source of Capital capital structure Weights cost of WACC (%)
(₹ in millions) capital (%)
Equity share capital
9,000 0.813 15.000 12.195
(150 million share x ₹ 60)
10.5% Preference share
capital (1 million shares x 98.15 0.0089 10.970 0.098
₹98.15)
9.5 % Debentures
1,471.575 0.1329 6.872 0.913
(1.5 million x ₹981.05)
8.5% Term loans 500 0.0452 5.525 0.249
11,069.725 1.000 13.455
(ii) Marginal cost of capital (MCC) schedule :
New capital of ₹750 million will be raised in proportion of 20% Debt and 80% equity share
capital i.e. ₹150 million debt and ₹600 million equity.
Cost of equity shares (Ke) = Risk free rate + (Beta × Risk premium)
= 0.055 + (1.4375 × 0.08) = 0.17 or 17%
Cost of Debt (Kd):
for first ₹100 million = 9.5% (1 - 0.35) = 6.175%
for next ₹50 million = 10% (1 - 0.35) = 6.5%
Marginal Cost of Capital = 0.17 x ₹600m + (0.06175 x ₹100m + 0.065 x ₹50m)
₹750m ₹750m ₹750m

= 0.136 + (0.008 + 0.004) = 0.148 or 14.8%

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Chapter- 2: Financial Decisions

UNIT-III CAPITAL STRUCTURE

PART- 1 CAPITAL STRUCTURE THEORIES

1. NET INCOME APPROACH & TRADITIONAL APPROACH

A. QUESTION FROM STUDY MATERIAL

Illustration 1
Rupa Ltd.’s EBIT is ₹ 5,00,000. The company has 10%,₹ 20 lakh debentures. The equity
capitalization rate i.e. Ke is 16%.
You are required to Calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital.
Hints: ₹38,75,000, 12.9%

Illustration 2
Indra Ltd. has EBIT of ₹ 1,00,000. The company makes use of debt and equity capital. The firm has
10% debentures of ₹ 5,00,000 and the firm’s equity capitalization rate is 15%.
You are required to Compute:
(i) Current value of the firm
(ii) Overall cost of capital.
Hints: ₹8,33,333, 12%

Illustration 3
Determine the optimal capital structure of a company from the following information:
Options Cost of Cost of Percentage of Debt on total
Debt(Kd) in % Equity(Ke) in % value (Debt +Equity)
1 11 13.0 0.0
2 11 13.0 0.1
3 11.6 14.0 0.2
4 12.0 15.0 0.3
5 13.0 16.0 0.4
6 15.0 18.0 0.5
7 18.0 20.0 0.6
Hints: 13%, 12.8%, 13.52%, 14.1%, 14.8%, 16.5%, 18.8%

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

B. PAST YEAR QUESTION

Jan 21 Q-3 (10 Marks)
A Limited and B Limited are identical except for capital structures. A Ltd. has 60 per cent debt and
40 per cent equity, whereas B Ltd. has 20 per cent debt and 80 per cent equity. (All percentages are
in market-value terms.) The borrowing rate for both companies is 8 per cent in a no-tax world, and
capital markets are assumed to be perfect.
(a) (i) If X, owns 3 per cent of the equity shares of A Ltd., determine his return if the Company
has net operating income of ₹ 4,50,000 and the overall capitalization rate of the company,
(Ko) is 18 per cent.
(ii) Calculate the implied required rate of return on equity of A Ltd.

(b) B Ltd. has the same net operating income as A Ltd.

(i) Calculate the implied required equity return of B Ltd.
(ii) Analyse why does it differ from that of A Ltd.
Solution:
(a) Value of A Ltd. = NOI = ₹4,50,000 = ₹25,00,000
Ko 18%

(i) Return on Shares of X on A Ltd.

Particulars Amount (₹)

Value of the company 25,00,000
Market value of debt (60% x ₹ 25,00,000) 15,00,000
Market value of shares (40% x ₹ 25,00,000) 10,00,000
Particulars Amount (₹)
Net operating income 4,50,000
Interest on debt (8% × ₹ 15,00,000) 1,20,000
Earnings available to shareholders 3,30,000
Return on 3% shares (3% × ₹ 3,30,000) 9,900

(ii) Implied required rate of return on equity of A Ltd. = ₹3,30,000 = 33%

₹10,00,000

(b) (i) Calculation of Implied rate of return of B Ltd.

Particulars Amount (₹)

Total value of company 25,00,000
Market value of debt (20% × ₹ 25,00,000) 5,00,000
Market value of equity (80% × ₹ 25,00,000) 20,00,000

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Particulars Amount (₹)

Net operating income 4,50,000
Interest on debt (8% × ₹ 5,00,000) 40,000
Earnings available to shareholders 4,10,000

Implied required rate of return on equity = ₹4,10,000 = 20.5%

₹20,00,000

(ii) Implied required rate of return on equity of B Ltd. is lower than that of A Ltd. because
B Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the
debt-to-equity ratio when we use the net operating income approach, the decline in required equity
return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt funds.

2. NET OPERATING INCOME APPROACH

A. QUESTION FROM STUDY MATERIAL

Illustration 4
Amita Ltd’s operating income (EBIT) is ₹ 5,00,000. The firm’s cost of debt is 10% and currently
the firm employs ₹ 15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to Calculate:
(i) Total value of the firm.
(ii) Cost of equity.
Hints: ₹33,33,333, 19.09%

Illustration 5
Alpha Limited and Beta Limited are identical except for capital structures. Alpha Ltd. has 50 per
cent debt and 50 per cent equity, whereas Beta Ltd. has 20 per cent debt and 80 per cent equity. (All
percentages are in market-value terms). The borrowing rate for both companies is 8 per cent in a no-
tax world, and capital markets are assumed to be perfect.
(a) (i) If you own 2 per cent of the shares of Alpha Ltd., Determine your return if the company
has net operating income of ₹3,60,000 and the overall capitalisation rate of the company, K0
is 18 per cent?
(ii) Calculate the implied required rate of return on equity?
(b) Beta Ltd. has the same net operating income as Alpha Ltd. (i) DETERMINE the implied
required equity return of Beta Ltd.? (ii) ANALYSE why does it differ from that of Alpha
Ltd.?
Hints: ₹20,00,000, 28%, 20.5%

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

3. MODIGLIANI-MILLER (MM APPROACH)

A. QUESTION FROM STUDY MATERIAL
Illustration 6
There are two company N Ltd. and M Ltd., having same earnings before interest and taxes i.e. EBIT
of ₹ 20,000. M Ltd. is a levered company having a debt of ₹1,00,000 @ 7% rate of interest. The
cost of equity of N Ltd. is 10% and of M Ltd. is 11.50%.
Compute how arbitrage process will be carried on?
Hints: Surplus Cash = ₹1,304.3

Illustration 7
Following data is available in respect of two companies having same business risk: Capital
employed = ₹ 2,00,000, EBIT = ₹ 30,000
Ke = 12.5%
Sources Levered Company (₹) Unlevered Company(₹)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 2,00,000
Investor is holding 15% shares in levered company. Calculate increase in annual earnings of investor
if he switches his holding from Levered to Unlevered company.
Hints: Incremental Income = ₹375

Illustration 8
There are two companies U Ltd. and L Ltd., having same NOI of ₹20,000 except that L Ltd. is a
levered company having a debt of ₹1,00,000 @ 7% and cost of equity of U Ltd. & L Ltd. are 10%
and 18% respectively.
Compute how arbitrage process will work.
Hints: Surplus Cash = ₹2,778

Illustration 9
Following data is available in respect of two companies having same business risk: Capital
employed = ₹ 2,00,000 ,EBIT = ₹ 30,000
Sources Levered Company Unlevered Company(₹)
(₹)
Debt (@10%) 1,00,000 Nil
Equity 1,00,000 200000
Ke 20 % 12.5%
Investor is holding 15% shares in Unlevered company. Calculate increase in annual earnings of
investor if he switches his holding from Unlevered to Levered Company.
Hints: Incremental Income = ₹900

Illustration 10
Blue Ltd., an all equity financed company is considering the repurchase of ₹ 275 lakhs equity shares
and to replace it with 15% debentures of the same amount. Current market value of the company is
₹ 1,750 lakhs with its cost of capital of 20%. The company's Earnings before Interest and Taxes
(EBIT) are expected to remain constant in future years. The company also has a policy of distributing
its entire earnings as dividend.
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Assuming the corporate tax rate as 30%, you are required to CALCULATE the impact on the
following on account of the change in the capital structure as per Modigliani and Miller (MM)
Approach:
(i) Market value of the company
(ii) Overall Cost of capital
(iii) Cost of equity
Hints:
(i) ₹82.50 Lakhs
(ii) 19.11%
(iii) 20.62%

TEST YOUR KNOWLEDGE

Question-1 (Study Material Q-5)
One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost
of 10 per cent. Another company, Samsui Limited, is identical in every respect to Sanghmani
Limited, except that its capital structure is all equity and its cost of equity is 16% according to
Modigliani and Miller, if we ignored taxation and tax relief on debt capital, Compute the Cost of
Equity of Sanghmani Limited ?
Hints: Ko = 16%, Ke = 19%

B. PAST YEAR QUESTION

Nov 22 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.
Solution:
(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 100 55005.5 55005.5

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

5,000 x 100 5,000 x 100

9.09 9.09

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

Particulars A B
Equilibrium value (₹) 55,005.5 55,005.5
Less: Value of Debt - 30,000
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) x 100 = 6% Cost of
Equity of Firm B (Levered) = KO + (KO - Kd ) x (Debt / Equity)
= 9.09 + (9.09 – 6) x (30000/25005.5)
= 9.09 + 3.09 x 1.2 = 9.09 + 3.71 = 12.80% (OR)

Cost of Equity of Firm B (Levered) = ( NI ) x 100

Value of Equity
= 3200 x 100
25005.5

Nov 18 Q-5 (10 Marks)

The following data relate to two companies belonging to the same risk class :
Particulars A Ltd. B Ltd.
Expected Net Operating Income ₹ 18,00,000 ₹ 18,00,000
12% Debt ₹ 54,00,000 -
Equity Capitalization Rate - 18

Required:
(a) Determine the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average
cost of capital for each company assuming 40% taxes as per M.M. Approach.

Solution:
(a) Assuming no tax as per MM Approach.
Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis Market
Value of ‘B Ltd’ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = ₹ 1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Nil) = ₹ 1,00,00,000 + (54,00,000 × nil)
= ₹1,00,00,000

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC)
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Particulars A Ltd. B Ltd.

A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC 0.18 0.18
(ko)]* ko = (ke×S/V) + (kd×D/V)

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18

*Kd = 12% (since there is no tax)

WACC = 18%

(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis Market
Value of ‘B Ltd’ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= ₹60,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= ₹ 60,00,000 + (54,00,000 × 0.4)
= ₹ 81,60,000
Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’
= 18% (i.e. Ke = Ko)

Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC) of a Ltd
Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Less: Market Value of Debt 54,00,000

Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)
*Computation of WACC A Ltd
Component of Capital Amount Weight Cost of Capital WACC
Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323

*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%

WACC = 13.23%

May 18 Q-1(a) (5 Marks)

Stopgo Ltd, an all equity financed company, is considering the repurchase of ₹ 200 lakhs equity and
to replace it with 15% debentures of the same amount. Current market Value of the company is ₹
1140 lakhs and it's cost of capital is 20%. It's Earnings before Interest and Taxes (EBIT) are
expected to remain constant in future. It's entire earnings are distributed as dividend. Applicable tax
rate is 30 per cent.

You are required to calculate the impact on the following on account of the change in the capital
structure as per Modigliani and Miller (MM) Hypothesis:

(i) The market value of the company

(ii) It's cost of capital, and
(iii) It’s cost of equity

Solution:
(a) Working:
Net Income (NI) for equity holders = Market Value of Equity
Ke
Net Income (NI) for equity holders = ₹1,140 lakhs
0.20

Therefore, Net Income to equity–holders = ₹ 228 lakhs

EBIT = ₹ 228 lakhs / 0.7 = ₹ 325.70 lakhs
All Equity Debt of Equity
(₹ In lakhs) (₹ In lakhs)
EBIT 325.70 325.70
Interest on ₹200 lakhs @ 15% -- 30.00
EBT 325.70 295.70
Tax @ 30 % 97.70 88.70
Income available to equity holders 228 207

(i) Market value of levered firm = Value of unlevered firm + Tax Advantage
= ₹ 1,140 lakhs + (₹200 lakhs x 0.3)
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

= ₹ 1,200 lakhs
The impact is that the market value of the company has increased by ₹ 60 lakhs (₹
1,200 lakhs – ₹ 1,140 lakhs)

Calculation of Cost of Equity

Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %

(ii) Cost of Capital

Components Amount Cost of Capital Weight WACC
(₹ In lakhs) % %
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00
The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax
relief on debt interest payment.

(iii) Cost of Equity is 20.7% [As calculated in point (i)]

The impact is that cost of equity has risen by 0.7% i.e. 20.7% - 20% due to the
presence of financial risk.
Further, Cost of Capital and Cost of equity can also be calculated with the help of
formulas as below, though there will be no change in final answers.
Cost of Capital (Ko) = Keu(1-tL)
Where,
Keu = Cost of equity in an unlevered company
t = Tax rate
L = Debt
Debt + Equity
Ke = 0.20 + (0.20 - 0.15) x ₹ 200 lakh x 0.7
₹ 1,000 lakh
Ke = 0.20 + 0.007 = 0.207 or 20.7%
So, Cost of Equity = 20.70%

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
There are two firms P and Q which are identical except P does not use any debt in its capital structure
while Q has ₹ 8,00,000, 9% debentures in its capital structure. Both the firms have earnings before
interest and tax of ₹ 2,60,000 p.a. and the capitalization rate is 10%. Assuming the corporate tax of
30%, calculate the value of these firms according to MM Hypothesis.
Solution:
(i) Calculation of Value of Firms P and Q according to MM Hypothesis
Market Value of Firm P (Unlevered)

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

VF = EBIT (1-t) = 2,60,000 (1-0.30) - ₹1,82,000 = ₹18,20,000

Ke 10% 10%
Market Value of Firm Q (Levered)
Vg = Vu + TB
= ₹18,20,000 + (₹ 8,00,000 × 0.30) = ₹18,20,000 + ₹ 2,40,000 = ₹ 20,60,000

Question-2
RES Ltd. is an all equity financed company with a market value of ₹ 25,00,000 and cost of equity
(Ke) 21%. The company wants to buyback equity shares worth ₹ 5,00,000 by issuing and raising
15% perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital
restructuring and applying MM Model (with taxes), you are required to calculate:
(i) Market value of RES Ltd.
(ii) Cost of Equity (Ke)
(iii) Weighted average cost of capital (using market weights) and comment on it.
Solution:
Value of a company (V) = Value of equity (S) + Value of debt (D)
₹25,00,000 = Net Income (NI) = ₹5,00,000
Ke
Or, Net Income (NI) = 0.21 (₹25,00,000 – ₹5,00,000)
Market Value of Equity = 25,00,000
Ke = 21%
Net Income (NI) for equity holder = Market Value of Equity
Ke
Net Income (NI) for equity holder = 25,00,000
0.21
Net income for equity holders= 5,25,000
EBIT= 5,25,000/0.7 = 7,50,000
All Equity Debt and Equity
EBIT 7,50,000 7,50,000
Interest to debt-holders - 75,000
EBT 7,50,000 6,75,000
Taxes (30%) 2,25,000 2,02,500
Income available to equity shareholders 5,25,000 4,72,500
Income to debt holders plus income 5,25,000 5,47,500
available to shareholders
Present value of tax-shield benefits = ₹ 5,00,000 × 0.30 = ₹1,50,000

(i) Value of Restructured firm

= ₹ 25,00,000 + ₹ 1,50,000 = ₹ 26,50,000

(ii) Cost of Equity (Ke)

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Total Value = ₹ 26,50,000

Less: Value of Debt = ₹ 5,00,000
Value of Equity = ₹ 21,50,000
Ke = 4,72,500 = 0.219 = 21.98%
21,50,000

(iii) WACC (on market value weight)

Cost of Debt (after tax) = 15% (1- 0.3) = 0.15 (0.70) = 0.105 = 10.5%
Components of Costs Amount Cost of Capital Weight WACC
(%) (%)
Equity 21,50,000 21.98 0.81 17.80
Debt 5,00,000 10.50 0.19 2.00
26,50,000 19.80
Comment: At present the company is all equity financed. So, Ke = Ko i.e. 21%. However
after restructuring, the Ko would be reduced to 19.80% and Ke would increase from 21% to
21.98%.

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

PART- 2 EBIT, EPS, MP ANALYSIS

A. QUESTION FROM STUDY MATERIAL

Illustration 10
Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of ₹ 10
per share. The firm wants to raise ₹ 250,000 to finance its investments and is considering three
alternative methods of financing – (i) to issue 25,000 ordinary shares at ₹ 10 each, (ii) to borrow ₹
2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference shares of ₹ 100 each at an 8 per
cent rate of dividend. If the firm’s earnings before interest and taxes after additional investment
are ₹ 3,12,500 and the tax rate is 50 per cent, FIND the effect on the earnings per share under the
three financing alternatives.
Hints: ₹1.25, ₹1.46, ₹1.36

Illustration 11
Best of Luck Ltd., a profit making company, has a paid-up capital of ₹ 100 lakhs consisting of 10
lakhs ordinary shares of ₹ 10 each. Currently, it is earning an annual pre-tax profit of ₹ 60 lakhs.
The company's shares are listed and are quoted in the range of ₹ 50 to ₹ 80. The management wants
to diversify production and has approved a project which will cost ₹ 50 lakhs and which is expected
to yield a pre-tax income of ₹ 40 lakhs per annum. To raise this additional capital, the following
options are under consideration of the management:
(a) To issue equity share capital for the entire additional amount. It is expected that the
new shares (face value of ₹ 10) can be sold at a premium of ₹ 15.
(b) To issue 16% non-convertible debentures of ₹ 100 each for the entire amount.
(c) To issue equity capital for ₹ 25 lakhs (face value of ₹ 10) and 16% non- convertible
debentures for the balance amount. In this case, the company can issue shares at a
premium of ₹ 40 each.
Calculate the additional capital can be raised, keeping in mind that the management wants to
maximise the earnings per share to maintain its goodwill. The company is paying income tax at
50%.
Hints: ₹4.17, ₹4.6, ₹4.57

Illustration 12
Shahji Steels Limited requires ₹ 25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of ₹ 5,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per share. It has three alternatives to finance the
project - by raising debt of ₹ 2,50,000 or ₹ 10,00,000or ₹ 15,00,000 and the balance, in each case,
by issuing equity shares. The company's share is currently selling at ₹ 150, but is expected to decline
to ₹ 125 in case the funds are borrowed in excess of ₹ 10,00,000. The funds can be borrowed at the
rate of 10 percent upto ₹ 2,50,000, at 15 percent over ₹ 2,50,000 and upto ₹ 10,00,000 and at 20
percent over ₹ 10,00,000. The tax rate applicable to the company is 50 percent. ANALYSE which
form of financing should the company choose?
Hints: ₹15.83, ₹18.13, ₹16.41

Illustration 13
The following data are presented in respect of Quality Automation Ltd.:
Amount (₹)
Profit before interest and tax 52,00,000

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Less : Interest on debentures @ 12% 12,00,000

Profit before tax 40,00,000
Less : Income tax @ 50% 20,00,000
Profit After tax 20,00,000
No. of equity shares (of ₹ 10 each) 8,00,000
EPS 2.5
P/E Ratio 10
Market price per share 25
The company is planning to start a new project requiring a total capital outlay of ₹ 40,00,000.
You are informed that a debt equity ratio (D/D+E) higher than 35% push the Ke up to 12.5% means
reduce PE ratio to 8 and rises the interest rate on additional amount borrowed at 14%. Find Out the
probable price of share if:
(i) the additional funds are raised as a loan.
(ii) the amount is raised by issuing equity shares. (Note : Retained earnings of the
company is ₹ 1.2 crore)
Hints: MPS = ₹20.66, ₹24.44

TEST YOUR KNOWLEDGE

Question-2
Yoyo Limited presently has ₹36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It
wishes to finance a ₹40,00,000 expansion programme and is considering three alternatives: additional
debt at 12 per cent interest, preference shares with an 11 per cent dividend, and the issue of equity
shares at ₹16 per share. The company presently has 8,00,000 shares outstanding and is in a 40 per
cent tax bracket.
(a) If earnings before interest and taxes are presently ₹15,00,000, Determine earnings
per share for the three alternatives, assuming no immediate increase in profitability?
(b) Analyse which alternative do you prefer? Compute how much would EBIT need to
increase before the next alternative would be best?
Hints:
(a) ₹0.495, ₹0.305, ₹0.651
(b) Equity alternative is preferred.

B. PAST YEAR QUESTION

May 23 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
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

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.
Solution:
Working notes:
(i) Interest Coverage ratio = 8
EBIT / Interest =8
EBIT/ 1,20,000 =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) = 10,00,000 = 13.42%

74,50,000
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) = 44,50,000 = 111.25%
40,00,000
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

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

(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
Issued (₹) TermDebt
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% NIL 5,52,000
on ₹ 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 9,10,500 5,24,100
Equityshareholders
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.

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

May 22 Q-4 (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
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%?
Solution:
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
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

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
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 = ₹ (20,00,000 - 5,00,000) = ₹ 15,00,000 = 7,500 shares
₹ 200 (Market price of share) ₹200
Alternative 2 = ₹ (20,00,000 - 10,00,000) = ₹ 10,00,000 = 5,000
shares ₹ 200 (Market price of share) ₹200
Alternative 3 = ₹ (20,00,000 - 14,00,000) = ₹ 6,00,000 = 3,000
shares ₹ 200 (Market price of share) ₹200
(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

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Total no. of equity shares 1,07,500 1,05,000 1,03,000

Nov 20 Q-3 (10 Marks)

J Ltd. is considering three financing plans. The-key information is as follows:
(a) Total investment to be raised ₹ 4,00,000.
(b) Plans showing the Financing Proportion:
Plans Equity Debt Preference Shares
X 100% - -
Y 50% 50% -
Z 50% - 50%

(c) Cost of Debt 10%

Cost of preference shares 10%
(d) Tax Rate 50%
(e) Equity shares of the face value of ₹10 each will be issued at a premium of ₹ 10 per share.
(f) Expected EBIT is ₹ 1,00,000.
You are required to compute the following for each plan :
(i) Earnings per share (EPS)
(ii) Financial break even point
(iii) Indifference Point between the plans and indicate if any of the plans dominate.
Solution:
(i) Computation of Earnings per Share (EPS)
Plans X (₹) Y (₹) Z (₹)
Earnings before interest & tax (EBIT) 1,00,000 1,00,000 1,00,000
Less: Interest charges (10% of ₹ 2,00,000) -- (20,000) --
Earnings before tax (EBT) 1,00,000 80,000 1,00,000
Less: Tax @ 50% (50,000) (40,000) (50,000)
Earnings after tax (EAT) 50,000 40,000 50,000
Less: Preference share dividend (10% of -- -- (20,000)
₹2,00,000)
Earnings available for equity shareholders (A) 50,000 40,000 30,000
No. of equity shares (B) 20,000 10,000 10,000
Plan X = ₹ 4,00,000/ ₹ 20
Plan Y = ₹ 2,00,000 / ₹ 20
Plan Z = ₹ 2,00,000 / ₹ 20
E.P.S (A / B) 2.5 4 3
(ii) Computation of Financial Break-even Points
Financial Break-even point = Interest + Preference dividend/(1 - tax rate)

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Proposal ‘X’ = 0
Proposal ‘Y’ = ₹ 20,000 (Interest charges)
Proposal ‘Z’ = Earnings required for payment of preference share dividend
= ₹ 20,000 ÷ (1- 0.5 Tax Rate) = ₹ 40,000
(iii) Computation of Indifference Point between the plans
Combination of Proposals
(a) Indifference point where EBIT of proposal “X” and proposal ‘Y’ is equal
(EBIT) (1-0.5) = (EBIT- ₹ 20,000) (1-0.5)
20,000 shares 10,000 shares
0.5 EBIT = EBIT – ₹ 20,000 EBIT = ₹ 40,000
(b) Indifference point where EBIT of proposal ‘X’ and proposal ‘Z’ is equal:
(EBIT) (1-0.5) = EBIT(1-0.5) - ₹ 20,000
20,000 shares 10,000 shares
0.5 EBIT = EBIT- ₹ 40,000
0.5 EBIT = ₹ 40,000
EBIT = ₹40,000 = ₹ 80,000
0.5
(c) Indifference point where EBIT of proposal ‘Y’ and proposal ‘Z’ are equal:
(EBIT- ₹ 20,000) (1-0.5) = EBIT (1-0.5) - ₹ 20,000
10,000 shares 10,000 shares
0.5 EBIT – ₹ 10,000 = 0.5 EBIT – ₹ 20,000
There is no indifference point between proposal ‘Y’ and proposal ‘Z’
Analysis: It can be seen that financial proposal ‘Y’ dominates proposal ‘Z’, since the
financial break-even-point of the former is only ₹ 20,000 but in case of latter, it is
₹ 40,000. EPS of plan ‘Y’ is also higher.

Nov 18 Q-1(a) (05 Marks)

Y Limited requires ₹ 50,00,000 for a new project. This project is expected to yield earnings
before interest and taxes of ₹ 10,00,000. While deciding about the financial plan, the company
considers the objective of maximizing earnings per' share. It has two alternatives to finance the
project - by raising debt ₹ 5,00,000 or ₹ 20,00,000 and the balance, in each case, by issuing Equity
Shares. The company's share is currently selling at ₹ 300, but is expected to decline to ₹ 250 in case
the funds are borrowed in excess of ₹ 20,00,000. The funds can be borrowed at the rate of 12 percent
upto ₹ 5,00,000 and at 10 percent over ₹ 5,00,000. The tax rate applicable to the company is 25
percent.
Which form of financing should the company choose?
Solution:
Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Plan II = Raising Debt of ₹ 20 lakh + Equity of ₹ 30 lakh.

Calculation of Earnings per share (EPS)

Financial Plans
Particulars Plan I Plan II
₹ ₹
Expected EBIT 10,00,000 10,00,000
Less: Interest (Working Note 1) (60,000) (2,10,000)
Earnings before taxes 9,40,000 7,90,000
Less: Taxes @ 25% (2,35,000) (1,97,500)
Earnings after taxes (EAT) 7,05,000 5,92,500
Number of shares (Working Note 2) 15,000 10,000
Earnings per share (EPS) 47 59.25

Financing Plan II (i.e. Raising debt of ₹ 20 lakh and issue of equity share capital of
₹ 30 lakh) is the option which maximises the earnings per share.

Working Notes:
1. Calculation of interest on Debt.
Plan I (₹ 5,00,000 x 12%) ₹ 60,000
Plan II (₹ 5,00,000 x 12%) ₹ 60,000 ₹ 2,10,000
(₹ 15,00,000 x 10%) ₹ 1,50,000

2. Number of equity shares to be issued

Plan I : ₹45,00,000 = 15,000 shares

₹300 (Market Price of Share)

Plan II : ₹30,00,000 = 10,000 shares

₹300 (Market Price of Share)
(*Alternatively, interest on Debt for Plan II can be 20,00,000 X 10% i.e. ₹ 2,00,000.
accordingly, the EPS for the Plan II will be ₹60)

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
A Company earns a profit of ₹ 3,00,000 per annum after meeting its Interest liability of
₹ 1,20,000 on 12% debentures. The Tax rate is 50%. The number of Equity Shares of ₹ 10 each are
80,000 and the retained earnings amount to ₹ 12,00,000. The company proposes to take up an
expansion scheme for which a sum of ₹ 4,00,000 is required. It is anticipated that after expansion,
the company will be able to achieve the same return on investment as at present. The funds required
for expansion can be raised either through debt at the rate of 12% or by issuing Equity Shares at par.
Required:
(i) Compute the Earnings per Share (EPS), if:
➢ The additional funds were raised as debt
➢ The additional funds were raised by issue of equity shares.
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

(ii) Advise the company as to which source of finance is preferable.

Solution:

Working Notes:
1. Capital employed before expansion plan:
(₹)
Equity shares (₹10 × 80,000 shares) 8,00,000
Debentures {(₹ 1,20,000/12) x 100} 10,00,000
Retained earnings 12,00,000
Total capital employed 30,00,000

2. Earnings before the payment of interest and tax (EBIT):

(₹)
Profit (EBT) 3,00,000
Interest 1,20,000
EBIT 4,20,000

3. Return on Capital Employed (ROCE):

ROCE = EBIT x 100 = ₹4,20,000 x 100 = 14%
Capital Employed ₹30,00,000

4. Earnings before interest and tax (EBIT) after expansion scheme:

After expansion, capital employed = ₹ 30,00,000 + ₹4,00,000 = ₹ 34,00,000
Desired EBIT = 14% ₹34,00,000 = ₹4,76,000

i. Computation of Earnings Per Share (EPS) under the following options:

Present Expansion scheme
situation Additional funds raised as
Debt Equity
(₹) (₹) (₹)
Earnings before Interest and 4,20,000 4,76,000 476,000
Tax (EBIT)
Less: Interest - Old capital 1,20,000 1,20,000 1,20,000
- New capital -- 48,000 --
(₹4,00,000 x
12%)
Earnings before Tax (EBT)
3,00,000 3,08,000 3,56,000
Less: Tax (50% of EBT) 1,50,000 1,54,000 1,78,000
PAT 1,50,000 1,54,000 1,78,000
No. of shares outstanding 80,000 80,000 1,20,000
Earnings per Share (EPS) 1.875 1.925 1.48
₹1,50,000 ₹1,54,000 ₹1,78,000
80,000 80,000 1,20,000
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

ii. Advise to the Company: When the expansion scheme is financed by additional debt,
the EPS is higher. Hence, the company should finance the expansion scheme by raising
debt.

Question-2
A Company needs ₹ 31,25,000 for the construction of a new plant. The following three plans are
feasible:
I The Company may issue 3,12,500 equity shares at ₹ 10 per share.
II The Company may issue 1,56,250 equity shares at ₹ 10 per share and 15,625
debentures of ₹ 100 denomination bearing a 8% rate of interest.
III The Company may issue 1,56,250 equity shares at ₹ 10 per share and 15,625
cumulative preference shares at ₹ 100 per share bearing a 8% rate of dividend.
(i) if the Company's earnings before interest and taxes are ₹ 62,500, ₹ 1,25,000,
₹ 2,50,000, ₹ 3,75,000 and ₹ 6,25,000, what are the earnings per share under
each of three financial plans ? Assume a Corporate Income tax rate of 40%.
(ii) Which alternative would you recommend and why?
(iii) Determine the EBIT-EPS indifference points by formulae between Financing
Plan I and Plan II and Plan I and Plan III.

Solution:
1. Computation of EPS under three-financial plans.
Plan I: Equity Financing
(₹) (₹) (₹) (₹) (₹)
EBIT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Tax @ 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
37,500 75,000 1,50,000 2,25,000 3,75,000
PAT 3,12,500 3,12,500 3,12,500 3,12,500 3,12,500
No. of equity shares 0.12 0.24 0.48 0.72 1.20
EPS

Plan II: Debt – Equity Mix

(₹) (₹) (₹) (₹) (₹)
EBIT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Interest 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
EBT (62,500) 0 1,25,000 2,50,000 5,00,000
Less: Tax @ 40% 25,000* 0 50,000 1,00,000 2,00,000
PAT (37,500) 0 75,000 1,50,000 3,00,000
No. of equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
(₹ 0.24) 0 0.48 0.96 1.92
EPS
* The Company can set off losses against the overall business profit or may carry forward it to next
financial years.

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Plan III: Preference Shares – Equity Mix

(₹) (₹) (₹) (₹) (₹)
EBIT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Tax @ 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
PAT 37,500 75,000 1,50,000 2,25,000 3,75,000
Less: Pref. dividend 1,25,000* 1,25,000* 1,25,000 1,25,000 1,25,000
PAT after Pref. dividend. (87,500) (50,000) 25,000 1,00,000 2,50,000
No. of Equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.56) (0.32) 0.16 0.64 1.60
* In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits.

2. From the above EPS computations tables under the three financial plans we can see that when
EBIT is ₹ 2,50,000 or more, Plan II: Debt-Equity mix is preferable over the Plan I and Plan III,
as rate of EPS is more under this plan. On the other hand an EBIT of less than ₹2,50,000, Plan I:
Equity Financing has higher EPS than Plan II and Plan III. Plan III Preference share-Equity mix
is not acceptable at any level of EBIT, as EPS under this plan is lower.
The choice of the financing plan will depend on the performance of the company and other macro
economic conditions. If the company is expected to have higher operating profit Plan II: Debt –
Equity Mix is preferable. Moreover, debt financing gives more benefit due to availability of tax
shield.

3. EBIT – EPS Indifference point : Plan I and Plan II

EBIT1 x (1-t) = (EBIT2 –Interest) x (1-t)
No. of Equity Share (N1) No. of Equity Shares (N2)

EBIT (1 – 0.40) = (EBIT - ₹1,25,000) x (1 – 0.40)

3,12,500 Shares 1,56,250 Shares
0.6 EBIT = 1.2 EBIT – ₹1,50,000
EBIT = ₹1,50,000/0.6 = ₹2,50,000
Indifference points between Plan I and Plan II is ₹ 2,50,000

EBIT – EPS Indifference Point: Plan I and Plan III

EBIT1 x (1-t) = EBIT3 (1-t) – Preference Dividend
No. of Equity Share (N1) No. of Equity Shares (N2)

EBIT (1 – 0.40) = EBIT3 (1 – 0.40) - ₹1,25,000

3,12,500 Shares 1,56,250 Shares

0.6 EBIT = 1.2 EBIT – ₹ 2,50,000

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

EBIT = ₹2,50,000/0.6 = ₹4,16,667

Indifference points between Plan I and Plan III is ₹ 4,16,667.

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

PART- 3 FINANCIAL BREAKEVEN & INDIFFERENCE

A. QUESTION FROM STUDY MATERIAL

TEST YOUR KNOWLEDGE

Question-3
Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives
in financing the project cost.
Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each
Alternative-II: Debt-equity ratio 2:1 (issuing equity shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%.
Calculate the indifference point between the two alternative methods of financing.
Hints: ₹10,80,000

Question-4
Ganapati Limited is considering three financing plans. The key information is as follows:
(a) Total investment to be raised ₹ 2,00,000
(b) Plans of Financing Proportion:
Plans Equity Debt Preference Shares
A 100% - -
B 50% 50% -
C 50% - 50%

(c) Cost of debt 8%

Cost of preference shares 8%
(d) Tax rate 50%
(e) Equity shares of the face value of ₹10 each will be issued at a premium of ₹10 per share.
(f) Expected EBIT is ₹80,000

You are required to Determine for each plan: -

(i) Earnings per share (EPS)
(ii) The financial break-even point.
(iii) Indicate if any of the plans dominate and compute the EBIT range among the plans for
indifference.
Hints:
(i) EPS = ₹4, ₹7.2, ₹6.4
(ii) ₹16,000, ₹32,000, ₹8,000

Question-5
Alpha Limited requires funds amounting to ₹80 lakh for its new project. To ra ise the funds, the
company has following two alternatives:
(i) To issue Equity Shares of ₹100 each (at par) amounting to ₹60 lakh and borrow the
balance amount at the interest of 12% p.a.; or
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

(ii) To issue Equity Shares of ₹100 each (at par) and 12% Debentures in equal proportion.
The Income-tax rate is 30%.
IDENTIFY the point of indifference between the available two modes of financing and state which
option will be beneficial in different situations.
Hints:
(i) Indifference Point = ₹9,60,000

Question-6
Xylo Ltd. is considering two alternative financing plans as follows:
Particulars Plan – A (₹) Plan – B (₹)
Equity shares of ₹ 10 each 8,00,000 8,00,000
Preference Shares of ₹ 100 each - 4,00,000
12% Debentures 4,00,000 -
12,00,000 12,00,000
The indifference point between the plans is ₹ 4,80,000. Corporate tax rate is 30%. CALCULATE
the rate of dividend on preference shares.
Hints: 8.4%

Question-7
Ganesha Limited is setting up a project with a capital outlay of ₹ 60,00,000. It has two alternatives
in financing the project cost.
Alternative-I: 100% equity finance by issuing equity shares of ₹ 10 each Alternative-II: Debt-equity
ratio 2:1 (issuing equity shares of ₹ 10 each)
The rate of interest payable on the debts is 18% p.a. The corporate tax rate is 40%. CALCULATE
the indifference point between the two alternative methods of financing.
Hints: EBIT of ₹ 10,80,000 earnings per share for the two alternatives is equal.

B. PAST YEAR QUESTION

May 18 Q-1(d) (05 Marks)

Sun Ltd. is considering two financing plans. Details of which are as under:
(i) Fund's requirement – ₹ 100 Lakhs
(ii) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%
(iii) Cost of debt – 12% p.a.
(iv) Tax Rate – 30%
(v) Equity Share ₹ 10 each, issued at a premium of ₹ 15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) ₹ 40 Lakhs You are required to
compute:
(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iii) Indifference point between Plan I and II

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Solution:
(i) Computation of Earnings Per Share (EPS)
Plans I (₹) II (₹)
Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of ₹75 lakh) -- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ ₹10+₹15) 4,00,000 1,00,000
E.P.S (₹) 7.00 21.70

(ii) Computation of Financial Break-even Points

Plan ‘I’ = 0 – Under this plan there is no interest payment, hence the financial break-
even point will be zero.
Plan ‘II’ = ₹ 9,00,000 - Under this plan there is an interest payment of ₹9,00,000, hence
the financial break -even point will be ₹9 lakhs.

(iii) Computation of Indifference Point between Plan I and Plan II:

Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be
calculated by applying the following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2
So, EBIT (1-0.3) = (EBIT - ₹9,00,000) (1-0.3)
4,00,000 shares 1,00,000 shares
Or, 2.8 EBIT – 25,20,000 = 0.7EBIT
Or, 2.1EBIT = 25,20,000
EBIT =12,00,000
C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference point
between the following financing alternatives will occur.
(i) Equity share capital of ₹ 6,00,000 and 12% debentures of ₹ 4,00,000.
Or
(ii) Equity share capital of ₹ 4,00,000, 14% preference share capital of ₹ 2,00,000 and
12% debentures of ₹ 4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is ₹ 10 in each case.

Solution:
Computation of level of earnings before interest and tax (EBIT)

In case alternative (i) is accepted, then the EPS of the firm would be:
EPS Alternative (i) = (EBIT - Interest) (1 - tax rate)
No. of Equity Share
= (EBIT – 0.12 x ₹4,00,000) (1-0.35)
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

60,000 Shares

In case the alternative (ii) is accepted, then the EPS of the firm would be
EPS Alternative (ii) = (EBIT - 0.12 x ₹ 4,00,000) (1 - 0.35) - (0.14 x ₹ 2,00,000)
40,000 Shares
In order to determine the indifference level of EBIT, the EPS under the two alternative plans should
be equated as follows:

(EBIT - 0.12 x ₹ 4, 00, 000) (1 - 0.35) = (EBIT - 0.12 x ₹ 4, 00,000) (1 - 0.35) - (0.14 x ₹ 2,00,000)
60, 000 Shares 40,000 Shares

Or 0.65 EBIT - ₹ 31,200 = 0.65 EBIT - ₹59,200

3 2
Or 1.30 EBIT - ₹ 62,400 = 1.95 EBIT - ₹1,77,600
Or (1.95 - 1.30) EBIT = ₹1,77,600 - ₹62,400 = ₹1,15,200
Or EBIT = ₹ 1,15,200/0.65
Or EBIT = ₹ 1,77,231

Question-2
A new project is under consideration in Zip Ltd., which requires a capital investment of ₹ 4.50
crores. Interest on term loan is 12% and Corporate Tax rate is 50%. If the Debt Equity ratio insisted
by the financing agencies is 2 : 1, calculate the point of indifference for the project.

Solution:
The capital investment can be financed in two ways i.e.
(i) By issuing equity shares only worth ₹4.5 crore or
(ii) By raising capital through taking a term loan of ₹ 3 crores and ₹ 1.50 crores through
issuing equity shares (as the company has to comply with the 2 : 1 Debt Equity ratio
insisted by financing agencies).

In first option interest will be Zero and in second option the interest will be ₹ 36,00,000 Point of
Indifference between the above two alternatives =
EBIT1 x (1-t) = (EBIT2 – Interest) x (1-t)
No. of equity shares (N1) No. of equity shares (N2)
Or,
EBIT (1-0.50) = (EBIT - ₹3,60,000) x (1-0.50)
45,00,000 shares 15,00,000 shares
Or, 0.5 EBIT = 1.5 EBIT – ₹ 54,00,000
EBIT = ₹ 54,00,000
EBIT at point of Indifference will be ₹ 54 Lakhs.
(The face value of the equity shares is assumed as ₹10 per share. However, indifference point will
be same irrespective of face value per share).

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Question-3
X Ltd. is considering the following two alternative financing plans:
Plan – I (₹) Plan – II (₹)
Equity shares of ₹ 10 each 4,00,000 4,00,000

12% Debentures 2,00,000 -

Preference Shares of ₹ 100 each - 2,00,000

6,00,000 6,00,000
The indifference point between the plans is ₹ 2,40,000. Corporate tax rate is 30%. Calculate the rate
of dividend on preference shares.

Solution:
Computation of Rate of Preference Dividend
(EBIT - Interest) (1- t) = EBIT (1- t) - Preference Dividend
No. of Equity Shares (N1) No. of Equity Shares (N2)

(₹2, 40,000 - ₹24,000) (1- 0.30) = ₹2,40,000 (1-0.30) – Preference Dividend

40,000 shares 40,000 shares

₹2,16,000 (1- 0.30) = ₹1,68,000 - Preference Dividend

40,000 shares 40,000 shares

₹ 1,51,200 = ₹ 1,68,000 – Preference Dividend

Preference Dividend = ₹ 1,68,000 – ₹ 1,51,200 = ₹ 16,800
Rate of Dividend = Preference Dividend x 100 = ₹16,800 x 100 = 8.4%
Pref. Share Capital 2,00,000

Question-4
A Ltd. and B Ltd. are identical in every respect except capital structure. A Ltd. does not employ
debts in its capital structure whereas B Ltd. employs 12% Debentures amounting to ₹ 10 lakhs.
Assuming that :
(i) All assumptions of M-M model are met;
(ii) Income-tax rate is 30%;
(iii) EBIT is ₹ 2,50,000 and
(iv) The Equity capitalization rate of ‘A' Ltd. is 20%.
Calculate the value of both the companies and also find out the Weighted Average Cost of Capital
for both the companies.
Solution:
(i) Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM Hypothesis
Market Value of ‘A Ltd’ (Unlevered)
VF = EBIT (1-t) = ₹2,50,000 (1-0.30) = ₹1,75,000 = ₹8,75,000
Ke 20% 20%
Market Value of ‘B Ltd.’ (Levered) Vg = Vu + TB
= ₹ 8,75,000 + (₹10,00,000 × 0.30)
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

= ₹ 8,75,000 + ₹ 3,00,000 = ₹ 11,75,000

(ii) Computation of Weighted Average Cost of Capital (WACC)

WACC of ‘A Ltd.’ = 20% (i.e. Ke = Ko)
WACC of ‘B Ltd.’
B Ltd. (₹)
EBIT 2,50,000
Interest to Debt holders (1,20,000)

EBT 1,30,000
Taxes @ 30% (39,000)

Income available to Equity Shareholders 91,000

Total Value of Firm 11,75,000
Less: Market Value of Debt (10,00,000)

Market Value of Equity 1,75,000

Return on equity (Ke) = 91,000 / 1,75,000 0.52
Computation of WACC B. Ltd
Component of Capital Amount Weight Cost of Capital WACC
Equity 1,75,000 0.149 0.52 0.0775
Debt 10,00,000 0.851 0.084* 0.0715
Total 11,75,000 0.1490
*Kd= 12% (1- 0.3) = 12% × 0.7 = 8.4%
WACC = 14.90%
Question-5
The management of Z Company Ltd. wants to raise its funds from market to meet out the financial
demands of its long-term projects. The company has various combinations of proposals to raise its
funds. You are given the following proposals of the company:
Proposal Equity shares (%) Debts (%) Preference shares (%)
P 100 - 50 -
Q 50 - - 50
R 50
(i) Cost of debt and preference shares is 10% each.
(ii) Tax rate – 50%
(iii) Equity shares of the face value of ₹ 10 each will be issued at a premium of ₹ 10 per share.
(iv) Total investment to be raised ₹ 40,00,000.
(v) Expected earnings before interest and tax ₹ 18,00,000.
From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:
• Earnings per share
• Financial break-even-point
• Compute the EBIT range among the plans for indifference. Also indicate if any of the plans

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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

dominate.
Solution:
(i) Computation of Earnings per Share (EPS)
Plans P (₹) Q (₹) R (₹)
Earnings before interest & tax (EBIT) 18,00,000 18,00,000 18,00,000
Less: Interest charges -- (2,00,000) --
Earnings before tax (EBT) 18,00,000 16,00,000 18,00,000
Less : Tax @ 50% (9,00,000) (8,00,000) (9,00,000)
Earnings after tax (EAT) 9,00,000 8,00,000 9,00,000
Less : Preference share dividend -- -- (2,00,000)
Earnings available for equity shareholders 9,00,000 8,00,000 7,00,000
No. of equity shares 2,00,000 1,00,000 1,00,000
E.P.S 4.5 8 7
(ii) Computation of Financial Break-even Points
Proposal ‘P’ =0
Proposal ‘Q’ = ₹ 2,00,000 (Interest charges)
Proposal ‘R’ = Earnings required for payment of preference share dividend
i.e. ₹ 2,00,000/0.5 (Tax Rate) = ₹ 4,00,000

(iii) Computation of Indifference Point between the Proposals

Combination of Proposals
(a) Indifference point where EBIT of proposal "P" and proposal 'Q' is equal
EBIT(1- 0.5) = (EBIT - ₹2,00,000)(1- 0.5)
2,00,000 shares 1,00,000 Shares
0.5 EBIT = EBIT – ₹ 2,00,000
EBIT = ₹ 4,00,000
(b) Indifference point where EBIT of proposal ‘P’ and proposal ‘R’ is equal:
EBIT(1- 0.50) = EBIT(1- 0.50) - ₹2,00,000
2,00,000 shares 1,00,000 shares

0.5EBIT = 0.5EBIT - ₹2,00,000

2,00,000 shares 1,00,000 shares

0.25 EBIT = 0.5 EBIT – ₹ 2,00,000

EBIT = ₹2,00,000/0.25 =₹ 8,00,000

(c) Indifference point where EBIT of proposal ‘Q’ and proposal ‘R’ are equal
(EBIT - ₹2,00,000)(1- 0.5) = EBIT(1- 0.5) - ₹2,00,000
1,00,000 shares 1,00,000 shares

0.5 EBIT – ₹1,00,000 = 0.5 EBIT – ₹2,00,000

There is no indifference point between proposal ‘Q’ and proposal ‘R’
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Financial Decisions- Capital Structure By: CA PRAKASH PATEL

Analysis: It can be seen that financial proposal ‘Q’ dominates proposal ‘R’, since the
financial break-even-point of the former is only ₹ 2,00,000 but in case of latter, it is ₹
4,00,000.

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Investment Decision By: CA PRAKASH PATEL

Chapter- 3: Investment Decision

1. CAPITAL BUDGETING TECHNIQUES
A. QUESTION FROM STUDY MATERIAL
Illustration 1 (CF Estimation)
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of ₹1,00,000;
expected economic life of 4 years and change in earnings before taxes and depreciation of ₹45,000
in year 1, ₹30,000 in year 2, ₹25,000 in year 3 and ₹35,000 in year 4. Assume straight-line
depreciation and a 20% tax rate. You are required to COMPUTE relevant cash flows.
Hints: ₹41,000, ₹29,000, ₹25,000, ₹33,000

Illustration 2 (ARR)
A project requiring an investment of ₹10,00,000 and it yields profit after tax and depreciation which
is as follows:
Years Profit after tax and depreciation (₹)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project can be sold
for ₹ 80,000. DETERMINE Average Rate of Return.
Hints: ARR = 9.2% or 17.00%

Illustration 3 (NPV)
COMPUTE the net present value for a project with a net investment of ₹1,00,000 and net cash flows
year one is ₹55,000; for year two is ₹80,000 and for year three is ₹ 15,000. Further, the company’s
cost of capital is 10%?
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]
Hints: NPV = ₹27,340

Illustration 4 (NPV)
ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the
purchase of equipment; the company uses the net present value technique to evaluate projects. The
capital budget is limited to ₹ 500,000 which ABC Ltd believes is the maximum capital it can raise.
The initial investment and projected net cash flows for each project are shown below. The cost of
capital of ABC Ltd is 12%. You are required to COMPUTE the NPV of the different projects.
Project A Project B Project C Project D
Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000

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Investment Decision By: CA PRAKASH PATEL

4 50,000 75,000 80,000 40,000

5 50,000 75,000 100,000 20,000
Hints: NPV = (₹19,750), ₹25,635, ₹27,050, (₹3,750)

Illustration 5 (PI)
Suppose we have three projects involving discounted cash outflow of ₹5,50,000, ₹ 75,000 and
₹1,00,20,000 respectively. Suppose further that the sum of discounted cash inflows for these projects
are ₹6,50,000, ₹95,000 and ₹1,00,30,000 respectively. CALCULATE the desirability factors for the
three projects.
Hints: PI = 1.18, 1.27, 1.001

Illustration 6 (IRR)
A Ltd. is evaluating a project involving an outlay of ₹10,00,000 resulting in an annual cash inflow
of ₹ 2,50,000 for 6 years. Assuming salvage value of the project is zero; DETERMINE the IRR of
the project.
Hints: IRR = 12.98%

Illustration 7 (IRR)
CALCULATE the internal rate of return of an investment of ₹1,36,000 which yields the following
cash inflows:
Year Cash Inflows (in ₹)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Hints: IRR = 10.70%

Illustration 8 (IRR)
A company proposes to install machine involving a capital cost of ₹3,60,000. The life of the machine
is 5 years and its salvage value at the end of the life is nil. The machine will produce the net operating
income after depreciation of ₹68,000 per annum. The company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
You are required to CALCULATE the internal rate of return of the proposal.
Hints: IRR = 15.74%

Illustration 9 (MIRR)
An investment of ₹1,36,000 yields the following cash inflows (profits before depreciation but after
tax). DETERMINE MIRR considering 8% as cost of capital.
Year ₹
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
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Investment Decision By: CA PRAKASH PATEL

1,80,000
Hints: MIRR = 9%

Illustration 10 (NPV & IRR)

Suppose there are two Project A and Project B are under consideration. The cash flows associated
with these projects are as follows:
Year Project A Project B
0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
Assuming Cost of Capital equal to 10% IDENTIFY which project should be accepted as per NPV
Method and IRR Method.
Hints:
NPV: A = ₹25,050, B = ₹59,300
IRR: A = 24.26%, B = 21.48%

Illustration 11 (NPV & IRR)

Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash flows
associated with these projects are as follows:
Year Project X Project Y
0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000
Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted as per NPV Method
and IRR Method.
Hints:
NPV: X = ₹51,590, Y = ₹53,350
IRR: X = 24.87%, Y = 17.60%

Illustration 12 (NPV & IRR)

Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash flows
associated with these projects are as follows:
Year Project A Project B
0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000
Assuming Cost of Capital equal to 12%, ANALYSE which project should be accepted as per NPV
Method and IRR Method?
Hints:
NPV: A = ₹1,69,750, B = ₹3,36,400
IRR: A = 50%, B = 43.07%.

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Investment Decision By: CA PRAKASH PATEL

Illustration 15 (Mix Question)

Alpha Company is considering the following investment projects:
Cash Flows (₹)
Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000
(a) ANALYSE the rank the projects according to each of the following methods: (i) Payback,
(ii) ARR, (iii) IRR and (iv) NPV, assuming discount rates of 10 and 30 per cent.
(b) Assuming the projects are independent, which one should be accepted? If the projects are
mutually exclusive, IDENTIFY which project is the best?
Hints:
A B C D
BP (years) 1 1.33 2.33 1
ARR 0% 50% 53% 40%
IRR 0% 32% 26.5% 37.6%
NPV10% (₹910) ₹3,013 ₹4,134 ₹3,821
NPV30% (₹2,310) ₹208 (₹633) ₹831

Illustration 16 (Mix Question)

The expected cash flows of three projects are given below. The cost of capital is 10 per cent.
(a) CALCULATE the payback period, net present value, internal rate of return and accounting
rate of return of each project.
(b) IDENTIFY the rankings of the projects by each of the four methods.
(figures in ‘000)
Period Project A (₹) Project B (₹) Project C (₹)
0 (5,000) (5,000) (5,000)
1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600
Hints:
A B C
PBP (years) 5.5 5.4 2.5
ARR (%) 16 26 20
IRR (%) 12.42 16.72 16.52
NPV (₹) ₹530.50 ₹1,591 ₹655

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Investment Decision By: CA PRAKASH PATEL

Illustration 17
X Limited is considering purchasing of new plant worth ₹ 80,00,000. The expected net cash flows
after taxes and before depreciation are as follows:
Year Net Cash Flows (₹)
1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000
The rate of cost of capital is 10%. You are required to CALCULATE:
(i) Pay-back period
(ii) Net present value at 10 discount factor
(iii) Profitability index at 10 discount factor
(iv) Internal rate of return with the help of 10% and 15% discount factor The following present
value table is given for you:
Present value of ₹ 1 at10% Present value of ₹ 1 at15%
Year
discount rate discount rate
1 0.909 0.87
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247

Hints:

(i) 5.625 years or 5 years 7.5 months

(ii) 17,92,200
(iii) 1.224
(iv) 14.7%

TEST YOUR KNOWLEDGE

Question-1 (NPV, PI & DPBP)

Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A
and B are available at the same cost of ₹5 lakhs each. Salvage value of the old machine is ₹1 lakh.
The utilities of the existing machine can be used if the company purchases A. Additional cost of
utilities to be purchased in that case are ₹1 lakh. If the company purchases B then all the existing
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Investment Decision By: CA PRAKASH PATEL

utilities will have to be replaced with new utilities costing ₹2 lakhs. The salvage value of the old
utilities will be ₹0.20 lakhs. The earnings after taxation are expected to be:
(cash in-flows of)
Year A₹ B₹ P.V. Factor @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage Value at the end of 50,000 60,000
Year 5
The targeted return on capital is 15%. You are required to (i) COMPUTE, for the two machines
separately, net present value, discounted payback period and desirability factor and (ii) ADVICE
which of the machines is to be selected?
Hints:
NPV = 0.44, 0.20, DPBP = 4.6 years, 4.6 years, PI = 1.088, 1.034

Question-2 (NPV, IRR & PBP)

Hindlever Company is considering a new product line to supplement its range of products. It is
anticipated that the new product line will involve cash investments of ₹7,00,000 at time 0 and
₹10,00,000 in year 1. After-tax cash inflows of ₹2,50,000 are expected in year 2, ₹3,00,000 in year
3, ₹3,50,000 in year 4 and ₹4,00,000 each year thereafter through year 10. Although the product line
might be viable after year 10, the company prefers to be conservative and end all calculations at that
time.
(a) If the required rate of return is 15 per cent, COMPUTE net present value of the project? Is it
acceptable?
(b) ANALYSE What would be the case if the required rate of return were 10 per cent?
(c) CALCULATE its internal rate of return?
(d) COMPUTE the project’s payback period?
Hints:
NPV = (₹1,18,200), NPV10% = ₹2,51,450, IRR = 13.4%, PBP = 6 years

Question-3 (NPV)
Elite Cooker Company is evaluating three investment situations: (1) produce a new line of
aluminium skillets, (2) expand its existing cooker line to include several new sizes, and (3) develop
a new, higher-quality line of cookers. If only the project in question is undertaken, the expected
present values and the amounts of investment required are:

Project Investment Present value of Future Cash-

required Flows
₹ ₹
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and
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Investment Decision By: CA PRAKASH PATEL

present values will simply be the sum of the parts. With projects 1 and 3, economies are possible in
investment because one of the machines acquired can be used in both production processes. The
total investment required for projects 1 and 3 combined is ₹4,40,000. If projects 2 and 3 are
undertaken, there are economies to be achieved in marketing and producing the products but not in
investment. The expected present value of future cash flows for projects 2 and 3 is ₹6,20,000. If all
three projects are undertaken simultaneously, the economics noted will still hold. However, a
₹1,25,000 extension on the plant will be necessary, as space is not available for all three projects. .
ANALYSE which project or projects should be chosen?
Hints:
Project 1 and 3 should be taken, NPV13 = ₹2,50,000

Question-4 (NPV)
Cello Limited is considering buying a new machine which would have a useful economic life of five
years, a cost of ₹1,25,000 and a scrap value of ₹30,000, with 80 per cent of the cost being payable
at the start of the project and 20 per cent at the end of the first year. The machine would produce
50,000 units per annum of a new product with an estimated selling price of ₹3 per unit. Direct costs
would be ₹1.75 per unit and annual fixed costs, including depreciation calculated on a straight- line
basis, would be ₹40,000 per annum.
In the first year and the second year, special sales promotion expenditure, not included in the above
costs, would be incurred, amounting to ₹10,000 and ₹15,000 respectively.
ANALYSE the project using the NPV method of investment appraisal, assuming the company’s
cost of capital to be 10 percent.
Hints: NPV = ₹31,712

Question-5
Following data has been available for a capital project:
Annual cash inflows ₹ 1,00,000
Useful life 4 years
Salvage value 0
Internal rate of return 12%
Profitability index 1.064
You are required to CALCULATE the following for this project:
(i) Cost of project
(ii) Cost of capital
(iii) Net present value
(iv) Payback period
PV factors at different rates are given below:
Discount factor 12% 11% 10% 9%
1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708
Hints:
(i) ₹3,03,800
(ii) 9% (approx.)
(iii) ₹ 19,443.20
(iv) 3.038 years

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Investment Decision By: CA PRAKASH PATEL

Question-6
NavJeevani hospital is considering to purchase a machine for medical projectional radiography
which is priced at ₹ 2,00,000. The projected life of the machine is 8 years and has an expected
salvage value of ₹ 18,000 at the end of 8th year. The annual operating cost of the machine is ₹
22,500. It is expected to generate revenues of ₹ 1,20,000 per year for eight years. Presently, the
hospital is outsourcing the radiography work to its neighbour Test Center and is earning commission
income of ₹ 36,000 per annum, net of taxes.
Required:
ANALYSE whether it would be profitable for the hospital to purchase the machine. Give your
recommendation under:
(i) Net Present Value method
(ii) Profitability Index method
Consider tax @30%. PV factors at 10% are given below:
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Hints:
(i) 16,832.06
(ii) =1.084

Question-7
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. Initial equipment
cost will be ₹ 3.5 crores. Additional equipment costing
₹ 25,00,000 will be purchased at the end of the third year from the cash inflow of this year. At the
end of 8 years, the original equipment will have no resale value, but additional equipment can be
sold for ₹ 2,50,000. A working capital of
₹ 40,00,000 will be needed and it will be released at the end of eighth year. The project will be
financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units per year 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sales price of ₹ 240 per unit is expected and variable expenses will amount to 60% of sales
revenue. Fixed cash operating costs will amount ₹ 36,00,000 per year. The loss of any year will be
set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and
considers 12 per cent to be an appropriate after-tax cost of capital for this project. The company
follows straight line method of depreciation.
CALCULATE the net present value of the project and advise the management to take appropriate
decision.
The PV factors at 12% are
Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Hints: 161.11

Question-8
A large profit making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing process to be converted into a marketable product.
At present, the waste is removed by a contractor for disposal on payment by the company of ₹ 150
lakh per annum for the next four years. The contract can be terminated upon installation of the

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Investment Decision By: CA PRAKASH PATEL

aforesaid machine on payment of a compensation of ₹ 90 lakh before the processing operation starts.
This compensation is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ₹ 600 lakh. At the end of the 4th year,
the machine can be sold for ₹ 60 lakh and the cost of dismantling and removal will be ₹ 45 lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated as
under:
(₹ In lakh)
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as perincome 150 114 84 63
tax rules)
Initial stock of materials required before commencement of the processing operations is ₹ 60 lakh
at the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will
be ₹ 165 lakh and the stocks at the end of year 4 will be nil. The storage of materials will utilise
space which would otherwise have been rented out for ₹ 30 lakh per annum. Labour costs include
wages of 40 workers, whose transfer to this process will reduce idle time payments of ₹ 45 lakh in
the year- 1 and ₹ 30 lakh in the year- 2. Factory overheads include apportionment of general factory
overheads except to the extent of insurance charges of ₹ 90 lakh per annum payable on this venture.
The company’s tax rate is 30%.
Consider cost of capital @ 14%, the present value factors of which is given below for four years:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592
ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer.

Hints: Since the net present value of cash flows is ₹ 528.16 lakh which is positive the management
should install the machine for processing the waste.

Question-9
A chemical company is presently paying an outside firm ₹ 1 per gallon to dispose off the waste
resulting from its manufacturing operations. At normal operating capacity, the waste is about 50,000
gallons per year.
After spending ₹ 60,000 on research, the company discovered that the waste could be sold for ₹ 10
per gallon if it was processed further. Additional processing would, however, require an investment
of ₹ 6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage
value. Depreciation would be calculated by straight line method.
Except for the costs incurred in advertising ₹ 20,000 per year, no change in the present selling and
administrative expenses is expected, if the new product is sold. The details of additional processing
costs are as follows:
Variable : ₹ 5 per gallon of waste put into process. Fixed : (Excluding Depreciation) ₹
30,000 per year.
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 50,000 gallons of the product could be sold
each year.
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Investment Decision By: CA PRAKASH PATEL

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.
You should consider Present value of Annuity of ₹ 1 per year @ 15% p.a. for 10 years as 5.019.

Hints: Processing of waste is a better option as it gives a positive Net Present Value.

B. PAST YEAR QUESTION

Nov 22 Q-3 (10 Marks)

A firm is in need of a small vehicle to make deliveries. It is in tending to choose between two
options. One option is to buy a new three wheeler that would cost ₹ 1,50,000 and will remain in
service for 10 years.
The other alternative is to buy a second hand vehicle for ₹ 80,000 that could remain in service for
5 years. Thereafter the firm, can buy another second hand vehicle for ₹ 60,000 that will last for
another 5 years.
The scrap value of the discarded vehicle will be equal to it written down value (WDV). The firm
pays 30% tax and is allowed to claim depreciation on vehicles @ 25% on WDV basis.
The cost of capital of the firm is 12%.
You are required to advise the best option. Given:
t 1 2 3 4 5 6 7 8 9 10
PVIF (t,12%) 0.892 0.797 0.711 0.635 0.567 0.506 0.452 0.403 0.360 0.322

Solution:
Selection of Investment Decision
Tax shield on Purchase of New vehicle
Year WDV Dep. @ 25% Tax shield @ 30%
1 1,50,000 37,500 11,250
2 1,12,500 28,125 8,437
3 84,375 21,094 6,328
4 63,281 15,820 4,746
5 47,461 11,865 3,560
6 35,596 8,899 2,670
7 26,697 6,674 2,002
8 20,023 5,006 1,502
9 15,017 3,754 1,126
10 11,263 2,816 845
11 8,447 Scrap value

Tax shield on Purchase of Second hand vehicles

Year WDV Dep. @ 25% Tax shield @ 30%

1 80,000 20,000 6,000
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Investment Decision By: CA PRAKASH PATEL

2 60,000 15,000 4,500

3 45,000 11,250 3,375
4 33,750 8,437 2,531
5 25,313 6,328 1,898 Scrap value = ₹ 18,985
6 60,000 15,000 4,500
7 45,000 11,250 3,375
8 33,750 8,437 2,531
9 25,313 6,328 1,898
10 18,985 4,746 1,424 Scrap value = ₹ 14,239

Calculation of PV of Net outflow of New Vehicle

Year Cash OF/IF PV Factor PV of OF/IF
0 1,50,000 1 1,50,000
1 (11,250) 0.892 (10,035)
2 (8,437) 0.797 (6,724)
3 (6,328) 0.711 (4,499)
4 (4,746) 0.635 (3,014)
5 (3,560) 0.567 (2,018)
6 (2,670) 0.506 (1,351)
7 (2,002) 0.452 (905)
8 (1,502) 0.403 (605)
9 (1,126) 0.360 (405)
10 (845 + 8447) 0.322 (2,992)
PVNOF 1,17,452

Calculation of PV of Net outflow of Second hand Vehicles

Year Cash OF/IF PV Factor PV of OF/IF
0 80,000 1 80,000
1 (6,000) 0.892 (5,352)
2 (4,500) 0.797 (3,587)
3 (3,375) 0.711 (2,400)
4 (2,531) 0.635 (1,607)
5 (60000 – 18985 – 1898) = 39,117 0.567 22,179
6 (4,500) 0.506 (2,277)
7 (3,375) 0.452 (1,525)
8 (2,531) 0.403 (1,020)
9 (1,898) 0.360 (683)
10 (1424 + 14239) = (15,663) 0.322 (5,043)
PVNOF 78,686
Advise: The PV of net outflow is low in case of buying the second hand vehicles.
Therefore, it is advisable to buy second hand vehicles.

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Investment Decision By: CA PRAKASH PATEL

May 22 Q-3 (10 Marks)

Alpha Limited is a manufacturer of computers. It wants to introduce artificial intelligence while
making computers. The estimated annual saving from introduction of the artificial intelligence
(AI) is as follows:
• reduction of five employees with annual salaries of ₹ 3,00,000 each
• reduction of ₹ 3,00,000 in production delays caused by inventory problem
• reduction in lost sales ₹ 2,50,000 and
• Gain due to timely billing ₹ 2,00,000
The purchase price of the system for installation of artificial intelligence is ₹ 20,00,000 and
installation cost is ₹ 1,00,000. 80% of the purchase price will be paid in the year of purchase and
remaining will be paid in next year.
The estimated life of the system is 5 years and it will be depreciated on a straight -line basis.
However, the operation of the new system requires two computer specialists with annual salaries
of ₹ 5,00,000 per person.
In addition to above, annual maintenance and operating cost for five years are as below:
(Amount in ₹)
Year 1 2 3 4 5
Maintenance & Operating Cost 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance and operating cost are payable in advance.
The company's tax rate is 30% and its required rate of return is 15%.
Year 1 2 3 4 5
PVIF 0.10, t 0.909 0.826 0.751 0.683 0.621
PVIF 0.12, t 0.893 0.797 0.712 0.636 0.567
PVIF 0.15, t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using Net Present Value and Profitability Index.
Solution:
Computation of Annual Cash Flow after Tax
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in Salaries 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Production Delays
Reduction in Lost 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Sales
Gain due to Timely 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Billing
Salary to Computer (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
Specialist
Maintenance and (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
Operating Cost
(payable in advance)
Depreciation (21 (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
lakhs/5)

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Investment Decision By: CA PRAKASH PATEL

Gain Before Tax 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000

Less: Tax (30%) 1,89,000 1,95,000 2,01,000 2,07,000 2,13,000

Gain After Tax 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000

Add: Depreciation 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000

Add: Maintenance 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000

and Operating Cost
(payable in advance)
Less: Maintenance (2,00,00 (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
and Operating Cost 0)
(payable in advance)
Net CFAT (2,00,00 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000
0)

Note: Annual cash flows can also be calculated Considering tax shield on depreciation &
maintenance and operating cost. There will be no change in the final cash flows after tax.
Computation of NPV
Particulars Year Cash Flows (₹) PVF PV (₹)
Initial Investment (80% of 20 Lacs) 0 16,00,000 1 16,00,000
Installation Expenses 0 1,00,000 1 1,00,000
Instalment of Purchase Price 1 4,00,000 0.870 3,48,000
PV of Outflows (A) 20,48,000
CFAT 0 (2,00,000) 1 (2,00,000)
CFAT 1 8,81,000 0.870 7,66,470
CFAT 2 8,95,000 0.756 6,76,620
CFAT 3 9,09,000 0.658 5,98,122
CFAT 4 9,23,000 0.572 5,27,956
CFAT 5 10,37,000 0.497 5,15,389
PV of Inflows (B) 28,84,557
NPV (B-A) 8,36,557
Profitability Index (B/A) 1.408 or 1.41
Evaluation: Since the NPV is positive (i.e. ₹ 8,36,557) and Profitability Index is also greater than
1 (i.e. 1.41), Alpha Ltd. may introduce artificial intelligence (AI) while making computers.

Jan 21 Q-5 (10 Marks)

A company wants to buy a machine, and two different models namely A and B are
available. Following further particulars are available:
Particulars Machine-A Machine-B
Original Cost (₹) 8,00,000 6,00,000
Estimated Life in years 4 4
Salvage Value (₹) 0 0
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Investment Decision By: CA PRAKASH PATEL

The company provides depreciation under Straight Line Method. Income tax rate applicable is
30%.
The present value of ₹ 1 at 12% discounting factor and net profit before depreciation and tax are
as under:

Year Net Profit Before Depreciation and tax PV Factor

Machine-A Machine-B
₹ ₹
1. 2,30,000 1,75,000 0.893
2. 2,40,000 2,60,000 0.797
3. 2,20,000 3,20,000 0.712
4. 5,60,000 1,50,000 0.636

Calculate:
1. NPV (Net Present Value)
2. Discounted pay-back period
3. PI (Profitability Index)
Suggest: Purchase of which machine is more beneficial under Discounted pay-back period method,
NPV method and PI method.
Solution:
Workings:
(i) Calculation of Annual Depreciation
Depreciation on Machine – A = ₹8,00,000 = ₹2,00,000
4
Depreciation on Machine – B = ₹6,00,000 = ₹1,50,000
4
(ii) Calculation of Annual Cash Inflows
Particulars Machine-A (₹)

1 2 3 4
Net Profit before Depreciation 2,30,000 2,40,000 2,20,000 5,60,000
and Tax
Less: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Profit before Tax 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% 9,000 12,000 6,000 1,08,000
Profit after Tax 21,000 28,000 14,000 2,52,000
Add: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Annual Cash Inflows 2,21,000 2,28,000 2,14,000 4,52,000

Particulars Machine-B (₹)

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Investment Decision By: CA PRAKASH PATEL

1 2 3 4
Net Profit before Depreciation 1,75,000 2,60,000 3,20,000 1,50,000
and Tax
Less: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Profit before Tax 25,000 1,10,000 1,70,000 0
Less: Tax @ 30% 7,500 33,000 51,000 0
Profit after Tax 17,500 77,000 1,19,000 0
Add: Depreciation 1,50,000 1,50,000 1,50,000 1,50,000
Annual Cash Inflows 1,67,500 2,27,000 2,69,000 1,50,000

(iii) Calculation of PV of Cash Flows

Machine – A Machine - B

Year PV of Re 1 Cash PV Cumulative Cash flow PV (₹) Cumulative

@ 12% flow (₹) (₹) PV (₹) (₹) PV (₹)
1 0.893 2,21,000 1,97,353 1,97,353 1,67,500 1,49,578 1,49,578
2 0.797 2,28,000 1,81,716 3,79,069 2,27,000 1,80,919 3,30,497
3 0.712 2,14,000 1,52,368 5,31,437 2,69,000 1,91,528 5,22,025
4 0.636 4,52,000 2,87,472 8,18,909 1,50,000 95,400 6,17,425

1. NPV (Net Present Value)

Machine – A
NPV = ₹ 8,18,909 - ₹ 8,00,000 = ₹ 18,909
Machine – B
NPV = ₹ 6,17,425 – ₹ 6,00,000 = ₹ 17,425

2. Discounted Payback Period

Machine – A
Discounted Payback Period = 3 + ₹8,00,000 + ₹5,31,437
₹2,87,472
= 3 + 0.934
= 3.934 years or 3 years 11.21 months
Machine – B
Discounted Payback Period = 3 + ₹6,00,000 + ₹5,22,025
₹95,400
= 3.817 years or 3 years 9.80 months

3. PI (Profitability Index)
Machine – A
Profitability Index = ₹8,18,909 = 1.024
₹8,00,000
Machine – B
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Investment Decision By: CA PRAKASH PATEL

Profitability Index = ₹6,17,425 = 1.029

₹6,00,000

Suggestion:
Method Machine - A Machine - B Suggested Machine
Net Present Value ₹ 18,909 ₹ 17,425 Machine A
Discounted Payback Period 3.934 years 3.817 years Machine B
Profitability Index 1.024 1.029 Machine B

Nov 20 Q-1(b) (05 Marks)

CK Ltd. is planning to buy a new machine. Details of which are as follows:
Cost of the Machine at the commencement ₹ 2,50,000
Economic Life of the Machine 8 year
Residual Value Nil
Annual Production Capacity of the Machine 1,00,000 units
Estimated Selling Price per unit ₹6
Estimated Variable Cost per unit ₹3

Estimated Annual Fixed Cost ₹ 1,00,000

(Excluding depreciation)
Advertisement Expenses in 1st year in addition of
annual fixed cost ₹ 20,000
Maintenance Expenses in 5th year in addition of
annual fixed cost ₹ 30,000
Cost of Capital 12%
Ignore Tax.
Analyse the above mentioned proposal using the Net Present Value Method and advice.
P.V. factor @ 12% are as under:

Year 1 2 3 4 5 6 7 8
PV Factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404

Solution:
Calculation of Net Cash flows
Contribution = (₹ 6 – ₹ 3) x 1,00,000 units = ₹ 3,00,000
Fixed costs (excluding depreciation) = ₹ 1,00,000
Year Capital(₹) Contribution (₹) Fixed costs(₹) Advertisement/ Net cashflow
Maintenance (₹)
expenses (₹)
0 (2,50,000) (2,50,000)
1 3,00,000 (1,00,000) (20,000) 1,80,000
2 3,00,000 (1,00,000) 2,00,000
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Investment Decision By: CA PRAKASH PATEL

3 3,00,000 (1,00,000) 2,00,000

4 3,00,000 (1,00,000) 2,00,000
5 3,00,000 (1,00,000) (30,000) 1,70,000
6 3,00,000 (1,00,000) 2,00,000
7 3,00,000 (1,00,000) 2,00,000
8 3,00,000 (1,00,000) 2,00,000

Calculation of Net Present Value

Year Net cash flow (₹) 12% discount factor Present value (₹)
0 (2,50,000) 1.000 (2,50,000)
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
7,08,730
Advise: CK Ltd. should buy the new machine, as the net present value of the proposal
is positive i.e ₹ 7,08,730.

May 19 Q-3 (10 Marks)

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
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
Solution:
(a) Payback Period of Projects
Projects C0(₹) C1(₹) C2(₹) C3(₹) Payback
A (10,000) 2000 2000 6,000 2,000+2,000+6,000 =10,000 i.e 3 years
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Investment Decision By: CA PRAKASH PATEL

B (2,000) 0 2,000 NA 0+2,000 = 2,000 i.e 2 years

C (10,000) 2000 2000 6,000 2,000+2,000+6,000 = 10,000 i.e 3 years
(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 cutoff date, meaning that future years’
cash inflows are not considered. Thus, payback is biased towards short-term projects.

Nov 18 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
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
Advise about the project acceptability.

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Investment Decision By: CA PRAKASH PATEL

Solution:
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.
72,00,000 96,00,000 1,68,00,000 1,44,00,000
of 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
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 0.467 55,68,975
30,00,000
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.

May 18 Q-4 (10 Marks)

A company is evaluating a project that requires initial investment of ₹ 60 lakhs in fixed assets and
₹ 12 lakhs towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by ₹ 24,00,000 during
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Investment Decision By: CA PRAKASH PATEL

its life. The fixed assets would have zero residual value at the end of life of 5 years. The
company follows straight line method of depreciation which is expected for tax purposes also.
Inflation is expected to be 6% per year. For evaluating similar projects, the company uses
discounting rate of 12% in real terms. Company's tax rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms.
PVIF (12%, 5 years) PVIF (12%, 5 years)
Year 1 0.893 Year 1 0.943
Year 2 0.797 0.890
Year 3 0.712 0.840
Year 4 0.636 0.792
Year 5 0.567 Year 5 0.747

Solution:
(i) Equipment’s initial cost = ₹ 60,00,000 + ₹ 12,00,000
= ₹ 72,00,000
(ii) Annual straight line depreciation = ₹ 60,00,000/5
= ₹ 12,00,000.
(iii) Net Annual cash flows can be calculated as follows:
= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= ₹ 24,00,000 × (1 – 0.3) + (0.3 x ₹ 12,00,000)
= ₹ 16,80,000 + ₹ 3,60,000 = ₹ 20,40,000

So, Total Present Value = PV of inflow + PV of working capital released

= (₹ 20,40,000 × PVIF 12%, 5 years) + (₹ 12,00,000 × 0.567)
= (₹ 20,40,000 × 3.605) + ₹ 6,80,400
= ₹ 73,54,200 + ₹ 6,80,400
= ₹ 80,34,600

So NPV = PV of Inflows – Initial Cost

= ₹ 80,34,600 – ₹ 72,00,000
= ₹ 8,34,600

Advice: Company should accept the project as the NPV is Positive

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1 (IRR)
A company proposes to install a machine involving a Capital Cost of ₹ 3,60,000. The life of the
machine is 5 years and its salvage value at the end of the life is nil. The machine will produce the
net operating income after depreciation of ₹ 68,000 per annum. The Company’s tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting Rate : 14 15 16 17 18
Cumulative factor : 3.43 3.35 3.27 3.20 3.13
You are required to calculate the internal rate of return of the proposal.

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Solution:
Computation of cash inflow per annum ₹
Net operating income per annum 68,000
Less: Tax @ 45% 30,600
Profit after tax 37,400
Add: Depreciation (₹ 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400
The IRR of the investment can be found as follows:
NPV = - ₹ 3,60,000 + ₹ 1,09,400 (PVAF5, r) = 0
or PVA F5 r ( Cumulative factor) = ₹ 3,60,000 = 3.29
1,09,400
Computation of internal rate of return
Discounting rate 15% 16%
Cumulative factor 3.35 3.27
Total NPV(₹ ) 3,66,490 3,57,738
(₹ 1,09,400 x 3.35) (₹ 1,09,400 x 3.27)
Internal outlay (₹ ) 3,60,000 3,60,000
Surplus (Deficit) (₹ ) 6,490 (2262)

IRR = 15 + (6,490) = 15 + 0.74 = 15.74%

6,490 + 2,262

Question-2 (NPV & IRR)

The Management of a Company has two alternative proposals under consideration. Project A
requires a capital outlay of ₹ 12,00,000 and project ‘B” requires ₹ 18,00,000. Both are estimated to
provide a cash flow for five years:
Project A ₹ 4,00,000 per year and Project B ₹ 5,80,000 per year. The cost of capital is 10%. Show
which of the two projects is preferable from the view point of (i) Net present value method,
(ii) Present value index method (PI method), (iii) Internal rate of return method.
The present values of Re. 1 of 10%, 18% and 20% to be received annually for 5 years being 3.791,
3.127 and 2.991 respectively.

Solution:
Recommendations regarding Two Alternative Proposals
(i) Net Present Value Method
Computation of Present Value
Project A = ₹ 4,00,000 x 3.791 = ₹ 15,16,400
Project B = ₹ 5,80,000 x 3.791 = ₹ 21,98,780
Computation of Net Present Value
Project A = ₹ 15,16,400 - 12,00,000 = ₹ 3,16,400
Project B = ₹ 21,98,780 - 18,00,000 = ₹ 3,98,780
Advise: Since the net present value of Project B is higher than that of Project A,
therefore, Project B should be selected.

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Investment Decision By: CA PRAKASH PATEL

(ii) Present Value Index Method

Present Value Index = Present Value of Cash Inflow
Initial Investment
Project A = 15,16,400 = 1.264
12,00,000
Project B = 21,98,780 = 1.222
18,00,000
Advise: Since the present value index of Project A is higher than that of Project B,
therefore, Project A should be selected.

(iii) Internal Rate of Return (IRR)

Project A
P.V. Factor = Initial Investment = 12,00,000 =3
Annual Cash Inflow 4,00,000
PV factor falls between 18% and 20%
Present Value of cash inflow at 18% and 20% will be:
Present Value at 18% = 3.127 x 4,00,000 = 12,50,800
Present Value at 20% = 2.991 x 4,00,000 = 11,96,400
IRR = 18 + 12,50,800 - 12,00,000 x (20 - 18)
12,50,800 - 11,96,400
= 18 + 50,800 x 2
54,400
= 18 + 1.8676 = 19.868%

Project B
P.V. Factor = 18,00,000 = 3.103
5,80,000
Present Value of cash inflow at 18% and 20% will be:
Present Value at 18% = 3.127 x 5,80,000 = 18,13,660
Present Value at 20% = 2.991 x 5,80,000 = 17,34,780
IRR = 18 + 18,13,660 - 18,00,000 x (20 -18)
18,13,660 - 17,34,780
= 18 + 13,660 x 2
78,880
= 18 + 0.3463 = 18.346 %
Advise: Since the internal rate of return of Project A is higher than that of Project B,
therefore, Project A should be selected.

Question-3 (NPV)
A company wants to invest in a machinery that would cost ₹ 50,000 at the beginning of year 1. It is
estimated that the net cash inflows from operations will be ₹ 18,000 per annum for 3 years, if the
company opts to service a part of the machine at the end of year 1 at ₹ 10,000. In such a case, the
scrap value at the end of year 3 will be ₹ 12,500. However, if the company decides not to service

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the part, then it will have to be replaced at the end of year 2 at ₹ 15,400. But in this case, the machine
will work for the 4th year also and get operational cash inflow of ₹ 18,000 for the 4th year. It will
have to be scrapped at the end of year 4 at ₹ 9,000. Assuming cost of capital at 10% and ignoring
taxes, will you recommend the purchase of this machine based on the net present value of its cash
flows?
If the supplier gives a discount of ₹ 5,000 for purchase, what would be your decision? (The present
value factors at the end of years 0, 1, 2, 3, 4, 5 and 6 are respectively 1, 0.9091, 0.8264,
0.7513, 0.6830, 0.6209 and 0.5644).

Solution:
Option I : Purchase Machinery and Service Part at the end of Year 1.
Net Present value of cash flow @ 10% per annum discount rate.
NPV = - 50,000 + 18,000 + 18,000 + 18,000 - 10,000 + 12,500
(1.1) (1.1)2 (1.1)3 (1.1) (1.1)3
= - 50,000 + 18,000 (0.9091 + 0.8264 + 0.7513) – (10,000 x 0.9091) + (12,500 x 0.7513)
= - 50,000 + (18,000 x 2.4868) – 9,091 + 9,391
= - 50,000 + 44,762 – 9,091 + 9,391
NPV = - 4,938
Since, Net Present Value is negative; therefore, this option is not to be considered.
If Supplier gives a discount of ₹ 5,000 then,
NPV = +5,000 – 4,938 = + 62
In this case, Net Present Value is positive but very small; therefore, this option may not be advisable.

Option II : Purchase Machinery and Replace Part at the end of Year 2.

NPV = -50,000 + 18,000 + 18,000 + 18,000 - 15,400 + 27,000
(1.1) (1.1)2 (1.1)3 (1.1)2 (1.1)4
= - 50,000+ 18,000 (0.9091 + 0.8264 + 0.7513) – (15,400 x 0.8264) + (27,000 x 0.6830)
= - 50,000 + 18,000 (2.4868) – (15,400 x 0.8264) + (27,000 x 0.6830)
= - 50,000 + 44,762 – (15,400 x 0.8264) + (27,000 x 0.6830)
= - 50,000 + 44,762 – 12,727+ 18,441
= - 62,727+ 63,203 = +476
Net Present Value is positive, but very low as compared to the investment.
If the Supplier gives a discount of ₹ 5,000, then
NPV = 5,000 + 476 = 5,476
Decision: Option II is worth investing as the net present value is positive and higher as compared to
Option I.

Question-4 (PBP, NPV, PI & IRR)

A Company is considering a proposal of installing a drying equipment. The equipment would
involve a Cash outlay of ₹ 6,00,000 and net Working Capital of ₹ 80,000. The expected life of the
project is 5 years without any salvage value. Assume that the company is allowed to charge
depreciation on straight-line basis for Income-tax purpose. The estimated before-tax cash inflows
are given below:
Before-tax Cash inflows (₹ ‘000)
Year 1 2 3 4 5
240 275 210 180 160
The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity Cost of
Capital is 12%, calculate the equipment’s discounted payback period, payback period, net present
value and internal rate of return.
The PV factors at 12%, 14% and 15% are:

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Investment Decision By: CA PRAKASH PATEL

Year 1 2 3 4 5
PV factor at 12% 0.8929 0.7972 0.7118 0.6355 0.5674
PV factor at 14% 0.8772 0.7695 0.6750 0.5921 0.5194
PV factor at 15% 0.8696 0.7561 0.6575 0.5718 0.4972

Solution:
(i) Equipment’s initial cost = ₹ 6,00,000 + 80,000 = ₹ 6,80,000
(ii) Annual straight line depreciation = ₹ 6,00,000/5 = ₹ 1,20,000.
(iii) Net cash flows can be calculated as follows:
= Before tax CFs × (1 – Tc) + Tc × Depreciation
(₹ ‘000)
CFs
Year 0 1 2 3 4 5
1. Initial cost (680)
2. Before tax CFs 240 275 210 180 160
3. Tax @ 35% 84 96.25 73.5 63 56
4. After tax-CFs 156 178.75 136.5 117 104
5. Depreciation tax shield
(Depreciation × Tc) 42 42 42 42 42
6. Working capital released − − − − 80
7. Net Cash Flow (4 + 5 + 6) 198 220.75 178.5 159 226
8. PVF at 12% 1.00 0. 8929 0.7972 0.7118 0.6355 0.5674
9. PV (7 × 8) (680) 176.79 175.98 127.06 101.04 128.23
10. NPV 29.12

0 1 2 3 4 5
PVF at 15% 1 0.8696 0.7561 0.6575 0.5718 0.4972
PV (680) 172.18 166.91 117.36 90.92 112.37
NPV −20.26

Internal Rate of Return

IRR = 12% + 29.12 x 3% = 13.77%
49.68
Discounted Payback Period
Discounted CFs at K = 12% considered = 176.79 + 175.98 + 127.06 + 101.04 + 12 × 99.13
128.24
= 4 years and 9.28 months
Payback Period (NCFs are considered)
= 198 + 220.75 + 178.5 + 12 × 82.75 = 3 years and 6.25 months
159

Question-5 (PBP, NPV, PI & IRR)

Given below are the data on a capital project 'M'.
Annual cash inflows ₹ 60,000
Useful life 4 years
Internal rate of return 15%

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Investment Decision By: CA PRAKASH PATEL

Profitability index 1.064

Salvage value 0

You are required to calculate for this project M :

(i) Cost of project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value
PV factors at different rates are given below:
Discount factor 15% 14% 13% 12%
1 year 0.869 0.877 0.885 0.893
2 year 0.756 0.769 0.783 0.797
3 year 0.658 0.675 0.693 0.712
4 year 0.572 0.592 0.613 0.636

Solution:
1. Cost of Project 'M'
At 15% internal rate of return (IRR), the sum of total cash inflows = cost of the project
i.e initial cash outlay
Annual cash inflows = ₹ 60,000
Useful life = 4 years
Considering the discount factor table @ 15%, cumulative present value of cash inflows for 4
years is 2.855 (0.869 + 0.756 + 0.658 + 0.572)
Hence, Total Cash inflows for 4 years for Project M is
₹ 60,000 × 2.855 = ₹ 1,71,300
Hence, Cost of the Project = ₹ 1,71,300

2. Payback Period
Payback period = Cost of the Project = ₹1,71,300 = 2.855 years
Annual Cash Inflows ₹60,000
3. Cost of Capital
Profitability index = Sum of Discounted Cash inflows
Cost of the Project
1.064 = Sum of Discounted Cash inflows
₹ 1,71,300
Sum of Discounted Cash inflows = ₹ 1,82,263.20
Since, Annual Cash Inflows = ₹ 60,000

Hence, cumulative discount factor for 4 years = ₹1,82,263.20

60,000
From the discount factor table, at discount rate of 12%, the cumulative discount factor for 4
years is 3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Cost of Capital = 12%

4. Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ₹ 1,82,263.20 – ₹ 1,71,300 = ₹ 10,963.20
Net Present Value = ₹10,963.20

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Question-6 (Decision Making)

The cash flows of projects C and D are reproduced below:
Cash Flow NPV
Project C0 C1 C2 C3 IRR
at 10%
C - ₹ 10,000 + 2,000 + 4,000 + 12,000 + ₹ 4,139 26.5%
D - ₹ 10,000 + 10,000 + 3,000 + 3,000 + ₹ 3,823 37.6%
(i) Why there is a conflict of rankings?
(ii) Why should you recommend project C in spite of lower internal rate of return?

Period
Time 1 2 3
PVIF0.10, t 0.9090 0.8264 0.7513
PVIF0.14, t 0.8772 0.7695 0.6750
PVIF0.15, t 0.8696 0.7561 0.6575
PVIF0.30, t 0.7692 0.5917 0.4552
PVIF0.40, t 0.7143 0.5102 0.3644
Solution:
(i) Net Present Value at different discounting rates
Project 0% 10% 15% 30% 40%
₹ ₹ ₹ ₹ ₹
C 8,000 4,139 2,654 -632 -2,158
{₹ 2,000 {₹ 2,000 x 0.909 {₹ 2,000 x 0.8696 {₹ 2,000 x 0.7692 {₹ 2,000 x 0.7143
+₹ 4,000 +₹ 4,000 x 0.8264 + ₹ 4,000 x 0.7561 + ₹ 4,000 x 0.5917 + ₹ 4,000 x 0.5102
+₹ 12,000 +₹ 12,000 x + ₹ 12,000 x 0.6575 +₹ 12,000 x 0.4552 + ₹ 12,000 x 0.3644
0.7513
-₹ 10,000} -₹ 10,000} - ₹ 10,000} - ₹ 10,000} x ₹ 10,000}
Ranking I I II II II
D 6,000 3,823 2,937 833 - 233
{₹ 10,000 {₹ 10,000 x 0.909 {₹ 10,000 x 0.8696 {₹ 10,000 x 0.7692 {₹ 10,000 x 0.7143
+₹ 3,000 +₹ 3,000 x 0.8264 +₹ 3,000 x 0.7561 + ₹ 3,000 x 0.5917 +₹ 3,000 x 0.5102
+₹ 3,000 +₹ 3,000 x 0.7513 +₹ 3,000 x 0.6575 + ₹ 3,000 x 0.4552 +₹ 3,000 x 0.3644
-₹ 10,000} - ₹ 10,000} - ₹ 10,000} - ₹ 10,000} - ₹ 10,000}
Ranking II II I I I

The conflict in ranking arises because of skewness in cash flows. In the case of Project C
cash flows occur later in the life and in the case of Project D, cash flows are skewed towards
the beginning.
At lower discount rate, project C’s NPV will be higher than that of project D. As the discount
rate increases, Project C’s NPV will fall at a faster rate, due to compounding effect.
After break even discount rate, Project D has higher NPV as well as higher IRR.

(ii) If the opportunity cost of funds is 10%, project C should be accepted because the firm's
wealth will increase by ₹ 316 (₹ 4,139 ₹ 3,823)
The following statement of incremental analysis will substantiate the above point.

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Investment Decision By: CA PRAKASH PATEL

Cash Flows (₹ ) NPV at IRR

Project C0 C1 C2 C3 10% 12.5%
₹ ₹ ₹ ₹
C-D 0 -8,000 1,000 9,000 316 0
{-8,000 x 0.909 {-8,000 x 0.88884
+1,000 x 0.8264 + 1,000 x 0.7898
+ 9,000 x 0.7513} + 9,000 x 0.7019}
Hence, the project C should be accepted, when opportunity cost of funds is 10%.

Question-7
SS Limited is considering the purchase of a new automatic machine which will carry out some
operations which are at present performed by manual labour. NM-A1 and NM-A2, two alternative
models are available in the market. The following details are collected :
Machine
NM-A1 NM-A2
Cost of Machine (₹) 20,00,000 25,00,000
Estimated working life 5 Years 5 Years
Estimated saving in direct wages per annum (₹) 7,00,000 9,00,000
Estimated saving in scrap per annum (₹) 60,000 1,00,000
Estimated additional cost of indirect material per annum (₹) 30,000 90,000
Estimated additional cost of indirect labour per annum (₹) 40,000 50,000
Estimated additional cost of repairs and maintenance
per annum (₹) 45,000 85,000
Depreciation will be charged on a straight line method. Corporate tax rate is 30 percent and expected
rate of return may be 12 percent.
You are required to evaluate the alternatives by calculating the:
(i) Pay-back Period
(ii) Accounting (Average) Rate of Return; and
(iii) Profitability Index or P.V. Index (P.V. factor for ₹ 1 @ 12% 0.893; 0.797; 0.712; 0.636;
0.567; 0.507)
Solution:
Evaluation of Alternatives
Working Notes:
Depreciation on Machine NM-A1 = 20,00,000/5 = 4,00,000
Depreciation on Machine NM-A2 = 25,00,000/5 = 5,00,000
Particulars Machine NM-A1 Machine NM-A2
(₹) (₹)
Annual Savings:
Direct Wages 7,00,000 9,00,000
Scraps 60,000 1,00,000
Total Savings (A) 7,60,000 10,00,000
Annual Estimated Cash Cost :
Indirect Material 30,000 90,000
Indirect Labour 40,000 50,000
Repairs and Maintenance 45,000 85,000
Total Cost (B) 1,15,000 2,25,000

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Annual Cash Savings (A-B) 6,45,000 7,75,000

Less: Depreciation 4,00,000 5,00,000
Annual Savings before Tax 2,45,000 2,75,000
Less: Tax @ 30% 73,500 82,500
Annual Savings /Profits after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
Annual Cash Inflows 5,71,500 6,92,500

1. Payback Period
Machine NM – A1 = Total Initial Capital Investment
Annual expected after tax net cash flow
= 20,00,000 = 3.50 years
5,71,500

Machine NM – A2 = 25,00,000 = 3.61 years

6,92,500
Decision: Machine NM-A1 is better.
2. Accounting (Average) Rate of Return (ARR)

ARR = Average Annual Net Savings x 100

Average investment

Machine NM – A1 = 1,71,500 x 100 = 17.15%

10,00,000

Machine NM – A2 = 1,92,500 x 100 = 15.4%

12,50,000
Decision: Machine NM-A1 is better.
(Note: ARR may be computed alternatively by taking initial investment in the denominator.)
3. Profitability Index or P V Index
Present Value Cash Inflow = Annual Cash Inflow x PV factor at 12%
Machine NM-A1 = 5, 71,500 x 3.605 = ₹ 20, 60,258
Machine NM-A2 = 6, 92,500 x 3.605 = ₹ 24, 96,463

PV Index = Present Value of Cash Inflow

Investment
Machine NM-A1 = 20,60,258 = 1.03
20,00,000

Machine NM-A2 = 24,96,463 = 0.998 = 1.0 approx.

25,00,000
Decision: Machine NM-A1 is better.

Question-8 (NPV & PI with Opportunity Cost)

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; net of taxes.
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Investment Decision By: CA PRAKASH PATEL

Required:
Whether it would be profitable for the hospital to purchase the machine? Give your recommendation
under:
(i) Net Present Value method
(ii) Profitability Index method.

PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Solution:
Advise to the Hospital Management
Determination of Cash inflows
Sales Revenue 40,000
Less: Operating Cost 7,500
32,500
Less: Depreciation (80,000 – 6,000)/8 9,250
Net Income 23,250
Tax @ 30% 6,975
Earnings after Tax (EAT) 16,275
Add: Depreciation 9,250
Cash inflow after tax per annum 25,525
Less: Loss of Commission Income 12,000
Net Cash inflow after tax per annum 13,525
In 8th Year :
New Cash inflow after tax 13,525
Add: Salvage Value of Machine 6,000
Net Cash inflow in year 8 19,525
Calculation of Net Present Value (NPV)
Year CFAT PV Factor @10% Present Value of Cash inflows
1 to 7 13,525 4.867 65,826.18
8 19,525 0.467 9,118.18
74,944.36
Less: Cash Outflows 80,000.00
NPV (5,055.64)
Profitability Index = Sum of discounted cash inflows = 74,944.36 = 0.937
Present value of cash outflows 80,000

Advise: Since the net present value is negative and profitability index is also less than 1, therefore,
the hospital should not purchase the diagnostic machine.

Note: Since the tax rate is not mentioned in the question, therefore, it is assumed to be 30 percent in
the given solution.

Question-9 (IRR, NP, PI, ARR)

C Ltd. is considering investing in a project. The expected original investment in the project will be
₹ 2,00,000, the life of project will be 5 year with no salvage value. The expected profit after
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Investment Decision By: CA PRAKASH PATEL

depreciation but before tax during the life of the project will be as following:
Year 1 2 3 4 5
₹ 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subjected to 30%
tax rate.
Required:
(i) Calculate payback period and average rate of return (ARR)
(ii) Calculate net present value and net present value index, if cost of capital is 10%.
(iii) Calculate internal rate of return.
Note: The P.V. factors are:
Year P.V. at 10% P.V. at 37% P.V. at 38% P.V. at 40%
1 .909 .730 .725 .714
2 .826 .533 .525 .510
3 .751 .389 .381 .364
4 .683 .284 .276 .260
5 .621 .207 .200 .186
Solution:

Project Outflow ₹ 2,00,000

Year 1 2 3 4 5
₹ ₹ ₹ ₹ ₹
Profit after
depreciation but 85,000 1,00,000 80,000 80,000 40,000
Less: Tax (30 %) 25,500 30,000 24,000 24,000 12,000
PAT 59,500 70,000 56,000 56,000 28,000 Average = ₹ 53,900
Add: Dep. 40,000 40,000 40,000 40,000 40,000
Net cash inflow 99,500 1,10,000 96,000 96,000 68,000 Average = ₹ 93,900.

1. Calculation of payback period

= 1 + 1,00,500 = 1.914 years
1,10,000
2. Calculation of ARR
Initial investment 2,00,000 1,60,000 1,20,000 80,000 40,000
Depreciation 40,000 40,000 40,000 40,000 40,000
Closing investment 1,60,000 1,20,000 80,000 40,000 0
Average 1,80,000 1,40,000 1,00,000 60,000 20,000 Average=1,00,000
investment
ARR = Average of profit after tax / Average investment = 53,900 = 53.90%
1,00,000
3. Calculation of net present Value 10%
Net cash inflow 99,500.00 1,10,000.00 96,000.00 96,000.00 68,000.00
0.909 0.826 0.751 0.683 0.621
Present value 90,445.50 90,860.00 72,096.00 65,568.00 42,228.00 3,61,197.50
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Investment Decision By: CA PRAKASH PATEL

Net present value = ₹ 3,61,197.50 – ₹ 2,00,000 = ₹ 1,61,197.50

Net present value index = NPV = ₹ 1,61,197.50/₹ 2,00,000 = 0.81

PV of Cash Outflows
4. Calculation of IRR
Present value factor-Initial investment / Average annual cash inflow
2,00,000 / 93,900 = 2.13
It lies in between 38 % and 40%

IRR is calculated by Interpolation:

IRR = LDR + (P1 - Q) / P1 - P2 (SDR - LDR)
= 38 + (2,06,559.50 - 2,00,000) / (2,06,559.50 - 1,99,695) x (40 - 38)
= 39.911137% = 39.91%

Question-10
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be
set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the
State Government of ₹ 25,00,000 on capital investment. Initial equipment cost will be
₹ 1.75 crores. Additional equipment costing ₹ 12,50,000 will be purchased at the end of the third
year from the cash inflow of this year. At the end of 8 years, the original equipment will have no
resale value, but additional equipment can be sold for ₹ 1,25,000. A working capital of ₹ 20,00,000
will be needed and it will be released at the end of eighth year. The project will be financed with
sufficient amount of equity capital.

The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ₹ 120 per unit is expected and variable expenses will amount to 60% of sales
revenue. Fixed cash operating costs will amount ₹ 18,00,000 per year. The loss of any year will be
set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and
considers 12 per cent to be an appropriate after tax cost of capital for this project. The company
follows straight line method of depreciation.
Required:
Calculate the net present value of the project and advise the management to take appropriate
decision.
Note:
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Investment Decision By: CA PRAKASH PATEL

The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404
Solution:
(₹’000)
Year Sales VC FC Dep. Profit Tax PAT Dep. Cash
inflow
1 86.40 51.84 18 21.875 (5.315) - - 21.875 16.56
2 129.60 77.76 18 21.875 11.965 1.995* 9.97 21.875 31.845
3 312.00 187.20 18 21.875 84.925 25.4775 59.4475 21.875 81.3225
4-5 324.00 194.40 18 24.125 87.475 26.2425 61.2325 24.125 85.3575
6-8 216.00 129.60 18 24.125 44.275 13.2825 30.9925 24.125 55.1175

* (30% of 11.965 – 30% of 5.315) = 3.5895 – 1.5945 = 1.995)

₹
Cost of New Equipment 1,75,00,000
Less: Subsidy 25,00,000
Add: Working Capital 20,00,000
Outflow 1,70,00,000

Calculation of NPV
Year Cash inflows PV factor NPV
(₹ ) (₹ )
1 16,56,000 .893 14,78,808
2 31,84,500 .797 25,38,047
3 81,32,250 - 12,50,000 = 68,82,250 .712 49,00,162
4 85,35,750 .636 54,28,737
5 85,35,750 .567 48,39,770
6 55,11,750 .507 27,94,457
7 55,11,750 .452 24,91,311
8 55,11,750 + 20,00,000 + 1,25,000 = 76,36,750 .404 30,85,247
Net Present Value 2,75,56,539

NPV 2,75,56,539
Less: Out flow 1,70,00,000
Saving 1,05,56,539
Advise: Since the project has a positive NPV, therefore, it should be accepted.

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Investment Decision By: CA PRAKASH PATEL

2. SPECIAL CASES IN CAPITAL BUDGETING

A. QUESTION FROM STUDY MATERIAL

Illustration 13 (Capital Rationing)
Shiva Limited is planning its capital investment programme for next year. It has five projects all of
which give a positive NPV at the company cut-off rate of 15 percent, the investment outflows and
present values being as follows:
Project Investment NPV @ 15%
₹000 ₹000
A (50) 15.4
B (40) 18.7
C (25) 10.1
D (30) 11.2
E (35) 19.3
The company is limited to a capital spending of ₹1,20,000.
You are required to ILLUSTRATE the returns from a package of projects within the capital spending
limit. The projects are independent of each other and are divisible (i.e., part- project is possible).
Hints: NPV = ₹55.6

Illustration 14 (Unequal Life)

R plc is considering modernizing its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as per
discounting rate of 12% and IRR is as follows:
Year Cash Flow
Project A (₹) Project B (₹)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%
IDENTIFY which project should R plc accept?
Hints: Equivalent annualized NPV = ₹1,57,854 & ₹2,14,608

Illustration 18 (Replacement)
HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new
machine. The old machine had been fully depreciated for tax purpose but has a book value of ₹
2,40,000 on 31st March 2021. The machine has begun causing problems with breakdowns and it
cannot fetch more than ₹ 30,000 if sold in the market at present. It will have no realizable value after
10 years. The company has been offered
₹ 1,00,000 for the old machine as a trade in on the new machine which has a price (before allowance
for trade in) of ₹ 4,50,000. The expected life of new machine is 10 years with salvage value of ₹

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Investment Decision By: CA PRAKASH PATEL

35,000.
Further, the company follows straight line depreciation method but for tax purpose, written down
value method depreciation @ 7.5% is allowed taking that this is the only machine in the block of
assets.
Given below are the expected sales and costs from both old and new machine:
Old machine (₹) New machine (₹)
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if
required rate of return is 10%? Ignore capital gain tax.
PV factors @ 10%:
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Hints: Since the Incremental NPV is positive, the old machine should be replaced.

TEST YOUR KNOWLEDGE

Question-6 (Unequal Life)

Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a choice between the
two identical machines, in terms of Capacity, ‘X’ and ‘Y’. Despite being designed differently, both
machines do the same job. Further, details regarding both the machines are given below:
Particulars Machine ‘X’ Machine ‘Y’
Purchase Cost of the Machine (₹) 15,00,000 10,00,000
Life (years) 3 2
Running cost per year (₹) 4,00,000 6,00,000
The opportunity cost of capital is 9%.
You are required to IDENTIFY the machine which the company should buy? The present value
(PV) factors at 9% are:
Year t1 t2 t3
PVIF0.09.t 0.917 0.842 0.772

Hints:
Ae Bee Cee Ltd. should buy Machine ‘X’ since equivalent annual cash outflow is less than that of
Machine ‘Y’.

Question-7
Alley Pvt. Ltd. is planning to invest in a machinery that would cost ₹ 1,00,000 at the beginning of
year 1. Net cash inflows from operations have been estimated at ₹ 36,000 per annum for 3 years.
The company has two options for smooth functioning of the machinery - one is service, and another
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Investment Decision By: CA PRAKASH PATEL

is replacement of parts. If the company opts to service a part of the machinery at the end of year 1
at ₹ 20,000, in such a case, the scrap value at the end of year 3 will be ₹ 25,000. However, if the
company decides not to service the part, then it will have to be replaced at the end of year 2 at ₹
30,800, and in this case, the machinery will work for the 4th year also and get operational cash
inflow of ₹ 36,000 for the 4th year. It will have to be scrapped at the end of year 4 at ₹ 18,000.
Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase of this machinery
based on the net present value of its cash flows.
If the supplier gives a discount of ₹ 10,000 for purchase, what would be your decision?
Note: The PV factors at 10% are:
Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

Hints:
Option I: Purchase Machinery and Service Part at the end of Year 1.

Net Present value of cash flow @ 10% per annum discount rate.
NPV (in ₹) = -1,00,000 + 36,000 + 36,000 + 36,000 - 20,000 + 25,000
(1.1) (1.1)2 (1.1)3 (1.1) (1.1)3

= - 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (20,000 x 0.9091) + (25,000 x 0.7513)

= - 1,00,000 + (36,000 x 2.4868) – 18,182 + 18,782.5
= - 1,00,000 + 89,524.8 – 18,182 + 18,782.5
NPV = - 9,874.7
Since, Net Present Value is negative; therefore, this option is not to be considered.

If Supplier gives a discount of ₹ 10,000, then:

NPV (in ₹) = + 10,000 – 9,874.7 = + 125.3
In this case, Net Present Value is positive but very small; therefore, this option may not be advisable.

Option II: Purchase Machinery and Replace Part at the end of Year 2.

NPV (in ₹) = - 1,00,000 + 36,000 + 36,000 + 36,000 - 30,800 + 54,000

(1.1) (1.1)2 (1.1)3 (1.1)2 (1.1)4
= - 1,00,000+ 36,000 (0.9091 + 0.8264 + 0.7513) – (30,800 x 0.8264) + (54,000 x 0.6830)
= - 1,00,000 + 36,000 (2.4868) – 25,453.12 + 36,882
= - 1,00,000 + 89,524.8 – 25,453.12 + 36,882
NPV = + 953.68
Net Present Value is positive, but very low as compared to the investment.

If the Supplier gives a discount of ₹ 10,000, then:

NPV (in ₹) = 10,000 + 953.68 = 10,953.68

Decision: Option II is worth investing as the net present value is positive and higher as compared to
Option I.

Question-8 (Replacement)
A & Co. is contemplating whether to replace an existing machine or to spend money on overhauling
it. A & Co. currently pays no taxes. The replacement machine costs ₹ 90,000 now and requires
maintenance of ₹ 10,000 at the end of every year for eight years. At the end of eight years it would
have a salvage value of ₹ 20,000 and would be sold. The existing machine requires increasing
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Investment Decision By: CA PRAKASH PATEL

amounts of maintenance each year and its salvage value falls each year as follows:
Year Maintenance (₹) Salvage (₹)
Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%.
REQUIRED:
When should the company replace the machine?
(Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate of 15% : 4.4873;
present value of Re. 1 to be received after 8 years at interest rate of 15% : 0.3269).

Hints: The company should replace the old machine immediately because the PV of cost of
replacing the old machine with new machine is least.

B. PAST YEAR QUESTION

May 23 Q-(5) (10 Marks)

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

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Investment Decision By: CA PRAKASH PATEL

Solution:
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
₹ ₹ ₹ ₹
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 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

(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

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Investment Decision By: CA PRAKASH PATEL

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 (₹ 3,49,800
5,50,000 × 0.636)
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
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)]

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Investment Decision By: CA PRAKASH PATEL

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 (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 641307.420

(12 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.

Dec 21 Q-(4) (10 Marks)

Stand Ltd. is contemplating replacement of one of its machines which has become outdated and
inefficient. Its financial manager has prepared a report outlining two possible replacement
machines. The details of each machine are as follows:
Machine 1 Machine 2
Initial investment ₹ 12,00,000 ₹ 16,00,000
Estimated useful life 3 years 5 years
Residual value ₹ 1,20,000 ₹ 1,00,000
Contribution per annum ₹ 11,60,000 ₹ 12,00,000
Fixed maintenance costs per annum ₹ 40,000 ₹ 80,000
Other fixed operating costs per annum ₹ 7,20,000 ₹ 6,10,000
The maintenance costs are payable annually in advance. All other cash flows apart from the initial
investment assumed to occur at the end of each year. Depreciation has been calculated by straight
line method and has been included in other fixed operating costs. The expected cost of capital for
this project is assumed as 12% p.a.
Required:
(i) Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
(ii) Calculate the sensitivity of your recommendation in part (i) to changes in the contribution
generated by machine 1.
Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112

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Investment Decision By: CA PRAKASH PATEL

Solution:
(i) Calculation of Net Cash flows Machine 1
Other fixed operating costs (excluding depreciation)
= 7,20,000–[(12,00,000–1,20,000)/3]
= ₹ 3,60,000
Year Initial Contribution Fixed Other fixed Residual Net cash
Investment maintenance operating Value flow
costs costs
(excluding
depreciation)
(₹) (₹) (₹) (₹) (₹) (₹)
0 (12,00,000) (40,000) (12,40,000)
1 11,60,000 (40,000) (3,60,000) 7,60,000
2 11,60,000 (40,000) (3,60,000) 7,60,000
3 11,60,000 (3,60,000) 1,20,000 9,20,000

Machine 2
Other fixed operating costs (excluding depreciation) = 6,10,000 –
[(16,00,000–1,00,000)/5]
= ₹ 3,10,000
Year Initial Contribution Fixed Other fixed Residual Net cash
Investment maintenance operating Value flow
costs costs
(excluding
depreciation)
(₹) (₹) (₹) (₹) (₹) (₹)
0 (16,00,000) (80,000) (16,80,000)
1 12,00,000 (80,000) (3,10,000) 8,10,000
2 12,00,000 (80,000) (3,10,000) 8,10,000
3 12,00,000 (80,000) (3,10,000) 8,10,000
4 12,00,000 (80,000) (3,10,000) 8,10,000
5 12,00,000 (3,10,000) 1,00,000 9,90,000

Calculation of Net Present Value

Machine 1 Machine 2
Year 12% discount Net cash Present Net cash Present
factor flow (₹) value (₹) flow (₹) value (₹)
0 1.000 (12,40,000) (12,40,000) (16,80,000) (16,80,000)
1 0.893 7,60,000 6,78,680 8,10,000 7,23,330
2 0.797 7,60,000 6,05,720 8,10,000 6,45,570
3 0.712 9,20,000 6,55,040 8,10,000 5,76,720
4 0.636 8,10,000 5,15,160
5 0.567 9,90,000 5,61,330
NPV @ 12% 6,99,440 13,42,110
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Investment Decision By: CA PRAKASH PATEL

PVAF @ 12% 2.402 3.605

Equivalent Annualized Criterion 2,91,190.674 3,72,291.262

Recommendation: Machine 2 is more beneficial using Equivalent Annualized

Criterion.
(ii) Calculation of sensitivity of recommendation in part (i) to changes in the
contribution generated by machine 1
Difference in Equivalent Annualized Criterion of Machines required for
changing the recommendation in part (i) = 3,72,291.262- 2,91,190.674 =
₹ 81,100.588
Sensitivity relating to contribution = ₹ 81,100.588 x 100 = 6.991 or 7%
yearly ₹ 11,60,000.00
Alternatively,
The annualized equivalent cash flow for machine 1 is lower by ₹ (3,72,291.262–
2,91,190.674) = ₹81,100.588 than for machine 2. Therefore, it would need to increase
contribution for complete 3 years before the decision would be to invest in this
machine.
Sensitivity w.r.t contribution = 81,100.588 / (11,60,000 × 2.402) x100 = 2.911%

July 21 Q-(4) (10 Marks)

An existing company has a machine which has been in operation for two years, its estimated
remaining useful life is 4 years with no residual value in the end. Its current market value is ₹ 3
lakhs. The management is considering a proposal to purchase an improved model of a machine
gives increase output. The details are as under:
Particulars Existing Machine New Machine
Purchase Price ₹ 6,00,000 ₹ 10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ₹ 10 ₹ 10
Material cost per unit ₹2 ₹2
Output per hour in units 20 40
Labour cost per hour ₹ 20 ₹ 30
Fixed overhead per annum excluding depreciation ₹ 1,00,000 ₹ 60,000
Working Capital ₹ 1,00,000 ₹ 2,00,000
Income-tax rate 30% 30%
Assuming that - cost of capital is 10% and the company uses written down value of depreciation
@ 20% and it has several machines in 20% block.
Advice the management on the Replacement of Machine as per the NPV method.
The discounting factors table given below:
Discounting Factors Year 1 Year 2 Year 3 Year 4
10% 0.909 0.826 0.751 0.683
Solution:
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Investment Decision By: CA PRAKASH PATEL

(i) Calculation of Net Initial Cash Outflows:

Particulars ₹
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual Profit Before Tax and depreciation

Particulars Existing New Differential
machine Machine
(1) (2) (3) (4) = (3) – (2)
Annual output 36,000 units 72,000 units 36,000 units
₹ ₹ ₹
(A) Sales revenue @ ₹ 10 per unit 3,60,000 7,20,000 3,60,000
(B) Cost of Operation
Material @ ₹ 2 per unit 72,000 1,44,000 72,000
Labour
Old = 1,800 ₹ 20 36,000
New = 1,800 ₹ 30 54,000 18,000
Fixed overhead excluding depreciation 1,00,000 60,000 (40,000)
Total Cost (B) 2,08,000 2,58,000 50,000
Profit Before Tax and depreciation 1,52,000 4,62,000 3,10,000
(PBTD) (A – B)

(iii) Calculation of Net Present value on replacement of machine

Depreciati
on @ Tax Net PVF
Year PBTD PBT PAT PV
20% @ cash @
WDV
flow 10
30%
%

(1) (2) (3) (4 = 2-3) (5) (6 = 4-5) (7 = 6 + (8) (9 = 7 x 8)

3)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.000
2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.600
3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.880
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.232
7,88,478.712
Add: Release of net working capital at year end 4 (1,00,000 x 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000

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Investment Decision By: CA PRAKASH PATEL

NPV 56,778.712

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

Working Notes:
1. Calculation of Annual Output
Annual output = (Annual operating days x Operating hours per day) x output
per hour Existing machine = (300 x 6) x 20 = 1,800 x 20 = 36,000 units
New machine = (300 x 6) x 40 = 1,800 x 40 = 72,000 units

2. Base for incremental depreciation

Particulars ₹
WDV of Existing Machine
Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000

Depreciation base of New Machine

Purchase price of new machine 10,00,000
Add: WDV of existing machine 3,84,000
Less: Sales value of existing machine 3,00,000
Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000
(Note: The above solution have been done based on incremental approach)

Alternatively, solution can be done based on Total Approach as below:

(i) Calculation of depreciation:
Existing Machine
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Opening balance 6,00,000 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608.00
Less: Depreciation
@ 20% 1,20,000 96,000 76,800 61,440 49,152 39,321.60
WDV 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608 1,57,286.40

New Machine
Year 1 Year 2 Year 3 Year 4
Opening balance 10,84,000* 8,67,200 6,93,760 5,55,008.00
Less: Depreciation 2,16,800 1,73,440 1,38,752 1,11,001.60
@ 20%
WDV 8,67,200 6,93,760 5,55,008 4,44,006.40
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Investment Decision By: CA PRAKASH PATEL

* As the company has several machines in 20% block, the value of Existing
Machine from the block calculated as below shall be added to the new
machine of ₹ 10,00,000:

WDV of existing machine at the beginning of the year ₹ 3,84,000 Less: Sale
Value of Machine ₹ 3,00,000
WDV of existing machine in the block ₹ 84,000
Therefore, opening balance for depreciation of block = ₹ 10,00,000 + ₹
84,000
= ₹ 10,84,000

(ii) Calculation of annual cash inflows from operation:

Particulars EXISTING MACHINE
Year 3 Year 4 Year 5 Year 6
Annual output (300 operating 36,000 36,000 36,000 36,000 units
days x 6 operating hours x 20 units units units
output per hour)
₹ ₹ ₹ ₹
(A) Sales revenue @ ₹ 10 3,60,000.00 3,60,000.00 3,60,000.00 3,60,000.00
per unit
(B) Less: Cost of Operation
Material @ ₹ 2 per unit 72,000.00 72,000.00 72,000.00 72,000.00
Labour @ ₹ 20 per hour for 36,000.00 36,000.00 36,000.00 36,000.00
(300 x 6) hours
Fixed overhead 1,00,000.00 1,00,000.00 1,00,000.00 1,00,000.00
Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Total Cost (B) 2,84,800.00 2,69,440.00 2,57,152.00 2,47,321.60
Profit Before Tax (A – B) 75,200.00 90,560.00 1,02,848.00 1,12,678.40
Less: Tax @ 30% 22,560.00 27,168.00 30,854.40 33,803.52
Profit After Tax 52,640.00 63,392.00 71,993.60 78,874.88
Add: Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Add: Release of Working
Capital 1,00,000.00
Annual Cash Inflows 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48

Particulars NEW MACHINE

Year 1 Year 2 Year 3 Year 4
Annual output (300 operating 72,000 72,000 72,000 72,000
days x 6 operating hours x 40 units units units units
output per hour)
₹ ₹ ₹ ₹
(A) Sales revenue @ ₹ 10 7,20,000.00 7,20,000.00 7,20,000.00 7,20,000.00
per unit

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Investment Decision By: CA PRAKASH PATEL

(B) Less: Cost of Operation

Material @ ₹ 2 per unit 1,44,000.00 1,44,000.00 1,44,000.00 1,44,000.00

Labour @ ₹ 30 per hour for 54,000.00 54,000.00 54,000.00 54,000.00

(300 x 6) hours
Fixed overhead 60,000.00 60,000.00 60,000.00 60,000.00

Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60

Total Cost (B) 4,74,800.00 4,31,440.00 3,96,752.00 3,69,001.60

Profit Before Tax (A – B) 2,45,200.00 2,88,560.00 3,23,248.00 3,50,998.40

Less: Tax @ 30% 73,560.00 86,568.00 96,974.40 1,05,299.52

Profit After Tax 1,71,640.00 2,01,992.00 2,26,273.60 2,45,698.88

Add: Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60

Add: Release of Working

Capital 2,00,000.00
Annual Cash Inflows 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48

(iii) Calculation of Incremental Annual Cash Flow:

Particulars Year 1 (₹) Year 2 (₹) Year 3 (₹) Year 4 (₹)
Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48
Incremental Annual 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00
Cash Flow (B – A)

(iv) Calculation of Net Present Value on replacement of machine:

Year Incremental Discounting factor Present Value of
Annua @ 10% (B) Incremental Annual
l Cash Flow (₹) (A) Cash Flow (₹) (A x
B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232
Total Incremental Inflows 8,56,778.712
Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712
Advice: Since the incremental NPV is positive, existing machine should
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Investment Decision By: CA PRAKASH PATEL

be replaced.
Working Note:
Calculation of Net Initial Cash Outflows:
Particulars ₹
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required (₹ 2,00,000 – ₹ 1,00,000) 1,00,000
Net initial cash outflows 8,00,000

Nov 19 Q-(1)(d) (05 Marks)

A company has ₹ 1,00,000 available for investment and has identified the following four
investments in which to invest.
Project Investment (₹) NPV (₹)
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit
if-
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible.

Solution:
1. Optimizing returns when projects are independent and divisible.

Computation of NPVs per Re. 1 of Investment and Ranking of the Projects

Project Investment NPV NPV per Re. 1 Ranking
invested
(₹) (₹) (₹)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4

Building up of a Package of Projects based on their Rankings

Project Investment NPV
(₹) (₹)
C 40,000 20,000
E 50,000 24,000
D 10,000 3,500
(1/10th of
Project)
Total 1,00,000 47,500

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Investment Decision By: CA PRAKASH PATEL

The company would be well advised to invest in Projects C, E and D (1/10 th) and reject
Project F to optimise return within the amount of ₹ 1,00,000 available for investment.

2. Optimizing returns when projects are indivisible.

Package of Project Investment (₹) Total NPV (₹)
C and E 90,000 44,000
(40,000 + 50,000) (20,000 + 24,000)
C and F 1,00,000 38,000
(40,000 + 60,000) (20,000 + 18,000)
Only D 1,00,000 35,000
The company would be well advised to invest in Projects C and E to optimise return within
the amount of ₹ 1,00,000 available for investment.

May 18 Q-(2)(a) (Adjusted NPV) (08 Marks)

XYZ Ltd. is presently all equity financed. The directors of the company have been
evaluating investment in a project which will require ₹ 270 lakhs capital expenditure
on new machinery. They expect the capital investment to provide annual cash flows
of ₹ 42 lakhs indefinitely which is net of all tax adjustments. The discount rate which
it applies to such investment decisions is 14% net.
The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt, and propose to finance the new project with undated
perpetual debt secured on the company's assets. The company intends to issue
sufficient debt to cover the cost of capital expenditure and the after tax cost of issue.
The current annual gross rate of interest required by the market on corporate undated
debt of similar risk is 10%. The after tax costs of issue are expected to be ₹ 10 lakhs.
Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be
used to evaluate future investments.
Solution:
1. Calculation of Adjusted Present Value of Investment (APV)
Adjusted PV = Base Case PV + PV of financing decisions associated with the project
Base Case NPV for the project:
(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs
= ₹ 30
Issue costs = ₹ 10 lakhs
Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs
= ₹ 280 lakhs
Annual tax relief on interest payment = ₹ 280 X 0.1 X 0.3
= ₹ 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1
= ₹ 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest

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Investment Decision By: CA PRAKASH PATEL

= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs = ₹ 104 lakhs

2. Calculation of Adjusted Discount Rate (ADR)
Annual Income / Savings required to allow an NPV to zero Let the annual
income be x.
(-) ₹280 lakhs X (Annual Income / 0.14) = (-) ₹104 lakhs
Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs
Therefore, Annual income = ₹ 176 X 0.14 = ₹ 24.64 lakhs
Adjusted discount rate = (₹ 24.64 lakhs / ₹280 lakhs) X 100
= 8.8%
3. Useable circumstances
This ADR may be used to evaluate future investments only if the business risk of the new
venture is identical to the one being evaluated here and the project is to be financed by the
same method on the same terms. The effect on the company’s cost of capital of introducing
debt into the capital structure cannot be ignored.
C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1 (Replacement)
MNP Limited is thinking of replacing its existing machine by a new machine which would cost ₹
60 lakhs. The company’s current production is ₹ 80,000 units, and is expected to increase to 1,00,000
units, if the new machine is bought. The selling price of the product would remain unchanged at ₹
200 per unit. The following is the cost of producing one unit of product using both the existing and
new machine:
Unit cost (₹ )
Existing Machine New Machine Difference
(80,000 units) (1,00,000 units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.50 2.50
183.25 165.50 (17.75)
The existing machine has an accounting book value of ₹ 1,00,000, and it has been fully depreciated
for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new
machine has offered to accept the old machine for ₹ 2,50,000. However, the market price of old
machine today is ₹ 1,50,000 and it is expected to be ₹ 35,000 after 5 years. The new machine has a
life of 5 years and a salvage value of ₹ 2,50,000 at the end of its economic life. Assume corporate
Income tax rate at 40%, and depreciation is charged on straight line basis for Income-tax purposes.
Further assume that book profit is treated as ordinary income for tax purpose. The opportunity cost
of capital of the Company is 15%.
Required:
(i) Estimate net present value of the replacement decision.
(ii) Estimate the internal rate of return of the replacement decision.
(iii) Should Company go ahead with the replacement decision? Suggest.

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Investment Decision By: CA PRAKASH PATEL

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230
Solution:
1. Initial Cash Outflow:
Amount (₹)
Cost of new machine 60,00,000
Less: Sale Price of existing machine 1,50,000
Net of Tax (₹ 2,50,0100 × 0.60)
58,50,000

2. Terminal Cash Flows:

a. New Machine
Amount (₹)
Salvage value of Machine 2,50,000
Less: Depreciated WDV 2,50,000
{₹ 60,00,000 - (₹11,50,000 × 5 years)}
STCG Nil
Tax Nil
Net Salvage Value (cash flows) 2,50,000

(b) Old Machine

Cash realised on disposal of existing machine after ₹ 35,000 Additional cash flows
at terminal year = ₹ 2,15,000 (2,50,000-35,000)

3. Calculation of Net Cash Flows

Existing
Particulars Machine New Machine Incremental
1. Production 80,000 Units 1,00,000 Units 20,000 Units
(₹) (₹) (₹)
2. Selling Price 200 200
3. Variable Cost 173 148
4. Earnings before
depreciation and Tax per 27 52
Unit
5. Total earnings before 21,60,000 52,00,000 30,40,000
depreciation and Tax(1*4)

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Investment Decision By: CA PRAKASH PATEL

6. Less: Depreciation
( 60,00,000-2,50,000 ) 11,50,000
5
7.Earning after 18,90,000
depreciation before Tax

8. Less: Tax @40% 7,56,000

9. Earning after 11,34,000

depreciation and Tax

10. .Add: Depreciation 11,50,000

11. Net Cash inflow 22,84,000

Alternatively,
3. Computation of additional cash flows (yearly)
Particulars Amount (₹) Amount (₹)
Sales 1,60,00,000 2,00,00,000
Material 60,00,000 63,75,000
Wages & Salaries 41,00,000 37,50,000
Supervision 16,00,000 25,00,000
Repair & Maintenance 9,00,000 7,50,000
Power & fuel 12,40,000 14,25,000
Depreciation -- 11,50,000
Total cost 1,38,40,000 1,59,50,000
Profit(Sales – Total cost) 21,60,000 40,50,000
Less: Tax@40% 8,64,000 16,20,000
12,96,000 24,30,000
Add: Depreciation ** 11,50,000*
12,96,000 35,80,000
Incremental Cash inflow 22,84,000
*Calculation of Depreciation 60, 00,000 - 2,50, 000 = 11, 50,000
5
** As mention in the question WDV of Machine is zero for tax purpose hence no
depreciation shall be provided in existing machine.

4. Computation of NPV @ 15%

Period Cash flow (₹) PVF PV (₹)
Incremental 1-5 22,84,000 3.352 76,55,968
cash flows
5 2,15,000 0.4972 1,06,898
Add; Terminal
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Investment Decision By: CA PRAKASH PATEL

year cash

77,62,866
Less: 0 58,50,000 1
58,50,000
Additional cash
outflow
NPV 19,12,866

5. Calculation of IRR
(ii) IRR- Since NPV computed in Part (i) is positive. Let us discount cash flows at higher
rate say at 30%
Period Cash flow (₹) PVF PV (₹)
Incremental 1-5 22,84,000 2.436 55,63,824
cash flows
5 2,15,000 0.2693 57,900
Add:
Termina
l year cash
55,05,924
Less: 0 58,50,000 1
58,50,000
Additional cash
outflow
NPV - 3,44,076
Now we use interpolation formula
15% + 19,12,866 x 15%
19,12, 866 - (- 3, 44, 076)
= 15% + 12.71% = 27.71%

Question-2 (Replacement)
WX Ltd. has a machine which has been in operation for 3 years. Its remaining estimated useful life
is 8 years with no salvage value in the end. Its current market value is ₹ 2,00,000. The company is
considering a proposal to purchase a new model of machine to replace the existing machine. The
relevant information is as follows:
Existing Machine New Machine
Cost of machine ₹ 3,30,000 ₹ 10,00,000
Estimated life 11 years 8 years
Salvage value Nil ₹ 40,000
Annual output 30,000 units 75,000 units
Selling price per unit ₹ 15 ₹ 15
Annual operating hours 3,000 3,000
Material cost per unit ₹4 ₹4
Labour cost per hour* ₹ 40 ₹ 70
Indirect cash cost per annum ₹ 50,000 ₹ 65,000

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Investment Decision By: CA PRAKASH PATEL

The company follow the straight line method of depreciation. The corporate tax rate is 30 per cent
and WX Ltd. does not make any investment, if it yields less than 12 per cent. Present value of annuity
of Re. 1 at 12% rate of discount for 8 years is 4.968. Present value of ₹ 1 at 12% rate of discount,
received at the end of 8th year is 0.404. Ignore capital gain tax.
Advise WX Ltd. whether the existing machine should be replaced or not.
* In the question paper this word was wrongly printed as ‘unit’ instead of word ‘hour’. The answer
provided here is on the basis of correct word i.e. ‘Labour cost per hour’.

Solution:
1. Calculation of Net Initial Cash Outflows:
₹
Cost of new machine 10,00,000
Less: Sale proceeds of existing 2,00,000
machine
Net initial cash outflows 8,00,000
2. Calculation of annual depreciation:
On old machine = ₹ 3,30,000 = ₹30,000 per annum
11 years
On new machine = ₹ 10,00,000 - ₹40,000 = 1,20,000 per annum
8 years
3. Calculation of annual cash inflows from operation:
Particulars Existing New Machine Differential
machine
(1) (2) (3) (4) =(3) – (2)
Annual output 30,000 units 75,000 units 45,000 units
₹ ₹ ₹
(A) Sales revenue @ ₹ 15 per unit 4,50,000 11,25,000 6,75,000
(B) Less: Cost of Operation
Material @ ₹ 4 per unit 1,20,000 3,00,000 1,80,000
Labour
Old = 3,000 x ₹ 40 1,20,000 90,000
New = 3,000 x ₹ 70 2,10,000
Indirect cash cost 50,000 65,000 15,000
Depreciation 30,000 1,20,000 90,000
Total Cost (B) 3,20,000 6,95,000 3,75,000
Profit Before Tax (A – B) 1,30,000 4,30,000 3,00,000
Less: Tax @ 30% 39,000 1,29,000 90,000
Profit After Tax 91,000 3,01,000 2,10,000
Add: Depreciation 30,000 1,20,000 90,000
Annual Cash Inflows 1,21,000 4,21,000 3,00,000
4. Calculation of Net Present Value:
₹
Present value of annual net cash
Inflows: 1 – 8 years = ₹ 3,00,000 x 4.968 14,90,400
Add: Present value of salvage value of new machine at
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Investment Decision By: CA PRAKASH PATEL

the end of 8th year (₹ 40,000 x 0.404) 16,160

Total present value 15,06,560
Less: Net Initial Cash Outflows 8,00,000
NPV 7,06,560
Alternative Solution:
Calculation of Net Present Value (NPV)
Particulars Period Cash Flow Present Value Present
(Year) (₹ ) Factor (PVF) Value (₹ )
@ 12%
Purchase of new machine 0 -8,00,000 1.00 -8,00,000
Incremental Annual Cash Inflow 1–8 3,00,000 4.968 14,90,400
Salvage value of new machine 8 40,000 0.404 16,160
Net Present Value (NPV) 7,06,560
Advise: Hence, existing machine should be replaced because NPV is positive.

Question-3 (Cost-Based)
Company X is forced to choose between two machines A and B. The two machines are designed
differently, but have identical capacity and do exactly the same job. Machine A costs ₹ 1,50,000
and will last for 3 years. It costs ₹ 40,000 per year to run. Machine B is an ‘economy’ model costing
only ₹ 1,00,000, but will last only for 2 years, and costs ₹ 60,000 per year to run. These are real cash
flows. The costs are forecasted in rupees of constant purchasing power. Ignore tax. Opportunity cost
of capital is 10 per cent. Which machine company X should buy?
Solution:
Statement showing the Evaluation of Two Machines
Machines A B
Purchase cost (₹): (i) 1,50,000 1,00,000
Life of machines (years) 3 2
Running cost of machine per year (₹): (ii) 40,000 60,000
Cumulative present value factor for 1-3 years @ 10%: (iii) 2.486 -
Cumulative present value factor for 1-2 years @ 10%: (iv) - 1.735
Present value of running cost of machines (₹): (v) 99,440 1,04,100
[(ii) x (iii)] [(ii) x (iv)]
Cash outflow of machines (₹): (vi)=(i) +(v) 2,49,440 2,04,100
Equivalent present value of annual cash outflow 1,00,338 1,17,637
[(vi)÷(iii)] [(vi) ÷(iv)]

Decision: Company X should buy machine A since its equivalent cash outflow is less than
machine B.

Question-4 (Cost-Based)
A company is required to choose between two machines A and B. The two machines are designed
differently, but have identical capacity and do exactly the same job. Machine A costs ₹ 6,00,000 and
will last for 3 years. It costs ₹ 1,20,000 per year to run.
Machine B is an ‘economy’ model costing ₹ 4,00,000 but will last only for two years, and costs

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Investment Decision By: CA PRAKASH PATEL

₹ 1,80,000 per year to run. These are real cash flows. The costs are forecasted in rupees of constant
purchasing power. Opportunity cost of capital is 10%. Which machine company should buy? Ignore
tax.
PVIF0.10, 1 = 0.9091, PVIF0. 10, 2 = 0.8264, PVIF0. 10, 3 = 0.7513.

Solution:
Advise to the Management Regarding Buying of Machines
Statement Showing Evaluation of Two Machines
Machines A B
Purchase cost (₹ ): (i) 6,00,000 4,00,000
Life of machines (years) 3 2
Running cost of machine per year (₹ ): (ii) 1,20,000 1,80,000
Cumulative present value factor for 1-3 years @ 10%: (iii) 2.4868 -
Cumulative present value factor for 1-2 years @ 10%: (iv) - 1.7355
Present value of running cost of machines (₹ ): (v) 2,98,416 3,12,390
[(ii) x (iii)] [(ii) x (iv)]
Cash outflow of machines (₹ ): (vi)=(i) +(v) 8,98,416 7,12,390
Equivalent present value of annual cash outflow 3,61,273.93 4,10,481.13
[(vi)÷(iii)] [(vi) ÷(iv)]
Recommendation: The Company should buy Machine A since its equivalent cash outflow is less
than Machine B.

Question-5 (Cost-Based)
APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two machines
have identical capacity, do exactly the same job, but designed differently.
Machine 'A' costs ₹ 8,00,000, having useful life of three years. It costs ₹ 1,30,000 per year to run.
Machine 'B' is an economy model costing ₹ 6,00,000, having useful life of two years. It costs
₹ 2,50,000 per year to run.
The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore taxes.
The opportunity cost of capital is 10%. The present value factors at 10% are :
Year t1 t2 t3
PVIF0.10,t 0.9091 0.8264 0.7513
PVIFA0.10,2 = 1.7355
PVIFA0.10,3 = 2.4868
Which machine would you recommend the company to buy?

Solution:
Statement Showing Evaluation of Two Machines
Particulars Machine A Machine B
Purchase Cost (₹) : (i) 8,00,000 6,00,000
Life of Machines (in years) 3 2
Running Cost of Machine per year (₹) : (ii) 1,30,000 2,50,000
Cumulative PVF for 1-3 years @ 10% : (iii) 2.4868 -
Cumulative PVF for 1-2 years @ 10% : (iv) - 1.7355
Present Value of Running Cost of Machines (₹): 3,23,284 4,33,875
(v) = [(ii) x (iii)]
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Investment Decision By: CA PRAKASH PATEL

Cash Outflow of Machines (₹) : (vi) = (i) + (v) 11,23,284 10,33,875

Equivalent Present Value of Annual Cash Outflow 4,51,698.57 5,95,721.69
[(vi) / (iii)] Or 4,51,699 Or 5,95,722
Recommendation: APZ Limited should consider buying Machine A since its equivalent Cash
outflow is less than Machine B.

Question-6 (Unequal-life)
The cash flows of two mutually exclusive Projects are as under:
t0 t1 t2 t3 t4 t5 t6
Project ‘P’ (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
(₹ )
Project ‘J’ (₹ ) (20,000) 7,000 13,000 12,000 - - -
Required:
(i) Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the hurdle rate.
(ii) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(iii) Why there is a conflict in the project choice by using NPV and IRR criterion?
(iv) Which criteria you will use in such a situation? Estimate the value at that criterion. Make a
project choice.

The present value interest factor values at different rates of discount are as under:
Rate of t0 t1 t2 t3 t4 t5 t6
discount
0.15 1.00 0.8696 0.7561 0.6575 0.5718 0.4972 0.4323
0.18 1.00 0.8475 0.7182 0.6086 0.5158 0.4371 0.3704
0.20 1.00 0.8333 0.6944 0.5787 0.4823 0.4019 0.3349
0.24 1.00 0.8065 0.6504 0.5245 0.4230 0.3411 0.2751
0.26 1.00 0.7937 0.6299 0.4999 0.3968 0.3149 0.2499

Solution:
(i) Estimation of net present value (NPV) of the Project ‘P’ and ‘J ’ using 15% as the
hurdle rate:
NPV of Project ‘P’ :
= - 40,000 + 13,000 + 8,000 + 14,000 + 12,000 + 11,000 + 15,000
(1.15)1 (1.15)2 (1.15)3 (1.15)4 (1.15)5 (1.15)6
= - 40,000 + 11,304.35 + 6,049.15 + 9,205.68 + 6,861.45 + 5,469.37 + 6,485.65
= ₹ 5,375.65 or ₹ 5,376

NPV of Project ‘J ’ :
= - 20,000 + 7,000 + 13,000 + 12,000
(1.15)1 (1.15)2 (1.15)3
= - 20,000 + 6,086.96 + 9,829.87 + 7,890.58
= ₹ 3,807.41

(ii) Estimation of internal rate of return (IRR) of the Project ‘P ‘ and ‘ J ‘

Internal rate of return r (IRR) is that rate at which the sum of cash inflows after discounting
equals to the discounted cash out flows. The value of r in the case of given projects can be
determined by using the following formula:
COo = CF0 + CF1 + ------------------ + CFn + SV + WC

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Investment Decision By: CA PRAKASH PATEL

(1+ r )0 (1+ r )1 (1+ r )n (1+ r )n

Where,
Co = Cash flows at the time O
CFt = Cash inflow at the end of year t r = Discount rate
n = Life of the project
SV & WC = Salvage value and working capital at the end of n years.
In the case of project ‘P’ the value of r (IRR) is given by the following relation:

40,000 = 13,000 + 8,000 + 14,000 + 12,000 + 11,000 + 15,000

(1+ r %)1 (1+ r %)2 (1+ r %)3 (1+ r %)4 (1+ r %)5 (1+ r %)6

r = 19.73%
Similarly we can determine the internal rate of return for the project ‘J’. In the case of
project ‘J’ it comes to:
r = 25.20%

(iii) The conflict between NPV and IRR rule in the case of mutually exclusive project situation
arises due to re-investment rate assumption. NPV rule assumes that intermediate cash flows
are reinvested at k and IRR assumes that they are reinvested at r. The assumption of NPV
rule is more realistic.

(iv) When there is a conflict in the project choice by using NPV and IRR criterion, we would
prefer to use “Equal Annualized Criterion”. According to this criterion the net annual cash
inflow in the case of Projects ‘P’ and ‘J’ respectively would be:

Project ‘P’ = (Net present value/ cumulative present value of Re.1 p.a. @15% for 6 years)
= (₹ 5,375.65 / 3.7845) = ₹ 1,420.44
Project ‘J’ = (₹ 3807.41/2.2832) = ₹ 1667.58

Advise: Since the cash inflow per annum in the case of project ‘J’ is more than that of project ‘P’,
so Project J is recommended.

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Dividend Decisions By: CA PRAKSAH PATEL

Chapter- 5: Dividend Decisions

1. TRADITIONAL MODEL (GRAHAM & DODD MODEL)

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 1
The earnings per share of a company is ₹ 30 and dividend payout ratio is 60%. Multiplier is 2.
Determine the price per share as per Graham & Dodd model.
Hints: ₹56

ILLUSTRATION 2
The following information regarding the equity shares of M Ltd. is given below:
Market price ₹ 58.33
Dividend per share ₹5
Multiplier 7
According to the Graham & Dodd approach to the dividend policy, COMPUTE the EPS.
Hints: EPS= 10

TEST YOUR KNOWLEDGE

Question-1
The dividend payout ratio of H ltd. is 40%. If the company follows traditional approach to dividend
policy with a multiplier of 9. Compute P/E ratio.
Hints: P/E Ratio = 6.6 times

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Dividend Decisions By: CA PRAKSAH PATEL

2. WALTER’S MODEL

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 3
XYZ Ltd. earns ₹ 10/ share. Capitalization rate and return on investment are 10% and 12%
respectively.
Determine the optimum dividend payout ratio and the price of the share at the payout.
Hints: Dividend = ₹0, MPS = ₹120

ILLUSTRATION 4
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
Compute the approximate dividend pay-out ratio so as to keep the share price at ₹ 42 by using
Walter’s model?
Hints: Pay-out Ratio = 52%
ILLUSTRATION 5
The following information pertains to M/s XY Ltd.

Earnings of the Company ₹ 5,00,000

Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%
CALCULATE:
(i) What would be the market value per share as per Walter’s model?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value
of Company’s share at that payout ratio?
Hints:
(i) ₹45.83
(ii) ₹52.08

ILLUSTRATION 6
The following information is given below in case of Aditya Ltd.:
Earnings per share = ₹ 60
Capitalisation rate = 15%
Return on investment = 25%
Dividend payout ratio = 30%
(i) COMPUTE price per share using Walter’s Model.

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Dividend Decisions By: CA PRAKSAH PATEL

(ii) WHAT would be optimum dividend payout ratio per share under Gordon’s Model.
Hints:
(i) ₹ 586.67
(ii) As per Gordon’s model, when r > Ke, optimum dividend payout ratio is ‘Zero’.

TEST YOUR KNOWLEDGE

Question-2
The following information is supplied to you:

₹
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5
Applying Walter’s Model
(i) Analyse whether the company is following an optimal dividend policy.
(ii) Compute P/E ratio at which the dividend policy will have no effect on the value of the share.
(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? Analyse.
Hints: r = 10%, Re = 8%, Payout Ratio = 0%, MPS = ₹156.25

Question-3
With the help of following figures CALCULATE the market price of a share of a company by using:
(i) Walter’s formula
(ii) Dividend growth model (Gordon’s formula)
Earning Per Share (EPS) ₹10
Dividend Per Share (DPS) ₹6
Cost of Capital (Ke) 20%
Internal Rate of Return on Investment 25%
Retention Ratio 40%
Hints: Walter’s Model = ₹55, Gordon’s Model = ₹60
Question-4
The following information is supplied to you:
₹
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5
Applying Walter’s Model:
(i) ANALYSE whether the company is following an optimal dividend policy.
(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on the value of the share.

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Dividend Decisions By: CA PRAKSAH PATEL

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5? ANALYSE.
Hints:
(i) The market price of the share can be increased by adopting a zero payout.
(ii) 10
(iii) ₹ 76

B. PAST YEAR QUESTION

May 23 Q-1(a) (05 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 payout ratio.
(ii) Market price of share at optimum dividend payout 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.
Solution:
(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:
P = D + r (E-D)
Ke
Ke
P = D + 12%(10-D)
8%
8%
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

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Dividend Decisions By: CA PRAKSAH PATEL

would be:
P = 0 + 12%(10-0)
8%
8%
P = ₹187.5
So, theoretically the market price of the share can be increased by adopting 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) of 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:
P = D + r (E-D)
Ke
Ke
= 9.2 + 0.12(10-9.2)
0.12
0.12
= ₹83.33
(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
P = D1 = 9.2883/(0.08 – 0.0096) = 9.2883/0.0704 = ₹ 131.936
(Ke-g)
Alternative
Alternatively, without applying growth on dividend
P = E(1-b) = 10(1- 0.08) = ₹130.68
Ke – br 0.08 - (0.08x 0.12)
Jan 21 Q-1(b) (05 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%

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Dividend Decisions By: CA PRAKSAH PATEL

Calculate the market price of the share using:

(1) Gordon's Model
(2) Walter's Model
Solution:
Market price per share by-
(1) Gordon’s Model:
Present market price per share (Po)* = Do (1+g)
Ke -g
OR
Present market price per share (Po) = D1
Ke –g
Where,
Po = Present market price per share.
g = Growth rate (br) = 0.75 X 0.22 = 0.165
b = Retention ratio (i.e., % of earnings retained)
r = Internal rate of return (IRR)
D0 = E x (1 – b) = 3 X (1 – 0.75) = 0.75
E = Earnings per share
Po = 0.75 (1 0.165) = 0.875 = ₹58.27 approx.
0.18 - 0.165 0.015

*Alternatively, Po can be calculated as E (1-b) = ₹50

k - br

(2) Walter’s Model:

P = D + r (E-D)
Ke
Ke
= 0.75 + 0.22 (3 - 0.75)
0.18 = ₹19.44
0.18
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)

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Dividend Decisions By: CA PRAKSAH PATEL

Earnings for equity shareholders

No. of equity shares (₹ 60,00,000/₹10)

Therefore, Earnings per share: ₹ 18,00,000/6,00,000 = ₹ 3.00
Earning for equity shareholders
No. of equity Shares

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 = ₹ 0.75
(Earnings per share x Dividend pay-out ratio)

Nov 20 Q-1(c) (05 Marks)

The following figures are extracted from the annual report of RJ Ltd.:
Net Profit ₹ 50 Lakhs
Outstanding 13% preference shares ₹ 200 Lakhs
No. of Equity Shares 6 Lakhs
Return on Investment 25%
Cost of Capital (Ke) 15%
You are required to compute the approximate dividend pay-out ratio by keeping the share price at
₹ 40 by using Walter's Model.
Solution:
Particulars ₹ in lakhs
Net Profit 50
Less: Preference dividend (₹ 200,00,000 x 13%) 26
Earning for equity shareholders 24
Therefore, earning per share = ₹ 24 lakh /6 lakh shares = ₹ 4

Let, the dividend per share be D to get share price of ₹ 40

P = D + r (E - D)
Ke

Ke
₹40 = D + 0.25(₹4 - D)
0.15

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Dividend Decisions By: CA PRAKSAH PATEL

0.15
6 = 0.15D + 1 - 0.25D
0.15
0.1D = 1 – 0.9 D =₹1
D/P ratio = DPS x 100 = ₹1 x 100 = 25%
EPS ₹4
So, the required dividend pay-out ratio will be = 25%

Nov 19 Q-1(c) (05 Marks)

Following figures and information were extracted from the company A Ltd.
Earnings of the company ₹ 10,00,000
Dividend paid ₹ 6,00,000
No. of shares outstanding 2,00,000
Price Earnings Ratio 10
Rate of return on investment 20%

You are required to calculate:

(i) Current Market price of the share
(ii) Capitalisation rate of its risk class
(iii) What should be the optimum pay-out ratio?
(iv) What should be the market price per share at optimal pay-out ratio? (use Walter’s Model)
Solution:
(i) Current Market price of shares (applying Walter’s Model)
• The EPS of the firm is ₹ 5 (i.e., Rs 10,00,000 / 2,00,000).
• Rate of return on Investment (r) = 20%.
• The Price Earnings (P/E) Ratio is given as 10, so capitalization rate (Ke), may be taken
at the inverse of P/E Ratio. Therefore, Ke is 10% or .10 (i.e., 1/10).
• The firm is distributing total dividends of ₹ 6,00,000 among 2,00,000 shares, giving a
dividend per share of ₹ 3.
The value of the share as per Walter’s model may be found as follows:
Walter’s model is given by-
P = D + r (E - D)
Ke

Ke
Where,
P = Market price per share.
E = Earnings per share = ₹ 5
D = Dividend per share = ₹ 3

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Dividend Decisions By: CA PRAKSAH PATEL

R = Return earned on investment = 20 %

Ke = Cost of equity capital = 10% or .10
P = 3 + 0.20 (5 - 3)
0.10

0.10
Current Market Price of shares can also be calculated as follows:
Price Earnings (P/E) Ratio = Market Price of Share
Earnings per Shares
Or, 10 = Market Price of Share
₹10,00,000/2,00,000
Or, 10 = Market Price of Share
5
Market Price of Share = ₹ 50
(ii) Capitalization rate (Ke) of its risk class is 10% or .10 (i.e., 1/10).
(iii) Optimum dividend pay-out ratio
According to Walter’s model when the return on investment is more than the cost of
equity capital (10%), the price per share increases as the dividend pay-out ratio
decreases. Hence, the optimum dividend pay-out ratio in this case is nil or 0 (zero).
(iv) Market price per share at optimum dividend pay-out ratio
At a pay-out ratio of zero, the market value of the company’s share will be:
P = 0 + 0.20 (5 - 0)
0.10
= ₹100
0.10

May 19 Q-1(d) (05 Marks)

The following information is supplied to you :
Total Earning ₹ 40 Lakhs
No. of Equity Shares (of ₹ 100 each) 4,00,000
Dividend Per Share ₹4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%
Calculate the market price of a share of a company by using :
(i) WaIter’s Formula
(ii) Gordon's Formula

Solution:
Earning Per share (E) = ₹ 40 Lakhs = ₹ 10
4,00,000

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Dividend Decisions By: CA PRAKSAH PATEL

Calculation of Market price per share by

(i) Walter’s formula: Market Price (P) = D + r (E - D)
Ke

Ke
Where,
P = Market Price of the share.
E = Earnings per share.
D = Dividend per share.
Ke = Cost of equity/ rate of capitalization/ discount rate.
R = Internal rate of return/ return on investment
P = 4 + 0.20 (10 - 4)
0.16
= 4 + 7.5 = ₹71.88
0.16 0.16

(ii) Gordon’s formula: When the growth is incorporated in earnings and dividend, the present
value of market price per share (Po) is determined as follows
Gordon’s theory: Po = E (1- b)
k - br
Where,
P0 = Present market price per share.
E = Earnings per share
b = Retention ratio (i.e. % of earnings retained) r = Internal rate of return (IRR)
Growth rate (g) = br
Now Po = 10 (1- .60) = ₹4 = ₹100
.16 - (.60 x .20) 0.4

Nov 18 Q-1(b) (05 Marks)

Following information relating to Jee Ltd. are given:
Particulars
Profit after tax ₹ 10,00,000
Dividend payout ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%
(i) What would be the market value per share as per Walter's Model?
(ii) What is the optimum dividend payout ratio according to Walter's Model and Market value of
equity share at that payout ratio?

Solution:
(i) Walter's model is given by –
P = D+(E -D)(r / Ke )

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Dividend Decisions By: CA PRAKSAH PATEL

Ke

Where,
P = Market price per share,
E = Earnings per share = ₹ 10,00,000 ÷ 50,000 = ₹ 20
D = Dividend per share = 50% of 20 = ₹ 10
r = Return earned on investment = 12%
Ke = Cost of equity capital = 10%

P = 10 + (20-10) x 0.12/0.1 = 22 = ₹220

0.10 0.10

(ii) According to Walter’s model when the return on investment is more than the cost of
equity capital, the price per share increases as the dividend pay-out ratio decreases.
Hence, the optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of
zero, the market value of the company’s share will be:-
P = 0+ (20-0) x 0.12/0.1 = 24 = ₹240
0.10 0.10

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question- 1
The following figures are collected from the annual report of XYZ Ltd.:
₹
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
What should be the approximate dividend pay-out ratio so as to keep the share price at ₹ 42 by
using Walter model?

Solution:
₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share ₹ 18 lakhs / 3 lakhs = ₹ 6.00
Cost of capital i.e. (ke) (Assumed) 16%*
Let, the dividend payout ratio be X and so the share price will be:
P = D + r (E-D)/Ke
Ke Ke
Here D = 6x; E = ₹ 6; r = 0.20 and Ke = 0.16 and P = ₹ 42

Hence ₹42 = 6x + 0.2 (6 - 6x)

0.16 0.16 x 0.16
Or, ₹ 42 = 37.50X + 46.875 (1 –x)
= 9.375x = 4.875

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Dividend Decisions By: CA PRAKSAH PATEL

x = 0.52
So, the required dividend payout ratio will be = 52%
*Students can assume any percentage other than 16%.
Question-2
Goldi locks Ltd. was started a year back with equity capital of ₹ 40 lakhs. The other details are as
under:
Earnings of the company ₹ 4,00,000
Price Earnings ratio 12.5
Dividend paid ₹ 3,20,000
Number of Shares 40,000
Find the current market price of the share. Use Walter's Model.
Find whether the company's D/ P ratio is optimal, use Walter's formula.

Solution:
Goldilocks Ltd.
(i) Walter’s model is given by
P = D + (E-D)(r/Ke)
Ke
Where,
P = Market price per share.
E = Earnings per share = ₹ 10
D = Dividend per share = ₹ 8
R = Return earned on investment = 10%
Ke = Cost of equity capital = 1/12.5 = 8%

P = 8 + (10-8) x 0.10/0.08 = 8 + 2 x 0.10/0.08

0.08 0.08
= ₹131.25

(ii) According to Walter’s model when the return on investment is more than the cost of equity
capital, the price per share increases as the dividend pay-out ratio decreases. Hence, the
optimum dividend pay-out ratio in this case is nil.
So, at a pay-out ratio of zero, the market value of the company’s share will be:
0 + (10-0) x 0.10/0.08 = ₹156.25
0.08
Question-3
The following information relates to Maya Ltd:
Earnings of the company ₹ 10,00,000
Dividend payout ratio 60%
No. of Shares outstanding 2,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
(i) What would be the market value per share as per Walter’s model ?
(ii) What is the optimum dividend payout ratio according to Walter’s model and the market value
of company’s share at that payout ratio?
Solution:
MAYA Ltd.
(i) Walter’s model is given by –
P = D + (E - D) (r/Ke)

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Dividend Decisions By: CA PRAKSAH PATEL

Ke
Where,
P = Market price per share,
E = Earning per share – ₹ 5
D = Dividend per share – ₹ 3
r = Return earned on investment – 15%
ke = Cost of equity capital – 12%

P = 3 + (5 – 3) x 0.15/0.12 = 3+2 x 0.15/.012 = ₹45.83

0.12 0.12

(ii) According to Walter’s model when the return on investment is more than the cost of
equity capital, the price per share increases as the dividend pay-out ratio decreases.
Hence, the optimum dividend pay-out ratio in this case is Nil. So, at a payout ratio of
zero, the market value of the company’s share will be:-

0 + (5 – 0) x 0.15/0.12 = ₹52.08
0.12

Question-4
X Ltd has an internal rate of return @ 20%. It has declared dividend @ 18% on its equity shares,
having face value of ₹ 10 each. The payout ratio is 36% and Price Earning Ratio is 7.25. Find the
cost of equity according to Walter's Model and hence determine the limiting value of its shares in
case the payout ratio is varied as per the said model.
Solution:
Internal Rate of Return (r) = 0.20
Dividend (D) = 1.80
Earnings Per share (E) = 1.8/0.36 =5
Price of share (P) = 5 x 7.25 = 36.25

P = D + r/Ke (E – D)
Ke
36.25 = 1.80 + 0.20/Ke(5 – 1.80)
Ke
36.25 Ke = 1.80 + 0.20 (3.20)
Ke
36.25 Ke = 1.80 + 0.64
Ke
36.25 Ke2 = 1.80 Ke + 0.64

Ke = −b  b2 − 4ac
2a
= -1.80  (1.80)2 - 4 (-36.25) 0.64

2  (-36.25)
Ke = 16%
Alternatively, it can also be calculated as follows:
36.25 Ke2 – 1.80 Ke – 0.64 = 0
Taking 36.25 common

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Dividend Decisions By: CA PRAKSAH PATEL

Ke2 – 0.05 Ke – 0.0176 = 0

Ke2 – 0.16 Ke + 0.11 Ke – 0.0176 = 0
Ke (Ke – 0.16) + 0.11 (Ke – 0.16) = 0
(Ke + 0.11) (Ke – 0.16) = 0
Since Ke = -0.11 is not possible, the possible answer shall be Ke = 0.16 i.e. 16%. Since the
firm is a growing firm, then 100% payout ratio will give limiting value of share

P = 5 + 0.20 (5-5)/0.16
0.16
= 5/0.16 = ₹31.25
Thus limiting value is ₹ 31.25
Alternatively, 0% payout ratio gives limiting value of shares as follows:
P = 0 + 0.20 (5-0)/0.16
0.16
= 1 = ₹39.06
(0.16)2
Thus, limiting value is ₹ 39.06

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Dividend Decisions By: CA PRAKSAH PATEL

3. GORDON‘S MODEL

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 7
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%
Calculate price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and
(iii) 100%.
Hints: (i) ₹50, (ii) ₹50, (iii) ₹37.5
ILLUSTRATION 8
X Ltd. is a no growth company, pays a dividend of ₹ 5 per share. If the cost of capital is 10%,
Compute the current market price of the share?
Hints: ₹50
ILLUSTRATION 9
XYZ is a company having share capital of ₹10 lakhs of ₹10 each. It distributed current dividend of
20% per annum. Annual growth rate in dividend expected is 2%. The expected rate of return on its
equity capital is 15%. Calculate price of share applying Gordons growth Model.
Hints: ₹15.29
ILLUSTRATION 10
A firm had been paid dividend at ₹2 per share last year. The estimated growth of the dividends from
the company is estimated to be 5% p.a. DETERMINE the estimated market price of the equity share
if the estimated growth rate of dividends (i) rises to 8%, and (ii) falls to 3%. Also Find Out the
present market price of the share, given that the required rate of return of the equity investors is 15%.
Hints: ₹21, ₹30.86, ₹17.17
ILLUSTRATION 11
Again taking an example of three different firms i.e. growth, normal and declining firm. Calculate
the Gordon’s model with the help of a following example:
Factors Growth Normal Declining
Firm Firm Firm
r > Ke r = Ke r < Ke

r (rate of return on retained earnings) 15% 10% 8%

Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) ₹ 10 ₹ 10 ₹ 10
b (Retained Earnings) 0.6 0.6 0.6
1- b 0.4 0.4 0.4
Hints:
(i) ₹400, ₹100, ₹76.92
(ii) ₹150, ₹100, ₹88.24 (If retention ratio changes from 0.6 to 0.4).

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Dividend Decisions By: CA PRAKSAH PATEL

TEST YOUR KNOWLEDGE

Question-5
A&R Ltd. is a large-cap multinational company listed in BSE in India with a face value of ₹ 100 per
share. The company is expected to grow @ 15% p.a. for next four years then 5% for an indefinite
period. The shareholders expect 20% return on their share investments. Company paid ₹ 120 as
dividend per share for the FY 2020-21. The shares of the company traded at an average price of ₹ 3,122
on last day. FIND out the intrinsic value of per share and state whether shares are overpriced or
underpriced.
Hints: ₹ 1,140.50

Question-6
In May 2020, shares of RT Ltd. was sold for ₹ 1,460 per share. A long term earnings growth rate of
7.5% is anticipated. RT Ltd. is expected to pay dividend of ₹ 20 per share.
(i) CALCULATE rate of return an investor can expect to earn assuming that dividends are
expected to grow along with earnings at 7.5% per year in perpetuity?
(ii) It is expected that RT Ltd. will earn about 10% on retained earnings and shall retain 60% of
earnings. In this case, STATE whether, there would be any change in growth rate and cost of Equity?
Hints:
(i) 8.97%
(ii) g = 0.06, Ke = 8.19%

B. PAST YEAR QUESTION

Dec 21 Q-1(c) (05 Marks)
X Ltd. is a multinational company. Current market price per share is ₹ 2,185. During the
F.Y. 2020-21, the company paid ₹ 140 as dividend per share. The company is expected to grow @
12% p.a. for next four years, then 5% p.a. for an indefinite period. Expected rate of return of
shareholders is 18% p.a.
(i) Find out intrinsic value per share.
(ii) State whether shares are overpriced or underpriced.
Year 1 2 3 4 5
Discounting Factor @ 18% 0.847 0.718 0.608 0.515 0.436
Solution:
As per Dividend discount model, the price of share is calculated as follows:
P = D1 + D2 + D3 + D4 + D4(1+g) × 1
(1+Ke)1 (1+Ke)2 (1+Ke)3 (1+Ke)4 (Ke-g) (1+Ke)4
Where,
P = Price per share
Ke = Required rate of return on equity g = Growth rate
P = ₹ 140 × 1.12 + ₹156.80 × 1.12 + ₹175.62 × 1.12 + ₹196.69 × 1.12 + ₹ 220.29 (1 + 0.05) × 1
(1 + 0.18)1 (1+0.18)2 (1+0.18)3 (1+0.18)4 (0.18-0.05) (1+0.18)4
P= 132.81 + 126.10 + 119.59 + 113.45 + 916.34 = ₹ 1,408.29
Intrinsic value of share is ₹ 1,408.29 as compared to latest market price of ₹2,185. Market price of share is
over-priced by ₹ 776.71.

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Dividend Decisions By: CA PRAKSAH PATEL

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
The following information is collected from the annual reports of J Ltd:
Profit before tax ₹ 2.50 crore
Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent
What should be the market price per share according to Gordon's model of dividend policy?

Solution:

Gordon’s Formula
Po = E (1-b)
K-br
P0 = Market price per share
E = Earnings per share (₹ 1.50crore/ 50,00,000) = ₹ 3
K = Cost of Capital = 12%
b = Retention Ratio (%) = 40%
r = IRR = 15%
br = Growth Rate (0.40X15%) = 6%
Po = 3(1-0.40)
0.12-0.06
= 1.80 = ₹30.00
0.06

Question-2
Mr. A is contemplating purchase of 1,000 equity shares of a Company. His expectation of return is
10% before tax by way of dividend with an annual growth of 5%. The Company’s last dividend was ₹
2 per share. Even as he is contemplating, Mr. A suddenly finds, due to a Budget announcement
Dividends have been exempted from Tax in the hands of the recipients. But the imposition of Dividend
Distribution Tax on the Company is likely to lead to a fall in dividend of 20 paise per share. A’s
marginal tax rate is 30%.
Required:
Calculate what should be Mr. A’s estimates of the price per share before and after the Budget
announcement?

Solution:
The formula for determining value of a share based on expected dividend is:
Po = Do (1+g)
(k-g)
Where
P0 = Price (or value) per share
D0 = Dividend per share
g = Growth rate expected in dividend k = Expected rate of return

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Dividend Decisions By: CA PRAKSAH PATEL

Hence,
Price estimate before budget announcement:
Po = 2 x (1 + 0.05) = ₹42.00
(0.10 – 0.05)

Price estimate after budget announcement:

Po = 1.80 x (1.05) = ₹94.50 Or, Po = 2 x 1.05-0.20 = ₹95.00
(0.07 – 0.05) (0.07 – 0.05)

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Dividend Decisions By: CA PRAKSAH PATEL

4. MODIGLIANI & MILLER (MM) MODEL

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 12
AB Engineering Ltd. belongs to a risk class for which the capitalization rate is 10%. It currently has
outstanding 10,000 shares selling at ₹ 100 each. The firm is contemplating the declaration of a dividend
of ₹ 5/ share at the end of the current financial year. It expects to have a net income of ₹ 1,00,000 and
has a proposal for making new investments of ₹ 2,00,000. Calculate the value of the firms when
dividends (i) are not paid (ii) are paid
Hints: (i) ₹10,00,000, (ii) ₹10,00,000

ILLUSTRATION 13
RST Ltd. has a capital of ₹ 10,00,000 in equity shares of ₹ 100 each. The shares are currently quoted
at par. The company proposes to declare a dividend of ₹ 10 per share at the end of the current
financial year. The capitalization rate for the risk class of which the company belongs is 12%.
Compute market price of the share at the end of the year, if
(i) dividend is not declared ?
(ii) dividend is declared ?
(iii) assuming that the company pays the dividend and has net profits of ₹5,00,000 and
makes new investments of ₹10,00,000 during the period, how many new shares must
be issued? Use the MM model.
Hints: ₹112, ₹102, No. of Shares = 588 shares

TEST YOUR KNOWLEDGE

Question-7
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding shares
and the current market price is ₹ 100. It expects a net profit of ₹ 2,50,000 for the year and the Board is
considering dividend of ₹ 5 per share.
M Ltd. requires to raise ₹ 5,00,000 for an approved investment expenditure. Illustrate, how the MM
approach affects the value of M Ltd. if dividends are paid or not paid.
Hints: (i) ₹25,00,000 (ii) ₹25,00,000

Question-8
Aakash Ltd. has 10 lakh equity shares outstanding at the start of the accounting year 2021. The existing
market price per share is ₹ 150. Expected dividend is ₹ 8 per share. The rate of capitalization
appropriate to the risk class to which the company belongs is 10%.
(i) CALCULATE the market price per share when expected dividends are: (a) declared, and
(b) not declared, based on the Miller – Modigliani approach.
(ii) CALCULATE number of shares to be issued by the company at the end of the accounting
year on the assumption that the net income for the year is ₹ 3 crore, investment budget is ₹
6 crores, when (a) Dividends are declared, and (b) Dividends are not declared.
(iii) PROOF that the market value of the shares at the end of the accounting year will remain
unchanged irrespective of whether (a) Dividends are declared, or (ii) Dividends are not
declared.
Hints:
(i) (a) P1 = ₹ 157, (b) P1 = ₹ 165

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Dividend Decisions By: CA PRAKSAH PATEL

(ii)
(a) (b)
Dividends are Dividends are not
declared(₹ Declared
lakh) (₹ lakh)
No. of new shares to be issued (in lakh)(₹ 380 2.42 1.82
÷ 157; ₹ 300 ÷ 165)

(iii)
(a) (b)
Dividends are Dividends are not
declared Declared
Total market value of shares at the 12.42 × 157 11.82 × 165
end of the year (₹ in lakh) = 1,950 (approx.) = 1,950 (approx.)

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Dividend Decisions By: CA PRAKSAH PATEL

5. LINTER’S MODEL

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 14
Given the last year’s dividend is ₹ 9.80, speed of adjustment = 45%, target payout ratio 60% and EPS
for current year ₹ 20. COMPUTE current year’s dividend using Linter’s model.

Hints: D1 = ₹10.79

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Dividend Decisions By: CA PRAKSAH PATEL

6. MISCELLANEOUS

Question-1 (Buy-back)
Rahul Ltd. has surplus cash of ₹ 100 lakhs and wants to distribute 27% of it to the shareholders. The
company decides to buy back shares. The Finance Manager of the company estimates that its share
price after re-purchase is likely to be 10% above the buyback price-if the buyback route is taken.
The number of shares outstanding at present is 10 lakhs and the current EPS is ₹ 3.
You are required to determine:
(i) The price at which the shares can be re-purchased, if the market capitalization of the company
should be ₹ 210 lakhs after buyback,
(ii) The number of shares that can be re-purchased, and
(iii) The impact of share re-purchase on the EPS, assuming that net income is the same.
Solution:
(i) Let P be the buyback price decided by Rahul Ltd.
Market Capitalisation after Buyback
1.1P (Original Shares – Shares Bought Back)
= 1.1P (10 lakhs - 27% of 100 lakhs)
P
= 11 lakhs x P – 27 lakhs x 1.1 = 11 lakhs P – 29.7 lakhs
Again, 11 lakhs P – 29.7 lakhs
or 11 lakhs P = 210 lakhs + 29.7 lakhs
or P = 239.7 = ₹21.79 per share
11
(ii) Number of Shares to be Bought Back :-
₹27 lakhs = 1.24 lakhs (approx.) or 123910 share
₹21.79
(iii) New Equity Shares :-
10 lakhs – 1.24 lakhs = 8.76 lakhs or 1000000 – 123910 = 876090 shares
EPS = 3 x 10 lakhs = ₹3.43
8.76 lakhs
Thus, EPS of Rahul Ltd., increases to ₹ 3.43.

Question-2 (Right Shares)

ABC Limited’s shares are currently selling at ₹ 13 per share. There are 10,00,000 shares outstanding.
The firm is planning to raise ₹ 20 lakhs to Finance a new project.
Required:
What are the ex-right price of shares and the value of a right, if
(i) The firm offers one right share for every two shares held.
(ii) The firm offers one right share for every four shares held.
(iii) How does the shareholders’ wealth change from (i) to (ii)? How does right issue increases
shareholders’ wealth?
Solution:
(i) Number of shares to be issued : 5,00,000
Subscription price ₹ 20,00,000 / 5,00,000 = ₹ 4
Ex- right price = ₹1,30,00,000 + ₹20,00,000 = ₹10
15,00,000
Value of right = ₹10 - ₹4 = 3
2
Or = ₹ 10 – ₹ 4 = ₹ 6

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Dividend Decisions By: CA PRAKSAH PATEL

(ii) Subscription price ₹ 20,00,000 / 2,50,000 = ₹ 8

Ex-right price = ₹1,30,00,000 + ₹20,00,000 = ₹12
12,50,000
Value of right = ₹12 - ₹8 = ₹1
4
Or = ₹ 12 – ₹ 8 = ₹ 4

(iii) Calculation of effect of right issue on wealth of Shareholder’s wealth who is holding,
say 100 shares.
(a) When firm offers one share for two shares held.
Value of Shares after right issue (150 X ₹ 10) ₹ 1,500
Less: Amount paid to acquire right shares (50X₹4) ₹ 200
₹1,300
(b) When firm offers one share for every four shares held.
Value of Shares after right issue (125 X ₹ 12) ₹ 1,500
Less: Amount paid to acquire right shares (25X₹8) ₹ 200
₹1,300
(c) Wealth of Shareholders before Right Issue ₹1,300
Thus, there will be no change in the wealth of shareholders from (i) and (ii).
Question-3 (Right Shares)
The stock of the Soni plc is selling for £50 per common stock. The company then issues rights to
subscribe to one new share at £40 for each five rights held.
(a) What is the theoretical value of a right when the stock is selling rights-on?
(b) What is the theoretical value of one share of stock when it goes ex-rights?
(c) What is the theoretical value of a right when the stock sells ex-rights at £50?
(d) John Speculator has £1,000 at the time Soni plc goes ex-rights at £50 per common stock. He
feels that the price of the stock will rise to £60 by the time the rights expire. Compute his return
on his £1,000 if he (1) buys Soni plc stock at £50, or (2) buys the rights as the price computed in
part c, assuming his price expectations are valid.
Solution:
(a) R0 = P0 - S = £50 - £40 = £1.67
N+1 5+1

(b) Px = (P0 x N) + S = (£50 x 5) + £40 = £48.33

N+1 6

(c) Rx = Px - S = £50 - £40 = £2.00

N 5

(d) (1) £1,000/£50 =20 shares x £60 = £1,200

£1,200 - £1,000 = £200
(2) £1,000 / £2 = 500 rights X £4* = £2,000

£2,000-£1,000 = £1,000
*Rx = (£60 - £40)/5 = £4

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Dividend Decisions By: CA PRAKSAH PATEL

Question-4 (Right Shares)

Pragya Limited has issued 75,000 equity shares of ₹ 10 each. The current market price per share is ₹
24. The company has a plan to make a rights issue of one new equity share at a price of ₹ 16 for every
four share held.
You are required to:
(i) Calculate the theoretical post-rights price per share;
(ii) Calculate the theoretical value of the right alone;
(iii) Show the effect of the rights issue on the wealth of a shareholder, who has 1,000 shares
assuming he sells the entire rights; and
(iv) Show the effect, if the same shareholder does not take any action and ignores the issue.
Solution:
(i) Calculation of theoretical Post-rights (ex-right) price per share:
Ex-right value = (MN + S R)
N+R
Where,
M = Market price,
N = Number of old shares for a right share S = Subscription price
R = Right share offer
= (₹24 x 4) + (₹16 x 1) = ₹ 22.40
4+1
(ii) Calculation of theoretical value of the rights alone:
= Ex-right price – Cost of rights share
= ₹ 22.40 – ₹ 16 = ₹ 6.40
Or, ₹22.40 - ₹16 = ₹1.60
4
(iii) Calculation of effect of the rights issue on the wealth of a shareholder who has 1,000
shares assuming he sells the entire rights:
₹
(a) Value of shares before right
issue (1,000 shares × ₹ 24) 24,000
(b) Value of shares after right
issue (1,000 shares × ₹ 22.40) 22,400
Add: Sale proceeds of rights
renunciation (250 shares × ₹ 6.40) 1,600
24,000
There is no change in the wealth of the shareholder even if he sells his right.

(iv) Calculation of effect if the shareholder does not take any action and ignores the
issue:
₹
Value of shares before right
issue (1,000 shares × ₹ 24) 24,000
Less: Value of shares after right issue
(1,000 shares × ₹ 22.40) 22,400
Loss of wealth to shareholders, if rights ignored 1,600

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Working Capital Management By: CA PRAKASH PATEL

Chapter- 6: Working Capital

Unit-I Working Capital Management
PART-I OPERATING CYCLE APPROACH
A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 1 (Study Material – illustration-2)

From the following information of XYZ Ltd., you are required to Calculate:
(a) Net operating cycle period.
(b) Number of operating cycles in a year.
(₹)
(i) Raw material inventory consumed during the year 6,00,000
(ii) Average stock of raw material 50,000
(iii) Work-in-progress inventory 5,00,000
(iv) Average work-in-progress inventory 30,000
(v) Finished goods inventory 8,00,000
(vi) Average finished goods stock held 40,000
(vii) Average collection period from debtors 45 days
(viii) Average credit period availed 30 days
(ix) No. of days in a year 360ys
Hints: 85 Days, 4.23 times

TEST YOUR KNOWLEDGE

Question-1
Following information is forecasted by R Limited for the year ending 31st March, 2021:
Balance as at31st Balance as at31st
March, 2021 March, 2020
(₹ in lakh) (₹ in lakh)
Raw Material 65 45
Work-in-progress 51 35
Finished goods 70 60
Receivables 135 112
Payables 71 68
Annual purchases of raw material (all 400
credit)
Annual cost of production 450
Annual cost of goods sold 525
Annual operating cost 325
Annual sales (all credit) 585

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Working Capital Management By: CA PRAKASH PATEL

You may take one year as equal to 365 days. You are required to CALCULATE:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.
Hints:
(i) Net operating cycle period: 146 days
(ii) Number of operating cycles in the year: 146
(iii) Amount of working capital requirement: ₹ 130 lakh

B. PAST YEAR QUESTION

Jan 21 Q-1 (d) (05 Marks)
The following information is provided by MNP Ltd. for the year ending 31st March,
2020:
Raw Material Storage period 45 days
Work-in-Progress conversion period 20 days
Finished Goods storage period 25 days
Debt Collection period 30 days
Creditors payment period 60 days
Annual Operating Cost ₹ 25,00,000
(Including Depreciation of ₹ 2,50,000) Assume 360 days in a year.
You are required to calculate:
(i) Operating Cycle period
(ii) Number of Operating Cycle in a year.
(iii) Amount of working capital required for the company on a cost basis.
(iv) The company is a market leader in its product and it has no competitor in the
market. Based on a market survey it is planning to discontinue sales on credit and
deliver products based on pre-payments in order to reduce its working capital
requirement substantially. You are required to compute the reduction in working
capital requirement in such a scenario.
Solution:
(i) Calculation of Operating Cycle Period:
Operating Cycle Period =R+W+F+D–C
= 45 + 20 + 25 + 30 – 60 = 60 days
(ii) Number of Operating Cycle in a Year
= 360 = 360 = 6
Operating Cycle Period 60

(iii) Amount of Working Capital Required

= Annual operating cost = ₹ 25,00,000 - ₹ 2,50,000
Number of operating cycle 6

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Working Capital Management By: CA PRAKASH PATEL

= ₹22,50,000 = ₹3,75,000
6
(iv) Reduction in Working Capital
Operating Cycle Period = R + W + F – C
= 45 + 20 + 25 – 60 = 30 days
Amount of Working Capital Required = ₹ 22,50,000 x 30 = ₹1,87,500
360
Reduction in Working Capital = ₹ 3,75,000 – ₹ 1,87,500 = ₹ 1,87,500
Note: If we use Total Cost basis, then amount of Working Capital required will be
₹ 4,16,666.67 (approx.) and Reduction in Working Capital will be ₹ 2,08,333.33 (approx.)

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
The following information is provided by the DVP Ltd. for the year ending 31st March, 20X5.
Raw Material storage period 50 days
Work in progress conversion period 18 days
Finished Goods storage period 22 days
Debt Collection period 45 days
Creditors' payment period 55 days
Annual Operating Cost 21 Lacs
(Including depreciation of ₹ 2,10,000) (1 year = 360 days)
You are required to calculate:
(i) Operating Cycle period.
(ii) Number of Operating Cycles in a year.
(iii) Amount of working capital required for the company on a cash cost basis.
(iv) The company is a market leader in its product, there is virtually no competitor in the
market. Based on a market research, it is planning to discontinue sales on credit and
deliver products based on pre-payments. Thereby, it can reduce its working capital
requirement substantially. What would be the reduction in working capital
requirement due to such decision?
Solution:
(i) Calculation of Operating Cycle Period:
Operating Cycle Period =R+W+F+D–C
= 50 + 18 + 22 + 45 – 55 = 80 days
(ii) Number of Operating Cycle in a Year
= 360 = 360 = 4.5 times
Operating Cycle Period 80
(iii) Amount of Working Capital Required
= Annual Operating Cost = (₹21,00,000 - ₹2,10,000)
Number of Operating Cycle 4.5
= 18,90,000 = 4,20,000
4.5
(iv) Reduction in Working Capital
Operating Cycle Period =R+W+F–C
= 50 + 18 + 22 – 55 = 35 days
Amount of Working Capital Required = 18,90,000 × 35 = ₹1,83,750
360
Reduction in Working Capital = ₹4,20,000 – ₹1,83,750 = ₹2,36,250
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Working Capital Management By: CA PRAKASH PATEL

Question-2
Following information is forecasted by the CS Limited for the year ending 31st March, 20X6:
Balance as at Balance as at 31st
1st April, 20X5 March, 20X6
(₹) (₹)
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Receivables 1,12,123 1,35,000
Payables 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days. You are required to calculate:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement.
Solution:
Working Notes:
1. Raw Material Storage Period (R)
= Average Stock of Raw Material x 365
Annual Consumption of Raw Material
₹45,000 + ₹65,356
= 2 x 365 = 53 days
₹3,79,644
Annual Consumption of Raw Material = Opening Stock + Purchases - Closing Stock
= ₹45,000 + ₹4,00,000 – ₹65,356
= ₹ 3,79,644
2. Work – in - Progress (WIP) Conversion Period (W)
WIP Conversion Period = Average Stock of WIP x 365
Annual Cost of Production
₹35,000 + 51,300
= 2 x 365 = 21 days
₹7,50,000
3. Finished Stock Storage Period (F)
= Average Stock of Finished Goods
x 365
Cost of Goods Sold

₹60,187 + ₹70,175
= 2 = ₹65,178 x 365 = 26 days
₹9,15,000 ₹9,15,000
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4. Receivables (Debtors) Collection Period (D)

= Average Receivable x 365

Annual Credit Sales

₹1,12,123 + ₹1,35,000
= 2 = ₹1,23,561.50 x 365 = 41 days
₹11,00,000 ₹11,00,000
5. Payables (Creditors) Payment Period (C)
= Average Payables for materials x 365
Annual Credit purchases
= ₹ 50,079 + 70,469
2 x 365 = 55 days
₹4,00,000
(i) Net Operating Cycle Period
=R+W+F+D-C
= 53 + 21 + 26 + 41 - 55
= 86 days
(ii) Number of Operating Cycles in the Year
= 365 = 365 = 4.244 times
Operating Cycle Period 86
(iii) Amount of Working Capital Required
= Annual Operating Cycle = ₹9,50,000 = ₹2,23,845
Number of Operating Cycle 4.244

Question – 3
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 20X1 is
given below:

Particulars Amount Amount Particulars Amount Amount

(₹ ) (₹ ) (₹ ) (₹)
To Opening Stock: By Sales (Credit) 20,00,000
-Raw Materials 1,80,000 By Closing Stock:
-Work- in- progress 60,000 -Raw Materials 2,00,000
-Finished Goods 2,60,000 5,00,000 -Work-in-progress 1,00,000
To Purchases (credit) 11,00,000 -Finished Goods 3,00,000 6,00,000
To Wages 3,00,000
To Production 2,00,000
Expenses
To Gross Profit c/d 5,00,000
26,00,000 26,00,000
To Administration 1,75,000 By Gross Profit b/d 5,00,000
Expenses
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Working Capital Management By: CA PRAKASH PATEL

To Selling Expenses 75,000

To Net Profit 2,50,000
5,00,000 5,00,000
The opening and closing balances of receivables were ₹ 1,50,000 and ₹ 2,00,000 respectively
whereas opening and closing payables for raw materials were ₹ 2,00,000 and ₹ 2,40,000
respectively.
You are required to ascertain the working capital requirement by operating cycle method.

Solution:
Computation of Operating Cycle
(1) Raw Material Storage Period (R)
Raw Material Storage Period (R) = Average Stock of Raw Material
Daily Avg. Consumption of Raw Material
= (1,80,000 + 2,00,000)/2 = 63.33 days
10,80,000/360
Raw Material Consumed = Opening Stock + Purchases – Closing Stock
= ₹ 1,80,000 + ₹ 11,00,000 – ₹ 2,00,000 = ₹10,80,000

(2) Conversion/Work-in-Process Period (W)

Conversion/Processing Period = Average Stock of WIP
Daily Average Production Cost
= (60,000 + 1,00,000)/2 = 18.7 days
15,40,000/360
Production Cost: ₹
Opening Stock of WIP = 60,000
Add: Raw Material Consumed = 10,80,000
Add: Wages = 3,00,000
Add: Production Expenses = 2,00,000
16,40,000
Less: Closing Stock of WIP = 1,00,000
Production Cost 15,40,000

(3) Finished Goods Storage Period (F)

Finished Goods Storage Period = Average Stock of Finished Goods
Daily Average Cost of Goods Sold
= (2,60,000 + 3,00,000)/2 = 67.2 Days
15,00,000/360
Cost of Goods Sold ₹
Opening Stock of Finished Goods 2,60,000
Add: Production Cost 15,40,000
18,00,000
Less: Closing Stock of Finished Goods (3,00,000)
15,00,000

(4) Receivables Collection Period (D)

Receivables Collection Period = Average Receivables
Daily Average Credit Sales

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= (1,50,000 + 2,00,000)/2 = 315 Days

20,00,000/360

(5) Payables Payment Period (C)

Payables Payment Period = Average Payables
Daily Average Credit Purchase
= (2,00,000 +2,40,000)/2 = 72 days
11,00,000/360

(6) Duration of Operating Cycle (O)

O = R+W+F+D–C
= 63.33 + 18.7 + 67.2 + 31.5 – 72
= 108.73 days

Computation of Working Capital

(i) Number of Operating Cycles per Year

= 360/Duration Operating Cycle = 360/108.73 = 3.311

(ii) Total Operating Expenses ₹

Total Cost of Goods sold 15,00,000
Add: Administration Expenses 1,75,000
Add: Selling Expenses 75,000
17,50,000

(iii) Working Capital Required

Working Capital Requirement = Total Operating Expenses
Number of Operating Cycles per year
= 17,50,000 = ₹5,28,541
3.311
[Note: The solution can also be solved by taking of 365 days a year.]

PART-II INDIVIDUAL COMPONENT APPROACH

A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 2 (Study Material – illustration-1)

A firm has the following data for the year ending 31st March, 2017:
(₹)
Sales (1,00,000 @ ₹ 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are ₹ 5,00,000, ₹ 4,00,000 and ₹ 3,00,000. It
is assumed that fixed assets level is constant and profits do not vary with current assets levels.
Analyse the effect of the three alternative current assets policies.
Hints: Trade-off between profitability (ROA) & Liquidity.

ILLUSTRATION 3 (Study Material – illustration-3)

On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of working
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capital that will be required during the year. From the following information PREPARE the
working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of activity would
be maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10% and
Overheads 20%.
Raw materials are expected to remain in store for an average of 2 months before issue to production.
Each unit is expected to be in process for one month, the raw materials being fed into the pipeline
immediately and the labour and overhead costs accruing evenly during the month.
Finished goods will stay in the warehouse awaiting dispatch to customers for approximately 3
months.
Credit allowed by creditors is 2 months from the date of delivery of raw material. Credit allowed
to debtors is 3 months from the date of dispatch.
Selling price is ₹ 5 per unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month. The company
normally keeps cash in hand to the extent of ₹ 20,000.
Hints: Working Capital = ₹1,66,250

ILLUSTRATION 4 (Study Material – illustration-4)

The following annual figures relate to XYZ Co.,
(₹)
Sales (at two months’ credit) 36,00,000
Materials consumed (suppliers extend two months’ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses (expenses are paid one month in 9,60,000
arrear)
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000
The company sells its products on gross profit of 25%. Depreciation is considered as a part of the
cost of production. It keeps one month’s stock each of raw materials and finished goods, and a
cash balance of ₹ 1,00,000.
Assuming a 20% safety margin, Compute the working capital requirements of the company on cash
cost basis. Ignore work-in-process.
Hints: Working Capital = ₹7,20,000

ILLUSTRATION 5 (Study Material – illustration-5) (Double Shift)

Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a single shift
working with the following cost structure:
Per unit (₹)
Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00

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Working Capital Management By: CA PRAKASH PATEL

Sales during 2016-17 – ₹ 4,32,000.

As at 31.3.2017 the company held:

(₹)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift.
It is expected that a 10% discount will be available from suppliers of raw materials in view of
increased volume of business. Selling price will remain the same. The credit period allowed to
customers will remain unaltered. Credit availed of from suppliers will continue to remain at the
present level i.e., 2 months. Lag in payment of wages and expenses will continue to remain half a
month.
You are required to prepare the additional working capital requirements, if the policy to increase
output is implemented.
Hints: Working Capital = ₹1,92,000 & ₹2,86,800

TEST YOUR KNOWLEDGE

Question-2
PQ Ltd., a company newly commencing business in 2019 has the following projected Profit and
Loss Account:
Particulars ₹ ₹
Sales 2,10,000
COGS 1,53,000
Gross profit 57,000
Administrative expenses 14,000
Selling expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
-Material used 84,000
-Wages and manufacturing expenses 62,500
-Depreciation 23,500
1,70,000
Less: Stock of finished goods (10% of goods produced not yet sold) 17,000
1,53,000
The figure given above relate only to finished goods and not to work-in- progress. Goods equal to
15% of the year’s production (in terms of physical units) will be in process on the average requiring
full materials but only 40% of the other expenses. The company believes in keeping materials equal
to two months’ consumption in stock.
All expenses will be paid one month in advance. Suppliers of materials will extend 1-1/2 months
credit. Sales will be 20% for cash and the rest at two months’ credit. 70% of the Income tax will be
paid in advance in quarterly instalments. The company wishes to keep ₹ 8,000 in cash. 10% has to
be added to the estimated figure for unforeseen contingencies.
Prepare an estimate of working capital.
Note: All workings should form part of the answer.
Hints: Working Capital = ₹75,584
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Working Capital Management By: CA PRAKASH PATEL

Question-3
M.A. Limited is commencing a new project for manufacture of a plastic component. The following
cost information has been ascertained for annual production of 12,000 units which is the full
capacity:
Particulars Cost per unit (₹)
Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00
The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per unit, 80% of which
is variable.
In the first two years of operations, production and sales are expected to be as follows:
Year Production (No. of units) Sales (No. of units)
1 6,000 5,000
2 9,000 8,500
To assess the working capital requirements, the following additional information is available:
(a) Stock of materials 2.25 months’ average consumption
(b) Work-in-process Nil
(c) Debtors 1 month’s average sales.
(d) Cash balance ₹ 10,000
(e) Creditors for supply of 1 month’s average purchase during the year.
materials
(f) Creditors for expenses 1 month’s average of all expenses during the year.
Prepare, for the two years:
(i) A projected statement of Profit/Loss (Ignoring taxation); and
(ii) A projected statement of working capital requirements.

Hints:
1 2
P/L (₹52,000) ₹22,000
Working Capital ₹1,24,583 ₹1,84,042

Question-4
Aneja Limited, a newly formed company, has applied to a commercial bank for the first time for
financing its working capital requirements. The following information is available about the
projections for current year:
Estimated level of activity; 1,04,000 completed units of production plus 4,000 units of work-in-
progress. Based on the above activity, estimated cost per units:
Raw Material ₹80 per unit
Direct wages ₹30 per unit
Overheads (exclusive of depreciation) ₹60 per unit
Total Cost ₹170 per unit
Selling price ₹200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion
stage in respect of conversion cost) (materials issued at the start of the processing).
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Finished goods in stock 8,000 units

Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at banks (for smooth operation) is expected to be ₹ 25,000.
Assume that production is carried on evenly throughout the year (52 weeks) and wages and
overheads accrue similarly. All sales are on credit basis only.
You are required to calculate the net working capital required.
Hints: ₹42,52,913

Question-5
The following data relating to an auto component manufacturing company is available for the year
2020-21:
Raw material held in storage 20 days
Receivables’ collection period 30 days
Conversion process period 10 days
(raw material – 100%, other costs – 50% complete)
Finished goods storage period 45 days
Credit period from suppliers 60 days
Advance payment to suppliers 5 days
Total cash operating expenses per annum ₹ 800 lakhs
75% of the total cash operating expenses are for raw material. 360 days are assumed in a year.
You are required to CALCULATE:
(i) Each item of current assets and current liabilities,
(ii) The working capital requirement, if the company wants to maintain a cash balance of ?
10 lakhs at all times.
Hints: Working capital: 133.78

Question-6
The following figures and ratios are related to a company:
(i) Sales for the year (all credit) ₹ 90,00,000
(ii) Gross Profit ratio 35 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1.5:1
(vi) Current ratio 2.5:1
(vii) Receivables (Debtors) collection period 1 month
(viii) Reserves and surplus to Share capital 1:1.5
(ix) Capital gearing ratio 0.7875
(x) Fixed assets to net worth 1.3 : 1
You are required to PREPARE:
(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a
provision for contingencies @15 percent of net working capital.
Hints:
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Working Capital Management By: CA PRAKASH PATEL

(a) Balance Sheet: 63,37,500

(b) Working capital requirement: 16,81,875

Question-7
The management of Trux Company Ltd. is planning to expand its business and consults you to
prepare an estimated working capital statement. The records of the company reveals the following
annual information:
(₹)
Sales – Domestic at one month’s credit 18,00,000
Export at three month’s credit (sales price 10% below 8,10,000
domestic price)
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000
Lag in payment of Administration Expenses – 1 month 1,80,000
Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four installments, of which one falls in 1,68,000
the next financial year
Rate of gross profit is 20%. Ignore work-in-progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and believes in
keeping ₹ 2,50,000 available to it including the overdraft limit of ₹ 75,000 not yet utilized by the
company.
The management is also of the opinion to make 10% margin for contingencies on computed figure.
You are required to PREPARE the estimated working capital statement for the next year.
Hints: Total Working Capital required : 5,48,702

B. PAST YEAR QUESTION

Nov 20 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 ₹ 3,60,000) 32,40,000
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.

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Working Capital Management By: CA PRAKASH PATEL

(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.
Solution:
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) 19,35,000
Receivables (₹ 88,20,000 × 3/12) 22,05,000
Administrative and Selling Overhead (₹ 10,80,000 × 1/12) 90,000
Cash in Hand 3,00,000
Gross Working Capital 52,05,000 52,05,000
B. Current Liabilities:
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 10,95,000 10,95,000
Net Working Capital (A-B) 41,10,000
Add: Safety margin @ 10% 4,11,000
Total Working Capital requirements 45,21,000
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.

May 19 Q-5 (10 Marks)

Bita Limited manufactures used in the steel industry. The following information
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Working Capital Management By: CA PRAKASH PATEL

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
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.
Solution:
Statement showing Estimate of Working Capital Requirement
(Amount in (Amount in ₹)
₹)
A. Current Assets
(i) Inventories:
- Raw material inventory (9,000 units x ₹80 x 2 months) 1,20,000
12 months

- Work in Progress:
Raw material ( 9,000units×₹ 80 × 0.5 month)
30,000
12months

Wages ( 9,000units×₹ 20 × 0.5 month) × 50%

3,750
12 months

Overheads (9,000units×₹ 60 × 0.5 month) × 50%

11,250
12 months
45,000
(Other than Depreciation)
Finished goods (inventory held for 1 months)
( 9,000 units×₹ 160 ×1 month) 1,20,000
12months
(ii) Debtors (for 2 months)
( 9,000 units ×₹ 160 × 2 month) × 80% or

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12 months 1,92,000
(11,52,000 × 2 month)
12 months
(iii) Cash balance expected 67,500
Total Current assets 5,44,500
B. Current Liabilities
(i) Creditors for Raw material (1 month)
(9,000 units×₹ 80 ×1 month) 60,000
12 months
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
Hence, Cash cost of credit sale ( 14,40,000 x 4 ) = ₹11,52,000
5
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
(9,000 units x ₹200 x 2 months) x 80% Or, (14,40,000 x 2 months) = ₹2,40,000
12 months 12 months
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].

May 18 Q-5 (10 Marks)

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 informations are available about the projections
for the current year:
Estimated Level of Activity Completed Units of Production 31200 plus unit of
work in progress 12000
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
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Working Capital Management By: CA PRAKASH PATEL

Work in Progress Stock Material 100% and Conversion Cost 50%

Finished Goods Stock 24000 Units
Credit Allowed by the 30 days
supplier
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in 15 days
payment)
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.

Solution:
Calculation of Net Working Capital requirement:
(₹) (₹)
A. Current Assets:
Inventories:
Stock of Raw material 1,44,000
(Refer to Working
note (iii)
Stock of Work in 7,50,000
progress (Refer to
Working note (ii)
Stock of Finished 20,40,000
goods (Refer to
Working note (iv)
Debtors for Sales 1,02,000
(Refer to Working note (v)
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases 1,56,000
(Refer to Working note (vi)
Creditors for wages
(Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750

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

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Working Capital Management By: CA PRAKASH PATEL

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
(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 = ₹17,28,000 x 30 days = ₹1,44,000
360 days
(iv) Finished goods stock:
24,000 units @ ₹ (40+15+30) per unit = ₹20,40,000

(v) Debtors for sale: ₹ 6,12,000 x 60days = ₹1,02,000

360 days

(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 ₹ 1,44,000
₹18,72,000
Credit allowed by suppliers = ₹18,72,000 × 30days = ₹1,56,000
360 days
(vii) Creditors for wages:
Outstanding wage payment = ₹5,58,000 ×15days = ₹ 23,250
360 days

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
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Working Capital Management By: CA PRAKASH PATEL

A proforma cost sheet of a company provides the following particulars:

Amount per unit(₹)
Raw materials cost 100.00
Direct labour cost 37.50
Overheads cost 75.00

Total cost 212.50

Profit 37.50

250.00
Selling Price
The Company keeps raw material in stock, on an average for one month; work-in-progress, on an
average for one week; and finished goods in stock, on an average for two weeks.
The credit allowed by suppliers is three weeks and company allows four weeks credit to its debtors.
The lag in payment of wages is one week and lag in payment of overhead expenses is two weeks.
The Company sells one-fifth of the output against cash and maintains cash-in-hand and at bank put
together at ₹37,500.
Required:
Prepare a statement showing estimate of Working Capital needed to finance an activity level of
1,30,000 units of production. Assume that production is carried on evenly throughout the year, and
wages and overheads accrue similarly. Work-in-progress stock is 80% complete in all respects.

Solution:
Statement showing Estimate of Working Capital Needs
Particulars Amount in (₹) Amount in (₹)
A. Current Assets
(i) Inventories:
Raw Material (1 month or 4 weeks)
(1,30,000 units x ₹100 x 4 weeks) 10,00,000
52 weeks
WIP Inventory (1week)
(1,30,000 units x ₹212.50 x 1 weeks) x 0.8 4,25,000
52 weeks
Finished Goods Inventory (2 weeks)
(1,30,000 units x ₹212.50 x 2 weeks) 10,62,500 24,87,500
52 weeks
(ii) Receivables (Debtors) (4weeks)
(1,30,000 units x ₹212.5 x 4 weeks) x 4 17,00,000
52 weeks 5th
(iii) Cash and bank balance 37,500

Total Current Assets 42,25,000

B. Current Liabilities
(i) Payables (Creditors) for materials (3 weeks)
(1,30,000 units x ₹212.50 x 2 weeks) 7,50,000
52 weeks
(ii) Outstanding wages (1 week)
(1,30,000 units x ₹212.50 x 2 weeks) 93,750

52 weeks
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Working Capital Management By: CA PRAKASH PATEL

(iii) Outstanding overhead (2 weeks)

(1,30,000 units x ₹212.50 x 2 weeks) 3,75,000

52 weeks
Total Current Liabilities 12,18,750

Net Working Capital Needs (A – B) 30,06,250

Question-2
A proforma cost sheet of a Company provides the following data:
Amount (₹)
Raw material cost per unit 117.00
Direct Labour cost per unit 49.00
Factory overheads cost per unit 98.00
(includes depreciation of ₹ 18 per unit at budgeted level of
activity)

Total cost per unit 264.00

Profit 36.00

Selling price per unit 300.00

Following additional information is available:
Average raw material in stock : 4 weeks
Average work-in-process stock : 2 weeks
(% completion with respect to
Materials : 80%
Labour and Overheads : 60%)
Finished goods in stock : 3 weeks
Credit period allowed to debtors : 6 weeks
Credit period availed from suppliers : 8 weeks
Time lag in payment of wages : 1 week
Time lag in payment of overheads : 2 weeks
The company sells one-fifth of the output against cash and maintains cash balance of ₹ 2,50,000.
Required:
Prepare a statement showing estimate of working capital needed to finance a budgeted activity level
of 78,000 units of production. You may assume that production is carried on evenly throughout the
year and wages and overheads accrue similarly.

Solution:
Estimation of Working Capital Needs
Particulars Amount in (₹) Amount in (₹)
A. Current Assets
(i) Inventories:
Raw Material (4 weeks) 7,02,000
(78,000 units x ₹117 x 4 weeks)
52 weeks
WIP Inventory (2week) 2,80,800
- Material (78,000 units x ₹117 x 2 weeks) x 0.8
52 weeks

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Working Capital Management By: CA PRAKASH PATEL

- Labour and Overhead

(Other than depreciation) 5,13,000

(78,000 units x ₹129 x 2 weeks) x 0.6

52 weeks
- Finished Goods (3 weeks) 26,02800
(1,30,000 units x ₹246 x 3 weeks) 11,07,000
52 weeks
(ii) Receivables (Debtors) (6weeks)
(78,000 units x ₹246 x 6 weeks) x 4 17,71,200
52 weeks 5th
(iii) Cash and bank balance 2,50,000

Total Current Assets 43,43,200

B. Current Liabilities
(i) Payables (Creditors) for materials (8 weeks) 14,04,000
(78,000 units x ₹117 x 8 weeks)
52 weeks
(ii) Outstanding wages (1 week) 73,500
(78,000 units x ₹49 x 1 weeks)
52 weeks
(iii) Outstanding overhead (2 weeks) 2,40,000
(78,000 units x ₹80 x 2 weeks)
52 weeks
Total Current Liabilities 17,17,500

Net Working Capital Needs (A – B) 26,25,700

Question-3
MNO Ltd. has furnished the following cost data relating to the year ending of 31st March, 20X8.
₹ (in Lakhs)
Sales 450.00
Material consumed 150.00
Direct wages 30.00
Factory overheads (100% variable) 60.00
Office and Administrative overheads (100% variable) 60.00
Selling overheads 50.00
The company wants to make a forecast of working capital needed for the next year and anticipates
that:
➢ Sales will go up by 100%,
➢ Selling overheads will be ₹ 150 lakhs,
➢ Stock holdings for the next year will be
- Raw material for two and half months,
- Work-in-progress for one month,
- Finished goods for half month and
- Book debts for one and half months,
- Lags in payment will be of 3 months for suppliers,
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Working Capital Management By: CA PRAKASH PATEL

- 1 month for wages and half month for factory,

- Office and Administrative and Selling overheads.
You are required to prepare statement showing working capital requirements for next year.
Solution:
Working:
Statement showing the projected Cost and Profitability
for the year ending on 31-3-20X9
Year ending Year ending
31/3/20X8 31/3/20X9
(₹ in lakhs) (₹ in lakhs)
A. Sales 450.00 900.00
Direct Materials Consumed Direct 150.00 300.00
Wages 30.00 60.00
Prime Cost 180.00 360.00
Add: Factory overheads 60.00 120.00
Works cost 240.00 480.00
Add: Office & Administrative overheads 60.00 120.00
Cost of Production 300.00 600.00
Less: Closing stock of finished goods (₹ 600 × 0.5/12) -- (25.00)

Add: Selling overheads 50.00 150.00

B. Total Cost Profit 350.00 725.00
(A – B) 100.00 150.00

Statement showing Working Capital Requirements of MNO Ltd. for the year 31-3-20X9
Particulars Amount in (₹) Amount in (₹)
A. Current Assets
(i) Inventories:
Raw Material (2.5 months) 62.5
(₹150 x 2 x 2.5 months)
12 months
WIP Inventory (1 month) 25.00
- Material (150 x 2 x 1 month)
12 month
- Labour and Overhead
7.50
(₹30 + 60) x 2 x 1 month x 0.5
12 months
- Finished Goods (0.5 month) 25.00 120

(₹30 + 60 + 60) x 2 x 0.5 month

12 months
(ii) Receivables (Debtors) (1.5 months) 90.62
(725 x 1.5 months)
12 months
Total Current Assets 210.62

B. Current Liabilities
(i) Payables (Creditors) for materials (3 months) 90.62
(362.50 x 3 months)

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Working Capital Management By: CA PRAKASH PATEL

12 months
(ii) Outstanding wages (1 month) 5.00
(₹30 x 2 x 1 month)
12 months
(iii) Outstanding overhead (0.5 month) 16.25
(₹ 60 + 60) x 2 + ₹150 x 0.5 month
12 months
Total Current Liabilities 111.87

Net Working Capital Needs (A – B) 98.75

Working Note:
Value of raw material purchased
(₹ in lakhs)
Materials consumed 300.00
Add: Closing value of raw material inventory 62.50
Less: Opening value of raw material inventory --
Value of materials purchased 362.50
Assumptions:
(i) There is no opening and closing stock of raw materials in year 20X8, hence, no opening
stock in 20X9.
(ii) The value of opening and closing WIP in 20X8 is same and there is no change in volume
of WIP due to increase in sales in 20X9.
(iii) WIP inventory is 100% complete in respect of material and 50% in respect of labour and
overheads.
(iv) Office and Administrative overheads are related with the production process.
(v) There is no opening and closing stock of Finished goods in year 20X8, hence, no opening
stock in 20X9.

Question-4
The management of MNP Company Ltd. is planning to expand its business and consults you to
prepare an estimated working capital statement. The records of the company reveal the following
annual information:

(₹)
Sales –Domestic at one month’s credit 24,00,000
Export at three month’s credit (sales price 10% below domestic price) 10,80,000
Materials used (suppliers extend two months credit) 9,00,000
Lag in payment of wages – ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,20,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four installments of which one falls in the next financial year 2,25,000
Rate of gross profit is 20%.
Ignore work-in-progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and believes in
keeping ₹ 2,50,000 available to it including the overdraft limit of ₹ 75,000 not yet utilized by the
company.
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Working Capital Management By: CA PRAKASH PATEL

The management is also of the opinion to make 12% margin for contingencies on computed figure.
You are required to prepare the estimated working capital statement for the next year.

Solution:
Preparation of Statement of Working Capital Requirement for MNP Company Ltd
Particulars Amount in (₹) Amount in (₹)
A. Current Assets
(i) Inventories:
Material (1 months) 75,000
(₹9,00,000 x 1 months)
12 months
- Finished Goods (1 month) 2,40,000 3,15,000
₹28,80,000 x 1 month
12 months
(ii) Receivables (Debtors)
- For Domestic Sales (₹20,33,488 x 1 month)
12 months 1,68,621
- For Export Sales (₹10,06,552 x 3 moths)
12 months 2,51,638 4,20,259
(iii) Prepayment of Sales promotion expenses
(₹1,50,000 x 3 months)
12 months 37,500
(iv) Cash in hand & at bank 1,75,000
Total Current Assets 9,47,759
B. Current Liabilities
(i) Payables (Creditors) for materials (3 months) 1,50,000
(₹9,00,000 x 3 months)
12 months
(ii) Outstanding wages (0.5 months) 30,000
(₹7,20,000 x 0.5 month)
12 months
(iii) Outstanding manufacturing expenses 85,000
₹10,20,000 x 1 month
12 months
(iv) Outstanding administrative expenses 20,000
(₹2,40,000 x 1 month)
12 months
(v) Income tax payable 56,250
Total Current Liabilities 3,41,250
Net Working Capital Needs (A – B) 6,06,509
Add: 12% contingency margin 72,781
Total Working Capital required 6,79,290

Working Note:
1. Calculation of Cost of Goods Sold and Cost of Sales
Domestic (₹) Export(₹) Total (₹)
Domestic Sales 24,00,000 10,80,000 34,80,000
Less: Gross profit @ 20% on
domestic sales and 11.11% on
export (4,80,000) (1,20,000) (6,00,000)
sales (Working note-2)
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Working Capital Management By: CA PRAKASH PATEL

Cost of Goods Sold 19,20,000 9,60,000 28,80,000

Add: Sales promotion expenses
(Working note-3) 1,03,448 46,552 1,50,000
Cash Cost of Sales 20,23,448 10,06,552 30,30,000
2. Calculation of gross profit on Export Sales:
Let domestic selling price is ₹100. Gross profit is ₹20, and then cost per unit is ₹80
Export price is 10% less than the domestic price i.e. ₹100 – (1- 0.1) = ₹90
Now gross profit will be ₹90 - ₹80 = ₹10

Therefore Gross profit at domestic price will be ₹10 x 100 = 10%

₹100
Or, gross profit at export price will be ₹10 x 100 = 11.11%
₹90
3. Apportionment of Sales promotion expenses between Domestic and Exports sales:
Apportionment on the basis of sales value:
Domestic Sales = ₹1,50,000 x ₹24,00,000 = ₹1,03,448
₹34,80,000
Export Sales = ₹1,50,000 x ₹10,80,000 = ₹46,552
₹34,80,000
4. Assumptions
(i) It is assumed that administrative expenses relating to production activities.
(ii) Value of opening and closing stocks are equal.

Question-5
The following figures and ratios are related to a company:
(i) Sales for the year (all credit) ₹ 30,00,000
(ii) Gross Profit ratio 25 percent
(iii) Fixed assets turnover (based on cost of goods sold) 1.5
(iv) Stock turnover (based on cost of goods sold) 6
(v) Liquid ratio 1:1
(vi) Current ratio 1.5 : 1
(vii) Receivables (Debtors) collection period 2 months
(viii) Reserves and surplus to Share capital 0.6 : 1
(ix) Capital gearing ratio 0.5
(x) Fixed assets to net worth 1.20 : 1
You are required to prepare:
(a) Balance Sheet of the company on the basis of above details.
(b) The statement showing working capital requirement, if the company wants to make a
provision for contingencies @ 10 percent of net working capital including such provision.

Solution:
Working Notes:
(i) Cost of Goods Sold = Sales – Gross Profit (25% of Sales)
= ₹ 30,00,000 – ₹ 7,50,000
= ₹ 22,50,000
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Working Capital Management By: CA PRAKASH PATEL

(ii) Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 22,50,000/6 = ₹ 3,75,000
(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover
= ₹ 22,50,000/1.5
= ₹ 15,00,000
(iv) Current Assets : Current Ratio = 1.5 and Liquid Ratio = 1 Stock = 1.5 – 1 = 0.5
Current Assets = Amount of Stock × 1.5/0.5
= ₹ 3,75,000 × 1.5/0.5 = ₹ 11,25,000
(v) Liquid Assets (Debtors and Cash)
= Current Assets – Stock
= ₹ 11,25,000 – ₹ 3,75,000
= ₹ 7,50,000
(vi) Debtors = Sales × Debtors Collection period /12
= ₹ 30,00,000 × 2 /12
= ₹ 5,00,000
(vii) Cash = Liquid Assets – Debtors
= ₹ 7,50,000 – ₹ 5,00,000 = ₹ 2,50,000
(viii) Net worth = Fixed Assets /1.2
= ₹ 15,00,000/1.2 = ₹ 12,50,000
(ix) Reserves and Surplus
Reserves and Share Capital = 0.6 + 1 = 1.6
Reserves and Surplus = ₹ 12,50,000 × 0.6/1.6
= ₹ 4,68,750
(x) Share Capital = Net worth – Reserves and Surplus
= ₹ 12,50,000 – ₹ 4,68,750
= ₹ 7,81,250
(xi) Current Liabilities = Current Assets/ Current Ratio
= ₹ 11,25,000/1.5 = ₹ 7,50,000
(xii) Long-term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund
Long-term Debts = ₹ 12,50,000 × 0.5 = ₹ 6,25,000

(a) Preparation of Balance Sheet of a Company

Balance Sheet
Liabilities Amount (₹) Assets Amount (₹)
Equity Share Capital 7,81,250 Fixed Assets 15,00,000
Reserves and Surplus 4,68,750 Current Assets
Long-term Debts 6,25,000 Stock 3,75,000
Current Liabilities 7,50,000 Debtors 5,00,000
Cash 2,50,000
26,25,000 26,25,000

(b) Statement Showing Working Capital Requirement

(₹) (₹)

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Working Capital Management By: CA PRAKASH PATEL

A. Current Assets
(i) Stocks 3,75,000
(ii) Receivables (Debtors) (₹5,00,000 ÷ 1.25) 4,00,000
(iii) Cash in hand & at bank 2,50,000
Total Current Assets 10,25,000
B. Current Liabilities:
Total Current Liabilities 7,50,000
Net Working Capital (A – B) 2,75,000
Add: Provision for contingencies 30,556
(1/9th of Net Working Capital)
Working capital requirement 3,05,556

Question-6
The following data relating to an auto component manufacturing company is available for the year
20X4:
Raw material held in storage 20 days
Receivables collection period 30 days
Conversion process period (raw material – 100%, other costs – 50% complete) 10days
Finished goods storage period 45 days
Credit period from suppliers 60 days
Advance payment to suppliers 5 days
Total cash operating expenses per annum ₹800 lakhs
75% of the total cash operating expenses are for raw material. 360 days are assumed in a year.
You are required to calculate:
(i) Each item of current assets and current liabilities,
(ii) The working capital requirement, if the company wants to maintain a cash balance of ₹ 10
lakhs at all times.

Solution:
Particulars For Raw Material For Other Costs Total
Cash Operating expenses 75 25
x 800 = 600 x 800 = 200 800.00
100 100
Raw Material Stock Holding 20
x 600 = 33.33 - 33.33
360
WIP Conversion 10 5
x 600 = 16.67 x 200 = 2.78 19.45
360 360
Finished Goods Stock 45 45
Holding x 600 = 75 x 200 = 25 100.00
360 360
Receivable Collection Period 30 30 66.67
x 600 = 50 x 200 = 16.67
360 360
Advance to suppliers 5 8.33
x 600 = 8.33 -
360
Credit Period from suppliers 60 100.00
x 600 = 100 -
360

Computation of working capital

₹ in lakhs

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Working Capital Management By: CA PRAKASH PATEL

Raw Material Stock 33.33

WIP 19.45
Finished Goods stock 100.00
Receivables 66.67
Advance to Suppliers 8.33
Cash 10.00
237.78
Less: Payables (Creditors) 100.00
Working capital 133.78

Question-7
Black Limited has furnished the following cost sheet:
₹ Per
Unit
Raw Material 98.00
Direct Labour 53.00
Factory Overhead (Includes depreciation of ₹ 15 per unit at budgeted level of 88.00
activity)
Total Cost 239.00
Profit 43.00
Selling Price 282.00
Additional Information:
(i) Average raw material in stock 3 weeks
(ii) Average work-in-progress (% of completion with respect to Material- 75% Labour
& Overhead - 70%) 2 weeks
(iii) Finished goods in stock 4 weeks
(iv) Credit allowed to receivables 2½ weeks
(v) Credit allowed by suppliers 3½ weeks
(vi) Time lag in payments of labour 2 weeks
(vii) Time lag in payments of factory overheads 1½ weeks
(viii) Company sells, 25% of the output against cash
(ix) Cash in hand and bank is desired to be maintained ₹ 2,25,000
(x) Provision for contingencies is required @ 4% of working capital requirement
including that provision.
You may assume that production is carried on evenly throughout the year and labour and factory
overheads accrue similarly.
You are required to prepare a statement showing estimate of working capital needed to finance a
budgeted activity level of 1,04,000 units of production. Finished stock, receivables and overhead
are taken at cash cost.

Solution:
Statement of Estimation of Working Capital Needs
Particulars Amount in (₹) Amount in (₹)
A. Current Assets
(i) Inventories:
- Raw Material
(1,04,000 units x ₹98 x 3 weeks) 5,88,000
52 weeks
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Working Capital Management By: CA PRAKASH PATEL

- Work-in-process
Materials (1,04,000 units x ₹98 x 2 weeks) x 0.75 2,94,000
52 weeks
Labour & Overheads
(1,04,000 units x ₹126 x 2 weeks) x 0.7 3,52,800 30,26,800
52 weeks
Finished Goods
₹1,04,000 units x ₹224 x 1 month 17,92,000
52 weeks
(ii) Receivables
(1,04,000 units x ₹224 x 2.5 weeks ) x 0.75 8,40,000
52 weeks
(iii) Cash in hand & at bank 2,25,000
Total Current Assets 40,91,800
B. Current Liabilities
(i) Payables to supplier
(₹1,04,000 units x ₹98 x 3.5 weeks) 6,86,000
52 weeks
(ii) Direct wages payable
(₹1,04,000 units x ₹53 x 2 weeks) 2,12,000
52 weeks
(iii) Overheads payables
₹1,04,000 units x ₹73 x 1.5 weeks 2,19,000
52 weeks
Total Current Liabilities 11,17,000
Net Working Capital Needs (A – B) 29,74,800
Add: Provision for contingencies 1,23,950
Working Capital required 30,98,750

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Chapter- 6: Working Capital

Unit-II Cash Management
A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 6 (Study Material – illustration-6)

Prepare monthly cash budget for six months beginning from April 2017 on the basis of the
following information:-
(i) Estimated monthly sales are as follows:-
₹ ₹
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000
(ii) Wages and salaries are estimated to be payable as follows:-
₹ ₹
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000
(iii) 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 on credit and paid for in the month
preceding the sales.
(v) The firm has 10% debentures of ₹ 1,20,000. Interest on these has to be paid quarterly in
January, April and so on.
(vi) The firm is to make an advance payment of tax of ₹ 5,000 in July, 2017.
(vii) The firm had a cash balance of ₹ 20,000 on April 1, 2017, 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).
Hints:
Month April May June July August September
Closing ₹20,000 ₹20,000 ₹20,000 ₹20,000 ₹20,000 ₹20,000
Cash
Balance

ILLUSTRATION 7 (Study Material – illustration-7)

From the following information relating to a departmental store, you are required to PREPARE for
the three months ending 31st March, 2019:-
(a) Month-wise cash budget on receipts and payments basis; and
(b) Statement of Sources and uses of funds for the three months period.

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

It is anticipated that the working capital at 1st January, 2019 will be as follows:-
₹ in ‘000’s
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
Budgeted Profit Statement: ₹ in ‘000’s
January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, Selling and Distribution
Expenses 315 270 255
Net Profit before tax 150 125 115

Budgeted balances at the end of each ₹ in ‘000’s

months:

31st Jan. 28th Feb. 31st March

Short term investments 700 --- 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485 -- --
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550
Depreciation amount to ₹ 60,000 is included in the budgeted expenditure for each month.
Hints:
Month January February March
Cash Balance ₹315 ₹65 ₹290
Working Capital ₹2,085 - ₹2,085
Net Change in Working Capital is NIL

ILLUSTRATION 8 (Study Material – illustration-8)

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

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Profit and Loss Account

Year 1 Year 2 Year 1 Year 2
₹ ₹ ₹ ₹
To Opening stock 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
To Raw materials 3,00,00,000 4,00,00,000 By Closing stock 1,00,00,000 1,50,00,000
To Stores 1,00,00,000 1,20,00,000 By Misc. Income 10,00,000 10,00,000
To Manufacturing 1,00,00,000 1,60,00,000
Expenses
To Other 1,00,00,000 1,00,00,000
Expenses
To Depreciation 1,00,00,000 1,00,00,000
To Net Profit 1,30,00,000 1,80,00,000 - -
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000
Sales are expected to be ₹ 12,00,00,000 in year 3.
As a result, other expenses will increase by ₹ 50,00,000 besides other charges. Only raw materials
are in stock. Assume sales and purchases are in cash terms and the closing stock is expected to go
up by the same amount as between year 1 and 2. You may assume that no dividend is being paid.
The Company can use 75% of the cash generated to service a loan. COMPUTE how much cash
from operations will be available in year 3 for the purpose? Ignore income tax.
Hints:
Net Profit (3rd Year) = ₹204 Lakhs
Net Cash Flow = ₹254 Lakhs

ILLUSTRATION 9 (Study Material – illustration-9)

Prachi Ltd is a manufacturing company producing and selling a range of cleaning products to
wholesale customers. It has three suppliers and two customers. Prachi Ltd relies on its cleared funds
forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare a cleared funds
forecast for the period Monday 7 August to Friday 11 August 2019 inclusive. You have been
provided with the following information:

(1) Receipts from customers

Credit terms Payment 7 Aug 7 Jul 2019
method 2019 sales sales
W Ltd 1 calendar month BACS ₹ 150,000 ₹ 130,000
X Ltd None Cheque ₹ 180,000 ₹ 160,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale
is made and will clear on the third day following this (excluding day of payment).
(2) Payments to suppliers
Supplier Credit terms Payment 7 Aug 7 Jul 7 Jun
name method 2019 2019 2019
purchases purchases purchases
A Ltd 1 calendar Standing ₹ 65,000 ₹ 55,000 ₹ 45,000
month order
B Ltd 2 calendar Cheque ₹ 85,000 ₹ 80,000 ₹ 75,000
months
C Ltd None Cheque ₹ 95,000 ₹ 90,000 ₹ 85,000
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Working Capital Management - Cash Management By: CA PRAKASH PATEL

(a) Prachi Ltd has set up a standing order for ₹ 45,000 a month to pay for supplies from A
Ltd. This will leave Prachi’s bank account on 7 August. Every few months, an
adjustment is made to reflect the actual cost of supplies purchased (you do NOT need to
make this adjustment).
(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7 August. The amounts
will leave its bank account on the second day following this (excluding the day of
posting).

(3) Wages and salaries:

July 2019 August 2019
Weekly wages ₹ 12,000 ₹ 13,000
Monthly salaries ₹ 56,000 ₹ 59,000
(a) Factory workers are paid cash wages (weekly). They will be paid one week’s wages,
on 11 August, for the last week’s work done in July (i.e. they work a week in hand).
(b) All the office workers are paid salaries (monthly) by BACS. Salaries for July will be
paid on 7 August.
(4) Other miscellaneous payments:
(a) Every Monday morning, the petty cashier withdraws ₹ 200 from the company bank
account for the petty cash. The money leaves Prachi’s bank account straight away.
(b) The room cleaner is paid ₹ 30 from petty cash every Wednesday morning.
(c) Office stationery will be ordered by telephone on Tuesday 8 August to the value of
₹ 300. This is paid for by company debit card. Such payments are generally seen to
leave the company account on the next working day.
(d) Five new softwares will be ordered over the Internet on 10 August at a total cost of
₹ 6,500. A cheque will be sent out on the same day. The amount will leave Prachi
Ltd’s bank account on the second day following this (excluding the day of posting).
(5) Other information:
The balance on Prachi’s bank account will be ₹ 200,000 on 7 August 2019. This represents both
the book balance and the cleared funds.

Prepare a cleared funds forecast for the period Monday 7 August to Friday 7 August 2019 inclusive
using the information provided. Show clearly the uncleared funds float each day.
Hints:
Monday Tuesday Wednesday Thursday Friday
Total Book ₹2,38,800 ₹2,38,500 ₹2,38,500 ₹2,32,000 ₹2,20,000
Balance

ILLUSTRATION 10 (Study Material – illustration-10)

A firm maintains a separate account for cash disbursement. Total disbursement are ₹ 1,05,000 per
month or ₹ 12,60,000 per year. Administrative and transaction cost of transferring cash to
disbursement account is ₹ 20 per transfer. Marketable securities yield is 8% per annum.
Determine the optimum cash balance according to William J. Baumol model.
Hints: ₹25,100

ILLUSTRATION 11 (Study Material – illustration-11)

The following information is available in respect of Sai trading company:
(i) On an average, debtors are collected after 45 days; inventories have an average holding
period of 75 days and creditor’s payment period on an average is 30 days.
(ii) The firm spends a total of ₹ 120 lakhs annually at a constant rate.
(iii) It can earn 10 per cent on investments.
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Working Capital Management - Cash Management By: CA PRAKASH PATEL

From the above information, you are required to Calculate:

(a) The cash cycle and cash turnover,
(b) Minimum amounts of cash to be maintained to meet payments as they become due,
(c) Savings by reducing the average inventory holding period by 30 days.
Hints:
(a) 90 Days, 4 times
(b) ₹30 Lakhs,
(c) ₹1 Lakhs

TEST YOUR KNOWLEDGE

Question-4
The following information relates to Zeta Limited, a publishing company:
The selling price of a book is ₹15, and sales are made on credit through a book club and invoiced
on the last day of the month.
Variable costs of production per book are materials (₹5), labour (₹4), and overhead (₹2)
The sales manager has forecasted the following volumes:
Month No. of Books
November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August 2,300
Customers are expected to pay as follows:

One month after the sale 40%

Two months after the sale 60%
The company produces the books two months before they are sold and the creditors for materials
are paid two months after production.
Variable overheads are paid in the month following production and are expected to increase by 25%
in April; 75% of wages are paid in the month of production and 25% in the following month. A
wage increase of 12.5% will take place on 1st March.
The company is going through a restructuring and will sell one of its freehold properties in May for
₹25,000, but it is also planning to buy a new printing press in May for ₹10,000. Depreciation is
currently ₹1,000 per month, and will rise to ₹1,500 after the purchase of the new machine.
The company’s corporation tax (of ₹10,000) is due for payment in March.
The company presently has a cash balance at bank on 31 December 20X3, of ₹1,500.
You are required to Prepare a cash budget for the six months from January to June, 20X4.
Hints:
Months January February March April May June
Cumulative ₹3,250 ₹1,500 (₹11,912) (₹15,024) ₹576 ₹3,239
Cash Flow

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Question-5
From the information and the assumption that the cash balance in hand on 1st January 2017 is ₹
72,500 Prepare a cash budget.
Assume that 50 per cent of total sales are cash sales. Assets are to be acquired in the months of
February and April. Therefore, provisions should be made for the payment of ₹ 8,000 and ₹ 25,000
for the same. An application has been made to the bank for the grant of a loan of ₹ 30,000 and it is
hoped that the loan amount will be received in the month of May.
It is anticipated that a dividend of ₹ 35,000 will be paid in June. Debtors are allowed one month’s
credit. Creditors for materials purchased and overheads grant one month’s credit. Sales commission
at 3 per cent on sales is paid to the salesman each month.
Month Sales Materials Salaries & Production Office and
(₹) Purchases (₹) Wages Overheads Selling
(₹) (₹) Overheads (₹)
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500
April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500
Hints:
Months Balance
January ₹96,340
February ₹1,21,330
March ₹1,55,650
April ₹1,51,292
May ₹2,05,767
June ₹1,94,106

Question-6
Consider the balance sheet of Maya Limited as on 31 December,20X8. The company has received
a large order and anticipates the need to go to its bank to increase its borrowings. As a result, it has
to forecast its cash requirements for January, February and March, 20X9. Typically, the company
collects 20 per cent of its sales in the month of sale, 70 per cent in the subsequent month, and 10 per
cent in the second month after the sale. All sales are credit sales.
Equity & liabilities Amount Assets Amount
(₹ in ‘000) (₹ in ‘000)
Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,439 Inventories 545
Long-term borrowings 450 Accounts receivables 530
Accounts payables 360 Cash and bank 50
Loan from banks 400
Other liabilities 212
2,961 2,961
Purchases of raw materials are made in the month prior to the sale and amounts to 60 per cent of
sales. It is paid in the subsequent month. Payments for these purchases occur in the month after the
purchase. Labour Costs, including overtime are expected to be ₹1,50,000 in January ₹2,00,000 in
February and ₹1,60,000 in March selling, administrative, taxes and other cash expenses are expected
to be ₹1,00,000 per month for January through March. Actual sales in November and December and
projected sales for January through April are as follows (in thousands):
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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Month ₹ Month ₹ Month ₹

November 500 January 600 March 650
December 600 February 1,000 April 750
On the basis of this information:
(a) Prepare a cash budget for the months of January, February, and March.
(b) Determine the amount of additional bank borrowings necessary to maintain a cash
balance of ₹ 50,000 at all times.
(c) Prepare a pro forma balance sheet for March 31.
Hints:
Month January February March
Cash Balance (₹20) (₹220) ₹240
Add: Borrowing ₹20 ₹220 (₹240)
Balance Sheet total (Proforma) = ₹3,141

B. PAST YEAR QUESTION

Nov 22 Q-1(a) (05 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.
Solution:
(i) Computation of Average Cash balance:
Annual cash outflow (U) = 9,00,000 x 4 = ₹ 36,00,000
Fixed cost per transaction (P) = ₹ 60
Opportunity cost of one rupee p.a. (S) = 12/100 = 0.12
Optimum cash balance (C) = 2UP = 2x 36,00,000x 60 = ₹ 60,000
S 0.12

Average Cash balance = (0 + 60,000)/ 2 = ₹ 30,000

(ii) Number of conversions p.a.

Annual cash outflow = ₹ 36,00,000
Optimum cash balance = ₹ 60,000
No. of conversions p.a. = 36,00,000 / 60,000 = 60

(iii) Time interval between two conversions

No. of days in a year = 360
No. of conversions p.a. = 60
Time interval = 360/60 = 6 days

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

May 22 Q-1(b) (05 Marks)

Balance sheet of X Ltd for the year ended 31st March,2022 is given below:
(₹ in lakhs)
Liabilities Amount Assets Amount
Equity Shares ₹ 10 each 200 Fixed Assets 500
Retained earnings 200 Raw materials 150
11% Debentures 300 W.I.P 100
Public deposits (Short-Term) 100 Finished goods 50
Trade Creditors 80 Debtors 125
Bills Payable 100 Cash/Bank 55
980 980
Calculate the amount of maximum permissible bank finance under three methods as per Tandon
Committee lending norms.
The total core current assets are assumed to be ₹ 30 lakhs.

Solution:
Current Assets = 150 + 100 + 50 + 125 + 55 = ₹ 480 Lakhs
Current Liabilities = 100 + 80 + 100 = ₹ 280 Lakhs
Maximum Permissible Banks Finance under Tandon Committee Norms:

Method I
Maximum Permissible Bank Finance = 75% of (Current Assets – Current Liabilities)
= 75% of (480 - 280)
= ₹ 150 Lakhs

Method II
Maximum Permissible Bank Finance = 75% of Current Assets – Current Liabilities
= 75 % of 480 – 280
= ₹ 80 Lakhs

Method III
Maximum Permissible Bank Finance = 75% of (Current Assets – Core Current
Assets) – Current Liabilities
= 75 % of (480 - 30) – 280
= ₹ 57.5 Lakhs

Dec 21 Q-1(d) (05 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
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Working Capital Management - Cash Management By: CA PRAKASH PATEL

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.
Solution:
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 (Workingnote 512.00 704.00 480.00 480.00 640.00
1)
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 540 540 720
prior to sales)
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Working Capital Management - Cash Management By: CA PRAKASH PATEL

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

Nov 19 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.
Solution:
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
Trade Receivables (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 February March
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 1,95,000 2,10,000 2,25,000
unit (₹)
(a) Preparation of Cash Budget

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

January February March

Particulars (₹) (₹) (₹)
Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade 10,80,000 11,25,000 11,70,000
Receivables (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 5,62,500 5,85,000 6,30,000
Materials
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 9,00,000
per 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.

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
A firm maintains a separate account for cash disbursement. Total disbursements are ₹ 2,62,500 per
month. Administrative and transaction cost of transferring cash to disbursement account is ₹ 25
per transfer. Marketable securities yield is 7.5% per annum.
Determine the optimum cash balance according to William J Baumol model.

Solution:
Determination of Optimal Cash Balance according to William J. Baumol Model
The formula for determining optimum cash balance is:
2UP
C=
S

2 2,62,500 12  25 15,75,00,000

C= = =
0.075 0.075
Optimum Cash Balance, C, = ₹ 45,826

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Question-2
The following details are forecasted by a company for the purpose of effective utilization and
management of cash:
(i) Estimated sales and manufacturing costs:
Year and month Sales Materials Wages Overheads
2014 ₹ ₹ ₹ ₹
April 4,20,000 2,00,000 1,60,000 45,000
May 4,50,000 2,10,000 1,60,000 40,000
June 5,00,000 2,60,000 1,65,000 38,000
July 4,90,000 2,82,000 1,65,000 37,500
August 5,40,000 2,80,000 1,65,000 60,800
September 6,10,000 3,10,000 1,70,000 52,000
(ii) Credit terms:
- Sales – 20 percent sales are on cash, 50 percent of the credit sales are collected next
month and the balance in the following month.
- Credit allowed by suppliers is 2 months.
- Delay in payment of wages is ½ (one-half) month and of overheads is 1 (one)
month.
(iii) Interest on 12 percent debentures of ₹ 5,00,000 is to be paid half-yearly in June and
December.
(iv) Dividends on investments amounting to ₹ 25,000 are expected to be received in June,
2014.
(v) A new machinery will be installed in June, 2014 at a cost of ₹ 4,00,000 which is
payable in 20 monthly instalments from July, 2014 onwards.
(vi) Advance income-tax, to be paid in August, 2014, is ₹ 15,000.
(vii) Cash balance on 1st June, 2014 is expected to be ₹ 45,000 and the company wants to
keep it at the end of every month around this figure. The excess cash (in multiple of
thousand rupees) is being put in fixed deposit.
You are required to prepare monthly Cash budget on the basis of above information for
four months beginning from June, 2014.

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Working Capital Management - Cash Management By: CA PRAKASH PATEL

Solution:
Preparation of Monthly Cash Budget
Cash Budget for four months from June, 2014 to September, 2014

June July August September

Particulars (₹) (₹) (₹) (₹)
Opening Balance 45,000 45,500 45,500 45,000
Receipts:
Cash Sales 1,00,000 98,000 1,08,000 1,22,000
Collection from debtors 3,48,000 3,80,000 3,96,000 4,12,000
Dividends 25,000 - - -
Total (A) 5,18,000 5,23,500 5,49,500 5,79,000
Payments:
Creditors for Materials 2,00,000 2,10,000 2,60,000 2,82,000
Wages 1,62,500 1,65,000 1,65,000 1,67,500
Overheads 40,000 38,000 37,500 60,800
Installment for Machine - 20,000 20,000 20,000
Interest on Debentures 30,000 - - -
Advance Tax - - 15,000 -
Total (B) 4,32,500 4,33,000 4,97,500 5,30,300
Surplus (A – B) 85,500 90,500 52,000 48,700
Fixed Deposits 40,000 45,000 7,000 3,000
Closing Balance 45,500 45,500 45,000 45,700

Working Notes:
(1) Cash Sales and Collection from Debtors:
Total SalesCash Sales Credit Sales Collection from Debtors
Month (₹) (₹) (₹) June (₹) July (₹) Aug. (₹) Sept. (₹)
April, 2010 4,20,000 84,000 3,36,000 1,68,000 - - -
May, 2010 4,50,000 90,000 3,60,000 1,80,000 1,80,000 - -
June, 2010 5,00,000 1,00,000 4,00,000 - 2,00,000 2,00,000 -
July, 2010 4,90,000 98,000 3,92,000 - - 1,96,000 1,96,000
Aug., 2010 5,40,000 1,08,000 4,32,000 - - - 2,16,000
Sept., 2010 6,10,000 1,22,000 4,88,000 - - - -
Total 3,48,000 3,80,000 3,96,000 4,12,000

(2) Payment of Wages

June = 80,000 + 82,500 = 1,62,500;
July = 82,500 + 82,500 = 1,65,000;
Aug. = 82,500 + 82,500 = 1,65,000; and
Sept.= 82,500 + 85,000 = 1,67,500.
(Note: It has been assumed that the company wants to keep minimum cash balance of
₹ 45,000.)

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Working Capital Management - Receivable Management By: CA PRAKASH PATEL

Chapter- 6: Working Capital

Unit-III Receivable Management
A. QUESTION FROM STUDY MATERIAL

ILLUSTRATION 12 (Study Material – illustration-15)

A trader whose current sales are in the region of ₹ 6 lakhs per annum and an average collection
period of 30 days wants to pursue a more liberal policy to improve sales. A study made by a
management consultant reveals the following information:-
Credit Increase in Increase in sales Present default
Policy collection period anticipated
A 10 days ₹ 30,000 1.5%
B 20 days ₹ 48,000 2%
C 30 days ₹ 75,000 3%
D 45 days ₹ 90,000 4%
The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable costs per unit are ₹ 2.
The current bad debt loss is 1%. Required return on additional investment is 20%. Assume a 360
days year.
Analyse which of the above policies would you recommend for adoption?
Hints:
Policy Net Benefit
Present ₹1,36,500
A ₹1,40,106
B ₹1,39,651
C ₹1,38,083
D ₹1,31,150

ILLUSTRATION 13 (Study Material – illustration-16)

XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating
two proposed policies. Currently, the firm has annual credit sales of
₹ 50 lakhs and accounts receivable turnover ratio of 4 times a year. The current level of loss due to
bad debts is ₹ 1,50,000. The firm is required to give a return of 25% on the investment in new
accounts receivables. The company’s variable costs are 70% of the selling price. Given the
following information, IDENTIFY which is the better option?
(Amount in ₹)
Present Policy Policy
Policy Option I Option I
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover ratio 4 times 3 times 2.4 times
Bad debt losses 1,50,000 3,00,000 4,50,000
Hints:
Policy Net Benefit
Present ₹11,31,250
PI ₹11,50,000
PII ₹10,82,812
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Working Capital Management - Receivable Management By: CA PRAKASH PATEL

ILLUSTRATION 14 (Study Material – illustration-17) Factoring

A Factoring firm has credit sales of ₹ 360 lakhs and its average collection period is 30 days. The
financial controller estimates, bad debt losses are around 2% of credit sales. The firm spends ₹
1,40,000 annually on debtors administration. This cost comprises of telephonic and fax bills along
with salaries of staff members. These are the avoidable costs. A Factoring firm has offered to buy
the firm’s receivables. The factor will charge 1% commission and will pay an advance against
receivables on an interest @15% p.a. after withholding 10% as reserve. ANALYSE what should the
firm do?
Assume 360 days in a year.
Hints: Net Benefit = ₹99,500

ILLUSTRATION 15 (Study Material – illustration-18)

Mosaic Limited has current sales of ₹ 15 lakhs per year. Cost of sales is 75 per cent of sales and bad
debts are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent
fixed costs, while the company’s required rate of return is 12 per cent. Mosaic Limited currently
allows customers 30 days’ credit, but is considering increasing this to 60 days’ credit in order to
increase sales.
It has been estimated that this change in policy will increase sales by 15 per cent, while bad debts
will increase from one per cent to four per cent. It is not expected that the policy change will result
in an increase in fixed costs and creditors and stock will be unchanged.
Should Mosaic Limited introduce the proposed policy? ANALYSE (Assume a 360 days year)
Hints: Incremental Benefit = ₹22,050

ILLUSTRATION 16 (Study Material – illustration-19)

The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s
records by the owner, Mr. Gautam, revealed that payments are usually made 15 days after purchases
are made. When asked why the firm did not take advantage of its discounts, the accountant, Mr.
Rohit, replied that it cost only 2 per cent for these funds, whereas a bank loan would cost the
company 12 per cent.
(a) ANALYSE what mistake is Rohit making?
(b) If the firm could not borrow from the bank and was forced to resort to the use of
trade credit funds, what suggestion might be made to Rohit that would reduce the
annual interest cost? Identify.
Hints: Net Benefit = ₹1.84

TEST YOUR KNOWLEDGE

Question-7
PQR Ltd. having an annual sales of ₹ 30 lakhs, is re-considering its present collection policy. At
present, the average collection period is 50 days and the bad debt losses are 5% of sales. The
company is incurring an expenditure of ₹ 30,000 on account of collection of receivables. Cost of
funds is 10 percent.
The alternative policies are as under:
Alternative I Alternative II
Average Collection Period 40 days 30 days
Bad Debt Losses 4% of sales 3% of sales
Collection Expenses ₹ 60,000 ₹ 95,000
Determine the alternatives on the basis of incremental approach and state which alternative is more
beneficial.

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Hints:

Policy I II
Incremental Benefit ₹8,333 ₹11,667

Question-8
As a part of the strategy to increase sales and profits, the sales manager of a company proposes to
sell goods to a group of new customers with 10% risk of non-payment. This group would require
one and a half months credit and is likely to increase sales by ₹ 1,00,000 p.a. Production and Selling
expenses amount to 80% of sales and the income-tax rate is 50%. The company’s minimum
Required rate of return (after tax) is 25%.
Should the sales manager’s proposal be accepted? Analyze.
Also COMPUTE the degree of risk of non-payment that the company should be willing to assume
if the required rate of return (after tax) were (i) 30%, (ii) 40% and (iii) 60%.
Hints:
(i) Net Benefit = ₹2,500
(ii)
Rate of Return 30% 40% 60%
Bad Debt ₹14,000 ₹12,000 ₹8,000
% of Sale 14% 12% 8%

Question-9
Slow Payers are regular customers of Goods Dealers Ltd. and have approached the sellers for
extension of credit facility for enabling them to purchase goods. On an analysis of past performance
and on the basis of information supplied, the following pattern of payment schedule emerges in
regard to Slow Payers:
Pattern of Payment Schedule
At the end of 30 days 15% of the bill
At the end of 60 days 34% of the bill.
At the end of 90 days 30% of the bill.
At the end of 100 days 20% of the bill.
Non-recovery 1% of the bill.
Slow Payers want to enter into a firm commitment for purchase of goods of ₹ 15 lakhs in 20X7,
deliveries to be made in equal quantities on the first day of each quarter in the calendar year. The
price per unit of commodity is ₹ 150 on which a profit of ₹ 5 per unit is expected to be made. It is
anticipated by Goods Dealers Ltd., that taking up of this contract would mean an extra recurring
expenditure of ₹ 5,000 per annum. If the opportunity cost of funds in the hands of Goods Dealers is
24% per annum, would you as the finance manager of the seller recommend the grant of credit to
Slow Payers? Analyse. Workings should form part of your answer. Assume year of 365 days.
Hints: Net Benefit = (₹38,787)

B. PAST YEAR QUESTION

May 23 Q-1(b) (05 Marks)

A company has current sale of ₹ 12 lakhs per year. The profit-volume ratio is 20% and post-tax cost
of investment in receivables is 15%. The current credit terms are 1/10, net 50 days and average
collection period is 40 days. 50% of customers in terms of sales revenue are availing cash discount
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and bad debt is 2% of sales.

In order to increase sales, the company want to liberalize its existing credit terms to 2/10, net 35
days. Due to which, expected sales will increase to ₹ 15 lakhs. Percentage of default in sales will
remain same. Average collection period will decrease by 10 days. 80% of customers in terms of
sales revenue are expected to avail cash discount under this proposed policy.
Tax rate is 30%.
ADVISE, should the company change its credit terms. (Assume 360 days in a year.)
Solution:
(i) Calculation of Cash Discount
Cash Discount = Total credit sales × % of customers who take up discount × Rate
Present Policy = 12,00,000×50×0.01 = ₹6,000
100
Proposed Policy = 15,00,000 × 0.80 × 0.02 = ₹ 24,000

(ii) Opportunity Cost of Investment in Receivables

Present Policy: Opportunity Cost = Total Cost × Collection period × Rate of Return
360 100
= 9,60,000 × 40 × 15 = ₹ 16,000
360 100
Proposed Policy: = Total Cost × Collection period × Rate of Return
360 100
= 12,00,000 × 30 × 15 = ₹ 16,000
360 100

Statement showing Evaluation of Credit Policies

Particulars Present Proposed
Policy Policy
Credit Sales 12,00,000 15,00,000
Variable Cost @ 80%* of sales 9,60,000 12,00,000
Bad Debts @ 2% 24,000 30,000
Cash Discount 6,000 24,000
Profit before tax 2,10,000 2,46,000
Tax @ 30% 63,000 73,800
Profit after Tax 1,47,000 1,72,200
Opportunity Cost of Investment in Receivables 16,000 15,000
Net Profit 1,31,000 1,57,200
*Only relevant or variable costs are considered for calculating the opportunity costs on the funds
blocked in receivables. Since 20% is profit-volume ratio, hence the relevant costs are taken to be
80% of the respective sales.
Advise: Proposed policy should be adopted since the net benefit is increased by (₹ 1,57,200 - ₹
1,31,000) = ₹ 26,200.

Alternative presentation using incremental approach

₹
Incremental sales (15,00,000 – 12,00,000) 3,00,000
Less: Incremental variable cost (12,00,000 – 9,60,000) 2,40,000
Less: Incremental Bad debts (30,000 – 24,000) 6,000

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Less: Incremental Cash discount (24,000 – 6,000) 18,000

Increase in Profit Before Tax 36,000
Less: Tax @ 30% 10,800
Increase in Profit After Tax 25,200
Add: Savings in opportunity cost (16,000 - 15,000) 1,000
Increase in Net Profit 26,200

Advise: Proposed policy should be adopted since the net benefit is increased by (₹ 1,57,200 - ₹
1,31,000) = ₹ 26,200.

Dec 21 Q-1(a) (05 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?
Solution:
Particulars (₹)
A. Annual Savings (Benefit) on taking Factoring Service
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.

Nov 18 Q-4 (10 Marks)

MN Ltd. has a current turnover of ₹ 30,00,000 p.a. Cost of Sale is 80% of turnover and Bad Debts
are 2% of turnover, Cost of Sales includes 70% variable cost and 30% Fixed Cost, while
company's required rate of return is 15%. MN Ltd. currently allows 15 days credit to its customer,
but it is considering increase this to 45 days credit in order to increase turnover.
It has been estimated that this change in policy will increase turnover by 20%, while Bad Debts
will increase by 1%. It is not expected that the policy change will result in an increase in fixed cost
and creditors and stock will be unchanged.
Should MN Ltd. introduce the proposed policy? (Assume 360 days year)

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Solution:
Statement Showing Evaluation of Credit Policies
Particulars Present Policy Proposed Policy

A. Expected Contribution
(a) Credit Sales 30,00,000 36,00,000
(b) Less: Variable Cost 16,80,000 20,16,000
(c) Contribution 13,20,000 15,84,000
(d) Less: Bad Debts 60,000 1,08,000
(e) Contribution after Bad debt [(c)-(d)] 12,60,000 14,76,000
B. Opportunity Cost of investment in 15,000 54,000
Receivables
C. Net Benefits [A-B] 12,45,000 14,22,000
D. Increase in Benefit 1,77,000

Recommendation: Proposed Policy i.e credit from 15 days to 45 days should be implemented by
NM Ltd since the net benefit under this policy are higher than those under present policy
Working Note: (1)
Present Policy (₹) Propose Policy (₹)
Sales 30,00,000 36,00,000
Cost of Sales (80% of sales) 24,00,000 28,80,000
Variable cost (70% of cost of sales) 16,80,000 20,16,000
(2). Opportunity Costs of Average Investments
Variable Cost = Collection Period x Rate of Return
360
Present Policy = ₹24,00,000 x 45 x 15% =₹54,000
360
Proposed Policy = ₹28,80,000 x 15 x 15% =₹18,000
360

C. ADDITIONAL QUESTIONS FOR PRACTICE (PAST YEAR EXAM)

Question-1
A new customer with 10% risk of non-payment desires to establish business connections with you.
He would require 1.5 month of credit and is likely to increase your sales by ₹ 1,20,000 p.a. Cost of
sales amounted to 85% of sales. The tax rate is 30%. Should you accept the offer if the required
rate of return is 40% (after tax)?

Solution:
Evaluation of Credit to New Customer
Particulars (₹)
A. Profit on Additional Sales
Increase in Annual Sales 1,20,000
Less: Cost of Sales being 85% 1,02,000
18,000
Less: Bad Debts Loss (10% on sales) 12,000
Profit before Tax 6,000
Less: Tax @ 30% 1,800
Net Profit after Tax 4,200
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B. Opportunity Cost of investment in Receivables 5,100

C. Net Benefits [A-B] (900)

Decision: Since the estimated profit after tax on additional sales ₹ 4200 is less than the required
return on additional investment of ₹ 5,100 in receivables, hence the offer should not be accepted.

Working Notes:
1. Receivables Turnover = 12 = 8 times
1.5
2. Average Investment in Receivables = Cost of Sale = 1,02,000 = ₹12,750
Receivables Turnover 8
3. Opportunity Cost of Funds Blocked = 12,750 × 40/100 = 5,100

Question-2
A company has prepared the following projections for a year:
Sales 21,000 units
Selling Price per unit ₹ 40
Variable Costs per unit ₹ 25
Total Costs per unit ₹ 35
Credit period allowed One month
The Company proposes to increase the credit period allowed to its customers from one month to
two months. It is envisaged that the change in the policy as above will increase the sales by 8%.
The company desires a return of 25% on its investment.
You are required to examine and advise whether the proposed Credit Policy should be
implemented or not.

Solution:
Statement showing Evaluation of Credit Policies
Particulars Present Policy Proposed Policy
(1 month) (2 months)
A. Expected Profit:
(a) Net Credit Sales (Sales units × ₹ 40) 8,40,000 9,07,200
(b) Less: Total Cost:
Variable (Sales units × ₹ 25) 5,25,000 5,67,000
Fixed Cost 2,10,000 2,10,000
7,35,000 7,77,000
(c) Expected Profit [(a)-(b)] 1,05,000 1,30,200
B. Opportunity Cost of Investment in 15,313 32,375
Receivables
C. Net Benefits [A-B] 89,687 97,825

Recommendation: Proposed Policy should be implemented since the net benefit under this policy
are higher than those under present policy.

Working Note: Calculation of Opportunity Cost

Opportunity Cost = Total Cost x Collection Period x Rate of Return
12
Present Policy = ₹7,35,000 x 1 x 25 = ₹15,313
12 100
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Proposed Policy = ₹7,77,000 x 2 x 25 = ₹32,375

12 100

Question-3
A firm has a current sales of ₹ 2,56,48,750. The firm has unutilised capacity. In order to boost its
sales, it is considering the relaxation in its credit policy. The proposed terms of credit will be 60
days credit against the present policy of 45 days. As a result, the bad debts will increase from 1.5%
to 2% of sales. The firm’s sales are expected to increase by 10%. The variable operating costs are
72% of the sales. The Firm’s corporate tax rate is 35%, and it requires an after-tax return of 15%
on its investment. Should the firm change its credit period?

Solution:
Statement Showing Evaluation of Credit Policies
Particulars Present Policy Proposed Policy
A. Expected Profit
(a) Credit Sales 2,56,48,750 2,82,13,625
(b) Less: Total Cost other than Bad 1,84,67,100 2,03,13,810
Debts
(c) Less: Bad Debts 3,84,731 5,64,273
(d) Profit before tax [(a)-(b)-(c)] 67,96,919 73,35,542
(e) Less: Tax @ 35% 23,78,922 25,67,440
(f) Profit after tax [(d)-(e)] 44,17,997 47,68,102
B. Opportunity Cost of investment in 3,46,258 5,07,845
Receivables
C. Net Benefits [A-B] 40,71,739 42,60,257

Recommendation: Proposed Policy should be implemented since the net benefit under this policy
are higher than those under present policy.

Working Note: Opportunity Costs of Average Investments

= Total Cost x Collection Period x Rate of Return
360 days
Present Policy = ₹1,84,67,100 x 45 x 15% = ₹3,46,258
360
Proposed Policy = ₹2,03,13,810 x 45 x 15% = ₹5,07,845
360

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

Classification Default as a percentage of Average collection period- in

sales days for non-defaulting
accounts
1 0 45
2 2 42

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3 10 40
4 20 80
The average rate of interest is 15%. What conclusions do you draw about the company’s Credit
Policy? What other factors should be taken into account before changing the present policy?
Discuss.
Solution:
Since the amount of revenue generated from each category of customer is not given in the
question. Let us consider ₹ 100 as the amount of revenue generated from each type of customer.
Therefore, ₹ 100 shall be taken as the basis for reappraisal of Company’s credit policy.

Statement showing Evaluation of credit Policies

Particulars Classification of Customers
1 2 3 4
A. Expected Profit:
(a) Revenue 100 100 100 100
(b) Total Cost other than Bad Debt:
(i) Cost of Goods Sold 85 85 85 85
(ii) Fixed Cost 5 5 5 5
90 90 90 90
(c) Bad Debt 0 2.00 10.00 20.00
(d) Expected Profit [(a)-(b)-(c)] 10 8.00 0 (10.00)
B. Opportunity Cost of Investment in Receivables* 1.66 1.55 1.48 2.96
C. Net Benefits [A-B] 8.34 6.45 (1.48) (12.96)

Recommendation: The reappraisal of company’s credit policy indicates that the company either
follows a lenient credit policy or it is inefficient in collection of debts. Even though the company
sells its products on terms of net 30 days, it allows average collection period for more than 30 to all
categories of its customers.
The company can continue with customers covered in categories 1 and 2 since net benefits are
favourable. The company either should not continue with customer covered in categories 3 and 4 or
should reduce the bad debt % by at least 1.48% and 12.96% respectively since net benefits are
unfavourable to the extent of 1.48% and 12.96% of sales respectively. The other factors to be taken
into consideration before changing the present policy includes (i) past performance of the customers
and (ii) their credit worthiness.

*Working Note: Calculation of Opportunity Cost

Opportunity Cost = Total Cost x Average Collection Period x Rate of Interest
365
For Category 1 = ₹90 x 45 x 15 = ₹1.66
365 100
For Category 2 = ₹90 x 42 x 15 = ₹1.55
365 100
For Category 3 = ₹90 x 40 x 15 = ₹1.48
365 100
For Category 4 = ₹90 x 80 x 15 = ₹2.96
365 100
Question-5
A bank is analysing the receivables of Jackson Company in order to identify acceptable collateral
for a short-term loan. The company’s credit policy is 2/10 net 30. The bank lends 80 percent on
accounts where customers are not currently overdue and where the average payment period does not
exceed 10 days past the net period. A schedule of Jackson’s receivables has been prepared. How
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much will the bank lend on pledge of receivables, if the bank uses a 10 per cent allowance for cash
discount and returns?
Amount Average Payment
Account Days Outstanding in days
₹ Period historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48
1,08,800
Solution:
Analysis of the receivables of Jackson Company by the bank in order to identify acceptable collateral
for a short-term loan:
(i) The Jackson Company’s credit policy is 2/10 net 30.
The bank lends 80 per cent on accounts where customers are not currently overdue and
where the average payment period does not exceed 10 days past the net period i.e. thirty
days. From the schedule of receivables of Jackson Company Account No. 91 and Account
No. 114 are currently overdue and for Account No. 123 the average payment period
exceeds 40 days. Hence Account Nos. 91, 114 and 123 are eliminated. Therefore, the
selected Accounts are Account Nos. 74, 107, 108 and 116.

(ii) Statement showing the calculation of the amount which the bank will lend on a pledge
of receivables if the bank uses a 10 per cent allowances for cash discount and returns
Account No. Amount (₹) 90 per cent of amount (₹) 80% of amount (₹)
(a) (b)=90% of (a) (c)=80% of (b)
74 25,000 22,500 18,000
107 11,500 10,350 8280
108 2,300 2,070 1,656
116 29,000 26,100 20,880
Total loan amount 48,816

Question-6
JKL Ltd. is considering the revision of its credit policy with a view to increasing its sales and profit.
Currently all its sales are on credit and the customers are given one month’s time to settle the dues.
It has a contribution of 40% on sales and it can raise additional funds at a cost of 20% per annum.
The marketing manager of the company has given the following options along with estimates for
considerations:
Particulars Current Position I Option II Option III Option
Sales (₹ in lakhs) 200 210 220 250
Credit period (in months) 1 1½ 2 3
Bad debts (% of sales) 2 2½ 3 5
Cost of Credit administration (₹ in lakhs) 1.20 1.30 1.50 3.00
You are required to advise the company for the best option.

Solution:
Statement Showing Evaluation of Credit Policies

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Current position Option I (1.5 Option II Option III

Particulars (1 month) months) (2 months) (3 months)
Sales 200 210 220 250
Contribution @ 40% 80 84 88 100
Increase in contribution over - 4 8 20 (A)
current level
Debtors = 1×200 1.5×210 2×220 3×250
=16.67 =26.25 =36.67 =62.50
Average Collection period x Credit Sale
( ) 12 12 12 12
12

Increase in debtors over current - 9.58 20.00 45.83

level
Cost of funds for additional - 1.92 4.00 9.17 (B)
amount of debtors @ 20%
Credit administrative cost 1.20 1.30 1.50 3.00
Increase in credit administration
cost over present level - 0.10 0.30 1.80 (C)
Bad debts 4.00 5.25 6.60 12.50
Increase in bad debts over - 1.25 2.60 8.50 (D)
current levels
Net gain/loss A – (B + C + D) - 0.73 1.10 0.53
Advise: It is suggested that the company JKL Ltd. should implement Option II with a net gain of
₹1.10 lakhs which has a credit period of 2 months.
Question-7
A company is presently having credit sales of ₹ 12 lakh. The existing credit terms are 1/10, net 45
days and average collection period is 30 days. The current bad debts loss is 1.5%. In order to
accelerate the collection process further as also to increase sales, the company is contemplating
liberalization of its existing credit terms to 2/10, net 45 days. It is expected that sales are likely to
increase by 1/3 of existing sales, bad debts increase to 2% of sales and average collection period to
decline to 20 days. The contribution to sales ratio of the company is 22% and opportunity cost of
investment in receivables is 15 percent (pre-tax). 50 per cent and 80 percent of customers in terms
of sales revenue are expected to avail cash discount under existing and liberalization scheme
respectively. The tax rate is 30%.
Should the company change its credit terms? (Assume 360 days in a year).

Solution:
Working Notes:
(i) Calculation of Cash Discount
Cash Discount = Total credit sales × % of customers who take up discount × Rate
Present Policy = 12,00,000 x 50 x 0.01 = ₹6,000
100
Proposed Policy = 16,00,000 × 0.80 × 0.02 = ₹ 25,600
(ii) Opportunity Cost of Investment in Receivables
Present Policy = 9,36,000 x (30/360) x (70% of 15)/100 = 78,000 x 10.5/100 = ₹ 8,190
Proposed Policy = 12,48,000 x (20/360) x 10.50/100 = ₹ 7,280

Statement showing Evaluation of Credit Policies

Particulars Present Policy Proposed Policy
Credit Sales 12,00,000 16,00,000
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Variable Cost @ 78% of sales 9,36,000 12,48,000

Bad Debts @ 1.5% and 2% 18,000 32,000
Cash Discount 6,000 25,600
Profit before tax 2,40,000 2,94,400
Tax @ 30% 72,000 88,320
Profit after Tax 1,68,000 2,06,080
Opportunity Cost of Investment in 8,190 7,280
Receivables
Net Profit 1,59,810 1,98,800
Advise: Proposed policy should be adopted since the net benefit is increased by
(₹ 1,98,800 - 1,59,810) ₹ 38,990.

Question-8
RST Limited is considering relaxing its present credit policy and is in the process of evaluating two
proposed polices. Currently, the firm has annual credit sales of ₹ 225 lakhs and accounts receivable
turnover ratio of 5 times a year. The current level of loss due to bad debts is ₹ 7,50,000. The firm is
required to give a return of 20% on the investment in new accounts receivables. The company’s
variable costs are 60% of the selling price. Given the following information, which is a better option?

Particulars Present Policy Policy Option I Policy Option II

Annual credit sales(₹) 225 275 350
Accounts receivable turnover ratio 5 4 3
Bad debt losses (₹) 7.5 22.5 47.5

Solution:
Statement showing Evaluation of Credit Policies
Present Proposed Proposed
Particulars
Policy Policy I Policy II
A Expected Profit : ₹ ₹ ₹
(a) Credit Sales 225.00 275.00 350.00
(b) Total Cost other than Bad Debts:
Variable Costs 135.00 165.00 210.00
(c) Bad Debts 7.50 22.50 47.50
(d) Expected Profit [(a)-(b)-(c)] 82.50 87.50 92.50
B Opportunity Cost of Investment in Receivables* 5.40 8.25 14.00
C Net Benefits [A-B] 77.10 79.25 78.50

Recommendation: The Proposed Policy I should be adopted since the net benefits under this policy
are higher than those under other policies.
Working Note:
*Calculation of Opportunity Cost of Average Investments
Opportunity Cost = Total Cost x Collection Period x Rate of Return
12 100
Present Policy = ₹ 135 lacs x 2.4/12 x 20% = ₹ 5.40 lakhs
Proposed Policy I = ₹ 165 lacs x 3/12 x 20% = ₹ 8.25 lakhs
Proposed Policy II = ₹ 210 lacs x 4/12 x 20% = ₹ 14.00 lakhs

Question-9 (Factoring)
A firm has a total sales of ₹ 12,00,000 and its average collection period is 90 days. The past
experience indicates that bad debt losses are 1.5% on sales. The expenditure incurred by the firm in
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administering receivable collection efforts are ₹ 50,000. A factor is prepared to buy the firm’s
receivables by charging 2% commission. The factor will pay advance on receivables to the firm at
an interest rate of 16% p.a. after withholding 10% as reserve. Calculate net benefit to the firm.
Assume 360 days in a year.

Solution:
Working Notes:-
Average level of Receivables = 12,00,000 x 90/360 3,00,000
Factoring Commission = 3,00,000 x 2/100 6,000
Factoring Reserve = 3,00,000 x 10/100 30,000
Amount Available for Advance = ₹ 3,00,000-(6,000+30,000) 2,64,000
Factor will deduct his interest @ 16% :-
Interest = ₹2,64,000 x 16 x 90 =₹10,560
360 x 100
Advance to be paid = ₹ 2,64,000 – ₹ 10,560 = ₹ 2,53,440

Statement Showing Evaluation of Factoring Proposal

Particulars ₹
A. Annual Cost of Factoring to the Firm:
Factoring Commission (₹ 6,000 x 360/90) 24,000
Interest Charges (₹ 10,560 x 360/90) 42,240
Total 66,240
B. Firm’s Savings on taking Factoring Service: ₹
Cost of Administration Saved 50,000
Cost of Bad Debts (₹ 12,00,000 × 1.5/100) avoided 18,000
Total 68,000
C. Net Benefit to the Firm (₹ 68,000 – ₹ 66,240) 1,760

Question-10 (Factoring)
A firm has a total sales of ₹ 200 lakhs of which 80% is on credit. It is offering credit terms of 2/40,
net 120. Of the total, 50% of customers avail of discount and the balance pay in 120 days. Past
experience indicates that bad debt losses are around 1% of credit sales. The firm spends about ₹
2,40,000 per annum to administer its credit sales. These are avoidable as a factor is prepared to buy
the firm's receivables. He will charge 2% commission. He will pay advance against receivables to
the firm at an interest rate of 18% after withholding 10% as reserve.
(i) What is the effective cost of factoring? Consider year as 360 days.
(ii) If bank finance for working capital is available at 14% interest, should the firm avail
of factoring service.
Solution:
Particulars (₹)
Total Sales ₹ 200 lakhs
Credit Sales (80%) ₹ 160 lakhs
Receivables for 40 days ₹ 80 lakhs
Receivables for 120 days ₹ 80 lakhs
Average collection period [(40 x 0.5) + (120 × 0.5)] 80 days
Average level of Receivables (₹ 1,60,00,000 x 80/360) ₹ 35,55,556
Factoring Commission (₹ 35,55,556 x 2/100) ₹ 71,111
Factoring Reserve (₹ 35,55,556 x 10/100) ₹ 3,55,556
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Working Capital Management - Receivable Management By: CA PRAKASH PATEL

Amount available for advance {₹ 35,55,556 - (3,55,556 + ₹ 31,28,889

71,111)}
Factor will deduct his interest @ 18% :
₹31,28,889 ×18×80 ₹ 1,25,156
Interest =
100 × 360
Advance to be paid (₹ 31,28,889 – ₹ 1,25,156) ₹ 30,03,733

1. Statement Showing Evaluation of Factoring Proposal

₹
A. Annual Cost of Factoring to the Firm:
Factoring commission (₹ 71,111 x 360/80) 3,20,000
Interest charges (₹ 1,25,156 x 360/80) 5,63,200
Total 8,83,200
B. Firm’s Savings on taking Factoring Service: ₹
Cost of credit administration saved 2,40,000
Bad Debts (₹ 160,00,000 x 1/100) avoided 1,60,000
Total 4,00,000
C. Net Cost to the firm (A – B) (₹ 8,83,200 – ₹ 4,00,000) 4,83,200
Effective cost of factoring = ₹4,83,200 x 100 = 16.09* %
₹30,03,733
* If cost of factoring is calculated on the basis of total amount available for advance, then,
it will be
= ₹4,83,200 x 100 = 15.44%
₹31,28,889
2. If Bank finance for working capital is available at 14%, firm will not avail factoring service
as 14 % is less than 16.08% (or 15.44%).

Question – 11 (Factoring)
A Ltd. has total sales of ₹ 3.2 crores and its average collection period is 90 days. The past experience
indicates that bad-debt losses are 1.5% on sales. The expenditure incurred by the firm in
administering its receivable collection efforts are ₹ 5,00,000. A factor is prepared to buy the firm’s
receivables by charging 2% commission. The factor will pay advance on receivables to the firm at
an interest rate of 18% p.a. after withholding 10% as reserve.
Calculate the effective cost of factoring to the Firm.

Solution:
Average level of Receivables = 3,20,00,000 x 90/360 80,00,000
Factoring commission = 80,00,000 x 2/100 1,60,000
Factoring reserve = 80,00,000 x 10/100 8,00,000
Amount available for advance=₹ 80,00,000 - (1,60,000+8,00,000) 70,40,000
Factor will deduct his interest @ 18% :-
Interest = ₹70,40,000 x 18 x 90 = ₹3,16,800
100 x 360
Advance to be paid = ₹ 70,40,000 – ₹ 3,16,800 = ₹ 67,23,200

Statement Showing Evaluation of Factoring Proposal

₹

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Working Capital Management - Receivable Management By: CA PRAKASH PATEL

A. Annual Cost of Factoring to the Firm:

Factoring commission (₹ 1,60,000 x 360/90) 6,40,000
Interest charges (₹ 3,16,800 x 360/90) 12,67,200
Total 19,07,200
B. Firm’s Savings on taking Factoring Service: ₹
Cost of credit administration saved 5,00,000
Cost of Bad Debts (₹ 3,20,00,000 × 1.5/100) avoided 4,80,000
Total 9,80,000
C. Net Cost to the firm (₹ 19,07,200 – ₹ 9,80,000) 9,27,200
₹ 9,27,200 x 100
Effective rate of interest to the firm= 13.79%*
67,23,200

(Note: The number of days in a year has been assumed to be 360 days.)
* It also can be calculated on amount available for advance (₹70, 40,000).

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