COMPILED BY CMA AFSAL ALUNGAL

Question
(a) The wealth maximization objective is superior to the profit maximization objective of afirm.

Answer :

A firm‘s financial management may often have the following as their objectives:
(i) The maximisation of firm‘s profit.
(ii) The maximisation of firm‘s value / wealth.

The maximisation of profit is often considered as an implied objective of a firm. To

achieve the aforesaid objective various type of financing decisions may be taken.
Options resulting into maximisation of profit may be selected by the firm‘s decision
makers. They even sometime may adopt policies yielding exorbitant profits in short
run which may prove to be unhealthy for the growth, survival and overall interests of the
firm. The profit of the firm in this case is measured in terms of its total accounting profit
available to its shareholders.

The value/wealth of a firm is defined as the market price of the firm‘s stock. The market
price of a firm‘s stock represents the focal judgment of all market participants as to
what the value of the particular firm is. It takes into account present and prospective
future earnings per share,the timing and risk of these earnings, the dividend policy of
the firm and many other factors that bear upon the market price of the stock.

The value maximisation objective of a firm is superior to its profit maximisation

objective due to following reasons.
1. The value maximisation objective of a firm considers all future cash flows, dividends, earning
per share, risk of a decision etc. whereas profit maximisation objective does not consider the
effect of EPS, dividend paid or any other returns to shareholders or the wealth of the
shareholder.
2. A firm that wishes to maximise the shareholders wealth may pay regular dividends whereas
a firm with the objective of profit maximisation may refrain from dividend payment to its
shareholders.
3. Shareholders would prefer an increase in the firm‘s wealth against its generation of increasing
flow of profits.
4. The market price of a share reflects the shareholders expected return, considering the long-term
prospects of the firm, reflects the differences in timings of the returns, considers risk and
recognizes the importance of distribution of returns.

The maximisation of a firm‘s value as reflected in the market price of a share is viewed
as a proper goal of a firm. The profit maximisation can be considered as a part of the
wealth maximisation strategy.

YOU TUBE :- “AFSAL ALUNGAL CLASSES” 1

 COMPILED BY CMA AFSAL ALUNGAL

Question
D Ltd. has 10 lac equity shares outstanding at the beginning of the accounting year 2014. The current
market price of the shares is ` 150 each. The Board of Directors of the company has recommended ` 8
per share as dividend. The rate of capitalization , appropriate to the risk –
class to which the company belongs is 12%.

(i) Based on MM approach, calculate the market price of the share of the company when
recommended dividend is (a) declared (b) not declared.
(ii) How many new shares are to be issued by the company at the end of the accounting yearon the
assumption that the net income for the year is ` 2 crores and the investment budget is ` 4 crores
when (a) the above dividends are distributed and (b) dividends are not
declared.
(iii) Show that the market value of the shares at the end of accounting year will remain same
whether dividends are distributed or not declared.

Answer:
Under M-M

approach, P0 = P1+

D1/1+Ke

Where,
P0 = Existing market price per share, i.e Rs
150P1 = Market price per share at year end.

YOU TUBE :- “AFSAL ALUNGAL CLASSES” 2

D1 = Contemplated dividend per share , i.e

` 8Ke = Capitalisation rate , i.e 12% or 0.12

i) a) Share price when dividend is declared :

150 = P1 +8/1+ 0.12
or,150 +18 = P1 +8
or, P1
=168-8or,
P1=160

b) Share price when dividend is not declared :

150 = P1
+0/1+0.12 or,
P1=150+18-0 or,
P1=168

ii) No. of shares to be issued: ` in lacs

Particulars If dividend is declared If dividend is not
declared
Net Income 200 200
Less: Dividend paid 80 0
Retained earnings 120 200
Investment budget 400 400
Amount to be raised by issue of 280 200
new
shares
Market price per share Rs160/- `168/-
No. of shares to be issued 175000 119048

iii) Verification of MM Dividend irrelevancy theory:

Particulars If dividend is declared If dividend is not
declared
Existing shares 10,00,000 10,00,000
New equity shares 1,75,000 1,19,048
Total no. of shares at year end 11,75,000 11,19,048
Market price per share `160 `168
Total market value at end of the ` 1880 lacs `1880 lacs
year
From the above analysis we can observe that the market value of the shares at the end
of theyear will remain same whether dividends are distributed or not declared.

Question
(a) Balance Sheet of OP Ltd. as on 31st March, 2014 and 2015 are as follows:
Liabilities Amount Amount Assets Amount Amount
31.3.2014 31.3.2015 31.3.2014 31.3.2015

` ` ` `
Share capital 15,00,000 15,00,000 Land and Building 11,25,000 10,50,000

General Reserve 3,00,000 337500 Plant and 13,50,000 13,12,500

Machinery
Profit and Loss A/c 1,87,500 2,70,000 Investment 3,00,000 2,79,000

10% Debentures 7,50,000 6,00,000 Stock 3,60,000 6,37,500

Bank Loan (long- 3,75,000 4,50,000 Debtors 4,50,000 5,98,500
term)
Creditors 3,00,000 4,35,000 Prepaid Expenses 37,500 30,000

Outstanding 15,000 18,750 Cash and Bank 1,05,000 63,750

Expenses
Proposed Dividend 2,25,000 2,70,000

Provision for 75,000 90,000

taxation
37,27,500 39,71,250 37,27,500 39,71,250

Additional information:
(i) New machinery for ` 2,25,000 was purchased but an old machinery costing ` 1,08,750was
sold for ` 37,500 and accumulated depreciation thereon was ` 56,250.
(ii) 10% debentures were redeemed at 20% premium.
(iii) Investment were sold for ` 33,750, and its profit was transferred to general reserve.
(iv) Income-tax paid during the year 2014-15 was ` 60,000.
(v) An interim dividend of ` 90,000 has been paid during the year 2014-15
(vi) Assume the provision for taxation as current liability and proposed dividend as non-
current liability.
(vii) Investment are non-trade investment.
You are required to prepare:
(I) Schedule of changes in working capital.
(II) Funds flow statement.
Answer:
(i) Schedule of Changes in Working Capital

Particulars 31st March Working Capital

2014 2015 Increas Decreas
e e
` ` ` `

A. Current Assets:

Stock 360,000 637500 277500 

Debtors 450,000 598500 148500 

Prepaid Expenses 37500 30000  7500

Cash and Bank 105000 63750  41250

Total (A) 952500 1329750

B. Current Liabilities:
Creditors 300,000 435,000  1350000
Outstanding Expenses 15,000 18750  3750

Provision for Taxation 75,000 90000  15000

Total (B) 390,000 543750 ________ _______
Working Capital (A – B) 562500 786000 426000 202500

Increase in _______ 223500

Working
Capital
Total 426000, 426000

(ii) Funds Flow Statement

for the year ending 31st March, 2015

Sources of Funds Amount Application of Funds Amount

` `
 Funds from operations 7,97,250 Redemption of 1,80,000
debentures
Bank loan taken 75,000 Purchase of machinery 2,25,000

Sale of Machinery 37,500 Dividend paid 2,25,000

Sale of Investment 33,750 Interim Dividend paid 90,000
Increase in 2,23,500
working capital
9,43,500 9,43,500

Workings:
1. Funds from operations:
Adjusted Profit and Loss A/c
` ` `
To General Reserve 24,750 By Balance b/d 1,87,500
To Depreciation By Funds from
operations 7,97,250

On Land and Building 75,000 (Balancing

figure)
On Plant & Machinery 2,10,000 2,85,000

To Loss on Sale 15,000

ofMachine
To Premium on
Redemption 30,000
o
fDebentures
To Proposed Dividend 2,70,000
To Interim Dividend 90,000
To Balance c/d 2,70,000
9,84,750
9,84,750

2. Depreciation on Land and Building = ` 11,25,000 – ` 10,50,000

= ` 75,000
3. Loss on Sale of Old Machine = Cost ` 1,08,750 – ` 56,250 (Cum-Dep.) – ` 37500
(Sales value) = ` 15,000
4. Depreciation on Plant and Machinery:

Plant and Machinery A/c

Dr. Cr.
 ` `
To Balance b/d 1350000 By Bank A/c (Sold) 37500
To Bank A/c (Purchases) 225,000 By Profit and Loss A/c 15,000

(Loss on Sales)
By Depreciation 210000
(Balancing figure)

________ By Balance c/d 1312500

1575000 1575000

5. Premium on Redemption of Debentures:

Amount of Debenture Redeemed = ` 7,50,000 – ` 6,00,000
= ` 1,50,000
Premium = ` 1,50,000  20/100
= ` 30,000

6. Profit on sale of investment:

Investment A/c
Dr. Cr.
` `
To Balance b/d 3,00,000 By Bank 33,750
A/
c (Sales)
 To General 12,750 By Balance c/d 2,79,000
Reserve
(Profit on Sales)
3,12,750 3,12,750

7. Amount transferred to General Reserve from Profit and Loss A/c:

General Reserve A/c

Dr. Cr.
` `
To Balance c/d 3,37,500 By Balance b/d 3,00,000
By Investment A/c 12,750
_______ By Profit and Loss 24,750
A/c
3,37,500 3,37,500

Question
Super Grow Manufacturing Co. has two mutual exclusive projects. Projects A requires a cash outlay of
` 2,00,000 and requires cash running expenses of ` 70,000 per annum. Project Bwill cost ` 3,00,000
and requires cash running expenses of ` 40,000 per year. Both projects have an 8 year life. Project A
has a salvage value of ` 8,000 and project B has ` 28,000. The Company‘s tax rate is 50% and has a
10% required rate of return.
Assuming depreciation on straight line basis, advice the Company on the project to be chosen.

Answer :

Alternative I – Evaluation based on Net Present Cost

Computation of Annual Depreciation and Tax Savings on Depreciation

Particulars Project A Project B

Initial outlay 2,00,000 3,00,000
Less : Salvage Value 8,000 28,000
Depreciable value 1,92,000 2,72,000
Period of use 8 years 8 years
Annual depreciation 24,000 34,000
Tax savings on depreciation [Annual depreciation x Tax 12,000 17,000
rate @50%]
Computation of Annual Cash Flow
Particulars Project A Project B
Cash operating expenses 70,000 40,000
Less : Tax savings on cash operating expenses @ 50% 35,000 20,000
Net cash operating expenses 35,000 20,000
Less : Tax savings on depreciation 12,000 17,000
Net cash outflow 23,000 3,000

Evaluation
Particulars Year Disc. Factor Project A Project B
@ 10%
Cash flow DCF Cash flow DCF
Initial investment 0 1.000 2,00,000 2,00,000 3,00,000 3,00,000
Net operating cash 1-8 5.335 23,000 1,22,705 3,000 16,005
outflows
Total present value of 3,22,705 3,16,005
cashoutflows
Less : Salvage Value 8 0.467 8,000 3,736 28,000 13,076
Net present cost 3,18,969 3,02,929

Conclusion : Project B offers a lower net present cost, and hence should be preferred.

Alternative –II – Evaluation based on incremental cost Hypothesis –

Project B be selected.
Computation of Incremental Outflow
Particulars `
Investment for project B 3,00,000
Less : Investment for project A 2,00,000
Incremental investment cost in project B 1,00,000

Computation of Incremental Savings

Particulars ` `
Cash operating cost for project A 70,000
Less : Cash operating cost for Project B 40,000
Savings in operating cost due to selection of Project B 30,000
Less : Tax payable o cost savings 15,000
Net savings in cash operating cost 15,000
Add : Tax savings on additional depreciation
Depreciation for project B 34,000
Less : Depreciation for project A 24,000
Incremental depreciation for project B 10,000
Tax savings on additional depreciation – ` 10,000 x 50% 5,000
Total annual savings by selecting project B 20,000
Evaluation of Hypothesis
Particulars Year Disc. Factor @ Cash flow DCF
10%
Incremental savings per annum 1-8 5.335 20,000 1,06,700
Incremental salvage proceeds 8 0.467 20,000 9,340
[28,000 – 8,000]
Total present value of cash outflows 1,16,040
Less : Incremental investment 0 1.000 1,00,000 1,00,000
Net present value 16,040
Conclusion : There is a net saving of ` 16,040 in present value terms, by opting for project
B instead of project A. Therefore, the hypothesis is correct i.e. Project B should be selected.
Question
(a) Pawan Ltd. provides you the following information :
i. Capital structure as per Balance Sheet as at 1st April, 2014 :
Particulars `
15% Debentures of RS. 100 each 10,00,000
18% Preference shares of RS. 100 each 2,00,000
Equity shares of RS. 10 each 2,00,000
Retained earnings 4,40,000
Total 18,40,000
ii. Currently quoted prices in stock exchange (as at 31st March , 2015)15%
Debentures at ` 120 per debenture
18% Preference shares at RS. 120 per share Equity
shares at ` 78 per share
iii. EPS and DPS
EPS for the current year is ` 20 per share. Dividend Payout Ratio is 60%. Anticipated growth
rate is 4%.
iv. Corporate tax rate is 40%.
Required :
i. Calculate the weighted average cost of capital using (a) Book Value Weights, (b) Market
Value Weights.
ii. Calculate the cost of new debentures, new preference shares, new equity shares and
retained earnings if anticipated external financing opportunities are as follows :
a) 12% debentures of ` 100 each issued at par and redeemable after 5 years at 5%
premium. Flotation cost is 5% of issue price.
b) 15% preference shares of ` 100 each issued at par and redeemable after 5 yearsat 5%
premium. Flotation cost is 5% of the issue price.
c) Equity shares of ` 10 each issued at ` 60. Flotation cost being ` 5 per share.
iii. How much can be spent for capital investment before new equity shares must be issued
?
iv. Calculate the weighted average cost of capital using marginal weights if the company
requires ` 4,00,000 for future investment and intends to maintain the existing optimal capital
structure.
v. What is the required amount of capital budget if the company wants to expands its total
assets by 47.50% ? There are no short term debts.
vi. How much of the capital budget must be financed by the external equity to maintain the
optimal capital structure in part (v).
vii. Calculate the weighted average cost of capital using marginal weights in part (vi)
assuming that the company intends to maintain the existing optimal capital structure.
viii. Calculate the numbers of new equity shares, debentures and preference shares to be
issued in part (vi).

Answer :
Calculation of retained earnings as at 31.03.2015
Retained earnings as at 01.04.2014 `
4,40,000Add : Current year‘s retained earning [(20,000 x ` 20) x 40%]`
1,60,000 Retained earnings as at 31.03.2015 `
6,00,000

(i) (a) Statement showing the weighted average cost of capital (Using
book value weights)
 Source of capital Amount of each Proportion of After tax cost of Product
source of each source of each source of

A capital capital capital E=Cx

B (in lakhs) C D D
Equity share 2.00 0.100 0.200 0.0200
capital
Retained earnings 6.00 0.300 0.200 0.0600
18% preference 2.00 0.100 0.150 0.0150
share capital
15% debentures 10.00 0.500 0.075 0.0375
Total 20.00 1.000 0.1325

(i) (b) Statement showing the weighted average cost of capital (Using
market value weights)
Source of capital Amount of each Proportion of After tax cost of Product
source of each source of each source of
A capital capital capital E=Cx
B (in lakhs) C D D
Equity share 15.60 0.520 0.200 0.104
capital
18% preference 2.40 0.080 0.150 0.012
share capital
15% debentures 12.00 0.400 0.075 0.030
Total 30.00 1.000 0.146

Cost of equity capital (k e) or retained earnings (k r)

D0  (1  g) 12 (1  0.04)
=
D1
+g +0.04 = 0.16 + 0.04 = 0.20
+g
P0 = 78
= P0

ii. Calculation of the new cost

a) Cost of new debentures (kd)
Interest(1  tax rate) [(Redeemable value -Net saleproceeds)/ N
kd [(Redeemable value Net saleproceeds)/ 2

12(1 - 0.4)[(105 - 95)/5]

= = 0.092 or 9.2%
(105  95)/2

b) Cost of new preference share (kp)

Preference dividend [Redeemable value -Net sale proceeds)] /N
kp [(Redeemable value Net sale proceeds)/ 2]

=
 15 [(105 - 95)/5] = 0.17 or 17.00%
=
(105  95)/2

c) Cost of new equity shares (ke)

D1 D  (1  g) 12 (1  0.04)
ke + g= 0 +g= +0.04= 0.2269 + 0.04 = 0.2669 or 26.69%
=

P0 P0 (60  5)

d) Cost of retained earnings (kr)

D1 D  (1  g) 12 (1  0.04)
kr + g= 0 +g= +0.04 = 0.208 + 0.04 = 0.248 or 24.80%

P0 P0 60

iii. Calculation of investment before issue of equity shares

Retained earning available = Total number of shares x EPS – Dividend paid
= (20,000 x ` 20) – (20,000 x ` 12)
= ` 4,00,000 – ` 2,40,000 = ` 1,60,000
 Total investment = (1,60,000/0.40) = ` 4,00,000
Hence, the company can expand its project by Rs, 4,00,000 without issuing new
equity
shares.

iv. Calculation of weighted average cost by using marginal weights

Source of capital Amount of each Proportion of After tax cost of Product
source of each source of each source of
A capital capital capital E=Cx
B (in lakhs) C D D
Retained earnings 1.60 0.400 0.248 0.0992
New 15% 0.40 0.100 0.170 0.0170
preference share
capital
New 12% 2.00 0.500 0.092 0.0460
debentures
Total 4.00 1.000 0.1622

v. Required amount of capital budget = 47.5% of ` 20 lakhs = ` 9.50 lakhs

vi. External equity to be raised = Equity portion in new investment – Retained earnings
available
= (40% of ` 9,50,000) – ` 1,60,000 = ` 2,20,000

vii. Statement showing the weighted average cost of capital (using marginal weights)
Source of capital Amount of each Proportion of After tax cost of Product
source of each source of each source of
A capital capital capital E=Cx
B (in lakhs) C D D
New Equity 2.20 0.232 0.267 0.0619
sharecapital
Retained earnings 1.60 0.168 0.248 0.0417
New 15% 0.95 0.100 0.170 0.0170
preference share
capital
New 12% 4.75 0.500 0.092 0.0460
debentures
Total 9.50 1.000 0.1666

viii. Calculation of number of new securities

shar Rs. 2,20,000
No. of new equity shares Rs.55
es=
Rs. 95,000
= Rs.95

No. of new preference

= 4,000 = 1,000
Rs. 4,75,000
No. of new debentures Rs.95 = 5,000

=
 Question

Discuss stochastic Model of Cash Management.

Answer :

Stochastic Model of Cash Management

This model is developed to avoid the problems associated with EOQ mode. Model
developed by Miller and Orr. The basic assumption of this model is that cash balances
are irregular. Themodel prescribed two control limits.

Upper Control Limits (UCL) – When cash balance reaches the upper limits, a transfer of
cash to investment account should be made.

Lower Control Limits (LCL)- When cash balance reaches the lower point, a portion of
securities from investment account should be liquidated to return the cash balances to
its return point.

The Miller and Orr model is the simplest model to determine the optimal behavior in
irregular cash flow situation. The model is a control limit model to determine the time
and size of transfersbetween an investment account and cash account. The optimal point
(O) of cash balance is determined by

3TV
O=
3
4I

Where O-target (Optimal) cash balance; T- Fixed cost associated with security
transactions; I- Interest per day on marketable securities; V- Variance of daily net cash
flows.

Limitations : Problems in respect of collection of data- cost of time devoted by finance

manager- does not take in account short-term borrowings.

1) The first and important problem is in respect of collection of accurate data about transfer
costs, holding costs, number of transfers and expected average cash balance.
2) The cost of time devoted by financial managers in dealing with the transfers of cash to
Securities and vice-versa.
3) The model does not take into account the short-term borrowings as an alternative to selling
of marketable securities when cash balance reaches lower limit.

Question
(a) The selected financial data for A,B and C companies for the year ended March 31,2015are
as follows:
 Company A B C
Financial leverage 3:1 4:1 2:1
Interest `200 `300 `1,000
Operating leverage 4:1 5:1 3:1
Variable cost as a % to sales 66 2/3% 75% 50%
Income tax rate 45% 45% 45%
(i) Prepare Income statement for the year ended 31st March, 2015 for each company.
(ii) Comment on the financial position and capital structure of these companies.
Answer :

Company A:
Financial Leverage = 3 Operating Leverage = 4

EBIT Contribution
3 4
EBIT  200 EBIT
Sales V .Cost
4
300
3(EBIT-200) = EBIT
Sales – 66 2/3% sales =
3EBIT –EBIT= 600
120033 1/3% of Sales =
EBIT= 300
1200
Sales = 1200x 3 = 3600
Company B: Sales V .Cost
5
400
EBIT
4
EBIT  300 Sales – 75% Sales = 2000
25% Sales = 2000

4(EBIT – 300) = EBIT Sales = 2000x4

3EBIT = 1200 =8000

EBIT = 400
Company C : Sales V .Cost
3
EBIT 2000
2
EBIT 1000 Sales- 50% on Sales = 6000
50% Sales = 6000

2(EBIT – 1000) = Sales = 12,000

EBIT EBIT = 2000

Income Statement of Companies

A B C
Sales 3600 8000 12000
(-) Variable Cost 2400 6000 6000
Contribution 1200 2000 6000
(-) Fixed Cost (Contribution- 900 1600 4000
EBIT)
EBIT 300 400 2000
(-) Interest 200 300 1000
100 100 1000
(-) Tax @ 45% 45 45 450
55 55 550

Comment on the financial position - Company C is better than that of the other
companies A and B because of the following reasons:
- Company C has the least financial risk
- Total risk ( business and financial) complexion of company is the lowest (DCL: A-12, B-20, C-
6)
- Capacity of Company C to meet interest liability is better than that of companies A and C
(from EBIT/ Interest ratio )
[A = 300/200 = 1.5 B = 400/300 = 1.33 C = 2000/1000= 2]
Question

Trinadh Traders Limited currently sells on terms of net 30days. All the sales are on credit
basis and average collection period is 35 days. Currently, it sells 5,00,000 units at an average
price of `50 per unit. The variable cost to sales ratio is 75% and a bad debt to sales ratio is 3%. In order
to expand sales, the management of the company is considering changing the credit
terms from net 30 to 2/10, net 30.

Due to change in policy, sales are expected to go up by 10%, bad debt loss on additional saleswill
be 5% and bad debt loss on existing sales will remain unchanged at 3%. 40% of the customers
are expected to avail the discount and pay on the tenth day. The average collectionperiod for the
new policy ( in respect of additional sales) is expected to be 34 days. The company required a
return of 20% on its investment in receivables.

You are required to find out the impact of the change in credit policy on the profit of the company.
Also advise the management on implementation of new policy. Ignore taxes. Assume 1 year = 360
days.

Answer :
Appraisal of Credit Policy
Present Proposed
Credit Terms Net 30 2/10, Net 30
ACP (Average Collection 35 days 34 days
Period)
Discount Sales - 40%
Bad debts 3% 3%+5%
Sales ( in units) 5,00,000 5,50,000

Incremental Profit = 50000x50x25% = 6,25,000

Incremental Bad debts = 50000x50x5% =
(1,25,000) Discount = 5,50,000x40%x50x2% =
(2,20,000)
Incremental Investment in receivables = 50,000 x 50 x 75% x 34/360
= 1,77,083
Finance Cost = 1,77,083 x 20/100 = (35,417)

Total Benefits =`6,25,000

Total Cost = 1,25,000 + 2,20,000 + 35,417
 =`3,80,417
Net benefit due to new policy = `(6,25,000 – 3,80,417) = `2,44,583

Hence, Management is advised to implement the New credit policy.

Question
(a) AMRITAM Ltd. has a total sales of ` 3.2 crores and its average collection period is 90 days.
The past experience indicates that bad debts losses are 1.5% on sales. The expenditureincurred by
the firm in administering its receivable collection efforts is ` 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% per annum after withholding 10% as reserve. Assume
360 days in a year. Calculate the effective cost of factoring to the firm.

Answer :

Particulars `
90
Average level of receivables = `3.2 crores x
360
80,00,000
2
Factoring commission = `80 lakhs x
100
Factoring reserve = `80 lakhs x 10% 1,60,000
Amount available for advance = `[80- (1.6 +8)] lakhs
8,00,000
Factor will deduct his interest @ 18%
`70.4lakhs x18x 90 70,40,000
= = `3,16,800
100x 360
Advance to be paid = `(70,40,000 – 3,16,800)
Annual cost of factoring to the firm:
360
Factoring commission = `1,60,000 x 67,23,200
90
360
Interest charges = `3,16,800 x
90 6,40,000

12,67,200
Total 19,07,200
Firm‘s saving on taking factoring service:
Cost of credit administration saved 5,00,000
1.5
Cost of Bad debts = `3.20Cr. x avoided
100 4,80,000
Total 9,80,000

Net cost to the firm = `(19,07,200 – 9,80,000) = `9,27,200

Netcost 
Effective rate of interest to the firm 
= Advance topay
`9,27,200
x100
`67,23,200
 = 13.79%

Question
What are the differences between NPV and IRR?

Answer :
Difference between NPV and IRR

A. Causes for Conflict: Higher the NPV, higher will be the IRR. However, NPV and IRR may
giveconflicting results in the evaluation of different projects, in the following situations –
i) Initial Investment Disparity - i.e. Different Project Sizes,
ii) Project Life Disparity - i.e. Difference in Project Lives,
iii) Outflow Patterns - i.e. when Cash Outflows arise at different points of time during the
Project Life, rather than as Initial Investment (Time 0) only.

iv) Cash Flow Disparity - when there is a huge difference between initial CFAT and later
years‘ CFAT. A project with heavy initial CFAT than compared to later years will have
higher IRR and vice-versa.

B. Superiority of NPV: In case of conflicting decisions based on NPV and IRR, the NPV method
must prevail. Decisions are based on NPV, due to the comparative superiority of NPV, as
given from the following points –
i) NPV represents the surplus from the project but IRR represents the point of no surplus-
no deficit.
ii) NPV considers Cost of Capital as constant. Under IRR, the Discount Rate is determined
by reverse working, by setting NPV = 0.
iii) NPV aids decision-making by itself i.e. projects with positive NPV are accepted. IRR by
itself does not aid decision-making. For example, a project with IRR = 18% will be accepted
if K0 < 18%. However, the project will be rejected if KO = 21% (say > 18%).
iv) NPV method considers the timing differences in Cash Flows at the appropriate
discount rate. IRR is greatly affected by the volatility / variance in Cash Flow patterns.
v) IRR presumes that intermediate cash inflows will be reinvested at that rate (IRR),
whereas in the case of NPV method, intermediate cash inflows are presumed to be
reinvested at the cut-off rate. The latter presumption viz. Reinvestment at the Cut-Off
Rate, is more realistic than reinvestment at IRR.
vi) There may be projects with negative IRR/ Multiple IRR etc. if cash outflows arise at
different points of time. This leads to difficulty in interpretation. NPV does not pose
such interpretation problems.

Question

(a) From the following information, prepare the Balance Sheet.Net

Profit after Interest, Tax and Preference Dividend — ` 2,22,000

Tax Rate — 50%

18% Preference Share Capital — ?
15% Debentures—?
Return on Capital Employed — 50%
Return on Shareholder's funds — 60%
Return on Equity Shareholders' Funds — 74%
Current Ratio — 2:1
Net Fixed Assets ` 9,00,000.

Answer :
2,22,000
Equity share holders funds x100 = 3, 00,000
74
=

EAT
Return on share holders funds =
sh.fund
s
= 2,22,000 0.18x

(3,00,000 x)
0.6
Reference share capital (x) = 1,00,000

EAT = 2,22,000 + 0.18 (1,00,000) =

`2,40,000 Tax = 50% of EBT or 100% on EAT =
`2,40,000 EBT = EAT + TAX = 2,40,000 +
2,40,000 = `4,80,000

Let debentures be
Y Interest = 0.15y
EBIT = EBT + Int. on L.T. Debt
= 4,80,000 + 0.15Y

EBIT
Return on capital 100
Cap.
employed = employed

4,80,000  0.15Y
4,00,000  Y
0.50 =

15% debentures (Y) = `8, 00,000

Capital employed = (3,00,000 + 1,00,000) + 8,00,000 = `12,00,000

Working capital = Cap. Employed - Net FA
=12, 00,000 – 9, 00,000
= 3, 00,000 or CA - CL= 3, 00,000 (i)
CA
=2 :1
Current ratio CL
=

Or CA – 2 CL = 0…..(ii)
(i)– (ii) CL = 3, 00,000
CA = 3, 00,000 x 2 = 6,00,000

Total assets = FA + CA = 9, 00,000 + 6, 00,000 = 15,

00,000EBIT = 4,80,000 + 15% of `8,00,000 =
`6,00,000

Balance Sheet
Liabilitie ` Assets `
s
EQ. Sh. Holders funds 3,00,000 Fixed assets 9,00,000
Preference share capital 1,00,000 Current 6,00,000
assets
15% debentures 8,00,000
Current liabilities 3,00,000
Total 15,00,000 15,00,000

(b) The beta co-efficient of a security 'X' is 1.4. The risk free rate of return is 10% andthe required
rate of return is 14% on the market portfolio. If the dividend expected during the coming year is
` 3.50 per share and the growth rate of dividend and earning
is 8%, at what price should the security 'X' be sold, based on the CAPM?
Answer :
Expected rate of Return by applying CAPM Formula:
E(Ri) = Rf + Bi (Rm – Rf)
= 10% + 1.4 (14% - 10%) = 10% + 5.6% = 15.6%
Price of security X is calculated with the use of dividend growth model formula.

D1
Re = 
gP0
3.50
0.156   0.08
P0
3.50 0.08
0.156  
P0 1
3.50  0.08P0
0.156 
P0
0.156P0 = 3.50 + 0.08P0
0.156P0 – 0.08P0 = 3.50
0.076P0 = 3.50
3.50
P0   `46.05
0.076
Question
(a) PCT Ltd. is in the process of raising ` 15 lakhs as additional capital. For this purpose, two
mutually exclusive alternative financial plans have been identified. The current level of EBIT is ` 51 lakhs
which is likely to remain unchanged. The relevant information is as under:

Present capital structure 9,00,000 Equity shares of ` 10 each and 10% Bonds of ` 60
lakh
` 51,00,000
Current EBIT ` 2.50
Current EPS ` 50 per share
Current market price 50%
60,000 Equity shares @ ` 25 per share
Tax Rate
12% Debentures of ` 15,00,000
Financial Plan I
Financial Plan II

Required:
(i) Calculate the indifference level of EBIT between the two plans.
(ii) Calculate the financial BEP under both the plans.
(iii) Which alternative financial plan is better?

Answer :
(i) Indifference Point:

Plan -I Plan-II

EBIT X X
Less : Interest 6,00,000 7,80,000
EBT X - 6,00,000 x-7,80,000
Less : Tax 50% 0.5 (x- 0.5 (x-
6,00,000) 7,80,000)
EAT 0.5x - 0.5x-
3,00,000 3,90,000
No. of Equity Share 9,60,000 9,00,000
EPS 0.5x  0.5x 
3,00,000 3,90,000
9,60,000 9,00,000

Equal EPS under 0.5x  3,00,000

plan 9,60,000
 0.5x  3,90,000
=
9,00,000
9,00,000 (0.5x – 3,00,000) = 9,60,000 (0.5x – 3,90,000)
x = 34,80,000

The indifference Level of EBIT = ` 34,80,000

(ii) Financial BEP

0.5x  3,00,000
Plan – I =0
9,60,000
3,00,000
= ` 6,00,000
x 0.5
0.5x  3,90,000
=0
= 9,00,000
3,90,000
= ` 7, 80,000
0.5
Plan – II

(i) Selection of Financial Plan

(51,00,0006,00,000)(1 = ` 2.34 per Share
EPS (Plan I)
0.5)
9,60,000shares

(51,00,0006,00,0001,80,000)(1 0.5)
EPS (Plan II) = ` 2.4 per Share
9,00,000

Plan II is better.
(b) The initial investment outlay for a capital investment project consists of ` 100 lakhs forplant
and machinery and ` 40 lakhs for working capital. Other details are summarized below :

Output 1 lakh units of output per year for years 1 to 5

Selling price ` 120 per unit of output

Variable cost ` 60 per unit of output
Fixed overheads (excluding depreciation) ` 15 lakhs per year for years 1 to 5
Rate of depreciation on plant and 25% on WDV method

machinery
Salvage value of plant and machinery Equal to the WDV at the end of year 5
Applicable tax rate 40%
Time horizon 5 years
Post-tax cut off rate 12%

Indicate the financial viability of the project by calculating the net present value.

Answer :
Initial investment outlay ` 140 lakhs
Depreciation schedule (` In lakhs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening plant and 100 75.00 56.25 42.19 31.64
machinery
Annual depreciation 25 18.75 14.06 10.55 7.91
Closing plant and machinery 75 56.25 42.19 31.64 23.73
(` p.u.)
Selling price 120
Less : variable cost 60
Contribution 60
Total contribution per year = 1 lakh units
(` in lakhs)
Total contribution per year 60
Less : Fixed overheads, other than depreciation, per year 15
Profit before depreciation and tax per year (PBDT) 45

Computation of P.V. of Net Cash Inflow :

(` In lakhs)
End of year 1 2 3 4 5
PBDT 45 45.00 45.00 45.00 45.00
Less : Depreciation 25 18.75 14.06 10.55 7.91
PBT 20 26.25 30.94 34.45 37.09
Less : Tax @ 40% 8 10.50 12.38 13.78 14.84
PAT 12 15.75 18.56 20.67 22.25
Depreciation 25 18.75 14.06 10.55 7.91
Salvage value of plant and - - - - 23.73
machinery
Decrease in working capital - - - - 40.00
Net cash inflow 37 34.50 32.62 31.22 93.89
P.V. factor @ 12% 0.893 0.797 0.712 0.636 0.567
P.V. of net cash inflow 33.04 27.50 23.23 19.86 53.24
 NPV = P.V. of net cash inflow – Initial investment outlay = 15.87 – 140.00
= ` 16.87 lakhs
As the NPV @ 12% is positive, the project is financially viable.

Question
(a) From the following information of A Ltd., calculate (i) Gross Operating Cycle, (ii) Net
Operating Cycle, and (iii) No. of operating cycles in a year.

Particulars `

Raw material inventory consumed during the year 60,00,000

Average stock of raw material 10,00,000
Factory cost of goods produced 1,05,00,000
Average stock of work-in-progress 4,37,500
Cost of goods produced 1,14,00,000
Average stock of finished goods 9,50,000
Average trade debtors 11,25,000
Cost of credit sales 90,00,000
Average trade creditors 5,00,000
Expenses for the year 30,00,000
Average creditors for expenses 5,00,000
No. of working days in a year (Assume 360 days)

Answer :
Average stock of raw material
Raw material storage period =
Average cost of raw material consumption
per day
Rs.10,00,000
= = 60 days
Rs.
60,00,000

360
Average stock of work - in - progress
Work-in-progress holding period = Average cost in W.I.P. per day
Rs. 4,37,500
=
 Rs.1,05,00,000 = 15 days

360
Average stock of finished goods
Finished goods storage period = Average cost of goods produced per
day
Rs. 9,50,000
= = 30 days
Rs.1,14,0
0,000

360
Average trade debtors
Debtors collection period = Average cost of credit sales
per day
Rs.11,25,000
= = 45 days
Rs.90,00,
000

360
Average trade
Creditors‘ payment period = creditors Average credit
purchases per day
Rs.5,00,000
= = 30 days
Rs.
60,00,000

360
Average creditors for
Average time lag in payment of expenses Average
expenses = expenses per day
Rs.5,00,000
= = 60 days
Rs.30,00,
000

360
Gross operating cycle = 60 + 15 + 30 + 45 = 150 days
Net operating cycle = 60 + 15 + 30 + 45 – 30 – 60 = 60
daysNo. of operating cycle in a year
No. of daysin 360 days
= = = 6 operating cycles in a year
a year Net 60 days
operating
cyle

(b) The following is the balance sheet of M/S Yamuna Enterprise for the year ended 31-12-08;

Balance Sheet as on 31 st December, 2008

Liabilities ` Assets `
Equity share capital 1,00,000 Cash in hand 2,000
12% Preference share capital 1,00,000 Cash in Bank 10,000
16% debentures 40,000 Bills Receivable 30,000
18% Public debts 20,000 Investors 20,000
Bank overdraft 40,000 Debtors 70,000
Creditors 60,000 Stock 40,000
Proposed dividends 7,000 Furniture 30,000
Reserves 10,000 Machinery 1,00,000
Provision for taxation 1,50,000 Land & Building 2,20,000
Profit & Loss account 20,000 Goodwill 35,000
20,000 Preliminary expenses 10,000
5,67,000 5,67,000

During the year provision for taxation was `20,000. Dividend was proposed at `10,000. Profit carried
forward from the last year was ` 15,000. You are required to calculate:
(i) Short term solvency ratios, and
(ii) Long term solvency ratios.

Answer:
Short term solvency
ratios: Current Assets
Current Ratio =

CurrentLiabilities
1,52,000
= = 1.109 times
1,37,000
The ideal ratio is 2 but in the instant case it is only 1.109, hence it is not satisfactory.
LiquidAssets 1,12,000
Liquid ratio = = 0.818
1,37,000
= CurrentLiabiliti
es
The ideal ratio is 1; hence it is not quite satisfactory.
EBIT
Interest Coverage ratio
= Interes
t
 45,000
= = 4.5 times
10,000
EBIT
Profit retained 5000
(+) proposed dividend 10000
PAT 15000

(+) tax 20000

PBT 35000
(+) interest [6400 + 3600] 10000
EBIT 45000

Long term solvency ratios:

Long term debt
Debt equity ratio =
Long termfund
60,000
= = 0.156
3,85,00
Long term 0
debt:

Debentures 40000
Public debt 20000
60000

Share holder funds:

Particulars `
Equity capital 100000
Preference capital 100000
Reserves 150000
P & L a/c 20000
(-) good will 35000
(-) Preliminary exp 10000
325000

Long term debt/ share holders funds = 60000/ 325000 =

0.18Both are quite satisfactory.

It seems the company has adopted a conservative policy for raising Finance. Under
such policythe equity share holders may not avail the benefit of trading on equity.

Fixed assets ratio = Fixed assets/ long term funds = 350000/385000 =

0.91The ratio is satisfactory.
Proprietary ratio = share holder funds/ total tangible assets
= [325000 / (567000 – 45000)] = 0.6226
Ratio is ideal. And long term position is quite satisfactory, it is advised to improve short term.

Question
(a) The paid-up capital of a company is ` 100 lakh. It has been declaring 20% dividend forthe last
5 years.
It has under consideration an expansion programme involving an investment of ` 100 lakh and its
board of directors desires to raise the dividend to 25%. The expansion programme can be
financed by four alternatives – i) 100% equity; ii) 18% institutional loan (debt) and equity 50:50; iii) Equity
and debt, 70:30; and iv) 100% debt. Income tax and dividend tax rate are 35% and 10% respectively.
Assuming rate of return as X, analyse the various financing alternatives from the point of view of
taxes.
Answer :
Effect of taxes on Financing Alternatives
(` In lakhs)
Particulars A B C D
Return on ` 100 lakh 100X 100X 100X 100X
Less : Interest (0.18) - 9 5.4 18
Balance 100X 100X -9 100X – 5.4 100X – 18
Less : Tax (0.35) 35X 35X – 3.16 35X – 1.9 35X – 6.30
Balance 655X 65X – 5.86 65X – 3.52 65X – 11.70
Add : Distributable profit before 20 20 20 20
expansion
(0.20 x ` 100 lakh)
Total profits available for distribution (a) 20 + 14.14 + 65X 16.48 + 65X 8.30 + 65X
65X
Expected rate of dividend (%) 25 25 25 25
Expected dividend [0.25 x (` 100 lakh + 50 37.50 42.50 25
new capital)]
Dividend tax (0.10) 5 3.76 4.26 2.50
Total of dividend and dividend tax (b) 55 41.26 46.76 27.50
Rate of return (value of X) to pay 54* 42 47 30
dividendand dividend tax [value of X if (a)
= (b)]%
*20 + 65X = 55 or, X = 35/65 = 54%; other values are also determined like this.

(b) JKL Ltd. has the following book-value capital structure as on March 31, 2013.

`
Equity share capital (2,00,000 shares) 11.5% 40,00,000
preference shares 10,00,000
10% debentures 30,00,000
80,00,000

The equity share of the company sells for `20. It is expected that the company will pay next year a
dividend of ` 2 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35%
corporate tax rate.

Required:
(i) Compute weighted average cost of capital (WACC) of the company based on the existing
capital structure.
(ii) Compute the new WACC, if the company raises an additional `20 lakhs debt by issuing12%
debentures. This would result in increasing the expected equity dividend to `2.40 and leave the
growth rate unchanged, but the price of equity share will fall to `16 pershare.
(iii) Comment on the use of weights in the computation of weighted average cost of capital.

Answer:

(i)
Weighted Average Cost of Capital of the Company
(Based on Existing Capital Structure)
 After Weights Weighted
tax (Refer to working note cost
cost (a) 4)(b) (a) X (b)
Equity share capital 0.1 0.50 0.075
cost(Refer to working 5
note 1) 0.125 0.014375
Cost of preference share capital 0.11
@11.5%(Refer to working note 2) 5 0.375 0.02437
Cost of debentures 11.375%
(Refer to working note 0.06
3) 5
Weighted average cost of capital

Working Notes:
1. Cost of equity capital:
Dividend
Ke = 
Current market price of
g
share
= `2  5% = 15% or 0.15
`20
2. Cost of preference share capital:
Annual preferencesharedividend
=
Net proceeds intheissueofpreferenceshare
=
`1,15,00 = 0.115
0
`10,00,000

3. Cost of Debentures:
1
= (Interest Tax )
Net
proceeds

1 (`3,00,000 – `1,05,000)
=
`30,00,00
0

= 0.065
4. Weights of equity share capital, preference share capital and debentures in total
investment of `80,00,000:
Totalequity share
Weight of equity share capital = capital
Totalinvestments
= `40,00,000 = 0.50
`80,00,000
Total preference share amount
Weight of preference share capital =
total investments
`10, 00, 000
= = 0.125
`80, 00, 000
Total debentures
Weight of debentures =
Total investments
`30,00,000
= = 0.375
`80,00,000

(ii) New Weighted Average Cost of Capital of the Company

(Based on new capital structure)
 After tax Weights Weighted
cost (Refer to working note 4) cost
(a) (b) (a) x (b)
Cost of equity share capital 0.20 0.40 0.080
(Refer to working note 2)
Cost of preference share 0.115 0.10 0.0115
Cost of debentures @10% 0.065 0.30 0.0195
Cost of debentures @12% 0.078 0.20 0.0156
Weighted average cost of 12.66%
capital

Working Notes:
1. Weights of equity share capital, preference share and debentures in total investment
of `100,00,000
`40,00,000
Weight of equity share capital = 0.4
`1,00,00,000

=
`10,00,000
Weight of preference share capital = = 0.1
`1,00,00,000
`30,00,000
Weight of debentures @ 10% = = 0.30
`1,00,00,000
`20,00,000
Weight of debentures @12% = = 0.20
`1,00,00,000
2. Cost of equity capital:
`2.40
Dividend + 5% = 20%
Ke = g
= `16
Current market price of share

(iii) Comment: In the computation of weighted average cost of capital weights are preferred
to book value. For example, weights representing the capital structure under a corporate
financing situation, its cash flows are preferred to earnings and market. Balance sheet is
preferred to book value balance sheet.

Question
(a) The management of MNP Company Ltd. is planning to expand its business and consultsyou
to prepare an estimated working capital statement. The records of the company reveal thefollowing
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 10,80,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
 Income tax payable in four installments of which one falls in the new 2,25,000
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 12% margin for contingencies on computed
figure.
You are required to prepare the estimated working capital statement for the next year.

Answer :
Preparation of Statement of Working Capital Requirement for MNP Company Ltd.
Estimated Working Capital Statement

(A) Current Assets in terms of Cash Costs `

1
Debtors: Domestic Sales x 19,20,000
12 1,60,000
3
Export Sales x 9,60,000
12 2,40,000
Prepaid Sales promotion expenses
1 37,500
Stock of Raw materials x 9,00,000
12 75,000
1
Stock of finished goods x 28,80,000
12 2,40,000
Cash at Bank and in
Hand Total Current
1,75,000
Assets
9,27,500
(B) Current Liabilities in terms of Cash Costs `
Creditors for:
2
Material x 9,00,000
12 1,50,000
1
Wages x 7,20,000
24 30,000
1
Manufacturing expenses x 10,80,000
12 90,000
1
Administrative expenses x 2,40,000
12 20,000
Income Tax Payable
Total Current
Liabilities 56,250
3,46,250
(C) `
Net Current Assets (A-B) 5,81,250
Add: 12% margin for contingencies 69,750
Required Working Capital 6,51,000
Working Notes:
Cash cost of sales is calculated as under: ` `
Domestic Sales 24,00,000
Less: Gross profit @ 20% 4,80,000 19,20,000
Expert Sales 10,80,000
1,20,000 9,60,000
 10, 80, 000 28,80,00
` = 12,00,000 @ 10%
90 0

(b) In considering the most appropriate capital structure for the Bharat Manufacturers Ltd. (BML),
its finance department has made estimate of the interest rate on debt and the cost of equity capital
at various levels of debt-equity mix summarized below :

Debt-equity mix (leverage) Coupon rate (%) Cost of equity (%)

0 8 12.0
10 8 12.0
20 9 12.5
30 9 13.5
40 10 14.5
50 13 16.0
60 15 20.0
70 18 25.0

The debt is in the form of 10-year redeemable at par `1,000 debentures with coupon rates varying
with the equity-debt ratio and 5per cent flotation cost. As a matter of policy, BML always
keeps 10 per cent of its finances in the form of preference shares carrying 2 per cent extra return
compared to the debenture coupon rates. The duration and the floatation costs are similar to
debentures.

Required : Assuming (i) 17.5 per cent dividend distribution tax and (ii) corporate tax rate, 35 per cent,
determine the optimal capital structure (debt-equity mix) for the BML.

Answer :
Determination of Optimum Capital structure

Degree of Coupon rate Preference Cost of Kd Kp Ko

leverage (%) (I) dividend equity (Ke)
(%) (D p)
0 8.0 10.0 12.0 0.0585 0.1256 0.1206
10 8.0 10.0 12.0 0.0585 0.1256 0.1144
20 9.0 11.0 12.5 0.0651 0.1377 0.1143
30 9.0 11.0 13.5 0.0651 0.1377 0.1143
40 10. 12.0 14.5 0.0718 0.1497 0.1162
0
50 13. 15.0 16.0 0.0918 0.1859 0.1285
0
60 15. 17.0 20.0 0.1051 0.2100 0.1441
0
70 18. 20.0 25.0 0.1251 0.2462 0.1622
0
Conclusion: The optimum capital structure lies between 20 and 30 per cent of leverage.

Working note:
Kd = [I (1 – t) + Flotation costs/N] ÷ (RV + SV)/2
Kp = [Dp (1 + Dt) + Flotation costs/N] ÷ (RV + SV)/2

Where, I = Interest
Dp = Dividend on preference shares
 t = Tax rate
RV = Redemption value
SV = Sale value (face value – flotation
cost)n = Maturity period
Dt = Dividend payment
taxKo = (Wd x Kd) + (Wp x Kp) + (We + Ke)

It may be noted that 10% debt-equity mix implies 90% shareholders equity (consisting 10%
ofpreference shares and 80% of ordinary shares).

Question
(a) List out the main official foreign sources of finance.

Answer:
Official Main Foreign Sources of Finance:

(i) Foreign Collaboration: In India joint participation of foreign and domestic capital has
been quite common in recent years. Foreign collaboration could be either in the form of
joint participation between private firms, or between foreign firms and Indian
Government, or between foreign governments and Indian Government.

(ii) Bilateral Government Funding Arrangement: Generally, advanced countries provide aid
in the form of loans and advances, grants, subsidies to governments of under -developed
and developing countries. The aid is provided usually for financing government and public
sector projects. Funds are provided at concessional terms in respect of cost (interest),
maturity, and repayment schedule.

(iii) NRI Deposits and Investments: Non-resident Indians have always been making a
contribution in Indian economy. Government has been making efforts to encourage
their deposits and investments. Various schemes have been devised which ensure higher
returns; procedures have been simplified to attract investments in primary and secondary
market. Tax incentives are given on interest earned and dividends received by NRIs.

(iv) Loans from International Financial Institutions: International Bank for Reconstruction and
Development (IBRD), International Monetary Fund (IMF), Asian Development Bank (ADB),
and World Bank have been the major source of external finance to India.

(v) External Commercial Borrowing (CEB): Our country has also been obtaining foreign capital
in the form of external commercial borrowings from agencies like US EXIM Bank, Japanese
EXIM Bank, ECGC of UK, etc.

(b) List out the significance of Cash Management.

Answer:
Significance of Cash Management
 Cash planning: Cash is the most important as well as the least unproductive of all current
assets. Though, it is necessary to meet the firm‘s obligations, yet idle cash earns nothing.
Therefore, it is essential to have a sound cash planning neither excess nor inadequate.
 Management of cash flows: This is another important aspect of cash management.
Synchronisation between cash inflows and cash outflows rarely happens. Sometimes, the
 cash inflows will be more than outflows because of receipts from debtors, and
cash salesin huge amounts. At other times, cash outflows exceed inflows due to
payment of taxes,interest and dividends etc. Hence, the cash flows should be
managed for better cash management.
 Maintaining optimum cash balance: Every firm should maintain optimum cash balance.
The management should also consider the factors determining and influencing the cash
balances at various point of time. The cost of excess cash and danger of inadequate cash
should be matched to determine the optimum level of cash balances.
 Investment of excess cash: The firm has to invest the excess or idle funds in short term
securities or investments to earn profits as idle funds earn nothing. This is one of the important
aspects of management of cash.

Question 30.
(a) Company MTL is forced to choose between two machines A and B. The two machines are
designed differently, but have identical and do exactly the same job. Machine A costs
`2,50,000 and will last for 3 years. It costs `40,000 per year to run. Machine B is an ‗economy‘ model
Costing only `2, 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 percent. Which machine Company X should Buy?

Answer:
Working Notes:
Compound present value of 3 years @ 10% = 2.486
P.V. of Running cost of Machine A for 3 years = `40,000×2.486 =
`99,440Compound present value of 2 years @10% =1.735
P.V. of Running cost of Machine B for 2 years =`60,000 ×1.735
=`1, 04,100
Statement showing evaluation of Machine A and B
Particulars Machine A Machine B
Cost of purchase 2,50,000 2,00,000
Add: PV. Of running cost for 3 years 99,440 1,04,100
P.V. of Cash Outflow 349440 3,04,100
2.486 1.735
Equivalent Present Value of annual Cash outflows 1,40,563 1,75,274

Analysis: Since the annual Cash outflow of Machine B is highest, Machine A can be
purchased.

(b) The following information relates to nana 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 MarketValue
of Company‘s Share at that payout ratio?
Answer:

R
EPS DPS
Value per DPS  Ke
 
share


Ke Ke

Computation of Factors:
Earnings Per Share (EPS) `10 lakhs÷ 2 lakhs = `5 Cost of Equity (Ke) 12%
Dividend Per Share (DPS) EPS`5×payout60% =`3 Return on Investment (R) 15%

`5 `3 0.15

`3  0.12 `25 `20.83
(i) Value per 
0.1 `45.830.12
Share 2

(ii) Optimum payout Ratio: since the company‘s earning capacity i.e. ROI (of 15%) is
greater than Shareholder‘s Expectation (of 12%), the shareholder‘s Wealth would
be maximizedat ―Zero‖ payout, i.e. Nil Dividend.
 Financial Management

PART-I – Objective Question

1. (a) Multiple Choice Questions (MCQ)

(i) Which of the following is not a characteristic of GDR?
(A) Is a negotiable instrument
(B) Carry voting rights
(C ) Freely tradable in International Market
(D) Denominated in US Dollars.
(ii) Which of the following is a feature of Factoring?
(A) Tool of short term borrowing
(B)Purchase of export bill only.
(C)Used in Export business only.
(D)Done without recourse to the client.
(iii) Which of the following is a Profitability Ratio?
(A) Proprietary Ratio
(B)Debt – equity Ratio
(C )Price Earnings Ratio
(D)Fixed Asset Ratio.
(iv) GP Margin=20%, GP= ₹54000, Sales=
(A) ₹300000
(B) ₹270000
(C) ₹280000
(D) ₹290000
(v) EBIT=₹1120000, PBT=₹320000, Fixed Costs= ₹700000, Operating Leverage=
(A) 1.625
(B) 2.625
(C) 6.625
(B) 3.625
(vi) Which of the following is not a Source of Fund?
(A) Issue of Capital
(B) Issue of Debenture
(C) Decrease in working capital
(D)Increase in working capital.
(vii) Determinants of credit policy relates to:

(A) Credit standards

(B) Credit terms
( C)Collection Procedures
(D)All of the above
(viii) The following is not a Discounted Cas h Flow Technique:

(A) NPV
(B) PI
(C) Accounting of Average rate of return
(D) IRR
(ix) β(Beta ) of a security measures its:

(A) Diversifiable risk

(B) Financial risk
(C) Market risk
(D) None of above.
(x) Following method is also known as ‘Benefit Cost Ratio.’

(A) NPV
(B)IRR
(C)ARR
(D) PI
(b) Match the following:

Column 1 Column 2
(A) Capital Budgeting (i) Money Market Instrument
(B) Commercial Paper (ii) NOPAT/ Sales*Sales/ Average Capital
Employed
(C) Debtors Turnover Ratio (iii)Capital structure theory
(D) ROI (iv)Change in working capital between
two Balance Sheet dates
(E)Fund Flow Stat ement (v) Initial Investment/Annual Cash
Inflows
(F) NPV (vi)Functional area of Financial
Management
(G) Payback Period (vii) Credit Sales/Average collection
period
(H) Net Income Approach (viii)EBIT /EBT
(I) ADR (ix)Negotiable Instrument
(J) Financial Leverage (x)Cost of Capital
(c) State whether the following statement are True/ False.
(i) Cost of capital is highest in Equity share Financing.
(ii) Bill Financing is least liquid from Banker’s point of view
(iii) Payout Ratio=Earning per Equity share /D ividend per equity share
(iv) Liquid Assets=Current Assets- Inventory
(v) Under cash credit/overdraft arrangement , a predetermined limit for borrowing
is specified by the bank.
(vi) As per TANDON Committee norms under method 1 the proprietor should
contribute 75% of Working Capital Gap.
(vii) Value of right=Cum right share price minus Ex right share price
(viii)Combined leverage=Contribution/ EBT
(ix) DPP=Discounted Annual Cash Flow/Investment
(x) Project can be accepted when NPV is positive or at least zero

Ans:

1(a)

(i)-(B) (ii)-(A) (iii)-(C) (iv)-(B) (v)-(A) (vi)-(D)

(vii)-(D) (viii)-(C) (ix)-(C) (x)-(D)

1(b)

(A)-(vi) (B)-(i) (C)-(vii) (D)-(ii) (E)-(iv) (F)-(x)

( G)- (v) (H)-(iii) (I)-(ix) ( J)- (viii)

1(c)

(i)True (ii)False (iii)False (iv)True (v)True (vi)False

(vii)True (viii)True (ix)False (x) True
 Part II: Subjective Questions

Financial Ratio Analysis

2) The following accounting information and financial ratios of PQR Ltd. relate to the year
ended 31st March, 2018:
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 equals to 3 months usage;
stock of finished goods is 6% of works Cost, debt collection period 60 days. All sales are
on credit.
Fixed Assets to Sales 1:3 ; Fixed Assets to Current Assets 13:11 ; Current ratio 2:1 ; Long
term loans to current liabilities 2:1 ; Capital to Reserves & Surplus 1:4.
If value of fixed assets as on 31st March, 2017 amounted to ₹26 lakhs, prepare a
summarised Profit and Loss Account of the company for the year ended 31st March, 2018
and also the Balance Sheet as on 31st March, 2018.

Ans: (2)
(a) ) Working Notes:
(i) Calculation of Sales
Fixed Assets 1

Sales 3
26,00,000 1  Sales ` 78,00,000
  
Sales 3

(ii) Calculation of Current Assets

Fixed Assets 13

Current Assets 11

26,00,000  13  Current Assets ` 22,00,000

Current Assets 11

(iii) Calculation of Raw Material Consumption and Direct Wages

₹
Sales 78,00,000
Less: Gross Profit 11,70,000
Works Cost 66,30,000
Raw Material Consu mption (20% of Works Cost) ₹13,26,000
Direct W ages (10% of Works C ost) ₹ 6,63,000

(iv) Calculation of Stock of Raw Materials (= 3 months usage)

3 ` 3,31,500
= 13,26,000  12

(v) Calculation of Stock of Finished Goods (= 6% of Works Cost)

 6 ` 3,97,800
= 66,30,000 100
(vii) Calculation of Current Liabilities
Current Assets
2
Current Liabilities

22,00,000
 2  Current Liabilities  `11,00,000
Current Liabilities

(vii) Calculation of Debtors

Debtors
Average colle ction period =  365
Credit Sales

Debtors
 365  60  Debtors  `12,82,191.78 or `12,82,192
78,00,000

(viii) Calculation of Long term Loan

Long term Loan 2

Current Liabilities 1
Long termloan
 2 Long termloan  ` 22,00,000.
11,00,000 1
(ix) Calculation of Cash Balanc e
`
Current assets 22,00,000
Less: Debtors 12,82,192
Raw materials stock 3,31,500
Finished goods stock 3,97,800 20,11,492
Cash balan c e 1,88,508
(x) Calculation of Net worth
Fixed Assets 26,00,000
Current Assets 22,00,000
Total Assets 48,00,000
Less: Long term Loan 22,00,000
Current Liabilities 11,00,000 33,00,000
Net worth 15,00,000

Net worth = Share cap ital + Reserves = 15,00,000

1 1
Capital   Share Capital  15,00,000  ` 3,00,000

Reserves and Surplus 4 5

4
Reserves and Surplus  15,00,000  `12,00,000
5
 Profit and Loss Account of PQR Ltd for the year ended 31st March, 2018

Particulars ₹ Particul ars ₹

To Direct Materials 13,26,000 By Sales 78,00,000
To Direct Wages 6,63,000
To Works (Overhead) 46,41,000
Balancing figure

To Gross Profit c/d

(15% of Sales) 11,70,000
78,00,000 78,00,000
To Selling and Distribution 5,46,000 By Gross Profit 11,70,000
Expenses (Balancing b/d
figure)
To Net Profit (8% of Sales) 6,24,000
11,70,000 11,70,000

Balance Sheet of PQR Ltd.as at 31st March, 2018

Liabilities ₹ Assets ₹
Share Capital 3,00,000 Fixed Ass ets 26,00,000
Reserves and Surplus 12,00,000 Current Assets:
Long term loans 22,00,000 Stock of Raw 3,31,500
Material
Current liabilities 11,00,000 Stock of Finished 3,97,800
Goods
Debtors 12,82,192
________ Cash 1,88,508
48,00,000 48,00,000

3) A company has a profit margin of 20% and asset turnover of 3 times. What is the
company’s return on investment? How will this return on investment vary if?
Profit margin is increased by 5%?
Asset turnover is decreased to 2 times?
Profit margin is decreased by 5% and asset turnover is increase to 4 times?
Ans:

Net profit ratio = 20% (given)

Assets turnover ratio = 3 times (given)
Return on Invest ment (ROI) = Net Profit ratio x Assets turnover ratio
= 20% x 3 times = 60%
 If net profit ratio is increased by 5 %:

Then Revised Net Profit Ratio = 20 + 5 = 25%

Asset Turnover Ratio (as before) = 3 times
ROI = 25 % x 3 times = 75%
If assets turnover ratio is decreased to 2 times:

NP Ratio (as before) = 20%

Revised Asset Turnover Ratio = 2 times
ROI = 20% x 2 times = 40 %
If net profit ratio falls by 5% and assets turnover ratio raises to 4 times:

Then Revised NP Ratio = 20 – 5 = 15%

Revised Asset Turnover Ratio = 4 times
 ROI = 15% x 4 = 60%

Cash Flow Analysis

4) From the information contained in Income Statement and Balance Sheet of ‘A’ Ltd.,
prepare Cash Flow Statement:
Income Statement for the year ended March 31, 2018
₹
Net Sales (A) 2,52,00,000
Less:
Cash Cost of Sales 1,98,00,000
Depreciation 6,00,000
Salaries and Wages 24,00,000
Operating Expenses 8,00,000
Provision for Taxation 8,80,000
(B) 2,44,80,000
Net Operating Profit (A – B) 7,20,000
Non-recurring Income – Profits on sale of 1,20,000
equipment
8,40,000
Retained earnings and profits brought forward 15,18,000
23,58,000
Dividends declared and paid during the year 7,20,000
Profit and Loss Account balance as on March 3 1, 16,38,000
2018
Balance Sheet as on
Assets: March 31, 2017 March 31, 2018
(₹) (₹)
Fixed Assets:
Land 4,80,000 9,60,000
Buildings and Equipment 36,00,000 57,60,000
Current Assets:
Cash 6,00,000 7,20,000
Debtors 16,80,000 18,60,000
Stock 26,40,000 9,60,000
Advances 78,000 90,000
90,78,000 1,03,50,000
Liabilities and Equity: March 31, 2017 March 31, 2018
(₹) (₹)
Share Capital 36,00,000 44,40,000
Surplus in Profit and Loss 15,18,000 16,38,000
Account
Sundry Creditors 24,00,000 23,40,000
Outstanding Expenses 2,40,000 4,80,000
Income -tax payable 1,20,000 1,32,000
Accumulated Depreciation
on Buildings and 12,00,000 13,20,000
Equipment
90,78,000 1,03,50,000

The original cost of equipment sold during the year 2017- 18 was ₹ 7,20,000.

Ans:
Cash Flow Statement of Company A Ltd. for the year ending March 31, 2018
Cash flows from Operating Activities
`
Net Profits before Tax and Extra -ordinary Item 16,00,000
Add: Depreciation 6,00,000
Operating Profit s before Working Capital Changes 22,00,000
Increase in Debtors (1,80,000)
Decrease in Stock 16,80,000
Increase in Advances (12,000)
Decrease in Sundry Creditors (60,000)
Increase in Outstanding Expenses 2,40,000
Cash Generated from Operations 38,68,000
Income tax Paid 8,68,000
Net Cash from Operations 30,00,000
 Cash flows from Investment Activities
₹
Purchase of Land (4,80,000)
Purchase of Buildings and Equipment (28,80,000)
Sale of Equipment 3,60,000
Net Cash used in Investment A ctivities (30,00,000)

Cash flows from Financing Activities

₹
Issue of Share Capital 8,40,000
Dividends Paid (7,20,000)
Net Cash from Financing Activities 1,20,000

Net increase in Cash and Cash Equivalents 1,20,000

Cash and Cash Equivalents at the beginning 6,00,000
Cash and Cash Equivalents at the end 7,20,000

Buildings and Equipment Account

₹ ₹
Balance b/d 36,00,000 Sale of Asset 7,20,000
Cash/Bank Balance c/d 57,60,000
(purchase) 28,80,000
(Balancing figure)
64,80,000 64,80,000

Accumulated Depreciation on
Buildings and Equipment Account
₹ ₹
Sale of Asset Balance b/d 12,00,000
(Accumulated 4,80,000 Profit and Loss 6,00,000
depreciation) (Provisional)

Balance c/d 13,20,000

18,00,000 18,00,000

Statement showing Sale of Asset

₹
Original Cost 7,20,000
Less: Accumulated Depreciation 4,80,000
Net Cost 2,40,000
Profit on Sale of Asset 1,20,000
Sale Proceeds from Asset Sales 3,60,000
 Funds Flow Analysis

5) Following are the financial statements of Z Ltd.:

Balance Sheet as on
March 31, March 31,
2017 2016
₹ ₹
Capital and Liabilities:
Share capital, ₹ 10 par value 1,67,500 1,50,000
Share premium 3,35,000 2,37,500
Reserves and Surplus 1,74,300 1,23,250
Debentures 2,40,000

Long-term loans 40,000 50,000
Creditors 28,800 27,100
Bank Overdraft 7,500 6,250
Accrued expenses 4,350 4,600
Income -tax payable 48,250 16,850
10,45,700 6,15,550

March 31, March 31,

2017 2016
₹ ₹
Assets:
Land 3,600 3,600
Building, net of depreciation 6,01,800 1,78,400
Machinery, net of depreciation 1,10,850 1,07,050
Investment in ‘A’ Ltd. 75,000

Stock 58,800 46,150
Prepaid expenses 1,900 2,300
Debtors 76,350 77,150
Trade Investments 40,000 1,05,000
Cash 77,400 95,900
10,45,700 6,15,550

Income Statement
for the year ended March 31, 2017

₹
Net Sales 13,50,000
Less: Cost of goods sold and operating expen ses (including
depreciation on buildings of ₹ 6,600 and depreciation on 12,58,950
machinery of ₹ 11,400)
Net operating profit 91,050
Gain on sale of trade investments 6,400
 Gain on sale of machinery 1,850
Profits before tax 99,300
Income -tax 48,250
Profits after tax 51,050

Additional information:
(i) Machinery with a net book value of ₹ 9,150 was sold during the year.
(ii) The shares of ‘A’ Ltd. were acquired by issue of debentures.
Required:
Prepare a Funds Flow Statement (Statement of changes in Financial position on Working
capital basis) for the year ended March 31, 2017.
Ans:

Schedule of Changes in Working Capital

March 31, March 31, Impact on Working

2017 2016 Capital
Increase Decrease
Current Assets
Stock 58,800 46,150 12,650 

Prepaid expenses 1,900 2,300  400

Debtors 76,350 77,150  800
Trade Inv estments 40,000 1,05,000  65,000
Cash 77,400 95,900  18,500
2,54,450 3,26,500 12,650 84,700
Current Liabilities
Creditors 28,800 27,100  1,700
Bank overdraft 7,500 6,250  1,250
Accrued expenses 4,350 4,600 250 
Income tax pay able 48,250 16,850  31,400
88,900 54,800 250 34,350

Net Working Capital 1,65,550 2,71,700 12,900 1,19,050

Decrease in net working

capital 1,06,150  1,06,150 
2,71,700 2,71,700 1,19,050 1,19,050
 Machinery Account
₹ ₹
Balance b/d 1,07,050 Sale of machinery 9,150
(given)
Purchase of machinery (plug) 24,350 Depreciation (given) 11,400
Balance c/d 1,10,850
1,31,400 1,31,400
Trade Investments Account
₹ ₹
Balance b/d 1,05,000 Cash (sale of trade 65,000
investments)
Balance c/d 40,000
1,05,000 1,05,000
Estimation of Funds flow from Operations
₹
Profits after tax 51,050
Add: Depreciation on Buildings 6,600
Depreciation on Machinery 11,400 18,000
69,050
Less: G ain on sale of machinery 1,850
Funds from Operations 67,200

Gain on sale of trade investments has been considered as an operating income.

Trade investments have been considered as part of current assets.

Statement of Changes in Financial Position (Wo rking Capital basis)

for the year ended March 31, 2017
Sources: ₹
Funds from operations 67,200
Sale of machinery on gain (9,150 + 1,850) 11,000
Debentures issued (₹ 2,40,000 – 75,000) 1,65,000
Investment in ‘A’ Ltd. financial transaction and hence not affecting
working capital
Issue of share capital (including share premium) 1,15,000
Financial Resources Provided 3,58,200
Uses:
Purchase of building (6,01,800 + 6,600  1,78,400) 4,30,000
Purchase of machinery 24,350
Payment of long -term loan 10,000
Financial Resources Applied 4,64,350
Net Decrease in Working Capital 1,06,150
 Working Capital Management

6) Hello Limited is launching a new project for the manufacture of a unique component.
At full capacity of 48,000 units, the cost will be as follows:
Cost per unit ₹
Material 40
Labour and Variable Expenses 20
Fixed Manufacturing and Administrative Expenses 10
Depreciation 5
75
The selling price per unit is expected at ₹100 and the selling expenses per unit will be
₹ 5, 80% of which is variable.
In the first two years production and sales are expected to be as follows:
Year Production Sales
1 30,000 units 28,000 units
2 40,000 units 36,000 units

To assess working capital requirement, the following additional information i s given:

(a) Stock of raw material -3 months’ average consumption.
(b) Work-in-progress-Nil.
(c) Debtors-1 month average sales.
(d) Creditors for supply of materials- 2 months average purchases of the year.
(e) Creditors for expenses- 1 month average of al l expenses during the year.
(f) Cash balance -₹ 20,000
Stock of finished goods is taken at average cost.
You are required to prepare for the two years:
(1) A projected statement of profit/loss
(2) A projected statement of working capital requirements.
Ans:
Hello Ltd.
(1) Projected Statement of Profit/Loss
Year I Year II
₹ ₹

Production in units 15,000 20,000

Sales in units 14,000 18,000
Sales Revenue @ ` 100 per unit (A) 28,00,000 36,00,000
Cost of Production
Material @ ₹ 40 per unit 12,00,000 16,00,000
Direct labour & variable expenses @₹ 20 per 6,00,000 8,00,000
unit
Fixed manufacturing & Administrative expenses 4,80,000 4,80,000
@ ₹10 on 48,000 units

Depreciation @ ₹ 5 for 48,000 units 2,40,000 2,40,000

Total Cost of Production 25,20,000 31,20,000
Add: Opening stock of finished goods at - 1,68,000
 average cost *

*25,20,000  2,000
30,000
Cost of goods available 25,20,000 32,88,000
Less: Closing stock of finished goods at average 1,68,000 4,69,714#
cost
#32,88,000  6,000
42,000
Cost of goods so ld 23,52,000 28,18,286
Add: Selling expenses 1,12,000 1,44,000
(Variable at ₹ 4)
Selling expenses fixed at ₹ 1 48,000 48,000
Cost of Sales (B) 25,12,000 30,10,286
Profit A-B 2,88,000 5,89,714

Working Notes
Year I Year II
₹ ₹
(a) ) Creditors for supply of
material

Materials consumed 12,00,000 16,00,000

Add: Closing stock of Average consumption 3,00,000 4,00,000
(3 months)
15,00,000 20,00,000
Less: Opening Stock - 3,00,000
Purchases 15,00,000 17,00,000
Average purchases per month (Creditors) 1,25,000 1,41,667
Creditors (2 months for goods) 2,50,000 2,83,334
(b) Creditors for expenses 1,03,334* 1,22,667*
Total of Current Liabilities (B) 3,53,334 4,06,001
*Labour, Manufacturing expenses & Sell ing
expenses
6,00,000 8,00,000
4,80,000 4,80,000
1,12,000 1,44,000
48,000 48,000
12,40,000 14,72,000
12 12
(2) Proje cted Statement of Working Capital Requirements
Year I Year II
₹ ₹
Current Assets: 3,00,000 4,00,000
Stock of materials
(3 months average consumption)
Finished Goods 1,68,000 4,69,714
 Debtors (one month) 2,33,334 3,00,000
Cash 20,000 20,000
Total Current Assets 7,21,334 11,89,714
(A)
Current Lia bilities:
Creditors for supply of materials 2,50,000 2,83,334
Creditors for expenses 1,03,334 1,22,667
(See W.N. (b) above) _______ _______
Estimated Working Capital requirement 3,53,334 4,06,001
(B)
Estimated Working Capital 3,68,000 7,83,713

7) A newly formed company has applied to the commercial bank for the first time for
financing its working capital requirements. The following information is available
about the projections for the current year:
Estimated level of activity: 4,16,000 completed units of production plus 16,000 units
of work-in- progress. Based on the above activity, estimated cost per unit is:
Raw material ₹20 per unit
Direct wages ₹7.50 per unit
Overheads (exclusive of depreciation) ₹ 15 per unit
Total cost ₹ 75 per unit
Selling price ₹100 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).
Finished goods in stock 32,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1 1 weeks
2

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.
Find out
(i) the net working capital required; ( on Cost Basis)
(ii) the maximum permissible bank finance under first and se cond methods of
financing as per Tandom Committee Norms.
Ans:

(i) Estimate of the Requirement of Working Capital

₹ ₹
A. Current Assets:
Raw material stock 6,64,615
(Refer to Working note 3)
Work in progress stock 5,00,000
(Refer to Working note 2)
 Finished goods stock 13,60,000
(Refer to Working note 4)
Debtors 25,10,769
(Refer to Working note 5)
Cash and Bank balance 25,000 50,60,384
B. Current Liabilities:
Creditors for raw materi als 7,15,740
(Refer to Working note 6)
Creditors for wages 91,731 8,07,471
(Refer to Working note 7) ________
Net Working Capital (A -B) 42,52,913

(ii) The maximum permissible bank finance as per Tandom Committee Norms
First Method:
75% of the net working capital financed by bank i.e. 75% of ₹ 42,52,913
(Refer to (i) above)
= ₹ 31,89,685
Second Method:
(75% of Current Assets) - Current liabilities (i.e. 75% of ₹ 50,60,384) - ₹ 8,07,471
(Refer to (i) above)
= ₹37,95,288 – ₹ 8,07,471
= ₹ 28,87,817

Working Notes:
1. Annual cost of production
₹
Raw material requirements (4,16,000 units  ₹20) 83,20,000
Direct wages (4,16,000 units  ₹ 7.50) 31,20,000
Overheads (exclusive of depreciation)(4,16,000  ₹15) 62,40,000
1,76,80,000
2. Work in progress stock
₹
Raw material requirements (16,000 units  ₹ 20) 3,20,000
Direct wages (50%  16,000 units  ₹7.50) 60,000
Overheads (50%  16,000 units  ₹15) 1,20,000
5,00,000
3. Raw material stock
It is given that raw material in stock is aver age 4 weeks consumption. Sinc e, 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 (52 weeks) is as fol lows:
₹
For Finished goods 83,20,000
For Work in progress 3,20,000
86,40,000
 ` 86,40,000  4 weeks
Raw material stock 52 weeks = ₹6,64,615
4. Finished goods stock

32,000 units @ ₹ 42.50 per unit = ₹ 13,60,000

5. Debtors for sale
Credit allowed to debtors Average 8
weeks
Credit sales for year (52 weeks) i.e. (4,16,000 units - 3,84,000 units
32,000 units)
Selling price per unit ₹ 100
Credit sales for the ye ar (3,84,000 units  ₹ 42.50 ) ₹1,63,20,000
Debtors ` 1,63,20,000  8 weeks
52 weeks = ₹ 25,10,769
6. Creditors for raw material:
Credit allowed by suppliers Average 4 weeks
Purchases during the ye ar (52 weeks) i.e. ₹93,04,615
(₹83,20,000 + ₹ 3,20,000 + ₹ 6,64,615)
(Refer to Working notes 1,2 and 3 above)
Creditors ` 93.04.615  4 weeks
52 weeks =₹7,15,740
7. Creditors for wages
Lag in payment of wages Average 1
1
weeks
2
Direct wages for the year (52 weeks) i.e. =₹31,80,000
(₹31,20,000 + ₹60,000)
(Refer to Working notes 1 and 2 above)
Creditors ` 31,80,000 1 1 weeks
52 weeks 2
= ₹91,731

8) The following information has been extracted from the records of a Company:
Product Cost Sheet ₹/unit
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120

 Raw materials are in stock on an average of two months.

– The materials are in process on an average for 4 weeks. Th e degree of
completion is 50%.
 Finished goods stock on an average is for one month.
 Time lag in payment of wages and o verheads is 1½ weeks.
 Time lag in receipt of proceeds from debtors is 2 months.
 Credit allowed by suppliers is one month.
  20% of the output is sold against cash.
 The company expects to keep a Cash balance of ₹ 2,00,000.
 Take 52 weeks per annum .

The Company is poised for a manufacture of 1,50,000 units in the year. You are required
to prepare a statement showing the Working Capital requirements of the Company.

Ans:
Statement showing the Working Capital Requirement
Current Assets: ₹
Stock of raw materials 11,25,000
[₹67,50,000 / 12 months)  2 months
Work-in-progress 6,05,769
[(₹1,57,50,000  4) / 52 months]  50%
Finished goods 13,12,500
(₹1,57,50,000 / 12 months)
Debtors 24,00,000
(₹30,00,000  80%)
(Refer to Working not e 2)
Cash b alanc es 2,00,000
56,43,256
Current Liabilities:
Creditors of raw materials 5,62,500
(₹67,50,000 / 12 months)
Creditors for wages & overheads 2,59,615
 ` 90,00,000 

52 weeks 1.5 weeks 
 
Net Working Capital (C.A  C.L) 48,21,154

Working Notes:
1, Annual raw materials requirements ( ₹) 67,50,000
1,50,000 units  ₹45
Annual direct labour cost ( ₹) 30,00,000
1,50,000 units  ₹20
Annual overhead costs ( ₹) 60,00,000
1,50,000 units  ₹40
Total Cost ( ₹) 1,57,50,000
2. Total Sales: 1,80,00,000
(1,50,000 units  ₹120)
Two months sales 30,00,000
(₹1,80,80,000 / 6 months)
 Leverage Analysis

9) Calculate the operating leverage and financial leverage under situation A, B and C and
financial plans I, II and III respecti vely from the following information relating to the
operational and capital structure of XYZ Co. Also find out the combinations of operating
and financial leverage which give the highest value.

Installed Capacity 1200

units
Actual production and
800 units
sales
Selling price per unit ₹15
Variable cost per unit ₹10
Fixed cost Situation A ₹1000
Situation B ₹2000
Situation C ₹3000

Capital Structure Financial Plan

Equity 5,000 7,500 2,500
Debt 5,000 2,500 7,500
Cost of debt 12%
Answer
Calculation of Leverages under various Situations and Financial Plans:
A B C
Sales 12000 12000 12000
(-) variable cost 8000 8000 8000
Contribution 4000 4000 4000
(-) fixed cost 1000 2000 3000

EBIT 3000 2000 1000

DOL (Degree of Operating Leverage) 1.33 2 4

(C / EBIT) 1 2 3

Situation A

EBIT 3000 3000 3000

(-) interest 600 300 900

EBT 2400 2700 2100

DFL (EBIT / EBT) 1.25 1.11 1.43

Situation B

EBIT 2000 2000 2000

(-) interest 600 300 900

 EBT 1400 1700 1100

DFL (EBIT / EBT) 1.43 1.18 1.82

Situation C

EBIT 1000 1000 1000

(-)Interest 600 300 900

EBT 400 700 100

DFL 2.5 1.43 10

Situation C in plan 3 is 40 times variation gives maximum value.

10) 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. Show, how does the
M-M approach affect the value of M Ltd., if dividends are paid or not paid.

Ans:
(1) When dividend is paid
(a) Price per share at the end of year 1
100 = 1 (` 5 P 1)
1.10
110 = ₹5 + P1
P1 = 105
(b) Amount required to be raised from issue of new shares
₹5,00,000 – (2,50,000 – 1,25,000)
₹5,00,000 – 1,25,000 = ₹3,75,000
(c) Number of additional shares to be issued
3,75,000  75,000 shares or sa y 3572 shares
105 21
(d) Value of M Ltd.
(Number of shares × Expected Price per share)
i.e., (25,000 + 3,572) × ₹105 = ₹30,00,060

(2) When dividend is not paid

(a) Price per share at the end of year 1
p
100  1 P1 = 110
1.10
 (b) Amount required to be raised from issue of new shares
₹5,00,000 – 2,50,000 = 2,50,000

(c) Number of additional shares to be issued

2,50,000 25,000
 shares or say 2273 shares.
110 11

(d) Value of M Ltd.,

(25,000 + 2273) × ₹110
= ₹30,00,030
Whether dividend is paid or not, the value remains the same.

Cost of Capital

11) Determine the cost of capital for H P Ltd using the book (BV) and market value (MV)
weights from the following information:

Equity Shares: ₹ 1,20,00,000 (₹2,00,00,000, MV)

Retained earnings: ₹30,00,000
Preference Shares: ₹ 9,00,000 (₹10,40,000, MV)
Debentures: ₹ 36,00,000 (₹ 33,75,000, MV)

Additional information:
(i) Equity: Equity shares are quoted at ₹ 130 per share and a new issue priced at ₹125
will be fully subscribed; flotation costs will be ₹ 5 per share.
(ii) Dividend: During the previous 5 years, dividends have steadily grown from ₹10.60 to
₹ 14.19. Dividend at the current year - end is expected to be ₹15 per share.
(iii) Preference shares : 15% Irredeemable 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 ra te is 35%. Ignore dividend tax.

Ans: Specific cost of capital:

Where
[10.6 x (1 + g) 5 = 14.19, g = 6%]
 In order to earn 16% yield the company has to issue debentures at discount which is
calculated as follows:
(100 x 15) / 16 = ₹ 93.75  issue price

Calculation of K O (WACC)

Book value basis:

Rs Weight Cost of KO
Source capital
Equity 12000000 0.6154 18.50% 11.38
Reserves 3000000 0.1538 18.00% 2.76
Preference 900000 0.0462 14.29% 0.66
Debentures 3600000 0.1846 11.00% 2.03
19500000 16.84 %

Market value basis:

Source Rs Weight Cost of KO
capital
Equity 16000000 0.6553 18.50% 12.12
Reserves 4000000 0.1638 18.00% 2.95
Preference 1040000 0.0426 14.29% 0.61
Debentures 3375000 0.1383 11.00% 1.52
24415000 17.20%
 Capital Structure

12) In considering the most desirable capital structure of a company, the following estimates
of the cost of debt and equity capital (after tax) have been made at various levels of Debt
–equity Mix.
Debt as % of total capital Cost of Debt % Cost of equity %
employed
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
Calculate the optimal Debt- Equity Mix for the company by calculating composite cost
of capital.
Ans:
Composite cost of capital is calculated as follows:
Debt as
0 10 20 30 40 50 60
%of capital
Cost of
5.0 5.0 5.0 5.5 6.0 6.5 7.0
Debt %
Cost of
Equity% 12.0 12.0 12.5 13.0 14.0 16.0 20.0

0%*5+ 20%*5 30%*5.5

Composite 10%*5 40%*6+ 50%*6.5 60%*7
100%*12. +80%*12 +
cost of +90%*12 60%*14 +50%*16 40%*20
00 .5= 70%*13
capital 11.30 =10.8 =11.25 =12.20
12 11 =10.75

13) Project A and B are analysed and you have determined the following parameters.
Advise the investor on the choice of a project.
Particulars Project A Project B
Investment ₹8cr ₹6cr
Project Life 8years 10 years
Construction period 4 years 4 years
Cost of Capital 15% 18%
NPV @12% ₹3700 ₹4566
NPV @18% ₹425 ₹425
IRR 45% 32%
Rate of Return 20% 27%
Payback 5 years 7 years
BEP 45% 35%
Profitability Index 1.70 1.30
 COMPILED BY CMA AFSAL ALUNGAL

Ans:
Determination of priority of the project
A B
NPV at 12% II I
NPV at 18% Same Same
IRR I II
ARR II I
Payback I II
PI I II

Decision:
(i)As the outlays in the projects are different, NPV is not suitable for e valuation.
(ii)As there is a different life period, ARR is not appropriate for evaluation.
On basis of remaining evaluation methods (IRR, PBP, PI) project A is occupied first
priority. Hence , it is advised to choose Project A.

14) Company X is forced to c hoose 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’ mod el 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 12 per cent. Which ma chine company X should buy?
Ans:
Statement showing the evaluation of two machines
Machines A B
Purchase cost ( ₹): (i) 1,50,000 1,00,000
Life of machines (ye ars) 3 2
Running cost of machine per year ( ₹): (ii) 40,000 60,000
Cumulative present value factor for 1 -3 years @ 12% (iii) 2.4018 
Cumulative present value factor for 1 -2 years @ 10% (iv)  1.6901
Present value of running cost of machines ( ₹): (v) 96,072 1,01,406
[(ii)  (iii)] [(ii)  (iv)]
Cash outf low of machines ( ₹): (vi) = (i) + (v) 2,46,672 2,01,406
Equivalent present value of annual cash outflow 1,02,453 1,19,168
[(vi)  (iii)] [(vi)  (iv)]

Decision: Company X should buy machine A since its equivalent cash outflow is less
than machine B.

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Part III: Short Questions

15) Write short note on:
a) ADRs
b) Debt Service Coverage Ratio
c) Working Capital Cycle
d) Marginal Cost of Capital
e) Discounted Cash Flow Techniques

15 ( a) American Depository Receipt (ADR)

The depository re ceipt in the US market is called ADR. ADRs are those which are issued
and listed in any of the stock exchanges of US. It is an investment in the stock of
non- US corporation trading in the US stock exchange.
Characteristics:

1. The ADRs may or may not have voting rights .

2. The ADRs are issued in accordance with the provisions laid by SEC, USA.
3. The ADRs are bearer negotiable instrument and the holder can sell it in the
market.
4. The ADRs once sold can be re - issued. The operation of ADR - similar to that
of GDR
Advantages

1. The ADRs are an easy cost effective way for individuals to hold and own
shares in a foreign country.
2. They save considerable money by reducing administration cost and
avoiding foreign taxes on each transaction.
15 (b)
Debt Service Coverage Ratio (DSCR)

This ratio indicates whether the business is earning sufficient profits to pay not only the
interest charged, but also whether due of the principal amount. The ratio is calculated as
follows:
Debt Service Coverage Ratio = [Profit after Taxe s + Depreciation + Interest on Loan]/ [
Interest on Loan + Loan repayment in a year]
Significance: The ratio is the key indicator to the lender to assess the extent of ability of
the borrower to service the loan in regard to timely payment of interest and
repayment of loan installment. A ratio of 2 is considered satisfactory by the financial
institutions the greater debt service coverage ratio indicates the better debt servicing

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 COMPILED BY CMA AFSAL ALUNGAL

capacity of the organization.

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 COMPILED BY CMA AFSAL ALUNGAL

15(c) Working Capital Cycle or Operating Cycle a re synonymous terms in the context of
management of working capital. Any business concern, whether it is of
financial nature, trade organisation or a manufacturing organisation needs certain
time to net fruits of the efforts. That is, by investment of cash , producing or doing
something for some time will fetch profit. But soon after the investment of cash, it
cannot get that profit by way of cash again immediately. It takes time to do so.
The time required to take from investment of cash in some assets and
conversion of it
again into cash termed as operating or working capital cycle. Here the cycle refers to
the time period. Chart for Operating Cycle or Working Capital Cycle.

15(d) Marginal Cost of Capital

The weighted average cost of capital can be worked out on the basis of
marginalcost of capital than the historical costs. The weighted average cost of new
orincremental capital is known as the marginal cost of capital. This concept is used in
capital budgeting decisions. The marginal cost of capital is derived, when we
calculate the weighted average cost of capital using the marginal weights. The
marginal cost of capital would rise whenever any component cost increases. The
marginal cost of capital should be used as the cut off rate. The average cost
ofcapital should be used to evaluate the impact of the acceptance or rejection of the
entire capital expenditure on the value of the firm.

15(e) Discounted Cash Flow Techniques:

The discounted cash flow methods provide a more objective basis for evaluating a

ndselecting an investment project. These methods consider the magnitude and timing
of cash flows in each period of a project‘s life. Discounted Cash Flows methods
enable
us to isolate the differences in the timing of cash flows of the project by discounting
them to know the present value. The present value can be analyses to determine the
desirability of the project. These techniques adjust the cash flows over the life of a
project for the time value of money.

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The popular discounted cash flows techniques are:

(a) Net Present Value
(b) Internal Rate of Return, and
(c) Profitability Index

YOU TUBE :- “AFSAL ALUNGAL CLASSES” 81