CA Aspirants - ICAN

CA INTER

Financial Management

ICAI
PAST YEAR QUESTIONS

By

CA. Namit Arora Sir

This book is dedicated to my siblings

Mr. Manik Arora

&
Ms. Aarzoo Arora
 PREFACE TO THIS EDITION
This is a comprehensive book having thoroughly explained concepts with lucid
and systematic presentation of the subject matter. All attempts are made in this
book to keep concept easier to understand and remember with 100% coverage
of institute materials.
A special attention is given to presentation keeping in mind the
examination needs to the student. The book is primarily written exclusively for
CA - Inter.

For any suggestion please mail me at canamitarora@gmail.com

A word to the students

My dear student, hard work is the key to success. Though smart work is
publicized in today’s world but to be smart, you have to work hard. So always be
attentive in class and have thorough revision after the class. It is also important
to be motivated and inspired for working hard. The key for success is:

“Work hard in class, be attentive, grab the concepts and

appear in all tests
&
Work smart during revision, select important questions for
next revision.”

ALL THE BEST

CA. NAMIT ARORA
 INDEX
S. NO. CHAPTER NAME PAGE NO. MARKS

1 EBIT & EPS ANALYSIS 1.01 – 1.12 5 – 10

2 LEVERAGE 2.01 – 2.26 5 – 10

3 MANAGEMENT OF RECEIVABLES 3.01 – 3.18 5 – 10

4 MANAGEMENT OF WORKING 4.1 – 4.23 10

CAPITAL

5 MANAGEMENT OF CASH 5.1 – 5.7 5 – 10

6 RATIO ANALYSIS 6.1 – 6.27 5 – 10

7 CAPITAL BUDGETING 7.1 – 7.30 10

8 RISK ANALYSIS IN CAPITAL 8.1 – 8.4 5

BUDGETING

9 COST OF CAPITAL 9.1 – 9.19 5 – 10

10 CAPITAL STRUCTURE 10.1 -10.8 5 – 10

11 DIVIDEND DECISIONS 11.1 -11.4 5

 CHAPTER – 1

EBIT & EPS ANALYSIS

LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Understand relationship between EBIT and EPS.
 Understand basis of selection of best capital structure out of
various options.
 Understand how to calculate and interpret indifference point
between two different capital structures?
 Calculate a firm’s financial break-even point.
 Understand EBIT and EPS graph and it’s application in decision
making or selection of proper alternative of financing.
 EBIT - EPS ANALYSIS 1.2

PAST YEARS QUESTIONS

PYQ 1
The Modern Chemicals Ltd. 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 projects by raising debt of `2,50,000 or `10,00,000 or
`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% up to `2,50,000 at 15% over `2,50,000 and upto `10,00,000 and at 20% over
`10,00,000. The tax rate applicable to the company is 50%.
Which form of financing should the company choose?
[(7 Marks) Nov 1999]

Answer
Statement of EPS
Alternatives
Particulars
1 2 3
Earnings before interest and tax 5,00,000 5,00,000 5,00,000
Less: Interest:
@ 10% on first `2,50,000 25,000 25,000 25,000
@ 15% on `2,50,001 to `10,00,000 - 1,12,500 1,12,500
@ 20% on above `10,00,000 - - 1,00,000
EBT 4,75,000 3,62,500 2,62,500
Less: Tax @ 50% 2,37,500 1,81,250 1,31,250
EAT 2,37,500 1,81,250 1,31,250
÷ No. of Equity shares 15,000 10,000 8,000
(22,50,000/150) (15,00,000/150) (10,00,000/125)
EPS `15.833 `18.125 `16.406
Decision:
The earning per share is higher in alternative II i.e. if the company finance the project by raising debt of
`10,00,000 & issue equity shares of `15,00,000. Therefore, the company should choose this alternative to
finance the project.

PYQ 2
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:
(a) The additional funds were raised as debt
(b) The additional funds were raised by issue of equity shares.

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

[(6 Marks) Nov 2002]
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 EBIT - EPS ANALYSIS 1.3

Answer
(i) Statement of EPS
Alternatives
Particulars
Debt Plan Equity Plan
Earnings before interest and tax @ 14% of `34,00,000 4,76,000 4,76,000
Less: Interest:
Existing 1,20,000 1,20,000
New (12% on `4,00,000) 48,000 -
EBT 3,08,000 3,56,000
Less: Tax @ 50% 1,54,000 1,78,000
EAT 1,54,000 1,78,000
÷ No. of Equity shares
Existing 80,000 80,000
New - 40,000
EPS `1.925 `1.483
Working notes:
1. Calculation of capital employed before expansion plan:
Equity share capital `8,00,000
Retained earnings `12,00,000
Debentures (1,20,000/12%) `10,00,000
Total capital employed `30,00,000
2. Earnings before the payment of Interest and tax (EBIT):
Profit before tax `3,00,000
Interest `1,20,000
EBIT `4,20,000
3. Return on Capital Employed (ROCE):
EBIT 4,20,000
ROCE = × 100 = × 100 = 14%
Capital Employed 30,00,000

4. After expansion capital employed = `34,00,000 (`30,00,000 + `4,00,000)

(ii) Advise to the company: Since EPS is greater in the case when company arranges additional funds as
debt. Therefore, the company should finance the expansion scheme by raising debt.

PYQ 3
Calculate the level of earnings before interest and tax (EBIT) at which the EPS indifference point between
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% debenture
`4,00,000.
Assume the corporate tax rate is 35% and par value of equity share is `10 in each case.
[(5 Marks) May 2003]

Answer
Calculation of Indifference point:
EBIT  I 1  T =
EBIT  I 1  T  PD
N1 N2
EBIT  48,000 1  0.35 =
EBIT  48,000 1  0.35  28,000
60,000 40,000
EBIT = `1,77,231 approximately
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 EBIT - EPS ANALYSIS 1.4

PYQ 4
A Company needs `31,25,000 for the construction of 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 ordinary equity shares at `10 per share and 15,625 debentures of
`100 denomination bearing 8% rate of interest.
(III) The Company may issue 1,56,250 equity shares at `10 per share and 15,625 preference shares at `100
per share bearing a 8% rate of dividend.
Required:
(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 formula between Financing Plan I and Plan II and Plan I
and Plan III.
[(10 Marks) Nov 2005]

Answer
(i) Statement showing EPS with respect to various plans & different EBIT:
a. Equity Financing
Particulars ` ` ` ` `
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)
EAT 37,500 75,000 1,50,000 2,25,000 3,75,000
÷ No. of Equity Shares ÷ 3,12,500 ÷ 3,12,500 ÷ 3,12,500 ÷ 3,12,500 ÷ 3,12,500
EPS `0.12 `0.24 `0.48 `0.72 `1.20

b. Debt - Equity Mix

Particulars ` ` ` ` `
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)
EAT (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
EPS (`0.24) `0.00 `0.48 `0.96 `1.92

c. Preference Share - Equity Mix

Particulars ` ` ` ` `
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)
EAT 37,500 75,000 1,50,000 2,25,000 3,75,000
Less: Preferential Dividend (1,25,000)* (1,25,000)* (1,25,000) (1,25,000) (1,25,000)
EAT 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
*25,000 is the tax saving in case of loss ‘we will discuss it in chapter capital budgeting’.
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 EBIT - EPS ANALYSIS 1.5

*In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits.

(ii) 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.

(iii) Computation of EBIT – EPS indifference points:

Between financing Plan I & Plan II:
EBIT  I 1  T = EBIT  I 1  T
N1 N2
EBIT  Nil  1  0.40 =
EBIT  1,25,000 1  0.40
3,12,500 1,56,250
EBIT = 2,50,000
Between financing Plan I & Plan III:
EBIT  I 1  T =
EBIT  I 1  T  PD
N1 N3
EBIT  Nil 1  0.40 =
EBIT  Nil 1  0.40  1,25,000
3,12,500 1,56,250

EBIT = 4,16,667 approx

PYQ 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:

(i) Proposals Equity Shares (%) Debts (%) Preference shares (%)
P 100 - -
Q 50 50 -
R 50 - 50

(ii) Cost of debt and preference shares is 10% each.

(iii) Tax rate 50%.
(iv) Equity shares of the face value of `10 each will be issued at a premium of `10 per share.
(v) Total investment to be raised `40,00,000.
(vi) 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:

(1) Earnings per share

(2) Financial break-even-point
(3) Compute the EBIT range among the plans for indifference. Also indicate if any of the plans dominate.

[(12 Marks) May 2011]

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 EBIT - EPS ANALYSIS 1.6

Answer
(i) Statement of EPS
Alternatives
Particulars
P Q R
Earnings before interest and tax 18,00,000 18,00,000 18,00,000
Less: Interest @ 10% on `20,00,000 - 2,00,000 -
EBT 18,00,000 16,00,000 18,00,000
Less: Tax @ 50% 9,00,000 8,00,000 9,00,000
EAT 9,00,000 8,00,000 9,00,000
Less: Preference Dividend - - 2,00,000
Earning Available for Equity Shareholders 9,00,000 8,00,000 7,00,000
÷ No. of Equity shares (Issue price `20) 2,00,000 1,00,000 1,00,000
EPS `4.50 `8.00 `7.00
Recommendation: Company should select debt option having highest EPS among different plans.

(ii) Financial Break Even Point (EBIT equals to fixed financial cost):
Proposal P Financial B.E.P. = No Fixed Financial Cost = Zero
Proposal Q Financial B.E.P. = Interest on Debt = 2,00,000
Pr eference Dividend
Proposal R Financial B.E.P. = Gross Preference Dividend =
(1  t )
2,00,000
= = 4,00,000
1  0.50
(iii) Indifference Point:
Between Proposal P & Q:
EBIT  I 1  T = EBIT  I 1  T
N1 N2
EBIT  Nil  1  0.50 =
EBIT  2,00,000 1  0.50
2,00,000 1,00,000
EBIT = `4,00,000
Between Proposal P & R:
EBIT  I 1  T =
EBIT  I 1  T PD
N1 N3
EBIT  Nil  1  0.50 =
EBIT  Nil  1  0.40 2,00,000
2,00,000 1,00,000
EBIT = `8,00,000
Between Proposal Q & R:
If No. of equity shares between two plans are same then, indifference point can’t be calculate due to
difference in fixed financial cost in Proposal Q and R. Proposal Q having lower financial fixed cost is always
better than Proposal R having higher financial fixed cost.
Alternatively:
EBIT  I 1  T =
EBIT  I 1  T  PD
N2 N3
EBIT  2,00,000 1  0.50 =
EBIT  Nil  1  0.40  2,00,000
1,00,000 1,00,000
0.5 EBIT – 1,00,000 ≠ 0.5 EBIT – 2,00,000

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 EBIT - EPS ANALYSIS 1.7

There is no indifference point between proposal ‘Q’ and proposal ‘R’

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.

PYQ 6
X Ltd. is considering the following two alternative financing plans:

Particulars 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 30%.

Calculate the rate of dividend on preference shares.

[(Marks 5) Nov 2013]

Answer
Pr eference Dividend 16,800
Rate of dividend = × 100 = × 100 = 8.40%
Pr eference Share Capital 2,00,000

Working Notes:
Calculation of preference dividend:
EBIT  I 1  T = [EBIT  I 1  T ]  PD
N1 N2
2,40,000  24,000 1  0.30 =
[2,40,000  Nil  1  0.30]  PD
40,000 40,000
1,51,200 = 1,68,000 – PD

Preference dividend (PD) = 16,800

Alternatively:
In this question number of equity shares are same under both financing plans. Hence, Kd of plan I must be
equal to Kp of Plan II at indifference point.
Kd = Kp
Kd = I (1 - t)
= 12% (1 - .30)
Kp or rate of preference dividend = 8.40%

PYQ 7
Alpha Ltd. requires funds amounting to `80,00,000 for its new project. To raise the funds, the company has
following two alternatives:
(1) To issue Equity Shares of `100 each (at par) amounting to `60,00,000 and borrow the balance amount
at the interest of 12% p.a.; or
(2) To issue Equity Shares of `100 each (at par) and 12% Debentures in equal proportion.
Find out the point of indifference between two modes of financing and state which option will be
beneficial in different situations assuming tax rate 30%.
[(Marks 5) Nov 2014]

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 EBIT - EPS ANALYSIS 1.8

Answer
Calculation of Indifference two modes of financing:
EBIT  I 1  T = EBIT  I 1  T
N1 N2
EBIT  12% of 20 lakhs 1  0.30 = EBIT  12% of 40 lakhs 1  0.30
60,000 40,000
EBIT = `9,60,000
Course of action:
(a) If expected EBIT is less than `9,60,000 : Alternate 1
(b) If expected EBIT is equal to `9,60,000 : Alternate 1 or 2
(c) If expected EBIT is more than `9,60,000 : Alternate 2

PYQ 8
India Limited requires `50,00,000 for a New Plant. This Plant 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 3 alternatives to finance the Project: by raising Debt of `5,00,000 or `20,00,000 or `30,00,000
and the balance in each case, by issuing Equity Shares. The Company’s Share is currently selling at `150, but it
is expected to decline to `125 in case the funds are borrowed in excess of `20,00,000.
The Funds can be borrowed at the rate of 9% upto `5,00,000, at 14% over `5,00,000 and upto
`20,00,000 and at 19% over `20,00,000. The Tax rate applicable to the Company is 40%.
Which form of financing should the Company choose? Show EPS Amount upto two decimal points.
[(Marks 8) Nov 2016]

Answer
Statement of EPS
Alternatives
Particulars
1 2 3
Earnings before interest and tax 10,00,000 10,00,000 10,00,000
Less: Interest:
@ 9% on first `5,00,000 45,000 45,000 45,000
@ 14% on `5,00,001 to `20,00,000 - 2,10,000 2,10,000
@ 19% on above `20,00,000 - - 1,90,000
EBT 9,55,000 7,45,000 5,55,000
Less: Tax @ 40% 3,82,000 2,98,000 2,22,000
EAT 5,73,000 4,47,000 3,33,000
÷ No. of Equity shares 30,000 20,000 16,000
(45,00,000/150) (30,00,000/150) (20,00,000/125)
EPS `19.10 `22.35 `20.8125

Decision:
The earning per share is higher in alternative II i.e. if the company finance the project by raising debt of
`20,00,000 & issue equity shares of `30,00,000. Therefore, the company should choose this alternative to
finance the project.

PYQ 9
The X Ltd. Is willing to raise funds for its new project which requires an investment of `84,00,000. The
company has two options:

Option 1: To issue Equity Shares (`10 each) only.

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 EBIT - EPS ANALYSIS 1.9

Option 2: To avail term loan at an interest rate of 12%. But in this case, as insisted by the financing agencies,
the company will have to maintain a debt equity ratio of 2 : 1.

Find out the point of indifference for the project if corporate tax rate is 30%.
[(Marks 5) Nov 2017]

Answer
Calculation of point of Indifference:
EBIT  I 1  T = EBIT  I 1  T
N1 N2
EBIT  Nil  1  0.30 = EBIT  12% of 56,00,000 1  0.30
8,40,000 2,80,000
EBIT = `10,08,000

Calculation of amount of Debt and Equity in option 2:

Debt amount = 84,00,000 × 2/3 = 56,00,000
Equity amount = 84,00,000 × 1/3 = 28,00,000

PYQ 10
Sun Ltd. is considering two financing plans. Details of which are as under:
(a) Funds requirement is `100 Lakhs.
(b) Financial plans:
Plan Equity Debts
I 100% -
II 25% 75%
(c) Cost of debt is 12% p.a.
(d) Tax rate is 30%
(e) Equity shares `10 each, issued at a premium of `15 per share
(f) Expected earnings before interest and tax (EBIT) `40,00,000

You are required to compute:

(1) EPS in each of them plan
(2) The Financial break-even-point
(3) Indifference point between I and II
[(5 Marks) May 2018]

Answer
(1) Statement of EPS
Alternatives
Particulars
Plan I Plan II
Earnings before interest and tax 40,00,000 40,00,000
Less: Interest @ 12% on `75,00,000 - 9,00,000
EBT 40,00,000 31,00,000
Less: Tax @ 30% 12,00,000 9,30,000
EAT 28,00,000 21,70,000
÷ No. of Equity shares (Issue price `25) ÷ 4,00,000 ÷1,00,000
EPS `7.00 `21.70
Calculation of amount of number of Equity shares:
Under Plan I = 1,00,00,000 ÷ 25 (10 + 15) = 4,00,000
Under Plan I = 25,00,000 ÷ 25 (10 + 15) = 1,00,000
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 EBIT - EPS ANALYSIS 1.10

(2) Financial Break Even Point (EBIT equals to fixed financial cost):
Plan I Financial B.E.P. = No Fixed Financial Cost = Zero
Plan II Financial B.E.P. = Interest on Debt = 9,00,000

(3) Indifference Point:

(EBIT − I) (1 − t) (EBIT − I) (1 − t)
=
N1 N1
(EBIT − Nil) (1 − 0.30) (EBIT −9,00,000) (1 − 0.30)
=
4,00,000 1,00,000
EBIT = `12,00,000

PYQ 11
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 of `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% upto `5,00,000 and at 10% over `5,00,000. The tax rate applicable to the company is 25%.
Which form of financing should the company choose?
[(5 Marks) Nov 2018]

Answer
Statement of EPS
Alternatives
Particulars
1 2
Earnings before interest and tax 10,00,000 10,00,000
Less: Interest:
@ 12% on first `5,00,000 60,000 60,000
@ 10% on `5,00,001 to `20,00,000 - 1,50,000
EBT 9,40,000 7,90,000
Less: Tax @ 25% 2,35,000 1,97,500
EAT 7,05,000 5,92,500
÷ No. of Equity shares 15,000 10,000
(45,00,000/300) (30,00,000/300)
EPS `47.00 `59.25
Decision:
The earning per share is higher in alternative II i.e. if the company finance the project by raising debt of
`20,00,000 & issue equity shares of `30,00,000. Therefore, the company should choose this alternative to
finance the project.

PYQ 12
RM Steels Limited requires `10,00,000 for the construction of new plant. It is considering three financial plans:
(1) The Company may issue 1,00,000 ordinary shares at `10 per share.
(2) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 debentures of `100
denomination bearing 8% rate of interest.
(3) The Company may issue 50,000 ordinary shares at `10 per share and 5,000 preference shares at `100
per share bearing a 8% rate of dividend.
If RM Steels Limited’s earnings before interest and taxes are `20,000, `40,000, `80,000, `1,20,000 and
`2,00,000, you are required to compute the earning per share under each of the three plans? Which
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 EBIT - EPS ANALYSIS 1.11

alternative would you recommend for RM Steels and why? Tax rate is 50%.
[(10 Marks) May 2019]

Answer
1. Statement showing EPS with respect to various plans & different EBIT:
a. Equity Financing
Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% (10,000) (20,000) (40,000) (60,000) (1,00,000)
EAT 10,000 20,000 40,000 60,000 1,00,000
÷ No. of Equity Shares ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000 ÷ 1,00,000
EPS `0.10 `0.20 `0.40 `0.60 `1.00

b. Debt - Equity Mix

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest (40,000) (40,000) (40,000) (40,000) (40,000)
EBT (20,000) 0 40,000 80,000 1,60,000
Less: Tax @ 50% 10,000* 0 (20,000) (40,000) (80,000)
EAT (10,000) 0 20,000 40,000 80,000
÷ No. of Equity Shares ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000
EPS (`0.20) `0.00 `0.40 `0.80 `1.60

c. Preference Share - Equity Mix

Particulars ` ` ` ` `
EBIT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Interest 0 0 0 0 0
EBT 20,000 40,000 80,000 1,20,000 2,00,000
Less: Tax @ 50% (10,000) (20,000) (40,000) (60,000) (1,00,000)
EAT 10,000 20,000 40,000 60,000 1,00,000
Less: Preferential Dividend (40,000)** (40,000)** (40,000) (40,000) (40,000)
EAT after Pref. Dividend (30,000) (20,000) 0 20,000 60,000
÷ No. of Equity Shares ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000 ÷ 50,000
EPS (`0.60) (`0.40) `0.00 `0.40 `1.20
*10,000 is the tax saving in case of loss ‘we will discuss it in chapter capital budgeting’.
**In case of cumulative preference shares, the company has to pay cumulative dividend to preference
shareholders, when company earns sufficient profits.

2. Recommendation:
(a) If expected EBIT is less than `80,000 : Equity Finance (Alternative 1)
(b) If expected EBIT is equal to `80,000 : Equity or Debt - Equity Mix (Alternative 1 or 2)
(c) If expected EBIT is more than `80,000 : Debt – Equity Mix (Alternative 2)

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 EBIT - EPS ANALYSIS 1.12

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y -
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y -
5 Y Y Y Y
6 Y Y Y Y
7 Y Y Y Y
8 Y Y Y Y
9 Y Y - -
10 Y Y Y -
11 Y Y Y Y
12 Y Y Y Y

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 CHAPTER - 2

LEVERAGES
LEARNING OBJECTIVES

After studying this chapter you will be able to:

 Define, discuss, and quantify ‘Business Risk or Operating Risk’,
‘Financial Risk’ and ‘Combined Risk or Total Risk’.
 Explain in detail Operating, Financial and Combined Leverages
and identify causes of all these.
 Understand how to calculate and interpret a firm’s leverage?
 Calculate a firm’s operating, financial and combined break-even
(quantity) point and break-even (sales) point.
 Understand what is determining the appropriate amount of
financial leverage for a firm?
 Understand the concept of ‘Trading on Equity’
 Understand the concept of ‘Segment effect’ due to existence of ‘Debt
and Preferred Stock on Equity.
 LEVERAGES 2.2

PAST YEARS QUESTIONS

PYQ 1
The net Sales of A Ltd is `30 crores. Earning 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%.
Required:
(i) Calculate the Return on Equity (ROE) 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 its Combined Leverage is 3.
[5 Marks (May 2002)]

Answer
(i) Calculation of ROE:
Earnings for Equity Shareholde rs 1.36 Crores
ROE = × 100 = × 100
Equity Shareholde r' s Fund 10 Crores
= 13.60%

Segment:
EBIT 3.60 crores
ROCE / ROI = × 100 = × 100
Capital Employed 18 crores
= 20%

Segment due to Preference Share Capital = [20% (1-.40) – 13%] × 2 = - .20%

10

Segment due to Debentures = [(20% - 15%) (1-.40)] × 6 = 1.80%

10

Return on Equity with segment effect = ROI (1-t) - .20% + 1.80%

= [20% (1-.40)] - .20% + 1.80% = 13.60%

(ii) Operating Leverage = Combined Leverage ÷ Financial Leverage

= 3 times ÷ 1.59 times = 1.89 times

Working Notes:
1. Calculation of Earnings Available for Equity Shareholders
Particulars `
EBIT (12% of `30 Crores) 3,60,00,000
Less: Interest @ 15% of `6 Crores 90,00,000
Profit Before Tax 2,70,00,000
Less: Tax @ 40% 1,08,00,000
Profit After Tax 1,62,00,000
Less: Preference Dividend @ 13% of `2 Crores 26,00,000
Earnings Available for Equity Shareholders 1,36,00,000

2. Calculation of Financial Leverage:

Financial Leverage = EBIT = 3,60,00,000
Pr eference Dividend 26,00,000
EBT  2,70,00,000 
1  Tax 1  0.40
= 1.59 times

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 LEVERAGES 2.3

PYQ 2
The data relating to two Companies are as given below:
Company A Company B
Equity Share Capital `6,00,000 `3,50,000
12% Debentures `4,00,000 `6,50,000
Output (units) per annum 60,000 15,000
Selling price per unit `30 `250
Fixed cost per annum `7,00,000 `14,00,000
Variable cost per unit `10 `75
You are required to calculate the Operating leverage, Financial leverage and Combined leverage
of two Companies.
[(4 Marks) Nov 2002]

Answer
Statement of OL, FL and CL
Particulars A B
Number of units 60,000 15,000
Sales @ `30 and `250 per unit 18,00,000 37,50,000
Less: Variable cost @ `10 and `75 per unit 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less: Fixed cost 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less: Interest @ 12% of 4 lacs and 6.50 lacs 48,000 78,000
EBT 4,52,000 11,47,000
12,00,000 26,25,000
Operating leverage 
Contribution  5,00,000 12,25,000

 EBIT  2.40 times 2.143 times
5,00,000 12,25,000
Financial Leverage 
EBIT  4,52,000 11,47,000

 EBT  1.106 times 1.068 times
2.40 × 1.106 2.143 × 1.068
Combined Leverage (OL × FL) 2.654 times 2.289 times

PYQ 3
The following summarizes the percentage changes in operating income, percentage changes in revenue, and
Beta factors for four pharmaceutical firms.
Name of Firm Change in Revenue Change in Operating Income Beta Factor
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. [(8 Marks) Nov 2004]

Answer
(i) Calculation of operating leverage
Particulars PQR Ltd RST Ltd TUV Ltd WXY Ltd
Degree of Operating Leverage 25% 32% 36% 40%
 % Change in operating income  27% 25% 23% 21%
 
 % change in Revenue  0.93 1.28 1.57 1.91

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 LEVERAGES 2.4

WXY Ltd is operating its business with higher business risk.

(ii) High operating leverage leads to high beta. So when operating leverage is lowest i.e. 0.9259, Beta is
minimum 1.00 and when operating leverage is maximum i.e. 1.9048, beta is highest i.e. 1.40

PYQ 4
A Company had the following Balance Sheet as on March 31, 2006
Liabilities ` (in Crores) Assets ` (in Crores)
Equity Share Capital 10 Fixed Assets (net) 25
(1 Crores Shares of `10 each) Current Assets 15
Reserve and Surplus 2
15% Debentures 20
Current Liabilities 8
40 40
The additional information given is as under:
Fixed costs per annum (excluding interest) : `8 Crores
Variable operating costs ratio : 65% of sales
Total Assets turnover ratio : 2.5 times
Income tax rate : 40%
Calculate (i) Earnings per share, (ii) Operating Leverage, (iii) Financial Leverage, (iv) Combined Leverage.
[(8 Marks) Nov 2006]

Answer
(i) Statement of EPS
Particulars ` (in Crores)
Sales @ (2.50 times of `40 Crores) 100.00
Less: Variable cost @ 40% 65.00
Contribution 35.00
Less: Fixed cost 8.00
EBIT 27.00
Less: Interest @ 15% of 20 Crores 3.00
EBT 24.00
Less: Tax @ 40% 9.60
EAT 14.40
÷ No. of Equity Shares ÷1
EPS `14.40
Contribution 35 Crores
(ii) Operating Leverage = = = 1.296 times
EBIT 27 Crores

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.
EBIT 27 Crores
(iii) Financial Leverage = = = 1.125 times
EBT 24 Crores

The financial leverage is very comfortable since the debt service obligation is small vis-a-vis EBIT.
(iv) Combined Leverage = OL × FL = 1.296 × 1.125 = 1.458 times
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-a-vis change in sales.
The leverages - operating, financial and combined are measures of risk.

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 LEVERAGES 2.5

PYQ 5
The following details of RST Limited for the year ended 31 March, 2006 are given below:
Operating leverage 1.4 times
Combined leverage 2.8 times
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 per cent
Required:
(i) Calculate Financial Leverage.
(ii) Calculate 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?
[(8 Marks) May 2007]

Answer
(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.80 ÷ 1.40 = 2 times

(ii) P/V Ratio and EPS:

Contribution 7,14,000
P/V ratio = × 100 = × 100 = 23.80%
Sales 30,00,000

PAT 1,78,500
EPS = = = `1.05
No. of Shares 1,70,000

Calculation of contribution:
Contribution Contribution
Operating leverage = =
Contribution  FC Contribution  2,04,000
= 1.4 times
1.4 Contribution – 2,85,600 = Contribution = 7,14,000
Calculation of PAT:
Profit after tax = (Contribution – fixed cost – interest) (1 - t)
= (23.80% of 30 lacs – 2.04 lacs – 12% of 21.25lacs)(1 - 0.30)
= 1,78,500

(iii) Assets turnover:

Sales 30,00,000
Assets turnover = = = .784
Total Assets 38,25,000

0.784 < 1.5 means lower than industry assets turnover.

(iv) Level of sales to earn zero EBT:

EBT zero means 100% reduction in EBT. Since combined leverage is 2.8, sales have to be dropped by
100/2.8 = 35.7143%.
Hence new sales will be ` 30,00,000 × (100 – 35.7143)% = `19,28,571.
Therefore, at `19,28,700 level of sales, the Earnings before Tax of the company will be equal to
zero.

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 LEVERAGES 2.6

Alternatively
EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 76.20% sales – 2,04,000 – 2,55,000
23.80% of sales = 4,59,000
Sales = 19,28,571

PYQ 6
A firm has sales of `40 lakhs, variable cost of `25 lakhs, fixed cost of `6 lakhs, 10% debts of `30 lakhs and
Equity Capital of `45 lakhs. Calculate operating and financial leverage.
[(2 Marks) Nov 2007]

Answer
Contribution 40 Lacs  25 Lacs
Operating Leverage = = = 1.67 times
EBIT 40 Lacs  25 Lacs  6 Lacs

EBIT 40 Lacs  25 Lacs  6 Lacs

Financial Leverage = = = 1.5 times
EBT 40 Lacs  25 Lacs  6 Lacs  3 Lacs

PYQ 7
The following data relate to RST Ltd:
Earning before interest and tax (EBIT) `10,00,000
Fixed cost `20,00,000
Earning Before Tax (EBT) `8,00,000
Calculate combined leverage
[(2 Marks) May 2008]

Answer
Contribution 30,00,000
Combined Leverage = = = 3.75 times
EBT 8,00,000
Where, contribution = EBIT + Fixed Cost
= `10,00,000 + `20,00,000 = 30,00,000

PYQ 8
A Company operates at a production level of 1,000 units. The contribution is `60 per unit, operating leverage
is 6, and combined leverage is 24. If tax rate is 30%, what would be its earnings after tax?
[(3 Marks) Nov 2008]
Answer
Earning after tax = EBT (1 - t) = `2,500 (1 - 0.30) = `1,750
Working Notes:
Contribution
Combined leverage =
EBT
Contribution 1,000  60
24 times = =
EBT EBT
60,000
 EBT = = `2,500
24

PYQ 9
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

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 LEVERAGES 2.7

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
[(8 Marks) Nov 2009]

Answer
Income Statement
Particulars Company A Company B
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
Profit before interest and tax 15,000 10,500
Less: Interest 12,000 9,000
Profit before tax 3,000 1,500
Less: Tax @ 30% 900 450
Profit after tax 2,100 1,050

Working Notes (Company A):

EBIT EBIT
(a) Financial Leverage = = = 5 times
EBIT  Interest EBIT  12,000
EBIT = `15,000

(b) Contribution = EBIT + Fixed Cost = 15,000 + 20,000 = `35,000

(c) Sales = Contribution + VC = 35,000 + 56,000 = `91,000

Working Notes (Company B):

(a) Contribution = 40 % of sales (as variable costs is 60% of sales)

= 40 % of 1,05,000 = `42,000

Contribution 42,000
(b) Operating Leverage = = = 4 times
EBIT EBIT
EBIT = `10,500

(c) Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = `31,500

PYQ 10
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage
for following firms and interpret the results:
Particulars P Q R
Output (Units) 2,50,000 1,25,000 7,50,000
Fixed Cost `5,00,000 `2,50,000 `10,00,000
Unit Variable cost `5.00 `2.00 `7.50
Unit Selling price `7.50 `7.00 `10.00
Interest Expense `75,000 `25,000 Nil
[(4 Marks) Nov 2010]

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 LEVERAGES 2.8

Answer
Statement Showing OL, FL and CL
Particulars P Q R
Output (in units) 2,50,000 1,25,000 7,50,000
Sales @ `7.50, `7.00 and `10.00 per unit 18,75,000 8,75,000 75,00,000
Less: Variable cost @ `5.00, `2.00 and `7.50 p.u. 12,50,000 2,50,000 56,25,000
Contribution 6,25,000 6,25,000 18,75,000
Less: Fixed cost 5,00,000 2,50,000 10,00,000
EBIT 1,25,000 3,75,000 8,75,000
Less: Interest 75,000 25,000 Nil
EBT 50,000 3,50,000 8,75,000
6,25,000 6,25,000 18,75,000
Operating leverage  Contribution 
 EBIT  1,25,000 3,75,000 8,75,000
5 times 1.67 times 2.14 times
1,25,000 3,75,000 8,75,000
Financial leverage  EBIT 
 EBT  50,000 3,50,000 8,75,000
Combined leverage (OL × FL) 2.50 times 1.07 times 1 time
5 × 2.50 1.67 × 1.07 2.14 × 1
12.50 times 1.79 times 2.14 times
High Business, Medium
Comment on Risk Financial and Medium risk operating risk
Combined risk only
Moderate
Aggressive Moderate
Comment on Policy policy without
policy policy
Financial risk

PYQ 11
You are the given two financial plans of a company which has two financial situations. The detailed
information are as under:

Installed capacity : 10,000 units

Actual production and sales : 60% of installed capacity
Selling price per unit : `30
Variable cost per unit : `20

Fixed Cost:

Situation A : `20,000
Situation B : `25,000

Capital structure of the company is as follows:

Financial Plans

XY XM

Equity 12,000 35,000

12% Debt 40,000 10,000
52,000 45,000

You are required to calculate operating leverage and financial leverage of both the plans.
[(4 Marks) May 2011]

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 LEVERAGES 2.9

Answer
Statement Showing Operating & Financial leverage
Situation A Situation B
Particulars
Plan XY Plan XM Plan XY Plan XM
Sales (6,000 × `30) 1,80,000 1,80,000 1,80,000 1,80,000
Less: Variable cost (6,000 × `20) 1,20,000 1,20,000 1,20,000 1,20,000
Contribution 60,000 60,000 60,000 60,000
Less: Fixed Cost 20,000 20,000 25,000 25,000
EBIT 40,000 40,000 35,000 35,000
Less: Interest @ 12% 4,800 1,200 4,800 1,200
EBT 35,200 38,800 30,200 33,800
OL (Contribution ÷ EBIT) 1.50 times 1.50 times 1.71 times 1.71 times
FL (EBIT ÷ EBT) 1.14 times 1.03 times 1.16 times 1.04 times

PYQ 12
Alpha Ltd has furnished the following Balance Sheet as on March 31, 2011:
Liabilities ` Assets `
Equity Share Capital 10,00,000 Fixed Assets 30,00,000
(1,00,000 shares of `10 each) Current Assets 18,00,000
General Reserve 2,00,000
15% Debentures 28,00,000
Current Liabilities 8,00,000
48,00,000 48,00,000
Additional information:
(1) Annual Fixed Cost other than Interest `28,00,000
(2) Variable Cost Ratio 60% of sales
(3) Total Assets Turnover Ratio 2.5 times
(4) Tax Rate 30%

You are required to calculate:

(i) Earning per Share (EPS), and
(ii) Combined Leverage.
[(8 Marks) Nov 2011]

Answer
(i) Combined leverage = Contribution ÷ EBT = 48 lacs ÷ 15.80 lacs = 3.04

(ii) Calculation of EPS:

Particulars `
Sales (2.5 × 48,00,000) 1,20,00,000
Less: Variable cost @ of 60% of sales 72,00,000
Contribution 48,00,000
Less: Fixed cost 28,00,000
EBIT 20,00,000
Less: Interest @ 15% of 28,00,000 4,20,000
EBT 15,80,000
Less: Tax @ 30% 4,74,000
EAT 11,06,000
÷ No. of Shares ÷ 1,00,000
EPS `11.06

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 LEVERAGES 2.10

PYQ 13
The capital structure of JCPL Ltd. is as follows:
Equity share capital of `10 each : `8,00,000
8% Preference share capital of `10 each : `6,25,000
10% Debenture of `100 each : `4,00,000
Additional Information:
Profit after tax (tax rate 30%) : `1,82,000
Operating expenses (including depreciation `90,000) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : `20.00

Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.
[(8 Marks) May 2012]

Answer
(i) Operating & Financial leverage:
Contribution 3,90,000
Operating Leverage = = = 1.3 times
EBIT 3,00,000

EBIT 3,00,000
Financial Leverage = =
Pr eference Dividend 8% of 6,25,000
EBT  2,60,000 
1  Tax 1  0.30
3,00,000
= = 1.59 times
50,000
2,60,000 
0.70

(ii) Calculation of cover the preference & equity share dividends:

Pr ofit after tax
Cover the Preference Share Dividend =
Pr eference dividend
1,82,000
= = 3.64 times
50,000

Pr ofit after tax  Pr eference dividend

Cover the Equity Share Dividend =
Equity dividend
1,82,000  50,000
= = 1.10 times
15% of 8,00,000

(iii) Earning yield & price earning ratio:

EPS 1.65
Earning Yield Ratio = × 100 = × 100 = 8.25%
MPS 20.00
MPS 20
Price Earning Ratio = = = 12.12 times
EPS 1.65

PAT  Pr eference dividends 1,82,000  50,000

Calculation of EPS = =
No. of Equity shares 80,000
= `1.65

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 LEVERAGES 2.11

(iv) Net fund flow:

Net fund flow = PAT - Preference dividends - Equity dividends + Depreciation
= 1,82,000 – 50,000 – 1,20,000 + 90,000 = `1,02,000

Calculation of contribution:
Particulars `
Profit after tax 1,82,000
Add: Tax  1,82,000  30  78,000
 70 
Profit before tax 2,60,000
Add: Interest on debenture (4,00,000 × 10%) 40,000
Earning before interest and tax 3,00,000
Add: Fixed cost (assumed only depreciation is fixed) 90,000
Contribution 3,90,000

PYQ 14
X Limited has estimated that for a new product its break-even point is 20,000 units if the item is sold for `14
per unit and variable cost `9 per unit. Calculate the degree of operating leverage for sales volume 25,000 units
and 30,000 units.
[(5 Marks) Nov 2012]

Answer
Statement of Operating Leverage
Particulars 25,000 Units 30,000 Units
Contribution @ `5 (`14 - `9) per unit 1,25,000 1,50,000
Less: Operating fixed cost (W.N.) 1,00,000 1,00,000
EBIT 25,000 50,000
Operating Leverage (Contribution ÷ EBIT) 5 times 3 times

Calculation of operating fixed cost:

Contribution at BEP = Fixed Cost
`5 × 20,000 Units = `1,00,000

Note: BEP to be assumed as operating BEP or Financial fixed cost to be assumed as Nil.

PYQ 15
The following information related to XL company Ltd. for the year ended 31st March, 2013 are
available to you:
Equity share capital of `10 each : `25,00,000
11% Bonds of `1,000 each : `18,50,000
Sales : `42,00,000
Fixed cost (Excluding Interest) : `3,48,000
Financial leverage : 1.39
Profit Volume Ratio : 25.55%
Income Tax Rate : 35%

You are required to calculate:

(i) Operating Leverage;
(ii) Combined Leverage; and
(iii) Earning Per Share.
[(6 Marks) May 2013]

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 LEVERAGES 2.12

Answer
Contribution 10,73,100
(i) Operating Leverage = = = 1.48 times
EBIT 7,25,100

(ii) Combined Leverage = OL × FL = 1.48 × 1.39 = 2.06 times

PAT 3,39,040
(iii) Earnings Per Share = =
No of Equity shares 2,50,000
= `1.356

Working Notes:
(1) Contribution = Sales × PV Ratio
= 42 Lacs × 25.55% = 10,73,100
(2) EBIT = Contribution - Operating Fixed Cost
= 10,73,100 – 3,48,000 = 7,25,100
(3) Profit after tax = (EBIT – Interest) (1 - t)
= (7,25,100 – 11% of 18,50,000) (1 – 0.35)
= 3,39,040

PYQ 16
Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage
for the following firms:
Particulars N S D
Production (in units) 17,500 6,700 31,800
Fixed cost `4,00,000 `3,50,000 `2,50,000
Interest on loan `1,25,000 `75,000 Nil
Selling price per unit `85 `130 `37
Variable cost per unit `38.00 `42.50 `12.00
[(Nov 13) 5 Marks]

Answer
Statement of the Degree of OL, Degree of FL and the Degree of CL
Particulars N S D
Production (in units) 17,500 6,700 31,800
Sales value @ `85/ `130/ `37 per unit 14,87,500 8,71,000 11,76,600
Less: Variable cost @ `38/ `42.50/ `12 per unit 6,65,000 2,84,750 3,81,600
Contribution 8,22,500 5,86,250 7,95,000
Less: Fixed cost 4,00,000 3,50,000 2,50,000
EBIT 4,22,500 2,36,250 5,45,000
Less: Interest on loan 1,25,000 75,000 -
EBT 2,97,500 1,61,250 5,45,000
8,22,500 5,86,250 7,95,000
Operating leverage 
Contribution  4,22,500 2,36,250 5,45,000

 EBIT  1.95 2.48 1.46
4,22,500 2,36,250 5,45,000
Financial Leverage 
EBIT  2,97,500 1,61,250 5,45,000

 EBT  1.42 1.47 1.00
8,22,500 5,86,250 7,95,000
2,97,500 1,61,250 5,45,000
Combined Leverage 
Contribution 

 EBT  2.76 3.64 1.46

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 LEVERAGES 2.13

PYQ 17
A company had the following Balance Sheet as on 31st March, 2014: [in crores]
Liabilities ` Assets `
Equity Share Capital 5.00 Fixed Assets (Net) 12.50
(50 lakh shares of `10 each) Current Assets 7.50
Reserve and Surplus 1.00
15% Debentures 10.00
Current Liabilities 4.00
20.00 20.00

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:

(i) Earnings Per Share

(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage
[(8 Marks) May 2014]

Answer
(i) Calculation of EPS:
EAT 840 Lakhs
EPS = = = `16.80
No. of Shares 50 Lakhs
(ii) Calculation of OL:
Contribution 17.50 Crores
OL = = = 1.296 times
EBIT 13.50 Crores
(iii) Calculation of FL:
EBIT 13.50 Crores
FL = = = 1.125 times
EBT 12.00 Crores
(iv) Calculation of CL:
CL = OL × FL = 1.296 × 1.125 = 1.458 times

Working Notes:
Income Statement
Particulars ` (in
crores)
Sales (2.5 times of 20 crores) 50.00
Less: Variable Cost @ 65% of 50 crores 32.50
Contribution 17.50
Less: Fixed Cost 4.00
EBIT 13.50
Less: Interest @ 15% of 10 crores 1.50
EBT 12.00
Less: Tax @ 30% 3.60
EAT 8.40

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 LEVERAGES 2.14

PYQ 18
The capital structure of RST Ltd. is as follows:
Equity share capital of `10 each : `8,00,000
10% Preference share capital of `100 each : `5,00,000
12% Debenture of `100 each : `7,00,000
Additional Information:
Profit after tax (tax rate 30%) : `2,80,000
Operating expenses (including depreciation `96,800) : 1.50 times of EBIT
Equity share dividend paid : 15%
Market price per equity share : `23.00
Required to calculate:
(i) Operating and financial leverage.
(ii) Cover the preference and equity share dividends.
(iii) The earning yield and price earning ratio.
(iv) The net fund flow.
Note: All operating expenses (excluding depreciation) are variable.
[(8 Marks) Nov 2014]

Answer
(i) Operating & Financial leverage:
Contribution 5,80,800
Operating Leverage = = = 1.2 times
EBIT 4,84,000

EBIT 4,84,000
Financial Leverage = =
Pr eference Dividend 50,000
EBT  4,00,000 
1  Tax 1  0.30
= 1.473 times

(ii) Calculation of cover the preference & equity share dividends:

Pr ofit after tax
Cover the Preference Share Dividend =
Pr eference dividend
2,80,000
= = 5.6 times
50,000

Pr ofit after tax  Pr eference dividend

Cover the Equity Share Dividend =
Equity dividend
2,80,000  50,000
= = 1.92 times
15% of 8,00,000

(iii) Earning yield & price earning ratio:

EPS 2.875
Earning Yield Ratio = × 100 = × 100 = 12.50%
MPS 23.00

MPS 23.00
Price Earning Ratio = = = 8 times
EPS 2.875

PAT  Pr eference dividends 2,80,000  50,000

Calculation of EPS = =
No. of Equity shares 80,000
= `2.875

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 LEVERAGES 2.15

(iv) Net fund flow:

Net fund flow = PAT - Preference dividends - Equity dividends + Depreciation
= 2,80,000 – 50,000 – 1,20,000 + 96,800 = `2,06,800

Calculation of contribution
Particulars `
Profit after tax 2,80,000
Add: Tax (2,80,000 × 30/70) 1,20,000
Profit before tax 4,00,000
Add: Interest on debenture (7,00,000 × 12%) 84,000
Earning before interest and tax 4,84,000
Add: Fixed cost (only depreciation) 96,800
Contribution 5,80,800

PYQ 19
Following information are related to four firms of the same industry:
Firm Change in Revenue Change in Operating Income Change in EPS
P 27% 25% 30%
Q 25% 32% 24%
R 23% 36% 21%
S 21% 40% 23%

Find out:
(i) Degree of operating leverage , and
(ii) Degree of combined leverage of all the firms.
[(5 Marks) May 2015]

Answer
% Change in opereating income
(i) Degree of Operating Leverage =
% Chacge in revenue
P = 25% ÷ 27% = 0.93
Q = 32% ÷ 25% = 1.28
R = 36% ÷ 23% = 1.57
S = 40% ÷ 21% = 1.91

% Change in EPS
(ii) Degree of Combined Leverage =
% Chacge in revenue
P = 30% ÷ 27% = 1.11
Q = 24% ÷ 25% = 0.96
R = 21% ÷ 23% = 0.91
S = 23% ÷ 21% = 1.10

PYQ 20
The capital structure of the ABC Ltd as at 31.03.15 consists of ordinary share capital of `5,00,000 (face value
`100 each) and 10% debentures of `5,00,000 (`100 each). In the year ended March 15, sales decreased from
60,000 units to 50,000 units. During the year and in the previous year, the selling price is `12 per unit; variable
cost stood at `8 per unit and fixed expenses were at `1,00,000 p.a. The income tax rate was 30%.
You are required to calculate the following:
(i) The percentage decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units. [(5 Marks) June 2015]

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 LEVERAGES 2.16

Answer
(i) Calculation of % decrease in EPS
Particulars 60,000 units 50,000 units
Sales @ `12 per unit 7,20,000 6,00,000
Less: Variable cost @ `8 per unit 4,80,000 4,00,000
Contribution 2,40,000 2,00,000
Less: Fixed cost 1,00,000 1,00,000
Profit before interest and tax 1,40,000 1,00,000
Less: Interest @ 10% of `5,00,000 50,000 50,000
Profit before tax 90,000 50,000
Less: Tax @ 30% 27,000 15,000
Profit after tax 63,000 35,000
÷ No. of shares 5,000 5,000
Earning per share `12.60 `7.00
12.60  7.00
% Decrease in EPS = × 100 = 44.44%
12.60

Contribution
(ii) Degree of Operating Leverage =
EBIT
2,40,000
At 60,000 units = = 1.71 times
1,40,000
2,00,000
At 50,000 units = = 2 times
1,00,000

EBIT
(iii) Degree of Financial Leverage =
EBT
1,40,000
At 60,000 units = = 1.56 times
90,000
1,00,000
At 50,000 units = = 2 times
50,000

PYQ 21
From the following details of X Ltd., prepare the Income Statement for the year ended 31st December 2014:
Financial Leverage : 2
Interest : `2,000
Operating Leverage : 3
Variable cost as a % of sales : 75%
Income tax rate : 30%
[(5 Marks) Nov 2015]

Answer
Income Statement for the year ended 31st December, 2014
Particulars `
Sales 48,000
Less: Variable cost 36,000
Contribution 12,000
Less: Fixed cost 8,000
EBIT 4,000
Less: Interest 2,000
EBT 2,000
Less: Tax @ 30% 600
EAT 1,400

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 LEVERAGES 2.17

Working Notes:
(a) Calculation of EBIT:
EBIT EBIT
Financial Leverage = 2 = =
EBT EBIT  Interest
EBIT
= or EBIT = `4,000
EBIT  2,000

(b) Calculation of Contribution:

Contribution Contribution
Operating Leverage = 3 = =
EBIT 4,000

Contribution = `12,000

(c) Calculation of Sales:

Contribution 12,000
Sales Value = = = `48,000
PV Ratio 100%  75%

PYQ 22
A company had the following Balance Sheet as on 31st March, 2015.
Liabilities ` Assets `
Equity Share Capital of `10 each 40,00,000 Fixed Assets (Net) 1,28,00,000
Reserve and Surplus 8,00,000 Current Assets 32,00,000
15% Debentures 80,00,000
Current Liabilities 32,00,000
1,60,00,000 1,60,00,000
The additional information given is as under:
Fixed cost per annum (excluding interest) `32,00,000
Variable operating cost ratio 70%
Total assets turnover ratio 2.5
Income Tax rate 30%
Required:
(i) Operating Leverage, (ii) Financial Leverage, (iii) Combined Leverage and (iv) Earnings Per Share
[(5 Marks) May 2016]

Answer
(i) Calculation of OL:
Contribution 1,20,00,000
OL = = = 1.364 times
EBIT 88,00,000

(ii) Calculation of FL:

EBIT 88,00,000
FL = = = 1.158 times
EBT 76,00,000

(iii) Calculation of CL:

CL = OL × FL = 1.364 × 1.158 = 1.579 times
(iv) Calculation of EPS:
EAT 53,20,000
EPS = = = `13.30
No. of Shares 4,00,000

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 LEVERAGES 2.18

Working Notes:
Income Statement
Particulars `
Sales (2.5 times of 1,60,00,000) 4,00,00,000
Less: Variable Cost @ 70% of 400 Lacs 2,80,00,000
Contribution 1,20,00,000
Less: Fixed Cost 32,00,000
EBIT 88,00,000
Less: Interest @ 15% of 80,00,000 12,00,000
EBT 76,00,000
Less: Tax @ 30% 22,80,000
EAT 53,20,000

PYQ 23
The following information related to YZ company Ltd. for the year ended 31st March, 2016 are available
to you:
Equity share capital of `10 each : `50,00,000
12% Bonds of `1,000 each : `37,00,000
Sales : `84,00,000
Fixed cost (Excluding Interest) : `6,96,000
Financial leverage : 1.49
Profit Volume Ratio : 27.55%
Income Tax Rate : 40%
You are required to calculate:
(a) Operating Leverage;
(b) Combined Leverage; and
(c) Earning Per Share. [upto two decimal points]
[(5 Marks) Nov 2016]

Answer
Contribution 23,14,200
(a) Operating Leverage = = = 1.43 times
EBIT 16,18,200

(b) Combined Leverage = OL × FL = 1.43 × 1.49 = 2.13 times

PAT 7,04,520
(c) Earnings Per Share = = = `1.41
No of Equity shares 5,00,000

Working Notes:
1. Contribution = Sales × PV Ratio = 84 Lacs × 27.55%= 23,14,200

2. EBIT = Contribution - Operating Fixed Cost

= 23,14,200 – 6,96,000 = 16,18,200
3. Profit after tax = (EBIT – Interest) (1 - t)
= (16,18,200 – 12% of 37,00,000) (1 – 0.40) = 7,04,520
Author Note: Calculation of interest through financial leverage will provide different interest, therefore this
question alternatively can be solved by taking interest on the basis of following calculation:

Financial Leverage = EBIT ÷ EBT = 16,18,200 ÷ EBT = 1.49

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 LEVERAGES 2.19

EBT = 16,18,200 ÷ 1.49 = 10,86,040

Interest = EBIT – EBT = 16,18,200 – 10,86,040 = 5,32,160

PYQ 24
You are given the following information of 5 firms of the same industry:
Firm Change in Revenue Change in Operating Income Change in EPS
M 28% 26% 32%
N 27% 34% 26%
P 25% 38% 23%
Q 23% 43% 27%
R 25% 40% 28%

Find out:
(a) Degree of operating leverage , and
(b) Degree of combined leverage of all the firms.
[(5 Marks) May 2017]

Answer
% Change in opereating income
(a) Degree of Operating Leverage =
% Chacge in revenue
M = 26% ÷ 28% = 0.93
N = 34% ÷ 27% = 1.26
P = 38% ÷ 25% = 1.52
Q = 43% ÷ 23% = 1.87
R = 40% ÷ 25% = 1.60

% Change in EPS
(b) Degree of Combined Leverage =
% Chacge in revenue
M = 32% ÷ 28% = 1.14
N = 26% ÷ 27% = 0.96
P = 23% ÷ 25% = 0.92
Q = 27% ÷ 23% = 1.17
R = 28% ÷ 25% = 1.12

PYQ 25
The following details of a company for the year ended 31 March, 2017 are given below:
Operating leverage 2 times
Combined leverage 2.5 times
Fixed Cost (Excluding interest) `3.04 lakhs
Sales `50.00 lakhs
8% Debentures of `100 each `30.25 lakhs
Equity Share Capital of `10 each `34.00 lakhs
Income tax rate 30 per cent
Required:
(i) Calculate Financial Leverage.
(ii) Calculate 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?
[(8 Marks) Nov 2017]

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 LEVERAGES 2.20

Answer
(i) Calculation of Financial Leverage:
Financial Leverage = CL ÷ OL = 2.50 ÷ 2 = 1.25

(ii) P/V Ratio and EPS:

Contribution 6,08,000
P/V ratio = × 100 = × 100 = 12.16%
Sales 50,00,000

PAT 43,400
EPS = = = `0.1276
No. of Shares 3,40,000

Calculation of contribution:
Contribution Contribution
Operating leverage = =
Contribution  FC Contribution  3,04,000
= 2 times
2 Contribution – 6,08,000 = Contribution = 6,08,000

Calculation of PAT:
Profit after tax = (Contribution – fixed cost – interest) (1 - t)
= (6,08,000 – 3,04,000 – 8% of 30,25,000)(1 - 0.30)
= 43,400

Author Note: Calculation of interest through financial leverage will provide different interest, therefore this
question alternatively can be solved by taking interest on the basis of following calculation:

Financial Leverage = EBIT ÷ EBT = 6,08,000 – 3,04,000 ÷ EBT

= 1.25 = 3,04,000 ÷ EBT
EBT = 3,04,000 ÷ 1.25 = 2,43,200
Interest = EBIT – EBT = 3,04,000 – 2,43,200
= 60,800

(iii) Assets turnover:

Sales 50,00,000
Assets turnover = = = .778
Total Assets 64,25,000

0.778 < 1.5 means lower than industry assets turnover.

(iv) Level of sales to earn zero EBT:

EBT = Sales – Variable cost – Fixed cost – Interest
Nil = Sales – 87.84% sales – 3,04,000 – 2,42,000
12.16% of sales = 5,46,000
Sales = 44,90,132

PYQ 26
Following are the selected financial information of A Ltd and B Ltd for the year ended March 31, 2018:
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%

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 LEVERAGES 2.21

You are required to find out:

(1) EBIT
(2) Sales
(3) Fixed cost
(4) Identify the company which is better placed with reasons besed on leverages.
[(8 Marks) May 2018]

Answer
EBIT
(1) Financial Leverage =
EBIT - Interest

EBIT
Financial Leverage (A Ltd) = = 3 times
EBIT - 20,000

EBIT = `30,000

EBIT
Financial Leverage (B Ltd) = = 2 times
EBIT - 1,00,000

EBIT = `2,00,000

Contribution
(2) Operating Leverage =
EBIT
Contribution
Operating Leverage (A Ltd) = = 5 times
30,000
Contribution = `1,50,000

Sales = `1,50,000 ÷ 40% (PV) = `3,75,000

Contribution
Operating Leverage (B Ltd) = = 2 times
2,00,000
Contribution = `4,00,000

Sales = `4,00,000 ÷ 50% (PV) = `8,00,000

(3) Contribution = EBIT + Fixed Cost

Contribution (A Ltd) = 30,000 + Fixed Cost = `1,50,000

Fixed cost = `1,20,000

Contribution (B Ltd) = 2,00,000 + Fixed Cost = `4,00,000

Fixed cost = `2,00,000

(4) Comment based on leverage: B Ltd is better than A Ltd having lower degree of Business risk, Financial
risk and overall risk.

PYQ 27
The following data have been extracted from the books of LM Ltd:
Sales `100 Lakhs
Interest payable per annum `10 Lakhs
Operating leverage 1.2
Combined leverage 2.16

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 LEVERAGES 2.22

You are required to find out:

(1) The Financial leverage
(2) Fixed cost and
(3) P/V ratio
[(5 Marks) May 2018]

Answer
(1) Financial Leverage = Combined leverage ÷ Operating leverage
= 2.16 ÷ 1.2 = 1.8 times

(2) Calculation of fixed cost:

EBIT
Financial Leverage = = 1.8 times
EBIT - Interest

EBIT
= = 1.8 times
EBIT - 10,00,000

EBIT = `22,50,000

Contribution
Operating Leverage = = 1.2 times
EBIT
Contribution = `22,50,000 × 1.2 = `27,00,000

Fixed cost = Contribution – EBIT

= `27,00,000 – 22,50,000 = `4,50,000

(3) P/V ratio = Contribution ÷ Sales

= 27,00,000 ÷ 1,00,00,000 = 27%

PYQ 28
Following is Balance Sheet of Soni Ltd. as on 31st March, 2018.
Liabilities ` Assets `
Equity Share Capital of `10 each 25,00,000 Non Current Assets 60,00,000
Reserve and Surplus 5,00,000 Current Assets 40,00,000
Non Current liabilities (12% Debt) 50,00,000
Current Liabilities 20,00,000
1,00,00,000 1,00,00,000

Additional information:
Fixed cost per annum (excluding interest) `20,00,000
Variable operating cost ratio 60%
Total assets turnover ratio 5 times
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
[(10 Marks) Nov 2018]

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 LEVERAGES 2.23

Answer
(1) Income Statement
Particulars `
Sales (5 times of 1,00,00,000) 5,00,00,000
Less: Variable Cost @ 60% of 500 Lacs 3,00,00,000
Contribution 2,00,00,000
Less: Fixed Cost 20,00,000
EBIT 1,80,00,000
Less: Interest @ 12% of 50,00,000 6,00,000
EBT 1,74,00,000
Less: Tax @ 25% 43,50,000
EAT 1,30,50,000

(2) Calculation of OL:

Contribution 2,00,00,000
OL = = = 1.11 times
EBIT 1,80,00,000

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.

Calculation of FL:
EBIT 1,80,00,000
FL = = = 1.03 times
EBT 1,74,00,000

The financial leverage is very comfortable since the debt service obligation is small vis-à-vis EBIT.

Calculation of CL:
CL = OL × FL = 1.11 × 1.03 = 1.15 times

The combined leverage studied 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.

PYQ 29
A company has sales of `1,00,00,000; variable cost is 55% of sales and fixed cost is `6,00,000. The capital
structure of the company is: Equity `1,20,00,000 and 8% Debt `80,00,000.
Calculate:

(1) Operating, Financial and Combined Leverages.

(2) If the sales amount is increased by 12%, by what percentage EBIT will increase?
[(5 Marks) Nov 2018]

Answer
Contribution 1,00,00,000 × 45%
(1) Operating Leverage = =
EBIT 45,00,000 − 6,00,000
= 1.154 times

EBIT 39,00,000
Financial Leverage = =
EBT 39,00,000 − 8% of 80,00,000
= 1.196 times

Combined Leverage = OL × FL

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 LEVERAGES 2.24

= 1.154 × 1.196 = 1.38 times

(2) % increase on EBIT:

Δ EBIT (in %) = Δ Sales × DOL
= 12% × 1.154 times = 13.848%

PYQ 30
The capital structure of the Shiva Ltd. consists of an ordinary share capital of `20,00,000 (share of `100 par
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
cost amounts to `6 per unit and fixed expenses amount to `4,00,000.
The income tax rate is assumed to be 50%.
You are required to calculate the following:
(1) The percentage increase in earnings per share;
(2) Financial leverage at 2,00,000 units and 2,40,000 units.
(3) Operating leverage at 2,00,000 units and 2,40,000 units.
(4) Comment on the behavior of operating and financial leverages in relation to increase in production
from 2,00,000 units to 2,40,000 units.
[(10 Marks) May 2019]

Answer
(1) Calculation of % increase in EPS
2,00,000 2,40,000
Particulars
units units
Sales @ `10 per unit 20,00,000 24,00,000
Less: Variable cost 12,00,000 14,40,000
Contribution 8,00,000 9,60,000
Less: Fixed cost 4,00,000 4,00,000
Profit before interest and tax 4,00,000 5,60,000
Less: Interest @ 10% of `20,00,000 2,00,000 2,00,000
Profit before tax 2,00,000 3,60,000
Less: Tax @ 50% 1,00,000 1,80,000
Profit after tax 1,00,000 1,80,000
÷ No. of shares 20,000 20,000
Earning per share `5.00 `9.00
9.00 − 5.00
% increase in EPS = × 100 = 80%
5.00

EBIT
(2) Financial Leverage =
EBT
4,00,000
At 2,00,000 units = = 2 times
2,00,000
5,60,000
At 2,40,000 units = = 1.56 times
3,60,000

Contribution
(3) Operating Leverage =
EBIT
8,00,000
At 2,00,000 units = = 2 times
4,00,000
9,60,000
At 2,40,000 units = = 1.71 times
5,60,000

(4) Increase in production and sales will result in decrease in risk.

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 LEVERAGES 2.25

PYQ 31
The balance sheet of Gitashree Ltd. is given below:
Liabilities ` Assets `
Equity Share Capital 1,80,000 Net Fixed Assets 4,50,000
(`10 per share) Current Assets 1,50,000
Retained Earning 60,000
10% Long Term Debt 2,40,000
Current Liabilities 1,20,000
6,00,000 6,00,000

The company's total assets turnover ratio is 4 times, its fixed operating cost is `2,00,000 and its
variable operating cost ratio is 60%. The income tax rate is 30%.

You are required to:

1. (a) Degree of Operating Leverage.
(b) Degree of Financial Leverage.
(c) Degree of Combined Leverage.

2. Determine the likely level of EBIT if EPS is (A) `1.00, (B) `2.00 and (C) `Nil.
[(10 Marks) Nov 2019]

Answer
Contribution 9,60,000
1. (a) Operating Leverage = = = 1.26
EBIT 7,60,000

EBIT 7,60,000
(b) Financial Leverage = = = 1.03
EBT 7,36,000

(c) Combined Leverage = OL × FL = 1.26 × 1.03 = 1.30

2. Calculation of likely level of EBIT:

(EBIT − I) (1 − t)
Earnings Per Share =
N

(EBIT − 24,000) (1 − 0.30)

Case A: `1.00 = or EBIT = `49,714
18,000
(EBIT − 24,000) (1 − 0.30)
Case B: `2.00 = or EBIT = `75,429
18,000
(EBIT − 24,000) (1 − 0.30)
Case C: `0.00 = or EBIT = `24,000
18,000

Working Note: Income Statement

Particulars `
Sales (4 times of 6,00,000) 24,00,000
Less: Variable Cost @ 60% of 24,00,000 14,40,000
Contribution 9,60,000
Less: Fixed Cost 2,00,000
EBIT 7,60,000
Less: Interest @ 10% of 2,40,000 24,000
EBT 7,36,000

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 LEVERAGES 2.26

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y Y
5 Y Y Y Y
6 Y Y Y -
7 Y Y Y -
8 Y Y Y -
9 Y Y Y Y
10 Y Y Y -
11 Y Y Y Y
12 Y Y Y Y
13 Y Y Y Y
14 Y Y Y Y
15 Y Y Y Y
16 Y Y Y -
17 Y Y Y Y
18 Y Y Y Y
19 Y Y Y Y
20 Y Y Y Y
21 Y Y Y -
22 Y Y Y Y
23 Y Y Y Y
24 Y Y - -
25 Y - - -
26 Y Y Y -
27 Y Y Y -
28 Y Y Y Y
29 Y Y Y Y
30 Y Y Y -
31 Y Y Y -

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 CHAPTER - 3

MANAGEMENT OF
RECEIVABLES

LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Discuss in details about management of receivables, its meanings
and its significance to any business/firm.
 Understand the concept of credit policies and the estimation of
optimum credit period and credit amount.
 Understand the need for a business to invest in receivables.
 Know why it is important to manage efficiently the receivables?
 Discuss the cost of receivables.
 Understand the concept of factoring and its types.
 Understand the concept of management of payables.
 MANAGEMENT OF RECEIVABLES 3.2

PAST YEARS QUESTIONS

PYQ 1
The present credit terms of P Company are 1/10 net 30. Its annual sales is `80 lakhs, its average collection
period is 20 days. Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost
of capital is 10 per cent. The proportion of sales on which customers currently take discount is 0.5.
P Company is considering relaxing its discount terms to 2/10 net 30. Such relaxation is expected to
increase sales by `5 lakhs, reduce the average collection period to 14 days and increase the proportion of
discount sales to 0.8.
What will be the effect of relaxing the discount policy on company's profit? Take year as 360
days.
[(10 Marks) May 1998]

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 80,00,000 85,00,000
Less: Variable cost @ 85% 68,00,000 72,25,000
Less: Fixed Cost (10% of 80,00,000) 8,00,000 8,00,000
Profit before cost of credit 4,00,000 4,75,000
Less: Cash discount 40,000 1,36,000
Expected Profit 3,60,000 3,39,000
Less: Cost of investment in debtors 42,222 31,208
Net benefit 3,17,778 3,07,792
Effect: Income will be decreased by `9,986.
Working Notes:
(1) Calculation of cost of investment in debtors:
Existing = (68,00,000 + 8,00,000) × 10% × 20/360 = 42,222
Proposed = (72,25,000 + 8,00,000) × 10% × 14/360 = 31,208
(2) Calculation of cash discount:
Existing = 80,00,000 × 0.50 × 1% = 40,000
Proposed = 85,00,000 × 0.80 × 2% = 1,36,000

PYQ 2
Radiance Garments Ltd. manufactures readymade garments and sells them on credit basis through a
network of dealers. Its present sale is `60,00,000 per annum with 20 days credit period. The company is
contemplating an increase in the credit period with a view to increasing sales. Present variable costs are
70% of sales and the total fixed costs `8,00,000 per annum.
The company expects pre-tax return on investment @ 25%. Some other details are given as
under:
Proposed Credit Average Collection Expected Annual
Policy Period (days) Sales (` lakh)
I 30 65
II 40 70
III 50 74
IV 60 75
Required: Which credit policy should the company adopt? Present your solution in a tabular form. Assume
360 days a year. Calculations should be made upto two digits after decimal. [(10 Marks) Nov 1999]

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 MANAGEMENT OF RECEIVABLES 3.3

Answer
Statement of Evaluation
Policies
Particulars
Present I II III IV
Sales value 60,00,000 65,00,000 70,00,000 74,00,000 75,00,000
Less: Variable cost @ 70% 42,00,000 45,50,000 49,00,000 51,80,000 52,50,000
Less: Fixed Cost 8,00,000 8,00,000 8,00,000 8,00,000 8,00,000
Expected Profit 10,00,000 11,50,000 13,00,000 14,20,000 14,50,000
Less: Required return (WN) 69,444 1,11,459 1,58,333 2,07,640 2,52,083
Net benefit 9,30,556 10,38,541 11,41,666 12,12,360 11,97,916
Working Notes:
Calculation of required return on investment in cost of average debtors:
Present = (42,00,000 + 8,00,000) × 25% × 20/360 = 69,444
Option I = (45,50,000 + 8,00,000) × 25% × 30/360 = 1,11,459
Option II = (49,00,000 + 8,00,000) × 25% × 40/360 = 1,58,333
Option III = (51,80,000 + 8,00,000) × 25% × 50/360 = 2,07,640
Option IV = (52,50,000 + 8,00,000) × 25% × 60/360 = 2,52,083
Analysis:
The company should adopt the credit policy III (with collection period of 50 days) as it yields a maximum
profit to the company.

PYQ 3
A Bank is analyzing 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 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.
A schedule of Jackson’s receivables has been prepared. How much will the bank lend on a pledge of
receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
Account Amount Days Outstanding Average Pay Period
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
[(6 Marks) Nov 2000]

Answer
Statement of the amount lend by the banks on a pledge of receivables
(If bank allows 10% allowance or cash discount and returns)
Account No. Amount 90% of amount (10% allowance) 80% of amount (Loan)
74 `25,000 25,000 – 10% = 22,500 22,500 × 80% = 18,000
107 `11,500 11,500 – 10% = 10,350 10,350 × 80% = 8,280
108 `2,300 2,300 – 10% = 2,070 2,070 × 80% = 1,656
116 `29,000 29,000 – 10% = 26,100 26,100 × 80% = 20,880
Total loan amount `48,816

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 MANAGEMENT OF RECEIVABLES 3.4

For identification of acceptable collateral for a short term to loan, Bank analyses the receivables of Jackson
Company:
Bank lends 80% on A/c where customers are not currently overdue and average payment period
does not exceed 10 day past the period of 30 days.
On the basis of this, schedule of Jackson’s: Account No. 91 & Account No. 114 are currently overdue
and Account No. 123 payment period exceeds 40 days. So, these accounts are eliminated and Account No. 74,
107, 108 and 116 are selected or lending decision.

PYQ 4
The credit manager of XYZ Ltd. is reappraising the company’s credit policy. The company sells its 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 % of sales Average collection period
1 0 45 Days
2 2 42 Days
3 10 40 Days
4 20 80 Days
The average rate of interest is 15%. What conclusion do you draw about the Company’s credit policy? What
other factors should be taken into account before changing the present policy? Discuss.
[(6 Marks) May 2001]

Answer
Let the amount of revenue generated for each type of customers be `100.
Statement of Evaluation
Classifications
Particulars
1 2 3 4
Sales 100 100 100 100
Less: COGS @ 85% 85 85 85 85
Less: Further expenses 5% 5 5 5 5
Profit 10 10 10 10
Less: Bad debts - 2 10 20
Expected Profit 10 8 Nil (10)
Less: Interest cost 1.66 1.55 1.48 2.96
Net Benefit 8.34 6.45 (1.48) (12.96)
Evaluation Accept Accept Reject Reject
Calculation of interest cost
Category 1 Category 2 Category 3 Category 4
90  15%  45 days 90  15%  42 days 90  15%  40 days 90  15%  80 days
365 days 365 days 365 days 365 days
= `1.66 = `1.55 = `1.48 = `2.96
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
term of net 30 days, it allows average collection period for more than 30 days 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 (1) past
performance of the customers and (2) their credit worthiness.

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 MANAGEMENT OF RECEIVABLES 3.5

PYQ 5
A Ltd. has a total sale 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 is `5,00,000. A
factor is prepared to buy the firm’s receivables by charging 2% commissions.
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 (360 Days in a year).
[(6 Marks) May 2002]

Answer
Statement of Effective Cost of Factoring to the Firm
Particulars `
(A) Cost of factoring:
Factoring commission (1,60,000 × 360 Days/90 Days) 6,40,000
Interest charges (3,16,800 × 360 Days/90 Days) 12,67,200
Total (A) 19,07,200
(B) Savings:
Saving in credit administration cost 5,00,000
Saving in bad debts (1.5% of 3,20,00,000) 4,80,000
Total (B) 9,80,000
Effective cost of factoring (A - B) 9,27,200
Rate of effective cost  
9,27,200
100  13.79%
 67,23,200 

Working Notes:
Calculation of advance
Particulars `
Average receivables (3,20,00,000 × 90/360) 80,00,000
Less: Factor reserve @ 10% of 80,00,000 8,00,000
Maximum possible advance 72,00,000
Less: Commission @ 2% of 80,00,000 1,60,000
Advance net of commission 70,40,000
Less: Interest (70,40,000 × 18% × 90/360) 3,16,800
Amount of advance 67,23,200
Note: Alternatively rate of effective cost can be calculated on amount available for advance (70,40,000)

PYQ 6
A company has prepared the following projections for a year:
Sales 21,000 units
Selling price per unit `40
Variable cost 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. [(4 Marks) Nov 2002]

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 MANAGEMENT OF RECEIVABLES 3.6

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales units 21,000 22,680
Sales value @ `40 per unit 8,40,000 9,07,200
Less: Variable cost @ `25 per unit/ 62.50% 5,25,000 5,67,000
Less: Fixed Cost (21,000 × `10) 2,10,000 2,10,000
Expected Profit 1,05,000 1,30,200
Less: Required return (WN) 15,313 32,375
Net Benefit 89,687 97,825

Analysis: The proposal for a more liberal extension of credit by increasing the average collection period
from one month to two months is suggested to adopt.

Working notes:
Calculation of required return on investment in cost of debtors:
Existing = (5,25,000 + 2,10,000) × 1/12 × 25% = 15,313
Proposed = (5,67,000 + 2,10,000) × 2/12 × 25% = 32,375

PYQ 7
A firm has a current sales of `2,56,48,750. The firm has unutilized 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? Assume 360 days in a year.
[(4 Marks) Nov 2003]

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 2,56,48,750 2,82,13,625
Less: Variable cost @ 72% of sales 1,84,67,100 2,03,13,810
Profit before cost of credit 71,81,650 78,99,815
Less: Bad debts @ 1.5% / 2% 3,84,731 5,64,273
Expected PBT 67,96,919 73,35,542
Less: Tax @ 35% 23,78,922 25,67,440
Expected PAT 44,17,997 47,68,102
Less: Cost of investment in debtors 3,46,258 5,07,845
Net benefit after tax 40,71,739 42,60,257

Yes, the firm should change its credit period.

Working Notes:
Calculation of cost of investment in debtors:
Existing = 1,84,67,100 × 45/360 × 15% = 3,46,258
Proposed = 2,03,13,810 × 60/360 × 15% = 5,07,845

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 MANAGEMENT OF RECEIVABLES 3.7

PYQ 8
A firm is considering offering 30 days credit to its customers. The firm like to charge them an annualized rate
of 24%. The firm wants to structure the credit in terms of a cash discount for immediate payment.
How much would the discount rate have to be?
[(4 Marks) Nov 2004]

Answer
Interest @ 24% p.a. for a period of 30 days (year 365 days) = 0.24 × 30/365
= 0.019726 i.e. 1.9726%
Hence, the principal of `1 including the interest after 30 days will become 1.019726.
Hence, discount which can be offered to receivables as on zero date = 1 - 0.980656
= 0.019344 i.e. 1.93%.

PYQ 9
A company has sales of `25,00,000. Average collection period is 50 days, bad debt losses are 5% of sales and
collection expenses are `25,000. The cost of funds is 15%. The company has two alternative collection
programs:
Programme I Programme II
Average collection period reduced to 40 days 30 days
Bad debt losses reduced to 4% of sales 3% of sales
Collection expenses `50,000 `80,000
Evaluate which programme is viable.
[(6 Marks) May 2006]

Answer
Statement of Evaluation
Current Program 1 Program 2
Particulars
50 days 40 days 30 days
Sales 25,00,000 25,00,000 25,00,000
Cost of investment in Debtors 51,370 41,096 30,822
Bad debt losses 1,25,000 1,00,000 75,000
Collection expenses 25,000 50,000 80,000
Cost of credit 2,01,370 1,91,096 1,85,822
Analysis: The Proposed Policy II should be adopted since the total costs under this policy is least as
compared to other policies.
Note: In absence of Cost of Sales, sales has been taken for purpose of calculating cost of investment in
debtors.

Working Notes:
Calculation of cost of investment in debtors:
Existing = 25,00,000 × 50/365 × 15% = 51,370
Program 1 = 25,00,000 × 40/365 × 15% = 41,096
Program 2 = 25,00,000 × 30/365 × 15% = 30,822

PYQ 10
The sales manager of AB Limited suggests that if credit period is given for 1.5 months then sales may likely to
increases by `1,20,000 per annum. Cost of sales amounted to 90% of sales. The risk of non payment is 5%.
Income tax rate is 30%. The expected return on investment is `3,375 (after tax).
Should the company accept the suggestion of sales manager? [(3 marks) May 2008]

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 MANAGEMENT OF RECEIVABLES 3.8

Answer
Statement of Evaluation
Particulars `
Increase in sales 1,20,000
Less: Cost of sales @ 90% 1,08,000
Profit before cost of credit 12,000
Less: Risk of non payments @ 5% 6,000
Expected PBT 6,000
Less: Tax @ 30% 1,800
Expected PAT 4,200
Less: Required return after tax 3,375
Net Benefit 825

Conclusion:
Since company has positive benefit after fulfill of required return from investment in debtors, Suggestion of
the sales manager should be accepted.

PYQ 11
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 sale. The expenditure incurred by the firm in administering
receivable collection effort 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 this firm at an interest rate of 16% p.a. after withholding 10% as reserve.

Calculate effective cost of factoring to the firm. Assume 360 days in a year.
[May 2009]

Answer
Statement of Effective Cost of Factoring to the Firm
Particulars `
(A) Cost of factoring:
Factoring commission (12,00,000 × 2%) 24,000
Interest charges (10,560 × 360 Days/90 Days) 42,240
Total (A) 66,240
(B) Savings:
Saving in credit administration cost 50,000
Saving in bad debts (1.5% of 12,00,000) 18,000
Total (B) 68,000
Net Benefit to firm (B - A) 1,760
Calculation of advance
Particulars `
Average receivables (12,00,000 × 90/360) 3,00,000
Less: Factor reserve @ 10% of 3,00,000 30,000
Maximum possible advance 2,70,000
Less: Commission @ 2% of 3,00,000 6,000
Amount available for advance 2,64,000
Less: Interest (2,64,000 × 16% × 90/360) 10,560
Amount of advance 2,53,440

Conclusion: Since company has positive benefit, it is suggested to enter into factoring agreement.

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 MANAGEMENT OF RECEIVABLES 3.9

PYQ 12
RST Limited 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 `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.
On the basis of the following information, which is better option?

Particulars Present Option I Option II

Annual credit sales (`) 2,25,00,000 2,75,00,000 3,50,00,000
Accounts receivables turnover ratio 5 times 4 times 3 times
Bad debt losses (`) 7,50,000 22,50,000 47,50,000
[(8 Marks) Nov 2010]

Answer
Statement of Evaluation of Credit Policies (in Lakhs)
Particulars Present Option 1 Option 2
Credit sales 225.00 275.00 350.00
Less: Variable cost @ 60% 135.00 165.00 210.00
Profit before bad debt losses 90.00 110.00 140.00
Less: Bad debt losses 7.50 22.50 47.50
Expected Profit 82.50 87.50 92.50
Less: Required return on investment 5.40 8.25 14.00
(Variable cost × 1/DTR × 20%)
Net Benefit 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.

Note:
In the above solution, investment in accounts receivable is based on total cost of goods sold on credit. Since
fixed costs are not given in the problem, therefore, it is assumed that there are no fixed costs and investment
in receivables is determined with reference to variable costs only. The above solution may alternatively be
worked out on the basis of incremental approach. However, the recommendation would remain the same.

PYQ 13
The marketing manager of XY Ltd. is giving a proposal to the board of directors of the company that an
increase in credit period allowed to customers from the present one month to two months will bring a 25%
increase in sales volume in the next year.

The following operational data of the company for the current year are taken from the records
of the company:

Selling price `21 per unit

Variable cost `14 per unit
Total cost `18 per unit
Sales value `18,90,000

The board, by forwarding the above proposal and data requests you to give your expert opinion on the
adoption of the new credit policy in next year subject to a condition that the company’s required rate of
return on investments is 40%.
[(8 Marks) May 2011]

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 MANAGEMENT OF RECEIVABLES 3.10

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales units 90,000 1,12,500
Sales value @ `21 per unit 18,90,000 23,62,500
Less: Variable cost @ `14 per unit 12,60,000 15,75,000
Less: Fixed Cost (90,000 × `4) 3,60,000 3,60,000
Expected profit 2,70,000 4,27,500
Less: Required return (WN) 54,000 1,29,000
Net Benefit 2,16,000 2,98,500
Analysis:
The proposal for a more liberal extension of credit by increasing the average collection period from one
month to two months is suggested to adopt.
Working notes:
Calculation of required return on investment in cost of debtors:
Existing = (12,60,000 + 3,60,000) × 1/12 × 40% = 54,000
Proposed = (15,75,000 + 3,60,000) × 2/12 × 40% = 1,29,000

PYQ 14
A new customer with 10% risk of non-payment desires to establish business connection with you. He would
require 1.5 month of credit and is likely to increase you sales by `1,20,000 p.a. Cost of sales amounted to
85% of sales. The tax rate is 30%. Required rate of return is 40% (after tax).
Should you accept the offer?
[(4 Marks) Nov 2011]

Answer
Statement of Evaluation
Particulars `
Increase in sales 1,20,000
Less: Cost of sales @ 85% 1,02,000
18,000
Less: Expected bad debts loss (10% on sales) 12,000
Expected PBT 6,000
Less: Tax @ 30% 1,800
Expected PAT 4,200
Less: Required return after tax (1,02,000 × 1.5/12 × 40%) 5,100
Net benefit (after tax) (900)

Conclusion: Since company has negative benefit after tax ,offer should be rejected.

PYQ 15
A company is presently having credit sales of `12,00,000. 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 1/3 of existing sales, bad debts increase to 2% of sales
and average collection period to decline to 20 days.

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 MANAGEMENT OF RECEIVABLES 3.11

The contribution to sales ratio of the company is 22% and opportunity cost of investment in
receivables is 15 percent (pre tax). 50 percent and 80 percent of customers in term of sales revenue are
expected to avail cash discount under existing and liberalisation scheme respectively. The tax rate is 30%.

Should the company change its credit terms? (Assume 360 days in a year).
[(5 Marks) May 2012]

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 12,00,000 16,00,000
Less: Variable cost @ 78% 9,36,000 12,48,000
Contribution @ 22% 2,64,000 3,52,000
Less: Bad debts 18,000 32,000
Less: Cash discount (WN) 6,000 25,600
Expected Profit 2,40,000 2,94,400
Less: Opportunity cost of investment in receivables (WN) 11,700 10,400
Net Benefit Before Tax 2,28,300 2,84,000
Less: Tax @ 30% 68,490 85,200
Net Benefit After Tax 1,59,810 1,98,800

Advise: Company should change its credit terms having higher net benefit.

Working notes:

(1) Calculation of opportunity cost of investment in receivables:

Existing = 9,36,000 × 15% × 30/360 = 11,700
Proposed = 12,48,000 × 15% × 20/360 = 10,400

(2) Calculation of cash discount:

Existing = 12,00,000 × 50% × 1% = 6,000
Proposed = 16,00,000 × 80% × 2% = 25,600

PYQ 16
PTX Limited is considering a change in its present credit policy. Currently it is evaluating two policies. The
company is required to give a return of 20% on the investment in new receivables. The company’s variable
costs are 70% of selling price.

Information regarding present and proposed policies are as follows:

Policies
Particulars
Present Option 1 Option 2
Annual credit sales `30,00,000 `42,00,000 `45,00,000
Debtors turnover ratio 4 times 3 times 2.4 times
Loss due to bad debts 3% of sales 5% of sales 6% of sales

Note: Return on investment in new account receivable is based on cost of investment in debtors.

Which option would you recommend?

[(Marks 8) Nov 13]

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 MANAGEMENT OF RECEIVABLES 3.12

Answer
Statement of Evaluation
Particulars Existing Option 1 Option 2
Credit sales 30,00,000 42,00,000 45,00,000
Less: Variable cost @ 70% 21,00,000 39,40,000 31,50,000
Profit before bad debt losses 9,00,000 12,60,000 13,50,000
Less: Bad debt losses 90,000 2,10,000 2,70,000
Expected Profit 8,10,000 10,50,000 10,80,000
Less: Required return on investment ‘WN’ 1,05,000 1,96,000 2,62,500
(Variable cost × 1/DTR × 20%)
Net Benefit 7,05,000 8,54,000 8,17,500
Recommendation: PTX Limited is advised to adopt Policy Option 1.
Note:
In the above solution, investment in accounts receivable is based on total cost of goods sold on credit. Since
fixed costs are not given in the problem, therefore, it is assumed that there are no fixed costs and investment
in receivables is determined with reference to variable costs only. The above solution may alternatively be
worked out on the basis of incremental approach. However, the recommendation would remain the same.

PYQ 17
PQR Ltd. having annual sales of `30,00,000, is re considering its present collection policy. At present the
average collection period is 50 days, 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:
Alternative I Alternative II
Average collection period reduced to 40 days 30 days
Bad debt losses 4% of sales 3% of sales
Collection expenses `60,000 `95,000
Evaluate the alternatives on the basis of incremental approach and state which alternative is
more beneficial.
[(8 Marks) Nov 2014]

Answer
Statement of Evaluation
Particulars Current Alternate 1 Alternate 2
Sales 30,00,000 30,00,000 30,00,000
Cost of investment in Debtors 41,096 32,877 24,658
1. Saving in cost in Debtors - 8,219 16,438
Bad debt losses 1,50,000 1,20,000 90,000
2. Saving in Bad debt losses - 30,000 60,000
Collection expenses 30,000 60,000 95,000
3. Increase in collection expenses - 30,000 65,000
Incremental Benefit (1 + 2 - 3) - 8,219 11,438
Analysis: Since incremental benefit over present policy is higher in case of alternative II, select
Alternative II. It is suggested to reduce the collection period from existing 50 days to 30 days.
Working Notes:
Calculation of cost of investment in debtors:
Existing = 30,00,000 × 50/365 × 10% = 41,096
Alternative I = 30,00,000 × 40/365 × 10% = 32,877
Alternative II = 30,00,000 × 30/365 × 10% = 24,658

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 MANAGEMENT OF RECEIVABLES 3.13

PYQ 18
A new customer has approached a firm to establish new business connection. The customer require 1.5
month of credit. If the proposal is accepted, the sales of the firm will go up by `2,40,000 per annum. The new
customer is being considered as a member of 10% risk of non-payment group.
The cost of sales amounted to 80% of sales. The tax rate is 30% and required rate of return is 40%
(after tax).
Should the firm accept the offer? Give your opinion on the basis of calculations.
[(5 Marks) May 2015]
Answer
Statement of Evaluation
Particulars `
Increase in sales 2,40,000
Less: Cost of sales @ 80% 1,92,000
Profit before cost of credit 48,000
Less: Risk of non payments @ 10% 24,000
Expected PBT 24,000
Less: Tax @ 30% 7,200
Expected PAT 16,800
Less: Required return after tax (WN) 9,600
Net Benefit (After Tax) 7,200

Conclusion: Since company has positive benefit after fulfill of required return from investment in debtors,
offer should be accepted.

Working notes:
Calculation of cost of investment in debtors:
Existing = 1,92,000 × 1.5/12 × 40% = 9,600

PYQ 19
A firm has total sales as `200 lakhs of which 80% is on credit. It is offering credit term 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?
[(8 Marks) Nov 2015]

Answer
1. Calculation of advance:
Particulars `
Average receivables (`200 Lakhs × 80% × 80/360) 35,55,556
Less: Factor reserve @ 10% of `35,55,556 3,55,556
Maximum possible advance 32,00,000
Less: Commission @ 2% of `35,55,556 71,111
Amount available for advance 31,28,889
Less: Interest (`31,28,889 × 18% × 80/360) 1,25,156
Amount of advance 30,03,733

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 MANAGEMENT OF RECEIVABLES 3.14

2. Average collection period = 40 Days × ½ + 80 Days × ½ = 80 Days

(i) Statement of Effective Cost of Factoring to the Firm

Particulars `
(A) Cost of factoring:
Factoring commission (`71,111 × 360 Days/80 Days) 3,20,000
Interest charges (`31,28,889 × 18%) 5,63,200
Total (A) 8,83,200
(B) Savings:
Saving in credit administration cost 2,40,000
Saving in bad debts (1% × 80% × `2,00 Lakhs) 1,60,000
Total (B) 4,00,000
Effective cost of factoring (A - B) 4,83,200
Rate of effective cost  
4,83,200
100  16.09%
 30,03,733 

Alternatively:
If cost of factoring is calculated on the basis of total amount available for advance, then, it will be
 4,83,200 
Rate of effective cost =  100  = 15.44%
 31,28 ,889 

Assumptions:
(1) Factoring commission will be paid in advance.
(2) Factor will bear bad debt losses (Non recourse factoring).

(ii) If bank finance for working capital is available at 14%, firm will not avail factoring services as 14% is
less than 16.08% (or 15.44%).

PYQ 20
A trader whose current sales are `4,20,000 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:
Increase in Collection Present default
Credit Policy Increase in Sales
Period anticipated
I 10 days `21,000 1.5%
II 30 days `52,500 3%
III 45 days `63,000 4%
The selling price per unit is `3. Average cost per unit is `2.25 and variable cost per unit is `2. The current
bad-debts loss is 1%. Required return on additional investment is 20%. Assume a 360 days year.
Which of the above policies would you recommend for adoption?
[(8 Marks) May 2016]

Answer
Working notes:
Calculation of cost required rate of return:
Collection Period
Required rate of return = Total cost × × Rate of return
360Days
30
Existing = 3,15,000 × × 20% = 5,250
360 Days

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 MANAGEMENT OF RECEIVABLES 3.15

40
Credit Policy I = 3,29,000 × × 20% = 7,311
360 Days
60
Credit Policy II = 3,50,000 × × 20% = 11,667
360 Days
75
Credit Policy III = 3,57,000 × × 20% = 14,875
360 Days

Statement of Evaluation of Credit Policies

Particulars Present I II III
No of units 1,40,000 1,47,000 1,57,500 1,61,000
Credit sales @ `3 per unit 4,20,000 4,41,000 4,72,500 4,83,000
Less: Variable cost @ `2 per unit 2,80,000 2,94,000 3,15,000 3,22,000
Less: Fixed cost (2.25 - 2) × 1,40,000 35000 35,000 35,000 35,000
Profit before bad debt losses 1,05,000 1,12,000 1,22,500 1,26,000
Less: Bad debt losses 4,200 6,615 14,175 19,320
Expected Profit 1,00,800 1,05,385 1,08,325 1,06,680
Less: Required return on investment 5,250 7,311 11,667 14,875
Net Benefit 95,550 98,074 96,658 91,805

Recommendation: Proposed Policy I (i.e. increase in collection period by 10 days or total 40 days) should be
adopted since the net benefits under this policy are higher as compared to other policies.

PYQ 21
A current credit sales of a firm is `15,00,000 and the firm still has an unutilized capacity. In order to boost its
sales, the firm is willing to relax its credit policy.
The firm proposes a new credit policy of 2/10 net 60 days as against the present policy of 1/10 net
45 days. The firm expects an increase in the sales by 12%. However, it is also expected that bad debts will go
upto 2% of sales from 1.5%.
The contribution to sales ratio of the firm is 28%. The firm's tax rate is 30% and firm requires an
after tax return of 15% on its investment. 50 percent and 80 percent of customers in term of sales revenue
are expected to avail cash discount under existing and liberalization scheme respectively.

Should the firm change its credit period?

[(8 Marks) Nov 2017]

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 15,00,000 16,80,000
Less: Variable cost @ 72% of sales 10,80,000 12,09,600
Profit before cost of credit 4,20,000 4,70,400
Less: Bad debts @ 1.5% / 2% 22,500 33,600
Less: Cash Discount ‘WN’ 7,500 26,880
Expected PBT 3,90,000 4,09,920
Less: Tax @ 30% 1,17,000 1,22,976
Expected PAT 2,73,000 2,86,944
Less: Cost of investment in debtors ‘WN’ 12,205 9,942
Net benefit after tax 2,60,795 2,77,002
Yes, the firm should change its credit period.

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 MANAGEMENT OF RECEIVABLES 3.16

Working notes:
1. Calculation of opportunity cost of investment in receivables:
Existing = 10,80,000 × 15% × 27.5 (.5×10+.5×45)/365 = 12,205
Proposed = 12,09,600 × 15% × 20 (.8×10+.2×60)/365 = 9,942
2. Calculation of cash discount:
Existing = 15,00,000 × 50% × 1% = 7,500
Proposed = 16,80,000 × 80% × 2% = 26,880

PYQ 22
A company is considering to engage a factor. The following information is available:
 The current average collection period for the company's debtors is 90 days and ½% of debtors default.
The factor has agreed to pay money due after 60 days, and will take the responsibility of any loss on
account of bad debts.
 The annual charge for the factoring is 2% of turnover. Administration cost saving is likely to be `1,00,000
per annum.
 Annual credit sales are `1,20,00,000. Variable costs is 80% of sales price. The company's cost of
borrowings is 15% per annum. Assume 360 days in a year.
Should the company enter into a factoring agreement?
[(8 Marks) May 2018]

Answer
Statement of Evaluation
Particulars `
(A) Savings:
Saving in administration cost 1,00,000
Saving in bad debts (0.5% of 1,20,00,000) 60,000
*Saving in cost of debtors (1,20,00,000 × 80% × 90 – 60/360 × 15%) 1,20,000
Total (A) 2,80,000
(B) Cost:
Annual charges (2% of 1,20,00,000) 2,40,000
Total (B) 2,40,000
Net Benefit (A -B) 40,000
*Presently, the debtors of the company pay after 90 days. However, the factor has agreed to pay after 60 days
only. So, the investment in Debtors will be reduced by 30 days.
Conclusion: Yes, company should enter into factoring agreement.

PYQ 23
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)
[(10 Marks) Nov 2018]

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 MANAGEMENT OF RECEIVABLES 3.17

Answer
Statement of Evaluation
Policies
Particulars
Present Proposed
Sales value 30,00,000 36,00,000
Less: Variable cost 70% of 80% of sales 16,80,000 20,16,000
Less: Fixed cost (30% of 80% of current sales 30,00,000) 7,20,000 7,20,000
Profit before cost of credit 6,00,000 8,64,000
Less: Bad debts @ 2%/3% 60,000 1,08,000
Expected Profit 5,40,000 7,56,000
Less: Required return 15,000 51,300
Net benefit 5,25,000 7,04,700

Yes, the firm should change its credit period.

Working Notes:
Calculation of required return in debtors:
Existing = (16,80,000 + 7,20,000) × 15/360 × 15% = 15,000
Proposed = (20,16,000 + 7,20,000) × 45/360 × 15% = 51,300

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 MANAGEMENT OF RECEIVABLES 3.18

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
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 CHAPTER - 4

MANAGEMENT OF WORKING
CAPITAL
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Discuss in details about working capital management, its
meanings and its significance to any business/firm.
 Understand the concept of operating cycle and the estimation of
working capital needs.
 Understand the need for a business to invest in current assets.
 Know why it is important to manage efficiently the current assets
and current liabilities?
 Discuss the financing of working capital.
 MANAGEMENT OF WORKING CAPITAL 4.2

PAST YEARS QUESTIONS

PYQ 1
Aneja Limited, 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 is 1,04,000 completed units of production plus 4,000 units of work-in-
progress.
Based on the above activity, estimated cost per unit is:
Raw material `80
Direct wages `30
Overheads (exclusive of depreciation) `60
Total cost `170
Selling price `200
Raw materials in stock: average 4 weeks consumption, work-in-progress (assume 50% completion
stage in respect of conversion cost but materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at banks (for smooth operation) `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:
(a) The net working capital required;
(b) The maximum permissible bank finance under first and second methods of financing as per Tandon
Committee Norms.
[(12 Marks) Nov 1998]

Answer
(a) Statement of Working Capital Requirement
Particulars `
(1) Current Assets:
Raw materials (86,40,000 × 4/52) 6,64,615
Work in progress [4,000 units × (80 + 15 + 30)] 5,00,000
Finished goods (8,000 units × 170) 13,60,000
Debtors (1,63,20,000 × 8/52) 25,10,769
Cash 25,000
Total (1) 50,60,384
(2) Current Liabilities:
Creditors (86,40,000 + 6,64,615) × 4/52 7,15,740
Outstanding labour (31,80,000 × 1.5/52) 91,731
Total (2) 8,07,471
Working Capital (1 - 2) 42,52,913

(b) Calculation of MPBF under the suggestion of Tandon Committee Norms:

Method 1 = 75% (50,60,384 – 8,07,471) = 75% of 46,95,990 = `31,89,685

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 MANAGEMENT OF WORKING CAPITAL 4.3
Method 2 = (75% CA) – CL = (75% 50,60,384) – 8,07,471 = `29,87,817

Working Notes:
Projected Income Statement
Particulars `
Raw materials (1,08,000 × 80) 86,40,000
Direct labour (1,04,000 + ½ × 4,000) × 30 31,80,000
Overheads (1,04,000 + ½ × 4,000) × 60 63,60,000
Cost Upto Factory 1,81,80,000
Less: Closing WIP 4,000 units × (80 + 15 + 30) (5,00,000)
Cost of Production (1,08,000 units) 1,76,80,000
Less: Closing FG 8,000 units × 170 (13,60,000)
Cost of Goods Sold (96,000 units) 1,63,20,000
Profit 28,80,000
Sales (96,000 × 200) 1,92,00,000

PYQ 2
Q Ltd. sells goods at a uniform rate of gross profit of 20% on sales including depreciation as part of cost of
production.
Its annual figures are as under:
Sales (at 2 months' credit) `24,00,000
Materials consumed (suppliers credit 2 months) `6,00,000
Wages paid (monthly at the beginning of the subsequent month) `4,80,000
Manufacturing expenses (cash expenses are paid one month in arrear) `6,00,000
Administration expenses (cash expenses are paid one month in arrear) `1,50,000
Sales promotion expenses (paid quarterly in advance) `75,000
The company keeps one month stock each of raw materials and finished goods. A minimum cash
balance of `80,000 is always kept. The company wants to adopt a 10% safety margin in the maintenance of
working capital. The company has no work-in-progress.
Find out the requirements of working capital of the company on cash cost basis.
[(8 Marks) May 1994, 1999]

Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(1) Current Assets:
Raw Materials (6,00,000 × 1/12) 50,000
Finished Goods (16,80,000 × 1/12) 1,40,000
Debtors (19,05,000 × 2/12) 3,17,500
Cash 80,000
Prepaid Sales Promotion Expenses (75,000 × 1/4) 18,750
Total (1) 6,06,250
(2) Current Liabilities:
Creditors (6,00,000 × 2/12) 1,00,000
Outstanding labour (4,80,000 × 1/12) 40,000
Outstanding Manufacturing Expenses (6,00,000 × 1/12) 50,000
Outstanding Administrative Expenses (1,50,000 × 1/12) 12,500
Total (2) 2,02,500
Working Capital Before Provision (1 - 2) 4,03,750
Add : Safety Margin @ 10% of 4,03,750 40,375
Working Capital 4,44,125

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 MANAGEMENT OF WORKING CAPITAL 4.4
Working Notes:
Projected Income Statement
Particulars `
Raw Materials 6,00,000
Wages 4,80,000
Manufacturing Expenses (in cash) 6,00,000
Cash Cost of Goods Sold 16,80,000
Administration Expenses (in cash) 1,50,000
Sales Promotion Expenses (in cash) 75,000
Cash Cost of Sales 19,05,000

PYQ 3
A company is considering its working capital investment and financial policies for the next year. Estimated
fixed assets and current liabilities for the next year are `2.60 crores and `2.34 crores respectively. Estimated
sales and EBIT depends on current assets investment, particularly inventories and book-debts.
The Financial Controller of the company is examining the following alternative Working Capital
Policies:
(` Crore)
Working capital policy Investment in CA Estimated sales EBIT
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the adoption of the
moderate working capital policy. The company is now examining the use of long term and short term
borrowings for financing its assets. The company will use `2.50 crores of the equity funds. The corporate tax
rate is 35%.
The company is considering the following debt alternatives: (` Crore)
Financing policy Short term debt Long term debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate 12% 16%
You are required to calculate the following:
(1) Working Capital Investment for each policy:
a. Net working capital position, b. Rate of return on total assets, c. Current ratio.
(2) Financing for each policy:
a. Net working capital position, b. Rate of return on shareholder’s equity, c. Current ratio.
[Nov 2001]

Answer
(1) Statement Showing Working Capital Investment for Each Policy (` Crore)
Particulars Conservative Moderate Aggressive
(a) Net working capital position (CA – CL) 4.50 – 2.34 3.90 – 2.34 2.60 – 2.34
2.16 1.56 0.26
(b) Rate of return on total assets 1.23
×100 1.15
×100 1.00
×100
 EBIT  2.60  4.50 2.60  3.90 2.60  2.60
 100 
 Total assets  17.32% 17.69% 19.23%
(c) Current ratio (CA ÷ CL) 4.50 ÷ 2.34 3.90 ÷ 2.34 2.60 ÷ 2.34
1.92 : 1 1.67 : 1 1.11 : 1

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 MANAGEMENT OF WORKING CAPITAL 4.5
(2) Statement Showing Effect of Financing Policies (` Crore)
Particulars Conservative Moderate Aggressive
(a) Net working capital position (CA – CL) 3.90 – *2.88 3.90 – 3.34 3.90 – 3.84
CL includes short term borrowings 1.02 0.56 0.06
(b) Rate of return on shareholder’s equity 0.589
×100
0.601
×100
0.614
×100
 PAT  2.50 2.50 2.50
 100 
 Equity  23.56% 24.04% 24.56%
(c) Current ratio (CA ÷ CL) 3.90 ÷ 2.88 3.90 ÷ 3.34 3.90 ÷ 3.84
1.35 : 1 1.167 : 1 1.016 : 1
Calculation of PAT:
EBIT 1.15 1.15 1.15
Less: interest @ 12% on short term 0.065 0.12 0.18
Less: interest @ 16% on long term 0.179 0.106 0.026
EBT 0.906 0.924 0.944
Less: Tax @ 35% 0.317 0.323 0.330
PAT 0.589 0.601 0.614
* CL = CL + Short term borrowings = 2.34 + 0.54 = 2.88

PYQ 4
The following information has been extracted from the records of a Company, estimated cost per unit is:
Raw material `45
Direct wages `20
Overheads `40
Total cost `105
Profit `15
Selling price `120
(a) Raw materials are in stock on an average of two months.
(b) The materials are in process on an average for 4 weeks. The degree of completion is 50%.
(c) Finished goods stock on an average is for one month.
(d) Time lag in payment of wages and overheads is 1-½ weeks.
(e) Time lag in receipt of proceeds from debtors is 2 months.
(f) Credit allowed by suppliers is 1 month.
(g) 20% of the output is sold against cash.
(h) The company expects to keep a cash balance of `1,00,000.
(i) Take 52 weeks per annum.
(j) The company is poised for a manufacture of 1,44,000 units in the year.
You are required to prepare a statement showing the working capital requirements of the
company.
[Nov 2002]

Answer
Statement of Working Capital Requirement
Particulars `
(1) Current Assets:
Raw Materials (1,44,000 units × `45 × 2/12) 10,80,000
WIP (1,44,000 units × `105 × 50% × 4/52) 5,81,538
Finished Goods (1,44,000 units × `105 × 1/12) 12,60,000
Debtors (1,44,000 units × `105 × 80% × 2/12) 20,16,000
Cash 1,00,000
Total (1) 50,37,538

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 MANAGEMENT OF WORKING CAPITAL 4.6
(2) Current Liabilities:
Creditors (1,44,000 units × `45 × 1/12) 5,40,000
Outstanding labour (1,44,000 units × `20 × 1.5/52) 83,077
Outstanding Overhead (1,44,000 units × `40 × 1.5/52) 1,66,154
Total (2) 7,89,231
Working Capital (1 - 2) 42,48,307

PYQ 5
An engineering company is considering its working capital investment for the year 2003-04. The estimated
fixed assets and current liabilities for the next year are `6.63 crores and `5.967 crores respectively. The sales
and earnings before interest and taxes (EBIT) depend on investment in its current assets particularly
inventory and receivables.
The company is examining the following alternative working capital policies: (` Crore)
Working capital policy Investment in CA Estimated sales EBIT
Conservative 11.475 31.365 3.1365
Moderate 9.945 29.325 2.9325
Aggressive 6.63 25.50 2.55

You are required to calculate the following for each policy:

(a) Rate of return on total assets.
(b) Net working capital position.
(c) Current assets to fixed assets ratio.
(d) Discuss the risk-return trade off of each working capital policy.
[May 2003]

Answer
Statement Showing Working Capital Investment for Each Policy (` Crore)
Particulars Conservative Moderate Aggressive
(a) Rate of return on total assets 3.1365
×100 2.9325
×100 2.55
×100
 EBIT  11.475  6.63 9.945  6.63 6.63  6.63
  100 
 Total assets(CA  FA )  17.32% 17.69% 19.23%

(b) Net working capital position 11.475 – 5.967 9.945 – 5.967 6.63 – 5.967
(CA – CL) 5.508 3.978 0.663
(c) Current assets to fixed assets ratio 11.475 ÷ 6.63 9.945 ÷ 6.63 6.63 ÷ 6.63
(CA ÷ Fixed assets) 1.73 : 1 1.50 : 1 1:1

(d) Risk-return trade off: The net working capital or current ratio is a measure of risk. Rate of return on
total assets is a measure of return. The expected risk and return are minimum in the case of conservative
investment policy and maximum in case of aggressive investment policy. The firm can improve profitability
by reducing investment in working capital.

PYQ 6
The following annual figures relate to MNP Limited:
Sales (at 3 months credit) `90,00,000
Materials consumed (suppliers credit one and half months) `22,50,000
Wages paid (one month in arrear) `18,00,000
Manufacturing expenses outstanding (cash expenses are paid one month in arrear) `2,00,000
Administration expenses (cash expenses are paid one month in arrear) `6,00,000
Sales promotion expenses (paid quarterly in advance) `12,00,000
The company sells its products on gross profit of 25% of assuming depreciation as a part of cost of

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 MANAGEMENT OF WORKING CAPITAL 4.7
production. It keeps two month’s stock of finished goods and one month's stock of raw materials as
inventory. It keeps cash balance of `2,50,000.
Assume a 5% safety margin, work out the working capital requirements of the company on cash
cost basis. Ignore work-in-process
[May 2004]

Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (22,50,000 × 1/12) 1,87,500
Finished Goods (64,50,000 × 2/12) 10,75,000
Debtors (82,50,000 × 3/12) 20,62,500
Cash 2,50,000
Prepaid Sales Promotion Expenses (12,00,000 × 1/4) 3,00,000
Total (A) 38,75,000
(B) Current Liabilities:
Creditors (22,50,000 × 1.5/12) 2,81,250
Outstanding labour (18,00,000 × 1/12) 1,50,000
Outstanding Manufacturing Expenses 2,00,000
Outstanding Administrative Expenses (6,00,000 × 1/12) 50,000
Total (B) 6,81,250
Working Capital Before Provision (A - B) 31,93,750
Add : Safety Margin @ 5% of 31,93,750 1,59,688
Working Capital 33,53,438
Working Notes:
Projected Income Statement
Particulars `
Raw Materials 22,50,000
Wages 18,00,000
Manufacturing Expenses in cash (2,00,000 × 12 months) 24,00,000
Cash Cost of Goods Sold 64,50,000
Administration Expenses (in cash) 6,00,000
Sales Promotion Expenses (in cash) 12,00,000
Cash Cost of Sales 82,50,000

PYQ 7
XYZ Company Ltd. is a pipe manufacturing company. Its production cycle indicates that materials are
introduced in the beginning of the production cycle; wages and overhead accrue evenly throughout the
period of the cycle. Wages are paid in the next month following the month of accrual. Work in process
includes full units of raw materials used in the beginning of the production process and 50% of wages and
overheads are supposed to be conversion costs.
Details of production process and the components of working capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle 1 month
Raw materials inventory held 1 month consumption
Finished goods inventory held for 2 months
Credit allowed by creditors 1 months
Credit given to debtors 2 months
Cost price of raw materials `60 per units
Direct wages `10 per unit

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 MANAGEMENT OF WORKING CAPITAL 4.8
Overheads `20 per unit
Selling price of finished pipes `100 per unit

Required to calculate:
(1) The amount of working capital required for the company.
(2) Its maximum permissible bank finance under all the three methods of lending norms as suggested by
the Tandon Committee, assuming the value of core current assets `1,00,00,000.
[May 2005]

Answer
(1) Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw Materials (12,00,000 units × `60 × 1/12) 60,00,000
WIP:
Materials (12,00,000 units × `60 × 100% × 1/12) 60,00,000
Wages and Overheads (12,00,000 units × `30 × 50% × 1/12) 15,00,000
Finished Goods (12,00,000 units × `90 × 2/12) 1,80,00,000
Debtors (12,00,000 units × `90 × 2/12) 1,80,00,000
Total (A) 4,95,00,000
(B) Current Liabilities:
Creditors (12,00,000 units × `60 × 1/12) 60,00,000
Outstanding labour (12,00,000 units × `10 × 1/12) 10,00,000
Total (B) 70,00,000
Working Capital (A - B) 4,25,00,000

(2) Calculation of MPBF:

Method 1 = 75% (CA - CL) = 75% of 4,25,00,000 = `3,18,75,000
Method 2 = (75% CA) – CL = (75% of 495 Lacs) – 70 Lacs = `3,01,25,000
Method 3 = (75% CA other than core current assets) - CL
= 75% (4,95,,00,000 – 1,00,00,000) – 70,00,000 = `2,26,25,000

PYQ 8
A Proforma cost sheet of a company provides the following particulars, estimated cost per unit is:
Raw material `100.00
Direct wages `37.50
Overheads `75.00
Total cost `212.50
Profit `37.50
Selling price `250.00
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
supplier is three weeks and company allows four weeks credit to its debtors. The lag in payment of wages in
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.
Prepare a statement showing estimate of Working Capital needed of 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.
[(8 Marks) Nov 06]

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 MANAGEMENT OF WORKING CAPITAL 4.9
Answer
Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw Materials (1,30,000 units × `100 × 1/12) 10,83,333
WIP (1,30,000 units × `212.50 × 80% × 1/52) 4,25,000
Finished Goods (1,30,000 units × `212.50 × 2/52) 10,62,500
Debtors (1,30,000 units × `212.50 × 4/5 × 4/52) 17,00,000
Cash and Bank Balance 37,500
Total (A) 43,08,333
(B) Current Liabilities:
Creditors (1,30,000 units × `100 × 3/52) 7,50,000
Outstanding labour (1,30,000 units × `37.50 × 1/52) 93,750
Outstanding Overheads (1,30,000 units × `75 × 2/52) 3,75,000
Total (B) 12,18,750
Working Capital (A - B) 30,89,583
Note: One may valued debtors on the basis of total cost i.e. `212.50.

PYQ 9
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 projected cost per unit for the current year:
Raw material `40
Direct labour `15
Overhead `30
Total cost `85
Profit `15
Sales `100
Raw material in stock: average 4 weeks consumption, Work in progress (completion stage 50
percent), on an average half a month. Finished goods in stock: on an average one month. Credit allowed by
suppliers is one month. Credit allowed to debtors is two months. Average time lag in payment of wages is 1.5
weeks and 4 weeks in overhead expenses. Cash in hand and at bank is desired to be maintained at `50,000.
All Sales are on credit basis only.
Required:
(1) Prepare statement showing estimate of working capital needed to finance an activity level of 96,000
units of production. Assume that production is carried on evenly throughout the year and wages and
overhead accrue similarly. For the calculation purpose 4 weeks may be taken as equivalent to a
month and 52 weeks in a year.
(2) From the above information calculate the maximum permissible bank finance by all the three
methods for working capital as per Tandon Committee norms; assume the core current assets
constitute 25% of the current assets.
[(8 Marks) Nov 2007]

Answer
Working Notes:
Activity level = 96,000 units of production (Excluding WIP)
FG Stock = on an average one month
= 96,000 × 1 = 8,000 units
12
Units sold = 96,000 – 8,000 = 88,000 units

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 MANAGEMENT OF WORKING CAPITAL 4.10
WIP = on an average half a month
= 96,000 × .5 = 4,000 units
12

Projected Income Statement

Particulars `
Raw materials (96,000 + ½ × 4,000) × 40 39,20,000
Direct labour (96,000 + ½ × 4,000) × 15 14,70,000
Overheads (96,000 + ½ × 4,000) × 30 29,40,000
Cost Upto Factory 83,30,000
Less: Closing WIP 4,000 units × (20 + 7.50 + 15) (1,70,000)
Cost of Production (96,000 units) 81,60,000
Less: Closing FG 8,000 units × 85 (6,80,000)
Cost of Goods Sold (88,000 units) 74,80,000
Profit 13,20,000
Sales (88,000 × 100) 88,00,000

(1) Statement of Working Capital Requirement

Particulars `
(A) Current Assets:
Raw materials (39,20,000 × 4/52) 3,01,538
Work in progress 1,70,000
Finished goods 6,80,000
Debtors (74,80,000 × 2/12) 12,46,667
Cash 50,000
Total (A) 24,48,205
(B) Current Liabilities:
Creditors (39,20,000 + 3,01,538) × 1/12 3,51,795
Outstanding wages (14,70,000 × 1.5/52) 42,404
Outstanding overheads (29,40,000 × 4/52) 2,26,154
Total (B) 6,20,353
Working Capital (A - B) 18,27,852
Note: one may use 4 weeks instead of 1 month for the purpose of calculations.

(2) Calculation of MPBF under the suggestion of Tandon Committee Norms:

Method 1 = 75% of (CA – CL) = 75% of 18,27,852 = `13,70,889
Method 2 = (75% of CA) – CL = (75% of 24,48,205) – 6,20,353 = `12,15,801
Method 3 = (75% of CA other than core CA) - CL
= [75% of (24,48,205 – 25%)] – 6,20,353 = `7,56,762

PYQ 10
MN Ltd. is commencing a new project for manufacturing of electric toys. The following cost information
has been ascertained for annual production of 60,000 units at full capacity:
Cost per unit
Raw materials `20
Direct labour `15
Manufacturing overheads:
Variable `15
Fixed `10
Selling and Distribution overheads:
Variable `3
Fixed `1

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 MANAGEMENT OF WORKING CAPITAL 4.11
Total cost `64
Profit `16
Selling price `80

In the first year of operations expected production and sales are 40,000 units and 35,000 units
respectively. To assess the need of working capital the following additional information is available:

(i) Stock of raw material 3 months consumption

(ii) Credit allowable for debtors 1-½ months
(iii) Credit allowable by creditors 4 months
(iv) Lag in payment of wages 1 month
(v) Lag in payment of overheads ½ month
(vi) Cash in hand and bank is expected to `60,000

Provision for contingencies is required @10% of Working capital requirement including that
provision. You are required to prepare a projected statement of working capital requirement for the
first year of operation. Debtors are taken at cost.
[(8 Marks) Nov 2008]

Answer
Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw materials (8,00,000 × 3/12) 2,00,000
Finished goods 3,25,000
Debtors (24,40,000 × 1.5/12) 3,05,000
Cash 60,000
Total (A) 8,90,000
(B) Current Liabilities:
Creditors (8,00,000 + 2,00,000) × 4/12 3,33,333
Outstanding labour (6,00,000 × 1/12) 50,000
Outstanding overheads (13,65,000 × 0.5/12) 56,875
Total (B) 4,40,208
Gross Working Capital (A - B) 4,49,792
Add: Provision for contingencies @ 10% of Working Capital 49,977
Working Capital 4,99,769

WN:
Projected Income Statement
Particulars `
Raw Materials (40,000 × 20) 8,00,000
Direct Labour (40,000 × 15) 6,00,000
Manufacturing Overheads: Variable (40,000 × 15) 6,00,000
Fixed (60,000 × 10) 6,00,000
Cost of Production (40,000 units) 26,00,000
Less: Closing FG (26,00,000 × 5,000/40,000) (3,25,000)
Cost of Goods Sold (35,000 units) 22,75,000
Selling and Distribution Overheads: Variable (35,000 × 3) 1,05,000
Fixed (60,000 × 1) 60,000
Cost of Sales 24,40,000
Profit 3,60,000
Sales (35,000 × 80) 28,00,000

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 MANAGEMENT OF WORKING CAPITAL 4.12
PYQ 11
The management of MNP Company Ltd. is planning to expand its business and consult you to prepare an
estimated working capital statement.
The records of the company revealed the following annual information:
Sales:
Domestic at one month’s credit `24,00,000
Export at three month’s credit `10,80,000
(Sales price 10% below Domestic price)
Material 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 administrative 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. 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 next year.
[(16 Marks) May 2011]

Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (9,00,000 × 1/12) 75,000
Finished Goods (27,00,000 × 1/12) 2,25,000
Debtors:
Domestic (19,60,000 + 1,03,448) × 1/12 1,71,954
Export (9,80,000 + 46,552) × 3/12 2,56,638
Cash (2,50,000 – 75,000) 1,75,000
Prepaid Sales Promotion Expenses (1,50,000 × 1/4) 37,500
Total (A) 9,41,092
(B) Current Liabilities:
Creditors (9,00,000 × 2/12) 1,50,000
Outstanding labour (7,20,000 × ½) 30,000
Outstanding Manufacturing Expenses (10,80,000 × 1/12) 90,000
Outstanding Administrative Expenses (2,40,000 × 1/12) 20,000
Income Tax (2,25,000 × 1/4) 56,250
Total (B) 3,46,250
Working Capital Before Provision (A - B) 5,94,842
Add : Safety Margin @ 12% of 5,94,842 71,381
Working Capital 6,66,223

Working Notes:
1. Calculation of Cash cost of Debtors:
Export sales (10% below domestic sales price) = 10,80,000

Export sales equivalent to domestic sales = 10,80,000 × 100 = 12,00,000

90
Total equivalent domestic sales = 24,00,000 + 12,00,000 = 36,00,000

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 MANAGEMENT OF WORKING CAPITAL 4.13
Apportionment of cash cost of sales except sales promotion expenses in proportion of equivalent
domestic sales between Domestic and Foreign Sales:

Domestic sales = 29,40,000 × 24,00,000 = 19,60,000

36,00,000
Foreign sales = 29,40,000 × 12,00,000 = 9,80,000
36,00,000

Apportionment of sales promotion expenses between Domestic and Foreign Sales in sales ratio:

Domestic sales = 1,50,000 × 24,00,000 = 1,03,448

34,80,000
Foreign sales = 1,50,000 × 10,80,000 = 46,552
34,80,000

2. Projected Income Statement

Particulars `
Raw Materials 9,00,000
Wages 7,20,000
Manufacturing Expenses (in cash) 10,80,000
Cash Cost of Goods Sold 27,00,000
Administration Expenses (in cash) 2,40,000
Sales Promotion Expenses (in cash) 1,50,000
Cash Cost of Sales 30,90,000

PYQ 12
The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:
Particulars ` Particulars `
To Opening Stock: By Seles (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 Work-in-progress 1,00,000
To Purchases (credit) 11,00,000 Finished Goods 3,00,000
To Wages 3,00,000
To Production Expenses 2,00,000
To Gross Profit 5,00,000
26,00,000 26,00,000
To Administration Expenses 1,75,000 By Gross Profit 5,00,000
To Selling Expenses 75,000
To Net Profit 2,50,000
5,00,000 5,00,000
The opening and closing balances of debtors were `1,50,000 and `2,00,000 respectively whereas
opening and closing creditors were `2,00,000 and `2,40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.
[(8 Marks) Nov 2011]

Answer
Operating cycle
Working Capital = Annual cost of sales ×
365 Days
110.24
= (`20,00,000 – `2,50,000) × = `5,28,548
365
Operating cycle = R+W+F+D–C
= 64.21 + 18.96 + 68.13 + 31.94 – 73 = 110.24 Days

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 MANAGEMENT OF WORKING CAPITAL 4.14
Calculations:
Average stock of raw materials
Raw materials storage period =
Average cos t of raw materials consumption per day
1,90,000
= = 64.21 days
10,80,000  365

Raw materials consumed = Opening RM + Purchases - Closing RM

= 1,80,000 + 11,00,000 – 2,00,000 = 10,80,000

Average stock of WIP 80,000

WIP holding period = =
Average cos t of production per day 15,40,000  365
= 18.96 days

Cost of production = RMC + Wages + Production expenses + Op. WIP - Closing WIP
= 10,80,000 + 3,00,000 + 2,00,000 + 60,000 – 1,00,000
= 15,40,000

Average stock of FG 2,80,000

Finished Goods storage period = =
Average cos t of goods sold per day 15,00,000  365
= 68.13 days

Cost of goods sold = COP + Opening FG - Closing FG

= 15,40,000 + 2,60,000 – 3,00,000 = 15,00,000

Average debtors 1,75,000

Debtors collection period = =
Average credit sales per day 20,00,000  365
= 31.94 days

Average trade creditors 2,20,000

Credit period availed = =
Average credit purchases per day 11,00,000  365
= 73 days
Calculation of averages:
Average stock of raw materials = (1,80,000 + 2,00,000) ÷ 2 = 1,90,000
Average stock of WIP = (60,000 + 1,00,000) ÷ 2 = 80,000
Average stock of FG = (2,60,000 + 3,00,000) ÷ 2 = 2,80,000
Average debtors = (150,000 + 2,00,000) ÷ 2 = 1,75,000
Average trade creditors = (2,00,000 + 2,40,000) ÷ 2 = 2,20,000

PYQ 13
STN Ltd. is a readymade garment manufacturing company. Its production cycle indicates that materials are
introduced in the beginning of the production phase; wages and overhead accrue evenly throughout the
period of cycle.
The following figures for the 12 months ending 31st December 2011 are given:
Production of shirts 54,000 units
Selling price per unit `200
Duration of the production cycle 1 month
Raw material inventory held 2 month’s consumption
Finished goods stock held for 1 month
Credit allowed to debtors 1.5 months
Credit allowed by creditors 1 month

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 MANAGEMENT OF WORKING CAPITAL 4.15
Wages are paid in the next month following the month of accrual. In the work in progress 50% of
wages and overheads are supposed to be conversion costs. The ratios of cost to sales price are raw materials
60%, direct wages 10% and overheads 20%. Cash is to be held to the extent of 40% of current liabilities and
safety margin of 15% will be maintained.
Calculate amount of working capital required for the company on a cash cost basis.
[(8 Mark) May 12]

Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (64,80,000 × 2/12) 10,80,000
WIP:
Materials (64,80,000 units × 1/12 × 100%) 5,40,000
Wages and Overheads (32,40,000 units × 1/12 × 50%) 1,35,000
Finished Goods (97,20,000 × 1/12) 8,10,000
Debtors (97,20,000 × 1.5/12) 12,15,000
Cash (40% of 6,30,000) 2,52,000
Total (A) 40,32,000
(B) Current Liabilities:
Creditors (64,80,000 × 1/12) 5,40,000
Outstanding Wages (10,80,000 × 1/12) 90,000
Total (B) 6,30,000
Working Capital Before Provision (A - B) 34,02,000
Add : Safety Margin @ 15% of 34,02,000 5,10,300
Working Capital 39,12,300
Working Notes:
Projected Income Statement
Particulars `
Raw Materials (54,000 units × `200 × 60%) 64,80,000
Wages (54,000 units × `200 × 10%) 10,80,000
Overheads treated as cash (54,000 units × `200 × 20%) 21,60,000
Cash Cost of Goods Sold/ Cash Cost of Sales 97,20,000

PYQ 14
The following information is provided by the DPS Limited for the year ending 31st March, 2013
Raw material storage period 55 days
Work-in progress conversion period 18 days
Finished Goods storage period 22 days
Debt collection period 45 days
Creditor’s payment period 60 days
Annual Operating cost (including depreciation of `2,10,000) `21,00,000
1 year 360 days
You are required to calculate:
I. Operating Cycle period.
II. Number of Operating Cycle in a year.
III. Amount of working capital required of 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-
payment. Thereby, it can reduce its working capital requirement substantially. What would be the
reduction in working capital requirement due to such decision?
[(Marks 8) May 2013/ May 2015]

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 MANAGEMENT OF WORKING CAPITAL 4.16
Answer
I. Operating cycle = R+W+F+D–C = 55 + 18 + 22 + 45 – 60
= 80 Days
360
II. No. of operating cycle = = 4.5 times
80
Operating cycle
III. Working Capital = Annual cash operating cost ×
360 Days
80 Days
= (`21,00,000 – `2,10,000) × = `4,20,000
360 Days

IV. In case of cash sales operating cycle period will reduce by 45 Days (Debt collection period).
Revised operating cycle period = 55 + 18 + 22 – 60 = 35 Days
35 Days
Revised working capital = (`21,00,000 – `2,10,000) × = `1,83,750
360 Days

Reduction in working capital = `4,20,000 - `1,83,750 = `2,36,250

Or
80 Days  35 Days
Reduction in working capital = (`21,00,000 – `2,10,000) ×
360 Days
= `2,36,250

PYQ 15
Black Limited has furnished the following cost sheet:
Per Unit
Raw Material `98
Direct Labour `53
Factory Overhead `88
Total Cost `239
Profit `43
Selling Price `282
Factory overheads includes depreciation of `15 per unit at budgeted level of activity
Additional Information:
(i) Average raw material in stock 3 weeks
(ii) Average work-in-progress 2 weeks
(% of completion with respect to Materials 75% and Labour and Overhead 70%)
(iii) Finished goods in stock 4 weeks
(iv) Credit allowed to debtors 2.5 weeks
(v) Credit allowed by creditors 3.5 weeks
(vi) Time lag in payment of labour 2 weeks
(vii) Time lag in payment of factory overheads 1.5 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, debtors and overheads are
taken at cash cost.
[(8 Marks) May 2014]

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 MANAGEMENT OF WORKING CAPITAL 4.17
Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (1,01,92,000 × 3/52) 5,88,000
Work-in-progress:
Materials (1,01,92,000 × 75%) × 2/52 2,94,000
Labour and Overhead [(55,12,000 + 75,92,000) × 70%] × 2/52 3,52,800
Finished Goods (2,32,96,000 × 4/52) 17,92,000
Debtors (2,32,96,000 × 75% × 2.5/52) 8,40,000
Cash 2,25,000
Total (A) 40,91,800
(B) Current Liabilities:
Creditors (1,01,92,000 × 3.5/52) 6,86,000
Outstanding labour (55,12,000 × 2/52) 2,12,000
Outstanding Factory Overhead (75,92,000 × 1.5/52) 2,19,000
Total (B) 11,17,000
Working Capital Before Provision (A - B) 29,74,800
Add : Provision for contingencies @ 4% of wc including provision 1,23,950
Working Capital (29,74,800 ÷ 96%) 30,98,750

Working Notes:
Projected Income Statement (Production of 1,04,000 units)
Particulars `
Raw Materials (1,04,000 × 98) 1,01,92,000
Wages (1,04,000 × 53) 55,12,000
Factory Overhead in cash [1,04,000 × 73 (88 - 15)] 75,92,000
Cash Cost 2,32,96,000

PYQ 16
The following data relating to an auto component manufacturing company is available for the year
2014:
Raw material held in storage 20 days
Debtors collection period 30 days
Conversion process period (raw materials 100%, other cost 50%) 10 days
Finished Goods storage period 45 days
Credit period from supplier 60 days
Advance payment to supplier 5 days
Total cash operating expenses per annum `800 Lakhs
1 year 360 days
75% of total cash operating expenses for raw materials. 360 days assumed in a year.
You are required to calculate:
(a) Each item of current assets and current liabilities,
(b) The working capital requirement, if the company wants to maintain a cash balance of `10 Lakhs
at all the times.
[(Marks 8) June 2015]

Answer
(a) Calculation of each item of current assets and current liabilities:
Stock of Raw Materials = `800 Lacs × 75% × 20/360 = `33.33 Lacs
Debtors = `800 Lacs × 30/360 = `66.67 Lacs

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 MANAGEMENT OF WORKING CAPITAL 4.18
Stock of WIP = [(`800 Lacs ×75% ×100%) + (`800 Lacs ×25% ×50%)] × 10/360
= `19.44 Lacs
Stock of Finished Goods = `800 Lakhs × 45/360 = `100 Lacs
Advance to Supplier = `800 Lakhs × 75% × 5/360 = `8.33 Lacs
Creditors = `800 Lakhs × 75% × 60/360 = `100 Lacs
(b) Calculation of working capital requirement:
Working Capital = Current Assets – Current Liabilities
= (Raw Materials Stock + Debtors + WIP Stock + Finished Goods
Stock + Advance to Supplier + Cash Balance) - Creditors
= (`33.33 + `66.67 + `19.44 + `100 + `8.33 + `10) – `100
= `137.77 Lakhs

PYQ 17
PQ Limited wants to expand its business and has applied for a loan from a commercial bank for its growing
financial requirements.
The records of the company reveals that the company sells goods in the domestic market at a gross
profit of 25% not counting depreciation as part of the cost of goods sold.
The following additional information is also available for you:
Sales:
Home at one month’s credit `1,20,00,000
Export at three month’s credit `54,00,000
(Sales price 10% below Home price)
Material used (suppliers extend two months’ credit) `45,00,000
Wages paid ½ month in arrear `36,00,000
Manufacturing expenses (cash) paid (1 month in arrear) `54,00,000
Administrative expenses paid 1 month in arrear `12,00,000
Income tax payable in four installments (of which one falls in the next financial year) `15,00,000
The company keeps one month’s stock of raw materials and finished goods (each) and believes in
keeping `10,00,000 available to it including the overdraft limit of `5,00,000 not yet utilized by the company.
Assume a 15% margin for contingencies.
You are required to ascertain the requirement of the working capital of the company.
[(8 Marks) May 2017]

Answer
Statement of Working Capital Requirement (Cash Cost Basis)
Particulars `
(A) Current Assets:
Raw Materials (45,00,000 × 1/12) 3,75,000
Finished Goods (1,35,00,000 × 1/12) 11,25,000
Debtors:
Home (98,00,000 × 1/12) 8,16,667
Export (49,00,000 × 3/12) 12,25,000
Cash (10,00,000 – 5,00,000) 5,00,000
Total (A) 40,41,667
(B) Current Liabilities:
Creditors (45,00,000 × 2/12) 7,50,000
Outstanding labour (36,00,000 × ½) 1,50,000
Outstanding Manufacturing Expenses (54,00,000 × 1/12) 4,50,000
Outstanding Administrative Expenses (12,00,000 × 1/12) 1,00,000
Income Tax (15,00,000 × 1/4) 3,75,000
Total (B) 18,25,000

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 MANAGEMENT OF WORKING CAPITAL 4.19
Working Capital Before Provision (A - B) 22,16,667
Add: Contingency Margin @ 15% of 22,16,667 3,32,500
Working Capital 25,49,167
Working Notes:
1. Calculation of Cash cost of Debtors:
Export sales (10% below home sales price) = 54,00,000

Export sales equivalent to home sales = 54,00,000 × 100 = 60,00,000

90
Total equivalent home sales = 1,20,00,000 + 60,00,000= 1,80,00,000
Apportionment of cash cost of COGS and administrative expenses in proportion of equivalent home sales
between Home and Foreign Sales:

Home sales = 1,47,00,000 × 1,20,00,000 = 98,00,000

1,80,00,000
Foreign sales = 1,47,00,000 × 60,00,000 = 49,00,000
1,80,00,000

2. Projected Income Statement

Particulars `
Raw Materials 45,00,000
Wages 36,00,000
Manufacturing Expenses (in cash) 54,00,000
Cash Cost of Goods Sold 1,35,00,000
Administration Expenses 12,00,000
Cash Cost of sales 1,47,00,000

PYQ 18
Day Ltd., a newly formed company has applied to the Private bank for the first time for financing its working
capital requirements.
The following information is available about the projection for the current year:
Estimated level of activity Completed units of production 31,200 units
Plus units of WIP 12,000
Raw material cost `40 per unit
Direct wages cost `15 per unit
Overhead `40 per unit
(Inclusive Depreciation `10 per unit)
Selling price `130
Raw material in stock Average 30 days consumption
Work in progress stock Material 100% and conversion cost 50%
Finished goods stock 24,000 units
Credit allowed by suppliers 30 days
Credit allowed to purchasers 60 days
Direct wages (lag in payment) 15 days
Expected cash balance `2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and overhead
accrue similarly. All sales are on credit basis.
You are required to calculate the Net Working Capital requirement on Cash Cost Basis.
[(10 Marks) May 2018]

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 MANAGEMENT OF WORKING CAPITAL 4.20
Answer
Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw Materials Stock (17,28,000 × 30/360) 1,44,000
Work in progress 7,50,000
Finished goods 20,40,000
Debtors (6,12,000 × 60/360) 1,02,000
Cash 2,00,000
Total (A) 32,36,000
(B) Current Liabilities:
Creditors (17,28,000 + 1,44,000) × 30/360 1,56,000
Outstanding wages (5,58,000 × 15/360) 23,250
Total (B) 1,79,250
Working Capital (A - B) 30,56,750

Projected Cost of Goods Sold

Particulars `
Raw Materials (31,200 × 40 + 12,000 × 40) 17,28,000
Direct Wages (31,200 × 15 + 12,000 × 7.5) 5,58,000
Overheads excluding Depreciation (31,200 × 30 + 12,000 × 15) 11,16,000
Cost Upto Factory 34,02,000
Less: Closing WIP 12,000 units × (40 + 7.50 + 15) (7,50,000)
Cost of Production (31,200 units) 26,52,000
Less: Closing FG 24,000 units × (40 + 15 + 30) (20,40,000)
Cost of Goods Sold (7,200 units) 6,12,000

PYQ 19
Following information has been extracted from the books of ABS Limited:
01.04.17 31.03.18
Raw Material 1,00,000 70,000
Work-in-process 1,40,000 2,00,000
Finished goods 2,30,000 2,70,000
Average Receivables 2,10,000
Average Payables 3,14,000
Purchases 15,70,000
Wages and overheads 17,50,000
Selling expenses 3,20,000
Sales 42,00,000
All purchases and sales are on credit basis. Company is willing to know:
(1) Net operating cycle period.
(2) Amount of working capital requirement (Assume 360 days in a year).
[(8 Marks) Nov 2018]

Answer
(1) Operating cycle = R+W+F+D–C
= 19 + 19 + 28 + 18 – 72 = 12 Days

Calculations:
Average stock of raw materials
Raw materials storage period (R) =
Average cos t of raw materials consumption per day

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 MANAGEMENT OF WORKING CAPITAL 4.21

(1,00,000 + 70,000)÷ 2
= = 19 days
16,00,000 ÷ 360

Raw materials consumption = Opening RM + Purchases – Closing RM

= 1,00,000 + 15,70,000 – 70,000 = 16,00,000
Average stock of WIP
WIP holding period =
Average cos t of production per day

(1,40,000 + 2,00,000)÷ 2
= = 19 days
32,90,000 ÷ 360

Cost of Production = RM consumed + Wages and OH + Opening WIP

– Closing WIP
= 16,00,000 + 17,50,000 + 1,40,000 – 2,00,000
= 32,90,000
Average stock of FG
Finished Goods storage period =
Average cos t of goods sold per day

(2,30,000 + 2,70,000)÷2
= = 28 days
32,50,000 ÷ 360

Cost of Goods Sold = Cost of Production + Opening FG – Closing FG

= 32,90,000 + 2,30,000 – 2,70,000
= 32,50,000
Average book debts
Debtors collection period =
Average credit sales per day
2,10,000
= = 18 days
42,00,000 ÷360

Average trade creditors

Credit period availed =
Average credit purchases per day
3,14,000
= = 72 days
15,70,000 ÷ 360

(2) Amount of working capital required:

Annual Cost of Sales
Working Capital = ×Operating Cycle Period
360
35,70,000
= ×12 = `1,19,000
360
Cost of Sales = Cost of Goods Sold + Selling expenses
= 32,50,000 + 3,20,000
= 35,70,000

PYQ 20
Bita Limited manufactures a product used in the steel industry. The following information regarding
the company is given for your consideration:
(1) The cost structure for Bita Limited’s product is as follows:
Per Unit
Raw Material `80
Direct Labour `20
Overhead (including depreciation `20) `80

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 MANAGEMENT OF WORKING CAPITAL 4.22
Total Cost `180
Profit `20
Selling Price `200
(2) Expected level of production 9,000 units per annum.
(3) Raw materials are expected to remain in stores for an average of two months before issue to
production.
(4) Work-in-progress (50% complete as to conversion cost) will approximately to ½ month’s
production.
(5) Finished goods remain in warehouse on an average for one month.
(6) Credit allowed by supplier is one month.
(7) Two month’s credit is normally allowed to debtors.
(8) A minimum cash balance of `67,500 is expected to be maintained.
(9) Cash sales are 75% less than the credit sales.
(10) Safety margin of 20% to cover unforeseen contingencies.
(11) The production pattern is assumed to be even during the year.
You are required to estimate the working capital requirement of Bita Limited.
[(10 Marks) May 2019]

Answer
Statement of Working Capital Requirement
Particulars `
(A) Current Assets:
Raw Materials (7,20,000 × 2/12) 1,20,000
Work-in-progress:
Materials (7,20,000 × 0.5/12 × 100%) 30,000
Labour and Overhead [(1,80,000 + 7,20,000) × 50%] × 0.5/12 18,750
Finished Goods (16,20,000 × 1/12) 1,35,000
Debtors (16,20,000 × 4/5 × 2/12) 2,16,000
Cash 67,500
Total (A) 5,87,250
(B) Current Liabilities:
Creditors (7,20,000 × 1/12) 60,000
Total (B) 60,000
Working Capital Before Provision (A - B) 5,27,250
Add : Safety margin @ 20% 1,05,450
Working Capital 6,32,700

Working Notes:
1. Projected Income Statement (Production of 9,000 units)
Particulars `
Raw Materials (9,000 × 80) 7,20,000
Direct Labour (9,000 × 20) 1,80,000
Overhead : in cash (9,000 × 60) 5,40,000
: Depreciation (9,000 × 20) 1,80,000 7,20,000
Cost of Goods Sold 16,20,000
Profit (9,000 × 20) 1,80,000
Sales 18,00,000

2. Proportion between cash and credit sales:

Let Credit sales be x then cash sales will be 0.25 x (x – 75%)
Cash Sales : Credit Sales = x : .25x = 1 : .25 = 4:1

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 MANAGEMENT OF WORKING CAPITAL 4.23

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y -
4 Y Y Y -
5 Y Y - -
6 Y Y Y Y
7 Y Y Y -
8 Y Y Y Y
9 Y Y Y Y
10 Y Y Y Y
11 Y Y Y Y
12 Y Y Y Y
13 Y Y Y Y
14 Y Y Y Y
15 Y Y Y Y
16 Y Y Y -
17 Y Y Y Y
18 Y Y Y Y
19 Y Y Y -
20 Y Y Y Y

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 CHAPTER - 5

TREASURY AND CASH

MANAGEMENT
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Discuss in details about cash management, its meanings and its
significance to any business.
 Understand the concept of cash budget and the estimation of cash
needs.
 Understand the decision making in case of excess cash balance or
in case of deficiency of cash.
 Know why it is important to manage efficiently the cash?
 Discuss the cash models as suggested by Baumol, Miller & Orr.
 TREASURY AND CASH MANAGEMENT 5.2

PAST YEARS QUESTIONS

PYQ 1
JPL has two dates when it receives its cash inflows i.e. February 15 and August 15. On each of these dates, it
expects to receive `15 crores. Cash expenditures are expected to be steady throughout the subsequent 6
months period.
Presently the ROI in marketable securities is 8% per annum, and the cost of transfer from securities
to cash is `125 each time a transfer occurs.
(a) What is the optimal transfer size using the EOQ model? What is the average cash balance?
(b) What would be your Solution to part (a), if the ROI were 12% per annum and the transfer costs were
`75? Why do they differ from those in part (a)?
[(10 Marks) May 2001]

Answer
(a) Optimal transfer size and average cash:
2UP
Optimal transfer size =
S
Where,
U = Total annual cash required.
P = Transaction cost per transfer.
S = Interest rate per annum.

2 30,00,00,0 00  125
Optimal transfer size = = 9,68,246
0.08
Average cash balance = 1/2 × 9,68,246 = 4,84,123

(b) Revised optimum transfer and average cash:

2 30,00,00,0 00  75
Optimal transfer size = = 6,12,372
0.12
Average cash balance = 1/2 × 6,12,372 = 3,61,186
Causes of difference in figure (b) from the figure of part (a):
(i) Transaction cost is lower as comparison to part (a),
(ii) Higher opportunity cost of holding as comparison to part (a).

PYQ 2
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.
[(3 Marks) May 2009]

Answer
2UP
Optimal transfer size =
S
2 2,62,500  12  25
= = 45,826
0.075

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 TREASURY AND CASH MANAGEMENT 5.3
PYQ 3
The following details are forecasted by a company for the purpose of effective utilization and management of
cash:
(i) Estimated sales and manufacturing costs:
Month Sales ` Materials ` Wages ` Overheads `
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:
20% sales are on cash, 50% of the credit sales are collected next month and the balance in the
following month.
Credit allowed by suppliers is 2 months and delay in payment of wages is 1/2 month and of overheads
is 1 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, 2010.
(v) A new machinery will be installed in June, 2010 at a cost of `4,00,000 which is payable in 20 monthly
installments from July, 2010 onwards.
(vi) Advance income-tax to be paid in August, 2010 is `15,000.
(vii) Cash balance on 1st June, 2010 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) 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, 2010.
[(7 Marks) May 2010]

Answer
Cash Budget
(From July to September)
Particulars June July August September
Opening Balance 45,000 45,500 45,500 45,000
Cash Sales & Debtors Collection 4,48,000 4,78,000 5,04,000 5,34,000
Dividend 25,000 - - -
Total A 5,18,000 5,23,500 5,49,500 5,79,000
Payments to creditors 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
Interest 30,000 - - -
Machine installments - 20,000 20,000 20,000
Advance tax - - 15,000 -
Total B 4,32,500 4,33,000 4,97,500 5,30,300
Balance (A – B) 85,500 90,500 52,000 48,700
Less: Fixed deposit 40,000 45,000 7,000 3,000
Closing balance 45,500 45,500 45,000 45,700

Working Note 1: Cash Sales and Collection from Debtors:

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 TREASURY AND CASH MANAGEMENT 5.4
Cash From Debtors Total
Month Sales
Sales 20% 50% 50% Collection
April 4,20,000 - - - -
May 4,50,000 - - - -
June 5,00,000 1,00,000 1,80,000 1,68,000 4,48,000
July 4,90,000 98,000 2,00,000 1,80,000 4,78,000
August 5,40,000 1,08,000 1,96,000 2,00,000 5,04,000
September 6,10,000 1,22,000 2,16,000 1,96,000 5,34,000

Working Note 2: Payment of wages:

Payment
Month Wages Total Payment
50% 50%
May 1,60,000 - - -
June 1,65,000 80,000 82,500 1,62,500
July 1,65,000 82,500 82,500 1,65,000
August 1,65,000 82,500 82,000 1,65,000
September 1,70,000 82,500 85,000 1,67,500

PYQ 4
Following information relates to ABC company for the year 2016:
(a) Projected sales (` in lakhs)
August September October November December
35 40 40 45 46
(b) Gross profit margin will be 20% on sale.
(c) 10% of projected sale will be cash sale. Out of credit sale of each month, 50% will be collected in the
next month and the balance will be collected during the second month following the month of sale.
(d) Creditors will be paid in the first month following credit purchase. There will be credit purchase only.
(e) Wages and salaries will be paid on the first day of the next month. The amount will be `3 lakhs each
month.
(f) Interim dividend of `2 lakhs will be paid in December 2016.
(g) Machinery costing `10 lakhs will be purchased in September 2016. Repayment by instalment of
`50,000 p.m. will start from October 2016.
(h) Administrative expenses of `1,00,000 per month will be paid in the month of their incurrence.
(i) Assume no minimum cash balance is required. Opening cash balance as on 01.10.2016 is estimated at
`10 lakhs.
You are required to prepare the monthly cash budget for the 3 month period (October 2016 to
December 2016).
[(8 Marks) Nov 2016]

Answer
Cash Budget
(From Oct 2016 to December 2016)
Particulars October November December
Opening Balance 10,00,000 14,25,000 21,25,000
Cash Sales @ 10% of Sales 4,00,000 4,50,000 4,60,000
Debtors Collection:
50% of Credit Sales 1 Month 18,00,000 18,00,000 20,25,000
50% of Credit Sales 2 Month 15,75,000 18,00,000 18,00,000
Total A 47,75,000 54,75,000 64,10,000
Payments to creditors (1 Month Credit) 29,00,000 29,00,000 33,00,000

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 TREASURY AND CASH MANAGEMENT 5.5
Purchase = Sales – GP - Wages (40L – 20% - 3L) (40L – 20% - 3L) (45L – 20% - 3L)
Wages & Salaries 3,00,000 3,00,000 3,00,000
Admin Expenses 1,00,000 1,00,000 1,00,000
Interim dividend - - 2,00,000
Machine installments 50,000 50,000 50,000
Total B 33,50,000 33,50,000 39,50,000
Closing Balance (A - B) 14,25,000 21,25,000 24,60,000

PYQ 5
VK Co. Ltd. has total cash disbursement amounting `22,50,000 in the year 2017 and maintains a separate
account for cash disbursements. Company has an administrative and transaction cost on transferring cash to
disbursement account `15 per transfer. The yield rate on marketable securities is 12% per annum.
Determine the optimum cash balance according to William J Baumol model.
[(5 Marks) May 2017]

Answer
2UP 2 ×22,50,000 ×15
Optimal transfer size = √ = √ = 23,717
S 0.12

PYQ 6
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:
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 sales takes place one
month before sales. Each unit produced requires two units of raw material 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 excepted 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 month period.
(b) Calculate the forecast current ratio at the end of the three months period.
[(10 Marks) Nov 2019]

Answer
(a) Cash Budget
(for three months period January to March)
Particulars January February March
Opening Balance 35,000 3,57,500 6,87,500
Collection from debtors 10,80,000 11,25,000 11,70,000
Loan receivable - - 2,00,000
Total A 11,15,000 14,82,500 20,57,500
Payments to creditors 5,62,500 5,85,000 6,30,000
Variable overheads and wages 1,95,000 2,10,000 2,25,000
Purchase of machine - - 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

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 TREASURY AND CASH MANAGEMENT 5.6
Working note:
Calculation of Collection from debtors, payment for Purchases, Variable overheads and Wages:
Particulars December January February March
Forecast sales in units 1,800 1,875 1,950 2,100

1. Sales receipts:
Sales @ `600 per unit 10,80,000 11,25,000 11,70,000 12,60,000
Collection from debtors - 10,80,000 11,25,000 11,70,000

2. Payment for purchase:

Quantity produced 1,875 1,950 2,100 2,250
(1 months before sales)
Materials cost 5,62,500 5,85,000 6,30,000 6,75,000
@ `300 p.u. (150 × 2)
Payment after 1 month - 5,62,500 5,85,000 6,30,000

3. Payment for variable OH and wages:

Quantity produced - 1,950 2,100 2,250
Variable OH and wages @ `100 per unit - 1,95,000 2,10,000 2,25,000

(b) Forecast Current Ratio:

Expected Current Assets

Forecast Current Ratio =
Expected Current Liabilities

Current Assets = Cash and bank balance + Sundry debtors

Current Liabilities = Sundry creditors

3,57,500+11,25,000
January = = 2.53 times
5,85,000

6,87,500+11,70,000
February = = 2.95 times
6,30,000

9,02,500+12,60,000
March = = 3.20 times
6,75,000

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 TREASURY AND CASH MANAGEMENT 5.7

SUGGESTED REVISION
BQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y - -
2 Y Y Y -
3 Y Y Y -
4 Y Y Y Y
5 Y Y Y Y
6 Y Y Y Y
7 Y Y Y -
8 Y Y Y -
9 Y Y Y Y
10 Y Y Y Y
11 Y Y Y Y
12 Y Y Y Y
13 Y Y - -
14 Y Y - -
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y -
2 Y Y Y -
3 Y Y Y Y
4 Y Y Y Y
5 Y Y Y Y
6 Y Y Y Y

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 CHAPTER – 6

RATIO ANALYSIS
LEARNING OBJECTIVE

Learning Outcomes:
(a) Discuss Sources of financial data for Analysis.
(b) Discuss financial ratios and its Types.
(c) Discuss use of financial ratios to analyse the financial statement.
(d) Analyse the ratios from the perspective of investors, lenders,
suppliers, managers etc. to evaluate the profitability and financial
position of an entity.
(e) Describe the users and objective of Financial Analysis (A Birds Eye
View).
(f) Discuss Du Pont analysis
(g) State the limitations of Ratio Analysis.
 RATIO ANALYSIS 6.2

PAST YEARS QUESTIONS

PYQ 1
From the following information, prepare a summarised Balance Sheet as at 31st March, 2002:
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 1.5
[(6 Marks) Nov 2002]

Answer
Balance Sheet
As at 31.03.2002
Liabilities ` Assets `
Share Capital 8,00,000 Fixed Assets 7,20,000
Reserves and Surplus 1,60,000 Stock 1,60,000
Bank Overdraft 40,000 Other Current Assets 2,40,000
Other Current Liabilities 1,20,000
11,20,000 11,20,000
Working Notes:
1. Current assets and Current liabilities computation:
CA = 2.5
CL
CA = 2.5 CL
Working capital = CA – CL
2,40,000 = 2.5 CL – CL
CL = 1,60,000
CA = 1,60,000 × 2.5 = 4,00,000
2. Computation of stock:
Liquid Assets
Liquid ratio =
Current Liabilities
Current Assets - Stock
1.5 =
1,60,000
1.5 × 1,60,000 = 4,00,000 – Stock
Stock = 1,60,000
3. Computation of Proprietary fund, Fixed assets, Capital and Sundry Creditor
Fixed Assets
= 0.75
Proprietary Fund
Fixed assets = 0.75 Proprietary fund
Net working capital = 0.25 Proprietary fund
2,40,000 = Proprietary fund
2,40,000
Proprietary fund = = 9,60,000
0.25

Fixed assets = 0.75 Proprietary fund

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 RATIO ANALYSIS 6.3

= 0.75 × 9,60,000 = 7,20,000

Share Capital = Proprietary fund – R & S
= 9,60,000 - 1,60,000 = 8,00,000
Sundry creditors = CL - Bank overdraft
= 1,60,000 - 40,000 = 1,20,000

PYQ 2
Equity share capital `1,00,000
The relevant ratios of the company are as follows:
Current debt to total debt .40
Total debt to owner's equity .60
Fixed assets to owner's equity .60
Total assets turnover 2 Times
Inventory turnover 8 Times
Complete the following balance sheet from the above information:
Balance Sheet
Liabilities ` Assets `
Current Debt - Inventory -
Long Term Debt - Cash -
Total Debt - Total Current Assets -
Equity Share Capital - Fixed Assets -
- -
[(7 Marks) May 2005]

Answer
Balance Sheet
Liabilities ` Assets `
Current Debt 24,000 Inventory 40,000
Long Term Debt 36,000 Cash 60,000
Total Debt 60,000 Total Current Assets 1,00,000
Equity Share Capital 1,00,000 Fixed Assets 60,000
1,60,000 1,60,000
Working Notes:
1. Total debt:
Owners equity × 0.60 = 0.60 × `1,00,000 = `60,000
2. Current Debt:
Current debt to total debt = 0.40
Current debt = 0.40 × `60,000 = `24,000
3. Fixed assets:
0.60 × Owners equity = 0.60 × `1,00,000 = `60,000
4. Total of liability side:
Total debt + Owners equity = `60,000 + `1,00,000 = `1,60,000
5. Total assets consisting of fixed assets and current assets must be equal to `1,60,000 hence, current assets
should be `1,00,000.
6. Total assets turnover is 2 times:
Sales
= 2 times
Total Assets
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 RATIO ANALYSIS 6.4

Sales = `1,60,000 × 2 = `3,20,000

Inventory turnover is 8 times:

Sales
= 8 times
Inventory
Sales 3,20,000
Inventory = = = `40,000
8 8
7. Cash: = `1,00,000 – `40,000 = `60,000

PYQ 3
Gross profits `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 20 days (360 days a year)
Current ratio 1.8
Long term Debt to Equity 40%
Balance Sheet
Liabilities ` Assets `
Creditors - Cash -
Long Term Debt - Debtors -
Shareholder’s Fund - Inventory -
Fixed Assets -
- -
[(12 Marks) Nov 2005]

Answer
Balance Sheet
Liabilities ` Assets `
Creditors (b.f.) 60,000 Cash 42,000
Long Term Debt 2,40,000 Debtors 12,000
Shareholder’s Fund 6,00,000 Inventory 54,000
Fixed Assets (b.f.) 7,92,000
9,00,000 9,00,000

Working Notes:

1. Sales:
Gross profit margin = 20% of sales = `54,000
54,000
Sales = = `2,70,000
20%

2. Credit Sales:

Credit sales = 80% of total sales

= `2,70,000 × 80% = `2,16,000

3. Total Assets:
Sales
Total assets turnover = = 0.3 times
Total assets
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 RATIO ANALYSIS 6.5

2,70,000
Total assets = = `9,00,000
0.3
4. Inventory:
COGS
Inventory Turnover = = 4 times
Inventory
2,70,000  54,000
Inventory = = `54,000
4
5. Debtors:
Credit sales
Debtors = × 20 Days
360 Days
2,16,000
= × 20 Days = `12,000
360 Days

6. Long term debt:

Long term debt
= 40%
Equity

Long term debt = 40% of equity

= `6,00,000 × 40% = `2,40,000
7. Current Ratio:
CA
Current ratio =
CL

CA
= 1.8
Creditors

CA = 60,000 × 1.8 = `1,08,000

Cash + Debtors + Inventory = `1,08,000

Cash = 1,08,000 – 12,000 + 54,000 = `42,000

PYQ 4
JKL Limited has the following Balance Sheets as on March 31, 2006 and March 31, 2005:
Balance Sheet (` in Lakh)
Particulars 31.03.2006 31.03.2005

Sources of Funds: 1,472

Shareholder’s Fund 2,377 3,038
Loan Funds 3,570
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

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 RATIO ANALYSIS 6.6

The Income Statement of the JKL Ltd. for the year ended is as follows (` in Lakh):
Particulars 31.03.2006 31.03.2005
Sales 22,165 13,882
Less: Cost of Goods Sold 20,860 12,544
Gross profit 1,305 1,338
Less: Selling, General and Administration Expenses 1,135 752
EBIT 170 586
Less: Interest Expenses 113 105
PBT 57 481
Less: Tax 23 192
PAT 34 289
Required:
(1) Calculate for the years 2005 and 2006:
a. Inventory turnover ratio
b. Financial Leverage
c. Return on Investment (ROI)
d. Return on Equity (ROE)
e. Average Collection period.
(2) Give a brief comment on the financial position of JKL Limited.
[(10+2 Marks) May 2006]

Answer
(1) Computation of Ratios
Particulars 31.03.2006 31.03.2005
(a) Inventory turnover ratio
COGS 20,860 12,544
= 7.28 = 5.21
Clo sin g Stock 2,867 2,407
(b) Financial leverage
EBIT 170 568
= 2.98 = 1.22
EBT 57 481
(c) Return on investment
EBIT 170 586
× 100 × 100 = 2.86% × 100 = 12.86%
Capital Employed 5,947 4,555
(d) Return on equity
PAT 34 289
× 100 × 100 = 1.43% × 100 = 19.63%
Net worth 2,377 1,472
(e) Average collection period
Debtors 1,495 1,168
× 365 × 365 = 24.6 days × 365 = 30.7 days
Credit sales 22,165 13,882

(2) Brief comment on the financial position of JKL Ltd:

 The inventory turnover ratio is increased from 5.21 times to 7.28 times. This indicates the reduction
in investment of stock and increase in sale turnover with reduced stocks.
 The financial leverage of the company is increased from 1.22 times to 2.98 times, which indicates
the lower the cushion for paying interest on borrowings. The increase in ratio warns the increase
in risk as to over gearing, which constitutes a strain on profits.
 There is a steep fall in ROI from 12.86% to 2.86%, this may be due to increase in finances from fresh
issue of share and loan funds for expansion, modernization or new investment proposals, and
increase in sales has not resulted in increase of company’s profitability.

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 RATIO ANALYSIS 6.7

 The return on equity has also fallen from 19.63% to 1.43%. The current year PAT may not be
sufficient for declaration of dividends to shareholders.
 The increase in sale and reduction in investment in debtor’s balances has resulted in reduction of
average collection period from 30.7 days to 24.6 days.

PYQ 5
From the information given below calculate the amount of fixed assets and proprietor's fund.
Ratio of fixed assets to proprietor’s fund 0.75
Net working capital `6,00,000
[(2 Marks) Nov 2009]

Answer
Calculation of Fixed Assets and Proprietor’s Fund:
Fixed assets
= 0.75
Pr oprietor's fund
Fixed assets = 0.75 Proprietor’s fund
Net Working Capital = 0.25 Proprietor’s fund
6,00,000 = 0.25 Proprietor’s Fund
6,00,000
Proprietor’s fund = = `24,00,000
0.25
Fixed assets = 0.75 Proprietor’s fund
= 0.75 × 24, 00,000 = `18,00,000
Assumption: There is no long term debt in the business.

PYQ 6
The following figures and ratios are related to a company:
(a) Sales for the year (all credit) `30,00,000
(b) Gross profit ratio 25 percent
(c) Fixed assets turnover (basis on cost of goods sold) 1.5
(d) Stock turnover (basis on cost of goods sold) 6
(e) Liquid ratio 1:1
(f) Current ratio 1.5 : 1
(g) Debtors collection period 2 months
(h) Reserve and surplus to Share capital 0.6 : 1
(i) Capital gearing ratio 0.5
(j) Fixed assets to net worth 1.20 : 1
You are required to prepare:
1. Balance Sheet of the company on the basis of above details.
2. The statement showing working capital requirement, if the company wants to make a provision for
contingencies @ 10% of net working capital including such provision.
[(6+4 Marks) May 2010]

Answer
(1) Projected Balance Sheet Balance Sheet
Liabilities ` Assets `
Share Capital 7,81,250 Fixed Assets 15,00,000
Reserve & Surplus 4,68,750 Stock 3,75,000
Debt 6,25,000 Debtors 5,00,000
Current Liabilities 7,50,000 Cash 2,50,000
26,25,000 26,25,000
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 RATIO ANALYSIS 6.8

Working Notes:
a. Cost of Goods Sold = 30,00,000 - 25% = 22,50,000
COGS
b. Fixed Assets Turnover Ratio = = 1.5 times
Fixed Assets
22,50,000
Fixed Assets = = `15,00,000
1.5
Fixed Assets
c. Fixed Assets to Net Worth = = 1.2 times
Net Worth
15,00,000
Net Worth = = `12,50,000
1.2
Debt + Pr eference Debt + Nil
d. Capital Gearing = =
Equity 12,50,000

Debt = 0.5 × `12,50,000 = `6,25,000

Assumption: Preference Share capital is zero.
e. Reserves & Surplus = 12,50,000 × 0.6/1.6 = `4,68,750
f. Share Capital = 12,50,000 × 1/1.6 = `7,81,250
COGS
g. Stock Turnover = = 6 times
Stock
22,50,000
Stock = = `3,75,000
6
Collection Period
h. Debtors = Sales ×
12
2
= 30,00,000 × = `5,00,000
12
i. Stock = CL (Current ratio – Liquid ratio)
Stock
Current Liabilities =
CR  LR
3,75,000
= = `7,50,000
1.5  1
CA
j. Current Ratio = = 1.5 times
CL
Current Assets = 1.5 × 7,50,000 = `11,25,000
k. Cash in Hand = 11,25,000 - 3,75,000 - 5,00,000
= `2,50,000

(2) Statement of Working Capital Requirement

Particulars `
Current Assets: Stock 3,75,000
Debtors 5,00,000
Cash 2,50,000
11,25,000
Less: Current Liabilities (7,50,000)
Working Capital Before Provision (A - B) 3,75,000
Add: Provision for Contingencies @ 10% of WC (Including provision) 41,667
Working Capital Including Provision  3,75,000  100  4,16,667
 90 

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 RATIO ANALYSIS 6.9

PYQ 7
MNP Limited has made plans for the next year 2010-11. 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%.
You are required to calculate: (i) Net profit margin, (ii) Return on Assets, (iii) Assets turnover, (iv) Return
on equity [(4 Marks) Nov 2010]

Answer
EAT 2,65,500
(i) Net Profit Margin = × 100 = × 100 = 11.80%
Sales 22,50,000
EBIT (1−t) 5,10,000 (1−.40)
(ii) Return on Assets = = = 12.24%
Assets 25,00,000
Sales 22,50,000
(iii) Assets turnover = = = 0.90
Total Assets 25,00,000

EAT 2,65,500
(iv) Return on Equity = × 100= × 100 = 15.171%
Shareholde r' s Fund 17,50,000
Working Notes:
Particulars `
Sales Revenue 22,50,000
Less: Direct Cost 15,00,000
Gross Profit 7,50,000
Less: Other operating expenses 2,40,000
EBIT 5,10,000
Less: Interest on 9% Debt (2500000 × 30% × 9%) 67,500
EBT 4,42,500
Less: Taxes @ 40% 1,77,000
EAT 2,65,500

PYQ 8
The financial statements of a company contain the following information for the year ending 31 st March,
2011:
Statement of profit for the year ended 31st March, 2011
Sales (20% cash sales) 40,00,000
Less: Cost of goods sold 28,00,000
Profit Before Interest & Tax 12,00,000
Less: Interest 1,60,000
Profit Before Tax 10,40,000
Less: Tax @ 30% 3,12,000
Profit After Tax 7,28,000

Particulars `
Cash 1,60,000
Sundry Debtors 4,00,000
Short-term Investment 3,20,000
Stock 21,60,000
Prepaid Expenses 10,000
Total Current Assets 30,50,000
Current Liabilities 10,00,000
10% Debentures 16,00,000
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 RATIO ANALYSIS 6.10

Equity Share Capital 20,00,000

Retained Earnings 8,00,000
You are required to calculate:
(i) Quick Ratio
(ii) Debt-Equity Ratio
(iii) Return on Capital Employed, and
(iv) Average Collection Period (Assuming 360 days in a year)
[(8 Marks) Nov 2011]

Answer
CA  Stock  Pr epaid Expenses
(i) Quick Ratio =
Current Liabilities
30,50,000  21,60,000  10,000
= = .88 times
10,00,000

Debt
(ii) Debt-Equity Ratio =
Equity
16,00,000
= = 0.57 : 1
20,00,000  8,00,000

EBIT
(iii) ROCE = × 100
Capital Employed
12,00,000
= × 100 = 27.27%
20,00,000  8,00,000  16,00,000

Average Debtors
(iv) Average Collection Period = × 360
Credit Sales
4,00,000
= × 360 = 45 Days
80%  40,00,000

PYQ 9
The following accounting information and financial rations of M Limited relate to the year ended 31 st
March, 2012:
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 is 25% of credit sales; cash purchase `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
(viii) Current Liabilities
[(8 Marks) Nov 2012]

Answer
(i) Average Inventory:
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 RATIO ANALYSIS 6.11

COGS
Inventory Turnover Ratio = = 6 times
Average Inventory
COGS 30,00,000  25%
Average Inventory = =
6 6
= `3,75,000
(ii) Purchases:
Purchase = COGS + Closing Stock – Opening stock
= (30,00,000 – 25%) + 80,000 = `23,30,000
(iii) Average Debtors:
Credit Sales
Debtors Turnover Ratio = = 8 times
Average Debtors

Credit Sales 24,00,000

Average Debtors = =
8 Times 8 Times
= `3,00,000
Credit Sales:
Total Sales = Credit Sales + Cash Sales
30,00,000 = Credit Sales + 25% of Credit Sales
125% of Credit Sales = `30,00,000
30,00,000
Credit Sale = = `24,00,000
125%

(iv) Average Creditors:

Credit Purchase
Creditors Turnover Ratio = = 10 Times
Average Creditors

Credit Purchase
Average Creditors =
10 Times
23,30,000  2,30,000
= = `2,10,000
10
365 Days 365 Days
(v) Average Payment period = =
Creditors Turnover Ratio 10
= 36.5 Days
365 Days 365 Days
(vi) Average Collection Period = =
Debtors Turnover Ratio 8
= 45.625 Days
(vii) Current Assets
Working Capital = Current Assets – Current Liabilities
= 2,80,000 (i)
Current Assets
= 2.4
Current Liabilities
Current Assets = 2.4 Current Liabilities (ii)
CA – CL = 2,80,000
2.4 CL – CL = 2,80,000
2,80,000
Current Liabilities = = `2,00,000
1.40
Current Assets = 2.4 × `2,00,000 = `4,80,000

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 RATIO ANALYSIS 6.12

(viii) Current Liabilities = `2,00,000

PYQ 10
The following information relates to Beta Ltd for the year ended 31st March 2013.
Net Working Capital `12,00,000
Fixed Assets to Proprietor’s Fund Ratio 0.75
Working Capital Turnover Ratio 5 times
Return on Equity (ROE) 15%
There is no debt capital.
You are required to calculate:
(i) Proprietor’s Fund
(ii) Fixed Assets
(iii) Net Profit Ratio.
[(5 Marks) May 2013]

Answer
(i) Proprietor’s Fund = Net Working Capital + Fixed Assets
= 12,00,000 + 0.75 Proprietor’s Fund
0.25 Proprietor’s Fund = 12,00,000
12,00,000
Proprietor’s Fund = = 48,00,000
0.25
(ii) Fixed Assets:
Fixed Assets = 0.75 Proprietor’s Fund
= 0.75 of 48,00,000 = 36,00,000
PAT
(iii) Net profit Ratio = × 100
Sales
7,20,000
= × 100 = 12%
60,00,000

Working Notes:
PAT = 15% of Equity Fund/Proprietor’s Fund
= 15% of 48,00,000 = 7,20,000
Sales = 5 times of working capital
= 5 × 12,00,000 = 60,00,000

PYQ 11
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 2013 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
[(8 Marks) Nov 2013]
Answer
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 RATIO ANALYSIS 6.13

SONA Ltd
Balance Sheet
(As at 31.03.2013)
Liabilities ` Assets `
Share Capital 5,75,000 Fixed Assets (b.f.) 6,85,000
Reserves & Surplus 2,60,000 Current Assets:
Current Liabilities: Bank & Cash 65,000
Bank Credit 1,50,000 Inventory 2,10,000
Other 1,50,000 Debtors 1,75,000
11,35,000 11,35,000
Working Notes:
1. Calculation of Current Assets and Current Liabilities:
Current Ratio = CA = 1.5
CL
CA = 1.5 CL
CA – CL = 1,50,000
1.5 CL – CL = .5 CL = 1,50,000
CL = 3,00,000
CA = 1.5 CL = 1.5 × 3,00,000
= 4,50,000
2. Calculation of Bank Credit and other CL:
CL = 2:1
Bank Credit

Bank credit = CL ÷ 2 = 3,00,000 ÷ 2

= 1,50,000
Other CL = 1,50,000
3. Calculation of Inventory:
CA  Inventory
Quick Ratio = = 0.8
CL
CA – Inventory = 0.8 CL
4,50,000 – Inventory = 0.8 × 3,00,000
Inventory = 2,10,000
4. Calculation of Debtors and Bank and Cash:
COGS
Inventory Turnover = = 4
Inventory

COGS = 5 × 2,10,000 = 10,50,000

COGS 10,50,000
Sales = × 100 = × 100
100  m arg in 100  25
= 14,00,000

Debtors = Sales × Average Collection Period

12
= 14,00,000 × 1.5/12 = 1,75,000
Bank and Cash = CA – Inventory – Debtors
= 4,50,000 – 2,10,000 – 1,75,000
= 65,000
5. Calculation of Reserves & Surplus:

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 RATIO ANALYSIS 6.14

Re serves & Surplus

= 4 times
Bank & Cash

Reserves & Surplus = 4 × 65,000 = 2,60,000

PYQ 12
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 and Loss Account for the year ending 31st March, 2014.
[(5 Marks) May 2014]

Answer
Trading and Profit & Loss Account
(For the year ending 31st March, 2014)
Particulars ` Particulars `
To Opening Stock [WN (iv)] 3,37,500 By Sales [WN (ii)] 31,25,000
To Purchase and Conversion Cost 26,06,250 By Closing Stock 6,00,000
To Gross Profit [WN (iii)] 7,81,250
37,25,000 37,25,000
To Operating Expenses 1,56,250 By Gross Profit b/d 7,81,250
To Net Profit [WN (i)] 6,25,000
7,81,250 7,81,250
Working Notes:
(i) Calculation of Net Profit:
Net Pr ofit 1 Capital
= or Net Profit =
Capital 4 4
25,00,000
Net Profit = = `6,25,000
4
(ii) Calculation of Sales:
Net Pr ofit Net Pr ofit
= 20% or Sales =
Sales 20%
6,25,000
Sales = = `31,25,000
20%
(iii) Calculation of Gross Profit:
Gross Profit = 25% of Sales
= 25% of `31,25,000 = `7,81,250
(iv) Calculation of Opening Stock:
COGS
Stock Turnover Ratio = = 5 Times
Average Stock
COGS (Sales  25%)
Average Stock =
5

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 RATIO ANALYSIS 6.15

31,25,000  25%
= = `4,68,750
5
Opening Stock  Clo sin g Stock
Average Stock =
2
Average Stock × 2 = Opening Stock + Closing Stock
4,68,750 × 2 = Opening Stock + 6,00,000
Opening Stock = 9,37,500 – 6,00,000 = `3,37,500
Note: All figures in Trading and Profit and Loss A/c are balancing figures except calculated in working
notes.

PYQ 13
SRS Ltd has furnished the following ratios and information relating to the year ended 31st March,2015.
Sales `60,00,000
Return on Net Worth 25%
Rate of Income Tax 50%
Share Capital to Reserve 7: 3
Current Ratio 2
Net Profit to Sales (after tax) 6.25%
Inventory Turnover 12
(Based on cost of goods sold and closing stock)
Cost of Goods Sold `18,00,000
Interest on Debenture @ 15% `60,000
Sundry Debtors `2,00,000
Sundry Creditors `2,00,000
You are required to:
(i) Calculate the operating expenses for the year ended 31st March,2015.
(ii) Prepare Balance Sheet as on 31st March,2015.
[(8 Marks) May 2015]

Answer
(i) Operating Expenses = Gross Profit - EBIT
= `42,00,000 – `8,10,000 = `33,90,000

Working: Calculation of EBIT

Particulars `
Net Profit After Tax (EAT) 6.25% of `60,00,000 3,75,000
Add: Tax @ 50% (3,75,000 × 0.50/1-0.50) 3,75,000
Net Profit Before Tax (EBT) 7,50,000
Add: Interest 60,000
Earning Before Interest and Tax (EBIT) 8,10,000

(ii) Balance Sheet

(As on 31.03.2015)
Liabilities ` Assets `
Share Capital 10,50,000 Fixed Assets (b.f.) 17,00,000
Reserves 4,50,000 Current Assets:
Debentures 4,00,000 Bank & Cash 50,000
Sundry Creditors 2,00,000 Inventory 1,50,000
Debtors 2,00,000
21,00,000 21,00,000
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 RATIO ANALYSIS 6.16

Working Notes:

PAT
(a) Return on Net Worth = × 100 = 25%
Net Worth
3,75,000
Net Worth = = 15,00,000
25%
Net Worth = Share Capital + Reserve = 15,00,000

Share Capital to Reserve = 7:3

Share Capital = 15,00,000 × 7/10 = 10,50,000

Reserve = 15,00,000 × 3/10 = 4,50,000

Interest
(b) Debentures =
Rate of Interest
60,000
= = 4,00,000
15%

COGS
(c) Inventory Turnover =
Clo sin g Stock
COGS
Closing Stock =
Inventory Turnover
18,00,000
= = 1,50,000
12

CA
(d) Current Ratio = = 2 times
CL
Debtors  Clo sin g Stock  Cash
2 times =
Creditors
2,00,000  1,50,000  Cash
2 =
2,00,000

Cash and Bank = 4,00,000 – 3,50,000 = 50,000

PYQ 14
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.

[(8 Marks) Nov 2015]

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 RATIO ANALYSIS 6.17

Answer
Trading and Profit & Loss Account
(For the year ending 31st March, 2015)
Particulars ` Particulars `
To Opening Stock 4,50,000 By Sales 90,00,000
To Purchase & Conversion Cost (b.f.) 65,70,000 By Closing Stock (8% of 90 Lacs) 7,20,000
To Gross Profit c/d (30% of 90 Lacs) 27,00,000
97,20,000 97,20,000
To Operating Expenses (b.f.) 76,923 By Gross Profit b/d 27,00,000
To Interest on debt (14% of 50 Lacs) 7,00,000
To Income tax 6,73,077
To Net Profit 12,50,000
27,00,000 27,00,000

Working Notes:
(i) Calculation of Equity:
Debt
= 2:1
Equity
Equity = Debt ÷ 2
50,00,000 ÷ 2 = `25,00,000

(ii) Calculation of Net Profit After Tax(PAT):

PAT
Return on Equity = × 100 = 50%
Equity
Profit After Tax = 50% of 25,00,000 = `12,50,000

(iii) Calculation of Income Tax:

PAT
Income Tax = 35% of PBT = 35% of
1t
12,50,000
= 35% of = `6,73,077
1  .35

(iv) Calculation of Sales:

Sales Sales
Capital Turnover Ratio = =
Capital Equity  Debt
Sales
= 1.2 times
25,00,000  50,00,000
Sales = 75,00,000 × 1.2 = `90,00,000

PYQ 15
With the following ratios and further information given below prepare a Trading Account, Profit and
Loss Account and Balance Sheet of ABC Company.
Fixed Assets `40,00,000
Closing Stock `4,00,000
Stock turnover ratio 10 times
Gross Profit Ratio 25%
Net Profit Ratio 20%
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
[(8 Marks) May 2016]
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 RATIO ANALYSIS 6.18

Answer
Trading and Profit & Loss Account
Particulars ` Particulars `
To Opening Stock 80,000 By Sales 32,00,000
To Purchase & Conversion Cost (b.f.) 27,20,000 By Closing Stock 4,00,000
To Gross Profit c/d (25% of 32 Lacs) 8,00,000
36,00,000 36,00,000
To Operating Expenses (b.f.) 1,60,000 By Gross Profit b/d 8,00,000
To Net Profit 6,40,000
8,00,000 8,00,000

Balance Sheet
Liabilities ` Assets `
Capital 32,00,000 Fixed Assets 40,00,000
Other Liabilities 64,00,000 Current Assets:
Stock 4,00,000
Other CA (b.f.) 52,00,000 56,00,000
96,00,000 96,00,000

Working Notes:
(i) Calculation of Capital:
Fixed Assets
= 5/4 or Capital = 40,00,000 × 4/5
Capital
= `32,00,000
(ii) Calculation of Other Liabilities:
Capital
= 1/2 or Other Liabilities = 32,00,000 × 2
Other Liabilities
= `64,00,000
(iii) Calculation of Current Assets:
Fixed Assets
= 5/7 or Current Assets = 40,00,000 × 7/5
Current Assets
= `56,00,000
(iv) Calculation of Net Profit:
Net Pr ofit
= 1/5 or Net Profit = 32,00,000 × 1/5
Capital
= `6,40,000
(v) Calculation of Sales:
Net Pr ofit
= 20% or Sales = 6,40,000 ÷ 20%
Sales
= `32,00,000
(vi) Calculation of Opening Stock:
COGS = 75% of Sales = 75% of 32,00,000 = 24,00,000
COGS
= 10 or Average Stock = 24,00,000 ÷ 10
Average Stock
= 2,40,000
Average stock = (Opening Stock + Closing Stock) ÷ 2 = 2,40,000
Opening Stock = (2,40,000 × 2) – 4,00,000 = `80,000
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 RATIO ANALYSIS 6.19

PYQ 16
The following figures and ratios pertains 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 COGS) 1.5
Stock turnover ratio (based on COGS) 6
Quick ratio 1:1
Current ratio 1.5
Debtors collection period 45 days
Reserve 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. [(8 Marks) Nov 2016]

Answer
Balance Sheet
Liabilities ` Assets `
Equity Share Capital 12,50,000 Fixed Assets 24,00,000
Reserve 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. (b.f.) 5,75,000 18,00,000
42,00,000 42,00,000
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 and Current Liabilities
Stock = (CR - LR) × CL
6,00,000 = (1.5 – 1) CL OR CL = `12,00,000
Current Assets = 12,00,000 × 1.5 = `18,00,000
(v) Debtors = Sales × Debtors Collection Period(days) /360 days
= `50,00,000 × 45/360 = `6,25,000
(vi) Net worth = Fixed Assets / 1.2
= `24,00,000/1.2 = `20,00,000
(vii) Reserves and Surplus and Share Capital
Reserves & Surplus and Share Capital = 0.6 + 1 = 1.6
Reserves and Surplus = `20,00,000 × 0.6/1.6 = `7,50,000
Share Capital = Net worth – Reserves and Surplus
= `20,00,000 – `7,50,000 = `12,50,000
(viii) Long- term Debts
Capital Gearing Ratio = Long-term Debts / Equity Shareholders’ Fund (Net worth)
Long-term Debts = `20,00,000 × 0.5 = `10,00,000
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 RATIO ANALYSIS 6.20

PYQ 17
The following information relate to a concern:
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
Closing stock of the period is `10,000 above the opening stock.
Find out:
1. Sales and cost of goods sold
2. Sundry Debtors
3. Sundry Creditors
4. Closing Stock
5. Fixed Assets
[(8 Marks) May 2017]

Answer
1. Sales = Gross Profit ÷ Gross Profit Ratio
= `4,00,000 ÷ 25% = `16,00,000
Cost of goods sold = Sales - Gross Profit
= `16,00,000 - `4,00,000 = `12,00,000

2. Sundry debtors = Credit sales × 3/12 – Bills receivables

= `16,00,000 × 3/12 – `25,000 = `3,75,000

3. Sundry creditors = Credit Purchase × 2/12 – Bills payables

= `12,10,000 × 2/12 – `10,000 = `1,91,667

Credit purchase = COGS + Closing Stock – Opening Stock

= `12,00,000 + `10,000 = `12,10,000

4. Closing Stock:
Average Stock = COGS ÷ 1.5 = `12,00,000 ÷ 1.5 = `8,00,000
Opening Stock  Clo sin g Stock
Average Stock =
2
8,00,000 × 2 = Opening Stock + Closing Stock
16,00,000 = (Closing – 10,000) + Closing Stock
Closing Stock = `8,05,000
[Opening Stock = Closing – 10,000]

5. Fixed Asset Turnover = Sales ÷ Fixed asset

Fixed Asset = 16,00,000 ÷ 4 = `4,00,000

Assumption:
(i) All sales are credit sales
(ii) All purchases are credit Purchase
(iii) Stock Turnover Ratio and Fixed Asset Turnover Ratio may be calculated either on Sales or on Cost of
Goods Sold.

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 RATIO ANALYSIS 6.21

PYQ 18
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%
You are required to prepare Trading and Profit & Loss account for the year ending 31st March, 2017.
[(8 Marks) Nov 2017]

Answer
Trading and Profit & Loss Account
Particulars ` Particulars `
To Opening Stock 2,50,000 By Sales 12,50,000
To Purchase & Conversion Cost (b.f.) 9,00,000 By Closing Stock 1,50,000
To Gross Profit (20% of 12,50,000) 2,50,000
14,00,000 14,00,000
To Operating Expenses (b.f.) 50,000 By Gross Profit b/d 2,50,000
To Net Profit 2,00,000
2,50,000 2,50,000

Working Notes:
(i) Calculation of Net Profit:
Net Pr ofit
= 25% or Net Profit = 8,00,000 × 25%
Capital
= `2,00,000
(ii) Calculation of Sales:
Net Pr ofit
= 16% or Sales = 2,00,000 ÷ 16%
Sales
= `12,50,000
(iii) Calculation of Opening Stock:
COGS = 80% of Sales = 80% of 12,50,000 = 10,00,000
COGS
= 5 or Average Stock = 10,00,000 ÷ 5
Average Stock
= 2,00,000
Average stock = (Opening Stock + Closing Stock) ÷ 2 = 2,00,000
Opening Stock = (2,00,000 × 2) – 1,50,000 = `2,50,000

PYQ 19
Equity share capital G Ltd. has furnished the following information relating to the year ended 31st March,
2017 and 31st March, 2018:
Particulars 31st March, 2017 31st March, 2018
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%
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 RATIO ANALYSIS 6.22

 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, 2018 in following format:
Liabilities ` Assets `
Share Capital - Fixed Assets -
Reserve and Surplus - Sundry Debtors -
Long-Term Loan - Closing Stock -
Sundry Creditors - Cash in hand -
[(8 Marks) May 2018]

Answer
Balance Sheet
Liabilities ` Assets `
Share Capital 40,00,000 Fixed Assets 75,00,000
Reserve and Surplus 25,00,000 Sundry Debtors 15,62,500
Long-Term Loan 30,00,000 Closing Stock 12,50,000
Sundry Creditors (b.f.) 14,37,500 Cash in hand 6,25,000
1,09,37,500 1,09,37,500
Working Notes:
(1) Net Profit = Change in Reserve and Surplus
= 25,00,000 – 20,00,000 = `5,00,000

(2) Sales:
Net Profit ratio = 8% of sales
∴ Sales = Net Profit ÷ Net profit ratio
= 5,00,000 ÷ 8% = `62,50,000

(3) Cost of Goods Sold = Sales – Gross Profit (20% of Sales)

= `62,50,000 – 20% of `62,50,000 = `50,00,000

(4) Fixed Assets = Long term loan ÷ 40%

= `30,00,000 ÷ 40% = `75,00,000

(5) Closing Stock = Cost of Goods Sold ÷ Stock Turnover

= `50,00,000 ÷ 4 = `12,50,000

(6) Debtors = Sales × Debtors Collection Period(days)/360 days

= `62,50,000 × 90/360 = `15,62,500

(7) Cash Equivalent = COGS × 1.5/12

= `50,00,000 × 1.5/12 = `6,25,000

PYQ 20
The accountant of Moon Ltd. has reported the following data:
Gross profit : `60,000
Gross profit margin : 20%
Total Assets Turnover : 0.30 : 1
Net Worth to Total Assets : 0.90 : 1
Current Ratio : 1.5 : 1
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 RATIO ANALYSIS 6.23

Liquid Assets to current liability : 1:1

Credit Sales to Total Sales : 0.80 : 1
Average Collection Period : 60 days
Days in a Year : 360 days

You are required to complete the following:

Balance Sheet of Moon Ltd.
Liabilities ` Assets `
Net Worth - Fixed Assets -
Current Liabilities - Debtors -
Stock -
Cash -
Total Liabilities - Total Assets -
[(5 Marks) May 2018]

Answer
Balance Sheet of Moon Ltd.
Liabilities ` Assets `
Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities (b.f.) 1,00,000 Debtors 50,000
Stock 40,000
Cash 60,000
Total Liabilities 10,00,000 Total Assets 10,00,000
Working Notes:
(1) Sales = Gross Profit ÷ Gross Profit ratio
= 60,000 ÷ 20% = `3,00,000

(2) Total Assets = Sales / Total Assets Turnover

= 3,00,000 ÷ .030 = `10,00,000

(3) Net worth = Total Assets × 0.90

= `10,00,000 × 0.90 = `9,00,000

(4) Current Assets = Current Liabilities × 1.50

= `1,00,000 × 1.50 = `1,50,000

(5) Fixed Assets = Total Assets - Current Assets

= `10,00,000 - `1,50,000 = `8,50,000

(6) Liquid Assets = Current Liabilities × 1

= `1,00,000 × 1 = `1,00,000

(7) Closing Stock = Current Assets – Liquid Assets

= `1,50,000 - `1,00,000 = `50,000

(8) Debtors = Credit Sales × Debtors Collection Period(days)/360 days

= `3,00,000 × .080 × 60/360 = `40,000

(9) Cash = Current Assets – Stock - Debtors

= `1,50,000 - 50,000 - `40,000 = `60,000

PYQ 21
A limited Company’s books reveals following information:
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 RATIO ANALYSIS 6.24

Net Income : `3,60,000

Shareholder’s Equity : `4,00,000
Assets Turnover : 2.5 times
Net Profit Margin : 12%

You are required to calculate ROE of the company based on the ‘DuPont model’.
[(5 Marks) Nov 2018]

Answer
Return on Equity = Net Profit Margin × Asset Turnover × Equity Multiplier
= 12% × 2.5 times × 3 times = 90%
Working Notes:
1. Sales:
Net profit Margin = Net Income ÷ Sales = 12%
Sales = `3,60,000 ÷ 12% = `30,00,000
2. Total Assest:
Asset Turnover = Sales ÷ Total Assets = 2.5 times
Total Assets = Sales ÷ 2.5 = 30,00,000 ÷ 2.5 = `12,00,000
3. Equity Multiplier = Total Assets ÷ Equity
= `12,00,000 ÷ `4,00,000 = 3 times

PYQ 22
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 holding period 3 months
Non-current assets to sales 1:4
Non-current assets to current assets 1:2
Current ratio 2:1
Non-current liabilities to current liabilities 1:1
Share capital to reserve and surplus 4:1
Non-current assets as on 31.03.2017 `50,00,000
Assume that:
(a) No change in Non-current assets during the year 2017-18.
(b) No depreciation charged on Non-current assets during the year 2017-18
(c) Ignoring tax
You are required to calculate cost of goods sold, Net profit, Inventory, receivables and cash for the year
ended on 31.03.2018.
[(5 Marks) Nov 2018]

Answer
(a) Net Profit = 10% of sales = 10% of `2,00,00,000 = `20,00,000

(b) Cost of Goods Sold = Sales – Gross Profit

= `2,00,00,000 – 20% = `1,60,00,000

(c) Inventory = COGS × 3/12 = `1,60,00,000 × 3/12 = `40,00,000

(d) Receivables = Sales × 3/12 = `2,00,00,000 × 3/12 = `50,00,000

(e) Cash = Current assets – Stock – receivables
= `1,00,00,000 - `40,00,000 - `50,00,000 = `10,00,000
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 RATIO ANALYSIS 6.25

Working:
Non current assets 50,00,000
1. = ½ or = ½
Current assets Current assets
So, Current assets = `50,00,000 × 2 = `1,00,00,000

Non current assets 50,00,000

2. = ¼ or = 1/4
Sales Sales
So, Sales = `50,00,000 × 4 = `2,00,00,000

PYQ 23
Following figures and ratios are related to a company Q Ltd.:
Sales for the year (all credit) : `30,00,000
Gross Profit Ratio : 25%
Fixed Assets Turnover (based on COGS) : 1.5
Stock turnover (based on COGS) : 6
Liquid Ratio : 1:1
Current Ratio : 1.5 : 1
Receivables (Debtors) Collection Period : 2 months
Reserve and Surplus to Share Capital : 0.6 : 1
Capital Gearing Ratio : 0.5
Fixed Assets to Net Worth : 1.20 : 1
You are required to calculate Closing Stock, Fixed Assets, Current Assets, Debtors and Net Worth.
[(5 Marks) May 2019]

Answer
(1) Closing Stock:
Stock Turnover = COGS ÷ Closing Stock
6 = (`30,00,000 – 25%) ÷ Closing Stock
Closing Stock = `3,75,000

(2) Fixed Assets:

Fixed Assets Turnover = COGS ÷ Fixed Assets
1.5 = (`30,00,000 – 25%) ÷ Fixed Assets
Fixed Assets = `15,00,000

(3) Current Assets:

Liquid Ratio = [CA – Stock (Liquid Assets)] ÷ Current liabilities
1 = (CA - `3,75,000) ÷ Current liabilities
Current Liabilities = Current Assets - `3,75,000 …..Equation (i)

Current Ratio = Current Assets ÷ Current liabilities

1.5 Current Liabilities = Current Assets
1.5 (Current Assets - `3,75,000) = Current Assets
Current Assets = `11,25,000

(4) Debtors:
Debtors = Credit Sales × Average collection Period/12
= `30,00,000 × 2/12
= `5,00,000

(5) Net Worth:

Fixed Assets to Net Worth = Fixed Assets ÷ Net Worth
1.20 = `15,00,000 ÷ Net Worth
Net Worth = `12,50,000
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 RATIO ANALYSIS 6.26

PYQ 24
Following information has been gathered from the books of Tram Ltd. The equity share of which is trading in
the stock market at `14.
Particulars Amount (`)
Equity Share Capital (Face Value `10 each) 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:

(a) Return on Capital Employed
(b) Earnings Per Share
(c) PE Ratio
[(5 Marks) Nov 2019]

Answer
EBIT 4,00,000
(a) Return on Capital Employed = × 100 = × 100
Capital Employed 26,00,000
= 15.38%

PAT−PD 2,40,000−20,000
(b) Earnings Per Share (EPS) = =
Number of Shares 1,00,000
= `2.20

MPS 14
(c) Price Earning Ratio (PE) = =
EPS 2.20
= 6.36 times

Working Note:
Capital Employed = Equity Share Capital + Reserves + Preference Share Capital +
Debentures
= `10,00,000 + `8,00,000 + `2,00,000 + `6,00,000
= `26,00,000

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 RATIO ANALYSIS 6.27

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y -
5 Y Y Y -
6 Y Y Y Y
7 Y Y Y Y
8 Y Y Y -
9 Y Y Y -
10 Y Y Y Y
11 Y Y Y Y
12 Y Y Y Y
13 Y Y Y Y
14 Y Y Y Y
15 Y Y Y Y
16 Y Y Y Y
17 Y Y Y Y
18 Y Y - -
19 Y Y Y -
20 Y Y Y -
21 Y Y Y -
22 Y Y Y -
23 Y Y Y -
24 Y Y Y -

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 CHAPTER – 7

CAPITAL BUDGETING OR
INVESTMENT DECISION
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Understand the meaning of investment decisions or capital
budgeting decisions.
 Understand various techniques of capital budgeting.
 Understand traditional and discounted cash flow techniques.
 Know the importance of capital budgeting decisions.
 Understand the meaning of capital budgeting and its role in
financial management.
 CAPITAL BUDGETING 7.2

PAST YEAR QUESTIONS

PYQ 1
The cash flows of two mutually exclusive Projects are as under:
Project t0 t1 t2 t3 t4 t5 t6
P (40,000) 13,000 8,000 14,000 12,000 11,000 15,000
J (20,000) 7,000 13,000 12,000 - - -
Required:
(1) Estimate the net present value (NPV) of the Project ‘P’ and ‘J’ using 15% as the hurdle rate.
(2) Estimate the internal rate of return (IRR) of the Project ‘P’ and ‘J’.
(3) Why there is a conflict in the project choice by using NPV and IRR criterion?
(4) 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 t0 t1 t2 t3 t4 t5 t6
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
[(7 Marks) May 2004]

Answer
(1) Calculation of NPV using 15% as hurdle rate:
Project P = (40,000) × 1.00 + 13,000 × 0.8696 + 8,000 × 0.7561 + 14,000 × 0.6575 +
12,000 × 0.5718 + 11,000 × 0.4972 + 15,000 × 0.4323
= 5,374

Project J = (20,000) × 1.00 + 7,000 × 0.8696 + 13,000 × 0.7561 + 12,000 × 0.6575

= 3,807

(2) Calculation of IRR

Project P:
NPV (20% rate) = (40,000) × 1.00 + 13,000 × 0.8333 + 8,000 × 0.6944 + 14,000 × 0.5787 +
12,000 × 0.4823 + 11,000 × 0.4019 + 15,000 × 0.3349
= (278)
5,374
IRR = 15% + ×5% = 19.75%
5,374+ 278

Project J:
NPV (20% rate) = (20,000) × 1.00 + 7,000 × 0.8333 + 13,000 × 0.6944 + 12,000 × 0.5787
= 1,805
NPV (25% rate) = (20,000) × 1.00 + 7,000 × 0.8000 + 13,000 × 0.6400 + 12,000 × 0.5120
= 64
NPV (26% rate) = (20,000) × 1.00 + 7,000 × 0.7937 + 13,000 × 0.6299 + 12,000 × 0.4999
= (257)

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 CAPITAL BUDGETING 7.3
64
IRR = 25% + ×1% = 25.20%
64+ 257

(3) 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.

(4) When there is a conflict in the project choice by using NPV and IRR criterion, we would prefer to use
“Equal Annualized Criterion” in case of unequal life (otherwise normal NPV). According to this
criterion the net annual cash inflow in the case of Projects ‘P’ and ‘J’ respectively would be:
Project ‘P’ = `5,374 / 3.7845 = `1,420
Project ‘J’ = `3,807 / 2.2832 = `1,667

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.

PYQ 2
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:
Existing Machine New Machine
Particulars Difference
(80,000 units) (1,00,000 units)
Materials 75.00 63.75 (11.25)
Wages and Salaries 51.25 37.50 (13.75)
Supervision 20.00 25.00 5.00
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated Corporate Overheads 10.00 12.50 2.50
Total 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.
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 0.8000 0.6400 0.5120 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
[(8+3+1 = 12 Marks) Nov 2005]

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 CAPITAL BUDGETING 7.4
Answer
(i) Statement of NPV
Year Particulars ` DF @ 15% PV
0 Initial outflows (58,50,000) 1.0000 (58,50,000)
1-5 Cash Flow After Tax 22,84,000 3.3522 76,56,425
5 Net Salvage 2,50,000 – 35,000 (1 – 0.40) 2,29,000 0.4972 1,13,859
NPV 19,20,284
Working Notes:
1. Calculation of initial outflow:
Cost of new machine `60,00,000
Less: Exchange value of old machine (`2,50,000)
Add: Tax payment on profit on exchange of old machine `1,00,000
(2,50,000 – Nil) × 40%
Initial outflow `58,50,000

2. Calculation of incremental CFAT:

Increase in sales (200 × 20,000 units) `40,00,000
Less: Increase in operating cost (1,00,000 × 148) – (80,000 × 173) `9,60,000
(excluding Depreciation and Allocated overheads)
Less: Increase in depreciation [(60,00,00 – 2,50,000) ÷ 5] – Nil `11,50,000
Profit before tax `18,90,000
Less: Tax @ 40% `7,56,000
Profit after tax `11,34,000
Add: Depreciation `11,50,000
Incremental CFAT `22,84,000

3. Calculation of Incremental Salvage:

Salvage of new machine (Salvage = WDV; no gain or loss) `2,50,000
Less: Salvage of old machine (Salvage > WDV) `35,000
Tax on gain 40% of 35,000 (35,000 - Nil) `14,000 `21,000
Incremental Salvage `2,29,000

Notes:
(a) The old machine could be sold for `1,50,000 in the market. Since exchange value is more than the
market value, company will exchange it at `2,50,000.
(b) Old machine has fully depreciated for tax purpose, therefore depreciation of old machine as well as
WDV are NIL.
(c) Allocated overheads are allocations from corporate office therefore they are irrelevant for
computation of CFAT.

(ii) Calculation of IRR:

Since NPV computed in Part (i) is positive. Let us discount cash flows at higher rate say at 25% or 30%
Statement of NPV
Year Particulars ` DF @ 25% PV DF @ 30% PV
0 Initial outflows (58,50,000) 1.0000 (58,50,000) 1.0000 (58,50,000)
1-5 Cash Flow After Tax 22,84,000 2.6893 61,42,361 2.4355 55,62,682
5 Incremental Salvage 2,29,000 0.3277 75,043 0.2693 61,670
NPV 3,67,404 -2,25,648
3,67,404
IRR = 25% + 5% = 28.10%
3,67,404  2,25,648
(iii) Advise: The company should go ahead with replacement project, since it has positive NPV.

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 CAPITAL BUDGETING 7.5
PYQ 3
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:
Year 1 2 3 4 5
Before tax cash `2,40,000 `2,75,000 `2,10,000 `1,80,000 `1,60,000
The applicable Income-tax rate to the Company is 35%. If the Company’s opportunity cost of capital
is 12%, calculate the equipment’s net present value, discounted payback period, payback period, and
internal rate of return.
The PV factors at 12%, 14% and 15% are:
Year 1 2 3 4 5 Total
PV factor @ 12% 0.8929 0.7972 0.7118 0.6355 0.5674 3.6048
PV factor @ 14% 0.8772 0.7695 0.6750 0.5921 0.5194 3.4332
PV factor @ 15% 0.8696 0.7561 0.6575 0.5718 0.4972 3.3522
[(10 Marks) May 2006]

Answer
(1) Net Present Value
Year Particulars ` DF @ 12% PV
0 Initial outflows (6,80,000) 1.0000 (6,80,000)
1 CFAT 1,98,000 0.8929 1,76,794
2 CFAT 2,20,750 0.7972 1,75,982
3 CFAT 1,78,500 0.7118 1,27,056
4 CFAT 1,59,000 0.6355 1,01,045
5 CFAT and working capital 2,26,000 0.5674 1,28,234
(1,46,000 + 80,000)
NPV 29,111

Working Notes:
Calculation of CFAT:
Particulars 1 2 3 4 5
Before tax cash inflows 2,40,000 2,75,000 2,10,000 1,80,000 1,60,000
Less: Depreciation (6 lac÷ 5) 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
Profit before tax (PBT) 1,20,000 1,55,000 90,000 60,000 40,000
Less: Tax @ 35% 42,000 54,250 31,500 21,000 14,000
Profit after tax (PAT) 78,000 1,00,750 58,500 39,000 26,000
Add: Depreciation 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
CFAT 1,98,000 2,20,750 1,78,500 1,59,000 1,46,000

6,80,000  5,80,877
(2) Discounted Payback Period = 4 years +
1,28,234
= 4.77 years

6,80,000  5,97,250
(3) Payback Period = 3 years +
1,59,000
= 3.52 years

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 CAPITAL BUDGETING 7.6
(4) Internal Rate of Return:

Calculation of NPV by Using DF @ 12% and 14%

Year Particulars ` DF @ 12% PV DF @ 14% PV
0 Outflows (6,80,000) 1.0000 (6,80,000) 1.0000 (6,80,000)
1 Inflows 1,98,000 0.8929 1,76,794 0.8772 1,73,686
2 Inflows 2,20,750 0.7972 1,75,982 0.7695 1,69,867
3 Inflows 1,78,500 0.7118 1,27,056 0.6750 1,20,488
4 Inflows 1,59,000 0.6355 1,01,045 0.5921 94,144
5 Inflows 2,26,000 0.5674 1,28,234 0.5194 1,17,384
NPV 29,111 NPV (4431)

NPVLR 29,111
IRR = LR + × (HR - LR) = 12% + × (14 - 12)
NPVLR  NPVHR 29,111  (4,431)
= 12% + 1.736% = 13.736%

PYQ 4
Company UVW has to make a choice between two identical machines in terms of capacity ‘A’ and ‘B’. They
have been designed differently but do exactly the same job.
Machine ‘A’ costs `7,50,000 and will last for three years. It costs `2,00,000 per year to run. Machine
‘B’ is an economy model costing only `5,00,000 but will last for only two years. It costs `3,00,000 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 present value factors at 9% are:
Years t1 t2 t3
PVIF0.90t 0.9174 0.8417 0.7722
PVIFA0.09.2 = 1.7591
PVIFA0.09.3 = 2.5313

Which machine would you recommend the company to buy?

[(8 marks) Nov 2006]

Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B’
Initial outflow/ Purchase cost of machines 7,50,000 5,00,000
Annual running cost 2,00,000 3,00,000
Life of machines 3 years 2 years
PV of annual running cost 5,06,260 5,27,730
(Annual running cost × PVIFA) (2,00,000 × 2.5313) (3,00,000 × 1.7591)
Present value of total outflow 12,56,260 10,27,730
(initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.5313 ÷ 1.7591
Equivalent Annual outflow 4,96,290 5,84,236
Select the Machine A having lower equivalent annualized outflow.

PYQ 5
XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to setup in

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 CAPITAL BUDGETING 7.7
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 cost
`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 Units sold
1 72,000
2 1,08,000
3 2,60,000
4–5 2,70,000
6–8 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 percent 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

Note: The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
.893 .797 .712 .636 .567 .507 .452 .404
[Nov 2007]

Answer
Net Present Value
Year Particulars ` DF @ 12% PV
0 Initial outflows (1,70,00,000) 1.000 (1,70,00,000)
(175 – 25 + 20) Lacs
1 CFAT 16,56,000 0.893 14,78,808
2 CFAT 29,97,000 0.797 23,88,609
3 CFAT less Additional Equipment 67,88,500 0.712 48,33,412
(80,38,500 – 12,50,000)
4–5 CFAT 84,42,000 1.203 1,01,55,726
6–8 CFAT 54,18,000 1.363 73,84,734
8 Working Capital and Salvage 21,25,000 0.404 8,58,500
(20,00,000 + 1,25,000)
NPV 1,00,99,789

Company should accept the proposal having positive NPV of the project.

Working Notes:
1. Depreciation:
Original Cost  Subsidy  Salvage
Main equipment (t0 - t8) =
Life of Equipment
175 Lacs  25 Lacs  Nil
= = 18,75,000
8 Years

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 CAPITAL BUDGETING 7.8
Original Cost  Salvage 12,50,000  1,25,000
Additional equipment (t4 - t8) = =
Life of Equipment 5 Years
= 2,25,000

2. Tax for year 2 = 30% of (15,09,000 – 2,19,000) = 3,87,000

3. Statement of CFAT
Particulars 1 2 3 4–5 6–8
Units sold 72,000 1,08,000 2,60,000 2,70,000 1,80,000
Sales @ `120 p.u. 86,40,000 1,29,60,000 3,12,00,000 3,24,00,000 2,16,00,000
Less: VC @ 60% 51,84,000 77,76,000 1,87,20,000 1,94,40,000 1,29,60,000
Contribution 34,56,000 51,84,000 1,24,80,000 1,29,60,000 86,40,000
Less: Cash FC (18,00,000) (18,00,000) (18,00,000) (18,00,000) (18,00,000)
Less: Depreciation (18,75,000) (18,75,000) (18,75,000) (21,00,000) (21,00,000)
PBT (2,19,000) 15,09,000 88,05,000 90,60,000 47,40,000
Less: Tax @ 30% - (3,87,000) (26,41,500) (27,18,000) (14,22,000)
PAT (2,19,000) 11,22,000 61,63,500 63,42,000 33,18,000
Add: Depreciation 18,75,000 18,75,000 18,75,000 21,00,000 21,00,000
CFAT 16,56,000 29,97,000 80,38,500 84,42,000 54,18,000

PYQ 6
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 with no salvage value.
The expected net cash inflow after 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 (IRR).

Note: The P.V. factors are:

Year P.V. @ 10% P.V. @ 37% P.V. @ 38% P.V. @ 40%
1 .909 .730 .725 .715
2 .826 .533 .525 .510
3 .751 .389 .381 .364
4 .683 .284 .276 .260
5 .621 .207 .200 .186
[(8 Marks) May 2008]

Answer
(i) Calculation of Payback Period and ARR
2,00,000  99,500
Payback Period = 1 year + × 12 Months = 1.91 years
1,10,000

Average PAT 53,900

ARR = × 100 = × 100 = 26.95%
Initial Investment 2,00,000

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 CAPITAL BUDGETING 7.9
Working Notes:
59,500  70,000  56,000  56,000  28,000
Average PAT = = 53,900
5 Years

(ii) Calculation of NPV and NPV Index (PI):

Net Present Value
Year Particulars ` DF @ 10% PV
0 Initial outflows (2,00,000) 1.000 (2,00,000)
1 Cash Flow After Tax 99,500 0.909 90,446
2 Cash Flow After Tax 1,10,000 0.826 90,860
3 Cash Flow After Tax 96,000 0.751 72,096
4 Cash Flow After Tax 96,000 0.683 65,568
5 Cash Flow After Tax 68,000 0.621 42,228
NPV 1,61,198

PV of Inflows 3,61,198
NPV Index (PI) = = = 1.81
PV of Outflows 2,00,000

(iii) Calculation of IRR:

NPV by using DF @ 37%, 38% and 40%
PVF at PVF at PVF at
Year ` PV at 37% PV at 38% PV at 40%
37% 38% 40%
0 (2,00,000) 1.000 (2,00,000) 1.000 (2,00,000) 1.000 (2,00,000)
1 99,500 0.730 72,635 0.725 72,138 0.714 71,043
2 1,10,000 0.533 58,630 0.525 57,750 0.510 56,100
3 96,000 0.389 37,344 0.381 36,576 0.364 34,944
4 96,000 0.284 27,264 0.276 26,496 0.260 24,960
5 68,000 0.207 14,076 0.200 13,600 0.186 12,648
NPV +9,949 +6,560 (305)

NPVLR 6,560
IRR = LR + × (HR - LR) = 38% + × (40 - 38)
NPVLR  NPVHR 6,560  (305)
= 38% + 1.91% = 39.91%

Working Notes:
Calculation of PAT and CFAT
Particulars 1 2 3 4 5
Cash inflows after depreciation before tax 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
Add: Depreciation (2,00,000 ÷ 5) 40,000 40,000 40,000 40,000 40,000
CFAT 99,500 1,10,000 96,000 96,000 68,000

PYQ 7
A company wants to invest in 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 and the scrap value at the end of year 3 will be
`12,500.
However, if the company decides not to services the part, 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

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 CAPITAL BUDGETING 7.10
`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 0.9091, 0.8264, 0.7513, 0.6830, 0.6209
and 0.5644).
[(7 Marks) Nov 2008]

Answer
Option 1 (Part of the Machine is serviced):
Statement of NPV
Year Particulars ` PV Factor @ 10% PV of Cash flow
0 Initial Outflows (50,000) 1.0000 (50,000)
1 Inflows – Service Charges 18,000 – 10,000 0.9091 7,273
2 Inflows 18,000 0.8264 14,875
3 Inflows + Salvage 18,000 + 12,500 0.7513 22,915
NPV (4,937)

Option 2 (Part of the Machine is replaced):

Statement of NPV
Year Particulars ` PV Factor @ 10% PV of Cash flow
0 Initial Outflows (50,000) 1.0000 (50,000)
1 Inflows 18,000 0.9091 16,364
2 Inflows – Replacement 18,000 – 15,400 0.8264 2,149
3 Inflows 18,000 0.7513 13,523
4 Inflows + Salvage 18,000 + 9,000 0.6830 18,441
NPV 477

Decision: Option I has a negative NPV whereas option II has a positive NPV `477. Therefore, option II
(replacement of part) shall be opted.

If the supplier gives a discount of `5,000 for purchases:

Option 1: NPV = (4,937) + 5,000 = 63
Option 2: NPV = 477 + 5,000 = 5,477

Decision: Option I with very small NPV is not considerable, Option II having higher NPV shall be opted
(student can also show annualized NPV due to difference in life of projects).

PYQ 8
A company is required to choose between two machines ‘A’ and ‘B’. The two machines have identical
capacity, do exactly the same job, but designed differently.
Machine A costs `6,00,000, having useful life of three years. It costs `1,20,000 per year to run.
Machine B is an economic model costing `4,00,000, having useful life of two years. It costs `1,80,000 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%.
PVIF0.10, 1 = 0.9091, PVIF0.10, 2 = 0.8264, PVIF0.10, 3 = 0.7513.
Which machine would you recommend the company to buy? [(8 marks) May 2009]

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 CAPITAL BUDGETING 7.11
Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B’
Initial outflow/ Purchase cost of machines 6,00,000 4,00,000
Annual running cost 1,20,000 1,80,000
Life of machines 3 years 2 years
PV of annual running cost 2,98,416 3,12,390
(Annual running cost × PVIFA) (1,20,000 × 2.4868) (1,80,000 × 1.7355)
Present value of total outflow 8,98,416 7,12,390
(initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.4868 ÷ 1.7355
Equivalent Annual outflow 3,61,273 4,10,481
Select the Machine A having lower equivalent annualized outflow.

PYQ 9
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 is `12,000 per annum; net of
taxes.
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
[(8 Marks) Nov 2009]

Answer
(i) Net Present Value
Year Particulars ` DF @ 10% PV
0 Initial outflows (80,000) 1.000 (80,000)
1–8 Cash Flow After Tax 13,525 5.334 72,142
8 Salvage 6,000 0.467 2,802
NPV (5,056)
Recommendation: Reject the offer having negative NPV.

PV of Inflows 74,944
Profitability Index = = = .937
PV of Outflows 80,000

Recommendation: Reject the offer having PI less than 1.

Working Notes:
Calculation of CFAT:
Particulars `
Sales 40,000
Less: Operating cost 7,500
Less: Depreciation (80,000 – 6,000) ÷ 8 years 9,250

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 CAPITAL BUDGETING 7.12
Net Income 23,250
Less: Tax @ 30% (Assumed) 6,975
PAT 16,275
Add: Depreciation 9,250
Cash inflows after tax per annum 25,525
Less: Loss of commission income 12,000
Net CFAT 13,525

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

PYQ 10
The management of P Limited is considering to select a machine out of the two mutually exclusive machines.
The Company’s cost of capital is 12 percent and corporate tax rate for the company is 30 percent. Details of
the machines are as follows
Machine I Machine II
Cost of machine `10,00,000 `15,00,000
Expected life 5 Years 6 Years
Annual income before tax and depreciation `3,45,000 `4,55,000
Depreciation is to be charged on straight line basis.
You are required to:
(i) Calculate the discounted payback period, net present value and internal rate of return for each
machine.
(ii) Advise the management of P Limited as to which machine they should take up:

The present value factors of `1 are as follows:

Year 1 2 3 4 5 6
At 12% .893 .797 .712 .636 .567 .507
At 13% .885 .783 .693 .613 .543 .480
At 14% .877 .769 .675 .592 .519 .456
At 15% .870 .756 .658 .572 .497 .432
At 16% .862 .743 .641 .552 .476 .410
[(9 Marks) May 2010]

Answer
Net Present Value:
Machine I = 10,86,909 – 10,00,000 = 86,909
Machine II = 16,18,074 – 15,00,000 = 1,18,074

Equivalent NPV:
Machine I = 86,909 ÷ 3.605 = 24,108
Machine II = 1,18,074 ÷ 4.111 = 28,721

Discounted Pay Back Period:

10,00,000  9,15,958
Machine I = 4 Years + = 4.49 Years
1,70,951
15,00,000  14,18,569
Machine II = 5 Years + = 5.41 Years
1,99,505

Internal Rate of Return:

Machine I:

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 CAPITAL BUDGETING 7.13
Initial Investment 10,00,000
Sum of PV Factor @ IRR = =
Annual Cash Inflow 3,01,500
= 3.3167
PV factor falls between 15% and 16%:

NPV at 15% = 3,01,500 × 3.353 – 10,00,000 = 10,930

NPV at 16% = 3,01,500 × 3.274 – 10,00,000 = (12,889)

NPVLR 10,930
IRR = LR + × (HR - LR) = 15% + × (16 - 15)
NPVLR  NPVHR 10,930  (12,889)
= 15% + 0.459% = 15.459%

Machine II:
Initial Investment 15,00,000
Sum of PV Factor @ IRR = =
Annual Cash Inflow 3,93,500
= 3.8119

PV factor falls between 14% and 15%:

NPV at 14% = 3,93,500 × 3.888 – 15,00,000 = 29,928

NPV at 15% = 3,93,500 × 3.785 – 15,00,000 = (10,603)

NPVLR 29,928
IRR = LR + × (HR - LR) = 14% + × (15 - 14)
NPVLR  NPVHR 29,928  (10,603)
= 14% + 0.738% = 14.738%

Working Notes:
Calculation of CFAT
Machine
Particulars
1 2
Cash Flow Before Tax 3,45,000 4,55,000
Less: Depreciation 2,00,000 2,50,000
Profit Before Tax 1,45,000 2,05,000
Less: Tax @ 30% 43,500 61,500
Profit After Tax 1,01,000 1,43,500
Add: Deprecation 2,00,000 2,50,000
Cash Flow After Tax 3,01,500 3,95,500

Calculation of PV and Cumulative PV

PVF @ I II
Year
12% CFAT PV Cum PV CFAT PV Cum PV
1 0.893 3,01,500 2,69,240 2,96,240 3,93,500 3,51,396 3,51,396
2 0.797 3,01,500 2,40,296 5,09,536 3,93,500 3,13,620 6,65,016
3 0.712 3,01,500 2,14,668 7,24,204 3,93,500 2,80,172 9,45,188
4 0.636 3,01,500 1,91,754 9,15,958 3,93,500 2,50,266 11,95,454
5 0.567 3,01,500 1,70,951 10,86,909 3,93,500 2,23,115 14,18,569
6 0.507 - - - 3,93,500 1,99,505 16,18,074

Conclusion: On the basic of IRR and Discounted Payback Period Machine I is better but on the basic of NPV
and ENPV machine II is better. Since, Machine I has better ranking under two techniques so Machine I should
be selected.

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 CAPITAL BUDGETING 7.14
PYQ 11
A company has to make a choice two machines ‘X’ and ‘Y’. The two machines have identical capacity, do
exactly the same job, but designed differently.

Machine X costs `5,50,000 and will last for three years. It costs `1,25,000 per year to run. Machine Y
is an economic model costing `4,00,000 will last for two years. It costs `1,50,000 per year to run.

The cash flows of machine ‘X’ and ‘Y’ are real cash flows. The costs are forecasted in rupees of
constant purchasing power. Ignore taxes. The present value factors at 12% are:

Years t1 t2 t3
PVIF0.12t 0.8929 0.7972 0.7118
PVIFA0.12.2 = 1.6901
PVIFA0.12.3 = 2.4019

Which machine would you recommend the company to buy?

[(8 marks) Nov 2010]

Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘X’ Machine ‘Y’
Initial outflow/ Purchase cost of machines 5,50,000 4,00,000
Annual running cost 1,25,000 1,50,000
Life of machines 3 years 2 years
PV of annual running cost 3,00,238 2,53,515
(Annual running cost × PVIFA) (1,25,000 × 2.4019) (1,50,000 × 1.6901)
Present value of total outflow 8,50,238 6,53,515
÷ PVIFA ÷ 2.4019 ÷ 1.6901
Equivalent Annual outflow 3,53,986 3,86,672

Select the Machine X having lower equivalent annualized outflow.

PYQ 12
A Ltd. Is considering the purchase of a machine which will perform some operations which are at present
preformed by workers. Machines X and Y are alternative models. The following details are available:

Particulars Machine X Machine Y

Cost of machine `1,50,000 `2,40,000
Estimated life of machine 5 years 6 years
Estimated cost of maintenance per annum `7,000 `11,000
Estimated cost of indirect materials per annum `6,000 `8,000
Estimated savings in scrap per annum `10,000 `15,000
Estimated cost of supervision per annum `12,000 `16,000
Estimated saving in wages per annum `90,000 `1,20,000

Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternation
according to:

(a) Average rate of return method, and

(b) Present value index method assuming cost of capital being 10%.
(The present value of `1.00 @ p.a. for 5 years is 3.79 and for 6 years is 4.354)
[(8 marks) Nov 2011]

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 CAPITAL BUDGETING 7.15
Answer
(a) Statement Showing Evaluation of Two Machines (ARR)
Particulars Machine X Machine Y
A. Savings:
Saving in scrap (materials) 10,000 15,000
Savings in wages 90,000 1,20,000
Total savings (A) 1,00,000 1,35,000
B. Cost:
Cost of maintenance 7,000 11,000
Cost of indirect materials 6,000 8,000
Cost of supervision 12,000 16,000
Depreciation (Cost of machine ÷ Life of machine) 30,000 40,000
Total cost (B) 55,000 75,000
Profit (A – B) 45,000 60,000
Less: Tax @ 30% 13,500 18,000
Profit after tax 31,500 42,000
ARR  PAT 
100   31,500


100 
 42,000


100 
 Investment   1,50,000   2,40,000 
21% 17.50%
Selection as per ARR Yes No

(b) Statement Showing Evaluation of Two Machines (PI)

Particulars Machine X Machine Y
Profit after tax 31,500 42,000
Add: Depreciation 30,000 40,000
CFAT 61,500 82,000
Annuity factor for 5 years and 6 years 3.79 4.354
PV of Inflows 2,33,085 3,57,028
PV of outflows (Initial outflows × 1.000) 1,50,000 2,40,000
 
PI  PV of Inflows   2,33,085 
 
 3,57,028 
 
 PV of Outflows   1,50,000   2,40,000 
1.5539 1.4876
Selection as per PI Yes No

PYQ 13
ANP Ltd. Is providing the following information:
Annual cost of saving `96,000
Useful life 5 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.05

Table of discount factor:

Discount Years
Factor 1 2 3 4 5 Total
15% 0.870 0.756 0.658 0.572 0.497 3.353
14% 0.877 0.769 0.675 0.592 0.519 3.432
13% 0.886 0.783 0.693 0.614 0.544 3.52

You are required to calculate:

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 CAPITAL BUDGETING 7.16
(a) Cost of the project
(b) Payback period
(c) Net present value of cash inflow
(d) Cost of capital
[(8 Marks) May 2012]

Answer
(a) Cost of the project:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR for 5 years
= `96,000 × 3.353
Cost of project = `3,21,888

(b) Payback Period:

Initial Outflow
Payback period =
Equal Annual Cash Inflows/ Saving
3,21,888
= = 3.353 years
96,000

(c) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.05 =
3,21,888

PV of Inflows = 3,21,888 × 1.05 = `3,37,982.4

NPV = PV of inflows – PV of outflows

= `3,37,982.40 – `3,21,888 = `16,094.40

(d) Cost of Capital:

Pr esent Value of Inflows
Cum DF @ cost of capital for 5 years =
Annual Inflows
3,37,982.40
= = 3.52065
96,000

Cost of capital = 13% (Given in table)

PYQ 14
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:

Particulars Machine NM-A1 Machine NM-A2

Cost of machine `20,00,000 `25,00,000
Estimated life of machine 5 years 5 years
Estimated saving in direct wages per annum `7,00,000 `9,00,000
Estimated savings in scrap per annum `60,000 `1,00,000

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 CAPITAL BUDGETING 7.17
Estimated additional cost of indirect materials per annum `30,000 `90,000
Estimated additional cost of indirect labour per annum `40,000 `50,000
Estimated additional cost of 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:

(1) Pay- back Period
(2) Accounting (Average) Rate of Return and
(3) Profitability Index or P.V. Index (P.V. factor for `1 @ 12% 0.893; 0.797; 0.712; 0.636; 0.567)
[(10 Marks) Nov 2012]

Answer
Statement of Evaluation
Particulars NM-A1 NM-A2 Better
(1) Pay- back Period: 20,00,000 25,00,000
(Initial Outflow ÷ CFAT) 5,71,500 6,92,500 “NM-A1”
(2) ARR (Average): 3.499 years 3.61 years
PAT ( Avg) 1,71,500 1,92,500
 100  100  100 “NM-A1”
1 1
Avg Investment  20,00,000  25,00,000
2 2
(3) Profitability Index: 17.15% 15.40%
PV of Inflows 5,71,500  3.605 6,92,500  3.605 “NM-A1”
PV of Outflows 20,00,000 25,00,000
1.03 0.998

Working Note:
Calculation of Profit After Tax & CFAT:
Particulars Machine NM-A1 Machine NM-A2
(i) Savings:
Saving in scrap (materials) 60,000 1,00,000
Savings in wages 7,00,000 9,00,000
Total savings (A) 7,60,000 10,00,000
(ii) Cost:
Cost of indirect materials 30,000 90,000
Cost of indirect labour 40,000 50,000
Cost of maintenance 45,000 85,000
Depreciation (Cost of machine ÷ Life of machine) 4,00,000 5,00,000
Total cost (B) 5,15,000 7,25,000
Profit (i) – (ii) 2,45,000 2,75,000
Less: Tax @ 30% 73,500 82,500
Profit after tax 1,71,500 1,92,500
Add: Depreciation 4,00,000 5,00,000
CFAT 5,71,500 6,92,500

PYQ 15
APZ limited is considering selecting 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 economic model costing `6,00,000, having useful life of two years. It costs `2,50,000 per

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 CAPITAL BUDGETING 7.18
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:

Years t1 t2 t3
PVIF0.10t 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?

[(8 marks) Nov 13]

Answer
Statement Showing Evaluation of Two Machines
Particulars Machine ‘A’ Machine ‘B’
Initial outflow/ Purchase cost of machines 8,00,000 6,00,000
Annual running cost 1,30,000 2,50,000
Life of machines 3 years 2 years
PV of annual running cost 3,23,284 4,33,875
(Annual running cost × PVIFA) (1,30,000 × 2.4868) (2,50,000 × 1.7355)
Present value of total outflow 11,23,284 10,33,875
(initial outflow + PV of annual running cost)
÷ PVIFA ÷ 2.4868 ÷ 1.7355
Equivalent Annual outflow 4,51,699 5,95,722

Select the Machine A having lower equivalent annualized outflow.

PYQ 16
FH Hospital is considering to purchase a CT- Scan machine. Presently the hospital is outsourcing the CT-Scan
Machine and is earning commission of 15,000 per month (net of tax). The following details are given
regarding the machine:

Cost of CT-Scan machine `15,00,000

Operating cost per annum (excluding depreciation) `2,25,000
Expected revenue per annum `7,90,000
Salvage value of machine (after 5 years) `3,00,000
Expected life of machine 5 years

Assuming tax rate @ 30%, whether it would be profitable for the hospital to purchase the machine?

Give your recommendation under:

(i) Net Present Value Method, and

(ii) Profitability Index Method.

PV factors at 12% are given below:

Year 1 2 3 4 5
PV factor 0.893 0.797 0.712 0.636 0.567
[(8 Marks) May 2014]

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 CAPITAL BUDGETING 7.19
Answer
(i) Net Present Value
Year Particulars ` DF @ 12% PV
0 Cost of CT-Scan machine (15,00,000) 1.000 (15,00,000)
1-5 Cash Flow After Tax 2,87,500 3.605 10,36,438
5 Salvage at the end 3,00,000 0.567 1,70,100
NPV (2,93,462)

Recommendation: CT-Scan machine should not be purchased having negative NPV.

(ii) Calculation of Profitability Index:

PV of Inflows 12,06,538
Profitability Index = = = 0.804
PV of Outflows 15,00,000

Recommendation: Since PI is less than 1, CT-Scan machine should not be purchased.

Working Notes:
Calculation of Incremental CFAT:
Particulars `
Expected revenue per annum 7,90,000
Less: Operating cost per annum (excluding depreciation) (2,25,000)
Less: Depreciation (15,00,000 - 3,00,000) ÷ 5 years (2,40,000)
PBT 3,25,000
Less: Tax @ 30% (97,500)
PAT 2,27,500
Less: Loss of commission income per annum (15,000 × 12) (1,80,000)
Add: Depreciation 2,40,000
CFAT 2,87,500

PYQ 17
Given below are the data on a capital project ‘M’:
Annual cash inflow `60,000
Useful life 4 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.064

Table of discount factor:

Years
Discount Factor
1 2 3 4
15% 0.870 0.756 0.658 0.572
14% 0.877 0.769 0.675 0.592
13% 0.886 0.783 0.693 0.614
12% 0.893 0.797 0.712 0.636

You are required to calculate:

(i) Cost of the project
(ii) Payback period
(iii) Cost of capital
(iv) Net present value of cash inflow
[(8 Marks) May 2015]

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 CAPITAL BUDGETING 7.20
Answer
(i) Cost of the project:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cost of saving × Cumulative discount factor
@ IRR for 4 years
= `60,000 × 2.855
Cost of project = `1,71,300

(ii) Payback Period:

Initial Outflow 1,71,000
Payback period = =
Equal Annual Cash Inflows 60,000
= 2.855 years

(iii) Cost of Capital:

Pr esent Value of Inflows 1,82,263.20
Cum DF @ cost of capital for 4 years = =
Annual Inflows 60,000
= 3.038
From the discount factor table, at discount rate of 12%, the cumulative discount factor for four years is
3.038 (0.893 + 0.797 + 0.712 + 0.636)
Hence, Cost of capital = 12%

(iv) Net Present Value of cash inflows:

PV of Inflows
PI =
PV of Outflows
PV of Inflows
1.064 =
1,71,300
PV of Inflows = 1,71,300 × 1.064 = `1,82,263.2

NPV = PV of inflows – PV of outflows

= `1,82,263.20 – `1,71,300 = `10,963.20

PYQ 18
Domestic services (P) Ltd. is in the business of providing cleaning sewerage line services at homes. There is a
proposal before the company to purchase a mechanised sewerage cleaning system for a sum of `20 lakhs.
The present system of the company is to use manual labour for the job.
You are provided with the following information:

Proposed Machanised System:

Cost of machine `20 lakhs
Life of machine 10 years
Depreciation (on straight line basis) 10%
Cash Operating cost of machanised system `5 lakhs per annum

Present System (manual):

Manual labour 200 persons
Cost of manual labour `10,000 per person per annum

The company has after tax cost of fund at 10% per annum. The applicable tax rate is 30%.

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 CAPITAL BUDGETING 7.21
PV factor for 10 years at 10% are as given below:
Years 1 2 3 4 5 6 7 8 9 10
PV factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

You are required to find out whether it is advisable to purchase he machine. Give your
recommendation with workings.
[(8 Marks) June 2015]

Answer
Net Present Value
Year Particulars ` DF @ 10% PV
0 Cost of Machine (20,00,000) 1.000 (20,00,000)
1 - 10 Incremental CFAT 11,10,000 6.144 68,19,840
NPV 48,19,840

Recommendation: Company should purchase the machine having positive NPV.

Working Notes:
Calculation of Incremental CFAT:
Particulars `
Saving in labour cost (200 persons @ `10,000 p.a.) 20,00,000
Less: Cash Operating cost of mechanized system p.a. (5,00,000)
Less: Depareciation (2,00,000)
PBT 13,00000
Less: Tax @ 30% (3,90,000)
PAT 9,10,000
Add: Depreciation (20,00,000 ÷ 10 years) 2,00,000
CFAT 11,10,000

PYQ 19
Given below are the data on a capital project ‘C’:
Cost of the project `2,28,400
Useful life 4 years
Salvage value zero
Internal rate of return 15%
Profitability index 1.0417

You are required to calculate:

(a) Annual cash flow
(b) Cost of capital
(c) Net present value (NPV)
(d) Discounted Payback period
Table of discount factor:
Years
Discount Factor
1 2 3 4
15% 0.869 0.756 0.658 0.572
14% 0.877 0.769 0.675 0.592
13% 0.885 0.783 0.693 0.613
12% 0.893 0.797 0.712 0.636
[(8 Marks) May 2016]

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 CAPITAL BUDGETING 7.22
Answer
(a) Annual cash flow:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cash inflow × Cumulative discount factor
@ IRR for 4 years
2,28,400 = Annual cash inflow × 2.855
Annual cash Inflow = `80,000

(b) Cost of Capital:

Present value of inflows = Annual cash inflow × Cumulative discount factor
@ Cost of Capital for 4 years
Cost of project + NPV = 80,000 × Cumulative discount factor @ Cost of Capital
for 4 years
2,28,400 + 9,524 = 80,000 × PVIFA4
PVIFA 4 years = 2.974
Cost of capital = 13%

Alternatively
Pr esent Value of Inflows 2,37,924
Cum DF @ cost of capital for 4 years = =
Annual Inflows 80,000
= 2.974
Cost of capital = 13%

From the discount factor table, at discount rate of 13%, the cumulative discount factor for four years is 2.974
(0.885 + 0.783 + 0.693 + 0.613)

(c) Net Present Value (NPV):

NPV = Cost of project × (PI - 1)
NPV = 2,28,400 × (1.0417 - 1) = `9,524

(d) Discounted Payback Period:

Initial Outflows  Cumulative PV upto LLY
Discounted Payback Period = LLY +
PV of inf lows of ULY

2,28,400  1,88,880
= 3 years + = 3.806 years
49,040

Working notes:
Calculation of PV of cash inflow cumulative PV of cash inflow:

Years PV of cash inflow Cumulative PV of cash inflow

1 80,000 × 0.885 = 70,800 70,800

2 80,000 × 0.783 = 62,640 1,33,440
3 80,000 × 0.693 = 55,440 1,88,880
4 80,000 × 0.613 = 49,040 2,37,920

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 CAPITAL BUDGETING 7.23
PYQ 20
X Limited is considering to purchase of new plant worth `80,00,000. The rate of cost of capital is 10%. You
are required to calculate:

(a) Pay-back period

(b) Net present value at 10 discount factor
(c) Profitability index at 10 discount factor
(d) Internal rate of return with the help of 10% and 15% discount factor.

The expected net cash flows after taxes and before depreciation and present value table are as follows:
Net Cash Flow Present value of 1 at Present value of 1 at
Year
(`) 10% discount rate 15% discount rate
1 14,00,000 .909 .870
2 14,00,000 .826 .756
3 14,00,000 .751 .658
4 14,00,000 .683 .572
5 14,00,000 .621 .497
6 16,00,000 .564 .432
7 20,00,000 .513 .376
8 30,00,000 .467 .327
9 20,00,000 .424 .284
10 8,00,000 .386 .247
[(8 Marks) May 2017]

Answer
(a) Payback period:
Payback period = 14,00,000 + 14,00,000 + 14,00,000 + 14,00,000 + 14,00,000 +
10,00,000/16,00,000 = 5.625 Years

(b) Calculation of NPV

Years Cash Inflow PVIF @ 10% Present value
0 80,00,000 1.000 (80,00,000)
1 14,00,000 .909 12,72,600
2 14,00,000 .826 11,56,400
3 14,00,000 .751 10,51,400
4 14,00,000 .683 9,56,200
5 14,00,000 .621 8,69,400
6 16,00,000 .564 9,02,400
7 20,00,000 .513 10,26,000
8 30,00,000 .467 14,01,000
9 20,00,000 .424 8,48,000
10 8,00,000 .386 3,08,800
NPV 17,92,200

(c) Calculation of PI:

Profitability index = PV of Inflow ÷ PV of Outflow
= 97,92,200 ÷ 80,00,000 = 1.224

(d) Calculation of IRR:

NPV at 10% = 17,92,200

NPV at 15% = 14,00,000 × 3.353 + 16,00,000 × .432 + 20,00,000 × .376 + 30,00,000

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 CAPITAL BUDGETING 7.24
×.327 + 20,00,000 × .284 + 8,00,000 × .247 – 80,00,000
= - 1,16,000

NPVL
IRR = L+ H  L
NPVL  NPVH
17,92,200
= 10% + ×5% = 14.70%
17,92,200 ( 1,16,000)

PYQ 21
A firm can make investment in either of the following projects. The firm anticipates its cost of capital to be
10%. Pre-tax cash flows of the projects for five years are as follows:
Year 0 1 2 3 4 5
Project A (`) (2,00,000) 35,000 80,000 90,000 75,000 20,000
Project B (`) (2,00,000) 2,18,000 10,000 10,000 4,000 3,000

Ignore taxation. An amount of `35,000 will be spent on account of sales promotion in year 3 in case of
project A. this has not been taken into account in pre-tax cash inflows.

The discount factors are as under:

Year 0 1 2 3 4 5
PVF at 10% 1 0.91 0.83 0.75 0.68 0.62

You are required to calculate for each project:

(a) The payback period
(b) The discounted payback period
(c) Desirability factor
(d) Net present value
[(8 Marks) Nov 2017]

Answer
(a) Payback period:
Payback period A = 35,000 + 80,000 + 55,000 + 30,000/75,000 = 3.4 Years
Payback period B = 2,00,000/2,18,000 = 0.92 Years

Calculation of Present Value of pre-tax cash inflows:

Years Cash Inflow A Cash Inflow B PVIF @ 10% Present value A Present value B
1 35,000 2,18,000 .91 31,850 1,98,380
2 80,000 10,000 .83 66,400 8,300
3 55,000 10,000 .75 41,250 7,500
4 75,000 4,000 .68 51,000 2,720
5 20,000 3,000 .62 12,400 1,860
Total 2,02,900 2,18,760

(b) Discounted payback period:

Discounted payback A = 31,850 + 66,400 + 41,250 + 51,000 + 9,500/12,400

= 4.77 Years

Discounted payback B = 1,98,380 + 1,620/8,300

= 1.2 Years

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 CAPITAL BUDGETING 7.25
(c) Desirability factor:
Desirability factor = PV of Inflow ÷ PV of Outflow
Project A = 2,02,900 ÷ 2,00,000 = 1.0145
Project B = 2,18,760 ÷ 2,00,000 = 1.0938

(d) NPV:
NPV = PV of Inflow - PV of Outflow
Project A = 2,02,900 - 2,00,000 = 2,900
Project B = 2,18,760 - 2,00,000 = 18,760

PYQ 22
A proposal to invest in a project, which has a useful life of 5 years and no salvage value at the end of useful
life, is under consideration of a firm. It is anticipated that the project will generate a steady cash inflow of
`70,000 per annum. After analyzing other facts of the project, the following information were revealed:

Internal rate of return 13%

Profitability index 1.07762

Table of discount factor:

Discount Years
Total
Factor 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621 3.790
11% 0.901 0.812 0.731 0.659 0.593 3.696
12% 0.893 0.797 0.712 0.636 0.567 3.605
13% 0.885 0.783 0.693 0.613 0.543 3.517

You are required to calculate:

(1) Cost of the project
(2) Payback period
(3) Net present value
(4) Cost of capital
[(8 Marks) May 2018]

Answer
(1) Cost of the project:

At IRR,
Present value of inflows = Present value of outflows
Present value of outflows = Annual cash inflows × Cumulative discount factor
@ IRR for 5 years
= `70,000 × 3.517
Cost of the project = `2,46,190

(2) Payback Period:

Initial Outflow 2,46,190
Payback period = =
Annual Cash Inflow 70,000
= 3.517 years

(3) Net Present Value:

PV of Inflows PV of Inflow
PI = =
PV of Outflows 2,46,190
PV of Inflows = 2,46,190 × 1.07762 = `2,65,299

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 CAPITAL BUDGETING 7.26
NPV = PV of inflows – PV of outflows
= `2,65,299 – `2,46,190 = `19,109

(4) Cost of Capital:

Pr esent Value of Inflows 2,65,299
Cum DF @ cost of capital for 5 years = =
Annual Inflows 70,000
= 3.790

Cost of capital = 10% (Given in table)

PYQ 23
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 are expected as under:
Year Units
1 60,000
2 80,000
3-5 1,40,000
6-8 1,20,000

Other information:
1. Selling price per unit `200.
2. Variable cost is 40% of sales.
3. Fixed cost p.a. `30,00,000.
4. In addition to these advertisement expenditure will have to be incurred as under:
Year (` in lacs)
1 50
2 25
3-5 10
6-8 5
5. Income tax is 25%.
6. Straight line method of depreciation is permissible for tax purpose.
7. Cost of capital is 10%.
8. 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.

[(10 Marks) Nov 2018]

Answer
Net Present Value
Year Particulars ` DF @ 10% PV
0 Initial outflows (2,40,00,000 + 30,00,000) (2,70,00,000) 1.000 (2,70,00,000)
1 CFAT (8,00,000) 0.909 (7,27,200)
2 CFAT 38,25,000 0.826 31,59,450
3-5 CFAT 1,03,50,000 2.055 2,12,69,250

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 CAPITAL BUDGETING 7.27
6–8 CFAT 89,25,000 1.544 1,37,80,200
8 Working Capital 30,00,000 0.467 14,01,000
NPV 1,18,82,700

Company should accept the proposal having positive NPV of the project.

Working Notes:
Original Cost less Salvage 2,40,00,000
1. Depreciation: = =
Life of Equipment 8 Years
= 30,00,000

2. Statement showing CFAT:

Particulars 1 2 3–5 6–8
Units sold 60,000 80,000 1,40,000 1,20,000
Sales @ `200 p.u. 1,20,00,000 1,60,00,000 2,80,00,000 2,40,00,000
Less: VC @ 40% 48,00,000 64,00,000 1,12,00,000 96,00,000
Contribution 72,00,000 96,00,000 1,68,00,000 1,44,00,000
Less: Advertisement expenses (50,00,000) (25,00,000) (10,00,000) (5,00,000)
Less: Cash fixed cost (30,00,000) (30,00,000) (30,00,000) (30,00,000)
Less: Depreciation (30,00,000) (30,00,000) (30,00,000) (30,00,000)
PBT (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% - (2,75,000) (24,50,000) (19,75,000)
PAT (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
CFAT (8,00,000) 38,25,000 1,03,50,000 89,25,000

PYQ 24
AT Limited is considering three projects A, B and C. the cash flows associated with the projects are given
below:

Projects Co 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 NPV’s 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?

Present value table

Year 0 1 2 3 4 5
PVF@10% 1.000 0.909 0.826 0.751 0.683 0.621
[(10 Marks) May 2019]

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 CAPITAL BUDGETING 7.28
Answer
(a) Calculation of Cumulative Cash Flows:
Years Project A Project B Projects C
Cash Flow Cum. CF Cash Flow Cum. CF Cash Flow Cum. CF
1 2,000 2,000 0 0 2,000 2,000
2 2,000 4,000 2,000 2,000 2,000 4,000
3 6,000 10,000 4,000 6,000 6,000 10,000
4 - - 6,000 12,000 10,000 20,000

Payback Period:
Project A = 3 Years
Project B = 2 Years
Project C = 3 Years

(b) If cut-off period is two years then company should accept projects B.

(c) NPV:
NPV = Present value of Inflow – Present value of outflow

Project A = 2,000 × 0.909 + 2,000 × 0.826 + 6,000 × 0.751 – 10,000

= (2,024)
Project B = 0 × 0.909 + 2,000 × 0.826 + 4,000 × 0.751 + 6,000 × 0.683 – 2,000
= 6,754
Project C = 2,000 × 0.909 + 2,000 × 0.826 + 6,000 × 0.751 + 10,000 × 0.683 – 10,000
= 4,806

Project B and C have positive NPV.

(d) False:
Payback only considers cash flows from the initiation of the project till it’s payback period is being
reached, and ignores cash flows after the payback period.

(e) True:
When a firm use a single cut-off period for all projects, it is likely to accept too many short lived projects
having payback period within such cut-off date. Long term projects take time to reach at payback, in
case of single cut-off date these long term projects are ignored. Thus, payback is biased towards short-
term projects.

PYQ 25
A company has `1,00,000 available for investment and has identified the following four investment in which
to invest:
Project Name Initial 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 optimise the returns from a package of projects within the capital spending
limit if:
(a) The projects are independent of each other and are divisible.
(b) The projects are not divisible.
[(5 Marks) Nov 2019]

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 CAPITAL BUDGETING 7.29
Answer
(a) Statement of Rank and Selection of Projects
(Divisible Situation)
Projects PI (1+ NPV/Investment) Rank Project Cost Project (%) Investment
C 1 + 20,000/40,000 = 1.50 1 `40,000 100% `40,000
D 1 + 35,000/1,00,000 = 1.35 3 `1,00,000 10% `10,000
E 1 + 24,000/50,000 = 1.48 2 `50,000 100% `50,000
F 1 + 18,000/60,000 = 1.30 4 `60,000 - -
Total Investment `1,00,000

Optimum investment: 100% of C, E and 1/10 of D.

(b) Statement of Possible Combinations and Combined NPV

(Indivisible Situation)
Possible Combinations Combined Investment Combined NPV
C+E `90,000 `44,000
C+F `1,00,000 `38,000
D `1,00,000 `35,000

Invest in combination of C and E having highest combined NPV and invest remaining `10,000
elsewhere.

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 CAPITAL BUDGETING 7.30

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y Y
5 Y Y Y -
6 Y Y Y -
7 Y Y Y -
8 Y Y - -
9 Y Y Y Y
10 Y Y Y -
11 Y Y - -
12 Y Y Y -
13 Y Y Y Y
14 Y Y Y -
15 Y Y - -
16 Y Y - -
17 Y Y - -
18 Y Y Y -
19 Y Y - -
20 Y Y Y -
21 Y Y Y Y
22 Y Y - -
23 Y Y Y Y
24 Y Y Y Y
25 Y Y Y Y

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 CHAPTER – 8

RISK ANALYSIS
IN
CAPITAL BUDGETING
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Discuss the concept of Risk and Uncertainty in Capital Budgeting.
 Discuss the Sources of Risk.
 Understand reasons for adjusting risk in Capital Budgeting.
 Understand various techniques used in Risk Analysis in Capital
Budgeting.
 Discuss Concepts, Advantages and Limitations of various
techniques of Risk analysis in Capital Budgeting.
 RISK ANALYSIS IN CAPITAL BUDGETING 8.2

PAST YEAR QUESTIONS

PYQ 1
From the following details relating to a project, analyze the sensitivity of the project to changes in initial
project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 2,00,00,000
Annual Cash Inflow (`) 60,00,000
Project Life (Years) 5
Cost of Capital 10%
To which of the three factors, the project is most sensitive if the variable is adversely affected by 10%? (Use
annuity factors: for 10% 3.791 and 11% 3.696).
[(5 Marks) Nov 2018]

Answer
Calculation of NPV through Sensitivity Analysis:
NPV (Base) = 60,00,000 × 3.791 – 2,00,00,000 = 27,46,000
Situation NPV Changes in NPV
Base(present) ` 27,46,000 -
If initial project cost is (`2,27,46,000 - `2,20,00,000 ) (`27,46,000 – `7,46,000)/ `27,46,000
varied adversely by 10% = `7,46,000 = 72.83%

If annual cash flow is (`54,00,000 × 3.791) – `2,00,00,000 (`27,46,000 – `4,71,400)/ `27,46,000

varied adversely by 10% = `4,71,400 = 82.83%

If cost of capital is varied (`60,00,000 × 3.696) – `2,00,00,000 (`27,46,000-`21,76,000)/ `27,46,000

adversely by 10% i.e. 11% = `21,76,000 = 20.76%

Conclusion: Project is most sensitive to ‘annual cash inflow’.

PYQ 2
Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
Particular Project X (`) Project Y (`)
Initial Investments 1,20,000 1,20,000
Estimated cash inflows (per annum for 8 years):
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut off rate is 14%. The discount factor at 14% are:
Year 1 2 3 4 5 6 7 8 9
DF 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308

Advise management about the acceptability of projects X and Y.

[(5 Marks) May 2019]

Answer
NPV = PV of inflow – Initial Investment

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 RISK ANALYSIS IN CAPITAL BUDGETING 8.3
The Possible Outcomes of Project X and Project Y are as follows
Senarios/Situations NPV Project ‘X’ NPV Project ‘Y’ Advise
Pessimistic 26,000 × 4.639 – 1,20,000 12,000 × 4.639 – 1,20,000 Project X
= `614 = (`64,332)
Most Likely 28,000 × 4.639 – 1,20,000 28,000 × 4.639 – 1,20,000 Project X or Project Y
= `9,892 = `9,892
Optimistic 36,000 × 4.639 – 1,20,000 52,000 × 4.639 – 1,20,000 Project Y
= `47,004 = `1,21,228

In pessimistic situation project X will be better as it gives low but positive NPV whereas Project Y yield
highly negative NPV under this situation. In most likely situation both the project will give same result.
However, in optimistic situation Project Y will be better as it will gives very high NPV. So, project X is a risk
less project as it gives positive NPV in all the situation whereas Y is a risky project as it will result into negative
NPV in pessimistic situation and highly positive NPV in optimistic situation. So acceptability of project will
largely depend on the risk taking capacity (Risk seeking/ Risk aversion) of the management.

PYQ 3
Door ltd. is considering an investment of `4,00,000 this investments expected to generate substantial cash
inflows over the next five years. Unfortunately the annual cash flows from this investment is uncertain, but
the following probability distribution has been established:
Annual Cash Flow (`) Probability
50,000 0.3
1,00,000 0.3
1,50,000 0.4

At the end of its 5 years life, the investment is expected to have a residual value of `40,000. The cost of capital
is 5%.
(1) Calculate NPV under the three different scenarios.
(2) Calculate expected net present value
(3) Advise Door Ltd. on whether the investment is to be undertaken.

Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784
[(5 Marks) Nov 2019]

Answer
(1) NPV under different scenarios:
NPV = PV of inflow – Initial Investment
Situation 1 = 50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = (1,52,140)
Situation 2 = 1,00,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 64,360
Situation 3 = 1,50,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 2,80,860

(2) Expected NPV:

Expected NPV = PV of expected inflow – Initial Investment
= 1,05,000 × 4.33 + 40,000 × 0.784 – 4,00,000 = 86,010

Expected Inflow = 50,000 × 0.3 + 1,00,000 × 0.3 + 1,50,000 × 0.4 = 1,05,000

(3) Advise: Door Ltd. should accept the proposal having positive expected NPV.

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 RISK ANALYSIS IN CAPITAL BUDGETING 8.4

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y

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 CHAPTER - 09

COST OF CAPITAL
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Understand the concept of “Cost of Capital” that impacts the capital
investments decisions for a business.
 Understand what are the sources of capital (Debt, Equity Shares,
Preference Shares and Retained Earnings)?
 Understand what is the cost employing each of these sources of
capital?
 Know, what is weighted average cost of capital (WACC), overall cost
of capital for business and also what is marginal cost of capital?
 Summarize how cost of capital is important in financial
management?
 COST OF CAPITAL 9.2

PAST YEAR QUESTIONS

PYQ 1
The following is the capital structure of Simons Company Ltd. as on 31.12.1998:
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
would be declared for the year 1998. The dividend growth rate is 6%.
(i) If the company is in the 50% tax bracket, compute the WACC.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of
`10,00,000 bearing 14% rate of interest, What will be the company’s revised weighted average cost of
Capital? This financing decision is expected to increase dividends from `10 to `12 per share. However,
the market price of equity share is expected to decline from `110 to `105 per share.
[(10 Marks) Nov 1999]

Answer
(i) Calculation of Weighted Average Cost of Capital
WACC (Ko) = KeWe + KpWp + KdWd
= 15.09% × 10 + 10% × 4 + 6% × 6 = 11.35%
20 20 20

Ke = D1 + g = 10
+ .06 = 15.09%
P0 110

Kp = Rate of preferential dividend [FV = NP] = 10%

Kd = I (1 - t) = 12% (1 – 0.50) = 6%

(ii) Calculation of Revised WACC

Revised WACC (Ko) = KeWe + KpWp + KdWd + KTLWTL
= 17.43% × 10 + 10% × 4 + 6% × 6 + 7% × 10 = 10.68%
30 30 30 30

Revised Ke = D1 + g = 12
+ .06 = 17.43%
P0 105

KTL = I (1 - t) = 14% (1 – 0.50) = 7%

PYQ 2
XYZ Ltd. has the following book value capital structure:
Equity Share Capital (`10 each, fully paid up at par) `15 crores
11% Preference Share Capital (`100 each, fully paid up at par) `1 crores
Retained Earnings `20 crores
13.5% Debentures (of `100 each) `10 crores
15% Terms Loans `12.5 crores
The next expected dividend on equity shares per share is `3.60; the dividend per share is expected to
grow at the rate of 7%. The market price per share is `40. Preference stock, redeemable after 10 years, is

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 COST OF CAPITAL 9.3
currently selling at `75 per share. Debentures, redeemable after six years, are selling at `80 per debenture.
The income - tax rate for the company is 40%.
Required:
(i) Calculate the weighted average cost of capital (Ko) using:
a. Book value proportions; and
b. Market value proportions.
(ii) Define the weighted marginal cost of capital schedule for the company, if it raises `10 crores next year,
given the following information:
a. The amount will be raised by equity and debt in equal proportions;
b. The company expects to retain `1.5 crores earnings next year;
c. The additional issue of equity shares will result in the net price per share being fixed at `32;
d. The debt capital raised by way of term loans will cost 15% for the first `2.5 crores and 16% for
the next `2.5 crores.
[(12 Marks) Nov 2000]

Answer
(i) Calculation of WACC (Ko)
(a) By Using Book Value Proportions
Name of Source Amount Proportion K Ko
Equity Share Capital 15,00,00,000 0.2564 16% 4.1024%
Retained Earnings 20,00,00,000 0.3419 16% 5.4704%
Debentures 10,00,00,000 0.1709 12.70% 2.1704%
Preference Share Capital 1,00,00,000 0.0171 15.43% 0.2639%
Term Loan 12,50,00,000 0.2137 9% 1.9233%
Total 58,50,00,000 1.0000 WACC 13.9304%

(b) By Using Market Value Proportions

Name of Source Amount Proportion K Ko
*Equity & Retained Earnings 60,00,00,000 0.7385 16% 11.816%
Debentures 8,00,00,000 0.0985 12.70% 1.2510%
Preference Share Capital 75,00,000 0.0092 15.43% 0.1420%
Term Loan 12,50,00,000 0.1538 9% 1.3842%
Total 81,25,00,000 1.0000 WACC 14.5931%
* Ke & Kr are same, so calculated together.

(ii) Weighted Marginal Cost of Capital Schedule and Marginal WACC:

Marginal Cost of Capital Schedule:

Finance through Equity:
Retained earnings = `1.5 crores
New issue = `3.5 crores
Finance through Debt:
15% Debt = `2.5 crores
16% Debt = `2.5 crores

Marginal Cost of Capital

Name of Source Amount Proportion K Ko
Equity Share Capital (New) 3,50,00,000 0.35 18.25% 6.3875%
Retained Earnings 1,50,00,000 0.15 16% 2.4000%
15% Debt 2,50,00,000 0.25 9% 2.2500%
16% Debt 2,50,00,000 0.25 9.60% 2.4000%
Total 10,00,00,000 1.00 WACC 13.4375%

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 COST OF CAPITAL 9.4
Working Notes:
Calculation of existing Ke, Kr, Kd, Kp and KTL:
D1 3.60
Ke = +g = + 0.07 = 16%
P0 40
Kr = Ke = 16%
 RV  NP   100  80 
I 1  t     13.50 1  0.40   
Kd =  n  × 100 =  6  × 100
RV  NP 100  80
2 2
= 12.70%
 RV  NP   100  75 
PD    11   
Kp =  n  × 100 =  10  × 100 = 15.43%
RV  NP 100  75
2 2

KTL = I (1 - t) = 15% (1 – 0.40) = 9%

Calculation of revised Ke, Kr, Kd1 and Kd2

D1 3.60
Ke = +g = + 0.07 = 18.25%
P0 32
Kr = Ke (existing) = 16%
Kd1 = I (1 - t) = 15% (1 – 0.40) = 9%
Kd2 = I (1 - t) = 16% (1 – 0.40) = 9.60%

PYQ 3
JKL Ltd. has the following book value capital structure as on March 31, 2003:
Equity share capital (2,00,000 shares) `40,00,000
11.5% Preference share capital `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 issuing 12%
debentures. This would result in increasing the expected equity divided to `2.40 and leave the growth
rate unchanged, but the price of equity shares will fall to `16 per share.
(iii) Comment on the use of weights in the computation of weighted average cost of capital.
[(3+3+2 = 8 Marks) May 2003]

Answer
(i) Weighted Average Cost of Capital (Based on Existing Capital Structure)
Name of Source Amount Weight After tax cost Weighted cost
Equity Share Capital 40,00,000 0.50 15% 7.50%
11.5% Preference Share Capital 10,00,000 0.125 11.50% 1.4375%
10% Debenture 30,00,000 0.375 6.50% 2.4375%
Total 80,00,000 1.00 WACC 11.375%

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 COST OF CAPITAL 9.5
(ii) New Weighted Average Cost of Capital
Name of Source Amount Weight After tax cost Weighted cost
Equity Share Capital 40,00,000 0.40 20% 8%
11.5% Preference Share Capital 10,00,000 0.10 11.50% 1.15%
10% Debenture 30,00,000 0.30 6.50% 1.95%
12% Debt 20,00,000 0.20 7.80% 1.56%
Total 1,00,00,000 1.00 WACC 12.66%

Working Notes:
Calculation of existing Ke, Kp and Kd
D1 2
Ke = +g = + 0.05 = 15%
P0 20
Kp = Rate of Preference Dividend = 11.50%
Kd = I (1 - t) = 10% (1 – 0.35) = 6.50%

Calculation of new Ke, Kp, Kd1 and Kd2:

D1 2.40
Ke = +g = + 0.05 = 20%
P0 16
Kp = Rate of Preference Dividend = 11.50%
Kd1 = I (1 - t) = 10% (1 – 0.35) = 6.50%
Kd2 = I (1 - t) = 12% (1 – 0.35) = 7.80%
Comment:
On 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 & market. Balance sheet is preferred to book value balance sheet.

PYQ 4
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 target debt to value ratio of 20%. The beta of new project is 1.4375. The debt
capital will be raised through term loan will carry interest rate of 9.5% for the first 100 million and
10% for the next `50 million.
[(6+3 = 9 Marks) May 2004]

Answer
(i) Weighted Average Cost of capital (Using market value weights):

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 COST OF CAPITAL 9.6
WACC = KeWe + KpWp + KdWd + KTLWTL
= 15% × 81.30 + 10.9715% × .89 + 6.8718% × 13.29 + 5.525% × 4.52 = 13.46%
100 100 100 100
(Ke & Kr are same, so calculated together)

(ii) Marginal cost of capital (MCC) schedule:

Equity share capital = 600 million (80% of total requirement)
Debt = 150 million (20% of total requirement; 100 million through
9.5% debt and next 50 million through 10% debt)
MCC = KeWe + Kd1Wd1 + Kd2Wd2
= 17% × 600 + 6.175% × 100 + 6.50% × 50 = 14.86%
750 750 750

Working Notes:
Ke = Rf +  (Rm - Rf) = 5.5% + 1.1875 (8%) = 15%
 RV  NP   100  98.15 
PD    10.50   
Kp =  n  × 100 =  5  × 100 = 10.97%
RV  NP 100  98.15
2 2

 RV  NP   1,000  981.05 
I 1  t     95.00 1  0.35   
Kd =  n  × 100 =  3  × 100
RV  NP 1,000  981.05
2 2
= 6.8718%
KTL = I (1 - t) = 8.50% (1 – 0.35) = 5.525%

Computation of proportion of equity capital, preference share debenture & term loans in the market
value of capital structure: [` in million]
Name of source Market value Proportions
Equity share capital & Reserve and Surplus (150 million share × 60) 9,000 81.30
10.5% Preferential share capital (1 million share × 98.15) 98.15 0.89
9.5% Debentures (1.5 million debentures × 981.05) 1,471.575 13.29
8.5% term loans 500 4.52
11,069.725 100.00
Ke (New project) = 5.5% + 8% × 1.4375 = 17%
Kd1 (New project) = 9.50% × (1 – 0.35) = 6.175%
Kd2 (New project) = 10% × (1 – 0.35) = 6.50%

PYQ 5
The R & G Company has following capital structure at 31st March, 2004, which is considered to be
optimum:
13% debenture `3,60,000
11% preference share capital `1,20,000
Equity share capital (2,00,000 shares) `19,20,000
The company's share has a current market price of `27.75 per share. The expected dividend per share
in next year is 50 percent of the 2004 EPS. The EPS of last 10 years is as follows. The past trends are expected
to continue:
Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS (`) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773

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 COST OF CAPITAL 9.7
The company can issue 14 percent new debenture. The company's debenture is currently selling at
`98. The new preference issue can be sold at a net price of `9.80, paying a dividend of `1.20 per share. The
company's marginal tax rate is 50%.
(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity,
assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital.
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that
retained earning available for next year's investment are 50% of 2004 earnings.
(iv) What will be marginal cost of capital [cost of fund raised in excess of the amount calculated in part
(iii)] if the company can sell new ordinary shares to net `20 per share? The cost of debt and of
preference capital is constant.
[(2+1+2+2 = 7 Marks) May 2005]

Answer
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis
Name of source Amount (`) Proportion
13% debentures 3,60,000 0.15
11% Preference 1,20,000 0.05
Equity share capital 19,20,000 0.80
Total 24,00,000 1.00
(i) (a) After tax cost of new debt
I(1  t ) 14(1  .50)
Kd = × 100 = × 100 = 7.143%
NP 98
After tax cost of new preference shares
PD 1.20
Kp = × 100 = × 100 = 12.25%
NP 9.80
(b) Cost of new equity (comes from retained earnings)
D1 1.3865
Ke = +g = + 0.12 = 17%
P0 (old) 27.75

(ii) MCC (Ko) = KdWd + KpWp + KeWe

= 7.143% × .15 + 12.245% × .05 + 17% × .80 = 15.28%
(iii) The company can pay the following amount without selling the new shares:
Equity (retained earnings in this case) = 80% of the total capital
2,77,300
Therefore, investment before new issue = = `3,46,625
80%
Retained earnings = `1.3865 × 2,00,000 = `2,77,300
(iv) MCC (Ko)
= KdWd + KpWp + KeWe
= 7.143% × .15 + 12.245% × .05 + 18.93% × .80 = 16.83%
If the company pay more than `3,46,625, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.3865
Ke = +g = + 0.12 = 18.93%
P0 (new ) 20

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 COST OF CAPITAL 9.8
PYQ 6
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:
A. Calculate the cost of debt after tax, if debentures are issued at
a. Par,
b. 10% Discount,
c. 10% Premium.
B. If brokerage is paid at 2%, what will be the cost of debentures, if issue is at par?
[(5+1 = 6 Marks) May 2006]

Answer
A. Calculation of cost of debt, when debentures are issued at:
a. Par
 RV  NP   100  100 
I 1  t     12 1  0.35   
Kd =  n  × 100 =  7  × 100
RV  NP 100  100
2 2
= 7.80%
b. 10% Discount
 100  90 
12 1  0.35   
Kd =  7  × 100 = 9.71%
100  90
2

c. 10% Premium
 100  110 
12 1  0.35   
Kd =  7  × 100 = 6.07%
100  110
2

B. Cost of debentures, if brokerage is paid at 2% and debentures are issued at par:

 RV  NP   100  98 
I 1  t     12 1  0.35   
Kd =  n  × 100 =  7  × 100
RV  NP 98  100
2 2
= 8.17%

PYQ 7
ABC Ltd. wishes to raise additional finance of `20 lakhs for meeting its investment purpose. The company has
`4,00,000 in the form of retained earnings available for investment purposes. The following are the further
details:
Debt equity ratio : 25 : 75
Cost of debt:
Upto `2,00,000 : 10% (before tax) and
Beyond `2,00,000 : 13% (before tax)
Earning per share : `12 per share
Dividend payout : 50% of earnings
Expected growth rate : 10%
Current market price : `60 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%.

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 COST OF CAPITAL 9.9
Required:
(i) Calculate the post tax average cost of additional debt.
(ii) Calculate the cost of retained earnings and cost of equity.
(iii) Calculate the overall weighted average (after tax) cost of additional finance.
[(2+3+3 = 8 Marks) May 2008]

Answer
Total capital required is `20 lakhs. With a debt-equity ratio of 1:3. It means `5 lakhs is to be raised through
debt and `15 lakhs through equity. Out of `15 lakhs, `4 lakhs are available in the form of retained earnings
hence `11 lakhs will have to raise by issuing equity shares.
(i) Post tax average cost of additional debt:
Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%
Kd2 = I (1 - t) = 13% (1 – 0.30) = 9.10%

Average Kd = Kd1Wd1 + Kd2Wd2 = 7% × 2 + 9.10% × 3 = 8.26%

5 5

(ii) Cost of retained earning & cost of equity:

D1 6  10%
Ke = +g = + 0.10 = 21%
P0 60

Kr = Ke (1-PT) = 21% (1 - .20) = 16.80%

D0 = `12 × 50% = `6
(iii) Overall cost of additional finance:
Ko = KeWe + KrWr + KdWd
= 21% × 11 + 16.80% × 4 + 8.26% × 5 = 16.98%
20 20 20

Assumption: DPS is treated at Do.

PYQ 8
The capital structure of MNP Ltd. is as under:
9% Debentures `2,75,000
11% Preference shares `2,25,000
Equity shares (face value `10 per share) `5,00,000
Additional information:
(i) `100 per debenture redeemable at par has 2% floatation cost and 10 years of maturity. The market
price per debenture is `105.

(ii) `100 per preference share redeemable at par has 3% floatation cost and 10 years of maturity. The
market price per preference share is `106.

(iii) Equity share has `4 floatation cost and market price per share of `24. The next year expected dividend
is `2 per share will annual growth of 5%. The firm has a practice of paying all earnings in the form of
dividends.

(iv) Corporate Income-tax rate is 35%.

Calculate Weighted Average Cost of Capital (WACC) using market value weights.
[(9 Marks) May 2009]

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 COST OF CAPITAL 9.10
Answer
Calculation of Weighted Average Cost of Capital by Using Market Value Weight
Particular Market value Weight Cost Weighted cost
9% Debenture 2,88,750 0.1672 6.11% 1.020%
11% Preference share 2,38,500 0.1381 11.47% 1.583%
Equity Share Capital 12,00,000 0.6947 15.00% 10.425%
Total 17,27,250 1.0000 WACC 13.028%

Working notes:
D1 2
Ke = +g = + 0.05 = 15%
P0 24  4

 RV  NP   100  98 
I 1  t     9 1  0.35   
Kd =  n  × 100 =  10  × 100
RV  NP 100  98
2 2
= 6.11%

 RV  NP   100  97 
PD    11   
Kp =  n  × 100 =  10  × 100 = 11.47%
RV  NP 100  97
2 2

PYQ 9
Y Ltd. retains `7,50,000 out of its current earning. The expected rate of return to the shareholders, if they had
invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders came in 30% tax bracket.

Calculate the cost of retained earnings.

[(2 Marks) Nov 2009]

Answer
Kr = K (1 - B) (1 - PT) = 0.10 (1 – 0.03) (1 - 0.30) = 6.79%

PYQ 10
SK Limited has obtained funds from the following sources, the specific cost are also given against them:

Source of funds Amount (`) Cost of Capital

Equity shares 30,00,000 15 percent
Preference shares 8,00,000 8 percent
Retained earnings 12,00,000 11 percent
Debentures 10,00,000 9 percent (before tax)

You are required to calculate weighted average cost of capital. Assume that Corporate tax rate is 30%.
[(3 Marks) May 2010]

Answer
Ko = KeWe + KrWr + KpWp + KdWd

= 15% × 30 + 11% × 12 + 8% × 8 + 6.30% × 10 = 11.82%

60 60 60 60

Kd = I (1 - t) = 9% (1 - .30) = 6.30%

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 COST OF CAPITAL 9.11
PYQ 11
PQR Ltd. has the following capital structure on October 31, 2010:
Name of Source Amount (`)
Equity Share Capital (2,00,000 shares of `10 each) 20,00,000
Reserves & Surplus 20,00,000
12% Preference Shares 10,00,000
9% Debentures 30,00,000
Total 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.
[(5 Marks) Nov 2010]

Answer
Ko = KeWe + KpWp + KdWd
= 17% × 60 + 12% × 10 + 5.40% × 30 = 13.02%
100 100 100
(Ke & Kr are same, so calculated together)
Working notes:
D1 3
Ke = +g = + 0.07 = 17%
P0 30

Kp = Rate of preferential dividend = 12%

Kd = I (1 - t) = 9% (1 – 0.40 = 5.40%

Calculation of market value:

Equity Shares & Reserve and Surplus = 2,00,000 shares of `30 each = `60,00,000
Preference Shares = `10,00,000
Debentures = `30,00,000

PYQ 12
Beeta Ltd. has furnished the following information:
Earning per share (EPS) : `4.00
Dividend payout ratio : 25%
Market price per share : `40.00
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 equity and debt and the weighted average cost of capital.
[(4 Marks) Nov 2011]

Answer
Ko = KeWe + Kd1Wd1 + Kd2Wd2
= 10.7% × 6 + 7% × 2 + 10.50% × 2 = 9.92%
10 10 10

D1 4.00  25%  108%

Ke = +g = + 0.08 = 10.70%
P0 40

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 COST OF CAPITAL 9.12

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 15% (1 – 0.30) = 10.50%

Assumption: DPS `1.00 is treated at Do.

PYQ 13
A company issued 40,000, 12% Redeemable Preference Shares of `100 each at a premium of `5 each,
redeemable after 10 year 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.
[(5 Marks) May 2013]

Answer
 RV  NP   110  103 
PD    12   
Kp =  n  × 100 =  10  × 100 = 11.92%
RV  NP 110  103
2 2

PYQ 14
The following details are provided by GPS Limited:
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.
[(5 Marks) May 2014]

Answer
WACC = KeWe + KpWp + KrdWrd + KcdWcd
65 12 20 8
= 16.30% × + 12% × + 10.50% × + 7% × = 13.9952%
105 105 105 105
Working Notes:
(i) Calculation of cost of Preference Share Capital (Kp):
Kp = Rate of Preference Dividend = 12%

(ii) Calculation of cost of Redeemable Debentures (Krd):

Krd = I (1 - t) = 15% (1 - 0.30) = 10.50%

(iii) Calculation of cost Convertible Debentures (Kcd):

Kcd = I (1 - t) = 10% (1 - 0.30) = 7%

PYQ 15
A Ltd. wishes to raise additional finance of `30 lakhs for meeting its investment plans. The company has
`6,00,000 in the form of retained earnings available for investment purposes. The following are the further
details:
Debt equity ratio : 30 : 70
Cost of debt:
Upto `3,00,000 : 11% (before tax) and

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 COST OF CAPITAL 9.13
Beyond `3,00,000 : 14% (before tax)
Earning per share : `15 per share
Dividend payout : 70% of earnings
Expected growth rate : 10%
Current market price : `90 per share
Company’s tax rate : 30%
Shareholder’s personal tax rate : 20%.
You are required to:
1. Calculate the post tax average cost of additional debt.
2. Calculate the cost of retained earnings and cost of equity.
3. Calculate the overall weighted average (after tax) cost of additional finance.
[(8 Marks) May 2015]

Answer
Total capital required is `30 lakhs. With a debt - equity ratio of 30 : 70. It means `9 lakhs is to be raised through
debt and `21 lakhs through equity. Out of `21 lakhs, `6 lakhs are available in the form of retained earnings
hence `15 lakhs will have to raise by issuing equity shares.
1. Post tax average cost of additional debt:
Kd1 = I (1 - t) = 11% (1 – 0.30) = 7.70%
Kd2 = I (1 - t) = 14% (1 – 0.30) = 9.80%

Average Kd = Kd1Wd1 + Kd2Wd2 = 7.7% × 3 + 9.8% × 6 = 9.10%

9 9

2. Cost of retained earning & cost of equity:

D1 10.50  10%
Ke = +g = + 0.10 = 22.83%
P0 90

Kr = Ke (1 - PT) = 22.83% (1 - .20) = 18.27%

D0 = `15 × 70% = `10.50

3. Overall cost of additional finance:

Ko = KeWe + KrWr + KdWd
= 22.83% × 15 + 18.27% × 6 + 9.10% × 9 = 17.80%
30 30 30

Assumption: DPS `10.50 is treated at Do.

PYQ 16
A company issues 25,000, 14% debentures of `1,000 each. The debentures are redeemable after the expiry
period 5 years. Tax rate applicable to the company is 35%.

Calculate the cost of debt after tax if debentures are issued at 5% discount with 2% flotation cost.
[(5 Marks) Nov 2015]

Answer
 RV  NP   1000  930 
I 1  t     140 1  0.35   
Kd =  n  × 100 =  5  × 100
RV  NP 1000  930
2 2
= 10.88%

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 COST OF CAPITAL 9.14
Net Proceeds = 1,000 – 5% Discount – 2% Flotation cost = 930
Note: Floatation cost has been calculated on the basis of face value (i.e. 2% of `1,000 or `950 whichever is
higher).

PYQ 17
The X Company has following capital structure at 31st March, 20015, which is considered to be optimum:
14% debenture `3,00,000
11% preference share capital `1,00,000
Equity share capital (1,00,000 shares) `16,00,000
The company's share has a current market price of `23..60 per share. The expected dividend per share
in next year is 50 percent of the 2015 EPS. The EPS of last 10 years is as follows. The past trends are expected
to continue:
Year 2006 2007 2008 2009 2010 2011 2012 2013 2015 2015
EPS (`) 1.00 1.10 1.21 1.33 1.46 1.61 1.77 1.95 2.15 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is `96.
Preference shares `9.20 (with dividend of `1.1 per share) were also issued. The company is in 50% tax
bracket.
(i) Calculate the after tax cost of (a) New Debts, (b) New Preference Share, and (c) New Equity Share
(assuming new equity from retained earnings).
(ii) Calculate the marginal cost of capital when no new share was issued.
(iii) How much can be spent for capital investment before new ordinary shares must be sold? Assuming
that retained earnings for next year's investment are 50% of 2015.
(iv) What will be marginal cost of capital when the fund exceeds the amount calculated in (iii), assuming
new equity is issued at `20 per share?
[(8 Marks) May 2016]

Answer
Assumption: The present capital structure is optimum. Hence, it will be followed in future.
Existing Capital Structure Analysis
Name of source Amount (`) Proportion
14% debentures 3,00,000 0.15
11% Preference 1,00,000 0.05
Equity share capital 16,00,000 0.80
Total 20,00,000 1.00

(i) (a) After tax cost of new debt

I(1  t ) 16(1  .50)
Kd = × 100 = × 100 = 8.33%
NP 96
(b) After tax cost of new preference shares
PD 1.10
Kp = × 100 = × 100 = 11.96%
NP 9.20
(c) Cost of new equity or cost of retained earnings
D1 1.18
Kr = +g = + 0.10 = 15%
P0 (old) 23.60

(ii) MCC (Ko) when no new equity share was issued:

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 COST OF CAPITAL 9.15
KdWd + KpWp + KrWr = 8.33% × .15 + 11.96% × .05 + 15% × .80 = 13.85%

(iii) The company can pay the following amount before issue of new shares:

Equity (retained earnings in this case) = 80% of the total capital

1,18,000
Therefore, investment before new issue = = `1,47,500
80%
Retained earnings = `2.36 × 50% × 1,00,000 = `1,18,000

(iv) MCC (Ko) when funds exceeds `1,18,000

KdWd + KpWp + KeWe = 8.33% × .15 + 11.96% × .05 + 15.90% × .80 = 14.57%

If the company pay more than `1,18,000, it will have to issue new shares. The cost of new issue of
ordinary share is:
D1 1.18
Ke = +g = + 0.10 = 15.90%
P0 (new ) 20

WN: Calculation of growth:

Growth from year 2006 to 2007 = (1.10 – 1.00) ÷ 1.00 = 10%
[Same rate of growth is found in future years]

PYQ 18
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 anticipated growth rate is 8% per annum, calculate the indicated market price per share.
(iii) 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%, what will be the cost of debenture?
Assume Tax Rate to be 50%.
[(5 Marks) Nov 2016]

Answer
D1 2
(i) Ke = +g = + 0.06 = 14%
P0 25

Note: The cost of equity can be calculated with taking the effect of growth on dividend (i.e. D1 = 2.12).

D1 2
(ii) Po = = = `33.33
Ke  g 14%  8%

 RV  NP   112  96 
I 1  t     10 1  0.50   
(iii) Kd =  n  × 100 =  12  × 100
RV  NP 112  96
2 2
= 6.089%

PYQ 19
Following is the capital structure of RBT Ltd. As on 31st March 2016:

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 COST OF CAPITAL 9.16
Sources of Fund Book Value Market Value
Equity Share of `10 each `50,00,000 `1,05,00,000
Retained Earnings `13,00,000 Nil
11% Preference Share of `100 each `7,00,000 `9,00,000
14% Debentures of `100 each `30,00,000 `36,00,000

Market price of equity shares is `40 per share and it is expected that a dividend of `4 per share would be
declared. The dividend per share is expected to grow at the rate of 8% every year. Income tax rate applicable
to the company is 40% and shareholder’s personal income tax rate is 20%.
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.
[(8 Marks) Nov 2016]

Answer
(i) Calculation of cost of capital for each source of capital:
D1 4
Ke = +g = + 0.08 = 18%
P0 40
Kr = Ke (1 - PT) = 18% (1 – 0.20) = 14.40%
Kd = I (1 - t) = 14% (1 – 0.40) = 8.40%
Kp = Rate of PD = 11%

(ii) Calculation of WACC (Ko) using book value proportions

Name of Source Amount Proportion K Ko
Equity Share Capital 50,00,000 0.50 18% 9.00%
Retained Earnings 13,00,000 0.13 14.40% 1.87%
Preference Share Capital 7,00,000 0.07 11% 0.77%
Debentures 30,00,000 0.30 8.40% 2.52%
Total 1,00,00,000 1.00 WACC 14.16%

(iii) Calculation of WACC (Ko) using market value proportions

Name of Source Amount Proportion K Ko
Equity Share Capital 83,33,333 0.555 18% 9.99%
Retained Earnings 21,66,667 0.145 14.40% 2.09%
Preference Share Capital 9,00,000 0.060 11% 0.66%
Debentures 36,00,000 0.240 8.40% 2.02%
Total 1,50,00,000 1.000 WACC 14.76%

Market value of Equity Share Capital = `1,05,00,000 × 50/63 = `83,33,333

Market value of Retained Earnings = `1,05,00,000 × 13/63 = `21,66,667

*Market Value of equity has been apportioned in the ratio of Book Value of equity and retained earnings.

PYQ 20
JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of `20 and proposes to pay
60% dividend at the current year end with a P/E ratio 6.25, it wants to offer the issue at market price. The
flotation cost is expected to be 4% of the issue price.

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 COST OF CAPITAL 9.17
You are required to determine rate of return for equity share (cost of equity) before the issue and
after the issue.
[(5 Marks) May 2018]

Answer
Market price of share (MPS/P0) = EPS × PE = `20 × 6.25 = `125

Net proceeds = 125 – 4% = `120

Return on Equity (ROE) = 1/PE = 1/6.25 = 16%

Growth rate = r×b = 16% × 40% = 6.40%

D1 60% of 20
Ke (before issue) = +g = + 6.40% = 16%
P0 125

D1 60% of 20
Ke (after issue) = +g = + 6.40% = 16.40%
NP 120

PYQ 21
Alpha Ltd. has furnished the following information:
Earning per share (EPS) : `4.00
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% upto `2 lakhs and 15% beyond that.

Compute the after tax cost equity and debt and the weighted average cost of capital.
[(5 Marks) May 2019]

Answer
D1 4.00 × 25% × 110%
Ke = +g = + 0.10 = 12.20%
P0 50

Kd1 = I (1 - t) = 10% (1 – 0.30) = 7%

Kd2 = I (1 - t) = 15% (1 – 0.30) = 10.50%

Ko = KeWe + Kd1Wd1 + Kd2Wd2

= 12.20% × 6 + 7% × 2 + 10.50% × 2 = 10.82%
10 10 10

PYQ 22
A company wants to raise additional finance of `5 crore in next year. The company expected to retain `1 crore
in next year. Further details are as follows:

(i) The amount will be raised by equity and debt in the ratio of 3 : 1.
(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

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 COST OF CAPITAL 9.18
rate of 5%.
(v) Income tax rate of 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 earning and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax.
[(10 Marks) Nov 2019]

Answer
(a) Total capital required is `5 crore. With a debt-equity ratio of 1:3. It means `1.25 crore is to be raised
through debt and `3.75 crores through equity. Out of `3.75 crore, `1 crore are available in the form of
retained earnings hence `2.75 crore will have to raise by issuing equity shares.

(b) Post tax average cost of additional debt:

Kd1 = I (1 - t) = 10% (1 – 0.25) = 7.5%
Kd2 = I (1 - t) = 12% (1 – 0.25) = 9%

Average Kd = Kd1Wd1 + Kd2Wd2 = 7.5% × 75 + 9% × 50 = 8.10%

125 125

(c) Cost of retained earning & cost of equity:

D1 2
Ke = +g = + 0.05 = 13%
P0 25

Kr = Ke = 13%

(d) Overall cost of additional finance:

Ko = KeWe + KrWr + KdWd
= 13% × 275 + 13% × 100 + 8.10% × 125 = 11.78%
500 500 500

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 COST OF CAPITAL 9.19

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y Y
5 Y Y Y Y
6 Y Y - -
7 Y Y Y -
8 Y Y Y Y
9 Y Y Y -
10 Y Y Y -
11 Y Y Y -
12 Y Y Y -
13 Y Y Y -
14 Y Y Y -
15 Y Y Y Y
16 Y Y Y Y
17 Y Y Y Y
18 Y Y Y Y
29 Y Y Y Y
20 Y Y Y Y
21 Y Y - -
22 Y Y Y Y

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 CHAPTER - 10

CAPITAL STRUCTURE
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Discuss in details features of appropriate capital structure.
 Understand the various capital structure approaches.
 Understand the relationship between WACC of any company and
valuation of the company.
 Understand the meaning of over valuation of any firm and its
results.
 Understand the arbitrage process.
 CAPITAL STRUCTURE 10.2

PAST YEARS QUESTIONS

PYQ 1
Z Ltd’s operating income (before interest and tax) is `9,00,000. The firm’s cost of debt is 10% and currently
firm employs `30,00,000 of debt. The overall cost of capital 12%.
Calculate cost of Equity.
[(4 Marks) Nov 2007]

Answer
EBIT 9,00,000
Market value of firm = =
Ko 0.12
= `75,00,000
Market value of Equity = MV of firm – MV of debt
= 75,0000 – 30,00,000 = `45,00,000
PAT PAT
Ke = =
MV of Equity MV of Equity
9,00,000  3,00,000
= = 13.33%
45,00,000

PYQ 2
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% debenture in its capital structure. Both the firms have earnings before interest and tax
`2,60,000 p.a. and the capitalization rate is 10%. Assuming the corporate tax is 30%.
Calculate the value of these firms according to MM Hypothesis.
[(4 Marks) Nov 2009]

Answer
Market value of firms P and Q:
EBIT (1  t ) 2,60,000 (1  .30)
Market value of P (Unlevered) = =
Ke .10
= 18,20,000
Market value of Q (Levered) = Market value of P + Debt × Tax
= 18,20,000 + 8,00,000 × 30%
= 20,60,000

PYQ 3
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 amount
(Debt).
Rate of tax may be taken as 30%. After the capital restructuring and applying MM model with taxes.
You are required to calculate:
(a) Market value of RES Ltd.
(b) Cost of Equity Ke.
(c) Weighted average cost of capital and comment on it.
[(4 Marks) May 2012]

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 CAPITAL STRUCTURE 10.3
Answer
(a) Market Value (MV) of RES Ltd:
MV before restructuring (VUL) = 25,00,000
MV after restructuring (VL) = VUL + Debt × Tax
= 25,00,000 + 5,00,000 × 30% = 26,50,000
(b) Cost of Equity:
Ke = Ko + (Ko – Kd) × D(1  t )
E
5,00,000(1  .30)
= .21 + (.21 - .15) × = 21.97%
21,50,000

Here,
Kd = before tax cost of debt
Ko = Ko of unlevered firm
Ko of unlevered firm = Ke of unlevered firm = 21%

E = Value of Equity
E = Value of firm – Value of Debt
= 26,50,000 – 5,00,000 = 21,50,000
(c) Weighted average cost of capital:
WACC = KeWe + KdWd
= 21.97% × 21,50,000 + 10.50% × 5,00,000
26,50,000 26,50,000
= 19.806 %
Here,
Kd = I (1-t) = 15% (1- .30) = 10.50%
Comment: WACC after restructuring is lower than before restructuring. Hence, company should restructure
the firm.

PYQ 4
‘A’ Ltd. and ‘B’ Ltd. are identical in every respect except capital structure. ‘A’ Ltd. does not use any debt in its
capital structure whereas ‘B’ Ltd. employs 12% debentures amounting to `10,00,000. Assumung that:

(i) All assumptions of MM 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 Weighted Average Cost of Capital for
both the companies.
[(5 Marks) Nov 2014]

Answer
Calculation of value of ‘A’ Ltd and ‘B’ Ltd:

Value of ‘A’ Ltd. (Unlevered) = EBIT (1  t )

Ke
2,50,000 (1  .30)
= = 8,75,000
.20

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 CAPITAL STRUCTURE 10.4
Value of ‘B’ Ltd. (Levered) = Market value of ‘A’ Ltd + Debt × Tax
= 8,75,000 + 10,00,000 × 30%
= 11,75,000

Calculation of WACC of ‘A’ Ltd and ‘B’ Ltd:

K0 of ‘A’ Ltd. = Ke of ‘A’ Ltd

= 20%
[In case of All equity company Ko = Ke ]

EBIT (1  t )
K0 of ‘B’ Ltd. = × 100
V
2,50,000 (1  .30)
= × 100
11,75,000
= 14.89%

PYQ 5
RST Ltd. is expecting an EBIT of `4,00,000 for F.Y. 2015-16. Presently the company is financed by equity share
capital `20,00,000 with equity capitalization rate of 16%. The company is contemplating to redeem part of the
capital by introducing debt financing. The company has two options to raise debt to the extent of 30% or 50%
of the total fund. It is expected that for debt financing upto 30%, the rate of interest will be 10% and equity
capitalization rate will increase to 17%. If the company opts for 50% debt, then the interest rate will be 12%
and equity capitalization rate will be 20%.

You are required to compute value of the company; its overall cost of capital under different
options and also state which is the best option.
[(8 Marks) Nov 2015]

Answer
Statement of Value of Firm and Cost of Capital
Particulars All equity 30% Debt 50% Debt
Earnings before interest and tax 4,00,000 4,00,000 4,00,000
Less: Interest @ 10% of `6,00,000 or - 60,000 -
@ 12% of `10,00,000 - - 1,20,000
Earning available for Equity 4,00,000 3,40,000 2,80,000
÷ Ke 16% 17% 20%
Value of Equity (E) [PBT ÷ Ke] 25,00,000 20,00,000 14,00,000
Value of Debt (D) - 6,00,000 10,00,000
Value of Firm (V) 25,00,000 26,00,000 24,00,000
Ko (EBIT ÷ V) 16% 15.38% 16.67%

Decision: Company should opt for 30% debt finance having higher Value of firm and lower Ko.

PYQ 6
PNR Limited and PXR Limited are identical in every respect except capital structure. PNR limited does not
employ debts in its capital structure whereas PXR Limited employs 12% Debentures amounting to `20,00,000.

The following additional information are given to you:

(i) Income tax rate is 30%
(ii) EBIT is `5,00,000
(iii) The equity capitalization rate of PNR Limited is 20% and
(iv) All assumptions of Modigliani - Miller Approach are met.

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 CAPITAL STRUCTURE 10.5

Calculate:
(i) Value of both the companies,
(ii) Weighted average cost of capital for both the companies.
[(8 Marks) May 2017]

Answer
Calculation of value of ‘PNR’ Ltd and ‘PXR’ Ltd:

Value of ‘PNR’ Ltd. (Unlevered) = EBIT (1  t )

Ke
5,00,000 (1  .30)
= = 17,50,000
.20

Value of ‘PXR’ Ltd. (Levered) = Market value of ‘PNR’ Ltd + Debt × Tax
= 17,50,000 + 20,00,000 × 30%
= 23,50,000

Calculation of WACC of ‘PNR’ Ltd and ‘PXR’ Ltd:

K0 of ‘PNR’ Ltd. = Ke of ‘PNR’ Ltd

= 20%
[In case of All equity company Ko = Ke ]

EBIT (1  t )
K0 of ‘PXR’ Ltd. = × 100
V
= 5,00,000 (1  .30) × 100
23,50,000
= 14.89%

PYQ 7
Stopgo Ltd. an all equity financed company is considering the repurchase of `200 Lakhs euity 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 earning before interest and tax (EBIT) are expected to remain constant in future. It’s
entire earnings are distributed as dividend. Applicable tax rate is 30%.

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

(1) The market value of the company.

(2) It’s cost of capital, and
(3) It’s cost of equity.
[(5 Marks) May 2018]

Answer
(1) Market Value (MV) of Stopgo Ltd:
MV before repurchase (VUL) = 1,140 Lakhs
MV after repurchase (VL) = VUL + Debt × Tax
= 1,140 L + 200 L × 30% = 1,200 Lakhs
Impact on MV of firm = 1,200 L – 1,140 L
= Increase by 60 Lakhs

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 CAPITAL STRUCTURE 10.6
(2) Weighted average cost of capital:
WACC before repurchase = 20%
WACC after repurchase = KeWe + KdWd
1,000 L 200 L
= 20.70% × 1,200 L + 10.50% × 1,200 L
= 19%

Impact on MV of firm = 20% – 19%

= Decrease by 1%
Here,
Kd = I (1-t) = 15% (1- .30) = 10.50%

(3) Cost of Equity:

Ke before repurchase = 20%
D(1  t )
Ke after repurchase = Ko + (Ko – Kd) ×
E
200 L (1−.30)
= .20 + (.20 - .15) × = 20.70%
1,000 L
Impact on MV of firm = 20.70% – 20%
= Increase by 0.70%
Here,
Kd = before tax cost of debt
Ko = Ko of unlevered firm
Ko of unlevered firm = Ke of unlevered firm = 20%

E = Value of Equity
E = Value of firm – Value of Debt
= 1,200 L – 200 L = 1,000 L

PYQ 8
The following data relate to two companies belonging to the same risk class:
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.
[(10 Marks) Nov 2018]

Answer
(a) Various calculation without tax:

Market Value of firms:

Market Value of B Ltd. (VUL) = EBIT ÷ Ke

= `18,00,000 ÷ 18% = `1,00,00,000

Market Value of A Ltd. (VL) = Value of unlevered = `1,00,00,000

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 CAPITAL STRUCTURE 10.7
Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) ÷ *E (Value of Equity)

= (`18,00,000 – 12% × `54,00,000) ÷ `46,00,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `1,00,00,000 - `54,00,000 = `46,00,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT ÷ V (Value of Firm)

= `18,00,000 ÷ `1,00,00,000 = 18%

(b) Various calculation with tax:

Market Value of firms:

Market Value of B Ltd. (VUL) = EBIT (1 - t) ÷ Ke or Ko

= `18,00,000 (1 – 0.40) ÷ 18% = `60,00,000

Market Value of A Ltd. (VL) = Value of unlevered + Debt × Tax

= `60,00,000 + `54,00,000 × .4 = `81,60,000

Equity Capitalization Rate:

Equity Capitalization Rate (B Ltd.) = 18% (given in the question)

Equity Capitalization Rate (A Ltd.) = (EBIT – I) (1 - t) ÷ *E (Value of Equity)

= (`18,00,000 – 12% × `54,00,000) (1 – .4) ÷ `27,60,000
= 25.04%

*Value of Equity (E) of A Ltd. = Value of Firm – Debt

= `81,60,000 - `54,00,000 = `27,60,000

Weighted Average Cost of Capital:

Weighted Average Cost of Capital (B Ltd.) = Ke = Ko = 18%

Weighted Average Cost of Capital (A Ltd.) = EBIT (1 - t) ÷ V (Value of Firm)

= `18,00,000 (1 – 0.4) ÷ `81,60,000
= 13.24%

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 CAPITAL STRUCTURE 10.8

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y
4 Y Y Y Y
5 Y Y Y Y
6 Y Y Y Y
7 Y Y Y Y
8 Y Y Y Y

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 CHAPTER – 11

DIVIDEND DECISIONS
LEARNING OBJECTIVE

After studying this chapter you will be able to:

 Understand the Meaning of Dividend Decision.
 Understand the importance of Dividend Decision.
 Discuss various Forms of Dividend.
 Discuss various Determinants of Dividend.
 Explain various theories of Dividend Decisions.
 DIVIDEND DECISIONS 11.2

PAST YEAR QUESTIONS

PYQ 1
Following information relating to Jee Ltd. are given:
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%

(1) What would be the market value per share as per as per Walter’s Model?
(2) What is the optimum dividend payout ratio according to Walter’s Model and market value of equity
share at that payout ratio?
[(5 Marks) Nov 2018]

Answer
(1) Market value (P) per share as per Walter’s Model:
r 0.12
D + (E−D) × 10+(20−10) ×
Ke 0.10
P (Market value of share) = =
Ke 0.10
= `220.00

E (EPS) = `10,00,000 (PAT) ÷ 50,000 shares

= `20

(2) 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 payout ratio decreases. Hence, the optimum dividend
payout ratio in this case Nil. So, at a payout ratio zero, the market value of company’s share will be:
r 0.12
D + (E−D) × 0+(20−0) ×
Ke 0.10
P (Market value of share) = =
Ke 0.10
= `240.00

PYQ 2
The following information is supplied to you:
Total Earning : `40,00,000
Number of Equity Shares (of `100 each) : 4,00,000
Dividend Per Share : `4
Cost of Capital : 16%
Internal Rate of Return : 20%
Retention Ratio : 60%

Calculate the market price of a share of company by using:

(1) Walter’s Formula,
(2) Gordon’ Formula.
[(5 Marks) May 2019]

Answer
(1) Market Price of Share (P) as per Walter’s Formula:

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 DIVIDEND DECISIONS 11.3
r 0.20
D + (E−D) × 4+(10−4) ×
Ke 0.16
P (Market value of share) = =
Ke 0.16
= `71.875

E (EPS) = `40,00,000 (Earning) ÷ 4,00,000 shares

= `10

(2) Market Price of Share (P) as per Gordon’s Formula:

D1 4.00
P0 (Market value of share) = =
Ke −g 0.16−0.12
= `100.00

G (Growth Rate) = b×r = 20% × .6

= 12%

PYQ 3
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:

(1) Current market price of the share.
(2) Capitalization rate of its risk class.
(3) What should be the optimum payout ratio?
(4) What should be the market price per share at optimal payout ratio? (use Walter’s model)
[(5 Marks) Nov 2019]

Answer
(1) Current market price of share:
Current Market Price of Share = EPS × PE Ratio
10,00,000
= × 10 = `50
2,00,000

(2) Capitalization rate of its risk class:

Capitalization rate (Ke) = 1/PE
= 1/10 = 0.10 or 10%

(3) Optimum payout:

r > Ke, Therefore dividend payout should be Nil.

(4) Market Price of Share (P) as per Walter’s Formula as per optimal payout ratio:
r 0.20
D + (E−D) × 0+(5−0) ×
Ke 0.10
P (Market price of share) = =
Ke 0.10
= `100

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 DIVIDEND DECISIONS 11.4

SUGGESTED REVISION
PYQ OBSERVATION PN 1 2 3-5 FINAL
1 Y Y Y Y
2 Y Y Y Y
3 Y Y Y Y

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