CA Inter Group 2 Revision Sessions CA.

DINESH JAIN
www.bharadwajinstitute.com 9790809900 9841537255

FINANCIAL MANAGEMENT
REVISION BOOK

FOR CA INTER

BY CA. DINESH JAIN

Dedicated to My Lovable Father
RAMESH JAIN

Bharadwaj Institute Private Limited.

(Ideal Destination for CA Aspirants)
Ph: 9790809900 / 9841537255

www.bharadwajinstitute.com

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TABLE OF CONTENTS
CHAPTER-WISE MARK BREAK UP ...................................................................... 3
SUMMARY OF SYLLABUS ...................................................................................... 4
CHAPTER 3: RATIO ANALYSIS ............................................................................. 5
CHAPTER 4: COST OF CAPITAL .......................................................................... 27
CHAPTER 5: FINANCING DECISIONS – CAPITAL STRUCTURE ............. 49
CHAPTER 6: FINANCING DECISIONS – LEVERAGES ................................. 72
CHAPTER 7: INVESTMENT DECISIONS .......................................................... 87
CHAPTER 8: RISK ANALYSIS IN CAPITAL BUDGETING ......................... 121
CHAPTER 9: DIVIDEND DECISIONS .............................................................. 141
CHAPTER 10: MANAGEMENT OF WORKING CAPITAL ........................... 151
New Additional Problems...................................................................................... 186

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CHAPTER-WISE MARK BREAK UP

❖ Scope and objectives of financial management

(Chapter 1)
10% to 15%
❖ Financial analysis and planning – Ratio Analysis
(Chapter 3)
❖ Types of financing (Chapter 2)
❖ Cost of capital (Chapter 4)
❖ Financing decisions – capital structure (Chapter 5) 40% to 45%
❖ Financing decisions – Leverages (Chapter 6)
❖ Lease Financing (Chapter 9)
❖ Investment decisions (Chapter 7)
❖ Risk Analysis in Capital Budgeting (Chapter 8) 30% to 35%
❖ Dividend decisions (Chapter 10)
❖ Management of working capital (Chapter 11) 10% to 15%

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Chennai: 9790809900 / 9841537255 Tirupur-Kunnathur 9789427988
You shall also visit bhaaradwajinstitute.com/faculty for Faculty profiles

www.bharadwajinstitute.com

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SUMMARY OF SYLLABUS
No of
S.No Chapter Name question
s
1 Scope and Objectives of Financial Management 0
2 Types of Financing 0
3 Financial Analysis and Planning – Ratio Analysis 19
4 Cost of Capital 17
5 Financing Decisions – Capital Structure 20
6 Financing Decisions – Leverages 15
7 Investment Decisions 25
8 Risk Analysis in Capital Budgeting 16
9 Dividend Decisions 11
10 Management of Working Capital 34
Total 157

Note: Revision book covers questions till May 2022 RTP, Dec 2021 suggested
answers and Nov 2021 MTP

Bharadwaj Institute Private Limited.

(Ideal Destination for CA Aspirants)
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www.bharadwajinstitute.com

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CHAPTER 3: RATIO ANALYSIS

A. LIQUIDITY RATIOS – SHORT TERM SOLVENCY

Ratio Formula Numerator Denominator Significance/ Indicator
Sundry creditors (for goods) • Ability to repay short-
Inventories / stocks
(+) Outstanding expenses term commitments
(+) Debtors & B/R
(+) Short term loans and promptly (i.e., short-
(+) Cash & Bank
Current Assets advances (Cr) term solvency)
1 Current Ratio (+) Receivables / Accruals
Current Liabilities (+) Bank overdraft/cash credit • High ratio indicates
(+) Short term loans (Dr)
(+) Provision for taxation existence of idle current
(+) Marketable investment
(+) Proposed dividend assets
/short term securities
(+) Unclaimed divided
• It is one of the best
Quick ratio / Current assets measures of liquidity
Quick Assets and is a more
2 liquid ratio / (-) Inventories As above
acid test ratio Current Liabilities (-) Prepaid Expenses conservative measure
than current ratio

• Availability of funds to
meet short term
Cash in hand commitments.
Cash • A ratio of >1 may
Cash + Marketable Securities (+) Cash at Bank
3 ratio/absolute As above indicate that the firm
Current Liabilities (+) Marketable securities
liquidity ratio has liquid resources
/short term investments
which are low in
profitability

(COGS + Selling, admin and • Ability to meet regular

Basic Defense
other general expenses – cash expenses with
Interval Cash + Marketable Securities
4 As above Depreciation and non-cash available cash and cash
Measure (in Daily Operating Expenses
expenses)/ (Number of days in a equivalents
days)
year)
Bankers look at net working
Net working
5 Current assets – Current liabilities (excluding short term bank borrowing) capital for assessing WC
capital ratio
funding

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B. CAPITAL STRUCTURE RATIOS – INDICATOR OF LONG TERM SOLVENCY

Ratio Formula Numerator Denominator Significance/ Indicator

Total Debt Total outside liabilities or Indicator of use of external
1 Debt ratio Debt + Equity + Preference
Capital Employed total debt funds
Total Equity Indicates long term solvency
2 Equity ratio Owner’s funds Debt + Equity + Preference and extent of own funds
Capital Employed
used in operations
Total Outside Liabilities Short term debt +Long term Equity capital +Reserves &
Shareholders ′ equity debt + Outside liabilities Surplus +Preference capital
Debt to Equity Total Debt Short term debt + Long Equity capital +Reserves & Indicates the relationship
3
ratio Shareholders ′ equity term debt Surplus +Preference capital between debt and equity
Long Term Debt Equity capital +Reserves &
Long term debt
Shareholders ′ equity Surplus +Preference capital
Total Outside Liabilities Short term debt +Long term
All assets – fictitious assets Indicates the extent of debt
Debt to total Total Assets debt + Outside liabilities
4 funding of company’s entire
assets ratio Total Debt Short term debt + Long term
All assets – fictitious assets assets
Total Assets debt
Shows extent of advantage
Capital gearing Fixed Charge Bearing capital Preference share capital + Equity capital + Reserves &
5 or leverage enjoyed by
ratio Shareholders ′ equity Total debt Surplus – fictitious assets
equity shareholders
Shows extent of owners
Proprietary Proprietary Funds Equity capital +Reserves &
6 All assets – fictitious assets funds in financing the assets
ratio Total Assets Surplus +Preference capital
of the business

C. COVERAGE RATIOS – ABILITY TO SERVE FIXED LIABILITIES

Ratio Formula Numerator Denominator Significance/ Indicator
Profit after tax
(+) Interest on debt funds Indicates extent of current
(+) Non-cash operating earnings available for
Debt service Earnings for debt service Interest on debt
1 expenses (e.g. deprecation) meeting debt commitments;
coverage ratio Interest + Instalments (+) Installment of debt
(+) Non-operating ideal ratio would be
adjustments (e.g. loss on between 1.5 to 2 times.
sale of fixed assets)
Indicates ability to meet
Interest EBIT Earnings before interest and
2 Interest on debt interest obligations of the
coverage ratio Interest taxes
current year.

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Preference Indicates ability to pay
EAT
3 dividend Earnings after tax Preference dividend dividend on preference
coverage ratio Preference Dividend capital
Equity dividend EAES Earnings available to equity Indicates available coverage
4 Equity dividend
coverage ratio Equity Dividend shareholders for equity dividends
This ratio shows how many
EBIT + Depreciation
Fixed charges Interest + (Principal divided by times the cash flows are
5 Principal EBIT + Depreciation
coverage ratio Interest + [ ] 1- tax rate) available for covering all
1 − Tax
fixed financing charges

D. ACTIVITY RATIO / EFFICIENCY RATIO / PERFORMANCE RATIO / TURNOVER RATIO

Ratio Formula Numerator Denominator Significance/ Indicator
Total assets Sales (or)COGS Measures the efficiency with
1 Sales / COGS Total assets
turnover ratio Total Assets which total assets are used
Fixed assets Sales (or)COGS Fixed assets net of accumulated Ability to generate sales per
2 Sales/ COGS
turnover ratio Fixed Assets depreciation rupee of fixed asset
Capital/net Net fixed assets plus net current Ability to generate sales per
Sales (or)COGS
3 asset turnover Sales/COGS assets (current assets – current rupee of long-term
Capital Employed
ratio liabilities) investment
Current assets Sales (or)COGS Ability to generate sales per
4 Sales/COGS Current assets
turnover ratio Current Assets rupee of current asset
Ability to generate sales per
Working capital Sales (or)COGS Current assets (-) current
5 Sales/COGS rupee of working capital
turnover ratio Working capital liabilities
Inventory / Measures the efficiency with
COGS (or) Sales Opening stock + Closing stock
6 stock turnover COGS = Sales – Gross Profit which inventory is being
Average Inventory 2
ratio used
Measures how fast /
Raw material RM Consumed Opening stock + Purchases Opening stock + Closing stock
7 regularly raw materials are
turnover ratio Average RM – Closing stock 2 used
Measures the speed with
Debtors Credit sales Opening rbles + Closing rbles
8 Credit sales net of returns which receivables are
turnover ratio Average Accounts Receivables 2 collected
Measures the speed with
Payables Credit purchases Credit purchases net of Opg payables + Clg payables
9 which the payments are
turnover ratio Average Accounts payables returns 2 made to creditors
Note: T/O ratios can also be expressed in terms of days as 365 / T/O ratio. e.g. average collection period = 365 / Debtors turnover ratio

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E. PROFITABILITY RATIOS RELATED TO SALES
Ratio Formula Numerator Denominator Significance/ Indicator
Gross profit Gross Profit Gross profit as per trading Indicator of basic
1 x 100 Sales net of returns
ratio Sales account profitability
Net Profit Indicator of overall
2 Net profit ratio x 100 Net profit as per P&L A/c Sales net of returns
Sales profitability
Pre-tax profit PBT Indicator of overall
3 x 100 Earnings before tax Sales net of returns
ratio Sales profitability excluding taxes
Sales – cost of sales
(or)
Operating profit Operating Profit (or ) EBIT Indicator of operating
4 x 100 Net Profit Sales net of returns
ratio Sales performance of business
(+) Non-operating expenses
(-) Non-operating incomes
COGS Indicator of basic cost of the
5 COGS ratio x 100 Cost of goods sold Sales net of returns
Sales product
Measures the proportion of
Operating Operating Expenses Admin expense + Selling &
6 x 100 Sales net of returns operating expense per rupee
expenses ratio Sales Distribution expense
of sales
COGS + Operating Expenses COGS + Operating Measures the overall cost of
7 Operating ratio x 100 Sales net of returns
Sales expenses the product
Financial Financial Expenses Measures the interest cost
8 x 100 Interest expenses Sales net of returns
expense ratio Sales pre rupee of sale
F. PROFITABILITY RELATED TO OVERALL RETURN ON ASSETS / INVESTMENTS
Ratio Formula Numerator Denominator Significance/ Indicator
Return on EBIT Earnings after tax Overall profitability of the
investment x 100 Fixed assets + Net current assets
Capital Employed (+) Income Tax business on the total funds
(ROI) or Return (or) (or)
1 (+) Interest on debt funds employed
on capital Equity + Long term debt +
EBIT x (1 Tax) (+) Non-operating If ROCE> Interest rate, use
employed x 100 Preference
Capital Employed adjustments of debt funds is justified
(ROCE)
Return on
Equity (ROE) or Indicates profitability of
EAES Earnings after tax (-) Equity capital + Reserves &
2 Return on x 100 owners funds invested in
Equity shareholders ′ funds preference dividend surplus – fictitious assets
networth the business
(RONW)
Return on assets Net Profit after taxes Average of opening total assets Indicates net income pre
3 x 100 Earnings after tax
(ROA) Average Total Assets & closing total assets rupee of average total assets

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G. PROFITABILITY RATIOS FROM OWNERS POINT OF VIEW

Ratio Formula Numerator Denominator Significance/ Indicator
Earnings per EAES Earnings after tax (-)
1 No of equity shares Return or income per share
share (EPS) No of equity shares preference dividend
Dividend per Equity Dividend Amount of profits
2 Total dividend No of equity shares
share (DPS) No of equity shares distributed per share
Dividend DPS Indicates proportion of
3 x 100 DPS EPS
payout ratio EPS profits which are distributed
H. PROFITABILITY RATIOS RELATED TO MARKET / VALUATION / INVESTORS
Ratio Formula Numerator Denominator Significance/ Indicator
Indicates the relationship
Price Earnings MPS between market price and
1 Market price per share Earnings per share
ratio EPS EPS and the shareholders
perception of the company
Indicates the return on
DPS
2 Dividend yield x 100 Dividend per share Market price per share investment based on market
MPS price of share
EPS
3 Earnings yield x 100 Earnings per share Market price per share Inverse of PE multiple
MPS
Indicates how investors
Market value to Market price per share Share capital + R&S − Fict assets
4 Market price per share view the company from past
book value Book value per share No of equity shares
and future performance
It measures market value of
Market value of equity and liabilities Market value of equity and Estimated replacement cost of equity as well as debt in
5 Q Ratio
Replacement cost of assets liabilities assets comparison to all assets at
their replacement cost

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Question No.1 – Nov 2016, Nov 2020 RTP, May 2019, Nov 2021 MTP
The following information and ratios are related to a company:
Sales for the year (all credit) Rs.30,00,000
Gross Profit Ratio 25 percent
Fixed assets turnover based on COGS 1.5 times
Stock turnover ratio based on COGS 6 times
Liquid ratio 1:1
Current ratio 1.5:1
Debtors collection period 2 months
Reserves & surplus to share capital 0.6:1
Capital gearing ratio 0.5
Fixed assets to networth 1.20:1
You are required to prepare a balance sheet
Answer:
Balance Sheet:
Liabilities Amount Assets Amount
Share capital (Note 7) 7,81,250 Fixed Assets (Note 2) 15,00,000
Reserves and Surplus (Note 7) 4,68,750 Inventory (Note 3) 3,75,000
Fixed charge bearing capital (Note 8) 6,25,000 Debtors (Note 5) 5,00,000
Current Liabilities (Note 4) 7,50,000 Cash (Note 6) 2,50,000
Total 26,25,000 Total 26,25,000

Note 1: Computation of COGS:

• GP margin is 25 percent of sales and hence COGS will be 75 percent of sales
• COGS = 30,00,000 x 75% = Rs.22,50,000

Note 2: Computation of fixed assets:

COGS 22,50,000
Fixed Assets Turnover ratio = 1.50; = 1.50; = 1.50
Fixed Assets Fixed Assets
22,50,000
Fixed Assets = = Rs. 15,00,000
1.50

Note 3: Computation of inventory:

COGS 22,50,000
Inventory Turnover ratio = 6.00; = 6.00; = 6.00
Inventory Inventory
22,50,000
Inventory = = Rs. 3,75,000
6.00

Note 4: Computation of current assets and current liabilities:

Current Assets
Current ratio = 1.5; = 1.50; Current Assets = 1.50 Current Liabilities
Current Liabilities
Quick Assets
Liquid ratio = 1.0; = 1.00; Quick Assets = Current Liabilities
Current Liabilities
Current Assets − Quick Assets = Inventory
1.5CL − CL = 3,75,000; 0.5CL = 3,75,000; CL = 7,50,000
Current Assets = 7,50,000 x 1.50 = Rs.11,25,000

Note 5: Computation of debtors:

CP 2
Debtors = Sales x = 30,00,000 x = Rs. 5,00,000
12 12

Note 6: Computation of Cash:

• Cash = Total Current Assets – Inventory – Debtors

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• Cash = 11,25,000 – 3,75,000 – 5,00,000 = Rs.2,50,000

Note 7: Computation of Networth:

Fixed Assets 15,00,000 15,00,000
= 1.2; = 1.20; Networth = = Rs. 12,50,000
Networth Networth 1.20
Reserves
= 0.6; Reserves = 0.6 SC
SC
Networth = Reserves + SC = 12,50,000; 0.6SC + SC = 12,50,000
12,50,000
1.6SC = 12,50,000; SC = = Rs. 7,81,250
1.60
Reserves = 7,81,250 x 0.60 = Rs.4,68,750

Note 8: Computation of Fixed capital (Debt + Preference)

Fixed Charge Bearing Capital
Capital gearing ratio = 0.5; = 0.50
Networth
Fixed Charge Bearing Capital
= 0.50; Fixed charge bearing capital = Rs. 6,25,000
12,50,000

Question No.: 2 (November 2013 exam – 8 Marks)

The assets of SONA Limited 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 31 st March
2013 with the help of following information:
Share capital Rs.5,75,000
Working capital (CA – CL) Rs.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
Answer:
Balance Sheet of Sona Limited as on March 31, 2013:
Liabilities Amount Assets Amount
Share capital 5,75,000 Fixed assets (b/f) 6,85,000
Reserves & Surplus (Cash x 4) 2,60,000 Current Assets:
Current Liabilities: Inventories (Note 2) 2,10,000
Bank Credit (Note 5) 2,00,000 Debtors (Note 4) 1,75,000
Other current liabilities (Note 5) 1,00,000 Bank & cash (Note 4) 65,000
Total 11,35,000 Total 11,35,000

Note 1: Computation of current assets and current liabilities:

Current Assets CA
Current Ratio = ; 1.5 = ; 𝐂𝐀 = 𝟏. 𝟓𝐂𝐋
Current Liabilities CL
Net working capital = 1,50,000; 𝐂𝐀 − 𝐂𝐋 = 𝟏, 𝟓𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
1.5CL − CL = 1,50,000; 0.5CL = 1,50,000; 𝐂𝐋 = 𝐑𝐬. 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
CA = 3,00,000 x 1.50 = Rs.4,50,000

Note 2: Computation of inventory:

Quick Assets Quick Assets
Quick Ratio = ; 0.8 = ; 𝐐𝐮𝐢𝐜𝐤 𝐀𝐬𝐬𝐞𝐭𝐬 = 𝟎. 𝟖 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
Current Liabilities Current Liabilities
Quick Assets = 0.8 x 3,00,000 = Rs.2,40,000
Inventory = Current assets – Quick Assets = 4,50,000 – 2,40,000 = Rs.2,10,000

Note 3: Computation of COGS and Sales:

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COGS COGS
Inventory Turnover Ratio = ;5 = ; 𝐂𝐎𝐆𝐒 = 𝟏𝟎, 𝟓𝟎, 𝟎𝟎𝟎
Stock 2,10,000
Gross Profit = 25% of sales; Hence COGS = 75% of sales
COGS 10,50,000
Sales = = = Rs. 15,00,000
70% 70%

Note 4: Computation of Debtors and Bank & Cash:

1.5 1.5
Debtors = Sales x = 15,00,000 𝑥 = 𝑅𝑠. 1,75,000
12 12
Bank and cash = Current assets – stock – debtors
Bank and cash = 4,50,000 – 2,10,000 – 1,75,000 = Rs.65,000

Note 5: Computation of bank credit and other current liabilities:

2 2
Bank credit = Current liabilities x = 3,00,000 x = Rs. 2,00,000
3 3
1 1
Other current liabilities = Current liabilities x = 3,00,000 x = Rs. 1,00,000
3 3

Question No.: 3 – November 2014 exam

From the following information, prepare Balance Sheet of a firm:
Stock Turnover Ratio (based on COGS) 7 Times
Rate of Gross Profit to Sales 25%
Sales to Fixed assets 2 Times
Average debt collection period 1.5 months
Current ratio 2
Liquidity ratio 1.25
Net working capital 8,00,000
Reserves and Surplus to capital 0.25 Times
Long term debts Nil
All sales are on credit basis
Answer:
Balance sheet of ____________ as on _____________
Liabilities Amount Assets Amount
Share capital (Note 9) 28,80,000 Fixed assets (Note 7) 28,00,000
Reserves and surplus (Note 9) 7,20,000 Current assets
Long term loans - Stock (Note 2) 6,00,000
Current Liabilities (Note 1) 8,00,000 Debtors (Note 5) 7,00,000
Cash (Note 6) 3,00,000
Total 44,00,000 Total 44,00,000

Note 1: Computation of Current Assets and Current Liabilities:

Current Assets CA
Current Ratio = ;2 = ; 𝐂𝐀 = 𝟐𝐂𝐋
Current Liabilities CL
Net working capital = 8,00,000; 𝐂𝐀 − 𝐂𝐋 = 𝟖, 𝟎𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2CL − CL = 8,00,000; 𝐂𝐋 = 𝟖, 𝟎𝟎, 𝟎𝟎𝟎;
CA = 8,00,000 x 2 = Rs.16,00,000

Note 2: Computation of stock:

Quick Assets Quick Assets
Liquid Ratio = ; 1.25 = ; 𝐐𝐮𝐢𝐜𝐤 𝐚𝐬𝐬𝐞𝐭𝐬 = 𝟏𝟎, 𝟎𝟎, 𝟎𝟎𝟎
Current Liabilities 8,00,000
Stock = Current Assets − Quick Assets; Stock = 16,00,000 − 10,00,000 = Rs. 6,00,000

Note 3: Computation of COGS:

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COGS COGS
Stock Turnover Ratio = ;7 = ; 𝐂𝐎𝐆𝐒 = 𝐑𝐬. 𝟒𝟐, 𝟎𝟎, 𝟎𝟎𝟎
Stock 6,00,000

Note 4: Computation of sales:

Gross Profit = 25% of sales; Hence COGS = 75% of sales;
42,00,00
42,00,000 = 75% of sales; Sales = = Rs. 56,00,000
75%

Note 5: Computation of debtors:

1.5 1.5
Debtors = Sales x = 56,00,000 𝑥 = 𝑅𝑠. 7,00,000
12 12

Note 6: Computation of cash:

• It is assumed that current assets contain only inventory, receivables and cash
• Current assets = Inventory + Receivables + Cash
• 16,00,000= 6,00,000 + 7,00,000 + Cash
• Cash = Rs.3,00,000

Note 7: Computation of fixed assets:

Sales 56,00,000
= 2; = 2; Fixed assets = Rs. 28,00,000
Fixed Assets Fixed Assets

Note 8: Computation of Networth:

• Networth = Fixed assets + Current assets – Current liabilities – Long term debt
• Networth = 28,00,000 + 16,00,000 – 8,00,000 – 0 = Rs.36,00,000
• Share capital + Reserves and Surplus = Networth = Rs.36,00,000

Note 9: Computation of share capital and Reserves & Surplus:

Reserve & Surplus
= 0.25; Reserves & Surplus = 0.25 Share capital
Share capital
Share capital + Reserves & Surplus = Rs. 36,00,000
Share capital + 0.25 Share capital = Rs. 36,00,000
36,00,000
1.25 Share capital = Rs. 36,00,000; Share capital = = 𝑅𝑠. 28,80,000
1.25
Reserves and Surplus = Rs.28,80,000 x 0.25 = Rs.7,20,000

Question No.4 – May 2017 RTP

From the following information prepare a summarized balance sheet as at 31 st March
Working capital Rs.2,40,000
Bank overdraft Rs.40,000
Fixed assets to proprietary ratio 0.75
Reserves and surplus Rs.1,60,000
Current ratio 2.5
Liquid ratio 1.5
Answer:
Balance sheet as at 31st March:
Liabilities Amount Assets Amount
Proprietor’s Funds Fixed Assets 7,20,000
Share capital (9,60,000 – 1,60,000) 8,00,000 Inventory 1,60,000
Reserves and surplus 1,60,000 Other current assets 2,40,000
Bank overdraft 40,000
Other current liabilities 1,20,000
Total 11,20,000 Total 11,20,000

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Note 1: Computation of Current Assets and Current Liabilities:
Current Assets CA
Current Ratio = ; 2.5 = ; 𝐂𝐀 = 𝟐. 𝟓𝐂𝐋
Current Liabilities CL
Net working capital = Rs. 2,40,000; 𝐂𝐀 − 𝐂𝐋 = 𝟐, 𝟒𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2.5CL − CL = Rs. 2,40,000; 1.5CL = Rs. 2,40,000; 𝐂𝐋 = 𝐑𝐬. 𝟏, 𝟔𝟎, 𝟎𝟎𝟎
CA = 1,60,000 x 2.50 = Rs.4,00,000

Note 2: Computation of inventory:

Quick Assets QA
Liquidity Ratio = ; 1.5 = ; Quick Assets = Rs. 2,40,000
Current Liabilities 1,60,000
Quick Assets = Current Assets – Inventory
2,40,000 = 4,00,000 – Inventory; Inventory = Rs.1,60,000

Note 3: Computation of fixed assets and proprietor’s funds:

Fixed assets
= 0.75; 𝐅𝐀 = 𝟎. 𝟕𝟓𝐏𝐅
Proprietor ′ s funds
It is assumed that there is no debt or preference in the company
Capital Employed = Fixed Assets + Net working capital
PF = 0.75PF + 2,40,000; 0.25PF = 2,40,000; PF = Rs. 9,60,000
Fixed assets = 9,60,000 x 75% = Rs.7,20,000

Question No.: 5 (May 2013 RTP, July 2021)

T Ltd. has furnished the following ratios and information relating to the year ended 31st March, 2021
Sales Rs.600 lacs
Return on Networth 25%
Rate of income tax 40%
Share capital to reserves 7:3
Current Ratio 2
Net-profit to sales (after tax) 6.25%
Inventory turnover (based on COGS and Closing stock) 12
Cost of goods sold Rs.180 lacs
Interest on debentures (@ 15%) Rs.6,00,000
Trade receivables Rs.20,00,000
Trade Payables Rs.20,00,000
You are required to:
• Calculate the operating expenses for the year ended 31st March 2021
• Prepare a balance sheet as on March 31, 2021
Answer:
WN 1: Computation of operating expenses for the year ended 31 st March 2021:
Particulars Amount
Sales (Given) 6,00,00,000
Less: Cost of goods sold (Given) (1,80,00,000)
Gross Profit 4,20,00,000
Less: Operating expenses (b/f) 3,51,50,000
EBIT [Reverse worked] 68,50,000
Less: Interest 6,00,000
EBT [37,50,000/(1 -40%)] 62,50,000
Less: Tax (25,00,000)
EAT [6,00,00,000 x 6.25%] 37,50,000

WN 2: Balance Sheet as on March 31, 2021:

Liabilities Amount Assets Amount
Share capital (Note 1) 1,05,00,000 Fixed assets (b/f) 1,70,00,000

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Reserves and Surplus (Note 1) 45,00,000 Closing stock (Note 2) 15,00,000
15% debentures [6,00,000/15%] 40,00,000 Trade receivables (Given) 20,00,000
Trade payables (Given) 20,00,000 Cash and Bank (Note 3) 5,00,000
Total 2,10,00,000 2,10,00,000

Note 1: Computation of share capital and Reserves:

PAT
Return on Networth =
Networth
37,50,000 37,50,000
25% = ; Networth = = 1,50,00,000
Networth 25%
• Share capital and reserves are in the ratio of 7:3. Hence 7/10 of networth is share capital and 3/10
of networth is reserves
• Amount of share capital = 1,50,00,000 x (7/10) = Rs.1,05,00,000
• Amount of reserves = 1,50,00,000 x (3/10) = Rs.45,00,000

Note 2: Computation of closing stock:

COGS
Inventory Turnover Ratio =
Closing Stock
1,80,00,000 1,80,00,000
12 = ; Closing stock = = 15,00,000
Closing stock 12

Note 3: Computation of cash and bank:

Current Assets
Current Ratio =
Current Liabilities
Current Assets
2= ; Current Assets = Rs. 40,00,000
20,00,000
• Current assets = Inventory + Receivables + Cash
• 40,00,000 = 15,00,000 + 20,00,000 + Cash
• Cash = 5,00,000

Question No.6 – May 2018

Using the following information complete the balance sheet given below:
Gross Profits Rs.54,000
Shareholders funds Rs.6,00,000
Gross Profit Margin 20%
Credit sales to total sales 80%
Total assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8 times
Long-term debt to equity 40%

Liabilities Amount Assets Amount

Creditors ? Cash ?
Long-term debt ? Debtors ?
Shareholders funds ? Inventory ?
Fixed Assets ?
? ?
Answer:
Balance Sheet:
Liabilities Amount Assets Amount
Creditors (balancing figure) 60,000 Cash (Note 6) 42,000
Long-term debt 2,40,000 Debtors (Note 2) 12,000
Shareholders’ funds 6,00,000 Inventory (Note 4) 54,000

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Fixed Assets (balancing figure) 7,92,000
Total 9,00,000 Total 9,00,000

Note 1: Computation of sales:

Gross profit 54,000
= 0.20; = 0.20; Sales = Rs. 2,70,000
sales Sales

Note 2: Computation of debtors:

Credit Sales = 2,70,000 x 80% = Rs. 2,16,000
20
Debtors = 2,16,000 x ( ) = Rs. 12,000
360

Note 3: Computation of total assets:

Sales 2,70,000
Total Asset Turnover = 0.3; = 0.30; = 0.30
Total Assets Total assets
2,70,000
Total Assets = = Rs. 9,00,000
0.3

Note 4: Computation of inventory:

COGS (80% x 2,70,000)
Inventory Turnover = 4; = 4; =4
Inventory Inventory
2,16,000
Inventory = = Rs. 54,000
4

Note 5: Computation of long-term debt:

Long − term debt Long − term debt
= 0.4; = 0.4;
Equity 6,00,000
Long − term debt = 6,00,000 x 0.40 = Rs. 2,40,000

Note 6: Computation of cash:

Current Assets Current Assets
Current ratio = 1.80; = 1.80; = 1.80
Current Liabilities 60,000
Current Assets = 60,000 x 1.80 = Rs. 1,08,000
Cash = Current assets – Debtors – Inventory
Cash = 1,08,000 – 12,000 – 54,000 = Rs.42,000

Question No.7 [Jan 2021, May 2021 MTP, May 2019 MTP]
With the help of following information complete the balance sheet of ABC Limited:
Equity share capital Rs.1,00,000
Current debt to total debt 0.40
Total debt to owners equity 0.60
Fixed assets to owner’s equity 0.60
Total assets turnover 2 times
Inventory turnover 8 times
Answer:
Balance Sheet of ABC Limited:
Liabilities Amount Assets Amount
Equity share capital 1,00,000 Fixed assets 60,000
Long-term debt 36,000 Inventory 40,000
Current debt 24,000 Other current assets (b/f) 60,000
Total 1,60,000 Total 1,60,000

Note 1: Computation of total debt:

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Total debt Total debt
= 0.60; = 0.60; Total debt = Rs. 60,000
Equity 1,00,000

Note 2: Computation of current and long-term debt:

Current debt Current Debt
= 0.40; = 0.40; Current Debt = Rs. 24,000
Total debt 60,000
Long-term debt = 60,000 – 24,000 = Rs.36,000

Note 3: Computation of fixed assets:

Fixed assets
= 0.60; Fixed assets = 0.60 x 1,00,000 = Rs. 60,000
Equity

Note 4: Computation of sales:

Sales Sales
Total Assets Turnover Ratio = 2; = 2; = 2; Sales = Rs. 3,20,000
Total Assets 1,60,000

Note 5: Computation of inventory:

Sales 3,20,000
Inventory Turnover Ratio = 8; = 8; = 8; Inventory = Rs. 40,000
Inventory Inventory

Question No.8 [Nov 2020 MTP, May 2019]

Using the information given below, complete the balance sheet of PQR Private Limited:
Current Ratio 1.6:1
Cash and Bank Balance 15% of total current assets
Debtors Turnover Ratio 12 Times
Stock Turnover (cost of Goods Sold) ratio 16 Times
Creditors Turnover (cost of Goods sold) ratio 10 Times
Gross Profit Ratio 20%
Capital Gearing Ratio 0.6
Depreciation rate 15% on WDV
Net Fixed Assets 20% of total assets
(Assume all purchase and sales are on credit)
Balance Sheet of PQR Private Limited as at 31.03.2019
Liabilities Amount Assets Amount
Share capital 25,00,000 Fixed Assets
Reserves and Surplus ? Opening WDV ?
12% Long term debt ? Less: Depreciation ? ?
Current Liabilities Current Assets:
Creditors ? Stock ?
Provisions & outstanding 68,50,000 Debtors ?
Expenses ?
Cash and bank ? ?
Total ? Total ?
Answer:
Balance Sheet of PQR Private Limited as at 31.03.2019
Liabilities Amount Assets Amount
Share capital 25,00,000 Fixed Assets
Reserves and Surplus (Note 4) 17,81,250 Opening WDV (Note 2) 32,23,529
12% Long term debt (Note 4) 25,68,750 Less: Depreciation (Note 2) 4,83,529 27,40,000
Current Liabilities Current Assets:
Creditors (Note 3) 55,89,600 Stock (Note 3) 34,93,500
Provisions & outstanding 68,50,000 Debtors (Note 3) 58,22,500
Expenses (Note 3) 12,60,400
Cash and bank (Note 1) 16,44,000 1,09,60,000

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Total 1,37,00,000 Total 1,37,00,000

Note 1: Computation of Current Assets and Cash:

Current Assets Current assets
Current Ratio = ; 1.6 =
Current Liabilities 68,50,000
Current assets = 68,50,000 x 1.60 = Rs.1,09,60,000
Cash and Bank balance = 15% x 1,09,60,000 = Rs.16,44,000

Note 2: Computation of Total Assets, Fixed assets and depreciation:

Fixed assets = 20% of total assets; Current assets = 80% of total assets;
Current assets 1,09,60,000
Total assets = = = Rs. 1,37,00,000
80% 80%
Fixed assets = Total assets – Current assets
Fixed assets = 1,37,00,000 – 1,09,60,000 = Rs.27,40,000
Depreciation is at 15% of opening WDV. Hence closing assets is 85% of opening WDV
Closing WDV = Rs. 27,40,000; 85% x Opening WDV = Rs. 27,40,000;
27,40,000
Opening WDV = = Rs. 32,23,529
85%
Depreciation = Opening WDV – Closing WDV = 32,23,529 – 27,40,000 = Rs.4,83,529

Note 3: Calculation of Stock, Debtors, creditors and Provisions:

Stock + Debtors = Current Assets − Cash
Stock + Debtors = 1,09,60,000 − 16,44,000 = Rs. 93,16,000
Let us assume sales to be X. GP Margin is 20% and hence COGS will be 0.8X
Sales X X
Debtors Turnover Ratio = ; 12 = ; Debtors =
Debtors Debtors 12
COGS 0.8X 0.8X
Inventory Turnover Ratio = ; 16 = ; Stock =
Stock Stock 16
Stock + Debtors = Rs. 93,16,000
X 0.8𝑋 4𝑋 + 2.4𝑋
+ = 𝑅𝑠. 93,16,000; = 93,16,000; 6.4𝑋 = 93,16,000 𝑥 48;
12 16 48
93,16,000 x 48
X= = 𝑅𝑠. 6,98,70,000
6.4
Sales = Rs.6,98,70,000; COGS = 80% x 6,98,70,000 = Rs.5,58,96,000
Debtors = 6,98,70,000/12 = Rs.58,22,500
Inventory = 5,58,96,000/16 = Rs.34,93,500
Creditors = 5,58,96,000/10 = Rs.55,89,600
Provision and outstanding expenses = Current liabilities – Creditors
Provision and outstanding expenses = 68,50,000 – 55,89,600 = Rs.12,60,400

Note 4: Computation of Reserves and Surplus and Debt:

Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Capital Employed = 27,40,000 + 1,09,60,000 – 68,50,000 = Rs.68,50,000
Debt Debt
Captial Gearing Ratio = ; 0.6 = ; Debt = 0.6 Equity
Equity Equity
Capital Employed = Debt + Equity = 0.6 Equity + Equity = 1.6 Equity
Capital Employed = 1.60 Equity = Rs. 68,50,000
68,50,000
Equity = = 𝑅𝑠. 42,81,250
1.60
Reserves and surplus = Total Equity – Share capital
Reserves and surplus = 42,81,250 – 25,00,000 = Rs.17,81,250
Long term debt = Capital employed – Equity
Long term debt = 68,50,000 – 42,81,250 = Rs.25,68,750

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Question No.: 9 (November 2012, May 2020 MTP)

The following accounting information and financial ratios of M Limited relate to the year ended 31 st March,
2012:
Particulars Amount
Inventory Runover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4 Times
Gross Profit Ratio 25%
Total sales Rs.30,00,000; Cash sales = 25% of credit sales; Cash Purchases 2,30,000; working capital = 2,80,000;
Closing inventory is Rs.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
Answer:
Note 1: Computation of Average Inventory:
Gross Profit = 25% of sales
COGS = 75% of sales = 75% x 30,00,000 = Rs.22,50,000
COGS
Inventory Turnover Ratio =
Average Inventory
22,50,000
6= ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 = 𝟑, 𝟕𝟓, 𝟎𝟎𝟎
Average Inventory

Note 2: Computation of Purchases:

COGS = Opening stock + Purchases – Closing stock
22,50,000 = (Opening stock – Closing stock) + Purchases
22,50,000 = -80,000 + Purchases; Purchases = Rs.23,30,000

Note 3: Computation of Average Debtors:

Cash Sales + Credit sales = Total sales
0.25 Credit sales + Credit sales = Total Sales
1.25 credit sales = Rs.30,00,000
Credit sales = (30,00,000/1.25) = Rs.24,00,000
Credit Sales
Debtors Turnover Ratio =
Average Debtors
24,00,000
8= ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬 = 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
Average Debtors

Note 4: Computation of Average Creditors:

Credit purchases = Total purchases – Cash Purchases
Credit Purchases = 23,30,000 – 2,30,000 = Rs.21,00,000
Credit Purchases
Creditors Turnover Ratio =
Average creditors
21,00,000
10 = ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬 = 𝐑𝐬. 𝟐, 𝟏𝟎, 𝟎𝟎𝟎
Average creditors

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Note 5: Computation of average payment period:
365 365
Average Payment Period = = = 36.50 days
Creditors Turnover Ratio 10

Note 6: Computation of Average Collection period:

365 365
Average Collection Period = = = 45.625 days
Debtors Turnover Ratio 8

Note 7: Computation of Current Assets and Current Liabilities:

Current Assets CA
Current Ratio = ; 2.4 = ; 𝐂𝐀 = 𝟐. 𝟒𝐂𝐋
Current Liabilities CL
Net working capital = 2,80,000; 𝐂𝐀 − 𝐂𝐋 = 𝟐, 𝟖𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2.4CL − CL = 2,80,000; 1.4CL = 2,80,000; 𝐂𝐋 = 𝐑𝐬. 𝟐, 𝟎𝟎, 𝟎𝟎𝟎
CA = 2,00,000 x 2.40 = Rs.4,80,000

Question No.: 10 (May 2013 exam – 5 Marks)

The following information relates to Beta Limited for the year ended 31 st 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:
a) Proprietor’s Fund
b) Fixed Assets
c) Net Profit Ratio
Answer:
Computation of fixed assets and Proprietor’s funds:
Fixed assets
= 0.75; 𝐅𝐀 = 𝟎. 𝟕𝟓𝐏𝐅
Proprietor ′ s funds
Capital Employed = Fixed Assets + Net working capital
PF = 0.75PF + 12,00,000; 0.25PF = 12,00,000; PF = Rs. 48,00,000
Fixed assets = 48,00,000 x 75% = Rs.36,00,000

Computation of Net profit ratio:

Net profit
ROE = 15%; = 15%; Net profit = 15% x 48,00,000 = 𝐑𝐬. 𝟕, 𝟐𝟎, 𝟎𝟎𝟎
Proprietor funds
Sales Sales
Working capital Turnover = ;5 = ; Sales = 𝐑𝐬. 𝟔𝟎, 𝟎𝟎, 𝟎𝟎𝟎
Working Capital 12,00,000
PAT 7,20,000
Net profit Ratio = x100 = x 100 = 12%
Sales 60,00,000

Question No.: 11 (November 2012 RTP)

The total credit sales of a company are Rs.12,80,000. It has a gross profit margin of 15% and a current ratio of
1.75.

Other information are as follows:

Current Liabilities Rs.1,92,000
Closing inventories Rs.96,000
Cash balance Rs.32,000
Inventory turnover 4 Times
Opening debtors Rs.4,32,000
You are required to calculate:

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• The average inventory to be carried by the company
• Average collection period
(Assume 360 days year)
Answer:
Note 1: Computation of average inventory:
• Total credit sales is Rs.12,80,000. It is assumed that there is no cash sales and hence total sales is
Rs.12,80,000
• Gross profit margin is 15% and hence GP is 15% of sales
• This would further mean that cost of goods sold is 85% of sales. COGS = 12,80,000 x 85% =
Rs.10,88,000
COGS
Inventory Turnover =
Average Stock
10,88,000 10,88,000
4= ; Average stock = = Rs. 2,72,000
Average Stock 4
Average inventory to be carried by the company = Rs.2,72,000

Note 2: Computation of average collection period:

Current Assets
Current ratio =
Current Liabilities
Current Assets
1.75 = ; Current Assets = Rs. 3,36,000
1,92,000
Current Assets = Cash + Closing inventory + Closing receivables
3,36,000 = 32,000 + 96,000 + Closing receivables
Closing receivables = Rs.2,08,000
4,32,000 + 2,08,000
Average receivables = = Rs. 3,20,000
2
Average Receivables
Average Collection Period = x 360
Credit Sales
𝟑, 𝟐𝟎, 𝟎𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐨𝐥𝐥𝐞𝐜𝐭𝐢𝐨𝐧 𝐏𝐞𝐫𝐢𝐨𝐝 = 𝐱 𝟑𝟔𝟎 = 𝟗𝟎 𝐝𝐚𝐲𝐬
𝟏𝟐, 𝟖𝟎, 𝟎𝟎𝟎

Question No.12 – May 2017, May 2022 RTP

Following information relate to a concern:
Debtors Velocity 3 months
Creditors Velocity 2 months
Stock Turnover Ratio 1.5 Times
Gross Profit Ratio 25%
Bills receivables Rs.25,000
Bills payables Rs.10,000
Gross Profit Rs.4,00,000
Fixed assets turnover ratio 4
Opening stock is Rs.10,000 is less than closing stock
Calculate:
(a) Sales and cost of goods sold
(b) Sundry debtors
(c) Sundry creditors
(d) Closing stock
(e) Fixed assets
Answer:
Note 1: Computation of sales and COGS:
Gross Profit 4,00,000
GP Ratio = ; 25% = ; 𝐒𝐚𝐥𝐞𝐬 = 𝐑𝐬. 𝟏𝟔, 𝟎𝟎, 𝟎𝟎𝟎
Sales Sales
• Cost of goods sold = Sales – Gross Profit
• Cost of Goods sold = 16,00,000 – 4,00,000 = Rs.12,00,000

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Note 2: Computation of sundry debtors:
3 3
Accounts receivables = Sales x = 16,00,000 𝑥 = 𝑅𝑠. 4,00,000
12 12
• Accounts’ receivable = Debtors + Bills’ receivables
• 4,00,000 = Debtors + 25,000; Debtors = Rs.3,75,000

Note 3: Computation of closing stock:

COGS 12,00,000
Stock Turnover Ratio = ; 1.5 = ; Average stock = 8,00,000
Average stock Average stock
• Let us assume closing stock as X and hence opening stock will be X – 10,000
Opening stock + Closing Stock
Average Stock =
2
X − 10,000 + X
8,00,000 = ; 16,00,000 + 10,000 = 2X; X = Rs. 8,05,000
2
• Hence closing stock is equal to Rs.8,05,000

Note 4: Computation of sundry creditors:

Opening stock + Purchases – Closing stock = COGS
7,95,000 + Purchase – 8,05,000 = 12,00,000; Purchases = Rs.12,10,000
2 2
Accounts payables = Purchases x = 12,10,000 x = Rs. 2,01,667
12 12
• Accounts’ payable = Creditors + Bills’ payable
• 2,01,667= Creditors + 10,000; Creditors= Rs.1,91,667

Note 5: Computation of fixed assets:

Fixed Assets Turnover Ratio = 4
Sales 16,00,000
= 4; = 4; 𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 = 𝐑𝐬. 𝟒, 𝟎𝟎, 𝟎𝟎𝟎
Fixed Asssets Fixed Assets

Question No.13 – Nov 2018

The following is the information of XML Limited relate to the year ended 31 st March 2018:
Gross profit 20% of sales
Net Profit 10% of sales
Inventory Holding Period 3 months
Receivables collection period 3 months
Non-current Assets to Sales 1:4
Non-current assets to current assets 1:2
Current Ratio 2:1
Non-current liabilities to current liabilities 1:1
Share capital to reserves and surplus 4:1
Non-current assets as on 31st March, 2017 Rs.50,00,000
Assume that:
• No change in non-current assets during the year 2017-18
• No depreciation charged on non-current assets during the year 2017-18
• Ignoring tax
You are required to calculate cost of goods sold, Net Profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018
Answer:
Note 1: Computation of Current Assets:
Non − Current assets 2 50,00,000
= ; =2
Current Assets 1 Current Assets
Current Assets = 2 x 50,00,000 = Rs.1,00,00,000

Note 2: Computation of Sales:

Note 1: Computation of Current Assets:
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Non − Current assets 1 50,00,000
= ; =4
Sales 4 Sales
Sales = 4 x 50,00,000 = Rs.2,00,00,000

Note 3: Computation of Cost of Goods Sold:

Gross Profit = 20% of sales; COGS = 80% of sales
COGS = 80% x 2,00,00,000 = Rs.1,60,00,000

Note 4: Computation of Net Profit:

Net Profit = 10% of sales = 10% x 2,00,00,000 = Rs. 20,00,000

Note 5: Computation of inventory:

3 3
Inventory = COGS x = 1,60,00,000 x = Rs. 40,00,000
12 12

Note 6: Computation of receivables:

3 3
Receivables = Sales x = 2,00,00,000 x = Rs. 50,00,000
12 12

Note 7: Computation of cash:

• It is assumed that current assets contain only inventory, receivables and cash
• Current assets = Inventory + Receivables + Cash
• 1,00,00,000 = 40,00,000 + 50,00,000 + Cash
• Cash = Rs.10,00,000

Question No.14 – May 2021 MTP:

Compute the return on capital employed (total asset basis) from the following information relating to
companies X and Y.
Particulars Company X Company Y
Net sales for the year 3,25,000 ?
Total Assets ? 55,500
Net profit on sales 4% 17%
Turnover of total assets 5 Times ?
Gross Margin 38% 5,720 (25%)

Answer:
Computation of Return on capital employed:
EBIT
ROCE = x 100
Capital Employed
• In this question Net profit will be taken as proxy for EBIT
• Total assets will be taken as capital employed as indicated in question

Particulars Company X Company Y

Gross Profit 1,23,500 5,720
[3,25,000 x 38%]
Sales 3,25,000 22,880
[5,720 /25%]
Asset Turnover ratio 5 Time 0.41
[Sales/Assets] [22,880/55,550]
Total Assets 65,000 55,550
[Sales/Asset Turnover Ratio] [3,25,000/5]
Net Profit 13,000 3,890
[Sales x Net profit margin] [3,25,000 x 4%] [22,880 x 17%]
ROCE 20.00% 7.00%
[Net profit/Total Assets] [13,000/65,000] [3,890/55,550]

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Question No.15 – Nov 2020, Nov 2019 MTP:
MNP Limited has made plans for the next year 2010 -11. It is estimated that the company will employ total
assets of Rs. 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 Rs..15,00,000 and all other operating expenses are estimated at Rs. 2,40,000. The sales
revenue are estimated at Rs. 22,50,000. Tax rate is assumed to be 40%. Required to calculate:
(i) Net profit margin;
(ii) Return on Assets;
(iii) Asset turnover; and
(iv) Return on Equity.
Answer:
WN 1: Income statement of MNP Limited
Particulars Calculation Amount
Sales 22,50,000
Less: Direct cost -15,00,000
Less: Other operating expenses -2,40,000
EBIT 5,10,000
Less: Interest 25,00,000 x 30% x 9% -67,500
EBT 4,42,500
Less: Tax @ 40% 4,42,500 x 40% -1,77,000
EAT 2,65,500

WN 2: Solution:
Note 1: Computation of Net Profit Margin:
Net Profit 2,65,500
Net Profit Margin = x 100 = 𝑥 100 = 11.80%
Sales 22,50,000

Note 2: Computation of Return on assets:

PAT 2,65,500
ROA = x 100 = 𝑥 100 = 10.62%
Total Assets 25,00,000

Note 3: Computation of Asset Turnover:

Sales 22,50,000
Asset Turnover = = = 0.90 Times
Total Assets 25,00,000

Note 4: Computation of Return on Equity:

PAT 2,65,500
ROE = x 100 = 𝑥 100 = 15.17%
Total Equity 17,50,000

Question No.16 – Nov 2018

A Limited company’s books reveal following information:
Particulars Amount
Net income Rs.3,60,000
Shareholders’ equity Rs.4,00,000
Assets Turnover 2.5 Times
Net Profit Margin 12%
You are required to calculate ROE (Return on Equity) of the company based on the ‘Dupont Model’.
Answer:
PAT 3,60,000
ROE as per normal formula = x 100 = x 100 = 90%
Equity 4,00,000

ROE as per Dupont Model:

ROE = Net profit margin x Assets Turnover x Equity Multiplier
𝐑𝐎𝐄 = 𝟏𝟐% 𝐱 𝟐. 𝟓𝟎 𝐱 𝟑 = 𝟗𝟎%

Note: Computation of equity multiplier:

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Computation of sales:
Net profit 3,60,000
= 0.12; = 0.12; Sales = Rs. 30,00,000
sales Sales
Computation of total assets:
Sales 30,00,000 30,00,000
Asset Turnover = 2.5; = 2.5; = 2.5; Assets = = Rs. 12,00,000
Assets Assets 2.5
Computation of Equity Multiplier
Assets 12,00,000
Equity Multiplier = = = 3 Times
Equity 4,00,000

Question No.17 – November 2016 RTP, November 2018 RTP

Assuming the current ratio of a company is 2, State in each of the following cases whether the ratio will
improve or decline or will have no change:
a) Payment of current liability
b) Purchase of fixed assets by cash
c) Cash collected from customers
d) Bills receivable dishonoured
e) Issue of new shares
Answer:
Current ratio is currently 2 Times. Let us assume current assets is Rs.2,00,000 and current liabilities is
Rs.1,00,000
S.No Situation Impact Reason
(i) Payment of Improve • Let us assume we have paid cash of Rs.20,000
current liability • Current assets will decline to Rs.1,80,000 and current
liabilities will decline to Rs.80,000 and hence ratio will
improve to 2.25 Times (1,80,000/80,000)
(ii) Purchase of fixed Decline • Let us assume we have paid cash of Rs.20,000
assets by cash • Current assets will decline to Rs.1,80,000 and current
liabilities will remain at Rs.1,00,000 and hence ratio will
decline to 1.80 Times (1,80,000/1,00,000)
(iii) Cash collected No • Let us assume we collected cash of Rs.20,000
from customers change • Current assets will remain same at Rs.2,00,000 and current
liabilities will also remain same. Hence no change in current
ratio
(iv) Bills receivable No • Bills receivable will come down and sundry debtors will
dishonoured change increase
• Hence no change in current assets and current liabilities
(v) Issue of New Improve • Cash will increase and hence current assets will increase
shares • This would lead to improvement in current ratio

Question No.: 18 (May 2012 exam)

Explain the important ratios that would be used in each of the following situations:
(a) A bank is approached by a company for a loan of RS.50 lacs for working capital purposes
(b) A long-term creditor interested in determining whether his claim is adequately secured
(c) A shareholder who is examining his portfolio and who is to decide whether he should hold or sell
his holding in the company
(d) A finance manager interested to know the effectiveness with which a firm uses its available resources
Answer:
Important Ratios used in different situations
(i) Liquidity Ratios- Here Liquidity or short-term solvency ratios would be used by the bank to check the
ability of the company to pay its short-term liabilities. A bank may use Current ratio and Quick ratio to judge
short terms solvency of the firm.
(ii) Capital Structure/Leverage Ratios- Here the long-term creditor would use the capital structure/leverage
ratios to ensure the long term stability and structure of the firm. A long-term creditor interested in the
determining whether his claim is adequately secured may use Debt-service coverage and interest coverage
ratio.

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(iii) Profitability Ratios- The shareholder would use the profitability ratios to measure the profitability or
the operational efficiency of the firm to see the final results of business operations. A shareholder may use
return on equity, earning per share and dividend per share.
(iv) Activity Ratios- The finance manager would use these ratios to evaluate the efficiency with which the
firm manages and utilises its assets. Some important ratios are (a) Capital turnover ratio (b) Current and fixed
assets turnover ratio (c) Stock, Debtors and Creditors turnover ratio.

Question No.19 – November 2017 RTP

From the following table of financial ratios of R. Textiles Limited, comment on various ratios given at the
end:
Ratios 2017 2018 Average of Textile Industry
Liquidity Ratios:
Current Ratio 2.2 2.5 2.5
Quick Ratio 1.5 2.0 1.5
Receivables turnover ratio 6 6 6
Inventory Turnover ratio 9 10 6
Receivables collection period 87 days 86 days 85 days
Operating Profitability
Operating income – ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing Decisions
Debt Ratio 49.00% 48.00% 57.00%
Return
Return on equity 24% 25% 15%
Comment on the following aspect of R. Textiles Limited:
(a) Liquidity
(b) Operating profits
(c) Financing
(d) Return to the shareholders
Answer:
Ratios Comment
Liquidity • Current ratio improved from last year and matching the industry average
• Quick ratio also improved than last year and above the industry average. This
may happen due to reduction in receivable collection period and quick inventory
turnover. However, this ratio indicates idleness of funds
• Overall, it is reasonably good. All the liquidity ratios are either better or same in
both the years compared to the industry average
Operating profits • Operating income-ROI reduced from last year but operating profit margin has
been maintained. This may happen due to variability of cost on turnover.
However, both the ratio are still higher than the industry average
Financing • The company has reduced its debt capital by 1% and saved operating profit for
equity shareholders. It also signifies that dependency on debt compared to other
industry players (57%) is low
Return to the • R’s ROE is 24 percent in 2017 and 25 percent in 2018 compared to an industry
shareholders average of 15 percent. The ROE is stable and improved over the last year

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CHAPTER 4: COST OF CAPITAL

Cost of irredeemable debt:

Interest after tax
Cost of irredeemable debt =
Net Proceeds
Interest after tax = Interest * (1 – Tax Rate);
Interest = Interest rate * Face value
Net proceeds:
❖ New issue = Issue Price – Floatation cost
❖ Existing issue = Current Market Price

Cost of redeemable debt using approximation method:

Interest after tax + Average other Costs
Cost of redeemable debt =
Average Funds Employed
Redeemable value − Net Proceeds
Average Other costs =
Balance Life
Redeemable value + Net Proceeds
Average Funds Employed =
2

Cost of redeemable debt using Yield to Maturity (YTM) method:

Step 1: Calculate cash flows associated with the debt instrument
Step 2: Discount the cash flows at an initial guess rate and calculate NPV
Step 3: Increase the rate in case NPV is Positive and decrease the rate in case NPV is Negative.
Step 4: Repeat step 3 till we get one positive and one negative NPV
Step 5: Calculate IRR. The calculated IRR is the cost of debt

Cost of convertible debt:

Interest after tax + Average other Costs
Cost of convertible debt =
Average Funds Employed
Redeemable value = Higher of debt redemption value or fair value of equity post conversion

Cost of irredeemable preference share:

Preference Dividend
Cost of irredeemable preference Shares =
Net Proceeds
Preference Dividend = Preference Dividend (%) * Face value
Net proceeds:
❖ New issue = Issue Price – Floatation cost
❖ Existing issue = Current Market Price

Cost of redeemable preference share capital:

Preferece Dividend + Average other Costs
Cost of redeemable preference shares =
Average Funds Employed
Redeemable value − Net Proceeds
Average Other costs =
Balance Life
Redeemable value + Net Proceeds
Average Funds Employed =
2

Cost of Equity:
Dividend Price Approach with Under this situation the amount of dividend remains constant. The cost
no growth in dividend [May of equity is calculated with the help of formula for PV for Perpetuity.
2019 MTP, Nov 2006] Dividend
Cost of Equity =
CMP − Floatation cost

Dividend Price Approach with Under this approach the rate of dividend growth remains constant. The
constant growth in dividend cost of equity is calculated with the help of formula for PV for growing
[May 2019 MTP] Perpetuity
D1
Ke = + Growth rate
P0 − F
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Where D1 = Dividend of next year;
P0 = Current market price; F = Floatation cost
Earnings/Price Approach with Earnings
Ke =
constant earnings P0 − F
Earnings/Price Approach with E1
Ke = + Growth rate
growth in earnings [Nov 2006] P0 − F
Where E1 = Earnings of next year; P0 = Current market price; F =
Floatation cost
Realized yield approach Under this method the cost of equity is calculated on the basis of past
dividend and capital appreciation. We need to find out the cash flows
and compute the IRR. The computed IRR is the cost of equity as per
realized approach
CAPM Approach Cost of Equity = Rf + Beta * (Rm – Rf)
Where Rf = Risk-free rate of return and Rm = Market return

Computation of growth rate:

Point to Under this method the dividend of intervening years is ignored and the growth rate is
Point ascertained. The dividend of first year is taken as present value and the dividend of last year
Method is taken as future value. Compute the present value factor using present value and future
value. Identify the rate of interest corresponding to the computed PVAF. The identified rate
of interest is the growth rate
Using Growth rate = Retention ratio x Return on Equity
retention Retained earnings
Retention ratio =
ratio Total Earnings

Cost of Retained Earnings:

❖ The cost of retained earnings is often interchangeably with the cost of equity, as cost of retained
earnings is nothing but the expected return of the shareholders from the investment in the company
❖ Cost of retained earnings can sometimes be lower than cost of equity due to savings in floatation cost
and existence of personal tax
Existence of floatation costs: P0 – F is replaced with P0 in the formula for cost of equity
Personal taxes and floatation costs:
Cost of retained earnings (Kr) = [Ke x (1 – Personal Tax Rate)] – Floatation cost%

Weighted Average Cost of Capital:

Steps in computation of WACC:
❖ Step 1: Compute the cost of individual components of capital
❖ Step 2: Assign weights and compute WACC using the following format
Source Cost Weight Product
Book Value Market Value Book value Market Value
External equity
Debt
Preference
Retained earnings
Term Loan
Total

Sum of Products
WACC =
Sum of weights

Question No.1 (November 2016, Nov 2021 MTP)

ABC Company’s equity share is quoted in the market at Rs.25 per share currently. The company pays a
dividend of Rs.2 per share and the investor’s market expects a growth rate of 6% per year. You are required
to:
(a) Calculate the company’s cost of equity capital

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(b) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share
(c) If the company issues 10% debentures of face value of Rs.100 each and realizes Rs.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%
Answer:
Part (a):
Basic information:
Dividend of next year Rs.2
CMP/Issue price Rs.25
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟐
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟖 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟒(𝐨𝐫)𝟏𝟒. 𝟎𝟎%
𝟐𝟓 − 𝟎
• Company’s cost of capital = 14.00%
Note:
• It is assumed that dividend of Rs.2 is next year dividend

Part (b):
D1
Ke = + Growth rate
P0 − F
2 2
0.14 = + 0.08; 0.06 =
P0 − 0 P0
𝟐
𝐏𝟎 = = 𝐑𝐬. 𝟑𝟑. 𝟑𝟑 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝟎. 𝟎𝟔

Part (c):
Cost of debt:
Type of debt Redeemable
Face value Rs.100 (assumed)
Coupon rate 10%
Tax rate 50%
Net proceeds Issue price – FC = Rs.96
Redeemable value Rs.112
Balance life 12 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
112 − 96
5+ 5.00 + 1.33
Kd = 12 = x 100 = 6.08%
112 + 96 104.00
2

Question no.2 – November 2015

A company issues 1,000,000 12% debentures of Rs.100 each. The debentures are redeemable after the expiry
of fixed period of 7 years. The company is in 35% tax bracket.
• Calculate cost of debt after tax, if debentures are issued at i) Par ii) 10% discount and iii) 10%
premium
• If brokerage is paid at 2% what will be the cost of debentures, if issue is at par
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Answer:
Basic information
Particulars Situation 3A Situation 3B Situation 3C Situation 3D
Type of debt Redeemable Redeemable Redeemable Redeemable
Face value Rs.100 Rs.100 Rs.100 Rs.100
Coupon rate 12% 12% 12% 12%
Tax rate 35% 35% 35% 35%
Net proceeds = 100 – 0 = 90 – 0 = 110 – 0 = 100 – 2
(Issue price – FC) = 100 = 90 = 110 = 98
Redeemable value Rs.100 Rs.100 Rs.100 Rs.100
(assumed at par)
Balance life 7 years 7 years 7 years 7 years

Computation of Cost of Debt:

Redeemable value − Net proceeds
(Interest after tax + )
Balance life
Interest after tax + Average other costs Redeemable value + Net Proceeds
Kd = =
Average funds employed 2
100 − 100
(7.8 + )
7
100 + 100 7.8 + 0
Situation 3A = = x 100 = 7.8%
2 100
100 − 90
(7.8 + )
7
100 + 90 7.8 + 1.43
Situation 3B = = x 100 = 9.72%
2 95
100 − 110
(7.8 + )
7
100 + 110 7.8 − 1.43
Situation 3C = = x 100 = 6.07%
2 105
100 − 98
(7.8 + )
7
100 + 98 7.8 + 0.29
Situation 3D = = x 100 = 8.17%
2 99

Question No.: 3 (May 2013 exam – 5 Marks)

A company issued 40,000, 12% Redeemable Preference Share of Rs. 100 each at a premium of Rs. 5 each,
redeemable after 10 years at a premium of Rs. 10 each. The floatation cost of each share is Rs. 2. You are
required to calculate cost of preference share capital with dividend distribution tax of 20%.
Answer:
Basic information
Type of preference Redeemable
Face value Rs.100
Coupon rate 12%
Issue price – Floatation cost
Net proceeds 105 – 2 = Rs.103
Redeemable value Rs.110
Balance life 10 years
Dividend distribution tax 20%

Computation of Cost of preference:

RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
110 − 103
14.40 + 14.40 + 0.70
Kp = 10 = x 100 = 14.18%
110 + 103 106.50
2

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Question No.4 – May 2017 RTP
XYZ Limited is currently earning a profit after tax of Rs.25,00,000 and its shares are quoted in the market at
Rs.450 per share. The company has 1,00,000 shares outstanding and has not raised debt in its capital structure.
It is expected that the same level of earnings will be maintained for future years also. The company has 100
percent pay-out policy.
Required:
(a) Calculate the cost of equity
(b) If the company’s payout ratio is assumed to be 70% and it earns 20% rate of return on its investment,
then what would be the firm’s cost of equity?
Answer:
WN 1: Computation of cost of equity for original scenario:
Basic information:
Dividend of next year 25,00,000/1,00,000 = Rs.25 per share
CMP/Issue price Rs.450 per share
IRR/ROE/ROI NA
100% - Payout ratio
Retention ratio 100% - 100% = 0%
Growth rate 0%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟐𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟎 = 𝟎. 𝟎𝟓𝟓𝟔 + 𝟎. 𝟎𝟎 = 𝟎. 𝟎𝟓𝟓𝟔(𝐨𝐫)𝟓. 𝟓𝟔%
𝟒𝟓𝟎 − 𝟎

WN 2: Computation of cost of equity for rework scenario:

Basic information:
Dividend of next year 25 x 70% = Rs.17.50 per share
CMP/Issue price Rs.450 per share
IRR/ROE/ROI 20%
100% - Payout ratio
Retention ratio 100% - 70% = 30%
IRR x Retention ratio
Growth rate 20% x 30% = 6%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏𝟕. 𝟓𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟑𝟖𝟗 + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟗𝟖𝟗(𝐨𝐫)𝟗. 𝟖𝟗%
𝟒𝟓𝟎 − 𝟎

Question No.5 – May 2018

JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of Rs. 20 and proposes
to pay 60% dividend at the current year end. With a PIE ratio 6.25, it wants to offer the issue at market price.
The flotation cost is expected to be 4% of the issue price.

Required: Determine the required rate of return for equity share (cost of equity) before the issue and after the
issue
Answer:
• Required rate of return on equity is basically cost of equity.

Computation of return on equity before the issue:

Dividend of next year 20 x 60% = Rs.12
CMP/Issue price Rs.125 [ refer note]
IRR/ROE/ROI 16% (refer note)
Retention ratio 100% - 60% = 40%
Growth rate 16% x 40% = 6.4%

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Floatation cost 0
Note:
Computation of price:
MPS MPS
PE Multiple = ; 6.25 = ; MPS = 125
EPS 20

EPS 20
ROE = ; ROE = ; ROE = 0.16 (or)16%
Book value per share 125
• It is assumed that book value per share and market value per share is same.

D1
Ke = + Growth rate
P0 − F
𝟏𝟐
𝐊𝐞 = + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟎𝟗𝟔 + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟔(𝐨𝐫)𝟏𝟔. 𝟎𝟎%
𝟏𝟐𝟓 − 𝟎

Computation of return on equity after the issue:

Dividend of next year 20 x 60% = Rs.12
CMP/Issue price Rs.125
IRR/ROE/ROI 16%
Retention ratio 100% - 60% = 40%
Growth rate 16% x 40% = 6.4%
Floatation cost 125 x 4% = Rs.5
D1
Ke = + Growth rate
P0 − F
𝟏𝟐
𝐊𝐞 = + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟔𝟒(𝐨𝐫)𝟏𝟔. 𝟒𝟎%
𝟏𝟐𝟓 − 𝟓

Question No.6 [May 2019 MTP]

Annova Limited is considering raising of funds of about Rs.250 lakhs by any of two alternative methods, 14%
institutional term loan and 13% non-convertible debentures. The term loan option would attract no major
incidental cost and can be ignored. The debentures would have to be issued at a discount of 2.5% and would
involve cost of issue of 2% on face value. Advise the company as to the better option based on the effective
cost of capital in each case. Assume a tax rate of 50%
Answer:
Computation of cost of term loan:
Cost of term loan = Interest rate x (1 – Tax rate) = 14% x (1 – 50%) = 7.00%

Computation of cost of NCD:

Basic information
Type of debt Irredeemable
Face value Rs.100 (assumed)
Coupon rate 13%
Tax rate 50%
= Issue price – Floatation cost
Net proceeds = 97.50 – 2.00 = Rs.95.50
Redeemable value NA
Balance life NA

Interest after tax 6.50

Kd = = x 100 = 6.81%
Net proceeds 95.50

Conclusion:
The company should go ahead with NCD option as the cost of NCD is lower than cost of term loan.

Question No.7 – Nov 2020:

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TT Ltd. issued 20,000, 10% convertible debenture of Rs. 100 each with a maturity period of 5 years. At
maturity the debenture holders will have the option to convert debentures into equity shares of the company
in ratio of 1:5 (5 shares for each debenture). The current market price of the equity share is Rs. 20 each and
historically the growth rate of the share is 4% per annum. Assuming tax rate is 25%. Compute the cost of 10%
convertible debenture using Approximation Method and Internal Rate of Return Method
PV Factors are as under:
Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497
Answer:
Basic information
Type of debt Redeemable and convertible
Face value Rs.100
Coupon rate 10%
Tax rate 25%
Issue price – Floatation cost
Net proceeds 100 – 0 = Rs.100
Redeemable value Rs.121.67 (Note 1)
Balance life 5 years
Note 1: Computation of redeemable value:
• Debenture holder at the expiry of five years has the option to convert debentures into shares or
redeem the same
• Redeemable value will be higher of the following:
o Conversion into equity: One debenture will be converted into 5 equity shares. Current
market price of one equity share is Rs.20. Equity shares will grow at 4 percent and expected
price per share in year 5 is Rs.24.333 (20x (1.05) 5). Value of 5 shares received on redemption
is equal to Rs.121.67
o Redemption as debt: Debenture can be redeemed and debenture holder receive Rs.100

Computation of Cost of Debt:

Approximation method:
RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
121.67 − 100
7.50 + 7.50 + 4.334
Kd = 5 = x 100 = 10.676%
121.67 + 100 110.835
2

IRR Method:
Year Cash flow PVF @ 10% DCF PVF @ 15% DCF
0 -100.00 -1.000 -100.000 -1.000 -100.000
1 to 5 7.50 3.790 28.425 3.353 25.148
5 121.67 0.621 75.557 0.497 60.470
NPV +3.982 -14.382
𝟑. 𝟗𝟖𝟐
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟏𝟎 + [ 𝐱 (𝟏𝟓 − 𝟏𝟎)] = 𝟏𝟎 + 𝟏. 𝟎𝟖𝟒 = 𝟏𝟏. 𝟎𝟖𝟒%
𝟑. 𝟗𝟖𝟐 − (−𝟏𝟒. 𝟑𝟖𝟐)

Question No.8 – May 2021 MTP

Development Finance Corporation issued zero interest deep discount bonds of face value of Rs. 1,50,000 each
issued at Rs. 3,750 & repayable after 25 years. COMPUTE the cost of debt if there is no corporate tax.
Answer:
In case of zero interest deep discount bond, the company does not pay any interest and hence we cannot
analyze the same under our normal formula. We have to compute IRR for the cash flow. We have to start

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with a trial rate and then increase/decrease the same till we get one positive and one negative NPV to
compute IRR [Concept of IRR will be explained in investment decision chapter]

IRR computation:
Year Cash flow PVF @ 15% DCF PVF @ 16% DCF
0 -3,750 -1.000000 -3,750 -1.000000 -3,750
25 1,50,000 0.030378 4,556.7 0.024465 3,669.75
NPV 806.70 -80.25
Note: YTM approach is basically computing the IRR of the instrument. Normally we have an outflow in IRR
approach on day 0 and hence the first cash flow has been taken as outflow and other cash flows are taken as
inflows to compute IRR. The answer would remain same even if 3,750 is taken as inflow and 1,50,000 is taken
as outflow.
𝟖𝟎𝟔. 𝟕𝟎
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟏𝟓 + [ 𝐱 (𝟏𝟔 − 𝟏𝟓)] = 𝟏𝟓 + 𝟎. 𝟗𝟏 = 𝟏𝟓. 𝟗𝟏%
𝟖𝟎𝟔. 𝟕𝟎 − (−𝟖𝟎. 𝟐𝟓)

Question No.9 [Nov 2020 MTP, Nov 2018 MTP, Nov 2019 RTP, May 2020 MTP, May 2020 RTP, Nov 2010]
JKL Ltd. has the following book-value capital structure as on March 31, 2003.
Particulars Amount
Equity share capital (2,00,000 shares) 40,00,000
11.5% preference shares 10,00,000
10% debentures 30,00,000
Total 80,00,000
The equity share of the company sells for Rs. 20. It is expected that the company will pay next year a dividend
of Rs. 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 Rs. 20 lakhs debt by issuing 12%
debentures. This would result in increasing the expected equity dividend to Rs. 2.40 and leave the growth
rate unchanged, but the price of equity share will fall to Rs. 16 per share.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.2.00 per share
CMP/Issue price Rs.20 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 5 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟐. 𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟓(𝐨𝐫)𝟏𝟓. 𝟎𝟎%
𝟐𝟎. 𝟎𝟎

Cost of preference:
Cost of preference = Rate of dividend on preference shares = 11.50%

Cost of debentures:
Cost of debentures = Interest rate x (1 – tax rate) = 10% x (1 – 35%) = 6.50%

WN 2: Computation of WACC based on existing capital structure:

Source Cost Weight Product
Equity 15.00% 40,00,000 6,00,000

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Preference 11.50% 10,00,000 1,15,000
Debentures 6.50% 30,00,000 1,95,000
Total 80,00,000 9,10,000
Sum of product 9,10,000
WACC = = x 100 = 𝟏𝟏. 𝟑𝟕𝟓%
sum of weights 80,00,000

WN 3: Computation of revised WACC with new borrowings:

Cost of equity:
𝟐. 𝟒𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟓 + 𝟎. 𝟎𝟓 = 𝟎. 𝟐𝟎(𝐨𝐫)𝟐𝟎. 𝟎𝟎%
𝟏𝟔. 𝟎𝟎

• Cost of preference (no change) = 11.50%

• Cost of debentures (no change) = 6.50%
• Cost of new debt = 12% x (1 – 35%) = 7.80%

WN 4: Computation of revised WACC based on new capital structure:

Weight Product
Source Cost BV MV BV MV
32,00,000
Equity 20.00% 40,00,000 [2 lacs x 16] 8,00,000 6,40,000
Preference capital 11.50% 10,00,000 10,00,000 1,15,000 1,15,000
Existing debt 6.50% 30,00,000 30,00,000 1,95,000 1,95,000
New debt 7.80% 20,00,000 20,00,000 1,56,000 1,56,000
Total 1,00,00,000 92,00,000 12,66,000 11,06,000
Sum of product 12,66,000
WACC(based on BV weights) = = x 100 = 12.66%
sum of weights 1,00,00,000
Sum of product 11,06,000
WACC(based on MV weights) = = x 100 = 12.02%
sum of weights 92,00,000

Question No.10 [May 2018 MTP, May 2019 RTP, Nov 2020 MTP]
XYZ Ltd., has the following book value capital structure:
Equity Capital (in Shares of Rs.10 each, fully paid up-at par) Rs.15 Crores
11% preference Capital (in shares of Rs.100 each, fully paid up – at par) Rs.1 Crore
Retained Earnings Rs.20 Crores
13.5% Debentures (of Rs.100 each) Rs.10 Crores
15% Term Loans Rs.12.5 Crores
• The next expected dividend on equity shares per share is Rs.3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs.40.
• Preference stock, redeemable after ten years, is currently selling at Rs.75 per share.
• Debentures, redeemable after six years, are selling at Rs.80 per debenture.
• The Income-tax rate for the company is 40%.
(i) Required:
Calculate the weighted average cost of capital 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 Rs.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 Rs.1.5 Crores earnings next year:
(c) The additional issue of equity shares will result in the net price per share being fixed at Rs.32;
(d) The debt capital raised by way of term loans will cost 15% for the first Rs.2.5 Crores and 16% for the next
Rs.2.5 Crores.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:

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Basic information:
Dividend of next year Rs.3.60 per share
CMP/Issue price Rs.40 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 7 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟑. 𝟔𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟕 = 𝟎. 𝟎𝟗 + 𝟎. 𝟎𝟕 = 𝟎. 𝟏𝟔(𝐨𝐫)𝟏𝟔. 𝟎𝟎%
𝟒𝟎 − 𝟎

Cost of preference:
Basic information
Type of preference Redeemable
Face value Rs.100
Coupon rate 11%
Net proceeds Current market price = Rs.75
Redeemable value Rs.100 (assumed at par)
Balance life 10 years
Dividend distribution tax 0
Computation of Cost of preference:
RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 75
11.00 + 11.00 + 2.50
Kp = 10 = x 100 = 15.43%
100 + 75 87.50
2

Cost of retained earnings:

• Cost of retained earnings will be same as cost of equity. Cost of retained earnings = 16%

Cost of debentures:
Basic information:
Type of debt Redeemable
Face value Rs.100
Coupon rate 13.50%
Tax rate 40%
Net proceeds Current market price = Rs.80
Redeemable value Rs.100 (assumed at par)
Balance life 6 years
Computation of Cost of Debt:
RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
100 − 80
8.10 + 8.10 + 3.33
Kd = 6 = x 100 = 12.70%
100 + 80 90
2

Cost of term loan:

Cost of term loan = Interest rate x (1 – Tax rate)
Cost of term loan = 15% x (1 – 40%) = 9.00%
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WN 2: Computation of WACC
Weight (in lacs) Product (in lacs)
Source Cost BV MV BV MV
Equity 16.00% 1,500 2,571 240.00 411.36
75
Preference capital 15.43% 100 [1 lac x 75] 15.43 11.57
Retained earnings 16.00% 2,000 3,429 320.00 548.64
800
Debentures 12.70% 1,000 [10 lac x 80] 127.00 101.60
Term loan 9.00% 1,250 1,250 112.50 112.50
Total 5,850 8,125 814.93 1,185.67
• Market value of equity shares = 150 lacs shares x 40 = 6,000 lacs. This has been split in the ratio of
3:4 to get value of equity and retained earnings.

WACC Computation:
Sum of product 814.93
WACC(based on BV weights) = = x 100 = 13.93%
sum of weights 5,850
Sum of product 1,185.67
WACC(based on MV weights) = = x 100 = 14.59%
sum of weights 8,125

WN 3: Computation of WMCC:
Part 1: Money to be raised:
Money to be
raised = 10 Cr

Equity = Debt = 5
5cr cr

Int equity 15% debt

= 1.5 Cr = 2.5 cr

Ext equity 16% debt

= 3.5 cr = 2.5 cr
Part 2: Cost of components of capital:
Cost of retained Retained earnings is already available with company and hence its cost will
earnings continue to be 16%
Cost of equity D1 𝟑. 𝟔𝟎
Ke = + Growth rate = + 𝟎. 𝟎𝟕 = 𝟎. 𝟏𝟏𝟐𝟓 + 𝟎. 𝟎𝟕 = 𝟏𝟖. 𝟐𝟓%
P0 − F 𝟑𝟐
Cost of 15% debt Interest rate x (1 – Tax rate) = 15 x (1 – 0.4) = 9%
Cost of 16% debt 16 x (1 – 0.4) = 9.6%

Part 3: WMCC computation and Schedule:

Source Cost Weight (in lacs) Product (in lacs)
Retained earnings 16.00% 150 24.00
Equity 18.25% 350 63.88
15% debt 9.00% 250 22.50
16% debt 9.60% 250 24.00
Total 1,000 134.38
Sum of product 134.38
WMCC = = x 100 = 𝟏𝟑. 𝟒𝟒%
sum of weights 1,000
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Question No.: 11 (November 2014 RTP)

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 Rs.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 EPS (Rs.) 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
(Rs.) 1.00 1.120 1.254 1.405 1.574 1.762 1.974 2.211 2.476 2.773

The company can issue 14 percent new debenture. The company’s debenture is currently selling at Rs.98. The
new preference issue can be sold at a net price of Rs.9.80, paying a dividend of Rs.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 earnings available for next year’s investment are 50% of 2004 earnings
(iv) What will be marginal cost of capital (cost of funds raised in excess of the amount calculated in part (iii))
if the company can sell new ordinary shares to net Rs.20 per share? The cost of debt and of preference capital
is constant.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of debt:
Basic information
Type of debt Irredeemable
Face value Rs.100
Coupon rate 14%
Tax rate 50%
Issue price – floatation cost
Net proceeds 100 (assumed at par) – 0 = Rs.100
Redeemable value NA
Balance life NA
Interest after tax 7
Kd = = x 100 = 7.00%
Net proceeds 100

Cost of preference:
Basic information
Type of preference Irredeemable
Dividend Rs.1.20 per share
Net proceeds Rs.9.80 per share
Redeemable value NA
Balance life NA
Computation of Cost of Preference:
Preference Dividend 1.20
Kp = = x 100 = 12.24%
Net proceeds 9.80

Cost of ordinary equity (new equity comes from retained earnings)

Basic information:
Dividend of next year 2.773 x 50% = 1.3865 per share
CMP/Issue price Rs.27.75 per share
IRR/ROE/ROI NA

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Retention ratio NA
Growth rate 12% [Increase in dividend is 12% every year]
Floatation cost 0
D1
Kr = + Growth rate
P0
𝟏. 𝟑𝟖𝟔𝟓
𝐊𝐫 = + 𝟎. 𝟏𝟐 = 𝟎. 𝟎𝟓 + 𝟎. 𝟏𝟐 = 𝟎. 𝟏𝟕(𝐨𝐫)𝟏𝟕. 𝟎𝟎%
𝟐𝟕. 𝟕𝟓

WN 2: Marginal cost of capital schedule:

• The company is currently operating with an optimum capital structure. This would mean that any
fresh money would be raised in the same proportion
• Weight of debentures = (3,60,000/24,00,000) x 100 = 15.00%
• Weight of Preference = (1,20,000/24,00,000) x 100 = 5.00%
• Weight of equity = (19,20,000/24,00,000) x 100 = 80.00%
Source Cost Weight (in %) Product
Debentures 7.00% 15 1.05
Preference 12.24% 5 0.61
Equity 17.00% 80 13.60
Total 100 15.26
Sum of product 15.26
WMCC = = x 100 = 𝟏𝟓. 𝟐𝟔%
sum of weights 100

WN 3: Computation of possible investment with retained earnings:

Particulars Amount
EPS of 2004 2.773
No of equity shares 2,00,000
Total earnings of 2004 (2.773 x 2,00,000) 5,54,600
Retained earnings of 2004 (5,54,600 x 50%) 2,77,300
Weight of equity in capital structure 80%
Possible investment with retained earnings (2,77,300/80%) 3,46,625

WN 4: Marginal cost of capital schedule (for investment beyond 3,46,625):

Source Cost Weight (in %) Product
Debentures 7.00% 15 1.05
Preference 12.24% 5 0.61
18.93%
Equity [Note] 80 15.14
Total 100 16.80
Sum of product 16.80
WMCC = = x 100 = 𝟏𝟔. 𝟖𝟎%
sum of weights 100

Note: Revised cost of equity:

D1
Ke = + Growth rate
P0 − F
𝟏. 𝟑𝟖𝟔𝟓
𝐊𝐞 = + 𝟎. 𝟏𝟐 = 𝟎. 𝟎𝟔𝟗𝟑 + 𝟎. 𝟏𝟐 = 𝟎. 𝟏𝟖𝟗𝟑(𝐨𝐫)𝟏𝟖. 𝟗𝟑%
𝟐𝟎

Question No.12 – May 2016 RTP, May 2019 RTP

You are required to compute the weighted average cost of capital (WACC) of Ganpati Limited considering
the given data by using:
(a) Book value weights and

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(b) Market value weights.
The capital structure of Ganpati Limited is as under:
Particulars Amount
Debentures (Rs.100 per debenture) 5,00,000
Preference shares (Rs.100 per share) 5,00,000
Equity shares (Rs.10 per share) 10,00,000
The market prices of these securities are:
• Debentures : 105 per debenture
• Preference Shares : 110 per preference share
• Equity Shares : 24 each.
Additional information:
(i) 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10 year maturity.
(ii) 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 year maturity.
(iii) Equity shares has Rs. 4 floatation cost and market price Rs. 24 per share. The next year expected dividend
is Rs. 1 with annual growth of 5 percent. The firm has practice of paying all earnings in the form of dividend.
The corporate tax rate is 50 percent.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of debt:
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 50%
Net proceeds Issue price – Floatation cost
[issue assumed at par] 100 – 4 = Rs.96
Redeemable value Rs.100
Balance life 10 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
100 − 96
5+ 5.00 + 0.40
Kd = 10 = x 100 = 5.51%
100 + 96 98
2

Cost of preference:
Basic information
Type of preference Redeemable
Face value Rs.100
Coupon rate 5%
Net proceeds Issue price – Floatation cost
[issue assumed at par] 100 -2 = Rs.98
Redeemable value Rs.100
Balance life 10 years

Computation of Cost of preference:

RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 98
5.00 + 5.00 + 0.20
Kp = 10 = x 100 = 5.25%
100 + 98 99.00
2

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Cost of equity:
Basic information:
Dividend of next year Rs.1 per share
CMP/Issue price Rs.24 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 5 percent
Floatation cost Rs.4 per share
D1
Ke = + Growth rate
P0 − F
𝟏
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟎𝟓 + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟎(𝐨𝐫)𝟏𝟎. 𝟎𝟎%
𝟐𝟒 − 𝟒

WN 2: Computation of cost of capital:

Weight Product
Source Cost BV MV BV MV
24,00,000
Equity 10.00% 10,00,000 [1,00,000 x 24] 1,00,000 2,40,000
5,50,000
Preference shares 5.25% 5,00,000 [5,000 x 110] 26,250 28,875
5,25,000
Debentures 5.51% 5,00,000 [5,000 x 125] 27,550 28,928
Total 20,00,000 34,75,000 1,53,800 2,97,803
Sum of product 1,53,800
WACC(based on BV weights) = = x 100 = 7.69%
sum of weights 20,00,000
Sum of product 2,97,803
WACC(based on MV weights) = = x 100 = 8.57%
sum of weights 34,75,000

Question No.13 – November 2016 RTP, November 2018 RTP

M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company is presently
considering several alternative investment proposals costing less than Rs.20 lacs. The corporation always
raises the required funds without disturbing its present debt equity ratio.
The cost of raising the debt and equity are as under:
Project Cost Cost of debt Cost of equity
Upto Rs.2 lacs 10% 12%
Above Rs.2 lacs and upto Rs.5 lacs 11% 13%
Above Rs.5 lacs and upto Rs.10 lacs 12% 14%
Above Rs.10 lacs and upto Rs.20 lacs 13% 14.5%
Assuming the tax rate at 50%, calculate:
(a) Cost of capital of two projects X and Y whose fund requirements are Rs.6.5 lacs and Rs.14 lacs
respectively
(b) If a project is expected to give after tax return of 10%, determine under what conditions it would be
acceptable?
Answer:
WN 1: Computation of cost of capital:
Project X:
• Project X needs capital of Rs.6.5 lacs. The company funds projects with debt of 40% and equity of
60%
• It is assumed that cost of debt given in the above table is pre-tax cost of debt. Cost of debt for this
scenario is 12% x (1 – 50%) = 6%
• Cost of capital = (6% x 40%) + (14% x 60%) = 10.80%
Project Y:
• Project Y needs capital of Rs.14 lacs. Cost of debt for this scenario is 13% x (1 – 50%) = 6.50%
• Cost of capital = (6.5% x 40%) + (14.5% x 60%) = 11.30%

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WN 2: Acceptance of project if after tax rate of return is 10%:

• If a project is expected to give after tax rate of return is 10%, it would be acceptable provided the cost
of capital of the project is equal or less than 10%
• Cost of capital of project of 2 lacs = (5% x 40%) + (12% x 6%) = 9.20%
• Cost of capital of project of 2 to 5 lacs = (5.5% x 40%) + (13% x 6%) = 10.00%
• Hence we can conclude that company can do a project value of upto Rs.5 lacs if the after-tax rate of
return of project is 10%

Question No.14 – November 2016, Nov 2021 MTP

The following is the capital structure of Simons Company Ltd. as on 31-12-2010:
Particulars Book Market
Value Value
Equity shares: 10,000 shares of Rs.100 each 10,00,000 11,00,000
Retained earnings 1,00,000 -
10% Preference Shares (of Rs.100 each) 4,00,000 4,40,000
12% Debentures 6,00,000 7,20,000
20,00,000 22,60,000
The market price of the company’s share is Rs.110 and it is expected that a dividend of Rs.10 per share would
be declared for the year 2010. The dividend growth rate is 6%.
(i) If the company is in the 50% tax bracket and the investor’s rate of tax is 20%, compute the weighted average
cost of capital based on book value and market value.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs.10 lakh
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 Rs.10 to Rs.12 per share. However, the market
price of equity share is expected to decline from Rs.110 to Rs.105 per share.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.10 per share
CMP/Issue price Rs.110 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟗𝟎𝟗 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟓𝟎𝟗(𝐨𝐫)𝟏𝟓. 𝟎𝟗%
𝟏𝟏𝟎 − 𝟎

Cost of retained earnings:

K r = [K e x (1 − personal tax rate)] − Floatation cost%
K r = [15.09 x (1 − 20%)] − 0% = 15.09% x 80% = 12.07%
Cost of preference:
Basic information
Type of preference Irredeemable
Face value Rs.100
Coupon rate 10%
Current market price
Net proceeds =4,40,000/4,000 = Rs.110
Redeemable value NA
Balance life NA

Computation of Cost of Preference:

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Preference Dividend 10
Kp = = x 100 = 9.09%
Net proceeds 110

Cost of debt:
Basic information
Type of debt Irredeemable
Face value Rs.100 (assumed)
Coupon rate 12%
Tax rate 50%
CMP
Net proceeds =7,20,000/6,000 = Rs.120
Redeemable value NA
Balance life NA

Interest after tax 6

Kd = = x 100 = 5%
Net proceeds 120

WN 2: Computation of WACC:
Weight Product
Source Cost BV MV BV MV
Equity 15.09% 10,00,000 10,00,000 1,50,900 1,50,900
Retained earnings 12.07% 1,00,000 1,00,000 12,070 12,070
Preference shares 9.09% 4,00,000 4,40,000 36,360 39,996
Debentures 5.00% 6,00,000 7,20,000 30,000 36,000
Total 21,00,000 22,60,000 2,29,330 2,38,966
Sum of product 2,29,330
WACC(based on BV weights) = = x 100 = 10.92%
sum of weights 21,00,000
Sum of product 2,38,966
WACC(based on MV weights) = = x 100 = 10.57%
sum of weights 22,60,000

WN 3: Computation of revised cost of individual components of capital:

12
Ke = + 0.06 = 0.1143 + 0.06 = 0.1743(or)17.43%
105 − 0
K r = [17.43 x (1 − 20%)] − 0% = 17.43% x 80% = 13.93%
Cost of preference = 9.09% [No change]
Cost of debentures = 5.00% [No change]
Cost of fresh borrowings = Interest rate x (1 – Tax rate) = 14% x (1 – 50%) = 7%

WN 4: Computation of revised WACC:

Weight Product
Source Cost BV MV BV MV
Equity 17.43% 10,00,000 9,54,545 1,74,300 1,66,377
Retained earnings 13.93% 1,00,000 95,455 13,930 13,297
Preference shares 9.09% 4,00,000 4,40,000 36,360 39,996
Debentures 5.00% 6,00,000 7,20,000 30,000 36,000
14% borrowing 7.00% 10,00,000 10,00,000 70,000 70,000
Total 31,00,000 32,10,000 3,24,590 3,25,670
• Revised market value of equity = 10,000 shares x 105 = Rs.10,50,000. This has been split in the ratio
of 10:1 to get value of equity and retained earnings
WACC:
Sum of product 3,24,590
WACC(based on BV weights) = = x 100 = 10.47%
sum of weights 31,00,000

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Sum of product 3,25,670
WACC(based on MV weights) = = x 100 = 10.15%
sum of weights 32,10,000

Question No.15 [May 2018 RTP, Nov 2019, May 2008, May 2015, Nov 2015 RTP, May 2015 RTP, Nov 2017
RTP, July 2021]
Navya Limited wishes to raise additional capital of Rs.10 lakhs for meeting its modernization plan. It has
Rs.3,00,000 in the form of retained earnings available for investment purposes. The following are the further
details:
Debt/equity mix 40%/60%
Cost of debt (before tax)
Upto Rs.1,80,000 10%
Beyond Rs.1,80,000 16%
Earnings per share Rs.4
Dividend Payout Rs.2
Expected growth rate in dividend 10%
Current market price per share Rs.44
Tax rate 50%
Required:
a) To determine the pattern for raising the additional finance
b) To calculate the post-tax average cost of additional debt
c) To calculate the cost of retained earnings and cost of equity and
d) To determine the overall weighted average cost of capital (after tax)
Answer:
WN 1: Pattern of raising additional finance:

Money to be
raised = 10 lacs

Equity = 6 Debt = 4
lacs lacs

Int equity 10% debt =

= 3 lacs 1.8 lacs

Ext equity 16% debt =

= 3 lacs 2.2 lacs

WN 2: Computation of post-tax average cost of additional debt:

• Cost of 10% debt = 10% x (1 – 50%) = 5.00%
• Cost of 16% debt = 16% x (1 – 50%) = 8.00%
(5 x 1.8) + (8 x 2.2)
Average cost of debt = = 6.65%
1.8 + 2.2

WN 3: Computation of cost of equity and retained earnings:

Basic information:
Dividend of next year 2 + 10% = Rs.2.20 per share
CMP/Issue price Rs.44 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 10 percent
Floatation cost Rs.0 per share
D1
Ke = + Growth rate
P0 − F

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𝟐. 𝟐𝟎
𝐊𝐞 = + 𝟎. 𝟏𝟎 = 𝟎. 𝟎𝟓 + 𝟎. 𝟏𝟎 = 𝟎. 𝟏𝟓(𝐨𝐫)𝟏𝟓. 𝟎𝟎%
𝟒𝟒 − 𝟎

• Cost of equity as well as retained earnings will be 15%

WN 4: Computation of WACC:
Source Cost Weight Product
Equity 15.00% 3,00,000 45,000
Retained earnings 15.00% 3,00,000 45,000
Debt 6.65% 4,00,000 26,600
Total 10,00,000 1,16,600
Sum of product 1,16,600
WACC = = x 100 = 11.66%
sum of weights 10,00,000

Question No.16 – May 2021 MTP, Nov 2020 RTP:

Calculate the WACC by using market value weights:
The capital structure of company is as under:
Particulars Amount
Debentures (Rs.100 per debenture) 10,00,000
Preference shares (Rs.100 per share) 10,00,000
Equity shares (Rs.10 per share) 20,00,000
40,00,000
The market prices of these securities are:
• Debentures : 115 per debenture
• Preference Shares : 120 per preference share
• Equity Shares : 265 each.
Additional information:
(i) 100 per debenture redeemable at par, 10% coupon rate, 2% floatation costs, 10 year maturity.
(ii) 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 year maturity.
(iii) Equity shares has Rs. 1 floatation cost and market price Rs. 265 per share. The next year expected
dividend is Rs. 5 with annual growth of 15 percent. The firm has practice of paying all earnings in the form
of dividend. The corporate tax rate is 30 percent.
Use YTM Method to calculate cost of debentures and preference shares
Answer:
This question is similar to earlier question. However, cost of debt and preference is to be computed based
on yield to maturity (YTM) method.

WN 1: Computation of cost of individual components of capital:

Cost of debt:
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 30%
Current market price Rs.115
Net realization at CMP 115 – 2% = Rs.112.70
Redeemable value Rs.100
Balance life 10 years

IRR computation:
Year Cash flow PVF @ 5% DCF PVF @ 7% DCF
0 -112.70 -1.000 (112.70) 1.000 (112.70)
1 to 10 7 7.722 54.05 7.024 49.17
[10 x 70%]
10 100.00 0.614 61.40 0.508 50.80
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NPV +2.75 -12.73
Note: YTM approach is basically computing the IRR of the instrument. There will be a net inflow of Rs.112.70
on day 0. The company would be paying Rs.7 every year and Rs.100 at end of life. Normally we have an
outflow in IRR approach and hence the first cash flow has been taken as outflow and other cash flows are
taken as inflows to compute IRR.
𝟐. 𝟕𝟓
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟓 + [ 𝐱 (𝟕 − 𝟓)] = 𝟓 + 𝟎. 𝟑𝟔 = 𝟓. 𝟑𝟔%
𝟐. 𝟕𝟓 − (−𝟏𝟐. 𝟕𝟑)

Cost of preference:
Type of preference Redeemable
Face value Rs.100
Coupon rate 5%
Current market price Rs.120
Net realization at CMP 120 – 2% = Rs.117.60
Redeemable value Rs.100
Balance life 10 years

IRR computation:
Year Cash flow PVF @ 2% DCF PVF @ 5% DCF
0 -117.60 -1.000 (117.60) 1.000 (117.60)
1 to 10 5 8.983 44.92 7.722 38.61
10 100.00 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

9.32
IRR (or)Cost of preference = 2 + [ x (5 − 2)] = 2 + 1.04 = 3.04%
9.32 − (−17.59)

Cost of equity:
Basic information:
Dividend of next year Rs.5 per share
CMP/Issue price Rs.265 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 15 percent
Floatation cost Rs.1 per share
D1
Ke = + Growth rate
P0 − F
𝟓
𝐊𝐞 = + 𝟎. 𝟏𝟓 = 𝟎. 𝟏𝟔𝟖𝟗(𝐨𝐫)𝟏𝟔. 𝟖𝟗%
𝟐𝟔𝟓 − 𝟏

WN 2: Computation of cost of capital:

Weight
Source of capital Cost of capital
[MV] Product
5,30,00,000
Equity 16.89% [265 x 2,00,000] 89,51,700
12,00,000
Preference shares 3.04% [120 x 10,000] 36,480
11,50,000
Debentures 5.36% [115 x 10,000] 61,640
Total 5,53,50,000 90,49,820
Sum of product 90,49,820
WACC(based on MV weights) = = x 100 = 16.35%
sum of weights 5,53,50,000

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Question No.17 – May 2021 RTP, May 2022 RTP

Determine the cost of capital of BestLuck Limited using the book value (BV) and market value (MV) weights
from the following information:
Source of Capital Book Value Market Value
Equity Shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 9,00,000 10,40,000
Debentures 36,00,000 33,75,000
Additional information:
1. Equity: Equity shares are quoted at Rs.130 per share and new issue priced at Rs.125 per share will be
fully subscribed; floatation costs will be Rs.5 per share
2. Dividend: During the previous five years, dividends have steadily increased from Rs.10.60 to
Rs.14.19 per share. Dividend at the end of the current year is expected to be Rs.15 per share
3. Preference shares: 15% preference shares with face value of Rs.100 would realize Rs.105 per share
4. Debentures: The company proposes to issue 11-year 15% debentures but the yield on similar
maturity and risk class is 16%; floatation cost is 2%
5. Tax: Corporate tax rate is 35%. Ignore dividend tax
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.15 per share
CMP/Issue price Rs.125 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6 percent
Floatation cost Rs.5 per share
D1
Ke = + Growth rate
P0 − F
𝟏𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟐𝟓𝟎 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟖𝟓(𝐨𝐫)𝟏𝟖. 𝟓𝟎%
𝟏𝟐𝟓 − 𝟓

Note 1: Computation of growth rate:

• Dividend has grown from Rs.10.60 to Rs.14.19 over period of five years
14.19 = 10.60 x (1 + r)5
r = Growth rate
• Growth rate in dividend would be equal to 6 percent once we solve the above equation
• Using a growth rate of 6 percent, we get dividend of Rs.14.19 at the end of five years. Hence growth
rate in dividend is 6 percent

Cost of retained earnings:

D1
Kr = + Growth rate
P0
𝟏𝟓
𝐊𝐫 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟐 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟖(𝐨𝐫)𝟏𝟖. 𝟎𝟎%
𝟏𝟐𝟓

Cost of preference:
Basic information
Type of preference Irredeemable
Face value Rs.100
Coupon rate 15%
Issue price – floatation cost
Net proceeds Rs.105

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Redeemable value NA
Balance life NA

Computation of Cost of Preference:

Preference Dividend 15
Kp = = x 100 = 14.29%
Net proceeds 105

Cost of debt:
Type of debt Redeemable
Face value Rs.100 (assumed)
Coupon rate 15%
Tax rate 35%
Issue price – FC
Net proceeds 93.75 – 2 = Rs.91.75
Redeemable value Rs. 100 (assumed at par)
Balance life 11 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
100 − 91.75
9.75 + 9.75 + 0.75
Kd = 11 = x 100 = 10.95%
100 + 91.75 85.875
2
Note 1: Computation of net proceeds:
• The company pays interest rate of 15% whereas investors are expecting return of 16%
• The company is not meeting the expectations of investors. Hence the issue has to happen at discount
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝟏𝟎𝟎 𝐱 𝟏𝟓%
𝐈𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞 = = = 𝐑𝐬. 𝟗𝟑. 𝟕𝟓
𝐈𝐧𝐯𝐞𝐬𝐭𝐨𝐫 𝐞𝐱𝐩𝐞𝐜𝐭𝐚𝐭𝐢𝐨𝐧 𝟏𝟔%
• Net proceeds = Issue price – Floatation cost = Rs.93.75 -2 = Rs.91.75

WN 2: Computation of WACC:
Weight Product
Source Cost BV MV BV MV
Equity 18.50% 1,20,00,000 1,60,00,000 22,20,000 29,60,000
Retained earnings 18.00% 30,00,000 40,00,000 5,40,000 7,20,000
Preference shares 14.29% 9,00,000 10,40,000 1,28,610 1,48,616
Debentures 10.95% 36,00,000 33,75,000 3,94,200 3,69,563
Total 1,95,00,000 2,44,15,000 32,82,810 41,98,179
• There is no separate market value given for retained earnings. Market value given in question is
combined market value for equity and retained earnings. Hence we split the market value of
Rs.2,00,00,000 in the ratio of book values (4:1) to get market value of equity and retained earnings.

Sum of product 32,82,810

WACC(based on BV weights) = = x 100 = 16.83%
sum of weights 1,95,00,000
Sum of product 41,98,179
WACC(based on MV weights) = = x 100 = 17.19%
sum of weights 2,44,15,000

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CHAPTER 5: FINANCING DECISIONS – CAPITAL STRUCTURE

Net Income Theory of Capital Structure:

Specific assumptions ❖ Cost of debt is constant irrespective of leverage
❖ Cost of equity is constant irrespective of leverage
Conclusion The value of the firm changes with capital structure. As we substitute
costlier equity with cheaper debt, the WACC will come down. WACC is
lowest when the proportion of debt is highest.
Value of Firm Value of shares + Value of debt (or)
EBIT
Cost of Capital
Value of Equity EAT
Cost of Equity

Traditional Theory of Capital Structure:

Relevancy of This approach favours that as a result of financial leverage up to some point, cost of
capital structure capital comes down and value of firm increases. However, beyond that point,
on firm valuation reverse trends emerge. The principle implication of this approach is that the cost of
capital is dependent on the capital structure and there is an optimal capital structure
which minimises cost of capital.
Optimum capital Optimum capital structure occurs at the point where value of the firm is highest
structure and the cost of capital is the lowest

Net Operating Income Theory of Capital Structure:

Specific assumptions ❖ Cost of debt is constant irrespective of leverage
❖ Overall cost of capital is constant irrespective of leverage. This is
because the value of a firm is unaffected by debt-equity ratio
❖ Introduction of more debt into the capital structure increases the cost of
equity in such a way that the overall cost of capital is kept constant
Conclusion The value of the firm does not change with capital structure. Introduction
of more debt will increase the cost of equity and hence the overall cost of
capital and value of firm remains constant

Format for calculation of value of firm:

Particulars Amount
EBIT XXX
Less: Interest (XXX)
EBT / EAT XXX

Cost of debt XXX

Cost of Equity XXX
Cost of capital XXX

Value of debt XXX

Add: Value of equity XXX
Value of firm XXX
Formulae:
Interest
Value of debt =
Cost of Debt
EBT
Value of Equity =
Cost of Equity
EBIT
Value of Firm =
Cost of Capital

MM Approach:
MM approach without tax (1958):

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Specific assumptions ❖ Capital markets are perfect. All information is freely available and
there are no transaction costs.
❖ All investors are rational.
❖ Firms can be grouped into ‘Equivalent risk classes’ on the basis of their
business risk.
❖ Non-existence of corporate taxes.
Conclusion ❖ Total market value of a firm is equal to its expected net operating
income divided by the discount rate appropriate to its risk class decided
by the market
❖ A firm having debt in capital structure has higher cost of equity than an
unlevered firm. The cost of equity will include risk premium for the
financial risk.
❖ The structure of the capital (financial leverage) does not affect the
overall cost of capital. The cost of capital is only affected by the business
risk.
Justification for irrelevancy The operational justification of Modigliani-Miller hypothesis is
of capital structure explained through the functioning of the arbitrage process and
substitution of corporate leverage by personal leverage. Arbitrage refers
to buying asset or security at lower price in one market and selling it at a
higher price in another market. As a result, equilibrium is attained in
different markets.

MM approach with tax (1963):

Conclusion Value of the firm will increase or cost of capital will decrease where corporate taxes
exist. As a result, there will be some difference in the earnings of equity and debt-
holders in levered and unlevered firm and value of levered firm will be greater than
the value of unlevered firm by an amount equal to amount of debt multiplied by
corporate tax rate.
Value of Value of un-levered firm + (Amount of debt * Tax rate)
levered firm
with no
personal taxes
Value of (𝟏 − 𝐂𝐓)𝐱 (𝟏 − 𝐄𝐓)
levered firm 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐮𝐧𝐥𝐞𝐯𝐞𝐫𝐞𝐝 𝐟𝐢𝐫𝐦 + (𝟏 − 𝐱 𝐀𝐦𝐨𝐮𝐧𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭)
𝟏 − 𝐃𝐓
with personal Where CT = Corporate tax; ET = Equity tax rate; DT =Debt tax rate
taxes
Format for calculating value of firm with taxes:
Particulars Amount
EBIT XXX
Less: Interest (XXX)
EBT XXX
Less: Tax (XXX)
EAT XXX

Cost of debt XXX

Cost of Equity XXX
Cost of capital XXX

Value of debt XXX

Add: Value of equity XXX
Value of firm XXX
Formulae:
Interest x (1 − Tax Rate)
Value of debt =
Cost of Debt
EBT x (1 − Tax Rate)
Value of Equity =
Cost of Equity

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EBIT x (1 − Tax Rate)
Value of Firm =
Cost of Capital
Optimal Capital Structure:
❖ The basic objective of financial management is to design an appropriate capital structure which
can provide the highest earnings per share (EPS) over the company’s expected range of earnings
before interest and taxes (EBIT). The firm can use the EBIT-EPS analysis to decide an optimal capital
structure.
❖ Following are the steps involved in EBIT-EPS analysis:
Step 1 Identify the various alternatives for raising money
Step 2 Calculate Preference Dividend, Interest and Number of Equity shares for various
alternatives
Step 3 Calculate EPS/Market value of Firm and select the alternative which maximizes EPS/
Market value of Firm

Format for calculation of EPS/ Market Value of Firm:

Particulars Amount
Earnings before interest and tax (EBIT) XXX
Less: Interest (XXX)
Earnings before Tax (EBT) XXX
Less: Tax (XXX)
Earnings after Tax (EAT) XXX
Less: Preference Dividend (XXX)
Earnings available to equity shareholders (EAES) XXX
No of equity shares XXX
Earnings Per share (EPS) [EAES / No of shares] XXX
Price/earning multiple XXX
Market price per share [EPS x PE Multiple] XXX
No of shares XXX
Market value of shares (MPS x No of shares) X XX
Add: Market value of debt XXX
Add: Market value of preference XXX
Market value of Firm XXX

Financial Break-even Point and Indifference Point:

Financial break-even Financial BEP refers to the level of EBIT at which firm has EPS of Zero.
point Preference Dividend
Financial BEP = Interest cost +
1 − Tax rate
Indifference point Indifference point refers to the level of EBIT at which 2 different financial
plans gives the same amount of EPS. Following are the steps for computing
indifference point:
❖ Step 1: Identify the various financial plans
❖ Step 2: Calculate interest, preference dividend and number of
equity shares for various plans
❖ Step 3: Assume EBIT as X and get EPS in terms of X. Equate EPS of
two alternatives to get the indifference point between them

Question No.1 – November 2016

The Modern Chemicals Ltd. requires Rs.25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of Rs.5,00,000. While deciding about the financial plan, the company considers the
objective of maximizing earnings per share. It has three alternatives to finance the project by raising debt of
Rs. 2,50,000 or Rs.10,00,000 or Rs.15,00,000 and the balance, in each case, by issuing at Rs.150, but is expected
to decline to Rs.125 in cash the funds are borrowed in excess of Rs.10,00,000. The funds can be borrowed at
the rate of 10% upto Rs.2,50,000, at 15% over Rs.2,50,000 and upto 10,00,000 and at 20% over Rs.10,00,000.
The tax rate applicable to the company is 50%. Which form of financing should the company choose?
Answer:
WN 1: Identification of alternatives:
Alternative 1 – Borrow Rs.2,50,000 and issue equity worth Rs.22,50,000
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Alternative 2 – Borrow Rs.10,00,000 and issue equity worth Rs.15,00,000
Alternative 3 – Borrow Rs.15,00,000 and issue equity worth Rs.10,00,000

WN 2: Computation of interest, preference dividend and no of equity shares for three alternatives:
Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest - - -
New Interest 25,000 1,37,500 2,37,500
[2,50,000 x 10%] [2,50,000 x 10% + [2,50,000 x 10% +
7,50,000 x 15%] 7,50,000 x 15% +
5,00,000 x 20%]
Total Interest 25,000 1,37,500 2,37,500
Preference dividend
Existing - - -
New - - -
Total dividend - - -
No of equity shares
Existing - - -
New 15,000 10,000 8,000
(22,50,000/150) (15,00,000/150) (10,00,000/125)
Total 15,000 10,000 8,000
• It is assumed that interest rates given in the question are slab rates.

WN 3: Computation of EPS:
Particulars Alt 1 Alt 2 Alt 3
EBIT 5,00,000 5,00,000 5,00,000
Less: Interest [WN 2] -25,000 -1,37,500 -2,37,500
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
Less: Preference dividend - - -
EAES 2,37,500 1,81,250 1,31,250
No of shares 15,000 10,000 8,000
EPS (EAES/No of shares) 15.8333 18.1250 16.4063
The company should go ahead with Alternative 2 as the same results in maximum EPS.

Question No.:2 – November 2014 exam

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

WN 2: Computation of interest, preference dividend and no of equity shares:

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Particulars Alt 1 Alt 2
Interest
Existing interest - -
New Interest 48,000 48,000
Total Interest 48,000 48,000
Preference dividend
Existing - -
New - 28,000
Total dividend - 28,000
No of equity shares
Existing - -
New (issue price assumed as Rs.10) 60,000 40,000
Total shares 60,000 40,000

WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2
EBIT X X
Less: Interest -48,000 -48,000
EBT X-48,000 X-48,000
Less: Tax 0.35(X-48,000) 0.35(X-48,000)
EAT 0.65(X-48,000) 0.65(X-48,000)
Less: Preference dividend 0 -28,000
EAES 0.65X-31,200 0.65X-59,200
No of shares 60,000 40,000
0.65X − 31,200 0.65X − 59,200
EPS (EAES/No of shares) 60,000 40,000

Indifference point between Alt 1 and Alt 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Alt 1 = EPS of Alt 2
0.65X − 31,200 0.65X − 59,200
= ; 1.3X − 62,400 = 1.95X − 1,77,600; 0.65X = 1,15,400
60,000 40,000
𝟏, 𝟏𝟓, 𝟐𝟎𝟎
𝐗= = 𝐑𝐬. 𝟏, 𝟕𝟕, 𝟐𝟑𝟏
𝟎. 𝟔𝟓
• Indifference point between Alt 1 and Alt 2 = EBIT of Rs.1,77,231

Question No.3 – May 2017 RTP, Nov 2021 MTP

A Company needs Rs.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 Rs.10 per share.
II. The company may issue 1,56,250 ordinary equity shares at Rs.10 per share and 15,625 debentures of
Rs.100 denomination bearing a 8% rate of dividend.
III. The company may issue 1,56,250 equity shares at Rs.10 per share and 15,625 preference shares at
Rs.100 per share bearing a 8 % rate of dividend.
(a) If the company’s earnings before interest and taxes are Rs.62,500, Rs.1,25,000 , Rs.2,50,000
Rs.3,75,000 and Rs.6,25,000, what are the earnings per share under each of three financial
plans? Assume a corporate Income-tax rate of 40%
(b) Which alternative would you recommend and why?
(c) Calculate the financial breakeven point for all the alternatives
(d) Determine the EBIT-EPS indifference points by formulae between financing Plan I and Plan
II, I and III, and II and III
Answer:
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WN 1: Computation of financial break-even point:
Step 1: Identification of alternatives:
• Alternative 1 – Issue 3,12,500 equity shares of Rs.10 each
• Alternative 2 – Issue 1,56,250 equity shares of Rs.10 each and 15,625 8% debentures of Rs.100 each
• Alternative 3 – Issue 1,56,250 equity shares of Rs.10 each and 15,625 8% preference shares of Rs.100
each

Step 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest - - -
New Interest - 1,25,000 -
[15,62,500 x 8%]
Total Interest - 1,25,000 -
Preference dividend
Existing - - -
New - - 1,25,000
[15,62,500 x 8%]
Total dividend - - 1,25,000
No of equity shares
Existing - - -
New 3,12,500 1,56,250 1,56,250
Total shares 3,12,500 1,56,250 1,56,250

Step 3: Computation of financial break-even point:

PD
Financial BEP = Interest + ( )
1 − Tax rate
0
Financial BEP of Alt 1 = 0 + ( )=0
1 − 40%
0
Financial BEP of Alt 2 = 1,25,000 + ( ) = 1,25,000
1 − 40%
1,25,000
Financial BEP of Alt 3 = 0 + ( ) = 2,08,333
1 − 40%

WN 2: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2 Alt 3
EBIT X X X
Less: Interest 0 -1,25,000 0
EBT X X-1,25,000 X
Less: Tax 0.4X 0.4(X – 1,25,000) 0.4X
EAT 0.6X 0.6(X-1,25,000) 0.6X
Less: Preference dividend 0 0 -1,25,000
EAES 0.6X 0.6(X-1,25,000) 0.6X – 1,25,000
No of shares 3,12,500 1,56,250 1,56,250
0.6X 0.6X − 75,000 0.6X − 1,25,000
EPS (EAES/No of shares) 3,12,500 1,56,250 1,56,250

Indifference point between Plan 1 and Plan 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2

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EPS of Plan 1 = EPS of Plan 2
0.6X 0.6X − 75,000 1,50,000
= ; 0.6X = 1.2X − 1,50,000; X = = 𝟐, 𝟓𝟎, 𝟎𝟎𝟎
3,12,500 1,56,250 0.6
• Indifference point between Plan 1 and Plan 2 = EBIT of Rs.2,50,000

Indifference point between Plan 1 and Plan 3:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 3
EPS of Plan 1 = EPS of Plan 3
0.6X 0.6X − 1,25,000 2,50,000
= ; 0.6X = 1.2X − 2,50,000; X = = 𝟒, 𝟏𝟔, 𝟔𝟔𝟕
3,12,500 1,56,250 0.6
• Indifference point between Plan 1 and Plan 3 = EBIT of Rs.4,16,667

Indifference point between Plan 2 and Plan 3:

EPS of Plan 2 = EPS of Plan 3
0.6X − 75,000 0.6X − 1,25,000
= ;
1,56,250 1,56,250
• There is no indifference point between Plan 2 and Plan 3. This would mean that one plan is
dominating the other plan
• Plan with low financial break-even point will dominate the plan with high financial break-even
point.
• In this case, Plan 2 has lower financial BEP and hence Plan 2 dominates Plan 3

WN 3: Computation of EPS for different levels of EBIT:

Particulars Alt 1 Alt 2 Alt 3
0.6X 0.6X − 75,000 0.6X − 1,25,000
EPS 3,12,500 1,56,250 1,56,250
EPS if:
EBIT = 62,500 0.12 -0.24 -0.56
EBIT = 1,25,000 0.24 0.00 -0.32
EBIT = 2,50,000 0.48 0.48 0.16
EBIT = 3,75,000 0.72 0.96 0.64
EBIT = 6,25,000 1.20 1.92 1.60
• We need to substitute given EBIT numbers in place of X and compute EPS

Selection of alternative:
Alternative to be selected would depend on level of EBIT and the same is tabulated below:
Level of EBIT Plan to be selected
< 2,50,000 Plan 1
At 2,50,000 Plan 1 or Plan 2 (Indifferent)
> 2,50,000 Plan 2
• Plan 3 is not analyzed as Plan 2 dominates Plan 3

Question No.: 4 (November 2013 exam – 5 Marks)

X Ltd. is considering the following two alternative financing plans:
Particulars Plan – I Plan -II
Equity shares of Rs.10 each 4,00,000 4,00,000
12% debentures 2,00,000 -
Preference shares of Rs.100 each - 2,00,000
Total 6,00,000 6,00,000
The indifference point between the plans is Rs. 2,40,000. Corporate tax rate is 30%. Calculate the rate of
dividend on preference shares.
Answer:
Computation of rate of dividend on preference shares:

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Particulars Alt 1 Alt 2
EBIT 2,40,000 2,40,000
Less: Interest -24,000 -
EBT 2,16,000 2,40,000
Less: Tax -64,800 -72,000
EAT 1,51,200 1,68,000
-16,800
Less: Preference dividend - [1,16,800-1,151,200]
EAES 1,51,200 1,51,200
No of shares 40,000 40,000
EPS (EAES/No of shares) 3.78 3.78
𝟏𝟔, 𝟖𝟎𝟎
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐨𝐧 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐬 = 𝐱 𝟏𝟎𝟎 = 𝟖. 𝟒𝟎%
𝟐, 𝟎𝟎, 𝟎𝟎𝟎
Note:
• We will compute EPS of Alternative 1. It works out to be Rs.3.78 per share
• At indifferent point, EPS of Alternative 1 and 2 will match and hence EPS of Alt 2 is Rs.3.78. We will
reverse-work and preference dividend of Rs.16,800 will be balancing figure.

Question No.5 – May 2016 RTP, May 2019 RTP

Akash Limited provides you the following information:
Particulars Amount
Earnings before Interest and Tax 2,80,000
Less: Interest on debentures @ 10% (40,000)
EBT 2,40,000
Less: Income tax @ 50% (1,20,000)
EAT 1,20,000
No of equity shares (Rs.10 each) 30,000
EPS 4
PE Ratio 10
The company has reserves and surplus of Rs.7,00,000 and required Rs.4,00,000 further for modernization.
Return on Capital Employed (ROCE) is constant. Debt (Debt/Debt + Equity) Ratio higher than 40% will bring
the PE ratio down to 8 and increase the interest rate on additional debts to 12%. You are required to ascertain
the probable price of the share.
a) If the additional capital is raised as debt and
b) If the amount is raised by issuing equity shares at ruling market price
Answer:
WN 1: Computation of interest, preference dividend and no of equity shares for debt and equity
alternative:
Particulars Debt Equity
Interest
Existing interest 40,000 40,000
New Interest 48,000 -
[4,00,000 x 12%]
Total Interest 88,000 40,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 30,000 30,000
New - 10,000
Total shares 30,000 40,000
Note:

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• CMP of share = EPS x PE Multiple = 4 x 10 = Rs.40
• New shares issued = 4,00,000/40 = 10,000

WN 2: Computation of MPS for two alternatives:

Particulars Debt Equity
EBIT [Note 1] 3,60,000 3,60,000
Less: Interest [WN 1] -88,000 -40,000
EBT 2,72,000 3,20,000
Less: Tax @ 50% -1,36,000 -1,60,000
EAT 1,36,000 1,60,000
Less: Preference dividend - -
EAES 1,36,000 1,60,000
No of shares [WN 1] 30,000 40,000
EPS (EAES/No of shares) 4.53 4.00
PE Multiple 8 10
MPS (EPS x PE Multiple) 36.24 40.00

Note 1: Computation of EBIT

Particulars Existing Revised
EBIT 2,80,000 3,60,000
(20% x 18,00,000)
Capital employed: 14,00,000 18,00,000
Equity capital 3,00,000 3,00,000
Reserves and surplus 7,00,000 7,00,000
4,00,000 4,00,000
Debt [40,000/10%] [40,000/10%]
New capital introduced 0 4,00,000
ROI (EBIT/CE) 20.00% 20,00%
[2,80,000/14,00,000] x 100

Note 2: Identification of PE Multiple for two scenarios:

Particulars Debt Equity
Debt 8,00,000 4,00,000
10,00,000 14,00,000
Equity [7,00,000 + 3,00,000] [10,00,000+4,00,000]
Total capital employed
[Debt + Equity] 18,00,000 18,00,000
Debt 44.44% 22.22%
Debt Ratio =
Debt + Equity
Applicable PE Multiple 8 10

Question No.6 [May 2019 MTP, Dec 2021]

A company earns a profit of Rs.3,00,000 per annum after meeting its interest liability of Rs.1,20,000 on 12%
debentures. The Tax rate is 50%. The number of Equity Shares of Rs.10 each are 80,000 and the retained
earnings amount to Rs.12,00,000. The company proposes to take up an expansion scheme for which a sum
of Rs.4,00,000 is required. It is anticipated that after expansion, the company will be able to achieve the same
return on investment as at present. The funds required for expansion can be raised either through debt at
the rate of 12% or by issuing Equity Shares at par.
Required:
(i) compute the Earnings Per Share (EPS), if:
- The additional funds were raised as debt.
- The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable
Answer:
WN 1: Identification of alternatives:
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Alternative 1 – Raise Rs.4,00,000 in the form of 12% debt
Alternative 2 – Raise Rs.4,00,000 by issuing equity shares

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2
Interest
Existing interest 1,20,000 1,20,000
New Interest 48,000 -
[4,00,00 x 12%]
Total Interest 1,68,000 1,20,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 80,000 80,000
New - 40,000
[4,00,000/10]
Total shares 80,000 1,20,000

WN 3: Computation of EPS:
Particulars Alt 1 Alt 2
EBIT [Note 1] 4,76,000 4,76,000
Less: Interest [WN 2] -1,68,000 -1,20,000
EBT 3,08,000 3,56,000
Less: Tax @ 50% -1,54,000 -1,78,000
EAT 1,54,000 1,78,000
Less: Preference dividend - -
EAES 1,54,000 1,78,000
No of shares [WN 2] 80,000 1,20,000
EPS (EAES/No of shares) 1.9250 1.4833
Conclusion: The company should go ahead with Alternative 1 to maximize EPS

Note 1: Computation of EBIT:

Particulars Existing Revised
EBIT 4,20,000 4,76,000
[3,00,000 + 1,20,000] (14% x 34,00,000)
Capital employed: 30,00,000 34,00,000
Equity capital 8,00,000 8,00,000
Reserves and surplus 12,00,000 12,00,000
10,00,000 10,00,000
Debt [1,20,000/12%]
Preference 0 0
New capital introduced 0 4,00,000
ROI (EBIT/CE) 14.00% 14.00%
[4,20,000/30,00,000] x 100
• Existing ROI/ROCE is 14%. The company would be maintaining same ROI
• Revised EBIT = Revised capital x 14%. Capital will increase by Rs.4,00,000 introduced either in the
form of debt/equity. New capital = Rs.34,00,000
• New EBIT = 14% x 34,00,000 = Rs.4,76,000

Question No.7 [Nov 2019]

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The following figures of Theta Limited are presented as under:
Particulars Amount Amount
Earnings before Interest and Tax 23,00,000
Less: Debenture interest @ 8% 80,000
Long term Loan interest @ 11% 2,20,000 (3,00,000)
20,00,000
Less: Income Tax (10,00,000)
Earnings after Tax 10,00,000
No of equity shares of Rs.10 each 5,00,000
EPS Rs.2
Market price of a share Rs.20
P/E Ratio 10
The company has undistributed reserves and surplus of Rs.20 lakhs. It is in need of Rs.30 lakhs to pay off
debentures and modernize its plants. It seeks your advice on the following alternatives of raising finance:
• Alternative 1 – Raising entire amount as term loan from banks @ 12%
• Alternative 2 – Raising part of the funds by issue of 1,00,000 shares of Rs.20 each and the rest by term
loan at 12 percent

The company expects to improve its rate of return by 2 percent as a result of modernization, but P/E ratio is
likely to go down to 8 if the entire amount is raised as term loan.
a) Advise the company on the financial plan to be selected
b) If it is assumed that there will be no change in the P/E ratio if either of the two alternatives is adopted,
would your advice still hold good?
Answer:
WN 1: Computation of interest, preference dividend and no of equity shares:
Particulars Alt 1 Alt 2
Interest
Existing interest 2,20,000 2,20,000
New Interest 3,60,000 1,20,000
[30,00,000 x 12%] [10,00,000 x 12%]
Total Interest 5,80,000 3,40,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 5,00,000 5,00,000
New - 1,00,000
Total shares 5,00,000 6,00,000
• Note: Debentures would be paid off and hence existing interest will be Rs.2,20,000

WN 2: Selection of alternative if PE multiple is impacted:

Particulars Alt 1 Alt 2
EBIT [Note 1] 30,00,000 30,00,000
Less: Interest [WN 1] -5,80,000 -3,40,000
EBT 24,20,000 26,60,000
Less: Tax @ 50% -12,10,000 -13,30,000
EAT 12,10,000 13,30,000
Less: Preference dividend - -
EAES 12,10,000 13,30,000
No of shares [WN 1] 5,00,000 6,00,000
EPS (EAES/No of shares) 2.4200 2.2167
PE Multiple 8 10
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MPS (EPS x PE Multiple) 19.3600 22.1670
No of shares 5,00,000 6,00,000
Market value of equity [EPS x No of shares] 96,80,000 1,33,00,200
Market value of debt 50,00,000 30,00,000
Market value of preference - -
Market value of firm 1,46,80,000 1,63,00,200
• Company should go ahead with alternative 2 as it has better value of firm if PE multiple is impacted
due to fresh borrowings

Note 1: Computation of EBIT:

Particulars Existing Revised
EBIT 23,00,000 30,00,000
(25% x 1,20,00,000)
Capital employed: 1,00,00,000 1,20,00,000
Equity capital 50,00,000 50,00,000
Reserves and surplus 20,00,000 20,00,000
10,00,000 -
Debentures [80,000/8%]
20,00,000 20,00,000
Term loan [2,20,000/11%]
Preference 0 0
New capital introduced 0 30,00,000
ROI (EBIT/CE) 23.00% 25.00%
[23,00,000/1,00,00,000] x 100 [23.00% + 2.00%]
• Existing ROI is 23% and same will improve to 25%. Total capital will increase to Rs.120 lacs and
hence new EBIT will be 120 lacs x 25% = Rs.30,00,000

WN 3: Selection of alternative if PE Multiple does not change:

Particulars Alt 1 Alt 2
EPS as per WN 2 2.4200 2.2167
PE Multiple 10 10
MPS (EPS x PE Multiple) 24.2000 22.1670
No of shares 5,00,000 6,00,000
Market value of equity 1,21,00,000 1,33,00,200
Market value of debt 50,00,000 30,00,000
Market value of preference - -
Market value of firm 1,71,00,000 1,63,00,200
• Company should choose Alternative 1 if there is no change in PE multiple

Question No.8 [Nov 2019 MTP]

Yoyo Limited presently has Rs. 36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes
to finance a Rs. 40,00,000 expansion programme and is considering three alternatives: additional debt at 12
per cent interest, preference shares with an 11 per cent dividend, and the sale of equity shares at Rs. 16 per
share. The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax bracket.
I. If earnings before interest and taxes are presently Rs. 15,00,000, what would be earnings per share
for the three alternatives, assuming no immediate increase in profitability?
II. What is the indifference point among three alternatives?
III. Which alternative do you prefer? How much would EBIT need to increase before the next alternative
would be best?
Answer:
WN 1: Identification of alternatives
Alternative 1 – Additional debt at interest rate of 12 percent
Alternative 2 – Issue preference shares at 11 percent
Alternative 3 – Issue equity shares at issue price of Rs.16
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WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest 3,60,000 3,60,000 3,60,000
New Interest 4,80,000 - -
Total Interest 8,40,000 3,60,000 3,60,000
Preference dividend
Existing - - -
New - 4,40,000 -
Total dividend - 4,40,000 -
No of equity shares
Existing 8,00,000 8,00,000 8,00,000
New - - 2,50,000
Total shares 8,00,000 8,00,000 10,50,000

WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2 Alt 3
EBIT X X X
Less: Interest 8,40,000 3,60,000 3,60,000
EBT X-8,40,000 X-3,60,000 X-3,60,000
Less: Tax 0.4(X-8,40,000) 0.4(X-3,60,000) 0.4(X-3,60,000)
EAT 0.6(X-8,40,000) 0.6(X-3,60,000) 0.6(X-3,60,000)
Less: Preference dividend 0 4,40,000 0
EAES 0.6X – 5,04,000 0.6X – 6,56,000 0.6X – 2,16,000
No of shares 8,00,000 8,00,000 10,50,000
0.6X − 5,04,000 0.6X − 6,56,000 0.6X − 2,16,000
EPS (EAES/No of shares) 8,00,000 8,00,000 10,50,000

Indifference point between Plan 1 and Plan 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Plan 1 = EPS of Plan 2
0.6X − 5,04,000 0.6X − 6,56,000
= ;
8,00,000 8,00,000
• There is no indifference point between Plan 1 and Plan 2. This would mean that one plan is
dominating the other plan
• Plan 1 dominates Plan 2 as Plan 1 has lower financial BEP
• Financial BEP of Plan 1 = 8,40,000
• Financial BEP of Plan 2 = 3,60,000 + (4,40,000/0.6) = 3,60,000 + 7,33,333 = 10,93,333

Indifference point between Plan 1 and Plan 3:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 3
EPS of Plan 1 = EPS of Plan 3
0.6X − 5,04,000 0.6X − 2,16,000
= ; 6.3X − 52,92,000 = 4.8X − 17,28,000; 1.5X = 35,64,000
8,00,000 10,50,000
35,64,000
X= = Rs. 23,76,000
1.5
Indifference point between Plan 1 and Plan 3 = EBIT of Rs.23,76,000

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Indifference point between Plan 2 and Plan 3:
EPS of Plan 2 = EPS of Plan 3
0.6X − 6,56,000 0.6X − 2,16,000
= ; 6.3X − 68,80,000 = 4.8X − 17,28,000; 1.5X = 51,60,000
8,00,000 10,50,000
51,60,000
X= = Rs. 34,40,000
1.5
Indifference point between Plan 2 and Plan 3 = EBIT of Rs.34,40,000

WN 4: Computation of EPS when EBIT is Rs.15,00,000

Particulars Alt 1 Alt 2 Alt 3
EBIT 15,00,000 15,00,000 15,00,000
Less: Interest -8,40,000 -3,60,000 -3,60,000
EBT 6,60,000 11,40,000 11,40,000
Less: Tax -2,64,000 -4,56,000 -4,56,000
EAT 3,96,000 6,84,000 6,84,000
Less: Preference dividend - 4,40,000 -
EAES 3,96,000 2,44,000 6,84,000
No of shares 8,00,000 8,00,000 10,50,000
EPS (EAES/No of shares) 0.495 0.305 0.651
Selection of Alternative:
• We should go ahead with Alternative 3 (Issue of common shares) when EBIT is Rs.15,00,000. EBIT
would need to increase to Rs.23,76,000 before an indifference point on debt is reached. We can go
ahead with Alternative 1 if the EBIT increases by Rs.8,76,000

Question No.9 [Nov 2020, May 2018 MTP, Nov 2018 MTP, Nov 2018, Nov 2019 RTP, May 2018]
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:
Proposals % of Equity % of Debt % of preference shares
P 100 - -
Q 50 50 -
R 50 - 50
I. Cost of debt – 10%
Cost of preference shares – 10%
II. Tax rate – 50%
III. Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.
IV. Total investment to be raised Rs. 40,00,000.
V. Expected earnings before interest and tax Rs. 18,00,000.

From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:
• Earnings per share
• Financial break-even-point
• Compute the EBIT range among the plans for indifference. Also indicate if any of the plans dominate
Answer:
WN 1: Computation of financial break-even point:
Step 1: Identification of alternatives:
• Plan P – Issue equity of Rs.40,00,000 at issue price of Rs.20 per share
• Plan Q – Issue equity of Rs.20,00,000 and 10% debt of Rs.20,00,000
• Plan R – Issue equity of Rs.20,00,000 and 10% preference shares of Rs.20,00,000

Step 2: Computation of interest, preference dividend and no of equity shares:

Particulars Plan P Plan Q Plan R
Interest

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Existing interest - - -
New Interest - 2,00,000 -
Total Interest - 2,00,000 -
Preference dividend
Existing - - -
New - - 2,00,000
Total dividend - - 2,00,000
No of equity shares
Existing - - -
New 2,00,000 1,00,000 1,00,000
Total shares 2,00,000 1,00,000 1,00,000

Step 3: Computation of financial break-even point:

PD
Financial BEP = Interest + ( )
1 − Tax rate
0
Financial BEP of Plan P = 0 + ( )=0
1 − 50%
0
Financial BEP of Plan Q = 2,00,000 + ( ) = 2,00,000
1 − 50%
2,00,000
Financial BEP of Plan R = 0 + ( ) = 4,00,000
1 − 50%

WN 2: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Plan P Plan Q Plan R
EBIT X X X
Less: Interest 0 -2,00,000 0
EBT X X-2,00,000 X
Less: Tax 0.5X 0.5(X-2,00,000) 0.5X
EAT 0.5X 0.5(X-2,00,000) 0.5X
Less: Preference dividend 0 0 -2,00,000
EAES 0.5X 0.5X-1,00,000 0.5X-2,00,000
No of shares 2,00,000 1,00,000 1,00,000
0.5X 0.5X − 1,00,000 0.5X − 2,00,000
EPS (EAES/No of shares) 2,00,000 1,00,000 1,00,000

Indifference point between Plan P and Plan Q:

At indifference point EPS of Plan P will be equal to EPS of Plan Q
EPS of Plan P = EPS of Plan Q
0.5X 0.5X − 1,00,000 2,00,000
= ; 0.5X = X − 2,00,000; X = = 𝟒, 𝟎𝟎, 𝟎𝟎𝟎
2,00,000 1,00,000 0.5
• Indifference point between Plan P and Plan Q = EBIT of Rs.4,00,000

Indifference point between Plan P and Plan R:

At indifference point EPS of Plan P will be equal to EPS of Plan R
EPS of Plan P = EPS of Plan R
0.5X 0.5X − 2,00,000 4,00,000
= ; 0.5X = X − 4,00,000; X = = 𝟖, 𝟎𝟎, 𝟎𝟎𝟎
2,00,000 1,00,000 0.5
• Indifference point between Plan P and Plan R = EBIT of Rs.8,00,000

Indifference point between Plan Q and Plan R:

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EPS of Plan Q = EPS of Plan R
0.5X − 1,00,000 0.5X − 2,00,000
= ;
1,00,000 1,00,000
• There is no indifference point between Plan Q and Plan R. This would mean that one plan is
dominating the other plan
• Plan with low financial break-even point will dominate the plan with high financial break-even
point.
• In this case, Plan Q has lower financial BEP and hence Plan Q dominates Plan R

WN 3: Computation of indifference point when EBIT is Rs.18,00,000

Particulars Alt 1 Alt 2 Alt 3
0.5X 0.5X − 1,00,000 0.5X − 2,00,000
EPS 2,00,000 1,00,000 1,00,000
EPS if:
EBIT = 18,00,000 4.50 8.00 7.00

Question No.10 – Nov 2021 MTP:

A new project is under consideration in Zip Limited, which requires a capital investment of Rs.4.50 Crores.
Interest on term loan is 12% and the corporate tax rate is 50%. If the debt equity ratio insisted by the financing
agencies is 2:1, calculate the point of indifference for the project.
Answer:
WN 1: Identification of alternatives:
• Alternative 1 – Raise Rs.450 lacs as 300 lacs of 12% debt and 150 lacs of equity
• Alternative 2 – Raise entire Rs.450 lacs as equity

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2
Interest
Existing interest - -
New Interest 36,00,000 -
Total Interest 36,00,000 -
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing - -
New (issue price assumed as Rs.10) 15,00,000 45,00,000
Total shares 15,00,000 45,00,000

WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2
EBIT X X
Less: Interest -36,00,000 0
EBT X-36,00,000 X
Less: Tax 0.5(X-36,00,000) 0.5X
EAT 0.5(X-36,00,000) 0.5X
Less: Preference dividend 0 0
EAES 0.5(X-36,00,000) 0.5X
No of shares 15,00,000 45,00,000
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0.5(X − 36,00,000) 0.5X
EPS (EAES/No of shares) 15,00,000 45,00,000

Indifference point between Alt 1 and Alt 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Alt 1 = EPS of Alt 2
0.5X − 18,00,000 0.5X
= ; 1.5X − 54,00,000 = 0.5X; 𝐗 = 𝐑𝐬. 𝟓𝟒, 𝟎𝟎, 𝟎𝟎𝟎
15,00,000 45,00,000
• Indifference point between Alt 1 and Alt 2 = EBIT of Rs.54,00,000

Question No.11 – May 2021 RTP

Zordon Ltd. has net operating income of Rs. 5,00,000 and total capitalization of Rs. 50,00,000 during the
current year. The company is contemplating to introduce debt financing in capital structure and has various
options for the same. The following information is available at different levels of debt value:
Debt Value Interest rate Equity capitalization rate
0 - 10.00
5,00,000 6.00 10.50
10,00,000 6.00 11.00
15,00,000 6.20 11.30
20,00,000 7.00 12.40
25,00,000 7.50 13.50
30,00,000 8.00 16.00
Assuming no tax and that the firm always maintains books at book values, you are REQUIRED to calculate:
(i) Amount of debt to be employed by firm as per traditional approach.
(ii) Equity capitalization rate, if MM approach is followed.
Answer:
WN 1: Analysis under traditional approach:
Particulars Alt 1 Alt 2 Alt 3 Alt 4 Alt 5 Alt 6 Alt 7
EBIT 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest
[Debt x cost of debt] - -30,000 -60,000 -93,000 -1,40,000 -1,87,500 -2,40,000
EBT/EAT 5,00,000 4,70,000 4,40,000 4,07,000 3,60,000 3,12,500 2,60,000

Cost of debt - 6.00 6.00 6.20 7.00 7.50 8.00

Cost of equity 10.00 10.50 11.00 11.30 12.40 13.50 16.00
Cost of capital
[EBIT/Value of Firm] 10.00 10.05 10.00 9.80 10.20 10.38 10.81

Value of debt 0 5,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000

Value of equity
[EAT/Cost of equity] 50,00,000 44,76,190 40,00,000 36,01,770 29,03,226 23,14,815 16,25,000
Value of firm 50,00,000 49,76,190 50,00,000 51,01,770 49,03,226 48,14,815 46,25,000
• We should go ahead with Alternative 4 as the same leads to lowest cost of capital. Hence the
company should have debt of Rs.15,00,000

WN 2: Analysis under MM Approach:

• Under MM Approach the cost of capital and value of firm remains constant irrespective of capital
structure
Particulars Alt 1 Alt 2 Alt 3 Alt 4 Alt 5 Alt 6 Alt 7
EBIT 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest
[Debt x cost of debt] - -30,000 -60,000 -93,000 -1,40,000 -1,87,500 -2,40,000
EBT/EAT 5,00,000 4,70,000 4,40,000 4,07,000 3,60,000 3,12,500 2,60,000

Cost of debt - 6.00 6.00 6.20 7.00 7.50 8.00

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Cost of equity 10.00 10.44 11.00 11.63 12.00 12.50 13.00
Cost of capital 10.00 10.00 10.00 10.00 10.00 10.00 10.00

Value of debt 0 5,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000

Value of equity 50,00,000 45,00,000 40,00,000 35,00,000 30,00,000 25,00,000 20,00,000
Value of firm 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000
• Amount of equity = Value of firm – Value of debt
• Cost of equity = PAT/Amount of equity

Question No.12 – Jan 2021:

Alpha and Beta Limited are identical except for capital structures. Alpha has 50 percent debt and 50 percent
equity, whereas Beta has 20 percent debt and 80 percent equity (All percentages are in market value terms).
The borrowing rate for both the companies is 8 percent in a no-tax world and capital markets are assumed to
be perfect.
1. If you own 2 percent stock of Alpha, what is your return if the company has net operating income of
Rs.3,60,000 and the overall capitalization rate of the company is 18 percent. What is the implied rate of return
on equity?
2. Beta has the same net operating income as alpha. What is its implied rate of return and why it is lower than
that of Alpha.
Answer:
Particulars Alpha Beta
EBIT [Given] 3,60,000 3,60,000
Less: Interest -80,000 -32,000
[Cost of debt x Amount of debt] [10,00,000 x 8%] [4,00,000 x 8%]
EBT/EAT/EAES 2,80,000 3,28,000

Cost of debt [Given] 8.00% 8.00%

Cost of equity
[EAT/Value of Equity] 28.00% 20.50%
Cost of capital [Given] 18.00% 18.00%

10,00,000 4,00,000
Value of debt [20,00,000 x 50%] [20,00,000 x 20%]
10,00,000 16,00,000
Value of equity [20,00,000 x 50%] [20,00,000 x 80%]
Value of firm
[EBIT/Cost off Capital] 20,00,000 20,00,000
Notes:
• Overall capitalization rate (Cost of capital) of company Alpha is 18%. Company Beta will also have
the same capitalization rate as they are identical companies
• Value of firm = EBIT/Cost of capital. Value of firm for both companies is same at Rs.20,00,000
• Value of firm is split into debt and equity as per the ratio given in question

Solution:
• Return of investor = 2,80,000 [EBT/EAT/EAES] x 2% = Rs.5,600
• Implied rate of return on equity of company Alpha = 28.00%
• Implied rate of return on equity of company Beta = 20.50%
• Implied required rate of return on equity of Beta Ltd. is lower than that of Alpha Ltd. because Beta
Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the debt-
to-equity ratio when we use the net operating income approach, the decline in required equity
return offsets exactly the disadvantage of not employing so much in the way of “cheaper” debt
funds

Question No.:13 [Nov 2020]

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KLM Ltd., has an operating profit of Rs. 46,00,000 and has employed Debt (Total Interest Charge of Rs.
10,00,000). The existing Cost of Equity and Cost of Debt to the firm are 18% and 10% respectively. The firm
has a proposal before it requiring funds of Rs. 100 Lakhs (to be raised by issue of additional debt @ 10%)
which is expected to bring additional profit of Rs. 19,00,000. Assume no Tax. You are required to find out the
(i) Existing Weighted Average Cost of Capital (WACC)
(ii) New Weighted Average Cost of Capital (WACC)
Answer:
Particulars Existing Revised
EBIT 46,00,000 65,00,000
Less: Interest -10,00,000 -20,00,000
EBT/EAT 36,00,000 45,00,000

Cost of debt 10.00% 10.00%

Cost of equity
[EAT/Value of equity] 18.00% 22.50%
Cost of capital
[EBIT/Value of Firm] 15.33 16.25

Value of debt
[Interest/Cost of debt] 1,00,00,000 2,00,00,000
Value of equity
[EAT/Cost of equity] 2,00,00,000 2,00,00,000
Value of firm 3,00,00,000 4,00,00,000
• Cost of debt continues to be 10% as the new debt was taken at interest rate of 10%
• Value of equity is assumed to remain same in revised scenario and hence cost of equity will increase
due to increase in debt.

Question No.14 – May 2020 MTP

Indra company has EBIT of Rs. 1,00,000. The company makes use of debt and equity capital. The firm has
10% debentures of Rs. 5,00,000 and the firm’s equity capitalization rate is 15%.
You are required to compute:
(i) Current value of the firm
(ii) Overall cost of capital.
Answer:
Particulars Amount
EBIT [Given] 1,00,000
-50,000
Less: Interest [5,00,000 x 10%]
EBT 50,000

Cost of debt [Given] 10.00%

Cost of equity [Given] 15.00%
12.00%
Cost of capital [1,00,000/8,33,333]

Value of debt [Given] 5,00,000

3,33,333
Value of equity [50,000/15%]
8,33,333
Value of firm [5,00,000 + 3,33,333]

Question No.15 [May 2021 MTP, May 2018 MTP, Nov 2019 MTP, May 2017]
There are two firms P and Q which are identical except P does not use any debt in its capital structure while
Q has Rs. 8,00,000, 9% debentures in its capital structure. Both the firms have earnings before interest and tax
of Rs. 2,60,000 p.a. and the capitalization rate is 10%. Assuming the corporate tax of 30%, calculate the value

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of these firms according to MM Hypothesis.
Answer:
Valuation of firm as per MM Approach:
Particulars Firm P Firm Q
EBIT 2,60,000 2,60,000
Less: Interest
[Debt x Rate of interest] - -72,000
EBT 2,60,000 1,88,000
Less: Tax -78,000 -56,400
EAT 1,82,000 1,31,600

Cost of debt
[Interest rate x (1 – Tax rate)] NA 6.30%
Cost of equity
[EAT/Amount of equity] 10.00% 10.44%
Cost of capital
[EBIT x (1 – Tax)]/Value of firm 10.00% 8.83%

Value of debt - 8,00,000

Value of equity 18,20,000 12,60,000
Value of firm 18,20,000 20,60,000
Note:
• We will first start with valuation of unlevered firm. Amount of equity of unlevered firm = (EAT/Cost
of equity) = 1,82,000/10% = Rs.18,20,000
• Value of levered firm = Value of unlevered firm + (Amount of debt x Tax rate)
• Value of levered firm = 18,20,000 + (8,00,000 x 30%) = Rs.20,60,000

Question No.16 – Nov 2018, May 2022 RTP

The following data relate to two companies belonging to the same risk class:
Particulars Amount Amount
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 MM approach
b) Determine the total market value, equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per MM approach
Answer:
WN 1: Valuation of two firms as per MM approach without taxes:
Particulars Firm A Firm B
EBIT 18,00,000 18,00,000
-6,48,000
Less: Interest [54,00,000 x 12%] -
EBT 11,52,000 18,00,000

Cost of debt 12.00% NA

25.04% 18.00%
Cost of equity [11,52,000/46,00,000] [Given]
Cost of capital 18.00% 18.00%

Value of debt 54,00,000 -

46,00,000
Value of equity [1,00,00,000-54,00,000] 1,00,00,000

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Value of firm 1,00,00,000 1,00,00,000
• There are no taxes. We start with valuation of unlevered firm and the same is Rs.1,00,00,000
• Valuation of levered firm will remain same as unlevered firm as there are no taxes
• Cost of equity of Firm A = (11,52,000/46,00,000) x 100 = 25.04%

WN 2: Valuation of two firms as per MM approach with taxes:

Particulars Firm A Firm B
EBIT 18,00,000 18,00,000
-6,48,000
Less: Interest [54,00,000 x 12%] -
EBT 11,52,000 18,00,000
Less: Tax @ 40% -4,60,800 -7,20,000
EAT 6,91,200 10,80,000

7.20%
Cost of debt [12% x 60%] NA
25.04% 18.00%
Cost of equity [6,91,200/27,60,000] [Given]
Cost of capital 13.24% 18.00%

Value of debt 54,00,000 -

27,60,000 60,00,000
Value of equity [81,60,000-54,00,000] [10,80,000/18%]
81,60,000
Value of firm [Note] 60,00,000
Note:
• Value of unlevered firm = 10,80,000/18% = Rs.60,00,000
• Value of levered firm = 60,00,000 + (54,00,000 x 40%) = Rs.81,60,000

Question No.:17 (November 2013 RTP)

One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10 per
cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except that its
capital structure is all-equity, and its cost of equity is 16 per cent. According to Modigliani and Miller, if we
ignored taxation and tax relief on debt capital, what would be the cost of equity of Sanghmani Limited?
Answer:
Let us assume EBIT of both companies are Rs.1,60,000 (we can assume any number to do this question)
Particulars Sanghmani Sansui
EBIT 1,60,000 1,60,000
Less: Interest -33,333 -
EBT 1,26,667 1,60,000

Cost of debt 10.00% NA

Cost of equity 19.00% 16.00%
Cost of capital 16.00% 16.00%

Value of debt 3,33,333 -

Value of equity 6,66,667 10,00,000
Value of firm 10,00,000 10,00,000
Note:
• Sansui Limited has cost of equity of 16%. It has no debt and hence cost of capital of Sansui Limited
will also be 16%
• There is no tax in this situation and hence value of firm of both companies will be Rs.10,00,000
• Value of debt of Sanghmani Limited = 10,00,000 x (1/3) = Rs.3,33,333
• Value of equity of Sanghmani Limited = 10,00,000 x (2/3) = Rs.6,66,667
• Cost of equity = (EBT/Value of equity) = (1,26,667/6,66,667) x 100 =16.00%

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Question No.18 – November 2015 RTP

Company P and Q are identical in all respects including risk factors except of debt/equity, company P having
issued 10% debentures of Rs.18 lakhs while company Q is unlevered. Both the companies earn 20% before
interest and taxes on their total assets of Rs.30 lakhs. Assuming a tax rate of 50% and capitalization rate of
15% from an all-equity company.
Required:
Calculate the value of companies’ P and Q using (i) Net Income Approach and (ii) Net Operating Income
Approach
Answer:
WN 1: Valuation of firms as per Net Income Approach:
Particulars Comp P Comp Q
6,00,000 6,00,000
EBIT [30,00,000 x 20%] [30,00,000 x 20%]
-1,80,000
Less: Interest [18,00,000 x 10%] -
EBT 4,20,000 6,00,000
Less: Tax -2,10,000 -3,00,000
EAT 2,10,000 3,00,000

5.00%
Cost of debt [10% x 50%] NA
15.00% 15.00%
Cost of equity [Given] [Given]
9.38% 15.00%
Cost of capital [6,00,000 x 50%]/32,00,000 [6,00,000 x 50%]/20,00,000

18,00,000
Value of debt [Given] -
14,00,000 20,00,000
Value of equity [2,10,000/15%] [3,00,000/20%]
Value of firm 32,00,000 20,00,000

WN 2: Valuation of firm as per Net operating income approach:

Particulars Comp P Comp Q
6,00,000 6,00,000
EBIT [30,00,000 x 20%] [30,00,000 x 20%]
-1,80,000
Less: Interest [18,00,000 x 10%] -
EBT 4,20,000 6,00,000
Less: Tax -2,10,000 -3,00,000
EAT 2,10,000 3,00,000

5.00%
Cost of debt [10% x 50%] NA
19.09% 15.00%
Cost of equity [2,10,000/11,00,000] [Given]
10.34%
Cost of capital [6,00,000 x 50%]/29,00,000 15.00%

Value of debt 18,00,000 -

11,00,000 20,00,000
Value of equity [29,00,000-18,00,000] [3,00,000/15%]
29,00,000
Value of firm [Note] 20,00,000

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• Net operating income is similar to MM approach. In this question we have taxes and hence we should
value unlevered company (company Q) first.
• Value of company P (Levered) = Value of company Q + (Amount of debt x Tax rate)
• Value of company P (Levered) = 20,00,000 + (18,00,000 x 0.5) = Rs.29,00,000

Question No.: 19 (May 2012 exam – 5 Marks, November 2018 RTP)

RES Ltd. is an all equity financed company with a market value of Rs. 25,00,000 and cost of equity Ke = 21%.
The company wants to buyback equity shares worth Rs. 5,00,000 by issuing and raising 15% perpetual debt
of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying MM Model
(with taxes), you are required to calculate:
I. Market value of RES Ltd.
II. Cost of Equity Ke
III. Weighted average cost of capital and comment on it.
Answer:
Analysis of RES Limited before and after restructuring:
Before After
Particulars restructuring restructuring
7,50,000 7,50,000
EBIT [Reverse worked] [Same as before restructuring]
-75,000
Less: Interest - [5,00,000 x 15%]
7,50,000
EBT [5,25,000/70%] 6,75,000
Less: Tax @ 30% -2,25,000 -2,02,500
5,25,000
EAT [25,00,000 x 21%] 4,72,500

10.50%
Cost of debt NA [15% x 70%]
21.98%
Cost of equity 21.00% [4,72,500/21,50,000]
19.81%
Cost of capital 21.00% [7,50,000 x 70%]/26,50,000

Value of debt - 5,00,000

21,50,000
Value of equity 25,00,000 [26,50,000 – 5,00,000]
Value of firm 25,00,000 26,50,000 [Note]
Note:
• Value post restructuring = Value of unlevered firm + (Amount of debt x Tax rate)
• Value post restructuring = 25,00,000 + (5,00,000 x 30%) = 26,50,000

Comments:
• WACC of the company reduces from 21% to 19.81%. Improvement in WACC is due to higher
valuation of firm post restructuring. Value of RES Limited improves due to tax benefit on interest
payment of perpetual debt

Question No.20 – November 2015

RST Ltd. is expecting an EBIT of Rs. 4 lakhs for F.Y. 2015-16. Presently the company is financed entirely by
equity share capital of Rs. 20 lakhs 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.

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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.
Answer:
Particulars Existing 30% buyback 50% buyback
EBIT 4,00,000 4,00,000 4,00,000
-60,000 -1,20,000
Less: Interest - [6,00,000 x 10%] [10,00,000 x 12%]
EBT 4,00,000 3,40,000 2,80,000

Cost of debt [Given] NA 10.00% 12.00%

Cost of equity [Given] 16.00% 17.00% 20.00%
16.00% 15.38% 16.67%
Cost of capital [4,00,000/25,00,000] [4,00,000/26,00,000] [4,00,000/24,00,000]

Value of debt [Note] - 6,00,000 10,00,000

25,00,000 20,00,000 14,00,000
Value of equity [4,00,000/16%] [3,40,000/17%] [2,80,000/20%]
26,00,000 24,00,000
Value of firm 25,00,000 [6,00,000+20,00,000] [10,00,000+14,00,000]
Note:
• Existing EBIT is Rs.4,00,000 and cost of equity is 16%. This would lead to value of equity (including
reserves) of Rs.25,00,000 (4,00,000/16%)
• The company plans to buyback 30% of equity or 50% of equity. Hence debt can be Rs.6,00,000
[20,00,000 x 30%] in option 1 and Rs.10,00,000 [20,00,000 x 50%] in option 2
• Company should opt for 30% buyback as the same results in value increase from Rs.25,00,000 to
Rs.26,00,000

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CHAPTER 6: FINANCING DECISIONS – LEVERAGES
Format for calculation of leverages:
Particulars Amount
Sales XXX
Less: Variable costs (XXX)
Contribution XXX
Less: Fixed Costs (XXX)
Earnings before interest and tax (EBIT) XXX
Less: Interest (XXX)
Earnings before Tax (EBT) XXX
Less: Tax (XXX)
Earnings after Tax (EAT) XXX
Less: Preference Dividend (XXX)
Earnings available to equity shareholders (EAES) XXX
No of equity shares XXX
Earnings Per share (EPS) [EAES / No of shares] XXX

Formulae:
Type of Leverage Formula
Operating Leverage Contribution % Change in EBIT
(or)
EBIT % change in Sales
Financial Leverage EBIT % Change in EPS
(or)
PD % change in EBIT
EBT −
1 − Tax rate
Combined Leverage Contribution % Change in EPS
(or) (or) OL x FL
PD % change in sales
EBT −
1 − Tax rate

Question No.: 1 (November 2012 exam – 5 Marks)

X Limited has estimated that for a new product its break-even point is 20,000 units if the item is sold for Rs.
14 per unit and variable cost Rs. 9 per unit. Calculate the degree of operating leverage for sales volume 25,000
units and 30,000 units.
Answer:
25,000 30,000
Particulars units Units
Sales 3,50,000 4,20,000
Less: Variable cost -2,25,000 -2,70,000
Contribution 1,25,000 1,50,000
Less: Fixed cost (BEP x CPU) -1,00,000 -1,00,000
EBIT 25,000 50,000
Operating leverage 5 Times 3 Times

Question No.: 2 – May 2015 exam

The following summarises the percentage changes in operating income, percentage changes in revenues, and
betas for four pharmaceutical firms.
Firm Change in revenue Change in operating income Beta
PQR Limited 27% 25% 1.00
RST Limited 25% 32% 1.15
TUV Limited 23% 36% 1.30
WXY Limited 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.
Answer:
Computation of Operating Leverage
Firm Change in revenue (B) Change in operating income (A) OL (A/B)
PQR Limited 27% 25% 0.9259

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RST Limited 25% 32% 1.2800
TUV Limited 23% 36% 1.5652
WXY Limited 21% 40% 1.9048
• Operating income refers to EBIT. Operating leverage = Change in EBIT/Change in sales

Comments:
High operating leverage leads to high Beta. So when Operating leverage is lowest, Beta is minimum at 1 time
and when operating leverage is maximum (1.9048), beta is highest at 1.40 Times

Question No.3 – November 2016 RTP, Nov 2021 MTP

The capital structure of the Shiva Ltd. consists of equity share capital of Rs. 20,00,000 (Share of Rs. 100 per
value) and Rs. 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000 units, the
selling price is Rs. 10 per unit; variable costs amount to Rs. 6 per unit and fixed expenses amount to Rs.
4,00,000. The income tax rate is assumed to be 50%.
a) You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.
(b) Comment on the behaviour of operating and Financial leverages in relation to increase in production from
2,00,000 units to 2,40,000 units.
Answer:
WN 1: Income statement for 2,00,000 and 2,40,000 units:
Particulars 2,00,000 units 2,40,000 units
Sales @ 10 per unit 20,00,000 24,00,000
Less: Variable cost @ 6 per unit -12,00,000 -14,40,000
Contribution 8,00,000 9,60,000
Less: Fixed cost -4,00,000 -4,00,000
EBIT 4,00,000 5,60,000
Less: Interest [20,00,000 x 10%] -2,00,000 -2,00,000
EBT 2,00,000 3,60,000
Less: Tax @ 50% -1,00,000 -1,80,000
EAT 1,00,000 1,80,000
Less: PD 0 0
EAES 1,00,000 1,80,000
No of shares [20,00,000/100] 20,000 20,000
EPS 5.00 9.00
9−5
% Increase in EPS = 𝑥 100 = 80%
5
4,00,000 5,60,000
= = 2 Times = = 1.56 Times
Financial Leverage [EBIT/EBT] 2,00,000 3,60,000
8,00,000 9,60,000
= = 2 Times = = 1.71 Times
Operating Leverage [Contribution/EBIT] 4,00,000 5,60,000
Comments:
When production is increased from 2,00,000 units to 2,40,000 units both financial leverage and operating
leverages reduced from 2 to 1.56 and 1.71 respectively. Reduction in financial leverage and operating
leverages signifies reduction in business risk and financial risk

Question No.4 [Nov 2020 MTP, Nov 2019 MTP]

Betatronics Limited has the following balance sheet and income statement information:
Liabilities Amount Assets Amount
Equity shares capital (Rs.10 per share) 8,00,000 Net Fixed assets 10,00,000
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

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Sales 3,40,000
Operating expenses (including Rs.60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
EBT 1,60,000
Less: Taxes 56,000
EAT 1,04,000
a. Determine the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs.
b. If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 percent,
what will be the EPS at the new sales level.
Answer:
WN 1: Computation of leverages:
Particulars Amount
Sales 3,40,000
Less: Variable cost -60,000
Contribution 2,80,000
Less: Fixed cost -60,000
EBIT 2,20,000
Less: Interest -60,000
EBT 1,60,000
Less: Tax @ 35% -56,000
EAT 1,04,000
Less: PD 0
EAES 1,04,000
No of shares 80,000
EPS 1.30
Contribution 2,80,000
Operating leverage = = = 1.27 Times
EBIT 2,20,000
EBIT 2,20,000
Financial leverage = = = 1.375 Times
PD
EBT − ( ) 1,60,000 − 0
1 − Tax rate
Contribution 2,80,000
Combined leverage = = = 1.75 Times
PD
EBT − ( ) 1,60,000 − 0
1 − Tax rate

WN 2: Computation of revised EPS:

Particulars Amount
% change in sales 20%
Combined leverage 1.75
% change in EPS (20 x 1.75 Times) 35%
New EPS:
Sales increase by 20% (1.30 + 35%) 1.755
Sales decrease by 20% (1.30 – 35%) 0.845

Question No.5 [Nov 2019]

Z Limited is considering the installation of a new project costing Rs. 80,00,000. Expected annual sales revenue
from the project is Rs. 90,00,000 and its variable costs are 60 percent of sales.
Expected annual fixed cost other than interest is Rs. 10,00,000. Corporate tax rate is 30 percent. The company
wants to arrange the funds through issuing 4,00,000 equity shares of Rs. 10 each and 12 percent debentures
of Rs. 40,00,000.
You are required to:
• Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
• Determine the likely level of EBIT, if EPS is (1) Rs. 4, (2) Rs. 2, (3) Rs. 0.
Answer:

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WN 1: Income statement:
Particulars Amount
Sales 90,00,000
Less: Variable cost -54,00,000
Contribution 36,00,000
Less: Fixed cost -10,00,000
EBIT 26,00,000
Less: Interest -4,80,000
EBT 21,20,000
Less: Tax @ 30% -6,36,000
EAT 14,84,000
Less: PD -
EAES 14,84,000
No of shares 4,00,000
EPS 3.71

WN 2: Solution:
Note 1: Computation of leverages:
Contribution 36,00,000
Operating leverage = = = 1.3846 Times
EBIT 26,00,000
EBIT 26,00,000
Financial leverage = = = 1.2264 Times
PD 21,20,000 −0
EBT − ( )
1 − Tax rate
Contribution 36,00,000
Combined leverage = = = 1.6981 Times
PD
EBT − ( ) 21,20,000 − 0
1 − Tax rate
Note 2: EPS:
• EPS = 3.71 Times

Note 3: Computation of EBIT for target EPS:

Particulars EPS = 4 EPS = 2 EPS = 0
EPS 4 2 0
No of shares 4,00,000 4,00,000 4,00,000
EAES/EAT 16,00,000 8,00,000 -
EBT (EAT/1-Tax) 22,85,714 11,42,857 -
Interest 4,80,000 4,80,000 4,80,000
EBIT 27,65,714 16,22,857 4,80,000

Question No.6 – May 2021 MTP, Nov 2020

Following information has been extracted from the accounts of newly incorporated Textyl Private Limited
for the financial year 2020-21:
Sales 15,00,000
PV Ratio 70%
Operating Leverage 1.40
Financial leverage 1.25
Using the concept of leverage, find out and verify in each case:
(i) The percentage change in taxable income if sales increase by 15%.
(ii) The percentage change in EBIT if sales decrease by 10%.
(iii) The percentage change in taxable income if EBIT increase by 15%.
Answer:
WN 1: Preparation of income statement:
Particulars Amount
Sales 15,00,000
Less: Variable cost [Sales x 30%] -4,50,000

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Contribution 10,50,000
Less: Fixed cost (b/f) -3,00,000
EBIT [Note 1] 7,50,000
Less: Interest (b/f) -1,50,000
EBT [Note 2] 6,00,000

Note 1: Computation of EBIT:

Contribution
Operating Leverage =
EBIT
10,50,000 10,50,000
1.40 = ; EBIT = = 7,50,000
EBIT 1.40

Note 2: Computation of EBT:

EBIT
Financial Leverage =
PD
EBT − ( )
1 − Tax
7,50,000 7,50,000
1.25 = ; 𝐸𝐵𝑇 = = 𝑅𝑠. 6,00,000
𝐸𝐵𝑇 1.25

WN 2: Computation of percentage change in taxable income (PBT) if sales increase by 15%:

• Combined leverage = Operating leverage x Financial Leverage
• Combined leverage = 1.40 x 1.25 = 1.75 Times
• Combined leverage of 1.75 times would mean that PBT will increase by 1.75% for 1% change in
sales
• Sales will change by 15% and hence taxable income will change by 26.25% [15 x 1.75]

Verification:
Particulars Amount
Sales [15,00,000 + 15%] 17,25,000
Less: Variable cost [Sales x 30%] -5,17,500
Contribution 12,07,500
Less: Fixed cost -3,00,000
EBIT 9,07,500
Less: Interest -1,50,000
EBT 7,57,500
Old EBT 6,00,000
% increase in EBT [1,57,500/6,00,000] 26.25

WN 3: Computation of percentage change in EBIT if sales decline by 10%:

• Operating leverage = 1.40 Times
• Combined leverage of 1.40 times would mean that EBIT will increase by 1.40% for 1% change in
sales
• Sales will decline by 10% and hence EBIT will decline by 14.00% [1.40 x 10]

Verification:
Particulars Amount
Sales [15,00,000 - 10%] 13,50,000
Less: Variable cost [Sales x 30%] -4,05,000
Contribution 9,45,000
Less: Fixed cost -3,00,000
EBIT 6,45,000
Old EBIT 7,50,000
% fall [1,05,000/7,50,000 x 100] 14.00

WN 4: Computation of percentage change in taxable income (PBT) if EBIT increase by 15%:

• Financial leverage = 1.25 Times
• Financial leverage of 1.25 times would mean that PBT will increase by 125% for 1% change in EBIT

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• EBIT will increase by 15% and hence taxable income will increase by18.75% [15 x 1.25]

Verification:
Particulars Amount
EBIT [7,50,000 + 15%] 8,62,500
Less: Interest -1,50,000
EBT 7,12,500
Old EBT 6,00,000
% increase in EBT [1,12,500/6,00,000] 18.75

Question No.7 – May 2021 MTP:

The net sales of A Ltd. is Rs. 30 crores. Earnings before interest and tax of the company as a percentage of net
sales is 12%. The capital employed comprises Rs. 10 crores of equity, Rs. 2 crores of 13% Cumulative
Preference Share Capital and 15% Debentures of Rs. 6 crores. Income-tax rate is 40%.
• Calculate the Return-on-equity for the company and indicate its segments due to the presence of
Preference Share Capital and Borrowing (Debentures).
• Calculate the Operating Leverage of the Company given that combined leverage is 3.
Answer:
WN 1: Income statement:
Amount
Particulars [in lacs]
360.00
EBIT [3,000 x 12%]
-90.00
Less: Interest [600 x 15%]
EBT 270.00
-108.00
Less: Tax @ 40% [270 x 40%]
EAT 162.00
-26.00
Less: PD [200 x 13%]
EAES 136.00

Note 1: Computation of financial leverage:

EBIT 360 360
Financial leverage = = = = 1.5882 Times
PD 26 270 − 43.33
EBT − ( ) 270 − ( )
1 − Tax 0.6

Note 2: Computation of operating leverage:

Combined leverage = Operating leverage x Financial Leverage
𝟑
3 = Operating leverage x 1.5882; 𝐎𝐩𝐞𝐫𝐚𝐭𝐢𝐧𝐠 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = 𝟏. 𝟖𝟖𝟖𝟗 𝐓𝐢𝐦𝐞𝐬
𝟏. 𝟓𝟖𝟖𝟐

WN 2: Analysis of ROE:
Particulars Calculation Amount
ROCE EBIT x (1 − Tax) 360x0.6 12.00%
=
Capital employed 1,000 + 200 + 600
ROE EAES 136 13.60%
=
Amount of equity 1,000
Note:
• The company is earning return of 12% on capital employed. However, equity shareholders earn rate
of return of 13.60%.
• Excess return earned by equity shareholders could be because the company is paying lower return
to debt and preference shareholders
Type of Amount of Return eligible @ Actual Return Excess/lower
capital capital 12% paid return
Debt 600 72 54 -18

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[90 x 60%]
Preference 200 24 26 2
Equity 1,000 120 136 16
• Debenture holders should have been paid a return of 12% as the company is having ROCE of 12%.
They are eligible to get return of Rs.72 lacs. However, they have been paid after-tax interest of Rs.54
lacs (90 lacs x 60%). Hence, we have paid Rs.18 lacs less to debenture holders and the same would be
given to equity shareholders
• Preference holders should have been paid a return of 12% as the company is having ROCE of 12%.
They are eligible to get return of Rs.24 lacs. However, they have been paid preference dividend of
Rs.26 lacs. Hence, we have paid Rs.2 lacs excess to equity shareholders and the same would be
compensated by equity shareholders
• Return to equity shareholders = 120 lacs (1,000 x 12%) + 18 lacs – 2 lacs = Rs.136 lacs
• ROE segments:
o Company’s ROCE = 12%
o Excess return due to lower payment to debenture holders = (18/1,000) x 100 = 1.80%
o Lower return due to higher payment to preference = (2/1,000) x 100 = -0.20%
o Final ROE = 12% + 1.80% - 0.20% = 13.60%

Question No.8 – May 2018

If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find the
financial leverage and P/V ratio, given that the equity dividend per share is Rs. 2, interest payable per year
is Rs. 1 lakhs, total fixed cost Rs. 0.5 lakh and sales Rs. 10 lakhs.
Answer:
Computation statement:
Particulars Amount
Sales 10,00,000
Less: Variable cost [b/f] -7,50,000
Contribution [Note 2] 2,50,000
Less: Fixed cost -50,000
EBIT 2,00,000
Less: Interest -1,00,000
EBT 1,00,000

Note 1: Computation of financial leverage:

Combined Leverage = Operating Leverage x Financial Leverage
2.5 Times = 1.25 Times x Financial Leverage
𝟐. 𝟓
𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = 𝟐 𝐓𝐢𝐦𝐞𝐬
𝟏. 𝟐𝟓

Note 2: Computation of Contribution:

Let us assume contribution to be X
Contribution X
Operating Leverage = ; 1.25 = ; 1.25𝑋 − 62,500 = 𝑋
EBIT X − 50,000
𝟎. 𝟐𝟓𝐗 = 𝟔𝟐, 𝟓𝟎𝟎; 𝐗 = 𝟐, 𝟓𝟎, 𝟎𝟎𝟎

Note 3: Computation of PV Ratio:

Contribution 2,50,000
PVR = x 100 = x 100 = 𝟐𝟓%
sales 10,00,000

Question No.9 – November 2017, Nov 2021 MTP

The following details of RST Limited for the year ended 31st March, 2006 are given below:
Operating Leverage 1.4
Combined Leverage 2.8
Fixed cost (Excluding Interest) 2.04 lacs
Sales 30.00 lacs
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12% Debentures of Rs.100 each 21.25 lacs
Equity share capital of Rs.10 each 17.00 lacs
Income Tax rate 30 percent
Required:
a) Calculate financial leverage
b) Calculate PV Ratio and EPS
c) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low assets
leverage
d) At what level of sales the Earnings before Tax (EBT) of the company will be equal to zero?
Answer:
WN 1: Income statement of RST Limited for the year ended 31 st March, 2006:
Particulars Amount
Sales 30,00,000
Less: Variable cost (B/F) -22,86,000
Contribution 7,14,000
Less: Fixed cost -2,04,000
EBIT 5,10,000
Less: Interest (21,25,000 x 12%) -2,55,000
EBT 2,55,000
Less: Tax @ 30% -76,500
EAT 1,78,500
Less: PD -
EAES 1,78,500
No of shares 1,70,000
EPS 1.05

Note 1: Computation of Contribution:

• Let us assume contribution to be X
• EBIT = X – 2,04,000
X X
OL = ; 1.4 = ; 1.4X − 2,85,600 = X
X − 2,04,000 X − 2,04,000
0.4X = 2,85,600; 𝐗 = 𝟕, 𝟏𝟒, 𝟎𝟎𝟎

WN 2: Solution:
Note 1: Computation of financial leverage:
EBIT 5,10,000
Financial leverage = = = 2 Times
PD
EBT − ( ) 2,55,000
1 − Tax

Note 2: Computation of PV Ratio:

Contribution 7,14,000
PV Ratio = x 100 = x 100 = 23.80%
Sales 30,00,000

Note 3: Computation of EPS

• EPS =Rs.1.05 (as per WN 1)

Note 4: Comment on asset turnover:

Sales 30,00,000
Asset Turnover Ratio = = = 0.784 Times
Total Assets (17,00,000 + 21,25,000)
• Industry is operating at capital turnover ratio of 1.50 times whereas the firm operates at asset
turnover of 0.784 Times. This would mean that firm has low asset turnover ratio.

Note 5: Computation of sales to at which EBT = 0

• Combined leverage measures percentage change in EPS for percentage change in sales. In this
question, EBT change will be equal to EPS change. This is because there is no preference dividend

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• Hence, Combined Leverage measures percentage change in EBT for percentage change in sales in
this question
Particulars Amount
Target EBT 0
% fall in EBT 100%
Combined leverage 2.80
% fall in sales (100/2.80) 35.7142857
Sales at zero EBT (30,00,000 – 35.7142857%) 19,28,571

Question No.10 – November 2015 RTP, November 2018 RTP

A firm has sales of Rs. 75,00,000, Variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. it has a debt of
Rs. 45,00,000 at 9% and equity of Rs. 55,00,000
a. What is the firm’s ROI?
b. Does it have favorable financial leverage?
c. If the firm belongs to an industry whose capital turnover is 3, does it have a high or low
capital turnover?
d. What are the different leverages of the firm?
e. If the sales drop to Rs,. 50,00,000 what will be the new EBIT?
f. If the sales is increased by 10% by what percentage EBIT will increase?
g. At what level of sales the EBT of the firm will be equal to zero?
h. If EBIT increases by 20%, by what percentage EBT will increase?
Answer:
Computation statement:
Particulars Amount
Sales 75,00,000
Less: Variable cost -42,00,000
Contribution 33,00,000
Less: Fixed cost -6,00,000
EBIT 27,00,000
Less: Interest -4,05,000
EBT 22,95,000
Note 1: Computation of leverages:
Contribution 33,00,000
Operating leverage = = = 1.22 Times
EBIT 27,00,000
EBIT 27,00,000
Financial leverage = = = 1.18 Times
PD
EBT − ( ) 22,95,000 − 0
1 − Tax rate
Contribution 33,00,000
Combined leverage = = = 1.44 Times
PD 22,95,000 −0
EBT − ( )
1 − Tax rate

Note 2: Computation of ROI:

EBIT 27,00,000
𝐑𝐎𝐈 (𝐨𝐫)𝐑𝐎𝐂𝐄 = = x 100 = 𝟐𝟕%
Capital employed 45,00,000 + 55,00,000

Note 3: Comment on financial leverage:

• A firm has favorable leverage if return on investment is higher than cost of debt. Similarly, a firm
has adverse financial leverage if ROI is lower than cost of debt
• In this case, ROI (27%) is higher than cost of debt (9%) and hence firm has favorable financial leverage

Note 4: Comment on capital turnover:

Sales 75,00,000
Capital Turnover Ratio = = = 0.75 Times
Capital employed 1,00,00,000

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• Industry is operating at capital turnover ratio of 3 times whereas the firm operates at capital turnover
of 0.75 Times. This would mean that firm has low capital turnover ratio.

Note 5: Computation of revised EBIT:

Particulars Amount
Earlier sales 75,00,000
New sales 50,00,000
Decrease in sales 25,00,000
Decrease in sales (%) 33.33333%
Operating leverage 1.222222
% fall in EBIT (33.3333333 x 1.222222) 40.74074%
New EBIT (27,00,000 – 40.74074%) 16,00,000

Note 6: Computation of percentage increase in EBIT:

Particulars Amount
% increase in sales 10.00%
Operating leverage 1.2222
% increase in EBIT (10 x 1.2222) 12.22%

Note 7: Computation of sales to at which EBT = 0

• Combined leverage measures percentage change in EPS for percentage change in sales. In this
question, EBT change will be equal to EPS change. This is because there is no preference dividend
• Hence, Combined Leverage measures percentage change in EBT for percentage change in sales in
this question
Particulars Amount
Target EBT 0
% fall in EBT 100%
Combined leverage 1.437909
% fall in sales (100/1.437909 69.54543
Sales at zero EBT (75,00,000 – 69.54543%) 22,84,093

Note 8: Computation of percentage increase in EBT:

• Financial leverage in this question will measure percentage change in EBT(EPS) for percentage
change in EBIT
Particulars Amount
% change in EBIT 20.00%
Financial leverage 1.18
% change in EBT (20 x 1.18) 23.60%

Question No.11 – May 2018

From the following financial data of Company A and Company B: Prepare their Income Statements.
Company A B
Variable cost 56,000 60% of sales
Fixed cost 20,000 -
Interest expenses 12,000 9,000
Financial leverage 5:1 -
Operating leverage - 4:1
Income tax rate 30% 30%
Sales - 1,05,000
Answer:
WN 1: Income statement of Company A and Company B:
Particulars Company A Company B

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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
EBIT 15,000 10,500
Less: Interest -12,000 -9,000
EBT 3,000 1,500
Less: Tax -900 -450
EAT 2,100 1,050

WN 2: Analysis of Company A:
Note 1: Computation of EBIT:
• Let us assume EBIT of company A to be X
• EBT = X – 12,000
EBIT X
Financial leverage = ;5 = ; 5X − 60,000 = X; 4X = 60,000; X = 15,000
EBT X − 12,000

Note 2: Computation of sales:

• Contribution = EBIT + Fixed cost = 15,000 + 20,000 = Rs.35,000
• Sales = Fixed cost + Variable cost = 35,000 + 56,000 = Rs.91,000

WN 3: Analysis of Company B:
Note 1: Computation of EBIT:
Contribution 42,000 42,000
Operating leverage = ;4 = ; EBIT = = Rs. 10,500
EBIT EBIT 4

Question No.12 – November 2016

The following information related to XL Company Ltd. for the year ended 31st March, 2013 are available to
you:
Particulars Amount
Equity share capital of Rs.10 each 25,00,000
11% bonds of Rs.1,000 each 18,50,000
Fixed cost (excluding interest) 3,48,000
Sales 42,00,000
Financial leverage 1.39
Profit-volume ratio 25.55%
Income tax rate 35%
Market price per share Rs.20
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage;
(iii) Earning per Share.
(iv) Earning yield
Answer:
WN 1: Income statement:
Particulars Amount
Sales 42,00,000
Less: Variable cost (b/f) -31,26,900
Contribution (Sales x 25.55%) 10,73,100
Less: Fixed cost -3,48,000
EBIT 7,25,100
Less: Interest (18,50,000 x 11%) -2,03,500
EBT 5,21,600
Less: Tax -1,82,560
EAT 3,39,040
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Less: PD -
EAES 3,39,040
No of shares 2,50,000
EPS 1.36

WN 2: Solution:
Contribution 10,73,100
(i)Operating leverage = = = 1.48 Times
EBIT 7,25,100

Contribution 10,73,100
(ii)Combined leverage = = = 2.06 Times
PD
EBT − ( ) 5,21,600 − 0
1 − Tax
(iii)EPS = Rs. 1.36

EPS 1.36
(iv)Earnings Yield = x 100 = x100 = 6.80%
MPS 20

Question no.13 – November 2015

From the following prepare income statement of Company A, B and C
Company A B C
Financial Leverage 3:1 4:1 2:1
Interest Rs.200 Rs.300 Rs.1000
Operating leverage 4:1 5:1 3:1
Variable cost ratio 66 2/3% 75% 50%
Income tax rate 45% 45% 45%
Answer:
WN 1: Income statement of Company A, B and C:
Particulars Company A Company B Company C
Sales (Note 2) 3,600 8,000 12,000
Less: Variable cost (b/f) -2,400 -6,000 -6,000
Contribution (EBIT x OL) 1,200 2,000 6,000
Less: Fixed cost (b/f) -900 -1,600 -4,000
EBIT (Note 1) 300 400 2,000
Less: Interest -200 -300 -1,000
EBT 100 100 1,000
Less: Tax -45 -45 -450
EAT 55 55 550

Note 1: Computation of EBIT:

Let us assume EBIT to be X
EBIT
Financial leverage =
EBT
Company A:
X
3= ; 3X − 600 = X; 2X = 600; X = 300
X − 200
Company B:
X
4= ; 4X − 1,200 = X; 3X = 1,200; X = 400
X − 300
Company C:
X
2= ; 2X − 2,000 = X; X = 2,000
X − 1,000

Note 2: Computation of sales:

Particulars Company A Company B Company C

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Variable cost ratio 66.66666% 75.00% 50.00%
Profit volume ratio (100 – VCR) 33.33333% 25.00% 50.00%
Contribution 1,200 2,000 6,000
Sales (Contribution/PVR) 3,600 8,000 12,000

Question No.:14 (May 2012 exam – 8 Marks)

The capital structure of JCPL Limited is as follows:
Particulars Amount
Equity share capital of Rs.10 each 8,00,000
8% preference shares of Rs.10 each 6,25,000
10% debentures of Rs.100 each 4,00,000
18,25,000
Additional information:
• Profit after tax (tax rate 30%) Rs.1,82,000
• Operating expenses (including depreciation of Rs.90,000) being 1.50 times of EBIT
• Equity share dividend paid 15%
• Market price per equity share Rs.20
Required to calculate:
• Operating and financial leverage
• Cover for the preference and equity share of dividends
• The earnings yield and price earnings ratio
• The net fund flow
Answer:
WN 1: Computation of leverages:
Particulars Amount
Sales 7,50,000
Less: Variable cost -3,60,000
Contribution 3,90,000
Less: Fixed cost -90,000
EBIT 3,00,000
Less: Interest -40,000
EBT (100%) 2,60,000
Less: Tax (30%) -78,000
EAT (70%) 1,82,000
Less: PD -50,000
EAES 1,32,000
No of shares 80,000
EPS 1.65

Note 1: Computation of variable and fixed cost:

• Operating expenses = 1.5 times x 3,00,000 = Rs.4,50,000
• Fixed cost (Depreciation) = Rs.90,000
• Variable cost = 4,50,000 – 90,000 = Rs.3,60,000

Note 2: Computation of leverages:

Contribution 3,90,000
Operating leverage = = = 1.30 Times
EBIT 3,00,000
EBIT 3,00,000 3,00,000
Financial leverage = = =
PD 50,000
EBT − (
1 − Tax rate
) 2,60,000 − ( ) 2,60,000 − 71,429
1 − 0.3
𝟑, 𝟎𝟎, 𝟎𝟎𝟎
𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = 𝟏. 𝟓𝟗 𝐓𝐢𝐦𝐞𝐬
𝟏, 𝟖𝟖, 𝟓𝟕𝟏

WN 2: Computation of preference dividend and equity dividend coverage ratio:

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PAT 1,82,000
Preference Dividend Coverage Ratio = = = 𝟑. 𝟔𝟒 𝐓𝐢𝐦𝐞𝐬
Preference Dividend 50,000
EAES 1,32,000
Equity Dividend Coverage Ratio = = = 𝟏. 𝟏𝟎 𝐓𝐢𝐦𝐞𝐬
Equity Dividend 1,20,000

WN 3: Computation of earnings yield and price-earnings ratio:

MPS 20
Price earnings ratio = = = 12.12 Times
EPS 1.65
EPS 1.65
Earnings yield = x 100 = x 100 = 8.25%
MPS 20

WN 4: Computation of net fund flow:

Net fund flow = PAT + Depreciation – Preference Dividend – Equity dividend
Net fund flow = 1,82,000 + 90,000 – 50,000 – 1,20,000 = Rs.1,02,000

Question No.15 – May 2017 RTP

Calculate operating, financial and combined leverages under situations when fixed costs are: (a) Rs.5,000 and
(b) Rs, 10,000 and financial plans 1 and 2 respectively from the following information pertaining to the
operation and capital structure of a textile company:
Total assets: Rs.30,000 Total assets turnover 2 times Variable cost as a percentage of sales 60%
Capital structure Plan 1 Plan2
Equity 30,000 10,000
10% Debentures 10,000 30,000
Answer:
FC (5,000) + Plan FC (5,000) + Plan FC (10,000) + Plan FC (10,000) + Plan
Particulars 1 2 1 2
Sales 60,000 60,000 60,000 60,000
Less: Variable cost -36,000 -36,000 -36,000 -36,000
Contribution 24,000 24,000 24,000 24,000
Less: Fixed cost -5,000 -5,000 -10,000 -10,000
EBIT 19,000 19,000 14,000 14,000
Less: Interest -1,000 -3,000 -1,000 -3,000
EBT 18,000 16,000 13,000 11,000
1.26 1.26 1.71 1.71
OL [24,000/19,000] [24,000/19,000] [24,000/14,000] [24,000/14,000]
1.06 1.19 1.08 1.27
FL [19,000/18,000] [19,000/16,000] [14,000/13,000] [14,000/11,000]
1.33 1.50 1.85 2.18
CL [24,000/18,000] [24,000/16,000] [24,000/13,000] [24,000/11,000]
Note 1: Computation of sales:
Sales Sales
Asset Turnover ratio = ;2 = ; 𝐒𝐚𝐥𝐞𝐬 = 𝐑𝐬. 𝟔𝟎, 𝟎𝟎𝟎
Total assets 30,000

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CHAPTER 7: INVESTMENT DECISIONS

Special items in capital budgeting:

Depreciation Depreciation is a non-cash item and does not affect the cash flow. However, we
must consider tax shield or benefit from depreciation in our analysis. Since this
benefit reduces cash outflow for taxes it is considered as cash inflow
Opportunity cost Opportunity cost can occur both at the time of initial outlay or during the tenure
of the project. For example, if a company owns a piece of land acquired 10 years ago
for Rs.1 crore at that time, today it can be sold for Rs.10 crore. If company uses this
piece of land for a project then its sale value i.e. 10 crore forms the part of initial
outlay. The cost of acquisition 10 years ago shall be irrelevant for decision
making.
Sunk cost Sunk cost is an outlay that has already incurred and hence should be excluded from
capital budgeting analysis.
Working capital Initial working capital requirement should be treated as cash outflow and at the
end of the project its release should be treated as cash inflow. Further there may
be also a possibility that additional working capital may be required during the
life of the project. In such cases the additional working capital required is treated
as cash outflow at that period of time. Similarly, any reduction in working capital
shall be treated as cash inflow
Allocated / Allocated overheads are charged on the basis of some rational basis such as machine
General / hour, labour hour, direct material consumption etc. Since, expenditures already
corporate incurred are allocated to new proposal; they should not be considered as cash
overheads flows. However, it is expected that overhead cost shall be increased due to
acceptance of any proposal then incremental overhead cost shall be treated as cash
outflow
Additional capital Capital investment can also be required during the continuance of the project. In
investment such cases it shall be treated as cash outflows
Financing costs When cash flows relating to long-term funds are being defined, financing costs
of long-term funds (interest on long-term debt and equity dividend) should be
excluded from the analysis. The question arises why? The weighted average cost
of capital used for evaluating by discounting the cash flows takes into account the
cost of long-term funds. Putting it differently, the interest and dividend payments
are reflected in the weighted average cost of capital. Hence, if interest on long-term
debt and dividend on equity capital are deducted in defining the cash flows, the
cost of long-term funds will be counted twice
Post-tax cash Tax payments like other payments must be properly deducted in deriving the
flows cash flows. That is, cash flows must be defined in post-tax terms
Incremental cash It is the incremental cash flow and not total cash flow after tax
flows

Steps for calculation of cash flows:

Step 1: Initial Outflow
Particulars Amount
Capital expenditure (XXX)
Working capital (XXX)
Total outflow (XXX)

Step 2: In-between cash flows:

Particulars Amount
Revenues XXX
Less: All costs other than depreciation (XXX)
Profit before depreciation and tax (PBDT) XXX
Less: Depreciation (XXX)
Profit before Tax (PBT) XXX
Less: Tax (XXX)
Profit after Tax (PAT) XXX

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Add: Depreciation XXX
Cash flow after tax (CFAT) XXX
Add/Less: Increase/decrease in Working capital XXX
Less: Purchase of additional machinery / payment for original machine (XXX)
Revised CFAT XXX

Step 3: Terminal flow:

Particulars Amount
Net salvage value of capital expenditure (Note 1) XXX
Recapture of working capital XXX
Total terminal flow XXX

Note 1: Calculation of Net Salvage Value:

Particulars Amount
Sale value XXX
Less: Book value (XXX)
Capital gain/loss XXX
Tax Paid/saved XXX

Net salvage value (Sale value + Tax saved – Tax Paid) XXX

Step 4: Consolidate the cash flows in the below format and calculate appropriate technique (assuming life
of 5 years):
Year Cash flow
0 Step 1
1 Step 2
2 Step 2
3 Step 2
4 Step 2
5 Step 2 + Step 3

Payback:
Meaning Payback refer to the time period in which initial investment in the project will be recovered
Formula Base year + (Unrecovered cash flow of base year / Cash flow of next year)
Note: Base year refer to the last year in which cumulative cash flow is negative
Format Year Cash flow Cumulative cash flow
0 Outflow
1 Inflow
2 Inflow
3 Inflow

Payback reciprocal:
Payback reciprocal = (Average annual cash inflow / Initial investment)

Accounting Rate of Return:

Meaning The accounting rate of return of an investment measures the average annual net
income of the project (incremental income) as a percentage of the investment.
Formula ARR = Average PAT / (Initial or average investment)
Initial investment = Initial outflow
Average investment = Average of initial outflow and salvage value
Format Year Cash flow Depreciation PAT
1
2
3

Discounted Payback:

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Meaning Discounted payback refer to the time period in which initial investment in the project will be
recovered considering time value of money
Formula Base year + (Unrecovered discounted cash flow of base year / Discounted cash flow of nest
year)
Note: Base year refer to the last year in which cumulative cash flow is negative
Format Year Cash flow PVF DCF Cumulative DCF
0 Outflow
1 Inflow
2 Inflow
3 Inflow

Net Present Value:

Meaning NPV refer to the difference between the PV of cash inflows and PV of cash outflows
Formula PV of cash inflows – PV of cash outflows
Format Year Cash flow PVF Discounted Cash Flow
0
1
2
3

Profitability Index:
Meaning This measure the ratio of benefits (PV of cash inflows) to costs (PV of cash outflows)
Formula PV of cash inflows
PV of cash outflows
Format Year Cash flow PVF Discounted Cash Flow
0
1
2
3

Internal Rate of Return:

Meaning Internal rate of return for an investment proposal is the discount rate that equates the
present value of the expected net cash flows with the initial cash outflow.
Steps ❖ Step 1: Compute NPV at initial guess rate
❖ Step 2: If NPV under step 1 is positive NPV, then compute NPV at higher discount
rate. If NPV under step 1 is negative, then compute NPV at lower discount rate
❖ Step 3: Repeat step 2 till we get one positive and one negative NPV
Formula NPV at L1
L1 + x (L2 − L1 )
NPV at L1 − NPV at L2
L1 = Lower rate with + NPV
L2 = Higher rate with - NPV
Format Year Cash flow PVF Discounted Cash Flow
0
1
2
3

Capital Rationing:
Meaning The term capital rationing means money in short supply. Shorty supply means the
money is less than demand for money
Types Divisible Projects and indivisible projects
Divisible ❖ Step 1: Identify acceptable projects – Only those projects which has positive NPV is
Projects to be accepted
❖ Step 2: Identify whether capital rationing exist – Capital rationing exists when the
money available is not sufficient to take up all the acceptable projects
❖ Step 3: Rank the projects in the order of NPV/Initial outflow
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❖ Step 4:
o Allot money to projects in the order of rank
o If money is not available to undertake a project, part of the project should be
undertaken
❖ Step 5: Compute aggregate NPV of selected projects
Indivisible ❖ Step 1: Identify acceptable projects – Only those projects which has positive NPV is
Projects to be accepted
❖ Step 2: Identify whether capital rationing exist – Capital rationing exists when the
money available is not sufficient to take up all the acceptable projects
❖ Step 3: Rank the projects in the order of NPV/Initial outflow
❖ Step 4: Identify the various feasible combinations and compute the aggregate NPV
❖ Step 5: Select the combination which has the highest aggregate NPV

Projects with unequal lives:

❖ Life disparity exists when two mutually exclusive projects have unequal lives
❖ Project selection can be done with the help of Equated Annual Cost (EAC) / Equated Annual Benefit
(EAB)
❖ EAB = NPV / PVAF (Life, Cost of capital)
❖ EAC = Present value of outflows / PVAF (Life, Cost of capital)

Abandonment and Replacement of Project:

Abandonment Giving up an existing asset
Purchase Buying a new asset
Replacement Buying a new asset and giving up an existing asset (Abandonment + Purchase)
How to decide on abandonment of an asset?
Step 1: Initial outflow
Particulars Amount
NSV of existing asset at year 0 (XXX)
Working capital (XXX)
Total outflow (XXX)

Step 2: In-between flows – No change

Step3: Terminal flow:

Particulars Amount
NSV of existing asset at the end of life XXX
Recapture of working capital XXX
Total terminal flow XXX
Step 4: Consolidation of cash flows and calculation of NPV – No change
Conclusion: If the NPV of the project is positive then we should continue with the asset. However if
the same is negative then we have to abandon the asset

How to decide on replacement?

Method 1 : Total Approach:
❖ Step 1: Compute NPV of continuation option
❖ Step 2: Compute NPV of purchase option
❖ Step 3: Decide by comparing step 1 & step 2
o If step 1 is greater than we should continue with existing asset
o If step 2 is greater than we should replace the asset
Method 2: Incremental approach:
❖ Step 1: Compute incremental initial outflow
❖ Step 2: Compute incremental in between cash flows
❖ Step 3: Compute incremental terminal flow
❖ Step 4: If the NPV is positive then we should go ahead with replacement.

Question No.: 1 (November 2012 exam – 10 Marks)

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A Ltd. is considering the purchase of a machine which will perform some operations which are at present
performed 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 p.a. 7,000 11,000
Estimated cost of indirect material p.a. 6,000 8,000
Estimated savings in scrap p.a. 10,000 15,000
Estimated cost of supervision p.a. 12,000 16,000
Estimated savings in wages p.a. 90,000 1,20,000
Depreciation will be charged on straight line basis. The tax rate is 30%. Evaluate the alternatives according
to:
(i) Average rate of return method, and
(ii) Present value index method assuming cost of capital being 10%.
(The present value of Rs. 1.00 @ 10% p.a. for 5 years is 3.79 and for 6 years is 4.354)
Answer:
WN 1: Computation of cash flows:
Particulars Machine X Machine Y
Revenue/cost reduction
Savings in scrap 10,000 15,000
Savings in wages 90,000 1,20,000
Less: Maintenance cost (7,000) (11,000)
Less: Indirect material (6,000) (8,000)
Less: Supervision (12,000) (16,000)
Profit before Depreciation and Tax (PBDT) 75,000 1,00,000
Less: Depreciation (30,000) (40,000)
Profit before tax (PBT) 45,000 60,000
Less: Tax @ 30% (13,500) (18,000)
Profit after tax (PAT) 31,500 42,000
Add: Depreciation 30,000 40,000
Cash flow after taxes (CFAT) 61,500 82,000

WN 2: Computation of Average Rate of Return (ARR) of Machine X and Machine Y:

Particulars Machine X Machine Y
Average profit per year 31,500 42,000
Initial investment 1,50,000 2,40,000
Closing investment (scrap value) 0 0
Average investment (Initial + Closing)/2 75,000 1,20,000
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
31,500
ARR of Machine X = x 100 = 21.00%
1,50,000
42,000
ARR of Machine Y = x 100 = 17.50%
2,40,000

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
31,500
ARR of Machine X = x 100 = 42.00%
75,000
42,000
ARR of Machine Y = x 100 = 35.00%
1,20,000

WN 3: Computation of Present value index (Profitability index) of Machine X:

Year Cash flow PVF @ 10% DCF
0 (1,50,000) 1.000 (1,50,000)
1 to 5 61,500 3.790 2,33,085

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𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝟐, 𝟑𝟑, 𝟎𝟖𝟓
𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐈𝐧𝐝𝐞𝐱 (𝐢𝐧 %) = 𝐱 𝟏𝟎𝟎 = 𝐱 𝟏𝟎𝟎 = 𝟏𝟓𝟓. 𝟑𝟗%
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝟏, 𝟓𝟎, 𝟎𝟎𝟎
𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝟐, 𝟑𝟑, 𝟎𝟖𝟓
𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐈𝐧𝐝𝐞𝐱 (𝐢𝐧 𝐓𝐢𝐦𝐞𝐬) = = = 𝟏. 𝟓𝟓 𝐓𝐢𝐦𝐞𝐬
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝟏, 𝟓𝟎, 𝟎𝟎𝟎

WN 4: Computation of Present value index (Profitability index) of Machine Y:

Year Cash flow PVF @ 10% DCF
0 (2,40,000) 1.000 (2,40,000)
1 to 6 82,000 4.354 3,57,028

𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝟑, 𝟓𝟕, 𝟎𝟐𝟖

𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐈𝐧𝐝𝐞𝐱 (𝐢𝐧 %) = 𝐱 𝟏𝟎𝟎 = 𝐱 𝟏𝟎𝟎 = 𝟏𝟒𝟖. 𝟕𝟔%
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝟐, 𝟒𝟎, 𝟎𝟎𝟎
𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 𝟑, 𝟓𝟕, 𝟎𝟐𝟖
𝐏𝐫𝐨𝐟𝐢𝐭𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐈𝐧𝐝𝐞𝐱 (𝐢𝐧 𝐓𝐢𝐦𝐞𝐬) = = = 𝟏. 𝟒𝟗 𝐓𝐢𝐦𝐞𝐬
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰𝐬 𝟐, 𝟒𝟎, 𝟎𝟎𝟎

Question No.: 2 (May 2013 exam – 9 Marks)

The management of P Limited is considering selecting a machine out of two mutually exclusive machines.
The company’s cost of capital is 8% and the corporate tax rate for the company is 30%. Details of the machine
are as follows:

Particulars Machine I Machine II

Cost of the Machine 10,00,000 15,00,000
Expected life 5 years 5 years
Annual income before tax & depreciation 3,45,000 4,55,000

Depreciation is to be charged on straight line basis.

You are required to:
• Calculate pay back, discounted pay back, NPV, PI and ARR of each machine
• Advise the management of P Limited to which machine they should take up
Answer:
WN 1: Computation of cash flows:
Particulars Machine I Machine II
Profit before depreciation and tax 3,45,000 4,55,000
Less: Depreciation (2,00,000) (3,00,000)
Profit before Tax 1,45,000 1,55,000
Less: Tax @ 30% (43,500) (46,500)
Profit after Tax 1,01,500 1,08,500
Add: Depreciation 2,00,000 3,00,000
Cash flow after tax 3,01,500 4,08,500

WN 2: Analysis of Machine I
Year CF CCF PVF @ 8% DCF CDCF Depreciation PAT
0 -10,00,000 -10,00,000 1.000 -10,00,000 -10,00,000
1 3,01,500 -6,98,500 0.926 2,79,189 -7,20,811 2,00,000 1,01,500
2 3,01,500 -3,97,000 0.857 2,58,386 -4,62,425 2,00,000 1,01,500
3 3,01,500 -95,500 0.794 2,39,391 -2,23,034 2,00,000 1,01,500
4 3,01,500 2,06,000 0.735 2,21,603 -1,431 2,00,000 1,01,500
5 3,01,500 5,07,500 0.681 2,05,322 2,03,891 2,00,000 1,01,500
• CCF = Cumulative values of Cash flow column
• DCF = CF x PVF
• CDCF = Cumulative values of DCF column
• PAT = Cash flow - Depreciation

Calculation of all techniques:

Particulars Calculation Answer

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Payback Unrecovered cash flow of Base year 3.32 years (or)
Base year +
Cash flow of next year 3 years and 4 months
95,500
=3+ = 3 + 0.32
3,01,500
Discounted Unrecovered discounted cash flow of Base year 4.01 years
Base year +
Payback Discounted flow of next year
1,431
=4+ = 4 + 0.01
2,05,322
ARR on Average PAT 1,01,500 10.15%
x 100 = x 100
initial Initial investment 10,00,000
investment
ARR on Average PAT 1,01,500 20.30%
x 100 = x 100
average Average investment 10,00,000 + 0
investment 2
1,01,500
= x 100
5,00,000
NPV = PV of inflows – PV of outflow Rs.2,03,891
= 12,03,891 – 10,00,000
Profitability PV of inflows 12,03,891 120.39%
x 100 = x 100
Index (in %) PV of outflows 10,00,000
Profitability PV of inflows 12,03,891 1.20 Times
=
Index (in PV of outflows 10,00,000
Times)

WN 3: Analysis of Machine II
Year CF CCF PVF @ 8% DCF CDCF Depreciation PAT
0 -15,00,000 -15,00,000 1.000 -15,00,000 -15,00,000
1 4,08,500 -10,91,500 0.926 3,78,271 -11,21,729 3,00,000 1,08,500
2 4,08,500 -6,83,000 0.857 3,50,085 -7,71,644 3,00,000 1,08,500
3 4,08,500 -2,74,500 0.794 3,24,349 -4,47,295 3,00,000 1,08,500
4 4,08,500 1,34,000 0.735 3,00,248 -1,47,047 3,00,000 1,08,500
5 4,08,500 5,42,500 0.681 2,78,189 1,31,142 3,00,000 1,08,500

Calculation of all techniques:

Particulars Calculation Answer
Payback Unrecovered cash flow of Base year 3.67 years (or)
Base year +
Cash flow of next year 3 years and 8 months
2,74,500
=3+ = 3 + 0.67
4,08,500
Discounted Unrecovered discounted cash flow of Base year 4.53 years (or) 4 years
Base year +
Payback Discounted flow of next year and 6 months
1,47,047
=4+ = 4 + 0.53
2,78,189
ARR on Average PAT 1,08,500 7.23%
x 100 = x 100
initial Initial investment 15,00,000
investment
ARR on Average PAT 1,08,500 14.47%
x 100 = x 100
average Average investment 15,00,000 + 0
investment 2
1,08,500
= x 100
7,50,000
NPV = PV of inflows – PV of outflow 1,31,142
= 16,31,142 – 15,00,000
Profitability PV of inflows 16,31,142 108.74%
x 100 = x 100
Index (in %) PV of outflows 15,00,000
Profitability PV of inflows 16,31,142 1.09 Times
=
Index (in PV of outflows 15,00,000
Times)
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Conclusion:
• Company should go ahead with Machine I due to better performance in all techniques

Question no.3 – May 2017 RTP

A company has to make a choice between two projects namely A and B. The initial capital outlays of two
projects are Rs.1,35,000 and Rs.2,40,000 respectively for A and B. There will be no scrap value at the end of
the life of both the projects. The opportunity cost of capital of the company is 16%. The cash flows are as
under:
Year Project A Project B Discounting factor
Rs. Rs. @16%
1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

You are required to calculate for each project:

I. Payback
II. Discounted payback period
III. Accounting rate of return
IV. Net Present value
V. Profitability Index
Tabulate your results and indicate which project should be undertaken if the projects are mutually exclusive.
Assume that target payback is 3 years and the discounted payback is four years.
Answer:
WN 1: Computation of Payback of Project A:
Year Cash flow Cum Cash flow
0 -1,35,000 -1,35,000
1 - -1,35,000
2 30,000 -1,05,000
3 1,32,000 27,000
4 84,000 1,11,000
5 84,000 1,95,000

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
1,05,000
Payback = 2 + = 2 + 0.80 = 𝟐. 𝟖𝟎 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫)𝟐 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟏𝟎 𝐦𝐨𝐧𝐭𝐡𝐬
1,32,000
• Base year refers to the last year in which cumulative cash flow is negative

WN 2: Computation of Payback of Project B:

Year Cash flow Cum Cash flow
0 -2,40,000 -2,40,000
1 60,000 -1,80,000
2 84,000 -96,000
3 96,000 -
4 1,02,000 1,02,000
5 90,000 1,92,000

Payback = 3 years since cumulative cash flow is zero in year 3

WN 3: Computation of discounted payback of Project A:

Year CF PVF @ 16% DCF CDCF
0 -1,35,000 1.000 -1,35,000 -1,35,000
1 - 0.862 - -1,35,000
2 30,000 0.743 22,290 -1,12,710
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3 1,32,000 0.641 84,612 -28,098
4 84,000 0.552 46,368 18,270
5 84,000 0.476 39,984 58,254
Note:
• CF = Cash flow; DCF = Discounted cash flow; CDCF = Cumulative Discounted Cash Flow
• DCF = CF x PVF

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
28,098
Discounted Payback = 3 + = 3 + 0.61 = 𝟑. 𝟔𝟏 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫) 𝟑 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟕 𝐌𝐨𝐧𝐭𝐡𝐬
46,368
• Base year refers to the last year in which cumulative discounted cash flow is negative

WN 4: Computation of discounted payback of Project B:

Year CF PVF @ 16% DCF CDCF
0 -2,40,000 1.000 -2,40,000 -2,40,000
1 60,000 0.862 51,720 -1,88,280
2 84,000 0.743 62,412 -1,25,868
3 96,000 0.641 61,536 -64,332
4 1,02,000 0.552 56,304 -8,028
5 90,000 0.476 42,840 34,812

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
8,028
Discounted Payback = 4 + = 4 + 0.19 = 𝟒. 𝟏𝟗 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫) 𝟒 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟐 𝐦𝐨𝐧𝐭𝐡𝐬
42,840

WN 5: Computation of Accounting Rate of Return (ARR) of Project A and B:

Particulars Project A Project B
Total inflow for 5 years 3,30,000 4,32,000
Less: Depreciation for 5 years (1,35,000) (2,40,000)
Total profit for 5 years 1,95,000 1,92,000
Average profit per year 39,000 38,400
Initial investment 1,35,000 2,40,000
Closing investment (scrap value) 0 0
Average investment (Initial + Closing)/2 67,500 1,20,000
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
39,000
ARR of Project A = x 100 = 28.89%
1,35,000
38,400
ARR of Project B = x 100 = 16.00%
2,40,000

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
39,000
ARR of Project A = x 100 = 57.78%
67,500
38,400
ARR of Project B = x 100 = 32.00%
1,20,000

WN 6: Computation of Net Present Value (NPV) of Project A:

Year CF PVF @ 16% DCF
0 -1,35,000 1.000 -1,35,000
1 - 0.862 -
2 30,000 0.743 22,290
3 1,32,000 0.641 84,612

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4 84,000 0.552 46,368
5 84,000 0.476 39,984
NPV 58,254
• NPV = Present value of inflows – Present value of outflows
• NPV = 1,93,254 – 1,35,000 = Rs.58,254

WN 7: Computation of Net Present Value (NPV) of Project B:

Year CF PVF @ 16% DCF
0 -2,40,000 1.000 -2,40,000
1 60,000 0.862 51,720
2 84,000 0.743 62,412
3 96,000 0.641 61,536
4 1,02,000 0.552 56,304
5 90,000 0.476 42,840
NPV 34,812
• NPV = Present value of inflows – Present value of outflows
• NPV = 2,74,812 – 2,40,000 = Rs.34,812

WN 8: Computation of Profitability index of Project A and B:

Particulars Project A Project B
PV of inflows (A) 1,93,254 2,74,812
PV of outflows (B) 1,35,000 2,40,000
Profitability index in % (A/B) 143.15% 114.51%
Profitability index in Times (A/B) 1.43 Times 1.15 Times

WN 9: Selection of project:
Particulars Project A Project B Choice
Payback 2 years & 10 months 3 years A
Discounted Payback 3 years & 7 months 4 years & 2 months A
ARR on initial investment 28.89% 16.00% A
ARR on average investment 57.78% 32.00% A
NPV 58,254 34,812 A
Profitability Index 1.43 Times 1.15 Times A
• Company should go ahead with project A

Question No.:4 (November 2012 RTP)

Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A and B
are available at the same cost of Rs. 5 lakhs each. Salvage value of the old machine is Rs. 1 lakh. The utilities
of the existing machine can be used if the company purchases A. Additional cost of utilities to be purchased
in that case are Rs. 1 lakh. If the company purchases B then all the existing utilities will have to be replaced
with new utilities costing Rs. 2 lakhs. The salvage value of the old utilities will be Rs. 0.20 lakhs. The cash
flows are expected to be:
Year Project A Project B PVF @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage value at end of year 5 50,000 60,000
The targeted return on capital is 15%. You are required to (i) Compute, for the two machines separately, net
present value, discounted payback period and desirability factor and (ii) Advice which of the machines is to
be selected?
Answer:
WN 1: Analysis of Project A:
Year CF PVF @ 15% DCF CDCF
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0 -5,00,000 1.00 -5,00,000 -5,00,000
1 1,00,000 0.87 87,000 -4,13,000
2 1,50,000 0.76 1,14,000 -2,99,000
3 1,80,000 0.66 1,18,800 -1,80,200
4 2,00,000 0.57 1,14,000 -66,200
5 2,20,000 0.50 1,10,000 43,800
Note:
• Initial outflow = Purchase price of Rs.5,00,000 – Inflow of Rs.1,00,000 (sale value of old machine) +
Purchase of utilities of Rs.1,00,000 = Rs.5,00,000
• Year 5 inflow = Rs.1,70,000 + Rs.50,000 (salvage value) = Rs.2,20,000

Particulars Calculation Answer

Discounted Unrecovered discounted cash flow of Base year 4.60 years (or) 4 years
Base year +
Payback Discounted flow of next year and 7 months
66,200
=4+ = 4 + 0.60
1,10,000
NPV = PV of inflows – PV of outflow 43,800
= 5,43,800 – 5,00,000
Desirability PV of inflows 5,43,800 108.76%
x 100 = x 100
factor (in %) PV of outflows 5,00,000
Desirability PV of inflows 5,43,800 1.09 Times
=
factor (in PV of outflows 5,00,000
Times)

WN 2: Analysis of Project B:
Year CF PVF @ 15% DCF CDCF
0 -5,80,000 1.00 -5,80,000 -5,80,000
1 2,00,000 0.87 1,74,000 -4,06,000
2 2,10,000 0.76 1,59,600 -2,46,400
3 1,80,000 0.66 1,18,800 -1,27,600
4 1,70,000 0.57 96,900 -30,700
5 1,00,000 0.50 50,000 19,300
Note:
• Initial outflow = Purchase price of Rs.5,00,000 – Inflow of Rs.1,00,000 (sale value of old machine) +
Purchase of utilities of Rs.2,00,000 – inflow of Rs.20,000 (sale value of utilities) = Rs.5,80,000
• Year 5 inflow = Rs.40,000 + Rs.60,000 (salvage value) = Rs.1,00,000

Particulars Calculation Answer

Discounted Unrecovered discounted cash flow of Base year 4.61 years (or) 4 years
Base year +
Payback Discounted flow of next year and 7 months
30,700
=4+ = 4 + 0.61
50,000
NPV = PV of inflows – PV of outflow 19,300
= 5,99,300 – 5,80,000
Desirability PV of inflows 5,99,300 103.33%
x 100 = x 100
factor (in %) PV of outflows 5,80,000
Desirability PV of inflows 5,99,300 1.03 Times
=
factor (in PV of outflows 5,80,000
Times)

Conclusion:
We should go ahead with Project A as it has better NPV and profitability index. Discounted payback for both
projects is almost similar.

Question No.5 [May 2020 MTP, Nov 2018 MTP, Nov 2019 MTP, May 2017]
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H Limited is considering a new product line to supplement its range of products. It is anticipated that the
new product line will involve cash investments of Rs.70,00,000 at time 0 and Rs.1,00,00,000 in year 1. Net cash
flow after taxes but before depreciation of Rs.25,00,000 are expected in year 2, Rs.30,00,000 in year 3,
Rs.35,00,000 in year 4 and Rs.40,00,000 each year thereafter through year 10. Although the product line might
be viable after year 10, the company prefers to be conservative and end all calculations at that time.
(a) If the required rate of return is 15 percent, Find out the net present value of the project? Is it
acceptable?
(b) Compute NPV if the required rate of return were 10 percent?
(c) Compute the internal rate of return?
Answer:
Net cash flow after taxes but before depreciation is basically Cash flow after taxes as depreciation is a non-
cash item.
WN 1: Computation of NPV at 15% and 10%
Year CF PVF @ 15% DCF PVF @ 10% DCF
0 -70,00,000 1.000 -70,00,000 1.000 -70,00,000
1 -1,00,00,000 0.870 -87,00,000 0.909 -90,90,000
2 25,00,000 0.756 18,90,000 0.826 20,65,000
3 30,00,000 0.658 19,74,000 0.751 22,53,000
4 35,00,000 0.572 20,02,000 0.683 23,90,500
5 40,00,000 0.497 19,88,000 0.621 24,84,000
6 40,00,000 0.432 17,28,000 0.564 22,56,000
7 40,00,000 0.376 15,04,000 0.513 20,52,000
8 40,00,000 0.327 13,08,000 0.467 18,68,000
9 40,00,000 0.284 11,36,000 0.424 16,96,000
10 40,00,000 0.247 9,88,000 0.386 15,44,000
NPV -11,82,000 25,18,500
Note:
• Project is not acceptable if the required rate of return is 15 percent as NPV is negative
• Project is acceptable if the required rate of return is 10 percent as NPV is positive

WN 2: Computation of IRR:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
25,18,500
IRR = 10% + x (15% − 10%) = 10% + 3.40% = 13.40%
25,18,500 − (−11,82,000)

Question No.:6 [Nov 2020 MTP]

Calculate the internal rate of return of an investment of Rs. 1, 36,000 which yields the following cash inflows:
Year Cash flow
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Answer:
WN 1: Computation of initial guess rate for IRR computation:
Particulars Calculation Amount
Initial outflow 1,36,000
Sum of inflows 1,80,000
Total profit of project 1,80,000 – 1,36,000 44,000
Average profit of project 44,000 8,800
5
Average investment 1,36,000 + 0 68,000
2
ARR on average investment 𝟖, 𝟖𝟎𝟎 12.94
𝐱 𝟏𝟎𝟎
𝟔𝟖, 𝟎𝟎𝟎

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Initial guess rate 𝟐 8.63 ~ 9%
𝐱 𝟏𝟐. 𝟗𝟒
𝟑

WN 2: Computation of IRR
Let us assume an initial discount rate of 9 percent and compute NPV
Year Cash flow PVF @ 9% DCF PVF @ 11% DCF
0 (1,36,000) 1.000 (1,36,000) 1.000 (1,36,000)
1 30,000 0.917 27,510 0.901 27,030
2 40,000 0.842 33,680 0.812 32,480
3 60,000 0.772 46,320 0.731 43,860
4 30,000 0.708 21,240 0.659 19,770
5 20,000 0.650 13,000 0.593 11,860
NPV 5,750 (1,000)
• NPV is positive at a discount rate of 9 percent. We should increase the discount rate and check
whether we get NPV as zero or NPV become negative

𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
5,750
IRR = 9% + x (11% − 9%) = 9% + 1.70% = 𝟏𝟎. 𝟕𝟎%
5,750 − (−1,000)

Question No.7 – May 2016, May 2018

Following are the data on a capital project being evaluated by the management of X Ltd.:
Particulars Project M
Annual cost saving 40,000
Useful life 4 years
IRR 15%
Profitability Index 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0
Find the missing values considering the following table of discount factor only:
Discount Factor 15% 14% 13% 12%
Year 1 0.869 0.877 0.885 0.893
Year 2 0.756 0.769 0.783 0.797
Year 3 0.658 0.675 0.693 0.712
Year 4 0.572 0.592 0.613 0.636
Total 2.855 2.913 2.974 3.038
Answer:
WN 1: Computation of cost of project:
• IRR is the rate of return at which NPV of the project is zero
Year Cash flow PVF @ 15% DCF
0 -1,14,200 1.000 -1,14,200
1 to 4 40,000 2.855 1,14,200
NPV 0
• Cost of project = Rs.1,14,200 (sum of inflows as NPV is zero)

WN 2: Computation of NPV:
PV of inflows
Profitability index =
PV of outflows
PV of inflows
1.064 = ; 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 = (𝟏, 𝟏𝟒, 𝟐𝟎𝟎 𝐱 𝟏. 𝟎𝟔𝟒) = 𝐑𝐬. 𝟏, 𝟐𝟏, 𝟓𝟎𝟗
1,14,200
𝐍𝐏𝐕 = 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰 − 𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 = 𝟏, 𝟐𝟏, 𝟓𝟎𝟗 − 𝟏, 𝟏𝟒, 𝟐𝟎𝟎 = 𝐑𝐬. 𝟕, 𝟑𝟎𝟗

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WN 3: Computation of cost of capital:

Year Cash flow PVF @ ?? DCF
0 -1,14,200 1.000 -1,14,200
1 to 4 40,000 3.038 1,21,509
NPV 7,309
From the given tables PVAF of 3.038 correspond to 4 years and 12 percent. Hence cost of capital is 12%

WN 4: Computation of Payback:
Year Cash flow Cum Cash flow
0 -1,14,200 -1,14,200
1 40,000 -74,200
2 40,000 -34,200
3 40,000 5,800
4 40,000 45,800
𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
34,200
Payback = 2 + = 2 + 0.855 = 𝟐. 𝟖𝟓𝟓 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫)𝟐 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟏𝟎 𝐦𝐨𝐧𝐭𝐡𝐬
40,000

Question No.: 8 (May 2014 exam – 8 Marks)

A hospital is considering to purchase a diagnostic machine costing Rs.80,000. The projected life of the
machine is 8 years and has an expected salvage value of Rs.6,000 at the end of 8 years. The annual operating
cost of the machine is Rs.7,500. It is expected to generate revenues of Rs.40,000 per year for eight years.
Presently the hospital is outsourcing the diagnostic work and is earning commission income of Rs.12,000 per
annum, net of taxes. Whether it would be profitable for the hospital to purchase the machine?
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure (80,000)
Working capital -
Initial outflow (80,000)

WN 2: In-between cash flows:

Particulars Year 1 to 8
Revenues 40,000
Less: Operating costs (7,500)
Less: Commission (12,000/75%) (16,000)
[Opportunity cost]
PBDT 16,500
Less: Depreciation (80,000 – 6,000)/8 (9,250)
PBT 7,250
Less: Tax @ 25% (1,813)
PAT 5,437
Add: Depreciation 9,250
CFAT 14,687
Note:
• It is assumed that income tax rate is 25%
• Commission is an opportunity cost as the same would be lost after purchase of diagnostic machine.
The amount is after-tax and hence it is converted to PBT level to make it comparable

WN 3: Terminal flow:
Particulars Amount
Sale value 6,000

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Less: Book value (6,000)
Capital gain 0
Tax paid 0

Net salvage value 6,000

WN 4: Consolidation of cash flows and computation of NPV:

It is assumed that discount rate (cost of capital) is 10%
Year Cash flow PVF @ 10% DCF
0 (80,000) 1.000 (80,000)
1 to 8 14,687 5.335 78,355
8 6,000 0.467 2,802
NPV 1,157
Conclusion: The company should go ahead with purchase of machine due to positive NPV

Question No.9 – November 2016 RTP

X Ltd. an existing profit making company is planning to introduce a new product with a projected life for 8
years. Initial equipment cost will be Rs.120 lacs and additional equipment costing Rs.10 lacs will be needed
at the beginning of the third year. At the end of the 8 years, the original equipment will have resale value
equivalent to the cost of removal, but the additional equipment would be sold for Rs.1 lac. Working capital
of Rs. 15 lacs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum but the production
and sales volume are as under:
Year 1 2 3-5 6-8
Capacity Utilization 20 30 75 50
Advertisement expenditure (in lacs) per year 30 15 10 4
A sale price of Rs.100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed operating costs
are likely to be Rs.16 lacs per annum. In addition to this the advertisement expenditure will have to be
incurred as mentioned in the above table.
The company is subject to 50% tax, straight line method of depreciation (permissible for tax purposes also)
and taking 12% as appropriate after-tax cost of capital should the project be accepted?
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (120)
Working capital (15)
Initial outflow (135)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Units sold
[4 x capacity utiln] 0.80 1.20 3.00 3.00 3.00 2.00 2.00 2.00
Selling price 100 100 100 100 100 100 100 100
Revenues
[Units x SP] 80.00 120.00 300.00 300.00 300.00 200.00 200.00 200.00
Less: Variable cost
[Units x 40] -32.00 -48.00 -120.00 -120.00 -120.00 -80.00 -80.00 -80.00
Less: Fixed cost -16.00 -16.00 -16.00 -16.00 -16.00 -16.00 -16.00 -16.00
Less: Advertisement -30.00 -15.00 -10.00 -10.00 -10.00 -4.00 -4.00 -4.00
PBDT 2.00 41.00 154.00 154.00 154.00 100.00 100.00 100.00
Less: Depreciation -15.00 -15.00 -16.50 -16.50 -16.50 -16.50 -16.50 -16.50
PBT -13.00 26.00 137.50 137.50 137.50 83.50 83.50 83.50
Less: Tax 6.50 -13.00 -68.75 -68.75 -68.75 -41.75 -41.75 -41.75
PAT -6.50 13.00 68.75 68.75 68.75 41.75 41.75 41.75

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Add: Depreciation 15.00 15.00 16.50 16.50 16.50 16.50 16.50 16.50
CFAT 8.50 28.00 85.25 85.25 85.25 58.25 58.25 58.25
Less: Purchase of
additional machine -10.00
Revised CFAT 8.50 18.00 85.25 85.25 85.25 58.25 58.25 58.25
• Depreciation on original equipment (all 8 years) = (120 – 0)/8 = 15 lacs
• Depreciation on additional equipment (3 to 8 years) = (10 – 1)/6 = 1.5 lacs
• Company makes loss in year 1. It is an existing profit-making company and hence would save taxes
due to loss
• Additional machine has been purchased at beginning of year 3. Beginning of year 3 will be taken as
end of year 2 in cash flow analysis. This is because it is generally assumed that cash flows happen at
end of the year

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value of original machine 0.00
Net salvage value of additional machine 1.00
Recapture of working capital 15.00
Total terminal flow 16.00

Note: Computation of Net Salvage Value:

Particulars Original Additional
Sale value 0.00 1.00
Less: Book value 0.00 1.00
Capital gain/loss 0.00 0.00
Tax paid/saved 0.00 0.00

Net salvage value 0.00 1.00

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF
0 -135.00 1.000 -135.00
1 8.50 0.893 7.59
2 18.00 0.797 14.35
3 85.25 0.712 60.70
4 85.25 0.636 54.22
5 85.25 0.567 48.34
6 58.25 0.507 29.53
7 58.25 0.452 26.33
74.25
8 [58.25 + 16.00] 0.404 30.00
NPV 136.06
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.136.06 lacs.

Question No.10 – May 2016 RTP, November 2018 RTP

MNP Limited is thinking of replacing its existing machine by a new machine, which would cost Rs.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 Rs.200 per unit. The
following is the cost of production one unit of product using both the existing and new machine:
Existing Machine New Machine (1,00,000 Unit cost (Rs.)
(80,000 units) units) Difference
Materials 75.00 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
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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 10.00 12.50 2.50
Overheads
183.25 165.50 (17.75)
The existing machine has an accounting book value of Rs.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 Rs.2,50,000. However, the market price of old machine today is Rs.1,50,000 and
it is expected to be Rs.35,000 after 5 year. The new machine has a life of 5 years and a salvage value of
Rs.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 purpose. The opportunity cost of capital of the Company is
15%.
Required:
Estimate net present value of the replacement decision.
Answer:
WN 1: Initial outflow
Particulars Existing New
NSV of existing machine on day 0 (1,50,000) 0
Working capital blocked 0 0
Capital expenditure 0 (60,00,000)
Total outflow (1,50,000) (60,00,000)

Note 1: Computation of NSV of existing machine on day 0:

Particulars Amount
Sale value 2,50,000
Less: Book value 0
Capital gain 2,50,000
Tax paid @ 40% 1,00,000

Net salvage value 1,50,000

• Asset has been fully depreciated under Income Tax Act and hence the book value will be taken as
zero for computing capital gains

WN 2: In-between flows:
Particulars Existing New
Sales 1,60,00,000 2,00,00,000
Less: Material cost -60,00,000 -63,75,000
Less: Wages and salaries -41,00,000 -37,50,000
Less: Supervision -16,00,000 -25,00,000
Less: Repairs and maintenance -9,00,000 -7,50,000
Less: Power and fuel -12,40,000 -14,25,000
Less: Allocated corporate Overheads - -
PBDT 21,60,000 52,00,000
Less: Depreciation - -11,50,000
PBT 21,60,000 40,50,000
Less: Tax @ 40% -8,64,000 -16,20,000
PAT 12,96,000 24,30,000
Add: Depreciation - 11,50,000
CFAT 12,96,000 35,80,000
Note:
• Allocated corporate overheads are an irrelevant expenditure and hence not considered in cash flow
computation
• Depreciation has been computed as per Income Tax Act and not companies’ books
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WN 3: Terminal flow:
Particulars Existing New
NSV of asset in year 5 21,000 2,50,000
Working capital released 0 0
Total terminal flow 21,000 2,50,000

Particulars Existing New

Sale value 35,000 2,50,000
Less: Book value 0 2,50,000
Capital gain/loss 35,000 0
Tax paid/saved @ 40% 14,000 0

Net salvage value 21,000 2,50,000

WN 4: Computation of incremental cash flows and NPV:

Year Existing New Incremental PVF @ 15% DCF
0 -1,50,000 -60,00,000 -58,50,000 1.0000 -58,50,000
1 to 5 12,96,000 35,80,000 22,84,000 3.3522 76,56,425
5 21,000 2,50,000 2,29,000 0.4972 1,13,859
Incremental NPV 19,20,284
Conclusion: The company should go ahead with replacement decision as the project generates positive
NPV of Rs.19,20,284.

Question No.:11 (November 2013 RTP)

Beta Limited receives Rs. 15,00,000 a year after taxes from an investment in an automatic plant that has 12
more years of service life. The company’s required rate is 12%. Beta Limited can make improvements to the
plant to raise its service life to 20 years and its annual after tax cash flow to Rs. 48,00,000 per year. These
investments would cost Rs. 2,10,00,000. With the improvements, the plant’s value at the end of 12 years
would rise from Rs.7,50,000 to Rs.75,00,000. Would the improvements produce a return satisfactory to Beta
Limited?
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure (2,10,00,000)
Working capital -
Initial outflow (2,10,00,000)

WN 2: In-between cash flows:

Year 1 to 12 incremental cash flow = Rs.48,00,000 – Rs.15,00,000 = Rs.33,00,000

WN 3: Terminal cash flow:

Particulars Amount
Incremental salvage value (75,00,000 – 7,50,000) 67,50,000
Recapture of Working capital -
Terminal flow 67,50,000

Note: Life of the project increases to 20 years. However, we don’t have information beyond 12 years and
hence the analysis has been restricted to 12 years. Cash flow of year 13 to 20 is indirectly factored in higher
value of asset at end of year 12

WN 4: Computation of NPV:
Year CF PVF @ 12% DCF
0 -2,10,00,000 1.000 -2,10,00,000
1 to 12 33,00,000 6.194 2,04,40,200
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12 67,50,000 0.257 17,34,750
NPV 11,74,950
Conclusion: Since the NPV is positive, the improvements produce a satisfactory return to the firm

Question No.: 12 (May 2014 RTP)

Best Luck company is considering building an assembly plant and the company has two options, out of which
it wishes to choose the best plant. The projected output is 10,000 units per month. The following data are
available:
Particulars Plant A Plant B
Initial cost 60,00,000 44,00,000
Direct labour cost p.a. (1st shift) 30,00,000 15,00,000
(2nd shift) - 19,00,000
Overhead (per year) 5,00,000 4,20,000
Both the plants have an expected life of 10 years after which there will be no salvage value. The cost of capital
is 10%. The present value of an ordinary annuity of Re.1 for 10 years @ 10% is 6.1446. Ignore effect of taxation.
You are required to determine:
• What would be the desirable choice?
Answer:
Computation of present value of outflow:
Cash flow DCF
Year Plant A Plant B PVF @ 10% Plant A Plant B
0 60,00,000 44,00,000 1.0000 60,00,000 44,00,000
1 to 10 35,00,000 38,20,000 6.1446 2,15,06,100 2,34,72,372
PV of outflow 2,75,06,100 2,78,72,372
Conclusion: The company should go ahead with Plant A as it has lower PV of outflow

Question No.:13 (May 2014 RTP)

Fibroplast Limited, a toy manufacturing company, is considering replacing an older machine which was fully
depreciated for tax purposes with a new machine costing Rs.40,000. The new machine will be depreciated
over its eight-year life. It is estimated that the new machine will reduce labour costs by Rs.8,000 per year. The
management believes that there will be no change in other expenses and revenues of the firm due to the
machine. The company requires an after-tax return on investment of 10 percent. Its rate of tax is 35 percent.
The company’s income statement for the current year is given for other information.
Incomes statement for the current year:
Particulars Amount Amount
Sales 5,00,000
Costs:
Materials 1,50,000
Labour 2,00,000
Factory and administrative 40,000
Depreciation 40,000 4,30,000
Net income after taxes 70,000
Taxes (24,500)
Earnings after taxes 45,500
Should the Fibroplast Limited buy the new machine? You may assume the company follows straight-line
method of depreciation and the same is allowed for tax purposes.
Answer:
WN 1: Initial Outflow:
Particulars Amount
Capital expenditure (40,000)
Working capital 0
Initial outflow (40,000)

WN 2: In-between cash flows:

Particulars Year 1 to 8

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Revenue/cost reduction
Savings in labour cost 8,000
Less: Depreciation (40,000/8 years) (5,000)
Profit before tax (PBT) 3,000
Less: Tax @ 35% (1,050)
Profit after tax (PAT) 1,950
Add: Depreciation 5,000
Cash flow after taxes (CFAT) 6,950
Note:
• Existing cash flows are not relevant for analysis. The only benefit of the machine is cost reduction
and the same has been considered as inflow in our analysis

WN 3: Terminal cash flow:

Particulars Amount
Net salvage value -
Recapture of working capital -
Total terminal flow -

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value 0.00
Capital gain/loss 0.00
Tax paid/saved 0.00

Net salvage value 0.00

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF
0 (40,000) 1.000 (40,000)
1 to 8 6,950 5.335 37,078
8 - 0.467 -
NPV (2,922)
Conclusion: Since the NPV is negative, the machine is not to be purchased.

Question No.14 – Nov 2018

PD Limited an existing company, is planning to introduce a new product with projected life of 8 years. Project
cost will be Rs.2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of
Rs.30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units per annum but the production
and sales volume are expected are as under:
Year Number of units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units
Other information:
• Selling Price per unit = Rs.200
• Variable cost is 40 percent of sales
• Fixed cost of Rs.30,00,000
• Advertisement expenditure will have to be incurred as under:
Year Expenditure
1 50,00,000
2 25,00,000
3-5 10,00,000

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6-8 5,00,000
• Income tax is 25%
• Straight line method of depreciation is permissible for tax purpose
• Cost of capital is 10%
• Assume that loss cannot be carried forward
Advise about the project acceptability.
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (240)
Working capital (30)
Initial outflow (270)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Revenues 120.00 160.00 280.00 280.00 280.00 240.00 240.00 240.00
Less: Variable cost -48.00 -64.00 -112.00 -112.00 -112.00 -96.00 -96.00 -96.00
Less: Fixed cost -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00
Less: Advertisement -50.00 -25.00 -10.00 -10.00 -10.00 -5.00 -5.00 -5.00
PBDT -8.00 41.00 128.00 128.00 128.00 109.00 109.00 109.00
Less: Depreciation -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00
PBT -38.00 11.00 98.00 98.00 98.00 79.00 79.00 79.00
Less: Tax 0.00 -2.75 -24.50 -24.50 -24.50 -19.75 -19.75 -19.75
PAT -38.00 8.25 73.50 73.50 73.50 59.25 59.25 59.25
Add: Depreciation 30.00 30.00 30.00 30.00 30.00 30.00 30.00 30.00
CFAT -8.00 38.25 103.50 103.50 103.50 89.25 89.25 89.25
• Loss cannot be carried forward. Question also doesn’t specify that it is an existing profit

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value 0.00
Recapture of working capital 30.00
Total terminal flow 30.00

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value 0.00
Capital gain/loss 0.00
Tax paid/saved 0.00

Net salvage value 0.00

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 10% DCF
0 -270.00 1.000 -270.00
1 -8.00 0.909 -7.27
2 38.25 0.826 31.59

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3 103.50 0.751 77.73
4 103.50 0.683 70.69
5 103.50 0.621 64.27
6 89.25 0.564 50.34
7 89.25 0.513 45.79
8 119.25 0.467 55.69
NPV 118.83
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.118.83 lacs.

Question No.15 [May 2019]

Aar Cee Manufacturing Company is considering a proposal to replace one of its existing machines by the
CNC machine. In this connection, the following information is available:

The existing machine was brought 3 years ago for Rs.15,40,000. It was depreciated on straight line basis and
has a remaining useful life of 7 years. Its annual maintenance cost is expected to increase by Rs.40,000 from
the sixth year of its installation. Its present realizable value is Rs.6,50,000.

The purchase price of CNC machine is Rs.27,00,000 and installation expenses of Rs.95,000 will be incurred.
Subsidy equal to 15% of the purchase price will be received at the end of first year of its installation. It is
subject to same rate of depreciation. Its realizable value after 7 years is Rs.5,70,000. With the CNC machine,
annual cash operating costs are expected to decrease by Rs.2,16,000. In addition, CNC machine would
increase productivity on account of which net cash revenue would increase by Rs.2,76,000 per annum.

The tax rate applicable to firm is 30% and cost of capital is 11%.
Required:
Advise the firm whether to replace the existing machine with CNC machine on the basis of net present value
Answer:
WN 1: Initial outflow
Particulars Existing New
NSV of existing machine on day 0 (7,78,400) -
Working capital blocked - -
Capital expenditure - (27,95,000)
Total outflow (7,78,400) (27,95,000)

Note 1: Computation of NSV of existing machine on day 0:

Particulars Amount
Sale value 6,50,000
Less: Book value 10,78,000
Capital loss 4,28,000
Tax paid @ 30% 1,28,400

Net salvage value 7,78,400

• Depreciation per year of existing machine = 15,40,000/10 years = Rs.1,54,000
• Old machine has already been used for three years and hence depreciation for 3 years is Rs.4,62,000
• Book value of old machine = 15,40,000 – 4,62,000 = Rs.10,78,000

WN 2: In-between flows:
Existing New
Particulars Year 1 to 2 Year 3 to 7 Year 1 Year 2 to 7
Revenues - - 2,76,000 2,76,000
Saving in operating cost - - 2,16,000 2,16,000
Less: Maintenance cost - -40,000 - -
PBDT - -40,000 4,92,000 4,92,000
Less: Depreciation -1,54,000 -1,54,000 -2,60,000 -2,60,000

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PBT -1,54,000 -1,94,000 2,32,000 2,32,000
Less: Tax @ 30% 46,200 58,200 -69,600 -69,600
PAT -1,07,800 -1,35,800 1,62,400 1,62,400
Add: Depreciation 1,54,000 1,54,000 2,60,000 2,60,000
CFAT 46,200 18,200 4,22,400 4,22,400
Subsidy 4,05,000
Revised CFAT 46,200 18,200 8,27,400 4,22,400
Note:
• Depreciable value of new machine = Original cost + Installation expenses – subsidy – salvage value
= 27,00,000 + 95,000 – 5,70,000 – 4,05,000 = Rs.18,20,000
• Depreciation of new machine = 18,20,000/7 years = Rs.2,60,000
• It is assumed subsidy is adjusted against the cost of the asset

WN 3: Terminal flow:
Particulars Existing New
NSV of asset in year 7 0 5,70,000
Working capital released 0 0
Total terminal flow 0 5,70,000

Particulars Existing New

Sale value 0 5,70,000
Less: Book value 0 5,70,000
Capital gain/loss 0 0
Tax paid/saved 0 0

Net salvage value 0 5,70,000

WN 4: Computation of incremental cash flows and NPV:

Year Existing New Incremental PVF @ 11% DCF
0 -7,78,400 -27,95,000 -20,16,600 1 -20,16,600
1 46,200 8,27,400 7,81,200 0.901 7,03,861
2 46,200 4,22,400 3,76,200 0.812 3,05,474
3 18,200 4,22,400 4,04,200 0.731 2,95,470
4 18,200 4,22,400 4,04,200 0.659 2,66,368
5 18,200 4,22,400 4,04,200 0.593 2,39,691
6 18,200 4,22,400 4,04,200 0.535 2,16,247
7 18,200 9,92,400 9,74,200 0.482 4,69,564
Incremental NPV 4,80,075

Conclusion: The company should not ahead with replacement decision as the project generates positive
NPV

Question No.16 – May 2020 MTP

A company is considering the proposal of taking up a new project which requires as investment of Rs.800
lacs on machinery and other assets. The project is expected to yield the following earnings (before
depreciation and taxes) over the next five years.
Year Earnings (in lacs)
1 320
2 320
3 360
4 360
5 300
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on WDV basis. The
scrap value at the end of five-year period may be taken as zero. Income-tax applicable to the company is 40%.
Bharadwaj Institute Pvt Ltd No 58/19 North Mada St, Nungambakkam, Chennai-34 109
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You are required to calculate the NPV of the project and advise the management to take appropriate decision.
Also calculate the IRR of the project.
Note: Present values of Re.1 at different rates of interest are as follows:
Year 10% 12% 14% 16% 20%
1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (800)
Working capital 0
Initial outflow (800)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
PBDT 320.00 320.00 360.00 360.00 300.00
Less: Depreciation -160.00 -128.00 -102.40 -81.92 -65.54
PBT 160.00 192.00 257.60 278.08 234.46
Less: Tax @ 40% -64.00 -76.80 -103.04 -111.23 -93.79
PAT 96.00 115.20 154.56 166.85 140.68
Add: Depreciation 160.00 128.00 102.40 81.92 65.54
CFAT 256.00 243.20 256.96 248.77 206.21
Note:
• Depreciation of year 1 = 800 lacs x 20% = Rs.160 lacs
• Depreciation of year 2 = (800 – 160) x 20% = Rs.128 lacs
• Depreciation of year 3,4 and 5 is calculated in similar manner

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value 0.00
Recapture of working capital 30.00
Total terminal flow 30.00

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value (800 lacs – Depreciation of 5 years) 262.14
Capital loss 262.14
Tax saved (262.14 x 40%) 104.86

Net salvage value [Sale value + Tax saved] 104.86

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF PVF @ 16% DCF PVF @ 20% DCF
0 -800.00 1.00 -800.00 1.00 -800.00 1.00 -800.00
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1 256.00 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.04
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
NPV 141.36 50.71 -26.83

• NPV of the project = Rs.141.36 lacs

Computation of IRR:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
50.71
IRR = 16% + x (20% − 16%) = 16% + 2.62% = 𝟏𝟖. 𝟔𝟐%
50.71 − (−26.83)

Question No.17 [Nov 2020]

CK Limited is planning to buy a new machine. Details of which are as follows:
Cost of the machine at the commencement 2,50,000
Economic life of the machine 8 years
Residual value Nil
Annual production capacity of the machine 1,00,000 units
Estimated selling price per unit Rs.6
Estimated variable cost per unit Rs.3
Estimated annual fixed cost 1,00,000
[Excluding depreciation]
Advertisement expenses in 1st year in addition of annual fixed cost Rs.20,000
Maintenance expenses in 5th year in addition of annual fixed cost 30,000
Cost of capital 12%
Ignore tax
Analyse the above mentioned proposal using the Net Present Value Method and advice.
Answer:
WN 1: Initial outflow
Particulars Amount
Capital expenditure (2,50,000)
Working capital -
Initial outflow (2,50,000)

WN 2: In-between cash flows:

Particulars Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8
Revenues 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000
Less: Variable cost 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Less: Fixed cost 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Less: Advert 20,000 0 0 0 0 0 0 0
Less: Maintenance 0 0 0 0 30,000 0 0 0
PBDT/ CFAT 1,80,000 2,00,000 2,00,000 2,00,000 1,70,000 2,00,000 2,00,000 2,00,000
Note: Taxes are ignored and hence depreciation is not considered in above statement

WN 3: Terminal cash flow:

Particulars Amount
Salvage value -
Recapture of Working capital -
Terminal flow -

WN 4: Consolidation of cash flows and computation of NPV:

Year CF PVF @ 12% DCF

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0 -2,50,000 1.000 -2,50,000
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
NPV 7,08,730
Conclusion: The company should go ahead with the project as it generates positive NPV.

Question No.18 [Jan 2021]

ABC Ltd., a profit-making company, is engaged in the business of car manufacturing. In order to be
independent in terms of its electricity needs, the company's management has proposed to put up a Solar
Power Plant to generate the electricity. The details of the proposal are as follows:
(1) Cost of the power plant = Rs.280 lacs
(2) Cost of land = Rs.30 lacs
(3) Subsidy of Rs.25 lakhs from state government to be received at the end of first year of installation.
(4) Sale of electricity to State Electricity Board will be at Rs. 2.25 per unit in year 1. This will increase by Rs.
0.25 per unit every year till year 7. After that it will increase by Rs. 0.50 per unit every year.
(5) Maintenance cost will be Rs. 4 lakhs in year 1 and the same will increase by Rs. 2 lakhs every year.
(6) Estimated life is 10 years.
(7) Cost of capital 15%.
(8) Residual value of power plant is nil. However, land value will go up to Rs. 90 lakhs at the end of year 10.
(9) Depreciation will be 100% of the cost of the power plant in year 1 (entire Rs. 280 lakhs is to be depreciated
in year 1 without considering subsidy) and the same will be allowed for tax purposes.
(10) Gross electricity generated will be 25 lakhs units per annum. 4% of this electricity generated will be
committed free to the State Electricity Board as per the agreement.
(11) Tax rate is 50%.
You are required to suggest the viability of the proposal by calculating the 'Net Present Value' while ignoring
the tax on capital profit. Assume that the tax savings, if any, are utilized in the year of their occurrence.
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure – Power Plant (280.00)
Capital expenditure – Land (30.00)
Working capital 0
Initial outflow (310.00)

WN 2: In-between cash flows:

Particulars Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10
Units generated 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00 25.00
Less: Free
electricity [4% x
25] -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00 -1.00
Units sold 24.00 24.00 24.00 24.00 24.00 24.00 24.00 24.00 24.00 24.00
Selling price 2.25 2.50 2.75 3.00 3.25 3.50 3.75 4.25 4.75 5.25
Sales 54.00 60.00 66.00 72.00 78.00 84.00 90.00 102.00 114.00 126.00
Less:
Maintenance cost 4.00 6.00 8.00 10.00 12.00 14.00 16.00 18.00 20.00 22.00
Less:
Depreciation 280.00 - - - - - - - - -
Profit/loss before
tax -230.00 54.00 58.00 62.00 66.00 70.00 74.00 84.00 94.00 104.00
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Add/ Less: Tax
paid/ saved @
50% -115.00 27.00 29.00 31.00 33.00 35.00 37.00 42.00 47.00 52.00
Profit/loss after
tax -115.00 27.00 29.00 31.00 33.00 35.00 37.00 42.00 47.00 52.00
Add:
Depreciation 280.00
Add: Subsidy 25.00
Cash flow after
taxes 190.00 27.00 29.00 31.00 33.00 35.00 37.00 42.00 47.00 52.00

Note:
• Depreciation is entirely charged in year 1. The company is an existing profit-making company and
hence the loss can be set-off against other existing profits. Therefore, it will save tax of Rs.115 lacs in
year 1.

WN 3: Terminal flow:
Amount
Particulars (in lacs)
Salvage value of land 90.00
Salvage value of power plant 0.00
Recapture of working capital 0.00
Total terminal flow 90.00

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 15% DCF
0 -310.00 1.000 -310.000
1 190.00 0.870 165.300
2 27.00 0.756 20.412
3 29.00 0.658 19.082
4 31.00 0.572 17.732
5 33.00 0.497 16.401
6 35.00 0.432 15.120
7 37.00 0.376 13.912
8 42.00 0.327 13.734
9 47.00 0.284 13.348
142.00
10 [52.00 + 90.00] 0.247 35.074
NPV 20.115
The proposed project has NPV of Rs. 20,11,500 and is viable to undertake

Question No.19 – May 2021 MTP, May 2018 MTP

Domestic services (P) Limited is in the business of providing cleaning sewerage line services at homes. There
is a proposal before the company to purchase a mechanize sewerage cleaning system for a sum of Rs.20 lacs.
The present system of the company is to use manual labour for the job. You are provided with the following
information:
Proposed Mechanized System
Cost of the machine Rs.20 lacs
Life of the machine 10 years
Depreciation (on straight line basis) 10%
Operating cost of mechanized system Rs.5 lacs per annum
Present system (Manual):
Manual labour 200 persons
Cost of manual labour Rs.10,000 per person per annum

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The company has an after-tax cost of funds at 10% per annum. The applicable tax rate is 30%. You are required
to determine whether it is advisable to purchase the machine.
Answer:
WN 1: Initial Outflow:
Particulars Amount
Capital expenditure (20,00,000)
Working capital 0
Initial outflow (20,00,000)

WN 2: In-between cash flows:

Particulars Amount
Revenue/cost reduction
Savings in labour cost (10,000 x 200) 20,00,000
Less: Operating cost (5,00,000)
Profit before Depreciation and Tax (PBDT) 15,00,000
Less: Depreciation (20,00,000/10 years) (2,00,000)
Profit before tax (PBT) 13,00,000
Less: Tax @ 30% (3,90,000)
Profit after tax (PAT) 9,10,000
Add: Depreciation 2,00,000
Cash flow after taxes (CFAT) 11,10,000

WN 3: Terminal cash flow:

Particulars Amount
Net salvage value -
Recapture of working capital -
Total terminal flow -

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value 0.00
Capital gain/loss 0.00
Tax paid/saved 0.00

Net salvage value 0.00

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF
0 -20,00,000 1.000 -20,00,000
1 to 10 11,10,000 6.144 68,19,840
10 - 0.386 -
NPV 48,19,840
Conclusion: The company should go ahead with purchase of machine as NPV is positive.

Question No.20 – May 2021 RTP:

The General Manager of Merry Ltd. is considering the replacement of five-year-old equipment. The company
has to incur excessive maintenance cost of the equipment. The equipment has zero written down value. It
can be modernized at a cost of Rs. 1,40,000 enhancing its economic life to 5 years. The equipment could be
sold for Rs. 30,000 after 5 years. The modernization would help in material handling and in reducing labour
, maintenance & repairs costs.

The company has another alternative to buy a new machine at a cost of Rs. 3,50,000 with an economic life of
5 years and salvage value of Rs. 60,000. The new machine is expected to be more efficient in reducing costs
of material handling, labour, maintenance & repairs, etc.
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The annual cost are as follows:

Particulars Existing Equipment Modernization New Machine
Wages and salaries 45,000 35,500 15,000
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
Total 1,20,000 70,500 39,500
Assuming tax rate of 50% and required rate of return of 10%, should the company modernize the equipment
or buy a new machine?
Answer:
WN 1: Initial outflow:
Particulars Modernization New machine
Capital expenditure -1,40,000 -3,50,000
Working capital 0 0
Initial Outflow 1,40,000 3,50,000

WN 2: In-between flows:
Particulars Modernization New machine
Saving in cost 49,500 80,500
[1,20,000 – 70,500] [1,20,000 – 39,500]
Less: Depreciation 22,000 58,000
[1,40,000-30,000]/5 [3,50,000-60,000]/5
PBT 27,500 22,500
Less: Tax @ 50% -13,750 -11,250
PAT 13,750 11,250
Add: Depreciation 22,000 58,000
CFAT 35,750 69,250

WN 3: Terminal flow:
Particulars Modernization New machine
Salvage value 30,000 60,000
Recapture of working capital 0 0
Total terminal flow 30,000 60,000

WN 4: Computation of NPV:
Cash flow DCF
Year Modernization New PVF @ 10% Modernization New
0 -1,40,000 -3,50,000 1.000 -1,40,000 -3,50,000
1 to 5 35,750 69,250 3.790 1,35,493 2,62,458
5 30,000 60,000 0.621 18,630 37,260
NPV 14,123 -50,282
Conclusion: The company should modernize its existing equipment and not buy a new machine because
NPV is positive in modernization of equipment.

Question No.21 – May 2021 MTP:

WX Ltd. is considering a proposal to replace an existing machine. The details of existing machine and new
machine are as under:
Particulars Existing Machine New Machine
Cost of machine 3,75,000 5,25,000
Estimated life (in years) 10 5
Present book value 1,87,500
• Out of the Life of 10 years of present machine, five years have already lapsed. The management can
continue with this machine for the remaining lifetime.
• The activity level of both the machines is same.
• Residual value of new machine at the end of the life - Rs. 60,000.
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• There will be a saving of Rs. 2,40,000 in the variable cost each year by new machine.
• If the old machine is sold, then it will fetch Rs. 90,000.
• WX Ltd. expects a minimum return of 11 % on the investment.
• Corporate tax - 30%
• No depreciation is to be charged in the year of sale.
You are required to comment on the suitability of replacement of the old machine.
Answer:
WN 1: Initial outflow:
Particulars Existing New
NSV of existing machine on day 0 (1,19,250) -
Working capital blocked - -
Capital expenditure - (5,25,000)
Total outflow (1,19,250) (5,25,000)
• Incremental outflow = Rs.4,05,750

Computation of NSV of existing machine:

Particulars Amount
Sale value 90,000
Less: Book value (1,87,500)
Capital loss 97,500
Tax saved (97,500 x 30%) 29,250
Net salvage value {Sale value + Tax saved} 1,19,250

WN 2: In-between cash flows:

Particulars Year 1 to 4 Year 5
Saving in variable cost 2,40,000 2,40,000
Less: Depreciation -55,500 0
[93,000 – 37,500]
Profit before tax 1,84,500 2,40,000
Less: Tax @ 30% -55,350 -72,000
Profit after tax 1,29,150 1,68,000
Add: Depreciation 55,350 -
Cash flow after tax 1,84,650 1,68,000

Note:
• Depreciation of old machine = 3,75,000/10 = Rs.37,500
• Depreciation of new machine = (5,25,000 – 60,000)/5 = Rs.93,000
• Depreciation is not charged in year of sale and hence the same is not considered

WN 3: Terminal flow:
Particulars Old New
Sale value 0 60,000
Less: Book value (37,500) (93,000)
[one year of depreciation as no depreciation is charged in last year]
Capital loss 37,500 93,000
Tax saved @ 30% 11,250 27,900
Net salvage value {Sale value + Tax saved} 11,250 87,900
• Incremental terminal flow = 87,900 – 11,250 = Rs.76,650

WN 4: Computation of NPV:
Year Cash flow PVF @ 11% DCF
0 -4,05,750 1.000 -4,05,750
1 to 4 1,84,650 3.103 5,72,969
2,44,650
5 [1,68,000 + 76,650] 0.593 1,45,077
NPV of project 3,12,296

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Comment: It is advisable to replace the existing machine since NPV is positive

Question No.: 22 (November 2013 exam – 8 Marks)

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 Rs. 7,50,000 and will last for three years. It costs Rs.2,00,000 per year to run.
Machine B is an economy model costing only Rs.5,00,000 but will last for only two years. It costs Rs.3,00,000
per year to run.
The cash flows of machine A and B are real cash flows. The opportunity cost of capital is 9%. Which machine
should the company buy?
Answer:
• Question has provided information on outflows only. There is no information on cash inflow. We
should compute PV of outflow to decide the project

WN 1: Computation of PV of outflow:
Machine A:
Year Cash flow PVF @ 9% DCF
0 7,50,000 1.000 7,50,000
1 to 3 2,00,000 2.531 5,06,200
PV of outflow 12,56,200

Machine B:
Year Cash flow PVF @ 9% DCF
0 5,00,000 1.000 5,00,000
1 to 2 3,00,000 1.759 5,27,700
PV of outflow 10,27,700

WN 2: Computation of Equated Annual Cost (EAC):

• Life of two projects is different and hence we have to compute EAC
Particulars Machine A Machine B
PV of outflow 12,56,200 10,27,700
Life 3 year 2 years
PVAF 2.531 1.759
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 4,96,326 5,84,252
𝐄𝐀𝐂 =
𝐏𝐕𝐀𝐅
Company should go ahead with Machine A as it has lower Equated Annual Cost.

Question No.23 – November 2015 RTP, May 2019 RTP

BT Pathology Lab Limited is using an X-ray machines which reached at the end of their useful lives.
Following new X-ray machines are of two different brands with same features are available for the purchase.
Brand Cost of Machine Life of Machine Maintenance Cost Rate of depreciation
Year 1-5 Year 6-10 Year 11-15
XYZ 6,00,000 15 years 20,000 28,000 39,000 4%
ABC 4,50,000 10 years 31,000 53,000 - 6%
Residual value of both of above machines shall be dropped by 1/3 of purchase price in the first year and
thereafter shall be depreciated at the rate mentioned above.
Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner after use
on the following terms and conditions:
• Annual rent shall be paid in the beginning of each year and for first year it shall be Rs.1,02,000
• Annual rent for the subsequent 4 years shall be Rs.1,02,500
• Annual rent for the final 5 years shall be Rs.1,09,950
• The rent agreement can be terminated by BT Labs by making a payment of Rs.1,00,000 as penalty.
This penalty would be reduced by Rs.10,000 each year of the period of rental agreement.
You are required to:

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(a) Advise which brand of X-ray machine should be acquired assuming that the use of machine shall be
continued for a period of 20 years
(b) State which of the option is most economical if machine is likely to be used for a period of 5 years
The cost of capital of BT Labs is 12%
Answer:
WN 1: Evaluation of project if requirement is for 20 years:
Available alternatives:
• Buy Brand XYZ which has a life of 15 years
• Buy Brand ABC which has a life of 10 years
• Take ABC on rent for a period of 10 years

Analysis:
• All three alternative has a life of less than 20 years. We should compute PV of outflow and then
decide alternative on the basis of Equated Annual Cost

Purchase of Brand XYZ:

Year Cash flow PVF @ 12% DCF
0 6,00,000 1.000 6,00,000
1 to 5 20,000 3.605 72,100
6 to 10 28,000 2.045 57,260
11 to 15 39,000 1.161 45,279
15 -64,000 0.183 -11,712
PV of outflow 7,62,927
Note:
• Residual value (salvage value) = Cost – Depreciation of 15 years
• Residual value = 6,00,000 – (1/3 of 6,00,000) – (6,00,000 x 4% x 14 years) = Rs.64,000

Purchase of Brand ABC:

Year Cash flow PVF @ 12% DCF
0 4,50,000 1.000 4,50,000
1 to 5 31,000 3.605 1,11,755
6 to 10 53,000 2.045 1,08,385
10 -57,000 0.322 -18,354
PV of outflow 6,51,786
Note:
• Residual value (salvage value) = Cost – Depreciation of 10 years
• Residual value = 4,50,000 – (1/3 of 4,50,000) – (4,50,000 x 6% x 9 years) = Rs.57,000

Rent of Brand ABC:

Year Cash flow PVF @ 12% DCF
0 1,02,000 1.000 1,02,000
1 to 4 1,02,500 3.037 3,11,293
5 to 9 1,09,950 2.291 2,51,895
PV of outflow 6,65,188
• Rent is paid at beginning of year and hence rent of year 1 is taken in year 0 and so on.

Computation of EAC:
Particulars Option 1 Option 2 Option 3
PV of outflow 7,62,927 6,51,786 6,65,188
Life 15 years 10 years 10 years
PVAF [Annuity factor for 12% and Life] 6.811 5.650 5.650
EAC [PV of outflow/PVAF] 1,12,014 1,15,360 1,17,732
Conclusion: Company should buy Brand XYZ as the same has the lowest Equated Annual Cost.

WN 2: Evaluation of project if requirement is for 5 years:

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Purchase of Brand XYZ:
Year Cash flow PVF @ 12% DCF
0 6,00,000 1.000 6,00,000
1 to 5 20,000 3.605 72,100
5 -3,04,000 0.567 -1,72,368
PV of outflow 4,99,732
Note:
• Residual value (salvage value) = Cost – Depreciation of 5 years
• Residual value = 6,00,000 – (1/3 of 6,00,000) – (6,00,000 x 4% x 4 years) = Rs.3,04,000

Purchase of Brand ABC:

Year Cash flow PVF @ 12% DCF
0 4,50,000 1.000 4,50,000
1 to 5 31,000 3.605 1,11,755
5 -1,92,000 0.567 -1,08,864
PV of outflow 4,52,891
Note:
• Residual value (salvage value) = Cost – Depreciation of 5 years
• Residual value = 4,50,000 – (1/3 of 4,50,000) – (4,50,000 x 6% x 4 years) = Rs.1,92,000

Rent of Brand ABC:

Year Cash flow PVF @ 12% DCF
0 1,02,000 1.000 1,02,000
1 to 4 1,02,500 3.037 3,11,293
5 50,000 0.567 28,350
PV of outflow 4,41,643
• Penalty is payable if the contract is terminated before 10 years. The amount of penalty of Rs.1,00,000
will be reduced by Rs.10,000 for completion of 1 year. In this case contract runs for 5 years and hence
the penalty amount would be Rs.50,000
Conclusion:
The company should go ahead with rent of Brand ABC as the PV of outflow is lowest

Question No.24 [May 2019 MTP]

Prem Limited has a maximum of Rs.8,00,000 available to invest in new projects. Three possibilities have
emerged and the business finance manager has calculated NPV for each of the projects as follows:
Investment Initial Cash Outlay NPV
Alpha 5,40,000 1,00,000
Beta 6,00,000 1,50,000
Gama 2,60,000 58,000
Determine which investment/combination of investments should the company invest in, if we assume that
the projects can be divided?
Answer:
Step 1: Check whether capital rationing exist:
Particulars Amount
Demand for money (5,40,000 +6,00,000 + 2,60,000) 14,00,000
Supply of money 8,00,000
Capital rationing exist as the demand for money is more than supply of money

Step 2: Statement of ranking:

Project Outflow NPV Profitability index Rank
Alpha 5,40,000 1,00,000 1.185 3
Beta 6,00,000 1,50,000 1.250 1
Gamma 2,60,000 58,000 1.223 2

Step 3: Statement of allocation:

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Project Money invested Balance Money NPV
Beta 6,00,000 2,00,000 1,50,000
20/26 of Gamma 2,00,000 - 44,615
Total NPV 1,94,615
• NPV of Gamma Project = 58,000 x (20/26) = Rs.44,615

Question No.25 [Nov 2019]

A company has Rs.1,00,000 available for investment and has identified the following four investments in
which to invest:
Project Investment NPV
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit if:
• The projects are independent of each other and are divisible
• The projects are not divisible
Answer:
Part 1: Projects are divisible:
Step 1: Check whether capital rationing exist:
Particulars Amount
Demand for money (40+100+50+60) 2,50,000
Supply of money 1,00,000
Capital rationing exist as the demand for money is more than supply of money

Step 2: Statement of ranking:

Profitability index
Project Outflow NPV [Outflow + NPV]/Outflow Rank
C 40,000 20,000 1.5000 1
D 1,00,000 35,000 1.3500 3
E 50,000 24,000 1.4800 2
F 60,000 18,000 1.3000 4

Step 3: Statement of allocation:

Project Money invested Balance Money NPV
C 40,000 60,000 20,000
E 50,000 10,000 24,000
3,500
1/10 of D 10,000 - [35,000 x 1/10]
Total NPV 47,500

Part 2: Projects are indivisible:

Step 1 and 2 – No change

Step 3: Selection of Projects:

Combination Amount invested NPV
C&E 90,000 44,000
C&F 1,00,000 38,000
D 1,00,000 35,000
Conclusion: Company should do project C and E to earn maximum NPV of Rs.44,000.

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CHAPTER 8: RISK ANALYSIS IN CAPITAL BUDGETING

Expected Value:
Expected value is the weighted average value with probability of occurrence being the assigned weight
❖ Expected value is a measure of return
Expected Value = ∑P * R
P = Probability of occurrence; R = Return
❖ Other things remaining same, the alternative with higher expected value is to be selected

Standard Deviation:
❖ Standard deviation is the deviation from the mean
❖ It is a measure of risk
SD = √pd2
d = X − (Average of X)
❖ Other things remaining same the alternative with lower standard deviation should be selected

Co-efficient of variation:
❖ Co-efficient of variation measures risk per unit of return
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐕𝐚𝐥𝐮𝐞
𝐂𝐕 =
𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧
❖ The project with lower CV should be selected
❖ CV forces every decision maker. Aggressive investor would like to select a project with higher return
and conservative investor will like to select a project with lower risk

RADR Approach:
❖ The project with a higher risk will be discounted at a higher rate (RADR). Select the project with
higher risk adjusted NPV
❖ RADR = Risk free rate + Risk Premium
❖ Even for a single project the company can discount the different types of cash flows at different rate.
For instance, certain cash flows like depreciation tax shield, guaranteed salvage value can be
discounted at normal cost of capital and uncertain cash flows like sales, cost structure, salvage value
can be discounted at RADR

Certainty Equivalent Approach:

❖ CEF is ratio of certain cash flows to uncertain cash flows
❖ Less the certainty, lower the value of CEF. Hence risk is considered to be more when CEF is less
❖ We should select a project with higher NPV
Steps:
❖ Convert uncertain cash flows into certain cash flows
o CCF = UCF x CEF
❖ The appropriate discount rate is risk free rate of return
❖ Compute NPV

Sensitivity and Scenario Analysis:

Sensitivity Analysis:
❖ It measures the percentage change in input parameters that would lead to a reversal in investment
decision
Change
Sensitivity % = x 100
Base
❖ The input parameters and the direction of change leading to sensitivity are as under
Parameter Direction
Size ↑
Cash Flows ↓
Discount Rate ↑
Life ↓
❖ A project is more sensitive to that input parameter whose sensitivity percent is least. This is because
a small change would lead to a reversal of investment decision

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Sensitivity Analysis – Uneven cash flows:

❖ Compute PV of uneven cash flows
❖ The above value has to change by the amount of NPV for the project to become unviable
NPV
Sensitivity % = x 100
PV of Uneven Cash flows

Scenario Analysis:
❖ Sensitivity analysis is probably the most widely used risk analysis technique, it does have
limitations. Therefore, we need to extend sensitivity analysis to deal with the probability
distributions of the inputs.
❖ In addition, it would be useful to vary more than one variable at a time so we could see the
combined effects of changes in the variables. Scenario analysis provides answer to these situations
of extensions.
❖ This analysis brings in the probabilities of changes in key variables and also allows us to change
more than one variable at a time.
❖ This analysis begins with base case or most likely set of values for the input variables. Then, go for
worst case scenario (low unit sales, low sale price, high variable cost and so on) and best case
scenario. So, in a nutshell Scenario analysis examine the risk of investment, so as to analyse the
impact of alternative combinations of variables, on the project’s NPV (or IRR).

1. Calculation of NPV and Standard Deviation

Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs Rs. 36,000 and
project B Rs. 30,000. You have been given below the net present value probability distribution
for each project.
Project A Project B
NPV estimate Probability NPV estimate Probability
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
❖ Compute the expected net present values of projects A and B.
❖ Compute the risk attached to each project i.e. standard deviation of each probability
distribution.
❖ Compute the profitability index of each project.
❖ Which project do you recommend? State with reasons.
Answer:
WN 1: Computation of risk and return of Project A:
(in ‘000s)
NPV Probability Product Deviation 𝐏𝐝 𝟐

15 0.20 3.00 6.00 7.20

12 0.30 3.60 3.00 2.70
6 0.30 1.80 -3.00 2.70
3 0.20 0.60 -6.00 7.20
Total 9.00 19.80
• Product = NPV x Probability
• Deviation = Column 1 – Sum of product
• Column 5 = Product x Deviation x Deviation

Risk and return:

Expected NPV Sum of products 9,000
Standard deviation √Pd2 = √19.80 4,450

WN 2: Computation of risk and return of Project B:

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(in ‘000s)
NPV Probability Product Deviation 𝐏𝐝𝟐

15 0.10 1.50 6.00 3.60

12 0.40 4.80 3.00 3.60
6 0.40 2.40 -3.00 3.60
3 0.10 0.30 -6.00 3.60
Total 9.00 14.40

Risk and return:

Expected NPV Sum of products 9,000
Standard deviation √Pd2 = √14.40 3,795

WN 3: Computation of Profitability index

PV of Inflow
Profitability Index =
PV of outflow
Particulars Project A Project B
PV of outflow 36,000 30,000
NPV 9,000 9,000
PV of inflow (NPV + Outflow) 45,000 39,000
Profitability Index (Inflow/Outflow) 1.25 Times 1.30 Times

Selection of project:
• Project A and B give same amount of NPV. Hence, we can say that we are indifferent between A and
B if return is criteria to select the project
• Project B carries lower risk and hence the investor would prefer Project B if risk is criteria to select
the project
• Considering the above analysis, it is recommended that company goes ahead with Project B.

2. Computation of expected cash flow, standard deviation and co-efficient of variation [Nov 2020,
Nov 2019 MTP]
A Ltd. is considering two mutually exclusive projects X and Y. You have been given below the Net Cash flow
probability distribution of each project:
Project X Project Y
Net cash flow Probability Net cash flow Probability
50,000 0.30 1,30,000 0.20
60,000 0.30 1,10,000 0.30
70,000 0.40 90,000 0.50
Compute the following:
• Expected net cash flow of the project
• Variance of each project
• Standard deviation of each project
• Co-efficient of variation
• Identify which project do you recommend and why
Answer:
WN 1: Analysis of project X:
(in ‘000s)
Cash flow Probability Product Deviation 𝐏𝐝𝟐
50 0.30 15.00 -11.00 36.30
60 0.30 18.00 -1.00 0.30
70 0.40 28.00 9.00 32.40
Total 61.00 69.00

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Risk and return:

Expected cash flow Sum of products 61,000
Variance 69.00 x 1,000 x 1,000 6,90,00,000
Standard deviation √Pd2 = √69.00 8,306
Co-efficient of variation 8,306/61,000 0.136 (or) 13.60%

WN 2: Analysis of project Y:
(in ‘000s)
Cash flow Probability Product Deviation 𝐏𝐝 𝟐

130 0.20 26.00 26.00 135.20

110 0.30 33.00 6.00 10.80
90 0.50 45.00 -14.00 98.00
Total 104.00 244.00

Risk and return:

Expected cash flow Sum of products 1,04,000
Variance 244.00 x 1,000 x 1,000 24,40,00,000
Standard deviation √Pd2 = √244 15,620
Co-efficient of variation 15,620/1,04,000 0.150 (or) 15.00%

Conclusion:
In project X risk per rupee of cash flow is 0.136 (approx.) while in project Y it is 0.15 (approx.). Therefore,
Project X is better than Project Y.

3. Hillier’s model – May 2018 RTP

Project X and Project Y are under the evaluation of XY company. The estimated cash flows and their
probabilities are as below:
Project X: Investment of Rs.70 lacs in year 0
Probability weights 0.30 0.40 0.30
Years Rs. Lacs Rs. Lacs Rs. Lacs
1 30 50 65
2 30 40 55
3 30 40 45

Project Y: Investment of Rs.80 lacs in year 0; Life = 3 years

Probability weights Annual cash flows through life
Years Rs. Lacs
0.20 40
0.50 45
0.30 50
• Which project is better based on NPV, criterion with a discount rate of 10%?
• Compute the standard deviation of the present value distribution and analyse the inherent risk of
the projects
Answer:
WN 1: Computation of expected cash flow and standard deviation of Project X for year 1, 2 and 3:
Year 1:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝 𝟐

30 0.3 9.00 -18.50 102.68

50 0.4 20.00 1.50 0.90
65 0.3 19.50 16.50 81.67

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Total 48.50 185.25

Expected cash flow and SD:

Expected cash flow Sum of products 48.50
Standard deviation √Pd2 = √185.25 13.61

Year 2:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝𝟐

30 0.3 9.00 -11.50 39.68

40 0.4 16.00 -1.50 0.90
55 0.3 16.50 13.50 54.67
Total 41.50 95.25

Expected cash flow and SD:

Expected cash flow Sum of products 41.50
Standard deviation √Pd2 = √95.25 9.76

Year 3:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝𝟐
30 0.3 9.00 -8.50 21.68
40 0.4 16.00 1.50 0.90
45 0.3 13.50 6.50 12.67
Total 38.50 35.25

Expected cash flow and SD:

Expected cash flow Sum of products 38.50
Standard deviation √Pd2 = √35.25 5.94

WN 2: Computation of expected NPV of Project X:

(in lacs)
Year Cash flow PVF @ 10% DCF
0 -70.00 1.000 -70.00
1 48.50 0.909 44.09
2 41.50 0.826 34.28
3 38.50 0.751 28.91
Expected NPV 37.28
• Expected NPV = Rs.37,28,000

WN 3: Computation of Standard deviation of Project X:

Year SD PVF @ 10% DSD 𝐃𝐒𝐃𝟐
[SD x PVF]
1 13.61 0.909 12.37 153.02
2 9.76 0.826 8.06 64.96
3 5.94 0.751 4.46 19.89
Total 24.89 237.87

Expected SD:
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SD if cash flows are dependent Sum of DSD Rs.24.89 lacs
SD if cash flows are independent √DSD2 = √237.87 Rs.15.42 lacs

WN 4: Computation of expected cash flow and standard deviation of Project Y for year 1, 2 and 3:
Year 1 to 3:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝 𝟐

40 0.2 8.00 -5.50 6.05

45 0.5 22.50 -0.50 0.13
50 0.3 15.00 4.50 6.07
Total 45.50 12.25

Expected cash flow and SD:

Expected cash flow Sum of products 45.50
Standard deviation √Pd2 = √12.25 3.50

WN 5: Computation of expected NPV of Project Y:

(in lacs)
Year Cash flow PVF @ 10% DCF
0 -80.00 1.000 -80.00
1 to 3 45.50 2.487 113.16
Expected NPV 33.16
• Expected NPV = Rs.33,16,000

WN 6: Computation of Standard deviation of Project Y:

Year SD PVF @ 10% DSD 𝐃𝐒𝐃𝟐
[SD x PVF]
1 3.50 0.909 3.18 10.11
2 3.50 0.826 2.89 8.35
3 3.50 0.751 2.63 6.92
Total 8.70 25.38

Expected SD:
SD if cash flows are dependent Sum of DSD Rs.8.70 lacs
SD if cash flows are independent √DSD2 = √25.38 Rs.5.04 lacs

4. Hillier’s model – November 2016 RTP

Jet Airways is planning to acquire a light commercial aircraft for flying class clients at an investment of
Rs.50,00,000. The expected cash flow after tax for the next three years is as follows:
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1

The Company wishes to take into consideration all possible risk factor relating to an airline operations. The
company wants to know:
1. The expected NPV assuming with 6 % risk free rate of interest.
2. The possible deviation in the expected value

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a) If the cash flows are independent
b) If the cash flows are dependent
Answer:
WN 1: Computation of expected cash flow and standard deviation of year 1, 2 and 3:
Year 1:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝𝟐

14 0.1 1.40 -13.00 16.90

18 0.2 3.60 -9.00 16.20
25 0.4 10.00 -2.00 1.60
40 0.3 12.00 13.00 50.70
Total 27.00 85.40

Expected cash flow and SD:

Expected cash flow Sum of products 27.00
Standard deviation √Pd2 = √85.40 9.24

Year 2:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝𝟐

15 0.1 1.50 -14.30 20.45

20 0.3 6.00 -9.30 25.95
32 0.4 12.80 2.70 2.92
45 0.2 9.00 15.70 49.30
Total 29.30 98.62

Expected cash flow and SD:

Expected cash flow Sum of products 29.30
Standard deviation √Pd2 = √98.62 9.93

Year 3:
(in lacs)
Cash flow Probability Product Deviation 𝐏𝐝𝟐

18 0.2 3.60 -9.90 19.60

25 0.5 12.50 -2.90 4.21
35 0.2 7.00 7.10 10.08
48 0.1 4.80 20.10 40.40
Total 27.90 74.29

Expected cash flow and SD:

Expected cash flow Sum of products 27.90
Standard deviation √Pd2 = √74.29 8.62

WN 2: Computation of expected NPV:

(in lacs)
Year Cash flow PVF @ 6% DCF
0 -50.00 1.000 -50.00
1 27.00 0.943 25.46
2 29.30 0.890 26.08

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3 27.90 0.840 23.44
Expected NPV 24.98
• Expected NPV = Rs.24,98,000

WN 3: Computation of Standard deviation:

Year SD PVF @ 6% DSD 𝐃𝐒𝐃𝟐
[SD x PVF]
1 9.24 0.943 8.71 75.86
2 9.93 0.890 8.84 78.15
3 8.62 0.840 7.24 52.42
Total 24.79 206.43
Note:
• Dependent cash flows are considered to be riskier. In this case a weak cash flow will always be
followed by a weak cash flow and a good cash flow will always be followed by a good cash flow
• Hence SD of dependent cash flows is always higher than cash flows of independent cash flows
• Sum of Discounted standard deviation (Col 4) gives the SD of dependent cash flows
• Column 5 is basically square of column 4. We square the number and sum them. Post this we take a
square root. This would be called as SD if cash flows are independent
Expected SD:
SD if cash flows are dependent Sum of DSD Rs.24.79 lacs
SD if cash flows are independent √DSD2 = √206.43 Rs.14.37 lacs

5. Best-case and worst-case NPV – November 2015 RTP

XY Limited has under its consideration a project with an initial investment of Rs.1,00,000. Three probable
cash inflow scenarios with their probabilities of occurrence have been estimated as follows:
Annual cash inflow 20,000 30,000 40,000
Probability 0.10 0.70 0.20
The present life is 5 years and the desired rate of return is 20%. The estimated terminal values of the project
assets under the three probability alternatives, respectively, are Rs.0, Rs.20,000 and Rs.30,000
You are required to:
• Find the probable NPV
• Find the worst-case NPV and the best-case NPV and
• State the probability occurrence of the worst case, if the cash flows are perfectly positively correlated
over time
Answer:
WN 1: Computation of different NPV:
(in ‘000s)
Year Cash flow PVF DCF
P = 0.1 P = 0.7 P = 0.2 @ 20% P = 0.1 P = 0.7 P = 0.2
0 -100 -100 -100 1.000 -100.00 -100.00 -100.00
1 to 5 20 30 40 2.991 59.82 89.73 119.64
5 0 20 30 0.402 0.00 8.04 12.06
Total -40.18 -2.23 31.70

WN 2: Computation of probable NPV:

NPV Probability Product
-40.18 0.10 -4.02
-2.23 0.70 -1.56
31.70 0.20 6.34
Total 0.76

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WN 3: Solution:
Probable NPV (WN 2) 760
Worst-case NPV (WN 1) -40,180
Best-case NPV (WN 1) 31,700
Probability of worst-case NPV 10%
[Cash flows are dependent]

6. Risk Adjusted Discount Rate – May 2016

ABC Limited is evaluating 3 projects, P-l, P-ll, P-lll. Following information is available in respect of these
projects:
Particulars P-I P-II P-III
Cost Rs. 15,00,000 Rs. 11,00,000 Rs. 19,00,000
Inflows-Year1 Rs. 6,00,000 Rs. 6,00,000 Rs. 4,00,000
Year 2 Rs. 6,00,000 Rs. 4,00,000 Rs. 6,00,000
Year 3 Rs. 6,00,000 Rs. 5,00,000 Rs. 8,00,000
Year 4 Rs. 6,00,000 Rs. 2,00,000 Rs. 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk-free interest rate
is 10%.
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?
Answer:
WN 1: Computation of Risk-adjusted discount rate:
RADR = R f + Risk index x (R m − R f )
RADR of P1 = 10 + 1.80 x (15 − 10) = 19.00%
RADR of P2 = 10 + 1.00 x (15 − 10) = 15.00%
RADR of P3 = 10 + 0.60 x (15 − 10) = 13.00%

WN 2: Computation of NPV:
Project 1
Year Cash flow PVF @ 19% DCF
0 -15,00,000 1.000 -15,00,000
1 6,00,000 0.840 5,04,000
2 6,00,000 0.706 4,23,600
3 6,00,000 0.593 3,55,800
4 6,00,000 0.499 2,99,400
Risk-adjusted NPV 82,800

Project 2:
Year Cash flow PVF @ 15% DCF
0 -11,00,000 1.000 -11,00,000
1 6,00,000 0.870 5,22,000
2 4,00,000 0.756 3,02,400
3 5,00,000 0.658 3,29,000
4 2,00,000 0.572 1,14,400
Risk-adjusted NPV 1,67,800

Project 3:
Year Cash flow PVF @ 13% DCF
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0 -19,00,000 1.000 -19,00,000
1 4,00,000 0.885 3,54,000
2 6,00,000 0.783 4,69,800
3 8,00,000 0.693 5,54,400
4 12,00,000 0.613 7,35,600
Risk-adjusted NPV 2,13,800
Conclusion:
• The company should go ahead with Project 3 as it has highest risk-adjusted NPV

7. RADR [May 2018 MTP, Nov 2018 MTP, May 2019 RTP, Nov 2019 RTP]
An enterprise is investing Rs.100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected
by the management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated
over the life of the project.
Year Cash flows (in lacs)
1 25
2 60
3 75
4 80
5 65
Calculate NPV of the project based on risk-free rate and also on the basis of risk adjusted discount rate.
Answer:
WN 1: Computation of NPV based on risk-free rate of 7%:
Year Cash flow PVF @ 7% DCF
(in lacs) (in lacs)
0 -100.00 1.000 -100.00
1 25.00 0.935 23.38
2 60.00 0.873 52.38
3 75.00 0.816 61.20
4 80.00 0.763 61.04
5 65.00 0.713 46.35
NPV 144.34

WN 2: Computation of NPV based on RADR of 14%:

• Risk-free rate is 7% and there is a risk premium of 7%. Hence risk-adjusted discount rate is 14%

Year Cash flow PVF @ 14% DCF

(in lacs) (in lacs)
0 -100.00 1.000 -100.00
1 25.00 0.877 21.93
2 60.00 0.769 46.14
3 75.00 0.675 50.63
4 80.00 0.592 47.36
5 65.00 0.519 33.74
NPV 99.80

8. RADR [May 2019 MTP]

Invest corporation Limited adjusts risk through discount rates by adding various risk premiums to the risk-
free rate. Depending on the resultant rate, the proposed project in judged to be a low, medium or high-risk
project.
Risk Level Risk free rate (%) Risk Premium (%)
Low 8 4
Medium 8 7

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High 8 10
Demonstrate the acceptability of the project on the basis of risk adjusted rate
Answer:
WN 1: Calculation of risk-adjusted discount rate:
Risk Level Risk free rate (%) Risk Premium (%) Risk-adjusted discount rate (%)
Low 8 4 12
Medium 8 7 15
High 8 10 18

WN 2: Computation of different NPV:

Let us assume cash flows of project as under:
Year Cash flow
0 -100
1 45
2 80
• We can assume any amount as cash flow. This was just an example to explain the impact of RADR
on decision.

Computation of different NPV for low, medium and high-risk scenario:

Year Cash flow PVF @ DCF
12% 15% 18% 12% 15% 18%
0 -100.00 -1.000 -1.000 -1.000 -100.00 -100.00 -100.00
1 45.00 0.893 0.870 0.847 40.19 39.15 38.12
2 80.00 0.797 0.756 0.718 63.76 60.48 57.44
Total 3.95 -0.37 -4.44
Conclusion: Project will be accepted if the cash flows are of low-risk as it has positive NPV. Project will be
rejected if the cash flows are of medium and high-risk as it has negative NPV.

9. RADR [May 2019 MTP]

Determine the risk adjusted net present value of the following projects:
Particulars X Y Z
Net cash outlays 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual cash inflow 70,000 42,000 30,000
Coefficient of variation 1.20 0.80 0.40
The company selects the risk-adjusted rate of discount on the basis of the co-efficient of variation:
Coefficient of variation RADR PV factor of 1 to 5 years at RADR
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
2.0 22% 2.864
More than 2.0 25% 2.689
Answer:
WN 1: Identification of discount rate for different projects:
Project Coefficient of variation RADR
X 1.20 16%
Y 0.80 14%
Z 0.40 12%

WN 2: Computation of NPV:
Project X:
Year Cash flow PVF @ 16% DCF
0 -21,0,000 1.000 -2,10,000
1 to 5 70,000 3.274 2,29,180

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Risk-adjusted NPV 19,180

Project Y:
Year Cash flow PVF @ 14% DCF
0 -1,20,000 1.000 -1,20,000
1 to 5 42,000 3.433 1,44,186
Risk-adjusted NPV 24,186

Project Z:
Year Cash flow PVF @ 12% DCF
0 -1,00,000 1.000 -1,00,000
1 to 5 30,000 3.605 1,08,150
Risk-adjusted NPV 8,150

10. Certainty equivalent approach:

Oil country tubular Ltd. is considering an investment in one of the two mutually exclusive proposals –
Projects X and Y, which require cash outlays of Rs.3, 40,000 and Rs.3, 30,000 respectively. The certainty-
equivalent (C.E.) approach is used in incorporating risk in capital budgeting decisions. The current yield on
government bond is 8% and this be used as the risk free rate. The expected net cash flows and their certainty-
equivalents are as follows:
Project X Project Y
Year-end Cash flow C.E.F Cash flow C.E.F
1 1,80,000 0.8 1,80,000 0.9
2 2,00,000 0.7 2,00,000 0.8
3 2,00,000 0.5 2,00,000 0.7
Required:
(i) Which project should be accepted?
(ii) If risk adjusted discount rate method is used, which project would be analyzed with a higher rate?
(iii) Discuss the advantages of certainty equivalent method?
Answer:
WN 1: Computation of NPV of Project X using Certainty equivalent factor approach:
Year Cash flows PVF @ 8% DCF
Uncertain CEF Certain
0 -3,40,000 1.0 -3,40,000 1.000 -3,40,000
1 1,80,000 0.8 1,44,000 0.926 1,33,344
2 2,00,000 0.7 1,40,000 0.857 1,19,980
3 2,00,000 0.5 1,00,000 0.794 79,400
Expected NPV -7,276
Note:
• Certain cash flow = Uncertain cash flow x CEF
• DCF = Certain cash flow x PVF

WN 2: Computation of NPV of Project Y using certainty equivalent factor approach:

Year Cash flows PVF @ 8% DCF
Uncertain CEF Certain
0 -3,30,000 1.0 -3,30,000 1.000 -3,30,000
1 1,80,000 0.9 1,62,000 0.926 1,50,012
2 2,00,000 0.8 1,60,000 0.857 1,37,120
3 2,00,000 0.7 1,40,000 0.794 1,11,160
Expected NPV 68,292
Conclusion:
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• The company should go ahead with Project Y as it results in better NPV

Usage of RADR Approach:

• Cumulative CEF of 3 years is 2.0 and 2.4 for Project X and Project Y respectively
• Higher CEF would indicate lower risk. This would mean Project Y has lower risk and Project X has
higher risk
• High-risk project needs to be discounted at higher rate and hence Project X will be discounted at
higher RADR

Advantages of certainty equivalent method:

• The certainty equivalent method is simple and easy to understand and apply.
• It can easily be calculated for different risk levels applicable to different cash flows. For example, if
in a particular year, a higher risk is associated with the cash flow, it can be easily adjusted and the
NPV can be recalculated accordingly

11. Sensitivity analysis – May 2018 RTP

PNR Limited is considering a project with the following cash flows:
Year Cost of Plant Running Cost Savings
0 12,00,00,000
1 4,00,00,000 12,00,00,000
2 5,00,00,000 14,00,00,000
3 6,00,00,000 11,00,00,000
The cost of capital is 12%. Measure the sensitivity of the project to the changes in the levels of Plant cost,
running cost and savings (considering each factor at a time) such that NPV becomes zero. Determine the
factor which is the most sensitive to affect the acceptability of the project?
Answer:
WN 1: Computation of NPV of Project:
Year Cash Flow PVF @ DCF
Cost of Running cost Savings 12% Cost of Plant Running cost Savings
Plant
0 -12,00,00,000 1.000 -12,00,00,000 0 0
1 -4,00,00,000 12,00,00,000 0.892 0 -3,56,80,000 10,70,40,000
2 -5,00,00,000 14,00,00,000 0.797 0 -3,98,50,000 11,15,80,000
3 -6,00,00,000 11,00,00,000 0.711 0 -4,26,60,000 7,82,10,000
Total -12,00,00,000 -11,81,90,000 29,68,30,000
• NPV of project = -12,00,00,000 – 11,81,90,000 + 29,68,30,000 = Rs.5,86,40,000

WN 2: Computation of sensitivity of different parameters:

Plant cost:
• The project will have zero NPV if the cost of plant increases by Rs.5,86,40,000 (amount of NPV).
This is because any increase in cost of plant will reduce NPV and finally it will become zero

Change 5,86,40,000
Sensitivity % = 𝑥 100 = 𝑥100 = 48.87%
Base 12,00,00,000
• Base represents current plant cost of Rs.12,00,00,000

Running cost:
• The project will have zero NPV if the PV of running cost increases by Rs.5,86,40,000 (amount of
NPV). This is because any increase in increase in running cost will reduce NPV and finally it will
become zero

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Change 5,86,40,000
Sensitivity % = 𝑥 100 = 𝑥100 = 49.61%
Base 11,81,90,000
• Base represents current running cost of Rs.11,81,90,000

Savings:
• The project will have zero NPV if the PV of savings decline by Rs.5,86,40,000 (amount of NPV).
This is because any decline in savings will reduce NPV and finally it will become zero

Change 5,86,40,000
Sensitivity % = 𝑥 100 = 𝑥100 = 19.75%
Base 29,68,30,000
• Base represents current savings cost of Rs.29,68,30,000

Conclusion: Project is most sensitive to savings factor as only a change beyond 19.75% in savings makes
the project unacceptable.

12. Sensitivity analysis (May 2018 RTP)

From the following details relating to a project, analyze the sensitivity of the project to changes in the initial
project cost, annual cash inflow and cost of capital:
Particulars Amount
Initial Project Cost 2,00,00,000
Annual cash inflow 60,00,000
Project life 5 years
Cost of capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10 percent?
Answer:
Sensitivity Analysis:
Particulars Base case Project cost Cash inflow Cost of capital
Annual inflow 60,00,000 60,00,000 54,00,000 60,00,000
[60,00,000-10%]
Discount rate 10% 10% 10% 11%
[10% + 10 of 10%]
PVAF 3.791 3.791 3.791 3.696
PV of inflow (A) 2,27,46,000 2,27,46,000 2,04,71,400 2,21,76,000
Initial outflow (B) 2,00,00,000 2,20,00,000 2,00,00,000 2,00,00,000
[2,00,00,000 + 10%]
NPV (A-B) 27,46,000 7,46,000 4,71,400 21,76,000
Change in NPV NA 20,00,000 22,74,600 5,70,000
% Change in NPV NA 72.83 82.83 20.76
• Project is most sensitive to annual cash inflow as 10 percent change in inflow leads to 82.83 percent
change in NPV

13. Sensitivity Analysis [May 2020 MTP]

A&R Limited has undertaken a project which has an initial investment of Rs.2,000 lakhs in plant & machinery
and Rs.800 lakhs for working capital. The Plant & machinery would have a salvage value of Rs.474.61 lakhs
at the end of the fifth year. Depreciation at the rate of 25% p.a. under WDV method. The other details of the
project for the five-year period are as follows:
Sales 10,00,000 units p.a.
Selling price Rs.500
Variable cost 50% of selling price
Fixed overheads (excluding depreciation) Rs.300 lacs p.a.
Corporate tax rate 35%
Rate of interest on bank loan 12%
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After tax required rate of return 15%
Required:
• Calculate NPV of the project and determine the viability of the project
• Determine the sensitivity of project’s NPV under each of the following conditions:
o Decrease in selling price by 10%
o Increase in cost of plant and machinery by 10%
Answer:
WN 1: Initial Outflow:
Amount
Particulars (in lacs)
Capital expenditure (2,000.00)
Working capital (800.00)
Initial Outflow (2,800.00)

WN 2: In-between flows:
(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Units sold 10.00 10.00 10.00 10.00 10.00
Contribution per unit [500-250] 250.00 250.00 250.00 250.00 250.00
Total Contribution 2,500.00 2,500.00 2,500.00 2,500.00 2,500.00
Less: Fixed cost -300.00 -300.00 -300.00 -300.00 -300.00
PBDT 2,200.00 2,200.00 2,200.00 2,200.00 2,200.00
Less: Depreciation [Note 1] -500.00 -375.00 -281.25 -210.94 -158.20
PBT 1,700.00 1,825.00 1,918.75 1,989.06 2,041.80
Less: Tax @ 35% -595.00 -638.75 -671.56 -696.17 -714.63
PAT 1,105.00 1,186.25 1,247.19 1,292.89 1,327.17
Add: Depreciation 500.00 375.00 281.25 210.94 158.20
CFAT 1,605.00 1,561.25 1,528.44 1,503.83 1,485.37

Note 1: Computation of depreciation:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening balance 2,000.00 1,500.00 1,125.00 843.75 632.81
Less: Depreciation @ 25% -500.00 -375.00 -281.25 -210.94 -158.20
Closing balance 1,500.00 1,125.00 843.75 632.81 474.61

WN 3: Terminal flow:
Amount
Particulars (in lacs)
Salvage value 474.61
Working capital 800.00
Total terminal flow 1,274.61

WN 4: Computation of NPV:
(in lacs)
Year Cash flow PVF @ 15% DCF
0 -2,800.00 1.000 -2,800.00
1 1,605.00 0.869 1,394.74
2 1,561.25 0.756 1,180.31
3 1,528.44 0.657 1,004.18
4 1,503.83 0.571 858.68

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5 2,759.98 0.497 1,371.71
Amount of NPV 3,009.62
The NPV of the project is positive, hence, the project is viable.

WN 2: Sensitivity Analysis with decrease in selling price by 10%:

• Initial outflow and terminal flow will not change with change in selling price
• In-between flows is computed as under:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Units sold 10.00 10.00 10.00 10.00 10.00
Contribution per unit [450-250] 200.00 200.00 200.00 200.00 200.00
Total Contribution 2,000.00 2,000.00 2,000.00 2,000.00 2,000.00
Less: Fixed cost -300.00 -300.00 -300.00 -300.00 -300.00
PBDT 1,700.00 1,700.00 1,700.00 1,700.00 1,700.00
Less: Depreciation [Note 1] -500.00 -375.00 -281.25 -210.94 -158.20
PBT 1,200.00 1,325.00 1,418.75 1,489.06 1,541.80
Less: Tax @ 35% -420.00 -463.75 -496.56 -521.17 -539.63
PAT 780.00 861.25 922.19 967.89 1,002.17
Add: Depreciation 500.00 375.00 281.25 210.94 158.20
CFAT 1,280.00 1,236.25 1,203.44 1,178.83 1,160.37

Computation of NPV:
Year Cash flow PVF @ 15% DCF
0 -2,800.00 1 -2,800.00
1 1,280.00 0.869 1,112.32
2 1,236.25 0.756 934.61
3 1,203.44 0.657 790.66
4 1,178.83 0.571 673.11
5 2,434.98 0.497 1,210.19
Amount of NPV 1,920.89
• NPV of the project has reduced from Rs.3,009.62 lacs to Rs.1,920.89 lacs
• Fall in NPV = 3009.62 lacs – 1,920.89 lacs = 1,083.73 lacs
• % fall in NPV = (1,083.73/3,009.62) x 100 = 36%

WN 3: Sensitivity analysis with increase in plant cost by 10%:

WN 1: Initial Outflow:
Amount
Particulars (in lacs)
Capital expenditure (2,200.00)
Working capital (800.00)
Initial Outflow (3,000.00)

WN 2: In-between flows:
(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Units sold 10.00 10.00 10.00 10.00 10.00
Contribution per unit [500-250] 250.00 250.00 250.00 250.00 250.00
Total Contribution 2,500.00 2,500.00 2,500.00 2,500.00 2,500.00
Less: Fixed cost -300.00 -300.00 -300.00 -300.00 -300.00

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PBDT 2,200.00 2,200.00 2,200.00 2,200.00 2,200.00
Less: Depreciation [Note 1] -550.00 -412.50 -309.38 -232.04 -174.03
PBT 1,650.00 1,787.50 1,890.62 1,967.96 2,025.97
Less: Tax @ 35% -577.50 -625.63 -661.72 -688.79 -709.09
PAT 1,072.50 1,161.87 1,228.90 1,279.17 1,316.88
Add: Depreciation 550.00 412.50 309.38 232.04 174.03
CFAT 1,622.50 1,574.37 1,538.28 1,511.21 1,490.91

Note 1: Computation of depreciation:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening balance 2,200.00 1,650.00 1,237.50 928.12 696.09
Less: Depreciation @ 25% -550.00 -412.50 -309.38 -232.03 -174.02
Closing balance 1,650.00 1,237.50 928.12 696.09 522.07

WN 3: Terminal flow:
Amount
Particulars (in lacs)
Net Salvage value (Note 1) 491.22
Working capital 800.00
Total terminal flow 1,291.22

Net salvage value:

Amount
Particulars (in lacs)
Sale value 474.61
Less: Book value -522.07
Capital loss 47.46
Tax saved @ 35% 16.61
Net salvage value 491.22

WN 4: Computation of NPV:
(in lacs)
Year Cash flow PVF @ 15% DCF
0 -3,000.00 1.000 -3,000.00
1 1,622.50 0.869 1,409.95
2 1,574.37 0.756 1,190.22
3 1,538.28 0.657 1,010.65
4 1,511.21 0.571 862.90
5 2,782.13 0.497 1,382.72
Amount of NPV 2,856.44
• NPV of the project has reduced from Rs.3,009.62 lacs to Rs.2,856.44 lacs
• Fall in NPV = 3009.62 lacs – 2,856.44 lacs = 153.18 lacs
• % fall in NPV = (153.18/3,009.62) x 100 = 5.09%

14. Sensitivity analysis [May 2021 RTP]

X Limited is considering its new product with the following details:
Initial capital cost Rs.400 Crores
Annual unit sales Rs.5 Crores
Selling Price Per unit Rs.100
Variable cost per unit Rs.50

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Fixed costs per year Rs.50 Crores
Discount rate 6%
❖ Calculate NPV of the Project
❖ Find the impact on the project’s NPV of a 2.5 percent adverse variance in each variable. Which
variable is having maximum effect
Answer:
WN 1: Computation of base NPV:
Part 1: Computation of cash flows:
Particulars Amount
(in cr)
Units sold 5.00
Selling price 100.00
Sales (A) 500.00
Variable cost per unit 50.00
Total variable cost (B) 250.00
Total Fixed cost (C) 50.00
Profit/Cash flow (A – B – C) 200.00

Part 2: Computation of NPV:

(in crores)
Year Cash flow PVF @ 6% DCF
0 -400.00 1.000 -400.00
1 to 4 200.00 3.465 693.00
Expected NPV 293.00

WN 2: Sensitivity analysis and NPV Impact:

(in crores)
Particulars Capital Unit sales SP VC Fixed Discount
cost cost rate
Units sold 5.00 4.875 5.00 5.00 5.00 5.00
[5.00-
2.5%]
Selling price 100.00 100.00 97.50 100.00 100.00 100.00
[100-
2.5%]
Sales (A) 500.00 487.50 487.50 500.00 500.00 500.00
Variable cost per unit 50.00 50.00 50.00 51.25 50.00 50.00
[50+2.5%]
Total variable cost (B) 250.00 243.75 250.00 256.25 250.00 250.00
Total Fixed cost (C) 50.00 50.00 50.00 50.00 51.25 50.00
[50+2.5%]
Profit/Cash flow 200.00 193.75 187.50 193.75 198.75 200.00
[A – B – C]
PVF 3.465 3.465 3.465 3.465 3.465 3.453
PV of inflows 693.00 671.34 649.69 671.34 688.67 690.60
[Cash flow x PVF]
Initial capital cost 410.00 400.00 400.00 400.00 400.00 400.00
[400+2.5%]
NPV 283.00 271.34 249.69 271.34 288.67 290.60
Change in NPV 10.00 21.66 43.31 21.66 4.33 2.40

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[Old NPV – New
NPV]
% Change in NPV 3.41 7.39 14.78 7.39 1.48 0.82
Conclusion:
• The project is most sensitive to selling price as 2.5 percent change in SP will impact NPV by 14.78%
Note:
Sensitivity analysis of discount rate:
• The current discount rate of the project is 6%. There is going to be an adverse variation of 2.5% in
discount rate.
• New discount rate = 6 + (6 x 2.5%) = (6 + 0.15) = 6.15%
• PVAF for 4 years at 6.15% = 3.453

15. Scenario Analysis [Nov 2020 MTP]

XYZ Limited is considering a Project A with an initial outlay of Rs.14,00,000 and the possible three cash
flow attached with the project are as follows:
Particulars Year 1 Year 2 Year 3
Worst case 450 400 700
Most Likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is certain about the most
likely result but uncertain about the third year’s cash flow, what will be the NPV expecting worst scenario
in the third year.
Answer:
WN 1: Computation of NPV for worst case, most likely and best-case scenario:
Year Cash flow PVF DCF
Worst Likely Best @ 9% Worst Likely Best
0 -14,00,000 -14,00,000 -14,00,000 1.000 -14,00,000 -14,00,000 -14,00,000
1 4,50,000 5,50,000 6,50,000 0.917 4,12,659 5,04,350 5,96,050
2 4,00,000 4,50,000 5,00,000 0.842 3,36,800 3,78,900 4,21,000
3 7,00,000 8,00,000 9,00,000 0.772 5,40,400 6,17,600 6,94,800
Expected NPV -1,10,141 1,00,850 3,11,850

WN 2: Scenario Analysis:
• It is given that most likely scenario will happen. However, there is uncertainty about third year and
for that year we are going to assume worst case scenario
Year Cash flow PVF @ 9% DCF
0 -14,00,000 1.000 -14,00,000
1 5,50,000 0.917 5,04,350
2 4,50,000 0.842 3,78,900
3 7,00,000 0.772 5,40,400
Expected NPV 23,650

16. NPV Computation [May 2019]

Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y. The particulars are as under:
Particulars Project X Project Y
Initial investment 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%. Advise management about the acceptability of projects X and Y.

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Answer:
Computation of NPV of Project X and Project Y for different scenarios:
Project X:
Year Cash flow PVF DCF
Pessimistic Most Likely Optimistic @ 14% Pessimistic Most Likely Optimistic
0 -1,20,000 -1,20,000 -1,20,000 1.000 -1,20,000 -1,20,000 -1,20,000
1 to 8 26,000 28,000 36,000 4.639 1,20,614 1,29,892 1,67,004
Expected NPV 614 9,892 47,004

Project Y:
Year Cash flow PVF DCF
Pessimistic Most Likely Optimistic @ 14% Pessimistic Most Likely Optimistic
0 -1,20,000 -1,20,000 -1,20,000 1.000 -1,20,000 -1,20,000 -1,20,000
1 to 8 12,000 28,000 52,000 4.639 55,668 1,29,892 2,41,228
Expected NPV -64,332 9,892 1,21,228
Conclusion:
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 gives very high NPV. So project X is a risk less project as
it gives positive NPV in all situations whereas project 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.

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CHAPTER 9: DIVIDEND DECISIONS

MM Approach:
❖ Market value of equity shares of its firm depends solely on its earning power and is not influence
by the manner in which its earnings are split between dividends and retained earnings. Market value
of equity shares is not affected by dividend size.
((n + m)P1 ) − I1 + X1
nP0 =
1 + Ke
Where:
P0 = CMP; n = Present no. of shares; P1 = Year end MP
m = Additional shares issues at year end market price to finance capex
I1 = Investment made at year end; X1 = Earnings of year 1
Ke = Cost of equity
Note: The market capitalization is not affected whereas market price does change

Steps:
Description Formula
Step 1: Compute year-end MP P1 = P0 * (1 + Ke) – D1

Step 2: Compute money available as retained earnings Retained earnings = PAT – Equity dividend

Step 3: Compute money to be raised at year end Fresh equity = Investment in Y1 – Step 2

Step 4: Compute shares to be raised at year end Step 3 / Step 1

Step 5: Compare LHS and RHS of MM equation

Walter’s Model:
The market price of a share is the present value of infinite cash flows of
❖ Constant dividend
❖ Capital gain
r
D ( ) x (E − D)
Ke
P0 = ( ) +
Ke Ke
Where:
P0 = Current Market Price; D = Dividend per share
E = Earnings per share; r = Rate of return ; K e = Cost of equity
THE COST OF EQUITY AT TIMES IS EXPRESSED AS THE INVERSE OF PE RATIO AND THIS
WOULD MEAN THAT ALL EARNINGS ARE DISTRIBUTED AND THAT THERE IS NO GROWTH
IN DIVIDEND
1 EPS
Ke = (or)
PE Multiple MPS

Approach to dividend payout

Nature of Firm Equation Payout
Growth K<R 0%
Decline K>R 100%
Normal K=R Indifferent
Note:
❖ K equal to cost of capital and refer to rate of return which the investors want to earn
❖ R equal to the rate of return actually being earned by the company

Gordon’s Model of Dividend Policy:

❖ The MP of a share is the Present Value of a stream of constantly growing dividend. This is similar to
PV of growing perpetuity
𝐷1
P0 =
𝐾𝑒 − 𝐺
Where

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P0 = Current Market Price; D1 = Dividend of next year Ke = Cost of equity;
G = Growth rate in dividend
Growth rate = Retention ratio x Return on equity

Graham and Dodd Model:

❖ Dividends are the weighted average of past earnings
❖ Investors discount “ DISTANT DIVIDENDS” (CG) at a higher rate than “NEARBY DIVIDEND”
E
Price = M x (D + )
3
Where P = FMP ; D = DPS; E = EPS ; M = Multiplier
Note:
❖ The multiplier could be a historical multiplier and be based on the relationship between MPS, DPS
and EPS

Lintner’s approach:
Dividend amount under this model is calculated as follows:
D1 = D0 + [ (EPS * Target Payout) – D0 ] * AF
Steps:
❖ Step 1: Find tentative DPS using CY EPS and target DPO
❖ Step 2: Find tentative increase in EPS
❖ Step 3: Actual increase = Step 2 * Adjustment Factor
❖ Step 4: Current year dividend = Last year dividend + Step 3

Question No.1 (May 2017 RTP, November 2013 RTP)

X Limited has 8 lakhs equity shares outstanding at the beginning of the year. The current market price per
share is Rs.120. The Board of Directors of the company is contemplating Rs.6.4 per share as dividend. The
rate of capitalization, appropriate to the risk-class to which the company belongs is 9.6%.
• Based on MM Approach, calculate the market price of the share of the company when the dividend
is (a) declared and (b) not declared
• How many new shares are to be issued by the company, if the company desired to fund an
investment budget of Rs.3.20 crores by the end of the year assuming net income for the year will be
Rs.1.60 Crores?
Answer:
WN 1: Computation of market price as per MM Model:
P1 = P0 x (1 + Ke ) − 𝐷1

Dividend not declared:

P1 = P0 x (1 + Ke ) − D1 = 120 x (1 + 9.6%) − 0 = Rs. 131.52

Dividend is declared:
P1 = P0 x (1 + Ke ) − D1 = 100 x (1 + 9.6%) − 6.40 = Rs. 125.12

WN 2: Computation of No of shares to be issued

Particulars Dividend Paid Dividend not paid
1. Total earnings 1,60,00,000 1,60,00,000
2. Dividends paid 51,20,000 -
3. Retained earnings 1,08,80,000 1,60,00,000
4. New investments to be made 3,20,00,000 3,20,00,000
5. Fresh capital to be raised 2,11,20,000 1,60,00,000
6. Year-end share price 125.12 131.52
7. No of shares to be issued 1,68,798 1,21,655

Question No.2 (November 2014, Nov 2021 MTP)

RST Ltd. has a capital of Rs.10,00,000 in equity shares of Rs.100 each. The shares are currently quoted at
par. The company proposes to declare a dividend of Rs.10 per share at the end of the current financial

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year. The capitalization rate for the risk class of which the company belongs is 12%. What will be the
market price of the share at the end of the year, if
❖ a dividend is not declared ?
❖ a dividend is declared ?
❖ assuming that the company pays the dividend and has net profits of Rs.5,00,000 and makes
new investments of Rs.10,00,000 during the period, how many new shares must be issued? Use
the MM model?
❖ Prove that the value of the firm does not get affected by the dividend decision?
Answer:
WN 1: Computation of market price as per MM Model:
P1 = P0 x (1 + Ke ) − 𝐷1

Dividend not declared:

P1 = P0 x (1 + Ke ) − D1 = 100 x (1 + 12%) − 0 = Rs. 112

Dividend is declared:
P1 = P0 x (1 + Ke ) − D1 = 100 x (1 + 12%) − 10 = Rs. 102

WN 2: Valuation of Firm with/without dividend payout:

Particulars Dividend Paid Dividend not paid
1. Total earnings 5,00,000 5,00,000
1,00,000
2. Dividends paid [10,000 x 10] -
3. Retained earnings [2-1] 4,00,000 5,00,000
4. New investments to be made 10,00,000 10,00,000
5. Fresh capital to be raised [4-3] 6,00,000 5,00,000
6. Year-end share price 102 112
7. No of shares to be issued [5/6] 5,882 4,464
8. Closing shares [10,000 + item (7)] 15,882 14,464
9. Closing price 102 112
10. Value of firm [8 x 9] 16,19,964 16,19,968
• Value of firm is not impacted by dividend decision
• Shares to be issued if dividend is paid = 5,882 shares

Question No.3 (November 2012 RTP)

The following information is supplied to you:
Amount
(Crores)
Share capital @ Rs.10 per share 25.00
Reserves 15.00
Profit after tax (PAT) 3.70
Dividend paid 3.00
Price/Earnings Ratio 26.70
Using Walter’s model
❖ Comment on firm’s dividend policy
❖ Determine the optimal payout ratio
❖ Find out what should be the P/E ratio at which the dividend policy will have no effect on the value
of the share?
Answer:
Basic information:
Earnings per share 3,70,00,000
= = Rs. 1.48 per share
2,50,00,000
Return on equity Total earnings 3,70,00,000
= x 100 = x100 = 9.25%
Value of equity 40,00,00,000
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Dividend per share 3,00,00,000
= = Rs. 1.20 per share
2,50,00,000
Current market price = 1.48 x 26.70 = Rs.39.52
Pay-out ratio 1.20
= 𝑥 100 = 81.08%
1.48
Retention ratio =100% - 81.08% = 18.92%
Growth rate = IRR x Retention ratio = 9.25% x 18.92% = 1.75%
Cost of equity D1 (1.20 + 1.75%)
= + Growth = + 1.75% = 4.84%
P0 39.52

Part (i):
Valuation of share as per Walter’s model:
r
D K e x (E − D)
Price = +
Ke Ke
9.25
1.20 x (1.48 − 1.20)
Price = + 4.84 = 24.79 + 11.06 = 𝑅𝑠. 35.85
4.84% 4.84%
Comment on dividend policy:
The firm has a dividend payout of 81.08% (i.e., Rs. 3 crores) out of Profit after tax of Rs. 3.7 crores with
value of the share at Rs. 35.85. The rate of return on investment (r) is 9.25% and it is more than the Ke of
4.84%, therefore, by distributing 81.08% of earnings, the firm is not following an optimal dividend policy.

Part (ii):
Under Walter’s model, when return on investment is more than cost of capital (r > Ke), the market share
price will be maximum if 100% retention policy is followed. So, the optimal payout ratio would be to
pay zero dividend and in such a situation, the market price would be
9.25
0.00 x (1.48 − 0.00)
Price = + 4.84 = 0.00 + 58.44 = 𝑅𝑠. 58.44
4.84% 4.84%

Part (iii):
The P/E ratio at which dividend payout will have no effect on share price is at which the Ke would be
equal to the rate of return (r) of the firm i.e. 9.25%.
D1
Cost of equity = + Growth
P0
(1.20 + 1.75%)
0.0925 = + 0.0175
P0
(1.20 + 1.75%) 1.221
0.075 = ; Po = = Rs. 16.28
P0 0.075
Price of 16.28
PE Multiple = = 11 Times
EPS of 1.48
Therefore, at the P/E ratio of 11, the dividend payout will have no effect on share price.

Question No.4 (Nov 2020, May 2017):

The following figures are collected from the annual report of XYZ Ltd.:
Particulars Amount
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of equity 16%
• What should be the approximate dividend pay-out ratio so as to keep the share price at Rs.42 by

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using Walter model?
• DETERMINE the optimum dividend pay-out ratio and the price of the share at such pay-out
• PROVE that the dividend pay-out ratio as determined above in (b) is optimum by using random pay-
out ratio

Answer:
Basic information:
Particulars Amount
Dividend per share ?
Earnings per share 6.00
Return on Equity/Investment 20%
Cost of equity 16%

Note 1: Computation of EPS:

Particulars Amount
PAT 30,00,000
Less: Preference dividend -12,00,000
EAES 18,00,000
No of equity shares 3,00,000
EPS 6.00

Computation of Dividend per share:

0.20
D x (6 − D) D + 1.25(6 − D)
42 = + 0.16 ; 42 =
0.16 0.16 0.16
0.78
42 x 0.16 = D + 7.50 − 1.25D; 6.72 = −0.25D + 7.50; 0.25D = 0.78; D = = 3.12 per share
0.25
DPS 3.12
Dividend Payout Ratio = x 100 = x 100 = 𝟓𝟐%
EPS 6

Part (b):
• Return on equity is 20 percent whereas cost of equity is 16% and hence optimum payout ratio is 0%
• Price of share at 0% payout:

0.20
0 x (6 − 0)
Price = + 0.16 = Rs. 46.875
0.16 0.16

Part (c):
The optimality of the above pay-out ratio can be proved by using 25%, 50%, 75% and 100% as pay- out
ratio:
25% payout 50% payout 75% payout 100% payout
0.20 0.20 0.20 0.20
1.5 x (6 − 1.5) 3.00 0.16 x (6 − 3.00) 4.50 0.16 x (6 − 4.5) 6.00 0.16 x (6 − 6)
0.16
+ + + +
0.16 0.16 0.16 0.16 0.16 0.16 0.16 0.16
Rs.44.53 Rs.42.19 Rs.39.84 Rs.37.50
From the above it can be seen that price of share is maximum when dividend pay-out ratio is ‘zero’ as
determined in (b) above.

Question No.5 (November 2012)

X Limited earns Rs.6 per share having a capitalization rate of 10 percent and has a return on investment of
20%. According to Walter’s model, what should be the price of the share at 25% dividend payout?
Answer:
r
D K e x (E − D)
Price = +
Ke Ke
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0.20
1.50 x (6.00 − 1.50)
Price = + 0.10 = 15 + 90 = Rs. 105
0.10 0.10
Question No.6 (May 2012)
X Ltd has an internal rate of return of 20%. It has declared dividend @ 18% on its equity shares,
having face value of Rs.10 each. The payout ratio is 36% and Price Earning Ratio is 7.25. Find the cost
of equity according to Walter's Model and hence determine the limiting value of its shares in case the
payout ratio is varied as per the said model.
Answer:
Basic information:
Particulars Amount
Dividend per share (10 x 18%) 1.80
Earnings per share (1.80/36%) 5.00
Return on Equity/Investment 20%
Cost of equity ?
Price (EPS x PE Multiple) 36.25

Computation of cost of equity:

r
D K e x (E − D)
Price = +
Ke Ke
0.20
1.80 x (5 − 1.80) 1.80K e + 0.20(3.20)
K
36.25 = + e ; 36.25 =
Ke Ke K 2e
2 𝟐
36.25K e = 1.80K e + 0.64; 𝟑𝟔. 𝟐𝟓𝐊 𝐞 − 𝟏. 𝟖𝟎𝐊 𝐞 − 𝟎. 𝟔𝟒 = 𝟎
𝟑𝟔. 𝟐𝟓𝐊 𝟐𝐞 − 𝟓. 𝟖𝟎𝐊 𝐞 + 𝟒𝐊 𝐞 − 𝟎. 𝟔𝟒 = 𝟎
36.25𝐾𝑒 (𝐾𝑒 − 0.16) + 4(𝐾𝑒 − 0.16) = 0; (36.25𝐾𝑒 + 4)(𝐾𝑒 − 0.16) = 0
4
Ke = − = −0.1103 (or)Ke − 0.16 = 0 = 0.16 (or)16%
36.25
• Final cost of equity is 16% as Ke cannot be negative

Computation of Limiting value:

• Limiting value is the minimum value of a share. This is computed by following a payout ratio which
is opposite of optimum payout ratio
• Return on equity is 20%; Cost of equity is 16%; Optimum payout ratio = 0%. Hence, limiting value
will be calculated assuming payout ratio of 100%
r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟐𝟎
𝟓 𝐱 (𝟓 − 𝟓)
𝐋𝐢𝐦𝐢𝐭𝐢𝐧𝐠 𝐯𝐚𝐥𝐮𝐞 = + 𝟎. 𝟏𝟔 = 𝟑𝟏. 𝟐𝟓 + 𝟎 = 𝐑𝐬. 𝟑𝟏. 𝟐𝟓 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝟎. 𝟏𝟔 𝟎. 𝟏𝟔

Question No.7 – Nov 2018 RTP

The earnings per share of a company is Rs.10 and the rate of capitalisation applicable to it is 10 per
cent. The company has three options of paying dividend i.e.(i) 50%, (ii)75% and (iii)100%. Calculate the
market price of the share as per Walter’s model if it can earn a return of (a) 15, (b) 10 and (c) 5 per cent
on its retained earnings.
Answer:
r
D K e x (E − D)
Price = +
Ke Ke
Computation of price:
Particulars Payout of 50% Payout of 75% Payout of 100%

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R = 15% 0.15 0.15 0.15
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10
= 50 + 75 = Rs.125 = 75 + 37.50 = Rs.112.50 = 100 + 0 = Rs.100
R = 10% 0.10 0.10 0.10
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10
= 50 + 50 = Rs.100 = 75 + 25 = Rs.100 = 100 + 0 = Rs.100
R = 5% 0.05 0.05 0.05
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10
= 50 + 25 = Rs.75 = 75 + 12.50 = Rs.87.50 = 100 + 0 = Rs.100

Question No.8 (May 2015)

The following information is collected from the annual reports of J Limited:
Particulars Amount
Profit before tax Rs.2.50 Crores
Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent
What should be the market price per share according to Walter and Gordon’s model of dividend policy?
Answer:
Basic information:
Particulars Amount
Dividend per share (3 x 60%) 1.80
Earnings per share 3.00
Return on Equity/Investment 15%
Cost of equity 12%

Note 1: Computation of EPS:

Particulars Amount
PBT 2,50,00,000
Less: Tax -1,00,00,000
PAT 1,50,00,000
Less: Preference dividend 0
EAES 1,50,00,000
No of equity shares 50,00,000
EPS 3.00
r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟏𝟓
𝟏. 𝟖𝟎 𝟎. 𝟏𝟐 𝐱 (𝟑 − 𝟏. 𝟖𝟎)
𝐏𝐫𝐢𝐜𝐞 = + = 𝟏𝟓 + 𝟏𝟐. 𝟓𝟎 = 𝟐𝟕. 𝟓𝟎
𝟎. 𝟏𝟐 𝟎. 𝟏𝟐

Gordon’s model:
Particulars Amount
Dividend per share (3 x 60%) 1.80
Growth rate (IRR x Retention ratio) 6.00%
Cost of equity 12%
• It is assumed that DPS of Rs.1.80 is D1

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D1 1.80 1.80
Price = = = = Rs. 30
K e − G 12% − 6% 6%

Alternate answer if DPS of Rs.1.80 is D0:

D1 1.80 + 6% 1.908
Price = = = = Rs. 31.80
K e − G 12% − 6% 6%

Question No.9 – May 2019 RTP

The following figures are collected from the annual report of XYZ Limited:
Particulars Amount
Net Profit 60,00,000
Outstanding 10% preference capital 100,00,000
No of equity shares 5,00,000
Return on investment 20%
Cost of capital (Ke) 14%
Calculate price per share using Gordon’s model when dividend pay-out is
• 25%
• 50% and
• 100%
Answer:
WN 1: Computation of EPS:
Particulars Amount
Net Profit 60,00,000
Less: Preference Dividend -10,00,000
EAES 50,00,000
No of shares 5,00,000
EPS Rs.10

WN 2: Computation of market price at different payout ratio:

Payout ratio is 25%:
• Dividend per share = Rs.10 x 25% = Rs.2.50 per share
• Growth rate = 20% x 75% = 15%

D1 2.50 2.50
Price = = = = −250
K e − G 14% − 15% −1%

As per Gordon’s model of Dividend relevance model, the cost of equity should be greater than the growth
rate. In this case, growth rate is higher than cost of equity and hence price cannot be computed as per
Gordon’s model

Payout ratio is 50%:

• Dividend per share = Rs.10 x 50% = Rs.5.00 per share
• Growth rate = 20% x 50% = 10%

D1 5.00 5.00
Price = = = = Rs. 125
K e − G 14% − 10% 4%

Payout ratio is 100%:

• Dividend per share = Rs.10 x 100% = Rs.10.00 per share
• Growth rate = 20% x 0% = 0%

D1 10.00 10.00
Price = = = = Rs. 71.43
K e − G 14% − 0% 14%

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Question No.10 – Jan 2021, May 2021 MTP, Nov 2020 RTP
The following information is given for QB Ltd.
Net Profit for the year 30,00,000
12% preference share capital 1,00,00,000
Equity share capital (of Rs.10 each) 15,00,000
Retention ratio 75%
Cost of capital 18%
Internal Rate of Return on investment 22%
Calculate the market price per share using
❖ Gordon’s formula
❖ Walter’s formula
Answer:
Computation of EPS:
Particulars Amount
PAT 30,00,000
Less: Preference Dividend [1,00,00,000 x 12%] -12,00,000
EAES 18,00,000
No of equity shares (15,00,000/10) 1,50,000
Earnings per share [EAES/No of equity shares] 12
Dividend per share [12 x (100% – 75%)] 3

Basic information:
Particulars Amount
Dividend per share 3.00
Earnings per share 12.00
Return on Equity/Investment 22%
Cost of equity 18%

r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟐𝟐
𝟑 𝐱 (𝟏𝟐 − 𝟑)
𝐏𝐫𝐢𝐜𝐞 = + 𝟎. 𝟏𝟖 = 𝟏𝟔. 𝟔𝟕 + 𝟔𝟏. 𝟏𝟏 = 𝟕𝟕. 𝟕𝟖
𝟎. 𝟏𝟖 𝟎. 𝟏𝟖

Gordon’s model:
Particulars Amount
Dividend per share 3.00
Payout ratio (3/12) 25%
Retention ratio (1 – Payout ratio) 75%
Growth rate (IRR x Retention ratio) 16.50%
Cost of equity 18%
• It is assumed that DPS of Rs.3.00 is D1
D1 3.00 3.00
Price = = = = Rs. 200
K e − G 18% − 16.5% 1.50%

Alternate answer if DPS of Rs.3.00 is D0:

D1 3.00 + 16.50% 3.495
Price = = = = Rs. 233
Ke − G 12% − 6% 6%

Question No.11 (May 2012)

In December, 2011 AB Co.'s share was sold for Rs. 219 per share. A long term earnings growth rate of
11.25% is anticipated. AB Co. is expected to pay dividend of Rs. 5.04 per share.
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❖ What rate of return an investor can expect to earn assuming that dividends are expected to grow
along with earnings at 11.25% per year in perpetuity?
❖ It is expected that AB Co. will earn about 15% on book Equity and shall retain 60% of earnings.
In this case, whether, there would be any change in growth rate and cost of Equity?
Answer:
WN 1: Computation of rate of return an investor expects (Cost of equity) for original scenario:
Basic information:
Particulars Amount
Dividend per Share (D1) 5.04
Growth rate 11.25%
Cost of equity ?
Price 219
D1 5.04
Cost of equity = + Growth rate = + 0.1125 = 0.023 + 0.1125 = 0.1355 (or)13.55%
P0 219

WN 2: Rework scenario:
Note 1: Computation of DPS:
• The company will be earning 15% on book equity. Growth rate for revised scenario will be IRR x
Retention ratio = 15% x 60% = 9%
• Growth rate for the original scenario was 11.25%. This is further analyzed below:
Original scenario Analysis:
Growth rate = ROE x Retention ratio
11.25% = 15% x Retention ratio
𝟏𝟏. 𝟐𝟓%
𝐑𝐞𝐭𝐞𝐧𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐢𝐨 = = 𝟕𝟓%
𝟏𝟓%
Payout ratio in original scenario = 25%
5.04
EPS = = 20.16
25%
Revised DPS =20.16 x 40% = 8.064

D1 8.064
Cost of equity = + Growth rate = + 0.09 = 0.0368 + 0.09 = 0.1268 (or)12.68%
P0 219

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CHAPTER 10: MANAGEMENT OF WORKING CAPITAL

Operating Cycle or Working Capital Cycle:

❖ Working Capital cycle indicates the length of time between a company’s paying for materials,
entering into stock and receiving the cash from sales of finished goods.
❖ It can be determined by adding the number of days required for each stage in the cycle.
❖ Working capital cycle = RM days + WIP days + FG days + Debtors days – Creditors days

Cash

Raw
Debtors
Material

Stock WIP

❖ The various components of working capital is calculated with the help of the following formulae:
Raw Material Storage Period Average stock of Raw Material * 365
Raw material consumed

Work-in-progress Period Average stock of Work-in-process * 365

Cost of Production

FG Period Average stock of Finished Goods * 365

Cost of goods sold

Receivables Period Average Receivables * 365

Credit Sales

Payables Period Average Payables * 365

Credit Purchases

Individual estimation of working capital:

❖ Individual estimation of working capital can be analysed separately for a new entity and an existing
entity
❖ Estimation of working capital will involve the following two steps:
o Preparation of cost sheet
o Estimation of working capital
❖ Furthermore there are two approaches for estimating working capital:
o Full cost
o Cash cost – Approach under which profit and non-cash items like depreciation is ignored

Steps for existing entity:

Step 1: Preparation of Cost Sheet
Particulars Total Cash Cost
Approach Approach
Direct Material XXX XXX
Direct Wages XXX XXX
Overheads other than depreciation XXX XXX

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Depreciation XXX NA
Gross Works Cost/ Net Works cost/ Cost of Production/ Cost of XXX XXX
Goods Sold
Add: Other overheads XXX XXX
Cost of sales XXX XXX
Profit XXX NA
Sales XXX XXX

Step 2: Working capital forecast statement:

Particulars Total Approach Cash Cost Approach
Current Assets
Stock of RM [RM consumed x Days/365]
Stock of WIP [Cost of production x Days/365]
Stock of FG [Cost of production x Days/365]
Debtors [Credit sales x Days/365]
Cash
Other Current Assets
Total Current Assets (A)
Current Liabilities:
Creditors [Credit purchases x Days/365]
Outstanding expenses
Other Current Liabilities
Total Current Liabilities (B)
Working Capital (A-B)
Add: Safety Margin
Final Working capital forecast

Steps for new entity:

Step 1: Preparation of Cost Sheet
Particulars Total Approach Cash Cost Approach
Opening stock of Raw Material 0 0
Add: Purchases of Raw Material XXX XXX
Less: Closing stock of Raw Material (XXX) (XXX)
Raw Material Consumed XXX XXX
Direct Wages XXX XXX
Overheads other than depreciation XXX XXX
Depreciation XXX NA
Gross Works Cost XXX XXX
Add: Opening WIP 0 0
Less: Closing WIP (XXX) (XXX)
Net Works Cost/ Cost of Production XXX XXX
Add: Opening FG 0 0
Less: Closing FG (XXX) (XXX)
Cost of Goods Sold XXX XXX
Add: Other overheads XXX XXX
Cost of sales XXX XXX
Profit XXX NA
Sales XXX XXX

Step 2: Working capital forecast statement:

Particulars Total Approach Cash Cost Approach
Current Assets
Stock of RM
Stock of WIP
Stock of FG
Debtors
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Cash
Other Current Assets
Total Current Assets (A)
Current Liabilities:
Creditors
Outstanding expenses
Other Current Liabilities
Total Current Liabilities (B)
Working Capital (A-B)
Add: Safety Margin
Final Working capital forecast

Optimum cash balance:

Baumol Model ❖ Optimum cash level is that level of cash where the carrying costs and
(Similar to EOQ transactions costs are the minimum.
Model) ❖ Carrying costs refer to the cost of holding cash, namely, the interest
foregone on marketable securities. The transaction costs refer to the cost
involved in getting the marketable securities converted into cash
Optimum cash = Square root (2 * Annual demand * Transaction cost
Opportunity Costs

Effective cost of factoring:

Step 1: Compute the amount lent by factor:
Particulars Calculation Amount
Credit Sales XXX
Credit Period XXX
Average receivables Credit sales X credit period / 365 XXX
Less: Reserve XX % of receivables (XXX)
Less: Commission XX % of receivables (XXX)
Amount eligible to be lent XXX
Less: Interest Eligible amount x Interest rate (%) x Credit period/365 (XXX)
Amount actually lent XXX

Step 2: Calculation of effective cost of factoring:

Particulars Calculation Amount
Costs of factoring:
Commission Commission as per WN 1 x 365/Credit period XXX
Interest Interest expense as per WN 1 x 365/Credit period XXX
Total costs (A) XXX
Benefits of factoring:
Savings in administration charges XXX
Savings in bad debt XXX
Total Savings (B) XXX
Net Cost of factoring (A-B) XXX
Amount lent by factor WN 1 XXX
Effective cost of factoring Net cost / Amount actually lent XXX

Maximum Permissible Bank Finance:

Bank funding is an important source for funding working capital. Following are the three methods of
ascertaining MPBF:
Method I 75% of (Current Assets – Current Liabilities)
Method II 75% of current assets – 100% of current liabilities
Method III 75% of non-core current assets – 100% of current liabilities
Note:
❖ Core current assets is permanent component of current assets which are required throughout the
year for a company to run continuously and to stay viable

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❖ The term “Core Current Assets” was framed by Tandon Committee while explaining the amount of
stock a company can hold in its current assets. Generally, such assets are financed by long term
funds. Sometimes core current assets are also referred to as “Hardcore Working Capital”.
❖ Examples of Core Current Assets are Raw materials, Work in Progress, Finished Goods, Cash in
Hand and at Bank etc.
❖ Examples of Non-Core Assets are natural resources, bonds, options and so on.

Question No.: 1 (May 2013 exam – 8 Marks)

The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
Raw material storage period 45 days
Work-in-progress conversion period 20 days
Finished goods storage period 25 days
Debt collection period 30 days
Creditors payment period 60 days
Annual operating cost Rs.25,00,000
(including depreciation of Rs.2,50,000)
Assume 360 days in a year.
You are required to calculate:
a) Operating cycle period
b) Number of operating cycles in a year
c) Amount of working capital required for the company on cost basis
d) The company is a market leader in its product and it has no competitor in the market. Based on a
market survey it is planning to discontinue sales on credit and deliver products based on pre-
payments in order to reduce its working capital requirement substantially. You are required to
compute the reduction in working capital requirement in such a scenario.
e) Amount of increase in working capital requirement if all purchases are made on cash basis only

Answer:
(a) Computation of operating cycle:
Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Operating cycle = 45 + 20 + 25 + 30 – 60 = 60 days

(b) and (c): Computation of number of operating cycles and amount of working capital requirement:
Particulars Calculation Amount
60 days = 1 operating cycle
Number of operating cycles 360 days = ? operating cycle 6 cycles
OC in days
Annual Cash operating cost x
365
60
Amount of working capital required = 22,50,000 x ( ) Rs.3,75,000
360
Note: It is assumed that company is following cash cost approach for estimating the working capital
requirement.

(d): Reduction in working capital requirement due to discontinuation of credit:

• Revised operating cycle = 45 days + 20 days + 25 days + 0 days – 60 days = 30 days
• Amount of working capital required = 22,50,000 x (30/360) = Rs.1,87,500
• Reduction in working capital requirement = 3,75,000 – 1,87,500 = Rs.1,87,500

(e): Increase in working capital requirement due to all purchases being made in cash:
• Revised operating cycle = 45 days + 20 days + 25 days + 30 days – 0 days = 120 days
• Amount of working capital required = 22,50,000 x (120/360) = Rs.7,50,000
• Increase in working capital requirement = 7,50,000 – 3,75,000 = Rs.3,75,000

Question No.2 – November 2015 RTP

Following information is forecasted by the CS Limited for the year ending 31st March, 2010:
Particulars Balance as on April 1, 2009 Balance as on March 31, 2010

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Raw material 45,000 65,356
Work in process 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchase of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
You may take one year as equal to 365 days.

You are required to calculate:

I. Net operating cycle period.
II. Number of operating cycles in the year.
III. Amount of working capital requirement
Answer:
WN 1: Computation of operating cycle:
Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Particulars Calculation Amount
Average RM
x 365
RM consumed
45,000 + 65,356
= 2 x 365
RM Days 45,000 + 4,00,000 − 65,356 53.05 days
Average WIP
x 365
Cost of Production
35,000 + 51,300
= 2 x 365
WIP Days 7,50,000 20.99 days
Average FG
x 365
Cost of Goods Sold
60,181 + 70,175
= 2 x 365
FG Days 9,15,000 25.99 days
Average Debtors
x 365
Credit sales
1,12,123 + 1,35,000
= 2 x 365
Debtor days 11,00,000 40.99 days
Average creditors
x 365
Credit Purchases
50,079 + 70,469
= 2 x 365
Creditor days 4,00,000 55 days
Operating cycle (in days) 53.05+20.99+25.99+40.99-55 86 days

WN 2: Amount of working capital required and number of operating cycles:

Particulars Calculation Amount
OC in days
Annual operating cost x
365
86
Amount of working capital required = 9,50,000 x ( ) Rs.2,23,836
365
86 days = 1 operating cycle
Number of operating cycles 365 days = ? operating cycle 4.24 cycles

Question No.3 – Nov 2018

The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:
Particulars Amount Amount Particulars Amount Amount

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To opening stock By sales (credit) 20,00,000
Raw material 1,80,000 By closing stock
Work in process 60,000 Raw material 2,00,000
Finished goods 2,60,000 5,00,000 Work in process 1,00,000
To Purchases (Credit) 11,00,000 Finished goods 3,00,000 6,00,000
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 Rs. 1,50,000 and Rs. 2,00,000 respectively whereas opening
and closing creditors were Rs. 2,00,000 and Rs. 2,40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.
Answer:
WN 1: Cost Sheet of Beta Limited for the year ended 31 st March 2011
Particulars Amount Amount
Direct Material:
Opening stock of RM 1,80,000
Purchases 11,00,000
Less: Closing stock of RM -2,00,000 10,80,000
Direct Labour 3,00,000
Direct expenses 0
Factory Overheads 2,00,000
Gross works cost 15,80,000
Add: Opening WIP 60,000
Less: Closing WIP -1,00,000
Net works cost 15,40,000
Admin OH relating to production 0
Cost of Production 15,40,000
Add: Opening FG 2,60,000
Less: Closing FG -3,00,000
Cost of Goods sold 15,00,000
General and administrative overheads 1,75,000
Selling and distribution overheads 75,000
Cost of sales 17,50,000
Profit 2,50,000
Sales 20,00,000
• It is assumed that admin overheads is general and administrative overheads

WN 2: Computation of operating cycle:

Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Particulars Calculation Amount
Average RM
x 365
RM consumed
1,80,000 + 2,00,000
= 2 x 365
RM Days 10,80,000 64.21 days
Average WIP
WIP Days x 365 18.96 days
Cost of Production

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60,000 + 1,00,000
= 2 x 365
15,40,000
Average FG
x 365
Cost of Goods Sold
2,60,000 + 3,00,000
= 2 x 365
FG Days 15,00,000 68.13 days
Average Debtors
x 365
Credit sales
1,50,000 + 2,00,000
= 2 x 365
Debtor days 20,00,000 31.94 days
Average creditors
x 365
Credit Purchases
2,00,000 + 2,40,000
= 2 x 365
Creditor days 11,00,000 73 days
Operating cycle (in days) 64.21+18.96+68.13+31.94-73 110 days

WN 3: Amount of working capital required

Particulars Calculation Amount
OC in days
Annual operating cost x
365
110
Amount of working capital required = 17,50,000 x ( ) Rs.5,27,397
365

Question No.: 4 (May 2019 RTP, May 2019, May 2020 MTP)
A proforma cost sheet of a Company provides the following data:
Particulars Amount
Raw material cost per unit 117
Direct labour cost per unit 49
Factory overheads cost per unit 98
(includes depreciation of Rs.18 per unit at budgeted level of activity)
Total cost per unit 264
Profit 36
Selling price per unit 300

Following additional information is available:

Average raw material in stock 4 weeks
Average work in process stock 2 weeks
DOC for material 80%
DOC for labour and overheads 60%
Finished goods in stock 3 weeks
Credit period allowed to debtors 6 weeks
Credit period availed from suppliers 8 weeks
Time lag in payment of wages 1 week
Time lag in payment of overheads 2 weeks
The company sells one-fifth of the output against cash and maintains cash balance of Rs. 2,50,000.
Required:
Prepare a statement showing estimate of working capital needed to finance a budgeted activity level of 78,000
units of production. You may assume that production is carried on evenly throughout the year and wages
and overheads accrue similarly.
Answer:
• It is assumed that the company follows total approach for estimation of working capital

WN 1: Cost sheet:
Particulars Calculation Amount

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RM consumed/purchased 78,000 units x 117 91,26,000
Direct labour 78,000 units x 49 38,22,000
FOH other than depreciation 78,000 units x 80 62,40,000
Depreciation 78,000 units x 18 14,04,000
GWC/NWC/COP/COGS/COS 2,05,92,000
Profit 28,08,000
Sales 78,000 units x 300 2,34,00,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
4
Stock of raw material 91,26,000 x ( ) 7,02,000
52
Stock of WIP Note 1 5,45,400
3
Stock of FG 2,05,92,000 x ( ) 11,88,000
52
6
Debtors 2,34,00,000 x 80% x ( ) 21,60,000
52
Cash 2,50,000
Total Current Assets (A) 48,45,400
Current Liabilities:
8
Creditors 91,26,000 x ( ) 14,04,000
52
1
Outstanding wages 38,22,000 x ( ) 73,500
52
2
Overheads payable 62,40,000 x ( ) 2,40,000
52
Total Current Liabilities (B) 17,17,500
Working capital (A-B) 31,27,900

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 2,05,92,000
Direct Material 91,26,000
Other costs 1,14,66,000
Degree of Completion:
Direct Material 80%
Other costs 60%
Stock of WIP:
2
Direct Material 91,26,000 x ( ) x 80% 2,80,800
52
2
Other costs 1,14,66,000 x ( ) x 60% 2,64,600
52
Overall stock of WIP 5,45,400

Question No.:5 [May 2021 MTP, May 2012]

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 Rs.200
Duration of production cycle 1 month
Raw material inventory held 2 months consumption
Finished goods stock held for 1 month
Credit allowed to debtors 1.5 months

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Credit allowed by creditors 1 month
• 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:
o Raw materials 60%
o Direct wages 10% and
o 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.
Answer:
WN 1: Cost sheet:
Particulars Calculation Amount
Material consumed/purchased 54,000 x 200 x 60% 64,80,000
Direct wages 54,000 x 200 x 10% 10,80,000
Factory overheads 54,000 x 200 x 20% 21,60,000
GWC/NWC/COP/COGS/COS 97,20,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM 2
(Based on RM Consumed) 64,80,000 x ( ) 10,80,000
12
Stock of WIP Note 1 6,75,000
Stock of FG 1
(Based on COGS) 97,20,000 x ( ) 8,10,000
12
Debtors 1.5
(Based on Sales) 97,20,000 x ( ) 12,15,000
12
Cash 2,52,000
Total Current Assets (A) 40,32,000
Current Liabilities:
Creditors 1
(Based on RM Purchased) 64,80,000 x ( ) 5,40,000
12
Wages payable 1
(Based on total wages) 10,80,000 x ( ) 90,000
12
Total Current Liabilities (B) 6,30,000
Working capital (A-B) 34,02,000
Add: Safety margin @ 15% 5,10,300
Final working capital 39,12,300

Note 1: Computation of WIP:

Amount
Particulars Calculation (in lacs)
Cost of Production: 97,20,000
Direct Material 64,80,000
Other costs 32,40,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
1
Direct Material 64,80,000 x ( ) x 100% 5,40,000
12
1
Other costs 32,40,000 x ( ) x 50%% 1,35,000
12

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Overall stock of WIP 6,75,000

Question No.6 (May 2017 RTP, November 2017 RTP)

The following information has been extracted from the records of a Company:
Particulars Amount per unit
Raw material cost 45.00
Direct labour cost 20.00
Overhead cost 40.00
Total cost 105.00
Profit 15.00
Selling price 120.00
I. Raw materials are in stock on an average of two months.
II. The materials are in process on an average for 4 weeks. The degree of completion is 50%.
III. Finished goods stock on an average is for one month.
IV. Time lag in payment of wages and overheads is 1½ weeks.
V. Time lag in receipt of proceeds from debtors is 2 months.
VI. Credit allowed by suppliers is one month.
VII. 20% of the output is sold against cash.
VIII. The company expects to keep a Cash balance of Rs. 1,00,000.
IX. Take 52 weeks per annum.
X. 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.
Answer:
• It is assumed that the company follows cash cost approach for estimation of working capital

WN 1: Cost sheet:
Particulars Calculation Amount
RM consumed/purchased 1,44,000 units x 45 64,80,000
Direct labour 1,44,000 units x 20 28,80,000
Factory overheads 1,44,000 units x 40 57,60,000
GWC/NWC/COP/COGS/COS 1,51,20,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
2
Stock of raw material 64,80,000 x ( ) 10,80,000
12
Stock of WIP Note 1 5,81,358
1
Stock of FG 1,51,20,000 x ( ) 12,60,000
12
2
Debtors 1,51,20,000 x 80% x ( ) 20,16,000
12
Cash 1,00,000
Total Current Assets (A) 50,37,538
Current Liabilities:
1
Creditors 64,80,000 x ( ) 5,40,000
12
1.5
Outstanding wages 28,80,000 x ( ) 83,077
52
1.5
Overheads payable 57,60,000 x ( ) 1,66,154
52
Total Current Liabilities (B) 7,89,231
Working capital (A-B) 42,48,307

Note 1: Computation of WIP:

Particulars Calculation Amount
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Cost of Production: 1,51,20,000
Direct Material 64,80,000
Other costs 86,40,000
Degree of Completion:
Direct Material 50%
Other costs 50%
Stock of WIP:
4
Direct Material 64,80,000 x ( ) x 50% 2,49,231
52
4
Other costs 86,40,000 x ( ) x 50% 3,32,307
52
Overall stock of WIP 5,81,358

Question No.: 7 (November 2013 RTP)

The following annual figures relate to XYZ Co.,
Particulars Amount
Sales (at two months credit) 36,00,000
Material consumed (suppliers extend two months credit) 9,00,000
Wages paid (monthly in arrears) 7,20,000
Manufacturing expenses outstanding at end of the year 80,000
(cash expenses are paid one month in arrears)
Total administrative expenses paid as above 2,40,000
Sales promotion expenses, paid quarterly in advance 1,20,000
The company sells its products on gross profit of 25% counting depreciation as part of the cost of production.
It keeps one months’ stock each of raw materials and finished goods, and a cash balance of Rs.1,00,000.
Assuming a 20% safety margin, work out the working capital requirements of the company on cash cost basis
and total approach. Ignore work-in-process.
Answer:
WN 1: Cost sheet of XYZ Company:
Particulars Calculation Total Approach Cash cost Approach
Direct material 9,00,000 9,00,000
Direct wages 7,20,000 7,20,000
Manufacturing expenses 80,000 x 12 9,60,000 9,60,000
Depreciation 1,20,000 NA
GWC/NWC/COP/COGS 27,00,000 25,80,000
Administrative expenses 2,40,000 2,40,000
Selling expenses 1,20,000 1,20,000
Cost of sales 30,60,000 29,40,000
Profit 5,40,000 NA
Sales 36,00,000 NA

Note 1: Computation of Cost of Production:

• Gross profit = 25% of sales
• Cost of production = 75% of sales = 75% x 36,00,000 = Rs.27,00,000

WN 2: Estimation of working capital under total approach:

Particulars Calculation Amount
Current Assets:
Debtors 2
(Based on credit sales) 36,00,000 x ( ) 6,00,000
12
1
Prepaid sales promotion 1,20,000 x ( ) 30,000
4
1
Stock of Raw material 9,00,000 x ( ) 75,000
12
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(Based on RM consumed)
Stock of FG 1
(Based on COGS) 27,00,000 x ( ) 2,25,000
12
Cash Given 1,00,000
Current Assets (A) 10,30,000

Current Liabilities
Creditors 2
(Based on credit purchases) 9,00,000 x ( ) 1,50,000
12
Outstanding wages 1
(Based on total wages) 7,20,000 x ( ) 60,000
12
Outstanding manufacturing expenses Given 80,000
1
Outstanding admin expenses 2,40,000 x ( ) 20,000
12
Current liabilities (B) 3,10,000
Working capital (A – B) 7,20,000
Add: Safety margin (20%) 7,20,000 x 20% 1,44,000
Final Working Capital 8,64,000

WN 3: Estimation of working capital under cash cost approach:

Particulars Calculation Amount
Current Assets:
Debtors 2
(Based on Cash cost of sales) 29,40,000 x ( ) 4,90,000
12
1
Prepaid sales promotion 1,20,000 x ( ) 30,000
4
Stock of Raw material 1
(Based on RM consumed) 9,00,000 x ( ) 75,000
12
Stock of FG 1
(Based on COGS) 25,80,000 x ( ) 2,15,000
12
Cash Given 1,00,000
Current Assets (A) 9,10,000

Current Liabilities
Creditors 2
(Based on credit purchases) 9,00,000 x ( ) 1,50,000
12
Outstanding wages 1
(Based on total wages) 7,20,000 x ( ) 60,000
12
Outstanding manufacturing expenses Given 80,000
1
Outstanding admin expenses 2,40,000 x ( ) 20,000
12
Current liabilities (B) 3,10,000
Working capital (A – B) 6,00,000
Add: Safety margin (20%) 6,00,000 x 20% 1,20,000
Final Working Capital 7,20,000

Question No.8 – May 2017

The management of MNP Company Ltd. is planning to expand its business and consults you to prepare an
estimated working capital statement. The records of the company reveal the following annual information:
Particulars Amount
Sales – Domestic at one-month credit 24,00,000
Sales - Exports at three months 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 – 0.5 month 7,20,000

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Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of administration expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four instalments 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 Rs. 2,50,000 available to it including the overdraft limit of Rs. 75,000 not yet utilized by the
company.
• The management is also of the opinion to make 12% margin for contingencies on computed figure.
You are required to prepare the estimated working capital statement for the next year
Answer:
• It is assumed that the company follows total approach for working capital estimation:
WN 1: Cost sheet of MNP Company Limited:
Particulars Calculation Amount
Direct material 9,00,000
Direct wages 7,20,000
Manufacturing expenses 10,80,000
Other expenses Bal figure 1,80,000
GWC/NWC/COP/COGS 19,20,000 + 9,60,000 28,80,000
Admin expenses 2,40,000
Sales promotion 1,50,000
Cost of sales 32,70,000
Profit Bal figure 2,10,000
Sales 34,80,000

Note:
Note 1: Computation of COGS:
Particulars Domestic Export
Actual Sales 24,00,000 10,80,000
Adjusted sales 12,00,000
(adjusted for discount) 24,00,000 (10,80,000x 100/90)
COGS @ 80% of adjusted sales 19,20,000 9,60,000

WN 2: Estimation of working capital:

Particulars Calculation Amount
Current Assets:
1
Debtors for domestic sales 24,00,000 x ( ) 2,00,000
12
3
Debtors for export sales 10,80,000 x ( ) 2,70,000
12
1
Prepaid sales promotion 1,50,000 x ( ) 37,500
4
Stock of FG 1
(Based on COGS) 28,80,000 x ( ) 2,40,000
12
Stock of RM 1
(based on RM consumed) 9,00,000 x ( ) 75,000
12
Cash 2,50,000 – 75,000 1,75,000
Total Current Assets (A) 9,97,500
Current Liabilities:
Creditors 2
(Based on RM Purchased) 9,00,000 x ( ) 1,50,000
12
Wages payable 0.5
(Based on total wages) 7,20,000 x ( ) 30,000
12

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1
Outstanding manufacturing expenses 10,80,000 x ( ) 90,000
12
Outstanding admin expenses 1
2,40,000 x ( ) 20,000
12
1
Income tax payable 2,25,000 x ( ) 56,250
4
Total Current Liabilities (B) 3,46,250
Working capital (A-B) 6,51,250
Add: Contingencies @ 12% 78,150
Final working capital 7,29,400

Question No.9 – May 2019

Electropipes Limited manufactures products used in the steel industry. The following information regarding
the company is given for your consideration:
• Expected level of production is 6,000 units
• Raw materials are expected to remain in stores for an average of two months before issue to
production
• Work-in-progress (50 percent complete as to conversion cost) will approximate to 0.5 month’s
production
• Finished goods remain in warehouse on an average for one month
• Credit allowed by suppliers is one month
• Two month’s credit is normally allowed to debtors
• A minimum cash balance of Rs.45,000 is expected to be maintained
• Cash sales are 75 percent less than the credit sales
• Safety margin of 20 percent to cover unforeseen contingencies
• The production pattern is assumed to be even during the year
• The cost structure of Electropipes Limited’s product is as follows:
Raw material Rs.80 per unit

Direct Labour Rs.20 per unit

Overheads (including depreciation of Rs.20) Rs.80 per unit

Total Cost Rs.180 per unit

Profit Rs.20 per unit

Selling price Rs.200 per unit

You are required to estimate the working capital requirement of Electropipes Limited.
Answer:
It is assumed that the company follow cash cost approach for estimation of working capital

WN 1: Cost sheet:
Particulars Calculation Amount
RM consumed/purchased 6,000 units x 80 4,80,000
Direct labour 6,000 units x 20 1,20,000
Factory overheads 6,000 units x 60 3,60,000
GWC/NWC/COP/COGS/COS 9,60,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
2
Stock of raw material 4,80,000 x ( ) 80,000
12
Stock of WIP Note 1 30,000
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1
Stock of FG 9,60,000 x ( ) 80,000
12
2
Debtors 9,60,000 x 80% x ( ) 1,28,000
12
Cash 45,000
Total Current Assets (A) 3,63,000
Current Liabilities:
1
Creditors 4,80,000 x ( ) 40,000
12
Total Current Liabilities (B) 40,000
Working capital (A-B) 3,23,000
Add: Safety margin @ 20% 3,23,000 x 20% 64,600
Final working capital 3,87,600
Note:
• Debtors would be computed based on credit sales. Cash sales are 75 percent less than credit sales
• Let us assume credit sales to be X. Hence cash sales are expected to be 0.25X
• X + 0.25X = 12,00,000
• 1.25X = 12,00,000; X = 9,60,000. Hence, we can conclude the credit sales is 80 percent of overall sales
and cash sales is 20 percent of overall sales

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 9,60,000
Direct Material 4,80,000
Other costs 4,80,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
0.5
Direct Material 4,80,000 x ( ) x 100% 20,000
12
0.5
Other costs 4,80,000 x ( ) x 50% 10,000
12
Overall stock of WIP 30,000

Question No.10 – May 2018

Day Limited, 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 projections for the current
year:
Estimated level of activity Completed units of production 31,200 plus units of work-in-
progress 12,000
Raw material cost 40 per unit
Direct wages cost 15 per unit
Overhead 40 per unit (inclusive of depreciation of Rs.10 per unit)
Selling price 130 per unit
Raw material in stock Average 30 days consumption
Work in progress stock Material 100% and Conversion cost 50%
Finished goods stock 24,000 units
Credit allowed by the supplier 30 days
Credit allowed to purchasers 60 days
Direct wages (lag in payment) 15 days
Expected cash balance 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and overheads accrue
similarly. All sales are on the credit basis. You are required to calculate the net working capital requirements
on cash cost basis.
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Answer:
WN 1: Cost sheet:
Particulars Calculation Amount
RM Consumed:
Opening RM -
Add: Purchases Bal figure 18,72,000
30
Less: Closing RM 17,28,000 x 1,44,000
360
RM consumed (31,200 x 40) + (12,000 x 40) 17,28,000
Direct wages (31,200 x 15) + (12,000 x 7.50) 5,58,000
Overheads (excluding depreciation) (31,200 x 30) + (12,000 x 15.00) 11,16,000
GWC 34,02,000
Add: Opening WIP -
Less: Closing WIP (12,000 x 40) + (12,000 x 22.50) -7,50,000
NWC/COP (31,200 units) 26,52,000
Add: Opening FG -
24,000
26,52,000 x
Less: Closing FG 31,200 -20,40,000
COGS/COS 6,12,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM WN 1 1,44,000
Stock of WIP WN 1 7,50,000
Stock of FG WN 1 20,40,000
Debtors 60
(Based on Cost of Sales) 6,12,000 x ( ) 1,02,000
360
Cash 2,00,000
Total Current Assets (A) 32,36,000
Current Liabilities:
Creditors 30
(Based on RM Purchased) 18,72,000 x ( ) 1,56,000
360
Wages payable 15
(Based on total wages) 5,58,000 x ( ) 23,250
360
Total Current Liabilities (B) 1,79,250
Working capital (A-B) 30,56,750

Note 1: Computation of WIP:

Amount
Particulars Calculation (in lacs)
Cost of Production: 480.00
Direct Material 300.00
Other costs 180.00
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
1
Direct Material 300 x ( ) x 100% 25.00
12
1
Other costs 180 x ( ) x 50% 7.50
12
Overall stock of WIP 32.50

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Question No.11 [Nov 2020 MTP, May 2018 MTP, Nov 2018 MTP]
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: 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 Rs.80 per unit
Direct wages Rs.30 per unit
Overheads (exclusive of depreciation) Rs.60 per unit
Total cost Rs.170 per unit
Selling price Rs.200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion
stage in respect of conversion cost) (materials issued at the start of the processing).
Finished goods in stock 8,000 units

Credit allowed by suppliers Average 4 weeks

Credit allowed to debtors/receivables Average 8 weeks

Lag in payment of wages Average 1.5 weeks

Cash at banks (for smooth operation) is expected to be Rs. 25,000.

Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads
accrue similarly. All sales are on credit basis only.
You are required to calculate:
(i) The net working capital required;
(ii) Maximum Permissible Bank Finance under three methods if core-current assets is 20% of total current
assets
Answer:
WN 1: Cost sheet of Aneja Limited:
Particulars Calculation Amount
RM Consumed:
Opening RM -
Add: Purchases b/f 93,04,615
Less: Closing RM 86,40,000 x (4/52) -6,64,615
RM consumed (1,04,000 x 80) + (4,000 x 80 x 100%) 86,40,000
Direct wages (1,04,000 x 30) + (4,000 x 30 x 50%) 31,80,000
Overheads (1,04,000 x 60) + (4,000 x 60 x 50%) 63,60,000
GWC 1,81,80,000
Add: Opening WIP -
Less: Closing WIP (4,000 x 80 x 100%) + (4,000 x 90 x 50%) -5,00,000
NWC/COP (1,04,000 units) 1,76,80,000
Add: Opening FG -
Less: Closing FG 8,000 units x 170 -13,60,000
COGS/COS 1,63,20,000
Profit 28,80,000
Sales 1,92,00,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM 6,64,615
Stock of WIP 5,00,000

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Stock of FG 13,60,000
Debtors (1,92,00,000 x 8/52) 29,53,846
Cash 25,000
Total Current Assets (A) 55,03,461
Current Liabilities:
Creditors 93,04,615 x (4/52) 7,15,740
Wages payable 31,80,000 x (1.5/52) 91,731
Total current liabilities (B) 8,07,471
Working capital (A-B) 46,95,990

WN 3: Computation of maximum permissible bank finance under three methods:

Particulars Calculation Amount
= 75% of CA – 75% of CL
Method 1 = (75% x 55,03,461) – (75% x 8,07,471) 35,21,993
= 75% of CA – 100% of CL
Method 2 = (75% x 55,03,461) – (100% x 8,07,471) 33,20,125
= 75% of Non-core CA – 100% of CL
Method 3 = (75% x (80% x 55,03,461) – (100% x 8,07,471) 24,94,606
• Maximum Permissible Bank Finance (Lower of three methods) = Rs.24,94,606

Question No.12: May 2022 RTP:

A newly formed company has applied for a loan to a commercial bank for financing its working capital
requirements. You are requested by the bank to prepare an estimate of the requirements of the working
capital for the company. Add 10% to your estimated figure to cover unforeseen contingencies. The
information about the projected profit and loss account of this company is as under:
Particulars Amount Amount
Sales 21,00,000
Less: Cost of goods sold 15,30,000
Gross Profit 5,70,000
Less: Administrative expenses 1,40,000
Less: Selling expenses 1,30,000 2,70,000
Profit before tax 3,00,000
Provision for tax 1,00,000
Cost of goods sold has been derived as follows:
Particulars Amount
Material used 8,40,000
Wages and manufacturing expenses 6,25,000
Depreciation 2,35,000
17,00,000
Less: Stock of finished goods (10%) 1,70,000
15,30,000
The figures given above relate only to the goods that have been finished and not to work in progress; goods
equal to 15% of the year’s production (in terms of physical units) are in progress on an average, requiring
full materials but only 40% of other expenses. The company believes in keeping two months consumption
of material in stock; Desired cash balance Rs. 40000
Average time lag in payment of all expenses in 1 month; suppliers of materials extend 1.5 months credit;
sales are 20% cash; rest are at two months credit; 70% of the income tax has to be paid in advance in quarterly
installments.
You can make such other assumptions as you deem necessary for estimating working capital requirements
on cash cost basis
Answer:
WN 1: Cost sheet of the company under cash cost approach:
Particulars Calculation Amount
Opening Raw material 0
Add: Purchases (b/f) 11,27,000
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Less: Closing Raw material 9,66,000 x ( ) -1,61,000
12
Raw material consumed 9,66,000
Wages and manufacturing expenses 6,62,500
Depreciation (Nil due to cash cost) 0
Gross works cost 16,28,500
Add: Opening WIP 0
Less: Closing WIP -1,63,500
Net works cost/Cost of production 14,65,000
Add: Opening FG 0
Less: Closing FG 10% x 14,65,000 -1,46,500
Cost of Goods sold 13,18,500
Administrative expenses 1,40,000
Selling expenses 1,30,000
Cost of sales 15,88,500

Note:
Computation of RM consumed:
• The company has incurred Rs.8,40,000 as Raw material cost. This cost is incurred only for units
produced
• Let us assume that the company has produced 100 units. 15% of year’s production (in terms of
physical units) is closing WIP. Hence closing WIP is 15 units
• DOC of material for closing WIP = 100%
• Equivalent units produced (for computing RM cost) = 100 units of FG + 15 units of WIP = 115 units
• RM consumed = (8,40,000/100) x 115 = Rs.9,66,000

Computation of wages and manufacturing expenses:

• The company has incurred Rs.6,25,000 as wages and manufacturing expenses. This cost is incurred
only for units produced
• DOC of wages for closing WIP = 40%
• Equivalent units produced (for computing wages cost) = 100 units of FG + 6 units of WIP (15 x 40%)
= 106 units
• Wages and manufacturing expenses = (6,25,000/100) x 106 = Rs.6,62,500

Closing WIP:
Particulars Equivalent units Value
Materials 15 1,26,000
(8,400 x 15)
Wages and manufacturing expenses 6 37,500
(6,250 x 6)
Total 1,63,500

WN 2: Working capital estimation under cash cost approach:

Particulars Calculation Amount
Current Assets:
Stock of RM WN 1 1,61,000
Stock of WIP WN 1 1,63,500
Stock of FG WN 1 1,46,500
Cash 40,000
Debtors 2
(Based on cash cost of sales) 15,88,500 x 80% x ( ) 2,11,800
12
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Total Current Assets (A) 7,22,800
Current Liabilities:
1.5
Creditors 11,27,000 x ( ) 1,40,875
12
1
Outstanding expenses 9,32,500 x ( ) 77,708
12
Income tax payable 1,00,000 x 30% 30,000
Current liabilities (B) 2,48,583
Working capital (A – B) 4,74,217
Add: Safety margin (10%) 47,422
Final Working Capital 5,21,639

Question No.13 – Nov 2019 RTP:

Marks ltd. is launching a new project for the manufacture of a unique component. At full capacity of 24,000
units, the cost per unit will be as follows;
Direct material 80
Labour and variable expenses 40
Fixed manufacturing and administrative expenses 20
Depreciation 10
Total cost 150
The selling price per unit is expected at Rs. 200 and the selling expenses per unit will be Rs 10 – 80% being
variable.
In the first two years, production and sales are expected to be as follows:
Year Production units Sales units
1 15,000 14,000
2 20,000 18,000
To assess working capital requirement, the following additional information is given:
a. Stock of Raw material – 3 month’s average consumption.
b. Work in process – nil
c. Debtors – 1 month average cost of sales
d. Creditors for supply of materials – 2 months average purchases of the year
e. Creditors for expenses – 1 month average of all expenses during the year
f. Minimum cash balance desired – Rs. 20000
g. Stock of finished goods is taken at average cost
You are required to prepare a projected statement of profitability and working capital requirement for two
years based on total approach.
Answer:
WN 1: Statement of Profitability of Marks Limited for two years:
Particulars Year 1 Year 2
RM Consumed
Opening Raw material - 3,00,000
Add: Purchases (b/f) 15,00,000 17,00,000
Less: Closing Raw material (RM consumed x 3/12) -3,00,000 -4,00,000
RM Consumed (units produced x 80) 12,00,000 16,00,000
Labour and variable expenses (units produced x 40) 6,00,000 8,00,000
Fixed Manufacturing and admin expenses (24,000 units x 20) 4,80,000 4,80,000
Depreciation (24,000 units x 10) 2,40,000 2,40,000
GWC/NWC/COP 25,20,000 31,20,000
Add: Opening FG - 1,68,000
Less: Closing FG -1,68,000 -4,69,714
Cost of Goods sold 23,52,000 28,18,286
Selling expenses 1,60,000 1,92,000
Cost of sales 25,12,000 30,10,286
Profit 2,88,000 5,89,714
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Sales 28,00,000 36,00,000
Note:
Note 1: Closing FG of year 1:
25,20,000
Closing FG = x 1,000 = Rs. 1,68,000
15,000

Note 2: Selling expenses:

• Selling expenses = (8 x units sold) + (2 x full capacity)
• Selling expenses of year 1 = (8 x 14,000) + (2 x 24,000) = Rs.1,60,000
• Selling expenses of year 2 = (8 x 18,000) + (2 x 24,000) = Rs.1,92,000

Note 3: Closing FG of year 2:

(31,20,000 + 1,68,000)
Closing FG = x 3,000 = Rs. 4,69,714
(20,000 + 1,000)

WN 2: Working capital estimation for two years:

Particulars Year 1 Year 2
Current Assets:
Stock of RM 3,00,000 4,00,000
Stock of FG 1,68,000 4,69,714
Debtors (based on cost of sales) 2,09,333 2,50,857
Cash 20,000 20,000
Total Current Assets (A) 6,97,333 11,40,571
Current liabilities
Creditors (based on purchases) 2,50,000 2,83,333
Creditors for expenses (based on all expenses) 1,03,333 1,22,667
Total current liabilities (B) 3,53,333 4,06,000
Working capital (A-B) 3,44,000 7,34,571

Question No.14 – May 2017

A firm maintains a separate account for cash disbursement. Total disbursements are Rs. 2,62,500 per month.
Administrative and transaction cost of transferring cash to disbursement account is Rs. 25 per transfer.
Marketable securities yield is 7.5% per annum. Determine the optimum cash balance according to William J
Baumol model.
Answer:
2 x annual demand for money x transfer cost
Optimum cash balance = √
Interest cost

2 x ( 12 x 2,62,500) x 25
Optimum cash balance = √ = 𝐑𝐬. 𝟒𝟓, 𝟖𝟐𝟔
0.075

Question No.15 – Nov 2021 RTP, Nov 2019 MTP

Prepare monthly cash budget for six months beginning from April 2017 on the basis of the following
information:
Estimated monthly sales:
Particulars Amount Particulars Amount
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

Wages and salaries:

Particulars Amount Particulars Amount
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April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

Other information:
• Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses
• Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the
sales
• The firm has 10% debentures of Rs.1,20,000. Interest on these has to be paid quarterly in January,
April and so on
• The firm has to make and advance payment of tax of Rs.5,000 in July, 2017
• The firm had a cash balance of Rs.20,000 on April 1, 2017, which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary
investments/liquidation of temporary investments or temporary borrowings at the end of each
month (interest on these to be ignored)
Answer:
Cash budget for six months from April 2007:
Particulars Apr May Jun Jul Aug Sep
Opening cash balance (A) 20,000 20,000 20,000 20,000 20,000 20,000
Add: Receipts
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections
Feb month sales 24,000
Mar month sales 84,000 28,000
Apr month sales 48,000 16,000
May month sales 36,000 12,000
June month sales 48,000 16,000
July month sales 60,000 20,000
August month sales 48,000
Total receipts (B) 1,24,000 88,000 68,000 80,000 92,000 80,000

Payments
Payment to suppliers
(80% of preceding month sales) 48,000 64,000 80,000 64,000 48,000 80,000
Wages and salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 3,000
Advance tax 5,000
Total Payments (C) 60,000 72,000 90,000 82,000 57,000 89,000
Closing cash (A+B-C) 84,000 36,000 -2,000 18,000 55,000 11,000
New deposit/liquidation of deposit -64,000 -16,000 22,000 2,000 -35,000 9,000
Revised cash 20,000 20,000 20,000 20,000 20,000 20,000

Question No.16– Nov 2019

Slide Limited is preparing a cash flow forecast for the three months period for January to the end of March.
The following sales volumes have been forecasted:
Month December January February March April
Sales (units) 1,800 1,875 1,950 2,100 2,250
Selling price per unit is Rs.600. Sales are all on one-month credit. Production of goods for sale takes place one
month before sales. Each unit produced requires two units of raw material costing Rs.150 per unit. No raw
material inventory is held. Raw materials purchases are on one-month credit. Variable overheads and wages
equal to Rs.100 per unit are incurred during production and are paid in the month of production. The opening
cash balance on 1st January is expected to be Rs.35,000. A long-term loan of Rs.2,00,000 is expected to be
received in the month of March. A machine costing Rs.3,00,000 will be purchased in march.

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• Prepare a cash budget for the months of January, February and March and calculate the cash balance
at the end of each months in the three months period
• Calculate the forecast current ratio at the end of three months period
Answer:
WN 1: Cash budget for the months of January, February and March:
Particulars Jan Feb Mar
Opening cash balance (A) 35,000 3,57,500 6,87,500
Add: Receipts
Collections (previous month sales) 10,80,000 11,25,000 11,70,000
Long term loan 2,00,000
Total receipts (B) 10,80,000 11,25,000 13,70,000

Payments
Payment to suppliers (units sold x 2 x 500)
(Purchase = One month before sales)
(Payment = after one month and hence payment month equal to
sales month) 5,62,500 5,85,000 6,30,000
Variable Overheads
(Next month sales x 100) 1,95,000 2,10,000 2,25,000
Payment for machinery 3,00,000
Total Payments (C) 7,57,500 7,95,000 11,55,000
Closing cash (A+B-C) 3,57,500 6,87,500 9,02,500

WN 2: Forecast current ratio at end of three months period:

Particulars Calculation Amount
Current Assets:
Debtors (March month sales) 2,100 units x 600 12,60,000
Inventory (March month production 2,250 x (300 +100) 9,00,000
For April sales)
Cash balance WN 1 9,02,500
Total Current Assets (A) 30,62,500
Current Liabilities:
Creditors (March month purchases) 2,250 x 300 6,75,000
Total current liabilities (B) 6,75,000
Current Ratio (A/B) 30,62,500/6,75,000 4.54:1

Question No.17 [May 2021 MTP, Nov 2019 MTP]

Prepare monthly cash budget for six months beginning from April 2017 on the basis of the following
information:
Estimated monthly sales:
Particulars Amount Particulars Amount
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

Wages and salaries:

Particulars Amount Particulars Amount
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

Other information:

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• Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one month
and the balance in two months. There are no bad debt losses
• Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the
sales
• The firm has 10% debentures of Rs.1,20,000. Interest on these has to be paid quarterly in January,
April and so on
• The firm has to make and advance payment of tax of Rs.5,000 in July, 2017
• The firm had a cash balance of Rs.20,000 on April 1, 2017, which is the minimum desired level of cash
balance. Any cash surplus/deficit above/below this level is made up by temporary
investments/liquidation of temporary investments or temporary borrowings at the end of each
month (interest on these to be ignored)
Answer:
Cash budget for six months from April 2007:
Particulars Apr May Jun Jul Aug Sep
Opening cash balance (A) 20,000 20,000 20,000 20,000 20,000 20,000
Add: Receipts
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections
Feb month sales 24,000
Mar month sales 84,000 28,000
Apr month sales 48,000 16,000
May month sales 36,000 12,000
June month sales 48,000 16,000
July month sales 60,000 20,000
August month sales 48,000
Total receipts (B) 1,24,000 88,000 68,000 80,000 92,000 80,000

Payments
Payment to suppliers
(80% of preceding month sales) 48,000 64,000 80,000 64,000 48,000 80,000
Wages and salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 3,000
Advance tax 5,000
Total Payments (C) 60,000 72,000 90,000 82,000 57,000 89,000
Closing cash (A+B-C) 84,000 36,000 -2,000 18,000 55,000 11,000
New deposit/liquidation of deposit -64,000 -16,000 22,000 2,000 -35,000 9,000
Revised cash 20,000 20,000 20,000 20,000 20,000 20,000

Question No.18 – May 2016

Radiance Garments Ltd. manufacturers readymade garments and sells them on credit basis through a
network of dealers. Its present sale is Rs. 60 lakh 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 Rs. 8 lakh per annum. The company expects pre-tax return on investment @
25%. Some other details are given as under:

Proposed credit Policy Average collection period Annual sales

(Days) (Rs.Lacs)
I 30 65
II 40 70
III 50 74
IV 60 75
Required: Which credit policy should the company adopt? Present your answer in a tabular form. Assume
360 days in a year. Calculations should be made up-to two digits after decimal.

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Answer:
Evaluation of credit policy:
(in lacs)
Particulars Present Policy 1 Policy 2 Policy 3 Policy 4
Sales 60.00 65.00 70.00 74.00 75.00
Less: Variable cost (70% of sales) -42.00 -45.50 -49.00 -51.80 -52.50
Less: Fixed cost -8.00 -8.00 -8.00 -8.00 -8.00
Gross Benefit 10.00 11.50 13.00 14.20 14.50
Less: Interest cost (Note 1) -0.70 -1.12 -1.58 -2.08 -2.52
Net Benefit 9.30 10.38 11.42 12.12 11.98
• The company should go ahead with Policy option 3 (Collection period of 50 days) as the same has
highest net benefit.

Note 1: Computation of interest cost:

Particulars Present Policy 1 Policy 2 Policy 3 Policy 4
Full cost of sales (VC + FC) 50.00 53.50 57.00 59.80 60.50
Debtors (Full cost x CP/360) 2.78 4.46 6.33 8.31 10.08
Interest cost (Debtors x Return%) 0.70 1.12 1.58 2.08 2.52
• It is assumed debtors are valued on full cost of sales

Question No.: 19 (May 2012 exam – 8 Marks)

A company is presently having credit sales of Rs.12 lakhs. 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 the sales, the company is contemplating liberalization of its existing terms
to 2/10 net 45 days. It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase
to 2 % of sales and average collection period to decline to 20 days. The contribution to sales ratio of the
company is 22 percent and opportunity cost of investment in receivables is 15% (pre-tax). 50 percent and 80
percent of customers in terms of sales revenue are expected to avail cash discount under existing and
liberalization scheme respectively. The tax rate is 30 percent. Should the company change its credit terms?
(Assume 360 days in a year)
Answer:
• Existing credit terms are “1/10 net 45”. This would mean that company will give 1 percent cash
discount if payment is done in 10 days. And the normal credit period is 45 days if person does not
opt for cash discount
Particulars Existing Revised
Sales 12,00,000 16,00,000
Less: Variable cost -9,36,000 -12,48,000
Less: Fixed cost - -
Gross Benefit 2,64,000 3,52,000
Less: Interest cost (Note 1) -11,700 -10,400
-6,000 -25,600
Less: Cash discount [12,00,000 x 50% x 1%] [16,00,000 x 80% x 2%]
Less: Bad debt -18,000 -32,000
Net Benefit 2,28,300 2,84,000
• Company should go ahead with liberalization scheme as the same leads to higher net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 9,36,000 12,48,000
Debtors (Full Cost x CP/360) 78,000 69,333
Interest cost (Debtors x Return %) 11,700 10,400

Question No.: 20 (November 2013 exam – 8 Marks)

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XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two
proposed policies. Currently, the firm has annual credit sales of Rs. 50 lakhs and accounts receivable turnover
ratio of 4 times a year. The current level of loss due to bad debts is Rs. 1,50,000. The firm is required to give a
return of 25% on the investment in new accounts receivables. The company’s variable costs are 70% of the
selling price.
Given the following information, which is the better option?
Particulars Present Policy Policy Option I Policy Option II
Annual credit sales 50,00,000 60,00,000 67,50,000
Debtors turnover ratio 4 Times 3 Times 2.4 Times
Loss due to bad debts 1,50,000 3,00,000 4,50,000
Answer:
Evaluation of credit policy:
Particulars Present Option 1 Option 2
Sales 50,00,000 60,00,000 67,50,000
Less: Variable cost (70% of sales) -35,00,000 -42,00,000 -47,25,000
Less: Fixed cost - - -
Gross Benefit 15,00,000 18,00,000 20,25,000
Less: Interest cost (Note 1) -2,18,750 -3,50,000 -4,92,188
Less: Bad debt -1,50,000 -3,00,000 -4,50,000
Net Benefit 11,31,250 11,50,000 10,82,812
• The company should go ahead with option 1 as the same leads to higher net benefit.

Note 1: Computation of interest cost:

Particulars Present Option 1 Option 2
Full cost of Sales (VC + FC) 35,00,000 42,00,000 47,25,000
Debtors (Full Cost/DTR) 8,75,000 14,00,000 19,68,750
Interest cost (Debtors x Return %) 2,18,750 3,50,000 4,92,188
• Note: It is assumed that debtors are valued based on full cost of sales

Question No.:21 – November 2014 exam

A Company has sales of Rs. 25,00,000. Average collection period is 50 days, bad debt losses are 5% of sales
and collection expenses are Rs. 25,000. The cost of funds is 15%. The Company has two alternative Collection
Programmes:
Particulars Programme I Programme II
Average collection period reduced to 40 days 30 days
Bad debt loss reduced to 4% of sales 3% of sales
Collection expenses 50,000 80,000
Evaluate which Programme is viable.
Answer:
Evaluation of collection programme:
Particulars Existing Option 1 Option 2
Collection expenses 25,000 50,000 80,000
Bad debt 1,25,000 1,00,000 75,000
Interest cost (Note 1) 52,083 41,667 31,250
Total cost 2,02,083 1,91,667 1,86,250
• Company should go ahead with collection programme 2 as the same leads to lowest cost

Note 1: Computation of interest cost:

Particulars Existing Option 1 Option 2
Sales 25,00,000 25,00,000 25,00,000
Debtors (Sales x CP/360) 3,47,222 2,77,778 2,08,333
Interest cost (Debtors x Return %) 52,083 41,667 31,250
• It is assumed year consist of 360 days

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Question No.: 22 – May 2015 exam
As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods
to a group of new customers with 10% risk of non-payment. This group would require one and a half months
credit and is likely to increase sales by Rs.1,00,000 p.a. Production and Selling expenses amount to 80% of
sales and the income-tax rate is 50%. The company’s minimum required rate of return (after tax) is 25%.
Should the sales manager’s proposal be accepted? Also find the degree of risk of non-payment that the
company should be willing to assume if the required rate of return (after tax) were (i) 30%, (ii) 40% and (iii)
60%.
Answer:
WN 1: Computation of actual post-tax return:
Particulars Amount
Sales 1,00,000
Less: Production and selling expenses -80,000
Gross Benefit 20,000
Less: Bad debt -10,000
Profit before tax 10,000
Less: Tax @ 50% -5,000
Profit after tax 5,000
Debtors (Full cost x 1.5/12) 10,000
Return on investment (PAT/Debtors x 100) 50%
• The company should go ahead with sales as actual return (50%) is higher than required return

WN 2: Computation of degree of risk of non-payment for required return:

Particulars Return = 30% Return = 40% Return = 60%
Sales 1,00,000 1,00,000 1,00,000
Less: Production and selling expenses -80,000 -80,000 -80,000
Gross Benefit 20,000 20,000 20,000
Less: Bad debt (bal figure) -14,000 -12,000 -8,000
Profit before tax (PAT/(1-Tax)) 6,000 8,000 12,000
Less: Tax @ 50% -3,000 -4,000 -6,000
Profit after tax (Debtors x ROI) 3,000 4,000 6,000
Debtors (Full cost x 1.5/12) 10,000 10,000 10,000
Return on investment (Given) 30% 40% 60%
Degree of risk of non-payment
(Bad debt/sales x 100) 14% 12% 8%
• The above table has been filled through reverse working

Question No.:23 (May 2014 RTP)

The present credit terms of P Company are 1/10 net 30. Its annual sales are Rs. 80 lakhs, its average collection
period is 20 days. Its variable cost 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 Rs.
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.
Answer:
Evaluation of credit policy:
Particulars Existing Revised
Sales 80,00,000 85,00,000
Less: Variable cost -68,00,000 -72,25,000
Less: Fixed cost -8,00,000 -8,00,000
Gross Benefit 4,00,000 4,75,000
Less: Interest cost (Note 1) -42,222 -31,208
-40,000 -1,36,000
Less: Cash discount [80,00,000 x 50% x 1%] [85,00,000 x 80% x 2%]

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Net Benefit 3,17,778 3,07,792
• Company should not go ahead with revised scheme as the same leads to lower net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 76,00,000 80,25,000
Debtors (Full Cost x CP/360) 4,22,222 3,12,083
Interest cost (Debtors x Return %) 42,222 31,208

Question No.24 – Nov 2018 RTP

Tony Limited manufactures colour TV sets, is considering the liberalization of existing credit terms to three
of their large customers A, B and C. The credit period and likely quantity of TV sets that will be sold to the
customers in addition to the other sales are as follows:
Quantity sold (No of TV Sets):
Credit Period (Days) A B C
0 1,000 1,000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The selling price per TV set is Rs.9,000. The expected contribution is 20% of the selling price. The cost of
carrying receivables averages 20 percent per annum.
You are required:
• Determine the credit period allowed to each customer (assume 360 days in a year for calculation
purpose)
• What other problems the company might face in allowing the credit period as determined above
Answer:
WN 1: Determination of credit period to be provided to different customers:
Customer A:
• In case of customer A, there is no increase in sales even if we increase the credit period. Hence the
company should not provide any credit period to customer A and sell 1,000 units to customer A

Customer B:
Particulars 0 days 30 days 60 days 90 days
Sales 90,00,000 1,35,00,000 1,80,00,000 2,25,00,000
Less: Variable cost -72,00,000 -1,08,00,000 -1,44,00,000 -1,80,00,000
Less: Fixed cost - - - -
Gross Benefit 18,00,000 27,00,000 36,00,000 45,00,000
Less: Interest cost (Note 1) - -1,80,000 -4,80,000 -9,00,000
Net Benefit 18,00,000 25,20,000 31,20,000 36,00,000
• Company should provide 90 days credit to customer B. They would be able to sell 2,500 units and
will have the highest net benefit

Note 1: Computation of interest cost:

Particulars 0 days 30 days 60 days 90 days
Full cost of sales (VC + FC) 72,00,000 1,08,00,000 1,44,00,000 1,80,00,000
Debtors (Full cost x CP/360) - 9,00,000 24,00,000 45,00,000
Interest cost (Debtors x Return%) - 1,80,000 4,80,000 9,00,000

Customer C:
Particulars 60 days 90 days
Sales 90,00,000 1,35,00,000
Less: Variable cost -72,00,000 -1,08,00,000
Less: Fixed cost - -
Gross Benefit 18,00,000 27,00,000
Less: Interest cost (Note 1) -2,40,000 -5,40,000
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Net Benefit 15,60,000 21,60,000
• Company should provide 90 days credit to customer C. They would be able to sell 1,500 units and
will have the highest net benefit

Note 1: Computation of interest cost:

Particulars 60 days 90 days
Full cost of sales (VC + FC) 72,00,000 1,08,00,000
Debtors (Full cost x CP/360) 12,00,000 27,00,000
Interest cost (Debtors x Return%) 2,40,000 5,40,000

WN 2: Problems to be faced by the company:

• Customer A is taking 1,000 TV Sets whether credit is there or not. Customer C is taking 1,000 TV sets
at credit for 60 days. Hence A may also demand credit for 60 days compulsorily
• B will take 2,500 TV Sets for credit period for 90 days whereas C would lift 1,500 sets only. In such
case B will demand further relaxation in credit period i.e. B may ask for 120 days credit

Question No.25 – May 2019:

Misha Limited presently gives terms of net 30 days. It has Rs. 6 crores in sales, and its average collection
period is 45 days. To stimulate demand, the company may give terms of net 60 days. If it does instigate these
terms, sales are expected to increase by 15 per cent. After the change, the average collection period is expected
to be 75 days, with no difference in payment habits between old and new customers. Variable costs are Rs.
0.80 for every Rs. 1.00 of sales, and the company’s required rate of return on investment in receivables is 20
per cent. Should the company extend its credit period? (Assume a 360 days year).
Answer:
Evaluation of credit policy:
Particulars Existing Revised
Sales 6,00,00,000 6,90,00,000
Less: Variable cost -4,80,00,000 -5,52,00,000
Less: Fixed cost - -
Gross Benefit 1,20,00,000 1,38,00,000
Less: Interest cost (Note 1) -12,00,000 -23,00,000
Net Benefit 1,08,00,000 1,15,00,000
• The company should go ahead with revised credit policy as the same leads to increase in net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 4,80,00,000 5,52,00,000
Debtors (Full Cost x CP/360) 60,00,000 1,15,00,000
Interest cost (Debtors x Return %) 12,00,000 23,00,000

Question No.26 – May 2019 MTP:

A bank is analysing the receivables of Jackson Company in order to identify acceptable collateral for a short-
term loan. The company’s credit policy is 2/10 net 30. The bank lends 80 percent on accounts where
customers are not currently overdue and where the average payment period does not exceed 10 days past
the net period. A schedule of Jackson’s receivables has been prepared. How much will the bank lend on
pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
Account Amount Outstanding in days Historical average payment 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
1,08,800
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Answer:
Computation of eligible accounts for funding:
• The company provides a normal credit period of 30 days. Any accounts which are overdue (above
30 days) are not eligible for funding. This would mean Account No.91 and 114 is not eligible for
computing amount to be lent
• Average payment period should not exceed 10 days past the net period. This would mean average
payment period should not exceed 40 days. Account No.123 is not meeting this condition and hence
is not eligible for funding
• Accounts eligible for funding = 74, 107, 108 and 116

Computation of amount to be lent:

Account Amount 80% of amount Amount lent
74 25,000 20,000 18,000
107 11,500 9,200 8,280
108 2,300 1,840 1,656
116 29,000 23,200 20,880
Amount lent 48,816
• Final amount lent is 90% of column 3. This is because 10% is deducted for cash discount and returns

Question No.27 – Nov 2019 RTP

Slow Payers are regular customers of Goods Dealers Ltd., Calcutta and have approached the sellers for
extension of a credit facility for enabling them to purchase goods from Goods Dealers Ltd. On an analysis of
past performance and on the basis of information supplied, the following pattern of payment schedule
emerges in regard to Slow Payers:
Particulars Pattern of Payment Schedule
At the end of 30 days 15% of the bill
At the end of 60 days 34% of the bill
At the end of 90 days 30% of the bill
At the end of 100 days 20% of the bill
Non-recovery 1% of the bill
Slow Payers want to enter into a firm commitment for purchase of goods of Rs. 15 lakhs in 2013, deliveries
to be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is Rs. 150 on which a profit of Rs. 5 per unit is expected to be made. It is anticipated by Goods
Dealers Ltd., that taking up of this contract would mean an extra recurring expenditure of Rs. 5,000 per
annum. If the opportunity cost of funds in the hands of Goods Dealers is 24% per annum, would you as the
finance manager of the seller recommend the grant of credit to Slow Payers? Workings should form part of
your answer.
Assume year of 360 days.
Answer:
Decision on providing credit to Slow Payers Limited:
Particulars Amount
Sales 15,00,000
Less: Variable Cost (15 lacs/150 x 145) -14,50,000
Less: Recurring cost -5,000
Gross Benefit 45,000
Less: Interest cost (Note 1) -68,787
Less: Bad debt (15,00,000 x 1%) -15,000
Net Benefit -38,787
• The company should not provide credit to Slow Payers Limited as the net benefit is negative

Note 1: Computation of interest cost:

Particulars 15% of sales 34% of sales 30% of sales 20% of sales
Full cost of Sales (14,55,000 x %) 2,18,250 4,94,700 4,36,500 2,91,000
Collection period 30 60 90 100
Debtors (Full Cost x CP/365) 17,938 81,321 1,07,630 79,726
Interest cost (Debtors x Return %) 4,305 19,517 25,831 19,134
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• Total interest cost = Rs.68,787

Question No.28 [Nov 2020 RTP, May 2013 RTP, Nov 2014 RTP]
H Ltd. has present annual sales of 10,000 units at Rs. 300 per unit. The variable cost is Rs. 200 per unit and
the fixed costs amount to Rs. 3,00,000 per annum. The present credit period allowed by the company is 1
month. The company is considering a proposal to increase the credit period to 2 months and 3 months and
has made the following estimates:
Particulars Existing Proposed 1 Proposed 2
Credit period 1 month 2 months 3 months
Increase in sales - 15% 30%
% of bad debts 1% 3% 5%
There will be increase in fixed cost by Rs. 50,000 on account of increase of sales beyond 25% of present level.
The company plans on a pre-tax return of 20% on investment in receivables. You are required to calculate the
most paying credit policy for the company.
Answer:
Evaluation of credit policy:
Particulars Present Option 1 Option 2
Sales 30,00,000 34,50,000 39,00,000
Less: Variable cost -20,00,000 -23,00,000 -26,00,000
Less: Fixed cost -3,00,000 -3,00,000 -3,50,000
Gross Benefit 7,00,000 8,50,000 9,50,000
Less: Interest cost (Note 1) -30,000 -1,03,500 -1,95,000
Less: Bad debt (% of sales) -38,333 -86,667 -1,47,500
Net Benefit 6,31,667 6,59,833 6,07,500
• The company should go ahead with option 1 as the same leads to higher net benefit.

Note 1: Computation of interest cost:

Particulars Present Option 1 Option 2
Full cost of Sales (VC + FC) 23,00,000 26,00,000 29,50,000
Debtors (Full Cost x CP/12) 1,91,667 4,33,333 7,37,500
Interest cost (Debtors x Return %) 38,333 86,667 1,47,500
• Note: It is assumed that debtors are valued based on full cost of sales

Question No.29 – May 2021 RTP:

Zeta Limited has current sales of Rs.7,20,000. It is considering revising its credit policy. The proposed term
of credit will be 2/10 net 30 against the present policy of net 30. As a result, Zeta Limited’s sales are expected
to increase by Rs.20,000 and the average collection period will reduce from 30 days to 20 days. It is also
expected that 50 percent of the customer will take the discounts and pay on the 10th day and rest of the
customers will pay on the 30th day. Bad debt losses will remain at 2 percent of sales. The variable cost ratio is
70 percent. Its corporate tax rate is 50 percent and opportunity cost of investment in receivables is 10 percent.
Advise whether Zeta Limited should change its credit period?
Answer:
Evaluation of credit policy:
Particulars Existing Revised
Sales 7,20,000 7,40,000
Less: Variable cost -5,04,000 -5,18,000
Less: Fixed cost - -
Gross Benefit 2,16,000 2,22,000
Less: Interest cost (Note 1) -4,200 -2,878
Less: Bad debt -14,400 -14,800
Less: Cash discount - -7,400
Net Benefit 1,97,400 1,96,922
• Company should not go ahead with revised scheme as the same leads to lower net benefit

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Note 1: Computation of interest cost:
Particulars Existing Revised
Full cost of Sales (VC + FC) 5,04,000 5,18,000
Debtors (Full Cost x CP/360) 42,000 28,778
Interest cost (Debtors x Return %) 4,200 2,878
• Credit period for existing scenario = 30 days
• Credit period for revised scenario = (10 x 50%) + (30 x 50%) = 20 days
• It is assumed a year consist of 360 days
• It is assumed debtors are valued based on full cost of sales

Question No.30 – November 2015

A Ltd. has total sales of Rs. 3.2 crores and its average collection period is 90 days. The past experience
indicates that bad-debt losses are 1.5% on sales. The expenditure incurred by the firm in administering its
receivable collection efforts are Rs. 5,00,000. A factor is prepared to buy the firm’s receivables by charging
2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after
withholding 10% as reserve. Calculate the effective cost of factoring to the Firm.
Answer:
WN 1: Computation of amount lent by factor:
Particulars Calculation Amount
1. Credit sales 3,20,00,000
2. Average collection period 90 days
3. Amount of debtors 3,20,00,000 x (90/360) 80,00,000
4. Less: Reserve 80,00,000 x 10% -8,00,000
5. Less: Commission 80,00,000 x 2% -1,60,000
6. Amount eligible to be lent 70,40,000
7. Less: Interest 70,40,000 x 18% x (90/360) -3,16,800
8. Amount actually lent 67,23,200

WN 2: Computation of effective cost of factoring:

Particulars Calculation Amount
A. Costs:
Commission 3,20,00,000 x 2% 6,40,000
Interest 70,40,000 x 18% 12,67,200
Total Costs 19,07,200
B. Benefits
Saving in bad debt 3,20,00,000 x 1.5% 4,80,000
Saving in admin cost 5,00,000
Total benefits 9,80,000
Effective cost of factoring (in Rs.) 19,07,200 - 9,80,000 9,27,200
Amount lent by factor WN 1 67,23,200
Effective cost of factoring (in %) 13.79
• Effective cost of factoring = 13.79%
• The above cost is compared with rate of interest on bank loan to decide whether we can go ahead
with factoring arrangement.
• If bank loan interest rate is higher than 13.79% then we will choose factoring option. Alternatively, if
interest is lower than 13.79% then we will choose bank loan

Question No.31 – May 2019 MTP:

Navya Ltd has annual credit sales of Rs. 45 lakhs. Credit terms are 30 days, but its management of receivables
has been poor and the average collection period is 50 days, Bad debt is 0.4 per cent of sales. A factor has
offered to take over the task of debt administration and credit checking, at an annual fee of 1 per cent of credit
sales. Navya Ltd. estimates that it would save Rs. 35,000 per year in administration costs as a result. Due to
the efficiency of the factor, the average collection period would reduce to 30 days and bad debts would be
zero. The factor would advance 80 per cent of invoiced debts at an annual interest rate of 11 per cent. Navya
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Ltd. is currently financing receivables from an overdraft costing 10 per cent per year. If occurrence of credit
sales is throughout the year, calculate whether the factor’s services should be accepted or rejected. Assume
365 days in a year
Answer:
Cost benefit analysis of factoring arrangement:
Particulars Calculation Amount
A. Benefits
Saving in bad debt 45,00,000 x 0.4% 18,000
Saving in admin cost 35,000
Saving in interest on bank overdraft 45,00,000 x (50/365) x 10% 61,644
Total Benefits 1,14,644
B. Costs
Commission 45,00,000 x 1% 45,000
Interest cost:
To factor 45,00,000 x (30/365) x 80% x 11% 32,548
To others (bank OD) 45,00,000 x (30/365) x 20% x 10% 7,397
Total Costs 84,945
Net benefit of factoring 29,699
• The company should go ahead with factoring arrangement as net benefit of factoring arrangement
is Rs.29,699

Question No.32 – May 2018, Dec 2021

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 0.5 percent 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 factoring is 2% of turnover. Administration cost saving is likely to be
Rs.1,00,000 per annum
• Annual credit sales are Rs.1,20,00,000. Variable cost is 80% of sales price. The company’s cost of
borrowing is 15% per annum. Assume 360 days in a year.
Should the company enter into a factoring agreement?
Answer:
Particulars Calculation Amount
A. Benefits
Saving in bad debt 1,20,00,000 x 0.5% 60,000
Saving in admin cost 1,00,000
Interest saving Note 1 1,20,000
Total Benefits 2,80,000
B. Costs
Commission 1,20,00,000 x 2% 2,40,000
Net benefit of factoring 40,000
• Conclusion: The company should go ahead with factoring arrangement as benefits are higher than
costs.

Note 1: Computation of interest costs:

Particulars Existing Factoring
1. Sales 1,20,00,000 1,20,00,000
2. Variable cost of sales 96,00,000 96,00,000
3. Fixed cost - -
4. Full cost of sales 96,00,000 96,00,000
5. Average collection period 90 days 60 days
6. Debtors (Full cost of sales x CP/360) 24,00,000 16,00,000
7. Interest cost (Debtors x 15%) 3,60,000 2,40,000
8. Interest saving under factoring 1,20,000

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Question No.:33 (May 2018 RTP)

A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular basis. As per
the terms of agreement the payment must be made within 40 days of purchase. However, A Ltd. has a choice
of paying Rs. 98.50 per Rs. 100 it owes to X Ltd. on or before 10th day of purchase. Required: EXAMINE
whether A Ltd. should accept the offer of discount assuming average billing of A Ltd. with X Ltd. is Rs.
10,00,000 and an alternative investment yield a return of 15% and company pays the invoice.
Answer:
Annual benefit of availing discount:
1.50 365
Annual Benefit = x x 100 = 18.53%
98.50 30

Annual benefit of availing cash discount is 18.53%. Opportunity cost is 15%. Hence the company should go
ahead with availing of cash discount

Question No.34 – Nov 2018 RTP, May 2019 RTP

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 Rs. 2.60 crores and Rs. 2.34 crores respectively.
Estimated Sales and EBIT depend on current assets investment, particularly inventories and book-debts. The
financial controller of the company is examining the following alternative Working Capital Policies:
Working capital policy Investment in current assets 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 Rs. 2.50 crores of the equity funds. The corporate
tax rate is 35%. The company is considering the following debt alternatives.

Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12

Moderate 1 0.66
Aggressive 1.5 0.16

Interest rate-Average 12% 16%

You are required to calculate the following:

• Working capital position for each policy:
o New working capital position
o Rate of return on total assets
o Current ratio
• Analysis of financing policies for
o Net working capital position
o Rate of return on shareholders equity
o Current ratio
Answer:
WN 1: Analysis of working capital policies:
Particulars Conservative Moderate Aggressive
Current Assets 4.50 3.90 2.60
Fixed assets 2.60 2.60 2.60
Total Assets 7.10 6.50 5.20
Current liabilities 2.34 2.34 2.34
Net working capital (CA - CL) 2.16 1.56 0.26
Current ratio [Current Assets/Current Liabilities] 1.92 1.67 1.11
EBIT 1.23 1.15 1.00
Rate of return on total assets (EBIT/Total assets) 17.32 17.69 19.23
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Note:
• We have analyzed the various working capital policies given in the question and the financing for
the same will be analyzed in the next working note

WN 2: Analysis of financing policies:

• The company has decided to go ahead with moderate working capital policy from assets side. We
will now analyze the three financing policies given in the question
Particulars Conservative Moderate Aggressive
Current Assets 3.90 3.90 3.90
Fixed assets 2.60 2.60 2.60
Total Assets 6.50 6.50 6.50
Equity share capital 2.50 2.50 2.50
Long term debt 1.12 0.66 0.16
Short term debt 0.54 1.00 1.50
Current liabilities 2.34 2.34 2.34
Total liabilities 6.50 6.50 6.50
Net working capital (CA - CL - short term debt) 1.02 0.56 0.06
Current ratio (CA/(CL+Short term debt)) 1.35 1.17 1.02
EBIT 1.1500 1.1500 1.1500
Less: Interest on short-term debt -0.0648 -0.1200 -0.1800
Less: Interest on long-term debt -0.1792 -0.1056 -0.0256
EBT 0.9060 0.9244 0.9444
Less: Tax @ 35% -0.3171 -0.3235 -0.3305
EAT/EAES 0.5889 0.6009 0.6139
Return on equity (EAES/Equity) x 100 23.56 24.04 24.56

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New Additional Problems

The section covers new additions from Nov 2021 RTP, May 2022 RTP, Nov 2021 MTP, July 2021 and Dec
2021 Suggested Answers

1. Ratio Analysis [Nov 2021 MTP]

ABC Ltd. has total sales of 10,00,000 all of which are credit sales. It has a gross profit ratio of 25% and a
current ratio of 2. The company’s current liabilities are Rs. 2,00,000. Further, it has inventories of Rs. 80,000,
marketable securities of Rs. 50,000 and cash of Rs. 30,000. From the above information:
• CALCULATE the average inventory, if the expected inventory turnover ratio is three times?
• Also CALCULATE the average collection period if the opening balance of debtors is expected to be
Rs. 1,50,000.
Assume 360 days a year.
Answer:
Computation of average inventory:
COGS
Inventory Turnover Ratio =
Average inventory
75% of 10,00,000 7,50,000
3= ; Average inventory = ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 = 𝐑𝐬. 𝟐, 𝟓𝟎, 𝟎𝟎𝟎
Average inventory 3

Computation of Average collection period:

Sales
Debtors Turnover Ratio =
Average debtors
10,00,000 10,00,000
Debtors Turnover Ratio = = = 5.13 Times
[2,40,000 + 1,50,000] 1,95,000
2
360
Average Collection Period = = 70.2 (or)70 days
5.13
Note:
• Closing debtors = Closing current assets – inventory – marketable securities – cash
• Closing current assets = Two times of current liabilities = 2 x 2,00,000 = Rs.4,00,000
• Closing debtors = 4,00,000 – 80,000 – 50,000 – 30,000 = Rs.2,40,000

2. Ratio Analysis [Nov 2021 RTP]

Following information has been gathered from the books of Cram Ltd. for the year ended 31st March 2021,
the equity shares of which is trading in the stock market at Rs. 28:
Particulars Amount
Equity share capital (Face value @ Rs.20) 20,00,000
10% preference share capital 4,00,000
Reserves and surplus 16,00,000
12.5% debentures 12,00,000
Profit before interest and tax for the year 8,00,000
CALCULATE the following when company falls within 25% tax bracket:
(i) Return on Capital Employed
(ii) Earnings Per share
(iii) P/E Ratio
Answer:
WN 1: Income statement of Cram Limited for the year ended 31 st March 2021:
Particulars Amount
Profit before interest and tax 8,00,000
Less: Interest on debentures -1,50,000
Profit before tax 6,50,000
Less: Tax @ 25% -1,62,500
Profit after tax 4,87,500
Less: Preference dividend -40,000

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Earnings available to equity shareholders [EAES] 4,47,500
No of equity shares 1,00,000
EPS [4,47,500/1,00,000] 4.475
MPS 28
PE Multiple [28/4.475] 6.26

Computation of Return on Capital Employed:

EBIT 8,00,000
ROCE (pre − tax) = = = 15.38%
Capital Employed 20,00,000 + 4,00,000 + 16,00,000 + 12,00,000
EBIT x (1 − Tax) 8,00,000 x (1 − 0.25)
ROCE (post − tax) = = = 11.54%
Capital Employed 20,00,000 + 4,00,000 + 16,00,000 + 12,00,000

3. Ratio Analysis [Nov 2021 MTP]

Jensen and spencer pharmaceutical is in the business of manufacturing pharmaceutical drugs including the
newly invented Covid vaccine. Due to increase in demand of Covid vaccines, the production had increased
at all time high level and the company urgently needs a loan to meet the cash and investment requirements.
It had already submitted a detailed loan proposal and project report to Expo-Impo bank, along with the
financial statements of previous three years as follows:

Statement of Profit and Loss

(in ‘000s)
Particulars 2018-19 2019-20 2021-21
Sales
Cash 400 960 1,600
Credit 3,600 8,640 14,400
Total sales 4,000 9,600 16,000
Cost of goods sold 2,480 5,664 9,600
Gross Profit 1,520 3,936 6,400
Operating expenses:
General, admin and selling expenses 160 900 2,000
Depreciation 200 800 1,320
Interest expenses (on borrowings) 120 316 680
Profit before tax (PBT) 1,040 1,920 2,400
Tax @ 30% 312 576 720
Profit after tax (PAT) 728 1,344 1,680

Balance Sheet
(in ‘000s)
Particulars 2018-19 2019-20 2021-21
Assets
Non-current assets:
Fixed assets (net of depreciation) 3,800 5,000 9,400
Current Assets:
Cash and cash equivalents 80 200 212
Accounts receivable 600 3,000 4,200
Inventories 640 3,000 4,500
Total 5,120 11,200 18,312
Equity and Liabilities:
Equity share capital of Rs.10 each 2,400 3,200 4,000
Other equity 728 2,072 3,752
Non-current borrowings 1,472 2,472 5,000
Current liabilities 520 3,456 5,560
Total 5,120 11,200 18,312

Industry average of Key ratios:

Ratio Sector Average

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Current Ratio 2.30:1
Acid test ratio (quick ratio) 1.20:1
Receivables turnover ratio 7 Times
Inventory turnover ratio 4.85 Times
Long-term debt to total debt 24%
Debt-to-equity ratio 35%
Net profit ratio 18%
Return on total assets 10%
Interest coverage ratio (times interest earned) 10
As a loan officer of Expo-Impo Bank, you are REQUIRED to apprise the loan proposal on the basis of
comparison with industry average of key ratios considering closing balance for accounts receivable of Rs.
6,00,000 and inventories of Rs. 6,40,000 respectively as on 31st March, 2018
Answer:
Computation of Ratios:
Particulars Formula 2018-19 2019-20 2020-21 Industry
average
Current Ratio Current Assets 1,320 6,200 8.912 2.30:1
Current Liabilities 520 3,456 5,560
= 2.54 = 1.80 = 1.60
Acid Test Ratio Quick Assets 680 3,200 4,412 1.20:1
Current Liabilities 520 3,456 5,560
= 1.31 = 0.93 = 0.79
Receivables Credit Sales 3,600 8,640 14,400 7 Times
Turnover Ratio Average receivables 600 + 600 600 + 3,000 3,000 + 4,200
[ ] [ ] [ ]
2 2 2
= 6.00 = 4.80 = 4.00
Inventory COGS 2,480 5,664 9,600 4.85
Turnover Ratio Average Stock 640 + 640 640 + 3,000 3,000 + 4,500 Times
[ ] [ ] [ ]
2 2 2
= 3.88 = 3.11 = 2.56
Long-term debt Long term debt 1,472 2,472 5,000 24.00%
x 100 x 100 x 100 x 100
to total debt Total debt 1,992 5,928 10,560
= 73.90% = 41.70% = 47.35%
Debt-to-equity Long term debt 1,472 2,472 5,000 35.00%
x 100 x 100 x 100 x 100
ratio Shareholder equity 3,128 5,272 7,752
= 47.06% = 46.89% = 64.50%
Net Profit Ratio Net Profit 728 1,344 1,680 18.00%
x 100 x 100 x 100 x 100
Sales 4,000 9,600 16,000
= 18.20% = 14.00% = 10.50%
Return on total Net Profit 728 1,344 1,680 10.00%
x 100 x 100 x 100 x 100
assets Total Assets 5,120 11,200 18,312
= 14.22% = 12.00% = 9.17%
Interest EBIT 1,160 2,236 3,080 10.00
coverage ratio Interest 120 316 680
= 9.67 = 7.08 = 4.53
Conclusion:
• In the last two years, the current ratio and quick ratio are less than the ideal ratio (2:1 and 1:1
respectively) indicating that the company is not having enough resources to meet its current
obligations.
• Receivables are growing slower. Inventory turnover is slowing down as well, indicating a relative
build-up in inventories or increased investment in stock.
• High Long-term debt to total debt ratio and Debt to equity ratio compared to that of industry average
indicates high dependency on long term debt by the company.
• The net profit ratio is declining substantially and is much lower than the industry norm.
Additionally, though the Return on Total Asset(ROTA) is near to industry average, it is declining as
well.

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• The interest coverage ratio measures how many times a company can cover its current interest
payment with its available earnings. A high interest coverage ratio means that an enterprise can
easily meet its interest obligations, however, it is declining in the case of Jensen & Spencer and is also
below the industry average indicating excessive use of debt or inefficient operations.
• On overall comparison of the industry average of key ratios than that of Jensen & Spencer, the
company is in deterioration position. The company’s profitability has declined steadily over the
period.
• However, before jumping to the conclusion relying only on the key ratios, it is pertinent to keep in
mind the industry, the company dealing in with i.e. manufacturing of pharmaceutical drugs. The
pharmaceutical industry is one of the major contributors to the economy and is expected to grow
further. After the covid situation, people are more cautious towards their health and are going to
spend relatively more on health medicines. Thus, while analysing the loan proposal, both the factors,
financial and non-financial, needs to be kept in mind.

4. Ratio Analysis [Dec 2021]

Following are the data in respect of ABC Industries for the year ended 31 st March, 2021:
Debt to Total Assets Ratio 0.40 Times
Long-term debts to equity ratio 30%
Gross profit margin on sales 20%
Accounts receivable period 36 days
Quick ratio 0.90 Times
Inventory holding period 55 days
Cost of goods sold Rs.64,00,000

Liabilities Amount Assets Amount

Equity share capital 20,00,000 Fixed assets
Reserves and surplus Inventories
Long-term debt Accounts receivable
Accounts payable Cash
Total 50,00,000 Total
Required:
Complete the Balance Sheet of ABC Industries as on 31st March, 2021. All calculations should be in nearest
Rupee. Assume 360 days in a year.
Answer:
Balance Sheet of ABC Limited as on 31 st March 2021:
Liabilities Amount Assets Amount
Equity share capital 20,00,000 Fixed assets (b/f) 30,32,222
Reserves and surplus (Note 1) 10,00,000 Inventories (Note 3) 9,77,778
Long-term debt (Note 2) 9,00,000 Accounts receivable (Note 4) 8,00,000
Accounts payable (Note 2) 11,00,000 Cash (Note 5) 1,90,000
Total 50,00,000 Total 50,00,000

Note 1: Computation of Reserves and Surplus

Total outside liabilities
Debt to total assets ratio =
Total assets
Total outside liabilities
0.40 = ; 𝐓𝐨𝐭𝐚𝐥 𝐨𝐮𝐭𝐬𝐢𝐝𝐞 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 = 𝟐𝟎, 𝟎𝟎, 𝟎𝟎𝟎
50,00,000
Note:
• It is assumed that debt includes accounts payable and we have considered total outside liabilities
for calculation
• Total assets = Total liabilities = Rs.50,00,000
Reserves and surplus = 50,00,000 – share capital (20,00,000) – outside liabilities (20,00,000) = Rs.10,00,000

Note 2: Computation of long-term debt and accounts payable:

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Long term debt
Long term debt to equity shareholders funds =
Equity shareholder funds
Long term debt
0.30 = ; 𝐋𝐨𝐧𝐠 𝐭𝐞𝐫𝐦 𝐝𝐞𝐛𝐭 = 𝐑𝐬. 𝟗, 𝟎𝟎, 𝟎𝟎𝟎
20,00,000 + 10,00,000
• Accounts payable = Total outside liabilities – Long term debt
• Accounts payable = 20,00,000 – 9,00,000 = Rs.11,00,000

Note 3: Computation of inventory:

Inventory days
Inventory = COGS x
360
55
Inventory = 64,00,000 x = 𝑅𝑠. 9,77,778
360

Note 4: Computation of Accounts Receivables:

• Gross profit is 20% of sales and hence COGS is 80% of sales
• Sales = 64,00,000/80% = Rs.80,00,000
Debtors days
Receivables = Sales x
360
𝟑𝟔
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 = 𝟖𝟎, 𝟎𝟎, 𝟎𝟎𝟎 𝐱 = 𝐑𝐬. 𝟖, 𝟎𝟎, 𝟎𝟎𝟎
𝟑𝟔𝟎

Note 5: Computation of Cash:

Quick Assets
Quick Ratio =
Current Liabilities
Quick Assets
0.90 Times =
11,00,000
Quick assets = Rs.9,90,000
Quick assets = Cash + Debtors
9,90,000 = Cash + 8,00,000
Cash = Rs.1,90,000

5. WACC computation [Nov 2021 RTP]

Kalyanam Ltd. has an operating profit of Rs. 34,50,000 and has employed Debt which gives total Interest
Charge of Rs. 7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8% respectively.
The firm has a new proposal before it, which requires funds of Rs. 75 Lakhs and is expected to bring an
additional profit of Rs. 14,25,000. To finance the proposal, the firm is expecting to issue an additional debt at
8% and will not be issuing any new equity shares in the market. Assume no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:
a) Before the new proposal
b) After the new proposal
Answer:
WN 1: Computation of WACC before the new proposal:
Source Cost Weight Product
Debt 8.00% 93,75,000 7,50,000
(Note 1)
Equity 16.00% 1,68,75,000 27,00,000
(Note 2)
Total 13.14% 2,62,50,000 34,50,000
Note 1:
Interest 7,50,000
Value of debt = = = Rs. 93,75,000
Cost of debt 8%
Note 2:
EBT 34,50,000 − 7,50,000
Value of equity = = = Rs. 93,75,000
Cost of equity 8%

Sum of Products 34,50,000

WACC = = = 13.14%
Sum of weights 2,62,50,000
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WN 2: Computation of WACC after new proposal:
Source Cost Weight Product
Debt 8.00% 93,75,000 7,50,000
(Note 1)
Debt 8.00% 75,00,000 6,00,000
Equity 20.89%% 1,68,75,000 35,25,000
Total 14.44% 3,37,50,000 48,75,000
Note 1:
EBT 27,00,000 + 14,25,000 − 6,00,000
New Cost of equity = = = Rs. 20.89%
Value of equity 1,68,75,000

Sum of Products 48,75,000

WACC = = = 𝟏𝟒. 𝟒𝟒%
Sum of weights 3,37,50,000

6. MM Approach without tax (July 2021)

The details about two companies R Ltd. and S Ltd. having same operating risk are given below:
Particulars R Limited S Limited
Profit before interest and tax 10,00,000 10,00,000
Equity share capital @ Rs.10 each 17,00,000 50,00,000
Long-term borrowings @ 10% 33,00,000 -
Cost of equity 18.00% 15.00%
You are required to:
a) Calculate the value of equity of both the companies on the basis of M.M. Approach without tax.
b) Calculate the Total Value of both the companies on the basis of M.M. Approach without tax.
Answer:
Particulars R Limited S Limited
EBIT 10,00,000 10,00,000
-3,30,000
Less: Interest [33,00,000 x 10%] -
EBT 6,70,000 10,00,000

Cost of debt [Given] 10.00% NA

Cost of equity [Given] 18.00% 15.00%
14.24% 15.00%
Cost of capital [10,00,000/70,22,222] [10,00,000/66,66,667]

Value of debt [Given] 33,00,000 -

37,22,222 66,66,667
Value of equity [6,70,000/18%] [10,00,000/15%]
70,22,222
Value of firm [33,00,000 + 37,22,222] 66,66,6667

7. Arbitrage [Nov 2021 MTP]

In respect of two companies having same business risk, following information is given:
Capital employed = Rs. 4,00,000; EBIT = Rs. 60,000; Ke = 12%
Sources Levered Company Unlevered Company
Debt @ 10% 1,50,000 Nil
Equity 1,50,000 3,00,000
Investor is holding 20% shares in levered company. CALCULATE increase in annual earnings of investor if
he switches his holding from Levered to Unlevered company
Answer:
WN 1: Valuation of two firms:
Particulars Levered company Unlevered company
EBIT 60,000 60,000
Less: Interest -15,000 -

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[1,50,000 x 10%]
EBT 45,000 60,000

Cost of debt [Given] 10.00% NA

Cost of equity [Given] 12.00% 12.00%
11.43% 12.00%
Cost of capital [60,000/5,25,000] [60,000/5,00,000]

Value of debt 1,50,000 -

3,75,000 5,00,000
Value of equity [45,000/12.00%] [60,000/12%]
Value of firm 5,25,000 5,00,000
• Primary arbitrage exists as the value of levered firm is higher than value of unlevered firm

WN 2: Calculate of present earnings with 20% investment in levered company:

Particulars Amount
Value of levered company 5,25,000
Value of equity of levered company 3,75,000
Our investment (20% of equity) 75,000
Total dividend of levered company 45,000
Our earnings (45,000 x 20%) 9,000

WN 3: Sell shares of levered firm (high risk) and invest in equity of unlevered company:
• Investor has to sell shares of levered company and invest in equity of unlevered company
• We are moving from high risk company to low risk company. This would lead to risk reduction. In
order to maintain same risk, we should borrow money in line with corporate leverage
Particulars Amount
Sell shares of unlevered company 75,000
Borrow money @ 10% (1,50,000 x 20%) 30,000
Total amount available 1,05,000
Invest in equity of unlevered company 1,05,000
% stake of other company [1,05,000/5,00,000] x 100 21.00

WN 4: Compute new earnings:

Particulars Amount
Dividend of unlevered company 60,000
Earnings of the investor (60,000 x 21%) 12,600
Less: Interest paid (30,000 x 10%) -3,000
Revised earnings 9,600
Increase in earnings [9,600 – 9,000] 600

8. Leverages [July 2021]

A company had the following balance sheet as on 31 st March 2021:
Liabilities Amount Assets Amount
in Crores in Crores
Equity share capital (75 lac 7.50 Building 12.50
shares of Rs.10 each)
Reserves and surplus 1.50 Machinery 6.25
15% debentures 15.00 Current assets:
Current liabilities 6.00 Stock 3.00
Debtors 3.25
Bank balance 5.00
30.00 30.00
The additional information is given as under:

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• Fixed cost per annum (excluding interest) = Rs.6 Crores
• Variable operating cost ratio = 60%
• Total assets turnover ratio = 2.5
• Income-tax rate = 40%
Calculate the following and comment:
a) Earnings per share
b) Operating leverage
c) Financial leverage
d) Combined leverage

Answer:
WN 1: Income statement:
Particulars Rs. Crores
Revenues [30 x 2.5 Times] 75.00
Less: Variable cost [75 x 60%] -45.00
Contribution 30.00
Less: Fixed cost -6.00
EBIT 24.00
Less: Interest on 15% debentures [15 x 15%] -2.25
Earnings before tax 21.75
Less: Tax @ 40% -8.70
Earnings after tax 13.05
No of equity shares 0.75
Earnings per share [13.05/0.75] 17.40
Note:
• EPS indicates the amount the company earns per share. Investors use this as a guide while valuing
the share and making investment decisions. It is also an indicator used in comparing firms within
an industry or industry segment.

WN 2: Computation of leverages:
Contribution 30.00
Operating leverage = = = 1.25 Times
EBIT 24.00
• It indicates the choice of technology and fixed cost in cost structure. It is level specific. When
firm operates beyond operating break-even level, then operating leverage is low. It indicates
sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.
EBIT 24.00
Financial leverage = = = 1.103 Times
PD
EBT − ( ) 21.75
1 − Tax rate
• The financial leverage is very comfortable since the debt service obligation is small vis -àvis
EBIT.
Contribution 30.00
Combined leverage = = = 1.379 Times
PD
EBT − ( ) 21.75
1 − Tax rate
• The combined leverage studies the choice of fixed cost in cost structure and choice of debt in
capital structure. It studies how sensitive the change in EPS is vis-à-vis change in sales. The
leverages operating, financial and combined are used as measurement of risk.

9. Leverages [May 2022 RTP]

Company P and Q are having same earnings before tax. However, the margin of safety of Company P is 0.20
and, for Company Q, is 1.25 times than that of Company P. The interest expense of Company P is Rs. 1,50,000
and, for Company Q, is 1/3rd less than that of Company P. Further, the financial leverage of Company P is
4 and, for Company Q, is 75% of Company P.
Other information is given as below:
Particulars Company P Company Q

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Profit volume ratio 25% 33.33%
Tax rate 45% 45%
You are required to PREPARE Income Statement for both the companies.
Answer:
Income statement of Company P and Company Q:
Particulars Company P Company Q
Sales [Contribution/PVR] 40,00,000 18,00,000
Less: Variable cost -30,00,000 -12,00,000
Contribution 10,00,000 6,00,000
Less: Fixed cost -8,00,000 -4,50,000
EBIT (Note 1) 2,00,000 1,50,000
Less: Interest -1,50,000 -1,00,000
EBT 50,000 50,000
Less: Tax (45%) -22,500 -22,500
EAT 27,500 27,500

Note 1: Computation of EBIT:

EBIT
Financial leverage =
EBT
Let us assume EBIT of company as X
Company P:
X
4= ;
X − 1,50,000
4X − 6,00,000 = X
𝟑𝐗 = 𝟔, 𝟎𝟎, 𝟎𝟎𝟎; 𝐗 = 𝟐, 𝟎𝟎, 𝟎𝟎𝟎
Company Q:
X
3= ;
X − 1,00,000
3X − 3,00,000 = X
𝟐𝐗 = 𝟑, 𝟎𝟎, 𝟎𝟎𝟎; 𝐗 = 𝟏, 𝟓𝟎, 𝟎𝟎𝟎

Note 2: Computation of Contribution:

MOS of Company P = 0.20 Times
MOS of Company Q = 0.20 x 1.25 = 0.25 Times
• MOS of company P is 20%. Hence break-even sales is 80% of sales
• We can therefore conclude that fixed cost is 80% of contribution and EBIT is 20% of contribution
Contribution 1
= = 5 Times.
EBIT 0.20
In other words, we can assume that inverse of MOS is operating leverage. Hence OL of company P is 5
times (1/0.20) and of company Q is 4 Times (1/0.25)
Company P:
Contribution
Operating leverage =
EBIT
Contribution
5 Times = ; Contribution = 10,00,000
2,00,000
Company Q:
Contribution
Operating leverage =
EBIT
Contribution
4 Times = ; Contribution = 6,00,000
1,50,000

10. Leverages:
The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given:
Output 1,00,000 units at normal capacity
Selling price per unit Rs.40
Variable cost per unit Rs.20
Fixed cost Rs.10,00,000

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

Particulars Amount
Equity share capital (1,00,000 shares of Rs. 10 each) Rs.10,00,000
Reserves and Surplus Rs.5,00,000
7% debentures Rs.10,00,000
Current liabilities Rs.5,00,000
Total Rs.30,00,000
Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve Rs.
10 lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by Rs. 5,00,000 and
variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling price
without any adverse impact on the market.

The following alternative schemes for financing the proposed expansion programme are planned:
• Entirely by equity shares of Rs. 10 each at par.
• Rs. 5 lakh by issue of equity shares of Rs. 10 each and the balance by issue of 6% debentures of Rs.
100 each at par.
• Entirely by 6% debentures of Rs. 100 each at par.
FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference
to the risk and return involved, assuming a corporate tax of 40%.
Answer:
Evaluation of alternatives:
(in lacs)
Particulars Existing Alternative (i) Alternative (ii) Alternative (iii)
Equity share capital (Existing) 10.00 10.00 10.00 10.00
New issues - 10.00 5.00 -
Total equity capital 10.00 20.00 15.00 10.00
7% debentures 10.00 10.00 10.00 10.00
6% debentures - - 5.00 10.00
Total debentures 10.00 10.00 15.00 20.00
Debenture interest (7%) 0.70 0.70 0.70 0.70
Debenture interest (6%) - - 0.30 0.60
Total Interest 0.70 0.70 1.00 1.30
Output (in lacs) 1.00 1.50 1.50 1.50
Contribution per unit 20.00 22.00 22.00 22.00
Total contribution 20.00 33.00 33.00 33.00
Less: Fixed cost 10.00 15.00 15.00 15.00
EBIT 10.00 18.00 18.00 18.00
Less: Interest 0.70 0.70 1.00 1.30
EBT 9.30 17.30 17.00 16.70
Less: Tax @ 40% -3.72 -6.92 -6.80 -6.68
EAT 5.58 10.38 10.20 10.02
No of shares 1.00 2.00 1.50 1.00
EPS 5.58 5.19 6.80 10.02
Operating leverage (Cont/EBIT) 2.00 1.83 1.83 1.83
Financial leverage (EBIT/EBT) 1.08 1.04 1.06 1.08
Combined leverage (Cont/EBT) 2.15 1.91 1.94 1.98
Risk Lowest Lower than Highest
option (3)
Return Lowest Lower than Highest
option (3)
From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial
Leverage differs. Alternative (iii) uses the maximum amount of debt and result into the highest degree of
financial leverage, followed by alternative ( ii). Accordingly, risk of the company will be maximum in these
options. Corresponding to this scheme, however, maximum EPS (i.e., Rs. 10.02 per share) will be also in
option (iii).
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So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In case
of opting for less risk, alternative (ii) is the next best option with a reduced EPS of Rs. 6.80 per share. In case
of alternative (i), EPS is even lower than the existing option, hence not recommended.

11. Leverages [Dec 2021]

Information of A Ltd. is given below:
• Earnings after tax: 5% on sales
• Income tax rate: 50%
• Degree of Operating Leverage: 4 times
• 10% Debenture in capital structure: Rs. 3 lakhs
• Variable costs: Rs. 6 lakhs
Required:
(i) From the given data complete following statement:
Sales XXX
Less: Variable costs -6,00,000
Contribution XXX
Less: Fixed costs XXX
EBIT XXX
Less: Interest XXX
EBT XXX
Less: Tax XXX
EAT XXX
(ii) Calculate the financial and combined leverage
(iii) Calculate the percentage increase in earnings per share if sales increased by 5%
Answer:
WN 1: Income Statement:
Particulars Amount
Sales (Note 1) 12,00,000
Less: Variable costs -6,00,000
Contribution 6,00,000
Less: Fixed costs -4,50,000
EBIT [Contribution/4] 1,50,000
Less: Interest [3,00,000 x 10%] 30,000
EBT 1,20,000
Less: Tax @ 50% -60,000
EAT 60,000

Note 1: Computation of Sales:

• EAT is 5% of sales. Income tax rate is 50%
EAT 5% of sales
EBT = = = 10% of Sales
1 − Tax 1 − 0.50
EBIT = EBT + Interest
EBIT = 10% of Sales + 30,000
Contribution Contribution
OL = ;4 = ; 𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 = 𝟒 𝐭𝐢𝐦𝐞𝐬 𝐨𝐟 𝐄𝐁𝐈𝐓
EBIT EBIT
Substituting the EBIT in above equation:
𝐂𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 = 𝟒 𝐭𝐢𝐦𝐞𝐬 𝐨𝐟 𝐄𝐁𝐈𝐓
Contribution = 4 [10% of sales + 30,000]
Sales − 6,00,000 = 4 [10% of sales + 30,000]
Sales − 6,00,000 = 0.40 sales + 1,20,000
0.60 Sales = 7,20,000
𝟕, 𝟐𝟎, 𝟎𝟎𝟎
𝐒𝐚𝐥𝐞𝐬 = = 𝐑𝐬. 𝟏𝟐, 𝟎𝟎, 𝟎𝟎𝟎
𝟎. 𝟔𝟎

WN 2: Computation of financial and combined leverage:

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EBIT 1,50,000
Financial leverage = = = 1.25 Times
EBT 1,20,000
Combined leverage = Financial leverage x Operating leverage = 1.25 times x 4 Times = 5 Times

WN 3: Percentage increase in EPS for 5 percentage increase in sales:

• Combined leverage links percentage change in EPS and percentage change in sales. Combined
leverage is 5 Times. Sales has increased by 5 percent and hence EPS will increase by 25 percent [5
percent x 5 Times]

12. Investment Decision [Nov 2021 MTP]

Sadbhavna Limited is a manufacturer of computers. It wants to introduce artificial intelligence while making
computers. It estimates that the annual savings from the artificial intelligence (AI) include a reduction of five
employees with annual salaries of Rs. 3,00,000 each, Rs. 3,00,000 from reduction in production delays caused
by inventory problem, reduction in lost sales Rs. 2,50,000 and Rs. 2,00,000 from billing issues.

The purchase price of the system for installation of artificial intelligence is Rs. 20,00,000 with installation cost
of Rs. 1,00,000. The life of the system is 5 years and it will be depreciated on a straight -line basis. The salvage
value is zero which will be its market value after the end of its life of five years.

However, the operation of the new system for AI requires two computer specialists with annual salaries of
Rs. 5,00,000 per person. Also, the estimated maintenance and operating expenses of 1,50,000 is required. The
company’s tax rate is 30% and its required rate of return is 12%.
From the above information:
(i) CALCULATE the initial cash outflow and annual operating cash flow over its life of 5 years.
(ii) You are also REQUIRED to obtain the cash flows and NPV on the assumption that book salvage
value for depreciation purposes is Rs. 2,00,000 even though the machine is having no real worth in
terms of its resale value. Also, the book salvage value of Rs. 2,00,000 is allowed for tax purposes.
Answer:
Part (i) of the question:
Note 1: Initial outflow:
Particulars Amount
Capital expenditure -20,00,000
Installation cost -1,00,000
Initial outflow -21,00,000

Note 2: Annual operating cash flows:

Particulars Amount
Benefits:
Salaries reduction [3,00,000 x 5] 15,00,000
Production delay reduction 3,00,000
Lost sales reduction 2,50,000
Billing issues 2,00,000
Total Benefits 22,50,000
Less: Salaries of computer specialists -10,00,000
Less: Maintenance and operating expenses -1,50,000
Profit before depreciation and tax 11,00,000
Less: Depreciation [21,00,000/5] -4,20,000
Profit before tax 6,80,000
Less: Tax @ 30% -2,04,000
Profit after tax 4,76,000
Add: Depreciation 4,20,000
Cash flow after tax 8,96,000

Part (ii) of the question:

Note 1: Initial outflow:

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Particulars Amount
Capital expenditure -20,00,000
Installation cost -1,00,000
Initial outflow -21,00,000

Note 2: Annual operating cash flows:

Particulars Amount
Benefits:
Salaries reduction [3,00,000 x 5] 15,00,000
Production delay reduction 3,00,000
Lost sales reduction 2,50,000
Billing issues 2,00,000
Total Benefits 22,50,000
Less: Salaries of computer specialists -10,00,000
Less: Maintenance and operating expenses -1,50,000
Profit before depreciation and tax 11,00,000
Less: Depreciation [21,00,000 – 2,00,000/5] -3,80,000
Profit before tax 7,20,000
Less: Tax @ 30% -2,16,000
Profit after tax 5,04,000
Add: Depreciation 3,80,000
Cash flow after tax 8,84,000

Note 3: Terminal flow:

Particulars Amount
Sale value 0
Less: Book value 2,00,000
Capital loss 2,00,000
Tax saved [2,00,000 x 30%] 60,000
Net salvage value [SV + Tax saved] 60,000

13. Investment decision [Nov 2021 MTP]

Superb Ltd. constructs customized parts for satellites to be launched by USA and Canada. The parts are
constructed in eight locations (including the central headquarter) around the world. The Finance Director,
Ms. Kuthrapali, chooses to implement video conferencing to speed up the budget process and save travel
costs. She finds that, in earlier years, the company sent two officers from each location to the central
headquarter to discuss the budget twice a year. The average travel cost per person, including air fare, hotels
and meals, is Rs. 27,000 per trip. The cost of using video conferencing is Rs. 8,25,000 to set up a system at
each location plus Rs. 300 per hour average cost of telephone time to transmit signals. A total 48 hours of
transmission time will be needed to complete the budget each year. The company depreciates this type of
equipment over five years by using straight line method. An alternative approach is to travel to local rented
video conferencing facilities, which can be rented for Rs. 1,500 per hour plus Rs. 400 per hour averge cost for
telephone charges. You are Senior Officer of Finance Department. You have been asked by Ms. Kuthrapali to
EVALUATE the proposal and SUGGEST if it would be worthwhile for the company to implement video
conferencing.
Answer:
Particulars No video conferencing Video conferencing – Video conferencing -
own Rental
Travel cost 7,56,000
[7 locations x 2 persons x 2
trips x Rs.27,000]
Depreciation on 13,20,000
equipment [8,25,000 x 8
locations]/5 years
Transmission cost 1,15,200

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[48 hours x 8 locations
x Rs.300]
Rental cost 5,76,000
[48 hours x 8 location x
Rs.1,500]
Telephone cost 1,53,600
[48 hours x 8 location x
Rs.400 per hour]
Total relevant cost 7,56,000 14,35,200 7,29,600
Analysis: The annual cash outflow is minimum, if video conferencing facility is engaged on rental basis.
Therefore, Option III is suggested

14. Replacement decision (July 2021)

An existing company has a machine which has been in operation for two years, its estimated remaining
useful life is 4 years with no residual value in the end. Its current market value is Rs. 3 lakhs. The management
is considering a proposal to purchase an improved model of a machine gives increase output. The details are
as under:
Particulars Existing Machine New Machine
Purchase price Rs.6,00,000 Rs.10,00,000
Estimated life 6 years 4 years
Residual value 0 0
Annual operating days 300 300
Operating hours per day 6 6
Selling price per unit Rs.10 Rs.10
Material cost per unit Rs.2 Rs.2
Output per hour in units 20 40
Labour cost per hour Rs.20 Rs.30
Fixed overhead per annum excluding depreciation Rs.1,00,000 Rs.60,000
Working capital Rs.1,00,000 Rs.2,00,000
Income-tax rate 30% 30%
Assuming that - cost of capital is 10% and the company uses written down value of depreciation @ 20% and
it has several machines in 20% block. Advice the management on the Replacement of Machine as per the
NPV method.
Answer:
WN 1: Computation of initial outflow:
Particulars Existing Machine New Machine
Capital expenditure - (10,00,000)
NSV of existing asset (3,00,000) -
Working capital (1,00,000) 2,00,000
Initial outflow (4,00,000) (12,00,000)
Note: The company has many assets under 20% block and hence sale of asset will not lead to capital gain and
hence salvage value has been taken as net salvage value

WN 2: In-between cash flows:

New machine:
Particulars Year 1 Year 2 Year 3 Year 4
Units sold [300 days x 6 hours x 40 units] 72,000 72,000 72,000 72,000
Revenues [Units sold x Rs.10] 7,20,000 7,20,000 7,20,000 7,20,000
Less: Material cost -1,44,000 -1,44,000 -1,44,000 -1,44,000
Less: Labour cost [1800 hours x 30] -54,000 -54,000 -54,000 -54,000
Less: Fixed overhead -60,000 -60,000 -60,000 -60,000
Profit before depreciation and taxes [PBDT] 4,62,000 4,62,000 4,62,000 4,62,000
Less: Depreciation (Note 1) -2,16,800 -1,73,440 -1,38,752 -1,11,002
Profit before tax 2,45,200 2,88,560 3,23,248 3,50,998
Less: Tax @ 30% -73,560 -86,568 -96,974 -1,05,299

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Profit after tax 1,71,640 2,01,992 2,26,274 2,45,699
Add: Depreciation 2,16,800 1,73,440 1,38,752 1,11,002
Cash flow after taxes 3,88,440 3,75,432 3,65,026 3,56,701
Note 1: Computation of depreciation:
Particulars Year 1 Year 2 Year 3 Year 4
Opening WDV 10,84,000 8,67,200 6,93,760 5,55,008
Less: Depreciation @ 20% -2,16,800 -1,73,440 -1,38,752 -1,11,002
Closing WDV 8,67,200 6,93,760 5,55,008 4,44,006
• WDV of block at beginning of year 1 = 10,00,000 (capital expenditure) + 3,84,000 (WDV of existing
asset – computed in note 2) – 3,00,000 (sale value of old asset) = Rs.10,84,000

Existing Machine:
Particulars Year 1 Year 2 Year 3 Year 4
Units sold [300 days x 6 hours x 20 units] 36,000 36,000 36,000 36,000
Revenues [Units sold x Rs.10] 3,60,000 3,60,000 3,60,000 3,60,000
Less: Material cost -72,000 -72,000 -72,000 -72,000
Less: Labour cost [1800 hours x 20] -36,000 -36,000 -36,000 -36,000
Less: Fixed overhead -1,00,000 -1,00,000 -1,00,000 -1,00,000
Profit before depreciation and taxes [PBDT] 1,52,000 1,52,000 1,52,000 1,52,000
Less: Depreciation (Note 2) -76,800 -61,440 -49,152 -39,322
Profit before tax 75,200 90,560 1,02,848 1,12,678
Less: Tax @ 30% -22,560 -27,168 -30,854 -33,803
Profit after tax 52,640 63,392 71,994 78,875
Add: Depreciation 76,800 61,440 49,152 39,322
Cash flow after taxes 1,29,440 1,24,832 1,21,146 1,18,197

Note 2: Computation of depreciation:

• Purchase value of asset = Rs.6,00,000
• WDV at end of year 1 = 6,00,000 – (20% x 6,00,000) = Rs.4,80,000
• WDV at end of year 2 = 4,80,000 – (20% x 4,80,000) = Rs.3,84,000 [Today value]
Particulars Year 1 Year 2 Year 3 Year 4
Opening WDV 3,84,000 3,07,200 2,45,760 1,96,608
Less: Depreciation @ 20% -76,800 -61,440 -49,152 -39,322
Closing WDV 3,07,200 2,45,760 1,96,608 1,57,286

WN 3: Computation of terminal flow:

Particulars Existing Machine New Machine
Recapture of working capital 1,00,000 2,00,000
Salvage value of asset 0 0
Terminal flow 1,00,000 2,00,000
Note: There are multiple machines in 20% block and hence we can conclude that there will be no capital loss
at end of year 4. There is no salvage value given in question for these assets

WN 4: Computation of NPV:
Cash flow
Year Existing New Incremental PVF @ 10% DCF
0 -3,00,000 -11,00,000 -8,00,000 1.000 -8,00,000
1 1,29,440 3,88,440 2,59,000 0.909 2,35,431
2 1,24,832 3,75,432 2,50,600 0.826 2,06,996
3 1,21,146 3,65,026 2,43,880 0.751 1,83,154
4 1,18,197 3,56,701 2,38,504 0.683 1,62,898
4 1,00,000 2,00,000 1,00,000 0.683 68,300
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Incremental NPV 56,779
Conclusion: The company should go ahead with the replacement as the same results in incremental positive
NPV of Rs.56,779.

15. Replacement decision [Nov 2021 RTP]

HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of Rs. 2,40,000 on 31st
March 2021. The machine has begun causing problems with breakdowns and it cannot fetch more than Rs.
30,000 if sold in the market at present. It will have no realizable value after 10 years. The company has been
offered Rs. 1,00,000 for the old machine as a trade in on the new machine which has a price (before allowance
for trade in) of Rs. 4,50,000. The expected life of new machine is 10 years with salvage value of Rs. 35,000.

Further, the company follows straight line depreciation method but for tax purpose, written down value
method depreciation @ 7.5% is allowed taking that this is the only machine in the block of assets.

Given below are the expected sales and costs from both old and new machine:
Particulars Old Machine New Machine
Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable OH 56,250 47,500
Fixed OH 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if required rate
of return is 10%? Ignore capital gain tax.
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure -4,50,000
Sale price of old machine 1,00,000
Net outflow -3,50,000
• Capital gain on sale of old asset is to be ignored as question says to ignore capital gain tax

WN 2: In-between flows:
Particulars Calculation Amount
Incremental PBT of new machine 3,87,250 – 3,24,750 62,500
Add: Incremental depreciation as per books 41,500 – 24,000 17,500
Incremental PBDT of new machine 80,000

Cash flows:
Particulars Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
PBDT 80,000 80,000 80,000 80,000 80,000 80,000 80,000 80,000 80,000 80,000
Less: Depreciation -26,250 -24,281 -22,460 -20,776 -19,217 -17,776 -16,443 -15,210 -14,069 -13,014
Profit before tax 53,750 55,719 57,540 59,224 60,783 62,224 63,557 64,790 65,931 66,986
Less: Tax @ 30% -16,125 -16,716 -17,262 -17,767 -18,235 -18,667 -19,067 -19,437 -19,779 -20,096
Profit after tax 37,625 39,003 40,278 41,457 42,548 43,557 44,490 45,353 46,152 46,890
Add: Depreciation 26,250 24,281 22,460 20,776 19,217 17,776 16,443 15,210 14,069 13,014
Cash flow after taxes 63,875 63,284 62,738 62,233 61,765 61,333 60,933 60,563 60,221 59,904

Depreciation:
Particulars Y1 Y2 Y3 Y4 Y5 Y6 Y7 Y8 Y9 Y10
Opening WDV 3,50,000 3,23,750 2,99,469 2,77,009 2,56,233 2,37,016 2,19,240 2,02,797 1,87,587 1,73,518

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Less: Depn -26,250 -24,281 -22,460 -20,776 -19,217 -17,776 -16,443 -15,210 -14,069 -13,014
Closing WDV 3,23,750 2,99,469 2,77,009 2,56,233 2,37,016 2,19,240 2,02,797 1,87,587 1,73,518 1,60,504

WN 3: Terminal flow:
Particulars Amount
Salvage value 35,000
Recapture of working capital 0
Net cash inflow 35,000

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF
0 (3,50,000) 1.000 (3,50,000)
1 63,875 0.909 58,062
2 63,284 0.826 52,273
3 62,738 0.751 47,116
4 62,233 0.683 42,505
5 61,765 0.621 38,356
6 61,333 0.564 34,592
7 60,933 0.513 31,259
8 60,563 0.467 28,283
9 60,221 0.424 25,534
10 94,904 0.386 36,633
NPV 44,613
Conclusion: Since the Incremental NPV is positive, the old machine should be replaced

16. Replacement decision [May 2022 RTP]

ABC & Co. is considering whether to replace an existing machine or to spend money on revamping it. ABC
& Co. currently pays no taxes. The replacement machine costs Rs. 18,00,000 now and requires maintenance
of Rs. 2,00,000 at the end of every year for eight years. At the end of eight years, it would have a salvage value
of Rs. 4,00,000 and would be sold. The existing machine requires increasing amounts of maintenance each
year and its salvage value fall each year as follows
Year Maintenance Salvage
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0
The opportunity cost of capital for ABC & Co. is 15%.
REQUIRED:
When should the company replace the machine?
Answer:
WN 1: PV of outflow if machine is replaced today:
Year Cash flow PVF @ 15% DCF
0 -10,00,000 1.000 -10,00,000
[-18,00,000 + 10,00,000]
1 to 8 -2,00,000 4.487 -8,97,400
8 4,00,000 0.327 1,30,800
PV of outflow 17,66,600
No of years 8 years
PVAF (15%, 8 years) 4.487
EAC 3,93,715

WN 2: PV of outflow if machine is replaced at end of year 1:

Year Cash flow PVF @ 15% DCF
0 0 1.000 0

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1 -15,00,000 0.870 -13,05,000
[-18,00,000 – 5,00,000 – 2,00,000]
2 to 9 -2,00,000 3.902 -7,80,400
9 4,00,000 0.284 1,13,600
PV of outflow 19,71,800
No of years 9 years
PVAF (15%, 8 years) 4.772
EAC 4,13,202

WN 3: PV of outflow if machine is replaced at end of year 2:

Year Cash flow PVF @ 15% DCF
0 0 1.000 0
1 -2,00,000 0.870 -1,74,000
2 -19,00,000 0.756 -14,36,400
[-18,00,000 - 4,00,000 + 3,00,000]
3 to 10 -2,00,000 3.393 -6,78,600
10 4,00,000 0.247 98,800
PV of outflow 21,90,200
No of years 10 years
PVAF (15%, 8 years) 5.019
EAC 4,36,382

WN 4: PV of outflow if machine is replaced at end of year 3:

Year Cash flow PVF @ 15% DCF
0 0 1.000 0
1 -2,00,000 0.870 -1,74,000
2 -4,00,000 0.756 -3,02,400
3 -22,00,000 0.658 -14,47,600
[-18,00,000 - 6,00,000 + 2,00,000]
4 to 11 -2,00,000 2.950 -5,90,000
11 4,00,000 0.215 86,000
PV of outflow 24,28,000
No of years 11 years
PVAF (15%, 8 years) 5.234
EAC 4,63,890

WN 5: PV of outflow if machine is replaced at end of year 4:

Year Cash flow PVF @ 15% DCF
0 0 1.000 0
1 -2,00,000 0.870 -1,74,000
2 -4,00,000 0.756 -3,02,400
3 -6,00,000 0.658 -3,94,800
4 -26,00,000 0.572 -14,87,200
[-18,00,000 - 8,00,000]
5 to 12 -2,00,000 2.566 -5,13,200
12 4,00,000 0.187 74,800
PV of outflow 27,96,800
No of years 12 years
PVAF (15%, 8 years) 5.421
EAC 5,15,920
Conclusion:
• The company should go ahead with immediate replacement as the same has the lowest equated
annual cost

17. Replacement Decision [Dec 2021]

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Stand Ltd. is contemplating replacement of one of its machines which has become outdated and inefficient.
Its financial manager has prepared a report outlining two possible replacement machines. The details of each
machine are as follows:
Particulars Machine 1 Machine 2
Initial investment 12,00,000 16,00,000
Estimated useful life 3 years 5 years
Residual value 1,20,000 1,00,000
Contribution per annum 11,60,000 12,00,000
Fixed maintenance costs per annum 40,000 80,000
Other fixed operating costs per annum 7,20,000 6,10,000
The maintenance costs are payable annually in advance. All other cash flows apart from the initial investment
assumed to occur at the end of each year. Depreciation has been calculated by straight line method and has
been included in other fixed operating costs. The expected cost of capital for this project is assumed as 12%
p.a.
Required:
a) Which machine is more beneficial, using Annualized Equivalent Approach? Ignore tax.
b) Calculate the sensitivity of your recommendation in part (a) to changes in the contribution generated
by machine 1.

Answer:
WN 1: Computation of cash flows:
Machine 1:
Year Investment Salvage Contribution Maintenance Other fixed Net cash
value cost cost flow
0 -12,00,000 - -40,000 -12,40,000
1 - - 11,60,000 -40,000 -3,60,000 7,60,000
2 - - 11,60,000 -40,000 -3,60,000 7,60,000
3 - 1,20,000 11,60,000 -3,60,000 9,20,000
Note:
• Depreciation per annum = [12,00,000 – 1,20,000]/3 = Rs.3,60,000
• Other fixed cash cost = 7,20,000 – 3,60,000 = Rs.3,60,000
Machine 2:
Machine 1:
Year Investment Salvage Contribution Maintenance Other fixed Net cash
value cost cost flow
0 -16,00,000 - -80,000 - -16,80,000
1 - - 12,00,000 -80,000 -3,10,000 8,10,000
2 - - 12,00,000 -80,000 -3,10,000 8,10,000
3 - - 12,00,000 -80,000 -3,10,000 8,10,000
4 - - 12,00,000 -80,000 -3,10,000 8,10,000
5 - 1,00,000 12,00,000 -3,10,000 9,90,000
Note:
• Depreciation per annum = [16,00,000 – 1,00,000]/5 = Rs.3,00,000
• Other fixed cash cost = 6,10,000 – 3,00,000 = Rs.3,10,000

WN 2: Computation of NPV and EAB:

Machine 1:
Year Cash flow PVF @ 12% DCF
0 -12,40,000 1.000 -12,40,000
1 7,60,000 0.893 6,78,680
2 7,60,000 0.797 6,05,720
3 9,20,000 0.712 6,55,040
NPV of Project 6,99,440
PVAF (12%,3 years) 2.402
EAB of Project 2,91,191

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Machine 2:
Year Cash flow PVF @ 12% DCF
0 -16,80,000 1.000 -16,80,000
1 8,10,000 0.893 7,23,330
2 8,10,000 0.797 6,45,570
3 8,10,000 0.712 5,76,720
4 8,10,000 0.636 5,15,160
5 9,90,000 0.567 5,61,330
NPV of Project 13,42,110
PVAF (12%,5 years) 3.605
EAB of Project 3,72,291
Recommendation: Machine 2 is more beneficial using Equivalent Annualized Criterion.

WN 3: Sensitivity Analysis:
Approach 1:
Difference in Equivalent Annualized Criterion of Machines required for changing the recommendation in
part (i) = 3,72,291- 2,91,191 = Rs.81,100

𝟖𝟏, 𝟏𝟎𝟎
𝐒𝐞𝐧𝐬𝐢𝐭𝐢𝐯𝐢𝐭𝐲 % = 𝐱 𝟏𝟎𝟎 = 𝟔. 𝟗𝟗% (𝐨𝐫)𝟕% 𝐨𝐟 𝐜𝐨𝐧𝐭𝐫𝐢𝐛𝐮𝐭𝐢𝐨𝐧 𝐨𝐟 𝐌𝐚𝐜𝐡𝐢𝐧𝐞 𝟏
𝟏𝟏, 𝟔𝟎, 𝟎𝟎𝟎

18. Best and worst case NPV [May 2022 RTP]

ASG Ltd. is considering a project “Z” with an initial outlay of Rs. 15,00,000 and life of 5 years. The estimates
of project are as follows:
Particulars Lower estimates Base Upper estimates
Sales (units) 9,000 10,000 11,000
Amount Amount Amount
Selling price per unit 175 200 225
Variable cost per unit 100 125 150
Fixed cost 1,00,000 1,50,000 2,00,000
Depreciation included in Fixed cost is Rs. 70,000 and corporate tax is 25%. Assuming the cost of capital as
15%, DETERMINE NPV in three scenarios i.e worst, base and best case scenario.
Answer:
WN 1: Computation of CFAT under different scenarios:
• Best case = Highest units (11,000), highest SP (225), lowest VC (100) and lowest FC (1,00,000)
• Worst case = Lowest units (9,000), lowest SP (175), highest V (150) and highest FC (2,00,000)
• Base case =As given in question

Particulars Worst Base Best

Sales (units) 9,000 10,000 11,000
Selling price 175 200 225
Less: VC per unit 150 125 100
Contribution per unit 25 75 125
Total Contribution 2,25,000 7,50,000 13,75,000
Less: Fixed cost -2,00,000 -1,50,000 -1,00,000
Profit before tax 25,000 6,00,000 12,75,000
Less: Tax @ 25% -6,250 -1,50,000 -3,18,750
Profit after tax 18,750 4,50,000 9,56,250
Add: Depreciation 70,000 70,000 70,000
Cash flow after tax 88,750 5,20,000 10,26,250

WN 2: Computation of NPV:
Particulars Worst Base Best
Initial outlay 15,00,000 15,00,000 15,00,000
Cash inflow per year 88,750 5,20,000 10,26,250
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Cumulative PVF for 5 years 3.353 3.353 3.353
PV of cash inflows 2,97,579 17,43,560 34,41,016
NPV -12,02,421 2,43,560 19,41,016

19. RADR Approach (July 2021)

K.P. Ltd. is investing Rs. 50 lakhs in a project. The life of the project is 4 years. Risk free rate of return is 6%
and risk premium is 6%, other information is as under
Sales of 1st year Rs.50,00,000
Sales of 2nd year Rs.60,00,000
Sales of 3rd year Rs.70,00,000
Sales of 4th year Rs.80,00,000
PVR (same in all years) 50%
Fixed cost (excluding depreciation) of first year Rs.10,00,000
Fixed cost (excluding depreciation) of second year Rs.12,00,000
Fixed cost (excluding depreciation) of third year Rs.14,00,000
Fixed cost (excluding depreciation) of fourth year Rs.16,00,000
Ignoring interest and taxes. You are required to calculate NPV of given project on the basis of Risk Adjusted
Discount Rate.
Answer:
WN 1: Computation of project cash flows:
Particulars Year 1 Year 2 Year 3 Year 4
Sales 50,00,000 60,00,000 70,00,000 80,00,000
Contribution 25,00,000 30,00,000 35,00,000 40,00,000
[Sales x PVR]
Less: Fixed cost -10,00,000 -12,00,000 -14,00,000 -16,00,000
PBDT/CFAT 15,00,000 18,00,000 21,00,000 24,00,000
Note: Interest and taxes are to be ignored and hence PBDT would be equal to CFAT.
WN 2: Computation of Risk-adjusted NPV:
Year Cash flow PVF @ 12% DCF
0 -50,00,000 1.000 -50,00,000
1 15,00,000 0.893 13,39,500
2 18,00,000 0.797 14,34,600
3 21,00,000 0.712 14,95,200
4 24,00,000 0.636 57,95,700
NPV of project 7,95,700

20. Step-up growth model [Dec 2021]

X Ltd. is a multinational company. Current market price per share is Rs. 2,185. During the F.Y. 2020-21, the
company paid Rs. 140 as dividend per share. The company is expected to grow @ 12% p.a. for next four years,
then 5% p.a. for an indefinite period. Expected rate of return of shareholders is 18% p.a.
• Find out intrinsic value per share.
• State whether shares are overpriced or underpriced.
Answer:
WN 1: Computation of dividends till first year of stabilization phase [Year 5]
Year Growth Rate Dividend
1 12% 156.80
[140 + 12%]
2 12% 175.62
[156.80 + 12%]
3 12% 196.69
[175.62 + 12%]
4 12% 220.29
[196.69 + 12%]
5 5% 231.30

WN 2: Computation of MPS at beginning of stabilization phase [Year 4]

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D5 231.30
P4 = = = 𝑅𝑠. 1,779.23
K e − G 18% − 5%

WN 3: Computation of intrinsic value:

Year Cash flow PVF @ 18% DCF
1 156.80 0.847 132.81
2 175.62 0.718 126.10
3 196.69 0.608 119.59
4 220.29 0.515 113.45
4 1,779.23 0.515 916.30
Intrinsic Value of Share 1,408.25
Intrinsic value of share is Rs.1,408.25 as compared to latest market price of Rs.2,185. Market price of share is
over-priced by Rs.776.75.

21. Working capital forecast, P&L and Balance Sheet [Nov 2021 MTP]
On 01st April, 2020, the Board of Director of ABC Ltd. wish to know the amount of working capital that
will be required to meet the programme they have planned for
the year. From the following information, PREPARE a working capital requirement forecast and a forecast
profit and loss account and balance sheet:
• Issued share capital = Rs.6,00,000
• 10% debentures = Rs.1,00,000
• Fixed assets = Rs.4,50,000
Production during the previous year was 1,20,000 units; it is planned that this level of activity should be
maintained during the present year. The expected ratios of cost to selling price are: raw materials 60%, direct
wages 10% overheads 20% Raw materials are expected to remain in store for an average of two months before
issue to production. Each unit of production is expected to be in process for one month. The time lag in wage
payment is one month. Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately three months. Credit allowed by creditors is two months from the date of delivery of raw
materials. Credit given to debtors is three months from the date of dispatch. Selling price is Rs. 5 per unit.
There is a regular production and sales cycle and wages and overheads accrue evenly
Answer:
WN 1: Preparation of Profit and Loss Account:
Particulars Amount Particulars Amount
To Material consumed 3,60,000 By Sales [1,20,000 x 5] 6,00,000
[1,20,000 x 3]
To Direct wages 60,000
[1,20,000 x 0.50]
To Overheads 1,20,000
[1,20,000 x 1.00]
To Gross Profit 60,000
Total 6,00,000 Total 6,00,000
To Debenture interest 10,000 By Gross Profit 60,000
[1,00,000 x 10%]
To Net profit 50,000
Total 60,000 Total 60,000

WN 2: Estimation of working capital:

Particulars Calculation Amount
Current Assets:
Stock of Raw material 2
(Based on RM Consumed) 3,60,000 x ( ) 60,000
12
Stock of WIP Note 1 37,500

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(based on COP)
Stock of FG 3
(based on COGS) 5,40,000 x ( ) 1,35,000
12
Debtors 3
(based on credit sales) 6,00,000 x ( ) 1,50,000
12
Total Current Assets (A) 3,82,500

Current liabilities
Creditors 2
(Based on credit purchases) 3,60,000 x ( ) 60,000
12
Outstanding wages 1
(Based on total wages) 60,000 x ( ) 5,000
12
Total Current Liabilities (B) 65,000
Working capital (A-B) 3,17,500

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 5,40,000
Direct Material 3,60,000
Other costs 1,80,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
1
Direct Material 3,60,000 x ( ) x 100% 30,000
12
1
Other costs 1,80,000 x ( ) x 50% 7,500
12
Overall stock of WIP 37,500

WN 3: Balance Sheet as on 31.03.2021:

Liabilities Amount Assets Amount
Issued share capital 6,00,000 Fixed assets 4,50,000
Profit and loss account 50,000 Current assets:
10% debentures 1,00,000 Stock of RM 60,000
Creditors 65,000 Stock of WIP 37,500
Bank OD (b/f) 17,500 Stock of FG 1,35,000
Debtors 1,50,000
Total 8,32,500 Total 8,32,500

22. Cash flow management [May 2022 RTP]

You are given below the Profit & Loss Accounts for two years for a company:
Particulars Year 1 Year 2 Particulars Year 1 Year 2
To opening stock 32,00,000 40,00,000 By sales 3,20,00,000 4,00,00,000
To Raw materials 1,20,00,000 1,60,00,000 By closing stock 40,00,000 60,00,000
To stores 38,40,000 48,00,000 By Misc income 4,00,000 4,00,000
To manufacturing expenses 51,20,000 64,00,000
To other expenses 40,00,000 40,00,000
To Depreciation 40,00,000 40,00,000
To Net profit 42,40,000 72,00,000
Total 3,64,00,000 4,64,00,000 Total 3,64,00,000 4,64,00,000
Sales are expected to be Rs. 4,80,00,000 in year 3.
As a result, other expenses will increase by Rs. 20,00,000 besides other charges. Only raw materials are in
stock. Assume sales and purchases are in cash terms and the closing stock is expected to go up by the same
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amount as between year 1 and 2. You may assume that no dividend is being paid. The Company can use 75%
of the cash generated to service a loan. COMPUTE how much cash from operations will be available in year
3 for the purpose? Ignore income tax.
Answer:
(in lacs)
Particulars Year 1 Year 2 Year 3
Sales 320.00 400.00 480.00
Less: RM consumed -152.00 -140.00 -168.00
[O/s + Purchase – C/s]
Less: Stores -38.40 -48.00 -57.60
Less: Manufacturing expenses -51.20 -64.00 -76.80
Less: Other expenses -40.00 -40.00 -60.00
Profit before depreciation and tax 38.40 108.00 117.60
Add: Miscellaneous income 4.00 4.00 4.00
Cash flow 42.40 112.00 121.60
Less: Change in working capital -8.00 -20.00 -20.00
Cash flow post WC changes 32.40 92.00 101.60
• Amount available for servicing loan = 75% x 1,01,60,000 = Rs.76,20,000
Note:
• RM consumed in year 1 and year 2 = 35% of sales. Hence RM consumed of year 3 = 35% of 480 lacs
= Rs.168 lacs
• Stores in year 1 and year 2 = 12% of sales. Hence stores of year 3 = 12% of 480 lacs = Rs.57.60 lacs
• Manufacturing expenses of year 1 and 2 = 16% of sales. Hence expenses of year 3 = 16% x 480 lacs =
Rs.76.80 lacs

23. Cash budget [Dec 2021]

A garment trader is preparing cash forecast for first three months of calendar year 2021. His estimated sales
for the forecasted periods are as below:
January February March
Total sales 6,00,000 6,00,000 8,00,000
• The trader sells directly to public against cash payments and to other entities on credit. Credit sales
are expected to be four times the value of direct sales to public. He expects 15% customers to pay in
the month in which credit sales are made, 25% to pay in the next month and 58% to pay in the next
to next month. The outstanding balance is expected to be written off.
• Purchases of goods are made in the month prior to sales and it amounts to 90% of sales and are made
on credit. Payments of these occur in the month after the purchase. No inventories of goods are held.
• Cash balance as on 1st January, 2021 is Rs. 50,000.
• Actual sales for the last two months of calendar year 2020 are as below:
November December
Total sales 6,40,000 8,80,000
You are required to prepare a monthly cash, budget for the three months from January to March, 2021.
Answer:
Monthly cash budget for the period of January to March 2021:
Particulars January February March
Opening cash balance 50,000 1,74,960 2,89,680
Add: Inflows
Cash sales 1,20,000 1,20,000 1,60,000
Collection from customers 5,44,960 6,00,320 4,94,400
Total inflows 6,64,960 7,20,320 6,54,400
Less: Outflows
Payment to suppliers [Note 2] 5,40,000 5,40,000 7,20,000
Closing cash balance 1,74,960 3,55,280 2,89,680

Note 1: Computation of cash sales and collection from customers:

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Particulars November December January February March Total
Total Sales 6,40,000 8,80,000 6,00,000 6,00,000 8,00,000
Cash sales 1,28,000 1,76,000 1,20,000 1,20,000 1,60,000
Credit sales 5,12,000 7,04,000 4,80,000 4,80,000 6,40,000
Collection in Jan 2,96,960 1,76,000 72,000 NA 5,44,960
Collection in Feb 4,08,320 1,20,000 72,000 6,00,320
Collection in Mar 2,78,400 1,20,000 96,000 4,94,400
• Credit sales are four times of cash sales. Cash sales + Credit sales = Total sales; Cash sales + 4 (cash
sales) = Total sales; 5 (Cash sales) = Total sales; Cash sales = 20% of credit sales
• Credit sales collection = 15% in same month + 25% in next month and 58% in second month
• Collection in January for Nov month sales = 5,12,000 x 58%
• Collection in January for Dec month sales = 7,04,000 x 25%
• Other amounts are computed in similar manner

Note 2: Payment to suppliers:

• Purchase = 90% of previous month sales. Payment is made in the next month of purchases. Hence,
we can conclude that payment to suppliers is equal to 90% of sales of current month

24. Receivables Management [Nov 2021 RTP]

The Alliance Ltd., a Petrochemical sector company had just invested huge amount in its new expansion
project. Due to huge capital investment, the company is in need of an additional Rs. 1,50,000 in working
capital immediately. The Finance Manger has determined the following three feasible sources of working
capital funds:
(i) Bank loan: The Company's bank will lend Rs. 2,00,000 at 15%. A 10% compensating balance will be
required, which otherwise would not be maintained by the company.
(ii) Trade credit: The company has been offered credit terms from its major supplier of 3/30, net 90 for
purchasing raw materials worth Rs. 1,00,000 per month.
(iii) Factoring: A factoring firm will buy the company’s receivables of Rs. 2,00,000 per month, which have a
collection period of 60 days. The factor will advance up to 75% of the face value of the receivables at 12% on
an annual basis. The factor will also charge commission of 2% on all receivables purchased. It has been
estimated that the factor’s services will save the company a credit department expense and bad debt expense
of Rs. 1,250 and Rs. 1,750 per month respectively.
On the basis of annual percentage cost, ADVISE which alternative should the company select? Assume 360
days year
Answer:
Cost of Bank Loan:
Since the compensating balance would not otherwise be maintained, the real annual cost of taking bank loan
would be:
15
Cost of Bank loan = x 100 = 16.67%
90

Cost of Trade Credit:

Amount upto Rs.1,50,000 can be raised within 2 months or 60 days. The real annual cost of trade credit would
be:
3 360
Cost of Trade Credit = x x 100 = 18.56%
97 60

Cost of Factoring:
Particulars Amount
Commission charges [2% x 24,00,000] 48,000
Less: Admin cost saving [1,250 + 1,750] x 12 -36,000
Net cost of factoring (excluding interest) 12,000
Annual Cost of Borrowing Rs.1,50,000 receivables through factoring would be:
(12% x 1,50,000) + 12,000 18,000 + 12,000
x 100 = 𝑥 100 = 20.00%
1,50,000 1,50,000

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Conclusion: The company should select alternative of Bank Loan as it has the lowest annual cost i.e. 16.67%
p.a.

25. Receivables Management (July 2021)

Current annual sale of SKD Ltd. is Rs. 360 lakhs. It's directors are of the opinion that company's current
expenditure on receivables management is too high and with a view to reduce the expenditure they are
considering following two new alternate credit policies:
Particulars Policy X Policy Y
Average collection period 1.5 months 1 month
% of default 2% 1%
Annual collection expenditure 12,00,000 20,00,000
Selling price per unit is Rs.150. Total cost per unit is Rs.120. Current credit terms are 2 months and percentage
of default is 3%. Current annual collection expenditure is Rs.8,00,000. Required rate of return on investment
of SKD Limited is 20%. Determine which credit policy SKD Limited should follow.
Answer:
Evaluation of credit policy:
Particulars Existing Policy X Policy Y
Sales 360.00 360.00 360.00
Less: Total Cost [360.00 x 120/150] -288.00 -288.00 -288.00
Gross Benefit 72.00 72.00 72.00
Less: Interest cost (Note 1) -9.60 -7.20 -4.80
Less: Bad debt -10.80 -7.20 -3.60
Less: Collection expenditure -8.00 -12.00 -20.00
Net Benefit 43.60 45.60 43.60
• Company should go ahead with Policy X as it has the highest net benefit

Note 1: Computation of interest cost:

Particulars Existing Policy X Policy Y
Full cost of Sales 288.00 288.00 288.00
Debtors (Full Cost x CP/12) 48.00 36.00 24.00
Interest cost (Debtors x Return %) 9.60 7.20 4.80
• It is assumed debtors are valued based on full cost of sales

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