CA INTER FM

FINANCIAL
MANAGEMENT

 Revised & Updated

 ICAI Study Material Coverage
 Includes Examination Questions, MTP & RTP
 Video Lectures Available in Google Drive & Pendrive

Published By
FINANCIAL MANAGEMENT

COPYRIGHT © 2020 PAVAN SIR SFM CLASSES

All rights reserved. This book or any portion thereof may not be reproduced or used in any
manner whatsoever without the express written permission of the publisher except for the use
of brief quotations in a book review.

CONNECT WITH US

https://www.pavansirsfmclasses.com

https://www.youtube.com/c/CAPAVANKARMELE

pavansirclasses1982@gmail.com

pavansir_classes

+91 9977213599, +91 9617826417

Contact Us for Technical and General Help

+91 9977213599

+91 9617826417

+91 7804910484

Printed by Pavan Sir SFM Classes

Printed in the India

Available from website and other retail outlets

 INDEX
Chapters Page No.
5_INVESTMENT_DECISIONS 409 – 539

6_DIVIDEND_DECISIONS 540 – 611

7_MANAGEMENT_OF_WORKING_CAPITAL 612 – 784

8_TABLES
 [INVESTMENT DECISIONS]

CHAPTER – 05

INVESTMENT DECISIONS

(1) BASICS

Question – 01
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base
of ₹ 1,00,000; expected economic life of 4 years and change in earnings before
taxes and depreciation of ₹ 45,000 in year 1, ₹ 30,000 in year 2, ₹ 25,000 in
year 3 and ₹ 35,000 in year 4. Assume straight-line depreciation and a 20% tax
rate. You are required to COMPUTE relevant cash flows.

(Study Material ICAI Illus – 01)

Solution:

Depreciation = ₹ 1,00,000 ÷ 4 = ₹ 25,000

Amount in (₹)

Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
Earnings after tax 16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000

Question – 02
A project requiring an investment of ₹ 10,00,000 and it yields profit after tax
and depreciation which is as follows:

Years Profit after tax and depreciation (₹)

1 50,000
2 75,000
3 1,25,000
4 1,30,000

409
 [INVESTMENT DECISIONS]

5 80,000
Total 4,60,000

Suppose further that at the end of the 5th year, the plant and machinery of the
project can be sold for ₹ 80,000. DETERMINE Average Rate of Return.

(Study Material ICAI Illus – 02)

Solution:

In this case the rate of return can be calculated as follows:

Total Profit ÷ No. of years

× 100
Average investment/Initial Investment

(a) If initial investment is considered then,

₹ 4,60,000÷ 5 years ₹ 92,000

= × 100 = × 100 = 9.2%
₹ 10,00,000 ₹ 10,00,000

This rate is compared with the rate expected on other projects, had the
same funds been invested alternatively in those projects. Sometimes, the
management compares this rate with the minimum rate (called-cut off
rate). For example, management may decide that they will not undertake
any project which has an average annual yield after tax less than 20%.
Any capital expenditure proposal which has an average annual yield of
less than 20%, will be automatically rejected.

(b) If average investment is considered then,

₹ 92,000 ₹ 92,000
= × 100 = × 100 = 17.04%
Average Investment ₹ 50,40,000

Where,

Average Investment

= ½ (Initial investment – Salvage value) + Salvage value

= ½ (₹ 10,00,000 – ₹ 80,000) + ₹ 80,000

= ₹ 4,60,000 + ₹ 80,000

= ₹ 5,40,000

410
 [INVESTMENT DECISIONS]

Question – 03
COMPUTE the net present value for a project with a net investment of ₹
1,00,000 and net cash flows for year one is ₹ 55,000; for year two is ₹ 80,000
and for year three is ₹ 15,000. Further, the company‟s cost of capital is 10%.

[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]

(Study Material ICAI Illus – 03)

Solution:

Year Nest Cash PVIF @ 10% Discounted Cash

Flows (₹) Flows (₹)
0 (1,00,000) 1.000 (1,00,000)
1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
Net Present Value 27,340

Recommendation: Since the net present value of the project is positive, the
company should accept the project.

Question – 04
ABC Ltd. is a small company that is currently analyzing capital expenditure
proposals for the purchase of equipment; the company uses the net present
value technique to evaluate projects. The capital budget is limited to ₹ 500,000
which ABC Ltd. believes is the maximum capital it can raise. The initial
investment and projected net cash flows for each project are shown below. The
cost of capital of ABC Ltd is 12%. You are required to COMPUTE the NPV of the
different projects.

Project A Project B Project C Project D

(₹) (₹) (₹) (₹)
Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows:
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000

(Study Material ICAI Illus – 04)

411
 [INVESTMENT DECISIONS]

Solution:

Calculation of net present value:

Period PV Factor Project A Project B Project C Project D

(₹) (₹) (₹) (₹)
0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)

Question – 05
Suppose we have three projects involving discounted cash outflow of ₹
5,50,000, ₹ 75,000 and ₹ 1,00,20,000 respectively. Suppose further that the
sum of discounted cash inflows for these projects are ₹ 6,50,000, ₹ 95,000 and
₹ 1,00,30,000 respectively. CALCULATE the desirability factors for the three
projects.

(Study Material ICAI Illus – 05)

Solution:

The desirability factors for the three projects would be as follows:

₹6,50,000
1. = = 1.18
₹5,50,000

₹95,000
2. = = 1.27
₹75,000

₹1,00,30,000
3. = = 1.001
₹1,00,20,000

It can be seen that in absolute terms, project 3 gives the highest cash inflows
yet its desirability factor is low. This is because the outflow is also very high.
The Desirability/ Profitability Index factor helps us in ranking various
projects.

Since PI is an extension of NPV, it has same advantages and limitation.

412
 [INVESTMENT DECISIONS]

Question – 06
A Ltd. is evaluating a project involving an outlay of ₹ 10,00,000 resulting in an
annual cash inflow of ₹ 2,50,000 for 6 years. Assuming salvage value of the
project is zero; DETERMINE the IRR of the project.

(Study Material ICAI Illus – 06)

Solution:

First of all, we shall find an approximation of the payback period:

10,00,000
= =4
2,50,000

Now, we shall search this figure in the PVAF table corresponding to 6-year row.

The value 4 lies between values 4.111 and 3.998, correspondingly discounting
rates are 12% and 13% respectively

NPV @ 12% and 13% is:

NPV12% = (10,00,000) + 4.111 × 2,50,000 = +27,750

NPV13% = (10,00,000) + 3.998 × 2,50,000 = -500

The internal rate of return is, thus, more than 12% but less than 13%. The
exact rate can be obtained by interpolation:

27,750
IRR = 12% + × (13% - 12%)
2,50,000 – (-500)

27,750
= 12% + = 12.978%
28,250

IRR = 12.978%

Question – 07
CALCULATE the internal rate of return of an investment of ₹ 1,36,000 which
yields the following cash inflows:

Year Cash Inflows (₹)

1 30,000
2 40,000
3 60,000

413
 [INVESTMENT DECISIONS]

4 30,000
5 20,000

(Study Material ICAI Illus – 07)

Solution:

Let us discount cash flows by 10%.

Year Cash Inflows (₹) Discounting Present Value (₹)

Factor at 10%
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
Total present value 1,38,280
Less: Initial Investment 1,36,000
NPV +2,280

The NPV calculated @ 10% is positive. Therefore, a higher discount rate is

suggested, say, 12%.

Year Cash Inflows (₹) Discounting Present Value (₹)

Factor at 12%
1 30,000 0.893 26,790
2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Total present value 1,31,810
Less: Initial Investment 1,36,000
NPV - 4,190

The internal rate of return is, thus, more than 10% but less than 12%. The
exact rate can be obtained by interpolation:

NPV at LR
IRR = LR + × (HR – LR%)
NPV at LR – NPV at HR

₹ 2,280
= 10 + × (12 – 10)
₹ 2,280 – (-4,190)

414
 [INVESTMENT DECISIONS]

₹ 2,280
= 10 + × (12 – 10) = 10 + 0.704
₹ 6,470

IRR = 10.704%.

Question – 08
A company proposes to install machine involving a capital cost of ₹ 3,60,000.
The life of the machine is 5 years and its salvage value at the end of the life is
nil. The machine will produce the net operating income after depreciation of ₹
68,000 per annum. The company's tax rate is 45%.

The Net Present Value factors for 5 years are as under:

Discounting Rate 14 15 16 17 18
Cumulative Factor 3.43 3.35 3.27 3.20 3.13

You are required to COMPUTE the internal rate of return of the proposal.

(Study Material ICAI Illus – 08)

Solution:

Computation of Cash inflow per annum

Particulars (₹)
Net operating income per annum 68,000
Less: Tax @ 45% (30,600)
Profit after tax 37,400
Add: Depreciation (₹ 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400

The IRR of the investment can be found as follows:

NPV = − ₹ 3,60,000 + ₹ 1,09,400 (PVAF5, r) = 0

₹ 3,60,000
or PVAF5,r (Cumulative factor) = = 3.29
₹ 1,09,400

As 3.29 falls between Discounted rate 15 & 16, the computation is as below :

Computation of Internal Rate of Return

Discounting Rate
15% 16%
Cumulative factor 3.35 3.27

415
 [INVESTMENT DECISIONS]

PV of Inflows (₹) 3,66,490 3,57,738

(₹ 1,09,400 × 3.35) (₹ 1,09,400 × 3.27)
Less: Initial outlay (₹) 3,60,000 3,60,000
NPV (₹) 6,490 (2,262)

6,490
IRR = 15 + × (16 – 15) = 15 + 0.74 = 15.74%.
6,490+2,262

Question – 09
An investment of ₹ 1,36,000 yields the following cash inflows (profits before
depreciation but after tax). DETERMINE MIRR considering 8% as cost of
capital.

Year (₹)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

(Study Material ICAI Illus – 09)

Solution:

Year 0 – Cash outflow = ₹ 1,36,000

The MIRR is calculated on the basis of investing the inflows at the cost of
capital. The table below shows the value of the inflows, if they are immediately
reinvested at 8%.

Year Cash Flow @ 8% Reinvestment (₹)

Rate Factor
1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587

* Investment of ₹ 1 at the end of the year 1 is reinvested for 4 years (at the end
of 5 years) shall become 1(1.08)4 = 1.3605. Similarly, reinvestment rate factor

416
 [INVESTMENT DECISIONS]

for remaining years shall be calculated. Please note that the investment at the
end of 5th year shall be reinvested for zero year, hence, reinvestment rate
factor shall be 1.

The total cash outflow in year 0 (₹ 1,36,000) is compared with the possible
1,36,000
inflow at year 5 and the resulting figure = = 0.6367 is the discount
2,13,587
factor in year 5. By looking at the year 5 row in the present value tables, you
will see that this gives a return of 9%. This means that the ₹ 2,13,587 received
in year 5 is equivalent to ₹ 1,36,000 in year 0 if the discount rate is 9%.
Alternatively, we can compute MIRR as follows:

2,13,587
Total return = = 1.5705
1,36,000

1/5
MIRR = 1.5705 – 1 = 9%.

Question – 10
Suppose there are two Project A and Project B are under consideration. The
cash flows associated with these projects are as follows:

Year Project B (₹) Project B (₹)

0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000

Assuming Cost of Capital equal to 10%, IDENTIFY which project should be

accepted as per NPV Method and IRR Method.

(Study Material ICAI Illus – 10)

Solution:

Net Present Value (NPV) of Projects

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @
(₹) (₹) 10% (₹) (₹)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.909 45,450 1,27,260

417
 [INVESTMENT DECISIONS]

2 60,000 1,90,000 0.826 49,560 1,56,940

3 40,000 1,00,000 0.751 30,040 75,100
NPV 25,050 59,300

Internal Rate of Returns (IRR) of projects

Since by discounting cash flows at 10%, we are getting values very far from
zero. Therefore, let us discount cash flows using 20% discounting rate.

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @
(₹) (₹) 20% (₹) (₹)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.833 41,650 1,16,620
2 60,000 1,90,000 0.694 41,640 1,31,860
3 40,000 1,00,000 0.579 23,160 57,900
NPV 6,450 6,380

Even by discounting cash flows at 20%, we are getting values far from zero.
Therefore, let us discount cash flows using 25% discounting rate.

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @
(₹) (₹) 25% (₹) (₹)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600
3 40,000 1,00,000 0.512 20,480 51,200
NPV (1,120) (15,200)

The internal rate of return is, thus, more than 20% but less than 25%. The
exact rate can be obtained by interpolation:

6,450
IRRA = 20% + × (25% - 20%)
6,450 – (1,120)

6,450
= 20% + 7,570 × 5% = 24.26%

6,380
IRRB = 20% + × (25% - 20%)
6,380 – (15,200)

418
 [INVESTMENT DECISIONS]

6,380
= 20% + 21,580 × 5% = 21.48%

Overall Position

Project A Project B
NPV @ 10% ₹ 25,050 ₹ 59,300
IRR 24.26% 21.48%

Thus, there is contradiction in ranking by two methods.

Question – 11
Suppose ABC Ltd. is considering two Project X and Project Y for investment.
The cash flows associated with these projects are as follows:

Year Project X (₹) Project Y (₹)

0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000

Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted

as per NPV Method and IRR Method.

(Study Material ICAI Illus – 11)

Solution:

Net Present Value of Projects

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project X Project Y
Project X Project Y Factor @ (₹) (₹)
(₹) (₹) 10%
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.909 1,81,800 45,450
2 1,00,000 1,00,000 0.826 82,600 82,600
3 50,000 3,00,000 0.751 37,550 2,25,300
NPV 51,950 53,350

Internal Rate of Returns of projects

Since, by discounting cash flows at 10%, we are getting values far from zero.
Therefore, let us discount cash flows using 20% discounting rate.

419
 [INVESTMENT DECISIONS]

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project X Project Y
Project X Project Y Factor @ (₹) (₹)
(₹) (₹) 20%
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.833 1,66,600 41,650
2 1,00,000 1,00,000 0.694 69,400 69,400
3 50,000 3,00,000 0.579 28,950 1,73,700
NPV 14,950 (15,250)

Since, by discounting cash flows at 20% we are getting that value of Project X
is positive and value of Project Y is negative. Therefore, let us discount cash
flows of Project X using 25% discounting rate and Project Y using discount rate
of 15%.

Year Cash Present PV of Cash Present PV of

Inflows of Value Project X Inflows of Value Project Y
Project X Factor @ (₹) Project Y Factor @ (₹)
(₹) 25% (₹) 15%
0 (2,50,000) 1.000 (2,50,000) (3,00,000) 1.000 (3,00,000)
1 2,00,000 0.800 1,60,000 50,000 0.870 43,500
2 1,00,000 0.640 64,000 1,00,000 0.756 75,600
3 50,000 0.512 25,600 3,00,000 0.658 1,97,400
NPV (400) 16,500

The internal rate can be obtained by interpolation:

14,950
IRRX = 20% + × (25% - 20%)
14,950 – (400)

14,950
= 20% + 15,350 × 5% = 24.87%

16,500
IRRY = 15% + × (20% - 15%)
16,500 – (15,520)

16,500
= 15% + 31,750 × 5% = 17.60%

Overall Position

Project A Project B
NPV @ 10% ₹ 51,590 ₹ 53,350

420
 [INVESTMENT DECISIONS]

IRR 24.87% 17.60%

Thus, there is contradiction in ranking by two methods.

Question – 12
Suppose MVA Ltd. is considering two Project A and Project B for investment.
The cash flows associated with these projects are as follows:

Year Project A (₹) Project B (₹)

0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000

Assuming Cost of Capital equal to 12%, ANALYSE which project should be

accepted as per NPV Method and IRR Method?

(Study Material ICAI Illus – 12)

Solution:

Net Present Value of Projects

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @ (₹) (₹)
(₹) (₹) 12%
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.893 6,69,750 1,78,600
2 0 2,00,000 0.797 0 1,59,400
3 0 7,00,000 0.712 0 4,98,400
NPV 1,69,750 3,36,400

Internal Rate of Returns of projects

Let us discount cash flows using 50% discounting rate.

Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @ (₹) (₹)
(₹) (₹) 50%
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)
1 7,50,000 2,00,000 0.667 5,00,250 1,33,400

421
 [INVESTMENT DECISIONS]

2 0 2,00,000 0.444 0 88,800

3 0 7,00,000 0.296 0 2,07,200
NPV 250 (70,600)

Since, IRR of project A shall be 50% as NPV is very small. Further, by

discounting cash flows at 50%, we are getting NPV of Project B negative.
Therefore, let us discount cash flows of Project B using 15% discounting rate.

Year Cash Inflows of Present Value PV of Project B (₹)

Project B (₹) Factor @ 15%
0 (5,00,000) 1.000 (5,00,000)
1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200
3 7,00,000 0.658 4,60,600
NPV 2,85,800

The internal rate can be obtained by interpolation:

2,85,800
IRRB = 15% + × (50% - 15%)
2,85,800 – (70,600)

2,85,800
= 15% + 3,56,400 × 35% = 43.07%

Overall Position

Project A Project B
NPV @ 12% ₹ 1,69,750 ₹ 3,36,400
IRR 50.00% 43.07%

Thus, there is contradiction in ranking by two methods.

Question – 13
Shiva Limited is planning its capital investment programme for next year. It
has five projects all of which give a positive NPV at the company cut-off rate of
15 percent, the investment outflows and present values being as follows:

Project Investment (₹) NPV @ 15% (₹)

A (50,000) 15,400
B (40,000) 18,700
C (25,000) 10,100
D (30,000) 11,200
E (35,000) 19,300

422
 [INVESTMENT DECISIONS]

The company is limited to a capital spending of ₹ 1,20,000.

You are required to ILLUSTRATE the returns from a package of projects within
the capital spending limit. The projects are independent of each other and are
divisible (i.e., part project is possible).

(Study Material ICAI Illus – 13)

Solution:

Computation of NPVs per ₹ 1 of Investment and Ranking of the Projects

Project Investment NPV @ 15% NPV per ₹ 1 Ranking

₹ ‘000 ₹ ‘000 invested
A (50) 15.4 0.31 5
B (40) 18.7 0.47 2
C (25) 10.1 0.40 3
D (30) 11.2 0.37 4
E (35) 19.3 0.55 1

Building up of a Programme of Projects based on their Rankings

Project Investment NPV @ 15%

₹ ‘000 ₹ ‘000
E (35) 19.3
B (40) 18.7
C (25) 10.1
D (20) 7.5
120 55.6

Thus, Project A should be rejected and only two-third of Project D be

undertaken. If the projects are not divisible then other combinations can be
examined as:

Investment NPV @ 15%

₹ ‘000 ₹ ‘000
E+B+C 100 48.1
E+B+D 105 49.2

In this case E + B + D would be preferable as it provides a higher NPV despite

D ranking lower than C.

423
 [INVESTMENT DECISIONS]

Question – 14
R Pvt. Ltd. is considering modernizing its production facilities and it has two
proposals under consideration. The expected cash flows associated with these
projects and their NPV as per discounting rate of 12% and IRR is as follows:

Year Cash Flow

Project A (₹) Project B (₹)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @ 12% 6,49,094 5,15,488
IRR 17.47% 25.20%

IDENTIFY which project should R Pvt. Ltd. accept?

(Study Material ICAI Illus – 14)

Solution:

Although from NPV point of view, Project A appears to be better but from IRR
point of view, Project B appears to be better. Since, both projects have unequal
lives, selection on the basis of these two methods shall not be proper. In such
situation, we shall use any of the following method:

(i) Replacement Chain (Common Life) Method: Since the life of the
Project A is 6 years and Project B is 3 years, to equalize lives, we can
have second opportunity of investing in project B after one time
investing. The position of cash flows in such situation shall be as follows:

424
 [INVESTMENT DECISIONS]

NPV of extended life of 6 years of Project B shall be ₹ 8,82,403 and IRR of

25.20%. Accordingly, with extended life NPV of Project B it appears to be
more attractive.

(ii) Equivalent Annualized Criterion: The method discussed above has one
drawback when we have to compare two projects with one has a life of 3
years and other has 5 years. In such case, the above method shall
require analysis of a period of 15 years i.e. common multiple of these two
values. The simple solution to this problem is use of Equivalent
Annualized Criterion involving following steps:

(a) Compute NPV using the WACC or discounting rate.

(b) Compute Present Value Annuity Factor (PVAF) of discounting

factor used above for the period of each project.

(c) Divide NPV computed under step (a) by PVAF as computed under
step (b) and compare the values.

Accordingly, for proposal under consideration:

Project A Project B
NPV @ 12% ₹ 6,49,094 ₹ 5,15,488
PVAF @12% 4.112 2.402
Equivalent Annualized Criterion ₹ 1,57,854 ₹ 2,14,608

Thus, Project B should be selected.

Question – 15
Alpha Company is considering the following investment projects:

Cash Flows (₹)

Projects C0 C1 C2 C3
A -10,000 +10,000
B -10,000 +7,500 +7,500
C -10,000 +2,000 +4,000 +12,000
D -10,000 +10,000 +3,000 +3,000

(a) ANALYSE and rank the projects according to each of the following
methods: (i) Payback, (ii) ARR, (iii) IRR and (iv) NPV, assuming discount
rates of 10 and 30 per cent.

425
 [INVESTMENT DECISIONS]

(b) Assuming the projects are independent, which one should be accepted?
If the projects are mutually exclusive, IDENTIFY which project is the
best?

(Study Material ICAI Illus – 15)

Solution:

(a) (i) Payback Period

Project A: ₹ 10,000/₹ 10,000 = 1 year

1
Project B: ₹ 10,000/₹ 7,500 =1 years
3

₹ 10,000 − ₹ 6,000 1
Project C: 2 years + =2 years
₹ 12,000 3

Project D: 1 year

(ii) ARR (Figures in ₹)

(10,000 – 10,000)1/2
Project A: =0
(10,000)1/2

(15,000 – 10,000)1/2 2,500

Project B: = = 50%
(10,000)1/2 5,000

(18,000 – 10,000)1/3 2,667

Project C: = = 53%
(10,000)1/2 5,000

(16,000 – 10,000)1/3 2,000

Project D: = = 40%
(10,000)1/2 5,000

Note: This net cash proceed includes recovery of investment also.

Therefore, net cash earnings are found by deducting initial
investment.

(iii) IRR

Project A: The net cash proceeds in year 1 are just equal to

investment. Therefore, r = 0%.

426
 [INVESTMENT DECISIONS]

Project B: This project produces an annuity of ₹ 7,500 for two

years. Therefore, the required PVAF is: ₹ 10,000/₹
7,500 = 1.33. This factor is found under 32% column.
Therefore, r = 32%
Project C: Since cash flows are uneven, the trial and error
method will be followed. Using 20% rate of discount,
the NPV is + ₹ 1,389. At 30% rate of discount, the
NPV is − ₹ 633. The true rate of return should be less
than 30%. At 27% rate of discount, it is found that
the NPV is − ₹ 86 and + ₹ 105 at 26%. Through
interpolation, we find r = 26.5%
Project D: In this case also by using the trial and error method,
it is found that at 37.6% rate of discount, NPV
becomes almost zero. Therefore, r = 37.6%.

(iv) NPV

Project A:

at 10% -10,000 + 10,000 × 0.909 = -910

at 30% -10,000+10,000×0.769 = -2,310

Project B:

at 10% -10,000 + 7,500(0.909 + 0.826) = +3,013

at 30% -10,000 + 7,500(0.769 + 0.592) = +208

Project C:

at 10% -10,000+2,000×0.909+4,000×0.826+12,000×0.751

= +4,134

at 30% -10,000+2,000×0.769+4,000×0.592+12,000×0.455

= -633

Project D:

at 10% -10,000 + 10,000 × 0.909+3,000 × (0.826 + 0.751)

= + 3,821

427
 [INVESTMENT DECISIONS]

at 30% -10,000 + 10,000 × 0.769 + 3,000 × (0.592 + 0.455)

= + 831

The projects are ranked as follows according to the various methods:

Projects PBP ARR IRR NPV (10%) NPV (30%)

A 1 4 4 4 4
B 2 2 2 3 2
C 3 1 3 1 3
D 1 3 1 2 1

(b) Payback and ARR are theoretically unsound method for choosing
between the investment projects. Between the two time-adjusted (DCF)
investment criteria, NPV and IRR, NPV gives consistent results. If the
projects are independent (and there is no capital rationing), either IRR or
NPV can be used since the same set of projects will be accepted by any of
the methods. In the present case, except Project A all the three projects
should be accepted if the discount rate is 10%. Only Projects B and D
should be undertaken if the discount rate is 30%.

If it is assumed that the projects are mutually exclusive, then under the
assumption of 30% discount rate, the choice is between B and D (A and
C are unprofitable). Both criteria IRR and NPV give the same results – D
is the best. Under the assumption of 10% discount rate, ranking
according to IRR and NPV conflict (except for Project A). If the IRR rule is
followed, Project D should be accepted. But the NPV rule tells that
Project C is the best. The NPV rule generally gives consistent results in
conformity with the wealth maximization principle. Therefore, Project C
should be accepted following the NPV rule.

Question – 16
The expected cash flows of three projects are given below. The cost of capital is
10 per cent.

(a) CALCULATE the payback period, net present value, internal rate of
return and accounting rate of return of each project.

(b) IDENTIFY the rankings of the projects by each of the four methods.

(₹ in „000)
Period Project A (₹) Project B (₹) Project (₹)

428
 [INVESTMENT DECISIONS]

0 (5,000) (5,000) (5,000)

1 900 700 2,000
2 900 800 2,000
3 900 900 2,000
4 900 1,000 1,000
5 900 1,100
6 900 1,200
7 900 1,300
8 900 1,400
9 900 1,500
10 900 1,600

(Study Material ICAI Illus – 16)

Solution:

(a) Payback Period Method:

A = 5 + (500/900) = 5.56 years

B = 5 + (500/1,200) = 5.42 years

C = 2 + (1,000/2,000) = 2.5 years

Net Present Value Method:

NPVA = (− 5,000) + (900 × 6.145) = (5,000) + 5,530.5 = ₹ 530.5

NPVB is calculated as follows:

Year Cash Flow (₹) 10% Discount Factor Present Value (₹)
0 (5000) 1.000 (5,000)
1 700 0.909 636
2 800 0.826 661
3 900 0.751 676
4 1000 0.683 683
5 1100 0.621 683
6 1200 0.564 677
7 1300 0.513 667
8 1400 0.467 654
9 1500 0.424 636
10 1600 0.386 618
1591

429
 [INVESTMENT DECISIONS]

NPVC is calculated as follows:

Year Cash Flow (₹) 10% Discount Factor Present Value (₹)
0 (5000) 1.000 (5,000)
1 2000 0.909 1818
2 2000 0.826 1652
3 2000 0.751 1502
4 1000 0.683 683
655

Internal Rate of Return

Project A

NPV at 12% = (5,000) + 900 × 5.650

= (5,000) + 5085 = 85

NPV at 13% = (5,000) + 900 × 5.426

= (5,000) + 4,883.40 = -116.60

85
IRRA = 12 + × (13 – 12) = 12 + 0.42
85+116.60

= 12.42%

Project B

IRRB

Year Cash 10% Present 16% Present

Flow (₹) Discount Value (₹) Discount Value (₹)
Factor Factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 700 0.909 636 0.862 603
2 800 0.826 661 0.743 595
3 900 0.751 676 0.641 577
4 1,000 0.683 683 0.552 552
5 1,100 0.621 683 0.476 524
6 1,200 0.564 677 0.410 493
7 1,300 0.513 667 0.354 460
8 1,400 0.467 654 0.305 427

430
 [INVESTMENT DECISIONS]

9 1,500 0.424 636 0.263 394

10 1,600 0.386 618 0.227 363
1,591 (12)

1,591
Interpolating: IRRB = 10% + × (16% − 10%)
(1.591+12)

= 10% + 5.94% = 15.94%

Project C

IRRC

Year Cash 15% Present 18% Present

Flow (₹) Discount Value (₹) Discount Value (₹)
Factor Factor
0 (5,000) 1.000 (5,000) 1.000 (5,000)
1 2,000 0.870 1,740 0.847 1,694
2 2,000 0.756 1,512 0.718 1,436
3 2,000 0.658 1,316 0.609 1,218
4 1,000 0.572 572 0.516 516
140 (136)

140
Interpolating: IRRC = 15% + × (18% − 15%)
(140+136)

= 15% + 1.52% = 16.52%

Accounting Rate of Return:

5,000
ARRA: Average capital employed = = ₹ 2,500
2

(9,000 – 5,000)
Average accounting profit = = ₹ 400
10

(4,000 × 100)
ARRA = = 16 per cent
2,500

(11,500 – 5,000)
ARRB: Average accounting profit = = ₹ 650
10

431
 [INVESTMENT DECISIONS]

(650 × 100)
ARRB = = 26 per cent
2,500

(7,000 – 5,000)
ARRC: Average accounting profit = = ₹ 500
4

(500 × 100)
ARRC = = 20 per cent
2,500

(b) Summary of Results

A B C
Payback (years) 5.5 5.4 2.5
NPV (₹) 530.50 1,591 655
IRR (%) 12.42 15.94 16.52
ARR (%) 16 26 20

Comparison of Rankings

Method Payback NPV IRR ARR

1 C B C B
2 B C B C
3 A A A A

Question – 17
X Limited is considering purchasing of new plant worth ₹ 80,00,000. The
expected net cash flows after taxes and before depreciation are as follows:

Year Net Cash Flows (₹)

1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000

The rate of cost of capital is 10%.

You are required to CALCULATE:

432
 [INVESTMENT DECISIONS]

(i) Pay-back period

(ii) Net present value at 10 discount factor

(iii) Profitability index at 10 discount factor

(iv) Internal rate of return with the help of 10% and 15% discount factor

The following present value table is given for you:

Year Present value of ₹ 1 Present value of ₹ 1

at 10% discount rate at 15% discount rate
1 0.909 0.87
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247

(Study Material ICAI Illus – 17)

Solution:

(i) Calculation of Pay-back Period

Cash Outlay of the Project = ₹ 80,00,000

Total Cash Inflow for the first five years = ₹ 70,00,000

Balance of cash outlay left to be paid back in the 6th year = ₹ 10,00,000

Cash inflow for 6th year = ₹ 16,00,000

So, the payback period is between 5th and 6th years, i.e.,

₹ 10,00,000
5 years + = 5.625 years or 5 years 7.5 months
₹ 16,00,000

(ii) Calculation of Net Present Value (NPV) @10% discount rate:

433
 [INVESTMENT DECISIONS]

Year Net Cash Inflow Present Value at Present Value

(₹) Discount Rate of (₹)
10%
(a) (b) (c) = (a) × (b)
1 14,00,000 0.909 12,72,600
2 14,00,000 0.826 11,56,400
3 14,00,000 0.751 10,51,400
4 14,00,000 0.683 9,56,200
5 14,00,000 0.621 8,69,400
6 16,00,000 0.564 9,02,400
7 20,00,000 0.513 10,26,000
8 30,00,000 0.467 14,01,000
9 20,00,000 0.424 8,48,000
10 8,00,000 0.386 3,08,800
97,92,200

Net Present Value (NPV)

= Cash Outflow – Present Value of Cash Inflows

= ₹ 80,00,000 – ₹ 97,92,200 = 17,92,200

(iii) Calculation of Profitability Index @ 10% discount rate:

Present Value of Cash Inflows

Profitability Index =
Cost of the Investment

₹ 97,92,200
= = 1.224
₹ 80,00,000

(iv) Calculation of Internal Rate of Return:

Net present value @ 10% interest rate factor has already been calculated
in (ii) above, we will calculate Net present value @15% rate factor.

Year Net Cash Inflow Present Value at Present Value

(₹) Discount Rate of (₹)
15%
(a) (b) (c) = (a) × (b)
1 14,00,000 0.870 12,18,000
2 14,00,000 0.756 10,58,400
3 14,00,000 0.658 9,21,200
4 14,00,000 0.572 8,00,800

434
 [INVESTMENT DECISIONS]

5 14,00,000 0.497 6,95,800

6 16,00,000 0.432 6,91,200
7 20,00,000 0.376 7,52,000
8 30,00,000 0.327 9,81,000
9 20,00,000 0.284 5,68,000
10 8,00,000 0.247 1,97,600
78,84,000

Net Present Value at 15% = ₹ 78,84,000 – ₹ 80,00,000 = ₹ -1,16,000

As the net present value @ 15% discount rate is negative, hence internal
rate of return falls in between 10% and 15%. The correct internal rate of
return can be calculated as follows:

NPVL
IRR =L+ (H – L)
NPVL−NPVH

₹17,92,200
= 10% + (15% – 10%)
₹17,92,200 – (− ₹ 1,16,000)

₹17,92,200
= 10% + × 5% = 14.7%
₹19,08,200

Question – 18
Following data has been available for a capital project:

Annual cash inflows ₹ 1,00,000

Useful life 4 years

Salvage value 0

Internal rate of return 12%

Profitability index 1.064

You are required to CALCULATE the following for this project:

(i) Cost of project

(ii) Cost of capital

(iii) Net present value

435
 [INVESTMENT DECISIONS]

(iv) Payback period

PV factors at different rates are given below:

Discount factor 12% 11% 10% 9%

1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708

(Study Material ICAI TYK – 01)

Solution:

(i) Cost of the Project

At 12% internal rate of return (IRR), the sum of total cash inflows = cost
of the project i.e initial cash outlay

Annual cash inflows = ₹ 1,00,000

Useful life = 4 years

Considering the discount factor table @ 12%, cumulative present value of

cash inflows for 4 years is 3.038 (0.893 + 0.797 + 0.712 + 0.636).

Hence, Total Cash inflows for 4 years for the Project is:

₹ 1,00,000 × 3.038 = ₹ 3,03,800

Hence, Cost of the Project = ₹ 3,03,800

(ii) Cost of Capital

Sum of Discounted Cash Inflows

Profitability Index =
Cost of the Project

Sum of Discounted Cash Inflows

1.064 =
₹ 3,03,800

∴ Sum of Discounted Cash inflows = ₹ 3,23,243.20

Since, Annual Cash Inflows = ₹ 1,00,000

436
 [INVESTMENT DECISIONS]

₹ 3,23,243.20
Hence, cumulative discount factor for 4 years = = 3.232
₹ 1,00,000

From the discount factor table, at discount rate of 9%, the cumulative
discount factor for 4 years is 3.239 (0.917 + 0.842 + 0.772 + 0.708).

Hence, Cost of Capital = 9% (approx.)

(iii) Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project

= ₹ 3,23,243.20 – ₹ 3,03,800 = ₹ 19,443.20

(iv) Payback Period

Cost of the Project ₹ 3,03,800

Payback Period = = = 3.038 years
Annual Cash Inflows ₹ 1,00,000

Question – 19
Hindlever Company is considering a new product line to supplement its range
of products. It is anticipated that the new product line will involve cash
investments of ₹ 7,00,000 at time 0 and ₹ 10,00,000 in year 1. After-tax cash
inflows of ₹ 2,50,000 are expected in year 2, ₹ 3,00,000 in year 3, ₹ 3,50,000 in
year 4 and ₹ 4,00,000 each year thereafter through year 10. Although the
product line might be viable even after year 10, the company prefers to be
conservative and end all calculations at that time.

(a) If the required rate of return is 15 per cent, COMPUTE net present value
of the project. Is it acceptable?

(b) ANALYSE what would be the case if the required rate of return were 10
per cent.

(c) CALCULATE its internal rate of return.

(d) COMPUTE the project‟s payback period.

(Study Material ICAI TYK – 03)

Solution:

(a) Computation of NPV at 15% discount rate

437
 [INVESTMENT DECISIONS]

Year Cash Flow Discount Factor (15%) Present Value

(₹) (₹)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.870 (8,70,000)
2 2,50,000 0.756 1,89,000
3 3,00,000 0.658 1,97,400
4 3,50,000 0.572 2,00,200
5 – 10 4,00,000 2.163 8,65,200
Net Present Value (1,18,200)

As the net present value is negative, the project is unacceptable.

(b) Computation of NPV if discount rate would be 10% discount rate

Year Cash Flow Discount Factor (10%) Present Value

(₹) (₹)
0 (7,00,000) 1.000 (7,00,000)
1 (10,00,000) 0.909 (9,09,000)
2 2,50,000 0.826 2,06,500
3 3,00,000 0.751 2,25,300
4 3,50,000 0.683 2,39,050
5 – 10 4,00,000 2.974 11,89,600
Net Present Value 2,51,450

Since NPV = ₹ 2,51,450 is positive, hence the project would be

acceptable.

(c) Calculation of IRR:

NPV at LR
IRR = LR + × (HR – LR)
NPV at LR – NPV at HR

₹ 2,51,450
= 10% + × (15% – 10%)
₹ 2,51,450 – (-)1,18,200

= 10% + 3.4012 or 13.40%

(d) Computation of Pay-back period of the project:

Payback Period = 6 years:

− ₹ 7,00,000 − ₹ 10,00,000 + ₹ 2,50,000 + ₹ 3,00,000 + ₹ 3,50,000 + ₹

4,00,000 + ₹ 4,00,000 = 0

438
 [INVESTMENT DECISIONS]

Question – 20
Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a
choice between the two identical machines, in terms of Capacity, „X‟ and „Y‟.
Despite being designed differently, both machines do the same job. Further,
details regarding both the machines are given below:

Particulars Machine ‘X’ Machine ‘Y’

Purchase Cost of the Machine (₹) 15,00,000 10,00,000
Life (years) 3 2
Running cost per year (₹) 4,00,000 6,00,000

The opportunity cost of capital is 9%.

You are required to IDENTIFY the machine which the company should buy?

The present value (PV) factors at 9% are:

Year t1 t2 t3

PVIF0.09.t 0.917 0.842 0.772

(Study Material ICAI TYK – 06)

Solution:

Statement Showing the Evaluation of Two Machines

Particulars Machine ‘X’ Machine ‘Y’

(i) Purchase Cost ₹ 15,00,000 ₹ 10,00,000
(ii) Life of Machine 3 years 2 years
(iii) Running Cost of Machine per year ₹ 4,00,000 ₹ 6,00,000
(iv) PVIFA (0.09, 3) 2.531
PVIFA (0.09, 2) 1.759
(v) PV of Running Cost of Machine {(iii) × (iv)} ₹ 10,12,400 ₹ 10,55,400
(vi) Cash outflows of Machine {(i) + (v)} ₹ 25,12,400 ₹ 20,55,400
(vii) Equivalent PV of Annual Cash outflow ₹ 9,92,651 ₹ 11,68,505
{(vi)/(iv)}

Recommendation: Ae Bee Cee Ltd. should buy Machine „X‟ since equivalent
annual cash outflow is less than that of Machine „Y‟.

439
 [INVESTMENT DECISIONS]

Question – 21
NavJeevani hospital is considering to purchase a machine for medical
projectional radiography which is priced at ₹ 2,00,000. The projected life of the
machine is 8 years and has an expected salvage value of ₹ 18,000 at the end of
8th year. The annual operating cost of the machine is ₹ 22,500. It is expected to
generate revenues of ₹ 1,20,000 per year for eight years. Presently, the hospital
is outsourcing the radiography work to its neighbour Test Center and is
earning commission income of ₹ 36,000 per annum, net of taxes.

Required:

ANALYSE whether it would be profitable for the hospital to purchase the

machine. Give your recommendation under:

(i) Net Present Value method

(ii) Profitability Index method

Consider tax @30%. PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

(Study Material ICAI TYK – 08)

Solution:

Determination of Cash inflows

Particulars (₹)
Sales Revenue 1,20,000
Less: Operating Cost 22,500
97,500
Less: Depreciation (₹ 2,00,000 – ₹ 18,000)/8 22,750
Net Income 74,750
Less: Tax @ 30% 22,425
Earnings after Tax (EAT) 52,325
Add: Depreciation 22,750
Cash inflow after tax per annum 75,075
Less: Loss of Commission Income 36,000
Net Cash inflow after tax per annum 39,075
In 8th Year :
New Cash inflow after tax 39,075

440
 [INVESTMENT DECISIONS]

Add: Salvage Value of Machine 18,000

Net Cash inflow in year 8 57,075

(i) Calculation of Net Present Value (NPV)

Year CFAT (₹) PV Factor @10% Present Value of

Cash inflows (₹)
1 to 7 39,075 4.867 1,90,178.03
8 57,075 0.467 26,654.03
2,16,832.06
Less: Cash Outflows 2,00,000.00
NPV 16,832.06

(ii) Calculation of Profitability Index

Sum of discounted cash in flows

Profitability Index =
Present Value of Cash Out flows

2,16,832.06
= = 1.084
2,00,000

Advise: Since the net present value (NPV) is positive and profitability
index is also greater than 1, the hospital may purchase the machine.

Question – 22
XYZ Ltd. is planning to introduce a new product with a project life of 8 years.
Initial equipment cost will be ₹ 3.5 crores. Additional equipment costing ₹
25,00,000 will be purchased at the end of the third year from the cash inflow of
this year. At the end of 8 years, the original equipment will have no resale
value, but additional equipment can be sold for ₹ 2,50,000. A working capital
of ₹ 40,00,000 will be needed and it will be released at the end of eighth year.
The project will be financed with sufficient amount of equity capital.

The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4–5 6–8

Units per year 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ₹ 240 per unit is expected and variable expenses will amount to
60% of sales revenue. Fixed cash operating costs will amount ₹ 36,00,000 per
year. The loss of any year will be set off from the profits of subsequent two
years. The company is subject to 30 per cent tax rate and considers 12 per cent

441
 [INVESTMENT DECISIONS]

to be an appropriate after-tax cost of capital for this project. The company

follows straight line method of depreciation.

CALCULATE the net present value of the project and advise the management to
take appropriate decision.

The PV factors at 12% are

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

(Study Material ICAI TYK – 09)

Solution:

Workings:

(a) Calculation of annual cash flows (₹ in lakh)

Year Sales VC FC Dep. Profit Tax PAT Dep. Cash

Inflow
1 172.80 103.68 36 43.75 (10.63) − − 43.75 33.12
2 259.20 155.52 36 43.75 23.93 3.99* 19.94 43.75 63.69
3 624.00 374.40 36 43.75 169.85 50.955 118.895 43.75 162.645
4–5 648.00 388.80 36 48.25 174.95 52.485 122.465 48.25 170.715
6–8 432.00 259.20 36 48.25 88.55 26.565 61.985 48.25 110.235

(b) Calculation of Depreciation:

₹ 350 lakh
- On Initial equipment = = 43.75 lakh
8 years

(₹ 25 – ₹ 2.5) lakh
- On additional equipment = = 4.5 lakh
5 years

(c) *Calculation of tax in 2nd Year:

₹ in lakh
Profit for the year 23.93
Less: Set off of unabsorbed depreciation in 1st year (10.63)
Taxable profit 13.30
Tax @ 30% 3.99

(d) Calculation of Initial cash outflow

442
 [INVESTMENT DECISIONS]

₹ in lakh
Cost of new equipment 350
Add: Working Capital 40
Outflow 390

Calculation of NPV (₹ in lakh)

Year Cash PV factor PV of cash Remark

flows @12% flows
0 (390) 1.000 (390.00) Initial equipment cost
1 33.12 0.893 29.57
2 63.69 0.797 50.76
3 162.645 0.712 115.80
3 (25.00) 0.712 (17.80) Additional equipment cost
4 170.715 0.636 108.57
5 170.715 0.567 96.79
6 110.235 0.507 55.89
7 110.235 0.452 49.83
8 110.235 0.404 44.53
8 40.00 0.404 16.16 Release of working capital
8 2.50 0.404 1.01 Additional equipment
salvage value
Net Present Value 161.11

Advise: Since the project has a positive NPV, therefore, it should be accepted.

Question – 23
A chemical company is presently paying an outside firm ₹ 1 per gallon to
dispose off the waste resulting from its manufacturing operations. At normal
operating capacity, the waste is about 50,000 gallons per year.

After spending ₹ 60,000 on research, the company discovered that the waste
could be sold for ₹ 10 per gallon if it was processed further. Additional
processing would, however, require an investment of ₹ 6,00,000 in new
equipment, which would have an estimated life of 10 years with no salvage
value. Depreciation would be calculated by straight line method.

Except for the costs incurred in advertising ₹ 20,000 per year, no change in the
present selling and administrative expenses is expected, if the new product is
sold. The details of additional processing costs are as follows:

Variable : ₹ 5 per gallon of waste put into process.

443
 [INVESTMENT DECISIONS]

Fixed : (Excluding Depreciation) ₹ 30,000 per year.

There will be no losses in processing, and it is assumed that the total waste
processed in a given year will be sold in the same year. Estimates indicate that
50,000 gallons of the product could be sold each year.

The management when confronted with the choice of disposing off the waste or
processing it further and selling it, seeks your ADVICE. Which alternative
would you recommend? Assume that the firm's cost of capital is 15% and it
pays on an average 50% Tax on its income.

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

(Study Material ICAI TYK – 13)

Solution:

Evaluation of alternatives:

Saving in disposing off the waste

Particulars (₹)
Outflow (50,000 × ₹ 1) 50,000
Less: tax saving @ 50% 25,000
Net outflow per year 25,000

Calculation of Annual Cash inflows in Processing of waste Material

Particulars Amount Amount

(₹) (₹)
Sale value of waste (₹ 10 × 50,000 gallon) 5,00,000
Less: Variable processing cost (₹ 5 × 50,000 gallon) 2,50,000
Less: Fixed processing cost 30,000
Less: Advertisement cost 20,000
Less: Depreciation 60,000 (3,60,000)
Earnings before tax (EBT) 1,40,000
Less: Tax @ 50% (70,000)
Earnings after tax (EAT) 70,000
Add: Depreciation 60,000
Annual Cash inflows 1,30,000

Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in
disposal cost

444
 [INVESTMENT DECISIONS]

= ₹ 1,30,000 + ₹ 25,000 = ₹ 1,55,000

Calculation of Net Present Value

Year Particulars Amount (₹)

0 Investment in new equipment (6,00,000)
1 to 10 Total annual benefits × PVAF (10 years, 15%)
₹ 1,55,000 × 5.019 7,77,945
Net Present Value 1,77,945

Recommendation: Processing of waste is a better option as it gives a positive

Net Present Value.

Note- Research cost of ₹ 60,000 is not relevant for decision making as it is

sunk cost.

Question – 24
Embros Ltd. is planning to invest in a new product with a project life of 8
years. Initial equipment cost will be ₹ 35 crores. Additional equipment costing ₹
2.50 crores will be purchased at the end of the third year from the cash inflow
of this year. At the end of 8 th year, the original equipment will have no resale
value, but additional equipment can be sold at 10% of its original cost. A
working capital of ₹ 4 crores will be needed, and it will be released at the end of
8 th year. The project will be financed with sufficient amount of equity capital.

The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4−5 6−8

Units 14,40,000 21,60,000 52,00,000 54,00,000 36,00,000

Sales price of ₹ 120 per unit is expected and variable expenses will amount to
60% of sales revenue. Fixed cash operating costs will amount ₹ 3.60 crores per
year. The loss of any year will be set off from the profits of subsequent year.
The company follows straight line method of depreciation and is subject to 30%
tax rate. Considering 12% after-tax cost of capital for this project, you are
required to CALCULATE the net present value (NPV) of the project and advise
the management to take appropriate decision.

PV factors @ 12% are:

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

445
 [INVESTMENT DECISIONS]

(MTP Sep – 2022)

Solution:

Calculation of year-wise Cash Inflow ( ₹ in crores)

Year sales VC FC Dep. Profit Tax PAT Dep. Cash

(60% of (@30%) Inflow
Sales
Value)
1 17.28 10.368 3.6 4.375 (1.063) - (1.0630) 4.375 3.312
2 25.92 15.552 3.6 4.375 2.393 0.3990* 1.9940 4.375 6.369
3 62.4 37.44 3.6 4.375 16.985 5.0955 11.8895 4.375 16.2645
4-5 64.8 38.88 3.6 4.825# 17.495 5.2485 12.2465 4.825 17.0715
6-8 43.2 25.92 3.6 4.825 8.855 2.6565 6.1985 4.825 11.0235

*(30% of 2.393 -30% of 1.063) = 0.7179 -0.3189 = 0.3990

#4.375 + (2.50 - .25)/5 = 4.825

Calculation of Cash Outflow at the beginning

Particulars ₹
Cost of New Equipment 35,00,00,000
Add: Working Capital 4,00,00,000
Outflow 39,00,00,000

Calculation of NPV

Year Cash inflows PV NPV

factor
(₹) (₹)
1 3,31,20,000 .893 2,95,76,160
2 6,36,90,000 .797 5,07,60,930
3 .712 9,80,03,240
16,26,45,000 - 2,50,00,000 =13,76,45,000
4 .636 10,85,74,740
17,07,15,000
5 .567 9,67,95,405
17,07,15,000
6 .507 5,58,89,145
11,02,35,000
7 .452 4,98,26,220
11,02,35,000
8 .404 6,17,04,940
11,02,35,000 + 4,00,00,000 + 25,00,000
= 15,27,35,000
Present Value of Inflow 55,11,30,780
Less: Out flow 39,00,00,000
Net Present Value 16,11,30,780

446
 [INVESTMENT DECISIONS]

Advise: Since the project has a positive NPV, it may be accepted.

Question – 25
An existing profitable company, RMC World Ltd. is considering a new project
for manufacture of home automation gadget involving a capital expenditure of ₹
1000 Lakhs and working capital of ₹ 150 Lakhs. The capacity of the plants for
an annual production of 3 lakh units and capacity utilization during 5 year life
of the project is expected to be as indicated below:

Year 1 2 3 4 5
Capacity Utilization (%) 50 65 80 100 100

The average price per unit of product is expected to be ₹ 600 netting a

contribution of 60 percent. The annual fixed costs, excluding depreciation, are
estimated to be ₹ 500 Lakhs per annum from the third year onwards. For the
first and second year, it would be ₹ 200 lakhs and ₹ 350 lakhs respectively.

Scrap value of the capital asset at the end of 5th year is ₹ 200 Lakhs.
Depreciation on capital asset is provided on written down value basis @ 40%
p.a. for income tax purpose. The rate of income tax may be taken at 30%. The
cost of capital is 12%. At end of the third year an additional investment of ₹
200 lakhs would be required for working capital. There is no capital gain tax
applicable.

COMPUTE the NPV of the project. RMC World Ltd. is about to make a
presentation to Secure Venture Capital Firm. Secure Venture Capital Firms will
invest in any project if the net addition to shareholder wealth from the project
is above ₹ 100 lakhs.

(MTP April – 2024)

Solution:

Calculation of Cash Flow after Tax

Year 1 Year 2 Year 3 Year 4 Year 5

Capacity 50% 65% 80% 100% 100%
Units 1,50,000 1,95,000 2,40,000 3,00,000 3,00,000
Contribution 360 360 360 360 360
p.u.
(600 × 60%)
Total 5,40,00,000 7,02,00,000 8,64,00,000 10,80,00,00 10,80,00,000
Contribution 0

447
 [INVESTMENT DECISIONS]

Less: Fixed 2,00,00,000 3,50,00,000 5,00,00,000 5,00,00,000 5,00,00,000

Asset
Less: 4,00,00,000 2,40,00,000 1,44,00,000 86,40,000 51,84,000
Depreciation
(W.N.)
PBT (60,00,000) 1,12,00,000 2,20,00,000 4,93,60,000 5,28,16,000
Less: Tax (18,00,000) 33,60,000 66,00,000 1,48,08,000 1,58,44,800
PAT (42,00,000) 78,40,000 1,54,00,000 3,45,52,000 3,69,71,200
Add: 4,00,00,000 2,40,00,000 1,44,00,000 86,40,000 51,84,000
Depreciation
CFAT 3,58,00,000 3,18,40,000 2,98,00,000 4,31,92,000 4,21,55,200

Calculation of NPV

Year Description Cash Flow PVF @12% PV

0 Initial Investment (10,00,00,000) 1 (10,00,00,000)
0 WC introduced (1,50,00,000) 1 (1,50,00,000)
3 WC introduced (2,00,00,000) 0.7118 (1,42,36,000)
1 CFAT 3,58,00,000 0.8929 3,19,65,820
2 CFAT 3,18,40,000 0.7972 2,53,82,848
3 CFAT 2,98,00,000 0.7118 2,12,11,640
4 CFAT 4,31,92,000 0.6355 2,74,48,516
5 CFAT 4,21,55,200 0.5674 2,39,18,860
5 WC released 3,50,00,000 0.5674 1,98,59,000
5 Scrap Sale 2,00,00,000 0.5674 1,13,48,000
Net Present Value 3,18,98,684

Working notes (W.N.)

Calculation of Depreciation

Year Opening WDV Depreciation Closing WDV

1 10,00,00,000 4,00,00,000 6,00,00,000
2 6,00,00,000 2,40,00,000 3,60,00,000
3 3,60,00,000 1,44,00,000 2,16,00,000
4 2,16,00,000 86,40,000 1,29,60,000
5 1,29,60,000 51,84,000 77,76,000

Question – 26
A firm can make investment in either of the following two projects. The firm
anticipates its cost of capital to be 10%. The pre-tax cash flows of the projects
for five years are as follows:

448
 [INVESTMENT DECISIONS]

Year 0 1 2 3 4 5
Project A(₹) (3,00,000) 55,000 1,20,000 1,30,000 1,05,000 40,000
Project B(₹) (3,00,000) 3,18,000 20,000 20,000 8,000 6,000

Ignore Taxation

An amount of ₹ 45,000 will be spent on account of sales promotion in year 3 in

case of Project A. This has not been considered in calculation of pre-tax cash
flows.

The discount factors are as under:

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

You are required to calculate for each project:

(i) The payback period

(ii) The discounted payback period

(iii) Desirability factor

(iv) Net Present Value

(MTP September – 2023)

Solution:

Calculation of Present Value of cash flows

Year PV Project -A Project -B

factor @
10 %
Cash flow (₹) Discount Cash flow Discount
ed cash (₹) ed cash
flows flows
0 1.00 (3,00,000) (3,00,000) (3,00,000) (3,00,000)
1 0.91 55,000 50,050 3,18,000 2,89,380
2 0.83 1,20,000 99,600 20,000 16,600
3 0.75 85,000(1,30,000 – 63,750 20,000 15,000
45,000)
4 0.68 1,05,000 71,400 8,000 5,440
5 0.62 40,000 24,800 6,000 3,720

449
 [INVESTMENT DECISIONS]

Net Present Value 9,600 30,140

(i) The Payback period of the projects:

Project-A: The cumulative cash inflows up-to year 3 is ₹ 2,60,000 and

remaining amount required to equate the cash outflow is ₹ 40,000 i.e. (₹

3,00,000 - -
₹ 2,60,000) which will be recovered from year 4 cash inflow.
Hence, Payback period will be calculated as below:

40,000
3 year + = 3.381 years or 3 years, 4 months, 9 days (approx.)
1.05,000
Project-B: The cash inflow in year-1 is ₹ 3,18,000 and the amount
required to equate the cash outflow is ₹ 3,00,000, which can be
recovered in a period less than a year. Hence, Payback period will be
calculated as below:

3,00,000
= 0.943 years or 11 months
3,18,000

(ii) Discounted Payback period for the projects:

Project-A: The cumulative discounted cash inflows up-to year 4 is ₹

2,84,800 and remaining amount required to equate the cash outflow is ₹
15,200 i.e. (₹ 3,00,000 – ₹ 2,84,800) which will be recovered from year-5
cash inflow. Hence, Payback period will be calculated as below:

15,200
4 year + = 4.613 years or 4 years, 2 months, and 11 days
24,800

Project-B: The cash inflow in year-1 is ₹ 2,89,380 and remaining

amount required to equate the cash outflow is ₹ 10,620 i.e. (₹ 3,00,000 -
₹ 2,89,380) which will be recovered from year-2 cash inflow. Hence,
Payback period will be calculated as below:

10,620
1 year + = 1.640 years or 1 Year, 7 months and 23 days.
16,600

(iii) Desirability factor of the projects

Desirability Factor (Profitability Index)

450
 [INVESTMENT DECISIONS]

Discounted value Cash Inflows

=
Discounted value of Cash Outflows

3,09,600
Project A = = 1.032
3,00,000

3,30,140
Project B = = 1.100
3,00,000

(iv) Net Present Value (NPV) of the projects:

Please refer the above table.

Project A- ₹ 9,600

Project B- ₹ 30,140

Question – 27
A company has to make a choice between two projects namely A and B. The
initial capital outlay of two Projects are ₹ 1,35,000 and ₹ 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 annual
incomes are as under:

Year Project A (₹) Project B (₹) Discounting factor @ 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

Required:

CALCULATE for each project:

(i) Discounted payback period

(ii) Profitability index

(iii) Net present value DECIDE which of these projects should be accepted?

(RTP May – 2018)

Solution:

451
 [INVESTMENT DECISIONS]

Working notes

1 Computation of Net Present Values of Projects

Year Cash flows Disct. Discounted Cash flow

Project A Project B factor @ Project A Project B
(₹) (₹) 16 (₹) (₹)
1 2 3 (3) × (1) (3) × (2)
0 (1,35,000) (2,40,000) 1.000 (1,35,000) (2,40,000)
1 -- 60,000 0.862 -- 51,720
2 30,000 84,000 0.743 22,290 62,412
3 1,32,000 96,000 0.641 84,612 61,536
4 84,000 1,02,000 0.552 46,368 56,304
5 84,000 90,000 0.476 39,984 42,840
Net present value 58,254 34,812

2 Computation of Cumulative Present Values of Projects Cash inflows

Year Project A Project B

PV of cash Cumulative PV (₹) PV of Cumulative
inflows (₹) PV (₹) cash inflows PV (₹)
(₹)
1 -- -- 51,720 51,720
2 22,290 22,290 62,412 1,14,132
3 84,612 1,06,902 61,536 1,75,668
4 46,368 1,53,270 56,304 2,31,972
5 39,984 1,93,254 42,840 2,74,812

(i) Discounted payback period: (Refer to Working note 2)

Cost of Project A = ₹ 1,35,000

Cost of Project B = ₹ 2,40,000

Cumulative PV of cash inflows of Project A after 4 years

= ₹ 1,53,270

Cumulative PV of cash inflows of Project B after 5 years

= ₹ 2,74,812

A comparison of projects cost with their cumulative PV clearly

shows that the project A‟s cost will be recovered in less than 4

452
 [INVESTMENT DECISIONS]

years and that of project B in less than 5 years. The exact duration
of discounted payback period can be computed as follows:

Project A Project B
Excess PV of cash 18,270 34,812
inflows over the (₹ 1,53,270 - ₹ (₹ 2,74,812 - ₹
project cost (₹) 1,35,000) 2,40,000)
Computation of 0.39 year 0.81 years
period required to (₹ 18,270 ÷ ₹ 46,368) (₹ 34,812 ÷ ₹
recover excess 42,840)
amount of
cumulative PV over
project cost (Refer to
Working note 2)
Discounted payback 3.61 year 4.19 years
period (4-0.39) years (5-0.81) years

Sum of discounted cash inflows

(ii) Profitability Index(PI): =
Initian cash outlay

₹ 1,93,254
Profitability Index (for Project A) = = 1.43
₹ 1,35,000

₹ 2,74,812
Profitability Index (for Project B) = = 1.15
₹ 2,40,000

(iii) Net present value (NPV) (for Project A) = ₹ 58,254

Net present value (NPV) (for Project B) = ₹ 34,812

(Refer to Working note 1)

Conclusion: As the NPV, PI of Project A is higher and Discounted

Pay back is lower, therefore Project a should be accepted.

Question – 28
A company is considering the proposal of taking up a new project which
requires an investment of ₹ 800 lakhs 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 lakhs)

1 320
2 320
3 360

453
 [INVESTMENT DECISIONS]

4 360
5 300

The cost of raising the additional capital is 12% and assets have to be
depreciated at 20% on written down value basis. The scrap value at the end of
the five year period may be taken as zero. Income-tax applicable to the
company is 40%.

You are required to CALCULATE the net present value of the project and advise
the management to take appropriate decision. Also CALCULATE the Internal
Rate of Return 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

(RTP May – 2020)

Solution:

(i) Calculation of Net Cash Flow

(₹ in lakhs)
Year Profit Depreciation PBT PAT Net cash
before dep. (20% on WDV) flow
and tax
(1) (2) (3) (4) (5) (3) + (5)
1 320 800 × 20% 160 96 256
= 160
2 320 (800 - 160) × 20% 192 115.20 243.20
= 128
3 360 (640 - 128) × 20% 257.6 154.56 256.96
= 102.4
4 360 (512 - 102.4) × 20% 278.08 166.85 248.77
= 81.92
5 300 (409.6 - 81.92) -27.68 -16.61 311.07
= 327.68*

*this is treated as a short term capital loss.

454
 [INVESTMENT DECISIONS]

(ii) Calculation of Net Present Value (NPV)

( ₹ in lakhs)
Year Net Cash 12% 16% 20%
Flow D.F P.V D.F P.V D.F P.V
1 256 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 0.58 149.03
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
941.36 850.71 773.16
Less: Initial Investment 800.00 800.00 800.00
NPV 141.36 50.71 -26.84

(iii) Advise: Since Net Present Value of the project at 12% = 141.36 lakhs,
therefore the project should be implemented.

(iv) Calculation of Internal Rate of Return (IRR)

50.71 × 4
IRR = 16% +
50.71−(−26.84)

2.03
= 16% + = 16% + 2.62% = 18.62%.
77.55

Question – 29
Dharma Ltd, an existing profit-making company, is planning to introduce a
new product with a projected life of 8 years. Initial equipment cost will be ₹ 240
lakhs and additional equipment costing ₹ 26 lakhs will be needed at the
beginning of third year. At the end of 8 years, the original equipment will have
resale value equivalent to the cost of removal, but the additional equipment
would be sold for ₹ 2 lakhs. Working Capital of ₹ 25 lakhs will be needed at the
beginning of the operations. The 100% capacity of the plant is of 4,00,000
units per annum, but the production and sales volume expected are as under:

Year Capacity (%)

1 20
2 30
3-5 75
6-8 50

A sale price of ₹100 per unit with a profit volume ratio (contribution/sales) of
60% is likely to be obtained. Fixed operating cash cost are likely to be ₹ 16

455
 [INVESTMENT DECISIONS]

lakhs per annum. In addition to this the advertisement expenditure will have to
be incurred as under:

Year 1 2 3-5 6-8

Expenditure (₹ Lakhs each year) 30 15 10 4

The company is subjected to 50% tax rate and consider 12% to be an

appropriate cost of capital. Straight line method of depreciation is followed by
the company. ADVISE the management on the desirability of the project.

(RTP May – 2023)

Solution:

Calculation of Cash Flow After tax

Year 1 2 3 to 5 6 to 8
A Capacity 20% 30% 75% 50%
B Units 80,000 1,20,000 3,00,000 2,00,000
C Contribution p.u. ₹ 60 ₹ 60 ₹ 60 ₹ 60
D Contribution ₹ 48,00,000 ₹ 72,00,000 ₹ 1,80,00,000 ₹ 1,20,00,000
E Fixed Cash Cost ₹ 16,00,000 ₹ 16,00,000 ₹ 16,00,000 ₹ 16,00,000
Depreciation
F Original ₹ 30,00,000 ₹ 30,00,000 ₹ 30,00,000 ₹ 30,00,000
Equipment
(₹240Lakhs/8)
G Additional -- -- ₹ 4,00,000 ₹ 4,00,000
Equipment (₹
24Lakhs/6)
H Advertisement ₹ 30,00,000 ₹ 15,00,000 ₹ 10,00,000 ₹ 4,00,000
Expenditure
I Profit Before Tax ₹ (28,00,000) ₹ 11,00,000 ₹ 1,20,00,000 ₹ 66,00,000
(DE-F-G-H)
J Tax savings/ ₹ 14,00,000 ₹ (5,50,000) ₹ (60,00,000) ₹ (33,00,000)
(expenditure)
K Profit After Tax ₹ (14,00,000) ₹ 5,50,000 ₹ 60,00,000 ₹ 33,00,000
L Add: Depreciation ₹ 30,00,000 ₹ 30,00,000 ₹ 34,00,000 ₹ 34,00,000
(F+G)
M Cash Flow After ₹16,00,000 ₹ 35,50,000 ₹ 94,00,000 ₹ 67,00,000
Tax

Calculation of NPV
Year Particulars Cash Flows PV PV
Factor
Initial Investment ₹ (2,40,00,000) 1.000 ₹ (2,40,00,000)

456
 [INVESTMENT DECISIONS]

0 Working Capital Introduced ₹ (25,00,000) 1.000 ₹ (25,00,000)

1 CFAT ₹16,00,000 0.893 ₹ 14,28,800
2 CFAT ₹ 35,50,000 0.797 ₹ 28,29,350
2 Additional Equipment ₹ (26,00,000) 0.797 ₹ (20,72,200)
3 CFAT ₹ 94,00,000 0.712 ₹ 66,92,800
4 CFAT ₹ 94,00,000 0.636 ₹ 59,78,400
5 CFAT ₹ 94,00,000 0.567 ₹ 53,29,800
6 CFAT ₹ 67,00,000 0.507 ₹ 33,96,900
7 CFAT ₹ 67,00,000 0.452 ₹ 30,28,400
8 CFAT ₹ 67,00,000 0.404 ₹ 27,06,800
8 WC Released ₹ 25,00,000 0.404 ₹ 10,10,000
8 Salvage Value ₹ 2,00,000 0.404 ₹ 80,800
Net Present Value ₹ 39,09,850

Since the NPV is positive, the proposed project should be implemented.

Question – 30
MTR Limited is considering buying a new machine which would have a useful
economic life of five years, at a cost of ₹ 25,00,000 and a scrap value of ₹
3,00,000, with 80 per cent of the cost being payable at the start of the project
and 20 per cent at the end of the first year. The machine would produce 75,000
units per annum of a new product with an estimated selling price of ₹ 300 per
unit. Direct costs would be ₹ 285 per unit and annual fixed costs, including
depreciation calculated on a straight- line basis, would be ₹ 8,40,000 per
annum.

In the first year and the second year, special sales promotion expenditure, not
included in the above costs, would be incurred, amounting to ₹ 1,00,000 and ₹
1,50,000 respectively.

EVALUATE the project using the NPV method of investment appraisal,

assuming the company‟s cost of capital to be 15 percent.

(RTP Nov – 2019)

Solution:

Calculation of Net Cash flows

Contribution = (300 – 285) × 75,000 = ₹ 11,25,000

Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = ₹ 4,00,000

457
 [INVESTMENT DECISIONS]

Year Capital (₹) Contribution Fixed Adverts Net cash

(₹) costs (₹) (₹) flow (₹)
0 (20,00,000) (20,00,000)
1 (5,00,000) 11,25,000 (4,00,000) (1,00,000) 1,25,000
2 11,25,000 (4,00,000) (1,50,000) 5,75,000
3 11,25,000 (4,00,000) 7,25,000
4 11,25,000 (4,00,000) 7,25,000
5 3,00,000 11,25,000 (4,00,000) 10,25,000

Calculation of Net Present Value

Year Net cash flow (₹) 12% discount factor Present value (₹)
0 (20,00,000) 1.000 (20,00,000)
1 1,25,000 0.892 1,11,500
2 5,75,000 0.797 4,58,275
3 7,25,000 0.711 5,15,475
4 7,25,000 0.635 4,60,375
5 10,25,000 0.567 5,81,175
1,26,800.

The net present value of the project is ₹ 1,26,800.

Question – 31
K. K. M. M Hospital is considering purchasing an MRI machine. Presently, the
hospital is outsourcing the work received relating to MRI machine and is
earning commission of ₹ 6,60,000 per annum (net of tax). The following details
are given regarding the machine:

(₹)
Cost of MRI machine 90,00,000
Operating cost per annum (excluding Depreciation) 14,00,000
Expected revenue per annum 45,00,000
Salvage value of the machine (after 5 years) 10,00,000
Expected life of the machine 5 years

Assuming tax rate @ 40%, whether it would be profitable for the hospital to
purchase the machine?

Give your RECOMMENDATION under:

(i) Net Present Value Method, and

(ii) Profitability Index Method.

458
 [INVESTMENT DECISIONS]

PV factors at 10% are given below:

Year 1 2 3 4 5
PV factor 0.909 0.826 0.751 0.683 0.620

(RTP Nov – 2022)

Solution:

Determination of Cash inflows

Elements (₹)
Sales Revenue 45,00,000
Less: Operating Cost 14,00,000
31,00,000
Less: Depreciation (90,00,000 – 10,00,000)/5 16,00,000
Net Income 15,00,000
Tax @ 40% 6,00,000
Earnings after Tax (EAT) 9,00,000
Add: Depreciation 16,00,000
Cash inflow after tax per annum 25,00,000
Less: Loss of Commission Income 6,60,000
Net Cash inflow after tax per annum 18,40,000
In 5th Year:
New Cash inflow after tax 18,40,000
Add: Salvage Value of Machine 10,00,000
Net Cash inflow in year 5 28,40,000

Calculation of Net Present Value (NPV)

Year CFAT PV Factor Present Value of

@10% Cash inflows
1 to 4 18,40,000 3.169 58,30,960
5 28,40,000 0.620 17,60,800
75,91,760
Less: Cash Outflows 90,00,000
NPV (14,08,240)

Sum of discounted cash inflows 75,91,760

Profitability Index = = = 0.844
Present value of cash outflows 90,00,000

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

459
 [INVESTMENT DECISIONS]

Question – 32
PQR Limited is considering buying a new machine which would have a useful
economic life of five years, at a cost of ₹ 40,00,000 and a scrap value of ₹
5,00,000, with 80 per cent of the cost being payable at the start of the project
and 20 per cent at the end of the first year. The machine would produce 80,000
units per annum of a new product with an estimated selling price of ₹ 400 per
unit. Direct costs would be ₹ 375 per unit and annual fixed costs, including
depreciation calculated on a straight- line basis, would be ₹ 10,40,000 per
annum. In the first year and the second year, special sales promotion
expenditure, not included in the above costs, would be incurred, amounting to
₹ 1,25,000 and ₹ 1,75,000 respectively.

EVALUATE the project using the NPV method of investment appraisal,

assuming the company‟s cost of capital to be 12 percent.

(RTP Nov – 2023)

Solution:

Calculation of Net Cash flows

Contribution = (400 – 375) × 80,000 = ₹ 20,00,000

Fixed costs = 10,40,000 – [(40,00,000 –5,00,000)/5] = ₹ 3,40,000

Capital Contribution Fixed Promotion Net Cash

Year (₹) (₹) Costs (₹) (₹) Flow (₹)
0 (32,00,000) (32,00,000)
1 (8,00,000) 20,00,000 (3,40,000) (1,25 ,000) 7,35,000
2 20,00,000 (3,40,000) (1,75,000) 14,85,000
3 20,00,000 (3,40,000) 16,60,000
4 20,00,000 (3,40,000) 16,60,000
5 5,00,000 20,00,000 (3,40,000) 21,60,000

Calculation of Net Present Value

Year Net Cash Flow 12% Discount Factor Present Value (₹)
(₹)
0 (32,00,000) 1.000 (32,00,000)
1 7,35,000 0.893 6,56,355
2 14,85,000 0.797 11,83,545
3 16,60,000 0.712 11,81,920
4 16,60,000 0.636 10,55,760
5 21,60,000 0.567 12,24,720

460
 [INVESTMENT DECISIONS]

21,02,300

The net present value of the project is ₹ 21,02,300.

Question – 33
Stand Ltd. is contemplating replacement of one of it‟s machines which has
become outdated and inefficient. It‟s financial manager has prepared a report
outlining two possible replacement machines. The details of each machine are
as follows:-

Machine 1 Machine 2
Initial Investment ₹ 12,00,000 ₹ 16,00,000
Estimated useful life 3 years 5 years
Residual value ₹ 1,20,000 ₹ 1,00,000
Contribution per annum ₹ 11,60,000 ₹ 12,00,000
Fixed maintenance costs per annum ₹ 40,000 ₹ 80,000
Other fixed operating costs per annum ₹ 7,20,000 ₹ 6,10,000

The maintenance cost 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 lien method and has been
included in other fixed operating costs. The expected cost of capital for this
project is assumed as 12% p.a.

Required:

(i) Which machine is more beneficial, using annualized equivalent

approach? Ignore tax.

(ii) Calculate the sensitivity of your recommendation in part (i) to changes in

the contribution generated by machine 1.

Year 1 2 3 4 5 6
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567 0.507
PVIFA0.12,t 0.893 1.690 2.402 3.038 3.605 4.112

(Exam, Dec – 2021)

Solution:

(i) Calculation of Net Cash flows

Machine 1

461
 [INVESTMENT DECISIONS]

Other fixed operating costs (excluding depreciation)

= 7,20,000 – [(12,00,000–1,20,000)/3] = ₹ 3,60,000

Year Initial Contribu Fixed Other fixed Residual Net cash

Investmen tion mainten operating costs Value flow
t (₹) (₹) ance (excluding (₹) (₹)
costs depreciation)
(₹) (₹)

0 (12,00,000) (40,000) (12,40,000)

1 11,60,000 (40,000) (3,60,000) 7,60,000
2 11,60,000 (40,000) (3,60,000) 7,60,000
3 11,60,000 (3,60,000) 1,20,000 9,20,000

Machine 2

Other fixed operating costs (excluding depreciation)

= 6,10,000 – [(16,00,000 –1,00,000)/5] = ₹ 3,10,000

Year Initial Contribut Fixed Other fixed Residual Net cash

Investme ion mainten operating costs Value (₹) flow (₹)
nt (₹) (₹) ance (excluding
costs depreciation)
(₹) (₹)

0 (16,00,000) (80,000) (16,80,000)

1 12,00,000 (80,000) (3,10,000) 8,10,000
2 12,00,000 (80,000) (3,10,000) 8,10,000
3 12,00,000 (80,000) (3,10,000) 8,10,000
4 12,00,000 (80,000) (3,10,000) 8,10,000
5 12,00,000 (3,10,000) 1,00,000 9,90,000

Calculation of Net Present Value

Machine 1 Machine 2
Year 12% Net cash Present Net cash Present
discount flow (₹) value (₹) flow (₹) value (₹)
factor
0 1.000 (12,40,000) (12,40,000) (16,80,000) (16,80,000)
1 0.893 7,60,000 6,78,680 8,10,000 7,23,330
2 0.797 7,60,000 6,05,720 8,10,000 6,45,570
3 0.712 9,20,000 6,55,040 8,10,000 5,76,720
4 0.636 8,10,000 5,15,160
5 0.567 9,90,000 5,61,330

462
 [INVESTMENT DECISIONS]

NPV @ 12% 6,99,440 13,42,110

PVAF @ 12% 2.402 3.605
Equivalent Annualized Criterion 2,91,190.674 3,72,291.262

Recommendation: Machine 2 is more beneficial using Equivalent

Annualized Criterion.

(ii) Calculation of sensitivity of recommendation in part (i) to changes

in the contribution generated by machine 1

Difference in Equivalent Annualized Criterion of Machines required for

changing the recommendation in part (i)

= 3,72,291.262 − 2,91,190.674 = ₹ 81,100.588

₹ 81,100.588
∴ Sensitivity relating to contribution = × 100
₹ 11,60,000.00

= 6.991 or 7% yearly

Alternatively,

The annualized equivalent cash flow for machine 1 is lower by ₹

(3,72,291.262 – 2,91,190.674) = ₹ 81,100.588 than for machine 2.
Therefore, it would need to increase contribution for complete 3 years
before the decision would be to invest in this machine.

Sensitivity w.r.t contribution = 81,100.588/(11,60,000 × 2.402) × 100

= 2.911%

Question – 34
A company wants to buy a machine, and two different models namely A and B
are available. Following further particulars are available:

Particulars Machine-A Machine-B

Original Cost (₹) 8,00,000 6,00,000
Estimated Life in year 4 4
Salvage Value (₹) 0 0

The company provides depreciation under Straight Line Method. Income tax
rate applicable is 30%.

463
 [INVESTMENT DECISIONS]

The present value of ₹ 1 at 12% discounting factor and net profit before
depreciation and tax are as under:

Year Net Profit Before Depreciation and tax PV Factor

Machine-A ₹ Machine-B ₹

1 2,30,000 1,75,000 0.893

2 2,40,000 2,60,000 0.797
3 2,20,000 3,20,000 0.712
4 5,60,000 1,50,000 0.636

Calculate:

1. NPV (Net Present Value)

2. Discounted pay-back period

3. PI (Profitability Index)

Suggest : Purchase of which machine is more beneficial under Discounted

payback period method, NPV method and PI method.

(Exam Jan – 2021)

Solution:

Workings:

(i) Calculation of Annual Depreciation

₹ 8,00,000
Depreciation on Machine – A = = ₹ 2,00,000
4

₹ 6,00,000
Depreciation on Machine – B = = ₹ 1,50,000
4

(ii) Calculation of Annual Cash Inflows

Particulars Machine-A (₹)

1 2 3 4
Net Profit before 2,30,000 2,40,000 2,20,000 5,60,000
Depreciation and Tax
Less: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Profit before Tax 30,000 40,000 20,000 3,60,000
Less: Tax @ 30% 9,000 12,000 6,000 1,08,000

464
 [INVESTMENT DECISIONS]

Profit after Tax 21,000 28,000 14,000 2,52,000

Add: Depreciation 2,00,000 2,00,000 2,00,000 2,00,000
Annual Cash Inflows 2,21,000 2,28,000 2,14,000 4,52,000

Particulars Machine-B (₹)

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

(iii) Calculation of PV of Cash Flows

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

1. NPV (Net Present Value)

Machine – A

NPV = ₹ 8,18,909 − ₹ 8,00,000 = ₹ 18,909

Machine – B

NPV = ₹ 6,17,425 – ₹ 6,00,000 = ₹ 17,425

2. Discounted Payback Period

Machine – A
₹ 8,00,000 − ₹ 5,31,437
Discounted Payback Period =3+
₹ 2,87,472
= 3 + 0.934

465
 [INVESTMENT DECISIONS]

= 3.934 years or 3 years 11.21

months
Machine – B
₹ 6,00,000 - ₹ 5,22,025
Discounted Payback Period =3+
₹ 95,400
= 3 + 0.817
= 3.817 years or 3 years 9.80
months
3. PI (Profitability Index)

Machine – A
₹ 8,18,909
Profitability Index = = 1.024
₹ 8,00,000
Machine – B
₹ 6,17,425
Profitability Index = = 1.029
₹ 6,00,000
Suggestion:

Method Machine - A Machine - B Suggested

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

Question – 35
Maruti Ltd. requires a plant costing ₹ 200 lakhs for a period of 5 years. The
company can use the plant for the stipulated period through leasing
arrangement or the requisite amount can be borrowed to buy the plant. In case
of leasing , the company received a proposal to pay annual lease rent of ₹ 48
lakhs at the end of each year for a period of 5 years.

In case of purchase, the company would have a 12%, 5 years loan to be paid in
equated annual installment, each installment becoming due in the beginning of
each year. It is estimated that plant can be sold for ₹ 40 lakhs at the end of 5th
year. The company uses straight line method of depreciation. Corporate tax
rate is 30%. Cost of Capital after tax for the company is 10%.

The PVIF @ 10% and 12% for the five years are given below;

Year 1 2 3 4 5
PVIF @ 10% 0.909 0.826 0.751 0.683 0.621

466
 [INVESTMENT DECISIONS]

PVIF @ 12% 0.893 0.797 0.712 0.636 0.567

You are required to advise whether the plant should be purchased or taken on
lease.

(Exam, May – 2018)

Solution:

Purchase Option

Loan installment = ₹ 200 lakhs/(1 + PVIFA 12%, 4)

= ₹ 200 lakhs/(1 + 3.038) = ₹ 49.53 lakhs

Interest payable = (₹ 49.53 × 5) – ₹ 200 lakhs = ₹ 47.65 lakhs

Working note:

Amortization of Loan Installment

Year Loan Installment Interest Principal O/S Amount

amount (₹ (₹ In Lakhs) (₹ In (₹ In (₹ In Lakhs)
In Lakhs) Lakhs) Lakhs)

0 200 49.53 0.00 49.53 150.47

1 150.47 49.53 18.06 31.47 119.00
2 119.00 49.53 14.28 35.25 83.75
3 83.75 49.53 10.05 39.48 44.27
4 44.27 49.53 *5.26 44.27 -
5 0 0 0 0 0

Calculation of PV of outflow under Purchase Option

(₹ In Lakhs)
(1) (2) (3) (4) (5) (6) (7) (8)
End Debt Int. of the Dep. Tax Net Cash PV PV
Payment o/s Shield outflows factors
Principal [(3) (2) – (5) @ 10%
+(4)] ×
0.3
0 49.53 0.00 0.00 0.00 49.53 1.000 49.53
1 49.53 18.06 32.00 15.02 34.51 0.909 31.37
2 49.53 14.28 32.00 13.88 35.65 0.826 29.44

467
 [INVESTMENT DECISIONS]

3 49.53 10.05 32.00 12.61 36.92 0.751 27.72

4 49.53 *5.26 32.00 11.18 38.35 0.683 26.19)
5 49.53 0 32.00 9.60 (9.60) 0.621 (5.96)
47.65 160.00 158.29
Less: PV of Salvage Value (₹ 40 lakhs × 0.621) = 24.84
Total PV of Outflow 133.45

*Balancing Figure

Leasing Option

PV of Outflows under lease @ 10% = ₹ 48 lakhs × (1-0.30) × 3.790

= ₹ 127.34 lakhs

Decision: The plant should be taken on lease because the PV of outflows is less
as compared to purchase option.

Question – 36
AT Limited is considering three projects A, B and C. The cash flows associated
with the projects are given below :

Cash flows associated with the three projects (₹)

Project C0 C1 C2 C3 C4

A (10,000) 2,000 2,000 6,000 0

B (2,000) 0 2,000 4,000 6,000

C (10,000) 2,000 2,000 6,000 10,000

You are required to :

(a) Calculate the payback period of each of the three project.

(b) If the cut-off period is two years, then which project should be accepted
should be accepted ?

(c) Project with positive NPVs if the opportunity cost of capital is 10 percent.

(d) “Payback gives to much weight to cash flows that occur after the cut-off
date”. True or false ?

(e) “If a firm used a single cut-off period for all projects, it is likely to accept
too many short lived project” True or false ?

468
 [INVESTMENT DECISIONS]

P.V. Factor @ 10%

Year 0 1 2 3 4 5
P.V. 1.000 0.909 0.826 0.751 0.683 0.621

(Exam May – 2019)

Solution:

(a) Payback Period of Projects

Projects C0 (₹) C1 (₹) C2 (₹) C3 (₹) Payback

A (10,000) 2000 2000 6,000 2,000 + 2,000 + 6,000
=10,000 i.e 3 years
B (2,000) 0 2,000 NA 0 + 2,000
= 2,000 i.e 2 years
C (10,000) 2000 2000 6,000 2,000 + 2,000 + 6,000
= 10,000 i.e 3 years

(b) If standard payback period is 2 years, Project B is the only acceptable

project.

(c) Calculation of NPV

Year PVF @ Project A Project B Project C

10% Cash PV of Cash PV of Cash PV of
Flows cash Flows cash Flows cash
(₹) flows (₹) flows (₹) flows
(₹) (₹) (₹)
0 1 (10,000) (10,000) (2,000) (2,000) (10,000) (10,000)
1 0.909 2,000 1,818 0 0 2,000 1,818
2 0.826 2,000 1,652 2,000 1,652 2,000 1,652
3 0.751 6,000 4506 4,000 3004 6,000 4,506
4 0.683 0 0 6,000 4,098 10,000 6,830
NPV (-2,024) 6,754 4,806

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

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

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

469
 [INVESTMENT DECISIONS]

Question – 37
Alpha Limited is a manufacturer of computers. It wants to introduce artificial
intelligence while making computers. The estimated annual saving from
introduction of the artificial intelligence (AI) is as follows:

 Reduction of five employees with annual salaries of ₹ 3,00,000

 Reduction of ₹ 3,00,000 in production delays caused by inventory problem
 Reduction is lost sales ₹2,50,000 and
 Gain due to timely billing ₹ 2,00,000

The Purchase price of the system for installation of artificial intelligence is ₹

20,00,000 and installation cost is ₹ 1,00,000. 80% of the purchase price will be
paid in the year of purchase and remaining will be paid in next year.

The estimated life of the system is 5 years and it will be depreciated on a

straight-line basis.

However, the operation of the new system requires two computer specialists with
annual salaries of ₹ 5,00,000 per person.

In addition to above, annual maintenance and operating cost for five years are as
below:

Year 1 2 3 4 5
Maintenance & 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Operation cost

Maintenance and operating cost are payable is advance.

The Company‟s tax rate is 30% and its required rate of return is 15%.

Year 1 2 3 4 5
PVIF0.10,t 0.909 0.826 0.751 0.683 0.621
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567
PVIF0.15,t 0.870 0.756 0.658 0.572 0.497

Evaluate the project by using net present value and profitability index.

(Exam May – 2022)

Solution:

470
 [INVESTMENT DECISIONS]

Computation of Annual Cash Flow after Tax

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in 15,00,000 15,00,000 15,00,000 15,00,000 15,00,000
Salaries
Reduction in 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Production
Delays
Reduction in 2,50,000 2,50,000 2,50,000 2,50,000 2,50,000
Lost Sales
Gain due to 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Timely Billing
Salary to (10,00,000) (10,00,000) (10,00,000) (10,00,000) (10,00,000)
Computer
Specialist
Maintenance (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000)
and Operating
Cost (payable
in advance)
Depreciation (4,20,000) (4,20,000) (4,20,000) (4,20,000) (4,20,000)
(21 lakhs/5)
Gain Before 6,30,000 6,50,000 6,70,000 6,90,000 7,10,000
Tax
Less: Tax 1,89,000 1,95,000 2,01,000 2,07,000 2,13,000
(30%)
Gain After Tax 4,41,000 4,55,000 4,69,000 4,83,000 4,97,000
Add: 4,20,000 4,20,000 4,20,000 4,20,000 4,20,000
Depreciation
Add: 2,00,000 1,80,000 1,60,000 1,40,000 1,20,000
Maintenance
and Operating
Cost (payable
in advance)
Less: (2,00,000) (1,80,000) (1,60,000) (1,40,000) (1,20,000) -
Maintenance
and Operating
Cost (payable
in advance)
Net CFAT (2,00,000) 8,81,000 8,95,000 9,09,000 9,23,000 10,37,000

Note: Annual cash flows can also be calculated Considering tax shield on
depreciation & maintenance and operating cost. There will be no change in the
final cash flows after tax.

471
 [INVESTMENT DECISIONS]

Computation of NPV
Particulars Year Cash PVF PV (₹)
Flows (₹)
Initial Investment 0 16,00,000 1 16,00,000
(80% of 20 Lacs)
Installation Expenses 0 1,00,000 1 1,00,000
Installment of Purchase Price 1 4,00,000 0.870 3,48,000
PV of Outflows (A) 20,48,000
CFAT 0 (2,00,000) 1 (2,00,000)
CFAT 1 8,81,000 0.870 7,66,470
CFAT 2 8,95,000 0.756 6,76,620
CFAT 3 9,09,000 0.658 5,98,122
CFAT 4 9,23,000 0.572 5,27,956
CFAT 5 10,37,000 0.497 5,15,389
PV of Inflows (B) 28,84,557
NPV (B-A) 8,36,557
Profitability Index (B/A) 1.408 or 1.41

Evaluation: Since the NPV is positive (i.e. ₹ 8,36,557) and Profitability Index is
also greater than 1 (i.e. 1.41), Alpha Ltd. may introduce artificial intelligence
(AI) while making computers.

Question – 38
PD Ltd. an existing company, is planning to introduce a new product with
projected life of 8 year. Project cost will be ₹ 2,40,00,000. At the end of 8 years
no residual value will be realized. Working capital of ₹30,00,000 will be needed.
The 100% capacity of the project is 2,00,000 units p.a but the production and
Sales Volume is expected are as under:

Year Number of units

1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units

Other Information :

(i) Selling price per unit ₹ 200

(ii) Variable cost is 40% of sales.

(iii) Fixed cost p.a. 30,00,000.

472
 [INVESTMENT DECISIONS]

(iv) In addition to this advertisement expenditure will have to be incurred as

under:

Year 1 2 3-5 6-8

Expenditure (₹) 50,00,000 25,00,000 10,00,000 5,00,000

(v) Income Tax is 25%.

(vi) Straight line method of depreciation is permissible for tax purpose.

(vii) Cost of capital is 10%.

(viii) Assume that loss cannot be carried forward.

Present Value Table

Year 1 2 3 4 5 6 7 8
PVF @ 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
10%

Advise about the project acceptability.

(Exam Nov – 2018)

Solution:

(1) Calculation of Annual Cash Inflows:

Years 1 2 3-5 6–8

(a) Sales in units 60,000 80,000 1,40,000 1,20,000
₹ ₹ ₹ ₹
(b) Contribution @ ₹ 120 72,00,000 96,00,000 1,68,00,000 1,44,00,00
p.u. [SP 200 × 60% PV
Ratio]
(c) Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
(d) Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
(e) Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
(2,40,00,000/8)
(f) Profit /(Loss) (38,00,000) 11,00,000 98,00,000 79,00,000
[b-c-d-e]
(g) Tax @ 25% *(9,50,000) 2,75,000 24,50,000 19,75,000
(h) Profit/(Loss) after tax (28,50,000) 8,25,000 73,50,000 59,25,000
[f-g]
(i) Cash inflow [ h + e ] 1,50,000 38,25,000 1,03,50,000 89,25,000

473
 [INVESTMENT DECISIONS]

*Note : PD Ltd. is an existing company, hence it is assumed that the loss of

year 1 can be set off with other income of year 1 itself and hence tax @ 25%
can be saved in year 1.

(2) Computation of NPV:

Particulars Year Cashflow (₹) PVF @ PV (₹)

10%
Initial Project cost 0 (2,40,00,000) 1.00 (2,40,00,000)
Investment in working capital 0 (30,00,000) 1.00 (30,00,000)
Annual Cash Inflows : (WN1) 1 1,50,000 0.909 1,36,350
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000 0.467 41,67,975
Release of working capital 8 30,00,000 0.467 14,01,000
Net Present Value (NPV) NPV 1,27,46,250

Recommendation: Accept the project in view of positive NPV.

Question – 39
CK Ltd. is planning to buy a new machine. Details of which are as follows:

Cost of the Machine at the commencement ₹ 2,50,000

Economic Life of the Machine 8 year

Residual Value Nil

Annual Production Capacity of the Machine 1,00,000 units

Estimated Selling Price per unit ₹6

Estimated Variable Cost per unit ₹3

Estimated Annual Fixed Cost ₹ 1,00,000

(Excluding depreciation)

Advertisement Expenses in 1st year in addition of

annual fixed cost ₹ 20,000

474
 [INVESTMENT DECISIONS]

Maintenance Expenses in 5th year in addition

of annual fixed cost ₹ 30,000

Cost of Capital 12%

Ignore Tax. Analyze the above-mentioned proposal using the Net Present Value
Method and advice. P.V. factor @ 12% are as under:

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

(Exam Nov – 2020)

Solution:

Calculation of Net Cash flows

Contribution = (₹ 6 – ₹ 3) × 1,00,000 units = ₹ 3,00,000

Fixed costs (excluding depreciation) = ₹ 1,00,000

Year Capital (₹) Contribution Fixed Advertisement/ Net cash

(₹) costs (₹) Maintenance flow (₹)
expenses (₹)
0 (2,50,000) (2,50,000)
1 3,00,000 (1,00,000) (20,000) 1,80,000
2 3,00,000 (1,00,000) 2,00,000
3 3,00,000 (1,00,000) 2,00,000
4 3,00,000 (1,00,000) 2,00,000
5 3,00,000 (1,00,000) (30,000) 1,70,000
6 3,00,000 (1,00,000) 2,00,000
7 3,00,000 (1,00,000) 2,00,000
8 3,00,000 (1,00,000) 2,00,000

475
 [INVESTMENT DECISIONS]

Calculation of Net Present Value

Year Net cash flow (₹) 12% discount factor Present value (₹)
0 (2,50,000) 1.000 (2,50,000)
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
7,08,730

Advise: CK Ltd. should buy the new machine, as the net present value of the
proposal is positive i.e ₹ 7,08,730.

Question – 40
A firm is in need of a small vehicle to make deliveries. It is intending to choose
between two options. One option is to buy a new three wheeler that would cost
₹ 1,50,000 and will remain in service for 10 years.

The other alternative is to buy a second hand vehicle for ₹ 80,000 that could
remain in service for 5 years. Thereafter the firm, can buy another second hand
vehicle for ₹ 60,000 that will last for another 5 years.

The scrap value of the discarded vehicle will be equal to it written down value
(WDV). The firm pays 30% tax and is allowed to claim depreciation on vehicles
@ 25% on WDV basis.

The cost of capital of the firm is 12%.

You are required to advise the best option.

Given:

t 1 2 3 4 5 6 7 8 9 10
PVIF 0.892 0.797 0.711 0.635 0.567 0.506 0.452 0.403 0.360 0.322
(t,12%)

(Exam, Nov – 2022)

Solution:

476
 [INVESTMENT DECISIONS]

Selection of Investment Decision

Tax shield on Purchase of New vehicle

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

Tax shield on Purchase of Second hand vehicles

Tax shield on Purchase of New vehicle

Year WDV Dep. @ 25% Tax shield @
30%
1 80,000 20,000 6,000
2 60,000 15,000 4,500
3 45,000 11,250 3,375
4 33,750 8,437 2,531
5 25,313 6,328 1,898 Scrap value = ₹ 18,985
6 60,000 15,000 4,500
7 45,000 11,250 3,375
8 33,750 8,437 2,531
9 25,313 6,328 1,898
10 18,985 4,746 1,424 Scrap value = ₹ 14,239

Calculation of PV of Net outflow of New Vehicle

Year Cash OF/IF PV Factor PV of OF/IF

0 1,50,000 1 1,50,000
1 (11,250) 0.892 (10,035)
2 (8,437) 0.797 (6,724)
3 (6,328) 0.711 (4,499)
4 (4,746) 0.635 (3,014)
5 (3,560) 0.567 (2,018)
6 (2,670) 0.506 (1,351)

477
 [INVESTMENT DECISIONS]

7 (2,002) 0.452 (905)

8 (1,502) 0.403 (605)
9 (1,126) 0.360 (405)
10 (845 + 8447) 0.322 (2,992)
PVNOF 1,17,452

Calculation of PV of Net outflow of Second hand Vehicles

Year Cash OF/IF PV Factor PV of OF/IF

0 80,000 1 80,000
1 (6,000) 0.892 (5,352)
2 (4,500) 0.797 (3,587)
3 (3,375) 0.711 (2,400)
4 (2,531) 0.635 (1,607)
5 (60000 – 18985 – 1898) = 39,117 0.567 22,179
6 (4,500) 0.506 (2,277)
7 (3,375) 0.452 (1,525)
8 (2,531) 0.403 (1,020)
9 (1,898) 0.360 (683)
10 (1424 + 14239) = (15,663) 0.322 (5,043)
PVNOF 78,686

Advise: The PV of net outflow is low in case of buying the second hand
vehicles. Therefore, it is advisable to buy second hand vehicles.

Question – 41
A hospital is considering to purchase a diagnostic machine costing ₹ 80,000.
The projected life of the machine is 8 years and has an expected salvage value
of ₹ 6,000 at the end of 8 years. The annual operating cost of the machine is ₹
7,500. It is expected to generate revenues of ₹ 40,000 per year for eight years.
Presently, the hospital is outsourcing the diagnostic work and is earning
commission income of ₹ 12,000 per annum.

Consider tax rate of 30% and Discounting Rate as 10%.

Advise:

Whether it would be profitable for the hospital to purchase the machine?

Give your recommendation as per Net Present Value method and Present Value
Index method under below mentioned two situations:

(i) If Commission income of ₹ 12,000 p.a. is before taxes.

478
 [INVESTMENT DECISIONS]

(ii) If Commission income of ₹ 12,000 p.a. is net of taxes.

Given:

t 1 2 3 4 5 6 7 8
PVIF (t,10%) 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

(Exam, Nov – 2022)

Solution:

Analysis of Investment Decisions

Situation-(i) Situation-(ii)
Determination of Cash inflows Commission Commission
Income before Income
taxes after taxes
Cash flow up-to 7th year:
Sales Revenue 40,000 40,000
Less: Operating Cost (7,500) (7,500)
32,500 32,500
Less: Depreciation (80,000 – 6,000) ÷ 8 (9,250) (9,250)
Net Income 23,250 23,250
Tax @ 30% (6,975) (6,975)
Earnings after Tax (EAT) 16,275 16,275
Add: Depreciation 9,250 9,250
Cash inflow after tax per annum 25,525 25,525
Less: Loss of Commission Income (8,400) (12,000)
Net Cash inflow after tax per annum 17,125 13,525
In 8th Year:
Net Cash inflow after tax 17,125 13,525
Add: Salvage Value of Machine 6,000 6,000
Net Cash inflow in year 8 23,125 19,525

Calculation of Net Present Value (NPV) and Profitability Index (PI)

Particulars PV Situation-(i) Situation-(ii)

factor [Commission [Commission
@10% Income before Income after
taxes] taxes]
A Present value of cash 4.867 83,347.38 65,826.18
inflows (1st to 7th year) (17,125 × 4.867) (13,525 × 4.867)
B Present value of cash inflow 0.467 10,799.38 9,118.18
at 8th year (23,125 × 0.467) (19,525 × 0.467)

479
 [INVESTMENT DECISIONS]

C PV of cash inflows 94,146.76 74,944.36

D Less: Cash Outflow 1.00 (80,000) (80,000)
E Net Present Value (NPV) 14,146.76 (5,055.64)
F PI = (C÷D) 1.18 0.94

Recommendation: The hospital may consider purchasing of diagnostic

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

Question – 42
ABC Ltd. is considering to purchase a machine which is priced at ₹ 5,00,000.
The estimated life of machine is 5 years and has an expected salvage value of ₹
45,000 at the end of 5 years. It is expected to generate revenues of ₹ 1,50,000
per annum for five years. The annual operating cost of the machine is ₹
28,125, Corporate Tax Rate is 20% and the cost of capital is 10%.

You are required to analyze whether it would be profitable for the company to
purchase the machine by using;

(i) Payback period Method

(ii) Net Present value method

(iii) Profitability Index Method

(Exam, Nov – 2023)

Solution:

Computation of Annual Cash Flows

Particular (₹)
Revenue 1,50,000
Less: Operating Cost (28,125)
(5,00,000 − 45,000) (91,000)
Less: Depreciation
5
Profit before Tax 30,875
Less: Tax (6,175)
Profit after Tax 24,700
Add: Depreciation 91,000
Annual Cash Inflows 1,15,700

480
 [INVESTMENT DECISIONS]

(i) Computation of Payback Period

Year Cash Flows Cumulative Present Value

1 1,15,700 1,15,700
2 1,15,700 2,31,400
3 1,15,700 3,47,100
4 1,15,700 4,62,800
5 (Including Salvage) 1,60,700 6,23,500

Amount to be recovered in 5th year cash flow = ₹ 5,00,000 – ₹ 4,62,800

= ₹ 37,200
37,200
Payback period = 4 years + = 4.23 years
1,60,700
Since the payback period is less than the life of machinery, the company
may purchase the machine.

(ii) Computation of Net Present Value

Year Cash Flows PVF @10% Present Value

0 (5,00,000) 1.000 (5,00,000)
1-5 1,15,700 3.791 4,38,594
5 45,000 0.621 27,941
Net Present Value (33,465)

Since the net present value (NPV) is negative, the company should not
purchase the machine.

(iii) Computation of Profitability Index (PI)

Sum of present value of net cash inflow

Profitability Index (PI) =
Initial cash outflow

₹ 4,38,594 + ₹ 27,941
= = 0.93
₹ 5,00,000

Since the profitability index is less than 1, the company should not
purchase the machine.

481
 [INVESTMENT DECISIONS]

(2) REPLACEMENT DECISION

Question – 43
HMR Ltd. is considering replacing a manually operated old machine with a
fully automatic new machine. The old machine had been fully depreciated for
tax purpose but has a book value of ₹ 2,40,000 on 31st March . The machine
has begun causing problems with breakdowns and it cannot fetch more than ₹
30,000 if sold in the market at present. It will have no realizable value after 10
years. The company has been offered ₹ 1,00,000 for the old machine as a trade
in on the new machine which has a price (before allowance for trade in) of ₹
4,50,000. The expected life of new machine is 10 years with salvage value of ₹
35,000.

Further, the company follows straight line depreciation method but for tax
purpose, written down value method depreciation @ 7.5% is considering that
this is the only machine in the block of assets.

Given below are the expected sales and costs from both old and new machine:

Old machine (₹) New machine (₹)

Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075

From the above information, ANALYSE whether the old machine should be
replaced or not if required rate of return is 10%? Ignore capital gain tax.

PV factors @ 10%:

Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

(Study Material ICAI Illus – 18)

Solution:

482
 [INVESTMENT DECISIONS]

Workings:

1. Calculation of Base for depreciation or Cost of New Machine

Particulars (₹)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000

2. Calculation of Profit before tax as per books

Particulars Old New Difference

Machine Machine (₹)
(₹) (₹)
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per boks 24,000 41,500 17,500
Profit before tax and depreciation 3,48,750 4,28,750 80,000
(PBTD)

Calculation of Incremental NPV

Year PVF @ PBTD Dep. @ PBT (₹) Tax @ Cash PV of Cash

10% (₹) 7.5% (₹) 30% (₹) Inflows Inflows (₹)
(₹)
(1) (2) (3) (4) (5) = (4) × (6) = (4) – (7) = (6) ×
0.30 (5) + (3) (1)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38
2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21
6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73
7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage value of new machine (₹ 35,000 × 0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44

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

483
 [INVESTMENT DECISIONS]

Question – 44
Lockwood Limited wants to replace its old machine with a new automatic
machine. Two models A and B are available at the same cost of ₹ 5 lakhs each.
Salvage value of the old machine is ₹ 1 lakh. The utilities of the existing
machine can be used if the company purchases model A. Additional cost of
utilities to be purchased in this case will be ₹ 1 lakh. If the company purchases
B, then all the existing utilities will have to be replaced with new utilities
costing ₹ 2 lakhs. The salvage value of the old utilities will be ₹ 0.20 lakhs. The
cash flows are expected to be:

Year Cash inflows Cash inflows P.V. Factor

of A (₹) of B (₹) @ 15%
1 1,00,000 2,00,000 0.870
2 1,50,000 2,10,000 0.756
3 1,80,000 1,80,000 0.658
4 2,00,000 1,70,000 0.572
5 1,70,000 40,000 0.497
Salvage Value at the 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) STATE which of the machines is to be selected?

(Study Material ICAI TYK – 02)

Solution:

Working:

Calculation of Cash -outflow at year zero

Particulars A (₹) B (₹)

Cost of Machine 5,00,000 5,00,000
Cost of Utilities 1,00,000 2,00,000
Salvage value of Old Machine (1,00,000) (1,00,000)
Salvage of value Old Utilities – (20,000)
Total Expenditure (Net) 5,00,000 5,00,000

(i) (a) Calculation of NPV

Year PV Machine A Machine B

Factor Cash Discounted Cash Discounted

484
 [INVESTMENT DECISIONS]

@ 15% Inflows (₹) value of Inflows (₹) value of

inflows (₹) inflows (₹)
0 1.000 (5,00,000) (5,00,000) (5,80,000) (5,80,000)
1 0.870 1,00,000 87,000 2,00,000 1,74,000
2 0.756 1,50,000 1,13,400 2,10,000 1,58,760
3 0.658 1,80,000 1,18,440 1,80,000 1,18,440
4 0.572 2,00,000 1,14,400 1,70,000 97,240
5 0.497 1,70,000 84,490 40,000 19,880
Salvage 0.497 50,000 24,850 60,000 29,820
Net Present Value 42,580 18,140

Since the Net present Value of both the machines is positive both are
acceptable.

(b) Discounted Pay-back Period (Amount in ₹)

Year Machine A Machine B

Discounted Cumulative Discounted Cumulative
cash inflows Discounted cash Discounted
cash inflows inflows cash inflows
1 87,000 87,000 1,74,000 1,74,000
2 1,13,400 2,00,400 1,58,760 3,32,760
3 1,18,440 3,18,840 1,18,440 4,51,200
4 1,14,400 4,33,240 97,240 5,48,440
5 1,09,340* 5,42,580 49,700* 5,98,140

* Includes salvage value.

Discounted Payback Period (For A and B):

5,00,000−4,33,240
Machine A = 4 years + = 4.61 years
1,09,340

5,80,000−5,48,440
Machine B = 4 years + = 4.63 years
49,700

(c) Desirability Factor or Profitability Index:

Sum of present value of net cash inflow

Profitability Index (PI) =
Initial cash outflow

₹ 5,42,580
Machine A = = 1.08;
₹ 5,00,000

485
 [INVESTMENT DECISIONS]

₹ 5,98,140
Machine A = = 1.03
₹ 5,80,000

(ii) Since the absolute surplus in the case of A is more than B and also the
desirability factor, it is better to choose A.

The discounted payback period in both the cases is almost same, also
the net present value is positive in both the cases, but the desirability
factor (profitability index) is higher in the case of Machine A, it is
therefore better to choose Machine A.

Question – 45
Cello Limited is considering buying a new machine which would have a useful
economic life of five years, a cost of ₹ 1,25,000 and a scrap value of ₹ 30,000,
with 80 per cent of the cost being payable at the start of the project and 20 per
cent at the end of the first year. The machine would produce 50,000 units per
annum of a new product with an estimated selling price of ₹ 3 per unit. Direct
costs would be ₹ 1.75 per unit and annual fixed costs, including depreciation
calculated on a straight- line basis, would be ₹ 40,000 per annum.

In the first year and the second year, special sales promotion expenditure, not
included in the above costs, would be incurred, amounting to ₹ 10,000 and ₹
15,000 respectively.

CALCULATE NPV of the project for investment appraisal, assuming that the
company‟s cost of capital is 10 percent.

(Study Material ICAI TYK – 05)

Solution:

Calculation of Net Cash flow

Contribution = (3.00 – 1.75) × 50,000 = ₹ 62,500

Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ₹ 21,000

Year Capital Contribution Fixed costs Adverts Net cash flow

(₹) (₹) (₹) (₹) (₹)
0 (1,00,000) - - - (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 - 62,500 (21,000) (15,000) 26,500
3 - 62,500 (21,000) - 41,500
4 - 62,500 (21,000) - 41,500

486
 [INVESTMENT DECISIONS]

5 - 62,500 (21,000) - 71,500

Calculation of Net Present Value

Year Net cash flow 10% discount Present value

(₹) factor (₹)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
Net Present Value 31,712

The net present value of the project is ₹ 31,712.

Question – 46
Xavly Ltd. has a machine which has been in operation for 3 years. The machine
has a remaining estimated useful life of 5 years with no salvage value in the
end. Its current market value is ₹ 2,00,000. The company is considering a
proposal to purchase a new model of machine to replace the existing machine.
The relevant information is as follows:

Existing Machine New Machine

Cost of machine ₹ 3,30,000 ₹ 10,00,000
Estimated life 8 years 5 years
Salvage value Nil ₹ 40,000
Annual output 30,000 units 75,000 units
Selling price per unit ₹ 15 ₹ 15
Annual operating hours 3,000 3,000
Material cost per unit ₹4 ₹4
Labour cost per hour ₹ 40 ₹ 70
Indirect cash cost per annum ₹ 50,000 ₹ 65,000

The company uses written down value of depreciation @ 20% and it has several
other machines in the block of assets. The Income tax rate is 30 per cent and
Xavly Ltd. does not make any investment, if it yields less than 12 per cent.

ADVISE Xavly Ltd. whether the existing machine should be replaced or not.

PV factors @12%:

487
 [INVESTMENT DECISIONS]

Year 1 2 3 4 5
PVF 0.893 0.797 0.712 0.636 0.567

(Study Material ICAI TYK – 11)

Solution:

(i) Calculation of Net Initial Cash Outflows:

₹
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 2,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of Base for depreciation

Particulars ₹
WDV of Existing Machine
Cost of existing machine 3,30,000
Less: Depreciation for Year 1 66,000
Depreciation for Year 2 52,800
Depreciation for Year 3 42,240 1,61,040
WDV of Existing Machine (i) 1,68,960
Depreciation base of New Machine
Cost of new machine 10,00,000
Add: WDV of existing machine 1,68,960
Less: Sales value of existing machine 2,00,000
Depreciation base of New Machine (ii) 9,68,960
Base for incremental depreciation [(ii) – (i)] 8,00,000

(iii) Calculation of annual profit before tax and depreciation

Particulars Existing New Differential

machine Machine
(1) (2) (3) (4)=(3)–(2)
Annual output 30,000 units 75,000 units 45,000 units
₹ ₹ ₹
(A) Sales revenue @ ₹ 15 per unit 4,50,000 11,25,000 6,75,000
(B) Less: Cost of Operation
Material @ ₹ 4 per unit 1,20,000 3,00,000 1,80,000
Labour
Old = 3,000 × ₹ 40 1,20,000 90,000

488
 [INVESTMENT DECISIONS]

New = 3,000 × ₹ 70 2,10,000

Indirect cash cost 50,000 65,000 15,000
Total Cost (B) 2,90,000 5,75,000 2,85,000
Profit Before Tax and 1,60,000 5,50,000 3,90,000
depreciation (PBTD) (A – B)

(iv) Calculation of Incremental Net Present Value:

Year PBTD Dep. @ PBT Tax @ Net cash PVF @ PV

20% 30% flow 12%
(1) (2) (3) (4=2-3) (5) (6=4-5+3) (7) (8=6 × 7)
1 3,90,000 1,60,000 2,30,000 69,000.00 3,21,000.00 0.893 2,86,653.00
2 3,90,000 1,28,000 2,62,000 78,600.00 3,11,400.00 0.797 2,48,185.80
3 3,90,000 1,02,400 2,87,600 86,280.00 3,03,720.00 0.712 2,16,248.64
4 3,90,000 81,920 3,08,080 92,424.00 2,97,576.00 0.636 1,89,258.34
5 3,90,000 65,536 3,24,464 97,339.20 2,92,660.80 0.567 1,65,938.67
11,06,284.45
Add: PV of Salvage Value of new machine (₹ 40,000 × 0.567) 22,680.00
Less: Initial Cash Outflow 8,00,000.00
NPV 3,28,964.45

Advice: Since the incremental NPV is positive, existing machine should be

replaced.

Question – 47
A & Co. is contemplating whether to replace an existing machine or to spend
money on overhauling it. A & Co. currently pays no taxes. The replacement
machine costs ₹ 90,000 now and requires maintenance of ₹ 10,000 at the end
of every year for eight years. At the end of eight years it would have a salvage
value of ₹ 20,000 and would be sold. The existing machine requires increasing
amounts of maintenance each year and its salvage value falls each year as
follows:

Year Maintenance (₹) Salvage (₹)

Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0

The opportunity cost of capital for A & Co. is 15%.

REQUIRED:

489
 [INVESTMENT DECISIONS]

When should the company replace the machine?

(Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate
of 15% : 4.4873; present value of Re. 1 to be received after 8 years at interest
rate of 15% : 0.3269).

(Study Material ICAI TYK – 12)

Solution:

A & Co.

Equivalent cost of (EAC) of new machine

₹
(i) Cost of new machine now 90,000
Add: PV of annual repairs @ ₹ 10,000 per annum for 8 years
(₹ 10,000 × 4.4873) 44,873
1,34,873
Less: PV of salvage value at the end of 8 years 6,538
(₹ 20,000 × 0.3269)
1,28,335

Equivalent annual cost (EAC) (₹ 1,28,335/4.4873) 28,600

PV of cost of replacing the old machine in each of 4 years

with new machine

Scenario Year Cash Flow PV @ 15% PV

(₹) (₹)
Replace Immediately 0 (28,600) 1.00 28,600
40,000 1.00 40,000
11,400
Replace in one year 1 (28,600) 0.870 (24,882)
1 (10,000) 0.870 (8,700)
1 25,0000 0.870 21,750
(11,832)
Replace in two years 1 (10,000) 0.870 (8,700)
2 (28,600) 0.756 (21,622)
2 (20,000) 0.756 (15,120)
2 15,000 0.756 11,340
(34,102)
Replace in three years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)

490
 [INVESTMENT DECISIONS]

3 (28,600) 0.658 (18,819)

3 (30,000) 0.658 (19,740)
3 10,000 0.658 6,580
(55,799)
Replace in four years 1 (10,000) 0.870 (8,700)
2 (20,000) 0.756 (15,120)
3 (30,000) 0.658 (19,740)
4 (28,600) 0.572 (16,359)
4 (40,000) 0.572 (22,880)
(82,799)

Advice: The company should replace the old machine immediately because the
PV of cost of replacing the old machine with new machine is least.

Question – 48
GG Pathology Lab Ltd. is using 2D sonography machine which has reached the
end of its useful life. The lab is intending to upgrade along with the technology
by investing in 3D sonography machine as per the choices preferred by the
patients. Following new 3D sonography machine of two different brands with
same features is available in the market:

Brand Cost of Life of Maintenance Cost (₹) SLM

Machine Machine Year Year Year Depreciation
(₹) (₹) 1-15 6-10 11-15 rate (%)
X 15,00,000 15 50,000 70,000 98,000 6
Y 10,00,000 10 70,000 1,15,000 - 6

Residual Value of machines shall be dropped by 10% and 40% of Purchase

price for Brand X and Y respectively in the first year and thereafter shall be
depreciated at the rate mentioned above on the original cost.

Alternatively, the machine of Brand Y can also be taken on rent to be returned

back to the owner after use on the following terms and conditions:

• Annual Rent shall be paid in the beginning of each year and for first year
it shall be ₹ 2,24,000. Annual Rent for the subsequent 4 years shall be ₹
2,25,000.

• Annual Rent for the final 5 years shall be ₹ 2,70,000.

• The Rent/Agreement can be terminated by GG Labs by making a

payment of Rs. 2,20,000 as penalty. This penalty would be reduced by ₹
22,000 each year of the period of rental agreement.

491
 [INVESTMENT DECISIONS]

You are required to:

(i) ADVISE which brand of 3D sonography machine should be acquired

assuming that the use of machine shall be continued for a period of 20
years.

(ii) STATE which of the option is most economical if machine is likely to be

used for a period of 5 years?

The cost of capital of GG Labs is 12%.

The present value factor of Rs. 1 @ 12% for different years is given as under:

Year PVF Year PVF

1 0.893 9 0.361
2 0.797 10 0.322
3 0.712 11 0.287
4 0.636 12 0.257
5 0.567 13 0.229
6 0.507 14 0.205
7 0.452 15 0.183
8 0.404 16 0.163
(MTP March – 2021)

Solution:

Since the life span of each machine is different and time span exceeds the
useful lives of each modeI, we shall use Equivalent Annual Cost method to
decide which brand should be chosen.

(i) If machine is used for 20 years

(a) Residual value of machine of brand X

= [₹ 15,00,000 - (1 -0.10)] -(₹ 15,00,000 × 0.06 × 14)

= ₹ 90,000

(b) Residual value of machine of brand Y

= [₹10,00,000 - (1 - 0.40)] - (₹ 10,00,000 × 0.06 × 9)

= ₹ 60,000

492
 [INVESTMENT DECISIONS]

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

Period Cash Outflow (₹) PVF @ 12% PV (₹)

0 15,00,000 1.000 15,00,000
1- 5 50,000 3.605 1,80,250
6 - 10 70,000 2.046 1,43,220
11 - 15 98,000 1.161 1,13,778
15 (90,000) 0.183 (16,470)
19,20,778

PVAF for 1-15 years = ₹ 6.812

₹ 19,20,778
Equivalent Annual Cost = = ₹ 2,81,969.76
6.812

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

Period Cash Outflow (₹) PVF @ 12% PV (₹)

0 10,00,000 1,000 10,00,000
1 -5 70,000 3.605 2,52,350
6 -10 1,15,000 2.046 2,35,290
10 (60,000) 0.322 (19,320)
14,68,320

PVAF for 1-10 years = 5.651

₹ 14,68,320
Equivalent Annual Cost ₹ 2,59,833.66
5.651

Present Value (PV) of cost if machine of brand Y is taken on rent

Period Cash Outflow PVF @ 12% PV (₹)

(₹)

0 2,24,000 1.000 2,24,000

1 -4 2,25,000 3.038 6,83,550
5–9 2,70,000 2.291 6,18,570
15,26,120

PVAF for 1-10 years = 5.651

₹ 15,26,120
Equivalent Annual Cost = = ₹ 2,70,061.94
5.651

493
 [INVESTMENT DECISIONS]

Decision: Since Equivalent Annual Cash Outflow is least in case of

purchase of Machine of brand Y the same should be purchased.

(ii) If machine is used for 5 years

(a) Scrap value of machine of brand X

= [₹ 15,00,000 - (1 - 0.10)] - (₹ 15,00,000 × 0.06 × 4) = ₹ 9,90,000

(b) Scrap value of machine of brand Y

= [₹ 10,00,000 - (1-0.40)] - (₹ 10,00,000 × 0.06 × 4) = ₹ 3,60,000

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

Period Cash Outflow (₹) PVF @ 12% PV (₹)

0 15,00,000 1.000 15,00,000
1-5 50,000 3.605 1,80,250
5 (9,90,000) 0.567 (5,61,330)
11,18,920

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

Period Cash Outflow (₹) PVF @ 12% PV (₹)

0 10,00,000 1.000 10,00,000
1-5 70,000 3.605 2,52,350
5 (3,60,000) 0.567 (2,04,120)
10,48,230

Present Value (PV) of cost if machine of brand Y is taken on rent

Period Cash Outflow (₹) PVF @ 12% PV (₹)

0 2,24,000 1.000 2,24,000
1-4 2,25,000 3.038 6,83,550
5 1,10,000* 0.567 62,370
9,69,920

* [₹ 2,20,000 - (₹ 22,000 × 5) = ₹ 1,10,000]

Decision: Since Cash Outflow is least in case of rent of Machine of brand

Y the same should be taken on rent.

494
 [INVESTMENT DECISIONS]

Question – 49
Yellow bells Ltd. wants to replace its old machine with new automatic machine.
The old machine had been fully depreciated for tax purpose but has a book
value of ₹ 3,50,000 on 31st March 2022. The machine cannot fetch more than ₹
45,000 if sold in the market at present. It will have no realizable value after 10
years. The company has been offered ₹ 1,60,000 for the old machine as a trade
in on the new machine which has a price (before allowance for trade in) of ₹
6,50,000. The expected life of new machine is 10 years with salvage value of ₹
63,000.

Further, the company follows straight line depreciation method but for tax
purpose, written down value method depreciation @ 9% is allowed taking that
this is the only machine in the block of assets.

Given below are the expected sales and costs from both old and new machine:

Old Machine (₹) New Machine(₹)

Sales 11,74,500 11,74,500
Material cost 2,61,000 1,83,063
Labour cost 1,95,750 1,59,500
Variable overhead 81,563 68,875
Fixed overhead 1,30,500 1,41,375
Depreciation 34,800 60,175
Profit Before Tax(PBT) 4,70,088 5,61,513
Tax @ 25% 1,17,722 1,40,378
Profit After Tax(PAT) 3,53,166 4,21,134

From the above information, ANALYSE whether the old machine should be
replaced or not if required rate of return is 10%? Ignore capital gain tax.

PV factors @ 10%:

Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

(MTP March – 2023)

Solution:

(i) Calculation of Base for depreciation or Cost of New Machine

Particulars (₹)
Purchase price of new machine 6,50,000
Less: Sale price of old machine 1,60,000
4,90,000

495
 [INVESTMENT DECISIONS]

(ii) Calculation of Profit before tax as per books

Particulars Old New Difference

machine machine
(₹) (₹) (₹)
PBT as per books 4,70,888 5,61,513 90,625
Add: Depreciation as per books 34,800 60,175 25,375
Profit before tax and depreciation 5,05,688 6,21,688 1,16,000
(PBTD)

Calculation of Incremental NPV

PVF PBTD Dep. @ 9 PBT Tax @ 25 Cash PV of Cash

% % Inflow Inflow
Year
@ 10 (₹) (₹) (₹) (₹) (₹) (₹)
%
1 2 3 4 (2-3) 5 = (4) × 6 = (4)−(5) 7
0.25 + (3)
1 0.909 1,16,000.00 44,100.00 71,900.00 17,975.00 98,025.00 89,104.73
2 0.826 1,16,000.00 40,131.00 75,869.00 18,967.25 97,032.75 80,149.05
3 0.751 1,16,000.00 36,519.21 79,480.79 19,870.20 96,129.80 72,193.48
4 0.683 1,16,000.00 33,232.48 82,767.52 20,691.88 95,308.12 65,095.45
5 0.621 1,16,000.00 30,241.56 85,758.44 21,439.61 94,560.39 58,722.00
6 0.564 1,16,000.00 27,519.82 88,480.18 22,120.05 93,879.95 52,948.29
7 0.513 1,16,000.00 25,043.03 90,956.97 22,739.24 93,260.76 47,842.77
8 0.467 1,16,000.00 22,789.16 93,210.84 23,302.71 92,697.29 43,289.63
9 0.424 1,16,000.00 20,738.14 95,261.86 23,815.47 92,184.53 39,086.24
10 0.386 1,16,000.00 18,871.70 97,128.30 24,282.07 91,717.93 35,403.12
5,83,834.77
Add: PV of Salvage value of new machine (₹ 63,000 ₹ 0.386) 24,318.00
Total PV of incremental cash inflows 6,08,152.77
Less: Cost of new machine [as calculated in point (i)] 4,90,000.00
Incremental Net Present Value 1,18,152.77

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

Question – 50
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 ₹ 1,40,000 enhancing its economic life to 5 years. The equipment

496
 [INVESTMENT DECISIONS]

could be sold for ₹ 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 ₹

3,50,000 with an economic life of 5 years and salvage value of ₹ 60,000. The
new machine is expected to be more efficient in reducing costs of material
handling, labour, maintenance & repairs, etc.

The annual cost are as follows:

Existing Equipment Modernization New Machine

(₹) (₹) (₹)
Wages & 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
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?

PV factor at 10% are as follows:

Year 1 2 3 4 5
PV Factor 0.909 0.826 0.751 0.683 0.621

(RTP May – 2021)

Solution:

Workings:

Calculation of Depreciation:
₹ 1,40,000 − ₹ 30,000
On Modernized Equipment = = ₹ 22,000 p.a.
5 years

₹ 3,50,000 − ₹ 60,000
On New machine = = ₹ 58,000 p.a.
5 years

(i) Calculation of Incremental annual cash inflows/ savings:

497
 [INVESTMENT DECISIONS]

Existing
Particulars Equipment Modernization New Machine
(₹) Amount Saving Amount Saving
(₹) s(₹) (₹) s (₹)
(1) (2) (3)=(1)- (4) (5)=(1)-
(2) (4)
Wages & Salaries 45,000 35,500 9,500 15,000 30,000
Supervision 20,000 10,000 10,000 7,000 13,000
Maintenance 25,000 5,000 20,000 2,500 22,500
Power 30,000 20,000 10,000 15,000 15,000
Total 1,20,000 70,500 49,500 39,500 80,500
Less:
Depreciation 22,000 58,000
(Refer Workings)
Total Savings 27,500 22,500
Less: Tax @ 50% 13,750 11,250
After Tax Savings 13,750 11,250
Add: Depreciation 22,000 58,000
Incremental
Annual 35,750 69,250
Cash Inflows

(ii) Calculation of Net Present Value (NPV)

Particulars Year Modernization (₹) New Machine(₹)

Initial Cash outflow (A) 0 1,40,000.00 3,50,000.00
Incremental Cash 1-5 1,35,492.50 2,62,457.50
Inflows (35,750 × 3.790) (69,250 × 3.790)
Salvage value 5 18,630.00 37,260.00
(30,000 × 0.621) (60,000 × 0.621)
PV of Cash inflows (B) 1,54,122.50 2,99,717.50
Net Present Value 14,122.50 (50,282.50)
(B - A)

Advise: The company should modernize its existing equipment and not buy a
new machine because NPV is positive in modernization of equipment.

Question – 51
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 ₹ 18,00,000 now and requires maintenance of ₹ 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 ₹ 4,00,000 and would be sold. The existing machine requires

498
 [INVESTMENT DECISIONS]

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?

The following present value table is given for you:

Year Present Value of ₹ 1 at 15% discount rate

1 0.8696
2 0.7561
3 0.6575
4 0.5718
5 0.4972
6 0.4323
7 0.3759
8 0.3269

(RTP May – 2022)

Solution:

ABC & Co.

Equivalent Annual Cost (EAC) of new machine

(₹)
(i) Cost of new machine now 18,00,000
Add: PV of annual repairs @ ₹ 2,00,000 per annum for 8
years (₹ 2,00,000 × 4.4873) 8,97,460
26,97,460
Less: PV of salvage value at the end of 8 years
(₹ 4,00,000 × 0.3269) 1,30,760
25,66,700

499
 [INVESTMENT DECISIONS]

Equivalent annual cost (EAC) (₹ 25,66,700/4.4873) 5,71,992

PV of cost of replacing the old machine in each of 4 years

with new machine

Scenario Year Cash Flow PV @ 15% PV

(₹) (₹)
Replace Immediately 0 (5,71,992) 1.00 (5,71,992)
0 8,00,000 1.00 8,00,000
2,28,008
Replace in one year 1 (5,71,992) 0.8696 (4,97,404)
1 (2,00,000) 0.8696 (1,73,920)
1 5,00,000 0.8696 4,34,800
(2,36,524)
Replace in two years 1 (2,00,000) 0.8696 (1,73,920)
2 (5,71,992) 0.7561 (4,32,483)
2 (4,00,000) 0.7561 (3,02,440)
2 3,00,000) 0.7561 2,26,830
(6,82,013
Replace in three years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (5,71,992) 0.6575 (3,76,085)
3 (6,00,000) 0.6575 (3,94,500)
3 2,00,000 0.6575 1,31,500
(11,15,445)
Replace in four years 1 (2,00,000) 0.8696 (1,73,920)
2 (4,00,000) 0.7561 (3,02,440)
3 (6,00,000) 0.6575 (3,94,500)
4 (5,71,992) 0.5718 (3,27,065)
4 (8,00,000) 0.5718 (4,57,440)
(16,55,365)

Advice: The company should replace the old machine immediately because the
PV of cost of replacing the old machine with new machine is least.

Question – 52
HMR Ltd. is considering replacing a manually operated old machine with a
fully automatic new machine. The old machine had been fully depreciated for
tax purpose but has a book value of ₹ 2,50,000 on 31st March. The machine
has begun causing problems with breakdowns and it cannot fetch more than ₹

500
 [INVESTMENT DECISIONS]

40,000 if sold in the market at present. It will have no realizable value after 10
years. The company has been offered ₹ 1,50,000 for the old machine as a trade
in on the new machine which has a price (before allowance for trade in) of ₹
6,00,000. The expected life of new machine is 10 years with salvage value of ₹
35,000.

Further, the company follows written down value method depreciation @ 10%
but for tax purpose, straight line method depreciation is used considering that
this is the only machine in the block of assets. A working capital of ₹ 50,000
will be needed and it will be released at the end of tenth year.

Given below are the expected sales and costs from both old and new machine:

Old Machine New Machine

Annual output 60,000 units 80,000 units
Selling price per unit ₹ 18 ₹ 18
Annual operating hours 2,800 2,800
Material cost per unit ₹5 ₹5
Labour cost per hour ₹ 50 ₹ 75
Indirect cash cost per annum ₹ 1,00,000 ₹ 1,75,000

From the above information, ANALYSE whether the old machine should be
replaced or not if the opportunity cost of capital of the Company is 10%?

The Income tax rate is 30%. Further assume that book profit is treated as
ordinary income for tax purpose.

Also ESTIMATE the internal rate of return of the replacement decision.

All calculations to be calculated to 3 decimal places.

(RTP May – 2024)

Solution:

Workings:

(i) Initial Cash Outflow:

Amount (₹)
Cost of new machine 6,00,000
Less: Sale Price of existing machine 1,05,000
Net of Tax (₹ 1,50,000 × 0.70)
4,95,000

501
 [INVESTMENT DECISIONS]

(ii) Terminal Cash Flows:

New Machine

Amount (₹)
Salvage value of Machine 35,000
Less: Depreciated WDV 35,000
{₹ 6,00,000 − (₹ 56,500 × 10 years)}
Short Term Capital Gain (STCG) Nil
Tax Nil
Net Salvage Value (cash flows) 35,000

(iii) Computation of additional cash flows (yearly)

Particulars Existing New Incremental

machine Machine
(1) (2) (3) (4) = (3) – (2)
Annual output 60,000 units 80,000 units 20,000 units
₹ ₹ ₹
(A) Sales revenue @ ₹ 18 per 10,80,000 14,40,000 3,60,000
unit
(B) Less: Cost of Operation
Material @ ₹ 5 per unit 3,00,000 4,00,000 1,00,000
Labour
Old = 2,800 × ₹ 50 1,40,000 70,000
New = 2,800 × ₹ 75 2,10,000
Indirect cash cost 1,00,000 1,75,000 75,000
Total Cost (B) 5,40,000 7,85,000 2,45,000
Profit Before Tax and 5,40,000 6,55,000 1,15,000
depreciation (PBTD) (A – B)
Less: Depreciation 56,500
6,00,000 − 35,000
=
10
Earning after depreciation before 58,500
Tax
Less: Tax @30% 17,550
Earning after depreciation and 40,950
Tax
Add: Depreciation 56,500
Net Cash inflow 97,450

Analysis: Since the Incremental Cash flow is positive, the old machine
should be replaced.

Note: As mentioned in the question WDV of Machine is zero for tax

purpose hence no depreciation shall be provided in existing machine.

502
 [INVESTMENT DECISIONS]

(iv) Calculation of IRR

Computation of NPV @ 10%

Period Cash PVF @ PV (₹)

flow (₹) 10%
Incremental cash flows 1-10 97,450 6.144 5,98,733
Add: Release of Working 10 50,000 0.386 19,300
Capital
Add: Terminal year cash 10 35,000 0.386 13,510
6,31,543
Less: Initial cash outflow 0 4,95,000 1 4,95,000
Less: Working capital 0 50,000 1 50,000
NPV 86,543

Since NPV computed in Part (i) is positive. Let us discount cash flows at
higher rate say at 20%

Period Cash PVF @ PV (₹)

flow (₹) 20%
Incremental cash flows 1-10 97,450 4.192 4,08,510
Add: Release of Working 10 50,000 0.162 8,100
Capital
Add: Terminal year cash 10 35,000 0.162 5,670
4,22,280
Less: Initial cash outflow 0 4,95,00 1 4,95,000
Less: Working capital 0 50,000 1 50,000
NPV (1,22,720)

Now we use interpolation formula:

86,543
10% + × 10%
86,543-(- 1,22,720)

86,543
10% + × 10%
2,09,263)

IRR = 10% + 4.14% = 14.14%

Summary of Results

Decision
Incremental Cash Flow ₹ 97,450 Accept
IRR 14.14% > Cost of Capital (10%) Accept

503
 [INVESTMENT DECISIONS]

Question – 53
Shiv Limited is thinking of replacing its existing machine by a new machine
which would cost ₹ 60 lakhs. The company‟s current production is 80,000
units, and is expected to increase to 1,00,000 units, if the new machine is
bought. The selling price of the product would remain unchanged at ₹ 200 per
unit. The following is the cost of producing one unit of product using both the
existing and new machine:

Unit cost (₹)

Existing New Machine Difference
Machine (1,00,000
(80,000 units) units)
Materials 75.0 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.0 25.0 5.0
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.0 4.75
Allocated Corporate Overheads 10.0 12.50 2.50
183.25 165.50 17.75

The existing machine has an accounting book value of ₹ 1,00,000, and it has
been fully depreciated for tax purpose. It is estimated that machine will be
useful for 5 years. The supplier of the new machine has offered to accept the
old machine for ₹2,50,000. However, the market price of old machine today is ₹
1,50,000 and it is expected to be ₹ 35,000 after 5 years. The new machine has
a life of 5 years and a salvage value of ₹ 2,50,000 at the end of its economic life.
Assume corporate Income tax rate at 40%, and depreciation is charged on
straight line basis for Income-tax purposes. Further assume that book profit is
treated as ordinary income for tax purpose. The opportunity cost of capital of
the Company is 15%.

Required:

(i) ESTIMATE net present value of the replacement decision.

(ii) CALCULATE the internal rate of return of the replacement decision.

(iii) Should Company go ahead with the replacement decision? ANALYSE.

Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693

504
 [INVESTMENT DECISIONS]

PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230

(RTP Nov – 2018)

Solution:

(i) Net Cash Outlay of New Machine

Purchase Price ₹ 60,00,000

Less: Exchange value of old machine

[2,50,000 – 0.4(2,50,000 – 0)] 1,50,000

₹ 58,50,000

Market Value of Old Machine: The old machine could be sold for ₹
1,50,000 in the market. Since the exchange value is more than the
market value, this option is not attractive. This opportunity will be lost
whether the old machine is retained or replaced. Thus, on incremental
basis, it has no impact.

Depreciation base: Old machine has been fully depreciated for tax
purpose.

Thus, the depreciation base of the new machine will be its original cost
i.e. ₹ 60,00,000.

Net Cash Flows: Unit cost includes depreciation and allocated

overheads. Allocated overheads are allocated from corporate office
therefore they are irrelevant. The depreciation tax shield may be
computed separately. Excluding depreciation and allocated overheads,
unit costs can be calculated. The company will obtain additional revenue
from additional 20,000 units sold.

Thus, after-tax saving, excluding depreciation, tax shield, would be

= {100,000(200 – 148) – 80,000(200 – 173)} × (1 – 0.40)

= {52,00,000 – 21,60,000} × 0.60

= ₹ 18,24,000

After adjusting depreciation tax shield and salvage value, net cash flows
and net present value are estimated.

505
 [INVESTMENT DECISIONS]

Calculation of Cash flows and Project Profitability

₹ (‘000)
0 1 2 3 4 5
1 After-tax savings - - 1824 1824 1824 1824 1824
2 Depreciation - 1150 1150 1150 1150 1150
(₹ 60,00,000 –
2,50,000)/5
3 Tax shield on - 460 460 460 460 460
Depreciation
(Depreciation ×
Tax rate)
4 Net cash flows from - 2284 2284 2284 2284 2284
operations (1 + 3)*
5 Initial cost (5850)
6 Net Salvage Value - - - - - 215
(2,50,000 – 35,000)
7 Net Cash Flows (5850) 2284 2284 2284 2284 2499
(4+5+6)
8 PVF at 15% 1.00 0.8696 0.7561 0.6575 0.5718 0.4972
9 PV (5850) 1986.166 1726.932 1501.73 1305.99 1242.50
10 NPV ₹ 1913.32

* Alternately Net Cash flows from operation can be calculated as follows:

Profit before depreciation and tax

= ₹ 1,00,000 (200 -148) - 80,000 (200 -173)

= ₹ 52,00,000 – 21,60,000

= ₹ 30,40,000

So profit after depreciation and tax is

₹ (30,40,000 -11,50,000) × (1 - .40)

= ₹ 11,34,000

So profit before depreciation and after tax is :

₹ 11,34,000 + ₹ 11,50,000 (Depreciation added back) = ₹ 22,84,000

506
 [INVESTMENT DECISIONS]

(ii)

₹ (‘000)
0 1 2 3 4 5
NCF (5850) 2284 2284 2284 2284 2499
PVF at 20% 1.00 0.8333 0.6944 0.5787 0.4823 0.4019
PV (5850) 1903.257 1586.01 1321.751 1101.57 1004.35
PV of benefits 6916.94
PVF at 30% 1.00 0.7692 0.5917 0.4550 0.3501 0.2693
PV (5850) 1756.85 1351.44 1039.22 799.63 672.98
PV of benefits 5620.12

1066.94
IRR = 20% + 10% × = 28.23%
1296.82

(iii) Advise: The Company should go ahead with replacement project, since it
is positive NPV decision.

Question – 54
HMR Ltd. is considering replacing a manually operated old machine with a
fully automatic new machine. The old machine had been fully depreciated for
tax purpose but has a book value of ₹ 2,40,000 on 31st March 2021. The
machine has begun causing problems with breakdowns and it cannot fetch
more than ₹ 30,000 if sold in the market at present. It will have no realizable
value after 10 years. The company has been offered ₹ 1,00,000 for the old
machine as a trade in on the new machine which has a price (before allowance
for trade in) of ₹ 4,50,000. The expected life of new machine is 10 years with
salvage value of ₹ 35,000.

Further, the company follows straight line depreciation method but for tax
purpose, written down value method depreciation @ 7.5% is allowed taking
that this is the only machine in the block of assets.

Given below are the expected sales and costs from both old and new machine:

Old machine (₹) New machine (₹)

Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250

507
 [INVESTMENT DECISIONS]

Tax @ 30% 97,425 1,16,175

PAT 2,27,325 2,71,075

From the above information, ANALYSE whether the old machine should be
replaced or not if required rate of return is 10%? Ignore capital gain tax.

PV factors @ 10%:

Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

(RTP Nov – 2021)

Solution:

Workings:

1. Calculation of Base for depreciation or Cost of New Machine

Particulars (₹)
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000

2. Calculation of Profit before tax as per books

Particulars Old machine New machine Difference

PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per 24,000 41,500 17,500
books
Profit before tax and 3,48,750 4,28,750 80,000
depreciation (PBTD)

Calculation of Incremental NPV

Year PVF PBTD Dep. @ PBT Tax @ Cash PV of Cash

@ (₹) 7.5% (₹) 30% Inflows Inflows
10% (₹) (₹) (₹) (₹)
(1) (2) (3) (4) (5)= (4) × (6) = (4) – (7)
0.30 (5) + (3) = (6) × (1)

1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38

2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93

508
 [INVESTMENT DECISIONS]

5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21

6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73
7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage value of new machine (35,000 × 0.386) 13,510.00
Total PV of incremental cash inflows 3,94,612.44
Less: Cost of new machine 3,50,000.00
Incremental Net Present Value 44,612.44

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

Question – 55
An existing company has a machine which has been in operation for two years,
its estimated remaining useful life is 4 years with no residual value in the end.
Its current market value is ₹ 3 lakhs. The management is considering a proposal
to purchase an improved model of a machine gives increase output. The details
are as under:

Particulars Existing Machine New Machine

Purchase Price ₹ 6,00,000 ₹10,00,000
Estimated Life 6 years 4 years
Residual Value 0 0
Annual Operating days 300 300
Operating hours per day 6 6
Selling price per unit ₹10 ₹10
Material cost per unit ₹2 ₹2
Output per hour in units 20 40
Labour cost per hour ₹20 ₹30
Fixed overhead per annum excluding ₹1,00,000 ₹1,00,000
depreciation
Working Capital ₹1,00,000 ₹1,00,000
Income-tax rate 30% 30%

Assuming that - cost of capital is 10% and the company uses written down value
of depreciation @ 20% and it has several machines in 20% block.

Advice the management on the Replacement of Machine as per the NPV method.

The discounting factors table given below:

509
 [INVESTMENT DECISIONS]

Discounting Factors Year 1 Year 2 Year 3 Year 4

10% 0.909 0.826 0.751 0.683

(Exam July – 2021)

Solution:

(i) Calculation of Net Initial Cash Outflows:

Particulars ₹
Purchase Price of new machine 10,00,000
Add: Net Working Capital 1,00,000
Less: Sale proceeds of existing machine 3,00,000
Net initial cash outflows 8,00,000

(ii) Calculation of annual Profit Before Tax and depreciation

Particulars Existing New Differential

machine Machine
(1) (2) (3) (4)
= (3) – (2)
Annual output 36,000 72,000 36,000
units units units
₹ ₹ ₹
(A) Sales revenue @ ₹ 10 per unit 3,60,000 7,20,000 3,60,000
(B) Cost of Operation Material @ 72,000 1,44,000 72,000
₹ 2 per unit
Labour
Old = 1,800 × ₹ 20 36,000
New = 1,800 × ₹ 30 54,000 18,000
Fixed overhead excluding 1,00,000 60,000 (40,000)
depreciation
Total Cost (B) 2,08,000 2,58,000 50,000
Profit Before Tax and 1,52,000 4,62,000 3,10,000
depreciation (PBTD) (A – B)

(iii) Calculation of Net Present value on replacement of machine

Year PBTD Depreci PBT Tax @ PAT Net PVF PV

ati on @ 30% cash @
20% flow 10%
WDV
(1) (2) (3) (4 = 2-3) (5) (6 = 4- (7 = 6 (8) (9 = 7 × 8)
5) + 3)
1 3,10,000 1,40,000 1,70,000 51,000 1,19,000 2,59,000 0.909 2,35,431.000

510
 [INVESTMENT DECISIONS]

2 3,10,000 1,12,000 1,98,000 59,400 1,38,600 2,50,600 0.826 2,06,995.600

3 3,10,000 89,600 2,20,400 66,120 1,54,280 2,43,880 0.751 1,83,153.880
4 3,10,000 71,680 2,38,320 71,496 1,66,824 2,38,504 0.683 1,62,898.232
7,88,478.712
Add: Release of net working capital at year end 4 (1,00,000 × 0.683) 68,300.000
Less: Initial Cash Outflow 8,00,000.000
NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should be

replaced.

Working Notes:

1. Calculation of Annual Output

Annual output = (Annual operating days × Operating hours per day) ×

output per hour

Existing machine = (300 × 6) × 20 = 1,800 × 20 = 36,000 units

New machine = (300 × 6) × 40 = 1,800 × 40 = 72,000 units

2. Base for incremental depreciation

Particulars ₹
WDV of Existing Machine
Purchase price of existing machine 6,00,000
Less: Depreciation for year 1 1,20,000
Depreciation for Year 2 96,000 2,16,000
WDV of Existing Machine (i) 3,84,000

Depreciation base of New Machine

Purchase price of new machine 10,00,000
Add: WDV of existing machine 3,84,000
Less: Sales value of existing machine 3,00,000
Depreciation base of New Machine (ii) 10,84,000
Base for incremental depreciation [(ii) – (i)] 7,00,000

(Note: The above solution have been done based on incremental

approach)

Alternatively, solution can be done based on Total Approach as

below:

(i) Calculation of depreciation:

511
 [INVESTMENT DECISIONS]

Existing Machine
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Opening 6,00,000 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608.00
balance
Less: 1,20,000 96,000 76,800 61,440 49,152 39,321.60
Depreciation
@ 20%
WDV 4,80,000 3,84,000 3,07,200 2,45,760 1,96,608 1,57,286.40

New Machine
Year 1 Year 2 Year 3 Year 4
Opening balance 10,84,000* 8,67,200 6,93,760 5,55,008.00
Less: Depreciation @ 20% 2,16,800 1,73,440 1,38,752 1,11,001.60
WDV 8,67,200 6,93,760 5,55,008 4,44,006.40

* As the company has several machines in 20% block, the value of

Existing Machine from the block calculated as below shall be added to
the new machine of ₹ 10,00,000:

WDV of existing machine at the beginning of the year ₹ 3,84,000

Less: Sale Value of Machine ₹ 3,00,000

WDV of existing machine in the block ₹ 84,000

Therefore, opening balance for depreciation of block = ₹ 10,00,000 +

₹ 84,000 = ₹ 10,84,000

(ii) Calculation of annual cash inflows from operation:

Particulars EXISTING MACHINE

Year 3 Year 4 Year 5 Year 6
Annual output
(300 operating
days × 6 operating 36,000 units 36,000 units 36,000 units 36,000 units
hours × 20 output
per hour)
₹ ₹ ₹ ₹
(A) Sales revenue 3,60,000.00 3,60,000.00 3,60,000.00 3,60,000.00
@ ₹ 10 per unit
(B) Less: Cost of
Operation Material 72,000.00 72,000.00 72,000.00 72,000.00
@ ₹ 2 per unit

512
 [INVESTMENT DECISIONS]

Labour @ ₹ 20 per
hour for (300 × 6) 36,000.00 36,000.00 36,000.00 36,000.00
hours
Fixed overhead 1,00,000.00 1,00,000.00 1,00,000.00 1,00,000.00
Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Total Cost (B) 2,84,800.00 2,69,440.00 2,57,152.00 2,47,321.60
Profit Before Tax 75,200.00 90,560.00 1,02,848.00 1,12,678.40
(A – B)
Less: Tax @ 30% 22,560.00 27,168.00 30,854.40 33,803.52
Profit After Tax 52,640.00 63,392.00 71,993.60 78,874.88
Add: Depreciation 76,800.00 61,440.00 49,152.00 39,321.60
Add: Release of 1,00,000.00
Working Capital
Annual Cash 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
Inflows

Particulars NEW MACHINE

Year 1 Year 2 Year 3 Year 4
Annual output
(300 operating
days × 6 operating 72,000 units 72,000 units 72,000 units 72,000 units
hours × 40 output
per hour)
₹ ₹ ₹ ₹
(A) Sales revenue 7,20,000.00 7,20,000.00 7,20,000.00 7,20,000.00
@ ₹ 10 per unit
(B) Less: Cost of
Operation
Material @ ₹ 2 per 1,44,000.00 1,44,000.00 1,44,000.00 1,44,000.00
unit
Labour @ ₹ 30 per 54,000.00 54,000.00 54,000.00 54,000.00
hour for (300 × 6)
hours
Fixed overhead 60,000.00 60,000.00 60,000.00 60,000.00
Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Total Cost (B) 4,74,800.00 4,31,440.00 3,96,752.00 3,69,001.60
Profit Before Tax 2,45,200.00 2,88,560.00 3,23,248.00 3,50,998.40
(A – B)
Less: Tax @ 30% 73,560.00 86,568.00 96,974.40 1,05,299.52
Profit After Tax 1,71,640.00 2,01,992.00 2,26,273.60 2,45,698.88
Add: Depreciation 2,16,800.00 1,73,440.00 1,38,752.00 1,11,001.60
Add: Release of 2,00,000.00
Working Capital
Annual Cash 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48
Inflows

513
 [INVESTMENT DECISIONS]

(iii) Calculation of Incremental Annual Cash Flow:

Particulars Year 1 (₹) Year 2 (₹) Year 3 (₹) Year 4 (₹)

Existing Machine (A) 1,29,440.00 1,24,832.00 1,21,145.60 2,18,196.48
New Machine (B) 3,88,440.00 3,75,432.00 3,65,025.60 5,56,700.48
Incremental Annual 2,59,000.00 2,50,600.00 2,43,880.00 3,38,504.00
Cash Flow (B – A)

(iv) Calculation of Net Present Value on replacement of machine:

Year Incremental Discounting Present Value of

Annual Cash Flow factor @ 10% Incremental Annual
(₹) (A) (B) Cash Flow (₹) (A × B)
1 2,59,000.00 0.909 2,35,431.000
2 2,50,600.00 0.826 2,06,995.600
3 2,43,880.00 0.751 1,83,153.880
4 3,38,504.00 0.683 2,31,198.232
Total Incremental Inflows 8,56,778.712
Less: Net Initial Cash Outflows (Working note) 8,00,000.000
Incremental NPV 56,778.712

Advice: Since the incremental NPV is positive, existing machine should

be replaced.

Working Note:

Calculation of Net Initial Cash Outflows:

Particulars ₹
Cost of new machine 10,00,000
Less: Sale proceeds of existing machine 3,00,000
Add: incremental working capital required 1,00,000
(₹ 2,00,000 – ₹ 1,00,000)
Net initial cash outflows 8,00,000

Question – 56
Four years ago, Z Ltd. had purchased a machine of ₹ 4,80,000 having
estimated useful life of 8 years with zero salvage value. Depreciation is charged
using SLM method over the useful life. The company want to replace this
machine with a new machine. Details of new machine are as below:

514
 [INVESTMENT DECISIONS]

• Cost of new machine is ₹ 12,00,000, Vendor of this machine is agreed to

take old machine at a value of ₹ 2,40,000. Cost of dismantling and
removal of old machine will be ₹ 40,000. 80% of net purchase price will
be paid on spot and remaining will be paid at the end of one year.

• Depreciation will be charged @ 20% p.a. under WDV method.

• Estimated useful life of new machine is four years and it has salvage
value of ₹ 1,00,000 at the end of year four.

• Incremental annual sales revenue is ₹ 12,25,000.

• Contribution margin is 50%.

• Incremental indirect cost (excluding depreciation) is ₹ 1,18,750 per year.

• Additional working capital of ₹ 2,50,000 is required at the beginning of

year and ₹ 3,00,000 at the beginning of year three. Working capital at the
end of year four will be nil.

• Tax rate is 30%.

• Ignore tax on capital gain.

Z Ltd. will not make any additional investment, if it yields less than 12%

Advice, whether existing machine should be replaced or not.

Year 1 2 3 4 5
PVIF0.12,t 0.893 0.797 0.712 0.636 0.567

(Exam, May – 2023)

Solution:

Working Notes:

(i) Calculation of Net Initial Cash Outflow

Particulars ₹
Cost of New Machine 12,00,000
Less: Sale proceeds of existing machine 2,00,000
Net Purchase Price 10,00,000
Paid in year 0 8,00,000
Paid in year 1 2,00,000

515
 [INVESTMENT DECISIONS]

(ii) Calculation of Additional Depreciation

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

(iii) Calculation of Annual Profit before Depreciation and Tax (PBDT)

Particulars Incremental Values (₹)

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

Calculation of Incremental NPV

Year PVF PBTD Incremen- PBT Tax @ Cash PV of Cash

@ (₹) tal (₹) 30% (₹) Inflows Inflows (₹)
12% Deprecia- (₹)
tion (₹)

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

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

Year 2 (₹ 3,00,000 × 0.797) 2,39,100
Add: Working Capital released - Year 4 (₹ 5,50,000 × 0.636) 3,49,800
Incremental Net Present Value 79,739.470

516
 [INVESTMENT DECISIONS]

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

Alternative Presentation

Computation of Outflow for new Machine:

₹
Cost of new machine 12,00,000
Replaced cost of old machine 2,40,000
Cost of removal 40,000
Net Purchase price 10,00,000
Outflow at year 0 8,00,000
Outflow at year 1 2,00,000

Computation of additional deprecation

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

Computation of NPV

Year 0 1 2 3 4
₹ ₹ ₹ ₹
1. Increase in 12,25,000 12,25,000 12,25,000 12,25,000
sales revenue
2. Contribution 6,12,500 6,12,500 6,12,500 6,12,500
3. Increase in 1,18,750 1,18,750 1,18,750 1,18,750
fixed cost
4 Incremental 1,40,000 1,00,000 68,000 42,400
Depreciation
5 Net profit before 3,53,750 3,93,750 4,25,750 4,51,350
tax
[1-(2+3+4)]
6 Net Profit after 2,47,625 2,75,625 2,98,025 3,15,945
tax (5 × 70%)
7 Add: 1,40,000 1,00,000 68,000 42,400
Incremental

517
 [INVESTMENT DECISIONS]

depreciation
8 Net Annual 3,87,625 3,75,625 3,66,025 3,58,345
cash inflows
(6 + 7)
9 Release of 1,00,000
salvage value
10 (investment)/di (2,50,000) (3,00,000) 5,50,000
sinvestment in
working capital
11 Initial cost (8,00,000) (2,00,000)
12 Total net cash (10,50,000) 1,87,625.0 75,625 3,66,025 10,08,345
flows
13 Discounting 1 0.893 0.797 0.712 0.636
Factor
14 Discounted (10,50,000) 1,67,549.125 60,273.125 2,60,609.800 6,41,307.420
cash flows
(12 × 13)

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

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

Question – 57
HCP Ltd. is a holding manufacturer of railway parts for passenger coaches and
freight wagons. Due to high wastage of material and quality issue in
production, the General Manager of the company is considering the
replacement of machine A with a new CNC machine B. Machine A has a book
value of ₹ 4,80,000 and remaining economic life is 6 years. It could be sold now
at ₹ 1,80,000 and zero salvage value at the end of sixth year. The purchase
price of Machine B is ₹ 24,00,000 with economic life of 6 years. It will require ₹
1,40,000 for installation and ₹ 60,000 for testing. Subsidy of 15% on the
purchase price of the machine B will be received from Government at the end
of 1st year. Salvage value at the end of sixth year will be ₹ 3,20,000.

The General Manager estimates that the annual savings due to installation of
machine B include a reduction of three skilled workers with annual salaries of
₹ 1,68,000 each, ₹ 4,80,000 from reduced wastage of materials and defectives
and ₹ 3,50,000 from loss in sales due to delay in execution of purchase orders.
Operation of Machine B will require the services of a trained technician with
annual salary of ₹ 3,90,000 and annual operation and maintenance cost will
increase by ₹ 1,54,000. The company‟s tax rate is 30% and it‟s required rate of
return is 14%. The company follows straight line method of depreciation.
Ignore tax saving on loss due to sale of existing machine.

The present value factors at 14% are:

518
 [INVESTMENT DECISIONS]

Years 0 1 2 3 4 5 6
PV Factors 1 0.877 0.769 0.675 0.592 0.519 0.456

Required:

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

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

(Exam, May – 2024)

(3) RESIDUAL

Question – 58
XYZ Ltd. is presently all equity financed. The directors of the company have
been evaluating investment in a project which will require ₹ 270 lakhs capital
expenditure on new machinery. They expect the capital investment to provide
annual cash flows of ₹ 42 lakhs indefinitely which is net of all tax adjustments.
The discount rate which it applies to such investment decisions is 14% net.

The directors of the company believe that the current capital structure fails to
take advantage of tax benefits of debt and propose to finance the new project
with undated perpetual debt secured on the company's assets. The company
intends to issue sufficient debt to cover the cost of capital expenditure and the
after tax cost of issue.

The current annual gross rate of interest required by the market on corporate
undated debt of similar risk is 10%. The after tax costs of issue are expected to
be ₹ 10 lakhs. Company's tax rate is 30%.

You are REQUIRED to:

(i) Calculate the adjusted present value of the investment,

(ii) Calculate the adjusted discount rate and

(iii) Explain the circumstances under which this adjusted discount rate may
be used to evaluate future investments.

(Study Material ICAI Illus – 19)

Solution:

519
 [INVESTMENT DECISIONS]

(i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV

= Base Case PV + PV of financing decisions associated with the project

Base Case NPV for the project:

(-) ₹ 270 lakhs + (₹ 42 lakhs / 0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs

= ₹ 30

Issue costs = ₹ 10 lakhs

Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs

= ₹ 280 lakhs

Annual tax relief on interest payment = ₹ 280 × 0.1 × 0.3

= ₹ 8.4 lakhs in perpetuity

The value of tax relief in perpetuity = ₹ 8.4 lakhs / 0.1

= ₹ 84 lakhs

Therefore, APV

= Base case PV – Issue Costs + PV of Tax Relief on debt interest

= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs = ₹ 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income / Savings required to allow an NPV to zero

Let the annual income be x.

(-) ₹ 280 lakhs + (Annual Income / 0.14) = (-) ₹ 104 lakhs

Annual Income / 0.14 = (-) ₹ 104 + ₹ 280 lakhs

Therefore, Annual income = ₹ 176 × 0.14 = ₹ 24.64 lakhs

Adjusted discount rate = (₹ 24.64 lakhs /₹ 280 lakhs) × 100

= 8.8%

520
 [INVESTMENT DECISIONS]

(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the

business risk of the new venture is identical to the one being evaluated
here and the project is to be financed by the same method on the same
terms. The effect on the company‟s cost of capital of introducing debt into
the capital structure cannot be ignored.

Question – 59
Elite Cooker Company is evaluating three investment situations: (1) Produce a
new line of aluminium skillets, (2) Expand its existing cooker line to include
several new sizes, and (3) Develop a new, higher-quality line of cookers. If only
the project in question is undertaken, the expected present values and the
amounts of investment required are:

Project Investment Required Present Value of Future Cash-Flows

₹ ₹
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the

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

(Study Material ICAI TYK – 04)

Solution:

Calculation of NPV

Project Investment Present value of Net Present

Required Future Cash Flows value

521
 [INVESTMENT DECISIONS]

₹ ₹ ₹
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000
1 and 2 3,15,000 4,75,000 1,60,000
1 and 3 4,40,000 6,90,000 2,50,000
2 and 3 3,85,000 6,20,000 2,35,000
1, 2 and 3 6,80,000* 9,10,000 2,30,000
(Refer Working Note)

Working Note:

(i) Total Investment required if all the three projects are undertaken
simultaneously:

(₹)
Project 1 & 3 4,40,000
Project 2 1,15,000
Plant extension cost 1,25,000
Total 6,80,000

(ii) Total of Present value of Cash flows if all the three projects are
undertaken simultaneously:

(₹)
Project 2 & 3 6,20,000
Project 1 2,90,000
Total 9,10,000

Projects 1 and 3 should be chosen, as they provide the highest net

present value.

Question – 60
A large profit making company is considering the installation of a machine to
process the waste produced by one of its existing manufacturing process to be
converted into a marketable product. At present, the waste is removed by a
contractor for disposal on payment by the company of ₹ 150 lakh per annum
for the next four years. The contract can be terminated upon installation of the
aforesaid machine on payment of a compensation of ₹ 90 lakh before the
processing operation starts. This compensation is not allowed as deduction for
tax purposes.

522
 [INVESTMENT DECISIONS]

The machine required for carrying out the processing will cost ₹ 600 lakh. At
the end of the 4th year, the machine can be sold for ₹ 60 lakh and the cost of
dismantling and removal will be ₹ 45 lakh.

Sales and direct costs of the product emerging from waste processing for 4
years are estimated as under:

(₹ in lakh)

Year 1 2 3 4
Sales 966 966 1,254 1,254
Material Consumption 90 120 255 255
Wages 225 225 255 300
Other Expenses 120 135 162 210
Factory Overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing

operations is ₹ 60 lakh at the start of year 1. The stock levels of materials to be
maintained at the end of year 1, 2 and 3 will be ₹ 165 lakh and the stocks at
the end of year 4 will be nil. The storage of materials will utilise space which
would otherwise have been rented out for ₹ 30 lakh per annum. Labour costs
include wages of 40 workers, whose transfer to this process will reduce idle
time payments of ₹ 45 lakh in the year - 1 and ₹ 30 lakh in the year - 2.
Factory overheads include apportionment of general factory overheads except
to the extent of insurance charges of ₹ 90 lakh per annum payable on this
venture. The company‟s tax rate is 30%.

Consider cost of capital @ 14%, the present value factors of which is given
below for four years:

Year 1 2 3 4
PV Factor @ 14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for

processing the waste. All calculations should form part of the answer.

(Study Material ICAI TYK – 10)

Solution:

Statement of Operating Profit from processing of waste

523
 [INVESTMENT DECISIONS]

(₹ in lakh)

Year 1 2 3 4

Sales (A) 966 966 1,254 1,254

Material consumption 90 120 255 255

Wages 180 195 255 300

Other expenses 120 135 162 210

Factory overheads (insurance only) 90 90 90 90

Depreciation (as per income tax rules) 150 114 84 63

Total cost (B) 630 654 846 918

Profit {(C)=(A) - (B)} 336 312 408 336
Less: Tax (30%) 100.8 93.6 122.4 100.8
Profit after Tax (PAT) 235.2 218.4 285.6 235.2
Less: Loss of rent on storage space
(opportunity cost) 30 30 30 30

PAT after opportunity cost 205.2 188.4 255.6 205.2

Statement of Incremental Cash Flows

(₹ in lakh)

Year 0 1 2 3 4

Cost of Machine (600)

Material stock (60) (105) - - 165

Compensation for contract (90) - - - -

Contract payment saved - 150 150 150 150

Tax on contract payment - (45) (45) (45) (45)

Incremental profit - 336 312 408 336

Depreciation added back - 150 114 84 63

524
 [INVESTMENT DECISIONS]

Tax on profits - (100.8) (93.6) (122.4) (100.8)

Profit on sale of machinery (net) - - - - 15

Total incremental cash flows (750) 385.2 437.4 474.6 583.2

Present value factor 1 0.877 0.769 0.674 0.592

Present value of cash flows (750) 337.82 336.36 319.88 345.25

Net present value 589.32

Advice: Since the net present value of cash flows is ₹ 589.32 lakh which is
positive the management should install the machine for processing the waste.

Notes:

1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered.

3. Apportioned factory overheads are not relevant only insurance charges of

this project are relevant.

4. Sale of machinery - Net income after deducting removal expenses taken.

Tax on Capital gains is ignored.

5. Saving in contract payment and income tax thereon is considered in the

cash flows.

Question – 61
Manoranjan Ltd is a News broadcasting channel having its broadcasting Centre
in Mumbai. There are total 200 employees in the organization including top
management. As a part of employee benefit expenses, the company serves tea
or coffee to its employees, which is outsourced from a third-party. The
company offers tea or coffee three times a day to each of its employees. 120
employees prefer tea all three times, 40 employees prefer coffee all three times
and remaining prefer tea only once in a day. The third-party charges ₹ 10 for
each cup of tea and ₹ 15 for each cup of coffee. The company works for 200
days in a year.

525
 [INVESTMENT DECISIONS]

Looking at the substantial amount of expenditure on tea and coffee, the finance
department has proposed to the management an installation of a master tea
and coffee vending machine which will cost ₹ 10,00,000 with a useful life of five
years. Upon purchasing the machine, the company will have to enter into an
annual maintenance contract with the vendor, which will require a payment of
₹ 75,000 every year. The machine would require electricity consumption of 500
units p.m. and current incremental cost of electricity for the company is ₹ 12
per unit. Apart from these running costs, the company will have to incur the
following consumables expenditure also:

(1) Packets of Coffee beans at a cost of ₹ 90 per packet.

(2) Packet of tea powder at a cost of ₹ 70 per packet.

(3) Sugar at a cost of ₹ 50 per Kg.

(4) Milk at a cost of ₹ 50 per litre.

(5) Paper cup at a cost of 20 paise per cup.

Each packet of coffee beans would produce 200 cups of coffee and same goes
for tea powder packet. Each cup of tea or coffee would consist of 10g of sugar
on an average and 100 ml of milk.

The company anticipate that due to ready availability of tea and coffee through
vending machines its employees would end up consuming more tea and coffee.

It estimates that the consumption will increase by on an average 20% for all
class of employees. Also, the paper cups consumption will be 10% more than
the actual cups served due to leakages in them.

The company is in the 25% tax bracket and has a current cost of capital at
12% per annum. Straight line method of depreciation is allowed for the
purpose of taxation. You as a financial consultant is required to ADVISE on the
feasibility of acquiring the vending machine.

PV factors @ 12%:

Year 1 2 3 4 5
PVF 0.8929 0.7972 0.7118 0.6355 0.5674

(Study Material ICAI TYK – 14)

526
 [INVESTMENT DECISIONS]

Solution:

A. Computation of CFAT (Year 1 to 5)

Particulars Amount
(₹)
(a) Savings in existing (120 × 10 × 3) + (40 × 15 × 3) + 11,60,000
Tea & Coffee charges (40 × 10 × 1) × 200 days
(b) AMC of machine (75,000)
(c) Electricity charges 500 × 12 × 12 (72,000)
(d) Coffee Beans (W.N.) 144 × 90 (12,960)
(e) Tea Powder (W.N.) 480 × 70 (33,600)
(f) Sugar (W.N.) 1248 × 50 (62,400)
(g) Milk (W.N.) 12480 × 50 (6,24,000)
(h) Paper Cup (W.N.) 1,37,280 × 0.2 (27,456)
(i) Depreciation 10,00,000/5 (2,00,000)
Profit before Tax 52,584
(-) Tax @ 25% (13,146)
Profit after Tax 39,438
Depreciation 2,00,000
CFAT 2,39,438

B. Computation of NPV

Year Particulars CF PVF @ 12% PV

0 Cost of Machine (10,00,000) 1 (10,00,000)
1-5 CFAT 2,39,438 3.6048 8,63,126
Net Present Value (1,36,874)

Since NPV of the machine is negative, it should not be purchased.

Working Note:

Computation of Qty of consumable

No. of Tea Cups = [(120 × 3 × 200 days) + (40 × 1 × 200 days) × 1.2

= 96,000

No. of Coffee cups = 40 × 3 × 200 days × 1.2 = 28,800

28,800
No. of Coffee beans packet = = 144
200

527
 [INVESTMENT DECISIONS]

96,000
No. of Tea powder packets = = 480
200

(96,000 + 28,800)6,000
Qty of Sugar = = 1,248 kgs
1,000 g

(96,000 + 28,800)6,000
Qty of Milk = = 12,480 liters
1,000 ml

No. of Paper Cups = (96,000 + 28,800) × 1.1 = 1,37,280

Question – 62
Superb Ltd. constructs customized parts for satellites to be launched by USA
and Canada. The parts are constructed in eight locations (including the central
headquarter) around the world. The Finance Director, Ms. Kuthrapali, chooses
to implement video conferencing to speed up the budget process and save
travel costs. She finds that, in earlier years, the company sent two officers from
each location to the central headquarter to discuss the budget twice a year.
The average travel cost per person, including air fare, hotels and meals, is ₹
27,000 per trip. The cost of using video conferencing is ₹ 8,25,000 to set up a
system at each location plus ₹ 300 per hour average cost of telephone time to
transmit signals. A total 48 hours of transmission time will be needed to
complete the budget each year. The company depreciates this type of
equipment over five years by using straight line method. An alternative
approach is to travel to local rented video conferencing facilities, which can be
rented for ₹ 1,500 per hour plus ₹ 400 per hour average 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.

(MTP Nov – 2021)

Solution:

Option I : Cost of travel, in case Video Conferencing facility is not

provided

Total Trip = No. of Locations × No. of Persons × No. of Trips per Person = 7 × 2
× 2 = 28 Trips

Total Travel Cost (including air fare, hotel accommodation and meals) (28 trips
× ₹ 27,000 per trip) = ₹ 7,56,000

528
 [INVESTMENT DECISIONS]

Option II : Video Conferencing Facility is provided by Installation of Own

Equipment at Different Locations

Cost of Equipment at each location (₹ 8,25,000 × 8 locations) = ₹ 66,00,000

Economic life of Machines (5 years). Annual depreciation (66,00,000/5)

= ₹ 13,20,000

Annual transmission cost (48 hrs. transmission × 8 locations × ₹ 300 per hour)
= ₹ 1,15,200

Annual cost of operation (13,20,000 + 1,15,200) = ₹ 14,35,200

Option III : Engaging Video Conferencing Facility on Rental Basis

Rental cost (48 hrs. × 8 location × ₹ 1,500 per hr) = ₹ 5,76,000

Telephone cost (48 hrs. × 8 locations × ₹ 400 per hr.) = ₹ 1,53,600

Total rental cost of equipment (5,76,000 + 1,53,600) = ₹ 7,29,600

Analysis: The annual cash outflow is minimum, if video conferencing facility is

engaged on rental basis. Therefore, Option III is suggested.

Question – 63
A large profit making company is considering the installation of a machine to
process the waste produced by one of its existing manufacturing process to be
converted into a marketable product. At present, the waste is removed by a
contractor for disposal on payment by the company of ₹ 150 lakh per annum
for the next four years. The contract can be terminated upon installation of the
aforesaid machine on payment of a compensation of ₹ 90 lakh before the
processing operation starts. This compensation is not allowed as deduction for
tax purposes.

The machine required for carrying out the processing will cost ₹ 600 lakh to be
financed by a loan repayable in 4 equal installments commencing from end of
the year 1. The interest rate is 14% per annum. At the end of the 4th year, the
machine can be sold for ₹ 60 lakh and the cost of dismantling and removal will
be ₹ 45 lakh.

Sales and direct costs of the product emerging from waste processing for 4
years are estimated as under:

529
 [INVESTMENT DECISIONS]

(₹ in lakh)

Year 1 2 3 4
Sales 966 966 1,254 1,254
Material Consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing

operations is ₹ 60 lakh at the start of year 1. The stock levels of materials to be
maintained at the end of year 1, 2 and 3 will be ₹ 165 lakh and the stocks at
the end of year 4 will be nil. The storage of materials will utilize space which
would otherwise have been rented out for ₹ 30 lakh per annum. Labour costs
include wages of 40 workers, whose transfer to this process will reduce idle
time payments of ₹ 45 lakh in the year - 1 and ₹ 30 lakh in the year - 2. Factory
overheads include apportionment of general factory overheads except to the
extent of insurance charges of ₹ 90 lakh per annum payable on this venture.
The company‟s tax rate is 30%.

Present value factors for four years are as under:

Year 1 2 3 4
Pv factor @ 14 % 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for

processing the waste. All calculations should form part of the answer.

(RTP Nov – 2020)

Solution:

Statement of Operating Profit from processing of waste (₹ in lakh)

Year 1 2 3 4
Sales : (A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space 30 30 30 30

530
 [INVESTMENT DECISIONS]

(opportunity cost)
Interest @14% 84 63 42 21
Depreciation (as per income tax rules) 150 114 84 63
Total cost: (B) 744 747 918 969
Profit (C)=(A)-(B) 222 219 336 285
Tax (30%) 66.6 65.7 100.8 85.5
Profit after Tax (PAT) 155.4 153.3 235.2 199.5

Statement of Incremental Cash Flows (₹ in lakh)

Year 0 1 2 3 4
Material stock (60) (105) - - 165
Compensation for contract (90) - - - -
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 222 219 336 285
Depreciation added back - 150 114 84 63
Tax on profits - (66.6) (65.7) (100.8) (85.5)
Loan repayment - (150) (150) (150) (150)
Profit on sale of machinery (net) - - - - 15
Total incremental cash flows (150) 155.4 222.3 274.2 397.5
Present value factor 1.00 0.877 0.769 0.674 0.592
Present value of cash flows (150) 136.28 170.95 184.81 235.32
Net present value 577.36

Advice: Since the net present value of cash flows is ₹ 577.36 lakh which is
positive the management should install the machine for processing the waste.

Notes:

(i) Material stock increases are taken in cash flows.

(ii) Idle time wages have also been considered.

(iii) Apportioned factory overheads are not relevant only insurance charges of
this project are relevant.

(iv) Interest calculated at 14% based on 4 equal installments of loan

repayment.

(v) Sale of machinery- Net income after deducting removal expenses taken.
Tax on Capital gains ignored.

531
 [INVESTMENT DECISIONS]

(vi) Saving in contract payment and income tax thereon considered in the
cash flows.

Question – 64
XYZ Ltd. is presently all equity financed. The directors of the company have
been evaluating investment in a project which will require ₹ 270 lakhs capital
expenditure on new machinery. They expected the capital investment to
provide annual cash flows of ₹ 42 lakhs indefinitely which is net of all tax
adjustments. The discount rate which it applies to such investment decisions
is 14% net.

The directors of the company believe that the current capital structure fails to
take advantage of tax benefits of debt, and propose to finance the new project
with undated perpetual debt secured on the company‟s assets. The company
intends to issue sufficient debt to cover the cost of capital expenditure and the
after tax cost of issue.

The current annual gross rate of interest required by the market on corporate
undated debt of similar risk is 10%. The after tax costs of issue are expected to
be ₹ 10 lakhs. Company‟s tax rate is 30%.

You are required to calculate:

(i) The adjusted present value of the investment,

(ii) The adjusted discount rate and

(iii) Explain the circumstance under which this adjusted discount rate may
be used to evaluate future investments.

(Exam, May – 2018)

Solution:

(i) Calculation of Adjusted Present Value of Investment (APV)

Adjusted PV = Base Case PV + PV of financing decisions associated with

the project

Base Case NPV for the project:

(-) ₹ 270 lakhs + (₹ 42 lakhs/0.14) = (-) ₹ 270 lakhs + ₹ 300 lakhs

= ₹ 30

532
 [INVESTMENT DECISIONS]

Issue costs = ₹ 10 lakhs

Thus, the amount to be raised = ₹ 270 lakhs + ₹ 10 lakhs

= ₹ 280 lakhs

Annual tax relief on interest payment = ₹ 280 × 0.1 × 0.3

= ₹ 8.4 lakhs in perpetuity

The value of tax relief in perpetuity = ₹ 8.4 lakhs/0.1

= ₹ 84 lakhs

Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on

debt interest

= ₹ 30 lakhs – ₹ 10 lakhs + 84 lakhs = ₹ 104 lakhs

(ii) Calculation of Adjusted Discount Rate (ADR)

Annual Income/Savings required to allow an NPV to zero

Let the annual income be x.

(-) ₹ 280 lakhs × (Annual Income/0.14) = (−) ₹104 lakhs

Annual Income/0.14 = (−) ₹ 104 + ₹ 280 lakhs

Therefore, Annual income = ₹ 176 × 0.14 = ₹ 24.64 lakhs

Adjusted discount rate = (₹ 24.64 lakhs / ₹280 lakhs) × 100

= 8.8%

(iii) Useable circumstances

This ADR may be used to evaluate future investments only if the

business risk of the new venture is identical to the one being evaluated
here and the project is to be financed by the same method on the same
terms. The effect on the company‟s cost of capital of introducing debt
into the capital structure cannot be ignored.

533
 [INVESTMENT DECISIONS]

Question – 65
Alley Pvt. Ltd. is planning to invest in a machinery that would cost ₹ 1,00,000
at the beginning of year 1. Net cash inflows from operations have been
estimated at ₹ 36,000 per annum for 3 years. The company has two options for
smooth functioning of the machinery - one is service, and another is
replacement of parts. If the company opts to service a part of the machinery at
the end of year 1 at ₹ 20,000, in such a case, the scrap value at the end of year
3 will be ₹ 25,000. However, if the company decides not to service the part,
then it will have to be replaced at the end of year 2 at ₹ 30,800, and in this
case, the machinery will work for the 4th year also and get operational cash
inflow of ₹ 36,000 for the 4th year. It will have to be scrapped at the end of year
4 at ₹ 18,000.

Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase
of this machinery based on the net present value of its cash flows.

If the supplier gives a discount of ₹ 10,000 for purchase, what would be your
decision?

Note: The PV factors at 10% are:

Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

(Study Material ICAI TYK – 07)

Solution:

Option I: Purchase machinery and service part at the end of Year 1.

Net present value of cash flow @ 10% per annum discount rate.

36,000 36,000 36,000 20,000 20,000

NPV (in ₹) = -1,00,000 + + + + +
(1.1) (1.1)2 (1.1)3 (1.1) (1.1)3

= − 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (20,000 ×

0.9091) + (25,000 × 0.7513)

= − 1,00,000 + (36,000 × 2.4868) – 18,182 + 18,782.5

= − 1,00,000 + 89,524.8 – 18,182 + 18,782.5

NPV = − 9,874.7

534
 [INVESTMENT DECISIONS]

Since, Net Present Value is negative; therefore, this option is not to be

considered.

If Supplier gives a discount of ₹ 10,000, then:

NPV (in ₹) = + 10,000 – 9,874.7 = + 125.3

In this case, Net Present Value is positive but very small; therefore, this option
may not be advisable.

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

36,000 36,000 36,000 30,800 54,000

NPV (in ₹) = -1,00,000 + + + − +
(1.1) 2
(1.1) 3
(1.1) 2
(1.1) (1.1)4

= − 1,00,000 + 36,000 (0.9091 + 0.8264 + 0.7513) – (30,800 ×

0.8264) + (54,000 × 0.6830)

= − 1,00,000 + 36,000 (2.4868) – 25,453.12 + 36,882

= − 1,00,000 + 89,524.8 – 25,453.12 + 36,882

NPV = + 953.68

Net Present Value is positive, but very low as compared to the investment.

If the Supplier gives a discount of ₹ 10,000, then:

NPV (in ₹) = 10,000 + 953.68 = 10,953.68

Decision: Option II is worth investing as the net present value is positive and
higher as compared to Option I.

Multiple Choice Questions (MCQs)

1. A capital budgeting technique which does not require the computation of

cost of capital for decision making purposes is:

(a) Net Present Value method

(b) Internal Rate of Return method

(c) Modified Internal Rate of Return method

(d) Payback Period method

535
 [INVESTMENT DECISIONS]

2. If two alternative proposals are such that the acceptance of one shall
exclude the possibility of the acceptance of another then such decision
making will lead to:

(a) Mutually exclusive decisions

(b) Accept reject decisions

(c) Contingent decisions

(d) None of the above

3. In case a company considers a discounting factor higher than the cost of

capital for arriving at present values, the present values of cash inflows
will be:

(a) Less than those computed on the basis of cost of capital

(b) More than those computed on the basis of cost of capital

(c) Equal to those computed on the basis of the cost of capital

(d) None of the above

4. If the cut off rate of a project is greater than IRR, we may:

(a) Accept the proposal

(b) Reject the proposal

(c) Be neutral about it

(d) Wait for the IRR to increase and match the cut off rate

5. While evaluating capital investment proposals, time value of money is

used in which of the following techniques:

(a) Payback Period method

(b) Accounting rate of return

(c) Net present value

(d) None of the above

6. IRR would favour project proposals which have:

536
 [INVESTMENT DECISIONS]

(a) Heavy cash inflows in the early stages of the project.

(b) Evenly distributed cash inflows throughout the project.

(c) Heavy cash inflows at the later stages of the project.

(d) None of the above.

7. The re-investment assumption in the case of the IRR technique assumes

that:

(a) Cash flows can be re-invested at the projects IRR.

(b) Cash flows can be re-invested at the weighted cost of capital.

(c) Cash flows can be re-invested at the marginal cost of capital.

(d) None of the above

8. Multiple IRRs are obtained when:

(a) Cash flows in the early stages of the project exceed cash flows
during the later stages.

(b) Cash flows reverse their signs during the project.

(c) Cash flows are uneven.

(d) None of the above.

9. Depreciation is included as a cost in which of the following techniques:

(a) Accounting rate of return

(b) Net present value

(c) Internal rate of return

(d) None of the above

10. Management is considering a ₹ 1,00,000 investment in a project with a 5

year life and no residual value. If the total income from the project is
expected to be ₹ 60,000 and recognition is given to the effect of straight
line depreciation on the investment, the average rate of return is:

(a) 12%

537
 [INVESTMENT DECISIONS]

(b) 24%

(c) 60%

(d) 75%

11. Assume cash outflow equals ₹ 1,20,000 followed by cash inflows of ₹

25,000 per year for 8 years and a cost of capital of 11%. What is the Net
present value?

(a) (₹ 38,214)

(b) ₹ 9,653

(c) ₹ 8,653

(d) ₹ 38,214

12. What is the Internal rate of return for a project having cash flows of ₹
40,000 per year for 10 years and a cost of ₹ 2,26,009?

(a) 8%

(b) 9%

(c) 10%

(d) 12%

13. While evaluating investments, the release of working capital at the end of
the project's life should be considered as:

(a) Cash inflow

(b) Cash outflow

(c) Having no effect upon the capital budgeting decision

(d) None of the above

14. Capital rationing refers to a situation where:

(a) Funds are restricted and the management has to choose from
amongst available alternative investments.

(b) Funds are unlimited and the management has to decide how to
allocate them to suitable projects.

538
 [INVESTMENT DECISIONS]

(c) Very few feasible investment proposals are available with the
management.

(d) None of the above.

15. Capital budgeting is done for:

(a) Evaluating short term investment decisions.

(b) Evaluating medium term investment decisions.

(c) Evaluating long term investment decisions.

(d) None of the above.

539
 [DIVIDEND DECISIONS]

CHAPTER – 06

DIVIDEND DECISIONS

(1) WALTER’S MODEL

Question – 01
XYZ Ltd. earns ₹ 10/ share. Capitalization rate and return on investment are
10% and 12% respectively.

DETERMINE the optimum dividend payout ratio and the price of the share at
the payout.

(Study Material ICAI Illus – 02)

Solution:

Since r > Ke , the optimum dividend pay-out ratio would ‘Zero’ (i.e. D = 0),

Accordingly, value of a share:

D + Kr (E – D)
e
P =
Ke

0.12
D+ × (10 – 0)
0.10
P =
0.10

= ₹ 120

The optimality of the above payout ratio can be proved by using 25%, 50%,
75% and 100% as pay- out ratio:

At 25% pay-out ratio

0.12
5 + 0.10 × (10 – 5)
P = = ₹ 115
0.10

At 50% pay-out ratio

540
 [DIVIDEND DECISIONS]

0.12
2.5 + 0.10 × (10 – 25)
P = = ₹ 110
0.10

At 75% pay-out ratio

0.12
7.5 + 0.10 × (10 – 7.5)
P = = ₹ 105
0.10

At 100% pay-out ratio

0.12
10 + × (10 – 10)
0.10
P = = ₹ 100
0.10

Question – 02
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

COMPUTE the approximate dividend pay-out ratio so as to keep the share price
at ₹ 42 by using Walter’s model?

(Study Material ICAI Illus – 03)

Solution:

₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Earning per share 18/3 = ₹ 6.00

Let, the dividend per share be D to get share price of ₹ 42

r
D + Ke × (E – D)
P =
Ke

541
 [DIVIDEND DECISIONS]

0.20
D + 0.16 × (6 – D)
₹ 42 =
0.16

0.16D + 1.2 – 0.20D)

6.72 =
0.16

0.04D = 1.2 – 1.0752

D = 3.12

DPS 3.12
D/P ratio = × 100 = × 100 = 52%
EPS 6

So, the required dividend payout ratio will be = 52%

Question – 03
The following figures are collected from the annual report of XYZ Ltd.:

Net Profit ₹ 30 lakhs

Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is (i)
25%; (ii) 50% and (iii) 100%.

(Study Material ICAI Illus – 04)

Solution:

₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Earning per share 18/3 = ₹ 6.00

Price per share according to Gordon’s Model is calculated as follows:

E1 (1−b)
P0 =
Ke −br

Here, E1 = 6, Ke = 16%

542
 [DIVIDEND DECISIONS]

(i) When dividend pay-out is 25%

6 × 0.25 1.5
P0 = = = 150
0.16 – (0.75 × 0.2) 0.16 – 0.15

(ii) When dividend pay-out is 50%

6 × 0.25 3
P0 = = = 50
0.16 – (0.5 × 0.2) 0.16 – 0.10

(iii) When dividend pay-out is 100%

6 ×1 6
P0 = = = 37.50
0.16 – (0 × 0.2) 0.16

Question – 04
The following information pertains to M/s XY Ltd.

Earnings of the Company ₹ 5,00,000

Dividend Payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%

CALCULATE:

(i) Market value per share as per Walter’s model.

(ii) Optimum dividend payout ratio according to Walter’s model and the
market value of Company’s share at that payout ratio.

(Study Material ICAI Illus – 09)

Solution:

(i) As per Walter’s model:

r
D+ K (E−D)
e
P =
Ke

Where,

P = Market price per share.

543
 [DIVIDEND DECISIONS]

E = Earnings per share = ₹ 5

D = Dividend per share = ₹ 3

R = Return earned on investment = 15%

Ke = Cost of equity capital = 12%

0.15
3 + 0.12(5−3)
P = = ₹ 45.83
0.12

(ii) According to Walter’s model, when the return on investment is more than
the cost of equity capital, the price per share increases as the dividend
pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is nil.

So, at a pay-out ratio of zero, the market value of the company’s share
will be:

0.15
0 + 0.12(5−0)
P = = ₹ 52.08
0.12

Question – 05
The following information is supplied to you:

₹
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.

(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on
the value of the share.

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
ANALYSE.

(Study Material ICAI TYK – 02)

544
 [DIVIDEND DECISIONS]

Solution:

(i) The EPS of the firm is ₹ 10 (i.e., ₹ 2,00,000/ 20,000), r = ₹ 2,00,000/

(20,000 shares × ₹ 100) = 10%. The P/E Ratio is given at 12.5 and the
cost of capital (Ke) may be taken at the inverse of P/E ratio. Therefore, Ke
is 8 (i.e., 1/12.5). The firm is distributing total dividends of ₹ 1,50,000
among 20,000 shares, giving a dividend per share of ₹ 7.50. the value of
the share as per Walter’s model may be found as follows:

r
D+ K (E−D) 7.5+ 0.1 (10−7.5)
e 0.08
P = = = ₹ 132.81
Ke 0.08

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total
earnings of ₹ 2,00,000. Since, the rate of return of the firm (r) is 10% and
it is more than the Ke of 8%, therefore, by distributing 75% of earnings,
the firm is not following an optimal dividend policy. The optimal dividend
policy for the firm would be to pay zero dividend and in such a situation,
the market price would be:

0.1
0+ 0.08(10−0)
= = ₹ 156.25
0.08

So, theoretically the market price of the share can be increased by

adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the
value of the share is such at which the Ke would be equal to the rate of
return (r) of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect
on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E
ratio, would be 12.5 and in such a situation ke> r and the market price,
as per Walter’s model would be:

r
D+ K (E−D) 7.5+ 0.1 (10−7.5)
e 0.125
P = = = ₹ 76
Ke 0.125

545
 [DIVIDEND DECISIONS]

Question – 06
The following information is supplied to you:

Particulars ₹
Total Earnings 5,00,000
Equity shares (of ₹ 100 each) 50,00,000
Dividend paid 3,75,000
Price/Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.

(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on
the value of the share.

(iii) Will your decision change, if the P/E ratio is 8 instead of 12.5?
ANALYSE.

(MTP Nov – 2021)

Solution:

(i) The EPS of the firm is ₹ 10 (i.e.₹ 5,00,000/ 50,000). r =

5,00,000/50,00,000 = 10%. The P/E Ratio is given at 12.5 and the cost
of capital,Ke , may be taken at the inverse of P/E ratio. Therefore, Ke is 8
(i.e.,1/12.5). The firm is distributing total dividends of ₹ 3,75,000 among
50,000 shares, giving a dividend per share of ₹ 7.50. The value of the
share as per Walter’s model may be found as follows:

r
D + K (E-D) 7.5 + 0.1 (10-7.5)
e 0.08
P= = = ₹ 132.81
Ke 0.08

The firm has a dividend payout of 75% (i.e., ₹ 3,75,000) out of total
earnings of ₹ 5,00,000. Since, the rate of return of the firm, r, is 10% and
it is more than the Ke of 8%, therefore, by distributing 75% of earnings,
the firm is not following an optimal dividend policy. The optimal dividend
policy for the firm would be to pay zero dividend and in such a situation,
the market price would be,

0.1
0+ (10-0)
0.08
= ₹ 156.25
0.08

546
 [DIVIDEND DECISIONS]

So, theoretically, the market price of the share can be increased by

adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the
value of the share is such at which the Ke would be equal to the rate of
return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect
on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E
ratio, would be 12.5 and in such a situation Ke > r and the market price,
as per Walter’s model would be:

r 0.1
D+ (E -D) 7.5 + (10 -7.5)
Ke 0.125
P= = = ₹ 76
Ke 0.125

Question – 07
The following information relates to Navya Ltd:

Earnings of the company ₹ 20,00,000

Dividend pay-out ratio 60%
No. of Shares outstanding 4,00,000
Rate of return on investment 15%
Equity capitalization rate 12%

Required:

(i) DETERMINE what would be the market value per share as per Walter’s
model.

(ii) COMPUTE optimum dividend pay-out ratio according to Walter’s model

and the market value of company’s share at that pay-out ratio.

(RTP May – 2018)

Solution:

Navya Ltd.

(i) Walter’s model is given by –

D + E − D (r/Ke )
P=
Ke

547
 [DIVIDEND DECISIONS]

Where,

P = Market price per share,

E = Earnings per share = ₹ 20,00,000 ÷ 4,00,000 = ₹ 5

D = Dividend per share = 60% of 5 = ₹ 3

r = Return earned on investment = 15%

Ke = Cost of equity capital = 12%

0.15 0.15
3 + 5−3 × 3+2×
0.12 0.12
∴P = = × ₹ 45.83
0.12 0.12

(ii) According to Walter’s model when the return on investment is more than
the cost of equity capital, the price per share increases as the dividend
pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is Nil. So, at a payout ratio of zero, the market value of the
company’s share will be:-

0.15
0 + 5 − 0 × 0.12
= = ₹ 52.08
0.12

Question – 08
Following information relating to Jee Ltd. is given:

Particulars

Profit after tax ₹ 10,00,000

Dividend pay-out ratio 50%

Number of Equity Shares 50,000

Cost of Equity 10%

Rate of Return on Investment 12%

(i) CALCULATE market value per share as per Walter's Model?

(ii) What is the optimum dividend pay-out ratio according to Walter's Model
and Market value of equity share at that pay-out ratio?

(RTP May – 2020)

548
 [DIVIDEND DECISIONS]

Solution:

(i) Walter’s model is given by –

D + E − D (r/Ke )
P=
Ke

Where,

P = Market price per share,

E = Earnings per share = ₹ 10,00,000 ÷ 50,000 = ₹ 20

D = Dividend per share = 50% of 20 = ₹ 10

r = Return earned on investment = 12%

Ke = Cost of equity capital = 10%

0.12
10 + 20 −10 × 22
0.10
∴P= = = ₹ 220
0.10 0.10

(ii) According to Walter’s model when the return on investment is more than
the cost of equity capital, the price per share increases as the dividend
pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is Nil. So, at a pay-out ratio of zero, the market value of the
company’s share will be:

0.12
10 + 20 − 0 × 0.10 24
= = ₹ 240
0.10 0.10

Question – 09
The Following information is supplied to you:

(₹)
Total Earnings 2,00,000
No. of equity shares (of ₹ 100 each) 20,000
Dividend paid 1,50,000
Price/Earnings ratio 12.5

Applying Walter’s Model:

(i) ANALYSE whether the company is following an optimal dividend policy.

549
 [DIVIDEND DECISIONS]

(ii) COMPUTE P/E ratio at which the dividend policy will have no effect on
the value of the share.

(iii) Will your decision change if the P/E ratio is 8 instead of 12.5? ANALYSE.

(RTP May – 2021)

Solution:

(i) The EPS of the firm is ₹ 10 (i.e.,₹ 2,00,000/ 20,000) and r = 2,00,000/
(20,000 shares × ₹ 100) = 10%. The P/E Ratio is given at 12.5 and the
cost of capital, Ke , may be taken at the inverse of P/E ratio. Therefore, Ke
is 8 (i.e., 1/12.5). The firm is distributing total dividends of ₹1,50,000
among 20,000 shares, giving a dividend per share of ₹7.50. the value of
the share as per Walter’s model may be found as follows:

r 0.1
D +K 7.5 + 0.08
e
P= (E − D) = (10 − 7.5) = ₹ 132.81
Ke 0.08

The firm has a dividend payout of 75% (i.e., ₹ 1,50,000) out of total
earnings of ₹ 2,00,000. Since, the rate of return of the firm, r, is 10% and
it is more than the Ke of 8%, therefore, by distributing 75% of earnings,
the firm is not following an optimal dividend policy. The optimal dividend
policy for the firm would be to pay zero dividend and in such a situation,
the market price would be-

0.1
0 + 0.08 (10 − 0)
= = ₹ 156.25
0.08

So, theoretically the market price of the share can be increased by

adopting a zero payout.

(ii) The P/E ratio at which the dividend policy will have no effect on the
value of the share is such at which the Ke would be equal to the rate of
return, r, of the firm. The Ke would be 10% (= r) at the P/E ratio of 10.
Therefore, at the P/E ratio of 10, the dividend policy would have no effect
on the value of the share.

(iii) If the P/E is 8 instead of 12.5, then the Ke which is the inverse of P/E
ratio, would be 12.5 and in such a situation ke> r and the market price,
as per Walter’s model would be.

550
 [DIVIDEND DECISIONS]

r 0.1
D + k (E−D) 7.5 + 0.125 (10 − 7.5)
P= e
= = ₹ 76
Ke 0.125

Question – 10
The following figures have been collected from the annual report of ABC Ltd. for
the current financial year:

Net Profit ₹ 75 lakhs

Outstanding 12% preference shares ₹ 250 lakhs
No. of equity shares 7.50 lakhs
Return on investment 20%
Cost of capital i.e. (Ke) 16%

(a) COMPUTE the approximate dividend pay-out ratio so as to keep the

share price at ₹ 42 by using Walter’s model?

(b) DETERMINE the optimum dividend pay-out ratio and the price of the
share at such pay-out.

(c) PROVE that the dividend pay-out ratio as determined above in (b) is
optimum by using random pay-out ratio.

(RTP May – 2022)

Solution:

(a)
₹ in lakhs
Net Profit 75
Less: Preference dividend 30
Earning for equity shareholders 45
Earning per share = 45/7.5 = ₹ 6.00

Let, the dividend per share be D to get share price of ₹ 42

r
D + K (E−D)
e
P =
Ke
0.20
D + 0.16 (6−D)
₹ 42 =
0.16

0.16D + 1.2-0.20D
6.72 =
0.16

551
 [DIVIDEND DECISIONS]

0.04D = 1.2 – 1.0752

D = 3.12
DPS 3.12
D/P ratio = × 100 = × 100 = 52%
EPS 6
So, the required dividend payout ratio will be = 52%

(b) Since r > Ke , the optimum dividend pay-out ratio would ‘Zero’ (i.e. D = 0),
Accordingly, value of a share:
r
D+ (E−D)
Ke
P =
Ke
0.20
0 + 0.16 (6−0)
P = = ₹ 46.875
0.16
(c) The optimality of the above pay-out ratio can be proved by using 25%,
50%, 75% and 100% as pay- out ratio:

At 25% pay-out ratio

0.20
1.5 + 0.16 (6 −1.5)
P = = ₹ 44.531
0.16
At 50% pay-out ratio
0.20
3 + 0.16 (6−3)
P = = ₹ 42.188
0.16
At 75% pay-out ratio
0.20
4.5 + 0.16 (6 − 4.5)
P = = ₹ 39.844
0.16
At 100% pay-out ratio
0.20
6+ (6−6)
0.16
P = = ₹ 37.50
0.16
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.

552
 [DIVIDEND DECISIONS]

Question – 11
The following information pertains to SD Ltd.

Earnings of the Company ₹ 50,00,000

Dividend Payout ratio 60 %
No. of shares outstanding 10,00,000
Equity capitalization rate 12 %
Rate of return on investment 15 %

(i) COMPUTE the market value per share as per Walter’s model?

(ii) COMPUTE the optimum dividend payout ratio according to Walter’s

model and the market value of Company’s share at that payout ratio?

(RTP Nov – 2019)

Solution:

(i) Walter’s model is given by

r
D+ (E−D)
Ke
P=
Ke

Where P = Market price per share.

E = Earnings per share = ₹ 5

D = Dividend per share = ₹ 3

R = Return earned on investment = 15%

Ke = Cost of equity capital = 12%

0.15
3+ (5 − 3)
0.12
P= = ₹ 45.83
Ke

(ii) According to Walter’s model when the return on investment is more than
the cost of equity capital, the price per share increases as the dividend
pay-out ratio decreases. Hence, the optimum dividend pay-out ratio in
this case is nil.

So, at a pay-out ratio of zero, the market value of the company’s share
will be:

553
 [DIVIDEND DECISIONS]

0.15
0 + 0.12 (5−0)
P= = ₹ 52.08
0.12

Question – 12
The following figure are extracted from the annual report of RJ Ltd.:

Net Profit ₹ 50 lakhs

Outstanding 13% preference shares ₹ 200 lakhs

No. of Equity Shares 6 lakhs

Return on Investment 25%

Cost of Capital (Ke) 15%

You are required to compute the approximate dividend pay-out ratio by keeping
the share price at ₹ 40 by using Walter’s Model.

(Exam Nov – 2020)

Solution:

Particulars ₹ in lakhs
Net Profit 50
Less: Preference dividend (₹ 200,00,000 × 13%) 26
Earning for equity shareholders 24
Therefore, earning per share = ₹ 24 lakh /6 lakh shares = ₹ 4

Let, the dividend per share be D to get share price of ₹ 40

r
D + K E−D
e
P =
Ke

0.25
D + 0.15 ₹ 4 − D
₹ 40 =
0.15

0.15D + 1−0.25D
6 =
0.15

0.1D = 1 – 0.9

D =₹1

554
 [DIVIDEND DECISIONS]

DPS ₹1
D/P ratio = × 100 = × 100 = 25%
EPS ₹4

So, the required dividend pay-out ratio will be = 25%

(2) GORDON’S MODEL

Question – 13
XYZ is a company having share capital of ₹ 10 lakhs of ₹ 10 each. It distributed
current dividend of 20% per annum. Annual growth rate in dividend expected
is 2%. The expected rate of return on its equity capital is 15%. CALCULATE
price of share applying Gordon’s growth Model.

(Study Material ICAI Illus – 06)

Solution:

D0 (1+g) 2(1+ 0.02)

P = = = ₹ 15.69
Ke − g 0.15 – 0.02

Question – 14
A firm had paid dividend at ₹ 2 per share last year. The estimated growth of the
dividends from the company is estimated to be 5% p.a. DETERMINE the
estimated market price of the equity share if the estimated growth rate of
dividends (i) rises to 8%, and (ii) falls to 3%. Also FIND OUT the present market
price of the share, given that the required rate of return of the equity investors
is 15%.

(Study Material ICAI Illus – 07)

Solution:

In the present situation, the current MPS is as follows:

D0 (1+g) 2(1+ 0.05)

P = = = ₹ 21
Ke − g 0.15 – 0.05

(i) The impact of changes in growth rate to 8% on MPS will be as follows:

2(1+ 0.08)
P = = ₹ 30.86
0.15 – 0.08

(ii) The impact of changes in growth rate to 3% on MPS will be as follows:

555
 [DIVIDEND DECISIONS]

2(1+ 0.03)
P = = ₹ 17.17
0.15 – 0.03

So, the market price of the share is expected to vary in response to change in
expected growth rate of dividends.

Question – 15
Taking an example of three different firms i.e. growth, normal and declining,
CALCULATE the share price using Gordon’s model.

Factors Growth Normal Declining

Firm Firm Firm
r > Ke r = Ke r < Ke
r (rate of return on retained earnings) 15% 10% 8%
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) ₹ 10 ₹ 10 ₹ 10
b (Retained Earnings) 0.6 0.6 0.6
1- b (Dividend Payout) 0.4 0.4 0.4

(Study Material ICAI Illus – 10)

Solution:

E(1−b)
P0 =
Ke −br

(i) Situation-1: Growth Firm r > Ke

10(1−0.6) 4
P0 = = = ₹ 400
0.10−0.15 × 0.6 0.10−0.09

(ii) Situation-2: Normal Firm r = Ke

10(1−0.6) 4
P0 = = = ₹ 100
0.10−0.10 × 0.6 0.10−0.06

(ii) Situation-2: Normal Firm r < Ke

10(1−0.6) 4
P0 = = = ₹ 76.92
0.10−0.08 × 0.6 0.10−0.048

If the retention ratio (b) is changed from 0.6 to 0.4, the new share price will be
as follows:

556
 [DIVIDEND DECISIONS]

Growth Firm

10(1−0.4) 6
P0 = = = ₹ 150
0.10−0.15 × 0.4 0.10−0.06

Normal Firm

10(1−0.4) 6
P0 = = = ₹ 100
0.10−0.10 × 0.4 0.10−0.04

Declining Firm

10(1−0.4) 6
P0 = = = ₹ 88.24
0.10−0.08 × 0.4 0.10−0.032

From the above analysis, it can be concluded that:

When r > k, the market value increases with retention ratio.

When r < k, the market value of share stands to decrease.

When r = k, the market value is not affected by dividend policy.

The conclusion of the Gordon’s model is similar to that of Walter’s model.

Question – 16
The following information is given below in case of Aditya Ltd.:

Earnings per share = ₹ 60

Capitalization rate = 15%

Return on investment = 25%

Dividend payout ratio = 30%

(i) COMPUTE price per share using Walter’s Model.

(ii) WHAT would be optimum dividend payout ratio per share under
Gordon’s Model.

(Study Material ICAI Illus – 11)

Solution:

557
 [DIVIDEND DECISIONS]

(i) As per Walter’s Model, Price per share is computed by using the
following formula:

r
D+ K (E−D)
e
P =
Ke

Where,

P = Market Price of the share.

E = Earnings per share.

D = Dividend per share.

Ke = Cost of equity/ rate of capitalization/ discount rate.

r = Internal rate of return/ return on investment

Applying the above formula, price per share

0.25
18+ 0.15(60−18)
P =
0.15

18+70
Or, P = = ₹ 586.67
0.15

(ii) As per Gordon’s model, when r > Ke, optimum dividend payout ratio
is ‘Zero’.

Question – 17
With the help of following figures CALCULATE the market price of a share of a
company by using:

(i) Walter’s formula

(ii) Dividend growth model (Gordon’s formula)

Earning per share (EPS) ₹ 10

Dividend per share (DPS) ₹6
Cost of capital (Ke) 20%
Internal rate of return on investment 25%
Retention Ratio 40%

558
 [DIVIDEND DECISIONS]

(Study Material ICAI TYK – 03)

Solution:

Market price per share by

(i) Walter’s model

r
D+ K (E−D) 6+ 0.25(10−6)
e 0.20
P = = = ₹ 55
Ke 0.20

(ii) Gordon’s model

Present market price per share

E(1 – b)
(P0) =
k – br

10(1 – 0.40)
P0 =
0.20 – (0.4 × 0.25)

6
= = ₹ 60
0.1

Question – 18
The annual report of XYZ Ltd. provides the following information:

Particulars Amount (₹)

Net Profit 50 lakhs
Outstanding 15% preference shares 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 16%

CALCULATE price per share using Gordon’s Model when dividend pay-out is:

(i) 25%;

(ii) 50%;

(iii) 100%.

(Study Material ICAI TYK – 04)

559
 [DIVIDEND DECISIONS]

Solution:

Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in ₹
Net Profit 50 lakhs
Less: Preference dividend 15 lakhs
Earnings for equity shareholders 35 lakhs
Earnings per share 35 lakhs/5 lakhs = ₹ 7.00

Price per share according to Gordon’s Model is calculated as follows:

E1 (1 – b)
(P0) =
k – br

Here, E1 = 7, Ke = 16%

(i) When dividend pay-out is 25%

7 × 0.25 1.75
P0 = = = ₹ 175
0.16 – (0.75 × 0.2) 0.16 – 0.15

(ii) When dividend pay-out is 50%

7 × 0.5 3.5
P0 = = = ₹ 58.33
0.16 – (0.5 × 0.2) 0.16 – 0.10

(iii) When dividend pay-out is 100%

7×1 7
P0 = = = ₹ 43.75
0.16 – (0 × 0.2) 0.16

Question – 19
A&R Ltd. is a large-cap multinational company listed in BSE in India with a
face value of ₹ 100 per share. The company is expected to grow @ 15% p.a. for
next four years then 5% for an indefinite period. The shareholders expect 20%
return on their share investments. Company paid ₹ 120 as dividend per share
for the current Financial Year. The shares of the company traded at an average
price of ₹ 3,122 on last day. FIND out the intrinsic value per share and state
whether shares are overpriced or underpriced.

(Study Material ICAI TYK – 05)

560
 [DIVIDEND DECISIONS]

Solution:

As per Dividend discount model, the price of share is calculated as

follows:

D1 D2 D3 D4 D5 1
P = + + + + ×
1+Ke 1 1+Ke 2 1+Ke 3 1+Ke 4 (K e −g) 1+Ke 5

Where,

P = Price per share

Ke = Required rate of return on equity

g = Growth rate

₹120×1.15 ₹138×1.15 ₹158.7×1.15 ₹182.5×1.15 ₹209.88×1.05

P = + + + +
1+0.2 1 1+0.2 2 1+0.2 3 1+0.2 4 (0.2−0.05)
1
×
1+0.2 5

P = 115 + 110.2 + 105.6 + 101.2 + 590.42 = ₹ 1,022.42

Intrinsic value of share is ₹ 1,022.42 as compared to latest market price of ₹

3,122. Market price of a share is overpriced by ₹ 2,099.58.

Question – 20
In the month of May of the current Financial Year, shares of RT Ltd. was sold
for ₹ 1,460 per share. A long term earnings growth rate of 7.5% is anticipated.
RT Ltd. is expected to pay dividend of ₹ 20 per share.

(i) CALCULATE rate of return an investor can expect to earn assuming that
dividends are expected to grow along with earnings at 7.5% per year in
perpetuity?

(ii) It is expected that RT Ltd. will earn about 10% on retained earnings and
shall retain 60% of earnings. In this case, STATE whether, there would
be any change in growth rate and cost of Equity?

(Study Material ICAI TYK – 06)

Solution:

561
 [DIVIDEND DECISIONS]

(i) According to Dividend Discount Model approach, the firm’s expected or

required return on equity is computed as follows:

D1
Ke = +g
P0

20(1+0.075)
Ke = + 7.5%
1,460

= 0.0147 + 0.075 = 0.0897 or 8.97%

(ii) With rate of return on retained earnings (r) is 10% and retention ratio (b)
is 60%, new growth rate will be as follows:

g = br = 0.10 × 0.60 = 0.06

Accordingly, dividend will also get changed and to calculate this, first we
shall calculate previous retention ratio (b1) and then EPS assuming that
rate of return on retained earnings (r) is same.

With previous Growth Rate of 7.5% and r =10%, the retention ratio
comes out to be:

0.075 = b1 × 0.10

b1 = 0.75 and payout ratio = 0.25

With 0.25 payout ratio the EPS will be as follows:

₹20
= ₹ 80
0.25

With new 0.40 (1 – 0.60) payout ratio, the new dividend will be

D1 = ₹ 80 × 0.40 = ₹ 32

Accordingly, new Ke will be

32
Ke = + 6.0%
1,460

Or, Ke = 8.19%

562
 [DIVIDEND DECISIONS]

Question – 21
The following information is given:

Dividend per share (DPS) ₹9

Cost of capital (Ke) 19%

Internal rate of return on investment 24%

Retention ratio 25%

Calculation the market price per share by using:

(i) Walter’s formula

(ii) Gordon’s formula (Dividend Growth Model)

(MTP March – 2021)

Solution:

Working:

Calculation of Earnings per share (EPS):

DPS
EPS =
Dividend Payout Ratio

₹9
EPS = = ₹ 12
1-0.25

Market price per share by

(i) Walter’s model:

r
D+
Ke
(E -D)
P =
Ke

0.24
₹ 9 + 0.19 (₹12 - ₹ 9)
=
0.19

= ₹ 67.31

(ii) Gordon’s model (Dividend Growth model):

563
 [DIVIDEND DECISIONS]

D0 (1 + g)
P0 =
Ke − g

Where,

P0 = Present market price per share.

g = Growth rate (br) = 0.25 × 0.24 = 0.06

b = Retention ratio

k = Cost of Capital

r = Internal rate of return (IRR)

D0 = Dividend per share

E = Earnings per share

₹ 9 (1 + 0.06) ₹ 9.54
= = = ₹ 73.38
₹ 0.19 − 0.06 ₹ 0.13

Alternatively,

E (1-b)
P0 =
k-br

12 ( 1-0.25) 9
P0 = = = ₹ 69.23
0.19-0.06 0.13

Question – 22
Following information is given for WN Ltd.:

Earnings ₹ 30 per share

Dividend ₹ 9 per share

Cost of capital 15%

Internal Rate of Return on investment 20%

You are required to CALCULATE the market price per share using-

564
 [DIVIDEND DECISIONS]

(i) Gordon’s formula

(ii) Walter’s formula

(MTP Sep – 2022)

Solution:

(i) As per Gordon’s Model, Price per share is computed using the formula:

E1 (1 - b)
P0 =
Ke − br

Where,

P0 = Price per share

E1 = Earnings per share

b = Retention ratio; (1 -b = Pay-out ratio)

Ke = Cost of capital

r = IRR

br = Growth rate (g)

Applying the above formula, price per share

30 × 0.3* 9
P0 = = = ₹ 900
0.150.70 × 0.2 0.01
₹9
*Dividend pay-out ratio = = 0.3 or 30%
₹ 30

(ii) As per Walter’s Model, Price per share is computed using the
formula:

r
D + K (E -D)
e
Price (P) =
Ke

Where,

P = Market Price of the share

565
 [DIVIDEND DECISIONS]

E = Earnings per share

D = Dividend per share

Ke = Cost of equity/ rate of capitalization/ discount rate

r = Internal rate of return/ return on investment

Applying the above formula, price per share

0.20
9 + 0.15(30 − 9) 37
P= = = ₹ 246.67
0.15 0.15

Question – 23
The annual report of XYZ Ltd. provides the following information for the
Financial Year 2019-20:

Particulars Amount (₹)

Net Profit 78 lakhs
Outstanding 15% preference shares 120 lakhs
No. of equity shares 6 lakhs
Return on Investment 20 %
Cost of capital i.e. (ke ) 16 %

CALCULATE price per share using Gordon’s Model when dividend pay-out is-

(i) 30%;

(ii) 50%;

(iii) 100%.

(MTP October – 2022)

Solution:

Price per share according to Gordon’s Model is calculated as follows:

Particulars Amount in ₹
Net Profit 78 Lakhs
Less : preference dividend (120 lakhs @ 15 %) 18 lakhs
Earnings for equity shareholders 60 lakhs
Earning Per share 60 lakhs/6 lakhs = ₹ 10.00

Price per share according to Gordon’s Model is calculated as follows:

566
 [DIVIDEND DECISIONS]

E1 (1-B)
P0 =
Ke - br

Here , E1 = 10 Ke = 16 %

(i) When dividend pay-out is 30%

10 × 0.30 3
P0 = = = ₹ 150
0.16 (0.70 × 0.2 ) 0.16 − 0.14

(ii) When dividend pay-out is 50%

10 × 0.5 5
P0 = = = ₹ 83.33
0.16 -(0.5 × 0.2 ) 0.16 - 0.10
(iii) When dividend pay-out is 100%

10 × 1 10
P0 = = = ₹ 62.5
0.16 − (0 × 0.2 ) 0.16

Question – 24
The following figures are collected from the annual report of XYZ Ltd.:

Year Cash Flows (₹ in lakhs)

Net Profit ₹ 30 lakhs
Outstanding 12% preference shares ₹ 100 lakhs
No. of equity shares ₹ 3 lakhs
Return on investment 20%
Cost of capital i.e. (Ke) 16%

CALCUALTE price per share using Gordon’s Model when dividend pay-out is (i)
25%; (ii) 50% and (iii) 100%.

(RTP May – 2019)

Solution:

₹ in lakhs
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3 = 6.00

Price per share according to Gordon’s Model is calculated as follows:

567
 [DIVIDEND DECISIONS]

E1 (1−b)
P0 =
Ke −br

Here, E1 = 6, Ke = 16%

(i) When dividend pay-out is 25%

6 × 0.25 1.5
P0 = = = 150
0.16 − (0.75 × 0.2) 0.16-0.15

(ii) When dividend pay-out is 50%

6 × 0.5 3
P0 = = = 50
0.16-(0.5 × 0.2) 0.16 − 0.10

(iii) When dividend pay-out is 100%

6×1 6
P0 = = = 37.50
0.16 - (0 × 0.2) 0.16

Question – 25
The following information is given for QB Ltd.

Earnings per share ₹ 120

Dividend per share ₹ 36

Cost of capital 15%

Internal Rate of Return on investment 20%

CALCULATE the market price per share using

(a) Gordon’s formula

(b) Walter’s formula

(RTP Nov – 2020)

Solution:

(a) As per Gordon’s Model, Price per share is computed using the
formula:

568
 [DIVIDEND DECISIONS]

E1 (1−b)
P0 =
Ke −br

Where,

P0 = Price per share

E1 = Earnings per share

b = Retention ratio; (1 - b = Pay-out ratio)

Ke = Cost of capital

r = IRR

br = Growth rate (g)

Applying the above formula, price per share

120 (1−0.7) 36
P0 = = = ₹ 3,600
0.15 − 0.70 × 0.2 0.01

(b) As per Walter’s Model, Price per share is computed using the
formula:
r
D + K (E−D)
e
Price (𝐏) =
Ke

Where,

P = Market Price of the share.

E = Earnings per share.

D = Dividend per share.

Ke = Cost of equity/ rate of capitalization/ discount rate.

r = Internal rate of return/ return on investment

Applying the above formula, price per share

0.20
36 + 0.15 (120-36) 36
P = = = ₹ 3,600
0.15 0.01

569
 [DIVIDEND DECISIONS]

36 +112
Or, P = = ₹ 986.67
0.15

Question – 26
X Ltd. is a multinational company. Current market price per share is ₹ 2,185.
During the F.Y. 2020-21, the company paid ₹ 140 as dividend per share. The
company is expected to grow @ 12% p.a. for next four years, then 5% p.a. for
an indefinite period. Expected rate of return of shareholders is 18% p.a.

(i) Find out intrinsic value per share.

(ii) State whether shares are overpriced or underpriced.

Year 1 2 3 4 5
Discounting Factor @ 18% 0.847 0.718 0.608 0.515 0.436

(Exam, Dec – 2021)

Solution:

As per Dividend discount model, the price of share is calculated as follows:

D1 D2 D3 D4 D4 (1+g) 1
P= 1 + 2 + 3 + 4 + 4 ×
1 + Ke 1 + Ke 1+ Ke 1+ Ke Ke −g 1 + Ke 4

Where,

P = Price per share

Ke = Required rate of return on equity

g = Growth rate

₹ 140 × 1.12 ₹ 156.80 × 1.12 ₹ 175.62 × 1.12 ₹ 196.69 × 1.12

P= 1 + 2 + 3 +
1 + 0.18 1 + 0.18 1 + 0.18 1 + 0.18 4

₹ 220.29 (1+0.05) 1
+ ×
(0.18−0.05) (1 + 0.18)4

P = 132.81 + 126.10 + 119.59 + 113.45 + 916.34 = ₹ 1,408.29

Intrinsic value of share is ₹ 1,408.29 as compared to latest market price of ₹

2,185. Market price of share is over-priced by ₹ 776.71.

570
 [DIVIDEND DECISIONS]

Question – 27
The following information is taken from ABC Ltd.

Net Profit for the year ₹ 30,00,000

12% Preference share capital ₹ 1,00,00,000

Equity share capital (Share of ₹ 10 each) ₹ 60,00,000

Internal rate of return on investment 22%

Cost of Equity Capital 18%

Retention Ratio 75%

Calculate the market price of the share using:

(1) Gordon's Model

(2) Walter's Model

(Exam, Jan – 2021)

Solution:

Market price per share by-

(1) Gordon’s Model:

D0 (1+g)
Present market price per share (P0 )* =
Ke −g

OR

D1
Present market price per share (P0 ) =
Ke −g

Where,

P0 = Present market price per share.

g = Growth rate (br) = 0.75 × 0.22 = 0.165

b = Retention ratio (i.e., % of earnings retained)

r = Internal rate of return (IRR)

571
 [DIVIDEND DECISIONS]

D0 = E × (1 – b) = 3 × (1 – 0.75) = 0.75

E = Earnings per share

0.75 (1 + 0.165) 0.874

P0 = = = ₹ 58.27 approx.
0.18 − 0.165 0.015

E (1−b)
*Alternatively, Po can be calculated as = ₹ 50.
K−br

(2) Walter’s Model:

r
D+ (E−D)
Ke
P =
Ke

0.22
0.75 + 0.18 (3 − 0.75)
= = ₹ 19.44
0.18

Workings:

1. Calculation of Earnings per share

Particulars Amount (₹)

Net Profit for the year 30,00,000
Less: Preference dividend (12% of ₹ 1,00,00,000) (12,00,000)
Earnings for equity shareholders 18,00,000
No. of equity shares (₹ 60,00,000/₹10) 6,00,000
Therefore, Earnings per share ₹ 18,00,000/6,00,000
Earning for equity shareholders = ₹ 3.00
No. of equity shares

2. Calculation of Dividend per share

Particulars
Earnings per share ₹3
Retention Ratio (b) 75%
Dividend pay-out ratio (1-b) 25%
Dividend per share ₹ 3 × 0.25 = ₹ 0.75
(Earnings per share × Dividend pay-out ratio)

572
 [DIVIDEND DECISIONS]

Question – 28
The following information relates to LMN Ltd.

Earning of the company ₹ 30,00,000

Dividend pay-out ratio 60%

No. of shares outstanding 5,00,000

Rate of return on investment 15%

Equity capitalized rate 13%

Required:

(i) Determine what would be the market value per share as per Walter’s
model.

(ii) Compute optimum dividend pay-out ratio according to Walter’s model

and the market value of company’s share at that pay-out ratio.

(Exam, July – 2021)

Solution:

(i) Calculation of market value per share as per Walter’s model

r
D + K (E−D)
e
P=
Ke

Where,

P = Market price per share.

E = Earnings per share = ₹ 30,00,000/5,00,000 = ₹ 6

D = Dividend per share = ₹ 6 × 0.60 = ₹ 3.6

r = Return earned on investment = 15%

Ke = Cost of equity capital = 13%

0.15
3.6 + (6 − 3.6)
0.13
P = = ₹ 49
0.13

573
 [DIVIDEND DECISIONS]

(ii) According to Walter’s model, when the return on investment (r) is more
than the cost of equity capital (Ke ), the price per share increases as the
dividend pay-out ratio decreases. Hence, the optimum dividend pay-out
ratio in this case is nil.

So, at a pay-out ratio of zero, the market value of the company’s share
will be:

0.15
0+ (6 − 0)
0.13
P= = ₹ 53.254
0.13

Question – 29
The following information is supplied to your :

Total Earning ₹ 40 Lakhs

No. of Equity shares (of ₹ 100 each) 4,00,000
Dividend per share ₹4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%

Calculate the market price of a share of a company by using

(i) Walter’s formula

(ii) Gordon’s formula

(Exam, May – 2019)

Solution:

₹ 40 Lakhs
Earning Per share (E) = = ₹ 10
4,00,000

Calculation of Market price per share by

r
D+ (E−D)
Ke
(i) Walter’s formula: Market Price (P) =
Ke

Where,

P = Market Price of the share.

574
 [DIVIDEND DECISIONS]

E = Earnings per share.

D = Dividend per share.

Ke = Cost of equity/ rate of capitalization/ discount rate.

R = Internal rate of return/ return on investment

0.20
4 + 0.16 (10−4) 4+7.5
P= = = ₹ 71.88
0.16 0.16

(ii) Gordon’s formula: When the growth is incorporated in earnings and

dividend, the present value of market price per share (Po) is determined
as follows

E (1−b)
Gordon’s theory: P0 =
k−br

Where,

P0 = Present market price per share.

E = Earnings per share

b = Retention ratio (i.e. % of earnings retained)

r = Internal rate of return (IRR)

Growth rate (g) = br

10 (1−.60) 4
Now P0 = = ₹ = ₹ 100
.16-(.60 ×.20) .04
Question – 30
Following information relating to Jee Ltd. are given :

Particulars

Profit after tax ₹ 10,00,000

Dividend pay 50%

Number of Equity Shares 50,000

Cost of Equity 10%

575
 [DIVIDEND DECISIONS]

Rate of return on Investment 12%

(i) What would be the market value per share as per Walter’s Model ?

(ii) what is the optimum dividend payout ratio according to Walter’s Model
and market value of equity share at that payout ratio ?

(Exam, Nov – 2018)

Solution:

(i) Walter’s model is given by –

D + (E – D)(r/Ke)
P=
Ke

Where,

P = Market price per share

E = Earnings per share ₹ 10,00,000/50,000 = ₹ 20

E = Dividend per share = 50% of 20 = ₹ 10

r = Return earned on investment = 12%

Ke = Cost of equity capital = 10%

0.12
10 + (20 – 10) × 22
0.10
P= = = ₹ 220
0.10 0.10

(ii) According to Walter’s model when the return on investment is more than
the cost of equity capital, the price per share increases as the dividend
payout ratio decreases. Hence, the optimum dividend payout ratio in this
case is Nil. So, at a payout ratio of zero, the market value of the
company’s share will be :-

0.12
0 + (20 – 0) × 24
0.10
P= = = ₹ 240
0.10 0.10

Question – 31
Following figures and information were extracted from the company A Ltd.

Earnings of the company ₹ 10,00,000

576
 [DIVIDEND DECISIONS]

Dividend paid ₹ 6,00,000

No. of shares outstanding 2,00,000

Price earnings Ratio 10

Rate of return on investment 20%

You are required to calculate :

(i) Current Market price of the share

(ii) Capitalization Rate of its risk class.

(iii) What should be the optimum payout ratio ?

(iv) What should be the market price per share at option payout ratio ? (use
Walter’s Model)
(Exam Nov – 2019)

Solution:

(i) Current Market price of shares (applying Walter’s Model)

• The EPS of the firm is ₹ 5 (i.e., ₹ 10,00,000/2,00,000).

• Rate of return on Investment (r) = 20%.

• The Price Earnings (P/E) Ratio is given as 10, so capitalization rate

(Ke ), may be taken at the inverse of P/E Ratio. Therefore, Ke is 10%
or .10 (i.e., 1/10).

• The firm is distributing total dividends of ₹ 6,00,000 among

2,00,000 shares, giving a dividend per share of ₹ 3.

The value of the share as per Walter’s model may be found as follows:

Walter’s model is given by-

r
D + K (E−D)
e
P=
Ke

Where,

P = Market price per share.

577
 [DIVIDEND DECISIONS]

E = Earnings per share = ₹ 5

D = Dividend per share = ₹ 3

R = Return earned on investment = 20 %

Ke = Cost of equity capital = 10% or .10

0.20
3+ (5−3)
0.10
P = = ₹ 70
0.10

Current Market Price of shares can also be calculated as follows:

Market Price of Share

Price Earnings (P/E) Ratio =
Earnings per Shares

Market Price of Share

Or, 10 =
₹ 10,00,000/2,00,000

Market Price of Share

Or, 10 =
₹5

Market Price of Share = ₹ 50

(ii) Capitalization rate (Ke ) of its risk class is 10% or .10 (i.e., 1/10).

(iii) Optimum dividend pay-out ratio

According to Walter’s model when the return on investment is more than

the cost of equity capital (10%), the price per share increases as the
dividend pay-out ratio decreases. Hence, the optimum dividend pay-out
ratio in this case is nil or 0 (zero).

(iv) Market price per share at optimum dividend pay-out ratio

At a pay-out ratio of zero, the market value of the company’s share will
be:
0.20
0+ (5−0)
0.10
P= = ₹ 100
0.10

578
 [DIVIDEND DECISIONS]

(3) M.M. MODEL

Question – 32
AB Engineering Ltd. belongs to a risk class for which the capitalization rate is
10%. It currently has outstanding 10,000 shares selling at ₹ 100 each. The firm
is contemplating the declaration of a dividend of ₹ 5 share at the end of the
current financial year. It expects to have a net income of ₹ 1,00,000 and has a
proposal for making new investments of ₹ 2,00,000. CALCULATE the value of
the firm when dividends (i) are not paid (ii) are paid.

(Study Material ICAI Illus – 01)

Solution:

CASE 1: Value of the firm when dividends are not paid.

Step 1: Calculate price at the end of the period

Ke= 10%, P₀= 100, D₁= 0

P1 +D1
P0 =
1+Ke

P1 +0
100 =
1+0.10

P1 = 110

Step 2: Calculation of funds required for investment

Earning ₹ 1,00,000

Dividend distributed Nil

Fund available for investment ₹ 1,00,000

Total Investment ₹ 2,00,000

Balance Funds required ₹ 2,00,000 - ₹ 1,00,000

= ₹ 1,00,000

Step 3: Calculation of No. of shares required to be issued for balance funds

Funds Required
No. of shares =
Price at end (P1)

579
 [DIVIDEND DECISIONS]

1,00,000
∆n =
110

Step 4: Calculation of value of firm

(n + ∆n)P1− I+E
nP0 =
1 + Ke

₹ 1,00,000
(10,000 + ₹ 110
) × ₹ 110 − ₹ 2,00,000 + ₹ 1,00,000
nP0 =
(1 + 0.10)

= ₹ 10,00,000

CASE 2: Value of the firm when dividends are paid.

Step 1: Calculate price at the end of the period

Ke = 10%, P₀= 100, D₁= 5

P1 +D1
P0 =
1+Ke

P1 +5
100 =
1+0.10

P1 = 105

Step 2: Calculation of funds required for investment

Earning ₹ 1,00,000

Dividend distributed ₹ 50,000

Fund available for investment ₹ 50,000

Total Investment ₹ 2,00,000

Balance Funds required ₹ 2,00,000 - ₹ 50,000

= ₹ 1,50,000

Step 3: Calculation of No. of shares required to be issued for balance funds

Funds Required
No. of shares =
Price at end (P1)

580
 [DIVIDEND DECISIONS]

₹ 1,50,000
∆n =
₹ 110

Step 4: Calculation of value of firm

(n + ∆n)P1− I+E
nP0 =
1 + Ke

₹ 1,50,000
(10,000 + ₹ 105
) × ₹ 105 − ₹ 2,00,000 + ₹ 1,00,000
nP0 =
(1 + 0.10)

= ₹ 10,00,000

Thus, it can be seen from the above illustration that the value of the firm
remains the same in either case.

In real world, market imperfections create some problems for MM’s dividend
policy irrelevance proposition.

Question – 33
RST Ltd. has a capital of ₹ 10,00,000 in equity shares of ₹ 100 each. The
shares are currently quoted at par. The company proposes to declare a
dividend of ₹ 10 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is 12%.
COMPUTE market price of the share at the end of the year, if

(i) dividend is not declared

(ii) dividend is declared

Assuming that the company pays the dividend and has net profits of ₹
5,00,000 and makes new investments of ₹ 10,00,000 during the period,
CALCULATE number of new shares to be issued? Use the MM model.

(Study Material ICAI Illus – 08)

Solution:

Given,

Cost of Equity (Ke) 12%

Number of shares in the beginning (n) 10,000
Current Market Price (P0) ₹ 100

581
 [DIVIDEND DECISIONS]

Net Profit (E) ₹ 5,00,000

Expected Dividend (D1) ₹ 10 per share
Investment (I) ₹ 10,00,000

Computation of market price per share, when:

(i) No dividend is declared:

P1 +D1
P0 =
1+Ke

P1 +0
100 =
1+0.12

P1 = 112 – 0 = ₹ 112

(ii) Dividend is declared:

P1 +10
100 =
1+0.12

P1 = 112 – 10 = ₹ 102

Calculation of number of shares required for investment

₹
Earning 5,00,000
Dividend distributed 1,00,000
Fund available for investment 4,00,000
Total Investment 10,00,000
Balance Funds required 10,00,000 – 4,00,000 = 6,00,000

Funds Required
No. of shares =
Price at end (P 1 )

6,00,000
∆n = = 5,882.35 or 5,883 Shares
102

Question – 34
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has
25,000 outstanding shares and the current market price is ₹ 100. It expects a
net profit of ₹ 2,50,000 for the year and the Board is considering dividend of ₹ 5
per share.

582
 [DIVIDEND DECISIONS]

M Ltd. requires to raise ₹ 5,00,000 for an approved investment expenditure.

ILLUSTRATE, how the MM approach affects the value of M Ltd. if dividends are
paid or not paid.

(Study Material ICAI TYK – 01)

Solution:

Given,

Cost of Equity (Ke) 10%

Number of shares in the beginning (n) 25,000
Current Market Price (P0) ₹ 100
Net Profit (E) ₹ 2,50,000
Expected Dividend (D1) ₹ 5 per share
Investment (I) ₹ 5,00,000

Case 1 - When dividends are paid

Step – 1

P1 +D1
P0 =
1+Ke

P1 +5
100 =
1+0.10

P1 = 110 – 5 = 105

Step – 2

Calculation of funds required

= [Total Investment – (Net profit - Dividend)]

= 5,00,000 - (2,50,000 - 1,25,000)

= 3,75,000

Step – 3

No. of shares required to be issued for balance fund

583
 [DIVIDEND DECISIONS]

Funds Required
No. of shares =
Price at end (P1)

3,75,000
∆n =
105

= 3,571.4285

Step – 4

Calculation of value of firm

(n + ∆n)P1−I+E
Vf =
(1 + Ke)

3,75,000
(25,000 + )105 – 5,00,000 + 2,50,000
105
Vf =
(1 + 0.10)

= ₹ 25,00,000

Case 2 - When dividends are not paid

Step – 1

P1 +D1
P0 =
1+Ke

P1 +0
100 =
1+0.10

P1 = 110 – 0 = 110

Step – 2

Calculation of funds required

= [Total Investment – (Net profit - Dividend)]

= 5,00,000 - (2,50,000 - 0)

= 2,50,000

Step – 3

584
 [DIVIDEND DECISIONS]

No. of shares required to be issued for balance fund

Funds Required
No. of shares =
Price at end (P1)

2,50,000
∆n =
110

= 2,272.73

Step – 4

Calculation of value of firm

(n + ∆n)P1−I+E
Vf =
(1 + Ke)

2,50,000
(25,000 + 110
)110 – 5,00,000 + 2,50,000
Vf =
(1 + 0.10)

= ₹ 25,00,000

Question – 35
Aakash Ltd. has 10 lakh equity shares outstanding at the start of the
accounting year. The existing market price per share is ₹ 150. Expected
dividend is ₹ 8 per share. The rate of capitalization appropriate to the risk class
to which the company belongs is 10%.

(i) CALCULATE the market price per share when expected dividends are: (a)
declared, and (b) not declared, based on the Miller – Modigliani approach.

(ii) CALCULATE number of shares to be issued by the company at the end of

the accounting year on the assumption that the net income for the year
is ₹ 3 crore, investment budget is ₹ 6 crores, when (a) Dividends are
declared, and (b) Dividends are not declared.

(iii) PROOF that the market value of the shares at the end of the accounting
year will remain unchanged irrespective of whether (a) Dividends are
declared, or (ii) Dividends are not declared.

(Study Material ICAI TYK – 07)

Solution:

585
 [DIVIDEND DECISIONS]

(i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

P1 +D1
P0 =
1+Ke

Where, Existing market price (P0) = ₹ 150

Expected dividend per share (D1) =₹8

Capitalization rate (ke) = 0.10

Market price at year end (P1) = to be determined

(a) If expected dividends are declared, then

P1 +₹ 8
₹ 150 =
1+0.10

∴ P1 = ₹ 157

(b) If expected dividends are not declared, then

P1 +0
₹ 150 =
1+0.10

∴ P1 = ₹ 165

(ii) Calculation of number of shares to be issued

(a) (b)
Dividends Dividends are
are declared not declared
(₹ lakh) (₹ lakh)
Net income 300 300
Total dividends (80) -
Retained earnings 220 300
Investment budget 600 600
Amount to be raised by new issues 380 300
Relevant market price (₹ per share) 157 165
No. of new shares to be issued (in lakh) 2.42 1.82
(₹ 380 ÷ 157; ₹ 300 ÷ 165)

586
 [DIVIDEND DECISIONS]

(iii) Calculation of market value of the shares

(a) (b)
Dividends Dividends are
are declared not declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (₹) 157 165
Total market value of shares at the end 12.42 × 157 11.82 × 165
of the year (₹ in lakh) = 1.950 = 1,950
(approx.) (approx.)

Hence, it is proved that the total market value of shares remains

unchanged irrespective of whether dividends are declared, or not
declared.

Question – 36
SOC Ltd has 10 lakh equity shares outstanding at the beginning of the
accounting year 2024. The existing market price per share is ₹ 600. Expected
dividend is ₹ 40 per share. The rate of capitalization appropriate to the risk
class to which the company belongs is 20%.

(i) CALCULATE the market price per share by the end of the year when
expected dividends are: (a) declared, and (b) not declared, based on the
Miller – Modigliani approach.

(ii) CALCULATE the number of shares to be issued by the company at the

end of the accounting year on the assumption that the net income for the
year is ₹ 15 crore; investment budget is ₹ 20 crores, when (a) Dividends
are declared, and (b) Dividends are not declared.

(iii) PROVE that the market value of the shares at the end of the accounting
year will remain unchanged irrespective of whether (a) Dividends are
declared, or (ii) Dividends are not declared.

(MTP April – 2024)

Solution:

(i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

587
 [DIVIDEND DECISIONS]

P1 + D1
P0 =
1+Ke

Where,

Existing market price (P0 ) = ₹ 600

Expected dividend per share (D1 ) = ₹ 40

Capitalization rate (Ke ) = 0.20

Market price at year end (P1 ) =?

a. If expected dividends are declared, then

600 = (P1 + 40)/(1 + 0.2)

600 × 1.2 = P1 + 40

P1 = 680

b. If expected dividends are not declared, then

600 = (P1 + 0)/(1 + 0.2)

600 × 1.2 = P1

P1 = 720

(ii) Calculation of number of shares to be issued

(a) (b)
Dividends Dividends
are are not
declared Declared
(₹ lakh) (₹ lakh)
Net income 1500 1500
Total dividends (400) -
Retained earnings 1100 1500
Investment budget 2000 2000
Amount to be raised by new issues 900 500
Relevant market price (₹ per share) 680 720
No. of new shares to be issued (in lakh) 1.3235 0.6944
(₹ 900 ÷ 680; ₹ 500 ÷ 720)

588
 [DIVIDEND DECISIONS]

(iii) Calculation of market value of the shares

(a) (b)
Particulars Dividends are
Dividends are not Declared
declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 1.3235 0.6944
Total shares (in lakhs) 11.3235 10.6944
Market price per share (₹) 680 720
Total market value of shares at 11.3235 × 680 10.6944 × 720
the end of the year (₹ in lakh) = 7,700 (approx.) = 7,700 (approx.)

Hence, it is proved that the total market value of shares remains

unchanged irrespective of whether dividends are declared, or not
declared.

Question – 37
Roma Nov Ltd. has a capital of ₹ 25,00,000 in equity shares of ₹ 100 each. The
shares are currently quoted at ₹ 120. The company proposes to declare a
dividend of ₹ 15 per share at the end of the current financial year. The
capitalization rate for the risk class of which the company belongs is 15%.
COMPUTE market price of the share at the end of the year, if

(i) Dividend is not declared.

(ii) Dividend is declared.

Assuming that the company pays the dividend and has net profits of ₹ 9,00,000
and makes new investments of ₹ 15,00,000 during the period, CALCULATE
number of new shares to be issued? Use the MM model.

(MTP March – 2023)

Solution:

Given,

Cost of Equity (Ke ) 15 %

Number of shares in the beginning (n) 25,000
Current Market Price (P0 ) 120
Net Profit (E) 9,00,000
Expected Dividend (D1 ) 15
Investment (I) 15,00,000

589
 [DIVIDEND DECISIONS]

Computation of market price per share, when:

(i) No dividend is declared:

P1 +D1
P0 =
1+Ke

P1 + 0
₹120 =
1 + 0.15

P1 = ₹ 138 – 0 = ₹ 138

(ii) Dividend is declared:

P1 +15
₹ 120 =
1 + 0.15

P1 = ₹ 138 – ₹ 15 = ₹ 123

Calculation of number of shares required for investment.

₹
Earnings 9,00,000
Dividend distributed 3,75,000
Fund available for 12,75,000
investment
Total Investment 15,00,000
Balance Funds required 15,00,000 – 12,75,000 = 2,25,000

Funds required
No. of shares =
price at the end (P1 )

2,25,000
= = 1,830 Shares(approx.)
123

Question – 38
ZX Ltd. has a paid-up share capital of ₹ 2,00,00,000, face value of ₹100 each.
The current market price of the shares is ₹ 100 each. The Board of Directors of
the company has an agenda of meeting to pay a dividend of 50% to its
shareholders. The company expects a net income of ₹ 1,50,00,000 at the end of
the current financial year. Company also plans for a capital expenditure for the
next financial year for a cost of ₹ 1,90,00,000, which can be financed through
retained earnings and issue of new equity shares.
Company’s desired rate of investment is 15%.

590
 [DIVIDEND DECISIONS]

Required:

Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the

company when:

(i) It does not pay dividend and

(ii) It does pay dividend

(MTP September – 2023)

Solution:

As per MM Hypothesis, value of firm/company is calculated as below:

vf = Value of firm in the beginning of the period

n = number of shares in the beginning of the period

∆n = number of shares issued to raise the funds required

I = Amount required for investment

E = total earnings during the period

(i) Value of the ZX Ltd. when dividends are not paid.

n + ∆ n P1 − I + E
nPo =
1 + Ke

4,00,000
2,00,000 + × 115 − ₹ 1,90,000 + ₹ 1,50,000
115
nPo =
1 + 0.15

₹ 2,70, 00,000 − ₹ 1,90,000 + ₹ 1,50,000

= = ₹ 2,00,00,000
(1 + 0.15)

Working notes:

1. Price of share at the end of the period (P1 )

P1 + D1
P0 =
1 + Ke

P1 + 0
100 = or, P1 = 115
1+ 0.15

591
 [DIVIDEND DECISIONS]

2. Calculation of funds required for investment

Earning ₹ 1,50,00,000
Dividend distributed Nil
Fund available for investment ₹ 1,50,00,000
Total Investment ₹ 1,90,00,000
Balance Fund investment ₹ 40,00,000

3. Calculation of no. of shares required to be issued for balance fund

Fund Required 40,00,000

No. of Share (∆ n) = = share
Price at end (p1) 115

(ii) Value of the ZX Ltd. when dividends are paid.

n + ∆ n P1 - I+E
nPo =
1 + Ke

1,40,00,000
2,00,000 + × ₹ 65 − ₹ 1,90,00,000 + ₹ 1,50,00,000
65
nPo =
1 + 0.15

₹ 2,70,00,000 − ₹ 1,90,00,000 + ₹ 1,50,00,000

= = ₹ 2,00,00,000
(1 + 0.15)

Working notes:

4. Price of share at the end of the period (P1 )

P1 + D1
P0 =
1 + Ke

P1 + 50
100 = or P1 = ₹ 65
1 + 0.15

5. Calculation of funds required for investment

Earning 1,50,00,000
Dividend distributed 1,00,00,000
Fund available for investment 50,00,000
Total Investment 1,90,00,000
Balance Fund required 1,40,00,000

6. Calculation of no. of shares required to be issued for balance fund

592
 [DIVIDEND DECISIONS]

Fund Required
No. of shares (∆n) =
Price at the end (P1 )

1,40,00,000
= = 2,15,385 shares(approx.)
65

Note- As per MM-hypothesis of dividend irrelevance, value of firm remains

same irrespective of dividend paid. In the solution, there may be variation in
value, which is due to rounding off error.

Question – 39
Rambo Limited Has 1,00,000 equity shares outstanding for the year 2022. The
current market price of the shares is ₹ 100 each. Company is planning to pay
dividend of ₹ 10 per share. Required rate of return is 15%. Based on
Modigliani-Miller approach, calculate the market price of the share of the
company when the recommended dividend is 1) declared and 2) not declared.

How many new shares are to be issued by the company at the end of the year
on the assumption that net income for the year is ₹ 40 Lac and the investment
budget is ₹ 50,00,000 when dividend is declared, or dividend is not declared.

PROOF that the market value of the company at the end of the accounting year
will remain same whether dividends are distributed or not distributed.

(RTP May – 2023)

Solution:

CASE 1: Value of the firm when dividends are not paid.

Step 1: Calculate price at the end of the period

Ke = 15%, P0 = ₹ 100, D1 = 0

P1 + D1
P0 =
1 + Ke

P1 + 0
₹ 100 =
1 + 0.15

P1 = ₹115

Step 2: Calculation of funds required for investment

Earning ₹ 40,00,000
Dividend distributed Nil

593
 [DIVIDEND DECISIONS]

Fund available for investment ₹ 40,00,000

Total Investment ₹ 50,00,000
Balance Funds required ₹ 50,00,000 - ₹ 40,00,000 = ₹ 10,00,000

Step 3: Calculation of No. of shares required to be issued for balance funds

No. of shares = Funds required/P1

∆n = ₹ 10,00,000/₹ 115

Step 4: Calculation of value of firm

nP0 = [(n + ∆n) P1 – I + E]/(1 + Ke )

nP0 = [(1,00,000 + 10,00,000/₹ 115) ₹ 115 - ₹5000000 + ₹ 40,00,000]/(1.15)

= ₹1,00,00,000

CASE 2: Value of the firm when dividends are paid.

Step 1: Calculate price at the end of the period

Ke = 15%, P₀ = ₹100, D₁ = ₹ 10

P1 + D1
P0 =
1 + Ke

P1 + 10
₹ 100 =
1 + 0.15

P1 = ₹ 105

Step 2: Calculation of funds required for investment

Earning ₹ 40,00,000
Dividend distributed ₹ 10,00,000
Fund available for investment ₹ 30,00,000
Total Investment ₹ 50,00,000
Balance Funds required ₹ 50,00,000 - ₹ 30,00,000 = ₹ 20,00,000

Step 3: Calculation of No. of shares required to be issued for balance fund

No. of shares = Funds Required/P1

∆n = ₹ 20,00,000/₹ 105

594
 [DIVIDEND DECISIONS]

Step 4: Calculation of value of firm

nP0 = [(n + ∆n) P1 – I + E]/(1 + Ke )

nP0 = [(1,00,000+20,00,000/₹ 105)₹ 105 – ₹ 50,00,000 + ₹ 40,00,000]/(1.15)

= ₹ 1,00,00,000

Thus, it can be seen from the above calculations that the value of the firm
remains the same in either case.

Question – 40
MCO Ltd. has a paid-up share capital of ₹ 10,00,000, face value of ₹ 10 each.
The current market price of the shares is ₹ 20 each. The Board of Directors of
the company has an agenda of meeting to pay a dividend of 25% to its
shareholders. The company expects a net income of ₹ 5,20,000 at the end of
the current financial year. Company also plans for a capital expenditure for the
next financial year for a cost of ₹ 7,50,000, which can be financed through
retained earnings and issue of new equity shares.

Company’s desired rate of investment is 15%.

Required:

Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the

company when:

(i) It does not pay dividend and

(ii) It does pay dividend

(RTP May – 2024)

Solution:

As per MM Hypothesis, value of firm/ company is calculated as below:

n + ∆n P1 −l+E
Vf or nP0 =
(1+Ke)

Where,

Vf = Value of firm in the beginning of the period

n = number of shares in the beginning of the period

∆n = number of shares issued to raise the funds required

595
 [DIVIDEND DECISIONS]

I = Amount required for investment

E = total earnings during the period

(i) Value of the ZX Ltd. when dividends are not paid.

n + ∆n P1−l+E
nP0 =
(1+Ke )

2,30,000
1,00,000 + 23
× ₹ 23 − ₹ 7,50,000 + ₹ 5,20,000
nP0 =
(1 + 0.15)

₹ 25,30,000 − ₹ 7,50,000 + ₹5,20,000

= = ₹ 20,00,000
(1 + 0.15)

Working notes:

1. Price of share at the end of the period (P1 )

P1 + D1
P1 =
1 + Ke

P1 + 0
20 =
1+ 0.15
Or, P1 = ₹ 23

2. Calculation of funds required for investment

Earnings ₹ 5,20,000
Dividend distributed Nil
Fund available for investment ₹ 5,20,000
Total Investment ₹ 7,50,000
Balance Funds required ₹ 2,30,000

3. Calculation of no. of shares required to be issued for balance fund

Funds required 2,30,000

No. of shares (∆n) = = shares
Price at end P1 23

= 10,000 shares

(ii) Value of the ZX Ltd. when dividends are paid.

n + ∆n P1−l+E
nP0 =
(1+Ke )

596
 [DIVIDEND DECISIONS]

4,80,000
1,00,000 + 20.5
× ₹ 20.5 − ₹ 7,50,000 + ₹ 5,20,000
nP0 =
(1 + 0.15)

₹ 25,30,000 − ₹ 7,50,000 + ₹ 5,20,000

= = ₹ 20,00,000
(1 + 0.15)

Working notes:

4. Price of share at the end of the period (P1 )

P1 +D1
P1 =
1+Ke

P1 +2.5
20 =
1+0.15
Or, P1 = ₹ 20.5

5. Calculation of funds required for investment

Earnings ₹ 5,20,000
Dividend distributed ₹ 2,50,000
Fund available for investment ₹ 2,70,000
Total Investment ₹ 7,50,000
Balance Funds required ₹ 4,80,000

6. Calculation of no. of shares required to be issued for balance fund

Funds required 4,80,000

No. of shares (∆n) = = shares
Price at end P1 20.5

= ₹ 23,415 shares (approx.)

Question – 41
Aakash Ltd. has 10 lakh equity shares outstanding at the start of the
accounting year 2021. The existing market price per share is ₹ 150. Expected
dividend is ₹ 8 per share. The rate of capitalization appropriate to the risk class
to which the company belongs is 10%.

(i) CALCULATE the market price per share when expected dividends are: (a)
declared, and (b) not declared, based on the Miller – Modigliani approach.

(ii) CALCULATE number of shares to be issued by the company at the end of

the accounting year on the assumption that the net income for the year
is ₹ 3 crore, investment budget is ₹ 6 crores, when (a) Dividends are
declared, and (b) Dividends are not declared.

597
 [DIVIDEND DECISIONS]

(iii) PROOF that the market value of the shares at the end of the accounting
year will remain unchanged irrespective of whether (a) Dividends are
declared, or (ii) Dividends are not declared.

(RTP Nov – 2021)

Solution:

(i) Calculation of market price per share

According to Miller – Modigliani (MM) Approach:

P1 + D1
P0 =
1+Ke

Where,

Existing market price (P0 ) = 150

Expected dividend per share (D1 ) =8

Capitalization rate (Ke ) = 0.10

Market price at year end (p1 ) = to be determined

(a) If expected dividends are declared, then

P1 + ₹ 8
₹ 150 =
1 + 0.10

∴ P1 = ₹157

(b) If expected dividends are not declared, then

P1 + 0
₹ 150 =
1 + 0.10

∴ P1 = ₹ 165

(ii) Calculation of number of shares to be issued

(a) (b)
Dividends Dividends are
are declared not Declared

598
 [DIVIDEND DECISIONS]

(₹lakh) (₹lakh)
Net income 300 300
Total dividends (80) -
Retained earnings 220 300
Investment budget 600 600
Amount to be raised by new issues 380 300
Relevant market price (per share) 157 165
No. of new shares to be issued (in 2.42 1.82
lakh) (₹ 380 ÷ 157; ₹ 300 ÷ 165)

(iii) Calculation of market value of the shares

(a) (b)
Dividends are Dividends are
declared not Declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 2.42 1.82
Total shares (in lakhs) 12.42 11.82
Market price per share (₹) 157 165
Total market value of shares 12.42 × 157 11.82 × 165
at the end of the year (in lakh) = 1,950 (approx.) = 1,950 (approx.)

Hence, it is proved that the total market value of shares remains unchanged
irrespective of whether dividends are declared, or not declared.

Question – 42
Ordinary shares of a listed company are currently trading at ₹ 10 per share
with two lakh shares outstanding. The company anticipates that its earnings
for next year will be ₹ 5,00,000. Existing cost of capital for equity shares is
15%. The company has certain investment proposals under discussion which
will cause an additional 26,089 ordinary shares to be issued if no dividend is
paid or an additional 47,619 ordinary shares to be issued if dividend is paid.

Applying the MM hypothesis on dividend decisions, CALCULATE the amount of

investment and dividend that is under consideration by the company.

(RTP Nov – 2022)

Solution:

599
 [DIVIDEND DECISIONS]

P0 = ₹ 10 n = 2,00,000, E = ₹ 5,00,000

Ke = 15%, ∆n = 26,089, I = ?

P1
P0 =
1 + Ke

P1
10 =
1.15

∴ P1 = 11.5
I−E + nD1
∆n =
P1

I − 5,00,000
26,089 =
11.5

I = 8,00,024

Now,

P0 = ₹ 10, n = ₹ 2,00,000,

E = ₹ 5,00,000, I = 8,00,024,

Ke = 15%, ∆n 47,619, D1 = ?

P1 + D1
P0 =
1 + Ke

P1 + D1
10 =
1.15

P1 + D1 = 11.5

∴ P1 = 11.5 − D1 ………………………… 1

I-E + nD1
∵ ∆n =
P1

8,00,024 − 5,00,000 + 2,00,000D1

47,619 =
P1

600
 [DIVIDEND DECISIONS]

47,619 P1 = 2,00,000 D1 + 3,00,024

From 1,

47619 (11.5 – D1 ) = 2,00,000 D1 + 3,00,024

5,47,618.5 – 47,619D1 = 2,00,000D1 + 3,00,024

∴ 2,47,594.5 = 2,00,000D1 + 47,619 D1

∴ 2,47,594.5 = 2,47,619 D1

2,47,594.5
∴ D1 = = 0.99 ≈ ₹ 1
2,47,619

∴ P1 = 11.5 – D1

P1 = 11.5 – 1

P1 = 10.5

(n−∆n) P1− I+E

∵ n. P0 =
1 + Ke

(2,00,000 + 47,619)(10.5) − 8,00,024 + 5,00,000

=
1.15

n. P0 = ₹ 19,99,979 ≈ ₹ 20,00,000

Using direct calculation,

n. P0 = 2,00,000 × 10 = ₹ 20,00,000

(4) RESIDUAL

Question – 43
Mr H is currently holding 1,00,000 shares of HM ltd, and currently the share of
HM ltd is trading on Bombay Stock Exchange at ₹ 50 per share. Mr A have a
policy to re-invest the amount of any dividend received into the shared back
again of HM ltd. If HM ltd has declared a dividend of ₹ 10 per share, please
determine the no of shares that Mr A would hold after he re-invests dividend in
shares of HM ltd.

601
 [DIVIDEND DECISIONS]

(Study Material ICAI TYK – 08)

Solution:

Ex-dividend price is ₹ 40 (50-10).

The total amount of dividend received is ₹ 10,00,000 which is re-invested at the

rate of ₹ 40 per share.

Hence additional shares purchased would be 25,000.

Total holding would be 1,25,000 shares (1,00,000 + 25,000)

Question – 44
Following information is given pertaining to DG ltd,

No of shares outstanding 1 lakh shares

Earnings Per share 25 per share

P/E Ratio 20

Book Value per share 400 per share

If company decides to repurchase 25,000 shares, at the prevailing market

price, what is the resulting book value per share after repurchasing.

(Study Material ICAI TYK – 09)

Solution:

Current Market price = 20 × 25 = 500 per share

Book value of the company before repurchase = ₹ 4 cr (400 × 1 lakh shares)

Amount paid for repurchase = 1.25 cr (25,000 shares × 500 per share)

Book Value of company after repurchase = ₹ 2.75 cr (4cr –1.25cr)

No of shares after repurchase = 75,000 shares

Book value per share = 367 per share.

Question – 45
HM Ltd. is listed on Bombay Stock Exchange which is currently been evaluated
by Mr. A on certain parameters.

602
 [DIVIDEND DECISIONS]

Mr. A collated following information:

(a) The company generally gives a quarterly interim dividend. ₹ 2.5 per share
is the last dividend declared.

(b) The company’s sales are growing by 20% on a 5-year Compounded

Annual Growth Rate (CAGR) basis, however the company expects
following retention amounts against probabilities mentioned as
contention is dependent upon cash requirements for the company. Rate
of return is 10% generated by the company.

Situation Prob. Retention Ratio

A 30 % 50 %
B 40 % 60 %
C 30 % 50 %

(c) The current risk-free rate is 3.75% and with a beta of 1.2 company is
having a risk premium of 4.25%.

You are required to help Mr. A in calculating the current market price
using Gordon’s formula.

(RTP Nov – 2023)

Solution:

Market price using Gordon’s formula

D0 (1 + g)
P0 =
Ke −g

D0 = 2.5 × 4 = 10 per share (annual)

g = br or retention ratio x rate of return

Calculation of expected retention ratio

Situation Prob. Retention Ratio Expected Retention Ratio

A 30% 50% 0.15
B 40% 60% 0.24
C 30% 50% 0.15
Total 0.54

g = 0.54 × 0.10= 0.054 or 5.4%

603
 [DIVIDEND DECISIONS]

D0 (1 + g)
P0 =
Ke −g

10 (1 + 0.054) 10.54
P0 = = = 305.51
0.0885-0.054 0.0345

Ke = Risk free rate + (Beta × Risk Premium)

= 3.75% + (1.2 × 4.25%) = 8.85%

Question – 46
Following information are given for a company:

Earnings per share ₹ 10

P/E Ratio 12.5
Rate of return on investment 12%
Market price per shares as per Walter’s Model ₹ 130

You are required to calculate:

(i) Dividend payout ratio.

(ii) Market price of share at optimum dividend payout ratio.

(iii) P/E ratio, at which the dividend policy will have no effect on the price of
share.

(iv) Market price of share at this P/E ratio.

(v) Market price of share using Dividend growth model.

(Exam, May – 2023)

Solution:

(i) The EPS of the firm is ₹ 10, r =12%. The P/E Ratio is given at 12.5 and
the cost of capital (Ke ) may be taken as the inverse of P/E ratio.
Therefore, Ke is 8% (i.e., 1/12.5). The value of the share is ₹ 130 which
may be equated with Walter Model as follows:
r 12%
D + K E−D D + 8% 10−D
e
P= or P =
Ke 8%

or [D+1.5(10−D)]/0.08 = 130

604
 [DIVIDEND DECISIONS]

or D+15−1.5D = 10.4

or -0.5D = -4.6

So, D = ₹ 9.2

The firm has a dividend pay-out of 92% (i.e., 9.2/10).

(ii) Since the rate of return of the firm (r) is 12% and it is more than the Ke
of 8%, therefore, by distributing 92% of earnings, the firm is not following
an optimal dividend policy. The optimal dividend policy for the firm
would be to pay zero dividend and in such a situation, the market price
would be:

12%
0+ 10−0
8%
P=
8%

P = ₹ 187.5

So, theoretically the market price of the share can be increased by

adopting a zero pay-out.

(iii) The P/E ratio at which the dividend policy will have no effect on the
value of the share is such at which the Ke would be equal to the rate of
return (r) of the firm. The Ke would be 12% (= r) at the P/E ratio of
1/12%=8.33. Therefore, at the P/E ratio of 8.33, the dividend policy
would have no effect on the value of the share.

(iv) If the P/E is 8.33 instead of 12.5, then the Ke which is the inverse of P/E
ratio, would be 12% and in such a situation Ke = r and the market price,
as per Walter’s model would be:
r 0.12
D + K E−D 9.2 + 10−9.2
e 0.12
P= = = ₹ 83.33
Ke 0.12

(v) Dividend Growth Model applying growth on dividend

Ke = 8%, r = 12%, D0 = 9.2, b = 0.08

g = b.r

g = 0.08 × 0.12 = 0.96%

D1 = D0 (1+g) = 9.2 (1+0.0096) = ₹ 9.2883

605
 [DIVIDEND DECISIONS]

D1
P= = 9.2883/(0.08 – 0.0096) = 9.2883/0.0704 = ₹ 131.936
Ke - g

Alternative

Alternatively, without applying growth on dividend

E(1−b) 10(1−0.08)
P= = = ₹ 130.68
Ke −br 0.08−(0.08 × 0.12)

Question – 47
(i) EPS of a company is ₹ 60 and Dividend payout ratio is 60%. Multiplier is
5. Determine price per share as per Graham & Dodd model.

(ii) Last year's dividend is ₹ 6.34, adjustment factor is 45%, target payout
ratio is 60% and current year's EPS is ₹ 12. Compute current year's
dividend using Linter's model.

(Exam, Nov – 2023)

Solution:

E
(i) Price per share (P) = m D +
3

Where,

m = Multiplier

D = Dividend

E = EPS

60
P = 5 60 × 0.6 +
3

P = 5(36 + 20) = ₹ 280

(ii) D1 = D0 + [(EPS × Target payout) - D0 ] × Adjustment factor

D1 = 6.34 + [(12 × 60%) – 6.34] × 0.45

D1 = 6.34 + 0.387 = ₹ 6.727

606
 [DIVIDEND DECISIONS]

Question – 48
INFO Ltd is a listed company having share capital of ₹ 2,400 Crores of ₹ 5 each.

During the year 2022-23

Dividend distributed 1000%

Expected Annual growth rate in dividend 14%

Expected rate of return on its equity capital 18%

Required:

(a) Calculate price of share applying Gordon's growth Model.

(b) What will be the price of share if the Annual growth rate in dividend is
only 10%?

(c) According to Gordon's growth Model, if Internal Rate of Return is 25%,

then what should be the optimum dividend payout ratio in case of
growing stage of company? Comment.

(Exam, Nov – 2023)

Solution:

(a) In the present situation, the current MPS is as follows:

D0 (1+ g)
P =
Ke − g

Where

P = Market price per share

D0 = Current year dividend

g = Growth rate of dividends

Ke = Cost of equity capital/ expected rate of return

50 (1 + 0.14)
P = = ₹ 1425
0.18 − 0.14

(b) The impact of changes in growth rate to 10% on MPS will be as follows:

607
 [DIVIDEND DECISIONS]

50 (1 + 0.10)
P = = ₹ 687.5
0.18 − 0.10

(c) If Internal rate of return, r = 25% and Ke = 18%

As per Gordon’s model, when r > Ke , optimum dividend payout ratio is

‘Zero’. When IRR is greater than cost of capital, the price per share
increases and dividend payout decreases.

Question – 49
Vista Limited’s retained earnings per share for the year ending 31.03.2023
being 40% is ₹ 3.60 per share. Company is foreseeing a growth rate of 10% per
annum in the next two years. After that the growth rate is expected to stabilize
at 8% per annum. Company will maintain its existing pay-out ratio. If the
investor’s required rate of return is 15%, Calculate the intrinsic value per share
as of date using dividend discount model.

(Exam, May – 2024)

Multiple Choice Questions (MCQs)

1. Which one of the following is the assumption of Gordon’s Model:

(a) Ke > g

(b) Retention ratio, (b), once decide upon, is constant

(c) Firm is an all equity firm

(d) All of the above

2. What should be the optimum Dividend pay-out ratio, when r = 15% & Ke
= 12%:

(a) 100%

(b) 50%

(c) Zero

(d) None of the above.

3. Which of the following is the irrelevance theory?

(a) Walter model

608
 [DIVIDEND DECISIONS]

(b) Gordon model

(c) M.M. hypothesis

(d) Linter’s model

4. If the company’s D/P ratio is 60% & ROI is 16%, what should be the
growth rate?

(a) 5%

(b) 7%

(c) 6.4%

(d) 9.6%

5. If the shareholders prefer regular income, how does this affect the
dividend decision:

(a) It will lead to payment of dividend

(b) It is the indicator to retain more earnings

(c) It has no impact on dividend decision

(d) Can’t say

6. Mature companies having few investment opportunities will show high

payout ratios, this statement is:

(a) False

(b) True

(c) Partial true

(d) None of these

7. Which of the following is the limitation of Linter’s model?

(a) This model does not offer a market price for the shares.

(b) The adjustment factor is an arbitrary number and not based on

any scientific criterion or methods.

(c) Both (a) & (b)

609
 [DIVIDEND DECISIONS]

(d) None of the above.

8. What are the different options other than cash used for distributing
profits to shareholders?

(a) Bonus shares

(b) Stock split

(c) Both (a) and (b)

(d) None of the above

9. Which of the following statement is correct with respect to Gordon’s

model?

(a) When IRR is greater than cost of capital, the price per share
increases and dividend pay-out decreases.

(b) When IRR is greater than cost of capital, the price per share
decreases and dividend pay-out increases.

(c) When IRR is equal to cost of capital, the price per share increases
and dividend pay-out decreases.

(d) When IRR is lower than cost of capital, the price per share
increases and dividend pay-out decreases.

10. Compute EPS according to Graham & Dodd approach from the given
information:

Market Price ₹ 56

Dividend Pay-out Ratio 60%

Multiplier 2

(a) ₹ 30

(b) ₹ 56

(c) ₹ 28

(d) ₹ 84

11. Which among the following is not an assumption of Walter’s Model?

610
 [DIVIDEND DECISIONS]

(a) Rate of return and cost of capital are constant

(b) Information is freely available to all

(c) There is discrimination in taxes

(d) The firm has perpetual life

611
 [MANAGEMENT OF WORKING CAPITAL]

CHAPTER – 07

MANAGEMENT OF WORKING
CAPITAL

(1) WORKING CAPITAL

Question – 01
From the following information of XYZ Ltd., you are required to calculate:

(a) Net operating cycle period.

(b) Number of operating cycles in a year.

(₹)
i Raw material inventory consumed during the year 6,00,000
ii Average stock of raw material 50,000
iii Work-in-progress inventory 5,00,000
iv Average work-in-progress inventory 30,000
v Finished goods inventory 8,00,000
vi Average finished goods stock held 40,000
vii Average collection period from debtors 45 days
viii Average credit period availed 30 days
ix No. of days in a year 360 days

(Study Material ICAI Illus – 02)

Solution:

(a) Calculation of Net Operating Cycle period of XYZ Ltd.

Raw Material storage period (R) =

Average Stock of Raw Material

Average Cost of Raw Material Consumption Per day

₹ 50,000 ₹ 50,000
= = = 30 days
₹ 6,00,000 ÷ 360 days 1,667

612
 [MANAGEMENT OF WORKING CAPITAL]

Work-in-progress inventory holding period (W)

Average Work-in-progress inventory

=
Average Cost of Production per day

₹ 30,000 ₹ 30,000
= = = 22 days
₹ 5,00,000 ÷ 360 days 1,389

Finished Goods storage period (F)

Average Stock of Finished Goods

=
Average Cost of Goods Sold per day

₹ 40,000 ₹ 40,000
= = = 18 days
₹ 8,00,000 ÷ 360 days 2,222

Receivables (Debtors) collection period (D) = 45 days

Credit Period allowed by creditors © = 30 days

Net Operating Cycle = R + W + F+ D – C = 30 + 22 + 18 + 45 – 30

= 85 day

No. of days in a year

(b) Number of Operating Cycle s in a year =
Operating Cycle Period

360 days
= = 4.23 times
85 days

Question – 02
On 1st January, the Managing Director of Naureen Ltd. wishes to know the
amount of working capital that will be required during the year. From the
following information prepare the working capital requirements forecast.

Production during the previous year was 60,000 units. It is planned that this
level of activity would be maintained during the present year. The expected
ratios of the cost to selling prices are Raw materials 60%, Direct wages 10%
and Overheads 20%.

Raw materials are expected to remain in store for an average of 2 months

before issue to production.

613
 [MANAGEMENT OF WORKING CAPITAL]

Each unit is expected to be in process for one month, the raw materials being
fed into the pipeline immediately and the labour and overhead costs accruing
evenly during the month.

Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately 3 months.

Credit allowed by creditors is 2 months from the date of delivery of raw

material.

Credit allowed to debtors is 3 months from the date of dispatch.

Selling price is ₹ 5per unit.

There is a regular production and sales cycle.

Wages and overheads are paid on the 1st of each month for the previous
month.

The company normally keeps cash in hand to the extent of ₹ 20,000.

(Study Material ICAI Illus – 03)

Solution:

Working Notes:

1. Raw material inventory: The cost of materials for the whole year is 60%
of the Sales value.

360 days
Hence it is 60,000 units × ₹ 5 × = 1,80,000.
85 days

The monthly consumption of raw material would be ₹ 15,000. Raw

material requirements would be for two months; hence raw materials in
stock would be ₹ 30,000.

2. Work-in-process: (Students may give special attention to this point). It is

stated that each unit of production is expected to be in process for one
month).

(₹)
(a) Raw materials in work-in-process (being one month‟s 15,000
raw material requirements)
(b) Labour costs in work-in-process (It is stated that it 1,250
accrues evenly during the month. Thus, on the first day

614
 [MANAGEMENT OF WORKING CAPITAL]

of each month it would be zero and on the last day of

month the work-in-process would include one month‟s
labour costs. On an average therefore, it would be
equivalent to ½ of the month‟s labour costs)
10% of (60,000 × ₹ 5)
× 0.5 Months
12 Months
(c) Overheads 2,500
(For ½ month as explained above)
20% of (60,000 × ₹ 5)
× 0.5 Months
12 Months
Total work-in-process 18,750

3. Finished goods inventory: (3 month‟s cost of production)

60% of (60,000 × ₹ 5) 45,000

Raw Materials × 3 Months
12 Months
10% of (60,000 × ₹ 5) 7,500
Labour × 3 Months
12 Months
20% of (60,000 × ₹ 5) 15,000
Overheads × 3 Months
12 Months
Total finished goods inventory 67,500
Alternatively, (60,000 units × ₹ 5 × 90%) × 3/12 67,500

4. Debtors: The total cost of sales = 2,70,000.

3
Therefore, debtors = ₹ 2,70,000 × = ₹ 67,500
12

Where, Total Cost of Sales = RM + Wages + Overheads + Opening

Finished goods inventory – Closing finished goods inventory.

= ₹ 1,80,000 + ₹ 30,000 + ₹ 60,000 + ₹ 67,500 – ₹ 67,500 = ₹ 2,70,000.

5. Creditors: Suppliers allow a two months‟ credit period. Hence, the

average amount of creditors would be two months consumption of raw
materials i.e.

60% of (60,000 × ₹ 5)
× 2 Months = ₹ 30,000.
12 Months

10% of (60,000 × ₹ 5)
6. Direct Wages payable: × 1 Months = ₹ 2,500.
12 Months

615
 [MANAGEMENT OF WORKING CAPITAL]

20% of (60,000 × ₹ 5)
7. Overheads Payable: × 1 Months = ₹ 5,000
12 Months

Here it has been assumed that inventory level is uniform throughout the year,
therefore opening inventory equals closing inventory.

Statement of Working Capital Required

(₹) (₹)
Current Assets or Gross Working Capital:
Raw materials inventory (Refer to working note 1) 30,000
Working–in-process (Refer to working note 2) 18,750
Finished goods inventory (Refer to working note 3) 67,500
Debtors (Refer to working note 4) 67,500
Cash 20,000 2,03,750
Current Liabilities:
Creditors (Refer to working note 5) 30,000
Direct wages payable (Refer to working note 6) 2,500
Overheads payable (Refer to working note 7) 5,000 (37,500)
Estimated working capital requirements 1,66,250

Question – 03
The following annual figures relate to XYZ Co.,

(₹)
Sales (at two months‟ credit) 36,00,000
Materials consumed (suppliers extend two months‟ credit) 9,00,000
Wages paid (1 month lag in payment) 7,20,000
Cash manufacturing expenses (expenses are paid one month in 9,60,000
arrear)
Administrative expenses (1 month lag in payment) 2,40,000
Sales promotion expenses (paid quarterly in advance) 1,20,000

The company sells its products on gross profit of 25%. Depreciation is

considered as a part of the cost of production. It keeps one month‟s stock each
of raw materials and finished goods, and a cash balance of ₹ 1,00,000.

Assuming a 20% safety margin, work out the working capital requirements of
the company on cash cost basis. Ignore work-in-process.

(Study Material ICAI Illus – 04)

Solution:

616
 [MANAGEMENT OF WORKING CAPITAL]

Statement of Working Capital requirements (cash cost basis)

(₹) (₹)
A. Current Assets
Inventory:
₹ 9,00,000 75,000
- Raw materials × 1 month
12 Months
₹ 25,80,000 2,15,000
- Finished Goods × 1 month
12 Months
₹ 29,40,000 4,90,000
- Receivables (Debtors) × 2 months
12 Months
- Sales Promotion expenses paid in advance 30,000
₹ 1,20,000
× 3 months
12 Months
Cash Balance 1,00,000 9,10,000
Gross Working Capital 9,10,000
B. Current Liabilities:
Payables:
₹ 9,00,000 1,50,000
- Creditors for materials × 2 months
12 Months
₹ 7,20,000 60,000
- Wages outstanding × 1month
12 Months
- Manufacturing expenses outstanding 80,000
₹ 9,60,000
× 1month
12 Months
- Administrative expenses outstanding 20,000 3,10,000
₹ 2,40,000
× 1month
12 Months
Net working capital (A - B) 6,00,000
Add: Safety margin @ 20% 1,20,000
Total Working Capital requirements 7,20,000

Working Notes:

(i) Computation of Annual Cash Cost of Production (₹)

Material consumed 9,00,000
Wages 7,20,000
Manufacturing expenses 9,60,000
Total cash cost of production 25,80,000
(ii) Computation of Annual Cash Cost of Sales: (₹)

617
 [MANAGEMENT OF WORKING CAPITAL]

Total Cash cost of production as in (i) above 25,80,000

Administrative Expenses 2,40,000
Sales promotion expenses 1,20,000
Total cash cost of sales 29,40,000

Question – 04
Samreen Enterprises has been operating its manufacturing facilities till
31.3.2017 on a single shift working with the following cost structure:

Per unit (₹)

Cost of Materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling Price 18.00
Sales during 2016-17– ₹ 4,32,000

As at 31.3.2017 the company held:

(₹)
Stock of raw materials (at cost) 36,000
Work-in-progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000

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

working an extra shift. It is expected that a 10% discount will be available
from suppliers of raw materials in view of increased volume of business.
Selling price will remain the same. The credit period allowed to customers will
remain unaltered. Credit availed of from suppliers will continue to remain at
the present level i.e., 2 months. Lag in payment of wages and expenses will
continue to remain half a month.

You are required to assess the additional working capital requirements, if the
policy to increase output is implemented.

(Study Material ICAI Illus – 05)

Solution:

This question can be solved using two approaches:

(i) To assess the impact of double shift for long term as a matter of
production policy.

618
 [MANAGEMENT OF WORKING CAPITAL]

(ii) To assess the impact of double shift to mitigate the immediate demand
for next year only.

The first approach is more appropriate and fulfilling the requirement of the
question.

(i) Assessment of impact of double shift for long term as a matter of

production policy:

Comparative Statement of Working Capital Requirement

Single Shift (24,000) Double Shift (48,000)

Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: 2,26,000 3,44,000
(A)
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 8,000 5.40 43,200
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current 34,000 57,200
Liabilities: (B)
Working Capital: 1,92,000 2,86,800
(A) – (B)

Additional Working Capital requirement = ₹ 2,86,800 – ₹ 1,92,000 = ₹ 94,800

Workings:

(1) Statement of cost at single shift and double shift working

24,000 units 48,000 Units

Per unit Total Per unit Total
(₹) (₹) (₹) (₹)
Raw materials 6.00 1,44,000 5.40 2,59,200
1. Wages – Variable 3.00 72,000 3.00 1,44,000
Fixed 2.00 48,000 1.00 48,000

619
 [MANAGEMENT OF WORKING CAPITAL]

Overheads – Variable 1.00 24,000 1.00 48,000

Fixed 4.00 96,000 2.00 96,000
Total cost 16.00 3,84,000 12.40 5,95,200
Profit 2.00 48,000 5.60 2,68,800
18.00 4,32,000 18.00 8,64,000

Sales ₹ 4,32,000
(2) Sales in units 2020-21 = = = 24,000 units
Unit Selling Price ₹ 18

(3) Stock of Raw Materials in units on 31.03.2021

Value of Stock ₹ 36,000

= = = 6,000 units
Cost per unit 6

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

Value of work-in-progress ₹ 22,000

= = = 2,000 units
Prime Cost per unit (₹ 6 + ₹ 5)

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

Value of Stock ₹ 72,000

= = = 4,500 units
Total Cost per unit ₹ 16

(ii) Assessment of the impact of double shift to mitigate the immediate

demand for next year only & not as part of policy implementation.

In this approach, working capital shall be computed as if we are

calculating the same for the next / second year with double production.
Whereas, in the first approach to implement double-shift as part of policy
implementation, we calculated comparative analysis of working capital
requirement for single & double shift within the same year.

Workings:

(6) Calculation of no. of units to be sold:

No. of units to be Produced 48,000

Add: Opening stock of finished goods 4,500
Less: Closing stock of finished goods (9,000)
No. of units to be Sold 43,500

620
 [MANAGEMENT OF WORKING CAPITAL]

(7) Calculation of Material to be consumed and materials to be purchased in

units:

No. of units Produced 48,000

Add: Closing stock of WIP 2,000
Less: Opening stock of WIP (2,000)
Raw Materials to be consumed in units 48,000
Add: Closing stock of Raw material 12,000
Less: Opening stock of Raw material (6,000)
Raw Materials to be purchased (in units) 54,000

(8) Credit allowed by suppliers:

No. of units to purchased × Cost per unit

= × 2 months
12 Months

54,000 × ₹ 5.40
= × 2 months = ₹ 48,600
12 Months

Comparative Statement of Working Capital Requirement

Single Shift (Current Double Shift (Next Year

Year – 24,000 units) – 48,000 units)
Unit Rate Amount Unit Rate Amount
(₹) (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 6.00 36,000 12,000 5.40 64,800
Work-in-Progress 2,000 11.00 22,000 2,000 9.40 18,800
Finished Goods 4,500 16.00 72,000 9,000 12.40 1,11,600
Sundry Debtors 6,000 16.00 96,000 12,000 12.40 1,48,800
Total Current Assets: 2,26,000 3,44,000
(A)
Current Liabilities
Creditors for Materials 4,000 6.00 24,000 9,000 5.40 48,600
Creditors for Wages 1,000 5.00 5,000 2,000 4.00 8,000
Creditors for Expenses 1,000 5.00 5,000 2,000 3.00 6,000
Total Current 34,000 62,600
Liabilities: (B)
Working Capital: 1,92,000 2,81,400
(A) – (B)

Additional Working Capital requirement = ₹ 2,81,400 – ₹ 1,92,000 = ₹ 89,400

621
 [MANAGEMENT OF WORKING CAPITAL]

Notes:

(i) The quantity of material in process will not change due to double shift
working since work started in the first shift will be completed in the
second shift.

(ii) It is given in the question that the WIP is valued at prime cost hence, it is
assumed that the WIP is 100% complete in respect of material and
labour.

(iii) In absence of any information on proportion of credit sales to total sales,

debtors quantity has been doubled for double shift. Hence, the units
have been taken as 12,000 only.

(iv) It is assumed that all purchases are on credit.

(v) The valuation of work-in-progress based on prime cost (i.e. material &
labor) as per the policy of the company is as under.

Single Shift (₹) Double Shift (₹)

Materials 6.00 5.40
Wages – Variable 3.00 3.00
Fixed 2.00 1.00
11.00 9.40

Question – 05
Following information is forecasted by R Limited for the year ending 31 st
March, 2021:

Balance as at Balance as at
31st March, 31st March,
2021 2020
(₹ in lakh) (₹ in lakh)
Raw Material 65 45
Work-in-progress 51 35
Finished goods 70 60
Receivables 135 112
Payables 71 68
Annual purchases of raw material (all credit) 400
Annual cost of production 450
Annual cost of goods sold 525
Annual operating cost 325

622
 [MANAGEMENT OF WORKING CAPITAL]

Annual sales (all credit) 585

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.

(Study Material ICAI TYK – 01)

Solution:

Working Notes:

1. Raw Material Storage Period (R)

Average Stock of Raw Material

= × 365
Annual Consumption Raw Material

₹ 45 + ₹ 65
2
= × 365 = 52.38 or 53 days
₹ 380

Annual Consumption of Raw Material

= Opening Stock + Purchase – Closing Stock

= ₹ 45 + ₹ 400 − ₹ 65 = ₹ 380 lakh

2. Work in Progress (WIP) Conversion Period (W)

Average Stock of WIP

= × 365
Annual Cost of Production

₹ 35 + ₹ 51
2
= × 365 = 34.87 or 35 days
₹ 450

3. Finished Stock Storage Period (F)

Average Stock of Finished Goods

= × 365
Cost of Goods Sold

623
 [MANAGEMENT OF WORKING CAPITAL]

₹ 60 + ₹ 70
2
= × 365 = 45.19 or 45 days
₹ 525

4. Receivables (Debtors) Collection Period (D)

Average Receivables
= × 365
Annual Credit Sales

₹ 112 + ₹ 135
2
= × 365 = 77.05 or 77 days
₹ 585

5. Payables (Creditors) Payment Period (C)

Average Payables for Materials

= × 365
Annual Credit Purchases

₹ 68 + ₹ 71
2
= × 365 = 63.41 or 64 days
₹ 400

(i) Net Operating Cycle Period

=R+W+F+D–C

= 53 + 35 + 45 + 77 – 64 = 146 days

(ii) Number of Operating Cycle in the Year

365 365
= = = 2.5 times
Operating Cycle Period 146

(iii) Amount of Working Capital Required

Annual Operating Cost ₹ 325

= = = ₹ 130 lakh
Number of Operating Cycles 2.48

Question – 06
The following data relating to an auto component manufacturing company is
available for the year 2020-21:

Raw material held in storage 20 days

Receivables‟ collection period 30 days

624
 [MANAGEMENT OF WORKING CAPITAL]

Conversion process period 10 days

(raw material – 100%, other costs – 50% complete)

Finished goods storage period 45 days

Credit period from suppliers 60 days

Advance payment to suppliers 5

days

Total cash operating expenses per annum ₹ 800 lakhs

75% of the total cash operating expenses are for raw material. 360 days are
assumed in a year.

You are required to CALCULATE:

(i) Each item of current assets and current liabilities,

(ii) The working capital requirement, if the company wants to maintain a

cash balance of ₹ 10 lakhs at all times.

(Study Material ICAI TYK – 02)

Solution:

Since WIP is 100% complete in terms of material and 50% complete in terms of
other cost, the same has been considered for number of days for WIP inventory
i.e. 10 days for material and 5 days for other costs respectively.

Particulars For Raw Material For Other Costs Total

Cash Operating expenses 75 25 800.00
× 800 = 600 × 800 = 200
100 100
Raw Material Stock Holding 20 - 33.33
× 600 = 33.33
360
WIP Conversion 10 5 19.45
× 600 = 16.67 × 200 = 2.78
360 360
Finished Goods Stock 45 45 100.00
Holding × 600 = 75 × 200 = 25
360 360
Receivable Collection Period 30 30 66.67
× 600 = 50 × 200 = 16.67
360 360
Advance to suppliers 5 - 8.33
× 600 = 8.33
360

625
 [MANAGEMENT OF WORKING CAPITAL]

Credit Period from 60 - 100.00

suppliers × 600 = 100
360

Computation of Working Capital

₹ in lakhs
Raw Materials Stock 33.33
WIP 19.45
Finished Goods Stock 100.00
Receivables 66.67
Advance to Suppliers 8.33
Cash 10.00
237.78
Less: Payable (Creditors) 100.00
Working Capital 133.78

Question – 07
The following figures and ratios are related to a company:

(i) Sales for the year (all credit) ₹ 90,00,000

(ii) Gross Profit ratio 35 percent

(iii) Fixed assets turnover (based on cost of goods sold) 1.5

(iv) Stock turnover (based on cost of goods sold) 6

(v) Liquid ratio 1.5:1

(vi) Current ratio 2.5:1

(vii) Receivables (Debtors) collection period 1 month

(viii) Reserves and surplus to Share capital 1:1.5

(ix) Capital gearing ratio 0.7875

(x) Fixed assets to net worth 1.3 : 1

You are required to PREPARE:

(a) Balance Sheet of the company on the basis of above details.

626
 [MANAGEMENT OF WORKING CAPITAL]

(b) The statement showing working capital requirement, if the company

wants to make a provision for contingencies @15 percent of net working
capital.

(Study Material ICAI TYK – 03)

Solution:

Working Notes:

(i) Cost of Goods Sold = Sales – Gross Profit (35% of Sales)

= ₹ 90,00,000 – ₹ 31,50,000

= ₹ 58,50,000

(ii) Closing Stock = Cost of Goods Sold / Stock Turnover

= ₹ 58,50,000/6

= ₹ 9,75,000

(iii) Fixed Assets = Cost of Goods Sold / Fixed Assets Turnover

= ₹ 58,50,000/1.5

= ₹ 39,00,000

(iv) Current Assets and Current Liabilities

Current Ratio = 2.5 and Liquid Ratio = 1.5

CA / CL = 2.5 … (i)

(CA – Inventories) / CL = 1.5 …(ii)

By subtracting equation (ii) from (i), we get,

Inventories / CL =1

Current Liabilities = Inventories (stock) = ₹ 9,75,000

∴ Current Assets = ₹ 9,75,000 × 2.5 = ₹ 24,37,500

Or

627
 [MANAGEMENT OF WORKING CAPITAL]

Current Ratio / Quick Ratio = Current Assets / Quick Assets

2.5 / 1.5 = Current Assets / (Current Assets – Inventory)

2.5/1.5 Current Assets – 2.5/1.5 × ₹ 9,75,000 = Current Assets

Hence, Current Assets = ₹ 24,37,500

(v) Liquid Assets (Receivables and Cash)

= Current Assets – Inventories (Stock)

= ₹ 24,37,500 – ₹ 9,75,000

= ₹ 14,62,500

(vi) Receivables (Debtors) = Sales × Debtors Collection period /12

= ₹ 90,00,000 × 1/12 = ₹ 7,50,000

(vii) Cash = Liquid Assets – Receivables (Debtors)

= ₹14,62,500 – ₹ 7,50,000

= ₹ 7,12,500

(viii) Net worth = Fixed Assets /1.3

= ₹ 39,00,000/1.3 = ₹ 30,00,000

(ix) Reserves and Surplus

Reserves and Surplus / Share Capital = 1/1.5

Share Capital = 1.5 Reserves and Surplus … (i)

Now, Reserves and Surplus + Share Capital = Net worth … (ii)

From (i) and (ii), we get,

2.5 Reserves and Surplus = Net worth

Reserves and Surplus = ₹ 30,00,000 / 2.5 = ₹ 12,00,000

(x) Share Capital = Net worth – Reserves and Surplus

628
 [MANAGEMENT OF WORKING CAPITAL]

= ₹ 30,00,000 – ₹ 12,00,000

= ₹ 18,00,000

(xi) Long-term Debts

Capital Gearing Ratio = Long-term Debts / Equity Shareholders‟ Fund

Long-term Debts = ₹ 30,00,000 × 0.7875 = ₹ 23,62,500

(a) Balance Sheet of the Company

Particulars Figures as the Figures as the

end of end of
31-03-2021 (₹) 31-03-2020 (₹)
I. EQUITY AND LIABILITIES -
Shareholders’ funds -
(a) Share capital 18,00,000 -
(b) Reserves and surplus 12,00,000 -
Non-current liabilities -
(a) Long-term borrowings 23,62,500 -
Current liabilities 9,75,000 -
TOTAL 63,37,500 -
II. ASSETS -
Non-current assets -
Fixed assets 39,00,000 -
Current assets -
Inventories 9,75,000 -
Trade receivables 7,50,000 -
Cash and cash equivalents 7,12,500 -
TOTAL 63,37,500 -

(b) Statement Showing Working Capital Requirement

(₹) (₹)
A. Current Assets
(i) Inventories (Stocks) 9,75,000
(ii) Receivables (Debtors) 7,50,000
(iii) Cash in hand & at bank 7,12,500
Total Current Assets 24,37,500
B. Current Liabilities:
Total Current Liabilities 9,75,000

629
 [MANAGEMENT OF WORKING CAPITAL]

Net Working Capital (A – B) 14,62,500

Add: Provision for contingencies 2,19,375
(15% of Net Working Capital)
Working capital requirement 16,81,875

Question – 08
PQ Ltd., a company newly commencing business in 2020-21 has the following
projected Profit and Loss Account:

(₹) (₹)
Sales 2,10,000
Cost of goods sold 1,53,000
Gross Profit 57,000
Administrative Expenses 14,000
Selling Expenses 13,000 27,000
Profit before tax 30,000
Provision for taxation 10,000
Profit after tax 20,000
The cost of goods sold has been arrived at as under:
Materials used 84,000
Wages and manufacturing Expenses 62,500
Depreciation 23,500
1,70,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 17,000
1,53,000

The figure given above relate only to finished goods and not to work-inprogress.
Goods equal to 15% of the year‟s production (in terms of physical units) will be
in process on the average requiring full materials but only 40% of the other
expenses. The company believes in keeping materials equal to two months‟
consumption in stock.

All expenses will be paid one month in advance. Suppliers of materials will
extend 1-1/2 months credit. Sales will be 20% for cash and the rest at two
months‟ credit. 70% of the Income tax will be paid in advance in quarterly
installments. The company wishes to keep ₹ 8,000 in cash. 10% has to be
added to the estimated figure for unforeseen contingencies.

PREPARE an estimate of working capital.

Note: All workings should form part of the answer.

630
 [MANAGEMENT OF WORKING CAPITAL]

(Study Material ICAI TYK – 04)

Solution:

Statement showing the requirements of Working Capital

Particulars (₹) (₹)

A. Current Assets:
Inventory:
Stock of Raw material (₹ 96,600 × 2/12) 16,100
Stock of Work-in-progress (As per Working Note) 16,350
Stock of Finished goods (₹ 1,46,500 × 10/100) 14,650
Receivables (Debtors) (₹ 1,27,080 × 2/12) 21,180
Cash in Hand 8,000
Prepaid Expenses:
Wages & Mfg. Expenses (₹ 66,250 × 1/12) 5,521
Administrative expenses (₹ 14,000 × 1/12) 1,167
Selling & Distribution Expenses (₹ 13,000 × 1/12) 1,083
Advance taxes paid {(70% of ₹ 10,000) × 3/12} 1,750
Gross Working Capital 85,801 85,801
B. Current Liabilities:
Payables for Raw materials (₹ 1,12,700 × 1.5/12) 14,088
Provision for Taxation (Net of Advance Tax) 3,000
(₹ 10,000 × 30/100)
Total Current Liabilities 17,088 17,088
C. Excess of CA over CL 68,713
Add: 10% for unforeseen contingencies 6,871
Net Working Capital requirements 75,584

Working Notes:

(i) Calculation of Stock of Work-in-progress

Particulars (₹)
Raw Material (₹ 84,000 × 15%) 12,600
Wages & Mfg. Expenses (₹ 62,500 × 15% × 40%) 3,750
Total 16,350

(ii) Calculation of Stock of Finished Goods and Cost of Sales

Particulars (₹)
Direct material Cost [₹ 84,000 + ₹ 12,600] 96,600

631
 [MANAGEMENT OF WORKING CAPITAL]

Wages & Mfg. Expenses [₹ 62,500 + ₹ 3,750] 66,250

Depreciation 0
Gross Factory Cost 1,62,850
Less: Closing W.I.P (16,350)
Cost of goods produced 1,46,500
Add: Administrative Expenses 14,000
1,60,500
Less: Closing stock (14,650)
Cost of Goods Sold 1,45,850
Add: Selling and Distribution Expenses 13,000
Total Cash Cost of Sales
1,58,850
Debtors (80% of cash cost of sales)
1,27,080

(iii) Calculation of Credit Purchase

Particulars (₹)
Raw Materials Consumed 96,600
Add: Closing Stock 16,100
Less: Opening Stock -
Purchase 1,12,700

Question – 09
M.A. Limited is commencing a new project for manufacture of a plastic
component. The following cost information has been ascertained for annual
production of 12,000 units which is the full capacity:

Costs per unit (₹)

Materials 40.00
Direct labour and variable expenses 20.00
Fixed manufacturing expenses 6.00
Depreciation 10.00
Fixed administration expenses 4.00
80.00

The selling price per unit is expected to be ₹ 96 and the selling expenses ₹ 5 per
unit, 80% of which is variable.

In the first two years of operations, production and sales are expected to be as
follows:

Year Production (No. of units) Sales (No. of units)

1 6,000 5,000
2 9,000 8,500

632
 [MANAGEMENT OF WORKING CAPITAL]

To assess the working capital requirements, the following additional

information is available:

(a) Stock of materials 2.25 month‟s average consumption

(b) Work-in-process Nil

(c) Debtors 1 month‟s average sales.

(d) Cash balance ₹ 10,000

(e) Creditors for supply of 1 month‟s average purchase during the

materials year.

(f) Creditors for expenses 1 month‟s average of all expense during

the year.

PREPARE, for the two years:

(i) A projected statement of Profit/Loss (Ignoring taxation); and

(ii) A projected statement of working capital requirements.

(Study Material ICAI TYK – 05)

Solution:

(i) M.A. Limited Projected Statement of Profit / Loss (Ignoring Taxation)

Year 1 Year 2
Production (Units) 6,000 9,000
Sales (Units) 5,000 8,500
(₹) (₹)
Sales revenue (A) (Sales unit × ₹ 96) 4,80,000 8,16,000
Cost of production:
Materials cost (Units produced × ₹ 40) 2,40,000 3,60,000
Direct labour and variable expenses 1,20,000 1,80,000
(Units produced × ₹ 20)
Fixed manufacturing expenses 72,000 72,000
(Production Capacity: 12,000 units × ₹ 6)
Depreciation 1,20,000 1,20,000
(Production Capacity : 12,000 units × ₹ 10)
Fixed administration expenses 48,000 48,000
(Production Capacity : 12,000 units × ₹ 4)

633
 [MANAGEMENT OF WORKING CAPITAL]

Total Costs of Production 6,00,000 7,80,000

Add: Opening stock of finished goods --- 1,00,000
(Year 1 : Nil; Year 2 : 1,000 units)
Cost of Goods available for sale 6,00,000 8,80,000
(Year 1: 6,000 units; Year 2: 10,000 units)
Less: Closing stock of finished goods at average cost (1,00,000) (1,32,000)
(year 1: 1000 units, year 2 : 1500 units)
(Cost of Production × Closing stock/ units
produced)
Cost of Goods Sold 5,00,000 7,48,000
Add: Selling expenses – Variable (Sales unit × ₹ 4) 20,000 34,000
Add: Selling expenses − Fixed (12,000 units × ₹ 1) 12,000 12,000
Cost of Sales : (B) 5,32,000 7,94,000
Profit (+) / Loss (−): (A − B) (−) 52,000 (+) 22,000

Working Notes:

1. Calculation of creditors for supply of materials:

Year 1 (₹) Year 2 (₹)

Materials consumed during the year 2,40,000 3,60,000
Add: Closing stock (2.25 month‟s average 45,000 67,500
consumption)
2,85,000 4,27,500
Less: Opening Stock --- 45,000
Purchases during the year 2,85,000 3,82,500
Average purchases per month (Creditors) 23,750 31,875

2. Creditors for expenses:

Year 1 (₹) Year 2 (₹)

Direct labour and variable expenses 1,20,000 1,80,000
Fixed manufacturing expenses 72,000 72,000
Fixed administration expenses 48,000 48,000
Selling expenses (variable + fixed) 32,000 46,000
Total (including) 2,72,000 3,46,000
Average per month 22,667 28,833

(ii) Projected Statement of Working Capital requirements

Year 1 Year 2
(₹) (₹)
Current Assets:

634
 [MANAGEMENT OF WORKING CAPITAL]

Inventories:
- Stock of materials 45,000 67,500
(2.25 month‟s average consumption)
- Finished goods 1,00,000 1,32,000
Debtors (1 month‟s average sales) (including profit) 40,000 68,000
Cash 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,95,000 2,77,500
Current Liabilities:
Creditors for supply of materials 23,750 31,875
(Refer to working note 1)
Creditors for expenses (Refer to working note 2) 22,667 28,833
Total Current Liabilities: (B) 46,417 60,708
Estimated Working Capital Requirements: (A-B) 1,48,583 2,16,792

Projected Statement of Working Capital Requirement (Cash Cost Basis)

Year 1 Year 2
(₹) (₹)
(A) Current Assets
Inventories:
- Stock of Raw Material 45,000 67,500
(6,000 units × ₹ 40 × 2.25/12);
(9,000 units × ₹ 40 × 2.25 /12)
- Finished Goods (Refer working note 3) 80,000 1,11,000
Receivables (Debtors) (Refer working note 4) 36,000 56,250
Minimum Cash balance 10,000 10,000
Total Current Assets/ Gross working capital (A) 1,71,000 2,44,750
(B) Current Liabilities
Creditors for raw material (Refer working note 1) 23,750 31,875
Creditors for Expenses (Refer working note 2) 22,667 28,833
Total Current Liabilities 46,417 60,708
Net Working Capital (A – B) 1,24,583 1,84,042

Working Note:

3. Cash Cost of Production:

Year 1 (₹) Year 2 (₹)

Cost of Production as per projected Statement of P&L 6,00,000 7,80,000
Less: Depreciation 1,20,000 1,20,000
Cash Cost of Production 4,80,000 6,60,000
Add: Opening Stock at Average Cost: --- 80,000

635
 [MANAGEMENT OF WORKING CAPITAL]

Cash Cost of Goods Available for sale 4,80,000 7,40,000

Less : Closing Stock at Avg. Cost (80,000) (1,11,000)
₹ 4,80,000 × 1,000 ₹ 7,40,000 × 1,500
;
6,000 10,000
Cash Cost of Goods Sold 4,00,000 6,29,000

4. Receivables (Debtors)

Year 1 Year 2
(₹) (₹)
Cash Cost of Goods Sold 4,00,000 6,29,000
Add : Variable Expenses @ ₹ 4 20,000 34,000
Add : Total Fixed Selling expenses (12,000 units × ₹1) 12,000 12,000
Cash Cost of Debtors 4,32,000 6,75,000
Average Debtors 36,000 56,250

Question – 10
Aneja Limited, a newly formed company, has applied to a commercial bank for
the first time for financing its working capital requirements. The following
information is available about the projections for 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 ₹ 80 per unit

Direct wages ₹ 30 per unit

Overheads (exclusive of depreciation) ₹ 60 per unit

Total cost ₹ 170 per unit

Selling price ₹ 200 per unit

Raw materials in stock: Average 4 weeks consumption, work-in-progress

(assume 50% completion stage in respect of conversion cost) (materials issued
at the start of the processing).

Finished goods in stock 8,000 units

Credit allowed by suppliers Average 4 weeks

636
 [MANAGEMENT OF WORKING CAPITAL]

Credit allowed to debtors/receivables Average 8 weeks

Lag in payment of wages Average 1.5 weeks

Cash at banks (for smooth operation) is expected to be ₹ 25,000.

Assume that production is carried on evenly throughout the year (52 weeks)
and wages and overheads accrue similarly. All sales are on credit basis only.

You are required to CALCULATE the net working capital required.

(Study Material ICAI TYK – 06)

Solution:

Calculation of Net Working Capital requirement:

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

Working Notes:

1. Annual cost of production

(₹)
Raw material requirements 86,40,000
{(1,04,000 units × ₹ 80) + ₹ 3,20,000}
Direct wages {(1,04,000 units × ₹ 30) + ₹ 60,000} 31,80,000
Overheads (exclusive of depreciation) 63,60,000
{(1,04,000 × ₹ 60) + ₹ 1,20,000}
Gross Factory Cost 1,81,80,000

637
 [MANAGEMENT OF WORKING CAPITAL]

Less: Closing W.I.P (5,00,000)

Cost of Goods Produced 1,76,80,000
Less: Closing Stock of Finished Goods (13,60,000)
(₹ 1,76,80,000 × 8,000/1,04,000)
Total Cash Cost of Sales 1,63,20,000

2. Work in progress stock

(₹)
Raw material requirements (4,000 units × ₹ 80) 3,20,000
Direct wages (50% × 4,000 units × ₹ 30) 60,000
Overheads (50% × 4,000 units × ₹ 60) 1,20,000
5,00,000

3. Raw material stock

It is given that raw material in stock is average 4 weeks consumption. Since,

the company is newly formed, the raw material requirement for production and
work in progress will be issued and consumed during the year.

Hence, the raw material consumption for the year (52 weeks) is as follows:

(₹)
For Finished goods (1,04,000 × ₹ 80) 83,20,000
For Work in progress (4,000 × ₹ 80) 3,20,000
86,40,000

₹ 86,40,000
Raw material stock × 4 weeks i.e. ₹ 6,64,615
52 weeks

4. Finished goods stock: 8,000 units @ ₹ 170 per unit = ₹ 13,60,000

8
5. Debtors for sale: 1,63,20,000 × = ₹ 25,10,769
52

6. Creditors for raw material:

Material Consumed (₹ 83,20,000 + ₹ 3,20,000) ₹ 86,40,000

Add: Closing stock of raw material ₹ 6,64,615

Purchases of Raw Material ₹ 93,04,615

638
 [MANAGEMENT OF WORKING CAPITAL]

₹ 93,04,615
Credit allowed by suppliers = × 4 weeks = ₹ 7,15,740
52 weeks

7. Creditors for wages:

₹ 31,80,000
Outstanding wage payment = × 1.5 weeks = ₹ 91,731
52 weeks

Question – 11
The management of Trux Company Ltd. is planning to expand its business and
consults you to prepare an estimated working capital statement. The records of
the company reveals the following annual information:

(₹)
Sales – Domestic at one month‟s credit 18,00,000
Export at three month‟s credit (sales price 10% below domestic 8,10,000
price)
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000
Lag in payment of Administration Expenses – 1 month 1,80,000
Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four installments, of which one falls in 1,68,000
the next financial year

Rate of gross profit is 20%. Ignore work-in-progress and depreciation.

The company keeps one month‟s stock of raw materials and finished goods
(each) and believes in keeping ₹ 2,50,000 available to it including the overdraft
limit of ₹ 75,000 not yet utilized by the company.

The management is also of the opinion to make 10% margin for contingencies
on computed figure.

You are required to PREPARE the estimated working capital statement for the
next year.

(Study Material ICAI TYK – 07)

Solution:

Preparation of Statement of Working Capital Requirement for Trux

Company Ltd.

639
 [MANAGEMENT OF WORKING CAPITAL]

(₹) (₹)
A. Current Assets
(i) Inventories:
Material (1 month)
₹ 6,75,000 56,250
× 1 month
12 months
Finished Goods (1 month)
₹ 21,60,000 1,80,000 2,36,250
× 1 month
12 months
(ii) Receivables (Debtors)
For Domestic Sales
₹ 15,17,586 1,26,466
× 1 month
12 months
Foe Export Sales
₹ 7,54,914 1,88,729 3,15,195
× 3 months
12 months
(iii) Prepayment of Selling Expenses
₹ 1,12,500 28,125
× 3 months
12 months
(iv) Cash in hand & at bank (net of overdraft) 1,75,000
Total Current Assets 7,54,570
B. Current Liabilities:
(i) Payables (Creditors) for materials (2 months)
₹ 6,75,500 1,12,500
× 2 months
12 months
(ii) Outstanding wages (0.5 months)
₹ 5,40,000 22,500
× 0.5 month
12 months
(iii) Outstanding manufacturing expenses
₹ 7,65,000
× 1 month 63,750
12 months
(iv) Outstanding Administrative Expenses
₹ 1,80,000 15,000
× 0.5 months
12 months
(v) Income Tax Payable 42,000
Total Current Liabilities 2,55,750
Net Working Capital (A – B) 4,98,820
Add: 10% Contingency margin 49,882
Total Working Capital Required 5,48,702

640
 [MANAGEMENT OF WORKING CAPITAL]

Working Notes:

1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic (₹) Export (₹) Total (₹)

Domestic Sales 18,00,000 8,10,000 26,10,000
Less: Gross profit @ 20% on 3,60,000 90,000 4,50,000
domestic sales and 11.11% on
export sales (Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,000
Add: Selling expenses (Working 77,586 34,914 1,12,500
note-3)
Cash Cost of Sales 15,17,586 7,54,914 22,72,500

2. Calculation of gross profit on Export Sales

Let domestic selling price is ₹ 100. Gross profit is ₹ 20, and then cost per
unit is ₹ 80

Export price is 10% less than the domestic price i.e. ₹ 100–(1-0.1)= ₹ 90

Now, gross profit will be = ₹ 90 - ₹ 80 = ₹ 10

₹ 10
So, Gross profit ratio at export price will be = × 100 = 11.11%
₹ 90

3. Apportionment of Selling expenses between Domestic and Exports

sales:

Apportionment on the basis of sales value:

₹ 1,12,500
Domestic Sales = × ₹ 18,00,000 = ₹ 77,586
₹ 26,10,000

₹ 1,12,500
Export Sales = × ₹ 18,10,000 = ₹ 34,914
₹ 26,10,000

4. Assumptions

(i) It is assumed that administrative expenses is related to production

activities.

(ii) Value of opening and closing stocks are equal.

641
 [MANAGEMENT OF WORKING CAPITAL]

Question – 12
PREPARE a working capital estimate to finance an activity level of 52,000 units
a year (52 weeks) based on the following data:

Raw Materials - ₹ 400 per unit

Direct Wages - ₹ 150 per unit

Overheads (Manufacturing) - ₹ 200 per unit

Overheads (Selling & Distribution) - ₹ 100 per unit

Selling Price - ₹ 1,000 per unit, Raw materials & Finished Goods remain in
stock for 4 weeks, Work in process takes 4 weeks. Debtors are allowed 8 weeks
for payment whereas creditors allow us 4 weeks.

Minimum cash balance expected is ₹ 50,000. Receivables are valued at Selling

Price.

(Study Material ICAI TYK – 14)

Solution:

Cost Structure for 52,000 units

Particulars Amount (₹)
Raw Material @ ₹ 400P 2,08,00,000
Direct Wages @ ₹ 150 78,00,000
Manufacturing Overheads @ ₹ 200 1,04,00,000
Selling and Distribution OH @ ₹ 100 52,00,000
Total Cost 4,42,00,000
Sales @ ₹ 1,000 5,20,00,000

Particulars Calculation Amount (₹)

A. Current Assets:
Raw Materials Stock 4 16,00,000
2,08,00,000 ×
52
Work in Progress 2,08,00,000 23,00,000
(WIP Stock)** (78,00,000 + 1,04,00,000) 4
+ × 52
2
Finished Goods Stock 4 34,00,000
4,42,00,000 ×
52
Receivables 8 80,00,000
5,20,00,000 ×
52

642
 [MANAGEMENT OF WORKING CAPITAL]

Cash 50,000
Total Current Assets 1,53,50,000
B. Current Liabilities:
Creditors 4 16,00,000
2,08,00,000 ×
52
C. Working Capital 1,37,50,000
Estimates (A-B)

** Assuming that labour and overhead are incurred evenly throughout the year.

Question – 13
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 ₹ 6,00,000

10% Debentures ₹ 1,00,000

Fixed Assets ₹ 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 ₹ 5 per unit.

There is a regular production and sales cycle and wages and overheads accrue
evenly.

643
 [MANAGEMENT OF WORKING CAPITAL]

(MTP Nov – 2021)

Solution:

Forecast Profit and Loss Account for the period 01.04.2020 to 31.03.2021

Particulars ₹ Particulars ₹
Materials consumed 3,60,000 By Sales 1,20,000 @ ₹ 5 6,00,000
1,20,000 @ ₹ 3

Direct wages :
1,20,000 @ ₹ 0.5 60,000

Overheads :
1,20,000 @ ₹ 1 1,20,000
Gross profit c/d
60,000
6,00,000 6,00,000
Debenture interest 10,000 By gross profit b/d 60,000
(10% of 1,00,000)
Net profit c/d 50,000
6,00,000 6,00,000

Working Capital Requirement Forecast for the year 01.04.2020 to

31.03.2021

Particulars Period Total (₹) Current

(Month Liabilit-
s) Current Assets (₹) ies (₹)

Raw Work- Finis Debtors Credi-

mater in- hed tors
ials progres goods
s
1. Material
In store 2 60,000
In work-in-progress 1 30,000
In finished goods 3 90,000
Credit to debtors 3 90,000
9
Less : Credit from 2 60,000
creditors
Net block period 7 2,10,000
2. Wages:
In work-in-progress ½ 2,500
In finished goods 3 15,000
Credit to debtors 3 15,000

644
 [MANAGEMENT OF WORKING CAPITAL]

6½
Less : Time lag in 1 5,000
payment
Net block period 5½ 27,500
3. Overheads:
In work-in-progress 5,000
In finished goods 3 30,000
Credit to debtors 3 30,000
Net block period 6½ 65,000
4. Profit
Credit to debtors 3 15,000
Net block period 3 15,000
Total (₹) 3,17,500 60,000 37,500 1,35,000 1,50,000 65,000

Forecast Balance Sheet as on 31.03.2021

(₹) (₹)
Issued share capital 6,00,000 Fixed Assets 4,50,000
Profit and Loss A/c 50,000 Current Assets:
10% Debentures 1,00,000 Stock:
Sundry creditors 65,000 Raw materials 60,000
Bank overdraft - Work-in-progress 37,500
Balancing figure 17,500 Finished goods 1,35,000 2,32,500
Debtors 1,50,000
8,32,500 8,32,500

The Total amount of working capital, thus, stands as follows: ₹

Requirement as per working capital 3,17,500
Less: Bank overdraft as per balance sheet 17,500
Net requirement 3,00,000

1. Average monthly production: 1,20,000 ÷ 12 = 10,000 units

2. Average cost per month:

Raw Material 10,000 × (₹ 5 × 0.6) = ₹ 30,000

Direct wages 10,000 × (₹ 5 × 0.1) = ₹ 5,000

Overheads 10,000 × (₹ 5 × 0.2) = ₹ 10,000

3. Average profit per month: 10,000 × (₹ 5 × 0.1) = ₹ 5,000

4. Wages and overheads accrue evenly over the period and, hence, are
assumed to be completely introduced for half the processing time.

645
 [MANAGEMENT OF WORKING CAPITAL]

Question – 14
The below information for Lever Ltd is provided on annual basis:

₹
Sales at 3 months credit 48,00,000
Materials consumed (suppliers extend 2 months credit) 12,00,000
Wages paid (one month lag in payment) 9,60,000
Cash manufacturing expenses (paid on month in arrear) 12,00,000
Administrative expense (one month lag in payment) 3,60,000
Sales promotion expense (paid monthly in advance) 1,20,000

The Company sells its products at a gross profit of 20%.

The Company keeps two months stock of raw materials and two months stock
of finished goods.

Depreciation is considered as a part of cost of production.

Cash balance is retained at ₹ 1,00,000,

Assuming a 15% margin, COMPUTE the working capital requirements of the

Company on cash cost basis. Ignore work-in progress.

(MTP April – 2024)

Solution:

(i) Working Notes:

(i) Computation of Annual Cash cost of production (₹)

Material consumed 12,00,000
Wages 9,60,000
Manufacturing expenses 12,00,000
Total cash cost of production 33,60,000
(ii) Computation of Annual Cash Cost of Sales: (₹)
Total Cash cost of production as in (i) above 33,60,000
Administrative Expenses 3,60,000
Sales promotion expenses 1,20,000
Total cash cost of sales 38,40,000
Add: Gross Profit @ 20% on sales (25% on cost of 9,60,000
sales)
Sales Value 48,00,000

Statement of Working Capital requirements (cash cost basis)

646
 [MANAGEMENT OF WORKING CAPITAL]

(₹) (₹)
A. Current Assets
(i) Inventories:
- Raw material 2,00,000
12,00,000
× 2 months
12 months
Finished goods 5,60,000
₹ 33,60,000
× 2 months
12 months
Receivables (Debtors) 9,60,000
₹ 38,40,000
× 3 months
12 months
Sales Promotion expenses paid in advance 10,000
₹ 1,20,000
× 1 months
12 months
Cash Balance 1,00,000 18,30,000
Gross Working Capital 18,30,000
B. Current Liabilities:
Payables:
- Creditors for materials 2,00,000
₹ 12,00,000
× 2 months
12 months
Wages Outstanding 80,000
₹ 9,60,000
× 1months
12 months
Manufacturing expenses outstanding 1,00,000
₹ 12,00,000
× 1months
12 months
Administrative expenses outstanding 30,000 4,10,000
₹ 3,60,000
× 1months
12 months
Net working capital (A - B) 14,20,000
Add: Safety margin @ 15% 2,13,000
Total Working Capital requirements 16,33,000

Question – 15
PREPARE a working capital estimate to finance an activity level of 52,000 units
a year (52 weeks) based on the following data:

Raw Materials - ₹ 400 per unit

Direct Wages - ₹150 per unit

647
 [MANAGEMENT OF WORKING CAPITAL]

Overheads (Manufacturing) - ₹ 200 per unit

Overheads (Selling & Distribution) - ₹ 100perunit

Selling Price - ₹ 1,000 per unit, Raw materials & Finished Goods remain in
stock for 4 weeks, Work in process takes 4 weeks. Debtors are allowed 8 weeks
for payment whereas creditors allow us 4 weeks.

Minimum cash balance expected is ₹ 50,000. Receivables are valued at Selling

Price.

(MTP October – 2022)

Solution:

Cost Structure for 52000 units

Particular Amount (₹)
Raw Material @ ₹ 400 2,08,00,000
Direct Wages @ ₹ 150 78,00,000
Manufacturing overheads ₹ @ 200 1,04,00,000
Selling and Distribution OH ₹ @ 100 52,00,000
Total Cost 4,42,00,000
Sales @ ₹ 1000 5,20,00,000

Particulars Calculation Amount (₹)

A. Current Assets:
Raw Material Stock 4 16,00,000
2,08, 00,000 ×
52
Work in Progress 2,08,00,000 +
(WIP) Stock ( 78,00,000 +1,04,00,000) 4 23,00,000
×
2 52
Finished Goods Stock 4 34,00,000
4,42,00,000 ×
52
Receivables 8 80,00,000
5,20,00,000 ×
52
Cash 50,000
Total Current Assets 1,53,50,000
B. Current Liabilities:
Creditors 4 16,00,000
20800000 ×
52
C. Working Capital 1,37,50,000
Estimates (A-B)

648
 [MANAGEMENT OF WORKING CAPITAL]

Question – 16
Following information is forecasted by the Puja Limited for the year ending 31st
March, 20X8:

Balance as at Balance as at
1 April 2017 31 March 2018
st st

(₹) (₹)
Raw Material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchases of raw material (all 4,00,000
credit)
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.

Required:

CALCULATE

(i) Net operating cycle period.

(ii) Number of operating cycles in the year.

(iii) Amount of working capital requirement using operating cycles.

(RTP May – 2018)

Solution:

Working Notes:

1. Raw Material Storage Period (R)

Average Stock of Raw Material

= × 365
Annual Consumption of Raw Material

₹ 45,000 + 65,356
2
= × 365
₹ 3,79,644

649
 [MANAGEMENT OF WORKING CAPITAL]

= 53 days.

Annual Consumption of Raw Material

= Opening Stock + Purchases – Closing Stock

= ₹ 45,000 + ₹ 4,00,000 – ₹ 65,356

= ₹ 3,79,644 2.

2. Work-in-Progress (WIP) Conversion Period (W)

Average Stock of WIP

WIP Conversion Period = × 365
Annual Cost of Production
₹ 35,000 + 51,300
2
= × 365
₹ 7,50,000

= 21 days.

3. Finished Stock Storage Period (F)

Average Stock of Finished Goods

= × 365
Cost of Goods Sold
₹ 65,178
= × 365 = 26 days.
₹ 9,15,000

₹ 60,181+ ₹ 70,175
Average Stock = = ₹ 65,178.
2

4. Debtors Collection Period (D)

Average Debtors
= × 365
Annual Credit Sales
₹ 1,23,561.50
= = 41 days.
₹ 11,00,000

₹ 1,12,123 + 1,35,000
Average debtors = = ₹ 1,23,561.50
2

5. Creditors Payment Period (C)

Average Creditors
= × 365
Annual Net Credit Purchases

650
 [MANAGEMENT OF WORKING CAPITAL]

₹ 50,079 + ₹ 70,469
2
= × 365
₹ 4,00,000

= 55 days.

(i) Operating Cycle Period

=R+W+ F+D-C

= 53 + 21 + 26 + 41 - 55

= 86 days

(ii) Number of Operating Cycles in the Year

365 365
= = = 4.244
Operating Cycle Period 86

(iii) Amount of Working Capital Required

Annual Operating Cost ₹ 9,50,000

= = = ₹ 2,23,845.42
Number of Operating Cycles 4.244

Question – 17
A proforma cost sheet of a company provides the following particulars:

Amount per unit (₹)

Raw materials cost 100.00
Direct labour cost 37.50
Overheads cost 75.00
Total cost 212.50
Profit 37.50
Selling Price 250.00

The Company keeps raw material in stock, on an average for one month; work-
in-progress, on an average for one week; and finished goods in stock, on an
average for two weeks.

The credit allowed by suppliers is three weeks and company allows four weeks
credit to its debtors. The lag in payment of wages is one week and lag in
payment of overhead expenses is two weeks.

The Company sells one-fifth of the output against cash and maintains cash-in-
hand and at bank put together at ₹ 37,500.

651
 [MANAGEMENT OF WORKING CAPITAL]

Required:

PREPARE a statement showing estimate of Working Capital needed to finance

an activity level of 1,30,000 units of production. Assume that production is
carried on evenly throughout the year, and wages and overheads accrue
similarly. Work-in-progress stock is 80% complete in all respects.

(RTP May – 2019)

Solution:

(Amount (Amount
in ₹) in ₹)
A. Current Assets
(i) Inventories:
Raw material (1 month or 4 weeks)
1,30,000 units × ₹ 100 10,00,000
× 4 weeks
₹ 52 weeks
WIP Inventory (1 week)
1,30,000 units × ₹ 212.50 4,25,000
× 1 weeks × 0.8
₹ 52 weeks
Finished goods inventory (2 weeks)
1,30,000 units × ₹ 212.50 10,62,500 24,87,500
× 2 weeks
₹ 52 weeks
(ii) Receivables (Debtors) (4 weeks)
1,30,000 units × ₹ 212.50 4 17,00,000
× 4 weeks ×
₹ 52 weeks 5th
(iii) Cash and bank balance 37,500
Total Current Assets 42,25,000
B. Current Liabilities:
(i) Payables (Creditors) for materials (3 weeks)
1,30,000 units × ₹ 100 7,50,000
× 3 weeks
₹ 52 weeks
(ii) Outstanding wages (1 week)
1,30,000 units × ₹ 37.50 93,750
× 1 weeks
₹ 52 weeks
(iii) Outstanding overheads (2 weeks)
1,30,000 units × ₹ 75 3,75,000
× 1 weeks
₹ 52 weeks
Total Current Liabilities 12,18,750
Net Working Capital Needs (A – B) 30,06,250

652
 [MANAGEMENT OF WORKING CAPITAL]

Question – 18
Day Ltd., a newly formed company has applied to the Private Bank for the first
time for financing it's Working Capital Requirements. The following information
is available about the projections for the current year:

Estimated Level of Activity Completed Units of Production 31,200 plus

unit of work in progress 12,000
Raw Material Cost ₹ 40 per unit
Direct Wages Cost ₹ 15 per unit
Overhead ₹ 40 per unit (inclusive of Depreciation ₹ 10
per unit)
Selling Price ₹ 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24,000 Units
Credit Allowed by the supplier 30 days
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance ₹ 2,00,000

Assume that production is carried on evenly throughout the year (360 days)
and wages and overheads accrue similarly. All sales are on the credit basis.
You are required to CALCULATE the Net Working Capital Requirement on Cash
Cost Basis.
(RTP May – 2020)

Solution:

Calculation of Net Working Capital requirement:

(₹) (₹)
A. Current Assets:
Inventories:
Stock of Raw material (Refer to Working note (iii) 1,44,000
Stock of Work in progress (Refer to Working note (ii) 7,50,000
Stock of Finished goods (Refer to Working note (iv) 20,40,000

653
 [MANAGEMENT OF WORKING CAPITAL]

Debtors for Sales(Refer to Working note (v) 1,02,000

Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases (Refer to Working note (vi) 1,56,000
Creditors for wages (Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750

Working Notes:

(i) Annual cost of production

(₹)
Raw material requirements 17,28,000
{(31,200 × ₹ 40) + (12,000 × ₹ 40)}
Direct wages {(31,200 × ₹ 15) + (12,000 × ₹ 15 × 0.5)} 5,58,000
Overheads (exclusive of depreciation) 11,16,000
{(31,200 × ₹ 30) + (12,000 × ₹ 30 × 0.5)}
Gross Factory Cost 34,02,000 Less: Closing W.I.P (7,50,000)
[12,000 (₹ 40 + ₹ 7.5 + ₹15)]
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods (20,40,000)
(₹ 26,52,000 × 24,000/31,200)
Total Cash Cost of Sales* 6,12,000

[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000

units) × (₹ 40 + ₹ 15 + ₹ 30) = ₹ 6,12,000]

(ii) Work in progress stock

(₹)
Raw material requirements (12,000 units × ₹ 40) 4,80,000
Direct wages (50% × 12,000 units × ₹ 15) 90,000
Overheads (50% × 12,000 units × ₹ 30) 1,80,000
7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption.

Since, the company is newly formed; the raw material requirement for
production and work in progress will be issued and consumed during the

654
 [MANAGEMENT OF WORKING CAPITAL]

year. Hence, the raw material consumption for the year (360 days) is as
follows:

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

17,28,000
Raw material stock = × 30 days = ₹1,44,000
360 days

(iv) Finished goods stock:

24,000 units @ ₹ (40 + 15 + 30) per unit = ₹ 20,40,000

60 days
(v) Debtors for sale: ₹ 6,12,000 × = ₹1,02,000
360 days

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

Annual Material Consumed (₹12,48,000 + ₹4,80,000) ₹17,28,000

Add: Closing stock of raw material

[(₹17,28,000 × 30 days)/360 days] ₹ 1,44,000

₹ 18,72,000

₹ 18,72,000
Credit allowed by suppliers = × 30 days = ₹1,56,000
360 days

(vii) Creditors for wages:

Outstanding wage payment = [(31,200 units × ₹ 15) + (12,000 units × ₹

15 × .50)] × 15 days / 360 days

₹ 5,58,000
= × 15 days = ₹ 23,250
360 days

Question – 19
MT Ltd. has been operating its manufacturing facilities till 31.3.2021 on a
single shift working with the following cost structure:

655
 [MANAGEMENT OF WORKING CAPITAL]

Per Unit (₹)

Cost of Materials 24
Wages (out of which 60% variable) 20
Overheads (out of which 20% variable) 20
64
Profit 8
Selling Price 72

As at 31.03.2021 with the sales of ₹ 17,28,000 the company held:

Per Unit (₹)

Stock of raw materials (at cost) 1,44,000
Work-in-progress (valued at prime cost) 88,000
Finished goods (valued at total cost) 2,88,000
Sundry debtors 4,32,000

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

working an extra shift. It is expected that a 10% discount will be available from
suppliers of raw materials in view of increased volume of business. Selling price
will remain the same. The credit period allowed to customers will remain
unaltered. Credit availed from suppliers will continue to remain at the present
level i.e. 2 months. Lag in payment of wages and overheads will continue to
remain at one month.

You are required to CALCULATE the additional working capital requirements, if

the policy to increase output is implemented, to assess the impact of double
shift for long term as a matter of production policy.

(RTP May – 2021)

Solution:

Workings:

(1) Statement of cost at single shift and double shift working

24,000 units 48,000 Units

Per Total(₹) Per Total (₹)
unit (₹) unit (₹)

656
 [MANAGEMENT OF WORKING CAPITAL]

Raw materials 24 5,76,000 21.6 10,36,000

Wages:
Variable 12 2,88,000 12 5,76,000
Fixed 8 1,92,000 4 1,92,000
Overheads:
Variable 4 96,000 4 1,92,000
Fixed 16 3,84,000 8 3,84,000
Total cost 64 15,36,000 49.6 23,80,800
Profit 8 1,92,000 22.4 10,75,200
Sales 72 17,28,000 72 34,56,000

sales ₹ 17,28,000
(2) Sales in units 2020-21 = = = 24,000 units
Unit selling price ₹ 72

(3) Stock of Raw Materials in units on 31.3.2021

Value of stock ₹ 1,44,000

= = = 6,000 units
Cost per unit ₹ 24

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

Value of work-in-progress ₹ 88,000

= = = 2,000 units
Prime Cost per unit ₹ (24 + 20)

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

Value of stock ₹ 2,88,000

= = = 4,500 units
Total Cost per unit ₹ 64

Comparative Statement of Working Capital Requirement

Single Shift (24,000 Double Shift (48,000

units) units)
Units Rat Amount Units Rate Amount(₹)
e (₹) (₹) (₹)
Current Assets
Inventories:
Raw Materials 6,000 24 1,44,000 12,000 21.6 2,59,200
Work-in-Progress 2,000 44 88,000 2,000 37.6 75,200
Finished Goods 4,500 64 2,88,000 9,000 49.6 4,46,400
Sundry Debtors 6,000 64 3,84,000 12,000 49.6 5,95,200

657
 [MANAGEMENT OF WORKING CAPITAL]

Total Current Assets (A) 9,04,000 13,76,000

Current Liabilities
Creditors for Materials 4,000 24 96,000 8,000 21.6 1,72,800
Creditors for Wages 2,000 20 40,000 4,000 16 64,000
Creditors for Overheads 2,000 20 40,000 4,000 12 48,000
Total Current Liabilities (B) 1,76,000 2,84,800
Working Capital (A) – (B) 7,28,000 10,91,200

Analysis: Additional Working Capital requirement = ₹ 10,91,200 – ₹ 7,28,000 =

₹ 3,63,200, if the policy to increase output is implemented.

Question – 20
While applying for financing of working capital requirements to a commercial
bank, TN Industries Ltd. projected the following information for the next year:

Cost Element Per Unit (₹) Per Unit (₹)

Raw Materials
X 30
Y 7
Z 6 43
Direct Labour 25
Manufacturing and administration overheads 20
(excluding depreciation) 10
Depreciation 15
Selling overheads 113

Additional Information:

(a) Raw Materials are purchased from different suppliers leading to different
credit period allowed as follows: X – 2 months; Y– 1 months; Z – ½
month

(b) Production cycle is of ½ month. Production process requires full unit of X

and Y in the beginning of the production. Z is required only to the extent
of half unit in the beginning and the remaining half unit is needed at a
uniform rate during the production process.

(c) X is required to be stored for 2 months and other materials for 1 month.

(d) Finished goods are held for 1 month.

(e) 25% of the total sales is on cash basis and remaining on credit basis.
The credit allowed by debtors is 2 months.

658
 [MANAGEMENT OF WORKING CAPITAL]

(f) Average time lag in payment of all overheads is 1 months and ½ months
for direct labour.

(g) Minimum cash balance of ₹ 8,00,000 is to be maintained.

CALCULATE the estimated working capital required by the company on cash

cost basis if the budgeted level of activity is 1,50,000 units for the next year.
The company also intends to increase the estimated working capital
requirement by 10% to meet the contingencies. (You may assume that
production is carried on evenly throughout the year and direct labour and
other overheads accrue similarly.)

(RTP May – 2021)

Solution:

Statement showing Working Capital Requirements of TN Industries Ltd.

(on cash cost basis)

Amount Amount
in (₹) in (₹)
A. Current Assets
(i) Inventories:
Raw material
1,50,000units × ₹ 30
X[ × 2 months] 7,50,000
12 months

1,50,000 unit × ₹ 7 87,500

Y [ ×1 month]
12 months

1,50,000 units × ₹ 6 75,000

Z[ ×1 month]
12 months

1,50,000 units × ₹ 64 4,00,000

WIP [ × 0.5 month]
12 months

1,50,000 units × ₹ 88 11,00,000 24,12,500

Finished goods [ 1 month]
12 months
(ii) Receivables (Debtors) 19,31,250
1,50,000 units ₹ 103
[ × 2 months] × 0.75
12 months
(iii) Cash and bank balance 8,00,000
Total Current Assets 51,43,750
B. Current Liabilities:

659
 [MANAGEMENT OF WORKING CAPITAL]

(i) Payables (Creditors) for Raw materials

1,50,000 units × ₹ 30 7,50,000

X[ × 2 months]
12 month
1,50,000 units × ₹ 7 87,500
Y[ × 1 month]
12 months
1,50,000units × ₹ 6
Z[ × 0.5 month] 37,500 8,75,000
12 months
(ii) Outstanding Direct Labour 1,56,250
1,50,000 units × ₹ 25
[ × 0.5 month]
12 months
(iii) Outstanding Manufacturing and
administration 2,50,000

1,50,000units × ₹ 20
[ × 1 month]
12 months
(iv) Outstanding Selling overheads 1,87,500
1,50,000units × ₹ 15
[ × 1 month]
12 months
Total Current Liabilities 14,68,750
Net Working Capital Needs (A – B) 36,75,000
Add: Provision for contingencies @ 10% 3,67,500
Working capital requirement 40,42,500

Workings:

1.
(i) Computation of Cash Cost of Production Per unit (₹)
Raw Material consumed 43
Direct Labour 25
Manufacturing and administration overheads 20
Cash cost of production 88
(ii) Cash cost of production Per unit (₹)
Cash cost of production as in (i) above 88
Selling overheads 15
Cash cost of sales 103

2. Calculation of cost of WIP

Particulars Per unit (₹)

Raw material (added at the beginning):
X 30
Y 7

660
 [MANAGEMENT OF WORKING CAPITAL]

Z (₹ 6 × 50%) 3
Cost during the year:
Z {(₹ 6 × 50%) × 50%} 1.5
Direct Labour (₹ 25 × 50%) 12.5
Manufacturing and administration overheads (20 × 50%) 10
64

Question – 21
You are given below the Profit & Loss Accounts for two years for a company:

Profit and Loss Account

Year 1 Year 2 Year 1 Year 2

(₹) (₹) (₹) (₹)
To Opening 32,00,000 40,00,000 By Sales 3,20,00,000 4,00,00,000
Stock
To Raw 1,20,00,000 1,60,00,000 By 40,00,000 60,00,000
Materials Closing
stock
To Stores 38,40,000 48,00,000 By Misc. 4,00,000 4,00,000
Income
To 51,20,000 64,00,000
Manufacturing
Expenses
To Other 40,00,000 40,00,000
Expenses
To 40,00,000 40,00,000
Depreciation
To Net Profit 42,40,000 72,00,000 - -
3,64,00,000 4,64,00,000 3,64,00,000 4,64,00,000

Sales are expected to be ₹ 4,80,00,000 in year 3.

As a result, other expenses will increase by ₹ 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 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.

(RTP May – 2022)

661
 [MANAGEMENT OF WORKING CAPITAL]

Solution:

Projected Profit and Loss Account for the year 3

Particulars Year 2 Year 3 Particulars Year 2 Year 3

Actual Projected Actual Projected
(₹ in (₹ in (₹ in (₹ in
lakhs) lakhs) lakhs) lakhs

To Materials 140.00 168.00 By Sales 400.00 480.00

consumed
To Stores 48.00 57.60 By Misc. Income 4.00 4.00
To Mfg. Expenses 64.00 76.80
To Other expenses 40.00 60.00
To Depreciation 40.00 40.00
To Net profit 72.00 81.60
404.00 484.00 484.00 484.00

Cash Flow:

Particulars (₹ in lakhs)
Profit 81.60
Add: Depreciation 40.00
121.60
Less: Cash required for increase in stock 20.00
Net cash inflow 101.60

Available for servicing the loan: 75% of ₹ 1,01,60,000 or ₹ 76,20,000

Working Notes:

(i) Material consumed in year 1 = (32 + 120 – 40)/320 = 35%

Material consumed in year 2 = (40 + 160 – 60)/400 = 35%

35
Likely consumption in year 3 = 480 × = ₹ 168 (lakhs)
100
(ii) Stores are 12% of sales & Manufacturing expenses are 16% of sales for
both the years.

Question – 22
PQR Ltd., a company newly commencing business in the year 2021-22,
provides the following projected Profit and Loss Account:

662
 [MANAGEMENT OF WORKING CAPITAL]

(₹) (₹)
Sales 5,04,000
Cost of goods sold 3,67,200
Gross Profit 1,36,800
Administrative Expenses 33,600
Selling Expenses 31,200 64,800
Profit before tax 72,000
Provision for taxation 24,000
Profit after tax 48,000
The cost of goods sold has been arrived at as under:
Materials used 2,01,600
Wages and manufacturing Expenses 1,50,000
Depreciation 56,400
4,08,000
Less: Stock of Finished goods
(10% of goods produced not yet sold) 40,800
3,67,200

The figure given above relate only to finished goods and not to work-in-
progress. Goods equal to 15% of the year‟s production (in terms of physical
units) will be in process on the average requiring full materials but only 40% of
the other expenses. The company believes in keeping materials equal to two
months‟ consumption in stock.

All expenses will be paid one month in advance. Suppliers of materials will
extend 1-1/2 months credit. Sales will be 20% for cash and the rest at two
months‟ credit. 70% of th e Income tax will be paid in advance in quarterly
installments. The company wishes to keep ₹ 19,200 in cash. 10% must be
added to the estimated figure for unforeseen contingencies.

PREPARE an estimate of working capital.

(RTP May – 2022)

Solution:

Statement showing the requirements of Working Capital

Particulars (₹) (₹)

A. Current Assets:
Inventory:
Stock of Raw material (₹ 2,31,840 × 2/12) 38,640
Stock of Work-in-progress (As per Working Note) 39,240

663
 [MANAGEMENT OF WORKING CAPITAL]

Stock of Finished goods (₹ 3,51,600 × 10/100) 35,160

Receivables (Debtors) (₹3,04,992 × 2/12) 50,832
Cash in Hand 19,200
Prepaid Expenses:
Wages & Mfg. Expenses (₹ 1,59,000 × 1/12) 13,250
Administrative expenses (₹ 33,600 × 1/12) 2,800
Selling & Distribution Expenses (₹ 31,200 × 1/12) 2,600
Advance taxes paid {(70% of ₹ 24,000) × 3/12} 4,200
Gross Working Capital 2,05,922 2,05,922
B. Current Liabilities:
Payables for Raw materials (₹ 2,70,480 × 1.5/12) 33,810
Provision for Taxation (Net of Advance Tax) 7,200
(₹ 24,000 × 30/100)
Total Current Liabilities 41,010 41,010
C. Excess of CA over CL 1,64,912
Add: 10% for unforeseen contingencies 16,491
Net Working Capital requirements 1,81,403

Working Notes:

(i) Calculation of Stock of Work-in-progress

Particulars (₹)
Particulars (₹) Raw Material (₹ 2,01,600 × 15%) 30,240
Wages & Mfg. Expenses (₹ 1,50,000 × 15% × 40%) 9,000
Total 39,240

(ii) Calculation of Stock of Finished Goods and Cost of Sales

Particulars (₹)
Direct material Cost [₹ 2,01,600 + ₹ 30,240] 2,31,840
Wages & Mfg. Expenses [₹ 1,50,000 + ₹ 9,000] 1,59,000
Depreciation 0
Gross Factory Cost 3,90,840
Less: Closing W.I.P. (39,240)
Cost of goods produced 3,51,600
Add: Administrative Expenses 33,600
3,85,200
Less: Closing stock (35,160)
Cost of Goods Sold 3,50,040
Add: Selling and Distribution Expenses 31,200
Total Cash Cost of Sales 3,81,240
Debtors (80% of cash cost of sales) 3,04,992

664
 [MANAGEMENT OF WORKING CAPITAL]

(iii) Calculation of Credit Purchase

Particulars (₹)
Raw material consumed 2,31,840
Add: Closing Stock 38,640
Less: Opening Stock -
Purchases 2,70,480

Question – 23
Kalyan limited has provided you the following information for the year 2021-22:

By working at 60% of its capacity the company was able to generate sales of ₹
72,00,000. Direct labour cost per unit amounted to ₹ 20 per unit. Direct
material cost per unit was 40% of the selling price per unit. Selling price was 3
times the direct labour cost per unit. Profit margin was 25% on the total cost.

For the year 2022-23, the company makes the following estimates:

Production and sales will increase to 90% of its capacity. Raw material per unit
price will remain unchanged. Direct expense per unit will increase by 50%.
Direct labour per unit will increase by 10%. Despite the fluctuations in the cost
structure, the company wants to maintain the same profit margin on sales.

Raw materials will be in stock for one month whereas finished goods will
remain in stock for two months. Production cycle is for 2 months. Credit period
allowed by suppliers is 2 months. Sales are made to three zones:

Zone Percentage of Sale Mode of Credit

A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash Sales

There are no cash purchase and cash balance will be ₹ 1,11,000

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

(RTP May – 2023)

Solution:

Cost Structure

665
 [MANAGEMENT OF WORKING CAPITAL]

2021-22 2022-23
Particulars Calculations P.U Amount Calculations P.U. Amount (p. u.
. (p.u. X X units)
units)
Direct 40% of SP ₹ 24 ₹ 28,80,000 Same as PY ₹ 24 ₹ 43,20,000
Material
Direct Given ₹ 20 ₹ 24,00,000 20*1.1 ₹ 22 ₹ 39,60,000
labour
Direct bal. fig. ₹4 ₹ 4,80,000 4*1.5 ₹6 ₹ 10,80,000
Expenses
Total Cost SP - Profit ₹ 48 ₹ 57,60,000 ₹ 52 ₹ 93,60,000
Profit (SP/125 × 25) ₹ 12 ₹ 14,40,000 52*25% ₹ 13 ₹ 23,40,000
Sales 3 × Direct ₹ 60 ₹ 72,00,000 ₹ 65 ₹ 1,17,00,000
Labour p.u.
*units= ₹ 72,00,000 / ₹ 60 1,20,000/60 × 90 =
=1,20,000 1,80,000

Operating Cycle

Raw material holding period 1 month

Finished Goods holding period 2 months
WIP conversion period 2 months
Creditor Payment Period 2 months
Receivables Collection Period 2/3 months

Estimation of Working Capital

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

666
 [MANAGEMENT OF WORKING CAPITAL]

Net Working Capital ₹ 42,83,500

Opening RM stock = 28,80,000 × 1/12 = ₹ 2,40,000

* RM purchased = RM consumed – Opening Stock + Closing Stock

= ₹ 43,20,000 – ₹ 2,40,000 + ₹ 3,60,000

= ₹ 44,40,000

Computation of Maximum Permissible Bank Finance

Method Formula Calculation ₹
I 75% × (Current Assets 75% × (₹ 50,23,500 - ₹ ₹ 32,12,625
Current Liabilities) 7,40,000)
II 75% × Current Assets 75% × ₹ 50,23,500 - ₹ ₹ 30,27,625
Current Liabilities 7,40,000

III 75% × (Current Assets- 75% × (₹ 50,23,500 - ₹ ₹ 18,57,625

Core CA)- Current 15,60,000) - ₹ 7,40,000
Liabilities

Question – 24
PQ Ltd. has commenced new business segment in 2023-24. The following
information has been ascertained for annual production of 25,000 units which
is the full capacity.

Cost per unit (₹)

Material 100
Labour and variable overhead expenses 50
Fixed manufacturing expenses 35
Depreciation 15
Selling expenses (80% variable) 10

In the first two years of operations, production and sales are expected to be as
follows:

Year Production (No. of units) Sales (No. of units)

1 12,000 10,000
2 18,000 9,000

The selling price is expected to be ₹ 250 .

To assess the working capital requirements, the following additional

information is available:

(a) Stock of materials 2 months‟ average consumption

667
 [MANAGEMENT OF WORKING CAPITAL]

(b) Debtors 1.5 month‟s average sales.

(c) Cash balance ₹ 50,000
(d) Creditors for supply of 1 month‟s average purchase during the
materials year.
(e) Expenses All expenses will be paid 1 month in
advance during the year.

Goods equal to 15% of the year‟s production (in terms of physical units) will be
in process on the average requiring full materials but only 40% of the other
expenses.

The management is also of the opinion to make 10% margin for contingencies
on computed figure and value the closing stock at cost of production.

PREPARE, for the two years:

(i) A projected statement of Profit/Loss (Ignoring taxation); and

(ii) A projected statement of working capital requirements on a cash cost

basis.

(RTP May – 2024)

Solution:

(i)
PQ Limited
Projected Statement of Profit / Loss
(Ignoring Taxation)

Year 1 Year 2
Production (Units) 12,000 18,000
Sales (Units) 10,000 19,000
(₹) (₹)
Sales revenue (A) (Sales unit × ₹ 250) 25,00,000 47,50,000
Cost of production:
Materials cost (Units produced × ₹ 100) 12,00,000 18,00,000
Direct labour and variable expenses 6,00,000 9,00,000
(Units produced × ₹ 50)
Fixed manufacturing expenses 8,75,000 8,75,000
(Production Capacity: 25,000 units × ₹ 35)
Depreciation 3,75,000 3,75,000
(Production Capacity: 25,000 units × ₹ 15)
Gross Factory Cost 30,50,000 39,50,000
Add: Opening W.I.P. - 2,91,000

668
 [MANAGEMENT OF WORKING CAPITAL]

Less: Closing W.I.P. 2,91,000 3,99,000

Cost of goods produced 27,59,000 38,42,000
Add: Opening stock of finished goods - 4,59,833
(Year 1 : Nil; Year 2 : 2,000 units)
Cost of Goods available for sale 27,59,000 43,01,833
(Year 1: 12,000 units; Year 2: 20,000 units)
Less: Closing stock of finished goods at average
cost
(year 1: 2000 units, year 2 : 1000 units) (Cost of 4,59,833 2,13,444
Production × Closing stock/ units produced)
Cost of Goods Sold 22,99,167 40,88,389
Add: Selling expenses – Variable (Sales unit × ₹ 80,000 1,52,000
8)
Add: Selling expenses -Fixed (25,000 units × ₹ 2) 50,000 50,000
Cost of Sales : (B) 24,29,167 42,90,389
Profit (+) / Loss (-): (A - B) 70,833 4,59,611

Working Notes:

Calculation of Stock of Work-in-progress

Particulars Year 1 Year 2

(₹) (₹)
Raw Material (material cost × 15%) 1,80,000 2,70,000
Labour & Mfg. Expenses 88,500 1,06,500
(Labour & mfg. expenses × 15% × 40%)
Depreciation (Depreciation × 15% × 40%) 22,500 22,500
Total 2,91,000 3,99,000

1. Calculation of creditors for supply of materials:

Year 1 (₹) Year 2 (₹)

Materials consumed during the year 12,00,000 18,00,000
Add: Closing stock 2,00,000 3,00,000
(2 month‟s average consumption)
14,00,000 21,00,000
Less: Opening Stock - 2,00,000
Purchases during the year 14,00,000 19,00,000
Average purchases per month (Creditors) 1,16,667 1,58,333

669
 [MANAGEMENT OF WORKING CAPITAL]

2. Prepayment for expenses:

Year 1 (₹) Year 2 (₹)

Direct labour and variable expenses 6,00,000 9,00,000
Fixed manufacturing expenses 8,75,000 8,75,000
Selling expenses (variable + fixed) 1,30,000 2,02,000
Total 16,05,000 19,77,000
Average per month 1,33,750 1,64,750

(ii) Projected Statement of Working Capital Requirement (Cash Cost

Basis)

Year 1 (₹) Year 2 (₹)

(A) Current Assets
Inventories:
- Stock of Raw Material 2,00,000 3,00,000
(12,000 units ₹ 100 2/12);
(18,000 units ₹ 100 2/12)
- Finished Goods 4,01,083 1,92,611
(Refer working note 3)
- Work In Process 2,68,500 3,76,500
(Refer working note 5)
Receivables (Debtors) 2,66,927 4,84,684
(Refer working note 4)
Prepayment for Expenses 1,33,750 1,64,750
(Refer working note 2)
Minimum Cash balance 50,000 50,000
Total Current Assets/ Gross working 13,20,260 15,68,545
capital (A)
(B) Current Liabilities
Creditors for raw material 1,16,667 1,58,333
(Refer working note 1)
Total Current Liabilities 1,16,667 1,58,333
Net Working Capital (A – B) 12,03,594 14,10,212
Add: 10% contingency margin 1,20,359 1,41,021
Total Working capital required 13,23,953 15,51,233

Working Note:

3. Cash Cost of Production:

Year 1 (₹) Year 2 (₹)

Gross Factory Cost as per projected 30,50,000 39,50,000

670
 [MANAGEMENT OF WORKING CAPITAL]

Statement of P&L
Add: Opening W.I.P - 2,68,500
Less: Closing W.I.P 2,68,500 3,76,500
Cost of goods produced 27,81,500 38,42,000
Less: Depreciation (3,75,000) (3,75,000)
Cash Cost of Production 24,06,500 34,67,000
Add: Opening Stock at Average Cost: - 4,01,083
Cash Cost of Goods Available for sale 24,06,500 38,68,083
Less: Closing Stock at Avg. Cost 4,01,083 1,92,611
₹ 24,06,500 × 2,000
12,000
₹ 44,67,000 × 1,000
18,000
Cash Cost of Goods Sold 20,05,417 36,75,472

4. Receivables (Debtors)

Year 1 (₹) Year 2 (₹)

Cash Cost of Goods Sold 20,05,417 36,75,472
Add: Selling expenses – Variable 80,000 1,52,000
(Sales unit × ₹ 8)
Add: Selling expenses -Fixed 50,000 50,000
(25,000 units × ₹ 2)
Cash Cost of Debtors 21,35,417 38,77,472
Average Debtors 2,66,927 4,84,684

Calculation of Stock of Work-in-progress (Cash Cost Basis)

Particulars (₹)
Raw Material (material cost × 15%) 1,80,000 2,70,000
Labour & Mfg. Expenses 88,500 1,06,500
(Labour & mfg. expenses × 15% × 40%)
Total 2,68,500 3,76,500

Question – 25
Following are cost information of KG Ltd., which has commenced a new project
for an annual production of 24,000 units which is the full capacity:

Costs per unit (₹)

Materials 80.00
Direct labour and variable expenses 40.00
Fixed manufacturing expenses 12.00
Depreciation 20.00

671
 [MANAGEMENT OF WORKING CAPITAL]

Fixed administration expenses 8.00

160.00

The selling price per unit is expected to be ₹ 192 and the selling expenses ₹ 10
per unit, 80% of which is variable.

In the first two years of operations, production and sales are expected to be as
follows:

Year Production (No. of units) Sales (No. of units)

1 12,000 10,000
2 8,000 17,000

To assess the working capital requirements, the following additional

information is available:

(a) Stock of market 2 months of average consumption

(b) Work in progress NIL

(c) Debtors 2 month‟s average sales.

(d) Cash balance 1,00,000

(e) Creditors for supply 1 month‟s average purchase during the year.
of materials

(f) Creditor for expenses 1 month‟s average of all expenses during the
year.

PREPARE, for the two years:

(i) A projected statement of Profit/Loss (Ignoring taxation); and

(ii) A projected statement of working capital requirements

(RTP Nov – 2019)

Solution:

(i) Projected Statement of Profit / Loss

(Ignoring Taxation)

Year 1 Year 2
Production (Units) 12,000 18,000
Sales (Units) 10,000 17,000

672
 [MANAGEMENT OF WORKING CAPITAL]

(₹) (₹)
Sales revenue (A) (Sales unit × ₹ 192) 19,20,000 32,64,000
Cost of production:
Materials cost (Units produced × ₹ 80) 9,60,000 14,40,000
Direct labour and variable expenses (Units 4,80,000 7,20,000
produced × ₹ 40)
Fixed manufacturing expenses (Production 2,88,000 2,88,000
Capacity: 24,000 units × ₹ 12)
Depreciation (Production Capacity : 24,000 units 4,80,000 4,80,000
× ₹ 20)
Fixed administration expenses (Production 1,92,000 1,92,000
Capacity : 24,000 units × ₹ 8)
Total Costs of Production 24,00,000 31,20,000
Add: Opening stock of finished goods (Year 1 : --- 4,00,000
Nil; Year 2 : 2,000 units)
Cost of Goods available for sale (Year 1: 12,000 24,00,000 35,20,000
units; Year 2: 20,000 units)
Less: Closing stock of finished goods at average (4,00,000) (5,28,000)
cost (year 1: 2000 units, year 2 : 3000 units)
(Cost of Production × Closing stock/units
produced)
Cost of Goods Sold 20,00,000 29,92,000
Add: Selling expenses–Variable (Sales unit × ₹ 8) 80,000 1,36,000
Add: Selling expenses -Fixed (24,000 units × ₹ 2) 48,000 48,000
Cost of Sales : (B) 21,28,000 31,76,000
Profit (+) / Loss (-): (A - B) (-) 2,08,000 (+) 88,000

Working Notes:

1. Calculation of creditors for supply of materials:

Year 1 (₹) Year 2 (₹)

Materials consumed during the year 9,60,000 14,40,000
Add: Closing stock (2 month‟s average 1,60,000 2,40,000
consumption)
11,20,000 16,80,000
Less: Opening Stock --- 1,60,000
Purchases during the year 11,20,000 15,20,000
Average purchases per month (Creditors) 93,333 1,26,667

673
 [MANAGEMENT OF WORKING CAPITAL]

2. Creditors for expenses:

Year 1 (₹) Year 2 (₹)

Direct labour and variable expenses 4,80,000 7,20,000
Fixed manufacturing expenses 2,88,000 2,88,000
Fixed administration expenses 1,92,000 1,92,000
Selling expenses (variable + fixed) 1,28,000 1,84,000
Total 10,88,000 13,84,000
Average per month 90,667 1,15,333

(ii) Projected Statement of Working Capital requirements

Year 1 (₹) Year 2 (₹)

Current Assets:
Inventories:
- Stock of materials 1,60,000 2,40,000
(2 month‟s average consumption)

- Finished goods 4,00,000 5,28,000

Debtors 3,20,000 5,44,000
(2 month‟s average sales) (including profit)
Cash 1,00,000 1,00,000
Total Current Assets/ Gross working capital (A) 9,80,000 14,12,000
Current Liabilities:
Creditors for supply of materials 93,333 1,26,667
(Refer to working note 1)
Creditors for expenses (Refer to working note 2) 90,667 1,15,333
Total Current Liabilities: (B) 1,84,000 2,42,000
Estimated Working Capital Requirements: (A-B) 7,96,000 11,70,000

Question – 26
The management of Trux Company Ltd. is planning to expand its business and
consults you to prepare an estimated working capital statement. The records of
the company reveals the following annual information:

(₹)
Sales – Domestic at one month‟s credit 18,00,000
Export at three month‟s credit (sales price 10% below domestic 8,10,000
price)
Materials used (suppliers extend two months credit) 6,75,000
Lag in payment of wages – ½ month 5,40,000
Lag in payment of manufacturing expenses (cash) – 1 month 7,65,000

674
 [MANAGEMENT OF WORKING CAPITAL]

Lag in payment of Administration Expenses – 1 month 1,80,000

Selling expenses payable quarterly in advance 1,12,500
Income tax payable in four instalment‟s of which one falls in 1,68,000
the next financial year

Rate of gross profit is 20%. Ignore work-in-progress and depreciation.

The company keeps one month‟s stock of raw materials and finished goods
(each) and believes in keeping ₹ 2,50,000 available to it including the overdraft
limit of ₹ 75,000 not yet utilized by the company.

The management is also of the opinion to make 10% margin for contingencies
on computed figure.
You are required to PREPARE the estimated working capital statement for the
next year.

(RTP Nov – 2021)

Solution:

Preparation of Statement of Working Capital Requirement for Trux

Company Ltd.

(₹) (₹)
A. Current Assets
(i) Inventories:
Material (1 month)
₹ 6,75,000 56,250
× 1 month
₹ 12 month
Finished goods (1 month)
₹ 21,60,000 1,80,000 2,36,250
× 1 month
₹ 12 month
(ii) Receivables (Debtors)
For Domestic Sales
₹ 15,17,586 1,26,466
× 1 month
12 month
For Export Sales
₹ 7,54,914
× 3 month
12 month 1,88,729 3,15,195
(iii) Prepayment of Selling expenses
28,125

675
 [MANAGEMENT OF WORKING CAPITAL]

₹ 1,12,500
12 month
× 3 month
(iii) Cash in hand & at bank 1,75,000
Total Current Assets 7,54,570
B. Current Liabilities:
(i) Payables (Creditors) for materials (2 months)
₹ 6,75,000
12 month
× 2 month
1,12,500
(ii) Outstanding wages (0.5 months)
₹ 5,40,000 22,500
12 month
× 0.5 month
(iii) Outstanding manufacturing expenses
₹ 7,65,000
12 month
× 1 month
63,750
(iv) Outstanding administrative expense
₹ 1,80,000 15,000
12 month
× 1month
(v) Income tax payable 42,000
Total Current Liabilities 2,55,750
Net Working Capital (A – B) 4,98,820
Add: 10% contingency margin 49,882
Total Working Capital required 5,48,702

Working Notes:

1. Calculation of Cost of Goods Sold and Cost of Sales

Domestic (₹) Export (₹) Total (₹)

Domestic Sales 18,00,000 8,10,000 26,10,000
Less: Gross profit @ 20% on 3,60,000 90,000 4,50,000
domestic sales and 11.11% on
export sales (Working note-2)
Cost of Goods Sold 14,40,000 7,20,000 21,60,000
Add: Selling expenses 77,586 34,914 1,12,500
(Working note-3)
Cash Cost of Sales 15,17,586 7,54,914 22,72,500

2. Calculation of gross profit on Export Sales

676
 [MANAGEMENT OF WORKING CAPITAL]

Let domestic selling price is ₹ 100. Gross profit is ₹ 20, and then cost per
unit is ₹ 80

Export price is 10% less than the domestic price i.e. 100 – (1− 0.1) = 90

Now, gross profit will be = ₹ 90 − ₹ 80 = ₹ 10

₹ 10
So, Gross profit ratio at export price will be = × 100 = 11.11%
₹ 90

3. Apportionment of Selling expenses between Domestic and Exports

sales:

Apportionment on the basis of sales value:

₹ 1,12,500
Domestic Sales = × ₹ 18,00,000 = ₹ 77,586
₹ 26,10,000

₹ 1,12,500
Exports Sales = × ₹ 8,10,000 = ₹ 34,914
₹ 26,10,000

4. Assumptions

(i) It is assumed that administrative expenses is related to production

activities.

(ii) Value of opening and closing stocks are equal.

Question – 27
Trading and Profit and Loss Account of Beat Ltd. for the year ended 31st March,
2022 is given below:

Particulars Amount Amount Particulars Amount Amont (₹)

(₹) (₹) (₹)
To opening By 1,60,00,000
stock : Sales(Credit)
-Raw Materials 14,40,000
By Closing
-Work-in- 4,80,000 Stock:
progress
- Raw 16,00,00
- Finished 20,80,000 40,00,000 Materials
Goods
- Work-in 8,00,000
To Purchases 88,00,000 progress
(credit)
- Finished 48,00,000

677
 [MANAGEMENT OF WORKING CAPITAL]

To Wages Goods 24,00,000

24,00,000
To Production
Exp. 16,00,000
To Gross Profit
c/d 40,00,000

2,08,00,000 2,08,00,000
To By Gross
Administration 14,00,000 Profit b/d
Exp.
40,00,000
To Selling Exp.
6,00,000
To Net Profit
20,00,000
40,00,000
40,00,000

The opening and closing payables for raw materials were ₹ 16,00,000 and ₹
19,20,000 respectively whereas the opening and closing balances of receivables
were ₹ 12,00,000 and ₹ 16,00,000 respectively.

You are required to ASCERTAIN the working capital requirement by operating

cycle method.

(RTP Nov – 2022)

Solution:

Computation of Operating Cycle

(1) Raw Material Storage Period (R)

Raw Material Storage Period (R)

Average Stock of Raw Material

=
Daily Average Consumption of Raw material

(14,40,000 + 16,00,000) /2
= = 64.21 Days
86,40,000 /365

Raw Material Consumed = Opening Stock + Purchases – Closing Stock

= ₹ 14,40,000 + ₹ 88,00,000 – ₹ 16,00,000

678
 [MANAGEMENT OF WORKING CAPITAL]

= ₹ 86,40,000

(2) Conversion/Work-in-Process Period (W)

Average Stock of WIP

Conversion/Processing Period =
Daily Average Production cost

(4,80,000 + 8,00,000) /2
= = 18.96 days
1,23,20,000/365

Production Cost: ₹

Opening Stock of WIP 4,80,000

Add: Raw Material Consumed 86,40,000

Add: Wages 24,00,000

Add: Production Expenses 16,00,000

1,31,20,000

Less: Closing Stock of WIP 8,00,000

Production Cost 1,23,20,000

(3) Finished Goods Storage Period (F)

Average Stock of Finished Goods

Conversion/Processing Period =
Daily Average Cost of Good Sold

(20,80,000 + 24,00,000) /2
= = 68.13days
1,20,00,000/365

Cost of Goods Sold ₹

Opening Stock of Finished Goods 20,80,000

Add: Production Cost 1,23,20,000

1,44,00,000

Less: Closing Stock of Finished Goods (24,00,000)

679
 [MANAGEMENT OF WORKING CAPITAL]

1,20,00,000

(4) Receivables Collection Period (D)

Average Receivables
Receivables Collection Period =
Daily average credit sales

(12,00,000 + 16,00,000) /2
=
1,60,00,000/365

= 31.94 days

(5) Payables Payment Period (C)

Average Payables
Payables Payment Period =
Daily average credit purchase

(16,00,000 + 19,20,000) /2
= = 73 days
88,00,000/365

(6) Duration of Operating Cycle (O)

O = R+W+F+D–C

= 64.21 + 18.96 + 68.13 + 31.94 – 73

= 110.24 days

Computation of Working Capital

(i) Number of Operating Cycles per Year

= 365/Duration Operating Cycle = 365/110.24 = 3.311

(ii) Total Operating Expenses ₹

Total Cost of Goods sold 1,20,00,000

Add: Administration Expenses 14,00,000

Add: Selling Expenses 6,00,000

1,40,00,000

680
 [MANAGEMENT OF WORKING CAPITAL]

(iii) Working Capital Required

Total Operating Expenses

Working Capital Required =
Number of Operating Cycles per year

1,40,00,000
= = ₹ 42,28,329.81
3.311
Question – 28
The following information is provided by MNP Ltd. for the year ending 31st
March, 2020:

Raw Material storage period 45 days

Work-in-progress conversion period 20 days

Finished Goods storage period 25 days

Debt collection period 30 days

Creditors payment period 60 days

Annual Operating Cost ₹ 25,00,000

(Including Depreciation of ₹ 25,00,000)

Assume 360 days in a year.

You are required to calculate:

(i) Operating cycle period

(ii) Number of operating cycle in a year.

(iii) Amount of working capital required for the company on a cost basis.

(iv) The company is 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.

(Exam, Jan – 2021)

Solution:

681
 [MANAGEMENT OF WORKING CAPITAL]

(i) Calculation of Operating Cycle Period:

Operating Cycle Period = R + W + F + D – C

= 45 + 20 + 25 + 30 – 60 = 60 days

(ii) Number of Operating Cycle in a Year

360 360
= = =6
Operating cycle period 60

(iii) Amount of Working Capital Required

Annual operating cost ₹ 25,00,000 − ₹ 2,50,000

=
Number of operating cycle 6

₹ 22,50,000
= = ₹ 3,75,000
6

(iv) Reduction in Working Capital

Operating Cycle Period = R + W + F – C

= 45 + 20 + 25 – 60 = 30 days

₹ 22,50,000
Amount of Working Capital Required = × 30 = ₹ 1,87,500
360

Reduction in Working Capital = ₹ 3,75,000 – ₹ 1,87,500

= ₹ 1,87,500

Note: If we use Total Cost basis, then amount of Working Capital required will
be ₹ 4,16,666.67 (approx.) and Reduction in Working Capital will be
₹ 2,08,333.33 (approx.)

Question – 29
Day Ltd., a newly formed company has applied to the private Bank for the first
time for financing it‟s working Capital Requirements. The following information
are available about the projections for the current year :

Estimated Level of Activity Completed Units of Production 31200 plum

Unit of Work in Progress 12000
Raw Material Cost ₹ 40 per unit

682
 [MANAGEMENT OF WORKING CAPITAL]

Direct wages Cost ₹15 per unit

Overhead ₹ 40 per unit (inclusive of depreciation 10 per
unit)
Selling price ₹ 130 per unit
Raw Material is Stock Average 30 days consumption
Work in progress stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the 30 days
Suppliers
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in Payment) 15 days
Expected Cash Balance ₹ 2,00,000

Assume that production is carried on evenly throughout the year (360 days) and
wages and overheads accrue similarly. All sales are on the credit basis.

You are required to calculate the net working capital requirement on cash cost
basis.

(Exam, May – 2018)

Solution:

Calculation of Net Working Capital requirement:

(₹) (₹)
A. Current Assets:
Inventories:
Stock of Raw material
(Refer to Working note (iii) 1,44,000
Stock of Work in progress
(Refer to Working note (ii) 7,50,000
Stock of Finished goods
(Refer to Working note (iv) 20,40,000
Debtors for Sales
(Refer to Working note (v) 1,02,000
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases
(Refer to Working note (vi) 1,56,000
Creditors for wages
(Refer to Working note (vii) 23,250

683
 [MANAGEMENT OF WORKING CAPITAL]

1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750

Working Notes:

(i) Annual cost of production

(₹)
Raw material requirements 17,28,000
{(31,200 × ₹ 40) + (12,000 × ₹ 40)}
Direct wages {(31,200 × ₹ 15) + (12,000 × ₹ 15 × 0.5)} 5,58,000
Overheads (exclusive of depreciation) {(31,200 × ₹ 30) + 11,16,000
(12,000 × ₹ 30 × 0.5)}
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (₹ 40 + ₹ 7.5 + ₹15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods (20,40,000)
(₹ 26,52,000 × 24,000/31,200)
Total Cash Cost of Sales 6,12,000

(ii) Work in progress stock

(₹)
Raw material requirements (12,000 units × ₹40) 4,80,000
Direct wages (50% × 12,000 units × ₹ 15) 90,000
Overheads (50% × 12,000 units × ₹ 30) 1,80,000
7,50,000

(iii) Raw material stock

It is given that raw material in stock is average 30 days consumption.

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

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

₹ 17,28,000
Raw material stock = × 30 days = ₹ 1,44,000
360 days

684
 [MANAGEMENT OF WORKING CAPITAL]

(iv) Finished goods stock:

24,000 units @ ₹ (40+15+30) per unit = ₹ 20,40,000

60 days
(v) Debtors for sale: 6,12,000 × = ₹ 1,02,000
360 days

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

Annual Material Consumed (₹ 12,48,000 + ₹ 4,80,000) ₹ 17,28,000

Add: Closing stock of raw material ₹ 1,44,000

₹ 18,72,000

₹ 18,72,000
Credit allowed by suppliers = × 30 days = ₹ 1,56,000
360 days

(vii) Creditors for wages:

₹ 5,58,000
Outstanding wage payment = × 15 days = ₹ 23,250
360 days
Question – 30
Bita Limited manufactures used in the steel industry. The following information
regarding the company is given for your consideration :

(i) Expected level of production 9000 units per annum.

(ii) Raw materials are expected to remain in store for an average of two
months before issue to production.

(iii) Work-in progress (50 percent complete as to conversion cost) will

approximate to ½ month‟s production.

(iv) Finished goods remain is warehouse on an average for on months.

(v) Credit allowed by suppliers is one month.

(vi) Two month‟s credit is normally allowed to debtors.

(vii) A minimum cash balance of ₹ 67,500 is expected to be maintained.

(viii) Cash sales are 75 percent less than the credit sales.

(ix) Safety margin of 20 percent to cover unforeseen contingencies.

685
 [MANAGEMENT OF WORKING CAPITAL]

(x) The production pattern is assumed to be even during the year.

(xi) The cost structure for Bita Limited‟s product is as follows:

Raw Materials 80 per unit

Direct Lobour 20 per unit

Overheads (including depreciation) 80 per unit

Total Cost 180 per unit

Profit 20 per unit

Selling Price 200 per unit

You are required to estimate the working capital requirement of Bita

limited.
(Exam, May – 2019)

Solution:

Statement showing Estimate of Working Capital Requirement

(Amount (Amount
in ₹) in ₹)
A. Current Assets
(i) Inventories:
- Raw material inventory 1,20,000
9,000 unit × ₹ 80
× 2 months
12 months
- Work in Progress:
Raw material
9,000 unit × ₹ 80
× 0.5 months 30,000
12 months
Wages
9,000 unit × ₹ 20
× 0.5 months × 50% 3,750
12 months
Overheads
9,000 unit × ₹ 60
× 0.5 months × 50% 11,250 45,000
12 months
(Other than Depreciation)
Finished goods (inventory held for 1 1,20,000

686
 [MANAGEMENT OF WORKING CAPITAL]

months)
9,000 unit × ₹ 160
× 1 months
12 months
(ii) Debtors (for 2 months) 1,92,000
9,000 unit × ₹ 160
× 2 months × 80% or
12 months
11,52,000
× 2 months
12 months
(iii) Cash balance expected 67,500
Total Current assets 5,44,500
B. Current Liabilities
(i) Creditors for Raw material (1month) 60,000
9,000 unit × ₹ 80
× 1 months
12 months
Total current liabilities 60,000
Net working capital (A – B) 4,84,500
Add: Safety margin of 20 percent 96,900
Working capital Requirement 5,81,400

Working Notes:

1. If Credit sales is x then cash sales is x-75% of x i.e. x/4.

Or x + 0.25x = ₹ 18,00,000

Or x = ₹ 14,40,000

So, credit Sales is ₹ 14,40,000

₹ 14,40,000
Hence, Cash cost of credit sales ×4 = ₹ 11,52,000
5

2. It is assumed that safety margin of 20% is on net working capital.

3. No information is given regarding lag in payment of wages, hence ignored

assuming it is paid regularly.

4. Debtors/Receivables is calculated based on total cost.

[If Debtors/Receivables is calculated based on sales, then debtors will be

9,000 unit × ₹ 200 ₹ 14,40,000

× 2 months × 80% or × 2 months
12 months 12 months

687
 [MANAGEMENT OF WORKING CAPITAL]

= ₹ 2,40,000

Then Total Current assets will be ₹ 5,92,500 and accordingly Net working
capital and Working capital requirement will be ₹ 5,32,500 and ₹
6,39,000 respectively].

Question – 31
Balance sheet of X Ltd for the year ended 31st March, 2022 is given below :

Liabilities Amount Assets Amount

Equity shares ₹ 10 each 200 Fixed Assets 500
Retained earnings 200 Raw materials 150
11% Debentures 300 W.I.P 100
Public deposits (short-Term) 100 Finished goods 50
Trade Creditors 80 Debtors 125
Bill payable 100 Cash/Back 55

980 980

Calculate the amount of maximum permissible back finance under three

methods as per Tandon Committee lending norms.

The total core current assets are assumed to be ₹ 30 lakhs.

(Exam, May – 2022)

Solution:

Current Assets = 150 + 100 + 50 + 125 + 55 = ₹ 480 Lakhs

Current Liabilities = 100 + 80 + 100 = ₹ 280 Lakhs

Maximum Permissible Banks Finance under Tandon Committee Norms:

Method I

Maximum Permissible Bank Finance

= 75% of (Current Assets – Current Liabilities)

= 75% of (480 − 280)

= 150 Lakhs

Method II

688
 [MANAGEMENT OF WORKING CAPITAL]

Maximum Permissible Bank Finance

= 75% of Current Assets – Current Liabilities

= 75 % of 480 – 280

= 80 Lakhs

Method III

Maximum Permissible Bank Finance

= 75% of (Current Assets – Core Current Assets) – Current Liabilities

= 75 % of (480 - 30) – 280

= 57.5 Lakhs

Question – 32
PK Ltd., a manufacturing company, provides the following information:

(₹)
Sales 1,08,00,000
Raw Material Consumed 27,00,000
Labour Paid 21,60,000
Manufacturing Overhead 32,40,000
(Including Depreciation for the year ₹ 3,60,000)
Administrative & Selling Overhead 10,80,000

Additional Information:

(a) Receivables are allowed 3 month‟s credit.

(b) Raw material supplier extends 3 month‟s credit.

(c) Lag in payment of Labour is 1 month.

(d) Manufacturing overhead are paid one month in arrear.

(e) Administrative & Selling Overhead is paid one month advance.

(f) Inventory holding period of Raw Material & Finished Goods are of 3
months.

(g) Work-in-Progress is Nil.

689
 [MANAGEMENT OF WORKING CAPITAL]

1
(h) PK Ltd. sells goods at Cost plus 33 %.
3

(i) Cash balance ₹ 3,00,000.

(j) Safety Margin 10%.

You are required to compute the Working Capital Requirements of PK Ltd. on

Cash Cost basis.

(Exam Nov – 2020)

Solution:

Statement showing the requirements of Working Capital (Cash Cost basis)

Particulars (₹) (₹)

A. Current Assets:
Inventory:
Stock of Raw material (₹ 27,00,000 × 3/12) 6,75,000
Stock of Finished goods (₹ 77,40,000 × 3/12) 19,35,000
Receivables (₹ 88,20,000 × 3/12) 22,05,000
Administrative and Selling Overhead 90,000
(₹ 10,80,000 × 1/12)
Cash in Hand 3,00,000

Gross Working Capital 52,05,000 52,05,000

B. Current Liabilities:
Payables for Raw materials* (₹ 27,00,000 × 3/12) 6,75,000
Outstanding Expenses:
Wages Expenses (₹ 21,60,000 × 1/12) 1,80,000
Manufacturing Overhead (₹ 28,80,000 × 1/12) 2,40,000

Total Current Liabilities

Net Working Capital (A-B) 10,95,000 10,95,000
Add: Safety margin @ 10% 41,10,000
Total Working Capital requirements 4,11,000

690
 [MANAGEMENT OF WORKING CAPITAL]

45,21,000

Working Notes:

(i)

(A) Computation of Annual Cash Cost of Production (₹)

Raw Material consumed 27,00,000
Wages (Labour paid) 21,60,000
Manufacturing overhead (₹ 32,40,000 - ₹ 3,60,000) 28,80,000
Total cash cost of production 77,40,000
(B) Computation of Annual Cash Cost of Sales (₹)
Cash cost of production as in (A) above 77,40,000
Administrative & Selling overhead 10,80,000
Total cash cost of sales 88,20,000

*Purchase of Raw material can also be calculated by adjusting Closing Stock

and Opening Stock (assumed nil). In that case Purchase will be Raw material
consumed + Closing Stock-Opening Stock i.e ₹ 27,00,000 + ₹ 6,75,000 - Nil = ₹
33,75,000. Accordingly, Total Working Capital requirements (₹ 43,35,375) can
be calculated.

Question – 33
X Ltd. has furnished following cost sheet of per unit cost;

Raw material cost ₹ 150

Direct labour cost ₹ 40

Overhead cost ₹ 60

Total Cost ₹ 250

Profit ₹ 50

Selling Price ₹ 300

The company keeps raw material in stock on an average for 2 months; work in
progress on an average for 3 months and finished goods in stock on an average
1 month. The credit allowed by suppliers is 1.5 months and company allows 2
months credit to its debtors. The lag in payment of wages is 1 month and lag in
payment of overhead expenses is 1.5 months. The company sells 25% of the
output against cash and maintain cash in hand at bank put together at ₹

691
 [MANAGEMENT OF WORKING CAPITAL]

1,50,000. Production is carried on evenly throughout the year and wages and
overheads also similarly. Work in progress stock is 75% complete in all
respects. Prepare statement showing estimate of working capital requirements
to finance an activity level of 15,000 units of production.

(Exam, Nov – 2023)

Solution:

Statement showing Estimate of Working Capital Needs

(Receivables (Debtors) are calculated based on Cost of goods sold)

(₹) (₹)
A. Current Assets
(i) Inventories:
Raw material (2 months) 3,75,000
15,000 units × ₹ 150
× 2 months
12 months
WIP Inventory (3 months) 7,03,125
15,000 units × ₹ 250
× 3 months × 0.75
12 months
Finished goods inventory (1 months) 3,12,500 13,90,625
15,000 units × ₹ 250
× 1 months
12 months
Receivables (Debtors) (2 months)
(ii) 15,000 units × ₹ 250 4,68,750
× 2 months × 0.75
12 months
(iii) Cash and bank balance 1,50,000
Total Current Assets 20,09,375
B. Current Liabilities:
(i) Payables (Creditors) for materials (1.5 months)
15,000 units × ₹ 150
× 1.5 months × 0.75 2,81,250
12 months
(ii) Outstanding wages (1 months) 50,000
15,000 units × ₹ 40
× 1months
12 months
(iii) Outstanding overheads (1.5 months)
15,000 units × ₹ 60
× 1.5 months 1,12,500
12 months
Total Current Liabilities 4,43,750
Net Working Capital Needs (A – B) 15,65,625

692
 [MANAGEMENT OF WORKING CAPITAL]

Alternative Solution

Statement showing Estimate of Working Capital Needs

(Receivables (Debtors) are calculated based on Selling price)

(₹) (₹)
A. Current Assets
(i) Inventories:
Raw material (2 months)
15,000 units × ₹ 150 3,75,000
× 2 months
12 months
WIP Inventory (3 months)
15,000 units × ₹ 250
× 3 months × 0.75 7,03,125
12 months
Finished goods inventory (1 months)
15,000 units × ₹ 250 3,12,500 13,90,625
× 1 months
12 months
(ii) Receivables (Debtors) (2 months)
15,000 units × ₹ 300
× 2 months × 0.75 5,62,500
12 months
(iii) Cash and bank balance 1,50,000
Total Current Assets 21,03,125
B. Current Liabilities:
(i) Payables (Creditors) for materials (1.5 months)
15,000 units × ₹ 150
× 1.5 months 2,81,250
12 months
(ii) Outstanding wages (1 months) 50,000
15,000 units × ₹ 40
× 1months
12 months
(iii) Outstanding overheads (1.5 months)
15,000 units × ₹ 60
× 1.5 months 1,12,500
12 months
Total Current Liabilities 4,43,750
Net Working Capital Needs (A – B) 16,59,375

(2) DEBTORS MANAGEMENT

Question – 34
The following information is available in respect of Sai trading company:

693
 [MANAGEMENT OF WORKING CAPITAL]

(i) On an average, debtors are collected after 45 days; inventories have an

average holding period of 75 days and creditor‟s payment period on an
average is 30 days.

(ii) The firm spends a total of ₹ 120 lakhs annually at a constant rate.

(iii) It can earn 10 per cent on investments.

From the above information, you are required to CALCULATE:

(a) The cash cycle and cash turnover,

(b) Minimum amounts of cash to be maintained to meet payments as they

become due,

(c) Savings by reducing the average inventory holding period by 30 days.

(Study Material ICAI Illus – 11)

Solution:

(a) Cash cycle = 45 days + 75 days – 30 days = 90 days (3 months)

Cash turnover = 12 months (360 days)/3 months (90 days) = 4.

(b) Minimum operating cash = Total operating annual outlay/cash turnover,

that is, ₹ 120 lakhs/4 = ₹ 30 lakhs.

(c) Cash cycle = 45 days + 45 days – 30 days = 60 days (2 months).

Cash turnover = 12 months (360 days)/2 months (60 days) = 6.

Minimum operating cash = ₹ 120 lakhs/6 = ₹ 20 lakhs.

Reduction in investments = ₹ 30 lakhs – ₹ 20 lakhs = ₹ 10 lakhs.

Savings = 0.10 × ₹ 10 lakhs = ₹ 1 lakh.

Question – 35
A trader whose current sales are in the region of ₹ 6 lakhs per annum and an
average collection period of 30 days wants to pursue a more liberal policy to
improve sales. A study made by a management consultant reveals the following
information:-

Credit Policy Increase in Increase in sales Present default

collection period anticipated

694
 [MANAGEMENT OF WORKING CAPITAL]

A 10 days ₹ 30,000 1.5%

B 20 days ₹ 48,000 2%
C 30 days ₹ 75,000 3%
D 40 days ₹ 90,000 4%

The selling price per unit is ₹ 3. Average cost per unit is 2.25 and variable costs
per unit are ₹ 2. The current bad debt loss is 1%. Required return on additional
investment is 20%. Assume a 360 days year.

Which of the above policies would you recommend for adoption?

(Study Material ICAI Illus – 12)

Solution:

A. Statement showing the Evaluation of Debtors Policies (Total Approach)

Particulars Present Proposed Proposed Proposed Proposed

Policy Policy A Policy B Policy C Policy D
30 days 40 days 50 days 60 days 75 days
₹ ₹ ₹ ₹ ₹
A. Expected Profit:
(a) Credit Sales 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
(b) Total Cost other
than Bad Debts
(i) Variable Cost 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
[Sales × 2/3]
(ii) Fixed Costs 50,000 50,000 50,000 50,000 50,000
4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
(c) Bad Debts 6,000 9,450 12,960 20,250 27,600
(d) Expected Profit 1,44,000 1,50,550 1,53,040 1,54,750 1,52,400
[(a) – (b) – (c)]
B. Opportunity Cost 7,500 10,444 13,389 16,667 21,250
of Investments in
Receivables
C. Net Benefits 1,36,500 1,40,106 1,39,651 1,38,083 1,31,150
(A – B)

Recommendation: The Proposed Policy A (i.e. increase in collection period by

10 days or total 40 days) should be adopted since the net benefits under this
policy are higher as compared to other policies.

Working Notes:

(i) Calculation of Fixed Cost

695
 [MANAGEMENT OF WORKING CAPITAL]

= [Average Cost per unit – Variable Cost per unit] × No. of Units sold

= [₹ 2.25 - ₹ 2.00] × (₹ 6,00,000/3)

= ₹ 0.25 × 2,00,000 = ₹ 50,000

(ii) Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return

Opportunity Cost = Total Cost × ×
360 100

30 20
Present Policy = 4,50,000 × × = 7,500
360 100

40 20
Policy A = 4,70,000 × × = 10,444
360 100

50 20
Policy B = 4,82,000 × × = 13,389
360 100

60 20
Policy C = 5,00,000 × × = 16,667
360 100

75 20
Policy D = 5,10,000 × × = 21,250
360 100

B. Another method of solving the problem is Incremental Approach. Here

we assume that sales are all credit sales.

Particulars Present Proposed Proposed Proposed Proposed

Policy Policy A Policy B Policy C Policy D
30 days 40 days 50 days 60 days 75 days
₹ ₹ ₹ ₹ ₹
A. Incremental
Expected Profit:
(a) Incremental --- 30,000 48,000 75,000 90,000
Credit Sales
(b) Incremental
Costs
(i) Variable --- 20,000 32,000 50,000 60,000
Costs
(ii)Fixed Costs --- - - - -
(c) Incremental --- 3,450 6,960 14,250 21,600
Bad Debt
Losses

696
 [MANAGEMENT OF WORKING CAPITAL]

(d) Incremental 6,550 9,040 10,750 8,400

Expected Profit
(a – b –c)]
B. Required Return on
Incremental
Investments:
(a) Cost of Credit 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
Sales
(b) Collection 30 40 50 60 75
period
(c) Investment in 37,500 52,222 66,944 83,333 1,06,250
Receivable
(a × b/360)
(d) Incremental --- 14,722 29,444 45,833 68,750
Investment in
Receivables
(e) Required Rate 20 20 20 20
of Return (in %)
(f) Required --- 2,944 5,889 9,167 13,750
Return on
Incremental
Investments
(d × e)
C. Net Benefits (A – B) --- 3,606 3,151 1,583 - 5,350

Recommendation: The Proposed Policy A should be adopted since the

net benefits under this policy are higher than those under other policies.

C. Another method of solving the problem is by computing the Expected

Rate of Return.

Incremental Expected Profit

Expected Rate of Return = × 100
Incremental Investment in Receivables

₹ 6,550
For Policy A = × 100 = 44.49%
₹ 14,722

₹ 9,040
For Policy B = × 100 = 30.70%
₹ 29,444

₹ 10,750
For Policy C = × 100 = 23.45%
₹ 45,833

₹ 8,440
For Policy D = × 100 = 12.22%
₹ 68,750

697
 [MANAGEMENT OF WORKING CAPITAL]

Recommendation: The Proposed Policy A should be adopted since the

Expected Rate of Return (44.49%) is more than the Required Rate of Return
(20%) and is highest among the given policies compared.

Question – 36
XYZ Corporation is considering relaxing its present credit policy and is in the
process of evaluating two proposed policies. Currently, the firm has annual
credit sales of ₹ 50 lakhs and accounts receivable turnover ratio of 4 times a
year. The current level of loss due to bad debts is ₹ 1,50,000. The firm is
required to give a return of 25% on the investment in new accounts receivables.
The company‟s variable costs are 70% of the selling price. Given the following
information, which is the better option?

Present Policy Policy

Policy Option I Option II
Annual credit sales 50,00,000 60,00,000 67,50,000
Accounts receivable turnover ratio 4 times 3 times 2.4 times
Bad debt losses 1,50,000 3,00,000 4,50,000
Bad debt losses 1,50,000 3,00,000 4,50,000

(Study Material ICAI Illus – 13)

Solution:

Statement showing the Evaluation of Debtors Policies

Particulars Present Proposed Proposed

Policy Policy I Policy II
₹ ₹ ₹
A Expected Profit:
(a) Credit Sales 50,00,000 60,00,000 67,50,000
(b) Total Cost other than Bad
Debts:
(i) Variable Costs 35,00,000 42,00,000 47,25,000
(c) Bad Debts 1,50,000 3,00,000 4,50,000
(d) Expected Profit 13,50,000 15,00,000 15,75,000
[(a) – (b) – (c)]
B Opportunity Cost of 2,18,750 3,50,000 4,92,188
Investments in Receivables
C Net Benefits (A – B) 11,31,250 11,50,000 10,82,812

Recommendation: The Proposed Policy I should be adopted since the net

benefits under this policy are higher as compared to other policies.

698
 [MANAGEMENT OF WORKING CAPITAL]

Working Note: Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return

Opportunity Cost = Total Cost × ×
12 100

Collection Period in months = 12 / Accounts Receivable Turnover Ratio

Present Policy = ₹ 35,00,000 × 3/12 × 25% = ₹ 2,18,750

Proposed Policy I = ₹ 42,00,000 × 4/12 × 25% = ₹ 3,50,000

Proposed Policy II = ₹ 47,25,000 × 5/12 × 25% = ₹ 4,92,188

Question – 37
A company is presently having credit sales of ₹ 12 lakh. The existing credit
terms are 1/10, net 45 days and average collection period is 30 days. The
current bad debts loss is 1.5%. In order to accelerate the collection process
further as also to increase sales, the company is contemplating liberalization of
its existing credit terms to 2/10, net 45 days. It is expected that sales are likely
to increase by 1/3 of existing sales, bad debts increase to 2% of sales and
average collection period to decline to 20 days. The contribution to sales ratio
of the company is 22% and opportunity cost of investment in receivables is 15
percent (pre-tax). 50 per cent and 80 percent of customers in terms of sales
revenue are expected to avail cash discount under existing and liberalization
scheme respectively. The tax rate is 30%.

ADVISE, should the company change its credit terms? (Assume 360 days in a
year).

(Study Material ICAI Illus – 14)

Solution:

Working Notes:

(i) Calculation of Cash Discount

Cash Discount = Total credit sales × % of customers who take up

discount × Rate

12,00,000 × 50 × .01
Present Policy = = ₹ 6,000
100

Proposed Policy = 16,00,000 × 0.80 × 0.02 = ₹ 25,600

699
 [MANAGEMENT OF WORKING CAPITAL]

(ii) Opportunity Cost of Investment in Receivables

Present Policy = 9,36,000 × (30/360) × (70% of 15)/100 = 78,000 ×

10.5/100 = ₹ 8,190

Proposed Policy = 12,48,000 × (20/360) × 10.50/100 = ₹ 7,280

Statement showing Evaluation of Credit Policies

Particulars Present Proposed

Policy Policy

Credit Sales 12,00,000 16,00,000

Variable Cost @ 78%* of sales 9,36,000 12,48,000

Bad Debts @ 1.5% and 2% 18,000 32,000

Cash Discount 6,000 25,600

Profit before tax 2,40,000 2,94,400

Tax @ 30% 72,000 88,320

Profit after Tax 1,68,000 2,06,080

Opportunity Cost of Investment in Receivables 8,190 7,280

Net Profit 1,59,810 1,98,800

*Only relevant or variable costs are considered for calculating the

opportunity costs on the funds blocked in receivables. Since 22% is
contribution, hence the relevant costs are taken to be 78% of the
respective sales.

Advise: Proposed policy should be adopted since the net benefit is

increased by (₹1,98,800 − ₹1,59,810) ₹ 38,990.

Question – 38
Mosaic Limited has current sales of ₹ 15 lakhs per year. Cost of sales is 75 per
cent of sales and bad debts are one per cent of sales. Cost of sales comprises
80 per cent variable costs and 20 per cent fixed costs, while the company‟s
required rate of return is 12 per cent. Mosaic Limited currently allows
customers 30 days‟ credit, but is considering increasing this to 60 days‟ credit
in order to increase sales.

700
 [MANAGEMENT OF WORKING CAPITAL]

It has been estimated that this change in policy will increase sales by 15 per
cent, while bad debts will increase from one per cent to four per cent. It is not
expected that the policy change will result in an increase in fixed costs and
creditors and stock will be unchanged.

Should Mosaic Limited introduce the proposed policy? (Assume a 360 days
year)

(Study Material ICAI Illus – 16)

Solution:

New level of sales will be 15,00,000 × 1.15 = ₹ 17,25,000

Variable costs are 80% × 75% = 60% of sales

Contribution from sales is therefore 40% of sales

Fixed Cost are 20% × 75% = 15% of sales

Particulars ₹ ₹
Proposed investment in debtors
= Variable Cost + Fixed Cost *
= (17,25,000 × 60%) + (15,00,000 × 15%)
60
= (10,35,000 + 2,25,000) × 2,10,000
360
Current investment in debtors
30
= [(15,00,000 × 60%) + (15,00,000 × 15%)] × 93,750
360
Increase in investment in debtors 1,16,250
Increase in contribution = 15% × 15,00,000 × 40% 90,000
New level of bad debts = (17,25,000 × 4%) 69,000
Current level of bad debts = (15,00,000 × 1%) 15,000
Increase in bad debts (54,000)
Additional financing costs = 1,16,250 × 12% = (13,950)
Savings by introducing change in policy 22,050

*Fixed cost is taken at existing level in case of proposed investment as well

Advise: Mosaic Limited should introduce the proposed policy.

Question – 39
PQR Ltd. having an annual sales of ₹ 30 lakhs, is re-considering its present
collection policy. At present, the average collection period is 50 days and the

701
 [MANAGEMENT OF WORKING CAPITAL]

bad debt losses are 5% of sales. The company is incurring an expenditure of ₹

30,000 on account of collection of receivables. Cost of funds is 10 percent.

The alternative policies are as under:

Alternative I Alternative II
Average Collection Period 40 days 30 days
Bad Debt Losses 4% of sales 3% of sales
Collection Expenses ₹ 60,000 ₹ 95,000

DETERMINE the alternatives on the basis of incremental approach and state

which alternative is more beneficial.

(Study Material ICAI TYK – 11)

Solution:

Evaluation of Alternative Collection Programmes

Present Alternative Alternative

Policy I II
₹ ₹ ₹
Sales Revenues 30,00,000 30,00,000 30,00,000
Average Collection Period (ACP) (days) 50 40 30
ACP 4,16,667 3,33,333 2,50,000
Receivables (₹) Sales ×
360
Reduction in Receivables from - 83,334 1,66,667
Present Level (₹)
Savings in Interest @ 10% p.a. (A) − ₹ 8,333 ₹ 16,667
% of Bad Debt Loss 5% 4% 3%
Amount (₹) 1,50,000 1,20,000 90,000
Reduction in Bad Debts from Present − 30,000 60,000
Level (B)
Incremental Benefits from Present − 38,333 76,667
Level (C) = (A) + (B)
Collection Expenses (₹) 30,000 60,000 95,000
Incremental Collection Expenses from − 30,000 65,000
Present Level (D)
Incremental Net Benefit (C – D) − ₹ 8,333 ₹ 11,667

Conclusion: From the analysis it is apparent that Alternative I has a benefit of

₹ 8,333 and Alternative II has a benefit of ₹ 11,667 over present level.

702
 [MANAGEMENT OF WORKING CAPITAL]

Alternative II has a benefit of ` 3,334 more than Alternative I. Hence Alternative

II is more viable.

(Note: In absence of Cost of Sales, sales has been taken for purpose of
calculating investment in receivables. 1 year = 360 days.)

Question – 40
As a part of the strategy to increase sales and profits, the sales manager of a
company proposes to sell goods to a group of new customers with 10% risk of
non-payment. This group would require one and a half months credit and is
likely to increase sales by ₹ 1,00,000 p.a. Production and Selling expenses
amount to 80% of sales and the income-tax rate is 50%. The company‟s
minimum required rate of return (after tax) is 25%.

Should the sales manager‟s proposal be accepted? ANALYSE

Also COMPUTE the degree of risk of non-payment that the company should be
willing to assume if the required rate of return (after tax) were (i) 30%, (ii) 40%
and (iii) 60%.

(Study Material ICAI TYK – 12)

Solution:

Statement showing the Evaluation of Proposal

Particulars ₹
A. Expected Profit:
Net Sales 1,00,000
Less: Production and Selling Expenses @ 80% (80,000)
Profit before providing for Bad Debts 20,000
Less: Bad Debts @10% (10,000)
Profit before Tax 10,000
Less: Tax @ 50% (5,000)
Profit after Tax 5,000
B. Opportunity Cost of Investment in Receivables (2,500)
C. Net Benefits (A – B) 2,500

Advise: The sales manager‟s proposal should be accepted.

Working Note: Calculation of Opportunity Cost of Funds

Opportunity Cost

703
 [MANAGEMENT OF WORKING CAPITAL]

Collection Period Required Rate of Return

= Total Cost of Credit Sales × ×
12 100

1.5 25
= ₹ 80,000 × × = ₹ 2,500
12 100

Statement showing the Acceptable Degree of Risk of Non-payment

Particulars Required Rate of Return

30% 40% 60%
Sales 1,00,000 1,00,000 1,00,000
Less: Production and 80,000 80,000 80,000
Sales Expenses
Profit before providing 20,000 20,000 20,000
for Bad Debts
Less: Bad Debts X X X
(assume X)
Profit before tax 20,000 – X 20,000 – X 20,000 – X
Less: Tax @ 50% (20,000 – X) 0.5 (20,000 – X) 0.5 (20,000 – X) 0.5
Profit after Tax 10,000 –0.5X 10,000 –0.5X 10,000 –0.5X
Required Return (given) 30% of 10,000* 40% of 10,000* 60% of 10,000*
= ₹ 3,000 = ₹ 4,000 = ₹ 6,000

Collection Period
*Average Debtors = Total Cost of Credit Sales ×
12

1.5
= ₹ 80,000 × = ₹ 10,000
12

Computation of the value and percentage of X in each case is as follows:

Case I 10,000 – 0.5x = 3,000

0.5x = 7,000

X = 7,000/0.5 = ₹ 14,000

Bad Debts as % of sales = ₹ 14,000/₹ 1,00,000 × 100 = 14%

Case II 10,000 – 0.5x = 4,000

0.5x = 6,000

X = 6,000/0.5 = ₹ 12,000

704
 [MANAGEMENT OF WORKING CAPITAL]

Bad Debts as % of sales = ₹ 12,000/₹ 1,00,000 × 100 = 12%

Case III 10,000 – 0.5x = 6,000

0.5x = 4,000

X = 4,000/0.5 = ₹ 8,000

Bad Debts as % of sales = ₹ 8,000/₹ 1,00,000 × 100 = 8%

Thus, it is found that the Acceptable Degree of risk of non-payment is 14%,

12% and 8% if required rate of return (after tax) is 30%, 40% and 60%
respectively.

Question – 41
Slow Payers are regular customers of Goods Dealers Ltd. and have approached
the sellers for extension of credit facility for enabling them to purchase goods.
On an analysis of past performance and on the basis of information supplied,
the following pattern of payment schedule emerges in regard to Slow Payers:

Pattern of Payment Schedule

At the end of 30 days 15% of the bill
At the end of 60 days 34% of the bill
At the end of 90 days 30% of the bill
At the end of 100 days 20% of the bill
Non-recovery 1% of the bill

Slow Payers want to enter into a firm commitment for purchase of goods of ₹ 15
lakhs in 2021-22, deliveries to be made in equal quantities on the first day of
each quarter in the calendar year. The price per unit of commodity is ₹ 150 on
which a profit of ₹ 5 per unit is expected to be made. It is anticipated by Goods
Dealers Ltd., that taking up of this contract would mean an extra recurring
expenditure of ₹ 5,000 per annum. If the opportunity cost of funds in the
hands of Goods Dealers is 24% per annum, would you as the finance manager
of the seller recommend the grant of credit to Slow Payers? ANALYSE.
Workings should form part of your answer. Assume year of 365 days.

(Study Material ICAI TYK – 13)

Solution:

Statement showing the Evaluation of Debtors Policies

705
 [MANAGEMENT OF WORKING CAPITAL]

Particulars Proposed
Policy ₹
A. Expected Profit:
(a) Credit Sales 15,00,000
(b) Total Cost
(i) Variable Cost 14,50,000
(ii) Recurring Costs 5,000
14,55,000
(c) Bad Debts 15,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investment in Receivables 68,787
C. Net Benefits (A – B) (38,787)

Recommendation: The Proposed Policy should not be adopted since the net
benefits under this policy are negative

Working Note: Calculation of Opportunity Cost of Average Investments

Collection Period Rate of Return

Opportunity Cost = Total Cost × ×
365 100

Particulars 15% 34% 30% 20% Total

A. Total Cost 2,18,250 4,94,700 4,36,500 2,91,000 14,40,450
B. Collection 30/365 60/365 90/365 100/365
Period
C. Required Rate 24% 24% 24% 24%
of Return
D. Opportunity 4,305 19,517 25,831 19,134 68,787
Cost (A×B×C)

Question – 42
Avesh Pvt. Ltd. is considering relaxing its present credit policy for accounts
receivable and is in the process of evaluating two proposed policies. Currently,
the company has annual credit sales of ₹ 55 lakhs and accounts receivable
turnover ratio of 5 times a year. The current level of loss due to bad debts is ₹
2,00,000. The company is required to give a return of 15% on the investment in
new accounts receivable. The company‟s variable costs are 75% of the selling
price. Given the following information, IDENTIFY which is the better policy?

(Amountin₹)

Particular Present Proposed Proposed

Policy Policy - 1 Policy - 2

706
 [MANAGEMENT OF WORKING CAPITAL]

Annual credit sales 55,00,000 65,00,000 70,00,000

Account receivable turnover ratio 5 times 3 times 4 times
Bad debt losses 2,00,000 3,50,000 5,00,000

(MTP October – 2022)

Solution:

Statement showing the Evaluation of Accounts Receivable Policies

(Amount in ₹)

Particulars Present Present Present

Policy Policy Policy
1 2
A Expected Profit:
(a) Credit Sales 55,00,000 65,00,000 70,00,000
(b) Total Cost other than Bad
Debts:
(i) Variable Costs (75%) 41,25,000 48,75,000 52,50,000
(c) Bad Debts 2,00,000 3,50,000 5,00,000
(d) Expected Profit 11,75,000 12,75,000 12,50,000
[(a) (b) (c)]
B Opportunity Cost of Investments in 1,23,750 1,82,813 2,62,500
Accounts Receivable (Working Note)
C Net Benefits (A – B) 10,51,250 10,92,187 9,87,500

Recommendation: The Proposed Policy 1 should be adopted since the net

benefits under this policy are higher as compared to other policies.

Working Note:

Calculation of Opportunity Cost of Average Investments

Opportunity Cost = Total Cost × Collection period/12 × Rate of Return/100

Present Policy = ₹ 41,25,000 × 2.4/12 × 15% = ₹ 1,23,750
Proposed Policy 1 = ₹ 48,75,000 × 3/12 × 15% = ₹ 1,82,813
Proposed Policy 2 = ₹ 52,50,000 × 4/12 × 15% = ₹ 2,62,500

707
 [MANAGEMENT OF WORKING CAPITAL]

Question – 43
A Ltd. is in the manufacturing business and it acquires raw material from X
Ltd. on a regular basis. As per the terms of agreement the payment must be
made within 40 days of purchase. However, A Ltd. has a choice of paying ₹
98.50 per ₹ 100 it owes to X Ltd. on or before 10th day of purchase.

Required:

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

(RTP May – 2018)

Solution:

Annual Benefit of accepting the Discount

₹ 1.5 365 days

× = 18.53%
₹ 100 - ₹1.50 40-10 days

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

If average invoice amount is ₹ 10,00,000

If discount is
Accepted (₹) Not Accepted (₹)
Payment to Supplier (₹) 9,85000 10,00,000
Return on investment of ₹ 9,85,000 for (12,144)
30 days {₹ 9,85,000 × (30/365) × 15%}
9,85,000 9,87,856

Thus, from above table it can be seen that it is cheaper to accept the discount.

Question – 44
TM Limited, a manufacturer of colour TV sets is considering the liberalization
of existing credit terms to three of their large customers A, B and C. The credit
period and likely quantity of TV sets that will be sold to the customers in
addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 10,000 10,000 -

708
 [MANAGEMENT OF WORKING CAPITAL]

30 10,000 15,000 -
60 10,000 20,000 10,000
90 10,000 25,000 15,000

The selling price per TV set is ₹ 15,000. The expected contribution is 50% of
the selling price. The cost of carrying receivable averages 20% per annum.

You are required to COMPUTE the credit period to be allowed to each

customer.

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

(RTP May – 2020)

Solution:

In case of customer A, there is no increase in sales even if the credit is given.

Hence comparative statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period 0 30 60 90 0 30 60 90
(days)
2. Sales Units 10,000 15,000 20,000 25,000 - - 10,000 15,000
₹ in lakh ₹ in lakh
3. Sales Value 1,500 2,250 3,000 3,750 - - 1,500 2,250
4. Contribution at 750 1,125 1,500 1,875 - - 750 1,125
50% (A)
5. Receivables:- - 187.5 500 937.5 250 562.5
Credit Period × Sales
360
6. Debtors at cost - 93.75 250 468.75 - - 125 281.25

7. Cost of - 18.75 50 93.75 - - 25 56.25

carrying debtors
at 20% (B)

8. Excess of 750 1,106.25 1,406.25 1,781.25 - - 725 1,068.75

contributions
over cost of
carrying debtors
(A – B)

The excess of contribution over cost of carrying Debtors is highest in case of

credit period of 90 days in respect of both the customers B and C. Hence,
credit period of 90 days should be allowed to B and C.

709
 [MANAGEMENT OF WORKING CAPITAL]

Question – 45
River limited currently uses the credit terms of 1.5/15 net 45 days and average
collection period was 30 days. The company presently having sales of ₹
50,00,000 and 30% customers availing the discount. The chances of default
are currently 5%. Variable cost constitutes 65% and total cost constitute 85%
of sales. The company is planning liberalization of credit terms to 2/20 net 50
days. It is expected that sales are likely to increase by ₹ 5,00,000, the default
chances are 10% and average collection period will decline to 25 days. There
won't be any change in the fixed cost and 50% customers are expected to avail
the discount. Tax rate is 35%.

EVALUATE this policy in comparison with the current policy and recommend
whether the new policy should be implemented. Assume cost of capital to be
10% (post tax) and 360 days in a year.

(RTP May – 2023)

Solution:

Evaluation of Credit Policies

Particulars 1.5/15 net 2/20 net

45 50
A Sales ₹ 50,00,000 ₹ 55,00,000
B Variable Cost (65%) ₹ 32,50,000 ₹ 35,75,000
C Fixed Cost (20% in 1st Case) ₹ 10,00,000 ₹ 10,00,000
D Bad Debts (5% and 10%) ₹ 2,50,000 ₹ 5,50,000
E Discounts
(₹ 50,00,000 × 30% ×1.5%) ₹ 22,500 -
(₹ 55,00,000 × 50% × 2%) - ₹ 55,000
F PBT (A-B-C-D-E) ₹ 4,77,500 ₹ 3,20,000
G Tax @ 35% ₹ 1,67,125 ₹ 1,12,000
H PAT ₹ 3,10,375 ₹ 2,08,000
I Opportunity Cost
(₹ 32,50,000 + ₹ 10,00,000) ×30/360×10% ₹ 35,417 -
(₹ 35,75,000 + ₹ 10,00,000) × 25/360 × 10% - ₹ 31,771
J Net Benefit ₹ 2,74,958 ₹ 1,76,229

The new policy leads to lower net benefit for the company. Hence it
should not be implemented.

Question – 46
Tony Limited, manufacturer of Colour TV sets is considering the liberalization
of existing credit terms to three of their large customers A, B and C. The credit

710
 [MANAGEMENT OF WORKING CAPITAL]

period and likely quantity of TV sets that will be sold to the customers in
addition to other sales are as follows:

Quantity sold (No. of TV Sets)

Credit Period (Days) A B C

0 1,000 1.000 -
30 1,000 1,500 -
60 1,000 2,000 1,000
90 1,000 2,500 1,500

The selling price per TV set is ₹ 9,000. The expected contribution is 20% of the
selling price. The cost of carrying receivable averages 20% per annum.

You are required:

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

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

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

(RTP Nov – 2018)

Solution:

(a) In case of customer A, there is no increase in sales even if the credit is

given. Hence comparative statement for B & C is given below:

Particulars Customer B Customer C

1. Credit period 0 30 60 90 0 30 60 90
(days)
2. Sales Units 1,000 1,500 2,000 2,500 - - 1,000 1,500
₹ in lakhs ₹ in lakhs
3. Sales Value 90 135 180 225 - - 90 135
4. Contribution at 18 27 36 45 - - 18 27
20% (A)
5. Receivables: - 11.25 30 56.25 - - 15 33.75
Credit Period × Sales
360
6. Debtors at cost - 9 24 45 - - 12 27
i.e. 80% of 11.25
7. Cost of carrying - 1.8 4.8 9 - - 2.4 5.4
debtors at 20%

711
 [MANAGEMENT OF WORKING CAPITAL]

(B)
8. Excess of 18 25.2 31.2 36 - - 15.6 21.6
contributions
over cost of
carrying debtors
(A – B)

The excess of contribution over cost of carrying Debtors is highest in case

of credit period of 90 days in respect of both the customers B and C.
Hence, credit period of 90 days should be allowed to B and C.

(b) Problem:

(i) Customer A is taking 1000 TV sets whether credit is given or not.

Customer C is taking 1000 TV sets at credit for 60 days. Hence A
also may demand credit for 60 days compulsorily.

(ii) B will take 2500 TV sets at credit for 90 days whereas C would lift
1500 sets only. In such case B will demand further relaxation in
credit period i.e. B may ask for 120 days credit.

Question – 47
A regular customer of your company has approached to you for extension of
credit facility for purchasing of goods. On analysis of past performance and on
the basis of information supplied, the following pattern of payment schedule
emerges:

Pattern of Payment Schedule

At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.
At the end of 90 days 30% of the bill.
At the end of 100 days 18% of the bill.
Non-recovery 2% of the bill.

The customer wants to enter into a firm commitment for purchase of goods of ₹
30 lakhs in 2019, 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 ₹ 300 on
which a profit of ₹ 10 per unit is expected to be made. It is anticipated that
taking up of this contract would mean an extra recurring expenditure of ₹
10,000 per annum. If the opportunity cost is 18% per annum, would you as
the finance manager of the company RECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.

(RTP Nov – 2019)

712
 [MANAGEMENT OF WORKING CAPITAL]

Solution:

Statement showing the Evaluation of credit Policies

Particulars Proposed Policy ₹

A. Expected Profit:
(a) Credit Sales 30,00,000
(b) Total Cost
(i) Variable Costs 29,00,000
(ii) Recurring Costs 10,000
29,10,000
(c) Bad Debts 60,000
(d) Expected Profit [(a) – (b) – (c)] 30,000
B. Opportunity Cost of Investments in 1,00,395
Receivables
C. Net Benefits (A – B) (70,395)

Recommendation: The Proposed Policy should not be adopted since the net
benefits under this policy are negative

Working Note: Calculation of Opportunity Cost of Average Investments

Collection period Rate of Return

Opportunity Cost = Total Cost × ×
360 100

Particulars 20% 30% 30% 18% Total

A. Total Cost 5,82,000 8,73,000 8,73,000 5,23,800 28,51,800
B. Collection 30/360 60/360 90/360 100/360
period
C. Required 18% 18% 18% 18%
Rate of
Return
D. Opportunity 8,730 26,190 39,285 26,190 1,00,395
Cost
(A × B × C)

Question – 48
A company wants to follow a more prudent policy to improve its sales for the
region which is ₹ 9 lakhs per annum at present, having an average collection
period of 45 days. After certain researches, the management consultant of the
company reveals the following information:

Credit Increase in Increase in sales Present default

Policy collection period anticipated

713
 [MANAGEMENT OF WORKING CAPITAL]

W 15 days 60,000 1.5 %

X 30 days 90,000 2%
Y 45 days 1,50,000 3%
Z 70 days 2,10,000 4%

The selling price per unit is ₹ 3. Average cost per unit is ₹ 2.25 and variable
costs per unit are ₹ 2. The current bad debt loss is 1%. Required return on
additional investment is 20%. (Assume 360 days year)

ANALYSE which of the above policies would you recommend for adoption?

(RTP Nov – 2020)

Solution:

A. Statement showing the Evaluation of Debtors Policies (Total Approach)

(Amount in ₹ )

Present Propose Proposed Proposed Proposed

Particulars Policy d Policy Policy X Policy Y Policy Z
45 days W 60 75 days 90 days 115 days
days
I Expected Profit:
(a) Credit 9,00,000 9,60,000 9,90,000 10,50,000 11,10,000
Sales
(b) Total Cost
other than
Bad Debts
(i) Variable Costs 6,00,000 6,40,000 6,60,000 7,00,000 7,40,000
[Sales × 2/ 3]

(ii) Fixed Costs 75,000 75,000 75,000 75,000 75,000

6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
(c) Bad Debts 9,000 14,400 19,800 31,500 44,400
(d) Expected 2,16,000 2,30,600 2,35,200 2,43,500 2,50,600
Profit
[(a) – (b) – (c)]
II. Opportunity Cost of 16,875 23,833 30,625 38,750 52,069
Investments in
Receivables
III. Net Benefits (I – II) 1,99,125 2,06,767 2,04,575 2,04,750 1,98,531

714
 [MANAGEMENT OF WORKING CAPITAL]

Recommendation: The Proposed Policy W (i.e. increase in collection period by

15 days or total 60 days) should be adopted since the net benefits under this
policy are higher as compared to other policies.

Working Notes:

(i) Calculation of Fixed Cost = [Average Cost per unit – Variable Cost
per unit] × No. of Units sold

= [₹ 2.25 - ₹ 2.00] × (₹ 9,00,000/3)

= ₹ 0.25 × 3,00,000 = ₹ 75,000

(ii) Calculation of Opportunity Cost of Average Investments

Collection period Rate of Return

Opportunity Cost = Total Cost × ×
360 100

45 20
Present Policy = 6,75,000 × × = 16,875
360 100

60 20
Policy W = 7,15,000 × × = 23,833
360 100

75 20
Policy X = 7,35,000 × × = 30,625
360 100
90 20
Policy Y = 7,75,000 × × = 38,750
360 100

115 20
Policy Z = 8,15,000 × × = 52,069
360 100

B. Another method of solving the problem is Incremental Approach. Here we

assume that sales are all credit sales. (Amount in ₹)

Present Proposed Proposed Proposed Proposed

Particulars Policy Policy W Policy X Policy Y Policy Z
45 days 60 days 75 days 90 days 115 days
I Incremental Expected
Profit:
(a) Incremental 0 60,000 90,000 1,50,000 2,10,000
Credit Sales
(b) Incremental
Costs
(i) Variable 6,00,000 40,000 60,000 1,00,000 1,40,000

715
 [MANAGEMENT OF WORKING CAPITAL]

Costs
(ii) Fixed Costs 75,000 - - - -
(c) Incremental Bad 9,000 5,400 10,800 22,500 35,400
Debt Losses
(d) Incremental 14,600 19,200 27,500 34,600
Expected
Profit
(a – b –c)]
II. Required Return on
Incremental
Investments:
(a) Cost of 6,75,000 7,15,000 7,35,000 7,75,000 8,15,000
Credit
Sales
(b) Collection 45 60 75 90 115
period
(c) Investment in 84,375 1,19,167 1,53,125 1,93,750 2,60,347
Receivable
(a × b/360)
(d) Incremental - 34,792 68,750 1,09,375 1,75,972
Investment in
Receivables
(e) Required Rate of 20 20 20 20
Return (in %)
(f) Required Return - 6,958 13,750 21,875 35,194
on Incremental
Investments
(d × e)
III. Net Benefits (I – II) - 7,642 5,450 5,625 (594)

Recommendation: The Proposed Policy W should be adopted since the net

benefits under this policy are higher than those under other policies.

C. Another method of solving the problem is by computing the Expected

Rate of Return.

Incremental Expected Profit

Expected Rate of Return = × 100
Incremental Investment in Receivables

₹ 14,600
For Policy W = × 100 = 41.96%
₹ 34,792

₹ 19,200
For Policy X = × 100 = 27.93%
₹ 68,750

716
 [MANAGEMENT OF WORKING CAPITAL]

₹ 27,500
For Policy Y = × 100 = 25.14%
₹ 1,09,375

₹ 34,600
For Policy Z = × 100 = 19.66%
₹ 1,75,972

Recommendation: The Proposed Policy W should be adopted since the

Expected Rate of Return (41.96%) is more than the Required Rate of Return
(20%) and is highest among the given policies compared.

Question – 49
A regular customer of your company has approached to you for extension of
credit facility for purchasing of goods. On analysis of past performance and on
the basis of information supplied, the following pattern of payment schedule
emerges:

Pattern of Payment Schedule

At the end of 30 days 20% of the bill
At the end of 60 days 30% of the bill.
At the end of 90 days 30% of the bill
At the end of 100 days 18% of the bill
Non-recovery 2% of the bill

The customer wants to enter into a firm commitment for purchase of goods of ₹
40 lakhs in 2022, 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 ₹ 400 on
which a profit of ₹ 20 per unit is expected to be made. It is anticipated that
taking up of this contract would mean an extra recurring expenditure of ₹
20,000 per annum. If the opportunity cost is 18% per annum, would you as
the finance manager of the company RECOMMEND the grant of credit to the
customer? Assume 1 year = 360 days.

(RTP Nov – 2023)

Solution:

Statement showing the Evaluation of credit Policies

Particulars Proposed Policy ₹

A. Expected Profit:
(a) Credit Sales 40,00,000
(b) Total Cost
(i) Variable Costs (₹ 380 × 10000 units) 38,00,000
(ii) Recurring Costs 20,000

717
 [MANAGEMENT OF WORKING CAPITAL]

38,20,000
(c) Bad Debts 80,000
(d) Expected Profit [(a) – (b) – (c)] 1,00,000
B. Opportunity Cost of Investments in Receivables 1,31,790
C. Net Benefits (A – B) (31,790)

Recommendation: The Proposed Policy should not be adopted since the net
benefits under this policy are negative.

Working Note: Calculation of Opportunity Cost of Average Investments

Collection period Rate of Return

Opportunity Cost = Total Cost × ×
360 100

Particulars 20% 30% 30% 18% Total

A. Total Cost 7,64,000 11,46,000 11,46,000 6,87,600 37,43,600
B. Collection 30/360 60/360 90/360 100/360
Period
C. Required 18% 18% 18% 18%
Rate of
Return
D. Opportunity 11,460 34,380 51,570 34,380 1,31,790
Cost
(A × B × C)

Question – 50
Current annual sale of SKD Ltd. is ₹ 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:

Policy X Policy Y

Average collection period 1.5 months 1 month

% of default 2% 1%

Annual collection expenditure ₹ 12 lakh ₹ 20 lakh

Selling price per unit of product is ₹ 150. Total cost per unit is ₹ 120.

Current credit terms are 2 months and percentage of default is 3%.

718
 [MANAGEMENT OF WORKING CAPITAL]

Current annual collection expenditure is ₹ 8 lakh. Required rate of return on

investment of SKD Ltd. is 20%. Determine which credit policy SKD Ltd. should
follow.

(Exam, July – 2021)

Solution:

Statement showing the Evaluation of Credit policies (Total Approach)

Particulars Present Proposed Proposed

Policy Policy X Policy Y
(2 Months) (1.5 Months) (1 Month)
₹ in lakhs ₹ in lakhs ₹ in lakhs
A. Expected Profit:
(a) Credit Sales* 360 360 360
(b) Total Cost other 288 288 288
than Bad Debts and
collection expenditure
(360/150 × 120)
(c) Bad Debts 10.8 7.2 3.6
(360 × 0.03) (360 × 0.02) (360 × 0.01)
(d) Collection expenditure 8 12 20
(e) Expected Profit 53.2 52.8 48.4
[(a) – (b) – (c) - (d)]
B. Opportunity Cost of 9.6 7.2 4.8
Investments in Receivables
(Working Note)
C. Net Benefits (A – B) 43.6 45.6 43.6

Recommendation: The Proposed Policy X should be followed since the net

benefits under this policy are higher as compared to other policies.

*Note: It is assumed that all sales are on credit.

Working Note:

Calculation of Opportunity Cost of Average Investments

Collection period Rate of Return

Opportunity Cost = Total Cost × ×
12 100

2 20
Present Policy = ₹ 288 lakhs × × = ₹ 9.6 lakhs
12 100

719
 [MANAGEMENT OF WORKING CAPITAL]

1.5 20
Policy X = ₹ 288 lakhs × × = ₹ 7.2 lakhs
12 100

1 20
Policy Y = ₹ 288 lakhs × × = ₹ 4.8 lakhs
12 100

Alternatively
Statement showing the Evaluation of Credit policies
(Incremental Approach)

Present Proposed Proposed

Particulars Policy Policy X Policy Y
(2 Months) (1.5 (1 Month)
Months)
₹ in lakhs ₹ in lakhs ₹ in lakhs
(a) Credit Sales* 360 360 360
(b) Cost of sales 288 288 288
(360/150 ×120)
(c) Receivables (Refer 48 36 24
Working Note)
(d) Reduction in - 12 24
receivables from
present policy
(A) Savings in Opportunity - 2.4 4.8
Cost of Investment in
Receivables (@ 20%)
(e) Bad Debts 10.8 7.2 3.6
(360 × 0.03) (360 × 0.02) (360 × 0.01)
(B) Reduction in bad debts from - 3.6 7.2
present policy
(f) Collection expenditure 8 12 20
(C) Increase in Collection - 4 12
expenditure from Present
policy
(D) Net Benefits (A + B − C) 2 0

Recommendation: The Proposed Policy X should be followed since the net

benefits under this policy are higher as compared to other policies.

*Note: It is assumed that all sales are on credit.

Working Note:

Calculation of Investment in Receivables

720
 [MANAGEMENT OF WORKING CAPITAL]

Collection period
= Total Cost ×
12

2
Present Policy = ₹ 288 lakhs × = ₹ 48 lakhs
12

1.5
Policy X = ₹ 288 lakhs × = ₹ 36 lakhs
12

1
Policy Y = ₹ 288 lakhs × = ₹ 24 lakhs
12

Question – 51
MN Ltd. has a current turnover of 30,00,000 p.a Cost of sales is 80% of turnover
and Bad Debts are 2% of turnover, Cost of sales includes 70% Variable cost and
30% fixed Cost, While Company‟s required rate of return is 15%. MN Ltd.
currently allows 15 days credit to its customer, but it is considering increases
this to 45 days credit in order to increase turnover.

It has been estimated that this change in policy will increase turnover by 20%,
while Bed Debts will increase by 1%. It is not expected that the policy change
will result in an increase in fixed cost and creditors and stock will be unchanged.

Should MN Ltd. introduce the proposed policy ? (Assume a 360 day year)

(Exam, Nov – 2018)

Solution:

Student Notes to avoid Possible Mistakes:

(a) 'Cost of Sales' given in the question should be interpreted as 'Cost of

Goods Sold'. It is 80% of sales.

(b) Variable cost is given as 70% of cost of sales and not 70% of sales. It
means, variable cost is 70% of 80%, i.e. 56% of sales.

(c) Fixed cost is also given as 30% of cost of sales and it will remain same.

(d) Credit period at present is 15 days and it will increase to 45 days. It will
not increase by 45 days, but will increase to 45 days.

Statement Showing Evaluation of Credit Policies: (Figures in ₹)

721
 [MANAGEMENT OF WORKING CAPITAL]

Particulars Present Proposed

Policy Policy
(a) Sales Turnover 30,00,000 36,00,000
(Given) (30L + 20%)
(b) Variable Cost [56% of (a)] 16,80,000 20,16,000
(c) Fixed Cost [ 30,00,000 × 80% × 30%] 7,20,000 7,20,000
(d) Total Cost of Sales [b + c] 24,00,000 27,36,000
(e) Bad debts as % of sales 2% 3%
(f) Bad debt loss [a × e] 60,000 1,08,000
(g) Profit [a - d - e] 5,40,000 7,56,000
(h) Credit Period 15 days 45 days
(i) Investment in receivables [d × h/360 days] 1,00,000 3,42,000
(j) Opportunity cost [15% × (i)] 15,000 51,300
(k) Net Benefit [g - j] 5,25,000 7,04,700
(l) Incremental benefit to the company --- 1,79,700

Recommendation: Proposed Policy i.e. credit of 45 days should be

implemented by MN Ltd. since the net benefit under this policy is higher than
those under present policy.

Question – 52
A company has current sale of ₹ 12 lakhs per year. The profit-volume ratio is
20% and post-tax cost of investment in receivables is 15%. The current credit
terms are 1/10, net 50 days and average collection period is 40 days. 50% of
customers in terms of sales revenue are availing cash discount and bad debt is
2% of sales.

In order to increase sales, the company want to liberalize its existing credit
terms to 2/10, net 35 days. Due to which, expected sales will increase to ₹ 15
lakhs. Percentage of default in sales will remain same. Average collection period
will decrease by 10 days. 80% of customers in terms of sales revenue are
expected to avail cash discount under this proposed policy.

Tax rate is 30%.

722
 [MANAGEMENT OF WORKING CAPITAL]

ADVISE, should the company change its credit terms. (Assume 360 days in a
year.)

(Exam, May – 2023)

Solution:

(i) Calculation of Cash Discount

Cash Discount = Total credit sales × % of customers who take up

discount × Rate

12,00,000 × 50 × 0.01
Present Policy = = ₹ 6,000
100

Proposed Policy = ₹ 15,00,000 × 0.80 × 0.02 = ₹ 24,000

(ii) Opportunity Cost of Investment in Receivables

Present Policy: Opportunity Cost

Collection period Rate of Return

= Total Cost × ×
360 100

40 15
= ₹ 9,60,000 × × = ₹ 16,000
360 100

Collection period Rate of Return

Proposed Policy: = Total Cost × ×
360 100

30 15
= 12,00,000 × × = ₹ 15,000
360 100

Statement showing Evaluation of Credit Policies

Particulars Present Proposed

Policy Policy
Credit Sales 12,00,000 15,00,000
Variable Cost @ 80%* of sales 9,60,000 12,00,000
Bad Debts @ 2% 24,000 30,000
Cash Discount 6,000 24,000
Profit before tax 2,10,000 2,46,000
Tax @ 30% 63,000 73,800
Profit after Tax 1,47,000 1,72,200
Opportunity Cost of Investment in Receivables 16,000 15,000

723
 [MANAGEMENT OF WORKING CAPITAL]

Net Profit 1,31,000 1,57,200

*Only relevant or variable costs are considered for calculating the

opportunity costs on the funds blocked in receivables. Since 20% is
profit-volume ratio, hence the relevant costs are taken to be 80% of the
respective sales.

Advise: Proposed policy should be adopted since the net benefit is

increased by (₹ 1,57,200 - ₹ 1,31,000) = ₹ 26,200.

Alternative presentation using incremental approach

Incremental sales (15,00,000 – 12,00,000) 3,00,000

Less: Incremental variable cost (12,00,000 – 9,60,000) 2,40,000

Less: Incremental Bad debts (30,000 – 24,000) 6,000

Less: Incremental Cash discount (24,000 – 6,000) 18,000

Increase in Profit Before Tax 36,000

Less: Tax @ 30% 10,800

Increase in Profit After Tax 25,200

Add: Savings in opportunity cost (16,000 – 15,000) 1,000

Increase in Net Profit 26,200

Advise: Proposed policy should be adopted since the net benefit is

increased by (₹ 1,57,200 − ₹ 1,31,000)

= ₹ 26,200.

Question – 53
GT Ltd. is taking into account the revision of its credit policy with a view to
increasing its sales and profit. Currently, all its sales are on one month credit.
Other information is as follows:

Contribution 2/5th of Sales Revenue

Additional funds raising cost 20% per annum

724
 [MANAGEMENT OF WORKING CAPITAL]

The marketing manager of the company has given the following options along
with estimates for considerations:

Particulars Current Option I Option II Option III

Position
Sales Revenue (₹) 40,00,000 42,00,000 44,00,000 50,00,000
Credit period (in months) 1 1½ 2 3
Bad debts (% of sales) 2 2½ 3 5
Cost of Credit administration 24,000 26,000 30,000 60,000
(₹)

You are required to ADVISE the company for the best option.

(MTP Sep – 2022)

Solution:

Statement Showing Evaluation of Credit Policies

( ₹ In Lakhs)

Particulars Current Option I Option II Option III

position (1.5 months) (2 months) (3 months)
(1 month)
Sales Revenue 40,00,000 42,00,000 44,00,000 50,00,000
Contribution @ 40% 16,00,000 16,80,000 17,60,000 20,00,000
Increase in contribution - 80,000 1,60,000 4,00,000
over current level (A)
Debtors = 1 × 40,00,000 1.5 × 42,00,000 2 × 44,00,000 3 × 50,00,000
Average 12 12 12 12
Collection × Credit = 12,50,000
Sales
= 3,33,333.33 = 5,25,000 = 7,33,333.33
12

Increase in debtors over - 1,91,666.67 4,00,000.00 9,16,666.67

current level
Cost of funds for - 38,333.33 80,000.00 1,83,333.33
additional amount of
debtors @ 20% (B)
Credit administrative 24,000 26,000 30,000 60,000
cost
Increase in credit - 2,000 6,000 36,000
administration cost over
present level (C)
Bad debts 80,000 1,05,000 1,32,000 2,50,000
Increase in bad debts - 25,000 52,000 1,70,000
over current levels (D)
Net gain/loss A − (B + C _ 14,666.67 22,000.00 10,666.67
+D)

725
 [MANAGEMENT OF WORKING CAPITAL]

Advise: It is suggested that the company GT Ltd. should implement Option II

with a net gain of ₹ 22,000 which has a credit period of 2 months.

(3) FACTORING

Question – 54
A Factoring firm has credit sales of ₹ 360 lakhs and its average collection
period is 30 days. The financial controller estimates, bad debt losses are
around 2% of credit sales. The firm spends ₹ 1,40,000 annually on debtors
administration. This cost comprises of telephonic and fax bills along with
salaries of staff members. These are the avoidable costs. A Factoring firm has
offered to buy the firm‟s receivables. The factor will charge 1%commission and
will pay an advance against receivables on an interest @15% p.a. after
withholding 10% as reserve. What should the firm do?

Assume 360 days in a year.

(Study Material ICAI Illus – 15)

Solution:

Working Notes:

30
Average level of receivables = ₹ 360 lakhs × = 30 lakhs
360

Factoring Commission = 1% of ₹ 30,00,000 = ₹ 30,000

Reserve = 10% of ₹ 30,00,000 = ₹ 3,00,000

Total (i) = ₹ 3,30,000

Thus the amount available for advance is

Average level of receivables ₹ 30,00,000

Less: Total (i) from above ₹ 3,30,000

(ii) ₹ 26,70,000

Less: Interest @ 15% p.a. for 30 days ₹ 33,375

Net Amount of Advance available. ₹ 26,36,625

Evaluation of Factoring Proposal

726
 [MANAGEMENT OF WORKING CAPITAL]

Particulars ₹ ₹
A. Saving (Benefit) to the firm
Cost of credit administration ₹ 1,40,000 ₹ 1,40,000
Cost of bad-debt losses (0.02 × 360 lakhs) ₹ 7,20,000
Total ₹ 8,60,000
B. Cost to the Firm:
Factoring commission [annual credit 360 ₹ 3,60,000
sales × % of commission (or ₹ 30,000 ×
30
calculated annually)]
Interest Charges 360 ₹ 4,00,500
₹ 33,375 ×
30
Total ₹ 7,60,500
C. Net Benefit to the firm: (A – B) ₹ 99,500

Advice: Since the saving to the firm exceeds the cost to the firm on account of
factoring. Therefore, the proposal is acceptable.

(4) CASH MANAGEMENT

Question – 55
Prepare monthly cash budget for six months beginning from April 2017 on the
basis of the following information:

i. Estimated monthly sales are as follows:

(₹) (₹)
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

ii. Wages and salaries are estimated to be payable as follows:

₹ ₹
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

iii. Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales
are collected within one month and the balance in two months. There
are no bad debt losses.

727
 [MANAGEMENT OF WORKING CAPITAL]

iv. Purchases amount to 80% of sales and are made on credit and paid for
in the month preceding the sales.

v. The firm has 10% debentures of ₹ 1,20,000. Interest on these has to be

paid quarterly in January, April and so on.

vi. The firm is to make an advance payment of tax of ₹ 5,000 in July, 2017.

vii. The firm had a cash balance of ₹ 20,000 on April 1, 2017, which is the
minimum desired level of cash balance. Any cash surplus/deficit
above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each
month (interest on these to be ignored).

(Study Material ICAI Illus – 06)

Solution:

Workings:

Collection from debtors:

(Amount in ₹)

Feb Mar Apr May June July Aug Sep

Total sales 1,20,000 1,40,000 80,000 60,000 80,000 1,00,000 80,000 60,000
Credit sales 96,000 1,12,000 64,000 48,000 64,000 80,000 64,000 48,000
(80% of
total sales)
Collections:
One month 72,000 84,000 48,000 36,000 48,000 60,000 48,000
Two months 24,000 28,000 16,000 12,000 16,000 20,000
Total 1,08,000 76,000 52,000 60,000 76,000 68,000
collections

Monthly Cash Budget for Six months, April to September, 2022

(Amount in ₹)

Apr May June July Aug Sep

Receipts:
Opening balance 20,000 20,000 20,000 20,000 20,000 20,000
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collection from debtors 1,08,000 76,000 52,000 60,000 76,000 68,000
Total cash available (A) 1,44,000 1,08,000 88,000 1,00,000 1,12,000 1,00,000
Payments:
Purchases 48,000 64,000 80,000 64,000 48,000 80,000

728
 [MANAGEMENT OF WORKING CAPITAL]

Wages & salaries 9,000 8,000 10,000 10,000 9,000 9,000

Interest on debentures 3,000 --- --- 3,000 --- ---
Tax payment --- --- --- 5,000 --- ---
Total payments (B) 60,000 72,000 90,000 82,000 57,000 89,000
Minimum cash balance 20,000 20,000 20,000 20,000 20,000 20,000
desired
Total cash needed (C) 80,000 92,000 1,10,000 1,02,000 77,000 1,09,000
Surplus - deficit (A-C) 64,000 16,000 (22,000) (2,000) 35,000 (9,000)
Investment/financing
Temporary (64,000) (16,000) ---- (35,000) -----
Investments
Liquidation of ---- ---- 22,000 2,000 ---- 9,000
temporary investments
or temporary
borrowings
Total effect of
investment/financing (64,000) (16,000) 22,000 2,000 (35,000) 9,000
(D)
Closing cash balance 20,000 20,000 20,000 20,000 20,000 20,000
(A+D-B)

Question – 56
From the following information relating to a departmental store, you are
required to prepare for the three months ending 31st March, 2017:

a. Month-wise cash budget on receipts and payments basis; and

b. Statement of Sources and uses of funds for the three months period.

It is anticipated that the working capital at 1st January, 2017 will be as follows
:-

₹ in ‘000’s
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
Budgeted Profit Statement: ₹ in ‘000’s
January February March
Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330

729
 [MANAGEMENT OF WORKING CAPITAL]

Gross Profit 465 395 370

Administrative, Selling and 315 270 255
Distribution Expenses
Net Profit before tax 150 125 115

Budgeted balances at the end of ₹ in ‘000’s

each months 31st Jan. 28th Feb. 31st March
Short term investments 700 - 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485 - -
Tax due 320 320 320
Plant (depreciation ignored) 800 1,600 1,550

Depreciation amount to ₹ 60,000 is included in the budgeted expenditure for

each month.

(Study Material ICAI Illus – 07)

Solution:

Working:

₹ in ‘000
Jan. Feb. March
(1) Payments to creditors:
Cost of goods sold 1,635 1,405 1,330
Add: Closing Stocks 1,200 1,100 1,000
2,835 2,505 2,330
Less: Opening Stocks 1,300 1,200 1,100
Purchase 1,535 1,305 1,230
Add: Trade Creditors, Opening Balance 2,110 2,000 1,950
3,645 3,305 3,180
Less: Trade Creditors, Closing Balance 2,000 1,950 1,900
Payment 1,645 1,355 1,280
(2) Receipts from debtors:
Debtors, Opening Balance 2,570 2,600 2,500
Add: Sales 2,100 1,800 1,700
4,670 4,400 4,200
Less: Debtors, Closing Balance 2,600 2,500 2,350

730
 [MANAGEMENT OF WORKING CAPITAL]

Receipt 2,070 1,900 1,850

Cash Budget

(a) 3 months ending 31st March, 2022

(₹ in 000)
January, February, March,
2022 2022 2022
Opening cash balances 545 315 65
Add: Receipts:
From Debtors 2,070 1,900 1,850
Sale of Investments --- 700 ----
Sale of Plant --- --- 50
Total (A) 2,615 2,915 1,965
Deduct: Payments
Creditors 1,645 1,355 1,280
Expenses 255 210 195
Capital Expenditure --- 800 ---
Payment of dividend --- 485 ---
Purchase of investments 400 --- 200
Total payments (B) 2,300 2,850 1,675
Closing cash balance (A-B) 315 65 290

(b) Statement of Sources and uses of Funds for the three month period
ending 31st March, 2022

₹ ‘000 ₹ ‘000
Sources:
Funds from operation:
Net profit (150 + 125 + 115) 390
Add: Depreciation (60 × 3) 180 570
Sale of plant 50
620
Decrease in Working Capital 655
(Refer Statement of changes in working capital)
Total 1,285
Uses:
Purchase of plant 800
Payment by dividends 485
Total 1,285

731
 [MANAGEMENT OF WORKING CAPITAL]

Statement of Changes in Working Capital

January,22 March,22 Increase Decrease

₹’ 000 ₹’ 000 ₹’ 000 ₹’ 000
Current Assets
Cash in hand and at Bank 545 290 255
Short term Investments 300 200 100
Debtors 2,570 2,350 220
Stock 1,300 1,000 300
4,715 3,840
Current Liabilities
Trade Creditors 2,110 1,900 210 ---
Other Creditors 200 200 --- ---
Tax Due 320 320 --- ---
2,630 2,420
Working Capital 2,085 1,420
Decrease - 665 665
2,085 2,085 875 875

Question – 57
You are given below the Profit & Loss Accounts for two years for a company:

Profit and Loss Account

Year 1 Year 2 Year 1 Year 2

(₹) (₹) (₹) (₹)
To Opening 80,00,000 1,00,00,000 By Sales 8,00,00,000 10,00,00,000
stock
To Raw 3,00,00,000 4,00,00,000 By Closing 1,00,00,000 1,50,00,000
materials stock
To Stores 1,00,00,000 1,20,00,000 By Misc. 10,00,000 10,00,000
Income
To 1,00,00,000 1,60,00,000
Manufacturing
Expenses
To Other 1,00,00,000 1,00,00,000
Expenses
To 1,00,00,000 1,00,00,000
Depreciation
To Net Profit 1,30,00,000 1,80,00,000
9,10,00,000 11,60,00,000 9,10,00,000 11,60,00,000

Sales are expected to be ₹ 12,00,00,000 in year 3.

As a result, other expenses will increase by ₹ 50,00,000 besides other charges.

Only raw materials are in stock. Assume sales and purchases are in cash

732
 [MANAGEMENT OF WORKING CAPITAL]

terms and the closing stock is expected to go up by the same amount as

between year 1 and 2. You may assume that no dividend is being paid. The
Company can use 75% of the cash generated to service a loan. How much cash
from operations will be available in year 3 for the purpose? Ignore income tax.

(Study Material ICAI Illus – 08)

Solution:

Projected Profit and Loss Account for the year 3

Year 2 Year 3 Year 2 Year 3

Actual Project Actual Project
(₹ in ed (₹ in (₹ in ed (₹ in
lakhs) lakhs) lakhs) lakhs)
To Materials consume 350 420 By Sales 1,000 1,200
To Stores 120 144 By Misc. Income 10 10
To Mfg. Expenses 160 192
To Other expenses 100 150
To Depreciation 100 100
To Net profit 180 204
1,010 1,210 1,010 1,210

Cash Flow:

(₹ in lakhs)
Profit 204
Add: Depreciation 100
304
Less: Cash required for increase in stock 50
Net cash inflow 254

Available for servicing the loan: 75% of ₹ 2,54,00,000 or ₹ 1,90,50,000

Working Notes:

(i) Material consumed in year 2: 35% of sales,

35
Likely consumption in year 3: ₹ 1,200 × or ₹ 420 (lakhs)
100

(ii) Stores are 12% of sales, as in year 2.

(iii) Manufacturing expenses are 16% of sales.

733
 [MANAGEMENT OF WORKING CAPITAL]

Note: The above also shows how a projected profit and loss account is
prepared.

Question – 58
Prachi Ltd is a manufacturing company producing and selling a range of
cleaning products to wholesale customers. It has three suppliers and two
customers. Prachi Ltd relies on its cleared funds forecast to manage its cash.

You are an accounting technician for the company and have been asked
to prepare a cleared funds forecast for the period Monday 7 January to
Friday 11 January 2017 inclusive. You have been provided with the following
information:

1. Receipts from customers

Customer Credit terms Payment 7 Jan 7 Dec

name method 2017 2016
sales sales
W Ltd 1 calendar month BACS ₹ 150,000 ₹ 130,000
X Ltd None Cheque ₹ 180,000 ₹ 160,000

(a) Receipt of money by BACS (Bankers‟ Automated Clearing Services)

is instantaneous.

(b) X Ltd‟s cheque will be paid into Prachi Ltd‟s bank account on the
same day as the sale is made and will clear on the third day
following this (excluding day of payment).

2. Payments to suppliers

Supplier Credit Payment 7 Jan 7 Dec 7 Nov

name terms method 2017 2016 2016
purchases purchases purchases
A Ltd 1 calendar Standing ₹ 65,000 ₹ 55,000 ₹ 45,000
month order

B Ltd 2 calendar Cheque ₹ 85,000 ₹ 80,000 ₹ 75,000

months

C Ltd None Cheque ₹ 95,000 ₹ 90,000 ₹ 85,000

(a) Prachi Ltd has set up a standing order for ₹ 45,000 a month to pay
for supplies from A Ltd. This will leave Prachi‟s bank account on 7

734
 [MANAGEMENT OF WORKING CAPITAL]

January. Every few months, an adjustment is made to reflect the

actual cost of supplies purchased (you do not need to make this
adjustment).

(b) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 7
January. The amounts will leave its bank account on the second
day following this (excluding the day of posting)

3. Wages and salaries

December 2016 January 2017

Weekly wages ₹ 12,000 ₹ 13,000
Monthly salaries ₹ 56,000 ₹ 59,000

(a) Factory workers are paid cash wages (weekly). They will be paid
one week‟s wages, on 11 January, for the last week‟s work done in
December (i.e. they work a week in hand).

(b) All the office workers are paid salaries (monthly) by BACS. Salaries
for December will be paid on 7 January.

4. Other miscellaneous payments

(a) Every Monday morning, the petty cashier withdraws ₹ 200 from
the company bank account for the petty cash. The money leaves
Prachi‟s bank account straight away.

(b) The room cleaner is paid ₹ 30 from petty cash every Wednesday
morning.

(c) Office stationery will be ordered by telephone on Tuesday 8

January to the value of ₹ 300. This is paid for by company debit
card. Such payments are generally seen to leave the company
account on the next working day.

(d) Five new software‟s will be ordered over the Internet on 10 January
at a total cost of ₹ 6,500. A cheque will be sent out on the same
day. The amount will leave Prachi Ltd‟s bank account on the
second day following this (excluding the day of posting).

735
 [MANAGEMENT OF WORKING CAPITAL]

5. Other information

The balance on Prachi‟s bank account will be ₹ 200,000 on 7 January

2017. This represents both the book balance and the cleared funds.

Required:
Prepare a cleared funds forecast for the period Monday 7 January to Friday 7
January 2017 inclusive using the information provided. Show clearly the un-
cleared funds float each day.

(Study Material ICAI Illus – 09)

Solution:

Cleared Funds Forecast

9 Aug 10 Aug 11 Aug 12 Aug 13 Aug

(Saturday) (Sunday) (Monday) (Tuesday) (Wednes-
₹ ₹ ₹ ₹ day)
₹
Receipts
W Ltd 1,30,000 0 0 0 0
X Ltd 0 0 0 1,80,000 0
(a) 1,30,000 0 0 1,80,000 0
Payments
A Ltd 45,000 0 0 0 0
B Ltd 0 0 75,000 0 0
C Ltd 0 0 95,000 0 0
Wages 0 0 0 0 12,000
Salaries 56,000 0 0 0 0
Petty Cash 200 0 0 0 0
Stationery 0 0 300 0 0
(b) 1,01,200 0 1,70,300 0 12,000
Cleared excess Receipts
over payments (a) – (b) 28,800 0 (1,70,300) 1,80,000 (12,000)
Cleared balance b/f 2,00,000 2,28,800 2,28,800 58,500 2,38,500
Cleared balance c/f (c) 2,28,800 2,28,800 58,500 2,38,500 2,26,500
Un-cleared funds float
Receipts 1,80,000 1,80,000 1,80,000 0 0
Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)
(d) 10,000 9,700 180,000 (6,500) (6,500)
Total book balance c/f 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000
(c) + (d)

736
 [MANAGEMENT OF WORKING CAPITAL]

Question – 59
A firm maintains a separate account for cash disbursement. Total
disbursement are₹ 1,05,000 per month or ₹ 12,60,000 per year. Administrative
and transaction cost of transferring cash to disbursement account is ₹ 20 per
transfer. Marketable securities yield is 8% per annum.

Determine the optimum cash balance according to William J. Baumol model.

(Study Material ICAI Illus – 10)

Solution:

2 × ₹ 12,60,000 × ₹ 20
The optimum cash balance C = = ₹ 25,100
0.08

The limitation of the Baumol‟s model is that it does not allow the cash flows to
fluctuate. Firms in practice do not use their cash balance uniformly nor are
they able to predict daily cash inflows and outflows. The Miller-Orr (MO) model,
as discussed below, overcomes this shortcoming and allows for daily cash flow
variation.

Question – 60
The following information relates to Zeta Limited, a publishing company:

The selling price of a book is ₹ 15, and sales are made on credit through a book
club and invoiced on the last day of the month.

Variable costs of production per book are materials (₹ 5), labour (₹ 4), and
overhead (₹ 2)

737
 [MANAGEMENT OF WORKING CAPITAL]

The sales manager has forecasted the following volumes:

Month No. of Books

November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August 2,300

Customers are expected to pay as follows:

One month after the sale 40%

Two months after the sale 60%

The company produces the books two months before they are sold and the
creditors for materials are paid two months after production.

Variable overheads are paid in the month following production and are
expected to increase by 25% in April; 75% of wages are paid in the month of
production and 25% in the following month. A wage increase of 12.5% will take
place on 1st March.

The company is going through a restructuring and will sell one of its freehold
properties in May for ₹ 25,000, but it is also planning to buy a new printing
press in May for ₹ 10,000. Depreciation is currently ₹ 1,000 per month, and
will rise to ₹ 1,500 after the purchase of the new machine.

The company‟s corporation tax (of ₹ 10,000) is due for payment in March.

The company presently has a cash balance at bank on 31 December 2021, of ₹

1,500.

You are required to PREPARE a cash budget for the six months from January
to June, 2022.

(Study Material ICAI TYK – 08)

Solution:

738
 [MANAGEMENT OF WORKING CAPITAL]

Workings:

1. Sale Receipts

Month Nov Dec Jan Feb Mar Apr May Jun

Forecast 1,000 1,000 1,000 1,250 1,500 2,000 1,900 2,200
sales (S)
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
S × 15 15,000 15,000 15,000 18,750 22,500 30,000 28,500 33,000
Debtors
pay:
1 month 6,000 6,000 6,000 7,500 9,000 12,000 11,400
40%
2 month - 9,000 9,000 9,000 11,250 13,500 18,000
60%
- - 15,000 15,000 16,500 20,250 25,500 29,400

2. Payment for materials – books produced two months before sale

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
Materials 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
(Q × 5)
Paid (2 months - - 5,000 6,250 7,500 10,000 9,500 11,000
after)

3. Variable overheads

Month Nov Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹ ₹
Var. overhead 2,000 2,500 3,000 4,000 3,800
(Q × 2)
Var. overhead 5,500 5,500 5,750
(Q × 2.50)
Paid one month 2,000 2,500 3,000 4,000 3,800 5,500 5,500
later

4. Wages payments

Month Dec Jan Feb Mar Apr May Jun

Qty produced (Q) 1,250 1,500 2,000 1,900 2,200 2,200 2,300
₹ ₹ ₹ ₹ ₹ ₹ ₹
Wages (Q × 4) 5,000 6,000 8,000
Wages (Q × 4.50) 8,550 9,900 9,900 10,350

739
 [MANAGEMENT OF WORKING CAPITAL]

75% this month 3,750 4,500 6,000 6,412 7,425 7,425 7,762
25% this month 1,250 1,500 2,000 2,137 2,475 2,475
5,750 7,500 8,412 9,562 9,900 10,237

Cash budget – six months ended June

Jan Feb Mar Apr May Jun

₹ ₹ ₹ ₹ ₹ ₹
Receipts:
Credit sales 15,000 15,000 16,500 20,250 25,500 29,400
Premises disposal - - - - 25,000 -
15,000 15,000 16,500 20,250 50,500 29,400
Payments:
Materials 5,000 6,250 7,500 10,000 9,500 11,000
Var. overheads 2,500 3,000 4,000 3,800 5,500 5,500
Wages 5,750 7,500 8,412 9,563 9,900 10,237
Fixed assets - - - - 10,000 -
Corporation tax - - 10,000 - - -
13,250 16,750 29,912 23,363 34,900 26,737
Net cash flow 1,750 (1,750) (13,412) (3,113) 15,600 2,663
Balance b/f 1,500 3,250 1,500 (11,912) (15,025) 575
Cumulative cash flow 3,250 1,500 (11,912) (15,025) 575 3,238

Question – 61
From the information and the assumption that the cash balance in hand on 1 st
January 2021 is ₹ 72,500, PREPARE a cash budget.

Assume that 50 per cent of total sales are cash sales. Assets are to be acquired
in the months of February and April. Therefore, provisions should be made for
the payment of ₹ 8,000 and ₹ 25,000 for the same. An application has been
made to the bank for the grant of a loan of ₹ 30,000 and it is hoped that the
loan amount will be received in the month of May.

It is anticipated that a dividend of ₹ 35,000 will be paid in June. Debtors are

allowed one month‟s credit. Creditors for materials purchased and overheads
grant one month‟s credit. Sales commission at 3 per cent on sales is paid to the
salesman each month.

Month Sales (₹) Materials Salaries Production Office and

Purchases & Wages Overheads Selling
(₹) (₹) (₹) Overheads (₹)
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700

740
 [MANAGEMENT OF WORKING CAPITAL]

March 86,000 25,500 10,600 6,000 7,500

April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500

(Study Material ICAI TYK – 09)

Solution:

Cash Budget

Jan Feb Mar Apr May June Total

₹ ₹ ₹ ₹ ₹ ₹ ₹
Receipts
Cash sales 36,000 48,500 43,000 44,300 51,250 54,350 2,77,400
Collections - 36,000 48,500 43,000 44,300 51,250 2,23,050
from debtors
Bank loan - - - - 30,000 - 30,000
Total 36,000 84,500 91,500 87,300 1,25,550 1,05,600 5,30,450
Payments
Materials - 25,000 31,000 25,500 30,600 37,000 1,49,100
Salaries and 10,000 12,100 10,600 25,000 22,000 23,000 1,02,700
wages
Production - 6,000 6,300 6,000 6,500 8,000 32,800
overheads
Office & - 5,500 6,700 7,500 8,900 11,000 39,600
selling
overheads
Sales 2,160 2,910 2,580 2,658 3,075 3,261 16,644
commission
Capital - 8,000 - 25,000 - - 33,000
expenditure
Dividend - - - - - 35,000 35,000
Total 12,160 59,510 57,180 91,658 71,075 1,17,261 4,08,844
Net cash 23,840 24,990 34,320 (4,358) 54,475 (11,661) 1,21,606
flow
Balance, 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106
beginning of
month
Balance, 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106 3,15,712
end of
month

Question – 62
Consider the balance sheet of Maya Limited at December 31 (in thousands).
The company has received a large order and anticipates the need to go to its
bank to increase its borrowings. As a result, it has to forecast its cash
requirements for January, February and March. Typically, the company

741
 [MANAGEMENT OF WORKING CAPITAL]

collects 20 per cent of its sales in the month of sale, 70 per cent in the
subsequent month, and 10 per cent in the second month after the sale.
All sales are credit sales.

₹ ₹
Cash 50 Accounts payable Bank 360
Accounts receivable 530 Bank loan 400
Inventories 545 Accruals 212
Current assets 1,125 Current liabilities 972
Net fixed assets 1,836 Long-term debt 450
Common stock 100
Retained earnings 1,439
Total assets 2,961 Total liabilities and equity 2,961

Purchases of raw materials are made in the month prior to the sale and
amount to 60 per cent of sales in the subsequent month. Payments for these
purchases occur in the month after the purchase. Labour costs, including
overtime, are expected to be ₹ 1,50,000 in January, ₹ 2,00,000 in February,
and ₹ 1,60,000 in March. Selling, administrative, taxes, and other cash
expenses are expected to be ₹ 1,00,000 per month for January through March.
Actual sales in November and December and projected sales for January
through April are as follows (in thousands):

₹ ₹ ₹
November 500 January 600 March 650
December 600 February 1,000 April 750

On the basis of this information:

a. Prepare a cash budget for the months of January, February, and March.

b. Determine the amount of additional bank borrowings necessary to

maintain a cash balance of ₹ 50,000 at all times.

c. Prepare a pro forma balance sheet for March 31.

(Study Material ICAI TYK – 10)

Solution:

742
 [MANAGEMENT OF WORKING CAPITAL]

A. Cash Budget
(in thousands)

Nov. Dec. Jan. Feb. Mar.

₹ ₹ ₹ ₹ ₹
Opening Balance (A) 50 50 50
Sales 500 600 600 1,000 650
Receipts:
Collections, current month‟s sales 120 200 130
Collections, previous month‟s sales 420 420 700
Collections, previous 2 month‟s sales 50 60 60
Total (B) 590 680 890
Purchases 360 600 390 450
Payments:
Payment for purchases 360 600 390
Labour costs 150 200 160
Other expenses 100 100 100
Total (C) 610 900 650
Surplus/Deficit (D) = (A + B – C) 30 (170) 290
Minimum cash balance (E) 50 50 50
Additional borrowings (F) = (E − D) 20 220 (240)

Jan. ₹ Feb. ₹ Mar. ₹

Additional Borrowing 20 220 (240)
Cumulative Borrowing 420 640 400

The amount of financing peaks in February owing to the need to pay for
purchases made the previous month and higher labour costs. In March,
substantial collections are made on the prior month‟s billings, causing large
net cash inflow sufficient to pay off the additional borrowings.

B. Pro Forma Balance Sheet, March 31 (in thousands)

Equity & liabilities Amount Assets Amount

(₹ in ‘000) (₹ in ‘000)
Equity shares capital 100 Net fixed assets 1,836
Retained earnings 1,529 Inventories 635
Long-term borrowings 450 Accounts receivables 620
Accounts payables 450 Cash and bank 50
Loan from banks 400
Other liabilities 212

743
 [MANAGEMENT OF WORKING CAPITAL]

3,141 3,141

Accounts receivable = Sales in March × 0.8 + Sales in February × 0.1

= ₹ 650 × 0.8 + ₹ 1,000 × 0.1 = ₹ 620

Inventories = ₹ 545 + Total purchases from January to March –

Total sales from January to March × 0.6

= ₹ 545 + (₹ 600 + ₹ 390 + ₹ 450) − (₹ 600 + ₹ 1000 +

₹ 650) × 0.6 = ₹ 635

Accounts payable = Purchases in March = ₹ 450

Retained earnings = ₹ 1,439 + Sales – Payment for purchases – Labour

costs and – Other expenses, all for January to March

= ₹ 1,439 + (₹ 600 + ₹ 1000 + ₹ 650) – (₹ 360 + ₹ 600

+ ₹ 390) – (₹ 150 + ₹ 200 + ₹ 160) – (₹ 100 + ₹ 100 + ₹
100) = ₹ 1,529

Question – 63
A company was incorporated w.e.f. 1st April, 2021. Its authorized capital was ₹
1,00,00,000 divided into 10 lakh equity shares of ₹10 each. It intends to raise
capital by issuing equity shares of ₹ 50,00,000 (fully paid) on 1st April. Besides
this, a loan of ₹ 6,50,000 @ 12% per annum will be obtained from a financial
institution on 1st April and further borrowings will be made at same rate of
interest on the first day of the month in which borrowing is required. All
borrowings will be repaid along with interest on the expiry of one year. The
company will make payment for the following assets in April.

Particulars (₹)
Plant and Machinery 10,00,000
Land and Building 20,00,000
Furniture 5,00,000
Motor Vehicles 5,00,000
Stock of Raw Materials 5,00,000

The following further details are available:

(1) Projected Sales (April-September):

744
 [MANAGEMENT OF WORKING CAPITAL]

(₹)
April 15,00,000
May 17,50,000
June 17,50,000
July 20,00,000
August 20,00,000
September 22,50,000

(2) Gross profit margin will be 25% on sales.

(3) The company will make credit sales only and these will be collected in
the second month following sales.

(4) Creditors will be paid in the first month following credit purchases. There
will be credit purchases only.

(5) The company will keep minimum stock of raw materials of ₹ 5,00,000.

(6) Depreciation will be charged @ 10% per annum on cost on all fixed
assets.

(7) Payment of miscellaneous expenses of ₹ 50,000 will be made in April.

(8) Wages and salaries will be ₹ 1,00,000 each month and will be paid on the
first day of the next month.

(9) Administrative expenses of ₹ 50,000 per month will be paid in the month
of their incurrence.

(10) No minimum cash balance is required.

You are required to PREPARE the monthly cash budget (April-September), the
projected Income Statement for the 6 months period and the projected Balance
Sheet as on 30th September, 2021.

(RTP Nov – 2022)

Solution:

Monthly Cash Budget (April-September) (₹)

Apr May Jun Jul Aug Sep

Opening
cash - 10,50,000 - 1,37,500 5,25,000 7,25,000
balance
A. Cash

745
 [MANAGEMENT OF WORKING CAPITAL]

inflows
Equity 50,00,000 - - - - -
shares
Loans
(Refer to 6,50,000 1,25,000 - - - -
working
note 1)
Receipt - - 15,00,000 17,50,000 17,50,000 20,00,000
from
debtors
Total (A) 56,50,000 11,75,000 15,00,000 18,87,500 22,75,000 27,25,000
B. Cash
Outflows
Plant and 10,00,000 - - - - -
Machinery
Land and 20,00,000 - - - - -
Building
Furniture 5,00,000 - - - - -
Motor 5,00,000 - - - - -
Vehicles
Stock of
raw
materials 5,00,000 - - - - -
(Minimum
stock)
Miscellane
ous 50,000 - - - - -
expenses
Payment to
creditors
for credit
purchases - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
(Refer to
working
note 2)
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
Admn. 50,000 50,000 50,000 50,000 50,000 50,000
expenses
Total :(B) 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Closing
balance 10,50,000 - 1,37,500 5,25,000 7,25,000 11,75,000
(A)-(B)

746
 [MANAGEMENT OF WORKING CAPITAL]

Budgeted Income Statement for six-month period ending 30th September

Particulars (₹) Particulars (₹)

To Purchases 83,37,500 By Sales 1,12,50,000
To Wages and Salaries 6,00,000 By Closing stock 5,00,000
To Gross profit c/d 28,12,500
1,17,50,000 1,17,50,000
To Admn. expenses 3,00,000 By Gross profit b/d 28,12,500
To Depreciation 2,00,000
(10% on ₹ 40 lakhs for
six months)
To Accrued interest on 45,250
loan (Refer to working
note 3)

To Miscellaneous 50,000
expenses To
Net profit c/d 22,17,250
28,12,500 28,12,500

Projected Balance Sheet as on 30 th September, 2021

Liabilities Amount Assets Amount

(₹) (₹)
Share Capital: Fixed Assets:

Authorized capital Land and 20,00,000

10,00,000 equity 1,00,00,000 Building
shares of ₹ 10 each
Less: 1,00,000 19,00,000
Issued, subscribed Depreciation
and paid up capital
5,00,000 equity 50,00,000 Plant and 10,00,000
shares of ₹ 10 each Machinery

Reserve and Less: 50,000 9,50,000

Surplus: Depreciation

Profit and Loss 22,17,250 Furniture 5,00,000

Long-term loans Less: 25,000 4,75,000 38,00,000

7,75,000 Depreciation
Current liabilities
and provisions: Motor Vehicles 5,00,000

Less: 25,000 4,75,000

Depreciation

Current Assets:

Sundry creditors 15,87,500 Stock 5,00,000

747
 [MANAGEMENT OF WORKING CAPITAL]

Accrued interest 45,250 Sundry debtors 42,50,000

Outstanding 1,00,000 Cash 11,75,000 59,25,000
expenses 17,32,750
97,75,000 97,75,000

Working Notes:
Subsequent Borrowings Needed

Apr May Jun Jul Aug Sep

A. Cash Inflow
Equity shares 50,00,000
Loans 6,50,000
Receipt from - - 15,00,000 17,50,000 17,50,000 20,00,000
debtors
Total (A) 56,50,000 - 15,00,000 17,50,000 17,50,000 20,00,000
B. Cash Outflow
Purchase of fixed 40,00,000
assets
Stock 5,00,000
Miscellaneous 50,000
expenses
Payment to - 10,25,000 12,12,500 12,12,500 14,00,000 14,00,000
creditors
Wages and - 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
salaries
expenses 50,000 50,000 50,000 50,000 50,000 50,000
Total 46,00,000 11,75,000 13,62,500 13,62,500 15,50,000 15,50,000
Surplus/ (Deficit) 10,50,000 (11,75,000) 1,37,500 3,87,500 2,00,000 4,50,000
Cumulative 10,50,000 (1,25,000) 12,500 4,00,000 6,00,000 10,50,000
balance

1. There is shortage of cash in May of ₹ 1,25,000 which will be met by

borrowings in May.

2. Payment to Creditors

Purchases = Cost of goods sold - Wages and salaries

Purchases for April = (75% of 15,00,000) - ₹ 1,00,000 = ₹ 10,25,000

(Note: Since gross margin is 25% of sales, cost of manufacture i.e.

materials plus wages and salaries should be 75% of sales)

Hence, Purchases = Cost of manufacture minus wages and salaries of ₹

1,00,000)

The creditors are paid in the first month following purchases.

748
 [MANAGEMENT OF WORKING CAPITAL]

Therefore, payment in May is ₹ 10,25,000

The same procedure will be followed for other months.

April (75% of 15,00,000) - ₹ 1,00,000 = ₹ 10,25,000

May (75% of 17,50,000) - ₹ 1,00,000 = ₹ 12,12,500

June (75% of 17,50,000) - ₹ 1,00,000 = ₹ 12,12,500

July (75% of 20,00,000) - ₹ 1,00,000 = ₹ 14,00,000

August (75% of 20,00,000) - ₹ 1,00,000 = ₹ 14,00,000

September (75% of 22,50,000) - ₹ 1,00,000 = ₹ 15,87,500

Minimum Stock ₹ 5,00,000

Total Purchases ₹ 83,37,500

3. Accrued Interest on Loan

12% interest on ₹ 6,50,000 for 6 months 39,000

Add: 12% interest on ₹ 1,25,000 for 5 months 6,250

45,250

Question – 64
A garment trader is preparing cash forecast for first three months of calendar
year 2021. His estimated sales for the forecasted periods are as below:

January ( ₹ '000) February (₹ '000) March (₹ '000)

Total sales 600 600 800

(i) The trader sells directly to public against cash payments and to other
entities on credit. Credit sales are expected to be four times the value of
direct sales to public. He expects 15% customers to pay in the month in
which credit sales are made, 25% to pay in the next month and 58% to
pay in the next to next month. The outstanding balance is expected to be
written off.

749
 [MANAGEMENT OF WORKING CAPITAL]

(ii) Purchases of goods are made in the month prior to sales and it amounts
to 90% of sales and are made on credit. Payments of these occur in the
month after the purchase. No inventories of goods are held.

(iii) Cash balance as on 1st January, 2021 is ₹ 50,000.

(iv) Actual sales for the last two months of calendar year 2020 are as below:

November (₹'000) December (₹ '000)

Total sales 640 880

You are required to prepare a monthly cash, budget for the three months from
January to March, 2021.

(Exam, Dec – 2021)

Solution:

Working Notes:

(1) Calculation of cash and credit sales (₹ in thousands)

Nov. Dec. Jan. Feb. Mar.

Total Sales 640 880 600 600 800
Cash Sales (1/5th of total sales) 128 176 120 120 160
Credit Sales (4/5th of total sales) 512 704 480 480 640

(2) Calculation of Credit Sales Receipts

Month Nov. Dec. Jan. Feb. Mar.

Forecast Credit sales 512.00 704.00 480.00 480.00 640.00
(Working note 1)
Receipts:
15% in the month of sales 72.00 72.00 96.00
25% in next month 176.00 120.00 120.00
58% in next to next 296.96 408.32 278.40
month
Total 544.96 600.32 494.40

Cash Budget (₹ in thousands)

Nov. Dec. Jan. Feb. Mar.

Opening Balance (A) 50.00 174.96 355.28
Sales 640.00 880.00 600.00 600.00 800.00

750
 [MANAGEMENT OF WORKING CAPITAL]

Receipts:
Cash Collection (Working 120.00 120.00 160.00
note 1)
Credit Collections (Working 544.96 600.32 494.40
note 2)
Total (B) 664.96 720.32 654.40
Purchases (90% of sales in 540 540 720
the month prior to sales)

Payments:
Payment for purchases (next 540 540 720
month)
Total (C) 540 540 720
Closing balance (D) 174.96 355.28 289.68
= (A + B – C)

Question – 65
Slide Ltd. is preparing a cash flow forecast for the three month period from
January to the end of March. The following sales volumes have been forecasted :

December January February March April

Sales (units) 1800 1875 1950 2100 2250

Selling price per unit ₹ 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 ₹ 150 per unit. No raw material inventory is
held. Raw materials purchases are on one month credit. Variable overheads and
wages equal to ₹ 100 per unit are incurred during production and paid in the
month of production. The opening cash balance on 1st January is expected to be
₹ 35,000. A long term loan of ₹ 2,00,000 is expected to be received in the month
of March. A machine costing ₹ 3,00,000 will be purchased in March.

(a) Prepare a cash budget for the months of January, February and March
and calculate the cash balance at the end of each month is the three
months period.

(b) Calculate the forecast current ration at the end of the three months
period.
(Exam, Nov – 2019)

Solution:

Working Notes:

751
 [MANAGEMENT OF WORKING CAPITAL]

(1) Calculation of Collection from Trade Receivables:

Particulars December January February March

Sales (units) 1,800 1,875 1,950 2,100
Sales (@ ₹ 600 per 11,25,000 11,70,000 12,60,000
unit) /Trade 10,80,000
Receivables (Debtors)
(₹)
Collection from Trade 10,80,000 11,25,000 11,70,000
Receivables (Debtors)
(₹)

(2) Calculation of Payment to Trade Payables:

Particulars December January February March

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

(3) Calculation of Variable Overheads and Wages:

Particulars January February March

Output (units) 1,950 2,100 2,250
Payment in the same month @ ₹ 100 1,95,000 2,10,000 2,25,000
per unit (₹)

(a) Preparation of Cash Budget

Particulars January (₹) February (₹) March (₹)

Opening Balance 35,000 3,57,500 6,87,500
Receipts:
Collection from Trade 10,80,000 11,25,000 11,70,000
Receivables (Debtors)
Receipt of Long-Term Loan 2,00,000
Total (A) 11,15,000 14,82,500 20,57,500
Payments:
Trade Payables (Creditors) for 5,62,500 5,85,000 6,30,000
Materials

752
 [MANAGEMENT OF WORKING CAPITAL]

Variable Overheads and 1,95,000 2,10,000 2,25,000

Wages
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,000
Closing Balance (A – B) 3,57,500 6,87,500 9,02,500

(b) Calculation of Current Ratio

Particulars March (₹)

Output Inventory (i.e. units produced in March)
[(2,250 units × 2 units of raw material per unit of 9,00,000
output × ₹ 150 per unit of raw material) + 2,250 units
× ₹ 100 for variable overheads and wages]
or, [6,75,000 + 2,25,000] from Working Notes 2 and 3
Trade Receivables (Debtors) 12,60,000
Cash Balance 9,02,500
Current Assets 30,62,500
Trade Payables (Creditors) 6,75,000
Current Liabilities 6,75,000
Current Ratio (Current Assets/Current Liabilities) 4.537 approx.

Question – 66
K Ltd. has a Quarterly cash outflow of ₹ 9,00,000 arising uniformly during the
Quarter. The company has an Investment portfolio of Marketable Securities. It
plans to meet the demands for cash by periodically selling marketable
securities. The marketable securities are generating a return of 12% p.a.
Transaction cost of converting investments to cash is ₹ 60. The company uses
Baumol model to find out the optimal transaction size for converting
marketable securities into cash.

Consider 360 days in a year.

You are required to calculate

(i) Company's average cash balance,

(ii) Number of conversions each year and

(iii) Time interval between two conversions.

(Exam, Nov – 2022)

Solution:

753
 [MANAGEMENT OF WORKING CAPITAL]

(i) Computation of Average Cash balance:

Annual cash outflow (U) = 9,00,000 × 4 = ₹ 36,00,000

Fixed cost per transaction (P) = ₹ 60

12
Opportunity cost of one rupee p.a. (S) = = 0.12
100

2UP 2 × 36,00,000 × 60
Optimum cash balance (C) = = = ₹ 60,000
S S

0 + 60,000
∴ Average Cash balance = = ₹ 30,000
2

(ii) Number of conversions p.a.

Annual cash outflow = ₹ 36,00,000

Optimum cash balance = ₹ 60,000

36,00,000
∴ No. of conversions p.a = = 60
60,000

(iii) Time interval between two conversions

No. of days in a year = 360

No. of conversions p.a. = 60

360
∴ No. of conversions p.a = = 6 days
60

Question – 67
You are given the following information:

Estimated monthly Sales are as follows:

₹ ₹
January 5,50,000 June 4,40,000
February 6,60,000 July 5,50,000
March 7,70,000 August 4,40,000
April 4,40,000 September 3,30,000
May 3,30,000 October 5,50,000

754
 [MANAGEMENT OF WORKING CAPITAL]

(i) Wages and Salaries are estimated to be payable as follows:

₹ ₹
April 49,500 July 55,000
May 44,000 August 49,500
June 55,000 September 49,500

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales
are collected within one month and the balance in two months. There are
no bad debt losses.

(iv) Purchases amount to 75% of sales and are made and paid for in the
month preceding the sales.

(v) The firm has taken a loan of ₹ 6,00,000. Interest @ 12% p.a. has to be
paid quarterly in January, April and so on.

(vi) The firm is to make payment of tax of ₹26,000 in July 2023.

(vii) The firm had a cash balance of ₹ 35,000 on 1st April 2023 which is the
minimum desired level of cash balance. Any cash surplus/deficit
above/below this level is made up by temporary investments/liquidation
of temporary investments or temporary borrowings at the end of each
month (interest on these to be ignored).

Required:

PREPARE monthly cash budgets for six months beginning from April, 2023 on
the basis of the above information.

(MTP March – 2023)

Solution:

Computation – Collections from Customers

Particulars Feb Mar Apr May Jun Jul Aug Sep

(₹) (₹) (₹) (₹) (₹) (₹) (₹) (₹)
Total Sales 6,60,000 7,70,000 4,40,000 3,30,000 4,40,000 5,50,000 4,40,000 3,30,000
Credit Sales 4,95,000 5,77,500 3,30,000 2,47,500 3,30,000 4,12,500 3,30,000 2,47,500
(75% of total
Sales)
Collection 2,97,000 3,46,500 1,98,000 1,48,500 1,98,000 2,47,500 1,98,000
(within one
month)
Collection 1,98,000 2,31,000 1,32,000 99,000 1,32,000 1,65,000
(within two

755
 [MANAGEMENT OF WORKING CAPITAL]

months)
Total 5,44,500 4,29,000 2,80,500 2,97,000 3,79,500 3,63,000
Collections

Monthly Cash Budget for Six Months: April to September 2023

Particulars April May June July August Sept.

(₹) (₹) (₹) (₹) (₹) (₹)
Receipts:
Opening Balance 35,000 35,000 35,000 35,000 35,000 35,000
Cash Sales 1,10,000 82,500 1,10,000 1,37,500 1,10,000 82,500
Collections from Debtors 5,44,500 4,29,000 2,80,500 2,97,000 3,79,500 3,63,000
Total Receipts (A) 6,89,500 5,46,500 4,25,500 4,69,500 5,24,500 4,80,500
Payments:
Purchases 2,47,500 3,30,000 4,12,500 3,30,000 2,47,500 4,12,500
Wages and Salaries 49,500 44,000 55,000 55,000 49,500 49,500
Interest on Loan 18,000 ------ ------ 18,000 ------- ------
Tax Payment ------ ------- _------- 26,000 ------ -----
Total Payment (B) 3,15,000 3,74,000 4,67,500 4,29,000 2,97,000 4,62,000
Minimum Cash Balance 35,000 35,000 35,000 35,000 35,000 35,000
Total Cash Required (C) 3,50,000 4,09,000 5,02,500 4,64,000 3,32,000 4,97,000
Surplus/ (Deficit) (A)-(C) 3,39,500 1,37,500 -77,000 5,500 1,92,500 -16,500
Investment/Financing:
Total effect of (Invest)/ -3,39,500 -1,37,500 77,000 -5,500 -1,92,500 16,500
Financing (D)
Closing Cash Balance (A) 35,000 35,000 35,000 35,000 35,000 35,000
+ (D) - (B)

Question – 68
PREPARE monthly cash budget for the first six months of 2021 on the basis of
the following information:

(i) Actual and estimated monthly sales are as follows:

Actual (₹) Estimated (₹)

October 2020 2,00,000 January 2021 60,000
November 2020 2,20,000 February 2021 80,000
December 2020 2,40,000 March 2021 1,00,000
April 2021 1,20,000
May 2021 80,000
June 2021 60,000
July 2021 1,20,000

(ii) Operating Expenses (including salary & wages) are estimated to be

payable as follows:

756
 [MANAGEMENT OF WORKING CAPITAL]

Month (₹) Month (₹)

January 2021 22,000 April 2021 30,000
February 2021 25,000 May 2021 25,000
March 2021 30,000 June 2021 24,000

(iii) Of the sales, 75% is on credit and 25% for cash. 60% of the credit sales
are collected after one month, 30% after two months and 10% after three
months.

(iv) Purchases amount to 80% of sales and are made on credit and paid for
in the month preceding the sales.

(v) The firm has 12% debentures of ₹ 1,00,000. Interest on these has to be
paid quarterly in January, April and so on.

(vi) The firm is to make an advance payment of tax of ₹ 5,000 in April.

(vii) The firm had a cash balance of ₹ 40,000 at 31st Dec. 2020, 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).

(MTP March – 2021)

Solution:

Monthly Cash Budget for first six months of 2021

(Amount in ₹ )

Particulars Jan. Feb. Mar. April. May. June.

Opening balance 40,000 40,000 40,000 40,000 40,000 40,000
Receipts:
Cash sales 15,000 20,000 25,000 30,000 20,000 15,000
Collection from debtors 1,72,500 97,500 67,500 67,500 82,500 70,500
Total cash available (A) 2,27,500 1,57,500 1,32,500 1,37,500 1,42,500 1,25,500
Payments:
Purchases 64,000 80,000 96,000 64,000 48,000 96,000
Operating Expenses 22,000 25,000 30,000 30,000 25,000 24,000
Interest on debentures 3,000 - - 3,000 - -
Tax payment - - - 5,000 - -
Total payments (B) 89,000 1,05,000 1,26,000 1,02,000 73,000 1,20,000
Minimum cash balance 40,000 40,000 40,000 40,000 40,000 40,000
desired

757
 [MANAGEMENT OF WORKING CAPITAL]

Total cash needed (C) 1,29,000 1,45,000 1,66,000 1,42,000 1,13,000 1,60,000
Surplus/(deficit) (A -C) 98,500 12,500 (33,500) (4,500) 29,500 (34,500)
Investment/financing
Temporary Investments
Liquidation of temporary (98,500) (12,500) - - (29,500) -
investments or 33,500 4,500
temporary borrowings - 34,500
Total effect of (98,500) (12,500) 33,500 4,500 (29,500) 34,500
investment/financing(D)
Closing cash balance 40,000 40,000 40,000 40,000 40,000 40,000
(A + D- B)

Workings:

1. Collection from debtors: (Amount in ₹)

Year 2020 Year 2021

Oct. Nov. Dec. Jan. Feb Mar. April May June
Total sales 2,00,000 2,20,000 2,40,000 60,000 80,000 1,00,000 1,20,000 80,000 60,000
Credit sales 1,50,000 1,65,000 1,80,000 45,000 60,000 75,000 90,000 60,000 45,000
(75% of total
sales)
Collections:
One month 90,000 99,000 1,08,000 27,000 36,000 45,000 54,000 36,000
Two months 45,000 49,500 54,000 13,500 18,000 22,500 27,000
Three months 15,000 16,500 18,000 4,500 6,000 7,500

Total 1,72,500 97,500 67,500 67,500 82,500 70,500

collections

2. Payment to Creditors: (Amount in ₹)

Year 2021
Jan Feb Mar Apr May Jun Jul
Total sales 60,000 80,000 1,00,000 1,20,000 80,000 60,000 1,20,000
Purchases
(80% of total sales) 48,000 64,000 80,000 96,000 64,000 48,000 96,000
Payment
One Month Prior 64,000 80,000 96,000 64,000 48,000 96,000

(5) INVENTORY MANAGEMENT

Question – 69
A Company requires 36,000 units of a product per year at cost of ₹ 100 per unit.
Ordering cost per order is ₹ 250 and the carrying cost is 4.5% per year of the
inventory cost. Normal lead time is 25 days and safety.

Stock is NIL.

758
 [MANAGEMENT OF WORKING CAPITAL]

Assume 360 working days in a year.

(i) Calculate the Reorder Inventory Level.

(ii) Calculate the economic order Quantity (EOQ).

(iii) If the supplier offers 1% Quantity discount for purchase in lots of 9,000
units or more, should the company accept the proposal ?

(Exam, May – 2022)

Solution:

Annual Consumption = 36,000 (A)

Ordering Cost = 250 per order (O)

4.5
Carrying Cost = × 100 = 4.5 (C)
100

Lead Time = 25 days

(i) Reorder Level = Lead Time × Daily Consumption

36,000
= 25 ×
360

= 2,500 units

2AO
(ii) Economic Order Quantity (EOQ) =
C

2 × 36,000 × 250
=
4.5

= 2,000 units

(iii) Evaluation of Profitability of Quantity Discount Offer:

(a) When EOQ is ordered

(₹)
Purchase Cost (36,000 units × 100) 36,00,000
Ordering Cost [(36,000 units/2,000 units) × 250] 4,500
Carrying Cost (2,000 units × ½ × 4.5) 4,500

759
 [MANAGEMENT OF WORKING CAPITAL]

Total Cost 36,09,000

(b) When Quantity Discount is accepted

(₹)
Purchase Cost (36,000 units × ₹ 99*) 35,64,000
Ordering Cost [(36,000 units/9,000 units) × ₹250] 1,000
Carrying Cost (9,000 units × ½ × ₹ 99 × 4.5%) 20,048
Total Cost 35,85,048

*Unit Cost = ₹100

Less: Quantity Discount @ 1% = ₹ 1

Purchase Cost = ₹ 99

Advise – The total cost of inventory is lower if Quantity Discount is

accepted. Hence, the company is advised to accept the proposal.

(6) RESIDUAL

Question – 70
A firm has the following data for the year ending 31st March, 2017:

(₹)
Sales (1,00,000 @ ₹ 20) 20,00,000
Earnings before Interest and Taxes 2,00,000
Fixed Assets 5,00,000

The three possible current assets holdings of the firm are ₹ 5,00,000, ₹
4,00,000 and ₹ 3,00,000. It is assumed that fixed assets level is constant and
profits do not vary with current assets levels. So, the effect of the three
alternative current assets policies.

(Study Material ICAI Illus – 01)

Solution:

Conservative Moderate Aggressive

(₹) (₹) (₹)
Sales 20,00,000 20,00,000 20,00,000
Earnings before Interest and Taxes 2,00,000 2,00,000 2,00,000
(EBIT)
Current Assets 5,00,000 4,00,000 3,00,000

760
 [MANAGEMENT OF WORKING CAPITAL]

Fixed Assets 5,00,000 5,00,000 5,00,000

Total Assets 10,00,000 9,00,000 8,00,000
Return on Total Assets (EBIT÷ Total 20% 22.22% 25%
Assets)
Current Assets/Fixed Assets 1.00 0.80 0.60

The aforesaid calculation shows that the conservative policy provides greater
liquidity (solvency) to the firm, but lower return on total assets. On the other
hand, the aggressive policy gives higher return, but low liquidity and thus is
very risky. The moderate policy generates return higher than Conservative
policy but lower than aggressive policy. This is less risky than aggressive policy
but riskier than conservative policy. It also reflects inverse relationship
between Current Assets / Fixed Assets ratio and Return on Total Assets.

In determining the optimum level of current assets, the firm should balance the
profitability – solvency tangle by minimizing total costs – Cost of liquidity and
cost of illiquidity.

Question – 71
Suppose ABC Ltd. has been offered credit terms from its major supplier of
2/10, net 45. Hence the company has the choice of paying ₹ 10 per ₹ 100 or to
invest ₹ 98 for an additional 35 days and eventually pay the supplier ₹ 100 per
₹ 100. The decision as to whether the discount should be accepted depends on
the opportunity cost of investing ₹ 98 for 35 days. What should the company
do?

(Study Material ICAI Illus – 17)

Solution:

If the company does not avail the cash discount and pays the amount after 45
days, the implied cost of interest per annum would be approximately.
365
100 35
− 1 = 23.5%
100 − 2

Now let us assume the ABC Ltd. can invest the additional cash and can obtain
an annual return of 25% and if the amount of invoice is ₹ 10,000. The
alternatives are as follows:

761
 [MANAGEMENT OF WORKING CAPITAL]

Refuse Accept
Discount Discount
₹ ₹
Payment to supplier 10,000 9,800
Return from investing ₹ 9,800 between day 10 and day
35 (235)
45: × ₹ 9,800 × 25%
365
Net Cost 9,765 9,800

Advise: Thus it is better for the company to refuse the discount, as return on
cash retained is more than the saving on account of discount.

Question – 72
The Dolce Company purchases raw materials on terms of 2/10, net 30. A
review of the company‟s records by the owner, Mr. Gautam, revealed that
payments are usually made 15 days after purchases are made. When asked
why the firm did not take advantage of its discounts, the accountant, Mr.
Rohit, replied that it cost only 2 per cent for these funds, whereas a bank loan
would cost the company 12 per cent.

(a) ANALYSE what mistake is Rohit making?

(b) If the firm could not borrow from the bank and was forced to resort to
the use of trade credit funds, what suggestion might be made to Rohit
that would reduce the annual interest cost? IDENTIFY.

(Study Material ICAI Illus – 18)

Solution:

(a) Rohit‟s argument of comparing 2% discount with 12% bank loan rate is
not rational as 2% discount can be earned by making payment 5 days in
advance i.e. within 10 days rather 15 days as payments are made
presently. Whereas 12% bank loan rate is for a year.

Assume that the purchase value is ₹ 100, the discount can be earned by
making payment within 10 days is ₹ 2, therefore, net payment would be ₹
98 only. Annualized benefit

₹2 365 days
= × × 100 = 149%
₹ 98 5 days

This means cost of not taking cash discount is 149%.

762
 [MANAGEMENT OF WORKING CAPITAL]

(b) If the bank loan facility could not be available, then in this case the
company should resort to utilize maximum credit period as possible.

Therefore, payment should be made in 30 days to reduce the interest

cost.

Question – 73
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 ₹’000)

2018–19 2019–20 2020–21

Sales
Cash 400 960 1,600
Credit 3,600 8,640 14,400
Total sales 4,000 9,600 16,000
Cost of goods sold 2,480 5,664 9,600
Gross profit 1,520 3,936 6,400
Operating expenses:
General, administration, and selling 160 900 2,000
expenses
Depreciation 200 800 1,320
Interest expenses (on borrowings) 120 316 680
Profit before tax (PBT) 1,040 1,920 2,400
Tax @ 30% 312 576 720
Profit after tax (PAT) 728 1,344 1,680

BALANCE SHEET (In ₹’000)

2018–19 2019–20 2020–21

Assets
Non-Current Assets
Fixed assets (net of depreciation) 3,800 5,000 9,400
Current Assets
Cash and cash equivalents 80 200 212
Accounts receivable 600 3,000 4,200

763
 [MANAGEMENT OF WORKING CAPITAL]

Inventories 640 3,000 4,500

Total 5,120 11,200 18,312
Equity & Liabilities
Equity share capital (shares of ₹10 each) 2,400 3,200 4,000
Other Equity 728 2,072 3,752
Non-Current borrowings 1,472 2,472 5,000
Current liabilities 520 3,456 5,560
Total 5,120 11,200 18,312

INDUSTRY AVERAGE OF KEY RATIOS

Ratio Sector Average

Current ratio 2.30:1
Acid test ratio (quick ratio) 1.20:1
Receivable turnover ratio 7 times
Inventory turnover ratio 4.85 times
Long-term debt to total debt 24%
Debt-to-equity ratio 35%
Net profit ratio 18%
Return on total assets 10%
Interest coverage ratio (times interest earned) 10

As a loan officer of Expo-Impo Bank, you are REQUIRED to apprise the loan
proposal on the basis of comparison with industry average of key ratios
considering closing balance for accounts receivable of ₹ 6,00,000 and
inventories of ₹ 6,40,000 respectively as on 31st March, 2018.

(MTP Nov – 2021)

Solution:
(In ₹ ‘000)
Ratio Formula 2018–19 2019–20 2020–21 Indus-
try
Average
Current Current Assets 1,320 6,200 8,912
ratio Current Liabilities 520 3,456 5,560 2.30:1
= 2.54 = 1.80 = 1.60
Acid test 680 3,200 4,212
= 1.31 = 0.93 = 0.79
ratio Quick Assets 520 3,456 5,560 1.20:1
Current Liabilities
(quick
ratio)
Receivable 3,600 8,640 14,400
turnover Credit Sales (600+600)/2 (600+3,000)/2 (3,000+4,200/2 7 times
ratio Average Accounts Receivable =6 = 4,80 =4

764
 [MANAGEMENT OF WORKING CAPITAL]

Inventory COGS 2,480 5,664 9,600

turnover Average Inventory 600+640 /2) 640+3,000 /2 (3,000 + 4,500)/2 4.85
ratio = 3.88 = 3.11 = 2.56 times
Long-term Long term Debt 1,472 2,472 5,000
×100 × 100 × 100 × 100
debt to Total Debt 1,992 5,928 10,560 24 %
total debt = 73.90% = 41.70 = 47.35%
Debt-to- 1,472 2,472 5,000 35 %
× 100 × 100 × 100
equity Long term Debt 3,128 5,272 7,752
× 100
ratio shareholders ' Equity
= 47.06% = 46.89% = 64.50%
Net profit Net profit 728 1,344 1,680 18%
× 100 × 100 × 100 × 100
ratio Sales 4,000 9,600 16,000

= 18.2% = 14% = 10.5%

Return on Net Profit After Tax 728 1,344 1,680 10%
× 100 × 100 × 100 × 100
total Total Assets 5,120 11,200 18,312
assets
= 14.22% = 12% = 9.17%
Interest 1,160 2,236 3,080 10
coverage EBIT 120 316 680
ratio Interest
(times = 9.67 = 7.08 = 4.53
interest
earned)

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 onthe industry norm. Additionally, though the
Return on Total Asset (ROTA) is near to industry average, it is declining as well.
The interest coverage ratio measures how many times a company can cover its
current interest payment with its available earnings. A high interest coverage
ratio means that an enterprise can easily meet its interest obligations, however,
it is declining in the case of Jensen & Spencer and is also below the industry
average indicating excessive use of debt or inefficient operations.

On overall comparison of the industry average of key ratios than that of Jensen
& Spencer, the company is in deterioration position. The company‟s
profitability has declined steadily over the period. However, before jumping to
the conclusion relying only on the key ratios, it is pertinent to keep in mind the
industry, the company dealing in with i.e. manufacturing of pharmaceutical
drugs. The pharmaceutical industry is one of the major contributors to the

765
 [MANAGEMENT OF WORKING CAPITAL]

economy and is expected to grow further. After the covid situation, people are
more cautious towards their health and are going to spend relatively more on
health medicines. Thus, while analysing the loan proposal, both the factors,
financial and non-financial, needs to be kept in mind.

Question – 74
A company is considering its working capital investment and financial policies
for the next year. Estimated fixed assets and current liabilities for the next year
are ₹ 2.60 crores and ₹ 2.34 crores respectively. Estimated Sales and EBIT
depend on current assets investment, particularly inventories and book-debts.
The Financial Controller of the company is examining the following alternative
Working Capital Policies:

(₹ in crore)
Working Capital Investment in Estimated Sales EBIT
Policy Current Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00

After evaluating the working capital policy, the Financial Controller has advised
the adoption of the moderate working capital policy. The company is now
examining the use of long-term and short-term borrowings for financing its
assets. The company will use ₹ 2.50 crores of the equity funds. The corporate
tax rate is 35%. The company is considering the following debt alternatives.

(₹ in crore)
Financing Policy Short-term Debt Long-term Debt
Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16%

You are required to CALCULATE the following:

(i) Working Capital Investment for each policy:

(a) Net Working Capital position

(b) Rate of Return

(c) Current ratio

766
 [MANAGEMENT OF WORKING CAPITAL]

(ii) Financing for each policy:

(a) Net Working Capital position.

(b) Rate of Return on Shareholders‟ equity.

(c) Current ratio.

(RTP May – 2019)

Solution:

(i) Statement showing Working Capital Investment for each policy

(₹ in crore)
Working Capital Policy
Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v) = (iii) - (iv) 4.76 4.16 2.86
Total liabilities: (iv) + (v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital 2.16 1.56 0.26
position: (i) - (iv)
(b) Rate of return: (vii) 17.32% 17.69% 19.23%
/(iii)
(c) Current ratio: (i)/ (iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy

(₹ in crore)
Working Capital Policy
Financing Policy Conservative Moderate Aggressive
Current Assets (i) 3.90 3.90 3.90
Fixed Assets (ii) 2.60 2.60 2.60
Total Assets (iii) 6.50 6.50 6.50
Current Liabilities (iv) 2.34 2.34 2.34
Short term Debt (v) 0.54 1.00 1.50
Total current liabilities (vi) 2.88 3.34 3.84
= (iv) + (v)
Long term Debt (vii) 1.12 0.66 0.16

767
 [MANAGEMENT OF WORKING CAPITAL]

Equity Capital (viii) 2.50 2.50 2.50

Total liabilities (ix) = (vi) + 6.50 6.50 6.50
(vii) + (viii)
Forecasted Sales 11.50 11.50 11.50
EBIT (x) 1.15 1.15 1.15
Less: Interest on short-term 0.06 0.12 0.18
debt (12% of ₹0.54) (12% of ₹ 1) (12% of ₹ 1.5)
Interest on long term debt 0.18 0.11 0.03
(16% of ₹1.12) (16% of ₹0.66) (16% of ₹ 0.16)
Earnings before tax (EBT) 0.91 0.92 0.94
(xi)
Taxes @ 35% (xii) 0.32 0.32 0.33
Earnings after tax: (xiii) = 0.59 0.60 0.61
(xi) – (xii)
(a) Net Working Capital 1.02 0.56 0.06
Position: (i) - [(iv)
+ (v)]
(b) Rate of return on 23.6% 24.0% 24.4%
shareholders
Equity capital :
(xiii)/ (viii)
(c) Current Ratio (i) / 1.35 1.17 1.02
(vi)

Question – 75
Given below are the estimations for the next year by Niti Ltd.:

Particulars (₹ in corores)
Fixed Assets 5.20
Current Liabilities 4.68
Current Assets 7.80
Sales 23.00
EBIT 2.30

The company will issue equity funds of ₹ 5 crores in the next year. It is also
considering the debt alternatives of ₹ 3.32 crores for financing the assets. The
company wants to adopt one of the policies given below:

(₹ in crores)

Financing Policy Short term debt @ Long term debt @ Total

12% 16%
Conservative 1.08 2.24 3.32
Moderate 2.00 1.32 3.32
Aggressive 3.00 0.32 3.32

768
 [MANAGEMENT OF WORKING CAPITAL]

Assuming corporate tax rate at 30%, CALCULATE the following for each of the
financing policy:

(i) Return on total assets

(ii) Return on owner's equity

(iii) Net Working capital

(iv) Current Ratio

Also advise which Financing policy should be adopted if the company wants
high returns.

(RTP May – 2021)

Solution:

(i) Return on total assets

EBIT(1−T)
Return on total assets =
Total assets (FA + CA)

₹ 2.30 crores (1 − 0.3)

=
₹ 5.20 crores + ₹ 7.80 crores

₹1.61crores
= = 0.1238 or 12.38%
₹13 crores

(ii) Return on owner's equity

(Amount in ₹)
Financing policy (₹)
Conservative Moderate Aggressive
Expected EBIT 2,30,00,000 2,30,00,000 2,30,00,000
Less: Interest
Short term Debt @ 12% 12,96,000 24,00,000 36,00,000
Long term Debt @ 16% 35,84,000 21,12,000 5,12,000
Earnings before tax (EBT) 1,81,20,000 1,84,88,000 1,88,88,000
Less: Tax @ 30% 54,36,000 55,46,400 56,66,400
Earnings after Tax (EAT) 1,26,84,000 1,29,41,600 1,32,21,600
Owner's Equity 5,00,00,000 5,00,00,000 5,00,00,000
Return on owner's equity 1,26,84,000 1,29,41,600 1,32,21,600
= = =
5,00,00,000 5,00,00,000 5,00,00,000
Net Profit after taxes (EAT)
= = 0.2537 or = 0.2588 or = 0.2644 or
Owner's equity
25.37% 25.88% 26.44%

769
 [MANAGEMENT OF WORKING CAPITAL]

(iii) Net Working capital

(₹ in crores)
Financing policy
Conservative Moderate Aggressive
Current Liabilities 4.68 4.68 4.68
(Excluding Short Term
Debt)
Short term Debt 1.08 2.00 3.00
Total Current Liabilities 5.76 6.68 7.68
Current Assets 7.80 7.80 7.80
Net Working capital 7.80 - 5.76 7.80 - 6.68 7.80 - 7.68
= Current Assets – Current
= 2.04 = 1.12 = 0.12
Liabilities

(iv) Current ratio

(₹ in crores)
Financing policy
Conservative Moderate Aggressive
Current Ratio 7.80 7.80 7.80
Current Assets = = 1.35 = 1.35 = = 1.17 = = 1.02
5.76 6.68 7.68
=
Current Liabilities

Advise: It is advisable to adopt aggressive financial policy, if the company

wants high return as the return on owner's equity is maximum in this policy
i.e. 26.44%.

Question – 76
A company is considering its working capital investment and financial policies
for the next year. Estimated fixed assets and current liabilities for the next year
are ₹ 2.60 crores and ₹ 2.34 crores respectively. Estimated Sales and EBIT
depend on current assets investment, particularly inventories and book-debts.
The financial controller of the company is examining the following alternative
Working Capital Policies:

(₹ Crores)

Working Capital Policy Investment in Estimated Sales EBIT

Current Assets
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15

770
 [MANAGEMENT OF WORKING CAPITAL]

Aggressive 2.60 10.00 1.00

After evaluating the working capital policy, the Financial Controller has advised
the adoption of the moderate working capital policy. The company is now
examining the use of long-term and short-term borrowings for financing its
assets. The company will use ₹ 2.50 crores of the equity funds. The corporate
tax rate is 35%. The company is considering the following debt alternatives.

(₹ Crores)

Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12
Moderate 1.00 0.66
Aggressive 1.50 0.16
Interest rate-Average 12% 16 %

You are required to CALCULATE the following:

(i) Working Capital Investment for each policy:

(a) Net Working Capital position

(b) Rate of Return

(c) Current ratio

(ii) Financing for each policy:

(a) Net Working Capital position.

(b) Rate of Return on Shareholders‟ equity.

(c) Current ratio.

(RTP Nov – 2018)

Solution:

(i) Statement showing Working Capital for each policy

(₹ in crores)

Working Capital Policy

Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60

771
 [MANAGEMENT OF WORKING CAPITAL]

Total Assets: (iii) 7.10 6.50 5.20

Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital 2.16 1.56 0.26
position: (i)-(iv)
(b) Rate of return: 17.3% 17.7% 19.2%
(vii)/(iii)
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11

(ii) Statement Showing Effect of Alternative Financing Policy

(₹ in crores)

Financing Policy Conservative Moderate Aggressive

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

772
 [MANAGEMENT OF WORKING CAPITAL]

Multiple Choice Questions (MCQs)

1. Tiago Ltd is an all-equity company engaged in manufacturing of batteries

for electric vehicles. There has been a surge in demand for their products
due to rising oil prices. The company was established 5 years ago with an
initial capital of ₹ 10,00,000 and since then it has raised funds by IPO
taking the total paid up capital to ₹ 1 crore comprising of fully paid-up
equity shares of face value ₹ 10 each. The company currently has
undistributed reserves of ₹ 60,00,000. The company has been following
constant dividend payout policy of 40% of earnings. The retained
earnings by company are going to provide a return on equity of 20%. The
current EPS is estimated as ₹ 20 and prevailing PE ratio on the share of
company is 15x. The company wants to expand its capital base by
raising additional funds by way of debt, preference and equity mix. The
company requires an additional fund of ₹ 1,20,00,000. The target ratio of
owned to borrowed funds is 4:1 post the fund-raising activity. Capital
gearing is to be kept at 0.4x.

The existing debt markets are under pressure due to ongoing RBI action
on NPAs of the commercial bank. Due to challenges in raising the debt
funds, the company will have to offer ₹ 100 face value debentures at an
attractive yield of 9.5% and a coupon rate of 8% to the investors. Issue
expenses will amount to 4% of the proceeds.

The preference shares will have a face value of ₹ 1000 each offering a
dividend rate of 10%. The preference shares will be issued at a premium
of 5% and redeemed at a premium of 10% after 10 years at the same
time at which debentures will be redeemed.

The CFO of the company is evaluating a new battery technology to invest

the above raised money. The technology is expected to have a life of 7
years. It will generate a after tax marginal operating cash flow of ₹
25,00,000 p.a. Assume marginal tax rate to be 27%.

(MTP April – 2024)

1. Which of the following is best estimate of cost of equity for Tiago

Ltd?

(a) 12.99%

(b) 11.99%

773
 [MANAGEMENT OF WORKING CAPITAL]

(c) 13.99%

(d) 14.99%

2. Which of the following is the most accurate measure of issue price

of debentures?

(a) 100

(b) 96

(c) 90.58

(d) 95.88

3. Which of the following is the best estimate of cost of debentures to

be issued by the company? (Using approximation method)

(a) 7.64%

(b) 6.74%

(c) 4.64%

(d) 5.78%

4. Calculate the cost of preference shares using approximation

method

(a) 10.23%

(b) 11.22%

(c) 12.12%

(d) 12.22%

5. Which of the following best represents the overall cost of marginal

capital to be raised?

(a) 11.76%

(b) 17.16%

(c) 16.17%

(d) 16.71%

774
 [MANAGEMENT OF WORKING CAPITAL]

2. Ranu & Co. has issued 10% debenture of face value 100 for ₹ 10 lakh.
The debenture is expected to be sold at 5% discount. It will also involve
floatation costs of ₹ 10 per debenture. The debentures are redeemable at
a premium of 10% after 10 years. Calculate the cost of debenture if the
tax rate is 30%.

(a) 8.97%

(b) 9.56%

(c) 8.25%

(d) 10.12%

3. Given Data: Sales is ₹ 10,00,000, Break even sales is ₹ 6,00,000. What is

the Degree of operating leverage?

(a) 3

(b) 2

(c) 2.5

(d) 2.2

4. A project requires an initial investment of ₹ 20,000 and it would give

annual cash inflow of ₹ 4,000. The useful life of the project is estimated
to be 10 years. What is payback reciprocal/Approximated IRR?

(a) 20%

(b) 15%

(c) 25%

(d) 12%

5. The credit terms may be expressed as “3/15 net 60”. This means that a
3% discount will be granted if the customer pays within 15 days, if he
does not avail the offer, he must make payment within 60 days.

(a) I agree with the statement

(b) I do not agree with the statement

(c) I cannot say.

775
 [MANAGEMENT OF WORKING CAPITAL]

6. The term „net 50‟ implies that the customer will make payment:

(a) Exactly on 50th day

(b) Before 50th day

(c) Not later than 50th day

(d) None of the above.

7. Trade credit is a source of :

(a) Long-term finance

(b) Medium term finance

(c) Spontaneous source of finance

(d) None of the above.

8. The term float is used in:

(a) Inventory Management

(b) Receivable Management

(c) Cash Management

(d) Marketable securities.

9. William J Baumol‟s model of Cash Management determines optimum

cash level where the carrying cost and transaction cost are:

(a) Maximum

(b) Minimum

(c) Medium

(d) None of the above.

10. In Miller – ORR Model of Cash Management:

(a) The lower, upper limit, and return point of Cash Balances are set
out

776
 [MANAGEMENT OF WORKING CAPITAL]

(b) Only upper limit and return point are decided

(c) Only lower limit and return point are decided

(d) None of the above are decided.

11. Working Capital is defined as:

(a) Excess of current assets over current liabilities

(b) Excess of current liabilities over current assets

(c) Excess of Fixed Assets over long-term liabilities

(d) None of the above.

12. Working Capital is also known as “Circulating Capital, fluctuating

Capital and revolving capital”. The aforesaid statement is;

(a) Correct

(b) Incorrect

(c) Cannot say.

13. The basic objectives of Working Capital Management are:

(a) Optimum utilization of resources for profitability

(b) To meet day-to-day current obligations

(c) Ensuring marginal return on current assets is always more than

cost of capital

(d) Select any one of the above statements.

14. The term Gross Working Capital is known as:

(a) The investment in current liabilities

(b) The investment in long-term liability

(c) The investment in current assets

(d) None of the above.

777
 [MANAGEMENT OF WORKING CAPITAL]

15. The term net working capital refers to the difference between the current
assets minus current liabilities.

(a) The statement is correct

(b) The statement is incorrect

(c) I cannot say.

16. The term “Core current assets‟ was coined by:

(a) Chore Committee

(b) Tandon Committee

(c) Jilani Committee

(d) None of the above.

17. The concept operating cycle refers to the average time which elapses
between the acquisition of raw materials and the final cash realization.
This statement is:

(a) Correct

(b) Incorrect

(c) Partially True

(d) I cannot say.

18. As a matter of self-imposed financial discipline can there be a situation of

zero working capital now-a-days in some of the professionally managed
organizations.

(a) Yes

(b) No

(c) Impossible

(d) Cannot say.

778
 [MANAGEMENT OF WORKING CAPITAL]

19. Over trading arises when a business expands beyond the level of funds
available. The statement is:

(a) Incorrect

(b) Correct

(c) Partially correct

(d) I cannot say.

20. A Conservative Working Capital strategy calls for high levels of current
assets in relation to sales.

(a) I agree

(b) Do not agree

(c) I cannot say.

21. The term Working Capital leverage refer to the impact of level of working
capital on company‟s profitability. This measures the responsiveness of
ROCE for changes in current assets.

(a) I agree

(b) Do not agree

(c) The statement is partially true.

22. The term spontaneous source of finance refers to the finance which
naturally arise in the course of business operations. The statement is:

(a) Correct

(b) Incorrect

(c) Partially Correct

(d) I cannot say.

23. Under hedging approach to financing of working capital requirements of

a firm, each asset in the balance sheet assets side would be offset with a

779
 [MANAGEMENT OF WORKING CAPITAL]

financing instrument of the same approximate maturity. This statement

is:

(a) Incorrect

(b) Correct

(c) Partially correct

(d) I cannot say.

24. Trade credit is a:

(a) Negotiated source of finance

(b) Hybrid source of finance

(c) Spontaneous source of finance (d) None of the above.

25. Factoring is a method of financing whereby a firm sells its trade debts at
a discount to a financial institution. The statement is:

(a) Correct

(b) Incorrect

(c) Partially correct

(d) I cannot say.

26. A factoring arrangement can be both with recourse as well as without

recourse:

(a) True

(b) False

(c) Partially correct

(d) Cannot say.

27. The Bank financing of working capital will generally be in the following
form. Cash Credit, Overdraft, bills discounting, bills acceptance, line of
credit; Letter of credit and bank guarantee.

780
 [MANAGEMENT OF WORKING CAPITAL]

(a) I agree

(b) I do not agree

(c) I cannot say.

28. When the items of inventory are classified according to value of usage,
the technique is known as:

(a) XYZ Analysis

(b) ABC Analysis

(c) DEF Analysis

(d) None of the above.

29. When a firm advises its customers to mail their payments to special Post
Office collection centers, the system is known as.

(a) Concentration banking

(b) Lock Box system

(c) Playing the float

(d) None of the above.

30. NV Industries Ltd. is a manufacturing industry which manages its

accounts receivables internally by its sales and credit department. It
supplies small articles to different industries. The total sales ledger of the
company stands at ₹ 200 lakhs of which 80% is credit sales. The
company has a credit policy of 2/40, net 120. Past experience of the
company has been that on average out of the total, 50% of customers
avail of discount and the balance of the receivables are collected on
average in 120 days. The finance controller estimated, bad debt losses
are around 1% of credit sales.

With escalating cost associated with the in-house management of the

debtors coupled with the need to unburden the management with the
task so as to focus on sales promotion, the CFO is examining the
possibility of outsourcing its factoring service for managing its
receivables. Currently, the firm spends about ₹ 2,40,000 per annum to

781
 [MANAGEMENT OF WORKING CAPITAL]

administer its credit sales. These are avoidable as a factoring firm is

prepared to buy the firm's receivables. The main elements of the proposal
are : (i) It will charge 2% commission (ii) It will pay advance against
receivables to the firm at an interest rate of 18% after withholding 10%
as reserve.

Also, company has option to take long term loan at 15% interest or may
take bank finance for working capital at 14% interest.

You were also present at the meeting; being a financial consultant, the
CFO has asked you to be ready with the following questions:

Consider year as 360 days.

I. What is average level of receivables of the company?

a. ₹ 53,33,333

b. ₹ 35,55,556

c. ₹ 44,44,444

d. ₹ 71,11,111

II. How much advance factor will pay against receivables?

a. ₹ 31,28,889

b. ₹ 39,11,111

c. ₹ 30,03,733

d. ₹ 46,93,333

III. What is the annual cost of factoring to the company?

a. ₹ 8,83,200

b. ₹ 4,26,667

c. ₹ 5,51,823

d. ₹ 4,00,000

IV. What is the net cost to the company on taking factoring service?

782
 [MANAGEMENT OF WORKING CAPITAL]

a. ₹ 4,00,000

b. ₹ 4,26,667

c. ₹ 3,50,000

d. ₹ 4,83,200

V. What is the effective cost of factoring on advance received?

a. 16.09%

b. 13.31%

c. 12.78%

d. 15.89%

31. Ramu Ltd. wants to implement a project for which ₹ 25 lakhs is required.
Following financing options are at hand:

Option 1:

Equity Shares 25,000 @ ₹ 100

Option 2:

Equity Shares 10,000 @ ₹ 100

12% Preference Shares 5,000@ ₹ 100

10% Debentures 10,000@ ₹ 100

What is the indifference point & EPS at that level of EBIT assuming
corporate tax to be 35%.

(a) ₹ 2,94,872; ₹ 11.80

(b) ₹ 3,20,513; ₹ 8.33

(c) ₹ 2,94,872; ₹ 7.67

(d) ₹ 3,20513; ₹ 12.82

32. "If EBIT increases by 6%, net profit increases by 6.9%. If sales increase
by 6%, net profit will increase by 24%.

783
 [MANAGEMENT OF WORKING CAPITAL]

Financial leverage must be -…………."

(a) 1.19

(b) 1.13

(c) 1.12

(d) 1.15

33. What is the maximum period for which company can accept Public
Deposits?

(a) 1 year

(b) 6 months

(c) 3 years

(d) 5 years

(MTP March - 2024)

784
 TABLES

TABLES

Page 1
www.pavansirsfmclasses.com
 TABLES

Page 2
www.pavansirsfmclasses.com
 TABLES

Page 3
www.pavansirsfmclasses.com
 TABLES

Page 4
www.pavansirsfmclasses.com
 TABLES

Standard Normal Distribution Table

Entries represent Pr(Z ≤ z). The value of z to the first decimal is given in the left
column. The second decimal is given in the top row.

Values of z for selected values of Pr(Z ≤ z)

z 0.842 1.036 1.282 1.645 1.960 2.326 2.576
Pr(Z ≤ z) 0.800 0.850 0.900 0.950 0.975 0.990 0.995

Page 5
www.pavansirsfmclasses.com
 TABLES

Normal Probability Distribution Table

Page 6
www.pavansirsfmclasses.com
 TABLES

Student’s T Distribution
Level of Significance for One Tailed Test
df 0.100 0.050 0.025 0.01 0.005 0.0005
Level of Significance for Two Tailed Test
df 0.20 0.10 0.05 0.02 0.01 0.001
1 3.078 6.314 12.706 31.821 63.657 636.619
2 1.886 2.920 4.303 6.965 9.925 31.599
3 1.638 2.353 3.182 4.541 5.841 12.294
4 1.533 2.132 2.776 3.747 4.604 8.610
5 1.476 2.015 2.571 3.365 4.032 6.869
6 1.440 1.943 2.447 3.140 3.707 5.959
7 1.415 1.895 2.365 2.998 3.499 5.408
8 1.397 1.560 2.306 2.896 3.355 5.041
9 1.383 1.833 2.262 2.821 3.250 4.781
10 1.372 1.812 2.228 2.764 3.169 4.587
11 1.363 1.796 2.201 2.718 3.106 4.437
12 1.356 1.782 2.179 2.681 3.055 4.318
13 1.350 1.771 2.160 2.650 3.012 4.221
14 1.345 1.761 2.145 2.624 2.977 4.140
15 1.341 1.753 2.131 2.602 2.947 4.073

16 1.337 1.746 2.120 2.583 2.921 4.015

17 1.333 1.740 2.110 2.567 2.898 3.965
18 1.330 1.734 2.101 2.552 2.878 3.922
19 1.328 1.729 2.093 2.539 2.861 3.883
20 1.325 1.725 2.086 2.528 2.845 3.850
21 1.323 1.721 2.080 2.518 2.831 3.819
22 1.321 1.717 2.074 2.508 2.819 3.792
23 1.319 1.714 2.069 2.500 2.807 3.768
24 1.318 1.711 2.064 2.492 2.797 3.745
25 1.316 1.708 2.060 2.485 2.787 3.725
26 1.315 1.706 2.056 2.479 2.779 3.707
27 1.314 1.703 2.052 2.473 2.771 3.690
28 1.313 1.701 2.048 2.467 2.763 3.674
29 1.311 1.699 2.045 2.462 2.756 3.666
30 1.310 1.697 2.042 2.457 2.750 3.646
40 1.303 1.684 2.021 2.423 2.704 3.551
60 1.296 1.671 2.000 2.390 2.660 3.460
120 1.289 1.658 1.980 2.358 2.617 3.373
0 1.282 1.645 1.9600 2.326 2.576 3.291

Page 7
www.pavansirsfmclasses.com
 TABLES

Continuous Compounding, Discrete Cash Flows

r = 1%

Page 8
www.pavansirsfmclasses.com