FM RTP, MTP, S.Answer Final File

FINANCIAL
MANAGEMENT
Updated upto:
 Exam Question and Suggested Answer – November 2019
 RTP / MTP – May 2020
INDEX
S. CHAPTER NAME Page No.
NO.
1 Chapter 3 3.1-3.17
2 Chapter 4 4.1-4.12
3 Chapter 5 5.1-5.15
4 Chapter 6 6.1-6.14
5 Chapter 7 7.1-7.19
6 Chapter 8 8.1-8.11
7 Chapter 9 9.1-9.10
8 Chapter 10(I) 10(I).1-10(I).13
9 Chapter 10(II) 10(II).14-10(II).15
10 Chapter 10(IV) 10(IV).16-10(IV).22
11 Chapter 10(V) 10(V).23
12 Chapter 11(Miscellaneous) 11.1-11.20

Mittal Commerce Classes
CHAPTER-3
Ratio Analysis
Question 1.
Following figures are available in the books Tirupati Ltd.
Fixed assets turnover ratio 8 times (based on cost of goods sold)
Capital turnover ratio 2 times (based on cost of goods sold)
Inventory Turnover 8 times
Receivable turnover 4 times
Payable turnover 6 times
G P Ratio 25%
Gross profit during the year amounts to Rs. 8,00,000. There is no long-term loan or overdraft. Reserve and
surplus amount to Rs. 2,00,000. Ending inventory of the year is Rs. 20,000 above the beginning inventory.
Required:
CALCULATE various assets and liabilities and PREPARE a Balance sheet of Tirupati Ltd. (RTP May 2018)
Answer
3.1| P a g e
3.2 | P a g e
3.3| P a g e
Question 2..
Assuming the current ratio of a Company is 2, STATE in each of the following cases whether the ratio
will improve or decline or will have no change:
(i) Payment of current liability
(ii) Purchase of fixed assets by cash
(iii) Cash collected from Customers
(iv) Bills receivable dishonoured
(v) Issue of new shares (RTP Nov.2018 )
Answer
3.4 | P a g e
Question 3.
From the following table of financial ratios of R. Textiles Limited, comment on various ratios given at the end:
Ratios 2017 2018 Average of

Textile Industry
Liquidity Ratios
Current ratio 2.2 2.5 2.5
Quick ratio 1.5 2 1.5
Receivable turnover ratio 6 6 6
Inventory turnover 9 10 6
Receivables collection period 87 days 86 days 85 days
Operating profitability
Operating income –ROI 25% 22% 15%
Operating profit margin 19% 19% 10%
Financing decisions
Debt ratio 49.00% 48.00% 57%
Return
Return on equity 24% 25% 15%
COMMENT on the following aspect of R. Textiles Limited
(i) Liquidity
(ii) Operating profits
(iii) Financing
(iv) Return to the shareholders (RTP May 2019)
Answer
Ratios Comment
Liquidity Current ratio has improved from last year and matching the
industry average.
Quick ratio also improved than last year and above the
industry average. This may happen due to reduction in
receivable collection period and quick inventory turnover.
However, this also indicates idleness of funds.
Overall it is reasonably good. All the liquidity ratios are
either better or same in both the year compare to the
Industry Average.
3.5| P a g e
Operating Profits Operating Income-ROI reduced from last year but
Operating Profit Margin has been maintained. This may
happen due to variability of cost on turnover. However,
both the ratio are still higher than the industry average.
Financing The company has reduced its debt capital by 1% and
saved operating profit for equity shareholders. It also
signifies that dependency on debt compared to other
industry players (57%) is low.
Return to the shareholders R’s ROE is 24 per cent in 2017 and 25 per cent in 2018
compared to an industry average of 15 per cent. The ROE
is stable and improved over the last year.
Question 4.
Using the following information, PREPARE and complete the Balance Sheet given below:
(i) Total debt to net worth : 1:2
(ii) Total assets turnover : 2
(iii) Gross profit on sales : 30%
(iv) Average collection period : 40 days
(Assume 360 days in a year)
(v) Inventory turnover ratio based on cost of goods sold and year-end inventory : 3
(vi) Acid test ratio : 0.75
(MTP March 2019)

Liabilities Rs. Assets Rs.
Equity Shares Capital 4,00,000 Plant and Machinery -
Reserves and Surplus 6,00,000 and other Fixed Assets
Total Debt: Current Assets:
Current Liabilities - Inventory -
Debtors -
- Cash -
3.6 | P a g e
Answer
3.7| P a g e
Question 5.
With the help of the following information ANALYSE and complete the Balance Sheet of Anup Ltd.:
Equity share capital Rs. 1,00,000

The relevant ratios of the company are as follows:
Current debt to total debt 0.40
Total debt to Equity share capital 0.60
Fixed assets to Equity share capital 0.60
Total assets turnover 2 Times
Inventory turnover 8 Times
(MTP April 2019)
Answer
3.8 | P a g e
Question 6.
The accountant of Moon Ltd. has reported the following data:
Gross profit Rs. 60,000

Gross Profit Margin 20 per cent
Total Assets Turnover 0.30:1
Net Worth to Total Assets 0.90:1
Current Ratio 1.5:1
Liquid Assets to Current Liability 1:1
Credit Sales to Total Sales 0.80:1
Average Collection Period 60 days
Assume 360 days in a year
You are required to complete the following
Balance Sheet of Moon Ltd. ( May Exam 2018)

Net Worth Fixed Assets
Current Liabilities Stock
Debtors
Cash
Total Liabilities Total Assets
3.9| P a g e
Answer
Preparation of Balance Sheet

Working Notes:
Sales = Gross Profit / Gross Profit Margin
= 60,000 / 0.2 = Rs.3,00,000
Total Assets = Sales / Total Asset Turnover
= 3,00,000 / 0.3 = Rs. 10,00,000
Net Worth = 0.9 X Total Assets
= 0.9 X Rs.10,00,000 = Rs. 9,00,00
Current Liability = Total Assets – Net Worth
= Rs. 10,00,000 – Rs.9,00,000
= Rs. 1,00,000
Current Assets = 1.5 x Current Liability
= 1.5 x Rs. 1,00,000 = Rs. 1,50,000
Stock = Current Assets – Liquid Assets
= Current Assets – (Liquid Assets / Current Liabilities =1)
= 1,50,000 – (LA / 1,00,000 = 1) = Rs. 50,000
Debtors = Average Collection Period X Credit Sales / 360
= 60 x 0.8 x 3,00,000 / 360 = Rs. 40,000
Cash = Current Assets – Debtors – Stock
= Rs. 1,50,000 – Rs. 40,000 – Rs. 50,000
= Rs. 60,000
Fixed Assets = Total Assets – Current Assets
= Rs. 10,00,000 – Rs.1,50,000
= Rs. 8,50,000
Balance Sheet

Net Worth 9,00,000 Fixed Assets 8,50,000
Current Liabilities 1,00,000 Stock 50,000
Debtors 40,000
Cash 60,000
Total liabilities 10,00,000 Total Assets 10,00,000
3.10 | P a g e
Question 7.
The following is the information of XML Ltd. relate to the year ended 31-03-2018 :
Gross Profit 20% of Sales
Net Profit 10% of Sales
Inventory Holding period 3 months
Receivable collection period 3 months
Non-Current Assets to Sales 1:4
Non-Current Assets to Current Assets 1:2
Current Ratio 2:1
Non-Current Liabilities to Current Liabilities 1:1
Share Capital to Reserve and Surplus 4:1
Non-current Assets as on 31st March, 2017 Rs.50,00,000
(i) No change in Non-Current Assets during the year 2017-18
(ii) No depreciation charged on Non-Current Assets during the year 2017-18.
(iii) Ignoring Tax
You are required to Calculate cost of goods sold, Net profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018 (Nov Exam 2018)
Answer
Workings
Non Current Assets = 1
1 Current Assets 2
50,00,000 1
or =
Current Assets 2
So, Current Assets = Rs.1,00,00,000 Now further,
Non Current Assets 1
=
Sales 4
50,00,000 1
or =
Sales 4
So, Sales = Rs.2,00,00,000
Calculation of Cost of Goods sold, Net profit, Inventory, Receivables and Cash:
(i) Cost of Goods Sold (COGS):
Cost of Goods Sold = Sales- Gross Profit
= Rs.2,00,00,000 – 20% of Rs.2,00,00,000
= Rs.1,60,00,000
(ii) Net Profit = 10% of Sales = 10% of Rs.2,00,00,000
= Rs.20,00,000
(iii) Inventory:
12 Months
Inventory Holding Period =
Inventory Turnover Ratio
3.11| P a g e
Inventory Turnover Ratio = 12/ 3 = 4
COGS
4
Average Inventory
1,60,00,000
4
Average Inventory
Average or Closing Inventory =Rs.40,00,000
(iv) Receivables :
12 Months
Receivable Collection Period =
ReceivablesTurnover Ratio
Credit Sales
Or Receivables Turnover Ratio = 12/ 3 = 4 =
Average Accounts Receivable
2,00,00,000
Or 4
Average Accounts Receivable
So, Average Accounts Receivable/Receivables =Rs. 50,00,000/-
(v) Cash:
Cash* = Current Assets* – Inventory- Receivables Cash =
Rs.1,00,00,000 - Rs. 40,00,000 - Rs. 50,00,000
= Rs.10,00,000
(it is assumed that no other current assets are included in the Current Asset)
Question 8:
The following is the Profit and loss account and Balance sheet of KLM LLP.
Trading and Profit & Loss Account
Particulars Amount (Rs.) Particulars Amount (Rs.)
To Opening stock 12,46,000 By Sales 1,96,56,000
To Purchases 1,56,20,000 By Closing stock 14,28,000
To Gross profit c/d 42,18,000
2,10,84,000 2,10,84,000
By Gross profit b/d 42,18,000
To Administrative expenses 18,40,000 By Interest on investment 24,600
To Selling & distribution expenses 7,56,000 By Dividend received 22,000
To Interest on loan 2,60,000
To Net profit 14,08,600
42,64,600 42,64,600
3.12 | P a g e
Balance Sheet as on……….
Capital & Liabilities Amount (Rs.) Assets Amount (Rs.)
Capital 20,00,000 Plant & machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General reserve 12,00,000 Furniture 12,00,000
Term loan from bank 26,00,000 Sundry receivables 13,50,000
Sundry Payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash & Bank balance 4,22,000
1,10,00,000 1,10,00,000
You are required to COMPUTE:
(i) Gross profit ratio (ii) Net profit ratio (iii) Operating cost ratio
(iv) Operating profit ratio (v) Inventory turnover ratio (vi) Current ratio
(vii) Quick ratio (viii) Interest coverage ratio (ix) Return on capital employed
(x) Debt to assets ratio.
(RTP Nov 2019)
Answer
3.13| P a g e
Question 9:
MNP Limited has made plans for the year 2019 -20. It is estimated that the company will employ total
assets of Rs.50,00,000; 30% of assets being financed by debt at an interest cost of 9% p.a. The
direct costs for the year are estimated at Rs. 30,00,000 and all other operating expenses are estimated
at Rs. 4,80,000. The sales revenue are estimated at Rs. 45,00,000. Tax rate is assumed to be 40%.
CALCULATE:
(i) Net profit margin (After tax);
(ii) Return on Assets (After tax);
(iii) Asset turnover; and
(iv) Return on Equity.
(MTP Nov. 19)
Answer
The net profit is calculated as follows:
Rs.
Sales Revenue 45,00,000
Less: Direct Costs 30,00,000
Gross Profits 15,00,000
Less: Operating Expense 4,80,000
Earnings before Interest and tax (EBIT) 10,20,000
Less: Interest on debt (9% × 15,00,000) 1,35,000
Earnings before Tax) (EBT) 8,85,000
Less: Taxes (@ 40%) 3,54,000
Profit after Tax (PAT) 5,31,000
3.14 | P a g e
ROE = 15.17%
Question 10
Following information has been gathered from the books of Tram Ltd. the equity shares of which is
trading in the stock market at Rs. 14.
Particulars Amount (Rs.)
Equity Share Capital (face value Rs. 10) 10,00,000
10% Preference Shares 2,00,000
Reserves 8,00,000
10% Debentures 6,00,000
Profit before Interest and Tax for the year 4,00,000
Interest 60,000
Profit after Tax for the year 2,40,000
Calculate the following:
(i) Return on Capital Employed
(ii) Earnings per share
(iii) PE ratio
(Examination May 2019)
Answer
(i) Calculation of Return on capital employed (ROCE)
Capital employed = Equity Shareholders’ funds + Debenture + Preference
shares
= Rs. (10,00,000 + 8,00,000 + 6,00,000 + 2,00,000)
= Rs. 26,00,000
3.15| P a g e
Question 11
MT Limited has the following Balance Sheet as on March 31, 2019 and March 31, 2020:
Balance Sheet
Rs. in lakhs
March 31, 2019 March 31, 2020
Sources of Funds:
Shareholders’ Funds 2,500 2,500
Loan Funds 3,500 3,000
6,000 5,500
Applications of Funds:
Fixed Assets 3,500 3,000
Cash and bank 450 400
Receivables 1,400 1,100
Inventories 2,500 2,000
Other Current Assets 1,500 1,000
Less: Current Liabilities (1,850) (2,000)
6,000 5,500
3.16 | P a g e
The Income Statement of the MT Ltd. for the year ended is as follows:
Rs. in lakhs
March 31, 2019 March 31, 2020
Sales 22,500 23,800
Less: Cost of Goods sold (20,860) (21,100)
Gross Profit 1,640 2,700
Less: Selling, General and Administrative expenses (1,100) (1,750)
Earnings before Interest and Tax (EBIT) 540 950
Less: Interest Expense (350) (300)
Earnings before Tax (EBT) 190 650
Less: Tax (57) (195)
Profits after Tax (PAT) 133 455
Required:
CALCULATE for the year 2019-20-
(a) Inventory turnover ratio
(b) Financial Leverage
(c) Return on Capital Employed (ROCE)
(d) Return on Equity (ROE)
(e) Average Collection period.
[Take 1 year = 365 days]
(RTP May 2020)
Answer
__**__
3.17| P a g e
CHAPTER-4
Cost of Capital
Question 1.
Navya Limited wishes to raise additional capital of Rs.10 lakhs for meeting its modernisation plan. It has
Rs. 3,00,000 in the form of retained earnings available for investments purposes. The following are the
further details:
Debt/ equity mix 40%/60%

Cost of debt (before tax)
Upto Rs. 1,80,000 10%
Beyond Rs. 1,80,000 16%
Earnings per share Rs. 4
Dividend pay out Rs. 2
Expected growth rate in dividend 10%
Current market price per share Rs. 44
Tax rate 50%
Required:
(i) To DETERMINE the pattern for raising the additional finance.
(ii) To CALCULATE the post-tax average cost of additional debt.
(iii) To CALCULATE the cost of retained earnings and cost of equity, and
(iv) To DETERMINE the overall weighted average cost of capital (after tax) (RTP May 2018)
Answer
4.1| P a g e
Question 2.
M/s. Navya Corporation has a capital structure of 40% debt and 60% equity. The company is
presently considering several alternative investment proposals costing less than RS.20 lakhs. The
corporation always raises the required funds without disturbing its present debt equity ratio.
The cost of raising the debt and equity are as under: (RTP Nov 2018)
Project cost Cost of debt Cost of equity

Upto RS. 2 lakhs 10% 12%
Above RS. 2 lakhs & upto to RS. 5 lakhs 11% 13%
Above RS. 5 lakhs & upto RS.10 lakhs 12% 14%
Above RS.10 lakhs & upto RS. 20 lakhs 13% 14.5%
Assuming the tax rate at 50%, CALCULATE:
(i) Cost of capital of two projects X and Y whose fund requirements are RS. 6.5 lakhs and
RS. 14 lakhs respectively.
(ii) If a project is expected to give after tax return of 10%, DETERMINE under what
conditions it would be acceptable?
Answer
4.2 | P a g e
Question 3.
As a financial analyst of a large electronics company, you are required to DETERMINE the weighted
average cost of capital of the company using (a) book value weights and (b) market value weights. The
following information is available for your perusal.
The Company’s present book value capital structure is:
(RS)
Debentures (RS100 per debenture) 8,00,000
Preference shares (RS100 per share) 2,00,000
Equity shares (RS10 per share) 10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are:
Debentures, RS110 per debenture, Preference shares, RS120 per share, and Equity shares,
RS 22 per share Anticipated external financing opportunities are:
4.3| P a g e
(i) RS 100 per debenture redeemable at par; 10 year maturity, 11 per cent coupon rate, 4 per
cent flotation costs, sale price, RS100
(iii) RS 100 preference share redeemable at par; 10 year maturity, 12 per cent dividend rate, 5
per cent flotation costs, sale price, RS100.
(iii) Equity shares: RS 2 per share flotation costs, sale price = RS 22.
In addition, the dividend expected on the equity share at the end of the year is RS 2 per share the
anticipated growth rate in dividends is 7 per cent and the firm has the practice of paying all its earnings
in the form of dividends. The corporate tax rate is 35 per cent. (RTP May 2019)
Answer
4.4 | P a g e
Question 4.
Answer the following:
(a) The proportion and required return of debt and equity was recorded for a company with its
increased financial leverage as below:
Debt Required Equity Required Return Weighted Average Cost
(%) return (Kd) (%) (Ke) (%) of Capital (WACC)
(%) (Ko)(%)
0 5 100 15 15
20 6 80 16 ?
40 7 60 18 ?
60 10 40 23 ?
80 15 20 35 ?
You are required to complete the table and IDENTIFY which capital structure is most beneficial for this
company. (Based on traditional theory, i.e., capital structure is relevant).
(b) Annova Ltd is considering raising of funds of about Rs.250 lakhs by any of two alternative
methods, viz., 14% institutional term loan and 13% non-convertible debentures. The term loan
option would attract no major incidental cost and can be ignored. The debentures would have to
be issued at a discount of 2.5% and would involve cost of issue of 2% on face value.
ADVISE the company as to the better option based on the effective cost of capital in each
case. Assume a tax rate of 50%. (MTP April 2019)
4.5| P a g e
Answer
(a)
5. Stopgo Ltd, an all equity financed company, is considering the repurchase of Rs. 200 lakhs equity and to
replace it with 15% debentures of the same amount. Current market Value of the company is Rs. 1140
lakhs and it's cost of capital is 20%. It's Earnings before Interest and Taxes (EBIT) are expected to
remain constant in future. It's entire earnings are distributed as dividend. Applicable tax rate is 30 per
cent.
You are required to calculate the impact on the following on account of the change in the capital structure
as per Modigliani and Miller (MM) Hypothesis:
4.6 | P a g e
(i) The market value of the company
(ii) It's cost of capital, and
(iii) It’s cost of equity (May Exam 2018)
Answer
Working Note
Net income (NI) for equity - holders
= Market Value of Equity
Ke
Net income (NI) for equity holders = Rs. 1,140 lakhs
0.20
Therefore, Net Income to equity–holders = Rs. 228 lakhs
EBIT = Rs. 228 lakhs / 0.7 = Rs. 325.70 lakhs
All Equity Debt of Equity
(RS. In (RS. In lakhs)
lakhs)
EBIT 325.70 325.70
Interest on RS.200 lakhs @ 15% -- 30.00
EBT 325.70 295.70
Tax @ 30 % 97.70 88.70
Income available to equity holders 228 207
(i) Market value of levered firm = Value of unlevered firm + Tax Advantage
= Rs. 1,140 lakhs + (Rs.200 lakhs x 0.3)
= Rs. 1,200 lakhs
The impact is that the market value of the company has increased by Rs. 60 lakhs (Rs. 1,200 lakhs – Rs.
1,140 lakhs)
Calculation of Cost of Equity
Ke = (Net Income to equity holders / Equity Value ) X 100
= (207 lakhs / 1200 lakhs – 200 lakhs ) X 100
= (207/ 1000) X 100
= 20.7 %
(ii) Cost of Capital
Components Amount Cost of Capital Weight WACC %

(RS. In %
lakhs)
Equity 1000 20.7 83.33 17.25
Debt 200 (15% X 0.7) =10.5 16.67 1.75
1200 19.00
4.7| P a g e
The impact is that the WACC has fallen by 1% (20% - 19%) due to the benefit of tax relief on debt interest
payment.
(iii) Cost of Equity is 20.7% [As calculated in point (i)]
The impact is that cost of equity has risen by 0.7% i.e. 20.7% - 20% due to the presence of financial
risk.
Further, Cost of Capital and Cost of equity can also be calculated with the help of formulas as below,
though there will be no change in final answers.
Cost of Capital (Ko) = Keu(1-tL)
Where,
Keu = Cost of equity in an unlevered company
T = Tax rate
L = Debt
Debt + Equity
K2 = 0.2 x ( )
So. Cost of capital = 0.19 or 19%
Cost of Equity (Ke) = Keu + (Kev – Kd) Debt (1-t)

Equity
Where,
Keu = Cost of equity in an unlevered company
Kd = Cost of debt
T = Tax rate
'200lakh 0.7
Ke = 0.20+ 0.20 0.15
'1,200 lakh
Ke = 0.20+0.007 = 0.207 or 20.7%
So. Cost of Equity = 20.70%
Question 6.
Alpha Ltd. has furnished the following
- Earning Per Share (EPS) Rs. 4
- Dividend payout ratio 25%
- Market price per share Rs.50
- Rate of tax 30%
- Growth rate of dividend 10%
The company wants to raise additional capital of Rs.10 lakhs including debt of Rs.4 lakhs . The cost of debt
(before tax) is 10% up to Rs.2 lakhs and 15% beyond that. Compute the after tax cost of equity and debt
and also weighted average cost of capital. (May Exam 2019)
4.8 | P a g e
Question 7:
KM Ltd. has the following capital structure on September 30, 2019:
Sources of capital (Rs.)
Equity Share Capital (40,00,000 Shares of Rs. 10 each) 4,00,00,000
Reserves & Surplus 4,00,00,000
12% Preference Shares 2,00,00,000
9% Debentures 6,00,00,000
16,00,00,000
The market price of equity share is Rs.60. It is expected that the company will pay next year a
dividend of Rs.6 per share, which will grow at 10% forever.
Assume 40% income tax rate.
You are required to COMPUTE weighted average cost of capital using market value weights.
(RTP Nov. 19)
Answer
Computation of Weighted Average Cost of Capital (WACC using market value weights)
Source of capital Market Value Weight Cost of WACC
of capital capital (%) (%)
(Rs.)
9% Debentures 6,00,00,000 0.1875 5.40 1.01
12% Preference Shares 2,00,00,000 0.0625 12.00 0.75
Equity Share Capital (Rs.60 24,00,00,000 0.7500 20.00 15.00
× 40,00,000 shares)
Total 32,00,00,000 1.00 16.76
Question 8:
A Company wants to raise additional finance of Rs. 5 crore in the next year. The company expects to
retain Rs. 1 crore earning next year. Further details are as follows:
(i) The amount will be raised by equity and debt in the ratio of 3: 1.
(ii) The additional issue of equity shares will result in price per share being fixed at Rs. 25.
(iii) The debt capital raised by way of term loan will cost 10% for the first Rs. 75 lakh and 12% for
the next Rs. 50 lakh.
(iv) The net expected dividend on equity shares is Rs. 2.00 per share. The dividend is expected to
grow at the rate of 5%.
(v) Income tax rate is 25%.
You are required:
(a) To determine the amount of equity and debt for raising additional finance.
(b) To determine the post-tax average cost of additional debt.
(c) To determine the cost of retained earnings and cost of equity.
(d) To compute the overall weighted average cost of additional finance after tax.
4.9| P a g e
Answer
(a) Determination of the amount of equity and debt for raising additional finance:
Pattern of raising additional finance
Equity 3/4 of Rs. 5 Crore = Rs. 3.75 Crore
Debt 1/4 of Rs. 5 Crore = Rs. 1.25 Crore
The capital structure after raising additional finance:

Particulars (Rs. In crore)
Shareholders’ Funds
Equity Capital (3.75 – 1.00) 2.75
Retained earnings 1.00
Debt (Interest at 10% p.a.) 0.75
(Interest at 12% p.a.) (1.25-0.75) 0.50
Total Funds 5.00
(b) Determination of post-tax average cost of additional debt

Kd = I (1 – t)
Where,
I = Interest Rate
t = Corporate tax-rate
On Rs. 75,00,000 = 10% (1 – 0.25) = 7.5% or 0.075
On Rs. 50,00,000 = 12% (1 – 0.25) = 9% or 0.09
Average Cost of Debt
(c) Determination of cost of retained earnings and cost of equity (Applying Dividend growth model):
Where,
Ke = Cost of equity D1 = DO (1+ g)
D0 = Dividend paid (i.e = Rs. 2)
g = Growth rate
P0 = Current market price per share
Cost of retained earnings equals to cost of Equity i.e. 13.4%
(d) Computation of overall weighted average after tax cost of additional finance
4.10 | P a g e
Particular (Rs.) Weight Cost of Weighted Cost
s funds (%)
Equity (including retained earnings) 3,75,00,000 3/4 13.4% 10.05
Debt 1,25,00,000 1/4 8.1% 2.025
WACC 5,00,00,000 12.075
Question 9:
PK Ltd. has the following book-value capital structure as on March 31, 2020.
(Rs.)
Equity share capital (10,00,000 shares) 2,00,00,000
11.5% Preference shares 60,00,000
10% Debentures 1,00,00,000
3,60,00,000
The equity shares of the company are sold for Rs. 200. It is expected that the company will pay next
year a dividend of Rs. 10 per equity share, which is expected to grow by 5% p.a. forever. Assume a
35% corporate tax rate.
Required:
(i) COMPUTE weighted average cost of capital (WACC) of the company based on the existing
capital structure.
(ii) COMPUTE the new WACC, if the company raises an additional Rs.50 lakhs debt by issuing
12% debentures. This would result in increasing the expected equity dividend to Rs.12.40 and
leave the growth rate unchanged, but the price of equity share will fall to Rs. 160 per share.
(RTP May 2020)
Answer
(i) Computation of Weighted Average Cost of Capital based on existing capital structure
Existing Weights After tax WACC
Source of Capital Capital cost of (%)
structure capital
(Rs.) (%)
(a) (b) (a) (b)
Equity share capital (W.N.1) 2,00,00,000 0.555 10.00 5.55
11.5% Preference share capital 60,00,000 0.167 11.50 1.92
10% Debentures (W.N.2) 1,00,00,000 0.278 6.50 1.81
3,60,00,000 1.000 9.28
Working Notes (W.N.):

1. Cost of equity capital:
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10% Debentures (W.N. 2) 1,00,00,000 0.244 6.50 1.59

12% Debentures (W.N.4) 50,00,000 0.122 7.80 0.95
4,10,00,000 1.00 10.32
__**__
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CHAPTER-5
Capital Structure Decisions & Theories
Question 1.
Company P and Q are identical in all respects including risk factors except for debt/equity, company P
having issued 10% debentures of Rs. 18 lakhs while company Q is unlevered. Both the companies earn
20% before interest and taxes on their total assets of Rs. 30 lakhs.
Assuming a tax rate of 50% and capitalization rate of 15% for an all-equity company.
Required:
CALCULATE the value of companies‟ P and Q using (i) Net Income Approach and (ii) Net Operating Income
Approach. (RTP May 2018)
Answer
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Question 2.
Rounak Ltd. is an all equity financed company with a market value of RS. 25,00,000 and cost of equity
(Ke) 21%. The company wants to buyback equity shares worth RS. 5,00,000 by issuing and raising 15%
perpetual debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and
applying MM Model (with taxes), you are required to COMPUTE:
(i) Market value of J Ltd.
(ii) Cost of Equity (Ke)
(iii) Weighted average cost of capital (using market weights) and
comment on it. (RTP Nov. 2018)
Answer
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Question 3.
Akash Limited provides you the following information:
(Rs)
Profit (EBIT) 2,80,000
Less: Interest on Debenture @ 10% (40,000)
EBT 2,40,000
Less Income Tax @ 50% (1,20,000)
1,20,000
No. of Equity Shares (RS 10 each) 30,000
Earnings per share (EPS) 4
Price /EPS (PE) Ratio 10
The company has reserves and surplus of Rs 7,00,000 and required Rs 4,00,000 further for
modernisation. Return on Capital Employed (ROCE) is constant. Debt (Debt/ Debt + Equity) Ratio
higher than 40% will bring the P/E Ratio down to 8 and increase the interest rate on additional debts to
12%. You are required to ASCERTAIN the probable price of the share.
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(i) If the additional capital are raised as debt; and
(ii) If the amount is raised by issuing equity shares at ruling market price. (RTP May 2019)
Answer
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Question 4.
A Company earns a profit of Rs.6,00,000 per annum after meeting its interest liability of Rs.1,20,000 on
12% debentures. The Tax rate is 50%. The number of Equity Shares of Rs.10 each are 80,000 and the
retained earnings amount to Rs.18,00,000. The company proposes to take up an expansion scheme for
which a sum of Rs.8,00,000 is required. It is anticipated that after expansion, the company will be able to
achieve the same return on investment as at present. The funds required for expansion can be raised
either through debt at the rate of 12% or by issuing equity shares at par.
Required:
(i) COMPUTE the Earnings per Share (EPS), if:
 The additional funds were raised as debt
 The additional funds were raised by issue of equity shares.
(ii) ADVISE the company as to which source of finance is preferable . (MTP March 2019)
Answer
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Question 5:
A company needs Rs.31,25,000 for the construction of a new plant. The following three plans are feasible:
I The company may issue 3,12,500 equity shares at Rs. 10 per share.
II The company may issue 1,56,250 equity shares at Rs. 10 per share and 15,625
debentures of Rs. 100 denomination bearing a 8% rate of interest.
III The company may issue 1,56,250 equity shares at Rs. 10 per share and 15,625 cumulative
preference shares at Rs. 100 per share bearing a 8% rate of dividend.
(i) If the company's earnings before interest and taxes are Rs. 62,500, Rs. 1,25,000, Rs.
2,50,000, Rs. 3,75,000 and Rs. 6,25,000, DETERMINE earnings per share under each of
three financial plans? Assume a corporate income tax rate of 40%.
(ii) IDENTIFY which alternative would you recommend and why?
(iii) DETERMINE the EBIT-EPS indifference points by formulae between Financing Plan I and
Plan II and Plan I and Plan III. (Mtp March 2019)
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Answer
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Question 6.
EXPLAIN the principles of “Trading on equity”. (MTP April 2019)
Answer
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Question 7.
Sun Ltd. is considering two financing plans. Details of which are as under:
(i) Fund's requirement – Rs. 100 Lakhs
(ii) Financial Plan
Plan Equity Debt

I 100% -
II 25% 75%
(iii) Cost of debt – 12% p.a.
(iv) Tax Rate – 30%
(v) Equity Share Rs. 10 each, issued at a premium of Rs. 15 per share
(vi) Expected Earnings before Interest and Taxes (EBIT) Rs. 40 Lakhs
You are required to compute:
(i) EPS in each of the plan
(ii) The Financial Break Even Point
(iii) Indifference point between Plan I and II (May Exam 2018)
Answer
(i) Computation of Earnings Per Share (EPS)
Plans I (Rs.) II (Rs.)

Earnings before interest & tax (EBIT) 40,00,000 40,00,000
Less: Interest charges (12% of Rs.75 lakh) -- (9,00,000)
Earnings before tax (EBT) 40,00,000 31,00,000
Less: Tax @ 30% (12,00,000) (9,30,000)
Earnings after tax (EAT) 28,00,000 21,70,000
No. of equity shares (@ Rs.10+Rs.15) 4,00,000 1,00,000
E.P.S (Rs.) 7.00 21.70
(ii) Computation of Financial Break-even Points

Plan „I‟ = 0 – Under this plan there is no interest payment, hence the financial breakeven point will be
zero.
Plan „II‟ = Rs. 9,00,000 - Under this plan there is an interest payment of Rs.9,00,000, hence the financial
break -even point will be Rs.9 lakhs
(iii) Computation of Indifference Point between Plan I and Plan II:
Indifference point is a point where EBIT of Plan-I and Plan-II are equal. This can be calculated by
applying the following formula:
{(EBIT –I1 ) (1- T)} / E1 = {(EBIT –I2 ) (1- T)} / E2
So
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Or, 2.8 EBIT – 25,20,000 = 0.7EBIT
Or, 2.1EBIT = 25,20,000
EBIT =12,00,000
Question 8.
Y Limited requires Rs.50,00,000 for a new project. This project is expected to yield earnings before
interest and taxes of Rs. 10,00,000. While deciding about the financial plan, the company considers the
objective of maximizing earnings per' share. It has two alternatives to finance the project - by raising debt
Rs.5,00,000 or Rs.20,00,000 and the balance, in each case, by issuing Equity Shares. The company's
share is currently selling at Rs.300, but is expected to decline to Rs.250 in case the funds are borrowed in
excess of Rs.20,00,000. The funds can be borrowed at the rate of 12 percent upto Rs.5,00,000 and at 10
percent over Rs.5,00,000. The tax rate applicable to the company is 25 percent.
Which form of financing should the company choose? ( Nov. Exam 2018)
Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.

Plan II = Raising Debt of Rs.20 lakh + Equity of Rs.30 lakh.
Calculation of Earnings per share (EPS)
Financial Plans
Particulars Plan I Plan II
Rs. Rs.
Expected EBIT 10,00,000 10,00,000
Less: Interest (Working Note 1) (60,000) (2,10,000)
Earnings before taxes 9,40,000 7,90,000
Less: Taxes @ 25% (2,35,000) (1,97,500)
Earnings after taxes (EAT) 7,05,000 5,92,500
Number of shares (Working Note 2) 15,000 10,000
Earnings per share (EPS) 47 59.25
Financing Plan II (i.e. Raising debt of Rs.20 lakh and issue of equity share capital of Rs.30 lakh) is the option
which maximises the earnings per share.
Working Notes:
1. Calculation of interest on Debt.
Plan I (Rs. Rs.60,000
Plan II (Rs. Rs.60,000 Rs.2,10,000
(Rs. Rs.1,50,000
2. Number of equity shares to be issued
Rs. 45,00,000 = 15,000 shares
Plan I:
Rs. 300 (Market Price of share)
Rs. 30,00,000 = 10,000 shares
Plan II:
Rs. 300 (Market Price of share)
(*Alternatively, interest on Debt for Plan II can be 20,00,000 X 10% i.e. Rs.2,00,000. accordingly, the EPS
for the Plan II will be Rs.60)
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Question 9.
The following data relate to two companies belonging to the same risk class :
Particulars A Ltd. B Ltd.

Expected Net Operating Income Rs.18,00,000 Rs.18,00,000
12% Debt Rs.54,00,000 -
Equity Capitalization Rate - 18
Required:
(a) Determine the total market value, Equity capitalization rate and weighted average cost of capital for each
company assuming no taxes as per M.M. Approach.
(b) Determine the total market value, Equity capitalization rate and weighted average cost of capital for
each company assuming 40% taxes as per M.M. Approach. (Nov. Exam 2018)
Answer
(a) Assuming no tax as per MM Approach.
Calculation of Value of Firms „A Ltd.‟ and „B Ltd‟ according to MM Hypothesis Market
Value of „B Ltd‟ [Unlevered(u)]
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = Rs.1,00,00,000
Ke of Unlevered Firm (given) = 0.18

Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of „A Ltd‟ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Nil) = Rs.1,00,00,000 + (54,00,000 × nil)
= Rs.1,00,00,000
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC)
Particulars A Ltd. B Ltd.
A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital [WACC (ko)]* 0.18 0.18
ko = (ke×S/V) + (kd×D/V)
*Computation of WACC A Ltd
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Component of Capital Amount Weight Cost of Capital WACC
Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18
*Kd = 12% (since there is no tax)
WACC = 18%
(b) Assuming 40% taxes as per MM Approach

Calculation of Value of Firms „A Ltd.‟ and „B Ltd‟ according to MM Hypothesis
Market Value of „B Ltd‟ [Unlevered(u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)] / 0.18
= Rs.60,00,000
Ke of unlevered Firm (given) = 0.18

Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of „A Ltd‟ [Levered Firm (I)]
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= Rs.60,00,000 + (54,00,000 × 0.4)
= Rs.81,60,000
Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.‟
= 18% (i.e. Ke = Ko)
Computation of Equity Capitalization Rate and
Weighted Average Cost of Capital (WACC) of a Ltd

Particulars A Ltd.
Net Operating Income (NOI) 18,00,000
Less: Interest on Debt (I) 6,48,000
Earnings Before Tax (EBT) 11,52,000
Less: Tax @ 40% 4,60,800
Earnings for equity shareholders (NI) 6,91,200
Total Value of Firm (V) as calculated above 81,60,000
Less: Market Value of Debt 54,00,000
Market Value of Equity (S) 27,60,000
Equity Capitalization Rate [ke = NI/S] 0.2504
Weighted Average Cost of Capital (ko)* 13.23
ko = (ke×S/V) + (kd×D/V)
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*Computation of WACC A Ltd

Equity 27,60,000 0.338 0.2504 0.0846
Debt 54,00,000 0.662 0.072* 0.0477
Total 81,60,000 0.1323
*Kd= 12% (1- 0.4) = 12% × 0.6 = 7.2%
WACC = 13.23%
Question 10.
RM steels Limited requires „ 10,00,000 for construction of a new plant. It is considering three financial
plans:
(i) The company may issue 1,00,000 ordinary shares at „ 10 per share;
(ii) The company may issue 50,000 ordinary shares at „ 10 per share and 5000 debentures of „ 100
denominations bearing a 8 per cent rate of interest; and
(iii) The company may issue 50,000 ordinary at „ 10 per share and 5,000 preference shares at ‟100 per
share bearing a 8 per cent rate of dividend.
If RM Steels Limited‟s earning before interest and taxes are „ 20,000; ‟40,000; ‟80,000; „1,20,000 and
„2,00,000, you are required to compute the earnings per share under each of the three financial plans?
Which alterative would you recommend for RM Steels and why? Tax rate is 50% ( May Exam 2019)
Question 11
A Ltd. and B Ltd. are identical in every respect except capital structure. A Ltd. does not employ debts
in its capital structure whereas B Ltd. employs 12% Debentures amounting to Rs.100 lakhs. Assuming
that :
i. All assumptions of M-M model are met;
ii. Income-tax rate is 30%;
iii. EBIT is Rs. 25,00,000 and
iv. The Equity capitalization rate of „A' Ltd. is 20%.
CALCULATE the value of both the companies and also find out the Weighted Average Cost of Capital
for both the companies.
(MTP Nov. 19)
Answer
Market Value of „B Ltd.‟ (Levered)

Vg = Vu + TB
= Rs. 87,50,000 + (Rs.1,00,00,000 × 0.30)
= Rs. 87,50,000 + Rs.30,00,000 = Rs.1,17,50,000
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(ii) Computation of Weighted Average Cost of Capital (WACC)

WACC of „A Ltd.‟ = 20% (i.e. Ke = Ko)
WACC of „B Ltd.‟
B Ltd. (Rs.)
EBIT 25,00,000
Interest to Debt holders (12,00,000)
EBT 13,00,000
Taxes @ 30% (3,90,000)
Income available to Equity Shareholders 9,10,000
Total Value of Firm 1,17,50,000
Less: Market Value of Debt (1,00,00,000)
Market Value of Equity 17,50,000
Return on equity (Ke) = 9,10,000 / 17,50,000 0.52
Computation of WACC B. Ltd

Equity 17,50,000 0.149 0.52 0.0775
Debt 1,00,00,000 0.851 0.084* 0.0715
Total 1,17,50,000 0.1490
*Kd= 12% (1- 0.3) = 12% × 0.7 = 8.4%

WACC = 14.90%
Question 12:
CALCULATE the level of earnings before interest and tax (EBIT) at which the EPS indifference point
between the following financing alternatives will occur.
(i) Equity share capital of Rs.60,00,000 and 12% debentures of Rs.40,00,000.
Or
(ii) Equity share capital of Rs.40,00,000, 14% preference share capital of Rs.20,00,000 and 12%
debentures of Rs.40,00,000.
Assume the corporate tax rate is 35% and par value of equity share is Rs.100 in each case.
(RTP May 2020)
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Answer
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CHAPTER-6
Leverage
Question 1.
CALCULATE the operating leverage, financial leverage and combined leverage from the following data
under Situation I and II and Financial Plan A and B: (RTP May 2018)
Installed Capacity 4,000 units
Actual Production and Sales 75% of the Capacity
Selling Price Rs.30 per unit
Variable Cost Rs.15 per unit
Fixed Cost:
Under Situation I Rs. 15,000

Under Situation-II Rs. 20,000
Capital Structure:
Answer
Financial Plan
A (Rs.) B (Rs.)
Equity 10,000 15,000
Debt (Rate of Interest at 20%) 10,000 5,000
20,000 20,000
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Question 2.
A firm has sales of RS. 75,00,000 variable cost is 56% and fixed cost isRS. 6,00,000. It has a debt of RS.
45,00,000 at 9% and equity of RS. 55,00,000. You are required to INTERPRET:
(i) The firm’s ROI?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose capital turnover is 3, does it have a high or low capital
turnover?
(iv) The operating, financial and combined leverages of the firm?
(v) If the sales is increased by 10% by what percentage EBIT will increase?
(vi) At what level of sales the EBT of the firm will be equal to zero?
(vii) If EBIT increases by 20%, by what percentage EBT will increase? (RTP Nov. 2018)
Answer
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Question 3.
A Company had the following Balance Sheet as on March 31, 2019: (RTP May 2019)
Equity and Liabilities (RS in Assets (RS in

crore) crore)
Equity Share Capital Fixed Assets (Net) 250
100
(10 crore shares of RS10 each)
Reserves and Surplus 20 Current Assets 150
15% Debentures 200
Current Liabilities 80
400 400
The additional information given is as under:
Fixed Costs per annum (excluding interest) RS 80 crores
Variable operating costs ratio 65%
Total Assets turnover ratio 2.5
Income-tax rate 40%
Required:
CALCULATE the following and comment:
(i) Earnings per share
(ii) Operating Leverage
(iii) Financial Leverage
(iv) Combined Leverage.
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Answer
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Question 4.
From the following details of X Ltd., PREPARE the Income Statement for the year ended 31 st
March, 20X8:
Financial Leverage 2
Interest Rs. 5,000
Operating Leverage 3
Variable cost as a percentage of sales 75%
Income tax rate 30% (MTP March 2019)
Answer
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Question 5.
. The capital structure of Anshu Ltd. as at 31.3.2019 consisted of ordinary share capital of Rs. 5,00,000
(face value Rs. 100 each) and 10% debentures of Rs. 5,00,000 (Rs.100 each).In the year ended with
March 2019, sales decreased from 60,000 units to 50,000 units. During this year and in the previous year,
the selling price was Rs. 12 per unit; variable cost stood at Rs. 8 per unit and fixed expenses were at
Rs.1,00,000 p.a. The income tax rate was 30%.
You are required to CALCULATE the following:

(i) The percentage of decrease in earnings per share.
(ii) The degree of operating leverage at 60,000 units and 50,000 units.
(iii) The degree of financial leverage at 60,000 units and 50,000 units. (MTP April 2019)
Answer
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Question 6.
Following data have been extracted from the books of LM Ltd:
Sales - Rs.100 lakhs

Interest Payable per annum - Rs. 10 lakhs Operating
leverage - 1.2
Combined leverage - 2.16 You are
required to calculate:
(i) The financial leverage,
(ii) Fixed cost and
(iii) P/V ratio (May Exam 2018)
Answer
(i) Calculation of Financial Leverage:
Combined Leverage (CL) = Operating Leverage Financial Leverage (FL)
2.16 = 1.2 FL
FL = 1.8
(ii) Calculation of Fixed cost:

EBIT
Financial Leverage =
EBT i.e EBIT - Interest
EBIT
1.8 =
EBIT - 10,00,000
1.8 (EBIT – 10,00,000) = EBIT
1.8 EBIT - 18,00,000 = EBIT

18,00,000 = Rs. 22,50,000
EBIT =
0.8
Contribution
Further, Operating Leverage =
EBIT
Contribution
1.2 =
Rs. 22,50,000
Contribution = Rs. 27,00,000
Fixed Cost = Contribution – EBIT
= Rs. 27, 00,000 – Rs. 22,50,000
Fixed cost = Rs. 4,50,000
(iii) Calculation of P/V ratio:

P/V ratio = Contribution (C) × 100 = 27,00,000 × 100 = 27%
Sales (S) 100,00,000
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Question 7.
Following is the Balance Sheet of Soni Ltd. as on 31st March, 2018 :
Liabilities Amount in Rs.

Shareholder's Fund
Equity Share Capital (Rs.10 each) 25,00,000
Reserve and Surplus 5,00,000
Non-Current Liabilities (12 Debentures) 50,00,000
Current Liabilities 20,00,000
Total 1,00,00,000
Assets Amount in Rs.
Non-Current Assets 60,00,000
Current Assets 40,00,000
Total 1,00,00,000
Additional Information:
(i) Variable Cost is 60% of Sales.
(ii) Fixed Cost p.a. excluding interest Rs.20,00,000.
(iii) Total Asset Turnover Ratio is 5 times.
(iv) Income Tax Rate 25%
You are required to:
(1) Prepare Income Statement
(2) Calculate the following and comment:
(a) Operating Leverage
(c) Combined Leverage (Examination Nov. 2018)
Answer
Workings:-
Total Assets = Rs.1 crore
Total Sales
Total Asset Turnover Ratio i.e. =5
Total Assets
Hence, Total Sales = Rs.1 Crore 5 = Rs.5 crore
(1) Income Statement
(Rs.in crore)
Sales 5
Less: Variable cost @ 60% 3
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Contribution 2
Less: Fixed cost (other than Interest) 0 .2
EBIT (Earnings before interest and tax) 1.8
Less: Interest on debentures (12% 50 lakhs) 0 .06
EBT (Earning before tax) 1.74
Less: Tax 25% 0.435
EAT (Earning after tax) 1.305
(2) (a) Operating Leverage

Contribution 2
Operating leverage = = = 1.11
EBIT 1.8
It indicates fixed cost in cost structure. It indicates sensitivity of earnings before interest and tax (EBIT)
to change in sales at a particular level.
EBIT 1.8
Financial Leverage = = = 1.03
EBT 1.74
The financial leverage is very comfortable since the debt service obligation is small vis-à-vis EBIT.
(c) Combined Leverage
Contribution EBIT
Combined Leverage = × = 1.11 x 1.03 = 1.15
EBIT EBT
Or
Contribution = 2 = 1.15
EBT 1.74
The combined leverage studies the choice of fixed cost in cost structure and choice of debt in capital
structure. It studies how sensitive the change in EPS is vis-à-vis change in sales.
The leverages operating, financial and combined are measures of risk.
Question 8.
The capital structure of the Shiva Ltd. consists of equity share capital of ‘ 20,00,000 (Share of ‘ 100 per
value) and ‘ 20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000 units,
the selling price is ‘ 10 per units; variable costs amount to ‘ 6 per unit and fixed expenses amount to ‘
4,00,000. The income tax rate is assumed to be 50%.
(a) You are required to calculate the following:
(i) The percentage increase in earnings per share:
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.
(b) Comment on the behaviour of operating and Financial leverages in relation to increase in
production from 2,00,000 units to 2,40,000 units. (Examination May 2019)
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Question 9
B LLP. has the following balance sheet and Income statement information:
Balance Sheet as on March 31st 2019

Liabilities (Rs.) Assets (Rs.)
Partners’ Capital 80,00,000 Net Fixed Assets 1,00,00,000
Term Loan 60,00,000 Inventories 45,00,000
Retained Earnings 35,00,000 Trade Receivables 40,50,000
Trade Payables 15,00,000 Cash & Bank 4,50,000
1,90,00,000 1,90,00,000
Income Statement for the year ending March 31st 2019

(Rs.)
Sales 34,00,000
Operating expenses (including Rs. 6,00,000 depreciation) 12,00,000
EBIT 22,00,000
Less: Interest 6,00,000
Earnings before tax 16,00,000
Less: Taxes 5,60,000
Net Earnings (EAT) 10,40,000
COMPUTE the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs.
(MTP Nov. 19)
Answer
Question 10
The Balance Sheet of Gitashree Ltd. is given below:

Liabilities (Rs. )
Shareholders’ fund
Equity share capital of Rs. 10 each Rs. 1,80,000
Retained earnings Rs. 60,000 2,40,000
Non-current liabilities 10% debt 2,40,000
Current liabilities 1,20,000
6,00,000
Assets
Fixed Assets 4,50,000
6,00,000
The company's total asset turnover ratio is 4. Its fixed operating cost is Rs. 2,00,000 and its variable
operating cost ratio is 60%. The income tax rate is 30%.
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Calculate:
(i) (a) Degree of Operating leverage.
(b) Degree of Financial leverage.
(c) Degree of Combined leverage.
(ii) Find out EBIT if EPS is (a) Rs. 1 (b) Rs. 2 and (c) Rs. 0.
(Examination Nov. 2019)
Answer
Working Notes:
Computation of Profits after Tax (PAT)

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

Financial Leverage
= 1.263 1.033 = 1.304 (approx.)
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Or, EBIT = Rs. 24,000

Alternatively, if EPS is 0 (zero), EBIT will be equal to interest on debt i.e. Rs. 24,000.
Question 11:
The following information is related to YZ Company Ltd. for the year ended 31st March, 2020:
Equity share capital (of Rs. 10 each) Rs. 50 lakhs
12% Bonds of Rs. 1,000 each Rs. 37 lakhs
Sales Rs. 84 lakhs
Fixed cost (excluding interest) Rs. 6.96 lakhs
Financial leverage 1.49
Profit-volume Ratio 27.55%
Income Tax Applicable 40%
You are required to CALCULATE:
(i) Operating Leverage;
(ii) Combined leverage; and
(iii) Earnings per share.
Show calculations up-to two decimal points.
(RTP May 2020)
Answer
Computation of Profits after Tax (PAT)
Particulars Amount (Rs.)
Sales 84,00,000
Contribution (Sales × P/V ratio) 23,14,200
Less: Fixed cost (excluding Interest) (6,96,000)
EBIT (Earnings before interest and tax) 16,18,200
Less: Interest on debentures (12% Rs.37 lakhs) (4,44,000)
Less: Other fixed Interest (balancing figure) (88,160)
EBT (Earnings before tax) 10,86,040*
Less: Tax @ 40% 4,34,416
PAT (Profit after tax) 6,51,624
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__**__
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CHAPTER-7
Investment Decision
Question 1.
A company has to make a choice between two projects namely A and B. The initial capital outlay of two
Projects are Rs. 1,35,000 and Rs. 2,40,000 respectively for A and B. There will be no scrap value at the
end of the life of both the projects. The opportunity Cost of Capital of the company is 16%. The annual
incomes are as under:
Year Project A (Rs.) Project B (Rs.) 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)
Answer
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Question 2.
Shiv Limited is thinking of replacing its existing machine by a new machine which would cost RS. 60 lakhs.
The company‟s current production is 80,000 units, and is expected to increase to 1,00,000 units, if the
new machine is bought. The selling price of the product would remain unchanged at RS. 200 per unit. The
following is the cost of producing one unit of product using both the existing and new machine:
Unit cost (Rs.)

Existing Machine New Machine Difference
(80,000 (1,00,00
units) 0 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 RS. 1,00,000, and it has been fully depreciated
for tax purpose. It is estimated that machine will be useful for 5 years. The supplier of the new machine
has offered to accept the old machine for RS. 2,50,000. However, the market price of old machine
today is RS. 1,50,000 and it is expected to be
RS. 35,000 after 5 years. The new machine has a life of 5 years and a salvage value of
RS. 2,50,000 at the end of its economic life. Assume corporate Income tax rate at 40%, and
depreciation is charged on straight line basis for Income-tax purposes. Further assume that book profit
is treated as ordinary income for tax purpose. The opportunity cost of capital of the Company is 15%.
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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. (RTP Nov 2018)
Year (t) 1 2 3 4 5
PVIF0.15,t 0.8696 0.7561 0.6575 0.5718 0.4972
PVIF0.20,t 0.8333 0.6944 0.5787 0.4823 0.4019
PVIF0.25,t 0.80 0.64 0.512 0.4096 0.3277
PVIF0.30,t 0.7692 0.5917 0.4552 0.3501 0.2693
PVIF0.35,t 0.7407 0.5487 0.4064 0.3011 0.2230
Answer
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Question 3.
BT Pathology Lab Ltd. is using an X-ray machines which reached at the end of their useful lives. Following
new X-ray machines are of two different brands with same features are available for the purchase.
Cost of Life of Maintenance Cost Rate of
Brand
Machine Machine Year 1-5 Year 6-10 Year 11-15 Depreciation
XYZ Rs. 6,00,000 15 years Rs. 20,000 Rs. 28,000 Rs. 39,000 4%
ABC Rs. 4,50,000 10 years Rs. 31,000 Rs. 53,000 -- 6%
Residual Value of both of above machines shall be dropped by 1/3 of Purchase price in the first year
and thereafter shall be depreciated at the rate mentioned above.
Alternatively, the machine of Brand ABC can also be taken on rent to be returned back to the owner
after use on the following terms and conditions:
Annual Rent shall be paid in the beginning of each year and for first year it shall be
RS1,02,000.
Annual Rent for the subsequent 4 years shall be RS1,02,500.
Annual Rent for the final 5 years shall be RS1,09,950.
The Rent Agreement can be terminated by BT Labs by making a payment of RS 1,00,000 as
penalty. This penalty would be reduced by RS10,000 each year of the period of rental agreement.
You are required to:
(a) ADVISE which brand of X-ray machine should be acquired assuming that the use of machine
shall be continued for a period of 20 years.
(b) STATE which of the option is most economical if machine is likely to be used for a period of 5
years?
The cost of capital of BT Labs is 12%. (RTP May 2019)
Answer
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Question 4.
XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment in
a project which will require Rs. 270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of Rs. 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 Rs. 10 lakhs. Company's tax rate is 30%.
You are required to calculate:
(i) The adjusted present value of the investment,
(ii) The adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments. (Examination May 2018)
Answer
(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:
(-) Rs. 270 lakhs + (Rs. 42 lakhs / 0.14) = (-) Rs. 270 lakhs + Rs. 300 lakhs
= Rs. 30
Issue costs = Rs. 10 lakhs
Thus, the amount to be raised = Rs. 270 lakhs + Rs. 10 lakhs
= Rs. 280 lakhs
Annual tax relief on interest payment = Rs. 280 X 0.1 X 0.3
= Rs. 8.4 lakhs in perpetuity
The value of tax relief in perpetuity = Rs. 8.4 lakhs / 0.1
= Rs. 84 lakhs
Therefore, APV = Base case PV – Issue Costs + PV of Tax Relief on debt interest
= Rs. 30 lakhs – Rs. 10 lakhs + 84 lakhs = Rs. 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.
(-) Rs.280 lakhs X (Annual Income / 0.14) = (-) Rs.104 lakhs
Annual Income / 0.14 = (-) Rs. 104 + Rs. 280 lakhs
Therefore, Annual income = Rs. 176 X 0.14 = Rs. 24.64 lakhs
Adjusted discount rate = (Rs. 24.64 lakhs / Rs.280 lakhs) X 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
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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 5
A company is evaluating a project that requires initial investment of Rs. 60 lakhs in fixed assets and
Rs. 12 lakhs towards additional working capital.
The project is expected to increase annual real cash inflow before taxes by Rs. 24,00,000 during its
life. The fixed assets would have zero residual value at the end of life of 5 years. The company
follows straight line method of depreciation which is expected for tax purposes also. Inflation is
expected to be 6% per year. For evaluating similar projects, the company uses discounting rate of
12% in real terms. Company's tax rate is 30%.
Advise whether the company should accept the project, by calculating NPV in real terms. (Examination
May 2018)
PVIF (12%, 5 years) PVIF (6%, 5 years)
Year 1 0.893 Year 1 0.943
Year 2 0.797 Year 2 0.890
Year 3 0.712 Year 3 0.840
Year 4 0.636 Year 4 0.792
Year 5 0.567 Year 5 0.747
Answer
(i) Equipment‟s initial cost = Rs. 60,00,000 + Rs. 12,00,000
= Rs. 72,00,000
(ii) Annual straight line depreciation = Rs. 60,00,000/5
= Rs. 12,00,000.
(iii) Net Annual cash flows can be calculated as follows:
= Before Tax CFs × (1 – Tc) + Tc × Depreciation (Tc = Corporate tax i.e. 30%)
= Rs. 24,00,000 × (1 – 0.3) + (0.3 x Rs. 12,00,000)
= Rs. 16,80,000 + Rs. 3,60,000 = Rs. 20,40,000
So, Total Present Value = PV of inflow + PV of working capital released
= (Rs. 20,40,000 × PVIF 12%, 5 years) + (Rs. 12,00,000 × 0.567)
= (Rs. 20,40,000 × 3.605) + Rs. 6,80,400
= Rs. 73,54,200 + Rs. 6,80,400
= Rs. 80,34,600
So NPV = PV of Inflows – Initial Cost
= Rs. 80,34,600 – Rs. 72,00,000
= Rs. 8,34,600
Advice: Company should accept the project as the NPV is Positive
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Question 6.
AT Limited is considering three projects A, B and C. The cash flows associated with the projects are give
below :
Cash flows associate with the Three Projects („)
Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (20,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000
You are required to :

(a) Calculate the payback period of each of the three projects.
(b) If the cut-off period is two years, then which projects should be accepted ?
(c) Projects with positive NPVs if the opportunity cost of capital is 10 percent.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or false ?
(e) “If a firm used a single cut-off period for all projects, it is likely to accept too many short lived
projects.” True of false ? (Examination May 2019)
Question 7.
Determine the risk adjusted net present value of the following projects (MTP March 2019)
X Y Z
Net cash outlays (Rs.) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (Rs.) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:
Coefficient of Variation Risk-Adjusted Rate of Return P.V. Factor 1 to 5 years At risk

adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
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Answer
Question 8.
X Ltd. is considering to select a machine out of two mutually exclusive machines. The company‟s cost
of capital is 15 per cent and corporate tax rate is 30 per cent. Other information relating to both machines
is as follows:
Machine – I Machine – II
Cost of Machine Rs. 30,00,000 Rs. 40,00,000
Expected Life 10 years. 10 years.

Annual Income
(Before Tax and Depreciation) Rs. 12,50,000 Rs. 17,50,000
Depreciation is to be charged on straight line basis:
You are required to CALCULATE:
(i) Discounted Pay Back Period
(ii) Net Present Value
(iii) Profitability Index
The present value factors of Re.1 @ 15% are as follows:
Year 01 02 03 04 05
PV factor @ 15% 0.870 0.756 0.658 0.572 0.497.
(MTP March 2019)
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Answer
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Question 9.
Rio Ltd has a maximum of Rs. 8,00,000 available to invest in new projects. Three possibilities have
emerged and the business finance manager has calculated Net present Value (NPVs) for each of the
projects as follows :
Investment Initial cash NPV

outlay Rs.
Rs.
Alfa (α) 5,40,000 1,00,000
Beta(β) 6,00,000 1,50,000
Gama (γ) 2,60,000 58,000
DETERMINE which investment/combination of investments should the company invest in, if we
assume that the projects can be divided? (MTP April 2019)
Answer
Question 10.
PD Ltd. an existing company, is planning to introduce a new product with projected life of 8 years.
Project cost will be Rs.2,40,00,000. At the end of 8 years no residual value will be realized. Working
capital of Rs.30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the
Production and Sales Volume is expected are as under : (Examination Nov. 2018)
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:
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(i) Selling price per unit Rs.200
(ii) Variable cost is 40 of sales.
(iii) Fixed cost p.a. Rs.30,00,000.
(iv) In addition to these advertisement expenditure will have to be incurred as under:
Year 1 2 3-5 6-8

Expenditure (`) 50,00,000 25,00,000 10,00,000 5,00,000
(v) Income Tax is 25%.
(vi) Straight line method of depreciation is permissible for tax purpose.
(vii) Cost of capital is 10%.
(viii) Assume that loss cannot be carried forward.
Present Value Table
Year 1 2 3 4 5 6 7 8
PVF@ 10 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Advise about the project acceptability.
Answer
Computation of initial cash outlay(COF)
(RS.in lakhs)
Project Cost 240
Working Capital 30
270
Calculation of Cash Inflows(CIF):
Years 1 2 3-5 6-8

Sales in units 60,000 80,000 1,40,000 1,20,000
Rs. Rs. Rs. Rs.
Contribution (RS.200 x 60% x No.
72,00,000 96,00,000 1,68,00,000 1,44,00,000
of Unit)
Less: Fixed cost 30,00,000 30,00,000 30,00,000 30,00,000
Less: Advertisement 50,00,000 25,00,000 10,00,000 5,00,000
Less: Depreciation (24000000/8)
30,00,000 30,00,000 30,00,000 30,00,000
= 30,00,000
Profit /(loss) (38,00,000) 11,00,000 98,00,000 79,00,000
Less: Tax @ 25% NIL 2,75,000 24,50,000 19,75,000
Profit/(Loss) after tax (38,00,000) 8,25,000 73,50,000 59,25,000
Add: Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
Cash inflow (8,00,000) 38,25,000 1,03,50,000 89,25,000
(Note: Since variable cost is 40%, Contribution shall be 60% of sales)
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Computation of PV of CIF
CIF PV Factor
Year Rs.
Rs. @ 10%
1 (8,00,000) 0.909 (7,27,200)
2 38,25,000 0.826 31,59,450
3 1,03,50,000 0.751 77,72,850
4 1,03,50,000 0.683 70,69,050
5 1,03,50,000 0.621 64,27,350
6 89,25,000 0.564 50,33,700
7 89,25,000 0.513 45,78,525
8 89,25,000
Working Capital 30,00,000 0.467 55,68,975
3,88,82,700
PV of COF 2,70,00,000
NPV 1,18,82,700
Recommendation: Accept the project in view of positive NPV.
Question 11:
MTR Limited is considering buying a new machine which would have a useful economic life of five years,
at a cost of Rs.25,00,000 and a scrap value of Rs.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 sellingpriceof Rs.300 per unit. Direct costs would be
Rs.285 per unit and annual fixed costs, including depreciation calculated on a straight- line basis, would
be Rs.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 Rs.1,00,000 and Rs.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. 19)
Answer
Calculation of Net Cash flows
Contribution = (300 – 285) 75,000 = Rs.11,25,000
Fixed costs = 8,40,000 – [(25,00,000 – 3,00,000)/5] = Rs.4,00,000
Year Capital Contribution Fixed costs Adverts Net cash flow
(Rs.) (Rs.) (Rs.) (Rs.) (Rs.)
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
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Calculation of Net Present Value
Year Net cash flow (Rs.) 12% discount factor Present value (Rs.)
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 Rs. 1,26,800.
Question 12:
A company has Rs. 1,00,000 available for investment and has identified the following four investments in
which to invest.
Project Investment (Rs.) NPV (Rs.)
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit if-
(i) The projects are independent of each other and are divisible.
(ii) The projects are not divisible.
Answer
(i) Optimizing returns when projects are independent and divisible. Computation of NPVs per
Re. 1 of Investment and Ranking of the Projects
Project Investment NPV NPV per Re. 1 Ranking
invested
(Rs.) (Rs.) (Rs.)
C 40,000 20,000 0.50 1
D 1,00,000 35,000 0.35 3
E 50,000 24,000 0.48 2
F 60,000 18,000 0.30 4
Building up of a Package of Projects based on their Rankings

Project Investment (Rs.) NPV (Rs.)
C 40,000 20,000
E 50,000 24,000
D 10,000 3,500
(1/10th of Project)
Total 1,00,000 47,500
The company would be well advised to invest in Projects C, E and D (1/10 th) and reject Project F
to optimise return within the amount of Rs.1,00,000 available for investment.
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(ii) Optimizing returns when projects are indivisible.

Package of Project Investment (Rs.) Total NPV (Rs.)
C and E 90,000 44,000
(40,000 + 50,000) (20,000 + 24,000)
C and F 1,00,000 38,000
(40,000 + 60,000) (20,000 + 18,000)
Only D 1,00,000 35,000
The company would be well advised to invest in Projects C and E to optimise return within the amount of
Rs.1,00,000 available for investment.
Question 13:
A company is considering the proposal of taking up a new project which requires an investment of
Rs.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 (Rs. in lakhs)
1 320
2 320
3 360
4 360
5 300
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on 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)
Answer
(i) Calculation of Net Cash Flow
(Rs. in lakhs)
Year Profit before Depreciation (20% on WDV) PBT PAT Net cash
dep. and tax flow
(1) (2) (3) (4) (5) (3) + (5)
1 320 800 20% = 160 160 96 256
2 320 (800 160) 20% = 128 192 115.20 243.20
3 360 (640 128) 20% = 102.4 257.6 154.56 256.96
4 360 (512 102.4) 20% = 81.92 278.08 166.85 248.77
5 300 (409.6 81.92) = 327.68* 27.68 16.61 311.07
*this is treated as a short term capital loss.
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(ii) Calculation of Net Present Value (NPV)
(Rs. 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.
__**__
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CHAPTER-8
Risk Analysis in Capital Budgeting
Question 1.
From the following details relating to a project, analyse the sensitivity of the project to changes in initial
project cost, annual cash inflow and cost of capital:
Initial Project Cost (Rs.) 1,20,000

Annual Cash Inflow (Rs.) 45,000
Project Life (Years) 4
Cost of Capital 10%
Required:
EXAMINE which of the three factors, the project is most sensitive? (Use annuity factors: for 10% 3.169
and 11% 3.103). (RTP May 2018)
Answer
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Question 2.
Gaurav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalent

quotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project should
be accepted? (RTP Nov. 2018)
Answer
Question 3.
An enterprise is investing Rs 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows that
are estimated over the life of the project.
Year Cash flows (RSIn

lakhs)
1 25
2 60
3 75
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4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate. (RTP May 2019)
Answer
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Question 4.
Probabilities for net cash flows for 3 years of a project of Ganesh Ltd are as follows:
Year 1 Year 2 Year 3

Cash Flow Probability Cash Flow Probability Cash Flow Probability
(Rs.) (Rs.) (Rs.)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
CALCULATE the expected net cash flows and the present value of the expected cash flow, using 10 per
cent discount rate. Initial Investment is Rs. 10,000 (MTP April 2019)
Answer
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Question 5.
Invest Corporation Ltd. adjusts risk through discount rates by adding various risk premiums to the risk free
rate. Depending on the resultant rate, the proposed project is judged to be a low, medium or high risk
project.
Risk level Risk free rate Risk Premium

(%) (%)
Low 8 4
Medium 8 7
High 8 10
DEMONSTRATE the acceptability of the project on the basis of Risk Adjusted rate. (MTP April 2019)
Answer
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Question 6.
From the following details relating to a project, analyse the sensitivity of the project to changes in the
Initial Project Cost, Annual Cash Inflow and Cost of Capital :
Particulars
Initial Project Cost Rs.2,00,00,000
Annual Cash Inflow Rs.60,00,000
Project Life 5 years
Cost of Capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696.
Answer
Calculation of NPV through Sensitivity Analysis
Rs.
PV of cash inflows (RS.60,00,000 × 3.791) 2,27,46,000
Initial Project Cost 2,00,00,000
NPV 27,46,000
Situation NPV Changes in NPV

Base(present) Rs.27,46,000
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If initial project cost is (Rs.2,27,46,000 – Rs.27, 46,000 - Rs.7, 46,000
varied adversely by 10% Rs.2,20,00,000*)
Rs.27, 46,000
= Rs.7,46,000
= (72.83%)
If annual cash inflow is [Rs.54,00,000(revised Rs.27, 46,000 - Rs.4,71, 400

varied adversely by 10% cash flow) ** × 3.791) – Rs.27, 46,000
(Rs.2,00,00,000)] = 82.83%
= Rs.4,71,400
If cost of capital is varied (Rs.60,00,000 × 3.696)– Rs.27, 46,000 - Rs.21,76, 400
adversely by 10% i.e. it Rs.2,00,00,000
Rs.27, 46,000
becomes 11% = Rs.21,76,000 = 20.76%
*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000

**Revised Cash Flow = Rs.60,00,000 x (100 – 10) % = Rs.54,00,000
Conclusion: Project is most sensitive to ‘annual cash inflow’
Question 7.
Kanoria Enterprises wishes to evaluate two mutually exclusive projects x and y .
The particulars are as under:
Project X (‘) Project Y (‘)
Initial Investment 1,20,000 1,20,000
Estimated cash inflows
(per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000
The cut off rate is 14% The discount factor at 14% are:
Year 1 2 3 4 5 6 7 8 9
Discount 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308
Factor
Advise management about the acceptability of projects X and Y. (Examination May 2019)
Question 8
SL Ltd. has invested Rs.1,000 lakhs in a project. The risk-free rate of return is 5%. Risk premium
expected by the Management is 10%. The life of the project is 5 years. Following are the cash flows
that are estimated over the life of the project.
Year Cash flows (Rs. in lakhs)
1 125
2 300
3 375
4 400
5 325
8.7| P a g e
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.
(RTP Nov. 19)
Answer
The Present Value of the Cash Flows for all the years by discounting the cash flow at 5% is calculated
as below:
Year Cash flows Discounting Factor Present value of Cash
Rs. in lakhs @5% Flows Rs. In Lakhs
1 125 0.952 119.00
2 300 0.907 272.10
3 375 0.863 323.62
4 400 0.822 328.80
5 325 0.783 254.47
Total of present value of Cash flow 1,297.99
Less: Initial investment 1,000.00
Net Present Value (NPV) 297.99
Now when the risk-free rate is 5% and the risk premium expected by the Management is 10%. So the
risk adjusted discount rate is 5% + 10% =15%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Year Cash flows Discounting Present Value of Cash Flows
Rs. in Lakhs Factor@15% Rs.in lakhs
1 125 0.869 108.62
2 300 0.756 226.80
3 375 0.657 246.37
4 400 0.571 228.40
5 325 0.497 161.52
Total of present value of Cash flow 971.71

Initial investment 1,000.00
Net present value (NPV) (28.29)
Question 9
CALCULATE Variance and Standard Deviation on the basis of following information:
Project A Project B
Possible
Cash Flow Probability Cash Flow Probability
Event
(Rs.) (Rs.)
A 80,000 0.10 2,40,000 0.10
B 1,00,000 0.20 2,00,000 0.15
C 1,20,000 0.40 1,60,000 0.50
D 1,40,000 0.20 1,20,000 0.15
E 1,60,000 0.10 80,000 0.10
(MTP Nov. 19)
8.8 | P a g e
Answer
Calculation of Expected Value for Project A and Project B
Project A Project B
Possible Net Cash Probability Expected Cash Flow Probability Expected
Event Flow Value (Rs.) Value
(Rs.) (Rs.) (Rs.)
A 80,000 0.10 8,000 2,40,000 0.10 24,000
B 1,00,000 0.20 20,000 2,00,000 0.15 30,000
C 1,20,000 0.40 48,000 1,60,000 0.50 80,000
D 1,40,000 0.20 28,000 1,20,000 0.15 18,000
E 1,60,000 0.10 16,000 80,000 0.10 8,000
ENCF 1,20,000 1,60,000
Project A:
Variance (σ2) = (80,000 – 1,20,000)2 × (0.1) + (1,00,000 -1,20,000)2 × (0.2) + (1,20,000 – 1,20,000)2
× (0.4) + (1,40,000 – 1,20,000)2 × (0.2) + (1,60,000 – 1,20,000)2 × (0.1)
= 16,00,00,000 + 8,00,00,000 + 0 + 8,00,00,000 + 16,00,00,000
= 48,00,00,000
Project B:
Variance(σ2) = (2,40,000 – 1,60,000)2 × (0.1) + (2,00,000 – 1,60,000)2 × (0.15) + (1,60,000 –
1,60,000)2 ×(0.5) + (1,20,000 – 1,60,000)2 × (0.15) + (80,000 – 1,60,000)2 × (0.1)
= 64,00,00,000 + 24,00,00,000 + 0 + 24,00,00,000 + 64,00,00,000
= 1,76,00,00,000
Question 10
Door Ltd. is considering an investment of Rs. 4,00,000. This investment is expected to generate
substantial cash inflows over the next five years. Unfortunately, the annual cash flows from this
investment is uncertain, and the following profitability distribution has been established.
Annual Cash Flow (Rs.) Probability
50,000 0.3
1,00,000 0.3
1,50,000 0.4
At the end of its 5 years life, the investment is expected to have a residual value of Rs. 40,000.
The cost of capital is 5%
(i) Calculate NPV under the three different scenarios.
(ii) Calculate Expected Net Present Value.
(iii) Advise Door Ltd. on whether the investment is to be undertaken.
Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784
8.9| P a g e
Answer
(i) Calculation of NPV under three different scenarios (Amount in Rs.)
Particulars 1st Scenario 2nd Scenario 3rd Scenario
Annual Cash Flow 50,000 1,00,000 1,50,000
PV of cash inflows (Annual Cash Flow × 4.33*) 2,16,500 4,33,000 6,49,500
PV of Residual Value (Rs. 40,000 × 0.784) 31,360 31,360 31,360
Total PV of Cash Inflow 2,47,860 4,64,360 6,80,860
Initial investment 4,00,000 4,00,000 4,00,000
NPV (1,52,140) 64,360 2,80,860
* .952 + .907 + .864 + .823 + .784 = 4.33
(ii) Calculation of Expected Net present Value under three different scenarios
Particulars 1st Scenario 2nd Scenario 3rd Scenario Total (Rs.)
Annual Cash Flow Rs. 50,000 Rs. 1,00,000 Rs. 1,50,000
Probability 0.3 0.3 0.4
Expected Value Rs. 15,000 Rs. 30,000 Rs. 60,000 1,05,000
PV of Expected value (1,05,000 × 4.33) 4,54,650
PV of Residual Value (40,000 × 0.784) 31,360
Total PV of Cash Inflow 4,86,010
Initial investment 4,00,000
Expected Net Present Value 86,010
(iii) Since the expected net present value of the Investment is positive, the Investment should be
undertaken.
Question 11
G Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following information
regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalent quotient
0 (8,00,000) 1.0
1 6,40,000 0.8
2 5,60,000 0.7
3 5,20,000 0.6
4 4,80,000 0.4
5 3,20,000 0.3
Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the project
should be accepted?
(RTP May 2020)
8.10 | P a g e
Answer
Determination of Net Present Value (NPV)
Year Expected Cash flow Certainty- Adjusted Cash flow PV Total PV
(Rs.) equivalent (CE) (Cash flow × CE) (Rs.) factor (at 0.06) (Rs.)
0 (8,00,000) 1.0 (8,00,000) 1.000 (8,00,000)
1 6,40,000 0.8 5,12,000 0.943 4,82,816
2 5,60,000 0.7 3,92,000 0.890 3,48,880
3 5,20,000 0.6 3,12,000 0.840 2,62,080
4 4,80,000 0.4 1,92,000 0.792 1,52,064
5 3,20,000 0.3 96,000 0.747 71,712
NPV = (13,17,552 – 8,00,000) 5,17,552
As the Net Present Value is positive the project should be accepted.
__**__
8.11| P a g e
CHAPTER-9
Dividend Decisions
Question 1.
The following information relates to Navya Ltd:
Earnings of the company Rs. 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)
Answer
9.1| P a g e
Question 2.
The earnings per share of a company is RS. 10 and the rate of capitalisation applicable to it is 10 per
cent. The company has three options of paying dividend i.e. (i) 50%, (ii) 75% and (iii) 100%.
CALCULATE the market price of the share as per Walter’s model if it can earn a return of (a)15, (b) 10 and
(c) 5 per cent on its retained earnings. (RTP Nov 2018)
Answer.
9.2 | P a g e
Question 3.
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit RS 30 lakhs

Outstanding 12% preference shares RS 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%. (RTP May 2019)
Answer
9.3| P a g e
Question 4.
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) (MTP March 2019)
Earnings per share (EPS) Rs. 10

Dividend per share (DPS) Rs. 6
Cost of capital (k) 20%
Internal rate of return on investment 25%
Retention Ratio 60%
Answer
9.4 | P a g e
Question 5.
The following information is supplied to you:
Rs.
Total Earnings 2,00,000
No. of equity shares (of Rs. 100 each) 20,000
Dividend paid 1,50,000
Price/ Earnings ratio 12.5
Applying Walter’s Model

(i) DETERMINE whether the company is following an optimal dividend policy.
(ii) IDENTIFY, what should be the 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 April 2019)
Answer
9.5| P a g e
Question 6.
Following information relating to Jee Ltd. are given:

Particulars Rs.
Profit after tax Rs.10,00,000
Dividend payout ratio 50%
Number of Equity Shares 50,000
Cost of Equity 10%
Rate of Return on Investment 12%
(i) What would be the market value per share as per Walter's Model?
(ii) What is the optimum dividend payout ratio according to Walter's Model and Market value of equity share
at that payout ratio?
Answer
(i) Walter’s model is given by –
D (E D)(r / Ke )
P
Ke
Where,
P = Market price per share,
E = Earnings per share = Rs.10,00,000 ÷ 50,000 = Rs.20
D = Dividend per share = 50% of 20 = Rs.10
r = Return earned on investment = 12%
Ke = Cost of equity capital = 10%
10 + (20 – 10) x 0.12 22
P= 0.10 = = Rs.220
0.10 0.10
(ii) According to Walter’s model when the return on investment is more than the cost of equity capital, the
price per share increases as the dividend pay-out ratio decreases. Hence, the optimum dividend
pay-out ratio in this case is Nil. So, at a payout ratio of zero, the market value of the company’s share will
be:-
0 + (20 – 10) x 0.12 24

P= 0.10 = = Rs. 240
0.10 0.10
Question 7.
The following information is supplied to you:

Total Earning Rs. 40 Lakhs
No, of Equity Shares (of ‘ 100 each) 4,00,000
Dividend Per Shares Rs. 4
Cost of Capital 16%
Internal rate of return on investment 20%
Retention ratio 60%
9.6 | P a g e
Calculate the market price of a share of a company by using:
(i) Walter’s Formula
(ii) Gordon’s Formula (Examination May 2019)
Question 8:
The following information pertains to SD Ltd.
Earnings of the Company Rs. 50,00,000
Dividend Payout ratio 60%
No. of shares outstanding 10,00,000
Equity capitalization rate 12%
(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)
Answer
Question 9:
The following figures are collected from the annual report of XYZ Ltd.:
Net Profit Rs. 60 lakhs

Outstanding 10% preference shares Rs. 100 lakhs
No. of equity shares 5 lakhs
Return on Investment 20%
Cost of capital i.e. (Ke) 14%
9.7| P a g e
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%; (ii) 50% and (iii)
100%.
(MTP Nov. 19)
Answer
Rs. in lakhs
Net Profit 60
Less: Preference dividend 10
Earning for equity shareholders 50
Therefore earning per share 50/5 = Rs.10.00
Price per share according to Gordon’s Model is calculated as follows:
Question 10
Following figures and information were extracted from the company A Ltd.
Earnings of the company Rs. 10,00,000
Dividend paid Rs. 6,00,000
No. of shares outstanding 2,00,000
Price Earnings Ratio 10
You are required to calculate:
(i) Current Market price of the share
(ii) Capitalisation rate of its risk class
(iii) What should be the optimum pay-out ratio?
(iv) What should be the market price per share at optimal pay-out ratio? (use Walter’s Model)
Answer
(a) (i) Current Market price of shares (applying Walter’s Model)
The EPS of the firm is Rs. 5 (i.e., Rs 10,00,000 / 2,00,000).
9.8 | P a g e
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 Rs. 6,00,000 among 2,00,000 shares,
giving a dividend per share of Rs. 3.
(b) The value of the share as per Walter’s model may be found as follows: Walter’s model
is given by-
Where,
P = Market price per share.
E = Earnings per share = Rs. 5
D = Dividend per share = Rs. 3
R = Return earned on investment = 20 %
Ke = Cost of equity capital = 10% or .10
Market Price of Share = Rs. 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:
Question 11
Following information relating to Jee Ltd. is given:
Particulars
Profit after tax Rs. 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)
9.9| P a g e
Answer
(i) Walter’s model is given by –
Where,
P = Market price per share,
E = Earnings per share = Rs. 10,00,000 ÷ 50,000 = Rs. 20 D =
Dividend per share = 50% of 20 = Rs. 10
r = Return earned on investment = 12% Ke = Cost
of equity capital = 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:
__**__
9.10 | P a g e
CHAPTER-10
Unit I :-Management of Working Capital
Question 1.
A company is considering its working capital investment and financial policies for the next year.
Estimated fixed assets and current liabilities for the next year are Rs 2.60 crores and
Rs 2.34 crores respectively. Estimated Sales and EBIT depend on current assets
investment, particularly inventories and book-debts. The Financial Controller of the company is
examining the following alternative Working Capital Policies:
(Rs in crore)
Working Investment in Estimated EBI
Capit Current Assets Sales T
al Policy
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the adoption of the
moderate working capital policy. The company is now examining the use of long-term and short-term
borrowings for financing its assets. The company will use
Rs 2.50 crores of the equity funds. The corporate tax rate is 35%. The company is
considering the following debt alternatives.
(Rs in crore)
Financing Policy Short-term Long-term
Debt 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:
(d) Net Working Capital position.
(e) Rate of Return on Shareholders’ equity.
(f) Current ratio. (RTP May 2019)
(RTP Nov. 2018)
10(I).1| P a g e
Answer
10(I).2 | P a g e
Question 2.
Following information is forecasted by the Puja Limited for the year ending 31 st March, 20X8:
Balance as at 1st April, Balance as at 31st March,

20X7 20X8
(Rs.) (Rs.)
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 credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit) 11,00,000
10(I).3| P a g e
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)
.
Answer
10(I).4 | P a g e
10(I).5| P a g e
Question 3.
A proforma cost sheet of a company provides the following particulars:
Amount per unit

(Rs)
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 Rs37,500.
Required:
PREPARE a statement showing estimate of Working Capital needed to finance an activity level of 1,30,000
units of production. Assume that production is carried on evenly throughout the year, and wages and
overheads accrue similarly. Work-in-progress stock is 80% complete in all respects. (RTP May 2019)
Answer
10(I).6 | P a g e
Question 4.
Day Ltd., a newly formed company has applied to the Private Bank for the first time for financing it's
Working Capital Requirements. The following informations are available about the projections for the
current year:
Estimated Level of Activity Completed Units of Production 31200 plus unit of work in
progress 12000
Raw Material Cost Rs. 40 per unit
Direct Wages Cost Rs. 15 per unit
Overhead Rs. 40 per unit (inclusive of Depreciation Rs.10 per unit)
Selling Price Rs. 130 per unit
Raw Material in Stock Average 30 days consumption
Work in Progress Stock Material 100% and Conversion Cost 50%
Finished Goods Stock 24000 Units
Credit Allowed by the supplier 30 days
10(I).7| P a g e
Credit Allowed to Purchasers 60 days
Direct Wages (Lag in payment) 15 days
Expected Cash Balance Rs. 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. (Examination May 2018)
Answer
Calculation of Net Working Capital requirement:
(Rs.) (Rs.)
A. Current Assets:
Inventories:
Stock of Raw material 1,44,000
(Refer to Working note (iii)
Stock of Work in progress 7,50,000
(Refer to Working note (ii)
Stock of Finished goods 20,40,000
(Refer to Working note (iv)
Debtors for Sales 1,02,000
(Refer to Working note (v)
Cash 2,00,000
Gross Working Capital 32,36,000 32,36,000
B. Current Liabilities:
Creditors for Purchases 1,56,000
(Refer to Working note (vi)
Creditors for wages
(Refer to Working note (vii) 23,250
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
Working Notes:
(i) Annual cost of production
(Rs.)
Raw material requirements
{(31,200 × Rs. 40) + (12,000 x Rs. 40)} 17,28,000
Direct wages {(31,200 ×Rs. 15) +(12,000 X Rs. 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × Rs. 30) + (12,000 x Rs. 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
10(I).8 | P a g e
Less: Closing W.I.P [12,000 (Rs. 40 + Rs. 7.5 + Rs.15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods
(Rs. 26,52,000 × 24,000/31,200) (20,40,000)
Total Cash Cost of Sales 6,12,000
(ii) Work in progress stock
(R
s.)
Raw material requirements (12,000 units × Rs.40) 4,80,000
Direct wages (50% × 12,000 units × Rs. 15) 90,000
Overheads (50% × 12,000 units × Rs. 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:
(Rs.)
For Finished goods (31,200 × Rs. 40) 12,48,000
For Work in progress (12,000 × Rs. 40) 4,80,000
17,28,000
Raw material stock = Rs.17,28,000 × 30 days = Rs.1,44,000
360days
(iv) Finished goods stock:
24,000 units @ Rs. (40+15+30) per unit = Rs.20,40,000
60days
(v) Debtors for sale: Rs. 6,12,000 1,02,000
360days
(vi) Creditors for raw material Purchases [Working Note (iii)]:
Annual Material Consumed (Rs.12,48,000 + Rs.17,28,000
Rs.4,80,000)
Add: Closing stock of raw material Rs. 1,44,000
Rs.18,72,000
Rs.18,72,000
Credit allowed by suppliers = × 30days= Rs. 1,56,000
360days
(vii) Creditors for wages:
Rs.5,58,000
Outstanding wage payment = ×15days = Rs. 23,250
360days
10(I).9| P a g e
Question 5.
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 in warehouse on an average for one month.
(v) Credit allowed by suppliers is one month.
(vi) Two month’s credit is normally allowed to debtors.
(vii) A minimum cash balance of ‘ 67,500 is expected to be maintained.
(viii) Cash sales are 75 percent less than the credit sales.
(ix) Safety margin of 20 percent to cover unforeseen contingencies.
(x) The production pattern is assumed to be even during the year.
(xi) The cost structure for Bita Limited’s product is as follows:
‘
Ram Materials 80 per unit
Direct Labour 20 per unit
Overheads (including depreciation ‘ 20) 80 per unit
Total Cost 180 per unit
Profit 20 per unit
Selling Price 200 per unit
You are required to estimate the working capital requirement of Bita limited.
Answer
10(I).10 | P a g e
Question 6:
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 Rs. 40 per unit
Direct Wages Cost Rs. 15 per unit
Overhead Rs. 40 per unit (inclusive of Depreciation Rs.10 per unit)
Selling Price Rs. 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 Rs. 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)
Answer
Calculation of Net Working Capital requirement:
(Rs.) (Rs.)
A. Current Assets:
10(I).11| P a g e
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
1,79,250 1,79,250
Net Working Capital (A - B) 30,56,750
Working Notes:
(i) Annual cost of production

(Rs.)
Raw material requirements
{(31,200 × Rs. 40) + (12,000 x Rs. 40)} 17,28,000
Direct wages {(31,200 ×Rs. 15) +(12,000 X Rs. 15 x 0.5)} 5,58,000
Overheads (exclusive of depreciation)
{(31,200 × Rs. 30) + (12,000 x Rs. 30 x 0.5)} 11,16,000
Gross Factory Cost 34,02,000
Less: Closing W.I.P [12,000 (Rs. 40 + Rs. 7.5 + Rs.15)] (7,50,000)
Cost of Goods Produced 26,52,000
Less: Closing Stock of Finished Goods (Rs. 26,52,000 ×
24,000/31,200) (20,40,000)
Total Cash Cost of Sales* 6,12,000
[*Note: Alternatively, Total Cash Cost of Sales = (31,200 units – 24,000 units) x (Rs. 40 + Rs. 15 + Rs. 30)
= Rs. 6,12,000]
(ii) Work in progress stock

(Rs.)
Raw material requirements (12,000 units × Rs.40) 4,80,000
Direct wages (50% × 12,000 units × Rs. 15) 90,000
Overheads (50% × 12,000 units × Rs. 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:
(Rs.)
For Finished goods (31,200 × Rs. 40) 12,48,000
For Work in progress (12,000 × Rs. 40) 4,80,000
17,28,000
10(I).12 | P a g e
Rs. 17,28,000
Raw material stock x 30 day s Rs. 1,44,000
360 day s
(iv) Finished goods stock:

24,000 units @ Rs. (40+15+30) per unit = Rs. 20,40,000
60 day s
(v) Debtors for sale : Rs. 6,12,000 x Rs. 1,02,000
360 day s
(vi) Creditors for raw material Purchases [Working Note (iii)]:

Annual Material Consumed (Rs.12,48,000 + Rs.4,80,000) Rs.17,28,000
Add: Closing stock of raw material [(Rs.17,28,000 x 30 days) / 360 days] Rs. 1,44,000
Rs.18,72,000
Rs. 18,72,000
Credit allow ed by suppliers x 30 day s Rs. 1,56,000
360 day s
(vii) Creditors for wages:
Outstanding wage payment = [(31,200 units x Rs. 15) + (12,000 units x Rs. 15 x .50)] x 15 days / 360
days
Rs. 5,58,000
x 15 day s Rs. 23,250
360 day s
__**__
10(I).13| P a g e
CHAPTER-10
Unit II :- Treasury and Cash Management
Question 1
A firm maintains a separate account for cash disbursement. Total disbursement are Rs.10,50,000 per
month or Rs. 1,26,00,000 per year. Administrative and transaction cost of transferring cash to
disbursement account is Rs.20 per transfer. Marketable securities yield is 8% per annum.
COMPUTE the optimum cash balance according to William J. Baumol model.
(MTP Nov. 19)
Answer
Question 2
Slide Ltd. is preparing a cash flow forecast for the three months period from January to the end of
March. The following sales volumes have been forecasted:
Months December January February March April
Sales (units) 1,800 1,875 1,950 2,100 2,250
Selling price per unit is Rs. 600. Sales are all on one month credit. Production of goods for sale takes
place one month before sales. Each unit produced requires two units of raw materials costing Rs. 150
per unit. No raw material inventory is held. Raw materials purchases are on one month credit.
Variable overheads and wages equal to Rs. 100 per unit are incurred during production and paid in the
month of production. The opening cash balance on 1st January is expected to be Rs. 35,000. A long
term loan of Rs. 2,00,000 is expected to be received in the month of March. A machine costing Rs.
3,00,000 will be purchased in March.
(a) Prepare a cash budget for the months of January, February and March and calculate the cash
balance at the end of each month in the three months period.
(b) Calculate the forecast current ratio at the end of the three months period.
Answer
Working Notes:
(1) Calculation of Collection from Trade Receivables:
Particulars December January February March
Sales (units) 1,800 1,875 1,950 2,100
Sales (@ Rs. 600 per unit) / Trade 10,80,000 11,25,000 11,70,000 12,60,000
Receivables (Debtors) (Rs.)
Collection from Trade Receivables 10,80,000 11,25,000 11,70,000
(Debtors) (Rs.)
(2) Calculation of Payment to Trade Payables:
Particulars December January February March
Output (units) 1,875 1,950 2,100 2,250
Raw Material (2 units per output) (units) 3,750 3,900 4,200 4,500
Raw Material (@ Rs. 150 per unit) / Trade 5,62,500 5,85,000 6,30,000 6,75,000
Payables (Creditors) (Rs.)
Payment to Trade Payables 5,62,500 5,85,000 6,30,000
(Creditors) (Rs.)
10(II).14 | P a g e
(3) Calculation of Variable Overheads and Wages:
Particulars January February March
Output (units) 1,950 2,100 2,250
Payment in the same month @ Rs.100 per 1,95,000 2,10,000 2,25,000
unit (Rs.)
(a) Preparation of Cash Budget

Particulars January February March
(Rs.) (Rs.) (Rs.)
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 Materials 5,62,500 5,85,000 6,30,000
Variable Overheads and Wages 1,95,000 2,10,000 2,25,000
Purchase of Machinery 3,00,000
Total (B) 7,57,500 7,95,000 11,55,000
Closing Balance (A – B) 3,57,500 6,87,500 9,02,500
(b) Calculation of Current Ratio

Particulars March (Rs.)
Output Inventory (i.e. units produced in March)
[(2,250 units x 2 units of raw material per unit of output x Rs. 150 per 9,00,000
unit of raw material) + 2,250 units x Rs. 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
Trade Payables (Creditors) 6,75,000
Current Liabilities 6,75,000
Current Ratio (Current Assets / Current Liabilities) 4.537 approx.
__**__
10(II).15| P a g e
CHAPTER-10
Unit IV :- Management of Receivables ( Debtors)
Question 1.
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 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 RS. 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)
Answer
10(IV).16 | P a g e
Question 2.
A bank is analysing the receivables of J Ltd. in order to identify acceptable collateral for short-term loan.
The company’s credit policy is 2/10 net 30. The bank lends 80 percent on accounts where customers are
not currently overdue and where the average payment period does not exceed 10 days past the net
period. A schedule of J Ltd.’s receivables has been prepared. ANALYSE, how much will the bank lend on
pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
(Mtp March 2019)
Account Amount Days Outstanding in Average Payment Period

Rs. days historically
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48
1,08,800
10(IV).17| P a g e
Answer
10(IV).18 | P a g e
Question 3.
Navya Ltd has annual credit sales of Rs.45 lakhs. Credit terms are 30 days, but its management of
receivables has been poor and the average collection period is 50 days, Bad debt is 0.4 per cent of sales.
A factor has offered to take over the task of debt administration and credit checking, at an annual fee of 1
per cent of credit sales. Navya Ltd. estimates that it would save Rs. 35,000 per year in administration
costs as a result. Due to the efficiency of the factor, the average collection period would reduce to 30
days and bad debts would be zero. The factor would advance 80 per cent of invoiced debts at an
annual interest rate of 11 percent. Navya Ltd. is currently financing receivables from an overdraft costing
10 per cent per year.
If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s
services should be accepted or rejected. Assume 365 days in a year. (MTP April 2019)
Answer
Question 4.
MN Ltd. has a current turnover of Rs.30,00,000 p.a. Cost of Sale is 80% of turnover and Bad Debts are
2% of turnover, Cost of Sales includes 70% variable cost and 30% Fixed Cost, while company's
required rate of return is 15%. MN Ltd. currently allows 15 days credit to its customer, but it is considering
increase this to 45 days credit in order to increase turnover.
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It has been estimated that this change in policy will increase turnover by 20%, while Bad Debts will
increase by 1%. It is not expected that the policy change will result in an increase in fixed cost and creditors
and stock will be unchanged.
Should MN Ltd. introduce the proposed policy? (Assume 360 days year) (Examination Nov. 2018)
Answer
Statement Showing Evaluation of Credit Policies
Particulars Present Policy Proposed

Policy
A. Expected Contribution
(a) Credit Sales 30,00,000 36,00,000
(b) Less: Variable Cost 16,80,000 20,16,000
(c) Contribution 13,20,000 15,84,000
(d) Less: Bad Debts 60,000 1,08,000
(e) Contribution after Bad debt [(c)-(d)] 12,60,000 14,76,000
B. Opportunity Cost of investment in 15,000 54,000
Receivables
C. Net Benefits [A-B] 12,45,000 14,22,000
D. Increase in Benefit 1,77,000
Recommendation: Proposed Policy i.e credit from 15 days to 45 days should be implemented by NM
Ltd since the net benefit under this policy are higher than those under present policy
Working Note:
(1)
Present Policy Propose Policy

(Rs.) (Rs.)
Sales 30,00,000 36,00,000
Cost of Sales (80% of sales) 24,00,000 28,80,000
Variable cost (70% of cost of sales) 16,80,000 20,16,000
2. Opportunity Costs of Average Investments

Collection Period
= Variable Cost × × Rate of
Return 360
15
Present Policy = Rs. 24,00,000 x x 15% = Rs. 15,000
360
45
Proposed Policy = Rs. 28,00,000 x x 15% = Rs . 54,000
360
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Question 5:
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.
Non-recovery 2% of the bill.
The customer wants to enter into a firm commitment for purchase of goods of Rs.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 Rs.300 on which a profit of Rs.10 per unit is expected to be made. It is
anticipated that taking up of this contract would mean an extra recurring expenditure of Rs.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. 19)
Answer
Statement showing the Evaluation of credit Policies
Particulars Proposed Policy Rs.
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 Receivables 1,00,395
C. Net Benefits (A – B) (70,395)
Recommendation: The Proposed Policy should not be adopted since the net benefits under this
policyare 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 period 30/360 60/360 90/360 100/360
C. Required Rate of Return 18% 18% 18% 18%
D. Opportunity Cost 8,730 26,190 39,285 26,190 1,00,395
(A × B × C)
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Question 6
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 -
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 Rs.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)
Answer
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 (days) 0 30 60 90 0 30 60 90
2. Sales Units 10,000 15,000 20,000 25,000 - - 10,000 15,000
Rs. in lakh Rs. in lakh
3. Sales Value 1,500 2,250 3,000 3,750 - - 1,500 2,250
4. Contribution at 50% (A) 750 1,125 1,500 1,875 - - 750 1,125
5. Receivables:-
Credit Period × Sales 360 - 187.5 500 937.5 - - 250 562.5
6. Debtors at cost 93.75 250 468.75 - - 125 281.25
-
7. Cost of carrying debtors at - 18.75 50 93.75 - - 25 56.25
20% (B)
8. Excess of contributions over 750 1,106.25 1,406.25 1,781.25 - - 725 1,068.75
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.
__**__
10(IV).22 | P a g e
Chapter - 10
Unit V :-Management of Payables (Creditors)
Question1.
A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular basis. As per
the terms of agreement the payment must be made within 40 days of purchase. However, A Ltd. has a
choice of paying Rs. 98.50 per Rs. 100 it owes to X Ltd. on or before 10th day of purchase.
Required:
EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd. with X
Ltd. is Rs. 10,00,000 and an alternative investment yield a return of 15% and company pays the invoice.
(RTP May 2018)
Answer
__**__
10(V).23| P a g e
MISCELLANEOUS- THEORIES
Question 1.
(i) “The profit maximization is not an operationally feasible criterion. DISCUSS
(ii) EXPLAIN the followings:
(a) Bridge Finance
(b) Floating Rate Bonds
(c) Packing Credit.
(iii) “Financial Leverage is a double-edged sword” DISCUSS (RTP May 2018)
Answer
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11.2 | P a g e
Question 2.
(i) “The profit maximization is not an operationally feasible criterion.” IDENTIFY.
(ii) EXPLAIN the difference between Financial Lease and Operating Lease. (RTP Nov. 2018)
Answer
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Question 3.
Write short notes on the following:
(a) Functions of Finance Manager.
(b) Inter relationship between investment, financing and dividend decisions.
(c) Debt securitization (RTP May 2019)
Answer
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11.5| P a g e
Question 4.
(a) EXPLAIN the difference between Business risk and Financial risk
(b) EXPLAIN as to how the wealth maximisation objective is superior to the profit maximisation
objective What is the cost of these sources?
(c) DISCUSS the dividend-price approach to estimate cost of equity capital (MTP March 2019)
Answer
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Question 5.
(a) DESCRIBE Bridge Finance.
(b) STATE Virtual Banking? DISCUSS its advantages.
(c) EXPLAIN Concentration Banking (MTP April 2019)
Answer
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Question 6.
(a) What are the sources of short term financial requirement of the company?
(b) What is certainty Equivalent?
(c) What are the roles of Finance Executive in Modem World?
OR
What are the two main aspects of the Finance Function? (Examination May 2018)
Answer
(a) There are various sources available to meet short-term needs of finance. The different sources are
discussed below:
(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale. The
usual duration of such credit is 15 to 90 days. It generates automatically in the course of business
and is common to almost all business operations. It can be in the form of an 'open account' or
'bills payable'.
(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a
company has to pay for the services which it has already received like wages, taxes, interest
and dividends.
(iii) Advances from Customers: Manufacturers and contractors engaged in producing or
constructing costly goods involving considerable length of manufacturing or construction time
usually demand advance money from their customers at the time of accepting their orders for
executing their contracts or supplying the goods. This is a cost free source of finance and
really useful.
(iv) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued
11.9| P a g e
in the form of a promissory note.

(v) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills,
commonly referred to as T-Bills are issued by Government of India to meet short term
borrowing requirements with maturities ranging between 14 to 364 days.
(vi) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate
with a fixed maturity date of not less than 15 days up to a maximum of one year.
(vii) Bank Advances: Banks receive deposits from public for different periods at varying rates of
interest. These funds are invested and lent in such a manner that when required, they may be
called back.
(b) Certainty Equivalent (CE)
It is a coefficient used to deal with risk in a capital budgeting context. It expresses risky future cash flows
in terms of the certain cash flows which would be considered by the decision maker, as their equivalent.
That is the decision maker would be indifferent between the risky amount and the (Lower) riskless
amount considered to be its equivalent.
It is a guaranteed return that the management would accept rather than accepting a higher but
uncertain return. Calculation of this equivalent involves the following three steps:
Step 1: Remove risks by substituting equivalent certain cash flows in the place of risky cash flows. This
can be done by multiplying each risky cash flow by the appropriate CE Coefficient.
Step 2: Obtain discounted value of cash flow by applying riskless rate of interest.
Step 3: Apply normal capital budgeting method to calculate NPV by using the firm’s
required rate of return.
n
NCFt
NPV = t
1
t 0 1 k1
Where,
NCFt = the forecasts of net cash flow without risk-adjustment
α t = the risk-adjustment factor or the certainly equivalent coefficient.
Kf = risk-free rate assumed to be constant for all periods.

Certainty Coefficient lies between 0 and 1.
(c) Role of Finance Executive in modern World

Today, the role of Financial Executive, is no longer confined to accounting, financial reporting and risk
management. Some of the key activities that highlight the changing role of a Finance Executive are as
follows:-
Budgeting
Forecasting
Managing M & As
Profitability analysis relating to customers or products
Pricing Analysis
11.10 | P a g e
Decisions about outsourcing
Overseeing the IT function.
Overseeing the HR function.
Strategic planning (sometimes overseeing this function).
Regulatory compliance.
Risk managemen
Or
(c) Value of a firm will depend on various finance functions/decisions. It can be expressed as:
V = f (I,F,D).
The finance functions are divided into long term and short term functions/decisions
Long term Finance Function Decisions
(a) Investment decisions (I): These decisions relate to the selection of assets in which funds will be
invested by a firm. Funds procured from different sources have to be invested in various kinds of assets.
Long term funds are used in a project for various fixed assets and also for current assets.
(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial
objectives and seeing that fixed and working capital are effectively managed.
(c) Dividend decisions(D): These decisions relate to the determination as to how much and how
frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders.
The owner of any profit-making organization looks for reward for his investment in two ways, the growth
of the capital invested and the cash paid out as income; for a sole trader this income would be termed
as drawings and for a limited liability company the term is dividends.
Short- term Finance Decisions/Function
Working capital Management (WCM): Generally short term decision are reduced to management of
current asset and liability (i.e., working capital management)
Question 7.
(a) Explain in brief following Financial Instruments:
(i) Euro Bonds
(ii) Floating Rate Notes
(iii) Euro Commercial paper
(iv) Fully Hedged Bond
(b) Discuss the Advantages of Leasing.
(c) Write two main objectives of Financial Management.
OR
Write two main reasons for considering risk in Capital Budgeting decisions. (Examination Nov. 2018)
Answer
(a) (i) Euro bonds: Euro bonds are debt instruments which are not denominated in the currency of the
country in which they are issued. E.g. a Yen note floated in Germany.
(ii) Floating Rate Notes: Floating Rate Notes: are issued up to seven years maturity. Interest rates are
adjusted to reflect the prevailing exchange rates. They provide cheaper money than foreign loans.
(iii) Euro Commercial Paper(ECP): ECPs are short term money market instruments. They are for
11.11| P a g e
maturities less than one year. They are usually designated in US Dollars.
(iv) Fully Hedged Bond: In foreign bonds, the risk of currency fluctuations exists. Fully hedged bonds
eliminate the risk by selling in forward markets the entire stream of principal and interest payments.
(b) (i) Lease may low cost alternative: Leasing is alternative to purchasing. As the lessee is to
make a series of payments for using an asset, a lease arrangement is similar to a debt contract. The
benefit of lease is based on a comparison between leasing and buying an asset. Many lessees
find lease more attractive because of low cost.
(ii) Tax benefit: In certain cases tax benefit of depreciation available for owning an asset may be less
than that available for lease payment
(iii) Working capital conservation: When a firm buy an equipment by borrowing from a bank (or financial
institution), they never provide 100% financing. But in case of lease one gets normally 100%
financing. This enables conservation of working capital.
(iv) Preservation of Debt Capacity: So, operating lease does not matter in computing debt equity ratio.
This enables the lessee to go for debt financing more easily. The access to and ability of a firm to
get debt financing is called debt capacity (also, reserve debt capacity).
(v) Obsolescence and Disposal: After purchase of leased asset there may be technological obsolescence
of the asset. That means a technologically upgraded asset with better capacity may come into existence
after purchase. To retain competitive advantage the lessee as user may have to go for the upgraded
asset.
(c) Two Main Objective of Financial Management Two objectives of financial management are:
(i) Profit Maximisation
It has traditionally been argued that the primary objective of a company is to earn profit; hence the
objective of financial management is also profit maximisation.
Wealth / Value Maximization
Wealth / Value Maximization Model. Shareholders wealth are the result of cost benefit analysis
adjusted with their timing and risk i.e. time value of money. This is the real objective of Financial
Management. So,
Wealth = Present Value of benefits – Present Value of Costs

Or
(c) Main reasons for considering risk in capital budgeting decisions:

Main reasons for considering risk in capital budgeting decisions are as follows
(i) There is an opportunity cost involved while investing in a project for the level of risk. Adjustment of risk
is necessary to help make the decision as to whether the returns out of the project are proportionate
with the risks borne and whether it is worth investing in the project over the other investment options
available.
(ii) Risk adjustment is required to know the real value of the Cash Inflows.
Question 8.
(a) Explain the steps of Sensitivity Analysis.
(b) What is the process of Debt Securitisation?
(c) Explain any two steps involved in Decision tree Analysis.
OR
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Give any two limitations of lesing. (Examination May 2019)
Questio
n 9.
What
are
Masala
Bonds?
(Exami
nation
May
2018)
(a) Masala Bond:

Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate
borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated
in Indian Rupees. NTPC raised Rs.2,000 crore via masala bonds for its capital expenditure in the year
2016.
Question 10.
LIST the factors determining the dividend policy of a company. (MTP March 2019)
Answer
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Question 11.
EXPLAIN the limitations of Leasing? (MTP April 2019)
Answer
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Question 12:
STATE the meaning of Payback Reciprocal.
(RTP Nov. 19)
Answer
As the name indicates it is the reciprocal of payback period. A major drawback of the payback period
method of capital budgeting is that it does not indicate any cut off period for the purpose of investment
decision. It is, however, argued that the reciprocal of the payback would be a close approximation of
the Internal Rate of Return (later discussed in detail) if the life of the project is at least twice the
payback period and the project generates equal amount of the annual cash inflows. In practice, the
payback reciprocal is a helpful tool for quick estimation of rate of return of a project provided its life is
at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow

Payback Reciprocal =
Initial investment
Question 13:
STATE the functions of treasury department.
(RTP Nov. 19)
Answer
1. Cash Management: It involves efficient cash collection process and managing payment of cash
both inside the organisation and to third parties.
There may be complete centralization within a group treasury or the treasury may simply
advise subsidiaries and divisions on policy matter viz., collection/payment periods, discounts, etc.
Treasury will also manage surplus funds in an investment portfolio. Investment policy will
consider future needs for liquid funds and acceptable levels of risk as determined by company
policy.
2. Currency Management: The treasury department manages the foreign currency risk
exposure of the company. In a large multinational company (MNC) the first step will usually be to
set off intra-group indebtedness. The use of matching receipts and payments in the same
currency will save transaction costs. Treasury might advise on the currency to be used when
invoicing overseas sales.
The treasury will manage any net exchange exposures in accordance with company policy. If
risks are to be minimized then forward contracts can be used either to buy or sell currency
forward.
3. Fund Management: Treasury department is responsible for planning and sourcing the
company’s short, medium and long-term cash needs. Treasury department will also participate
in the decision on capital structure and forecast future interest and foreign currency rates.
4. Banking: It is important that a company maintains a good relationship with its bankers.
Treasury department carry out negotiations with bankers and act as the initial point of
contact with them. Short-term finance can come in the form of bank loans or through the sale
of commercial paper in the money market.
5. Corporate Finance: Treasury department is involved with both acquisition and divestment
activities within the group. In addition, it will often have responsibility for investor relations. The
latter activity has assumed increased importance in markets where share-price performance is
regarded as crucial and may affect the company’s ability to undertake acquisition activity or, if
the price falls drastically, render it vulnerable to a hostile bid.
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Question 14:
DESCRIBE the Inter relationship between investment, financing and dividend decisions.
(RTP Nov. 19)
Answer
Inter-relationship between Investment, Financing and Dividend Decisions: The finance functions are divided
into three major decisions, viz., investment, financing and dividend decisions. It is correct to say that these
decisions are inter-related because the underlying objective of these three decisions is the same, i.e. maximisation
of shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated, one has to consider
the joint impact of these decisions on the market price of the company’s shares and these decisions should also
be solved jointly. The decision to invest in a new project needs the finance for the investment. The financing
decision, in turn, is influenced by and influences dividend decision because retained earnings used in internal
financing deprive shareholders of their dividends. An efficient financial management can ensure optimal joint
decisions. This is possible by evaluating each decision in relation to its effect on the shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter- relationship and to see how they can
help in maximising the shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after a careful assessment of the various projects
through capital budgeting and uncertainty analysis. However, only that investment proposal is to be accepted
which is expected to yield at least so much return as is adequate to meet its cost of financing. This have an
influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the total
volume of long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. The optimum financing
mix will increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of
dividends and what portion should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to be
taken jointly keeping in view their joint effect on the shareholders’ wealth.
Question 15:
DISCUSS the Inter relationship between investment, financing and dividend decisions.
(MTP Nov. 19)
Answer
Inter-relationship between Investment, Financing and Dividend Decisions: The finance functions are divided
into three major decisions, viz., investment, financing and dividend decisions. It is correct to say that these
decisions are inter-related because the underlying objective of these three decisions is the same, i.e. maximisation
of shareholders’ wealth. Since investment, financing and dividend decisions are all interrelated, one has to consider
the joint impact of these decisions on the market price of the company’s shares and these decisions should also
be solved jointly. The decision to invest in a new project needs the finance for the investment. The financing
decision, in turn, is influenced by and influences dividend decision because retained earnings used in internal
financing deprive shareholders of their dividends. An efficient financial management can ensure optimal joint
decisions. This is possible by evaluating each decision in relation to its effect on the shareholders’ wealth.
The above three decisions are briefly examined below in the light of their inter-relationship and to see how they can
help in maximising the shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be
accepted which is expected to yield at least so much return as is adequate to meet its cost of financing. This have
11.16 | P a g e
an influence on the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different issues. The
finance manager has to maintain a proper balance between long-term and short-term funds. With the total volume of
long-term funds, he has to ensure a proper mix of loan funds and owner’s funds. The optimum financing mix will
increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way
of dividends and what portion should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders’ wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated
and are to be taken jointly keeping in view their joint effect on the shareholders’ wealth.
Question 16:
What is debt securitisation? EXPLAIN the basics of debt securitisation process.
(MTP Nov. 19)
Answer
Debt Securitisation: It is a method of recycling of funds. It is especially beneficial to financial intermediaries to
support the lending volumes. Assets generating steady cash flows are packaged together and against this asset
pool, market securities can be issued, e.g. housing finance, auto loans, and credit card receivables.
Process of Debt Securitisation
(i) The origination function – A borrower seeks a loan from a finance company, bank, HDFC. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule structured over
the life of the loan.
(ii) The pooling function – Similar loans on receivables are clubbed together to create an underlying pool of
assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a trustee for
investors.
(iii) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The securities
carry a coupon and expected maturity which can be asset-based/mortgage based. These are generally sold
to investors through merchant bankers. Investors are – pension funds, mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer is
under an obligation to pay to investors only if the cash flows are received by him from the collateral. The
benefits to the originator are that assets are shifted off the balance sheet, thus giving the originator recourse
to off-balance sheet funding.
Question 17:
EXPLAIN the concept of discounted payback period.
(MTP Nov. 19)
Answer
Concept of Discounted Payback Period
Payback period is time taken to recover the original investment from project cash flows. It is also termed as break
even period. The focus of the analysis is on liquidity aspect and it suffers from the limitation of ignoring time value of
money and profitability. Discounted payback period considers present value of cash flows, discounted at company’s
cost of capital to estimate breakeven period i.e. it is that period in which future discounted cash flows equal the initial
outflow. The shorter the period, better it is. It also ignores post discounted payback period cash flows.
Question 18:
(a) Briefly explain the three finance function decisions.
(b) Explain the steps while using the equivalent annualized criterion.
(c) Explain the significance of Cost of Capital.
OR
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Briefly describe any four sources of short-term finance.

Answer
(a) The finance functions are divided into long term and short term functions/ decisions:
Long term Finance Function Decisions
(i) Investment decisions (I): These decisions relate to the selection of assets in which funds will
be invested by a firm. Funds procured from different sources have to be invested in various
kinds of assets. Long term funds are used in a project for various fixed assets and also for
current assets.
(ii) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet
financial objectives and seeing that fixed and working capital are effectively managed. The
financial manager needs to possess a good knowledge of the sources of available funds and
their respective costs and needs to ensure that the company has a sound capital structure, i.e. a
proper balance between equity capital and debt.
(iii) Dividend decisions (D): These decisions relate to the determination as to how much and how
frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders. The owner of any profit-making organization looks for reward for his
investment in two ways, the growth of the capital invested and the cash paid out as income; for
a sole trader this income would be termed as drawings and for a limited liability company the
term is dividends.
Short- term Finance Decisions/Function
Working capital Management (WCM): Generally short term decision is reduced to management of
current asset and current liability (i.e., working capital Management).
(b) Equivalent Annualized Criterion: This method involves the following steps-
(i) Compute NPV using the WACC or discounting rate.
(ii) Compute Present Value Annuity Factor (PVAF) of discounting factor used above for the period
of each project.
(iii) Divide NPV computed under step (i) by PVAF as computed under step (ii) and compare the
values.
(c) Significance of the Cost of Capital: The cost of capital is important to arrive at correct amount and
helps the management or an investor to take an appropriate decision. The correct cost of capital helps in
the following decision making:
(i) Evaluation of investment options: The estimated benefits (future cashflows) from available
investment opportunities (business or project) are converted into the present value of benefits
by discounting them with the relevant cost of capital. Here it is pertinent to mention that every
investment option may have different cost of capital hence it is very important to use the cost of
capital which is relevant to the options available. Here Internal Rate of Return (IRR) is treated
as cost of capital for evaluation of two options (projects).
(ii) Performance Appraisal: Cost of capital is used to appraise the performance of a particulars
project or business. The performance of a project or business in compared against the cost of
capital which is known here as cut-off rate or hurdle rate.
(iii) Designing of optimum credit policy: While appraising the credit period to be allowed to the
customers, the cost of allowing credit period is compared against the benefit/ profit earned by
providing credit to customer of segment of customers. Here cost of capital is used to arrive at
the present value of cost and benefits received.
OR
Sources of Short Term Finance: There are various sources available to meet short- term needs of
finance. The different sources are discussed below-
(i) Trade Credit: It represents credit granted by suppliers of goods, etc., as an incident of sale.
The usual duration of such credit is 15 to 90 days. It generates automatically in the course of
11.18 | P a g e
business and is common to almost all business operations. It can be in the form of an 'open
account' or 'bills payable'.
(ii) Accrued Expenses and Deferred Income: Accrued expenses represent liabilities which a
company has to pay for the services which it has already received like wages, taxes, interest
and dividends. Such expenses arise out of the day-to-day activities of the company and hence
represent a spontaneous source of finance.
(iii) Deferred Income: These are the amounts received by a company in lieu of goods and services
to be provided in the future. Since these receipts increases a company’s liquidity, they are also
considered to be an important sources of short- term finance.
(iv) Advances from Customers: Manufacturers and contractors engaged in producing or
constructing costly goods involving considerable length of manufacturing or construction time
usually demand advance money from their customers at the time of accepting their orders for
executing their contracts or supplying the goods. This is a cost free source of finance and really
useful.
(v) Commercial Paper: A Commercial Paper is an unsecured money market instrument issued
in the form of a promissory note. The Reserve Bank of India introduced the commercial paper
scheme in the year 1989 with a view to enabling highly rated corporate borrowers to diversify
their sources of short-term borrowings and to provide an additional instrument to investors.
(vi) Treasury Bills: Treasury bills are a class of Central Government Securities. Treasury bills,
commonly referred to as T-Bills are issued by Government of India to meet short term
borrowing requirements with maturities ranging between 14 to 364 days.
(vii) Certificates of Deposit (CD): A certificate of deposit (CD) is basically a savings certificate with
a fixed maturity date of not less than 15 days up to a maximum of one year.
(viii) Bank Advances: Banks receive deposits from public for different periods at varying rates of
interest. These funds are invested and lent in such a manner that when required, they may be
called back. Lending results in gross revenues out of which costs, such as interest on deposits,
administrative costs, etc., are met and a reasonable profit is made. A bank's lending policy is
not merely profit motivated but has to also keep in mind the socio- economic development of the
country. Some of the facilities provided by banks are Short Term Loans, Overdraft, Cash
Credits, Advances against goods, Bills Purchased/Discounted.
(ix) Financing of Export Trade by Banks: Exports play an important role in accelerating the
economic growth of developing countries like India. Of the several factors influencing export
growth, credit is a very important factor which enables exporters in efficiently executing their
export orders. The commercial banks provide short-term export finance mainly by way of pre
and post-shipment credit. Export finance is granted in Rupees as well as in foreign currency.
(x) Inter Corporate Deposits: The companies can borrow funds for a short period say 6 months
from other companies which have surplus liquidity. The rate of interest on inter corporate
deposits varies depending upon the amount involved and time period.
(xi) Certificate of Deposit (CD): The certificate of deposit is a document of title similar to a time
deposit receipt issued by a bank except that there is no prescribed interest rate on such funds.
The main advantage of CD is that banker is not required to encash the deposit before maturity
period and the investor is assured of liquidity because he can sell the CD in secondary
market.
(xii) Public Deposits: Public deposits are very important source of short-term and medium term
finances particularly due to credit squeeze by the Reserve Bank of India. A company can
accept public deposits subject to the stipulations of Reserve Bank of India from time to time
maximum up to 35 per cent of its paid up capital and reserves, from the public and shareholders.
These deposits may be accepted for a period of six months to three years. Public deposits are
unsecured loans; they should not be used for acquiring fixed assets since they are to be repaid
within a period of 3 years. These are mainly used to finance working capital requirements.
11.19| P a g e
Question 19:
(i) “The profit maximization is not an operationally feasible criterion.” IDENTIFY.
(ii) EXPLAIN the basics of debt securitisation process.
(RTP May 2020)
Answer:
(i) The profit maximisation is not an operationally feasible criterion.” This statement is true because profit
maximisation can be a short-term objective for any organisation and cannot be its sole objective. Profit
maximization fails to serve as an operational criterion for maximizing the owner's economic welfare. It
fails to provide an operationally feasible measure for ranking alternative courses of action in terms of their
economic efficiency. It suffers from the following limitations:
(a) Vague term: The definition of the term profit is ambiguous. Does it mean short term or long term
profit? Does it refer to profit before or after tax? Total profit or profit per share?
(b) Timing of Return: The profit maximization objective does not make distinction between returns
received in different time periods. It gives no consideration to the time value of money, and values
benefits received today and benefits received after a period as the same.
(c) It ignores the risk factor.
(d) The term maximization is also vague.
(ii) Process of Debt Securitisation:
(a) The origination function – A borrower seeks a loan from a finance company or a bank. The credit
worthiness of borrower is evaluated and contract is entered into with repayment schedule
structured over the life of the loan.
(b) The pooling function – Similar loans on receivables are clubbed together to create an underlying
pool of assets. The pool is transferred in favour of Special purpose Vehicle (SPV), which acts as a
trustee for investors.
(c) The securitisation function – SPV will structure and issue securities on the basis of asset pool. The
securities carry a coupon and expected maturity which can be asset-based/mortgage based.
These are generally sold to investors through merchant bankers. Investors are – pension funds,
mutual funds, insurance funds.
The process of securitization is generally without recourse i.e. investors bear the credit risk and issuer
is under an obligation to pay to investors only if the cash flows are received by him from the collateral.
The benefits to the originator are that assets are shifted off the balance sheet, thus giving the originator
recourse to off -balance sheet funding.
__**__
11.20 | P a g e

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FINANCIAL

8 Chapter 10(I) 10(I).1-10(I).13

9 Chapter 10(II) 10(II).14-10(II).15

10 Chapter 10(IV) 10(IV).16-10(IV).22

11 Chapter 10(V) 10(V).23

12 Chapter 11(Miscellaneous) 11.1-11.20

Fixed assets turnover ratio 8 times (based on cost of goods sold)

Capital turnover ratio 2 times (based on cost of goods sold)

Inventory Turnover 8 times

Receivable turnover 4 times

Payable turnover 6 times

Ratios 2017 2018 Average of

(i) Total debt to net worth : 1:2

(ii) Total assets turnover : 2

(iii) Gross profit on sales : 30%

(iv) Average collection period : 40 days

(Assume 360 days in a year)

(vi) Acid test ratio : 0.75

(MTP March 2019)

Equity share capital Rs. 1,00,000

The accountant of Moon Ltd. has reported the following data:

Gross profit Rs. 60,000

Balance Sheet of Moon Ltd. ( May Exam 2018)

Liabilities Rs. Assets Rs.

Preparation of Balance Sheet

Liabilities Rs. Assets Rs.

So, Average Accounts Receivable/Receivables =Rs. 50,00,000/-

Debt/ equity mix 40%/60%

Project cost Cost of debt Cost of equity

Components Amount Cost of Capital Weight WACC %

So. Cost of capital = 0.19 or 19%

Cost of Equity (Ke) = Keu + (Kev – Kd) Debt (1-t)

So. Cost of Equity = 20.70%

The capital structure after raising additional finance:

(b) Determination of post-tax average cost of additional debt

Average Cost of Debt

Cost of retained earnings equals to cost of Equity i.e. 13.4%

Working Notes (W.N.):

10% Debentures (W.N. 2) 1,00,00,000 0.244 6.50 1.59

Plan Equity Debt

Plans I (Rs.) II (Rs.)

(ii) Computation of Financial Break-even Points

Plan I = Raising Debt of Rs 5 lakh + Equity of Rs 45 lakh.

Particulars A Ltd. B Ltd.

Ke of Unlevered Firm (given) = 0.18

(b) Assuming 40% taxes as per MM Approach

Ke of unlevered Firm (given) = 0.18

Weighted Average Cost of Capital (WACC) of a Ltd

*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC

Market Value of „B Ltd.‟ (Levered)

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

Computation of WACC B. Ltd

*Kd= 12% (1- 0.3) = 12% × 0.7 = 8.4%

Under Situation I Rs. 15,000

Equity and Liabilities (RS in Assets (RS in

Reserves and Surplus 20 Current Assets 150

15% Debentures 200

The additional information given is as under: