CA Amit Sharma

CAPITAL STRUCTURE

QUESTIONS AND SOLUTIONS

1. CAPITAL STRUCTURE FORMAT QUESTIONS:

Q1. Syntex Ltd. is planning an expansion programme which will require Rs. 30
Crore and can be funded through any of the following three options:
Option 1: Issue further equity shares of Rs. 100 each.
Option 2: Raise debt at 15% interest.
Option 3: Issue preference shares at 12%.
Present paid-up capital is 60 Crore and average annual earnings before
interest and taxes (EBIT) is 12 Crore. Company's income tax rate is 30%.
After the expansion, annual EBIT is expected to be 15 Crore.
You are required to –
1. Calculate the earnings per share (EPS) under the three financing options
indicating the alternative giving the highest return to the equity shareholders.
2. Calculate the equivalency level of EBIT between the equity share capital and
debt alternatives.
[June 2013 (12 Marks)]
SOLUTION:
Capital structure for new finance: (in Crore)
Particulars Option 1 Option 2 Option 3

Equity Share Capital 30 - -

15% Debts - 30 -
12% Preference - - 30
Shares
30 30 30

Statement showing profit available for equity shareholder and EPS:

Particulars Option 1 Option 2 Option 3

EBIT 15.00 15.00 15.00
(-) Interest - (4.50) -
EBT 15.00 10.50 15.00

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(-) Tax@ 30% (4.50) (3.15) (4.50)
PAT 10.50 7.35 10.50
(-) Preference dividend - - (3.60)
Profit for equity shareholders 10.50 7.35 6.90
No. of equity shares (in Crore) 0.9 0.6 0.6
EPS 11.67 12.25 11.50
Analysis: Option 2 has high EPS, hence Option 2 i.e. debt financing is recommended.

Calculation of indifferent point between Option 1 & 2:

(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−0)(1−0.3) (𝑥−4.5)(1−0.3)
=
0.9 0.6
0.7𝑥 0.7𝑥−3.15
=
0.9 0.6

0.42𝑥 = 0.63𝑥 − 2.835

−0.21𝑥 = 2.835
x = EBIT = 13.5 Crore

Q2. Simplex Co. Ltd. is considering an expansion programme which is expected

to cost Rs. 10,00,000. The company can finance either through debt or
equity. Its current financing plan is given as under:

Particulars Rs.
Equity capital (50,000 shares @ 10 each) 5,00,000
Reserves and surplus 2,00,000
Debt (10%) 3,00,000
Total 10,00,000

The latest income statement reveals the following information:

Particulars Rs.
Sales 64,00,000
Less: total costs 59,00,000
EBIT 5,00,000
Less: interest 30,000
EBT 4,70,000

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Less: income-tax @ 50% 2,35,000
EAT 2,35,000

The expansion programme is expected to generate additional sales of 16,00,000

with a return of 15% on sales before interest and taxes. If the expansion is
financed through debt, the rate of new debt will be 12% and the price-earnings
ratio will be 4 times.
If the expansion programme is financed through equity shares, i.e., the new
shares can be sold at a price of 240 and the price-earnings ratio will be 5 times.
Which form of financing should the company choose, if the objective of
financial management in the company is maximization of shareholders' wealth?
[Dec. 2014 (8 Marks)]
SOLUTION:
Capital structure for new finance:
Particulars Option 1 Option 2
12% Debts 10,00,000 -
Equity Share Capital - 2,50,000
Securities Premium - 7,50,000
10,00,000 10,00,000
Statement showing profit available for equity shareholder and EPS:
Particulars Option 1 Option 2
EBIT[5,00,000+ (16,00,000 x 15%)] 7,40,000 7,40,000
(-) Interest
-Existing (30,000) (30,000)
-New (1,20,000) -
EBT 5,90,000 7,10,000
(-) Tax @ 50% (2,95,000) (3,55,000)
PAT/Profit for equity shareholders 2,95,000 3,55,000
No. of equity shares 50,000 75,000
EPS 5.9 4.73
P/E Ratio 4 5
Market Price 23.6 23.67
Analysis: Though there is a marginal difference in market value of shares under
Option Es advised to the company higher EPS, 15.15

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Q3. Maxwell Ltd. is operating in electronic equipments development and its

sales and EBIT for the current year were Rs. 70,00,000 and Rs. 18,00,000
respectively. During the year, interest expense was 16,000 and preference
dividend was 20,000. These fixed charges are expected to continue for
the next year. The company is thinking to diversify its operations which
will require Rs. 7,00,000 and is expected to increase EBIT by Rs. 4,00,000
to 22,00,000.
The company has the following three financing alternatives under its
consideration:
Alternative-1: Issue 10,000 equity shares at 70 per share. The company has
currently 80,000 shares of common stock outstanding.
Alternative-2: Issue Rs. 7,00,000, 15 years 15% debentures. Sinking fund
payments on these debentures will commence after 15 years.
Alternative-3: Issue Rs. 7,00,000, 14% preference shares.

You are required to calculate –

1. The EPS at the expected earnings before interest and taxes level of Rs.
22,00,000 for each financing alternative.
2. The equivalency level of earnings before interest and taxes between the debt
and common stock alternatives.
3. The equivalency level of earnings before interest and taxes between the
preference shares and common stock alternatives.
Assume 30% income-tax rate.
[June 2012 (12 Marks)], [Dec. 2014 (8 Marks)]

SOLUTION:
Capital structure for new finance:
Particulars Alternative 1 Alternative Alternative
2 3
Equity Share Capital 1,00,000 - -
Securities Premium 6,00,000 - -
15% Debts - 7,00,000 -
14% Preference Shares - - 7,00,000
7,00,000 7,00,000 7,00,000

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Statement showing profit available for equity shareholder and EPS
Particulars Present Alternative Alternative Alternative
1 2 3
EBIT 18,00,000 22,00,000 22,00,000 22,00,000
(-) Interest
- Existing (16,000) (16,000) (16,000) (16,000)
-New - - (1,05,000) -
EBT 17,84,000 21,84,000 20,79,000 21,84,000
(-) Tax @ 30% (5,35,200) (6,55,200) (6,23,700) (6,55,200)
PAT 12,48,800 15,28,800 14,55,300 15,28,800
(-) Preference share
-Existing (20,000) (20,000) (20,000) (20,000)
-New - - - (98,000)
Profit for equity 12,28,800 15,08,800 14,35,300 14,10,800
shareholders 80,000 90,000 80,000 80,000
No. of equity shares 15.36 16.76 17.94 17.64
EPS
Calculation of indifferent point between Alternatives 1 & 2
(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−16,000)(1−0.3)−20,000 (𝑥−1,21,000)(1−0.3)−20,000
=
90,000 80,000
0.7𝑥−31,200 0.7𝑥−1,04,700
=
9 8

5.6𝑥 − 2,49,600 = 6.3𝑥 − 9,42,300

−0.7𝑥 = −9,43,300
x = EBIT = 9,89,571

Calculation of indifferent point between Alternatives 1 & 3

(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−16,000)(1−0.3)−20,000 (𝑥−16,000)(1−0.3)−1,18,000
=
90,000 80,000
0.7𝑥−31,200 0.7𝑥−1,29,200
=
9 8

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CA Amit Sharma
5.6𝑥 − 2,49,600 = 6.3𝑥 − 11,62,800
−0.7𝑥 = −9,13,200
x = EBIT = 13,04,571

2. INDIFFERENCE POINT:

Q4. The following data pertains to yagya ltd.

Existing Capital Structure :
20 Lakh equity shares of Rs. 10 each
Tax rate 50%
Yagya Ltd. plans to raise additional capital of 200 lakh for financing an
expansion project. It is evaluating two alternative financing plans:
1. Issue of 20,00,000 equity shares of Rs. 10 each and
2. Issue of Rs. 200 lakh debentures carrying 14% interest.
You are required to compute indifference point.
[Dec. 2018 (4 Marks)]
SOLUTION:
Capital structure:
Particulars Alternative I Alternative II
Existing equity share capital 2,00,00,000 2,00,00,000
New Finance:
Equity Share Capital 2,00,00,000 -
14% Debentures - 2,00,00,000
No. of equity shares
Calculation of indifferent point between Alternative I & Alternative II:

(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−0)(1−0.5)−0 (𝑥−28,00,000)(1−0.5)−0
=
40,00,000 20,00,000
0.5𝑥 0.5𝑥−14,00,000
=
4 2

𝑥 = 2𝑥 − 56,00,000
−𝑥 = −56,00,000
x = EBIT = 56,00,000 lakh EPS under both option will be same i.e. Rs. 0.7 per
share.

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Verification:
Particulars Alternative I Alternative II
EBIT 56,00,000 56,00,000
(-) Interest - (28,00,000)
EBT 56,00,000 28,00,000
(-) Tax @ 50% (28,00,000) (14,00,000)
PAT/Profit available to equity shareholders 28,00,000 14,00,000
No. of equity shares 40,00,000 20,00,000
EPS 0.7 0.7

Q5. X Ltd. is considering the following two alternative financing plans

Particulars Plan I Plan II

Equity shares Rs. 10 each 4,00,000 4,00,000
12% Debentures 2,00,000 -
Preference shares 100 each - 2,00,000
Total 6,00,000 6,00,000

The Earning Before Interest and Tax (EBIT) at indifference point between the
plans is Rs. 2,40,000. Corporate tax rate is 30%. Calculate the rate of
dividend on preference shares.
[June 2019 (4 Marks)]

SOLUTION:
Calculation of indifferent point between Plan I & Plan II:

(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the dividend on preference shares be 'x'.

(2,40,000−24,000)(1−0.3)−0 (2,40,000−0)(1−0.3)−𝑥
=
40,000 40,000
1,51,200 1,68,000−𝑥
=
4 4

1,51,200 = 1,68,000 − 𝑥
−16,800 = −𝑥
x = preference dividend = 16,800

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16,800
Rate of Preference Dividend = × 100 = 8.4%
2,00,000

Q6. Calculate the level of Earnings Before Interest and Tax (EBIT) at which the
EPS indifference point between the following financing Tax (EBIT)will occur.
(a) Equity share capital of Rs. 12,00,000 and 12% debentures of Rs. 8,00,000.
Or
(b) Equity share capital of Rs. 8,00,000, 14% preference share capital of Rs.
4,00,000 and 12% debentures of Rs. 8,00,000.
Assume corporate tax is 35% and par value of equity share, preference shares
and debentures are Rs. 100 in each case.
[Dec. 2021 (4 Marks)]

SOLUTION:
Calculation of indifferent point between Option 1 & 2:
(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
=
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−96,000)(1−0.35)−0 (𝑥−96,000)(1−0.35)−56,000
=
12,000 8,000
065𝑥−64,400 0.65𝑥−62,400−56,000
=
12 8

5.2𝑥 = 4,99,999 = 7.8𝑥 − 14,20,800

−2.6𝑥 = −9,21,600
x = EBIT = 3,54,462

Q7. A Company is considering two financial alternatives to Finance its

expansion plan to Rs. 1.00 Crore.
First alternative : Issue of equity shares @ 12.50.
Second alternative: Issue 14% debentures.
Tax to be considered at 40%.
Its present capital structure consists of equity shares of Rs. 20,00,000 (face
value 10) and 8% debentures of Rs. 50,00,000.
Expected price earnings ratio in case of:
First alternative is -14
Second alternative is - 12.

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You are required to calculate the indifference point at which market price of
share under both alternatives will be same.
[Dec. 2021 (4 Marks)]
SOLUTION:
Capital structure:
Particulars Alternative I Alternative
II
Existing:
Equity Share Capital 20,00,000 20,00,000
8% Debentures 50,00,000 50,00,000
New
Equity Share Capital 80,00,000 -
Securities Premium 20,00,000 -
14% Debentures - 1,00,00,000
Calculation of indifferent point between Alternatives I & II
(𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝 (𝐸𝐵𝐼𝑇−𝐼)(1−𝑇)− 𝐷𝑝
× 14 = × 12
𝑁1 𝑁2

let the EBIT be 'x'.

(𝑥−4,00,000)(1−0.40) (𝑥−18,00,000)(1−0.40)
× 14 = × 12
10,00,000 2,00,000
06𝑥−2,40,000 0.6𝑥−10,80,000
× 14 = × 12
10 2
8.4𝑥−33,60,000 7.2𝑥−1,29,60,000
=
10 2

16.8𝑥 − 67,20,000 = 72𝑥 − 12,96,00,000

−55.2𝑥 = −12,28,80,000
x = EBIT = 22,26,087
Thus EBIT at Rs. 22,67,087 the market price of both the companies will be same
Particulars Alternative Alternative
I II
EBIT 22,26,087 22,26,087
(-) Interest (4,00,000) (18,00,000)
EBT 18,26,087 4,26,087
(-) Tax @ 40% (7,30,435) (1,70,435)
PAT/Profit available to equity 10,95,652 2,55,652
shareholders 10,00,000 2,00,000

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No. of equity shares 1.09565 1.27826
EPS 14 12
P/E Ratio 15.34 15.34
Market price

Q8. Jakarta Ltd. is considering financing an expansion project of 100 lakh. The
finance manager has worked out the two options by studying the macro factors
of the economy, and also the operating performance of the company. The
present tax rate applicable to company is 30%. The details of present position
and different financing plans are as under.

Particulars Present position and Financial plans

Present 20 lakh equity shares and debentures of 50
lakh carrying interest rate 8%
Plan A Issue of Equity shares at the rate of Rs. 12.50
The expected Price earnings Ratio: 14
Plan B Issuance of Debentures carrying interest rate
14%.
The expected Price earnings Ratio: 12

From the above information, calculate the indifference point at which EPS
would be the same by both plan.
[June 2018 (4 Marks)]

SOLUTION:
Capital Structure (Rs. in lakh)
Particulars Plan A Plan B
Existing Capital
Equity share capital 200 200
8% Debentures 50 50
50 50
New Finance
Equity share capital 80 -
Securities premium 20 -
14% Debentures - 100

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100 100
Total Equity shares 28 28
(𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑇) − 𝐷𝑝 (𝐸𝐵𝐼𝑇 − 𝐼)(1 − 𝑇) − 𝐷𝑝
=
𝑁 𝑁

let the EBIT be 'x'.

(𝑥−4)(1−0.30) (𝑥−18)(1−0.30)
=
28 20
0.70𝑥−2.8 0.70𝑥−12.6
=
28 20

14𝑥 − 56 = 19.6𝑥 − 352.8

−5.6𝑥 = −296.8
x = EBIT = 53 lakh
Particulars Option 1 Option 2
EBIT 53 53
(-) Interest
-Existing (4) (4)
-New - (14)
EBT 46 35
(-) Tax @ 30% (14.7) (10.5)
PAT 34.3 24.5
No. shares 28 20
EPS 1.225 1.225

3. NET INCOME/NET OPERATING INCOME APPROACH

Q9. Ruta Max Ltd. and Buta Max Ltd. operate in the same risk class and are
identical in all respect except that Ruta Max Ltd. uses debt financing while Buta
Max Ltd. does not opt for debt financing.
Ruta Max Ltd. has Rs. 25,00,000 debentures carrying coupon rate of 10%. Both
the companies earn 20% profit before interest and taxes on their total assets
of Rs. 50 lakh. Assume perfect capital markets and rational investors and so
on. The capitalization rate for an all equity company is 15%. The corporate tax
rate is 30%.
You are required to compute the value of both companies according to net
income (NI) and net operating income (NOI) approach.
[June 2012 (8 Marks)]

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SOLUTION:
Capital structure of Company Ruta Max Ltd. & Buta Max Ltd.:
Particulars Ruta Max Ltd. Buta Max Ltd.
Equity Share Capital 25,00,000 50,00,000
10% Debenture 25,00,000 -
Total Assets 50,00,000 50,00,000
Calculation of total market value Net Income Approach:
Particulars
Particulars Ruta Max Buta Max
Ltd. Ltd.
EBIT 10,00,000 10,00,000
(-) Interest (2,50,000) -
EBT 7,50,000 10,00,000
(-) Tax @ 30% (2,25,000) (3,00,000)
PAT/Net income available to equity 5,25,000 7,00,000
shareholders 15% 15%
Capitalization rate
Market value of equity (NI/Capitalization rate) x 35,00,000 46,66,667
100 25,00,000 -
Value of debt 60,00,000 46,66,667
Total Market Value
Calculation of total market value Net Operating Income Approach:
Particulars Ruta Max Buta Max
Ltd. Ltd.

Capitalization of earning = [
10,00,000 (1 –0.3)
] 46,66,667 46,66,667
15%

(-) Post tax value of debt 25,00,000 (1–0.5)

(17,50,000) -
Value of equity 29,16,667 46,66,667
(+) Value of debt 25,00,000 -
54,16,667 46,66,667

Q10. The operating income of Fine Crockery Ltd. is 9 lakh before interest and
taxes. The cost of debt is 10 per cent and the current borrowing is 30 lakh. The
cost of capital is 12%.
Calculate the cost of equity for Fine Crockery Ltd. Ignore Taxation.

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CA Amit Sharma
[Dec. 2020 (4 Marks)]
SOLUTION:
Net operating income/EBIT 9,00,000
(-) Interest on debentures (30,00,000 × (3,00,000)
10%) 6,00,000
Earnings available for equity holders
𝐸𝐵𝐼𝑇 9,00,000
Market value of firm = = = 75,00,000
𝐾0 12%

Market value of equity =75,00,000-30,00,000=45,00,000

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑒𝑞𝑢𝑖𝑡𝑦 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 6,00,000
𝐾𝑒 = = 45,00,000 = 0.1333 𝑖. 𝑒. 13.33%
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

4. MM APPROACH:

Q11. Following is the data regarding two companies, Company A and Company
B, belonging to the same risk class

Company A Company B
Number of equity shares 1,00,000 2,00,000
Market price per share (Rs. ) 15 7
10% Debentures (Rs. ) 2,00,000 -
Profit before interest (%) 1,20,000 1,20,000
10,00,000 10,00,000

Dividend payout ratio is 100%. Explain how under Modigliani & Miller approach,
Ramesh, an investor, holding 10% of shares in Company A will be better off in
switching his holding to Company B.
[Dec. 2014 (4 Marks)]
SOLUTION:
Particulars Company A Company B
Profit before interest 1,20,000 1,20,000
(-) Interest (20,000)
Net Profit 1,00,000 1,20,000
An investor owns 10% shares of Company-A.
He sells his shares for Rs. 1,50,000 (1,00,000 x 15 x 10%).
He wishes to purchase 10% equity shares in Company-B which will cost him
Rs. 1,40,000 (2,00,000 x 7 x 10%)
He invests 1,40,000 Rs. 10% equity shares in Company-B.

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Particulars P Ltd. Q Ltd.
Dividend income (10% of net profit) 10,000 12,000
Thus, the income of the investor increases by switching from Company-A to
Company-B and surplus funds left are Rs. 10,000 (1,50,000-1,40,000).

Q12. Distance Sensor Ltd. is an all equity financed company with a market
value of Rs. 35,00,000 and cost of equity, Ke = 20%. The company wants to buy-
back equity shares worth Rs.8,00,000 by issuing and raising 10% perpetual debt
of the same amount. Rate of tax may be taken at 35%.
Applying the MM Model (with taxes), how would the capital restructuring affect-
1. Market value of Distance Sensor Ltd.
2. Cost of equity (Ke)
3. Weighted average cost of capital (WACC) of the company.
[Dec. 2009 (10 Marks)], [Dec. 2014 (4 Marks)]
SOLUTION:
Computation of EBIT of the unlevered company:
Particulars Rs.
EBIT 10,76,923
(-) Interest -
EBT 10,76,923
(-) Tax 35% (3,76,923)
PAT 7,00,000
Capitalization rate 20%
Market value of equity (PAT/Capitalization rate) x 100 35,00,000
(given)
Perform reverse calculation to find out EBIT.
Particulars All Equity Equity + Debt
EBIT 10,76,923 10,76,923
(-) Interest - (80,000)
EBT 10,76,923 9,96,923
(-) Tax 35% (3,76,923) (3,48,923)
PAT 7,00,000 6,48,000
According to MM, the value of levered firm would exceed that of the unlevered firm
by an amount equal to the levered firms debt multiplied by the tax rate.
Value of unlevered firm+ (Value of debt x Tax rate) = Total Value

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Value of the company with 8,00,000 in debt:
35,00,000+ (8,00,000 x 35%) = 37,80,000
Total value - Value of debt = Value of equity
37,80,000-8,00,000= 29,80,000
𝐷 6,48,000
𝐾𝑒 = = 29,80,000 = 0.2175 𝑖. 𝑒. 21.75%
𝑃𝑜

Cost of Debts
Kd = I (1 – t)
= 10 (1 – 0.35)
= 6.5%
Calculation of overall cost of capital (market value basis):
Types of capital Rs. % Cost of Product
Capital
Equity shares capital 29,80,000 78.84% 21.75% 1,714.77
15% Debt 8,00,000 21.16% 6.5% 137.54
37,80,000 100% 1,852.31

1,852.31
WACC = = 18.52%
100

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 15
CA Amit Sharma

LEVERAGES

QUESTIONS AND SOLUTIONS

Q1. From the following given operating data, calculate the degree of operating
leverage of the two companies:

ABC Ltd. XYZ Ltd.

Sales (Rs.) 40 lakh 50 lakh
Variable expense (as % of sales) 40% 30%
Fixed cost (Rs.) 10 lakh 20 lakh

Also, state which company has the greater business risk and why?
[Dec. 2015(4 Marks)]

SOLUTION:
Particulars ABC Ltd. XYZ Ltd.
Sales 40,00,000 50,00,000
Variable cost (16,00,000) (15,00,000)
Contribution 24,00,000 35,00,000
(-) Fixed cost (10,00,000) (20,00,000)
Earnings before interest & tax 14,00,000 15,00,000
(EBIT)
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Operating Leverage = 𝐸𝐵𝐼𝑇
24,00,000
ABC Ltd. = 14,00,000 = 1.7143
35,00,000
XYZ Ltd. = 15,00,000 = 2.3333

XYZ Ltd. has high operating leverage as compared to ABC Ltd. In XYZ Ltd. the EBIT
is likely to very more with fluctuation in sales and hence it has higher degree
of operating risk
Q2. ABC Ltd. has an average selling price of 10 per unit. Its variable unit costs
are 17 and fixed costs amount to Rs.1,70,000. It finances all its assets by equity
funds. It pays 30% tax on its income. PQR Ltd. is identical to ABC Ltd. except
in respect of the pattern of financing. The latter finances its assets 50% by
equity and 50% by debt, the interest on which amounts to 20,000.

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CA Amit Sharma
Determine the degree of operating, financial and combined leverages at
77,00,000 sales for both the companies and interpret the results.
[Dec. 2016 (4 Marks)]
SOLUTION:
7,00,000
No. of units = = 70,000 units.
10

Particulars ABC Ltd. PQR Ltd.

Sales 7,00,000 7,00,000
(-) Variable cost (4,90,000) (4,90,000)
Contribution 2,10,000 2,10,000
(-) Fixed costs (1,70,000) (1,70,000)
EBIT 40,000 40,000
(-) Interest - (20,000)
EBT 40,000 20,000
(-) Tax@ 30% (12,000) (6,000)
PAT 28,000 14,000
Operating leverage 5.25 5.25
Financial leverage 1.00 2.00
Combined leverage 5.25 10.5
Analysis:
(1) High operating leverage shows higher burden of fixed cost consequently
higher business risk. As both companies has similar operating leverage
hence both has same business risk.
(2) High financial leverage shows higher burden of interest cost consequently
higher financial risk. As POR Ltd. has higher financial leverage hence it has
high financial risk as compared to ABC Ltd.
(3) High combined leverage shows combined effect of higher burden of fixed
and interest cost consequently higher business & financial risk. As POR
Ltd. has higher combined leverage hence it has high business risk &
financial risk as compared to ABC Ltd.

Q3. A firm has sales of Rs.10 lakh and fixed cost of Rs. 1.5 lakh. Contribution
margin is 30%. It has 10% debt of Rs.8 lakh. Find out Operating leverage,
Financial leverage and Combined leverage. Also find out that if the firm wants
to double the EBIT, how much per cent increase in sales is needed?
[Dec. 2017 (4 Marks)]

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 17
CA Amit Sharma
SOLUTION:
Particulars Rs.
Sales 10,00,000
(Variable Cost) (7,00,000)
Contribution (30% of sales) 3,00,000
(-) Fixed Cost (1,50,000)
EBIT 1,50,000
(-) Interest (8,00,000 x 10%) (80,000)
EBT 70,000
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 3,00,000
Operating Leverage = = 1,50,000 = 2
𝐸𝐵𝑇
𝐸𝐵𝐼𝑇 1,50,000
Financial Leverage = = = 2.14
𝐸𝐵𝑇 70,000
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 3,00,000
Combined Leverage = = = 4.28
𝐸𝐵𝑇 70,000

If operating leverage is 2, this means that 1% change in sales will cause 2%

change in EBIT.

Q4. ABC Ltd. had the following Balance Sheet as on 31st March, 2018

LIABILITIES Rs. in ASSETS Rs. in

Crore Crore
Equity share capital 10 Fixed Asset(Net) 25
(100 lakh shares @10 Current Assets 15
each)
Reserves & Surplus 2
15% Debentures 20
Current Liabilities 8
40 40

The additional information are as under:

Fixed cost per annum (excluding interest) Rs. 8 Crore
Variable Operating Cost Ratio 65%
Total Assets Turnover Ratio 2.5
Income Tax Rate 30%
You are required to calculate the following:
(a) Earnings per Share
(b) Operating Leverage
(c) Financial Leverage

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 18
CA Amit Sharma
(d) Combined Leverage
[Dec. 2018 (4 Marks)]
SOLUTION:
𝑆𝑎𝑙𝑒𝑠
Assets Turnover Ratio = 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
𝑆𝑎𝑙𝑒𝑠
2.5 = 40

Sales = Rs. 100 Crore

Particulars Rs. in Crore

Sales 100
Variable cost (65)
Contribution 35
(-)Fixed cost (8)
Earnings before interest & tax (EBIT) 27
(-)Interest (3)
Earnings before tax (EBT) 24
(-)Tax 40% (9.6)
Profit after tax (PAT) 14.4

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑡𝑜 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 14.4

EPS = = = 14.4 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
𝑁𝑜.𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠 1
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 35
Operating Leverage = = 27 = 1.296
𝐸𝐵𝑇
𝐸𝐵𝐼𝑇 27
Financial Leverage = = 24 = 1.125
𝐸𝐵𝑇
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 35
Combined Leverage = = 24 = 1.458
𝐸𝐵𝑇

Q5. Consider the following information of Sunshine Ltd.:

Rs. in lakh
Earnings before interest and taxes 2,000
Earnings before taxes 600
Fixed Cost 1,400
Calculate the percentage of change in Earnings per share, if sales increase by
2%, disregarding other factors.
[Dec. 2020 (4 Marks)]

SOLUTION:

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 19
CA Amit Sharma
Income Statement
Particulars Rs. in lakh
Contribution 3,400
(-) Fixed cost (1,400)
EBIT 2,000
(Interest) (1,400)
EBT 600

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 3,400
Combined Leverage = = = 5.67
𝐸𝐵𝑇 600

The combined leverage of 5.67 implies that for 1% change in sales would bring 5.67%
changes in EPS.
Therefore, with a 2% change in sales, change in EPS would be 5.67×2=11.34%

Q6. Compute the degree of financial leverage for each of the companies Tattoos
Ltd. and Gherkins Ltd. based on the following information:
Tattoos Ltd. (in Gherkins Ltd. (in
Rs.) Rs.)
Earnings Before Interest 50,000 1,25,000
and Tax
Debentures @8% 2,50,000 3,00,000
Preference share capital 1,00,000 1,50,000
10%
Tax Rate 35% 35%

SOLUTION:
Income Statement
Particulars Tattoos Ltd. Gherkins Ltd.
EBIT 50,000 1,25,000
(-)Interest (20,000) (24,000)
EBT 30,000 1,01,000
(-) Tax 35% (10,500) (33,350)
PAT 19,500 65,650
(-)Preference Dividend (10,000) (15,000)
Profit available for equity 9,500 50,650
shareholders

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 20
CA Amit Sharma
Tattoos Ltd.
𝐸𝐵𝐼𝑇
𝐷𝐹𝐿 =
𝐷𝑝
𝐸𝐵𝑇 − [ ]
(1 − 𝑡)

50,000
𝐷𝐹𝐿 =
10,000
30,000 − [ ]
(1 − 0.35)

50,000
𝐷𝐹𝐿 =
14,615

𝐷𝐹𝐿 = 3.421

Gherkins Ltd.

𝐸𝐵𝐼𝑇
𝐷𝐹𝐿 =
𝐷𝑝
𝐸𝐵𝑇 − [ ]
(1 − 𝑡)

1,25,000
𝐷𝐹𝐿 =
15,000
1,01,000 − [ ]
(1 − 0.35)

1,25,000
𝐷𝐹𝐿 =
77,923

𝐷𝐹𝐿 = 1.604

Q7. The net sales of ABC Ltd. is 30 Crore. Earnings before interest and tax of
the company as a percentage of net sales is 15%.
The capital employed comprise of :
Equity Rs. 12 Crore
13% cumulative pref. shares Rs. 5 Crore
Debentures @ 15% Rs. 6 Crore
Calculate operating leverage of the company given that combined leverage is 3.
[Dec. 2017 (4 Marks)]
SOLUTION:
Particulars Rs.
Sales 30,00,00,000
Variable cost (19,20,00,000)

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 21
CA Amit Sharma
Contribution 10,80,00,000
(-) Fixed cost (6,30,00,000)
EBIT [15% of sales] 4,50,00,000
(-) Interest [6,00,00,000 x 15%] (90,00,000)
Earnings before tax (EBT) 3,60,00,000

Let the contribution be 'x'.

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Combined Leverage = 𝐸𝐵𝑇
𝑥
3 = 3,60,00,000

x = Contribution = 10,80,00,000

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Combined Leverage = 𝐸𝐵𝐼𝑇
10,80,00,000
= 4,50,00,000

= 2.4
Q8. M/s Abacus Ltd. has decided to fill up the position of finance officer, To
test the analytical capacity of applicant, following information is provided in
the scanning test. You are one of the applicants for the position of finance
officer You are required to prepare the Income Statement in the vertical format
based on information given hereunder.
1. The operating leverage is 2.50.
2. The financial leverage is 3.00.
3. The earnings per share is 30.
4. Present market price per share is 225.
5. Applicable tax rate is 33.0357%.
6. Number of equity shares outstanding as of date are 20,000.
[June 2018 (4 Marks)]

SOLUTION:
Income Statement:
Particulars Rs.
Contribution 67,20,000
(-) Fixed cost (40,32,000)
Earnings before interest & tax (EBIT) 26,88,000

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CA Amit Sharma
(-) Interest (17,92,000)
Profit before tax (EBT) 8,96,000
(-) Tax @ 33.0357% (2,96,000)
Profit after 6,00,000

𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥

EPS = 𝑁𝑜.𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
𝑃𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
30 = 20,000

Profit after tax = 20,000 × 30 = 6,00,000

6,00,000 6,00,000
Profit after tax = = 66.9643% = 8,96,000
100%−33.0357%
𝐸𝐵𝐼𝑇
Financial Leverage = 𝐸𝐵𝑇
𝐸𝐵𝐼𝑇
3= 8,96,000

EBIT = 8,96,000 × 3 = 26,88,000

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Operating Leverage = 𝐸𝐵𝑇
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
2.5 = 26,88,000

Contribution = 26,88,000 × 2.5 = 67,20,000

Q9. The following data relates to Ribbon Ltd.:

Rs.
Earnings Before Interest & Taxes (EBIT) 30,00,000
Profit After Tax 13,50,000
Operating Fixed Costs 22,50,000
Tax Rate 40%

Required:
1. Prepare the Income Statement of Ribbon Ltd.
2. If the company wants to increase its profit after tax by 40%, how much
should be the percentage rise in EBIT that is required?
[June 2019 (4 Marks)]
SOLUTION:
Particulars
Contribution 52,50,000

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 23
CA Amit Sharma
(-) Fixed cost (22,50,000)
Earnings before interest & tax (EBIT) 30,00,000
(-) Interest [Bal. Fig.] (7,50,000)
Earnings before tax (EBT) 22,50,000
(-) Tax 40% (9,00,000)
Profit after tax (PAT) 13,50,000

𝐸𝐵𝐼𝑇 30,00,000
Financial Leverage = = 22,50,000 = 1.333
𝐸𝐵𝑇

For 1.33% increase in PAT, EBIT should increase by 1%

For 40% increase in PAT, EBIT should increase by 40/1.33= 30% (Approx.)

Q10. From the following selected operating data, determine the degree of
operating leverage. Which company has the greater amount of business risk?
Why?

Company A Company B
Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000

Variable expenses as a percentage of sales are 50% for company A and 25% for
company B.

SOLUTION:

Company A Company B
Sales 25,00,000 30,00,000
Less : Variable cost 12,50,000 7,50,000
Contribution 12,50,000 22,50,000
Less : Fixed cost 7,50,000 15,00,000
Operating Profit (EBIT) 5,00,000 7,50,000

𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛
Operating Leverage =
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡
1250000
Company ‘A Operating Leverage = 500000
= 2.5
2250000
Similarly for Company B Operating Leverage would be = =3
750000

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CA Amit Sharma
Operating leverage for Company B is higher than that of Company A ; Company B
has a higher degree of operating risk. The tendency of operating profit may vary
proportionately with sales, is higher for Company B as compared to Company A.

Q11. A Company has the following capital structure:

Particulars `
Equity share capital 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000

The present EBIT is ` 50,000. Calculate the financial leverage assuming that
the company is in 50% tax bracket.

SOLUTION:
Statement of profit:
Earnings before Interest and Tax 50,000
(EBIT) or operating profit
Less: Interest on Debenture (1,25,000 (10,000)
× 8 /100 )
Earnings before Tax (EBT) 40,000
Income Tax (20,000)
Profit 20,000

𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 (𝑂𝑃)

Financial leverage = 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 (𝑃𝐵𝑇)
50000
= = 1.25
40000

Q12. XYZ Ltd. decides to use two financial plans and they need ` 50,000 for
total investment.

Particulars Plan A Plan B

Debenture (interest at ` 40,000 `10,000
10%)
Equity share (` 10 ` 10,000 `40,000
each)
Total investment ` 50,000 ` 50,000
needed

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CA Amit Sharma
Number of equity 1,000 4,000
shares

The earnings before interest and tax are assumed at ` 5,000, and 12,500. The
tax rate is 50%. Calculate the EPS.

SOLUTION:
When EBIT is ` 5,000
Particulars Plan A Plan B
Earnings before interest ` 5,000 ` 5,000
and tax (EBIT)
Less : Interest on debt ` 4,000 ` 1,000
(10%)
Earnings before tax ` 1,000 ` 4,000
(EBT)
Less : Tax at 50% ` 500 ` 2,000
Earnings available to ` 500 ` 2,000
equity shareholders.
No. of equity shares 1,000 4,000
Earnings per share ` 0.5 ` 0.5
(EPS) Earnings/No. of
equity shares

When EBIT is ` 12,500

Particulars Plan A Plan B
Earnings before interest ` 12,500 ` 12,500
and tax (EBIT)
Less : Interest on debt ` 4,000 ` 1,000
(10%)
Earnings before tax ` 8,500 ` 11,500
(EBT)
Less : Tax at 50% ` 4,250 ` 5,750
Earnings available to ` 4,250 ` 5,750
equity shareholders.
No. of equity shares 1,000 4,000
Earnings per share ` 4.25 ` 1.44
(EPS) Earnings/No. of
equity shares

Q13. Kumar Company has sales of ` 25,00,000. Variable cost of ` 15,00,000 and
fixed cost of ` 5,00,000 and debt of ` 12,50,000 at 8% rate of interest. Calculate
combined leverage.

SOLUTION:

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CA Amit Sharma
Statement of Profit

Sales 25,00,000

Less: Variable cost (15,00,000)

Contribution 10,00,000

Less: Fixed cost (5,00,000)

Operating Profit 5,00,000

Combined leverage =Operating leverage x Financial leverage

Calculation of operating leverage
𝑐𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 1000000
= =2
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 500000
Calculation of financial leverage

Earning before Interest and Tax (EBIT) ` 5,00,000

Less: Interest on Debenture ( 8% of 12,50,000) (` 1,00,000)

Earnings before Tax ` 4,00,000

𝐸𝐵𝐼𝑇
Financial Leverage = 𝐸𝐵𝑇

500000
Financial Leverage = = 1.25
400000
1000000
Combined leverage = 2 × 1.25 = 2.5 OR = 400000 = 2.5

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CA Amit Sharma

COST OF CAPITAL

QUESTIONS AND SOLUTIONS

1. DEBENTURES:

Q1. SK Ltd. issued 10,000, 14% debentures of Rs. 100 each at a discount of 5%.
The debentures are irredeemable. Cost of issue is 2% and the rate of tax is 50%.
Calculate cost of capital before tax.

SOLUTION:
𝑖 140000
Cd (before tax) = × 100 = 930000 × 100 = 15.05%
𝑁𝑃

Workings: i = 14% of 10,00,000 = Rs. 1,40,000

NP = 10,00,000 – (5% of 10,00,000 + 2% of 10,00,000) = Rs. 9,30,000
𝑖(1−𝑡) 140000(1−0.50)
Cd (after tax) = × 100 = × 100 = 7.525%
𝑁𝑃 930000

Q 2. SK Co. is willing to issue 1,000 7% Debentures of Rs. 100 each and for
which the company will have to incur the following expenses: Underwriting
commission 1.5% Brokerage 0.5% Printing and Other Expenses Rs. 500.
Assuming tax rate at 50% find out the cost of debt capital.

SOLUTION:
𝑖 7000
Cd (before tax) =𝑁𝑃 × 100 = 97000 × 100 = 7.18%

Where, i = 7% of 1,00,000 = 7,000

N.P. = (1,00,000 – (1,500 + 500 + 500) = 97,500
𝑖(1−𝑡) 7000(1−0.50)
Cd (after tax) = × 100 = × 100 = 3.59%
𝑁𝑃 97000

2. PREFERENCE SHARES:

Q3. SK Ltd. has issued 8% 10,000 Preference Shares of Rs. 100 each and has
incurred the following expenses:
Underwriting Commission 2%, Brokerage 1%, Other Expenses Rs. 5,000. If the
present company tax rate is 50%, what will be the cost of capital after tax and
before tax?
Also calculate cost of preference capital, if corporate dividend tax is 10%.

SOLUTION:
NP = 10,00,000 – 20,000 – 10,000 – 5,000 = Rs. 9,65,000

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CA Amit Sharma
PD 80000
Cp (after – tax ) = × 100 = × 100 = 8.29%
NP 965000
1 1
Cp (before – tax ) = After tax cost = 8.29 = = 16.58%
1−𝑡 1−0.5

If corporate dividend tax is paid:

𝑃𝐷 (1+𝐷1) 8(1+0.1)
Cp (after tax ) = × 100 = × 100 = 9.12%
𝑁𝑃 95.5

Q4. SK Ltd. issued at par 10,000 10% Preference Shares of Rs. 100 each. These
shares are redeemable after 10 years at a premium of Rs. 5 per share. The cost
of issue is Rs. 2 per share. Find out the cost of preference capital. Assume 50%
tax rate.

SOLUTION:
1050000−980000
100000+
Cp (after tax) = 10
1050000−980000 × 100
2

100000+7000
= × 100 = 10.54%
1015000

1
Cp (before tax) = 10.54(1−0.50) = 21.08%

3. EQUITY SHARES:

Q5. Calculate the cost of equity capital for a company whose Risk-free rate
=10%, equity market required return =18% with a beta of 0.5.

SOLUTION:
Ke = 0.10 + 0.5(0.18 - 0.10)
= 0.14 or 14%.

Q6. SK Ltd. has issued 20,000 equity shares of Rs. 100 each as fully paid. The
present market price of these shares of Rs. 160 per share. The company has
paid a dividend of Rs. 8 per share. Find out the cost of equity capital.

SOLUTION:
𝐷𝑃𝑆 8
Ce = × 100 = × 100 = 5%
𝑀𝑃 160

Q7. SK Ltd. has issued 1,000 equity shares of Rs. 100 each as fully paid. It has
earned a profit of Rs. 10,000 after tax. The market price of these shares is Rs.
160 per share. Find out the cost of equity capital before and after tax assuming
a tax rate of 50%.

SOLUTION:

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CA Amit Sharma
𝐸𝑃𝑆 10000/1000
Ce (after tax) = × 100 = × 100 = 6.25%
𝑀𝑃 160
𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 6.25 6.25
Ce (before tax) = = = = 12.5%
1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 1−50% 1−0.5

Q8. Calculate cost of new equity capital issue from the following information:
Face value of share = Rs. 100
Market value = Rs 105
Securities premium = Rs. 3 per share
After-tax net earnings = Rs. 10.50 per share
Cost of issue = Rs. 3 per share
Tax Rate = 50%

SOLUTION:
𝐸𝑃𝑆 10.50
Ce (after -tax) = × 100 = × 100 = 10.50%
𝑁𝑃 103−3

It must be noted that the present E/P Ratio is

𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 10.50
Ce (before tax) = = = 21%
1−𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 1−50%

4. WACC:

Q9. A company has obtained capital from the following sources, the specific
costs are also noted down against them:

Source of Book Value Market Value Cost of Capital

Capital

Debentures 4,00,000 3,80,000 5%

Preference 1,00,000 1,10,000 8%
Shares
Equity Shares
6,00,000 12,00,000 13%
Retained
2,00,000 -- 9%
Earnings

You are required to calculate weighted average cost of capital using (i) book
value weights, and (ii) market value weights.

SOLUTION:
Weighted Average Cost
(Book Value Weights)

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CA Amit Sharma
Source Amount Rs. Weight Cost of Weighted
Capital (%) Average
(1) (2) (3)
Cost
(4)
(5) = (3) x (4)
Debentures 4,00,000 .308 5 1.540
Preference 1,00,000 .007 8 0.616
Share
Equity
6,00,000 .461 13 5.993
Shares
2,00,000 .154 9 1.386
Retained
Earnings
Total 13,00,000 1.000 9.535

Weighted Average Cost

(Market Value Weights)
Source Amount Weight Cost of Weighted
Rs. Capital (%) Average
(1) (3)
Cost
(2) (4)
(5) = (3) x
(4)
Debentures 3,80,000 .225 5 1.125
Preference 10,000 0.084 8 0.672
Share
Equity
9,00,000 0.692 13 8.996
Shares
Retained
Earnings 3,00,000 0.230 9 2.07
Total 13,00,000 1.000 10.167
Working Note: - The Market value of equity share capital and retained earnings has
been ascertained as follows:
Market Value of Retained Earnings = (12, 00,000 x 2, 00,000) /8, 00,000 = Rs. 3,
00,000
Market Value of Equity Share = (12, 00,000 x 6, 00,000) / 8, 00,000 = Rs. 9, 00,000

Q10. The capital structure of a firm consists of equity of Rs. 80 lakhs; 10%
preference shares 20lakhs and 14% debentures of Rs. 60 lakhs. At present its
equity share is selling for Rs. 25. It is expected that the company will pay a

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 31
CA Amit Sharma
dividend of Rs. 2. It has been growing @ 7% p.a. If the company is subject to
50% tax rate, determine its weighted average cost of capital.

SOLUTION:
Cost of Debt (after tax)
Kd= 14 ( 1-.5) = 7%
Cost of Equity Share Capital
Ke = DPS/MP + g
= Rs. 2/Rs. 25 + 0.7
= .08 + .07 = 15%
Calculation of Weighted Average Cost of Capital (WACC)
Source Amount Rs. Weight Specific Weight x
cost of Cost of
capital capital
Equity Share 80,000 .500 .15 .07500
Capital
10% Pref. Share
20,00,000 .125 .10 .01250
Capital

60,00,000 .375 .07 .01625

14% Debentures

1,60,000 .11375

Q11. Indigo Ltd. has the following capital structure:

Rs. in Lakh
Ordinary shares of Rs. 1 each 1,000
Retained earnings 160
8% Debentures 440
1,600
In order to undertake of programme of expansion, the company requires to raise
additional capital of Rs. 400 lakh and three alternative financing schemes are
under consideration:
1. A rights issue, at nominal value, of an additional 400 lakh 1 ordinary shares
or
2. Issue, at nominal value, 400 lakh, 10% preference shares of Rs.1
or
3. Issue an additional Rs. 400 lakh of 8% debentures.

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CA Amit Sharma
Without the expansion programme, Indigo Ltd's estimated annual profit before
interest and tax in the foreseeable future is Rs. 200 lakh. It the programme
proceeds, this will rise to Rs. 280 lakh.

At present, the market values of the company's securities are:

Ordinary shares Rs. 5.40 (ex-dividend) per share
Debentures Rs. 110 per Rs. 100 nominal

The last ordinary dividend was 20 paise per share. If expansion does not take
place, ordinary dividends are expected to grow at a constant rate of 2.5% per
annum. After some initial fluctuations, the anticipated effect of expansion on
dividends and market values is expected to stabilize as follows:

Expansion Financed by
Rights Preference Debentures
Issue Shares
Market value of an ordinary share Rs. 5.60 Rs. 5.80 Rs. 6.00
Market value of debentures per Rs. 110 Rs. 110 Rs. 108
Rs.100 NA Rs. 1.14 NA
Market value of a preference 3.5% 4.0% 5.0%
share
Annual growth rate in ordinary
shares

The company's profit is subject to corporation tax at 35% and this rate is
unlikely to change.
You are required to calculate for each alternative financing scheme:
Gearing ratio
Profit available per ordinary share
Weighted average cost of capital based on market value.
Calculations may be restricted to two decimal places.
[June 2011 & Dec. 2014 (14 Marks)]

SOLUTION:
1. Gearing Ratio for existing capital structure :
𝐹𝑖𝑥𝑒𝑑 𝑖𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑎𝑟𝑖𝑛𝑔 𝑓𝑢𝑛𝑑𝑠 440
Gearing ratio = = 1,160 = 0.379
𝐸𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑓𝑢𝑛𝑑𝑠

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CA Amit Sharma
if expansion programme is funded by issuing ordinary shares :
440
= 0.282
1,560
if expansion programme is funded by issuing preference shares or debentures :
840
= 0.724
1,160

2. Statement showing profit available per ordinary share : (Rs. in lakh)

Particulars Existing Right Preference Debentures
Issue shares
EBIT 200.00 280.00 280.00 280.00
(-) Interest
– Existing (35.20) (35.20) (35.20) (35.20)
– New - - - (32.00)
EBT 164.80 244.80 244.80 212.80
(-) Tax @35% (57.68) (85.68) (85.68) (74.48)
PAT 107.12 159.12 159.12 138.32
(-) Preference dividend - - (40.00) -
Profit available for equity 107.12 159.12 119.12 138.32
Shareholders
No. of equity shares (in lakh) 1,000 1,400 1,000 1,000
EPS 0.107 0.114 0.119 0.138

3. Computation of WACC of existing capital structure

Dividend growth method :
𝐷1
𝐾𝑒 = + 𝑔
𝑃𝑜

D1 = D0 (1 + g)
= 0.20 (1 + 0.025)
= 0.205
0.205
= + 0.025
5.40

𝐾𝑒 = 0.06296 i.e. 6.296%

Cost of existing 8% debentures (on market price) :
𝐼(1−𝑡)
𝐾𝑑 = 𝑃𝑜
8(1−0.35)
𝐾𝑑 = 110

= 0.04727 i.e. 4.727%

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CA Amit Sharma
Calculation of WACC of existing capital structure (market value basis) :
Types of capital Rs. % Cost of Capital Product
Equity shares 5,400 91.77% 6.296% 577.78
8%Debentures 484 8.23% 4.727% 38.90
(Existing) 5,884 100% 616.68

616.68
WACC = = 6.17%
100

(a) Computation of WACC if expansion is financed by issue of right shares :

Dividend growth method :
𝐷1
𝐾𝑒 = + 𝑔
𝑃𝑜

D1 = D0 (1 + g)
= 0.20 (1 + 0.035)
= 0.207
0.207
= + 0.035
5.60

𝐾𝑒 = 0.196 i.e. 7.196%

Cost of existing 8% debentures (on market price) :
𝐾𝑑 = 0.04727 i.e. 4.727%
Calculation of WACC (market value basis) :
Types of capital Rs. % Cost of Capital Product
Equity shares 7,840 94.19% 7.196% 677.79
8% Debentures 484 5.81% 4.727% 27.46
8,324 100% 705.25

705.25
WACC = = 7.05%
100

(a) Computation of WACC if expansion is financed by issue of preference shares :

Dividend growth method :
𝐷1
𝐾𝑒 = + 𝑔
𝑃𝑜

D1 = D0 (1 + g)
= 0.20 (1 + 0.04)
= 0.208
0.208
= + 0.04
5.80

𝐾𝑒 = 0.07586 i.e. 7.586%

Cost of existing 8% debentures (on market price) :
𝐾𝑑 = 0.04727 i.e. 4.727%

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CA Amit Sharma
Cost of 10% preference shares (on market price) :
𝐷𝑃
𝐾𝑃 =
𝑃𝑜
0.1
𝐾𝑃 = 1.14

= 0.08772 i.e. 8.772%

Calculation of WACC (market value basis) :

Types of capital Rs. % Cost of Capital Product
Equity shares 5,800 86.05% 7.586% 652.78
8% Debentures 484 7.18% 4.727% 33.94
10% preference shares 456 6.77% 8.772% 59.39
6,740 100% 746.11

746.11
WACC = = 7.46%
100

(a) Computation of WACC if expansion is financed by issue of new 8% debenture :

Dividend growth method :
𝐷1
𝐾𝑒 = + 𝑔
𝑃𝑜

D1 = D0 (1 + g)
= 0.20 (1 + 0.05)
= 0.21
0.21
= + 0.05
6

𝐾𝑒 = 0.085 i.e. 8.5%

Cost of 8% debentures (based on market value) :
𝐼(1−𝑡)
𝐾𝑑 = 𝑃𝑜
8(1−0.35)
𝐾𝑑 = 108

= 0.04815 i.e. 4.815%

Calculation of WACC (market value basis) :
Types of capital Rs. % Cost of Capital Product
Equity shares 6,000 86.87% 8.5% 738.40
8% Debentures 907.2 13.13% 4.815% 63.22
6,907.2 100% 801.62

801.62
WACC = = 8.02%
100

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CA Amit Sharma

Q12. Krishna Ltd. is currently financed with Rs.10,00,000, 7% bonds and

20,00,000 of common stock. The stock has a beta of 1.5, risk-free rate of return
4% and market risk premium 3.5%. The marginal tax rate for a company of this
size is 35%.
Compute the WACC of Krishna Ltd.?
[Dec. 2014 (4 Marks)]
SOLUTION:
Cost of equity – CAPM Method:
Ke = Rf + 𝛽 (Rm – Rf) Risk premium = (Rm – Rf)
= 4 + 1.5 (3.5)
=9.25%
Cost of debt
Kd = I (1 – t)
= 7 (1 – 0.35)
= 4.55%
Calculation of WACC (book value basis) :
Types of capital Rs. % Cost of Product
Capital
Equity shares 20,00,000 66.67% 9.25% 616.70
7% Bonds 10,00,000 33.33% 4.55% 151.65
30,00,000 100% 768.35

768.35
WACC = = 7.68%
100

Q13. Using capital employed, compute the EVA with the help of following
information

2021–2022 2022–2023 2023–2024

Rs. Rs. Rs.
Equity 10,00,000 15,00,000 17,00,000
Debt(10%) 5,00,000 7,00,000 7,00,000
Profit after tax 2,00,000 4,00,000 8,00,000

Risk free rate of return is 7% Beta (𝜷) = 0.9, Market rate of return = 15%
Applicable tax rate is 40%.

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CA Amit Sharma
[Dec. 2014 (8 Marks)]
SOLUTION:
Particulars 2021– 2022– 2023–
2022 2023 2024
Profit after Tax (PAT) 2,00,000 4,00,000 8,00,000
Add: Interest (1–t) 30,000 42,000 42,000
Net Operating Profit after tax (NOPAT) 2,30,000 4,42,000 8,42,000
Less : Cost of capital (1,72,050) (2,54,980) (2,83,440)
Economics value added 57,950 1,87,020 5,58,560

Calculation of cost of equity :

Ke = Rf + 𝛽 (Rm – Rf) Rf = Risk free rate of interest
= 7 + 0.9 (15–7) Rm = Market rate of return
= 14.2% 𝛽 = Beta factor
Calculation of cost of debts :
Kd = I (1 – t) I = Interest
= 10(1–0.4) t = Tax rate
= 6%
Capital Rs. % Cost of Product
Capital
Equity 10,00,000 66.67% 14.2% 946.67
10% Debt 5,00,000 33.33% 6% 200
15,00,000 100.00% 1,146.67
1,146.67
WACC (2021–2022) = = 11.47%
100

Capital Rs. % Cost of Product

Capital
Equity 15,00,000 68.18% 14.2% 968.16
10% Debt 7,00,000 31.82% 6% 190.92
22,00,000 100.00% 1159.08
1,159.08
WACC (2022–2023) = = 11.59%
100

Capital Rs. % Cost of Product

Capital
Equity 17,00,000 70.83% 14.2% 1,005.79

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CA Amit Sharma
10% Debt 7,00,000 31.82% 6% 175.02
24,00,000 100.00% 1,180.81

1,180.81
WACC (2021–2022) = = 11.81%
100

Q14. Apoorva Ltd. has assets of Rs.32,00,000 that have been financed as
follows:
Rs.
Equity shares of Rs.100 each 18,00,000
General reserve 3,60,000
Debt 10,40,000
For the year ended 31st March, 2014, the company's total profits before
interest and taxes were 6,23,000. The company pays 8% interest on borrowed
capital and the tax bracket is 40%. The market value of the equity as on 31st
March, 2014 was Rs. 150 per share.
From the above, determine the weighted average cost of capital using market
values as weights.
[June 2015 (8 Marks)]
SOLUTION:
Particulars Rs.
EBIT 6,23,000
(-) Interest (49840)
EBT 5,73,160
(-) Tax @ 40% (2,29,264)
Profit available for equity 3,43,896
shareholders

3,23,880
EPS = = 19 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
18,000

Cost of equity – price earning method

𝐸𝑃𝑆
Ke = 𝑃0
19
= 150

= 0.126 i.e. 12%

Cost of debt:

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CA Amit Sharma
Kd = I (1 – t)
= 8 (1–0.4)
= 4.8%
Capital Rs. % Cost of Product
Capital
Equity 27,00,000 72.19% 12% 866.28
10% Debt 10,40,000 27.81% 4.8% 133.49
37,40,000 100.00% 999.77

999.77
WACC = = 9.998% 𝑖. 𝑒. 10%
100

Q15. Prosperous Bank has a criterion that it will give loans to companies that
have an Economic Value Added (EVA) greater than zero for the past three years
on an average.
The bank is considering lending money to a small company that has the
economic value characteristics shown below:
1. Average operating income after tax equals to Rs.25,00,000 per year for the
last 3 years.
2. Average total assets over the last 3 years equals Rs.75,00,000.
3. Weighted average cost of capital appropriate for the company is 10%,
applicable for all 3 years.
4. The company's average current liabilities over the past 3 years are
Rs.15,00,000.

Does the company meet the bank's criterion for a positive EVA? Show your
workings.
[June 2015 (5 Marks)]

SOLUTION:
Particulars Rs.
Net Operating Profit After Tax (NOPAT) 25,00,000
Less: Cost of Capital (60,00,000 × 10%) (6,00,000)
Economic Value Added 19,00,000

Total Assets - Current Liabilities = Capital Employed

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CA Amit Sharma
75,00,000-15,00,000= 60,00,000
Analysis: Since, Company has positive EVA, Prosperous Bank can grant the loan.

Q16. ABC Ltd. has 10,000 shares of Rs.7 each, Rs.10,000, 12% debentures and
Rs. 20,000 as short term loan 10%. Tax rate for the company is 30%.
Assume the cost of equity capital as 20%.
Calculate weighted average cost of capital at book value.
[Dec. 2015 (4 Marks)]
SOLUTION:
Cost of 12% debentures:
Kd = I (1 – t)
= 12 (1–0.3)
= 8.4%
Cost of short term loan :
Kd = I (1 – t)
= 10 (1–0.3)
= 7%
Calculation of WACC (book value basis) :
Capital Rs. % Cost of Product
Capital
Equity 70,000 70% 20% 1,400
12% Debentures 10,000 10% 8.4% 84
1 0% short term loan 20,000 20% 7% 140
1,00,000 100.00% 1,624

1,624
WACC = = 16.24%
100

Q17. From the following data determine the cost of capital using market value
as weights:

Rs. Market Value (Rs.)

Debentures @1,000 each 15,00,000 1,100 each

Preference shares @ 10 each 5,00,000 12 each

Equity shares @100 each 20,00,000 200 each

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CA Amit Sharma

TOTAL 40,00,000

Debentures carry 8% rate of interest, issued and redeemable at par with

maturity period of 20 years and floating cost 4%.
Preference shares carry 10% dividend rate, issued and redeemable at par with
maturity period of 15 years and floating cost 5%.
Equity dividend expected at the end of year is Rs.20 per share whereas
anticipated dividend growth rate is 5%. Corporate tax is 30%.
[Dec. 2015 (8 Marks)]
SOLUTION:
Cost of debt:
𝑅 –𝑆
[𝐼(1−𝑡)]+ ( 𝑣 𝑣 )
𝐾𝑑 = 𝑅 +𝑆
𝑁
Sv = 1,000 – 40 = 960
( 𝑣 𝑣)
𝑁
1,000–960
[80(1−0.3)]+ ( )
20
𝐾𝑑 = 1,000+960
( )
20

56+2
𝐾𝑑 = 980

𝐾𝑑 = 0.5918 𝑖. 𝑒. 5.92%

Cost of redeemable preference shares :

𝑅 –𝑆
[ 𝐷𝑝 + ( 𝑣 𝑣 )]
𝑁
𝐾𝑝 = 𝑅 +𝑆
( 𝑣 𝑣)
2
10−9.5
[ 1+ ( )]
15
𝐾𝑑 = 10+9.5
( )
2

1.0333
𝐾𝑑 = 9.75

𝐾𝑑 = 0.10598 𝑖. 𝑒. 10.598%

Calculation of WACC (market value basis) :

Types of Capital Rs. % Cost of Product
Capital
8% Debentures 16,50,000 26.4% 5.92% 156.29
10% preference shares 6,00,000 9.6% 10.598% 101.74
Equity shares 40,00,000 64% 15% 960.00
62,50,000 100.00% 1,218.03

1,218.03
WACC = = 12.18%
100

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CA Amit Sharma

Q18. Zoya Ltd. has obtained capital from the following sources and the specific
costs are given against them:

Type of Capital Book Value Market Value Cost Value

(Rs. in lakh) (Rs. in lakh) (Rs. in lakh)
Debentures 4 3.8 5
Preference Shares 1 1.1 8
Equity Shares 6 9.0 13
Retained earnings 2 3.0 9
13 16.9

SOLUTION:
Calculation of WACC (book value basis) :
Types of Capital Rs. in lakh % Cost of Product
Capital
Debentures 4 30.77% 5% 153.85
Preference shares 1 7.69% 8% 61.52
Equity shares 6 46.15% 13% 599.95
Retained earnings 2 15.38% 9% 138.42
13 100% 953.74

953.74
WACC = = 9.54%
100

Calculation of WACC (market value basis) :

Types of Capital Rs. in lakh % Cost of Product
Capital
Debentures 3.8 22.49% 5% 112.45
Preference shares 1.1 6.51% 8% 52.08
Equity shares 9.0 53.25% 13% 692.25
Retained earnings 3.0 17.75% 9% 159.75
16.9 100% 1016.53

1016.53
WACC = = 10.17%
100

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CA Amit Sharma

Q19. Determine weighted average cost of capital using market value weights

Book Value Structure Rs.

Debentures (Rs. 100 per debenture) 8,00,000
Preference shares (Rs. 100 per share) 2,00,000
Equity shares (Rs. 10 per share) 10,00,000
20,00,000

Market prices of these securities are :

Debentures : Rs. 110 per debenture
Preference shares : Rs. 120 per share
Equity shares : Rs. 22 per share

Based on external investment opportunities, the expected return on such

debentures, preference shares and equity shares have been determined at
6.84%, 14.62% and 16.10% respectively.
[June 2016 (6 Marks)]

SOLUTION:
Calculation of WACC (market value basis) :
Types of Capital Rs. % Cost of Product
Capital
Debentures 8,80,000 26.51% 6.84% 181.33
Preference shares 2,40,000 7.23% 14.62% 105.70
Equity shares 22,00,000 66.27% 16.10% 1,066.95
33,20,000 100% 1,353.98

1,353.98
WACC = = 13.54%
100

Q20. Balance sheet of Zupiter Ltd. as on 31st March, 2013 is as under:

Particulars Rs.
I. Equity and Liabilities
(1) Shareholders funds
Equity share capital 10,00,000

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CA Amit Sharma
(2) Non-current liabilities
Long-term debts 15,00,000
(3) Current Liabilities
(a) Trade payables 52,000
(b) Bank overdraft 1,21,000
Total 26,73,000
II. Assets
(1) Non-current assets
Fixed assets 25,00,000
(2) Current assets
(a) Inventories 64,440
(b) Trade receivables 1,07,325
(c) Cash and bank 1,235
Total 23,73,000

Statement of profit and Loss

Sales 15,62,000
Less : Operating Expenses 9,48,000
EBIT 6,14,000
Less : Tax 2,45,600
Net Operating profit after tax 3,68,400

The average rate of return of similar type of companies is 20% and risk-free
rate of return is 15%. Rate of interest charged by bank is 18% and tax rate is
40%.
Calculate Economic Value Added (EVA).
[June 2016 (5 Marks)]
SOLUTION:
Particulars Calculations Rs.
EBIT 6,14,000
Less : Interest (15,00,000  18%) (2,70,000)
EBT 3,44,000
Less : Tax @ 40% (3,44,000  40%) (1,37,600)
Profit after tax (PAT) 2,06,400

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CA Amit Sharma
Add : Interest (1-t) [2,70,000 (1-0.4)] 1,62,000
Net Operating profit after tax 3,68,400
(NOPAT) (26,21,000 x (3,47,283)
Less : Cost of capital 13.25%)
Economic Value Added 21,117

Cost of equity :
Ke = Average rate of return of similar companies = 20%
Cost of long term debts :
I = Risk Free rate of return = 15%
Kb = I (1 – t)
= 15(1–0.4)
= 9%

Kb = I (1 – t)
= 18(1–0.4)
= 10.08%

Calculation of WACC (book value basis) :

Types of Capital Rs. % Cost of Product
Capital
Equity shares Capital 10,00,000 38.15% 20.00% 763.00
Long term debts 15,00,000 57.23% 9.00% 515.07
Bank overdrafts 1,21,000 4.62% 10.08% 46.57
26,21,000 100% 1324.64

1,324.64
WACC = = 13.25%
100

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CA Amit Sharma

OPERATIONAL SPECTS OF FINANCIAL MANAGEMENT

QUESTIONS AND SOLUTIONS

1. PV RATIO :

Q1. From the following particulars calculate:

1. P/V Ratio b. Fixed Cost
2. I year sales Rs. 1, 95,000 profit Rs. 9,000
3. II Year sales Rs. 2, 25,000 profit Rs. 15,000

SOLUTION:
P/V Ratio = Change in Profit / Change in Sales
= 15,000 - 9,000 / 2,25,000 1,95,000 = 6,000 /30,000 × 100
P/V Ratio = 20%
Variable Cost = Sales (1- P/V Ratio)
= Rs. 2,25,000 (1- 0.20)
= Rs. 2,25,000 × 0.80 = Rs. 1,80,000
Fixed Cost = Sales – Variable Cost – Profit
= Rs. 2,25,000 – Rs. 1,80,000 – 15,000 = Rs. 30,000

Q2. X Ltd. Made sales during a certain period for Rs. 1,00,000. The net profit
for the same period was Rs. 10,000 and the fixed overheads were Rs. 15,000.
Find out: (i) P/V Ratio (ii) Sales needed to generate a profit of Rs. 15,000 (iii) A
net profit of Rs. 150,000 from sales. (iv) Point sales that break even.

SOLUTION:
(i) P/V Ratio = {(F+P) / S} x 100 Here, F = Rs. 15,000, P = Rs. 10,000 and S = Rs.
1,00,000. P/V Ratio = [(15,000 + 10,000) / 1,00,000] x 100 P/V Ratio = 25%.
(ii) P/V Ratio = {(F+P) / S} x 100 Here 25 = {(15,000+15,000) /S}x100 [ Given Profit =
Rs. 15,000] Or, S = (30,000/25) x 100 Sales = 1,20,000 Sales required to earn a profit
of Rs. 15,000 = Rs.1,20,000.
(iii) When Sales =Rs.1,50,000, Then Profit = ? P/V Ratio ={(F+P) / S} x 100 Here, 25
= [(15,000+P)1,50,000] x 100 [Given Sales= Rs.1,50,000] Or, 15,000 + P = 1,50,000
x 25 / 100 Or, 15,000 + P = 37,500 Profit = 37,500 – 15,000 = Rs.22,500 Net Profit
from sales of Rs.1,50,000 = Rs. 22,500.

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(iv) We know, at BEP – P/V Ratio = F+ BEP Sales x 100 Or, 25 = (15,000 / BEP Sales)
x 100 Or, BEP Sales = (15,000 / 25) x 100 = 60,000 ÷ Break – even Point Sales = Rs.
60,000.

2. BEP :

Q3. StarX Ltd. Sold goods for ` 30,00,000 in a year. In that year, the variable
cost is 60% of sales and profit is ` 8,00,000. Find out: (i) P/V Ratio, (ii) Fixed
Cost, (iii) Break-even sales, (iv) sales that would still be profitable if the selling
price were cut by 10% but fixed costs were raised by 1,00,000.

SOLUTION:
Sales = 30,00,000
Less: Variable Cost (60% of Sales) = 18,00,000
Contribution = 12,00,000
Less: Fixed Cost *
Profit = 8,00,000

Profit = C – FC
8,00,000 = 12,00,000 – FC
FC = 4,00,000……………. (ii)
P/V Ratio = 𝐶𝑆 x 100 = 12,00,000 30,00,000 x 100 = 40%............(i)
BEP = 𝐹𝐶𝑃𝑉𝑅𝑎𝑡𝑖𝑜 = 4,00,000 40% = 10,00,000………………(iii)
iv….. Required Statement
Sales (30,00,000 ÷ 10%) = 27,00,000
Less: V.C = 18,00,000
Contribution = 9,00,000
Revised P/V Ratio = 𝐶𝑆 x 100 = 9,00,000 27,00,000 𝑥 100 = 1 3 𝑥 100 = 33 1/ 3 %
Revised BEP 𝐹𝐶𝑃𝑉𝑅𝑎𝑡𝑖𝑜 = 4,00,000+1,00,000 331 3 % = ` 15,00,000

Q4. A company manufactures a products, currently providing 80% capacity

with a turnover of `8, 00,000 at ` 25 per unit. The cost data are as under:
Material cost `7.50 per unit, Labour cost `6.25 per unit. Semi-variable cost
(including variable cost of `3.75 per unit) `1, 80, 000. Fixed cost `90,000 up to
80% level of output, beyond this an additional `20,000 will be incurred.
Calculate: 1. Activity level at breakeven point

SOLUTION:

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1. Number of units sold = Sales ÷ Selling price p.u. = `8,00,000 ÷ 25 per unit = 32,000
units
Fixed cost included in the semi-variable cost = Total semi variable cost – variable
element
= `1,80,000 – (`3.75 p.u. x 32,000 units) = `60,000
Variable cost p.u. = `7.50 + 6.25 + 3.75 =`17.50
Contribution p.u, = Selling price – variable cost = `(25 – 17.50) = `7.50
Breakeven Point = Fixed Cost/Contribution per unit = 90000+60000/7.50 = 20,000
units
`Activity level at BEP = 80% / 32000 units * 20,000 units = 50.00%

Q5. MNP Ltd sold 2,75,000 units of its product at `37.50 per unit. Variable costs
are ` 17.50 per unit (manufacturing costs of ` 14 and selling cost ` 3.50 per
unit). Fixed costs are incurred uniformly throughout the year and amounting
to ` 35, 00,000 (including depreciation of ` 15, 00,000). There is no beginning
or ending inventories. Required: COMPUTE breakeven sales level quantity and
cash breakeven sales level quantity.

SOLUTION:
Break even Sales Quantity = Fixed cost/ Contribution margin per unit
= 35, 00,000 / 20 ` = 1,75,000 units
Cash Break-even Sales Quantity = Cash Fixed Cost/ Contribution margin per unit
= 20,00,000/ 20 ` =1,00,000 units.

3. MARGIN OF SAFETY:

Q7. From the following information of Akansha Co. Ltd. Calculate P/V Ratio
and Margin of Safety.
i. Sales -- Rs. 10, 00,000
ii. Variable Cost -- Rs. 4, 00,000
iii. Profit -- Rs. 3, 00,000

SOLUTION:
Contribution = Sales – Variable Cost
= Rs. 10,00,000 – Rs. 4,00,000
= Rs. 6,00,000
Fixed Cost = Sales – Variable Cost – Profit or Contribution - Profit
= Rs. 10,00,000 – Rs. 4,00,000 – Rs. 3,00,000

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= Rs. 10,00,000 – Rs. 7,00,000
= Rs. 3,00,000
P/V Ratio = 6,00,000/ 10,00,000*100
= 60%
BEP (Value) = Fixed Cost / P V Ratio
= 3, 00,000 / 0.6 = Rs. 5, 00,000
Margin of Safety = Sales – BEP
= Rs. 10, 00,000 – Rs. 5, 00,000
= Rs. 5, 00,000

Q8. Surya Ltd has a total turnover of Rs. 10 lakhs. It is enjoying 30% margin of
safety. Its total variable cost is 60% of sales. Determine Fixed Cost and BEP in
Sales.

SOLUTION:
Variable Cost = 60% of Sales
= 0.60 × Rs. 10, 00,000 = Rs. 6,00,000
Contribution = Sales – Variable Cost
= Rs. 10,00,000 – Rs. 6,00,000
= Rs. 4,00,000
P/V Ratio = Contribution/ Sales
= 4,00,000/10,00,000*100 = 40%
Margin of Safety = 30% of Rs. 10,00,000
= Rs. 3,00,000
Margin of Safety = Profit/ P V Ratio :
. Profit = Margin of Safety × P/V Ratio
= Rs. 3, 00,000 × 0.40
Profit = Rs. 1, 20,000
Fixed Cost = Contribution – Profit
= Rs. 4, 00,000 – Rs. 1, 20,000
= Rs. 2,80,000
BEP (Value) = Actual Sales – Margin of Safety
= Rs. 10,00,000 – 3,00,000
= Rs. 7,00,000

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4. COMBINED QUESTIONS:

Q9. A company produces a single product and sells it at Rs. 200 each. The
variable cost of the product is Rs. 120 per unit and the fixed cost for the
year is Rs. 96,000.
Calculate
1. P/V ratio
2. Sales at break even point
3. Sales units required to earn a target net profit of Rs. 1,20,000
4. Sales units required to earn a target net profit of Rs. 1,00,000 after income
tax, assuming income tax rate to be 50%.
5. Profit at sales of Rs. 7,00,000
[June 2007(10 Marks)]

SOLUTION:
Sales – Variable cost = Contribution p.u.
200 – 120 = 80
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 80
(i) P/V ratio = × 100 = 200 × 100 = 40%
𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 96,000
(ii) BEP (in value) = = = 2,40,000
𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 40%

(iii) Sales units required to earn a target net profit of Rs. 1,20,000 :

Particulars Rs.
Sales 5,40,000
Less : Variable cost (3,24,000)
Contribution 2,16,000
Less : Fixed Cost (96,000)
Profit 1,20,000

2,16,000
Sales = = 5,40,000
40%
5,40,000
Sales unit = = 2,700
200

(iv) Sales units required to earn a target net profit of Rs. 1,00,000 after income tax
Particulars Rs.
Sales 7,00,000
Less : Variable cost (4,44,000)

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Contribution 2,96,000
Less : Fixed cost (96,000)
Profit 2,00,000
Less : Tax (1,00,000)
Profit after tax 1,00,000
2,96,000
Sales = = 7,40,000
40%
7,40,000
Sales units = = 3,700 𝑢𝑛𝑖𝑡𝑠
200

(v) Profit at sales of Rs. 7,00,000

Particulars Rs.
Sales 7,00,000
Less : Variable cost (4,20,000)
Contribution 2,80,000
Less : Fixed cost (96,000)
Profit 1,84,000

Q10. A factory produces 300 units of a product per month. The selling price is
120 per unit and variable cost is Rs 80 per unit. The fixed expenses of the
factory amount to 78,000 per month.
Calculate:
The estimated profit in a month wherein 240 units are produced.
The break-even sales quantity.
The sales to be made to earn a profit of Rs. 7,000 per month.
[Dec. 2010 (5 Marks)]
SOLUTION:
Present monthly profitability statement
No. of units p.u. 300
Particulars Total
Sales 120 36,000
Less: Variable cost (80) (24,000)
Contribution 40 12,000
Less: Fixed cost (8,000)
Profit 4,000

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(i) Calculation of estimated profit in a month wherein 240 units are produced:
No. of units p.u. 240
Particulars Total
Sales 120 25,800
Less: Variable cost (80) (19,200)
Contribution 40 9,600
Less: Fixed cost (8,000)
Profit 1,600

(ii) Calculation of break-even sales quantity:

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 8,000
BEP (in units) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝.𝑢. = = 200 𝑢𝑛𝑖𝑡𝑠
40

(iii) Calculation of sales to be made to earn a profit of Rs.7,000 per month:

No. of units p.u. Total
Particulars
Sales 120 45,000
Less: Variable cost (80) (30,000)
Contribution 40 15,000
Less: Fixed cost (8,000)
Profit 7,000

15,000
Required sales = × 120 = 45,000
40

Q11. The following data is obtained from the records of an industrial unit :

Sales of 4,000 units @ Rs. 25 40,000 1,00,000

each
Material consumed 10,000
Variable overheads
Labour charges 20,000
Fixed overheads 88,000
Net Profit 18,000

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CA Amit Sharma

You are required to calculate:

1. The number of units by selling which the company will neither lose not gain
anything.
2. The sales needed to earn a profit of 20% on sales.
3. The extra units which should be sold to obtain the present profit if it is
proposed to reduce the selling price by 20%.
4. The selling price to be fixed to bring down its break-even point to 500
SOLUTION:
No. of units particulars p.u. 4,000
Sales 25.00 1,00,000
Less: Variable cost (17.50) (70,000)
Contribution 7.50 30,000
Less: Fixed cost (18,000)
Net Profit 12,000

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 30,000
P/V ratio = × 100 = 1,00,000 × 100 = 30%
𝑆𝑎𝑙𝑒𝑠

(v) Calculation of number of units by selling which the company will neither lose
not gain (i.e. BEP) :
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 18,000
BEP (in value) = = = 60,000
𝑆𝑎𝑙𝑒𝑠 30%
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 18,000
BEP (in value) = 𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑝.𝑢. = = 2,400
7.5

(vi) Calculation of the sales needed to earn a profit of 20% on sales.

Particulars Rs.
Sales x
Less : Variable cost (0.7x)
Contribution 0.3x
Less : Fixed cost (18,000)
Profit 0.2x
0.3x – 18,000 = 0.2x
– 18,000 = –0.1x
x = 1,80,000
(vii) Calculation of extra units which should be sold to obtain the present profit if
it is proposed to reduce the selling price by 20%
Present selling price per unit is Rs. 25 which after 20% it reduction will be Rs.
20 p.u.

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No. of units particulars p.u. 4,000
Rs
Sales 20 2,40,000
Less: Variable cost (17.5) (2,10,000)
Contribution 2.50 30,000
Less: Fixed cost (18,000)
Net Profit 12,000

Q12. The sales turnover and profit during two periods were as follows:
Period-1 Sales: 20 lakh and Profit: 2 lakh
Period-2 Sales: 30 lakh and Profit: 4 lakh
Calculate:
1. P/V ratio
2. Sales required to earn a profit of Rs.5 lakh and
3. Profit when sales are Rs.10 lakh.
[Dec. 2009 (6 Marks)]

SOLUTION:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡
(i) P/V ratio = × 100
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
4,00,000−2,00,000
= 30,00,000−20,00,000 × 100

= 20%
Particulars Period 1 Period 2
Sales 100% 20,00,000 30,00,000
Less: Variable cost (80%) (16,00,000) (24,00,000)
Contribution 20% 4,00,000 6,00,000
Less: Fixed cost (2,00,000) (2,00,000)
Profit 2,00,000 4,00,000
(ii) Sales to earn a profit of Rs.5,00,000:
Particulars Rs.
Sales 100% 35,00,000
Less: Variable cost (80%) (28,00,000)
Contribution 20% 7,00,000
Less: Fixed cost (2,00,000)
Profit 5,00,000

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7,00,000
Required sales = = 35,00,000
20%

(iii) Profit when sales are Rs.10,00,000:

Particulars Rs.
Sales 100% 10,00,000
Less: Variable cost (80%) (8,00,000)
Contribution 20% 2,00,000
Less: Fixed cost (2,00,000)
Profit Nil

Q13. A company is producing an identical product in two factories. The

following are the details in respect of both the factories.

Factory X Factory Y
Selling price per unit (Rs.) 50 50
Variable cost per unit (Rs.) 40 35
Fixed cost (Rs.) 2,00,000 3,00,000
Depreciation included in fixed cost 40,000 30,000
(Rs.)
Sales (Units) 30,000 20,000
Production capacity (units) 40,000 30,000

You are required to determine:

Break-Even point (BEP) for each factory individually.
Which factory is more profitable.
Cash BEP for each factory individually.
BEP for company as a whole, assuming the present product mix of Factory X &
Factory Y is 3:2.
Note : Indicate BEP in unit.
[Dec. 2006(10 Marks)]
SOLUTION:

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Particulars Factory X Factory Y
p.u. Sales Production p.u. Sales Productio
Capacity n
Capacity
Units 30,000 40,000 20,000 30,000
Sales 50 15,00,000 20,00,000 50 10,00,00 15,00,000
Less : Variable (40) (12,00,00 (16,00,000) (35) 0 (10,50,00
cost 0) (7,00,000 0)
Contribution )
Less : Fixed 10 3,00,000 4,00,000 15 3,00,000 4,50,000
cost (2,00,000) (2,00,000) (3,00,000 (3,00,000)
Profit )
1,00,000 1,00,000 Nil 1,50,000

(i) Calculation of BEP for each factory individually :

𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 10
P/V ratio (Factory X) = × 100 = 50 × 100 = 20%
𝑆𝑎𝑙𝑒𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 15
P/V ratio (Factory Y) = × 100 = 50 × 100 = 30%
𝑆𝑎𝑙𝑒𝑠
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 2,00,000
BEP (in value) (Factory X) = = = 10,00,000
𝑃/𝑉 𝑅𝑎𝑡𝑖𝑜 20%
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 3,00,000
BEP (in value) (Factory Y) = 𝑃/𝑉 = = 10,00,000
𝑅𝑎𝑡𝑖𝑜 30%

(ii) Factory Y is more profitable because it give higher contribution per unit.
(iii) Calculation of Cash BEP for each factory individually :
Fixed cost considering non-cash fixed expenses i.e. depreciation
Factory X = 2,00,000 – 40,000 = 1,60,000
Factory Y = 3,00,000 – 30,000 = 2,70,000
𝐶𝑎𝑠ℎ 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 1,60,000
BEP (in value) (Factory X) = = = 8,00,000
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 20%
𝐶𝑎𝑠ℎ 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 2,70,000
BEP (in value) (Factory Y) = = = 9,00,000
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 30%

(iv) Calculation of BEP for company as a whole, assuming the present product mix
of factory X & factory Y is 3:2.
Calculation of equivalent P/V ratio :
20%  3/5 = 12%
30%  2/5 = 12%
24%
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 5,00,000
BEP (in value) = 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 = = 20,83,333
24%

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20,83,333
BEP sales units = = 41,667
50

Q14. A company has annual fixed cost of Rs.1,40,00,000. In the year 2017-
2018, sales amounted to 6,00,00,000 as compared with Rs.4,50,00,000 in the
preceding year Profit in 2017-2018 is 742,00,000 more than that in 2016-2017.
On the basis of the above information, answer the following:
(i) At what level of sales, the company would have break even?
(ii) Determine profit/loss on a forecasted sales volume of Rs.8,00,00,000.
If there is a reduction in selling price by 10% in the financial year 2018-2019
and company desires to earn the same amount of profit as in 2017-2018, what
would b the required sales volume?
[Dec. 2008 (9 Marks)], [Dec. 2011 (6 Marks)]
SOLUTION:
Year 2016-2017 2017-2018
Particulars Rs. Rs.
Sales 4,50,00,000 6,00,00,000
Less: Variable cost ? ?
Contribution ? ?
Less: Fixed cost (1,40,00,000) (1,40,00,000)
Net Profit x x + 42,00,000

𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑝𝑟𝑜𝑓𝑖𝑡
P/V Ratio = × 100
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠
(𝑥+42,00,000)−𝑥
= 6,00,00,000−4,50,00,000 × 100
42,00,000
= 1,50,00,000 × 100

= 28%

Year 2016-2017 2017-2018

Sales 100% 4,50,00,000 6,00,00,000
Less: Variable cost (72%) (3,24,00,000) (4,32,00,000)
Contribution 28% 1,26,00,000 1,68,00,000
Less: Fixed cost (1,40,00,000) (1,40,00,000)
Net Profit (14,00,000) 28,00,000

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(i) Calculation of BEP :
𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡 1,40,00,000
BEP (in value) = = = 5,00,00,000
𝑃/𝑉 𝑟𝑎𝑡𝑖𝑜 28%

(ii) Calculation of profit/loss on a forecasted sales volume of Rs. 8,00,00,000 :

Year 2016-2017
Sales 100% 8,00,00,000
Less: Variable cost (72%) (5,76,00,000)
Contribution 28% 2,24,00,000
Less: Fixed cost (1,40,00,000)
Net Profit 84,00,000

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DIVIDEND POLICY

QUESTIONS AND SOLUTIONS

1. WALTER MODEL:

Q1. ABC Ltd. was started a year back with a paid-up capital of Rs. 40,00,000
the other details are as under:
Earning of the company : Rs. 4,00,000
Dividend paid : Rs. 3,20,000
Price earnings ratio : 12.5
Number of shares : 40,000
You are required to find out whether the company's dividend payout ratio is
optimal, using Walter's formula.

SOLUTION:
4,00,000
EPS = = 10 per share
40,000
3,20,000
DPS = = 8 per share
40,000
1 1
𝐾𝑒 = = 12.5 = 0.08 𝑖. 𝑒. 8%
𝑃/𝐸 𝑅𝑎𝑡𝑖𝑜
4,00,000
Return of Investment (𝑅𝑎 ) = 40,00,000 × 100 = 10%
𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃𝑜 = 𝑅𝑐
0.10
8+ (10−8)
0.08
= 0.08
10.5
= 0.08

= Rs. 131.25

ABC Ltd. is growth firm as Ra > Rc. Hence, optimal dividend payout ratio is nil. This
can be confirmed from following calculations -
𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃𝑜 = 𝑅𝑐
0.10
0+ (10−0)
0.08
= 0.08
12.5
= 0.08

= Rs. 156.25

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Q2. The following information's is available in respect of Sober Ltd.

No. of shares outstanding : 1 Lakh
Earnings per share : Rs. 4
Dividend payout per share : Rs. 2.4
Equity capitalization rate : 12%
Rate of return on investment : 15%
You are required to calculate –
Market value per share as per Walter's Model.
Dividend payout ratio to keep share price at Rs. 40.
Optimum dividend payout ratio as per Walter's Model.
Market value per share at the optimum dividend payout ratio based on Walter's
Model.
[June 2015 (4 Marks)]
SOLUTION:
(i) Market Value per share as per Walter's Model :
𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃= 𝑅𝑐
0.15
2.4 + (4−2.4)
0.12
= 0.12
4.4
= 0.12

= Rs. 36.67
(ii) Dividend payout ratio to keep share price at Rs. 40 :
𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃= 𝑅𝑐
0.15
𝑥+ (4−𝑥)
0.12
40 = 0.12
0.6−0.15𝑥
4.8 = 𝑥 + 0.12
0.12𝑥 + 0.6 − 0.15𝑥
4.8 = 0.12

0.576 = 0.12x + 0.6 – 0.15x

0.576 = 0.6 – 0.03x
0.024 = 0.03x
x = D = Dividend = 0.8
0.8
Payout ratio = × 100 = 20%
4

(iii) Sober Ltd. is growth firm as its rate of return on investment is greater than
cost of capital i.e. Ra > Re. Optimal payout ratio as per Walter's Model is nil.

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(iv) Market value per share at the optimum dividend payout ratio based on Walter's
model:
𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃= 𝑅𝑐
0.15
0+ (4−0)
0.12
= 0.12
5
= 0.12

= Rs. 41.67

Q3. Following details are available to you for two companies. Beauty Ltd. Pretty
Ltd.

Beauty Ltd. Pretty Ltd.

Internal rate of return (%) 15 10
Capitalization rate (%) 12 10
Earnings per share (Rs.) 12 10
Cash dividend per share (Rs.) 5 2

Calculate the value of an equity share for the companies.

[June 2016 (4 Marks)]
SOLUTION:

Beauty Ltd. Pretty Ltd.

𝑅 𝑅
𝐷+ 𝑎 (𝐸−𝐷) 𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐 𝑅𝑐
𝑃= 𝑃=
𝑅𝑐 𝑅𝑐
0.15 0.10
5+ (12−5) 2+ (10−2)
0.15 0.10
= =
0.15 0.15
12 10
= =
0.15 0.15

= Rs. 80 = Rs. 66.67

Q4. The following information pertains to M/s Kanagana Limited:

Earnings of the company Rs. 5 Lakh
Dividend payout ratio 60%
No. of shares outstanding 1,00,000
Equity capitalization rate 12%
Rate of return on investment 15%
What would be the market value per share as per Walter's model?
[June 2017 (2 Marks)]

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SOLUTION:
5,00,000
EPS = = 𝑅𝑠. 5
1,00,000

D = 5  60% = Rs. 3
𝑹
𝐷+ 𝒂 (𝑬−𝑫)
𝑹𝒄
𝑃= 𝑹𝒄
𝟎.𝟏𝟓
𝟑+ (𝟓−𝟑)
𝟎.𝟏𝟐
= 𝟎.𝟏𝟐
5.5
= 0.12

= Rs. 45.83

Q5. The Earning per share of a company is Rs. 16. The market capitalization
rate applicable to the company is 12.5%. Retained earnings can be employed
to yield a return of 10%. The company is considering a payout of 25%, 50% and
75%. Which of these would maximize the wealth of shareholders as per Walter's
Model of dividend.
[June 2019 (4 Marks)]

SOLUTION:
In given case, the firm is declining firm as its rate of return on investment is less that
cost of capital i.e. Ra < Rc. Optimal payout ratio as per Walter's Model is 100%. Thus,
increase in payout ratio increases the market price for declining firm.
Dividend payout ratio is 25%:

16  25% = 4
𝑹
𝑫+ 𝒂 (𝑬−𝑫)
𝑹𝒄
𝑷= 𝑹𝒄
0.10
4+ (16−4)
0.125
= 0.125
𝟏𝟑.𝟔
= 𝟎.𝟏𝟐𝟓

= Rs. 108.80
Dividend payout ratio is 50% :

16  50% = 8
𝑹
𝑫+ 𝒂 (𝑬−𝑫)
𝑹𝒄
𝑷= 𝑹𝒄
𝟎.𝟏𝟎
𝟒+ (𝟏𝟔−𝟖)
𝟎.𝟏𝟐𝟓
= 𝟎.𝟏𝟐𝟓
𝟏𝟒.𝟒
= 𝟎.𝟏𝟐𝟓

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= Rs. 115.20

Dividend payout ratio is 75% :

16  75% = 12
𝑹
𝑫+ 𝒂 (𝑬−𝑫)
𝑹𝒄
𝑷= 𝑹𝒄
𝟎.𝟏𝟎
𝟒+ (𝟏𝟔−𝟏𝟐)
𝟎.𝟏𝟐𝟓
= 𝟎.𝟏𝟐𝟓
𝟏𝟓.𝟐
= 𝟎.𝟏𝟐𝟓

= Rs. 121.60
Above result shows that the wealth of the shareholders would be maximized when
the company adopts 75% payout ratio.

Q6. ABC Autos Ltd. started its business one year back with paid-up equity
capital of Rs. 40 Lakh. Other details are as under:

Earnings of the year : Rs. 4,00,000

Dividend paid : Rs. 3,20,000

Price-earnings ratio : 12.5

Number of shares : 40,000

You are required to find out whether the company's dividend payout ratio is
optimal using Walter's Model.
[Dec. 2020 (4 Marks)]

SOLUTION:
𝟒,𝟎𝟎,𝟎𝟎𝟎 𝟑,𝟐𝟎,𝟎𝟎𝟎 𝟏
EPS = = 𝟏𝟎 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆; DPS = = 𝟖 𝒑𝒆𝒓 𝒔𝒉𝒂𝒓𝒆; 𝑲𝒆 = 𝑷/𝑬 𝑹𝒂𝒕𝒊𝒐 =
𝟒𝟎,𝟎𝟎𝟎 𝟒𝟎,𝟎𝟎𝟎
𝟏
= 𝟎. 𝟎𝟖 𝒊. 𝒆. 𝟖%
𝟏𝟐.𝟓
𝟒,𝟎𝟎,𝟎𝟎𝟎
Rate of return on Investment (Ra) = × 𝟏𝟎𝟎 = 𝟏𝟎%
𝟒𝟎,𝟎𝟎,𝟎𝟎𝟎
𝑹
𝑫+ 𝒂 (𝑬−𝑫) 𝟖+
𝟎.𝟏𝟎
(𝟏𝟎−𝟖)
𝑹𝒄 𝟎.𝟎𝟖
𝑷= =
𝑹𝒄 𝟎.𝟎𝟖
𝟏𝟎.𝟓
= 𝟎.𝟎𝟖

= Rs. 131.25

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ABC Ltd. is growth firm as Ra > Rc. Hence, optimal dividend payout ratio in nil. This
can be confirmed form following calculations
𝑹
𝑫+ 𝒂 (𝑬−𝑫)
𝑹𝒄
𝑷= 𝑹𝒄
𝟎.𝟏𝟎
𝟎+ (𝟏𝟎−𝟎)
𝟎.𝟎𝟖
= 𝟎.𝟎𝟖
𝟏𝟐.𝟓
= 𝟎.𝟎𝟖

= Rs. 156.25

Q7. The earnings per share of a company are Rs.8 and the rate of capitalization
applicable to the company is 10%. The company has before it an option of
adopting a payout ratio of 25% or 50% or 75%. Using Walter’s formula of
dividend payout, compute the market value of the company’s share if the
productivity of retained earnings is (A) 15%, (B) 10% and (C) 5%. Explain fully
what inference can be drawn from the above exercise.
SOLUTION:
Calculation of market value of the company’s share under different payout options:
Walter’s Formula

𝑅
𝐷+ 𝑎 (𝐸−𝐷)
𝑅𝑐
𝑃= 𝑅𝑐

Here,
Ke = ? , Ra = (a) 15% .15 (b) 10% .10 (c) 5% or .5, Rc = 10% or .10
E = Rs.8 and D = (i) 25% of Rs.8, i.e., Rs.2
(ii) 50% of Rs.8, i.e., Rs.4 and
(iii) 75% of Rs.8, i.e., Rs.6 per share
(A) If productivity of retained earnings is 15%:
(i.e., Ra = 15% or .15)
i) If Payout Ratio is 25%:

15
2+ (8−2) 2+1.5×6 11
Ke = 10
= = = Rs.110 per share
10 .10 .10

ii) If Payout Ratio is 50%:

.15
4+ (8−2) 4+1.5×4 10
Ke = .10
= = = Rs.100 per share
10 .10 .10

iii) If Payout Ratio is 75%:

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.15
6+ (8−6) 6+1.5×2 9
Ke = .10
= = = Rs.90 per share
10 .10 .10

(B) If productivity of retained earnings is 10%: (i.e., Ra = 10% or .10)

i) If Payout Ratio is 25%:
.10
2+ (8−2) 2+1×6 8
Ke = .10
= = = Rs.80 per share
10 .10 .10

ii) If Payout Ratio is 50%:

.10
4+ (8−4) 4+1×4 8
Ke = .10
= = = Rs.80 per share
10 .10 .10

iii) If Payout Ratio is 75%:

.10
6+ (8−6) 6+1×2 8
Ke = .10
= = = Rs.80 per share
10 .10 .10

(C) If productivity of retained earnings is 5% (i.e.., Ra = 5% or .05)

i) If Payout Ratio is 25%:
.05
2+ (8−2) 2+5×6 5
Ke = .10
= = = Rs.50 per share
10 .10 .10

ii) If Payout Ratio is 50%:

.05
4+ (8−4) 4+.5×4 6
Ke = .10
= = = Rs.60 per share
10 .10 .10

iii) If Payout Ratio is 75%:

.05
6+ (8−6) 6+.5×2 7
Ke = .10
= = = Rs.70 per share
10 .10 .10

2. GORDANS MODEL:

Q8. Anurag has invested in a share whose dividend is expected to grow @15%
for 5 years and thereafter @5% till life of the company. Find out the value of
the share, if current dividend is Rs. 4 per share and investors required rate of
return is 6%.

SOLUTION:
Year Growth Dividend Cash Flow PV Factor PV
Rate @6%
1 15% 4.60 4.60 0.943 4.34
2 15% 5.9 5.29 0.890 4.71
3 15% 6.08 6.08 0.840 5.11
4 15% 7.00 7.00 0.792 5.54

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5 15% 8.05 8.05 + 845 = 0.747 637.23
6 5% 8.45 853.05
656.93

𝐷6 8.45 8.45
P5 = = 0.06−0.05 = 0.01 = 845
𝐾𝑒 −𝑔

Intrinsic value of the company is Rs. 656.93.

Q9. Vivu Ltd. is a reputed chemical producing company. Vivu's shares are
quoted in the market at the price of Rs. 340. Roma mutual Fund's manager of
Roma with respect to buy decision through the application of gordon model
based on the following information.
1. The expected rate of return by equity shareholders is 10%
2. The retention ratio is 40%
3. The earnings per share recorded in the recent past year is Rs. 20.
4. The expected earnings per share for next year is Rs. 25.
5. The internal rate of return of Vivu Ltd. is 15%.

SOLUTION:
𝑬(𝟏−𝒃)
𝑷𝟎 = 𝑲𝒆 −𝒃𝒓

Where,
P0 = Market price at Year 0
E = Earnings per share (EPS)
b = Retention Ratio
br = g = growth rate
Ke = Capitaliation rate / cost of capital
𝟐𝟓(𝟏−𝟎.𝟒) 𝟏𝟓
𝑷𝟎 = = 𝟎.𝟎𝟒 = 𝟑𝟕𝟓
𝟎.𝟏𝟎−(𝟎.𝟒 ×𝟎.𝟏𝟓)

Expected price of Vivu Ltd. as per Gordon's model is Rs. 375 whereas current Market
price of share is Rs. 340. Thus, Manager of Roma Mutual Fund is advised to buy the
shares as the market price of shares of Vivu Ltd. is less than expected price.

3. MM MODEL:

Q10. Abhishek Steel Ltd. has one lakh equity shares outstanding which are
selling at Rs. 100 each. Its capitalization rate is 14%. The company is expecting
Rs. 65 lakh income for the current year and is planning to pay dividend

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amounting to Rs. 4 lakh. The company wants to invest in a new project which
will cost Rs. 75 lakh. It is assumed that the Modigliani and Miller Model on
dividend policy is applicable to the company.
Compute the price per share at the end of the current year and the number of
shares to be issued for financing the investment when :
(i) Dividend amounting to Rs. 4 lakh is paid.
(ii) Dividend is not paid.
SOLUTION:
(a) If dividend is not declared:
0+𝑃1
100 = 1+0.14

P1 = 114
(b) If dividend is declared :
4+𝑃1
100 = 1+0.14

114 = 4 + P1
P1 = 110
Calculation of number of shares to be issued:
Particulars If dividend If dividend
is not is declared
declared
Net income 65,00,000 65,00,000
(-) Dividend - (4,00,000)
Retained earnings 65,00,000 61,00,000
New Investment 75,00,000 75,00,000
Amount to be raised by issued of new shares 10,00,000 14,00,000
Market price per share 114 110
Number of shares to be issued 8771.93 12,727.27

Verification of MM Model :
Particulars If dividend If dividend
is not is declared
declared
Existing shares 1,00,000 1,00,000
New shares to be issued 87,719.93 12,727.27
Total number of shares 1,08,771.93 1,12,727.27
Market price per share 114 110

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Total market value at the end of year 1,24,00,000 1,24,00,000

Q11. D Ltd. has 10 lakh equity shares outstanding at the beginning of the
accounting year. The current market price of the shares is Rs. 150 each. The
board of directors of the company has recommended dividend of Rs. 8 per
share. The rate of capitalization, appropriate to the risk class to which company
belongs is 12%
1. Based on MM Approach, calculate the market price of the shares of the
company when recommended dividend is (a) declared and (b) not declared.
2. How many shares are to be issued by the company at the end of accounting
year on the assumption that the net income for the year is Rs. 2 Crore and the
investment budget is Rs. 4 crore.
3. Show that market value of the shares at the end of accounting year will
remain same whether dividend is declared or not declared. [Dec. 2015 (4 Marks)]
SOLUTION:
Calculation of price of share under MM Model:
𝐷1 + 𝑃1
𝑃0 = 1+ 𝐾𝑒

(a) If dividend is declared.

8 + 𝑃1
150 = 1+ 0.12

165 = 8 + P1
P1 = 160
(b) if dividend is not declared:
0+𝑃1
150 = = 168
1+0.12

Calculation of number of shares to be issued :

Particulars If dividend If dividend
is not is declared
declared
Net income 2,00,00,000 2,00,00,000
(-) Dividend - (80,00,000)
Retained earnings 2,00,00,000 1,20,00,000
New Investment 4,00,00,000 4,00,00,000
Amount to be raised by issued of new shares 2,00,00,000 2,80,00,000
Market price per share 168 160

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Number of shares to be issued 1,19,047.62 1,75,000
Verification of MM Model :
Particulars If dividend is If dividend
not declared is declared
Existing shares 10,00,000 10,00,000
New shares to be issued 1,19,047.62 1,75,000
Total number of shares 11,19,047.62 11,75,000
Market price per share 168 160
Total market value at the end of year 18,80,00,000 18,80,00,000

Q12. D Ltd. has 10 lakh equity shares outstanding at the beginning of the
accounting year. The current market price of the shares is Rs. 150 each. The
board of directors of the company has recommended dividend of Rs. 8 per
share. The rate of capitalization, appropriate to the risk class to which company
belongs is 12%
1. Based on MM Approach, calculate the market price of the shares of the
company when recommended dividend is (a) declared and (b) not declared.
2. How many shares are to be issued by the company at the end of accounting
year on the assumption that the net income for the year is Rs. 2 Crore and the
investment budget is Rs. 4 crore.
3. Show that market value of the shares at the end of accounting year will
remain same whether dividend is declared or not declared.
[Dec. 2015 (4 Marks)]
SOLUTION:
Calculation of price of share under MM Model :
𝐷1 + 𝑃1
𝑃0 = 1+ 𝐾𝑒

(a) If dividend is not declared.

8 + 𝑃1
150 = 1+ 0.12

165 = 8 + P1
P1 = 160
Calculation of number of shares to be issued :

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Particulars If dividend If dividend
is not is declared
declared
Net income 2,00,00,000 2,00,00,000
(-) Dividend - (80,00,000)
Retained earnings 2,00,00,000 1,20,00,000
New Investment 4,00,00,000 4,00,00,000
Amount to be raised by issued of new shares 2,00,00,000 2,80,00,000
Market price per share 168 160
Number of shares to be issued 1,19,047.62 1,75,000

Verification of MM Model :
Particulars If dividend is If dividend
not declared is declared
Existing shares 10,00,000 10,00,000
New shares to be issued 1,19,047.62 1,75,000
Total number of shares 11,19,047.62 11,75,000
Market price per share 168 160
Total market value at the end of year 18,80,00,000 18,80,00,000

Q13. XYZ Ltd. has 25,000 outstanding shares at current market price of Rs.
100. It belongs to a risk class with capitalization rate of 20%. The company
expects to earn a net profit of Rs. 5,00,000 during a year.
What will be the price of share if dividend is not paid?
[Dec. 2017 (4 Marks)]
SOLUTION:
Calculation of price of share under MM Model if dividend is not paid :
𝑫𝟏 + 𝑷𝟏
𝑷𝟎 = 𝟏+ 𝑲𝒆
𝟎 + 𝑷𝟏
100 = 𝟏+ 𝟎.𝟐

P1 = 120

Q14. Raj Limited had 50,000 equity shares of Rs. 10 each outstanding on 1st
January. The shares are currently being quoted at par in the market. The
company now intends to pay a dividend of Rs. 2 per share for the current
calendar year. It belongs to a risk class whose appropriate capitalization rate is
15 percent. Using Modigliani-Miller model and assuming no taxes, ascertain the

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price of the company's share as it is likely to prevail at the end of the year
under following conditions.
(a) When dividend is declared.
(b) When no dividend is declared.
(c) Also, find out the number of new equity shares that the company
must issue to meet its investment needs of Rs. 2 lakh, assuming a net income
of Rs. 1.1 lakh and dividend is paid.
[June 2021 (4 Marks)]
SOLUTION:
Calculation of price of share under MM Model :
𝐷1 + 𝑃1
𝑃0 = 1+ 𝐾𝑒

(a) If dividend is not declared

0+ 𝑃1
10 = 1+ 0.15

(b) If dividend is declared

2+ 𝑃1
10 = 1+ 0.15

11.5 = +P1
P1 = 9.5
Calculation of number of shares to be issued if not declared :
Particulars If dividend If dividend
is not is declared
declared
Net income 1,10,000 1,10,000
(-) Dividend - (1,00,000)
Retained earnings 1,10,000 10,000
New Investment 2,00,000 2,00,000
Amount to be raised by issued of new 90,000 1,90,000
shares 11.5 9.5
Market price per share 7,826.09 20,000
Number of shares to be issued

Verification of MM Model :
Particulars If dividend If dividend
is not is declared
declared
Existing shares 50,000 50,000
New shares to be issued 7,826.09 20,000

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Total number of shares 57,826.09 70,000
Market price per share 11.5 9.5
Total market value at the end of year 6,65,000 6,65,000

Q15. Companies U and L are identical in every respect, except that company U
is unlevered while Company L is levered. Company L has 20 Lakh of 8%
debentures outstanding.
Assume that :
(i) All the MM assumptions are met.
(ii) The tax rate is 50%.
(iii) EBIT is Rs. 06.00 Lakh
(iv) Equity capitalization rate of Company U is 10%.
What would be the value for each firm according to MM's approach.
[Dec. 2021(4 Marks)]
SOLUTION:
Value of unlevered company: (Company U)
Particulars Rs.
EBIT 6,00,000
(-) Interest -
EBT 6,00,000
(-) Tax @ 50% (3,00,000)
PAT 3,00,000
Capitalization Rate 10%
Market value of equity (PAT/Capitalization rate)  30,00,000
100

According to MM, the value of levered firm would exceed that of the unlevered firm
by an amount equal to the levered firms debt multiplied by the tax rate.
Value of unlevered firm + (Value of debt  Tax rate) = Total Value of levered firm
Value of the Company L with Rs. 20,00,000 in debt :
30,00,000 + (20,00,000  50%) = 40,00,000
Total value - Value of debt = Value of equity
40,00,000 – 20,00,000 = 20,00,000

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TIME VALUE OF MONEY

QUESTIONS AND SOLUTIONS

Q. 1 A sum of Rs. 50,000 is invested @12% p.a. for 6 years. What will be the
present value of its maturity value, assuming a required rate of return of 10%?
[Dec. 2019 (1 Mark)]
SOLUTION:
Future value (FV) of Rs. 50,000 @12% after 6 years :
= 50,000 (1+0.12)6
= 50,000  1.974
= 98,7000
PV of 98,700 at the end of 6th year = 97,700  0.564 = 55,667

Q. 2 What is the present value of the maturity value of Rs. 10,000 which has
been given in 15% interest for five years while required rate of return is 10% ?
[FV@ 15% after 5 years is 2.01136, FV@10% after 5 years is 1.61051]
[Dec. 2020 (1 Mark)]
SOLUTION:
FV of Rs. 10,000 @15% after 5 years = Rs. 10,000 (1+0.15)5 = Rs. 20,113.57
Present value of Rs. 20,113.57 which is to be received after 5 years
= Rs. 20,113.57 (1+0.10)5 = Rs. 12,488.94

Q. 3 Find the amount of an annuity if payment of Rs. 50,000 is made annually

for 7 years at interest rate of 14% compounded annually.
[June 2021 (1 Mark)]
SOLUTION:
R = 50,000, n = 7, i = 0.14
FVA = 500  FVIVA (7, 0.14) = 50,000  10.73 = 5,36,500

Q. 4 Find the present value of Rs. 1,00,000 to be received 3 years later when
rate of return is 10% p.a. compounded annually.
[June 2022 (1 Mark)]
SOLUTION:

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 74
CA Amit Sharma
x  (1 + 0.10)3 = 1,00,000
x  1.331 = 1,00,000
x = 75,131

Q. 5 A deposited Rs. 1,00,000 in a bank for a period of 5 years and the rate of
interest is 5% p.a. compounded annually. How much amount A will receive after
5 years?
[June 2022 (1 Mark)]
SOLUTION:
FV = 1,00,000 (1 + 0.05)5
= 1,00,000  1.2762815
= 1,27,628

Q. 6 What will br the approximate present value of Rs. 25,000 to be received

at the end of each of the next 5 years, if the discount rate is 12%?
[June 2022(1 Marks)]

SOLUTION:
Annuity factor of 12% for 5 years = 3.60
25,000  3.60 = 90,000

Q. 7 A bond carries a coupon rate of 12.4% p.a. compounded quarterly. What

will be effective yield on the bond?
[June 2022(1 Marks)]
SOLUTION:
Effective yield = (1 + 0.124/4)1  4 – 1
= 1.1299 – 1
= 0.1299 i.e. 12.99%

Q. 8 Z invested Rs. 2,40,000 at annual rate of interest of 10 percent. What is

the amount after 3 years if the compounding is done?
[Dec. 2020 (4 Marks)]
SOLUTION:
(a) Annual compounding:
FVn = P (1 + i)n

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 75
CA Amit Sharma
Here, P = 2,40,000
L = 10% of 0.10
FV3 = 2,40,000 (1 ÷ 0.13)3
= 2,40,000  1.13
= 2,40,000  1.331
= Rs. 3,19,440
(b) Semi-annual compounding
n = 3  2 = 6, i = 10  ½ = 5% or 0.05
FV6 = 2,40,000  1.056
= 2,40,000  1.3401
= Rs. 3,21,624

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 76
CA Amit Sharma

CAPITL BUDGETING

QUESTIONS AND SOLUTIONS

Q1. A project costs Rs. 3,00,000 and yields annually a profit of Rs. 80,000 after
depreciation @ 12% p.a. but before tax of 50%. Calculate the payback period.

SOLUTION:
Profitability Statement
Profit before tax 80,000
Less Tax @ 50% 40,000
Profit after tax 40,000
Add back Depreciation @ 12% on Rs. 60,000
5,00,000
Annual Cash inflow or Cash 1,00,000
Earnings

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡 300000

Rate of Return = = = 3 𝑦𝑒𝑎𝑟𝑠
𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 100000

Q2. A project with an outlay of Rs. 12,000 yields Rs. 2,000, Rs. 3,000, Rs. 4,000
and Rs. 6,000 respectively in the first, second, third and fourth year, the
payback period will be calculated as thus:

Year Cash-inflow Cumulative Cash-

in-flow
1 2,000 2,000
2 3,000 5,000
3 4,000 9,000
4 6,000 15,000

SOLUTION:
𝐵
PB. P = E +𝐶
12000−9000
= 3 years + × 12 = 3 𝑦𝑒𝑎𝑟𝑠 6 𝑚𝑜𝑛𝑡ℎ𝑠
6000

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 77
CA Amit Sharma

Q3. The following are the details relating to two projects:

Cost of Project 1,60,000 2,00,000

Estimated Scrap 16,000 24,000
Estimated Savings:
1st year 20,000 40,000
2nd year 30,000 60,000
3rd year 50,000 60,000
4th year 50,000 60,000
5th year 40,000 30,000
6th year 30,000 20,000
7th year 10,000 -

Calculate Payback Period and consider which project is better.

SOLUTION:
Table Showing Cumulative Cash Flow of Projects
Year Project X Project Y
Cash Flow Cumulative Cash Flow
Cumulative
Cash Cash
Flow Flow
Rs. Rs. Rs. Rs.
1 20,000 20,000 40,000 40,000
2 30,000 50,000 60,000 1,00,000
3 50,000 1,00,000 60,000 1,60,000
4 50,000 1,50,000 60,000 2,20,000
5 40,000 1,90,000 30,000 2,50,000
6 30,000 2,20,000 44,000* 2,94,000
7 26000 246000 - -

Calculation of Payback Period

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 78
CA Amit Sharma
PROJECT X PROJECT Y
P.B.P. = = 4 years and 3 months = 3 year and 8 months
Post Payback 2,46,000 – 1,60,000 2,94,000 – 2,00,000
Profitability
= Total Cash Flows –
Investment Outlay
(Post-Payback) = Rs. 86,000 = Rs. 94,000
Profitability Index
𝑃.𝑃.𝐵 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 86000 94000
= × 100 × 100 = 53.75% × 100= 47%
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 200000
160000

Q4. Calculate discounted payback period from the information given below:
Cost of Project Rs. 10,00,000
Life 5 years
Annual Cash inflow Rs. 4,00,000
Cut-off Rate 10%.

SOLUTION:
Year Annual Cash P.V. Factor Discounted Cumulative
Inflow Rs. at 10% Cash Flow D.C.F. Rs.
Rs.
1 4,00,000 0.909 3,63,600 3,63,600
2 4,00,000 0.826 3,30,400 6,94,000
3 4,00,000 0.751 3,00,400 9,94,400
4 4,00,000 0.683 2,73,200 12,67,600
5 4,00,000 0.621 2,48,400 15,16,000

1000000−994400
Discounted payback period = 3 years + × 365
273200

= 3 years and 8 days.

Q5. Rank the following investment proposals for A&G pvt. Ltd. in order of their
profitability using (a) Payback period method, (b) Accounting rate of return
method and (c) Present value index method (cost of capital – 10%):

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 79
CA Amit Sharma
Project Initial Annual Life
Outlay Cash Flow
Rs. Rs. (in
years)
A 96,000 15,000 12
B 48,000 10,000 8
C 80,000 14,000 10
D 40,000 9,000 8

SOLUTION:
(a) Ranking of the Projects under Payback Period Method
Project Initial Annual Paybac Rank
Outlay Cash k
Flow Period
A 96,000 15,000 6.4 4
B 48,000 10,000 4.8 2
C 80,000 14,000 5.7 3
D 40,000 9,000 4.4 1

(b) Ranking of the Projects under Accounting Rate of Return Method

Projec Initial Avera Annua Life Annua Net Retur Rank
t Outla ge l Cash l Incom n
y Rs. Outla Flow Depre e Ra. Avera
y Rs. Rs ciatio ge
n Outla
y%
A 96,00 48,00 15,00 12 8,000 7,000 14.58 4
0 0 0
B 48,00 24,00 10,00 8 6,000 4,000 16.67 2
0 0 0
C 80,00 40,00 14,00 10 8,000 6,000 15 3
0 0 0
D 40,00 20,00 9,000 8 5,000 4,000 20 1
0 0

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 80
CA Amit Sharma
(b) Ranking of the Projects under the Present Value Index Method

Project Initial Annual Life P.V. P.V. of P.V. Rank

Outlay Cash Factor Cash Index of
Rs. Flow Rs (at 10%) Flows Rs.1
Years
A 96,000 15,000 12 6.814 1,02,21 1.06 4
0
B 48,000 10,000 8 5.335 53, 350 1.11 2
C 80,000 14,000 10 6.145 86, 030 1.08 3
D 40,000 9,000 8 5.335 48, 015 1.20 1

Q6. SK & ABC Company Ltd. is considering the purchase of a new investment.
Two alternative investments are available (A and B) each costing Rs. 1,00,000.
Cash inflows are expected to be as follows:

Cash Investmen Investmen

Inflows ts A tB
Years Rs. Rs.
1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000

The company has a target return on capital of 10%. Risk premium rates are 2%
and 8% respectively for investments A and B. Which investment should be
preferred?

SOLUTION:
The profitability of the two investments can be compared on the basic of net present
values cash inflows adjusted for risk premium rates as follows:
Year Discount Cash Present Discount Cash Payment
Factor Inflow Value Factor @ Inflows Value
@
Rs. Rs. 10%+8%= Rs. Rs.
10%+2%=12% 18%
1 0.893 40,000 35,720 0.847 50,000 42,350
2 0.797 35,000 27,895 0.718 40,000 28,720

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CA Amit Sharma
3 0.712 25,000 17,800 0.609 30,000 18,270
4 0.635 20,000 12,700 0.516 30,000 15,480

94,115 1,04,820
Investment A
Net Present value = Rs, 94,115 – 1,00,000
= Rs. (-) 5,885
Investment B
Net Present value = Rs. 1,04,820 – 1,00,000
= Rs. 4,820
As even at a higher discount rate investment B gives a higher net present value,
investment B should be preferred.

Q7. There are two projects X and Y. each involves an investment of Rs. 40,000.
The expected cash inflows and the certainly coefficients are as under:

Year Project X Project Y

Cash Certainty Cash Inflow Certainty
Inflow Coefficient Coefficient
Rs. Rs.
1 25,000 0.8 20,000 0.9
2 20,000 0.7 30,000 0.8
3 20,000 0.9 20,000 0.7
Risk-free cut-off rate is 10%. Suggest which of the two projects should be preferred.
SOLUTION:
Calculations of Cash Inflows with Certainty
Year Project X Project Y
Cash Certainty Certain cash Cash Certainty Certain
inflow coefficient inflow inflow coefficient cash
inflow
RS. RS RS RS
1 25000 0.8 20000 20000 0.9 18000
2 20000 0.7 14000 30000 0.8 24000
3 20000 0.9 18000 20000 0.7 14000

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CA Amit Sharma
Calculations of Present Values of Cash Inflows

Year Discount Project X Project Y

factor
@10% Cash inflows Present values Cash inflow Present
values
1 0.909 20000 18180 18000 16362
2 0.826 14000 11564 24000 19824
3 0.751 18000 13518 14000 10514

43262 46700

Project X Project Y

Net Present Value = Rs. 43,262-40,000 46,700-40,000

= Rs. 3,262 Rs. 6,700
As the net present value of present Y is more than that of Project X, Project Y should
be preferred.

Q8. Mr. ABC, a risky investor is considering two mutually exclusive projects A
and B. You are required to advise him about the acceptability of the project
from the following information.

Project A (Rs.) Project B (Rs.)

Cost of the 50,000 50,000

investment
Forecast cash flows per annum for 5 years
Optimistic 30,000 40,000
Most likely 20,000 20,000
Pessimistic 15,000 5,000
(The cut-off rate may be assumed to be 15%)
SOLUTION:
Calculation of Net Present Value of Cash Inflows at a Discount Rate of 15%
(Annuity of Re. 1 For 5 Years)

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Project A Project B
Annual Discoun Presen Net Annua Discou Present Net
Cash t Factor t Value Present l Cash nt Value Presen
@15% (Rs.) Value Inflow Factor (Rs.) t
Flow
(Rs.) (Rs.) @15% Value
(Rs.)
Optimisti 30,000 3.3522 1,00,5 50,566 40,000 3.3522 1,34,0 84,088
c 66 88
Most 20,000 3.3522 67,014 17,044 20,000 3.3522 67,044 17,044
Likely
Pessimisti 15,000 3.3522 50,283 283 5,000 3.3522 16,761 (33,23
c 9)

Q9. Calculate the ‘pay-back period’, ‘average rate of return’ and ‘net present
value’ for a project which requires an initial outlay of Rs. 10,000 and generates
year ending cash flows (after tax but before depreciation) of Rs. 6,000; Rs.
3,000; Rs. 2,000; Rs. 5000 and Rs. 5,000 from the end of the first year to the
end of fifth year. The required rate of return is 10 percent and pays tax at 50
percent rate. The project has a life of five years and depreciated on straight line
basis.
Year 1 2 3 4 5
Discount Rate at 10% .909 .826 .751 .683 .620

SOLUTION:
i) Pay-back Period Method

Year Initial Cash Inflows Cumulative Cash

Investment Inflows

Rs. Rs. Rs.

1 10,000 6,000 6,000
2 - 3,000 9,000
3 - 2,000 11,000
4 - 5,000 16,000
5 - 5,000 21,000

Pay-back Period = 2 + (10,0000 – 9,000) / 2,000 = 2.5 years

ii) Average Rate of Return Method

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CA Amit Sharma
ARR = (Average Annual Cash Inflows – Annual Depreciation)/Average Investment x
100
= (Rs. 4,200 – Rs. 2,000) / 5,000 x 100
= ( Rs. 2,200 / Rs. 5,000 ) x 100 = 44%
Average Annual Cash Inflows = Total Cash Inflows / Life in Years = Rs. 21,000 / 5 =
Rs.4,200
iii) Net Present Value Method

Year Cash inflows P.V. Factor at Present Value

10%

1 Rs. .909 Rs.

2 6,000 .826 5,454
3 3,000 .751 2,478
4 2,000 .683 1,502
5 5,000 .621 3,415
5,000 3,105

Total Present Value 15,954

Net Present Value = Present Value – Initial Investment

= Rs. 15,954 – Rs. 10,000
= Rs. 5,954

Q10. The following details of SK & ABC Co. relate to the two machines X and Y:
Machine X Machine Y

Cost Rs. 56,125 Rs. 56,125

Estimated Life 5 years 5 years

Estimated salvage value Rs. 3,000 Rs. 3,000

Annual income after tax and depreciation:

Year Rs. Rs.

I 3,375 11,375

II 5,375 9,375

III 7,375 7,375

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CA Amit Sharma
IV 9,375 5,375

V 11,375 3,375

Overhauling charges at the end of third year Rs. 25,000 on machine Y.

Depreciation has been charged at straight line method. Discount rate is 10%,
P.V.F. at 10% for five years are 0.909, 0.826, 0.751, 0.683 and 0.621. Suggest
which project should be accepted.

SOLUTION:
i) Calculation of Present Value of Cash-outflows:
YEAR INVESTMENT P.V FACTOR AT PRESENT VALUE
10%
X Y X Y
RS. RS. RS. RS.

0 56125 56125 1.000 56125 56125

III - 25000 0.751 - 18775

56125 74900

ii) Calculation of Cash Inflows:

Year Machine X Machine Y

Annual Depreci Cash Annual Deprecia Cash

Income ation Inflows Income tion Inflow

I Rs. Rs. Rs. Rs. Rs. Rs.

II 3,375 10,625 14,000 11,375 10,625 22,000
III 5,375 10,625 16,000 9,375 10,625 20,000
IV 7,375 10,625 18,000 7,375 10,625 18,000
V 9,375 10,625 20,000 5,375 10,625 16,000
11,375 10,625 22,000 3,375 10,625 14,000

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CA Amit Sharma
iii) Calculation of present Value of Cash Inflows:

YEAR CASH INFLOWS P.V PRESENT VALUE

MACHINES FACTOR AT MACHINES
10%
X Y X Y
RS. RS. RS. RS.
I 14000 22000 0.909 12726 19998
II 16000 20000 0.826 13216 16520
III 18000 08000 0.751 13518 13518
IV 20000 16000 0.683 13660 10928
V 22000 14000 0.621 15525 10557
3000* 3000*

68645 71521

*Salvage value at the end of life of the machines.

Net Present Value = P.V. of Cash Inflows – P.V. of Cash Outflows
Machine X = Rs. 68,645 – Rs. 56,125 = Rs. 12,520
Machine Y = Rs. 71,521 - Rs. 74,900 = Rs. (-) 3,379
Decision: Machine X should be selected.

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CA Amit Sharma

WORKING CAPITAL

QUESTIONS AND SOLUTIONS

1. WORKING CAPITAL:

Q1. Calculate the Net Working Capital requirement for Vertical Ltd. from the
following information:

(per unit)
Raw Material 160
Direct Labour 60
Overheads 120
Total Cost 340
Profit 60
Selling Price 400

Raw material is held in stock on an average for four weeks. Materials are in
process on an average for two weeks. Finished goods are in stock on an average
for four weeks. Credit allowed by supplier four weeks. Credit allowed by Debtors
eight weeks. Work in progress comprise 100% material cost and 50%
conversion cost. Lag in payment of wages 1½ week. Time lag in payment of
overhead expense, four weeks.
Other information:
Cash Sales ½ of total sales
Cash in hand/bank Rs. 50000
Expected level of production1,04,000 units
One year is taken as 52 weeks.
Production is carried evenly throughout the year.
State your assumptions, if any.
[June 2017 (4 Marks)]

SOLUTION:
Statement showing working capital estimation

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CA Amit Sharma
Particulars Norms Calculations Rs.
Current Assets :
Finished goods stock 4 Weeks (3,53,60,000 × 52)
4 27,20,000

Debtors (on cost) 8 Weeks (3,12,00,000 × 52)

8 48,00,000

Cash & Bank Given 50,000

(A) 6,35,000
Current Liabilities
Creditors 4 Weeks (28,08,000 × 52)
4 2,16,000

Outstanding wages 2 Weeks 2

(4,68,000 × 52) 18,000

Outstanding 2 Weeks 2
(4,68,000 × 52) 18,000
overheads
(B) 2,52,000
Working capital (A) – (B) 3,83,000

Working notes:
Note 1: Cost structure (1,04,000 units)
Particulars % Per Total
unit
Material 40% 160 1,66,40,000
Wages 20% 60 62,40,000
Overheads 20% 120 1,24,80,000
Total cost 80% 340 3,53,60,000
Profit 20% 60 62,40,000
Sales 100% 400 4,16,00,000
Note 2 : Computation of base for WIP :
Particulars Degree of completion Rs.
Material 100% 1,66,40,000
Wages 50% 31,20,000
Overheads 50% 62,40,000
Total 2,60,00,000

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CA Amit Sharma

Q2. A company has prepared its annual budget, relevant details of which are
reproduced below :

(i) Sales Rs. 46.80 Lakh : 78,000 units

(25% cash sales and balance on credit)
(ii) Raw material cost : 60% of sales
value
(iii) Labour cost : Rs. 6 per unit
(iv) Variable overheads : Rs. 1 per unit
(v) Fixed overheads : Rs. 5,00,000
(including Rs. 1,10,000 as depreciation)
(vi) Budgeted stock levels :
Raw Materials : 3 weeks
Work-in-progress : 1 weeks
(material 100%; labour & overheads 50%)
Finished goods : 2 weeks
(vii) Debtors are allowed credit : 4 weeks
(viii) Creditors allow : 4 weeks
(ix) Lag in payment of overheads : 2 weeks
(x) Cash in hand required : Rs. 50,000
(xi) Wages are paid as follows
(a) For 1st and 2nd weeks : in the 3rd weeks
(b) For 3rd and 4th week : in the next week

Prepare working capital budget (requirement) for a year for the company.
Assume one year = 52 weeks [Dec. 2013(20 marks)], [June 2016 (10
Marks)],
[June 2019 (16 Marks)]
SOLUTION:
Statement showing working capital estimation :
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock 3 Weeks 3
(28,08,000 × 52) 1,62,000

WIP Stock 1 Week 1

(32,76,000 × 52) 63,000

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CA Amit Sharma
Finished goods stock 2 Weeks (37,44,000 × 52)
2 1,44,000

Debtors (on cost) 4 Weeks (28,08,000 × 52)

4 2,16,000

Cash & Bank Given 50,000

(A) 6,35,000
Current Liabilities
Creditors 4 Weeks (28,08,000 × 52)
4 2,16,000

Outstanding wages 2 Weeks 2

(4,68,000 × 52) 18,000

Outstanding 2 Weeks 2
(4,68,000 × 52) 18,000
overheads
(B) 2,52,000
Working capital (A) – (B) 3,83,000

Note 1: Cost structure: (For 78,000 units)

Selling price per unit = 46,80,000/78,000 = 60
Particulars Per unit Total
Raw material 36 28,08,000
Labour 6 4,68,000
Variable overheads 1 78,000
Fixed overheads (excluding depreciation) 3,90,000
Total Cost 37,44,000

Note 2: Cost structure for WIP:

Particulars Degree of completion Rs.
Raw Material 100% 28,08,000
Wages 50% 2,34,000
Variable overheads 50% 39,000
Fixed overheads 50% 1,95,000
Total 32,76,000

Note 3 : Calculation of cash cost of sales :

Particulars Total
Cost of sales i.e. total cost 37,44,000
(-) Cash sales i.e. 25% (9,36,000)
Cash cost of credit sales 28,08,000

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CA Amit Sharma

Q3. Compute the requirement of Working Capital of a company from the

following information provided
Sales for current year: Rs.25,00,000
There will be increase in sales by 40% in the next year.
Gross Profit: 20% on sale
Creditor purchase: 1/4th of Cost of Goods Sold
Average collection period = 60 days
Average payment period = 60 days
Inventory Holding Period = 90 days
(On the basis of cost of goods sold)
Cash and Bank Balance 2% of Sales
For calculation 1 year to be taken 12 x 30 = 360 days.
[Dec. 2017 (8 Marks)
SOLUTION:
Sales (after 40% increase) 35,00,000
(-) Gross profit (20% on sales) (7,00,000)
Cost of goods sold 28,00,000
Credit purchase = 28,00,000 × ¼ = 7,00,000

Particulars Norms Calculations Rs.

Current Assets :
Inventory 90 days 90
(28,00,000 × 360) 7,00,000

Debtors (on sales) 60 days 60

(35,00,000 × 360) 5,83,333

Cash & Bank 2% of sales 70,000

(A) 13,53,333
Current Liabilities
Creditors 60 days 60
(7,00,000 × 360) 1,16,667

(B) 1,16,667
Working capital (A) – (B) 12,36,666

Q4. Gayatri Textiles Limited is a readymade garment manufacturing Problany.

Its production cycle indicates that material are introduced in ginning of the
production phase; wages and overhead accrue evenly throughout the period of

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cycle. The following figures for the 12 months ending 31st March, 2019 are
given below:
Production of shirts 54,000 units
Selling price per unit Rs 200
Duration of the production cycle 1 month
Raw material inventory held 2 month's consumption
Finished goods stock held 1 month
Credit allowed to debtors is 1.5 months and credit allowed by creditors is 1
month. Wages and overheads are paid in the next month following the month
of accrual. In the work-in-progress 50% of wage and overheads are supposed to
be conversion costs. The ratios of cost to sales price are - raw materials 60%,
direct wages 10% and overheads 20%.
Cash is to be held to the extent of 40% of current liabilities and an additional
safety margin of 15% on gross working capital will be maintained. Calculate
amount of working capital required for the company.
[Dec. 2020 (4 Marks)]
SOLUTION:
Statement showing working capital estimation
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock 2 months 2
(64,80,000 × 12) 10,80,000

WIP Stock 1 month 1

(81,00,000 × 12) 6,75,000

Finished goods stock 1 month 1

(97,20,000 × 12) 8,10,000

Debtors (on sales) 1.5 months (1,08,00,000 × 12 )

1.5 13,50,000

Cash & Bank 40% of current liabilities 3,24,000

(A) 42,39,000
Current Liabilities
Creditors 1 month 1
(64,80,000 × 12) 5,40,000

Outstanding wages 1 month 1

(10,80,000 × 12) 90,000

Outstanding overheads 1 months 1

(21,60,000 × 12) 1,80,000

(B) 8,10,000
Gross working capital 34,29,000

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 93
CA Amit Sharma
Safety Margin 15% 5,14,350
Working capital (A) – (B) 39,43,350

Note 1: Cash cost structure for the year (54,000 units)

Particulars per unit Per unit total
Raw Material 60% 120 64,80,000
Direct Labour 10% 20 10,80,000
Overheads 20% 40 21,60,000
Total Cost 90% 180 97,20,000
Profit 10% 20 10,80,000
Sales 100% 200 1,08,00,000

Note 2: Cash cost structure for WIP:

Particulars Degree of Total
completion
Raw Material 100% 65,80,000
Direct wages 50% 5,40,000
Overheads 50% 10,80,000
Total 81,00,000

Q5. From the following information provided, you are required to calculate the
working capital requirement for the company. Present your calculation in a
Tabular Form.

(a) Cost per unit:

Rs.
Raw Material 208
Direct Labour 78
Overheads 156
Total Cost 442
Profit 78
Selling Price per 520
unit

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 94
CA Amit Sharma

(b) Raw material will be in stock on an average for one month holding.
1. Work in Process will comprise of 100% of material, 50% of wages and
overheads for average of half a month.
2. Finished goods will be in stock on average of one month.
3. Credit allowed by suppliers of Raw Material is one month.
4. Time lag in payment of wages is 1½ weeks.
5. Time lag in payment of overheads is 1 month.
6. Time lag in payment from Debtors is 2 months.
7. Cash Balance is to be maintained at a minimum of 4,80,000.

(c)Level of activity : Production of 70,000 units per annum. It is to be assumed

that production is carried on evenly throughout the year and wags and overhead
accrue similarly.
(d)Calculation to be based on 30 days a month and 52 weeks in a year.
(e)Finished goods will be valued at total cost.
[Dec. 2018(16 Marks)]

SOLUTION:
Statement showing working capital estimation
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock 1 month 1
(1,45,60,000 × 12) 12,13,333

WIP Stock 0.5 month 0.5

(2,27,50,000 × 12 ) 9,47,917

Finished goods stock 1 month 1

(3,09,40,000 × 12) 25,78,333

Debtors (on sales) 2 months 2

(3,64,00,000 × 12) 60,66,667

Cash & Bank Given 4,80,000

(A) 1,12,86,250
Current Liabilities
Creditors 1 month 1
(1,45,60,000 × 12) 12,13,333

Outstanding wages 1.5 week 1.5

(54,60,000 × 52 ) 1,57,500

Outstanding overheads 1 months 1

(1,09,20,000 × 12) 9,10,000

(B) 22,80,833

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 95
CA Amit Sharma
Working capital (A) – (B) 90,05,417

Note 1 : Cash cost structure for the year (70,000 units)

Particulars per unit total
Raw Material 208 1,45,60,000
Direct Labour 78 54,60,000
Overheads 156 1,09,20,000
Total Cost 442 3,09,40,000
Profit 78 54,60,000
Sales 520 3,64,00,000

Note 2 : Cash cost structure for WIP :

Particulars Degree of Total
completion
Material 100% 1,45,60,000
Labour 50% 27,30,000
Overheads 50% 54,60,000
Total 1,08,00,000

Q6. Management of Rose Ltd. is contemplating the next year budget, and hence
required to work out the working capital requirements for the next year. The
following information has been provided by the budget committee.
Estimated value for per unit of finished product:

Particulats (Per
Unit)
Raw materials 60
Direct wages 30
Cash based Manufacturing & administrative 20
overhead 10
Depreciation 10
Selling and distribution overhead 130
Total cost 200
Selling price

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 96
CA Amit Sharma

Additional information provided by the concerned committee member of

budget committee is as under.
(1) Expected level of activity would be 60,000 units.

(2) Raw material cost consists of the following:

Particulars (Per Unit)

Dried milk powder 40

Coco butter 18

Vanilla essence 2

(3) Raw materials are purchased from different suppliers, and those s suppliers
are extending different credit period as indicated hereunder:

Particulars Credit period in months

Dried milk powder 2

Coco butter ½

Vanilla essence 1

(4) Product is in process for a period of ½ month. Production process requires

100%t dried milk powder and coco butter in the beginning of the process Vanilla
essence is required at a uniform and constant rate during the process

(5) Direct wages and other overhead accrue at a uniform rate throughout
production process.

(6) Past trends indicate that dried milk powder is required to be stored for
two months period and other materials to be stored for one month, before it
would be given for the production process.

(7) Finished goods are kept in stock for a period of one month.

(8) It is estimated that one-fourth of total sales would be on cash basis.

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 97
CA Amit Sharma

(9) The past experience also indicates that it took generally two months time
to collect the receivables from the debtors.
(10) Average time-lag in payment of all overhead is one month and ½ month
in case of labour payment.

(11) Desired cash balance to be maintained throughout the year at the level of
1 lakh.
From the above information, you are required to determine the net working
capital requirement on cash basis.
[June 2018 (16 Marks)]
SOLUTION:
Statement showing working capital estimation
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock
Dried milk powder 2 months (24,00,000 × 12)
2 4,00,000

Coco butter 1 month (10,80,000 × 12)

1 90,000

Vanilla essence 1 month 1

(1,20,000 × 12) 10,000

WIP Stock 0.5 month 0.5

(50,40,000 × 12 ) 2,10,000

Finished goods stock 1 month (66,00,000 × 12)

1 5,50,000

Debtors (Note 3) 2 months (54,00,000 × 12)

2 9,00,000

Cash & Bank Given 1,00,000

(A) 22,60,000
Current Liabilities
Creditors for raw material
Dried milk powder 2 months (28,00,000 × 12)
2 4,66,667

Coco butter 0.5 months 0.5

(11,70,000 × 12 ) 48,750

Vanilla essence 1 month 1

(1,30,000 × 12) 10,833

Outstanding direct wages 0.5 month 0.5

(18,00,000 × 12 ) 75,000

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 98
CA Amit Sharma
Outstanding 1 months (12,00,000 × 12)
1 1,00,000
manufacturing &
administration overheads
Outstanding selling and 1 months (6,00,000 × 12)
1 50,000
distribution overheads
(B) 7,51,250
Working capital (A) – (B) 15,08,750

Note 1 : Cash cost structure for the year (60,000 units)

Particulars per unit total
Raw material
− Dried milk powder 40 24,00,000
− COCO butter 18 10,80,000
− Vanilla essence 2 1,20,000
Direct wages 30 18,00,000
Manufacturing & administration 20 12,00,000
overheads 110 66,00,000
Cash cost of production 10 6,00,000
Selling distribution overheads 120 72,00,000
Cash cost of sales

Note 2 : Cash cost structure for WIP :

Particulars Degree of total
completion
Raw material
− Dried milk powder 100% 24,00,000
− COCO butter 100% 10,80,000
− Vanilla essence 50% 60,000
Direct wages 50% 9,00,000
Manufacturing & administration 50% 6,00,000
overheads 50,40,000
Total

Note 3: Computation of cash cost of credit sales:

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 99
CA Amit Sharma
Particulars Rs.
Cash cost of sales 72,00,000
(-) Cash cost cash sales (72,00,000 × 25%) (18,00,000)
Credit Sales 54,00,000

Note 4: Computation of purchase:

Opening stock Purchase - Closing stock = Raw Material consumed
Opening stock is not given in problem so equation for calculation of purchase will
be-
Raw Material consumed Closing stock = Purchase
Dried milk powder =24,00,000+4.00,000=28,00,000
Coco butter =10,80,000+90,000=11,70,000
Vanilla essence =1,20,000+10,000=1,30,000
NOTE: One can also calculate creditors for raw material by taking 'Raw Material
Consumed as base instead of 'Purchase as calculated above.

Q7. Ice Descor Lad, sells goods at a uniform rate of gross profit of 20% on sales
including depreciation as part of cost of production. Its annual figures for the current
year are as under

Sales (at 2 months credit) 24,00,000

Materials consumed (suppliers credit 2 months) 6,00,000
Wages paid (monthly at the beginning of the subsequent 4,80,000
month) 6,00,000
Manufacturing expenses (cash expenses are paid - one
month in arrear) 1,50,000
Administration expenses (cash expenses are paid one
month in arrear) 75,00,000
Sales promotion expenses (paid quarterly in advance)

The company keeps one month stock each of raw materials and finished goods.
A minimum cash balance of Rs 80,000 is always kept. The company wants to
adopt 10% safety margin in the maintenance of working capital. The company
has no Work-in-progress
Find out the requirement of working capital of the company on cash cost basis.
[June 2021 (16 marks)], [Dec. 2010 (12 marks)], [June 2012 (20 Marks)]

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 100
CA Amit Sharma
SOLUTION:
Statement showing working capital estimation on cash cost basis :
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock 1 months (6,00,000 × 1 ) 50,000
12

Finished goods stock 1 month (97,20,000 × 12)

1 8,10,000

Debtors 2 months (19,05,000 × 2 ) 3,17,500

12

Prepaid sales promotion exp 1 quarter (75,000 × 4)

1 18,750

Cash & Bank Given 80,000

(A) 42,39,000
Current Liabilities
Creditors 2 months (6,00,000 × 2 ) 1,00,000
12

Outstanding wages 1 month (4,80,000 × 12)

1 40,000

Outstanding manufacturing 1 months (60,000 × 1 ) 50,000

12
exp
Outstanding admin exp 1 months (1,50,000 × 1 ) 12,500
12

(B) 2,02,500
Working capital (A) – (B) 4,03,750

Note 1: Computation of cost of goods sold :

Particulars Rs.
Sales 24,00,000
(-) Gross profit @20% (4,80,000)
Cost of production 19,20,000

Above calculated cost of production contains depreciation; hence following

computation has to be made to find out cash cost of production and
depreciation.
Note 2. Cost Structure:
Particulars Total
Material Consumption 6,00,000

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 101
CA Amit Sharma
Wages 4,80,000
Cash manufacturing expenses 6,00,000
Cost of production 16,80,000
Depreciation (Bal. Fig.) 2,40,000
Cash cost of production 19,20,000

Note 3: Computation of cash cost of sales:

Particulars Rs.
Cash cost of production 16,80,000
Administrative expenses 1,50,000
Sales promotion expenses 75,000
Cash cost of sales 19,05,000

Q8. Fortune Ltd. plans to manufacture and sell 400 units of electronic
appliances per month at a price of 600 each. The ratios of cost to selling price
are as follows:
(% of selling price)
Raw materials 30%
Packing material 10%
Direct labour 15%
Direct expenses 5%
Fixed overhead are estimated at 4,32,000 per annum.

The following norms are maintained for inventory management:

Raw materials 30 days
Packing materials 15 days
Finished goods 200 units
Work-in-progress 7 days

Other particulars are given below:

1. Credit sales represent 80% of total sales and dealers enjoy 30 working days
credit. Balance 20% are cash sales.
2. Creditors allow 21 working days credit for payment.
3. Lag in payment of overhead and expenses is 15 working days.
4. Cash requirements to be 12% of net working capital.

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 102
CA Amit Sharma
5. Working days in year are taken as 300 days for budget year.
Calculate the net working capital required and the maximum permissible bank
finance under second method of financing as per Tandon Committee norms.
[Dec. 2021 (16 Marks)]
SOLUTION:
Statement showing working capital estimation on cash cost basis :
Particulars Norms Calculations Rs.
Current Assets :
Raw material stock 30 days 30
(8,64,000 × 300) 86,400

Packing materials 15 days (2,88,000 ×

15
) 14,400
300

WIP Stock 7 days 7

(13,68,000 × 300) 31,920

Finished goods stock 200 units (21,60,000 × 200 𝑢𝑛𝑖𝑡𝑠 ) 90,000

4,800 𝑢𝑛𝑖𝑡𝑠

Debtors (on sales) 30 days 30

(23,04,000 × 300) 2,30,400

(A) 4,53,120
Current Liabilities
Creditors for raw material 21 days 21
(8,64,000 × 300) 60,480

Creditors for packing 21 days 21

(2,88,000 × 300) 20,160
material
Outstanding direct 15 days 15
(1,44,000 × 300) 7,200
expenses
Outstanding overheads 15 days 15
(4,32,000 × 300) 21,600

(B) 1,09,440
Net working capital (A) – (B) 3,43,680
Cash (12% of working 41,242
capital)
Total Working capital 3,84,922

Note 1 : Cost structure for the year (400  12 = 4,800 units)

Particulars % per unit total
Raw material 30% 180 8,64,000
Packing material 10% 60 2,88,000
Direct Labour 15% 90 4,32,000

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 103
CA Amit Sharma
Direct expenses 5% 30 1,44,000
Fixed overheads 4,32,000
Total cost 21,60,000
Profit (Bal. Fig.) 7,20,000
Sales 100% 600 28,80,000

Note 2 : Cost structure for WIP :

Particulars Degree of completion Rs.
Raw material 100% 8,64,000
Direct Labour 50% 2,16,000
Direct Expenses 50% 72,000
Fixed overheads 50% 2,16,000
Total 13,68,000

Note 3 : Computation of credit sales

Particulars Rs.
Total sales 28,80,000
(–) cash sales (28,80,000  20%) (5,76,000)
Credit sales 23,04,000

Maximum permissible bank borrowing as per 1st and 2nd method of lending under
the Tandon committee norms
Method 2 : = [75% of current Assets – Current Liabilities]
= [(75%  4,53,120) – 1,09,440]
= 2,30,400

Q9. The following projected figures are available for Ritu Ltd., a trading concern
for the year 2017-2018:
Sales: Rs. 27,00,000
Purchase: Rs. 18,70,000
01-04-2017 31-03-2018
Inventory 3,00,000 3,40,000
Debtors 3,40,000 2,60,000
Creditors 1,80,000 1,40,000
All sales and purchase are on credit and assume 365 days in a year.

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 104
CA Amit Sharma
Compute the cash operating cycle in days.
[Dec. 2017 (4 Marks)]
SOLUTION:
Op. inventory + purchase – Cl. inventory = inventory consumed
3,00,000 + 18,70,000 – 3,40,000 = 18,30,000
Calculation of operating cycle :
Inventory conversion period :
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 3,20,000
× 365 𝑑𝑎𝑦𝑠 = 18,30,000 × 365 = 64 𝑑𝑎𝑦𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑐𝑜𝑛𝑠𝑢𝑚𝑒𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟

Debtors collection period

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 3,00,000
× 365 𝑑𝑎𝑦𝑠 = 27,00,000 × 365 = 41 𝑑𝑎𝑦𝑠
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠

Creditors payment period

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 1,60,000
× 365 𝑑𝑎𝑦𝑠 = 18,70,000 × 365 = 31 𝑑𝑎𝑦𝑠
𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒

Operating cycle = (64+41–31) = 74 days

Q10. Following facts are available for Astro Ltd. :

(i) Cash turnover rate is 5.
(ii) Annual cash outflow is Rs. 1,75,000.
(iii) Accounts payable can be stretched by 12 days.
What would be the effect of stretching accounts payable on the minimum
operating cash requirements? If the firm can earn 10% on its investments, what
would be the savings on cost?
Assume 360 days in a year.
[Dec. 2009 (6 Marks)]
SOLUTION:
Present cash cycle = 360 days / 5 = 72 days
Proposed cash cycle when accounts payable stretched by 12 days =
72 days – 12 days = 60 days
Proposed cash turnover rate would be = 360 days / 60 days = 6
Minimum operating cash requirement:
Present = Rs. 1,75,000/5 = Rs 35,000
Proposed = Rs. 1,75,000/6 = Rs. 29,167

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 105
CA Amit Sharma
Reduction in investment= Rs. 35,000 – Rs. 29,167 = Rs. 5,833
Therefore, savings in cost = Rs. 5,833  10% = Rs. 583.30

2. CASH BUDGET:

Q11. Following results are expected by XYZ Ltd. by quarters next year :

Quarter 1 2 3 4
Sales 7,500 10,500 18,000 10,500
Cash payment
Production costs 7,000 10,000 8,000 8,500
Selling, admin and other costs 1,100 2,000 2,900 1,600
Purchase of plant and other fixed assets 100 1,000 2,100 2,100

Debtors at the end of a quarter are one-third of sales for the quarter. The
opening balance of debtors is Rs. 30,00,000. Cash on hand at the beginning of
the year is Rs. 6,50,000 and the desired minimum balances is Rs. 5,00,000.
Borrowings are made at the beginning of quarter in which the need will occur
in multiples of Rs. 10,000 and are repaid at the end of quarter. Interest charges
may be ignored.
You are required to prepare :
(i) A cash budget by quarters for the year, and
(ii) State the amount of loan outstanding at the end of the year.
[Dec. 2021(8 Marks)]
SOLUTION:
Cash Budget
Quarter 1 2 3 4
Opening cash balance (A) 650 550 500 500
Receipts
– Cash sales 5,000 7,000 12,000 7,000
– Cash received from debtors 3,000 2,500 3,500 6,000
Total receipts (B) 8,000 9,500 15,500 13,000
Payments:
– Production cost 7,000 10,000 8,000 8,500
– Selling, admin and other costs 1,000 2,000 2,900 1,600
– Purchase of plant and other fixed 100 1,000 2,100 2,100
assets 8,100 13,000 13,000 12,200

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 106
CA Amit Sharma
Total payment (C) 550 (2,950) 3,000 1,300
Closing cash balance (A) + (B) – (C) – 3,450 (2,500) (800)
Borrowings taken or repaid 550 500 500 500
Required minimum balance

3. EOQ AND MATERIAL STOCK LEVEL:

Q12. Bharati fiber products produces a special fiber at the rate of 5,000 meters
per hour. The fiber is used in other products made by the company at the rate
of 20,000 meters per day. Cost of fiber is Rs. 5 per meter. The inventory
carrying cost is 25% and set-up costs are Rs. 4,050.
Compute the optimum number of cycles required in a year for the manufacture
of this special fiber. Working hours per day are 8 hours. Assume 365 days in a
a year.
[June 2015(8 marks)]
SOLUTION:
Annual requirement = 20,000  365 = 73,00,000
Annual carrying cost :
Production rate of fiber = 5,000 meters per hour
20,000
Usage rate = = 2,500 meters per hour
8

Carrying cost p.u. - 5  25% = 1.25

1.25
Annual carrying cost p.u. = 5,000 × (5,000 − 2,500) = 0.625

2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑆𝑒𝑡𝑢𝑝 𝑐𝑜𝑠𝑡

EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×73,00,000 ×4,050
EOQ = √ 0.625

EOQ = 3,07,584.13 say 3,07,584

73,00,000
Optimum cycles = = 23.73 𝑠𝑎𝑦 24 𝑐𝑦𝑐𝑙𝑒𝑠
3,07,584

Q13. In happy Ltd. for one of the A-class items, the following data are available:
Annual demand : 1,00 units
Ordering cost : Rs. 400
Holding cost : 40%
Cost per unit : Rs. 20
Following three strategies are under consideration for the procurement:

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 107
CA Amit Sharma
(i)Place 4 orders of equal size every year.
(ii)Place an order for 500 units at a time and avail a discount of 10% on the cost
of items.
(iii)Follow EOQ police.
Which of the above strategies do you recommend ? Justify your answer.
[Dec. 2014 (5 Marks)]
SOLUTION:
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×1,000 ×400
EOQ = √ 20 ×40%

8,00,000
EOQ = √ 8

EOQ = 316.23 say 316 units

Total cost at EOQ policy :

Rs.
Material Cost (1,000  20) 20,000
(+) Ordering cost 1,000
[ 316 × 400] 1,266

(+) Carrying cost [

316
× 20 × 40%] 1,264
2

22,530

Total cost when 4 orders of equal size are placed every year:
Rs.
Material Cost (1,000  20) 20,000
(+) Ordering cost 1,000
[ 250 × 400] 1,600

(+) Carrying cost [

250
× 20 × 40%] 1,000
2

22,600

Total cost when order for 500 units at a time is placed to avail a discount of 10%
Rs.
Material Cost (1,000  18) 18,000
(+) Ordering cost 1,000
[ 500 × 400] 800

Fast Cost FM by AB
DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 108
CA Amit Sharma
(+) Carrying cost [
500
× 20 × 40%] 1,800
2

20,600

Analysis: Total cost is less when order for 500 units at a time is placed to avail a
discount of 10%.

Q14. Sona Ltd. manufactures a product which has a weekly demand of 2,500
units. The product requires 5 kg of material for every finished unit of product.
Material is purchased at Rs. 104 per unit. The ordering cost is Rs. 200 per order
and the carrying cost is 10% per annum.
Answer the following
(i)Calculate economic order quantity. Assume 52 weeks in a year.
(ii)Should the company accept and offer of 3% discount by the supplier who
wants to supply the annual requirement of the material in five equal
installments?
[June 2015(8 Marks)], [June 2016(8 Marks)]
SOLUTION:
Weekly demand = 2,500 units; Annual demand = 1,30,000 units
Calculation of annual consumption :
For 1 finished unit = 5 kg
For 1,30,000 units = ?
1,30,000 ×5
= 6,50,000 kg.
1

2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡

EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×6,50,000 ×200
EOQ = √ 104 ×10%

EOQ = 5,000 kg

Total cost at EOQ policy :

EOQ = 316.23 say 316 units
Rs.
Material Cost (6,50,000  104) 6,76,00,000
(+) Ordering cost [
6,50,000
× 200] 26,000
5,000

(+) Carrying cost [

1,581
× 104 × 10%] 26,000
2

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CA Amit Sharma
6,76,52,000

Total cost when 3% discount is offered by supplier for supply of material in 5 equal
installments:
Rs.
Material Cost (6,50,000  100.88) 6,55,72,000
(+) Ordering cost 6,50,000
[1,30,000 × 200] 1,000

(+) Carrying cost [

1,30,000
× 100.88 × 10%] 6,55,720
2

6,62,28,720
Analysis : Supplier offer can be accepted as it will save Rs. 14,23,280.

Q15. Product Y is sold for Rs. 20 per unit. The demand for the product is at a
constant rate of 2,000 units per month. The cost price per unit is Rs. 10. The
ordering cost is Rs. 1.20 per order and the carrying cost is 10% per annum.
Calculate EOQ and number of orders needed per year.
[Dec. 2016(4 Marks)]
SOLUTION:
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×24,000 ×1.2
EOQ = √ 10 ×10%

57,600
EOQ = √ 1

EOQ = 240
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 24,000
No. of orders = 𝑅𝑒−𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔/𝐸𝑂𝑄 𝑄𝑡𝑦. = = 100 𝑜𝑟𝑑𝑒𝑟𝑠
240

Q16. Calculate the minimum stock level, Maximum stock level, Reordering
level and Average stock level from the following information :
(1)Minimum Consumption = 100 units per day
(2)Maximum Consumption = 150 units per day
(3)Normal Consumption = 120 units per day
(4)Re-order period = 10 (min) – 15 (max) units per day
(5)Re-order quantity = 1,500 units per day
(6)Normal re-order period = 12 days

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CA Amit Sharma
[June 2017 (4 Marks)]
SOLUTION:
Calculation of Re-order Level :
(Maximum usage  Maximum delivery period)
(150 units  15 days)
2,250 units

Calculation of Minimum Level :

Re-order level - (Normal usage  Normal delivery period)
2,250 units - (120 units  12 days)
810 units

Calculation of Maximum level :

(Re-order level + Re-ordering qty.) – (Minimum usage  Minimum delivery period)
(2,250 units + 1,500 units) – (100 units  10 days)
2,750 units

Calculation of Maximum level :

𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝐿𝑒𝑣𝑒𝑙+𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐿𝑒𝑣𝑒𝑙
2

(810 units + 2,750 units) / 2

1,780 units
OR
Average Level = Minimum Level + ½ Recording quantity
= 810 units + ½ 1,500 units
= 1,560 units

Q17. The following information is available for a component in use at TQR Ltd.
Normal usage 150 Units per month
Maximum usage 250 units per month
Minimum usages 50 units per month
Economic order quantity (EOQ) 1,000 units
Lead time for orders 1 to 2 months
Calculate following parameters for the component :
(i) Re-order level
(ii) Maximum level

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CA Amit Sharma
(iii) Minimum Level
(iv) Average Level
[June 2021 (4 Marks)]
SOLUTION:
Re-order level = (Maximum usage  Maximum delivery period)
= (250  2)
= 500
Minimum level = Re-order level – (Normal usage  Average delivery period)
= 500 – (150  1.5)
= 275
Maximum level = (Re-order level + Re-ordering qty.) – Minimum usage  Minimum
delivery period)
= (500 + 1,000) – (50  1)
= 1,450
𝑀𝑖𝑛𝑖𝑚𝑢𝑚 𝑙𝑒𝑣𝑒𝑙+𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝐿𝑒𝑣𝑒𝑙
Average level = 2

= (275+1,450)/2
= 862.5
OR
Average level = Minimum level + ½ Re-ordering quantity
= 275 + ½ 1,000
= 775

Q18. In Delhi Ltd. the following data is available for one of the A class items of
inventory:
Annual usage 1,000 units
Ordering cost Rs. 400
Carrying cost 40%
Unit cost Rs. 20
Which of the following strategies being considered would you advise ?
Give detailed working in support of your SOLUTION:
(i) Place 4 orders of equal size every year.
(ii) Place an order for 500 units at a time and avail a discount of 10%
on the cost of items.
[Dec. 2017(4 Marks)]
SOLUTION:

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2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×1,000 ×𝑅𝑠.400
EOQ = √ 𝑅𝑠.20 ×10%

8,00,000
EOQ = √ 8

EOQ = 316.22 say 316 units

Total cost at EOQ level purchase :

Rs.

Material Cost (1,000 units  Rs. 20) 20,000

(+) Ordering cost 1,000 𝑢𝑛𝑖𝑡𝑠
[ 316 𝑢𝑛𝑖𝑡𝑠 × 𝑅𝑠. 400] 1,266

(+) Carrying cost [

316 𝑢𝑛𝑖𝑡𝑠
× 𝑅𝑠. 8] 1,264
2

22,530

Total cost when purchased in 4 orders of equal size every year i.e. in lot of 250 unit.
Rs.
Material Cost (1,000 units  Rs. 20) 20,000
(+) Ordering cost 1,000 𝑢𝑛𝑖𝑡𝑠
[ 250 𝑢𝑛𝑖𝑡𝑠 × 𝑅𝑠. 400] 1,600

(+) Carrying cost [

250 𝑢𝑛𝑖𝑡𝑠
× 𝑅𝑠. 8] 1,000
2

22,600

Total cost when purchased in lot of 500 units at 10% discount:

Rs.
Material Cost (1,000 units  Rs. 18) 18,000
(+) Ordering cost 1,000 𝑢𝑛𝑖𝑡𝑠
[ 500 𝑢𝑛𝑖𝑡𝑠 × 𝑅𝑠. 400] 800

(+) Carrying cost [

500 𝑢𝑛𝑖𝑡𝑠
× 𝑅𝑠. 7.2] 1,800
2

20,600
Analysis: As total cost is minimum when purchased in lot of 500 units at 10%
discount, this strategy is recommended.

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CA Amit Sharma

Q19. Kopla Ltd. manufactures a product X. To produce one unit of finished

produce one unit of finished product, 4 kg of raw material is required. The sales
department has estimated an annual demand of 5,00,000 units. Stock position
at the beginning of the year is as below :
Product X 20,000 units
Raw material 40,000 kg
To place an order the company has to spent Rs. 1,500. The company is
financing its working capital using a bank cash credit @12%.
Product X is sold at Rs. 1,040 per unit, Material is purchased at Rs. 150 per kg.
Compute :
(a) Economic order quantity.
(b) Number of orders place in a year.
[Dec. 2018(4 Marks)]
SOLUTION:
Annual demand = 5,00,000 units
Opening units = 20,000 units
Units required to be produced = 4,80,000 units
Calculation of annual consumption :
For 1 finished unit = 4 kg
For 4,80,000 units = ?
4,80,000 × 4
= 19,20,000 𝑘𝑔
1
Opening stock of raw material = 40,000 kg
19,20,000 kg – 40,000 kg = 18,80,000
Calculation of EOQ :
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×18,80,000 ×1,500
EOQ = √ 150 ×12%

EOQ = 17,701 kg

Calculation of No. of orders :

𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 18,80,000
= = 106 𝑜𝑟𝑑𝑒𝑟𝑠
𝑅𝑒 − 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑜𝑟 𝐸𝑂𝑄 𝑞𝑡𝑦 17,701

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Q20. A firm purchases 4,000 units of a particular item per annum at Rs. 40 per
unit. Ordering cost is Rs. 100 per order and inventory carrying cost is 12.5%.
Required
(a)Determine optimal order quantity.
(b)If a 3% discount is offered by the supplier for purchase in lot of 1,000 or
more, should the firm accept the offer?
[June 2019 (4 Marks)]

SOLUTION:
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √
𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×4,000 ×100
EOQ = √ 40 ×12.5%

8,00,000
EOQ = √ 5

EOQ = 400

Total cost at EOQ policy

Rs.
Material Cost (4,000 units  40) 1,60,000
(+) Ordering cost 4,000
[ 400 × 100] 1,000

(+) Carrying cost [

400
× 40 × 12.5%] 1,000
2

1,62,000

Total cost when 3% discount is offered by supplier for purchase in lot of 1,000
Rs.
Material Cost (4,000  38.8) 1,55,200
(+) Ordering cost 4,000
[1,000 × 100] 400

(+) Carrying cost [

1,000
× 38.8 × 12.5%] 2,425
2

1,58,025
Analysis: Offer of supplier can be accepted as it will save Rs. 3,975.

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CA Amit Sharma

Q21. XYZ Ltd. has an annual requirement for a certain material of 500 tonnes.
The ordering cost per order is Rs. 6,250 and the stock holding cost is estimated
at 25% of the material cost per annum.
You are required to :
(i) Compute EOQ if the price per tonne is Rs. 5,250.
(ii) Calculate the total number of orders to be placed per year.
[Dec. 2020(4 Marks)]
SOLUTION:
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×500 ×6,250
EOQ = √ 5,250 ×25%

65,50,000
EOQ = √ 1,312.5

EOQ = 69

Q22. The quarterly producing of a company's product which has a steady

market of 20,000 units. Each unit of a product requires 0.5 kg of raw material
at a cost of Rs. 20 per kg. The cost of placing an order for raw material is Rs.
100 and inventory carrying cost is 10%.
You are required to calculate :
(i) Economic order quantity.
(ii) Number of order placed in a year.
[Dec. 2021 (4 marks)]
SOLUTION:
Calculation of annual consumption :
20,000  4 = 80,000
For 1 unit – 0.5 kg of raw material
For 80,000 – ?
2 ×𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ×𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
EOQ = √ 𝐶𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 𝑝.𝑢.𝑝.𝑎

2 ×40,000 ×100
EOQ = √ 40 ×10%

80,00,000
EOQ = √ 2

EOQ = 2,000

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Calculation of No. orders :
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑛𝑢𝑚𝑝𝑡𝑖𝑜𝑛 40,000
= = 20 𝑜𝑟𝑑𝑒𝑟𝑠
𝑅𝑒 − 𝑜𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝑜𝑟 𝐸𝑂𝑄 𝑞𝑡𝑦. 2,000

4. ABC ANALYSIS:

Q23. A company is considering selective inventory control using the following

data.

Item No. Units Unit cost (Rs.)

1 6,000 4.00
2 61,200 0.05
3 16,800 2.10
4 3,000 6.00
5 55,800 0.20
6 22,680 0.50
7 26,640 0.65
8 14,760 0.40
9 20,520 0.40
10 90,000 0.10
11 29,940 0.30
12 24,660 0.50

Arrange the data for presentation to management for implementation of ABC

technique of inventory management.
[June 2016(4 Marks)]
SOLUTION:
Item No. Units Unit cost Total cost Total cost Classification
(Rs.) in %
1 6,000 4.00 24,000 14.58% A
2 61,200 0.05 3,060 1.86% C
3 16,800 2.10 35,280 21.44% A
4 3,000 6.00 18,000 10.94% A
5 55,800 0.20 11,160 6.78% A
6 22,680 0.50 11,340 6.89% A
7 26,640 0.5 17,316 10.52% A

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8 14,760 0.40 5,904 3.59% C
9 20,520 0.40 8,208 4.99% B
10 90,000 0.10 9,000 5.47% B
11 29,940 0.30 8,982 5.46% B
12 24,660 0.50 12,330 7.49% A

Summary of classification :
Classification Item Total Cost Rs. Total Cost in %
A 1,3,4,5,6,7,12 1,29,426 78.68%
B 9,10,11 26,190 15.91%
C 2,8 8,964 5.45%
1,64,580 100.00%

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SECURITY ANALYSIS

QUESTIONS AND SOLUTIONS

Q1. Your client is holding following securities as proxy of market portfolio :

Particulars Purchase Dividends Expected Beta 𝜷

of Securities Price (Rs.) (Rs.) market
price after 1
year
Equity
shares : 8,000 800 8,200 0.80
Company A 10,000 800 10,500 0.70
Company B 16,000 800 22,000 0.50
Company C 34,000 3,400 32,300 1.00
PSU Bonds

Assume a risk free rate of 15%.

Calculate expected rate of return in each, using capital asset pricing model if
shares are held for 1 year.
[June 2014(4 marks)],
[Dec. 2017 (4 Marks)]
SOLUTION:
Calculation of expected rate of return on market portfolio :
Particulars Initial price Dividends (Rs.) Capital gain
(Rs.) (Rs.)
Equity shares :
Company A 8,000 800 200
Company B 10,000 800 500
Company C 16,000 800 6,000
PSU Bonds 34,000 3,400 (1,750)
68,000 5,800 5,000

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 5,800 + 5,000

× 100 = × 100 = 15.88%
𝐼𝑛𝑖𝑡𝑖𝑎𝑛 𝑃𝑟𝑖𝑐𝑒 68,000
Expected rate of retun on individual security using CAPM :

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ER = Rf + 𝛽 (Rm – Rf)
Company A = 15 + 0.8 (15.88 – 15) = 15.704 %
Company B = 15 + 0.7 (15.88 – 15) = 15.616 %
Company C = 15 + 0.5 (15.88 – 15) = 15.44 %
PSU bonds = 15 + 1.00 (15.88 – 15) = 15.88 %
Calculation of average return of portfolio :
15.704+15.616+15.44+15.88
= 15.66
4

Q. 2 Zebra Ltd has a beta (𝜷) of 1.15. The return on market portfolio is 14%.
What would be the expected rate of return on the shares of Zebra Ltd., if the
risk free rate of return is 5%? What are the implications? Also compute the
alpha, if the actual rates of returns over 4 observations are as under :
Year Year 1 Year 2 Year 3 Year 4
Return of Zebra (%) 18.33 12.65 15.35 16.57
[Dec. 2014 (4 Marks)]
SOLUTION:
ER = Rf + 𝛽 (Rm – Rf)
= 5 + 1.15 (14–5)
= 15.35 %
Actual Required Alpha Strategy Reason
return return as per Value
CAPM (𝛼)
18.33% 15.35% 2.98 Buy Security is undervalued
12.65% 15.35% -2.70 Sell Security is overvalued
15.35% 15.35% 0 Hold Security is correctly
16.57% 15.35% 1.22 Buy valued
Security is undervalued

Q. 3 Following particulars about four corporate securities are available: -

Security Today's Predicted price Expected Beta

price after one year dividend during Estimates
(Rs.) (Rs.) coming year (Rs.)
A 490 580 7.0 1.4
B 180 200 7.0 1.2
C 570 640 5.0 1.0
D 220 245 6.0 0.5

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Expected rate of return in the market is 14% and the risk free rate of return is
8%. You are required to calculate for each security –
(i) The estimated return based on the CAPM model and
(ii) Predicted return.
[Dec.2014(10 Marks)]
SOLUTION:
Calculation f expected rate of return on market portfolio :
Security Initial Price Dividends (Rs.) Capital gain
(Rs.) (Rs.)
A 490 7.0 90
B 180 7.0 20
C 570 5.0 70
D 220 6.0 25
1,460 25.0 205

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑔𝑎𝑖𝑛 25 + 205

× 100 = × 100 = 15.75%
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑝𝑟𝑖𝑐𝑒 1,460

Expected rate of retun on individual security using CAPM:

ER = Rf + 𝛽 (Rm – Rf)
A = 8 + 1.4 (14 – 8) = 16.4 %
B = 8 + 1.2 (14 – 8) = 15.2 %
C = 8 + 1.0 (14 – 8) = 14.0 %
D = 15 + 1.00 (15.88 – 15) = 15.88 %
Calculation of average return of portfolio:
15.704+15.616+15.44+15.88
= 15.66
4

Q. 4 Return on Luck Ltd.'s share has a standard deviation of 22%, as against

the standard deviation of the market as 12%. The correlation co-efficient
between market at 12%. The correlation co-efficient between market and stock
of lucky ltd. is 0.7%.
Computer the Beta (𝜷) value, systematic risk and unsystematic risk of Lucky
Ltd's shares.
[June2015(4 Marks)]
SOLUTION:
𝜎
𝛽 = 𝜎 × 𝐶𝑜𝑟𝑟𝑆𝑀
22
= 12 × 0.7

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= 1.2833
Systematic risk = Beta  SD of market
= 𝛽 × 𝜎𝑀
= 15.4%
Unsystematic risk = Total risk – Systematic risk
= 22 – 15.4
= 6.6%

Q. 5 In a portfolio of the company Rs. 2,00,000 have been invested in Asset–

X which has an expected return of 8.5%, Rs. 2,80,000 in Asset–Y, which has an
expected return of 10.2% and Rs. 3,20,000 in Asset–Z. Which has an expected
return of 12%.
What is the expected return for the portfolio?
[Dec.2015(4 Marks)]
SOLUTION:
Asset Rs. Weight Return Product
X 2,00,000 25% 8.5 212.5
Y 2,80,000 35% 10.2 357.0
Z 3,20,000 40% 12 480.0
8,00,000 100% 1,049.5

1,049.5
Expected return for the portfolio = = = 10.495%
100

Q. 6 Kareena software, a technology firm, has three divisions with the

following characteristics:

Division Beta Market value

(Rs. in lakh)
Personal Computers 1.40 120
Software 1.90 160
Computer mainframes 1.00 260
Total 540

You are required to answer the following –

(i) What is beta of the equity of the firm?

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(ii) What would happen to the beta of equity if the firm divested itself
of its software business ?

If you are asked to value the software business for the divestiture, which beta
would you use in your valuation ? Restrict calculations to two decimal points.
[June 2016 (4 Marks)]
SOLUTION:
Computation of beta
Division Market value Weight Beta Product
(Rs. in lakh)
Personal computers 120 22.22% 1.40 31.11
Software 160 29.63% 1.90 56.30
Computer mainframes 260 48.15% 1.00 48.15
Total 540 100% 135.56

135.56
Beta of the equity of the firm = = 1.3556
100

Beta of equity if the firm divested itself of its software business

Division Market value Weight Beta Product
(Rs. in lakh)
Personal computers 120 31.58% 1.40 44.21
Computer mainframes 260 68.42% 1.00 68.42
Total 380 100% 112.63

112.63
New beta of the firm after disinvestment in software business = = 1.1263
100

To value the software business for the divestiture, beta 1.9 would be used for
valuation.

Q. 7 The following data relate to two securities, A and B:

A B

Expected return 22% 17%

Beta factor (𝜷) 1.5 0.7

Assume RF = 10% and RM = 18%.

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Find out whether the securities, A and B are correctly priced ?
[Dec. 2016 (4 marks)]
SOLUTION:
ERA = Rf + 𝛽 (Rm – Rf) ERB = Rf + 𝛽 (Rm – Rf)
= 10 + 1.5 (18–10) = 10 + 0.7 (18–10)
= 22% = 15.6%

Security Required Expected Strategy Reason

return as per return
CAPM
A 22% 22% Hold As security is correctly
B 15.6% 17% Buy valued
As security is
undervalued

Q. 8 The following information is available in respect of security X and

security Y.

Security 𝜷 Expected rate of return

X 1.8 22.00%
Y 1.6 20.40%

Rate of return of market portfolio is 15.3%. If risk-free rate of return is 7%, are
these securities correctly priced? What would be the risk-free rate of return, if
they are correctly priced?
SOLUTION:
ERX = Rf + 𝛽 (Rm – Rf)
= 7 + 1.8 (15.3–7)
= 21.94%
ERY = Rf + 𝛽 (Rm – Rf)
= 7 + 1.6 (15.3–7)
= 20.28%

Computation of alpha value :

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Security Actual return required return as per Deviation 𝛼
CAPM
X 22.00 21.94 0.06
Y 20.40 20.28 0.12
Alpha value is positive for both securities and hence securities are undervalued. Such
security should be bought.
Computation of risk free rate so that securities are correctly priced.
Let the Rf be 'x'
ERX = Rf + 𝛽 (Rm – Rf) ERX = Rf + 𝛽 (Rm – Rf)
22 = x + 1.8 (Rm – Rf) 20.40 = x + 1.6 (Rm – Rf)
22−𝑥 20.4−𝑥
= (Rm – Rf) = (Rm – Rf)
1.8 1.6

22 − 𝑥 20.4 − 𝑥
=
1.8 1.6
35.2 – 1.6𝑥 = 36.72 − 1.8𝑥
−1.52 = −0.2𝑥
𝑥 = 7.6
Therefore, both securities would be correctly valued when the risk free rate of return
is 7.6%.

Q. 9 King has purchased a bond for Rs. 1,000 with a coupon payment of Rs.
250 and sold for Rs. 1,200.
(i) What is the holding return of King?
(ii) If king sells the bond for Rs. 800 after receiving the Rs. 250 as coupon
payment then what is the holding return of King?
[June 2017(4 marks)]
SOLUTION:
(𝑃1 − 𝑃0 )+1
Holding period return = × 100 = 15.55%
𝑃0
(1,200−1,000)+250
(i) Holding period return = × 100 = 45%
1,000
(800−1,000)+250
(ii) Holding period return = × 100 = 5%
1,000

Q. 10 From the information related to annual return earned by investor's

through investment in the shares of Pink Ltd., and also the return earned

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by investor's community at large from index rate movements in the
recognized stock exchange; compute the beta value of Pink Ltd.

Year Return on shares Return earned by

of Pink Ltd. (%) Investors community
(%)
2012 14.00 6.00
2013 21.00 8.00
2014 (6.00) (2.00)
2015 4.00 12.00
2016 20.00 14.00
2017 1900 16.00

[June 2018(4 marks)]

SOLUTION:
Method 1 :
𝛴𝑋𝑌 − 𝑛 𝑋̅𝑌̅
𝛽=
𝛴𝑌 2 − 𝑁 𝑌̅ 2
X Y XY Y2
14 6 84 36
21 8 168 64
(6) (2) 12 4
4 12 48 144
20 14 280 196
19 16 304 256
𝑋̅ = 12 𝑌̅ = 9 ΣXY = 896 ΣY2 = 700

𝛴𝑋𝑌−𝑛 𝑋̅ 𝑌̅ 896−6×12×9 248

𝛽= = = = 1.16
𝛴𝑌 2 −𝑁 𝑌̅ 2 700−6×81 214

Method 2
Alternatively, beta can be calculated using following formula :
𝐶𝑜𝑣𝑆𝑀
𝛽= (𝜎𝑀 )2

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Calculation of covariance between security & market :
P Ds DM P  DS  DM
0.1667 2 (3) (1)
0.1667 9 (1) (1.5)
0.1666 (18) (11) 32.99
0.1667 (8) 3 (4)
0.1667 8 5 6.67
0.1666 7 7 8.16
CovSM 41.32

R D D2 P PD2
6 (3) 9 0.1667 1.5
8 (1) 1 0.1667 0.17
(2) (11) 121 0.1666 20.16
12 3 9 0.1667 1.5
14 5 25 0.1667 4.17
16 7 49 0.1666 8.16
𝑌̅ = 9 𝜎2 35.66
𝜎 5.97%

𝐶𝑜𝑣𝑆𝑀 41.32
𝛽= (𝜎𝑀 )2
= 35.66 = 1.16

Method 3 : Alternatively, beta can be calculated using following formula :

𝜎
𝛽 = 𝜎 𝑠 × 𝐶𝑜𝑟𝑟𝑆𝑀
𝑀

Calculation of standard deviation of security :

R D D2 P PD2
14 2 4 0.1667 1
21 9 81 0.1667 13.50
(6) (18) 324 0.1666 53.98
4 (8) 64 0.1667 10.67
20 8 64 0.1667 10.67
19 7 49 0.1666 8.16
𝑌̅ = 12 𝜎2 97.98
𝜎 9.99%

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𝐶𝑜𝑣𝑆𝑀 41.32 41.32
𝐶𝑜𝑟𝑟𝑆𝑀 = 𝜎 = 9.99 ×5.97 = 59.64 = 0.6928
𝑆 × 𝜎𝑀

𝜎 9.99
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 5.97 × 0.6928 = 1.16
𝑀

Q. 11 Aarvi, a portfolio manager of WX Mutul fund coordinates and take all

necessary decisions to provide the sufficient return to the investors of fund.
The following information is available with respect to the portfolio created and
managed by her:
(1)Risk Free rate of interest generally applicable in an economy is 8%.
(2)Expected market return by investing community is 14%.
(3)Standard deviation of assets deployed by fund is 3.0%.
(4)Standard deviation registered and normally recorded by market is 4%.
(5)Correlation coefficient of portfolio of fund with market is 1%.
From the above information, calculate the expected rate of return of portfolio.
[June 2018(8 Marks)]
SOLUTION:
𝜎 3
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 4 × 1 = 0.75
𝑀

Calculation of required return on the security :

ER = Rf + 𝛽 (Rm – Rf)
= 8 + 0.75 (14–8)
= 12.5%
Q. 12 Raj has recently created his portfolio and he has provided the information
given below :

Security Amount invested Expected Return Beta

Stock A (Rs.) (%) 0.80
Stock B 10,000 8 0.95
Stock C 20,000 12 1.10
Stock D 30,000 15 1.40
40,000 18

Calculate his expected return from this portfolio. What is the beta of this
portfolio? Comment on this portfolio also.
[Dec. 2018(4 Marks)]
SOLUTION:
Calculation of expected return of portfolio :

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Security Rs. Weight Expected Return (%) Product
Stock A 10,000 10% 8% 80
Stock B 20,000 20% 12% 240
Stock C 30,000 30% 15% 450
Stock D 40,000 40% 18% 720
1,00,000 100% 1,490
Portfolio return = Weighted return = 1,490/100 = 14.90%

Calculation of beta of portfolio:

Security Rs. Weight 𝛽 Product
Stock A 10,000 10% 0.80 8
Stock B 20,000 20% 0.95 19
Stock C 30,000 30% 1.10 33
Stock D 40,000 40% 1.40 56
1,00,000 100% 116
Portfolio return = Weighted beta = 𝛽 = 116/100 = 1.16

Q. 13 Apple Ltd. and Banana Ltd. have been paying a dividend of Rs. 64 per
share each year to their shareholders. Beta coefficient of these two companies
is 1.25 and 1.40 respectively. If the risk-free return is 6% and market return is
10%, what is the prediction about share price of these two entities?
[June 2019(4 Marks)]
SOLUTION:
Expected return of Apple Ltd :
ER = Rf + 𝛽 (Rm – Rf)
= 6 + 1.25 (10–6)
= 11%
Predication of price of Apple Ltd.
𝐷
𝑃0 = 𝐾
𝑒

64
= 0.11 = 581.82

Expected return of Apple Ltd :

ER = Rf + 𝛽 (Rm – Rf)
= 6 + 1.40 (10–6)
= 11.6%

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Predication of price of Apple Ltd.
𝐷
𝑃0 =
𝐾𝑒
64
= 0.116 = 551.72

Q. 14 A portfolio manager has the following five stocks in his portfolio:

Security No. of shares Price/Share (Rs.) Beta

A 10,000 50 1.2
B 5,000 20 2.0
C 8,000 25 0.7
D 1,000 100 1.0
E 500 200 1.3

Required:
(a)Calculate portfolio Beta.
(b)If the manager wants to reduce the beta to 0.8, how much of risk-free
investment should he bring in? What will be the new portfolio?
[June 2019 (4 Marks)]
SOLUTION:
Security Total Market Value Weight 𝜷 Product
(Rs.)
A 5,00,000 50% 1.2 0.6
B 1,00,000 10% 2.0 0.2
C 2,00,000 20% 0.7 0.14
D 1,00,000 10% 1.0 0.1
E 1,00,000 10% 1.3 0.13
Portfolio beta = Weighed beta = 𝛽 = 1.17
To reduce the beta from 1.17 to 0.8, the portfolio manager may sell of a portion of
the portfolio and use the proceeds to but the risk free securities.
Let the percentage investment in Existing portfolio = x
Thus percentage investment in risk free securities = (1–x)
Beta of risk free security = 0 [Zero]
Beta of portfolio = [x  1.17] + [(1 – x)  0] = 0.8
1.17x = 0.8
x = 0.6838 i.e. 68.38%
Thus,

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Weight of Existing portfolio = 68.38%
Weight of risk free securities = 31.62% (100–68.38)
Conclusion = This implies that a portfolio consisting of Rs. 6,83,800 (0.6838 
10,00,000) invested in the 5 securities and Rs. 3,16,200 in risk free securities will
have a beta of 0.8.

Q. 15 As an investment manager, you are given the following information

Investment in Expected Standard Beta

equity share of Return (%) Deviation (%)
A Ltd. 22% 40% 0.86
B Ltd. 24% 38% 1.24

The correlation coefficient between the returns of two stocks is 0.72. The
standard deviation of the market return is 20%.
Required:
(i) Is investment in B Ltd. better than A. Ltd?
(ii) If you invest 70% in A Ltd. and 30% in B Ltd., what is your expected rate
of return and standard deviation?
(iii) What is the rate of return on market portfolio and what is risk free rate?
(iv) What is beta of portfolio, If weights of A Ltd. and B Ltd. are 70% and 30%
respectively?
[June 2019 (8 marks)]
SOLUTION:
(i)
Particulars A Ltd. B Ltd.
Expected return 22% 24%
Standard 40% 28%
deviation
A Ltd. has lower return and carries high risk as compared to B Ltd. Hence, investing
in B Ltd. is better than investing in A Ltd.
(ii) Investing 30% in B Ltd. and 70% in A Ltd.
Expected return = (22  70%) + (24  30%) = 22.6%
𝐶𝑜𝑣𝐴𝐵
𝐶𝑜𝑟𝑟𝐴𝐵 = 𝜎
𝐴 × 𝜎𝐵
𝐶𝑜𝑣𝐴𝐵
0.72 = 40 × 38

𝐶𝑜𝑣𝐴𝐵 = 0.72  40  38 = 1,094.4

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A B
0.7 0.3
A 0.7 1,600 1,094.4
B 0.3 1,094.4 1,444

1 0.7  0.7  1,600 = 784.00

2 0.7  0.3  1,094.4 = 229.82
3 0.3  0.7  1,094.4 = 229.82
4 0.3  0.3  1,444 = 129.96
𝜎2 = 1,373.60
𝜎 = 37.06%

Alternatively portfolio risk can be calculated by using formula method as follows :

√(𝜎𝐴 )2 × (𝑊𝐴 )2 + (𝜎𝐵 )2 × (𝑊𝐵 )2 + [2 × 𝜎𝐴 × 𝑊𝐴 × 𝜎𝐵 × 𝑊𝐵 × 𝐶𝑜𝑟𝑟𝐴𝐵 ]

√1600 × 0.49 + 1,444 × 0.09 + [2 × 40 × 0.7 × 38 × 0.3 × 0.72]

√784 + 129.96 + 459.65

√1373.61
Portfolio risk = 𝜎 = 37.06%

(iii) Calculation of risk free rate of return

Let the be Rf 'x' and (Rm – Rf) be 'y'
ERA = Rf + 𝛽 (Rm – Rf) ERB = Rf + 𝛽 (Rm – Rf)
22 = x + 0.86  y 24 = x + 1.24  y
22 = x + 0.86y 24 = x + 1.24y
22 = x + 0.86y
24 = x + 1.24y
– 2 = –0.38y
y = 2/0.38 = 5.2632
y = Rm - Rf = 5.2632

Putting value of 'y' in first equation we can get value of 'x'

22 = x + 0.86y
22 = x + 0.86  5.2632
22 = x + 4.5264
x = Risk free rate = 17.47%

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Calculation market rate of return :
Rm – Rf = 5.2632
Rm – 17.47 = 5.2632
Rm = 22.73%

(iv)Calculation of beta of portfolio if A Ltd's weight is 70% and B Ltd's weight is 30%.
(0.86  0.7) + (1.24  0.3) = 0.974

Q.16 Security A offers an expected rate of return of 14% with a standard

deviation of 8%. Security B offers an expected rate of return of 11% with a
standard deviation of 6%. If an investor wishes to construct a portfolio with a
12.8% expected return, What percentage of the portfolio will consist of security
A?
[Dec. 2020 (4 Marks)]
SOLUTION:
Weight of Security A = x
Weight of security B = (1–x)
Expected return of the portfolio = [x  0.14] + [(1–x)  0.11] = 0.128
0.14x + 0.11 – 0.11x = 0.128
0.03x + 0.11 = 0.128
0.03x = 0.018
x = 0.6 i.e. 60%
Thus, investment in security A is 60% and in security B is 40%.

Q. 17 A portfolio manager (PM) has the following four stocks in his portfolio:

Security No. of Market price per share Beta

shares (Rs.)
Dahila Ltd. 10,000 50 0.9
Rose Ltd. 5,000 20 1.0
Cauliflower Ltd. 8,000 25 1.5
Apples Ltd. 2,000 200 1.2

Compute the following:

(i) Portfolio beta
(ii) If the PM seeks to reduce the beta to 0.8, how much risk free investment
should be bring in?

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(iii) If the PM seeks to increase the beta is 1.2, how much risk free investment
should he bring in?
[Dec. 2020 (4 marks)]
SOLUTION:
Security Total Market value (Rs.) Weight 𝛽 Product
Dahila Ltd. 5,00,000 41.67% 0.9 0.3750
Rose Ltd. 1,00,000 8.33% 1.0 0.833
Cauliflower 2,00,000 16.67% 1.5 0.2501
Ltd. 4,00,000 33.33% 1.2 0.4000
Apples Ltd. 12,00,000 100% 1.1084
Portfolio Beta = Weighted beta = 𝛽 = 1.1084
Reduction of beta to 0.8
To reduce the beta from 1.1084 to 0.8, the portfolio manager may sell off a portion of
the portfolio and use the proceeds to buy the risk free securities.
Let the percentage investment in Existing portfolio = x
Thus percentage investment in Existing portfolio = (1–x)
Beta of risk free security = 0 [Zero]
Beta of portfolio = [x  1.17] + [1(1–x) 0] = 0.8
1.1084x = 0.8
x = 0.7218 i.e. 72.18%
Thus,
Weight of Existing portfolio = 72.18%
Weight of risk free securities = 27.82% (100–68.38)
Conclusion : This implies that a portfolio consisting of Rs. 8,66,160 (12,00,000 
72.18%) invested in the 4 securities and Rs. 3,33,840 in risk free securities will have
a beta of 0.8.

Increase in beta to 1.2 :

Let the percentage investment in Existing portfolio = x
Thus percentage investment in risk free securities = (1–x)
Beta of risk free security = 0[Zero]
Beta of portfolio = [x  1.17] + [(1–x)  0] = 1.2
1.1084x = 1.2
x = 1.0826 i.e. 108.26%
Thus,

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Weight of Existing portfolio = 108.26%
Weight of risk-free securities = –8.26% (100–108.26)
Conclusion: The portfolio manager should borrow Rs. 99,120 (12,00,000  8.26%)
at the risk -free rate and invest total funds Rs. 12,99,120 in the four securities.

Q. 18 From the following information, calculate the expected rate of return of

a portfolio:

Risk free rate of return 12% p.a.

Expected return on market portfolio 20% p.a.
Standard deviation of an asset 3%
Market standard deviation 2.5%
Correlation coefficient of portfolio with market 0.80

[June 2021 (4 marks)]

SOLUTION:
𝜎 3
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 2.5 × 0.8 = 0.96
𝑀

Calculation of required return of security :

ER = Rf + 𝛽 (Rm – Rf)
= 22 + 0.96 (20–12)
= 19.68%

Q. 19 Following particulars about four corporate securities (shares) are

available:

Security Today's Predicted Expected Beta

price (Rs.) price after one dividend estimates
year during coming (𝜷)
year
A 490 580 7.0 1.4
B 180 200 7.0 1.2
C 570 640 5.0 1.0
D 220 245 6.0 0.5
Expected rate of return in the market is 14% and the risk free rate of return is
8%. You are required to calculate for each security :
(i) The estimated return based on the capital asset pricing model (CAPM),and
(ii) Predicted return
Also state, whether the securities are undervalued or overvalued.
[June 2021 (8 marks)]

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SOLUTION:
Expected rate of return on individual security using CAPM :
ER = Rf + 𝛽 (Rm – Rf)
A = 8 + 1.4 (14-8) = 16.40 %
B = 8 + 1.2 (14-8) = 12.50 %
C = 8 + 1.0 (14-8) = 14.00 %
D = 8+0.5 (14-8) = 11.00%

Predicted return :
(𝑃1 −𝑃0 )+𝐷
𝑅= × 100
𝑃0
(580−490)+7
A= × 100 = 19.80%
490
(200−180)+7
B= × 100 = 15.00%
490
(640−570)+5
C= × 100 = 13.16%
180
(245−220)+6
D= × 100 = 13.16%
220

Security Required Predicted Reason

return as per return
CAPM
A 16.40% 19.80% Security is undervalued
B 15.20% 15.00% Security is overvalued
C 14.00% 13.16% Security is overvalued
D 11.00% 14.09% Security is undervalued

Q. 20 In the context of CAPM, what is the expected return of security 'J' if it

has the following characteristics and if the following information holds for the
market portfolio?
Standard Deviation, Security J 0.20
Standard Deviation, Market Portfolio 0.15
Expected return, Market portfolio 0.13
Co-relation between possible returns
for security J and the market portfolio 0.80
Risk free rate of return 0.07
You are required to comment:
(a)What would happen to the required return if the standard deviation for the
security were higher.

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(b)What would happen if the correlation co-efficient were less ?
(c)What is the functional relationship between the required return for a securing
and market risk?
[Dec. 2021(4 Marks)]
SOLUTION:
𝜎 0.20
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 0.15 × 0.8 = 1.06
𝑀

Calculation of required return of security :

ER = Rf + 𝛽 (Rm – Rf)
= 7 + 1.06 (13–7)
= 13.36%
(a)if the standard deviation for the security is higher, Expected return (ER) will be
increase.
Thus, if we increase standard deviation of security from 0.20 to 0.25, ER increase to
14.98%.
𝜎 0.25
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 0.15 × 0.8 = 1.33
𝑀

ER = Rf + 𝛽 (Rm – Rf)
= 7 + 1.33 (13–7)
= 14.98%
(b)If the correlation co-efficient decreases, the ER will decrease. Thus, If we decrease
correlation co-efficient from 0.80 to 0.70, ER increase to %
𝜎 0.20
𝛽 = 𝜎 𝑆 × 𝐶𝑜𝑟𝑟𝑆𝑀 = 0.15 × 0.70 = 0.93
𝑀

ER = Rf + 𝛽 (Rm – Rf)
= 7 + 0.93 (13–7)
= 12.58%
(c)If standard deviation [𝜎] is higher, the expected return would increase and if
standard deviation [𝜎] is low, the expected return would decrease. Therefore, the
return for a security is directly proportional to market risk.

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INTRODUCTION TO FINANCIAL MANAGEMENT

QUESTIONS AND SOLUTIONS

Q1. Distinguish between financial distress and financial insolvency.

[June 2021 (5 marks)]

SOLUTION:
Financial distress is a tight cash situation in which a business cannot pay the own
amounts on the due date. If prolonged this situation can force the organization into
bankruptcy or forced liquidation.
Financial insolvency means the organization can no longer meet its financial
obligations with its lender or lenders as debt becomes due. insolvency can lead to
insolvency proceedings in which legal actions will be taken against the insolvent
entity and assets may be liquidated to pay off outstanding debts.
That is the difference between the illness and death.
A permanent financial distress may lead an organization to the chaotic financial
insolvency state.

Q2. An investor suffers dilution of financial interest when he does not exercise
his preemptive rights. Comment.
[June 2008(5 marks)]

SOLUTION:
To preserve the shareholder’s proportionate dividend, liquidation and voting rights,
preemptive rights are often recognized, but their existence and scope can be affected
by provisions in the article. However sec 62 of companies act 2013secures
shareholders preemptive rights with regard to the further issue of share capital by
the company.
As per sec 62 of companies act 2013 where at any tie a company having a share
capital proposes to increase its subscribed capital by the issue of further shares such
shares shall be offered to existing shareholders in proportion to the paid-up share
capital on those shares by sending letter of offer.
Thus, existing shareholders are given option to subscribe new shares if shareholder
does not exercise his preemptive rights his financial interests dilutes.

Q3. Financial management I science as well as art. Comment.

[dec 2015 (5 marks)]

SOLUTION:

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The financial management is neither a pure science nor an art. It deals with various
methods and techniques which can be adopted depending on the situation of the
business and the purpose of decision. As a science it uses various statistical and
mathematical models and computer applications fir solving the financial problems
relating to the firm, for ex: capital investment appraisal, capital allocation, and
rationing, optimizing capital structure mix, portfolio management etc.

Q4. Investment, financial and dividend decisions are interrelated. Comment.

[June 2021(5 marks) ]

SOLUTION:
Financial manager has to take following 3 types of decisions:
(a) Investment decisions: investment decisions relate to the careful selection of
viable and profitable investment proposals, allocation of funds to the
investment proposals with the view to obtain net present value of the future
earnings of the company and to maximize its value. It is a function of a finance
manager to carefully analyze the different alternatives of investment,
determination of investment levels in different assets i.e., fixed assets and
current assets.
(b) Finance decisions: one of the important functions of finance manager is
procurement of funds for the firm’s investment proposals and its working
capital requirements. In fund raising decisions he should keep in view the cost
of funds from various sources, determination of debt-equity mix, the
advantages of debt component in the capital mix, impact of taxation and
depreciation in maximization of earning per share to equity holder’s
consideration of control and financial strain on the firm in determining level of
gearing, impact of interest and inflation rates on the firm etc.
(c) Dividend decisions: the dividend decisions of the finance manager are mainly
concerned with the decisions relating to the distribution of earning of the
company among its equity holders and the amounts to be retained by the
company.
The investment, finance and dividend decisions are interrelated to each other and,
therefore, the finance manager while taking any decision, should consider the impact
from all the three angles simultaneously.

Q5. Elaborate the symptoms through which an analyst can get indication about
the probable financial distress of firm.
[June 2018 (4marks)]
SOLUTION:

Following are the symptoms to get an indication of financial distress:

1. Liquidity problems
2. Difficulty in obtaining market credit

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CA Amit Sharma
3. Higher prices charged by supplier of raw materials and services.
4. Difficulty in obtaining the market credit.
5. Delay in payment beyond the maturity or due date of payment.
6. Delay in realization of funds from debtors.
7. Excessive borrowing to meet the operating expenses.

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DEEPAK KEWALIA (CS,M.COM,LLB) 9799172734 140