ANSWERS OF MODEL TEST PAPER 1

INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
PART I
1. I. (b) ` 35,55,556
II. (c) ` 30,03,733
III. (a) ` 8,83,200
IV. (d) ` 4,83,200
V. (a) 16.09%
Working Note
Particulars (`)
Total Sales ` 200 lakhs
Credit Sales (80%) ` 160 lakhs
Receivables for 40 days ` 80 lakhs
Receivables for 120 days ` 80 lakhs
Average collection period [(40 x 0.5) + (120 × 0.5)] 80 days
Average level of Receivables (` 1,60,00,000  80/360) ` 35,55,556
Factoring Commission (` 35,55,556  2/100) ` 71,111
Factoring Reserve (` 35,55,556  10/100) ` 3,55,556
Amount available for advance {` 35,55,556 - (3,55,556 + ` 31,28,889
71,111)}
Factor will deduct his interest @ 18%:
`31,28,889 ×18×80 ` 1,25,156
Interest =
100 × 360
Advance to be paid (` 31,28,889 – ` 1,25,156) ` 30,03,733
(i) Statement Showing Evaluation of Factoring Proposal
`
A. Annual Cost of Factoring to the Company:
Factoring commission (` 71,111  360/80) 3,20,000
Interest charges (` 1,25,156  360/80) 5,63,200
Total 8,83,200
B. Company’s Savings on taking Factoring Service: `
Cost of credit administration saved 2,40,000
Bad Debts (` 160,00,000 x 1/100) avoided 1,60,000
Total 4,00,000

503
 C. Net Cost to the company (A – B) (` 8,83,200 – ` 4,83,200
4,00,000)
` 4,83,200
Effective cost of factoring = ×100 = 16.09%
` 30,03,733

2. B. ` 3,20,513; ` 8.33
(EBIT -I)(1- t) - Dp (EBIT -I)(1- t) - Dp
=
N1 N2
(x - 0)(1- 0.35) (x -1,00,000)(1- 0.35) - 60,000
=
25,000 10,000
x = EBIT = ` 3,20,513
At EBIT of ` 3,20,513, EPS under both options will be the same i.e.,
` 8.33 per share
3. D. 1.15
FL= % change in NP/%change in EBIT=6.9/6=1.15
4. C. 3 years
These deposits may be accepted for a period of six months to three
years.
PART II
1. (a)
Particulars (`’ in lakhs)
Net Profit 54
Less: Preference dividend 24
Earnings for equity shareholders 30
Earnings per share 30/2 = ` 15
Let, the dividend per share be D to get share price of ` 120.
r
D+Ke(E-D)
P =
Ke
Where,
P = Market price per share.
E = Earnings per share = ` 15
D = Dividend per share
R = Return earned on investment = 22%
Ke = Cost of equity capital = 15%
0.22
D + 0.15 (15-D)
120 =
0.15

504
 0.15D + 3.3 - 0.22D
18 =
0.15
0.07D = 3.3 – 2.7
D = 8.57
DPS 8.57
D/P ratio = ×100 = x 100 = 57.13%
EPS 15

So, the required dividend pay-out ratio will be = 57.13%

NOI ` 10,00,000
(b) Value of AN Ltd. = = = ` 50,00,000
Ko 20%

(i) Return on Shares of Mr. R on AN Ltd.

Particulars Amount (`)
Value of the company 50,00,000
Market value of debt (50% x ` 50,00,000) 25,00,000
Market value of shares (50% x ` 50,00,000) 25,00,000
Particulars Amount (`)
Net operating income 10,00,000
Interest on debt (10% × ` 25,00,000) 2,50,000
Earnings available to shareholders 7,50,000
Return on 8% shares (8% × ` 7,50,000) 60,000
` 7,50,000
(ii) Implied required rate of return on equity of AN Ltd. =
` 25,00,000
= 30%
(c) ANVY Ltd
Balance Sheet as on 31 st March, 2023
Liabilities ` Assets `
Equity share capital 2,00,000 Fixed assets 1,40,000
Current debt 60,000 Cash (balancing figure) 1,00,000
Long term debt 60,000 Inventory 80,000
3,20,000 3,20,000
Working Notes
1. Total debt = 0.60 x Equity share capital = 0.60 ` 2,00,000
= ` 1,20,000
Further, Current debt to total debt = 0.50. So, current debt
= 0.50 x `1,20,000 = ` 60,000,
Long term debt = `1,20,000 - `60,000= ` 60,000
2. Fixed assets = 0.70 × Equity share Capital = 0.70 × ` 2,00,000
= ` 1,40,000
3. Total assets to turnover = 2.5 Times: Inventory turnover = 10 Times

505
 Hence, Inventory /Total assets = 2.5/10=1/4, Total assets = ` 3,20,000
Therefore Inventory = ` 3,20,000/4 = ` 80,000
2. (a) Cash inflows after tax (CFAT)
Particular `
Current production (units per week) 5,000 units
New capacity (units per week) 15,000 units
Demand (units per week) 10,000 units
Increase in sales (units per week) A. 5,000 units
Contribution per unit (` 30,000 x 0.10) B. 3,000
Increase in contribution A x B x 56 84 crores
Less: Additional fixed cost 10 crores
Increase in profit 74 crores
Less: Tax @ 40% 29.6 crores
Profit after tax 44.4 crores
Tax shield due to depreciation
Year Depreciation Tax Shield PV Factor Total Present
(` in Crore) (` in Crore) @ 20% Value (` in Crore)
1 25.00 10 0.83 8.33
2 18.75 7.5 0.69 5.18
3 14.06 5.62 0.58 3.26
4 10.55 4.22 0.48 2.03
5 7.91 3.16 0.40 1.27
Total 20.07
Tax shield on capital loss = (23.73-20.00) x 30% = ` 1.12 crores
Net Present Value (NPV)
Particulars Year Cash Flow PVAF @ Present Value
(` in Crores) 20% (` in Crores)
Initial Investment 0 (100) 1 (100)
Working capital 0 (3) 1 (3)
Profit after tax 1-5 44.4 2.99 132.76
Salvage value 5 20 0.40 8.00
Tax shield on 1-5 20.07
Depreciation
Tax shield on 5 1.12 0.40 0.45
capital loss
Release of 5 3 0.40 1.20
Working Capital
NPV 59.47

506
 The company is advised to replace the old machine since the NPV of the
new machine is positive.
(b) Cut-off Rate: It is the minimum rate which the management wishes to
have from any project. Usually this is based upon the cost of capital. The
management gains only if a project gives return of more than the cut -
off rate. Therefore, the cut - off rate can be used as the discount rate or
the opportunity cost rate.
3. (a) Working Note:
Let the rate of Interest on debenture be x
 Rate of Interest on loan = 1.4x
RV -NP
Int (1- t)+
 kd on debentures = n
RV + NP
2
100 - 98
100x(1- 0.30)+
4
= 100 +98
2
70x +0.5
=
99
 Kd on bank loan = 1.4 x (1 – 0.30) = 0.98x
EPS 1 1 1
Ke = = = = = 0.25
MPS MPS / EPS PE 4
Ke = 0.25
Computation of WACC
Capital Amount Weights Cost Product
Equity 20,00,000 0.2 0.25 0.05
Reserves 30,00,000 0.3 0.25 0.075
Debentures 30,00,000 0.3 (70x+0.5)/99 (21x+0.15)/99
Bank Loan 20,00,000 0.2 0.98x 0.196x
1,00,00,000 1 0.125+0.196x
21x + 0.15
+
99
WACC = 16%

 0.125+0.196x+ 21x + 0.15 = 0.16

99
 12.375+19.404x+21x+0.15 = (0.16)(99)
 40.404x = 15.84 – 12.525
 40.404x = 3.315

507
  x = 3.315
40.404
 x = 8.20%
(i) Rate of interest on debenture = x = 8.20%
(ii) Rate of interest on Bank loan = 1.4x = (1.4)(8.20%) = 11.48%.
(b) In dividend price approach, cost of equity capital is computed by dividing
the expected dividend by market price per share. This ratio expresses
the cost of equity capital in relation to what yield the company should
pay to attract investors. It is computed as:
D1
Ke =
P0

Where,
Ke= Cost of equity
D = Expected dividend (also written as D 1)
P0 = Market price of equity (ex- dividend)
4. (a) Limitations of Profit Maximisation objective of financial management.
(i) The term profit is vague. It does not clarify what exactly it
means. It conveys a different meaning to different people. For
example, profit may be in short term or long term period; it may be
total profit or rate of profit etc.
(ii) Profit maximisation has to be attempted with a realisation of
risks involved. There is a direct relationship between risk and
profit. Many risky propositions yield high profit. Higher the risk,
higher is the possibility of profits. If profit maximisation is the only
goal, then risk factor is altogether ignored. This implies that finance
manager will accept highly risky proposals also, if they give high
profits. In practice, however, risk is very important consideration
and has to be balanced with the profit objective.
(iii) Profit maximisation as an objective does not take into account
the time pattern of returns. Proposal A may give a higher amount
of profits as compared to proposal B, yet if the returns of proposal
A begin to flow say 10 years later, proposal B may be preferred
which may have lower overall profit but the returns flow is more
early and quick.
(iv) Profit maximisation as an objective is too narrow. It fails to take
into account the social considerations as also the obligations to
various interests of workers, consumers, society, as well as ethical
trade practices. If these factors are ignored, a company cannot

508
 survive for long. Profit maximization at the cost of social and moral
obligations is a short sighted policy.
(b) Some common methods of venture capital financing are as follows:
(i) Equity financing: The venture capital undertakings generally
require funds for a longer period but may not be able to provide
returns to the investors during the initial stages. Therefore, the
venture capital finance is generally provided by way of equity share
capital. The equity contribution of venture capital firm does not
exceed 49% of the total equity capital of venture capital
undertakings so that the effective control and ownership remains
with the entrepreneur.
(ii) Conditional loan: A conditional loan is repayable in the form of a
royalty after the venture is able to generate sales. No interest is
paid on such loans. In India venture capital financiers charge
royalty ranging between 2 and 15 per cent; actual rate depends on
other factors of the venture such as gestation period, cash flow
patterns, risk and other factors of the enterprise. Some Venture
capital financiers give a choice to the enterprise of paying a high
rate of interest (which could be well above 20 per cent) instead of
royalty on sales once it becomes commercially sound.
(iii) Income note: It is a hybrid security which combines the features of
both conventional loan and conditional loan. The entrepreneur has
to pay both interest and royalty on sales but at substantially low
rates. IDBI’s VCF provides funding equal to 80 – 87.50% of the
projects cost for commercial application of indigenous technology.
(iv) Participating debenture: Such security carries charges in three
phases — in the start-up phase no interest is charged, next stage
a low rate of interest is charged up to a particular level of operation,
after that, a high rate of interest is required to be paid.
(c) Optimum Capital Structure: The capital structure is said to be optimum
when the firm has selected such a combination of equity and debt so that
the wealth of firm is maximum. At this capital structure, the cost of capital
is minimum and the market price per share i.e. value of the firm is
maximum.

509
 OR
Financial leverage indicates the use of funds with fixed cost like long
term debts and preference share capital along with equity share capital
which is known as trading on equity. The basic aim of financial leverage
is to increase the earnings available to equity shareholders using fixed
cost fund.
A firm is known to have a positive/favourable leverage when its earnings
are more than the cost of debt. If earnings are equal to or less than cost
of debt, it will be an negative/unfavourable leverage. When the quantity
of fixed cost fund is relatively high in comparison to equity capital it is
said that the firm is ‘’trading on equity”.

510
 ANSWERS OF MODEL TEST PAPER 2
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
PART I – Case Scenario based MCQs
1. 1. (d) 14.99%
B = retention ratio=0.6, r=return on equity=20%, DPS=D0=20 x 0.4= 8,
MPS = P0 = EPS x PE = 20 x 15=300
G = b.r =0.6 x 20% = 12%
D1 = D0(1+g) = 8 (1.12) = 8.96
Ke = D1/P0 + g = 8.96/300 + 0.12 = 14.99%
2. (c) 90.58
Price of debentures= PV of future cash flows for investor
discounted at their yield
= 8 x PVAF(9.5%,10 years)+ 100 x PVF(9.5%, 10 years)
= 8 x 6.2788 + 100 x 0.4035
=50.2304 + 40.35
=90.58
3. (a) 7.64%
NP = 90.58 x 96% = 86.96, RV = 100, Interest = 8, t = 0.27, n = 10
Int (1 − t ) + ( RV − NP ) / n
Kd =
( RV + NP ) / 2
8 (1− 0.27 ) + (100 − 86.96 ) /10
=
(100 + 86.96 ) / 2
= 7.64%
4. (b) 9.77%
PD + ( RV − NP ) / n
Kp =
(RV + NP ) / 2
100 + (1100 − 1050 ) /10
=
(1100 + 1050 ) / 2
= 9.77%
5. (a) 10.52%
Existing Total Additional
Equity Funds 1,60,00,000 2,00,00,000 40,00,000

511
 Preference Shares 24,00,000 24,00,000
Debt 56,00,000 56,00,000
1,60,00,000 2,80,00,000 1,20,00,000

Capital gearing = 0.4

(PSC + Debt)/Equity = 0.4

(Total Funds -Equity)/
Equity = 0.4
(2.8 crores-Equity)/
equity = 0.4

Equity = 2 crores

Weighted avg cost Weights Cost W.C

of marginal capital
Equity Funds 40,00,000 0.333333333 14.99% 5.00%
Preference Shares 24,00,000 0.2 9.77% 1.952%
Debt 56,00,000 0.466666667 7.64% 3.565%
Total 1,20,00,000 10.52%
2. (a) 9.74%
RV -NP
I(1- t) +
K = n
d RV +NP
2
 110 - 85 
10(0.7)+ 10 
K = 
d 97.5
 
 
= 9.50/97.5 = 9.74%
3. (c) 2.5
Margin of safety = (sales – BEP sales)/sales x 100
= 40%
Degree of operating leverage = 1/MOS
= 1/40% = 2.5
4. (a) 20%
Average annual cash in flow
Payback Reciprocal =
Initial investment
` 4,000×100
= = 20%
` 20,000

512
 PART II – Descriptive Questions
1. (a) (i) Working Notes:
(i) Computation of Annual Cash Cost of (`)
Production
Material consumed 12,00,000
Wages 9,60,000
Manufacturing expenses 12,00,000
Total cash cost of production 33,60,000
(ii) Computation of Annual Cash Cost of Sales: (`)
Total Cash cost of production as in (i) above 33,60,000
Administrative Expenses 3,60,000
Sales promotion expenses 1,20,000
Total cash cost of sales 38,40,000
Add: Gross Profit @ 20% on sales (25% on cost 9,60,000
of sales)
Sales Value 48,00,000
Statement of Working Capital requirements (cash cost basis)
(`) (`)
A. Current Assets
Inventory:
- Raw materials 2,00,000
 ` 12,00,000 
 ×2 months 
 12months 
- Finished Goods 5,60,000
 ` 33,60,000 
 ×2 months 
 12months 
Receivables (Debtors) 9,60,000
 ` 38,40,000 
 ×3 months 
 12months 
Sales Promotion expenses paid in 10,000
 `1,20,000 
advance  ×1 month 
 12 months 
Cash balance 1,00,000 18,30,000
Gross Working Capital 18,30,000

513
 B. Current Liabilities:
Payables:
- Creditors for materials 2,00,000
 ` 12,00,000 
 ×2 months 
 12months 
Wages outstanding 80,000
 ` 9,60,000 
 ×1 month 
 12months 
Manufacturing expenses 1,00,000
outstanding
 ` 12,00,000 
 ×1 month 
 12months 
Administrative expenses outstanding 30,000 4,10,000
 ` 3,60,000 
 ×1 month 
 12months 
Net working capital (A - B) 14,20,000
Add: Safety margin @ 15% 2,13,000
Total Working Capital requirements 16,33,000
(b) (i) Calculation of market price per share
According to Miller – Modigliani (MM) Approach:

Where,
Existing market price (Po) = ` 600
Expected dividend per share (D 1) = ` 40
Capitalization rate (ke) = 0.20
Market price at year end (P1) =?
a. If expected dividends are declared, then
600=(P1+40)/(1+0.2)
600 x 1.2 = P1+40
P1 = 680
b. If expected dividends are not declared, then
600 = (P1+0)/(1 + 0.2)
600 x 1.2 = P1
P1= 720

514
 (ii) Calculation of number of shares to be issued
(a) (b)
Dividends are Dividends are
declared not Declared
(` lakh) (` lakh)
Net income 1500 1500
Total dividends (400) -
Retained earnings 1100 1500
Investment budget 2000 2000
Amount to be raised by new 900 500
issues
Relevant market price (` per 680 720
share)
No. of new shares to be issued 1.3235 0.6944
(in lakh)
(` 900 ÷ 680; ` 500 ÷ 720)
(iii) Calculation of market value of the shares
(a) (b)
Particulars Dividends are Dividends are
declared not Declared
Existing shares (in lakhs) 10.00 10.00
New shares (in lakhs) 1.3235 0.6944
Total shares (in lakhs) 11.3235 10.6944
Market price per share (`) 680 720
Total market value of shares 11.3235 × 680 10.6944 × 720
at the end of the year (` = 7,700 (approx.) = 7,700 (approx.)
in lakh)
Hence, it is proved that the total market value of shares remains
unchanged irrespective of whether dividends are declared, or not
declared.
(c) Calculation of Cash Flow after Tax
Year 1 Year 2 Year 3 Year 4 Year 5
Capacity 50% 65% 80% 100% 100%
Units 1,50,000 1,95,000 2,40,000 3,00,000 3,00,000
Contribution p.u. 360 360 360 360 360
(600 x 60%)
Total Contribution 5,40,00,000 7,02,00,000 8,64,00,000 10,80,00,000 10,80,00,000
Less: Fixed Asset 2,00,00,000 3,50,00,000 5,00,00,000 5,00,00,000 5,00,00,000
Less: Depreciation 4,00,00,000 2,40,00,000 1,44,00,000 86,40,000 51,84,000
(W.N.)

515
 PBT (60,00,000) 1,12,00,000 2,20,00,000 4,93,60,000 5,28,16,000
Less: Tax (18,00,000) 33,60,000 66,00,000 1,48,08,000 1,58,44,800
PAT (42,00,000) 78,40,000 1,54,00,000 3,45,52,000 3,69,71,200
Add: Depreciation 4,00,00,000 2,40,00,000 1,44,00,000 86,40,000 51,84,000
CFAT 3,58,00,000 3,18,40,000 2,98,00,000 4,31,92,000 4,21,55,200

Calculation of NPV
Year Description Cash Flow PVF PV
@12%
0 Initial Investment (10,00,00,000) 1 (10,00,00,000)
0 WC introduced (1,50,00,000) 1 (1,50,00,000)
3 WC introduced (2,00,00,000) 0.7118 (1,42,36,000)
1 CFAT 3,58,00,000 0.8929 3,19,65,820
2 CFAT 3,18,40,000 0.7972 2,53,82,848
3 CFAT 2,98,00,000 0.7118 2,12,11,640
4 CFAT 4,31,92,000 0.6355 2,74,48,516
5 CFAT 4,21,55,200 0.5674 2,39,18,860
5 WC released 3,50,00,000 0.5674 1,98,59,000
5 Scrap Sale 2,00,00,000 0.5674 1,13,48,000
Net Present Value 3,18,98,684
Working Notes (W.N.)
Calculation of Depreciation
Year Opening WDV Depreciation Closing WDV
1 10,00,00,000 4,00,00,000 6,00,00,000
2 6,00,00,000 2,40,00,000 3,60,00,000
3 3,60,00,000 1,44,00,000 2,16,00,000
4 2,16,00,000 86,40,000 1,29,60,000
5 1,29,60,000 51,84,000 77,76,000
2. (a) Income statement
Particulars P Q
(`) (`)
Sales 50,00,000 48,00,000
(–) Variable Cost 33,50,000 24,00,000
Contribution 16,50,000 24,00,000
Fixed Cost 8,25,000 16,00,000
EBIT 8,25,000 8,00,000
(–) Interest 5,50,000 6,00,000
EBT 2,75,000 2,00,000

516
 (–) Tax 82,500 60,000
EAT 1,92,500 1,40,000
(÷) No. of Shares 1,00,000 70,000
EPS ₹ 1.93 ₹ 2.00
Working Note :
1. Financial = EBIT = EBIT
Leverage EBT (EBIT – Int.)
Let the EBIT be X
P Q
3 = X/(X – 5,50,000) 4 = X/(X – 6,00,000)
3(X – 5,50,000) = X 4(X – 6,00,000) = X
3X – 16,50,000 = X 4X – 24,00,000 = X
2X = 16,50,000 3X = 24,00,000
X = 8,25,000 X = 8,00,000
2. Operating Leverage = Contribution/EBIT
Let the Contribution be X
P Q
2 = X/8,25,000 3= X/8,00,000
X = 16,50,000 X = 24,00,000

3. Sales
Let the Sales be 100
Sales – Variable Cost = Contribution
P Q
Contribution = 100 – 67 = 100 – 50
= 33 = 50
Sales =
P Q
For 33 = 16,50,000 For 50 = 24,00,000
For 100 = 50,00,000 For 100 = 48,00,000
(b) Expected return on capital employed
Capital Employed = Debt + Equity
= (` 63,00,000 + ` 54,00,000) + (` 70,00,000 + ` 1,30,00,000)
= ` 3,17,00,000
 EBIT 
Return on capital employed/ROI =   x 100
 Capital employed 

517
At present:
 54,00,000 
=   x 100
 3,17,00,000 
= 17.03%
Now company expects 2% more as ROI
So, Expected ROI = 17.03% + 2%
= 19.03%
Proposed EBIT = Proposed Capital Employed x Return on capital
employed
= (` 3,17,00,000 + ` 50,00,000) x 19.03% = ` 69,84,010
(i) Market Price per Share:
Particular Financial Options
Option – I Option II
12% term 1,00,000 equity
loan of shares @ ` 20
` 50,00,000 and 11%
debentures of
` 30,00,000
(`) (`)
EBIT 69,84,010 69,84,010
Less: Interest
- 10% on old debentures 6,30,000 6,30,000
- 11% on new debentures - 3,30,000
- 12% on old term loan 6,48,000 6,48,000
- 12% on new term loan 6,00,000
Total Interest 18,78,000 16,08,000
EBT 51,06,010 53,76,010
Less Tax @ 30% 15,31,803 16,12,803
EAT 35,74,207 37,63,207
No. of equity shares 7,00,000 8,00,000
Earnings per share 5.11 4.70
P/E ratio 10 10
Market Price per Share = EPS x
51.06 47.04
P/E ratio

518
 (ii) Recommendation:
The option I is better and may be opted as both EPS and MPS are
higher.
Inventory 38,60,000 × 365
3. (a) Inventory Turnover = ×365 = = 184.41 days
COGS 76,40,000
= 185 days (apx)
Receivables
Receivables Turnover = ×365 = 39,97,000×365
1,25,00,000
= 116.71
Sales
= 117 days (apx)
Equity to Reserves = 1
Reserves = 1 x 30,00,000 = 30,00,000
Projected profit = 30,00,000 - 18,00,000 = 12,00,000
Net Profit Margin = 15%
12,00,000/ Sales = 0.15
Sales = 80,00,000
Gross Profit = 80,00,000 x 50% = 40,00,000
COGS = 80,00,000 - 40,00,000 = 40,00,000
Closing Receivables
Projected Debtors Turnover = 100 days = x 365
Sales
Closing Receivables
100 = x 365
80,00,000
80,00,000 x 100
Closing Receivables = = 21,91,781
365
Projected Closing Inventory = 70% of opening inventory = 70% of
38,60,000 = 27,02,000
Closing Creditors
Projected Creditor Turnover= 100 days = x365
COGS
COGS
Closing Creditors = x100
365
40,00,000
Closing Creditor = x100 = 10,95,890
365
Equity Share Capital + Reserves = 30,00,000 + 30,00,000 = 60,00,000
Long Term Debt to Equity = 0.5
LTD
= 0.5
60,00,000
Long Term Debt = 0.5 x 60,00,000
Long Term Debt = 30,00,000

519
 (b) Financial Instruments in the International Market
Some of the various financial instruments dealt with in the international
market are:
(a) Euro Bonds
(b) Foreign Bonds
(c) Fully Hedged Bonds
(d) Medium Term Notes
(e) Floating Rate Notes
(f) External Commercial Borrowings
(g) Foreign Currency Futures
(h) Foreign Currency Option
(i) Euro Commercial Papers.
4. (a) Inter-relationship between Investment, Financing and Dividend
Decisions: The finance functions are divided into three major decisions,
viz., investment, financing and dividend decisions. It is correct to say that
these decisions are inter-related because the underlying objective of
these three decisions is the same, i.e. maximisation of shareholders’
wealth. Since investment, financing and dividend decisions are all
interrelated, one has to consider the joint impact of these decisions on
the market price of the company’s shares and these decisions should
also be solved jointly. The decision to invest in a new project needs the
finance for the investment. The financing decision, in turn, is influenced
by and influences dividend decision because retained earnings used in
internal financing deprive shareholders of their dividends. An efficient
financial management can ensure optimal joint decisions. This is
possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their
inter-relationship and to see how they can help in maximising the
shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after
a careful assessment of the various projects through capital budgeting
and uncertainty analysis. However, only that investment proposal is to
be accepted which is expected to yield at least so much return as is
adequate to meet its cost of financing. This have an influence on the
profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each
source of funds involves different issues. The finance manager has to
maintain a proper balance between long-term and short-term funds. With
the total volume of long-term funds, he has to ensure a proper mix of
loan funds and owner’s funds. The optimum financing mix will increase
return to equity shareholders and thus maximise their wealth.

520
 Dividend decision: The finance manager is also concerned with the
decision to pay or declare dividend. He assists the top management in
deciding as to what portion of the profit should be paid to the
shareholders by way of dividends and what portion should be retained in
the business. An optimal dividend pay-out ratio maximises shareholders’
wealth.
The above discussion makes it clear that investment, financing and
dividend decisions are interrelated and are to be taken jointly keeping in
view their joint effect on the shareholders’ wealth.
(b) Liquidity versus Profitability Issue in Management of Working
Capital
Working capital management entails the control and monitoring of all
components of working capital i.e. cash, marketable securities, debtors,
creditors etc. Finance manager has to pay particular attention to the
levels of current assets and their financing. To decide the level of
financing of current assets, the risk return trade off must be taken into
account. The level of current assets can be measured by creating a
relationship between current assets and fixed assets. A firm may follow
a conservative, aggressive or moderate policy.

A conservative policy means lower return and risk while an aggressive

policy produces higher return and risk. The two important aims of the
working capital management are profitability and solvency. A liquid firm
has less risk of insolvency i.e. it will hardly experience a cash shortage
or a stock out situation. However, there is a cost associated with
maintaining a sound liquidity position. So, to have a higher profitability
the firm may have to sacrifice solvency and maintain a relatively low level
of current assets.
(c) Concept of Discounted Payback Period
Payback period is time taken to recover the original investment from
project cash flows. It is also termed as break even period. The focus of
the analysis is on liquidity aspect and it suffers from the limitation of
ignoring time value of money and profitability. Discounted payback

521
 period considers present value of cash flows, discounted at company’s
cost of capital to estimate breakeven period i.e. it is that period in which
future discounted cash flows equal the initial outflow. The shorter the
period, better it is. It also ignores post discounted payback period cash
flows.
OR
(c) Concept of Indian Depository Receipts: The concept of the depository
receipt mechanism which is used to raise funds in foreign currency has
been applied in the Indian capital market through the issue of Indian
Depository Receipts (IDRs). Foreign companies can issue IDRs to raise
funds from Indian market on the same lines as an Indian company uses
ADRs/GDRs to raise foreign capital. The IDRs are listed and traded in
India in the same way as other Indian securities are traded.

522
 ANSWERS OF MODEL TEST PAPER 3
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
PART I – Case Scenario based MCQs
1. 1. (c) Calculation of cost of capital
Capital Weight Cost Product
Debt 0.3 10% 3.00%
Preference 0.2 11% 2.20%
Equity 0.5 15% 7.50%
Ko= 12.70%
2. (a)
3. (c)
4. (d)
5. (a)
Calculation of CFAT
Year 1 2 3 4 5 6
A) No. of quick 10,000 12,000 13,800 15,180 15,939 15,939
deliveries p.d.
B) No. of 2,000 2,400 2,760 3,036 3,188 3,188
overnight
deliveries p.d.
C) No. of quick 36,50,000 43,80,000 50,37,000 55,40,700 58,17,735 58,17,735
deliveries p.a.
D) No. of 7,30,000 8,76,000 10,07,400 11,08,140 11,63,547 11,63,547
overnight
deliveries p.a.
E) Chargeable 18,25,000 21,90,000 25,18,500 27,70,350 29,08,868 29,08,868
quick deliveries
F) No. of 1.5x(A+B)/ 600 720 828 911 956 956
delivery partners 30
Revenue (in
crores)
From quick (E x 40) 7.30 8.76 10.07 11.08 11.64 11.64
deliveries (QD)
From QD seller (C x 700 x 12.775 15.330 17.630 19.392 20.362 20.362
commission 5%)
From Overnight (B/2 x 0.500 0.600 0.690 0.759 0.797 0.797
delivery 5000)
subscription

523
From OD seller (C x 750 x 3.83 4.60 5.29 5.82 6.11 6.11
commission 7%)
Total Revenue 24.41 29.29 33.68 37.05 38.90 38.90
Cost (in crores)
Advertising 7 8 10 0 0 0
IT and customer 8 8 8 8 8 8
care
Delivery partner (F x 15000) 0.90 1.08 1.24 1.37 1.43 1.43
salary
Delivery partner (C+D) x 20 8.76 10.51 12.09 13.30 13.96 13.96
commission
Depreciation on 6 6 6 6 6
investment
in year 0
on 4 4 4 4 4
investment
in year 2
on 5 5 5
investment
in year 4
Total Cost 30.66 37.59 41.33 37.66 38.40 32.40
PBT -6.25 -8.30 -7.65 -0.61 0.51 6.51
Less: Tax 1.56 2.08 1.91 0.15 -0.13 -1.63
PAT -4.69 -6.23 -5.74 -0.46 0.38 4.88
Add: 6.00 10.00 10.00 15.00 15.00 9.00
Depreciation
CFAT 1.31 3.77 4.26 14.54 15.38 13.88

Computation of NPV
Year Particulars Cash Flows PVF @ PV
(in crores) 12.7% (in crores)
0 Investment -30 1 -30
1 Investment -20 0.887 -17.75
3 Investment -25 0.699 -17.46
1 Operating CFAT 1.31 0.887 1.16
2 Operating CFAT 3.77 0.787 2.97
3 Operating CFAT 4.26 0.699 2.98
4 Operating CFAT 14.54 0.620 9.01
5 Operating CFAT 15.38 0.550 8.46
6 Operating CFAT 13.88 0.488 6.77
6 Sale Proceeds (30+20+25)x2 150 0.488 73.21
NPV 39.35

524
2. (d) FL=%change in NP/%change in EBIT=6.9/6=1.15
3. (c) Since IRR of projects of company is greater than its cost of capital, the
company should retain all ist earnings i.e. DPR = 0. As per walter Po =
[0 + (0.15/0.125)10]/0.125 = 96
4. (d) 180 days
PART II – Descriptive Questions
1. (a) Determination of specific costs
(RV − NP) (`100 − `96)
Interest (1 − t) + `11(1 − 0.35) +
N 10 years
(i) Cost Debt (K d) = =
(RV + NP) (`100 + `96)
2 2
` 7.15 + ` 0.4
= = 0.077 or 7.70%
` 98

(RV − NP) (`100 − `95)

PD + `12 +
N 10 years
(ii) Cost of Preference Shares (K p) = =
(RV + NP) (`100 + `95)
2 2
` 12 + ` 0.5
= = 0.1282 or 12.82%
` 97.5

D1 `2
(iii) Cost of Equity shares (K e) = +G = + 0.07 = 0.17 or 17%
P0 ` 22 − ` 2

I – Interest, t – Tax, RV- Redeemable value, NP- Net proceeds, N- No. of

years, PD- Preference dividend, D 1- Dividend at the end of the year, P 0-
Price of share (net)

Using these specific costs we can calculate the book value and market
value weights as follows:
(a) Weighted Average Cost of Capital (K 0) based on Book value
weights
Source of capital Book value Specific cost (k) Total costs
(BV) (%) [BV (×) k]
Debentures ` 8,00,000 7.7 ` 61,600
Preferences 2,00,000 12.8 25,600
shares
Equity shares 10,00,000 17.0 1,70,000
20,00,000 2,57,200
K0 = ` 2,57,200/` 20,00,000 = 12.86 per cent

525
 (b) Weighted Average Cost of Capital (K 0) based on market value
weights
Source of Market Value Specific cost Total costs
Capital (MV) (k) (%) [MV (×) k]
Debentures ` 8,80,000 7.7 ` 67,760,
Preference 2,40,000 12.8 30,720
shares
Equity 22,00,000 17.0 3,74,000
shares
Total 33,20,000 4,72,480
capital
K0 = ` 4,72,480/` 33,20,000 = 14.23 per cent

(b) Total Assets = ` 400 crores

Total Asset Turnover Ratio = 2.5
Hence, Total Sales = 400  2.5 = ` 1000 crores
Computation of Profits after Tax (PAT)
(` in crores)
Sales 1000
Less: Variable operating cost @ 65% 650
Contribution 350
Less: Fixed cost (other than Interest) 80
EBIT 270
Less: Interest on debentures (15%  200) 30
EBT 240
Less: Tax 40% 96
EAT 144

(i) Earnings per share

` 144 crores
 EPS = = ` 14.40
10 crore equity shares

(ii) Operating Leverage

Contribution 350
Operating leverage = = = 1.296
EBIT 270
It indicates the choice of technology and fixed cost in cost structure.
It is level specific. When firm operates beyond operating break-
even level, then operating leverage is low. It indicates sensitivity
of earnings before interest and tax (EBIT) to change in sales at a
particular level.

526
 (iii) Financial Leverage
EBIT 270
Financial Leverage = = = 1.125
EBT 240
The financial leverage is very comfortable since the debt service
obligation is small vis-à-vis EBIT.
(iv) Combined Leverage
Contribution EBIT
Combined Leverage =  Or Operating Leverage x
EBIT EBT
Financial Leverage
= 1.296  1.125 = 1.458
The combined leverage studies the choice of fixed cost in cost
structure and choice of debt in capital structure. It studies how
sensitive the change in EPS is vis-à-vis change in sales.
(c) Working notes:
1. Computation of Current Assets and Current Liabilities:

Current Assets 2.5 Current Assets Current Liabilities

= or = = k (say)
Current Liabilities 1 2.5 1
Or, Current Assets = 2.5 k and Current Liabilities = k
Or, Working capital = (Current Assets − Current Liabilities)
Or, `2,40,000 = k (2.5 − 1) = 1.5 k
Or, k = `1,60,000
 Current liabilities = `1,60,000
Current assets = `1,60,000  2.5 = `4,00,000
2. Computation of Inventories
Liquid assets
Liquid ratio =
Current liabilitie s
Current assets - Inventories
Or, 1.5 =
`1,60,000

Or, 1.5  `1,60,000 = `4,00,000 − Inventories

Or, Inventories = `1,60,000
3. Computation of Proprietary fund; Fixed assets; Capital and
Trade payables
Fixed assets
Proprietary ratio = = 0.75
Proprietary fund

 Fixed assets = 0.75 Proprietary fund

and Net working capital = 0.25 Proprietary fund

527
 Or, `2,40,000/0.25 = Proprietary fund
Or, Proprietary fund = `9,60,000
and Fixed assets = 0.75 proprietary fund
= 0.75  `9,60,000
= `7,20,000
Capital = Proprietary fund − Reserves & Surplus
= `9,60,000 − `1,60,000
= `8,00,000
Trade payables = (Current liabilities − Bank overdraft)
= (`1,60,000 − `40,000)
= `1,20,000
Construction of Balance sheet
(Refer to working notes 1 to 3)
Balance Sheet as at 31st March, 2023
Liabilities (`) Assets (`)
Capital 8,00,000 Fixed assets 7,20,000
Reserves & Surplus 1,60,000 Inventories 1,60,000
Bank overdraft 40,000 Current assets (other 2,40,000
than inventories)
Trade Payables 1,20,000
11,20,000 11,20,000
2. (a)
Ascertainment of probable price of shares of Akash limited
Particulars Plan (i) (If Plan (ii) If
` 4,00,000 ` 4,00,000 is
is raised raised by
as debt) issuing equity
(`) shares (`)
Earnings Before Interest (EBIT) 3,60,000 3,60,000
20% on (14,00,000 +4,00,000)
Less: Interest on old debentures @ 10% on 40,000 40,000
4,00,000 3,20,000 3,20,000
Less: Interest on New debt @ 12% on 48,000 –––
` 4,00,000
Earnings Before Tax (After interest) 2,72,000 3,20,000
Less Tax @ 50% 1,36,000 1,60,000
Earnings for equity shareholders (EAIT) 1,36,000 1,60,000
Number of Equity Shares 30,000 40,000
Earnings per Share (EPS) ` 4.53 ` 4.00

528
 Price/ Earning Ratio 8 10
Probable Price Per Share (PE ratio x EPS) ` 36.24 ` 40

Working Notes
`
1. Calculation of Present Rate of Earnings
Equity Share capital (30,000x 10) 3,00,000
 100  4,00,000
10% Debentures  40,000 
 10 
Reserves and Surplus 7,00,000
14,00,000
Earnings before interest and tax (EBIT) given 2,80,000
2,80,000 20%
Rate of Present Earnings =  100
14,00,000
2. Number of Equity Shares to be issued in Plan 4,00,000
=10,000
40
Thus, after the issue total number of shares 30,000+ 10,000
= 40,000
3. Debt/Equity Ratio if ` 4,00,000 is raised as debt:
8,00,000
 100 = 44.44%
18,00,000

As the debt equity ratio is more than 40% the P/E ratio shall be 8 in plan
(i)
(b) In this case the company has paid dividend of `2 per share during the
last year. The growth rate (g) is 5%. Then, the current year dividend (D 1)
with the expected growth rate of 5% will be ` 2.10.
D1
The share price is = P o =
Ke - g

` 2.10
=
0.155 − 0.05
= ` 20
In case the growth rate rises to 8% then the dividend for the current year.
(D1) would be ` 2.16 and market price would be-
` 2.16
=
0.155 − 0.08
= ` 28.80
In case growth rate falls to 3% then the dividend for the current year (D 1)
would be ` 2.06 and market price would be-

529
 ` 2.06
=
0.155 − 0.03
= `16.48
So, the market price of the share is expected to vary in response to
change in expected growth rate is dividends.
3. Statement showing Working Capital for each policy
(` in crores)

Working Capital Policy

Conservative Moderate Aggressive
Current Assets: (i) 4.50 3.90 2.60
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 7.10 6.50 5.20
Current liabilities: (iv) 2.34 2.34 2.34
Net Worth: (v)=(iii)-(iv) 4.76 4.16 2.86
Total liabilities: (iv)+(v) 7.10 6.50 5.20
Estimated Sales: (vi) 12.30 11.50 10.00
EBIT: (vii) 1.23 1.15 1.00
(a) Net working capital position: (i)-(iv) 2.16 1.56 0.26
(b) Rate of return: (vii)/(iii) 17.3% 17.7% 19.2%
(c) Current ratio: (i)/(iv) 1.92 1.67 1.11
Statement Showing Effect of Alternative Financing Policy
(` in crores)

Financing Policy Conservative Moderate Aggressive

Current Assets: (i) 3.90 3.90 3.90
Fixed Assets: (ii) 2.60 2.60 2.60
Total Assets: (iii) 6.50 6.50 6.50
Current Liabilities: (iv) 2.34 2.34 2.34
Short term Debt: (v) 0.54 1.00 1.50
Long term Debt: (vi) 1.12 0.66 0.16
Equity Capital 2.50 2.50 2.50
Total liabilities 6.50 6.50 6.50
Forecasted Sales 11.50 11.50 11.50
EBIT: (vii) 1.15 1.15 1.15
Less: Interest short-term debt : (viii) 0.06 0.12 0.18
(12% of ` 0.54) (12% of (12% of
` 1.00) ` 1.50)
Long term debt : (ix) 0.18 0.11 0.03
(16% of ` 1.12) (16% of (16% of
` 0.66) ` 0.16)

530
 Earning before tax: (x)-(viii+ix) 0.91 0.92 0.94
Taxes @ 35% 0.32 0.32 0.33
Earning after tax: (xi) 0.59 0.60 0.61
(a) Net Working Capital
Position: (i)-[(iv)+(v)] 1.02 0.56 0.06
(b) Rate of return on 23.6% 24% 24.4%
shareholders Equity
capital:(xi)/Equity Capital
(c) Current Ratio: [(i)/(iv)+(v)] 1.35% 1.17 1.02

4. (a) “The profit maximisation is not an operationally feasible criterion.” This

statement is true because Profit maximisation can be a short-term
objective for any organisation and cannot be its sole objective. Profit
maximization fails to serve as an operational criterion for maximizing the
owner's economic welfare. It fails to provide an operationally feasible
measure for ranking alternative courses of action in terms of their
economic efficiency. It suffers from the following limitations:
(i) Vague term: The definition of the term profit is ambiguous. Does it
mean short term or long term profit? Does it refer to profit before or
after tax? Total profit or profit per share?
(ii) Timing of Return: The profit maximization objective does not make
distinction between returns received in different time periods. It
gives no consideration to the time value of money, and values
benefits received today and benefits received after a period as the
same.
(iii) It ignores the risk factor.
(iv) The term maximization is also vague.
(b) “Financing a business through borrowing is cheaper than using equity”
(i) Debt capital is cheaper than equity capital from the point of its cost
and interest being deductible for income tax purpose, whereas no
such deduction is allowed for dividends.
(ii) Issue of new equity dilutes existing control pattern while borrowing
does not result in dilution of control.
(iii) In a period of rising prices, borrowing is advantageous. The fixed
monetary outgo decreases in real terms as the price level
increases.
(c) Meaning of Weighted Average Cost of Capital (WACC): The
composite or overall cost of capital of a firm is the weighted average of
the costs of the various sources of funds. Weights are taken to be in the
proportion of each source of fund in the capital structure. While making
financial decisions this overall or weighted cost is used. Each
investment is financed from a pool of funds which represents the various
sources from which funds have been raised. Any decision of investment,
therefore, has to be made with reference to the overall cost of capital

531
 and not with reference to the cost of a specific source of fund used in the
investment decision.
The weighted average cost of capital is calculated by:
(i) Calculating the cost of specific source of fund e.g. cost of debt,
equity etc;
(ii) Multiplying the cost of each source by its proportion in capital
structure; and
(iii) Adding the weighted component cost to get the firm’s WACC
represented by K 0.
K0 = K1 W1 + K2 W2 + ……….
Where,
K1, K2 are component costs and W 1, W2 are weights.
OR
(c) Assumptions of Modigliani – Miller Theory
(a) Capital markets are perfect. All information is freely available and
there is no transaction cost.
(b) All investors are rational.
(c) No existence of corporate taxes.
(d) Firms can be grouped into “equivalent risk classes” on the basis of
their business risk.

532
 ANSWERS OF MODEL TEST PAPER 4
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
DIVISION A
1. (c) 18.65%, 16.58%
Ke under two approaches
Calculation of Ke (Using Gordon’s Model)
D1
Ke = +g
Po
Share Price has grown from 150 to 301 in 5 years,
150 (1 + g)5 = 301.
(1 + g)5 = 2.01
Therefore, g = 15%, (From Annuity table – Re 1 after 5 years becomes
` 2.01 at rate of 15%)
D1 = 8 + 15% of 8 = 9.2
Po = Average of 52 weeks High price in last 5 years
Po = (185 + 210 +252 +325 +280) / 5
= 252.40
Ke = 9.2 / 252.40 + 0.15
= 18.65%
Calculation of Ke (Using CAPM)
Ke = Rf + (Rm – Rf) X Beta
= 8 + (11 x 0.78)
= 16.58%
2. (a) 17.82%
Overall Ke for the company
Approach Cost of Equity (k) Weight (w) Kxw
Gordon’s 18.65% 0.6 11.19%
CAPM 16.58% 0.4 6.63%
Total Ke = 17.82%
3. (b) 12%
Intrinsic Value of Debentures today is ` 9,740

533
 WN 1 – Calculation of the Pattern of Future Cash flows
YR PRINCIPAL INTEREST (II) = Coupon PV OF PV OF (I + II)
(I) Rate = 9.5% (7.5% + 2%) (I + II) @ 15%
@ 10%
1 1,500 997.50 2270.45 2171.74
2 1,500 855 1946.28 1780.72
3 1,500 712.5 1662.28 1454.75
4 1,500 570 1413.84 1183.53
5 1,500 427.50 1196.83 958.31
6 1,500 285 1007.59 771.70
7 1,500 142.50 842.86 617.48
10340.13 8938.23

(10,340.13 − 9,740 ) x5% = 12.14% = 12% (approx.)

= 10% +
(10,340.13 − 8,938.23)

4. (c) 16.07%, ` 87,75,000

Ko = Wd x Kd + We x Ke
= 0.3 X 12 + 0.7 X 17.82
= 16.07%
Purchase Consideration using M-Cap method
= 1,30,000 eq shares x 45 MPS x 1.5X
= ` 87,75,000
5. (d) ` 66,58,997
It is to be paid equally over 5 years and first instalment is to be paid
immediately at Yr 0
Discount rate will be the Ko calculated as above of the company and not
15% which is Ko of Prestige Limited
Year Amount each year PV @ 16.07% PV (`)
0 17,55,000 1.0000 17,55,000
1 17,55,000 0.8615 15,11,933
2 17,55,000 0.7423 13,02,737
3 17,55,000 0.6395 11,22,323
4 17,55,000 0.5510 9,67,005
TOTAL PV 66,58,997

534
6. (d) 19.5%
Financial Leverage (FL) indicates % impact in EPS, if EBIT is affected by
12%
FL = Combined Leverage (CL) /Operating Leverage (OL)
CL = 6.5 (Measure of total risk)
OL = 1 / Margin of Safety
Actual Sales − B.E Sales
Margin of Safety (MOS) =
Actual Sales
MOS = 20 lakhs – 15 lakhs / 20 lakhs = 0.25
Therefore, OL = 1 / 0.25 = 4
So, FL = 6.5 / 4 = 1.625
So % Change in EPS = 12 x 1.625 = 19.5%
7. (c) 1:2
Item Cost Weight Product
Debt 8% W 8W
Equity 11% 1–W 11 – 11W
WACC = 10

Wd = 1/3 and We = 2/3 Debt Equity Ratio = 1/2

8. (c) ` 350 Lakhs
Value of Equity = 30 Lakhs ÷ 15% = ` 200 Lakhs
Value of Debt = ` 150 Lakhs
Value of Firm = 200 Lakhs + 150 Lakhs = ` 350 Lakhs

DIVISION B – Descriptive Questions

1. (a) 1. Cost of Goods Sold = Sales – Gross Profit
= ` 7,20,000 – 25% x ` 7,20,000 = ` 5,40,000
Cost of Goods Sold ` 5,40,000
2. Stock Turnover = Average Stock
= Average Stock
= 5 times.

` 5,40 ,000
Average Stock = 5
= ` 1,08,000

3. Let Opening Stock be x.

Closing Stock is ` 30,000 more than Opening Stock.
Closing Stock = (x + 30,000)

535
 x + x + 30 ,000
Average Stock = 2
= 1,08,000.

2x = 2,16,000 – 30,000
1,86 ,000
x = = 93,000 = Opening Stock.
2

Closing Stock = x + 30,000

= 93,000 + 30,000 = ` 1,23,000
Liquid Assets Liquid Assets
4. Liquid Ratio = = = 1.25.
Current Liabilitie s 2,40,000

Liquid Assets = ` 3,00,000

5. Current Assets = Liquid Assets + Closing Stock
= ` 3,00,000 + ` 1,23,000 = ` 4,23,000
(b) Calculation of slab wise Overall Cost of Capital
(i)
Project Cost Capital Weights Cost wxk
Source (w) (k) (%)
Upto 5 Lakhs Debt 0.3 10 3
Equity 0.7 12 8.4
Ko 11.4
Above 5 lakhs upto 10 lakhs Debt 0.3 12 3.6
Equity 0.7 13.5 9.45
Ko 13.05
Above 10 lakhs upto 20 lakhs Debt 0.3 13 3.9
Equity 0.7 15 10.5
Ko 14.4
Above 20 lakhs Debt 0.3 14 4.2
Equity 0.7 16 11.2
Ko 15.4

Cost of Raising funds for Project I

Total Capital Ko(%) Total Cost (in `)
5,00,000 11.40 57,000
5,00,000 13.05 65,250
5,00,000 14.40 72,000
15,00,000 1,94,250

536
 Overall COC (%) = Total Cost (in `) / Total Capital
= 1,94,250/15,00,000 * 100
= 12.95 %
Cost of Raising funds for Project II
Total Capital Ko(%) Total Cost (in `)
5,00,000 11.4 57,000
5,00,000 13.05 65,250
10,00,000 14.4 1,44,000
6,00,000 15.4 92,400
26,00,000 3,58,650
Overall COC (%) = 358650 / 2600000 * 100 = 13.79%
(ii) If any project is expected to give an after-tax return of 13%, it can
be accepted only if the maximum Overall COC (%) of that project
equals 13% or less, as at 13%, project would be at break-even i.e
earning 13% from the project and incurring 13% COC.
So, under that scenario, Project I can be taken as its COC is
12.95% whereas Project II can’t be taken as its COC is 13.79%.
Maximum Value of the Project that can be taken at 13% is approx.
(Using IRR technique Interpolation)
At 15 Lakhs Ko = 12.95%
At 26 Lakhs Ko = 13.79%
By interpolation, maximum value of Project at 13% will be
15 Lakhs + {(0.05 x 11)/0.84}
= 15.6548 lakhs
(c) Income Statement
EBIT EBT + Interest EBT + 2,000 2
DFL = EBT
= EBT
= EBT
= .
1

EBT + ` 2000 = 2 EBT.

EBT = ` 2,000
EBIT = EBT + Interest = ` 2000 + ` 2000 = ` 4,000.
Contribution 3
Contribution = Contribution =
EBIT 4,000 1

Contribution 12,000 48,000

Sales = 25%
PVR
Less: Variable Cost Given = 75% (36,000)
Contribution 12,000
Less: Fixed Cost( Contribution - EBIT = ` 12,000 – ` 4,000) (8,000)

537
 EBIT 4,000
Less: Interest (2,000)
EBT 2,000
Less: Tax at 30% (600)
EAT 1,400
2. (a)
Particulars Result
Current liabilities 1,56,000
Total Variable expenses =
Purchases & Operating 1,56,000 ÷ 60 × 360 = 9,36,000
Expenses
Variable expenses % of Sales 9,36,000 ÷ 12,00,000 × 100 = 78%

Particulars Present Proposed

1 Lakh ÷ 30 × 360 12 Lakhs + 1/3rd
1. Sales
= 12,00,000 = 16,00,000
2. Variable Cost at
9,36,000 12,48,000
78%
12 Lakh × 50% × 1% 16 Lakh × 80% × 2%
3. Cash Discount
= 6,000 = 25,600
12 Lakh × 1.5% 16 Lakh × 2%
4. Bad debts
= 18,000 = 32,000
5. Profit before Tax 2,40,000 2,94,400
6. Tax @ 30% 72,000 88,320
7. Profit after Tax 1,68,000 2,06,080
8. Opportunity Cost 9,36,000 × 30/360 × 12,48,000 × 20/360 ×
of Invest. in
70% ×15% = 8,190 70% × 15% = 7,280
Debtors
9. Net Benefit 1,59,810 1,98,800
Advise: Proposed policy should be adopted since the net benefit is
increased by (` 1,98,800 - 1,59,810) = ` 38,990.
(b) (i) As per Gordon’s Model, Price per share is computed using the
formula:
E1(1 − b)
P0 =
Ke − br
Where,
P0 = Price per share
E1 = Earnings per share
Payout ratio = 45/180 = 25%
b = Retention ratio; (1 - b = Pay-out ratio) = 1-0.25 = 0.75

538
 Ke = Cost of capital
r = IRR
br = Growth rate (g)
Applying the above formula, price per share
180(1 − 0.75) 45
P0 = = = ` 2,250
0.17 − 0.75  0.2 0.02
(ii) As per Walter’s Model, Price per share is computed using the
formula:
r
D+Ke(E-D)
Price (P) = Ke
Where,
P = Market Price of the share.
E = Earnings per share.
D = Dividend per share.
Ke = Cost of equity/ rate of capitalization/ discount rate.
r = Internal rate of return/ return on investment
Applying the above formula, price per share
0.20
45+ 0.17 (180-45)
P = 0.17
45+158.82
Or, P = = ` 1,200 (approx..)
0.17
3. (a) Calculation of Present value of cash inflows (PVCI)
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Savings in cost - 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000
due to
Production
Delays
Savings in - 21,00,000 21,00,000 21,00,000 21,00,000 21,00,000
Salaries
Reduction in lost - 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000
sales
Gain due to - 3,25,000 3,25,000 3,25,000 3,25,000 3,25,000
timely billing
- 29,50,000 29,50,000 29,50,000 29,50,000 29,50,000
Less:
Salary of AI - 13,00,000 13,00,000 13,00,000 13,00,000 13,00,000
specialists
Annual Maint. & - 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000
Op Cost
NPBDT - 14,70,000 14,50,000 15,30,000 15,40,000 15,20,000
(-) Depreciation 9,20,000 5,52,000 3,31,200 1,98,720 1,19,232
-

539
NPBT - 5,50,000 8,98,000 11,98,800 13,41,280 14,00,768
(-) Tax @ 25% - 1,37,500 2,24,500 2,99,700 3,35,320 3,50,192
NPAT - 4,12,500 6,73,500 8,99,100 10,05,960 10,50,576
(+) Depreciation - 9,20,000 5,52,000 3,31,200 1,98,720 1,19,232
(+) Annual Maint. - 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000
& Op Cost
Gross Cash - 15,12,500 14,25,500 13,50,300 13,14,680 12,99,808
Inflows
(-) Annual Maint. 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000 -
& Op Cost
actually paid
Net Cash Inflows -1,80,000 13,12,500 13,05,500 12,40,300 11,84,680 12,99,808
(+) Sale Value at - - - - - 1,90,000
the end of life
-1,80,000 13,12,500 13,05,500 12,40,300 11,84,680 14,89,808
PV Factor @ 1 0.8929 0.7`972 0.7118 0.6355 0.5674
12%
PV of Cash -1,80,000 11,71,875 10,40,737 8,82,821 7,52,886 8,45,357
Inflows
Total PV of 45,13,675
Cash Inflows

Calculation of Present value of cash outflows (PVCO)

As mentioned in the question, 75% of the depreciable value will be paid
at the beginning. Depreciable value means purchase price plus the
installation cost.
Year 0 Year 1
Purchase Price & Installation Cost 17,25,000 5,75,000
PV Factor @ 12% 1 0.8929
PVCO 17,25,000 5,13,418
(2) Total PVCO = 22,38,418
(3) PV of Tax on Capital Gains (Only asset in the block) - 5th Year end
Capital Gains = Sale Price (-) Closing WDV at 5th year
= 1,90,000 (-) 1,78,848
= 11,152
Tax @ 20% on above = 2230.40
PV = 2,230.40 x 0.5674 = 1,266
Net PVCI = PVCI - PV of Tax on Capital Gains
= 45,13,675 - 1,266 = 45,12,409
NPV = Net PVCI – PVCO
= 45,12,409 - 22,38,418

540
 = 22,73,991
(II) PI = PVCI / PVCO = 45,12,409/ 22,38,418 = 2.0158
(III) ARR = Average NPAT / Initial Investment
= 8,08,327.2/23,00,000 x 100 = 35.145%
Note – ARR is calculated based on Initial Investment, similarly it can be
calculated based on Average Investment
(b) Lintner’s model has two parameters:
i. The target payout ratio,
ii. The spread at which current dividends adjust to the target.
4. (a) Normally it is considered that the trade credit does not carry any cost.
However, it carries the following costs:
(i) Price: There is often a discount on the price that the firm undergoes
when it uses trade credit, since it can take advantage of the
discount only if it pays immediately. This discount can translate into
a high implicit cost.
(ii) Loss of goodwill: If the credit is overstepped, suppliers may
discriminate against delinquent customers if supplies become
short. As with the effect of any loss of goodwill, it depends very
much on the relative market strengths of the parties involved.
(iii) Cost of managing: Management of creditors involves
administrative and accounting costs that would otherwise be
incurred.
(iv) Conditions: Sometimes most of the suppliers insist that for availing
the credit facility the order should be of some minimum size or even
on regular basis.
(b) (i) Fully Hedged Bonds: In foreign bonds, the risk of currency
fluctuations exists. Fully hedged bonds eliminate the risk by selling
in forward markets the entire stream of principal and interest
payments.
(ii) Medium Term Notes (MTN): Certain issuers need frequent
financing through the Bond route including that of the Euro bond.
However, it may be costly and ineffective to go in for frequent
issues. Instead, investors can follow the MTN programme. Under
this programme, several lots of bonds can be issued, all having
different features e.g. different coupon rates, different currencies
etc. The timing of each lot can be decided keeping in mind the
future market opportunities. The entire documentation and various
regulatory approvals can be taken at one point of time.
(iii) Floating Rate Notes (FRN): These are issued up to seven years
maturity. Interest rates are adjusted to reflect the prevailing
exchange rates. They provide cheaper money than foreign loans.

541
 (iv) Euro Commercial Papers (ECP): ECPs are short term money
market instruments. They have maturity period of less than one
year. They are usually designated in US Dollars.
(c) DOL can never be between zero and one. It can be zero or less or it can
be one or more.
When Sales is much higher than BEP sales, DOL will be slightly more
than one. With decrease in sales, DOL will increase. At BEP, DOL will
be infinite. When sales is slightly less than BEP, DOL will be negative
infinite. With further reduction in sale, DOL will move towards zero. At
zero sales, DOL will also be zero.
OR
The finance executive of an organisation plays an important role in the
company’s goals, policies, and financial success. His responsibilities
include:
(a) Financial analysis and planning: Determining the proper amount
of funds to employ in the firm, i.e. designating the size of the firm
and its rate of growth.
(b) Investment decisions: The efficient allocation of funds to specific
assets.
(c) Financing and capital structure decisions: Raising funds on
favourable terms as possible i.e. determining the composition of
liabilities.
(d) Management of financial resources (such as working capital).
(e) Risk management: Protecting assets.

542
 ANSWERS OF MODEL TEST PAPER 5
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
Suggested Answers/ Hints
PART I – Case Scenario based MCQs
1. (d)
2. (b)
Particulars Computation Result
Sales 100 × 5,00,000 5,00,00,000
Less Variable cost 100 × 4,50,000 4,50,00,000
Contribution 50,00,000
Less Fixed cost 25,00,000
EBIT 25,00,000
Less Interest 15% × 40,00,000 6,00,000
EBT 19,00,000
Operating leverage = Contribution ÷ EBIT = 50 Lakhs ÷ 25 Lakhs = 2
times
Operating leverage = % Change in EBIT ÷ % Change in Sales i.e. if sales
increase by 10%, EBIT increase by 20%.
Financial leverage = EBIT ÷ EBT = 25 Lakhs ÷ 19 Lakhs = 1.315 times
Combined leverage = Operating leverage × Financial leverage
= 2 × 1.315 = 2.63 times
3. (b)
Particulars Weights Cost in % Weights × Cost
Share Capital 40,00,000 5 + 1.9 × (10 – 5) = 14.5 5,80,000
Reserves & Surplus 25,00,000 14.5 3,62,500
Preference Share
Capital 12,00,000 12 1,44,000
15% Debentures 20,00,000 15 × (1 – 25%) = 11.25 2,25,000
Total 97,00,000 Total Cost 13,11,500

Discount rate = WACC = 13,11,500 ÷ 97,00,000 × 100 = 13.52%

543
4. (b)
Particulars Computation Result
Savings in Tea cost 200 Employees × 200 days × 3 12,00,000
times × ` 10
Less: Annual maintenance (25,000)
Less: Cost of Electricity 500 units × ` 24 per unit × 12
months (1,44,000)
Less: Consumables (8,00,000)
Less: Depreciation 5,00,000 ÷ 5 years (1,00,000)
Profit before tax 1,31,000
Less: Tax 1,31,000 × 25% 32,750
Profit after tax 98,250
Add: Depreciation 1,00,000
Cash flow after tax 98,250 + 1,00,000 1,98,250
5. (b)
Year Particulars Cash flow [email protected]% PV
0 Initial investment 5,00,000 1 (5,00,000)
1 to 5 Savings 1,98,250 3.473 6,88,522
Net present value 1,88,522
6. (b) ROCE = EBIT / Total Capital Employed
Total Capital Employed = Total Assets – Current Liabilities
= 50 lakhs – 10 lakhs
= 40 lakhs
EBIT = 40 lakhs x 15%
= 6 lakhs
Now, OL of 3.5 = Contribution / EBIT
Therefore Contribution = 6 Lakhs X 3.5 = 21 lakhs
Sales = Contribution / PV Ratio = 21 lakhs / 0.7 = 30 lakhs
7. (d) Calculation: Cost of Debt = (Interest Payment/ Market Price of Bond)
= (8,000 / 95,000) = 8.42%
8. (d) Cost of equity will increase. As the company increases its debt ratio, the
financial risk increases, which typically leads to an increase in the cost
of equity as equity investors demand a higher return for the additional
risk.

544
 PART II – Descriptive Questions
1. (a) Let the EBIT at the Indifference Point level be E
Particulars Alternative 1 Alternative 2
Description Fully Equity of Debt = 56 Lakhs,
84 Lakhs Equity = 28 Lakhs
EBIT E E
Less: Interest at 12% of ` 56 Nil 6.72
Lakhs
EBT E E – 6.72
Less: Tax at 30% 0.3 E 0.3 E – 2.016
EAT 0.7 E 0.7 E – 4.704
Less: Preference Dividend Nil Nil
Residual Earnings 0.7 E 0.7 E – 4.704
No. of Equity Shares (Face 8.4 Lakh Shares 2.8 Lakh Shares
Value ` 10)
EPS = 0.7 E 0.7 E - 4.704
Re sidual Earnings 8.4 Lakh Shares 2.8 Lakh Shares
No. of Equity Shares

For indifference between the above alternatives, EPS should be equal.

0.7 E 0.7 E - 4.704
So, =
8.4 Lakh Shares 2.8 Lakh Shares

On cross multiplication and simplification, 2.1 E – 14.112 = 0.7 E. So,

1.4 E = 14.112
14.112
So, E = = 10.08
1.4

So, for same EPS, required EBIT = ` 10.08 Lakhs. EPS at that level
= ` 0.84
Note: Presentation of solution may differ.
(b) Computation of PV of Future Cash Flows
Year Nature Cash Flow DF @ 12% DCF
1 Dividends (` 100 × 20%) 20 0.893 17.86
2 Dividends (` 100 × 20%) 20 0.797 15.94
3 Dividends (` 100 × 20%) 20 0.712 14.24
4 Dividends (` 100 × 20%) 20 0.636 12.72
5 Dividends (` 100 × 1.2 × 20%) 24 0.567 13.61
6 Dividends (` 100 × 1.2 × 20%) 24 0.507 12.17
7 Dividends (` 100 × 1.2 × 20%) 24 0.452 10.85
7 Net Sale Proceeds (` 900 × 1,026
1.2 – 5%) 0.452 463.75

545
 Present Value of Cash Inflows 561.14
0 Less: Initial Investment (` 500 525 1 525.00
+ 5%)
Net Present Value 36.14
Note: At the end of Year 4, Anand will have 1.2 Share i.e. 1 Bought Share
+ 1/5th Bonus Share.
(c) i. No of Eq. Shares (before buyback) = Total Earnings (before
buyback)/EPS
= 18,00,000/(270/18)
= 1,20,000 shares
ii. Buyback price = 270 + 10% premium = 297
iii. No of Eq. shares (after buyback) = 1,20,000 (-) 20,000 = 1,00,000
shares
iv. Total Book Value of Equity (after buyback) = 1,00,000 X 193.20
= 1,93,20,000
Now,
Total BV of Eq. (after buyback) = Total BV of Eq.(before buyback) (-)
Amt of buyback
1,93,20,000 = x (-) (20,000 X 297)
Therefore x = Total BV (before buyback)
= 2,52,60,000
BV per share (before buyback) = 2,52,60,000 / 1,20,000
= 210.50 per share
2. (a) Evaluation of Factoring Proposal -
PARTICULARS ` `
(A) Savings (Benefit) to the firm
Administration Cost 45,000 45,000
Bad Debts Cost (On Recourse
basis)
In House – 75 lakhs X 1%
Factoring – 75 lakhs X 0.5% (75 lakhs X 0.5%) 37,500
Net Savings in bad debts cost
Cost of Carrying Debtors Cost (WN – 1) 1,06,750
TOTAL 1,89,250
(B) Cost to the Firm:

546
 Factor Commission [Annual 75 lakhs X 1.5% 1,12,500
credit Sales × % of Commission]
Interest Cost on Net advances (See WN – 1) 53,100
TOTAL 1,65,600
(C) Net Benefits to the Firm (A – B) 23,650
Advice: Since the savings to the firm exceed the cost due to factoring,
the proposal is acceptable.
WN-1 : Calculation of Savings in Interest Cost of Carrying Debtors
(I) In house Management:
Interest Cost = Credit Sales X Avg Collection Period / 360 X Interest
(%) p.a
= 75,00,000 x 60/360 x 10%
= 1,25,000
(II) If Factoring services availed: If factoring services are availed,
then Sukrut Limited must raise the funds blocked in receivables to
the extent which is not funded by the factor (i.e amount of factor
reserve (+) amount of factor commission for 30 days (+) 20% of net
advances)
Calculation of Net Advances to the firm -
Debtors = 75 lakhs x 30/360 = 6,25,000
(-) Factor Reserve = 10% of above = (62,500)
(-) Factor Commission = 1.5% of Debtors = (9,375)
Net Advance = 5,53,125
Advance from Factor = 5,53,125 x 80% = 4,42,500
Int cost on Advance from Factor = 4,42,500 x 12% = 53,100
Now, the amount that is not funded by the factor (6,25,000 -
4,42,500) needs to be funded by Sukrut Limited from overdraft
facility at 10%
Therefore, Int cost on Overdraft (Cost of carrying debtors)
= 1,82,500 x 10% = 18,250
Net Savings in Interest Cost of Carrying Debtors = 1,25,000 (-)
18,250 = 1,06,750
(b) Level of investment depends on the various factors listed below:
(a) Nature of Industry: Construction companies, breweries etc.
requires large investment in working capital due long gestation
period.
(b) Types of products: Consumer durable has large inventory as
compared to perishable products.

547
 (c) Manufacturing Vs Trading Vs Service: A manufacturing entity
has to maintain three levels of inventory i.e. raw material, work-in-
process and finished goods whereas a trading and a service entity
has to maintain inventory only in the form of trading stock and
consumables respectively.
(d) Volume of sales: Where the sales are high, there is a possibility
of high receivables as well.
(e) Credit policy: An entity whose credit policy is liberal has not only
high level of receivables but may require more capital to fund raw
material purchases as that will depend on credit period allowed by
suppliers.
3. (a) WN-1 : Calculation of Cost of Debt (Kd)
Int (1-t)+(RV – NP)/N
Approximation Method =
(RV + NP) / 2
RV = 100 + 10% = 110, NP = 105 - 4% = 100.8
10 (1- 0.25)+(110 – 100.8)/10
= = 7.99%
(110 + 100.8) / 2
YTM Method:
CMP (Po) (-) Floatation Cost = {Int(1-t) × PVAF (r%,10years)} + {RV ×
PVIF (r%,10th Year)}
105 - 4% = {10 (1 – 0.25) × PVAF (r%,10 years)} + {110 × PVIF (r%,10th
year)}
Using trial and error method, NPV at 5% & 10%
Year Cash Disc PV (`) Disc Factor PV (`)
flows Factor @ @ 10%
5%
0 -100.8 1 -100.8 1 -100.8
1 to 10 7.5 7.7217 57.91275 6.1446 46.0845
10 110 0.6139 67.529 0.3855 42.405
24.64175 -12.3105
24.64175
IRR = 5+ X (10-5) = 8.33%
24.64175-(-12.3105)
Therefore overall cost of debt (Kd) = (7.99 + 8.33) / 2 = 8.16%
WN-2 : Calculation of Cost of Preference (Kp)
Pref. Div.+(RV – NP)/N
Approximation Method =
(RV + NP) / 2
RV = 100 NP = 115 - 2% = 112.7
12 +(100 – 112.7)/10
= = 10.09%
(100 + 112.7) / 2

548
 YTM Method:
CMP (Po) (-) Floatation Cost = {Pref Div × PVAF (r%,10years)} + {RV ×
PVIF (r%,10th Year)}
115 - 2% = {12 × PVAF (r%,10 years)} + {100 × PVIF (r%,10th year)}
Using trial and error method, NPV at 5% & 10%
Year Cash Disc Factor PV (`) Disc Factor PV (`)
flows @ 5% @ 10%
0 -112.7 1 -112.7 1 -112.7
1 to 10 12 7.7217 92.6604 6.1446 73.7352
10 100 0.6139 61.39 0.3855 38.55
41.3504 -0.4148
41.3504
IRR = 5+ X (10-5) = 9.95%
41.3504 -(-0.4148)
Therefore, overall cost of debt (Kp) = (10.09 + 9.95) / 2 = 10.02%
WN-3 : Calculation of Cost of equity (Ke)
Ke = {D1 / (Po - Floatation)} + G
= {2+9% / 27 – 4.5} + 0.09
= 18.69%
Calculation of WACC using market value weights
Source of Working Market Weigh Cost WACC
Capital Value ts (K) (Ko)
(`) (A) (B) (A x B)
Equity 27 x 150000 40,50,000 0.7377 18.69 13.7877
Reserves Included in - - - -
equity
Preference 115 x 7500 8,62,500 0.1571 10.02 1.5741
Debentures 105 x 5500 5,77,500 0.1052 8.16 0.8584
54,90,000 1 16.22%
WACC (Ko) = 16.22%
(b) Change in Reserve & Surplus = ` 25, 00,000 – ` 20,00,000 = `
5,00,000
So, Net profit = ` 5, 00,000
(i) Net Profit Ratio = 8%
5,00,000
∴ Sales = =` 62,50,000
8%
(ii) Cost of Goods sold

549
 = Sales – Gross profit Margin
= ` 62, 50,000 – 20% of ` 62, 50,000
= ` 50, 00,000
` 30,00,000
(iii) Fixed Assets = =` 75,00,000
40%
Cost of Goods Sold 50,00,000
(iv) Stock = = = ` 12,50,000
STR 4
62,50,000
(v) Debtors = × 90 = ` 15,62,500
360
50,00,000
(vi) Cash Equivalent = ×1.5 = ` 6,25,000
12
Balance Sheet as on 31st March 2024
Liabilities (`) Assets (`)
Share Capital 50,00,000 Fixed Assets 75,00,000
Reserve and Surplus 25,00,000 Sundry Debtors 15,62,500
Long-term loan 30,00,000 Closing Stock 12,50,000
Sundry Creditors 4,37,500 Cash in hand 6,25,000
(Balancing Figure)
1,09,37,500 1,09,37,500
4. (a) Though in a sole proprietorship firm, partnership etc., owners participate
in management but in corporates, owners are not active in management
so, there is a separation between owner/ shareholders and managers.
In theory managers should act in the best interest of shareholders
however in reality, managers may try to maximise their individual goal
like salary, perks etc., so there is a principal agent relationship
between managers and owners, which is known as Agency
Problem. In a nutshell, Agency Problem is the chances that managers
may place personal goals ahead of the goal of owners. Agency Problem
leads to Agency Cost. Agency cost is the additional cost borne by the
shareholders to monitor the manager and control their behaviour so as
to maximise shareholders wealth. Generally, Agency Costs are of four
types (i) monitoring (ii) bonding (iii) opportunity (iv) structuring.
Addressing the agency problem
The agency problem arises if manager’s interests are not aligned to the
interests of the debt lender and equity investors. The agency problem of
debt lender would be addressed by imposing negative covenants i.e. the
managers cannot borrow beyond a point. This is one of the most
important concepts of modern day finance and the application of this
would be applied in the Credit Risk Management of Bank, Fund Raising,
Valuing distressed companies.

550
 Agency problem between the managers and shareholders can be
addressed if the interests of the managers are aligned to the interests of
the share- holders. It is easier said than done.
However, following efforts have been made to address these issues:
♦ Managerial compensation is linked to profit of the company to some
extent and also with the long term objectives of the company.
♦ Employee is also designed to address the issue with the underlying
assumption that maximisation of the stock price is the objective of
the investors.
♦ Effecting monitoring can be done.
(b) (i) Sales and Lease Back: Under this type of lease, the owner of an
asset sells the asset to a party (the buyer), who in turn leases back
the same asset to the owner in consideration of a lease rentals.
Under this arrangement, the asset is not physically exchanged but
it all happen in records only. The main advantage of this method
is that the lessee can satisfy himself completely regarding the
quality of an asset and after possession of the asset convert the
sale into a lease agreement.
Under this transaction, the seller assumes the role of lessee (as the
same asset which he has sold came back to him in the form of
lease) and the buyer assumes the role of a lessor (as asset
purchased by him was leased back to the seller). So, the seller gets
the agreed selling price and the buyer gets the lease rentals.
(ii) Leveraged Lease: Under this lease, a third party is involved
besides lessor and the lessee. The lessor borrows a part of the
purchase cost (say 80%) of the asset from the third party i.e., lender
and asset so purchased is held as security against the loan. The
lender is paid off from the lease rentals directly by the lessee and
the surplus after meeting the claims of the lender goes to the lessor.
The lessor is entitled to claim depreciation allowance.
(iii) Sales-aid Lease: Under this lease contract, the lessor enters into
a tie up with a manufacturer for marketing the latter’s product
through his own leasing operations, it is called a sales-aid lease. In
consideration of the aid in sales, the manufacturer may grant either
credit or a commission to the lessor. Thus, the lessor earns from
both sources i.e. From lessee as well as the manufacturer.
(iv) Close-ended and Open-ended Leases: In the close-ended lease,
the assets get transferred to the lessor at the end of lease, the risk
of obsolescence, residual value etc., remain with the lessor being
the legal owner of the asset. In the open-ended lease, the lessee
has the option of purchasing the asset at the end of the lease
period.

551
(c) The basic objective of financial management is to design an appropriate
capital structure which can provide the highest wealth, i.e., highest MPS,
which in turn depends on EPS.
Given a level of EBIT, EPS will be different under different financing mix
depending upon the extent of debt financing. The effect of leverage on
the EPS emerges because of the existence of fixed financial charge i.e.,
interest on debt, financial fixed dividend on preference share capital. The
effect of fixed financial charge on the EPS depends upon the relationship
between the rate of return on assets and the rate of fixed charge. If the
rate of return on assets is higher than the cost of financing, then the
increasing use of fixed charge financing (i.e., debt and preference share
capital) will result in increase in the EPS. This situation is also known as
favourable financial leverage or Trading on Equity. On the other hand, if
the rate of return on assets is less than the cost of financing, then the
effect may be negative and, therefore, the increasing use of debt and
preference share capital may reduce the EPS of the firm.
The fixed financial charge financing may further be analysed with
reference to the choice between the debt financing and the issue of
preference shares. Theoretically, the choice is tilted in favour of debt
financing for two reasons: (i) the explicit cost of debt financing i.e., the
rate of interest payable on debt instruments or loans is generally lower
than the rate of fixed dividend payable on preference shares, and (ii)
interest on debt financing is tax-deductible and therefore the real cost
(after-tax) is lower than the cost of preference share capital.
OR
(c) When the cost of ‘fixed cost fund’ is less than the return on investment,
financial leverage will help to increase return on equity and EPS. The
firm will also benefit from the saving of tax on interest on debts etc.
However, when cost of debt will be more than the return it will affect
return of equity and EPS unfavourably and as a result firm can be under
financial distress. Therefore, financial leverage is also known as “double
edged sword”.
Effect on EPS and ROE:
When, ROI > Interest – Favourable – Advantage
When, ROI < Interest – Unfavourable – Disadvantage
When, ROI = Interest – Neutral – Neither advantage nor disadvantage

552
 ANSWERS OF MODEL TEST PAPER 6
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
Suggested Answers/ Hints
PART I – Case Scenario based MCQs
1. (c) ` 0.72
Computation of EPS under financial plan I: Equity Financing
(`)
EBIT 37,50,000.00
Interest -
EBT 37,50,000.00
Less: Taxes 40% (15,00,000.00)
PAT 22,50,000.00
No. of equity shares 31,25,000.00
EPS 0.72
2. (b) ` 0.90
Computation of EPS under financial plan II: Debt – Equity Mix
(`)
EBIT 37,50,000.00
Less: Interest (14,06,250.00)
EBT 23,43,750.00
Less: Taxes 40% (9,37,500.00)
PAT 14,06,250.00
No. of equity shares 15,62,500.00
EPS 0.90
3. (a) ` 0.44
Computation of EPS under financial plan III: Preference Shares –
Equity Mix
(`)
EBIT 37,50,000.00
Less: Interest -

553
 EBT 37,50,000.00
Less: Taxes (40%) (15,00,000.00)
PAT 22,50,000.00
Less: Pref. dividend (15,62,500.00)
PAT for equity shareholders 6,87,500.00
No. of Equity shares 15,62,500.00
EPS 0.44
4. (a) ` 28,12,500
EBIT – EPS Indifference Point- Plan I and Plan II:
(EBIT) × (1- TC ) (EBIT − Interest) × (1 − TC )
=
N1 N2

EBIT(1 − 0.40) (EBIT − 14,06,250) × (1 − 0.40)

=
31,25,000 15,62,500
0.6EBIT = 1.2 EBIT – 16,87,500
= ` 28,12,500
5. (d) ` 52,08,333.33
EBIT – EPS Indifference Point: Plan I and Plan III
EBIT(1 − Tc ) EBIT(1 − Tc ) − Pref. Div.
=
N1 N2

EBIT(1 − 0.4) EBIT(1 − 0.4) − 15,62,500

=
31,25,000 15,62,500
0.6EBIT = 1.2EBIT – 31,25,000
EBIT = ` 52,08,333.33
6. (b) 30%
The formula for Degree of Combined Leverage (DCL) is:
DCL=DOL×DFL
DCL=2×3=6
The percentage change in EPS is:
% Δ EPS = DCL × % Δ Sales
% Δ EPS = 6 × 5% = 30%
7. (c) 3.79
Initial Investment = Annual Cost Savings × PVAF
Annual cost savings = ` 1,80,000
PVAF (10%, 5 years) = 3.79
Initial Investment = 1,80,000 × 3.79 = 6,82,200

554
 Payback Period = Initial Investment/ Annual Cost Savings
= 6,82,200/1,80,000
= 3.79 years
8. (c) Remains unchanged because value depends on earnings and
investment policy.
(Explanation: M&M's theory suggests that dividend policy has no impact
on shareholder wealth in a perfect market.)

PART II – Descriptive Questions

1. (a) Statement showing Computation of Combined leverage
`
Sales 2,00,000
Less: Variable costs (50%) 1,00,000
Contribution 1,00,000
Less: Fixed operating costs 40,000
EBIT 60,000
Less: Interest 10,000
Taxable Income (PBT) 50,000
C 1,00,000
Combined leverage = = =2
PBT 50,000

The combined leverage of '2' indicates that with every increase of ` 1 in

sales, the taxable income will increase by ` 2 (i.e. 1×2). This can be
verified by the following computations when the sales increase by 10%
`
Sales 2,20,000
Less: variable costs (50%) 1,10,000
Contribution 1,10,000
Less: Fixed operating costs 40,000
EBIT 70,000
Less: Interest 10,000
Taxable Income (PBT) 60,000
It is clear from the above computation that on account of increase in
sales by 10%, the profit before tax has increased by 20%.

555
(b) (i) Computation of Weighted Average Cost of Capital based on
existing capital structure
Source of Capital Existing Weights After tax WACC
Capital cost of (%)
structure (a) capital (%)
(`) (b) (a) × (b)
Equity share capital
10,00,000 0.250 10.000 2.500
(W.N.1)
12% Preference
15,00,000 0.375 12.000 4.500
share capital
10% Debentures
15,00,000 0.375 6.500 2.438
(W.N.2)
Total 40,00,000 1.000 9.438
Working Notes:
1. Cost of Equity Capital:
Expecteddividend(D1 )
Ke = + Growth(g)
CurrentMarketPrice(P0 )

`5
= + 0.05
` 100
= 10%
2. Cost of 10% Debentures
Interest(1- t)
Kd =
Netproceeds

` 1,50,000 (1- 0.35)

=
` 15,00,000
= 0.065 or 6.5%
(ii) Computation of Weighted Average Cost of Capital based on
new capital structure
Source of Capital New Weights After tax WACC
Capital cost of (%)
structure (a) capital (%)
(`) (b) (a) x (b)
Equity share capital 10,00,000 0.222 12.777 2.836
(W.N.3)
12% Preference 15,00,000 0.334 12.000 4.000
share capital
10% Debentures 15,00,000 0.333 6.500 2.165
(W.N.2)

556
 12% Debentures 5,00,000 0.111 7.800 0.866
(W.N.4)
Total 45,00,000 1.000 9.867
Working Notes:
3. Cost of Equity Capital:
`7
Ke = + 0.05
` 90
= 12.777%
4. Cost of 12% Debentures
` 60,000 (1- 0.35)
Kd =
` 5,00,000
= 0.078 or 7.8%
(c) Fair Value of Company = Present Value all future cash flows discounted
at the expected Rate of return of acquiring company.
WN 1 – Calculation of Cash flows ` in Lakhs
YEAR 1 2 3 4 5 6
Contribution 10 12 14.4 20.16 28.22 35.28
(40% on sales)
(-) Fixed Cost -12 -12 -10 -10 -10 -10
NPBT (A) -2 0 4.4 10.16 18.22 25.28
(-) Losses Set Off 0 0 -2(Setoff) 0 0 0
Taxable Income 0 0 2.4 10.16 18.22 25.28
(-) Tax @ 25% 0 0 0.6 2.54 4.55 6.32
(B)
Cash Flow (A – -2 0 3.8 7.62 13.66 18.96
B)
PV OF CASH -1.740 0 2.50 4.35 6.79 8.19
FLOWS @ 15%
Total PV of cash flows (yr 1 to 6) = 20.08 lakhs
18.96 + 10%
(+) PV of cash flow at terminal value (end of Year 6) =
0.15 - 0.10
= 417.12 Lakhs
Therefore, PV of above = 417.12 X PV factor (15%, 6th Year)
= 180.20 lakhs
Total fair value of Aryayash limited = 20.08 + 180.20 = 200.28 Lakhs
Note – 1. Discounting rate should be the desired rate of acquiring
company i.e. of Vyom Limited

557
 2. Terminal value of cash flows means the cash flows at that point
from where it would grow at constant rate. Here it assumed that
from 7th year, Cash flows/NPAT will grow at a constant rate and not
sales
2. (a) Working Note:
1. Current Liabilities and Current Assets:
Let Current Liabilities be x
Given Current ratio = 2.5
Current Assets = 2.5x
Working Capital = 2.5x- x =1.5x
or x = 1,20,000/1.5 = 80,000
So Current Liabilities = 80,000
And Current Assets = 80,000 x 2.5 = 2,00,000
2. Closing Stock
Given, Quick Ratio = 1.3
CurrentAssets - Closing Stock
=1.3
CurrentLiabilities - Bank Overdraft
2,00,000 - Closing Stock
= 1.3
80,000 -15,000
or Closing Stock = 2,00,000-84,500 =1,15,500
Opening Stock = 1,15,000 x 100/110 =1,05,000
3. Debtors
Given Debtors Velocity = 40 days
Debtors
x 365 = 40
Sales
7,30,000x40
Debtors = = 80,000
365
4. Gross Profit = 7,30,000 x 10/100 = 73,000
5. Proprietary Fund:
Proprietary Ratio = 0.6
Fixed Assets
= 0.6
Proprietary Fund
Working Capital
0.4
Proprietary Fund
1,20,000
Proprietary Fund = = 3,00,000
0.4

558
 Fixed Assets = 3,00,000 x 0.6 = 1,80,000
Net Profit = 10% of Proprietary Fund = 30,000
M/s Anya Co Ltd.
Trading and Profit and loss Account for the year ended
31 March 2024
Amount in Particulars Amount in
Particulars ` `
To Opening Stock 1,05,000 By Sales 7,30,000
To Purchase By Closing
(Balancing Fig.) 6,67,500 Stock 1,15,500
To Gross Profit 73,000
8,45,500 8,45,500
To Operating By Gross Profit 73,000
Expenses (Balancing
Figure) 43,000
To Net Profit 30,000
73,000 73,000

Balance Sheet as on 31 March 2024

Liabilities Amount in Assets Amount in
` `
Share Capital 2,50,000 Fixed Assets 1,80,000
Reserves & Surplus
(Opening bal. +
current profit) 50,000
Current Liabilities Current Assets
Bank Overdraft 15,000 Stock 1,15,500
Other Current
Liabilities 65,000 Debtors 80,000
Other Current
Assets 4,500
3,80,000 3,80,000
(b) As per Dividend discount model, the price of share is calculated as
follows:
D1 D2 D3 D4 D5 1
P= 1 + 2 + 3 + 4 + (K × 4
(1+Ke ) (1+Ke ) (1+Ke ) (1+Ke ) e -g) (1+Ke )

Where,
P = Price per share
Ke = Required rate of return on equity

559
 g = Growth rate
Calculation PV of Dividends
Year Dividend per share PVF @ 15% PV
1 4.4 0.870 3.828
2 4.84 0.756 3.660
3 5.324 0.658 3.503
4 5.856 0.572 3.350
Total 14.341
`5.856x1.05 1
PV of Terminal Value = 1
× = 61.488 x .572 = 35.171
(0.15 - 0.05) (1+ 0.15)4

Intrinsic value of share = PV of Dividends + PV of terminal value

= 14.341 + 35.171 = ` 49.512
3. 1. In-House Management of Receivables (With Dynamic Discounting)
Particulars:
1. Cash Discount Cost:
o Revised discount rate: 2.5%
o 60% of customers avail discount.
o Cost of Discount: ` 90,00,000 × 60% × 2.5% = ` 1,35,000
2. Bad Debts (Reduced to 0.8% due to dynamic discounting):
o ` 90,00,000 × 0.8% = ` 72,000
3. Administration Cost: ` 1,20,000
4. Cost of Financing Receivables:
o Working Note 1 (Average Collection Period): (10 days × 60%)
+ (60 days × 40%) = 30 days
o Working Note 2 (Average Receivables): ` 90,00,000 ×
(30/360) = ` 7,50,000
o Working Note 3 (Cost of Financing):
 Cost of Bank Funds: ` 7,50,000 × 1/2 × 15% = ` 56,250
 Cost of Owned Funds: ` 7,50,000 × 1/2 × 14% = ` 52,500
 Total Cost of Financing Receivables: ` 1,08,750
Total Cost with In-House Receivables Management and Dynamic
Discounting:
Particulars Amount (`)
Cash Discount (` 90,00,000 × 60% × 2.5%) 1,35,000
Bad Debts (` 90,00,000 × 0.8%) 72,000
Admin Cost 1,20,000

560
 Cost of Financing Receivables 1,08,750
Total Cost (In-House with Dynamic Discounting): 4,35,750
2. Factoring Firm’s Offer:
Particulars:
1. Factoring Commission: ` 90,00,000 × 4% = ` 3,60,000
2. Interest Charges on Receivables: Factor Reserve: 12%, so
financing on 88% of receivables. Interest for 25 days: (` 90,00,000-
3,60,000) × 88% × 15% × (25/360) = ` 79,200
3. Cost of Owned Funds (Receivables not factored): ` 13,96,800 ×
14% × (25/360) = ` 13580
Owned Funds: (` 90,00,000-3,60,000) × 12% + 3,60,000 = ` 13,96,800
Total Cost with Factoring Firm:
Particulars Amount (`)
Factoring Commission (` 90,00,000 × 4%) 3,60,000
Interest Charges on Receivables 79,200
Cost of Owned Funds 13,580
Total Cost with Factoring: 4,52,780
3. Impact of Extending Credit Period:
If Zomo Ltd. extends the credit period to 75 days:
• Sales increase: 10% of ` 120,00,000 = ` 12,00,000
New total turnover = ` 120,00,000 + ` 12,00,000 = ` 1,32,00,000
Credit Sales (75%) = ` 99,00,000
• Increased Bad Debts (1.5%): ` 99,00,000 × 1.5% = ` 1,48,500
• Late Payment Penalty: Customers delaying beyond 60 days (40%):
` 99,00,000 × 40% × 5% = ` 1,98,000
A. Cash Discount Cost:
• Discount rate: 2% (since there’s no mention of dynamic
discounting in this case)
• Percentage of customers availing discount: 60%
• Calculation: ` 99,00,000 × 60% × 2% = ` 1,18,800
B. Bad Debts (Increased to 1.5%):
• Calculation: ` 99,00,000 × 1.5% = ` 1,48,500
C. Administration Costs (Remains the same):
• The administration cost stays fixed at ` 1,20,000, as no change
in admin structure is mentioned.

561
 D. Cost of Financing Receivables (Based on the new extended
credit period):
• Working Note 1 (Average Collection Period): Credit period
has been extended to 75 days for customers who don't take the
discount (40% of customers).
o Revised Average Collection Period: (10 days × 60%) +
(75 days × 40%) = 36 days
• Working Note 2 (Average Receivables): ` 99,00,000 ×
(36/360) = ` 9,90,000
• Working Note 3 (Cost of Financing Receivables):
o Cost of Bank Funds (15%): ` 9,90,000× 1/2 × 15%
= ` 74,250
o Cost of Owned Funds (14%): ` 9,90,000 × 1/2 × 14%
= ` 69,300
o Total Cost of Financing Receivables: ` 74,250 +
` 69,300 = ` 1,43,550
Revised Bad Debts after Penalty:
• Bad debts before penalty: ` 1,48,500
• Penalty earned: ` 1,98,000
• Net effect on bad debts: ` 1,48,500 - ` 1,98,000 = (-` 49,500)
(Zomo Ltd. would effectively earn ` 49,500 from penalties,
reducing bad debt cost.)
4. Total Cost Calculation:
Now, summing up all the components:
Particulars Amount (`)
Cash Discount (` 99,00,000 × 60% × 2%) 1,18,800
Net Bad Debts after Penalty (–` 49,500) -49,500
Administration Costs 1,20,000
Cost of Financing Receivables 1,43,550
Total Cost (In-House with Extended Credit Period) ` 3,32,850

5. Final Decision:
Option Total Cost (`)
In-House with Dynamic Discounting 4,35,750
Factoring Firm’s Offer 4,52,780
In-House with Extended Credit Period 3,32,850
Recommendation: Zomo Ltd. should extend the credit period and
continue in-house management. This option will not only reduce costs

562
 (due to lower bad debts offset by penalties) but also increase sales by
10%. Factoring is the least beneficial due to its high commission
charges, and dynamic discounting offers only marginal savings
compared to the credit extension option.
4. (a) The financing of current assets involves a trade off between risk and
return. A firm can choose from short or long term sources of finance.
Short term financing is less expensive than long term financing but at the
same time, short term financing involves greater risk than long term
financing.
Depending on the mix of short term and long term financing, the
approach followed by a company may be referred as matching approach,
conservative approach and aggressive approach.
In matching approach, long-term finance is used to finance fixed assets
and permanent current assets and short term financing to finance
temporary or variable current assets. Under the conservative plan, the
firm finances its permanent assets and also a part of temporary current
assets with long term financing and hence less risk of facing the problem
of shortage of funds.
An aggressive policy is said to be followed by the firm when it uses more
short term financing than warranted by the matching plan and finances
a part of its permanent current assets with short term financing.
(b) Over-capitalization and its Causes and Consequences
It is a situation where a firm has more capital than it needs or in other
words assets are worth less than its issued share capital, and earnings
are insufficient to pay dividend and interest.
Causes of Over Capitalization
Over-capitalisation arises due to following reasons:
(i) Raising more money through issue of shares or debentures than
company can employ profitably.
(ii) Borrowing huge amount at higher rate than rate at which company
can earn.
(iii) Excessive payment for the acquisition of fictitious assets such as
goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and
distribution of dividends at a higher rate.
(v) Wrong estimation of earnings and capitalization.
Consequences of Over-Capitalisation
Over-capitalisation results in the following consequences:
(i) Considerable reduction in the rate of dividend and interest
payments.
(ii) Reduction in the market price of shares.

563
 (iii) Resorting to “window dressing”.
(iv) Some companies may opt for reorganization. However, sometimes
the matter gets worse and the company may go into liquidation.
(c) “The profit maximisation is not an operationally feasible criterion.” This
statement is true because Profit maximisation can be a short-term
objective for any organisation and cannot be its sole objective. Profit
maximization fails to serve as an operational criterion for maximizing the
owner's economic welfare. It fails to provide an operationally feasible
measure for ranking alternative courses of action in terms of their
economic efficiency. It suffers from the following limitations:
(i) Vague term: The definition of the term profit is ambiguous. Does it
mean short term or long term profit? Does it refer to profit before or
after tax? Total profit or profit per share?
(ii) Timing of Return: The profit maximization objective does not make
distinction between returns received in different time periods. It
gives no consideration to the time value of money, and values
benefits received today and benefits received after a period as the
same.
(iii) It ignores the risk factor.
(iv) The term maximization is also vague.
OR
(c) Modified Internal Rate of Return (MIRR): There are several limitations
attached with the concept of the conventional Internal Rate of Return.
The MIRR addresses some of these deficiencies. For example, it
eliminates multiple IRR rates; it addresses the reinvestment rate issue
and produces results, which are consistent with the Net Present Value
method.
Under this method, all cash flows, apart from the initial investment, are
brought to the terminal value using an appropriate discount rate (usually
the cost of capital). This results in a single stream of cash inflow in the
terminal year. The MIRR is obtained by assuming a single outflow in the
zeroth year and the terminal cash inflow as mentioned above. The
discount rate which equates the present value of the terminal cash inflow
to the zeroth year outflow is called the MIRR.

564
 ANSWERS OF MODEL TEST PAPER 7

INTERMEDIATE: GROUP – II

PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT

PAPER 6A : FINANCIAL MANAGEMENT

Suggested Answers/ Hints

PART I – Case Scenario based MCQs

D1
1. (b) Ke = P0
+g
2
= +0.05 = 15%
20

I (1- t )+
(RV-NP ) (100-102.90)

2. (b) Kd = n =
9(1-0.35)+
10
= 5.48%
(RV+NP ) (100+102.90)
2
2

PD+
(RV-NP )
n
(RV+NP )
3. (a) Kp = 2
100- 102.82
11 + � �
Kp = 10
100 + 102.82 = 10.57%
� �
2

4. (a) Calculation of WACC using market value weights

Source of capital Market Weights After tax WACC (Ko)

Value cost of
capital
(`) (a) (b) (c) = (a)×(b)
Debentures (` 105 per 2,88,750 0.1672 0.0548 0.0092
debenture)
Preference shares (` 106 2,38,500 0.1381 0.1057 0.0146
per preference share)
Equity shares (` 24) 12,00,000 0.6947 0.1500 0.1042
17,27,250 1.00 0.1280
WACC (Ko) = 12.80%

565
 D1
5. (a) Current Market Price =
Ke-g

2
= = ` 40 per share
0.10 − 0.05
EBIT
6. (c) DFL =
EBT
DFL = 4,00,000/3,00,000 = 1.33
EBIT
Interest Coverage Ratio =
Interest Expense
= 4,00,000/1,00,000 =4
Sales
Operating Profit Margin = x100
EBIT
Operating Profit Margin = (4,00,000/16,00,000) × 100 = 25%
7. (c) COGS = Sales x (1−Gross Profit Margin)
COGS = 6,00,000 x (1−0.20) = 6,00,000 x 0.80 = 4,80,000
The velocity of stock is 3 months.
stock turnovers per year (12/3) = 4
Stock Turnover Ratio = COGS / Average Stock
Average Stock = 4,80,000/4 = 1,20,000
Average Stock = (Opening Stock + Closing Stock)/2
Closing Stock = 1,50,000
8. (d) 1, 2 and 3

PART II – Descriptive Questions

1. (a) Balance Sheets of Alpha Limited
` `
Liabilities 31 March 31 March Assets 31 March 31 March
2023 2024 2023 2024
Equity share 20,00,000 20,00,000 Fixed Assets
capital (` 10 (`18,90,000– `90,000) 18,00,000 15,39,000
each fully paid)
Reserve and 1,30,000 1,30,000 Long term investment − 2,96,600
Surplus
(balancing)
Profit & Loss 2,70,000 6,15,600 Current Assets
A/c (` 10,00,000)
(15% of sales)

566
Current Stock 4,00,000 5,20,000
Liabilities
Bank Overdraft 1,00,000 − Sundry Debtors 3,00,000 4,95,000
Creditors 3,00,000 4,15,000 Cash at Bank 3,00,000 3,10,000
(Balancing)
Total 28,00,000 31,60,600 Total 28,00,000 31,60,600

Calculation for 31st March, 2023

(i) Calculation of Current Liabilities
Suppose that Current Liabilities = x, then current assets will be
2.5 x
Working capital = Current Assets – Current Liabilities
6,00,000 = 2.5x – x
x = 6,00,000 / 1.5 = ` 4,00,000 (C.L.)
Other Current Liabilities = Current Liabilities – Bank
Overdraft
(Creditors) = 4,00,000 – 1,00,000 = ` 3,00,000
Current Assets = 2.5 x 4,00,000 = ` 10,00,000
Liquid Assets
(ii) Liquid Ratio =
Current Liabilities
Liquid Assets
1.5 =
4,00,000
Liquid assets = `6,00,000
Liquid assets = Current Assets – Stock
6,00,000 = 10,00,000 – Stock
So, Stock = ` 4,00,000
(iii) Calculation of fixed assets: Fixed assets to proprietary fund is 0.75,
working capital is therefore 0.25 of proprietary fund. So,
Fixed Assets = 6,00,000 / 0.25 x 0.75 = ` 18,00,000
(iv) Sales = (14,40,000 / 80) × 100 = ` 18,00,000
2
(v) Debtors = x Sales
12
2 / 12 × 18,00,000 = ` 3,00,000
(vi) Net profit = 15% of `18,00,000 = ` 2,70,000
Calculation for the year 31st March, 2024
(vii) Sales = 18,00,000 + (18,00,000 × 0.2) = 21,60,000
(viii) Calculation of fixed assets

567
 ` `
To Opening 18,00,000 By Banks (Sale) 90,000
balance
By Loss on sales of Fixed 90,000
asset
By P & L (Dep.) (5% as in
previous year) 81,000
________ By Balance b/d 15,39,000
Total 18,00,000 18,00,000
(ix) Net profit for the year 2011, 16% × 21,60,000 = ` 3,45,600
Total Profit = 2,70,000 + 3,45,600 = ` 6,15,600
(b) EBIT = ` 3,00,000
Less: Interest = ` 10,00,000 × 10% = ` 1,00,000
Earnings available to equity shareholders = ` 2,00,000
Equity capitalization rate = 12.5%
` 2,00,000
Market value of equity = = ` 16,00,000
12.5%
Market value of debt = ` 10,00,000
Market value of the firm = ` 26,00,000
` 3,00,000 × 100
Overall cost of capital = = 11.54%
` 26,00,000

(c) (i) Increase in taxable income if sales increase by 6%.

Contribution ` 1,40,000
Combined Leverage= = =4
EBT ` 35,000
If the sales increases by 6%, EBT will increase by 24%. (4 × 6%)
(ii) Increase in EBIT if sales increase by 10%.
Contribution `1,40,000
Operating Leverage= = = 3.5
Earnings before interest and tax ` 40,000
If sales increases by 10%, EBIT will increase by (3.5× 10) 35%.
(iii) Increase in taxable income if EBIT increase by 6%.
Earnings before interest and tax(EBIT) ` 40,000
Financial Leverage = =
EBT `35,000
=1.14
If EBIT increases by 6%, EBT will increase by 6.8%. (1.14 × 6%)

568
2. (a) Problem mentions that the company has applied to the Private Bank for
financing its working capital needs. Ideally, banks would not finance for
Depreciation cost being a non-cash cost and it would also not finance
the profit for you. So, problem needs to be solved using Cash Cost Basis.
Estimation of working capital required (cash cost basis)

Particulars Amount
A) Current Assets
A1) Stock of RM 15,84,960 x 30/360 1,32,080.00
A2) Stock of WIP (From Cost Statement) 4,77,360.00
A3) Stock of FG (From Cost Statement) 2,37,500.00
A4) Debtors 32,74,686 x 45/360 4,09,335.75
A5) Cash & Cash
(Given) 1,25,000.00
Equivalents
Gross Working
13,81,275.75
Capital

Less: B) Current Liabilites

B1) Creditors 17,17,040 x 30/360 1,43,086.67
B2) Lag in Wages
9,20,400 x 15/360 38,350.00
Payment
Excess of Current
Assets Over Current (A) - (B) 11,99,839.08
Liabilites
Safety Margin @ 15%
Add: Of Net Working
Capital 2,11,736.31
Net Working Capital 14,11,575.39
WN -1: Calculation of Profit
Profit = 25% of total cost i.e 20% of sales price
= {(31,200-2,500) x 150} x 20% = Rs. 8,61,000
WN – 2:

Completed Units WIP Units

31,200 9,360
Raw Mat. Consumed 12,48,000 3,36,960
Direct Wages 7,80,000 1,40,400
Overheads 9,36,000 1,68,480
29,64,000 6,45,840
Gross Factory Cost 36,09,840

569
 Add: Op WIP -
Less: Cl. WIP (At Prime Cost) 4,77,360
Cost of Production 31,32,480
Add: Op FG Stock -
Less: Cl. FG Stock 2,37,500
Cash Cost of Goods Sold 28,94,980
Add: Selling & Distribution Expenses
3,79,706
(Bal. Figure)
Cost Of Sales 32,74,686
Profit* 8,61,000
Sales 41,35,686
*It is assumed that profit is unchanged
WN 3 - Calculation of WIP stock (units) and WIP stock amount
WIP UNITS = 30% of FG produced units i.e 30% of 31,200 units
= 9,360 units
WIP amount (at prime cost)
Raw materials = 9,360 x 40 x 90% = 3,36,960
Direct wages = 9,360 x 25 x 60% = 1,40,400
WN 4 - Calculation of purchases from suppliers
Raw Materials Consumed = OP RM Stock + Purchases - Closing RM
Stock
15,84,960 = 0 + Purchases – 1,32,080
Purchases = 17,17,040
WN 5 – Calculation of safety margin
Safety Margin = 15% Of Net Working Capital Needs
Excess Of CA Less CL 85 11,99,839.08
Safety Margin 15 2,11,736.31
Net Working Capital 100 1411575.388
(b) EPS = ROE x BVPS (WN 1)
EPS = 0.15 x 125 = ` 18.75
Growth = ROE x Retention Ratio
= 0.15 x 0.65
= 9.75%
D1 = Do (1 + g)

570
 = (18.75 x 35%)(1 + 0.0975)
= ` 7.20
Intrinsic Value of share today - Gordon’s Formula
D1
Po =
Ke-g

7.20
=
0.20-0.0975
Po = ` 70.24
Intrinsic Value of share today - Walter’s Model
r
D+ (E -D)
Po = Ke
Ke
Here D = Do assuming it would remain constant through infinity
0.15
6.5625+ (18.75 - 6.5625)
Po = 0.20
0.20
Po = ` 78.51
WN 1 - Relationship between ROE-EPS-BVPS

Earnings for Equity Shareholders

ROE =
Equity shareholders funds

If we divide the numerator and denominator with “No of equity shares”

Earnings for Equity Shareholders / No of equity shares

ROE =
Equity shareholders funds / No of equity shares
Therefore, ROE = EPS / BVPS
3. Calculation of NPV (Amount in crores)
Year 1 2 3 4 5 6 7 8 9 10
EBT 2.000 2.500 4.000 4.750 6.000 6.400 6.150 5.250 3.800 2.900
Add: Interest 0.195 0.195 0.195 0.252 0.252 0.252 0.252 0.252 0.252 0.252
Add: Allocated
0.125 0.125 0.125 0.125 0.125 0.125 0.125 0.125 0.125 0.125
Common Cost
Project Profit Before
2.320 2.820 4.320 5.127 6.377 6.777 6.527 5.627 4.177 3.277
Tax
Less: Tax - - - 1.154 1.435 1.525 1.469 1.266 0.940 0.737
Profit After Tax 2.320 2.820 4.320 3.973 4.942 5.252 5.058 4.361 3.237 2.539
Add: Depreciation 2.410 2.410 2.410 2.410 2.410 2.410 2.410 2.410 2.410 -
Cash Inflows 4.730 5.230 6.730 6.383 7.352 7.662 7.468 6.771 5.647 2.539

571
Add: Release Of
- - - - - - - - - 5.000
Working Capital
Add: Net Cash Inflow
from sale of asset - - - - - - - - 3.471
-
(Net Of Tax) (WN-3)
Total Cash Inflows 4.730 5.230 6.730 6.383 7.352 7.662 7.468 6.771 5.647 11.010
DF @ 15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247
PV Cash Inflow 4.113 3.955 4.425 3.650 3.655 3.312 2.808 2.213 1.605 2.722

TOTAL PV CI = 32.458 Crores

(-) TOTAL PVCO = 30.000 Crores (Initial Outlay + Working Capital)
NPV = 2.458 Crores
ADVISE - Since NPV is positive, company should go for the project.
Notes - 1. Allocated common costs are to be excluded from cash inflows
2. Dividend distribution are deemed irrelevant for cash flow analysis
3. Discounting rate = MCLR + premium = 12 + 3 = 15%
4. Interest exp is to be excluded from the cash inflows as it is already
getting covered in the discounting rate above
5. Professional fees paid for project report and R&D costs being
sunk costs are irrelevant for decision making
WN 1 – Calculation of applicable taxes each year
For the first 3 years, tax will be zero and for the next 7 years tax rate applicable
would 22.5% (30 x 0.75) as balance tax will be paid in Australia, so it will have
no relevance under India perspective calculations.
WN – 2 Calculation of interest expense each year
Since post tax interest rate is given in the question, firstly it needs to be
converted to pre-tax rate. However, for the first 3 years of the project, post-
tax and pre-tax rate would be same owing to zero taxes
Interest Expense (first 3 years) = 3,00,00,000 X 6.5% = 19,50,000 or 0.195
crores
Interest Expense (next 7 years) = 3,00,00,000 x 8.39% = 25,17,000 or 0.2517
crores
Post tax Rate
Pre-tax Interest Rate =
1 – India Tax Rate
= 6.5 / (1 - 0.225)
= 8.39%
WN 3 – CALCULATION OF CAPITAL GAINS INCOME IN YEAR 10
Cost of Asset remaining in the block at the beginning of Year 10
= 3,31,00,000 (2,41,00,000 + 90,00,000)

572
 (+) New Asset purchased during the year = 0
(-) Sale Value of the Asset = 3,50,00,000
Capital Gains Income before tax = 19,00,000
(-) Capital Gains tax = 19,00,000 x 15% = 2,85,000
Net Cash Inflow after tax = 3,50,00,000- 2,85,000
= 3,47,15,000
B) Current Payback Period = 4 + 1.927 /7.352
= 4.262 years
Target Payback Period = 3.5 years
Some key measures to reduce your Payback period are as follows
(Only illustrative):
i. Emphasizing on reduction of operational costs
ii. Improving marketing thereby resulting into higher sales
iii. Incorporate product-led growth strategies
iv. Judicious efforts in bringing down the overall cost of capital thereby
reducing the discounting rate and in turn better Payback period.
v. Leveraging out the presence of the fixed cost
4. (a)
Particulars Factoring Forfaiting
A) Meaning Factoring involves Forfaiting is a form of
sales of receivables to export financing where
the financial institution the exporter sells the
called factor in rights to trade
exchange for immediate receivables to a forfaiter
cash payment and receives instant
cash
B) Recourse or May be on Recourse or Always non-recourse
non-recourse Non-recourse basis
C) Amount paid Firms are generally paid 100% on the value of
80% to 90% upfront exported goods is paid
D) Type of Receivables may either Receivables are
receivables domestic or international
international
E) Cost Factoring cost in the Overseas Buyer bears
form of factor the forfaiting cost, if any
commission or fees is to
be borne by the seller

573
 F) Secondary Factoring does not Forfaiting has a
market involve a secondary secondary market
market for the where the receivables
receivables, meaning can be traded,
that the transaction is enhancing liquidity and
complete once the providing additional
receivables are sold to opportunities for
the factor. investors
(b) Some of the tasks that demonstrate the importance of good
financial management
• Taking care not to over invest in fixed assets
• Balancing cash-outflows with cash-inflows
• Ensuring that there is a sufficient level of working capital
• Setting sales revenue targets that will deliver growth
• Increasing the Gross profit by setting the correct pricing for products
or services
• Controlling the level of general and administration expenses by
finding more cost-efficient ways of running the day-to-day business
operations
• Tax Planning that will minimize the taxes a business has to pay
(c) A drop lock is an arrangement whereby the interest rate on a floating-
rate note becomes fixed if it falls to a specified level. Above that level the
rate floats based on a benchmark market rate, typically with a semi-
annual reset. In other words, drop lock bonds marry the attributes of both
floating-rate securities and fixed-rate securities. The drop lock
effectively sets a floor on the rate and a guaranteed minimum return to
Or
(c) Advantage to the Company - Stock dividends are suitable in the
situation of cash crunch and deficiency faced by the company and
suitable when restrictions are imposed by lenders to pay the cash
dividend
Advantage to the investor – Improves liquidity in the hands of the
investors as bonus shares leads to breaking down of higher priced
shares into lower priced shares and hence give a choice to shareholders
to sell some of the lower priced shares and get some liquidity

574
 ANSWERS OF MODEL TEST PAPER 8
INTERMEDIATE: GROUP – II
PAPER – 6: FINANCIAL MANAGEMENT & STRATEGIC MANAGEMENT
PAPER 6A : FINANCIAL MANAGEMENT
Suggested Answers/ Hints
PART I – Case Scenario based MCQs
1. i. (D) ` 3.3779
ii. (B) ` 8.3655
iii. (A) ` 72.28
iv. (C) ` 45.79
v. (B) ` 54.33
Intrinsic Value = Sum of PV of Expected Dividends + PV of Share Price at the
end of the period
The following steps are required:
A. Determine PV of expected dividends to be received in the next four years.
B. Determine PV share at the end of 4th Year.
C. Add the values of A and B above.
(A)
Year D1 = D0(1+g) PV Discount PV in
Factor @ 12% `
1 2(1+14%) =2.28 0.893 2.0364
2 2.28(1+14%) =2.5992 0.797 2.0715
3 2.5992(1+14%) =2.9631 0.712 2.1097
4 2.9631(1+14%) =3.3779 0.636 2.1483
(A) Total PV of Expected Dividend ` 8.3655

𝐷𝐷5 𝐷𝐷4 (1+𝑔𝑔) 3.3779(1+7%)

𝑃𝑃4 = 𝐾𝐾 = = = ` 72.28
𝑒𝑒 −𝑔𝑔 𝐾𝐾𝑒𝑒 −𝑔𝑔 12%−7%

(B) PV of share at the end of 4th Year = ` 72.28 x 0.636 =` 45.97

(C) Market Price of shares = ` 8.3655 + ` 45.97=` 54.33
2. (B) 6.16%
To calculate WACC, we use the formula:
WACC = (E/V) × Re + (D/V) × Rd × (1 - Tc)
Let V be the total value of the firm, then Debt is equal to 1.5/(1+1.5) times
the value of the firm and Equity is equal to 1/(1+1.5) times the value of
the firm.
So, D/V = 1.5/(1+1.5) = 0.6 and E/V = 1/(1+1.5) = 0.4

575
 WACC = 0.4 × 10% + 0.6 × 6% × (1 - 40%) = 4% + 2.16% = 6.16%
Therefore, the company's weighted average cost of capital is 6.16%.
3. (A) 1.11
EBIT = 3,00,000 x (3-1) – 3,50,000 = 2,50,000,
PBT = 2,50,000 – 25,000 – 2,25,000
FL = 2,50,000/2,25,000 = 1.11
4. (C) both automatic and approval route

PART II – Descriptive Questions

1. (a) Calculation of Cost of Preference Shares (Kp)
Preference Dividend (PD) = 0.12 x 40,000 x 100 = 4,80,000
Floatation Cost = 40,000 x 2 = ` 80,000
Net Proceeds (NP) = 42,00,000 – 80,000 = 41,20,000
Redemption Value (RV)= 40,000 x 110 = 44,00,000
PD + (RV - NP) / N
Cost of Redeemable Preference Shares =
RV + NP
2
4,80,000 + (44,00,000 - 41,20,000) / 10
Kp =
44,00,000 + 41,20,000
2
4,80,000 + (2,80,000) / 10
=
85,20,000 / 2
4,80,000 + 28,000 5,08,000
= =
42,60,000 42,60,000
= 0.1192
Kp = 11.92%
(Note: Kp may be computed alternatively by taking the RV and NP for
one unit of preference shares. Final figure would remain unchanged).
(b) Calculation of Net Cash flow
Contribution = (3.00 – 1.75) × 50,000 = ` 62,500
Fixed costs = 40,000 – [(1,25,000 – 30,000)/5] = ` 21,000
Year Capital Contribution Fixed Adverts Net cash
(`) (`) costs (`) (`) flow (`)
0 (1,00,000) - - - (1,00,000)
1 (25,000) 62,500 (21,000) (10,000) 6,500
2 - 62,500 (21,000) (15,000) 26,500
3 - 62,500 (21,000) - 41,500

576
 4 - 62,500 (21,000) - 41,500
5 30,000 62,500 (21,000) - 71,500
Calculation of Net Present Value
Year Net cash flow 10% discount factor Present value
(`) (`)
0 (1,00,000) 1.000 (1,00,000)
1 6,500 0.909 5,909
2 26,500 0.826 21,889
3 41,500 0.751 31,167
4 41,500 0.683 28,345
5 71,500 0.621 44,402
NPV 31,712
The net present value of the project is ` 31,712.
(c)
(`)
Sales 24,00,000
Less: Variable cost 12,00,000
Contribution 12,00,000
Less: Fixed cost 10,00,000
EBIT 2,00,000
Less: Interest 1,00,000
EBT 1,00,000
Less: Tax (50%) 50,000
EAT 50,000
No. of equity shares 10,000
EPS 5
`12,00,000
(a) Operating Leverage
= = 6 times
`2,00,000
`2,00,000
(b) Financial Leverage
= = 2 times
`1,00,000
(c) Combined Leverage = OL × FL = 6 × 2 = 12 times.
`50,000
(d) =
ROI =× 100 5%
`10,00,000
EAT-Pref.Dividend
Here ROI is calculated as ROE i.e.
Equity shareholders'fund
(e) Operating Leverage = 6
Δ EBIT
6=
0.25
577
 6 ×1
Δ EBIT
= = 1.5
4
Increase in EBIT = ` 2,00,000 × 1.5
= ` 3,00,000
New EBIT = ` 5,00,000
2. Working Notes:
1. Raw Material Storage Period (R)
Average Stock of Raw Material
=  365
Annual Consumption of Raw Material
` 45,000 + ` 65,356
= 2 ×365
` 3,79,644
= 53 days.
Annual Consumption of Raw Material = Opening Stock + Purchases-
Closing Stock
= ` 45,000 + ` 4,00,000 – ` 65,356
= ` 3,79,644
2. Work-in-Progress (WIP) Conversion Period (W)
Average Stock of WIP
WIP Conversion Period = 365
Annual Cost of Pr oduction

` 35,000 + ` 51,300
= 2 ×365
` 7,50,000
= 21 days
3. Finished Stock Storage Period (F)
Average Stock of Finished Goods
= × 365
Cost of Goods Sold
` 65,178
= 365 = 26 days.
` 9,15,000

` 60,181 + ` 70,175
Average Stock =
2
= ` 65,178.
4. Debtors Collection Period (D)
Average Debtors
= × 365
Annual Credit Sales

` 1,23,561.50
= 365
` 11,00,000
578
 = 41 days
` 1,12,123 + ` 1,35,000
Average debtors =  ` 1,23,561.50
2
5. Creditors Payment Period (C)
Average Creditors
= × 365
Annual Net Credit Purchases

 `50,079 + `70,469 
 
 2 
= × 365
` 4,00,000
= 55 days
(i) Operating Cycle Period
= R + W + F+ D - C
= 53 + 21 + 26 + 41 - 55
= 86 days
(ii) Number of Operating Cycles in the Year
365 365
= = = 4.244
Operating Cycle Period 86

(iii) Amount of Working Capital Required

Annual Operating Cost ` 9,50,000
= = = ` 2, 23,845.42
Number of Operating Cycles 4.244

3. (a) Plan I = Raising Debt of ` 2.5 lakh + Equity of ` 22.5 lakh

Plan II = Raising Debt of ` 10 lakh + Equity of ` 15 lakh
Plan III = Raising Debt of ` 15 lakh + Equity of ` 10 lakh
Calculation of Earnings per share (EPS):
FINANCIAL PLANS
Particulars Plan I Plan II Plan III
` ` `
Expected EBIT 5,00,000 5,00,000 5,00,000
Less: Interest (a) (25,000) (1,37,500) (2,37,500)
Earnings before taxes 4,75,000 3,62,500 2,62,500
Less: Taxes @ 50% (2,37,500) (1,81,250) (1,31,250)
Earnings after taxes (EAT) 2,37,500 1,81,250 1,31,250
Number of shares (b) 15,000 10,000 8,000
Earnings per share (EPS) 15.83 18.13 16.41
Financing Plan II (i.e. Raising debt of ` 10 lakh and issue of equity share
capital of ` 15 lakh) is the option which maximises the earnings per
share.
579
 Working Notes:
(a) Calculation of interest on Debt
Plan ` `
I (` 2,50,000 ´ 10%) 25,000
II (` 2,50,000 ´ 10%) 25,000
(` 7,50,000 ´ 15%) 1,12,500 1,37,500
III (` 2,50,000 ´ 10%) 25,000
(` 7,50,000 ´ 15%) 1,12,500
(` 5,00,000 ´ 20%) 1,00,000 2,37,500
(b) Number of equity shares to be issued
` 22,50,000
Plan I = = 15,000 shares
` 150 (Market price of share)

` 15,00,000
Plan II = =10,000 shares
` 150
` 10,00,000
Plan III = = 8,000 shares
` 125
(b)
Ratios Navya Ltd. Industry
Norms
Current Assets `52,80,000 2.50
1. Current Ratio = = 2.67
Current Liabilities `19,80,000

2 Receivable Turnover Ratio `1,10,00,000 8.00

= 10.0
Sales `11,00,000
=
Debtors
Sales `1,10,00,000 9.00
3. Inventory turnover ratio = = 3.33
Stock `33,00,000

4. Total Asset Turnover ratio `1,10,00,000 2.00

= 1.43
Sales `77,00,000
=
Total Assets
Net Profit `2,31,000 3.50%
5 Net Profit Ratio = = 2.10%
Sales `1,10,00,000

6. Return on Total Asset `5,54,000 7%

= 7.19%
EBIT `77,00,000
=
Total Assets

580
 Net Profit `2,31,000 10.5%
7. Return on Net worth = = 4.81%
Net Worth ` 48,00,000

Total Debt `29,00,000 60%

8. = 37.66%
Total Assets `77,00,000

Comments:
1. The position of Navya Ltd. is better than the industry norm with
respect to Current Ratio and Receivables Turnover Ratio.
2. However, the Inventory turnover ratio and Total Asset Turnover
ratio is poor comparing to industry norm indicating that company is
inefficient to utilize its inventory and assets.
3. The firm also has its net profit ratio and return on net worth ratio
much lower than the industry norm.
4. Total debt to total assets ratio is lower that the industry standard
which suggests that the firm is less levered by debt and more by
equity resulting in less risky company.
4. (a) Inter-relationship between Investment, Financing and Dividend
Decisions: The finance functions are divided into three major decisions,
viz., investment, financing and dividend decisions. It is correct to say that
these decisions are inter-related because the underlying objective of
these three decisions is the same, i.e. maximisation of shareholders’
wealth. Since investment, financing and dividend decisions are all
interrelated, one has to consider the joint impact of these decisions on
the market price of the company’s shares and these decisions should
also be solved jointly. The decision to invest in a new project needs the
finance for the investment. The financing decision, in turn, is influenced
by and influences dividend decision because retained earnings used in
internal financing deprive shareholders of their dividends. An efficient
financial management can ensure optimal joint decisions. This is
possible by evaluating each decision in relation to its effect on the
shareholders’ wealth.
The above three decisions are briefly examined below in the light of their
inter-relationship and to see how they can help in maximising the
shareholders’ wealth i.e. market price of the company’s shares.
Investment decision: The investment of long term funds is made after
a careful assessment of the various projects through capital budgeting
and uncertainty analysis. However, only that investment proposal is to
be accepted which is expected to yield at least so much return as is
adequate to meet its cost of financing. This have an influence on the
profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each
source of funds involves different issues. The finance manager has to
maintain a proper balance between long-term and short-term funds. With
the total volume of long-term funds, he has to ensure a proper mix of
581
 loan funds and owner’s funds. The optimum financing mix will increase
return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the
decision to pay or declare dividend. He assists the top management in
deciding as to what portion of the profit should be paid to the
shareholders by way of dividends and what portion should be retained in
the business. An optimal dividend pay-out ratio maximises shareholders’
wealth.
The above discussion makes it clear that investment, financing and
dividend decisions are interrelated and are to be taken jointly keeping in
view their joint effect on the shareholders’ wealth.
(b) The financing of current assets involves a trade off between risk and
return. A firm can choose from short or long term sources of finance.
Short term financing is less expensive than long term financing but at the
same time, short term financing involves greater risk than long term
financing.
Depending on the mix of short term and long term financing, the
approach followed by a company may be referred as matching approach,
conservative approach and aggressive approach.
In matching approach, long-term finance is used to finance fixed assets
and permanent current assets and short term financing to finance
temporary or variable current assets. Under the conservative plan, the
firm finances its permanent assets and also a part of temporary current
assets with long term financing and hence less risk of facing the problem
of shortage of funds.
An aggressive policy is said to be followed by the firm when it uses more
short term financing than warranted by the matching plan and finances
a part of its permanent current assets with short term financing.
(c) Optimum Capital Structure: The capital structure is said to be optimum
when the firm has selected such a combination of equity and debt so that
the wealth of firm is maximum. At this capital structure, the cost of capital
is minimum and the market price per share is maximum.
Or
(c) In dividend price approach, cost of equity capital is computed by dividing
the current dividend by average market price per share. This ratio
expresses the cost of equity capital in relation to what yield the company
should pay to attract investors. It is computed as:
D1
Ke =
P0

Where,
D1 = Dividend per share in period 1
P0 = Market price per share today

582