INDEX

Sr Chapter Name Page Number

No.

1) INTRODUCTION TO FINANCIAL MANAGEMENT 1.1 – 1.25

2) TIME VALUE OF MONEY 2.1 – 2.13

3) CAPITAL BUDGETING 3.1 – 3.37

4) COST OF CAPITAL 4.1 – 4.21

5) CAPITAL STRUCTURE & LEVERAGE 5.1 – 5.41

6) DIVIDEND DECISIONS 6.1 – 6.23

7) WORING CAPITAL MANAGEMENT 7.1 – 7.43

8) SECURITY ANALYSIS 8.1 – 8.15

9) OPERATIONAL APPROACH TO FINANCIAL DECISIONS 9.1 – 9.31

 FINANCIAL MANAGEMENT 1.1

INTRODUCTION (FINANCIAL MANAGEMENT)

FINANCIAL Elements of Investment Decisions
FRAMEWORK
Elements of Financing Decisions
Elements of Dividend Decisions
Costing and Risk
Profit Maximisation Vs. Shareholder Wealth Maximisation
Relationship of Finance to Economics and Accounting

INTRODUCTION

Section Details

i) What capital investments are required? (e.g., real estate,

machinery, R&D, IT infrastructure)
Key Questions
ii) How will capital be procured? (fusion of equity and debt in capital
Before Starting a
structure)
Business
iii) How to manage day-to-day financial activities? (e.g., receivables
collection, payments to suppliers)

Relevance of Financial management helps entrepreneurs, companies, and

Financial organisations make robust financial decisions in starting and
Management managing businesses.

Divided into three phases:

Evolution of
1) Traditional Phase
Financial
2) Transitional Phase
Management
3) Modern Phase

- Time Period: Nearly four decades (early 20th century)

- Focus: Episodic events like formation, capital issuance, expansion,
merger, liquidation
- Approach: Descriptive and institutional
- Core Aspects: Instruments of financing, capital market procedures,
Traditional Phase legal aspects
- Perspective: Outsider’s point of view (investment bankers, lenders,
outsiders)
- Example Work: The Financial Policy of Corporations by Arthur S.
Dewing
- Treatment Style: Descriptive, institutional, legalistic

- Time Period: Early 1940s to early 1950s

Transitional Phase - Similar to traditional phase, but with shift
- Focus: Day-to-day financial issues

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- Key Areas: Funds analysis, planning, control, working capital

management
- Example Work: Essays on Business Finance by Wilford J. Eitman et
al.

- Time Period: Began mid-1950s, continues to present

- Focus: Rational matching of funds to uses to maximise shareholder
wealth
- Approach: Analytical and quantitative
Modern Phase
- Key Developments: Capital budgeting, asset pricing, capital
structure, efficient market theory, option pricing, agency theory,
valuation models, dividend policy, working capital management,
financial modelling, behavioural finance.

MEANING OF FINANCE

Section Details
- Finance is the backbone of any business.
- It defines the feasible area of operation and forms the
foundation of strategic planning.
Finance – Importance
- Finance is the art or science of managing money.
- It involves procurement and effective utilization of funds in
business.
- Finance in business = Oil in machines or Blood in the human body.
Analogy - Without finance, setting up, operating, or developing a business
is not possible.
- The word finance is derived from Latin word ‘finis’ meaning
end/finish.
Origin & - It can be interpreted as fund, money, investment, capital,
Interpretation amount, etc.
- Acts as a medium for acquisition and usage of funds across
departments (production, purchase, R&D).
- Finance is the science of managing, creating, and studying
money, banking, credit, investments, assets, and liabilities.
Extended Definition
- It includes financial systems (public, private, government
bodies), and the study of financial instruments.
Finance is the “Science or study of the management of funds,”
including:
Webster’s Dictionary – Circulation of money
Definition – Granting of credit
– Making investments
– Provision of banking facilities
- Deals with management, creation, and study of money and
Finance – Key
investments.
Characteristics
- Involves credit, debt, securities, and investment.

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- Strongly linked with time value of money, interest rates, and

future income flows.
1. Public Finance
Broad Categories of
2. Corporate Finance
Finance
3. Personal Finance
- Used by Central, State, and Local governments.
- Finances are collected via taxation and other means.
- Used as per predetermined policies and constitutional limits.
i) Public Finance
- Objective is social and economic upliftment, not profit.
- Studied separately to understand governmental financial
matters.
- Subfield dealing with corporate funding, capital structuring,
investment decisions, accounting.
- Goal: Maximize shareholder value via financial planning and
ii) Corporate Finance
strategies.
- Activities: Capital investment, tax planning, cash flow monitoring,
financial statement preparation, long-term financing (e.g., bonds).
- Covers individual money management, saving, investing.
- Includes: Budgeting, banking, insurance, mortgages, investments,
retirement, tax, estate planning.
iii) Personal Finance
- Involves creating plans to meet personal goals within financial
limits.
- Requires financial awareness to make informed decisions.

DEFINITION OF FINANCIAL MANAGEMENT

Section Details
Financial management is an integral part of overall management,
Core Idea focusing on raising and effectively utilizing funds to meet business
goals and enhance value.
Definition by “It is concerned with the efficient use of an important economic
Solomon resource namely, capital funds.”
Definition by Howard Financial management is “an application of general managerial
& Upton principles to the area of financial decision-making.”
Definition by Weston Financial management is “an area of financial decision-making,
& Brigham harmonizing individual motives and enterprise goals.”
Financial management is the “operational activity of a business
Definition by Joseph
responsible for obtaining and effectively utilizing funds for efficient
& Massie
operations.”
Definition by “Financial management is the activity concerned with planning,
Guthman & Dougal raising, controlling, and administering of funds used in the business.”
“Financial management is that area of business management devoted
Definition by J.F.
to judicious use of capital and careful selection of the source of
Brandley
capital to reach goals.”
Definition by Khan & “Finance is the art and science of managing money.”
Jain

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Definition by S.C. “Financial Management deals with procurement of funds and their
Kuchal effective utilization in the business.”
“Business finance is that business activity which concerns with the
Definition by
acquisition and conversion of capital funds to meet financial needs
Wheeler
and overall objectives.”
Definition by E.W. “Business finance is about planning, coordinating, controlling, and
Walker implementing financial activities of a business institution.”
Definition by Henry “Business Finance is concerned with the financing and investment
Hoagland decisions made by management in pursuit of corporate goals.”
“Business finance is concerned with the sources of funds available to
Definition by Gloss &
enterprises and the proper use of money or credit obtained from
Baker
such sources.”
“Business finance deals primarily with raising, administering, and
Definition by Parhter
disbursing funds by privately owned business units in non-financial
& Wert
fields of industry.”
“Corporation finance deals with financial problems of corporate
enterprises, including:
Encyclopaedia of – Promotion and early development
Social Sciences – Capital vs. income accounting issues
– Growth & expansion administration
– Financial adjustments for rehabilitation”
- Financial management broadly involves:
→ Raising funds at minimum cost
Conclusion
→ Efficient fund allocation to create asset value
→ Maximizing returns through optimal fund flow decisions

NATURE, SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

Section Details
- Money = Life-blood of business.
- All economic activities are carried out using money.
Importance of Money
- Money is required to pool resources, obtain physical/material
in Business
inputs, conduct business operations, pay for sales and compensate
suppliers.
Finance as an - Financial management is an organic function of business.
Organic Function - It is an important and indispensable part of every organisation.
- Organisations cannot sustain without proper finance.
Sustainability Aspect - Efficient management of financial resources is critical for long-
term viability and sustainability.
- Financial Management is the task of providing required funds on
most favourable terms.
Definition (Group of - Primarily focused on procurement of funds.
Experts) - Includes instruments, institutions, practices for raising funds.
- Covers legal and accounting relationships with fund sources.
- Financial management is broader than just procurement.
- It involves strategic planning, organising, directing, and
Comprehensive View
controlling financial undertakings.

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- Applies management principles to financial assets.

- Plays a key role in fiscal management.
Financial management = Effective and efficient planning,
organising, directing, and controlling of all financial processes.
Includes:
Detailed Definition
– Fund procurement
– Resource allocation
– Fund utilisation
- Financial management is pervasive.
- Applicable to all kinds of organisations:
→ Business
Universal Application → Philanthropic
→ Educational
→ Religious, etc.
- Wherever finance exists, financial management is crucial.
- It is not limited to fund-raising.
- Also focuses on efficient use of capital resources through:
Modern Perspective → Financial planning
→ Financial organisation
→ Financial control
- Ensuring fund availability
- Allocating funds for different uses
- Managing funds
- Investing wisely
Key Financial
- Controlling costs
Management Tasks
- Forecasting financial needs
- Profit planning
- Estimating return on investment (ROI)
- Assessing working capital

TYPES OF FINANCIAL DECISIONS

INVESTMENT DECISIONS
Section Details
- Most important decision for value creation.
- Investment = Using money to earn profits/returns.
Meaning of Investment Decision - Can be in physical assets (e.g., machinery) or
financial assets (e.g., shares, debentures).
- Always involves risk and uncertainty.
- Finance manager decides which activity should
receive resources.
- Investment proposals may come from all departments
Role in Firm
(marketing, production, HR, top management).
- Tied to capital budgeting: Will capital expenditure
today bring sufficient revenue tomorrow?

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1. Inventory Management – Stock holding =

Investment.
2. Strategic Investment – For long-term market
strength, delayed returns.
3. Modernisation – Tech upgrades to reduce cost =
Categories of Investment
capital deepening.
Decisions
4. New Business – Diversification or new product
lines.
5. Replacement – Substituting obsolete assets.
6. Expansion – Increase in capacity = capital
widening.
- Capital budgeting
- Cost of capital
- Risk measurement
Key Areas Involved
- Liquidity management
- Business restructuring
- Buy vs hire vs lease decisions
i) Capital outlays & earnings forecasts (value
Factors Determining Investment engineering & market forecasting)
Decisions ii) Availability and cost of capital (financial analysis)
iii) Selection standards (project appraisal & ROI)
- Long-term investment decision-making process.
- Involves large funds, hence careful evaluation is
Capital Budgeting
required.
- Returns expected over multiple years.
i) Expansion
ii) Acquisition
iii) Replacement
Examples of Capital Budgeting
iv) New Product
Decisions
v) R&D
vi) Major Advertisement
vii) Employee Welfare
a) High risk
Characteristics of Capital
b) Large estimated profits
Budgeting
c) Long time lag between investment and return
- Steps:
→ Forecast cash flows
Investment Decision Analysis
→ Determine opportunity cost of capital
→ Apply investment criteria
- Use cash flows, not earnings (earnings are non-cash
and manipulable)
- Consider incremental cash flows only
Issues to Consider
- Exclude sunk costs
- Choose correct investment criteria: NPV, IRR,
Payback, AAR, PI

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- Evaluate mutually exclusive vs independent projects

- Run sensitivity analysis
- Cash flows are real and spendable.
- Earnings can be manipulated (e.g., Forrest Gump
Earnings vs Cash Flow case).
- Financial decisions should focus on cash flow, not just
book profits.
1. Source of Funds: Are investments funded from
ops/retained earnings or debt?
2. Nature of Investments: Core business growth vs
unrelated securities?
3. Capital Intensity: High capex businesses reduce
free cash flow.
Cash Flow from Investing 4. Capitalisation of OpEx: Watch for inflated profits
Activities: What to Check via wrongly capitalised costs.
5. Inorganic Expansion: Are acquisitions value-adding
or risky diversifications?
6. Sale of Assets/Units: Is the sale strategic and
compliant?
7. R&D & In-house Spending: Only those creating
recognisable assets qualify as investing activity.
- Generally, cash outflows dominate this section.
- Can indicate growth (capex) or misdirection (poor
Understanding Investing
allocation).
Activities in Cash Flow Statement
- Negative cash flow is not always bad, if backed by
good returns.
- Disposal of PPE
Cash Flow from Investing –
- Sale of equity/debt securities
Inflows
- Maturity proceeds
- Purchase of PPE
Cash Flow from Investing –
- Acquisition of equity/debt
Outflows
- Long-term asset purchases
- Interest/dividends
- Debt/equity financing
Items Not Included
- Depreciation
- Normal operating income/expenses

FINANCING DECISIONS
Topic Description
Financing decisions are concerned with determining the best capital
Financing structure or financing mix to execute investment decisions. It involves
Decisions selecting the sources of long-term finance, such as equity, preference
shares, debentures, and loans.
- Capital structure is how a firm divides its cash flows into a fixed
Capital Structure component (debt obligations) and a residual component (equity
shareholders' returns).

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- It refers to the mix of debt and equity a company uses to fund its
operations and assets.
Components of - Owner's funds (Equity): Equity share capital, preference share capital,
Capital Structure reserves & surplus, retained earnings.
- Borrowed funds: Loans, debentures, public deposits.
Optimal Capital Capital structure is considered optimal when the proportion of debt
Structure and equity maximizes the value of the equity share of the company.
Financing decisions are integrated into top-management policy,
Role of Financing
affecting capital budgeting, long-range planning, and financial
Decisions
performance evaluation.
Factors Affecting 1. Cost: Finance managers prefer sources with the least cost.
Financing
Decisions
2. Risk: Borrowed funds have higher risk than owner’s funds. Managers
prefer securities with moderate risk.
3. Cash Flow Position: Companies with steady cash flow can afford
borrowed funds; those with poor cash flow prefer owner’s funds.
4. Control Considerations: Shareholders’ control preferences influence
financing decisions (debt vs. equity).
5. Floatation Cost: Finance managers consider floatation costs
(broker’s commission, underwriters’ fees, etc.) when choosing financing
sources.
Financial - Risk and Return Analysis: Used for investment and financing decisions
Management and to design an optimal capital structure.
Leverage
- Operating Leverage: Analyses fixed vs. variable costs to assess risk.
- Financial Leverage: Analyses how financing decisions affect earnings
per share (EPS).
- Combined Leverage: Combines operating and financial leverage to
assess the overall risk-return balance.
Cash Flow from - Financing activities in the cash flow statement include raising capital,
Financing paying back investors, issuing stock, taking on or repaying debt, and
Activities paying dividends.
- Positive cash flow from financing activities indicates inflows (e.g.,
issuing stock or debt). Negative cash flow indicates outflows (e.g.,
repaying debt, paying dividends).
Examples of Cash - Cash from issuing stock or repurchasing shares.
Flow Items
- Cash from issuing debt or paying down debt.
- Paying dividends to shareholders.
- Proceeds from stock options being exercised.
- Issuing convertible debt or other hybrid securities.

DIVIDEND DECISIONS
Topic Key Points

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Dividend Decision - A major area of financial management.

- Decides whether profits should be distributed, retained, or a
portion of each.
- Influenced by factors like shareholder tax position, firm’s cash
flow, and future growth needs.
- Interlinked with investment and financing decisions.
Factors Influencing
Dividend Policy
- No legal compulsion, but rules like net profit, capital impairment,
Legal Requirements
and insolvency apply.
Firm’s Liquidity - Liquidity affects the ability to pay dividends, even if earnings are
Position sufficient.
- If funds are needed for debt repayment, the capacity to pay
Repayment Need
dividends decreases.
Expected Rate of - Higher returns on new investments may lead firms to retain
Return earnings instead of paying dividends.
- Stable earnings lead to higher dividends, whereas fluctuating
Stability of Earnings
earnings reduce dividend payouts.
Dividend Decision - Dividends and investment are impacted by factors like FCFE (Free
Matrix Cash Flow to Equity) and ROE (Return on Equity).
Stable Dividend - Policies like stable payout ratio, stable dividends per share, and
Policy regular plus extra dividend policy are common.
Rationale for Stable - Stockholders prefer stability for financial security.
Policy
- Reduces uncertainty, leading to lower capital costs and higher
stock prices.
- Principles: "Bigger and Better" (larger benefits preferred) and "A
Decision Criteria
Bird in Hand" (early benefits preferred).
Investment Decision
Criteria
Urgency - Priority given to urgent projects.
- Projects with quicker paybacks are preferred. Example
Payback Period
calculations provided.
- Measures profitability as a percentage of capital employed. Can
Rate of Return (ROR)
be calculated through simple or annualized methods.
Undiscounted - Simple ratio of benefits to costs, though not as reliable as
Benefit-Cost Ratio discounted methods.
Discounted Benefit- - More reliable than undiscounted, as it considers the time value of
Cost Ratio money.
Present Value - Evaluates projects based on the present value of future benefits
Method and costs.
- The discount rate that equates the net benefits’ present value with
Internal Rate of
the project cost. A higher IRR compared to cost of capital signals a
Return (IRR)
favorable project.

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- Consists of equity (owners’ capital) and debt (debenture holders’

Capital Structure
interest in assets).
- Factors for including debt: tax savings, lower flotation cost,
advantage of leverage, no equity dilution, and better financial
ratios.
- Debt raised only on an adequate equity base to serve as a cushion
for debt financing.
- Leverage effect is crucial to determine the optimal mix of debt and
equity.
Value of Firm - Risk
and Return
Risk and Return - Greater risk is associated with greater expected return.
Relationship
- Government bonds are low-risk, low-return; shares are higher risk,
higher return.
- Finance manager needs to balance risk and return to maximize the
Risk-Return Trade-off
market value of the firm.
- A specific combination of risk and return optimizes the market
price of shares.
- Risk and return are interrelated, and managing this balance is key
to wealth maximization.
- Investment, financing, and dividend decisions affect the risk-
Financial Decisions
return trade-off and ultimately the firm's market price.
- Financial management decisions should aim to achieve the right
balance between risk and return.

LIQUIDITY
Topic Key Points
- Refers to the ability of a company to meet its short-term
Liquidity Concept
obligations.
- It measures how quickly a company can convert its assets into cash
to pay debts in the near future.
- Liquidity is crucial for managing liquid resources, minimizing costs,
and ensuring the availability of funds.
- Used to assess the effectiveness of managing current assets to meet
obligations.
Liquidity as a - Used to manage and monitor cash resources, inventories,
Decision Criterion receivables, and short-term obligations.
- Influenced by the company’s transaction, precautionary, and
speculative motives (transaction, precautionary, and speculative
motives for maintaining liquidity).
- Key ratios for assessing liquidity include Current Ratio, Quick Ratio,
Liquidity Ratios
and various receivables/inventory ratios.
- The ratio of current assets to current liabilities, used to assess the
Current Ratio
company's ability to pay off short-term obligations.

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- A higher ratio indicates better liquidity, but it can be a crude

measure if asset liquidity varies.
- Excludes inventory from current assets, focusing only on cash,
Quick Ratio receivables, and marketable securities for a more accurate liquidity
assessment.
- Measures the company’s ability to meet short-term liabilities
without relying on the sale of inventory.
- Difference between current assets and current liabilities;
Net Working Capital
represents funds available to meet day-to-day business needs.
- Net working capital divided by sales shows how much liquidity is
available per rupee of sales.
Liquidity of - Assessed using Average Collection Period (ACP) and Receivables
Receivables Turnover Ratio (RTR).
- ACP indicates the average time it takes to convert receivables into
cash.
- RTR is the inverse of ACP and shows how quickly receivables are
collected.
- Shortcomings: Low ACP may signal overly restrictive credit policies,
and high ACP indicates too liberal credit policies, possibly leading to
more bad debts.
Comparing - Comparing ACP and Receivables Turnover Ratio with accounts
Receivables with payable turnover ratio helps manage the liquidity position.
Payables
- Accelerating receivables collection while deferring payments can
help maintain liquidity, but it affects the company’s credit standing.
- Assessed using Inventory Turnover Ratio, which is the ratio of cost
Inventory Liquidity
of goods sold to average inventory.
- A higher ratio indicates efficient inventory management, with quick
conversion of inventory into receivables.
Liquidity and - Liquidity analysis affects various financial decisions including:
Financial Decisions
1. Management of cash and marketable securities.
2. Credit policies and receivables collection procedures.
3. Inventory management and control.
4. Management of fixed assets.
5. Efficient use of current assets with minimal cost.
6. Maintaining a strong financial position to avoid bankruptcy risks.
Liability - Liquidity management also involves assessing long and medium-term
Management debts and repayment arrangements.
- This precautionary approach ensures the company avoids risks
related to debt repayment and potential bankruptcy.

PROFITABILITY
Topic Key Points

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- Profitability is used as a decision-making criterion to evaluate a

Profitability
company's performance across various dimensions (e.g., profit per
Concept
unit of sale).
- Different users (creditors, shareholders, investors) assess
profitability using different ratios.
- Profitability ratios are used to assess the company’s ability to
Profitability Ratios
generate profits relative to sales, capital employed, or net worth.
Profitability to - Reflects the ability to generate profits per unit of sales. A higher
Sales Ratio ratio indicates better profitability and efficiency.
Profitability to - Profitability can also be assessed by comparing profits to total
Capital Employed capital employed or equity.
- Measures the profitability of equity holders’ investment. It’s
Return on Equity
calculated as net income or earnings available to common
(ROE)
shareholders divided by total equity.
- Two forms of calculation: Earnings available to common shareholders
/ Total Equity or Net Income after tax / Total Equity.
- Measures the efficiency of operations and pricing. Calculated as
Profit Margin
operating income divided by sales.
Gross Profit Margin - Assesses profitability after deducting the cost of goods sold.
- Indicates the efficiency of production operations and relationship
between production costs and selling price.
Net Profit Margin - Measures the company’s ability to generate profit after taxes and
(NPM) all expenses. Decline indicates higher expenses or tax burden.
Return on - Measures how well management earns a return on shareholder
Investment (ROI) resources.
- Calculated as earnings before interest and taxes (EBIT) to capital
employed or through asset turnover and margin of profit.
- A high ROI indicates efficient use of assets, while a low ROI suggests
inefficiency.
- Assesses the company’s ability to meet interest obligations.
Times Interest
Calculated as EBIT divided by interest charges. A ratio of 5-6 times
Earned (TIE)
is considered satisfactory.
Liquidity vs. - Liquidity ensures short-term survival, while profitability ensures
Profitability long-term growth and survival.
- Both goals compete, and a firm must maintain a balance between
liquidity and profitability to ensure overall success.
Examples of Return - Example 1: Vegan Steaks ROI for the year was 6.55% based on
on Investment average asset value.
- Example 2: The best-performing division (based on ROI) among the
divisions of It’ll Heal Medical Company was the Splint Division with an
ROI of 9%.

COSTING AND RISK

Topic Key Points

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- Refers to assessing the cost of capital from various sources (e.g.,

Costing
equity, debentures, long-term borrowings).
- Equity capital is owner’s money, while borrowed funds (debt) carry
interest and repayment obligations, introducing risk.
Risk of Borrowed - Interest on debt is a fixed charge and must be paid regardless of
Funds profit, leading to financial risk.
- High financial gearing can increase risk, as large borrowings may result
in higher fixed interest charges that need to be met even when earnings
decline.
- The use of debt in capital structure is called financial gearing or
Financial Gearing leverage. High gearing increases the potential for higher returns in good
times, but risks in poor times.
- Leverage/Financial Gearing: High leverage can increase earnings per
share if EBIT (earnings before interest and taxes) rises, but it can also
cause a steeper decline when EBIT falls.
Impact of - The optimal level of gearing minimizes the cost of capital.
Capital Gearing
- Modigliani and Miller theory suggests that the cost of capital is
independent of capital structure, assuming perfect market conditions.
- Risks can be classified into systematic (market-wide risks, e.g.,
Risk
inflation, recession) and unsystematic (specific to companies or
Classification
industries, e.g., lawsuits, strikes).
1. Financial Risk: Related to the use of debt and its impact on equity
Types of Risks
returns.
2. Business Risk: Operational risk, e.g., variability in company earnings.
3. Systematic Risk: Market-wide risk affecting all investments (e.g.,
inflation, war).
4. Unsystematic Risk: Unique to a company, can be diversified (e.g.,
lawsuits, internal operational issues).
5. Purchasing Power Risk (Inflation Risk): The risk that inflation reduces
the real value of future cash flows from investments.
6. Market Risk: Losses due to factors affecting the overall financial
market (e.g., stock market declines).
7. Interest Rate Risk: Investment losses from changes in interest rates
(e.g., rising rates decrease bond values).
8. Social Risk: Risk from actions affecting communities, such as labor
issues or human rights violations within a company.
9. Regulatory Risk: Risk from changes in laws or regulations affecting
companies or industries.
10. Reputational Risk: Loss of company reputation, caused by internal
actions or external factors (e.g., scandals, joint partner issues).
11. Operational Risk: Risks due to unforeseen events (e.g., natural
disasters, fires) that disrupt business operations.

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12. Competition Risk: The threat from competitors and market

saturation, especially if a company becomes complacent and fails to
innovate or adapt.

OBJECTIVES OF A FIRM
Objective Profit Maximization Shareholder Wealth Maximization
Focuses on maximizing Focuses on maximizing the net present
profits, achieved when value (NPV) of actions, i.e., the difference
Definition
marginal revenue equals between the present value of benefits and
marginal cost. costs.
Short-term focus on Long-term focus on maximizing the value
maximizing profits and for shareholders by increasing NPV,
Focus efficiency of resource considering time value of money and risks.
allocation in competitive
markets.
Hayek (1950), Fredman Solomon
Key Proponents
(1970)
Profit is the most NPV (Net Present Value) is used to
appropriate measure of a calculate the wealth maximization goal,
Concept firm’s performance under focusing on increasing shareholder wealth.
competitive market
conditions.
- Vague and hard to define - More comprehensive and operationally
- Ignores timing of returns feasible.
- Ignores risk - Takes long-term focus, risks, and the time
- Focuses on short-term value of money into account.
Criticisms
profits - Encourages sustainable growth and
- May lead to decisions with wealth creation.
long-term negative effects
- Can reduce share prices
Risk of ignoring other Takes risks into account, aiming for
stakeholders (e.g., sustainable growth.
Risks
employees, customers,
community).
To maximize profit in the To maximize the present value for
short term under shareholders and other stakeholders,
Goal
competitive market ensuring sustainable growth and returns
conditions. over the long run.
Often overlooks the Aims to benefit shareholders while
Stakeholders interests of other considering the needs of employees,
Consideration stakeholders, focusing customers, suppliers, and the community.
mainly on shareholders.
- Profits are measurable - Wealth maximization is a dynamic and
Operational
and easier to track. flexible approach.
Feasibility
- Decisions often based on - Provides a clear criterion for financial

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immediate financial management decisions in investments,

outcomes. financing, and dividends.
- Increase production - Revenue growth through increased sales
efficiency volume or price hikes.
- Minimize costs - Increase operating margin by reducing
Methods of
- Maximize output for input costs (e.g., COGS, SG&A).
Implementation
- Improve capital efficiency (e.g., Return
on Capital Employed, inventory
management).
- Focus on short-term - Increase sales volume or sales price to
profits. boost revenue.
Strategies for - Maximize operational - Reduce operating costs, focusing on
Achieving efficiency for immediate optimizing SG&A and COGS.
returns. - Increase return on capital employed
(ROCE) to improve capital efficiency.
- Businesses may opt for - Companies focusing on long-term
aggressive cost-cutting or strategies like diversifying products,
Example of
price hikes for immediate innovating, reducing costs, and managing
Operational
profit. assets effectively to maximize shareholder
Success
value (e.g., GM’s turnaround after the 2008
recession).
- May overlook ethical and - Can balance profitability with social
Ethical social considerations in responsibility, ensuring sustainable growth
Considerations Favor of maximizing short- without compromising social concerns.
term profits.

Criteria Profit Maximisation Shareholder Wealth Maximisation

Maximising profits in the short Maximising the market value of
Goal
term shares in the long term
Short-term profit generation Long-term value creation for
Focus
shareholders
Risk Consideration Ignores risk and uncertainty Considers risk and uncertainty
Timing of Returns Ignores the timing of returns Considers the time value of money
Shareholder’s Not directly focused on Directly focused on maximising
Return shareholders' returns shareholder returns
Aimed at short-term profit Aimed at increasing stock price and
Financial Decisions
maximisation shareholder wealth
Short-term goal Long-term goal focusing on
Objective Type
sustained growth
Relationship to Directly linked to profit Indirectly linked via stock price and
Profit generation cash flows
Decision-Making May involve non-sustainable, Focus on sustainable, long-term
Impact immediate financial actions strategies for growth

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 FINANCIAL MANAGEMENT 1.16

Influence on May overlook broader Considers long-term interests of

Stakeholders stakeholder interests shareholders and stakeholders

Economic Value-Added (EVA) – A Criterion to Gauge Shareholder’s Value

Aspect Description
Economic Value Added (EVA) is the net operating profit after tax
Definition of EVA
(NOPAT) minus the cost of capital.

Formula

Key Components - NOPAT (Net Operating Profit After Tax)

- Cost of Capital
- Capital Employed
EVA as a - Measures true economic profit, accounting for both operating costs
Performance and capital costs.
Measure
- Aligns managerial incentives with shareholder interests.
EVA as a Corporate - Encourages managers to focus on value-enhancing activities.
Philosophy
- Links managerial compensation to EVA for better alignment with
shareholder wealth.
Advantages - Focuses on shareholder wealth creation.
- Helps investors evaluate a company’s true performance and
potential.
- Useful in decentralized enterprises to track performance of
different units.
- Improves corporate governance and management transparency.
Disadvantages - Does not account for size differences between units.
- Potential for misuse by managers.
- May overemphasize short-term profits.
- Positive EVA means value creation, negative EVA means value
Interpreting EVA
destruction.
- Monitor EVA trends over time to evaluate ongoing performance.
- For projects, consider the full project life cycle when assessing EVA.

MARKET VALUE ADDED (MVA) – ANOTHER CRITERION TO GAUGE WEALTH MAXIMIZATION

Aspect Details

Definition of The difference between the market value of a company and the capital
MVA contributed by all investors.

Formula MVA=V−K

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- MVA: Market Value Added

Variables - V: Market value of the firm (equity + debt)
- K: Total capital invested in the firm.

To assess the wealth generated for shareholders and bondholders by

Purpose
comparing the market value and invested capital.

FINANCIAL DISTRESS AND INSOLVENCY

Aspect Details

Business Risk The firm must manage risks related to demand variability, product
Management prices, input prices, and fixed costs.

High debt levels lead to high interest payments. Inadequate cash

Financial Risk inflows can result in difficulties in paying interest and repaying
principal.

Consequences of If cash inflows are insufficient, the firm faces pressure from
Financial Distress creditors, failing sales, and a reduced ability to produce.

In financial distress, the firm may have to sell assets at below their
Distress Sale
economic value to meet obligations.

When liabilities exceed assets (negative net worth), the firm

Bankruptcy
becomes bankrupt after due legal processes.

- Technical Bankruptcy: Unable to meet current obligations, which

might be temporary and remediable.
Types of Bankruptcy
- Bankruptcy (Common Understanding): Liabilities exceed assets
permanently.

- Technical Bankruptcy: Measured by current ratio or quick ratio.

Indicators of
- Solvency Ratios: Measures long-term liquidity, such as debt-to-
Bankruptcy
equity ratio, debt-to-total funds ratio, and interest coverage ratio.

Analysing financial trends for the past 3-5 years to detect potential
Trend Analysis
bankruptcy signals.

FINANCIAL MANAGEMENT IS A SCIENCE OR AN ART

Aspect Details
Financial management is a subject within social science, closely
Nature of Financial
related to applied sciences, as it deals with people and uses tested
Management
knowledge in practical affairs.
Based on systematic principles, some of which can be tested
Scientific
mathematically (like laws in physics and chemistry). Tools like
Principles
computers and statistical techniques are widely used.

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 FINANCIAL MANAGEMENT 1.18

Role of Value Despite scientific tools, there is still a significant role for value
Judgement judgement, intuition, and experience in financial decision-making.
Financial management is both an art and a science. It requires
Finance as an Art
analytical skills and knowledge of financial techniques, as well as
and Science
intuitive capacities and personal judgment.
Financial functions (planning, organization, and control) involve both
Weston’s View
science (methodology, techniques) and art (value judgement, human
(Finance Functions)
skills).
Planning Function Short-term and long-term goals in planning require a mix of science
Example (techniques) and art (interpretation, judgement).
Financial management is both a science (theory and systematic
Conclusion
knowledge) and an art (application, value judgement).

EMERGING ROLES OF FINANCIAL MANAGER

Responsibility Description
Ensures successful day-to-day operations by matching cash
1. Forecasting of Cash Flow inflows and outflows, forecasting sources and timing of inflows
to meet liabilities.
Plans and mobilizes funds from various sources to meet the
2. Raising Funds enterprise’s short-term, medium-term, and long-term financial
needs.
3. Managing the Flow of Monitors surplus in bank accounts to ensure liquidity and
Internal Funds minimize external borrowings.
4. To Facilitate Cost Recognizes when costs exceed budgeted figures and
Control recommends measures for cost control to top management.
Provides information on cost changes and profit margins,
5. To Facilitate Pricing of
contributing to pricing decisions alongside the marketing
Products/Services
manager.
Collects relevant data and forecasts profit levels for the
6. Forecasting Profits
future.
Determines the required rate of return and decides whether
7. Measuring Required
investment proposals should be accepted based on expected
Return
returns.
Focuses on decision-making related to the optimal use of
8. Managing Assets assets, improving liquidity and profitability by reducing costs
and waste.
Ensures sufficient funds for business operations, payment of
9. Managing Funds bills, and dividends, balancing liquidity and profitability in
managing financing sources and assets.

RELATION OF FINANCE TO ECONOMICS AND ACCOUNTING

Aspect Finance & Economics Finance & Accounting

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 FINANCIAL MANAGEMENT 1.19

- Finance is influenced by - Macro-economic factors shape

macroeconomic factors like growth the environment for financial
Relation to
rate, inflation, tax structure, interest decision-making.
Economics
rates, and external economic
relationships.
- Micro-economics provides tools for - Understanding micro-
financial decision-making, like marginal economics sharpens financial
analysis (comparing incremental analysis.
benefits and costs).
- Finance and accounting are often - Accounting focuses on
Finance and linked but serve different functions. recording past financial
Accounting performance, while finance is
aimed at maximizing value.
- Accounting is focused on - Financial management focuses
Score Keeping
performance measurement and tax on creating shareholder value
vs. Value
base. through investments and
Maximizing
minimizing financing costs.
- Accounting uses the accrual method, - Finance focuses on cash flow,
Accrual Method
recognizing revenues when sales which looks at the timing,
vs. Cash Flow
occur, regardless of cash flow timing. magnitude, and risk of cash
Method
flows.
- Accounting deals with past data, thus - Finance is future-oriented,
Certainty vs. more objective and certain. involving decision-making under
Uncertainty uncertainty with a higher degree
of subjectivity.

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QUESTION BANK
Question 1
The ABC company is planning to purchase a machine known as machine X. Machine X would
cost $25,000 and would have a useful life of 10 years with zero salvage value. The expected
annual cash inflow of the machine is $10,000. Compute payback period of machine X and
conclude whether or not the machine would be purchased if the maximum desired payback
period of ABC company is 3 years.

Solution:
Since the annual cash inflow is even in this project, we can simply divide the initial investment
by the annual cash inflow to compute the payback period. It is shown below:
Payback period = $25,000/$10,000 = 2.5 years.

According to payback period analysis, the purchase of machine X is desirable because its
payback period is 2.5 years which is shorter than the maximum payback period of the company.

Question 2
Due to increased demand, the management of XYZ Beverage Company is considering to
purchase a new equipment to increase the production and revenues. The useful life of the
equipment is 10 years and the company’s maximum desired payback period is 4 years. The
inflow and outflow of cash associated with the new equipment is given below:
Initial cost of equipment: $37,500
Annual cash inflows: Cost of ingredients: $45,000
Salaries expenses: $13,500 Maintenance expenses: $1,500
Should XYZ Beverage Company purchase the new equipment? Use payback method for deriving
answer.

Solution:
Step 1:
In order to compute the payback period of the equipment, we need to work out the net annual
cash inflow by deducting the total of cash outflow from the total of cash inflow associated
with the equipment.
Computation of net annual cash inflow:
$75,000 – ($45,000 + $13,500 + $1,500) = $15,000

Step 2:
Now, the amount of investment required to purchase the equipment would be divided by the
amount of net annual cash inflow (computed in step 1) to find the payback period of the
equipment.
= $37,500/$15,000
=2.5 years

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 FINANCIAL MANAGEMENT 1.21

According to payback method, the equipment should be purchased because the payback
period of the equipment is 2.5 years which is shorter than the maximum desired payback
period of 4 years.

Question 3
The management of ABC company wants to reduce its labor cost by installing a new machine.
Two types of machines are available in the market – machine X and machine Y. Machine X
would cost $18,000 whereas machine Y would cost $15,000. Both the machines can reduce
annual labor cost by $3,000. Which is the best machine to purchase according to payback
method?

Solution:
Payback period of machine X: $18,000/$3,000 = 6 years
Payback period of machine y: $15,000/$3,000 = 5 years

According to payback method, machine Y is more desirable than machine X because it has a
shorter payback period than machine X.

Pay back decision criterion does not follow the principles laid down above viz. “the bigger
and better” and “bird in hand”. It ignores the first principle completely as it does not take
into account the cash flows after investment have been recovered. It also does not satisfy
entirely the second principle as it assigns zero value to the receipts, subsequent to recovery
of the amount.

Question 4
Amit is a retail investor and decides to purchase 10 shares of Company A at a per-unit price
of $20. Adam holds onto shares of Company A for two years. In that time frame, Company A
paid yearly dividends of $1 per share. After holding them for two years, Adam decides to sell
all 10 shares of Company A at an ex-dividend price of $25. Adam would like to determine the
rate of return during the two years he owned the shares.

Solution:
To determine the rate of return, first, calculate the number of dividends he received over the
two-year period:
10 shares x ($1 annual dividend x 2) = $20 in dividends from 10 shares
Next, calculate how much he sold the shares for:
10 shares x $25 = $250 (Gain from selling 10 shares)
Lastly, determine how much it cost Adam to purchase 10 shares of Company A:
10 shares x $20 = $200 (Cost of purchasing 10 shares)
Plug all the numbers into the rate of return formula:
= (($250 + $20 – $200) / $200) x 100 = 35%
Therefore, Adam realized a 35% return on his shares over the two-year period.

Question 5
An individual placed their money into two different investment products:

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 FINANCIAL MANAGEMENT 1.22

1. A $100,000 investment into a high-interest savings account with a variable interest rate.
With no additional contributions, six years later, the account balance amounts to $115,900.
2. An investment property in Miami that was bought for $350,000 in 2015. Five years later, the
property is now worth $410,000.
With two completely different investments, which one provides the best return?

Solution:
We can use the annualized rate of return formula to calculate the rate of return for both
investments on an annual basis.
Using the formula given above, we substitute the figures:
1) ARR = (115,900 / 100,000) (1/6) – 1
ARR = 0.02489 ≈ 2.50%
2) ARR = (410,000 / 350,000) (1/5) – 1
ARR = 0.03215 ≈ 3.21%
By using the annualized rate of return formula, we are now able to compare the returns for
both investments over the same time frame. Therefore, we can conclude that the investment
property in Miami provides the best return at an annualized rate of 3.21%.

Question 6
Cash flow projections for a project are provided below. The relevant discount rate is 10%.
Time t=0 t=1 t=2 t=3
Costs -$5000 -$10,000 -$10,000 -$15,000
Benefits - - $50,000 $75,000
Net Cash Flow -$5000 -$10,000 $40,000 $60,000
What is the benefit-cost ratio of the project?

Solution:
Time Discounted Costs Discounted Benefits
t=0 -$5000 0
t=1 -$10,000 (1+10%)1 = $9,090.91 0
t=2 -$10,000 (1 + 10%)2 = $8,264.46 $50,000 / (1 + 10%)2 = $41,322.21
t=3 -$15,000 / (1 + 10%)3 = $11,269.72 $75,000 / (1 + 10%)3 = $56,348.61
Total $97,670.92

Question 7
Company A ltd wanted to know their net present value of cash flow if they invest 100000 today.
And their initial investment in the project is 80000 for the 3 years of time, and they are
expecting the rate of return is 10 % yearly. From the above available information, calculate
the NPV.

Solution:
NPV = Cash flow / (1 + i)t – initial investment
= 100000/ (1-10)3 -80000
NPV = 57174.21
So, in this example, NPV is positive, so we can accept the project.

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Question 8
Company has an option to replace its machinery.
The cost and return are as follows:
Initial investment = Rs.5,00,000
Incremental increase per year = Rs.2,00,000
Replacement value = Rs.45,270
Life of asset = 3 years
If we assume IRR to be 13%, the computation will be as follows.

Solution:
Year Cash flows Discounted cash flows Computation
0 -5,00,000 -500000 (5,00,000 * 1)
1 2,00,000 176991 2,00,000 * (1/1.13)1
2 2,00,000 156229 2,00,000 * (1/1.13)2
3 2,00,000 138610 2,00,000 * (1/1.13)3
4 45,270 27765 45,270 * (1/1.13)4

The total of the column Discounted Cash Flows approximately sums up to zero making the NPV
equal to Zero. Hence, this discounted rate is the best rate. As can be seen from the above,
using the rate of 13%, the cash flows, both positive and negative become minimum.
Hence, it is the best rate of return on investment. The cost of capital of the company is 10%.
Since the IRR is higher than the cost of capital, the project can be selected.
If the company has another opportunity to invest the money in a project that gives a 12%
return, the company will still go in for the machinery replacement since it gives the highest
IRR.

Question 9
Vegan Steaks had the best year ever, with sales of $4,500,000 and operating profit of
$950,000. The balance sheet at the beginning of the year showed assets used in production
with a cost of $20,000,000 and accumulated depreciation of $5,000,000. The company didn’t
buy any assets during the year but did have depreciation expense of $1,000,000. Calculate
the ROI for the year.

Solution:
Beginning of the year book value:
20,000,000 – 5,000,000 = 15,000,000
End of year book value:
20,000,000 – (5,000,000 + 1,000,000) = 14,000,000
So, the average book value of assets is $14,500,000.
,
=.0655
, ,
or ROI of 6.55%.

Question 10

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 FINANCIAL MANAGEMENT 1.24

Management of It’ll Heal Medical Company are evaluating the performance of three divisions
of the company. The Booboo Division had operating profit of $499 and on average used assets
with a book value of $6,238. The Splint Division had operating profit of $350 and used average
assets of $3,889. The Intensive Care Division had operating profit of $570 and average assets
of $9,500. Which division is performing the best?

Solution:
The Splint Division is performing the best with an ROI of 9%. ROI is a good way to compare
divisions of different sizes. You calculate ROI as operating profit divided by average assets.

=.8
,
or 8% ROI for the Booboo Division.

=.9
,
or 9% ROI for the Splint Division.

=.6
,
or 6% ROI for the Intensive Care Division.

Question 11
XYZ Ltd. has capital investment of ₹ 150 crores. After tax operating income is ₹ 20 crores
and company has a cost of capital of 12%. Estimate the Economic Value Added of the firm.

Solution:
Capital employed 150 crores NOPAT= ₹ 20 crores
WACC = 12 %
EVA = NOPAT- (WACC-CE)
= 20 – (12% x 150) = ₹ 2 crores
NOPAT - Net Operating Profit after Tax
WACC - Weighted Average Cost of Capital
CE- Capital Employed

Question 12
Calculate the market value added using the following information:
Total number of shares issued = 20,000,000
Number of shares held as treasury stock =1,100,000
Current share price = $35.5
Total invested capital plus retained earnings = $453,503,000
Cost of treasury stock = $39,050,000
Assume that the market value of debt equals its book value.

Solution:
Number of Shares Outstanding = 20,000,000 − 1,100,000 = 18,900,000
Market Capitalization = 18,900,000 × $35.5 = $670,950,000

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 FINANCIAL MANAGEMENT 1.25

Total Shareholders’ Equity

= Total Invested Capital + Retained Earnings − Cost of Treasury Stock
= $453,503,000 − $39,050,000 = $414,453,000
Market Value Added for Shareholders = $670,950,000 − $414,453,000 = $256,497,000
Market Value Added for all Investors
= Market Value of Equity − Total Shareholders’ Equity + Market Value of Debt − Book Value of
Debt
= $256,497,000 + 0 = $256,497,000

Question 13
Company XYZ whose shareholders’ equity amounts to $750,000. The company owns 5,000
preferred shares and 100,000 common shares outstanding. The present market value for the
common shares is $12.50 per share and $100 per share for the preferred shares.

Solution:
Market Value of Common Shares = 100,000 * $12.50 = $1,250,000
Market Value of Preferred Shares = 5,000 * $100 = $500,000
Total Market Value of Shares = $1,250,000 + $500,000 = $1,750,000
Using the figures obtained above:
Market Value Added = $1,750,000 – 750,000 = $1,000,000

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FINANCIAL MANAGEMENT 2.1

TIME VALUE OF MONEY

INTRODUCTION

Aspect Details

Time Value of Money (TVM) means a rupee today is more valuable than a
Core Concept
rupee in the future due to its earning potential.

i) Individuals prefer current consumption over future consumption.

Key Reasons ii) Capital can generate positive returns.
iii) Inflation erodes future purchasing power.

Financial Most financial problems involve cash flows at different times, which need
Relevance to be compared by converting them to a common time point.

Tools like compounding and discounting are essential for:

- Valuing securities
- Project analysis
Why Tools Are
- Lease rental determination
Needed
- Choosing financing instruments
- Loan amortisation schedules
- Company valuation

Definition of TVM states that the current value of money is greater than its future
TVM value due to its potential to earn returns over time.

Expanded TVM is central to finance as it recognises money has different values at

Concept different times depending on when it is received or paid.

1. A sum of money is worth more now than in the future.

2. Delayed investment = Lost opportunity.
Key Takeaways 3. TVM formula includes amount, future value, rate, time.
4. Compounding periods affect returns.
5. Inflation negatively impacts TVM.

CONCEPTS OF TIME VALUE OF MONEY

Topic Formula Explanation / Key Points Example / Notes

FV = PV × [1 + (r × Interest earned only on ₹1,000 at 12% for 5
Simple Interest n)] the principal; not years → ₹1,600
reinvested
FV = PV × (1 + r)^n Interest is reinvested to Commonly used in
Compound earn more interest; investments,
Interest grows faster than simple compounding annually or
more frequently

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FINANCIAL MANAGEMENT 2.2

Present Value PV = FV / (1 + r)^n Value today of receiving $15,000 in 5 years at 12%

of a Single a future sum → calculate PV
Amount
Present Value PV = Σ [CFn / (1 + Used when cash flows Discount each year's
of Uneven Cash r)^n] are irregular or non- cash flow separately
Flows equal
P = PMT × [1 – (1 / Value today of equal Higher discount rate →
Present Value
(1 + r)^n)] / r future payments over a lower PV
of an Annuity
fixed period
PV = CF / r Value of infinite, Used in preferred
Present Value
identical payments stocks, real estate
of Perpetuity
income
Growing PV = CF / (r – g) Value of perpetuity with g < r required for
Perpetuity constant growth rate g convergence
FV = I × (1 + R × T) Value of current Single investment
Future Value of
investment taken to a compounded over time
a Single Amount
future date
FV = PMT × [(1 + Value of recurring Annuity grows faster
Future Value of
r)^n – 1] / r payments at a future with higher r or n
an Annuity
date
Ordinary Same as above (FV Payments at end of each Used in loan repayments,
Annuity & PV) period; lower PV dividends
Modify PV/FV Payments at beginning of Used in rent, leases,
formulas to each period; higher PV insurance
Annuity Due
account for
earlier payments
Doubling Time ≈ 72 Handy rule for 8% interest → 72 / 8 = 9
Doubling Period
/r compounding interest; years
– Rule of 72
best for 6%–10%
Doubling Time ≈ More precise for Accurate, but doesn't
Doubling Period
(69 / r) + 0.35 continuous compounding account for dividends
– Rule of 69
like equity
N/A Used in preferred Helps assign finite value
Uses of PV of stocks, real estate, to infinite streams
Perpetuity endowment & retirement
planning
N/A Money today > same Applies to PV, FV,
Key Time Value
amount in future; due to annuities, etc.
Concepts
investment opportunity

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FINANCIAL MANAGEMENT 2.3

QUESTION BANK
Question 1
Suppose a company expects to receive $8,000 after 5 years. Calculate the present value of
this sum if the current market interest rate is 12% and the interest is compounded annually.

Solution:
The way to solve this is to apply the above present value formula. In this example, the number
of periods (n) is 5 and the interest rate (i) is 12%. Therefore, the present value (PV) is
calculated as follows:

PV = FV x 1 / (1+i)n
= 8,000 x 1 / (1+12%)5
= 8,000 x 0.5674
PV = $4,540

Question 2
What is the present value of $1,000 received in two years if the interest rate is?
(a) 12% per year discounted annually.
(b) 12% per year discounted semi-annually.
(c) 12% per year discounted daily.

Solution:
(a) 12% per year discounted annually.
=1,000 / (1 + 0.12) 2
= $797.19

(b) 12% per year discounted semi-annually.

= 1,000 / (1 + 0.12/2) 2*2
= $792.09

(c) 12% per year discounted daily

= 1,000 / (1 + 0.12/365) 2*365
= $786.66

Question 3
$7,000 for 10 years from now at 7% is worth how much today?

Solution:
= 7,000 / (1 + 0.07) 10

= $3,558.45

Question 4
What is the present value of $84,253 to be received or paid in 5 years discounted at 11% by
table and factor formula?

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FINANCIAL MANAGEMENT 2.4

Solution:
PV = 84,253 (PVIF 11%, 5)
PV = 84,253 (0.5935)
PV = 50,004.

Question 5
Mr. Nadeem owes a total of $3,060 which includes 12% interest for the three years he
borrowed the money. How much did he originally borrow?

Solution:
= 3,060 / (1 + 0.12) 3

= 2178.05

Question 6
If Ramesh want $2,000 three years from now and the compounded interest rate is 8%, how
much should he invest today?

Solution:
=2,000 / (1 + 0.08) 3

= $1,587.66

Question 7
What is the present value of an offer of $14,000 two years from now if the opportunity cost of
capital (discount rate) is 17% per year discounted annually?

Solution:
=14,000 / (1 + 0.17) 2

= $10,227.19

Question 8
If you invested $50,000 at one point in time and received back $80,000 ten years later, what
annual interest (or growth) rate (compounded annually) would you have obtained?

Solution:
= (80,000/50,000) (1/10) – 1
= 4.81%

Question 9
How much would you have to deposit today to have $10,000 in five years at 6% interest
discounted quarterly?

Solution:
= 10,000 / (1 + 0.06 / 4) 5*4

= $7,424.46

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FINANCIAL MANAGEMENT 2.5

Question 10
What is the present value of an offer of $15,000 one year from now if the opportunity cost of
capital (discount rate) is 12% per year nominal annual rate compounded monthly?

Solution:
= 15,000 / (1 + 0.12/12) 1*12

= $13,311.74

Question 11
Calculate the present value of each cash flow using a discount rate of 7%. Which do you most
prefer most?

S. no Cash flows Solution:

1 Cash flow A: receive $60 today and then receive PV of A = 60+60*1.07 -4 =
$60 in four years $105.77
2 Cash flow B: receive $12 every year, forever, 12+12/0.07= $183.43
starting today.
3 Cash flow C: pay $50 every year for five years, -50/0.07*(1-1.07-5)+30/0.07*(1-
with the first payment being next year, and then 1.07-20)*1.07-5 = $21.59
subsequently receive $30 every year for 20
years.

4 Cash flow D: receive $9 every other year, 9/(1.072-1)*1.07 = $66.46

forever, with the first payment being next year

Question 12
A project generates the following cash flows;
Beginning of years:
1 – ($100,000) (contractors’ fees)
2 – ($200,000) (contractors’ fees)
3 – ($200,000) (contractors’ fees)
End of Year 3: $1,000,000 (sales)

Calculate the NPV of the project using a risk discount rate of 20% per year.

Solution:
NPV = 100,000 – 200,000 (1+ 0.2)-1 – 200,000(1 + 0.2)-2 +1000,000(1+ 0.2)-3
= -100,000 – 166,667 – 138,889 + 578,704
= $173,148.

Question 13
Assume a person has the opportunity to receive an ordinary annuity that pays $50,000 per
year for the next 25 years, with a 6% discount rate, or take a $650,000 lump-sum payment.
Which is the better option? Using the above formula, the present value of the annuity is:

Solution:

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FINANCIAL MANAGEMENT 2.6
– ( /( . ) )
Present Value = $50,000 x
.
= $639,168

Question 14
Issac has just won the lottery and decides to take the 20-year annuity option. The lottery
commission invests his winnings in an account that pays 4.8% interest, compounded annually.
Each year for those 20 years, Tom receives a check from the lottery commission for $250,000.
What is the present value of Tom’s winnings? (Notice that this would be the amount that Tom
would get if he chose the lump-sum option). What is the total amount of money that Tom gets
over the 20-year period?

Solution:
This is clearly an annuity question since it says so in the problem. We are told what the
payments are for the annuity, and asked to find the present value, so we use the present value
formula for an annuity:

–( )
PV = PMT x

Since this annuity is compounded annually (and the payments are made annually), (meaning
and), and we get

–( . )
PV = 250000 x
.

= $31,69,070.90

Question 15
John has just received an inheritance of $400,000 and would like to be able to make monthly
withdrawals over the next 15 years. She decides on an annuity that pays 6.7%, compounded
monthly. How much will her monthly payments be in order to draw the account down to zero
at the end of 15 years?

Solution:
Since John will be making periodic withdrawals from an account, this is an annuity question.
She would like to know how much each withdrawal will be so that the entire inheritance will
be gone after 15 years. We use the payment formula for an annuity to find out how much each
withdrawal (payment) will be:

PMT = PV x
–( )

. /
= 400,000 x
–( ) ∗

= $3528.56

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Thus, each withdrawal will be $3,528.56. At the end of the 15 years, nothing will be left.

Question 16
Amar is working in a tire factory that offers a pension in the form of an annuity that pays 5%
annual interest, compounded monthly. He wants to work for 30 years and then have a
retirement income of $4000 per month for 25 years. How much do he and his employer together
have to deposit per month into the pension fund to accomplish this?

Solution:
This problem is probably the most realistic, and most closely matches what a typical person
will do in his or her life (save money during their working life, then spend that money during
retirement). The only thing we know is what Amar wants to have during retirement: $4,000 per
month for 25 years.

Since this is money he will be withdrawing from an account, it is an annuity. We would first like
to know how much money he needs in order to be able to make these monthly withdrawals for
25 years. Thus, we need the present value of an annuity:

–( )
PV = PMT x

–( . / ) ∗
= 4000 x
. /

= $684,240.19
Thus, Amar will need $684,240.19 to fund his retirement annuity.

Question 17
Rebeca has set up a savings account with her bank and will be paying $350 a month into the
account for the next five years. The annual interest rate is 3% and the annual growth rate is
2%. How can Rebecca work out the present value of these payments?

Solution:
Since the interest in this example is applied annually, the number of periods (n) will be 5, and
the total annual payment is $350 x 12 = $4,200. If the interest rate was applied monthly, we
would take the annual interest rates and divide them by 12 to get a monthly discount rate (i)
of 0.0025% and a monthly growth rate (g) of 0.0017%, using a total number of periods (n) of
60.

( –( %) ( %)
PV = $4,200 X = $19,996.28
% %

Now, what if Rebeca’s bank did pay the interest monthly instead of annually? In that case, the
formula would look like this:

( –( . %) ( . %) )
PV = $350 x = $20,994.52
. % . %

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FINANCIAL MANAGEMENT 2.8

It can be seen that the PV of the annuity is growing faster because the payments are
compounding 12 times a year at the 2% growth rate instead of just once a year with annual
interest.

Question 18
Mr. Z is looking ahead to his retirement and want to be able to retire at 70 and hope to live
to 95 and make $3200 a month from an account compounding monthly at 4.5%. He is currently
27 and going to deposit $1000 at the beginning of each quarter until he is 70 in an account
that pays 8.5% and is compounded quarterly. Will he have enough to make it happen and by
how much amount he is having surplus or deficit?

Solution:
Find the amount Mr. Z need to support those requirements from age 70 to 95.

–( . / ) ( )
PV = 3200
. /

PV = $575713.03 is needed by Mr. Z to support himself from 70-95 years old.

Question 19
Magnificent Limited pays $2 in dividends annually and estimates that they will pay the
dividends indefinitely. How much are investors willing to pay for the dividend with a required
rate of return of 5%?

Solution:
PV = 2/5% = $40
An investor will consider investing in the company if the stock price is $40 or less.

Question 20
You are scheduled to receive Rs.13,000 in two years. When you receive it, you will invest it for
six more years at 8 percent per year. How much will you have in eight years?

Solution:
The amount that will be received in eight years will be –
= 13,000 (1 + 0.08)6
= Rs. 20,629.37

Question 21
You have Rs.9,000 to deposit. Jupiter Bank offers 12 percent per year compounded monthly,
while Saturn Bank offers 12 percent but will only compound annually. How much will your
investment be worth in 10 years at each bank?

Solution:
Jupiter Bank
9,000 (1 + 0.12/12) 10 * 12
= Rs.29,703.48

Saturn Bank

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FINANCIAL MANAGEMENT 2.9

9,000 (1 + 0.12) 10
= Rs.27,952.63

Variance = Rs.1,750.85

Question 22
What is the future value of Rs. 26 invested for 32 years at an average rate of return of 7%?

Solution
FV= 26 (1.07) 32
= Rs.226.60

Question 23
Find the future value of Rs.100,000 for 15 years. The current five-year rate is 6%. Rates for
the second and third five-year periods and expected to be 6.5% and 7.5%, respectively.

Solution:
FV = 100,000 (1.06)5(1.065)5(1.075)5
FV = 100,000 (1.3382) (1.37009) (1.43563)
FV = 100,000 (2.6322)
FV = Rs.263,220

Question 24
If farm land is currently worth Rs. 1,750 per acre and is expected to increase in value at a
rate of 5 percent annually, what will it be worth in 5 years? In 10 years? In 20 years by factor
formula and table?

Solution:
i) In 5 years
= Rs. 1,750 x 1.2763 = Rs.2,233.53

ii) In 10 years
= Rs. 1,750 x 1.6289 = Rs. 2,850.58

iii) In 20 years
= Rs.1,750 x 2.6533 = Rs.4,643.28

Question 25
What will be the future value at the end of the 5 years of $1,000 paying a 5% rate of interest?

Solution:
FV = 1000 (1+.10)5
FV = 1620

Question 26
If a person deposits $100 at the end of the first year, $200 at the end of the second year, and
$250 at the end of the third year in a bank, what will be his future value if the interest rate
is 10%?

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FINANCIAL MANAGEMENT 2.10

Solution:
= 100 (1+.10)3 -1 + 200 (1+.10)3-2 +250 (1+.10)3 -3
= 121+220+250
FV= 591

Question 27
You decide to put $12,000 in a money market fund that pays interest at the annual rate of
8.4%, compounding it monthly. You plan to take the money out after one year and pay the
income tax on the interest earned. You are in the 15% tax bracket. Find the total amount
available to you after taxes.

Solution:
The monthly interest rate is .084/12 =.007. Using it as the growth rate, the future value of
money after twelve months is:
FV = 12000(1.007)12 = $13,047.73

The interest earned = 13,047.73 – 12,000 = $1047.73. You have to pay 15% tax on this amount.
Thus, after paying taxes, it becomes =1047.73(1 – .15) = $890.57.
Total amount available after 12 months = 12,000 + 890.57 = $12,890.57

Question 28
You have borrowed $850 from your sister and you have promised to pay her $1000 after 3
years. With annual compounding, find the implied rate of interest for this loan.

Solution:
The future value of the loaned money is FV = $1000, while its present value is PV = $850. The
time for compounding is n = 3 years. The interest rate r is unknown.

Using FV = PV (1 + r) n
We get 1000 = 850(1 + r) 3
or, (1000/850)1/3 = 1 + r
or, 1 + r = 1.0556672
which gives r = 0.0557 = 5.57%

Question 29
You have borrowed $10,000 from a bank with the understanding that you will pay it off with a
lump sum of $12,000 after 2 years. Find the annual rate of interest on this loan.

Solution:
Here the future value is $12,000, present value $10,000, and n = 2.
Use FV = PV (1 + r) n
This gives 12,000 = 10,000 (1 + r) 2
Or, r = 12‚000 10‚000 − 1 = .09545 = 9.545%

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Question 30
Global Banking Corporation offers two types of certificates of deposit, each requiring a
deposit of $10,000. The first one pays $11,271.60 after 24 months, and the second one pays
$12,139.47 after 36 months. Find their monthly-compounded rate of return.

Solution:
Using FV = PV (1 + r) n

We get for the first CD,

11,271.60 = 10,000(1 + R1) 24

Solving for R1 , we get

, .
R1 = [ ]1/24
,

Similarly working on the second CD, we get

, .
R2 = [ ]1/24
,

The first certificate gives a return of .5%, and the second one .54% per month. The second
one is higher because the investor has to tie up the money for a longer period

Question 31
Assume someone decides to invest $125,000 per year for the next five years in an annuity they
expect to compound at 8% per year. What will be the expected future value of this payment
stream?

Solution:
(( . ) )
Future Value = $125,000 x = $733,325
.

With an annuity due, where payments are made at the beginning of each period, the formula
is slightly different. To find the future value of an annuity due, simply multiply the formula
above by a factor of (1 + r). So:

(( ) )
P = PMT x x (1 +r)

If the same example as above were an annuity due, its future value would be calculated as
follows:
( . ) –
Future Value = $125,000 x x (1 + 0.08)
.
= $791,991.

Question 32
John deposits money into his savings account at the beginning of each year, depending on the
returns of the business. He deposits $1000 in the first year, $2000 in the second year, $5000
in the third, and $7000 in the fourth year. The account credits interest at an annual interest

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rate of 7%. What is the closest value of the accumulated money in the savings account at the
beginning of year 4?

Solution:
The future value of the unequal payments is the sum of individual accumulations:
= 1000(1.07)3 + 2000(1.07)2 + 5000(1.07)1 + 7000(1.07)0
= $16,975.38

Question 33
Suppose Arjun invest $2000 per year in a stock index fund, which earns 9% per year, for the
next ten years, what would be the closest value of the accumulated value of the investment
upon payment of the last installment?
Solution:
From the information given in the question:
A=2000
N=10
r=9%

So that:
(( ) )
FVN = A
(( ) )
=2000
.
= $ 30,385.8594

Question 34
An individual makes rental payments of $1,200 per month and wants to know the present value
of their annual rentals over a 12-month period. The payments are made at the start of each
month. The current interest rate is 8% per annum.

Solution:

( ( . / ))
PV = $1,200 x x (1 + (0.08/12))
( . / )

FV of investment = $1200 x 11.57 FV of investment = $13,886.90

Question 35
A company wants to invest $3,500 every six months for four years to purchase a delivery truck.
The investment will be compounded at an annual interest rate of 12% per annum. The initial
investment will be made now, and thereafter, at the beginning of every six months. What is the
future value of the cash flow payments?

Solution:

$ ( . / )
FV of the investment = x (1 + (0.12 / 2))
( . / )

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FV of the Investment = $3,500 x 10.49

FV of the Investment = $36,715

Question 36
Due to the large capital needed to establish a factory and warehouse for coffee machines,
Akshay have turned to private investors to fund the expenditure. He met with Jacob, who is a
high net-worth individual willing to contribute $1,000,000 to Akshay’s company.

However, Jacob is only willing to contribute the said amount on the presumption that he will
get a 12% annual rate of return on his investment, compounded yearly. He wants to know how
long it will take for his investment in Akshay’s company to double in value.

Solution:
Using the Rule of 72-
Doubling time (number of years) = 72 /12% = 6 years.
It will take approximately six years for Jacob’s investment to double in value.

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CAPITAL BUDGETING
INTRODUCTION

Section Details
1. Capital Expenditure: Investment in fixed assets (long-term).
Types of Business
2. Revenue Expenditure: Day-to-day operational expenses (short-
Expenditures
term).
1. Charles T. Horngren: "Capital budgeting is long-term planning for
making and financing proposed capital outlays."

2. Milton H. Spencer: "Capital budgeting involves the planning of

Capital Budgeting – expenditures for assets the returns from which will be realized in
Definitions future time periods."

3. R. M. Lynch: "Capital budgeting consists in planning the

development of available capital for the purpose of maximizing the
long-term profitability (return on investment) of the firm."
General Meaning of Decision-making regarding the investment of funds in fixed assets.
Capital Budgeting
1. Helps in expanding production facilities in response to projected
sales demand.
2. Assesses alternatives for replacing old or obsolete assets.
3. Aids long-term planning and asset purchase timing.
4. Estimates capital requirements with yearly breakdowns for timely
fund arrangement.
5. Supports capital structure planning (as ROI depends on cost of
Importance of
capital and structure).
Capital Budgeting
6. Assists in preparing cash forecasts and budgets.
7. Aids in formulating depreciation and asset replacement policies.
8. Guides dividend policy aligned with profit maximization and
internal resource generation.
9. Helps identify cost-minimization methods and modernization
opportunities.
10. Highlights potential for replacing human labour with machines.

CAPITAL BUDGETING PROCESS

Step Description
- Capital expenditure requirements forecasted.
- Proposals can originate from all levels of the organization (top
1. Project
management to operational level).
Generation
- Management conducts periodic reviews of earnings, costs,
procedures, and product lines to encourage idea generation.
2. Project - Estimating costs and benefits in terms of cash flows.
Evaluation - Selecting appropriate criteria for judging project desirability.

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- Evaluation based on techniques like NPV, IRR, payback period, etc. (to
be discussed later).
- Screening and selecting projects based on the firm’s criteria.
- Conducted by financial manager or capital expenditure planning
3. Project committee.
Selection - After selection, projects are prioritized to avoid delays and cost
overruns.
- Selected projects are submitted to top management for final approval.
- Once approved, funds are allocated for the projects.
- The executive committee ensures funds are spent according to the
4. Project
capital budget.
Execution
- Periodical reports are prepared and submitted to controllers for
expenditure control.
- Evaluation of the project after its implementation.
- Comparison of actual performance vs. budgeted data to improve
5. Follow-Up future forecasting.
- Forces departmental heads to be more realistic and careful in project
execution.

SCOPE OF CAPITAL BUDGETING DECISIONS

Decision Type Description

- Involves decisions on acquiring new machinery, building, or
adding to existing facilities.
1. Expansion Decisions
- Decisions based on the cost of investment and expected profits
from the goods produced.
- Decisions regarding replacing old or obsolete machinery with
2. Replacement new, more efficient machinery.
Decisions - Evaluated based on savings in operating costs and increased
output volume from the new plant.
- Involves choosing between purchasing or leasing fixed assets.
3. Buy or Lease
- Decisions are made by comparing the cost of purchasing the
Decisions
asset with the lease payment terms.
- Involves selecting the best machine or equipment from multiple
alternatives.
4. Choice of Equipment
- Decisions are made by comparing the costs of different assets
with their respective profitability.
- Concerns decisions aimed at reducing costs or improving
5. Product or Process product quality through changes in production processes.
Improvement - Evaluated by comparing the cost of changes with the potential
additional income or savings from the improvements.

COST AND BENEFITS OF PROJECT (CAPITAL BUDGETING DECISION)

Type of Cash Description Computation

Flow

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Expenditures made at the Components:

initiation of the project to - Cost of Fixed Asset (purchase price)
acquire fixed assets. - Installation Cost
1. Initial - Insurance, Freight
Investment / - Increase in Working Capital
Outlay - Subtracted: Salvage Value of scrap
or wastage
- Subtracted: Decrease in Working
Capital
Formula:
Cost of Fixed Asset + Installation Cost
Computation of
+ Insurance + Freight + Increase in
Initial
Working Capital - Salvage Value of
Investment
scrap or wastage - Decrease in
Working Capital
Cash inflows from the project, Computation of Operating Cash Flows:
typically received annually, - Annual Sale Income (Revenue)
after considering operating - Subtract Operating Expenses (with
expenses, depreciation, and depreciation)
2. Net Annual
taxes. - Income Before Tax
Cash Inflows
- Subtract Income Tax
- Net Income After Tax
- Add Depreciation (non-cash expense)
Result: Net Cash Inflows
Another method of calculating Formula:
net cash inflows based on Estimated Savings in Direct Wages +
Alternative Net operational savings and Estimated Savings in Direct Materials -
Cash Inflows additional costs. Estimated Additional Operating Costs -
Income Tax + Depreciation = Net Cash
Inflows
Cash inflows at the end of the Computation:
project, including the recovery - Estimated Salvage Value of Scrap
3. Terminal of working capital and the - Add any Working Capital Released
Cash Inflows salvage value of assets. - Subtract any Estimated Additional
Costs
Result: Terminal Cash Inflows

CAPITAL BUDGETING TECHNIQUES

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PAYBACK PERIOD METHOD

Category Details
Payback Period Method is a popular capital budgeting technique
Concept used to evaluate investment proposals. It measures the time period
required to recover the initial investment from net cash inflows.
Helps in selecting projects that return invested funds in the shortest
Purpose time. Firms prefer projects with quicker payback to reduce risk and
improve liquidity.
Among various alternatives, the project with the shortest payback
Selection Criteria period is preferred. Projects are ranked based on estimated time
to recover investment.
1. Simple to calculate, understand, apply, and interpret.
2. Realistic – aligns with business need for speedy recovery.
Merits / Advantages
3. Emphasizes early returns and reduces exposure to long-term risk.
4. Safe – avoids incalculable long-term risks and uncertainties.
1. A crude rule of thumb – overemphasizes liquidity, ignores
profitability.
2. Only considers cost recovery, not earnings after payback period.
3. Ignores project life beyond payback period.
Demerits / 4. Ignores risk factor – may favour high-risk projects with low
Limitations payback.
5. Ignores cost of capital.
6. Ignores time value of money – treats all cash flows equally.
7. Ignores salvage value.
8. Cannot calculate rate of return.
A) Even Cash Inflows:
Payback Period PBP = Initial Investment ÷ Annual Cash Flow
Calculation B) Uneven Cash Inflows:
PBP = E + (B ÷ C), where:

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E = Years before full recovery

B = Balance amount to be recovered
C = Cash flow in year of final recovery
Post Payback Addresses a major weakness of traditional method: ignores post-
Profitability (PPB payback profits. Used to evaluate the relative profitability of
Profit) projects after recovery of investment.
- Salvage value is included in the earnings of the last year.
Notes on PPB Profit - Projects with higher post-payback profitability are preferred.
- If costs of projects differ significantly, use profitability index.
Post Payback PPB Profitability Index = (PPB Profits ÷ Investment) × 100
Profitability Index
Formula
- Overcomes the limitation of ignoring the time value of money.
- Annual cash inflows are discounted using required rate of return
Discounted Payback
(cut-off rate).
Period
- Discounted inflows are cumulated, and the payback period is
calculated from these.

Accounting Rate of Return Method (ARR Method)

Category Details
Other Names Unadjusted Rate of Return Method, Financial Statement Method
Uses figures from accounting statements to calculate the
Basis
percentage return on investment.
Definition Calculates the rate of return of annual net profit on investment.
- If based on initial investment: Return on Investment (ROI)
Types
- If based on average investment: Average Rate of Return
Use of Average Net If net income fluctuates annually, use average annual net income in
Income the calculation.
Formula ARR = (Average Annual Net Profit ÷ Average Investment) × 100
If cash inflows are Adapt formula accordingly to reflect cash inflow data.
given
Average Investment Average Investment = (Initial Investment + Scrap Value) ÷ 2
Formula
- ARR is compared with a cut-off or pre-specified rate.
Project Evaluation - Accept the project if ARR > Cut-off rate.
Criteria - In case of mutually exclusive projects, choose the one with
highest ARR among those exceeding the cut-off.
1. Simple to compute, understand, and interpret.
2. Considers total earnings over the entire economic life of the
project.
3. Emphasizes profitability.
Merits / Advantages
4. Recognizes net earnings after depreciation – a correct income
measure.
5. Ignores project life in investment calculation, so initial and
average investment stay the same.

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1. Averages results – ignores external factors impacting profits.

2. Ignores economic life of projects – biases against short-life
projects.
Demerits / 3. Does not account for time value of money – no discounting of
Limitations future earnings.
4. Fair rate of return is not objectively determined – left to
management discretion.
5. Ignores risk analysis – does not assess project-specific risks.

PRESENT VALUE METHOD

Category Details
Also Known As Discounted Cash Flow Method
Considers the time value of money by discounting all future cash inflows
Core Concept and outflows to their present values using a given discount rate (cost of
capital or interest rate).
“A bird in hand is worth more than two in the bush” – Money today is
Rationale
more valuable than the same amount in the future.
Discounting Process of converting future cash flows to present values.
P = S / (1 + i)ⁿ
Where:
Formula for P = Present value
Present Value S = Future value
i = Interest/discount rate
n = Number of years
There are three present value techniques used for capital investment
Present Value
appraisal. One major method explained is: Net Present Value (NPV)
Methods
Method
NPV Method Excess Present Value Method or Net Gain Method
(Also Known As)
1. Calculate present value of inflows using:
Annual Cash Inflow × Present Value Factor
(Include salvage value and released working capital at end as
inflows in final year)
2. Calculate present value of outflows:
Steps in NPV
- Initial investment and working capital at time zero → not
Calculation
discounted (PV factor = 1)
- Later outflows → discounted to present value
3. Calculate NPV:
NPV = Total Present Value of Inflows − Total Present Value of
Outflows
- NPV > 0 → Accept the project
- NPV = 0 → Accept/Reject based on non-economic factors
NPV Decision
- NPV < 0 → Reject the project
Rule
→ Among mutually exclusive projects, higher NPV is preferred (if
costs are similar)

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1. Recognizes time value of money and cost of capital

2. Simple to calculate and interpret
Merits of NPV 3. Covers entire life and earnings of the project, including salvage
Method value
4. Applicable to both even and uneven cash flows
5. Aligns with maximizing owner’s wealth
1. More complex than Payback or ARR methods
2. Difficult to determine the appropriate discount rate
3. Using one discount rate across projects with different
risks/lifespans is problematic
Demerits of NPV 4. May give biased results for projects with unequal lives
Method 5. Assumes reinvestment of intermediate cash flows at cost of capital,
which may not hold
6. May contradict IRR results in mutually exclusive cases
7. NPV is sensitive to discount rate – a small change can change
decision outcome

Profitability Index Method or Present Value Index Method

Category Details
Also Known As Present Value Index Method or Benefit-Cost Ratio
A variant of the NPV method; preferred when capital costs of
Relation to NPV
mutually exclusive projects differ significantly
Measures the relationship between present value of cash inflows and
Purpose
present value of cash outflows (cost of investment)
P.V. Index = Present Value of Cash Inflows / Present Value of Cash
Formula (Re. 1 Basis)
Outflows
Formula (Percentage P.V. Index (%) = (Present Value of Cash Inflows / Present Value of
Basis) Cash Outflows) × 100
- Allows ready comparability of projects with different investment
Use/Significance magnitudes
- Used to evaluate the efficiency of capital allocation
- P.V. Index ≥ 1 → Accept the project
Decision Rule
- P.V. Index < 1 → Reject the project
A Profitability Index < 1 does not mean loss, but indicates that the
Note on
cost of capital exceeds the project's return, making the project
Interpretation
financially undesirable

TIME ADJUSTED RATE OF RETURN METHOD (TAR Method) or INTERNAL RATE OF RETURN
METHOD (IRR Method)

Category Details
Alternate Names for - Marginal Efficiency of Investment- Internal Rate of Project-
IRR Breakeven Rate
Method Type Discounted Cash Flow (DCF) method – considers time value of money

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The rate at which present value of future cash inflows equals the
Definition of IRR
present value of cash outflows (NPV = 0)
- IRR > Required Rate → Accept
- IRR < Required Rate → Reject
Decision Rule (IRR)
- IRR = Required Rate → Decide on non-economic criteria
- For mutually exclusive projects: Choose highest IRR
Calculation – Even 1. Calculate PV Factor = Investment / Annual Cash Inflows
Cash Inflows 2. Find corresponding rate from PV table (based on lifespan)
Investment = ₹10,432; Annual Cash Inflows = ₹2,000; PV Factor =
Example (Even)
5.216 → IRR = 14% (10 years)
Note on If exact PV factor not found in table, use interpolation technique:
Approximation r = r1 + [(V1 - V) / (V1 - V2)] × (r2 - r1)
1. Compute Average Annual Cash Inflows (fake annuity)
Calculation – Uneven 2. Take PV Factor = Investment / Avg. Inflows
Cash Inflows 3. Find closest rate using PV Table4. Adjust using trial & error until
NPV = 0
Alternative to Trial & Use two discount rates: one gives positive NPV, one gives negative
Error NPV, then interpolate
1. Considers time value of money2. Considers total cash
Merits of IRR inflows/outflows3. Easier for managers to interpret rates than
amounts
1. Complex and involves trial & error/interpolation
2. Assumes reinvestment at IRR (often unrealistic)
Demerits of IRR 3. Requires estimating minimum return
4. May result in multiple IRRs if cash flows change sign5. Poor at
comparing projects with different durations
Addresses IRR limitations by assuming reinvestment at a more
Modified IRR (MIRR)
realistic rate (cost of capital or expected reinvestment rate)
Step 1: Present Value of Costs (PVC):PVC = Σ [Cash Outflow / (1 +
r)^t]
Steps to Calculate
Step 2: Terminal Value (TV) of inflows: TV = Σ [Cash Inflow_t × (1 +
MIRR
r)^(n - t)]
Step 3: Solve = TV / (1 + MIRR)^n
Resolves conflicts between NPV and IRR, especially due to timing,
Use Case for MIRR
size, and life disparities
1. Avoids multiple IRR issue
Advantages of MIRR 2. Assumes realistic reinvestment rate
3. Useful in comparing alternatives fairly
1. Possible conflict with NPV if reinvestment rate < cost of capital
Disadvantages of
2. Not always aligned with NPV’s assumption (reinvest at discount
MIRR
rate)
Arise due to:1. Time Disparity (cash flow timing)
Conflicts between
2. Size Disparity (investment amount)
IRR & NPV
3. Life Disparity (project duration)

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Use Modified NPV or MIRR with defined reinvestment rate Formulas:

Resolution of Conflict
TV = CF × (1 + r*)^(n - t)MNPV = [TV / (1 + K)^n] - IMIRR = (TV / I)^(1/n)
(Time Disparity)
-1
Life Disparity Use: EAB (Equivalent Annual Benefit) = NPV × Capital Recovery
Resolution (Unequal Factor or NPV / PVIFAk, n EAC (Equivalent Annual Cost) = PV of Cost
Lives) / PVIFAk, n Capital Recovery Factor = k(1 + k)^n / [(1 + k)^n - 1]

CAPITAL RATIONING

Aspect Explanation
Purpose of Control The main purpose is to balance the demand for capital from various
Device departments with the supply of capital from different sources.
Demand for capital arises from all departments within the company,
and control should be exercised to ensure that the demand remains
Capital Demand
minimal, meeting only the objectives inherent in capital investment
decisions.
Capital is a scarce commodity, and companies must manage it carefully.
Capital Supply Expenditure is incurred to avail capital, and there is a need to exercise
economy in capital expenditure for optimal benefit.
Capital rationing is the process of imposing constraints on capital
Capital Rationing expenditure to match the available capital with the company's needs
and objectives.
Since capital is scarce and costly, it is necessary for a finance manager
Need for Capital
to control and optimize the use of capital to avoid unnecessary
Rationing
expenditure.
Firms may impose limits on capital investments, such as restricting
Capital Rationing
capital investment within a certain period (e.g., a year) and seeking
Mechanism
the greatest profitability within these limits.
Capital Rationing Firms may enforce capital rationing by setting a budget ceiling for
through Budget investment, or by financing investment proposals solely through
Ceiling retained earnings, limiting capital expenditures.
Capital rationing may lead to accepting smaller, less profitable
Result of Capital
investments or rejecting higher-return investments due to budget
Rationing
limits. This results in suboptimal outcomes.
1. Hard (External) Capital Rationing: Imposed by external factors such
as creditors' agreements, and when a firm is raising new capital
Types of Capital
(debt/equity).
Rationing
2. Soft (Internal) Capital Rationing: Caused by internal factors like
internal rate of return (IRR) policies or dividend policies.
Occurs due to external constraints, such as creditor-imposed
Hard Capital
restrictions or the need to raise new capital. Aims to improve cash flow
Rationing
and investor attractiveness.
Caused by internal policies like required IRR thresholds for projects
Soft Capital or dividend policies. These constraints may cause management to
Rationing prioritize dividends over capital investments to maintain stock price
stability.

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CONSIDERATION OTHER THAN PROFITABILITY IN MANAGERIAL DECISIONS

Factor Explanation
1. Urgency of the Investment decisions may be driven by the urgency to avoid losses
Project (e.g., replacing broken machinery) rather than profitability.
Availability of funds plays a crucial role. A more profitable project
2. Funds Available might be ignored if funds are insufficient, and a less profitable one
with a quicker payback period may be chosen.
3. Available Technical Management needs to assess if the firm has the necessary
Know-how and technical expertise and managerial capability to implement the
Managerial Capability project successfully.
4. Availability of If future funds can be raised, current funds may be invested in the
Additional Funds project, but if not, working capital must be considered.
If there are ample funds, it may be better to invest them in the
5. Fuller Utilization of
next best project, even if it offers a lower rate of return, to
Funds
maximize overall profit.
Future profitable investments may influence current decisions.
6. Future Expectations Management may prefer short-term projects to free up funds for
of Earnings future, more profitable investments. Conversely, if returns are
expected to decline, long-term projects may be favored.
Certainty about the project's future income can affect decisions.
7. Degree of Certainty
A lower income project with more certainty may be preferred
of Net Income
over a higher, but uncertain, income project.
In rapidly evolving industries, projects with shorter payback
8. Risk of Obsolescence periods may be preferred to avoid the risk of technological
obsolescence, even if they are less profitable.
Sometimes, projects with lower returns may be accepted to
9. Maintaining Market
maintain market share or the firm's earning capacity, especially in
Share
a competitive market.

RISK AND UNCERTAINTY IN CAPITAL BUDGETING

Risk Evaluation Description
Technique
This method adjusts the discount rate to account for the riskiness of the
1. Risk Adjusted
investment. The RADR is calculated by adding the risk-free rate to a risk
Discount Rate
premium specific to the investment. More risky projects are discounted
(RADR)
at higher rates than less risky ones.
This method reduces uncertain future cash flows to certain levels by
2. Certainty
applying a certainty equivalent co-efficient. The cash flows are adjusted
Equivalent
by multiplying them by the co-efficient to make them comparable to risk-
Technique
free cash flows.
Under this method, cash inflows are multiplied by the assigned
3. Probability
probability of occurrence. The resulting expected monetary values are
Technique
then discounted at an appropriate rate to compute present values. This

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helps in assessing risk by considering the likelihood of different cash

flows.
Standard deviation measures the spread or variability of the expected
4. Standard cash flows from the mean. A higher standard deviation indicates greater
Deviation risk. It is a widely used statistical tool that reflects the variability around
the average return of a project.
This is a relative measure of risk that standardizes the standard
5. Coefficient of deviation by the mean of expected cash flows. It is useful when
Variation comparing projects of different sizes and helps to measure risk relative
to the expected return.
This technique involves making multiple forecasts of future cash inflows
6. Sensitivity (e.g., optimistic, most likely, pessimistic). The net present value (NPV) is
Technique then calculated under each scenario. Significant variation in NPVs
indicates higher risk in the project.
This technique is a graphical representation of sequential decisions,
7. Decision Tree where each decision is linked to future events and outcomes. It is useful
Technique for complex projects that involve multiple stages of decisions. Cash flows
and probabilities are forecasted to evaluate alternative paths.

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QUESTION BANK
Question 1
A project costs Rs. 3,00,000 and yields annually a profit of Rs. 80,000 after depreciation @
12% p.a. but before tax of 50%. Calculate the payback period

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

Rate of Return = = = 3 years

Question 2
A project with an outlay of Rs. 12,000 yields Rs. 2,000, Rs. 3,000, Rs. 4,000 and Rs. 6,000
respectively in the first, second, third and fourth year, the payback period will be calculated
as thus:
year Cash-inflow Cumulative Cash-in-flow
1 2,000 2,000
2 3,000 5,000
3 4,000 9,000
4 6,000 15,000

Solution:
P.B.P = E +
= 3 Years + X 12 = 3 Years and 6 months
(3 Years are taken from the highlighted row which is showing the at least fully completed years
to be taken by the project)

Question 3
The following are the details relating to two projects:
Project X (Rs.) Project Y (Rs.)
Cost of project 1,60,000 2,00,000
Estimated scrops 16,000 24,000
Estimated Savings:
1st year 20,000 40,000
2st year 30,000 60,000
3st year 50,000 60,000
4st year 50,000 60,000

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5st year 40,000 30,000

6st year 30,000 20,000
7st year 10,000

Calculate Payback Period and consider which project is better.

Solution:
Table Showing Cumulative Cash Flow of Project
year Project X Project Y
Cash flow cumulative Cash flow Cumulative
Cash flow Cash flow
Rs. Rs. Rs. Rs
1 20,000 20,000 40,000 40,000
2 30,000 50,000 60,000 1,00,000
3 50,000 1,00,000 60,000 1,60,000
4 50,000 1,50,000 60,000 2,20,000
5 40,000 1,90,000 30,000 2,50,000
6 30,000 2,20,000 44,000 2,94,000
7 26,000 2,46,000

* Including the estimated scrap.

Calculation of Payback Period
Project X Project Y
P.B.P = 4 years and 3 months = 3 year and 8 months
Post Payback Profitability = Total
Cash Flows – Investment Outlay 2,46,000 – 1,60,000 2,94,000 – 2,00,000

(Post-Payback) Profitability Index

= Rs. 86,000 = Rs. 94,000
. . . , ,
= x 100 = x 100 = 53.75% = x 100 = 47%
, , , ,

Comment: Project Y is better because of its shorter payback period and larger post-payback
profitability.

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

Solution:

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year Annual Cash P.V. Factor at 10% Discounted Cash Cumulative

Inflow Rs. Flow Rs. D.C.F. Rs.
1 4,00,000 0.909 3,63,600 3,63,600
2 4,00,000 0.826 3,30,400 6,94,000
3 4,00,000 0.751 3,00,400 9,94,400
4 4,00,000 0.638 2,73,200 12,67,600
5 4,00,000 0.621 2,48,400 15,16,000

Discounted Payback Period = 3 years + x 365

= 3 years and 8 days

Question 5
A company is considering the purchase of a machine. Management does not want to purchase
a machine if its payback period is more than 3 years and its rate of return of investment is
less than 20%.

Two machines – X and Y are under consideration. Cost of each machine is Rs. 10,000 and
working life is 4 years. Scrap value is Rs. 1,200 and Rs. 400 respectively. Annual cash inflows
are as under:
Year Machine X Machine Y
Rs. Rs.
First 2,000 3,000
Second 3,000 4,000
Third 4,000 5,000
Fourth 8,000 5,000

Evaluate the two proposals and suggest as to which machine should be purchased?

Solution:
Table Showing Cumulative Cash Inflows:
Year Machine X Machine Y
Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow
Rs. Rs. Rs. Rs.
First 2,000 2,000 3,000 3,000
Second 3,000 5,000 4,000 7,000
Third 4,000 9,000 5,000 12,000
Fourth 8,000 17,000 5,000 17,000
1,200 18,200 400 17,400

(1) Payback Method:

Machine X Machine Y
P.B.P = E + B/C 3+
, ,
X 12 2+
, ,
X 12
,
= 3 years and 1.5 months = 2 years and 7.2 months

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Post Payback Profitability 18,200 – 10,000 = Rs. 8,200 17,400 - 10,000 = Rs. 7,400

(2) Rate of Return Method:

Machine X Machine Y
a) Average Annual Cash 2,000 + 3,000 + 4,000 + 8,000 3,000 + 4,000 + 5,000 + 5,000
Inflow 4 4
= Rs. 4,250 = Rs. 4,250
b) Annual Depreciation , – ,
= Rs. 2,200
, –
= Rs. 2,400
c) Average Annual Net
4,250 – 2,200 = Rs. 2,050 4,250 – 2,400 = Rs. 1,850
Income
d) Average Investment , – ,
= Rs. 5,600
,
= Rs. 5,200
e) Return on Investment ,
x 100 = 36.61%
,
x 100 = 35.58%
, ,

Conclusion:
Though ROI of Machine X is more than 20% its payback period is more than 3 years, hence
this machine will be rejected. Machine Y will be selected because of its payback being less
than 3 years and ROI more than 20%.

Question 6
ABC & SK Co. Ltd. is considering the purchase of a machine. Two machines, X and Y, are
available each costing Rs. 50,000 and salvage is estimated at Rs. 3,000 and Rs. 2,000
respectively. Earnings after taxation are expected to be as follows:
Year Cash Flow
Machine X (Rs.) Machine Y (Rs.)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000

Evaluate the two alternatives according to:

a) The payback method;
b) Unadjusted Rate of Return Method;
c) Net Present value Method. A discount rate of 10% is to be used.

Solution:
a) Payback Method:
Table Showing Cumulative Cash Flow of Projects
Year Project X Project Y
Cash Flow Cumulative Cash Flow Cash Flow Cumulative Cash Flow
Rs. Rs. Rs. Rs.
1 15,000 15,000 5,000 5,000

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2 20,000 35,000 15,000 20,000

3 25,000 60,000 20,000 40,000
4 15,000 75,000 30,000 70,000
5 13,000 88,000 22,000 92,000

* Including salvage value.

(i) Payback Period = E +

, – ,
Machine X: 2 + = 2 years
,
, – ,
Machine Y: 3 + = 3 years
,

(ii) Post Payback Profitability = Total Cash Flows – Investment Outlay

Machine X: 88,000 - 50,000 = Rs. 38,000
Machine Y: 92,000 – 50,000 = Rs. 42,000

b) Unadjusted Rate of Return Method:

–
(i) Annual Depreciation =
, – ,
Machine X: = Rs. 9,400
, – ,
Machine Y: = Rs. 9,600

(ii) Average Annual Cash Flow =

.
, , , , ,
Machine X: = Rs. 17,000
, , , , ,
Machine Y: = Rs. 18,000

–
(iii) Unadjusted Rate of Return = x 100
, – , ,
Machine X : x 100 = x 100 = 28.68 %
( , , )÷ ,
, – , ,
Machine Y : x 100 = x 100 = 32.31%
( , , )÷ ,

c) Net Present Value Method:

Calculation of Present Value of Cash Inflows
Year Discount Project X Project Y
Factor Cash Flow Present Value Cash Flow Present Value
(at 10%) Rs. Rs. Rs. Rs.
1 .909 15,000 13,636 5,000 4,545
2 .826 20,000 16,520 15,000 12,390
3 .751 25,000 18,775 20,000 15,020
4 .683 15,000 10,245 30,000 20,490

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5 .621 13,000 8,073 22,000 13,662

Total 88,000 67,248 92,000 66,107

Net Present Value = Total Present Value – Investment

Machine X: Rs. 67,248 – Rs. 50,000 = Rs. 17,248
Machine Y: Rs. 66,107 – Rs. 50,000 = Rs. 16,107

Question 7
Rank the following investment proposals for A&G pvt. Ltd. in order of their profitability using
(a) Payback period method, (b) Accounting rate of return method and (c) Present value index
method (cost of capital – 10%):
Project Initial Outlay Annual Cash Flow Life
Rs. Rs. (in years)
A 96,000 15,000 12
B 48,000 10,000 8
C 80,000 14,000 10
D 40,000 9,000 8

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

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

Annual Return
Initial Average Annual Net
Project Cash Life Average Rank
Outlay Outlay Depreciation Income
Flow Outlay %
A 96,000 48,000 15,000 12 8,000 7,000 14.58 4
B 48,000 24,000 10,000 8 6,000 4,000 16.67 3
C 80,000 40,000 14,000 10 8,000 6,000 15 2
D 40,000 20,000 9,000 8 5,000 4,000 20 1

(c) Ranking of the Projects under the Present Value Index Method
Initial Annual Cash P.V. Factor P.V. of Cash P.V. Index
Project Life Rank
Outlay Flow (at 10%) Flows Years of Rs.1
A 96,000 15,000 12 6.814 1,02,210 1.06 4
B 48,000 10,000 8 5.335 53,350 1.11 3
C 80,000 14,000 10 6.145 86,030 1.08 2
D 40,000 9,000 8 5.335 48,015 1.20 1

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Question 8
A project costs Rs. 10,000 and cash inflows in the first, second, third and fourth years
respectively is Rs. 2,000, Rs. 3,000, Rs. 5,000 and Rs. 6,000. Calculate time adjusted rate of
return for the project.

Solution:
Total Cash Inflows of 4 years = Rs. 16,000
Average Annual Cash Inflow = Rs. 4,000
P.V. Factor = 10000/40000 =2.5
Locating this factor in cumulative P.V. Table on the line corresponding to the 4th year, TAR is
found to be about 22%. Now, we have to verify this TAR as follows:
Year Cash Inflow P.V. Factor at 22% Present Value
Rs. Rs.
1 2,000 0.820 1,640
2 3,000 0.672 2,016
3 5,000 0.551 2,755
4 6,000 0.451 2,706
9,117

As the total present value of cash-inflows at 22% is less than the cost of investment, the TAR
must be below 22%. Because the difference between these two figures is quite large, so we
take out next trial at 16%.
Year Cash Inflow P.V. Factor at 16% Present Value
Rs. Rs.
1 2,000 0.862 1,724
2 3,000 0.743 2,229
3 5,000 0.641 3,205
4 6,000 0.552 3,312
10,470

As it is clear from the above, the total present value of cash inflows at 16% is more than the
cost of investment, so the TAR is somewhere between 16% and 22% and the exact rate can be
found out by interpolation as follows:
r = r1 + (r2 – r1 )
–
, – ,
r = 16 + (22 – 16)
, – ,
= 18.08%

Question 9
SK & ABC Company Ltd. is considering the purchase of a new investment. Two alternative
investments are available (A and B) each costing Rs. 1,00,000. Cash inflows are expected to
be as follows:
Cash Inflows Investments A Investment B
Years Rs. Rs.

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FINANCIAL MANAGEMENT 3.19

1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000

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

Solution:
The profitability of the two investments can be compared on the basic of net present values
cash inflows adjusted for risk premium rates as follows:
Investment A Investment B
Discount Present Discount Payment
Years Cash Inflow Cash Inflows
Factor @ Value Factor @ Value
10%+2%=12
Rs. Rs. 10%+8%=18% Rs. Rs.
%
1 0.893 40,000 35,720 0.847 50,000 42,350
2 0.797 35,000 27,895 0.718 40,000 28,720
3 0.712 25,000 17,800 0.609 30,000 18,270
4 0.635 20,000 12,700 0.516 30,000 15,480
94,115 1,04,820

Investment A
Net Present value = Rs, 94,115 – 1,00,000 = Rs. (-) 5,885

Investment B
Net Present value = Rs. 1,04,820 – 1,00,000 = Rs. 4,820

As even at a higher discount rate investment B gives a higher net present value, investment
B should be preferred.

Question 10
There are two projects X and Y. each involves an investment of Rs. 40,000. The expected cash
inflows and the certainly coefficients are as under:
Year Project X Project Y
Cash Inflow Certainty Coefficient Cash Inflow Certainty Coefficient
Rs. Rs.
1 25,000 0.8 20,000 0.9
2 20,000 0.7 30,000 0.8
3 20,000 0.9 20,000 0.7
Risk-free cut-off rate is 10%. Suggest which of the two projects should be preferred.

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Solution:
Calculations of Cash Inflows with Certainty
Year Project X Project Y
Cash Certainty Certain Cash Certainty Certain
Inflow Coefficient Cash Inflow Inflow Coefficient Cash Inflow
Rs. Rs. Rs. Rs.
1 25,000 0.8 20,000 20,000 0.9 18,000
2 20,000 0.7 14,000 30,000 0.8 24,000
3 20,000 0.9 18,000 20,000 0.7 14,000

Calculations of Present Values of Cash Inflows

Year Discount Project X Project Y
Factor @ 10% Cash Inflows Present Values Cash Inflows Present Values
1 0.909 20,000 18,180 18,000 16,362
2 0.826 14,000 11,564 24,000 19,824
3 0.751 18,000 13,518 14,000 10,514
43,262 46,700

Project X Project Y
Net Present Value = Rs. 43,262-40,000 = 46,700-40,000
= Rs. 3,262 = Rs. 6,700

As the net present value of present Y is more than that of Project X, Project Y should be
preferred.

Question 11
Two mutually exclusive investment proposals are being considered. The following information
is available:
Project A (Rs.) Project B (Rs.)
Cost 6,000 6,000
Year Cash Inflow Probability Cash Inflow Probability
Rs. Rs.
1 4,000 0.2 7,000 0.2
2 8,000 0.6 8,000 0.6
3 12,000 0.2 9,000 0.2

Assuming cost of capital at 10%, advice for the selection of the project.

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Solution:
Calculation of the Net Present Values of the Two Projects
Project X Project Y
Year P.V. Cash Proba Moneta Presen Cash Proba Monetary Prese
Factor Inflow bility ry t Value Inflows bility Value nt
@ 10% s Value Value
1 0.909 4,000 0.2 800 727 7,000 0.2 1,400 1,273
2 0.826 8,000 0.6 4,800 3,965 8,000 0.6 4,800 3,965
3 0.751 12,000 0.2 2,400 1,802 9,000 0.2 1,800 1,352

Total Present Value 6,494 6,590

Total Present value 6,494 6,590
Less: Cost of Investment 6,000 6,000
Net Present Value 494 590

As net present value of Project Y is more than that of Project X after taking into consideration
those probabilities of cash inflows, Project Y is more profitable.

Question 12
From the following information, ascertain which project is more risky on the basis of standard
deviation:
Project A Project B
Cash Inflow (Rs.) Probability Cash Inflow (Rs.) Probability
2,000 .2 2,000 .1
4,000 .3 4,000 .4
6,000 .3 6,000 .4
8,000 .2 8,000 .1

Solution:
Calculation of Standard Deviation (Project A)
Cash Inflows Deviation from Square of Probability (Pi) Weighted Square
(Rs.) Mean (d) [5,000] Deviations Deviations (Pid2)
2,000 -3000 90,00,000 .2 18,00,000
4,000 -1000 10,00,000 .3 3,00,000
6,000 +1000 10,00,000 .3 3,00,000
8,000 +3000 90,00,000 .2 18,00,000
n=1 (Pid2) = 42,00,000

Standard Deviation = √∑ Pid2 = √4200000= 2,050

Cash Inflows Deviation from Square of Probability (Pi) Weighted Square
(Rs.) Mean (d) [5,000] Deviations Deviations (Pid2)
2,000 -3000 90,00,000 .1 9,00,000
4,000 -1000 10,00,000 .4 4,00,000
6,000 +1000 10,00,000 .4 4,00,000

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8,000 +3000 90,00,000 .1 9,00,000

n=1 26,00,000

Standard Deviation = √∑ Pid2 = √2600000 = 1,612

As the Standard Deviation of Project A is more than that of project B, A is more risky.

Question 13
Project A Project B
Probability Profit (Rs.) Probability Profit (Rs.)
0.3 300 0.2 (800)
0.3 400 0.6 600
0.4 500 0.1 800
0.1 1600

Solution:
Project A Project B
Probability Profit (Rs.) MV (Rs.) Probability Profit (Rs.) MV (Rs.)
0.3 300 90 0.2 (800) (160)
0.3 400 120 0.6 600 360
0.4 500 200 0.1 800 60
0.1 1600 160
410 440

On the basis of MVs above, it is observed that project B is marginally preferable to X, by Rs.
30,000. Project B is however is riskier, offering profit Rs. 16,00,000 but also loss to the extent
Rs. 8,00,000.

Let us compute standard deviation of each project as follows:

(Project A)
Probability Profit (Rs.) (d) Pi d2
P x
0.3 300 (110) 3,630
0.3 400 (10) 30
0.4 500 90 3,240
MV = 410 6,900

Here X = 410
Standard deviation = √∑ Pid2 = √6,900 = Rs. 83.066

(Project B)
Probability Profit (Rs.) (d) Pi d2
P x

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0.2 (800) (1240) 3,07,520

0.6 600 160 15,360
0.1 800 360 12,960
0.1 1600 1160 1,34,560
MV = 440 4,70,400

Standard deviation = √4,70,400 = 685.857

As the MV of the project differs, we have to find out coefficient of variation for each project,
as follows:
Project A Project B
(a) Standard deviation Rs. 83.066 Rs. 685.857
(b) Mean 410 440
Coefficient of variation = (a)/(b) x 100 20.26 155.88

Here, Project A is, less risky and should be selected.

Question 14
Mr. ABC, a risky investor is considering two mutually exclusive projects A and B. You are
required to advise him about the acceptability of the project from the following information.
Project A (Rs.) Project B (Rs.)
Cost of the investment 50,000 50,000
Forecast cash flows per annum for 5 years
Optimistic 30,000 40,000
Most likely 20,000 20,000
Pessimistic 15,000 5,000
(The cut-off rate may be assumed to be 15%)

Solution:
Calculation of Net Present Value of Cash Inflows at a Discount Rate of 15%
(Annuity of Re. 1 For 5 Years)
Project A Project B
Annual Discoun Present Net Annual Discou Present Net
Cash t Value Presen Cash nt Value Present
Inflow Factor (Rs.) t Value Inflow Factor (Rs.) Value
(Rs.) @15% (Rs.) (Rs.) @15% (Rs.)
Optimist 30,000 3.3522 1,00,566 50,566 40,000 3.3522 1,34,088 84,088
ic
Most 20,000 3.3522 67,014 17,044 20,000 3.3522 67,044 17,044
Likely
Pessimis 15,000 3.3522 50,283 283 5,000 3.3522 16,761 (33,239)
tic

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Question 15
Consider a project with initial investment of Rs. 500 L funded as follow:
Equity = 300L
Long Term loan = 200L
Interest Rate on loan = 14%, Tax rate = 30%, Cost of Equity = 21%, The project is expected
to generate the following after Tax cash flows.
Years 1 2 3 4
Cash Flows 220 200 240 210

Find out the NPV of the project.

Solution:
Kc = We x Ke + Wd x Kd
= (60% x 0.21) + (40% x 0.14 x (1-0.30))
= 12.6 + 3.92 = 16.52%

Years Net CF PVF @ 16.52%

0 (500) 1 (500)
1 220 0.8582 188.804
2 200 0.7365 177.12
3 240 0.6321 151.704
4 210 0.5424 113.94
NPV 101.532

Question 16
Consider the following project cash flows
Years 0 1 2 3 4 5
NCF (80) 60 100 (30) 50 70
Kc = 18%, Calculate NPV.

Solution:
Years Net CF PVF@18%
0 (80) 1 (80)
1 60 0.8475 50.85
2 100 0.7182 71.82
3 (30) 0.6086 (18.258)
4 50 0.5158 25.79
5 70 0.4371 30.597
NPV 80.79%

Question 17
Consider the following projects
Years Net cash flows (Rs. In Lakhs)
0 (70)

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FINANCIAL MANAGEMENT 3.25

1 50
2 (30)
3 80
Kc = 10 , Find PI.

Solution:
Years Net cash flow PVF @ 10%
0 (70) 1 (70)
1 50 0.9091 45.455
2 (30) 0.8264 (24.792)
3 80 0.7513 60.104
4 120 0.6830 81.96
NPV 92.727

.
PI = = = 2.32

Question 18
Consider the following project –
Years 0 1 2 3 4
NCF (1200) 400 500 300 700
Ke = 20%, Calculate IRR and advice.

Solution:
Years Net cash flow PVF @ 10%
0 (1200) 1 (1200)
1 400 0.8333 333.32
2 500 0.6944 347.2
3 300 0.5787 173.61
4 700 0.4822 337.54
NPV -8.33

16.309
= 19 + (
16.309−(−8.33)
) x (1)
16.309
= 19 + (
24.639
) x (1)
= 19.662 %

Question 19
Sagar Ltd an existing profit – making company, is planning to introduce a New product with a
projected life of 8 years. Initial equipment cost will be Rs. 120 lakhs and additional working
capital 15 lakhs equipment costing Rs. 10 lakhs will be needed at the beginning of third year.

At the end of the 8 years, the original equipment will have resale value equivalent to the cost
of removal, but the additional equipment would be sold for Rs. 1 lakh will be needed. The 100%

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FINANCIAL MANAGEMENT 3.26

capacity of the plant is of 4,00,000 units per annum, but the production and sales – volume
expected are as under:

NPV calculate KC = 12%, Tax = 50%

A sale price of Rs. 100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed
operating cash cost are likely to be Rs. 16 lakhs per annum. In addition to this the
advertisement expenditure will have to be in incurred as under:
Year Advertisement expenses
1 30L
2 15L
3-5 10L
6-8 4L

Solution:
T0 T 1 – T 2 – T 3 – T4 – T 5 – T 6 – T 7 – T 8
ll → (120L) (10L) SV – 1L
Wc → (15L) WCR – 15L

When question is silent then always assume production – sales

Particular ₹ in lakhs
0 1 2 3 4 5 6 7 8
Cost plant (120L) (10L)
WC (15L)
Production sales 0.8 1.20 3 3 3 2 2 2
units
Computation @ 60 48 72 180 180 180 120 120 120
p.u.
Cash FC 16 16 16 16 16 16 16 16
Adv. Cost 30 15 10 10 10 4 4 4
Dep. 15 15 16.5 16.5 16.5 16.5 16.5 16.5
EBIT (13) 26 137.5 137.5 137.5 83.5 83.5 83.5
(d – e – f – g)
NO PAT (6.5) 13 68.75 68.75 68.75 41.75 41.75 41.75
(EBIT(1 – t))
SV 1
Wek 15

Depreciation 15 15 16.5 16.5 16.5 16.5 16.5 16.5

CFAT 8.5 18 85.25 85.25 85.25 58.25 58.25 58.25

PVF @ 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
7.59 4.35 60.7 54.22 48.34 29.53 26.33 23.53
5.46

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Question 20
AT Ltd is considering three projects A, B and C. The cash flow associated with the projects
are given below (Rs.):
Project C0 C1 C2 C3 C4
A (10,000) 2,000 2,000 6,000 0
B (2,000) 0 2,000 4,000 6,000
C (10,000) 2,000 2,000 6,000 10,000

You are required to –

(a) Calculate the payback period of each of the three projects.
(b) If the cut – off period is 2 years, then which project should be accepted?
(c) Projects with positive NPVs if the opportunity cost of capital is 10%.
(d) “Payback gives too much weight to cash flows that occur after the cut-off date”. True or
false?
(e) “If a firm used a single cut-off period of all projects, it is likely to accept too many short-
lived projects’. True or false?
Year 0 1 2 3 4 5
PV Factor at 10% 1.000 0.909 0.826 0.751 0.683 0.621

Solution:
1. Working for NPV and cumulative DCF
Project A Project B Project C
Year PVF CF DCF CUM CF DCF CUM CF DCF CUM
DCF DCF DCF
1 0.909 2,000 1,818 1,818 0 0 0 2,000 1,818 1,818
2 0.826 2,000 1,652 3,470 2,000 1,652 1,652 2,000 1,652 3,470
3 0.751 6,000 4,506 7,976 4,000 3,004 4,656 6,000 4,506 7,976
4 0.683 0 0 7,976 6,000 4,098 8,754 10,000 6,830 14,806
Total 7,976 8,754 14,806
DCF
Less: (10,000) (2,000) (10,000)
Initial
invest
ment

NPV (2,024) 6,754 4,806

2. Discounted payback period:

Project A does not payback considering TVM at 10%.
Discounted PBP on time proportion basis is computed as under –
Project B Project C
Initial Invest. Of Rs. 2,000 is exceeded Initial Invest. Of Rs. 10,000 is exceeded
between Year 2 & 3. between Year 3 & 4.

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So, proportionate time period for earning So, proportionate time period for earning
(2,000 – 1,652) (10,000 – 7,976)
= Rs. 348 = Rs. 2,024
= Rs. 348 x 12 = Rs. 2,024 x 12
Rs. 3,004 Rs. 6,830
= 2 years and 1.39 months = 3 years and 3.56 months

So, Discounted PBP = 2 years and 1.39 So, Discounted PBP = 3 years and 3.56
months months
Note: Alternatively, discounted PBP can Note: Alternatively, discounted PBP can
,
also be expressed as 2 + = 2.11 yrs also be expressed as 2 + = 3.30 yrs
, ,

3. Answers to Question
Qn. Answer
(a) Discounted payback period for project A: Nil, B = 2.11 Years, c = 3.30 years (as
per WN 2 above)
(b) If the Cut-off period is 2 years, then none of the above projects are acceptable
since PBP is higher.
Note: However, without considering TVM at 10%, project B has a PBP of exactly 2
years, and hence, may be considered acceptable.
(c) (Refer WN 1 above). Projects B and C have positive NPV.
(d) False, PBP does not consider Post – Payback Cash flows at all.
(e) True, there may be projects with less inflows in initial years and heavy inflows in
later years, Such projects may be rejected because of longer payback. This
problem arises when a firm uses a single cut – off period for all the projects. As
a result, it may accept too many short lived projects.

Question 21
New thoughts Company is evaluating an investment proposal of Rs. 3,06,000 with expected
cash flows as –
Years 1 2 3 4
CFAT(Rs) 1,00,000 1,30,000 1,50,000 1,00,000

The company’s cost of capital is 10%. Compute the NPV and PI for this project.

Solution:
Year CFAT Factor at 10% DCFAT
1 Rs. 1,00,000 0.9091 Rs. 90,910
2 Rs. 1,30,000 0.8264 Rs. 1,07,432
3 Rs. 1,50,000 0.7513 Rs. 1,12,695
4 Rs. 1,00,000 0.6830 Rs. 68,300
Total DCFAT = Discounted cash inflows Rs. 3,79,373
Initial investment = Discounted cash outflows Rs. 3,06,000
Net present value (NPV) = Total DCFAT less initial investment 1.24

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Profitability index (PI) =

Question 22
Given below are the data on a Capital You are required to calculate for this
project ‘M”: project ‘M’
Annual cost saving – Rs. 60,000 1. Cost of project
Useful life – 4 years 2. Payback period
Internal Rate of Return – 15% 3. Cost of capital
Profitability Index – 1.064 4. Net Present Value
Salvage Value - 0 Given the following table of discount
factors:

Discount Factor 15% 14% 13% 12%

1 years 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636

Solution:
Since IRR = 15% , Discounted Cash
Inflows at 15% = Initial Investment in the project.
So, Cost of project = Initial Investment = CFAT p.a. x Cum. PVF
at 15% for 4 years = Rs. 60,000 x 2.855 Rs. 1,71,300
Payback Period = =
. , , 2.855 years
. ,

( See Note below)

Profitability Index = = 1.064 (given) 1.064 x 1,71,300

Rs. 1,82,263
So, total DCFAT = PI x Initial investment = DCFAT = CFAT p.a. x
at Ko. On substitution, Rs.
1,82,263 = Rs. 60,000 x PVF at Ko.
. , ,
On solving, PVF at Ko = = 3.038
. ,
From the above table Ko = 12%
NPV = Total DFAT (WN3) – Initial Investment (WN1) = Rs. 10,963
Rs. 1,82,263 – Rs. 1,71,300

Note: Discounted PBP can be computed as under –

Year CFAT PVF DCFAT 12% Cum DCF 12%
1 60,000 0.877 52,620 52,620 Prop. Time for earning (1,71,300 –
2 60,000 0.769 46,140 98,760 1,39,260) = Rs. 32,040

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FINANCIAL MANAGEMENT 3.30
.
x 12 = 10.82 Months
.
Disc. PBP = 3 years, 10.80 months.

Question 23
Pd Ltd. an existing company, is planning to introduce a new product with project life of 8
years. Project cost will be Rs. 2,40,00,000. At the end of 8 years, no residual value will be
realized. Working capital of Rs. 30,00,000 will be needed. The 100% capacity of the project is
2,00,000 units p.a. but the production and sales volume is expected are as under -
Years 1 2 3-5 6-8
No. Of units 60,000 units 80,000 units 1,40,000 units 1,20,000 units

Other information –
(a) Selling price per unit Rs. 200
(b) Variable cost is 40% of sales
(c) Fixed cost p.a. Rs. 30,00,000
(d) In addition to this advertisement expenditure will have to be incurred as under –
Years 1 2 3-5 6-8
Expenditure (Rs.) 50,00,000 25,00,000 10,00,000 5,00,000

(e) Income tax is 25%

(f) Straight line method of depreciation is permissible for tax purpose.
(g) Cost of capital is 10%
(h) Assume that loss cannot be carried forward.
Present value @10% for 8 years are 0.909, 0.826, 0.751, 0.683, 0.621, 0.564, 0.513 and 0.467
respectively.

Advise about the project acceptability.

Solution:
1. Computation of cash flow after tax (Rs. In lakhs)
Year
Particulars
1 2 3-5 6-8
Contribution 60,000 x 120= 80,000 x 120= 1,40,000 x 1,20,000 x
(WN1) 7200 96.00 120= 168.00 120= 144.00
Less: Dep(WN2) (30.00) (30.00) (30.00) (30.00)
Fixed cost (30.00) (30.00) (30.00) (30.00)
Advertisement (50.00) (20.00) (10.00) (5.00)
EBT (38.00) 11.00 98.00 79.00
Less: Tax at 25% No. c/f of loss (2.75) (24.50) (19.75)
(Nil)
PAT (38.00) 8.25 73.50 59.25
Add: Dep 30.00 30.00 30.00 30.00
CFAT (8.00) 38.25 103.50 89.25

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Working Note:
1. Contribution per unit = Selling price per unit Rs. 200 – variable Cost 40% = Rs. 120
.
2. Depreciation per annum = = = Rs. 30 lakhs
3. Computation of NPV (Rs. In Lakhs)
Year Cash flow PV factor Disc. Cash flow
1 (8.00) 0.909 (7.27)
2 38.25 0.826 31.59
3–5 103.50 0.751 + 0.683 + 0.621 = 2.055 212.69
6–8 89.25 0.564 + 0.513 + .467 = 1.544 137.81
8 Working capital recovery 0.467 14.01
30.00
Present value of cash inflows 388.83
Less: initial investment (project cost Rs. 240 lakhs + WC Rs. 30 lakhs) (270.00)
Net present value 118.83

Observation: Since, NPV is positive, the project is acceptable.

Question 24
A ltd is considering two mutually exclusive projects X and Y. You have been given below the
net cash flow probability distribution for each project.
Project X Project Y
NPV Estimate Probability NPV Estimate Probability
(Rs.) (Rs.)
50,000 0.30 1,30,000 0.20
60,000 0.30 1,10,000 0.30
70,000 0.40 90,000 0.50

1. Compute the following - (a) Expected net cash flow of each project,
(b)Variance of each project,
(c) Standard Deviation of each project,
(d) Co-efficient of variation of each project.
2. Identify which project do you recommend? Give reason.

Solution:
Net Prob Px D D2 P x D2 Net Pro Px D D2 P x D2
CF =p NP CF b NP
V =p V
50 0.30 15 50 – 61 = 121 36.3 130 0.20 26 130 – 676 135.2
-11 104 = 6

60 0.30 18 60 – 61 = 1 0.3 110 0.30 33 110 – 36 10.8

-1 104 = 6

70 0.40 28 70 – 61 = 9 81 32.4 90 0.50 45 90 – 196 98

104 =
-14

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Total E. 61 69.0 104 244

NPV
Expected NPV = 61 = Rs. 61,000 Expected NPV = 104 = Rs. 1,04,000
Std. Deviation = √𝑃 x D2 = √69 = 8.3066 = Std. Deviation = √𝑃 x D2 = √244 = 15.6205
Rs. 8,307 = Rs. 15,621
Coefficient of variation = Coefficient of variation =
= = 0.136 = = 0.150

Observation:- Project Y is more risky, due to higher standard deviation and higher coefficient
of variation. Hence, Project X is recommended from Risk perspective, due to lower risk (lower
SD, lower co-efficient of variation).

Question 25
The textile manufacturing company Itd is considering one of two mutually exclusive proposals,
Project M and N, which require cash outlays of Rs. 8,50,000 and Rs. 8,25,000 respectively.

The certainty-equivalent approach is used in incorporating risk in capital budgeting decisions.

The current yield on government bonds is 6% and this is the risk free rate.
The expected net cash flows and their certainty equivalents are as follows -
Year end Project M Project N
Cash flow (Rs.) C.E. Cash flow (Rs.) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7

Required (a) Which project should be accepted? (b) If risk adjusted discount rate method is
used, while project would be appraised with a higher rate and why?

Solution:
1. Computation of NPV of project M and N
Year PV Project M Project N
Facto Cash CE Adj.CF DCF Cash CE Adj.CF DC
r flow factor flow factor F
@6%
1 0.943 4,50,000 0.8 3,60,000 3,39,480 4,50,000 0.9 4,05,000 3,81
,915
2 0.890 5,00,000 0.7 3,50,000 3,11,500 4,50,000 0.8 3,60,000 38,4
00
3 0.840 5,00,000 0.5 2,50,000 2,10,000 5,00,000 0.7 3,50,000 94,0
00

Recommendation: NPV of Project N is higher, Therefore, Project N should be accepted and

implemented. The certainties associated with Project N (2.40) are also higher than that of

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FINANCIAL MANAGEMENT 3.33

Project M (2.00), signifying that risk associated with cash flows in Project N is comparatively
lower than Project M.

2.Application of risk adjusted discount rate

If Risk adjusted discount rate is used, Project M will be subjected to a higher discount rate
than Project N. This is because the certainty factor associated with Project M is lower than
Project N. This signifies a higher risk association for cash flows in Project M than Project N.

Question 26
A Project requires an Initial Outlay of Rs. 3,00,000. The Company uses certainty equivalent
method approach to evaluate the project. The risk free rate is 7%. The following information
is available:
year Cash flow after tax (CFAT) (Rs.) CE
1 1,00,000 0.90
2 1,50,000 0.80
3 1,15,000 0.60
4 1,00,000 0.55
5 50,000 0.50

PVF at 7% for years 1 to 5 are 0.935, 0.873, 0.816, 0.763 and 0.713
Evaluate the above.
Is investment in the project beneficial?

Solution:
Certain cash flows = DCF of CCF
year CFAT CE Coefficient PVF 7%
CFAT x CE 7%
1 1,00,000 0.90 90,000 0.935 84,150
2 1,50,000 0.80 1,20,000 0.83 1,04,760
3 1,15,000 0.60 69,000 0.816 56,304
4 1,00,000 0.55 55,000 0.763 41965
5 50,000 0.25 25,000 0.713 17,825
Total DCF 3,05,004
Less: initial 3,00,000
investment
NPV 5,004

Since NPV of the project is positive after recognizing certainty equivalent and risk-free rates,
it is considered beneficial.

Question 27
SK Co. is considering the purchase of a Machine. Model ‘A’ and Model ‘B’ are available for this
purpose each costing Rs. 1,00,000. Estimated working life of each machine is 5 years and
salvage value is Rs. 4,000 and Rs. 6,000 respectively. Estimated annual cash flows are
estimated to be as under:

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Year Machine A (Rs.) Machine B (Rs.)

First 60,000 20,000
Second 50,000 30,000
Third 40,000 40,000
Fourth 20,000 50,000
Fifth 20,000 60,000

Evaluate these proposals according to payback period method.

Solution:
P.B.P – 1 years; B: 3 years. Hence, A is better.

Question 28
From the followings details of SK Corporation relating to two projects, calculate the payback
period and suggest which project is better:
Project A Project B
Cost of the Project Rs. 1,80,000 2,00,000
Estimated Scrap Value 20,000 25,000
Estimated Savings:
1st year 25,000 35,000
2nd year 30,000 50,000
3rd year 45,000 70,000
4th year 50,000 65,000
5th year 40,000 30,000
6th year 30,000 20,000
7th year 10,000 -

Solution:
P.B.P. A – 4 years 9 months; B – 3 years 8 months. Project B is better.

Question 29
Cost of a Machine is Rs. 2,50,000 and its working life is estimated to be 5 year. Annual cash
inflows are as under:
Year I II III IV V
Annual Cash Inflows (Rs.) 60,000 70,000 60,000 90,000 50,000

Calculate:
A) Pay Back Period
B) Post Payback Period
C) Post Payback Profits
D) Index of Post Payback Profits

Solution:
(A) 3 years 8 months, (B) 1 year 4 months, (C) Rs. 80,000, (D) 32%

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Question 30
SK Ltd. is considering the purchase of a new machine. Two machines A and B are available,
each costing Rs. 50,000. Earnings after taxation are expected to be as under:
Cash flow
Year Machine A Machine B
Rs. Rs.
1 15,000 5,000
2 20,000 15,000
3 30,000 20,000
4 15,000 30,000
5 5,000 20,000

Evaluate the two alternatives according to (a) Payback Period Method (b) Return on
Investment Method (c) Present Value Index Method. A discount rate of 10% is to be used.

Solution:
(a) P.B.P.: A – 2 years 6 months, B – 3 years 4 months,
P.P.B. Profitability: A – Rs. 35,000; B – Rs. 40,000;
(b) ROI: A – 28%, B – 32%, Machine A is better according to P.B.P.
According to P.P.B.P. and ROI, Machine B would be preferred.
(c) A – 1.345; B - 1.322

Question 31
SK Ltd. is considering the purchase of a machine. Two machine X and Y are available each
costing Rs. 5,000. Earnings after taxation and depreciation on the basis of fixed installment
system are expected to be as follows:
Year Machine X Machine Y
1 500 200
2 1,000 300
3 1,500 1,000
4 400 2,000
5 100 1,000

Evaluate the two alternatives according to:

(a) The payback period method, and
(b) Return on investment method.

Solution:
(a) P.B.P.: X – 2 years; Y – 3 years, Machine X is better.
(b) ROI: X – 28%; Y – 36%, Machine Y is better

Question 32
Given data for ABC Ltd.:
Initial Investment 20,000

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FINANCIAL MANAGEMENT 3.36

Net Cash Inflow:

Ist year 2,000
IInd year 2,000
IIIrd to 10th year 2,500

Work out net present value with a discount rate at 10% and express whether the investment
will be worthwhile. The P.V.F. @ 10% are as follows:
Year 1 2 3 4 5 6 7 8 9 10
P.V.F .909 .826 .751 .683 .621 .564 .513 .467 .424 .386

Solution:
NPV = Rs. 5,507.50; Hence, investment is not worthwhile.

Question 33
ABC Ltd. has to purchase a machine. Two models A and B are available. You are to
determine as to which machine should be purchased using
(i) Payback Period Method,
(ii) Unadjusted Rate of Return Method and
(iii) Present Value Index Method (Cost of Capital - 12%):
Particulars Machine A Machine B
Rs. Rs.
Cost of Machine 42,000 54,000
Working Life 4 years 5 years
Scrap Value 2,000
Annual Savings after depreciation and tax:
Ist year 12,000 12,000
IInd year 16,000 12,000
IIIrd year 10,000 12,000
IVth year 8,000 12,000
Vth year - 12,000

Solution:
(i) PBP: A 1 year 281 days, B 2 years 166 days; (ii) ROI: A 52.27%, B 41.38% (iii) PVI: A 1.603, B
1.51
[Hint: Annual Cash Flow = Annual Savings + Depreciation]

Question 34
Rank the following investment proposals in order of their profitability according to:
(a) Payback period method,
(b) Unadjusted rate of return method and
(c) Present value index method. The cost of capital is 10%.
Project No. Initial Quality Annual Cash Flow Life
Rs. Rs. (in years)
A 60,000 8,000 15
B 25,000 3,000 10

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FINANCIAL MANAGEMENT 3.37

C 3,000 1,000 5
D 2,150 1,000 3
E 20,000 4,000 10
F 40,000 8,000 8

Solution:
(a) 4, 5, 2, 1, 3, 3; (b) 5, 6, 1, 2, 3, 4; (c) 5, Rejected, 1, 3, 2, 4

Question 35
Golden Brick Company has got up to Rs. 3,50,000 to invest. The following proposals are
under consideration:
Proposal Initial outlay Annual Cash Flow Life (years)
A 1,25,000 16,000 15
B 2,50,000 75,000 20
C 3,00,000 25,000 18
D 60,000 9,000 12
E 1,00,000 26,000 11

Cost of Capital is 10%.

Rank these projects according to (i) Payback period and (ii) Net present value index method.
Which projects would you recommend?

Solution:
(1) 4, 1, 5, 3, 2, (ii) Reject., 1, Reject., 3, 2 ; Hence, invest in B and E

Question 36
A project requires an initial outlay of Rs. 32,400. Its estimated economic life is 3 years. The
cash streams generated by it are expected to be as follows:
Year Estimated Annual Cash Flows (Rs.)
1 16,000
2 14,000
3 12,000

Compute its IRR. If the cost of capital to the firm is 12%, advise the management whether
the project should be accepted or rejected.

Solution:
IRR = 15%. The project must be accepted as its IRR exceeds the cost of the funds. The
project will contribute 3% to the value of the firm.

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COST OF CAPITAL
INTRODUCTION

Aspect Details
The minimum rate of return a firm must earn on its investments to
Cost of Capital maintain the firm’s market value. It acts as a benchmark (cut-off rate,
hurdle rate) for evaluating investments.
1. Milton H. Spencer: The rate of return a firm must earn to undertake
an investment.
2. Solomon Ezra: Minimum required earnings rate or cut-off for
Definition of Cost capital expenditure.
of Capital 3. James C. Van Horne: The rate of return that keeps the stock price
unchanged.
4. John J. Hampton: The return rate required to increase the firm's
value in the market.
1. Designing Optimal Capital Structure: Helps select the most
economical and sound source of finance by comparing costs and risks.
2. Evaluating Expansion Projects: Helps assess whether the marginal
return exceeds financing cost.
3. Rational Resource Allocation: Provides the basis for efficient
Importance of
allocation of resources in the economy.
Cost of Capital
4. Evaluating Financial Performance: Compares actual returns with
cost of capital to evaluate management performance.
5. Financing and Dividend Decisions: Assists in dividend,
capitalization, rights issues, and working capital management
decisions.
1. General Economic Conditions: Affects supply/demand for capital
and inflation, influencing the risk-free rate of return.
2. Market Conditions: Risk premiums increase with higher investment
risk, increasing cost. Market liquidity and price stability influence
required returns.
Factors
3. Operating and Financing Decisions: Business risk (variability of
Determining Cost
returns from investments) and financial risk (increased returns
of Capital
variability due to debt or preferred stock financing) influence the
cost of capital.
4. Amount of Financing: Larger financing needs increase the cost of
capital due to flotation costs and the difficulty in placing larger
security issues in the market.
1. Optimal Capital Structure Design: It helps in determining the most
cost-effective financing mix.
Role of Cost of 2. Investment Project Evaluation: Ensures the marginal return on
Capital investment exceeds its financing cost.
3. Financial Resource Allocation: Important for the optimal allocation
of national or organizational resources.

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FINANCIAL MANAGEMENT 4.2

4. Management Performance Evaluation: Helps assess executive

performance by comparing actual profitability with projected cost of
capital.

MEASUREMENT OF COST OF CAPITAL OR COMPONENTS OF COST OF CAPITAL

SECTION SUMMARY
Cost of capital varies across sources due to differences in issuance
Company’s Cost cost, interest/dividend, and tax impact. The company’s cost of capital is
of Capital calculated by determining the specific cost of each source and then
computing the weighted average.
1. Financial/business risks are unaffected by new investments.
Assumption of 2. Capital structure remains unchanged.
Cost of Capital 3. Cost is determined after tax.
4. Cost of old capital is irrelevant for new capital.
Debt includes loans, bonds, debentures with fixed interest. Real cost is
interest over net proceeds (adjusted for floatation costs like ads,
brokerage).
Types:
Cost of Debt A) Perpetual Debt: Cost = Interest / Net Proceeds × 100
Capital B) Redeemable Debt: Cost = [Interest + (MV - NP) / n] / [(MV + NP)/2] ×
100
After-tax Cost:
- Perpetual: Cost × (1 - tax)
- Redeemable: Same formula with adjusted interest = i(1 - t)
Fixed-dividend securities, not tax deductible.
Cost of
Types:
Preference
A) Irredeemable: Cost = Dividend / Net Proceeds × 100
Share Capital
B) With Dividend Tax: Cost = PD (1 + Dt) / NP × 100
No fixed dividend; estimated via shareholder expectations.
Methods:
1. CAPM: Ke = Rf + (Rm - Rf) × β
2. Dividend Yield: Ke = DPS / MP × 100
Cost of Equity
3. Earnings Yield: Ke = EPS / MP × 100
Share Capital
4. Dividend + Growth:
- Constant growth: Ke = (DPS / MP) × 100 + G
- Variable growth: Present value of supernormal and normal growth
streams summed to equal MP.
Higher due to flotation costs reducing net proceeds.
Cost of Newly Formulas:
Issued Equity - EPS / NP × 100
Shares - DPS / NP × 100
- (DPS / NP + G) × 100
Treated as opportunity cost of dividends foregone by shareholders.
Cost of Retained
Formulas:
Earnings
Cr = DPS(1 – Ti)(1 – B) / MP(1 – Te) × 100

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FINANCIAL MANAGEMENT 4.3

Cr = (DPS + G)(1 – Ti)(1 – B) / MP(1 – Te) × 100

Before-tax: After-tax cost / (1 – tax rate)

OVERALL COST OF CAPITAL

SECTION SUMMARY
Companies use multiple financing sources, each with a different
cost. The aim is to balance capital structure and increase returns
OVERALL COST OF for equity shareholders. Overall cost of capital is the average of
CAPITAL specific costs and helps in investment decision-making. Weighted
average is preferred over simple average as it reflects actual
capital proportions.
Involves four steps:
1) Compute specific cost of each capital source.
Computation of
2) Assign weights to each source.
Weighted Average
3) Multiply each cost by its weight to get weighted costs.
Cost of Capital
4) Sum all weighted costs to get the overall weighted average cost
of capital.
Determining the proportion of each capital source in the total
capital structure. Three approaches:
i) Historical Weights Approach: Based on existing capital structure.
• a) Book Value Weights: Uses accounting/book values—easier but
less reflective of market realities.
Assignment of • b) Market Value Weights: Uses market prices—more accurate but
Weights harder to compute.
ii) Target Weights Approach: Based on a firm’s ideal or “optimal”
capital structure to maximize shareholder wealth.
iii) Marginal Weights Approach: Based on the proportion of new
capital to be raised from each source—used when financing new
projects.
MCC is the cost of raising additional capital. It reflects changes in
Marginal Cost of
capital structure due to varying capital needs. Used when new
Capital (MCC)
investments require new financing.

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QUESTION BANK
Question 1
SK Ltd. Issued 10,000, 14% debentures of Rs.100 each at a discount of 5%. The debentures are
irredeemable cost of issue is 2% and the rate of tax is 50%. Calculate cost of capital before
tax.

Solution:
1,40,000
Cd (before tax)= ×100= ×100= 15.05%
9,30,000

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

NP=10,00,000 – (5% of 10,00,000 +2% of 10,00,000) = Rs.9,30,000

( ) , , ( . )
Cd(after tax)= ×100= ×100= 7.525%
, ,

Question 2
SK Co. is willing to issue 1,000 7% debentures of Rs.100 each and for which the company will
have to incur the following expenses:

Underwriting commission 1.5% Brokerage 0.5% Printing and Other Expenses Rs.500. Assuming
tax rate at 50%. Find out the cost of debt capital.

Solution:
,
Cd(before tax)= ×100= ×100= 7.18%
,

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

N.P. =(1,00,000 –(1,500 + 500 + 500) =97,500

( ) 7,000(1−0.50)
Cd(after tax) = ×100 = ×100 = 3.59%
97,000

Question 3
SK company issued 10,000 ten-years 8% debentures of Rs.100 each at 4% discount. Under the
terms of debentures trust, these debentures are to be redeemed after 10 years at 5%
premium. The cost of issue is 2%. Assuming tax rate at 50%, Calculate the cost of debt capital.

Solution:
NP = 10,00,000 - 40,000 - 20,000 =Rs.9,40,000
MV = 10,00,000 + 50,000 = Rs.10,50,000
i = 8% of 10,00,000 = Rs.80,000
, , , ,

Cd (before tax) = ×100= , , , , ×100

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FINANCIAL MANAGEMENT 4.5
, ,
= ×100 = 9.15%
, ,
( )
Cd (after tax) = ×100
, , , ,
, ×( . )
= , , , , ×100 = 5.126%

Question 4
SK Company issued 1,000 10% debentures of Rs. 100 each at a premium of 5%, with a maturity
period of 10 years. The cost of issue is 2%. The tax rate applicable to the firm is 50%. Find
out the cost of capital.

Solution:
Net Proceeds (NP) = 1,05,000 – 2% of 1,00,000 = Rs. 1,03,000

, , , ,
,
Cd (before tax)= × 100 = , , , , x 100

,
= x 100 = 9.556%
, ,

( )
Cd (After tax)= × 100

, , , ,,
, ( . )
Cd (After tax)= , , , ,

,
= x 100 = 4.63%
, ,

Question 5
SK Ltd. has issued 8% 10,000 Preference Shares of Rs. 100 each and has incurred the following
expenses:

Underwriting Commission 2%, Brokerage 1%, Other Expenses Rs. 5,000. If the present company
tax rate is 50%, what will be the cost of capital after tax and before tax?

Also calculate cost of preference capital, if corporate dividend tax is 10%.

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

,
Cp (after – tax ) = x 100 = x 100 = 8.29%
, ,

1
Cp (before – tax ) = After tax cost = 8.29 = 16.58%
1−𝑡 .

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FINANCIAL MANAGEMENT 4.6

If corporate dividend tax is paid:

( ) ( . )
Cp (after tax ) x 100 = x 100 = 9.12%
.

Question 6
SK Ltd. issued at par 10,000 10% Preference Shares of Rs. 100 each. These shares are
redeemable after 10 years at a premium of Rs. 5 per share. The cost of issue is Rs. 2 per
share. Find out the cost of preference capital. Assume 50% tax rate.

Solution:

, , , ,
, ,
Cp (after – tax )= , , , , x 100

, ,
= x 100 = 10.54%
, ,

Cp (before–tax )= 10.54{ } = 21.08%

.

Question 7
Calculate the cost of equity capital for a company whose Risk-free rate =10%, equity market
required return =18% with a beta of 0.5.

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

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

Solution:
Ce = x 100 = x 100 = 5%

Question 9
SK Ltd. has issued 1,000 equity shares of Rs. 100 each as fully paid. It has earned a profit of
Rs. 10,000 after tax. The market price of these shares is Rs. 160 per share. Find out the cost
of equity capital before and after tax assuming a tax rate of 50%.

Solution:

. , / ,
Ce (after tax)= x 100 = x 100 = 6.25%

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FINANCIAL MANAGEMENT 4.7
.
Ce (before tax)= x 100 = x 100 = 12.5%
.

Question 10
The average rate of dividend paid by SK Ltd. for the last five years is 21 per cent. The earnings
of the company have recorded a growth rate of 3 per cent per annum. The market value of
the equity shares is estimated to be Rs. 105. Find out (a) the cost of equity share capital. (b)
Determine the estimated market price of the equity shares if the anticipated growth rate of
the firm rises to 5%. (c) If the company’s cost of capital is 20% and anticipated growth rate
is 5%, determine the market price of the share, assuming the same dividend per share.

Solution:
(a) Ce (after tax)= { x 100} + G = { x 100} + 3 = 23%
( )

(b) Determination of market price of growth rate rises to 5%:

Ce (after tax)= { x 100} + G

( )

23 = { x 100} + G

,
Or 23 – 5 = or 18 MP = 2,100

MP = 2,100 ÷ 18 = Rs. 116.67 per share

(c) Determination of market price if cost of capital is 20%:

Ce (after tax)= { x 100} + G or 20= { x 100} + 5

= 20 – 5 = 2,100 / MP

MP = 2,100 15 = Rs. 140 per share

Question 11
The SK Company declared last dividend of Rs. 1.50 last year. The company is likely to have
growth rate of 12%in the next two years, 10% in the third year and fourth year and thereafter
the growth rate would stabilize at 8%. Find the price at which the share shall be purchased
if the shareholders expected rate of return is 16%.

Solution:
In this case, we need to determine the intrinsic value of the shares which will be equal to the
present value of the next four dividends + present value of the market price of the share in
the fourth year.

Year Dividend PV@16% Total PV

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FINANCIAL MANAGEMENT 4.8

0 1.5 Not required

1 1.68 0.862 1.44
2 1.88 0.743 1.39
3 2.06 0.641 1.32
4 2.27 0.552 1.25
Total 5.40

Price in the fourth year = P4=D5 / (Ce – g)

D5 = Expected dividend = 2.27(1+8%)

D5 = Expected dividend = 2.45

.
Price of the end of fourth year =
% %

Therefore, price at the end of the fourth year = Rs. 30.62

Present value of the market price at the end of the fourth year = 30.62 x 0.552 = 16.90

Total Intrinsic Value = Rs. 5.40 + Rs. 16.90 = Rs. 22.30

The share not be bought for rupees more than 22.30.

Question 12
Calculate cost of new equity capital issue from the following information:
Face value of share Rs. 100
Market value Rs. 105
Securities premium Rs. 3 per share
After tax net earning Rs. 10.50 per share
Cost of issue Rs. 3 per share
Tax rate 50%

Solution:

.
Ce (After – tax) = X 100 = X 100 = 10.50%

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

. %
Ce (before – tax) = = = 21%
%

Question 13
Find out the cost of retained earnings from the information given below:
Dividend per share Rs. 10
Personal Income – Tax Rate 30%

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FINANCIAL MANAGEMENT 4.9

Personal Capital Gains Tax Rate 20%

Corporate Tax Rate 50%
Market Price Per Share Rs.100
Brokerage 2%

Solution:

( )( ) ( )( . )
Cr (After – Tax) = X 100 = X 100 = 8.575%
( ) ( . )

Cr (Before – Tax) = 8.575 x { } = 17.15%

.

Question 14
The capital structure of a company and its specific costs are given below. Find out simple and
the weighted average cost of capital of the company.
Sources Amount Specific Cost (after tax)
Long term debts Rs. 15,00,000 4%
Preference shares 10,00,000 12%
Equity shares 20,00,000 15%
Retained earning 5,00,000 15%
50,00,000

Solution:
Calculation of Average Cost of Capital (using historical weights):

Sources of Book-value weighted Specific Weighted

Amount Rs.
capital Cost rate costs
Percentage Proportion
Long – term 15,00,000 30% 0.30 4% 1.20
debts
Preference 10,00,000 20% 0.20 12% 2.40
Shares
Equity Shares 20,00,000 40% 0.40 15% 6.00
Retained 5,00,00 10% 0.10 15% 1.50
Earnings
Total 50,00,000 100% 1.00 11.10

Thus, weighted average cost of capital is 11.10% while simple average of cost of capital= 46%
/ 4 = 11.50%.

Question 15
In question no. 14, assume market value of preference shares at 150% equity shares and
retained earnings at 160% and debentures at par, calculate average cost of capital.

Solution:

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FINANCIAL MANAGEMENT 4.10

Source of Market value Weights Specific Weighted

Market value
capital Percentage Proportion costs costs
Long term
15,00,000 21.4 .214 4 0.856
debts
Preference
15,00,000 21,4 .214 12 2.568
shares
Equity shares 32,00,000 45.7 .457 15 6.855
Retained
8,00,000 11.5 .115 15 1.725
earnings
Total 70,00,000 100.0 1.000 46 12.004

Question 16
If illustration no.14, the firm believed that its optimal capital structure is consisting of 40%
debt, 10% preference shares, 35% equity shares and 15% retained earnings, calculate
weighted average cost of capital using target weights.

Solution:
Calculation of Weighted Average Cost of Capital
(Using Target Weights)
Source Target Proportions Specific cost Weighted cost
Long term debts 40% .40 4% 1.60
Preference shares 10% .10 12% 1.20
Equity shares 35% .35 15% 5.25
Retained earnings 15% .15 15% 2.25
Total 100% 1.00 10.30%

Question 17
A company’s cost of capital for specific sources is as under:

Cost of Debentures 5%
Cost of Preference Shares 10%
Cost of Equity Shares 14%
Cost of Retained Earnings 13%

The company wishes to raise Rs. 5,00,000 for the expansion of its plant. It is estimated that
Rs. 1,00,000 will be available as retained earnings and the balance of the additional funds will
be raised as under:

Debenture issue Rs. 3,00,000

Preference share issue Rs. 1,00,000

Using marginal weights, calculate weighted average cost of capital.

Solution:
Calculation of Weighted Average Cost

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FINANCIAL MANAGEMENT 4.11

Source Amount Weights Specific Weighted average

Rs. Cost% Cost%
Retained earnings 1,00,000 .2 13 2.6
Debentures 3,00,000 .6 5 3.0
Preference shares 1,00,000 .2 10 2.0
Total 5,00,000 1.0 7.6

Question 18
The capital structure of SK Ltd. is as under:

3,000 12% Debentures of Rs. 100 each Rs. 3,00,000

2,000 10% Preference shares of Rs. 100 each 2,00,000
4,000 Equity Shares of Rs. 100 each 4,00,000
Retained Earnings 1,00,000

The earning per share of the company in the past many years have been Rs. 15. The shares of
the company are sold in the market at book value. The company tax rate is 50%. The
shareholder’s tax liability may be assumed as 25%. Find out the Weighed Average Cost of
Capital.

Solution:
( ) ( . )
(1) Cost of debentures ( after tax) = x 100 = x 100 = 6%

(2) Cost of Preference share capital (after tax)= x 100 = x 100 = 10%

(3) Cost of Equity share capital (after tax)= x 100 = x 100 = 12%

( ) ( . )
(4) Cost of Retained Earnings (after – tax) = x 100 = x 100 = 9%
( ) ( )

Workings:

, , , ,
Market price per share= = Rs. 125
,

In the absence of any information to the contrary, it has been assumed that company’s pay-
out ratio is 100% and so dividend per share and earnings per share are equal in this company.

Calculation of Weighted Average Cost of Capital

Weighted
Amount Weights Specific
Source average
Rs. Cost% Cost%

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FINANCIAL MANAGEMENT 4.12

Debentures 3,00,000 .3 6 1.8

Preference shares 2,00,000 .2 10 2.0
Equity shares 4,00,000 .4 12 4.8
Retained earnings 1,00,000 .1 9 0.9
Total 10,00,000 1.0 9.5

Question 19
Sinking ltd has an operating profit of Rs. 46,00,000 and has employed debt (total interest
charge of Rs. 10,0,000). The existing cost of equity and cost of debt to the firm are 18% and
10% respectively. The firm has a proposal before it requiring funds of Rs. 100 lakhs (to be
raised by issue of additional debt at 10%), which is expected to bring additional profit of Rs.
19,00,000.
Assume no tax.
Find out –
1) Existing weighted average cost of capital
2) New weighted average cost of capital

Solution:
Present Amt (in New Amt (in
Particulars Present WACC New WACC
lakhs) lakhs)

= 100 + new 100 = 10% x =

Debt 10% x = 3.33%
= 100 200 4.44%
%

=
Equity 18% x = 12% =250 18% x = 10%
= 200 %
%

Total 300 15.33% 450 14.44%

Question 20
Bablu ltd has furnished the following information:
Earnings per share Rs. 4 Rate of tax 30%
Dividend payout ratio 25% Growth rate of dividend 8%
Market price per share Rs. 40
The company wants to raise additional capital of Rs. 4 lakhs. The cost of debt (before tax) is
10% upto Rs. 2 lakhs and 15% beyond that. Compute the after-tax cost of equity & debt, and
the weighted average cost of capital.

Solution:
Interest on loan (Rs. 20,00,00 x 10%) + (Rs. 2,00,000+15%) Rs. 50,000
= Rs. 20,000 + Rs. 30,000

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FINANCIAL MANAGEMENT 4.13

Kd =
( % )
=
, ( % %) 8.75%
,

Ke = =
% % % 10.70%

K0 = (kdx wd) + (ke x we ) = (8.75% x 40%) + (10.70% x 60%) 9.92%

Question 21
Dhruv Ltd wishes to raise additional finance of Rs. 30 Lakhs for meeting its investment plans.
The company has Rs. 6,00,000 in the form of retained earnings available for investment
purposes. The following are further details-

 Debt equity ratio 30:70

 Cost of debt at the rate of 11% (before tax) up to Rs.3,00,000 and 14% (before tax)
beyond that.
 Earnings per share = Rs. 15 and dividend payout = 70% of earnings
 Expected growth rate in dividend 10%
 Current market price per share = Rs. 90
 Company’s tax rate is 30% and shareholders personal tax rate is 20%

Calculate the following –

 Post tax average cost of additional debt

 Cost of retained earnings and cost of equity
 Overall weighted average (after tax) cost of additional finance

Solution:
Loan required = 30% of Rs. 30 lakhs Rs. 9,00,000
Interest on loan = (Rs. 3,00,000 x 11%) + (Rs. 6,00,000 x 14%) = Rs. Rs. 1,17,000
33,000 + Rs. 84,000

Kd =
( % ) 9.10%

Ke = =
% % % 22.83%

Ko = ( kdx wa) + (ke x we) = (9.10% x 30%) + (22.83% x 70%) 18.711%

Note:
DPS1 has been considered in computation of ke Alternatively, earnings growth model may also
be applied.

Shareholders personal tax rate is not considered in kr since dividend are tax-exempt in their
hands.

Alternatively, kr may be taken as post tax opportunity cost = ke(1-tp)= 22.83% x (100%-20%) =
18.26%

In such case, ko will be computed as under-

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FINANCIAL MANAGEMENT 4.14

Component Rs. % Individual cost WACC

Debt 9,00,000 30% Kd = 9.10% 2.73%
Retained earnings 6,00,000 20% Kr = 18.26 3.65%
Equity capital 15,00,000 50% Ke = 22.83% 11.42%
Total 30,00,000 100% 17.80%

Question 22
Techno mate Limited has the following Capital Structure:
9% Debenture Rs.2,75,000
11% Preference shares Rs.2,25,000
Equity shares (Face value: Rs. 10 per share) Rs.5,00,000
TOTAL Rs. 10,00,000

Additional Information:

Rs. 100 Per Debenture Redeemable at par has 2% Floatation cost and 10 Years of maturity.
The market price per Debentures is Rs. 105

Rs. 100 Per Preference Share Redeemable at Par has 3% Floatation Cost and 10 Years of
maturity. The Market Price Per Preference Share is Rs. 106

Equity Share has Rs. 4 Floatation Cost and Market price Per Share of Rs. 24. The next year
expected Dividend is Rs. 2 Per Share with Annual Growth of 5%. The firm has a practice of
paying all earnings in the form of dividends.

Corporate Income-Tax Rate is 35%

You are required to calculate weighted average cost of capital (WACC) using Market Value
Weights.

Solution:
Calculation of cost of capital

.
( . ) .
Kd= . = = 5.48%
.

.
.
Kp= . = = 10.57%
.

Ke = + 0.05% = 15%

Calculate WACC at Market Value Weights

Source Amount Weights Cost of capital after tax WACC
Debt 288750 0.167 5.48% 0.92

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FINANCIAL MANAGEMENT 4.15

Preference 238500 0.138 10.57% 1.46

Equity 1200000 0.695 15% 10.43
TOTAL 17,27,250 12.81%

Question 23
The following is the capital structure of reliance ltd as n 31 st march.
Source of capital Book value Rs. Market value Rs.
Equity share of Rs. 10 each 50,00,000 1,05,00,000
Retained earnings 13,00,000 Nil
11% preference share at Rs. 100 each 7,00,000 9,00,000
14% Debenture 30,00,000 36,00,000
Market price of equity share is Rs. 40 per share and it is expected that a dividend of Rs. 4
per share would be declared. The dividend per share is expected to grow at the Rate of 8%
every year. Income tax rate applicable to the company is 40% and shareholders personal
income tax rate is 20%. You are required to calculate:

 Cost of capital for each source of capital

 Weighted average cost of capital on the basis of book value weights.
 Weighted average cost of capital on the basis of market value weights

Solution:
Computation of individual cost of capital (book value based computation)
Components & Formulas Computation Cost

Kd =
( % )
Kd =
( , , %) ( % %) 8.40%
, ,

Kp = =
, , % 11.00%
, ,

Ke = +𝑔
%
+ 8% 18.80%

Computation of individual cost of capital (market value based computation)

Components & Formulas Computation Cost
Kd =
( % )
Kd =
( , , %) ( % %) 7.00%
, ,

Kp = =
, , % 8.56%
, ,

Ke = +g
4 x 108% 18.80%
+ 8%
40

Computation of WACC based on book value proportion

Components Amount Proportion Individual cost WACC
Debentures 30 lakhs 30% 8.40% 2.52%
Preference shares 7 lakhs 7% 11.00% 0.77%
Equity capital 50 lakhs 50% 18.80% 9.40%

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FINANCIAL MANAGEMENT 4.16

Retained earnings 13 lakhs 13% 18.80 2.44%

Total 100 lakhs 100% 15.53%

Computation of WACC based on Market value proportion

Components Amount Proportion Individual cost WACC
Debentures 36 lakhs 24% 7.0% 1.68%
Preference shares 9 lakhs 6% 8.56% 0.51%
Equity capital 105 lakhs 70% 18.80% 13.16%
Total 150 lakhs 100% 15.53%

Alternative assumption/treatment:

In all the computation above, the shareholders personal income tax rate of 20% has not been
considered, since it is assumed that dividends are not taxable in his hands. Alternatively, post
tax opportunity cots may be considered for computing cost of retained earning as ke(1-tp)

However, if dividends is considered taxable , the cost of equity shall be re-computed for after
tax effect as under-

( %) % ( % %)
Ke = +g= + 5 = 15.5%

Also , instead of adjusting ke as above ,kr may be re-computed while using book value weights
as post tax opportunity cost = ke(1 – tp) = 18.80% x (100% - 20%) = 15.04%

Question 24
Redmi ltd has the following capital structure at book value:

Equity share capital (Rs. 10 each) = Rs. 1,50,00,000

10% preference share capital (Rs. 100 each) = Rs. 50,00,000
9% debentures (Rs. 1,000) each= Rs. 1,50,00,000
9.5% term loan= Rs. 2,00,00,000

Debentures are redeemable after 3 years and are being currently quoted at Rs. 980 per
debenture in the market.

Preference shares are also redeemable after 5 years and currently selling at Rs. 98.50 per
share.

The current market price of one equity share is Rs. 75. The risk free interest rate is 6.25%.
The market portfolio return is 15.25%. The beta of the company is 1.93. The applicable income
tax rate of the company is 35%.

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FINANCIAL MANAGEMENT 4.17

You are required to calculate the cost of the following using market value as weights – equity
share – preference share – 9% debentures – 9.5% term loan – weighted average cost of
capital.

Solution:
( % )
Kd (cost of 9% debenture) =

( % %)
Kd (cost of 9% debenture) = = 6.58%

( % )
Kd (cost of term loan) =

. %( % %)
Kd (cost of 9% debenture) = = 6.175%

Kp (cost of 10% PSC) =

Kp (cost of 10% PSC) = . = 10.38%

Alternative approaches are available in respect of computation of cost of debt and
preference capital.

Computation of cost of equity under CAPM approach , under CAPM approach,

Ke Rf + β (Rm – Rf) = 6.25% + 1.93 x (15.25% - 6.25%) = 23.62%

Computation of WACC based on market value proportions

Item Nos MKT price MKT value % Cost WACC
150L/1000 =
Debentures 980 147L 9.66% 6.58% 0.64%
15,000
Term loan 200L - 200L 13.15% 6.175% 0.81%
Preference 50L/100 =
98.50 49.25L 3.24% 10.38% 0.34%
capital 50,000
150L/10 =
Equity capital 75 1125L 73.95% 23.62% 17.47%
15,00,000

Question 25
The capital structure of a firm consists of equity of Rs. 80 lakhs; 10% preference shares
20lakhs and 14% debentures of Rs. 60 lakhs. At present its equity share is selling for Rs. 25. It

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FINANCIAL MANAGEMENT 4.18

is expected that the company will pay a dividend of Rs. 2. It has been growing @ 7% p.a. If
the company is subject to 50% tax rate, determine its weighted average cost of capital.

Solution:
Cost of Debt (after tax)
Kd= 14 (1-0.5) = 7%

Cost of Equity Share Capital

Ke = DPS/MP + g
= Rs. 2/Rs. 25 + 0.7
= .08 + .07 = 15%

Calculation of Weighted Average Cost of Capital (WACC)

Source Amount rs. Weight Specific cost of Weight x cost
capital of capital
Equity share 80,000 .500 .15 .07500
capital
10% Pref. Share 20,00,000 .125 .10 .01250
capital
14% debentures 60,00,000 .375 .07 .01625
1,60,000 .11375

Question 26
Calculate weighted average cost of capital from the following information:
4,000 Equity Shares (fully paid up) 4,00,000
3,000 6% Debentures 3,00,000
2,000 6% Preference Shares 2,00,000
Retained Earnings 1,00,000

Earning per equity share has been Rs. 10 during the past year and equity shares are being
sold in the market at par. Assume corporate tax at 50 per cent and shareholders’ personal
tax liability 10%.

Solution:
(A) Specific Cost of Various Components of Capital

i) Cost of Equity share Capital

Ke (after tax) = EPS/MP x 100= 10/100 x 100 =10%

ii) Cost of Retained Earnings

Kr (after tax) = E(1 – tp) / MP x 100 = 10 x (1 - .10) / 100 x 100 = 9%

iii) Cost of Preference share Capital

Kp (after tax) = DPS / NP x 100 = 6/100 x 100 = 6%

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iv) Cost of Debentures

Kd (after tax) = R x100 (1 – t)/NP = 6 x 100(1- .50) /100 = 6 x .50 = 3%

(B) Computation of Weighted Average Cost of Capital

Source Amount Rs. Weight Cost of capital Weighted
(1) (2) (3) (4) Average cost
(5) =(3) x(4)
Equity Share Capital 4,00,000 .4 .10 .040
Debentures 3,00,000 .3 .03 .009
Pref. Share Capital 2,00,000 .2 .06 .012
Retained Earnings 1,00,000 .1 .09 .009
Weighted Average Cost of Capital .070 0r 7%

Question 27
The Capital structure of Vandana Ltd. is as under:
Rs.
2,000 6% Debentures of Rs. 100 each (first issue) 2,00,000
1,000 7% Debentures of Rs. 100 each (second issue) 1,00,000
2,000 8% Cumulative Preference Shares of Rs. 100 each 2,00,000
4,000 Equity Shares of Rs. 100 each 4,00,000
Retained Earnings 1,00,000

The earnings per share of the company in the past many years has been Rs. 15. The shares of
the company are sold in the market at book value. The company’s tax rate is 50% and
shareholders’ personal tax liability is 10%. Find out the weighted average cost of capital.

Solution:
i) Cost of Equity Capital
Ke (after tax) = EPS / MP x 100 = 15/125 x 100 = 12% MP
= (Rs. 4, 00,000 + Rx. 1, 00,000) / 4,000 = Rs. 125

ii) Cost of Debentures (first issue)

Kd (after tax) = R/NP x 100(1-t)
= 6 / 100 x 100(1 - .50)
= 6 x .50 = 3%

iii) Cost of Debentures (second issue)

Kd (after tax) = R / NP x 100(1 – t)
= 7/100 x 100(1 - .50) = 6 x .50 = 3.5%

iv) Cost of Preference Share Capital

Kp (after tax) = DPS/NP x 100
= 8/100 x 100 = 8%

v) Cost of Retained Earnings

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FINANCIAL MANAGEMENT 4.20

Kr (after tax) = E (1-tp) / MP x 100

= 15 x (1 - .10) /100 x 100
= 10.8%

Weighted Average Cost

Source Amount Rs. Weight Cost of Weighted
(1) (2) (3) capital Average cost
(4) (5) =(3) x(4)
Equity Share Capital 4,00,000 .4 .12 .0480
Debentures (1st issue) 2,00,000 .2 .03 .0060
Debentures (2 issue)
nd
1,00,000 .1 .035 .0035
Pref. Share Capital 2,00,000 .2 .08 .0160
Retained Earnings 1,00,000 .1 .108 .0108
Weighted Average Cost of Capital .0843 0r 8.43%

Question 28
A company has obtained capital from the following sources, the specific costs are also noted
down against them:
Source of capital Book value Market value Cost of capital
Rs. Rs.
Debentures 4,00,000 3,80,000 5%
Preference shares 1,00,000 1,10,000 8%
Equity shares 6,00,000 12,00,000 13%
Retained earnings 2,00,000 - 9%
You are required to calculate weighted average cost of capital using (i) book value weights,
and (ii) market value weights.

Solution:
Weighted Average Cost
(Book Value Weights)
Source Amount Rs. Weight Cost of capital Weighted
(1) (2) (3) (%) average cost
(4) (5) = (3) x (4)
Debentures 4,00,000 .308 5 1.540
Preference 1,00,000 .007 8 0.616
shares
Equity shares 6,00,000 .461 13 5.993
Retained 2,00,000 .154 9 1.386
earnings
Total 13,00,000 .1000 9.535

Weighted Average Cost

(Market Value Weights)

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Source Amount Rs. Weight Cost of capital Weighted

(1) (2) (3) (%) average cost
(4) (5) = (3) x (4)
Debentures 3,80,000 .225 5 1.125
Preference 1,10,000 .065 8 0.520
shares
Equity shares 9,00,000 .533 13 6.929
Retained 3,00,000 .177 9 1.593
earnings
Total 13,00,000 1.000 10.167

Working Note: - The Market value of equity share capital and retained earnings has been
ascertained as follows:

Market Value of Retained Earnings = (12, 00,000 x 2, 00,000) /8, 00,000 = Rs. 3, 00,000
Market Value of Equity Share = (12, 00,000 x 6, 00,000) / 8, 00,000 = Rs. 9, 00,000

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CAPITAL STRUCTURE
INTRODUCTION
Section Details
Given the Capital Budgeting decision of a firm, it has to decide how
capital projects will be financed. Every investment decision requires a
financing decision (e.g., how to fund a machinery purchase—equity,
debt, or both?). A firm must evaluate implications and determine the
Introduction appropriate debt-equity mix. Capital structure refers to the break-up of
capital employed, including owner’s capital and long-term debt. It may
also include quasi equity (e.g., convertible debt). The capital structure
decision significantly affects shareholders’ return and risk, and thus
market value of the share.
- Gerstenberg: “Capital Structure of a company refers to the
Definition of composition or make up of its capitalization and it includes all long-term
Capital capital resources.”
Structure - James C. Van Horne: “The mix of a firm’s permanent long-term financing
represented by debt, preferred stock and common stock equity.”
1. Horizontal Capital Structure: Zero debt in structure. Stable structure.
Expansion through equity or retained earnings. No financial leverage.
Structure unlikely to be disturbed.
2. Vertical Capital Structure: Small equity base with preference share
capital and debt forming the rest. Growth mostly through debt. Low
retained earnings, high dividend payout. Higher cost of equity than debt.
Types of Capital High debt increases financial risk and instability. Firm vulnerable to
Structure takeovers.
3. Pyramid Shaped Capital Structure: Large equity and retained earnings
ploughed back over time. Cost of share capital and retained earnings
lower than debt. Indicates conservative, risk-averse firms.
4. Inverted Pyramid Shaped Capital Structure: Small equity, moderate
retained earnings, increasing debt. Increase in debt due to declining
retained earnings from losses. Highly collapse-prone structure.
1. Reflects the Firm’s Strategy: Shows growth pace. Faster growth
involves more debt. For inorganic growth (e.g., acquisitions), financial
Significance of leverage is useful.
Capital 2. Indicator of Risk Profile: Capital structure reflects risk. High debt
Structure means high fixed interest cost and increased risk. No long-term debt
implies risk aversion or lower cost of equity/retained earnings than debt.
3. Tax Management Tool: Interest on borrowings is tax deductible. Firms

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with strong operating profits may use more debt.

4. Brightens Firm Image: Issuing equity at a premium to small investors
builds retained earnings and improves image. Also reduces hostile
takeover risks.

CAPITAL STRUCTURE VIS-A-VIS FINANCIAL STRUCTURE

Aspect Details
In engineering, a structure refers to different parts of a building.
Similarly, in financial terms, financial structure includes all
Meaning of Financial
components of finance in an organization. It consists of all assets,
Structure
all liabilities, and capital. The manner in which an organization’s
assets are financed is referred to as its financial structure.
The entire left-hand side of a company’s balance sheet, including
Relation to Balance
liabilities and equity, is considered the financial structure. It
Sheet
includes both long-term and short-term sources of capital.
Capital structure is the sum total of all long-term sources of
capital and is thus a part of the financial structure. It includes:
- Debentures
Capital Structure - Long-term debt
- Preference share capital
- Equity share capital
- Retained earnings
Capital structure = that part of the financial structure which
Simplest Definition
reflects long-term sources of capital.
- Capital structure relates to long-term capital deployment for
creation of long-term assets.
- Financial structure involves creation of both long-term and
short-term assets.
Differences Between - Capital structure is the core element of financial structure.
Capital Structure and Capital structure can exist without current liabilities, in which
Financial Structure case capital structure = financial structure. But a firm cannot
exist with only current liabilities and no long-term capital.
- Components of capital structure may be used to build current
assets. But current liabilities should not be used to finance fixed
assets, as that would create an asset-liability mismatch.

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PLANNING AND DESIGNING OF CAPITAL STRUCTURE

Category Points Covered
- Planning and design of capital structure is as important as
that of a physical structure.
- A well-planned structure ensures shareholder wealth
Importance & Timing maximization.
- Planning starts as early as the firm's incorporation.
- Early planning is necessary to arrange funds for project
implementation.
- How should the investment project be financed?
- Does the way in which the investment projects are
financed matter?
- How does financing affect the shareholders’ risk, return
Key Questions for and value?
Management - Does there exist an optimum financing mix in terms of
maximum shareholder value?
- Can the optimum financing mix be determined in practice?
- What factors should a company consider in designing its
financing policy?
- Return: Should generate maximum return to shareholders
without additional cost.
- Risk: Debt should not be excessive; use it only when it
doesn’t add significant risk.
Attributes of a Well-Planned - Flexibility: Should allow easy adaptation to change,
Capital Structure enabling timely fund availability.
- Capacity: Should be within the firm’s debt capacity (based
on future cash flows).
- Control: Should minimize risk of loss of control, especially
for closely-held companies.
- Functional: Should align with the firm’s long-term strategy
and avoid operational bottlenecks.
- Flexible: Should allow temporary expansion/contraction in
Designing Capital Structure
the share of components.
- Statutory Compliance: Must conform to legal/statutory
guidelines and lenders’ equity requirements.

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OPTIMAL CAPITAL STRUCTURE

Aspect Details
- A specific arrangement of capital components aligned with
both long-term and short-term objectives.
Definition
- The best debt-to-equity ratio that maximizes firm value.
- Balances ideal debt-equity range and minimizes cost of capital.
- Any combination above or below the optimal mix is
Effect of Deviation unsatisfactory.
- A sub-optimal mix affects shareholder wealth maximization.
- Requirement of capital of the firm
Information Required to - Availability of different components
Design It - Cost of these components
- Rate of return from investment
- Exact information on above factors is not realistically
available.
Limitations in Practice
- Available data is only valid for a specific time period.
- Planning must be done in a static setup, which lacks flexibility.
- Business environment is dynamic, with changing capital
structure components.
- Optimal capital structure must be determined in a dynamic
Real-World Application framework.
- It acts as a benchmark for performance, not a fixed target.
- Firms can only aim for moderated versions depending on
project dynamics.

FACTORS INFLUENCING CAPITAL STRUCTURE

Factor Explanation
Strong future cash flows allow safe use of debt due to interest
Cash Flow Position
and principal repayment needs.
Measures how many times EBIT covers interest; higher ratio =
Interest Coverage
higher debt capacity. However, cash flow should still be
Ratio (ICR)
considered.
Debt Service Coverage Considers actual cash available for obligations; more accurate
Ratio (DSCR) than ICR. Higher DSCR = better debt capacity.
Return on Investment Higher ROI increases the company’s ability to utilize more debt.
(ROI)

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Lower interest rates make debt more attractive. Higher cost

Cost of Debt
discourages debt use.
High tax rates reduce the effective cost of debt due to interest
Tax Rate
deductibility, encouraging debt usage.
More debt increases equity risk, thus increasing cost of equity.
Cost of Equity Capital Excessive debt raises shareholder risk and may reduce market
value.
Debt generally has lower issuance costs than equity, making it
Floatation Costs
more attractive.
- Operating Risk: Inability to meet operating costs.
Risk Consideration - Financial Risk: Inability to meet fixed financial obligations. Low
operating risk allows higher financial risk (more debt).
Capital structure should allow easy increase/decrease of
Flexibility capital. Debt and preference shares offer more flexibility than
equity.
Issuing equity may dilute control of existing shareholders. Debt
Control
doesn’t affect control, thus preferred for preserving ownership.
Legal norms (e.g., debt-equity ratios, SEBI rules) may restrict
Regulatory Framework
financing options or enforce industry-specific guidelines.
Stock Market In dull markets, investors avoid shares; in bullish markets, shares
Conditions are attractive. Capital source depends on market sentiment.
Industry norms influence structure. Similar industries often
Capital Structure of
follow similar debt-equity ratios based on shared
Other Companies
characteristics.

CAPITAL STRUCTURE AND VALUATION

Aspect Explanation
Capital structure should aim to increase the market/realisable
Valuation Objective
value of the owners’ equity.
Valuation depends on the value of:
Components of
• Share Capital
Equity
• Retained Earnings
Reflected in market value of the firm (if listed).
Share Capital Value This market value ≠ face value or book value.
Should reflect the inherent value of the firm.
Retained Earnings • Book value: as carried in financial records.
Value • Inherent value: based on future returns these earnings generate.

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Through increase in earnings, which can occur via:

1. Direct Increase – due to higher operations (investment
How Valuation
decisions).
Increases
2. Indirect Increase – due to lower cost of capital (capital
structure decisions).
• Does not affect direct earnings (which depend on investments).
Role of Capital
• Reduces cost of capital, leading to higher earnings and hence,
Structure
higher valuation.

CAPITAL STRUCTURE THEORIES

Theory Key Concept Assumptions Implications Formulas /
Notes
• Higher debt → Ko = (Kd ×
Value of the firm 1. Kd < Ke
1. Net lower WACC (Ko) → D/D+E) + (Ke
increases with higher 2. Kd & Ke
Income (NI) higher firm value × E/D+E)
debt due to lower cost constant
Approach • Firms should More debt =
of debt (Kd < Ke). 3. No taxes
maximize debt lower Ko

Theory Key Concept Assumptions Implications Formulas /

Notes
1. Investors
value firm as a
• Value of firm
whole Value =
2. Net Capital structure is remains unchanged
2. Ko is EBIT / Ko
Operating irrelevant; value with change in
constant Ke = Ko +
Income (NOI) depends only on leverage
3. Kd constant (Ko − Kd)
Approach EBIT & Ko • Debt doesn’t
4. Ke increases (D/E)
increase value
with debt
5. No taxes

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Theory Key Concept Assumptions Implications Formulas /

Notes
1. Kd remains
constant to a
Graph: U-
point, then rises • Moderate use of
There exists an shaped
2. Ke remains debt reduces Ko
3. optimal capital WACC curve
constant to a • Beyond optimum
Traditional structure which Optimum =
point, then rises point, cost
Approach minimizes WACC and minimum
due to risk increases due to
maximizes firm value WACC, max
3. Ko first higher risk
firm value
declines, then
rises

Theory Key Concept Assumptions Implications Formulas / Notes

1. No taxes
2. No transaction
Value of firm is
costs • Leverage has V_l =
4. independent of
3. Same no effect V_u =
Modigliani- capital
borrowing cost • Arbitrage EBIT / Ko
Miller (MM) structure
for firms & ensures same Ke = Ko + (Ko –
– No Tax (perfect
investors firm value Kd)(D/E)
markets)
4. No bankruptcy
risk

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• More debt →
Value increases
Firm value higher value due
MM with with interest tax
increases with Same as MM + to tax savings
Corporate shield
more debt due corporate taxes • 100% debt
Taxes But unrealistic in
to tax shield suggested in
practice
pure theory
• There is an
Balance
optimal capital
MM Modified between tax
Real-world structure Used in practical
(Trade-off benefits and
variation of MM • Too much debt financial planning
Theory) bankruptcy
increases risk
costs
and cost
• Firms avoid
equity due to
No fixed target Explains why firms
dilution and high
Pecking Firms prefer structure; focus don’t follow
info cost
Order internal finance on cost of optimal capital
• Debt is
Theory > debt > equity financing due to structure models
preferred when
asymmetric info strictly
external funds
needed
• Higher debt
may increase
Examines effect EPS Helps find financial
EBIT–EPS of leverage on • But excessive structure that
—
Analysis earnings per debt increases maximizes EPS &
share financial risk and shareholder value
may reduce
equity value

EBITDA ANALYSIS (EARNINGS BEFORE INTEREST, TAX, DEPRECIATION AND AMORTIZATION)

Section Summary
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and
Definition of Amortization. It is calculated by adding back interest, taxes,
EBITDA depreciation, and amortization to net income to measure a company's
operating profitability.
EBITDA allows analysts to focus on the operating performance of a
Purpose of company by excluding non-operating activities (such as interest
EBITDA expenses, tax rates, and large non-cash items like depreciation and
amortization). It helps to analyze profitability without these factors.

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EBITDA is useful for comparing companies within the same industry, as

Usefulness of
it highlights operating profitability, offering a clearer view of core
EBITDA in Analysis
business performance.
EBITDA can be misleading by making unprofitable companies seem
Limitations of financially healthy, as it excludes interest, taxes, depreciation, and
EBITDA amortization. It can be easily manipulated by inflating revenues or
expenses.
Operating cash flow is a better measure of how much cash a company
Comparison with generates, as it considers changes in working capital. EBITDA does
Cash Flow not reflect this important aspect and might miss signals that a
company is losing money.
EBITDA as a EBITDA is used to estimate cash flow available for debt payment on
Shortcut for Debt long-term assets. This can help calculate the debt coverage ratio
Payment (EBITDA divided by debt payments).
EBITDA is more useful for evaluating companies with legitimate
Limitations in profitability, particularly in old-line industries where capital
Application to expenditures are predictable. It may be less useful for new or highly
Certain Firms capital-intensive firms like tech startups or telecoms, where ongoing
technology upgrades significantly impact profitability.
EBITDA can help compare different companies within the same
Comparing
industry and against industry averages. It removes certain factors,
Companies Using
providing an "apples-to-apples" comparison of companies' core profit
EBITDA
trends.
Despite its usefulness, EBITDA should not replace cash flow analysis,
Caveats with which includes changes in working capital. Cash flow is critical for
EBITDA assessing "true" profitability and the company’s ability to continue
operations.

MEASURES OF OPERATING AND FINANCIAL LEVERAGE

Section Summary
Leverage in finance refers to using fixed-cost assets or funds to
Definition of increase returns to shareholders. James Horne defines leverage as
Leverage employing assets or funds for which the firm pays a fixed cost or
return.
Leverage is classified into three types: financial leverage, operating
Types of
leverage, and investment leverage. Operating leverage magnifies the
Leverage
effect of changes in sales on EBIT and EPS.

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Operating leverage arises from fixed operating costs in a company. It

Operating refers to the company’s ability to use fixed operating costs to magnify
Leverage the impact of sales changes on earnings before interest and taxes
(EBIT).
A company has a high degree of operating leverage when it uses more
High Degree of
fixed costs and fewer variable costs. The degree of operating
Operating
leverage depends on the proportion of fixed versus variable costs in
Leverage
the company’s cost structure.
Degree of The degree of operating leverage is the percentage change in EBIT
Operating resulting from a percentage change in sales. It is used to measure how
Leverage sensitive operating income (EBIT) is to changes in sales.
Uses of Operating leverage helps measure the impact of sales changes on a
Operating company’s profits. It identifies the relationship between fixed and
Leverage variable costs and the effect of sales changes on profitability.
Importance of Operating leverage allows a company to understand its fixed cost
Operating investment in business activities and the overall position of fixed
Leverage operating costs in relation to revenue generation.

FINANCIAL LEVERAGE
Section Summary
Financial leverage represents the relationship between EBIT
Definition of Financial (Earnings Before Interest and Taxes) and the earnings available to
Leverage equity shareholders. It refers to using fixed-cost funds to increase
returns to shareholders.
Financial leverage involves using long-term, fixed-interest-bearing
Financial Leverage debt and preference share capital along with share capital to
Concept increase returns to equity shareholders, also known as "trading on
equity."
- Favourable (Positive): Occurs when the company earns more on
Favourable vs assets purchased with funds than the fixed cost of using those
Unfavourable funds.
Financial Leverage - Unfavourable (Negative): Occurs when the company does not
earn enough to cover the cost of the funds used.
Degree of financial leverage measures the percentage change in
Degree of Financial taxable profit resulting from a percentage change in EBIT. It
Leverage indicates how much financial leverage magnifies the impact of EBIT
on taxable profit.

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According to Gitmar, financial leverage is the ability to use fixed

Alternative Definition financial costs to magnify the effects of changes in EBIT on EPS
(Earnings Per Share).
- Helps analyse the relationship between EBIT and EPS.
- Measures the percentage change in taxable income relative to
EBIT.
Uses of Financial
- Used to make profitable financial decisions about capital
Leverage
structure.
- Helps in understanding the impact of fixed-cost funds on
profitability.

DIFFERENCE BETWEEN OPERATING LEVERAGE AND FINANCIAL LEVERAGE

Sl. Operating Leverage Financial Leverage
No
Operating leverage is associated with Financial leverage is associated with
1
investment activities of the company. financing activities of the company.
Operating leverage consists of fixed Financial leverage consists of Fixed
2
operating expenses of the company. Financial Expenses of the company.
It represents the ability to use fixed It represents the ability to use fixed
3
operating cost. financial cost.
Operating leverage can be calculated by= Financial leverage can be calculated
4
Contribution/EBIT by= EBIT/EBT
A percentage change in the profits
A percentage change in taxable
resulting from a percentage change in the
5 profit is the result of percentage
sales is called as degree of operating
change in EBIT.
leverage.
Trading on equity is possible only
Trading on equity is not possible by using
6 when the company uses financial
operating leverage
leverage.
Financial leverage depends upon
Operating leverage depends upon fixed
7 the operating profits & fixed
cost and variable cost.
financial costs.
Tax rate and interest rate will not affect Financial leverage will change due to
8
the operating leverage. tax rate and interest rate.

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Financial Break Even Point & Indifference Point

Section Summary
The level of EBIT (Earnings Before Interest and Taxes) at which all fixed
financing costs (interest and preference dividend) are covered, and EPS
Financial (Earnings Per Share) becomes zero.
Break Even Formula:
Point (FBP)

The EBIT level at which different debt ratios (debt-to-capital ratio) result
in the same EPS. Beyond this point, the use of fixed charge sources (debt) is
Indifference
favourable to increase EPS. If EBIT exceeds this point, financial leverage
Point
becomes favourable.
If EBIT is below this point, using equity capital is more favourable for EPS.

Formula for
Indifference
Point

COMBINED LEVERAGE
Section Summary
Combined Leverage (also known as composite leverage or total leverage)
Definition refers to the use of both financial and operating leverage to magnify the
impact of changes in sales on earnings per share (EPS).
Formula for
Combined
Leverage
(DCL)
Contributio The relationship between revenue (sales) and taxable income (EBIT to PBT).
n
Degree of Combined Leverage measures the percentage change in EPS
resulting from a 1% change in sales. It is calculated by multiplying the
Degree of Degree of Operating Leverage (DOL) and Degree of Financial Leverage
Combined (DFL) at a particular sales level.
Leverage Formula:

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WORKING CAPITAL LEVERAGE

Section Summary
Working Capital Leverage measures the sensitivity of return on investment
Definition (ROI) to changes in the level of current assets (working capital) within a
company.
Formula
for
Working
Capital
Leverage
Working capital leverage helps assess how changes in current assets affect
Explanation
the company's return on investment (ROI).
If earnings are not impacted by changes in current assets, the working
When
capital leverage can be calculated using:
Earnings
are
Unaffected
by Changes
in Current
Assets

EFFECTS OF LEVERAGE ON SHAREHOLDERS’ RETURNS

Section Summary
A financial plan affects market value, cost of capital, and
Definition of Financial shareholders' return. The debt-to-equity ratio in the financial plan
Plan is called leverage. Proper management of leverage can maximize
EPS value and shareholder returns.
- High Operating Leverage: If % change in EBIT > % change in
sales, ROE increases as fixed costs per unit decrease. A 2:1 ratio
means a 100% increase in sales results in a 200% increase in
Operating Leverage
EBIT.
Effect
- Low Operating Leverage: Useful when sales market is
fluctuating.
- Risk: Too high operating leverage is risky.
- High Financial Leverage: Over-leveraging means borrowing funds
Effect of Financial
at low interest rates and investing in high-risk assets to maximize
Leverage on ROE
returns.

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- Low Financial Leverage: Involves low debt and may positively

affect ROE if the value of bought assets decreases.
Effect of High
Operating & Financial - This combination increases ROE but is highly risky.
Leverage
Effect of Low
Operating Leverage & - This is an optimum combination for bringing maximum return on
High Financial equity.
Leverage

RISK AND LEVERAGE

Section Summary
Risk refers to the probability that future revenue streams will vary
Definition of Risk from expected figures, generally on the negative side. Positive
variations reduce investment risk, which is always desirable.
Risk is divided into two broad categories:
1. Business Risk: Associated with the firm’s day-to-day operations.
It includes decisions regarding raw materials, manufacturing, and
administrative expenses. These affect operational profitability
Categories of Risk
(EBIT).
2. Financial Risk: Linked to the use of fixed interest-bearing debt in
the capital structure. It creates a prior charge on EBIT before
profits are distributed to shareholders.
As financial leverage increases, the break-even point rises, meaning
Relationship between the company must sell more to break even. High financial leverage
Financial Risk and increases risk for banks and lenders due to higher bankruptcy
Financial Leverage probability. It also increases risk for stockholders, as greater
leverage leads to more volatility in earnings and stock prices.

Hamada Equation
Section Summary
The Hamada equation is used to quantify the effect of financial
Definition of leverage on a firm's cost of capital. It analyses how a firm's beta
Hamada Equation changes with leverage, helping to measure systemic risk relative to the
overall market.
- Levered Beta (βL): Reflects the firm's risk, including the impact of
Key Components financial leverage.
- Unlevered Beta (βu): Reflects the firm's market risk without

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FINANCIAL MANAGEMENT 5.15

considering debt.
- Tax Rate (T): The effect of taxes on the firm's risk.
- Debt-to-Equity Ratio (D/E): A measure of the company's financial
leverage.
The formula for Hamada Equation is:
βL = βu [1 + (1 - T) (D/E)]
Where:
Formula βL = Levered Beta
βu = Unlevered Beta
T = Tax Rate
D/E = Debt-to-Equity Ratio
- The Hamada equation extends the Modigliani-Miller theorem on
capital structure.
Key Points - A higher βL indicates higher risk for the firm.
- The equation helps to understand how financial leverage affects a
firm’s risk profile.
The equation was developed by Robert Hamada, a former professor at
Background the University of Chicago Booth School of Business. His work was
published in 1972 in the Journal of Finance.

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QUESTION BANK
Question 1
Super manufacturing company expects to earn net operating income of INR 1,50,000 annually.
The company has INR 6,00,000, 8% debentures. The cost of equity capital of the company is
10%. What would be the value of the company? Also calculate overall cost of capital.

Solution:
Calculation of Value of Super Manufacturing Company:
Particulars Amount (INR)
Net Operating Income 1,50,000
Less: Interest on 8% debentures (I) 48,000
Earnings available to equity shareholders (NI) 1,02,000
Equity capitalization rate (Ke) 0.10
Market value of equity (S) = NI / Ke 10,20,000
Market value of debt (B) 6,00,000
Total value of firms (S+B)= V 16,20,000

Overall cost of capital = K0 = EBIT / V

= INR 1,50,000 / 16,20,000
= 0.093 = 9.3% approximately

Question 2
Find out the value of the Magic Limited with the help of given information:
Particulars Amount (Rs.)
Earnings Before Interest and Tax 3,50,000
Cost of Equity 10%
Cost of Debt 7.2%
Debenture 1,00,000
Find out the Value of firm with the help of net income approach. (Assume tax rate-10%).

Solution:
Particulars Amount (Rs.)
Earnings Before Interest and Tax 3,50,000
Less: Interest @ 7.2% 7200
Earnings Before Interest and Tax 3,42,800
Less: Tax@10% 34,280
Net Income 3,08,520
Cost of equity 10%
Market value of equity (S = net income / cost of equity) 30,85,200
Market value of Debt (B) 1,00,000
Value of the firm (S+B) 31,85,200

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Question 3
Compute the value of Elite limited from the following figures. Further, assume that the
proportion of debt increases from US$300,000 to US$400,000, and everything else remains
the same what will be the value of the company? Using Net Income Approach.
Particulars Amount ($)
Earnings before Interest and Tax (EBIT) 1,00,000
Bonds (Debt part) 3,00,000
Cost of bonds issued (Debt) 10%
Cost of Equity 14%

Solution:
Particulars Amount ($)
EBIT 1,00,000
Less: Interest cost (10% of 3,00,000) 30,000
Earnings (since tax is assumed to be absent) 70,000
Shareholders’ Earnings 70,000
Market value of Equity (70,000/14%) 5,00,000
Market value of Debt 3,00,000
Total Market value 8,00,000
Overall cost of capital 1,00,000/8,00,000
= 12.5%

When the proportion of debt increases from US$300,000 to US$400,000.

Particulars Amount ($)
EBIT 1,00,000
Less: Interest cost (10% of 4,00,000) 40,000
Earnings (since tax is assumed to be absent) 60,000
Shareholders’ Earnings 60,000
Market value of Equity (70,000/14%) 4,28,570 (approx)
Market value of Debt 4,00,000
Total Market value 8,28,570
Overall cost of capital 1,00,000/8,28,570
= 12% (approx)

Question 4
Bliss limited has an EBIT of Rs. 4,00,000 and belongs to a risk class of 10% i.e. its overall cost
of capital is 10%. What is the value of equity capital if it employees 5% debt to the extent of
30%, 40% or 50% of the total capital of Rs. 20,00,000? Assume that Net Operating Income
approach applies.

Solution:
Particulars 30% Debt 40% Debt 50% Debt
EBIT (A) 4,00,000 4,00,000 4,00,000
Overall cost of capital (Ko) 10% 10% 10%

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Value of the firm (V = EBIT/ Ko) 40,00,000 40,00,000 40,00,000

Value of debt (D) 30%, 40%, 50% of Rs. 20 lacs 6,00,000 8,00,000 10,00,000
Value of Equity (E = V–D) 34,00,000 32,00,000 30,00,000
Interest on debt @5% (B) 30,000 40,000 50,000
Net profit available for equity shareholders
3,70,000 3,60,000 3,50,000
(A–B)
Ke (Net profit for equity shareholders / Value of
10.88% 11.258% 11.67%
Equity)

The cost of equity capital increases with the increase in the proportion of debt capital. Cost
of Equity can also be calculated using the following formula:

Ke = Ko + (Ko – Kd) D/E

Ke = 10 + (10–5) 6,00,000/34,00,000 = 10.88%
Ke = 10 + (10–5) 8,00,000/32,00,000 = 11.25%
Ke = 10 + (10–5) 10,00,000/30,00,000 = 11.67%

Question 5
Ample limited operating income (EBIT) is Rs.5,00,000. The firm’s cost of debt is 10% and
currently the firm employ Rs.15,00,000 of debt. The overall cost of capital of the firm is 15%.
You are required to calculate:
(i) Total value of firm
(ii) Cost of equity

Solution:
(i) Statement showing value of the firm
Particulars Amount (Rs.)
Net Operating Income (EBIT) 5,00,000
Less: Interest on debentures (10% of Rs.15,00,000) 1,50,000
Earnings available for equity holders 3,50,000
Total cost of capital (KO) (given) 15%
Value of the firm V = EBIT / KO = Rs.5,00,000 / 0.15 33,33,333

(ii) Calculation of cost of equity

Particulars Amount (Rs.)
Market value of debt (D) 15,00,000
Market value of equity (S) = V – D 18,33,333
= Rs.33,33,333 – Rs.15,00,000

Ke = Ke = Ke x + KD
( )

, , , ,
OR =
– =0.15 [ ] -0.10 [ ]
, , , ,

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FINANCIAL MANAGEMENT 5.19
. , , 1
= X 100 = (0.15x33,33,333) – (0.15 x 15,00,000)
. , , 18,33,333

= 19.09% = 19.09%

Question 6
A ltd. and B ltd. are identical except for capital structures. A ltd. has 50 percent debt and 50
percent equity, whereas B ltd. has 20 percent debt and 80 percent equity. It is to be noted
that all percentages are in market-value terms. The borrowing rate for both companies is 8
percent in a no-tax world, and capital markets are assumed to be perfect.

(a)
(i) If you own 2 percent of the shares of A ltd., determine your return if the company has net
operating income of Rs.3,60,000 and the overall capitalization rate of the company, Ko is 18
percent?
(ii) Calculate the implied rate of return on equity?

(b) B ltd. has the same net operating income as A ltd.

(i) Determine the implied required equity return of B ltd.
(ii) Analyze why does it differ from A ltd.

Solution:
. , ,
(a) Value of A ltd. = = = Rs. 20,00,000
%

(i) Return on shares of A ltd.

Particulars Amount (Rs.)
Value of the company 20,00,000
Market value of debt (50%) 10,00,000
Market value of equity (50%) 10,00,000
Net Operating Income 3,60,000
Interest on debt (8% x Rs. 10,00,000) 80,000
Earnings available to shareholders 2,80,000
Return on equity ( 2% x 2,80,000) 5,600

(ii) Implied rate of return on equity

. , ,
= x 100 = 28%
. , ,

(b) (i) Calculation of Implied Rate of Return

Particulars Rs.
Total value of company 20,00,000
Market value of debt (20% x Rs.20,00,000) 4,00,000
Market value of equity (80% x Rs.20,00,000) 16,00,000
Net Operating Income 3,60,000

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Interest on debt (8% x Rs.4,00,000) 32,000

Earnings available to shareholders 3,28,000

. , ,
Implied required rate of return on equity = x 100 = 20.5%
. , ,

(ii) It is lower than the A ltd. because B ltd. uses less debt in its capital structure. As the
equity capitalization is a linear function of the debt-to-equity ratio when we use the net
operating income approach, the decline in required equity returns offsets exactly the
disadvantage of not employing so much in a way of “cheaper” debt funds.

Question 7
Let us take the case of two firms X and Y, similar in all respects except in their capital
structure. Firm X is financed by equity only; firm Y is financed by a mixture of equity and debt.
The financial parameters of the two firms are as follows:

Financial Particulars of Firms X and Y

Amount in ₹
Particulars Firm X Firm Y
Total Capital Employed 10,00,000 10,00,000
Equity Capital 10,00,000 6,00,000
Debt Nil 4,00,000
Net operating Income 1,00,000 1,00,000
Debt Interest 0 20,000
Market value of debt 0 4,00,000
Equity earnings 1,00,000 80,000
Equity capitalization rate 10% 12%
Market value of equity 10,00,000 6,66,667
Total market value of the firm 10,00,000 10,66,667
Average cost of capital 10% 9.37%
Debt-Equity ratio 0 0.6

Solution:
From the above particulars, it can be seen that the value of leveraged firm Y is higher than
that of the unleveraged firm. According to Modigliani Miller approach, such a situation cannot
persist because equity investors would do well to sell their equity investment in firm Y and
invest in the equity of firm X with personal leverage. For example, an equity investor who owns
1% equity in firm Y would do well to:

– Sell his equity in Firm Y for ` 6,667

– Borrow ₹ 4,000 at 5% interest on personal account and
– Buy 1.0667% of the equity of firm X with the amount of ₹ 10,667 that he has.

Such an action will result in the following income:

Particulars (₹)

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FINANCIAL MANAGEMENT 5.21

Income on investment in firm X 1066.70

Less: Interest (4000 x 5%) 200.00
Net Income 866.70

This net income of ₹ 866.7 is higher than a net income of ₹ 800 foregone by selling 1 percent
equity of firm Y and the leverage ratio is the same in both the cases.

When investors sell their equity in firm Y and buy the equity in firm X with personal leverage,
the market value of equity of firm Y tends to decline and the market value of equity of firm X
tends to rise. This process continues until the net market values of both the firms become
equal because only then the possibility of earning a higher income for a given level of
investment and leverage by arbitraging is eliminated. As a result of this the cost of capital
for both the firms is the same.

The above example explains that due to the arbitrage mechanism the value of a leveraged firm
cannot be higher than that of an unleveraged firm, other things being equal. It can also be
proved that the value of an unleveraged firm cannot be higher than that of leveraged firm,
other things being equal.

Let us assume the valuation of the two firms X and Y is the other way around and is as
follows:
Amount in INR
Particulars Firm X Firm Y
Debt Interest 0 20,000
Market Value of debt (Debt capitalization rate is 5%) 0 4,00,000
Equity earnings 1,00,000 80,000
Equity Capitalization rate 8% 12%
Market value of equity 12,50,000 6,66,667
Total Market value 12,50,000 10,66,667

If a situation like this arises, equity investors in firm X would do well to sell the equity in firm
X and use the proceeds partly for investment in the equity of firm Y and partly for investment
in the debt of firm Y. For example, an equity investor who owns 1 percent equity in firm X
would do well to:

– Sell his 1% equity in firm X for ₹ 12,500

– Buy 1.01% of the equity and debt in firm Y involving an outlay of INR 10,773

Such an action will result in an increase of income by INR 1727 without changing the risk
shouldered by the investor. When investors resort to such a change, the market value of the
equity of firm X tends to decline and the market value of the equity of firm Y tends to rise.
This process continues until the total market value of both the firms becomes equal.

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Question 8
From the following selected operating data, determine the degree of operating leverage.
Which company has the greater amount of business risk? Why?

Particulars Company A (₹) Company B (₹)

Sales 25,00,000 30,00,000
Fixed costs 7,50,000 15,00,000
Variable expenses as a percentage of sales are 50% for company A and 25% for company B.

Solution:
Statement of Profit
Amount in ₹
Particulars Company A Company B
Sales 25,00,000 30,00,000
Less : Variable cost 12,50,000 7,50,000
Contribution 12,50,000 22,50,000
Less : Fixed cost 7,50,000 15,00,000
Operating Profit (EBIT) 5,00,000 7,50,000

Operating Leverage =

, ,
Company ‘A Operating Leverage = = 2.5
, ,

, ,
Similarly for Company B Operating Leverage would be = =3
, ,

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

Question 9
A Company has the following capital structure:
Particulars ₹
Equity share capital 1,00,000
10% Preference share capital 1,00,000
8% Debentures 1,25,000

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

Solution:
Statement of Profit ₹
Earnings before Interest and Tax (EBIT) or operating profit 50,000

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FINANCIAL MANAGEMENT 5.23

Less: Interest on Debenture (1,25,000 × 8/100 ) (10,000)

Earnings before Tax (EBT) 40,000
Income Tax (20,000)
Profit 20,000

( ) ,
Financial leverage = = = 1.25
( ) ,

Question 10
XYZ Ltd. decides to use two financial plans and they need ₹ 50,000 for total investment.
Particulars Plan A Plan B
Debenture (interest at 10%) ₹ 40,000 ₹ 10,000
Equity share (₹ 10 each) ₹ 10,000 ₹ 40,000
Total investment needed ₹ 50,000 ₹ 50,000
Number of equity shares 1,000 1,000
The earnings before interest and tax are assumed at ₹ 5,000, and 12,500. The tax rate is 50%.
Calculate the EPS.

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

When EBIT is ₹ 12,500

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

Question 11
ABC Limited has the following capital structure and want to know its Financial Break Even
Point.
Equity shares (FV = ₹ 100) ₹ 5,00,000

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FINANCIAL MANAGEMENT 5.24

12% Preference Shares (FV = ₹ 100) ₹ 5,00,000

10% Debentures (FV = ₹ 100) ₹ 10,00,000
Tax Rate 40%

Solution:
FBP = Interest +
( – )

, ,
= 1,00,000 + = ₹ 11,00,000
( – . )

In other words, the EPS of the firm will be zero at Rs 11,00,000 level of EBIT.
Amount in ₹
EBIT 11,00,000
Less : Interest (1,00,000)
EBT 10,00,000
Less : Taxes @ 40% (4,00,000)
EAT 6,00,000
Less : Preference Dividend (6,00,000)
Earnings Available for Equity Shareholders Nil
No. of Equity Shares 5,000
EPS Nil

Question 12
A new project requires a capital outlay of ₹ 400 lakhs. The required amount to be raised
either fully by equity shares of ` 100 each or by equity shares of the value of ₹ 200 lakhs and
by loan of ₹ 200 lakhs at 15% interest. Assuming a tax rate of 40%, calculate the figure of
EBIT that would keep the equity investors indifferent to the two options.

Solution:
Particulars Option A (Full Equity) Option B (debt + equity)
Equity (FV 100) Rs. 400 lakhs Rs. 200 lakhs
15% Debt Nil Rs. 200 lakhs
Total capital Rs. 400 lakhs Rs. 400 lakhs
No. of equity shares 4,00,000 2,00,000

Let us assume Indifference Level of EBIT is ₹ X. Thus

(( )( . ) ) ( – , , )( – . )–
= =
, , , ,

( , , ) { . – , , }
0.6X =
, ,

0.6X = 1.2X - 36,00,000

36,00,000 = 1.2X - 0.6X

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FINANCIAL MANAGEMENT 5.25

0.6X = 36,00,000 X
= ₹ 60,00,000

Thus the EPS under two different financial options will be equal at ₹ 60 lakhs EBIT Level. This
can be verified as follows:
Particulars Option A (in Rs.) Option B (in Rs.)
EBIT 60,00,000 60,00,000
Less : Interest Nil 30,00,000
EBT 60,00,000 30,00,000
Less : Taxes @ 40% 24,00,000 12,00,000
Earnings available for equity 36,00,000 18,00,000
No. of Equity Shares 4,00,000 2,00,000
EPS (Earnings available for Equity Shares / 9 9
No. of Shares)

Question 13
Kumar Company has sales of ₹ 25,00,000. Variable cost of ₹ 15,00,000 and fixed cost of ₹
5,00,000 and debt of ₹ 12,50,000 at 8% rate of interest. Calculate combined leverage.

Solution:
Statement of Profit
Particulars Amount in Rs.
Sales 25,00,000
Less: Variable cost 15,00,000
Contribution 10,00,000
Less: Fixed cost 5,00,000
Operating profit 5,00,000

Combined leverage = Operating leverage x financial leverage

Calculation of operating leverage

, ,
= =2
, ,

Calculation of financial leverage

Earnings before Interest and Tax (EBIT) Rs. 5,00,000
Less: Interest on Debenture ( 8% of 12,50,000) Rs. 1,00,000
Earnings before Tax Rs. 4,00,000

Financial leverage=

, ,
Financial leverage= = 1.25
, ,

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FINANCIAL MANAGEMENT 5.26
, ,
Combined leverage = 2 × 1.25 = 2.5 OR = = 2.5
, ,

Question 14
Calculate the operating, financial and combined leverage under situations 1 and 2 and the
financial plans for X and Y respectively from the following information relating to the operating
and capital structure of a company, and also find out which gives the highest and the least
value? Installed capacity is 5000 units. Annual Production and sales at 60% of installed
capacity.

Selling price per unit ₹ 25 Variable cost per unit ₹ 15

Fixed cost:
Situation 1: ₹ 10,000
Situation 2: ₹ 12,000

Particulars Financial Plan

X (₹) Y (₹)
Equity 25,000 50,000
Debt (10%) 50,000 25,000
Total 75,000 75,000

Solution:
Annual production and sales 60% of 5,000 = 3000 Unit
Selling 25 Per Unit
Variable Cost 15 Per Unit
Contribution Per Unit 10 Per Unit
Total contribution is 3000 Units × ₹ 10 = ₹ 30,000

Computation of leverage.
Amount of ₹
Particulars PLAN- X PLAN- Y
Situation 1 Situation 2 Situation 1 Situation 2
Contribution 30,000 30,000 30,000 30,000
Fixed cost 10,000 12,000 10,000 12,000
operating Profit or EBIT 20,000 18,000 20,000 18,000
Interest on Debts
10% of 50,000 5,000 5,000
10% of 25,000 2,500 2,500
Earnings before Tax 15,000 13,000 17,500 15,500
Operating Leverage 1.50 1.67 1.5 1.67
(Contribution/ EBIT)
Financial Leverage (EBIT/EBT) 1.33 1.38 1.14 1.16
Combined leverage (OL X FL) 2.00 2.31 1.71 1.94

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FINANCIAL MANAGEMENT 5.27

Highest and least value of combined leverage. Highest Value = 2.31 under situation 2 plan X.
Least Value = 1.71 under situation 1 plan Y.

Question 15
XYZ company has a choice of the following three financial plans. You are required to
calculate the financial leverage in each case.
Particulars Plan I (₹) Plan II (₹) Plan III (₹)
Equity capital 2,000 1,000 3,000
Debt 2,000 3,000 1,000
EBIT 400 400 400
Interest @10% per annum on debts in all cases.

Solution:
Particulars Plan I (₹) Plan II (₹) Plan III (₹)
EBIT 400 400 400
Less Interest-(I) 200 300 100
EBT 200 100 300
FL (EBIT/EBT) 2 4 1.33

Question 16
Calculate operating leverage and financial leverage under situations A, B and C and financial
plans 1, 2 and 3 respectively from the following information relating to the operating and
financial leverage which give the highest value and the least value.

Installed capacity (units) 1,200

Actual production and sales (units) 800
Selling price per unit (₹) 15
Variable cost per unit (₹) 10

Situation A 1,000
Fixed cost (₹) Situation B 2,000
Situation C 3,000

Particulars Financial Plan (₹)

Sources of Fund 1 2 3
Equity 5,000 7,500 2,500
Debt 5,000 2,500 7,500
Cost of debt 12 per cent per annum

Solution:
Amount in ₹
Particulars A B C
S – VC 4,000 4,000 4,000
EBIT 3,000 2,000 1,000

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FINANCIAL MANAGEMENT 5.28

Degree of Operative Leverage = (S – VC)/EBIT 1.33 2 4

FINANCIAL LEVERAGE
Situation A 1 2 3
EBIT 3,000 3,000 3,000
Less : Interest 600 300 900
EBT 2,400 2,700 2,100
Financial Leverage 1.25 1.11 1.43

Situation B 1 2 3
EBIT 2,000 2,000 2,000
Less : Interest 600 300 900
EBT 1,400 1,700 1,100
Financial Leverage 1.43 1.18 1.82

Situation C 1 2 3
EBIT 1,000 1,000 1,000
Less: Interest 600 300 900
EBT 400 700 100
Financial Leverage 2.5 1.43 10

Question 17
A company has a debt-to-equity ratio of 0.70:1.00, a tax rate of 34%, and an unlevered beta
of 0.75. Calculate Hamada coefficient or leveraged beta.

Solution:
The Hamada coefficient or leveraged beta would be:

ßL = ßU [ 1+ (1-T) (D/E)]
0.75 [1 + (1-.34) (.70)] = 1.09
Here, the leveraged beta is 1.09,

It means that the financial leverage of the company increases the overall risk by the beta
amount of 0.34 (1.09 less .75) or 34%.

Therefore, as the beta of the coefficient rises, the associated risk of having higher debt also
rises.

Question 18
There are two firms Neha and Mohan, having same earnings before interest and taxes, i.e.,
BIT of Rs. 20,000. Firm Mohan is a levered company having debt of Rs. 1,00,000 @7% interest
rate. Cost of equity of company Neha is 10% and of company Mohan is 11.50% explain how
arbitrage process will be carried on in this case.

Solution:

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Particulars Unlevered firm Neha Levered firm Mohan

NOI (I.E.EBIT) RS. 20,000 RS.20,000
Value of debt (D) - Rs. 1,00,000
Value of equity (E) , , ,
% . %
= = Rs. 2,00,000 = Rs. 1,13,043
Value of firm (F) = (E) + (D) Rs. 2,00,000 Rs. 2,13,043

Suppose an investor MR x has 10 % shares of unlevered firm Mohan, therefore investment in

10% of equity of levered company M = 10% x Rs. 1,13,043 = Rs. 11,304.30. on this investment,
the investor is entitled to a return/income = 10% of earnings for equity holders = 10% of (Rs.
20,000 – Rs. 7,000) = Rs. 1,300

Arbitrage process will operate as under – (moving from firm Mohan – Firm Neha).

Sell the 10% shares in levered firm for Rs. 11,304.30, and borrow 10% of levered firms’ debt
i.e., 10% rs. 1,00,000, and invest money = i.e. 10% in unlevered firms’ stock.

Total resource available = 11,304.30 + Rs. 10,000 = Rs. 21,304.30 but in investment in unlevered
company N= 10% of Rs. 2,00,000 = Rs. 20,000

Return obtained now = 10% EBIT of unlevered firm (less) interest to be on paid borrowed funds
= 10% of Rs. 20,000 (-)7% of Rs. 10,000 = 2,000- 700 = Rs. 1,300

Question 19
There are two firms’ parrot and queen which are identical except parrot does not use any
debt in its capital structure, while queen has Rs. 2,60,000 p.a. and the capitalization rate id
10%. Assuming corporate tax 30%, calculate the value of these firms according to M&M
hypothesis.

Solution:
Particulars Computation Rs.
Value of unlevered firm = 2,60,000 𝑥 (100% − 30%)
18,20,000
10%
Tax shield of levered firm
8,00,000 x 30% 2,40,000
= Debt x tax rate
Value of levered firm
20,60,000
= value of unlevered firm + tax shield

Question 20
Ashoke ltd and Babita ltd are identical except for capital structure. Ashoke ltd has 60% and
40% equity, whereas Babita Ltd has 20% debt and 80% equity. (all % are in market – value
terms). The borrowing rate for both companies is 8% in a no-tax world, and capital markets
are assumed to be perfect.

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a. If X owns 3% of the equity shares of Ashoke ltd, determine his return if the company has
net operating income Rs. 4,50,000 and the overall capitalization rate of the company is 18%.
Calculate the implied required rate of return on equity of Ashoke Ltd.

b. Babita has the same net operating income as Ashoke ltd. Calculate the implied required
return of Babita ltd. Analyze why does it differ from that of Ashoke ltd.

Solution:
Net operating income approach is applicable in this case, since companies are identical,
capital market are perfect, no tax.
Particulars Ashoke ltd. Babita ltd.
, , , ,
Value of firm (F) = = 25,00,000 = 25,00,000
% %
Value of debt (D) 60% = 15,00,000 20% = 5,00,000
Value of equity = F –D 10,00,000 20,00,000
Net operating income = EBIT 4,50,000 4,50,000
Interest on debt
1,20,000 40,000
(8% on debt in item 2)
Net income EBT for equity holders 3,30,000 4,10,000
Implied required equity return= 33% 20.5%

Question 21
The following data related to four firms?
Firm A B C D
EBIT 2,00,000 3,00,000 5,00,000 6,00,000
Interest 20,000 60,000 2,00,000 2,40,000
Equity capitalization rate 12% 16% 15% 18%
Assuming that there are no taxes and interest rate on debt is 10%, determine the value and
WACC of each firm using the net income approach. What happens if firm A borrows Rs. 2 lakhs
at 10% to repay equity capital?

Solution:
Firm A B C D
EBIT Rs. 2,00,000 Rs. 3,00,000 Rs. 5,00,000 Rs. 6,00,000
Less: interest Rs, 20,000 Rs. 60,000 Rs. 2,00,000 Rs. 2,40,000
EBT = Net income Rs. 1,80,000 Rs. 2,40,000 Rs. 3,00,000 Rs. 3,60,000
Ke 12% 16% 15% 18%
Value of equity (E) = Rs. 15,00,000 Rs. 15,00,000 Rs.20,00,000 Rs.20,00,000

Value of debt (D) = Rs. 2,00,000 Rs. 6,00,000 Rs. 20,00,000 Rs. 24,00,000

Value of firm (F) = (E+D) 17,00,000 21,00,000 40,00,000 44,00,000

Ko = WACC = 11.76% 14.29% 12.50% 13.64%

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When firm A borrows Rs. 2 lakhs at 10 % interest rate, to repay equity capital. The effect on
WACC will be as under:
Firm Before After
EBIT Rs. 2,00,000 Rs. 2,00,000
Less: Interest Rs, 20,000 Rs. 40,000
EBT = Net income Rs. 1,80,000 Rs. 1,60,000
Ke 12% 12%
Value of equity (E) = Rs. 15,00,000 Rs. 13,33,333

Value of debt (D) = Rs. 2,00,000 Rs. 4,00,000

Value of firm (F) = (E+D) 17,00,000 Rs. 17,33,333
Ko = WACC = 11.76% 11.54%

Under Net Income Approach, increases in debt contents leads to increase in value of firm and
decrease in WACC.

Question 22
Sohan ltd. Is considering two financing plans, details of which are as under fund requirement-
Rs.100 lakhs.

a) Financial Plan
Plan Equity Debt
I 100% -
II 25% 75%
b) Cost of debt – 12%p.a.
c) Tax rate – 30%
d) Equity shares Rs. 10 each, issued at a premium of Rs. 15 per shares
e) Expected earnings before interest and tax (EBIT) Rs. 40 lakhs

Required: 1) EPS in each of the plan

2) financial breakeven point
3) indifference point between plan I & II

Solution:
Computation of EPS with given EBIT of Rs. 40,00,000 and financial BEP is as under:
Particulars Plan I Plan II
Capital required Rs. 100 Lakh Rs. 100 Lakh
Less: debt component Nil Rs. 75 Lakhs
Balance equity capital required Rs. 100 Lakhs Rs. 25 Lakhs
Issue price per share = face value Rs. 10 +
Rs. 25 Rs. 25
premium Rs. 15
No. of equity shares to be issued = 4 lakhs shares 1 lakhs shares
EBIT Rs. 40,00,000 Rs. 40,00,000

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Less interest (12% on debt) Nil Rs. 9,00,000

EBT Rs. 40,00,000 Rs. 31,00,000
Less tax at 30% Rs. 12,00,000 Rs. 9,30,000
EAT residual earnings Rs. 40,00,000 Rs. 21,70,000
EPS = Rs. 7.00 Rs. 21.70
.
Financial BEP i.e., required EBIT = interest +
Nil Rs. 9,00,000
%

Conclusion: EPS is maximum under plan II and hence, plan II is preferable.

Computation of EBIT-EPS indifference point:

Particulars Plan I (Rs.) Plan II (Rs.)
EBIT E E
Less interest (12% on debt) Nil Rs. 9,00,000
EBT E E – 9,00,000
Less tax at 30% 0.3 E 0.3 E – 2,70,000
EAT residual earnings 0.7 E 0.7 E – 6,30,000
No. of equity shares 4,00,000 shares 1,00,000 shares
0.7 𝐸 0.7 𝐸 − 6,30,000
EPS =
. 4,00,000 𝑠ℎ𝑎𝑟𝑒𝑠 1,00,000 𝑠ℎ𝑎𝑟𝑒𝑠

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

Points are as under -

. . , ,
For plan I & II: =
, , , ,

on simplification, 0.7E-2.8E-25,20,000. So, E = 12,00,000

Question 23
Jokey Ltd wants is considering 3 financial plans. The key information is as follows-
-Total investment to be raised Rs. 4,00,000.
- Plans showing the financial proportion:

Plans % of Equity % of Debt % of Preference Shares

P 100 - -
Q 50 50 -
R 50 - 50
-Cost of debt 10%, cost of preference shares -10%
-Tax rate -50%
-Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.
-Expected earnings before interest & tax Rs. 1,00,000.

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Compute the following for each plan

1) Earnings Per Share
2) Financial Break-even point
3) Indifference point among the plans, and indicate if any of the plans dominate.

Solution:
Particulars Plan P Plan Q Plan R
Capital required Rs. 4,00,000
Rs. 4,00,000 Rs. 4,00,000
Less debt component Rs. 2,00,000
Nil Nil
Preference share capital Nil
Balance equity capital required Rs. 4,00,000 Rs. 2,00,000 Rs. 2,00,000
Issue price per share Rs. 20 Rs. 20 Rs. 20
No. of equity shares 20,000 shares 10,000 shares 10,000 shares
EBIT Rs. 1,00,000 Rs. 1,00,000 Rs. 1,00,000
Less interest (10% on debt) Nil Rs. 20,000 Nil
EBT Rs. 1,00,000 Rs. 80,000 Rs. 1,00,000
Less tax at 50% Rs. 50,000 Rs. 40,000 Rs. 50,000
EAT
Rs. 50,000 Rs. 40,000 Rs. 50,000
Less preference dividend (10% on
Nil Nil Rs. 20,000
PSC)
Residual earnings Rs. 50,000 Rs. 40,000 Rs. 30,000
EPS = Rs. 2.50 Rs. 4.00 Rs. 3.00
.
Financial BEP i.e., required EBIT = . ,
Nil Rs. 20,000 -50%
interest + ,
%

Computation of EBIT EPS indifferent point:

Particulars Plan P Plan Q Plan R
EBIT E E E
Less interest (10% on debt) Nil Rs. 20,000 Nil
EBT E E – 20,000 E
Less tax at 50% 0.5 E 0.5 E – 10,000 0.5 E
EAT 0.5 E 0.5 E – 10,000 0.5 E
Less preference dividend Nil Nil Rs. 20,000
(10% on PSC)
Residual earnings 0.5 E 0.5 E – 10,000 0.5 E – 20,000
No. of equity shares 20,000 shares 20,000 shares 20,000 shares
0.5𝐸 0.5𝐸 − 10,000 0.5𝐸 − 10,000
EPS =
. 20,000 𝑠ℎ𝑎𝑟𝑒𝑠 10,000 − 𝑠ℎ𝑎𝑟𝑒𝑠 10,000 𝑠ℎ𝑎𝑟𝑒𝑠

For indifference between the above alternatives, EPS should be equal. Hence, indifference
points are as under-
. . ,
For plan P & Q: =
, ,

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FINANCIAL MANAGEMENT 5.34
. , . ,
For plan Q & R : =
, ,

Hence, there is no indifference point at all between plans Q & R

. , .
for plan R & P = =
, ,

on simplification, 1 E – 40,000 = 0.5E. so, E = 80,000

Plan Q dominates plan R since financial BEP of plan Q is only Rs.20,000

Whereas for plan R it is Rs. 40,000

Question 24
X ltd is willing to raise funds for its new project which requires an investment of Rs. 84
lakhs. The company has two options:

Option 1: To issue equity shares (Rs. 10 each) only

Option II: To avail term loan at an interest rate of 12%. But in this case, as insisted by the
financing agencies, the company will have to maintain a debt equity proportion of 2:1.

The corporate tax rate is 30%. Find out the point of indifference for the project.

Solution:
Let the EBIT at the indifference point level be Rs. E.
Particulars Alternative 1 Alternative 2
Description Fully equity of 84 Debt-56 lakhs,
lakhs Equity = 28 lakhs
EBIT E E
Less: 12% Interest NIL 6.72
EBT E E-6.72
Less tax at 30% 0.3E 0.3E - 2.016
EAT 0.7E 0.7E - 4.704
Less preference dividend NIL NIL
Residual earnings for equity shareholders 0.7E 0.7E – 4.704
No. of equity share (face value 10) 8.4 lakh shares 2.8 lakh shares
EPS = 0.7𝐸 0.7𝐸 − 4.704
.
8.4 𝑙𝑎𝑘ℎ 𝑠ℎ𝑎𝑟𝑒𝑠 2.8 𝑙𝑎𝑘ℎ 𝑠ℎ𝑎𝑟𝑒𝑠
For indifference between the above alternatives, EPS should be equal. So,
. . .
=
. .

on cross multiplications and simplification, 2.1E - 14.112 = 0.7E so, 4E = 14.112

.
so, E = = 10.08.
.

So, for same EPS, required EBIT = Rs. 10.08 lakhs. EPS at the level = Rs 0.84

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Question 25
Aloo ltd requires funds amounting to Rs80 lakhs for its new project. To raise funds, the
company has following two alternatives:
1. To issue equity shares & debt in the proportion of 3:1.
2. To issue equity shares (at par) and 12% debentures in equal proportion.
The income tax rate is 30%. Find out the point of difference between the available two
modes of financing and state which option will be beneficial in different situations.

Solution:
Let the EBIT at the indifference point level be Rs. E.
Particulars Alternative 1 Alternative 2
Description ESC = 60lakhs, ESC = 40 lakhs,
Debt = 20 lakhs Debt = 40 lakhs
EBIT E E
Less interest 20 lakhs x 12% = 40 lakhs x 12% =
2,40,000 4,80,000
EBT E - 2, 40,000 E - 4, 80000
Less tax at 30% 0.3E – 72,000 0.3E – 1,44,000
EAT = residual earnings for ESH 0.7E - 1, 68000 0, 7E - 3, 36000
No. of equity shares 60,000 shares 40,000 shares
(Assuming FV Rs. 100)
0.7𝐸 − 1,68,000 0.7𝐸 − 3,36,000
EPS =
. 60,000 40,000

For indifference between the above alternatives, EPS should be equal. underline So, =
. , , . , ,
= =
, ,
Solving, E = 9,60,000 so, for same EPS, required EBIT = Rs. 9,60,000 EPS = Rs. 8.4 Per Share.

Question 26
The data relating to two companies are as given below:
Particulars Company A Company B
Equity Capital 6,00,000 3,50,000
12% debentures 4,00,000 6,50,000
Output(units) per annum 60,000 15,000
Selling Price / Unit 30 250
Fixed COSTS per annum 7,00,000 14,00,000
Variable Cost per unit 10 75

You are required to calculate the Operating Leverage, Financial leverage and Combined
Leverage of two companies.

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Solution:

Company A Company B
Sales 18,00,000 37,50,000
Less: variable cost (6,00,000) (11,25,000)
Contribution 12,00,000 26,25,000
Less: fixed cost (7,00,000) (14,00,000)
EBIT 5,00,000 12,25,000
Less: interest (48,000) (78,000)
EBT/PET 4,52,000 11,47,000
Less: tax - -
PAT 4,52,000 11,47,000

Operating leverage=
, , , ,
Company A= Company B=
, , , ,
=2.4 = 2.14
Financial leverage=
, , , ,
Company A= Company B=
, , , ,
=1.11 = 1.07
Combined leverage=
, , , ,
Company A= Company B=
, , , ,
=2.65 = 2.29

Question 27
The following data is available for Iron Ltd-
Sales ₹5,00,000
Less: variable cost 40% ₹2,00,000
Contribution ₹3,00,000
Less: fixed cost ₹2,00,000
EBIT ₹1,00,000
Less: interest ₹25,000
EBT ₹75,000

Using the concept of leverage, find out-

% change in taxable income if EBIT increases by 10%
% change in EBIT if sales increase by 10%
% change in taxable income if sales increase by 10%
Also verify results in each of the above case.

Solution:
Computation of leverage-

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FINANCIAL MANAGEMENT 5.37

Leverage & Computation Concepts

Financial leverage= DFL= =
, ,
This measures the % change in taxable income
,
=1.33 times (EBT), for every change in EBIT.

Operating leverage= DOL= = This measures the % change in EBIT, for every
, , change in sales.
= 3 times
, ,

Combined leverage= DCL= = This measures the % change in taxable income

, , (EBT), for every change in sales.
= 4 times
,

Computation of revised values if basic variable changes-

Situation Revised values as required
New EBT, if EBIT Taxable income (EBT) will increase by 10% × DFL 1.33 times
increases by 10% = 13.33%
= ₹ 85,000
New EBIT, if sales EBIT will increases by 10% × DOL 3 times = 30%. So,
increases by 10% revised EBIT = ₹1,00,000 + 30% thereon = ₹1,30,000
New EBT, if sales increase Taxable income (EBT) will increases by 10% × DCL 4 times =
by 10% 40%. So, revised EBT = ₹75,000 + 40% thereon = ₹1,05,000

Question 28
Sun pharma ltd has furnished the following balance sheet as on 31 st march –
Liabilities ₹ Assets ₹
Equity shares capital(1,00,000 equity 10,00,000 Fixed assets 30,00,000
share of 10 each)
General reserve 2,00,000 Current assets 18,00,000
15% debentures 28,00,000
Current liabilities 8,00,000
48,00,000 48,00,000

Additional information:
Annual fixed cost other ₹28,00,000 Tax rate 30%
than interest
Variable cost ratio 60%
Total asset turnover 2.5
ratio
You are required to calculate EPS and combined leverage.

Solution:
Particulars ₹ If EBIT increase by If sales increases by
10% 10%
Sales 5,00,000 5,00,000+10% =5,50,000
Less: variable cost 2,00,000

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FINANCIAL MANAGEMENT 5.38

40% on 5,50,000=
2,20,000
Contribution 3,00,000 3,30,000
Less: fixed cost 2,00,000 2,00,000
EBIT 1,00,000 1,00,000+10%=1,10,000 1,30,000
Less: interest 25,000 25000 25,000
EBT 75000 85000 1,05,000

Verification of results:
Total assets T.O. = =2.5 times
So, = 2.5
, , , ,

Hence, sales = 2.5 × 48,00,000 = ₹1,20,00,000

Profitability statement (to compute EPS & DCL)-

Particulars Computation ₹
Sales 1,20,00,000
Given 60%
Less: variable cost (72,00,000)
Contribution Sales less variable cost 48,00,000
Less: fixed cost given (28,00,000)
EBIT Contribution less fixed cost 20,00,000
Less: interest 15% on debt ₹28,00,000 (4,20,000)
EBT EBIT less interest 30% on 15,80,000
Less: tax at 30% EBT (4,74,000)
PAT= Residual earnings EBT less tax 11,06,600
EPS= residual earnings 11,06,000
1,00,000 equity shares 11.06
1,00,000
Combined leverage 48,00,000
3.04 times
(DCL)= 15,80,000

Question 29
Following is the selected financial information of Arjun ltd and Karan ltd for the year ended
31st march:
Particulars Arjun ltd Karan ltd
Variable cost ratio 60% 50%
Interest ₹ 20,000 ₹ 1,00,000
Operating leverage 5 2
Financial leverage 3 2
Tax rate 30% 30%

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FINANCIAL MANAGEMENT 5.39

Find out- EBIT, sales, fixed cost. Identify the company which is better placed with reasons
based on leverages.

Solution:
Income statement
Particulars Arjun ltd Karan ltd
Sales (note 3) 3,75,000 (note 3) 8,00,000
Less: variable cost 60% of sales 2,25,000 50% of sales 4,00,000
Contribution (note 2) 1,50,000 (note 2) 4,00,000
Less: fixed cost 1,20,000 2,00,000
EBIT (EBIT + interest) 30,000 (EBIT + interest)2,00,000
Less: interest 20,000 1,00,000
EBT (note 1) 10,000 (note 1) 1,00,000
Less: tax (30% on EBT)3,000 (30% on EBT) 30,000
PAT (EBT less tax) 7,000 (EBT less tax) 30,000
Note 1 DFL= = EBT+ DFL= = EBT+
, , ,
3= EBT+ on solving, EBT= 2= EBT+ on solving, EBT=
10,000 1,00,000
Note 2 DOL= = DOL= =
, , ,
On solving, contribution= On solving, contribution=
1,50,000 4,00,000
Note 3 PVR= 100%- Variable cost PVR= 100%- Variable cost
60%= 40% 50%= 50%
, , , ,
So, Sales= = So, Sales= =
% %

Observation: Karan ltd is better placed due to – higher PVR – lower DOL – lower combined
risk
(DOL × DFL = DCL) – better interest coverage ratio =

Question 30
Following information are related to four firms of the same industry:
Change in operating Change in Earnings
Firm Change in revenue
income per share
P 27% 25% 30%
Q 25% 32% 24%
R 23% 36% 21%
S 21% 40% 23%

Find out:
1) Degree of Operating leverage
2) Degree of Combined leverage for all the firms.

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Solution:
%
Degree of Operating leverage=
%
% %
P= =0.92 times R= = 1.56 times
% %

% %
Q= =1.28 times S= = 1.90 times
% %

%
Degree of Combined leverage=
%
% %
P= =1.11 times R= = 0.91 times
% %

% %
Q= =0.96 times S= = 1.095 times
% %

Question 31
The following information is related to sunrise Ltd.:
Sales ₹4,00,000
Less: Variable expenses 35% ₹1,40,000
Contribution ₹2,60,000
Less: Fixed expenses ₹1,80,000
EBIT ₹80,000
Less: Interest ₹10,000
Taxable income ₹70,000
You are required to submit the following to management of the company:
(i) What percentage will taxable income increase, if the sales increase by 6%? Use combined
leverage.
(ii) What percentage will EBIT increase, if there is a 10% increase in sales? Use operating
leverage.
(iii) What percentage will taxable income increase, if EBIT increases by 6%? Use financial
leverage.

Solution:
(i) Particulars of Sunrise Ltd:
Sales 4,00,000
Less: VC (@ 35%) 1,40,000
Contribution 2,60,000
Less: Fixed Cost 1,80,000
EBIT 80,000
Less: Interest 10,000
EBIT 70,000

Using combined leverage, find increase in taxable income if sales increase by 6% Combined
Leverage at present:
, ,
CL = = = 3.714
,
If sales increase by 6%

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FINANCIAL MANAGEMENT 5.41

3.714 × 0.06 = .2228

Thus, the taxable income will increase by 22.28% in case the sales increase by 6%.

(ii) Using operating leverage, find increase in EBIT if sales increase by 10%.
, ,
OL = = = 3.25
,
If sales increase by 10% = 3.25 × .10 = .325
= 32.50%
Thus, EBIT will increase by 32.5% if sales increase by 10%.

(iii) Using financial leverage, find increase in taxable income, if EBIT increase by 6%
,
FL = = = 1.14
,
If EBIT increase by 6% = 1.14 × .06 = .0684
= 6.84%
Thus, the taxable will increase by 6.84% in case EBIT increase by 6%.

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FINANCIAL MANAGEMENT 6.1

DIVIDEND DECISIONS
INTRODUCTION
Topic Details
Part of company profits distributed among shareholders; reward for
Meaning of Dividend
investment. Return on shareholding.
“A dividend is a distribution to shareholders out of profit or reserves
ICAI Definition
available for this purpose.”
Policy concerning quantum of profit to be distributed as dividend.
Dividend Policy Pattern of dividend payment evolved by BOD with bearing on future
actions.
Weston & Brigham “Dividend policy determines the division of earnings between
Definition payments to shareholders and retained earnings.”
Dividend = shareholder cash flow; Retained earnings = fund for
Managerial Dilemma corporate growth. Higher dividend = less retained earnings, and vice
versa.
Theoretical vs. Theory: Retain funds for use above capitalization rate. Practice: Must
Practical Conflict consider shareholder preference.

Forms/Kinds of Dividend
Type Description
Paid on equity shares. Rate set by BOD and approved by
1. Equity Dividend
shareholders.
2. Preference Fixed dividend paid on preference shares before equity dividend. No
Dividend BOD recommendation required.
Paid before closing accounts if company earns heavily during the
3. Interim Dividend
year.
4. Regular Usual rate dividend. Preferred by retired persons, widows,
Dividend economically weaker individuals.
Usual method; results in cash outflow and reduces company’s net
5. Cash Dividend worth. Preferred by ordinary shareholders. Requires adequate
liquidity.
Bonus shares issued. Suitable when company lacks liquidity.
6. Stock Dividend
Capitalizes earnings without affecting cash.
7. Scrip or Bond Issued as notes/bonds when cash is insufficient. Postpones payment.
Dividend Bears interest and can be used as collateral.

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8. Property Paid in assets other than cash. Used in exceptional cases. Not
Dividend popular in India.
9. Composite
Paid partly in cash, partly in property.
Dividend
10. Optional
Shareholders are given a choice between cash or property dividend.
Dividend
11. Extra/Special Non-recurring. Declared when there is high profit/reserve and
Dividend company avoids frequent rate changes.

STOCK SPLITS
Aspect Details
A decision by a company's Board to increase the number of outstanding
Definition
shares by issuing more shares to existing shareholders.
Example (2-for-1 Original: 2,000 shares × ₹20 = ₹40,000. After split: 4,000 shares × ₹10 =
Split) ₹40,000. Total value remains unchanged.
More shares owned, but same total investment value. Share price
Investor Impact
decreases, increasing trading liquidity and attractiveness.
1. High price makes shares unaffordable for some investors; splitting
lowers the price.
2. Increased number of shares improves stock liquidity, easing trade
Reasons for
and enabling cost-effective buybacks.
Stock Split
3. Investors own more shares and can gain more profit when prices rise
again.
4. To meet exchange listing criteria (esp. in reverse stock splits).

SHARE REPURCHASE
Aspect Details
A stock buyback (share repurchase) occurs when a company buys back
its own shares from the market using accumulated cash. This reduces
Definition
the number of shares outstanding and increases each investor’s
ownership stake.
• Stock may be undervalued—considered a good investment.
Reasons for • Seen as a sign of confidence by investors.
Share • Avoids commitment to ongoing dividends during uncertain times.
Repurchase • Prevents added tax burden for large shareholders.
• Offsets dilution from employee stock option plans.

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• Reduction in outstanding shares leads to increase in EPS and CFPS

due to lower denominator—artificial inflation.
Impact of Share
• Stock price may rise due to reduced supply, assuming constant
Repurchase
demand—investors must assess if it's due to real value or technical
effects.

DETERMINANTS OF DIVIDEND POLICY

Determinant Description
Dividends must be paid from earnings. Legal contracts or
Legal Restrictions bond/loan agreements may restrict dividends to prevent capital
impairment or insolvency.
Magnitude and Trend Earnings determine the upper limit of dividends. Current and past
of Earnings trends of profitability must be considered.
Shareholder preferences vary based on economic status. Retirees
Desire and Type of
may prefer regular dividends; wealthy investors may prefer
Shareholders
capital gains.
Industries with stable and predictable demand support consistent
Nature of Industry
dividends, unlike cyclical industries.
New companies often retain earnings for growth, while older firms
Age of the Company
may pay higher dividends due to accumulated reserves.
Future Financial Companies must balance shareholder desires with the firm’s own
Requirements future funding needs.
High taxes reduce distributable profits. Dividend taxes can also
Taxation Policy
discourage high payout ratios.
To maintain control, companies may retain earnings and limit the
Policy of Control
entry of new shareholders.
Dividend policy may change based on economic cycles, demand for
Stage of Business Cycle
capital, and money supply.
If external financing is costlier than retained earnings, firms adopt
Cost of Capital
a conservative dividend approach.
Some firms prioritize consistent dividend payments, even using
Regularity
past earnings if current profits are low.
Requirements of Institutions prefer regular dividend policies and may impose
Institutional Investors specific terms for dividend payments.

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Even with adequate profits, insufficient liquidity may prevent

Liquid Resources
dividend payments. Liquidity is key to dividend decision-making.

TYPES OF DIVIDEND POLICY

No. Type of Description Advantages / Reasons
Dividend
Policy
(a) Establishes profitable record
(b) Builds shareholder confidence
Dividend is paid at the usual rate, (c) Aids long-term financing
Regular
preferred by investors like (d) Stabilizes share price
1. Dividend
retired persons, widows, and (e) Meets daily needs of small
Policy
economically weaker individuals. investors
(f) Avoids tax burden from
accumulation
Note: Suited to companies with
stable earnings. Better to keep
regular dividend lower than
average earnings.
(i) Signals operational stability
(ii) Stabilizes share value
(iii) Builds investor confidence
Stable Consistent or minimum regular
(iv) Supports income-dependent
2. Dividend dividend is paid. Can be
investors
Policy implemented in three ways:
(v) Meets institutional investor
needs
(vi) Enhances creditworthiness
Fixed dividend per share every
a) Constant
year, irrespective of earnings. Suitable for companies with stable
Dividend
Supported by creating a ‘Reserve earnings.
Policy
for Dividend Equalization’.
Fixed percentage of net earnings
b) Constant Preferred as it aligns with
paid as dividend. Dividend amount
Payout Ratio company’s ability to pay.
varies with earnings.
c) Stable
Rupee Low regular dividend + extra Useful for companies with
Dividend + dividend in profitable years. fluctuating earnings.
Extra

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Reasons: (i) Uncertain earnings

Irregular (ii) Unsuccessful operations
Dividends are not consistent or
3. Dividend (iii) Lack of liquidity
predictable.
Policy (iv) Concern for financial
reputation
Due to poor working capital or
No Dividend
4. No dividend is paid at all. need to retain funds for growth
Policy
and expansion.

ESSENTIALS OF A SOUND DIVIDEND POLICY

Essential Description
Regular and consistent dividend payments are preferred. Medium,
Stability
stable dividends are better than high but inconsistent payments.
The company should aim to increase dividend rates over time in line
Gradually Rising
with income growth. Special dividends can be paid in highly profitable
Dividends
years.
Distribution of Dividends should ideally be paid in cash. Stock dividends are acceptable
Cash Dividend if reserves are high, but should be limited to avoid over-capitalization.
Newly established companies should begin with low dividend rates to
Moderate Start strengthen financial position, with gradual increases as the company
grows.
Dividends should only be paid from actual earned profits. Dividends
Other Factors should not be declared if past losses are not yet set off. Interim
dividends may boost morale.

DIVIDEND THEORIES / DIVIDEND MODELS

Theory M-M Model Walter's Model Gordon's Model Gordon’s Revised
(Irrelevance) (Relevance) (Relevance) Model
Modigliani & Prof. James E. Myron Gordon Myron Gordon
Concept
Miller (1961) Walter (updated)
Dividend is Dividend affects Dividend affects Dividend affects
Key
irrelevant firm value firm value firm value under
Proponents
uncertainty
Value of firm is Dividend policy Investors prefer Incorporates risk
Core Idea
based on earning is relevant and certain dividends aversion:

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FINANCIAL MANAGEMENT 6.6

power and depends on over uncertain Investors

investment policy, relationship future gains discount future
not dividend between r (“bird in hand” dividends more
policy (return) and k theory) heavily due to
(cost) risk
1. Perfect capital 1. Only internal 1. All-equity firm Same as original,
markets financing 2. No external plus:
2. No taxes 2. Constant r financing 1. Investors are
3. Rational and k 3. Constant r, b, risk averse
Assumptions
investors 3. EPS and DPS and Ke 2. Prefer current
4. Fixed are constant 4. No taxes dividends
investment policy 4. Infinite firm 5. Infinite life
5. No risk life
P₀ = (D₁ + P₁) / (1 + P = [D + (r / k) × P = E(1 - b) / (Ke - D₁ = D₀(1 + g)^t
Ke) (E - D)] / k br) or P = D / (Ke P = D₁ / (Ke - g)
Formula
P₁ = P₀ (1 + Ke) - - g) Ke = (D₁ / P₀) + g
D₁
Unrealistic Unrealistic Ignores market Realistic in terms
assumptions (e.g., assumptions imperfections and of behaviour, but
perfect markets) Ignores external taxes still simplified; all
Tax differences, financing, Assumes constant investors may not
Criticisms /
floatation costs, changing r and k return and behave the same
Limitations
transaction costs, Over-simplifies growth rate way
uncertainty, non- dividend impact May not hold if
rigid investment investors do not
policies prefer dividends

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QUESTION BANK
Question 1
Show that the payment or non-payment of dividend does not affect the value of the firm as
per MM approach with the help of the following information:

A company belongs to a risk class for which the appropriate rate of capitalization is 10%. The
total number of equity shares is 30,000. The current market price of an equity share is Rs.80.
The company is thinking to declare a dividend of Rs.4 per share at the end of the current
year. The company expects to have a net income of Rs. 3,00,000. It has proposal of making
investment of Rs.6,00,000 in new proposals. If MM approach is adopted, show that payment
or non-payment of dividend does not affect the value of equity shares of the company.

Solution:
Here, P0 = 80, D1 = Rs.4, CR = 10% or .1, P1 =?
(A) When dividend is paid:
i) Price per share at the end of year 1:
P0 =
80 =
.
88 – 4 = P1
P1 = Rs. 84

ii) Value of the company:

(a)
Amount needed for investment Rs. 6,00,000
Less Profit retained
Profit 3,00,000
Less dividend (30,000 x Rs. 4) 1,20,000 1,80,000
Amount to be raised through new issue 4,20,000

. , ,
b) No. of new shares = = 5,000 shares
.

c) Total no. of shares = 30,000 + 5,000 = 35,000

d) Value of total shares = 35,000 x Rs.84 = Rs.2,94,00,000

–( – )
e) Value of the firm =

Where, I = Total investment required

E = Earnings during the period

, , –( , , – , , ) , ,
Value= =
. .

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FINANCIAL MANAGEMENT 6.8

= Rs. 24,00,000

(B) When dividend is not paid, total profit is retained and additional funds required for
proposals are raised by issuing equity shares:
i) Price per share at the end of year 1:
Po =
P1 = Rs. 88

ii) Value of the company:

a)
Amount needed for investment Rs. 6,00,000
Less: profit retained 3,00,000
Amount to be retained by new issues 3,00,000

, ,
b) No. of new shares = = 3,409 shares
.

c) Total no. of shares = 30,000 + 3,409 = 33,409

d) Value of total shares = 33,409 × Rs.88 = Rs.29,39,992

( )
e) Value of the firm =

, , ( , , , , )
=
.

, ,
=
.

= Rs.23,99,993 or Rs.24,00,000

Question 2
Ram Company belongs to a risk class for which the appropriate capitalization rate is 12%. It
currently has outstanding 30000 shares selling at Rs. 100 each. The firm is contemplating the
declaration of dividend of Rs. 6 per share at the end of the current financial year. The
company expects to have a net income of Rs. 3,00,000 and a proposal for making new
investments of Rs. 6,00,000. Show that under the MM assumptions, the payment of dividend
does not affect the value of the firm. How many new shares issued and what is the market
value at the end of the year?

Solution:
( )
P0=
P0 = market price per share at 0 time
Ke = Capitalization rate for firm in that risk class (assumed constant throughout)
D1 = dividend per share at time 1
P1 = market price per share at time 1. In the given problem

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FINANCIAL MANAGEMENT 6.9

Po = 100
D1 = r 6
P1 =?
Ke = 12%

( )
P0 =
)
= 100(1.12) = 6 + P1

OR

6 + P1 = 112
P1 = 112 – 6
P1 =Rs. 106

If Dividend is not declared

Ke = 12%, Po = 100, D1 = 0, P1 =?
100 = (0 + P1)
1+ 0.12
112 = P1

The following illustration shows the calculation of number of new shares to be issued/ Market
Value of Firm when dividend is paid/not paid
Dividends are paid Dividends are not paid
Net Income (r) 3,00,000 3,00,000
Total Dividend (r) 1,80,000 Nil
Retained earnings (r) 1,20,000 3,00,000
Investment required (r) 6,00,000 6,00,000
Amount to be raised from new shares 4,80,000 3,00,000
(A) (r)
Relevant Market Price (B) (r) 106 112
No. of shares to be issued (A/B) (r) 4,528 2,679
Total number of shares at the end of the 30,000 30,000
year
Total Number of shares 34,528 32,679
Market Price per share (r) 106 112
Market Value for shares (r) 36,60,000 36,60,000

There is no change in the total market value of shares whether dividends are distributed or
not distributed.

Question 3
Z Ltd. has 1,000 shares at $100 per share. The company is contemplating a $10 per share
dividend at the end of the year. It expects a net income of $25,000.

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FINANCIAL MANAGEMENT 6.10

Required: Calculate the company’s share price under the following conditions:
 Dividend declared
 Dividend not declared

Also, assuming that the company pays dividends and makes a new investment of $48,000 in the
coming period, how many new shares will need to be issued to the Finance Investment Program
me (as per the MM) approach with a 20% risk factor?

Solution:
The price of share can be expressed as follows:
P1 = P0 (1 + k) – D1

When a dividend is not paid:

P1 = $100 (1 + 10) - 0
= 100 x 1.10 =$110

When a dividend is paid:

P1 = 100 (1 + .10) - 10 = $100

New shares:
M x P1 = I - (X – ND1)
M x 100 = 48,000 - (25,000 - 10,000)
110M = 33,000
M = 33,000 / 100
M = 330 shares

Question 4
The earnings per share of a company are Rs.16. The market rate of discount (capitalization
rate) to the company is 12.5%. Retained earnings can be employed to yield a return of 10%.
The company is considering a payout of 25%, 50% and 75%. Which of these would maximize the
wealth of shareholders?

Solution:
Wealth of shareholders will be maximized only when the market value of the share is maximized.
For finding out the impact of the payout on market price per share, we have to use Walter’s
formula which is as follows:
( )
Ve =
Where, Ve = ?, Ra = 10% or .10, Rc = 12.5% or .125

E = Rs.16 and D = (i) 25% of Rs.16, i.e., Rs.4

(ii) 50% of Rs.16, i.e., Rs.8 and
(iii) 75% of Rs.16, i.e., Rs.12 per share.

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FINANCIAL MANAGEMENT 6.11

Market value of share under different payout options:

25% payout 50% payout 75% payout
. . .
( ) . ( ) . ( ) .
Ve = .
= = Ve = .
= = Ve = .
= =
. . . . . .
. . .
= Rs. 108.80 per share = Rs. 115.20 per share = Rs. 121.60 per share
. . .

The above computations show that the payout ratio of 75% would maximize the wealth of the
shareholders.

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

Solution:
Calculation of market value of the company’s share under different payout options:
Walter’s Formula:
( )
Ve =
Where, Ve = ?, Ra = (a) 15% or .15,
(b) 10% or .10,
(c) 5% or 0.05,
Rc = 10% or .10

E = Rs.8 and D = (i) 25% of Rs.8, i.e., Rs.2

(ii) 50% of Rs.8, i.e., Rs.4 and
(iii) 75% of Rs.8, i.e., Rs.6 per share.

Retained Payout Ratio

earnings
25% payout 50% payout 75% payout
(Ra )
.
( ) . . .
Ve = .
= ( ) . ( ) .
. . Ve = .
= = Ve = .
= =
15% . . . .
= = Rs. 110 per
. = Rs. 100 per share = Rs. 90 per share
share . .
. . .
( ) ( ) ( )
Ve = .
= = Ve = .
= = Ve = .
= =
10% . . . . . .
= Rs. 80 per share = Rs. 80 per share = Rs. 80 per share
. . .
.
( ) . . .
Ve = .
= ( ) . ( ) .
. . Ve = .
= = Ve = .
= =
5% . . . .
= = Rs. 50 per
. = Rs. 60 per share = Rs. 70 per share
. .
share

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FINANCIAL MANAGEMENT 6.12

Question 6
The Best Performers Ltd. which earns Rs. 10 per share, is capitalized 20% and has a return
on investment of 25%. Determine the price per share, using Walter’s model.

Solution:
P = D + r / K (E – D) / K
= 25% / 20% (Rs.10) / 20%
= Rs.12.50 / 20%
= Rs. 62.50

Question 7
The following information is available in respect of the rate of return on investment, the cost
of capital and earning per share of Arora Ltd.
Rate of return on investment (r) = (i) 15%; (ii) 12%; and (iii) 10%
Cost of Capital (CR) = 12%
Earnings per share (E) = Rs.10
Determine the value of its shares using Gordon’s Model assuming the following:
D/p ratio (1 – b) Retention Ratio (b)
(a) 100 0
(b) 80 20
(c) 40 60

Solution:
Dividend Policy and the Value of Shares
(i) r = 15% (r > CR) (ii) r = 12% (r = CR) (iii) r = 10% (r < CR)
Retention
r = 15% (r > CR) r = 12% (r = CR) r = 10% (r < CR)
ratio (b)
( ) ( ) ( )
Ve = = Ve = = = Ve = =
b=0 . ( )( . ) . . ( )( . ) . . ( )( . ) .
= Rs. 83.33 Rs. 83.33 = Rs. 83.33
( . ) ( . ) ( . )
Ve =
( . )( .
= Ve =
( . )( .
= Ve =
( . )( .
=
. ) . ) . )
b = 0.20
= Rs. 88.89 = Rs. 83.33 = Rs. 80
. . .
( . ) ( . )
Ve =
( . )( .
= Ve =
( . )
= Ve =
( . )( .
=
. ) . )
b = 0.60 . ( . )( . ) .
= Rs. 133.33 = Rs. 83.33 = Rs. 66.67
. .

Question 8
The dividends of A & G Company Ltd. are expected to grow at a rate of 25% for 2 years, after
which the growth rate is expected to fall to 5%. The dividend paid last year was Rs.2. The
investor desires a 12% return. You are required to find the value of this stock.

PV Factor @ 12% is as under:

Year 1 2 3
value 0.893 0.797 0.712

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FINANCIAL MANAGEMENT 6.13

Solution:
Value of dividend at period Dt = D0 ( 1 + g)t
D0 = Dividend of last year (Rs.2 given)
D1 = Dividend of 1st year
D2 = Dividend of 2nd year
D3 = Dividend of 3rd year
g = Growth rate
CR = Expected Rate of Return
D1 = D0 (1 + g) = 2 (1 + 0.25) = Rs.2.50
D2 = D1 (1 + g) = 2.50 (1 + 0.25) = Rs.3.125
D3 = D2 (1 + g) = 3.125 (1 + 0.05) = Rs.3.281

. .
Price of Stock at the end of second year = = = = Rs. 46.86
. . .
Calculation of present value of stock price
Year Rs. PVF at 12% PV (Rs.)
1 2.50 0.893 2.23
2 3.125 0.797 2.49
3 46.86 0.797 37.34
Present value of stock 42.06

Question 9
Expected EPS by year end Rs. 250
ROE (r) 25%
Ke 25%

Using Gorden’s model, determine present value of shares if DPOR is?

Case 01 – 40%
Case 02 – 60%
Case 03 – 80%

Solution:
Case 01
D1 = EPS x DPOR
=250 x 40%= Rs. 100
G = bxr
= 60 % x 0.25= 15%
Po =

=
. .
=Rs. 100

Case 02
D1 = EPS x DPOR
= 250 x 60%
= Rs. 150

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FINANCIAL MANAGEMENT 6.14

G = bxr
=40% x 0.25
= 10%
Po =

=
. .
= Rs. 1000

Case 03
D1 = EPS x DPOR
= 250 x 80%
= Rs. 200
G = bxr
= 20% x 0.25
= 5%
Po =

=
. .
= Rs. 1000

Important Note:
When ROE (r) is same as expected rate of return by ESH (Ke) i.e., r = Ke then Present value of
equity shares will be same, irrespective of any POR.

In other words, dividend policy of a company cannot affect value of shares when r = Ke

Question 10
Expected dividend by year end (D1) Rs. 15
Expected Market price per share Rs.155
The expected rate of return by equity shareholders (ke) 25%
Determine the current market price of equity shares.

Solution:
𝑃1+𝐷1
PO =
1+𝐾𝑒
=
.
Rs. 136

Question 11
The rate of return on investment 40%
The rate of return expected by equity shareholders 25%
Expected earnings per share Rs. 20
Dividend payout ratio 50%

Determine the present worth of shares using Walter’s formula.

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FINANCIAL MANAGEMENT 6.15

What will be your answer if dividend payout ratio is –

a. Reduced to zero
b. Increase to 100%

Solution:
D = EPS x ROE
= 20 x 50%
=Rs. 10
( )

Po =
. ( )

= . .
.
=40 + 64
Rs. 104

1) DPOR is reduced to zero

D = EPS x DPOR
=20 x 0%= 0
( )

Po =
. ( )

= . .
.
= 40+64=Rs. 104

a. DPOR is reduced to zero

D = EPS x DPOR
=20 x 0%= 0
( )
Po =
. ( )

= . .
.
=0 + 128
Rs. 128

b. DPOR is increased to 100%

D = EPS x DPOR
=20 x 0%= 0
( )

Po =
. ( )

= . .
.
= 80 + 0= Rs. 80

Question 12
The rate of return on investment 25%
The rate of return expected by equity share holders 25%

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FINANCIAL MANAGEMENT 6.16

Expected earnings per share Rs. 20

Dividend payout ratio 50%

Determine the present worth of shares using Walter’s formula.

What will be your answer if dividend payout ratio is –
a. Reduced to zero
b. Increase to 100%

Solution:
D = EPS x ROE
= 20 x 50%=Rs. 10
( )

Po =
. ( )

= . .
.
= 40 + 40 = Rs.80

a. DPOR is reduced to zero

D = EPS x DPOR
=20 x 0%= 0
( )

Po =
. ( )

= . .
.
= Rs. 80

Question 13
The rate of return on investment 25%
The rate of return expected by equity share holders 25%
Expected earnings per share Rs. 20
Dividend payout ratio 50%

Determine the present worth of shares using Walter’s formula.

What will be your answer if dividend payout ratio is –
a. Reduced to zero
b. Increase to 100%

Solution:
D = EPS x ROE
= 20 x 50%=Rs. 10
( )

Po=
. ( )

= . .
.
=40+64=Rs. 104

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FINANCIAL MANAGEMENT 6.17

c. DPOR is reduced to zero

D = EPS x DPOR
=20 x 0%= 0
( )

Po =
. ( )

= . .
.
= Rs. 64

d. DPOR is increased to 100%

D = EPS x DPOR
=20 x 0%= 0
( )

Po=
. ( )

= . .
.
= 80 + 0= Rs. 80

Observation from outcome of example 9A , 9 B and 9C.

Dividend payout ration

0% 50% 100%
r > ke 128 104 80
r = ke 80 80 80
r < ke 64 72 80

 When r = ke value of shares remain same irrespective of dividend payout ration

 When dividend payout ratio is 100 % then the value of shares remains the same
irrespective of relationship between r and ke
 When r > ke and dividend payout ratio is 0% value of shares will be maximized.
 Therefore, when r> le value can be maximum be setting dividend payout ratio zero
 When r< ke and dividend payout ratio is 0% value of shares will be minimum
 Therefore, when r< ke value can be maximized be setting dividend payout ratio 100%

Question 14
The following figures are collected from annual reports of XYZ Itd.
Net profit for the year 30lac
Outstanding 12% preference share capital 100lac
Number of equity shares 3lac
The rate of return on investment (Roi) ( r) 20%
Assume opportunity cost of capital (ke) 16%

What should be the appropriate payout ratio so as to keep share price at Rs. 42 by using
Walter’s model

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FINANCIAL MANAGEMENT 6.18

Solution:
Net profit 30lac
(-) preference dividend 12lac
Earning available equity shareholders 18lac

EPS =
, ,
=
, ,
= Rs. 6

( )
Po = +
.
( )
42 = D + .
.
.
D=
.
D= 3.12

DPOR = x 100
.
= x 100
= 52%

Question 15
Dividend paid by X Itd in current year is Rs. 15. Equity capitalization rate (ke) is 20%. You are
required to determine the present value of equity if dividend per share grows at 16% p.a. for
the first two years and 14% p.a. for next two years and thereafter 12% p.a. forever.

Solution:
D1 = Do (1 + g) = 15(1.16) = 17.4
D2 = D1 (1 + g) = 17.4(1.16) = 20.18
D3 = D2(1 + g) = 20.18(1.14) =23
D4 = D2(1 + g) = 23(1.14) = 26.22
D5 = D4(1 + g) = 26.22(1.12) = 29.37

Po = + + ( )
+ ( )
( )
. . . .
Po = + ( . )
+ ( . )
+ ( . )
.
Po = 14.5 + 14.01 + 13.31 + 189.69
Po = Rs. 231.51

Question 16
Dividend paid by X Ltd in the current year = RS 15
Equity capitalization rate (Ke) = 20%

You are required to determine the present value of equity-

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FINANCIAL MANAGEMENT 6.19

a) If growth for first two years is 8%p.a., next two years is 10% p.a., and thereafter 12%p.a.,
forever.
b) If dividend per share remains constant.
c) If dividend per share constantly grows at 12% p.a.,

Solution:
Case 01
D1 = Do(1 + g) D1 = 15(1.08) D1=RS 16.2
D2 = D1(1 + g) D2 = 16.2(1.08) D2 = RS 17.05
D3 = D2(1 + g) D3 = 17.5(1.1) D3 = RS 19.25
D4 = D3(1 + g) D4 = 19.25(1.10) D4 = RS 21.18
D5 = D4(1 + g) D5 = 21.18(1.12) D5 = RS 23.72

P4 =
.
P4 =
. .
P4 = RS 296.5

Po = + + ( )
+ ( )
( )
. . . . .
Po = + ( . )
+ ( . )
+ ( . )
.
Po = 13.5 + 12.15 + 11.14 + 153.2
Po = RS 189.99

Case 02
Po = = = Rs. 75
.

Case 03
D1= Do (1+g)
D1=15 (1.12)
D1=RS 16.8

Po =
.
Po =
. .
Po = RS 210

MM APPROCH
Market value of firm will remain constant whether the company will distribute its dividend or
not.
Market capitalization (value of firm) = market price per share x number of equity shareholders.

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FINANCIAL MANAGEMENT 6.20

Question 17
P/E 10
Number of equity shares 50000
Po 100
D1 8
Given the assumption of MM answers, the following questions?

What will be the price of shares at the end of the year?

a. If dividend is not declared.
b. If dividend is declared.

Assuming that the firm pays dividend RS 8 and has a net income of RS 5,00,000 and makes a
new investment of RS 10 lac during the period. How many new shares must be issued.
What will be the correct value of firm if?
a. Dividend declared.
b. Dividend not declared.

Solution:
PART I
a. When dividend is not declared
ke =
ke =
ke = 0.10 i.e. 10 %

Po =
100 =
.
P1 = Rs. 110

b. when dividend is declared

Po =
100 =
.
100 = P1 + 8
P1 = 110 – 8
P1 = 102

PART II

a. when dividend is declared

D1 = 8 market price per share = 102
EBIT 5,00,000
(-) Dividend (50000 x 8) 4,00,000
Retained earnings 1,00,000

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FINANCIAL MANAGEMENT 6.21

(-) new investment required 10,00,000

Found to be raised 9,00,000
(-) Market price per share 102
New no. of equity shares to be issued 8823.53
Existing equity shares 50000
(+) new equity shares 8823.53
Total equity shares 58823.53
Market value of firm = market price per share x number of equity shares
Market value of firm = 102 x 558823.53
Market value of firm = Rs. 60,00,000

b. When dividend is not declared

D1 = 0 market price per share
EBIT 5,00,000
(-) Dividend (50000 x 8) -
Retained earnings 5,00,000
(-) new investment required 10,00,000
Fund to be raised 5,00,000
(-) Market price per share 110
New no. of equity shares to be issued 4545.45
Existing equity shares 50000
(+) new equity shares 4545.45
Total equity shares 54545.45
Market value of firm = market price per share x number of equity shares
Market value of firm = 110 x 54545.45
Market value of firm = Rs. 60,00,000

Question 18
Earnings 500000
Number of shares 100000
Earning per share 5
Payout ratio 70%
Expectation of equity shares 12%
Rate of return on investment 15%
Find
a. Market price as per Walter
b. What is the optimum payout ratio as per Walter

what should be the market price at that payout ratio

Solution:
D = EPS x DPOR
D = 5 x 70%
D = Rs. 3.5

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FINANCIAL MANAGEMENT 6.22

( )
Po =
.
. ( . )
Po = .
.
Po = Rs. 44.80

r > ke
15% > 12%

Optimum payout ratio should be “0”

( )
Po =
.
( )
Po = .
.
Po = Rs. 52.08

Question 19
Current market price 200
Equity capitalization rate 25%
Number of equity shares at the beginning 20000
The company has an investment plan at the year end 20 lacs

Determine expected price of the shares of the year end if dividend is –

CASE I – not declared
CASE II – expected dividend Rs. 50 per share, DPOR = 100%

In order to finance, the new project show the no. of equity shares to be issued under ach of
the above case. Use MM model to prove that market value of firm remains same irrespective
of dividend

Solution:
CASE I
Dividend not declared
Po =
Po =
.
P1 = Rs. 250

CASE II
Dividend declared
Po =
200=
.
200 x 1.25 = P1 + 50
250 – 50 = P1

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FINANCIAL MANAGEMENT 6.23

P1 = 200

Since DPOR = 100%

DPS = EPS = Rs. 50

Total earnings (E1) = n x eps

Total earnings = 20000 x 50 = 10lacs
CASE I CASE II
Dividend not declared Dividend is declared
Total earnings (E1) 10,00,000 10,00,000
(-) dividend (D1)(n xD1) - 10,00,000
Retained earnings (E1 – n D1) 10,00,000 -
Investment Obligation (i1) 20,00,000 20,00,000
Funds to be raised 10,00,000 20,00,000
P1 250 200
New shares to be raised 4000 10000
Value of firm
Existing equity shares 20000 20000
(+) new shares 4000 10000
Total equity shares 24000 30000
(x)P1 250 200
60,00,000 60,00,000

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FINANCIAL MANAGEMENT 7.1

WORKING CAPITAL MANAGEMENT

INTRODUCTION
Topic Details
- Capital is required for two purposes: establishment (fixed
capital) and day-to-day operations (working capital).
- Fixed capital refers to long-term funds for assets like plant,
machine, land, etc.
- Working capital refers to funds required for financing short-term
Introduction
assets like cash, marketable securities, debtors, and inventories.
- Shubin's definition: Working capital is the amount of funds
necessary for operating an enterprise.
- Gerstenberg's definition: Circulating capital means current
assets changed in ordinary course of business.
1. Purchase of raw materials, components, and spares.
2. Payment of wages and salaries.
3. Day-to-day expenses (fuel, power, office expenses).
Working Capital
4. Selling costs (packing, advertising, etc.).
Purposes
5. Providing credit facilities to customers.
6. Maintaining inventories (raw material, work in progress, finished
stock, etc.).
1. Based on Balance Sheet Concept:
- Gross Working Capital = Total Current Assets.
- Net Working Capital = Current Assets – Current Liabilities.
Types of Working 2. Based on Requirement (Time):
Capital - Permanent Working Capital: Minimum investment in fixed/current
assets to ensure smooth business operations.
- Variable Working Capital: Excess working capital required based
on fluctuations in business activities (seasonal, special).
1. Maintains solvency of the business.
2. Helps in creating and maintaining goodwill.
3. Enables easy loans from banks due to good credit standing.
4. Allows firms to avail cash discounts on purchases, reducing
Importance of costs.
Working Capital 5. Ensures regular supply of raw materials and continuous
production.
6. Ensures regular payments of salaries, wages, and other
commitments, boosting employee morale and efficiency.
7. Exploits favourable market conditions (bulk purchases at lower

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FINANCIAL MANAGEMENT 7.2

prices).
8. Helps in facing crises (e.g., during depressions).
9. Ensures regular returns on investments, gaining investor
confidence.
10. Boosts morale, security, and efficiency within the company.
1. Nature of Business: Public utility firms need less working capital
compared to trading and manufacturing businesses.
2. Size of Business: Larger firms generally require more working
capital.
3. Manufacturing Process/Production Cycle: Longer production
cycles require more working capital.
4. Seasonal Variations: Certain industries require larger working
capital due to seasonal demand for raw materials.
5. Working Capital Cycle: The speed of converting working capital
into cash influences its requirements.
6. Rate of Stock Turnover: High turnover means lower working
Factors Determining
capital requirements.
Working Capital
7. Firm’s Credit Policy: Selling on credit and purchasing for cash
impacts working capital needs.
8. Business Cycles: During boom periods, businesses need more
working capital; during recessions, they may have idle capital.
9. Rate of Growth of Business: Growing businesses require more
working capital to support expansion.
10. Earning Capacity and Dividend Policy: High earning capacity
can contribute to working capital.
11. Other Factors: Operating efficiency, management skills,
political stability, and banking facilities also influence working
capital requirements.

THE CONCEPT OF NEGATIVE WORKING CAPITAL

Topic Details
- Negative working capital occurs when current liabilities exceed
current assets.
- It is generally a sign of financial trouble or bankruptcy, leading
Negative Working
to financial pressure, increased borrowing, and late payments to
Capital
creditors.
- Poor working capital can lower credit ratings, causing banks to
charge higher interest rates, which increases costs over time.

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FINANCIAL MANAGEMENT 7.3

- Companies with negative working capital may lack the necessary

funds for growth.
- Some companies manage negative working capital by selling
inventory quickly, or by receiving customer payments upfront
(e.g., Amazon, McDonald’s).
- These companies can generate cash quickly enough to operate
How Negative Working
despite having negative working capital.
Capital Can Be
- Example: McDonald’s had a negative working capital of $698.5
Managed
million between 1999 and 2000.
- Example: Amazon.com sells products and receives payments
upfront, allowing them to manage negative working capital
effectively.
- Wal-Mart orders products (e.g., DVDs) from suppliers and has a
payment period (e.g., 30 days).
- By the time payment is due, they have already sold the product
to customers and made a profit.
- As long as transactions are timed right, Wal-Mart doesn’t need
Example: Wal-Mart
to have enough cash on hand to pay accounts payable
immediately.
- This approach maximizes efficiency, with payments being made
when due, using profits from sales before the payment is
required.
- Negative working capital can indicate strong managerial
Sign of Managerial
efficiency, especially in businesses with low inventory and
Efficiency
accounts receivable, operating almost entirely on a cash basis.

MANAGEMENT OF WORKING CAPITAL

Topic Details
- Working capital refers to the excess of current assets over
current liabilities.
- Management of working capital involves managing current
Definition of Working
assets, current liabilities, and the inter-relationship between
Capital Management
them.
- It is concerned with the administration of both current
assets and liabilities.
- The goal is to maintain a satisfactory level of working
Goal of Working Capital
capital, which is neither inadequate nor excessive.
Management
- Inadequate working capital can lead to insolvency, while

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FINANCIAL MANAGEMENT 7.4

excessive working capital implies idle funds that do not earn

profits.
Impact of Working Capital - Proper management affects profitability, liquidity, and the
Management structural health of the organization.
1. Dimension I: Formulation of policies related to
profitability, risk, and liquidity.
Three Dimensions of
2. Dimension II: Decisions regarding the composition and
Working Capital
level of current assets.
Management
3. Dimension III: Decisions regarding the composition and
level of current liabilities.

ESTIMATION OF WORKING CAPITAL REQUIREMENT

Method Description
- Traditional and simple method.
- Establishes a relationship between sales and working capital
based on previous year’s sales (assumed as 100%).
Percentage (%) on
- Current assets and liabilities are calculated based on expected
Sales Method
future sales.
- Simple and useful for short-term projections but may not work
universally due to the assumption of a linear relationship.
- Statistical method used to forecast working capital
requirement.
- Establishes the average relationship between sales and
working capital based on historical data.
- Uses the least squares method with the equation:
Regression Analysis
Y = a + bx
Method
Where:
- Y = Working capital level (dependent variable)
- x = Sales (independent variable)
- a = Intercept
- b = Slope of the line
- Popular method for computing working capital.
Forecasting Net - Forecasted current assets and liabilities are calculated, and
Current Assets Method net current assets (current assets - current liabilities) are
identified.
Projected Balance - All estimated assets and liabilities are included in a projected
Sheet Method balance sheet, excluding cash.

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FINANCIAL MANAGEMENT 7.5

- The balance of liabilities over assets determines cash, while

the balance of assets over liabilities indicates bank overdraft.

THE OPERATIONAL CYCLE METHOD CONCEPT AND APPLICATION OF QUANTITATIVE

TECHNIQUES
Concept Description
- Refers to the period a business takes to convert cash into cash
again.
Operational
- In manufacturing, it involves cash acquisition for inventory, turning
Cycle
inventory into semi-finished goods, then finished goods, selling them to
customers, and collecting cash.
- The operating cycle expresses each stage in terms of the number of
days and requires investment.
Application
- Total working capital = Sum of investments across each stage of the
cycle.
t = (r - c) + w + f + b
Where:
- t = Total period of operating cycle in days
Formula for - r = Days of raw materials and stores consumption
Operating Cycle - c = Days of purchases in trade creditors
- w = Days of cost of production in work-in-progress
- f = Days of cost of sales in finished goods inventory
- b = Days of sales in book debts
- r = Average inventory of raw materials / Average daily consumption
of raw materials
- c = Average trade creditors / Average daily credit purchases
Calculations
- w = Average work-in-progress / Average daily production cost
- f = Average finished goods inventory / Average daily cost of sales
- b = Average book debts / Average daily sales
- The average figures for inventory, trade creditors, work-in-progress,
finished goods, and book debts are calculated by averaging the
Method Details opening and closing balances.
- Average daily figures are calculated by dividing annual figures by 365
days.
- The method gives only an average estimate.
Limitations - It doesn't account for fluctuations due to seasonal factors or other
changes.

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FINANCIAL MANAGEMENT 7.6

- Continuous short-run forecasting and budgeting are needed to

consider these fluctuations.

MANAGEMENT OF CASH
Concept Description
- Cash includes money in hand, at the bank, and marketable
securities.
Nature of Cash
- Cash itself doesn’t produce goods or services but is used to
acquire other assets.
1) Transaction Motive: Cash is needed for day-to-day transactions
(purchases, paying expenses, taxes, dividends, etc.).
2) Precautionary Motive: Cash is needed for contingencies like
Motives for Holding
unexpected delays in payments or increased cash payments.
Cash
3) Speculative Motive: Cash is held to seize profitable opportunities
that may arise unexpectedly (e.g., buying low-priced shares or raw
materials).
1) Credit Policy: Liberal credit policies increase the need for cash.
2) Nature of the Product: Necessity products may require a
different cash balance compared to luxury products.
3) Size and Area of Operation: Larger operations require higher
cash reserves.
Factors
4) Duration of Production Cycle: Longer production cycles increase
Determining Cash
cash requirements.
Level
5) Policy on Disbursements: Frequent disbursements like weekly
payments increase cash needs.
6) Relations with Banks and Credit Standing: Good relationships with
banks and a strong credit standing reduce the need for high cash
reserves.
1) Maintenance of Goodwill: Timely payments enhance business
reputation.
2) Cash Discount: Sufficient cash allows a firm to avail cash
discounts, lowering costs.
Advantages of
3) Good Bank Relations: Firms with ample cash can secure credit at
Ample Cash
favourable terms.
4) Exploitation of Business Opportunities: Ample cash allows the firm
to take advantage of opportunities.
5) Encouragement to New Investments: A sound cash policy

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FINANCIAL MANAGEMENT 7.7

encourages shareholder investment through cash dividends.

6) Increase in Efficiency: Adequate cash ensures smooth production,
improving labor efficiency.

CASH MANAGEMENT MODELS

Model Type Key Concept Formula / Assumptions Key Takeaways
Approach

C = Optimal
Balances cash
Ideal for
transaction balance ✔ Cash
predictable cash
cost and A = Annual needs are
flow
opportunity cash known
Baumol Under Ensures minimum
cost to outflows ✔ Outflows
Model Certainty total cost
determine F = Fixed are uniform
Simple but
optimal cash. transaction ✔ Costs are
impractical for
Treats cash like cost constant
uncertain conditions
inventory. O=
Opportunity
cost
Realistic model
Uses control ✖ Cash flow
for dynamic
limits: only acts is uncertain
environments
when cash h = l + 3z ✔ Variance
Miller- No daily
Under balance hits Return Point and cost
Orr adjustments needed
Uncertainty upper or lower =l+z known
Model Better for
limits. Allows Avg Cash = l ✔ Random
businesses with
randomness in +z fluctuations
unpredictable
cash flows. allowed
receipts/payments

MANAGING CASH FLOWS

Section Method Description Key Takeaways
Speed up collections via Faster inflows
A. Accelerating 1. Prompt Payment
prompt billing and offering improve liquidity.
Cash Inflows by Customers
cash discounts. Reduces

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FINANCIAL MANAGEMENT 7.8

receivables
outstanding.
2. Quick
Early processing of cheques Improves cash
Conversion of
for faster realization. position quickly.
Payments
Set up regional collection Saves time.
3. Decentralized
centres to shorten mailing Reduces working
Collections
time. capital needs.
Speeds up
collections
Post office boxes managed
significantly.
4. Lock Box System by banks to collect customer
Lowers
cheques directly.
processing and
mailing delays.
B. Slowing Cash 1. Paying on Last Utilize full credit period Conserves cash
Outflows Date before making payment. for longer.
2. Payments Delays withdrawal as drafts Buys additional
through Drafts take time to process. float time.
Reduce payment frequency
3. Adjusting Lowers cash
or time salary disbursements
Payroll Funds outflow spikes.
efficiently.
Use central office to issue
4. Centralization Gains postal float
payments to create delay in
of Payments benefit.
clearance.
Optimizes idle
cash.
5. Inter-bank Move funds only when needed
Prevents excess
Transfers across bank accounts.
balance in any one
bank.

MANAGEMENT OF INVENTORY
Category Description Key Takeaways
Stock of goods held for production, sales, Inventory types differ
Definition of or maintenance. Includes raw materials, by usage & entry point in
Inventory WIP, finished goods, consumables, and operations.
spares. High portion of

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FINANCIAL MANAGEMENT 7.9

working capital is tied up

in inventory.
a) Raw Materials
b) Work-in-Progress (WIP) Essential for smooth
Components of
c) Consumables operations and fulfilling
Inventory
d) Finished Goods demand.
e) Spares
1. Transaction Motive: To ensure smooth
production/sales.
Inventory is held for
Motives for 2. Precautionary Motive: For uncertain
operational continuity
Holding Inventory demand/supply.
and economic advantage.
3. Speculative Motive: To benefit from
price discounts and bulk orders.
1. Ensure continuous supply.
2. Avoid over/under-stocking.
3. Optimize investment.
Aims to balance
4. Control material costs.
Objectives of availability and cost
5. Avoid duplication.
Inventory efficiency.
6. Minimize losses.
Management Supports production
7. Establish accountability.
and financial health.
8. Maintain accurate records.
9. Ensure quality at fair prices.
10. Provide data for planning.
1. Price Decline: Competitive or market
changes.
Inventory can lose
Risks Associated 2. Deterioration: Due to poor storage or
value due to market or
with Inventory shelf life.
storage risks.
3. Obsolescence: From tech, design, or
consumer preference shifts.
1. Material Cost: Price of goods bought. Inventory involves
2. Ordering Cost: Expenses in procurement both visible and hidden
Costs Related to process. costs.
Inventory 3. Carrying Cost: Storage, insurance, Reducing unnecessary
depreciation. costs improves overall
4. Stock-out Cost: Losses from shortages. efficiency.

TOOLS AND TECHNIQUES OF INVENTORY MANAGEMENT

Tool/Technique Description Key Takeaways

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FINANCIAL MANAGEMENT 7.10

Maintains balance between too much

or too little inventory to optimize
costs and ensure smooth operations.
Includes: Prevents disruption and
Minimum Level (avoid stock-outs) excess costs.
1. Stock Levels
Maximum Level (avoid Helps in planning and timely
overstocking) procurement.
Reorder Level (when to order)
Danger Level (emergency action)
Average Stock Level
Balances between risk of
Extra inventory held to prevent
stock-outs and holding costs.
2. Safety Stock stock-outs caused by variability in
Critical for unpredictable
demand or supply delays.
environments.
Choosing between systems like fixed- System selection affects
3. Ordering System order quantity or periodic review to ordering frequency and stock
manage replenishment. levels.
Reduces total inventory
cost.
4. Economic Order The order size that minimizes the
EOQ = √(2DS/H), where D =
Quantity (EOQ) total of ordering and holding costs.
demand, S = ordering cost, H =
holding cost/unit/year.
Classifies inventory into:
Focuses control on high-
A: High value, low quantity
5. A-B-C Analysis value items.
B: Moderate value
Effective use of resources.
C: Low value, high quantity
Inventory classification based on
criticality: Useful in healthcare,
6. VED Analysis V = Vital defense, or production-
E = Essential critical parts.
D = Desirable
Requires reliable suppliers.
7. JIT (Just-in- Inventory received only as needed,
Improves efficiency but
Time) minimizing holding costs.
risky in volatile environments.
Measures how often inventory is sold Higher ratio = efficient use
8. Inventory and replaced. of inventory.
Turnover Ratio Formula: Cost of Goods Sold / Low ratio signals overstock
Average Inventory or slow-moving goods.

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FINANCIAL MANAGEMENT 7.11

Breaks down inventory by age to

Helps reduce wastage,
9. Ageing Schedule identify obsolete or slow-moving
improves decision-making.
stock.
Increases accuracy.
10. Perpetual Real-time inventory tracking using
Enables continuous stock
Inventory System technology.
visibility.

ORDERING SYSTEMS OF INVENTORY

Category Technique / Tool Description Purpose / Formula / Key
Benefit Points
Based on
Prevents
Inventory Lowest stock to consumption, lead
Minimum Level production
Control avoid stoppage time, and stock-
halts
out cost
Prevents stock Re-order Level =
Re-ordering Point to place
falling below Max Usage × Max
Level new order
minimum Lead Time
Avoids Based on space,
Upper limit of
Maximum Level overstocking cost, demand
inventory
and cost fluctuation
Immediate
Emergency stock Usually < Minimum
Danger Level reordering
limit Level
trigger
Average Stock Mean inventory Aids in planning Avg. Level = (Min +
Level level and evaluation Max) / 2
Buffer for Balances stock-
Prevents costly
Safety Stock demand/supply out vs carrying
stock-outs
fluctuation cost
Fixed order
Ordering EOQ (Fixed Cost-efficient EOQ = √(2 × R ×
quantity at re-
Systems Quantity) ordering CP / CH)
order point
Fixed Period Order at fixed Simplifies Quantity varies
System intervals planning per order
Single Order + One-time bulk
Suitable for Reduces order
Scheduled order, multiple
long projects frequency
Delivery deliveries

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FINANCIAL MANAGEMENT 7.12

A = High value, B = Prioritizes

Inventory Focuses efforts on
ABC Analysis Moderate, C = control based
Analysis critical items
Low on value
V = Vital, E = Ensures
Used for spare
VED Analysis Essential, D = availability of
parts
Desirable critical parts
Measures how Evaluates
Efficiency Inventory Turnover = COGS
often stock is inventory
Metrics Turnover Ratio / Avg. Inventory
sold/replaced performance
Sorts stock by Helps clear old Highlights
Inventory Ageing
purchase date inventory obsolete items
Perpetual Immediate Avoids stock-outs,
Real-time stock
Inventory visibility & supports decision-
tracking
System control making
Trade-off:
Receivables Sets credit limits, Balances risk vs
Credit Policy Liquidity vs
Management terms sales growth
Profitability
Credit period,
Influences sales Aligned with
Credit Terms discounts,
and collections company strategy
standards
5 C's: Character,
Analyze Ensures
Credit Capacity, Capital,
applicants using 5 reliable
Evaluation Collateral,
C’s customer base
Conditions
Includes
Steps to recover Minimizes bad
Collection Policy reminders, follow-
dues debts
ups
Receivables Cost of funds tied Impacts cash Related to
Financing Cost
Costs in debtors flow opportunity cost
Credit checks,
Administrative Adds to Required for due
record
Cost overhead diligence
maintenance
Reminders, legal Reduces Manage through
Collection Cost
action profitability policy
Default/Bad Unrecovered Direct loss to Must be minimized
Debt receivables firm via evaluation

FACTORS AFFECTING THE SIZE OF RECEIVABLES

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FINANCIAL MANAGEMENT 7.13

Category Factor Description / Impact

General Type & Nature of Service-based businesses may have different credit
Factors Business patterns compared to manufacturing.
Anticipated Sales Higher expected sales usually result in larger
Volume receivables.
Inflation or deflation can affect the value and terms
Price-Level Variations
of receivables.
Access to working capital affects how much credit
Availability of Funds
can be extended.
Higher interest rates increase the opportunity cost
Interest Rates
of tied-up funds in receivables.
Technological Tech adoption may streamline credit processes,
Advancement influencing receivables efficiency.
Industry practices often set the benchmark for
Industry Norms
credit periods and collection policies.
Specific Volume of Credit Direct correlation — more credit sales lead to
Factors Sales higher receivables.
Terms of Sale Longer or more relaxed terms increase receivables.
Seasonal or instalment sales create spikes in
Stability of Sales
receivables during certain periods.
Credit & Collection Liberal policies boost receivables; strict ones keep
Policy them controlled.
Bills Discounting / Discounting or endorsing bills reduces the
Endorsement receivable balance on the books.
Longer credit terms mean receivables stay on the
Credit Period Allowed
books longer, increasing their size.

WORKING CAPITAL FINANCING

Category Type Description Sources / Key Notes /
Strategies Features
1. Issue of Shares
Used to support
(Equity,
Minimum level of base-level
Working Preference)
Permanent current assets operations. Long-
Capital 2. Debentures
(Fixed) needed term finance
Requirement 3. Public Deposits
continuously. sources
4. Ploughing Back
recommended.
Profits

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FINANCIAL MANAGEMENT 7.14

5. Loans from
Financial
Institutions (e.g.,
LIC, IDBI)
1. Indigenous
Bankers
2. Trade Credit
3. Instalment
Credit
4. Customer
Advances
5. Factoring /
Receivable
Additional Short-term
Credit
capital required sources, flexible
Temporary 6. Accrued
during peak or and adaptable to
(Variable) Expenses
seasonal demand
7. Deferred
operations. fluctuations.
Income
8. Commercial
Paper
9. Commercial
Bank Finance
(Loan, Cash
Credit,
Overdraft, Bill
Discounting)
Loan – Lump-sum;
interest on full
amount.
Cash Credit –
Preferred for
Financing Interest on used
operational
Bank Finance provided by amount only.
Short-Term liquidity. Easy
Instruments commercial Overdraft –
access, varied
banks. Temporary excess
terms.
withdrawal.
Bill Discounting –
Immediate funds
for credit sales.

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FINANCIAL MANAGEMENT 7.15

Long-term
Financing Match maturity finance for fixed Balance of cost and
Policies for Matching of asset with & permanent risk. Difficult to
Current Approach maturity of current assets; implement precisely
Assets source. short-term for due to uncertainty.
temporary.
Use long-term
funds for all Low risk, higher
Excess funds can
Conservative permanent & stability. Lower
be invested
Approach part of profitability due to
temporarily.
temporary idle funds.
current assets.
Use short-term
High risk, potential
finance even for
Aggressive Heavy reliance on liquidity crisis if
part of
Approach short-term funds. short-term funds
permanent
dry up.
assets.
Business type,
sales volume,
Factors External factors
General price changes, Affect all firms
Affecting impacting
Factors tech pace, equally.
Receivables receivables.
industry norms,
interest rates.
a) Volume of
Credit Sales
b) Terms of Sale
Directly impact
c) Sales Stability
Specific Internal, firm- size of receivables
d) Credit Policy
Factors level factors. and working capital
e) Bills
cycle.
Discounting
f) Credit Period
Allowed

BANKING NORMS AND MACRO ASPECT

Topic Details
Purpose of Banks provide working capital finance to maintain an appropriate level
Working Capital of current assets (raw materials, work in progress, finished goods,
Finance sundry debtors) for production and sales.

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FINANCIAL MANAGEMENT 7.16

- Essential for production.

- Can be sourced from domestic or international suppliers, each with
Raw Material different procurement and payment times.
- Fund requirement is calculated by multiplying monthly consumption by
the cost of materials.
- Funds are required for raw material conversion into finished goods.
Work in Process - Assessment involves considering raw material consumption and
production expenses during the processing period.
- Funds blocked in finished goods inventory are assessed by estimating
Finished Goods
the manufacturing cost of the product.
- Generated when goods are sold on credit.
- The credit period depends on industry practices.
Sundry Debtors
- Investment in accounts receivable remains blocked until payment is
received.
- One month’s total expenses (direct/indirect) are included as a
Expenses cushion in assessing working capital needs.
- Includes rent, salaries, etc., based on the operating cycle.
Trade Credit - Reduces the working capital requirement.
Received - Must be accounted for in the assessment of funds.
Advances - Advances received with purchase orders reduce the working capital
Received requirement.

FACTORING AND FORFAITING

Topic Details
Financial service where a firm sells its receivables to a
Factoring factor to get immediate cash flow and avoid the risk of bad
debts.
- Credit and collection function
- Credit protection
Functions of Factoring - Encashing receivables
- Collateral functions
- Advisory services to clients
- Accounts Receivable Loan: Secured loan against
Factoring vs. Accounts receivables, firm retains collection responsibility
Receivable Loans - Factoring: Outright sale of receivables, factor handles
collection and credit risk

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FINANCIAL MANAGEMENT 7.17

Factoring vs. Bill - Bill Discounting: Firm collects bills, usually with recourse
Discounting - Factoring: Factor handles collections, can be non-recourse
1. Seller negotiates factoring relationship
2. Credit check on buyer
Mechanics of Factoring 3. Seller sells goods to buyer
4. Seller sends invoice to factor
5. Factor pays seller after collecting payment
- Full Source (Non-Recourse): Finance, protection, collection,
and credit advice
- Recourse Factoring: Same as full source but with recourse
for bad debts
- Agency Factoring: Collection only, no ledger admin
Types of Factoring
- Bulk Factoring: Same as agency factoring but for larger
receivables
- Invoice Discounting: Finance only, no collection
- Undisclosed Factoring: Finance only, no collection or
disclosure to customers
Financing of international trade by selling promissory notes
Forfaiting
or bills at a discount, with the forfeiter assuming all risks.
- Forfaiting: Full purchase of receivables, non-recourse,
Forfaiting vs. Export typically long-term (3-5 years)
Factoring - Export Factoring: Factor finances part of receivable,
retains risk for bad debts
- Forfaiting: Full receivable purchase, bank guarantees,
Key Differences between longer term
Factoring and Forfaiting - Factoring: Partial finance, short-term, includes collection
and advisory services

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FINANCIAL MANAGEMENT 7.18

QUESTION BANK
Question 1
A Performa cost sheet of a company provides the following particulars:
Element of Cost Amount per Unit (Rs.)
Raw Material 80
Direct Labor 30
Overheads 60
Total 170
Profit 30
Selling Price 200

The following further particulars are available:

 Raw materials are in stock on an average one month.
 Materials are in process, on an average half a month.
 Finished goods are in stock on average one month.
 Credit allowed by suppliers is one month.
 Credit allowed to debtors is two months.
 Lag in payment of wages is 1½ weeks.
 Lag in payment of overhead expenses is one month.
 One-fourth of the output is sold against cash.
 Cash on hand and at bank is expected to be Rs.25,000.
You are required to prepare a statement showing the working capital needed to finance a
level of activity of 1,04,000 units of production.
You may assume that production is carried on evenly throughout the year, wages and
overheads accrue similarly and a time period of four weeks is equivalent to a month.

Solution:
Statement of Working Capital Requirements Forecast
Current Assets: Rs.
1. Stock of Raw Materials (4 weeks) (1,60,000 × 4) 6,40,000
2. Stock of Finished Goods (4 weeks): Rs
Raw Material 1,60,000 × 4 6,40,000
Direct Labor 60,000 × 4 2,40,000
Overheads 1,20,000 × 4 4,80,000 13,60,000
3. Work-in-Progress (2 weeks):
Raw Material 1,60,000 × 2 3,20,000
Direct Labour 60,000 × 1 60,000
Overheads 1,20,000 × 1 1,20,000 5,00,000
4. Debtors (8 weeks):
Raw Material 1,20,000 × 8 9,60,000
Direct Labour 45,000 × 8 3,60,000
Overheads 90,000 × 8 7,20,000 20,40,000

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FINANCIAL MANAGEMENT 7.19

5. Cash Balance 25,000

45,65,000
Less Current Liabilities:
6. Creditors for Raw Materials (4 weeks) (1,60,000 × 4) 6,40,000
7. Lag in payment of wages (1½ weeks) (60,000 × 1½) 90,000
8. Lag in payment of overheads (4 (1,20,000 × 4) 4,80,000 12,10,000
weeks)
9. Net Working Capital Required 33,55,000

Question 2
From the following information, prepare a statement showing the average amount of working
capital required by Solvent Ltd., taking 360 days in a year.
Annual sales are estimated at 5,00,000 units at Rs.2 per unit. Production quantities coincide
with sales and will be carried on evenly throughout the year and the production cost is:

Materials Re. 1 per unit

Labor Re. 0.40 per unit
Overheads Re. 0.35 per unit

 Customers are given 45 days’ credit and 60 days’ credit is taken from suppliers – 36 days’
supply of raw materials and 15 days’ supply of finished goods are kept.
 Production cycle is 18 days and all material is issued at the commencement of each
production cycle.
 A cash balance equivalent to one-third of the average of other working capital
requirement is kept for contingencies.

Solution:
Statement of Working Capital Requirements Forecast
Current assets: Rs.
1. Stock of Raw Materials x 500000 50,000.00

2. Stock of Finished Goods x 875000 36,458.33

3. Work-in-Progress:
Material x 500000 25,000

Labor and Overheads x 375000 x 50% 9,375 34,375.00

4. Debtors x 875000 1,09,375.00

Total Current Assets excluding 2,30,208.33

cash
Less Current Liabilities:
Creditors of Raw Materials x 500000 83,333.33

Other Working Capital 1,46,875.00

Requirement

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FINANCIAL MANAGEMENT 7.20

Add Cash for contingencies (1/3) 48,958.33

Working Capital Required 1,95,833.33

Note:
(i) Debtors have been taken at total cost of sales. Alternatively, they may be taken at selling
price.
(ii) It has been assumed that labor and overheads are incurred evenly throughout the
production process.

Question 3
On 1st January, 2006, the board of directors of Littlemore & Co. desire to know the amount
of working capital that will be required to meet the program me they have planned for the
year. From the following information, prepare an estimate of working capital requirements
and a forecast of Profit and Loss Account and Balance Sheet.

Issued Shared Capital Rs. 2,00,000

8% Debentures Rs. 50,000
Fixed Assets as on 1st Jan. Rs. 1,25,000

Production during the previous year was 60,000 units and it proposed to maintain the same
during 2006. The expected ratios of cost to selling price are: raw materials 60%, direct wages
10%, and overheads 20%. Following further information are available:

1) Raw materials are expected to remain in stores for an average of two months before issue
to production.
2) Each unit of production is expected to be in process for one month.
3) Finished goods will stay in the warehouse awaiting dispatch to customers for approximately
three months.
4) Credit allowed by creditors is two months from date of delivery of raw materials.
5) Credit given to debtors is three months from date of dispatch.
6) Selling price is Rs.5 per unit.
7) Sales and production follow a consistent pattern.

Solution:
Statement of Working Capital Requirement Forecast
Current Assets: Rs.
Stock of Raw materials (2 months) (60,000 × 3 × 2/12) 30,000
Stock of Finished Goods (3 months):
Material 60,000 × 3 × 3/12 45,000
Labor 60,000 × 0.5 × 3/12 7,500
Overhead 60,000 × 1.0 × 3/12 15,000 67,500
Work-in-Progress (1 month):
Material 60,000 × 3 × 1/12 15,000

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Labor 60,000 × 0.5 × 50% ×

1,250
1/12
Overhead 60,000 × 1 × 50% × 1/12 2,500 18,750
Debtors (3 months):
Material 60,000 × 3 × 3/12 45,000
Labor 60,000 × 0.5 × 3/12 7,500
Overhead 60,000 × 1.0 × 3/12 15,000 67,500
1,87,750
Less Current Liabilities:
Creditors of Raw materials (2 months) (60,000 × 3 × 2/12) 30,000
Net Working Capital Required 1,53,750

Forecast Profit & Loss Account

Particulars Rs. Particulars Rs.
To Material 1,80,000 By Sales 3,00,000
To Direct Labor 30,000
To Overheads 60,000
To G.P. c/d 30,000
3,00,000 3,00,000
To Debenture Interest 4,000 By G.P. b/d 30,000
To Net Profit 26,000
30,000 30,000

Forecast Balance Sheet

Liabilities Amount Rs. Assets Amount Rs.
Issued Capital 2,00,000 Fixed Assets 1,25,000
Profit Balance 26,000 Working Capital:
5% Debentures 50,000 Current Assets:
Stocks:
Raw Materials 30,000
Work-in-Progress 18,750
Finished Goods 67,500
1,16,250
Debtors 75,000
1,91,250
Less Current Liabilities:
Creditors 30,000
Bank overdraft 10,250 40,250 1,51,000
2,76,000 2,76,000

Question 4
From the following information extracted from the books of a manufacturing company, compute
the operational cycle in days:

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FINANCIAL MANAGEMENT 7.22

Period Covered: 365 days

Average period of credit allowed by suppliers: 16 days
Average total of debtors outstanding Rs. 4,80,000
Raw material consumption Rs. 44,00,000
Total production cost Rs. 1,00,00,000
Total cost of sales Rs. 1,05,00,000
Sales for the year Rs. 1,60,00,000
Value of average stock maintained:
Raw Material Rs. 3,20,000
Work-in-Progress Rs. 3,50,000
Finished Goods Rs. 2,60,000

Solution:
Computation of Operational Cycle
a) Materials Storage Period =

= = = 27 days
÷
Less Average Credit Period granted by suppliers =

..
b) Production Process Period =

= = = 13 days
÷

c) Finished Goods Storage Period =

= = = 9 days
÷

d) Debtors Collection Period =

= = = 11 days
÷

Operational Cycle Period = 44 days

Question 5
The following information is available for SK Ltd.
(Amount in Rs.)
Average stock of raw materials and stores 2,00,000
Average work-in-progress inventory 3,00,000
Average finished goods inventory 1,80,000
Average accounts receivable 3,00,000
Average accounts payable 1,80,000
Average raw materials and stores purchased on credit and
10,000
consumed per day

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FINANCIAL MANAGEMENT 7.23

Average work-in-progress value of raw materials committed per day 12,500

Average cost of goods sold per day 18,000
Average sales per day 20,000

Calculate the duration of operating cycle.

Solution:
Calculation of operating cycle
2,00,000
Period of raw material stage = 20 days
10,000
3,00,000
Period of work-in-progress stage = 24 days
12,500
1,80,000
Period of finished goods stage = 10 days
18,000
3,00,000
Period of Accounts receivable stage = 15 days
20,000
1,80,000
Period of Accounts payable stage = 18 days
10,000

Duration of operating cycle = (20 + 24 + 10 + 15) – 18 =51 days

Question 6
The annual cash requirement of XYZ Ltd. is Rs.10 lakh. The company has marketable securities
in lot sizes of Rs.50,000, Rs.1,00,000, Rs.2,00,000 and Rs.2,50,000. Cost of conversion of
marketable securities per lot is Rs.1,000. The company’s opportunity cost of funds is 5% per
annum.

You are required to prepare a table indicating which lot size will have to be sold by the
company. Also determine economic lot size by Baumol Model.

Solution:
Table Indicating Lot Size
a) Annual requirement of cash
10,00,000 10,00,000 10,00,000 10,00,000
(Rs.)
b) Lot size of securities (Rs.) 50,000 1,00,000 2,00,000 2,50,000
c) No. of lot sizes (a ÷ b) 20 10 5 4
d) Average holding of cash (b ÷ 2) 25,000 50,000 1,00,000 1,25,000
e) Opportunity cost of funds (Rs.)
1,250 2,500 5,000 6,250
(5% of d)
f) Conversion cost per
1,000 1,000 1,000 1,000
transaction (Rs.)
g) Total conversion cost (Rs.) (c ×
20,000 10,000 5,000 4,000
f)
h) Total cost (Rs.) (e ÷ g) 21,250 12,500 10,000 10,250

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FINANCIAL MANAGEMENT 7.24

As total cost is minimum at lot size of Rs.2,00,000 and so it is economic lot size of selling
securities. The company should make 10,00,000 ÷ 2,00,000 = 5 transactions regarding sale of
marketable securities for conversion into cash during the year.

Calculation of Economic Lot Size by Baumol Model:

× × , , × ,
C= = = Rs.2,00,000
.

Question 7
Amit Ltd. has a policy of maintaining a minimum cash balance of Rs.5,00,000. The standard
deviation of the company’s daily cash flows is Rs.2,00,000. The annual interest rate is 14%.
The transaction cost of buying or selling securities is Rs.150 per transaction. Determine Amit’s
upper control limit and return point as per Miller-Orr Model.

Solution:

× ×( , , ) ×( , , )
Z= = = = Rs.2,27,226
. / . /

Upper Control Limit = Lower Limit + 3z

= 5,00,000 + 3 × 2,27,226
= Rs.11,81,678

Return Point = Lower Limit + z

= 5,00,000 + 2,27,226
= Rs.7,27,226

Average Cash Balance = Lower Limit + z

= 5,00,000 + × 2,27,226
= Rs.9,02,96

Question 8
From the following budgeted figures, prepare a Cash Budget in respect of three months to
June 30:
Months Sales Rs. Materials Rs. Wages Rs. Overheads Rs.
January 60,000 40,000 11,000 6,200
February 56,000 48,000 11,600 6,600
March 64,000 50,000 12,000 6,800
April 80,000 56,000 12,400 7,200
May 84,000 62,000 13,000 8,600
June 76,000 50,000 14,000 8,000

Expected Cash Balance on 1st April Rs.20,000. Other informations are as follows:

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FINANCIAL MANAGEMENT 7.25

1) Materials and overheads are to be paid during the month following the month of supply.
2) Wages are to be paid during the month in which they are incurred.
3) Terms of Sales: The terms of credit sales are payment by the end of the month following the
month of sales; ½ of the sales are paid when due, the other half to be paid during the next
month.
4) 5% sales commission is to be paid within the month following actual sales.
5) Preference dividend for Rs.30,000 is to be paid on 1st May.
6) Share call money for Rs.25,000 is due on 1st April and 1st June.
7) Plant and Machinery worth Rs.10,000 is to be installed in the month of January and the
payment is to be made in the month of June.

Solution:
Cash Budget
Period three months ending June
Details April (Rs.) May (Rs.) June (Rs.)
Balance b/d 20,000 32,600 - 5,600
Receipts:
Cash from debtors:
February Sales 28,000
March Sales 32,000 32,000
April Sales 40,000 40,000
May Sales 42,000
Share Call Money 25,000 – 25,000
Total Cash Available (A) 1,05,000 1,04,600 1,01,400

Disbursements:
Materials 50,000 56,000 62,000
Overheads 6,800 7,200 8,600
Wages 12,400 13,000 14,000
Sales Commission 3,200 4,000 4,200
Preference Dividend 30,000
Payment for Plant and Machinery – – 10,000
Total Disbursements (B) 72,400 1,10,200 98,800
Closing Cash Balance (A – B) 32,600 – 5,600 2,600

Question 9
From the following forecasts of income and expenditure, prepare a cash budget for the half
year ended on 30th June 2008:
Year Months Sales Purchase Wages Manufacturing Administration Selling
(Credit) (Credit) Rs. Expenses Rs. Expenses Rs. Expenses
Rs. Rs. Rs.
2007 Nov. 25,000 10,000 2,500 1,100 1,000 600
Dec. 30,000 15,000 2,800 1,200 975 650
2008 Jan. 20,000 10,000 2,000 1,250 1,060 550

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FINANCIAL MANAGEMENT 7.26

Feb. 25,000 15,000 2,200 1,150 1,040 650

Mar. 30,000 17,500 2,400 1,300 1,105 750
Apr. 35,000 20,000 2,600 1,350 1,120 800
May. 40,000 22,500 2,800 1,450 1,180 825
June. 45,000 25,000 3,000 1,500 1,185 875

1) A sales commission of 5% on sales and due two months after sales, is payable in addition to
the above selling expenses.
2) Capital Expenditure – Plant purchased, 1st January for Rs.10,000, its payment being
immediately due; Building purchased in January for RS.80,000, payable in two half-yearly
installments, the first in February.
3) A dividend of Rs.5,000 (net) is payable in April.
4) Period of credit allowed by creditors and to customers is 2 months.
5) Lag in payment of wages – 1/8th month.
6) Lag in payment of other expenses – 1 month.
7) Cash Balance on January 1, 2008 was expected to be Rs.37,500.

Solution:
Cash Budget
Period half-year ending: 30th June 2005
Months
Jan. Rs. Feb. Rs. Mar. Rs. Apr. Rs May Rs. June Rs.
Receipts:
Balance b/d 37,500 36,325 4,790 8,575 6,595 11,550
Cash realized from 25,000 30,000 20,000 25,000 30,000 35,000
debtors
Cash Available (A) 62,500 66,326 24,790 33,575 36,595 46,550
Payments:
Accounts Payable 10,000 15,000 10,000 15,000 17,500 20,000
(purchase)
Wages 2,100 2,175 2,375 2,575 2,775 2,975
Manufacturing Expenses 1,200 1,250 1,150 1,300 1,350 1,450
Administration Expenses 975 1,060 1,040 1,105 1,120 1,180
Selling Expenses 650 550 650 750 800 825
Sales Commission 1,250 1,500 1,000 1,250 1,500 1,750
Plant Purchased 10,000 - - - - -
Building Purchased - 40,000 - - - -
Dividend Paid - - - 5,000 - -
Cash Disbursements (B) 26,175 61,535 16,215 26,980 25,045 28,180
Closing Cash Balance (A 36,325 4,790 8,575 6,595 11,550 18,370
– B)

Calculation of wages:

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FINANCIAL MANAGEMENT 7.27

Delay in wages payment is 1/8 so the balance 7/8 will be realized in the same month.

Calculation for the month of Jan:

1/8 of the month of Dec. i.e. 1/8 (2800) = 350
7/8 of the month of Jan. i.e. 7/8 (2000) = 1750
Total = 2100

The same procedure is used for other months

Question 10
Two components X and Y are used as follows:
Normal usage 300 units per week
Maximum usage 450 units per week
Minimum usage 150 units per week

Reorder Quantity X – 2,000 units and Y – 4,000 units

Re-order Period X – 4 to 6 weeks and Y – 2 to 4 weeks

Calculate for each component —

(1) Re-order Level, (2) Maximum Level, (3) Minimum Level (4) Average Inventory.

Solution:
Component X Component Y
1) Reorder Level = Maximum Usage × = 450 × 6 = 450 × 4
Maximum Reorder Period = 2,700 units = 1,800 units
= 2,700 – (300 × 5) = 1,800 – (300 × 3)
2) Minimum Level = Reorder Level –
= 2,700 – 1,500 = 1,800 – 900
(Normal Usage × Average Delivery Period)
= 1,200 units = 900 units
= 2,700 + 2,000 – = 1,800 + 4,000 –
3) Maximum Level = Reorder Level +
(150 × 4) (150 × 2)
Reorder Quantity – (Minimum Usage ×
= 4,700 – 600 = 5,800 – 300
Minimum Delivery Period)
= 4,100 units = 5,500 units
= 1,200 + ½ of 2,000 = 900 + ½ of 4,000
= 1,200 + 1,000 = 900 + 2,000
= 2,200 units = 2,900 units
4) Average Inventory = Minimum Level + ½
of Reorder Quantity Or
Maximum Level + Minimum Level
2
= 2,650 units = 3,200 units

Question 11
Calculate the economic order quantity from the following information and also state the
number of orders to be placed in a year.

Consumption of materials per annum = 10,000 kgs.

Order Placing Cost Per Order = Rs.25

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FINANCIAL MANAGEMENT 7.28

Cost per kg. of raw material = Rs.2

Storage Costs = 4% on average inventory

Solution:
, , , , ,
EOQ = = = = = 62,50,000 = 2,500 Kgs

Number of order to be placed in a year =

= 10,000 / 2,500 kg. = 4 orders per year

Question 12
A manufacturer requires 1,000 units of a raw material per month. The ordering cost is Rs.15
per order. The carrying cost in addition to Rs.2 per unit is estimated to be 15% of the average
inventory per unit per year. The purchase price of the raw material is Rs.10 per unit. Find
economic lot size and total cost. The manufacturer is offered a 5% discount in purchase price
for orders of 2,000 units or more but less than 5,000 units. A further 2% discount is available
for orders of 5,000 units or more. Which of these three alternative ways of purchase he should
select?

Solution:
Annual Requirement R = 1,000 × 12 = 12,000 units
Purchase Price Per Unit P = Rs.10
Ordering Cost Cp = Rs.15 per order
Carrying Cost Ch = Rs.2 + P × 0.15 = Rs.2 + 10 × 0.15 = Rs.3.50

TIC at EOQ = Purchase Price + Ordering Costs + Carrying Costs

= (R x P) + ( x Cp) + ( x Ch )
= 1,20,000 + 561 + 561 = Rs.1,21,122

, ,
Total Cost at EOQ of 2,000 units = 12,000 x 9.50 + x 15 + x 3.425
,
= 1,14,000 + 90 + 3,425 = Rs.1,17,515

, ,
Total Cost at EOQ of 5,000 units = 12,000 x 9.30 + x 15 + x 3.395
,
= 1,11,600 + 36 + 8,487.50 = Rs.1,20,123.50

The manufacturer should opt the alternative of 5% discount and order for 2,000 units at each
time because at this option, the total inventory cost is the minimum.

Question 13
ABC Limited has 7 different items in its inventory. The average number of units in inventory
together with their average cost per unit is presented below. Suggest a break-down of the
items into ABC classification assuming that the Company wants to introduce ABC Inventory
System.

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FINANCIAL MANAGEMENT 7.29

Items (Nos.) Average number of units in inventory Average cost per unit (Rs.)
1 25,000 12
2 25,000 4
3 70,000 4
4 30,000 15
5 10,000 110
6 20,000 50
7 20,000 3

Solution:
Per Inventory Total Value
Unit Cumu Cumul
Item Total Categ
Cost Units % of Total lativ % of Total ative
Cost Rs. ory
(Rs) e% %
5 110 10,000 5 11,00,000 33.4
6 50 20,000 10 15% 15 10,00,000 30.4 63.8% 63.8 A
4 15 30,000 15 27.5% 42.5 4,50,000 13.7 22.8% 86.6 B
1 12 25,000 12.5 57.5% 100 3,00,000 9.1 13.4% 100 C
3 4 70,000 35 2,80,000 8.5
2 4 25,000 12.5 1,00,000 3.1
7 3 20,000 10 60,000 1.8
Total 2,00,000 100% 32,90,000 100%

Question 14
ABC Ltd. has present annual sales of 10,000 units at Rs.300 per unit. The variable cost is Rs.200
per unit and fixed costs amount to Rs.3,00,000 per annum. The present credit period allowed
by the company is 1 month. The company is considering a proposal to increase the credit
period to 2 months and 3 months and has made the following estimates:
Existing Proposed
Credit Policy 1 month 2 month 3 month
Increase in sales - 15% 30%
% of Bad Debts 1% 3% 5%

There will be increase in fixed cost by Rs.50,000 on account of increase of sales beyond 25%
of present level.
The company plans on a return of 20% on investment in receivables.
You are required to calculate existing and proposed net profit and also calculate most paying
credit policy for the company.

Solution:
Evaluation of Credit Policy of ABC Ltd.
Existing Policy Proposed Policy
Particulars
1 month 2 month 3 month

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FINANCIAL MANAGEMENT 7.30

(A) Sales (Units) 10,000 11,500 13,000

(B) Sale Proceeds 30,00,000 34,50,000 39,00,000
Variables cost @ Rs.200 p.u. 20,00,000 23,00,000 26,00,000
Contribution 10,00,000 11,50,000 13,00,000
Fixed Cost 3,00,000 3,00,000 3,50,000
(C) Net Margin 7,00,000 8,50,000 9,50,000
(D) Investment 1,91,667 4,33,333 7,37,500
(E) Expected Return on Receivables
38,333 86,667 1,47,500
at 20%
(F) Bad Debts 30,000 1,03,500 1,95,000
(G) Net Profit (C – E – F) 6,31,667 6,59,833 6,07,500
(H) Increase in Profits 28,167 -52,333

As, 2 months credit policy yields higher return, it should be adopted.

Working Notes:
Investment in receivables = x No. of months credit

1 month: 23,00,000 × 1/12 = Rs.1,91,667

2 months: 26,00,000 × 2/12 = Rs.4,33,333
3 months: 29,50,000 × 3/12 = Rs.7,37,500

Question 15
A trade whose current sales are Rs.6 lacs per annum and an average collection period of 30
days wants to pursue a more liberal credit policy to improve sales. A study made by a
management consultant reveals the following information:
Increase in collection Bad debt loss
Credit Policy Increase in Sales
period anticipated
A 10 days Rs.30,000 1.5%
B 20 days Rs.48,000 2.0%
C 30 days Rs.75,000 3.0%
D 45 days Rs.90,000 4.0%

The selling price per unit is Rs.3, average cost per unit is Rs.2.25 and variable cost per unit
is Rs.2. The current bad debt loss is 1%. Required return on average investment is 20%.
Assume 360 days in a year. Which of the above policies would you recommend for adoption?

Solution:
Evaluation of Credit Policy
Part I Existing Credit Policy
A B C D
Credit Period (Days) 30 40 50 60 75
Expected Additional Sales (Rs.) 30,000 48,000 75,000 90,000
Contribution on additional sales

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FINANCIAL MANAGEMENT 7.31

(One-third of selling price) 10,000 16,000 25,000 30,000

Bad Debts (Expected Sales ×
6,000 9,450 12,960 20,250 27,600
Default %)
Additional bad debts - 3,450 6,960 14,250 21,600
Contribution on additional sales
less
Additional bad debts (a) - 6,550 9,040 10,750 8,400
Part II
Expected Sales (Rs.) 6,00,000 52,222 66,944 83,333 1,06,250
Cost of Sales (Rs.) 4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
Receivables turnover ratio 12 9 7.2 6 4.8
Average investment in receivable
= Cost of Sales/Receivables 37,500 52,222 66,944 83,333 1,06,250
turnover
Additional investment in
- 14,722 29,444 45,833 68,750
receivables
Required return on average
- 2,944 5,889 9,167 13,750
investment at 20% (b)
Net Benefit (a – b) - 3,606 3,151 1,583 (5,350)

The net benefit (additional contribution over required return on additional investment in
receivables) is maximum under credit Policy A. Hence, Policy A is recommended for adoption
followed by B and C. Policy D cannot be adopted because it would result in the reduction of
the existing profits.

Question 16
ABC & XYZ Ltd. Plans to sell 30,000 units next year . The expected cost of goods sold is as
follows:
Rs. (per unit)
Raw Material 100
Manufacturing Expenses 30
Selling, Administration and Finance Expenses 20
Selling Price 200

The duration of various stages of the operating cycle is expected to be as follows:

Raw Material stage 2 months
Work-in-progress stage 1 month
Finished Goods stage 1/2 month
Debtors stage 1 month

Assuming the monthly sales level of 2500 units; estimate the gross working capital
requirements if the desired cash balance is 5% of the gross working capital requirements.

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Solution:
Statement of Gross Working Capital requirements
Current Assets Rs. Rs.
(i) Raw Material (2 months)
(Rs. 2,500 X 100 X 2) 5,00,000
(ii) Work-in-progress (1 month)
Raw Material (Rs. 2,500 X 100 X 1) 2,50,000
Mfg. Expenses (Rs. 2,500 X 30 X 1) 75,000 3,25,000
(iii) Finished Goods (1/2 month)
Raw Material (2500 X 100 X ½) 1,25,000
Mfg. Expenses (2500 X 30 X ½) 37,500 1,62,500
(iv) Debtors (1 month)
(2500 X 150 X 1) 3,75,000
(v) Cash 13,62,500
(5 % of gross working capital i.e. 13,62,500 X 5/95)
Gross Working Capital Required
71,711
14,34,211

Question 17
The following information has been extracted from the books of MNQ Limited:
Period beginning (₹) Period End (₹)
Raw Material Work in progress 1,00,000 70,000
Finished goods 1,40,000 2,00,000
2,30,000 2,70,000

Other Information for the year (₹)

Average Receivables 2,10,000 Wages and Overheads 17,50,000
Average Payables 3,14,000 3,20,000

Purchases 15,70,000 Selling expenses sales 42,00,000

All purchases and sales are on credit basis. The Company is willing to know-(a) Net Operating
Cycle Period, and (b) Annual of Working Capital Requirements. (Assume 360 days in year).

Solution:
Computation of Operating Cycle in days and WC Requirement
Component Numerator Denominator T/O ratio No. of
days
(3) = (1) ÷ (4) = 360
Column (1) (2)
(2) ÷ (3)
, , ,
Raw material consumed = =
1. RM stock 18.82 times 20 days
Opg. RM + Purchases – Clg. 85,000

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FINANCIAL MANAGEMENT 7.33

RM = 1,00,000 + 15,70,000 –
70,000 = 16,00,000
Factory cost = RM consumed
+ wages + POH + Opg. WIP = , , , ,
=
2. WIP stock 16,00,000 + 17,50,000 + 19.35 times 19 days
1,40,000 – 2,00,000 = 1,70,000
32,90,000
Cost of goods sold = Fy Cost
, , , ,
(=COP) + Opg Fg – Clg FG = =
3. FG stock 13 times 28 days
32,90,000 + 2,30,000 – 2,50,000
2,70,000 = 32,50,000
Credit sales given =
4. Debtors Given = 2,10,000 20 times 18 days
42,00,000
Credit purchases given =
5. Creditors Given = 3,14,000 5 times 72 days
15,70,000

So, Net operating cycle = 20 + 19 + 28 + 8 – 72 = 13 days

Hence, required net working capital = Projected sales x
= ₹ 42,00,000 x
= ₹ 1,51,667

Note: Debtors may also be taken on Total cost basis, rather than on sales value basis, if
profit related data is given.

Question 18
On 1st January, the board of Directors of Dowell Co. Ltd wishes to know the amount of Working
Capital that will be required to meet the activity programme they have planned for the year.

The following data is given-

1. Issued and Paid-up Capital of the Company is ₹ 2,00,000.
2. 5% Debentures (Secured on assets) ₹ 50,000.
3. Fixed Assets were valued at 1,25,000 on 31st December at the end of the year.
4. Production during the previous year was 60,000 units. It is planned that the same
level of activity should be maintained during the current year also.
5. The ratios of Costs to Selling Price are Materials- 60%, Wages 10%, and Overheads-20%.
6. Raw Materials are expected to remain in stores for an average of two months before they
are issued for production. Each unit of production is expected to be in process for one month.
7. Finished Goods will stay in the warehouse for approximately three months Trade Creditors
allow 2 months credit from the date of delivery of raw materials. The Company allows 3 months
credit to Debtors from the date. of dispatch.
8. Selling Price per unit is 5. There is a regular production and sales cycle.
9. The Company normally keeps cash in hand to the extent of ₹ 20,000.
10. Wages and Overheads are paid on the 1st of each month for the previous month.
Prepare- (1) Working Capital Requirement Forecast, (2) Projected P&L A/c for the year &
balance Sheet at the end of the year.

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Solution:
1. Statement of Working Capital Requirements (Total Approach)
Particulars Quantity Units Rate p.v. ₹
A. Current asset:
Raw materials Stock 60000 x 1 /12 = 10,000 RM Cost = 60% of 30,000
price = ₹5 x 60% = ₹
Work in progress stock 60000 x 1 /12 = 5,000 3.00 18,750

Finished goods stock 60000 x 3/12 = 15,000 67,500

Debtors 60000 x 3/12 = 15,000 75,000

Cash NA 20,000
Total 2,11,250
B. Current Liabilities; RM Cost = 60% of
Creditors 60000 x 2 /12 = 10,000 price = ₹5 x 60% = ₹
3.00
Wages payable 60000 x 1 /12 = 5,000 Labour cost= 10% of 2,500
price = ₹ 5 x 10% =
OH Payable 60000 x 1 /12 = 5,000 ₹0.50 5,000
OH cost = 20% of
price = ₹ 5 x 20% = ₹
1.00
Total 37,500
C. Net working Capital 1,73,750

2. Projected profit and loss account for the year ending 31 st December
Particulars p.u. ₹ ₹
Sales 60,000 units at ₹ 5 ₹ 5.00 3,00,000
Less: Cost of sales
Materials ₹ 3.00 1,80,000
Labour ₹ 0.50 30,000
Overheads ₹ 1.00 60,000 2,70,000
EBIT 30,000
Less: Interest on debentures 5% on ₹ 50,000 2,500
EBT 27,500

3. Projected Balance Sheet as on 31st December

Equity and liabilities ₹ Assets ₹
Share capital (given) 2,00,000 Fixed Assets (Given) 1,25,000
Reserve & surplus (Bal fig.) 21,250 Current Assets
Profit & loss (as above) 27,500 Raw materials (WN1) 30,000
5% Debentures (given) 50,000 Work in progress (WN1) 18,750
Sundry creditors (WN1) 30,000 Finished Goods (WN1) 67,500

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Wages payable (WN1) 2,500 Sundry Debtors (WN1) 75,000

OH payable (WN1) 5,000 Cash (given) 20,000
Total 3,36,250 Total 3,36,250

Question 19
MNO Ltd. a newly formed Company, has applied to the Private bank for the first time for
financing its Working Capital Requirements.
The following information are available about the projections for the current
year.
Estimated Level of activity Completed units of production 31,200 plus units of
work in progress 12,000
Raw material cost ₹ 40 per unit
Direct wages cost ₹ 15 per unit
Overhead ₹ 40 per unit(inclusive of depreciation ₹ 10 per unit)
Selling price ₹ 130 per unit
Raw material in stock Average 30 days consumption
Work in progress stock Material 100% and conversion cost 50%
Finished goods stock 24,000 units
Credit allowed by the suppliers 30 days
Credit allowed to purchasers 60 days
Direct wages (Lag in payment) 15 days
Expected cash balance ₹ 2,00,000

Assume that production is carried on evenly throughout the year (360 days) and wages and
overheads accrue similarly. All sales are on credit basis. You are required to calculate the
Net Working Capital Requirement on Cash Cost basis.

Solution:
Working Notes and Assumptions
1. Production Quantity p.a.
= 31,200 units (assumed per month) x 12 months= 3,74,400 units.
2. Sale Quantity p.a. Production Quantity (-) Closing Stock Quantity
= 3,74,400 - 24,000 3,50,400 units.
So, Debtors 3,50,400 x = 58,400 units
3. WIP Quantity of 12,000 units will remain throughout the period at the same level, since
partly completed output of a day/ week/ month, will be completed in the next day/ week/
month.
4. Quantity for which Raw Material Consumed p.a. = For Production 3,74,400 units + Closing
WIP (RM fully complete) 12,000 units = Total 3,86,400 units.
So, Raw material stockholding = 3,86,400 x = 32,200 units.
5. Raw Material Purchase Quantity p.a. Consumption Quantity (+) Closing Stock of raw
material = 3,86,400 + 32,200-4,18,600 units.
So, Creditors= 4,18,600 x = 34,883 units.

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6. Quantity for Wages Payable = [Production 3,74,400 units + WIP Stock (Wages 50%) 6,000
units) x = 15,800 units.
7. Depreciation is not included in the cost of WIP & Finished Goods or in Debtors since it is
not a cash expenditure.
8. Assumed that cash expense in OH is paid immediately, and hence there is no payable or
prepaid OH expense.

Statement of Working Capital Requirements (Cash Cost Approach)

Particulars Quantity units Rate p.u. ₹
A Current Assets:
Raw materials stock (WN4) 32,000 Given RM cost = ₹40 12,88,000
WIP stock (given + WN3) RM cost + 50% of labours & 7,50,000
OH excl. dep. = ₹40 + 50% of
[15 + (40 – 10)] = ₹ 62.50
Finished goods 12,000 ₹ 40 + ₹15 + (40 – 10) = ₹ 85 20,40,000
Debtors (given) 24,000 ₹ 40 + ₹15 + (40 – 10) = ₹ 85 49,64,000
Cash & bank balance 58,400 given 2,00,000
Total 92,42,000
B current liabilities:
Creditors (WN5) 34,883 Given RM cost = ₹ 40 13,95,320
Wages payable (WN6) 15,850 Wages cost = ₹ 15 2,37,750
Total 16,33,070
C net
Working capital 76,08,930

Alternative Approach: WN1: Computation of cost of production and cost of sales (on cash cost
basis)
Particulars ₹
Direct material cost [(31,200 units x ₹40) + (12,000 units x ₹40)] 17,28,000
Direct labour cost [(31,200 units x ₹15) + (12,000 units x ₹15 x 50%)] 5,58,000
Overheads excluding depreciation [(31,200 units x ₹30) + (12,000 units x 11,16,000
₹30 x 50%)]
Gross factory cost 34,02,000
Less: closing stock of WIP = 12,000 units x [materials ₹40 + labour ₹15 x (7,50,000)
50% + OH ₹30 x 50%]
Cost of production (for 31,200 units) 26,52,000
Less: closing stock of finished goods (for 24,000 units) = 26,52,000 x
, (20,40,000)
,
Cost of sales 6,12,000

WN2: Statement of working capital requirement (Cash cost approach)

A current assets: Rate p.u. ₹
(a) Raw materials stock From WN1 17,28,000 x 1,44,000

(b) WIP stock As per WN1 above 7,50,000

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FINANCIAL MANAGEMENT 7.37

(c) finished goods As per WN1 above 20,40,000

(d) debtors From WN1 6,12,000 x 1,02,000

(e) Cash & bank balances Given 2,00,000

Total 32,36,000

Particulars Rate p.u. ₹

B. Current liabilities:
(a) Creditors for purchases (Consumption 17,28,000 + closing RM 1,56,000
1,44,000) x
(b) Wages payable 23,250
From WN1 15,58,000 x
Total 1,79,250
C. Net working capital 30,56,750

Question 20
XYZ Ltd has started business in the current financial year and has provided the under
mentioned projected P&L A/c :
Sales ₹ 10,00,000
Less: Cost of goods Sold (as computed below) ₹ 6,12,000
Gross profit ₹ 3,88,000
Less: Administrative expenses ₹72,000
Selling expenses ₹60,000
₹ 1,32,000

Cost of goods sold has been derived as follow:

Material consumed 3,60,000
Wages and manufacturing expenses 2,40,000
Depreciation 1,20,000
Total cost of production 7,20,000
Less: Stock of finished goods (15% of goods produced not yet sold) 1,08,000
Cost of gold sold 6,12,000

There is no WIP and no opening stock of Raw Material and Finished Goods. The Company
believes in keeping materials equal to three months' consumption in Stock. All expenses will be
paid one in arrear, suppliers of material will extend 2 months credit, sales will be 50% for
cash, rest at 1 months credit. The company wishes to keep 50,000 in cash.
You are required to prepare an estimate of the requirements of working Capital on the basis
of estimates on cash cost basis. Assume no taxes.

Solution:
Statement of working capital requirements on cash cost basis
Particulars ₹
A. Current assets:
90,000

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FINANCIAL MANAGEMENT 7.38

Raw materials stock = based on RM for cost of product (₹3,60,000 x

) 90,000
Finished goods stock = 15% of COP = 10% of (RM 3,60,000 + Wages &
26,750
POH 2,40,000)
50,000
Debtors (WN1)
Cash in hand (given)
Total 2,56,750
B. Current liabilities
Sundry creditors purchases x = (usage 3,60,000 + closing RM 75,000

90,000) x 31,000
Outstanding expenses (wages etc. 2,40,000 + AOH , SOH 1,32,000) x
Total 1,06,000
C. Net working capital 1,50,750

WN: Debtors
Debtors on sales value basis = 10,00,000 x 50% Credit x ₹ 41,667

Dep. Included in the above = 1,20,000 x 85% x 50% x (85% is taken, ₹ 4,250
since 15% of production is in FG)
Profit included in above = 2,56,000 x 50% x ₹ 10,667

Cash cost component of debtors ₹ 26,750

Question 21
PQR Ltd haying an annual sale of ₹30 Lakhs is re-considering its present collection policy. At
present the Average Collection period is 50 days and the bad Debt Losses are 5% of Sale. The
Company is incurring an expenditure of ₹30000 an account of collection of receivables.

The alternative policies are given below. Evaluate them based on increment Approach and
state which is more beneficial.
Particulars Alternative I Alternative II
Average collection period 40 days 30 days
Bad debt losses 4% of sales 3% of sales
Collection expenses ₹ 60,000 ₹ 95,000

Solution:
Particulars Present Alternative I Alternative II
1. Sales 30,00,000 30,00,000 30,00,000
2. Collection Expenses 30,000 60,000 95,000
3. Bad debt (on sales)(5%, 4%, 3%) 1,50,000 1,20,000 90,000
4. Collection period (in days) 50 40 30
5. Average Debtors (sales x ) 4,10,959 3,28,726 2,46,575

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FINANCIAL MANAGEMENT 7.39

6. Interest on average debtors (assumed 41,096 32,877 24,658

at 10%)
7. Total costs (2+3+6) 2,21,096 2,12,877 2,09,658
8. Incremental benefits (based on line 7 - 8,219 11,438
above)

Note: Since the Rate of Return on investment has not been specified in the question, it is
assumed at 10% in the above

Conclusion: From the above table, by comparing Cost, Alternative 2 is more beneficial.

Question 22
The following information has been extracted from the records of a company.
Prepare a statement showing the working capital requirement of the company. The company
is poised for a manufacture of 1,44,000 units in the year.
Products cost sheet ₹ per unit
Raw material 45
Direct labor 20
Overhead 40
Total cost 105
Add: Profit 15
Selling price 120

Additional information:
1.Raw materials are in stock on an average of two months.
2. The material are in process on an average for 4 weeks. The degree pf completion is 50%.
3.Finished goods stock on an average is for one month.
4. Time lag in payment of wages and overhead is 1.5 weeks.
5.20% of the output is sold against cash. Time lag in receipt of proceeds from debtors is 2
months.
6. Credit allowed by suppliers is one month.
7. The company expects to keep a cash balance of ₹ 1,00,000.
8. Take 52 weeks per annum.

Solution:
Statement of working capital requirements (total approach)
Particular Quantity Rate p.u ₹
A. Current assets
B. Raw materials stock 1, 44,000 x 2/12= RM cost ₹45 10,80,000
24,000 units
WIP stock (see note 2) 1,44,000 x 4/52 = 50% of total cost 5,81,538
11,077 units 105 = ₹ 52.50
Finished goods stock 1,44,000 x 1/12 = Total cost ₹ 105 12,60,000
12,000 units

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FINANCIAL MANAGEMENT 7.40

Debtors 1,44,000 x 80% x 2/12 Sale price ₹ 120 23,04,000

= 19,200
Cash & bank Given 1,00,000
Total 53,25,538
b. Current liabilities
Creditors (note 1) 1,44,000 x 1/12 = RM cost ₹ 45 5,40,000
12,000 units
Wages payable 1,44,000 x 1,5/52 = Labor cost ₹ 20 83,077
4,154 units
OH payable 1,44,000 x 1.5/52 = OH cost ₹ 40 1,66,154
4,154 units
Total 7,89,231
C. Net working capital (A-B) 45.36,307

NOTE 1: Alternatively, the following quantity computations may also be adopted-

a) Total purchase quantity of RM = RM consumed for production 1,44,000 + RM stockholding
24,000 + RM include in WIP stock 11,077 1,79,077 units. Hence, creditors quantity 1,79,077 x
1/12-14,923 units.
b) Quantity for which wages & OH incurred wages for production 1,44,000 + wages for WIP
stock 11,077 1,55,077 units. So, quantity for wages & OH payable 1,55,077 x 1.5/52 = 4,473 units.

NOTE 2: WIP is taken 50% of total cost, as per the language used in the question. Alternatively,
it can be treated as material fully issued + conversion 50% complete.

Question 23
The following annual figures relate to MNP limited-
Sales at 3 months credit ₹ 90,00,000
Materials consumed (suppliers extend one and half Months credit) ₹ 22,50,000
Wages paid 1 Month in arrear ₹ 18,00,000
Manufacturing expenses outstanding at the end of the year (cash ₹ 2,00,000
expenses are paid 1 month 1 in arrear)
Total administrative expenses for the year (cash expenses are paid 1 ₹ 6,00,000
Month in arrear)
Sales promotion expenses for the year (paid quarterly in advance) ₹ 12,00,000

The company sells its products on gross profit of 25% assuming depreciation as part of the
cost of production. It keeps two months stock of finished goods & 1 month’s stock of Raw
materials as inventory. It keeps a cash balance of 2,50,000.

Assume 5% safety margin. Work out the working capital requirements of the company on cost
basis, Ignore WIP.

Solution:
Trading & P&L Account for the year (to compute depreciation & net profit)

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FINANCIAL MANAGEMENT 7.41

Particulars ₹ Particulars ₹
To Materials consumed 22,50,000 By sales 90,00,000
To wages 18,00,000
To Manufacturing exps: (cash 24,00,000
expenses ₹ 2,00,000 x 12)
To depreciation 3,00,000
To gross profit 22,50,000
Total 90,00,000 Total 90,00,000
To administration 6,00,000 By gross profit b/d 22,50,000
To sales promotion expense 12,00,000
To net profit (Bal fig) 4,50,000
Total 22,50,000 Total 22,50,000

Statement of working capital requirements (cash cost approach)

Particulars Computation ₹
A. Current assets
Raw Material stack (based on RM ₹ 22,50,000 x 1/12 1,87,500
consumed)
Finished goods stock (based on cash (₹ 22,50,000 + ₹ 18,00,000 + ₹ 10,75,000
COP) 24,00,000) x 2/12
Debtors (based on sales less profit & (₹ 90,00,000 - ₹ 4,50,000 - ₹ 20,62,500
dep 3,00,000) x 3/12
Prepaid sales promotion ₹ 12,00,000/4 3,00,000
expenses(given)
Cash & bank balance (given) 2,50,000
Total 38,75,000
B. Current liabilities
Creditors (based on RM consumed) ₹ 22,50,000 x 1.5/12 2,81,250
Wages payable (given) ₹ 18,00,000 x 1/12. 1,50,000
Manufacturing OH payable (given) Amount given in question 2,00,000
Administration OH payable (given) ₹ 6,00,000 x 1/12 50,000
Total 6,81,250
C. Net working capital A-B 31,93,750
D. Safety Margin 5% PN ₹ 31,93,750 1,59,688
E. Required working capital C+D 33,53,438

Question 24
Marvel limited uses a large quantity of salt in its production process. Annual consumption is
60,000 tonnes over 50 weeks working year. It costs ₹100 to initiate and process an order &
delivery follow two week later. Storage costs for the salt are estimated at 10 paise per tonne
per annum. The current practices is to order twice a year when the stock fails to 10,000 tones.
Recommend an appropriate ordering policy for marvel limited, and contrast It with the cost
of the current policy.

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Solution:

ECQ =

A = requirement of Raw materials = 60,000 tones

B = buying cost per order = ₹ 100 per lot
C = carrying cost per unit annum = ₹ 0.10 per tonne, p.a

On substituting, ECQ = 10,954 tonnes.

Cost of comparison of EOQ with 3 months consumption purchase Policy (quarterly purchase).
Particulars EOQ Current policy
a. Quantity ordered every time (Q) 10,945 times 60,000 x 2/12 = 30,000
tonnes
b. Number of orders p.a. = A/Q 60,000 =
. 2 orders
,
c. Buying cost p.a. at ₹ 100 5,477 x ₹100 = ₹547.70 2 x ₹ 100 = ₹ 200
d. Average inventory = ½ of a ½ x 10,954 = 547.70 ½ x 30,000 + 7,600 =
22,600 tonnes
e. Carrying cost p.a. at ₹0.10 5,477 x ₹ 0.10 = ₹ 22,600 x ₹ 0.10 = ₹
547.70 2,260
f. Associated costs p.a. = c + e ₹ 1,059.40 ₹ 2,460.00

Hence, cost saved by ordering at ECQ lots every time₹2,460.00 - ₹1,095.40

= 1,364.60 p.a.

Note-
Lead time consumption = 60,000 x 2/50 2,400 tonnes
Before delivery inventory has failed to 10,000 tonnes – 2,400 tonnes = 7,600
tonnes
Order are made twice per year 60,000/2 = 30,000 tonnes

Question 25
A Trader whose current Sales are x4,20,000 per annum and an Average collection Period of
30 days, wants to pursue a more liberal policy to improve sales. A study made by a Management
Consultant reveals the following Information:
Credit policy Increase in collection Increase in sales Present default
period anticipated
I 10 days ₹ 21,000 1.5%
II 30 days ₹ 52,000 3%
III 45 days ₹ 63,000 4%

The Selling Price per unit is ₹3. Average Cost per unit is ₹2.25 and Variable Cost per unit ₹2.
The current bad- Debt Loss is 1%. Required on Additional Investment is 20%. Assume a 360
days year.
Which of the above policies would you recommend for adoption?

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Solution:
Evaluation of Alternative Credit Policies( Amount in)
Particular Present Policy I Policy II Policy III
1. Sales 4,20,000 4,41,000 4,72,500 4,83,000
2. Variable cost at 2/3 rd
2,80,000 2,94,000 3,15,000 3,22,000
3. Contribution (1 – 2) 1,40,000 1,40,000 1,57,500 1,61,000
4. Fixed cost 35,000 35,000 35,000 35,000
5. Profit (3 – 4) 1,05,000 1,05,000 1,22,500 1,26,000
6. Cost of debtors p.a. = total cost 3,15,000 3,15,000 3,50,000 3,57,000
=2+4
7. Collection period 30 days 30 days 60 days 75 days
8. Average debtors = 26,250 26,250 58,333 74,375

9. Interest on avg debtors (8 x 5,250 5,250 11,667 14,875

20%)
10. Bad debt 4,200 4,200 14,175 19,320
11. Net benefit (5 – 9 – 10) 95,550 95,550 96,658 91,805

, ,
Note: present sale quantity = = 1,40,000 units.
. .
Also, fixed cost p.u. = total costs 2.25 less variable costs =₹ 0.25 pu. Hence, total fixed cost at
present = 1,40,000 x 0.25 = ₹35,000, which remains constant.

Conclusion:
Policy, I gives maximum net benefit and may be chosen (I rank)
Policy II gives net benefit higher than present situation, and may be preferred as II rank
Policy III should not be pursued at all, since the net benefit is lower than the present
situation.

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SECURITY ANALYSIS
INTRODUCTION
Topic Details
Commitment of money/resources in the present with
Definition of Investment
expectation of future benefits (Zvi Bodie, 2016).
Nature of Investment Foregoing current consumption for future benefits.
Forms of Investment Can be in any form – jewellery, commodities, real estate, etc.
Emphasis on financial assets like equity shares, bonds,
Focus of the Section
debentures.
Financial assets: Indirect/paper claims (e.g., equity, debt).
Financial vs. Real Assets Real assets: Tangible assets used in production (e.g., land,
machines).
A debt/equity instrument issued by a firm to raise funds for
What is a Security?
short or long term needs.
Why Financial Assets Are Due to liquidity and marketability, making them easier to trade
Attractive and exit in active markets.
- Asset class to invest in (e.g., shares, bonds, bullion).
Investor’s Key Decisions - Time horizon.
- Balancing expected return and risk appetite.
To explain securities and investment options available in the
Purpose of Chapter
Indian securities market.

WHAT ARE SECURITIES

Section Details
Instruments issued by fund seekers to fund providers in exchange
Definition of
for capital. Provide ownership and rights to benefits and
Securities
redemption.
1. Debt Securities
Types of Securities
2. Equity Securities
Securities include:
(i) Shares, scrips, stocks, bonds, debentures, etc.
(ia) Derivatives
Legal Definition (ib) Units from collective investment schemes
(Section 2(h), SCRA, (ic) Security receipts (as per SARFAESI Act, 2002)
1956) (id) Mutual fund units
(ii) Government securities
(iia) Instruments declared as securities by Central Govt.
(iii) Rights or interests in securities
Employment of funds in assets to earn income or capital
Definition of
appreciation. Involves sacrifice of present consumption with an
Investment
uncertain return in the future.
Key Attributes of 1. Time
Investment 2. Risk

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- Return comparison
Investor’s Decision- - Risk evaluation
Making Factors - Time horizon
- Personal risk profile
Three Investment
Objectives
Certainty of principal return is vital. Examples of secure
Security
instruments: Treasury bonds, T-bills, CDs, municipal and govt. bonds.
Ability to convert investment to cash without loss or delay. Highly
Liquidity liquid examples: common stock, some bonds. Less liquid: non-
tradable bonds, money market instruments with fixed terms.
Net return on investment. Should match investor expectations
Yield considering security and liquidity. A low yield may discourage
investment.

Investment vs. Speculation

Basis for Investment Speculation

Comparison
Purchase of assets with the Risky financial transactions
Definition
expectation of returns over time. aiming for large profits.
Fundamental analysis (e.g. company Hearsay, rumours, market
Decision Basis
performance). psychology, technical charts.
Time Horizon Long term. Short term.
Risk Level Moderate. High.
Profit from intrinsic value Profit from short-term price
Profit Intent
appreciation. changes.
Expected Modest and steady. High and often uncertain.
Returns
Source of Funds Own capital. Often borrowed funds.
Income Stability Stable and regular. Erratic and unpredictable.
Participant Conservative, cautious. Daring, sometimes reckless.
Behaviour

Investment vs. Gambling

Basis for Investment Gambling

Comparison
Planning Horizon Long term. Short term or instant.
Informed, research-based Based on chance, tips, rumours.
Decision Basis
analysis.
Structured, planned activity. Unpredictable, unstructured
Nature
activity.
Type of Risk Commercial (calculated). Artificial (chance-based).
Risk-adjusted returns. Pre-determined or negative
Return Expectation
returns.

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Wealth creation, capital Entertainment, thrill-seeking.

Primary Motive
protection.

SECURITY ANALYSIS

Section Key Points

Security analysis is the first step in investment decision-making. It
Definition determines a security's value to guide appropriate investment
decisions.
Approaches Two major types: Fundamental Analysis and Technical Analysis.
a) Economy Analysis
Fundamental
b) Industry Level Analysis
Analysis Levels
c) Company Analysis

Analysis of the Economy

Factor Description
Represents growth rate of economy via aggregate value of
GDP
goods/services. Higher GDP = better investment climate.
Savings & Growth needs investment, which depends on savings. Stock market
Investment channels savings to corporates.
High inflation reduces real growth and affects demand. Mild inflation
Inflation
benefits stock market; high inflation harms it.
Lower interest = lower financing cost = higher profitability. Encourages
Interest Rates
speculation and share price rise.
Deficit budget = higher inflation; Surplus = deflation. Balanced budget is
Budget
ideal for stock market.
Tax incentives promote industry-specific investment and encourage
Tax Structure
overall savings.
Includes balance of payment, monsoon, agriculture, infrastructure, and
Other Factors
demographics.

Industry Level Analysis

Point Description
Analyses specific industry: structure, economic significance, life
Focus
cycle stage, entry/exit barriers.
Group of units with similar end-products and market. Share similar
Industry
opportunities and challenges.
Pioneering Stage: New products, high profit, tech development,
attracts competition.
Industry Life Cycle Expansion Stage: Growth slows, stable prices/production, easy
Stages capital availability.
Stagnation Stage: Growth halts, no innovation, external/internal
capital reduces.

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Company Analysis

Point Description
Forecasting Analysis uses economy and industry forecasts to evaluate specific
Focus companies.
Internal Financial statements (income, balance sheet, cash flow) are primary
Information sources. Must be complete, accurate, comparable.
External Overcomes internal bias. Includes public pronouncements and third-
Information party sources.
Traditional Price-earnings ratio, dividend forecasting — best for short-term
Techniques analysis.
Modern Regression, trend/correlation analysis, decision trees, simulations —
Techniques improve on traditional limitations.

Financial Analysis Tool

Ratio Formula Explanation

Fundamental EPS (Earnings Per Net Income / Outstanding Measures profitability
Analysis Tools Share) Shares per share.
P/E (Price to Price per Share / Shows market valuation
Earnings) Earnings per Share relative to earnings.
Considers future
PEG (Price to P/E Ratio / Earnings per
earnings growth along
Earnings Growth) Share Growth
with P/E ratio.
P/S (Price to Market Capitalization / Values stock based on
Sales) Net Sales revenue.
P/B (Price to Price per Share / Book Market value vs. book
Book) Value per Share value comparison.
Annual Dividends per Return from dividends
Dividend Yield
Share / Price per Share relative to share price.
Dividend Payout Portion of earnings paid
Dividends / Net Income
Ratio as dividends.
Book Value per Total Equity / Outstanding Net asset value per
Share Shares share.
ROE (Return on Net Income / Profitability relative to
Equity) Shareholder’s Equity x 100 shareholder equity.
Ratio Analysis Liquidity Ratios
Current Assets / Current Measures ability to pay
Current Ratio
Liabilities short-term obligations.
(Current Assets - Measures liquidity using
Acid-Test (Quick)
Inventories) / Current only the most liquid
Ratio
Liabilities assets.
Turnover Ratios
Measures how often
Inventory COGS / Average
inventory is sold and
Turnover Inventory
replaced.

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Net Credit Sales /

Receivables Measures efficiency in
Average Accounts
Turnover collecting receivables.
Receivable
Efficiency of utilizing
Capital Employed Net Sales / Average
capital to generate
Turnover Capital Employed
sales.
Working Capital Net Sales / Working Efficiency of using
Turnover Capital working capital.
Measures asset
Net Sales / Average Total
Asset Turnover utilization to generate
Assets
sales.
Leverage Ratios
Debt-to-Assets Measures the portion of
Total Debt / Total Assets
Ratio assets financed by debt.
Measures the proportion
Debt-to-Equity
Total Debt / Total Equity of debt vs. equity used in
Ratio
financing.
Debt-to- Total Debt / (Debt + Measures debt’s share in
Capitalization Equity + Others) overall capital structure.
(Total Debt - Cash) / Adjusts debt by cash for
Net Debt-to-
(Debt + Equity + Others - a more accurate debt-
Capitalization
Cash) to-capital ratio.
Measures sensitivity of
Operating (Sales - Variable Costs) /
operating profit to
Leverage (DOL) Operating Profit
changes in sales.
Measures sensitivity of
Financial earnings per share to
EBIT / EBT
Leverage (DFL) changes in operating
income.
Profitability
Ratios
Gross Profit Gross Profit / Net Sales x Percentage of sales
Margin 100 remaining after COGS.
Percentage of sales
Operating Profit Operating Profit / Net
after operating
Margin Sales x 100
expenses.
Net Income / Net Sales x Measures profitability as
Net Profit Margin
100 a percentage of revenue.
Measures how well equity
ROE (Return on Net Profit after Taxes /
is used to generate
Equity) Shareholder’s Equity x 100
profits.
ROA (Return on Net Profit after Taxes / Measures profitability
Assets) Total Assets x 100 relative to total assets.
ROCE (Return on Measures return on both
EBIT / Capital Employed
Capital Employed) debt and equity.
Coverage Ratios

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Interest Operating Income / Measures ability to pay

Coverage Ratio Interest Expense interest on debt.
Debt Service Operating Income / Total Measures ability to cover
Coverage Ratio Debt Service all debt obligations.
Measures ability to pay
Cash Coverage Total Cash / Interest
interest with available
Ratio Expense
cash.
(Total Assets - Intangible
Measures ability to pay
Asset Coverage Assets - Current
debt with tangible
Ratio Liabilities) / Interest
assets.
Expense
Valuation Ratios
Shows the price
Price per Share / investors are willing to
P/E Ratio
Earnings per Share pay for each unit of
earnings.
Price per Share / Book Compares market price
P/B Ratio
Value per Share with book value.
Indicates how much
Market Capitalization / investors are willing to
P/S Ratio
Net Sales pay for each dollar of
sales.
Market Capitalization / Compares stock price to
P/CF Ratio
Operating Cash Flow operating cash flow.
Adjusts P/E ratio for
P/E Ratio / Earnings per
PEG Ratio projected earnings
Share Growth
growth.

Financial Description Advantages Disadvantages

Analysis Tool
Provides time
perspective by - Helps in trend - Can be misleading if
Comparative comparing balance analysis. historical data is
Financial sheet figures over - Identifies inconsistent.
Statements multiple years, either in growth/decline over - Doesn't reveal detailed
absolute terms or time. financial movements.
percentages.
- Highlights growth
Uses a base year for trends over multiple - May miss underlying
comparison to evaluate periods. factors causing trends.
Trend Analysis
growth or decline in - Offers insights into - Needs careful
sales, profits, etc. the company’s interpretation of data.
direction.

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Financial statements - Lacks standardized

- Makes it easier to
expressed as ratios, leading to
compare companies
Common Size percentages of a potential
and analyze trends.
Statement common figure, e.g., misinterpretations.
- Provides clarity on
total sales or total - Limited by
relative sizes.
assets. comparisons.
- Helps evaluate a
Expresses balance company’s leverage - Doesn't highlight the
sheet items as a and asset actual dollar value
Common Size
percentage of total management. changes.
Balance Sheet
assets, helping analyse - Useful for - Might not account for
capital structure. comparing industry sector-specific details.
norms.
- Easier comparison - Lacks industry
Expresses income
across companies. benchmarks for
Common Size statement items as a
- Identifies meaningful comparison.
Income percentage of total
operational - Limited value in
Statement sales, aiding margin
efficiency and companies with varying
analysis.
profitability trends. business models.
- Highlights how funds
are utilized in - Doesn’t provide real-
Focuses on the
operations, time operational cash
Fund Flow movement of funds and
dividends, and debt flow details.
Analysis changes in financial
repayments. - Requires accurate
position over time.
- Clarifies long-term historical data.
financing decisions.
- Provides insight
- Doesn’t reflect non-
Shows the inflows and into actual cash
cash transactions.
outflows of cash, position.
Cash Flow - Can be affected by
helping analyse the - Helps assess
Statement accounting methods
liquidity and financial liquidity and
(e.g., accrual vs. cash
health of a company. operational
accounting).
efficiency.

TECHNICAL ANALYSIS

Topic Description
Forecasts the direction of stock prices by studying past market data,
Definition of
primarily price and volume. It assumes market prices are determined
Technical Analysis
by supply-demand equilibrium.
1. Prices are determined by demand and supply.
2. Supply and demand are influenced by rational and irrational
factors.
Key Assumptions
3. Stock prices move in trends.
4. Trends change due to shifts in demand and supply.
5. Chart patterns tend to repeat.

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6. Markets behave randomly but follow repeatable patterns.

7. All relevant information is reflected in market prices.
1. Price Charts: Line, Bar, and Candlestick charts.
2. Moving Averages: Simple Moving Average (SMA) and Exponential
Key Tools in Moving Average (EMA).
Technical Analysis 3. Support and Resistance: Levels where trends pause or reverse.
4. Indicators and Oscillators: e.g., RSI, MACD, Bollinger Bands.
5. Volume: Measures the strength of price movements.
1. Flexible and can be applied to different time frames.
Advantages 2. Provides clear signals for trading decisions.
3. Objective and based on historical data.
1. Predictions are not always accurate.
2. Does not consider fundamental factors like company health or
Limitations
market sentiment.
3. More suitable for short-term trading.
Technical analysis helps forecast price movements but should be used
Conclusion
alongside fundamental analysis for comprehensive decision-making.

DOW JONES THEORY

Topic Description
Formulated by Charles H. Dow, the first editor of the Wall Street Journal
Origin
(USA).
Share prices follow a pattern over 4-5 years, divided into three cyclical
Key Concept
trends: Primary, Secondary (Intermediate), and Minor.
- Duration: 1 to 3 years.
- Movement: Can be upward (bullish) or downward (bearish).
Primary - Importance: The most significant trend, impacting secondary and minor
Trends trends.
- Bullish Phase: After each peak, the rise reaches a higher level.
- Bearish Phase: After each fall, the subsequent fall is sharper.
- Duration: 3 weeks to 3 months.
- Movement: Moves in the opposite direction of the primary trend, acting
as a correction.
Secondary
- Example: In a bullish phase, there are secondary downward trends. In a
Trends
bearish phase, there are secondary upward trends.
- Retracement: Typically ranges from one-third to two-thirds of the
primary trend’s movement.
- Duration: Less than 3 weeks.
- Movement: Short-term changes occurring within a narrow range.
Minor Trends
- Role: Typically corrective movements within secondary trends, not
indicative of major market movements.

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In a bullish phase, after each peak, there is a fall but the subsequent rise is higher than the
previous one. The prices reach higher level with each rise. After the peak has been reached,
the primary trend now turns to a bearish phase.

In a bearish phase, the overall trend is that of decline in share values. After each fall, there
is slight rise but the subsequent fall is even sharper.

TOOLS OF TECHNICAL ANALYSIS

Tool Description Graph

Used to plot prices and trading
volumes, predicting future price
1. Technical
movements based on demand-
Charts
supply dynamics. Includes different
types of charts.

A simple chart connecting closing

- Line Chart prices over a period, useful for
long-term trend analysis.

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Shows open, high, low, and close

for each period with vertical lines
representing price range. The bar
- Bar Chart
is shaded based on price
movement (black for rising, red for
falling).

Similar to bar charts but with

- Candlestick wider rectangles for open-close
Chart prices, with different colors (red
for falling, white for rising).

Focuses on price changes only,

- Point & ignoring time and volume. X's
Figure Chart represent rising prices, and O's
represent falling prices.

Patterns in Various patterns help predict

Charts price movements:
Support level: price can't go below
this level, Resistance level: price
- Support and
can't go above this level. Breaching
Resistance
these levels signals a new phase
(bull or bear).

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A pattern where a "head" is

- Heads and formed with two "shoulders" on
Shoulders either side. A reversal is expected
at the neckline.

- Triangle/Coil Indicates uncertainty; difficult to

Formation predict breakout direction.

- Double Top A bearish pattern suggesting the

Formation price will fall.

- Double
A bullish pattern suggesting the
Bottom
price will rise.
Formation

- Interpretation is subjective.
- Frequent short-term changes
Limitations of
lead to conflicting analyses.
Charts
- Often ignores other important
factors.

2. Technical Indicators based on stock prices used to support analysis. Some

Indicators common indicators:
- Advance- The ratio of stocks advancing vs. those declining. A ratio > 1 signals a
Decline Ratio bullish trend; a decline signals a trend change.
- Market Variation of Advance-Decline Ratio, showing the difference between
Breadth Index stocks rising and falling. Rising breadth confirms a bullish trend.
An average of stock prices over a set number of days (e.g., 50-day
- Moving
moving average). It helps identify future price direction. A price
Averages
above the moving average indicates limited upside.
- Relative A momentum indicator measuring price changes to evaluate
Strength Index overbought/oversold conditions. RSI > 70 is overbought (sell), RSI < 30
(RSI) is oversold (buy).

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Measures the strength of uptrends and downtrends by tracking the

- Aroon
time since the last highs and lows. Aroon Up > 50 indicates strong
Indicator
uptrend, Aroon Down > 50 signals strong downtrend.
Measures the percentage change in price between the current price
- Price Rate of
and a previous price. ROC > 0 confirms uptrend, ROC < 0 confirms
Change (ROC)
downtrend.

RISK AND ITS TYPES

Type of Risk Description

Risks that are external, uncontrollable, and affect a large number of
Systematic Risk organizations within a specific domain or sector. Cannot be
mitigated by an organization.
The risk of changes in the value of debt securities due to
- Interest Rate Risk fluctuations in market interest rates. Affects fixed-rate debt
securities.
Associated with fluctuations in the trading prices of securities.
- Market Risk Affected by overall stock market movements (rises and falls in share
prices).
Risk arising from the decrease in purchasing power due to inflation.
- Purchasing Power
It reduces the value of returns and makes investing in securities
or Inflation Risk
less desirable during inflationary periods.
Risks that arise from internal factors within a specific organization
Unsystematic Risk or industry. These risks are controllable and can be mitigated by
the organization.
Arises from changes in business conditions, economic cycles,
- Business or
technological changes, or other factors affecting the operations
Liquidity Risk
and liquidity of a company.
Arises due to changes in the company's capital structure (e.g.,
- Financial or Credit
changes in debt or equity financing). Affects the company’s ability
Risk
to meet financial obligations.

RETURN OF THE SECURITY

Concept Description
The reward for undertaking investment, representing the income and
Return
capital appreciation/depreciation generated from holding a security.
1. Current Return: Periodic income (e.g., dividends, interest) from the
Components of
investment. Calculated as periodic income relative to the investment's
Return
beginning price.
2. Capital Return: The price change (appreciation or depreciation) of
the asset. Calculated as the change in price divided by the beginning
price.
The sum of the current return and capital return: Total return = Current
Total Return
return + Capital return.

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Measuring Total return or Holding Period Return (HPR) is a measure of the return
Return achieved from holding an asset over a specific period.
HPR = (Income + (End of Period Value – Initial Value)) / Initial Value.
Holding Period
This measures total return over the holding period, expressed as a
Return (HPR)
percentage.
Annualized HPR is calculated to normalize returns over multiple years:
Annualized HPR Annualized HPR = {[(Income + (End of Period Value – Initial Value)] /
Initial Value + 1}^(1/n) – 1, where n is the number of years.
Converting (1 + HPR) = (1 + r1) × (1 + r2) × (1 + r3) × (1 + r4), where r1, r2, r3, and r4
Periodic are periodic returns. This formula converts periodic returns into a total
Returns holding period return.

APPROACHES TO VALUATION OF SECURITY

Approach Description
The fundamentalists believe every stock has an intrinsic value. The
intrinsic value is determined by analysing factors such as the company's
earnings potential, industry factors, management quality, operational
1. The Fundamental
efficiency, and financial policies. The intrinsic value is calculated as the
Approach
present value of expected future cash flows, discounted at an
appropriate risk-adjusted rate. If the intrinsic value is higher than the
market value, they recommend buying the security.
Technical analysts predict future stock prices based on historical
market data. They believe that stock prices depend on supply and
2. The Technical demand in the market, and market patterns tend to repeat over time.
Approach This approach disregards intrinsic value. Tools like the Dow Jones
theory, which identifies patterns in stock prices, and chart patterns
are used to predict future price movements.
The Efficient Market Hypothesis (EMH) suggests that it is impossible to
outperform the market because all relevant information is reflected in
3. Efficient Capital stock prices. According to this theory, in an efficient market, prices
Market Theory always incorporate all available public information. There are three key
(ECMT) assumptions: (1) Information is cost-free to all market participants; (2)
No transaction costs; (3) All investors interpret information similarly.
EMH challenges both fundamental and technical analysis.
Face Value: The nominal value of a security, such as the value assigned
Key Definitions
to shares when a company is established (e.g., `10/share).
Book Value: The value of a company's equity as recorded in the financial
statements, which may be higher than the face value. Book value
includes retained earnings and reserves.
Market Value: The current price at which a security is trading in the
market, based on supply and demand.
Intrinsic Value: The actual or perceived value of a security based on
fundamental analysis, which may differ from its market value.

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FUNDAMENTAL APPROACH TO VALUATION

Concept Explanation
The real or true value of a security, calculated using financial analysis
Intrinsic Value tools. It represents the equilibrium price where demand and supply are
balanced. Prices above or below this level will lead to instability.
Time Value of Money has a "time value" – tools like compounding and discounting are
Money used for valuing bonds and stocks.
Bonds have relatively easy valuations, based on the present value of
Bond Valuation
annual interest payments and the principal recovery.
More complex, as the value depends on the uncertain timing and amount
Equity Valuation of earnings and dividends. It’s valued as the discounted present value of
future uncertain dividends.
Dividend Yield The total return from equity includes dividend yield and price changes
& Capital Gains (capital gains).
Single-Year The stock price is calculated based on expected dividends and the price
Holding Period at the end of the year, discounted by the required rate of return (r).
If dividends grow at a constant rate, the stock price is the present
Multiple-Year value of expected dividends and the selling price, calculated using the
Holding Period formula P0=D1r−gP_0 = \frac{D_1} {r - g} P0=r−gD1, where g is the
growth rate.
Rate of Return The rate of return is the dividend yield plus the growth rate of
Formula dividends, expressed as r=D1P0+gr = \frac{D_1}{P_0} + gr=P0D1+g.
Conditional The intrinsic value depends on macroeconomic conditions
Factors (national/international), industry-specific, and company-specific factors.

ALTERNATIVE APPROACHES TO VALUATION

Approach Core Idea Key Characteristics Implications

- Stock prices rise and
- No need to predict
fall randomly.
Stock prices move in trends based on past
- Short-term price
1. Random a random, data.
changes are
Walk Theory unpredictable - Easy to invest without
independent.
manner. preference or
- Supports fundamental
evaluation.
analysis, not technical.
- Prices reflect all public
information. - Impossible to
2. Efficient Stock prices reflect - Instant price consistently outperform
Market all available adjustment to new the market.
Theory (EMH) information. information. - Investor's access to
- Transaction costs are information is equal.
negligible.
Explains relationship - Expected return based
3. Capital - Helps determine if an
between expected on risk-free rate,
Asset Pricing asset is fairly valued
return and systematic portfolio beta, and
Model (CAPM) based on its expected
risk. market return.

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- Helps in security return and associated

valuation considering risk.
risk.

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OPERATIONAL APPROACH TO FINANCIAL DECISION

INTRODUCTION
Section Details
- Cost Leadership is one of Porter’s generic strategies, the others
being Product Differentiation and Focus (Niche).
- It involves achieving the lowest cost of production while maintaining
desired quality and performance of the product/service.
Introduction
- Efficient Cost and Management Accounting systems are crucial in
achieving cost leadership.
- The chapter discusses cost accounting for both manufacturing and
service organizations.
- Costing: A method to allocate expenses to different business
segments, including departments, processes, products, services, etc.
- Helps in budgeting, forecasting, and cost control.
- Cost refers to the payment made for acquiring goods/services, not
always recorded as an expense in financial accounting.
- ICWAI (Institute of Cost and Works Accountants of India) defines
cost as a measurement in monetary terms of resources used or given
up for specific purposes.
- Economist’s Perspective: Views cost as opportunity cost, i.e.,
Overview of
benefits forgone from the next best alternative.
Costing
- Cost Accounting includes cost control and cost ascertainment,
involving the application of principles, methods, and techniques for
effective decision-making.
- CIMA (Chartered Institute of Management Accountants) defines cost
accounting as the process of applying costing principles for budget
preparation, cost control, and profitability assessment.
- It is considered a Science (systematic knowledge), an Art
(application of knowledge), and a Profession (requiring formal training
and a recognized body).
- Costing: A technique used to determine the cost of a product,
service, or process using principles, methods, and regulations.
Nature and Scope - Goes beyond analysing costs to include planning budgets and
of Costing analysing profitability.
- The scope extends to internal (managerial) as well as external
(statutory/financial) reporting.
1. Branch of Knowledge: Recognized as a separate discipline with
Nature of Costing independent rules and applications.
2. Science: Possesses a systematic body of knowledge, including input

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from accounting, engineering, economics, and mathematics.

3. Art: Requires practical application skill for accurate cost
estimation and allocation.
4. Profession: Requires specific education, adherence to a code of
conduct, and is supported by professional organizations.
(a) Costing Process has Two Parts:
- (i) Collection and classification of cost data.
- (ii) Apportionment/allocation of indirect costs to products/services.
(b) Cost Estimation Involves Three Stages:
- (i) Analysis of expenditure.
- (ii) Measurement of production output.
- (iii) Compensation of cost with estimated expenditure.
Costing Systems:
- Historical Costing: Costs are determined after the activity is
completed.
Costing
- Estimated Costing: Based on expected costs, used for quotations and
Methodology and
tenders.
Process
- Standard Costing: Based on predetermined norms to measure
efficiency.
Costing Techniques:
- Work Costing: For custom jobs.
- Contract Costing: For large, long-duration contracts.
- Output Costing: For mass production of homogeneous products.
- Absorption Costing: Includes both variable and fixed overheads.
- Marginal Costing: Focuses on variable costs only.
- Standard Costing: Compares actual with standard to measure
variances.
1. Ascertainment of Cost: Determines total cost for pricing and
assessing profitability.
2. Cost Control: Involves setting budgets, measuring actual
Objectives of
performance, and taking corrective actions.
Costing
3. Guidelines for Management: Provides a database for decision-
making related to efficiency, cost minimization, profitability, and
growth.
- Fixed Cost: Does not change with the level of production (e.g., rent).
- Variable Cost: Changes in direct proportion to activity level (e.g.,
raw materials).
Types of Costing
- Direct Cost: Can be directly attributed to a product/service (e.g.,
direct labour).
- Indirect Cost: Not directly attributable, shared among multiple

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FINANCIAL MANAGEMENT 9.3

products/services (e.g., factory rent).

- Relevant Cost: Affects current or future decisions (e.g., cost of
material for a special order).
- Irrelevant Cost: Does not affect decisions (e.g., past costs).
- Sunk Cost: Already incurred and not recoverable (e.g., old equipment
cost).
- Shutdown Cost: Fixed costs that continue during a temporary
shutdown (e.g., insurance).
- Imputed Cost: Notional cost with no cash flow (e.g., owner's salary in
own business).
- Out-of-Pocket Cost: Requires actual expenditure (e.g., cash
purchases).
1. Helps Measure and Improve Efficiency: Identifies weak areas for
improvement.
2. Helps Analyse Profitable and Non-profitable Activities: Cost-benefit
analysis for various segments.
3. Helps in Pricing of Goods and Services: Sets fair and competitive
selling prices.
4. Guides in Reducing Prices in Recession: Shows minimum acceptable
price.
5. Provides Information for Planning: Aids in planning machine/labour
usage.
Advantages of 6. Helps in Control of Materials: Ensures proper material use, prevents
Costing wastage, and avoids under/overstocking.
7. Helps Decide Between Machine vs. Labour: Compares costs to
choose efficient options.
8. Helps Decide on Product Expansion: Indicates which product lines to
expand.
9. Helps Analyse Reasons for Losses: Identifies factors contributing to
financial losses.
10. Helps in Decision-Making: Reduces risk by basing decisions on
detailed cost data.
11. Checks Accuracy of Financial Accounts: Reconciles cost and
financial accounts to ensure accuracy.
1. Expensive: Requires significant initial and ongoing investments.
2. Difficult to Understand: Complex systems and procedures.
Limitations of 3. Limited Applicability: Not suitable for all types of businesses.
Costing 4. Not Suitable for Small Businesses: Cost of implementation outweighs
benefits.
5. Lack of Uniformity: Different costing methods give different results

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FINANCIAL MANAGEMENT 9.4

for the same problem.

6. Lack of Accuracy: Relies on estimates and assumptions, not always
precise.

BASIC PRINCIPLES OF COSTING

Subheading Explanation
Each cost should be clearly linked to its root cause. Costs
1. Cause-and-effect must be attributed to departments based on where they
relationships were incurred. Only the units that pass through such
departments should share the related cost.
2. Previous Costs That Could
Attempting to recover unrecoverable past costs will
Not Be Collected in the Past
distort the outcomes of current period operations and
Should Not Be Included in
affect the reliability of financial statements.
Future Costs
Costs should only be included once they are genuinely
3. Charge of Cost Only Upon
incurred. For example, selling costs should not be included
Incurrence
in unit costs when a product is still under production.
Expenses from unusual situations like theft or negligence
4. Abnormal Costs Are
must be excluded from unit cost calculations to avoid
Excluded from Cost Accounts
misleading the management and distorting cost estimates.
Cost ledgers and control accounts should ideally follow
5. Double Entry Principles
double-entry principles to ensure accuracy and minimize
Preferably Should Be Obeyed
errors in cost sheets and cost statements.
Cost Accounting, Management Accounting, Financial
Relation to Other Accounting Accounting, and Financial Management are closely
Fields interconnected. These fields often interact and rely on
each other.

CLASSIFICATION OF COSTS

Subheading Explanation
Classification means categorizing costs based on common
Classification of characteristics. Major categories include: (i) By Nature or Element,
Costs (ii) By Functions, (iii) By Variability or Behaviour, (iv) By Capability,
(v) By Regularity, (vi) By Costs for Managerial Decision Making.
Cost of materials required for manufacturing a product or providing
Material Cost
a service. It excludes all indirect materials (e.g., cleaning supplies).
Employee (Labour) Total wages, employee benefits, and payroll taxes paid by employer.
Cost Divided into direct and indirect (overhead) costs.

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All expenses excluding material and labour. As defined by I.C.M.A.:

Other Expenses “The cost of service provided to an undertaking and the notional
cost of the use of owned assets.”
Cost incurred in producing one additional unit of output. It helps
determine the most efficient level of production. Calculated by
difference in cost between current and one more (or one less) unit.
Marginal Costing
Marginal cost consists of direct materials, direct labour, and
variable overheads. Fixed costs are excluded and treated
separately.
1. Cost-volume-profit data is directly available from regular
statements.
2. Profits are unaffected by fixed cost absorption changes due to
inventory fluctuations.
3. Direct cost format aligns with managerial thinking.
4. Fixed costs’ impact on profits is clearly visible in income
Need for Marginal
statement.
Costing
5. Enables evaluation of products, territories, customer classes, etc.,
without fixed cost distortion.
6. Supports effective cost control via standard costs and flexible
budgets.
7. Helps fix sales prices and quote tenders during low demand.
8. Essential for calculating break-even point.
1. Clear segregation of fixed and variable costs, including semi-
variable components.
2. Avoids issues of overhead absorption present in absorption
costing.
3. Facilitates decisions based on marginal contributions—
identifying profitable/unprofitable products.
4. A technique useful for cost analysis, reporting, and control at
various management levels.
Features of 5. Aids future profit planning using contribution and marginal cost
Marginal Costing ratios.
6. Helps evaluate performance of multiple products/units.
7. Useful for forecasting.
8. Determines Optimum Product Mix (most profitable combination of
products).
9. Determines Optimum Sales Mix (most profitable combination of
sales).
10. Inventory (finished goods/WIP) valued only at variable cost.
11. Fixed costs are expensed immediately, not added to product

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cost/inventory.
12. Prices are based on marginal cost and contribution.
13. Combines cost recording with cost reporting techniques.
Ascertainment of Contribution = Selling Price – Marginal Cost.
Profit under Also, Contribution = Fixed Expenses + Profit.
Marginal Cost Therefore, Profit = Contribution – Fixed Expenses.
1. Allows effective cost control by separating fixed and variable
elements.
2. Simplifies treatment of overheads by excluding fixed costs from
product cost.
3. Provides realistic and uniform stock valuation.
4. Aids management in decisions like launching new products, buy vs.
make, pricing, and tendering.
5. Supports production planning using cost-volume-profit relationship
and break-even charts.
Advantages of
6. Delivers better outcomes when used with standard costing.
Marginal Costing
7. Helps determine selling price based on cost behavior and
competition in different markets.
8. Aids in budgetary control through expense classification and
flexible budgeting.
9. Facilitates tender preparation by identifying minimum acceptable
price (floor price).
10. Assists in "Make or Buy" decisions by analyzing cost recovery.
11. Provides better managerial understanding using break-even
charts and graphs.

Breakeven Point

Subheading Explanation
It is the point where total cost equals total revenue—no profit or
Break-even Point loss. For trades/investments, it's where the asset's market price
(Definition) equals its original cost. For businesses, it's the production level where
total expenses are exactly covered by sales.
An analysis that determines likely profit or loss at various levels of
Break-even operation by comparing total revenue and total costs. It studies the
Analysis (Meaning) relation among sales revenue, variable costs, and fixed costs to find
the point of zero profit or loss.
Crucial for managerial decision-making and profit planning. Used to
Importance in evaluate profit/loss at different sales levels. Often presented using a
Decision-Making Break-even Chart that shows sales revenue, fixed costs, and variable
costs.

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1. Forecast profit accurately by understanding the relation between

profits, costs, and volume.
2. Assist in creating flexible budgets showing costs at various activity
levels.
Objectives of
3. Help performance evaluation and cost control by analyzing volume
Break-even
changes.
Analysis
4. Aid pricing decisions and policy formulation by projecting effects
of pricing on costs and profits.
5. Determine appropriate overhead absorption by relating costs to
production volumes.
1. Choose scale for horizontal axis (units of sales).
2. Choose scale for vertical axis (costs/revenues).
3. Draw fixed cost line (horizontal).
4. Draw total cost line starting from fixed cost point.
5. Draw sales line from origin to max sales.
Steps in 6. Find intersection of sales and total cost lines (break-even point).
Construction of 7. The intersection is the point of no profit or loss.
Break-even Chart 8. Horizontal and vertical lines from this point give break-even
quantity and value.
9. Sales below break-even show loss; above show profit.
10. Margin of Safety = Total Sales – Break-even Sales.
11. Angle of Incidence = Angle between sales and total cost line at
break-even point.
Helps assess business viability, plan for profits, and control costs. It's
Significance of
the sales/production level where total costs = total revenue. Beyond
Break-even Point
this point, any additional sales generate profit.
1. Selling price per unit is constant.
Assumptions in
2. Variable cost per unit is constant.
Break-even
3. Fixed costs are constant.
Analysis
4. Costs are accurately divided into fixed and variable.
Break-even point (units) = Fixed Cost ÷ Contribution per unit
Break-even point (Rs.) = Fixed Cost ÷ P/V Ratio
Formulae for
Or = Break-even units × Selling Price per unit
Break-even
P/V Ratio = (Contribution ÷ Sales) × 100
Analysis
Desired Sales (Rs.) = (Fixed Cost + Desired Profit) ÷ P/V Ratio
At Break-even Point: Contribution = Fixed Costs
1. Cost Separation: All costs must be divided into fixed and variable
Assumptions of
components. It’s difficult to accurately separate semi-variable costs.
Break-even
2. Fixed Costs Constancy: Fixed costs remain constant at all levels of
Analysis
production, though in reality, they can change.

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FINANCIAL MANAGEMENT 9.8

3. Variable Costs & Production Volume: Variable costs are assumed to

fluctuate directly with production volume, though in practice, the
relationship may not always be so linear.
4. Production Equals Sales: Assumes no inventory at the start or end
of the period, and production and sales are equal. In reality,
inventory will exist.
5. No Change in Sales Mix/Price: Assumes sales mix and selling price
remain constant, but in reality, these may change to optimize sales.
6. No Changes in Productivity/Operations: Assumes no changes in
production methods or operational effectiveness, though these
factors do fluctuate in real life.
7. Single Product Focus: Break-even charts focus on one product;
separate charts are needed for multiple products.
8. Capital Investment Ignored: Break-even analysis does not account
for the capital invested in the business, which is crucial for
profitability analysis.
9. Straight-Line Cost/Revenue Relationship: Assumes costs and
revenues follow straight lines, but in reality, they may have curvilinear
relationships.
1. Simplified Costing: Assumes simple division of costs into fixed and
variable, which may not be entirely accurate.
2. Static Costs: Fixed costs are assumed to be constant across all
activity levels, though they can vary.
3. Constant Sales Prices: Assumes sales price remains the same, while
in reality, pricing may change depending on competition, demand, or
Limitations of
sales strategy.
Break-even
4. Single Product Limitation: Only one product’s cost structure is
Analysis
represented, which limits its use for multi-product businesses.
5. Excludes Capital: Does not factor in the cost of capital or
investment in assets, which are critical for profitability evaluation.
6. Real-World Complexities: In reality, production and sales do not
always align perfectly, and the assumptions about fixed and variable
costs may not always hold true.

Profit Volume Ratio

Subheading Explanation
Profit-Volume The Profit-Volume Ratio measures the percentage of turnover that
(P/V) Ratio each product contributes to overall profitability. It shows the
(Definition) relationship between contribution margin and sales. It indicates how

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FINANCIAL MANAGEMENT 9.9

effectively a business is turning sales into profit. A higher P/V ratio

means a higher contribution from sales.
P/V Ratio = (Contribution ÷ Sales) × 100. This ratio helps determine
Formula for P/V
how much of each sale is contributing to covering fixed costs and
Ratio
generating profit.
1. Price Increase: Raising the selling price of products.
Methods to 2. Cost Reduction: Lowering variable costs through better utilization
Increase of resources, labour, and machinery.
Contribution 3. Product Mix Strategy: Emphasizing the sale of products with a
higher P/V ratio to improve overall profitability.
1. Revenue Surplus Dependence: The P/V ratio relies heavily on
revenue over variable costs, which may not always reflect the true
profitability.
2. Capital and Fixed Costs Ignored: The ratio does not take into
account the capital expenditures or increased fixed costs associated
with increasing production capacity.
3. General Guidance: While it gives a general understanding of
Limitations of P/V
profitability, it doesn’t help in making specific decisions between
Ratio
products or product lines.
4. Cost Classification Assumptions: Accurate separation of fixed and
variable costs is crucial. Oversimplifying the division can lead to
incorrect conclusions about profitability.
5. Profitability Comparison: A higher P/V ratio indicates higher
profitability, but only when other conditions (e.g., cost structure and
sales volume) remain constant.

Margin of Safety

Subheading Explanation
The margin of safety refers to sales above the break-even point,
representing the difference between actual sales and break-even
Margin of Safety sales. It measures the buffer that a company has between its
(Definition) current sales and the break-even point, indicating how much sales
can decline before the company starts making a loss. A higher
margin of safety indicates greater financial stability.
A high margin of safety indicates strong business viability,
offering the ability to withstand sales downturns. It’s particularly
Importance useful in periods of declining sales, helping the business
understand the level of sales required to remain profitable and
identify actions to improve the margin of safety.

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FINANCIAL MANAGEMENT 9.10

A low margin of safety typically signifies large fixed costs,

meaning the company needs higher sales to cover those costs and
Low Margin of Safety
reach profitability. This situation makes the business more
vulnerable to fluctuations in sales volume.
- Margin of Safety (units) = Actual Sales – Break-even Sales
- Margin of Safety (Profit) = Profit / P/V ratio
Margin of Safety - Margin of Safety (Value) = (Profit × Selling Price per Unit) /
Formulae (Selling Price per Unit – Variable Cost per Unit)
- Margin of Safety as % of Total Sales = (Margin of Safety / Total
Sales) × 100
A larger margin of safety correlates with a more secure financial
Significance of Margin position, offering the company greater flexibility and the ability to
of Safety absorb fluctuations in sales. A higher margin typically indicates
higher profitability and a safer operational position.
- Maintain maximum actual sales while keeping break-even point as
low as possible.
- Increase sales volume.
How to Improve - Raise the selling price.
Margin of Safety - Change the product mix to increase the contribution margin.
- Reduce fixed costs.
- Lower variable costs.
- Eliminate unprofitable products from the sales mix.
The angle of incidence is the angle formed by the intersection of
the total cost line and the total income (sales) line on a break-
Angle of Incidence
even chart. A larger angle indicates higher profitability, while a
(Definition)
smaller angle suggests lower profitability. It is a key indicator of
profitability once the company reaches the break-even point.
A larger angle of incidence suggests higher profit margins and
greater profitability after the break-even point is reached. A
Significance of Angle
smaller angle, on the other hand, indicates lower profitability. A
of Incidence
wider angle signifies that a business is operating more profitably
as its sales volume increases.
- Break-Even Level: The point where there is no profit or loss, i.e.,
sales just cover total costs. A company with a lower break-even
point is considered in a better position than one with a higher
Relationship of BEP,
break-even point.
Margin of Safety, and
- Angle of Incidence: The angle formed by the intersection of the
Angle of Incidence
cost and sales lines on the break-even chart. A larger angle
suggests greater profitability after the break-even point.
- Margin of Safety: The difference between actual sales and

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FINANCIAL MANAGEMENT 9.11

break-even sales. A higher margin of safety corresponds to a

better financial position. The ideal situation is when a business
has both a large margin of safety and a wide angle of incidence.

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QUESTION BANK
Question 1
MNP Ltd sold 2,75,000 units of its product at Rs. 37.50 per unit. Variable costs are Rs. 17.50
per unit (manufacturing costs of 14 and selling cost 3.50 per unit). Fixed cost is incurred
uniformly throughout the year and amounting to Rs. 35,00,000 (including depreciation of Rs.
15,00,000). There is no beginning or ending inventories.

Required:
Compute breakeven sales level quantity and cash breakeven sales level quantity.

Solution:

Breakeven Sales Quantity =

. , ,
= = 1,75,000 Units
.

Cash Breakeven Sales Quantity =

. , ,
= = 1,00,000 Units
.

Question 2
You are given the following particulars:
i. Fixed cost Rs. 1,50,000
ii. Variable cost Rs.15 per unit
iii. Selling price is Rs. 30 per unit

Calculate:
a) Breakeven point
b) Sales to earn a profit of Rs. 20,000

Solution:

a) Breakeven point (BEP) =

. , ,
= = 10,000 Units
.

b) Sales to earn a profit of Rs. 20,000:

= x Selling price per unit =

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FINANCIAL MANAGEMENT 9.13

. , , . , . , ,
= x Rs.30 =
. %

= Rs. 3,40,000
= Rs. 3,40,000

Question 3
A company has a PV ratio of 40%. Compute by what percentage must sales be increased to
offset: 20% reduction in selling price?

Solution:

.
1) Revised Sales value= = = 1.6
.

This means sales value to be increased by 60% of the existing sales.

. .
2) Revised PV ratio = = = 0.25
.

.
3) Required Sales Quantity = = = =2
× . × .

Therefore, sales value to be increased by 60% and sales quantity to be doubled to offset the
reduction in selling price.

Proof:
Let selling price per unit is Rs. 10 and sales quantity is 100 units.
Data before change in selling price
Particulars (Rs.)
Sales (310 x 100 units) 1,000
Contribution (40% of 1,000) 400
Variable cost (balancing figure) 600

Data after the change in selling price:

Selling price is reduced by 20% that means it became 8 per unit. Since, we have to maintain
the earlier contribution margin i.e. Rs. 400 by increasing the sales Quantity only. Therefore,
the target contribution will be Rs. 400.

The new PV ratio will be:

Particulars (Rs.)
Sales 8.00
Variable cost 6.00
Contribution per unit 2.00
PV ratio 25%

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FINANCIAL MANAGEMENT 9.14
.
Sales value = = = Rs. 1,600
.
.
Sales quantity = = = 200 units
.

Question 4
PQR Ltd. Has furnished the following data for the two years:
Particulars 2019-20 2020-21
Sales Rs. 8,00,000 ?
Profit/volume Ratio (PV ratio) 50% 37.5%
Margin of Safety sales as a % of total sales 40% 21.875%

There has been substantial savings in the fixed cost in the year 2020-21 due to the restricting
process. The company could maintain its sales quantity level of 2019-20 in 2020-21 by reducing
selling price.

You are required to calculate the following:

i) Sales for 2020-21 in value
ii) Fixed cost for 2020-21 in value
iii) Breakeven sales for 2020-21 in value

Solution:
In 2019-20, PV ratio = 50%
Variable cost ratio= 100% - 50% = 50%
Variable cost in 2019-20 = 3% = 8,00,000 x 50% = Rs. 4,00,000
In 2020-21, sales quantity has not changed. Thus, variable cost in 2020-21 is Rs. 4,00,000.
In 2020-21, PV ratio = 37.50%
Thus, variable cost ratio = 100% - 37.5% = 62.5%

, ,
i) Thus, sales in 2020-21 = = Rs. 6,40,000
. %

In 2020-21, Breakeven sales= 100% - 21.875% (Margin of safety)

= 78.125%

ii) Breakeven sales= 6,40,000 x 78.125% = Rs. 5,00,000

iii) Fixed cost = B.E. sales X PV ratio

= 5,00,000 x 37.50% = Rs. 1,87,500

Question 5
A company earned a profit of Rs. 30,000 during the year. If the marginal cost and selling
price of the product are Rs. 8 and Rs. 10 per unit respectively, Find out the amount of
margin of safety.

Solution:
. .
PV ratio = = = 20%
𝑅𝑠.
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FINANCIAL MANAGEMENT 9.15

,
Margin of safety= = = Rs. 1,50,000
%

Question 6
A Ltd. Maintains margin of safety of 37.5% with an overall contribution to sales ratio of 40%.
Its fixed costs amount to Rs. 5 lakhs.

Calculate the following:

i. Breakeven sales
ii. Total sales
iii. Total variable cost
iv. Current profit
v. New ‘margin of safety’ if the sales volume is increased by 7.5%

Solution:

(i) We know that: Break-even Sales (BES) x PV ratio = Fixed cost

Break-even Sales (BES) x 40% = Rs. 5,00,000
Break-even Sales (BES) = Rs. 12,50,000

(ii) Total sales (S) = Breakeven sales + Margin of safety

S = Rs. 12,50,000 + 0.375S
S-0.375S= Rs. 12,50,000
S= Rs. 20,00,000

(iii) Contribution to sales ratio = 40%

Therefore, Variable cost to Sales ratio = 60%
Variable cost = 12,00,000

(iv) Current profit = Sales – (Variable cost + Fixed cost)

= Rs. 20,00,000 – (12,00,000 + 5,00,000) = Rs. 3,00,000

(v) If sales value is increased by 7.5%

New sales value = Rs. 20,00,000 x 1.075 = Rs. 21,50,000

New Margin of safety = New sales value – BES
= Rs. 21,50,000 – Rs. 12,50,000
= Rs. 9,00,000

Question 7
By noting “PV will increase or PV will decrease or PV will not change”, as the case may be,
state how the following independent situations will affect the PV ratio:

i) An increase in the physical sales volume

ii) An increase in the fixed cost
iii) A decrease in the Variable cost per unit

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FINANCIAL MANAGEMENT 9.16

iv) A decrease in the contribution margin

v) An increase in selling price per unit
vi) A decrease in the fixed cost
vii) A 10% increase in both selling price and variable cost per unit
viii) A 10% increase in the selling price per unit and 10% decrease in the physical sales volume
ix) A 50% increase in the variable cost per unit and 50% decrease in the fixed cost
x) An increase in the angle of incidence.

Solution:
Item no. PV Ratio Reason
i) Will not change
ii) Will not change
iii) Will not change
iv) Will not change
v) Will not change
vi) Will not change
vii) Will not change Reasoning 1
viii) Will not change Reasoning 2
ix) Will not change Reasoning 3
x) Will not change Reasoning 4
A 10% increase in both selling price and variable cost per unit.

Reasoning 1
Assumptions: a) Variable cost is less than selling price.
b) Selling price Rs. 100 variable cost Rs. 90 per unit.
c) PV ratio = = 10%

10% increase in SP = Rs. 110

10% increase in variable cost = Rs. 99
PV ratio = = 10% i.e. PV ratio will not change.

Reasoning 2
Increase or decrease in physical sales volume will not change PV ratio.
Hence, 10% increase in selling price per unit will increase PV ratio.

Reasoning 3
Increase or decrease in fixed cost will not change PV ratio. Hence, 50% increase in the
variable cost per unit will decrease PV ratio.

Reasoning 4
Angle of incidence is the angle at which sales line cuts the total cost line. If it is large, it
indicates that the profits are being made at higher rate. Hence increase in the angle of
incidence will increase the PV ratio.
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FINANCIAL MANAGEMENT 9.17

Question 8
If PV ratio is 60% and the Marginal cost of the product is Rs. 20. Calculate the selling price?

Solution:

Variable cost = 100 –PV ratio

= 100 – 60
= 40
If variable cost is 40, then selling price = 100
If variable cost is 20, then selling price = (100/40) × 20) = Rs 50

Question 9
The ratio of variable cost to sales is 70%. The break – even point occurs at 60% of the
capacity sales. Find the capacity sales when fixed costs are Rs 90,000. Also compute profit
at 75% of the capacity sales.

Solution:

Variable cost to sales = 70% contribution to sales = 30%, Or PV ratio 30%

We know that: BES x PV Ratio = Fixed Cost
BES x 0.30 = Rs. 90,000
Or BES = Rs. 3,00,000

It given that break-even occurs at 60% capacity.

Capacity sales = Rs. 3,00,000 ÷ 0.60 = Rs. 5,00,000

Computation of profit of 75% capacity.

75% of capacity sales (i.e. Rs 5,00,000 x 0.75) Rs. 3,75,000
Less: Variable cost(i.e. Rs 3,75,000 x 0.70) (Rs. 2,62,500)
Contribution Rs. 1,12,500
Less: Fixed Cost (Rs. 90,000)
Profit Rs. 22,500

Question 10
You are required to
Determine profit, When sales = 2,00,000
Fixed Cost = 40,000
BEP = 1,60,000

Determine sales, when fixed cost = 20,000

Profit = 10,000
BEP = 40,000

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FINANCIAL MANAGEMENT 9.18

Solution:
(i) We know that: B.E. sales x PV ration = Fixed Cost
Or Rs. 1,60,000 x PV ratio = Rs. 40,000
PV ratio = 25%

We also know that: sales x PV ratio = Fixed Costs + Profit

Or Rs. 2,00,000 × 0.25 = 40,000 + Profit
Or Profit = Rs. 10,000

(ii) Again B.E. sales x PV ratio = Fixed Cost

Or Rs. 40,000 x PV ratio = Rs. 20,000
Or PV ratio = 50%

We also know that: sales x PV ratio = Fixed Cost + Profit

Or Sales x 0.50 = Rs. 2,00,000 + Rs. 10,000
Or Sales = Rs. 60,000

Question 11
A company has made a profit of Rs. 50,000 during the year. If the selling price and marginal
cost of the product are Rs. 15 and Rs. 12 per unit respectively. Find out the amount of margin
of safety.

Solution:

PV Ratio = x 100
= [(15-12/15] x 100
= (3/15) x 100 = 20%

Marginal of Safety = Profit ÷ PV ratio

= 50,000 ÷ 20%
= Rs. 2,50,000

Question 12
(a) If margin of safety is Rs. 2,40.000 (40% of sales) and PV ratio is 30% of AB Ltd, calculate
its (1) Break even sales, and (2) Amount of profit on sales of Rs. 9,00,000.

(b) X Ltd. Has earned a contribution of Rs. 2,00,000 and net profit of Rs. 1,50,000 of sales of
Rs. 8,00,000. What is its margin of safety?

Solution:
(a) Total Sales = 2,40,000 x = Rs. 6,00,000

Contribution = 6,00,000 x 30% = Rs. 1,80,000

Profit = MS x PV ratio = 2,40,000 x 30% = Rs. 72,000

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FINANCIAL MANAGEMENT 9.19

Fixed Cost = Contribution - Profit

= 1,80,000 – 72,000
= Rs. 1,08,000

1) Break – even sales =

, ,
= = Rs. 1,62,000
%

2) Profit = (Sales x PV ratio) – Fixed Cost

(9,00,000 x 30%) – 1,08,000 = Rs. 1,62,000
, ,
(b) PV ratio = = = 25%
, ,

, ,
Margin of safety = = = Rs. 6,00,000
%

Alternatively:
Fixed cost = Contribution – Profit
= Rs. 2,00,000 – Rs. 1,50,000
= Rs. 50,000

B.E. Point = Rs. 50,000 ÷ 25% = Rs. 2,00,000

Margin of safety = Actual Sales – B.E. sales
= 8,00,000 – 2,00,000
= 6,00,000

Question 13
A company sells its product at Rs. 15 per unit. In a period, if it produces and sells 8,000 units,
it incurs a loss of Rs. 5 per unit. If the volume is raised to 20,000 units, it earns a profit of Rs,
4 per unit. CALCULATE break-even point. both in terms of Value as well as in units.

Solution:
We know that S – V = F + P
Suppose variable cost = x, Fixed Cost = y
In first situation:
15 x 8,000 – 8,000 x = y – 40,000 (1)

In second situation:
15 x 20,000 – 20,000 x = y + 80,000 (2)
Or, 1,20,000 – 8,000 x = y – 40,000 (3)
3,00,000 – 20,000 x = y + 80,000 (4)

From (3) & (4) we get x = Rs. 5, Variable cost per unit = Rs. 5
Putting this value in 3rd equation:
1,20,000 – (8,000 x 5) = y – 40,000

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FINANCIAL MANAGEMENT 9.20

Or, y = Rs. 1,20,000

Fixed Cost = Rs. 1,20,000

PV ratio = = x 100 = 66 %

Suppose break – even sales = x

15x – 5x = 1,20,000 (at BEP, contribution will be equal to fixed cost)
X = 12,000 units.
Or, Break – even sales in units = 12,000, Break – even sales in value
= 12,000 x 15 = Rs, 1,80,000

Question 14
You are given the following data:
Particulars Sales Profit
Year 2019-20 Rs. 1,20,000 8,000
Year 2020-21 Rs. 1,40,000 13,000

Find OUT:
(i) PV ratio,
(ii) B.E. Point,
(iii) Profit when sales are Rs. 1,80,000
(iv) Sales required earn a profit of Rs. 12,000
(v) Margin of safety in year 2020-21.

Solution:
Particulars Sales Profit
Year 2019-20 Rs 1,20,000 8,000
Year 2020-21 Rs 1,40,000 13,000
Difference Rs 20,000 5,000

(i) PV ratio = x 100

,
= x 100
,
= 25%

Contribution in 2019-20 (1,20,000 x 25%) = Rs. 30,000

Less: Profit = Rs. 8,000
Fixed cost = Rs. 22,000

Contribution = Fixed Cost + Profit

Fixed Cost = Contribution – Profit

,
(ii) Break – even point = = = Rs. 88,000
%

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FINANCIAL MANAGEMENT 9.21

(iii) Profit when sales are Rs. 1,80,000 (Rs.)

Contribution (Rs. 1,80,000 x 25%) 45,000
Less: Fixed Cost 22,000
Profit 23,000

(iv) Sales to earn a profit of Rs. 12,000

, ,
= = Rs. 1,36,000
%

(v) Margin of safety in 2020 – 21

Margin of safety = Actual Sales – Break-even sales
= 1,40,000 – 88,000
= Rs. 52,000.

Question 15
A company had incurred fixed expense of Rs. 4,50,000 with sales of Rs. 15,00,000 and earned
a profit of Rs. 3,00,000 during the first half year. In the second half, it suffered a loss of Rs.
1,50,000.

Calculate:
(i) The profit volume ratio, breakeven point and margin of safety for the first half year.
(ii) Expected sales volume for the second half year assuming that selling price and fixed
expenses remained unchanged during the second half year.
(iii) The breakeven point and margin of safety for the whole year.

Solution:

(i) In the first half year:

Contribution = Fixed cost + Profit

= 4,50,000 + 3,00,000 = Rs. 7,50,000

, ,
PV ratio = 𝑥 100 = x 100 = 50%
, ,

, ,
Breakeven point = = x 100 = Rs. 9,00,000
%

Margin of safety = Actual sales – Breakeven point

= 15,00,000 – 9,00,000 = 6,00,000

(ii) In the second half year:

Contribution = Fixed cost – Loss

= 4,50,000 – 1,50,000 = Rs. 3,00,000

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FINANCIAL MANAGEMENT 9.22
, ,
Expected sales volume = = = Rs. 6,00,000
%

(iii) For the whole year:

, , ×
B.E. point = = = Rs. 18,00,000
%

, , , ,
Margin of safety = = = Rs. 3,00,000
%

Question 16
The following information is given by Star Ltd:
Margin of safety Rs. 1,87,500
Total cost Rs. 1,93,750
Margin of safety 3,750 units
Breakeven sales 1,250 units
Required:
Calculate Profit, PV ratio, BEP sales (in Rs.) and Fixed Cost.

Solution:

,
Margin of safety (%) = = 75%
, ,

. , ,
Total sales = = Rs.2,50,000
.

Profit = total sales – total cost

= Rs. 2,50,000 – Rs. 1,93,750
= Rs. 56,250

PV ratio = x 100
( .)
. ,
= x 100
. , ,
= 30%

Breakeven sales = Total sales x [100 – Margin of safety %]

= Rs. 2,50,000 x 0.25
= Rs. 62,500

Fixed cost = Sales x PV ratio – Profit

= Rs. 2,50,000 x 0,30 – Rs. 56,250
= Rs. 18,750

Question 17
From the following particulars calculate:
a. P/V Ratio b. Fixed Cost

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FINANCIAL MANAGEMENT 9.23

b. I year sales Rs. 1,95,000 profit Rs. 9,000

c. II Year sales Rs. 2,25,000 profit Rs. 15,000

Solution:
P/V Ratio = Change in Profit / Change in Sales
= 15,000 - 9,000 / 2,25,000 1,95,000
= 6,000 /30,000 × 100

P/V Ratio = 20%

Variable Cost= Sales (1- P/V Ratio)

= Rs. 2,25,000 (1- 0.20)
= Rs. 2,25,000 × 0.80
= Rs. 1,80,000

Fixed Cost = Sales – Variable Cost – Profit

= Rs. 2,25,000 – Rs. 1,80,000 – 15,000
= Rs. 30,000

Question 18
A cost sheet shows the following situations prevailing in Star Ltd., which is facing depression:
Direct Materials -- Rs. 50,000 Direct Wages -- Rs. 20,000 Overheads: Variable -- Rs. 10,000
Fixed -- Rs. 20,000 -- Rs. 30,000 Total Cost -- Rs.1,00,000 Sales 4,000 units @ Rs. 23 per unit
-- Rs. 92,000 Loss: -- Rs. 8,000 There is no sign of improvement in the situation. Therefore, the
management wants to know whether it is desirable to stop the production. What should be the
minimum price at which company should shut down its production?

Solution:

Even if there is a loss of Rs. 8,000, it is not desirable to stop the production. Because, fixed
costs will be incurred even if production is stopped and loss would be equal to fixed cost of
Rs. 20,000. Present loss is less because selling price is more than marginal cost and the same
contributes towards recovery of fixed costs. Therefore, so long as there is contribution, it is
not advisable to stop the production. The following statement gives the clear idea of the
situation.

Marginal Cost Per Unit Total (Rs.)

Sales price of 4,000 units 23.00 92,000
Less: Variable Cost 12.50 50,000
Direct Material
Direct Wages 5.00 20,000
Variable Overheads 2.50 10,000
Marginal (Variable) Cost 20.00 80,000
Contribution 3.00 12,000
Less: Fixed Cost 5.00 20,000
Loss 2.00 8,000
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FINANCIAL MANAGEMENT 9.24

The price per unit of Rs. 23 is more than marginal cost of Rs. 20. Therefore, the production
should be continued. The minimum price at which production should be discontinued should be
equal to marginal cost. In this case marginal cost is Rs. 20, so minimum price should be Rs. 20.
It is better to stop the production if selling price falls below the marginal cost of Rs. 20 to
avoid the loss more than fixed cost of Rs. 20,000.

Question 19
The National Company has just been formed. They have a patented process that will make
them the sole suppliers of Product A.

During the first year, the capacity of their plant will be 9,000 units, and this is the amount
they will be able to sell. Their costs are:
 Direct labor = $15 per unit
 Raw materials = $5 per unit
 Other variable costs = $10 per unit
 Fixed costs = $240,000

There are two parts to this question:

(a) If the company aims to make a profit of $210,000 for the first year, what should the
selling price be? What is the contribution margin at this price?

(b) If, at the end of first year, the company aims to increase its volume, how many units will
they have to sell to realize a profit of $760,000 given the following conditions?
 An increase of $100,000 in the annual fixed costs will increase their capacity to
50,000 units l
 Selling price is at $70 per unit and no other costs change
 $500,000 is invested in advertising

Solution:

(a) Calculation of selling price

Direct labor (9,000 x 15) = $135,000
Raw materials (9,000 x 5) = $45,000
Other variable costs (9,000 x 10) = $90,000
Total variable costs (PU 30) = 270,000
Add: Fixed Cost = 240,000
Profit = 210,000

Total sales value of 9,000 units @ $80 per unit = 720,000

(b) Sales in units

(Fixed expenses + Desired profit) / (Sales – Variable cost)

Thus,
Fixed Expenses = 2,40,000 (given) + 1,00,000 (extra) + 50,000 (advertisement cost)
= 840,000 + Desired Profit (760,000) = $1,600,000
= 1,600,000 / (70 – 30)
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FINANCIAL MANAGEMENT 9.25

= 40,000 units

Question 20
From the following particulars find out the amount of profit earned during the year using the
marginal costing technique:
Product A B C
Output (units) 10,000 20,000 30,000
Selling Price (per unit) Rs. 10 Rs. 10 Rs. 5
Variable cost (per unit) Rs. 6 Rs. 7.50 Rs. 4.5
Total Fixed Cost Rs. 80,000.

Solution:
Statement of Cost and Profit (Marginal Costing)
Particulars A (Rs) B (Rs) C (Rs) Total (Rs)
Sales Revenue 100,000 200,000 300,000 600,000
Marginal Costs 60,000 150,000 270,000 480,000
Contribution 40,000 50,000 30,000 120,000
Fixed Costs 80,000
Profit 40,000

Thus the technique of marginal costing assumes that the difference between the aggregate
value of sales and the aggregate value of variable costs or marginal costs, provides a fund
(called contribution) to meet the fixed costs and balance is the profit. The concept of
contribution is a very useful tool to management in managerial decisions making.

Question 21
Two companies A Ltd. and B Ltd. sell the same type of product. Their income statement are
as follows:
Particulars A Ltd. (Rs) B Ltd. (Rs)
Sales 2,40,000 2,40,000
Less : Variable Cost 96,000 1,20,000
Fixed Costs 64,000 40,000
Profit 80,000 80,000
State which company is likely to earn greater profit if there is: (i) heavy demand, (ii) poor
demand for its products.

Solution:

Particulars A Ltd. (Rs) B Ltd. (Rs)

Sales 2,40,000 2,40,000
Variable Cost 96,000 1,20,000
Contribution 144,000 1,20,000
P/V Ratio (Contribution ÷ Sales) 0.60 0.50

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FINANCIAL MANAGEMENT 9.26

In case of A Ltd., every sale of Rs. 100 gives a contribution of Rs. 60 whereas in case of B Ltd.
every sale of Rs. 100 provides a contribution of Rs. 50. In case of heavy demand, profit of A
Ltd. will rise much faster in comparison to B Ltd. During poor demand or decline in sales of Rs.
100 will lead to decline in contribution in A Ltd. and B Ltd. by Rs. 60 and Rs. 50 respectively.

Mathematically,
Sales = Variable cost + Fixed cost ± Profit.
Sales – Variable cost = Fixed Cost ± Profit
Sales – Variable cost = Contribution
Contribution –Fixed cost = ± Profit

To make profit, contribution should be greater than fixed cost. Further, to maximize profit,
contribution should be maximized. When contribution is equal to fixed cost, then a firm is at
‘no profit no loss point’ called breakeven point.

Formulae of Marginal Costing: The difference between the change in costs and the change in
quantity is used to compute marginal cost. Assume, for instance, that a factory wants to boost
its output to 10,000 units from its present 5,000 units. The marginal cost of production is equal
to the difference between the factory’s present cost of production ($100,000) and the cost
of production ($150,000) when production is increased (10,000 - 5,000).

Question 22
X Ltd. Made sales during a certain period for Rs. 1,00,000. The net profit for the same period
was Rs. 10,000 and the fixed overheads were Rs. 15,000. Find out: (i) P/V Ratio (ii) Sales needed
to generate a profit of Rs. 15,000 (iii) A net profit of Rs. 150,000 from sales. (iv) Point sales
that break even.

Solution:
(i) P/V Ratio = {(F+P) / S} x 100 Here, F = Rs. 15,000, P = Rs. 10,000 and S = Rs. 1,00,000. P/V
Ratio = [(15,000 + 10,000) / 1,00,000] x 100 P/V Ratio = 25%.

(ii) P/V Ratio = {(F+P) / S} x 100 Here 25 = {(15,000+15,000) /S}x100 [ Given Profit = Rs.
15,000] Or, S = (30,000/25) x 100 Sales = 1,20,000 Sales required to earn a profit of Rs.
15,000 = Rs.1,20,000.

(iii) When Sales =Rs.1,50,000, Then Profit = ? P/V Ratio ={(F+P) / S} x 100 Here, 25 =
[(15,000+P)1,50,000] x 100 [Given Sales= Rs.1,50,000] Or, 15,000 + P = 1,50,000 x 25 / 100 Or,
15,000 + P = 37,500 Profit = 37,500 – 15,000 = Rs.22,500 Net Profit from sales of Rs.1,50,000
= Rs. 22,500.

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

Question 23
The following data relate to a manufacturing company:
Plant capacity: 4,00,000 units per annum
Present utilization 40%
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FINANCIAL MANAGEMENT 9.27

Actuals for the year were

Selling price ₹ 50 per unit
Materials cost ₹ 20 per unit
Variable manufacturing costs ₹ 15 per unit
Fixed costs ₹ 27 lakhs

In order to improve capacity utilization the following proposals are being considered.
Reduce selling price by 10%.
Spend additionally ₹3 lakhs on sales promotion.
How many units should be made and sold in order to earn a profit of ₹5 lakhs per year?

Solution:
Revised selling price (₹50 less 10%) ₹45 per unit

Variable cost:
Material cost Rs.20
Variable manufacturing cost (per unit) Rs.15
Total variable cost Rs.35 per unit
Contribution Rs.10 per unit

Total contribution required:

Fixed costs Rs.27,00,000
Additional promotion expenses Rs.3,00,000
Profit Rs.5,00,000
Total Rs.35,00,000

Total number of units to be made and sold to earn a contribution of Rs. 35,00,000
Total Contribution = Contribution per unit Rs. 35,00,000
= Rs. 10 = 3,50,000 units.

Question 24
Star X Ltd. Sold goods for ₹ 30,00,000 in a year. In that year, the variable cost is 60% of
sales and profit is ₹ 8,00,000. Find out: (i) P/V Ratio, (ii) Fixed Cost, (iii) Break-even sales, (iv)
Sales that would still be profitable if the selling price were cut by 10% but fixed costs were
raised by 1,00,000.

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

Profit = C – FC
8,00,000 = 12,00,000 – FC
FC = 4,00,000……………. (ii)

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FINANCIAL MANAGEMENT 9.28

P/V Ratio = 𝐶/𝑆 x 100 = 12,00,000/30,00,000 x 100 = 40%............(i)

BEP = 𝐹𝐶/𝑃𝑉𝑅𝑎𝑡𝑖𝑜 = 4,00,000/40% = 10,00,000………………(iii)
iv….. Required Statement

Sales (30,00,000 ÷ 10%) = 27,00,000

Less: V.C = 18,00,000
Contribution = 9,00,000

Revised P/V Ratio = 𝐶/𝑆 x 100 = 9,00,000/27,00,000 𝑥 100 = 33.33%

Revised BEP 𝐹𝐶/𝑃𝑉𝑅𝑎𝑡i𝑜 = (4,00,000+1,00,000)/33.33% = ₹15,00,000

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

Solution:
1. Number of units sold = Sales ÷ Selling price p.u.
= ₹8,00,000 ÷ 25 per unit
= 32,000 units

Fixed cost included in the semi-variable cost = Total semi variable cost – variable element
= ₹1,80,000 – (₹3.75 p.u. x 32,000 units)
=₹60,000

Variable cost p.u. = ₹7.50 + 6.25 + 3.75 =₹17.50

Contribution p.u. = Selling price – variable cost = ₹ (25 – 17.50) = ₹7.50
Breakeven Point = Fixed Cost/Contribution per unit = 90000+60000/7.50 = 20,000 units
Activity level at BEP = 80% / 32000 units * 20,000 units = 50.00%

Question 26
MNP Ltd sold 2,75,000 units of its product at ₹37.50 per unit. Variable costs are ₹ 17.50 per
unit (manufacturing costs of ₹ 14 and selling cost ₹ 3.50 per unit). Fixed costs are incurred
uniformly throughout the year and amounting to ₹ 35, 00,000 (including depreciation of ₹ 15,
00,000). There is no beginning or ending inventories. Required: COMPUTE breakeven sales
level quantity and cash breakeven sales level quantity.

Solution:
Break even Sales Quantity = Fixed cost/ Contribution margin per unit
= 35,00,000 / 20 ₹
= 1,75,000 units

Cash Break-even Sales Quantity = Cash Fixed Cost/ Contribution margin per unit
= 20,00,000/ 20 ₹
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FINANCIAL MANAGEMENT 9.29

=1,00,000 units.

Question 27
Mahindra Ltd. sells two products, J and K. The sales mix is 4 units of J and 3 units of K. The
contribution margins per unit are ₹ 40 for J and ₹ 20 for K. Fixed costs are ₹ 6, 16,000 per
month.
Sales mix (in quantity) is 4 units of Product- J and 3 units of Product- K i.e. Sales ratio is 4:3.

Solution:
Composite contribution per unit by taking weights for the product sales quantity
=Product J- 40* 4/ 7 + Product K- 20*3/ 7
= ₹22.86 + ₹8.57
= Rs 31.43

Composite Break-even point = Common Fixed Cost/ Composite Contribution per unit
= 6,16,000 / 31.43
= 19,600 units

Break-even units of Product-J = 19,600*4/ 7 = 11,200 units

Break-even units of Product- K = 19,600*3/7 = 8,400 units

Question 28
The profit volume ratio of X Ltd. is 50% and the margin of safety is 40%. You are required to
calculate the net profit if the sales volume is ₹1,00,000.

Solution:
Margin safety Ratio = Margin Safety/Actual Sales *100
40 = Marginal Safety/100,000*100
Margin of Safety = Rs 40,000

Marginal safety = Profit /PV ratio

Rs 40,000= Profit/50%
Profit = 40000*50%
= Rs 20,000

Question 29
The following details have been provided by ABC Ltd. Sales of 20,000 units (at Rs. 5 per unit)
and per unit. for variable costs: Rs. 3. A fixed cost fee of Rs. 8,000 each year. Determine the
company’s break-even revenue and P.V. ratio.

Solution:

( . – . )
P.V. Ratio = x 100 = x 40% or 0.40
.

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FINANCIAL MANAGEMENT 9.30
. ,
Break – Even Sales = = = Rs. 2,00,000
. . .

Question 30
DB Ltd furnished the following information
Particulars 2005-2006 2006-2007
Sales (Rs 10/unit) 200,000 2,50,000
Profit 30,000 50,000

You are required to compute:

(a) P/V Ratio.
(b) Break-even point.
(c) Total variable cost for 2005-2006 & 2006-2007.
(d) Sales required to earn a profit of Rs. 60,000.
(e) Profit/Loss when sales are Rs. 1,00,000

Solution:
(a) P/V Ratio = Change in Profit Change in Sales x 100 Here, P/V Ratio = [(50,000–30,000) /
(2,50,000– 2,00,000)] x100 = 40%

(b) P/V Ratio = {(F+P) / S} x 100 In the year 2006-2007 – P/V Ratio = [(F + 50,000) /
2,50,000] x 100 Or, 40 = (F + 50,000) 2,500 Or, F + 50,000 = 1,00,000 Fixed Cost = Rs. 50,000
Now, BEP Sales = Fixed Cost / P/V Ratio x 100 BEP Sales = (50,000 /40) x 100 = Rs. 1,25,000.

(c) P/V Ratio = {(S – V ) / S} x 100 In the year 2005-2006 – 40 = {(2,00,000 – V) / 2,00,000}
x 100 Or, 80,000 = 2,00,000 – V Or, V = 2,00,000 – 80,000 Total Variable Cost for 2005-06 =
Rs. 1,20,000. In the year 2006-07 – 40 = {(2,50,000 – V) / 2,50,000} x 100 Or, 1,00,000 =
2,50,000 – V Or, V = 2,50,000 – 1,00,000 Total Variable Cost for 2005-06 = Rs. 1,50,000.

(d) P/V Ratio = {(F + P) / S} x 100 Here, 40 = {(50,000 + 60,000) / S} x 100 Or, S = (1,10,000 /
40) x 100 Required Sales = Rs. 2,75,000.

(e) P/V Ratio = {(F + P) / S} x 100 Here, 40 = {(50,000 + P) / 1,00,000} x 100 Or, 40,000 =
50,000 + P P = (10,000) Loss = Rs. 10,000

Question 31
From the following information of Akansha Co. Ltd. Calculate P/V Ratio and Margin of Safety.
i. Sales -- Rs. 10,00,000
ii. Variable Cost -- Rs. 4,00,000
iii. Profit -- Rs. 3,00,000

Solution:
Contribution = Sales – Variable Cost
= Rs. 10,00,000 – Rs. 4,00,000
= Rs. 6,00,000

Fixed Cost = Sales – Variable Cost – Profit or Contribution - Profit

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FINANCIAL MANAGEMENT 9.31

= Rs. 10,00,000 – Rs. 4,00,000 – Rs. 3,00,000

= Rs. 10,00,000 – Rs. 7,00,000 = Rs. 3,00,000

P/V Ratio = 6,00,000/ 10,00,000*100 = 60%

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

Question 32
Surya Ltd has a total turnover of Rs. 10 lakhs. It is enjoying 30% margin of safety. Its total
variable cost is 60% of sales. Determine Fixed Cost and BEP in Sales.

Solution:
Variable Cost = 60% of Sales
= 0.60 × Rs. 10, 00,000
= Rs. 6,00,000

Contribution = Sales – Variable Cost

= Rs. 10,00,000 – Rs. 6,00,000
= Rs. 4,00,000

P/V Ratio = Contribution/ Sales

= 4,00,000/10,00,000*100
= 40%
Margin of Safety = 30% of Rs. 10,00,000 = Rs. 3,00,000

Margin of Safety = Profit/ P V Ratio

Profit = Margin of Safety × P/V Ratio = Rs. 3, 00,000 × 0.40
Profit = Rs. 1,20,000

Fixed Cost = Contribution – Profit

= Rs. 4, 00,000 – Rs. 1, 20,000 = Rs. 2,80,000

BEP (Value) = Actual Sales – Margin of Safety

= Rs. 10,00,000 – 3,00,000 = Rs. 7,00,000

Question 33
You have access to XYZ Ltd.’s data for the fiscal year that concluded on March 31, 2009, sales
of 100,000 units at Rs. 10 p.u. for variable costs: Rs. 6. 3,00,000 rupees per year in fixed costs.
Determine the safety margin.

Solution:
Break-even Sales = Fixed cost/Contribution p.u. = Rs. 3,00,000/Rs. 4 = 75,000 units
Margin of Safety = Actual sales – Break-even sales
= 1,00,000 units – 75,000 units
= 25,000 units
= 25,000 units x Rs. 10 = Rs. 2,50,000.

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