Financial Management

Assignment - A
Question 1a: Should the titles of controller and treasurer be adopted under Indian
context? Would you like to modify their functions in view of the company practice in
India? Justify your opinion?

Answer
This unit introduces you to the importance of finance and the role it plays in organisations. It
explains the different functions of money and the ways in which finance is linked to
organisational strategies. The unit also explores the ways in which finance is linked to the
governance of organisations, how organisations fund their activities, and the role of the
finance and accounting functions.
The Controllers Institute changed its name to Financial Executives Institute in 1962 and
developed the following list of functions for controllers and treasurers. The controllership
functions are accounting functions while the treasurership functions are finance functions.
According to the FEI, the combination of these functions defines financial management.

Controller & Treasurer are independent & they have their own Perspectives & Drivers as
detailed below:
Financial controller
Preparation of external annual accounts
Preparation of internal monthly management accounts
Preparation of capital and revenue budgets
 Tracking of budget variances
Key relationship: auditors
Treasurer
Raising short-term and long-term external funds
Management of liquidity
Minimisation of cost of external funds
Management of cash within the organization
Management of exposure to financial risks – interest-rate and foreign exchange
Key relationships: existing and potential providers of funds, stock market analysts and the
financial press

Therefore, from the above it is clear that, controller & treasurer have different roles to play.
However, majority of the Indian companies works with Financial Controller who himself
takes care of the treasury department / Portfolio. Therefore, as far as from Indian context, it
can be concluded that, controller is also responsible for treasury jobs & there is no separate
treasurer / treasury department exists
Question 1b: firm purchases a machinery for Rs. 8, 00,000 by making a down payment
of Rs.1,50,000 and remainder in equal installments of Rs. 1,50,000 for six years. What is
the rate of interest to the firm?

Answer

Particulars Ref Year 0 Year 1 Year 2 Year 3 Year 4 Year

5 Year 6
Rs.
Cost of Machinery (a) 800,000

Down Payment

made by firm (b) 150,000

Financed through

Borrowings c = (ab) 650,000

Repayment in
Equal d=6*15
instalments 0,000 900,000 150,000 150,000 150,000 150,000 150,000
150,000
every year
(maximum of
Six years)

Total interest paid

over 6 year period e = d -c 250,000

Rate of Interest
= total interest
/ total
Borrowings f=e/c 38.46%

Rate of
Interest g = f / 6yrs 6.41%
per annum

Break of interest
cost / principal
repayment:

1.) Interest cost

(can be 6:5:4:3:
apportioned in 2:1 21 6 5 4 3
2 1
the ratio of
no of years
repayment - i.e.
earlier the years (6+5+4+3+2
more (ratio) +1)
 the interest cost &
vice versa) h 250000 71429 59524 47619 35714 23810
11905
(250,000 (250,000 (250,000 (250,000 (250,00
(250,000
*6/21) *5/21) *4/21) *3/21) * 2/21)
*1/21)

2) Principal
Outstanding
Adjustment i=d–h 650000 78571 90476 102381 114286 126190
138095

Yearwise
Interest
rates:
- Principal
Outstanding at
Year End j 650000 571429 480952 378571 264286 138095
0
(prinicpal o/s at
year beginning -
Principal 65000- 571429 (480952 (378571 (264286-
(138095
repayment) I i) -i) -i) i)
-i)

RATE OF
INTEREST h/
EVERY YEAR principal
o/s
at year
beginning) 11.0% 10.4% 9.9% 9.4% 9.0% 8.6%
(h / (h / (h / (h / (h /
(h /

650000) 571429) 480952) 378571) 264286)

138095)
Question 2a: Explain the mechanism of calculating the present value of cash flows.
What is annuity due? How can you calculate the present and future values of an annuity
due? Illustrate

Answer 2a:

Calculating Present Value of Cash flows:

Money has time value. For ex: Rs.1000 received today is not the same worth after a year
(actually it is less)
Present value of cash flows: It indicates the value of expected worth at current value.
(Discounts the expected cash flows at appropriate discount rate (may be 10%, 20% etc.,)

Discount rate will generally be equal to = Inflation rate + Reqd. rate of return + risk free
premium rate

Details required for calculating Present Value of cash flows: Cash flows year wise,
discount rate. This technique is very useful for decision-making.

Annuity due: Uniform/ Constant/ Equal cash flows every year

Present Value of an Annuity

The formula below calculates the current value of a stream of equal payments made at regular
intervals over a specified period of time. This value is referred to as the present value (PV) of
an annuity.

The PV of an annuity formula is used to calculate how much a stream of payments is worth
currently where "currently" does not necessarily mean right now but at some time prior to a
specified future date.

In practice the PV calculation is used as a valuation mechanism. It evaluates a series of

payments over a period of time and reduces or consolidates them into a single representative
value as of a certain date. The PV calculation is useful in a variety of situations including:

 valuing a series of retirement payments;

 calculating the lump sum value of lottery winnings;
 establishing the purchase price of property sold for installment payments;
 determining the value of periodic payments under an insurance contract or a
structured settlement;
 pricing a coupon bearing bond (this is actually a composite calculation involving the
present value of the periodic interest payments (an annuity) and the return of principal
at maturity (a single sum).

Note however that the PV of an annuity formula does not inherently take into account the
effect of inflation. So when we talk about the current value of a stream of future payments,
the valuation mechanism is the time value of money as represented by prevailing market
interest rates, not the inflation rate.
The PV of an annuity equation above can be rearranged algebraically to solve for the
payment amount (PMT) that will amortize (pay off) a loan or equate to a current sales price.

The formula above assumes an ordinary annuity, one in which the payments are made at the
end of each compounding period. An annuity-due is one in which the payments are made at
the beginning of the compounding period.

 Present value of annuity

1. Meaning

Worth of Lump sum consideration today which is going to be received tomorrow

2. Computation:

Annuity * Present value annuity factor (PVAF)

PVAF is calculated as = 1-[1/(1+r) to the power n].

3. Illustration:
Mr. A would like to receive Rs.1000/- every year for 10 years from now. It is assumed
discount rate 10%, the present value annuity factor for 10 years 10% is 6.144.

Present value of annuity = 1000 * 6.144 = Rs.6145/-

 Future value of annuity

1. Meaning
Value of fixed investment every year – worth tomorrow. (i.e. corpus it grows)

2. Computation:

Annuity * Future value annuity factor (FVAF)

FVAF is calculated as = [(1+r) to the power n] - 1

3. Illustration:

Mr.X would like to grow a corpus by investment of Rs.10, 000 – 10 years from now.
Rate of interest @10%, the future value annuity factor for 10 years 10% is 1.594

Future value of annuity = 10000 * 1.594= Rs.15937/-

Question 2b: "The increase in the risk-premium of all stocks, irrespective of their beta
is the same when risk aversion increases" Comment with practical examples

Answer

Risk premium is the minimum amount of money by which the expected return on a risky
asset must exceed the known return on a risk-free asset, or the expected return on a less risky
asset, in order to induce an individual to hold the risky asset rather than the risk-free asset.
(Note that risk premia may be negative.) Thus it is the minimum willingness to accept
compensation for the risk.

A risk premium is the difference between the rate of return on a risk-free asset and the
expected return on Stock i which has higher risk. The market risk premium is the difference
between the expected return on the market and the risk-free rate.

Finance

In finance, the risk premium refers to the amount by which an asset's expected rate of return
exceeds the risk-free interest rate. When measuring risk, a common approach is to compare
the risk-free return on T-bills and the risky return on other investments (using the ex post
return as a proxy for the ex ante expected return). The difference between these two returns
can be interpreted as a measure of the excess expected return on the risky asset. This excess
expected return is known as the risk premium.

 Equity: In the stock market the risk premium is the expected return of a company
stock, a group of company stocks, or a portfolio of all stock market company stocks,
minus the risk-free rate. The return from equity is the sum of the dividend yield and
capital gains. The risk premium for equities is also called the equity premium. Note
that this is an unobservable quantity since no one knows for sure what the expected
rate of return on equities is. Nonetheless, most people believe that there is a risk
premium built into equities, and this is what encourages investors to place at least
some of their money in equities.
 Debt: In the context of bonds, the term "risk premium" is often used imprecisely to
refer to the credit spread (the difference between the bond interest rate and the risk-
free rate). To see why this is inconsistent with the given definition, imagine that the
risk free rate is 3% and XYZ corporate bonds are yielding 10%. Does that mean that
the expected return in excess of the risk free rate is 7%? Almost certainly not; after
all, there is surely a positive probability of a default, as well as a positive probability
of positive or negative capital gains due to fluctuations in the market prices of bonds.
In reality, the risk premium (as defined above) is likely to be significantly less than
the credit spread; it could even be negative, if the bond's default scenarios are
negatively correlated with most other bonds' default scenarios. See Capital asset
pricing model.

A risk averse investor dislikes risk and requires a higher rate of return as an inducement
to buy riskier securities. A realized return is the actual return an investor receives on their
investment. It can be quite different than their expected return.

The risk premium on a high beta stock would increase more.

RPj = Risk Premium for Stock j = (rM - rRF)bj.
If risk aversion increases, the slope of the SML will increase, and so will the market risk
premium (rM – rRF). The product (rM – rRF)bj is the risk premium of the jth stock. If bj is
low (say, 0.5), then the product will be small; RPj will increase by only half the increase in
RPM. However, if bj is large (say, 2.0), then its risk premium will rise by twice the increase
in RPM.
According to the Security Market Line (SML) equation, an increase in beta will increase a
company’s expected return by an amount equal to the market risk premium times the change
in beta. For example, assume that the risk-free rate is 6 percent, and the market risk premium
is 5 percent. If the company’s beta doubles from 0.8 to 1.6 its expected return increases from
10 percent to 14 percent. Therefore, in general, a company’s expected return will not double
when its beta doubles.

The security's beta is a function of the correlation of the security's returns with the market
index returns and the variability of the security's returns relative to the variability of the index
returns. In simple, beta measures the sensitivity of the stock with reference to broad based
market index.

For instance: a beta of 1.2 for a stock would indicate that this stock is 20% riskier than the
index & similarly beta of 0.9 for a stock indicates 10% less riskier than the index. Finally, a
beta of 1.0 means, stock is as risky as the stock market index. Therefore, the given statement
is false. Expected risk-premium for stock is beta times the market risk premium. For ex: let
us assume beta = 1.2 times, market risk premium = 10%, then expected risk premium = 10%
* 1.2 times = 12%.
Question 3a: How leverage is linked with capital structure? Take example of a MNC
and analyze.

Answer
In finance, leverage (sometimes referred to as gearing in the United Kingdom and Australia)
is a general term for any technique to multiply gains and losses. Most often it involves buying
more of an asset by using borrowed funds, with the belief that the income from the asset or
asset price appreciation will be more than the cost of borrowing. Almost always this involves
the risk that borrowing costs will be larger than the income from the asset or the value of the
asset will fall, leading to incurred losses.

Operating leverage is the degree to which fixed costs exist in a company's cost structure.
Generally speaking, operating leverage is fixed costs divided by total costs.

Operating leverage is important to the investment community because it is an indicator of the

quality of earnings of a firm.

Accounting leverage has the same definition as in investments. There are several ways to
define operating leverage, the most common. is:

There are three measures of operating leverage:

1. Fixed costs to total costs: An increase in the ratio of fixed costs to total costs may indicate
lower earnings quality because higher fixed costs may result in greater earnings instability.

2. Percentage change in operating income to the percentage change in sales: An increase

in the ratio of the percentage change in operating income to the percentage change in sales
may indicate lower earnings quality because higher fixed costs may result in greater earnings
instability.

3. Net income to fixed costs: An decrease in the ratio of net income to fixed costs may
indicate lower earnings quality because higher fixed costs may result in greater earnings
instability.

A higher percentage of variable costs to total costs indicates greater earnings stability since
variable costs can change more easily than fixed costs to meet a decline in sales. Moreover, a
company with a high breakeven point is more vulnerable to economic declines
Financial leverage refers to the use of debt to acquire additional assets. Financial leverage is
also known as trading on equity.

Financial leverage is usually defined as:

Connection Between Leverage and Capital Structure

Leverage and capital structure are two items that link to a company operations, with financial
figures related to the items on the company balance sheet. Leverage represents monies paid
for fixed assets, which are items that cost a great deal of money but are necessary to produce
goods and services. Common types of funds for fixed assets often include bonds issued by the
company and debt from bank loans. The connection between leverage and capital structure is
that companies use a mix of debt and equity finance for operations, with stakeholders
interested in how a company manages its business. In some cases, companies with too much
leverage indicate a risky company that may not offer good financial returns.

There are few different types of leverage that exist outside of a company balance sheet,
namely operating and financial leverage. These items also have a connection to a
company’s balance sheet as the items provide capital for repaying bonds or debt.
Operating leverage is basically sales revenue less cost of goods sold and less operating
expenses, with the result being earnings before interest and taxes (EBIT). Financial leverage
is EBIT less interest expenses, taxes, and preferred stock dividends, which result in earnings
available for common shares, or earnings per share. The income statement forms of leverage
and capital structure as listed on the balance sheet are all important in business.

Business analysts or capital finance departments are typically the source of a company
defined capital structure. In most cases, a company has a set capital structure for all business
operations and possibly different structures for each department or project. Again, there is
most likely a mix of debt and equity funds that make up this structure. There is no single
answer on how a company should create this mix. In most cases, a company leverage and
capital structure comes down to the cost paid for the funds, the type of project that needs
financing, and the long-term results of the financing types.

In capital structure, a company most likely prefers to avoid the use of bonds and other debt.
These funds usually offer more rights to the other parties vested in the loans made for the
leverage and capital structure. This increases the risk for each project as debt repayments
must be made, or a company may face significant penalties that can reduce financial returns.
Equity funds — most often stock — do not have the same guarantees as debt, making these
funds more attractive. Small companies, however, may not have the ability to issue stock,
leaving their leverage and capital structure one sided.

Example:
XYZ ltd has the following nos:
Contribution – Rs.100 lacs, fixed cost – Rs.25 lacs, Financial Charges/debt cost – Rs.40 lacs.

Particulars Value (Rs. In lacs)

Contribution 10

Fixed cost 25

EBIT 75
Interest cost 35

EBT 40

XYZ Ltd. has following:

Operating leverage financial leverage

Contribution / EBIT = 100 / 75 = 1.33 EBIT / EBT = 75 / 40 =

1.87

It is always preferable to have low operating risk & high financial risk (subject to Return on
capital employed (ROCE) > Interest cost on debt funds)
We can conclude that, XYZ ltd (MNC) is having a optimum capital structure & manageable
risk.

Question 3b: The following figures relate to two companies (10)

 P LTD. Q LTD.
(In Rs. Lakhs)
Sales 500 1,000
Variable costs 200 300
----- --------
Contribution Fixed costs 300 700
Fixed Cost 150 400
----- --------
150 400
Interest 50 100
----- --------
Profit before tax 100 200
You are required to:
(i) Calculate the operating, financial and combined leverages for the two companies; and
Comment on the relative risk position of them

Answer 3b:
Particulars (in Rs. Lacs) P ltd Q ltd

Sales 1000
500
Variable costs 200 300
Contibution 300 700
Fixed cost 150 400
PBIT / EBIT 150 300
Interest 50 100
Profit before Tax / EBT 100 200
Computation:

a) Opearting leverage:
= Contribution / EBIT
2.0 2.3
b) Financial leverage:
= EBIT / EBT 1.5 1.5

c) Combined leverage:
= Contirbution / EBT 3.0 3.5

Comments: Operating risk is higher Operating risk is higher than

'P' ltd
(i.e. fixed costs are high) (i.e. fixed costs are high)

Financial risk looks low Financial risk looks low

Overall risk is low as Overall risk is high as

Compared to 'Q' ltd compared to 'P' ltd
 It is always preferable to have low Operating leverage &
high Financial leverage (provided, Return on capital
employed > Interest on debt funds)

Question 4a: Define various concepts of cost of capital. Explain the procedure of
calculating weighted average cost of capital.
Answer 4a:

Concepts of Cost of Capital:

Capital refers to the funds invested in a business. The capital can come from different sources
such as equity shares, preference shares, and debt. All capital has a cost. However, it varies
from one sources of capital to another, from one company to another and from one period of
time to another.

Cost of capital may be defined as the company's cost of collecting funds. This is equal to the
average rate of return that an investor in a company will expect for providing funds. It is the
minimum rate of return that the project must earn to keep the value of the company intact.
The minimum rate of return is equal to cost of capital.

The cost of capital in always expressed in terms of percentage. Proper allowance is made for
tax purposes. This is done to get a correct picture of the cost of capital.

The cost of capital is a term used in the field of financial investment to refer to the cost of a
company's funds (both debt and equity), or, from an investor's point of view "the
shareholder's required return on a portfolio company's existing securities".[1] It is used to
evaluate new projects of a company. It is the minimum return that investors expect for
providing capital to the company, thus setting a benchmark that a new project has to meet.

Once cost of debt and cost of equity have been determined, their blend, the weighted-average
cost of capital (WACC), can be calculated. This WACC can then be used as a discount rate
for a project's projected cash flows

 Cost of debt

When companies borrow funds from outside or take debt from financial institutions or other
resources the interest paid on that amount is called cost of debt. The cost of debt is computed
by taking the rate on a risk-free bond whose duration matches the term structure of the
corporate debt, then adding a default premium. This default premium will rise as the amount
of debt increases (since, all other things being equal, the risk rises as the amount of debt
rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed
as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as
well). Thus, for profitable firms, debt is discounted by the tax rate. The formula can be
written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk
free rate

 Cost of equity

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of
return) where Beta= sensitivity to movements in the relevant market

Where:
Es=The expected return for a security

Rf=The expected risk-free return in that market (government bond yield)

βs=The sensitivity to market risk for the security

RM=The historical return of the stock market/ equity market

(RM-Rf)=The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in the particular market, such as
government bonds.

An alternative to the estimation of the required return by the capital asset pricing model as
above, is the use of the Fama–French three-factor model.

Expected return

The expected return (or required rate of return for investors) can be calculated with the
"dividend capitalization model", which is

 Cost of retained earnings/cost of internal equity

Note that retained earnings are a component of equity, and therefore the cost of retained
earnings (internal equity) is equal to the cost of equity as explained above. Dividends
(earnings that are paid to investors and not retained) are a component of the return on capital
to equity holders, and influence the cost of capital through that mechanism.

Cost of internal equity = [(next year's dividend per share/(current market price per share -
flotation costs)] + growth rate of dividends)]

Weighted average cost of capital

The Weighted Cost of Capital (WACC) is used in finance to measure a firm's cost of capital.

The total capital for a firm is the value of its equity (for a firm without outstanding warrants
and options, this is the same as the company's market capitalization) plus the cost of its debt
(the cost of debt should be continually updated as the cost of debt changes as a result of
interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value
of all equity, not the shareholders' equity on the balance sheet.To calculate the firm’s
weighted cost of capital, we must first calculate the costs of the individual financing sources:
Cost of Debt, Cost of Preference Capital and Cost of Equity Cap.

Calculation of WACC is an iterative procedure which requires estimation of the fair market
value of equity capital

Importance of Cost of Capital

The concept of cost of capital is a major standard for comparison used in finance decisions.
Acceptance or rejection of an investment project depends on the cost that the company has to
pay for financing it. Good financial management calls for selection of such projects, which
are expected to earn returns, which are higher than the cost of capital. It is therefore,
important for the finance manager to calculate the cost of capital, which the company has to
pay and compare it with the rate of return, which the project is expected to earn.

In capital expenditure decisions, finance managers go on accepting projects arranged in

descending order of rate of return. He stops at the point where the cost of capital equals to the
rate of return offered by the project. That is, the finance manager finds out the break-even
point of the project. Accepting any project beyond the break-even point will cause financial
loss for the company.

The cost of capital is a guideline for determining the optimum capital structure of a company.

Calculation of Cost of Capital

In order to calculate the overall cost of capital, a finance manager has to take the following
steps:-

1. Determine the type of funds to be raised and their share in the capital structure.
2. Determine cost of each type of funds.
3. Calculate combined cost of capital of the company by giving weights to each type of
funds in terms of proportion of funds raised to total funds.

Question 4b: The following items have been extracted from the liabilities side of the
balance sheet of XYZ Company as on 31st December 2005.
Paid up capital:
4, 00,000 equity shares of Rs each 40,00,000
Loans:
16% non-convertible debentures 20,00,000
12% institutional loans 60,00,000

Other information about the company as relevant is given below:

31st dec Dividend Earning average market price
2005 Per share per share per share
7.2 10.50 65
You are required to calculate the weighted average cost of capital, using book values as
weights and earnings/price ratio as the basis of cost of equity. Assume 9.2% tax rate

Answer 4b:

Computation of Weighted Average Cost of Capital (WACC):

Nature of Capital Value Weights (basis Cost of capital

of book values Weights * Cost
O/S.) of Capital

a) Equity 4,000,000 33% 16.15 (refer 5.3

Capital W.No.1)
b) 16% non-
convertible 2,000,000 17% 14.53 Interest
debentures (1-taxrate) = 2.42
16% (100%-
9.2%)

c) 12%
institutional 6,000,000 50% 10.90
loans Interest (1-
taxrate) = 12%
(100%-9.2%) 5.45

Total 100% 13.25

12,000,000

Working Note: 1
Cost of equity:
Price earnings approach = Earnings per share / Market price per share
10.50 / 65 = 16.15%

Question 5a: A company has issued debentures of Rs. 50 Lakhs to be repaid after 7
years. How much should the company invest in a sinking fund earning 12% in order to
be able to repay debentures? Show the procedure of loan amortization and capital
recovery through an example.

Answer 5a:
Debentures to be redeemed after 7 years 5,000,000
Expected rate of return - on sinking fund investment to be created 12%
Discount rate@12%, 7 yrs 0.452
Present value of expected repayment of debentures @12% 7 yrs 2,261,746

Therefore, company has to invest Rs.22,61,746 @ 12% earning in Sinking fund to cover the
repayment expected 7 years from now.

 Loan Amortization

In banking and finance, an amortizing loan is a loan where the principal of the loan is paid
down over the life of the loan (that is, amortized) according to an amortization schedule,
typically through equal payments.

Similarly, an amortizing bond is a bond that repays part of the principal (face value) along
with the coupon payments. Compare with a sinking fund, which amortizes the total debt
outstanding by repurchasing some bonds.

A loan amortization schedule is a repayment plan that is calculated before repayment of a

loan begins. Amortization schedules are used for fixed interest long – term loans such as
mortgages, expenses like R& D expenses, Purchase of Goodwill, Voluntary Retirement
payment expenses, Amalgamation expenses etc.

Each payment to the lender will consist of a portion of interest and a portion of principal.
Mortgage loans are typically amortizing loans. The calculations for an amortizing loan are
those of an annuity using the time value of money formulas, and can be done using an
amortization calculator.

An amortizing loan should be contrasted with a bullet loan, where a large portion of the loan
will be paid at the final maturity date instead of being paid down gradually over the loan's
life.

An accumulated amortization loan represents the amount of amortization expense that has
been claimed since the acquisition of the asset

Effects

Amortization of debt has two major effects:

Credit risk

First and most importantly, it substantially reduces the credit risk of the loan or bond. In a
bullet loan (or bullet bond), the bulk of the credit risk is in the repayment of the principal at
maturity, at which point the debt must either be paid off in full or rolled over. By paying off
the principal over time, this risk is mitigated.
Interest rate risk

A secondary effect is that amortization reduces the duration of the debt, reducing the debt's
sensitivity to interest rate risk, as compared to debt with the same maturity and coupon rate.
This is because there are smaller payments in the future, so the weighted-average maturity of
the cash flows is lower.

Procedure with Ex:

M/s.XYZ ltd has incurred a Rs.50, 00,000 as lump sum payment towards voluntary
retirement separation charges during the accounting year 2009-2010.

XYZ ltd have planned to amortize the above expenses for a period of 10 years commencing
from FY.09-10

Therefore, the schedule of amortization for 10 year period as follows: Rs. 500,000/- per years
for 10 years

 Capital Recovery

DEFINITION of 'Capital Recovery'

1. The earning back of the initial funds put into an investment. Capital recovery must
occur before a company can earn a profit on its investment.

2. A euphemism for debt collection. Capital recovery companies obtain overdue

payments from individuals and businesses that have not paid their bills. Upon
obtaining payment and remitting it to the company to which it is owed, the capital
recovery company earns a fee for its services.

3. A company's recouping of the money it has invested in machinery and equipment

through asset disposition and liquidation.

The reciprocal of Present value annuity factor (PVAF) is the capital recovery. Below example
will clarify better the meaning:

Capital recovery factor

A capital recovery factor is the ratio of a constant annuity to the present value of receiving
that annuity for a given length of time. Using an interest rate i, the capital recovery factor is:
where is the number of annuities received.[1]

This is related to the annuity formula, which gives the present value in terms of the annuity,
the interest rate, and the number of annuities.

If , the reduces to . As , the

Procedure with Ex:

Mr.X plan to lend Rs.1 lac today for a period of 5 years @ int.rate of 12%, how much income
Mr.X should receive each year to recover investment & principal back.

The result is known as capital recovery & which can be arrived by capital recovery factor.

Calculation:

Present value = Annuity * PVAF @12%,5years

Capital Recovery = Annuity * 1 / PVAF@12%,5years
Therefore, capital recovery = 100,000 * 0.27739 = Rs.27,740 each year for 5 years.

Question 5b: A bank has offered to you an annuity of Rs. 1,800 for 10 years if you invest
Rs. 12,000 today. What is the rate of return you would earn? .
Answer

Particulars Rs
Return expected per annum 1800
Fixed return/annuity for no of years 10
Total return expected 18000
Investment required today 12000
Nett return expected from investment 6000
Percentage of return for 10 years 50%
Percentage of return per annum 5%

Assignment - C
Question 1: The proforma of cost-sheet of HLL provides the following data:
Cost (perunit): Rs.
Raw materials 52.0
Direct labour 19.5
Overheads 39.0
Total cost (per unit): 110.5
Profit 19.5
Selling price 130.0

The following is the additional information available:

Average raw material in stock: one month; Average materials in process: half month; Credit
allowed by suppliers: one month; Credit allowed to debtors: two months; Time lag in
payment of wages: one and half weeks; Overheads: one month. One-fourth of sales are on
cash basis. Cash balance expected to be Rs. 12,000.
You are required to prepare a statement showing the working capital needed o finance a level
of activity of 70,000 units of output. You may assume that production is carried on evenly
throughout the year and wages and overheads accrue similarly.

Answer 1:

Particulars Cost/unit Production = 70,000 units

cost (Rs.) for 70000 units

Raw Material 52 3640000

Direct Labour 19.5 1365000
Prime cost 5005000
Overheads 39 2730000
Total cost 110.5 7735000
Profit 19.5 1365000
Sales 130 9100000

Statement of Working Capital for HLL - 70,000 units production per year:

Particulars No of months Computation

Rs.

Current Assets:
(A)
Raw material stock 1 303333
Process stock – 0.52 36,40,000/12* 1month 208542
Work in progress 2 50,05,000/12*0.5 months 1137500
Debtors – customers 91,00,000*3/4 (credit 12000
Cash balance expected to sales)/12*2
maintain 1661375
Total of CURRENT
ASSETS - (A)
Current Liabilities: (B)

Creditors – suppliers 1 36,40,000/12*1month 303333

1.5 weeks 13,65,000/12*0.34 38675
Wages Outstanding Or 227500
Overheads outstanding 0.34 1 27,30,000/12*1
month
Total of CURRENT
LIABILITIES - (B)

569508

NETT WORKING 1091867

CAPITAL REQUIRED
 Question 2a: Through quantitative analysis prove that PI is a better technique than
NPV in Capital Budgeting.

Answer

Capital budgeting is the process of allocating capital after determining project feasibility.
Determining project feasibility is a 3 step process:-

Step 1] Qualitative Analysis – Relationship/Branding feasibility, Socio-Cultural & Political

feasibility

Step 2] Forecasting Performance – Financial Modelling & Structural analysis

Step 3] Quantitative Analysis –IRR (or MIRR), NPV, Payback period and other quantitative
analysis

In capital budgeting, there are a number of different approaches that can be used to evaluate
any given project, and each approach has its own distinct advantages and disadvantages. PI –
Profitability Index & NPV – Net Present Value both are capital budgeting techniques.

What is NPV method?

The NPV method aims to capture the amount available after meeting the cost of all capital
contributors (all claim holders).This method ‘discounts’ operating cash flows at a rate that
captures the cost of capital (i.e. the capital used/contributed to generate cash flows). In fact,
the NPV method is what leads to the concept of value creation through Economic Profit.

Net Present Value (NPV) = Total PV of future CF’s - Initial Investment

Estimating NPV:

1. Estimate future cash flows: how much? and when?

2. Estimate discount rate
3. Estimate initial costs

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV

In Short: A positive NPV is a must and the higher the better.

Quantitative analysis
Present value of inflows = Rs. 200,000
Present value of outflows = Rs. 100,000
NPV = Rs.100,000
Profitability Index

PI =Total PV of future cash flows/Initial Investment or 1 +(NPV/Initial Investment)

 Minimum Acceptance Criteria:

o Accept if PI > 1
 Ranking Criteria:
o Select alternative with highest PI
 Disadvantages:
o Problems with mutually exclusive investments
 Advantages:
o May be useful when available investment funds are limited
o Easy to understand and communicate

Quantitative analysis:
Present value of inflows = Rs. 200,000
Present value of outflows = Rs. 100,000
PI = 2

NPV technique is better than PI technique for capital budgeting decisions. NPV shows wealth
at the end in absolute amount, which will be helpful to make decisions clearly, whereas the
same advantage is not available with PI technique.
However, PI shows – return over investment in times, which will be very useful for
immediate decision making. Generally, over the years, organizations prefer NPV technique
for capital budgeting decisions than PI technique.
Question 2b: A company is considering the following investment projects:

Projects Cash Flows (Rs.)

C1 C3
Co C2

A - 10,000 +10,000 ----- -----

B -10,000 + 7,500 + 7,500 -----
C -10,000 + 2,000 + 4,000 + 12,000

D -10,000 -10,000 + 3,000 + 3,000

I. according to each of the following methods: (1.) Payback, (2.) ARR, (3.) IRR, (4.) NPV
assuming discount rates of 10 and 30 percent.
II. Assuming the project is independent, which one should be accepted? If the projects are
mutually exclusive, which project is the best?

Answer 2b:

I)
Project A Project B Project C Project D
Methods

(1) Payback 1 + years 1.13 years 2.14 years 1.7 years

@10% discount 1 + years 1.25 years 3 + years 2.8 years
rate
@30% discount
rate

(2) Accounting 100% 180% 160%

rate of return 150%
(ARR)

(3) NPV (909) 3017 4140 3824

@10% discount (2308) 207 (633) 833
rate
@30% discount
rate

(4) IRR 0% 32% 26% 38%

Independent project: Project with higher NPV needs to be selected, which shows wealth in
absolute value at the end of the project
Therefore, Project C needs to be accepted.
II) In case projects are mutually exclusive:
First disparity between projects needs to be resolved. NPV selects Project C whereas IRR
selects Project D, therefore, disparity exists. Since cash outflows (Rs.10, 000/-) are same for
both the projects, the disparity arisen is called as Cash flow disparity. It can be resolved by
using Incremental cash flow technique. After resolving, the right project can be accepted.

Workings are as follows:

PROJECT A:
The following has been calculated assuming discount rates of 10% & 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Yea Cash Disco Discoun Unrecov Yea Cash Disco Discoun Unrecov
rs flows unt ted cash ered rs flows unt ted cash ered
rate * flows discounte rate * flows discounte
@ d cash @ d cash
10% flows 30% flows

(1) (2) (3) 4) =(2) (5) (1) (2) (3) 4) =(2) (5)
* (3) * (3)
0 (10,0 1.000 (10,000 (10,000) 0 (10,0 1.000 (10,000 (10,000)
00) ) 00) )
1 10,00 0.909 9,091 (909) 1 10,00 0.769 7,692 (2,308)
0 0

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year

Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted
cash flows of next year) *12]

Payback period exceed 1 year, since unrecovered cash flows turns positive only from
IInd yr onwards

where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period @ 10% & 30% discount rate = 1 + years
=1+ years
2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depreciation & Tax / Initial investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered as
profits after depreciation & taxes
Therefore = (10,000 (inflow) / 10,000 =(investment)) * 100

accounting rate of return = 100%; effectively 0% return

(whatever invested taken back)

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%

Years Cash Discount Discounted Years Cash Discount Discounted
flows rate * cash flows flows rate * cash flows
@ 10% @ 30%

(1) (2) (3) 4) =(2) * (1) (2) (3) 4) =(2) *

(3) (3)
0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)
1 10,000 0.909 9,091 1 10,000 0.769 7,692
(909) NPV (2,308)
NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of return at which NPV = 0

In project A , IRR is '0'% at which NPV =0 (i.e. there is no return from the project)
PROJECT B:

The following has been calculated assuming discount rates of 10% & 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Yea Cash Disco Discou Unrecov Yea Cash Disco Discoun Unrecov
rs flows unt nted ered rs flows unt ted cash ered
rate * cash discounte rate * flows discounte
@ flows d cash @ d cash
10% flows 30% flows

(1) (2) (3) 4) =(2) (5) (1) (2) (3) 4) =(2) (5)
* (3) * (3)
0 (10,0 1.000 (10,000 (10000) 0 (10,0 1.000 (10,000 (10,000)
00) ) 00) )
1 7,500 0.909 6,818 (3,182), 1 7,500 0.769 5,769 (4,231)
2 7,500 0.826 6,198 3,017 2 7,500 0.592 4,438 207

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year / disocunted
cash flows of next year) *12] where base year = year in which unrecovered cash flows turns 0
or +ve

Payback period @ 10% discount rate= 1 + [(3182/3017)*12] =1.13 years

Payback period @ 30% discount rate= 1 + [(4231/207)*12] =1.25 years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depreciation & Tax / Initial investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered as
profits after depreciation & taxes

Therefore e = (15,000 (inflow) / 10,000 (investment)) * 100

accounting rate of return = 150%;

effectively 50% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%
Years Cash Discount Discounted Years Cash Discount Discounted
flows rate * cash flows flows rate * cash flows
@ 10% @ 30%

(1) (2) (3) 4) =(2) * (1) (2) (3) 4) =(2) *

(3) (3)
0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)
1 7,500 0.909 1 6,818 1 7,500 0.769 5,769
2 7,500 0.826 6,198 2 7,500 0.592 4,438
3,017 NPV 207
NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of return at which NPV = 0
For project B , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] * (L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at given required rate of return)
L2 = one more guess rate

Relationship between discount rate and NPV: inverse relationship:

Discount rate goes up NPV falls

NPV goes
Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30% @ discount rate NPV is +ve
by applying the relationship, increased disocunt rate) Let us calculate L2 = 32%

Discounted @32% (assumed rate)

Years Cash flows Discount rate * Discounted cash flows

@ 32%
(1) (2) (3) 4) =(2) * (3)
0 (10,000) 1.000 (10,000)
1 7,500 0.758 5,682
2 7,500 0.574 4,304
14
NPV
therefore, IRR for Project B = 30% + [207 /( 207+14)]*32% - 30%

IRR 30% + 1.873 31.87%

PROJECT C:
The following has been calculated assuming discount rates of 10% & 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Yea Cash Disco Discou Unrecov Yea Cash Disco Discoun Unrecov
rs flows unt nted ered rs flows unt ted cash ered
rate * cash discounte rate * flows discounte
@ flows d cash @ d cash
10% flows 30% flows

(1) (2) (3) 4) =(2) (5) (1) (2) (3) 4) =(2) (5)
* (3) * (3)
0 (10,0 1.000 (10,000 (10000) 0 (10,0 1.000 (10,000 (10,000)
00) ) 00) )
1 2,000 0.909 1,818 (8,182 1 2,000 0.769 1,538 (8,462)
2 4,000 0.592 2,367 (6,095)
2 4,000 0.826 3,306 (4,876) 3 12,00 0.455 5,462 (633)
3 12,00 0.751 9,016 4,140 0
0

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year / discounted
cash flows of next year) *12] where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 2 + [(4876/4140)*12] =2.14years

Payback period @ 30% discount rate= exceeds 3 years = 3 +years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered
as profits after depreciation & taxes
therefore = (18,000 (inflow) / 10,000 (investment)) * 100
accounting rate of return = 180%;
effectively 80% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%
Years Cash Discount Discounted Years Cash Discount Discounted
flows rate * cash flows flows rate * cash flows
@ 10% @ 30%

(1) (2) (3) 4) =(2) * (1) (2) (3) 4) =(2) *

(3) (3)
0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)
1 2,000 0.909 1 ,818 1 2,000 0.769 1,538
2 4,000 0.826 3,306 2 4,000 0.592 2,367
3 12,000 0.751 9,016 3 12,000 0.455 5,462

4,140 NPV (633)

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at given required rate of return)
L2 = one more guess rate

Relationship between discount rate and NPV: inverse relationship:

Discount rate goes up NPV falls

NPV goes
Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30% @ discount rate NPV is -ve
by applying the relationship, reduced disocunt rate)

Let us calculate L2 = 26%

Discounted @26% (assumed rate)

Years Cash flows Discount rate * Discounted cash flows

@ 26%
(1) (2) (3) 4) =(2) * (3)
0 (10,000) 1.000 (10,000)
1 2000 0.794 1,587
2 4000 0.630 2,520
3 12,000 0.500 5,999
106
NPV

therefore, IRR for Project B = 30% + [-633 /( -633-

106)]*26% - 30%
IRR
30% -
3.43 26.57

PROJECT D:
The following has been calculated assuming discount rates of 10% & 30% separately:

1) Payback period: time period to recover initial investment

a) Discounted @10% b) Discounted @30%

Yea Cash Disco Discou Unrecov Yea Cash Disco Discoun Unrecov
rs flows unt nted ered rs flows unt ted cash ered
rate * cash discounte rate * flows discounte
@ flows d cash @ d cash
10% flows 30% flows

(1) (2) (3) 4) =(2) (5) (1) (2) (3) 4) =(2) (5)
* (3) * (3)
0 (10,0 1.000 (10,000 (10000) 0 (10,0 1.000 (10,000 (10,000)
00) ) 00) )
1 10,00 0.909 9,091 (909) 1 10,00 0.769 7,692 (2,308)
0 0
2 3,000 0.826 2,479 1,570 2 3,000 0.592 1,775 (533)
3 3,000 0.751 2,254 0.751 3 3,000 0.455 1,365
833

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year
Payback period = Base year + [(unrecovered disocunted cash flow of base year /
disocunted cash flows of next year) *12]
where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period @ 10% discount rate= 1 +
[(909/1570)*12] =1.7 years

Payback period @ 30% discount rate=

2 + [(533/833)*12] = 2.8 years

2) Accounting rate of return: rate of return on initial investment made:

given as: Average profit after depriciation & Tax / Initial
investment

Since no information on profits, depreciation & taxes, it is treated cash inflows considered as
profits after depreciation & taxes
therefore =
(16,000 (inflow) / 10,000
(investment)) * 100
accounting rate of return = 160%;
effectively 60% return

4) NPV (net present value):

a) Discounted @10% b) Discounted @30%
Years Cash Discount Discounted Years Cash Discount Discounted
flows rate * cash flows flows rate * cash flows
@ 10% @ 30%

(1) (2) (3) 4) =(2) * (1) (2) (3) 4) =(2) *

(3) (3)
0 (10,000) 1.000 (10,000) 0 (10,000) 1.000 (10,000)
1 10,000 0.909 9,091 1 10,000 0.769 7,692
2 3,000 0.826 2,479 2 3,000 0.592 1,775
3 3,000 0.751 2,254 3 3,000 0.455 1,365

3,824 NPV 833

NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n;

where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at given required rate of return)
L2 = one more guess rate
Relationship between discount rate and NPV:
inverse relationship:
Discount rate goes up NPV falls
NPV goes

Discount rate comes down up

Let us assume L1 = 30% (why, because as could be seen at 30% @
discount rate NPV is+ve by applying the relationship, increased disocunt rate)
Let us calculate L2 = 38%
Discounted @38% (assumed rate)

Years Cash flows Discount rate * Discounted cash flows

@ 38%
(1) (2) (3) 4) =(2) * (3)
0 (10,000) 1.000 (10,000)
1 10,000 0.725 7,246
2 3,000 0.525 1,575
3 3,000 0.381 1,142
37
NPV

therefore, IRR for Project B = 30% + [833 /( 833+37)]*38% - 30%

30% +
IRR 7.66 37.66%

1) NPV (net present value): for increments cash flows

a) Discounted @10% b) Discounted @30%
Years Increme Discount Discounted Years Cash Discount Discounted
ntal rate * cash flows flows rate * cash flows
Cash @ 10% @ 30%
flows
(project
C–
project
D)

(1) (2) (3) 4) =(2) * (1) (2) (3) 4) =(2) *

(3) (3)
0 0 1.000 - 0 0 1.000 -
1 (8,000) 0.909 (7,273) 1 8,000 0.769 (6,154)
2 1,000 0.826 826 2 2 1,000 0.592 592
3 9,000 0.751 6,762 3 9,000 0.455 4,096

316 NPV (1,466)

NPV
* disocunt rate computed using formule = 1 / (1+r) to the power n;
where r = disocunt rate
& n = year

3) IRR (Internal rate of return): which is the rate of return at which NPV = 0
For project C , IRR is calculated as below:
IRR = L1 + [NPVL1 / (NPVL1 - NPVL2)] *
(L2 - L1)
where L1 = guess rate (depend on NPV, disocunted at given required rate of return)
L2 = one more guess
rate
Relationship between discount rate and NPV: inverse relationship:
Discount rate goes up NPV falls
NPV goes
Discount rate comes down up
Let us assume L1 = 10% (why, because as could be seen at 30% @
discount rate NPV is+ve by applying the relationship,
increased disocunt rate)
Let us calculate L2 = 13%

Discounted @13%
(assumed rate)

Years Cash flows Discount rate * Discounted cash

@ 13% flows

(1) (2) (3) 4) =(2) * (3)

0 0 1.000 -
1 8,000 0.885 (7,080)
2 1,000 0.783 783
3 9,000 0.693 6,237
(59)
NPV

therefore, IRR for Project B = 10% + [316 /(

316+59)]*13% - 10%
10% +
IRR 2.5 12.50%
Target return = 10%
IRR for incremental cash flows = 12.5%
since IRR for incremental cash flows > Target return, select / accept Project C
Question 3a: "Firm should follow a policy of very high dividend pay-out” Taking
example of two organization comment on this statement"
Answer

The dividend payout ratio is the amount of dividends paid to stockholders relative to the
amount of total net income of a company. The amount that is not paid out in dividends to
stockholders is held by the company for growth. The amount that is kept by the company is
called retained earnings

Alternative Formula

I.The retention ratio and the dividend payout ratio together equal 1 or 100% of net income.
The premise is that whatever amount not paid in dividends is kept by the company to reinvest
for expansion.

A simple example would be a company who pays out 100% of their net income in dividends.
In this situation, net income would be equal to dividends. Using the formula for this example,
the dividend payout ratio would be 1 or 100%. The retention ratio would be 0 or 0% as they
do not retain and reinvest any of their earnings for growth. Using the alternative formula 1 - 0
would be 1.

Alternatively, a company who pays no dividends would have a 0 dividend payout ratio and a
1 retention ratio, which means that the company reinvests all of their net income for growth

II.The dividend payout ratio formula can also be restated on a "per share" basis. If the
dividend per share and earnings per share is known, the dividend payout ratio can be
calculated using the same concept of dividends paid divided by earnings, or net income

The statement not necessarily be true. Let us take 2 companies;

High dividend pay out company – 100% payout

a) Less retained earnings

b) Slower / lower growth rate
c) Lower market price
d) Cost of equity (Ke) > IRR (r = rate of return earned by company on its investment.
e) Indicates that company is declining.

Low dividend payout company – 20% payout

a) More retained earnings

b) Accelerated/higher growth rate
c) Higher market price
d) Cost of equity (Ke) < IRR (r = rate of return earned by company on its investment.
e) Indicates that company is growing.
It must be noted that, dividend is a trade off between retaining money for capital expenditure
and issuing new shares.
Question 3b: An investor gains nothing from bonus share "Critically analyse the
statement through some real life situation of recent past.
Answer

A bonus share is a free share of stock given to current shareholders in a company, based
upon the number of shares that the shareholder already owns While the issue of bonus shares
increases the total number of shares issued and owned, it does not change the value of the
company. Although the total number of issued shares increases, the ratio of number of shares
held by each shareholder remains constant
A stock dividend represents a distribution of shares in lieu of or in addition to the cash
dividend (known as bonus shares in India) to the existing shareholders. This has the effect of
increasing the number of outstanding shares of the company.

The shares are distributed proportionately. Thus, a shareholder retains his proportionate
ownership of the company. For example, if a shareholder owns 100 shares at the time when a
10% stock dividend is declared, he will receive 10 additional shares

Advantages:
The stock dividend carries certain advantage both to shareholders and the company.

To shareholders:

One of the advantages to shareholders in the respect of stock dividends is the tax benefit. The
receipt of the stock dividends by the shareholder is not taxable as income. The payment of
stock dividend is normally interpreted by shareholders as an indication of higher profitability.

If a company has been following a policy of paying a fixed amount of dividend share and
continues it after the declaration of the stock dividend, the total cash dividends of the
shareholders will increase in future. The declaration of the stock dividend may have a
favourable psychological effect on shareholders.

To company:

The declaration of a stock dividend allows the company to declare a dividend without using
up cash (Conservation of cash) that may be needed to finance the profitable investment
opportunities within the company.

In some situations, even if the company’s intention is not to retain earnings, the stock
dividend is the only means to pay dividends and satisfy the desires of shareholders.
To increase the trading activity, sometimes the intention of a company in declaring the stock
dividend is to reduce the market price of the share and make it more attractive to investors.

Limitations:
1. Shareholders fail to realise that the stock dividend does not affect their wealth and,
therefore, in itself it has no value for them.

2. It is a formal way of recognising something (earnings) which the shareholders already

own. It merely divides the ownership of the company into a large number of snare
certificates.

3. Stock dividends are more costly to administer than cash dividend.

4. The stock dividend can be disadvantageous if the company declares periodic small stock
dividends.

The statement is false. An investor gains bonus shares at zero cost, However, the market price
of the stock will come down & over the long period, the investor definitely maximizes his
wealth due to bonus shares.
From company angle, bonus issue is only an accounting entry & it doesn’t change the
wealth/value of the firm.
Recently, Bharti Airtel have issued bonus share 2:1, due to which, the investors have gained
Bonus shares at zero cost & the market have come down to the extent of bonus issue &
immediately went up & investors have cashed the bonus shares thus maximized their wealth.
However, currently it is trading down due to varied reasons.
 CASE STUDY
Ques 1: You are required to make these calculations and in the light thereof advise the
finance manager about the suitability, or otherwise, of machine A or machine B.

Solution:
Advise to finance manager of Brown metals ltd, to select the appropriate machine:
Particulars Machine A (Rs. In lacs) Machine B (Rs. In lacs)
1) NPV 12 14
2) Profitability index 1.48 1.35
3) Pay Back period 2 years 3 years
4) Discounted pay back period 3.18 years 3.21 years

It is advised to go in for Machine B with enhanced capacity, which will add more value
to the firm. NPV is higher in respect of Machine B as compared to Machine A &
therefore machine with higher NPV needs to be invested.

Workings are as follows:

(a) to buy machine A which is similar to the existing machine:
a) Discounted @10%
Years Cash Unrecovered Discount Discounted Unrecovered
flows cash flows rate * cash flows discounted
@ 10% cash flows
@10%

(1) (2) (3) 4) =(2) * (5)

(3)
0 (25) (25) 1.000 (25) (25)
1 - (25) 0.909 - (25)
2 5 (20) 0.826 4 (21)
3 20 - 0.751 15 (6)
4 14 14 0.683 10 4
5 14 28 0.621 9 12
12
NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate &
n = year
1) Net Present value = Present value of inflows - Present value of outflows = 12 (as computed
above)
2) Profitability Index = Present value of inflows / present value of outflows which should be
>137 / 25 1.48
3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next
year) *12] where base year = year in which unrecovered cash flows turns 0 or +ve Payback
period = 2 + [(20/0)*12] = 2 years
4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year
/ disocunted cash flows of next year) *12] where base year = year in which unrecovered cash
flows turns 0 or +ve
Payback period = 3 + [(6/4)*12] =3.18 years
 (b) to go in for machine B which is more expensive & has much greater capacity:
Years Cash Unrecovered Discount Discounted Unrecovered
flows cash flows rate * cash flows discounted
@ 10% cash flows
@10%

(1) (2) (3) 4) =(2) * (5)

(3)
0 (40) (40) 1.000 (40) (40)
1 10 (30) 0.909 9 (31)
2 14 (16) 0.826 12 (19)
3 (16) - 0.751 12 (7)
4 17 17 0.683 12 4
5 15 32 0.621 9 14
14
NPV

* disocunt rate computed using formule = 1 / (1+r) to the power n; where r = disocunt rate &
n = year
1) Net Present value = Present value of inflows - Present value of outflows = 14 (as computed
above)
2) Profitability Index = Present value of inflows / present value of outflows which should be
>154 / 40 1.35
3) Payback period = Base year + [(unrecovered cash flow of base year / cash flows of next
year) *12] where base year = year in which unrecovered cash flows turns 0 or +ve
Payback period = 3 + [(16/0)*12] = 3 years
4) Discounted Payback period = Base year + [(unrecovered disocunted cash flow of base year
/ disocunted cash flows of next year) *12]
where base year = year in which unrecovered cash flows turns 0 or +ve Payback period = 3 +
[(7/4)*12] =3.21 years
 Assignment - C

1. The main function of a finance manager is

(a) capital budgeting

(b) capital structuring
(c) management of working capital
(d) (a),(b)and(c)
Answer – (d)

2. Earning per share

(a) refers to earning of equity and preference shareholders.

(b) refers to market value per share of the company.
(c) reflects the value of the firm.
(d) refers to earnings of equity shareholders after all other obligations of the company have
been met.
Answer – (d)

3. If the cut off rate of a project is greater than IRR, we may

(a) accept the proposal.

(b) reject the proposal.
(c) be neutral about it.
(d) wait for the IRR to increase and match the cut off rate.
Answer – (b)

4. Cost of equity share capital is

(a) equal to last dividend paid to equity shareholders.

(b) equal to rate of discount at which expected dividends are discounted to determine their
PV.
(c) less than the cost of debt capital.
(d) equal to dividend expectations of equity shareholders for coming year.
Answer – (b)

5. Degree of the total leverage (DTL) can be calculated by the following formula

[Given degree of operating leverage (DOL) and degree of financial leverage (DFL)]
(a) DOL + DFL
(b) DOL /DFL
(c) DFL-DOL
(d) DOL x DFL
Answer – (d)

6. Risk- Return trade off implies

(a) increasing the profits of the firm through increased production

(b) not taking any loans which increase the risk of the firm
(c) taking decisions in a way which optimizes the balance between risk and return
(d) not granting credit to risky customers
Answer – (c)

7. The goal of a firm should be

(a) maximization of profit

(b) maximization of earning per share
(c) maximization of value of the firm
(d) maximization of return on equity
Answer – (c)

8. Current Assets minus current liabilities is equal to

(a) Gross working capital

(b) Capital employed
(c) Net worth
(d) Net working capital.
Answer – (d)

9. The indifference level of EBIT is one at which

(a) EPS increases

(b) EPS remains the same
(c) EPS decreases
(d) EBIT=EPS.
Answer – (d)

10. Money has time value since

(a) The value of money gets compounded as time goes by

(b) The value of money gets discounted as time goes by
(c) Money in hand today is more certain than money in future
(d) (b) and (c)
Answer – (b)

11. Net working capital is

(a) excess of gross current assets over current liabilities

(b) same as net worth
(c) same as capital employed
(d) same as total assets employed
Answer – (a)

12. The internal rate of return of a project is the discount rate at which NPV is

(a) positive
(b) negative
(c) zero
(d) negative minus positive
Answer – (c)
13. Compounding technique is

(a) same as discounting technique

(b) slightly different from discounting technique
(c) exactly opposite of discounting technique
(d) one where interest is compounded more than once in a year.
Answer – (c)

14. For determining the value of a share on the basis of P/E ratio, information is
required regarding:

(a) earning per share

(b) normal rate of return
(c) capital employed in the business
(d) contingent liabilities
Answer – (a)

15. Tandon committee suggested inventory and receivable norms for

(a) 15 major industries

(b) 20 minor industries
(c) 25 major and minor industries
(d) 30 major and minor industries
Answer – (c)

16. Capital structure of ABC Ltd. consists of equity share capital of Rs. 1,00,000 (10,000
share of Rs. 10 each) and 8% debentures of Rs. 50,000 & earning before interest and tax
is Rs. 20,000. The degree of financial leverage is

(a) 1.00
(b) 1.25
(c) 2.50
(d) 2.00
Answer – (b)

17. The following data is given for a company. Unit SP = Rs. 2, Variable cost/unit = Re. 0.70,
Total fixed cost- Rs. 1,00,000 Interest Charges Rs. 3,668, Output-1,00,000 units. The degree
of operating leverage is

(a) 4.00
(b) 4.33
(c) 4.75
(d) 5.33
Answer – (b)
18. Market price of equity share of a company is Rs. 25 and the dividend expected a year
hence is Rs. 10. The expected rate of dividend growth is 5%. The cost of equal capital to
company will be

(a) 40%
(b) 45%
(c) 35%
(d) 50%
Answer – (b)

19. The dilemma of "liquidity Vs profitability" arise in case of

(a) Potentially sick unit

(b) Any business organization
(c) Only public sector unites
(d) Purely trading companies
Answer – (b)

20. The present value of Rs. 15000 receivable in 7 years at a discount rate of 15% is

(a) 5640
(b) 5500
(c) 5900
(d) 5940
Answer – (a)

21. A bond of Rs. 1000 bearing coupon rate of 12% is redeemable at par in 10 yrs. If the
required rate of return is 10% the value of bond is

(a) 1000
(b) 1123
(c) 1140
(d) 1150
Answer – (a)

22. The EPS of ABC Ltd. is Rs. 10 & cost of capital is 10%.The market price of share at
return rate of 15% and dividend pay out ratio of 40% is

(a) 100
(b) 120
(c) 130
(d) 150
Answer – (a)

23. The credit term offered by a supplier is 3/10 net 60.The annualized interest cost of
not availing the cash discount is

(a) 22.58%
(b) 27.45%
(c) 37.75%
(d) 38.50%
Answer – (a)

24. The costliest of long term sources of finance is

(a) Preference share capital

(b) Retained earnings
(c) Equity share capital
(d) Debentures
Answer – (c)

25. Which of the following approaches advocates that the cost of equity capital & debit
capital remains the degree of leverages varies

(a) Net income approach

(b) Net operating income approach
(c) Traditional approach
(d) Modigliani-Miller approach
Answer – (b) & (d)

26. Which of the following is not a feature of an optimal capital structure.

(a) Profitability
(b) Safety
(c) Flexibility
(d) Control
Answer – (b)

27. While calculating weighted average cost of capital

(a) Retained earnings are excluded

(b) Bank borrowings for working capital are included
(c) Cost of issues are included
(d) Weights are based on market value or on book value
Answer – (a)

28. Which of the following factors influence the capital structure of a business entity?

(a) Bargaining power with suppliers

(b) Demand for product of company
(c) Expected income
(d) Technology adopted
Answer – (c)

29. According to the Walters model, a firm should have 100% dividend pay-out ratio
when.

(a) r = ke
(b) r < ke
(c) r > ke
(d) g > ke
Answer – (a)

30. Operating cycle can be delayed by

(a) Increase in WIP period

(b) Decrease in raw material storage period
(c) Decrease in credit payment period
(d) Both a & c above
Answer – (d)

31. If net working capital is negative, it signifies that

(a) The liquidity position is not comfortable

(b) The current ratio is less then 1
(c) Long term uses are met out of short- term sources
(d) All of a, b and c above
Answer – (d)

32. Which of the following models on dividend policy stresses on investors preference
for the current dividend

(a) Traditional model

(b) Walters model
(c) Gordon model
(d) MM model
Answer – (d)

33. Which of the following is a technique for monitoring the status of receivables

(a) ageing schedule

(b) outstanding creditors
(c) selection matrix
(d) credit evaluation
Answer – (a)

34. Average collection period is equal to

(a) 360/ Receivables Turnover Ratio

(b) Average Creditors / Sales per day
(c) Sales / Debtors
(d) Purchases / Debtors
Answer – (a)

35. In IRR, the cash flows are assumed to be reinvested in the project at

(a) Internal rate of return

(b) cost of capital
(c) Marginal cost of capital
(d) risk free rate
Answer – (d)

36. In a capital budgeting decision, incremental cash flow mean

(a) cash flows which are increasing.

(b) cash flows occurring over a period of time
(c) cash flows directly related to the project
(d) difference between cash inflows and outflows for each and every expenditure.
Answer – (d)

37. The simple EOQ model will not hold good under which of the following conditions

(a) Stochastic demand

(b) constant unit price
(c) Zero lead time
(d) Fixed ordering costs
Answer – (a)

38. The opportunity cost of capital refers to the

(a) net present value of the investment.

(b) return that is foregone by investing in a project.
(c) required investment in a project.
(d) future value of the investments cash flows.
Answer – (b)

39. Which of the following factors does not influence the composition of Working
Capital requirements

(a) Nature of the business

(b) seasonality of operations
(c) availability of raw materials
(d) amount of fixed assets
Answer – (d)

40. The capital structure ratio measure the

(a) Financial Risk

(b) Business Risk
(c) Market Risk
(d) operating risks
Answer – (a)