Important Areas:

325201 rajeswari. 4:30 hsbc

Problems:
1. Capital Budgeting
2. Working Capital Management
3. Cost of Capital
4. Capital Structure
5. Dividend Policy
6. Cash Management
7. Receivables Management

Theory:

Refer Notes

Areas of least importance:

 Risk return analysis

 Time value of money
 Capital Budgeting
1. You are required to suggest which project would be more feasible if the cost of capital is
12% and initial investment of both the projects A & B is Rs.1500000. Calculate PBP,
ARR, NPV, PI, IRR

Cash inflow from Cash Inflow from

Year
Project A Project B

1 800000 200000
2 800000 400000
3 400000 400000
4 200000 400000
5   600000
6   800000

Sol:

Calculation of Depreciation:

Project A = (1500000-0) /4 = 375000

Project B = (1500000-0) / 6 = 250000

Calculation of Pay Back Period:

Cash inflow
Cumulative Cash Cash Inflow Cumulative Cash
Year from Project
flows of A from Project B flows of B
A

1 800000 800000 200000 200000

2 800000 1600000 400000 600000
3 400000 2000000 400000 1000000
4 200000 2200000 400000 1400000
5     600000 2000000
6     800000 2800000

Project A = 1 + 700000 = 1 + 0.875 = 1.875 years

800000

Project B = 4+ 100000 = 4 + 0.17 = 4.17 years

 600000

Calculation of ARR:
ARR = Avg. PATAD X 100
Avg. Investment
Conversion Table:

Cash inflow Cash Inflow

Year from Project A Depreciaiton PATAD from Project Depreciation PATAD
(PATBD) B (PATBD)

1 800000 375000 425000 200000 250000 -50000

2 800000 375000 425000 400000 250000 150000
3 400000 375000 25000 400000 250000 150000
4 200000 375000 -175000 400000 250000 150000
5       600000 250000 350000
6       800000 250000 550000
      700000     1300000

Project A

Avg. PATAD= 700000/4 = 175000

Avg Investment = (Initial Investment + Salvage Value)/2 = (1500000 + 0) / 2 =750000

ARR = (175000 / 750000) * 100 = 23.33%

Project B

Avg. PATAD = 1300000/6 = 216667

Avg. Investment = (Initial Investment + Salvage Value)/2 = (1500000 + 0) / 2 =750000

ARR = (216667 / 750000) * 100 = 28.88%

Calculation of NPV, PI and IRR:

NPV = ∑DCI –DCO

Profitability Index or Benefic cost ratio=

GPI/GBCR = ∑DCI
∑DCO
NPI/NBCR = NPV Or GBCR - 1
∑DCO

IRR = LRR + Positive NPV X 100

Positive NPV + Negative NPV

Project A

Cash inflow Discount Discounted Discount Discounted Discount Discounted

Year from Project factor at Cash Flows factor at Cash Flows factor at Cash Flows
A (PATBD) 17% @17% 25% @ 18% 12% @12%
1 800000 0.8547 683760 0.8000 640000 0.8929 714285.7143
2 800000 0.7305 584400 0.6400 512000 0.7972 637755.102
3 400000 0.6244 249760 0.5120 204800 0.7118 284712.0991
4 200000 0.5337 106740 0.4096 81920 0.6355 127103.6157
    ∑DCI 1624660   1438720   1763856.531
Less:
    DCO 1500000   1500000   1500000
    NPV 124660   -61280   263856.5311

NPV @ 12% = 263856.5311

GBCR = 1763856.531 = 1.1759

1500000

NBCR = 263856.5311 = 0.1759

1500000

IRR = 17 + 124660 X (25 – 17)

124660 +61280

= 17 + 124660 X 8
185940

= 17 +5.3635

= 22.3635%
Project B:
Cash Inflow Discount Discounted Discount Discounted Discount Discounted
Year from Project factor at Cash Flows factor at Cash Flows factor at Cash Flows
B (PATBD) 20% @20% 10% @ 10% 12% @ 12%
1 200000 0.8333 166666.6667 0.9091 181818.182 0.8929 178571.4286
2 400000 0.6944 277777.7778 0.8264 330578.512 0.7972 318877.551
3 400000 0.5787 231481.4815 0.7513 300525.92 0.7118 284712.0991
4 400000 0.4823 192901.2346 0.6830 273205.382 0.6355 254207.2314
5 600000 0.4019 241126.5432 0.6209 372552.794 0.5674 340456.1134
6 800000 0.3349 267918.3813 0.5645 451579.144 0.5066 405304.8969
    ∑DCI 1377872.085   1910259.93   1782129.32
    Less: DCO 1500000   1500000   1500000
    NPV -122127.915   410259.935   282129.3205

NPV @ 12% = 282129

GBCR = 1782129.32 = 1.19

1500000

NBCR = 282129.32 = 0.19

1500000

IRR = 10 + 410259.93 X (20 – 10)

410259.93 + 122127.92

= 10 + 410259.93 X 10
532387.85

= 10 + 7.7060 = 17.7060%
2. A Ltd. is examining two mutually exclusive proposals for new capital Investments. The
data on the proposals are as follows:

Particulars Project A Project B

Net Cash outlay 40000 50000
Estimated life 4 years 5 years
Income tax rate 50% 50%
Cut off rate for appraisal 10% 10%
PBDT    
Year 1 12000 14000
Year 2 14000 16000
Year 3 16000 18000
Year 4 22000 22000
Year 5   20000

Using different techniques of capital budgeting, advice which proposal would be

preferable.

Sol:
Calculation of Depreciation:
Project A = 40000-0 / 4 = 10000
Project B = 50000-0 / 5 = 10000

Conversion Table for Project A:

Project A Less tax at Add
Particulars Less Dep PBT PATAD PATBD
(PBDT) 50% Dep
Year 1 12000 10000 2000 1000 1000 10000 11000
Year 2 14000 10000 4000 2000 2000 10000 12000
Year 3 16000 10000 6000 3000 3000 10000 13000
Year 4 22000 10000 12000 6000 6000 10000 16000

Conversion Table for Project B:

Project A Less tax at Add
Particulars Less Dep PBTAD PATAD PATBD
(PBDT) 50% Dep
Year 1 14000 10000 4000 2000 2000 10000 12000
Year 2 16000 10000 6000 3000 3000 10000 13000
Year 3 18000 10000 8000 4000 4000 10000 14000
Year 4 22000 10000 12000 6000 6000 10000 16000
year 5 20000 10000 10000 5000 5000 10000 15000
Calculation of Pay back period:
Project A:

Cumulative
Particulars PATBD
Cash flows
Year 1 11000 11000
Year 2 12000 23000
Year 3 13000 36000
Year 4 16000 52000
PBP = 3 years + 4000
16000

= 3.25 years

Project B:
Cumulative
Particulars PATBD
Cash flows
Year 1 12000 12000
Year 2 13000 25000
Year 3 14000 39000
Year 4 16000 55000
year 5 15000 70000

PBP = 3 years + 1000

16000
= 3.0625 years

Calculation of Accounting rate of Return:

ARR = AVg. PATAD X 100

Avg. Investment

Project A
Avg. PATAD = (1000+2000+3000+6000)/4 = 3000
Avg. Investment = (40000 + 0)/2 = 20000
ARR = (3000/20000) * 100 = 15%

Project B
Avg. PATAD = (2000+3000+4000+6000+5000)/5 = 4000
Avg. Investment = (50000 + 0)/2 = 25000
ARR = (4000/25000) * 100 = 16%
Calculation of NPV, PI and IRR:
NPV = ∑DCI –DCO

Profitability Index or Benefic cost ratio=

GPI/GBCR = ∑DCI
∑DCO

NPI/NBCR = NPV Or GBCR - 1

∑DCO

IRR = LRR + Positive NPV X 100

Positive NPV + Negative NPV

Project A:

Discounted Discount Discounted

Discount
Particulars PATBD Cash flows factor at Cash flows
factor @ 10%
@ 10% 15% @ 15%
Year 1 11000 0.9091 10000.1 0.8696 9565.22
Year 2 12000 0.8264 9916.8 0.7561 9073.72
Year 3 13000 0.7513 9766.9 0.6575 8547.71
Year 4 16000 0.683 10928 0.5718 9148.05
    ∑DCI 40611.8   36334.70
    Less: DCO 40000   40000
    NPV 611.8   -3665.30

NPV @ 10% = 611.9

GBCR = 40611.8 = 1.015

40000

NBCR = 611.8 = 0.015

40000

IRR = 10 + 611.8 X (15 -10)

611.8+3665.30

=10.7152%
Project B:
 Discounted Discount Discounted
Discount
Particulars PATBD Cash flows factor at Cash flows
factor @ 10%
@ 10% 15% @ 15%
Year 1 12000 0.9091 10909.2 0.8696 10434.78
Year 2 13000 0.8264 10743.2 0.7561 9829.87
Year 3 14000 0.7513 10518.2 0.6575 9205.23
Year 4 16000 0.683 10928 0.5718 9148.05
Year 5 15000 0.6209 9313.5 0.4972 7458.00
    ∑DCI 52412.1   46075.93
    Less: DCO 50000   50000
    NPV 2412.1   -3924.07

NPV @ 10% = 2412.1

GBCR = 52412.1 = 1.048

50000

NBCR = 2412.1 = 0.048

50000

IRR = 10 + 2412.1 X (15 -10)

2412.1+3924.07

= 10 + 1.9034
= 11.9034
----------------------------
3. Bajaj Industries plans investment of Rs.75000 in new machinery. That would produce
cash inflow of Rs.25000 for every year for 5 years. The representative of another
equipment manufacturer presents an alternative proposal. By investing Rs.160000 in his
company’s equipment, Bajaj Industries can obtain a cash inflow of Rs.50000 every year
for 5 years in future . An investment of this type can be expected to yield a discounted
rate of return of 12%
You are required to find
a. Which alternative is more attractive if discountrate is 12%
b. The internal rate of return on investment alternatives
c. IRR on incremental Investment

Sol:
 1st 2nd
Particulars
Alternative Alternative
Cash outflow 75000 160000
Cash inflow per annum 25000 50000
PVAF @12% for 5 years 3.6048 3.6048
PV of cash inflows 90120 180240
NPV (PVCI - CO) 15120 20240
PI (PVCI/CO) 1.2016 1.1265

Accoridng to NPV, 2nd alternative is better choice where as according to PI method,

1st alternative is better choice

Calculation of IRR:
1st 2nd
Particulars
Alternative Alternative
Cash outflow 75000 160000
Cash inflow per annum 25000 50000
PVAF @20% for 5 years 2.9906 2.9906
PV of cash inflows 74765 149530
NPV (PVCI - CO) -235 -10470

IRR for 1st alternative=

=12 + 15120 X (20 – 12)

15120 + 235

=12 + 7.8776
=19.8776%

IRR for 2nd alternative

=12 + 20240 X (20 – 12)
20240 + 10470

=12 + 5.2725
=17.2725%

Calculation of Incremental IRR

 Particulars DF @ 14% DF @ 15%
Incremental Cash Outlfow (160000 - 75000) 85000 85000
Incremental cash invlow (50000-25000) 25000 25000
PVAF for 5 years 3.4331 3.3522
PV of Cash inflows 85827.5 83805
NPV 827.5 -1195

=14 + 827.5 X (15- 14)

827.5 + 1195

=14 + 0.4091
=14.4091%

Capital Structure

Traditional Approach
4. XYZ Ltd is expecting an EBIT of Rs. 300000. The Company presently raise its
entire fund requirement of Rs. 2000000 by issue of equity with equity
capitalization rate of 16%. The firm is now contemplating to redeem a part of
capital by introducing debt financing. The firm has two options to raise debgt to
the extent of 30% or 50% of total funds. IT is expected that for debt financing up
to 30% the rate of interest will be 10% and equity capitalization rate is expected to
increase to 17%. However, if the firm opts for 50% debt, then the interest rate will
be 12% and equity capitalization rate will be 20%
You are required to compute the value of the firm and its overall cost of capital
under different options.

Sol:
Particulars 0% debt 30% Debt 50% debt
Total Debt   600000 1000000
Rate of interest   10% 12%
EBIT 300000 300000 300000
Less Interest   60000 120000
EBT 300000 240000 180000
 Cost of equity 16% 17% 20%
Value of Equity (E) = EBT/Ke 1875000 1411765 900000
Value of Debt (D)   600000 1000000
Total value of the firm V = (E + D) 1875000 2011765 1900000
Overall cost of capital (EBIT /V) 16% 14.91% 15.79%

Modigliani and Miller Approach:

5. The following is the data regarding the two companies X and Y belonging to the
same equivalent risk class. Explain how under MM Approach, an investor holding
10% of share in co.X will be better off in switching his holdings to Co.Y

Particulars X Y
No. of equity shares 90000 150000
Market price of shares 1.2 1
65 debentures 60000 -
PBIT 18000 18000

Step 1: Investor will sell I the market 10% of shares in Co. X and will realize Rs.10800
(90000*1.2*10/100)

Step 2: He will borrow a sum or Rs.6000 (10% of debt of Co. X at 6% interest)

Step 3: The investor will invest in 16800 in shares of Co. Y by purchasing 16800 (16800/Rs.
1)

Present
income in X Income from Y
Particulars Ltd. Ltd.
EBIT 18000 18000
less Interest 3600 0
EBT 14400 18000
Less tax Nil Nil
EAT 14400 18000
Less Pref dividend nil Nil
EAESH 14400 18000
Return on 10% investment in shares of
X and 11.2% shares of Y 1440 2016
Less Interest on loan of 6000 0 360
Net return 1440 1656
The investor will be better of by switching of his investment from X to Y because he can get
better returns.
 6. In considering the most desirable capital structure of a Co., the following estimates
of the debt equity capital (after tax) have been made at various levels of debt equity
mix

Debt as a % of total Capital employed Cost of debt in % Cost of equity in %

0% 5% 12%
10% 5% 12%
20% 5% 12.5
30% 5.50% 13%
40% 6% 14%
50% 6.50% 16%
60% 7% 20%

Calculate the optimal debt equity mix of the co. by calculating composed cost of capital.
Debt as a % of total Cost of debt Cost of
Weighted avg. cost of capital
Capital employed in % equity in %  
0% 5% 12% (0.05*0)+(0.12*100)= 12%
10% 5% 12% (0.05*0.1)+(0.12*0.9)= 11.30%
20% 5% 12.5 (0.05*0.2)+(0.12*0.8)= 11%
30% 5.50% 13% (0.05*0.3)+(0.12*0.7)= 10.75%
40% 6% 14% (0.05*0.4)+(0.12*0.6)= 10.80%
50% 6.50% 16% (0.05*0.5+(0.12*0.5)= 11.25%
60% 7% 20% (0.05*0.6)+(0.12*0.4)= 12.20%

The optimal debt equity mix is 30:70 as the weighted average cost of capital is lowest at this
mix i.e 10.75%
---------------------------------
7. ABC ltd. has equity share capital of Rs. 500000 divided into shares of Rs.100 each. It
wishes to raise further 3 lakhs for expansion scheme. The co. plans the following
financing alternatives.
a. By issuing equity shares only
b. Rs. 100000 by issuing equity shares at Rs.200000 through debentures or term loan at
the rate of 10% p.a.
c. By raising term loan only at 10% p.a
d. Rs. 100000 by issuing equity shares and Rs. 200000 by issuing 8% oreference
shares. You are required to suggest the best alternative giving your comment
assuming that the estimated EBIT after expansion is Rs. 150000 and corporate tax
rate is 35%
Sol:
Calculation of earnings per share:

particulars 1 2 3 4
Equity existing 500000 500000 500000 500000
New equity 300000 100000 0 100000
8% preference
shares 0 0 0 200000
10% debt 0 200000 300000 0
No. of equity shares 8000 6000 5000 6000
         
EBIT 150000 150000 150000 150000
Less int 0 20000 30000 0
EBT 150000 130000 120000 150000
Less Tax at 35% 52500 45500 42000 52500
EAT 97500 84500 78000 97500
Less Pref dividend 0 0 0 16000
EAESH 97500 84500 78000 81500
EPS (EAESH / No. of
eq. shares) 12.1875 14.0833333 15.6 13.583333

Conclusion:
From the analysis it is observed that EPS is highest with 3rd alternative i.e further financing of
Rs. 300000 can be done by raising term loan only at 10% p.a.

Indifference point:
8. XYZ corporation has planned for expansion which calls for 50% increase in assets.
The alternatives before the corporations are issue of equity shares or debt at 14%.
Its balance sheet and P&L account are as given below

Balance sheet
Liabilities Rs Assets Rs.
12% Debentures 2500000 Total Assets 2000000
Equity shares
(1000000 eq shares
of Rs. 10 each) 10000000
General reserve 7500000
20000000 20000000
 P&L Account
Particulars Amt
Sales 75000000
Less total cost excluding interest 67500000
EBIT 7500000
Less Interest on debentures 300000
EBT 7200000
Less tax at 50% 3600000
EAT 3600000
EPS 3.6
PE ratio 5 times
market price (EPS* PE ratio) 18

If the corporation finances the expansion with debt, the incremental financing charges will be @
14% and PE ratio is expected to be 4 times. If expansion is through equity, the PE ratio will
remain at 5 times. The co. expects that its new issues will be subscribed to at a premium of 25%
With the above information, determine
a. If EBIT is 10% of sales, calculate EPS at sales levels of 40000000, 80000000 and
100000000
b. After expansion determine at what level of EBIT, the EPS would remain the same
whether new funds are raised by equity or debt
c. Using PE ratio, calculate the market value of shares at each sales level for both debt and
equity financing
Sol:
a. Calculation of EPS at different levels
  4 crore 8 crore 10 crore
particulars Debt Equity Debt Equity Debt Equity
EBIT @ 10% 40 40 80 80 100 100
Less interest (3 + 14) = 17 17 3 17 3 17 3
EBT 23 37 63 77 83 97
Less tax at 50% 11.5 18.5 31.5 38.5 41.5 48.5
EAT 11.5 18.5 31.5 38.5 41.5 48.5
No. of Equity shares 10 lakh 18 lakh 10 lakh 18 lakh 10lakh 18 lakh
Eps 1.15 1.03 3.15 2.14 4.15 2.69

Note: Existing share 10

New issue [ (10*25%) + 10] 12.5
 No. of shares = 10000000 = 800000 +1000000 = 1800000
12.5

b. Indifference between two alternative financing

EBIT – 300000(1-0.5) = EBIT – 1700000(1-0.5)

1800000 1000000

By solving above two equations you get EBIT = 3450000. At this level of EBIT, there exists
indifference point i.e EPS of both options will be same

------------------------------
9. (Internal paper)
X co. ltd. is considering three different plans to finance its total project cost of Rs.100 lakhs. The
plans are:
particulars Plan A Plan B Plan C
Equity (Rs.100 per share) 50 34 25
8% debentures 50 66 75

Sales are estimated at Rs. 100 lakhs and 20% EBIT is forecasted. Tax rate 50%.
Compute EPS under different plans.

Sol:
Particulars Plan A Plan B Plan C
EBIT in laksh 20 20 20
Less Interest 4 5.28 6
EBT in lakhs 16 14.72 14
Less tax @ 50% 8 7.36 7
EAT in lakhs 8 7.36 7
No. of Eq. shares ( Equity capital / 100) 50000 34000 25000
EPS 16 21.65 28
Rank III II I

-----------------------------
10. Leverages (internal paper):
A firm has a sales of Rs. 1000000, variable cost of Rs. 700000, fixed cost of Rs. 200000 and
10% debentures of Rs. 500000. What are the operating, financial and combined leverages.
Sol:
Particulars Amount
Sales 1000000
Less VC 700000
Contribution 300000
Less FC 200000
EBIT 100000
Less Interest @ 10% on 500000 50000
EBT 50000
Operating Leverage (Cont / EBIT) 3
Financial Leverage (EBIT / EBT) 2
Combined Leverage (Cont / EBT) 6

11. A firm has a sales of Rs.7500000, variable cost of Rs. 4200000 and fixed cost of
Rs.60000. It has a debt of Rs 4500000 @ 9% and equity of Rs.5500000.
a. What is the firms ROI
b. What are the operating, financial and combined leverages
c. If the sales drop to Rs.5000000, What will be the new EBIT.
d. At what level of sales, the firms EBT will be equal to zero.

Sol:

Sales 7500000
Less VC 4200000
Contribution 3300000
Less FC 600000
EBIT 2700000
Less int @ 9% on 4500000 405000
EBT 2295000

a. Calculation of Return on investment:

EBIT/Capital employed = 2700000/ (5500000 +4500000) = 27%
b. Operating Leverage: Cont/EBIT = 3300000/2700000 = 1.22
Financial Leverage: EBIT/EBT = 2700000/2295000 = 1.17
Combined leverage: Cont/EBT = 3300000/229500 = 1.44
c. EBIT
Sales 5000000
Less VC (5000000*56%) 2800000
Contribution 2200000
Less FC 600000
EBIT 1600000

d. Sales level at which EBT of the firm will be equal to zero.

Sales 2284091
Less VC (56% of sales) 1279091
Contribution(44% of sales) 1005000
Less FC 600000
EBIT 405000
Less int @ 9% on 4500000 405000
EBT 0

12. A fast growing co. wants to expand its total assets by 50%, by the end of the current
year. You have been given below the company’s capital structure, which it considers to
be optimal.

Particulars Amt.
8% debt 400000
9% Pref shares 100000
Equity shares 500000
New debentures would be sold at 14% coupon rate (interest) and will be sold at par.
Preference shares will have 15% rate and will also be sold at par. Equity share currently
selling at Rs.100 can be sold at Rs.95. The share holders required rate of return is 17%
consisting of a dividend yield of 10% and an expected growth rate of 7%.
The retained earnings for the year are estimated to be Rs.50000. The tax rate is 50%.
Calculate:
a. Assuming all asset expansion is included in the capital budget. What is the required
amt. of capital.
b. How much of the capital must be financed by issuing new equity shares to maintain
the optimal capital structure.
c. Calculate the cost of new issues of equity shares and retained earnings.
d. Calculate WACC using marginal weights.
Sol:
a. Present total capital = 1000000
Expansion in total assets = 50%
Total capital required for expansion = 1000000*50% = 500000

b. 14% debt = 200000

15% Preference shares = 50000
Equity shares = 200000
Retained earnings = 50000

c. Calculation of cost of new issues:

Cost of debentures= Kd = Kd(1-t) = 14% (1-0.5) = 7%
Cost of preference shares = 15%
Cost of equity shares = D1 X 100 + G = (10/95)*100+7 = 17.53%
Po
d. Calculation of WACC based on marginal rates
Weighted
Source Book value Weights Cost cost
14% Debt 200000 0.4 0.07 0.0280
15% Preference 50000 0.1 0.15 0.0150
Equity 200000 0.4 0.18% 0.0007
Retained
earnings 50000 0.1 0.1753 0.0175

Weighted average cost of capital 0.0612

13. From the following, determine the cost of equity shares of x Ltd.
a. Current market price of a share is Rs.150
b. Cost of floatation is Rs.3
c. Dividend paid on outstanding shares over past 6 years
Dividend per
year share
1 10.5
2 11.02
3 11.58
4 12.16
5 12.76
6 13.4

d. Assume a fixed dividend pay out ratio

 e. Expected dividend on new shares at the end of current year is Rs. 14.10 per share

Sol:
Approximate growth rate is: 5%

(11.02-10.5)/10.5 = 4.95%
(11.58-11.02)/11.02 = 5.08%
(12.16-11.58)/11.58= 5.00%
(12.76-12.16)/12.16 = 4.93%
(13.4-12.76)/12.76 = 5.02%

Ke = (D1/Po)*100 + G = (3/150)*100 + 5 = 14.59%

Operating Cycle

14. The following information is available for a company. Calculate the operating cycle duration
and working capital requirements of the company

Amount
Particulars (Rs. In
Lakhs)
Avg. stock of raw materials and
200
stores
Avg. WIP 300
Avg. finished goods inventory 180
Average accounts receivables 300
Avg. accounts payable 180
Average raw materials and stores 10
consumed per day
Average cost of production per day 12.5
Avg cost of goods sold per day 18
Average sales per day 20
Avg. credit purchases per day 10

Sol:
Raw materials = Avg. stock of RM
Avg Raw materials consumed

= 200 = 20 days
10
 Work in progress = Avg. stock of work in progress
Avg. cost of production
= 300/12.5 = 24 days

Finished goods = Avg. stock of finished goods

Avg cost of goods sold per day
= 180/18 = 10 days

Debtors = Average Accounts receivable

Avg. sales per day
= 300/20 = 15 days

Creditors = Avg. Accounts payable

Avg. credit purchases per day
= 180/10 = 18
Operating Cycle = Raw materials + work in progress + finished goods + Debtors
= 20 + 24 + 10 + 15
= 69 days

Cash cycle = Raw materials + work in progress + finished goods + Debtors – Creditors
= 20 + 24 + 10 + 15 -18
= 51 days

Working capital requirement = (Cost of goods sold * Cash cycle) + desired cash balance
= [18 * 51] + 0
= 918
-----------------------------------
15. Calculate Gross working capital requirements in the cash required for contingency is Rs. 4.75
lakh, from the following information.

Opening Closing
Particulars
Balance Balance
Raw material 230 250
WIP 50 52
Finished goods 260 300
Book debts (Receivables) 380 450
Trade creditors 250 300
Purchase of raw materials and stores is Rs.810 lakhs
Manufacturing expenses is Rs.380 lakhs
Depreciation Rs. 60 lakhs
Excise duty Rs.160 lakhs
Selling and distribution and financial cost Rs.240 lakhs
Sales Rs.2000 lakhs

Sol:
Avg. stock of RM = 230 + 250 / 2 = 480 / 2 = 240
Avg. stock of work in progress = 50 + 52 / 2 = 102 / 2 = 51
Avg. stock of finished goods = 260 + 300 / 2 = 560 / 2 = 280
Avg. stock of accounts receivables = 380 + 450 /2 = 830 /2 = 415
Avg. stock of accounts payable = 250 + 300 /2 = 550/2 = 275

Cost Sheet:

Opening Stock of RM 230

Add: Purchase 810
1040
Less closing stock of raw materials 250
Raw Materials Consumed 790
Add: Manufacturing Exp 380
Depreciation 60
Exercise Duty 160 600
1390
Add: Opening work in progress 50
1440
Less: Closing Work in progress 52
Cost of production 1388
ADD: Selling and distribution and
financial exp. 240
1628
Add: Opening stock of finished goods 260
1888
Less: Opening stock of Finished
goods 300
Cost of goods sold 1588
Calculation of Averages:
Average Raw materials consumed per day = 790/360 = 2.19 lakhs
Avg. Cost of production per day = 1388/360 = 3.86 lakhs
Avg. cost of goods sold per day = 1588/360 = 4.41 lakhs
Avg. credit sales per day = 2000/360 = 5.56 lakhs
Avg. credit purchases per day = 810 / 360 = 2.25 lakhs

Operating Cycle = Raw materials + Work in progress + Finished goods + Debtors +

Creditors

Raw materials: 240 / 2.19 = 109.59 days

Work in progress = 51/ 3.86 = 13.21 days

Finished goods = 280 / 4.41 = 63.40 days

Debtors = 415/ 5.56 = 74.64 days

Creditors = 275 / 2.25 = 122.22 days

Operating Cycle = 109.59 + 13.21+ 63.49+74.64 = 260.93

Cash cycle = 109.59 + 13.21+ 63.49+74.64 – 122.22 = 138.71

Working Capital Requirements:

(Avg. cost of goods sold * Cash cycle)+ Cash balance

= (4.41 *139)+4.75

= 617.74 lakhs

-------------------------------

Working Capital Estimation

16. XYZ ltd. sells its product at a gross profit of 20% on sales. The following
information is extracted from the Co’s annual accounts for the year ended
31/12/08.

Amount (In
Particulars RS)
Sales at 3 months credit 40,00,000
Raw materials 12,00,000
Wages paid (paid 15 days in arrears) 960000
manufacturing Expenses (paid 1 month in
1200000
arrears)
 Administration expenses (paid 1 month in
480000
arrears)
Sales promotion exp. Payable 1/2 year in
200000
advance
Income tax payable quarterly (last installment
400000
due)

The company enjoys one month credit from the suppliers of raw material and maintains 2
month sock of raw materials and half month finished goods stock. Cash balance is
maintained at Rs.100000 as precautionary balance. Assuming a 10% margin. Find out the
W C requirement for the company.

Sol:
Sales 4000000
Less: Gross Profit (4000000*20%) 800000
Cost of Goods Sold 3200000

Particulars Amount  
Current Assets    
Cash 100000  
Raw materials stock (1200000 *2/12) 200000  
Stock of finished goods (3200000* 0.5/52) 133333  
Debtors (3200000 * 3/12) 800000  
Advance payment of sales promotion expenses (200000*
6/12) 100000 1333333
Current Liabilities    
Creditors ( 1200000*1/12) 100000  
O/S wages (960000 * 15/360) 40000  
o/s administration expenses (480000*1/12) 40000  
O/s manufacturing expenses (1200000 *1/12) 100000  
O/s Income Tax (40000*1/4) 100000 380000
Working Capital   953333
Add: 10% Margin   95333
Net working capital requirement   1048666
 17. A proforma cost sheet of a co. provides the following particulars

Amount/unit
Elements of Cost (Rs)
Raw materials 80
Direct labour 30
Overheads 60
Total cost 170
Add: Profit 30
Selling Price 200

The following particulars are available:

 Raw materials are in stock for an average of 1 month
 Materials are in process on an avg. for ½ month
 Finished goods are in stock on an avg for 1 month
 Credit allowed by suppliers in 1 month
 Credit allowed to customers is 2 months
 Lag in payment of wages is 1 ½ weeks
 Lag in payment of overheads is 1 month
 The ¼ th of the output is sold against cash
 Cash in hand and at bank is expected to be Rs.25000

You are required to prepare a statement showing the working capital need to finance a level of
activity 104000 units production.

Sol:

Statement showing net working capital:

Particulars Amt Amt

Current assets    
Raw material (104000*80*1/2)   693333
Work in progress (2 weeks or 0.5 months)    
RM (104000*80*0.5/12) 346667  
Direct Labour (104000*30*0.5/12*50/100) 65000  
Over heads (104000*60*0.5/12*50/100) 130000 541667
Finished Goods    
RM (104000*80*1/12) 693333  
Direct Labour (104000*30*1/12) 260000  
 Over heads (104000*60*1/12) 520000 1473333
Debtors(75% of sales)    
RM (104000*75/100*80*2/12) 1040000  
Labour (104000* 75/100*30*2/12) 390000  
Overheads(104000*75/100*60*2/12) 780000 2210000
Cash in hand and at bank   25000
     
    4943333
Current Liabilities:    
Creditors    
RM (103000*80*1/12) 693333  
Outstanding wages (104000*30*1.5/52) 90000  
Outstanding overheads(104000*60*1/12) 520000 1303333
Net working capital   3640000

------------------------------------

18. A proforma cost sheet of a company provides the following particulars

Elements of Cost
Material 40%
Direct Labour 20%
Overheads 20%
The following further particulars are available:
a. It is proposed to maintain a level of activity of 200000 units
b. Selling price is Rs.12 per unit
c. Raw materials are expected to remain in stores for an avg. period of 1 month
d. Materials will be in process on an avg.-1/2 month
e. Finished goods are required to be in stock for an avg. period of 1 month
f. Credit allowed to debtors is 2 months
g. Credit allowed by suppliers is 1 month
You are required to prepare a statement of working capital and forecasted profit and loss account
and balance sheet of the company assuming that
Share capital 1500000
8% debentures 200000
Fixed assets 1300000
Statement of Net working Capital:

Particulars Amt Amt

Current assets    
Raw material (200000*12*40/100*0.5/12)   80000
Work in progress    
RM (200000*12*40/100*0.5/12) 40000  
Direct Labour
(200000*12*20/100*0.5/12*50/100) 10000  
Over heads (200000*12*20/100*0.5/12*50/100) 10000 60000
Finished Goods    
RM (200000*12*40/100*1/12) 80000  
Direct Labour (200000*12*20/100*1/12) 40000  
Over heads (200000*12*20/100*1/12) 40000 160000
Debtors(75% of sales)    
RM (200000*12*40/100*2/12) 160000  
Labour (200000*12*20/100*2/12) 80000  
Overheads(200000*12*20/100*2/12) 80000 320000
    620000
     
Current Liabilities:    
Creditors(200000*12*40/100*1/12)   80000
     
    540000

Forecasted P & L a/c

To materials (200000*12*40/100) 960000 By Cost of Goods sold 1920000

To labour (200000*12*20/100) 480000 (2400000*80/100)
To overheads (200000*12*20/100) 480000
1920000 1920000
To COGS 1920000 By sales 2400000
To GP C/d 480000
2400000 2400000

To int on debentures (200000*8/12) 16000 480000

To N/P 464000
 480000 480000

Forecasted balance sheet

Share capital 1500000 Fixed assets 1300000

18% debentures 200000 Current assets
Net profit 464000 RM 80000
Creditors 80000 WIP 60000
FG 160000
Debtors 320000
Cash and bank balance 324000
2244000 2244000

---------------------------------

19. Foods Ltd. is present to operating at 60% level producing 36000 packets fo snack food
and proposes to increase capacity utilization in the coming year by 33 1/3% over the
existing level of production. The following data is available
Unit Cost structure of the packet at current level:
Raw material 4
Wages (variables) 2
Overheads (Variables) 2
Fixed Overhead 1
Profit 3
Selling price 12

a. RM will remain in stores for 1 month before issuing for production material will
remain in process for further 1 month
b. Suppliers grant 3 month credit to the co.
c. Finished goods remain in warehouse for 1 month
d. Debtors are allowed credit for 2 months
e. Lag in wages and overhead payment is 1 month

Prepare a projected profitability statement and the working capital requirement at the new level,
assuming that a minimum cash balance of Rs.19500 is to be maintained.

Sol:

Units at 80% capacity = 36000/60*80 = 48000

 Projected profitability statement at 80%:

particulars Per Annum Per Month

Sales @ Rs.12 (A) 576000 48000
Less: Cost
RM @ Rs.4 192000 16000
Wages @ Rs.2 96000 8000
Overheads @ Rs. 2 96000 8000
overheads fixed 36000 3000

Total Cost (B) 420000 35000

Profit (A –B) 156000 13000
Statement of net working capital

Current assets    
Cash   19500
Raw materials(48000*1/12*4)   16000
Work in progress    
Raw materials 16000  
Wages (48000*2*1/12*50/100) 4000  
Overheads (48000*2*1/12*50/100) 4000  
Fixed overheads (36000*1/12*50/100) 1500 25500
Finished goods    
Raw materials 16000  
Wages (48000*2*1/12) 8000  
Overheads (48000*2*1/12) 8000  
Fixed overheads (36000*1/12) 3000 35000
Debtors    
Raw Materials (48000*4*2/12) 32000  
Wages (48000*2*2/12) 16000  
Overheads (4800*2*2/12) 16000  
Fixed overheads(36000*2/12) 6000 70000
  166000
Less: Current Liability    
Creditors (48000*4*3/12) 48000  
outstanding wages(48000*2*1/12) 8000  
Overheads:    
Variable (48000*2*1/2) 8000  
Fixed (36000*1/12) 3000 67000
Net working capital   99000
 20. From the following forecast of income and expenditure, prepare a cash budget for
3 months commencing form 1/6 when the bank balance to likely to be Rs.10000

Administration,
Factory
Month Sales Purchases Wages selling and dist.
expenses
Exp

April 80000 41000 5600 3900 10000

May 76500 40000 5400 4200 14000
June 78500 38500 5400 5100 15000
July 90000 37000 4800 5100 17000
August 95500 35000 4700 6000 13000

Additional Information:

 Assume 50% of sales are for cash

 There are 2 month credit period allowed to customers and received from suppliers
 A sales commission of 5% on total sales is payable in the 2nd month after sales
 A plant valued at Rs.65000 will be purchased and paid for the month of august
 Dividends of Rs.15000 has to be paid in july
 Advance Income tax is to be paid in June to the extent of Rs.10000
 Dividends from Investment amount to Rs.1000 are expected in July
 Lag in payment of wage is 1/4th month
 Share call money of Rs.30000 is due to be collected with a premium of Rs.5000 in the
first week of August.

Sol:

Cash budget for 3 months commencing from 1st June:

Particulars June July August

1. Opening Balance 10000 8750 7125
2. Receipts      
Cash sales of 50% 39250 45000 47750
Collection from debtors 40000 38250 39250
Dividend from investment   1000  
Share call money premium     35000
Payments      
Payment to creditors 41000 40000 38500
Wages 5400 4950 4725
Factory expenses 5100 5100 6000
Admn, sales and dist. Exp 15000 17000 13000
Sales commission 4000 3825 3925
Purchase of plant     65000
Payment of dividend   15000  
Advance Income tax 10000    
       
Closing Balance (1+2-3) 8750 7125 -2025
       

Working Note: Calculation of wages

June – May = 5400*1/4 = 1350
June = 5400 * ¾ = 4050
5400

July - June = 5400*1/4 = 1350

July = 4800*3/4 = 3600
4950

August - July = 4800*1/4 = 1200

Aug = 4700 *3/4 = 3525
4725

21. From the following data forecast cash position at the end of April, May and June

selling
Month Sales Purchases Wages
expenses
FEB 120000 80000 10000 5000
March 130000 98000 12000 9000
Apl 70000 100000 80000 5000
May 116000 103000 10000 10000
June 85000 80000 80000 6000

Further Information:
a. Sales at 10% are realized in the month of sales, balance is realized equally in two
subsequent months
b. Creditors are paid for in the month following the month of supply
c. 20% of wages paid in arrears in the following month
d. Selling expenses are paid in the month itself
e. Income tax of Rs.20000 is payable in June
f. Dividend of Rs.12000 is also payable in June
 g. Income from investment of Rs.2000 received half yearly in march and September
h. Cash on hand on 1st April is estimated to be 40000

Sol:
Working Notes: Calculation of wages

April
20% of march 12000 2400
80% of April 8000 6400
8800
May
20% of April 8000 1600
80% of May 10000 8000
9600

June
20% of May 10000 2000
80% of June 8000 6400
8400

Cash budget for the month of April, May and June

Particulars April May June
1. Opening Balance 40000 47700 29700
2. Receipts      
Cash sales @ 10% 7000 11600 8500
Collection from drs      
I st Installment 58500 31500 52200
2nd Installment 54000 58500 31500
3. Payments      
Payments to creditors 98000 100000 103000
Wages 8800 9600 8400
Selling expenses 5000 10000 6000
Income tax     20000
Dividend paid     12000
Closing Balance (1+2-3) 47700 29700 -27500

Receivables Management
 22. A company currently has an annual turnover of Rs.10,00,000 and an avg. Collection
period of 45 days. The company wants to experiment with more liberal credit policy on
the ground that increase in collection period will generate addl. Sales. From the
following information, kindly indicate which of the policies you would like the co. to
adopt

Increase in
Credit Increase in Increase in
collection
Policy sales default
period
1 15 days 50000 2%
2 30 days 80000 3%
3 40 days 100000 4%
4 60 days 125000 6%

The selling price of the product is Rs.5 and the average cost per unit at current level is Rs.4 and
variable cost per u it is Rs.3. The current bad debts losses is 1% and the required rate is 20%

Sol:
Particulars Existing 1 2 3 4
Collection period in days 45 60 75 85 105
Expected sales 1000000 1050000 1080000 1100000 1125000
Expected additional sales   50000 80000 100000 125000
Contribution on sales (sales –
vc/Sales)*100) i.e. 2/5 * 100 = 40%   20000 32000 40000 50000
Bad Debts (Expected sales * %ge of
default) 10000 21000 32400 44000 67500
Additional Bad debts   11000 22400 34000 57500
Contribution of addl sales – addl bad debts
(A)   9000 9600 6000 -7500
           
Average receivables (Expected
sales*Credit period/360) 125000 175000 225000 259722 328125
           
Investment in receivables at variable cost
(Receivables * Variable cost /selling
price) 75000 105000 135000 155833 196875
           
Increase in investment in receivables   30000 60000 80833 121875
           
Required return on addl invt at 20%(B)   6000 12000 16167 24375
           
 Excess of addl contribution over required
rate of return on addl invt. (A-B)   3000 -2400 -10167 -31875

Conclusion: The addl. Contribution over required rate of return on additional investment
in receivables is positive under credit policy no.1 only. Hence, policy 1 i.e extension of
credit upto 60 days is recommended for adoption by the company.
------------------------------------------
23. A co. has sales of Rs.1000000. Avg. collection period is 50 days, bad debt losses 6% of
sales and collection xpenses Rs.10000. The cost of funds is 15% p.a. The co. has 2
alternative collection programmes
particulars 1 2
Avg. collection period reduced to 40days 30 days
Bad debts losses reduced to 4% of sales 3% of sales
Collection expenses 20000 30000

Evaluate which programme is viable

Sol:
Particulars Present 1 2
Sales 1000000 1000000 1000000
Avg. collection period 50 40 30
Receivables (sales*50/365) 136987 109589 82192
Reduction in receivables   27398 54795
Savings in interest at 15% (A)   4109 8219
% bad debts 6 4 3
Bad debts 60000 40000 30000
Reduction in bad debt from present
level (B)   20000 30000
incremental Benefits (A+B)   24109 38219
Collection expenses 10000 20000 30000
Incremental collection expenses ©   10000 20000
Net incremental benefits (A+B-C)   14109 18219
       

Collection policy 2 is recommended as it results in higher profits

 THEORY MATERIAL
TWO MARK QUESTIONS:

1. Define Financial Management?

Ans: Any business for that matter whether large or small, profit motive or not is considered to be
a financial concern and its success or failure to a large extent depends on its financial decisions.
Financial Management as a discipline helps the finance manager to address the following key
issues of business:

1. What will be the total fund requirement of the business?

2. Whether a particular investment alternative is profitable?
3. Is a merger or acquisition or a strategic alliance advisable?
4. What should be the ideal Inventory, Cash, Debtors and other Current assets?
5. How much of its earnings should the company distribute as dividends?... etc

Thus Financial Management is an area of business which deals with 3 major decisions namely:

1. INVESTMENT DECISIONS,
2. FINANCING DECISIONS, and
3. DIVIDEND DECISIONS.

2. What are the objectives/goals of financial management?

Ans: Operations of a firm must be with a focus to achieve its objectives in a timely and well
planned manner. The financial decisions taken by a firm must confine and complement to its
objectives. The major objectives of Financial management include Profit maximization and
Wealth maximization.

3. What is time value of money?

Ans: There exists an inverse relationship between ‘time’ and ‘value of money’ i.e., as time
increases, value of money decreases and vice-versa. A rupee one worth today is more valuable
than a rupee worth tomorrow.

Causes:

a) Inflation.

b) Capital carries interest along with it.

c) Current consumption is preferred rather than future consumption.

4. What is Venture Capital Financing?

Ans: It is a long term investment in growth oriented small and medium firms. Such investments
can be an Equity investment or in the form of loan finance/Convertible debt. The main objective
of venture capital financing is to earn capital gain on equity investments. It is a high risk-high
return financing.

5. Define CAPM? Explain its importance and assumptions?

Ans: The Capital asset pricing model was an extension of Markowitz’s Porfolio Theory by
William Sharpe and others. The model attempts to determine the true price of an asset reflecting
the expected return and risk associated with the asset.

Thus CAPM theory predicts the relationship between risk of an asset and its expected return,
thereby makes an attempt to price an asset based on its risk – return relationship.

The CAPM is based on the following assumptions:

1. All investors prefer that security that provides highest return for a given level of

risk or the lowest risk for a given level of return.

2. All investors have similar or homogenous expectations regarding the expected returns,

Variance, Standard deviation, Co-variance and Co-relation of returns among all securities.

3. Investors can Borrow and Lend money at risk free rate of return which is assumed

to remain constant over a period of time.

4. Holding period among investors are common.

5. There are no taxes.

6. Define Derivative Instrument?

Ans: A Derivative may be a commodity derivative or a financial derivative whose value is

derived from the value of an underlying asset. Derivative has a derived value or a dependent
value and its value changes with changes in the value of the underlying asset. Derivative
instruments include Forwards, Futures, Options, Swaps etc.
Forward:

A Forward contract is a tailor made contract whose terms are negotiated between the buyer and
the seller which are not traded on organized exchanges and are useful to hedge forward
receivables and payables where the exact date of such transaction is not fixed or known.

Futures:

A Futures contract is a standardized forward contract where quantity, date and delivery
conditions are standardized. The Futures contracts are traded on organized exchanges which are
settled with differences.

Options:

An Option gives its Holder the right to buy or sell an underlying asset on or before a given date
at a fixed price but with no obligation to buy or sell the same on payment of a fixed premium to
the writer.

Swaps:

A Swap is a contract between two counter parties to exchange two streams of payments for an
agreed period of time. Swaps may either be an interest rate or currency swaps.

7. Define Securitization?

Ans: Securitization is a process of pooling and repacking of homogenous illiquid assets into
liquid marketable securities that can be sold to investors. Securitization involves creation of a
Special purpose vehicle (SPV) to hold the financial assets underlying the securities, sale of
financial asset by the Originator of asset to the SPV and the issuance of securities by the SPV to
investors against the financial asset held by it.

8. Define Capital Rationing?

Ans: It is the process of allocating scarce capital resource to unlimited capital requirement in an
optimal manner so as to maximize overall Net present value. Projects are ranked based on
Profitability Index and are selected in the order of Highest to lowest till the level of capital
availability.
9. Define Capital Budgeting. Explain its importance?

Ans: The term, ‘capital’ refers to capital assets or fixed assets and the term ‘budgeting’ refers to
a financial statement prepared for a specific future period with the approval of top management.

Thus, the term capital budgeting refers to future investment decision of a firm in purchase or
acquisition of fixed assets.

Importance:

a. Heavy Expenditure

b. Long Duration

c. Irreversibility of decision making

d. Complexity of decision making

e. Direct Impact on organization

10. What are ADR and GDR?

Ans: An ADR represents the ownership in the shares of a foreign company trading on US
financial markets. ADR enables an US investor to buy shares in foreign companies without
undertaking cross border transactions. ADR carries prices in US dollars and can be traded like
the shares of US based companies.

An ADR is a negotiable certificate issued by a U.S. bank representing a specified number of

shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated
in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs
help to reduce administration and duty costs that would otherwise be levied on each transaction.

A GDR is a financial instrument used by private markets to raise capital denominated in either
U.S. dollars or Euros. It is a bank certificate issued in more than one country for shares in a
foreign company. The shares are held by a foreign branch of an international bank. The shares
trade as domestic shares, but are offered for sale globally through the various bank branches.

11. What is a Private Placement?

Ans: It is the sale of security to a relatively small group of investors like large banks, mutual
funds, insurance companies and pension funds. Since the offer is not made to Public at large, the
placement does not have to be registered with the Securities and Exchange Commission, detailed
financial information is not disclosed and no need to prepare prospectus.

12. Define IPO?

Ans: It is the first sale of shares by a Private company to the Public. IPO’s are generally issued
by small and newly established companies seeking capital from the public to expand. The IPO
offer can be either fixed Price issue or a Book building issue.

13. What are Sweat Equity Shares?

Ans: It refers to shares issued to owners, employees or any other related persons to the company
for contributing their time and effort for a particular project or to the company in general. It
represents the efforts put into start up company by the promoters and employees in exchange for
ownership shares.

14. Define Stock Split? Bonus share? (Stock dividend) Reverse Stock split?
Rights Issue? (Preferential allotment)

Ans: It is a method to increase the number of outstanding shares through a proportional

reduction in the par value of the share. A share split affects the par value and the number of
outstanding shares of the company but however the Networth of the firm remains unaltered.

REASONS FOR SHARE SPLIT:

a) To make small investors interested.

b) To signify future profit opportunities.
c) To signify future growth.
d) To increase dividend.
e) To avoid future dilution of control.

Bonus share or Stock Dividend:

It is the payment of dividend in kind through Bonus issue. It increases the number of
outstanding shares of the company proportionately. The declaration of bonus shares will increase
the paid up share capital and reduces the reserves and surplus of the company, keeping the
networth (Share capital + Retained Earnings) constant.

DIFFERENCES BETWEEN BONUS ISSUE AND STOCK SPLIT:

In case of Bonus issue, the balance of Reserves and Surplus will decrease and Share capital
increases proportionately keeping the par value of the share unchanged. With a Stock split, the
equity share capital remains unchanged and only the par value of the share and the number of
shares changes.

REVERSE SPLIT:

It is the opposite of Stock Split wherein the number of outstanding shares are reduced with
increase in Par value of share so as to increase the market price of share.

Right Issue:

The existing shareholders have right to subscribe to the new issue on a preferential basis before
issuing it to the general public by the company. It is a right to prevent diversion of control.

15. Define Internal rate of return?

Ans: It is at the rate of return at which NPV of a project becomes zero. It is the discount rate that
equates the present value of cash inflows with the initial investment associated with a project. If
Internal rate of return is greater than the cost of capital then the project is said to yield positive
NPV or else it is not worthy accepting the project.

16. Identify various theories of Capital Structure?

Ans: The various theories of Capital structure include:

a) Net Income Approach.

b) Net Operating Income Approach.

c) Modigliani and Miller Approach.

17. Identify various theories of Dividend?

Ans: The various theories of Dividend include:

a) Walter relevance theory.

b) Gordon Approach.

c) Modigliani and Miller Approach.

18. Define Weighted Average Cost of Capital?

Ans: It is the Overall cost of various sources of funds being Debt, Preference, Equity, Reserves
and term loan in proportion to each sources of funds in the Capital structure.

Calculation of Weighted Average Cost of Capital

WACOC or KA = WD KD + WP KP + WE KE + WR KR + WT KT

19. What is Marginal Cost of Capital?

Ans: It is the cost of raising additional unit of finance over and above the current cost. In short it
is the cost of raising new source of finance.

20. What is Concentration Banking?

Ans: It is a collection procedure used in Cash management where payments are made to
regionally dispersed collection centres, then deposited in local banks for quick clearing. It
reduces float by shortening the postal and bank float.

21. What is Lock Box system?

Ans: It is a collection procedure in which payers send their payments/cheques to a nearby post
box that is emptied by the firm’s bank several times and the bank deposits the cheque in the
firm’s account, reduces float by shortening the lethargy as well as postal and bank floats.

22. Define operating cycle and cash cycle?

Ans: Operating cycle also called as Working capital cycle or Current asset cycle refers to total
time involved in conversion of cash to cash equivalents and back to cash.

CASH ---- RAW-MATERIAL----WIP----FG----DEBTORS----CASH

OC = R+W+F+D

CC = OC – Crs period.

23. Define Leverage? Explain the types of leverages?

Ans: The term Leverage refers to the firm’s ability to use fixed cost funds to magnify the return
to the shareholders. In other words Leverage is the employment of fixed assets or funds for
which a firm has to meet fixed costs like interest obligation, irrespective of the level of operating.

TYPES OF LEVERAGES:

1. OPERATING LEVERAGE:
 It measures the percentage change in EBIT for percentage change in sales.

Operating leverage may be defined as the effect of fixed expenses on the level of Net income,
the changes in net income and the level of business risk. Business risk also called as Operating
risk is the risk associated with the normal day to day operations of the firm. The components of
business risk are the chances that the firm will fail to create sufficient earnings before interest
and taxes and the variability of earnings before interest and taxes.

Operating Leverage = Contribution

EBIT

Degree of Operating Leverage = %Change in EBIT

%Change in Sales

2. FINANCIAL LEVERAGE:

It measures the percentage change in EPS for percentage change in EBIT.

Financial Leverage may be defined as the effect of interest on the level of EPS, changes in EPS
and Financial Risk. The components of Financial Risk is the chances of the firm will fail
because of its inability to meet interest burden and the variability of earnings available to equity
shareholders caused by fixed financial charges. The objective of using financial leverage is to
finance the incremental capital required through debt financing which is relatively cheaper
compared to equity financing. This magnifies the extra return to equity shareholders and hence
Financial leverage is also called as “Trading on equity”.

Trading on Equity:

According to this concept borrowing in debt is feasible provided Return on

Investment is greater than Borrowing Cost. The difference between
Return on Investment & Borrowing Cost is enjoyed by the equity
shareholders. But however too much of debt financing is not advisable
since the organization may fall into a ‘DEBT TRAP’
An ideal debt equity ratio of 1:2 is always preferable to be maintained.

Financial Leverage = EBIT

EBT

Degree of Financial Leverage = %Change in EPS

%Change in EBIT
3. COMBINED OR COMPOSITE OR TOTAL LEVERAGE:

It measures the percentage change in EPS for percentage change in SALES. Combined Leverage
may be defined as the effect of both Fixed expenses and interest on the level of EPS, changes in
EPS and Total risk associated with it.

Combined Leverage = Contribution

EBT

Degree of Combined Leverage = %Change in EPS

%Change in sales

24. Define JIT Policy?

Ans: Just in Time is an inventory strategy where zero level of inventories are maintained. They
reduce the cost of carrying inventories to large extent and they aim at production based on the
available orders. It aims at maximizing return on investment

25. Define Ageing Schedule?

Ans: It is a schedule of Total Debtors breakup based on age or time period. Ex: 30% of debtors
to be received within 1month, 20% within 1 to 2month and 50% above 2months. Larger the
debtors in the earlier days, better it is.

26. Define Sensitivity Analysis?

Ans: It is the study of change in NPV for changes in factors such as change in Life expectancy
of the asset, change in discount factor, change in expected cash flow estimates etc.
 MAK
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TECHNICAL ANALYSIS COURSE

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"Investment in stock market is not a bet on your luck instead it is bet on your knowledge".
BY: Prof. B. V. RUDRAMURTHY
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3. Convenient weekend Classes only on Saturdays and Sundays.
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markets.
5. Real time learning with live Charts and Stocks.
6. Examples drawn from Indian Capital Markets for better understanding.
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FACULTY PROFILE:
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M.Com, CA Inter, MFM, M-Phil, PGDBA (Symbiosis), PGDMM.
5years of teaching experience in various top B-Schools of Bangalore. He has a very high level of
practical experience in the areas of Accounting, Auditing, Finance and Taxation. He is the
Chairman of Technical Study India, an institute of excellence on training corporate and student
executives on areas of Capital Markets. He has conducted many workshops and one day
seminars in various B-Schools like Christ, St-Joseph etc. He has also authored a book on Income
Tax for Undergraduate students and has presented papers in various conferences.

EIGHT AND TWELVE MARK QUESTIONS:

1. Define Working Capital? What are the factors affecting Working capital requirement?

Ans: MEANING OF WORKING CAPITAL:

The term Working Capital refers to investment required for the day today business
administration. In other words it is the excess of Current assets over Current Liabilities.

WORKING CAPITAL MANAGEMENT:

It is the management of problems relating to Current assets and Current liabilities. It also
studies the interrelationship that exists between current assets and current liabilities.

FACTORS AFFECTING WORKING CAPITAL REQUIREMENT:

1. Nature of Business:
Automated and manufacturing units require higher working capital compared to labour
intensive and service units.
2. Production cycle:
Longer the production cycle, higher the working capital requirement and vice-versa.
3. Business cycle:
During the periods of business prosperity, higher working capital is required and vice-
versa.
4. Production policy:
 Organisations which follow continuous production policy through out the year, require
higher working capital compared to organization which adapt seasonal production policy.
5. Credit policy:
Liberal Credit policy from supplier leads to lower working capital requirement and strict
credit policy of the supplier leads to higher working capital.
6. Vagaries in purchase of raw materials:
A smooth and undisturbed supplies results in lesser stock holding and lower working
capital requirement and vice-versa.
7. Growth opportunities:
More the future growth prospectus, higher the working capital requirement and vice-
versa.
8. Profit level:
Higher the profits, higher the amount transferred to reserves and higher is the cash profits
available for working capital and vice-versa.
9. Tax level:
Higher the tax level, higher is the working capital requirement due to higher provisions
for tax and vice-versa.
10. Dividend policy.
Liberal dividend policy results in higher working capital requirement and strict dividend
policy will lead to higher profits being transferred to reserves and thereby lower working
capital requirement.

2. What do you mean by Dividend Policy/Decision? Explain the factors affecting

dividend policy of a firm?

Ans: MEANING OF DIVIDEND POLICY:

Dividend policy of an organisation refers to amount of earnings to be distributed as dividend

to shareholders and the amount of earnings to be retained by the firm.

The following factors affecting the dividend policy of the firm:

1. Fund requirement:
Higher the fund requirement, lower the dividend paid and vice-versa.
 2. Liquidity:
Higher the liquidity, higher is the dividend payment and vice-versa.

3. Access to capital markets:

Companies having better access to capital markets need not depend heavily on their
reserves and hence can pay higher dividend whereas companies having poor access to
capital markets will pay lesser dividends and transfer more amount to reserve.

4. Shareholders preference:
If shareholders prefer higher dividend, companies are bound to pay higher and if
shareholders prefer capital appreciation, companies pay lesser dividend and transfer
higher amount to reserve.
5. Tax benefits:
On payment of dividends, share holders pay no tax and they end up paying higher tax on
capital appreciation. Thus they demand higher dividends keeping in mind the tax benefit.

6. Diversion of control:
Higher the dividend, lesser the money transferred to reserves and higher is the
dependence on external equity which results in greater diversion of control and vice-
versa.

7. Difference in cost of external equity and retained earnings:

Higher the floatation cost, higher is the difference between external equity and retained
earnings and vice-versa. Thus companies with higher floatation cost will pay lesser
dividend and depend more on retained earnings and vice-versa.

8. Legal restrictions:
More the legal restrictions on payment of dividend, lesser is the dividend and vice-versa.

9. Investment opportunities:
Companies having better investment prospects pay lesser dividend and transfer more
funds to reserves and vice-versa.

10. Inflation:
Higher the inflation, company is forced to pay higher dividend to meet the raising prices
and vice-versa.

11. State of economy:

During periods of recession, companies pay lesser dividend and transfer more amount to
reserves and vice-versa.

12. Debt obligation:

Higher the debt obligation, higher is the interest burden and lower is the profits leftover
for distribution of dividend and vice-versa.

13. Loan covenants:

 Presence of loan covenants results in lesser payment of dividend and vice-versa.

14. Nature of earnings:

Higher the cash earnings, higher is the dividend and vice-versa.

15. Past dividend rates:

Higher the past dividend rates and better the track record of payment of dividend, higher
should be the level of current dividends too and vice-versa.

3. Briefly explain the dividend policy?

Ans: 1. Stable or Constant Dividend Payout ratio:

The ratio of dividend to earnings is known as payout ratio. According to this policy, the
percentage of earnings paid out as dividend remains constant. The above Dividend policy
transmits the variability of earnings to dividends. At any given payout ratio, the amount of
dividend and additions to reserve will increase with increase in earnings and vice versa.

2. Constant Dividend per share or dividend rate:

It is the policy of firm to pay a fixed amount per share as dividend or a fixed percentage
on paid up capital as dividend every year, irrespective of the fluctuations in earnings. This policy
does not mean that dividend will always remain constant and never increase. When the firm
reaches new level of earnings and expects to maintain it, the annual dividend per share or the
dividend rate may be increased. The above policy is suggested to those firms whose earnings are
stable and do not fluctuate much.
3. Constant Dividend per share plus extra dividend:

For companies with fluctuating earnings, the policy to pay a minimum dividend per share
with an Extra dividend based on earnings is desirable. The small amount of fixed dividend
ensures minimum dividend every year and in years of prosperity the company pays an additional
dividend over and above the minimum dividend.

SIGNIFICANCE OF STABILITY OF DIVIDENDS:

1. Confidence among shareholders.
2. Investors desire for current income.
3. Institutional investor’s attitude.
4. Stability in market prices of shares.
5. Raising additional finance.
6. Market for Debenture and Preference shares.
7. Large number of investors with small holdings reduces chances of dilution.
 4. Explain briefly Indian financial system?
Ans:

THE FINANCIAL ENVIRONMENT:

Financial decisions are to be made keeping in mind the finance environment surrounding
it. The growth of any economy is largely depended on the strength of its financial system.
The financial environment comprises of subsystems such as:

1. Financial Institutions.
2. Financial Markets.
3. Financial Instruments. and
4. Financial Services.
MUKESH ACADEMY FOR KNOWLEDGE
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E
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MBA
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5years of teaching experience in various top B-Schools of Bangalore. He has a very high
level of practical experience in the areas of Accounting, Auditing, Finance and Taxation.
He is the Chairman of Technical Study India, an institute of excellence on training
corporate and student executives on areas of Capital Markets. He has conducted many
workshops and one day seminars in various B-Schools like Christ, St-Joseph etc. He has
also authored a book on Income Tax for Undergraduate students and has presented papers
in various conferences.
2. Prof. Santanam: A Senior Professor who has taught in various reputed B-Schools and
has 40 years of teaching experience.
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Functions performed by a financial DETAILS CONTACT:
system or environment consist of:
9845620530/9844519866/080 23311916
1. Acts as intermediary between Lenders and Borrowers.
2. It channelises savings into productive investment avenues.
3. Provides payment system for exchange of goods and services.
4. Provides a mechanism for managing and controlling risk.
5. Decreases transaction costs.
6. Provides symmetry of information to all its participants.
7. Helps in Capital formation.

COMPONENTS OF INDIAN FINANCIAL SYSTEM:

1. Financial Institutions:
They act as intermediaries who bring investors and borrowers on a common
platform. They mobilize savings from investors and channelise them to productive
resources. Financial institutions are classified into Banking and Non-Banking
Institutions. Banking institutions in India fall under the category of both Organised and
Unorganised Sectors. Organised banking sector includes Commercial Banks,
NABARD, RRB’S, Co-Operative Banks, etc. Unorganised bankers include Money
lenders and Indigenous bankers.

2. Financial Markets:
Financial markets are market for creation and exchange of Financial assets and
other credit instruments. They facilitate price discovery mechanism and provide
liquidity to financial assets. Financial markets can be classified into Money market and
Capital Markets.

Money markets deal with short term financing instruments such as Call money,
Treasury bills, Certificate of Deposits (CD’S) and Commercial papers (CP’S). Whereas
Capital markets provides markets for long term borrowings and lending’s exceeding
 1year. It includes instruments such as Equity shares, Preference shares, Bonds and other
long term instruments

3. Financial Instruments:
Financial instruments represents claim against future income in the form of interest and
dividends; as well as capital appreciation in the form of increase in the principal value
of the asset. Financial Instruments include Primary issues were the company directly
issues these instruments to the ultimate investor and Secondary market issues where the
financial intermediaries exchange them at competitive prices.

4. Financial Services.
Financial services include intangible services rendered by Financial institutions to its
users. They include both Fund based and Fee based services. Services such as Leasing,
Hire purchase, Factoring, Venture capital etc are fund based services, whereas services
such as Credit rating, Portfolio management, Loan syndication etc are fee based
services.

5. Explain various Capital Structure theories?

Ans: (Refer Notes)

6. Explain the various sources of long term finance?

Ans: The various sources of Long term finance are:

1. Equity Capital:

It represents ownership capital as equity shareholders own the company, enjoy the
rewards and bear the risk of ownership. Their liabilities are limited to the extent of their
capital contribution. The rights of Equity shareholders include Pre-emptive right, right to
income, right to control, right in liquidation and right to vote.

Advantages:

a) Payment of equity dividend is not compulsory.

b) No redemption date or repayment date for capital.

c) Helps in raising other sources of finance.

d) Dividends are tax exempt for shareholders.

e) Encourages company to venture into new projects.

Disadvantages:
 a) Raising of external equity results in dilution of control.

b) Cost of Equity is very high.

c) Equity dividends won’t get any tax benefit.

d) Higher Floatation cost.

2. Preference Capital:

It represents hybrid form of financing which combines the features of equty and
debenture. Preference dividend is fixed in nature and redeemable after a specific period
of time. Preference shareholders generally do not enjoy voting power and payment of
preference dividend is not a tax deductible expense.

Advantages:

a) Payment of Preference dividend is not compulsory.

b) No financial crisis on redemption date.

c) Helps in raising other sources of finance.

d) No dilution of control.

e) Encourages company to venture into new projects.

f) No assets are pledged in favour of preference shareholders.

g) Cheaper than cost of Equity capital.

Disadvantages:

a) Expensive compared to debenture capital.

b) Any default on payment of dividend or redemption affects the goodwill of the

company.

c) Preference shareholders acquire voting power if dividends are skipped for more than
four continous years. .

d) Higher Floatation cost compared to debt capital.

3. Debentures:

It represents instruments for raising long term debt. Debentures are similar to any other
borrowing where interests and principal is paid at specific periods of time. It is more
 flexible than term loan as they offer greater flexibility with regard to maturity, interest
rate, repayment and security.

Advantages:

a) Payment of interest is a tax deductible expense .

b) It doesn’t result in dilution of control.

c) Lower floatation cost.

d) Debt holders do not participate in the surplus funds of the company.

e) The burden of financing debt is fixed in nominal terms.

Disadvantages:

a) Non payment of interest or principal in time results in loss of goodwill.

b) Higher debt financing increases financing leverage and thereby financial risk of the
company.

c) Debt covenants restricts the company in its decision making.

d) Lower Inflation cost results in higher payment in nominal terms since it is fixed in
nominal terms.

4. Term Loan:

It represents long term loans given by banks and other financial institutions. Similar to
debenture issue, interest and principal is repaid at fixed intervals of time.

Advantages:

a) Payment of interest is a tax deductible expense .

b) It doesn’t result in dilution of control.

c) Lower floatation cost.

d) Debt holders do not participate in the surplus funds of the company.

e) The burden of financing debt is fixed in nominal terms.

Disadvantages:

a) Non payment of interest or principal in time results in loss of goodwill.

 b) Higher debt financing increases financing leverage and thereby financial risk of the
company.

c) Debt covenants restrict the company in its decision making.

d) Lower Inflation cost results in higher payment in nominal terms since it is fixed in
nominal terms.

5. Retained Earnings or Reserves and Surplus:

It represents that portion of earnings which are not distributed as dividend. Depreciation
even forms source of internal accruals and generally these funds are used for acquisition
of Fixed assets.

Advantages:

a) Readily available internally.

b) It doesn’t result in dilution of control.

c) Eliminates floatation cost.

d) Does not carry any negative or bad impression on the company.

Disadvantages:

a) The amount of capital to be raised is restricted.

b) Higher cost of financing since it is equal to cost of equity.

c) May invest in sub marginal projects since few company view reserves as cost less.

7. Explain international financing instruments?

Ans:

1. Euromarkets:

Euromarkets refer to a collection of international banks that help firms in raising capital
in a global market which is beyond the purview of national regulatory body.

2. American Depository Receipt:

 An ADR represents the ownership in the shares of a foreign company trading on US
financial markets. ADR enables an US investor to buy shares in foreign companies without
undertaking cross border transactions. ADR carries prices in US dollars and can be traded like
the shares of US based companies.

An ADR is a negotiable certificate issued by a U.S. bank representing a specified number of

shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated
in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs
help to reduce administration and duty costs that would otherwise be levied on each transaction.

3. Global Depository Receipt:

A GDR is a financial instrument used by private markets to raise capital denominated in either
U.S. dollars or Euros. It is a bank certificate issued in more than one country for shares in a
foreign company. The shares are held by a foreign branch of an international bank. The shares
trade as domestic shares, but are offered for sale globally through the various bank branches.

8. Explain various factors influencing Capital Structure Decisions?

Ans:

1. Profitability Aspect – EBIT-EPS analysis.

2. Liquidity Aspect – The cash flow ability of the firm to finance its fixed charges.

3. Control Aspect- Attitude of the management towards control.

4. Leverage ratios for other firms in the industry- Comparing the debt equity ratio in the
industry in which the firm is operating.

5. Nature of Industry.

6. Tax Planning.

7. Timing issues.

9. Factors influencing Credit policy of a firm?

Ans:

1. Collection Cost:

It is the administrative cost incurred in the collecting of receivables. It includes costs such
as additional costs on creation and maintenance of credit department with staff,
 accounting records, stationery, postage expenses etc. It even includes expenses incurred
to acquire credit information, etc

2. Capital Cost:

It is the cost incurred on the use of additional capital to support the extra debtors due to
higher credit sale or extending the credit period.

3. Delinquency Cost:

It is the cost arising out of failure to pay on due date. It results in blocking up of funds for
extended time period, costs associated with collecting the overdues etc.

4. Default Cost:

It is cost of funds which cannot be recovered because of inability of the customer to pay.
Such debts are treated as bad debts and have to be written off as they cannot be realized.

10. What are the objectives of financial management?

Ans: Operations of a firm must be with a focus to achieve its objectives in a timely and well
planned manner. The financial decisions taken by a firm must confine and complement to its
objectives. The major objectives of Financial management include Profit maximization and
Wealth maximization.

1. PROFIT MAXIMIZATION:

Profit maximization being the predominant objective of any micro economic study can be
extended to even to area of financial management. It is said that “Let the business of business be
business” and thus profit maximization can be considered as the main objective of business.
However the above objective suffers from the following serious drawbacks:

d) It is a vague and static concept which doesn’t distinguish between short term and long run
profits.
e) It doesn’t define the term profit which is so ambiguous.
f) It ignores the concept of time value of money.
g) It ignores the degree of risk levels among different investment alternatives.
2. WEALTH MAXIMIZATION:

It is the present value of all future benefits what a shareholder of a firm expects to receive over a
defined period of time. It takes into consideration the returns available from different investment
alternatives and their risk levels over a definite time period. Wealth of a shareholder is measured
by the present market value of shareholders equity holding and total wealth of the firm equals the
number of shares outstanding times the market price per share.
Advantages of Wealth Maximization being the primary objective of a firm include:

a) It is conceptually possible to adapt wealth maximization as an objective in different

financial decisions. The firm should select those decisions which have the effect of
increasing the market price of the firms stock.
b) It is an impersonal and democratic policy where the shareholders who may be offended
by the firm’s policy are at liberty to sell their holdings and switch over to other
companies.
c) It considers risk too as a criterion for financial decision making and selection of best
alternative.
d) It does consider the value of money at different time intervals.
e) It gives maximum weightage to shareholders of firm who are the real owners of the firm.

Considering the drawbacks of Profit maximization as an Objective of financial management

and superiority of wealth maximization objective, one can reasonably assume wealth
maximization as a reasonable guide to financial management decisions.

11. Explain the scope of financial management?

Ans: The Scope of Financial Management refers to the discipline, area and subject matters that is
covered under the heading Financial Management. For better understanding, the scope of
financial management can be studied under 2 approaches, namely:

I. TRADITIONAL APPROACH:

a) It was viewed in a narrow sense.

b) Its Scope was restricted to procurement of funds to meet corporate financial

needs and commitments.

c) Different sources through which the required capital can be raised.

d) Institutional arrangements and Financial instruments through which the required

funds are raised.

e) Legal, Accounting and Procedural aspects of Capital markets.

Criticisms:

a) It concentrated only on external sources of financing and completely ignored

internal sources of financing.

b) It concentrated too much on events like mergers, acquisitions, reorganizations,

 etc which was a rare phenomenon and laid less stress on day today financial

problems (Working capital Management problems) which occurred often.

c) It ignored the area of allocation of capital, which is a central issue of Financial

Management.

II. MODERN APPROACH:

a) It was viewed in a broader sense.

b) Its Scope covered both the aspects of procurement of funds, as well as its

allocation.

c) It considered financial management as an integral part of overall Business

management..

d) It covered the 3 major functions of finance namely:

1. Investment Decision.

2. Financing Decision.

3. Dividend Decision.

12. Explain the changing roles of the finance manager?

Ans: With the growth of business boundaries to global arena, the role of finance manager is
becoming more complex, technical and more important in steering the organisation wheels in
proper direction. His key role in business covers the following areas:

1. Financial Planning decisions.

2. Capital Budgeting decisions.
3. Working Capital management decisions.
4. Mergers, Acquisitions, alliances and restructuring decisions.
5. Risk management and Hedging decisions.
6. Corporate governance.
7. Business ethics and transparency of external information.
8. Currency and other forex management decisions.
9. Financial relationships.
10. Addressing and resolving agency problems.
13. Explain the organization of finance function

Ans: Functions of Financial Management covers different areas of Financial decision making,
which are considered to be of prime importance to steer the ship of business. It includes areas
such as:

1. INVESTMENT DECISION:

Investment decisions refer to selection of various assets on which funds are invested. It is
concerned with allocation or deployment of funds among various short term and long term
assets. In short it is concerned with asset mix decision.

It covers both Capital budgeting decisions (Long term) and Working capital management
decisions (Short term).

2. FINANCING DECISION:

Financing decisions, also called as Capital Structure decisions are concerned with
selection of various sources of financing and their appropriate mix. It involves the study of
proportion of internal and external sources of financing. It covers both Debt (External) and
Equity (Internal) sources of financing.

3. DIVIDEND DECISION:

Dividend decisions are concerned with the firms decision of retaining a part of its
earnings in the form of reserves and declaring the balance as dividends. Dividend decisions are
to be decided based on Financing decisions of firm, available investment opportunities and
preference of Shareholders.

14. Explain the sources of short term financing?

Ans:

1. Trade Credit.

2. Commercial banks.

3. Advance received from customers.

4. Fixed deposits for a period less than 1year.

15. Explain various Dividend theories?

Ans: (Refer Notes)

16. Briefly explain the different methods and techniques of capital budgeting?
a) NPV b) IRR c) PI d) PBP e) ARR.
Ans:

Net present value

It is the excess of total discounted cash inflow over total discounted cash outflow. This method
takes into consideration the time value of money and attempts to calculate return on investments
by introducing the factor of time element. Higher the NPV better the proposal.

Internal rate of return

It is the rate of return at which NPV for the proposal is zero. It is also a modern technique
ofcapital budgeting that takes into account the time value of money. It is also known as ‘time
adjusted rate of return’ discounted cash flow’ ‘discounted rate of return,’ ‘yield method,’ and
‘trail and error yield method’. In the net present value method the net present value is
determined by discounting the future cash flows of a project at a predetermined or specified rate
called the cut-off rate.

Steps to calculate IRR.

1. Using trial and error method identify two r values in such a manner that one gives
positive NPV and other negative NPV.
2. Calculation of IRR
a. IRR=LRR+ +ve NPV *D.R
+ve NPV + -ve NPV

LRR=Lower rate of return.

DR = Difference in rate.

If IRR is greater than cost of capital, accept the proposal or else reject.

Profitability index or Benefit Cost Ratio

It is also time-adjusted method of evaluating the investment proposals. Profitability index also
called as benefit cost ratio. It is the relationship between present value of cash inflows and the
present value of cash outflows.

a. Gross profitability index

Higher the GPI better the proposal. Incase of independent projects, GPI > 1 shall be
accept or else rejected.

b. Net profitability index.

 Higher the NPI better the proposal incases of independent projects, NPI > 0 zero shall be
accepted.

Payback period

It is the period within which we get back our initial investment. The ‘pay back’ sometimes called
as pay out or pay off period method represents the period in which the total investment in
permanent assets pays back itself. This method is based on the principle that every capital
expenditure pays itself back within a certain period out of the additional earnings generated from
the capital assets.

PBP= Initial investment

Uniform annual cash inflow

Lower the PBP better the proposal.

Average Rate of Return:

Under this method average profit after tax and depreciation is calculated and then it is divided by
the total capital outlay or total investment in the project. In other words, it establishes the
relationship between average annual profits to total investments.

Steps to calculate the ARR

1. Calculation of average profit (A.P)

2. Calculation of ARR
ARR= Average profit * 100

Initial investment - scrap value

17. Explain the Working capital policy (Current asset policy) and also Working capital
financing policy.

Ans:

CURRENT ASSET POLICY OR LEVEL OF CURRENT ASSETS:

A. FLEXIBLE POLICY:
It is also called as Conservative approach where a firm does not want to take the risk of
maintaining a low level of current assets. The firm maintains huge balance of cash and
marketable securities carries large amounts of inventories and grants liberal credit to
customers. A Flexible policy results in fewer stoppages in production, ensures quick
deliveries to customers and stimulates sales due to liberal credit policy. The above
benefits come with a higher cost of investment in current assets called Carrying Cost.
 B. RESTRICTIVE POLICY:
It is also called as Aggressive approach where a firm makes low level of investment in
Current assets. The firm maintains low levels of cash, marketable securities, inventory
and will have a strict credit policy. A restrictive policy results in frequent production
stoppages, late delivery of goods to customers, and loss of sales. These costs which a
firm has to bear for maintaining low level of investment in current assets is called as
Shortage cost.

CURRENT ASSETS FINANCING POLICY:

It is the decision of the firm on mix of long term debt to be used to finance current assets.

STRATEGY A: Long term financing used to finance both fixed assets requirement as well as
Working capital requirement.

STRATEGY B: Long term financing used to finance fixed assts requirement, permanent
working capital and a portion of Fluctuating working capital requirements.

STRATEGY C: Long term financing used to finance fixed assets requirement and permanent
working capital requirements. Short term financing is used to meet Fluctuating working capital
requirements.

Modigiliani and Miller’s Irrelevant Dividend Theory:

According to Modigiliani and Miller, the value of firm solely depends on its earning power and it
is not influenced by the manner in which its earnings are split between dividend and retained
earnings. Thus according to MM, the value of firm or Market price will not be affected by
changes in Dividend Pay Out Ratio and it will get affected only by changes in EPS.

Assumptions of MM approach:

a. No tax advantage, associated with dividends

b. The investment and dividend decision of the firm are independent

c. Firms can issue stock without incurring any flotation cost.

d. The discount rate applicable to risk class for which the firm belongs remains
unchanged.

e. Perfect capital Market conditions

Substances of MM argument:
According to MM, if a co. retains earnings instead of giving it out as dividends, share holders
enjoy capital appreciation equal to the amount of earnings retained. If it distributes earnings by
way of dividends, instead of retaining it the share holders enjoy, dividend equal in value to the
amount by which their capital would have appreciated. Hence the division of earnings between
dividend and retained earnings is irrelevant from the point of view of share holders.

Share valuation formula:

Po = (D1 + P1)*1/ (1+r)n

Where Po= Market price per share at time 0

D1 = Dividend per share at time 1

P1 = Expected market price per share at time !

R= Discount rate applicable to the risk class to which the firm belongs

MM Dividend Irrelevance Theory, rests on the “Leverage Irrelevance Theory” i.e. change in
capital structure (DE ratio) has no bearing on value of firm.