FINANCIAL MANAGEMENT

CAPITAL BUDGETING TECHNIQUES

PRACTICAL QUESTIONS
SUBJECT EXPERT CA.AMITA BISSA
LECTURE COVERS QUESTIONS BASED ON
PAY BACK PERIOD
ACCOUNTING RATE OF RETURN
NET PRESENT VALUE
PROFITABILITY INDEX
RANKING OF PROJECTS BASED ON DIFFERENT METHODS
TYPICALILLUSTRATIONS BASED ON DECISION MAKING USING NPV TECHINQUE
• Capital Budgeting Techniques are employed to evaluate the viability of long-
term investments. The capital budgeting decisions are one of the critical financial
decisions that relate to the selection of investment proposal or the course of action
that will yield benefits in the future over the lifetime of the project.
CAPSULATE
Pay Back Period:
Average Rate of Return
Net Present Value
Profitability Index
Internal Rate of Return
CAPSULATE
Pay Back Period: helps to determine the length of time required to recover the initial cash outlay in
the project. Simply, it is the method used to calculate the time required to earn back the cost incurred
in the investments through the successive cash inflows.
Accept-Reject Criteria: The projects with the lesser payback are preferred.

Average Rate of Return : measures the profitability of the investments on the basis of the
information taken from the financial statements rather than the cash flows. It is also called
as Accounting Rate of Return
Average Rate of Return = Average Income / Average Investment over the life of the project
Where, Average Income = Average of post-tax operating profit
Average Investment = (Book value of investment in the beginning + book value of investments at the
end) / 2
Accept-Reject Criteria: The projects having the rate of return higher than the minimum
desired returns are accepted.
CAPSULATE
Net Present Value
is a discounting technique of capital budgeting wherein the profitability of investment
is measured through the difference between the cash inflows generated out of the
cash outflows or the investments made in the project.
• The formula to calculate the Net Present value is:
• Net present value = n∑t=1   Ct / (1+r)t – C0
• Where, Ct = cash inflow at the end of year t
n= life of the project
r= discount rate or the cost of capital
Co= cash outflow
• Accept – Reject Criteria: If the NPV is positive, the project is accepted.
CAPSULATE

Profitability Index
The Profitability Index measures the present value of returns derived from per rupee invested. It
shows the relationship between the benefits and cost of the project and therefore, it is also called
as, Benefit-Cost Ratio.
• The profitability Index helps in giving ranks to the projects on the basis of its value, the higher
the value the top rank the project gets. Therefore, this method helps in the Capital Rationing.
• The formula to calculate the Profitability Index is:
• PI = Present value of future cash inflows/ Present value of cash outflows
• Accept-Reject Criteria: The project is accepted when the value of PI exceeds 1. If the value is
equal to 1, then the firm is indifferent towards the project and in case the value is less than 1 the
proposal is rejected
 CAPSULATE

Internal Rate of Return

The Internal Rate of Return or IRR is a rate that makes the net present value of any project equal to zero. In other words,
the interest rate that equates the present value of cash inflow with the present value of cash outflow of any project is called
as Internal Rate of Return.
• nlike the Net present value method where we assume that the discount rate is known, in the case of Internal rate of return
method, we put the value of NPV zero and then find out the discount rate that satisfies this condition.
• The formula to calculate IRR is:
• CFo = n∑t=1 Ct / (1+r)t
• Where, CFo = Investment
Ct = Cash flow at the end of year t
r = internal rate of return
n= life of the project
• Accept- Reject criteria: If the project’s internal rate of return is greater than the firm’s cost of capital, accept the
proposal.
IILUSTRATION
FROM THE FOLLOWING PARTICULARS OF CAPITAL PROJECT, FIND
Pay back period
Rate of Return (ROI)
Present Value Index ( cost of capital 10%)
Initial Investment is Rs 12000, Annual cash inflow RS 2000 life in years 8 years
Present value of Re.1 received annually for 8 years is Rs 5.3349
solution
• Pay back Period

• Pay back period = Net Investment

Annual cash Inflow

= 12000 =6 years
2000
Return on Investment

ROI = Annual cash Inflow – Annual Depreciation

Average Investment

= 2000 – 1500 x 100 = 500 x 100 = 8.33%

12000 /2 6000
• PRESENT VALUE INDEX

• PV INDEX = PRESENT VALUE OF ANNUAL CASH INFLOWS

INITIAL INVESTMENT

= 2000X 5.3349 = 10670 = 0.889

12000 12000
EXAMPLE 2
The following is a summary of financial data in respect of
five investment proposals
NAME INIITAL OUTLAY NET ANNUAL LIFE IN YEARS
CASH FLOW
A 60,000 18,000 15
B 88,000 15,000 25
C 2,000 1,000 5
D 20,000 3,000 10
E 42,000 15,000 20
EXAMPLE 2
RANK THIS PROPOSALS ACCORDING TO
1 PAY- PACK PERIOD METHOD
2 AVERAGE RATE OF RETURN METHOD
3 NET PRESENT VALUE METHOD
4 PRESENT VALUE INDEX METHOD
THE COST OF CAPITAL BEING 6%
EXAMPLE 2
Ranking according to Pay back period Method
NAME INIITAL OUTLAY ANNUAL CASH Pay back period Rank
FLOW ( Annual cash flow/
Annual cash flow
A 60,000 18,000 3.33 years 3
B 88,000 15,000 5.87 years 4
C 2,000 1,000 2 years 1
D 20,000 3,000 6,.67 years 5
E 42,000 15,000 2.8 years 2
Ranking according to Average rate of return method
NAME ANNUAL ANNUAL Annual Average Average Rank
CASH Depreciatio income after Investm rate of
FLOW n depreciation ent return
( an.inco
me after
dep/av.
Investm
ent)*100
A 18,000 4000 14000 30000 46.67% 3
B 15,000 3520 11480 44000 26.09% 4
C 1,000 400 600 1000 60% 2
D 3,000 2000 1000 10000 10% 5
E 15,000 2100 12900 21000 61.43% 1
Ranking according to Net Present value Method
NAME Life in ANNUAL Present Net present Initial Net Rank
years CASH Value Value of Outlay present
FLOW factor@6 Cash flows value
%
A 15 18,000 9.712 174816 60000 114816 2
B 25 15,000 12.783 191745 88000 103745 3
C 5 1,000 4.212 4212 2000 2212 4
D 10 3,000 7.360 22080 20000 2080 5
E 20 15,000 11.470 172050 42000 130050 1
Ranking according to Present Value Index
Method
NAME Net present Initial Present Rank
Value of Outlay value
Cash flows index
A 174816 60000 2.91 2
B 191745 88000 2.18 3
C 4212 2000 2.11 4
D 22080 20000 1.10 5
E 172050 42000 4.10 1
SUMMARY
FINANCIAL MANAGEMENT
CAPITAL BUDGETING TECHNIQUES
TYPICAL PROBLEMS
SUBJECT EXPERT CA.AMITA BISSA
Typical Illustrations: 1
A company is considering replacing an older machine which is fully depreciated for
tax purposes with a new machine costing Rs 40,000. The new machine will be
depreciated over its eight years life time to zero on a straight line basis. It is
estimated that the new machine will reduce labour cost by Rs.8000 per year. The
management believes that there will be no chance in other expenses and revenues of
the firm due to the machine.
The company requires an after- tax return on investment @10% . Its rate of tax is
55%
The company’s income statement for the current year is given for other information.
Should the company buy the new machine?
Income statement for the current year
Sales 5,00,000
Cost
Material 1,50,000
Labour 2,00,000
Factory and administrative 40,000
overheads
Depreciation 40,000 4,30,000
Net Income before taxes 70,000
taxes@55% (38500)
Earning after tax 31500
Solution
Present cash inflow
Present Earnings after taxes 31500
Add Depreciation 40000
Present cash inflows 71500
Solution

Estimated cash inflows if the new machine is to be purchased

Sales 5,00,000
Less cost
Material 1,50,00
0
Labour 1,92,00
0
Factory & Adm. Overheads 40,000
Depreciation on present 40,000 and on new machinery 45,000 4,27,000
5000
Net income before tax 73,000
Less Taxes@55% 40150
Earnings after tax 32850
Add depreciation 45000
Estimated Cash Inflows 77850
Differential cash inflows = 77,850- 71500 = 6350
Calculation of Net Present Value
Present value of differential annual cash inflows of Rs 6350 = 6350 x 5.335
for 8 years at the PV factor 5.335
= 33877.25
Less cost of new machinery =40,000.00
Net Present value =- 6122.75
IT is negative hence machinery should not be purcahsed
Examination Problems
• A hospital is considering to purchase a diagnostic machine costing RS 80,000 The
projected life of the machine is 8 years and has an expected value of Rs 6000 at the
end of 8 years . The annual operating cost of the machine is Rs7500. It is expected
to generate revenues of RS. 40,000 per year for eight years. Presently, the hospital
is outsourcing the diagnostic work and is earning income of Rs 12000 per annum
net of taxes
• Required Whether it would be profitable for the hospital to purchase the machine?
• Give your recommendation under
a. Net Present Value
b. Profitability Index Method
Pv factors at 10% given below
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467
Calculation of Cash inflows
Sales : Revenue 40,000
Less: Operating cost 7500
Less Depreciation( 80,000-6000)/8 9250
Earnings before tax 23250
Tax @30% 6975
Earnings after tax 16257
Add depreciation 9250
Cash inflows after tax p.a. 25525
Less: Loss of Commission income 12000
Net cash inflow after tax p.a. 13525
Calculation of Cash inflows
In 8th year
Net cash inflow after tax p.a. 13525
Add Salvage value of machine 6000
Net cash inflow in 8th year 19525

Years CFAT PV FACTORS @10% PRESENT VALUE OF CASH

INFLOWS
1 to 7 13525 4,867 65826.18
years
8 th year 19525 0.467 9118.18
74944.36
Less cash 80,0000
outflows
npv -5055,64
Profitability index
• PI= Sum of discounted cash inflow
Present value of cash outflows

= 74,944.36
80,000

= 0.937
Advice : Since the net present value is negative and PI is less than 1, therefore, the
hospital should not purchase the diagnostic machiner.
We assumed tax rate to be 30%
Illustration
A doctor is planning to buy an X ray machine for his hospital. He has two options. He
can either purchase the machine by making a cash payment of 5,00,000 or Rs
6,15000 to be paid in six equal instalment

Which option do you think the doctor should exercise assuming rate of return is 12%.
Present value of Rs 1 at 12 percent rate of discount for six years is 4.111
solution
• Option 1 Cash down payment
Cash down payment is 5,00,000
Option 2
Annual Instalment basis
Annual instalment = 6,15,000 x 1/6= 1,02,500

Present value of 1 to 6 instalment @12% = 102500x 4.111 = 4,21,378

Advise: The doctor should buy x ray machine on instalment basis

THANK YOU
FINANCIAL MANAGEMENT
LEVERAGE: PRACTICAL QUESTIONS
SUBJECT EXPERT CA.AMITA BISSA
 Leverage is the ratio of the rate of
return on shareholders equity and
the rate of return on total
capitalisation
Leverage is the melting of fixed cost or paying a fixed return for employing
resources of fund. There can be
1. Operating Leverage
2. Financial Leverage
3. Combined Leverage
Operating Leverage : Operating leverage exists when changes in revenue produces
greater change in EBIT. Operating Leverage is the tendency of the operating profit to
vary disproportionately with sales. Operating Leverage can be computed as follows

DOL = Percentage change in EBIT

Percentage change in Sales

When EBIT of the same standard we can work out Operating leverage as
DOL= Sales- Variable cost = Contribution
EBIT Operating Profit

Operating Profit/ EBIT = Contribution – Fixed cost

Financial Leverage : Financial leverage exists whenever a firm has debts or
other sources of fund that carry fixed charges. It is ability of a firm to use fixed
financial charges to magnify the effect of change in EBIT on the firms earning
per share.

DFL = Percentage change in EBT

Percentage change in EBIT

DFL= EBIT = Operating Profit

EBT Profit before tax
Example
From the balance sheet given below find out the different kind of leverages
Liabilities Amount Assets Amount
Equity Capital (Rs 10 per 1,20,000 Net Fixed Assets 3,00,000
share)
10% Long term debts 1,60,000 Current Assets 1,00,000
Retained Earnings 40,000
Current Liabilities 80,000
4,00,000 4,00,000

The company’s total asset turnover is 3.0., its fixed

operating cost are 2,00,000 and its variable operating ratio
is 40% . The income tax is 50%
Income Statement of the company
Sales 12,00,000
Less: Variable cost ( being 40% of sales) 4,80,000
Contribution 7,20,000
Less: Fixed Costs 2,00,000
EBIT 5,20,000
Less: Interest cost 16,000
EBT 5,04,000
Less Taxes 2,52,000
Earnings after tax (EAT) 2,52,000
Working Note
Total Assets Turnover Ratio = S a l e s
Total Assets

3 = Sales
4,00,000

Sales = 4,00,00 x 3 = 12,00,000

Degree of Operating Leverage = Sales – Variable cost
EBIT
= 12,00,000 – 4,80,000
5,20,000

= 7,20,000
5,20,000

= 1.385 apprx.
Degree of Financial Leverage = Earnings before Interest and tax
EBIT – Fixed interest charges
= 5,20,000
5,20,000 – 16,000

= 5,20,000
5,04,000

= 1.032 apprx.
Degree of Combined Leverage = DOL x DFL
= 1.385 x 1,032
= 1.429
Problem
The financial manager of X Ltd expects that its earnings before interest and taxes in
current year would be Rs 30,000. The company has issued 5% debentures of Rs
1,20,000 while 10% preference shares amount to Rs 60,000. It has 3,000 equity
shares of Rs 10 each. What would be the degree of financial leverage assuming the
EBIT
(i) Rs18000
(ii) Rs 42000
The tax rate of the company may be taken as 50% . How would EPS be effected?
 D.F.L AND EPS CHANGES
CASE I BASE CASE II
% CHANGE IN EBIT -40% +40%
EBIT 18,000 30,000 42,000
Less: Interest on 6000 6000 6000
debentures
E.B.T 12000 24000 36000
Less Tax@50% 6000 12000 18000
Earning after tax 6000 12000 18000
Less Preference sh. 6000 6000 6000
Dividend
Earnings available Nil 6000 12000
to equity share
holders
% change in EPS -100% +100%
%change in DFL -40% +40%
unfavourable 2.5 favourable 2.5
Degree of Financial Leverage = %Change in EBT
%Change in EBIT

Case I = -100% = 2.5

-40%
Case II = 100% = 2.5
40%
• In Case I EBIT has declined by 40% from 30,000 to 18,000 where as EPS
(6000/3000) has declined 100% from Rs 2 to 0
• In Case II EBIT has increased by 40% from 30,000 to 42000 where as EPS increased
100%
• (6000/3000= 2) to 4 ( 12000/3000)
LEVERAGE
PART 2
Practical Questions on Leverage
 Typical examples
The financial data for three companies for the year ending 31 March 2017
as under
Company A Company B Company C
Variable cost as % of sales 66 2/3 75 50
Interest expenses Rs 200 Rs 300 Rs 50
OL 5-1 6-1 2-1
FL 3-1 4-1 2-1
Tax rate 50%
Prepare income statement of A , B and C company
Solution
Company A
Company A

FL = EBIT = Earning before interest and tax

EBT = EBIT – Interest OL =Contribution = Sales- Variable Cost
EBIT EBIT
3= EBIT
EBIT- 200 5 = Sales – 662/3S
3 ( EBIT-200) = EBIT 300
3 EBIT- 600 = EBIT
1500 = .331/3S
2 EBIT = 600
Sales = 1500x3 =4500
EBIT = 300
VC = 4500x 662/3 = 3000
Solution
Company B
Company B

FL = EBIT = Earning before interest and tax

EBT = EBIT – Interest OL =Contribution = Sales- Variable Cost
EBIT EBIT
4= EBIT
EBIT- 300 6 = Sales – .75S
4 ( EBIT-300) = EBIT 400
4 EBIT- 1200 = EBIT
2400 = .25s
3 EBIT = 1200
Sales = 2400x4 =9600
EBIT = 400
VC = 9600x 75%= 7200
Solution
Company C
Company C

FL = EBIT = Earning before interest and

tax OL =Contribution = Sales- Variable Cost
EBT = EBIT – Interest EBIT EBIT

2= EBIT 2 = Sales – .50S

EBIT- 1000 2000
2 ( EBIT-1000) = EBIT
4000 = .50S
2 EBIT- 2000 = EBIT
Sales = 4000x2 =8000
EBIT = 2000
VC = 8000x 50%= 4000
Solution
Company C
Company C

FL = EBIT = Earning before interest and

tax OL =Contribution = Sales- Variable Cost
EBT = EBIT – Interest EBIT EBIT

2= EBIT 2 = Sales – .50S

EBIT- 1000 2000
2 ( EBIT-1000) = EBIT
4000 = .50S
2 EBIT- 2000 = EBIT
Sales = 4000x2 =8000
EBIT = 2000
VC = 8000x 50%= 4000
Income Statement for the year ending 31 March 2017 as under
Company A Company B Company C
Sales 4500 9600 8000
Variable cost as % of sales 3000 7200 4000
Contribution 1500 2400 4000
Less Fixed Cost ( diff. between C 1200 2000 2000
and EBIT)
EBIT 300 400 2000
Less Interest 200 300 1000
EBT 100 100 1000
Tax @50% 50 50 500
EAT 50 50 500
question
Sales 240000
Variable cost 140000
contribution 100000
Fixed Operating cost 60000
ebit 40000
interest 15000
ebt 25000
On the basis of above particulars , calculate DOL, DFL and Combined Leverage
• Dol = c / ebit = 100000/40000 = 2.5
• Dfl = ebit/ebt = 40000/25000 = 1.6
• Dcl 2.5x 1.6 = 4
SUMMARY
 FINANCIAL MANAGEMENT
INTERNAL RATE OF RETURN
PRACTICAL QUESTIONS
SUBJECT EXPERT CA.AMITA BISSA
What is IRR?
• The discounted rate that equates the
present value of a project’s expected
cash inflows to the present value of the
project’s costs
What is IRR?
• The discount
rate which sets
the NPV of all
cash flows equal
to 0.
• Helps to
determine the
YIELD on an
investment.
How do we calculate IRR?
• NPV = Net Present Value of the project
• Initial Investment
• Ct=Cash flow at time t
• IRR = Internal Rate of Return
So now what?
• Once you’ve calculated IRR
If IRR is greater than the cost of capital, then you’ve got a
GOOD project on your hands (go for it!).
If IRR is less than the cost of capital, then you’ve got a BAD
project on your hands (don’t undertake the project…).
If the IRR and cost of capital are equal, then you should use
another method to evaluate the project!
Basically, the higher the IRR, the better the project
NPV vs. IRR
• NPV and IRR methods will always lead to the same accept/reject decisions for
independent projects
• NPV and IRR can give conflicting rankings for mutually exclusive projects (you must
pick one project, you cannot accept both)
NPV vs. IRR
• NPV profiles of projects can cross when project size differences exist (the cost of
one project is larger than that of the other) or when timing differences exist (most
of the cash flows from one project come in the early years, while most of the cash
flows from the other project come in the later years)
NPV vs. IRR NPV
• If the cost of
capital is greater
than this
crossover rate,
the two methods
Crossover rate
give same answer
• If the cost of Cost of capital
capital less than
NPVA
crossover rate,
two methods give NPVB
separate answers
NPV vs. IRR?
• The NPV calculation will usually always provide a more accurate indication of
whether or not a project should be undertaken or not.
• However, since IRR is a percentage, and NPV is shown in $$, it is more appealing for
a manager to show someone a particular rate of return, as opposed to $$ amounts.
Why do we use IRR?
• IRR is necessary from a capital budgeting standpoint.
• Just as NPV is a way to evaluate an investment, IRR provides more insight into
whether or not a project/investment should be undertaken.
• More useful for long term investments, with multiple cash flows
Conflicts
The project require different cash outlay.
The project have unequal lives.
The project have different pattern of cash flows
Calculate the internal rate of return of an investment of RS 136000 which
yields the following cash inflows
Years Cash inflows
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Lets discount cash flows by 10%
Years Cash inflows Discounted factor Present value
10%
1 30,000 0.909 27270
2 40,000 0.826 33040
3 60,000 0.751 45060
4 30,000 0.683 20490
5 20,000 0.621 12420
138280
The present value at 10% comes to 138280 which is more
than the initial investment . Therefore, higher discount
rate is suggested say 12%
Years Cash inflows Discounted factor Present value
12%
1 30,000 0.893 26790
2 40,000 0.797 31880
3 60,000 0.712 42720
4 30,000 0.636 19080
5 20,000 0.567 11340
131810
• The internal rate is more than 10% but less than 12% the exact rate can be
calculated
• Obtained by interpolation

IRR = 10+(138280-136000) x2
138280-131810

= 10+ [2280/6470 x2] = 10+.7 = 10.7%

Scale or size disparity
• Being IRR a relative measure and NPV an absolute measure in case of disparity in
scale or size both may give contradicting ranking. This can be understood with the
help of following example

• Suppose there are two projects Project A and Project B which are under
consideration.
Year Project A Project B
• The cash flows associated with these projects are as follows:
0 (100000) (300000)
1 50000 140000
2 60000 190000
3 40000 100000

Assume Cost of capital 10% which project to be accepted as per NPV or IRR
Solution NPV method
Year Cash Cash Inflow Present PV of PV or
inflows Project B factor Project A Project B
Project A @10%
0 (100000) (300000) 1 (100000) (300000)
1 50000 140000 0.909 45450 127260
2 60000 190000 0.826 49560 156940
3 40000 100000 0.751 30040 75100
25050 59300
Internal rate of returns of projects
Since by discounted with 10% we are getting values very far
from zero. Therefore, let us discount cash flows with 20%
discounting rate
Year Cash Cash Inflow Present PV of PV or
inflows Project B factor Project A Project B
Project A @20%
0 (100000) (300000) 1 (100000) (300000)
1 50000 140000 0.833 41650 116620
2 60000 190000 0.694 41640 131860
3 40000 100000 0.579 23160 57900
6450 6380
Internal rate of returns of projects
Since by discounted with 20% we are getting values very far
from zero. Therefore, let us discount cash flows with 25%
discounting rate
Year Cash Cash Inflow Present PV of PV or
inflows Project B factor Project A Project B
Project A @25%
0 (100000) (300000) 1 (100000) (300000)
1 50000 140000 0.800 40000 112000
2 60000 190000 0.640 38400 121600
3 40000 100000 0.512 20480 51200
(1120) (15200)
The internal rate of return is thus more than 20% and
less than 25% the exact rate can be obtained by
interpolation
IRR (A) = 20% + 6450 (25%-20%)
6450-(-1120)

= 24,26%

IRR (B) = 20% + 6380 (25%-20%)

6380-(-15200)

= 20% + (6380/21580)x5 = 21.48%

s
Overall Position Project A Project B
NPV @10% 25050 59300
IRR 24.46% 21.48%
SUMMARY
 FINANCIAL MANAGEMENT
MANAGEMENT OF RECEIVABLES
SUBJECT EXPERT CA.AMITA BISSA
introduction
• The basic objective of management of sundry debtors is to optimise the return on
investment on these assets known as Receivables.
• Large amounts are tied up in Sundry Debtors , there are chances of bad debts and
there will be cost of collection of debts .

• On the contrary, if the investment in sundry debtors is low, the sales may be
restricted, since the competitors my offer more liberal terms.
• Therefore, management of sundry debtors is an important issue and requires proper
policiies and their implementation
Aspects of Management of debtors
• Credit Policy
• Credit Analysis
• Control of Receivable
Aspects of Management of debtors
• Credit Policy:
The credit policy is to be determined. It involves a trade off between the profits on
additional sales that arises due to credit being extended on the one hand and the
cost of carrying those debtors and bad debts losses on the other.
This seeks to decide credit policy, cash discount and other relevant matters.
The credit period is generally stated in terms of NET DAYS
For example, if the firm’s credit terms are “net 50” it is expected that the customers
will repay credit obligations not later than 50 days
Credit Policy
• The cash discount policy of the firm specifies
A. The rate of cash discount
B. The cash discount period
C. The net credit period

For example, the credit terms may be expressed as “3/15 net 60” This means that a
3% discount may be granted if the customers pays within 15 days ,if he does not
avail the offer he must make payment within 60 days
Credit Analysis
This requires the finance manager to determine how risky it is to advance credit to a
particular party
Control over receivables
This requires finance manager to follow up debtors and decide about a suitable
credit collection period. It involves both laying down of credit policies and execution
of such policies. There is always costs of maintaining receivables which comprises of
following cost
a. The company requires additional funds as resources are blocked in receivables
which involves a cost in the form of interest ( loan funds) or opportunity cost (own
funds)
b. Administrative costs which includes record keeping, investigation of credit
worthiness etc
c. Collection costs
d. Defaulting costs
Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on total
approach)
Particulars Presen Proposed Proposed Proposed
t policy 1 policy 2 policy 3
policy
A Expected Profit
Credit Sales
Total cost other than
Bad debts and cash
discount
Variable cost
Fixed cost

Bad debts
Expected net profit
before tax
Less tax
 Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on total
approach)
Particulars Presen Proposed Proposed Proposed
t policy 1 policy 2 policy 3
policy
B. Opportunity cost of
investment in
receivable locked up in
collection period
Net Benefit ( A-B)

The policy NO… should be adopted since the net benefit is higher in comparison to
other policies
Working notes
• Total fixed cost=
• [Average cost per unit- variable cost per unit] x no. of units sold on credit under
present policy

• Opportunity cost = Total cost of credit sales x Collection Pd x Req. rate of return
365 days 100
INCREMENTAL APPROACH
Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on INCREMENTAL approach)
Particulars Presen Proposed Proposed Prop
t policy 1 policy 2 polic
policy
A Incrmental Expected Profit
Incremental Credit Sales
Less Incremental Total cost of credit sales
Variable cost
Fixed cost

Incremental bad debts, incremental cash

discount
Incremental Expected net profit before tax
Less tax
Incremental Expected profit after tax
 Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on total
approach)
Particulars Presen Proposed Proposed Proposed
t policy 1 policy 2 policy 3
policy
B. Required return on
Incremental
investments
Cost of credit sales (a)
Collection period (b)
Investment receivable (
axb)/365
Incremetnal
The policy investment
NO… should be adopted since the net benefit is higher in comparison to
in receviable
other policies
Net Benefit ( A-B)
Statement showing the evaluation of credit policy ( based on total
approach)
Particulars Presen Proposed Proposed Proposed
t policy 1 policy 2 policy 3
policy
B. Required return on
Incremental
investments
a) Cost of credit sales
(a)
b) Collection period
(b)
c) Investment
receivable
( axb)/365
d) Incremetnal
investment in
receivable
e) Required rate of
return %
f) Required return on
increemtnal
investment (dxe)
NEW LECTURE QUESTION
BASED ON EVALUATION OF
CREDIT POLICY
Practical questions on
Management of receivables
A trader whose current sales are in the region of 6 lakh per annum and an
average collection period of 30 days wants to pursue a more liberal a more
liberal policy to improve sales. A study made by a management consultant
reveals the following information
Credit Policy Increase in Increase in sales Present default
collection period anticipation
A 10 Days 30,000 1.5%
B 20 days 40,000 2%
C 30 days 75,000 3%
D 45 days 90,000 4%
The selling price per unit is 3 rupees. Average cost per unit is 2.25 and variable cost
per unit is Rs 2
The current bad debt loss is 1%. Required rate of return is 20%. Assume 360 days a
year.
Which policy to be adopted?
Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on
INCREMENTAL approach)
Particulars Present Propose Proposed Proposed Proposed policy
policy d policy B policy c D
30 days policy A 50 days 60 dyas 75 DAYS
40 day
A Expected Profit
a) Credit Sales 6,00,000 6,30,000 6,48,000 6,75,000 6,90,000
b) Less Total cost of
credit sales
I. Variable 4,00,000 4,20,000 4,32,000 4,50,000 4,60,000
cost ( saLES
X2/3)
ii. Fixed cost 50,000 50,000 50,000 50,000 50,000
4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
C) bad debts 6,000 9,450 12,960 20,250 27,600
Expected Profits 1,44,000 1,50,550 1,53,040 1,54,750 1,52,400
B. Opportunity cost 7,500 10,444 13,898 16,667 21,250
CALCULATION OF FIXED COST = ( AVERAGE COST PER UNIT- VARIABLE COST
PER UNIT) X NO OF UNITS OLD
= ( 2.25-2) X (600000/3) = 0.25X 200000 = 50,0000
CALCULATION OF OPPORTUNITY COST OF AVERAGE INVESTMENT
OPPORTUNTIY COST = TOTAL COST X COLLECTION X RATE OF RETURN
PERIOD 100
360
Present policy = 4,50,000 X30/360 X20/1 = 7500
00
Policy A 4,70,000 X40/360 X20/1 =10444
00
Policy B 482000 50/360 X20/1 =13,389
00
Policy C 500000 60/360 X20/1 = 16667
00
Policy D 510000 75x360 X20/1 = 21250
00
Incremental approach
Approaches to Evaluation of credit policies
Statement showing the evaluation of credit policy ( based on
INCREMENTAL approach)
Particulars Present Propose Proposed Proposed Proposed policy
policy d policy B policy c D
30 days policy A 50 days 60 dyas 75 DAYS
40 day
A Incre.Expected
Profit
a) Incr.Credit 30,000 48,000 75,000 90,000
Sales
b) Less Total cost of
credit sales
I. Variable 4,00,000 ,20,000 ,32,000 50,000 60,000
cost
ii. Fixed cost 50,000
4,50,000 4,70,000 4,82,000 5,00,000 5,10,000
C) Incr. bad debts 6,000 3,450 6,960 14,250 21,600
Incr. expe profit 6550 9040 10,750 8400
B. Required return on Incremental          
investments-
 45000 470000  48200  500000  510000
a)Cost of credit sales (a)
0 0
bCollection period (b)  30 40   50 60  75 
cInvestment in- receivable ( axb)/360  37500 52222 66944   83333 106250 
dIncremetnal investment in receivable  -  14722  29444  45833  68750
eRequired rate of return %    20  20  20  20
f)Required return on increemtnal investment (dxe)    2944  5899  9167  13750
Net benefit ( A-b) - 3606 3 151 1583 5350
SUMMARY
 LECTURE
PRACTICAL PROBLEMS ON CONCEPTS OF
RECEIVABLE MANAGEMENT
Practical questions on Receivable
management
• Problem 1
H Ltd has a present annual sales of 10,000 units of RS 300 per unit. The variable cost
is Rs 200 per unit and the fixed cost amount to Rs 3,00,000 per annum. The present
credit period allowed by the company is 1 month. The company is considering a
proposal to increase the credit period to 2 months and 3 months and has made the
following estimates

Existing Proposed
Credit Policy 1 month 2 months 3 months
Increase in 15% 30%
sales
% of Bad debts 1% 3% 5%
There will be increase in fixed cost by Rs 50,000 on account of increase of sales
beyond 25% of present level. The company plans on a pre-tax return of 20% on
investment in receivables.

You are required to calculate the most paying credit policy for the company
Statement showing the Evaluation of Credit Policy
Particulars Present Proposed Proposed
Policy Policy I Policy II
1 month 2 months 3 months
A. Expected Profit:
(a) Credit Sale ( Sales units x 300) 30,00,00 34,50,000 39,00,000
0
(b) Total Cost other Bad Debts
(i) Variable cost ( Sales unitx x200) 20,00,00 23,00,000 26,00,000
0
(ii) Fixed Cost 3,00,000 3,50,000
3,00,000
23,00,00 26,00,000 29,50,000
0
(C) Bad debts 1,03,500 1,95,000
30,000
(D) Expected Profit [ (a)-(b)-(c)] 6,70,000 7,46,500 7,55,000
B. Opportunity Cost of Investment in 38,333 86,667 1,47,500
receivables
Net Benefits [ A- B] 6,31,667 6,59,833 6,07,500
Recommendation: 2 months credit policy should be adopted since the net benefit
under this policy is higher than those under other policies

Working Note: Calculation of Opportunity Cost of Investments in Receivables

Opportunity cost = Total Cost X Collection Period X Rate of Return

12 100

I months Policy = 23,00,000 x1/12 x20% = Rs 38,333

2 months Policy = 26,00,000 x 2/12 x20% = Rs. 86,667
3 months Policy = 29,50,000 x 3/12 x 20% = Rs. 1,47,500
Question
A company is currently selling 1,00,000 units of products at
Rs 50 per unit. At the current level of production, the cost
per unit is Rs 45, variable cost per unit being Rs 40. The
company is currently extending one month’s ( 3o days)
credit to its customers. It is thinking of extending credit
period to two months ( 60 days) in the hope that sales will
increase by 25%. If the required rate of return before tax on
investment is 30% , is the new credit policy desirable?
Solution
(1) Additional Sales (25000 X50) 12,50,000
Less : Variable cost (25000 X 40) 10,00,000
Additional Income before tax 2,50,000

(2) Additional Investment in receivables

Before Extension
Receivables =45,00,000 x
30
360
= 3,75,000
Solution
After Extension
Receivables = 55,00,000* x 60
360
= 9,16,667

* It is calculated as under
1,00,000 x 45 = 45,00,000
25,000 x 40 = 10,00,000

55,00,000
Solution
Additional Investment = 9,16,667 – 3,75,000 = Rs. 5,41,667

Return on Additional = 5,41,667 x 30% = 1,62,500

Investment ( before tax)

Net income
Additional Income before 2,50,000
tax
Less: return on additional 1,62,500
investment ( before tax)
Yes credit can be extended 87,500
SUMMARY
LECTURE BASED ON TYPICAL
PROBLEMS ON RECEIVABLE
MANAGEMENT
Question
A firm has current sales of Rs 7,20,000. It is considering to offer
the credit term ‘2/10 net 30’ instead of ‘Net 30’ It is expected
that sales will increase by Rs 20,000 and average collection
period will decline from 30 days to 20 days. It is also expected
that 50% of the customers will avail discounts and pay on 10 th
day and the remaining 50% of the customers will pay on 30 th
day. Bad debt losses will remains on 2% on sales. The firm’s
variable cost ratio is 70% corporate tax is 50% and opportunity
cost of investment in receivable is 10%. Should the company
change its credit policy?
Solution
Loss ( Cash discount) = 7,40,000 X 50% X 2% = Rs 7400
Bad Debts = 20,000 X2% = Rs 400

Reduction in Investment in
Receivables
Investment before = 7,20,00 x 30 = Rs. 60,000
Discount 360
Investment after Discount = 7,40,000 x 20 = Rs. 41,111
360
Investment released = 60,000= 41,111 = Rs.18,889
Solution
Return on Investment released ( Savings) = 18,889x 10% = Rs 1,889
Additional contribution on add. Sales = 20,000 X 30% = Rs 6000
Thus, additional income = Rs 7889
Less
Additional Bad debts 400
Cash Discount (Loss) 7400 = Rs 7800
Net income = Rs 89
The company should change the credit
policy
question
An analysis of credit policy reveals that it is very loose and as a
result the firm’s collection period is very long as well as bad
debt losses are built up. The firm therefore, is thinking to
tighten up its credit standards by shortening credit period from
45 days to 30 days. The expected result of this policy would be
to reduce sales from Rs 6,00,000 to Rs 5,00,000 and bad debts
losses from 4 percent to 2 percent and collection expenses from
2 percent to 1 percent of total sales. The firm’s variable cost
ratio is 80%. Tax rate is 40% and after tax cost of funds is 12%.
Should credit standards be tightening up?
SOLUTION
Loss of contribution = 1,00,000x 20% = Rs 20,000
Reduction in Bad Debts:
Earlier =6,00,000 x4% =
24000
After = 5,00,000 x2% =
10,000
Savings in bad debts = Rs 14,000
Reduction in collection charges
Earlier =6,00,000x 2% =
12000
After = 5,00,000x 1% = =Rs 7000
5000

Net Savings =14000+7000- 20,000 = Rs 1000

Net savings after tax = 1000- 400 = Rs 600
SOLUTION
Reduction in Investment in Receivables
Earlier = 6,00,000 x45 = Rs 75,000
360
After =5,00,000 x 30 = Rs 41,667
360
Reduction = Rs. 33,333
Saving ( Return) on reduced Investments = 33,333 x 12% = Rs 4000

Thus, total savings = 600 + 4000 = Rs 4600

Credit standards should be tightened up.

Some simple conceptual
questions
F rom the following information calculate average collection
period

• Total sales 15,00,000

• Cash sales 3,00,000
• Sales return 1,20,000
• Debtors 1,35,000
• Bills Receivables 30,000
• Provisions for bad debts 15,000
Solution
Average Collection Period = Receivables X 360
Net Credit Sales

= 1,50,000 X 360
10,80,000

= 50 days
Receivables = Debtors + bills receivables- Bad debts
= 1,35,000 + 30,000 – 15000
= 1,50,000
Net credit sales = Total sales – ( Cash Sales + Sales Return)
= 15,00,000 – ( 3,00,000 + 1,20,000)
= 10,80,0000
SUMMARY
question
A company is considering pushing up its sales by extending credit facilities to
the following categories of customers

Category (a) Customers with 10% risk of non- payment

Category (b) Customers with 30% risk of non- payment

The incremental sales expected in the case of category (a) are Rs 4,00,000 while
in the case of category (b) they are Rs 5,00,000
The cost of production and selling costs are 60% of sales, while collection costs
amount to 5%of sales in the case of category (a) and 10% of sales in the case of
category (b)
You are required to advise the company about extending credit facilities to each
of the above categories of customers.
Solution
Category (a) - Risk of Non- payment 10%
Incremental sales 4,00,000
Less: Loss in collection (10%) 40,000
Net Sales Proceeds 3,60,000
Less Production & selling cost
60% of Sales 2,40,000
Collection cost (5%) 20,000 2,60,000
Incremental income 1,00,000
Solution
Category (b) - Risk of Non- payment 30%
Incremental sales 5,00,000
Less: Loss in collection (30%) 1,50,000
Net Sales Proceeds 3,50,000
Less Production & selling cost
60% of Sales 3,00,000
Collection cost (10%) 50,000 3,50,000
Incremental income nil
LECTURE BASED ON
WEIGHTED AVERAGE
COST OF CAPITAL
question
Capital Structure of Y Ltd and its after tax cost of capital from
different sources is as follows
Sources Amount Cost of capital
Debentures 3,00,000 4%
Preference Share capital 2,00,000 8%
Equity Share Capital 4,00,000 10%
Retained Earnings 1,00,000 9%
Compute Weighted average cost of capital
Solution
Statement showing Computation of WACC
Sources Amount Weights Cost of Weighted cost
capital ( weight tax after tax
( after cost)
tax)
Debentures 3,00,000 0.3 0.04 0.012
Preference Share 2,00,000 0.2 0.08 0.016
capital
Equity Share 4,00,000 0.4 0.10 0.040
Capital
Retained 1,00,000 0.1 0.09 0.009
Earnings
Weighted average cost of capital 0.077 or 7.7%
Question

Calculate weighted average cost of capital from the

following information
Sources Amount
8% Debentures 5,00,000
5% Preference Share capital 2,00,000
50,000 Equity Share 5,00,000
Retained Earnings 3,00,000
15,00,000
Compute Weighted average cost of capital
The market price of equity shares is Rs 30 per share. The company
has declared a dividend of Rs 3 per share. Assume corporate tax
rate at 50% and shareholders individual income tax rate at 25%
Solution
Statement showing Computation of WACC
Sources Amount Weights Cost of Weighted cost
capital ( weight tax after tax
( after cost)
tax)
8%Debentures 5,00,000 0.333 0.04 0.01332
Preference Share 2,00,000 0.133 0.05 0.00665
capital
Equity Share 5,00,000 0.333 0.10 0.0333
Capital
Retained 3,00,000 0.2 0.075 0.015
Earnings
Weighted average cost of capital 0.06827 or 6.83%
Calculation of after tax cost of
capital
• Cost of 8% Debeture = Kd ( before tax) X (1- tax)
• = 8 X (1-,50)
• = 4%

Cost of equity Shares = DPS X 100

MPS

= 3 X 100 = 10%
30
Calculation of after tax cost of
capital
Cost of Retained earnings = DPS (1 – Ti) X 100
MPS

= 3(1- ,25) X 100 = 7.5%

30
Important question on WACC
The capital Structure of MNP LTD is as under
9% Debentures Rs 2,75,000
11% Preference Shares Rs. 2,25,000
Equity Shares ( face value Rs 10 per Rs. 5,00,000
share)
Important question on WACC
Additional Information
1. Rs 100 per debenture redeemable at par has 2% floatation cost and 10 years of
maturity. The market price per debentures is Rs 105
2. Rs. 100 per preference share redeemable at par has 3% floatation cost and 10
years of maturity. The market price per preference shares is Rs 106
3. Equity Shares has Rs 4 floatation cost and market price per share of Rs 24. The
next year expected dividend is Rs 2 per shares with annual growth of 5% . The firm
has a practice of paying all earnings in the form of dividend.
4. Corporate income tax rate is 35%
solution
Computation of Weighted Average Cost of Capital using Market value
weights

A. Cost of Equity ( ke) = D1 +g = Rs 2 +5 = 15%

P0 Rs 24 – Rs 4

B. Cost of Debenture (kd) = Interest ( 1- tax) + (RV- NP)/N

( RV+NP)/2
= 9(1-0.35) +(100-98)/10 = 5.85+0.20 =
6.11%
(100+98)/2 99
solution
Computation of Weighted Average Cost of Capital using Market value
weights

c. Cost of Pretence shares (kp) = Dividend + (RV- NP)/N

( RV+NP)/2
= 11 +(100-97)/10 = 11.30 = 11.47%
(100+97)/2 98.5
Statement showing Computation of WACC
Sources Amount Weights Cost of Weighted cost
capital ( weight tax after tax
( after cost)
tax)
Debentures 2,88,750 0.1672 0.0611 0.0102
Preference Share 2,38,500 0.1381 0.1147 0.0158
capital
Equity Share 12,00,00 0.6947 0.1500 0.1042
Capital 0
17,27,25 1.0000 0.1302
0
Weighted average cost of capital 13.02%
Rational of using WACC
The rational behind use of WACC is that by financing in
specified proportion and accepting projects yielding more than
the weighted average cost of capital, firm is able to increase the
market price of its stock in the long run. This increase occurs
because investment projects accepted are expected to yield
more on their equity financed portion than the cost of equity
capital Ke. Once these expectations are apparent to the market
place, the market price of stock should rise, all other things
remaining the same.
SUMMARY