FM Books Solution - Nov 23

J.K.SHAH CLASSES INTER CA – F.M.
LEVERAGES
CLASSWORK SOLUTIONS
Solution 1:
Particulars 20,000 units 25,000 units 30,000 units
Sales 2,80,000 3,50,000 4,20,000
(-) Variable cost 1,80,000 2,25,000 2,70,000
Contribution 1,00,000 1,25,000 1,50,000
(-) Fixed cost (1,00, 000) (1,00,000) (1,00,000)
EBIT 0 25,000 50,000
1,25,000 1,50,000
OL 0
25,000 50,000
5 :1 3:1
Solution 2:
Sales 50
(-) Variable Cost (325)
Contribution 17.5
(-) Fixed Cost -4
EBIT 13.5
(-) Interest 1.5 Operating = 17.5 =
EBT 12 Leverage 13.5
(-) Tax 3.6 1.30 times
EAT 8.4
Total Assets Turnover = Sales

x 100
Total Assets
Sales
2.5 = x 100
20
2.5 x 20 = Sales
50 = Sales
13.5
Financial Leverage 
12
1.125:1
Combined Leverage = 1.47
:1:
Solution 3:
(i) Income Statement
Sales 75,00,000
(-) V.C 42,00,000
Cant 33,00,000 Capital Employed = Debt + Equity
(-) F.C. (6,00,000) = 1 Cr.
EBIT 27,00,000
- Interest (4,05,000)
EBT 22,95,000
EBIT
(i) ROI = x 100
CE
27,00,000
= x 100
10,000,000
= 27%
(ii) ROCE > cost


If ROCE is greater than cost of Debt, financial leverage is favourable
(27% > 9%)
(iii) Capital Turnover Ratio = Sales

C.E.
= 75,00,000
10,00,000
= 0.75 Capital Turnover Ratio is lower
C
(iv) OL =
EBIT
= 1.2:1
FL = EBIT
EBT
= 1.18:1
CL = 1.41:1
:2:
(v)
Sales 22,84,091 100
(-) V.C (12,79,091) 56
Cant 10,05,000 44
(-) F.C. (6,00,000)
EBIT (4,05,000)
Interest (4,05,000)
EBT 0
% Δ in EBIT
1.22 = S 75,00,000 87,50,000
% Δ in EBT
- V.C. 42,00,000 46,20,000
X
1.22 = C 33,00,000 36,30,000
10%
6L 6L
- F.C.
27L 30.30L
X = 12.22% OR EBIT +12.22%
Int.
EBT
% Δ in EBIT
(7) Financial Leverage =
% Δ in EBT
X 27,00,000 3,30,000
1.18 = 20% 100 (?)
 12.22%
= 23.6%
EBIT 27,00,000 32,40,000

- Int 4,05,000 4,05,000
EBT 22,95,000 28,30,000
5,40,000
22,95,000 5,40,000
100 (?)  23.6 %
:3:
Solution 4:
Income Statement
Sales 12,10,000
- Variable cost 629200
Cont 580800
- FC 96800
EBIT 4,84,000 + 20% 5,80,000
Int 84000 - 84000
EBT 4,00,000 100 496300
Tax 1,20,000 30 - 149040
EAT 2,80,000 70 347760
- PD (50,000) - 50,000
N.P for ESH 2,30,000 ÷ 80,000 297760 ÷ 80,000
(-) Eq dividend 1,20,000 (8,00,000 x 15%)
Returned 1,10,000 2.875
. 3.722
.
WN.1 operating Exp = 1.5 x EBIT
= 1.5 x 4840000
= 726000
VC FC
629200 96800
(i) OL = C
EBIT
= 580000
484000
= 1.2:1
EBIT
(i) FC =
EBT – PD FL = % ∆ in EPS
1–t % ∆ in EBIT
= 484000 ⸫ 1.4730 = % ∆ in EPS
4,00,000 – 50,000 20
1 – 30% ⸫% ∆ in EPS = 29.46
= 484000 OR
4,00,000 - 50,000 ∆ in EPS = 29.46%
0.7
:4:
484000
4,00,000 - 71429
484000
328571
= 1.47:1 1.4730:1
Cover for
(ii) Cover for Equity dividend
preference
EAT NP for Eq shares
PD ED
= 2,80,000 2,30,000
50,000 1,20,000
= 5.6:1 = 1.92:1
(3) Earning yield Ratio

EPS x 100 2,30,000 = 2.875
MPS 80,000
= 2.875 x 100
23
= 12.5%
Price Earning Ratio = MPS

EPS
= 23 = 8 times
2.875
(4) Net Fund Flow: -

 How much money available with you
After giving all dividend?
Retained Earnings 1,10,000
+ Dep (Non-cash) 96800
206800
OR
EAT + Dep – Dividends
:5:
Solution 5:
Calculation of EBIT & Preparation of Income statement
Sales = Rs 30Cr
EBIT = 12% of Sales
EBIT = 3.6 Cr
ROCE = EBIT x 100
CE
= 3.6 x 100
18
= 20%
EBIT is given as % of Sales
 Sales = ` 30 Cr.
EBIT = 12% of Sales
= 12% of 30 Cr
= 3.6 Cr
EBIT 3.6 Cr
(-) Int 0.9
EBT 2.7
(-) Tax 1.08
EAT 1.62
(-) P.D (0.26) (2cr x 13%)
1.36
for Equity shareholders funds
ROCE = EBIT x 100
CE
= 3.6 x 100
18 (6 + 10 + 2)
= 20%
Debts (6) PSC (2) ES (10)

EBIT 1.2 0.4 2
Int 0.9 - -
EBT 0.3 0.4 2
Tax 0.12 (0.16) 0.8
EAT 0.18 0.24 1.2
PD - (0.26) -
0.18 (0.02) 1.2
:6:
ROE = N.P for ESH x 100

ESHF
= 1.36 x 100
10
= 13.6%
Debts PS E
0.18 x 100 (0.02) x 100 1.2 x 100
10 10 10
= 1.8% + (0.02%) + 12%
= 13.6 %
Note: - The finance manager of the company should redeem the preference
shares because it leads to loss for equity shareholders.
(2)
FI = EBIT
EBT – PD (I + DDT)
1 – Tax
= 3.6
2.7 – (0.26) OL = C
1 – 0.4 EBIT
3.6 =
2.7 – (0.26) OL = CL
0.6 FL
3.6 OL = 3
2.7 – 0.43 1.59
3.6 = 1.89:1
2.27
= 1.59:1
:7:
Solution 6:
Estimation of Degree of Operating Leverage (DOL), Degree of Financial Leverage
(DFL) and Degree of Combined Leverage (DCL)
P Q R
Output (in units) 2,50,000 1,25,000 7,50,000
Rs. Rs. Rs.
Selling Price (per unit) 7.50 7 10
Sales Revenues (Output × Selling Price) 18,75,000 8,75,000 75,00,000
Less: Variable Cost (Output × Variable Cost ) 12,50,000 2,50,000 56,25,000
Contribution Margin 6,25,000 6,25,000 18,75,000

Less: Fixed Cost 5,00,000 2,50,000 10,00,000
Earnings before Interest and Tax (EBIT) 1,25,000 3,75,000 8,75,000
Less : Interest Expenses 75,000 25,000
Earnings before Tax (EBIT) 50,000 3,50,000 8,75,000
Contribution 5 1.67 2.14
DOI = EBIT
EBIT
DOI = EBT 2.5 1.07 1.00
DCL= DOL x DFL 12.5 1.79 2.14

Comment Aggressiv Moderate Moderate
ePolicy Policy Policy with
no financial
leverage
:8:
Solution 7:
DFL = 1.8, F/C= 4,50,000, P/V = 27%
EBIT = 22,50,000,
Contribution = 27,00,000
Solution 8:
Calculation of Degree of Operating leverage and Degree of Combined leverage
Firm Degree of Operating Leverage Degree of Combined Leverage
(DOL) (DCL)
%Change in Operating Income %Change in EPS

= =
%Change in Revenue %Change in Revenue
26% 32%
M = 0.929 = 1.143
28% 28%
34% 26%
N = 1.259 = 0.963
27% 27%
38% 23%
P = 1.520 = 0.920
25% 25%
43% 27%
Q = 1.870 = 1.174
23% 23%
40% 28%
R = 1.60 = 1.120
25% 25%
Solution 9:
Income Statement
EBIT 2,00,000
(-) Interest 70,000
1,30,000
(-) Tax 65,000 (50%)
EAT 65,000
(-) P.D. 15,000 N.P. = 50,000
i) EPS = Net Profit for ESH

No of shares
= 50,000
4000
= 12.50
:9:
(ii) FL = EBIT
EBT – PD (1 +DDT)
1 - Tax
= 2,00,000
1,30,000 - 15000
1 – 50 %
= 2,00,000
1,00,000
= 2
(2) FL = % in ∆ in dep variable

% in ∆ Ind variable
2 = % ∆ in EPS
% ∆ in EBIT
2 = X
± 30 %
X = ± 60%
Solution 10:
Income Statement
Particulars Company A (`) Company B (`)
Sales 80,000 36,000
Less: Variable Cost 60,000 24,000
Contribution 20,000 12,000
Less: Fixed Cost 16,000 9,000
EBIT 4,000 3,000
Less: Interest 3,000 2,000
EBT 1,000 1,000
Tax (45%) 450 450
EAT 550 550
(i) Company A
Financial Leverage = EBIT/(EBIT- Interest)
4 = EBIT/(EBIT- ` 3,000)
4EBIT – ` 12,000 = EBIT
3EBIT = ` 12,000
EBIT = ` 4,000
: 10 :
Company B
Financial Leverage = EBIT/(EBIT - Interest)
3 = EBIT/(EBIT – ` 2,000)
3EBIT – ` 6000 = EBIT
2EBIT = ` 6,000
EBIT = ` 3,000
(ii) Company A
Operating Leverage = 1/Margin of Safety
= 1/0.20 =5
Operating Leverage = Contribution/EBIT
5 = Contribution/` 4,000
Contribution = ` 20,000
Company B
Operating Leverage = 1/Margin of Safety
= 1/0.25 =4
Operating Leverage = Contribution/EBIT

4 = Contribution/` 3,000
Contribution = ` 12,000
(iii) Company A
Profit Volume Ratio = 25%(Given)
Profit Volume Ratio = Contribution/Sales × 100
25% = ` 20,000/Sales
Sales = ` 20,000/25%
Sales = ` 80,000
Company B
Profit Volume Ratio = 33.33%
Therefore, Sales = ` 12,000/33.33%
Sales = ` 36,000
: 11 :
CAPITAL STRUCTURE
CLASSWORK SOLUTIONS
Solution 1:
Summary of Financial Plan.
Plan 1 Plan 2
Eq. Shares 2,00,000 4,00,000
15% Loan 2,00,000 -
4,00,000 4,00,000
No. of ESH 2000 4000
(i) Selection of financial plan.

a) EBIT = 70,000 b) EBIT = 80,000
Plan 1 Plan 2 Plan 1 Plan2
EBIT 70,000 70,000 80,000 80,000
[2,00,000 x 15%] Invest (30,000) - (30,000) -
40,000 70,000 50,000 80,000
(14000) 24,500 (17,500) (28000)
EAT / EESH 26000 45,500 32,500 52,000
÷ No. of ESH 2000 4000 2000 4000
EPS ` 13 ` 11.37 ` 16.25 ` 13
Recommendation:
In either case of EBIT Plan 1 should be selected if the EPS is higher.
(ii) Calculation of IDF point:

At IDF point, EPS plan, = EPS plan2
( )( ) ( )
( )( ) ( )
Verification of indifference point:

Plan 1 Plan 2
EBIT. (IDF) 60,000 60,000
(-) Interest (30,000) ----
EBT 30,000 60,000
Tax (10,500) 21,000
EAT 19,500 39,000
No. of ES 2000 4000
EPS 9.75 9.75
12
Hence verified.
EBIT
(iii) Calculation of F – BEP
F BEP = Int + PD
(1 t)
Plan 1 = 30,000 + 0
1 0.35
= 30,000 + 0 = 30,000
*Plan 2 : - F BEP = 0
In an all equity plan F BEP is always Zero
Solution 2:
Summary of financial Plan:
Plan 1 Plan 2 Plan 3
[Bal. fig.] Eq. share 22,50,000 15,00,000 10,00,000
To loan 2,50,000 10,00,000 15,00,000
25,00,000 25,00,000 25,00,000

No. of Share 15000 10000 8000
22,50,000 15,00,000 10,00,000

150 150 * 125
* Since debt is greater than 10,00,000 the price is taken to be 125.
(i) Selection of plan:

EBIT 5,00,000 5,00,000 5,00,000
(-) Interest (25000) (1,37,500) (2,37,500)
4,75,000 3,62,500 2,62,500
Tax (2,37,600) 1,82,250 1,31,250
EAT / EESH 2,37,500 1,81,210 1,31,250
÷ No of shares 15,000 10000 3,000
15.38 18.125 16.40
Recommendation: - Plan 2 should be selected because EPS is higher.
Working 1.
 Interest : - Calculate
0 2,50,000 10% It as we calculate
2,50,000 10,00,000 15% Income tax.
10,00,000 ? - 20%
13
Solution No. 3
Summary of financial plan.
Plan A Plan B Plan C
Equity Share 2,00,000 1,00,000 1,00,000
8% Debt - 1,00,000 -
8% Pref. shares - - 1,00,000
Total Cap reqd. 2,00,000 2,00,000 2,00,000

No. of Eq. sh 10,000 5,000 5,000
2,00,000 1,00,000 1,00,000
20 20 20
(i) Calculation of EPS:

Plan A Plan B Plan C
EBIT 80,000 80,000 80,000
(-) Interest - (18,000) -
EBT 80,000 72,000 80,000
(-) Tax (40,000) (36,000) (40,000)
EAT 40,000 36,000 40,000
(-) PD - - 18,000
EESH 40,000 36,000 32,000
No. of ESH 10,000 5,000 5,000
EPS 4 7.2 6.4
Recommendation: - Plan B dominates the other 2 Plans as the EPS is highest
(ii) Calculation of F – BEP
F - BEP =
Plan 1 =
= 0
Plan 2: -
= 8000
Plan 3: -
14
= 16,000
(iii) Calculation of iDF point

(a) Between Plan A & B
(EBIT) (1 t) = (EBIT Int.) (1 t)
No. of Eq. sh. plan A No. of Eq. sh. plan B
EBIT (1 0.50) = (EBIT 8000) (1 0.50)

10,000 2 5000 1
EBIT = 2 (EBIT 8000)

EBIT = 16,000
(b) Between plan A & C
(EBIT) (1 t) = (EBIT Int.) (1 t) - PD
No. of Eq. sh. plan A No. of Eq. sh. plan C
EBIT (1 0.50) = (EBIT 8000) (1 0.50) (8000)

10,000 2 5000 1
0. 50 (EBIT) = 2((0.50) (EBIT 8000)

0.50 (EBIT) = EBIT - 16,000
EBIT = 32,000
(C) Between B & C
(EBIT) (1 t) = (EBIT Int.) (1 t) - PD
No. of Eq. sh. plan B No. of Eq. sh. plan C
(EBIT 8000) (1 0.50) = EBIT (1 0.50) 8000
5000 5000
(0.50) EBIT 1T - 8000 = EBIT (0.50) - 8000
Since EBIT itself gets cancelled it indicate that there is no indifference point between
plan B & C.
Solution 4:
(i) Capital Structure
Eq. shares 40,00,000
Retained Earnings 10,00,000
9 % Preference share 25,00,000
7 % Debentures 25,00,000
Existing capital 1,00,000
(+) Additional Capital 25,000

1,25,000
 New Capital
15
(ii) Existing ROCE = 12% (Given)
(iii) New ROCE = Existing ROCE = 12%
In absence of information about new ROCE it is information about new ROCE it is assured to
be the same as existing ROCE i.e. 12%
(iv) New EBIT = New capital x Existing ROCE
1,25,000 x 12%
= 15,00,000
(v) Summary of financial plan:

Eq. Shares 25,00,000 ---- ----
10% Preference share ---- 25,00,000 ----
8% Debentures ---- ---- 25,00,000
Total cap. Reqd. 25,00,000 25,00,000 25,00,000
60,000 40,000 40,0000
No. of Eq. share (Old + New) [40,000 + 20,000] [40,000 + 0] [40,000 + 0]
40,00,000
100
P/E Ratio 20 17 16
(a) Selection of financial plan

EBIT 15,00,000 15,00,000 15,00,000
(-) Invest
Existing (25L x 7%] (1,75,000) (1,75,000) (1,75,000)
New (25L x 5%) ---- ---- (2,00,000)
EBT 13,25,000 13,25,000 11,25,000
(-) TAX (6,62,500) (6,62,500) (5,62,500)
EAT (6,62,500) (6,62,500) (5,62,500)
(-) Preference Dividend
Existing (25L x 9%) (2,25,000) (2,25,000) (2,25,000)
New (25L x 10%) ---- (2,50,000) ----
EESH 4,37,500 1,87,500 3,37,500
÷ No. of Eq. sh. 60,000 40,000 40,000
EPS 7.29 4.68 8.43
P/E Ratio 20 17 16
145.8 79.56 134.88
16
Recommendation:
Plan 1 should be elected as Uu MPS is highest
(b) We have selected plan 1 because the MPS is highest and higher the MPS, greater
would be the wealth of shareholder which is the main objective of every company.
Solution 5:
Before After
Ebgt 200000 200000
(-) gnt (70000) -
EBT (500000 x 14%)
130000 200000
(-) Tax (35%) (45500) (70000)
PAT 84500 130000
(-) P.D - -
Pr. for ESH 84500 130000
 No of eq.sh 10000 15000
EPS 8.45 8.67
(x) P/E 20 25
MPS 169 216.67
Solution 6:
The capital investment can be financed in two ways i.e.
(i) By issuing equity shares only worth ` 4.5 crore or
(ii) By raising capital through taking a term loan of ` 3 crores and ` 1.50 crores
through issuing equity shares (as the company has to comply with the 2 : 1 Debt
Equity ratio insisted by financing agencies).
In first option interest will be Zero and in second option the interest will be ` 36,00,000
Point of Indifference between the above two alternatives =
EBIT 1 x (1 t) = (EBIT Interest) x (1 t)
No. of equity shares (N 1) No. of equity share (N 2)
Or, EBIT (1 - 0.50) = (EBIT- ` 36,00,000) x (1 - 0.50)
45,00, 000 shares 15,00,000 shares
Or, 0.5 EBIT = 1.5 EBIT ` 54,00,000
EBIT = ` 54,00,000
EBIT at point of Indifference will be ` 54 Lakhs.

(The face value of the equity shares is assumed as ` 10 per share. However,
indifference point will be same irrespective of face value per share).
17
Solution 7:
Ascertainment of probable price of shares of Akash limited
Plan – I Plan – II
If `4,00,000 is If `4,00,000 is raised
Particulars
raised as debt (`) by issuing equity
shares (`)
Earnings Before Interest and Tax (EBIT) 3,60,000 3,60,000
{20% of new capital i.e. 20% of
(`14,00,000 + `4,00,000)}
(Refer working note 1)
Less: Interest on old debentures (10% of (40,000) (40,000)
`4,00,000)
Less: Interest on new debt (12% of (48,000) ---
`4,00,000)
Earnings before Tax (EBT) 2,72,000 3,20,000
Less: Tax @ 50% (1,36,000) 1,60,000
Earnings for equity shareholders (EAT) 1,36,000 1,60,000
No. of Equity Shares (refer working note 2) 30,000 40,000
Earnings per Share (EPS) `4.53 `4.00
Price / earnings (P/E) Ratio (refer working 8 10
note 3)
Probable Price Per Share (PE Ratio  EPS) `36.24 `40
Working Notes:
1. Calculation of existing Return of Capital Employed (ROCE):
(`)
Equity Share capital (30,000 shares  `10) 3,00,000
 100  4,00,000
10% Debentures  ` 40,000 × 
 10 
Reserves and Surplus 7,00,000
Total Capital Employed 14,00,000
Earnings before interest and tax (EBIT) (given) 2,80,000
`2,80,000 20%
ROCE = × 100
`14,00,000
18
2. Number of Equity Shares to be issued in Plan – II:

` 4,00,000
× 10,000 Shares
` 40
Thus, after the issue total number of shares = 30,000 + 10,000 = 40,000
shares
3. Debt / equity Ratio if `4,00,000 is raised as debt:
`8,00,000
 × 100 = 44.44%
`18,00,000
As the debt equity ratio is more than 40% the P/E ratio will be brought
down to 8 in Plan - I
Solution 8:
(a)
Alternatives
Alternative – I: Alternative – II: Alternative – III:
Particulars Take additional Issue 11% Issue further
debt Preferences Equity Shares
Shares
` ` `
EBIT 15,00,000 15,00,000 15,00,000
Interest on Debts
- on existing debt @ 10% (3,60,000) (3,60,000) (3,60,000)
- on new debt @ 12% (4,80,000) --- ---
Profit before taxes 6,60,000 11,40,000 11,40,000
Taxes @ 40% (2,64,000) (4,56,000) (4,56,000)
Profit after taxes 3,96,000 6,84,000 6,84,000
Preference shares --- (4,40,000) ---
dividend
Earnings available to 3,96,000 2,44,000 6,84,000
equity Shareholders
Number of shares 8,00,000 8,00,000 8,00,000
Earnings per share 0.495 0.305 0.651
(b) For the Present EBIT level, equity shares are clearly preferable. EBIT would
need to increase by `2,376 - `1,500 = `876 before an indifference point
with debt is reached. One would want to be comfortably above this
19
indifference point before a strong case for debt should be made. The
lower the probability that actual EBIT will fall below the indifference point,
the stronger the case that can be made for debt, all other things the same.
Working Note:
Calculation of indifference point between debt and equity shares (in
thousands)-
EBIT -`840 EBIT -`360
=
800 1,050
EBIT (1,050) - `840 (1,050) = EBIT (800) - `360 (800)
250EBIT = `5,94,000
EBIT = `2,376
20
COST OF CAPITAL
CLASSWORK SOLUTIONS
Solution 1:
(a) (i) Issue is at par
Or
(ii) Issue is at 10% discount
(iii) Issue is at 10% premium
(b) If issue is at premium of 10% and brokerage is 2%
Solution 2:
Calculation of Ke (existing)
As per Gordon’s formula,
Calculation of Ke (new)
21
Solution 3:
Solution 4:
Solution 5:
Calculation of Ke (existing)
Solution 6:
(a) Pattern of raising additional finance
Additional Finance = 10,00,000
Debt 30% Equity 70%
Retained Earnings = Equity Share Capital =

10% Debt = 1,80,000 16% Debt = 1,20,000 4,90,000 2,10,000
(b) Calculation of Post tax Cost of Average Debt

Sources Amounts Weights Cost in % W* C
10% Debt 1,80,000 0.60 5 3.00
16% Debt 1,20,000 0.40 8 3.20
3,00,000 1 6.20 Kd
22
Working Notes
(c) Calculation of Ke and Kr

Calculation of Kr = Ke(existing)
(d) Calculation of Overall WACC using Marginal Value Weights

10% Debt 1,80,000 0.18 5 0.90
16% Debt 1,20,000 0.12 8 0.96
Equity Share Capital 4,90,000 0.49 15 7.35
Retained Earnings 2,10,000 0.21 15 3.15
10,00,000 1 12.36 % Ko
Solution 7:
(a) Calculation of WACC using Book Value Weights
Debentures 5,00,000 0.25 5.51 1.38
Preference Shares 5,00,000 0.25 5.25 1.31
Equity Shares 10,00,000 0.50 10 5.00
20,00,000 1 7.69 Ko
23
Working Notes
(b) Calculation of WACC using Market Value Weights

Debentures 5,25,000 0.15 5.51 0.83
Preference Shares 5,50,000 0.16 5.25 0.83
Equity Shares 24,00,000 0.69 10 6.91
34,75,000 1 8.57 % Ko
Solution 8:
(A)
(1)
24
(3) Calculation of Kr = Ke (existing)
(B) Calculation of Marginal Cost of Capital when no new shares are issued
Sources Amounts Weights Cost in %
W*C
Debentures ? 0.15 1.25 8.33
Preference Share Capital ? 0.05 0.60 11.96
Retained Earnings ? 0.8 12.00 15
13.85%
(C) Calculation of Maximum Capital Investment without Fresh Issue of Equity
Additional Finance = 14,750
Debentures = 2212.5 Preference Share Equity 11800

Capital = 737.5
Retained Earnings = Equity Share Capital =

11800 0
(D) Calculation of Marginal Cost of Capital if new shares are issued

Sources Amounts Weights Cost in % W*C
Debentures ? 0.15 8.33 1.25

Preference Share Capital ? 0.05 11.96 0.60
Equity Share Capital ? 0.8 15.9 12.72
k = 14.57%
Solution 9:
As per Gordon’s Formula
25
Solution 10:
Growth rate = Retention Ratio * Return on Equity
= 0.6*0.2
= 0.12 i.e. 12%
Solution 11:
Calculation of Cost of Retained Earnings
Maximum amount available for Investment (including brokerage) 103 7,50,000
Less: Brokerage 3 21,845
Maximum amount available for Investment (excluding brokerage) 100 7,28,155
Income on Investment 72,816
Less: Tax@ 30% 21,845
Profit after Tax 50,971
Kr = Rate of Return = 50971/750000*100 6.80%
Solution 12:
(a) Calculation of WACC using Market Value WeZZZ
Sources Amount Weights Cost W*C
in (%)
Equity Share Capital 9,000 0.81 15 12.20
(150 m shares * ` 60)
10.5% Preference Share Capital 98.15 0.01 10.97 0.10
(1 m shares * ` 98.15 )
W
9.5% Debentures 1,471.58 0.13 6.89 0.92
o
(1.5 m Debt * 981.05)
r
8.5% Term Loans 500 0.05 5.525 0.25
k
11,069.725 1.00 13.46 Ko
i
Working Notes
(i) As per CAPM,
(ii)
26
(iii)
(iv)
(b) Calculation of WACC using Marginal Value Weights

Sources Amount Weights Cost in (%) W*C
9.5% Term Loans 100 0.13 6.175 0.82
10% Term Loans 50.00 0.07 6.5 0.43
Equity Share Capital 600 0.80 17 13.60
750.000 1.00 14.86 Ko
As per CAPM,
27
Solution 13:
As per Gordon’s Formula
Average growth rate
Solution 14:
Ko = book value wt.
Source Cost Wt. Product
Equity share 14 45 630
R.E. 14 15 210
Pref. share 10 10 100
Debentures 5 30 150
100 1,090
Total Product 1090
K0 = = = 10.90%
Total Weight 100
Ko = Market Value Weight
Source Cost Wt. Product

Equity share 14 90 1,260
R.E. 14 0 ----
Pref. share 10 15 150
Debentures 5 35 175
140 1,585
Total Product 1585
Ko = =
Total Weight 100
= 11.32%
Solution 15:
D1 `15
(i) Cost of Equity (Ke) = +g= + 0.06 *
P0 - F `125 - ` 5
Ke = 0.125 + 0.06 = 0.185
*Calculation of g:
` 10.6(1+g)5 = ` 14.19
28
14.19
Or, (1+g)5 = = 1.338
10.6
Table (FVIF) suggests that ` 1 compounds to ` 1.338 in 5 years at the
compound rate of 6 percent. Therefore, g is 6 per cent.
D1 `15
(ii) Cost of Retained Earnings (Kr) = +g= + 0.06 = 0.18
P0 `125
PD `15
(iii) Cost of Preference Shares (Kp) = = = 0.1429
P0 `105
 RV - NP 
I1 - t  +  
(iv) Cost of Debentures (K d) =
 n 
RV - NP
2
 `100 - `91.75* 
`15 1 - 0.35 +  
=  11 years 
`100 + `91.75*
2
`15 × 0.65 + ` 0.75 `10.5
= = = 0.1095
`95.875 `95.875
*Since yield on similar type of debentures is 16 per cent, the company would
be required to offer debentures at discount.
Market price of debentures (approximation method)
= ` 15 ÷ 0.16 = ` 93.75
Sale proceeds from debentures = ` 93.75 – ` 2 (i.e., floatation cost) = `91.75
Market value (P0) of debentures can also be found out using the
present value method:
P0 = Annual Interest × PVIFA (16%, 11 years) + Redemption value × PVIF
(16%, 11 years)
P0 = ` 15 × 5.029 + ` 100 × 0.195
P0 = ` 75.435 + ` 19.5 = ` 94.935
Net Proceeds = ` 94.935 – 2% of ` 100

29 = ` 92.935
Total Cost of capital [BV weights and MV weights]
(Amount in (`) lakh)
Specific
Weights Total cost
Source of capital Cost (K)
BV MV (BV × K) (MV × K)
Equity Shares 120 160* 0.1850 22.2 29.6
Retained Earnings 30 40* 0.1800 5.4 7.2
Debentures 36 33.75 0.1095 3.942 3.70
Preference Shares 9 10.4 0.1429 1.2861 1.49
Total 195 244.15 32.8281 41.99
*Market Value of equity has been apportioned in the ratio of Book Value of
equity and retained earnings i.e., 120:30 or 4:1.
Weighted Average Cost of Capital (WACC):
`32.8281
Using Book Value = = 16.83%
`195
` 41.99
Using Market Value = = 17.19%
`195
30
CAPITAL STRUCTURE THEORY
CLASSWORK SOLUTIONS
Solution 1:
Calculation of V and Ko as per NI Approach
Value of the Firm = Value of Debt(D) + Value of Equity (E)
= 8,00,000 + 9,60,000
= 17,60,000
EBIT 2,00,000
Less: Interest 80,000
Dividend 1,20,000
Solution 2:
I II III
Debt = 0 Debt = 6L Debt = 10L
Kd = NA Kd = 10% Kd = 12%
Ke = 16% Ke = 17% Ke = 20%
EBIT 3,00,000 3,00,000 3,00,000
(-) Int. ---- (60,000) (1,20,000)
EBT / Div 3,00,000 2,40,000 1,80,000
E = Div. /Ke 3,00,000 2,40,000 1,80,000
0.16 0.17 0.20
= 18,75,000 = 14,11,765 = 9,00,000
14,11,765 + 9,00,000 +
V=E+D 18,75,000
6,00,000 10,00,000
= 20,11,765 = 19,00,000
Ko = EBIT 3,00,000 3,00,000 3,00,000
31
V 18,75,000 20,11,765 19,00,000
= 0.16 = 0.1491 = 0.1579
= 16% = 14.91% = 15.79%
Solution 3:
Calculation of V and Ke
Particulars 10% Debt 10% Debt 11% Debt 12% Debt 14% Debt
= 3 Lakhs = 4 Lakhs = 5 Lakhs = 6 Lakhs = 7 Lakhs
1) EBIT 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Less: Interest 30,000 40,000 55,000 72,000 98,000
Dividend 2,70,000 2,60,000 2,45,000 2,28,000 2,02,000
2) E= Dividend / Ke 22,50,000 20,80,000 18,14,815 15,20,000 11,22,222
3) V = E + D 11.76% 12.10% 12.96% 14.15% 16.46%
4) Ko = EBIT / V 11.76% 12.10% 12.96% 14.15% 16.46%
Company is advised to select Capital structure 1 as Ko is minimum.
Solution 4:
Calculation of Value of Firm and Ke as per NOI Approach
Particulars 8% Debt = 4 Lakhs 8% Debt = 7 Lakhs 8% Debt = 10 Lakhs
1) EBIT 4,00,000 4,00,000 4,00,000
Less: Interest 32,000 56,000 80,000
Dividend 3,68,000 3,44,000 3,20,000
2) V= EBIT / Ko 40,00,000 40,00,000 40,00,000
3) E = V –D 36,00,000 33,00,000 30,00,000
4) Ke = Dividend /E 10.22% 10.42% 10.67%
Solution 5:
32
Solution 6:
Calculation of Value of Co. P and Co. Q
As per MM Approach, if there are taxes
Value of Co. Q = Value of Co. P + Debt * Tax Rate
= 18,20,000 + 2,40,000
= 20,60,000
Value of Co. P
Solution 7:
a) Value of RES Ltd (after restructuring)
As per MM Approach, if there are taxes
Value of RES Ltd (after Restructuring) = Value of RES Ltd (before restructuring)
+ Debt * Tax Rate
= 25,00,000 + 5,00,000* 30%
= 26,50,000
b) Cost of Equity (Ke) (after restructuring)
E = V- D = 26,50,000 – 5,00,000 = 21,50,000
Particulars After Restructuring Before Restructuring

EBIT 7,50,000 7,50,000
Less: Interest 75,000 -
EBT 6,75,000 7,50,000 100
Less: Tax @ 30% 2,02,500 2,25,000 30
Dividend 4,72,500 5,25,000 70
(25,00,000* 21%)
c) Ko (after restructuring)
Companies Ko will decrease from 21% to 19.79% after restructuring.
33
Solution 8:
(a) Assuming no tax as per MM Approach.
Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM
Hypothesis
Market Value of ‘B Ltd’ *Unlevered(u)+
Total Value of Unlevered Firm (Vu) = [NOI/ke] = 18,00,000/0.18 = `
1,00,00,000
Ke of Unlevered Firm (given) = 0.18
Ko of Unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ *Levered Firm (I)+
Total Value of Levered Firm (VL) = Vu + (Debt× Nil) = ` 1,00,00,000 +
(54,00,000 × nil) = `1,00,00,000
Computation of Equity Capitalization Rate and

Weighted Average Cost of Capital (WACC)
Particulars A Ltd. B Ltd.
A. Net Operating Income (NOI) 18,00,000 18,00,000
B. Less: Interest on Debt (I) 6,48,000 -
C. Earnings of Equity Shareholders (NI) 11,52,000 18,00,000
D Overall Capitalization Rate (ko) 0.18 0.18
E Total Value of Firm (V = NOI/ko) 1,00,00,000 1,00,00,000
F Less: Market Value of Debt 54,00,000 -
G Market Value of Equity (S) 46,00,000 1,00,00,000
H Equity Capitalization Rate [ke = NI /S] 0.2504 0.18
I Weighted Average Cost of Capital 0.18 0.18
[WACC (ko)]*
ko = (ke × S/V) + (kd × D/V)
*Computation of WACC A Ltd

Component of Capital Amount Weight Cost of Capital WACC
Equity 46,00,000 0.46 0.2504 0.1152
Debt 54,00,000 0.54 0.12* 0.0648
Total 81,60,000 0.18
*Kd = 12% (since there is no tax)
WACC = 18%
34
(b) Assuming 40% taxes as per MM Approach
Calculation of Value of Firms ‘A Ltd.’ and ‘B Ltd’ according to MM
Hypothesis
Market Value of ‘B Ltd’ *Unlevered (u)]
Total Value of unlevered Firm (Vu) = [NOI (1 - t)/ke] = 18,00,000 (1 – 0.40)]
/ 0.18
= `60,00,000
Ke of unlevered Firm (given) = 0.18
Ko of unlevered Firm (Same as above = ke as there is no debt) = 0.18
Market Value of ‘A Ltd’ *Levered Firm (I)+
Total Value of Levered Firm (VL) = Vu + (Debt× Tax)
= ` 60,00,000 + (54,00,000 × 0.4)
= ` 81,60,000
Computation of Weighted Average Cost of Capital (WACC) of ‘B Ltd.’
= 18% (i.e. Ke = Ko)
Solution 9:
Particulars M Ltd N Ltd
EBIT 20,000 20,000
Dividend 13,000 20,000
Ke 11.50% 10%
E = Dividend/Ke 1,13,043 2,00,000
Debt (D) 1,00,000 -
V=E+D 2,13,043 2,00,000
Mr. X having 10% stake in M Ltd (assumption)

Existing income from M Ltd.
Dividend Income from M Ltd (13,000*10%) 1300
Switch over from M Ltd to N Ltd
Proceeds from sale of share of M Ltd 11,304.3
Loan taken @ 7% interest rates 10,000
Amount available from investment 21,304.3
35
Invest 20,000 Rs in N Ltd to make 10% holding
Income from N Ltd
Dividend from N Ltd 2000
Less: Interest on Loan taken 700
Net income after switch over 1300
Solution 10:
Particulars L Ltd. U Ltd.
EBIT 20,000 20,000
Dividend 13,000 20,000
Ke 18.00% 10%
E = Dividend / Ke 72,222 2,00,000
Debt (D) 1,00,000 -
V=E+D 1,72,222 2,00,000
Mr. X having 10% stake in U Ltd (assumption)

Existing income from U ltd
Dividend Income from U Ltd (20,000*10%) 2000
Switch over from U Ltd to L Ltd

Proceeds from sale of share of U Ltd 20,000
Loan given @ 7% interest rates 7,000
Amount available from investment 13,000
Invest 7,222 Rs in U Ltd to make 10% holding

Income from L Ltd
Dividend from L Ltd 1300
Less: Interest on Loan taken 700
Net income after switch over 2000
Surplus still available for investment = 20000-10000-7222 = 2778
36
CAPITAL BUDGETING - PART I
CLASSWORK SOLUTIONS
Solution 1:
Calculation of Average Rate of Return (ARR)
If we take Original Investment in the denominator then ARR will be 9.20%.
Solution 2:
Calculation of NPV for the respective projects
Project A Project B
Year DF @ 12% FVCI PVCI FVCI PVCI
1 0.8929 50,000 44,645 40,000 35,716
2 0.7972 50,000 39,860 50,000 39,860
3 0.7118 50,000 35,590 70,000 49,826
4 0.6355 50,000 31,775 75,000 47,633
5 0.5674 50,000 28,370 75,000 42,555
Total PVCI 1,80,240 2,15,620
(-) PVCO -2,00,000 -1,90,000
NPV (19,760) 25,620
Alternative calculation of NPV for Project A as cash flows are in the form of
Annuity
(i) PVCO
Cost of the Project 2,00,000 (a)
(ii) PVCI
Year Annuity PVAF (12%, 5yrs) PVCI
1-5 50,000 36,048 1,80,240 (b)
37
(iii) NPV = PVCI – PVCO
= b–a
= - 19,760
Solution 3:
Calculation of IRR
PVCO
Cost of the Project 1,36,000
Year FVCI DF @ 10% PVCI DF @ 11% PVCI
1 30,000 0.9091 27,273 0.9009 27,027
2 40,000 0.8264 33,056 0.8116 32,465
3 60,000 0.7513 45,078 0.7312 43,871
4 30,000 0.683 20,490 0.6587 19,762
5 20,000 0.6209 12,418 0.5935 11,869
1,38,315 1,34,994
-
= 10% = 10.70%
-
Solution 4:
Projects PVCO PVCI NPV PI Rankings
A 50,000 65,400 15,400 1.31 5
B 40,000 58,700 18,700 1.47 2
C 25,000 35,100 10,100 1.40 3
D 30,000 41,200 11,200 1.37 4
E 35,000 54,300 19,300 1.55 1
Select Project E, B, C and 2/3rd of D as it will maximize the NPV

Projects PVCO NPV
E 35,000 19,300
B 40,000 18,700
C 25,000 10,100
D 20,000 7,467
A ---- ----
1,20,000 55,567
38
Solution 5:
Year| -), Cash flow – ` 1,36,000
The MIRR is calculated on the basis of investing the inflows at the cost of capital. The
table below shows the value of the inflows if they are immediately reinvested at 8%
Year Cash Flow @ 8% reinvestment rate factor `
1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587
* Investment of ` 1 at the end of the year 1 is reinvested for 4 year (at the end of
5 year) shall become 1(1.08)4 = 1.3605. Similarly, reinvestment rate factor for
remaining years shall be calculated. Please note investment at the end of 5th
year shall be reinvested for zero year hence reinvestment rate factor shall be
1.00.
The total cash outflow in year 0 (` 1,36,000) is compared with the possible
inflow at year 5 and the resulting figure of = 0.6367 is the discount factor
in year 5. By looking at the 5 row in the present value tables, you will see that
this gives a return of 9%. This means that the ` 2,13,587 received in year 5 is
equivalent to ` 1,36,000 in year 0 if the discount rate is 9%. Alternatively, we
can compute MIRR as follows:
Total return = = 1.5705
MIRR = 1/5 √ – 1 = 9.466%
Solution 6:
Calculation of PBP, D-PBP, NPV and IRR
(i) PVCO
Cost of the Equipment 6,00,000
Investment in Working Capital 80,000
6,80,000 (a)
39
(ii) Calculation of Cash Inflows
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
CFBT / NPBT 2,40,000 2,75,000 2,10,000 1,80,000 1,60,000
Less: Depreciation 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
NPBT 1,20,000 1,55,000 90,000 60,000 40,000
Less: Tax @35% 42,000 54,250 31,500 21,000 14,000
NPAT @ 65% 78,000 1,00,750 58,500 39,000 26,000
Add: Depreciation 1,20,000 1,20,000 1,20,000 1,20,000 1,20,000
Add: Recovery of
---- ---- ---- ---- 80,000
Working Capital
CFAT / FVCI 1,98,000 2,20,750 178,500 1,59,000 2,26,000
PBP NPV D-PBP DF@15% PVCI

Year Cumu. DF @ Cumu.
FVCI PVCI
FVCI 12% PVCI
1 1,98,000 1,98,000 0.8929 1,76,786 1,76,786 0.8696 1,72,174
2 2,20,750 4,18,750 0.7972 1,75,981 3,52,766 0.7561 1,66,919
3 1,78,500 5,97,250 0.7118 1,27,053 4,79,819 0.6575 1,17,367
4 1,59,000 7,56,250 0.6355 1,01,047 5,80,866 0.5718 90,909
5 2,26,000 9,82,250 0.5674 1,28,238 7,09,105 0.4972 1,12,362
7,09,105 6,59,730
( - -
40
Solution 7:
Calculation of NPV and PI
(i) PVCO
Cost of the Machine 80,000 (a)
(ii) Calculation of Cash Inflows

Revenue p.a. 40,000
Less: Operating Cost 7,500
Less: Depreciation 9,250
NPBT 23,250
Less: Tax @ 40% 9,300
NPAT 13,950
Add: Depreciation 9,250
Less: Commission Income lost (12,000)
CFAT 11,200
x PVAF X 5.334
PVCI 59,741
(iii) PV of Salvage
Year Salvage PVF PV
5 6,000 0.467 2802 ©
(iv) NPV = PVCI – PVCO = b + c – a

= 59,741+2802-80000
= 62,543 – 80000
= (17,457)
(v) PI = 62,543 / 80,000 = 0.78

Since NPV is negative company is advised not to buy the diagnostic machine.
Assumption: It is assumed that the company is in 30% tax bracket.
41
Solution 8:
(a) Cost of the Project
At IRR, PVCI = PVCO i.e. NPV = 0
L t th o t of th oj t ‘x’
(i) PVCO
Cost of the Project x (a)
(ii) PVCI
Year Annuity PVAF (15%, 4 yrs.) PVCI
1-4 60,000 2,855 1,71,300 (b)
Since at IRR of 15%, PVCI = PVCO, accordingly cost of the project will
be 1,71,300/-.
(b) Payback Period
(d) NPV
t o
t o
PVCI (at coc) =182263.2
(c) Cost of Capital

(i) PVCO
Cost of the Project 171300 (a)
(ii) PVCI
Year Annuity PVAF (?%, 4 yrs.) PVCI
1-5 60,000 x 182263.2 (b)
42
60000x = 182263.2
Therefore x = 3.038
Reference to PVAF table indicates that PVAF (12%, 4 years) = 3.038.
Therefore COC = 12%.
Solution 9:
Calculation of Annualised Net PVCO if Machine A is selected
(i) PVCO
Cost of the Machine 1,50,000 (a)
(ii) PV of Running Cost

1-3 40,000 2.4869 99476 (b)
(iii) Net PVCO

= a+b
= 249476
(iv) Annualised Net PVCO

t
Calculation of Annualised Net PVCO if Machine B is selected

(i) PVCO
Cost of the Machine 1,00,000 (a)
(ii) PV of Running Cost

1-2 60,000 1.7355 104130 (b)
(iii) Net PVCO

=a+b
= 204130
43
(iv) Annualised Net PVCO
t
Company is advised to select Machine A as its annualized Net PVCO is less.
Solution 10:
Calculation of NPV if existing machine is replaced
Particulars Existing New
(i) PVCO
Cost of the Machine IRRELEVANT 10,00,000
Less: Resale Value of Existing Machine 0 2,00,000
0 8,00,000 (a)
(ii) Calculation of Cash Inflows and

Existing New
PVCI
Sales Quantity 30,000 75,000
Sales 4,50,000 11,25,000
Less: Material Cost 1,20,000 3,00,000
Less: Labour Cost 1,20,000 2,10,000
Less: Indirect Cash Cost 50,000 65,000
NPBDT / CFBT 1,60,000 5,50,000
Depreciation 30,000 1,20,000
NPBT 1,30,000 4,30,000
Less: Tax @ 30% 39,000 1,29,000
NPAT 91,000 3,01,000
Add: Depreciation 30,000 1,20,000
CFAT 1,21,000 4,21,000
* PVAF 4.968 4.968
PVCI 6,01,128 20,91,528 (b)
(iii) PV of Salvage
Salvage * PVF = 0 =40000 * .404
- 16,160 (c)
44
(iv) NPV
= PVC I- PVCO
=b+c–a 6,01,128 13,07,688
Company is advised to replace the existing machine as it will increase the NPV by
7,06,560.
Solution 11:
Calculation of ARR and Profitability Index
Particulars Machine X Machine Y
(i) PVCO
Cost of the Machine 1,50,000 2,40,000
(ii) Calculation of Cash Inflows and PVCI
Savings in Wages p.a. 90,000 1,20,000
Savings in Scrap p.a. 10,000 15,000
Increase in Cost of
Maintenance 7,000 11,000
Indirect Material 6,000 8,000
Supervision 12,000 16,000
Increase in Depreciation 30,000 40,000
Increase in NPBT 45,000 60,000
Less: Tax @ 30% 13,500 18,000
Increase in NPAT 31,500 42,000
Add: Increase in Depreciation 30,000 40,000
Increase in FVCI p.a. 61,500 82,000
* PVAF (10%, nyrs) 3.790 4.355
PVCI 2,33,085 3,57,135
t t
45
Solution 12:
Calculation of NPV if part of the machine is repaired at the end of Year 1
(i) PVCO
Cost of the Machine 50000 (a)
(ii) PV of Repairs
Year Repairs PVAF (10%, 1 yrs.) PVCI
1 10000 0.9091 9091 (b)
(iii) PVCI
Year Repairs PVAF (10%, 3 yrs.) PVCI
1-3 18000 2.4868 44762 (c)
(iv) PV of Salvage
Year Salvage PVAF (10%, 3 yrs.) PVCI
3 12500 0.7513 9391 (d)
(v) NPV
= PVCI – PVCO
=c+d–a-b
= (4,938)
Calculation of NPV if part of the machine is replaced at the end of Year 2

(i) PVCO
Cost of the Machine 50,000 (a)
(ii) PV of Repairs
Year Replacement cost PVAF (10%, 1 yrs.) PVCI
2 15400 0.8264 12727 (b)
46
(iii) PVCI
1-4 18000 3.1698 57056 (c)
(iv) PV of Salvage
Year Salvage PVAF (10%, 4 yrs.) PVCI
4 9000 0.6830 6147 (d)
(v) NPV
= PVCI – PVCO
=c+d–a-b
= 476
Company is advised to replace the part of the machine at the end of the second
year as the NPV is positive.
Solution 13:
Of both the methods NPV method is considered to be the best and hence decision
making is to be done on the basis of NPV. Since life of both the machines is different
we decide on the basis of Annualised NPV
Project A Project B
Since annualized NPV of Project B is higher, company is advised to select

Project B.
Replacement Chain Method

Year FV Cash Flows DF @ 12% PV
0 -20,00,000 1 - 20,00,000
1 7,00,000 0.8929 6,25,000
2 13,00,000 0.7972 10,36,352
3 12,00,000-20,00,000 0.7118 -5,69,424
4 7,00,000 0.6355 4,44,863
5 13,00,000 0.5674 7,37,655
6 12,00,000 0.5066 6,07,957
NPV 8,82,403
Since NPV of Project B is more, Project B should be selected.
47
Solution 14:
Statement to determine which project or projects to be selected
Project PVCO PVCI NPV
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000
1+2 3,15,000 4,75,000 1,60,000
1+3 4,40,000 6,90,000 2,50,000
2+3 3,85,000 6,20,000 2,35,000
1+2+3 440000+115000+125000 620000+290000 2,30,000
Combination 1 and 3 should be selected as it will maximize the NPV
Solution 15:
(a) Calculation of NPV if Project is financed by Retained Earnings
PVCO
PVCI
Year Annuity PVAF (21.33%, 3 yrs.) PVCI
1-3 10,00,000 2.0634 20,63,400 (b)
NPV = PVCI – PVCO
=b–a
= 63,400
Since the project is finance out of Retained Earnings Kr=Ko, and since the
company is all equity Ko=Ke. Accordingly, Ko = Ke = Kr
p Go o ’ fo
(b) Calculation of NPV if Project is financed by Fresh issue of Equity

PVCO
PVCI
Year Annuity PVAF (21.82%, 3 yrs.) PVCI
1-3 10,00,000 2.0479 20,47,900 (b)
48
NPV = PVCI – PVCO
=b–a
= 47,900
p Go o ’ fo
tp o
Solution 16:
Evaluation of Alternatives:
Saving in disposing off the waste
Particulars `
Outflow (50,000 × `1) 50,000
Less: tax savings @50% 25,000
Net Outflow per year 25,000
Calculation of Annual Cash inflows in Processing of waste Material

Particulars Amount ` Amount `
Sale value of waste 5,00,000
(`10 × 50,000 gallon)
Less: Variable Processing cost 2,50,000
(`5 × 50,000 gallon)
Less: Fixed processing cost 30,000
Less: Advertisement cost 20,000
Less: Depreciation 60,000 (3,60,000)
Earnings before tax (EBT) 1,40,000
Less: Tax @ 50% (70,000)
Earnings after tax (EAT) 70,000
Add: Depreciation 60,000
Annual Cash inflows 1,30,000
Total Annual Benefits = Annual Cash inflows + Net savings (adjusting tax) in
disposal cost
= `1,30,000 + `25,000 = `1,55,000
49
Calculation of Net Present Value
Year Particulars Amount (`)
0 Investment in new equipment (6,00,000)
1 to 10 Total Annual benefits × PVAF (10 years, 15%) 7,77,945
`1,55,000 × 5.019
Net Present Value 1,77,945
Recommendation: processing of waste is a better option as it gives a positive
Net Present Value.
Note – Research cost of `60,000 is not relevant for decision making as it is sunk
cost.
Solution 17:
NPV Yr CF DF @ 12% PV
1 33,12,000 0.893
2 63,69,000 0.797
3 1,37,64,500 0.712
4–5 1,70,71,500 1.203
6–8 1,10,23,500 1.363
8 S/V 42,50,000 0.404
PVCG = 5,51,13,078
(-) PVCO = (3,90,00,000)
NPV = 1,61,13,078
Y=1 Y=2 Y=3 Y = 4 to 5 Y = 6 to 8

Units = 72,000 1,08,000 1,60,000 2,70,000 1,80,000
Cont @ 96 69,12,000 1,03,68,000 2,49,60,000 2,59,20,000 1,72,80,000
(240 - 60%)
(-) F/C (36,00,000) (36,00,000) (36,00,000) (36,00,000) (36,00,000)
(-) Dep (43,75,000) (43,75,000) (43,75,000) (48,25,000) (48,25,000)
PBT (10,63,000) 23,93,000 1,69,85,000 1,74,95,000 88,55,000
(-) tax @ 3,18,900 (7,17,900) (50,95,500) (52,48,500) (26,56,500)
30%
--- (39,9000)
50
30%
[23,93,000 –
10,63,000]
PAT (10,63,000) 19,94,000
(+) Dep 43,75,000 43,75,000 43,75,000 48,25,000 48,25,000
CF 33,12,000 63,69,000 1,62,64,500 1,70,71,500 1,10,23,500
(-) Pur of (25,00,000)
Add m/c
1,37,64,500
51
CAPITAL BUDGETING - PART II
Solution 37:
I 1 - t  +
RV - NP 
Cost of debenture (Kd) = n
 RV + NP 
2
I = Interest on debenture = 10% of ` 100 = ` 10
NP = Current market price = ` 80
RV = Redemption value = ` 100
n = Period of debenture = 5 years
t = Tax rate = 35% or 0.35
`10 1 - 0.35 +
 `100 - `80 
5years
Kd =
 `100 + `80 
2
`10 × 0.65 + ` 4 `10.5
Or, Kd = = = 0.1166 or 11.67%
`90 `90
Solution 38:
Here,
Redemption Value (RV) = ` 1,00,000
Net Proceeds (NP) = ` 2,500
Interest = 0
Life of bond = 25 years
There is huge difference between RV and NP, therefore, in place of approximation
method, we should use trial & error method.
FV = PV x (1+r)n
1,00,000 = 2,500 x (1+r)25
40 = (1+r)25
Trial 1: r = 15%, (1.15)25 = 32.919
Trial 2: r = 16%, (1.16)25 = 40.874
Here:
L = 15%, H = 16%
52
NPVL = 32.919-40 = -7.081
NPVH = 40.874-40 = +0.874
NPVL
IRR = L+ H - L 
NPVL - NPVH
-7.081
= 15% + × 16% - 15%  = 15.89%
-7.081 -  0.874 
Solution 39:
The amount of interest will go on declining as the outstanding amount of bond will
be reducing due to amortisation. The amount of interest for five years will be:
First year: ` 5,000 × 0.08 = ` 400;
Second year: (` 5,000 – ` 1,000) × 0.08 = ` 320;
Third year: (` 4,000 – ` 1,000) × 0.08 = ` 240;
Fourth year: (` 3,000 – ` 1,000) × 0.08 = ` 160; and
Fifth year: (` 2,000 – ` 1,000) × 0.08 = ` 80
The outstanding amount of bond will be zero at the end of fifth year.
Since RBML will have to return ` 1,000 every year, the outflows every year will
consist of interest payment and repayment of principal as follows:
First year: ` 1,000 + ` 400 = ` 1,400;
Second year: ` 1,000 + ` 320 = ` 1,320;
Third year: ` 1,000 + ` 240 = ` 1,240;
Fourth year: ` 1,000 + ` 160 = ` 1,160; and
Fifth year: ` 1,000 + ` 80 = ` 1,080
The above cash flows of all five years will be discounted with the cost of capital.
Here, cost of capital will be the minimum expected rate of return i.e. 6%.
Value of the bond is calculated as follows:
`1,400 `1,320 `1,240 `1,160 `1,080
VB = + + + +
1.06  1.06  1.06  1.06  1.06 
1 2 3 4 5
`1,400 ` 1,320 ` 1,240 ` 1,160 ` 1,080

 + + + +
1.06 1.1236 1.1910 1.2624 1.3382
= ` 1,320.75 + ` 1,174.80 + ` 1,041.14 + ` 918.88 + ` 807.05 = ` 5,262.62
53
Solution 40:
We know that as per the realised yield approach, cost of equity is equal to the
realised rate of return. Therefore, it is important to compute the internal rate of
return by trial and error method. This realised rate of return is the discount rate
which equates the present value of the dividends received in the past five years plus
the present value of sale price of ` 1,128 to the purchase price of ` 1,000. The
discount rate which equalises these two is 12 percent approximately. Let us look at
the table given for a better understanding:
Year Dividend Sale Proceeds Discount Factor Present
(`) (`) @ 12% Value (`)
1 100 - 0.893 89.3
2 100 - 0.797 79.7
3 100 - 0.712 71.2
4 100 - 0.636 63.6
5 100 - 0.567 56.7
6 Beginning 1,128 0.567 639.576
1,000.076
We find that the purchase price of Alpha Limit ’ h w ` 1,000 and the
present value of the past five years of dividends plus the present value of the sale
price at the discount rate of 12 per cent is ` 1,000.076. Therefore, the realised rate
of return may be taken as 12 percent. This 12 percent is the cost of equity
Solution 41:
In this question, we will first calculate the yield for last 4 years and then will
t t’ o t
Yield for last 4 years:
D1 + P1 1 + 9.75
1 + Y1 = = = 1.1944
P0 9
D2 + P2 1 + 11.50
1 + Y2 = = = 1.2821
P1 9.75
D3 + P3 1.2 + 11
1 + Y3 = = = 1.0609
P2 11.5
D4 + P4 1.25 + 10.60
1 + Y4 = = = 1.0772
P3 11
Geometric mean:
Ke = [(1+Y1)×(1+Y2 ×…… Yn)]1/n-1
Ke = [1.1944×1.2821×1.0609×1.0772]1/4-1 = 0.15 = 15%
54
CAPITAL BUDGETING AND RISK ANALYSIS
CLASSWORK SOLUTIONS
Solution 1:
PVCO
(I) 100 x (DF =) 100
Cap. Exp.
(II) PVCI – op. C.I.

Yr. CI DF @ 7% PV DF @ 14% PV
1 25 0.9346 23.365 0.8772 21.93
2 60 0.8734 52.404 0.7695 46.17
3 75 0.8163 61.223 0.6750 50.625
4 80 0.7629 61.032 0.5921 47.368
5 65 0.7130 46.345 0.5194 33.761
244.369 199.854
(III) NPV = PVCI – PVCO

@ Risk free rate NPV = 244.369 – 100 = 144.369
@ Risk adj. rate NPV = 199.854 – 100 = 99.854
Solution 2:
Coefficient of variation is a measure of risk and higher the coefficient of variation higher
the risk.
Project X has a coefficient of variation 1.2 and hence, the appropriate risk adjusted
discount rate will be 16%. Similarly for project Y, it will be 14% &, 12%.
Calculation of NPV –
X Y Z
(i) PVCO
2,10,000 1,20,000 1,00,000
Cap. Exp.
(ii) PVCI - OP. C.J. 2,29,180 1,08,150
1,44,186
70,000 x 3.274 (30,000 x
(42,000 x 3.4333)
3.605)
(iii) NPV=PVCI - PVCO 19,180 24,186 8,150
Solution 3:
Evaluation of Project M –
PVCO
(I) 8,50,000
Cap. Exp.
55
(II) PCVL – op C.I.
UCF CEF Certainty
Yr. Uncertain Equivalent CCF DF @ 6% PV
Cash flows Factor
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
NPV = ` 8,60,980 – 8,50,000

= ` 10,980
Project N
PVCO
(i) 8,25,000
Cap. Exp.
(ii) PVCI – op C.I.

UCF CEF Certainty
Yr. Uncertain Equivalent CCF DF @ 6% PV
Cash flows Factor
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 5,00,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
9,96,315
(iii) NPV = PVCI – PVCO = 9,96,315 – 8,25,000 = 1,71,315

Project N should be selected since it has higher NPV.
The certainty equivalent factors for project M for inflows are lower as compared to
those for project N which implies higher uncertainty of project M and hence, higher
risk.
Since, project M has higher risk, while using risk adjusted discount rate, a higher rate
should be used for project M.
Solution 4:
Cash of NPV
PVCO
(i) 1,20,000 x (DF = 1)
Cap. Exp.
PVAF @ 10% for 4 years
(ii) PVCI – OP. C.I. 45,000 x 3.169
(iii) NPV = PVCI – PVCO = 1,42,605 – 1,20,000

56
Sensitivity analysis –
(a) W.r.t Initial project cost –
Inc. in initial project cost 12,000 (%1,20,000 x 10%)
Dec. in NPV ` 12,000
% 53.09 %
(b) W.r.t. annual cash inflow –

Dec. in PV of C.I. 1,28,344.5 – 1,42,605 = 14,260.5
Dec. in NPV ` 14,260.5
% 63.09 %
(c) W.r.t COC – If COC  by 10%, Revised COC = 11% ( 10% + 10%) of 10
NPV @ Revised COC 11% will be determined OS –
PVCO
(I) 1,20,000
Cap. Exp.
(ii) PVCI – Op. C.I

Op. C.I. 45,000 x 3.103 1,38,635
(III) MPV = PVCI – PVCO = 19,635

Dec. In NPV ` 2,970
% 13.14%
Solution 5:
PVCO
(I) 14,00,000 x (DF = 1) 14,00,000
Cap. Exp.
(ii) PVCI
Year C.I. DF @ 9% PV CI PV CI PV
1 4,50,000 0.9174 4,12,830 5,50,000 5,04,570 650 596.31
2 4,00,000 0.8417 3,36,680 4,50,000 3,78,765 500 420.85
3 7,00,000 0.7722 5,40,540 8,00,000 6,17,760 900 694.98
12,90,050 15,01,095 1,712.14
(iii) NPV = 1,09,950 1,01,995 3,12,140

(PVCI – PVCO)
57
II PVCI
Year CI DF @ 9% PV
1 5,50,000 0.9174 5,04,570
2 4,50,000 0.8417 3,78,765
3 7,00,000 0.7722 5,40,540
14,23,875
III. NPV = 15,78,315 – 14,00,000 = ` 23,875
Solution 6:
Evaluation of project – A:
I. Calculation of Expected Value of Cash Flows
Event Cash Flow (C) Prob. (P) CxP
A 8,000 0.1 800
B 10,000 0.2 2,000
C 12,000 0.4 4,800
D 14,000 0.2 2,800
E 16,000 0.1 1,600
12,000
II. Calculation of NPV

a. PVCO = 10,000 x (DF = 1) = 10,000
b. PVCI = op. C.I. = 12,000 x 0.9091 = 10,909
c. NPV = PVCI – PVCO = 10,909 – 10,000 = 909
Evaluation of project – B
I. Calculation of EVCF
Event Cash Flow (C) Prob. (P) CxP
A 4,000 0.10 400
B 20,000 0.15 3,000
C 16,000 0.50 8,000
D 12,000 0.15 1,800
E 8,000 0.10 800
EVCF = 14,000
II. Calculation of NPV

a. PVCO = 10,000 x (DF = 1) = 10,000
b. PVCI = Op. C.I. = 14,000 x 0.9091 = 12,727
c. NPV = PVCI – PVCO = 12,727 – 10,000 = 2,727
 Project B is preferable since it has higher NPV
58
Solution 7:
Calculation of EVCF and Std. deviation of Cash flow
Year 1
Situation C.F. (C) Prob. (P) C x P
1 2,000 0.1 200
2 4,000 0.2 800
3 6,000 0.3 1,800
4 8,000 0.4 3,200
6,000
Year 2
Situation C.F. (C) Prob. (P) CxP
1 2,000 0.2 400
2 4,000 0.3 1,200
3 6,000 0.4 2,400
4 8,000 0.1 800
4,800
Year 3
Situation C.F. (C) Prob. (P) CxP
1 2,000 0.3 600
2 4,000 0.4 1,600
3 6,000 0.2 1,200
4 8,000 0.1 800
4,200
I. Calculation of Expected Net Cash Flows:

Year 1 6,000
Year 2 4,800
Year 3 4,200
II. NPV
(a) PVCO = Cap. Exp = 10,000 x (DF – 1) 10,000
(b) PVCI – op C.I.

Year ENCF DF @ 10% PV
1 6,000 0.9091 5,455
2 4,800 0.8264 - 3,967
3 4,200 0.7513 3,155 12,576
12,576
(c) NPV = PVCI – PVCO = 12,576 – 10,000 = 2,576
59
Solution 8:
Evaluation of
Project – A
Situation NPV (C) Prob. (P) C x P C- ̅ (C - ̅ 2 ( C - ̅ )2
1 15,000 0.2 3,000 6,000 3.6 cr. 72 L
2 12,000 0.3 3,600 - 3,000 90 L 27 L
3 6,000 0.3 1,800 - 3,000 90 L 27 L
4 3,000 0.2 600 - 6,000 3.6 cr. 72 L
9,000 1.98 cr.
Project – B
Situation NPV (C) Prob. (P) C x P C- ̅ (C - ̅ 2 ( C - ̅ )2
1 15,000 0.1 1,500 6,000 3.6 cr. 36 L
2 12,000 0.4 4,800 - 3,000 90 L 36 L
3 6,000 0.4 2,400 - 3,000 90 L 36 L
4 3,000 0.1 300 - 6,000 3.6 cr. 36 L
9,000 1.44 cr.
(i) Expected NPV:

Project A ` 9,000
Project B ` 9,000
(ii) Risk attached to each project

Project A  NPV = √ = ` 4,450
Project B  NPV = √ = ` 3,795
PVCI
(iii) Profitability Index =
PVCO
9,000 + 36,000
Project A PI = = 1.25
36,000
9,000
Project B PI = 1 + = 1.30
30,000
Conclusion:
We recommended project B because the projects have the same NPVs but project B
has lower risk.
The Concept used in Question No.’s & are omitted by the ICAI from the
Syllabus.
60
Solution 9:
Evaluation of Project – A:
Good Normal Worse
(i) PVCO. Cap. Exp 5,00,000 5,00,000 5,00,000
(ii) PVCI – Op. C.I. 24,60,120 16,40,080 8,20,040
(6,00,000 x 4.1002) (4,00,000 x 4.1002) (2,00,000 x 4.1002)
(iii) NPV=PVCI - PVCO 19,60,120 11,40,080 3,20,040
Situation NPV (C) Prob. (P) CxP C-̅ (C - ̅ 2

p(C - ̅ )2
Good 19,60,120 0.3 5,88,036 8,20,040 a c
Normal 11,40,080 0.4 4,56,032 0 0 0
Worse 3,20,040 0.3 96,012 - 8,20,040 b d
11,40,080 e
= 2,01,72,98,40,120
= 6,72,43,28,00,400
= 4,03,45,96,80,240
Evaluation of project B –
Good Normal Worse
(i) PVCO. Cap. Exp 5L 5L 5L
(ii) PVCI – Op. C.I. 20,50,100 16,40,080 12,30,060
(5L x 4.1002) (4L x 4.1002) (3L x 4.1002)
(iii) NPV=PVCI-PVCO= 15,50,100 11,40,080 7,30,060
Situation NPV (C) (P) CxP C-̅ (C - ̅ 2
P (C - ̅ )2
Good 15,50,100 0.3 4,65,030 4,10,020 168116400400 50434920120
Normal 11,40,080 0.4 4,56,032 0 0 0
Worse 7,30,060 0.3 2,19,018 4,10,020 168116400400 50434920120
11,40,080 100869840240
(i) NPV (Expected Avg. NPV)
Project A 11,40,080
Project B 11,40,080
(ii) Risk of NPV =  NPVA = √ ( ̅ 2
Project A:  NPVA = √
Project B:  NPVB = √
= 3,17,600
= 6,35,202
61
Conclusion
Project B should be accepted since both project have the same NPV but project B
has lower risk as compared to project A.
Solution 10:
I II III
(i) PVCO. Cap. Exp 1,00,00 1,00,000 1,00,000
(ii) PVCI (i). C.I. 59,812 89,718 1,19,624
(20,000 x 2.9906) (30,000 x 2.9906) (4,00,000 x 2.9906)
+ (ii) salvage (0) + 8,038 12,057
(20,000 x 0.4019) (30,000 x 0.4019)
59,812 97,756 1,31,681
(iii) NPV (40,188) (2,224) 31,681
Situation NPV (C) Prob. (P) CxP

I (40,188) 0.1 (4,019)
II (2,244) 0.7 (1,517)
III 31,681 0.2 6,336
746
(i) Probable NPV = ` 746
(ii) Worst - case NPV = ` (40,188)
Best – Case = ` 31,681
(iii) Prob. Of worst case
Extra
If CF are Correlated If CF are not correlated
(Independent)
= 0.1 x 1 x 1 x 1 x 1 = 0.1 x 0.1 x 0.1 x 0.1 x 0.1
= 0.1 = 0.00001
Solution 11:
P.V. of Cash Flows
Year 1 Running Cost ` 4,000 x 0.917 = (` 3,668)
Savings ` 12,000 x 0.917 = ` 11,004
Savings ` 14,000 x 0.842 = ` 11,788
` 14,914
Year 0 Less: P.V. of Cash Outflow ` 10,000 x 1 ` 10,000
NPV ` 4,914
62
Sensitivity Analysis
(i) Increase of Plant Value by ` 4,914
4,914
 × 100 = 49.14%
10,000
(ii) Increase of Running Cost by ` 4,914

4,914 4,914
= × 100 = 62.38%
3,668 + 4,210 7,878
(iii) Fall in Saving by ` 4,914

4,914 4,914
= × 100 = 21.56%
11,004 + 11,788 22,792
Hence, savings factor is the most sensitive to affect the acceptability of the project
as in comparison of other two factors a slight % change in this fact shall more affect
the NPV than others.
Alternative Solution
P.V. of Cash Flows
Savings ` 12,000 x 0.917 = ` 11,004
Savings ` 14,000 x 0.842 = ` 11,788
` 14,914
Year 0 Less: P.V. of Cash Outflow ` 10,000 x 1 ` 10,000
NPV ` 4,914
Sensitivity Analysis
(i) If the initial project cost is varied adversely by say 10%*.

NPV (Revised) (` 4,914 – ` 1,000) = ` 3,914
` 4,914 - `3,914
Change in NPV = 20.35%
` 4,914
63
(ii) If Annual Running Cost is varied by say 10%*.
NPV (Revised) (` 4,914 – ` 400 X 0.917 – ` 500 X 0.843)
= ` 4,914 – ` 367 – ` 421= ` 4,126
` 4,914 - ` 4,126
` 4,914
(iii) If Saving is varied by say 10%*.

NPV (Revised) (` 4,914 – ` 1,200 X 0.917 – ` 1,400 X 0.843)
= ` 4,914 – ` 1,100 – ` 1,180 = ` 2,634
` 4,914 - `2,634
` 4,914
Hence, savings factor is the most sensitive to affect the acceptability of the
project.
* Any percentage of variation other than 10% can also be assumed
64
ESTIMATION OF WORKING CAPITAL
CLASSWORK SOLUTIONS
Solution 1:
WN1: - Breakup of Cost: (p.a) “Total cost”
1. Raw material consumed = (50 x 50,000) = 25,00,000
2. Direct Labour = (20 x 50,000) = 10,00,000
3. Factory O/H = (40 x 50,000) = 20,00,000
Factory cost / work cost / cost of production = 55,00,000
+ op. stock of FIG = NIL
(-) closing stock of EG = NIL
C.O.G.S = 55,00,000
+ Admin overheads = XX
(-) Selling overheads = XX
Total cost 55,00,000
Cash cost + Basis

Stock of RM 2,08,333
Stock of F.G. 8,33,333 [55,00,000 – 5,00,000 – 50,00,000 x 2/12)
Stock of WGP 2,08,334  25,00,000 
 x 1
 12 
Cash 1,00,000
Debtors 6,25,000 [50,00,000 x 75% x 2/12)
19,75,000
Creditors 2,08,333
O/s Wages 27,778
O/s Expenses 1,25,000
3,61,111
16,13,889
65
Solution 2:
Estimation of WC on cash Basis.
C.A.:
Particulars Period Working Amt.
1. Debtors 2m 29,00,000 x 2/12 4,90,000
2. Prepaid Sales 3m 1,20,000 x 3/12 30,000
3. Stock of RM 1m 9,00,000 x 1/12 75,000
4. Stock F.G. 1m 25,80,000 x 1/12 2,15,000
5. Cash Balance given 1,00,000
A 9,10,000
C.L.:
Particulars Period Working Amt.
1. Creditors 2m 9,00,000 x 2/12 1,50,000
2. O/s Wages 1m 7,20,000 x 1/12 60,000
3. O/s Mfg. Expenses 1m Given 80,000
4. O/s Admin. Expenses 1m 2,40,000 x 1/12 20,000
B 3,10,000
WC = A – B = 6,00,000
+ Safety = 1,20,000
Margin
Total W.C. 7,20,000
W.N. 1 Excludes Profits
Breakup of cost (pa) “cash cost” Excludes depreciation
Raw Material Consumed = 9,00,000
Direct Wages = 7,20,000
Factory O/HS = 9,60,000
Factory Cost = 25,80,000
+ Opening Stock of F.G. =
- Closing Stock of F.G. =
C.O.G.S. 25,80,000
+ Admin Overhead 2,40,000
+ S.D. 1,20,000
Total Cash Cost 29,40,000
66
Extra:
Sales = 36,00,000
(-) GP = 25%
COP / COGS 27,00,000
(-) COP
COGS as (25,80,000)
Cash Cost basis
Depreciation 1,20,000
If estimation of working capital was asked on total cost Basis, we will include depreciation
of ` 1,20,000 in C.O.P,  C.O.P / C.O.G.S will be ` 27,00,000.
Solution No. 3
WN : Breakup of cost : (pa) “ cash cost
Particulars SS DS
24,000 48,000
p.u Total p.u Total
1. R.M.C. 6 1,44,000 5.4 2,59,200
2. D.W.
Fixed 2 48,000 1 48,000
Variable 3 72,000 3 1,44,000
Prime Cost 11 2,64,000 9.4 4,51,200
3. Factory O/H
Fixed 4 96,000 2 96,000
Variable 1 24,000 1 48,000
FC / WC / COP / COGB 16 3,84,000 12.4 5,95,200
Estimation of WC on Cash Cost Basis

Particulars Period Working SS DS
CA: - (given)
1. Stock of R.M 3m 259200 x 3/12 36000 64800
2. Stock of W/P 2000 x 9.4 22000 18800
3. Stock of FG 2.25 m 595200 x 2.4 72000 111600
12
4 Debtors 3m 384000 x 3/12 96000 148800
595200 x 3/12
67
Ⓐ 226000 344000
CL
1. Crs 2m RMC x 2/12 24000 43200
2. O/s Exp 0.5 m (DWP Fix O/HS) 10,000 14000

X 0.5 /12
Ⓑ 34000 57200
(A – B) COC 192000 286800
DCP: - Cl. Drs x 12

Cr. Sales
= 108000 x 12 432000 – 12
OR
432000 108000 ?
= 3m
Cl Stock x
Stock of PGHP =
12
COGS
72000 x
= 384000 12
12
384000 72000 (?)
= 2.25 m = 2.25 m
Stock of RMHP 144000 - 12
36000 ?
Additional Capital = 286800 – 192000
= 94800
68
There are 2 ways to double the production
By Purchasing By working
an extra machine An extra shift
WIP units will be on same machine WIP units will
Increased remains the same this is because
in an extra shift we will first
complete the incomplete of first shift.
Therefore WIP will only remain
For the second shift for
The second shift ie 2000 units
Solution 4:
1. Working Notes:
1. Raw Material Storage Period (R)
Average Stock of Raw Material
= × 365
Annual Consumption of Raw Material
` 45 + `65
= 2 × 365 = 52.83 or 53 days
`380
Annual Consumption of Raw Material = Opening Stock + Purchases -
Closing Stock
= `45 + `400 – `65 = `380 lakh
2. Work – in - Progress (WIP) Conversion Period (W)

Average Stock of WIP
= × 365
Annual Cost of Production
`35 + ` 51
= 2 × 365 = 34.87 or 35 days
` 450
69
3. Finished Stock Storage Period (F)
Average Stock of FinishedGoods
= × 365
Cost of Goods Sold
`60 + `70
= 2 × 365 = 45.19 or 45 days.
` 525
4. Receivables (Debtors) Collection Period (D)

Average Receivables
= × 365
Annual Credit Sales
`112 + `135
= 2 × 365 = 77.05 or 77 days.
` 585
5. Payables (Creditors) Payment Period (C)

Average Payables formaterials
= × 365
Annual Credit purchases
`68 + `71
= 2 × 365 = 63.41 or 64 days
` 400
(i) Net Operating Cycle Period
=R+W+F+D-C
= 53 + 35 + 45 + 77 – 64 = 146 days
(ii) Number of Operating Cycles in the Year
365 365
= = = 2.5 times
Operating Cycle Period 146
(iii) Amount of Working Capital Required
Annual Operating Cost ` 325
= = = `130 lakh
Number of Operating Cycles 2.48
70
Solution 6:
Raw materials holding period 55 days
WIP 18 days
F.G Holding period 22 days
Debts collection 45 days
140 days
Less: Creditors’ Payment (60 days)
80 days
2. Calculation of no of operation cycle in a year =
3. Amount of working capital = 4,20,000 at Beginning

` 4,20,000 is required at Beginning of the year which will rotated 4.5 times in a year.
Higher the operating cycle duration,  the cycle which leads to  investment in W.C
4. Revised operating cycle duration
80 – 45 = 35 days
evised operating cycle
mount of C
evised in C –
= 236250 236250
Solution 7:
Conservation Moderate Aggressive
(a) Return on Total Assets
= EBIT x 100 = 3.1365 x 100 = 2.9325 x 100 = 2.55 x 100
Total Assets 6.63 + 11.45 6.63 + 9.945 6.63 + 6.63
= 17.32% = 17.69% = 19.23%
(b) Net working capital
= CA – CL = 11.475 –
= 9.945 – 5.967 = 6.63 – 5.967
5.967
= 3.978 = 0.663
= 5.508
(c) CA : FA Ratio
CA = 11.475 = 9.945 = 6.63
FA = 5.508 = 5.967 = 6.63
= 1.73:1 = 1.5:1 = 1:1
(d) Current Ratio
= CA = 11.475 = 9.945 = 6.63
CL 5.967 5.967 5.967
= 1.92:1 = 1.67:1 1.11:1
71
Both working capital gap & current Ratio are indicator of risk of non-payment of current
liabilities. Low WC gap & low current ratio indicates high risk of non-payment of CL &
Vice Versa. Risk under aggressive policy is more as current ratio is less but profitability is
also more as indicated by return on total Assets. Risk under conservative policy is less &
hence profitability is also less ccordingly universal rule prevails “Higher the risk
Higher would be the profit”
Solution 8:
I. w/c. statement
CA: Stock a) Rm 30000
b) wip 18750
c) FG 67500
Debtor (on (OST) 67500
C&B 20000
(A)…….. 203750
CL Cr 30000
o/s wages 2500
o/s o/t 5000
(B)…… 37500
W|c (A – B) 166250
II. Projected P&L
To, Rm 180000 By, sales 300000
To, Wages 30000
To, o/t 60000
To, Int 2500
To, NP 27500
X X
III. B/s
ESC 200000 FA 125000
RISOP (21250) CA
(+) NP 27500 (48750) S+ (Rm) 67500
5% Deb 50000 S+(WIP) 18750
CL Cr. 30000 S+ (FG) 67500
o/s wages 2500 CIB 20000
o/s o/t 5000 37500 Dr 75000 211250
(on Sales)
336250 336250
72
Solution 9:
Preparation of Statement of Working Capital Requirement for MNP Company Ltd.
(`) (`)
A. Current Assets
(i) Inventories :
Material (1 month) ` 9, 00, 000 x 1 month 75,000
12 months
Finished goods (1 month) 2,20,000

1
26,40,000 x
12
(ii) Receivables (Debtors)

1 1,68,333
For Domestic Sales 20, 20, 000 x 12
3 2,52,500
For Export Sales 10,10, 000 x 12
(iii) Prepayment of Sales promotion expenses ` 1, 50, 000 x 3 months 37,500

1 2 months
(iii) Cash in hand and at bank 1,75,000

Total Current Assets 9,47,759
B. Current Liabilities :
(i) Payables (Creditors) for materials (2 months) ` 9,00,000 x 2 months 1,50,000
12 months
(ii) ` 7,20,000 x 0.5 month 30,000
Outstanding wages (0.5 months) 12 months
(iii) Outstanding manufacturing expenses ` 10,20,000 x 1 month 85,000

12 months
(iv) Outstanding administrative expenses ` .2,40,000 x 1 month 20,000

12 months
(v) Income tax payable 56,250
Total Current Liabilities 3,41,250
Net Working Capital (A-B) 6,06,509
Add : 12% Contingency margin 72,781
Total Working Capital Required 6,79,290
73
Domestic Export Total ( )

( ) ( )
Domestic Sales 24,00,000 10,80,000 34,80,000
Less : Gross Profit @ 20% on domestic sales and (4,80,000) (1,20,000) (6,00,000)
11.11% on export sales (Working Note-2)
Cost of Goods Sold 19,20,000 9,60,000 28,80,000
Add : Sales promotion expenses (Working Note-3) 1,03,448 46,552 1,50,000
Cash Cost of Sales 20,23,448 1,06,552 30,30,000
Working Note:
1. Calculation of Cost of Goods Sold and Cost of Sales
2. Calculation of gross profit on Export Sales:

Let domestic selling price is ` 100. Gross profit is ` 20, and then cost per unit is
` 80. Export price is 10% less than the domestic price i.e. ` 100- (1-0.1) = ` 90.
Now gross profit will be ` 90 - ` 80 = ` 10.
Therefore Gross profit at domestic price will be ` 10 x 100 = 10%.
` 100
Or, gross profit at export price will be ` 10 x 100 = 11.11%.

` 90
3. Apportionment of Sales Promotion expenses between Domestic and Exports

Sales :
Apportionment on the basis of sales value:
Domestic Sales = ` 1,50,000 x ` 24,00,000 =` 1,03,448
` 34,80,000
4. Assumptions
(i) It is assumed that administrative expenses relating to production activities
(ii) Value of opening and closing stocks are equal.
74
Solution 10:
Statement Showing W.C. requirement
Particulars Amount (`)

Current Assets:
Stock:
Raw material (800000 x 3/17) 2,00,000
WIP -
F.G. 3,25,000
Debtors (2440000 x 15/12) 3,05,000
Cash 60,000
(A) 8,90,000
Current Liabilities :
Creditors (800000 + 200000 x 4/12) 3,33,333
O/S Wages (600000 x 1/12) 50,000
O/S O/H (F + A + S) (1365000 x 0.5/12) 36,875
(B) (4,40,208)
W.C. requirement (A-B) 90% 4,.49,792
(+) Safety Margin 10% 49,977
100% 4,99,769
W.N.
Material 8,00,000 (20 x 40,000)
(+) Wages 6,00,000 (15 x 40,000)
(+) FOH (V) 6,00,000 (15 x 40,000)
(F) 6,00,000 (10 x 60,000)
COP 26,00,000
COG 22,75,000
(+) S&D
(V) 1,05,000 (3 x 35,000)
(F) 60,000 (1 x 60,000)
COS 24,40,000
75
Solution 11:
Calculation of Net Working Capital requirement:
(`) (`)
A. Current Assets:
Inventories:
- Raw material stock (Refer to Working note 3) 6,64,615
- Work in progress stock (Refer to Working note 2) 5,00,000
- Finished goods stock(Refer to Working note 4) 13,60,000
Receivables (Debtors) (Refer to Working note 5) 25,40,769
Cash and Bank balance 25,000
Gross Working Capital 50,60,384 50,60,384
B. Current Liabilities:
Creditors for raw materials (Refer to Working note 6) 7,15,740
Creditors for wages (Refer to Working note 7) 91,731
8,07,471 8,07,471
Net Working Capital (A - B) 42,52,913
Working Notes:
1. Annual Cost of Production
(`)
Raw material requirements {(1,04,000 units × ` 80) + ` 86,40,000
3,20,000}
Direct wages {(1,04,000 units × ` 30) + ` 60,000} 31,80,000
Overheads (exclusive of depreciation) {(1,04,000 × ` 60)+ 63,60,000
` 1,20,000}
Gross Factory Cost 1,81,80,000
Less: Closing W.I.P (5,00,000)
Cost of Goods Produced 1,76,80,000
Less: Closing Stock of Finished Goods (` 1,76,80,000 × (13,60,000)
8,000/1,04,000)
Total Cash Cost of Sales 1,63,20,000
2. Work in Progress Stock
(`)
Raw material requirements (4,000 units × ` 80) 3,20,000
Direct wages (50% × 4,000 units × ` 30) 60,000
Overheads (50% × 4,000 units × ` 60) 1,20,000
5,00,000
76
3. Raw material stock
It is given that raw material in stock is average 4 weeks consumption. Since, the
company is newly formed, the raw material requirement for production and work in
progress will be issued and consumed during the year.
Hence, the raw material consumption for the year (52 weeks) is as follows:
(`)
For Finished goods (1,04,000 × ` 80) 83,20,000
For Work in progress (4,000 × ` 80) 3,20,000
86,40,000
Raw Material Stock ` 86,40,000 x 4 weeks i.e. ` 6,64,615

52 weeks
4. Finished goods stock: 8,000 units @ ` 170 per unit = ` 13,60,000
5. Debtors for sale: 1,63,20,000 x 8 = 25,10,769
52
6. Creditors for raw material :
Material Consumed (` 83,20,000 + ` 3,20,000) ` 86,40,000
Add: Closing stock of raw material ` 6,64,615
` 93,04,615
Credit allowed by suppliers = ` 93,04,615 x 4 weeks = ` 7,15,740
52 weeks
7. Creditors for Wages
Outstanding Wage Payment = ` 93,04,615 x 1.5 weeks = ` 91,731
52 weeks
Solution 12:
Ascertained as follows:
Method I: = 0.75 (CA – CL)
= 0.75 (510 – 160)
= `262.50 lakhs
Method II: = 0.75 CA – CL
= 0.75  510 – 160
= `222.50 lakhs
77
Method III: = 0.75 (CA – CCA) – CL
= 0.75 (510 – 200) – 160
= `72.50 lakhs
So, it may be noted that the MPBF decreases gradually from the first method to
second method and then to third method. As the firm, has already availed the bank
loan of 250 lakhs, it can still avail a loan of `12.50 lakhs as per the first method.
However, as per the second and third method, it is not eligible for additional
financing as maximum financing allowed is for `222.50 lakhs and `72.50 lakhs only
whereas its present bank borrowing are already `250 lakhs.
78

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J.K.SHAH CLASSES INTER CA – F.M.

Total Assets Turnover = Sales

(ii) ROCE > cost

(iii) Capital Turnover Ratio = Sales

EBIT 27,00,000 32,40,000

(3) Earning yield Ratio

Price Earning Ratio = MPS

(4) Net Fund Flow: -

Debts (6) PSC (2) ES (10)

ROE = N.P for ESH x 100

Less: Variable Cost (Output × Variable Cost ) 12,50,000 2,50,000 56,25,000

Contribution Margin 6,25,000 6,25,000 18,75,000

DCL= DOL x DFL 12.5 1.79 2.14

%Change in Operating Income %Change in EPS

i) EPS = Net Profit for ESH

(2) FL = % in ∆ in dep variable

Operating Leverage = Contribution/EBIT

(i) Selection of financial plan.

(ii) Calculation of IDF point:

Verification of indifference point:

(iii) Calculation of F – BEP

25,00,000 25,00,000 25,00,000

22,50,000 15,00,000 10,00,000

* Since debt is greater than 10,00,000 the price is taken to be 125.

(i) Selection of plan:

Total Cap reqd. 2,00,000 2,00,000 2,00,000

(i) Calculation of EPS:

EPS 4 7.2 6.4

Recommendation: - Plan B dominates the other 2 Plans as the EPS is highest

(ii) Calculation of F – BEP

(iii) Calculation of iDF point

EBIT (1 0.50) = (EBIT 8000) (1 0.50)

EBIT = 2 (EBIT 8000)

EBIT (1 0.50) = (EBIT 8000) (1 0.50) (8000)

0. 50 (EBIT) = 2((0.50) (EBIT 8000)

9 % Preference share 25,00,000

Existing capital 1,00,000

(+) Additional Capital 25,000

(iii) New ROCE = Existing ROCE = 12%

(v) Summary of financial plan:

(a) Selection of financial plan

EBIT at point of Indifference will be ` 54 Lakhs.

2. Number of Equity Shares to be issued in Plan – II:

(ii) Issue is at 10% discount

(iii) Issue is at 10% premium

(b) If issue is at premium of 10% and brokerage is 2%

Additional Finance = 10,00,000

Debt 30% Equity 70%

Retained Earnings = Equity Share Capital =

(b) Calculation of Post tax Cost of Average Debt

(c) Calculation of Ke and Kr

(d) Calculation of Overall WACC using Marginal Value Weights

(b) Calculation of WACC using Market Value Weights

Additional Finance = 14,750

Debentures = 2212.5 Preference Share Equity 11800

Retained Earnings = Equity Share Capital =

(D) Calculation of Marginal Cost of Capital if new shares are issued

Debentures ? 0.15 8.33 1.25

(b) Calculation of WACC using Marginal Value Weights

Average growth rate