Q Ans

CA Intermediate Financial Management
REVISION – 1: COST OF CAPITAL
INTRODUCTION
The basic task of a finance manager is the procurement of funds and its effective utilization.
Whereas the objective of financial management is the maximization of wealth. Here wealth or
value is equal to performance divided by expectations.
Therefore, the finance manager is required to select such a capital structure in which the
expectation of investors is minimum hence shareholders’ wealth is maximum. For that purpose,
first, he needs to calculate the cost of various sources of finance. In this chapter, we will learn to
calculate the cost of debt, cost of preference shares, cost of equity shares, cost of retained
earnings and also the overall cost of capital.
MEANING OF COST OF CAPITAL

Cost of capital is the return expected by the providers of capital (i.e. shareholders, lenders and
the debt-holders) to the business as compensation for their contribution to the total capital.
When an entity (corporate or others) procured finances from either source as listed above, it has
to pay some additional amount of money besides the principal amount. The additional money
paid to these financiers may be either a one-off payment or a regular payment at specified
intervals. This additional money paid is said to be the cost of using the capital and it is called the
cost of capital.
1 | Page CA Ganesh Bharadwaj

This cost of capital expressed in rate is used to discount/ compound the cash flow or stream of
cashflows. Cost of capital is also known as the ‘cut-off’ rate, ‘hurdle rate’, ‘minimum rate of
return’ etc. It is used as a benchmark for:
o Framing the debt policy of a firm.
o Taking Capital budgeting decisions.
DETERMINATION OF THE COST OF CAPITAL

The cost of any sources of finance is expressed in terms of percentage per annum. To calculate
cost first of all we should identify various cash flows like:
1. Inflow of amount received at the beginning.
2. Outflows of payment of interest, dividend, redemption amount etc.
3. Inflow of tax benefit on interest or Outflow of payment of dividend tax.
Thereafter we can use the trial & error method to arrive at a rate where the present value of
outflows is equal to the present value of inflows. That rate is basically IRR.
In investment decisions, IRR indicates income because there we have an initial outflow followed
by a series of inflows. In the Cost of Capital chapter, this IRR represents cost, because here we
have an initial inflow followed by a series of net outflows.
Alternatively, we can use shortcut formulas. Though these shortcut formulas are easy to use they
give an approximate answer and not the exact answer. We will discuss the cost of capital of each
source of finance separately.
KEY POINTS
1. Securities may be issued at Par (say ₹ 100) or at a Discount (say ₹ 90) or at a Premium (say ₹
110)
2. Similarly, securities may also be redeemed at Par (say ₹ 100) or at a Discount (say ₹ 90) or at
a Premium (say ₹ 110)
3. Flotation Cost or Issue Cost – These are costs associated with the issue of NEW securities. A
few examples are Brokerage, Commission, Underwriting Expenses etc. It should be noted
that these costs apply only to new securities and not to existing securities. Flotation Cost is
an outflow and should be deducted from the Issue Price to arrive at Net Proceeds.
4. ‘Net proceeds’ means issue price less issue expenses or floatation cost. If the issue price is
not given, then students can assume it to be equal to the current market price. If issue
expenses are not given, then simply assume it to be equal to zero.

5. Concept of Tax Saving on Interest Expense – The payment of interest to the debenture
holders or lenders is allowed as an expense for the purpose of tax determination. Hence,
interest paid to the debenture holders saves the tax liability of the company. Saving in the
tax liability is also known as ‘Tax Shield’.
COST OF LONG-TERM DEBT (Kd)

Cost of Irredeemable Debentures
Where,
Kd = Cost of debt after tax
I = Annual interest payment
NP = Net proceeds of debentures or Current market price
t = Tax rate
‘Net proceeds’ means issue price less issue expenses or floatation cost. If the issue price is not
given, then students can assume it to be equal to the current market price. If issue expenses are
not given, then simply assume it to be equal to zero.
Cost of Redeemable Debentures

Method-1: Yield to Maturity (YTM) Approach/ Present Value Method
The cost of redeemable debt (Kd) is calculated by discounting the relevant cash flows using the
Internal Rate of Return (IRR).
Method-2: Formula Method
Where,
I = Interest payment

NP = Net proceeds or Current market price

RV = Redemption value of debentures
t = Tax rate applicable to the company
n = Remaining life of debentures
COST OF PREFERENCE SHARE CAPITAL (Kp)

Cost of Irredeemable Preference Shares
Where,
PD = Annual preference dividend
Po = Net proceeds from issue of preference shares
Cost of Redeemable Preference Shares
Method-1: Yield to Maturity (YTM) Approach/ Present Value Method
The cost of redeemable debt (Kp) is calculated by discounting the relevant cash flows using the
Internal Rate of Return (IRR).
Method-2: Formula Method
Where,
PD = Annual preference dividend
RV = Redemption value of preference shares
NP = Net proceeds from issue of preference shares
n = Remaining life of preference shares

COST OF EQUITY SHARE CAPITAL (Ke)

Just like any other source of finance, the cost of equity is the expectation of equity shareholders.
We know that the value is performance divided by expectations. If we know the value and
performance, then we can calculate expectation as a balancing figure.
Here, performance means the amount paid by the company to investors, like interest, dividend,
redemption price etc. In the case of debentures and preference shares, the amount of interest
or dividend is fixed but in the case of equity shares, it is uncertain.
Therefore, there is not a single method to calculate the cost of equity but different methods.
1. Dividend Price Approach
2. Earnings Price Approach
3. Growth Approach (Gordon’s Model)
a. Dividend Growth
b. Earnings Growth
4. Realised Yield Approach
5. Capital Asset Pricing Model (CAPM)
1. Ke - Dividend Price Approach
Where,
Ke= Cost of equity
D = Expected dividend (also written as D1)
P0 = Market price of equity

2. Ke - Earnings Price Approach
Where,
E = Current earnings per share
P = Market price per share
3. Ke - Growth Approach (Gordon’s Model)

a. Dividend Growth Approach
Where,
D1 = [D0 (1+ g)] i.e. next expected dividend
P0 = Current Market price per share
g = Constant Growth Rate of Dividend
In the case of newly issued Equity Shares, P0 should be reduced by Flotation Cost.
b. Earnings Growth Approach
Same as the Dividend Growth Approach. Replace D1 with E1.
4. Ke – Realised Yield Approach

This method is done from the viewpoint of the investor. It is normally followed when the equity
shares are sold by the equity shareholder after a few years. The Ke is calculated by discounting
the relevant cash flows using the Internal Rate of Return (IRR).
5. Ke – Capital Asset Pricing Model (CAPM)
Where,
Ke = Cost of equity capital
Rf = Risk-free rate of return
ß = Beta coefficient
Rm = Rate of return on market portfolio
(Rm – Rf) = Market risk premium

COST OF EQUITY RETAINED EARNINGS (Kr)

Like other sources of fund, retained earnings also involves cost. It is the opportunity cost of
dividends foregone by shareholders. The cost of retained earnings is often used interchangeably
with the cost of equity, as the cost of retained earnings is nothing but the expected return of the
shareholders from the investment in shares of the company.
Kr = Ke
However, this formula is subject to a few exceptions.
WEIGHTED AVERAGE COST OF CAPITAL – WACC (Ko)

The Cost of Total Capital will be equal to the weighted average of the cost of individual sources
of finance.
The steps to calculate WACC is as follows:

Step 1: Calculate the total capital from all the sources of capital.
(Long-term debt capital + Pref. Share Capital + Equity Share Capital + Retained Earnings)
Step 2: Calculate the proportion (or %) of each source of capital to the total capital.
Equity Share Capital (for example)
( )
Total Capital (as calculated in Step1 above)
Step 3: Multiply the proportion as calculated in Step 2 above with the respective cost of capital.
(Ke × Proportion (%) of equity share capital (for example) calculated in Step 2 above)
Step 4: Aggregate the cost of capital as calculated in Step 3 above. This is the WACC.
(Ke + Kd + Kp + Ks as calculated in Step 3 above)

QUESTIONS FOR CLASSROOM DISCUSSION
PROBLEM – 1
The following is the capital structure of a Company:
Source of capital Book value Market value

Equity shares @ ₹ 100 each 80,00,000 1,60,00,000
9 per cent cumulative preference shares @ ₹ 100 each 20,00,000 24,00,000
11 per cent debentures 60,00,000 66,00,000
Retained earnings 40,00,000 -
2,00,00,000 2,50,00,000
The current market price of the company's equity share is ₹ 200. For the last year, the company
had paid an equity dividend at 25 per cent and its dividend is likely to grow by 5 per cent every
year. The corporate tax rate is 30 per cent and shareholders’ personal income tax rate is 20 per
cent.
You are required to calculate:
(i) Cost of capital for each source of capital.
(ii) Weighted average cost of capital on the basis of book value weights.
(iii) Weighted average cost of capital on the basis of market value weights.
SOLUTION
Calculation of Ke (Gordon Model)
D1
Ke = +g
P0
D1 = [D0 (1+ g)]

= 25 (1 + 0.05)
= 26.25
26.25
Ke = + 0.05
200
Ke = 18.125%

Calculation of Kp
Kp = 9 %
Calculation of Kd
Kd = Int (1 – Tax)
= 11 (1 – 30 %)
Kd = 7.7 %
Calculation of Kr
Kr = Ke * ( 1 – Brokerage Rate ) * ( 1 – Personal tax rate )
= 18.125% *(1- 0.00) * ( 1 – 0.20)
Kr = 14.5%
Calculation of WACC (Book Value Weighs)
Source Book value Weighs Cost Weight * Cost

Equity 80,00,000 0.4 18.125% 7.25%
Preference 20,00,000 0.1 9% 0.9%
Debenture 60,00,000 0.3 7.7% 2.31%
Retained 40,00,000 0.2 14.5% 2.9%
earnings
2,00,00,000 1 13.36%
Calculation of WACC (Market Value Weighs)

Equity 1,60,00,000 0.64 18.125% 11.6%
Preference 24,00,000 0.096 9% 0.864%
Debenture 66,00,000 0.264 7.7% 2.0328%
Retained 0 0 0 0%
earnings
2,50,00,000 1 14.497%
PROBLEM – 2
XYZ Ltd. has the following book value capital structure:
Equity Capital (in shares of ₹ 10 each, fully paid up at par) ₹ 15 crore
11% Preference Capital (in shares of ₹ 100 each, fully paid up at par) ₹ 1 crore

Retained Earnings ₹ 20 crores

13.5% Debentures (of ₹ 100 each) ₹ 10 crores
15% Term Loans ₹ 12.5 crores
The next expected dividend on equity shares per share is ₹ 3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is ₹ 40. Preference stock,
redeemable after ten years, is currently selling at ₹ 75 per share. Debentures, redeemable after
six years, are selling at ₹ 80 per debenture. The Income tax rate for the company is 40%.
Required
(i) Calculate the Weighted Average Cost of Capital using:
(a) Book Value proportions;
(b) Market Value proportions.
(ii) Define the weighted marginal cost of capital schedule for the company, if it raises ₹ 10
crores next year, given the following information:
(a) the amount will be raised by equity and debt in equal proportions;
(b) the company expects to retain ₹ 1.5 crores earnings next year;
(c) the additional issue of equity shares will result in the net price per share being fixed
at ₹ 32;
(d) the debt capital raised by way of term loans will cost 15% for the first ₹ 2.5 crores
and 16% for the next ₹ 2.5 crores
SOLUTION
Part 1: WACC
Calculation of Ke and Kr (Dividend Growth Model)
D1
Ke = +G
P0
3.6
+ 0.07
40
Ke = Kr = 16%
Calculation of Kp
𝑅𝑉−𝑁𝑃 𝑅𝑉+𝑁𝑃
Kp = PD + ( )÷( )
𝑛 2

100 − 75 100+75
= 11 + ( )÷( ) = 15.43%
10 2
Calculation of Kd
𝑅𝑉−𝑁𝑃 𝑅𝑉−𝑁𝑃
Kd = Int (1 – Tax Rate) ( )÷( )
𝑛 2
100 − 80 100+80
= 13.5 ( 1 – 0.4 ) + ( )÷( ) = 12.7%
6 2
Calculation of Kt
Kt = Int ( 1 – Tax Rate )
= 15 (1 – 40 %) = 9%
Calculation of WACC (Book Value Weighs) ( ₹ in Crores )

Equity 15 0.256 16% 4.096%
Preference 1 0.017 15.43% 0.262%
Debenture 10 0.171 12.7% 2.171%
Retained earnings 20 0.342 16% 5.472%
Loan 12.5 0.214 9% 1.926%
58.5 1 13.928%
Calculation of WACC (Market Value Weighs) ( ₹ in Crores )
Source Mkt value Weighs Cost Weight * Cost

Equity 60 0.738 16% 11.808%
Preference 0.75 0.009 15.43% 0.139%
Debenture 8 0.098 12.7% 1.245%
Loan 12.5 0.155 9% 1.395%
81.25 1 14.587%
Part 2
Weighted Marginal Cost of Capital schedule ( ₹ in Crores )
Additional Investment = 10
i. Equity = 5
• Equity Share Capital = 3.5
• Retained earnings = 1.5

ii. Debt = 5
• 15% Term Loan = 2.5
• 16% Term Loan = 2.5
Calculation of New Ke
D1
Ke = +G
P0
3.6
+ 0.07 = 18.25%
32
Calculation of Kt
Kt = Int ( 1 – Tax Rate )
For First 2.5 Crores = 15 ( 1 – 0.4 ) = 9%

For Next 2.5 Crores = 16 ( 1 – 0.4 ) = 9.6%
Calculation of WMCC ( ₹ in Crores )

Source Amount Weighs Cost Weight * Cost
Equity 3.5 0.35 18.25% 6.3875%
Retained Earnings 1.5 0.15 16% 2.4%
Term Loan
15% 2.5 0.25 9% 2.25%
16% 2.5 0.25 9.6% 2.4%
10 1 13.4375%

REVISION 2: LEVERAGES
INTRODUCTION
The term leverage represents influence or power. In financial analysis, leverage represents the
influence of one financial variable over some other related financial variable. These financial
variables may be costs, output, sales revenue, Earnings Before Interest and Tax (EBIT), Earning
Per Share (EPS) etc. Generally, if we want to calculate the impact of change in variable X on
variable Y,
it is termed as Leverage of Y with X, and it is calculated as follows:
CHAPTER OVERVIEW
The objective of financial management is to maximize wealth. To maximize value, company

should try to manage its risk. This risk may be business risk, financial risk or both as defined below:
Business Risk: It refers to the risk associated with the firm's operations. It is the uncertainty about
the future operating income (EBIT) i.e., how well can the operating income be predicted?
Financial Risk: It refers to the additional risk placed on the firm's shareholders because of use of
debt i.e., the additional risk, a shareholder bears when a company uses debt in addition to equity
financing. Companies that issue more debt instruments would have higher financial risk than
companies financed mostly or entirely by equity.

TYPES OF LEVERAGES
There are three commonly used measures of leverage in financial analysis. These are:
(i) Operating Leverage: It is the relationship between Sales and EBIT and indicates
business risk.
(ii) Financial Leverage: It is the relationship between EBIT and EPS and indicates financial
risk.
(iii) Combined Leverage: It is the relationship between Sales and EPS and indicates total
risk i.e., both business risk and financial risk.
CHART SHOWING THE DEGREE OF LEVERAGES
OPERATING LEVERAGE
Alternatively,

OTHER RELEVANT FORMULAS RELATING TO OPERATING LEVERAGE
FINANCIAL LEVERAGE
Alternatively,
When Preference Dividend is paid,

COMBINED LEVERAGE

PROBLEM – 1
The Capital structure of RST Ltd. is as follows:
Equity Share of 10 each 8,00,000

10% Preference Share of 100 each 5,00,000
12% Debentures of 100 each 7,00,000
20,00,000
Additional Information:
Profit after tax (Tax Rate 30%) is 2,80,000;
Operating Expenses (including Depreciation of 96,800) are 1.5 times of EBIT;
Equity Dividend paid is 15%;
Market price of Equity Share is ₹ 23
Calculate:
(i) Operating and Financial Leverage
(ii) Cover for preference and equity dividend
(iii) The Earning Yield Ratio and Price Earning Ratio
(iv) The Net Fund Flow
Note: All operating expenses (excluding depreciation) are variable
SOLUTION
Working:
Net Profit after Tax 2,80,000
Tax @ 30% 1,20,000
EBT 4,00,000
Interest on Debentures 84,000
EBIT 4,84,000
Operating Expenses (1.5 times of EBIT) 7,26,000
Sales 12,10,000
(i) Operating Leverage: = Contribution = 12,10,000-6,29,200 = 1.2 times

EBIT 4,84,000
Financial Leverage = EBIT = 4,84,000 = 1.21 times
EBT 4,00,000
OR Financial Leverage = EBIT = 4,84,000 = 1.47 times

Preference Dividend 50,000
EBT - 4,00,000 - (1−0.30)
1−Tax
Note: For FL both equations can be used in exams as per ICAI.

(ii) Cover for Preference Dividend = PAT = 2,80,000 = 5.6 times
Preference Share Dividend 50,000
Cover for Equity Dividend = (PAT-Preference Dividend) = (2,80,000-50,000) = 1.92 times
Equity Share Dividend 1,20,000
(iii) Earning Yield Ratio = EPS x 100 = 2.875 = 12.5%
Market Price 23
Working Notes: EPS = 2,30,000 ;
80,000
Price Earnings Ratio (PE Ratio) = Market Price = 23 = 8 times
EPS 2.875
(iv) Net Funds Flow = Net PAT + Depreciation - Total Dividend = 2,80,000+ 96,800 - (50,000+
1,20,000) = 3,76,800 -1,70,000 = 2,06,800
PROBLEM – 2
A firm has sales of ₹ 75,00,000 variable cost of ₹ 42,00,000 and fixed cost of ₹ 6,00,000. It has a
debt of ₹ 45,00,000 at 9% and equity of ₹ 55,00,000.
(i) What is the firm's ROI or ROCE?
(ii) Does it have favourable financial leverage?
(iii) If the firm belongs to an industry whose asset turnover is 3, does it have high or low
asset leverage?
(iv) What are the operating, financial and combined leverages of the firm?
(v) If the sales drop to ₹ 50,00,000, what will be the new EBIT?
(vi) At what Sales Level the EBT of the firm will be equal to zero?
SOLUTION
Workings: ₹
Sales 75,00,000
Less: Variable cost 42,00,000
Contribution 33,00,000
Less: Fixed costs 6,00,000

EBIT 27,00,000
Less: 9% interest on ₹ 45,00,000 4,05,000
EBT 22,95,000
(i) ROI or ROCE = EBIT = EBIT = 27,00,000 = 27%

Total Investment Debt + Equity 100,00,000
(ii) Since the return on investment (27%) is higher than the interest payable on debt at 9%, the
firm has a favourable financial leverage.
(iii) Asset Turnover = Net Sales = 75,00,000 = 0.75

Total Assets = Total Investment 100,00,000
The industry average is 3. Hence the firm has low asset leverage.
(iv) Operating Leverage = Contribution = 33,00,000 = 1.2222
EBIT 27,00,000
Financial leverage
= EBIT = 27,00,000 = 1.1764; Combined Leverage = Contribution = 33,00,000 = 1.438
EBT 22,95,000 EBT 22,95,000
(OR) Combined leverage = Operating leverage x Financial leverage = 1.2222 x 1.1764 = 1.438
(v) If the sales drop to ₹ 50,00,000 from ₹ 75,00,000, the fall is by 33.33% Hence EBIT will drop
by 40.73% (% Fall in sales x operating leverage or 1.2222 x 33.33%).
Hence the new EBIT will be ₹ 27,00,000 x (1-.4073) = ₹ 16,00,290 or rounded upto ₹
16,00,000
X
% Change in EBIT 27,000
(OR) Operating Leverage = % Change in Sales → 1.2222 = 25,00,000 → x = 11,00,000
75,00,000
Therefore New EBIT = 27,00,000 - 11,00,000 = 16,00,000

(vi) EBT (Taxable Profit) to become zero, means 100% reduction in EBT.
Combined Leverage
= % Change in EBT → 1.438 = 100% → % Change in Sales = 100 = 69.54%
%Change in Sales %Change in Sales 1.438
Hence the new sales will be ₹ 75,00,000 x (1 - .6954) = ₹ 2284500

REVISION 3: CAPITAL STRUCTURE DECISIONS
SELECTION OF SOURCES OF FINANCING

In this segment, we will find out the best alternative source(s) to fund a business.
The following are the various sources of Finance for an Entity:
1. Equity Share Capital
2. Retained Earnings
3. Preference Share Capital
4. Debenture
5. Long-Term Loans
Money/Funds can be raised from one or more sources and requires careful decision making.
SELECTION OF THE BEST SOURCE OF FINANCE

The decision of selecting the best source of finance can be taken on the basis of
1. Return on Equity (ROE)
2. Market Price per Share (MPS)
3. Earnings per Share (EPS) etc.

CAPITAL STRUCTURE THEORIES

In this segment, we will find out the Optimum Capital Structure under multiple methods or
theories of Capital Structure.
The Optimum Capital Structure must have the following features:
• Value of Firm should be Maximum

• Cost of Capital should be minimum
Assumptions in this segment:
1. There is no Preference Share Capital i.e., there are only two sources of Finance viz Equity and
Debt.
2. Tax Rate is assumed to be Zero unless otherwise mentioned.
3. Kd will always be less than Ke.
4. There is no Retained Earnings. That is, there is 100% Dividend Pay-out i.e., DPS = EPS.
5. Life of the company is perpetual.
General Formulas Used in this segment:
1. Value of Firm (VF) = Value of Equity (VE) + Value of Debt (VD) i.e., VF = VE + VD
EPS
2. Value of Equity (VE) per share = Ke
Total Interest
3. Value of Debt (VD) = Kd
EBIT
4. Value of Firm (VF) = Ko
5. Ko = KeWe + KdWd
Capital Structure Theories
Net Operating
Net Income (NI) Traditional
Income (NOI) MM Approach
Approach Approach
Approach
With Tax Without Tax

NET INCOME APPROACH (NI APPROACH)
• This approach was given in the year 1952 by David Durand.

• According to this approach, capital structure decision is relevant to the value of the firm.
• This theory suggests that the Value of Firm can be increased by decreasing Ko and Ko can
be decreased through a higher proportion of Debt in the Capital Structure.
• Under NI Approach,
o Ke > Kd
o Ke and Kd remain constant
• Therefore, Higher the Weight of Debt, Lower will be the Ko and vice versa.
NET OPERATING INCOME APPROACH (NOI APPROACH)
• This approach is exactly the opposite of the NI Approach.

• As per this approach, the Capital Structure Decisions are irrelevant.
• As per this approach, Value of Firm and Ko will always remain constant.
• Value of Firm cannot be increased or decreased by changing the proportion of Debt in the
Capital Structure.
• In short,
a) Ke > Kd
b) Kd will remain constant
c) Ko will remain constant
d) VF will remain constant
e) Ke will increase with the increase in Debt
• As per this approach, an increase in the use of debt which is apparently cheaper is offset
by an increase in the Ke. This happens because equity investors seek higher compensation
as they are opposed to greater risk due to the existence of fixed-return securities in the
capital structure.

TRADITIONAL APPROACH
• According to this approach, capital structure decision is relevant to the value of the firm.
• By a proper mix of Debt and Equity, Ko can be reduced and VF can be increased.
• This approach has 3 Stages:
• Stage – 1
a) Ke and Kd will remain constant
b) Ko will decrease with an increase in debt
c) Ke > Kd
• Stage – 2
a) Ke will increase with an increase in debt
b) Kd will remain constant
c) Ko will remain constant
d) Ke > Kd
• Stage – 3
a) Ke will increase with an increase in debt
b) Kd will increase with an increase in debt
c) Ko will increase with an increase in debt
d) Ke > Kd
• As per Traditional Approach, the Optimum Capital Structure will lie between Stage 1 and
Stage 3.

IV. MODIGLIANI-MILLER (MM) APPROACH

A. MM APPROACH WITHOUT TAX
o This approach was given by MM in the year 1958 and is very similar to NOI Approach.
o As per this approach, the Capital Structure Decisions are irrelevant.
o As per this approach, Value of Firm and Ko will always remain constant.
o Value of Firm cannot be increased or decreased by changing the proportion of Debt in the
Capital Structure.
o MM Approach has derived three propositions
▪ Proposition - 1:
The Total Value of Firm and Ko remains constant
EBIT
Value of Firm (VF) = Ko
Value of Levered Firm = Value of Unlevered Firm
Debt
Ke = Ko + (Ko-Kd) x Equity
The structure of the capital (financial leverage) does not affect the overall cost of
capital. The cost of capital is only affected by the business risk.

B. MM APPROACH WITH TAX

o As per MM, if Tax Rate is given, then the Value of Levered Firm will be Higher than
the Value of Unlevered Firm due to Tax Advantage on Interest Payment.
o Value of Levered Firm = Value of Unlevered Firm + (Debt x Tax Rate)

PROBLEM – 1
A Company needs ₹ 31,25,000 for the construction of a new plant. The following three plans are
feasible:
(a) The Company may issue 3,12,500 equity shares at ₹ 10 per share.
(b) The Company may issue 1,56,250 ordinary equity shares at ₹ 10 per share and 15,625
debentures of ₹ 100 denominations bearing an 8% rate of interest.
(c) The Company may issue 1,56,250 equity shares at ₹ 10 per share and 15,625 preference
shares at ₹ 100 per share bearing an 8% rate of dividend.
Required
(i) If the Company’s earnings before interest and taxes are ₹ 62,500, ₹ 1,25,000, ₹ 2,50,000, ₹
3,75,000 and ₹ 6,25,000, what are the earnings per share under each of three financial plans?
Assume a Corporate Income tax rate of 40%.
(ii) Which alternative would you recommend and why?
SOLUTION
(i) Computation of EPS under three-financial plans:
Plan I: Equity Financing
EBIT ₹ 62,500 ₹ 1,25,000 ₹ 2,50,000 ₹ 3,75,000 ₹ 6,25,000

Interest 0 0 0 0 0
EBT ₹ 62,500 ₹ 1,25,000 ₹ 2,50,000 ₹ 3,75,000 ₹ 6,25,000
Less: Taxes 40% ₹ 25,000 ₹ 50,000 ₹ 1,00,000 ₹ 1,50,000 ₹ 2,50,000
EAT ₹ 37,500 ₹ 75,000 ₹ 1,50,000 ₹ 2,25,000 ₹ 3,75,000
No. of equity 3,12,500 3,12,500 3,12,500 3,12,500 3,12,500
EPS (₹) 0.12 0.24 0.48 0.72 1.2
Plan II: Debt - Equity Mix
EBIT ₹ 62,500 ₹ 1,25,000 ₹ 2,50,000 ₹ 3,75,000 ₹ 6,25,000

Less: Interest 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
EBT (62,500) 0 1,25,000 2,50,000 5,00,000
Less: Taxes 40% 25,000* 0 50,000 1,00,000 2,00,000
EAT (37,500) 0 75,000 1,50,000 3,00,000
No. of equity 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS ( ₹ ) (0.24) 0 0.48 0.96 1.92

* The Company will be able to set off losses against other profits.
Plan III: Preference Shares – Equity Mix
EBIT ₹ 62,500 ₹ 1,25,000 ₹ 2,50,000 ₹ 3,75,000 ₹ 6,25,000

Less: Interest 0 0 0 0 0
EBT 62,500 1,25,000 2,50,000 3,75,000 6,25,000
Less: Taxes 40% 25,000 50,000 1,00,000 1,50,000 2,50,000
EAT 37,500 75,000 1,50,000 2,25,000 3,75,000
Less: Pref. dividend 1,25,000 1,25,000 1,25,000 1,25,000 1,25,000
PAT for ordinary shareholders (87,500) (50,000) 25,000 1,00,000 2,50,000
No. of Equity shares 1,56,250 1,56,250 1,56,250 1,56,250 1,56,250
EPS (0.56) (0.32) 0.16 0.64 1.6
(ii) The choice of the financing plan will depend on the state of economic conditions. If the
company's sales are increasing, the EPS will be maximum under Plan II: Debt - Equity Mix.
Under favourable economic conditions, debt financing gives more benefit due to tax
shield/savings availability than equity or preference financing. Also its EPS is increasing at a
higher rate as compared to other plans.
PROBLEM – 2
Company P and Q are identical in all respects including risk factors except for debt/equity,
company P having issued 10% debentures of ₹ 18 lakhs while company Q is unlevered. Both the
companies earn 20% before interest and taxes on their total assets of ₹ 30 lakhs. Assuming a tax
rate of 50% and capitalization rate of 15% from an all-equity company.
Required:
CALCULATE the value of companies' P & Q using
(i) Net Income Approach
(ii) Net Operating Income Approach.

SOLUTION
(i) Valuation under Net Income Approach
Particulars Amount ( ₹ ) P Amount ( ₹ ) Q
Earnings before Interest & Tax (EBIT)
(20% of ₹ 30,00,000) 6,00,000 6,00,000
Less: Interest (10% of ₹ 18,00,000) 1,80,000 -
Earnings before Tax (EBT) 4,20,000 6,00,000
Less: Tax @ 50% 2,10,000 3,00,000
Earnings after Tax (EAT) (available to equity holders) 2,10,000 3,00,000
Value of equity (capitalized @ 15%) 14,00,000 20,00,000
(2,10,000/15%) (3,00,000/15%)
Add: Total Value of debt 18,00,000 Nil
Total Value of Company 32,00,000 20,00,000
(ii) Valuation of Companies under Net Operating Income Approach
Value of Unlevered Firm = EBIT(1 - tax)/Ko = 6,00,000 (1.50)/15% = 20,00,000

Value of levered Firm = Value of Unlevered Firm + Debenture x Tax Rate =20,00,000+ 18,00,000
x 50%=29,00,000
PROBLEM – 3
A Ltd. is expecting an EBIT of ₹ 3,00,000. The company presently raised its entire fund
requirement of ₹ 20 lakhs by the issue of equity with equity capitalization rate of 16%. The firm
is now contemplating to redeem a part of capital by introducing debt financing. The firm has two
options- to raise debt to the extent of 30% or 50% of total funds. It is expected that for debt
financing up to 30% the rate of interest will be 10% and equity rate is expected to increase to
17%. However, if firm opts for 50% debt, then interest rate will be 12% and equity rate will be
20%.
You are required to compute
o value of firm and its overall cost of capital under Present situation and under two different
options if the traditional approach is held valid.

o Also suggest which is the best Option.
SOLUTION
Particular 0% Debt 30% Debt 50% Debt
Debt NIL 6,00,000 10,00,000
Equity Capital (Balancing Figure) 20,00,000 14,00,000 10,00,000
Total Assets or Capital Employed 20,00,000 20,00,000 20,00,000
EBIT 3,00,000 3,00,000 3,00,000
Less: Interest - 60,000 1,20,000
EBT 3,00,000 2,40,000 1,80,000
Less : Tax NIL NIL NIL
EAT or EFE 3,00,000 2,40,000 1,80,000
EFE
Value of Equity (E) [ Ke ] 18,75,000 14,12,000 9,00,000
Int
Value of Debt (D) Kd - 6,00,000 10,00,000
Value of Firm (E + D) 18,75,000 20,12,000 19,00,000

EBIT
WACC(KO) = 16% 14.90% 15.78%
VF

REVISION 4: INVESTMENT DECISIONS
INTRODUCTION
In this chapter, we will discuss the second important decision area of financial management
which is Investment Decision. The investment decision is concerned with the optimum utilization
of funds to maximize the wealth of the organization and in turn the wealth of its shareholder The
investment decision is very crucial for an organization to fulfil its objectives; in fact, it generates
revenue and ensures the long-term existence of the organization.
As we have seen in the financing decision chapters, each rupee of capital raised by an entity bears
some cost, commonly known as the cost of capital. It is necessary that each rupee raised is to be
invested in a very prudent manner. It requires proper planning for capital, and it is done through
proper budgeting. Proper budgeting requires all the characteristics of a budget. Due to this
feature, investment decisions are very popularly known as Capital Budgeting, which means
applying the principles of budgeting for capital investment.
In simple terms, Capital Budgeting involves:
▪ Identification of investment projects that are strategic to the business’s overall objectives;
▪ Estimating and evaluating post-tax incremental cash flows for each of the investment
proposals; and
▪ Selection of an investment proposal that maximizes the return to the investor.
IMPORTANT POINTS IN CAPITAL BUDGETING

While calculating Cash Flows in Capital Budgeting decisions, the following items need
consideration:
(a) Depreciation: Depreciation is a non-cash item and by itself does not affect the cash flow.
However, we must consider tax shield or benefit from depreciation in our analysis. Since this
benefit reduces cash outflow for taxes, it is considered as a cash inflow.
(b) Determining Discount Rate: An organization may establish a minimum rate of return that all
capital projects must meet; this minimum could be based on an industry average or the cost of
other investment opportunities. Many organizations choose to use the overall cost of capital or
Weighted Average Cost of Capital (WACC) that an organization has incurred in raising funds or
expects to incur in raising the funds needed for investment.
(c) Exclusion of Financing Costs: When cash flows relating to long-term funds are being defined,
financing costs of long-term funds (interest on long-term debt and equity dividend) should be
excluded from the analysis. The interest and dividend payments are reflected in the weighted
average cost of capital. Hence, if the interest on long-term debt and dividend on equity capital
are deducted in defining the cash flows, the cost of long-term funds will be counted twice.
(d) Post-tax Principle: Tax payments like other payments must be properly deducted in deriving the
cash flows. That is, cash flows must be defined in post-tax terms. It is always better to avoid using
pre-tax cash flows and using pre-tax discounting rate. The discounting rate and the cash flows,
both must be post-tax only.
CAPITAL BUDGETING TECHNIQUES

In order to maximize the return to the shareholders of a company, it is important that the best
or most profitable investment projects are selected. The results of making a bad long-term
investment decision can be devastating in both financial and strategic terms. Proper care is
required for investment project selection and evaluation.
There are a number of techniques available for the appraisal of investment proposals and can
be classified as presented below:

Organizations may use any one or more capital investment evaluation techniques. Some
organizations use different methods for different types of projects while others may use multiple
methods for evaluating each project.
The techniques discussed below are:
1. Payback Period
2. Accounting Rate of Return (ARR)
3. Net Present Value (NPV)
4. Profitability Index (PI)
5. Internal Rate of Return (IRR)
6. Discounted Payback Period
7. Modified Internal Rate of Return (MIRR)
1. PAYBACK PERIOD
Time required to recover the initial cash-outflow is called pay-back period. The payback period
of an investment is the length of time required for the cumulative total net cash flows from the
investment to equal the total initial cash outlays. At that point in time (payback period), the
investor has recovered all the money invested in the project.
Decision Rule: A project with a lower Payback Period is generally preferred
2. ACCOUNTING RATE OF RETURN (ARR)

The accounting rate of return of an investment measures the average annual net income of the
project (incremental income) as a percentage of the investment.
It should be noted that the method uses net income rather than cash flows; while net income is
a useful measure of profitability, the net cash flow is a better measure of an investment’s
performance.
Decision Rule: A project with a High ARR is generally preferred

3. NET PRESENT VALUE (NPV)

The net present value technique is a discounted cash flow method that considers the time value
of money in evaluating capital investments.
The net present value method uses a specified discount rate to bring all subsequent cash inflows
after the initial investment to their present values (the time of the initial investment is year 0).
Net present value = Present value of net cash inflow - Total net initial investment
4. PROFITABILITY INDEX (PI)

Profitability Index is also known as Desirability Factor or Present Value Index.
With the help of discounted cash flow technique, the two alternative proposals for capital
expenditure can be compared using NPV Technique. However, in certain cases, we have to
compare a number of proposals, each involving different amounts of cash inflows.
One of the methods of comparing such proposals is to work out what is known as the ‘Desirability
factor’, or ‘Profitability Index’, or ‘Present Value Index Method’.

The Profitability Index (PI) is calculated as below:
5. INTERNAL RATE OF RETURN METHOD (IRR)

The internal rate of return method considers the time value of money, the initial cash investment,
and all cash flows from the investment. But unlike the net present value method, the internal
rate of return method does not use the desired rate of return but estimates the discount rate
that makes the present value of subsequent cash inflows equal to the initial investment. This
discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount rate that equates
the present value of the expected cash inflows with the initial cash outflow.
IRR is calculated as follows:
Decision Rule:

6. DISCOUNTED PAYBACK METHOD

This is similar to the Payback period as discussed under the non-discounting method except that
the cash flows here are discounted at a predetermined rate and the payback period so calculated
is called Discounted payback period.
One of the most popular economic criteria for evaluating capital projects is the payback period.
The payback period is the time required for cumulative cash inflows to recover the cash outflows
of the project. This technique is considered superior to the simple payback period method
because it takes into the account time value of money.

SUMMARY OF DECISION CRITERIA OF CAPITAL BUDGETING TECHNIQUES


PROBLEM – 1 (Computation of CFAT)
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of ₹1,00,000;
expected economic life of 4 years and change in earnings before taxes and depreciation of
₹45,000 in year 1, ₹30,000 in year 2, ₹25,000 in year 3 and ₹35,000 in year 4. Assume straight-
line depreciation and a 20% tax rate. You are required to COMPUTE relevant cash flows.
SOLUTION
Depreciation = ₹1,00,000  4 = ₹25,000

Amount in (₹)
Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
Earnings after tax 16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000
PROBLEM – 2 (Average Rate of Return)

A project requiring an investment of ₹10,00,000 and it yields profit after tax and depreciation
which is as follows:
Years Profit after tax and depreciation (₹)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project can be
sold for ₹80,000. DETERMINE Average Rate of Return.

SOLUTION
In this case the rate of return can be calculated as follows:

TotalProfit  No. of years
 100
Average investment / InitialInvestment
(a) If Initial Investment is considered then,
Rs.4,60,000  5 years Rs.92,000

=  100 =  100 = 9.2%
Rs.10,00,000 Rs.10,00,000
This rate is compared with the rate expected on other projects, had the same funds been
invested alternatively in those projects. Sometimes, the managementcompares this rate with
the minimum rate (called-cut off rate). For example, management may decide that they will
not undertake any project which has an average annual yield after tax less than 20%. Any
capital expenditure proposal which has an average annual yield of less than 20%, will be
automatically rejected.
(b) If Average investment is considered, then,

Rs.92,000 Rs.92,000
=  100 =  100 = 17.04%
Averageinvestment Rs.5,40,000
Where,
Average Investment = ½ (Initial investment – Salvage value) + Salvage value
= ½ (₹10,00,000 – ₹80,000) + ₹80,000
= ₹4,60,000 + ₹80,000 = ₹5,40,000
PROBLEM – 3 (Payback Period & Discounted Payback Period)

Calculate Pay back and Discounted Pay Back for a Project with a ₹ 30,000 cash outlay and annual
cash inflows of ₹ 6,000 for a period of 10 years. Discount Rate is15%
SOLUTION
Payback Period = 30,000/6000 = 5 Years
Discounted Payback Period

Year Cash Flow (₹) PVF@15% PV (₹) Cumulative PV (₹)
1 6,000 0.870 5,220 5,220
2 6,000 0.756 4,536 9,756

3 6,000 0.658 3,948 13,704

4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114
The cumulative total of discounted cash flows after ten years is ₹30,114. Therefore, our
discounted payback is approximately 10 years as opposed to 5 years under simple payback. It
should be noted that as the required rate of return increases, the distortion between simple
payback and discounted payback grows.
PROBLEM – 4 (Missing Figures using IRR, NPV, COC, PI)

Following data has been available for a capital project:
Annual cash inflows ₹1,00,000
Useful life 4 years
Salvage value 0
Internal rate of return 12%
Profitability index 1.064
You are required to CALCULATE the following for this project:
(i) Cost of project
(ii) Cost of capital
(iii) Net present value
(iv) Payback period
PV factors at different rates are given below:
Discount factor 12% 11% 10% 9%

1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708

SOLUTION
Cost of the Project
At 12% internal rate of return (IRR), the sum of total cash inflows = cost ofthe project i.e initial
cash outlay
Annual cash inflows = ₹1,00,000
Useful life = 4 years
Considering the discount factor table @ 12%, cumulative present value ofcash inflows for 4 years
is 3.038 (0.893 + 0.797 + 0.712 + 0.636).
Hence, Total Cash inflows for 4 years for the Project is:
₹1,00,000 × 3.038 = ₹3,03,800
Hence, Cost of the Project = ₹3,03,800
Cost of Capital
Sum of DiscountedCash inflows
Profitability index = Cost of the project
Sum of DiscountedCash inflows
1.064 = Rs.3,03,800
Sum of Discounted Cash inflows = ₹3,23,243.20

Since, Annual Cash Inflows = ₹1,00,000
Rs.3,23,242.20
Hence, cumulative discount factor for 4 years =
Rs.1,00,000 = 3.232
From the discount factor table, at discount rate of 9%, the cumulativediscount factor for 4
years is 3.239 (0.917 + 0.842 + 0.772 + 0.708).
Hence, Cost of Capital = 9% (approx.)
Net Present Value (NPV)

NPV = Sum of Present Values of Cash inflows – Cost of the Project
= ₹3,23,243.20 – ₹3,03,800 = ₹19,443.20
Payback Period
Cost of the Project Rs.3,03,800
= = = 3.038 years
Payback period AnnualCashInflows Rs.1,00,000

PROBLEM – 5 (Case Study - Capital Budgeting with Working Capital)

A large profit-making company is considering the installation of a machine to process the waste
produced by one of its existing manufacturing processes to be converted into a marketable
product. At present, the waste is removed by a contractor for disposal on payment by the company
of ` 150 lakh per annum for the next four years. The contract can be terminated upon installation
of the aforesaid machine on payment of a compensation of ` 90 lakh before the processing
operation starts. This compensation is not allowed as deduction for tax purposes.
The machine required for carrying out the processing will cost ` 600 lakh. At the end of the 4th
year, the machine can be sold for ` 60 lakh and the cost of dismantling and removal will be ` 45
lakh.
Sales and direct costs of the product emerging from waste processing for 4 years are estimated
as under:
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63
Initial stock of materials required before commencement of the processing operations is ` 60 lakh
at the start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3
will be ` 165 lakh and the stocks at the end of year 4 will be nil. The storage of materials will utilize
space which would otherwise have been rented out for ` 30 lakh per annum. Labour costs include
wages of 40 workers, whose transfer to this process will reduce idle time payments of ` 45 lakh
in the year- 1 and ` 30 lakh in the year- 2. Factory overheads include apportionment of general
factory overheads except to the extent of insurance charges of ` 90 lakh per annum payable on
this venture. The company’s tax rate is 30%.
Consider cost of capital @ 14%, the present value factors of which is given below for four years:
Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592
ADVISE the management on the desirability of installing the machine for processing the
waste. All calculations should form part of the answer.

SOLUTION
Statement of Operating Profit from processing of waste ( ₹ in Lakhs )
Year 1 2 3 4
Sales (A) 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 180 195 255 300
Other expenses 120 135 162 210
Factory overheads (insurance only) 90 90 90 90
Loss of rent on storage space (opportunity cost) 30 30 30 30
Depreciation (as per income tax rules) 150 114 84 63
Total cost (B) 660 684 876 948
Profit {(C)=(A) - (B)} 306 282 378 306
Less: Tax (30%) 91.8 84.6 113.4 91.8
Profit after Tax (PAT) 214.2 197.4 264.6 214.2
Statement of Incremental Cash Flows (₹ in Lakhs)
Year 0 1 2 3 4
Cost of Machine (600)
Material stock (60) (105) - - 165
Compensation for (90) - - - -
contract
Contract payment saved - 150 150 150 150
Tax on contract payment - (45) (45) (45) (45)
Incremental profit - 306 282 378 306
Depreciation added back - 150 114 84 63
Tax on profits - (91.8) (84.6) (113.4) (91.8)
Profit on sale of - - - - 15
machinery (net)

Total Incremental CFs (750.0) 364.2 416.4 453.6 562.2

PVIF 1.000 0.877 0.769 0.674 0.592
PVCFs (750.00) 319.40 320.21 305.73 332.82
NPV 528.16
Advice:
Since the net present value of cash flows is ` 528.16 lakh which is positive the management
should install the machine for processing the waste.
Notes:
1. Material stock increases are taken in cash flows.

2. Idle time wages have also been considered.
3. Apportioned factory overheads are not relevant only insurance charges of this project
are relevant.
4. Sale of machinery - Net income after deducting removal expenses taken. Tax on
Capital gains is ignored.
5. Saving in contract payment and income tax thereon is considered in the cash flows.
PROBLEM – 6 (Case Study - Capital Budgeting in Replacement Decision)

HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new
machine. The old machine had been fully depreciated for tax purpose but has a book value of `
2,40,000 on 31st March 2021. The machine has begun causing problems with breakdowns and it
cannot fetch more than ` 30,000 if sold in the market at present. It will have no realizable value
after 10 years The company has been offered ` 1,00,000 for the old machine as a trade in on the
new machine which has a price (before allowance for trade in) of ` 4,50,000. The expected life of
new machine is 10 years with salvage value of ` 35,000.
Further, the company follows straight line depreciation method but for tax purpose, written
down value method depreciation @ 7.5% is allowed taking that this is the only machine in the
block of assets.
Given below are the expected sales and costs from both old and new machine:
Old machine (₹) New machine (₹)

Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labour cost 1,35,000 1,10,000
Variable overhead 56,250 47,500

Fixed overhead 90,000 97,500

Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax @ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075
From the above information, ANALYSE whether the old machine should be replaced or not if
required rate of return is 10%? Ignore capital gain tax.
PV factors @ 10%
Year 1 2 3 4 5 6 7 8 9 10
PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
SOLUTION
Workings:
Calculation of Base for depreciation or Cost of New Machine
Particulars (₹ )
Purchase price of new machine 4,50,000
Less: Sale price of old machine 1,00,000
3,50,000
Calculation of Profit before tax as per books
Old machine New Difference

Particulars
(₹ ) machine (₹) (₹ )
PBT as per books 3,24,750 3,87,250 62,500
Add: Depreciation as per 24,000 41,500 17,500
books
Profit before tax and 3,48,750 4,28,750 80,000
depreciation (PBTD)

Calculation of Incremental NPV
PVF Dep. @ Cash PV of Cash

PBTD PBT Tax Tax @ 30%
Year @ 7.5% Inflows Inflows
(₹) (₹) (₹)
10% (₹) (₹) (₹)
(1) (2) (3) (4) (5) = (4)x 0.30 (6) = (4) – (5) + (3) (7) = (6)x(1)
1 0.909 80,000.00 26,250.00 53,750.00 16,125.00 63,875.00 58,062.38

2 0.826 80,000.00 24,281.25 55,718.75 16,715.63 63,284.38 52,272.89
3 0.751 80,000.00 22,460.16 57,539.84 17,261.95 62,738.05 47,116.27
4 0.683 80,000.00 20,775.64 59,224.36 17,767.31 62,232.69 42,504.93
5 0.621 80,000.00 19,217.47 60,782.53 18,234.76 61,765.24 38,356.21
6 0.564 80,000.00 17,776.16 62,223.84 18,667.15 61,332.85 34,591.73
7 0.513 80,000.00 16,442.95 63,557.05 19,067.12 60,932.88 31,258.57
8 0.467 80,000.00 15,209.73 64,790.27 19,437.08 60,562.92 28,282.88
9 0.424 80,000.00 14,069.00 65,931.00 19,779.30 60,220.70 25,533.58
10 0.386 80,000.00 13,013.82 66,986.18 20,095.85 59,904.15 23,123.00
3,81,102.44
Add: PV of Salvage Value of New Machine (35,000 x 0.368) 13,510
Total PV of Incremental CFs 3,94,612.44
Less: Cost of New Machine 3,50,000
Incremental Net Present Value 44,612.44
Analysis:
Since the Incremental NPV is positive, the old machine should be replaced.

REVISION 5: MANAGEMENT OF WORKING CAPITAL
This chapter is divided into Six Units:

UNIT I: Introduction to Working Capital Management
UNIT II: Treasury and Cash Management
UNIT III: Management of Inventory
UNIT IV: Management of Receivables
UNIT V: Management of Payables
UNIT VI: Financing of Working Capital
UNIT I: INTRODUCTION TO WORKING CAPITAL MANAGEMENT

In accounting terms, working capital is defined as the difference between current assets
and current liabilities. If we break down the components of working capital we will find
working capital as follows:
For the purpose of working capital management, Current Assets of an entity can be
grouped into the following categories:
(a) Inventory (raw material, work in process and finished goods)
(b) Receivables (trade receivables and bills receivables)
(c) Cash or cash equivalents (including short-term marketable securities)
(d) Prepaid expenses
Other current assets may also include short-term loans or advances, any other accrued
revenue etc.
For the purpose of working capital management, Current Liabilities of an entity can be
grouped into the following categories:
(a) Payable (trade payables and bills payables)

(b) Outstanding payments (wages & salary, overheads & other expenses etc.)
Other current liabilities may also include short-term borrowings, current portion of long-
term debts, short-term provisions that are payable within twelve months such
as provision for taxes etc.
WORKING CAPITAL MANAGEMENT

Working Capital Management is the process which is designed to ensure that an
organization operates efficiently by monitoring & utilizing its current assets and current
liabilities to the best effect. The primary objective is to enable a company to maintain
sufficient cash flows in order to meet its day-to-day operating expenses and its short-
term obligations.
(a) Value: From the value point of view, Working Capital can be defined as Gross Working
Capital or Net Working Capital.
Gross working capital refers to the firm’s investment in current assets.
Net working capital refers to the difference between current assets and current liabilities.
A positive working capital indicates the company’s ability to pay its short-term
liabilities. On the other hand, a negative working capital shows the inability of an entity
to meet its short-term obligations.
(b) Time: From the point of view of time, working capital can be divided into two
categories viz., Permanent and Fluctuating (temporary).
Permanent working capital refers to the base working capital, which is the minimum level
of investment in the current assets that are carried by the entity at all times to carry out

its day-to-day activities. It generally stays invested in the business, unless the operations
are scaled up or down permanently which would also result in an increase or decrease in
permanent working capital. It is generally financed by long-term sources of finance.
Temporary working capital refers to that part of total working capital, which is required
by an entity in addition to the permanent working capital. It is also called variable or
fluctuating working capital which is used to finance the short-term working capital
requirements which arise due to fluctuation in sales volume. For instance, an
organization would maintain increased levels of inventory to meet increased seasonal
demand.
IMPORTANCE OF ADEQUATE WORKING CAPITAL

Management of working capital is an essential task of the finance manager. He has to
ensure that the amount of working capital available is neither too large nor too small for
its requirements.
A large amount of working capital would mean that the company has idle funds. Since
funds have a cost, the company has to pay huge amounts as interest on such funds that
are used to invest in surplus working capital.
On the other hand, if the firm has inadequate working capital, such a firm runs the risk
of insolvency. The paucity of working capital may lead to a situation where the firm may
not be able to meet its liabilities. It may also mean that a company may not be holding
enough inventory in order to meet the customers’ demand and hence would lose sales
and eventually some reputation as well.
An organization, therefore, has to be very careful in estimating its working capital
requirements. Maintaining adequate working capital is not just important in the short
term, sufficient liquidity must be maintained in order to ensure the survival of the
business in the long term as well.
When businesses make investment decisions, they must not only consider the financial
outlay involved with acquiring the new machine or the new building, etc. but must also
take into account the additional current assets that are usually required with any
expansion of activity.
DETERMINANTS OF WORKING CAPITAL

Working capital management is concerned with:

(a) Maintaining adequate working capital (managing the level of individual current
assets and the current liabilities) and
(b) Financing of the working capital.
For point (a) above, a Finance Manager needs to plan and compute the working capital
requirement for the business. And once the requirement has been computed he needs
to ensure that it is financed properly.
This whole exercise is known as Working Capital Management.
SCOPE OF WORKING CAPITAL
Liquidity and Profitability

For uninterrupted and smooth functioning of the day-to-day business of an entity, it is
important to maintain the liquidity of funds evenly. As we have already learnt in previous
chapters each rupee of capital bears some cost. So, while maintaining liquidity the cost
aspect needs to be borne in mind.
Also, a higher working capital may be intended to increase the revenue & hence
profitability, but at the same time unnecessary tying up of funds in idle assets not only
reduces the liquidity but also reduces the opportunity to earn a better return from a
productive asset.
Hence, a trade-off is required between liquidity and profitability which increases the
profitability without disturbing the day-to-day functioning. This requires 3Es i.e. Economy
in financing, Efficiency in utilisation and Effectiveness in achieving the intended
objectives.

Investment and Financing

Working capital policy is a function of two decisions, the first is investment in working
capital and the second is financing the investment.
Investment in working capital is concerned with the level of investment in the current
assets. It gives the answer of ‘How much’ fund to be tied in to achieve the organisation’s
objectives (i.e. Effectiveness of fund).
The financing decision is concerned with the arrangement of funds to finance the working
capital. It gives the answer ‘Where from’ fund to be sourced at the lowest cost possible
(i.e. Economy).
ESTIMATING WORKING CAPITAL NEEDS

The operating cycle is one of the most reliable methods of Computation of Working
Capital.
However, other methods like the Ratio of sales and the Ratio of fixed investment may
also be used to determine the Working Capital requirements. These methods are briefly
explained as follows:
(i) Current Assets Holding Period: To estimate working capital needs based on the
average holding period of current assets and relate them to costs based on the company’s
experience in the previous year. This method is essentially based on the Operating Cycle
Concept.
(ii) Ratio of Sales: To estimate working capital needs as a ratio of sales on the assumption
that current assets change with changes in sales.
(iii) Ratio of Fixed Investments: To estimate Working Capital requirements as a
percentage of fixed investments.


PROBLEM – 1
On 1st January, the Managing Director of Naureen Ltd. wishes to know the amount of
working capital that will be required during the year. From the following information,
PREPARE the working capital requirements forecast.
Production during the previous year was 60,000 units. It is planned that this level of
activity would be maintained during the present year.
The expected ratios of the cost to selling prices are Raw materials 60%, Direct wages 10%
and Overheads 20%.
Raw materials are expected to remain in store for an average of 2 months before issue
to production.
Each unit is expected to be in process for one month, the raw materials being fed into
the pipeline immediately and the labour and overhead costs accruing evenly during the
month.
Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately 3 months.
Credit allowed by creditors is 2 months from the date of delivery of raw material. Credit
allowed to debtors is 3 months from the date of dispatch.
Selling price is ₹5 per unit.
There is a regular production and sales cycle.
Wages and overheads are paid on the 1st of each month for the previous month. The
company normally keeps cash in hand to the extent of ₹20,000.
SOLUTION
Working Notes:
1. Raw material inventory:

The cost of materials for the whole year is 60% of the Sales value.
60
Hence it is 60,000 units × ₹5 × = ₹1,80,000 .
100
The monthly consumption of raw material would be ₹15,000. Raw material

requirements would be for two months; hence raw materials in stock would be
₹30,000.
2. Work-in-process: (Students may give special attention to this point). It is stated that
each unit of production is expected to be in process for one month).
(₹)
(a) Raw materials in work-in-process (being one month’s raw 15,000
material requirements)
(b) Labour costs in work-in-process 1,250
(It is stated that it accrues evenly during the month. Thus, on the
first day of each month it would be zero and on the last day of
month the work-in-process would include one month’s labour
costs. On an average therefore, it would be equivalent to ½ of the
month’s labour costs)
 10% of (60,000 Rs.5) 
  0.5month
 12months 
(c) Overheads 2,500

(For ½ month as explained above)
 20% of (60,000  Rs.5) 
  0.5 month
 12 months 
Total work-in-process 18,750
3. Finished goods inventory: (3 month’s cost of production)
 60% of (60,000  Rs.5)  45,000

  3 months
Raw Materials 12 months
 
 10% of (60,000  Rs.5)  7,500
  3months
Labour 12 months
 
 20% of (60,000  Rs.5)  15,000
  3 months
Overheads 12 months
 
Total finished goods inventory 67,500

Alternatively, (60,000 units x ₹5 x 90%) x 3/12 67,500
4. Debtors: The total cost of sales = 2,70,000.

3
Therefore, debtors = ₹2,70,000 × = ₹67,500
12
Where, Total Cost of Sales = RM + Wages + Overheads + Opening Finished goods
inventory – Closing finished goods inventory.
= ₹1,80,000 + ₹30,000 + ₹60,000 + ₹67,500 – ₹67,500 = ₹2,70,000.
5. Creditors: Suppliers allow a two months’ credit period. Hence, the average amount
of creditors would be two months consumption of raw materials i.e.
 60% of (60,000  Rs.5) 
  2 months = ₹30,000
 12 months 
 10% of (60,000  Rs.5) 
6. Direct Wages payable:   1 month = ₹2,500
 12 months 
 20% of (60,000  Rs.5) 

7. Overheads Payable:   1month =₹5,000
 12 months 
Here it has been assumed that inventory level is uniform throughout the year, therefore
opening inventory equals closing inventory.
Statement of Working Capital Required

(₹) (₹)
Current Assets or Gross Working Capital:
Raw materials inventory (Refer to working note 1) 30,000
Working–in-process (Refer to working note 2) 18,750
Finished goods inventory (Refer to working note 3) 67,500
Debtors (Refer to working note 4) 67,500
Cash 20,000 2,03,750
Current Liabilities:
Creditors (Refer to working note 5) 30,000
Direct wages payable (Refer to working note 6) 2,500
Overheads payable (Refer to working note 7) 5,000 (37,500)
Estimated working capital requirements 1,66,250

UNIT II: TREASURY AND CASH MANAGEMENT

Treasury management encompasses planning, organizing & controlling the funds &
working capital of an enterprise in order to ensure the best use of funds, maintain
liquidity, reduce the overall cost of funds and mitigate operational & financial risk. It
involves the corporate handling of all financial matters, the generation of external and
internal funds for business, the management of currencies and cash flows and the
complex, strategies, policies and procedures of corporate finance.
Treasury management mainly deals with:
▪ Working capital management; and
▪ Financial risk management (It includes forex and interest rate management).
The key goals of treasury management are:
▪ Maximize the return on the available cash;
▪ Minimize interest cost on borrowings;
▪ Mobilise as much cash as possible for corporate ventures for maximum returns; and
▪ Effective dealing in forex, money and commodity markets to reduce risks arising
because of fluctuating exchange rates, interest rates and prices which can in turn
affect the profitability of the organization.

PROBLEM – 2
Prachi Ltd is a manufacturing company producing and selling a range of cleaning products
to wholesale customer. It has three suppliers and two customers. Prachi Ltd relies on its
cleared funds forecast to manage its cash.
You are an accounting technician for the company and have been asked to prepare a
cleared funds forecast for the period Saturday 9 August to Wednesday 13 August 20X2
inclusive. You have been provided with the following information:
Receipts from customers
Credit terms Payment method 9 Aug 9 Jul 20X2

20X2 sales sales
W Ltd 1 calendar month BACS ₹ 150,000 ₹ 130,000
X Ltd None Cheque ₹ 180,000 ₹ 160,000

(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.

(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale
is made and will clear on the third day following this (excluding day of payment).
Payments to suppliers
Supplier Credit terms Payment 9 Aug 20X2 9 Jul 20X2 9 Jun 20X2
name method purchases purchases purchases
A Ltd 1 calendar Standing ₹ 65,000 ₹ 55,000 ₹ 45,000

month order
B Ltd 2 calendar Cheque ₹ 85,000 ₹ 80,000 ₹ 75,000
months
C Ltd None Cheque ₹ 95,000 ₹ 90,000 ₹ 85,000
(c) Prachi Ltd has set up a standing order for ₹ 45,000 a month to pay for supplies from
A Ltd. This will leave Prachi’s bank account on 9 August. Every few months, an
adjustment is made to reflect the actual cost of supplies purchased (you do NOT need
to make this adjustment).
(d) Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 9 August. The amounts
will leave its bank account on the second day following this (excluding the day of
posting).
Wages and salaries
July 20X2 August 20X2

Weekly wages ₹ 12,000 ₹ 13,000
Monthly salaries ₹ 56,000 ₹ 59,000
(e) Factory workers are paid cash wages (weekly). They will be paid one week’s wages,
on 13 August, for the last week’s work done in July (i.e. they work a week in hand).
(f) All the office workers are paid salaries (monthly) by BACS. Salaries for July will be paid
on 9 August.

Other miscellaneous payments

(g) Every Saturday morning, the petty cashier withdraws ₹ 200 from the company bank
account for the petty cash. The money leaves Prachi’s bank account straight away.
(h) The room cleaner is paid ₹ 30 from petty cash every Monday morning.
(i) Office stationery will be ordered by telephone on Sunday 10 August to the value of ₹
300. This is paid for by company debit card. Such payments are generally seen to leave
the company account on the next working day.
(j) Five new software’s will be ordered over the Internet on 12 August at a total cost of
₹ 6,500. A cheque will be sent out on the same day. The amount will leave Prachi Ltd’s
bank account on the second day following this (excluding the day of posting).
Other information
The balance on Prachi’s bank account will be ₹ 200,000 on 9 August 20X2. This
represents both the book balance and the cleared funds.
PREPARE a cleared funds forecast for the period Saturday 7th August to Wednesday
13th August 20X2 inclusive using the information provided. Show clearly the
uncleared funds float each day.
SOLUTION
Cleared Funds Forecast
9 Aug 10 Aug 11 Aug 12 Aug 13Aug

(Saturday) (Sunday) (Monday) (Tuesday) (Wednesday)
₹ ₹ ₹ ₹ ₹
Receipts
W Ltd 1,30,000 0 0 0 0
X Ltd 0 0 0 1,80,000 0
(a) 130000 0 0 1,80,000 0
Payments
A Ltd 45,000 0 0 0 0
B Ltd 0 0 75,000 0 0
C Ltd 0 0 95,000 0 0

9 Aug 10 Aug 11 Aug 12 Aug 13Aug

(Saturday) (Sunday) (Monday) (Tuesday) (Wednesday)
Wages 0 0 0 0 12,000
Salaries 56,000 0 0 0 0
Petty 200 0 0 0 0
Cash
Stationery 0 0 300 0 0
(b) 1,01,200 0 1,70,300 0 12,000
Cleared
excess
Receipts
over 28,800 0 (1,70,300) 1,80,000 (12,000)
payments
(a) – (b)
Cleared 2,00,000 2,28,800 2,28,800 58,500 2,38,500
balance
b/f
Cleared 2,28,800 2,28,800 58,500 2,38,500 2,26,500
balance
c/f (c)
Uncleared
funds
float
Receipt 1,80,000 1,80,000 1,80,000 0 0
Payments (1,70,000) (1,70,300) 0 (6,500) (6,500)
(d) 10,000 9,700 180,000 (6,500) (6,500)
Total 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000
book
balance
c/f (c)+(d)

UNIT III: MANAGEMENT OF INVENTORY

Inventories constitute a major element of working capital. It is, therefore, important that
investment in inventory is properly controlled. The objectives of inventory management
are, to a great extent, similar to the objectives of cash management. Inventory
management covers a large number of problems including fixation of minimum and
maximum levels, determining the size of inventory to be carried, deciding about the
issues, receipts and inspection procedures, determining the economic order quantity,
proper storage facilities, keeping a check over obsolescence and ensuring control over
the movement of inventories.
Note:
Inventory Management has been discussed in detail in chapter 2 (Material) Paper 3: Cost
and Management Accounting.

PROBLEM – 3
Marvel Limited uses a large quantity of salt in its production process. Annual
consumption is 60,000 tonnes over a 50-week working year. It costs ` 100 to initiate and
process an order and delivery follow two weeks later. Storage costs for the salt are
estimated at ` 0.10 per tonne per annum. The current practice is to order twice a year
when the stock falls to 10,000 tonnes. IDENTIFY an appropriate ordering policy for Marvel
Limited, and contrast it with the cost of the current policy.
SOLUTION
The recommended policy should be based on the
EOQ model. F = ` 100 per order
S = 60,000 tonnes per year
H = ` 0.10 per tonne per year
Substituting : EOQ = = 10,954 tonnes per order
Number of orders per year = 60,000/10,954 = 5.5

orders Re-order level = 2*60,000/50 = 2,400 tonnes

Total cost of optimum policy = holding costs + ordering costs

= (0.1*10954)/2 + (100*60,000)/10,954
= 547.70 + 547.74 = 1,095
To compare the optimum policy with the current policy, the average level of stock under
the current policy must be found. An order is placed when stock falls to 10,000 tonnes,
but the lead time is two weeks. The stock used in that time is (60,000*2)/50 = 2,400
tonnes. Before delivery, inventory has fallen to (10,000 – 2,400) = 7,600 tonnes. Orders
are made twice per year, and so the order size = 60,000/2 = 30,000 tonnes. The order will
increase stock level to 30,000 + 7,600 = 37,600 tonnes. Hence the average stock level =
7,600 + (30,000/2) = 22,600 tonnes.
Total costs of current policy = (0.1*22,600) + (100*2) = 2,460 per year.
Advise: The recommended policy should be adopted as the costs are less than the
current policy ( by 1,365 per year).

UNIT IV: MANAGEMENT OF RECEIVABLES

Management of receivables refers to planning and controlling of 'debt' owed to the firm
from customers on account of credit sales. It is also known as trade credit management.
The basic objective of the management of receivables (debtors) is to optimise the return
on investment on these assets.
When large amounts are tied up in receivables, there are chances of bad debts and there
will be a cost of collection of debts. On the contrary, if the investment in receivables is
low, the sales may be restricted, since the competitors may offer more liberal terms.
Therefore, management of receivables is an important issue and requires proper policies
and their implementation.
ASPECTS OF MANAGEMENT OF DEBTORS
There are basically three aspects of management of receivables:
1. Credit Policy: A balanced credit policy should be determined for effective management
of receivables. The decision of Credit standards, Credit terms and collection efforts are
included in the Credit policy. It involves a trade-off between the profits on additional sales
that arise due to credit being extended on the one hand and the cost of carrying those
debtors and bad debt losses on the other.
2. Credit Analysis: This requires the finance manager to determine as to how risky it is to
advance credit to a particular party. This involves due diligence or reputation check of
the customers with respect to their creditworthiness.
3. Control of Receivable: This requires the finance manager to follow up with debtors
and decide about a suitable credit collection policy. It involves both the laying down of
credit policies and the execution of such policies.
PROBLEM – 4
A Factoring firm has credit sales of ₹ 360 lakhs and its average collection period is 30 days.
The financial controller estimates, bad debt losses are around 2% of credit sales. The firm
spend ₹1,40,000 annually on debtor’s administration. This cost comprises of telephonic
and fax bills along with salaries of staff member. These are the avoidable costs. A

Factoring firm has offered to buy the firm’s receivables. The factor will charge 1%
commission and will pay an advance against receivables on an interest @15% p.a. after
withholding 10% as reserve. ANALYSE what should the firm do?
Assume 360 days in a year.
SOLUTION
Working notes:
30
Average level of receivables = ₹ 360 lakhs × = 30 lakhs
360
Factoring Commission = 1% of ₹ 30,00,000 = ₹ 30,000

Reserve = 10% of ₹ 30,00,000 = ₹ 3,00,000
Total (i) = ₹ 3,30,000
Thus, the amount available for advance is
Average level of receivables ₹ 30,00,000

Less: Total (i) from above ₹ 3,30,000
(ii) ₹ 26,70,000
Less: Interest @ 15% p.a. for 30 days ₹ 33,375
Net Amount of Advance available. ₹ 26,36,625
Evaluation of Factoring Proposal

Particulars ₹ ₹
A. Savings (Benefit) to the firm
Cost of Credit administration ₹ 1,40,000 ₹ 1,40,000
Cost of bad-debt losses (0.02 × 360 lakhs) ₹ 7,20,000
Total ₹ 8,60,000
B. Cost to the Firm:
Factoring Commission [Annual credit 360 ₹ 3,60,000
₹ 30,000×
Sales × % of Commission (or calculated 30
annually)]
Interest Charges 360 ₹ 4,00,500
₹ 33,375×
30

Total ₹ 7,60,500
C. Net Benefits to the Firm: (A-B) ₹ 99,500
Advice: Since the savings to the firm exceeds the cost to the firm on account of factoring,
therefore, the proposal is acceptable.

UNIT V: MANAGEMENT OF PAYABLES (CREDITORS)

Trade creditor is a spontaneous source of finance in the sense that it arises from ordinary
business transactions. Creditors are a vital part of effective cash management and should
be managed carefully to enhance the cash position.
COST OF AVAILING TRADE CREDIT

Normally it is considered that the trade credit does not carry any cost. However, it carries
the following costs:
(i) Price: There is often a discount on the price that the firm forgoes when it uses trade
credit since it can take advantage of the discount only if it pays immediately. This discount
can translate into a high implicit cost.
(ii) Loss of goodwill: If the credit is overstepped, suppliers may discriminate against
delinquent customers if supplies become short. As with the effect of any loss of goodwill,
it depends very much on the relative market strengths of the parties involved.
(iii) Cost of managing: Management of creditors involves administrative and accounting
costs that would otherwise be incurred.
(iv) Conditions: Sometimes most of the suppliers insist that for availing the credit facility
the order should be of some minimum size or even on regular basis.
COST OF NOT TAKING TRADE CREDIT

(i) Impact of Inflation: If inflation persists then the borrowers are favoured over the
lenders as they were better off paying the fixed outstanding amount later than sooner.
Also, the subsequent transactions shall be at higher prices.
(ii) Interest: Trade credit is a type of interest-free loan, therefore failure to avail this
facility has an interest cost. This cost is further increased if interest rates are higher.
(iii) Inconvenience: Sometimes it may also cause inconvenience to the supplier if the
supplier is geared to the deferred payment.


PROBLEM – 5
The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the
company’s records by the owner, Mr. Gautam, revealed that payments are usually made
15 days after purchases are made. When asked why the firm did not take advantage of
its discounts, the accountant, Mr. Rohit, replied that it cost only 2 per cent for these
funds, whereas a bank loan would cost the company 12 per cent.
1. ANALYSE what mistake is Rohit making?
2. If the firm could not borrow from the bank and was forced to resort to the use
of trade credit funds, what suggestion might be made to Rohit that would
reduce the annual interest cost? IDENTIFY.
SOLUTION
1. Rohit’s argument of comparing 2% discount with 12% bank loan rate is not
rational as 2% discount can be earned by making payment 5 days in advance
i.e. within 10 days rather 15 days as payments are made presently. Whereas
12% bank loan rate is for a year.
Assume that the purchase value is `100, the discount can be earned by making
payment within 10 days is `2, therefore, net payment would be `98 only.
Annualized benefit = 2 365days

× × 100
98 5days = 149%
This means cost of not taking cash discount is 149%.

2. If the bank loan facility could not be available, then in this case the company
should resort to utilise maximum credit period as possible.
Therefore, payment should be made in 30 days to reduce the interest cost.

UNIT VI: FINANCING OF WORKING CAPITAL
After determining the amount of working capital required, the next step to be taken by
the finance manager is to arrange the funds.
As discussed earlier, it is advisable that the finance manager bifurcate the working capital
requirements between the permanent working capital and temporary working capital.
Permanent working capital is always needed irrespective of sales fluctuation; hence it
should be financed by long-term sources such as debt and equity. On the contrary,
temporary working capital may be financed by short-term sources of finance.
Broadly speaking, working capital finance may be classified into two categories:
(i) Spontaneous sources; and (ii) Negotiable sources.
Spontaneous Sources: Spontaneous sources of finance are those which naturally arise in
the course of business operations. Trade credit, credit from employees, credit from
suppliers of services, etc. are some of the examples which may be quoted in this respect.
Negotiated Sources: On the other hand, the negotiated sources, as the name implies, are
those which have to be specifically negotiated with lenders say, commercial banks,
financial institutions, the general public etc.
The finance manager has to be very careful while selecting a particular source, or a
combination thereof for the financing of working capital.


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CA Intermediate Financial Management

REVISION – 1: COST OF CAPITAL

MEANING OF COST OF CAPITAL

1 | Page CA Ganesh Bharadwaj

DETERMINATION OF THE COST OF CAPITAL

2 | Page CA Ganesh Bharadwaj

COST OF LONG-TERM DEBT (Kd)

Cost of Redeemable Debentures

3 | Page CA Ganesh Bharadwaj

NP = Net proceeds or Current market price

COST OF PREFERENCE SHARE CAPITAL (Kp)

4 | Page CA Ganesh Bharadwaj

COST OF EQUITY SHARE CAPITAL (Ke)

1. Ke - Dividend Price Approach

5 | Page CA Ganesh Bharadwaj

2. Ke - Earnings Price Approach

3. Ke - Growth Approach (Gordon’s Model)

4. Ke – Realised Yield Approach

5. Ke – Capital Asset Pricing Model (CAPM)

6 | Page CA Ganesh Bharadwaj

COST OF EQUITY RETAINED EARNINGS (Kr)

However, this formula is subject to a few exceptions.

WEIGHTED AVERAGE COST OF CAPITAL – WACC (Ko)

The steps to calculate WACC is as follows:

7 | Page CA Ganesh Bharadwaj

QUESTIONS FOR CLASSROOM DISCUSSION

Source of capital Book value Market value

D1 = [D0 (1+ g)]

8 | Page CA Ganesh Bharadwaj

Source Book value Weighs Cost Weight * Cost

Calculation of WACC (Market Value Weighs)

Source Book value Weighs Cost Weight * Cost

9 | Page CA Ganesh Bharadwaj

Retained Earnings ₹ 20 crores

10 | Page CA Ganesh Bharadwaj

Kt = Int ( 1 – Tax Rate )

Calculation of WACC (Book Value Weighs) ( ₹ in Crores )

Source Book value Weighs Cost Weight * Cost

Calculation of WACC (Market Value Weighs) ( ₹ in Crores )

Source Mkt value Weighs Cost Weight * Cost

11 | Page CA Ganesh Bharadwaj

Kt = Int ( 1 – Tax Rate )

For First 2.5 Crores = 15 ( 1 – 0.4 ) = 9%

Calculation of WMCC ( ₹ in Crores )

12 | Page CA Ganesh Bharadwaj

The objective of financial management is to maximize wealth. To maximize value, company

13 | Page CA Ganesh Bharadwaj

14 | Page CA Ganesh Bharadwaj

OTHER RELEVANT FORMULAS RELATING TO OPERATING LEVERAGE

When Preference Dividend is paid,

15 | Page CA Ganesh Bharadwaj

16 | Page CA Ganesh Bharadwaj

QUESTIONS FOR CLASSROOM DISCUSSION

Equity Share of 10 each 8,00,000

(i) Operating Leverage: = Contribution = 12,10,000-6,29,200 = 1.2 times

OR Financial Leverage = EBIT = 4,84,000 = 1.47 times

Note: For FL both equations can be used in exams as per ICAI.

18 | Page CA Ganesh Bharadwaj

(i) ROI or ROCE = EBIT = EBIT = 27,00,000 = 27%