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 INDEX

Chapter -1 INTRODUCTION IN FINANCIAL MANAGEMENT 1-9

Chapter -2 TIME VALUE OF MONEY 10-21
Chapter -3 COST OF CAPITAL 22-38
Chapter -4 FINANCING DECISIONS – LEVERAGES 39-46
Chapter -5 CAPITAL STRUCTURE THEORIES 47-61
Chapter -6 WORKING CAPITAL MANAGEMENT 62-80
Chapter -7 CAPITAL EXPENDUTURE DECISION 81-105
Chapter -8 DIVIDEND DECISIONS 106-115
 INTRODUCTION IN FINANCIAL MANAGEMENT

1. Where to get the money from? (Financing Decision)

2. Where to get invest the money? (Investment Decision)

3. How much to distribute amongst shareholders to keep them satisfied?

(Dividend Decision)

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 • What is Financial Management?

Financial management is that managerial activity which is concerned with planning and
controlling of the firm's financial resources. In other words it is concerned with
acquiring, financing and managing assets to accomplish the overall goal of a business
enterprise (mainly to maximise the shareholder's wealth).

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 • OBJECTIVES OF FINANCIAL MANAGEMENT

Efficient financial management requires the existence of some objectives or goals

because judgment as to whether or not a financial decision is efficient must be made in
the light of some objective. Although various objectives are possible but we assume two
objectives of financial management for elaborate discussion.

These are:

• Profit Maximization

It has traditionally been argued that the primary objective of a company is to earn profit;
hence the objective of financial management is also profit maximization. This implies
that the finance manager has to make his decisions in a manner so that the profits of the
concern are maximised. Each alternative, therefore, is to be seen as to whether or not it
gives maximum profit.

However, profit maximisation cannot be the sole objective of a company. It is at best a

limited objective. If profit is given undue importance, a number of problems can arise.
Some of these have been discussed below:

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i. The term profit is vague. It does not clarify what exactly it means. It conveys
a different meaning to different people. For example, profit may be in short term
or long term period; it may be total profit or rate of profit etc.
ii. Profit maximisation has to be attempted with a realisation of risks involved.
There is a direct relationship between risk and profit. Many risky propositions
yield high profit. Higher the risk, higher is the possibility of profits. If profit
maximisation is the only goal, then risk factor is altogether ignored. This implies
that finance manager will accept highly risky proposals also, if they give high
profits. In practice, however, risk is very important consideration and has to be
balanced with the profit objective.
iii. Profit maximisation as an objective does not take into account the time
pattern of returns. Proposal A may give a higher amount of profits as compared
to proposal B, yet if the returns of proposal A begin to flow say 10 years later,
proposal B may be preferred which may have lower overall profit but the returns
flow is more early and quick.
iv. Profit maximisation as an objective is too narrow. It fails to take into account
the social considerations as also the obligations to various interests of workers,
consumers, society, as well as ethical trade practices. If these factors are ignored,
a company cannot survive for long. Profit maximization at the cost of social and
moral obligations is a short sighted policy.
• Wealth / Value Maximisation

We will first like to define what is Wealth / Value Maximization Model. Shareholders
wealth are the result of cost benefit analysis adjusted with their timing and risk i.e. time
value of money.

So,

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It is important that benefits measured by the finance manager are in terms of cash flow.
Finance manager should emphasis on Cash flow for investment or financing decisions
not on Accounting profit. The shareholder value maximization model holds that the
primary goal of the firm is to maximize its market value and implies that business
decisions should seek to increase the net present value of the economic profits of the
firm. So for measuring and maximising shareholders wealth finance manager should
follow:

i. Cash Flow approach not Accounting Profit

ii. Cost benefit analysis
iii. Application of time value of money.

How do we measure the value/wealth of a firm?

According to Van Horne, "Value of a firm is represented by the market price of the
company's common stock. The market price of a firm's stock represents the focal
judgment of all market participants as to what the value of the particular firm is. It takes
into account present and prospective future earnings per share, the timing and risk of
these earnings, the dividend policy of the firm and many other factors that bear upon
the market price of the stock. The market price serves as a performance index or report

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card of the firm's progress. It indicates how well management is doing on behalf of
stockholders."

Why Wealth Maximization Works? Before we answer this question it is important to

first understand and know what other goals a business enterprise may have. Some of the
other goals a business enterprise may follow are:-

i. Achieving a higher growth rate

ii. Attaining a larger market share

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iii. Gaining leadership in the market in terms of products and technology
iv. Promoting employee welfare
v. Increasing customer satisfaction
vi. Improving community life, supporting education and research, solving societal
problems, etc.

Though, the above goals are important but the primary goal remains to be wealth
maximization, as it is critical for the very existence of the business enterprise. If this
goal is not met, public/institutions would lose confidence in the enterprise and will not
invest further in the growth of the organization. If the growth of the organization is
restricted than the other goals like community welfare will not get fulfilled.

• ROLE OF CFO

Modern financial management has come a long way from the traditional corporate
finance. As the economy is opening up and global resources are being tapped, the
opportunities available to finance managers virtually have no limits. A new era has
ushered during the recent years for chief financial officers in different organisation to
finance executive is known in different name, however their role and functions are
similar. His role assumes significance in the present day context of liberalization,
deregulation and globalisation.

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To sum it up, the finance executive of an organisation plays an important role in the
company's goals, policies, and financial success. His responsibilities include:

I. Financial analysis and planning: Determining the proper amount of funds to

employ in the firm, i.e. designating the size of the firm and its rate of growth
II. Investment decisions: The efficient allocation of funds to specific assets.
III. Financing and capital structure decisions: Raising funds on favourable terms
as possible i.e. determining the composition of liabilities.
IV. Management of financial resources (such as working capital).
V. Risk management: Protecting assets.

The figure below shows how the finance function in a large organization may be
organized.

▪ Role of Finance executive in today's World vis-a-vis in the past

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Today, the role of chief financial officer, or CFO, is no longer confined to accounting,
financial reporting and risk management. It's about being a strategic business partner of
the chief executive officer, or CEO. Some of the key differences that highlight the
changing role of a CFO are as follows:-

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 TIME VALUE OF MONEY

WHAT IS TIME VALUE OF MONEY?

People earn money for spending it on housing, food, clothing, education, entertainment
etc. Sometimes extra expenditures have also to be met with. For example, there might
be a marriage in the family; one may want to buy house, one may want to set up his or
her business, one may want to buy a car and so on. Some people can manage to put aside
some money for such expected and unexpected expenditures. But most people have to
borrow money for such contingencies. From where they can borrow money?

Money can be borrowed from friends or money lenders or Banks. If you can arrange a
loan from your friend, it might be interest free but if you borrow money from lenders
or Banks you will have to pay some charge periodically for using money of money
lenders or Banks. This charge is called interest.

Let us take another view. People earn money for satisfying their various needs as
discussed above. After satisfying those needs some people may have some savings.
People may invest their savings in debentures or lend to another person or simply
deposit it into bank. In this way they can earn interest on their investment.
Most of you are very much aware of the term interest. Interest can be defined as the
price paid by a borrower for the use of a lender's money.

WHAT IS ANNUITY?
In many cases you must have noted that your parents have to pay an equal amount of
money regularly like every month or every year. For example, payment of life insurance
premium, rent of your house (if you stay in a rented house), payment of housing loan,
vehicle loan etc. In all these cases they pay a constant amount of money regularly. Time
period between two consecutive payments may be one month, one quarter or one year.

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Sometimes some people received a fixed amount of money regularly like pension rent
of house etc. In all these cases annuity comes into the picture. When we pay (or receive)
a fixed amount of money periodically over a specified time period we create an annuity.
Thus, annuity can be defined as a sequence of periodic payments (or receipts) regularly
over a specified period of time.
There is a special kind of annuity also that is called Perpetuity. It is one where the receipt
or payment takes place forever. Since the payment is forever, we cannot compute a
future value of perpetuity. However, we can compute the present value of the perpetuity.
We will discuss later about future value and present value of annuity.
To be called annuity a series of payments (or receipts) must have following features:
(1) Amount paid (or received) must be constant over the period of annuity and
(2) Time interval between two consecutive payments (or receipts) must be the same.

Annuity regular and Annuity due/immediate:

Annuity

Annuity regular Annuity due or annuity

immediate

First payment/receipt at First payment/receipt in

the end of the period the first period.

Annuity may be of two types:

(1) Annuity regular: In annuity regular first payment/ receipt takes place at the end of
first period. Consider following table:

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 We can see that first payment/ receipts takes place at the end of first year therefore
it is an annuity regular.

(2) Annuity Due or Annuity Immediate: When the first receipt or payment is made
today (at the beginning of the annuity) it is called annuity due or annuity immediate.
Consider following table:

We can see that first receipt or payment is made in the beginning of the first year. This
type of annuity is called annuity due or annuity immediate.

FUTURE VALUE:

Future value is the cash value of an investment at some time in the future.

• SINGLE CASH FLOW

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• ANNUITY REGULAR

• ANNUITY DUE

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PRESENT VALUE:

Present value is the value right now of some amount of money in the future.

• SINGLE CASH FLOW

• ANNUITY REGULAR

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 • ANNUITY DUE

PERPETUITY

Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date
and continue indefinitely or perpetually. Fixed coupon payments on permanently
invested (irredeemable) sums of money are prime examples of perpetuities.
The formula for evaluating perpetuity is relatively straight forward. Two points which
are important to understand in this regard are:
• The value of the perpetuity is finite because receipts that are anticipated far in the
future have extremely low present value (today’s value of the future cash flows).
• Additionally, because the principal is never repaid, there is no present value for
the principal.
Therefore, the price of perpetuity is simply the coupon amount over the appropriate
discount rate or yield.

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 Computation of present value

1. Calculating the present value of Rs 6,000 a) received one year from now; b) received
at the end of five year; c) received at the end of fifteen years. Assume a 5%-time
preference rate. Use Table.

2. Naba is offered either to receive Rs. 5,000 one year now or Rs 7,000 five years from
now. Which one Naba will accept and why if discount rate is 10%? Given, present
value of Rs 1 at 10% are 0.909 and 0.621 for 1st and 5th year respectively.
[2007]

Solution:

Method 1: Compounding Technique:

FVnth = PV0 * CVFn.i

Or, FV5th = 5,000 * 1.4641

Or, FV5th = 7,320.5

As future value of Rs 5,000 is more than what Naba will get in option 2. Therefore it
will be better to get Rs 5,000 now.

Method 2: Discounting Technique:

PV0 = FVnth * PVFn,I

Or, PV0 = 7,000 * 0.621

Or, PV0 = 4,347

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As present value of Rs 7,000 is less than option 1, therefore it will be recommended
to Naba to opt for Rs 5,000 right now.

Present value of even series of Cash Flow

3. Use the tables to determine the present value of Rs 7,000 each paid at the each of the
next six years. Assume a 8% rate of interest.

Computation of Annuity

4. At age 25, how much should one invest each year in order to have Rs 1,00,000 at
age 40? Assume 10% compound annual growth rate.
5. At age 20, what lump sum investment should be made to accumulate Rs 1,00,000 at
age 35, assuming a growth rate of 10% p.a.
6. Your father has promised to give you Rs2,00,000 in cash on your 21st birthday.
Today is your 12th birthday. He wants to know two thing. (a) If he decides to make
annual payment into a fund, how much will each have to be if he fund pay 8%? b) If
he decides to invest a lump sum in account now and let it compound annually, how
much will the lump sum be?
7. You want to make a gift of Rs1,00,000 to one of your friends after 4 years from now.
What amount of money your need to invest every year starting from the beginning
of the first year so that you can get the required amount after 4 years? The normal
return is 10%. [2013]
8. If the loan amount is Rs10 lakhs, tenure is for 3 years and rate of interest is 12%,
find out equated annual instalment. (PVIFA12%.3 = Rs 2.40). [2014]

Computation of Amount of Annual Drawing

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9. If an amount of Rs1,60,000 is a fixed deposit for seven years at 10% compound rate
of interest, how much can one withdraw each your to leave exactly zero in the
account at the seventh year?

Computation of Future Value

10.Union Bank pays 6% compound interest half yearly. If 10,000 are deposited initially,
how much shall it grow at the end of 5 years.

Solution: FVn = PV(1+i)n

Or, FVn = 10,000 * (1+0.1)5

or, FVn = 16,105

11.Shubha invested Rs 10,000 at an interest of 12% p.a. for 3 years. Compute future
value of investment assuming interest is compounded quarterly.
Given FVIF (3,12) = 1.4262 [2007]
12.A sum of Rs 5,000 is invested for 2 year at 10% interest rate compounded biannually.
Find the maturity amount. [2011]
13.Mrs. Sunita has Rs. 50,000 at her disposal. She wants to get her money doubled.
(a) If interest is compounded @ Rs12% p.a. annually, then how long she has to
wait to fulfil her desire? [Given log (1.12)=0.3010]
(b) If she is ready not to wait for more than 4 years then what should be the
approximate rate or compound interest? [2014]
14.Mr. X invested Rs 50,000 at an interest of 12% p.a. for 3 years. You are required to
compute future value of investment assuming interest is compounded quarterly.
[2015]
15.Exactly ten years from now Sri Chand will start receiving a pension of Rs5,000 a
year. The payment will continue for sixteen years. How much is the pension worth
now, if sir Chand’s time preference rate is 10%.

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 Computation of Present value of Annuity

16.You are approached by an insurance agent to buy an annuity of Rs 50,000 for 6 years
starting from the beginning of first year. How much you should be ready to pay now
for this annuity if you consider a discount factor of 8% per annum? [2015]

Essay Type:

Present value for an uneven series of cash inflows

1. An investor has an opportunity of receiving Rs2,000, Rs 3,000, Rs 1,600, Rs 2,200

and Rs 800 respectively at the end of each of the next five years. Find out the present
value of the stream of uneven cash flows, if the investors’ time preference rate is
8%?
2. Use the tables and assume a 10% discount rate. Compute the present value of Rs
2,200, Rs1,800; Rs. Rs3,000; and Rs. 1,400 received at the end of one through four
years.
3. An investor has an opportunity of receiving Rs 500, Rs1,000, Rs 1,500; Rs 2,000
and Rs. 2,500 respectively at the end of each of the next five yea Rs. Find out the
present value of this stream of uneven Cash Flows, if the investor’s time preference
rate is 10%
4. Find the present value of the following cash flows using a discount rate of 10%.
Year Cash Flow
1-3 1,000
4 2,000
5 3,000
6-14 1,000
15 4,000
Solution: Statement showing computation for present value of series
Year Amount DF10% Present Value

1 1,000 0.9090 909

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 2 1,000 0.8264 826
3 1,000 0.7513 751
4 2,000 0.6830 1366
5 3,000 0.6209 1863
6 1,000 0.5644 564
7 1,000 0.5131 513
8 1,000 0.4665 467
9 1,000 0.4241 424
10 1,000 0.3855 386
11 1,000 0.3505 351
12 1,000 0.3186 319
13 1,000 0.2897 290
14 1,000 0.2633 263
15 4,000 0.2394 958
Total 10,249

5. Rs 1,000 is to be deposited at the end year 1, Rs 2,000 at the end of year 2 and Rs
3,000 at the end of each of the next 13 years. To what sum will these deposits
accumulate at the end of 15th years, assuming the rate of interest is 10%?

Computation of Sum of Annuity Generated at the end of specified period

6. For each of the following cases, calculate the sum of annuity generated by the deposit
given the specified rate and number of year:

Cases Amount of deposit Annual interest rate No of years

A Rs 4,000 10% 5

B Rs 20,000 12% 10

C Rs 10,000 8% 4

D Rs12,000 14% 12
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7. For each of the following loans, determine the amount of the equal annual payment
required to fully amortise or repay it over the stated period:

Loan Principal Amount Interest Rate Life (in years)

Rs (%)

A 10,000 10 4

B 5,000 8 6

C 2,00,000 9 10

D 1,00,000 12 12

E 50,000 14 5

Solution: Value of Annual instalments

Case A: Loan Value = A * PVIFA n,i

Or, 10,000 = A * [1- 1/(1+i)n]/i

Or, 10,000 = A * [1 – 1/1.4641]/0.1

Or, 10,000 = A * 3.1699

Or, 10,000/3.1699 = A

Or, A = Rs 3,155

8. A dividend stream commencing one year hence at Rs. 66 is expected to grow at 10%
per annum for 15 years and then ceases. If the discount rate is 21%. What is the present
value of the expected series?

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 Source of Capital and Cost of Capital
What do you mean by Source of Finance?
A source or sources of finance, refer to where a business gets money from to fund their
business activities. A business can gain finance from
either internal or external sources. Source can be classified under different categories as
discussed below:

Difference sources of finance:

➢ Short term source
➢ Long term source

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 a 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 one off
payment or 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. This cost of capital expressed in rate is used to discount/ compound the
cashflow or stream of cashflows. Cost of capital is also known as ‘cut-off’ rate, ‘hurdle
rate’, ‘minimum rate of return’ etc.

It is used as a benchmark for:

➢ Framing debt policy of a firm.
➢ Taking Capital budgeting decisions.

SIGNIFICANCE OF THE COST OF CAPITAL:

The cost of capital is important to arrive at correct amount and helps the management
or an investor to take an appropriate decision. The correct cost of capital helps in the
following decision making:

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(i) Evaluation of investment options
(ii) Financing Decision
(iii) Designing of optimum credit policy

Cost of Long
term Debt.

Weighted
Cost of Pref. Cost of
Average Cost of
Share Capita Equity
Capital (WACC)

Cost of
Retained
Earnings

LONG-TERM DEBT (Kd):

External borrowings or debt instruments do no confers ownership to the providers of
finance. The providers of the debt fund do not participate in the affairs of the company
but enjoys the charge on the profit before taxes. Long term debt includes long term
loans from the financial institutions, capital from issuing debentures or bonds etc.

The calculation of cost of loan from a financial institution is similar to that of

redeemable debentures. Here, we will confine our discussion of cost of debt to
debentures or bonds only.

Features of debentures or bonds:

(i) Face Value: Debentures or bonds are denominated with some value; this
denominated value is called face value of the debenture. Interest is calculated on the
face value of the debenture. E.g., if a company issue 9%. non- convertible debentures

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of 100 each, this means the face value is 100 and the interest 9% will be calculated on
this face value.

(ii) Interest (Coupon) Rate: Each debenture bears a fixed interest (coupon) rate (except
Zero coupon bond and Deep discount bond). Interest (coupon) rate is applied to face
value of debenture to calculate interest, which is payable to the holders of debentures
periodically (annually, semi-annually, etc.).

(iii) Maturity period: Debentures or Bonds has a fixed maturity period for redemption.
However, in case of irredeemable debentures maturity period is not defined and it is
taken as infinite.

(iv) Redemption Value: Redeemable debentures or bonds are redeemed on its

specified maturity date. Based on the debt covenants, the redemption value is
determined. Redemption value may vary from the face value of the debenture.

(v) Benefit of tax shield: The payment of interest to the debenture holders are allowed
as expenses for the purpose of corporate tax determination. Hence, interest paid to
the debenture holders save the tax liability of the company. Saving in the tax liability
is also known as tax shield. The example given below will show you how interest paid
by a company reduces the tax liability:

Cost of Irredeemable Debt

Cost of long term Debt
Cost of Redeemable Debt

Cost of Irredeemable Debentures:

The debentures which are not redeemed by the issuer of the debentures is known as
irredeemable debentures. Cost of debentures not redeemable during the life time of
the company is calculated as below:

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Net proceeds mean issue price less issue expenses or floatation cost (defined below).
If issue price is not given, then students can assume it to be equal to current market
price. If issue expenses are not given, then simply assume it to be equal to zero.

Floatation Cost: The new issue of a security (debt or equity) involves some expenditure
in the form of underwriting or brokerage fees, legal and administrative charges,
registration fees, printing expenses etc. The sum of all these costs is known as
floatation cost. This expenditure is incurred to make the securities available to the
investors. Floatation cost is adjusted to arrive at net proceeds for the calculation of
cost of capital.

Cost of Redeemable Debentures:

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The above formula to calculate cost of debt is used where only interest on debt is tax deductible.
Sometime, debts are issued at discount and/ or redeemed at a premium. If discount on issue and/ or
premium on redemption are tax deductible, the following formula can be used to calculate the cost
of debt:

In absence of any specific information, students may use any of the above formulae to
calculate the Cost of Debt (Kd) with logical assumption.

COST OF PREFERENCE SHARE CAPITAL (Kp):

The preference shareholders are paid dividend at a specified rate on face value of
preference shares. Payment of dividend to the preference shareholders are not
mandatory but are given priority over the equity shareholder. The payment of dividend
to the preference shareholders are not charged as expenses but treated as an
appropriation of after-tax profit. Hence, dividend paid to preference shareholders
does not reduce the tax liability of the company. Like the debentures, Preference share
capital can also be categorised as redeemable and irredeemable.

Cost of Irredeemable Preference Share

Capital
Cost of Preference Share
Capital
Cost of Redeemable Preference Share
Capital

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Cost of Irredeemable Preference Shares:
The cost of irredeemable preference shares is similar to the calculation of perpetuity.
The cost of irredeemable preference share is calculated by dividing the preference
dividend with the current market price or net proceeds from the issue. The cost of
irredeemable preference share is as below:

Net proceeds mean issue price less issue expenses or floatation cost. If issue price is
not given, then students can assume it to be equal to current market price. If issue
expenses are not given, then simply assume it to be equal to zero.

Cost of Redeemable Preference Shares:

Preference shares issued by a company which are redeemed on its maturity is called
as redeemable preference shares. Cost of redeemable preference share is similar to
the cost of redeemable debentures with the exception that the dividends paid to the
preference shareholders are not tax deductible. Cost of preference capital is calculated
as follows:

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Net proceeds mean issue price less issue expenses or floatation cost. If issue price is
not given, then students can assume it to be equal to current market price. If issue
expenses are not given, then simply assume it to be equal to zero.

COST OF EQUITY SHARE CAPITAL (Ke):

Just like any other source of finance, cost of equity is 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 case of debentures and preference shares, amount
of interest or dividend is fixed but in case of equity shares it is uncertain.

Therefore, there is not a single method to calculate cost of equity but different
methods which depends on various factors like:

1) If dividend is expected to be constant, then dividend price approach should be used.

2) If earning per share is expected to be constant, then earning price approach should
be used.
3) If dividend and earning are expected to grow at a constant rate, then growth
approach (Gordon’s model) should be used.
4) If it is difficult to forecast future, then realised yield approach should be used, which
looks into past.
5) All the above methods calculate the cost of equity as a balancing figure.
When the cost of equity or expectation of investors is dependent on risk i.e., Higher
the risk, higher the expectations and vice versa, then Capital asset pricing model
(CAPM) should be used, which is based on risk.

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1. Dividend Price Approach:
This is also known as Dividend Valuation Model. This model makes an assumption that
the dividend per share is expected to remain constant forever.

2. Earnings Price Approach:

The advocates of this approach co-relate the earnings of the company with the market
price of its share. Accordingly, the cost of equity share capital would be based upon
the expected rate of earnings of a company. The argument is that each investor
expects a certain amount of earnings, whether distributed or not from the company in
whose shares he invests. Thus, if an investor expects that the company in which he is
going to subscribe for shares should have at least a 20% rate of earning, the cost of
equity share capital can be construed on this basis.

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3.(i) Growth Approach or Gordon’s Model:
As per this approach, the rate of dividend growth remains constant.

(ii) Gordon’s Growth Model:

Unlike the Average method, Gordon’s growth model attempts to derive a future
growth rate. As per this model, increase in the level of investment will give rise to an
increase in future dividends. This model takes Earnings retention rate (b) and rate of
return on investments (r) into account to estimate the future growth rate.

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4. Realized Yield Approach:
According to this approach, the average rate of return realized in the past few years is
historically regarded as ‘expected return’ in the future. It computes cost of equity
based on the past records of dividends actually realised by the equity shareholders.
Though, this approach provides a single mechanism of calculating cost of equity, it has
unrealistic assumptions like risks faced by the company remain same; the shareholders
continue to expect the same rate of return; and the reinvestment opportunity cost
(rate) of the shareholders is same as the realised yield.

5. Capital Asset Pricing Model (CAPM) Approach:

CAPM model describes the risk-return trade-off for securities. It describes the linear
relationship between risk and return of securities.

The risk to which a security is exposed, can be classified into two groups:
(i) Unsystematic Risk: This is also called company specific risk as the risk is related with
the company’s performance. This type of risk can be reduced or eliminated by
diversification of the securities portfolio. This is also known as diversifiable risk.

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(ii) Systematic Risk: It is the macro-economic or market specific risk under which a
company operates. This type of risk cannot be eliminated by the diversification hence,
it is non-diversifiable. The examples are inflation, Government policy, interest rate etc.

The shortcomings of this approach are:

(a) Estimation of beta with historical data is unrealistic; and
(b) Market imperfections may lead investors to unsystematic risk.

Despite these shortcomings, the CAPM is useful in calculating cost of equity, even
when the firm is suffering losses. The basic factor behind determining the cost of equity
share capital is to measure the expectation of investors from the equity shares of that
particular company.

Therefore, the whole question of determining the cost of equity shares hinges upon
the factors which go into the expectations of particular group of investors in a company
of a particular risk class.

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COST OF RETAINED EARNINGS (Kr):
Like other sources of fund, retained earnings also involves cost. It is the opportunity
cost of dividends foregone by shareholders. The given below figure depicts how a
company can either keep or reinvest cash or return it to the shareholders as dividends.
(Arrows represent possible cash flows or transfers.) If the cash is reinvested, the
opportunity cost is the expected rate of return that shareholders could have obtained
by investing in financial assets.

The cost of retained earnings is often used interchangeably with the cost of equity, as
cost of retained earnings is nothing but the expected return of the shareholders from
the investment in shares of the company. However, normally cost of equity remains
higher than the cost of retained earnings, due to issue of shares at a price lower than
current market price and floatation cost.

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WEIGHTED AVERAGE COST OF CAPITAL (WACC):
To balance financial risk, control over the company and cost of capital, a company
usually does not procure entire fund from a single source, rather it makes a mix of
various sources of finance. Hence, cost of total capital will be equal to weighted
average of 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 shares capital/ total capital.
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.
Choice of weights:

Book Value Market

(BV) Value (MV)

MARGINAL COST OF CAPITAL:

The marginal cost of capital may be defined as the cost of raising an additional rupee
of capital. Since the capital is raised in substantial amount in practice, marginal cost is
referred to as the cost incurred in raising new funds. Marginal cost of capital is derived,
when the average cost of capital is calculated using the marginal weights.

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 Ascertainment of Cost of Irredeemable Preference Share Capital

1. Metal Box Ltd. issued 10% irredeemable preference shares. The nominal value of each share is `
100. You are required to calculate the cost of preference shares capital in each of the following cases.
a) when issued at 6% discount; b) when issued at 6% premium.

𝐃𝐢𝐯 (𝟏+𝐂𝐃𝐓)
Solution: (A) Kp = Here, Div = Dividend per share
𝐈𝐏𝐧𝐞𝐭

= 10(1+0)/94 CDT = Corporate Div Tax

= 10.6383 IPnet = Net issued price
2. A Company issues 10% irredeemable preference shares of Rs. 100 each for Rs. 50,00,000. Flotation
costs are estimated at 5% of the expected sale price. What will be cost of preference share capital, if
preference shares are issued –
(i) at par, (ii) at a premium of 10% and (iii) at a discount of 10%.
3. Western Company Ltd. is planning for issue of 4,000, 12% preference shares of Rs. 100 each,
redeemable at par after 10 years. They are expected to be sold at a premium of 5% with a flotation
cost of 8%. The corporate tax rate assumed to be 35%. Calculate the cost of preference share capital
by using short cut method.
4. A company issues 12% redeemable preference share of Rs. 100 each at 5% premium redeemable
after 15 years at 10% premium. If the flotation cost of each share is Rs. 2, what is the value of Kp (cost
of preference share) to the Company? [2006]
5. X & Co. has issued 12% redeemable preference shares of face value Rs. 100 for Rs. 10 lakh. The
shares are expected to be sold at 5% discount; it will also involve floatation cost of Rs. 5 per share.
The shares are redeemable at a premium of 5% after 10 years. Calculate the cost of capital of
redeemable preference share, if the rate of tax is 50%. Ignore dividend tax. [2008]
6. Y Co. Ltd issues 10,000 12% Preference Shares of Rs. 100 each at a premium @ 10% but redeemable
at a premium @ 20% after 5 years. The company pays underwriting commission @ 5%. If tax on
dividend is 12.5%, surcharge is 2.5% and education cess is 3%,. Calculate the cost of Preference Share
Capital. [2009]
7. P Ltd. issued Rs. 10,00,000, 11% preference shares of Rs. 100 each. The floatation cost was @ 2%
on issued price. The preference shares will be redeemed at a premium of 5% after 5 years. The tax
rate applicable to the company is 30 %. The corporate Dividend Tax is 10. Compute the cost of
preference shares of P Ltd. [2014]

Ascertainment of cost of Equity Share Capital

8. The current market price of the shares of A Ltd. is Rs 95. The floatation cost are Rs. 5 per share.
Dividend per share amounts to Rs. 4.50 and is expected to grow at a rate of 7%. You are required to
calculate cost of equity share capital.

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Solution: Ke = [(D1/MPSnet) + Growth rate ] * 100
= (4.815/90) + 0.07
= 12.35%
9. The Xavier corporation, a dynamic growth firm which pays no dividends, anticipates a long-run
level of future earning of Rs. 7 per share. The current price of xavier’s shares is Rs. 55.45, floatation
costs for the sale of new equity shares would average about 10% of the price of the shares. What is
the post of new equity capital to Xavier?
10. TEXCO Ltd. has capital of 1,00,000 equity shares of Rs. 10 each. Its price earning ratio is 10 and
earning available to equity shareholders is Rs. 6,00,000. The earnings are expected to grow @ 10%
p.a. You are required to compute the cost of equity share under earnings growth model. [2010]
11. XYZ Ltd. has its share of Rs. 100 each quoted on the stock exchange, the current market price
share is Rs. 240. The dividends per share over the last four years have been Rs. 12.00, Rs. 13.20, Rs.
14.50 and Rs. 16.00. [2012]
12. The market price of the equity share of X Ltd. is Rs. 9 (face value Rs. 10 per share). The company
is expected to declare a dividend 25%. If dividend is expected to fall @ 3% every year, calculate the
cost of equity share capital. [2014]

Ascertainment of cost of equity by using CAPM approach

13. Using CAPM approach find out the cost of equity of Co. India Shining Ltd. whose beta factor is
1.5. The company wants to use 6% risk-free rate and 12% market return.
14. From the following information in respect of Kuchh Kuchh Hota hai Ltd., calculate the cost of
equity by using the CAPM approach.
(i) Risk-free return from Treasury bond is 10%
(iii) Bita–coefficient is 0.60
(iii) Initial price of investment in equity shares of the company Rs. 100.
(iv) Expected dividend at the end of year is Rs. 18
(v) Expected market price of equity shares at the end of year is 120.

Ascertainment of cost of Retained Earnings

15. Bikele Bhorer Phool Ltd. is earning a net of Rs. 2.00.000 p.a. The cost of equity is 16%. The
shareholders of the company are assumed to be in 30% personal tax bracket. It is expected that the
shareholders will have to incur 5% as brokerage on the after-tax dividends received by them.
Assuming that the entire earnings are distributed to the shareholders. Calculate the cost of retained
earnings by using tax Adjusted Rate of Return Approach.

Page | 36
 Ascertainment of cost of Irredeemable Debentures

16. Akash Company Ltd has 12% irredeemable debt of Rs. 10,00,000. The company is in the 40% tax
bracket. Compute the before tax and after-tax cost of debt assuming the debt is issued at 10%
premium.

Ascertainment of cost of Redeemable Debentures

17. A company raises Rs. 90,000 by the issue of 1,000 10% debentures of Rs. 100 each at a discount
of 10% repayable at par after 10 years. If the rate of company’s tax is 50%, then what is the cost of
debt capital to the firm?
18. Rimpa & Co. has issued 12% Debenture of face value Rs. 100 for Rs. 10 lakh. The debenture is
expected to be sold at 5% discount. It will also involve floatation costs of Rs. 5 per debenture. The
cost of debenture if the tax rate is 50%. [2007]
19. ABC Ltd. issues 12% debentures of face value Rs. 100 each at a discount of 3% and the floatation
cost is estimated to be 2%. The debentures are redeemable after 10 years at a premium of 10%.
Corporate tax rate is 40%. Calculate the cost of debt. [2012]

Ascertainment of weighted Average Cost of Capital

20. RIL Ltd. opst for the following capital structure :

Rs.
Equity shares (1,00,000 shares) 50,00,000
15% Debentures 50,00,000
Total 1.00.00.000

The company is expected to declare a dividend of Rs. 5 per share. The market price per share is Rs.
50. The Dividend is expected to grow at 10%. Compute weighted average cost of capital of RIL Ltd.
assuming 50% tax rate. [2008]

Solution:
Statement showing calculation of WACC

Source Specific Cost Weight Weighted cost

Equity 20% 50,00,000 10,00,000
Debenture 7.5% 50,00,000 3,75,000
100,00,000 13,75,000

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WACC = Total weighted cost / total weight
= 13,75,000/100,00,000
=13.75%
21. Swan Ltd. has assets of Rs. 3,20,000 which have been financial with Rs. 1,04,000 of debt, Rs.
1,80,000 of equity, and a general reserve of Rs. 36,000. The company’s total profit after interest and
taxes for the year ended 31.3.2013 were Rs. 27,000. It pays 8% interest on borrowed funds and is in
the 30% tax bracket. It has 1800 equity share of Rs. 100 per share, presently selling at a price of Rs.
120 per share. What is the weighted average cost of Swan Ltd.? [2013]

Ascertainment of Marginal Cost of Capital

22. Work out the marginal cost of capital from the following data:
Existing Capital : Rs. In lakh cost (%)
Equity 6000 15
Preference Capital 1000 10
Debt 4000 12
Retained Earnings 1000 18
Additional Requirement :
Equity 4000 18
Preference Capital 2000 12
Debt 3000 16
Retained Earnings 1000 18 [2015]

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 FINANCING DECISIONS – LEVERAGES
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.

Meaning of Leverage:
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.

Types of Leverage:
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.

OPERATING LEVERAGE:
Operating Leverage (OL) means tendency of operating income (EBIT) to change
disproportionately with change in sale volume. This disproportionate change is caused
by operating fixed cost, which does not change with change in sales volume.

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In other words, Operating Leverage maybe defined as the employment of an asset with
a fixed cost so that enough revenue can be generated to cover all the fixed and variable
costs.

The use of assets for which a company pays a fixed cost is called operating leverage

Operating leverage is a function of three factors:

✓ Amount of fixed cost,
✓ Variable contribution margin, and
✓ Volume of sales.

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 Operating Leverage and EBIT

Infinite/
Negative Possitive
Undefined

Operating at Lower Operating at a Higher

Operating at break
than break-even Level than break-even
even point
point point

EBIT= -Ve EBIT = 0 EBIT = +Ve

Positive and Negative Operating Leverage

FINANCIAL LEVERAGE:
Financial leverage (FL) maybe defined as ‘the use of funds with a fixed cost in order to
increase earnings per share’. In other words, it is the use of company funds on which it
pays a limited return. Financial leverage involves the use of funds obtained at a fixed
cost in the hope of increasing the return to common stockholders.

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 Financial leverage

Infinite/
Negative Possitive
Undefined

EBIT level is more Operating at

EBIT level is less than
than Fixed Financial Financial break
Fixed Financial Charge
Charge even point

EPS: will change

in the same No Profit no Loss EPS : Negative
direction as EBIT

COMBINED LEVERAGE:
Combined leverage maybe defined as the potential use of fixed costs, both operating
and financial, which magnifies the effect of sales volume change on the earning per
share of the firm.

Financial Leverage as ‘Trading on Equity’:

Financial leverage indicates the use of funds with fixed cost like long term debts and
preference share capital along with equity share capital which is known as trading on
equity. The basic aim of financial leverage is to increase the earnings available to equity
shareholders using fixed cost fund.

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A firm is known to have a positive/favourable leverage when its earnings are more than
the cost of debt. If earnings are equal to or less than cost of debt, it will be a
negative/unfavourable leverage. When the quantity of fixed cost fund is relatively high
in comparison to equity capital it is said that the firm is ‘’trading on equity”.

Financial Leverage as a ‘Double edged Sword’:

When the cost of ‘fixed cost fund’ is less than the return on investment, financial
leverage will help to increase return on equity and EPS. The firm will also benefit from
the saving of tax on interest on debts etc. However, when cost of debt will be more than
the return it will affect return of equity and EPS unfavourably and as a result firm can
be under financial distress. Therefore, financial leverage is also known as “double edged
sword”.

Computation of Operating Leverage

1. From the following information compute the degree of Operating Leverage: -

Sales 50,000 units @ Rs. Per units = Rs. 5,00,000.
Variable cost per unit @ Rs. 7
Fixed cost = Rs. 1,00,000

Computation of Financial Leverage

Page | 43
2. From the following information compute the degree of Financial Leverage
Rs.
Sales 4,00,000
Variable cost 2,00,000
Fixed cost 1,20,000
Interest charges 7,500

Computation of Operating, Financial and Combined Leverage

3. Given the following information -

Sales (10,000 units) Rs.10,00,000
Variable cost per unit Rs.60
Interest Rs.1,00,000
EBT Rs.2,00,000
DCL 2.5
Calculate Operating Leverage and Financial Leverage. [2012]
Solution:
Statement showing calculation of leverages
Particulars Amount
Sales 10,00,000
Less: Variable Cost ( 60 * 10,000) 6,00,000
Contribution 4,00,000
Less: Fixed Cost [Contribution -EBIT] 1,00,000
EBIT 3,00,000
Less: Interest 1,00,000
EBT (Given) 2,00,000
OL = Contribution/ EBIT 1.333

FL = EBIT/EBT 1.5

CL = OL * FL 2

4. Calculate operating, financial and combined leverages under situations when fixed costs are a) Rs.
5,000. and b) Rs. 10,000 under financial plans 1 and 2 respectively from the following information
pertaining to the operation and capital structure of a textile company:
Rs.
Total assets 30,000

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 Total assets turnover Ratio 2
Variable cost as a percentage of sales 60
Financial plan
1 2
Rs. Rs.
Equity 30,000 10,000
10% Debentures 10,000 30,000
5. Calculate the Operating, Leverage Financial Leverage and Combined Leverage from the following
information:
Rs.
Interest 5,000
Sales 50,000 (1,000 units)
Variable cost 25,000
Fixed costs 15,000

Computation of Combined Leverage & Operating Profit

6. A firm has sales of Rs. 5,00,000, variable cost of Rs. 3,50,000 and fixed cost of Rs. 1,00,000and debt
of Rs. 2,50,000 at 10% rate of interest. What is combined leverage? If the firm wants to double its
EBIT, how much of a rise in sales would be need on a percentage basis? [2006]

Computation of sales

7. From the following information compute sales : DOL-2; DFL-3, interest Rs. 3,00,000 and
contribution is 40% of sales. [2007]

Computation of percentage in EPS

8. The following information have been taken from the Income Statement of X Ltd.: Rs.
Fixed operating expenses 1,200
Fixed financial charges 600
Earning before tax 400
Calculate percentage of change in EPS, if sales increase by 10 percent. [2010]

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 Computation of Recommendation of Financial Plan

9. Which of the following financial plans would you recommend and why?
Particulars Equity Plan Equity Preference Equity debt Plan
Share Plan
Earning per share Rs. 9.50 Rs. 8 Rs.11.25
Price-earning Ratio 20 17 16 [2011]

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 CAPITAL STRUCTURE THEORIES

MEANING OF CAPITAL STRUCTURE:

Capital structure is the combination of capitals from different sources of finance. The
capital of a company consists of equity share holders’ fund, preference share capital
and long-term external debts. The source and quantum of capital is decided keeping
in mind the following factors:
1. Control: Capital structure should be designed in such a manner that existing
shareholders continue to hold majority stake.
2. Risk: Capital structure should be designed in such a manner that financial risk of a
company does not increase beyond tolerable limit.
3. Cost: Overall cost of capital remains minimum.

Page | 47
Financial decision Process Graph:

Common assumptions to be taken under consideration in capital structure theories

♦ There are only two kinds of funds used by a firm i.e. debt and equity.

♦ The total assets of the firm are given. The degree of leverage can be changed by
selling debt to purchase shares or selling shares to retire debt.

♦ Taxes are not considered.

♦ The dividend payout ratio is 100%.

♦ The firm’s total financing remains constant.

♦ Business risk is constant over time.

♦ The firm has perpetual life.

1. Net Income (NI) Approach:

According to this approach, capital structure decision is relevant to the value of the
firm. An increase in financial leverage will lead to decline in the weighted average cost
of capital (WACC), while the value of the firm as well as market price of ordinary share
will increase. Conversely, a decrease in the leverage will cause an increase in the
overall cost of capital and a consequent decline in the value as well as market price of
equity shares.

Page | 48
2. Traditional Approach:
This approach favours that as a result of financial leverage up to some point, cost of
capital comes down and value of firm increases. However, beyond that point, reverse
trends emerge. The principal implication of this approach is that the cost of capital is
dependent on the capital structure and there is an optimal capital structure which
minimises cost of capital.

Under this approach:

1. The rate of interest on debt remains constant for a certain period and thereafter
with an increase in leverage, it increases.
2. The expected rate by equity shareholders remains constant or increase gradually.
After that, the equity shareholders start perceiving a financial risk and then from the
optimal point, the expected rate increases speedily.
3. As a result of the activity of rate of interest and expected rate of return, the WACC
first decreases and then increases. The lowest point on the curve is optimal capital
structure.

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Optimum capital structure occurs at the point where value of the firm is highest and
the cost of capital is the lowest.

According to net operating income approach, capital structure decisions are totally
irrelevant. Modigliani-Miller supports the net operating income approach but provides
behavioural justification. The traditional approach strikes a balance between these
extremes.

Main Highlight of Traditional Approach

The firm should strive to reach the optimal capital structure and its total valuation
through a judicious use of both the debt and equity in capital structure. At the optimal
capital structure, the overall cost of capital will be minimum and the value of the firm
will be maximum.

3. Net Operating Income (NOI) Approach:

NOI means Earnings before interest and tax (EBIT). According to this approach, capital
structure decisions of the firm are irrelevant.

Any change in the leverage will not lead to any change in the total value of the firm
and the market price of shares, as the overall cost of capital is independent of the
degree of leverage. As a result, the division between debt and equity is irrelevant.

As per this approach, an increase in the use of debt which is apparently cheaper is
offset by an increase in the equity capitalization rate. 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.

Page | 50
The above diagram shows that Kw (Weighted Average Cost of Capital) and K d (debt
capitalization rate) are constant and Ke (Cost of equity) increases with leverage.
4. Modigliani-Miller (MM) Approach:

The NOI approach is definitional or conceptual and lacks behavioural significance. It

does not provide operational justification for irrelevance of capital structure. However,
Modigliani-Miller (MM) approach provides behavioural justification for constant
overall cost of capital and therefore, total value of the firm.

-
Miller (MM) Approach
MM Approach -1958: without
MM Approach – 1958: without tax:

This approach describes, in a perfect capital market where there is no transaction cost
and no taxes, the value and cost of capital of a company remain unchanged
irrespective of change in the capital structure.
This approach is based on further following additional assumptions:
♦ Capital markets are perfect. All information is freely available and there are no
transaction costs.
♦ All investors are rational.
♦ Firms can be grouped into ‘Equivalent risk classes’ on the basis of their business risk.
♦ Non-existence of corporate taxes.

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Based on the above assumptions, Modigliani-Miller approach derived the following
three propositions:
(i) Total market value of a firm is equal to its expected net operating income divided
by the discount rate appropriate to its risk class decided by the market.

(ii) A firm having debt in its capital structure has higher cost of equity than an unlevered
firm. The cost of equity will include risk premium for the financial risk. The cost of
equity in a levered firm is determined as under:

(iii) 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.

It is evident from the above diagram that the average cost of the capital (Kw) is
constant and is not affected by leverage.

The operational justification of Modigliani-Miller hypothesis is explained through the

functioning of the arbitrage process and substitution of corporate leverage by personal
leverage. Arbitrage refers to buying asset or security at lower price in one market and
selling it at a higher price in another market. As a result, equilibrium is attained in
different markets. This is illustrated by taking two identical firms of which one has debt
in the capital structure while the other does not. Investors of the firm whose value is
higher will sell their shares and instead buy the shares of the firm whose value is lower.
They will be able to earn the same return at lower outlay with the same perceived risk
or lower risk. They would, therefore, be better off.

Page | 52
The value of the levered firm can neither be greater nor lower than that of an
unlevered firm according to this approach. The two must be equal. There is neither
advantage nor disadvantage in using debt in the firm’s capital structure.

This approach considers capital structure of a firm as a whole pie divided into equity,
debt and other securities. No matter how the capital structure of a firm is divided
(among debt, equity etc.), there is a conservation of investment value. Since the total
investment value of a corporation depends upon its underlying profitability and risk, it
is invariant with respect to relative changes in the firm’s financial capitalization.
According to MM hypothesis, since the sum of the parts must be equal to the whole,
therefore, regardless of the financing mix, the total value of the firm stays the same.

The shortcoming of this approach is that the suggested arbitrage process will fail to
work because of imperfections in capital market, existence of transaction cost and
presence of corporate income taxes.

MM Approach-1963: with tax:

In 1963, MM model was amended by incorporating tax, they recognised that the value
of the firm will increase, or cost of capital will decrease where corporate taxes exist.
As a result, there will be some difference in the earnings of equity and debt-holders in
levered and unlevered firm and value of levered firm will be greater than the value of
unlevered firm by an amount equal to amount of debt multiplied by corporate tax rate.
MM has developed the following formulae for computation of cost of capital (Ko), cost
of equity (Ke) for the levered firm.

The Trade-off Theory:

The trade-off theory of capital structure refers to the idea that a company chooses
how much debt finance and how much equity finance to use by balancing the costs
and benefits. Trade-off theory of capital structure basically entails offsetting the costs
of debt against the benefits of debt.
Trade-off theory of capital structure primarily deals with two concepts - cost of
financial distress and agency costs. An important purpose of the trade-off theory of
capital structure is to explain the fact that corporations usually are financed partly with
debt and partly with equity.
It states that there is an advantage to financing with debt, the tax benefits of debt and
there is a cost of financing with debt, the costs of financial distress including

Page | 53
bankruptcy costs of debt and non-bankruptcy costs (e.g., staff leaving, suppliers
demanding disadvantageous payment terms, bondholder/ stockholder infighting, etc).
The marginal benefit of further increases in debt declines as debt increases, while the
marginal cost increases, so that a firm that is optimizing its overall value will focus on
this trade-off when choosing how much debt and equity to use for financing.
Modigliani and Miller in 1963 introduced the tax benefit of debt. Later work led to an
optimal capital structure which is given by the trade-off theory. According to
Modigliani and Miller, the attractiveness of debt decreases with the personal tax on
the interest income. A firm experiences financial distress when the firm is unable to
cope with the debt holders' obligations. If the firm continues to fail in making payments
to the debt holders, the firm can even be insolvent.

The first element of Trade-off theory of capital structure, considered as the cost of
debt is usually the financial distress costs or bankruptcy costs of debt. The direct cost
of financial distress refers to the cost of insolvency of a company. Once the
proceedings of insolvency start, the assets of the firm may be needed to be sold at
distress price, which is generally much lower than the current values of the assets. A
huge amount of administrative and legal costs is also associated with the insolvency.
Even if the company is not insolvent, the financial distress of the company may include
a number of indirect costs like - cost of employees, cost of customers, cost of suppliers,
cost of investors, cost of managers and cost of shareholders.

The firms may often experience a dispute of interests among the management of the
firm, debt holders and shareholders. These disputes generally give birth to agency
problems that in turn give rise to the agency costs. The agency costs may affect the
capital structure of a firm. There may be two types of conflicts - shareholders-
managers conflict and shareholders-debt holder’s conflict. The introduction of a
dynamic Trade-off theory of capital structure makes the predictions of this theory a lot
more accurate and reflective of that in practice.

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As the Debt-equity ratio (i.e., leverage) increases, there is a trade-off between the
interest tax shield and bankruptcy, causing an optimum capital structure.

6. Pecking order theory:

This theory is based on Asymmetric information, which refers to a situation in which

different parties have different information. In a firm, managers will have better
information than investors. This theory states that firms prefer to issue debt when they
are positive about future earnings. Equity is issued when they are doubtful and internal
finance is insufficient. The pecking order theory argues that the capital structure
decision is affected by manager’s choice of a source of capital that gives higher priority
to sources that reveal the least amount of information. Myers has given the name
‘PECKING ORDER’ theory as here is no well-defined debt-equity target and there are
two kinds of equity internal and external. Now Debt is cheaper than both internal and
external equity because of interest. Further internal equity is less than external equity
particularly because of no transaction/issue cost, no tax etc.

Pecking order theory suggests that managers may use various sources for raising of
fund in the following order:
1. Managers first choice is to use internal finance.
2. In absence of internal finance, they can use secured debt, unsecured debt, hybrid
debt etc.
3. Managers may issue new equity shares as a last option.

Factors affecting capital structure:

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While choosing a suitable financing pattern, certain fundamental principles should be
kept in mind, to design capital structure, which are discussed below:

(1) Financial leverage or Trading on Equity:

The use of long-term fixed interest-bearing debt and preference share capital along
with equity share capital is called financial leverage or trading on equity. The use of
long-term debt increases the earnings per share if the firm yields a return higher than
the cost of debt. The earnings per share also increase with the use of preference share
capital but due to the fact that interest is allowed to be deducted while computing tax,
the leverage impact of debt is much more. However, leverage can operate adversely
also if the rate of interest on long-term loan is more
than the expected rate of earnings of the firm. Therefore, it needs caution to plan the
capital structure of a firm.

(2) Growth and stability of sales:

The capital structure of a firm is highly influenced by the growth and stability of its
sales. If the sales of a firm are expected to remain fairly stable, it can raise a higher
level of debt. Stability of sales ensures that the firm will not face any difficulty in
meeting its fixed commitments of interest repayments of debt. Similarly, the rate of
the growth in sales also affects the capital structure decision. Usually, greater the rate
of growth of sales, greater can be the use of debt in the financing of firm. On the other
hand, if the sales of a firm are highly fluctuating or declining, it should not employ, as
far as possible, debt financing in its capital structure.

(3) Cost Principle:

According to this principle, an ideal pattern or capital structure is one that minimizes
cost of capital structure and maximizes earnings per share (EPS). For e.g. Debt capital
is cheaper than equity capital from the point of its cost and interest being deductible
for income tax purpose, whereas no such deduction is allowed for dividends.

(4) Risk Principle:

According to this principle, reliance is placed more on common equity for financing
capital requirements than excessive use of debt. Use of more and more debt means
higher commitment in form of interest payout. This would lead to erosion of

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shareholders’ value in unfavorable business situation. With increase in amount of
Debt, financial risk increases and vice versa.

(5) Control Principle:

While designing a capital structure, the finance manager may also keep in mind that
existing management control and ownership remains undisturbed. Issue of new equity
will dilute existing control pattern and it also involves higher cost. Issue of more debt
causes no dilution in control but causes a higher degree of financial risk.

(6) Flexibility Principle:

By flexibility, it means that the management chooses such a combination of sources of

financing which it finds easier to adjust according to changes in need of funds in future
too. While debt could be interchanged (If the company is loaded with a debt of 18%
and funds are available at 15%, it can return old debt with new debt, at a lesser interest
rate), but the same option may not be available in case of equity investment.

(7) Other Considerations:

Besides above principles, other factors such as nature of industry, timing of issue and
competition in the industry should also be considered. Industries facing severe
competition also resort to more equity than debt. Thus, a finance manager in designing
a suitable pattern of capital structure must bring about satisfactory compromise
between the above principles. The compromise can be reached by assigning weights
to these principles in terms of various characteristics of the company.

OPTIMAL CAPITAL STRUCTURE:

Objective of financial management is to maximize wealth. Therefore, one should
choose a capital structure which maximizes wealth. For this purpose, following analysis
should be done:
1) EBIT-EPS-MPS analysis: Chose a capital structure which maximizes market price per
share. For that, start with same EBIT for all capital structures and calculate EPS.
Thereafter, either multiply EPS by price earnings ratio or divide it by cost of equity to
arrive at MPS.

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2) Indifference Point analysis: In above analysis, we have considered value at a given
EBIT only. What will happen if EBIT changes? Will it change your decision also? To
answer this question, you can do indifference point analysis.
3) Financial Break-Even Point (BEP) analysis: With change in capital structure, financial
risk also changes. Though this risk has already been considered in PE ratio or in cost of
equity in point one above, but one may calculate and consider it separately also by
calculating Financial BEP.

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1.EXE Ltd. is considering three financial plans. Their key information is as follows:-
(a) total investment to be raised `2,00,000
(b) Plans of Financial Proportion
Plan Equity Debt Preference Share
A 100% - -
B 50% 50% -
C 50% - 50%
(C) Interest of debt. 8% Cost of Preference 8% Share.
(d) Tax Rate 50%
(e) Equity Shares of the face value of `10 each will be issued at a premium of `10 per share.
(f) expected PBIT is 80,000.
Determine for each plans:-
(i) Earning per share (EPS) and
(ii) The financial break-even points.
(iii) Compute the PBIT range among the plans for indifference.
2. A new project under consideration requires a capital outlay of `300 lakhs. The required
funds can be raised either fully by equity shares of `100 each or by equity share of the value
of `200 lakhs and by loan `100 lakhs at 15% interest. Assuming a tax rate of 50%, calculate the
figure of the profit, before tax that would keep the equity investors indifferent to the two
options.
Verify your answer by calculating the EPS.
3. A company provided the following figures:
Particulars `
Profit 26,00,000
Less: Interest on debentures @12% 6,00,000
20,00,000
Income tax @50% 10,00,000
Profit after tax 10,00,000
No of equity shares (`10 each) 4,00,000
EPS 2.50
Market price per share 25
Price/Earnings ratio (P/E ratio) 10
The company has undistributed reserves of `60,00,000. The company needs `20,00,000 for
expansion: this amount will earn at the same rate the funds already employed. You are
informed that a debt equity ratio [Debt/(Debit + Equity)] higher then 35% pulls P/E ratio down
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to 8 & interest rate on additional amount borrowed at 14%. You are required to ascertain
which of the following proposal should be preferred.
(i) Additional funds raised as a loan.
(ii) Additional funds raised by issuing equity shares.
4. The existing capital structure of a company is as follows:
Equity shares of `100 each `40,00,000
Retained earnings `10,00,000
9% Preference shares (`10 each) `25,00,000
7% Debentures `25,00,000
The existing rate of return on capital is 12% & the income tax rate is 40%. The company
requires a sum of `25,00,000 to finance expansion programme for which it is considering the
following alternatives
(a) The Company may issue equity shares at a premium of `25 per share, or
(b) Issue 10% preference Share, or
(c) Issue 8% debentures
It is estimated that P/E ratio in case of equity, preference & debenture financing would be
20, 17 & 16 respectively. Which of the alternatives would you consider to best
5. The management of ABC ltd. adopts NOI approach and believes that it is cost debt and
overall cost of capital is at 9% and 12% respectively. If the ratio of the market value of debt
to the market value of equity is 0.8, what rate of return is earned equity shareholders.
Assume that there are no taxes
6. A company requires `25,00,000 for a new plants, which is expected to yield earning before
interest taxes `5,00,000. The company seeks your advice on three financing alternatives
under consideration. The company’s objective is to maximize earnings per share. The
following particulars regarding the alternatives are available:
Alternative A: Raise `2,50,000 by debt and the rest by issue of fresh equity.
Alternative B: Raise `10,00,000 by debt and the rest by issue of fresh equity.
Alternative C: Raise `15,00,000 by debt and the rest by issue of fresh equity.
Funds can be borrowed at 10% p.a. upto `2,50,000, at 15% p.a. beyond `2,50,000 upto
10,00,000 and 20% p.a. beyond `10,00,000. The company’s shares are currently selling at 150
but, is expected to decline to `125 in case borrowed funds exceeds `10,00,000. The tax rate is
50%.

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7. A plastic manufacturing company is planning to expand its asset by 50%. All financing for
this plan will come from external source. The expansion will additional sales of `6 lakhs with
a return of 25% on sales before interest and taxes. Following are the three plans for
consideration.
(i) Issue 10% debentures
(ii) Issue 10% debentures of half the required amount & balance in equity shares at 25%
premium.
(iii) Issue equity share at 25% premium.

Balance Sheet
Equity capital (`10 each) 8,00,000 Total Assets 24,00,000
8% Debentures 6,00,000
Retained earnings 4,00,000
Current liabilities 6,00,000
24,00,000 24,00,000
Income Statement
Sale 35,00,000
Operating expenses 32,00,000
EBIT 6,00,000
Interest 48,000
PBT 5,52,000
Taxes at 50% 2,76,000
PAT 2,76,000
EPS 3.45
(i) Determine the indifference point between plans (a) 1 & 2 (b) 1 & 3 (c) 2 & 3
(ii) Assume that PE ratio for plans 1,2, & 3 respectively are 6,6, & 8. Find out the MPS in
each of the plans
8. ABC Ltd., is expecting earnings before interest & tax of Rs 4,00,000 and belongs to risk class
of 10% (i.e., K). You are required to find out the value of firm & cost equity capital if it employs
8% debt to the extent of 20%, 35% or 50% of the total financial requirement of Rs 20,00,000.

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 WORKING CAPITAL MANAGEMENT

MEANING AND CONCEPT OF WORKING CAPITAL:

In accounting term working capital is defined as the difference between current assets
and current liabilities. If we break down the components of working capital.
Current Assets:
An asset is classified as current when:
(i) It is expected to be realised or intends to be sold or consumed in normal operating
cycle of the entity or within twelve months after the reporting period whichever is
longer; and
(ii) The asset is held primarily for the purpose of trading in the ordinary course of
business.
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.

Current Liabilities:
A liability is classified as current when:
(i) It is expected to be settled in normal operating cycle of the entity or within twelve
months after the reporting period whichever is longer; and
(ii) It is settled either by the use of current assets or by creation of new current liability.
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)

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(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:

This is process which is designed to ensure that an organization operates efficiently by
monitoring & utilizing its current assets and current liabilities to the best effect. Primary
objective is to enable a company maintaining sufficient cash flows in order to meet its
day-to-day operating expenses and its short-term obligations.

The concept of working capital can also be explained through two angles.

(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 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).

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Permanent working capital refers to the base working capital, which is the minimum
level of investment in the current assets that is carried by the entity at all times to carry
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 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 arises due to fluctuation in sales volume. For instance, an
organization would maintain increased levels of inventory to meet increased seasonal
demand.

Both kinds of working capital i.e., permanent and fluctuating (temporary) are necessary
to facilitate production and sales through the operating cycle.

SIGNIFICANCE OF WORKING CAPITAL:

Importance of Adequate Working Capital:

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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 amount as interest on such funds that
are used to invest in surplus working capital. Another way to look at it is that there is an
opportunity cost involved where the company could have invested the surplus funds in
long term investments and earned some return on the same.

Various studies conducted by the Bureau of Public Enterprises have shown that one of
the reasons for the poor performance of public sector undertakings in our country has
been the large amount of funds locked up in working capital. This results in over
capitalization. Over capitalization implies that a company has too large funds for its
requirements, resulting in a low rate of return, a situation which implies a less than
optimal use of resources.
On the other hand, if the firm has inadequate working capital, such firm runs the risk of
insolvency. 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 account of the additional current assets that are usually required with
any expansion of activity.

➢ Increased production leads to holding of additional stocks of raw materials and

work-in-progress.
➢ An increased sale usually means that the level of debtors and the finished goods
inventory requirements will increase.

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 ➢ A general increase in the firm’s scale of operations tends to imply a need for
greater levels of working capital.

A question then arises what is an optimum amount of working capital for a firm? An
organization should neither have too high an amount of working capital nor should the
same be too low. It is the job of the finance manager to estimate the requirements of
working capital carefully and determine the optimum level of investment in working
capital.

Optimum Working Capital:

If a company’s current assets do not exceed its current liabilities, then it may run into
trouble with creditors that want their money quickly. Not being able to meet its short-
term obligations, company shall eventually lose its reputation and not many vendors
would like to do business with them.
Current ratio (current assets/current liabilities) (along with acid test ratio to supplement
it) has traditionally been considered the best indicator of the working capital situation.
It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the
firm has an optimum amount of working capital. A higher ratio may indicate inefficient
use of funds and a lower ratio would mean liquidity issues as mentioned above. This is
supplemented by Quick Ratio or Acid Test Ratio (Quick assets/Current liabilities)
which should be at least 1 (one) which would imply that there is a comfortable liquidity
position if liquid current assets are equal to current liabilities (where quick assets / liquid
current assets refer to current assets less inventory & prepaid expenses).

Bankers, financial institutions, financial analysts, investors and other people interested
in financial statements have, for years, considered the current ratio at ‘two’ and the acid
test ratio at ‘one’ as indicators of a good working capital situation. As a thumb rule, this
may be quite adequate.

However, it should be remembered that optimum working capital can be determined

only with reference to the particular circumstances of a specific situation. Thus, in a
company where the inventories are easily saleable and the sundry debtors are as good
as liquid cash, the current ratio may be lower than 2 and yet firm may be sound or where
the nature of finished goods are perishable in nature like a restaurant, then also the
organization cannot afford to hold large amount of working capital. On the other hand,

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an organization dealing in products which take a longer production time, may need a
higher amount of working capital.

MANAGEMENT OF WORKING CAPITAL:

The importance of working capital for an entity can be compared to importance of life
blood for a living body or of a lubricant/ fuel for an engine. Working capital is required
for smooth functioning of the business of an entity as lack of this may interrupt the
ordinary course of activities. Hence, the working capital needs adequate attention and
efficient management. When we talk about the management, it involves 3 Es i.e.,
Economy, Efficiency and Effectiveness and all these three are required for the working
capital management.

The scope of working capital management can be grouped into two broad areas:
(i) Liquidity and Profitability
(ii) Investment and Financing Decision.

Liquidity and Profitability:

For uninterrupted and smooth functioning of the day-to-day business of an entity, it is
important to maintain liquidity of funds evenly. As we have already learnt in previous
chapters that 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 better return from a productive asset. Hence, a trade-off is required between the
liquidity and profitability which increases the profitability without disturbing the day-
to-day functioning. This requires 3Es as discussed above i.e., economy in financing,
efficiency in utilisation and effectiveness in achieving the intended objectives.

2. Investment and Financing:

Working capital policy is a function of two decisions, first is investment in working
capital and the second is financing of 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 objectives (i.e., Effectiveness of
fund). Financing decision concerned with the arrangement of funds to finance the
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working capital. It gives the answer ‘Where from’ fund to be sourced at lowest cost as
possible (i.e., Economy). Financing decision, we will discuss this in later unit of this
chapter.

Investment of working capital: How much to be invested in current assets as working

capital is a matter of policy decision by an entity. It has to be decided in the light of
organisational objectives, trade policies and financial (cost-benefit) considerations.
There are not set or fixed rules for deciding the level of investment in working capital.
Some organisations due to its peculiarity require more investment than others. For
example, an infrastructure development company requires more investment in its
working capital as there may be huge inventory in the form of work in process on the
other hand a company which is engaged in fast food business, comparatively requires
less investment as inventory is of perishable nature & most sales are cash sales. Hence,
level of investment depends on the various factors listed below:

(a) Nature of Industry: Construction companies, breweries etc. requires large investment
in working capital due long gestation period.
(b) Types of products: Consumer durable has large inventory as compared to perishable
products.
(c) Manufacturing Vs Trading Vs Service: A manufacturing entity has to maintain three
levels of inventory i.e., raw material, work-in-process and finished goods whereas a
trading and a service entity has to maintain inventory only in the form of trading stock
and consumables respectively.
(d) Volume of sales: Where the sales are high, there is a possibility of high receivables
as well.
(e) Credit policy: An entity whose credit policy is liberal has not only high level of
receivables but may require more capital to fund raw material purchases as that will
depend on credit period allowed by suppliers.

Approaches of working capital investment:

Based on the organisational policy and risk-return trade off, working capital investment
decisions are categorised into three approaches i.e. aggressive, conservative and
moderate.

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(a) Aggressive: Here investment in working capital is kept at minimal investment in
current assets which means the entity does hold lower level of inventory, follow strict
credit policy, keeps less cash balance etc. The advantage of this approach is that lower
level of fund is tied in the working capital which results in lower financial costs but the
flip side could be risk of stock-outs & that the organisation could not grow which leads
to lower utilisation of fixed assets and long-term debts. In the long run firm may stay
behind the competitors.

(b) Conservative: In this approach, organisation choose to invest high capital in current
assets. Organisations use to keep inventory level higher, follows liberal credit policies,
and cash balance as high as to meet any current liabilities immediately. The advantages
of this approach are higher sales volume, increased demand due to liberal credit policy
and increase goodwill among the suppliers due to payment in short time. The
disadvantages are increase cost of capital, inventory obsolescence, higher risk of bad
debts, shortage of liquidity in long run due to longer operating cycles.
(c) Moderate: This approach is in between the above two approaches. Under this
approach a balance between the risk and return is maintained to gain more by using the
funds in very efficient manner. A conservative policy implies greater liquidity and lower
risk whereas an aggressive policy indicates higher risk and poor liquidity. Moderate
current assets policy will fall in the middle of conservative and aggressive policies
which most of the firms follow to strike an appropriate balance as per the requirements
of their trade or industry.

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Current Assets to Fixed Assets Ratio:
The finance manager is required to determine the optimum level of current assets so that
the shareholders’ value is maximized.
A firm needs both fixed and current assets to support a particular level of output. As the
firm’s output and sales increases, the need for current assets also increases. Generally,
current assets do not increase in direct proportion to output; current assets may increase
at a decreasing rate with output. As the output increases, the firm starts using its current
asset more efficiently.
The level of the current assets can be measured by creating a relationship between
current assets and fixed assets. Dividing current assets by fixed assets gives current
assets/fixed assets ratio.
Assuming a constant level of fixed assets, a higher current assets/fixed assets ratio
indicates a conservative current assets policy and a lower current assets/fixed assets
ratio means an aggressive current assets policy assuming all other factors to be constant.

ESTIMATING WORKING CAPITAL NEEDS:

(i) Current Assets Holding Period: To estimate working capital needs based on the
average holding period of current assets and relating them to costs based on the
company’s experience in the previous year.

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(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.

OPERATING OR WORKING CAPITAL CYCLE:

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Question 1
XYZ Co. Ltd. is a pipe manufacturing company. Its production cycle indicates the that
materials are introduced in the beginning of the production cycle; wages are overhead
accrued evenly throughout the period of the cycle. Wages are paid in the next month
following the month of accrual. Work in process includes full units of raw material used
in the beginning of the production process and 50% of wages. Components of working
capital are as follows:
Production of pipes 12,00,000 units
Duration of the production cycle One month
Raw materials inventory held One month consumption
Finished goods inventory held for Two months
Credit allowed by creditors One month
Credit given to debtors Two months
Cost price of raw materials Rs. 60 per unit
Direct wages Rs.10 per unit
Overheads Rs.20 per unit
Selling prices of finish pipes Rs.100 per unit

You are required to calculate the amount of working capital required for the company.
Solution: Statement Showing calculation of Working Capital Requirement

Particulars Amount Amount

A. Current Assets
i. Raw material Stock 6000000
ii. WIP stock 6500000
iii. Finished Goods stock 18000000
iv. Trade Receivables 20000000
v. Cash NIL 50500000
Gross Working Capital 50500000
B. Current Liabilities
vi. Creditors 6000000
vii. Outstanding Wages 1000000 7000000
Net Working Capital (A-B) 43500000

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Note: In case of old company, it is always assumed that production = consumption.
Working Note:
a. Raw Material Stock = (Units * price per unit)/12*Stock holding period

b. WIP Stock = (Units produced * Cost of production per unit)/12* processing time.

c. F.G Stock = (Units produced * COGS per unit)/12* Inventory holding period

d. Raw Material Stock = (Units * price per unit)/12*Stock holding period

e. Debtor = (Units sold * Price per unit)/12* credit period allowed

f. Creditor = (Units purchased * Price per unit)/12* credit period allowed

Question 2
A proforma cost sheet of a company provides the following particulars:
Raw materials cost Amount per unit(Rs.)
Direct labour cost 100.00
Overheads cost 37.50
Total cost 75.00
Profit 212.50
Selling price 37.50
250.00
The company keeps raw materials in stock, on an average for one month; work-in-
progress, on an average for one week; and finished goods in stocks, on an average for
two weeks.
The credit allowed by suppliers is three weeks and company allow four weeks credit to
its debtors. The lag in payment of wages is one week and lag in payment of overhead
expenses is two weeks.

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The company sells one fifth of the output against cash-in-hand and at bank put together
at Rs. 37,500.
Required:
Prepare to statement showing estimate of working capital needed to finance an activity
level of 1,30,000 units of production. Assume the production is carried on evenly
throughout the year, and wages and overheads accrue similarly. Work-in-progress stock
is 80% complete in all respects.

Question 3
A proforma cost sheet of a company provides the following data:
Amount (Rs.)
Raw materials cost per unit 117.00
Direct Labour cost per unit 49.00
Factory overheads cost per unit 98.00
(Includes depreciation of Rs.18 per unit at budgeted level of activity)
Total cost per unit 264.00
Profit 36.00
Selling price per unit 300.00

Following additional information is available:

Average raw material in stock : 4 weeks
Average work-in-process stock : 2 weeks
(% completion with respect to
Materials : 80%
Labour and overheads : 60%)
Finished goods in stock : 3 weeks
Credit period allowed to debtors : 6 weeks
Credit period availed from suppliers : 8 weeks
Time lag in payment of wages : 1week
Time lag in payment of overheads : 2 weeks

The company sells one-fifth of the output against cash and maintains cash balance of
Rs.2,50,000.
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Required:
Prepare a statement showing estimate of working capital needed to finance budgeted
activity level of 78,000 units of production. You may assume that production is carried
on evenly throughout the year and wages and overheads accrue similarly.

Question 4
MNO Ltd. has furnished the following cost data relating to the year ending of 31 st march,
20X8.
Particulars Rs. (in Lakhs)
Sales 450.00
Material consumed 150.00
Direct wages 30.00
Factory overheads (100% variable) 60.00
Office and Administrative overheads (100% variable) 60.00
Selling overheads 50.00
The company wants to make a forecast of working capital needed for the next year and
anticipates that:
1. Sales will go up by 100%,
2. Selling overheads will be Rs.150 lakhs,
3. Stock holding for the next year will be
- Raw materials for two and half months,
- Work-in-progress for one month
- Finished goods for half month and
- Book debts for one and half months,
- Legs in payment will be of three months for suppliers,
- 1 month for wages and half month for factory,
- Office and administrative and selling overheads.

You are required to prepare statement showing working capital requirements for next
year.
Question 5
Following information forecasted by the CS Limited for the year ending 31 st March,
20X6:

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 Balance as at Balance as at
1st 31st march,
april,20X5 20X6

(Rs.) (Rs.)
Raw material 45,000 65,356
Work-in-progress 35,000 51,300
Finished goods 60,181 70,175
Receivables 1,12,123 1,35,000
Payables 50,079 70,469
Annual purchases of raw material (all credit) 4,00,000
Annual cost of production 7,50,000
Annual cost of goods sold 9,15,000
Annual operating cost 9,50,000
Annual sales (all credit ) 11,00,000
You may take one year as equal to 365 days.
You are required to calculate:
(i) Net operating cycle period.
(ii) Number of operating cycles in the year.
(iii) Amount of working capital requirement

Question 6
A newly formed company has applied to the commercial bank for the first time for
financing its working capital requirements. The following information is available about
the projection of the current year:
Elements of cost Per unit (Rs)
Raw materials 40.00
Direct Labour 15.00
Overhead 30.00
Total cost 85.00
Profit 15.00
Sales 100.00
Other information:

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Raw material in stock: average 4 weeks consumption, work – in progress (completion
stage, 50 per cent), on an average half a month. Finished goods is stock: on an average,
one month.
Credit allowed by supplier is one month and Credit allowed to debtors is two month.
Average time lag in payment of wages is 11/2 weeks and 4weeks in overhead expenses.
Cash in hand and at bank is desired to be maintained at Rs.50,000. All sales are on credit
basis only.
Required:
Prepare statement showing estimate of working capital needed to finance an activity
level of 96,000 units of production. Assume that production is carried on evenly
throughout the year, and wages and overhead accrue similarly. For the calculation
purpose 4 weeks may be taken as equivalent to a month and 52 weeks in a year.
Question 7
The management of MNP Company Ltd. is planning to expand its business and consults
you to prepare an estimated working capital statement. The records of the company
reveal the following annual information:
Particulars (Rs.)
Sales –domestic at one month’s credit 24,00,000
Export at three month’s credit (sales price 10% below domestic price) 10,80,000
Materials used (suppliers extend two months credit) 9,00,000
Lag in payment of wages - ½ month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,20,000
Lag in payment of Adm. Expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four installments of which one falls in the next 2,25,000
financial year
Rate of gross profit is 20%. Ignore work – in – progress and depreciation.
The company keeps one month’s stock of raw materials and finished goods (each) and
believes in keeping Rs.2, 50, 000 available to it including the overdraft limit of
Rs.75,000 not yet utilized by the company.
The management is also of the opinion to make 12% margin for contingencies on
computed figure. You are required to prepare the estimated working capital statement
for the next year.

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Question 8
The Trading and Profit and Loss Account of Ltd. for the year ended 31 st march, 20X1
is given bellow:
Particulars Amount Amount(Rs.) Particulars Amount Amount
(Rs.) (Rs.) (Rs.)
To Opening By sales 20,00,000
Stock: (credit)
-Raw Materials 1,80,000 By closing
stock:
-work- in – 60,000 -raw
progress materials 2,00,000
-Finished Goods 2,60,000 5,00,000 -Work – in
- progress 1,00,000
To Purchases 11,00,000 -Finished 6,00,000
(credit) Goods 3,00,000
To Wages 3,00,000
To Production 2,00,000
Expenses
To Gross Profit 5,00,000
c/d
26,00,000 26,00,000
To 1,75,000 By Gross 5,00,000
Administration Profit b/d
Expenses
To Selling 75,000
Expenses
To Net Profit 2,50,000
5,00,000 5,00,000

The opening and closing balances of receivables were Rs. 1, 50, 000 and Rs. 2, 00, 000
respectively whereas opening and closing payables for raw materials were Rs. 2, 00,
000 and 2, 40, 000 respectively.
You are required to ascertain the working requirement by operating cycle method.

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Question 9
STN Ltd. is a readymade garment manufacturing company. Its production cycle
indicates that materials are introduced in the beginning of the production phase; wages
and overhead accrue evenly throughout the period of cycle. The followings figure for
the 12 months ending 31st December 20X1 are given.
Production of shirts 54,000 units
Selling price per unit Rs.200
Duration of the production cycle 1 month
Raw material inventory held 2 months consumption
Finished goods stock held for 1 month
Credit allowed to debtors is 1.5 months and credit allowed by creditors is 1 month.
Wages are paid in the next month following the month of accrual.
In the work- in – progress 50% wages and overheads are supposed to be conversion
costs.
The ratios of cost to sales price are –raw materials 60% direct wages 10% and overhead
20%. Cash is to be held to the extent of 40% of current liabilities and safety margin of
15% will be maintained.
Calculate amount of working capital required for the company on a cash cost basis.
Question 10
Black Limited has furnished the following cost sheet:
Rs. per unit
Raw Material 98.00
Direct Labour 53.00
Factory Overhead (includes depreciation of Rs.15 per unit at 88.00
budgeted level of activity)
Total Cost 239.00
Profit 43.00
Selling Price 282.00
Additional information:
(i)Average raw material in stock 3 weeks

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 (ii) Average work-in- progress (% of completion with respect to 2 weeks
material- 75% Labour & overhead – 70%)
(iii)Finished goods in stock 4 weeks
(iv)Credit allowed to receivables 21/2 weeks
(v)Credit allowed by suppliers 31/2weeks
(vi)Time lag in payments of labour 2 weeks
(vii)Time lag in payments of factory overheads 11/2 weeks
(viii)Company sells, 25% of the output against cash
(ix)cash in hand and bank is desired to be maintained Rs. 2,25,000
(x)provision for contingencies is required @ 4% of working
capital requirement including that provision.
You may assume that production is carried on evenly throughout the year and labour
and factory overheads accrue similarly.
you are required to prepare a statement showing estimate of working capital needed to
finance a budgeted activity level of 1,04,000 units of production. Finished stock,
receivables and overhead are taken at cash cost.

Question 11
The following information is provided by the DVP Ltd. for the year ending 31 st march,
20X5.
Raw material storage period 50 days
Work in progress conversion period 18 days
Finished goods storage period 22 days
Debt collection period 45 days
Creditor’s payment period 55 days
Annual operating cost 21 days
(Including depreciation of Rs.2,10,000) Note: 1 year = 360 days
You are required to calculate:
(i) Operation cycle period
(ii) Number of operating Cycles in a year

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 CAPITAL EXPENDUTURE DECISION

PURPOSE OF CAPITAL BUDGTETING:

The capital budgeting decisions are important, crucial and critical business decisions
due to the following reasons:

(i) Substantial expenditure: Investment decisions are related with fulfilment of long-
term objectives and existence of an organization. To invest in a project(s), a substantial
capital investment is required.

(ii) Long time period: The capital budgeting decision has its effect over a long period
of time. These decisions not only affect the future benefits and costs of the firm but also
influence the rate and direction of growth of the firm.

(iii) Irreversibility: Most of the investment decisions are irreversible. Once the decision
is implemented, it is very difficult and reasonably and economically not possible to
reverse the decision.

(iv) Complex decisions: The capital investment decision involves an assessment of

future events, which in fact is difficult to predict.

CAPITAL BUDGETING PROCESS:

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(i) Planning: The capital budgeting process begins with the identification of potential
investment opportunities.

(ii) Evaluation: This phase involves the determination of proposal and its investments,
inflows and outflows.

(iii) Selection: Considering the returns and risks associated with the individual projects
as well as the cost of capital to the organisation, the organisation will choose among
projects which maximises the shareholders’ wealth.

(iv) Implementation: When the final selection is made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the project.

(v) Control: The progress of the project is monitored with the aid of feedback reports.

(vi) Review: When a project terminates, or even before, the organisation should review
the entire project to explain its success or failure.

TYPES OF CAPITAL INVESTMENT DECISIONS:

There are many ways to classify the capital budgeting decision. Generally capital
investment decisions are classified in two ways. One way is to classify them on the basis
of firm’s existence. Another way is to classify them on the basis of decision situation.

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 •Replacement and Modernisation decisions
On the basis of •Expansion decisions
firm’s existence •Diversification decisions

•Mutually exclusive decisions

On the basis of •Accept-Reject decisions
decision situation •Contingent decitions

ESTIMATION OF PROJECT CASH FLOWS:

Capital Budgeting analysis considers only incremental cash flows from an investment
likely to result due to acceptance of any project. Therefore, one of the most important
tasks in capital budgeting is estimating future cash flows for a project. Though one of
the techniques i.e., Accounting Rate of Return (ARR) evaluates profitability of a project
on the basis of accounting profit, but accounting profit has its own limitations. Timings
of cash flow may not match with the period of profit.

An investment decision implies the choice of an objective, an appraisal technique and

the project’s life. The objective and technique must be related to definite period of time.
The life of the project may be determined by taking into consideration the following
factors:

(i) Technological obsolescence;

(ii) Physical deterioration; and

(iii) Decline in demand for the output of the project.

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Calculating Cash Flows:

Opportunity
Depreciation Sunk Cost
Cost

Additional
Working Allocated
Capital
Capital Overheads
Investment

Categories of Cash Flows: It is helpful to place project cash flows into three categories:

(a) Initial Cash Outflow

(b) Interim Cash Flows
(c) Terminal-Year Incremental Net Cash Flow

CAPITAL BUDGETING TECHNIQUES:

In order to maximise the return to the shareholders of a company, it is important that the
best or most profitable investment projects are selected. 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.

Traditional or Non-Discounting:

Payback Period:

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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.

1. Uniform Cash Flows:

When the cash inflows are uniform over the useful life of the project, the number of
years in the payback period can be calculated.

2. Non-Uniform Cash Flows:

When the annual cash inflows are not uniform, the cumulative cash inflow from
operations must be calculated for each year. The payback period shall be corresponding
period when total of cumulative cash inflows is equal to the initial capital investment.

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Advantages of Payback period:

✓ It is easy to compute.
✓ It is easy to understand as it provides a quick estimate of the time needed for the
organization to recoup the cash invested.
✓ The length of the payback period can also serve as an estimate of a project’s risk;
the longer the payback period, the riskier the project as long-term predictions are
less reliable. In some industries with high obsolescence risk like software industry
or in situations where an organization is short on cash, short payback periods
often become the determining factor for investments.

Limitations of Payback period:

✓ It ignores the time value of money. As long as the payback periods for two
projects are the same, the payback period technique considers them equal as
investments, even if one project generates most of its net cash inflows in the early
years of the project while the other project generates most of its net cash inflows
in the latter years of the payback period.
✓ A second limitation of this technique is its failure to consider an investment’s
total profitability; it only considers cash inflows up-to the period in which initial
investment is fully recovered and ignores cash flows after the payback period.
✓ Payback technique places much emphasis on short payback periods thereby
ignoring long-term projects.

Types of Payback Period:

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1. Payback Reciprocal:

2. Accounting (Book) Rate of Return (ARR) or Average 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.

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Advantages of ARR:

❖ This technique uses readily available data that is routinely generated for financial
reports and does not require any special procedures to generate data.
❖ This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the same
procedure in both decision-making and performance evaluation ensures
consistency.
❖ Calculation of the accounting rate of return method considers all net incomes over
the entire life of the project and provides a measure of the investment’s
profitability.

Limitations of ARR:

❖ The accounting rate of return technique, like the payback period technique,
ignores the time value of money and considers the value of all cash flows to be
equal.
❖ The technique uses accounting numbers that are dependent on the organization’s
choice of accounting procedures, and different accounting procedures, e.g.,
depreciation methods, can lead to substantially different amounts for an
investment’s net income and book values.
❖ 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.
❖ Furthermore, inclusion of only the book value of the invested asset ignores the
fact that a project can require commitments of working capital and other outlays
that are not included in the book value of the project.

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DISCOUNTING TECHNIQUES:

1. Net Present Value Technique (NPV):

The net present value technique is a discounted cash flow method that considers the
time value of money in evaluating capital investments. An investment has cash flows
throughout its life, and it is assumed that an amount of cash flow in the early years of
an investment is worth more than an amount of cash flow in a later year.

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).

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Advantages of NPV:

1. NPV method takes into account the time value of money.

2. The whole stream of cash flows is considered.
3. The net present value can be seen as the addition to the wealth of shareholders.
The criterion of NPV is thus in conformity with basic financial objectives.
4. The NPV uses the discounted cash flows i.e., expresses cash flows in terms of
current rupees. The NPVs of different projects therefore can be compared. It
implies that each project can be evaluated independent of others on its own merit.

Limitations of NPV:

1. It involves difficult calculations.

2. The application of this method necessitates forecasting cash flows and the
discount rate. Thus, accuracy of NPV depends on accurate estimation of these
two factors which may be quite difficult in practice.
3. The decision under NPV method is based on absolute measure. It ignores the
difference in initial outflows, size of different proposals etc. while evaluating
mutually exclusive projects.

2. Profitability Index /Desirability Factor/Present Value Index Method (PI):

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Advantages of PI:

1. The method also uses the concept of time value of money.

2. In the PI method, since the present value of cash inflows is divided by the present
value of cash outflow, it is a relative measure of a project’s profitability.
Limitations of PI:

1. Profitability index fails as a guide in resolving capital rationing where projects

are indivisible.
2. Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single
project is excluded.
3. Also, situations may arise where a project with a lower profitability index selected
may generate cash flows in such a way that another project can be taken up one
or two years later, the total NPV in such case being more than the one with a
project with highest Profitability Index.

3. 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

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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.

Advantages of IRR:

1. This method makes use of the concept of time value of money.

2. All the cash flows in the project are considered.
3. IRR is easier to use as instantaneous understanding of desirability can be
determined by comparing it with the cost of capital.

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 4. IRR technique helps in achieving the objective of maximisation of shareholder’s
wealth.

Limitations of IRR:

1. The calculation process is tedious if there is more than one cash outflow
interspersed between the cash inflows; there can be multiple IRR, the
interpretation of which is difficult.
2. The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
3. It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It ignores a firm’s ability to re-invest in
portfolio of different rates.
4. If mutually exclusive projects are considered as investment options which have
considerably different cash outlays. A project with a larger fund commitment but
lower IRR contributes more in terms of absolute NPV and increases the
shareholders’ wealth. In such situation decisions based only on IRR criterion may
not be correct.

4. Discounted Payback Period Method:

This is similar to Payback period as discussed in under the non-discounting method

except that the cash flows here are discounted at predetermined rate and the payback
period so calculated is called Discounted payback period.

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RANKING OF PROJECTS:

Page | 94
CAPITAL RATIONING:

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 Computation of Internal Rate of Return

1. Raj and Co. intends to invest Rs. 10 Lakh in a project having a life of 4 years. The cash inflows from
the project at the end of year one to the fourth year are expected as Rs. 3,00,000, Rs. 4,20,000, Rs.
4,00,000 and Rs. 3,30,000 before charging depreciation and tax you are required to calculate the
Accounting Rate of Return of the Project and comment on the use of the rate of return. [2007]

Computation of Discounted Pay Back Period Method

2. Using the information given below compute the Pat-Back Period under Discounted pay-Back
Method and comment.
Initial outlay Rs. 80,000
Estimated life 5 years
Profit after tax :
End of year 1 Rs. 6,000
2 Rs. 14,000
3 Rs. 24,000
4 Rs. 16,000
5 Rs. Nil
Depreciation has been calculated under straight line method. The cost of capital may be taken at 20%
p.a. and the P.V. Re. 1 at 20% p.a. is given below :
Year 1 2 3 4 5
P.V. factor .83 .69 .58 .48 .40 [2008]

Computation of Discounted Pay- Back period Method

3. Using the information given below, compute the Pay-back period under a) Traditional Pay – Back
Method and b) Discounted Pay – Back Method and Comment on the results.
Initial outlay Rs. 80,000
Estimated life 5 years
Profit after tax:
End of year 1 Rs. 6,000
2 Rs. 14,000
3 Rs. 24,000
4 Rs. 16,000

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 5 Nil
Depreciation has been calculated under straight line method. The cost of capital may be taken at 20%
p.a. and the P.V. of Rs. 1 at 20% p.a. is given below:
Year 1 2 3 4 5
PV Factor 0.83 0.69 0.58 0.48 0.40

4. A company is considering an investment project which requires an initial cash outlay of Rs. 5,00,000
on equipment and Rs. 20,000 as working capital. The project’s economic life is 6 years. An additional
investment of Rs. 50,000 each would also be necessary at the end of second and fourth year to
restore the efficiency of the equipment. The annual cash inflows expect from the project are:

Year Cash inflows (Rs.)

1 8,000
2 1,20,000
3 1,80,000
4 2,00,000
5 2,60,000
6 3,00,000
If the realizable scrap value of the equipment Rs. 20,000 after 6 years and cost of capital is 20%.
Justify whether the project should be accepted or not by determining the net present value. Assume
that working capital will be recovered in full at the end of the project life.
Given that,
Year : 1 2 3 4 5 6
PV Factor at 20% : 0.833 0.694 0.579 0.482 0.402 0.335 [2009]

5. A machine costing 12,00,000 is required in order to undertake a proposed project. The effective
life of machine is expected to be 5 years the with a residual value of 2,00,000. The company follows
straight line method of charging depreciation. The estimated earnings before tax of the project are
as follows :
year 1st 2nd 3rd 4th 5th
Earnings Rs. 4,80,000 5,60,000 6,40,000 4,00,000 3,20,000
before tax

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If the tax rate is 40%, cost of capital is 15%, calculate the net present value and suggest whether the
machine would be acquired or not.
Given : the present value factors at a discount rate of 15% rate are :
year 1 2 3 4 5
P.V. Factors 0.8696 0.7561 0.6575 0.5718 0.4972 10
[2014]

Internal Rate of Return Method

6. An Equipment requires an initial investment of Rs. 12,000. The annual cash flow is estimated at Rs.
4,000 each year for 5 years.
Calculate the internal rate of return.

7. X Limited has currently under examination a project which will yield the following returns over a
period of time
Year Gross Yield
Rs.
1 80,000
2 80,000
3 90,000
4 90,000
5 75,000
Cost of machinery to be installed amounts to Rs. 2,00,000 and the machine is to be depreciated at
20% per annum on WDV basis. Income tax rate is 50%.
If the average cost of raising capital is 11%, would you recommend accepting the project under the
internal rate of return method?
Present value of money at rates of interest is as under:
Year at 10% at 14%
1 0.91 0.88
2 0.83 0.77
3 0.75 0.67
4 0.68 0.59

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5 0.62 0.52

8. From the followings particulars given below calculate the internal rate of Return of the project.
(i) Net Profit after – tax over the four years of the project life:
Rs.
End of year 1— 13,750
2— 22,000
3— 27,500
4— 11,000
(ii) Initial outlay : Rs. 55,000. There will be no realizable scrap value at the end of the project life.
(iii) Present value of Rs. 1 receivable at the end of year 1,2,3 and 4 at different discount rates:
Discount PV factor (Rs.)
12% 0.892 0.797 0.712 0.636
13% 0.885 0.783 0.693 0.613
14% 0.877 0.770 0.675 0.592
15% 0.867 0.756 0.658 0.572
[2011]

Comprehensive Problem

9. X Ltd. is considering the purchase of a new machine which will carry out some operations at present
performed by labour. Two alternative models—A and B are available for the purpose. From the
following information prepare a profitability statement using Pay Back period and Pay Back
Profitability for submission to management:
Machine A Machine B
Estimated life (years) 5 6
Cost of machine Rs. 80,000 Rs. 1,50,000
Estimated additional Cost (Rs.)
Maintenance (per month) 500 750
Indirect Materials (p.a.) 2,000 3,000
Supervision (per quarter) 3,000 4,500
Estimated Savings in Scrap (p.a.) Rs. 8,000 12,000

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Estimated Savings in direct wages per annum:
Employees not required 10 15
Wages per employee (Rs.) 7,200 7,200
Depreciation is calculated using straight line method. Taxation may be taken at 50% of profit (net
savings).

10. An enterprise can make either of two investments at the beginning of 2000. Assuming a required
rate of return of 10% p.a.; evaluate the investment proposals under a) Return on Investment; b) Pay-
Back Profitability; c) Discounted Pay Back period and d) Profitability Index.
The forecast particulars are given below:
Proposal A Proposal B
Cost of Investment (Rs.) 20,000 28,000
Life (years) 4 5
Scrap Value Nil Nil
Net income (after depreciation & tax) Rs. Rs.
End of 2000 500 Nil
2001 2,000 3,400
2002 3,500 3,400
2003 2,500 3,400
2004 — 3,400
It is estimated that each of the alternative projects will require an additional working capital of Rs.
2,000 which will be received back in full after the expiry of each project life. Depreciation is provided
under straight line method. The present value of Rs. 1 to be received at the end of each year, at 10%
p.a. is given below:
Year 1 2 3 4 5
P.V. 0.91 0.83 0.75 0.68 0.62

11. A company can make either of two investments at the beginning of 2000. Evaluate the proposal
under a) Traditional Pay Back period, b) Discounted Pay Back period and c) Profitability Index.
The details of the investment proposals are given below:
Project-I Project-II
Initial outlay Rs. 20,000 Rs. 28,000
Expected Life 5 years 5 years

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Scrap value Nil Nil
Net cash flow Rs. Rs.
End of 2000 5,000 8,000
2001 5,000 8,000
2002 6,000 8,000
2003 6,000 8,000
2004 6,000 8,000
The cost of capital may be taken of 10% p.a. and the present value of Rs. 1. To be received at the end
of each year at 10% is given below:
Year 1 2 3 4 5
P.V. 0.91 0.83 0.75 0.68 0.62

12. A company has an investment opportunity costing Rs. 40,000 with the following expected net
cash flow (i.e. after taxes and before depreciation):
Year Net cash Flow
Rs.
1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Using 10% as the cost of capital, determine the following:
a) Pay-back period
b) Net present value at 10% discount Factor.
c) Profitability Index at 10% Discount factor.

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d) Internal rate of return with the help of 10%.
Discounting factor and 15% discounting factor.

13. A firm whose cost of capital is 10% is considering two mutually exclusive project X and Y, the
details of which are—
Project X Project Y
Rs. Rs.
Investment 70,000 70,000
Cash Flow
Year 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
Total Cash Flows 1,65,000 1,30,000
Compute the net present value at 10%. Profitability index and Internal Rate of Return for the two
projects.
14. Z Ltd. has to select one of the two alternative projects whose particulars are given below:
Project 1 — Initial Outlay – Rs. 2,40,000. The expected cash inflow from it at the end of first year
and second year are Rs. 50,000 and Rs. 2,50,000 respectively.
Project 2 — Initial outlay Rs. 235,930. The expected cash inflow from this project at the end of first
year and second year are Rs. 1,90,000 and Rs. 90,000 respectively.
Rank the two projects in order of preference by the NPV method and IRR method. Which of the
alternatives would you select and why? Assume cost of capital is 10%.
Present value of Rs. 1 at different rates of cost :
Year 10% 11% 12% 13% 14% 15%
1 0.909 0.901 0.892 0.885 0.877 0.867
2 0.826 0.812 0.797 0.783 0.770 0.756
[2010]
15. Following information available for two machines :

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 X (Rs.) Y (Rs.)
Initial Investment 1,00,000 1,00,000
Life 7 years 10 years
Net cash inflow 25,000 20,000
Realisable value after 5 years 50,000 75,000
With the help of pay back period method, evaluate the efficient one. [2014]

16. Company pay back period of a project of which the following details are available :
End of year 1 2 3 4 5
Book value of Fixed Assets ( Rs. in lakh ) 450 400 350 300 250
Profit after Tax ( Rs. in lakh ) 80 88 96 104 112 [2015]

17. Project I cost Rs. 8,00,000 and project II cost Rs. 12,80,000. Both have a ten year life. Uniform
cash receipts expected from project I – Rs. 1,60,000 and project II— Rs. 3,20,000. Salvage value
expected are project I Rs. 5,60,000 declining at an annual rate of Rs. 80,000 and project II Rs. 6,40,000
declining at an annual rate of Rs. 1,60,000.
Which one is to be selected ? [2015]

Computation of Accounting Rate of Return

18. The cost of a plant is Rs. 30,000. The expected life of the plant is 3 years. It is expected to generate
EBDIT (earnings before depreciation, interest and taxes) — Rs. 13,000, Rs. 15,000, Rs. 17,000
respectively. Compute Accounting Return of Return assuming 50% tax, and straight line method of
depreciation.

Pay back Reciprocal

19. You are requested to advice management about the purchase of a new machine on the basis of
a payback reciprocal of the two:-
Machine X Machine Y
Initial Outlay Rs. 2,00,000 Rs. 3,00,000
Estimated life (years) 10 14
Annual cash inflow after tax Rs. 25,000 Rs. 30,000 [2012]

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 Accounting Rate of Return

20. The cost of a plant is Rs. 60,000. The expected life of the plant is 3 years. It is expected to generate
EBDIT (Earnings before depreciation, interest and taxes) Rs. 26,000, Rs. 30,000 Rs. 34,000
respectively. Compute accounting rate of return assuming 30% tax and straight-line method of
depreciation. [2014]

21. M/S Bharat Industrial Limited purchased a machine five years ago. A proposal is under
consideration to replace it by a new machine. The life of the machine is estimated to be 10 years. The
existing machine can be sold at its written down value. As the cost accountant to the company, you
are required to submit your recommendations based on the following information:
Existing Machine New Machine
Initial cost Rs. 25,000 Rs. 50,000
Machine hours p.a. 2,000 2,000
Wages per running hour Rs. 1.25 Rs. 1.25
Power per hour Rs. 0.05 Rs. 2.00
Indirect materials p.a. Rs. 3,000 Rs. 5,000
Other expenses p.a. Rs. 12,000 Rs. 15,000
Cost of materials per unit Rs. 1 Rs. 1
Number of units produced per hour 12 18
Selling price per unit 2 2
Interest to be paid at 10% on fresh capital invested.

Pay-Back Period Method

22. Payoff Ltd. is producing articles mostly on hand labour and is considering to replace it by a new
machine. There are two alternative models M and N of the new Machine. Prepare a statement of
Profitability showing the pay-back period from the following information:
Machine M Machine N
Estimated life of Machine 4 years 5 years
Cost of Machine Rs. 9,000 Rs. 18,000
Estimated Saving in Scrap Rs. 500 Rs. 800

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Estimated savings in direct wages Rs. 6,000 Rs. 8,000
Additional cost of maintenance Rs. 800 Rs. 1,000
Additional cost of supervision Rs. 1,200 Rs. 1,800
Ignore taxation.

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 DIVIDEND DECISIONS

Long term Finance function decisions broadly covers three areas:

i. Financing decision
ii. Investment decision
iii. Dividend decision
"Dividend decision" which is one of the most important areas of management decisions.

MEANING OF DIVIDEND:
Dividend is that part of Profit After Tax (PAT) which is distributed to the shareholders
of the company. Further, the profit earned by a company after paying taxes can be used
for:
i. Distribution of dividend, or
ii. Retaining as surplus for future growth

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FORMS OF DIVIDEND:
Generally, the dividend can be of the following forms (depending upon some factors
that will be discussed later):
1. Cash dividend: It is the most common form of dividend. Cash here means cash,
cheque, warrant, demand draft, pay order or directly through Electronic Clearing
Service (ECS) but not in kind.

2. Stock dividend (Bonus Shares): It is a distribution of shares in lieu of cash dividend.

Advantages of Stock Dividend:

There are many advantages both to the shareholders and company. Some of the main
advantages are listed as under:

(1) To Shareholders:
(a) No tax is payable by shareholders on stock dividend received from domestic
company as it is not treated as dividend but capital asset under Income Tax Act, 1961.
(b) Policy of paying fixed dividend per share and its continuation even after declaration
of stock dividend will increase total cash dividend of the shareholders in future.

(2) To Company:
(a) Conservation of cash for meeting profitable investment opportunities.
(b) Suitable in case of cash deficiency and restrictions imposed by lenders to pay cash
dividend.

SIGNIFICANCE OF DIVIDEND POLICY:

Dividend policy of a firm is governed by:
(i) Long Term Financing Decision:

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As we know that one of the financing options is ‘Equity’. Equity can either be raised
externally through issue of new equity shares or can be generated internally through
retained earnings. For Equity, retained earnings are preferable because they do not
involve any floatation costs (issue expenses).
But whether to retain or distribute the profits, forms the basis of this decision. Further,
payment of cash dividend reduces the amount of funds required to finance profitable
investment opportunities thereby restricting its financing options.
In this backdrop, the decision is based on the following:
1. Whether the organization has opportunities in hand to invest the profit, if retained?
2. Whether the return on such investment (ROI) will be higher than the expectations of
shareholders i.e., Ke?
(ii) Wealth Maximization Decision:
Under this decision, we are facing the problem as to what amount of dividend shall be
distributed i.e., the Dividend Pay-out ratio (D/P) in relation to Market price of the shares
(MPS)? This decision is based on the following:
1. Due to market imperfections and uncertainty, shareholders give more importance to
near dividends than future dividends and capital gains. Payment of dividends influences
the market price of the share directly. Higher dividends increase the value of shares and
low dividends decrease it. A proper balance has to be struck between these two
approaches.
2. When the firm increases its retained earnings, shareholders' dividends decreases and
consequently market price is affected. Use of retained earnings to finance profitable
investments increases the future earnings per share. This is because, shareholders expect
those profitable investments made by the company may lead to higher return for them
in future. On the other hand, increase in dividends may cause the firm to forego
investment opportunities for lack of funds and thereby decrease the future earnings per
share.
Thus, management should develop a dividend policy which divides net earnings into
dividends and retained earnings in an optimum way so as to achieve the objective of
wealth maximization for shareholders. Such a policy will be influenced by investment
opportunities available to the firm and value of dividends as against capital gains to
shareholders.

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RELATIONSHIP BETWEEN RETAINED EARNINGS AND GROWTH:

DETERMINANTS OF DIVIDEND DECISIONS:

I. Availability of funds: If the business is in requirement of funds, then retained
earnings could be a good source.

II. Cost of capital: If the financing requirements are to be executed through debt
(relatively cheaper source of finance), then it would be preferable to distribute
more dividend.

III. Capital structure: An optimum Debt Equity ratio should also be considered for
the dividend decision.

IV. Stock price: Stock price here means market price of the shares. Generally, higher
dividends increase market value of shares and low dividends decrease the value.

V. Internal rate of return (IRR): If the internal rate of return (IRR) is more than the
cost of retained earnings (Kr), it is better to distribute the earnings as much as
possible.

VI. Trend of industry: The investors depend on some industries for their regular
dividend income.

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VII. Expectation of shareholders: The shareholders can be categorised into two
categories:
a. those who invests for regular income,
b. those who invests for growth.

THEORIES OF DIVIDEND:
Dividend’s Relevance Theory:
1. WALTER’S MODEL:
Walter’s approach is based on the following assumptions:
• All investment proposals of the firm are to be financed through retained earnings only.
• ‘r’ rate of return & ‘Ke’ cost of capital are constant.
• Perfect capital markets: The firm operates in a market in which all investors are
rational and information is freely available to all.
• No taxes or no tax discrimination between dividend income and capital appreciation
(capital gain). It means there is no difference in taxation of dividend income or capital
gain. This assumption is necessary for the universal applicability of the theory, since,
the tax rates may be different in different countries.
• No floatation or transaction cost: Similarly, these costs may differ country to country
or market to market.
• The firm has perpetual life.

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Advantages of Walter’s Model:
1. The formula is simple to understand and easy to compute.
2. It can envisage different possible market prices in different situations and considers
internal rate of return, market capitalisation rate and dividend pay-out ratio in the
determination of market value of shares.

Limitations of Walter’s Model:

1. The formula does not consider all the factors affecting dividend policy and share
prices. Moreover, determination of market capitalisation rate is difficult.
2. Further, the formula ignores such factors as taxation, various legal and contractual
obligations, management policy and attitude towards dividend policy and so on.

2. GORDON’S MODEL:
According to Gordon’s model, dividend is relevant and dividend policy of a company
affects its value.
Assumptions of Gordon’s Model:
This model is based on the following assumptions:
• Firm is an all-equity firm i.e., no debt.
• IRR will remain constant, because change in IRR will change the growth rate and
consequently the value will be affected. Hence this assumption is necessary.
• Ke will remain constant, because change in discount rate will affect the present value.
• Retention ratio (b), once decide upon, is constant i.e., constant dividend pay-out ratio
will be followed.
• Growth rate (g = br) is also constant, since retention ratio and IRR will remain
unchanged and growth, which is the function of these two variables will remain
unaffected.

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Advantages of Gordon’s Model:
1. The dividend discount model is a useful heuristic model that relates the present stock
price to the present value of its future cash flows.
2. This Model is easy to understand.

Limitations of Gordon’s Model:

1. The dividend discount model depends on projections about company growth rate and
future capitalization rates of the remaining cash flows, which may be difficult to
calculate accurately.
2. The true intrinsic value of a stock is difficult to determine realistically.

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 Walter’s Model

1. Z Co. Ltd. has an investment of Rs. 10,00,000 in equity share of Rs.100 each. The
profitability rate of the company is 16%. Pay out ratio is 80%. Cost of capital is 10%.
What will be the price per share as per Walter’s Model? Do you consider the given pay
out ratio as optimum? [2009]
2. XYZ Ltd. earns Rs 10/ share. Capitalization rate and return on investment are 10%
and 12% respectively. DETERMINE the optimum dividend pay-out ratio and the price
of the share at the pay out.
Solution: Since r > Ke , the optimum dividend pay-out ratio would ‘Zero’ (i.e. D = 0),
Accordingly, value of a share:
P = [0 + 0.12/0.10 x (10 - 0)]/0.10
= Rs 120
The optimality of the above pay out ratio can be proved by using 25%, 50%, 75% and
100% as pay- out ratio:
At 25% pay-out ratio
P = [2.5+ 0.12/0.10(10 - 2.5)]/0.10
P = Rs 115
At 50% pay-out ratio
P = [5+ 0.12/0.10 (10 - 5)]/0.10
P =Rs 110
At 75% pay-out ratio
P = [7.5+ 0.12/0.10 (10 - 7.5)]/0.10
P = Rs 105
At 100% pay-out ratio
P = [10+ 0.12/0.10 (10 -10)]/0.10
P = Rs 100
3. From the following information, calculate the market value of equity share of a
company as per Walter’s model :

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Earnings after tax — Rs. 15,00,000; number of equity shares outstanding — 3,00,000;
Dividend paid— Rs. 6,00,000; Price earning ratio — 10; Rate of return on investment
— 20%.
What is optimum dividend pay-out ratio in this case? [2011]
4. From the following data, calculate the value of an Equity Share of each of the
following three companies according to Walter’s Model when dividend pay out ratio is
(a) NIL, (b) 25% and (c) 75%
Companies M Ltd. L Ltd. N Ltd.
Internal rate of return (r) 15% 12% 10%
Cost of capital (K) 12% 12% 12%
Earnings per share (E) Rs. 10 Rs. 10 Rs. 10
What conclusion would you draw from your observation? [2014]

Gordon’s Model

5. The following figures are collected from the annual report of XYZ Ltd.: Net Profit `
30 lakhs Outstanding 12% preference shares Rs 100 lakhs. No. of equity shares 3 lakhs
Return on Investment 20% Cost of capital i.e. (Ke) 16%.
CALCULATE price per share using Gordon’s Model when dividend pay-out is (i) 25%;
(ii) 50% and (iii) 100%.
SOLUTION:
Net Profit 30
Less: Preference dividend 12
Earning for equity shareholders 18
Therefore earning per share 18/3
= Rs 6.00
Price per share according to Gordon’s Model is calculated as follows:
𝐸1(1 − 𝑏)
𝑃𝑜 =
𝐾𝑒 − 𝑏𝑟

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E1 = Rs 6 Ke = 16%
(i) When dividend pay-out is 25%
P0 = (0 6×0.25)/0.16-(0.75×0.2) = 150
(ii) When dividend pay-out is 50%
P0 = (0 6×0.5)/0.16-(0.5×0.2) = 50
(iii) When dividend pay-out is 100%
P0 =(0 6×1)/0.16-(0×0.2) =37.50

6. The following information is acquired from XYZ Ltd. Net earnings –Rs. 1,00,000.
Equity Capital 5,000 share of Rs. 10 each, cost of capital 10% expected rate of return
(i) 9%, (ii) 10% and (iii) 12%.
Assuming the dividend pay out ratio are 0%, 50% and 100% respectively determine the
effect of different dividend policies on the share price of XYZ Ltd. for the above
mentioned three alternatives’ levels of return using Gordon’s model. [2008]
7. Given Earnings per share is Rs 90. Calculate market price per share of a company
using Gordon’s model when dividend pay out is (i) 30% (ii) 60% assuming that :
(a) The company is a growth company (r>k) when r = 20%
(b) The company is a normal company (r=k) when r = k = 15%
(c) The company is a declining company (r<k) when r = 12% Also comment on
the result. [2015]

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