CA.

DINESH JAIN FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT
BY CA. DINESH JAIN
QUESTION BANK

DEDICATED TO MY
LOVABLE FATHER [RAMESH
JAIN]

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TABLE OF CONTENTS

Distribution Of Marks ................................................................................................ 3

Chapter 3: Financial Analysis and Planning – Ratio Analysis ............................ 4
Chapter 4: Cost of Capital ......................................................................................... 53
Chapter 5: Financing Decisions – Capital Structure ............................................ 93
Chapter 6: Financing Decisions – Leverages....................................................... 128
Chapter 7A: Time Value of Money ....................................................................... 150
Chapter 7B: Investment Decisions ........................................................................ 154
Chapter 8: Dividend Decisions.............................................................................. 218
Chapter 9: Management of Working Capital ...................................................... 234
APPENDIX ................................................................................................................ 293

Edition Details:
• Third Edition – Sep 2024
• Second Edition– Apr 2024
• First Edition – July 2023
Coverage Details:
• Material covers all questions of ICAI study material, RTP till Sep 2024,
Suggested answers till May 2024 and MTP till Sep 2024

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Distribution Of Marks

Chapter M N M N N Jan Jul N M N M N M Average

18 18 19 19 20 21 21 21 22 22 23 23 24
1 4 2 0 3 4 4 2 2 2 0 0 2 2 2.08
2 6 8 6 4 4 2 4 4 2 6 6 4 4 4.62
3 5 5 5 5 5 5 10 10 5 5 10 5 5 6.15
4 0 0 5 14 5 10 10 5 10 11 10 10 5 7.31
5 10 15 10 0 10 10 5 10 10 7 10 12 5 8.77
6 5 10 10 10 10 10 10 10 10 10 7 5 5 8.62
7 22 12 10 8 7 12 12 10 14 20 10 10 8 11.92
8 0 5 5 5 5 5 5 5 4 0 5 10 4 4.46
9 10 10 10 10 10 9 9 10 10 9 9 9 9 9.54
Total 62 67 61 59 60 67 67 66 67 68 67 67 47

Questions to be revised to cover maximum concepts:

Chapter Question No. Number of Questions
Chapter 3 1,2,3,4,6,10,13,15,16,18,19,22,24,25 14
Chapter 4 6,7,8,9,10,12,15,16,19,22,23,25,27,28,30,33,34,36 18
Chapter 5 2,3,5,6,9,11,13,16,17,23,24 11
Chapter 6 1,3,5,6,9,10,12,15,17 9
Chapter 7 1,4e,5,6,9,11,13,15,16,17,21,23,25,27,29,31,34,36,37 19
Chapter 8 2,4,7,8,11,12,14,17,18,19,20,22 12
Chapter 9 2,4,5,7,9,11,13,14,17,19,21,26,28,29,32,33,35,38,42,44,45,47 22
Total 105

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Chapter 3: Financial Analysis and Planning – Ratio Analysis

Overview:
• Computation of ratios
• Dupont framework for ROE computation
• Preparing balance sheet and income statement from ratios
• Interpretation and comments based on ratios

Part 1 – Computation of Ratios

1. Computation of Liquidity ratios

Calculate current ratio, liquid ratio, absolute liquidity ratio and basic defense interval from the balance
sheet of ABC Limited as at 31st March 2015
Liabilities [Link] Assets [Link]
Equity Shares 1,600 Land 1,240
Preference Shares 800 Plant 2,400
Securities Premium 160 Furniture 360
General Reserve 1160 Stock 1,060
Profit & Loss A/c 280 Debtors 940
10 lakh 12.5 % convertible debentures 2,000 Cash 130
Bills payable 160 Bank 600
Trade creditors 280 Bills receivable 270
Outstanding expenses 120
Provision for Tax 440
Total 7,000 Total 7,000
Daily operating expenses can be taken as 10 lacs
Answer:
Current Current Assets 1,060 + 940 + 130 + 600 + 270 3:1 (or)
Ratio Current Liabilities 160 + 280 + 120 + 440 3 Times
Quick Quick Assets 940 + 130 + 600 + 270 1.94:1
Ratio Current Liabilities 160 + 280 + 120 + 440 (or)
1.94
Times
Absolute Cash + Marketable securities 130 + 600 0.73:1
liquidity Current Liabilities 160 + 280 + 120 + 440 (or)
ratio 0.73
Times
Basic Cash + Net receivables + Marketable securities 130 + 600 + 940 + 270 194
defense Daily operating expenses 10 days
interval
(days)

2. Computation of Capital Structure Ratios

ABC Limited presents to you the following Balance Sheet as on March 31, 2015:
Liabilities [Link] Assets [Link]
Equity capital 500 Fixed assets 1,150
Less: Depreciation 275 875
14% Preference capital 100 Investments 300
General Reserve 400 Stock 250
Profit & Loss A/c 210 Debtors 150
Less: Provision 15 135
14% Debentures 200 Bank 65
Sundry Creditors 300 Preliminary Expenditure 85

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Total 1,710 Total 1,710
P&L A/c include Rs.200 lakhs made this year. Calculate a) Debt – equity b) Capital Gearing Ratio and C)
Proprietary ratio d) Debt ratio e) Equity ratio f) Debt to total assets ratio
Assumption Area:
• Consider Preference as part of equity shareholders’ funds
• Consider total debt and total outside liabilities as debt for computation of Debt-equity ratio and
debt to total assets ratio

Answer:
Computation of debt ratio:
Debt 200
Debt Ratio = = = 0.1509 Times (or)15.09%
Capital employed 1,325
• Debt = 14% debentures = Rs.200
• Capital employed = Debt + Equity + Preference= 200 + 500 + 400 + 210 – 85 + 100 = Rs.1,325
Note: Fictitious assets (Preliminary expenditure) is to be subtracted while computing amount of
equity.
Computation of equity ratio:
Equity 1,125
Equity Ratio = = = 0.8491 Times (or) 84.91%
Capital employed 1,325
• It is assumed that preference capital forms part of owners’ funds (equity). In practical
world, preference capital will either form part of equity capital or debt depending on
characteristics. If the preference capital is contributed by promoters then we can treat is
part of equity for all analysis
• Equity = 500 + 400 + 210 – 85 + 100 = Rs.1,125
Computation of debt-equity ratio:
Formula 1:
Total debt 200
Debt − equity ratio = = = 0.1778 Times
Equity 1,125
Formula 2:
Total outside liabilities 200 + 300
Debt − equity ratio = = = 0.4444 Times
Equity 1,125
Computation of Proprietary Ratio:
Proprietor ′ s funds 1,125
Proprietary Ratio = = = 0.6923 Times (or) 69.23%
Total Assets 1,710 − 85
Computation of debt to total assets ratio:
Formula 1:
Total debt 200
Debt to total asssets ratio = = = 0.1231 Times
Total assets 1,625
Formula 2:
Total outside liabilities 200 + 300
Debt to total assets ratio = = = 0.3077 Times
Total Assets 1,625
Computation of capital gearing ratio:
• For the purpose of capital gearing ratio, preference capital will always form part of fixed
charge bearing capital
• Revised equity = 1,125 – 100 = Rs.1,025
• Fixed charge bearing capital = Debt + Preference = 200 + 100 = Rs.300
Fixed charge bearing capital 300
Capital gearing ratio = = = 0.2927 Times
Equity 1,025

3. Computation of Profitability Ratios

ABC Limited has the following profit and loss account for the year ended 31 st March, 2015 and the balance
sheet as on that date:

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Profit and Loss Account for the year ended March 31, 2015
Particulars [Link] Particulars [Link]
Opening Stock 1.75 Sales: Credit 12.00
Add: Manufacturing cost 10.75 Cash 3.00
Less: Closing Stock (1.50)
Cost of goods sold 11.00
Gross Profit 4.00
Total 15.00 Total 15.00
Administrative expense 0.35 Gross Profit 4.00
Selling expense 0.25
Depreciation 0.41
Interest 0.47
Income-tax 1.26
Net Profit 1.26
Total 4.00 Total 4.00
Balance sheet as on March 31, 2015
Liabilities [Link] Assets [Link]
Equity Shares of Rs.10 each 3.50 Plant and Machinery 10.00
10% Preference Shares 2.00 Less: Depreciation 2.50
Reserves and surplus 2.00 Net Plant and Machinery 7.50
Long-term loan (12%) 1.00 Goodwill 1.40
Debentures (14%) 2.50 Stock 1.50
Creditors 0.60 Debtors 1.00
Bills Payable 0.20 Pre-paid expenses 0.25
Accrued expenses 0.20 Marketable securities 0.75
Provision for tax 0.65 Cash 0.25
Total 12.65 Total 12.65
The company had declared dividend of 10 percent on Preference capital and 20 percent on equity capital.
The company had repaid loans of Rs.0.50 lacs in last year.
Calculate the following ratios:
• Gross Profit Margin
• Net Profit Margin
• Pre-tax Profit Ratio
• Operating profit ratio
• COGS Ratio
• Operating Expenses Ratio
• Operating ratio
• Financial Expenses Ratio
• Return on capital employed (ROCE)
• Return on shareholders’ equity
• Return on assets
• Interest coverage
• Debt service coverage ratio
• Preference dividend coverage ratio
• Equity dividend coverage ratio
• Fixed charges coverage ratio
Answer:
Important principle of ratio analysis:
• A ratio can connect one item from P&L and another item from balance sheet (or) two items from
P&L (or) two items from balance sheet
• If a ratio takes an item from P&L and another item from balance sheet, then we should take
average numbers for balance sheet item if available in question. For example: Debtors turnover
ratio, ROCE, ROCE etc.
Computation of GP Ratio:

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Gross profit 4
GP Ratio = x 100 = x 100 = 26.67%
sales 15
Computation of NP Ratio:
Net profit 1.26
NP Ratio = x 100 = x 100 = 8.40%
sales 15
Computation of pre-tax profit ratio:
Profit before Tax 1.26 + 1.26
Pre − tax Profit Ratio = x 100 = x 100 = 16.80%
Sales 15
Computation of operating profit ratio:
Operating Profit 2.99
Operating Profit Ratio = x 100 = x 100 = 19.93%
Sales 15
• Operating profit = Gross Profit – operating expenses
• Operating expenses = 0.35 + 0.25 +0.41 = 1.01
• Operating profit = 4.00 – 1.01 = Rs.2.99
Computation of COGS Ratio:
COGS 11
COGS Ratio = x 100 = x 100 = 73.33%
Sales 15
• COGS = Sales – Gross Profit = 15 – 4 =Rs.11.00
Computation of Operating Expenses Ratio:
Operating expenses 1.01
Operating Expenses Ratio = x 100 = x 100 = 6.73%
Sales 15
Computation of Operating Ratio:
COGS + Operating expenses 11 + 1.01
Operating Ratio = x 100 = x 100 = 80.07%
Sales 15
Computation of Financial Expenses Ratio:
Financial Expenses 0.47
Financial Expenses Ratio = x 100 = x 100 = 3.13%
Sales 15
Computation of interest coverage ratio:
EBIT 2.99
Interest coverage = = = 6.36 Times
Interest 0.47

• EBIT = PAT + Tax + Interest = 1.26 + 1.26 + 0.47 = 2.99

Computation of Debt service coverage ratio:
PAT + Depreciation + Interest 1.26 + 0.41 + 0.47
DSCR = = = 2.21 Times
Interest + Principal 0.47 + 0.50
Computation of preference dividend coverage ratio:
PAT 1.26
Preference dividend coverage = = = 6.30 Times
Preference Dividend 0.20
Computation of equity dividend coverage ratio:
EAES 1.26 − 0.20
Equity dividend coverage = = = 1.51 Times
Equity Dividend 0.70
Computation of fixed charges coverage ratio:
EBIT + Depreciation 2.90 + 0.41 3.31
Fixed charges coverage ratio = = = = 3.41 Times
Interest + Instalment 0.47 + 0.50 0.97
Computation of Return on Capital Employed (ROCE):
EBIT 2.99
Pre − tax ROCE = = x 100 = 27.18 percent
Capital Employed 3.50 + 2.00 + 2.00 + 1.00 + 2.50
EBIT x (1 − Tax) 2.99 x (1 − 0.50)
Post − tax ROCE = = x 100 = 13.59 percent
Capital Employed 3.50 + 2.00 + 2.00 + 1.00 + 2.50
Computation of ROE:
EAES 1.06
ROE = = x 100 = 19.27%
Amount of equity 3.50 + 2.00
Computation of Return on assets:
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PBT 2.52
Pre − tax ROA = = x 100 = 19.92%
Total Assets 12.65
PAT 1.26
Post − tax ROA = = x 100 = 9.96%
Total Assets 12.65

4. Computation of Turnover ratios

The Balance Sheet of ABC Limited as on March 31, 2015 is given below:
Liabilities [Link] Assets [Link]
Equity capital 60 Plant 45
Reserves and surplus 18 Furniture 5
Creditors 12 Stock 18
Debtors 12
Bank 10
Total 90 Total 90
The other details are
• Total sales during the year have been Rs.100 lakh out of which cash sales amounted to Rs.20 lakh
• The gross profit has been earned @ 20%
• Amount ([Link] lakhs) as on 1.4.2014
o Debtors = 8
o Stock = 14
o Creditors = 3
• Cash paid to creditors during the year was Rs.21 lakh
Calculate:
a) Debtors turnover ratio b) Working capital turnover ratio c) Creditors turnover ratio d) Fixed asset
turnover ratio e) Stock turnover ratio and f) Total asset turnover ratio g) Capital Turnover ratio h) Current
assets turnover ratio
Answer:
Computation of Debtors Turnover Ratio:
Credit sales 80 80
Debtors Turnover Ratio = = = = 8 Times
Average Debtors 8 + 12 10
2
Computation of working capital Turnover Ratio:
Total Sales 100 100
Working capital Turnover Ratio = = = = 3.57 Times
Working Capital 18 + 12 + 10 − 12 28
Computation of Creditors Turnover Ratio:
Credit Purchases 30 30
Creditors Turnover Ratio = = = = 4 Times
Average Creditors 12 + 3 7.5
2
• Credit purchases =12 + 21 – 3 = 30 lacs
Computation of Fixed Assets Turnover Ratio:
Sales 100
Fixed Assets Turnover Ratio = = = 2 Times
Fixed Assets 50
Computation of Stock Turnover Ratio:
Cost of Goods Sold 100 − 20 80
Stock Turnover Ratio = = = = 5 Times
Average stock 18 + 14 16
2
Computation of Total Assets Turnover Ratio:
Sales 100
Total Assets Turnover Ratio = = = 1.11 Times
Total Assets 90
Computation of Capital Turnover Ratio:
Sales 100
Capital Turnover Ratio = = = 1.28 Times
Capital Employed 60 + 18
Computation of Current Assets Turnover Ratio:
Sales 100 100
Current Assets Turnover Ratio = = = = 2.50 Times
Current Assets 18 + 12 + 10 40

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5. Computation of return on capital employed [May 2021 MTP]

Compute the return on capital employed (total asset basis) from the following information relating to
companies X and Y.
Particulars Company X Company Y
Net sales for the year 3,25,000 ?
Total Assets ? 55,500
Net profit on sales 4% 17%
Turnover of total assets 5 Times ?
Gross Margin 38% 5,720 (25%)

Answer:
Computation of Return on capital employed:
EBIT
ROCE = x 100
Capital Employed
• In this question Net profit will be taken as proxy for EBIT
• Total assets will be taken as capital employed as indicated in question

Particulars Company X Company Y

Gross Profit 1,23,500 5,720
[3,25,000 x 38%]
Sales 3,25,000 22,880
[5,720 /25%]
Asset Turnover ratio 5 Time 0.41
[Sales/Assets] [22,880/55,550]
Total Assets 65,000 55,550
[Sales/Asset Turnover Ratio] [3,25,000/5]
Net Profit 13,000 3,890
[Sales x Net profit margin] [3,25,000 x 4%] [22,880 x 17%]
ROCE 20.00% 7.00%
[Net profit/Total Assets] [13,000/65,000] [3,890/55,550]

6. Computation of proprietor’s funds [May 2013]

The following information relates to Beta Limited for the year ended 31 st March 2013:
Net working capital 12,00,000
Fixed assets to Proprietor’s Fund Ratio 0.75
Working capital Turnover Ratio 5 Times
Return on Equity (ROE) 15%
There is no debt capital
You are required to calculate:
a) Proprietor’s Fund
b) Fixed Assets
c) Net Profit Ratio
Answer:
Computation of fixed assets and Proprietor’s funds:
Fixed assets
= 0.75; 𝐅𝐀 = 𝟎. 𝟕𝟓𝐏𝐅
Proprietor ′ s funds
Capital Employed = Fixed Assets + Net working capital
PF = 0.75PF + 12,00,000; 0.25PF = 12,00,000; PF = Rs. 48,00,000
Fixed assets = 48,00,000 x 75% = Rs.36,00,000

Computation of Net profit ratio:

Net profit
ROE = 15%; = 15%; Net profit = 15% x 48,00,000 = 𝐑𝐬. 𝟕, 𝟐𝟎, 𝟎𝟎𝟎
Proprietor funds

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Sales Sales
Working capital Turnover = ;5 = ; Sales = 𝐑𝐬. 𝟔𝟎, 𝟎𝟎, 𝟎𝟎𝟎
Working Capital 12,00,000
PAT 7,20,000
Net profit Ratio = x100 = x 100 = 12%
Sales 60,00,000

7. Computation of working capital data [May 2020 MTP, Nov 2012, Nov 2023, Sep 2024 MTP]
The following accounting information and financial ratios of M Limited relate to the year ended 31 st March,
2012:
Particulars Amount
Inventory Runover Ratio 6 Times
Creditors Turnover Ratio 10 Times
Debtors Turnover Ratio 8 Times
Current Ratio 2.4 Times
Gross Profit Ratio 25%
Total sales Rs.30,00,000; Cash sales = 25% of credit sales; Cash Purchases 2,30,000; working capital =
2,80,000; Closing inventory is Rs.80,000 more than opening inventory
You are required to calculate:
(i) Average inventory
(ii) Purchases
(iii) Average Debtors
(iv) Average Creditors
(v) Average Payment Period
(vi) Average Collection Period
(vii) Current Assets
(viii) Current Liabilities
Answer:
Note 1: Computation of Average Inventory:
Gross Profit = 25% of sales
COGS = 75% of sales = 75% x 30,00,000 = Rs.22,50,000
COGS
Inventory Turnover Ratio =
Average Inventory
22,50,000
6= ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 = 𝟑, 𝟕𝟓, 𝟎𝟎𝟎
Average Inventory

Note 2: Computation of Purchases:

COGS = Opening stock + Purchases – Closing stock
22,50,000 = (Opening stock – Closing stock) + Purchases
22,50,000 = -80,000 + Purchases; Purchases = Rs.23,30,000

Note 3: Computation of Average Debtors:

Cash Sales + Credit sales = Total sales
0.25 Credit sales + Credit sales = Total Sales
1.25 credit sales = Rs.30,00,000
Credit sales = (30,00,000/1.25) = Rs.24,00,000
Credit Sales
Debtors Turnover Ratio =
Average Debtors
24,00,000
8= ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐝𝐞𝐛𝐭𝐨𝐫𝐬 = 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
Average Debtors

Note 4: Computation of Average Creditors:

Credit purchases = Total purchases – Cash Purchases
Credit Purchases = 23,30,000 – 2,30,000 = Rs.21,00,000

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Credit Purchases
Creditors Turnover Ratio =
Average creditors
21,00,000
10 = ; 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐫𝐞𝐝𝐢𝐭𝐨𝐫𝐬 = 𝐑𝐬. 𝟐, 𝟏𝟎, 𝟎𝟎𝟎
Average creditors

Note 5: Computation of average payment period:

365 365
Average Payment Period = = = 36.50 days
Creditors Turnover Ratio 10

Note 6: Computation of Average Collection period:

365 365
Average Collection Period = = = 45.625 days
Debtors Turnover Ratio 8

Note 7: Computation of Current Assets and Current Liabilities:

Current Assets CA
Current Ratio = ; 2.4 = ; 𝐂𝐀 = 𝟐. 𝟒𝐂𝐋
Current Liabilities CL
Net working capital = 2,80,000; 𝐂𝐀 − 𝐂𝐋 = 𝟐, 𝟖𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2.4CL − CL = 2,80,000; 1.4CL = 2,80,000; 𝐂𝐋 = 𝐑𝐬. 𝟐, 𝟎𝟎, 𝟎𝟎𝟎
CA = 2,00,000 x 2.40 = Rs.4,80,000

8. Computation of few ratios [SM]

MN Limited gives you the following information related for the year ended 31 st March, 2016:
Current Ratio 2.5:1
Debt-equity ratio 1:1.5
Return on total assets (after tax) 15%
Total assets turnover ratio 2
Gross Profit Ratio 20%
Stock Turnover Ratio 7
CMP per equity share 16
Net working capital 4,50,000
Fixed Assets 10,00,000
60,000 Equity shares of Rs.10 each
20,000 9% preference shares of Rs.10 each
Opening stock Rs.3,80,000
You are required to calculate:
• Quick ratio
• Fixed assets turnover ratio
• Proprietary ratio
• Earnings per share
• Price-earnings ratio
Assumption Area:
• Consider Current liabilities to be part of debt and preference capital to be part of equity for debt-
equity ratio

Answer:
Note 1: Computation of Current Assets and Current Liabilities:
Current Assets CA
Current Ratio = ; 2.5 = ; 𝐂𝐀 = 𝟐. 𝟓𝐂𝐋
Current Liabilities CL
Net working capital = 4,50,000; 𝐂𝐀 − 𝐂𝐋 = 𝟒, 𝟓𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2.5CL − CL = 4,50,000; 1.5CL = 4,50,000; 𝐂𝐋 = 𝐑𝐬. 𝟑, 𝟎𝟎, 𝟎𝟎𝟎
CA = 3,00,000 x 2.5 = Rs.7,50,000

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Note 2: Computation of sales:

Sales Sales
Total Assets Turnover ratio = ;2 =
Total Assets Fixed assets + Current assets
Sales
2= ; 𝐒𝐚𝐥𝐞𝐬 = 𝟐 𝐱 𝟏𝟕, 𝟓𝟎, 𝟎𝟎𝟎 = 𝐑𝐬. 𝟑𝟓, 𝟎𝟎, 𝟎𝟎𝟎
10,00,000 + 7,50,000

Note 3: Computation of COGS:

GP = 20% of sales; COGS = 80% of sales = 80% x 35,00,000 = Rs. 28,00,000

Note 4: Computation of average stock:

COGS 28,00,000
Stock Turnover ratio = ;7 =
Average Stock Average stock
28,00,000
Average stock = = Rs. 4,00,000
7

Note 5: Computation of closing stock:

Opening stock + Closing stock 3,80,000 + Closing stock
Average stock = ; 4,00,000 =
2 2
Closing stock = (2 x 4,00,000) − 3,80,000 = Rs. 4,20,000

Note 6: Computation of Proprietary funds:

Debt 1
= ; Equity = 1.5 debt; Proprietary funds = 1.5debt
Equity 1.5
• Total assets = Rs.17,50,000
• Debt + Proprietary funds = Total assets
• Debt +1.5 debt = 17,50,000
• 2.5 debt = 17,50,000; Debt = Rs.7,00,000
• Proprietary funds = 1.5 x 7,00,000 = Rs.10,50,000
It is assumed that current liabilities from part of debt for the above formula and preference capital form
part of proprietary funds (equity)

Note 7: Computation of Profit after tax:

PAT PAT
Return on total assets = ; 15% =
Total Assets 17,50,000
PAT = 17,50,000 x 15% = Rs. 2,62,500

Note 8: Solution:
Quick ratio Quick Assets 7,50,000 − 4,20,000 1.1:1 (or) 1.1
Current Liabilities 3,00,000 Times
Fixed assets Total Sales 35,00,000 3.50 Times
turnover ratio Fixed Assets 10,00,000
Proprietary ratio Proprietary funds 10,50,000 0.6 Times
Total Assets 17,50,000
EPS PAT − Preferene Dividend 2,62,500 − (9% x 2,00,000) Rs.4.075 per
No of shares 60,000 share
Price-earnings MPS 16 3.926 Times
ratio EPS 4.075

9. Calculation of missing information [May 2017, May 2022 RTP, Nov 2023, SM]
Following information relate to a concern:
Debtors Velocity 3 months
Creditors Velocity 2 months

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Stock Turnover Ratio 1.5 Times
Gross Profit Ratio 25%
Bills receivables Rs.25,000
Bills payables Rs.10,000
Gross Profit Rs.4,00,000
Fixed assets turnover ratio 4
Opening stock is Rs.10,000 is less than closing stock
Calculate:
(a) Sales and cost of goods sold
(b) Sundry debtors
(c) Sundry creditors
(d) Closing stock
(e) Fixed assets
Answer:
Note 1: Computation of sales and COGS:
Gross Profit 4,00,000
GP Ratio = ; 25% = ; 𝐒𝐚𝐥𝐞𝐬 = 𝐑𝐬. 𝟏𝟔, 𝟎𝟎, 𝟎𝟎𝟎
Sales Sales
• Cost of goods sold = Sales – Gross Profit
• Cost of Goods sold = 16,00,000 – 4,00,000 = Rs.12,00,000

Note 2: Computation of sundry debtors:

3 3
Accounts receivables = Sales x = 16,00,000 𝑥 = 𝑅𝑠. 4,00,000
12 12
• Accounts’ receivable = Debtors + Bills’ receivables
• 4,00,000 = Debtors + 25,000; Debtors = Rs.3,75,000

Note 3: Computation of closing stock:

COGS 12,00,000
Stock Turnover Ratio = ; 1.5 = ; Average stock = 8,00,000
Average stock Average stock
• Let us assume closing stock as X and hence opening stock will be X – 10,000
Opening stock + Closing Stock
Average Stock =
2
X − 10,000 + X
8,00,000 = ; 16,00,000 + 10,000 = 2X; X = Rs. 8,05,000
2
• Hence closing stock is equal to Rs.8,05,000

Note 4: Computation of sundry creditors:

Opening stock + Purchases – Closing stock = COGS
7,95,000 + Purchase – 8,05,000 = 12,00,000; Purchases = Rs.12,10,000
2 2
Accounts payables = Purchases x = 12,10,000 x = Rs. 2,01,667
12 12
• Accounts’ payable = Creditors + Bills’ payable
• 2,01,667= Creditors + 10,000; Creditors= Rs.1,91,667

Note 5: Computation of fixed assets:

Fixed Assets Turnover Ratio = 4
Sales 16,00,000
= 4; = 4; 𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 = 𝐑𝐬. 𝟒, 𝟎𝟎, 𝟎𝟎𝟎
Fixed Asssets Fixed Assets

10. Calculation of ratios

The balance sheet of Musa Limited is given for your consideration:
(in ‘000s)
Liabilities Amount Assets Amount
Capital and Reserves 355 Net Fixed Assets 265

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P&L Credit Balance 7 Cash 1
Loan from SFC 100 Receivables 125
Bank Overdraft 38 Stocks 128
Creditors 26 Prepaid expenses 1
Provision for Tax 9 Intangible Assets 30
Proposed Dividend 15
Total 550 Total 550
Based on the above information, you are required to compute the following ratios:
a) Current Ratio
b) Quick Ratio
c) Debt Equity Ratio
d) Proprietary Ratio
e) Net working capital
f) If Net sales is Rs.15 lac, then what would be the stock turnover ratio in times?
g) Debtors velocity ratio if the sales are Rs.15 lacs
h) Creditors velocity ratio if purchases are Rs.10.5 lacs
Answer:
Note 1: Computation of current ratio:
Current Assets 1 + 125 + 128 + 1
Current Ratio = = = 2.90: 1 (or) 2.90 Times
Current Liabilities 38 + 26 + 9 + 15

Note 2: Computation of Quick Ratio:

Quick Assets 255 − 128 − 1
Quick Ratio = = = 1.43: 1 (or) 1.43 Times
Current Liabilities 38 + 26 + 9 + 15

Note 3: Computation of Debt-Equity Ratio:

Total Debt 100 + 38
Debt − Equity Ratio = = = 0.42 Times
Equity 355 + 7 − 30

Note 4: Computation of Proprietary Ratio:

Proprietor Funds 362 − 30
Proprietary Ratio = = = 0.64 Times
Total Assets 550 − 30

Note 5: Computation of Net working capital:

• Net working capital = Current assets – Current liabilities (excluding short-term borrowings)
• Net working capital = 255 – 50 = 205

Note 6: Computation of stock turnover ratio:

Sales 15,00,000
Stock Turnover Ratio = = = 11.72 Times
Stock 1,28,000

Note 7: Computation of Debtor velocity ratio:

Debtors 1,25,000
Debtor Velocity Ratio = x 12 months = x 12 = 1 Month
Sales 12,00,000

Note 8: Computation of Creditors velocity ratio:

Creditors 26,000
Creditor Velocity Ratio = x 12 months = x 12 = 0.30 Month
Purchases 10,50,000

11. Computation of Ratios (May 2022)

Following information and ratios are given for W Limited for the year ended 31st March, 2022:
Equity share capital of Rs.10 each Rs.10,00,000
Reserves and Surplus to Shareholders’ fund 0.50
Sales/Shareholders’ fund 1.50
Current Ratio 2.50

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Debtors Turnover Ratio 6.00
Stock Velocity 2 Months
Gross Profit Ratio 20%
Net working capital turnover ratio 2.50
You are required to calculate:
• Shareholders' Fund
• Stock
• Debtors
• Current liabilities
• Cash Balance.
Answer:
Note 1: Computation of shareholders’ fund:
Reserves and Surplus 0.50
=
Shareholders fund 1
Reserves and Surplus = 0.50 Shareholders ′ Fund
Reserves and surplus is 50 percent of shareholders’ fund and share capital is balance 50 percent of
shareholders fund
• Share capital = 50 percent of shareholders’ fund
• 10,00,000 = 50 percent of shareholders’ fund
Shareholders’ funds = Rs.20,00,000

Note 2: Computation of sales:

Sales
= 1.50
Shareholders fund
Sales
= 1.50
20,00,000
Sales = 1.50 x 20,00,000 = Rs.30,00,000

Note 3: Computation of debtors:

Credit Sales
Debtors Turnover Ratio =
Debtors
30,00,000
6 Times =
Debtors
30,00,000
Debtors = = Rs. 5,00,000
6

Note 4: Computation of stock:

Gross Profit = 20 percent of sales
COGS = 80 percent of sales
COGS = 80 percent x 30,00,000 = Rs. 24,00,000
2 2
Stock = COGS x = 24,00,000 x = Rs. 4,00,000
12 12

Note 5: Computation of Net Working Capital:

Sales
Net working capital turnover ratio =
Net Working Capital
30,00,000
2.50 Times =
Net Working Capital
30,00,000
Net Working Capital = = Rs. 12,00,000
2.50

Note 6: Computation of Current Assets and Current Liabilities:

Current Assets
Current Ratio =
Current Liabilities
CA
2.50 Times =
CL
CA = 2.5 CL
Net working capital = Current Assets – Current Liabilities
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12,00,000 = 2.5CL – CL
1.5CL = 12,00,000
Current liabilities = Rs.8,00,000
Current Assets = 8,00,000 x 2.50 = Rs.20,00,000

Note 7: Computation of Cash:

Current Assets = Debtors + Inventory + Cash
20,00,000 = 5,00,000 + 4,00,000 + Cash
Cash = Rs.11,00,000

12. Computation of Multiple Ratios [May 2024]

Theme Ltd provides you the following information:
12.5% Debt Rs.45,00,000
Debt to Equity Ratio 1.5:1
Return on shareholders’ fund 54%
Operating Ratio 85%
Ratio of operating expenses to Cost of Goods sold 2:6
Tax rate 25%
Fixed Assets Rs.39,00,000
Current Ratio 1.8:1
You are required to calculate:
(i) Interest Coverage Ratio
(ii) Gross Profit Ratio
(iii) Current Assets
Answer:
WN 1: Computation of Interest Coverage Ratio:
EBIT 27,22,500
Interest coverage ratio = = = 4.84 Times
Interest 5,62,500
• 12.5% debt = Rs.45,00,000; Debt to equity is 1.5:1 and hence equity is Rs.30,00,000
• EAT = 54% of 30,00,000 = Rs.16,20,000
• Tax rate = 25%; Hence EAT = 75% of EBT
• EBT = [16,20,000/0.75] = Rs.21,60,000
• Interest = 45,00,000 x 12.50% = Rs.5,62,500
• EBIT = EBT + Interest = 21,60,000 + 5,62,500 = Rs.27,22,500

WN 2: Computation of Gross Profit Ratio

COGS + Operating expenses
Operating ratio =
Sales
3 OE + OE
0.85 = ; 0.85 Sales = 4OE; Operating expenses = 21.25% of sales
Sales
• Operating expenses and COGS are in the ratio of 2:6. Hence COGS is 3 times of operating
expenses
• COGS is 3 times of operating expenses and hence the same is 63.75% of sales
• GP = 100 – 63.75% = 36.25% of Sales
• Gross Profit Ratio = 36.25%

WN 3: Computation of Current Assets

• Capital Employed = Long-term debt + Equity = 45,00,000 + 30,00,000 = Rs.75,00,000
• Capital Employed = Fixed Assets + Working capital
• 75,00,000 = 39,00,000 + Working capital; Working Capital = Rs.36,00,000
Current Assets CA
Current Ratio = ; 1.80 = ; 1.80CL = CA
Current Liabilities CL
• Working capital = Current Assets – Current Liabilties
• 36,00,000 = 1.80CL – CL
• Current Liabilities = (36,00,000/0.80) = Rs.45,00,000
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• Current Assets = 45,00,000 x 1.80 = Rs.81,00,000

Part 2 – Dupont Framework for ROE computation

13. DUPONT Model [Nov 2018]

A Limited company’s books reveal following information:
Particulars Amount
Net income Rs.3,60,000
Shareholders’ equity Rs.4,00,000
Assets Turnover 2.5 Times
Net Profit Margin 12%
You are required to calculate ROE (Return on Equity) of the company based on the ‘Dupont Model’.
Answer:
PAT 3,60,000
ROE as per normal formula = x 100 = x 100 = 90%
Equity 4,00,000

ROE as per Dupont Model:

ROE = Net profit margin x Assets Turnover x Equity Multiplier
𝐑𝐎𝐄 = 𝟏𝟐% 𝐱 𝟐. 𝟓𝟎 𝐱 𝟑 = 𝟗𝟎%

Note: Computation of equity multiplier:

Computation of sales:
Net profit 3,60,000
= 0.12; = 0.12; Sales = Rs. 30,00,000
sales Sales
Computation of total assets:
Sales 30,00,000 30,00,000
Asset Turnover = 2.5; = 2.5; = 2.5; Assets = = Rs. 12,00,000
Assets Assets 2.5
Computation of Equity Multiplier
Assets 12,00,000
Equity Multiplier = = = 3 Times
Equity 4,00,000

Part 3 – Preparing balance sheet and income statement from ratios

14. Comprehensive
The balance sheet of ABC Limited as on March 31, 2015 is as under:
Liabilities [Link] Assets [Link]
Share capital Fixed Assets
2,00,000 Equity shares of 100 each fully 200 Gross Block 500
paid Less: Depreciation 160 340
7.5 % Preference shares 100 Current Assets
General Reserve 60 Stock 80
Debentures 60 Debtors 80
Sundry creditors 80
Total 500 Total 500
The company wishes to forecast the Balance Sheet as on 31st March 2016. The following additional
information is available
• The fixed assets turnover ratio on the basis of gross value of fixed assets would be 1.5
• The stock turnover ratio would be 12 (calculated on the basis of average stock)
• The break-up of cost and profit would be as follows:
Materials 40%
Labour 25%
Manufacturing expenses 15%
Office and selling expenses 5%
Depreciation 5%

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Profit 10%
100%
• The profit is subject at taxation at 50 percent
• Debtors would be 1/10 of sales
• Creditors would be 1/5 of material consumed
• In March 2015 equity dividend @10 percent has been declared
You are required to forecast balance sheet as on 31st March 2016
Answer:
Balance sheet of ABC Limited as on March 31, 2016:
Liabilities Amount Assets Amount
(in lacs) (in lacs)
Share capital: Fixed Assets:
Equity share capital 200.00 Gross Block 500.00
Preference share capital 100.00 Less: Depreciation (160 + 37.50) -197.50 302.50
General Reserve (60 + 10) 70.00 Current Assets:
Debentures 60.00 Stock (Note 3) 20.00
Sundry creditors (1/5 x 300) 60.00 Debtors (1/10 x 750) 75.00
Cash (balancing figure) 92.50
Total 490.00 490.00

Note 1: Computation of sales:

Sales Sales
Fixed Assets Turnover Ratio = ; 1.5 = ; Sales = Rs. 750 lacs
Gross Block 500

Note 2: Profit and Loss Statement:

Particulars Calculation Amount
(in lacs)
Sales 750.00
Less: Material cost 750 x 40% -300.00
Less: Labour cost 750 x 25% -187.50
Less: Manufacturing expenses 750 x 15% -112.50
Less: Office and selling expenses 750 x 5% -37.50
Less: Depreciation 750 x 5% -37.50
Profit before tax 75.00
Less: Tax 75 x 50% -37.50
Profit after tax 37.50
Less: Preference dividend 100 x 7.5% -7.50
Less: Equity dividend 200 x 10% -20.00
Retained earnings 10.00

Note 3: Computation of closing stock:

COGS 300 + 187.50 + 112.50
Stock Turnover Ratio = ; 12 =
Average Stock Average stock
600
Average Stock = = Rs. 50 lacs
12
Opening stock + Closing stock
= 50; 80 + Closing stock = 100; 𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤 = 𝐑𝐬. 𝟐𝟎 𝐥𝐚𝐜𝐬
2

15. Trading, Profit and Loss Account and Balance Sheet [SM]
From the following ratios and information given below, PREPARE Trading Account, Profit and Loss
Account and Balance Sheet of Aebece Company:
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Fixed Assets Rs. 40,00,000
Closing Stock Rs. 4,00,000
Stock turnover ratio 10 Times
Gross profit ratio 25 percent
Net profit ratio 20 percent
Net profit to capital 1/5
Capital to total liabilities 1/2
Fixed assets to capital 5/4
Fixed assets/Total current assets 5/7

Assumption Area:
• Assume capital to be not part of total liabilities for capital to total liabilities ratio
Answer:
WN 1: Trading Account and Profit and Loss Account of Aebece Company:
Particulars Amount Particulars Amount
To Opening stock (Note 5) 80,000 By Sales (Note 3) 32,00,000
To Manufacturing expenses/Purchases (b/f) 27,20,000 By Closing stock 4,00,000
To Gross Profit (Note 4) 8,00,000
36,00,000 36,00,000
To Operating expenses (b/f) 1,60,000 By Gross Profit 8,00,000
To Net Profit (Note 3) 6,40,000
Total 8,00,000 8,00,000

WN 2: Balance Sheet of Aebece Company:

Liabilities Amount Assets Amount
Capital (Note 2) 32,00,000 Fixed Assets 40,00,000
Liabilities (Note 2) 64,00,000 Current Assets:
Closing stock 4,00,000
Other current assets (Note 1) 52,00,000
Total 96,00,000 96,00,000

Note 1: Computation of Total Current Assets:

Fixed Assets 5 40,00,000 5 7
= ; = ; 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 = (40,00,000 𝑥 )
Total Current Assets 7 𝑇𝑜𝑡𝑎𝑙 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 7 5
Total Current Assets = 56,00,000
• Closing stock = 4,00,000
• Other Current Assets = 56,00,000 – 4,00,000 = 52,00,000

Note 2: Computation of Capital:

Capital 1
= ; Capital = 0.5 Total liabilities
Total Liabilities 2
• Capital + Total liabilities = Total Assets
• 0.5 TL + TL = 96,00,000
• TL = 64,00,000
• Capital = 32,00,000
• It is assumed that capital does not form part of total liabilities

Note 3: Computation of Net Profit and Sales:

Net Profit 1 Net Profit 1
= ; = ; Net Profit = 6,40,000
Capital 5 32,00,000 5
Net Profit
Net Profit Margin = ( ) 𝑥 100
Sales
6,40,000
20 = ( ) 𝑥 100; Sales = 32,00,000
Sales

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Note 4: Computation of Gross profit and COGS:
Gross Profit = 25 percent of sales = 32,00,000 x 25% = 8,00,000
COGS = 75 percent of sales = 32,00,000 x 75% = 24,00,000

Note 5: Computation of opening stock:

COGS
Stock Turnover Ratio =
Average stock
24,00,000
10 = ; Average stock = 2,40,000
Average stock
• Average stock = 2,40,000
• Closing stock = 4,00,000
• Opening stock = 80,000

16. Constructing Balance Sheet

You are advised by the management of ABC Limited to project a Trading and P&L account and the balance
sheet on the basis of the following estimated figures and profit:
Ratio of gross profit 25%
Stock Turnover ratio 5 times
Average debt collection period 3 months
Creditors velocity 3 months
Current ratio 2 times
Proprietary ratio (Fixed assets to capital employed) 80%
Preference shares and debentures to capital employed 30%
Net profit to issued equity 10%
Reserves & Profit and Loss to issued capital equity 25%
Preference shares to Debentures 2 times
Materials purchased as a proportion of COGS 40%
Gross Profit Rs.1,250 lacs
Answer:
WN 1: Trading and Profit and Loss Account of ABC Limited:
(in lacs)
Particulars Amount Particulars Amount
To Material cost (Note 2) 1,500 By Sales (Note 1) 5,000
To Other direct cost (Note 2) 2,250
To Gross profit 1,250
Total 5,000 Total 5,000
To operating expenses (b/f) 970 By Gross Profit 1,250
To Net Profit (Note 10) 280
Total 1,250 Total 1,250

WN 2: Balance sheet of ABC Limited:

Liabilities Amount Assets Amount
Share capital (Note 9) 2,800 Fixed assets (Note 7) 4,000
Reserves and Surplus (Note 9) 700 Stock (Note 3) 750
Preference shares (Note 11) 1,000 Debtors (Note 4) 1,250
Debentures (Note 11) 500
Creditors (Note 5) 375
Other current liabilities (Note 6) 625
Total 6,000 6,000

Note 1: Computation of Sales:

Gross Profit 1,250 1,250 x 100
GP Margin = x 100; 25 = x 100; Sales = = 5,000 lacs
Sales Sales 25

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Note 2: Computation of Material purchased:
COGS = Sales − Gross Profit; COGS = 5,000 − 1,250 = 3,750 lacs
Material purchased – 40% of COGS = 40% x 3,750 = 1,500 lacs
Other direct cost = 3,750 lacs -1,500 lacs = 2,250 lacs

Note 3: Computation of Stock:

COGS 3,750
Stock Turnover Ratio = ;5 = ; Stock = 750 lacs
stock Stock

Note 4: Computation of Debtors:

Average debt collection period 3
Debtors = Sales x = 5,000 x = 1,250 lacs
12 12

Note 5: Computation of Creditors:

Creditor velocity 3
Creditors = Purchases x = 1,500 x = 375 lacs
12 12

Note 6: Computation of current assets and current liabilities:

• It is assumed that debtors and inventory are the only current assets. Total current assets = 750 +
1,250 = 2,000 lacs
Current Assets 2,000
Current ratio = ; 2 Times = ; Current Liabilities = 1,000 lacs
Current Liabilities Current Liabilities
• Creditors = 375 lacs and hence other current liabilities = Rs.625 lacs

Note 7: Computation of fixed assets and capital employed:

Fixed assets Fixed Assets
Proprietary ratio = ; 0.80 = ;
Capital Employed Capital Employed
𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 = 𝟎. 𝟖𝟎 𝐂𝐚𝐩𝐢𝐭𝐚𝐥 𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝
• Capital employed = Fixed assets + Working capital
• Working capital = Current assets – Current liabilities = 2,000 – 1,000 = 1,000 lacs
• Capital employed = 0.80 capital employed + 1,000 lacs
• 0.20 Capital employed = 1,000 lacs; Capital employed = Rs.5,000 lacs
• Fixed assets = 80% of capital employed = Rs.4,000 lacs

Note 8: Computation of preference shares and debentures:

Preference shares + Debentures
= 30%; Preference shares + Debentures = 30% x 5,000 = 1,500 lacs
Capital Employed
• Preference shares + Debentures = Rs.1,500 lacs
• Shareholders’ equity (Share capital + Reserves & Surplus) = 5,000 lacs – 1,500 lacs = Rs.3,500 lacs

Note 9: Computation of share capital and reserves & Surplus:

Reserves & Surplus
= 25%; Reserves & Surplus = 25% of share capital
Share capital
• Share capital + Reserves & Surplus = Rs.3,500 lacs
• Share capital + 0.25 share capital = Rs.3,500 lacs; 1.25 share capital = Rs.3,500 lacs; Share capital
= 3,500/1.25 = Rs.2,800 lacs
• Reserves and surplus = 25% of share capital = 25% of Rs.2,800 lacs = Rs.700 lacs

Note 10: Computation of Net Profit:

• Net profit = 10% of issued share capital = 10% of Rs.2,800 lacs = Rs.280 lacs

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Note 11: Computation of debentures and preference capital:

Preference shares
= 2; Preference shares = 2 Debentures
Debentures
• Preference shares + Debentures = Rs.1,500 lacs
• 2 Debentures + Debentures = Rs.1,500 lacs
• 3 Debentures = 1,500 lacs; Debentures = Rs.500 lacs
• Preference shares = 2 x 500 lacs = Rs.1,000 lacs

17. Constructing Balance Sheet [Nov 2020 MTP, Nov 2020 RTP, Nov 2018 MTP, May 2017 RTP, Nov
2023 MTP, SM]
From the following information prepare a summarized balance sheet as at 31 st March
Working capital Rs.2,40,000
Bank overdraft Rs.40,000
Fixed assets to proprietary ratio 0.75
Reserves and surplus Rs.1,60,000
Current ratio 2.5
Liquid ratio 1.5
Answer:
Balance sheet as at 31st March:
Liabilities Amount Assets Amount
Proprietor’s Funds Fixed Assets 7,20,000
Share capital (9,60,000 – 1,60,000) 8,00,000 Inventory 1,60,000
Reserves and surplus 1,60,000 Other current assets 2,40,000
Bank overdraft 40,000
Other current liabilities 1,20,000
Total 11,20,000 Total 11,20,000

Note 1: Computation of Current Assets and Current Liabilities:

Current Assets CA
Current Ratio = ; 2.5 = ; 𝐂𝐀 = 𝟐. 𝟓𝐂𝐋
Current Liabilities CL
Net working capital = Rs. 2,40,000; 𝐂𝐀 − 𝐂𝐋 = 𝟐, 𝟒𝟎, 𝟎𝟎𝟎
Substituting CA in NWC formula:
2.5CL − CL = Rs. 2,40,000; 1.5CL = Rs. 2,40,000; 𝐂𝐋 = 𝐑𝐬. 𝟏, 𝟔𝟎, 𝟎𝟎𝟎
CA = 1,60,000 x 2.50 = Rs.4,00,000

Note 2: Computation of inventory:

Quick Assets QA
Liquidity Ratio = ; 1.5 = ; Quick Assets = Rs. 2,40,000
Current Liabilities 1,60,000
Quick Assets = Current Assets – Inventory
2,40,000 = 4,00,000 – Inventory; Inventory = Rs.1,60,000

Note 3: Computation of fixed assets and proprietor’s funds:

Fixed assets
= 0.75; 𝐅𝐀 = 𝟎. 𝟕𝟓𝐏𝐅
Proprietor ′ s funds
It is assumed that there is no debt or preference in the company
Capital Employed = Fixed Assets + Net working capital
PF = 0.75PF + 2,40,000; 0.25PF = 2,40,000; PF = Rs. 9,60,000
Fixed assets = 9,60,000 x 75% = Rs.7,20,000

18. Constructing Balance Sheet [May 2018]

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Using the following information complete the balance sheet given below:
Gross Profits Rs.54,000
Shareholders funds Rs.6,00,000
Gross Profit Margin 20%
Credit sales to total sales 80%
Total assets turnover 0.3 times
Inventory turnover 4 times
Average collection period (a 360 days year) 20 days
Current ratio 1.8 times
Long-term debt to equity 40%

Liabilities Amount Assets Amount

Creditors ? Cash ?
Long-term debt ? Debtors ?
Shareholders funds ? Inventory ?
Fixed Assets ?
? ?
Answer:
Balance Sheet:
Liabilities Amount Assets Amount
Creditors (balancing figure) 60,000 Cash (Note 6) 42,000
Long-term debt 2,40,000 Debtors (Note 2) 12,000
Shareholders’ funds 6,00,000 Inventory (Note 4) 54,000
Fixed Assets (balancing figure) 7,92,000
Total 9,00,000 Total 9,00,000

Note 1: Computation of sales:

Gross profit 54,000
= 0.20; = 0.20; Sales = Rs. 2,70,000
sales Sales

Note 2: Computation of debtors:

Credit Sales = 2,70,000 x 80% = Rs. 2,16,000
20
Debtors = 2,16,000 x ( ) = Rs. 12,000
360

Note 3: Computation of total assets:

Sales 2,70,000
Total Asset Turnover = 0.3; = 0.30; = 0.30
Total Assets Total assets
2,70,000
Total Assets = = Rs. 9,00,000
0.3

Note 4: Computation of inventory:

COGS (80% x 2,70,000)
Inventory Turnover = 4; = 4; =4
Inventory Inventory
2,16,000
Inventory = = Rs. 54,000
4

Note 5: Computation of long-term debt:

Long − term debt Long − term debt
= 0.4; = 0.4;
Equity 6,00,000
Long − term debt = 6,00,000 x 0.40 = Rs. 2,40,000

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Note 6: Computation of cash:
Current Assets Current Assets
Current ratio = 1.80; = 1.80; = 1.80
Current Liabilities 60,000
Current Assets = 60,000 x 1.80 = Rs. 1,08,000
Cash = Current assets – Debtors – Inventory
Cash = 1,08,000 – 12,000 – 54,000 = Rs.42,000

19. Income statement and balance sheet preparation [SM]

Following is the abridged Balance Sheet of Ganesha Limited:
Balance Sheet as on March 31, 2013
Liabilities Amount Assets Amount Amount
Share capital 1,00,000 Land and Buildings 80,000
Profit and Loss Account 17,000 Plant and Machinery 50,000
Current Liabilities 40,000 Less: Depreciation (15,000) 35,000
1,15,000
Current Assets:
Stock 21,000
Debtors 20,000
Bank 1,000 42,000
Total 1,57,000 Total 1,57,000
With the help of the additional information furnished below, you are required to prepare Trading and
Profit & Loss Account and a Balance Sheet as on 31st March, 2014:
• The company went in for reorganization of capital structure, with share capital remaining the
same as follows:
Share capital 50%
Other shareholders’ Funds 15%
5% Debentures 10%
Trade Creditors 25%
• Debentures were issued on 1st April, interest being paid annually on 31 st March
• Land and Buildings remain unchanged. Additional Plant and Machinery has been bought and a
further Rs.5,000 depreciation written off. (The total fixed assets then constituted 60% of total fixed
and current assets)
• Working capital ratio was 8:5
• Quick assets ratio was 1:1
• The debtors (four-fifths of the quick assets) to sales ratio revealed a credit period of 2 months.
There were no cash sales
• Return on Networth was 10%
• Gross profit was at the rate of 15% of selling price
• Stock turnover was eight times for the year
• Ignore taxation
Answer:
WN 1: Trading and Profit and Loss Account for the period ended 31 st March 2014
Particulars Amount Particulars Amount
To Opening stock 21,000 By Sales (Note 5) 2,40,000
To Cost of goods sold (b/f) 2,13,000 By Closing stock 30,000
To Gross Profit (15% of sales) 36,000
Total 2,70,000 Total 2,70,000
To Debenture interest (5% x 20,000) 1,000 By Gross Profit 36,000
To Administration and other expenses [b/f] 22,000
To Net Profit [10% of 1,30,000] 13,000
Total 36,000 Total 36,000

WN 2: Balance Sheet as on 31st March 2014:

Liabilities Amount Assets Amount
Share capital [Note 1] 1,00,000 Land and Building [Note 2] 80,000
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Profit and Loss A/c [Note 1] 30,000 Plant and machinery 60,000 40,000
Less: Depreciation (20,000)
5% Debentures [Note 1] 20,000 Stock (Note 4) 30,000
Trade creditors [Note 1] 50,000 Debtors (Note 4) 40,000
Bank (Note 4) 10,000
Total 2,00,000 Total 2,00,000

Note 1: Computation of liabilities side:

• Share capital of the company would remain same at Rs.1,00,000 and this would now comprise 50%.
Other items on liabilities side are computed as under:
Liabilities % Amount
Share capital 50 1,00,000
Other shareholders’ funds 15 30,000
[Reserves and surplus]
5% Debentures 10 20,000
Trade creditors 25 50,000
Total 100 2,00,000

Note 2: Computation of fixed assets:

Particulars Calculation Amount
Fixed assets 60% of total assets 1,20,000
Total assets = Total Liabilities of Rs.2,00,000
60% x 2,00,000
Land and building Will remain same 80,000
Plant and machinery Balance fixed assets 40,000
Accumulated depreciation 15,000 + 5,000 20,000
Gross Plant and Machinery 60,000

Note 3: Computation of working capital

Particulars Calculation Amount
Current assets Total assets – Fixed assets 80,000
2,00,000 – 1,20,000
Current liabilities Trade creditors 50,000
Working capital 30,000

Note 4: Computation of inventory, debtors and cash:

Particulars Calculation Amount
Quick assets Quick assets = Current liabilities 50,000
Quick ratio is 1 time
Current assets 80,000
Inventory Current assets – Quick assets 30,000
Debtors (4/5) of quick assets 40,000
(4/5) x 50,000
Cash Current assets – inventory – debtors 10,000
80,000 – 30,000 – 40,000

Note 5: Computation of sales:

Debtors
Debtor credit period = x 12 months
Sales
40,000 40,000 x 12
2= x 12 months; Sales = = 𝑅𝑠. 2,40,000
Sales 2

20. Preparation of Balance Sheet [May 2021 MTP, May 2013 RTP, May 2015, July 2021, SM]
T Ltd. has furnished the following ratios and information relating to the year ended 31st March, 2021
Sales Rs.600 lacs

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Return on Networth 25%
Rate of income tax 40%
Share capital to reserves 7:3
Current Ratio 2
Net-profit to sales (after tax) 6.25%
Inventory turnover (based on COGS and Closing stock) 12
Cost of goods sold Rs.180 lacs
Interest on debentures (@ 15%) Rs.6,00,000
Trade receivables Rs.20,00,000
Trade Payables Rs.20,00,000
You are required to:
• Calculate the operating expenses for the year ended 31st March 2021
• Prepare a balance sheet as on March 31, 2021
Answer:
WN 1: Computation of operating expenses for the year ended 31st March 2021:
Particulars Amount
Sales (Given) 6,00,00,000
Less: Cost of goods sold (Given) (1,80,00,000)
Gross Profit 4,20,00,000
Less: Operating expenses (b/f) 3,51,50,000
EBIT [Reverse worked] 68,50,000
Less: Interest 6,00,000
EBT [37,50,000/(1 -40%)] 62,50,000
Less: Tax (25,00,000)
EAT [6,00,00,000 x 6.25%] 37,50,000

WN 2: Balance Sheet as on March 31, 2021:

Liabilities Amount Assets Amount
Share capital (Note 1) 1,05,00,000 Fixed assets (b/f) 1,70,00,000
Reserves and Surplus (Note 1) 45,00,000 Closing stock (Note 2) 15,00,000
15% debentures [6,00,000/15%] 40,00,000 Trade receivables (Given) 20,00,000
Trade payables (Given) 20,00,000 Cash and Bank (Note 3) 5,00,000
Total 2,10,00,000 2,10,00,000

Note 1: Computation of share capital and Reserves:

PAT
Return on Networth =
Networth
37,50,000 37,50,000
25% = ; Networth = = 1,50,00,000
Networth 25%
• Share capital and reserves are in the ratio of 7:3. Hence 7/10 of networth is share capital and
3/10 of networth is reserves
• Amount of share capital = 1,50,00,000 x (7/10) = Rs.1,05,00,000
• Amount of reserves = 1,50,00,000 x (3/10) = Rs.45,00,000

Note 2: Computation of closing stock:

COGS
Inventory Turnover Ratio =
Closing Stock
1,80,00,000 1,80,00,000
12 = ; Closing stock = = 15,00,000
Closing stock 12

Note 3: Computation of cash and bank:

Current Assets
Current Ratio =
Current Liabilities

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Current Assets
2= ; Current Assets = Rs. 40,00,000
20,00,000
• Current assets = Inventory + Receivables + Cash
• 40,00,000 = 15,00,000 + 20,00,000 + Cash
• Cash = 5,00,000

21. Constructing Balance Sheet [Sep 2024 MTP, SM]

Gig Ltd. has furnished the following information relating to the year ended 31st March, 2022 and 31st
March, 2023:
31st March 2022 31st March 2023
Share Capital 40,00,000 40,00,000
Reserves and Surplus 20,00,000 25,00,000
Long-term loan 30,00,000 30,00,000
• Net profit ratio: 8%
• Gross profit ratio: 20%
• Long-term loan has been used to finance 40% of the fixed assets.
• Stock turnover with respect to cost of goods sold is 4.
• Debtors represent 90 days sales.
• The company holds cash equivalent to 1½ months cost of goods sold.
• Ignore taxation and assume 360 days in a year.
You are required to PREPARE Balance Sheet as on 31st March, 2023 in the following format:
Liabilities Amount Assets Amount
Share capital - Fixed Assets -
Reserves and surplus - Sundry debtors -
Long-term loan - Closing stock -
Sundry creditors - Cash in hand -
Answer:
Balance Sheet as on 31st March 2023:
Liabilities Amount Assets Amount
Share capital 40,00,000 Fixed Assets (Note 1) 75,00,000
Reserves and surplus 25,00,000 Sundry debtors (Note 2) 15,62,500
Long-term loan 30,00,000 Closing stock (Note 2) 12,50,000
Sundry creditors (b/f) 14,37,500 Cash in hand (Note 2) 6,25,000
Total 1,09,37,500 Total 1,09,37,500
Note 1: Computation of Fixed Assets:
Long term loan = 40% of fixed assets
30,00,000 = 40% of fixed assets; Fixed assets = 75,00,000

Note 2: Computation of Sundry debtors, Closing stock and Cash in hand:

Net profit = 8% of sales
Net profit = Increase in reserves = Rs.5,00,000
5,00,000 = 8% of sales
Sales = Rs. 62,50,000
COGS = 62,50,000 x 80% = Rs. 50,00,000
Debtors = Sales x (90/360) = 62,50,000 x 90/360 = Rs.15,62,500
Cash = COGS x (1.5/12) = 50,00,000 x (1.5/12) = Rs.6,25,000
Stock = (COGS/4) = 50,00,000/4 = Rs.12,50,000

22. Income statement and Balance Sheet (Nov 2022 RTP, SM)
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The following information of ASD Ltd. relate to the year ended 31st March, 2022:
Net Profit 8% of sales
Raw Materials Consumed 20% of Cost of Goods Sold
Direct Wages 10% of Cost of Goods Sold
Stock of Raw Materials 3 months’ usage
Stock of Finished Goods 6% of Cost of Goods Sold
Gross Profit 15% of sales
Debt collection period 2 months
(All sales are on credit)
Current ratio 2:1
Fixed assets to current assets 13:11
Fixed assets to sales 1:3
Long-term loans to current liabilities 2:1
Capital to Reserves and Surplus 1:4

You are required to prepare:

(a) Profit & Loss Statement of ASD Limited for the year ended 31st March, 2022 in the following
format.
Particulars Amount Particulars Amount
To Direct Materials Consumed ? By Sales ?
To Direct Wages ?
To Works (Overhead) ?
To Gross Profit C/d ?
Total ? Total ?
To Selling and distribution expenses ? By Gross Profit b/d ?
To Net Profit ?
Total ? Total ?

(b) Balance Sheet as on 31st March, 2022 in the following format.

Liabilities Amount Assets Amount
Share Capital ? Fixed Assets 1,30,00,000
Reserves and Surplus ? Current Assets:
Long term loans ? Stock of Raw Material ?
Current Liabilities ? Stock of Finished Goods ?
Debtors ?
Cash ?
Total ? Total ?
Answer:
WN 1: Profit & Loss Statement of ASD Limited for the year ended 31st March, 2022:
Particulars Amount Particulars Amount
To Direct Materials Consumed (Note 4) 66,30,000 By Sales (Note 3) 3,90,00,000
To Direct Wages (Note 4) 33,15,000
To Works (Overhead) (Note 4) 2,32,05,000
To Gross Profit C/d [15% x 3,90,00,000] 58,50,000
Total 3,90,00,000 Total 3,90,00,000
To Selling and distribution expenses (b/f) 27,30,000 By Gross Profit b/d 58,50,000
To Net Profit (8% x 3,90,00,000) 31,20,000
Total 58,50,000 Total 58,50,000

WN 2: Balance Sheet as on 31st March, 2022:

Liabilities Amount Assets Amount
Share Capital (Note 9) 15,00,000 Fixed Assets 1,30,00,000
Reserves and Surplus (Note 9) 60,00,000 Current Assets:
Long term loans (Note 8) 1,10,00,000 Stock of Raw Material (Note 5) 16,57,500
Current Liabilities (Note 2) 55,00,000 Stock of Finished Goods (Note 5) 19,89,000
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Debtors (Note 6) 65,00,000
Cash (Note 7) 8,53,500
Total 2,40,00,000 Total 2,40,00,000

Note 1: Computation of Current Assets:

Fixed Assets 13
=
Current Assets 11
1,30,00,000 13
=
Current Assets 11
Current Assets = 1,10,00,000

Note 2: Computation of Current Liabilities:

Current Assets
Current Ratio =
Current Liabilities
1,10,00,000
2=
Current Liabilities
Current Liabilities = Rs.55,00,000

Note 3: Computation of Sales:

Fixed Assets 1
=
Sales 3
1,30,00,000 1
=
Sales 3
Sales = Rs.3,90,00,000

Note 4: Computation of Direct Material consumed, Direct wages and Works overhead:
Gross Profit = 15% of Sales
COGS = 85% of sales
COGS = 85% x 3,90,00,000 = Rs.3,31,50,000
Raw material consumed = 20% of COGS
RM consumed = 20% x 3,31,50,000 = Rs.66,30,000
Direct wages = 10% of COGS
Direct wages = 10% x 3,31,50,000 = Rs.33,15,000
COGS = Direct material + Direct wages + Works OH
3,31,50,000 = 66,30,000 + 33,15,000 + Works OH
Works OH = Rs2,32,05,000

Note 5: Computation of stock of raw material and stock of FG

3
Stock of Raw Material = RM Consumed x
12
3
Stock of Raw Material = 66,30,000 x = Rs. 16,57,500
12
Stock of FG = 6% of COGS
Stock of FG = 6% x 3,31,50,000 = Rs.19,89,000

Note 6: Computation of debtors

2 2
𝐷𝑒𝑏𝑡𝑜𝑟𝑠 = 𝑆𝑎𝑙𝑒𝑠 𝑥 = 3,90,00,000 𝑥 = 𝑅𝑠. 65,00,000
12 12

Note 7: Computation of cash:

Current Assets = Stock of RM + Stock of FG + Debtors + Cash
1,10,00,000 = 16,57,500 + 19,89,000 + 65,00,000 + Cash
Cash = 8,53,500

Note 8: Computation of Long-term loans:

Long term loans 2
=
Current Liabilities 1

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Long term loans 2
=
55,00,000 1
Long-term loans = 1,10,00,000

Note 9: Computation of capital and reserves and surplus:

Networth = Total Assets – Current liabilities – Long-term debt
Networth = 2,40,00,000 – 55,00,000 – 1,10,00,000
Networth = Rs.75,00,000
Capital 1
=
Reserves 4
Reserves = 4 Capital
Networth = Rs.75,00,000
Capital + Reserves = 75,00,000
Capital + 4 capital = 75,00,000
Capital = Rs.15,00,000
Reserves = 15,00,000 x 4 = Rs.60,00,000

23. Ratio Analysis (Nov 2022 MTP, May 2024 RTP, SM):
From the following information and ratios, PREPARE the Balance sheet as at 31st March 2022 and lncome
statement for the year ended on that date for M/s Ganguly & Co:
Average Stock Rs.10,00,000
Current Ratio 3:1
Acid Test Ratio 1:1
PBIT to PBT 2.2:1
Average collection period (Assume 360 days in a year) 30 days
Stock Turnover Ratio (Use Sales as turnover) 5 Times
Fixed assets turnover ratio 0.8 Times
Working Capital Rs.10,00,000
Net Profit Ratio 10%
Gross Profit Ratio 40%
Operating expenses (excluding interest) Rs.9,00,000
Long-term loan interest 12%
Tax Nil
Answer:
WN 1: Income statement for the year ended 31 st March 2022:
Particulars Amount
Sales (Note 3) 50,00,000
Less: COGS (60% of sales) -30,00,000
Gross Profit (40% of sales) 20,00,000
Less: Operating expenses -9,00,000
PBIT 11,00,000
Less: Interest (b/f) -6,00,000
PBT/PAT [50,00,000 x 10%] 5,00,000

WN 2: Balance Sheet as on 31st March, 2022:

Liabilities Amount Assets Amount
Share capital (b/f) 22,50,000 Fixed Assets (Note 6) 62,50,000

Long term loan 50,00,000 Current Assets:

(6,00,000/12%)
Current Liabilities (Note 1) 5,00,000 Inventory (Note 2) 10,00,000
Debtors (Note 4) 4,16,667
Others (Note 5) 83,333
Total 77,50,000 Total 77,50,000

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Note 1: Computation of Current Assets and Current Liabilities:
Current Assets
Current Ratio =
Current Liabilities
CA
3=
CL
CA = 3CL
Working capital = Current Assets – Current Liabilities
10,00,000 = 3CL – CL
Current Liabilities = 10,00,000/2 = Rs.5,00,000
Current Assets = 5,00,000 x 3 = Rs.15,00,000

Note 2: Computation of Closing Inventory:

Quick Assets
Acid Test Ratio =
Current Liabilities
Quick Assets
1=
5,00,000
Quick Assets = 5,00,000
Current Assets – Inventory = Quick Assets
15,00,000 – Inventory = 5,00,000
Inventory = Rs.10,00,000

Note 3: Computation of Sales:

Sales
Stock Turnover Ratio =
Average Stock
𝑆𝑎𝑙𝑒𝑠
5=
10,00,000
Sales = Rs.50,00,000

Note 4: Computation of Debtors:

30
Debtors = Sales x
360
30
Debtors = 50,00,000 x = Rs. 4,16,667
360

Note 5: Computation of other current assets:

Other Current assets = Total current assets – stock - debtors
Other current assets = 15,00,000 – 10,00,000 – 4,16,667
Other Current Assets = Rs.83,333

Note 6: Computation of fixed assets:

Sales
Fixed Assets Turnover Ratio =
Fixed Assets
50,00,000
0.80 =
Fixed Assets
Fixed assets = Rs.62,50,000

24. Preparation of Balance Sheet [Nov 2020 MTP, May 2019]

Using the information given below, complete the balance sheet of PQR Private Limited:
Current Ratio 1.6:1
Cash and Bank Balance 15% of total current assets
Debtors Turnover Ratio 12 Times
Stock Turnover (cost of Goods Sold) ratio 16 Times
Creditors Turnover (cost of Goods sold) ratio 10 Times
Gross Profit Ratio 20%
Capital Gearing Ratio 0.6
Depreciation rate 15% on WDV
Net Fixed Assets 20% of total assets

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(Assume all purchase and sales are on credit)
Balance Sheet of PQR Private Limited as at 31.03.2019
Liabilities Amount Assets Amount
Share capital 25,00,000 Fixed Assets
Reserves and Surplus ? Opening WDV ?
12% Long term debt ? Less: Depreciation ? ?
Current Liabilities Current Assets:
Creditors ? Stock ?
Provisions & outstanding 68,50,000 Debtors ?
Expenses ?
Cash and bank ? ?
Total ? Total ?
Answer:
Balance Sheet of PQR Private Limited as at 31.03.2019
Liabilities Amount Assets Amount
Share capital 25,00,000 Fixed Assets
Reserves and Surplus (Note 4) 17,81,250 Opening WDV (Note 2) 32,23,529
12% Long term debt (Note 4) 25,68,750 Less: Depreciation (Note 2) 4,83,529 27,40,000
Current Liabilities Current Assets:
Creditors (Note 3) 55,89,600 Stock (Note 3) 34,93,500
Provisions & outstanding 68,50,000 Debtors (Note 3) 58,22,500
Expenses (Note 3) 12,60,400
Cash and bank (Note 1) 16,44,000 1,09,60,000
Total 1,37,00,000 Total 1,37,00,000

Note 1: Computation of Current Assets and Cash:

Current Assets Current assets
Current Ratio = ; 1.6 =
Current Liabilities 68,50,000
Current assets = 68,50,000 x 1.60 = Rs.1,09,60,000
Cash and Bank balance = 15% x 1,09,60,000 = Rs.16,44,000

Note 2: Computation of Total Assets, Fixed assets and depreciation:

Fixed assets = 20% of total assets; Current assets = 80% of total assets;
Current assets 1,09,60,000
Total assets = = = Rs. 1,37,00,000
80% 80%
Fixed assets = Total assets – Current assets
Fixed assets = 1,37,00,000 – 1,09,60,000 = Rs.27,40,000
Depreciation is at 15% of opening WDV. Hence closing assets is 85% of opening WDV
Closing WDV = Rs. 27,40,000; 85% x Opening WDV = Rs. 27,40,000;
27,40,000
Opening WDV = = Rs. 32,23,529
85%
Depreciation = Opening WDV – Closing WDV = 32,23,529 – 27,40,000 = Rs.4,83,529

Note 3: Calculation of Stock, Debtors, creditors and Provisions:

Stock + Debtors = Current Assets − Cash
Stock + Debtors = 1,09,60,000 − 16,44,000 = Rs. 93,16,000
Let us assume sales to be X. GP Margin is 20% and hence COGS will be 0.8X
Sales X X
Debtors Turnover Ratio = ; 12 = ; Debtors =
Debtors Debtors 12
COGS 0.8X 0.8X
Inventory Turnover Ratio = ; 16 = ; Stock =
Stock Stock 16
Stock + Debtors = Rs. 93,16,000
X 0.8𝑋 4𝑋 + 2.4𝑋
+ = 𝑅𝑠. 93,16,000; = 93,16,000; 6.4𝑋 = 93,16,000 𝑥 48;
12 16 48
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93,16,000 x 48
X= = 𝑅𝑠. 6,98,70,000
6.4
Sales = Rs.6,98,70,000; COGS = 80% x 6,98,70,000 = Rs.5,58,96,000
Debtors = 6,98,70,000/12 = Rs.58,22,500
Inventory = 5,58,96,000/16 = Rs.34,93,500
Creditors = 5,58,96,000/10 = Rs.55,89,600
Provision and outstanding expenses = Current liabilities – Creditors
Provision and outstanding expenses = 68,50,000 – 55,89,600 = Rs.12,60,400

Note 4: Computation of Reserves and Surplus and Debt:

Capital Employed = Fixed Assets + Current Assets – Current Liabilities
Capital Employed = 27,40,000 + 1,09,60,000 – 68,50,000 = Rs.68,50,000
Debt Debt
Captial Gearing Ratio = ; 0.6 = ; Debt = 0.6 Equity
Equity Equity
Capital Employed = Debt + Equity = 0.6 Equity + Equity = 1.6 Equity
Capital Employed = 1.60 Equity = Rs. 68,50,000
68,50,000
Equity = = 𝑅𝑠. 42,81,250
1.60
Reserves and surplus = Total Equity – Share capital
Reserves and surplus = 42,81,250 – 25,00,000 = Rs.17,81,250
Long term debt = Capital employed – Equity
Long term debt = 68,50,000 – 42,81,250 = Rs.25,68,750

25. Summarized Balance Sheet [SM]

From the following information, you are required to PREPARE a summarised Balance Sheet for Rudra Ltd.
for the year ended 31st March, 2023:
Debt-Equity Ratio 1:1
Current Ratio 3:1
Acid Test Ratio 5:3
Fixed Assets Turnover (on the basis of Sales) 4
Stock Turnover (on the basis of Sales) 6
Cash in hand 5,00,000
Stock to Debtor 1:1
Sales to Networth 4
Capital to Reserves 1:2
Gross Profit 20% of cost
COGS to creditor 10:1
Interest for entire year is yet to be paid on Long Term loan @ 10%.
Answer:
Balance sheet of Rudra Limited for the year ended 31 st March 2023:
Liabilities Amount Assets Amount
Equity share capital (Note 3) 10,00,000 Fixed assets (1,20,00,000/4) 30,00,000
Reserves and surplus (Note 3) 20,00,000 Current Assets:
10% Long-term debt (1,20,00,000/4) 30,00,000 Stock in Trade (1,20,00,000/6) 20,00,000
Current Liabilities: Debtors (1,20,00,000/6) 20,00,000
Creditors (Note 4) 10,00,000 Cash 5,00,000
Interest payable (30,00,000 x 10%) 3,00,000
Other current liabilities (b/f) 2,00,000
Total 75,00,000 Total 75,00,000

Note 1: Computation of Total Liabilities:

Let us assume sales to be X

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Sales X
Networth = =
4 4
X
Long − term debt = Networth =
4
Current Assets
Current Liabilities =
3
X X Current Assets
Total Liabilities = Total Assets = ( ) + ( ) +
4 4 3
Note 2: Computation of Total Assets:
Sales 𝑋
Fixed assets = =
4 4
Sales 𝑋
Stock = =
6 6
X
Debtors = Stock = ( )
6
Cash = 5,00,000
X x
Total Current Assets = ( ) + ( ) + 5,00,000
6 6
X x x
Total Assets = ( ) + ( ) + ( ) + 5,00,000
4 6 6
x x X X 5,00,000 X x x
( )+( )+( )+( )+ = ( ) + ( ) + ( ) + 5,00,000
4 4 18 18 3 4 6 6
9X + 9X + 2X + 2X + 60,00,000 3X + 2X + 2X + 60,00,000
=
36 12
22X + 60,00,000 = 21X + 1,80,00,000
Sales = 1,20,00,000

Note 3: Computation of capital and reserves:

1,20,00,000
Networth = = 30,00,000
4
Networth = Capital + Reserves
30,00,000 = Capital + 2 Capital
Capital = 10,00,000
Reserves = 20,00,000

Note 4: Computation of Creditors:

1 1
Gross Profit = on cost = on sales
5 6
1
Gross Profit = 𝑥 1,20,00,000 = 20,00,000
6
COGS = 1,00,00,000
Creditor = 1,00,00,000/10 = 10,00,000

26. Ratio Analysis [May 2023]

Following information and ratios are given in respect of AQUA Ltd. for the year ended 31st March, 2023:
Current Ratio 4.0
Acid Test Ratio 2.5
Inventory Turnover Ratio (based on Sales) 6
Average collection period (days) 70
Earnings per share 3.50
Current liabilities 3,10,000
Total Assets Turnover (based on sales) 0.96
Cash Ratio 0.43
Proprietary Ratio 0.48
Total equity dividend 1,75,000
Equity Dividend Coverage Ratio 1.60
Assume 360 days in a year.
You are required to complete Balance Sheet as on 31stMarch, 2023.
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Balance sheet as on 31st March 2023
Liabilities Amount Assets Amount
Equity share capital (Rs.10 per share) XXX Fixed Assets XXX
Reserves and Surplus XXX Inventory XXX
Long-term debt XXX Debtors XXX
Current Liabilities 3,10,000 Loans and advances XXX
Cash and bank XXX
Total XXX Total XXX
Answer:
Liabilities Amount Assets Amount
Equity share capital (Rs.10 per share) (Note 1) 8,00,000 Fixed Assets (Note 3) 16,66,250
Reserves and Surplus (Note 4) 5,95,000 Inventory (Note 2) 4,65,000
Long-term debt (b/f) 12,01,250 Debtors 5,42,500
70
[27,90,000 𝑥 ]
360
Current Liabilities 3,10,000 Loans and advances (b/f) 99,200
Cash and bank (Note 5) 1,33,300
Total 29,06,250 Total 29,06,250

Note 1: Computation of Number of shares and equity capital:

EAES:
EAES 𝐸𝐴𝐸𝑆
Equity Dividend Coverage Ratio = ; 1.60 = ; 𝐸𝐴𝐸𝑆 = 2,80,000
Equity Dividend 1,75,000
Number of shares:
EAES 2,80,000 2,80,000
EPS = ; 3.50 = ; 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 = = 80,000
No of equity shares 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 3.50
Value of equity share capital:
Equity capital = 80,000 shares x 10 =Rs.8,00,000

Note 2: Computation of inventory:

Current Assets:
CA CA
Current ratio = ; 4.00 = ; Current Assets = 12,40,000
CL 3,10,000
Quick Assets:
𝑄𝐴 𝑄𝐴
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = ; 2.50 = ; 𝑄𝑢𝑖𝑐𝑘 𝐴𝑠𝑠𝑒𝑡𝑠 = 7,75,000
𝐶𝐿 3,10,000
Inventory:
• Inventory = Current Assets – Quick Assets
• Inventory = 12,40,000 – 7,75,000 = Rs.4,65,000

Note 3: Computation of Sales and Total Assets:

Sales:
Sales Sales
Inventory Turnover Ratio = ; 6.00 = ; Sales = 27,90,000
Inventory 4,65,000
Total Assets:
𝑆𝑎𝑙𝑒𝑠 27,90,000
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 = ; 0.96 = ; 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 = 29,06,250
𝑇𝐴 𝑇𝐴
Fixed Assets:
• Fixed assets = Total Assets – Current Assets
• Fixed assets = 29,06,250 – 12,40,000 = Rs.16,66,250

Note 4: Computation of Reserves and Surplus:

Proprietor funds:
PF 𝑃𝐹
Proprietary Ratio = ; 0.48 = ; 𝑃𝐹 = 13,95,000
TA 29,06,250

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Reserves and Surplus:
Reserves and surplus = PF – ESC = 13,95,000 – 8,00,000 = Rs.5,95,000

Note 5: Computation of Cash:

Cash:
Cash Cash
Cash Ratio = ; 0.43 = ; Cash = 1,33,300
CL 3,10,000

Part 4 – Interpretation and comments based on ratios

27. Company versus industry comparison [SM]

Following information are available for Navya Limited along with various ratio relevant to the particular
industry it belongs. Give your comments on strength and weakness of Navya Limited comparing its ratios
with the given industry norms
Balance sheet as on 31.03.2017
Liabilities Amount Assets Amount
Equity share capital 48,00,000 Fixed assets 24,20,000
10% Debentures 9,20,000 Cash 8,80,000
Sundry creditors 6,60,000 Sundry debtors 11,00,000
Bills payable 8,80,000 Stock 33,00,000
Other current liabilities 4,40,000
Total 77,00,000 Total 77,00,000

Statement of profitability for the year ending March 31, 2017

Particulars Amount Amount
Sales 1,10,00,000
Less: Cost of goods sold
Material 41,80,000
Wages 26,40,000
Factory overhead 12,98,000 (81,18,000)
Gross Profit 28,82,000
Less: Selling and distribution cost 11,00,000
Less: Administrative cost 12,28,000 (23,28,000)
Earnings before interest and tax (EBIT) 5,54,000
Less: Interest charges (92,000)
Earning before tax 4,62,000
Less: Tax @ 50% (2,31,000)
Earning after tax 2,31,000

Industry Norms:
Ratios Norm
Current assets/current liabilities 2.5
Sales/Debtors 8.0
Sales/stock 9.0
Sales/total assets 2.0
Net profit / sales 3.5%
Net profit / total assets 7.0%
Net profit / networth 10.5%
Total debt / total assets 60%
Answer:
Computation of ratios:
Ratio Navya Limited Industry
Current Assets 52,80,000 2.50
Current Ratio = = 2.67
Current Libilities 19,80,000

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Sales 1,10,00,000 8.00
Receivables Turnover Ratio = = 10.00
Debtors 11,00,000
Sales 1,10,00,000 9.00
Inventory Turnover Ratio = = 3.33
Stock 33,00,000
Sales 1,10,00,000 2.00
Total Assets Turnover Ratio = = 1.43
Total Assets 77,00,000
Net Profit 2,31,000 3.50%
Net Profit Ratio = = 2.10%
Sales 1,10,00,000
Net Profit 2,31,000 7.00%
Return on total assets = = 3.00%
Total Assets 77,00,000
Net Profit 2,31,000 10.50%
Return on Networth = = 4.81%
Networth 48,00,000
Total Debt 29,00,000 60.00%
Debt to assets ratio = = 37.66%
Total Assets 77,00,000
Comments:
• The position of Navya Limited is better than industry norm with respect to current ratios and sales
to debtors ratio
• However, the position of sales to stock and sales to total assets is poor comparing to industry norm.
• The firm also has its net profit ratios, net profit to total assets and net profit to total worth ratio
much lower than the industry norm.
• Total debt to total assets ratio suggest that, the firm is geared at lower level and debt are used to
Asset

28. Performance analysis [SM]

ABC Company sells plumbing fixtures on terms of 2/10, net 30. Its financial statement over the last 3 years
are as follows:
Particulars 2015 2016 2017
Cash 30,000 20,000 5,000
Accounts receivable 2,00,000 2,60,000 2,90,000
Inventory 4,00,000 4,80,000 6,00,000
Net fixed assets 8,00,000 8,00,000 8,00,000
Total 14,30,000 15,60,000 16,95,000
Accounts payable 2,30,000 3,00,000 3,80,000
Accruals 2,00,000 2,10,000 2,25,000
Bank loan, short-term 1,00,000 1,00,000 1,40,000
Long term debt 3,00,000 3,00,000 3,00,000
Common stock 1,00,000 1,00,000 1,00,000
Retained earnings 5,00,000 5,50,000 5,50,000
Total 14,30,000 15,60,000 16,95,000
Sales 40,00,000 43,00,000 38,00,000
Cost of Goods sold 32,00,000 36,00,000 33,00,000
Net Profit 3,00,000 2,00,000 1,00,000
Considering opening balance of Accounts Receivable and Inventory as 2,00,000 and 4,00,000 respectively
as on 01.04.2020, ANALYSE the company’s financial condition and performance over the last 3 years. Are
there any problems?
Answer:
Computation of ratios:
Particulars 2015 2016 2017
Current Ratio 1.19 1.25 1.20
Acid-test ratio 0.43 0.46 0.40
Average collection period 18.25 19.52 26.41
Inventory turnover ratio 8 8.18 6.11
Total debt to networth 1.38 1.40 1.61
Long-term debt to total capitalization 0.33 0.32 0.32
Gross Profit margin 20.0% 16.3% 13.2%
Net profit margin 7.5% 4.7% 2.6%
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Asset Turnover 2.80 2.76 2.24
Return on assets 0.21 0.13 0.06
Note:
Ratios computation for 2015 is shown below. Same formula is used for balance years
Current Assets 30,000 + 2,00,000 + 4,00,000
Current Ratio = = = 1.19 Times
Current Liabilities 2,30,000 + 2,00,000 + 1,00,000
Quick Assets 6,30,000 − 4,00,000
Acid − Test Ratio = = = 0.43 Times
Current Liabilities 5,30,000
2,00,000 + 2,00,000
Average Debtors 2
Average collection period = x 360 = x 365 = 18.25 days
Sales 40,00,000
32,00,000
COGS 4,00,000 + 4,00, ,000
Inventory Turnover ratio = = = 8 Times
Average Stock 2
Total outside liabilities 3,00,000 + 1,00,000 + 2,00,000 + 2,30,000
Total debt to Networth = = = 1.38
Networth 1,00,000 + 5,00,000
Long − term debt 2,00,000
Long − term debt to total capitalization = = = 0.33 𝑇𝑖𝑚𝑒𝑠
Equity 6,00,000
Gross Profit 8,00,000
Gross Profit Margin = 𝑥 100 = 𝑥 100 = 20.0%
Sales 40,00,000
Net Profit 3,00,000
Net Profit Margin = 𝑥 100 = 𝑥 100 = 7.5%
Sales 40,00,000
Sales 40,00,000
Asset Turnover = = = 2.80 Times
Total Assets 14,30,000
Net Profit 3,00,000
Return on assets = = = 0.21
Assets 14,30,000

Analysis : The company’s profitability has declined steadily over the period. As only Rs.50,000 is added to
retained earnings, the company must be paying substantial dividends. Receivables are growing slower,
although the average collection period is still very reasonable relative to the terms given. Inventory
turnover is slowing as well, indicating a relative buildup in inventories. The increase in receivables and
inventories, coupled with the fact that net worth has increased very little, has resulted in the total debt-to-
worth ratio increasing to what would have to be regarded on an absolute basis as a high level.

The current and acid-test ratios have fluctuated, but the current ratio is not particularly inspiring. The lack
of deterioration in these ratios is clouded by the relative build up in both receivables and inventories,
evidencing deterioration in the liquidity of these two assets. Both the gross profit and net profit margins
have declined substantially. The relationship between the two suggests that the company has reduced
relative expenses in 2016 in particular. The build up in inventories and receivables has resulted in a decline
in the asset turnover ratio, and this, coupled with the decline in profitability, has resulted in a sharp
decrease in the return on assets ratio.

29. Usage of ratios [May 2012]

Explain the important ratios that would be used in each of the following situations:
(a) A bank is approached by a company for a loan of RS.50 lacs for working capital purposes
(b) A long-term creditor interested in determining whether his claim is adequately secured
(c) A shareholder who is examining his portfolio and who is to decide whether he should hold or sell
his holding in the company
(d) A finance manager interested to know the effectiveness with which a firm uses its available
resources
Answer:
Important Ratios used in different situations
(i) Liquidity Ratios- Here Liquidity or short-term solvency ratios would be used by the bank to check the
ability of the company to pay its short-term liabilities. A bank may use Current ratio and Quick ratio to
judge short terms solvency of the firm.
(ii) Capital Structure/Leverage Ratios- Here the long-term creditor would use the capital
structure/leverage ratios to ensure the long term stability and structure of the firm. A long-term creditor

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interested in the determining whether his claim is adequately secured may use Debt-service coverage and
interest coverage ratio.
(iii) Profitability Ratios- The shareholder would use the profitability ratios to measure the profitability or
the operational efficiency of the firm to see the final results of business operations. A shareholder may use
return on equity, earning per share and dividend per share.
(iv) Activity Ratios- The finance manager would use these ratios to evaluate the efficiency with which the
firm manages and utilises its assets. Some important ratios are (a) Capital turnover ratio (b) Current and
fixed assets turnover ratio (c) Stock, Debtors and Creditors turnover ratio.

30. Event impact on current ratio [Nov 2018 RTP, Nov 2016 RTP]
Assuming the current ratio of a company is 2, State in each of the following cases whether the ratio will
improve or decline or will have no change:
a) Payment of current liability
b) Purchase of fixed assets by cash
c) Cash collected from customers
d) Bills receivable dishonoured
e) Issue of new shares
Answer:
Current ratio is currently 2 Times. Let us assume current assets is Rs.2,00,000 and current liabilities is
Rs.1,00,000
[Link] Situation Impact Reason
(i) Payment of Improve • Let us assume we have paid cash of Rs.20,000
current liability • Current assets will decline to Rs.1,80,000 and current
liabilities will decline to Rs.80,000 and hence ratio will
improve to 2.25 Times (1,80,000/80,000)
(ii) Purchase of fixed Decline • Let us assume we have paid cash of Rs.20,000
assets by cash • Current assets will decline to Rs.1,80,000 and current
liabilities will remain at Rs.1,00,000 and hence ratio will
decline to 1.80 Times (1,80,000/1,00,000)
(iii) Cash collected No • Let us assume we collected cash of Rs.20,000
from customers change • Current assets will remain same at Rs.2,00,000 and current
liabilities will also remain same. Hence no change in
current ratio
(iv) Bills receivable No • Bills receivable will come down and sundry debtors will
dishonoured change increase
• Hence no change in current assets and current liabilities
(v) Issue of New Improve • Cash will increase and hence current assets will increase
shares • This would lead to improvement in current ratio

Practice Questions

1. Ratios Computation [SM]

In a meeting held at Solan towards the end of 2021-22, the Directors of HPCL Ltd. have taken a decision to
diversify. At present HPCL Ltd. sells all finished goods from its own warehouse. The company issued
debentures on 01.04.2022 and purchased fixed assets on the same day. The purchase prices have remained
stable during the concerned period. Following information is provided to you:
Income Statement:
Particulars 2021-22 (Rs.) 2022-23 (Rs.)
Cash Sales 30,000 32,000
Credit Sales 2,70,000 3,00,000 3,42,000 3,74,000
Less: Cost of goods sold 2,36,000 2,98,000
Gross profit 64,000 76,000
Less: Operating Expenses:
Warehousing 13,000 14,000

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Transport 6,000 10,000
Administrative 19,000 19,000
Selling 11,000 49,000 14,000 57,000
Net Profit 15,000 19,000
Balance Sheet:
Assets & Liabilities 2021-22 (Rs.) 2022-23 (Rs.)
Fixed Assets (Net Block) - 30,000 - 40,000
Receivables 50,000 82,000
Cash at Bank 10,000 7,000
Stock 60,000 94,000
Total Current Assets (CA) 1,20,000 1,83,000

Payables 50,000 76,000

Total Current Liabilities (CL) 50,000 76,000

Working Capital (CA - CL) 70,000 1,07,000

Net Assets 1,00,000 1,47,000

Represented by:
Share Capital 75,000 75,000
Reserve and Surplus 25,000 42,000
Debentures - 30,000
1,00,000 1,47,000
You are required to CALCULATE the following ratios for the years 2021-22 and 2022-23:
• Gross Profit Ratio
• Operating Expenses to Sales Ratio
• Operating Profit Ratio
• Capital Turnover Ratio
• Stock Turnover Ratio
• Net Profit to Net Worth Ratio
• Receivables Collection Period
Ratio relating to capital employed should be based on the capital at the end of the year. Give the reasons
for change in the ratios for 2 years. Assume opening stock of Rs. 40,000 for the year 2021-22. Ignore
Taxation.
Answer:
Particulars Formula 2021-22 2022-23
GP Ratio Gross Profit 64,000 76,000
x 100 x 100 = 21.33% x 100
Sales 3,00,000 3,74,000
= 20.32%
Operating Operating expenses 49,000 57,000
x 100 x 100 = 16.33% x 100
expenses Sales 3,00,000 3,74,000
to sales ratio = 15.24%
Operating Operating Profit 15,000 19,000
x 100 x 100 = 5.00% x 100 = 5.08%
Profit Sales 3,00,000 3,74,000
Ratio
Capital Sales 3,00,000 3,74,000
= 3 Times = 2.54 Times
Turnover Capital Employed 1,00,000 1,47,000
Ratio
Stock Turnover COGS 2,36,000 2,98,000
Ratio Average Stock 40,000 + 60,000 60,000 + 94,000
( ) ( )
2 2
= 4.72 Times = 3.87 Times
NP to NW Net Profit 15,000 19,000
x100 x100 = 15.00% = 16.24%
Ratio Networth 1,00,000 1,17,000

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Receivables Rbles 50,000 82,000
x 365 x 365 = 67.6 Days x 365
Collection Credit Sales 2,70,000 3,42,000
Period = 87.5 Days

2. Computation of Ratio [Nov 2019 RTP]

The following is the Profit and loss account and Balance sheet of KLM LLP.
Trading and Profit & Loss Account
Particulars Amount Particulars Amount
To Opening Stock 12,46,000 By Sales 1,96,56,000
To Purchases 1,56,20,000 By Closing stock 14,28,000
To Gross Profit 42,18,000
2,10,84,000 2,10,84,000
To Administrative expenses 18,40,000 By Gross Profit 42,18,000
To Selling and distribution expenses 7,56,000 By Interest on Investment 24,600
To Interest on Loan 2,60,000 By Dividend Received 22,000
To Net Profit 14,08,600
42,64,000 42,64,000

Balance Sheet as on ……….

Liabilities Amount Assets Amount
Capital 20,00,000 Plant and machinery 24,00,000
Retained earnings 42,00,000 Building 42,00,000
General Reserve 12,00,000 Furniture 12,00,000
Term loan from Bank 26,00,000 Sundry receivables 13,50,000
Sundry payables 7,20,000 Inventory 14,28,000
Other liabilities 2,80,000 Cash and bank balances 4,22,000
1,10,00,000 1,10,00,000
You are required to COMPUTE:
(i) Gross profit ratio (ii) Net profit ratio (iii) Operating cost ratio (iv) Operating profit ratio (v) Inventory
turnover ratio (vi) Current ratio (vii) Quick ratio (viii) Interest coverage ratio (ix) Return on capital
employed (x) Debt-to-assets ratio
Answer:
Gross Profit 42,18,000
Gross Profit Ratio = x 100 = x 100 = 21.46 %
Sales 1,96,56,000
Net Profit 14,08,600
Net Profit Ratio = x 100 = x 100 = 7.17%
Sales 1,96,56,000
COGS + Operating expenses 1,80,34,000
Operating Cost Ratio = x 100 = x 100 = 91,75%
Sales 1,96,56,000

• COGS = 1,96,56,000 – 42,18,000 = 1,54,38,000

• Operating expenses = Admin + Selling = 18,40,000 + 7,56,000 = 25,96,000
• COGS + Operating Expenses = 1,54,38,000 + 25,96,000 = 1,80,34,000
Operating Profit 16,22,000
Operating Profit Ratio = x 100 = x 100 = 8.25%
Sales 1,96,56,000

• Operating Profit = Gross Profit – Admin expenses – Selling expenses

• Operating Profit = 42,18,000 – 18,40,000 – 7,56,000 = 16,22,000
COGS 1,96,56,000 − 42,18,000
Inventory Turnover Ratio = =
Average Stock (12,46,000 + 14,28,000)
2
1,54,38,000
Inventory Turnover Ratio = = 11.55 Times
13,37,000
Current Assets 13,50,000 + 14,28,000 + 4,22,000
Current Ratio = = = 3.20 Times
Current Liabilities 7,20,000 + 2,80,000
Current Assets − Inventory 32,00,000 − 14,28,000
Quick Ratio = = = 1.77 Times
Current Liabilities 7,20,000 + 2,80,000

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EBIT 16,68,600
Interest coverage ratio = = = 6.42 Times
Interest 2,60,000

• EBIT = PAT + Tax + Depreciation + Interest = 14,08,600 + 2,60,000 = 16,68,600

EBIT 16,68,600
ROCE = x 100 = x 100 = 16.69%
Capital Employed 1,00,00,000

• Capital employed = 20,00,000 + 42,00,000 + 12,00,000 + 26,00,000 = 1,00,00,000

26,00,000
Debt to Assets Ratio = x 100 = 23.64%
1,10,00,000

3. Profitability Ratios [SM]

The capital structure of Beta Limited is as follows:
Equity share capital of Rs. 10 each 8,00,000
9% preference share capital of Rs. 10 each 3,00,000
11,00,000
Additional information: Profit (after tax at 35 per cent) Rs. 2,70,000; Depreciation Rs. 60,000; Equity
dividend paid 20 per cent; Market price of equity shares Rs. 40.
You are required to COMPUTE the following, showing the necessary workings:
(a) Dividend yield on the equity shares
(b) Cover for the preference and equity dividends
(c) Earnings per shares
(d) Price-earnings ratio
Answer:
Income statement of Beta Limited:
Particulars Amount
Profit after tax 2,70,000
Less: Preference Dividend (3,00,000 x 9%) -27,000
Earnings available to equity shareholders 2,43,000
No of Equity Shares 80,000
EPS 3.0375
Price-earnings ratio (balancing figure) 13.17
MPS 40.00

Ratios computation:
DPS 2
Dividend Yield = ( ) 𝑥 100 = 𝑥 100 = 5.00%
MPS 40
PAT 2,70,000
Preference Dividend Coverage ratio = = = 10 Times
Preference Dividend 27,000
EAES 2,43,000
Equity Dividend Coverage ratio = = = 1.52 Times
Equity Dividend 1,60,000

4. Computation of ROE [Nov 2020, Nov 2019 MTP, Nov 2022, SM]
MNP Limited has made plans for the next year 2010 -11. It is estimated that the company will employ total
assets of Rs.25,00,000; 30% of assets being financed by debt at an interest cost of 9% p.a. The direct costs for
the year are estimated at Rs..15,00,000 and all other operating expenses are estimated at Rs.2,40,000. The
sales revenue are estimated at Rs.22,50,000. Tax rate is assumed to be 40%. Required to calculate:
(i) Net profit margin;
(ii) Return on Assets;
(iii) Asset turnover; and
(iv) Return on Equity.
Answer:
WN 1: Income statement of MNP Limited
Particulars Calculation Amount
Sales 22,50,000

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Less: Direct cost -15,00,000
Less: Other operating expenses -2,40,000
EBIT 5,10,000
Less: Interest 25,00,000 x 30% x 9% -67,500
EBT 4,42,500
Less: Tax @ 40% 4,42,500 x 40% -1,77,000
EAT 2,65,500

WN 2: Solution:
Note 1: Computation of Net Profit Margin:
Net Profit 2,65,500
Net Profit Margin = x 100 = 𝑥 100 = 11.80%
Sales 22,50,000

Note 2: Computation of Return on assets:

PAT 2,65,500
ROA = x 100 = 𝑥 100 = 10.62%
Total Assets 25,00,000

Note 3: Computation of Asset Turnover:

Sales 22,50,000
Asset Turnover = = = 0.90 Times
Total Assets 25,00,000

Note 4: Computation of Return on Equity:

PAT 2,65,500
ROE = x 100 = 𝑥 100 = 15.17%
Total Equity 17,50,000

5. Calculation of missing information [Nov 2018]

The following is the information of XML Limited relate to the year ended 31 st March 2018:
Gross profit 20% of sales
Net Profit 10% of sales
Inventory Holding Period 3 months
Receivables collection period 3 months
Non-current Assets to Sales 1:4
Non-current assets to current assets 1:2
Current Ratio 2:1
Non-current liabilities to current liabilities 1:1
Share capital to reserves and surplus 4:1
Non-current assets as on 31st March, 2017 Rs.50,00,000
Assume that:
• No change in non-current assets during the year 2017-18
• No depreciation charged on non-current assets during the year 2017-18
• Ignoring tax
You are required to calculate cost of goods sold, Net Profit, Inventory, Receivables and Cash for the year
ended on 31st March, 2018
Answer:
Note 1: Computation of Current Assets:
Non − Current assets 2 50,00,000
= ; =2
Current Assets 1 Current Assets
Current Assets = 2 x 50,00,000 = Rs.1,00,00,000

Note 2: Computation of Sales:

Non − Current assets 1 50,00,000
= ; =4
Sales 4 Sales
Sales = 4 x 50,00,000 = Rs.2,00,00,000

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Note 3: Computation of Cost of Goods Sold:
Gross Profit = 20% of sales; COGS = 80% of sales
COGS = 80% x 2,00,00,000 = Rs.1,60,00,000

Note 4: Computation of Net Profit:

Net Profit = 10% of sales = 10% x 2,00,00,000 = Rs. 20,00,000

Note 5: Computation of inventory:

3 3
Inventory = COGS x = 1,60,00,000 x = Rs. 40,00,000
12 12

Note 6: Computation of receivables:

3 3
Receivables = Sales x = 2,00,00,000 x = Rs. 50,00,000
12 12

Note 7: Computation of cash:

• It is assumed that current assets contain only inventory, receivables and cash
• Current assets = Inventory + Receivables + Cash
• 1,00,00,000 = 40,00,000 + 50,00,000 + Cash
• Cash = Rs.10,00,000

6. Computation of Working Capital Data [May 2024 MTP]

EOC Ltd is a listed company and has presented the below abridged financial statements below:
Particulars Amount Amount
Sales 1,25,00,000
Cost of goods sold -76,40,000
Gross Profit 48,60,000
Less: Operating expenses:
Administrative expenses 13,20,000
Selling and distribution expenses 15,90,000 -29,10,000
Operating Profit 19,50,000
Add: Non operating income 3,28,000
Less: Non operating expenses -1,27,000
PBIT 21,51,000
Less: Interest -4,39,000
Profit before Tax 17,12,000
Less: Tax -4,28,000
Profit after tax 12,84,000

Balance Sheet
Particulars Amount Amount
Owned Funds
Equity share capital 30,00,000
Reserves and surplus 18,00,000 48,00,000
Borrowed Funds
Secured Loan 10,00,000
Unsecured Loan 4,30,000 14,30,000
Total Funds Raised 62,30,000
Application of Funds
Non-current Assets
Building 7,50,000
Machinery 2,30,000
Furniture 7,60,000
Intangible Assets 50,000 17,90,000
Current Assets

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Inventory 38,60,000
Receivables 39,97,000
ST investments 3,00,000
Cash and Bank 2,30,000 83,87,000
Less: Current Liabilities
Creditors 25,67,000
ST Loan 13,80,000 -39,47,000
Total Funds Employed 62,30,000
The company has set certain standards for the upcoming year financial status. All the ratios are based on
closing figures in financial statements.
• Equity share capital to reserves = 1 Time
• Net Profit Ratio = 15%
• Gross Profit Ratio = 50%
• Long-term debt to equity = 0.50
• Debtor Turnover = 100 Days
• Creditors Turnover (based on COGS) = 100 Days
• Inventory = 70 percent of opening inventory
Cash Balance is assumed to remain same for next year
You are required to
(1) CALCULATE inventory turnover ratio in days for current year
(2) CALCULATE receivables turnover ratio in days for current year
(3) CALCULATE the projected receivables, inventory, payables and long term debt
Answer:
WN 1: Computation of inventory Turnover Ratio and Receivables Turnover Ratio:
Inventory 38,60,000
Inventory Turnover Ratio = x 365 = x 365 = 184.41 Days
COGS 76,40,000
Receivables 39,97,000
Receivables Turnover Ratio = x 365 = x 365 = 116.71 Days
Sales 1,25,00,000

WN 2: Computation of Sales and Net Profit of next year

• Reserves should be equal to share capital and hence closing reserves would be equal to
Rs.30,00,000
• Increase in reserves = Net Profit = Rs.12,00,000
• NP Margin = 15%
• Sales = (12,00,000/15%) = Rs.80,00,000
• COGS = 80,00,000 x 50% = Rs.40,00,000

WN 3: Computation of Receivables, Inventory, Payables and Long-term Debt:

100 100
Receivables = Sales x = 80,00,000 𝑥 = 𝑅𝑠. 21,91,781
365 365
Closing inventory = 70% x 38,60,000 = Rs.27,02,000
100 100
Payables = COGS x = 40,00,000 𝑥 = 𝑅𝑠. 10,95,890
365 365
• Equity = SC + Reserves = 30,00,000 + 30,00,000 = 60,00,000
• Long-term debt = 0.50 x 60,00,000 = Rs.30,00,000

7. Constructing Balance Sheet [May 2018 RTP, May 2018 MTP, May 2023 MTP]
Prepare a trading account and a balance sheet from the following information:
Stock velocity 6 times
Gross profit margin 20%
Capital turnover ratio 2 times
Fixed assets turnover ratio 4 times
Debt collection period 2 months
Creditors payment period 73 days
Gross profit Rs.60,00,000

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Excess of closing stock over opening stock 5,00,000
Answer:
Trading Account:
Particulars Amount Particulars Amount
To opening stock 37,50,000 By Sales 3,00,00,000
To Purchases (balancing figure) 2,45,00,000 By Closing stock 42,50,000
To Gross Profit 60,00,000
Total 3,42,50,000 3,42,50,000

Balance sheet:
Liabilities Amount Assets Amount
Capital employed (Note 4) 1,50,00,000 Fixed Assets (Note 3) 75,00,000

Creditors (Note 6) 49,00,000 Closing stock (Note 2) 42,50,000

Debtors (Note 5) 50,00,000
Cash (balancing figure) 31,50,000
Total 1,99,00,000 Total 1,99,00,000

Note 1: Computation of sales:

• Gross profit margin is 20%. This would mean gross profit is equal to 20% of sales
Gross Profit 60,00,000
Sales = = = Rs. 3,00,00,000
20% 20%

Note 2: Computation of closing and opening stock:

COGS = Sales − GP = 3,00,00,000 − 60,00,000 = Rs. 2,40,00,000
COGS 2,40,00,000
Stock Turnover Ratio = ;6 = ; Average stock = Rs. 40,00,000
Average stock Average stock
Opening stock + Closing stock
Average stock = = 40,00,000
2
Opening stock + Closing stock = Rs. 80,00,000
Closing stock − Opening stock = Rs. 5,00,000
Adding above two equations:
2 Closing stock = 85,00,000; 𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤 = 𝐑𝐬. 𝟒𝟐, 𝟓𝟎, 𝟎𝟎𝟎
Opening stock = 42,50,000 – 5,00,000 = Rs.37,50,000

Note 3: Computation of fixed assets:

Sales 3,00,00,000
Fixed Assets Turnover Ratio = ;4 = ; 𝐅𝐢𝐱𝐞𝐝 𝐚𝐬𝐬𝐞𝐭𝐬 = 𝐑𝐬. 𝟕𝟓, 𝟎𝟎, 𝟎𝟎𝟎
Fixed Assets Fixed assets

Note 4: Computation of capital employed:

Sales 3,00,00,000
Capital Turnover Ratio = ;2 = ; Capital Employed = Rs1,50,00,000
Capital Employed Capital Employed

Note 5: Computation of debtors:

CP 2
Debtors = Credit sales x = 3,00,00,000 x = Rs. 50,00,000
12 12

Note 6: Computation of creditors:

CP 73
Creditors = Credit purchases x = 2,45,00,000 x = Rs. 49,00,000
365 365

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8. Constructing balance sheet [Jan 2021, May 2021 MTP, May 2019 MTP, May 2022 MTP, May 2024
MTP]
With the help of following information complete the balance sheet of ABC Limited:
Equity share capital Rs.1,00,000
Current debt to total debt 0.40
Total debt to owners equity 0.60
Fixed assets to owner’s equity 0.60
Total assets turnover 2 times
Inventory turnover 8 times
Answer:
Balance Sheet of ABC Limited:
Liabilities Amount Assets Amount
Equity share capital 1,00,000 Fixed assets 60,000
Long-term debt 36,000 Inventory 40,000
Current debt 24,000 Other current assets (b/f) 60,000
Total 1,60,000 Total 1,60,000

Note 1: Computation of total debt:

Total debt Total debt
= 0.60; = 0.60; Total debt = Rs. 60,000
Equity 1,00,000

Note 2: Computation of current and long-term debt:

Current debt Current Debt
= 0.40; = 0.40; Current Debt = Rs. 24,000
Total debt 60,000
Long-term debt = 60,000 – 24,000 = Rs.36,000

Note 3: Computation of fixed assets:

Fixed assets
= 0.60; Fixed assets = 0.60 x 1,00,000 = Rs. 60,000
Equity

Note 4: Computation of sales:

Sales Sales
Total Assets Turnover Ratio = 2; = 2; = 2; Sales = Rs. 3,20,000
Total Assets 1,60,000

Note 5: Computation of inventory:

Sales 3,20,000
Inventory Turnover Ratio = 8; = 8; = 8; Inventory = Rs. 40,000
Inventory Inventory

9. Constructing Balance Sheet [May 2023 MTP, SM]

Using the following information, PREPARE the balance sheet:
Long-term debt to net worth 0.50
Total asset turnover 2.50
Average collection period* 18 days
Inventory turnover 9
Gross profit margin 10%
Acid-test ratio 1
*Assume a 360-day year and all sales on credit.
Amount Amount
Cash ? Notes and Payables 1,00,000
Accounts Receivable ? Long-term debt ?
Inventory ? Common Stock 1,00,000
Plant and equipment ? Retained earnings 1,00,000

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Total Assets ? Total liabilities and equity ?
Answer:
Balance Sheet:
Amount Amount
Cash (Note 4) 50,000 Notes and Payables 1,00,000
Accounts Receivable (Note 3) 50,000 Long-term debt (Note 1) 1,00,000
Inventory (Note 2) 1,00,000 Common Stock 1,00,000
Plant and equipment (b/f) 2,00,000 Retained earnings 1,00,000
Total Assets 4,00,000 Total liabilities and equity 4,00,000

Note 1: Computation of Long-term debt:

Long term debt
= 0.50; Long term debt = 0.50 x 2,00,000 = 1,00,000
Networth

Note 2: Computation of Inventory:

Sales
Total Assets Turnover ratio =
Total Assets
Sales
2.50 = ; Sales = 10,00,000
4,00,000
Gross Profit = 10% of sales
COGS = 90% of sales = Rs.9,00,000
COGS
Inventory Turnover ratio =
Inventory
9,00,000
9= ; Inventory = 1,00,000
Inventory

Note 3: Computation of Accounts receivables:

Accounts receivables = Sales x (18/360) = 10,00,000 x (18/360) = Rs.50,000

Note 4: Computation of Cash:

Quick Assets
Acid Test Ratio =
Current Liabilities
Quick Assets
1= ; Quick assets = 1,00,000
1,00,000
• Quick Assets = Cash + Accounts receivables
• 1,00,000 = Cash + 50,000
• Cash = 50,000

10. Constructing Balance Sheet [Nov 2020 RTP, May 2019]

The following information and ratios are related to a company:
Sales for the year (all credit) Rs.30,00,000
Gross Profit Ratio 25 percent
Fixed assets turnover based on COGS 1.5 times
Stock turnover ratio based on COGS 6 times
Liquid ratio 1:1
Current ratio 1.5:1
Debtors collection period 2 months
Reserves & surplus to share capital 0.6:1
Capital gearing ratio 0.5
Fixed assets to networth 1.20:1
You are required to prepare a balance sheet
Answer:
Balance Sheet:
Liabilities Amount Assets Amount

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Share capital (Note 7) 7,81,250 Fixed Assets (Note 2) 15,00,000
Reserves and Surplus (Note 7) 4,68,750 Inventory (Note 3) 3,75,000
Fixed charge bearing capital (Note 8) 6,25,000 Debtors (Note 5) 5,00,000
Current Liabilities (Note 4) 7,50,000 Cash (Note 6) 2,50,000
Total 26,25,000 Total 26,25,000

Note 1: Computation of COGS:

• GP margin is 25 percent of sales and hence COGS will be 75 percent of sales
• COGS = 30,00,000 x 75% = Rs.22,50,000

Note 2: Computation of fixed assets:

COGS 22,50,000
Fixed Assets Turnover ratio = 1.50; = 1.50; = 1.50
Fixed Assets Fixed Assets
22,50,000
Fixed Assets = = Rs. 15,00,000
1.50

Note 3: Computation of inventory:

COGS 22,50,000
Inventory Turnover ratio = 6.00; = 6.00; = 6.00
Inventory Inventory
22,50,000
Inventory = = Rs. 3,75,000
6.00

Note 4: Computation of current assets and current liabilities:

Current Assets
Current ratio = 1.5; = 1.50; Current Assets = 1.50 Current Liabilities
Current Liabilities
Quick Assets
Liquid ratio = 1.0; = 1.00; Quick Assets = Current Liabilities
Current Liabilities
Current Assets − Quick Assets = Inventory
1.5CL − CL = 3,75,000; 0.5CL = 3,75,000; CL = 7,50,000
Current Assets = 7,50,000 x 1.50 = Rs.11,25,000

Note 5: Computation of debtors:

CP 2
Debtors = Sales x = 30,00,000 x = Rs. 5,00,000
12 12

Note 6: Computation of Cash:

• Cash = Total Current Assets – Inventory – Debtors
• Cash = 11,25,000 – 3,75,000 – 5,00,000 = Rs.2,50,000

Note 7: Computation of Networth:

Fixed Assets 15,00,000 15,00,000
= 1.2; = 1.20; Networth = = Rs. 12,50,000
Networth Networth 1.20
Reserves
= 0.6; Reserves = 0.6 SC
SC
Networth = Reserves + SC = 12,50,000; 0.6SC + SC = 12,50,000
12,50,000
1.6SC = 12,50,000; SC = = Rs. 7,81,250
1.60
Reserves = 7,81,250 x 0.60 = Rs.4,68,750

Note 8: Computation of Fixed capital (Debt + Preference)

Fixed Charge Bearing Capital
Capital gearing ratio = 0.5; = 0.50
Networth
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Fixed Charge Bearing Capital
= 0.50; Fixed charge bearing capital = Rs. 6,25,000
12,50,000

11. Ratio Analysis [Dec 2021, Sep 2024 RTP]

Following are the data in respect of ABC Industries for the year ended 31 st March, 2021:
Debt to Total Assets Ratio 0.40 Times
Long-term debts to equity ratio 30%
Gross profit margin on sales 20%
Accounts receivable period 36 days
Quick ratio 0.90 Times
Inventory holding period 55 days
Cost of goods sold Rs.64,00,000

Liabilities Amount Assets Amount

Equity share capital 20,00,000 Fixed assets
Reserves and surplus Inventories
Long-term debt Accounts receivable
Accounts payable Cash
Total 50,00,000 Total
Required:
Complete the Balance Sheet of ABC Industries as on 31st March, 2021. All calculations should be in
nearest Rupee. Assume 360 days in a year.
Assumption Area:
• Consider debt to include accounts payable for the purpose of debt to total assets ratio

Answer:
Balance Sheet of ABC Limited as on 31 st March 2021:
Liabilities Amount Assets Amount
Equity share capital 20,00,000 Fixed assets (b/f) 30,32,222
Reserves and surplus (Note 1) 10,00,000 Inventories (Note 3) 9,77,778
Long-term debt (Note 2) 9,00,000 Accounts receivable (Note 4) 8,00,000
Accounts payable (Note 2) 11,00,000 Cash (Note 5) 1,90,000
Total 50,00,000 Total 50,00,000

Note 1: Computation of Reserves and Surplus

Total outside liabilities
Debt to total assets ratio =
Total assets
Total outside liabilities
0.40 = ; 𝐓𝐨𝐭𝐚𝐥 𝐨𝐮𝐭𝐬𝐢𝐝𝐞 𝐥𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 = 𝟐𝟎, 𝟎𝟎, 𝟎𝟎𝟎
50,00,000
Note:
• It is assumed that debt includes accounts payable and we have considered total outside liabilities
for calculation
• Total assets = Total liabilities = Rs.50,00,000
Reserves and surplus = 50,00,000 – share capital (20,00,000) – outside liabilities (20,00,000) = Rs.10,00,000

Note 2: Computation of long-term debt and accounts payable:

Long term debt
Long term debt to equity shareholders funds =
Equity shareholder funds
Long term debt
0.30 = ; 𝐋𝐨𝐧𝐠 𝐭𝐞𝐫𝐦 𝐝𝐞𝐛𝐭 = 𝐑𝐬. 𝟗, 𝟎𝟎, 𝟎𝟎𝟎
20,00,000 + 10,00,000
• Accounts payable = Total outside liabilities – Long term debt
• Accounts payable = 20,00,000 – 9,00,000 = Rs.11,00,000

Note 3: Computation of inventory:

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Inventory days
Inventory = COGS x
360
55
Inventory = 64,00,000 x = 𝑅𝑠. 9,77,778
360

Note 4: Computation of Accounts Receivables:

• Gross profit is 20% of sales and hence COGS is 80% of sales
• Sales = 64,00,000/80% = Rs.80,00,000
Debtors days
Receivables = Sales x
360
𝟑𝟔
𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞𝐬 = 𝟖𝟎, 𝟎𝟎, 𝟎𝟎𝟎 𝐱 = 𝐑𝐬. 𝟖, 𝟎𝟎, 𝟎𝟎𝟎
𝟑𝟔𝟎

Note 5: Computation of Cash:

Quick Assets
Quick Ratio =
Current Liabilities
Quick Assets
0.90 Times =
11,00,000
Quick assets = Rs.9,90,000
Quick assets = Cash + Debtors
9,90,000 = Cash + 8,00,000
Cash = Rs.1,90,000

12. Balance sheet [May 2023 RTP]

From the following information, find out missing figures and REWRITE the balance sheet of Mukesh
Enterprise.
• Current Ratio = 2:1
• Acid Test ratio = 3:2
• Reserves and surplus = 20% of equity share capital
• Long term debt = 45% of net worth
• Stock turnover velocity = 1.5 months
• Receivables turnover velocity = 2 months. You may assume closing Receivables as average
Receivables.
• Gross profit ratio = 20%
• Sales is Rs. 21,00,000 (25% sales are on cash basis and balance on credit basis)
• Closing stock is Rs. 40,000 more than opening stock.
• Accumulated depreciation is 1/6 of original cost of fixed assets.

Balance sheet of the company is as follows:

Liabilities Amount Assets Amount
Equity share capital ? Fixed assets (cost) ?
Reserves and surplus ? Less: Accumulated depreciation ?
Long-term debt 6,75,000 Fixed Assets (WDV) ?
Bank overdraft 60,000 Stock ?
Creditors ? Debtors ?
Cash ?
Total ? Total ?
Answer:
Balance sheet of the company is as follows:
Liabilities Amount Assets Amount
Equity share capital (Note 1) 12,50,000 Fixed assets (cost) [Note 5] 20,58,000
Reserves and surplus (Note 1) 2,50,000 Less: Accumulated depreciation [Note 5] (3,43,000)
Long-term debt 6,75,000 Fixed Assets (WDV) [Note 5] 17,15,000
Bank overdraft 60,000 Stock (Note 3) 2,30,000
Creditors (Note 4) 4,00,000 Debtors (Note 2) 2,62,500
Cash (Note 4) 4,27,500
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Total 26,35,000 Total 26,35,000

Note1: Computation of Networth:

Long term debt = 45% of Networth
6,75,000 = 45% of Networth
6,75,000
Networth = = 15,00,000
45%
Share capital + Reserves = Networth
Share capital + 0.2 share capital = 15,00,000
Share capital = 15,00,000/1.20 = Rs.12,50,000
Reserves = 2,50,000

Note 2: Computation of receivables:

2 2
Debtors = Credit sales x ( ) = 15,75,000 𝑥 = 2,62,500
12 12

Note 3: Computation of Closing Stock:

1.5 1.5
Average stock = COGS x = 16,80,000 𝑥 = 2,10,000
12 12
Opening stock + Closing stock
= 2,10,000
2
Opening stock + Opening stock + 40,000
= 2,10,000
2
Opening stock = 1,90,000
Closing stock = 2,30,000

Note 4: Computation of Cash and Creditors:

CA CA
Current ratio = ;2 = ; CA = 2CL
CL CL
QA 3 QA
Acid test ratio = ; = ; QA = 1.5 CL
CL 2 CL
Current Assets – Quick assets = Inventory
2CL – 1.5CL = 2,30,000
0.5CL = 2,30,000
CL = 4,60,000
CA = 4,60,000 x 2 = 9,20,000
Cash = 9,20,000 – 2,30,000 – 2,62,500 = 4,27,500
Creditors = 4,60,000 – 60,000 = 4,00,000

Note 5: Computation of Fixed Assets:

Fixed assets = Total assets − Current assets
Fixed assets = 26,35,000 – 9,20,000 = 17,15,000
Net block = 17,15,000
1
Accumulated depreciation = of cost
6
Cost = Depreciation + Net WDV
1
Cost = of cost + 17,15,000
6
6
Cost = 17,15,000 x = 20,58,000
5

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Chapter 4: Cost of Capital

Overview:
• Computation of Cost of Debt
• Computation of Cost of equity and retained earnings
• Computation of Cost of Preference
• Computation of WACC

Part 1 – Computation of Cost of Debt

1. Cost of Redeemable Debt:

An 8-year 12% bond with a face value of Rs.100 sold for Rs.92. Compute the cost of debt?
Answer:
Basic information
Type of debt Redeemable
Face value Rs.100
Coupon rate 12%
Tax rate 25% (assumed)
Issue price – floatation cost
Net proceeds 92 – 0 = Rs.92
Redeemable value Rs.100 (assumed redemption at par)
Balance life 8 years

Interest after tax + Average other costs 9 + 1

Kd = = x 100 = 10.42%
Average funds employed 96
Note:
• Interest = Face value x coupon rate = 100 x 12% = Rs.12
• Interest after tax = Interest x (1 – Tax rate) = 12 x (1 – 25%) = Rs.9
Redeemable value − Net proceeds 100 − 92
Average other costs = = = Rs. 1
Balance life 8
Redeemable value + Net proceeds 100 + 92
Average funds employed = = = Rs. 96
2 2

2. Cost of Redeemable Debt [SM]

A company issued 10,000, 10% debentures of Rs. 100 each at a premium of 10% on 1.4.2023 to be matured
on 1.4.2028. The debentures will be redeemed on maturity. COMPUTE the cost of debentures assuming
35% as tax rate.
Answer:
Basic information
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 35%
Issue price – floatation cost
Net proceeds 110 – 0 = Rs.110
Redeemable value Rs.100 (assumed redemption at par)
Balance life 5 years

Interest after tax + Average other costs 6.5 − 2

Kd = = x 100 = 4.29%
Average funds employed 105
Note:
• Interest = Face value x coupon rate = 100 x 10% = Rs.10
• Interest after tax = Interest x (1 – Tax rate) = 10 x (1 – 35%) = Rs.6.5

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Redeemable value − Net proceeds 100 − 110
Average other costs = = = −2
Balance life 5
Redeemable value + Net proceeds 100 + 110
Average funds employed = = = Rs. 105
2 2

3. Cost of Redeemable Debt [SM]

A company issued 10,000, 10% debentures of Rs. 100 each at par on 1.4.2018to be matured on 1.4.2028. The
company wants to know the cost of its existing debt on 1.4.2023when the market price of the debentures is
Rs. 80. COMPUTE the cost of existing debentures assuming 35% tax rate.
Answer:
Basic information
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 35%
Net proceeds Current Market Price = Rs.80
Redeemable value Rs.100 (assumed redemption at par)
Balance life 5 years

Interest after tax + Average other costs 6.5 + 4

Kd = = x 100 = 11.67%
Average funds employed 90
Note:
• Interest = Face value x coupon rate = 100 x 10% = Rs.10
• Interest after tax = Interest x (1 – Tax rate) = 10 x (1 – 35%) = Rs.6.5
Redeemable value − Net proceeds 100 − 80
Average other costs = = =4
Balance life 5
Redeemable value + Net proceeds 100 + 80
Average funds employed = = = Rs. 90
2 2

4. Cost of Redeemable Debt

A ten year, 10% Rs.1000 par bond sold at Rs.950 less 5% underwriting commission. Compute cost of debt?
Answer:
Basic information
Type of debt Redeemable
Face value Rs.1,000
Coupon rate 10%
Tax rate 25% (assumed)
Issue price – floatation cost
Net proceeds 950 – (950 x 5%) = 950 – 47.50 = Rs.902.50
Redeemable value Rs.1,000 (assumed redemption at par)
Balance life 10 years
• It is assumed that floatation cost is a percentage of issue price

Interest after tax + Average other costs 75 + 9.75

Kd = = x 100 = 8.91%
Average funds employed 951.25
Note:
• Interest = Face value x coupon rate = 1000 x 10% = Rs.100
• Interest after tax = Interest x (1 – Tax rate) = 100 x (1 – 25%) = Rs.75
Redeemable value − Net proceeds 1,000 − 902.50
Average other costs = = = Rs. 9.75
Balance life 10
Redeemable value + Net proceeds 1,000 + 902.50
Average funds employed = = = Rs. 951.25
2 2

5. Cost of Redeemable Debt

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A company issued debentures 5 years ago for a period of 10 years. The face value of the debenture is Rs.100
and its coupon rate is 10%. It incurred a floatation cost of 10% and its current market price is Rs.85. It will
be redeemed at a premium of 5%.
Answer:
Basic information
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 25% (assumed)
Net proceeds = Current market price = Rs.85
Redeemable value Rs.105
Balance life 5 years

Interest after tax + Average other costs 7.50 + 4

Kd = = x 100 = 12.11%
Average funds employed 95
Note:
• Interest = Face value x coupon rate = 100 x 10% = Rs.10
• Interest after tax = Interest x (1 – Tax rate) = 10 x (1 – 25%) = Rs.7.50
Redeemable value − Net proceeds 105 − 85
Average other costs = = = Rs. 4
Balance life 5
Redeemable value + Net proceeds 105 + 85
Average funds employed = = = Rs. 95
2 2

6. Cost of debt: [May 2006, Nov 2015, May 2022 MTP]

A company issues 1,000,000 12% debentures of Rs.100 each. The debentures are redeemable after the expiry
of fixed period of 7 years. The company is in 35% tax bracket.
• Calculate cost of debt after tax, if debentures are issued at i) Par ii) 10% discount and iii) 10%
premium
• If brokerage is paid at 2% what will be the cost of debentures, if issue is at par
Answer:
Basic information
Particulars Situation A Situation B Situation C Situation D
Type of debt Redeemable Redeemable Redeemable Redeemable
Face value Rs.100 Rs.100 Rs.100 Rs.100
Coupon rate 12% 12% 12% 12%
Tax rate 35% 35% 35% 35%
Net proceeds = 100 – 0 = 90 – 0 = 110 – 0 = 100 – 2
(Issue price – FC) = 100 = 90 = 110 = 98
Redeemable value Rs.100 Rs.100 Rs.100 Rs.100
(assumed at par)
Balance life 7 years 7 years 7 years 7 years

Computation of Cost of Debt:

Redeemable value − Net proceeds
(Interest after tax + )
Balance life
Interest after tax + Average other costs Redeemable value + Net Proceeds
Kd = =
Average funds employed 2
100 − 100
(7.8 + )
7
100 + 100 7.8 + 0
Situation A = = x 100 = 7.8%
2 100
100 − 90
(7.8 + )
7
100 + 90 7.8 + 1.43
Situation B = = x 100 = 9.72%
2 95

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100 − 110
(7.8 + )
7
100 + 110 7.8 − 1.43
Situation C = = x 100 = 6.07%
2 105
100 − 98
(7.8 + )
7
100 + 98 7.8 + 0.29
Situation D = = x 100 = 8.17%
2 99

7. Cost of deep discount bond [May 2021 MTP, SM]

Development Finance Corporation issued zero interest deep discount bonds of face value of Rs.1,50,000
each issued at Rs.3,750 & repayable after 25 years. COMPUTE the cost of debt if there is no corporate tax.
Answer:
In case of zero interest deep discount bond, the company does not pay any interest and hence we cannot
analyze the same under our normal formula. We have to compute IRR for the cash flow. We have to start
with a trial rate and then increase/decrease the same till we get one positive and one negative NPV to
compute IRR [Concept of IRR will be explained in investment decision chapter]

IRR computation:
Year Cash flow PVF @ 15% DCF PVF @ 16% DCF
0 3,750 1.000000 3,750 1.000000 3,750
25 -1,50,000 0.030378 -4,556.7 0.024465 -3,669.75
NPV -806.70 +80.25
Note: YTM approach is basically computing the IRR of the instrument.
−𝟖𝟎𝟔. 𝟕𝟎
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟏𝟓 + [ 𝐱 (𝟏𝟔 − 𝟏𝟓)] = 𝟏𝟓 + 𝟎. 𝟗𝟏 = 𝟏𝟓. 𝟗𝟏%
−𝟖𝟎𝟔. 𝟕𝟎 − (𝟖𝟎. 𝟐𝟓)

8. Cost of Irredeemable debt [SM]

Five years ago, Soma Limited issued 12 percent irredeemable debentures at Rs.103, a Rs.3 premium to their
par value of Rs.100. The current market price of these debentures is Rs.94. If the company pays corporate
tax at a rate of 35 percent what is the current cost of debenture capital?
Answer:
Basic information
Type of debt Irredeemable
Face value Rs.100
Coupon rate 12%
Tax rate 35%
Net proceeds Current market price = Rs.94
Redeemable value NA
Balance life NA

Interest after tax 7.80

Kd = = x 100 = 8.30%
Net proceeds 94

9. Valuation of Redeemable Bond [SM]

RBI proposes to sell a 5-year bond of Rs.5000 at 8 percent interest per annum. The bond amount will be
amortized equally over its life. What is the bond’s present value for an investor if he expects a minimum
rate of return of 6 percent?
Answer:
• Bond has a life of 5 years. The face value of bond is Rs.5,000. Bond will be equally amortized over
its life. This would mean company will pay back principal of Rs.1,000 every year
• Interest would be earned on Rs.5,000 for first year, Rs.4,000 for second year and so on
Year Cash flow PVF @ 6% DCF
1,400
1 [1,000 + 8% x 5,000] 0.943 1,320.20

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1,320
2 [1,000 + 8% x 4,000] 0.890 1,174.80
1,240
3 [1,000 + 8% x 3,000] 0.840 1,041.60
1,160
4 [1,000 + 8% x 2,000] 0.792 918.72
1,080
5 [1,000 + 8% x 1,000] 0.747 806.76
Fair Market Price 5,262.08

10. Cost of convertible debt: [Nov 2020, SM]

TT Ltd. issued 20,000, 10% convertible debenture of Rs.100 each with a maturity period of 5 years. At
maturity the debenture holders will have the option to convert debentures into equity shares of the
company in ratio of 1:5 (5 shares for each debenture). The current market price of the equity share is Rs.20
each and historically the growth rate of the share is 4% per annum. Assuming tax rate is 25%. Compute the
cost of 10% convertible debenture using Approximation Method and Internal Rate of Return Method
PV Factors are as under:
Year 1 2 3 4 5
PV Factor @ 10% 0.909 0.826 0.751 0.683 0.621
PV Factor @ 15% 0.870 0.756 0.658 0.572 0.497
Answer:
Basic information
Type of debt Redeemable and convertible
Face value Rs.100
Coupon rate 10%
Tax rate 25%
Issue price – Floatation cost
Net proceeds 100 – 0 = Rs.100
Redeemable value Rs.121.67 (Note 1)
Balance life 5 years
Note 1: Computation of redeemable value:
• Debenture holder at the expiry of five years has the option to convert debentures into shares or
redeem the same
• Redeemable value will be higher of the following:
o Conversion into equity: One debenture will be converted into 5 equity shares. Current
market price of one equity share is Rs.20. Equity shares will grow at 4 percent and expected
price per share in year 5 is Rs.24.333 (20x (1.05)5). Value of 5 shares received on redemption
is equal to Rs.121.67
o Redemption as debt: Debenture can be redeemed and debenture holder receive Rs.100

Computation of Cost of Debt:

Approximation method:
RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
121.67 − 100
7.50 + 7.50 + 4.334
Kd = 5 = x 100 = 10.676%
121.67 + 100 110.835
2

IRR Method:
Year Cash flow PVF @ 10% DCF PVF @ 15% DCF
0 -100.00 -1.000 -100.000 -1.000 -100.000

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1 to 5 7.50 3.790 28.425 3.353 25.148
5 121.67 0.621 75.557 0.497 60.470
NPV +3.982 -14.382
𝟑. 𝟗𝟖𝟐
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟏𝟎 + [ 𝐱 (𝟏𝟓 − 𝟏𝟎)] = 𝟏𝟎 + 𝟏. 𝟎𝟖𝟒 = 𝟏𝟏. 𝟎𝟖𝟒%
𝟑. 𝟗𝟖𝟐 − (−𝟏𝟒. 𝟑𝟖𝟐)

Part 2 – Computation of Cost of Equity and Retained earnings

11. Cost of Equity [SM]

A company has paid dividend of Rs. 1 per share (of face value of Rs. 10 each) last year and it is expected to
grow @ 10% every year. CALCULATE the cost of equity if the market price of share is Rs. 55.
Answer:
Basic information
Dividend of next year Rs.1.10 (1+10%)
CMP/Issue price Rs.55
IRR/ROE/ROI Not available
Retention ratio Not available
Growth rate 10%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏. 𝟏𝟎
𝐊𝐞 = + 𝟎. 𝟏𝟎 = 𝟎. 𝟎𝟐 + 𝟎. 𝟏𝟎 = 𝟎. 𝟏𝟐 (𝐨𝐫)𝟏𝟐%
𝟓𝟓 − 𝟎

12. Cost of equity [May 2022 MTP]

The dividend per share of a firm is expected to be Rs.8 next year and is to grow at 5% per year. Assume the
current market price per share is Rs.80. Calculate the cost of equity? What would be the position if the
growth rate was 0 percent?
Answer:
Basic information
Dividend of next year Rs.8
CMP/Issue price Rs.80
IRR/ROE/ROI Not available
Retention ratio Not available
Growth rate 5%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟖
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟓 (𝐨𝐫)𝟏𝟓%
𝟖𝟎 − 𝟎

Rework scenario: Growth rate of 0 percent:

𝟖
𝐊𝐞 = + 𝟎. 𝟎𝟎 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟎 = 𝟎. 𝟏𝟎 (𝐨𝐫)𝟏𝟎%
𝟖𝟎 − 𝟎

13. Cost of equity with negative growth:

A company is rapidly losing money and its future rate of growth in dividends is negative 10%. Dividend
today is Rs.10 per share and CMP is Rs.50. Calculate the cost of equity?
Answer:
Basic information
Dividend of next year Rs.10 – 10% = Rs.9
CMP/Issue price Rs.50
IRR/ROE/ROI NA
Retention ratio NA
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Growth rate -10%
Floatation cost 0

D1
Ke = + Growth rate
P0 − F
𝟗
𝐊𝐞 = − 𝟎. 𝟏𝟎 = 𝟎. 𝟏𝟖 − 𝟎. 𝟏𝟎 = 𝟎. 𝟎𝟖 (𝐨𝐫)𝟖%
𝟓𝟎 − 𝟎

14. Cost of equity – Growth computation based on past dividends

The current market price of a share is Rs.100, the cost of floatation per share on new shares is Rs.2 and the
dividend on the outstanding shares over the past six years are 10.00, 10.70, 11.24, 11.90,11.31, 12.00
respectively. Compute cost of equity?
Answer:
Basic information
Dividend of next year 12 + 3.81% = Rs.12.46
CMP/Issue price Rs.100
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 3.72%
Floatation cost Rs.2
Notes:
• The current market price of share is Rs.100. Question also provides for floatation cost of a new
share. This would mean that the company may be planning for a new issue
• It is assumed that issue price would be equal to current market price of Rs.100

Computation of growth rate (past average of growth rates taken as future growth rate):
Year Cash flow PVF @ 3% DCF PVF @ 4% DCF
0 -10.00 1.000 -10.00 1.000 -10.00
5 12.00 0.863 10.36 0.822 9.86
NPV 0.36 -0.14
0.36
IRR (Growth rate) = 3 + 𝑥 (4 − 3) = 3 + 0.72 = 3.72%
0.36 − (−0.14)

D1
Ke = + Growth rate
P0 − F
𝟏𝟐. 𝟒𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟑𝟕𝟐 = 𝟎. 𝟏𝟐𝟕𝟎 + 𝟎. 𝟎𝟑𝟕𝟐 = 𝟎. 𝟏𝟔𝟒𝟐 (𝐨𝐫)𝟏𝟔. 𝟒𝟐%
𝟏𝟎𝟎 − 𝟐

15. Cost of equity – Growth computation based on ROE:

Z Ltd’s share is selling at Rs.60 and its EPS is Rs.6. It has a payout ratio of 100%. What is the cost of equity?
If the firm’s payout ratio is assumed to be 40% and that it earns 15% on its investment opportunities, what
would be the firm’s cost of equity?
Answer:
Basic information
Dividend of next year 6 x 100% = Rs.6
CMP/Issue price Rs.60
IRR/ROE/ROI NA
100% - Payout ratio
Retention ratio 100% - 100% = 0%
Growth rate 0% (because retention is 0%)
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟔
𝐊𝐞 = + 𝟎. 𝟎𝟎 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟎 = 𝟎. 𝟏𝟎(𝐨𝐫)𝟏𝟎. 𝟎𝟎%
𝟔𝟎 − 𝟎
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Rework scenario:
Dividend of next year 2.616
CMP/Issue price Rs.60
IRR/ROE/ROI 15%
100% - Payout ratio
Retention ratio 100% - 40% = 60%
IRR x Retention ratio
Growth rate 15% x 60% = 9%
Floatation cost 0
Note:
• DPS = EPS x Payout ratio = 6 x 40% = Rs.2.40 per share
• D0 refers to nearby dividend (to be paid in < 3 months) and D1 refers to distant dividend (to be
paid later).
• It is assumed that Dividend of Rs.2.40 per share is nearby dividend (D0) and dividend of next year
= 2.40 + 9% = Rs.2.616. This is an area where clarity will not be there and hence assumption will
be needed to answer in exam.

D1
Ke = + Growth rate
P0 − F
𝟐. 𝟔𝟏𝟔
𝐊𝐞 = + 𝟎. 𝟎𝟗 = 𝟎. 𝟎𝟒𝟑𝟔 + 𝟎. 𝟎𝟗 = 𝟎. 𝟏𝟑𝟑𝟔(𝐨𝐫)𝟏𝟑. 𝟑𝟔%
𝟔𝟎 − 𝟎

16. Cost of equity under realized yield approach [SM]

[Link] had purchased a share of Alpha Limited for Rs.1,000. He received dividend for a period of 5
years at the rate of 10 percent. At the end of the fifth year, he sold the share of Alpha Limited for Rs.1128.
You are required to compute the cost of equity as per realized yield approach.
Answer:
• Cost of equity as per realized yield approach is equal to IRR of the investor
• We start discounting with an initial guess rate of 12% (closer to 10% dividend paid every year)
Year CF PVF @ 12% DCF
0 -1,000 1.000 -1,000.00
1 100 0.893 89.30
2 100 0.797 79.70
3 100 0.712 71.20
4 100 0.636 63.60
5 1,228 0.567 696.28
NPV 0.08
• IRR of the above cash flow is 12% and hence Cost of equity as per realized yield approach is 12%

17. Cost of equity under realized yield approach [SM]

Compute cost of equity using realized yield approach from the following information:
Price per share
Year Dividend Per share (At beginning of year)
1 1.00 9.00
2 1.00 9.75
3 1.20 11.50
4 1.25 11.00
5 1.15 10.60
Answer:
Let us first compute the returns for each of the years:
[𝐃𝐢𝐯𝐢𝐝𝐞𝐧𝐝 + (𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞)]
𝐑𝐞𝐭𝐮𝐫𝐧 =
𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐏𝐫𝐢𝐜𝐞

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[1.00 + (9.75 − 9.00)]
Return of year 1 = x 100 = 19.44%
9.00
[1.00 + (11.50 − 9.75)]
Return of year 2 = x 100 = 28.21%
9.75
[1.20 + (11.00 − 11.50)]
Return of year 3 = x 100 = 6.09%
11.50
[1.25 + (10.60 − 11.00)]
Return of year 4 = x 100 = 7.72%
11.00

Computation of overall return as per realized yield approach:

• Let us assume a person invests Rs.100 in this company
• Value in year 1 = 100 + 19.44% = Rs.119.44
• Value in year 2 = 119.44 + 28.21% = Rs.153.13
• Value in year 3 = 153.13 + 6.09% = Rs.162.46
• Value in year 4 = 162.46 + 7.72% = Rs.175.00
• The above analysis indicates that Rs.100 investment has become Rs.175 in four years
Future value = Present value x (1 + r)n
175.00 = 100.00 x (1 + r)4
1.75 = (1 + r)4
(1 + r) = 1.1502
r =0.1502 (or) 15.02%
Realized yield = 15.02% and hence cost of equity as per realized yield approach is 15.02%

18. Cost of equity using CAPM Approach [SM]

The risk-free rate of return is 8%. The beta of X Limited is 1.4. The risk premium of the market is 6%.
Compute cost of equity using CAPM.
Answer:
K e = R f + Beta x (R m − R f )
𝐊 𝐞 = 𝟖 + 𝟏. 𝟒 𝐱 (𝟔) = 𝟖 + 𝟖. 𝟒 = 𝟏𝟔. 𝟒𝟎%
• Note: Risk premium of market would mean Rm - Rf

19. Cost of equity using CAPM approach [SM]

Calculate the cost of equity capital of H Limited. whose risk free rate of return equals 10%. The firm’s beta
equals 1.75 and the return on the market portfolio equals to 15%.
Answer:
K e = R f + Beta x (R m − R f )
𝐊 𝐞 = 𝟏𝟎 + 𝟏. 𝟕𝟓 𝐱 (𝟏𝟓 − 𝟏𝟎) = 𝟏𝟎 + 𝟖. 𝟕𝟓 = 𝟏𝟖. 𝟕𝟓%

20. Computation of cost of equity [May 2018]

JC Ltd. is planning an equity issue in current year. It has an earning per share (EPS) of Rs.20 and proposes
to pay 60% dividend at the current year end. With a PIE ratio 6.25, it wants to offer the issue at market
price. The flotation cost is expected to be 4% of the issue price.

Required: Determine the required rate of return for equity share (cost of equity) before the issue and after
the issue
Answer:
• Required rate of return on equity is basically cost of equity.

Computation of return on equity before the issue:

Dividend of next year 20 x 60% = Rs.12
CMP/Issue price Rs.125 [ refer note]
IRR/ROE/ROI 16% (refer note)
Retention ratio 100% - 60% = 40%
Growth rate 16% x 40% = 6.4%
Floatation cost 0
Note:

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Computation of price:
MPS MPS
PE Multiple = ; 6.25 = ; MPS = 125
EPS 20

EPS 20
ROE = ; ROE = ; ROE = 0.16 (or)16%
Book value per share 125
• It is assumed that book value per share and market value per share is same.

D1
Ke = + Growth rate
P0 − F
𝟏𝟐
𝐊𝐞 = + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟎𝟗𝟔 + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟔(𝐨𝐫)𝟏𝟔. 𝟎𝟎%
𝟏𝟐𝟓 − 𝟎

Computation of return on equity after the issue:

Dividend of next year 20 x 60% = Rs.12
CMP/Issue price Rs.125
IRR/ROE/ROI 16%
Retention ratio 100% - 60% = 40%
Growth rate 16% x 40% = 6.4%
Floatation cost 125 x 4% = Rs.5
D1
Ke = + Growth rate
P0 − F
𝟏𝟐
𝐊𝐞 = + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟎 + 𝟎. 𝟎𝟔𝟒 = 𝟎. 𝟏𝟔𝟒(𝐨𝐫)𝟏𝟔. 𝟒𝟎%
𝟏𝟐𝟓 − 𝟓

21. Cost of retained earnings [SM]

Face value of equity shares of a company is Rs.10, while current market price is Rs.200 per share. Company
is going to start a new project, and is planning to finance it partially by new issue and partially by retained
earnings. You are required to CALCULATE cost of equity shares as well as cost of retained earnings if issue
price will be Rs.190 per share and floatation cost will beRs.5 per share. Dividend at the end of first year is
expected to be Rs.10 and growth rate will be 5%.
Answer:
D1 10
Cost of retained earnings = + Growth rate = + 5% = 0.05 + 0.05 = 10.00%
P0 200
D1 10
Cost of equity = + Growth rate = + 5% = 0.0541 + 0.05 = 10.41%
P0 − 𝐹 190 − 5

22. Calculation of cost of retained earnings [Nov 2009, SM]

Y Ltd. retains Rs.7,50,000 out of its current earnings. The expected rate of return to the shareholders, if they
had invested the funds elsewhere is 10%. The brokerage is 3% and the shareholders come in 30% tax
bracket. Calculate the cost of retained earnings.
Answer:
𝐊 𝐫 = [𝐊 𝐞 𝐱 (𝟏 − 𝐏𝐞𝐫𝐬𝐨𝐧𝐚𝐥 𝐭𝐚𝐱 𝐫𝐚𝐭𝐞%)] 𝐱 [𝟏 − 𝐅𝐥𝐨𝐚𝐭𝐚𝐭𝐢𝐨𝐧 𝐜𝐨𝐬𝐭%]
K r = [0.10 x (1 − 0.30)] x [1 − 0.03] = 0.0679 (or) 6.79%

Part 3 – Computation of Cost of Preference

23. Cost of Irredeemable Preference Shares [SM]

A company issues 10% irredeemable preference shares. The face value of the share is Rs.100 but the issue
price is Rs.95. What is the cost of preference share? Rework the cost if the issue price is Rs.105.
Answer:
Basic information
Particulars Situation 1 Situation 2
Type of preference Irredeemable Irredeemable
Face value Rs.100 Rs.100

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Coupon rate 10% 10%
Net proceeds Rs.95 Rs.105
Redeemable value NA NA
Balance life NA NA

Computation of Cost of Preference:

Preference Dividend
Kp =
Net proceeds
10
K p in situation 1 = x 100 = 10.53%
95
10
K p in situation 2 = x 100 = 9.52%
105

24. Cost of Redeemable Preference Shares [SM]

XYZ Ltd. issues 2,000 10% preference shares of Rs. 100 each at Rs. 95 each. The company proposes to redeem
the preference shares at the end of 10th year from the date of issue. CALCULATE the cost of preference
share?
Answer:
Basic information
Type of preference Redeemable
Face value Rs.100 (assumed)
Coupon rate 10%
Issue price – Floatation cost
Net proceeds 95 – 0 = Rs.95
Redeemable value Rs.100 (assumed at par)
Balance life 10 years

Computation of Cost of preference:

RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 95
10 + 10.00 + 0.50
Kp = 10 = x 100 = 10.77%
100 + 95 97.50
2

25. Cost of convertible debentures and preference shares (May 2022, Nov 2020, SM):
A company issues:
• 15% convertible debentures of Rs. 100 each at par with a maturity period of 6 years. On maturity,
each debenture will be converted into 2 equity shares of the company. The riskfree rate of return
is 10%, market risk premium is 18% and beta of the company is 1.25. The company has paid
dividend of Rs. 12.76 per share. Five year ago, it paid dividend of Rs. 10 per share. Flotation cost is
5% of issue amount.
• 5% preference shares of Rs. 100 each at premium of 10%. These shares are redeemable after 10 years
at par. Flotation cost is 6% of issue amount.
Assuming corporate tax rate is 40%. You are required to
• Calculate the cost of convertible debentures using the approximation method.
• Use YTM method to calculate cost of preference shares.
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.03, t 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744
PVIF 0.05, t 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614
PVIFA 0.03, t 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530
PVIFA 0.05, t 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722

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Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
FVIF i, 5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
FVIF i, 6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
FVIF i, 7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949

Answer:
WN 1: Computation of cost of convertible debentures:
Note 1: Basic information
Type of debt Redeemable/convertible
Life 6 years
Coupon rate 15%
Face value Rs.100
Tax rate 40%
Issue price - Floatation cost
Net proceeds 100 -5 = Rs.95
Redeemable value Rs.130.54 (Note 2)

Note 2: Computation of redeemable value:

• Redeemable value of convertible debentures is higher of the following:
o Redeem as debt = Rs.100
o Convert into shares = 2 shares x 65.27 = Rs.130.54

Equity share price at end of 6 years:

D7 17.95 17.95
Price6 = = = = Rs. 65.72
K e − G 32.5% − 5% 27.50%

Notes:
• Cost of equity = Rf + Beta x (Rm – Rf) = 10 + 1.25 x 18 = 32.50%

Computation of growth rate:

• Dividend of Rs.10 has become Rs.12.76 in five years
• Hence present value = Rs.10; Future value = Rs.12.76; Number of years = 5; rate of interest (growth
rate) = ?

Future value = Present value x (1 + r)n

12.76 = 10 x (1 + r)5
(1 + r)5 = 1.276
• From the given table values in question we can infer that r = 5% and hence growth rate is equal to
5 percent
• Dividend at end of 7 years = 12.76 x (1 +5%) 7 = Rs.17.95

Note 3: Computation of cost of debt:

Interest after tax + Average other costs 9 + 5.92
Kd = = x 100 = 13.23%
Average funds employed 112.77
Note:
• Interest = Face value x coupon rate = 100 x 15% = Rs.15
• Interest after tax = Interest x (1 – Tax rate) = 15 x (1 – 40%) = Rs.9
Redeemable value − Net proceeds 130.54 − 95
Average other costs = = = Rs. 5.92
Balance life 6
Redeemable value + Net proceeds 130.54 + 95
Average funds employed = = = Rs. 112.77
2 2

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WN 2: Computation of cost of preference:
Note 1: Basic information:
Type of preference Redeemable
Life 10 years
Coupon rate 5%
Face value Rs.100
Issue price - Floatation cost
Net proceeds 110 - (6% of 110) = 103.40
Redeemable value Rs.100

Note 2: Computation of YTM (IRR):

Year Cash flow PVF @ 3% DCF PVF @ 5% DCF
0 103.4 1.000 103.400 1.000 103.400
1 to 10 -5 8.530 -42.650 7.722 -38.610
10 -100 0.744 -74.400 0.614 -61.400
-13.650 3.390

−𝟏𝟑. 𝟔𝟓
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 = 𝟑 + [ 𝐱 (𝟓 − 𝟑)] = 𝟑 + 𝟏. 𝟔𝟎 = 𝟒. 𝟔𝟎%
−𝟏𝟑. 𝟔𝟓 − 𝟑. 𝟑𝟗

Part 4 – Computation of WACC

26. Computation of WACC [Nov 2022]

The following is the extract of the Balance Sheet of M/s KD Ltd.:
Particulars Amount
Ordinary shares (Face Value Rs. 10/- per share) 5,00,000
Share Premium 1,00,000
Retained profits 6,00,000
8% Preference Shares (Face Value Rs. 25/- per share) 4,00,000
12% Debentures (Face value Rs. 100/- each) 6,00,000
22,00,000
The ordinary shares are currently priced at Rs. 39 ex-dividend and preference share is priced at Rs. 18 cum-
dividend. The debentures are selling at 120 percent ex-interest. The applicable tax rate to KD Ltd. is 30
percent. KD Ltd.'s cost of equity has been estimated at 19 percent. Calculate the WACC (weighted average
cost of capital) of KD Ltd. on the basis of market value
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity = 19.00%
Cost of retained earnings = 19.00%
Preference Dividend 2
Cost of Preference = = 𝑥 100 = 12.50%
Net proceeds 16
• Net proceeds = Current market price and we should consider ex-dividend price as that is the
real price of the security. Ex-dividend price = 18 – 2 = Rs.16.00
Interest after tax 12 x 70%
Cost of Debentures = = 𝑥 100 = 7.00%
Net proceeds 120

WN 2: Computation of WACC:
Source Cost Weight Product
Equity share capital 19.00% 19,50,000 3,70,500
8% Preference share capital 12.50% 2,56,000 32,000
12% Debentures 7.00% 7,20,000 50,400

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Total 29,26,000 4,52,900
Note:
• Market value of equity = 50,000 shares x 39 = Rs.19,50,000. This has not been proportionally divided
between equity capital and retained earnings as the cost of equity and retained earnings is same
• Market value of preference = (4,00,000/25) x 16 = Rs.2,56,000
• Market value of debentures = (6,00,000/100) x 120 = Rs.7,20,000

Sum of product 4,52,900

WACC = = x 100 = 15.48%
sum of weights 29,26,000

27. WACC [May 2022 RTP]

Determine the cost of capital of BestLuck Limited using the book value (BV) and market value (MV)
weights from the following information:
Source of Capital Book Value Market Value
Equity Shares 1,20,00,000 2,00,00,000
Retained earnings 30,00,000 -
Preference shares 9,00,000 10,40,000
Debentures 36,00,000 33,75,000
Additional information:
1. Equity: New issue priced at Rs.125 per share will be fully subscribed; floatation costs will be Rs.5
per share
2. Dividend: During the previous five years, dividends have steadily increased from Rs.10.60 to
Rs.14.19 per share. Dividend at the end of the current year is expected to be Rs.15 per share
3. Preference shares: 15% preference shares with face value of Rs.100 would realize Rs.105 per share
4. Debentures: The company proposes to issue 11-year 15% debentures but the yield on similar
maturity and risk class is 16%; floatation cost is 2%
5. Tax: Corporate tax rate is 35%. Ignore dividend tax
Assumption Area:
• Compute market price of debenture as per approximation method
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.15 per share
CMP/Issue price Rs.125 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6 percent
Floatation cost Rs.5 per share
D1
Ke = + Growth rate
P0 − F
𝟏𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟐𝟓𝟎 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟖𝟓(𝐨𝐫)𝟏𝟖. 𝟓𝟎%
𝟏𝟐𝟓 − 𝟓

Note 1: Computation of growth rate:

• Dividend has grown from Rs.10.60 to Rs.14.19 over period of five years
14.19 = 10.60 x (1 + r)5
r = Growth rate
• Growth rate in dividend would be equal to 6 percent once we solve the above equation
• Using a growth rate of 6 percent, we get dividend of Rs.14.19 at the end of five years. Hence growth
rate in dividend is 6 percent

Cost of retained earnings:

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D1
Kr = + Growth rate
P0
𝟏𝟓
𝐊𝐫 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟐 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟖(𝐨𝐫)𝟏𝟖. 𝟎𝟎%
𝟏𝟐𝟓

Cost of preference:
Basic information
Type of preference Irredeemable
Face value Rs.100
Coupon rate 15%
Issue price – floatation cost
Net proceeds Rs.105
Redeemable value NA
Balance life NA

Computation of Cost of Preference:

Preference Dividend 15
Kp = = x 100 = 14.29%
Net proceeds 105

Cost of debt:
Type of debt Redeemable
Face value Rs.100 (assumed)
Coupon rate 15%
Tax rate 35%
Issue price – FC
Net proceeds 93.75 – 2 = Rs.91.75
Redeemable value Rs.100 (assumed at par)
Balance life 11 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
100 − 91.75
9.75 + 9.75 + 0.75
Kd = 11 = x 100 = 10.95%
100 + 91.75 85.875
2
Note 1: Computation of net proceeds:
• The company pays interest rate of 15% whereas investors are expecting return of 16%
• The company is not meeting the expectations of investors. Hence the issue has to happen at
discount
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝟏𝟎𝟎 𝐱 𝟏𝟓%
𝐈𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞 = = = 𝐑𝐬. 𝟗𝟑. 𝟕𝟓
𝐈𝐧𝐯𝐞𝐬𝐭𝐨𝐫 𝐞𝐱𝐩𝐞𝐜𝐭𝐚𝐭𝐢𝐨𝐧 𝟏𝟔%
• Net proceeds = Issue price – Floatation cost = Rs.93.75 -2 = Rs.91.75

WN 2: Computation of WACC:
Weight Product
Source Cost BV MV BV MV
Equity 18.50% 1,20,00,000 1,60,00,000 22,20,000 29,60,000
Retained earnings 18.00% 30,00,000 40,00,000 5,40,000 7,20,000
Preference shares 14.29% 9,00,000 10,40,000 1,28,610 1,48,616
Debentures 10.95% 36,00,000 33,75,000 3,94,200 3,69,563

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Total 1,95,00,000 2,44,15,000 32,82,810 41,98,179
• There is no separate market value given for retained earnings. Market value given in question is
combined market value for equity and retained earnings. Hence we split the market value of
Rs.2,00,00,000 in the ratio of book values (4:1) to get market value of equity and retained earnings.

Sum of product 32,82,810

WACC(based on BV weights) = = x 100 = 16.83%
sum of weights 1,95,00,000
Sum of product 41,98,179
WACC(based on MV weights) = = x 100 = 17.19%
sum of weights 2,44,15,000

28. Calculation of WACC [Jan 2021, Nov 2020 RTP, June 2009, May 2016 RTP, May 2019 RTP, Sep
2024 MTP]
ICAI Question:
Calculate the WACC using the following data by using Market Value weights:
Particulars Amount
Equity Shares (Rs. 10 per equity share) 15,00,000
Reserves & Surplus 5,00,000
Preference Shares (Rs. 100 per preference share) 7,50,000
Debentures (Rs. 100 per debenture) 5,50,000
The market prices of these securities are:
• Debentures - Rs. 105 per debenture
• Preference shares - Rs.115 per preference share
• Equity shares - Rs. 27 per equity share
Additional information:
• Rs. 100 FV per debenture redeemable at premium of 10%, 10% coupon rate, 4% floatation costs,
10-year maturity.
• Rs. 100 FV per preference share redeemable at par, 12% coupon rate, 2% floatation cost and 10-
year maturity.
• Equity shares have Rs. 4.5 floatation cost and market price of 27 per share. The last dividend
paid by the company was Rs. 2 which is expected to grow at an annual growth rate of 9%. The
firm has the practice of paying all earnings as a dividend. The corporate tax rate is 25%.
• To calculate the overall cost of debt & preference shares, take the average of their respective
costs using YTM & approximation method.
Modified Question:
• You are not required to separate the market value of equity into market value of shares and
reserves when calculating WACC, and there is no need to calculate the cost of retained earnings.

Important Assumption/Ambiguous Area:

• Net proceeds of debentures = Issue price – Floatation cost. In this question it is assumed that
issue price of new debenture is equal to current market price of the debenture. However, there
are multiple questions where ICAI has taken the issue price of debenture to be equal to face
value. Hence students have to be careful and write the assumption taken by them in solving the
question
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of debt using short-cut method:
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 25%
Net proceeds Issue price – Floatation cost
[issue assumed at CMP] 105 – 4% of 105 = Rs.100.80
Redeemable value Rs.110
Balance life 10 years

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Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
110 − 100.80
7.5 + 7.50 + 0.92
Kd = 10 = x 100 = 7.99%
110 + 100.80 105.40
2

Cost of Debt using YTM method

Year Cash flow PVF @ 8% DCF PVF @ 10% DCF
0 100.80 1.000 100.80 1.000 100.80
1 to 10 -7.50 6.710 -50.33 6.145 -46.09
10 -110 0.463 -50.93 0.386 -42.46
NPV -0.46 12.25
−0.46
IRR (K d ) = 8% + 𝑥 (10 − 8) = 8 + 0.07 = 8.07%
−0.46 − 12.25
• Final cost of debt = (7.99 + 8.07)/2 = 8.03%

Cost of preference: using short-cut method

Basic information
Type of preference Redeemable
Face value Rs.100
Coupon rate 12%
Net proceeds Issue price – Floatation cost
[issue assumed at par] 115 -2% = Rs.112.70
Redeemable value Rs.100
Balance life 10 years

Computation of Cost of preference:

RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 112.70
12.00 + 12.00 − 1.27
Kp = 10 = x 100 = 10.09%
100 + 112.70 106.35
2

Cost of Preference using YTM method

Year Cash flow PVF @ 10% DCF PVF @ 8% DCF
0 112.70 1.000 112.70 1.000 112.70
1 to 10 -12 6.145 -73.74 6.710 -80.52
10 -100 0.386 -38.60 0.463 -46.30
NPV 0.36 -14.12
−14.12
IRR (K d ) = 8% + 𝑥 (10 − 8) = 8 + 1.95 = 9.95%
−14.12 − 0.36
• Final cost of preference = (10.09 + 9.95)/2 = 10.02%

Cost of equity:
Basic information:
Dividend of next year 2 + 9% = 2.18 per share

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CMP/Issue price Rs.27 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 9 percent
Floatation cost Rs.4.5 per share
D1
Ke = + Growth rate
P0 − F
𝟐. 𝟏𝟖
𝐊𝐞 = + 𝟎. 𝟎𝟗 = 𝟎. 𝟎𝟗𝟔𝟗 + 𝟎. 𝟎𝟗 = 𝟎. 𝟏𝟖𝟔𝟗 (𝐨𝐫)𝟏𝟖. 𝟔𝟗%
𝟐𝟕 − 𝟒. 𝟓

WN 2: Computation of cost of capital using market value weights:

Source Cost Weight Product
40,50,000
Equity 18.69% [1,50,000 x 27] 7,56,945
8,62,500
Preference shares 10.02% [7,500 x 115] 86,423
5,77,500
Debentures 8.03% [5,500 x 105] 46,373
Total 54,90,000 8,89,741
Sum of product 8,89,741
WACC = = x 100 = 16.21%
sum of weights 54,90,000

29. Computation of WACC [May 2023]

Capital structure of D Ltd. as on 31stMarch, 2023 is given below:
Particulars Amount
Equity share capital (of Rs.10 each) 30,00,000
8% preference share capital (Rs.100 each) 10,00,000
12% Debentures (Rs.100 each) 10,00,000
• Current market price of equity share is Rs. 80 per share. The company has paid dividend of Rs.
14.07 per share. Seven years ago, it paid dividend of Rs. 10 per share. Expected dividend is Rs. 16
per share.
• 8% Preference shares are redeemable at 6% premium after five years. Current market price per
preference share is Rs. 104.
• 12% debentures are redeemable at 20% premium after 10 years. Flotation cost is Rs. 5 per
debenture.
• The company is in 40% tax bracket.
• In order to finance an expansion plan, the company intends to borrow 15% Long-term loan of Rs.
30,00,000 from bank. This financial decision is expected to increase dividend on equity share from
Rs. 16 per share to Rs. 18 per share. However, the market price of equity share is expected to decline
from Rs. 80 to Rs. 72 per share, because investors' required rate of return is based on current market
conditions.
Required:
(i) Determine the existing Weighted Average Cost of Capital (WACC) taking book value weights.
(ii) Compute Weighted Average Cost of Capital (WACC) after the expansion plan taking book
value weights.
[FVIF (5%, 7 years) = 1.407; FVIF (6%, 7 years) = 1.504; FVIF (7%, 7 years) = 1.606]
Answer:
WN 1: Computation of cost of individual components of capital
Cost of Equity:
𝐷1 16
Ke = +𝐺 = + 0.05 = 25.00%
𝑃0 80
Growth rate:
• Future value = Present value x Future Value Factor
• 14.07 = 10 x Future value factor (r, 7 years)

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• Future value factor = 1.407
• Future value factor of 1.407 corresponds to 7 years and 5%. Hence Growth rate is 5%

Cost of Preference:
Preferece Dividend + Average other Costs
Cost of redeemable preference shares =
Average Funds Employed
106 − 104
8+ 8.4
Kp = 5 = = 8%
106 + 104 105
2

Cost of Debt:
Interest after tax + Average other Costs
Cost of Debt =
Average Funds Employed
120 − 95
12 𝑥 0.60 + 9.70
Kd = 10 = = 9.02%
120 + 95 107.50
2

WN 2: Computation of WACC:
Source Cost Weight Product
Equity 25.00% 30,00,000 7,50,000
Preference share capital 8.00% 10,00,000 80,000
Debentures 9.02% 10,00,000 90,200
Total 50,00,000 9,20,200
Sum of Product 9,02,200
WACC = = = 18.40%
Sum of weights 50,00,000

WN 3: Computation of new WACC:

Note: Cost of individual components of capital (revised)
Cost of Equity:
𝐷1 18
Ke = +𝐺 = + 0.05 = 30.00%
𝑃0 72

Note 2: Computation of new WACC:

Source Cost Weight Product
Equity 30.00% 30,00,000 9,00,000
Preference share capital 8.00% 10,00,000 80,000
Debentures 9.02% 10,00,000 90,200
Term Loan 9.00% 30,00,000 2,70,000
Total 80,00,000 13,40,200

Sum of Product 13,40,200

WACC = = = 16.76%
Sum of weights 80,00,000

30. Computation of WACC [May 2018 RTP, Nov 2019, May 2008, May 2015, Nov 2015 RTP, May 2015
RTP, Nov 2017 RTP, July 2021, Nov 2023, Nov 2023 RTP, SM]
Navya Limited wishes to raise additional capital of Rs.10 lakhs for meeting its modernization plan. It has
Rs.3,00,000 in the form of retained earnings available for investment purposes. The following are the further
details:
Debt/equity mix 40%/60%
Cost of debt (before tax)
Upto Rs.1,80,000 10%
Beyond Rs.1,80,000 16%
Earnings per share Rs.4

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Dividend Payout Rs.2
Expected growth rate in dividend 10%
Current market price per share Rs.44
Tax rate 50%
Required:
a) To determine the pattern for raising the additional finance
b) To calculate the post-tax average cost of additional debt
c) To calculate the cost of retained earnings and cost of equity and
d) To determine the overall weighted average cost of capital (after tax)
Answer:
WN 1: Pattern of raising additional finance:

Money to be
raised = 10 lacs

Equity = 6 Debt = 4
lacs lacs

Int equity 10% debt =

= 3 lacs 1.8 lacs

Ext equity 16% debt =

= 3 lacs 2.2 lacs

WN 2: Computation of post-tax average cost of additional debt:

• Cost of 10% debt = 10% x (1 – 50%) = 5.00%
• Cost of 16% debt = 16% x (1 – 50%) = 8.00%
(5 x 1.8) + (8 x 2.2)
Average cost of debt = = 6.65%
1.8 + 2.2

WN 3: Computation of cost of equity and retained earnings:

Basic information:
Dividend of next year 2 + 10% = Rs.2.20 per share
CMP/Issue price Rs.44 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 10 percent
Floatation cost Rs.0 per share
D1
Ke = + Growth rate
P0 − F
𝟐. 𝟐𝟎
𝐊𝐞 = + 𝟎. 𝟏𝟎 = 𝟎. 𝟎𝟓 + 𝟎. 𝟏𝟎 = 𝟎. 𝟏𝟓(𝐨𝐫)𝟏𝟓. 𝟎𝟎%
𝟒𝟒 − 𝟎

• Cost of equity as well as retained earnings will be 15%

WN 4: Computation of WACC:
Source Cost Weight Product
Equity 15.00% 3,00,000 45,000
Retained earnings 15.00% 3,00,000 45,000
Debt 6.65% 4,00,000 26,600
Total 10,00,000 1,16,600
Sum of product 1,16,600
WACC = = x 100 = 11.66%
sum of weights 10,00,000
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31. Revised WACC Calculation [May 2019, Nov 2016, Nov 2021 MTP]
The following is the capital structure of Simons Company Ltd. as on 31-12-2010:
Particulars Book Market
Value Value
Equity shares: 10,000 shares of Rs.100 each 10,00,000 11,00,000
Retained earnings 1,00,000 -
10% Preference Shares (of Rs.100 each) 4,00,000 4,40,000
12% Debentures 6,00,000 7,20,000
20,00,000 22,60,000
The market price of the company’s share is Rs.110 and it is expected that a dividend of Rs.10 per share
would be declared for the year 2010. The dividend growth rate is 6%.
(i) If the company is in the 50% tax bracket and the investor’s rate of tax is 20%, compute the weighted
average cost of capital based on book value and market value.
(ii) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs.10
lakh bearing 14% rate of interest, what will be the company’s revised weighted average cost of capital? This
financing decision is expected to increase dividends from Rs.10 to Rs.12 per share. However, the market
price of equity share is expected to decline from Rs.110 to Rs.105 per share.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.10 per share
CMP/Issue price Rs.110 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟗𝟎𝟗 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟓𝟎𝟗(𝐨𝐫)𝟏𝟓. 𝟎𝟗%
𝟏𝟏𝟎 − 𝟎

Cost of retained earnings:

K r = [K e x (1 − personal tax rate)] x [1 − Floatation cost%]
K r = [15.09 x (1 − 20%) 𝑥 [1 − 0]%] = 15.09% x 80% = 12.07%
Cost of preference:
Basic information
Type of preference Irredeemable
Face value Rs.100
Coupon rate 10%
Current market price
Net proceeds =4,40,000/4,000 = Rs.110
Redeemable value NA
Balance life NA

Computation of Cost of Preference:

Preference Dividend 10
Kp = = x 100 = 9.09%
Net proceeds 110

Cost of debt:
Basic information
Type of debt Irredeemable

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Face value Rs.100 (assumed)
Coupon rate 12%
Tax rate 50%
CMP
Net proceeds =7,20,000/6,000 = Rs.120
Redeemable value NA
Balance life NA

Interest after tax 6

Kd = = x 100 = 5%
Net proceeds 120

WN 2: Computation of WACC:
Weight Product
Source Cost BV MV BV MV
Equity 15.09% 10,00,000 10,00,000 1,50,900 1,50,900
Retained earnings 12.07% 1,00,000 1,00,000 12,070 12,070
Preference shares 9.09% 4,00,000 4,40,000 36,360 39,996
Debentures 5.00% 6,00,000 7,20,000 30,000 36,000
Total 21,00,000 22,60,000 2,29,330 2,38,966
Sum of product 2,29,330
WACC(based on BV weights) = = x 100 = 10.92%
sum of weights 21,00,000
Sum of product 2,38,966
WACC(based on MV weights) = = x 100 = 10.57%
sum of weights 22,60,000

WN 3: Computation of revised cost of individual components of capital:

12
Ke = + 0.06 = 0.1143 + 0.06 = 0.1743(or)17.43%
105 − 0
K r = [17.43 x (1 − 20%)] − 0% = 17.43% x 80% = 13.93%
Cost of preference = 9.09% [No change]
Cost of debentures = 5.00% [No change]
Cost of fresh borrowings = Interest rate x (1 – Tax rate) = 14% x (1 – 50%) = 7%

WN 4: Computation of revised WACC:

Weight Product
Source Cost BV MV BV MV
Equity 17.43% 10,00,000 9,54,545 1,74,300 1,66,377
Retained earnings 13.93% 1,00,000 95,455 13,930 13,297
Preference shares 9.09% 4,00,000 4,40,000 36,360 39,996
Debentures 5.00% 6,00,000 7,20,000 30,000 36,000
14% borrowing 7.00% 10,00,000 10,00,000 70,000 70,000
Total 31,00,000 32,10,000 3,24,590 3,25,670
• Revised market value of equity = 10,000 shares x 105 = Rs.10,50,000. This has been split in the
ratio of 10:1 to get value of equity and retained earnings
WACC:
Sum of product 3,24,590
WACC(based on BV weights) = = x 100 = 10.47%
sum of weights 31,00,000
Sum of product 3,25,670
WACC(based on MV weights) = = x 100 = 10.15%
sum of weights 32,10,000

32. WACC and WMCC Schedule [May 2018 MTP, May 2019 RTP, Nov 2020 MTP, May 2022 MTP,
May 2023 RTP]
XYZ Ltd., has the following book value capital structure:
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Equity Capital (in Shares of Rs.10 each, fully paid up-at par) Rs.15 Crores
11% preference Capital (in shares of Rs.100 each, fully paid up – at par) Rs.1 Crore
Retained Earnings Rs.20 Crores
13.5% Debentures (of Rs.100 each) Rs.10 Crores
15% Term Loans Rs.12.5 Crores
• The next expected dividend on equity shares per share is Rs.3.60; the dividend per share is
expected to grow at the rate of 7%. The market price per share is Rs.40.
• Preference stock, redeemable after ten years, is currently selling at Rs.75 per share.
• Debentures, redeemable after six years, are selling at Rs.80 per debenture.
• The Income-tax rate for the company is 40%.
(i) Required:
Calculate the weighted average cost of capital using:
(a) book value proportions; and
(b) Market value proportions.
(ii) Define the weighted marginal cost of capital schedule for the company, if it raises Rs.10 Crores next
year, given the following information:
(a) The amount will be raised by equity and debt in equal proportions:
(b) The company expects to retain Rs.1.5 Crores earnings next year:
(c) The additional issue of equity shares will result in the net price per share being fixed at Rs.32;
(d) The debt capital raised by way of term loans will cost 15% for the first Rs.2.5 Crores and 16% for the
next Rs.2.5 Crores.
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.3.60 per share
CMP/Issue price Rs.40 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 7 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟑. 𝟔𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟕 = 𝟎. 𝟎𝟗 + 𝟎. 𝟎𝟕 = 𝟎. 𝟏𝟔(𝐨𝐫)𝟏𝟔. 𝟎𝟎%
𝟒𝟎 − 𝟎

Cost of preference:
Basic information
Type of preference Redeemable
Face value Rs.100
Coupon rate 11%
Net proceeds Current market price = Rs.75
Redeemable value Rs.100 (assumed at par)
Balance life 10 years
Dividend distribution tax 0
Computation of Cost of preference:
RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 75
11.00 + 11.00 + 2.50
Kp = 10 = x 100 = 15.43%
100 + 75 87.50
2

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Cost of retained earnings:
• Cost of retained earnings will be same as cost of equity. Cost of retained earnings = 16%

Cost of debentures:
Basic information:
Type of debt Redeemable
Face value Rs.100
Coupon rate 13.50%
Tax rate 40%
Net proceeds Current market price = Rs.80
Redeemable value Rs.100 (assumed at par)
Balance life 6 years
Computation of Cost of Debt:
RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
100 − 80
8.10 + 8.10 + 3.33
Kd = 6 = x 100 = 12.70%
100 + 80 90
2

Cost of term loan:

Cost of term loan = Interest rate x (1 – Tax rate)
Cost of term loan = 15% x (1 – 40%) = 9.00%

WN 2: Computation of WACC
Weight (in lacs) Product (in lacs)
Source Cost BV MV BV MV
Equity 16.00% 1,500 2,571 240.00 411.36
75
Preference capital 15.43% 100 [1 lac x 75] 15.43 11.57
Retained earnings 16.00% 2,000 3,429 320.00 548.64
800
Debentures 12.70% 1,000 [10 lac x 80] 127.00 101.60
Term loan 9.00% 1,250 1,250 112.50 112.50
Total 5,850 8,125 814.93 1,185.67
• Market value of equity shares = 150 lacs shares x 40 = 6,000 lacs. This has been split in the ratio of
3:4 to get value of equity and retained earnings.

WACC Computation:
Sum of product 814.93
WACC(based on BV weights) = = x 100 = 13.93%
sum of weights 5,850
Sum of product 1,185.67
WACC(based on MV weights) = = x 100 = 14.59%
sum of weights 8,125

WN 3: Computation of WMCC:
Part 1: Money to be raised:

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Money to be
raised = 10 Cr

Equity = Debt = 5
5cr cr

Int equity 15% debt

= 1.5 Cr = 2.5 cr

Ext equity 16% debt

= 3.5 cr = 2.5 cr
Part 2: Cost of components of capital:
Cost of retained Retained earnings is already available with company and hence its cost will
earnings continue to be 16%
Cost of equity D1 𝟑. 𝟔𝟎
Ke = + Growth rate = + 𝟎. 𝟎𝟕 = 𝟎. 𝟏𝟏𝟐𝟓 + 𝟎. 𝟎𝟕 = 𝟏𝟖. 𝟐𝟓%
P0 − F 𝟑𝟐
Cost of 15% debt Interest rate x (1 – Tax rate) = 15 x (1 – 0.4) = 9%
Cost of 16% debt 16 x (1 – 0.4) = 9.6%

Part 3: WMCC computation and Schedule:

Source Cost Weight (in lacs) Product (in lacs)
Retained earnings 16.00% 150 24.00
Equity 18.25% 350 63.88
15% debt 9.00% 250 22.50
16% debt 9.60% 250 24.00
Total 1,000 134.38
Sum of product 134.38
WMCC = = x 100 = 𝟏𝟑. 𝟒𝟒%
sum of weights 1,000

33. WMCC [May 2024 MTP]

Tiago Ltd is an all-equity company engaged in manufacturing of batteries for electric vehicles. There has
been a surge in demand for their products due to rising oil prices. The company was established 5 years
ago with an initial capital of Rs. 10,00,000 and since then it has raised funds by IPO taking the total paid up
capital to Rs. 1 crore comprising of fully paid-up equity shares of face value Rs. 10 each. The company
currently has undistributed reserves of Rs. 60,00,000. The company has been following constant dividend
payout policy of 40% of earnings. The retained earnings by company are going to provide a return on
equity of 20%. The current EPS is estimated as Rs 20 and prevailing PE ratio on the share of company is
15x. The company wants to expand its capital base by raising additional funds by way of debt, preference
and equity mix. The company requires an additional fund of Rs. 1,20,00,000. The target ratio of owned to
borrowed funds is 4:1 post the fund-raising activity. Capital gearing is to be kept at 0.4x.

The existing debt markets are under pressure due to ongoing RBI action on NPAs of the commercial bank.
Due to challenges in raising the debt funds, the company will have to offer Rs. 100 face value debentures
at an attractive yield of 9.5% and a coupon rate of 8% to the investors. Issue expenses will amount to 4% of
the proceeds.

The preference shares will have a face value of Rs. 1000 each offering a dividend rate of 10%. The preference
shares will be issued at a premium of 5% and redeemed at a premium of 10% after 10 years at the same
time at which debentures will be redeemed.

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The CFO of the company is evaluating a new battery technology to invest the above raised money. The
technology is expected to have a life of 7 years. It will generate a after tax marginal operating cash flow of
Rs. 25,00,000 p.a. Assume marginal tax rate to be 27%.

Question No.1: Which of the following is best estimate of cost of equity for Tiago Ltd?
a. 12.99% b. 11.99%
c. 13.99% d. 14.99%
Question No.2: Which of the following is the most accurate measure of issue price of debentures?
a. 100 b. 96
c. 90.58 d. 95.88
Question No.3: Which of the following is the best estimate of cost of debentures to be issued by the
company? (Using approximation method)
a. 7.64% b. 6.74%
c. 4.64% d. 5.78%
Question No.4: Calculate the cost of preference shares using approximation method
a. 10.23% b. 9.77%
c. 12.12% d. 12.22%
Question No.5: Which of the following best represents the overall cost of marginal capital to be raised?
a. 10.52% b. 17.16%
c. 16.17% d. 16.71%
Answer:
Question No.1
D1 8.96
Cost of equity = +𝐺 = + 0.12 = 0.0299 + 0.12 = 𝟎. 𝟏𝟒𝟗𝟗 (𝒐𝒓)𝟏𝟒. 𝟗𝟗%
P0 300
• Current EPS = Rs.20
• Current DPS = 20 x 40% = Rs.8; Next year DPS = 8 + 12% = 8.96
• Growth Rate = ROE x Retention Ratio = 20% x 60% = 12.00%
• Price = EPS x PE Multiple = 20 x 15 = 300
Question No.2
Year Cash flow PVF @ 9.5% DCF
1 to 10 8.00 6.2788 50.23
10 100.00 0.4035 40.35
Issue Price 90.58
Question No.3
Interest after tax + Average other costs 8 x 73% + 1.30
Kd = = x 100 = 7.64%
Average funds employed 93.48
Redeemable value − Net proceeds 100 − 86.96
Average other costs = = = Rs. 1.30
Balance life 10
Redeemable value + Net proceeds 100 + 86.96
Average funds employed = = = Rs. 93.48
2 2
Question No.4
Preference Dividend + Average other costs
Cost of redeemable preference (K p ) =
Average Funds Employed
1100 − 1050
(100 + ) 105
Kp = 10 = 𝑥 100 = 9.77%
1075 1075
Question No.5
Computation of Amount to be raised:
Particulars Calculation Amount
Existing capital 1,60,00,000
New funds to be raised 1,20,00,000
Total Capital Employed 2,80,00,000
Capital Gearing Ratio 0.40 Times
Fixed Charge bearing Capital (0.40) 80,00,000
Equity capital (1.00) 2,00,00,000
Manner in which new funds to be raised:

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Equity 2 Cr – 1.60 Cr 40,00,000
Debt (2,80,00,000 x 1/5) 56,00,000
Preference 1.2 cr – 0.40 cr – 0.56 Cr 24,00,000

Computation of WMCC:
Source Cost Weight Product
Equity 14.99 40,00,000 5,99,600
Debt 7.64 56,00,000 4,27,840
Preference 9.77 24,00,000 2,34,480
Total 10.52 1,20,00,000 12,61,920

34. WMCC [May 2021 RTP, Nov 2019 MTP, May 2005, Nov 2014 RTP, May 2016, Nov 2020 RTP, Nov
2022, May 2024 RTP, SM]
Totto Ltd. has following capital structure as on 31st December 2023, which is considered to be optimum:
12% debenture 4,50,000
10% Preference Share capital 1,50,000
Equity Share capital (2,00,000 shares) 24,00,000
The Company’s share has a current market price of Rs.30.25 per share: The expected dividend per share in
next year is 50 percent of the 2023 EPS. The EPS of last 10 years is as follows. The past trends are expected
to continue:
Year EPS (Rs.) 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
(Rs.) 1.180 1.311 1.456 1.616 1.794 1.99 2.209 2.452 2.723 3.023

The company can issue 14 percent new debenture and 12 percent new preference shares. The company’s
debenture is currently selling at Rs.99. The new preference issue can be sold at a net price of Rs.9.90, paying
a dividend of Rs.1.25 per share. The company’s marginal tax rate is 50%.
(i) Calculate the after tax cost (a) of a new debts and new preference share capital, (b) of ordinary equity,
assuming new equity comes from retained earnings.
(ii) Calculate the marginal cost of capital for the new funds raised
(iii) How much can be spent for capital investment before new ordinary share must be sold? Assuming that
retained earnings available for next year’s investment are 50% of 2023 earnings
(iv) What will be marginal cost of capital (cost of funds raised in excess of the amount calculated in part
(iii)) if the company can sell new ordinary shares to net Rs.22 per share? The cost of debt and of preference
capital is constant.
Important Assumption/Ambiguous Area:
• Net proceeds of debentures = Issue price – Floatation cost. In this question it is assumed that
issue price of new debenture is equal to current market price of the debenture. However, there
are multiple questions where ICAI has taken the issue price of debenture to be equal to face
value. Hence students have to be careful and write the assumption taken by them in solving the
question
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of debt:
Basic information
Type of debt Irredeemable
Face value Rs.100
Coupon rate 14%
Tax rate 50%
Issue price – floatation cost
Net proceeds 99 (assumed to be issued at CMP) – 0 = Rs.99
Redeemable value NA
Balance life NA
Interest after tax 7
Kd = = x 100 = 7.07%
Net proceeds 99
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Cost of preference:
Basic information
Type of preference Irredeemable
Dividend Rs.1.25 per share
Net proceeds Rs.9.90 per share
Redeemable value NA
Balance life NA
Computation of Cost of Preference:
Preference Dividend 1.25
Kp = = x 100 = 12.63%
Net proceeds 9.90

Cost of ordinary equity (new equity comes from retained earnings)

Basic information:
Dividend of next year 3.023 x 50% = 1.5115 per share
CMP/Issue price Rs.30.25 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 12% [Increase in dividend is 11% every year]
Floatation cost 0
D1
Kr = + Growth rate
P0
𝟏. 𝟓𝟏𝟏𝟓
𝐊𝐫 = + 𝟎. 𝟏𝟏 = 𝟎. 𝟎𝟓 + 𝟎. 𝟏𝟏 = 𝟎. 𝟏𝟔(𝐨𝐫)𝟏𝟔. 𝟎𝟎%
𝟑𝟎. 𝟐𝟓

WN 2: Marginal cost of capital schedule:

• The company is currently operating with an optimum capital structure. This would mean that
any fresh money would be raised in the same proportion
• Weight of debentures = (4,50,000/30,00,000) x 100 = 15.00%
• Weight of Preference = (1,50,000/30,00,000) x 100 = 5.00%
• Weight of equity = (24,00,000/30,00,000) x 100 = 80.00%
Source Cost Weight (in %) Product
Debentures 7.07% 15 1.0605
Preference 12.63% 5 0.6315
Equity 16.00% 80 12.800
Total 100 14.492
Sum of product 14.48
WMCC = = x 100 = 𝟏𝟒. 𝟒𝟗𝟐%
sum of weights 100

WN 3: Computation of possible investment with retained earnings:

Particulars Amount
EPS of 2023 3.023
No of equity shares 2,00,000
Total earnings of 2023 (3.023 x 2,00,000) 6,04,600
Retained earnings of 2023 (6,04,600 x 50%) 3,02,300
Weight of equity in capital structure 80%
Possible investment with retained earnings (3,02,300/80%) 3,77,875

WN 4: Marginal cost of capital schedule (for investment beyond 3,77,875):

Source Cost Weight (in %) Product
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Debentures 7.07% 15 1.0605
Preference 12.63% 5 0.6315
17.87%
Equity [Note] 80 14.296
Total 100 15.988
Sum of product 15.988
WMCC = = x 100 = 𝟏𝟓. 𝟗𝟖𝟖%
sum of weights 100

Note: Revised cost of equity:

D1
Ke = + Growth rate
P0 − F
𝟏. 𝟓𝟏𝟏𝟓
𝐊𝐞 = + 𝟎. 𝟏𝟏 = 𝟎. 𝟎𝟔𝟖𝟕 + 𝟎. 𝟏𝟏 = 𝟎. 𝟏𝟕𝟖𝟕 (𝐨𝐫)𝟏𝟕. 𝟖𝟕%
𝟐𝟐

35. Cost of Capital (Nov 2022 RTP, May 2024 MTP):

Bounce Ltd. evaluates all its capital projects using discounting rate of 15%. Its capital structure consists of
equity share capital, retained earnings, bank term loan and debentures redeemable at par.

Rate of interest on bank term loan is 1.5 times that of debenture. Remaining tenure of debenture and bank
loan is 3 years and 5 years respectively. Book value of equity share capital, retained earnings and bank loan
is Rs. 10,00,000, Rs. 15,00,000 and Rs. 10,00,000 respectively. Debentures which are having book value of
Rs. 15,00,000 are currently trading at Rs. 97 per debenture. The ongoing P/E multiple for the shares of the
company stands at 5. You are required to CALCULATE the rate of interest on bank loan and debentures if
tax rate applicable is 25%.
Answer:
WN 1: WACC Table:
• The company uses discount rate of 15 percent for project evaluation. We normally use cost of
capital as discount rate and hence we can conclude that weighted average cost of capital is 15%
Source Cost Weight Product
20.00
Equity (Note 1) 10.00 2.00
20.00
Retained earnings (Note 1) 15.00 3.00
75X + 1
98.50 1,125X + 15
Debentures (Note 2) 15.00 98.50
1.125X
Term Loans (Note 3) 10.00 11.25X
Overall 15.00 50.00 7.50
Solving X:
1,125X + 15
2.00 + 3.00 + + 11.25X = 7.50
98.50
1,125X + 15
+ 11.25X = 2.50
98.50
1,125X + 15 + 1,108.125X
= 2.50
98.50
2,233.125X = 231.25
231.25
X= x 100 = 10.36%
2,233.125
• Hence rate of interest on debentures = 10.36%
• Rate of interest on term loan = 10.36% x 1.50 = 15.54%

Note 1:

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1 1
Cost of equity = = = 20%
PE Multiple 5
• Cost of retained earnings is same as cost of equity in absence of personal taxes and floatation costs

Note 2: Cost of debentures:

• Let us assume interest rate of debentures to be X
• Face value of debentures is RS.100 and hence the interest paid on debentures is 100X
• After-tax interest cost = 100 x (1 – 0.25) = 75X
• Redeemable value = Rs.100
• Net proceeds = Current market price = Rs.97
Interest after tax + Average other costs 75X + 1.00
Kd = =
Average funds employed 98.50
Note:
Redeemable value − Net proceeds 100 − 97
Average other costs = = = Rs. 1.00
Balance life 3
Redeemable value + Net proceeds 100 + 97
Average funds employed = = = Rs. 98.50
2 2

Note 3: Cost of term loan

• Cost of term loan = Interest rate x (1 – Tax rate)
• Interest rate of term loan = 1.5 Times of debentures = 1.5X
• Cost of term loan = 1.5X x (1 – 0.25) = 1.125X

36. Selection of project and computation of WACC [Nov 2018 RTP, Nov 2016 RTP, Sep 2024 MTP]
Gitarth Limited has a current debt equity ratio of 3:7. The company is presently considering several
alternative investment proposals costing less than Rs. 25 lakhs. The company will always raise the funds
required without disturbing its current capital structure ratio.
The cost of raising the debt and equity are as under:
Project Cost Cost of debt Cost of equity
Upto Rs.5,00,000 10% 12%
Above 5 lacs and upto 10 lacs 12% 13.5%
Above 10 lacs and upto 20 lacs 13% 15%
Above 20 lacs 14% 16%
Assuming the tax rate at 30%, calculate:
(a) Cut off rate for two Projects I & Project II whose fund requirements are 15 lakhs & Rs. 26 lakhs
respectively.
(b) If a project is expected to give an after-tax return of 13%, determine under what conditions it would
be acceptable.
Assumption Based Area:
• Similar question appeared in the November 2018 RTP, where ICAI treated the above costs as
flat rates and applied them directly based on the cut-off provided in the question. However,
in the latest solution, ICAI has treated these costs as slab rates, leading to different solution. It is
critical to clearly state your assumptions in the exam.
Answer:
WN 1: Computation of cost of capital (Slab wise)
Project Cost Calculation Cost
Upto Rs.5,00,000 (10% x 0.30) + (12% x 0.70) 11.40%
Above 5 lacs and upto 10 lacs (12% x 0.30) + (13.5% x 0.70) 13.05%
Above 10 lacs and upto 20 lacs (13% x 0.30) + (15% x 0.70) 14.40%
Above 20 lacs (14% x 0.30) + (16% x 0.70) 15.40%

WN 2: Cost of capital (Hurdle Rate) of Project I and II

Project I
Source Cost Weight Product

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First 5,00,000 11.40% 5,00,000 57,000
Next 5,00,000 13.05% 5,00,000 65,250
Next 5,00,000 14.40% 5,00,000 72,000
Total 12.95% 15,00,000 1,94,250
• Overall cost of capital of Project I = 12.95%

Project II
Source Cost Weight Product
First 5,00,000 11.40% 5,00,000 57,000
Next 5,00,000 13.05% 5,00,000 65,250
Next 10,00,000 14.40% 5,00,000 1,44,000
Balance 6,00,000 15.40% 6,00,000 92,400
Total 13.79% 26,00,000 3,58,650
• Overall cost of capital of Project II = 13.79%

WN 3: Acceptability of project with return of 13%

• If any project is expected to give an after-tax return of 13%, it can be accepted only if the maximum
Overall COC (%) of that project equals 13% or less, as at 13%, project would be at break-even i.e
earning 13% from the project and incurring 13% COC.
• Project I is having COC of 12.95% and the same can increase further in case the project cost
increases and the same is presented below:

Source Cost Weight Product

First 5,00,000 11.40% 5,00,000 57,000
Next 5,00,000 13.05% 5,00,000 65,250
Balancing figure 14.40% X 0.144X
Total 13.00% 10,00,000 + X 1,30,000 + 0.13X =
1,22,250 + 0.144X

1,30,000 + 0.13X = 1,22,250 + 0.144X

7,750
0.014X = 7,750; X = = Rs. 5,53,571
0.014
• Hence overall project cost at 13% COC is equal to 10,00,000 + 5,53,571 = Rs.15,53,571

Alternate solution – Presented by ICAI – this is approximate answer and solution presented above is
accurate answer – in exam please present below solution
Project Cost Cost of capital
15,00,000 12.95%
26,00,000 13.79%
Change in cost 11,00,000
Change in cost of capital 0.84%
• Our cost of capital has increased by 0.84% for incremental project cost of Rs.11,00,000. We want
the WACC to increase from 12.95% to 13.00% and hence we can do proportionate cost
computation using the concept of interpolation
• 0.84% = 11,00,000; 0.05% = ?
• Extra proportionate project cost = 11,00,000 x (0.05/0.84) = Rs.65,476
• Hence Project cost would with 13% cost of capital = 15,00,000 + 65,476 = Rs.15,65,476

Practice Questions

1. Cost of Redeemable Debt

Assuming a tax rate of 50%, coupon of 10% face value of Rs.1000 and a maturity period of 20 years, compute
the cost of debentures which is sold at a discount of 5% and whose floatation costs are 3%.
Answer:
Basic information

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Type of debt Redeemable
Face value Rs.1,000
Coupon rate 10%
Tax rate 50%
Issue price – floatation cost
Net proceeds 950 – (3% x 950) = 950 – 28.50 = 921.50
Redeemable value Rs.1,000 (assumed redemption at par)
Balance life 20 years
It is assumed that floatation cost is a percentage of issue price

Interest after tax + Average other costs 50 + 3.925

Kd = = x 100 = 5.61%
Average funds employed 960.75
Note:
• Interest = Face value x coupon rate = 1000 x 10% = Rs.100
• Interest after tax = Interest x (1 – Tax rate) = 100 x (1 – 50%) = Rs.50
Redeemable value − Net proceeds 1,000 − 921.50
Average other costs = = = Rs. 3.925
Balance life 20
Redeemable value + Net proceeds 1,000 + 921.50
Average funds employed = = = Rs. 960.75
2 2

2. Cost of Redeemable Debt

XYZ company has debentures outstanding with 5 years left for maturity. The debentures are currently
selling for Rs.90 (the face value is Rs.100). The debentures are to be redeemed at 5% premium. The interest
is paid annually at a rate of interest of 12% and tax rate is 50% calculate cost of debt.
Answer:
Basic information
Type of debt Redeemable
Face value Rs.100
Coupon rate 12%
Tax rate 50%
Net proceeds Current market price = Rs.90
Redeemable value Rs.105
Balance life 5 years

Interest after tax + Average other costs 6 + 3

Kd = = x 100 = 9.23%
Average funds employed 97.50
Note:
• Interest = Face value x coupon rate = 100 x 12% = Rs.12
• Interest after tax = Interest x (1 – Tax rate) = 12 x (1 – 50%) = Rs.6
Redeemable value − Net proceeds 105 − 90
Average other costs = = = Rs. 3
Balance life 5
Redeemable value + Net proceeds 105 + 90
Average funds employed = = = Rs. 97.50
2 2

3. Computation of cost of equity [May 2017 RTP]

XYZ Limited is currently earning a profit after tax of Rs.25,00,000 and its shares are quoted in the market
at Rs.450 per share. The company has 1,00,000 shares outstanding and has not raised debt in its capital
structure. It is expected that the same level of earnings will be maintained for future years also. The
company has 100 percent pay-out policy.
Required:
(a) Calculate the cost of equity
(b) If the company’s payout ratio is assumed to be 70% and it earns 20% rate of return on its
investment, then what would be the firm’s cost of equity?

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Answer:
WN 1: Computation of cost of equity for original scenario:
Basic information:
Dividend of next year 25,00,000/1,00,000 = Rs.25 per share
CMP/Issue price Rs.450 per share
IRR/ROE/ROI NA
100% - Payout ratio
Retention ratio 100% - 100% = 0%
Growth rate 0%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟐𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟎 = 𝟎. 𝟎𝟓𝟓𝟔 + 𝟎. 𝟎𝟎 = 𝟎. 𝟎𝟓𝟓𝟔(𝐨𝐫)𝟓. 𝟓𝟔%
𝟒𝟓𝟎 − 𝟎

WN 2: Computation of cost of equity for rework scenario:

Basic information:
Dividend of next year 25 x 70% = Rs.17.50 per share
CMP/Issue price Rs.450 per share
IRR/ROE/ROI 20%
100% - Payout ratio
Retention ratio 100% - 70% = 30%
IRR x Retention ratio
Growth rate 20% x 30% = 6%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏𝟕. 𝟓𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟑𝟖𝟗 + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟗𝟖𝟗(𝐨𝐫)𝟗. 𝟖𝟗%
𝟒𝟓𝟎 − 𝟎

4. Computation of multiple components of capital [May 2021 RTP, Nov 2016, Nov 2023 MTP, SM]
ABC Company’s equity share is quoted in the market at Rs.25 per share currently. The company pays a
dividend of Rs.2 per share and the investor’s market expects a growth rate of 6% per year. You are required
to:
(a) Calculate the company’s cost of equity capital
(b) If the anticipated growth rate is 8% per annum, calculate the indicated market price per share
(c) If the company issues 10% debentures of face value of Rs.100 each and realizes Rs.96 per debenture
while the debentures are redeemable after 12 years at a premium of 12%, what will be the cost of
debenture?
Assume tax rate to be 50%
Answer:
Part (a):
Basic information:
Dividend of next year Rs.2 + 6% = 2.12
CMP/Issue price Rs.25
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 6%
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟐 + 𝟔%
𝐊𝐞 = + 𝟎. 𝟎𝟔 = 𝟎. 𝟎𝟖𝟒𝟖 + 𝟎. 𝟎𝟔 = 𝟎. 𝟏𝟒𝟒𝟖(𝐨𝐫)𝟏𝟒. 𝟒𝟖%
𝟐𝟓 − 𝟎
• Company’s cost of capital = 14.48%

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Part (b):
D1
Ke = + Growth rate
P0 − F
2.16 2.16
0.1448 = + 0.08; 0.0648 =
P0 − 0 P0
𝟐. 𝟏𝟔
𝐏𝟎 = = 𝐑𝐬. 𝟑𝟑. 𝟑𝟑 𝐩𝐞𝐫 𝐬𝐡𝐚𝐫𝐞
𝟎. 𝟎𝟔𝟒𝟖

Part (c):
Cost of debt:
Type of debt Redeemable
Face value Rs.100 (assumed)
Coupon rate 10%
Tax rate 50%
Net proceeds Issue price – FC = Rs.96
Redeemable value Rs.112
Balance life 12 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2
112 − 96
5+ 5.00 + 1.33
Kd = 12 = x 100 = 6.08%
112 + 96 104.00
2

5. Cost of Irredeemable Preference Shares [SM]

If reliance energy is issuing preferred stock at Rs.100 per share, with a fixed dividend of Rs.12 and a
floatation cost of 3%, what is the cost of preference share?
Answer:
Basic information
Type of preference Irredeemable
Face value Rs.100 (assumed)
Coupon rate 12%
Issue price – floatation cost
Net proceeds 100 – 3 = 97
Redeemable value NA
Balance life NA

Computation of Cost of Preference:

Preference Dividend 12
Kp = = x 100 = 12.37%
Net proceeds 97

6. Computation of WACC [Nov 2019 RTP, Dec 2021, SM]

The following details are provided by the GPS Limited:
Particulars Amount
Equity Share Capital 65,00,000
12% Preference Share Capital 12,00,000
15% Redeemable Debentures 20,00,000
10% Convertible Debentures 8,00,000

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The cost of equity capital for the company is 16.30% and income tax rate for the company is 30%. You are
required to CALCULATE the Weighted Average Cost of Capital (WACC) of the company.
Answer:
WN 1: Computation of WACC:
Source Cost Weight Product
Equity share capital 16.30% 65,00,000 10,59,500
Preference share capital 12.00% 12,00,000 1,44,000
Redeemable debentures 10.50% 20,00,000 2,10,000
Convertible debentures 7.00% 8,00,000 56,000
Total 1,05,00,000 14,69,500

Sum of product 14,69,500

WACC = = x 100 = 13.995%
sum of weights 1,05,00,000
Note:
• Cost of redeemable debentures = 15.00% x (1 – 30%) = 10.50%
• Cost of convertible debentures = 10.00% x (1 – 30%) = 7.00%

7. WACC Computation [SM]

Cost of equity of a company is 10.41% while cost of retained earnings is 10%. There are 50,000 equity shares
of Rs.10 each and retained earnings of Rs.15,00,000. Market price per equity share is Rs.50. Calculate WACC
using market value weights if there are no other sources of finance.
Answer:
Source Cost Weight Product
Equity capital 10.41% 6,25,000 65,063
Retained earnings 10.00% 18,75,000 1,87,500
Total 25,00,000 2,52,563
Note:
• Market value of equity shares = 50,000 x 50 = Rs.25,00,000
• Value needs to be split between equity capital and retained earnings in the ratio of book values
(5,00,000:15,00,000 (or) 1:3)

Sum of Products 2,52,563

WACC = = 𝑥 100 = 𝟏𝟎. 𝟏𝟎%
Sum of weights 25,00,000

8. Computation of revised WACC [Nov 2020 MTP, Nov 2018 MTP, Nov 2019 RTP, May 2020 MTP,
May 2020 RTP, Nov 2010, Nov 2023 MTP, Sep 2024 RTP]
BS Ltd. has the following book-value capital structure as on March 31, 2003.
Particulars Amount
Equity share capital (10,00,000 shares) 3,00,00,000
11.5% preference shares 60,00,000
10% debentures 1,00,00,000
Total 4,60,00,000
The equity share of the company sells for Rs.300. It is expected that the company will pay next year a
dividend of Rs.15 per equity share, which is expected to grow at 5% p.a. forever. Assume a 35%
corporate tax rate.
Required:
I. Compute weighted average cost of capital (WACC) of the company based on the existing capital
structure.
II. Compute the new WACC, if the company raises an additional Rs.50 lakhs debt by issuing 10 years 12%
debentures but the yield on debentures of similar maturity and risk class is 13%; flotation cost is 2%.
Face value of the debenture is Rs.100. This would result in increasing the expected equity dividend to
Rs. 20 and leave the growth rate unchanged, but the price of equity share will fall to Rs. 250 per share
Answer:

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WN 1: Computation of cost of individual components of capital:
Cost of equity:
Basic information:
Dividend of next year Rs.15.00 per share
CMP/Issue price Rs.300 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 5 percent
Floatation cost 0
D1
Ke = + Growth rate
P0 − F
𝟏𝟓
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟎𝟓 + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟎(𝐨𝐫)𝟏𝟎. 𝟎𝟎%
𝟑𝟎𝟎. 𝟎𝟎

Cost of preference:
Cost of preference = Rate of dividend on preference shares = 11.50%

Cost of debentures:
Cost of debentures = Interest rate x (1 – tax rate) = 10% x (1 – 35%) = 6.50%

WN 2: Computation of WACC based on existing capital structure:

Source Cost Weight Product
Equity 10.00% 3,00,00,000 30,00,000
Preference 11.50% 60,00,000 6,90,000
Debentures 6.50% 1,00,00,000 6,50,000
Total 4,60,00,000 43,40,000
Sum of product 43,40,000
WACC = = x 100 = 𝟗. 𝟒𝟑%
sum of weights 4,60,00,000

WN 3: Computation of revised WACC with new borrowings:

Cost of equity:
𝟐𝟎
𝐊𝐞 = + 𝟎. 𝟎𝟓 = 𝟎. 𝟎𝟖 + 𝟎. 𝟎𝟓 = 𝟎. 𝟏𝟑 (𝐨𝐫) 𝟏𝟑. 𝟎𝟎%
𝟐𝟓𝟎

• Cost of preference (no change) = 11.50%

• Cost of debentures (no change) = 6.50%

Computation of cost of new debt:

Type of debt Redeemable
Face value Rs.100
Coupon rate 12%
Tax rate 35%
Issue price – FC
Net proceeds 92.31 – 2 = Rs.90.31
Redeemable value Rs.100 (assumed at par)
Balance life 10 years

Computation of Cost of Debt:

RV − NP
Interest after tax + Average other costs Interest after tax + Balance life
Kd = =
Average funds employed RV + NP
2

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100 − 90.31
(12 x 65%) + 7.80 + 0.969
Kd = 10 = x 100 = 9.22%
100 + 90.31 95.155
2
Note 1: Computation of net proceeds:
• The company pays interest rate of 12% whereas investors are expecting return of 13%
• The company is not meeting the expectations of investors. Hence the issue has to happen at
discount
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝟏𝟎𝟎 𝐱 𝟏𝟐%
𝐈𝐬𝐬𝐮𝐞 𝐩𝐫𝐢𝐜𝐞 = = = 𝐑𝐬. 𝟗𝟐. 𝟑𝟏
𝐈𝐧𝐯𝐞𝐬𝐭𝐨𝐫 𝐞𝐱𝐩𝐞𝐜𝐭𝐚𝐭𝐢𝐨𝐧 𝟏𝟑%
• Net proceeds = Issue price – Floatation cost = Rs.92.31 -2 = Rs.90.31

WN 4: Computation of revised WACC based on new capital structure:

Source Cost Weight Product
Equity 13.00% 3,00,00,000 39,00,000
Preference capital 11.50% 60,00,000 6,90,000
Existing debt 6.50% 1,00,00,000 6,50,000
New debt 9.22% 50,00,000 4,61,000
Total 5,10,00,000 57,01,000
Sum of product 57,01,000
WACC = = x 100 = 11.18%
sum of weights 5,10,00,000

9. Computation of WACC
The capital structure of Bright Limited as on 31.03.2019 is as follows:
Particulars Amount in lacs
Equity share capital: 7,50,000 equity shares of Rs.100 each 750
Retained earnings 250
13.5% preference share capital 240
12.5% Debentures 360
The current market price per equity share is Rs.350. The prevailing default risk free interest rate is 6% and
rate of return on market portfolio is 15%. The Beta of the company is 1.289. The corporate tax rate is 30%.
The average tax rate of shareholders is 25% and brokerage cost is 2% that they have to pay while investing
dividends in alternative securities.
Required: Calculate the weighted average cost of capital on the basis of book value weights
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of equity:
K e = R f + Beta x (R m − R f )
K e = 6 + 1.289x (15 − 6) = 17.60%

Cost of retained earnings:

K r = [K e x (1 − personal tax rate)x (1 − Floatation cost)]
K r = [17.60 x (1 − 25%) 𝑥 (1 − 2%)] = 12.94%

Cost of preference:
Cost of preference = Rate of preference dividend = 13.50%

Cost of debt:
Cost of debt = Interest x (1 – Tax rate) = 12.50% x (1-30%) = 8.75%

WN 2: Computation of WACC using book value weights:

Weight Product
Source Cost (in lacs) (in lacs)

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Equity 17.60% 750.00 132.00
Retained earnings 12.94% 250.00 32.35
Preference capital 13.50% 240.00 32.40
Debentures 8.75% 360.00 31.50
Total 1,600.00 228.25
Sum of product 228.25
WACC = = x 100 = 𝟏𝟒. 𝟐𝟕%
sum of weights 1,600.00

10. Computation of cost of individual components of capital [May 2024]

The capital structure of Shine Ltd. as on 31.03.2024 is as under:
Particulars Amount
Equity share capital off 10 each 45,00,000
15% Preference share capital off 100 each 36,00,000
Retained earnings 32,00,000
13% Convertible Debenture off 100 each 67,00,000
11 % Term Loan 20,00,000
Total 2,00,00,000
Additional information
a. Company issued 13% Convertible Debentures of Rs. 100 each on 01.04.2023 with a maturity period
of 6 years. At maturity, the debenture holders will have an option to convert the debentures into
equity shares of the company in the ratio of 1 : 4 (4 shares for each debenture). The market price of
the equity share is Rs. 25 each as on 31.03.2024 and the growth rate of the share is 6% per annum.
b. Preference stock, redeemable after eight years, is currently selling at Rs. 150 per share.
c. The prevailing default-risk free interest rate on 10-year GOI treasury bonds is 6%. The average
market risk premium is 8% and the Beta () of the company is 1.54.
Corporate tax rate is 25% and rate of personal income tax is 20%.
You are required to calculate the cost of: (i) Equity Share Capital (ii) Preference Share Capital (iii)
Convertible Debenture (iv) Retained Earnings (v) Term Loan
Answer:
Computation of cost of equity
K e = R f + Beta x (R m − R f )
K e = 6 + 1.54 x (8) = 6 + 12.32 = 18.32%
• Note: Risk premium of market would mean Rm – Rf
Computation of cost of retained earnings:
𝐊 𝐫 = [𝐊 𝐞 𝐱 (𝟏 − 𝐏𝐞𝐫𝐬𝐨𝐧𝐚𝐥 𝐭𝐚𝐱 𝐫𝐚𝐭𝐞%)] 𝐱 [𝟏 − 𝐅𝐥𝐨𝐚𝐭𝐚𝐭𝐢𝐨𝐧 𝐜𝐨𝐬𝐭%]
K r = [0.1832 x (1 − 0.20)] x [1 − 0.00] = 0.15456 (or)14.656%
Cost of term loan
• Cost of term loan = 11% x (1 – tax rate) = 11% x (1 – 0.25) = 8.25%
Cost of preference:
RV − NP
Preference Dividend + Average other costs Preference Dividend + Balance life
Kp = =
Average funds employed RV + NP
2
100 − 150
15 + 15.00 − 6.25
Kp = 8 = x 100 = 7.00%
100 + 150 125
2
Cost of preference:
RV − NP
Interest after tax + Average other costs IAT + Balance life
Kd = =
Average funds employed RV + NP
2

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133.82 − 100
(13 x 0.75) + 9.75 + 6.764
Kd = 5 = x 100 = 14.13%
133.82 + 100 116.91
2
Note: Computation of redeemable value
Redeemable value would be higher of the following:
• Redeem as debt = Rs.100
• Convert into equity = Value of 4 equity shares on maturity date = Rs.133.82
Today share price Share price after 5 years Value of 4 shares = 33.455 x 4
(31.03.2024) (original issue was for 6 years and one shares = Rs.133.82
= Rs.25 year has got over)
= 25 𝑥 1.065 = 33.455

11. Calculation of WACC [May 2021 MTP, Nov 2020 RTP, SM]
Calculate the WACC by using market value weights:
The capital structure of company is as under:
Particulars Amount
Debentures (Rs.100 per debenture) 10,00,000
Preference shares (Rs.100 per share) 10,00,000
Equity shares (Rs.10 per share) 20,00,000
40,00,000
The market prices of these securities are:
• Debentures : 115 per debenture
• Preference Shares : 120 per preference share
• Equity Shares : 265 each.
Additional information:
(i) 100 per debenture redeemable at par, 10% coupon rate, 2% floatation costs, 10 year maturity.
(ii) 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10 year maturity.
(iii) Equity shares has Rs.1 floatation cost and market price Rs.265 per share. The next year expected
dividend is Rs.5 with annual growth of 15 percent. The firm has practice of paying all earnings in the form
of dividend. The corporate tax rate is 30 percent.
Use YTM Method to calculate cost of debentures and preference shares
Answer:
WN 1: Computation of cost of individual components of capital:
Cost of debt:
Type of debt Redeemable
Face value Rs.100
Coupon rate 10%
Tax rate 30%
Current market price Rs.115
Net realization at CMP 115 – 2% = Rs.112.70
Redeemable value Rs.100
Balance life 10 years

IRR computation:
Year Cash flow PVF @ 5% DCF PVF @ 7% DCF
0 -112.70 -1.000 (112.70) 1.000 (112.70)
1 to 10 7 7.722 54.05 7.024 49.17
[10 x 70%]
10 100.00 0.614 61.40 0.508 50.80
NPV +2.75 -12.73
Note: YTM approach is basically computing the IRR of the instrument. There will be a net inflow of
Rs.112.70 on day 0. The company would be paying Rs.7 every year and Rs.100 at end of life. Normally we
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have an outflow in IRR approach and hence the first cash flow has been taken as outflow and other cash
flows are taken as inflows to compute IRR.
𝟐. 𝟕𝟓
𝐈𝐑𝐑 (𝐨𝐫)𝐂𝐨𝐬𝐭 𝐨𝐟 𝐝𝐞𝐛𝐭 = 𝟓 + [ 𝐱 (𝟕 − 𝟓)] = 𝟓 + 𝟎. 𝟑𝟔 = 𝟓. 𝟑𝟔%
𝟐. 𝟕𝟓 − (−𝟏𝟐. 𝟕𝟑)

Cost of preference:
Type of preference Redeemable
Face value Rs.100
Coupon rate 5%
Current market price Rs.120
Net realization at CMP 120 – 2% = Rs.117.60
Redeemable value Rs.100
Balance life 10 years

IRR computation:
Year Cash flow PVF @ 2% DCF PVF @ 5% DCF
0 -117.60 -1.000 (117.60) 1.000 (117.60)
1 to 10 5 8.983 44.92 7.722 38.61
10 100.00 0.820 82.00 0.614 61.40
NPV +9.32 -17.59

9.32
IRR (or)Cost of preference = 2 + [ x (5 − 2)] = 2 + 1.04 = 3.04%
9.32 − (−17.59)

Cost of equity:
Basic information:
Dividend of next year Rs.5 per share
CMP/Issue price Rs.265 per share
IRR/ROE/ROI NA
Retention ratio NA
Growth rate 15 percent
Floatation cost Rs.1 per share
D1
Ke = + Growth rate
P0 − F
𝟓
𝐊𝐞 = + 𝟎. 𝟏𝟓 = 𝟎. 𝟏𝟔𝟖𝟗(𝐨𝐫)𝟏𝟔. 𝟖𝟗%
𝟐𝟔𝟓 − 𝟏

WN 2: Computation of cost of capital:

Weight
Source of capital Cost of capital
[MV] Product
5,30,00,000
Equity 16.89% [265 x 2,00,000] 89,51,700
12,00,000
Preference shares 3.04% [120 x 10,000] 36,480
11,50,000
Debentures 5.36% [115 x 10,000] 61,640
Total 5,53,50,000 90,49,820
Sum of product 90,49,820
WACC(based on MV weights) = = x 100 = 16.35%
sum of weights 5,53,50,000

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Chapter 5: Financing Decisions – Capital Structure

Overview:
• Optimum mix analysis
• Indifference Point and Financial Break-even point
• Valuation of firm and cost of capital using different capital structure theories
• Primary and Reverse Arbitrage

Part 1 – Optimum mix analysis

1. Optimum mix [May 2021 MTP, Nov 2020 MTP, May 2018 MTP, Nov 2018 MTP, Nov 2018, Nov
2016, May 2022 MTP, SM]
The Modern Chemicals Ltd. requires Rs.25,00,000 for a new plant. This plant is expected to yield earnings
before interest and taxes of Rs.5,00,000. While deciding about the financial plan, the company considers
the objective of maximizing earnings per share. It has three alternatives to finance the project by raising
debt of Rs.2,50,000 or Rs.10,00,000 or Rs.15,00,000 and the balance, in each case, by issuing at Rs.150, but is
expected to decline to Rs.125 in case the funds are borrowed in excess of Rs.10,00,000. The funds can be
borrowed at the rate of 10% upto Rs.2,50,000, at 15% over Rs.2,50,000 and upto 10,00,000 and at 20% over
Rs.10,00,000. The tax rate applicable to the company is 50%. Which form of financing should the company
choose?
Answer:
WN 1: Identification of alternatives:
Alternative 1 – Borrow Rs.2,50,000 and issue equity worth Rs.22,50,000
Alternative 2 – Borrow Rs.10,00,000 and issue equity worth Rs.15,00,000
Alternative 3 – Borrow Rs.15,00,000 and issue equity worth Rs.10,00,000

WN 2: Computation of interest, preference dividend and no of equity shares for three alternatives:
Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest - - -
New Interest 25,000 1,37,500 2,37,500
[2,50,000 x 10%] [2,50,000 x 10% + [2,50,000 x 10% +
7,50,000 x 15%] 7,50,000 x 15% +
5,00,000 x 20%]
Total Interest 25,000 1,37,500 2,37,500
Preference dividend
Existing - - -
New - - -
Total dividend - - -
No of equity shares
Existing - - -
New 15,000 10,000 8,000
(22,50,000/150) (15,00,000/150) (10,00,000/125)
Total 15,000 10,000 8,000
• It is assumed that interest rates given in the question are slab rates.

WN 3: Computation of EPS:
Particulars Alt 1 Alt 2 Alt 3
EBIT 5,00,000 5,00,000 5,00,000
Less: Interest [WN 2] -25,000 -1,37,500 -2,37,500
EBT 4,75,000 3,62,500 2,62,500

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Less: Tax @ 50% -2,37,500 -1,81,250 -1,31,250
EAT 2,37,500 1,81,250 1,31,250
Less: Preference dividend - - -
EAES 2,37,500 1,81,250 1,31,250
No of shares 15,000 10,000 8,000
EPS (EAES/No of shares) 15.8333 18.1250 16.4063
The company should go ahead with Alternative 2 as the same results in maximum EPS.

2. Optimum mix [May 2019 MTP, Dec 2021, Nov 2023 MTP]
A company earns a profit of Rs.3,00,000 per annum after meeting its interest liability of Rs.1,20,000 on 12%
debentures. The Tax rate is 50%. The number of Equity Shares of Rs.10 each are 80,000 and the retained
earnings amount to Rs.12,00,000. The company proposes to take up an expansion scheme for which a sum
of Rs.4,00,000 is required. It is anticipated that after expansion, the company will be able to achieve the
same return on investment as at present. The funds required for expansion can be raised either through
debt at the rate of 12% or by issuing Equity Shares at par.
Required:
(i) compute the Earnings Per Share (EPS), if:
- The additional funds were raised as debt.
- The additional funds were raised by issue of equity shares.
(ii) Advise the company as to which source of finance is preferable
Answer:
WN 1: Identification of alternatives:
Alternative 1 – Raise Rs.4,00,000 in the form of 12% debt
Alternative 2 – Raise Rs.4,00,000 by issuing equity shares

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2
Interest
Existing interest 1,20,000 1,20,000
New Interest 48,000 -
[4,00,00 x 12%]
Total Interest 1,68,000 1,20,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 80,000 80,000
New - 40,000
[4,00,000/10]
Total shares 80,000 1,20,000

WN 3: Computation of EPS:
Particulars Alt 1 Alt 2
EBIT [Note 1] 4,76,000 4,76,000
Less: Interest [WN 2] -1,68,000 -1,20,000
EBT 3,08,000 3,56,000
Less: Tax @ 50% -1,54,000 -1,78,000
EAT 1,54,000 1,78,000
Less: Preference dividend - -
EAES 1,54,000 1,78,000

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No of shares [WN 2] 80,000 1,20,000
EPS (EAES/No of shares) 1.9250 1.4833
Conclusion: The company should go ahead with Alternative 1 to maximize EPS

Note 1: Computation of EBIT:

Particulars Existing Revised
EBIT 4,20,000 4,76,000
[3,00,000 + 1,20,000] (14% x 34,00,000)
Capital employed: 30,00,000 34,00,000
Equity capital 8,00,000 8,00,000
Reserves and surplus 12,00,000 12,00,000
10,00,000 10,00,000
Debt [1,20,000/12%]
Preference 0 0
New capital introduced 0 4,00,000
ROI (EBIT/CE) 14.00% 14.00%
[4,20,000/30,00,000] x 100
• Existing ROI/ROCE is 14%. The company would be maintaining same ROI
• Revised EBIT = Revised capital x 14%. Capital will increase by Rs.4,00,000 introduced either in the
form of debt/equity. New capital = Rs.34,00,000
• New EBIT = 14% x 34,00,000 = Rs.4,76,000

3. Valuation of share on alternative financing plans [May 2024 MTP]

Vikalp Limited provides you the following information for the year ending 31.03.2019:
Particulars Amount
Earnings before Interest and Tax 28,80,000
Less: Interest on long term loans @ 12% (2,70,000)
Less: Interest on debentures @ 10% (3,60,000)
(Debentures issued on 1.8.2018)
Earnings before tax 22,50,000
Less: Tax @ 30% (6,75,000)
Earnings after tax 15,75,000
No of equity shares 6,30,000
Ruling market price per share 24
Undistributed reserves and surplus 60,50,000
The company needs to raise Rs.30,00,000 for modernization of its plants and has the following options of
raising the funds:
• Raise the entire funds by 13% long-term loan (or)
• Raise partly by issue of 75,000 equity shares @ 20 per share and the balance by 11% debentures
The company expects the rate of return on funds employed to be improved by 3% because of modernization
and that if Debt Equity ratio [Debt/(Debt + Equity)] exceeds 45%, then price earnings ratio to go down by
15%.
Required: If the company is to follow policy of maximizing the market value of equity share, which option
would it choose?
Answer:
WN 1: Computation of interest, preference dividend and no of equity shares for debt and equity
alternative:
Particulars Debt Debt +
Equity
Interest
Existing interest (Note) 8,10,000 8,10,000
New Interest 3,90,000 1,65,000
Total Interest 12,00,000 9,75,000
Preference dividend
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Existing - -
New - -
Total dividend - -
No of equity shares
Existing 6,30,000 6,30,000
New - 75,000
Total shares 6,30,000 7,05,000
Note:
• Interest on existing debentures is Rs.3,60,000 for 8 months. Hence the cost for the next year on
existing debentures will be Rs.5,40,000
• Existing interest = 5,40,000 + 2,70,000 = Rs.8,10,000
• Total amount raised in the form of equity in option 2 = (75,000 x 20) = Rs.15,00,000. Balance amount
raised as debt = Rs.15,00,000
• New interest under option 2 = 15,00,000 x 11% = Rs.1,65,000

WN 2: Computation of MPS for two alternatives:

Debt +
Particulars Debt Equity
EBIT [Note 1] 40,02,000 40,02,000
Less: Interest [WN 1] -12,00,000 -9,75,000
EBT 28,02,000 30,27,000
Less: Tax @ 30% -8,40,600 -9,08,100
EAT 19,61,400 21,18,900
Less: Preference dividend - -
EAES 19,61,400 21,18,900
No of shares [WN 1] 6,30,000 7,05,000
EPS (EAES/No of shares) 3.113 3.005
PE Multiple [Note 2] 8.16 9.60
MPS (EPS x PE Multiple) 25.40 28.85
• The company should choose alternative 2 (debt + equity) as the same has resulted in maximum
MPS

Note 1: Computation of EBIT:

Particulars Existing Revised
EBIT 28,80,000 40,02,000
(17.40% x 2,30,00,000)
Capital employed: 2,00,00,000 2,30,00,000
Equity capital 63,00,000 63,00,000
Reserves and surplus 60,50,000 60,50,000
22,50,000 22,50,000
12% Long term loan [2,70,000/12%]
54,00,000 54,00,000
10% debentures [5,40,000/10%]
New capital introduced 0 30,00,000
ROI (EBIT/CE) 14.40% 17.40%
[28,80,000/2,00,00,000] x 100 [14.40% + 3%]

Note 2: Identification of PE Multiple for two scenarios:

Debt +
Particulars Debt Equity
Debt 1,06,50,000 91,50,000
Total capital employed 2,30,00,000 2,30,00,000

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Debt 46.30% 39.78%
Debt Ratio =
Debt + Equity
Applicable PE Multiple 8.16 9.60
[9.60 x 85%]

Note 3: Computation of existing PE Multiple:

Particulars Amount
EAT 15,75,000
No of shares 6,30,000
EPS 2.50
MPS 24.00
PE Multiple (24/2.50) 9.60

4. Evaluation of Alternatives (Nov 2022 MTP, SM)

The financial advisor of Sun Ltd is confronted with following two alternative financing plans for raising
Rs. 10 lakhs that is needed for plant expansion and modernization
• Alternative I: Issue 80% of funds with 14% Debenture [Face value (FV) Rs. 100] at par and redeem
at a premium of 10% after 10 years and balance by issuing equity shares at 33.33 percent premium.
• Alternative II: Raise 10% of funds required by issuing 8% Irredeemable Debentures [Face value
(FV) Rs. 100] at par and the remaining by issuing equity shares at current market price of Rs.125.

Currently, the firm has an Earnings per share (EPS) of Rs. 21. The modernization and expansion
programme is expected to increase the firm’s Earnings before Interest and Taxation (EBIT) by Rs. 200,000
annually. The firm’s condensed Balance Sheet for the current year is given below:

Balance Sheet as on 31.3.2022

Liabilities Amount Assets Amount
Current Liabilities 5,00,000 Current Assets 16,00,000
10% Long-term loan 15,00,000 Plant and equipment 34,00,000
Reserves & surplus 10,00,000
Equity share capital (FV of Rs.100) 20,00,000
Total 50,00,000 Total 50,00,000
However, the finance advisor is concerned about the effect that issuing of debt might have on the firm. The
average debt ratio for firms in industry is 35%. He believes if this ratio is exceeded, the P/E ratio of the
company will be 7 because of the potentially greater risk.

If the firm increases its equity capital by more than 10 %, he expects the P/E ratio of the company will
increase to 8.5 irrespective of the debt ratio.

Assume Tax Rate of 25%. Assume target dividend pay-out under each alternative to be 60% for the next
year and growth rate to be 10% for the purpose of calculating Cost of Equity

SUGGEST with reason which alternative is better on the basis of each of the below given criteria:
• Earnings per share (EPS) & Market Price per share (MPS)
• Financial Leverage
• Weighted Average Cost of Capital & Marginal Cost of Capital (using Book Value weights)
Answer:
WN 1: Identification of alternatives:
• Alternative 1 = Raise debt of Rs.8,00,000 and equity of Rs.2,00,000
• Alternative 2 = Raise debt of Rs.1,00,000 and equity of Rs.9,00,000

Capital structure post raising money:

Particulars Calculation Alternative Calculation Alternative
1 2
Existing equity 20,00,000 20,00,000

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New equity shares issued 100 1,50,000 100 7,20,000
2,00,000 x 9,00,000 x
133.33 125.00
Total equity share capital 21,50,000 27,20,000
Existing reserves and 10,00,000 10,00,000
surplus
Securities premium 33.33 50,000 25 1,80,000
2,00,000 x 9,00,000 x
133.33 125.00
Total reserves and surplus 10,50,000 11,80,000
10% Long term debt 15,00,000 15,00,000
14% debentures (issued) 8,00,000 -
8% irredeemable - 1,00,000
debentures
(issued)
Total capital 55,00,000 55,00,000
Debt capital 15,00,000 + 23,00,000 15,00,000 + 16,00,000
8,00,000 1,00,000
Debt Ratio 23,00,000 41.82% 16,00,000 29.09%
x 100 x 100
Debt 55,00,000 55,00,000
Capital employed
% increase in equity capital 1,50,000 7.50% 7,20,000 36.00%
x 100 x 100
20,00,000 20,00,000
Applicable PE Multiple 7.00 8.50
Note:
• Applicable PE Multiple for alternative 1 is 7 times as debt ratio is more than 35 percent and the
percentage increase in share capital is less than 10 percent
• Applicable PE Multiple for alternative 2 is 8.50 times as the increase in equity is more than 10%

WN 2: Computation of existing EBIT:

Particulars Amount
EBIT (reverse working – 5,60,000 + 1,50,000) 7,10,000
Less: Interest (15,00,000 x 10%) 1,50,000
EBT (4,20,000/75%) 5,60,000
Less: Tax @ 25% -1,40,000
EAT (reverse working – 20,000 x 21) 4,20,000
No of equity shares 20,000
EPS 21.00

WN 3: Computation of EPS and MPS for alternatives

Particulars Calculation Alt 1 Calculation Alt 2
EBIT 7,10,000 + 2,00,000 9,10,000 7,10,000 + 2,00,000 9,10,000
Less: Interest 15,00,000 x 10% + -2,72,000 15,00,000 x 10% + -1,58,000
8,00,000 x 14% 1,00,000 x 8%
EBT 6,48,000 7,52,000
Less: Tax @ 25% -1,62,000 -1,88,000
EAT 4,86,000 5,64,000
No of equity shares 21,50,000/10 21,500 27,20,000/10 27,200
EPS 22.60 20.74
PE Multiple (WN 1) 7 8.50
MPS (EPS x PE Multiple) 158.20 176.29
Financial Leverage 𝟗, 𝟏𝟎, 𝟎𝟎𝟎 1.40 𝟗, 𝟏𝟎, 𝟎𝟎𝟎 1.21
𝟔, 𝟒𝟖, 𝟎𝟎𝟎 𝟕, 𝟓𝟐, 𝟎𝟎𝟎

WN 4: Computation of WACC
Alternative 1:
Source Cost Weight Product
Equity share capital 19.43% 21,50,000 4,17,745

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Reserves and Surplus 19.43% 10,50,000 2,04,015
10% Long term debt 7.50% 15,00,000 1,12,500
14% Debentures 10.95% 8,00,000 87,600
Total 55,00,000 8,21,860
Sum of Product 8,21,860
WACC = = x 100 = 14.94%
Sum of weights 55,00,000

Note 1: Computation of cost of equity:

D1
Ke = +G
Po
(22.60 x 0.60) + 10% 14.92
Ke = + 0.10 = + 0.10 = 0.0943 + 0.10 = 𝟎. 𝟏𝟗𝟒𝟑 (𝐨𝐫)𝟏𝟗. 𝟒𝟑%
158.20 158.20

Note 2: Computation of cost of long-term debt:

Cost of debt = 10 x (1 − 0.25) = 7.50%

Note 3: Computation of cost of debentures:

Interest after tax + Average other costs
Cost of redeemable debt =
Average funds employed
110 − 100
(14 x 0.75) + 11.5
Cost of redeemable debt = 10 = = 10.95%
110 + 100 105
2
Alternative 2:
Source Cost Weight Product
Equity share capital 17.76% 27,20,000 4,83,072
Reserves and Surplus 17.76% 11,80,000 2,09,568
10% Long term debt 7.50% 15,00,000 1,12,500
8% irredeemable debentures 6.00% 1,00,000 6,000
Total 55,00,000 8,11,140
Sum of Product 8,11,140
WACC = = x 100 = 14.75%
Sum of weights 55,00,000

Note 1: Computation of cost of equity:

D1
Ke = +G
Po
(20.74 x 0.60) + 10% 13.684
Ke = + 0.10 = + 0.10 = 0.0776 + 0.10 = 𝟎. 𝟏𝟕𝟕𝟔 (𝐨𝐫)𝟏𝟕. 𝟕𝟔%
176.29 176.29

Note 2: Computation of cost of long-term debt:

Cost of debt = 10 x (1 − 0.25) = 7.50%

Note 3: Computation of cost of debentures:

Interest after tax
Cost of irredeemable debt =
Net Proceeds
8 x (1 − 0.25)
Cost of irredeemable debt = = 6.00%
100

WN 5: Computation of marginal cost of capital:

• Marginal cost of capital is the weighted average cost of raising additional capital. In this case we
are raising Rs.10,00,000 and we need to compute cost of raising Rs.10,00,000
Alternative 1:
Source Cost Weight Product
Equity share capital 19.43% 1,50,000 29,145
Reserves and Surplus 19.43% 50,000 9,715
14% Debentures 10.95% 8,00,000 87,600
Total 10,00,000 1,26,460

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Sum of Product 1,26,460
WMCC = = x 100 = 12.65%
Sum of weights 10,00,000

Alternative 2:
Source Cost Weight Product
Equity share capital 17.76% 7,20,000 1,27,872
Reserves and Surplus 17.76% 1,80,000 31,968
14% Debentures 6.00% 1,00,000 6,000
Total 10,00,000 1,65,840
Sum of Product 1,65,840
WMCC = = x 100 = 16.58%
Sum of weights 10,00,000

Summary of solution:
Particulars Alternative 1 Alternative 2
EPS 22.60 20.74
MPS 158.20 176.29
Financial leverage 1.40 1.21
WACC 14.94% 14.75%
WMCC 12.65% 16.58%
Alternative 1 of financing will be preferred under the criteria of EPS and WMCC, whereas Alternative II of
financing will be preferred under the criteria of MPS, Financial leverage and WACC

Part 2 – Indifference Point and Financial Break-even Point

5. Indifference point [May 2019 MTP, May 2019, May 2017 RTP, Nov 2012 RTP, Nov 2019, May
2023 MTP, Nov 2023 MTP]
A Company needs Rs.31,25,000 for the construction of new plant. The following three plans are feasible:
I. The company may issue 3,12,500 equity shares at Rs.10 per share.
II. The company may issue 1,56,250 ordinary equity shares at Rs.10 per share and 15,625 debentures
of Rs.100 denomination bearing a 8% rate of dividend.
III. The company may issue 1,56,250 equity shares at Rs.10 per share and 15,625 preference shares at
Rs.100 per share bearing a 8 % rate of dividend.
(a) If the company’s earnings before interest and taxes are Rs.62,500, Rs.1,25,000 , Rs.2,50,000
Rs.3,75,000 and Rs.6,25,000, what are the earnings per share under each of three financial
plans? Assume a corporate Income-tax rate of 40%
(b) Which alternative would you recommend and why?
(c) Calculate the financial breakeven point for all the alternatives
(d) Determine the EBIT-EPS indifference points by formulae between financing Plan I and
Plan II, I and III, and II and III
Answer:
WN 1: Computation of financial break-even point:
Step 1: Identification of alternatives:
• Alternative 1 – Issue 3,12,500 equity shares of Rs.10 each
• Alternative 2 – Issue 1,56,250 equity shares of Rs.10 each and 15,625 8% debentures of Rs.100 each
• Alternative 3 – Issue 1,56,250 equity shares of Rs.10 each and 15,625 8% preference shares of Rs.100
each

Step 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest - - -
New Interest - 1,25,000 -
[15,62,500 x 8%]
Total Interest - 1,25,000 -

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Preference dividend
Existing - - -
New - - 1,25,000
[15,62,500 x 8%]
Total dividend - - 1,25,000
No of equity shares
Existing - - -
New 3,12,500 1,56,250 1,56,250
Total shares 3,12,500 1,56,250 1,56,250

Step 3: Computation of financial break-even point:

PD
Financial BEP = Interest + ( )
1 − Tax rate
0
Financial BEP of Alt 1 = 0 + ( )=0
1 − 40%
0
Financial BEP of Alt 2 = 1,25,000 + ( ) = 1,25,000
1 − 40%
1,25,000
Financial BEP of Alt 3 = 0 + ( ) = 2,08,333
1 − 40%

WN 2: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2 Alt 3
EBIT X X X
Less: Interest 0 -1,25,000 0
EBT X X-1,25,000 X
Less: Tax 0.4X 0.4(X – 1,25,000) 0.4X
EAT 0.6X 0.6(X-1,25,000) 0.6X
Less: Preference dividend 0 0 -1,25,000
EAES 0.6X 0.6(X-1,25,000) 0.6X – 1,25,000
No of shares 3,12,500 1,56,250 1,56,250
0.6X 0.6X − 75,000 0.6X − 1,25,000
EPS (EAES/No of shares) 3,12,500 1,56,250 1,56,250

Indifference point between Plan 1 and Plan 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Plan 1 = EPS of Plan 2
0.6X 0.6X − 75,000 1,50,000
= ; 0.6X = 1.2X − 1,50,000; X = = 𝟐, 𝟓𝟎, 𝟎𝟎𝟎
3,12,500 1,56,250 0.6
• Indifference point between Plan 1 and Plan 2 = EBIT of Rs.2,50,000

Indifference point between Plan 1 and Plan 3:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 3
EPS of Plan 1 = EPS of Plan 3
0.6X 0.6X − 1,25,000 2,50,000
= ; 0.6X = 1.2X − 2,50,000; X = = 𝟒, 𝟏𝟔, 𝟔𝟔𝟕
3,12,500 1,56,250 0.6
• Indifference point between Plan 1 and Plan 3 = EBIT of Rs.4,16,667

Indifference point between Plan 2 and Plan 3:

EPS of Plan 2 = EPS of Plan 3

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0.6X − 75,000 0.6X − 1,25,000
= ;
1,56,250 1,56,250
• There is no indifference point between Plan 2 and Plan 3. This would mean that one plan is
dominating the other plan
• Plan with low financial break-even point will dominate the plan with high financial break-even
point.
• In this case, Plan 2 has lower financial BEP and hence Plan 2 dominates Plan 3

WN 3: Computation of EPS for different levels of EBIT:

Particulars Alt 1 Alt 2 Alt 3
0.6X 0.6X − 75,000 0.6X − 1,25,000
EPS 3,12,500 1,56,250 1,56,250
EPS if:
EBIT = 62,500 0.12 -0.24 -0.56
EBIT = 1,25,000 0.24 0.00 -0.32
EBIT = 2,50,000 0.48 0.48 0.16
EBIT = 3,75,000 0.72 0.96 0.64
EBIT = 6,25,000 1.20 1.92 1.60
• We need to substitute given EBIT numbers in place of X and compute EPS

Selection of alternative:
Alternative to be selected would depend on level of EBIT and the same is tabulated below:
Level of EBIT Plan to be selected
< 2,50,000 Plan 1
At 2,50,000 Plan 1 or Plan 2 (Indifferent)
> 2,50,000 Plan 2
• Plan 3 is not analyzed as Plan 2 dominates Plan 3

6. Indifference point [Sep 2024 MTP, SM]

A new project is under consideration in Zip Limited, which requires a capital investment of Rs.4.50 Crores.
Interest on term loan is 12% and the corporate tax rate is 50%. If the debt equity ratio insisted by the
financing agencies is 2:1, calculate the point of indifference for the project.
Answer:
WN 1: Identification of alternatives:
• Alternative 1 – Raise Rs.450 lacs as 300 lacs of 12% debt and 150 lacs of equity
• Alternative 2 – Raise entire Rs.450 lacs as equity

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2
Interest
Existing interest - -
New Interest 36,00,000 -
Total Interest 36,00,000 -
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing - -
New (issue price assumed as Rs.10) 15,00,000 45,00,000
Total shares 15,00,000 45,00,000
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WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2
EBIT X X
Less: Interest -36,00,000 0
EBT X-36,00,000 X
Less: Tax 0.5(X-36,00,000) 0.5X
EAT 0.5(X-36,00,000) 0.5X
Less: Preference dividend 0 0
EAES 0.5(X-36,00,000) 0.5X
No of shares 15,00,000 45,00,000
0.5(X − 36,00,000) 0.5X
EPS (EAES/No of shares) 15,00,000 45,00,000

Indifference point between Alt 1 and Alt 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Alt 1 = EPS of Alt 2
0.5X − 18,00,000 0.5X
= ; 1.5X − 54,00,000 = 0.5X; 𝐗 = 𝐑𝐬. 𝟓𝟒, 𝟎𝟎, 𝟎𝟎𝟎
15,00,000 45,00,000
• Indifference point between Alt 1 and Alt 2 = EBIT of Rs.54,00,000

7. Indifference Point [May 2023 RTP]

Current Capital Structure of XYZ Ltd is as follows:
• Equity Share Capital of 7 lakh shares of face value Rs. 20 each
• Reserves of Rs. 10,00,000
• 9% bonds of Rs. 3,00,00,000
• 11% preference capital: 3,00,000 shares of face value Rs. 50 each
• Additional Funds required for XYZ Ltd are Rs. 5,00,00,000.

XYZ Ltd is evaluating the following alternatives:

I. Proposed alternative I: Raise the funds via 25% equity capital and 75% debt at 10%. PE ratio in such
scenario would be 12.
II. Proposed alternative II: Raise the funds via 50% equity capital and rest from 12% Preference capital .PE
ratio in such scenario would be 11.

Any new equity capital would be issued at a face value of Rs. 20 each. Any new preferential capital would
be issued at a face value of Rs. 20 each. Tax rate is 34%. DETERMINE the indifference point under both the
alternatives.
Answer:
WN 1: Identification of alternatives:
• Alternative 1 – Raise Rs.500 lacs as 375 lacs of 10% debt and 125 lacs of equity
• Alternative 2 – Raise Rs.500 lacs as Rs.250 lacs as equity and 12% preference capital of Rs.250 lacs

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2
Interest
Existing interest 27,00,000 27,00,000
New Interest 37,50,000 -
Total Interest 64,50,000 27,00,000
Preference dividend

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Existing 16,50,000 16,50,000
New - 30,00,000
Total dividend 16,50,000 46,50,000
No of equity shares
Existing 7,00,000 7,00,000
New (issued at Rs.20) 6,25,000 12,50,000
Total shares 13,25,000 19,50,000

WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2
EBIT X X
Less: Interest -64,50,000 -27,00,000
EBT X – 64,50,000 X – 27,00,000
Less: Tax 0.34 (X – 64,50,000) 0.34 (X – 27,00,000)
EAT 0.66 (X – 64,50,000) 0.66 (X – 27,00,000)
Less: Preference dividend -16,50,000 -46,50,000
EAES 0.66X – 59,07,000 0.66X – 64,32,000
No of shares 13,25,000 19,50,000
0.66X − 59,07,000 0.66X − 64,32,000
EPS (EAES/No of shares) 13,25,000 19,50,000

Indifference point between Alt 1 and Alt 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Alt 1 = EPS of Alt 2
0.66X − 59,07,000 0.66X − 64,32,000 0.66X − 59,07,000 0.66X − 64,32,000
= ; = ; ; 𝐗 = 𝐑𝐬. 𝟕𝟐, 𝟔𝟑, 𝟔𝟑𝟔
13,25,000 19,50,000 53 78
• Indifference point between Alt 1 and Alt 2 = EBIT of Rs.72,63,636

8. Indifference Point [Nov 2020 RTP, Nov 2013, May 2023 MTP, SM]
X Ltd. is considering the following two alternative financing plans:
Particulars Plan – I Plan -II
Equity shares of Rs.10 each 4,00,000 4,00,000
12% debentures 2,00,000 -
Preference shares of Rs.100 each - 2,00,000
Total 6,00,000 6,00,000
The indifference point between the plans is Rs.2,40,000. Corporate tax rate is 30%. Calculate the rate of
dividend on preference shares.
Answer:
Computation of rate of dividend on preference shares:
Particulars Alt 1 Alt 2
EBIT 2,40,000 2,40,000
Less: Interest -24,000 -
EBT 2,16,000 2,40,000
Less: Tax -64,800 -72,000
EAT 1,51,200 1,68,000
-16,800
Less: Preference dividend - [1,16,800-1,151,200]
EAES 1,51,200 1,51,200
No of shares 40,000 40,000
EPS (EAES/No of shares) 3.78 3.78
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𝟏𝟔, 𝟖𝟎𝟎
𝐑𝐚𝐭𝐞 𝐨𝐟 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝 𝐨𝐧 𝐩𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐬𝐡𝐚𝐫𝐞𝐬 = 𝐱 𝟏𝟎𝟎 = 𝟖. 𝟒𝟎%
𝟐, 𝟎𝟎, 𝟎𝟎𝟎
Note:
• We will compute EPS of Alternative 1. It works out to be Rs.3.78 per share
• At indifferent point, EPS of Alternative 1 and 2 will match and hence EPS of Alt 2 is Rs.3.78. We
will reverse-work and preference dividend of Rs.16,800 will be balancing figure.

Part 3 – Valuation of firm and cost of capital using different capital structure theories

9. Net Income approach

a. X Limited raised Rs.10 lakhs of debt and Rs.10 lakhs of equity. The cost of debt and the cost of equity are
8% and 14%. Compute i) Overall cost of capital and ii) Value of the firm using net income approach
b. Data as in (a) above. Rework the overall cost of capital and the value of the firm if interest amounts are
i) 88,000 ii) 96,000 iii) 1,04,000 iv) 1,12,000 and v) 1,20,000 respectively.
Answer:
Computation of cost of capital and value of firm:
Particulars Original b(i) b(ii) b(iii) b(iv) b(v)
EBIT 2,20,000 2,20,000 2,20,000 2,20,000 2,20,000 2,20,000
Less: Interest -80,000 -88,000 -96,000 -1,04,000 -1,12,000 -1,20,000
EBT/EAT 1,40,000 1,32,000 1,24,000 1,16,000 1,08,000 1,00,000

Cost of debt 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%

Cost of equity 14.00% 14.00% 14.00% 14.00% 14.00% 14.00%
Cost of capital
[EBIT/Value of Firm] 11.00% 10.77% 10.55% 10.34% 10.13% 9.94%

Value of debt 10,00,000 11,00,000 12,00,000 13,00,000 14,00,000 15,00,000

Value of equity 10,00,000 9,42,857 8,85,714 8,28,571 7,71,429 7,14,286
Value of firm
[Value of debt + Equity] 20,00,000 20,42,857 20,85,714 21,28,571 21,71,429 22,14,286
Note for original scenario:
• Interest = 10,00,000 x 8% = Rs.80,000
• EBT/EAT = 10,00,000 x 14% = Rs.1,40,000
• EBIT = 80,000 + 1,40,000 = Rs.2,20,000

Note for rework scenario:

• EBIT would remain same as there is no change in total earnings
• Cost of debt and equity would remain constant as per net income approach
• Value of debt = Interest/cost of debt
• Value of equity = EAT/cost of equity
• Value of firm = Value of debt + Value of equity
• Cost of capital = EBIT/Value of firm

10. Valuation of firm [SM]

Rupa Company’s EBIT is Rs.5,00,000. The company has 10%, 20 lakh debentures. The equity capitalization
rate i.e. Ke is 16%.
You are required to calculate:
(i) Market value of equity and value of firm
(ii) Overall cost of capital.
Answer:
Particulars Amount
EBIT [Given] 5,00,000
-2,00,000
Less: Interest [20,00,000 x 10%]

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EBT 3,00,000

Cost of debt [Given] 10.00%

Cost of equity [Given] 16.00%
12.90%
Cost of capital [5,00,000/38,75,000]

Value of debt [Given] 20,00,000

18,75,000
Value of equity [3,00,000/16%]
38,75,000
Value of firm [20,00,000+18,75,000]

11. Net Operating Income Approach

A firm’s EBIT is Rs.2,00,000. Its overall cost of capital is 10% and the cost of its Rs.6,00,000 debt is 6%.
a. Compute the cost of equity and the value of the firm under NOI approach
b. Will your answer change if the value of the debt is Rs.8,00,000?
c. How do the answers change for interest amounts of i)30,000 ii) 42,000 and iii) 54,000 respectively?
Answer:
Particulars Original b c (i) c (ii) c (iii)
EBIT 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
Less: Interest -36,000 -48,000 -30,000 -42,000 -54,000
EBT 1,64,000 1,52,000 1,70,000 1,58,000 1,46,000

Cost of debt 6.00% 6.00% 6.00% 6.00% 6.00%

Cost of equity 11.71% 12.67% 11.33% 12.15% 13.27%
Cost of capital 10.00% 10.00% 10.00% 10.00% 10.00%

Value of debt 6,00,000 8,00,000 5,00,000 7,00,000 9,00,000

Value of equity 14,00,000 12,00,000 15,00,000 13,00,000 11,00,000
Value of firm 20,00,000 20,00,000 20,00,000 20,00,000 20,00,000
Note for original scenario:
• Interest = 6,00,000 x 6% = Rs.36,000
• Value of firm = 2,00,000/10% = Rs20,00,000
• Value of equity = Value of firm – Value of debt = 20,00,000 – 6,00,000 = Rs.14,00,000
• Cost of equity = EAT/Amount of equity = 1,64,000/14,00,000 = 11.71%

Note for rework scenario:

• EBIT would remain same as there is no change in total earnings
• Cost of debt and capital would remain constant as per net operating income approach
• Value of firm would remain same as cost of capital does not change
• Value of debt = Interest/cost of debt
• Value of equity = Value of firm – Value of debt
• Cost of equity = EAT/Value of equity

12. Valuation of firm [Nov 2007, SM]

Amita Ltd’s operating income is Rs.5,00,000. The firm’s cost of debt is 10% and currently the firm employs
Rs.15,00,000 of debt. The overall cost of capital of the firm is 15%. You are required to determine:
I. Total value of the firm.
II. Cost of equity.
Answer:
Particulars Amount
EBIT [Given] 5,00,000
Less: Interest -1,50,000

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[15,00,000 x 10%]
EBT 3,50,000

Cost of debt [Given] 10.00%

19.09%
Cost of equity [3,50,000/13,33,333]
Cost of capital [Given] 15.00%

Value of debt [Given] 15,00,000

18,33,333
Value of equity [33,33,333 – 15,00,000]
33,33,333
Value of firm [5,00,000/15%]

13. Computation of implied rate of return on equity [Jan 2021, May 2022 MTP, May 2024 MTP, SM]
Alpha and Beta Limited are identical except for capital structures. Alpha has 50 percent debt and 50 percent
equity, whereas Beta has 20 percent debt and 80 percent equity (All percentages are in market value terms).
The borrowing rate for both the companies is 8 percent in a no-tax world and capital markets are assumed
to be perfect.
1. If you own 2 percent stock of Alpha, what is your return if the company has net operating income of
Rs.3,60,000 and the overall capitalization rate of the company is 18 percent. What is the implied rate of
return on equity?
2. Beta has the same net operating income as alpha. What is its implied rate of return and why it is lower
than that of Alpha.
Answer:
Particulars Alpha Beta
EBIT [Given] 3,60,000 3,60,000
Less: Interest -80,000 -32,000
[Cost of debt x Amount of debt] [10,00,000 x 8%] [4,00,000 x 8%]
EBT/EAT/EAES 2,80,000 3,28,000

Cost of debt [Given] 8.00% 8.00%

Cost of equity
[EAT/Value of Equity] 28.00% 20.50%
Cost of capital [Given] 18.00% 18.00%

10,00,000 4,00,000
Value of debt [20,00,000 x 50%] [20,00,000 x 20%]
10,00,000 16,00,000
Value of equity [20,00,000 x 50%] [20,00,000 x 80%]
Value of firm
[EBIT/Cost off Capital] 20,00,000 20,00,000
Notes:
• Overall capitalization rate (Cost of capital) of company Alpha is 18%. Company Beta will also have
the same capitalization rate as they are identical companies
• Value of firm = EBIT/Cost of capital. Value of firm for both companies is same at Rs.20,00,000
• Value of firm is split into debt and equity as per the ratio given in question

Solution:
• Return of investor = 2,80,000 [EBT/EAT/EAES] x 2% = Rs.5,600
• Implied rate of return on equity of company Alpha = 28.00%
• Implied rate of return on equity of company Beta = 20.50%

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• Implied required rate of return on equity of Beta Ltd. is lower than that of Alpha Ltd. because Beta
Ltd. uses less debt in its capital structure. As the equity capitalisation is a linear function of the
debt-to-equity ratio when we use the net operating income approach, the decline in required
equity return offsets exactly the disadvantage of not employing so much in the way of “cheaper”
debt funds

14. MM approach with taxes

ABC company has EBIT of Rs.30,00,000 and a 40 percent tax rate. Its required rate of return on equity in
the absence of borrowing is 18 percent. What is the value of the company in an MM world i. With no
leverage ii) with Rs.40,00,000 in debt and iii) with Rs.70,00,000 in debt?
Answer:
WN 1: Valuation of unlevered firm:
Particulars Amount
EBIT 30,00,000
Less: Interest -
EBT 30,00,000
Less: Tax @ 40% -12,00,000
EAT 18,00,000

Cost of debt NA
Cost of equity [Given] 18.00%
Cost of capital
[Same as cost of equity] 18.00%

Value of debt -
1,00,00,000
Value of equity [18,00,000/18%]
Value of firm 1,00,00,000

WN 2: Valuation under different scenarios

Particulars Amount
Value with no debt 1,00,00,000
Value with Rs.40,00,000 debt = 1,00,00,000 + (40,00,000 x 40%)
= 1,16,00,000
Value with Rs.70,00,000 debt = 1,00,00,000 + (70,00,000 x 40%)
= 1,28,00,000

15. MM Approach [Nov 2022]

The following are the costs and values for the firms A and B according to the traditional approach.
Particulars Firm A Firm B
Total value of firm, V (in Rs.) 50,000 60,000
Market value of debt, D (in Rs.) 0 30,000
Market value of equity, E (in Rs.) 50,000 30,000
Expected net operating income (in Rs.) 5,000 5,000
Cost of debt (in Rs.) 0 1,800
Net Income (in Rs.) 5,000 3,200
Cost of equity, Ke = NI/V 10.00% 10.70%
(i) Compute the Equilibrium value for Firm A and B in accordance with the M-M approach. Assume that
(a) taxes do not exist and (b) the equilibrium value of Ke is 9.09%.
(ii) Compute Value of Equity and Cost of Equity for both the firms.
Answer:
Particulars Firm A Firm B
EBIT 5,000 5,000

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Less: Interest 0 -1,800
EBT 5,000 3,200

6.00%
Cost of debt NA [1,800/30,000]
Cost of equity [Given] 9.09% 15.00%
12,80%
Cost of capital 9.09% [3,200/25,005]

Value of debt 0 30,000

55,005 25,005
Value of equity [5,000/9.09%]] [55,005 – 30,000]
Value of firm 55,005 55,005
• We need to first complete the valuation of unlevered company (Firm A). Value of levered firm
(Firm B) would be same as value of unlevered firm

16. MM approach and taxation [Nov 2018 RTP, May 2018, May 2020 MTP, May 2012, Nov 2021 RTP,
SM]
RES Ltd. is an all equity financed company with a market value of Rs.25,00,000 and cost of equity Ke =
21%. The company wants to buyback equity shares worth Rs.5,00,000 by issuing and raising 15% perpetual
debt of the same amount. Rate of tax may be taken as 30%. After the capital restructuring and applying
MM Model (with taxes), you are required to calculate:
I. Market value of RES Ltd.
II. Cost of Equity Ke
III. Weighted average cost of capital and comment on it.
Answer:
Analysis of RES Limited before and after restructuring:
Before After
Particulars restructuring restructuring
7,50,000 7,50,000
EBIT [Reverse worked] [Same as before restructuring]
-75,000
Less: Interest - [5,00,000 x 15%]
7,50,000
EBT [5,25,000/70%] 6,75,000
Less: Tax @ 30% -2,25,000 -2,02,500
5,25,000
EAT [25,00,000 x 21%] 4,72,500

10.50%
Cost of debt NA [15% x 70%]
21.98%
Cost of equity 21.00% [4,72,500/21,50,000]
19.81%
Cost of capital 21.00% [7,50,000 x 70%]/26,50,000

Value of debt - 5,00,000

21,50,000
Value of equity 25,00,000 [26,50,000 – 5,00,000]
Value of firm 25,00,000 26,50,000 [Note]
Note:
• Value post restructuring = Value of unlevered firm + (Amount of debt x Tax rate)
• Value post restructuring = 25,00,000 + (5,00,000 x 30%) = 26,50,000

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Comments:
• WACC of the company reduces from 21% to 19.81%. Improvement in WACC is due to higher
valuation of firm post restructuring. Value of RES Limited improves due to tax benefit on interest
payment of perpetual debt

17. Net income approach and net operating income approach [May 2018 RTP, Nov 2015 RTP]
Company P and Q are identical in all respects including risk factors except of debt/equity, company P
having issued 10% debentures of Rs.18 lakhs while company Q is unlevered. Both the companies earn 20%
before interest and taxes on their total assets of Rs.30 lakhs. Assuming a tax rate of 50% and capitalization
rate of 15% from an all-equity company.
Required:
Calculate the value of companies’ P and Q using (i) Net Income Approach and (ii) Net Operating Income
Approach
Answer:
WN 1: Valuation of firms as per Net Income Approach:
Particulars Comp P Comp Q
6,00,000 6,00,000
EBIT [30,00,000 x 20%] [30,00,000 x 20%]
-1,80,000
Less: Interest [18,00,000 x 10%] -
EBT 4,20,000 6,00,000
Less: Tax -2,10,000 -3,00,000
EAT 2,10,000 3,00,000

5.00%
Cost of debt [10% x 50%] NA
15.00% 15.00%
Cost of equity [Given] [Given]
9.38% 15.00%
Cost of capital [6,00,000 x 50%]/32,00,000 [6,00,000 x 50%]/20,00,000

18,00,000
Value of debt [Given] -
14,00,000 20,00,000
Value of equity [2,10,000/15%] [3,00,000/20%]
Value of firm 32,00,000 20,00,000

WN 2: Valuation of firm as per Net operating income approach:

Particulars Comp P Comp Q
6,00,000 6,00,000
EBIT [30,00,000 x 20%] [30,00,000 x 20%]
-1,80,000
Less: Interest [18,00,000 x 10%] -
EBT 4,20,000 6,00,000
Less: Tax -2,10,000 -3,00,000
EAT 2,10,000 3,00,000

5.00%
Cost of debt [10% x 50%] NA
19.09% 15.00%
Cost of equity [2,10,000/11,00,000] [Given]
10.34%
Cost of capital [6,00,000 x 50%]/29,00,000 15.00%

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Value of debt 18,00,000 -
11,00,000 20,00,000
Value of equity [29,00,000-18,00,000] [3,00,000/15%]
29,00,000
Value of firm [Note] 20,00,000
• Net operating income is similar to MM approach. In this question we have taxes and hence we
should value unlevered company (company Q) first.
• Value of company P (Levered) = Value of company Q + (Amount of debt x Tax rate)
• Value of company P (Levered) = 20,00,000 + (18,00,000 x 0.5) = Rs.29,00,000

18. MM Approach [SM]

One-third of the total market value of Sanghmani Limited consists of loan stock, which has a cost of 10 per
cent. Another company, Samsui Limited, is identical in every respect to Sanghmani Limited, except that its
capital structure is all-equity, and its cost of equity is 16 per cent. According to Modigliani and Miller, if
we ignored taxation and tax relief on debt capital, what would be the cost of equity of Sanghmani Limited?
Answer:
Let us assume EBIT of both companies are Rs.1,60,000 (we can assume any number to do this question)
Particulars Sanghmani Sansui
EBIT 1,60,000 1,60,000
Less: Interest -33,333 -
EBT 1,26,667 1,60,000

Cost of debt 10.00% NA

Cost of equity 19.00% 16.00%
Cost of capital 16.00% 16.00%

Value of debt 3,33,333 -

Value of equity 6,66,667 10,00,000
Value of firm 10,00,000 10,00,000
Note:
• Sansui Limited has cost of equity of 16%. It has no debt and hence cost of capital of Sansui Limited
will also be 16%
• There is no tax in this situation and hence value of firm of both companies will be Rs.10,00,000
• Value of debt of Sanghmani Limited = 10,00,000 x (1/3) = Rs.3,33,333
• Value of equity of Sanghmani Limited = 10,00,000 x (2/3) = Rs.6,66,667
• Cost of equity = (EBT/Value of equity) = (1,26,667/6,66,667) x 100 =16.00%

19. Valuation as per MM Approach [Nov 2018, May 2022 RTP, Sep 2024 RTP, SM]
The following data relate to two companies belonging to the same risk class:
Particulars Amount Amount
Expected Net Operating Income 18,00,000 18,00,000
12% Debt 54,00,000 -
Equity capitalization rate - 18
Required:
a) Determine the total market value, equity capitalization rate and weighted average cost of capital
for each company assuming no taxes as per MM approach
b) Determine the total market value, equity capitalization rate and weighted average cost of capital
for each company assuming 40% taxes as per MM approach
Answer:
WN 1: Valuation of two firms as per MM approach without taxes:
Particulars Firm A Firm B
EBIT 18,00,000 18,00,000
-6,48,000
Less: Interest [54,00,000 x 12%] -

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EBT 11,52,000 18,00,000

Cost of debt 12.00% NA

25.04% 18.00%
Cost of equity [11,52,000/46,00,000] [Given]
Cost of capital 18.00% 18.00%

Value of debt 54,00,000 -

46,00,000
Value of equity [1,00,00,000-54,00,000] 1,00,00,000
Value of firm 1,00,00,000 1,00,00,000
• There are no taxes. We start with valuation of unlevered firm and the same is Rs.1,00,00,000
• Valuation of levered firm will remain same as unlevered firm as there are no taxes
• Cost of equity of Firm A = (11,52,000/46,00,000) x 100 = 25.04%

WN 2: Valuation of two firms as per MM approach with taxes:

Particulars Firm A Firm B
EBIT 18,00,000 18,00,000
-6,48,000
Less: Interest [54,00,000 x 12%] -
EBT 11,52,000 18,00,000
Less: Tax @ 40% -4,60,800 -7,20,000
EAT 6,91,200 10,80,000

7.20%
Cost of debt [12% x 60%] NA
25.04% 18.00%
Cost of equity [6,91,200/27,60,000] [Given]
Cost of capital 13.24% 18.00%

Value of debt 54,00,000 -

27,60,000 60,00,000
Value of equity [81,60,000-54,00,000] [10,80,000/18%]
81,60,000
Value of firm [Note] 60,00,000
Note:
• Value of unlevered firm = 10,80,000/18% = Rs.60,00,000
• Value of levered firm = 60,00,000 + (54,00,000 x 40%) = Rs.81,60,000

20. Traditional approach and MM Approach [May 2021 RTP, SM]

Zordon Ltd. has net operating income of Rs.5,00,000 and total capitalization of Rs.50,00,000 during the
current year. The company is contemplating to introduce debt financing in capital structure and has various
options for the same. The following information is available at different levels of debt value:
Debt Value Interest rate Equity capitalization rate
0 - 10.00
5,00,000 6.00 10.50
10,00,000 6.00 11.00
15,00,000 6.20 11.30
20,00,000 7.00 12.40
25,00,000 7.50 13.50
30,00,000 8.00 16.00
Assuming no tax and that the firm always maintains books at book values, you are REQUIRED to calculate:
(i) Amount of debt to be employed by firm as per traditional approach.
(ii) Equity capitalization rate, if MM approach is followed.

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Answer:
WN 1: Analysis under traditional approach:
Particulars Alt 1 Alt 2 Alt 3 Alt 4 Alt 5 Alt 6 Alt 7
EBIT 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest
[Debt x cost of debt] - -30,000 -60,000 -93,000 -1,40,000 -1,87,500 -2,40,000
EBT/EAT 5,00,000 4,70,000 4,40,000 4,07,000 3,60,000 3,12,500 2,60,000

Cost of debt - 6.00 6.00 6.20 7.00 7.50 8.00

Cost of equity 10.00 10.50 11.00 11.30 12.40 13.50 16.00
Cost of capital
[EBIT/Value of Firm] 10.00 10.05 10.00 9.80 10.20 10.38 10.81

Value of debt 0 5,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000

Value of equity
[EAT/Cost of equity] 50,00,000 44,76,190 40,00,000 36,01,770 29,03,226 23,14,815 16,25,000
Value of firm 50,00,000 49,76,190 50,00,000 51,01,770 49,03,226 48,14,815 46,25,000
• We should go ahead with Alternative 4 as the same leads to lowest cost of capital. Hence the
company should have debt of Rs.15,00,000

WN 2: Analysis under MM Approach:

• Under MM Approach the cost of capital and value of firm remains constant irrespective of capital
structure
Particulars Alt 1 Alt 2 Alt 3 Alt 4 Alt 5 Alt 6 Alt 7
EBIT 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest
[Debt x cost of debt] - -30,000 -60,000 -93,000 -1,40,000 -1,87,500 -2,40,000
EBT/EAT 5,00,000 4,70,000 4,40,000 4,07,000 3,60,000 3,12,500 2,60,000

Cost of debt - 6.00 6.00 6.20 7.00 7.50 8.00

Cost of equity 10.00 10.44 11.00 11.63 12.00 12.50 13.00
Cost of capital 10.00 10.00 10.00 10.00 10.00 10.00 10.00

Value of debt 0 5,00,000 10,00,000 15,00,000 20,00,000 25,00,000 30,00,000

Value of equity 50,00,000 45,00,000 40,00,000 35,00,000 30,00,000 25,00,000 20,00,000
Value of firm 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000 50,00,000
• Amount of equity = Value of firm – Value of debt
• Cost of equity = PAT/Amount of equity

Part 4 – Primary and Reverse Arbitrage

21. Primary Arbitrage [SM]

There are two firms N and M having same EBIT of Rs.20,000. Firm M is a levered company having a debt
of Rs.1,00,000 @ 7% rate of interest. The cost of equity of N company is 10% and that of M company is
11.50%. Find out how arbitrage process will be carried on?
Answer:
WN 1: Valuation of two firms:
Particulars Firm M Firm N
EBIT 20,000 20,000
-7,000
Less: Interest [1,00,000 x 7%] -
EBT 13,000 20,000

Cost of debt [Given] 7.00% NA

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Cost of equity [Given] 11.50% 10.00%
9.39% 10.00%
Cost of capital [20,000/2,13,043] [20,000/2,00,000]

Value of debt 1,00,000 -

1,13,043 2,00,000
Value of equity [13,000/11.50%] [20,000/10%]
Value of firm 2,13,043 2,00,000
• Primary arbitrage exists as the value of levered firm (Firm M) is higher than value of unlevered
firm

WN 2: Assume 10% investment in equity of company having higher value and calculate present
earnings:
Particulars Amount
Company having higher value Firm M
Value of equity of Firm M 1,13,043
Our investment (10% of equity) 11,304
Total dividend of firm M 13,000
Our earnings (13,000 x 10%) 1,300

WN 3: Sell shares of Firm M (levered firm – high risk) and invest in equity of Firm N:
• Investor has to sell shares of Firm M and invest in equity of Firm N
• We are moving from high risk company to low risk company. This would lead to risk reduction.
In order to maintain same risk, we should borrow money in line with corporate leverage
Particulars Amount
Sell shares of Firm M 11,304
Borrow money @ 7% (1,00,000 x 10%) 10,000
Total amount available 21,304
Invest in equity of firm N (2,00,000 x 10%) 20,000
Surplus cash 1,304

WN 4: Compute new earnings:

Particulars Amount
Dividend of firm N 20,000
Earnings of the investor (20,000 x 10%) 2,000
Less: Interest paid (10,000 x 7%) 700
Revised earnings 1,300
Surplus cash 1,304
Conclusion:
• Arbitrage gain is confirmed as the investor is able to earn same amount while having surplus cash
of Rs.1,304. This surplus cash can be used for additional investment to increase the earnings of the
investor

22. Reverse Arbitrage [SM]

There are two firms N and M having same EBIT of Rs.20,000. Firm M is a levered company having a debt
of Rs.1,00,000 @ 7% rate of interest. The cost of equity of N company is 10% and that of M company is
18.00%. Find out how arbitrage process will be carried on?
Answer:
WN 1: Valuation of two firms:
Particulars Firm M Firm N
EBIT 20,000 20,000
-7,000
Less: Interest [1,00,000 x 7%] -
EBT 13,000 20,000

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Cost of debt [Given] 7.00% NA

Cost of equity [Given] 18.00% 10.00%
9.39% 10.00%
Cost of capital [20,000/1,72,222] [20,000/2,00,000]

Value of debt 1,00,000 -

72,222 2,00,000
Value of equity [13,000/18%] [20,000/10%]
Value of firm 1,72,222 2,00,000
• Reverse arbitrage exists as the value of unlevered firm (Firm N) is higher than value of levered
firm

WN 2: Assume 10% investment in equity of company having higher value and calculate present
earnings:
Particulars Amount
Company having higher value Firm N
Value of equity of Firm N 2,00,000
Our investment (10% of equity) 20,000
Total dividend of firm M 20,000
Our earnings (20,000 x 10%) 2,000

WN 3: Sell shares of Firm N (unlevered firm – low risk) and invest in equity of Firm M:
• Investor has to sell shares of Firm N and invest in equity of Firm M
• We are moving from low risk company to high risk company. This would lead to risk increase. In
order to maintain same risk, we should invest money in debt as well as equity
Particulars Amount
Sell shares of Firm N 20,000
Invest in debt (1,00,000 x 10%) 10,000
Invest in equity of firm M (72,222 x 10%) 7,222
Surplus cash 2,778

WN 4: Compute new earnings:

Particulars Amount
Dividend of firm M 13,000
Earnings of the investor (13,000 x 10%) 1,300
Interest income (1,00,000 x 7%) 700
Total earnings of the investor 2,000
Surplus cash 2,778
Conclusion:
• Arbitrage gain is confirmed as the investor is able to earn same amount while having surplus cash
of Rs.2,778. This surplus cash can be used for additional investment to increase the earnings of the
investor

23. Arbitrage [Nov 2021 MTP, May 2022 MTP, May 2024 RTP, May 2023 MTP, May 2024 SM]
In respect of two companies having same business risk, following information is given:
Capital employed = Rs.4,00,000; EBIT = Rs.60,000; Ke = 12%
Sources Levered Company Unlevered Company
Debt @ 10% 1,50,000 Nil
Equity 1,50,000 3,00,000
Investor is holding 20% shares in levered company. CALCULATE increase in annual earnings of investor
if he switches his holding from Levered to Unlevered company
Answer:
WN 1: Valuation of two firms:

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Particulars Levered company Unlevered company
EBIT 60,000 60,000
-15,000
Less: Interest [1,50,000 x 10%] -
EBT 45,000 60,000

Cost of debt [Given] 10.00% NA

Cost of equity [Given] 12.00% 12.00%
11.43% 12.00%
Cost of capital [60,000/5,25,000] [60,000/5,00,000]

Value of debt 1,50,000 -

3,75,000 5,00,000
Value of equity [45,000/12.00%] [60,000/12%]
Value of firm 5,25,000 5,00,000
• Primary arbitrage exists as the value of levered firm is higher than value of unlevered firm

WN 2: Calculate of present earnings with 20% investment in levered company:

Particulars Amount
Value of levered company 5,25,000
Value of equity of levered company 3,75,000
Our investment (20% of equity) 75,000
Total dividend of levered company 45,000
Our earnings (45,000 x 20%) 9,000

WN 3: Sell shares of levered firm (high risk) and invest in equity of unlevered company:
• Investor has to sell shares of levered company and invest in equity of unlevered company
• We are moving from high risk company to low risk company. This would lead to risk reduction.
In order to maintain same risk, we should borrow money in line with corporate leverage
Particulars Amount
Sell shares of levered company 75,000
Borrow money @ 10% (1,50,000 x 20%) 30,000
Total amount available 1,05,000
Invest in equity of unlevered company 1,05,000
% stake of other company [1,05,000/5,00,000] x 100 21.00

WN 4: Compute new earnings:

Particulars Amount
Dividend of unlevered company 60,000
Earnings of the investor (60,000 x 21%) 12,600
Less: Interest paid (30,000 x 10%) -3,000
Revised earnings 9,600
Increase in earnings [9,600 – 9,000] 600

24. Arbitrage [Nov 2021 MTP, May 2022 MTP, SM]

Following data is available in respect of two companies having same business risk:
Capital employed = Rs. 2,00,000, EBIT = Rs. 30,000
Sources Levered Company Unlevered Company
Debt @ 10% 1,00,000 Nil
Equity 1,00,000 2,00,000
Cost of equity 20% 12.50%
An investor is holding 15% shares in Unlevered company. CALCULATE the increase in annual earnings
of investor if he switches his holding from Unlevered to Levered Company.
Answer:
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WN 1: Valuation of two firms:
Particulars Levered Company Unlevered Company
EBIT 30,000 30,000
-10,000
Less: Interest [1,00,000 x 10%] -
EBT 20,000 30,000

Cost of debt [Given] 10.00% NA

Cost of equity [Given] 20.00% 12.50%
15.00%
Cost of capital [30,000/2,00,000]

Value of debt 1,00,000 -

1,00,000 2,40,000
Value of equity [20,000/20%] [30,000/12.50%]
Value of firm 2,00,000 2,40,000
• Reverse arbitrage exists as the value of unlevered firm is higher than value of levered firm

WN 2: Calculate present earnings of investor:

Particulars Amount
Value of equity of unlevered company 2,40,000
Our investment (15% of equity) 36,000
Total dividend of firm M 30,000
Our earnings (30,000 x 15%) 4,500

WN 3: Sell shares unlevered firm (low risk) and invest in equity and debt of levered company:
• Investor has to sell shares of unlevered company and invest in equity of levered company
• We are moving from low risk company to high risk company. This would lead to risk increase. In
order to maintain same risk, we should invest money in debt as well as equity
Particulars Amount
Sell shares of unlevered company 36,000
Invest in debt (36,000/2) 18,000
Invest in equity (36,000/2) 18,000

WN 4: Compute new earnings:

Particulars Amount
Dividend of levered company 20,000
Earnings of the investor (20,000 x 18%) 3,600
Interest income (18,000 x 10%) 1,800
Total earnings of the investor 5,400
Increase in earnings (5,400 – 4,500) 900

Practice Questions

1. Optimum Mix [Nov 2023 MTP]

Bhaskar Manufactures Ltd. have Equity Share Capital of Rs. 5,00,000 (face value Rs.100) to meet the
expenditure of an expansion programme, the company wishes to raise Rs. 3,00,000 and is having following
four alternative sources to raise the funds:
• Plan A: To have full money from equity shares.
• Plan B: To have Rs. 1 lakhs from equity and Rs. 2 lakhs from borrowing from the financial
institution @ 10% p.a.
• Plan C: Full money from borrowing @ 10% p.a.
• Plan D: Rs.1 lakh in equity and Rs. 2 lakhs from preference shares at 8% p.a.

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The company is expected to have an earning of Rs. 1,50,000. The corporate tax is 50%. Suggest a suitable
plan of the above four plans to raise the required funds.
Answer:
Computation of EPS
Particulars Alt 1 Alt 2 Alt 3 Alt 4
EBIT 1,50,000 1,50,000 1,50,000 1,50,000
Less: Interest - -20,000 -30,000 -
EBT 1,50,000 1,30,000 1,20,000 1,50,000
Less: Tax @ 40% -75,000 -65,000 -60,000 -75,000
EAT 75,000 65,000 60,000 75,000
Less: Preference Dividend - - - -16,000
EAES 75,000 65,000 60,000 59,000
No of shares 8,000 6,000 5,000 6,000
EPS 9.375 10.833 12.000 9.833
Plan C given the highest EPS and therefore to be accepted

2. Evaluation of multiple alternatives [Nov 2022 RTP, SM]

Best of Luck Ltd., a profit making company, has a paid-up capital of Rs.100 lakhs consisting of 10 lakhs
ordinary shares of Rs.10 each. Currently, it is earning an annual pre-tax profit of Rs.60 lakhs. The company's
shares are listed and are quoted in the range of Rs.50 to Rs.80. The management wants to diversify
production and has approved a project which will cost Rs.50 lakhs and which is expected to yield a pre-tax
income of Rs.40 lakhs per annum.
To raise this additional capital, the following options are under consideration of the management:
a) To issue equity capital for the entire additional amount. It is expected that the new shares (face
value of Rs.10) can be sold at a premium of Rs.15.
b) To issue 16% non-convertible debentures of Rs.100 each for the entire amount.
c) To issue equity capital for Rs.25 lakhs (face value of Rs.10) and 16% non-convertible debentures for
the balance amount. In this case, the company can issue shares at a premium of Rs.40 each.
You are required to advise the management as to how the additional capital can be raised, keeping in mind
that the management wants to maximise the earnings per share to maintain its goodwill. The company is
paying income tax at 50%.
Answer:
WN 1: Identification of alternatives:
Alternative 1 – Issue equity of Rs.50 lakhs at issue price of Rs.25 per share [10 + 15]
Alternative 2 – Issue 16% NCD of Rs.50 lakhs
Alternative 3 – Issue equity of Rs.25 lakhs at issue price of Rs.50 per share [10 + 40] and balance 16% NCD
of Rs.25 lakhs

WN 2: Computation of interest, preference dividend and no of equity shares for three alternatives:
Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest - - -
New Interest - 8,00,000 4,00,000
[50,00,000 x 16%] [25,00,000 x 16%]
Total Interest - 8,00,000 4,00,000
Preference dividend
Existing - - -
New - - -
Total dividend - - -
No of equity shares
Existing 10,00,000 10,00,000 10,00,000
New 2,00,000 - 50,000
[50,00,000/25] [25,00,000/50]
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Total 12,00,000 10,00,000 10,50,000

WN 3: Computation of EPS:
Particulars Alt 1 Alt 2 Alt 3
EBIT (60,00,000 + 40,00,000) 1,00,00,000 1,00,00,000 1,00,00,000
Less: Interest [WN 2] - -8,00,000 -4,00,000
EBT 1,00,00,000 92,00,000 96,00,000
Less: Tax @ 50% -50,00,000 -46,00,000 -48,00,000
EAT 50,00,000 46,00,000 48,00,000
Less: Preference dividend - - -
EAES 50,00,000 46,00,000 48,00,000
No of shares [WN 2] 12,00,000 10,00,000 10,50,000
EPS (EAES/No of shares) 4.17 4.60 4.57
• The term pre-tax profit would basically mean EBIT in this question.
Conclusion: The company should go ahead with Alternative 2 as the same results in maximum EPS.

3. Computation of probable price [May 2019 RTP, May 2016 RTP, Nov 2017 RTP, Nov 2022 RTP,
Nov 2023, Nov 2023 RTP, SM]
Akash Limited provides you the following information:
Particulars Amount
Earnings before Interest and Tax 2,80,000
Less: Interest on debentures @ 10% (40,000)
EBT 2,40,000
Less: Income tax @ 50% (1,20,000)
EAT 1,20,000
No of equity shares (Rs.10 each) 30,000
EPS 4
PE Ratio 10
The company has reserves and surplus of Rs.7,00,000 and required Rs.4,00,000 further for modernization.
Debt (Debt/Debt + Equity) Ratio higher than 40% will bring the PE ratio down to 8 and increase the interest
rate on additional debts to 12%. You are required to ascertain the probable price of the share.
a) If the additional capital is raised as debt and
b) If the amount is raised by issuing equity shares at ruling market price
Answer:
WN 1: Computation of interest, preference dividend and no of equity shares for debt and equity
alternative:
Particulars Debt Equity
Interest
Existing interest 40,000 40,000
New Interest 48,000 -
[4,00,000 x 12%]
Total Interest 88,000 40,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 30,000 30,000
New - 10,000
Total shares 30,000 40,000
Note:
• CMP of share = EPS x PE Multiple = 4 x 10 = Rs.40
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• New shares issued = 4,00,000/40 = 10,000

WN 2: Computation of MPS for two alternatives:

Particulars Debt Equity
EBIT [Note 1] 3,60,000 3,60,000
Less: Interest [WN 1] -88,000 -40,000
EBT 2,72,000 3,20,000
Less: Tax @ 50% -1,36,000 -1,60,000
EAT 1,36,000 1,60,000
Less: Preference dividend - -
EAES 1,36,000 1,60,000
No of shares [WN 1] 30,000 40,000
EPS (EAES/No of shares) 4.53 4.00
PE Multiple 8 10
MPS (EPS x PE Multiple) 36.24 40.00

Note 1: Computation of EBIT

• In this question, EBIT after proposed extension is not given. Therefore, we can assume that existing
return on capital employed will be maintained
Particulars Existing Revised
EBIT 2,80,000 3,60,000
(20% x 18,00,000)
Capital employed: 14,00,000 18,00,000
Equity capital 3,00,000 3,00,000
Reserves and surplus 7,00,000 7,00,000
4,00,000 4,00,000
Debt [40,000/10%] [40,000/10%]
New capital introduced 0 4,00,000
ROI (EBIT/CE) 20.00% 20,00%
[2,80,000/14,00,000] x 100

Note 2: Identification of PE Multiple for two scenarios:

Particulars Debt Equity
Debt 8,00,000 4,00,000
10,00,000 14,00,000
Equity [7,00,000 + 3,00,000] [10,00,000+4,00,000]
Total capital employed
[Debt + Equity] 18,00,000 18,00,000
Debt 44.44% 22.22%
Debt Ratio =
Debt + Equity
Applicable PE Multiple 8 10

4. Selection of alternative [May 2019 RTP, Nov 2019]

The following figures of Theta Limited are presented as under:
Particulars Amount Amount
Earnings before Interest and Tax 23,00,000
Less: Debenture interest @ 8% 80,000
Long term Loan interest @ 11% 2,20,000 (3,00,000)
20,00,000
Less: Income Tax (10,00,000)
Earnings after Tax 10,00,000
No of equity shares of Rs.10 each 5,00,000
EPS Rs.2

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Market price of a share Rs.20
P/E Ratio 10
The company has undistributed reserves and surplus of Rs.20 lakhs. It is in need of Rs.30 lakhs to pay off
debentures and modernize its plants. It seeks your advice on the following alternatives of raising finance:
• Alternative 1 – Raising entire amount as term loan from banks @ 12%
• Alternative 2 – Raising part of the funds by issue of 1,00,000 shares of Rs.20 each and the rest by
term loan at 12 percent

The company expects to improve its rate of return by 2 percent as a result of modernization, but P/E ratio
is likely to go down to 8 if the entire amount is raised as term loan.
a) Advise the company on the financial plan to be selected
b) If it is assumed that there will be no change in the P/E ratio if either of the two alternatives is
adopted, would your advice still hold good?
Answer:
WN 1: Computation of interest, preference dividend and no of equity shares:
Particulars Alt 1 Alt 2
Interest
Existing interest 2,20,000 2,20,000
New Interest 3,60,000 1,20,000
[30,00,000 x 12%] [10,00,000 x 12%]
Total Interest 5,80,000 3,40,000
Preference dividend
Existing - -
New - -
Total dividend - -
No of equity shares
Existing 5,00,000 5,00,000
New - 1,00,000
Total shares 5,00,000 6,00,000
• Note: Debentures would be paid off and hence existing interest will be Rs.2,20,000

WN 2: Selection of alternative if PE multiple is impacted:

Particulars Alt 1 Alt 2
EBIT [Note 1] 30,00,000 30,00,000
Less: Interest [WN 1] -5,80,000 -3,40,000
EBT 24,20,000 26,60,000
Less: Tax @ 50% -12,10,000 -13,30,000
EAT 12,10,000 13,30,000
Less: Preference dividend - -
EAES 12,10,000 13,30,000
No of shares [WN 1] 5,00,000 6,00,000
EPS (EAES/No of shares) 2.4200 2.2167
PE Multiple 8 10
MPS (EPS x PE Multiple) 19.3600 22.1670
No of shares 5,00,000 6,00,000
Market value of equity [EPS x No of shares] 96,80,000 1,33,00,200
Market value of debt 50,00,000 30,00,000
Market value of preference - -
Market value of firm 1,46,80,000 1,63,00,200
• Company should go ahead with alternative 2 as it has better value of firm if PE multiple is impacted
due to fresh borrowings

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Note 1: Computation of EBIT:

Particulars Existing Revised
EBIT 23,00,000 30,00,000
(25% x 1,20,00,000)
Capital employed: 1,00,00,000 1,20,00,000
Equity capital 50,00,000 50,00,000
Reserves and surplus 20,00,000 20,00,000
10,00,000 -
Debentures [80,000/8%]
20,00,000 20,00,000
Term loan [2,20,000/11%]
Preference 0 0
New capital introduced 0 30,00,000
ROI (EBIT/CE) 23.00% 25.00%
[23,00,000/1,00,00,000] x 100 [23.00% + 2.00%]
• Existing ROI is 23% and same will improve to 25%. Total capital will increase to Rs.120 lacs and
hence new EBIT will be 120 lacs x 25% = Rs.30,00,000

WN 3: Selection of alternative if PE Multiple does not change:

Particulars Alt 1 Alt 2
EPS as per WN 2 2.4200 2.2167
PE Multiple 10 10
MPS (EPS x PE Multiple) 24.2000 22.1670
No of shares 5,00,000 6,00,000
Market value of equity 1,21,00,000 1,33,00,200
Market value of debt 50,00,000 30,00,000
Market value of preference - -
Market value of firm 1,71,00,000 1,63,00,200
• Company should choose Alternative 1 if there is no change in PE multiple

5. Indifference point [Nov 2019 MTP, SM]

Yoyo Limited presently has Rs.36,00,000 in debt outstanding bearing an interest rate of 10 per cent. It wishes
to finance a Rs.40,00,000 expansion programme and is considering three alternatives: additional debt at 12
per cent interest, preference shares with an 11 per cent dividend, and the sale of equity shares at Rs.16 per
share. The company presently has 8,00,000 shares outstanding and is in a 40 per cent tax bracket.
I. If earnings before interest and taxes are presently Rs.15,00,000, what would be earnings per share
for the three alternatives, assuming no immediate increase in profitability?
II. What is the indifference point among three alternatives?
III. Which alternative do you prefer? How much would EBIT need to increase before the next
alternative would be best?
Answer:
WN 1: Identification of alternatives
Alternative 1 – Additional debt at interest rate of 12 percent
Alternative 2 – Issue preference shares at 11 percent
Alternative 3 – Issue equity shares at issue price of Rs.16

WN 2: Computation of interest, preference dividend and no of equity shares:

Particulars Alt 1 Alt 2 Alt 3
Interest
Existing interest 3,60,000 3,60,000 3,60,000
New Interest 4,80,000 - -

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Total Interest 8,40,000 3,60,000 3,60,000
Preference dividend
Existing - - -
New - 4,40,000 -
Total dividend - 4,40,000 -
No of equity shares
Existing 8,00,000 8,00,000 8,00,000
New - - 2,50,000
Total shares 8,00,000 8,00,000 10,50,000

WN 3: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Alt 1 Alt 2 Alt 3
EBIT X X X
Less: Interest 8,40,000 3,60,000 3,60,000
EBT X-8,40,000 X-3,60,000 X-3,60,000
Less: Tax 0.4(X-8,40,000) 0.4(X-3,60,000) 0.4(X-3,60,000)
EAT 0.6(X-8,40,000) 0.6(X-3,60,000) 0.6(X-3,60,000)
Less: Preference dividend 0 4,40,000 0
EAES 0.6X – 5,04,000 0.6X – 6,56,000 0.6X – 2,16,000
No of shares 8,00,000 8,00,000 10,50,000
0.6X − 5,04,000 0.6X − 6,56,000 0.6X − 2,16,000
EPS (EAES/No of shares) 8,00,000 8,00,000 10,50,000

Indifference point between Plan 1 and Plan 2:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 2
EPS of Plan 1 = EPS of Plan 2
0.6X − 5,04,000 0.6X − 6,56,000
= ;
8,00,000 8,00,000
• There is no indifference point between Plan 1 and Plan 2. This would mean that one plan is
dominating the other plan
• Plan 1 dominates Plan 2 as Plan 1 has lower financial BEP
• Financial BEP of Plan 1 = 8,40,000
• Financial BEP of Plan 2 = 3,60,000 + (4,40,000/0.6) = 3,60,000 + 7,33,333 = 10,93,333

Indifference point between Plan 1 and Plan 3:

At indifference point EPS of Plan 1 will be equal to EPS of Plan 3
EPS of Plan 1 = EPS of Plan 3
0.6X − 5,04,000 0.6X − 2,16,000
= ; 6.3X − 52,92,000 = 4.8X − 17,28,000; 1.5X = 35,64,000
8,00,000 10,50,000
35,64,000
X= = Rs. 23,76,000
1.5
Indifference point between Plan 1 and Plan 3 = EBIT of Rs.23,76,000

Indifference point between Plan 2 and Plan 3:

EPS of Plan 2 = EPS of Plan 3
0.6X − 6,56,000 0.6X − 2,16,000
= ; 6.3X − 68,80,000 = 4.8X − 17,28,000; 1.5X = 51,60,000
8,00,000 10,50,000
51,60,000
X= = Rs. 34,40,000
1.5
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Indifference point between Plan 2 and Plan 3 = EBIT of Rs.34,40,000

WN 4: Computation of EPS when EBIT is Rs.15,00,000

Particulars Alt 1 Alt 2 Alt 3
EBIT 15,00,000 15,00,000 15,00,000
Less: Interest -8,40,000 -3,60,000 -3,60,000
EBT 6,60,000 11,40,000 11,40,000
Less: Tax -2,64,000 -4,56,000 -4,56,000
EAT 3,96,000 6,84,000 6,84,000
Less: Preference dividend - 4,40,000 -
EAES 3,96,000 2,44,000 6,84,000
No of shares 8,00,000 8,00,000 10,50,000
EPS (EAES/No of shares) 0.495 0.305 0.651
Selection of Alternative:
• We should go ahead with Alternative 3 (Issue of common shares) when EBIT is Rs.15,00,000. EBIT
would need to increase to Rs.23,76,000 before an indifference point on debt is reached. We can go
ahead with Alternative 1 if the EBIT increases by Rs.8,76,000

6. Indifference Point [Nov 2020, May 2018 MTP, Nov 2018 MTP, Nov 2018, Nov 2019 RTP, May
2018, May 2021 MTP, SM]
The management of Z Company Ltd. wants to raise its funds from market to meet out the financial
demands of its long-term projects. The company has various combinations of proposals to raise its funds.
You are given the following proposals of the company:
Proposals % of Equity % of Debt % of preference shares
P 100 - -
Q 50 50 -
R 50 - 50
I. Cost of debt – 10%
Cost of preference shares – 10%
II. Tax rate – 50%
III. Equity shares of the face value of Rs.10 each will be issued at a premium of Rs.10 per share.
IV. Total investment to be raised Rs.40,00,000.
V. Expected earnings before interest and tax Rs.18,00,000.

From the above proposals the management wants to take advice from you for appropriate plan after
computing the following:
• Earnings per share
• Financial break-even-point
• Compute the EBIT range among the plans for indifference. Also indicate if any of the plans
dominate
Answer:
WN 1: Computation of financial break-even point:
Step 1: Identification of alternatives:
• Plan P – Issue equity of Rs.40,00,000 at issue price of Rs.20 per share
• Plan Q – Issue equity of Rs.20,00,000 and 10% debt of Rs.20,00,000
• Plan R – Issue equity of Rs.20,00,000 and 10% preference shares of Rs.20,00,000

Step 2: Computation of interest, preference dividend and no of equity shares:

Particulars Plan P Plan Q Plan R
Interest
Existing interest - - -
New Interest - 2,00,000 -
Total Interest - 2,00,000 -

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Preference dividend
Existing - - -
New - - 2,00,000
Total dividend - - 2,00,000
No of equity shares
Existing - - -
New 2,00,000 1,00,000 1,00,000
Total shares 2,00,000 1,00,000 1,00,000

Step 3: Computation of financial break-even point:

PD
Financial BEP = Interest + ( )
1 − Tax rate
0
Financial BEP of Plan P = 0 + ( )=0
1 − 50%
0
Financial BEP of Plan Q = 2,00,000 + ( ) = 2,00,000
1 − 50%
2,00,000
Financial BEP of Plan R = 0 + ( ) = 4,00,000
1 − 50%

WN 2: Computation of indifference point:

• Indifference point refers to level of EBIT at which EPS of two alternatives will be equal
• Let us assume EBIT to be X
Particulars Plan P Plan Q Plan R
EBIT X X X
Less: Interest 0 -2,00,000 0
EBT X X-2,00,000 X
Less: Tax 0.5X 0.5(X-2,00,000) 0.5X
EAT 0.5X 0.5(X-2,00,000) 0.5X
Less: Preference dividend 0 0 -2,00,000
EAES 0.5X 0.5X-1,00,000 0.5X-2,00,000
No of shares 2,00,000 1,00,000 1,00,000
0.5X 0.5X − 1,00,000 0.5X − 2,00,000
EPS (EAES/No of shares) 2,00,000 1,00,000 1,00,000

Indifference point between Plan P and Plan Q:

At indifference point EPS of Plan P will be equal to EPS of Plan Q
EPS of Plan P = EPS of Plan Q
0.5X 0.5X − 1,00,000 2,00,000
= ; 0.5X = X − 2,00,000; X = = 𝟒, 𝟎𝟎, 𝟎𝟎𝟎
2,00,000 1,00,000 0.5
• Indifference point between Plan P and Plan Q = EBIT of Rs.4,00,000

Indifference point between Plan P and Plan R:

At indifference point EPS of Plan P will be equal to EPS of Plan R
EPS of Plan P = EPS of Plan R
0.5X 0.5X − 2,00,000 4,00,000
= ; 0.5X = X − 4,00,000; X = = 𝟖, 𝟎𝟎, 𝟎𝟎𝟎
2,00,000 1,00,000 0.5
• Indifference point between Plan P and Plan R = EBIT of Rs.8,00,000

Indifference point between Plan Q and Plan R:

EPS of Plan Q = EPS of Plan R
0.5X − 1,00,000 0.5X − 2,00,000
= ;
1,00,000 1,00,000
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• There is no indifference point between Plan Q and Plan R. This would mean that one plan is
dominating the other plan
• Plan with low financial break-even point will dominate the plan with high financial break-even
point.
• In this case, Plan Q has lower financial BEP and hence Plan Q dominates Plan R

WN 3: Computation of indifference point when EBIT is Rs.18,00,000

Particulars Alt 1 Alt 2 Alt 3
0.5X 0.5X − 1,00,000 0.5X − 2,00,000
EPS 2,00,000 1,00,000 1,00,000
EPS if:
EBIT = 18,00,000 4.50 8.00 7.00

7. Traditional Approach [SM]

The proportion and required return on debt and equity was recorded for a company with its increased
financial leverage as below:
Debt (%) Required return on debt (Kd) Equity (%) Required return on Equity (Ke) WACC
0 5 100 15 15
20 6 80 16 ?
40 7 60 18 ?
60 10 40 23 ?
80 15 20 35 ?
You are required to complete the table and identify which capital structure is most beneficial for this
company (based on traditional theory i.e. capital structure is relevant).
Answer:
Computation of WACC:
Scenario Calculation WACC
I (5 x 0%) + (15 x 100%) 15.00%
II (6 x 20%) + (16 x 80%) 14.00%
III (7 x 40%) + (18 x 60%) 13.60%
IV (10 x 60%) + (23 x 40%) 15.20%
V (15 x 80%) + (35 x 20%) 19.00%
The optimum mix is scenario III and the same would be 40% debt and 60% equity due to lowest WACC.

8. MM approach [May 2021 MTP, May 2018 MTP, Nov 2019 MTP, May 2017]
There are two firms P and Q which are identical except P does not use any debt in its capital structure while
Q has Rs.8,00,000, 9% debentures in its capital structure. Both the firms have earnings before interest and
tax of Rs.2,60,000 p.a. and the capitalization rate is 10%. Assuming the corporate tax of 30%, calculate the
value of these firms according to MM Hypothesis.
Answer:
Valuation of firm as per MM Approach:
Particulars Firm P Firm Q
EBIT 2,60,000 2,60,000
Less: Interest
[Debt x Rate of interest] - -72,000
EBT 2,60,000 1,88,000
Less: Tax -78,000 -56,400
EAT 1,82,000 1,31,600

Cost of debt
[Interest rate x (1 – Tax rate)] NA 6.30%
Cost of equity
[EAT/Amount of equity] 10.00% 10.44%
Cost of capital 10.00% 8.83%

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[EBIT x (1 – Tax)]/Value of firm

Value of debt - 8,00,000

Value of equity 18,20,000 12,60,000
Value of firm 18,20,000 20,60,000
Note:
• We will first start with valuation of unlevered firm. Amount of equity of unlevered firm =
(EAT/Cost of equity) = 1,82,000/10% = Rs.18,20,000
• Value of levered firm = Value of unlevered firm + (Amount of debt x Tax rate)
• Value of levered firm = 18,20,000 + (8,00,000 x 30%) = Rs.20,60,000

9. WACC computation [Nov 2021 RTP, SM]

Kalyanam Ltd. has an operating profit of Rs.34,50,000 and has employed Debt which gives total Interest
Charge of Rs.7,50,000. The firm has an existing Cost of Equity and Cost of Debt as 16% and 8% respectively.
The firm has a new proposal before it, which requires funds of Rs.75 Lakhs and is expected to bring an
additional profit of Rs.14,25,000. To finance the proposal, the firm is expecting to issue an additional debt
at 8% and will not be issuing any new equity shares in the market. Assume no tax culture.
You are required to CALCULATE the Weighted Average Cost of Capital (WACC) of Kalyanam Ltd.:
a. Before the new proposal
b. After the new proposal
Assumption Area:
• Assume value of equity to remain same under revised proposal and Ke to change based on
increased debt levels
Answer:
WN 1: Computation of WACC before the new proposal:
Source Cost Weight Product
Debt 8.00% 93,75,000 7,50,000
(Note 1)
Equity 16.00% 1,68,75,000 27,00,000
(Note 2)
Total 13.14% 2,62,50,000 34,50,000
Note 1:
Interest 7,50,000
Value of debt = = = Rs. 93,75,000
Cost of debt 8%
Note 2:
EBT 34,50,000 − 7,50,000
Value of equity = = = Rs. 93,75,000
Cost of equity 8%

Sum of Products 34,50,000

WACC = = = 13.14%
Sum of weights 2,62,50,000
WN 2: Computation of WACC after new proposal:
Source Cost Weight Product
Debt 8.00% 93,75,000 7,50,000
Debt 8.00% 75,00,000 6,00,000
Equity 20.89% 1,68,75,000 35,25,000
(Note 1)
Total 14.44% 3,37,50,000 48,75,000
Note 1:
EBT 27,00,000 + 14,25,000 − 6,00,000
New Cost of equity = = = Rs. 20.89%
Value of equity 1,68,75,000

Sum of Products 48,75,000

WACC = = = 𝟏𝟒. 𝟒𝟒%
Sum of weights 3,37,50,000

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Chapter 6: Financing Decisions – Leverages

Overview:
• Leverages computation and interpretation
• Reverse working with leverages

Part 1 – Leverages computation and interpretation

1. Basic leverages – computation and interpretation

A simplified income statement of Zenith ltd is given below:
Particulars Amount
Sales 10,50,000
Variable cost 7,67,000
Fixed cost 75,000
Interest 28,000
Tax rate 30%
Calculate and interpret the following:
• Operating Leverage
• Financial Leverage
• Combined Leverage
Answer:
Computation of Leverages
Particulars Amount
Sales 10,50,000
Less: Variable cost -7,67,000
Contribution 2,83,000
Less: Fixed cost -75,000
EBIT 2,08,000
Less: Interest -28,000
EBT 1,80,000
Less: Tax @ 30% -54,000
EAT 1,26,000
Less: PD -
EAES 1,26,000

Leverage computation and interpretation:

Contribution 2,83,000
Operating leverage = = = 1.36 Times
EBIT 2,08,000
• OL of 1.36 times would mean that if sales increase by 10 percent EBIT will increase by 13.60
percent
EBIT 2,08,000
Financial leverage = = = 1.16 Times
PD 1,80,000 −0
EBT − ( )
1 − Tax rate
• FL of 1.16 times would mean that if EBIT increase by 10 percent EPS will increase by 11.60
percent
Contribution 2,83,000
Combined leverage = = = 1.57 Times
PD 1,80,000 −0
EBT − ( )
1 − Tax rate
• CL of 1.57 times would mean that if sales increase by 10 percent EPS will increase by 15.70
percent

2. Basic leverages
Find the Financial Leverage from the following data
Particulars Amount
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Networth 25,00,000
Debt/Equity 3:1
Interest rate 12%
Operating profit 20,00,000
Rework if there is equity of 25,00,000 Debt of 12,50,000 and 12% preference capital of 12,50,000 and tax rate
is 40 percent.
Answer:
Original scenario:
Particulars Amount
EBIT [Operating profit] 20,00,000
Less: Interest -9,00,000
EBT 11,00,000
Less: Tax @ 40% -4,40,000
EAT 6,60,000
Less: PD 0
EAES 6,60,000
Note 1: Computation of interest:
• Networth = Rs.25,00,000. This would mean equity capital is Rs.25,00,000
• Debt/Equity = 3/1. Hence Debt is equal to three times of equity capital and the same would be
Rs.75,00,000
• Interest = 75,00,000 x 12% = Rs.9,00,000

Note 2: Computation of leverages:

EBIT 20,00,000
Financial leverage = = = 1.82 Times
PD
EBT − ( ) 11,00,000 − 0
1 − Tax rate

Revised scenario:
Particulars Amount
EBIT 20,00,000
-1,50,000
Less: Interest [12,50,000 x 12%]
EBT 18,50,000
Less: Tax @ 40% -7,40,000
EAT 11,10,000
-1,50,000
Less: PD [12,50,000 x 12%]
EAES 9,60,000
EBIT 20,00,000 20,00,000
Financial leverage = = = = 1.25 Times
PD 1,50,000 16,00,000
EBT − ( ) 18,50,000 − ( )
1 − Tax rate 1 − 0.4

3. Basic Leverages [SM, May 2020 MTP]

Particulars Amount
Sales @ 100 per unit 24,00,000
Variable cost 50%
Fixed cost 10,00,000
10% Borrowings 10,00,000
Equity share capital (Face value of Rs.100) 10,00,000
You are required to calculate:
• Operating leverage
• Financial leverage
• Combined leverage
• Return on investment and return on equity
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• If the sales increases by Rs.6,00,000, what will be the new EBIT?
Answer:
Particulars Amount
Sales 24,00,000
Less: Variable cost -12,00,000
Contribution 12,00,000
Less: Fixed cost -10,00,000
EBIT 2,00,000
Less: Interest -1,00,000
EBT 1,00,000

Note 1: Computation of leverages:

Contribution 12,00,000
Operating leverage = = = 6 Times
EBIT 2,00,000
EBIT 2,00,000
Financial leverage = = = 2 Times
PD 1,00,000 −0
EBT − ( )
1 − Tax rate
Contribution 12,00,000
Combined leverage = = = 12 Times
PD
EBT − ( ) 1,00,000 − 0
1 − Tax rate

Note 2: Computation of ROI and ROE:

EBIT 2,00,000
𝐑𝐎𝐈 (𝐨𝐫)𝐑𝐎𝐂𝐄 = = x 100 = 𝟏𝟎%
Capital employed 10,00,000 + 10,00,000

EAES 1,00,000
𝐑𝐎𝐄 = = 𝑥 100 = 𝟏𝟎%
Value of equity 10,00,000
• Note: In the absence of income tax and preference dividend, EBT would be equal to EAES

Note 3: Computation of new EBIT if sales increase by 6,00,000:

Particulars Amount
Increase in sales 6,00,000
Old sales 24,00,000
% increase in sales 25%
Operating leverage
[OL = % change in EBIT/% change in sales] 6 Times
% increase in EBIT (25 x 6 Times) 150%
New EBIT (2,00,000 + 150%) 5,00,000

4. Leverages and percentage change [May 2021 RTP, Nov 2020]

Following information has been extracted from the accounts of newly incorporated Textyl Private
Limited for the financial year 2020-21:
Sales 15,00,000
PV Ratio 70%
Operating Leverage 1.40
Financial leverage 1.25
Using the concept of leverage, find out and verify in each case:
(i) The percentage change in taxable income if sales increase by 15%.
(ii) The percentage change in EBIT if sales decrease by 10%.
(iii) The percentage change in taxable income if EBIT increase by 15%.
Answer:
WN 1: Preparation of income statement:
Particulars Amount

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Sales 15,00,000
Less: Variable cost [Sales x 30%] -4,50,000
Contribution 10,50,000
Less: Fixed cost (b/f) -3,00,000
EBIT [Note 1] 7,50,000
Less: Interest (b/f) -1,50,000
EBT [Note 2] 6,00,000

Note 1: Computation of EBIT:

Contribution
Operating Leverage =
EBIT
10,50,000 10,50,000
1.40 = ; EBIT = = 7,50,000
EBIT 1.40

Note 2: Computation of EBT:

EBIT
Financial Leverage =
PD
EBT − ( )
1 − Tax
7,50,000 7,50,000
1.25 = ; 𝐸𝐵𝑇 = = 𝑅𝑠. 6,00,000
𝐸𝐵𝑇 1.25

WN 2: Computation of percentage change in taxable income (PBT) if sales increase by 15%:

• Combined leverage = Operating leverage x Financial Leverage
• Combined leverage = 1.40 x 1.25 = 1.75 Times
• Combined leverage of 1.75 times would mean that PBT will increase by 1.75% for 1% change in
sales
• Sales will change by 15% and hence taxable income will change by 26.25% [15 x 1.75]

Verification:
Particulars Amount
Sales [15,00,000 + 15%] 17,25,000
Less: Variable cost [Sales x 30%] -5,17,500
Contribution 12,07,500
Less: Fixed cost -3,00,000
EBIT 9,07,500
Less: Interest -1,50,000
EBT 7,57,500
Old EBT 6,00,000
% increase in EBT [1,57,500/6,00,000] 26.25

WN 3: Computation of percentage change in EBIT if sales decline by 10%:

• Operating leverage = 1.40 Times
• Combined leverage of 1.40 times would mean that EBIT will increase by 1.40% for 1% change in
sales
• Sales will decline by 10% and hence EBIT will decline by 14.00% [1.40 x 10]

Verification:
Particulars Amount
Sales [15,00,000 - 10%] 13,50,000
Less: Variable cost [Sales x 30%] -4,05,000
Contribution 9,45,000
Less: Fixed cost -3,00,000
EBIT 6,45,000
Old EBIT 7,50,000
% fall [1,05,000/7,50,000 x 100] 14.00

WN 4: Computation of percentage change in taxable income (PBT) if EBIT increase by 15%:

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• Financial leverage = 1.25 Times
• Financial leverage of 1.25 times would mean that PBT will increase by 125% for 1% change in
EBIT
• EBIT will increase by 15% and hence taxable income will increase by18.75% [15 x 1.25]

Verification:
Particulars Amount
EBIT [7,50,000 + 15%] 8,62,500
Less: Interest -1,50,000
EBT 7,12,500
Old EBT 6,00,000
% increase in EBT [1,12,500/6,00,000] 18.75

5. Leverages computation [Nov 2020 MTP, Nov 2019 MTP, SM]

Betatronics Limited has the following balance sheet and income statement information:
Liabilities Amount Assets Amount
Equity shares capital (Rs.10 per share) 8,00,000 Net Fixed assets 10,00,000
10% Debt 6,00,000 Current assets 9,00,000
Retained earnings 3,50,000
Current liabilities 1,50,000
19,00,000 19,00,000

Sales 3,40,000
Operating expenses (including Rs.60,000 depreciation) 1,20,000
EBIT 2,20,000
Less: Interest 60,000
EBT 1,60,000
Less: Taxes 56,000
EAT 1,04,000
a. Determine the degree of operating, financial and combined leverages at the current sales level, if all
operating expenses, other than depreciation, are variable costs.
b. If total assets remain at the same level, but sales (i) increase by 20 percent and (ii) decrease by 20 percent,
what will be the EPS at the new sales level.
Answer:
WN 1: Computation of leverages:
Particulars Amount
Sales 3,40,000
Less: Variable cost -60,000
Contribution 2,80,000
Less: Fixed cost -60,000
EBIT 2,20,000
Less: Interest -60,000
EBT 1,60,000
Less: Tax @ 35% -56,000
EAT 1,04,000
Less: PD 0
EAES 1,04,000
No of shares 80,000
EPS 1.30
Contribution 2,80,000
Operating leverage = = = 1.27 Times
EBIT 2,20,000
EBIT 2,20,000
Financial leverage = = = 1.375 Times
PD
EBT − ( ) 1,60,000 − 0
1 − Tax rate

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Contribution 2,80,000
Combined leverage = = = 1.75 Times
PD
EBT − ( ) 1,60,000 − 0
1 − Tax rate

WN 2: Computation of revised EPS:

Particulars Amount
% change in sales 20%
Combined leverage 1.75
% change in EPS (20 x 1.75 Times) 35%
New EPS:
Sales increase by 20% (1.30 + 35%) 1.755
Sales decrease by 20% (1.30 – 35%) 0.845

6. Leverages [Nov 2019 RTP, July 2021, Nov 2018, Nov 2019]
A company had the following balance sheet as on 31 st March 2021:
Liabilities Amount Assets Amount
in Crores in Crores
Equity share capital (75 lac 7.50 Building 12.50
shares of Rs.10 each)
Reserves and surplus 1.50 Machinery 6.25
15% debentures 15.00 Current assets:
Current liabilities 6.00 Stock 3.00
Debtors 3.25
Bank balance 5.00
30.00 30.00
The additional information is given as under:
• Fixed cost per annum (excluding interest) = Rs.6 Crores
• Variable operating cost ratio = 60%
• Total assets turnover ratio = 2.5
• Income-tax rate = 40%
Calculate the following and comment:
a. Earnings per share
b. Operating leverage
c. Financial leverage
d. Combined leverage
Answer:
WN 1: Income statement:
Particulars [Link]
Revenues [30 x 2.5 Times] 75.00
Less: Variable cost [75 x 60%] -45.00
Contribution 30.00
Less: Fixed cost -6.00
EBIT 24.00
Less: Interest on 15% debentures [15 x 15%] -2.25
Earnings before tax 21.75
Less: Tax @ 40% -8.70
Earnings after tax 13.05
No of equity shares 0.75
Earnings per share [13.05/0.75] 17.40
Note:
• EPS indicates the amount the company earns per share. Investors use this as a guide while
valuing the share and making investment decisions. It is also an indicator used in comparing
firms within an industry or industry segment.

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WN 2: Computation of leverages:
Contribution 30.00
Operating leverage = = = 1.25 Times
EBIT 24.00
• It indicates the choice of technology and fixed cost in cost structure. It is level specific. When
firm operates beyond operating break-even level, then operating leverage is low. It indicates
sensitivity of earnings before interest and tax (EBIT) to change in sales at a particular level.
EBIT 24.00
Financial leverage = = = 1.103 Times
PD
EBT − ( ) 21.75
1 − Tax rate
• The financial leverage is very comfortable since the debt service obligation is small vis -àvis
EBIT.
Contribution 30.00
Combined leverage = = = 1.379 Times
PD
EBT − ( ) 21.75
1 − Tax rate
• The combined leverage studies the choice of fixed cost in cost structure and choice of debt in
capital structure. It studies how sensitive the change in EPS is vis-à-vis change in sales. The
leverages operating, financial and combined are used as measurement of risk.

7. Leverages calculation [Nov 2012]

X Limited has estimated that for a new product its break-even point is 20,000 units if the item is sold for
Rs.14 per unit and variable cost Rs.9 per unit. Calculate the degree of operating leverage for sales volume
25,000 units and 30,000 units.
Answer:
25,000 30,000
Particulars units Units
Sales 3,50,000 4,20,000
Less: Variable cost -2,25,000 -2,70,000
Contribution 1,25,000 1,50,000
Less: Fixed cost (BEP x CPU) -1,00,000 -1,00,000
EBIT 25,000 50,000
Operating leverage 5 Times 3 Times

8. Change in EPS [SM]

From the following information extracted from the books of accounts of Imax Ltd., CALCULATE
percentage change in earnings per share, if sales increase by 10% and Fixed Operating cost is Rs. 1,57,500.
Particulars Amount
EBIT (Earnings before Interest and Tax) 31,50,000
Earnings before Tax (EBT) 14,00,000
Answer:
Contribution EBIT + Fixed Cost 31,50,000 + 1,57,500
Combined leverage = = =
PD 14,00,000 − 0 14,00,000
EBT − ( )
1 − Tax rate
Combined leverage = 2.3625 Times

• % Change in EPS = % change in sales x Combined Leverage

• % Change in EPS = 10% x 2.3625 = 23.625%

9. Leverages under alternative financial plans [May 2021 MTP, May 2018 RTP, May 2017 RTP, Sep
2024 RTP, SM]
Following data of PC Ltd. under Situations 1, 2 and 3 and Financial Plan A and B is given:
Installed capacity (units) 3,600
Actual production and Sales (units) 2,400
Selling price per unit Rs.30

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Variable cost per unit Rs.20
Fixed cost (Situation 1) 3,000
Fixed cost (Situation 2) 6,000
Fixed cost (Situation 3) 9,000

Capital structure Plan A Plan B

Equity 15,000 22,500
12% Debt 15,000 7,500
Required:
(i) CALCULATE the operating leverage and financial leverage.
(ii) FIND out the combinations of operating and financial leverage which give the highest value
and the least value.
Answer:
FC (3,000) FC (3,000) FC (6,000) FC (6,000) FC (9,000) FC (9,000)
Particulars + Plan A + Plan B + Plan A + Plan B + Plan A + Plan B
Sales 72,000 72,000 72,000 72,000 72,000 72,000
Less: Variable cost -48,000 -48,000 -48,000 -48,000 -48,000 -48,000
Contribution (A) 24,000 24,000 24,000 24,000 24,000 24,000
Less: Fixed cost -3,000 -3,000 -6,000 -6,000 -9,000 -9,000
EBIT (B) 21,000 21,000 18,000 18,000 15,000 15,000
Less: Interest -1,800 -900 -1,800 -900 -1,800 -900
EBT (C) 19,200 20,100 16,200 17,100 13,200 14,100
OL (A/B) 1.14 1.14 1.33 1.33 1.60 1.60
FL (B/C) 1.09 1.04 1.11 1.05 1.14 1.06
CL (A/C) 1.24 1.19 1.48 1.40 1.82 1.70
The above calculations suggest that the highest value is in Situation 3 financed by Financial Plan A and the
lowest value is in the Situation 1 financed by Financial Plan B.

10. Calculation of leverages [Nov 2020, May 2020 MTP, May 2012, Nov 2014, SM]
The capital structure of JCPL Limited is as follows:
Particulars Amount
Equity share capital of Rs.10 each 8,00,000
8% preference shares of Rs.10 each 6,25,000
10% debentures of Rs.100 each 4,00,000
18,25,000
Additional information:
• Profit after tax (tax rate 30%) Rs.1,82,000
• Operating expenses (including depreciation of Rs.90,000) being 1.50 times of EBIT
• Equity share dividend paid 15%
• Market price per equity share Rs.20
Required to calculate:
• Operating and financial leverage
• Cover for the preference and equity share of dividends
• The earnings yield and price earnings ratio
• The net fund flow
Answer:
WN 1: Computation of leverages:
Particulars Amount
Sales 7,50,000
Less: Variable cost -3,60,000
Contribution 3,90,000
Less: Fixed cost -90,000
EBIT 3,00,000
Less: Interest -40,000
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EBT (100%) 2,60,000
Less: Tax (30%) -78,000
EAT (70%) 1,82,000
Less: PD -50,000
EAES 1,32,000
No of shares 80,000
EPS 1.65

Note 1: Computation of variable and fixed cost:

• Operating expenses = 1.5 times x 3,00,000 = Rs.4,50,000
• Fixed cost (Depreciation) = Rs.90,000
• Variable cost = 4,50,000 – 90,000 = Rs.3,60,000

Note 2: Computation of leverages:

Contribution 3,90,000
Operating leverage = = = 1.30 Times
EBIT 3,00,000
EBIT 3,00,000 3,00,000
Financial leverage = = =
PD 50,000
EBT − (
1 − Tax rate
) 2,60,000 − ( ) 2,60,000 − 71,429
1 − 0.3
𝟑, 𝟎𝟎, 𝟎𝟎𝟎
𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐥𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = 𝟏. 𝟓𝟗 𝐓𝐢𝐦𝐞𝐬
𝟏, 𝟖𝟖, 𝟓𝟕𝟏

WN 2: Computation of preference dividend and equity dividend coverage ratio:

PAT 1,82,000
Preference Dividend Coverage Ratio = = = 𝟑. 𝟔𝟒 𝐓𝐢𝐦𝐞𝐬
Preference Dividend 50,000
EAES 1,32,000
Equity Dividend Coverage Ratio = = = 𝟏. 𝟏𝟎 𝐓𝐢𝐦𝐞𝐬
Equity Dividend 1,20,000

WN 3: Computation of earnings yield and price-earnings ratio:

MPS 20
Price earnings ratio = = = 12.12 Times
EPS 1.65
EPS 1.65
Earnings yield = x 100 = x 100 = 8.25%
MPS 20

WN 4: Computation of net fund flow:

Net fund flow = PAT + Depreciation – Preference Dividend – Equity dividend
Net fund flow = 1,82,000 + 90,000 – 50,000 – 1,20,000 = Rs.1,02,000

11. Comprehensive [Jan 2021, May 2021 RTP, May 2018 MTP, Nov 2023, SM]
The following details of RST Limited for the year ended 31 st March, 2006 are given below:
Operating Leverage 1.4
Combined Leverage 2.8
Fixed cost (Excluding Interest) 2.04 lacs
Sales 30.00 lacs
12% Debentures of Rs.100 each 21.25 lacs
Equity share capital of Rs.10 each 17.00 lacs
Income Tax rate 30 percent
Required:
a) Calculate financial leverage
b) Calculate PV Ratio and EPS
c) If the company belongs to an industry, whose assets turnover is 1.5, does it have a high or low
assets leverage
d) At what level of sales the Earnings before Tax (EBT) of the company will be equal to zero?

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Answer:
WN 1: Income statement of RST Limited for the year ended 31 st March, 2006:
Particulars Amount
Sales 30,00,000
Less: Variable cost (B/F) -22,86,000
Contribution 7,14,000
Less: Fixed cost -2,04,000
EBIT 5,10,000
Less: Interest (21,25,000 x 12%) -2,55,000
EBT 2,55,000
Less: Tax @ 30% -76,500
EAT 1,78,500
Less: PD -
EAES 1,78,500
No of shares 1,70,000
EPS 1.05

Note 1: Computation of Contribution:

• Let us assume contribution to be X
• EBIT = X – 2,04,000
X X
OL = ; 1.4 = ; 1.4X − 2,85,600 = X
X − 2,04,000 X − 2,04,000
0.4X = 2,85,600; 𝐗 = 𝟕, 𝟏𝟒, 𝟎𝟎𝟎

WN 2: Solution:
Note 1: Computation of financial leverage:
EBIT 5,10,000
Financial leverage = = = 2 Times
PD
EBT − ( ) 2,55,000
1 − Tax

Note 2: Computation of PV Ratio:

Contribution 7,14,000
PV Ratio = x 100 = x 100 = 23.80%
Sales 30,00,000

Note 3: Computation of EPS

• EPS =Rs.1.05 (as per WN 1)

Note 4: Comment on asset turnover:

Sales 30,00,000
Asset Turnover Ratio = = = 0.784 Times
Total Assets (17,00,000 + 21,25,000)
• Industry is operating at capital turnover ratio of 1.50 times whereas the firm operates at asset
turnover of 0.784 Times. This would mean that firm has low asset turnover ratio.

Note 5: Computation of sales to at which EBT = 0

• Combined leverage measures percentage change in EPS for percentage change in sales. In this
question, EBT change will be equal to EPS change. This is because there is no preference dividend
• Hence, Combined Leverage measures percentage change in EBT for percentage change in sales in
this question
Particulars Amount
Target EBT 0
% fall in EBT 100%
Combined leverage 2.80
% fall in sales (100/2.80) 35.7142857
Sales at zero EBT (30,00,000 – 35.7142857%) 19,28,571
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12. Comprehensive [Nov 2018 MTP, Nov 2018 RTP, May 2020 RTP, Nov 2019, Nov 2015 RTP, May
2015 RTP, Nov 2017 RTP, Nov 2022]
A firm has sales of Rs.75,00,000, Variable cost of Rs.42,00,000 and fixed cost of Rs.6,00,000. it has a debt of
Rs.45,00,000 at 9% and equity of Rs.55,00,000
a. What is the firm’s ROI?
b. Does it have favorable financial leverage?
c. If the firm belongs to an industry whose capital turnover is 3, does it have a high or low
capital turnover?
d. What are the different leverages of the firm?
e. If the sales drop to Rs,. 50,00,000 what will be the new EBIT?
f. If the sales is increased by 10% by what percentage EBIT will increase?
g. At what level of sales the EBT of the firm will be equal to zero?
h. If EBIT increases by 20%, by what percentage EBT will increase?
Answer:
Computation statement:
Particulars Amount
Sales 75,00,000
Less: Variable cost -42,00,000
Contribution 33,00,000
Less: Fixed cost -6,00,000
EBIT 27,00,000
Less: Interest -4,05,000
EBT 22,95,000
Note 1: Computation of leverages:
Contribution 33,00,000
Operating leverage = = = 1.22 Times
EBIT 27,00,000
EBIT 27,00,000
Financial leverage = = = 1.18 Times
PD 22,95,000 −0
EBT − ( )
1 − Tax rate
Contribution 33,00,000
Combined leverage = = = 1.44 Times
PD
EBT − ( ) 22,95,000 − 0
1 − Tax rate

Note 2: Computation of ROI:

EBIT 27,00,000
𝐑𝐎𝐈 (𝐨𝐫)𝐑𝐎𝐂𝐄 = = x 100 = 𝟐𝟕%
Capital employed 45,00,000 + 55,00,000

Note 3: Comment on financial leverage:

• A firm has favorable leverage if return on investment is higher than cost of debt. Similarly, a firm
has adverse financial leverage if ROI is lower than cost of debt
• In this case, ROI (27%) is higher than cost of debt (9%) and hence firm has favorable financial
leverage

Note 4: Comment on capital turnover:

Sales 75,00,000
Capital Turnover Ratio = = = 0.75 Times
Capital employed 1,00,00,000
• Industry is operating at capital turnover ratio of 3 times whereas the firm operates at capital
turnover of 0.75 Times. This would mean that firm has low capital turnover ratio.

Note 5: Computation of revised EBIT:

Particulars Amount
Earlier sales 75,00,000

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New sales 50,00,000
Decrease in sales 25,00,000
Decrease in sales (%) 33.33333%
Operating leverage 1.222222
% fall in EBIT (33.3333333 x 1.222222) 40.74074%
New EBIT (27,00,000 – 40.74074%) 16,00,000

Note 6: Computation of percentage increase in EBIT:

Particulars Amount
% increase in sales 10.00%
Operating leverage 1.2222
% increase in EBIT (10 x 1.2222) 12.22%

Note 7: Computation of sales to at which EBT = 0

• Combined leverage measures percentage change in EPS for percentage change in sales. In this
question, EBT change will be equal to EPS change. This is because there is no preference dividend
• Hence, Combined Leverage measures percentage change in EBT for percentage change in sales in
this question
Particulars Amount
Target EBT 0
% fall in EBT 100%
Combined leverage 1.437909
% fall in sales (100/1.437909 69.54543
Sales at zero EBT (75,00,000 – 69.54543%) 22,84,093

Note 8: Computation of percentage increase in EBT:

• Financial leverage in this question will measure percentage change in EBT(EPS) for percentage
change in EBIT
Particulars Amount
% change in EBIT 20.00%
Financial leverage 1.18
% change in EBT (20 x 1.18) 23.60%

13. Leverages [SM]

The following particulars relating to Navya Ltd. for the year ended 31st March 2021 is given:
Output 1,00,000 units at normal capacity
Selling price per unit Rs.40
Variable cost per unit Rs.20
Fixed cost Rs.10,00,000

The capital structure of the company as on 31st March 2021 is as follows:

Particulars Amount
Equity share capital (1,00,000 shares of Rs.10 each) Rs.10,00,000
Reserves and Surplus Rs.5,00,000
7% debentures Rs.10,00,000
Current liabilities Rs.5,00,000
Total Rs.30,00,000
Navya Ltd. has decided to undertake an expansion project to use the market potential, that will involve
Rs.10 lakhs. The company expects an increase in output by 50%. Fixed cost will be increased by Rs.5,00,000
and variable cost per unit will be decreased by 10%. The additional output can be sold at the existing selling
price without any adverse impact on the market.

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The following alternative schemes for financing the proposed expansion programme are planned:
• Entirely by equity shares of Rs.10 each at par.
• Rs.5 lakh by issue of equity shares of Rs.10 each and the balance by issue of 6% debentures of Rs.100
each at par.
• Entirely by 6% debentures of Rs.100 each at par.
FIND out which of the above-mentioned alternatives would you recommend for Navya Ltd. with reference
to the risk and return involved, assuming a corporate tax of 40%.
Answer:
Evaluation of alternatives:
(in lacs)
Particulars Existing Alternative (i) Alternative (ii) Alternative (iii)
Equity share capital (Existing) 10.00 10.00 10.00 10.00
New issues - 10.00 5.00 -
Total equity capital 10.00 20.00 15.00 10.00
7% debentures 10.00 10.00 10.00 10.00
6% debentures - - 5.00 10.00
Total debentures 10.00 10.00 15.00 20.00
Debenture interest (7%) 0.70 0.70 0.70 0.70
Debenture interest (6%) - - 0.30 0.60
Total Interest 0.70 0.70 1.00 1.30
Output (in lacs) 1.00 1.50 1.50 1.50
Contribution per unit 20.00 22.00 22.00 22.00
Total contribution 20.00 33.00 33.00 33.00
Less: Fixed cost 10.00 15.00 15.00 15.00
EBIT 10.00 18.00 18.00 18.00
Less: Interest 0.70 0.70 1.00 1.30
EBT 9.30 17.30 17.00 16.70
Less: Tax @ 40% -3.72 -6.92 -6.80 -6.68
EAT 5.58 10.38 10.20 10.02
No of shares 1.00 2.00 1.50 1.00
EPS 5.58 5.19 6.80 10.02
Operating leverage (Cont/EBIT) 2.00 1.83 1.83 1.83
Financial leverage (EBIT/EBT) 1.08 1.04 1.06 1.08
Combined leverage (Cont/EBT) 2.15 1.91 1.94 1.98
Risk Lowest Lower than Highest
option (3)
Return Lowest Lower than Highest
option (3)
From the above figures, we can see that the Operating Leverage is same in all alternatives though Financial
Leverage [Link] (iii) uses the maximum amount of debt and result into the highest degree of
financial leverage, followed by alternative ( ii). Accordingly, risk of the company will be maximum in these
options. Corresponding to this scheme, however, maximum EPS (i.e., Rs.10.02 per share) will be also in
option (iii).
So, if Navya Ltd. is ready to take a high degree of risk, then alternative (iii) is strongly recommended. In
case of opting for less risk, alternative (ii) is the next best option with a reduced EPS of Rs.6.80 per share.
In case of alternative (i), EPS is even lower than the existing option, hence not recommended.

14. Leverages (Nov 2022 MTP, SM)

Axar Ltd. has a Sales of Rs. 68,00,000 with a Variable cost Ratio of 60%. The company has fixed cost of
Rs.16,32,000. The capital of the company comprises of 12% long term debt, Rs.1,00,000 Preference Shares of
Rs. 10 each carrying dividend rate of 10% and 1,50,000 equity shares. The tax rate applicable for the
company is 30%. At current sales level, DETERMINE the Interest, EPS and amount of debt for the firm if a
25% decline in Sales will wipe out all the EPS.
Answer:
Particulars Calculation Amount

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Sales Given 68,00,000
Less: Variable cost 68,00,000 x 60% -40,80,000
Contribution 27,20,000
Less: Fixed cost -16,32,000
EBIT 10,88,000
Less: Interest b/f 3,93,714
EBT Note 4 6,94,286
Less: Tax @ 30% -2,08,286
EAT 4,86,000
Less: Preference dividend -10,000
EAES 4,76,000
No of equity shares 1,50,000
EPS 3.1733
Note:
Note 1: Computation of combined leverage:
• Combined leverage links decline in sales with fall in EPS. In this case sales declines by 25 percent
and EPS declines by 100 percent
% decline in EPS
Combined leverage =
% decline in sales
100
Combined leverage = = 4 Times
25

Note 2: Computation of operating leverage:

Contribution 27,20,000
Operating leverage = = 2.50 Times
EBIT 10,88,000

Note 3: Computation of financial leverage:

Combined leverage = Operating leverage x Financial leverage
4 = 2.50 x Financial leverage
Financial leverage = 1.60 Times

Note 4: Computation of interest:

EBIT
Financial leverage =
Preference dividend
EBT − ( )
1 − Tax rate
27,20,000
1.60 Times =
10,000
EBT − ( )
0.70
10,88,000
EBT − 14,286 =
1.60
EBT = 6,80,000 + 14,286 = 6,94,286

Summary solution:
• Interest = Rs.3,93,714
• EPS = Rs.3.1733
• Amount of debt = 3,93,714/12% = Rs.32,80,950

Part 2 – Reverse working with leverages

15. Leverages – Reverse working [Nov 2018, May 2018, SM]

If the combined leverage and operating leverage figures of a company are 2.5 and 1.25 respectively, find
the financial leverage and P/V ratio, given that the equity dividend per share is Rs.2, interest payable per
year is Rs.1 lakhs, total fixed cost Rs.0.5 lakh and sales Rs.10 lakhs.
Answer:
Computation statement:
Particulars Amount
Sales 10,00,000

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Less: Variable cost [b/f] -7,50,000
Contribution [Note 2] 2,50,000
Less: Fixed cost -50,000
EBIT 2,00,000
Less: Interest -1,00,000
EBT 1,00,000

Note 1: Computation of financial leverage:

Combined Leverage = Operating Leverage x Financial Leverage
2.5 Times = 1.25 Times x Financial Leverage
𝟐. 𝟓
𝐅𝐢𝐧𝐚𝐧𝐜𝐢𝐚𝐥 𝐋𝐞𝐯𝐞𝐫𝐚𝐠𝐞 = = 𝟐 𝐓𝐢𝐦𝐞𝐬
𝟏. 𝟐𝟓

Note 2: Computation of Contribution:

Let us assume contribution to be X
Contribution X
Operating Leverage = ; 1.25 = ; 1.25𝑋 − 62,500 = 𝑋
EBIT X − 50,000
𝟎. 𝟐𝟓𝐗 = 𝟔𝟐, 𝟓𝟎𝟎; 𝐗 = 𝟐, 𝟓𝟎, 𝟎𝟎𝟎

Note 3: Computation of PV Ratio:

Contribution 2,50,000
PVR = x 100 = x 100 = 𝟐𝟓%
sales 10,00,000

16. Income statement preparation [Nov 2020 MTP, Nov 2020 RTP, May 2019 MTP, Nov 2018 MTP,
Nov 2015, May 2022 MTP, May 2023 RTP, Nov 2023 MTP]
From the following prepare income statement of Company A, B and C
Company A B C
Financial Leverage 3:1 4:1 2:1
Interest Rs.200 Rs.300 Rs.1000
Operating leverage 4:1 5:1 3:1
Variable cost ratio 66 2/3% 75% 50%
Income tax rate 45% 45% 45%
Answer:
WN 1: Income statement of Company A, B and C:
Particulars Company A Company B Company C
Sales (Note 2) 3,600 8,000 12,000
Less: Variable cost (b/f) -2,400 -6,000 -6,000
Contribution (EBIT x OL) 1,200 2,000 6,000
Less: Fixed cost (b/f) -900 -1,600 -4,000
EBIT (Note 1) 300 400 2,000
Less: Interest -200 -300 -1,000
EBT 100 100 1,000
Less: Tax -45 -45 -450
EAT 55 55 550

Note 1: Computation of EBIT:

Let us assume EBIT to be X
EBIT
Financial leverage =
EBT
Company A:
X
3= ; 3X − 600 = X; 2X = 600; X = 300
X − 200

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Company B:
X
4= ; 4X − 1,200 = X; 3X = 1,200; X = 400
X − 300
Company C:
X
2= ; 2X − 2,000 = X; X = 2,000
X − 1,000

Note 2: Computation of sales:

Particulars Company A Company B Company C
Variable cost ratio 66.66666% 75.00% 50.00%
Profit volume ratio (100 – VCR) 33.33333% 25.00% 50.00%
Contribution 1,200 2,000 6,000
Sales (Contribution/PVR) 3,600 8,000 12,000

17. Leverages [May 2022 RTP, May 2024 RTP, May 2023 MTP, SM]
Company P and Q are having same earnings before tax. However, the margin of safety of Company P is
0.20 and, for Company Q, is 1.25 times than that of Company P. The interest expense of Company P is
Rs.1,50,000 and, for Company Q, is 1/3rd less than that of Company P. Further, the financial leverage of
Company P is 4 and, for Company Q, is 75% of Company P.
Other information is given as below:
Particulars Company P Company Q
Profit volume ratio 25% 33.33%
Tax rate 45% 45%
You are required to PREPARE Income Statement for both the companies.
Answer:
Income statement of Company P and Company Q:
Particulars Company P Company Q
Sales [Contribution/PVR] 40,00,000 18,00,000
Less: Variable cost -30,00,000 -12,00,000
Contribution 10,00,000 6,00,000
Less: Fixed cost -8,00,000 -4,50,000
EBIT (Note 1) 2,00,000 1,50,000
Less: Interest -1,50,000 -1,00,000
EBT 50,000 50,000
Less: Tax (45%) -22,500 -22,500
EAT 27,500 27,500

Note 1: Computation of EBIT:

EBIT
Financial leverage =
EBT
Let us assume EBIT of company as X
Company P:
X
4= ;
X − 1,50,000
4X − 6,00,000 = X
𝟑𝐗 = 𝟔, 𝟎𝟎, 𝟎𝟎𝟎; 𝐗 = 𝟐, 𝟎𝟎, 𝟎𝟎𝟎
Company Q:
X
3= ;
X − 1,00,000
3X − 3,00,000 = X
𝟐𝐗 = 𝟑, 𝟎𝟎, 𝟎𝟎𝟎; 𝐗 = 𝟏, 𝟓𝟎, 𝟎𝟎𝟎

Note 2: Computation of Contribution:

MOS of Company P = 0.20 Times
MOS of Company Q = 0.20 x 1.25 = 0.25 Times

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• MOS of company P is 20%. Hence break-even sales is 80% of sales
• We can therefore conclude that fixed cost is 80% of contribution and EBIT is 20% of contribution
Contribution 1
= = 5 Times.
EBIT 0.20
In other words, we can assume that inverse of MOS is operating leverage. Hence OL of company P is
5 times (1/0.20) and of company Q is 4 Times (1/0.25)
Company P:
Contribution
Operating leverage =
EBIT
Contribution
5 Times = ; Contribution = 10,00,000
2,00,000
Company Q:
Contribution
Operating leverage =
EBIT
Contribution
4 Times = ; Contribution = 6,00,000
1,50,000

Practice Questions

1. Operating Leverage [SM]

A Company produces and sells 10,000 shirts. The selling price per shirt is Rs. 500. Variable cost is Rs. 200
per shirt and fixed operating cost is Rs. 25,00,000. (a) CALCULATE operating leverage. (b) If sales are up
by 10%, then COMPUTE the impact on EBIT?
Answer:
Particulars Amount
Sales (10,000 x 500) 50,00,000
Less: Variable cost (10,000 x 200) -20,00,000
Contribution 30,00,000
Less: Fixed cost -25,00,000
EBIT 5,00,000
Contribution 30,00,000
Operating leverage = = = 6 Times
EBIT 5,00,000

Impact on EBIT:
• If sales increase by 10% then EBIT will increase by 60% (10% x 6)

2. Operating Leverage interpretation [SM]

CALCULATE the operating leverage for each of the four firms A, B, C and D from the following price and
cost data:
Particulars Firm A Firm B Firm C Firm D
Sale price per unit 20 32 50 70
Variable cost per unit 6 16 20 50
Fixed operating cost 60,000 40,000 1,00,000 Nil
What calculations can you draw with respect to levels of fixed cost and the degree of operating leverage
result? EXPLAIN. Assume number of units sold is 5,000.
Answer:
Particulars Firm A Firm B Firm C Firm D
Sales 1,00,000 1,60,000 2,50,000 3,50,000
Less: Variable cost -30,000 -80,000 -1,00,000 -2,50,000
Contribution 70,000 80,000 1,50,000 1,00,000
Less: Fixed cost -60,000 -40,000 -1,00,000 0
EBIT 10,000 40,000 50,000 1,00,000
Operating leverage
[Contribution/EBIT] 7.00 2.00 3.00 1.00
Comments:

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• The operating leverage exists only when there are fixed costs. In the case of firm D, there is no
magnified effect on the EBIT due to change in sales.
• In the case of other firms, operating leverage exists. It is maximum in firm A, followed by firm C
and minimum in firm B. The interception of DOL of 7 is that 1 per cent change in sales results in 7
per cent change in EBIT level in the direction of the change of sales level of firm A.

3. Leverages [May 2019, Nov 2016 RTP, Nov 2020 RTP May 2022 MTP, Nov 2023 RTP, Nov 2023
MTP, May 2024, SM]
The capital structure of the Shiva Ltd. consists of equity share capital of Rs.20,00,000 (Share of Rs.100 per
value) and Rs.20,00,000 of 10% Debentures, sales increased by 20% from 2,00,000 units to 2,40,000 units, the
selling price is Rs.10 per unit; variable costs amount to Rs.6 per unit and fixed expenses amount to
Rs.4,00,000. The income tax rate is assumed to be 50%.
a) You are required to calculate the following:
(i) The percentage increase in earnings per share;
(ii) Financial leverage at 2,00,000 units and 2,40,000 units.
(iii) Operating leverage at 2,00,000 units and 2,40,000 units.
(b) Comment on the behaviour of operating and Financial leverages in relation to increase in production
from 2,00,000 units to 2,40,000 units.
Answer:
WN 1: Income statement for 2,00,000 and 2,40,000 units:
Particulars 2,00,000 units 2,40,000 units
Sales @ 10 per unit 20,00,000 24,00,000
Less: Variable cost @ 6 per unit -12,00,000 -14,40,000
Contribution 8,00,000 9,60,000
Less: Fixed cost -4,00,000 -4,00,000
EBIT 4,00,000 5,60,000
Less: Interest [20,00,000 x 10%] -2,00,000 -2,00,000
EBT 2,00,000 3,60,000
Less: Tax @ 50% -1,00,000 -1,80,000
EAT 1,00,000 1,80,000
Less: PD 0 0
EAES 1,00,000 1,80,000
No of shares [20,00,000/100] 20,000 20,000
EPS 5.00 9.00
9−5
% Increase in EPS = 𝑥 100 = 80%
5
4,00,000 5,60,000
= = 2 Times = = 1.56 Times
Financial Leverage [EBIT/EBT] 2,00,000 3,60,000
8,00,000 9,60,000
= = 2 Times = = 1.71 Times
Operating Leverage [Contribution/EBIT] 4,00,000 5,60,000
Comments:
When production is increased from 2,00,000 units to 2,40,000 units both financial leverage and operating
leverages reduced from 2 to 1.56 and 1.71 respectively. Reduction in financial leverage and operating
leverages signifies reduction in business risk and financial risk

4. Comprehensive problem [Jan 2021, May 2018 MTP, May 2020 RTP, Nov 2016, May 2016, May
2019 RTP, May 2013, Nov 2017, Nov 2022, SM]
The following information related to XL Company Ltd. for the year ended 31st March, 2013 are available
to you:
Particulars Amount
Equity share capital of Rs.10 each 25,00,000
11% bonds of Rs.1,000 each 18,50,000
Fixed cost (excluding interest) 3,48,000
Sales 42,00,000
Financial leverage 1.39

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Profit-volume ratio 25.55%
Income tax rate 35%
Market price per share Rs.20
You are required to calculate:
(i) Operating Leverage;
(ii) Combined Leverage;
(iii) Earning per Share.
(iv) Earning yield
Answer:
WN 1: Income statement:
Particulars Amount
Sales 42,00,000
Less: Variable cost (b/f) -31,26,900
Contribution (Sales x 25.55%) 10,73,100
Less: Fixed cost -3,48,000
EBIT 7,25,100
Less: Interest (18,50,000 x 11%) -2,03,500
EBT 5,21,600
Less: Tax -1,82,560
EAT 3,39,040
Less: PD -
EAES 3,39,040
No of shares 2,50,000
EPS 1.36

WN 2: Solution:
Contribution 10,73,100
(i)Operating leverage = = = 1.48 Times
EBIT 7,25,100

Contribution 10,73,100
(ii)Combined leverage = = = 2.06 Times
PD
EBT − ( ) 5,21,600 − 0
1 − Tax
(iii)EPS = Rs. 1.36

EPS 1.36
(iv)Earnings Yield = x 100 = x100 = 6.80%
MPS 20

5. Leverages interpretation [May 2021 MTP, Nov 2019 RTP, May 2015, May 2017, SM]
The following summarises the percentage changes in operating income, percentage changes in revenues,
and betas for four pharmaceutical firms.
Firm Change in revenue Change in operating income Beta
PQR Limited 27% 25% 1.00
RST Limited 25% 32% 1.15
TUV Limited 23% 36% 1.30
WXY Limited 21% 40% 1.40
Required:
(i) Calculate the degree of operating leverage for each of these firms. Comment also.
(ii) Use the operating leverage to explain why these firms have different beta.
Answer:
Computation of Operating Leverage
Firm Change in revenue (B) Change in operating income (A) OL (A/B)
PQR Limited 27% 25% 0.9259
RST Limited 25% 32% 1.2800
TUV Limited 23% 36% 1.5652
WXY Limited 21% 40% 1.9048

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• Operating income refers to EBIT. Operating leverage = Change in EBIT/Change in sales

Comments:
High operating leverage leads to high Beta. So when Operating leverage is lowest, Beta is minimum at 1
time and when operating leverage is maximum (1.9048), beta is highest at 1.40 Times

6. Computation of leverages [Nov 2019]

Z Limited is considering the installation of a new project costing Rs.80,00,000. Expected annual sales
revenue from the project is Rs.90,00,000 and its variable costs are 60 percent of sales.
Expected annual fixed cost other than interest is Rs.10,00,000. Corporate tax rate is 30 percent. The company
wants to arrange the funds through issuing 4,00,000 equity shares of Rs.10 each and 12 percent debentures
of Rs.40,00,000.
You are required to:
• Calculate the operating, financial and combined leverages and Earnings per Share (EPS).
• Determine the likely level of EBIT, if EPS is (1) Rs.4, (2) Rs.2, (3) Rs.0.
Answer:
WN 1: Income statement:
Particulars Amount
Sales 90,00,000
Less: Variable cost -54,00,000
Contribution 36,00,000
Less: Fixed cost -10,00,000
EBIT 26,00,000
Less: Interest -4,80,000
EBT 21,20,000
Less: Tax @ 30% -6,36,000
EAT 14,84,000
Less: PD -
EAES 14,84,000
No of shares 4,00,000
EPS 3.71

WN 2: Solution:
Note 1: Computation of leverages:
Contribution 36,00,000
Operating leverage = = = 1.3846 Times
EBIT 26,00,000
EBIT 26,00,000
Financial leverage = = = 1.2264 Times
PD
EBT − ( ) 21,20,000 − 0
1 − Tax rate
Contribution 36,00,000
Combined leverage = = = 1.6981 Times
PD
EBT − ( ) 21,20,000 − 0
1 − Tax rate
Note 2: EPS:
• EPS = 3.71 Times

Note 3: Computation of EBIT for target EPS:

Particulars EPS = 4 EPS = 2 EPS = 0
EPS 4 2 0
No of shares 4,00,000 4,00,000 4,00,000
EAES/EAT 16,00,000 8,00,000 -
EBT (EAT/1-Tax) 22,85,714 11,42,857 -
Interest 4,80,000 4,80,000 4,80,000
EBIT 27,65,714 16,22,857 4,80,000

7. Reverse Working [SM, Sep 2024 MTP]

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Following are the selected financial information of A Ltd. and B Ltd. for the current Financial Year:
Particulars A Limited B Limited
Variable cost Ratio 60% 50%
Interest 20,000 1,00,000
Operating leverage 5 2
Financial leverage 3 2
Tax Rate 30% 30%
You are required to FIND out: (i) EBIT (ii) Sales (iii) Fixed Cost (iv) Identify the company which is better
placed with reasons based on leverages.
Answer:
WN 1: Income Statement:
Particulars A Limited B Limited
Sales [Contribution/PVR] 3,75,000 8,00,000
Less: Variable cost -2,25,000 -4,00,000
Contribution (EBIT x OL) 1,50,000 4,00,000
Less: Fixed cost -1,20,000 -2,00,000
EBIT (Note 1) 30,000 2,00,000
Less: Interest -20,000 -1,00,000
EBT 10,000 1,00,000
Less: Tax (30%) -3,000 -30,000
EAT 7,000 70,000
Comment based on leverages:
Company B is better than company A of the following reasons:
• Capacity of Company B to meet interest liability is better than that of companies A (from
EBIT/Interest ratio). Interest coverage of Company A is 1.50 Times (30,000/20,000) and Company
B is 2 Times (2,00,000/1,00,000)
• Company B has the least financial risk and the total risk (business and financial) of company B is
lower (combined leverage of Company A – 15 and Company B- 4)

Note 1: Computation of EBIT:

EBIT
Financial leverage =
EBT
Let us assume EBIT of company as X
A Limited:
X
3= ;
X − 20,000
3X − 60,000 = X
𝟐𝐗 = 𝟔𝟎, 𝟎𝟎𝟎; 𝐗 = 𝟑𝟎, 𝟎𝟎𝟎
B Limited:
X
2= ;
X − 1,00,000
2X − 2,00,000 = X
𝐗 = 𝟐, 𝟎𝟎, 𝟎𝟎𝟎

8. Income statement preparation [May 2018, May 2023 MTP, May 2024 MTP]
From the following financial data of Company A and Company B: Prepare their Income Statements.
Company A B
Variable cost 56,000 60% of sales
Fixed cost 20,000 -
Interest expenses 12,000 9,000
Financial leverage 5:1 -
Operating leverage - 4:1
Income tax rate 30% 30%
Sales - 1,05,000
Answer:
WN 1: Income statement of Company A and Company B:

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Particulars Company A Company B
Sales 91,000 1,05,000
Less: Variable cost -56,000 -63,000
Contribution 35,000 42,000
Less: Fixed cost -20,000 -31,500
EBIT 15,000 10,500
Less: Interest -12,000 -9,000
EBT 3,000 1,500
Less: Tax -900 -450
EAT 2,100 1,050

WN 2: Analysis of Company A:
Note 1: Computation of EBIT:
• Let us assume EBIT of company A to be X
• EBT = X – 12,000
EBIT X
Financial leverage = ;5 = ; 5X − 60,000 = X; 4X = 60,000; X = 15,000
EBT X − 12,000

Note 2: Computation of sales:

• Contribution = EBIT + Fixed cost = 15,000 + 20,000 = Rs.35,000
• Sales = Fixed cost + Variable cost = 35,000 + 56,000 = Rs.91,000

WN 3: Analysis of Company B:
Note 1: Computation of EBIT:
Contribution 42,000 42,000
Operating leverage = ;4 = ; EBIT = = Rs. 10,500
EBIT EBIT 4

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Chapter 7A: Time Value of Money

1. Future value computation of single cash flow

Ram has deposited Rs.55,650 in a bank, which is paying 15 per cent rate of interest on a ten-year time
deposit. Calculate the amount at the end of ten years?
Answer:
Basic Information:
Present value (Principal) 55,650
r (rate of interest) 15% p.a.
n (time period) 10 years
Future value (Amount) ?

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
Amount = 55,650 x (1 + 15%)10 = 55,650 𝑥 4.0456 = 𝐑𝐬. 𝟐, 𝟐𝟓, 𝟏𝟑𝟖
• Future value = Rs.2,25,138

Alternative approach to get answer:

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 𝐟𝐚𝐜𝐭𝐨𝐫(𝐫, 𝐧)
Amount = 55,650 x Future value factor (15%, 10) = 55,650 x 4.046 = 2,25,160

2. Present value computation of single cash flow

Calculate the amount which Mr. Shyam should deposit now to receive Rs.50,000 after 15 [Link] interest
rate is 9 per cent.
Answer:
Basic Information:
Present value (Principal) ?
r (rate of interest) 9% p.a.
n (time period) 15 years
Future value (Amount) 50,000

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
50,000 = P x (1 + 9%)15
50,000
50,000 = P x 3.642; P = = Rs. 13,729
3.642
• Amount to be deposited today = Rs.13,729
Alternative approach to get answer:
Present value = Future value x Present value factor (r, n)
Present value = 50,000 x Present value factor (9%, 15)
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = 𝟓𝟎, 𝟎𝟎𝟎 𝐱 𝟎. 𝟐𝟕𝟓 = 𝐑𝐬. 𝟏𝟑, 𝟕𝟓𝟎

3. Future and Present value of Annuity Regular and Immediate

If you deposit Rs.25,500 at the end of each of the next 15 years into an account paying 10% interest, how
much money will you have in the account in 15 years? What would be the sum if you made your investment
at the beginning of each year? Rework the amount of deposit to be made today if you want to receive
Rs.25,500 at the end of each of next 15 years. Also find out the amount of deposit to be made if you want to
receive Rs.25,500 at the beginning of each of next 15 years.
Answer:
Original scenario:
Type of cash flow Annuity
Type of Annuity Regular
Annuity Amount 25,500
n (time period) 15 years
r (rate of interest) 10% p.a.
Future value of annuity ?

𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐅𝐕𝐀𝐅(𝐫, 𝐧)

Future value = 25,500 x FVAF(10%, 15)
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𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝟐𝟓, 𝟓𝟎𝟎 𝐱 𝟑𝟏. 𝟕𝟕𝟐 = 𝐑𝐬. 𝟖, 𝟏𝟎, 𝟏𝟖𝟔

Rework scenario (1)

Type of cash flow Annuity
Type of Annuity Immediate
Annuity Amount 25,500
n (time period) 15 years
r (rate of interest) 10% p.a.
Future value of annuity ?

𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐅𝐕𝐀𝐅(𝐫, 𝐧) 𝐱 (𝟏 + 𝐫)

Future value = 25,500 x FVAF(10%, 15) x (1.10)
𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝟐𝟓, 𝟓𝟎𝟎 𝐱 𝟑𝟏. 𝟕𝟕𝟐 𝐱 𝟏. 𝟏𝟎 = 𝟖, 𝟗𝟏, 𝟐𝟎𝟓

Rework scenario (2):

Basic information:
Type of cash flow Annuity
Type of Annuity Regular
Annuity Amount 25,500
n (time period) 15 years
r (rate of interest) 10% p.a.
Present value of annuity ?

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐏𝐕𝐀𝐅(𝐫, 𝐧)

Present value = 25,500 x PVAF(10%, 15)
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = 𝟐𝟓, 𝟓𝟎𝟎 𝐱 𝟕. 𝟔𝟎𝟔 = 𝐑𝐬. 𝟏, 𝟗𝟑, 𝟗𝟓𝟑

Rework scenario (3):

Basic information:
Type of cash flow Annuity
Type of Annuity Immediate
Annuity Amount 25,500
n (time period) 15 years
r (rate of interest) 10% p.a.
Present value of annuity ?

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = (𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐏𝐕𝐀𝐅(𝐫, 𝐧) 𝐱 (𝟏 + 𝐫)

Present value = 2,5,500 x 7.606 x 1.10
𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = 𝐑𝐬. 𝟐, 𝟏𝟑, 𝟑𝟓𝟗

4. Computation of Annuity Amount

ABCL company has issued debentures of Rs.50 lakhs to be repaid after 7 [Link] much should the
company invest in sinking fund earning 12 percent in order to be able to pay the debentures?
Answer:
• The company has issued debentures of Rs.50,00,000. This needs to be repaid after 7 [Link]
would mean that company will need Rs.50,00,000 after 7 years and hence this would be equal to
future value of annuity
Basic information:
Type of cash flow Annuity
Type of Annuity Regular
Annuity Amount ?
n (time period) 7 years
r (rate of interest) 12% p.a.
Future value of annuity 50,00,000

𝐅𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞 = 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐅𝐕𝐀𝐅(𝐫, 𝐧)

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50,00,000 = Annuity Amount x FVAF(12%, 7)
50,00,000 = Annuity Amount x 10.089
𝟓𝟎, 𝟎𝟎, 𝟎𝟎𝟎
𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 = = 𝐑𝐬. 𝟒, 𝟗𝟓, 𝟓𝟖𝟗
𝟏𝟎. 𝟎𝟖𝟗

5. Computation of EMI
A has taken a 20-month car loan of Rs.6,00,000. The rate of interest is 12 percent per annum. What will be
the monthly loan amortization?
Answer:
• A has taken a loan of Rs.6,00,000. This needs to be repaid in the form of monthly loan amortization.
In short, the loan will be repaid with 20 equated monthly instalments.
• The above cash flow takes the character of an annuity. Today’s value of loan is Rs.6,00,000.
Therefore, present value of annuity is Rs.6,00,000
Basic information:
Type of cash flow Annuity
Type of Annuity Regular
Annuity Amount ?
n (time period) 20 months
r (rate of interest) 12% p.a. (or) 1% p.m.
Present value of annuity 6,00,000

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮𝐞 = 𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 𝐱 𝐏𝐕𝐀𝐅(𝐫, 𝐧)

6,00,000 = Annuity Amount x PVAF(1%, 20)
6,00,000 = Annuity Amount x 18.045
𝟔, 𝟎𝟎, 𝟎𝟎𝟎
𝐀𝐧𝐧𝐮𝐢𝐭𝐲 𝐀𝐦𝐨𝐮𝐧𝐭 = = 𝐑𝐬. 𝟑𝟑, 𝟐𝟓𝟎
𝟏𝟖. 𝟎𝟒𝟓

6. Valuation of Perpetuity
Ramesh wants to retire and receive Rs.36,000 a year. He wants to pass this yearly payment to future
generations after his death. He can earn an interest of 8% compounded annually. How much will he need
to set aside to achieve his perpetuity goal?
Answer:
Basic information:
Type of cash flow Perpetuity
Perpetuity Amount 36,000 p.a.
n (time period) NA
r (rate of interest) 8% p.a.
Present value of Perpetuity ?
Growth rate 0%
Perpetuity Amount 36,000
Present value = = = 𝐑𝐬. 𝟒, 𝟓𝟎, 𝟎𝟎𝟎
Rate of Interest − Growth Rate 8% − 0%

7. Valuation of Growing Perpetuity

Assuming that the discount rate is 7% per annum, how much would you pay to receive Rs.50, growing at
5%, annually, forever?
Answer:
Basic information:
Type of cash flow Perpetuity
Perpetuity Amount Rs.50
n (time period) NA
r (rate of interest) 7% p.a.
Present value of Perpetuity ?
Growth rate 5%
Perpetuity Amount 50
Present value = = = 𝐑𝐬. 𝟐, 𝟓𝟎𝟎
Rate of Interest − Growth Rate 7% − 5%

8. Computation of Effective Rate of Interest

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If the interest is 10% payable quarterly, find the effective rate of interest.
Answer:
Computation of rate of interest:
Basic information:
n (time period) 1 year (or) 4 quarters
r (rate of interest) 10% p.a. (or) 2.5% per quarter

Effective rate of interest = (1 + r)n − 1

𝐄𝐟𝐟𝐞𝐜𝐭𝐢𝐯𝐞 𝐫𝐚𝐭𝐞 𝐨𝐟 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 = (𝟏 + 𝟐. 𝟓%)𝟒 − 𝟏 = 𝟏. 𝟏𝟎𝟑𝟖 − 𝟏 = 𝟎. 𝟏𝟎𝟑𝟖 (𝐨𝐫) 𝟏𝟎. 𝟑𝟖% 𝐩. 𝐚..

9. Semi-Annual Compounding:
Ascertain the compound value and compound interest of an amount of Rs.75,000 at 8% compounded semi-
annually for 5 years.
Answer:
Basic Information:
Present value (Principal) 75,000
r (rate of interest) 8% p.a. (or) 4% per half-year
n (time period) 5 years (or) 10 half-years
Future value (Amount) ?

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
Amount = 75,000 x (1 + 4%)10 = 75,000 x 1.480 = 1,11,000

• Compound value = Rs.1,11,000

• Compound interest = 1,11,000 – 75,000 = Rs.36,000

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Chapter 7B: Investment Decisions

Overview:
• Project evaluation techniques – Basics
• Investment decision
• EAB and EAC Analysis
• Replacement decision
• Miscellaneous – Capital rationing, modified IRR

Part 1 - Project evaluation techniques - Basics

1. Techniques of capital budgeting [Nov 2020 MTP, Nov 2018 MTP, May 2018 RTP, May 2017 RTP]
A company has to make a choice between two projects namely A and B. The initial capital outlays of two
projects are Rs.1,35,000 and Rs.2,40,000 respectively for A and B. There will be no scrap value at the end of
the life of both the projects. The opportunity cost of capital of the company is 16%. The cash flows are as
under:
Year Project A Project B Discounting factor
Rs. Rs. @16%
1 - 60,000 0.862
2 30,000 84,000 0.743
3 1,32,000 96,000 0.641
4 84,000 1,02,000 0.552
5 84,000 90,000 0.476

You are required to calculate for each project:

I. Payback
II. Discounted payback period
III. Accounting rate of return
IV. Net Present value
V. Profitability Index
Tabulate your results and indicate which project should be undertaken if the projects are mutually
exclusive. Assume that target payback is 3 years and the discounted payback is four years.
Answer:
WN 1: Computation of Payback of Project A:
Year Cash flow Cum Cash flow
0 -1,35,000 -1,35,000
1 - -1,35,000
2 30,000 -1,05,000
3 1,32,000 27,000
4 84,000 1,11,000
5 84,000 1,95,000

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
1,05,000
Payback = 2 + = 2 + 0.80 = 𝟐. 𝟖𝟎 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫)𝟐 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟏𝟎 𝐦𝐨𝐧𝐭𝐡𝐬
1,32,000
• Base year refers to the last year in which cumulative cash flow is negative

WN 2: Computation of Payback of Project B:

Year Cash flow Cum Cash flow
0 -2,40,000 -2,40,000
1 60,000 -1,80,000
2 84,000 -96,000
3 96,000 -
4 1,02,000 1,02,000

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5 90,000 1,92,000

Payback = 3 years since cumulative cash flow is zero in year 3

WN 3: Computation of discounted payback of Project A:

Year CF PVF @ 16% DCF CDCF
0 -1,35,000 1.000 -1,35,000 -1,35,000
1 - 0.862 - -1,35,000
2 30,000 0.743 22,290 -1,12,710
3 1,32,000 0.641 84,612 -28,098
4 84,000 0.552 46,368 18,270
5 84,000 0.476 39,984 58,254
Note:
• CF = Cash flow; DCF = Discounted cash flow; CDCF = Cumulative Discounted Cash Flow
• DCF = CF x PVF

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
28,098
Discounted Payback = 3 + = 3 + 0.61 = 𝟑. 𝟔𝟏 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫) 𝟑 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟕 𝐌𝐨𝐧𝐭𝐡𝐬
46,368
• Base year refers to the last year in which cumulative discounted cash flow is negative

WN 4: Computation of discounted payback of Project B:

Year CF PVF @ 16% DCF CDCF
0 -2,40,000 1.000 -2,40,000 -2,40,000
1 60,000 0.862 51,720 -1,88,280
2 84,000 0.743 62,412 -1,25,868
3 96,000 0.641 61,536 -64,332
4 1,02,000 0.552 56,304 -8,028
5 90,000 0.476 42,840 34,812

𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫

𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐃𝐢𝐬𝐜𝐨𝐮𝐧𝐭𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
8,028
Discounted Payback = 4 + = 4 + 0.19 = 𝟒. 𝟏𝟗 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫) 𝟒 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟐 𝐦𝐨𝐧𝐭𝐡𝐬
42,840

WN 5: Computation of Accounting Rate of Return (ARR) of Project A and B:

Particulars Project A Project B
Total inflow for 5 years 3,30,000 4,32,000
Less: Depreciation for 5 years (1,35,000) (2,40,000)
Total profit for 5 years 1,95,000 1,92,000
Average profit per year 39,000 38,400
Initial investment 1,35,000 2,40,000
Closing investment (scrap value) 0 0
Average investment (Initial + Closing)/2 67,500 1,20,000
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐢𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭
39,000
ARR of Project A = x 100 = 28.89%
1,35,000
38,400
ARR of Project B = x 100 = 16.00%
2,40,000

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐏𝐀𝐓
𝐀𝐑𝐑 𝐨𝐧 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 = 𝐱 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐢𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

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39,000
ARR of Project A = x 100 = 57.78%
67,500
38,400
ARR of Project B = x 100 = 32.00%
1,20,000

WN 6: Computation of Net Present Value (NPV) of Project A:

Year CF PVF @ 16% DCF
0 -1,35,000 1.000 -1,35,000
1 - 0.862 -
2 30,000 0.743 22,290
3 1,32,000 0.641 84,612
4 84,000 0.552 46,368
5 84,000 0.476 39,984
NPV 58,254
• NPV = Present value of inflows – Present value of outflows
• NPV = 1,93,254 – 1,35,000 = Rs.58,254

WN 7: Computation of Net Present Value (NPV) of Project B:

Year CF PVF @ 16% DCF
0 -2,40,000 1.000 -2,40,000
1 60,000 0.862 51,720
2 84,000 0.743 62,412
3 96,000 0.641 61,536
4 1,02,000 0.552 56,304
5 90,000 0.476 42,840
NPV 34,812
• NPV = Present value of inflows – Present value of outflows
• NPV = 2,74,812 – 2,40,000 = Rs.34,812

WN 8: Computation of Profitability index of Project A and B:

Particulars Project A Project B
PV of inflows (A) 1,93,254 2,74,812
PV of outflows (B) 1,35,000 2,40,000
Profitability index in % (A/B) 143.15% 114.51%
Profitability index in Times (A/B) 1.43 Times 1.15 Times

WN 9: Selection of project:
Particulars Project A Project B Choice
Payback 2 years & 10 months 3 years A
Discounted Payback 3 years & 7 months 4 years & 2 months A
ARR on initial investment 28.89% 16.00% A
ARR on average investment 57.78% 32.00% A
NPV 58,254 34,812 A
Profitability Index 1.43 Times 1.15 Times A
• Company should go ahead with project A

2. Techniques of capital budgeting [Jan 2021, May 2019 MTP, Nov 2019, May 2013]
The management of P Limited is considering selecting a machine out of two mutually exclusive machines.
The company’s cost of capital is 8% and the corporate tax rate for the company is 30%. Details of the
machine are as follows:

Particulars Machine I Machine II

Cost of the Machine 10,00,000 15,00,000
Expected life 5 years 5 years

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Annual income before tax & depreciation 3,45,000 4,55,000

Depreciation is to be charged on straight line basis.

You are required to:
• Calculate pay back, discounted pay back, NPV, PI and ARR of each machine
• Advise the management of P Limited to which machine they should take up
Answer:
WN 1: Computation of cash flows:
Particulars Machine I Machine II
Profit before depreciation and tax 3,45,000 4,55,000
Less: Depreciation (2,00,000) (3,00,000)
Profit before Tax 1,45,000 1,55,000
Less: Tax @ 30% (43,500) (46,500)
Profit after Tax 1,01,500 1,08,500
Add: Depreciation 2,00,000 3,00,000
Cash flow after tax 3,01,500 4,08,500

WN 2: Analysis of Machine I
Year CF CCF PVF @ 8% DCF CDCF Depreciation PAT
0 -10,00,000 -10,00,000 1.000 -10,00,000 -10,00,000
1 3,01,500 -6,98,500 0.926 2,79,189 -7,20,811 2,00,000 1,01,500
2 3,01,500 -3,97,000 0.857 2,58,386 -4,62,425 2,00,000 1,01,500
3 3,01,500 -95,500 0.794 2,39,391 -2,23,034 2,00,000 1,01,500
4 3,01,500 2,06,000 0.735 2,21,603 -1,431 2,00,000 1,01,500
5 3,01,500 5,07,500 0.681 2,05,322 2,03,891 2,00,000 1,01,500
• CCF = Cumulative values of Cash flow column
• DCF = CF x PVF
• CDCF = Cumulative values of DCF column
• PAT = Cash flow - Depreciation

Calculation of all techniques:

Particulars Calculation Answer
Payback Unrecovered cash flow of Base year 3.32 years (or)
Base year +
Cash flow of next year 3 years and 4 months
95,500
=3+ = 3 + 0.32
3,01,500
Discounted Unrecovered discounted cash flow of Base year 4.01 years
Base year +
Payback Discounted flow of next year
1,431
=4+ = 4 + 0.01
2,05,322
ARR on Average PAT 1,01,500 10.15%
x 100 = x 100
initial Initial investment 10,00,000
investment
ARR on Average PAT 1,01,500 20.30%
x 100 = x 100
average Average investment 10,00,000 + 0
investment 2
1,01,500
= x 100
5,00,000
NPV = PV of inflows – PV of outflow Rs.2,03,891
= 12,03,891 – 10,00,000
Profitability PV of inflows 12,03,891 120.39%
x 100 = x 100
Index (in %) PV of outflows 10,00,000
Profitability PV of inflows 12,03,891 1.20 Times
=
Index (in PV of outflows 10,00,000
Times)

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WN 3: Analysis of Machine II
Year CF CCF PVF @ 8% DCF CDCF Depreciation PAT
0 -15,00,000 -15,00,000 1.000 -15,00,000 -15,00,000
1 4,08,500 -10,91,500 0.926 3,78,271 -11,21,729 3,00,000 1,08,500
2 4,08,500 -6,83,000 0.857 3,50,085 -7,71,644 3,00,000 1,08,500
3 4,08,500 -2,74,500 0.794 3,24,349 -4,47,295 3,00,000 1,08,500
4 4,08,500 1,34,000 0.735 3,00,248 -1,47,047 3,00,000 1,08,500
5 4,08,500 5,42,500 0.681 2,78,189 1,31,142 3,00,000 1,08,500

Calculation of all techniques:

Particulars Calculation Answer
Payback Unrecovered cash flow of Base year 3.67 years (or)
Base year +
Cash flow of next year 3 years and 8 months
2,74,500
=3+ = 3 + 0.67
4,08,500
Discounted Unrecovered discounted cash flow of Base year 4.53 years (or) 4 years
Base year +
Payback Discounted flow of next year and 6 months
1,47,047
=4+ = 4 + 0.53
2,78,189
ARR on Average PAT 1,08,500 7.23%
x 100 = x 100
initial Initial investment 15,00,000
investment
ARR on Average PAT 1,08,500 14.47%
x 100 = x 100
average Average investment 15,00,000 + 0
investment 2
1,08,500
= x 100
7,50,000
NPV = PV of inflows – PV of outflow 1,31,142
= 16,31,142 – 15,00,000
Profitability PV of inflows 16,31,142 108.74%
x 100 = x 100
Index (in %) PV of outflows 15,00,000
Profitability PV of inflows 16,31,142 1.09 Times
=
Index (in PV of outflows 15,00,000
Times)
Conclusion:
• Company should go ahead with Machine I due to better performance in all techniques

3. Payback reciprocal
Suppose a project requires an initial investment of Rs. 20,000 and it would give annual cash inflow of Rs.
4,000, The useful life of the project is estimated to be 10 years. Compute Payback Reciprocal
Answer:
Average cash flow 4,000
Payback Reciprocal = x 100 = x100 = 20.00%
Initial Investment 20,000

4. Calculation of IRR
a. Find the IRR of a project with a cash outflow of Rs.20,000 in year 0 and a cash inflow two years later of
Rs.25,992
b. Find the IRR of a project with a cash outflow in year 0 of Rs.50,000 and which produces cash inflows in
perpetuity of Rs.8,750
c. Find the IRR of a project with a cash outlay of Rs.50,000 and a four year annuity inflow of Rs.15,500
d. Rework if the annuity inflow is in advance
e. Find the IRR of the project whose cash flow is as under

Year 0 1 2 3
Cash flow (1000) 450 425 400
Answer:

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Question A
Basic Information:
Present value (outflow) 20,000
IRR (rate of interest) ?
n (time period) 2 years
Future value (Amount) 25,992

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
25,992 = 20,000 x (1 + 𝑟)2
25,992
(1 + r)2 = = 1.2996
20,000
(1 + r) = 1.14; 𝐫 = 𝟏𝟒%

Hence IRR of the cash flow is 14%.

Question B:
Basic information:
Type of cash flow Perpetuity
Perpetuity Amount 8,750
n (time period) NA
r (rate of interest) ?
Present value of Perpetuity 50,000
Growth rate 0%
Perpetuity Amount
Present value =
Rate of Interest − Growth Rate
8,750
50,000 =
Rate of Interest − 0%
8,750
Rate of interest = = 𝟎. 𝟏𝟕𝟓 (𝐨𝐫)𝟏𝟕. 𝟓𝟎%
50,000

Hence IRR of the cash flow is 17.50%.

Question C:
WN 1: Computation of initial guess rate for IRR computation:
Particulars Calculation Amount
Initial outflow 50,000
Sum of inflows 15,500 x 4 62,000
Total profit of project 12,000
Average profit of project 12,000 3,000
4
Average investment 50,000 + 0 25,000
2
ARR on average investment 𝟑, 𝟎𝟎𝟎 12%
𝐱 𝟏𝟎𝟎
𝟐𝟓, 𝟎𝟎𝟎
Initial guess rate 𝟐 8%
𝐱 𝟏𝟐
𝟑
• In order to compute IRR, we need one positive and one negative NPV. We need to start with some
rate for discounting. We take that as 2/3rd of ARR on average investment as final IRR is expected
to be closer to this number.

WN 2: Computation of IRR:
Let us assume an initial discount rate of 8 percent and compute NPV
Year Cash flow PVF @ 8% DCF PVF @ 10% DCF
0 -50,000 1 -50,000 1 -50,000
1 to 4 15,500 3.312 51,336 3.17 49,135
1,336 -865

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• We have to increase the discount rate if NPV is positive and discount rate is to be reduced if initial
NPV is negative. We will need one positive and one negative NPV to compute IRR.

IRR computation:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
1,336
IRR = 8% + x (10% − 8%) = 8% + 1.21% = 𝟗. 𝟐𝟏%
1,336 − (−865)
Note:
• L1 = Lower discount rate
• NPV at L1 = NPV at lower rate
• L2 = Higher discount rate
• NPV at L2 = NPV at higher rate

Question D:
WN 1: Computation of initial guess rate for IRR computation:
Particulars Calculation Amount
Initial outflow 50,000 – 15,500 34,500
Sum of inflows 15,500 x 3 46,500
Total profit of project 12,000
Average profit of project 12,000 4,000
3
Average investment 34,500 + 0 17,250
2
ARR on average investment 𝟒, 𝟎𝟎𝟎 23.19
𝐱 𝟏𝟎𝟎
𝟏𝟕, 𝟐𝟓𝟎
Initial guess rate 𝟐 15.46 ~ 16%
𝐱 𝟐𝟑. 𝟏𝟗
𝟑
• If annuity is in advance, then we will receive the amount at the beginning of period. Hence the
initial outflow will be only Rs.34,500 [50,000 – 15,500]
• Life of project will also reduce to three years as all money would be received by beginning of 4th
year (end of third year)

WN 2: Computation of IRR:
Let us assume an initial discount rate of 16 percent and compute NPV
Year Cash flow PVF @ 16% DCF PVF @ 18% DCF
0 -34,500 1 -34,500 1 -34,500
1 to 3 15,500 2.246 34,813 2.174 33,697
313 -803

IRR computation:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
313
IRR = 16% + x (18% − 16%) = 16% + 0.56% = 𝟏𝟔. 𝟓𝟔%
313 − (−803)

Question E:
WN 1: Computation of initial guess rate for IRR computation:
Particulars Calculation Amount
Initial outflow 1,000
Sum of inflows 1,275
Total profit of project 275
Average profit of project 275 92
3
Average investment 1,000 + 0 500
2

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ARR on average investment 𝟗𝟐 18.40
𝐱 𝟏𝟎𝟎
𝟓𝟎𝟎
Initial guess rate 𝟐 12.27 ~ 12%
𝐱 𝟏𝟖. 𝟒𝟎
𝟑

WN 2: Computation of IRR
Let us assume an initial discount rate of 12 percent and compute NPV
Year Cash flow PVF @ 12% DCF PVF @ 14% DCF
0 -1,000 1 -1,000.00 1 -1,000.00
1 450 0.893 401.85 0.877 394.65
2 425 0.797 338.73 0.769 326.83
3 400 0.712 284.80 0.675 270.00
25.38 -8.52

IRR computation:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
25.38
IRR = 12% + x (14% − 12%) = 12% + 1.50% = 𝟏𝟑. 𝟓𝟎%
25.38 − (−8.52)

5. Revision of all techniques [May 2016, May 2018, SM]

Following are the data on a capital project being evaluated by the management of X Ltd.:
Particulars Project M
Annual cost saving 40,000
Useful life 4 years
IRR 15%
Profitability Index 1.064
NPV ?
Cost of capital ?
Cost of project ?
Payback ?
Salvage value 0
Find the missing values considering the following table of discount factor only:
Discount Factor 15% 14% 13% 12%
Year 1 0.869 0.877 0.885 0.893
Year 2 0.756 0.769 0.783 0.797
Year 3 0.658 0.675 0.693 0.712
Year 4 0.572 0.592 0.613 0.636
Total 2.855 2.913 2.974 3.038
Answer:
WN 1: Computation of cost of project:
• IRR is the rate of return at which NPV of the project is zero
Year Cash flow PVF @ 15% DCF
0 -1,14,200 1.000 -1,14,200
1 to 4 40,000 2.855 1,14,200
NPV 0
• Cost of project = Rs.1,14,200 (sum of inflows as NPV is zero)

WN 2: Computation of NPV:
PV of inflows
Profitability index =
PV of outflows
PV of inflows
1.064 = ; 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰𝐬 = (𝟏, 𝟏𝟒, 𝟐𝟎𝟎 𝐱 𝟏. 𝟎𝟔𝟒) = 𝐑𝐬. 𝟏, 𝟐𝟏, 𝟓𝟎𝟗
1,14,200
𝐍𝐏𝐕 = 𝐏𝐕 𝐨𝐟 𝐢𝐧𝐟𝐥𝐨𝐰 − 𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 = 𝟏, 𝟐𝟏, 𝟓𝟎𝟗 − 𝟏, 𝟏𝟒, 𝟐𝟎𝟎 = 𝐑𝐬. 𝟕, 𝟑𝟎𝟗

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WN 3: Computation of cost of capital:
Year Cash flow PVF @ ?? DCF
0 -1,14,200 1.000 -1,14,200
1 to 4 40,000 3.038 1,21,509
NPV 7,309
From the given tables PVAF of 3.038 correspond to 4 years and 12 percent. Hence cost of capital is 12%

WN 4: Computation of Payback:
Year Cash flow Cum Cash flow
0 -1,14,200 -1,14,200
1 40,000 -74,200
2 40,000 -34,200
3 40,000 5,800
4 40,000 45,800
𝐔𝐧𝐫𝐞𝐜𝐨𝐯𝐞𝐫𝐞𝐝 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐁𝐚𝐬𝐞 𝐘𝐞𝐚𝐫
𝐏𝐚𝐲𝐛𝐚𝐜𝐤 = 𝐁𝐚𝐬𝐞 𝐲𝐞𝐚𝐫 +
𝐂𝐚𝐬𝐡 𝐟𝐥𝐨𝐰 𝐨𝐟 𝐧𝐞𝐱𝐭 𝐲𝐞𝐚𝐫
34,200
Payback = 2 + = 2 + 0.855 = 𝟐. 𝟖𝟓𝟓 𝐲𝐞𝐚𝐫𝐬 (𝐨𝐫)𝟐 𝐲𝐞𝐚𝐫𝐬 𝐚𝐧𝐝 𝟏𝟎 𝐦𝐨𝐧𝐭𝐡𝐬
40,000

Part 2 – Investment Decision

6. Revenue enhancement – Profit making company – Tax saving [Nov 2016 RTP, May 2023 RTP]
X Ltd. an existing profit making company is planning to introduce a new product with a projected life for
8 years. Initial equipment cost will be Rs.120 lacs and additional equipment costing Rs.10 lacs will be
needed at the beginning of the third year. At the end of the 8 years, the original equipment will have resale
value equivalent to the cost of removal, but the additional equipment would be sold for Rs.1 lac. Working
capital of Rs.15 lacs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum but the
production and sales volume are as under:
Year 1 2 3-5 6-8
Capacity Utilization 20 30 75 50
Advertisement expenditure (in lacs) per year 30 15 10 4
A sale price of Rs.100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed operating
costs are likely to be Rs.16 lacs per annum. In addition to this the advertisement expenditure will have to
be incurred as mentioned in the above table.
The company is subject to 50% tax, straight line method of depreciation (permissible for tax purposes also)
and taking 12% as appropriate after-tax cost of capital should the project be accepted?
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (120)
Working capital (15)
Initial outflow (135)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Units sold
[4 x capacity utiln] 0.80 1.20 3.00 3.00 3.00 2.00 2.00 2.00
Selling price 100 100 100 100 100 100 100 100
Revenues
[Units x SP] 80.00 120.00 300.00 300.00 300.00 200.00 200.00 200.00
Less: Variable cost
[Units x 40] -32.00 -48.00 -120.00 -120.00 -120.00 -80.00 -80.00 -80.00
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Less: Fixed cost -16.00 -16.00 -16.00 -16.00 -16.00 -16.00 -16.00 -16.00
Less: Advertisement -30.00 -15.00 -10.00 -10.00 -10.00 -4.00 -4.00 -4.00
PBDT 2.00 41.00 154.00 154.00 154.00 100.00 100.00 100.00
Less: Depreciation -15.00 -15.00 -16.50 -16.50 -16.50 -16.50 -16.50 -16.50
PBT -13.00 26.00 137.50 137.50 137.50 83.50 83.50 83.50
Less: Tax 6.50 -13.00 -68.75 -68.75 -68.75 -41.75 -41.75 -41.75
PAT -6.50 13.00 68.75 68.75 68.75 41.75 41.75 41.75
Add: Depreciation 15.00 15.00 16.50 16.50 16.50 16.50 16.50 16.50
CFAT 8.50 28.00 85.25 85.25 85.25 58.25 58.25 58.25
Less: Purchase of
additional machine -10.00
Revised CFAT 8.50 18.00 85.25 85.25 85.25 58.25 58.25 58.25
• Depreciation on original equipment (all 8 years) = (120 – 0)/8 = 15 lacs
• Depreciation on additional equipment (3 to 8 years) = (10 – 1)/6 = 1.5 lacs
• Company makes loss in year 1. It is an existing profit-making company and hence would save
taxes due to loss
• Additional machine has been purchased at beginning of year 3. Beginning of year 3 will be taken
as end of year 2 in cash flow analysis. This is because it is generally assumed that cash flows happen
at end of the year

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value of original machine 0.00
Net salvage value of additional machine 1.00
Recapture of working capital 15.00
Total terminal flow 16.00

Note: Computation of Net Salvage Value:

Particulars Original Additional
Sale value 0.00 1.00
Less: Book value 0.00 1.00
Capital gain/loss 0.00 0.00
Tax paid/saved 0.00 0.00

Net salvage value 0.00 1.00

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF
0 -135.00 1.000 -135.00
1 8.50 0.893 7.59
2 18.00 0.797 14.35
3 85.25 0.712 60.70
4 85.25 0.636 54.22
5 85.25 0.567 48.34
6 58.25 0.507 29.53
7 58.25 0.452 26.33
74.25
8 [58.25 + 16.00] 0.404 30.00
NPV 136.06
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.136.06 lacs.

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7. Revenue enhancement – Carry forward of loss and set-off [SM]
XYZ Limited is planning to introduce a new product with a project life of 8 years. The project is to be set
up in SEZ, qualifies for one-time (at starting) tax free subsidy from the state Government of Rs.25,00,000
on capital investment. Initial equipment cost will be Rs.1.75 crores. Additional equipment costing
Rs.12,50,000 will be purchased at the end of the third year from the cash flow of this year. At the end of 8
years, the original equipment will have no resale value, but additional equipment can be sold for
Rs.1,25,000. A working capital of Rs.20,00,000 will be needed and it will be released at the end of eighth
year. The project will be financed with sufficient amount of equity capital.

The sales volumes over eight years have been estimated as follows:
Year 1 2 3 4-5 6-8
Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000
A sales price of Rs.120 per unit is expected and variable expenses will amount to 60% of sales revenue.
Fixed cash operating costs will amount Rs.18,00,000 per year. The loss of any year will be set-off from the
profits of subsequent two [Link] company is subject to 30 percent tax rate and considers 12 percent to
be an appropriate after-tax cost of capital for this project. The company follows straight line method of
depreciation
Required:
Calculate the NPV of the project and advise the management to take appropriate decision
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (175)
Tax-free subsidy 25
Working capital (20)
Initial outflow (170)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Revenues 86.400 129.600 312.000 324.000 324.000 216.000 216.000 216.000
Less: Variable cost -51.840 -77.760 -187.200 -194.400 -194.400 -129.600 -129.600 -129.600
Less: Fixed cost -18.000 -18.000 -18.000 -18.000 -18.000 -18.000 -18.000 -18.000
PBDT 16.560 33.840 106.800 111.600 111.600 68.400 68.400 68.400
Less: Depreciation -21.875 -21.875 -21.875 -24.125 -24.125 -24.125 -24.125 -24.125
PBT -5.315 11.965 84.925 87.475 87.475 44.275 44.275 44.275
Less: Tax 0.000 -1.995 -25.478 -26.243 -26.243 -13.283 -13.283 -13.283
PAT -5.315 9.970 59.447 61.232 61.232 30.992 30.992 30.992
Add: Depreciation 21.875 21.875 21.875 24.125 24.125 24.125 24.125 24.125
CFAT 16.560 31.845 81.322 85.357 85.357 55.117 55.117 55.117
Less: Purchase of
additional machine -12.500
Revised CFAT 16.560 31.845 68.822 85.357 85.357 55.117 55.117 55.117
Note:
• Revenues = Units sold x SP
• Variable cost = 60% of revenues
• Depreciation of original machine = (175 lacs/8) = 21.875 lacs. We can alternatively credit tax
subsidy to cost of asset and charge depreciation on Rs.150 lacs.
• Depreciation of new machine = (12.50 lacs – 1.25 lacs)/5 years = 2.25 lacs. Machine has been
purchased at end of year 3 and hence depreciation can be charged for 5 years
• Loss can be carried forward and set-off against profits of two subsequent [Link] company has
loss in first year and there is no tax saving on same as loss cannot be immediately set-off

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• Taxable profit of year 2 = (11.965 – 5.315) = 6.650 lacs. Tax of year 2 = 6.650 lacs x 30% = Rs.1.995
lacs
• Tax for subsequent years would be equal to 30 percent of respective year profits

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value of original machine 0.00
Net salvage value of additional machine 1.25
Recapture of working capital 20.00
Total terminal flow 21.25

Note: Computation of Net Salvage Value:

Particulars Original Additional
Sale value 0.00 1.25
Less: Book value 0.00 1.25
Capital gain/loss 0.00 0.00
Tax paid/saved 0.00 0.00

Net salvage value 0.00 1.25

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF
0 -170.000 1.000 -170.00
1 16.560 0.893 14.79
2 31.845 0.797 25.38
3 68.822 0.712 49.00
4 85.357 0.636 54.29
5 85.357 0.567 48.40
6 55.117 0.507 27.94
7 55.117 0.452 24.91
8 76.367 0.404 30.85
NPV 105.56
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.105.56 lacs.

8. Investment decision – No carry forward of loss [Nov 2018]

PD Limited an existing company, is planning to introduce a new product with projected life of 8 years.
Project cost will be Rs.2,40,00,000. At the end of 8 years no residual value will be realized. Working capital
of Rs.30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units per annum but the
production and sales volume are expected are as under:
Year Number of units
1 60,000 units
2 80,000 units
3-5 1,40,000 units
6-8 1,20,000 units
Other information:
• Selling Price per unit = Rs.200
• Variable cost is 40 percent of sales
• Fixed cost of Rs.30,00,000
• Advertisement expenditure will have to be incurred as under:
Year Expenditure
1 50,00,000
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2 25,00,000
3-5 10,00,000
6-8 5,00,000
• Income tax is 25%
• Straight line method of depreciation is permissible for tax purpose
• Cost of capital is 10%
• Assume that loss cannot be carried forward
Advise about the project acceptability.
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (240)
Working capital (30)
Initial outflow (270)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Revenues 120.00 160.00 280.00 280.00 280.00 240.00 240.00 240.00
Less: Variable cost -48.00 -64.00 -112.00 -112.00 -112.00 -96.00 -96.00 -96.00
Less: Fixed cost -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00
Less: Advertisement -50.00 -25.00 -10.00 -10.00 -10.00 -5.00 -5.00 -5.00
PBDT -8.00 41.00 128.00 128.00 128.00 109.00 109.00 109.00
Less: Depreciation -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00 -30.00
PBT -38.00 11.00 98.00 98.00 98.00 79.00 79.00 79.00
Less: Tax 0.00 -2.75 -24.50 -24.50 -24.50 -19.75 -19.75 -19.75
PAT -38.00 8.25 73.50 73.50 73.50 59.25 59.25 59.25
Add: Depreciation 30.00 30.00 30.00 30.00 30.00 30.00 30.00 30.00
CFAT -8.00 38.25 103.50 103.50 103.50 89.25 89.25 89.25
• Loss cannot be carried forward. Question also doesn’t specify that it is an existing profit

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value 0.00
Recapture of working capital 30.00
Total terminal flow 30.00

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value 0.00
Capital gain/loss 0.00
Tax paid/saved 0.00

Net salvage value 0.00

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 10% DCF
0 -270.00 1.000 -270.00

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1 -8.00 0.909 -7.27
2 38.25 0.826 31.59
3 103.50 0.751 77.73
4 103.50 0.683 70.69
5 103.50 0.621 64.27
6 89.25 0.564 50.34
7 89.25 0.513 45.79
8 119.25 0.467 55.69
NPV 118.83
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.118.83 lacs.

9. Financing Decision and Investment Decision [May 2023 MTP]

Genzy Ltd. is planning to introduce a new product with a project life of 10 years. The initial equipment cost
will be Rs. 2.5 crores. At the end of 10 years, the equipment will have a resale value of 50 lakhs. A working
capital of Rs. 30,00,000 will be needed and it will be released at the end of the tenth year. The project will
be financed with the following capital sources.
Particulars Amount Issue Price (MP)
Equity Share Capital of Face value Rs. 10 each 1,50,00,000 30
Debentures of face value Rs. 100 each with a maturity of 10 years 90,00,000 90
Preference shares of Rs. 100 each with a maturity of 10 years 60,00,000 96
The existing yield on T-bills is averaging 8% p.a. The systematic risk measure for the proposed project is
1.6. NSE NIFTY is expected to yield 14% p.a. on average for the foreseeable future. Debenture holders have
been promised a coupon of 12% and preference shareholders have been committed a dividend of 15%.

The sales volumes over 10 years have been estimated as follows:

Years 1 2 3-5 6-8 9-10
Units per year 70,000 98,000 2,10,000 2,50,000 1,20,000
A sales price of Rs. 300 per unit is expected and variable expenses will amount to 60% of sales revenue.
Fixed cash operating costs will amount to Rs. 40,00,000 per year. The loss of any year will be set off from
the profits of subsequent years.
The company is subject to a 30 per cent tax rate. The company follows straight line method of depreciation
which is to be assumed to be admissible for tax purpose also.
CALCULATE the net present value of the project for the company and advise the management to take
appropriate decision.
The PV factors are to be taken as rounded figures upto 2 decimals. Use market value weights to COMPUTE
overall cost of capital.
Answer:
WN 1: Computation of WACC
Note 1: Computation of cost of individual components of capital
• Cost of Equity = Rf + Beta x (Rm – Rf) = 8 + 1.60 x (14 – 8) = 17.60%
Note: Systematic risk is basically Beta
100 − 90
(12 𝑥 0.7) +
10
Interest after tax + Average other Costs 100 + 90
Cost of redeemable debt = =
Average Funds Employed 2
9.4
Cost of redeemable debt = 𝑥 100 = 9.89%
95
100 − 96
15 +
10
Preference Dividend + Average other Costs 100 + 96
Cost of preference = =
Average Funds Employed 2
15.40
Cost of preference = 𝑥 100 = 15.71%
98

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Note 2: Computation of WACC:
Source Cost Weight Product
Equity 17.60% 1,50,00,000 26,40,000
Debt 9.89% 90,00,000 8,90,100
Preference 15.71% 60,00,000 9,42,600
Total 3,00,00,000 44,72,700
Sum of Product 44,72,700
WACC = = 𝑥 100 = 14.90%
Sum of weights 3,00,00,000

WN 2: Computation of cash flows:

Note 1: Initial outflow
Particulars Amount
Capital expenditure -2,50,00,000
Working capital -30,00,000
Initial outflow -2,80,00,000

Note 2: In-between flows

Particulars Year 1 year 2 Year 3 to 5 Year 6 to 8 Year 9 to 10

Units per year 70,000 98,000 2,10,000 2,50,000 1,20,000

Sales 2,10,00,000 2,94,00,000 6,30,00,000 7,50,00,000 3,60,00,000
Less: VC -1,26,00,000 -1,76,40,000 -3,78,00,000 -4,50,00,000 -2,16,00,000
Less: FC -40,00,000 -40,00,000 -40,00,000 -40,00,000 -40,00,000
Less: Depreciation -20,00,000 -20,00,000 -20,00,000 -20,00,000 -20,00,000
PBT 24,00,000 57,60,000 1,92,00,000 2,40,00,000 84,00,000
Less: Tax @ 30% -7,20,000 -17,28,000 -57,60,000 -72,00,000 -25,20,000
PAT 16,80,000 40,32,000 1,34,40,000 1,68,00,000 58,80,000
CFAT 36,80,000 60,32,000 1,54,40,000 1,88,00,000 78,80,000

Note 3: Terminal flow

Particulars Amount
NSV 50,00,000
Working capital 30,00,000
Terminal flow 80,00,000

WN 3: Computation of NPV
Year Cash flow PVF @ 14.90% DCF
0 -2,80,00,000 1 -2,80,00,000
1 36,80,000 0.87 32,01,600
2 60,32,000 0.76 45,84,320
3 1,54,40,000 0.66 1,01,90,400
4 1,54,40,000 0.57 88,00,800
5 1,54,40,000 0.5 77,20,000
6 1,88,00,000 0.43 80,84,000
7 1,88,00,000 0.38 71,44,000
8 1,88,00,000 0.33 62,04,000
9 78,80,000 0.29 22,85,200
10 1,58,80,000 0.25 39,70,000
NPV 3,41,84,320
The management should consider taking up the project as the Net Present Value of the Project is Positive

10. Cost reduction [May 2021 MTP, May 2018 MTP]

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Domestic services (P) Limited is in the business of providing cleaning sewerage line services at homes.
There is a proposal before the company to purchase a mechanize sewerage cleaning system for a sum of
Rs.20 lacs. The present system of the company is to use manual labour for the job. You are provided with
the following information:
Proposed Mechanized System
Cost of the machine Rs.20 lacs
Life of the machine 10 years
Depreciation (on straight line basis) 10%
Operating cost of mechanized system Rs.5 lacs per annum
Present system (Manual):
Manual labour 200 persons
Cost of manual labour Rs.10,000 per person per annum
The company has an after-tax cost of funds at 10% per annum. The applicable tax rate is 30%. You are
required to determine whether it is advisable to purchase the machine.
Answer:
WN 1: Initial Outflow:
Particulars Amount
Capital expenditure (20,00,000)
Working capital 0
Initial outflow (20,00,000)

WN 2: In-between cash flows:

Particulars Amount
Revenue/cost reduction
Savings in labour cost (10,000 x 200) 20,00,000
Less: Operating cost (5,00,000)
Profit before Depreciation and Tax (PBDT) 15,00,000
Less: Depreciation (20,00,000/10 years) (2,00,000)
Profit before tax (PBT) 13,00,000
Less: Tax @ 30% (3,90,000)
Profit after tax (PAT) 9,10,000
Add: Depreciation 2,00,000
Cash flow after taxes (CFAT) 11,10,000

WN 3: Terminal cash flow:

Particulars Amount
Net salvage value -
Recapture of working capital -
Total terminal flow -

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value 0.00
Capital gain/loss 0.00
Tax paid/saved 0.00

Net salvage value 0.00

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF
0 -20,00,000 1.000 -20,00,000
1 to 10 11,10,000 6.144 68,19,840
10 - 0.386 -
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NPV 48,19,840
Conclusion: The company should go ahead with purchase of machine as NPV is positive.

11. Investment decision – WDV Method [May 2020 RTP]

A company is considering the proposal of taking up a new project which requires as investment of Rs.800
lacs on machinery and other assets. The project is expected to yield the following earnings (before
depreciation and taxes) over the next five years.
Year Earnings (in lacs)
1 320
2 320
3 360
4 360
5 300
The cost of raising the additional capital is 12% and assets have to be depreciated at 20% on WDV basis.
The scrap value at the end of five-year period may be taken as zero. Income-tax applicable to the company
is 40%.

You are required to calculate the NPV of the project and advise the management to take appropriate
decision. Also calculate the IRR of the project.
Note: Present values of Re.1 at different rates of interest are as follows:
Year 10% 12% 14% 16% 20%
1 0.91 0.89 0.88 0.86 0.83
2 0.83 0.80 0.77 0.74 0.69
3 0.75 0.71 0.67 0.64 0.58
4 0.68 0.64 0.59 0.55 0.48
5 0.62 0.57 0.52 0.48 0.40
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure (800)
Working capital 0
Initial outflow (800)

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
PBDT 320.00 320.00 360.00 360.00 300.00
Less: Depreciation -160.00 -128.00 -102.40 -81.92 -65.54
PBT 160.00 192.00 257.60 278.08 234.46
Less: Tax @ 40% -64.00 -76.80 -103.04 -111.23 -93.79
PAT 96.00 115.20 154.56 166.85 140.68
Add: Depreciation 160.00 128.00 102.40 81.92 65.54
CFAT 256.00 243.20 256.96 248.77 206.21
Note:
• Depreciation of year 1 = 800 lacs x 20% = Rs.160 lacs
• Depreciation of year 2 = (800 – 160) x 20% = Rs.128 lacs
• Depreciation of year 3,4 and 5 is calculated in similar manner

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Net salvage value 0.00
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Recapture of working capital 30.00
Total terminal flow 30.00

Note: Computation of Net Salvage Value:

Particulars Amount
Sale value 0.00
Less: Book value (800 lacs – Depreciation of 5 years) 262.14
Capital loss 262.14
Tax saved (262.14 x 40%) 104.86

Net salvage value [Sale value + Tax saved] 104.86

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF PVF @ 16% DCF PVF @ 20% DCF
0 -800.00 1.00 -800.00 1.00 -800.00 1.00 -800.00
1 256.00 0.89 227.84 0.86 220.16 0.83 212.48
2 243.20 0.80 194.56 0.74 179.97 0.69 167.81
3 256.96 0.71 182.44 0.64 164.45 0.58 149.04
4 248.77 0.64 159.21 0.55 136.82 0.48 119.41
5 311.07 0.57 177.31 0.48 149.31 0.40 124.43
NPV 141.36 50.71 -26.83

• NPV of the project = Rs.141.36 lacs

Computation of IRR:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
50.71
IRR = 16% + x (20% − 16%) = 16% + 2.62% = 𝟏𝟖. 𝟔𝟐%
50.71 − (−26.83)

12. Revenue enhancement – Non-payment of full initial outflow [Nov 2019 RTP, Nov 2023 RTP,
SM]
Cello Limited is considering buying a new machine which would have a useful economic life of five years,
a cost of Rs.1,25,000 and a scrap value of Rs.30,000 with 80 percent of cost being payable at the start of the
project and the rest 20 percent at the end of the first year. The machine would produce 50,000 units per
annum of a new project with an estimated selling price of Rs.3 per unit. Direct costs would be Rs.1.75 per
unit and annual fixed costs, including depreciation calculated on SLM basis, would be Rs.40,000 per
annum. In the first year and the second year, special sales promotion expenditure, not included in the above
costs, would be incurred, amounting Rs.10,000 and Rs.15,000 respectively. Evaluate the project using the
NPV method of investment appraisal, assuming the company’s cost of capital to be 10 percent.
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure
[Amount paid alone is considered] (1,00,000)
Working capital -
Initial outflow (1,00,000)

WN 2: In-between cash flows:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Revenues [50,000 x 3] 1,50,000 1,50,000 1,50,000 1,50,000 1,50,000
Less: Direct cost [50,000 x 1.75] (87,500) (87,500) (87,500) (87,500) (87,500)
Less: Fixed cost (21,000) (21,000) (21,000) (21,000) (21,000)

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Less: Sales promotion (10,000) (15,000) - - -
PBDT 31,500 26,500 41,500 41,500 41,500
Less: Depreciation (19,000) (19,000) (19,000) (19,000) (19,000)
PBT 12,500 7,500 22,500 22,500 22,500
Less: Tax @ 25% (3,125) (1,875) (5,625) (5,625) (5,625)
PAT 9,375 5,625 16,875 16,875 16,875
Add: Depreciation 19,000 19,000 19,000 19,000 19,000
CFAT 28,375 24,625 35,875 35,875 35,875
Less: Payment for original machine (25,000)
Revised CFAT 3,375 24,625 35,875 35,875 35,875

Note:
• It is assumed that tax rate is 25 percent.

WN 3: Terminal flow:
Particulars Amount
Sale value 30,000
Less: Book value (30,000)
Capital gain 0
Tax paid 0

Net salvage value (30,000+0) 30,000

WN 4: Consolidation of cash flows and computation of NPV:

Year Cash flow PVF @ 10% DCF
0 -1,00,000 1.000 -1,00,000
1 3,375 0.909 3,068
2 24,625 0.826 20,340
3 35,875 0.751 26,942
4 35,875 0.683 24,503
5 65,875 0.621 40,908
NPV 15,761
• The company should go ahead with project as NPV is positive

13. Revenue enhancement – After-tax opportunity cost [May 2014, Nov 2022 RTP, Nov 2022, SM]
A hospital is considering to purchase a diagnostic machine costing Rs.80,000. The projected life of the
machine is 8 years and has an expected salvage value of Rs.6,000 at the end of 8 [Link] annual operating
cost of the machine is Rs.7,500. It is expected to generate revenues of Rs.40,000 per year for eight
[Link] the hospital is outsourcing the diagnostic work and is earning commission income of
Rs.12,000 per annum, net of taxes. Whether it would be profitable for the hospital to purchase the machine?
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure (80,000)
Working capital -
Initial outflow (80,000)

WN 2: In-between cash flows:

Particulars Year 1 to 8
Revenues 40,000
Less: Operating costs (7,500)
Less: Commission (12,000/75%) (16,000)
[Opportunity cost]

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PBDT 16,500
Less: Depreciation (80,000 – 6,000)/8 (9,250)
PBT 7,250
Less: Tax @ 25% (1,813)
PAT 5,437
Add: Depreciation 9,250
CFAT 14,687
Note:
• It is assumed that income tax rate is 25%
• Commission is an opportunity cost as the same would be lost after purchase of diagnostic machine.
The amount is after-tax and hence it is converted to PBT level to make it comparable

WN 3: Terminal flow:
Particulars Amount
Sale value 6,000
Less: Book value (6,000)
Capital gain 0
Tax paid 0

Net salvage value 6,000

WN 4: Consolidation of cash flows and computation of NPV:

It is assumed that discount rate (cost of capital) is 10%
Year Cash flow PVF @ 10% DCF
0 (80,000) 1.000 (80,000)
1 to 8 14,687 5.335 78,355
8 6,000 0.467 2,802
NPV 1,157
Conclusion: The company should go ahead with purchase of machine due to positive NPV

14. Adjusted Present Value Approach [May 2018, SM]

XYZ Ltd. is presently all equity financed. The directors of the company have been evaluating investment
in a project which will require Rs.270 lakhs capital expenditure on new machinery. They expect the capital
investment to provide annual cash flows of Rs.42 lakhs indefinitely which is net of all tax adjustments. The
discount rate which it applies to such investment decisions is 14% net.

The directors of the company believe that the current capital structure fails to take advantage of tax benefits
of debt and propose to finance the new project with undated perpetual debt secured on the company's
assets. The company intends to issue sufficient debt to cover the cost of capital expenditure and the after
tax cost of issue.

The current annual gross rate of interest required by the market on corporate undated debt of similar risk
is 10%. The after tax costs of issue are expected to be Rs.10 lakhs. Company's tax rate is 30%.

You are REQUIRED to:

(i) Calculate the adjusted present value of the investment,
(ii) Calculate the adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may be used to evaluate future
investments.
Answer:
WN 1: Computation of adjusted present value:
Adjusted Present Value = Base Case NPV – Issue costs + PV of financing benefit

Note 1: Computation of Base Case NPV:

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• Base Case NPV is computed assuming no debt funding for the project and the cash flows are
discounted at the rate given for the investment decision

42
Base Case NPV = PV of inflows − PV of outflows = ( ) − 270 = 300 − 270 = Rs. 30 lacs
14%

Note 2: PV of financing benefit:

• Cost of the project is Rs.270 lacs and the issue expenses is Rs.10 lacs. Hence the company has to
raise debt of Rs.280 lacs
• Interest paid on debt of Rs.280 lacs = 280 lacs x 10% = Rs.28 lacs
• Tax benefit on interest = 28 lacs x 30% = Rs.8.4 lacs
• Hence company would have a perpetual benefit of Rs.8.4 lacs due to raising of debt and the Present
value of the same would be computed in the same manner of valuing perpetuity
• Value of financing benefit = [8.4 lacs/10%] = Rs.84 lacs

Adjusted NPV = 30 lacs – 10 lacs + 84 lacs = Rs.104 lacs

WN 2: Computation of Adjusted Discount Rate:

• Adjusted discount rate would refer to that rate which would give adjusted NPV of the project as
zero
X
−104 = ( ) − 280; X = 176 x 14% = 𝐑𝐬. 𝟐𝟒. 𝟔𝟒 𝐥𝐚𝐜𝐬
14%
• Company will have zero adjusted NPV if the income every year is Rs.24.64 lacs
𝐈𝐧𝐜𝐨𝐦𝐞 𝟐𝟒. 𝟔𝟒
𝐀𝐝𝐣𝐮𝐬𝐭𝐞𝐝 𝐝𝐢𝐬𝐜𝐨𝐮𝐧𝐭 𝐫𝐚𝐭𝐞 = = 𝒙 𝟏𝟎𝟎 = 𝟖. 𝟖%
𝐀𝐦𝐨𝐮𝐧𝐭 𝐢𝐧𝐯𝐞𝐬𝐭𝐞𝐝 𝐢𝐧𝐜𝐥𝐮𝐝𝐢𝐧𝐠 𝐢𝐬𝐬𝐮𝐞 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬 𝟐𝟖𝟎

Useable circumstances:
This ADR may be used to evaluate future investments only if the business risk of the new venture is
identical to the one being evaluated here and the project is to be financed by the same method on the same
terms. The effect on the company’s cost of capital of introducing debt into the capital structure cannot be
ignored

15. Revenue enhancement and cost Reduction [Nov 2020 RTP, SM]
A large profit making company is considering the installation of a machine to process the waste produced
by one of its existing manufacturing process to be converted into a marketable product. At present, the
waste is removed by a contractor for disposal on payment by the company of Rs.150 lakh per annum for
the next four [Link] contract can be terminated upon installation of the aforesaid machine on payment
of a compensation of Rs.90 lakh before the processing operation starts. This compensation is not allowed
as deduction for tax purposes.

The machine required for carrying out the processing will cost Rs.600 lakh. At the end of the 4th year, the
machine can be sold for Rs.60 lakh and the cost of dismantling and removal will be Rs.45 lakh.

Sales and direct costs of the product emerging from waste processing for 4 years are estimated as under:
Year 1 2 3 4
Sales 966 966 1,254 1,254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per income tax rules) 150 114 84 63

Initial stock of materials required before commencement of the processing operations is Rs.60 lakh at the
start of year 1. The stock levels of materials to be maintained at the end of year 1, 2 and 3 will be Rs.165
lakh and the stocks at the end of year 4 will be nil. The storage of materials will utilise space which would

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otherwise have been rented out for Rs.30 lakh per annum. Labour costs include wages of 40 workers, whose
transfer to this process will
reduce idle time
payments of Rs.45 lakh in the year- 1 and Rs.30 lakh in the year- 2. Factory overheads include
apportionment of general factory overheads except to the extent of insurance charges of Rs.90 lakh per
annum payable on this venture. The company’s tax rate is 30%. Consider cost of capital @ 14% and ignore
tax on capital gains.

ADVISE the management on the desirability of installing the machine for processing the waste. All
calculations should form part of the answer
Answer:
WN 1: Initial outflow:
Particulars Amount (in lacs)
Capital expenditure (600.00)
Compensation paid (90.00)
Working capital (material) (60.00)
Initial outflow (750.00)

WN 2: In-between flows:
Particulars Year 1 Year 2 Year 3 Year 4
Sales 966.00 966.00 1,254.00 1,254.00
Saving in contractor charges 150.00 150.00 150.00 150.00
Less: Material cost -90.00 -120.00 -255.00 -255.00
Less: Wages -180.00 -195.00 -255.00 -300.00
Less: Other expenses -120.00 -135.00 -162.00 -210.00
Less: Factory OH -90.00 -90.00 -90.00 -90.00
Less: Opportunity cost -30.00 -30.00 -30.00 -30.00
Less: Depreciation -150.00 -114.00 -84.00 -63.00
Profit before tax 456.00 432.00 528.00 456.00
Less: Tax @ 30% -136.80 -129.60 -158.40 -136.80
Profit after tax 319.20 302.40 369.60 319.20
Add: Depreciation 150.00 114.00 84.00 63.00
Less: Increase in working capital -105.00 - - -
Cash flow after taxes 364.20 416.40 453.60 382.20

WN 3: Terminal cash flows:

Particulars Amount
Recapture of working capital 165.00
Salvage value 15.00
Total terminal flow 180.00

WN 4: Computation of NPV:
Year Cash flow PVF @ 14% DCF
0 -750.00 1.000 -750.00
1 364.20 0.877 319.40
2 416.40 0.769 320.21
3 453.60 0.674 305.73
4 562.20 0.592 332.82
NPV of Project 528.16
Advice: Since the net present value of cash flows is Rs.528.16 lakh which is positive the management should
install the machine for processing the waste

16. Cost reduction [May 2022 MTP, SM]

Manoranjan Ltd is a News broadcasting channel having its broadcasting Centre in Mumbai. There are total
200 employees in the organisation including top management. As a part of employee benefit expenses, the

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company serves tea or coffee to its employees, which is outsourced from a third -party. The company offers
tea or coffee three times a day to each of its employees. 120 employees prefer tea all three times, 40
employees prefer coffee all three times and remaining prefer tea only once in a day. The third-party charges
Rs.10 for each cup of tea and Rs.15 for each cup of coffee. The company works for 200 days in a year.

Looking at the substantial amount of expenditure on tea and coffee, the finance department has proposed
to the management an installation of a master tea and coffee vending machine which will cost Rs.10,00,000
with a useful life of five [Link] purchasing the machine, the company will have to enter into an annual
maintenance contract with the vendor, which will require a payment of Rs.75,000 every year. The machine
would require electricity consumption of 500 units p.m. and current incremental cost of electricity for the
company is Rs.12 per unit. Apart from these running costs, the company will have to incur the following
consumables expenditure also:
• Packets of Coffee beans at a cost of Rs.90 per packet.
• Packet of tea powder at a cost of Rs.70 per packet.
• Sugar at a cost of Rs.50 per Kg.
• Milk at a cost of Rs.50 per litre.
• Paper cup at a cost of 20 paise per cup

Each packet of coffee beans would produce 200 cups of coffee and same goes for tea powder packet. Each
cup of tea or coffee would consist of 10g of sugar on an average and 100 ml of milk.

The company anticipate that due to ready availability of tea and coffee through vending machines its
employees would end up consuming more tea and coffee. It estimates that the consumption will increase
by on an average 20% for all class of employees. Also, the paper cups consumption will be 10% more than
the actual cups served due to leakages in them.

The company is in the 25% tax bracket and has a current cost of capital at 12% per annum. Straight line
method of depreciation is allowed for the purpose of taxation. You as a financial consultant is required to
ADVISE on the feasibility of acquiring the vending machine.
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure -10,00,000
Working capital 0
Initial outflow -10,00,000

WN 2: In-between flows:
Particulars Calculation Amount
Reduction in tea and coffee cost ([120 x 10 x 3] + [40 x 15 x 3] + 11,60,000
[40 x 10 x 1]) x 200 days
Less: Costs
AMC of machine -75,000
Electricity charges 500 x Rs.12 per unit x 12 months -72,000
Coffee Beans 28,800 -12,960
x 90
200
Tea Powder 96,000 -33,600
x 70
200
Sugar 96,000 + 28,800 x 10 gram -62,400
x 50
1,000 gram
Milk 96,000 + 28,800 x 100 ml -6,24,000
x 50
1,000 ml
Paper cup (96,000 + 28,800) x 1.1 x 0.20 -27,456
Depreciation 10,00,000/5 -2,00,000
Profit before tax 52,584
Less: Tax @ 25% -13,146
Profit after tax 39,438

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Add: Depreciation 2,00,000
Cash flow after taxes 2,39,438
Note:
• No of Tea Cups = [120 x 3 x 200 days] + [40 x 1 x 200 days] x 1.20 = 96,000 cups
• No of coffee cups = 40 x 3 x 200 days x 1.2 = 28,800 cups

WN 3: Salvage Value:
Particulars Amount
Net salvage value 0
Recapture of Working capital 0
Terminal Flow 0

WN 4: Computation of NPV:
Year Cash flow PVF @ 12% DCF
0 -10,00,000 1.000 -10,00,000
1 to 5 2,39,438 3.6048 8,63,126
Net Present Value -1,36,874
Since NPV of the machine is negative, it should not be purchased.

17. Investment Decision – Payment of expenses in advance – Block of Assets Method (May 2022,
May 2024, Sep 2024 MTP):
Parmarth Limited is a manufacturer of computers. Owing to recent developments in Artificial Intelligence
(AI), it is planning to introduce AI in its computer process. This would result annual savings as follows:
• Savings of Rs. 3,50,000 in production delays caused by inventory problem.
• Savings in Salaries of 5 employees with an annual pay of Rs. 4,20,000 per annum
• Reduction in Lost sales of Rs. 1,75,000
• Gain due to timely billing is Rs. 3,25,000

The project would result in annual maintenance and operating costs as follows, which are to be paid in
advance (at the beginning)
Year 1 2 3 4 5
Cost 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000
Furthermore, the new system would need 2 AI specialists' professional drawing salaries of Rs. 6,50,000 per
annum per person. The purchase price of the new system for installing AI into computers would involve
an outlay of Rs. 21,50,000 and installation cost of Rs. 1,50,000.

75% of the total value for depreciation would be paid in the year of purchase and the balance would be
paid at the end of the 1st year. The new system will be sold for Rs. 1,90,000. This is the only asset in the
block for Income tax purpose.

The life of the system would be 5 years with the hurdle rate of 12%. Depreciation will be charged at 40%
on WDV basis, corporate tax rate is 25% and capital gains tax rate is at 20%.

CALCULATE NPV and advise the management on the acceptability of the proposal. Also calculate ARR
& PI.
Answer:
WN 1: Initial outflow:
Particulars Amount
1. Capital expenditure including installation expenses [23,00,000 x 75%] -17,25,000
2. Working capital -
3. Maintenance and operating cost [Year 1 CF] -1,80,000
Initial outflow -19,05,000
Note:
• Only 75 percent of depreciable value (includes installation cost) is paid on day 0 and hence
Rs.17,25,000 is considered as initial outflow for purchase of asset
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• Maintenance and operating cost is paid in advance and hence first year maintenance cost would
have been paid immediately

WN 2: In-between flows:
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
1. Saving in salaries 21,00,000 21,00,000 21,00,000 21,00,000 21,00,000
2. Reduction in prod delay cost 3,50,000 3,50,000 3,50,000 3,50,000 3,50,000
3. Reduction in lost sales 1,75,000 1,75,000 1,75,000 1,75,000 1,75,000
4. Gain due to timely billing 3,25,000 3,25,000 3,25,000 3,25,000 3,25,000
5. Less: Computer specialist cost -13,00,000 -13,00,000 -13,00,000 -13,00,000 -13,00,000
6. Less: Maintenance and operating cost -1,80,000 -2,00,000 -1,20,000 -1,10,000 -1,30,000
7. Less: Depreciation [Note 1 -9,20,000 -5,52,000 -3,31,200 -1,98,720 -1,19,232
8. Profit before tax 5,50,000 8,98,000 11,98,800 13,41,280 14,00,768
9. Less: Tax @ 30% -1,37,500 -2,24,500 -2,99,700 -3,35,320 -3,50,192
10. Profit after tax 4,12,500 6,73,500 8,99,100 10,05,960 10,50,576
11. Add: Depreciation 9,20,000 5,52,000 3,31,200 1,98,720 1,19,232
12. Add: Maintenance cost 1,80,000 2,00,000 1,20,000 1,10,000 1,30,000
13. Less: Maintenance cost -2,00,000 -1,20,000 -1,10,000 -1,30,000 -
14. Less: Payment for original machine -5,75,000 - - - -
15. Revised CFAT 7,37,500 13,05,500 12,40,300 11,84,680 12,99,808
Note:
• Maintenance cost of respective year has been subtracted while computing PBT. This is because tax
liability will be based on profit of respective years. However, the same was added back post PAT
computation.
• We have then subtracted the maintenance cost based on payments made. For instance,
maintenance cost of year 2 is paid in year 1 and hence the same was subtracted in first year cash
flows
• The company had paid the balance 25 percent of the depreciable value in year 1 and hence the
same was subtracted while computing CFAT.

Note 1: Computation of depreciation

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening WDV 23,00,000 13,80,000 8,28,000 4,96,800 2,98,080
Less: Depreciation @ 40% -9,20,000 -5,52,000 -3,31,200 -1,98,720 -1,19,232
Closing WDV 13,80,000 8,28,000 4,96,800 2,98,080 1,78,848

WN 3: Terminal Flow:
Particulars Amount
1. Net salvage value -
2. Recapture of working capital -
3. Total terminal flow -

Note 1: Computation of net salvage value

Particulars Amount
Sale value 1,90,000
Less: Book value 1,78,848
Capital Gain 11,152
Tax paid @ 20% 2,230
Net salvage value 1,87,770

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WN 4: Computation of NPV and Profitability Index:
Year Cash flow PVF @ 12% DCF
0 -19,05,000 1 -19,05,000
1 7,37,500 0.893 6,58,588
2 13,05,500 0.797 10,40,484
3 12,40,300 0.712 8,83,094
4 11,84,680 0.636 7,53,456
14,87,578
0.567 8,43,457
5 [12,99,808 + 1,87,770]
NPV 22,74,079
Profitability index
[41,79,079/19,05,000] 2.19 Times

Average PAT 8,08,327

ARR on initial investment = 𝑥 100 = 𝑥 100 = 35.145%
Initial investment 23,00,000
Note:
4,12,500 + 6,73,500 + 8,99,100 + 10,05,960 + 10,50,576
Average PAT = = 8,08,327
5

Alternative answer for Profitability Index:

• PV of outflow = 17,25,000 in year 0 + 5,75,000 in year 1 = 17,25,000 + (5,75,000 x 0.893) = 22,38,475
PV of inflow NPV + Outflow 22,74,079 + 22,38,475
PI = = = = 2.02 Times
PV of outflow outflow 22,38,475

18. Investment Decision with only outflows and tax saving on depreciation [Nov 2022]
A firm is in need of a small vehicle to make deliveries. It is intending to choose between two options. One
option is to buy a new three wheeler that would cost Rs. 1,50,000 and will remain in service for 10 years.
The other alternative is to buy a second hand vehicle for Rs. 80,000 that could remain in service for 5 years.
Thereafter the firm, can buy another second hand vehicle for Rs. 60,000 that will last for another 5 years.
The scrap value of the discarded vehicle will be equal to it written down value (WDV). The firm pays 30%
tax and is allowed to claim depreciation on vehicles @ 25% on WDV basis. The cost of capital of the firm is
12%. You are required to advise the best option
Answer:
WN 1: Computation of depreciation of new vehicle and Second-hand vehicle:
New Vehicle:
Year Opening balance Depreciation Closing Balance Tax Benefit
1 1,50,000 37,500 1,12,500 11,250
2 1,12,500 28,125 84,375 8,438
3 84,375 21,094 63,281 6,328
4 63,281 15,820 47,461 4,746
5 47,461 11,865 35,596 3,560
6 35,596 8,899 26,697 2,670
7 26,697 6,674 20,023 2,002
8 20,023 5,006 15,017 1,502
9 15,017 3,754 11,263 1,126
10 11,263 2,816 8,447 845
• Tax benefit = Depreciation x Rate of tax (30%)
• Other relevant cash flow from the above table would be salvage value inflow in year 10 of Rs.8,447

Second-hand vehicle
Year Opening balance Depreciation Closing Balance Tax Benefit
1 80,000 20,000 60,000 6,000

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2 60,000 15,000 45,000 4,500
3 45,000 11,250 33,750 3,375
4 33,750 8,438 25,312 2,531
5 25,312 6,328 18,984 1,898
6 60,000 15,000 45,000 4,500
7 45,000 11,250 33,750 3,375
8 33,750 8,438 25,312 2,531
9 25,312 6,328 18,984 1,898
10 18,984 4,746 14,238 1,424
• Relevant cash flows are salvage value inflow of Rs.18,984 and Rs.14,238 in year 5 and 10
respectively

WN 2: Computation of PV of outflow:
New Machine:
Year Cash flow PVF @ 12% DCF
0 -1,50,000 1.000 -1,50,000
1 11,250 0.893 10,046
2 8,438 0.797 6,725
3 6,328 0.712 4,506
4 4,746 0.636 3,018
5 3,560 0.567 2,019
6 2,670 0.507 1,354
7 2,002 0.452 905
8 1,502 0.404 607
9 1,126 0.361 406
10 9,292 0.322 2,992
PV of outflow -1,17,422
• Year 10 inflow = 845 + 8,447 = Rs.9,292

Second-hand machine:
Year Cash flow PVF @ 12% DCF
0 -80,000 1.000 -80,000
1 6,000 0.893 5,358
2 4,500 0.797 3,587
3 3,375 0.712 2,403
4 2,531 0.636 1,610
5 -39,118 0.567 -22,180
6 4,500 0.507 2,282
7 3,375 0.452 1,526
8 2,531 0.404 1,023
9 1,898 0.361 685
10 15,662 0.322 5,043
PV of outflow -78,663
• Year 5 cash flow = 1,898 + 18,984 – 60,000 = -39,118
• Year 10 cash flow = 1,424 + 14,238 = Rs.15,662

Conclusion:
• The PV of net outflow is low in case of buying the second hand vehicles. Therefore, it is advisable
to buy second hand vehicles

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19. Investment decision with only outflow and ignoring tax effect [May 2014 RTP]
Best Luck company is considering building an assembly plant and the company has two options, out of
which it wishes to choose the best plant. The projected output is 10,000 units per month. The following data
are available:
Particulars Plant A Plant B
Initial cost 60,00,000 44,00,000
Direct labour cost p.a. (1st shift) 30,00,000 15,00,000
(2nd shift) - 19,00,000
Overhead (per year) 5,00,000 4,20,000
Both the plants have an expected life of 10 years after which there will be no salvage value. The cost of
capital is 10%. The present value of an ordinary annuity of Re.1 for 10 years @ 10% is 6.1446. Ignore effect
of taxation.
You are required to determine:
• What would be the desirable choice?
Answer:
Computation of present value of outflow:
Cash flow DCF
Year Plant A Plant B PVF @ 10% Plant A Plant B
0 60,00,000 44,00,000 1.0000 60,00,000 44,00,000
1 to 10 35,00,000 38,20,000 6.1446 2,15,06,100 2,34,72,372
PV of outflow 2,75,06,100 2,78,72,372
Conclusion: The company should go ahead with Plant A as it has lower PV of outflow

20. Investment Decision [May 2023 MTP]

Rambow Ltd. is contemplating purchasing machinery that would cost Rs. 10,00,000 plus GST@ 18% at the
beginning of year 1. Cash inflows after tax from operations have been estimated at Rs. 2,56,000 per annum
for 5 years. The company has two options for the smooth functioning of the machinery - one is service, and
another is replacement of parts. The company has the option to service a part of the machinery at the end
of each of the years 2 and 4 at Rs. 1,00,000 plus GST @ 18% for each year. In such a case, the scrap value at
the end of year 5 will be Rs. 76,000. However, if the company decides not to service the part, then it will
have to be replaced at the end of year 3 at Rs. 3,00,000 plus GST@ 18% and in this case, the machinery will
work for the 6th year also and get operational cash inflow of Rs. 1,86,000 for the 6th year. It will have to be
scrapped at the end of year 6 at Rs. 1,36,000.

Assume cost of capital at 12% and GST paid on all inputs including capital goods are eligible for input tax
credit in the same month as and when incurred.

(i) DECIDE whether the machinery should be purchased under option 1 or under option 2 or it shouldn’t
be purchased at all.
(ii) If the supplier gives a discount of Rs. 90,000 for purchase, WHAT would be your decision?
Note: Use 4 decimal PVF for decision making
Answer:
Evaluation of option 1:
Year Cash flow PVF @ 12% DCF
0 -10,00,000 1.0000 -10,00,000
1 2,56,000 0.8928 2,28,557
1,56,000
2 [2,56,000 – 1,00,000] 0.7972 1,24,363
3 2,56,000 0.7118 1,82,221
1,56,000
4 [2,56,000 – 1,00,000] 0.6355 99,138
3,32,000
5 [2,56,000 + 76,000] 0.5674 1,88,377
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NPV -1,77,344
NPV with discount -87,344
• NPV is negative and hence option 1 is not viable with/without discount

Evaluation of option 2
Year Cash flow PVF @ 12% DCF
0 -10,00,000 1.0000 -10,00,000
1 2,56,000 0.8928 2,28,557
2 2,56,000 0.7972 2,04,083
-44,000
3 [2,56,000 – 3,00,000] 0.7118 -31,319
4 2,56,000 0.6355 1,62,688
5 2,56,000 0.5674 1,45,254
3,22,000
6 [1,86,000 + 1,36,000] 0.5066 1,63,125
NPV -1,27,612
NPV with discount -37,612
• NPV is negative and hence option 2 is not viable with/without discount
Decision: The Machinery should not be purchased as it will earn a negative NPV in both options of repair
and replacement.

21. WACC and investment decision [Sep 2024 MTP]

Kaivalyabodhi Limited (KbL) has completed 35 years of operations in India. It has many subsidiary &
associate companies in more than 100 countries. KbL’s business s include home and personal care, foods
and beverages, and industrial, agricultural and other products. It is one of the largest producers of soaps
and detergents in India. The company has grown organically as well as through acquisitions. Over the
years, the company has built a diverse portfolio of powerful brands, some being household names.

It is planning to acquire one of its competitors named Prestige Limited, which would enhance the growth
of ‘KbL’. The consideration amount will be 1.5X of its average Market Capitalization. Prestige limited has
1,30,000 outstanding equity shares and its shares were traded at an average market price of Rs. 45 as on the
valuation date. The consideration amount will be paid equally in 5 years where the first installment is to
be paid immediately. Prestige Limited has Ko of 15%

KbL will raise the funds required through debt and equity in the ratio of 30:70. The company requires the
cost of capital estimates for evaluating its acquisitions, investment decisions and the performance of its
businesses.

KbL’s share price has grown from Rs. 150 to Rs. 301 in the last 5 years and it will continue to grow at the
same rate. KbL pays dividends regularly. The company has recently paid a dividend of Rs. 8. For the
calculation of equity, an average of 52 weeks high market price in the last 5 years is to be considered, which
is as follows:
Year 1 Year 2 Year 3 Year 4 Year 5
MPS 195 MPS 210 MPS 252 MPS 325 MPS 280

Ke calculated as per growth model holds a weight of 0.6.

The company also wishes to calculate the equity’s expectation using CAPM which holds a weight of 0.4.
The risk-free rate is assumed as the yield on long-term government bonds that the company regards as
about 8%. KbL regards the market risk premium to be equal to 11 per cent. Its estimation on the Beta is
0.78.

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KbL will issue debentures with FV of Rs. 10,500 which is to be amortised equally over the life of 7 years.
The company considers the effective rate of interest applicable to an ‘AAA’ rated company with a markup
of 200 basis points as its coupon rate. It thinks that considering the trends over the years, ‘AAA’ rate is
7.5%.

Ignore taxation. Based on the above details, answer the question 1 to 5:

Question No.1: Calculate the cost of equity under both the methods
a. 11%, 16% b. 18.65%, 10.34%
c. 18.65%, 16.58% d. 16.5%, 9%
Question No.2: Calculate the overall cost of equity
a. 17.82% b. 17.63%
c. 15.37% d. 35.25%
Question No.3: Calculate the cost of debt, if the intrinsic value of debenture today is close to Rs. 9,740
a. 15% b. 12%
c. 9.5% d. 7.5%
Question No.4: Calculate the WACC & the amount of purchase consideration
a. 18%, Rs. 90,00,000 b. 15.21%, Rs. 87,75,000
c. 16.07%, Rs. 87,75,000 d. 15.94%, Rs. 58,50,000
Question No.5: Present Value of Purchase consideration is close to Rs.
a. 58,83,032 b. 67,65,487
c. 57,35,680 d. 66,58,997
Answer:
Question No.1 – 18.65% and 16.58%
Cost of equity under Method 1 (Dividend with growth model)
D1 9.20
Ke = +G= + 0.15 = 0.0365 + 0.15 = 𝟎. 𝟏𝟖𝟔𝟓 (𝐨𝐫)𝟏𝟖. 𝟔𝟓%
P0 252.40
Where:
• Price = Average of last 5 year prices as per question = 252.40
• Growth is computed by considering the growth in share price; Share price has increased from
Rs.150 to Rs.301 in 5 years and this would translate into growth rate of
Year Cash flow PVF @ 14% DCF PVF @ 15% DCF
0 -150 1.000 -150.00 1.000 -150.00
5 301 0.519 156.22 0.497 149.60
NPV 6.22 -0.40
6.22
IRR (Growth Rate) = 14 + 𝑥 (15 − 14) = 14 + 0.94 = 14.94% ~ 15.00%
6.22 − (−0.40)
• Next Dividend = 8 + 15.00% growth = Rs.9.20

Cost of equity under Method 2 (CAPM Approach)

K e = 𝑅𝑓 + 𝛽(𝑅𝑚 − 𝑅𝑓 ) = 8 + 0.78 𝑥 11 = 16.58%

Question No.2
Cost of equity = [18.65 x 0.60] + [16.58 x 0.40] = 17.82%
Question No.3 – 12.00%
In this question we have to compute cost of debt using IRR method
Year Cash flow PVF @ 12% DCF
0 9,740.00 1 9,740.00
-2,497.50
1 [10,500 x 9.5% + 1,500] 0.893 -2,230.27
-2,355.00
2 [9,000 x 9.5% + 1,500] 0.797 -1,876.94
-2,212.50
3 [7,500 x 9.5% + 1,500] 0.712 -1,575.30
4 -2,070.00 0.636 -1,316.52

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[6,000 x 9.5% + 1,500]
-1,927.50
5 [4,500 x 9.5% + 1,500] 0.567 -1,092.89
-1,785.00
6 [3,000 x 9.5% + 1,500] 0.507 -905.00
-1,642.50
7 [1,500 x 9.5% + 1,500] 0.452 -742.41
0.67
Note:
• Interest rate of bond = 7.5% + 2.00% = 9.50%
• NPV of cash flows is closer to zero and hence IRR (cost of debt) equal to 12%
Question No.4 – 16.07% and Rs.87,75,000
• WACC = (17.82% x 0.70 + 12% x 0.30] = 16.07%
• Purchase consideration = 1.5 times of market capitalization = 1.5 x (1,30,000 x 45) =
Rs.87,75,000
• Market capitalization = Market Value of equity shares
Question No.5 – Rs.66,58,997
Year Cash flow PVF @ 16.07% DCF
0 17,55,000 1 17,55,000
1 17,55,000 0.862 15,12,810
2 17,55,000 0.742 13,02,210
3 17,55,000 0.639 11,21,445
4 17,55,000 0.551 9,67,005
66,58,470
• Present value of consideration paid = Rs.66,58,470 ~ Rs.66,58,997

22. Comprehensive Capital Budgeting Question [Sep 2024 RTP]

Mr. Ronak, a doctor by profession, has his own private hospital at Goa having specialization in cardiac
treatments. However, now-a-days, Goa not only being a place for the tourists, but is also a place for
business delegates, cultural people, politicians, students and other classes of people. Gradually, Goa is
opening new windows for businesses and getting recognition as an important tourist and leisure hub in
South West India.

There are a number of hotels and resorts at Goa. However, the need still exists for more hotel services, in
particular with the excellent service, and because of the large number of visitors from all over the country
and all walks of life always favour Goa state for their recreation.

Mr. Ronak although being a doctor by profession is contemplating to establish a five-star hotel at Goa. The
hotel will consist of 5 floors. The hotel will include 40 normal rooms and 8 deluxe suites, as well as a
restaurant and couple of conference rooms with a small wedding hall on the ground floor. Following are
the estimated occupancy rate including fare composition in the Table 1. Being a five-star hotel, breakfast
would be complementary but lunch and dinner are on a-la-carte basis.

Table 1: Hotel accommodation, estimated occupancy rate and fare.

Types of Facilities Numbers Occupancy Average Rent per Room Growth Rate in
Rate per Day Rent
Normal Room 40 33% or 120 Rs.8,000 12%
days
Deluxe Suites 8 33% or 120 Rs.25,000 9%
days
Conference with 2 40 days Rs.3,00,000 9%
wedding hall
Restaurant 1 All days Rs.27,000 sales per day 8%
For the sake of simplicity in calculation, growth rate to be applied only once after completion of 10 years.
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The estimated cost of land will be Rs. 250 million and the construction cost will be Rs. 100 million. The
estimated salvage value at the end of 15th year will be 25% of the cost of construction. The cost of furniture
will be of Rs. 1,50,000 for each normal room and Rs. 3,80,000 for each deluxe suite. The cost of the furniture
for the conference room with wedding hall will be Rs. 7,00,000 each and for restaurant it will be 10,00,000.
In addition, the hotel will require 4 elevators at different locations and will be costing around Rs. 35,00,000
each. The cost of buying and installing electronic appliances like TV sets, Air conditioners, Fridge etc. will
be around Rs. 35 million. Elevators would be depreciated at a rate of 5% p.a. Electronic appliances will
have a salvage value of 15% of its acquisition cost at the end of 15 years.

The hotel will be built by renowned builder named ‘Harihar Infrastructure’. The builder estimated that
building will survive for 15 years. The required furniture will be supplied by the local reputed furniture
company named Veru Furnishings Ltd. They ensured that furniture will go for 10 years very smoothly. At
the end of tenth year, new furniture for normal rooms and deluxe suites will be bought and old furniture
for the same will be sold by the hotel owner. The owner of the hotel estimates that he would be able to
purchase the required furniture at 15% higher price than the previous purchase price. The salvage values
of the furniture at the end of tenth year will be 5% of their purchase prices with no book value remaining.
Furniture at restaurant, conference and wedding hall will not require any major changes as such except for
minor renovation which will cost Rs. 20,00,000 in total at the end of 12th year. Any scrap generated on
account of such renovation will be sold at Rs. 1,75,000.

In order to boost the tourism industry at Goa, the state govt will be granting subsidy of 15% on the initial
capex incurred, it will be paid at the time of cost incurred and additional subsidy of 10% on annual revenue
expenses for the first 3 years of operation, but will be credited directly in the bank account only at the end
of 5th year and the same shall be non-taxable.

The total annual recurring expenses will be Rs. 1,80,00,000/-. It includes salaries to managers, staff and
employees, utilities expenses, house keeping and security services’ contract, AMC for electronic appliances,
restaurant supplies and materials, other miscellaneous expenses, etc.

After the end of 10 years, annual recurring expenses will increase at a rate of 10% which is to be applied
once. Furthermore, the hotel authority is determined to provide the best and professional hotel services to
the clients by offering training to the employees. They decided to spend Rs. 5,00,000 per year for the
purpose of training of the employees.

The hotel project will be entitled to enjoy tax holiday for the first five years after which the corporate tax
rate of 25% will also be applied for the hotel. The Cost of equity for the company is 12% and the
estimated hurdle rate by considering the structure of capital of the proposed hotel is fixed at 15%.

(Depreciation to be taken on SLM basis and assume 360 days in a year. Ignore depreciation on furniture
used in restaurant, conference and wedding hall)
Based on above, please answer to the following MCQs.
Question No.1: The amount of net initial investment required is:
a. Rs.41.044 Crores b. Rs.34.887 Crores
c. Rs.6.156 Crores d. Rs.40.74 Crores

Question No.2: NPV of the project is:

a. Rs.7.0532 Crores b. Rs.8.4029 Crores
c. Rs.8.4935 Crores d. Rs.2.4700 Crores

Question No.3: Pay Back period of the project to recover the initial investment is:
a. 5.12 years b. 12.02 years

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c. 11.80 years d. 4.46 years

Question No.4: Estimated Recurring accounting profit/(loss) for first three years are:
a. Rs.7.0928 Crore per annum b. Rs.6.9078 Crores per annum
c. Rs.6.9937 Crore per annum d. Rs.9.6120 Crore per annum

Question No.5: IRR of the project is:

a. 16.25% b. 19.39%
c. 15% d. 12%
Answer:
Solution:
Question No.1 Option (B) – Rs.34.887 Crores (WN 1)
Question No.2 Option (A) – Rs.7.0532 Crores (WN 4)
Note: Rs.7.0595 Crores rounded off to closest Rs.7.0532 Crores
Question No.3 Option (D) – 4.46 years (WN 5)
Question No.4 Option (A) – Rs.7.0928 Crores
PAT + Subsidy = 690.7787 lacs + 18.5 lacs = 709.2787 lacs
Question No.5 Option (B) – 19.39% (WN 4)

WN 1: Initial outflow:
Particulars Amount (in lacs)
Land -2500.00
Construction Cost -1000.00
Furniture cost (1,50,000 x 40 + -114.40
3,80,000 x 8 + 7,00,000 x 2 + 10,00,000)
Elevator cost (35,00,000 x 4) -140.00
Electronic appliances -350.00
Initial Outflow -4104.40
Subsidy (4104.40 x 15%) 615.66
Net outflow -3488.74

WN 2: In-between recurring flows

Particulars Year 1 to 5 Year 6 to 10 Year 11 to 15
Revenues
Normal room 384.00 384.00 430.08
[8,000 x 40 x 120] [8,000 x 40 x 120] [8,000 x 40 x 120 x 1.12]
Deluxe Suites 240 240 261.60
[25,000 x 8 x 120] [25,000 x 8 x 120] [25,000 x 8 x 120 x 1.09]
Conference 240 240 261.60
[2 x 3,00,000 x 40] [2 x 3,00,000 x 40] [2 x 3,00,000 x 40 x 1.09]
Restaurant 97.20 97.20 104.976
[27,000 x 360] [27,000 x 360] [27,000 x 360 x 1.08]
Total Revenues 961.20 961.20 1058.256
Less: Expenses:
Recurring expenses -180.00 -180.00 -198.00
Training expense -5.00 -5.00 -5.00
Depreciation:
Construction cost -50.00 -50.00 -50.00
1000 − 250
[ ]
15
Furniture of rooms 8.588 8.588 10.396
(Note) 90.4 − 4.52 90.4 − 4.52 103.96 − 0
[ ] [ ] [ ]
10 10 10
Elevators 7.00 7.00 7.00
[1.4 Cr x 5%] [1.4 Cr x 5%] [1.4 Cr x 5%]
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Electronic appliance 19.8333 19.8333 19.8333
350 − 52.5 350 − 52.5 350 − 52.5
[ ] [ ] [ ]
15 15 15
Profit before tax 690.7787 690.7787 768.0267
Less: Tax @ 25% 0 -172.6947 -192.0067
Profit after tax 690.7787 518.0840 576.0200
Add: Depreciation 85.4213 85.4213 87.2293
Cash flow after tax 776.2000 603.5053 663.2493
Note:
• Question has indicated that no book value will remain at end of 10th year and hence salvage value
should not be subtracted while computing depreciation of furniture. However, we have answered
this as per ICAI solution

WN 3: In-between one-time cash flows:

Particulars Year 5 Year 10 Year 12 Year 15
Purchase of furniture -103.96
[90.4 lacs x 1.15]
Renovation expense -18.25
[20 – 1.25]
Subsidy 55.50
[ 185 x 10% x 3 year]
Salvage value of Old furniture 4.5200
[90.4 lacs x 5%]
Salvage value of building 250.00
[1000 x 25%]
Salvage value of 52.50
Electronic appliances [350 x 15%]
Salvage value of Land 0.00
(Ignored as per ICAI solution)
Total Cash flow 55.50 -99.44 -18.25 302.50

WN 4: Computation of NPV and IRR

Year Cash flow PVF @ 15% DCF PVF @ 20% DCF
0 -3488.74 1 -3488.74 1 -3488.74
1 776.2 0.87 675.29 0.833 646.575
2 776.2 0.756 586.81 0.694 538.683
3 776.2 0.658 510.74 0.579 449.42
4 776.2 0.572 443.99 0.482 374.128
831.7
5 [776.20 + 55.50] 0.497 413.35 0.402 334.343
6 603.5053 0.432 260.71 0.335 202.174
7 603.5053 0.376 226.92 0.279 168.378
8 603.5053 0.327 197.35 0.233 140.617
9 603.5053 0.284 171.4 0.194 117.08
504.0653
10 [603.5053 – 99.44] 0.247 124.5 0.162 81.659
11 663.2493 0.215 142.6 0.135 89.539
644.9993
12 [663.2493 – 18.25] 0.187 120.61 0.112 72.24
13 663.2493 0.163 108.11 0.093 61.682
14 663.2493 0.141 93.52 0.078 51.733
965.7493
15 [663.2493 + 302.50] 0.123 118.79 0.065 62.77
NPV 705.95 -97.73

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705.95 705.95
IRR = 15% + 𝑥 (20 − 15) = 15% + ( ) 𝑥 5% = 15% + 4.39% = 19.39%
705.95 − (−97.73) 803.68

WN 5: Computation of normal payback:

Year Cash flow Cum CF
0 -3488.74 -3488.74
1 776.2 -2712.54
2 776.2 -1936.34
3 776.2 -1160.14
4 776.2 -383.94
5 831.7 447.76
unrecovered CF of base year 383.94
Payback = Base year + =4+( ) = 4.46 years
cash flow of next year 831.70

Part 3 – EAB and EAC Analysis

23. Life Disparity - EAB

A firm, whose cost of capital is 10%, is evaluating the following two projects whose annual CFAT (in ‘000s)
are provided along side.

Year 0 1 2 3 4
X (200) 240 0 0 0
Y (200) 0 0 0 350
Compute NPV, IRR and EAB of each project. Is there a ranking conflict? If so resolve the conflict.
Answer:
WN 1: Computation of NPV:
Project X:
Year Cash flow PVF @ 10% DCF
0 -2,00,000 1.000 -2,00,000
1 2,40,000 0.909 2,18,160
NPV 18,160

Project Y:
Year Cash flow PVF @ 10% DCF
0 -2,00,000 1.000 -2,00,000
4 3,50,000 0.683 2,39,050
NPV 39,050

WN 2: Computation of IRR:
Project X:
Basic Information:
Present value (outflow) 2,00,000
IRR (rate of interest) ?
n (time period) 1 year
Future value (Amount) 2,40,000

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
2,40,000 = 2,00,000 x (1 + r)
2,40,000
(1 + r) = ; 𝐫 = 𝟐𝟎%
2,00,000
Hence IRR of the cash flow is 20%

Project Y:
Basic Information:

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Present value (outflow) 2,00,000
IRR (rate of interest) ?
n (time period) 4 years
Future value (Amount) 3,50,000

𝐀𝐦𝐨𝐮𝐧𝐭 = 𝐏 𝐱 (𝟏 + 𝐫)𝐧
3,50,000 = 2,00,000 x (1 + r)4
3,50,000
(1 + r)4 =
2,00,000
(1 + r)4 = 1.75
(1 + r) = 1.1502; 𝐫 = 𝟏𝟓. 𝟎𝟐%
Hence IRR of the cash flow is 15.02%.

WN 3: Analysis of conflict:
Particulars NPV IRR
Project X 18,160 20%
Project Y 39,050 15.02%
Choice Y X
• There is a conflict in ranking as NPV prefers Project Y whereas IRR prefers Project X. This conflict
arises due to change in reinvestment assumption
• NPV assumes that cash flows are reinvested at cost of capital whereas IRR assumes that cash flows
are reinvested at IRR
• Life of Project X is 1 year whereas life of Project Y is 4 [Link] is a situation of life disparity and
we need to compute Equated Annual Benefit (EAB) to resolve the conflict

WN 4: Computation of EAB:
Particulars Project X Project Y
NPV 18,160 39,050
Life 1 year 4 years
PVAF 0.909 3.170
𝐍𝐏𝐕 19,978 12,319
𝐄𝐀𝐁 =
𝐏𝐕𝐀𝐅
• Project X has better EAB and hence the company should go ahead with Project X

24. Life Disparity – Replacement Chain Method [SM]

R Pvt. Ltd. is considering modernizing its production facilities and it has two proposals under
consideration. The expected cash flows associated with these projects and their NPV as per discounting
rate of 12% and IRR is as follows:
Year Cash Flow
Project A Project B
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @ 12% 6,49,094 5,15,488
IRR 17.47% 25.20%
IDENTIFY which project should R Pvt. Ltd. Accept on the basis of Replacement Chain method?
Answer:
Although from NPV point of view, Project A appears to be better but from IRR point of view, Project B
appears to be better. Since, both projects have unequal lives, selection on the basis of these two methods
shall not be proper.

Computation of NPV assuming Project B is repeated again from Year 4 to Year 6:

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Year Cash flow PVF @ 12% DCF
0 -20,00,000 1.000 -20,00,000
1 7,00,000 0.893 6,25,100
2 13,00,000 0.797 10,36,100
3 -8,00,000 0.712 -5,69,600
4 7,00,000 0.636 4,45,200
5 13,00,000 0.567 7,37,100
6 12,00,000 0.507 6,08,400
NPV 8,82,300
• Project B gets over in year 3 and we re-invest Rs.20,00,000 again in year 3 and earn cash flows for
year 4 to 6
• Now the project would earn NPV of Rs.8,82,300 as compared to Project A NPV of Rs.6,49,094
• Accordingly, with extended life NPV of Project B it appears to be more attractive.

25. Life Disparity – EAC [Nov 2013, May 2013 RTP, SM]
Company UVW has to make a choice between two identical machines, in terms of capacity ‘A’ and ‘B’.
They have been designed differently, but do exactly the same job.
Machine A costs Rs.7,50,000 and will last for three [Link] costs Rs.2,00,000 per year to run.
Machine B is an economy model costing only Rs.5,00,000 but will last for only two [Link] costs Rs.3,00,000
per year to run.
The cash flows of machine A and B are real cash flows. The opportunity cost of capital is 9%. Which machine
should the company buy?
Answer:
• Question has provided information on outflows only. There is no information on cash inflow. We
should compute PV of outflow to decide the project

WN 1: Computation of PV of outflow:
Machine A:
Year Cash flow PVF @ 9% DCF
0 7,50,000 1.000 7,50,000
1 to 3 2,00,000 2.531 5,06,200
PV of outflow 12,56,200

Machine B:
Year Cash flow PVF @ 9% DCF
0 5,00,000 1.000 5,00,000
1 to 2 3,00,000 1.759 5,27,700
PV of outflow 10,27,700

WN 2: Computation of Equated Annual Cost (EAC):

• Life of two projects is different and hence we have to compute EAC
Particulars Machine A Machine B
PV of outflow 12,56,200 10,27,700
Life 3 year 2 years
PVAF 2.531 1.759
𝐏𝐕 𝐨𝐟 𝐨𝐮𝐭𝐟𝐥𝐨𝐰 4,96,326 5,84,252
𝐄𝐀𝐂 =
𝐏𝐕𝐀𝐅
Company should go ahead with Machine A as it has lower Equated Annual Cost.

Part 4 – Replacement Decision

26. Abandonment decision

A manufacturing firm is re-evaluating an ongoing machine line. Assume the machine line has a 5 year life,
and the expected after tax cash inflows are follows:
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Year 1 2 3 4 5
Cash Flows 30,000 35,000 40,000 45,000 50,000
The machine could be sold today for Rs.1,60,000 after taxes. The appropriate discount rate is 10%. Suggest
whether the machine can be abandoned.
Answer:
WN 1: Initial outflow:
Particulars Amount
NSV of existing asset on day 0
[Opportunity cost if we continue with asset] (1,60,000)
Working capital blocked -
Initial outflow (1,60,000)

WN 2: In-between flows:
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
CFAT 30,000 35,000 40,000 45,000 50,000

WN 3: Terminal flow:
Particulars Amount
NSV of existing asset in year 5 -
Working capital released -
Initial outflow -

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF
0 -1,60,000 1.000 -1,60,000
1 30,000 0.909 27,270
2 35,000 0.826 28,910
3 40,000 0.751 30,040
4 45,000 0.683 30,735
5 50,000 0.621 31,050
NPV -11,995
Conclusion: NPV of continuation option is negative and hence the asset should be immediately discarded
for Rs.1,60,000

27. Replacement decision [Nov 2018 RTP, May 2016 RTP]

MNP Limited is thinking of replacing its existing machine by a new machine, which would cost Rs.60 lakhs.
The company’s current production is 80,000 units, and is expected to increase to 1,00,000 units, if the new
machine is bought. The selling price of the product would remain unchanged at Rs.200 per unit. The
following is the cost of production one unit of product using both the existing and new machine:
Existing Machine New Machine Unit cost (Rs.)
(80,000 units) (1,00,000 units) Difference
Materials 75.00 63.75 (11.25)
Wages & Salaries 51.25 37.50 (13.75)
Supervision 20.00 25.00 5.00
Repairs and Maintenance 11.25 7.50 (3.75)
Power and Fuel 15.50 14.25 (1.25)
Depreciation 0.25 5.00 4.75
Allocated Corporate 10.00 12.50 2.50
Overheads
183.25 165.50 (17.75)
The existing machine has an accounting book value of Rs.1,00,000 and it has been fully depreciated for tax
purpose. It is estimated that machine will be useful for 5 [Link] supplier of the new machine has offered
to accept the old machine for Rs.2,50,000. However, the market price of old machine today is Rs.1,50,000
and it is expected to be Rs.35,000 after 5 year. The new machine has a life of 5 years and a salvage value of
Rs.2,50,000 at the end of its economic life. Assume corporate Income-tax rate at 40% and depreciation is
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charged on straight line basis for Income-tax purpose. The opportunity cost of capital of the Company is
15%.
Required:
Estimate net present value of the replacement decision.
Answer:
WN 1: Initial outflow
Particulars Amount
NSV of existing machine 1,50,000
Working capital blocked 0
Capital expenditure (60,00,000)
Total outflow (58,50,000)

Note 1: Computation of NSV of existing machine on day 0:

Particulars Amount
Sale value 2,50,000
Less: Book value 0
Capital gain 2,50,000
Tax paid @ 40% 1,00,000

Net salvage value 1,50,000

• Asset has been fully depreciated under Income Tax Act and hence the book value will be taken as
zero for computing capital gains

WN 2: In-between flows:
Particulars Existing New
Sales 1,60,00,000 2,00,00,000
Less: Material cost -60,00,000 -63,75,000
Less: Wages and salaries -41,00,000 -37,50,000
Less: Supervision -16,00,000 -25,00,000
Less: Repairs and maintenance -9,00,000 -7,50,000
Less: Power and fuel -12,40,000 -14,25,000
Less: Allocated corporate Overheads - -
PBDT 21,60,000 52,00,000
Less: Depreciation - -11,50,000
PBT 21,60,000 40,50,000
Less: Tax @ 40% -8,64,000 -16,20,000
PAT 12,96,000 24,30,000
Add: Depreciation - 11,50,000
CFAT 12,96,000 35,80,000
Note:
• Allocated corporate overheads are an irrelevant expenditure and hence not considered in cash flow
computation
• Depreciation has been computed as per Income Tax Act and not companies’ books
• Incremental CFAT = 35,80,000 – 12,96,000 = Rs.22,84,000

WN 3: Terminal flow:
Particulars Existing New
NSV of asset in year 5 21,000 2,50,000
Working capital released 0 0
Total terminal flow 21,000 2,50,000
• Incremental terminal flow = 2,50,000 – 21,000 = Rs.2,29,000

Particulars Existing New

Sale value 35,000 2,50,000

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Less: Book value 0 2,50,000
Capital gain/loss 35,000 0
Tax paid/saved @ 40% 14,000 0

Net salvage value 21,000 2,50,000

WN 4: Computation of incremental cash flows and NPV:

Year Cash flow PVF @ 15% DCF
0 -58,50,000 1.0000 -58,50,000
1 to 5 22,84,000 3.3522 76,56,425
5 2,29,000 0.4972 1,13,859
NPV 19,20,284
Conclusion: The company should go ahead with replacement decision as the project generates positive
NPV of Rs.19,20,284.

28. Replacement decision with saving in cost

Phoenix industries is considering replacing an existing assembly line with a new automated one. The
existing assembly line was installed 3 years ago at a cost of Rs.50,000. It is being depreciated on straight
line basis for tax purposes to zero value over its normal recovery period of 5 years. The old equipment will
last for 5 more years at which time its resale value will be Rs.20,000 but it would be sold now for Rs.40,000.
By replacing the existing line with new automated one the yearly expenses would reduce from Rs.5,10,000
to Rs.2,00,000. The cost of the new line is Rs.10 lacs and it is to be depreciated on straight line over its 5 year
normal recovery period. The estimated value of the new line in 5 years is zero. Phoenix tax rate is 40% and
the required rate of return is 16% post tax. Is it viable to replace the existing line with the new automated
one?
Answer:
WN 1: Initial outflow
Particulars Amount
Capital Expenditure (10,00,000)
NSV of existing asset (Note 1) 32,000
Total outflow (9,68,000)

Note 1: Computation of NSV of existing machine on day 0:

Particulars Amount
Sale value 40,000
Less: Book value (50,000 – 3 years depreciation of 10,000 each) 20,000
Capital gain 20,000
Tax paid @ 40% 8,000

Net salvage value 32,000

WN 2: In-between cash flows:

Particulars Year 1 to 2 Year 3 to 5
Saving in cost 3,10,000 3,10,000
Less: Expenses 0 0
PBDT 3,10,000 3,10,000
Less: Incremental Depreciation -1,90,000 -2,00,000
PBT 1,20,000 1,10,000
Less: Tax @ 40% -48,000 -44,000
PAT 72,000 66,000
Add: Depreciation 1,90,000 2,00,000
CFAT 2,62,000 2,66,000

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• Existing machine will have depreciation for 2 more years of Rs.10,000. New machine will have
depreciation of Rs.2,00,000. Hence incremental depreciation for first 2 years is Rs.1,90,000 and last
three years will be Rs.2,00,000

WN 3: Terminal flow:
Particulars Existing New
NSV of asset in year 5 12,000 0
Working capital released 0 0
Total terminal flow 12,000 0
• Incremental terminal flow = 0 – 12,000 = -12,000

Particulars Existing New

Sale value 20,000 0
Less: Book value - -
Capital gain/loss 20,000 -
Tax paid/saved @ 40% 8,000 -

Net salvage value 12,000 0

WN 4: Computation of incremental cash flows and NPV:

Year Cash flow PVF @ 16% DCF
0 -9,68,000 1 -9,68,000
1 2,62,000 0.862 2,25,844
2 2,62,000 0.743 1,94,666
3 2,66,000 0.641 1,70,506
4 2,66,000 0.552 1,46,832
5 2,54,000 0.476 1,20,904
NPV -1,09,248
Conclusion: The company should not go ahead with project as the same results in Negative NPV

29. Replacement Decision [May 2023]

Four years ago, Z Ltd. had purchased a machine of Rs. 4,80,000 having estimated useful life of 8 years with
zero salvage value. Depreciation is charged using SLM method over the useful life. The company want to
replace this machine with a new machine. Details of new machine are as below:
• Cost of new machine is Rs. 12,00,000, Vendor of this machine is agreed to take old machine at a
value of Rs. 2,40,000. Cost of dismantling and removal of old machine will be Rs. 40,000. 80% of
net purchase price will be paid on spot and remaining will be paid at the end of one year.
• Depreciation will be charged @ 20% p.a. under WDV method.
• Estimated useful life of new machine is four years and it has salvage value of Rs. 1,00,000 at the
end of year four.
• Incremental annual sales revenue is Rs. 12,25,000.
• Contribution margin is 50%.
• Incremental indirect cost (excluding depreciation) is Rs. 1,18,750 per year
• Additional working capital of Rs. 2,50,000 is required at the beginning of year and Rs. 3,00,000 at
the beginning of year three. Working capital at the end of year four will be nil.
• Tax rate is 30%.
• Ignore tax on capital gain
Z Ltd. will not make any additional investment, if it yields less than 12% Advice, whether existing machine
should be replaced or not.
Answer:
WN 1: Initial outflow:
Particulars Calculation Amount

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Purchase price of new machine -12,00,000
Sale value of old machine 2,40,000 – 40,000 2,00,000
Net Purchase Price 10,00,000
Amount paid in Year 0 10,00,000 x 80% 8,00,000
Amount paid in Year 1 10,00,000 x 20% 2,00,000
Working capital 2,50,000
Final outflow on day 0 8,00,000 + 2,50,000 10,50,000

WN 2: In-between flow:
Particulars Year 1 Year 2 Year 3 Year 4
Sales 12,25,000 12,25,000 12,25,000 12,25,000
Less: VC -6,12,500 -6,12,500 -6,12,500 -6,12,500
Less: FC -1,18,750 -1,18,750 -1,18,750 -1,18,750
Less: Depn (Note 1) -1,40,000 -1,00,000 -68,000 -42,400
PBT 3,53,750 3,93,750 4,25,750 4,51,350
Less: Tax @ 30% -1,06,125 -1,18,125 -1,27,725 -1,35,405
PAT 2,47,625 2,75,625 2,98,025 3,15,945
Add: Depreciation 1,40,000 1,00,000 68,000 42,400
CFAT 3,87,625 3,75,625 3,66,025 3,58,345
Less: Change in WC -3,00,000
Less: Payment for original machine -2,00,000
Revised CFAT 1,87,625 75,625 3,66,025 3,58,345

Note 1: Computation of incremental depreciation:

Particulars Year 1 Year 2 Year 3 Year 4
Opening WDV 10,00,000 8,00,000 6,40,000 5,12,000
Less: Depreciation @ 20% -2,00,000 -1,60,000 -1,28,000 -1,02,400
Closing WDV 8,00,000 6,40,000 5,12,000 4,09,600
Depn on old machine (4,80,000/8) 60,000 60,000 60,000 60,000
Incremental depreciation 1,40,000 1,00,000 68,000 42,400

WN 3: Terminal flow:
Particulars Year 1
Net salvage value 1,00,000
Recapture of working capital 5,50,000
Terminal flow 6,50,000

WN 4: Computation of NPV:
Year Cash flow PVF @ 12% DCF
0 -10,50,000 1 -10,50,000
1 1,87,625 0.893 1,67,549
2 75,625 0.797 60,273
3 3,66,025 0.712 2,60,610
4 10,08,345 0.636 6,41,307
NPV 79,739

30. Deciding time of replacement

Company Y is operating an elderly machine that is expected to produce a net cash inflow of Rs.40,000 in
the coming year and Rs.40,000 next year. Current salvage value is Rs.80,000 and next year’s value is
Rs.70,000. The machine can be replaced now with a new machine, which costs Rs.1,50,000, but is much
more efficient and will provide a cash inflow of Rs.80,000 a year for 3 years. Company Y wants to know
whether it should replace the equipment now or wait a year with the clear understanding that the new

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machine is the best of the available alternatives and that it in turn be replaced at the optimal point. Ignore
tax. Take opportunity cost of capital as 10 percent. Advise with reasons.
Answer:
WN 1: Identification of alternatives:
• Alternative 1 – Replace the machine today
• Alternative 2 – Replace the machine at the end of year 1

WN 2: Evaluation of Alternative 1:
Year CF PVF @ 10% DCF
0 -70,000 1.000 -70,000
1 80,000 0.909 72,720
2 80,000 0.826 66,080
3 80,000 0.751 60,080
NPV 1,28,880
Note:
• Cash flow in year 0 = Purchase price of new machine of Rs.1,50,000 – Sale value of old machine of
Rs.80,000 = Net outflow of Rs.70,000

WN 3: Evaluation of Alternative 2:
Year CF PVF @ 10% DCF
0 - 1.000 -
1 -40,000 0.909 -36,360
2 80,000 0.826 66,080
3 80,000 0.751 60,080
4 80,000 0.683 54,640
NPV 1,44,440
Note:
• No cash flow in year 0 as the replacement is not done immediately
• Old machine will be used for one year and then replaced at end of year 1. Cash flow of year 1 =
Inflow of Rs.40,000 from old machine + Sale value of Rs.70,000 of old machine – purchase price of
Rs.1,50,000 of new machine = -40,000

WN 4: Selection of Alternative:
ICAI Solution:
• Since Total NPV is higher in case of Replacement after one year Machine should be replaced
after 1 year.
Author Solution (Logical Solution)
• Alternative 1 has life of 3 years whereas Alternative 2 has life of 4 years. Selection of alternative
will be based one equated annual benefit
Particulars Alt 1 Alt 2
NPV 1,28,880 1,44,440
Life 3 years 4 years
PVAF 2.486 3.169
EAB [NPV/PVAF] 51,842 45,579
Conclusion: Company should go ahead with Alternative 1 as it has higher Equated Annual Benefit and
the machine should be replaced immediately.

31. Replacement decision with block of assets method [July 2021, SM]
WX Limited has a machine which has been in operation for 3 years. Its remaining estimated useful life is 5
years with no salvage value in the end. Its current market value is Rs.2,00,000. The company is considering
a proposal to purchase a new model of machine to replace the existing machine. The relevant information
is as follows:
Particulars Existing Machine New Machine
Cost of machine 3,30,000 10,00,000
Estimated life 8 years 5 years
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Salvage value Nil 40,000
Annual output 30,000 units 75,000 units
Selling price per unit Rs.15 Rs.15
Annual operating hours 3,000 3,000
Material cost per unit Rs.4 Rs.4
Labour cost per hour Rs.40 Rs.70
Indirect cash cost per annum Rs.50,000 Rs.65,000
The company uses written down value of depreciation @ 20% and it has several other machines in the block
of assets. The Income tax rate is 30 per cent and it does not make any investment, if it yields less than 12
per cent. Advise whether existing machine is to be replaced or not.
Answer:
WN 1: Initial outflow
Particulars New
NSV of existing machine on day 0 2,00,000
Working capital blocked -
Capital expenditure (10,00,000)
Total outflow (8,00,000)
Note: Capital gain tax is ignored as the company follows block of assets method and there are other assets
in the block

WN 2: In-between flows:
Note 1: Computation of incremental PBDT
Particulars Existing New
Sales [Units x SP] 4,50,000 11,25,000
Less: Material cost [Units x Material cost per unit] -1,20,000 -3,00,000
Less: Labour cost [Hours x Cost per hour] -1,20,000 -2,10,000
Less: Indirect cash cost -50,000 -65,000
PBDT 1,60,000 5,50,000
Note:
• Incremental PBDT = 5,50,000 – 1,60,000 = Rs.3,90,000

Note 2: Computation of net increase in asset block to compute incremental depreciation:

Particulars Calculation Amount
WDV of existing machine
Original cost of existing machine 3,30,000
Less: Depreciation of year 1 3,30,000 x 20% -66,000
Less: Depreciation of year 2 66,000 x 80% -52,800
Less: Depreciation of year 3 52,800 x 80% -42,240
WDV of existing machine 1,68,960
Depreciation base of new machine:
Cost of new machine 10,00,000
Add: WDV of existing machine 1,68,960
Less: Sale value of existing machine -2,00,000
Depreciation base of new machine 9,68,960
Base for incremental depreciation 9,68,960 – 1,68,960 8,00,000
Incremental depreciation of year 1 8,00,000 x 20% 1,60,000
Incremental depreciation of year 2 1,60,000 x 80% 1,28,000
Incremental depreciation of year 3 1,28,000 x 80% 1,02,400
Incremental depreciation of year 4 1,02,400 x 80% 81,920
Incremental depreciation of year 5 81,920 x 80% 65,536

Note 3: Computation of cash flows:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
PBDT 3,90,000 3,90,000 3,90,000 3,90,000 3,90,000
Less: Depreciation -1,60,000 -1,28,000 -1,02,400 -81,920 -65,536
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PBT 2,30,000 2,62,000 2,87,600 3,08,080 3,24,464
Less: Tax -69,000 -78,600 -86,280 -92,424 -97,339
PAT 1,61,000 1,83,400 2,01,320 2,15,656 2,27,125
Add: Depreciation 1,60,000 1,28,000 1,02,400 81,920 65,536
CFAT 3,21,000 3,11,400 3,03,720 2,97,576 2,92,661

WN 3: Terminal flow:
Particulars Existing New
NSV of asset in year 5 0 40,000
Working capital released 0 0
Total terminal flow 0 40,000

WN 4: Computation of NPV:
Year Cash flows PVF @ 12% DCF
0 -8,00,000 1.000 -8,00,000
1 3,21,000 0.893 2,86,653
2 3,11,400 0.797 2,48,186
3 3,03,720 0.712 2,16,249
4 2,97,576 0.636 1,89,258
5 3,32,661 0.567 1,88,619
NPV of replacement 3,28,965
Conclusion: The company should go ahead with replacement decision as the project generates positive
NPV

32. Replacement decision – No depreciation in year of sale [May 2021 MTP]

WX Ltd. is considering a proposal to replace an existing machine. The details of existing machine and new
machine are as under:
Particulars Existing Machine New Machine
Cost of machine 3,75,000 5,25,000
Estimated life (in years) 10 5
Present book value 1,87,500
• Out of the Life of 10 years of present machine, five years have already lapsed. The management
can continue with this machine for the remaining lifetime.
• The activity level of both the machines is same.
• Residual value of new machine at the end of the life - Rs.60,000.
• There will be a saving of Rs.2,40,000 in the variable cost each year by new machine.
• If the old machine is sold, then it will fetch Rs.90,000.
• WX Ltd. expects a minimum return of 11 % on the investment.
• Corporate tax - 30%
• No depreciation is to be charged in the year of sale.
You are required to comment on the suitability of replacement of the old machine.
Answer:
WN 1: Initial outflow:
Particulars Existing New
NSV of existing machine on day 0 (1,19,250) -
Working capital blocked - -
Capital expenditure - (5,25,000)
Total outflow (1,19,250) (5,25,000)
• Incremental outflow = Rs.4,05,750

Computation of NSV of existing machine:

Particulars Amount
Sale value 90,000
Less: Book value (1,87,500)
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Capital loss 97,500
Tax saved (97,500 x 30%) 29,250
Net salvage value {Sale value + Tax saved} 1,19,250

WN 2: In-between cash flows:

Particulars Year 1 to 4 Year 5
Saving in variable cost 2,40,000 2,40,000
Less: Depreciation -55,500 0
[93,000 – 37,500]
Profit before tax 1,84,500 2,40,000
Less: Tax @ 30% -55,350 -72,000
Profit after tax 1,29,150 1,68,000
Add: Depreciation 55,350 -
Cash flow after tax 1,84,650 1,68,000

Note:
• Depreciation of old machine = 3,75,000/10 = Rs.37,500
• Depreciation of new machine = (5,25,000 – 60,000)/5 = Rs.93,000
• Depreciation is not charged in year of sale and hence the same is not considered

WN 3: Terminal flow:
Particulars Old New
Sale value 0 60,000
Less: Book value (37,500) (93,000)
[one year of depreciation as no depreciation is charged in last year]
Capital loss 37,500 93,000
Tax saved @ 30% 11,250 27,900
Net salvage value {Sale value + Tax saved} 11,250 87,900
• Incremental terminal flow = 87,900 – 11,250 = Rs.76,650

WN 4: Computation of NPV:
Year Cash flow PVF @ 11% DCF
0 -4,05,750 1.000 -4,05,750
1 to 4 1,84,650 3.103 5,72,969
2,44,650
5 [1,68,000 + 76,650] 0.593 1,45,077
NPV of project 3,12,296
Comment: It is advisable to replace the existing machine since NPV is positive

33. Replacement decision [Nov 2021 RTP, May 2023 MTP, May 2024 RTP, SM]
HMR Ltd. is considering replacing a manually operated old machine with a fully automatic new machine.
The old machine had been fully depreciated for tax purpose but has a book value of Rs.2,50,000 on 31st
March 2021. The machine has begun causing problems with breakdowns and it cannot fetch more than
Rs.40,000 if sold in the market at present. It will have no realizable value after 10 years. The company has
been offered Rs.1,50,000 for the old machine as a trade in on the new machine which has a price (before
allowance for trade in) of Rs.6,00,000. The expected life of new machine is 10 years with salvage value of
Rs.35,000.

Further, the company follows written down value method depreciation @ 10% but for tax purpose, straight
line method depreciation is used considering that this is the only machine in the block of assets. A working
capital of Rs. 50,000 will be needed and it will be released at the end of tenth year.

Given below are the expected sales and costs from both old and new machine:
Particulars Old Machine New Machine
Annual output 60,000 units 80,000 units

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Selling price per unit Rs.18 Rs.18
Annual Operating hours 2,800 2,800
Material cost per unit Rs.5 Rs.5
Labour cost per hour Rs.50 Rs.75
Indirect cash cost per annum Rs.1,00,000 Rs.1,75,000
From the above information, ANALYSE whether the old machine should be replaced or not if the
opportunity cost of capital of the Company is 10%?
Assumption Area:
• The company is following block of assets method and hence capital gain/loss cannot arise until
block is fully sold. In this case we assume sale of old asset to happen first and then the purchase
of new asset. Hence there will be capital gain on sale of old asset and then the company buys
new asset on which it can claim depreciation on full asset value
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure -6,00,000
Sale price of old machine 1,05,000
Working capital -50,000
Net outflow -5,45,000

Note 1: Computation of NSV of old machine:

Particulars Amount
Sale value 1,50,00
Less: Book value 0
Capital Gain 1,50,000
Tax paid 45,000

NSV [1,50,000 – 45,000] 1,05,000

WN 2: In-between flows:
Particulars Existing New
Sales 10,80,000 14,40,000
Less: Material Cost -3,00,000 -4,00,000
Less: Labour cost -1,40,000 -2,10,000
Less: Indirect cash cost -1,00,000 -1,75,000
Less: Depreciation 0 -56,500
Profit before tax 5,40,000 5,98,500
Less: Tax @ 30% -1,62,000 -1,79,550
Profit after tax 3,78,000 4,18,950
Add: Depreciation 0 56,500
Cash flow after tax 3,78,000 4,75,450
Incremental CFAT 97,450

WN 3: Terminal flow:
Particulars Amount
Net Salvage value 35,000
Recapture of working capital 50,000
Net cash inflow 85,000
Note: No capital gain in year 10 as book value of asset would match salvage value

WN 4: Computation of NPV:
Year Cash flow PVF @ 10% DCF PVF @ 20% DCF
0 -5,45,000 1.000 -5,45,000 1.000 -5,45,000
1 to 10 97,450 6.144 5,98,733 4.192 4,08,510
10 85,000 0.386 32,810 0.162 13,770

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NPV 86,543 -1,22,720
86,543
IRR = 10 + 𝑥 (20 − 10) = 10 + 4.14 = 14.14%
86,543 − (−1,22,720)

Conclusion: Since the Incremental NPV is positive as well as IRR is greater than cost of capital, the old
machine should be replaced

34. Replacement decision – Timing of replacement [May 2022 RTP, SM]

ABC & Co. is considering whether to replace an existing machine or to spend money on revamping it. ABC
& Co. currently pays no taxes. The replacement machine costs Rs.18,00,000 now and requires maintenance
of Rs.2,00,000 at the end of every year for eight years. At the end of eight years, it would have a salvage
value of Rs.4,00,000 and would be sold. The existing machine requires increasing amounts of maintenance
each year and its salvage value fall each year as follows
Year Maintenance Salvage
Present 0 8,00,000
1 2,00,000 5,00,000
2 4,00,000 3,00,000
3 6,00,000 2,00,000
4 8,00,000 0
The opportunity cost of capital for ABC & Co. is 15%.
REQUIRED:
When should the company replace the machine?
Answer:
WN 1: Computation of Equated Annual Cost of New Machine:
Year Cash flow PVF @ 15% DCF
0 -90,000 1.000 -90,000
1 to 8 -10,000 4.487 -44,870
8 20,000 0.327 6,540
PV of outflow -1,28,330
Life 8 years
PVAF (8 years and 15%) 4.487
EAC 28,600

WN 2: Evaluation of optimum replacement time:

• The machine can be replaced today or at end of each of the next four years. We should compute
the amount of PV of outflow to decide the optimum option

Replace immediately:
• Old machine would be used for 0 years and new machine would be used for 4 years. (New machine
has utility even beyond 4 years but we restrict our cash flow analysis only for first four years to
compare the cash flows across multiple options)
Year Cash flow PVF @ 15% DCF
0 40,000 1.000 40,000
1 to 4 -28,600 2.855 -81,653
PV of outflow -41,653

Replace at end of year 1:

• Old machine would be used for 1 years and new machine would be used for 3 years.
Year Cash flow PVF @ 15% DCF
15,000
1 [-10,000 + 25,000] 0.870 13,050
2 to 4 -28,600 1.985 -56,771
PV of outflow -43,721

Replace at end of year 2:

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• Old machine would be used for 2 years and new machine would be used for 2 years.
Year Cash flow PVF @ 15% DCF
1 -10,000 0.870 -8,700
-5,000
2 [-20,000 + 15,000] 0.756 -3,780
2 to 4 -28,600 1.229 -35,149
PV of outflow -47,629

Replace at end of year 3:

• Old machine would be used for 3 years and new machine would be used for 1 years.
Year Cash flow PVF @ 15% DCF
1 -10,000 0.870 -8,700
2 -20,000 0.756 -15,120
-20,000
3 [-30,000 + 10,000] 0.658 -13,160
4 -28,600 0.572 -16,359
PV of outflow -53,339

Replace at end of year 4:

• Old machine would be used for 4 years and new machine would be used for 0 years.
Year Cash flow PVF @ 15% DCF
1 -10,000 0.870 -8,700
2 -20,000 0.756 -15,120
3 -30,000 0.658 -19,740
4 -40,000 0.572 -22,880
PV of outflow -66,440
Conclusion:
• Machine should be replaced immediately as the same has lowest PV of outflow.

Part 5 – Miscellaneous – Capital rationing, modified IRR

35. Capital Rationing [SM]

Elite Cooker Company is evaluating three investment situations: (1) produce a new line of aluminum
skillets, (2) expand its existing cooker line to include several new sizes, and (3) develop a new, higher-
quality line of cookers. If only the project in question is undertaken, the expected present values and the
amounts of investment required are:
Project Investment required PV of future cash flows
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000
If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and present
values will simply be the sum of the parts. With projects 1 and 3, economies are possible in investment
because one of the machines acquired can be used in both production processes. The total investment
required for projects 1 and 3 combined is Rs.4,40,000. If projects 2 and 3 are undertaken, there are
economies to be achieved in marketing and producing the products but not in investment. The expected
present value of future cash flows for projects 2 and 3 is Rs.6,20,000. If all three projects are undertaken
simultaneously, the economies noted will still hold. However, a Rs.1,25,000 extension on the plant will be
necessary, as space is not available for all three projects. Which project or projects should be chosen?
Answer:
Identification of projects to be selected:
Project Investment PV of inflow NPV
1 2,00,000 2,90,000 90,000
2 1,15,000 1,85,000 70,000
3 2,70,000 4,00,000 1,30,000

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3,15,000 4,75,000
1&2 [2,00,000 + 1,15,000] [2,90,000 + 1,85,000] 1,60,000
4,40,000 6,90,000
1&3 [Given] [2,90,000 + 4,40,000] 2,50,000
3,85,000 6,20,000
2&3 [1,15,000 + 2,70,000] [Given] 2,35,000
6,80,000 9,10,000
1,2 & 3 [4,40,000 + 1,15,000 + 1,25,000] [6,20,000 + 2,90,000] 2,30,000
The company should do project 1 and 3 as the same has highest positive NPV.

36. Capital Rationing with divisible and indivisible projects [Nov 2019, SM]
A company has Rs.1,00,000 available for investment and has identified the following four investments in
which to invest:
Project Investment NPV
C 40,000 20,000
D 1,00,000 35,000
E 50,000 24,000
F 60,000 18,000
You are required to optimize the returns from a package of projects within the capital spending limit if:
• The projects are independent of each other and are divisible
• The projects are not divisible
Answer:
Part 1: Projects are divisible:
Step 1: Check whether capital rationing exist:
Particulars Amount
Demand for money (40+100+50+60) 2,50,000
Supply of money 1,00,000
Capital rationing exist as the demand for money is more than supply of money

Step 2: Statement of ranking:

Profitability index
Project Outflow NPV [Outflow + NPV]/Outflow Rank
C 40,000 20,000 1.5000 1
D 1,00,000 35,000 1.3500 3
E 50,000 24,000 1.4800 2
F 60,000 18,000 1.3000 4

Step 3: Statement of allocation:

Project Money invested Balance Money NPV
C 40,000 60,000 20,000
E 50,000 10,000 24,000
3,500
1/10 of D 10,000 - [35,000 x 1/10]
Total NPV 47,500

Part 2: Projects are indivisible:

Step 1 and 2 – No change

Step 3: Selection of Projects:

Combination Amount invested NPV
C&E 90,000 44,000
C&F 1,00,000 38,000
D 1,00,000 35,000
Conclusion: Company should do project C and E to earn maximum NPV of Rs.44,000.

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37. Modified IRR [SM]
An investment of Rs.1,36,000 yields the following cash flows (profit before depreciation but after tax).
Determine MIRR considering 8% cost of capital
Year 1 2 3 4 5
Amount 30,000 40,000 60,000 30,000 20,000
Answer:
WN 1: Computation of maturity cash flow:
• Modified IRR approach assumes re-investment of cash flows at a rate given in question and
based on that we compute maturity cash flow.
Year Cash flow Reinvestment period FVF @ 8% Maturity CF
1 30,000 4 1.3605 40,815
2 40,000 3 1.2597 50,388
3 60,000 2 1.1664 69,984
4 30,000 1 1.0800 32,400
5 20,000 0 1.0000 20,000
2,13,587

WN 2: Computation of MIRR:
Year Cash flow PVF @ 9% DCF PVF @ 11% DCF
0 -1,36,000 1 -1,36,000 1 -1,36,000
5 2,13,587 0.650 1,38,832 0.593 1,26,657
NPV 2,832 -9,343

𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐌𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
2,832
MIRR = 9% + x (11% − 9%) = 9% + 0.47% = 9.47%
2,832 − (−9,343)

Practice Questions

1. Evaluation of multiple projects [May 2020 MTP, Nov 2012 RTP, SM]
Lockwood Limited wants to replace its old machine with a new automatic machine. Two models A and B
are available at the same cost of Rs.5 lakhs each. Salvage value of the old machine is Rs.1 lakh. The utilities
of the existing machine can be used if the company purchases A. Additional cost of utilities to be purchased
in that case are Rs.1 lakh. If the company purchases B then all the existing utilities will have to be replaced
with new utilities costing Rs.2 lakhs. The salvage value of the old utilities will be Rs.0.20 lakhs. The cash
flows are expected to be:
Year Project A Project B PVF @ 15%
1 1,00,000 2,00,000 0.87
2 1,50,000 2,10,000 0.76
3 1,80,000 1,80,000 0.66
4 2,00,000 1,70,000 0.57
5 1,70,000 40,000 0.50
Salvage value at end of year 5 50,000 60,000
The targeted return on capital is 15%. You are required to (i) Compute, for the two machines separately,
net present value, discounted payback period and desirability factor and (ii) Advice which of the machines
is to be selected?
Answer:
WN 1: Analysis of Project A:
Year CF PVF @ 15% DCF CDCF
0 -5,00,000 1.00 -5,00,000 -5,00,000
1 1,00,000 0.87 87,000 -4,13,000
2 1,50,000 0.76 1,14,000 -2,99,000
3 1,80,000 0.66 1,18,800 -1,80,200

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4 2,00,000 0.57 1,14,000 -66,200
5 2,20,000 0.50 1,10,000 43,800
Note:
• Initial outflow = Purchase price of Rs.5,00,000 – Inflow of Rs.1,00,000 (sale value of old machine) +
Purchase of utilities of Rs.1,00,000 = Rs.5,00,000
• Year 5 inflow = Rs.1,70,000 + Rs.50,000 (salvage value) = Rs.2,20,000

Particulars Calculation Answer

Discounted Unrecovered discounted cash flow of Base year 4.60 years (or) 4 years
Base year +
Payback Discounted flow of next year and 7 months
66,200
=4+ = 4 + 0.60
1,10,000
NPV = PV of inflows – PV of outflow 43,800
= 5,43,800 – 5,00,000
Desirability PV of inflows 5,43,800 108.76%
x 100 = x 100
factor (in %) PV of outflows 5,00,000
Desirability PV of inflows 5,43,800 1.09 Times
=
factor (in PV of outflows 5,00,000
Times)

WN 2: Analysis of Project B:
Year CF PVF @ 15% DCF CDCF
0 -5,80,000 1.00 -5,80,000 -5,80,000
1 2,00,000 0.87 1,74,000 -4,06,000
2 2,10,000 0.76 1,59,600 -2,46,400
3 1,80,000 0.66 1,18,800 -1,27,600
4 1,70,000 0.57 96,900 -30,700
5 1,00,000 0.50 50,000 19,300
Note:
• Initial outflow = Purchase price of Rs.5,00,000 – Inflow of Rs.1,00,000 (sale value of old machine) +
Purchase of utilities of Rs.2,00,000 – inflow of Rs.20,000 (sale value of utilities) = Rs.5,80,000
• Year 5 inflow = Rs.40,000 + Rs.60,000 (salvage value) = Rs.1,00,000

Particulars Calculation Answer

Discounted Unrecovered discounted cash flow of Base year 4.61 years (or) 4 years
Base year +
Payback Discounted flow of next year and 7 months
30,700
=4+ = 4 + 0.61
50,000
NPV = PV of inflows – PV of outflow 19,300
= 5,99,300 – 5,80,000
Desirability PV of inflows 5,99,300 103.33%
x 100 = x 100
factor (in %) PV of outflows 5,80,000
Desirability PV of inflows 5,99,300 1.03 Times
=
factor (in PV of outflows 5,80,000
Times)

Conclusion:
We should go ahead with Project A as it has better NPV and profitability index. Discounted payback for
both projects is almost similar.

2. Computation of IRR [Nov 2023 MTP, SM]

A company proposes to install machine involving a capital cost of Rs. 3,60,000. The life of the machine is 5
years and its salvage value at the end of the life is nil. The machine will produce the net operating income
after depreciation of Rs. 68,000 per annum. The company's tax rate is 45%. The Net Present Value factors
for 5 years are as under:
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Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
You are required to COMPUTE the internal rate of return of the proposal.
Answer:
WN 1: Computation of Cash flows:
• Net operating income after depreciation would basically mean Profit before tax.
Particulars Amount
Profit before tax 68,000
Less: Tax @ 45% -30,600
Profit after tax 37,400
Add: Depreciation (3,60,000/5) 72,000
Cash flow after tax 1,09,400

WN 2: Computation of IRR:
Year Cash flow PVF @ 15% DCF PVF @ 16% DCF
0 -3,60,000 1.00 -3,60,000 1.00 -3,60,000
1 to 5 1,09,400 3.35 3,66,490 3.27 3,57,738
NPV 6,490 -2,262

𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
6,490
IRR = 15% + x (16% − 15%) = 15% + 0.74% = 𝟏𝟓. 𝟕𝟒%
6,490 − (−2,262)

3. Computation of NPV and IRR: [May 2020 MTP, Nov 2018 MTP, Nov 2019 MTP, May 2017, SM]
H Limited is considering a new product line to supplement its range of products. It is anticipated that the
new product line will involve cash investments of Rs.70,00,000 at time 0 and Rs.1,00,00,000 in year 1. Net
cash flow after taxes but before depreciation of Rs.25,00,000 are expected in year 2, Rs.30,00,000 in year 3,
Rs.35,00,000 in year 4 and Rs.40,00,000 each year thereafter through year 10. Although the product line
might be viable after year 10, the company prefers to be conservative and end all calculations at that time.
(a) If the required rate of return is 15 percent, Find out the net present value of the project? Is it
acceptable?
(b) Compute NPV if the required rate of return were 10 percent?
(c) Compute the internal rate of return?
Answer:
Net cash flow after taxes but before depreciation is basically Cash flow after taxes as depreciation is a non-
cash item.
WN 1: Computation of NPV at 15% and 10%
Year CF PVF @ 15% DCF PVF @ 10% DCF
0 -70,00,000 1.000 -70,00,000 1.000 -70,00,000
1 -1,00,00,000 0.870 -87,00,000 0.909 -90,90,000
2 25,00,000 0.756 18,90,000 0.826 20,65,000
3 30,00,000 0.658 19,74,000 0.751 22,53,000
4 35,00,000 0.572 20,02,000 0.683 23,90,500
5 40,00,000 0.497 19,88,000 0.621 24,84,000
6 40,00,000 0.432 17,28,000 0.564 22,56,000
7 40,00,000 0.376 15,04,000 0.513 20,52,000
8 40,00,000 0.327 13,08,000 0.467 18,68,000
9 40,00,000 0.284 11,36,000 0.424 16,96,000
10 40,00,000 0.247 9,88,000 0.386 15,44,000
NPV -11,82,000 25,18,500
Note:
• Project is not acceptable if the required rate of return is 15 percent as NPV is negative
• Project is acceptable if the required rate of return is 10 percent as NPV is positive

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WN 2: Computation of IRR:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
25,18,500
IRR = 10% + x (15% − 10%) = 10% + 3.40% = 13.40%
25,18,500 − (−11,82,000)

4. Investment Decision [May 2024 MTP]

An existing profitable company, RMC World Ltd. is considering a new project for manufacture of home
automation gadget involving a capital expenditure of Rs. 1000 Lakhs and working capital of Rs. 150 Lakhs.
The capacity of the plants for an annual production of 3 lakh units and capacity utilization during 5 year
life of the project is expected to be as indicated below:
Year 1 2 3 4 5
Capacity Utilization 50 65 80 100 100
The average price per unit of product is expected to be Rs.600 netting a contribution of 60 percent. The
annual fixed costs, excluding depreciation, are estimated to be Rs.500 Lakhs per annum from the third year
onwards. For the first and second year, it would be Rs. 200 lakhs and Rs. 350 lakhs respectively.

Scrap value of the capital asset at the end of 5th year is Rs. 200 Lakhs. Depreciation on capital asset is
provided on written down value basis @ 40% p.a. for income tax purpose. The rate of income tax may be
taken at 30%. The cost of capital is 12%. At end of the third year an additional investment of Rs. 200 lakhs
would be required for working capital. There is no capital gain tax applicable.

COMPUTE the NPV of the project. RMC World Ltd. is about to make a presentation to Secure Venture
Capital Firm. Secure Venture Capital Firms will invest in any project if the net addition to shareholder
wealth from the project is above Rs. 100 lakhs
Answer:
WN 1: Initial outflow:
Amount
Particulars (in lacs)
Capital expenditure -1,000.00
Working capital -150.00
Initial outflow -1,150.00

WN 2: In-between cash flows:

(in lacs)
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Units sold 1.50 1.95 2.40 3.00 3.00
Contribution per unit 360 360 360 360 360
Total contribution 540.00 702.00 864.00 1,080.00 1,080.00
Less: Fixed cost -200.00 -350.00 -500.00 -500.00 -500.00
Less: Depreciation -400.00 -240.00 -144.00 -86.40 -51.84
PBT -60.00 112.00 220.00 493.60 528.16
Less: Tax 18.00 -33.60 -66.00 -148.08 -158.45
PAT -42.00 78.40 154.00 345.52 369.71
Add: Depreciation 400.00 240.00 144.00 86.40 51.84
CFAT 358.00 318.40 298.00 431.92 421.55
Less: Increase in WC - - -200.00 - -
Revised CFAT 358.00 318.40 98.00 431.92 421.55

Note 1: Computation of Depreciation

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening Balance 1,000.00 600.00 360.00 216.00 129.60
Less: Depreciation -400.00 -240.00 -144.00 -86.40 -51.84
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Closing Balance 600.00 360.00 216.00 129.60 77.76

WN 3: Terminal cash flow:

Amount
Particulars (in lacs)
Salvage value 200.00
Recapture of working capital 350.00
Total terminal flow 550.00
Note: Capital gain is ignored as there is no capital gain tax

WN 4: Consolidation of cash flows and computation of NPV:

(in lacs)
Year Cash flow PVF @ 12% DCF
0 -1,150.00 1 -1,150.00
1 358.00 0.893 319.69
2 318.40 0.797 253.76
3 98.00 0.712 69.78
4 431.92 0.636 274.70
5 971.55 0.567 550.87
NPV 318.80
Conclusion: The company should go ahead with project as it results in positive NPV of Rs.318.80 lacs as
the same is more than the requirement of 100 lacs increase in shareholder wealth.

5. Investment decision
C Ltd. is considering investing in a project. The expected original investment in the project will be
Rs.2,00,000, the life of project will be 5 year with no salvage value. The expected net cash inflows after
depreciation but before tax during the life of the project will be as following:
Year 1 2 3 4 5
Amount 85,000 1,00,000 80,000 80,000 40,000
The project will be depreciated at the rate of 20% on original cost. The company is subjected to 30% tax
rate.
Required:
(i) Calculate payback period and average rate of return (ARR)
(ii) Calculate net present value and net present value index, if cost of capital is 10%.
(iii) Calculate internal rate of return.
Note: The P.V. factors are:
Year PVF @ 10% PVF @ 37% PVF @ 38% PVF @ 40%
1 0.909 0.730 0.725 0.714
2 0.826 0.533 0.525 0.510
3 0.751 0.389 0.381 0.364
4 0.683 0.284 0.276 0.260
5 0.621 0.207 0.200 0.186
Answer:
WN 1: Computation of cash flows:
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Profit before tax 85,000 1,00,000 80,000 80,000 40,000
Less: Tax @ 30% -25,500 -30,000 -24,000 -24,000 -12,000
Profit after tax 59,500 70,000 56,000 56,000 28,000
Add: Depreciation 40,000 40,000 40,000 40,000 40,000
Cash flow after taxes 99,500 1,10,000 96,000 96,000 68,000
Note:

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• The team cash flow after depreciation but before tax would mean profit before tax. This is because
depreciation has been considered but tax is yet to be deducted.

WN 2: Calculation of all techniques:

Year CF CCF PVF @ 10% DCF Depreciation PAT
0 -2,00,000 -2,00,000 1.000 -2,00,000
1 99,500 -1,00,500 0.909 90,446 40,000 59,500
2 1,10,000 9,500 0.826 90,860 40,000 70,000
3 96,000 1,05,500 0.751 72,096 40,000 56,000
4 96,000 2,01,500 0.683 65,568 40,000 56,000
5 68,000 2,69,500 0.621 42,228 40,000 28,000
Total/average 1,61,198 53,900

Calculation of all techniques:

Particulars Calculation Answer
Payback Unrecovered cash flow of Base year 1.91 years (or) 1 year
Base year +
Cash flow of next year and 11 months
1,00,500
=1+ = 1 + 0.91
1,10,000
ARR on Average PAT 53,900 26.95%
x 100 = x 100
initial Initial investment 2,00,000
investment
ARR on Average PAT 53,900 53.90%
x 100 = x 100
average Average investment 2,00,000 + 0
investment 2
53,900
= x 100
1,00,000
NPV = PV of inflows – PV of outflow 1,61,198
= 3,61,198 – 2,00,000
NPV Index NPV 1,61,198 0.81 Times
=
PV of outflows 2,00,000
Note: NPV Index is similar to profitability index. However, the same is calculated as NPV/PV of outflow.

WN 3: Computation of IRR:
Year CF PVF @ 38% DCF PVF @ 40% DCF
0 -2,00,000 1.000 -2,00,000 1.000 -2,00,000
1 99,500 0.725 72,138 0.714 71,043
2 1,10,000 0.525 57,750 0.510 56,100
3 96,000 0.381 36,576 0.364 34,944
4 96,000 0.276 26,496 0.260 24,960
5 68,000 0.200 13,600 0.186 12,648
NPV 6,560 -305

Computation of IRR:
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏
𝐈𝐑𝐑 = 𝐋𝟏 + 𝐱 (𝐋𝟐 − 𝐋𝟏 )
𝐍𝐏𝐕 𝐚𝐭 𝐋𝟏 − 𝐍𝐏𝐕 𝐚𝐭 𝐋𝟐
6,560
IRR = 38% + x (40% − 38%) = 38% + 1.91% = 𝟑𝟗. 𝟗𝟏%
6,560 − (−305)

6. Investment decision – Tax to be ignored [Nov 2020]

CK Limited is planning to buy a new machine. Details of which are as follows:
Cost of the machine at the commencement 2,50,000
Economic life of the machine 8 years
Residual value Nil
Annual production capacity of the machine 1,00,000 units

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Estimated selling price per unit Rs.6
Estimated variable cost per unit Rs.3
Estimated annual fixed cost 1,00,000
[Excluding depreciation]
Advertisement expenses in 1st year in addition of annual fixed cost Rs.20,000
Maintenance expenses in 5th year in addition of annual fixed cost 30,000
Cost of capital 12%
Ignore tax
Analyse the above mentioned proposal using the Net Present Value Method and advice.
Answer:
WN 1: Initial outflow
Particulars Amount
Capital expenditure (2,50,000)
Working capital -
Initial outflow (2,50,000)

WN 2: In-between cash flows:

Particulars Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8
Revenues 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000
Less: Variable cost 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
Less: Fixed cost 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
Less: Advert 20,000 0 0 0 0 0 0 0
Less: Maintenance 0 0 0 0 30,000 0 0 0
PBDT/ CFAT 1,80,000 2,00,000 2,00,000 2,00,000 1,70,000 2,00,000 2,00,000 2,00,000
Note: Taxes are ignored and hence depreciation is not considered in above statement

WN 3: Terminal cash flow:

Particulars Amount
Salvage value -
Recapture of Working capital -
Terminal flow -

WN 4: Consolidation of cash flows and computation of NPV:

Year CF PVF @ 12% DCF
0 -2,50,000 1.000 -2,50,000
1 1,80,000 0.893 1,60,740
2 2,00,000 0.797 1,59,400
3 2,00,000 0.712 1,42,400
4 2,00,000 0.636 1,27,200
5 1,70,000 0.567 96,390
6 2,00,000 0.507 1,01,400
7 2,00,000 0.452 90,400
8 2,00,000 0.404 80,800
NPV 7,08,730
Conclusion: The company should go ahead with the project as it generates positive NPV.

7. Investment decision with sunk cost – Cost reduction and revenue enhancement [SM]
A chemical company is presently paying an outside firm Rs.1 per gallon to dispose off the waste resulting
from its manufacturing operations. At normal operating capacity, the waste is about 50,000 gallons per
year.

After spending Rs.60,000 on research, the company discovered that the waste could be sold for Rs.10 per
gallon if it was processed further. Additional processing would, however, require an investment of

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Rs.6,00,000 in new equipment, which would have an estimated life of 10 years with no salvage value.
Depreciation would be calculated by straight line method.

Except for the costs incurred in advertising Rs.20,000 per year, no change in the present selling and
administrative expenses is expected, if the new product is sold. The details of additional processing costs
are as follows:
• Variable : Rs.5 per gallon of waste put into process.
• Fixed : (Excluding Depreciation) Rs.30,000 per year.
There will be no losses in processing, and it is assumed that the total waste processed in a given year will
be sold in the same year. Estimates indicate that 50,000 gallons of the product could be sold each year.

The management when confronted with the choice of disposing off the waste or processing it further and
selling it, seeks your advice. Which alternative would you recommend? Assume that the firm's cost of
capital is 15% and it pays on an average 50% Tax on its income.
You should consider Present value of Annuity of Rs.1 per year @ 15% p.a. for 10 years as 5.019
Answer:
WN 1: Initial outflow:
Particulars Amount
Capital expenditure (6,00,000)
Research (sunk cost) -
Working capital -
Initial outflow (6,00,000)

WN 2: In-between cash flows:

Particulars Amount
Revenues (50,000 x 10) 5,00,000
Savings in disposal cost (50,000 x 1) 50,000
Less: Variable cost (50,000 x 5) -2,50,000
Less: Fixed cost -30,000
Less: Advertising cost -20,000
Profit before depreciation and tax 2,50,000
Less: Depreciation [6,00,000/10] -60,000
Profit before tax 1,90,000
Less: Tax @50% -95,000
Profit after tax 95,000
Add: Depreciation 60,000
Cash flow after taxes 1,55,000

WN 3: Terminal cash flow:

Particulars Amount
Salvage value 0
Recapture of Working capital -
Terminal flow 0

WN 4: Computation of NPV:
Year CF PVF @ 15% DCF
0 -6,00,000 1.000 -6,00,000
1 to 10 1,55,000 5.019 7,77,945
NPV 1,77,945
Conclusion: Processing of waste is a better option as it gives a positive Net Present Value.

8. Investment Decision – Revenue enhancement and WDV Method [May 2024 MTP]
NC Ltd. Is considering purchasing a new machine to increase its production facility. At present, it uses an
old machine which can process 5,000 units of TVs per week. NC could replace it with new machine, which
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is product specific and can produce 15,000 units per week. New machine cost Rs. 100 crores and requires
the working capital of Rs. 3 crores, which will be released at the end of 5th year. The new machine is
expected to have a salvage value of Rs. 20 crores.

The company expects demand for TVs to be 10,000 units per week. Each TV sells for Rs. 30,000 and has
Profit Volume Ratio (PV) of 0.10. The company works for the 56 weeks in the year. Additional fixed costs
(excluding depreciation) are estimated to increase by Rs. 10 crores. The company is subject to a 40% tax rate
and its after-tax cost of capital is 20%. The relevant rate of depreciation is 25 % for both taxation and
accounts. The company uses the WDV method of depreciation. The existing machine will have no scrap
value.

You are required to:

ADVISE whether the company should replace the old machine.
(Decimal may be taken up to 2 units)
Answer:
WN 1: Initial outflow
Particulars Amount
(in Cr)
Capital Expenditure -100.00
Working capital -3.00
Initial outflow -103.00

WN 2: In-between flows
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Incremental units sold per week 5,000 5,000 5,000 5,000 5,000
Extra units per year (5,000 x 56) 2,80,000 2,80,000 2,80,000 2,80,000 2,80,000
Contribution per unit 3,000 3,000 3,000 3,000 3,000
Total Contribution 84.00 84.00 84.00 84.00 84.00
Less: Fixed cost -10.00 -10.00 -10.00 -10.00 -10.00
Less: Depreciation (Note 1) -25.00 -18.75 -14.06 -10.55 -7.91
Profit before tax 49.00 55.25 59.94 63.45 66.09
Less: Tax @ 40% -19.60 -22.10 -23.98 -25.38 -26.44
Profit after tax 29.40 33.15 35.96 38.07 39.65
Add: Depreciation 25.00 18.75 14.06 10.55 7.91
Cash flow after tax 54.40 51.90 50.02 48.62 47.56

Note 1: Computation of depreciation:

Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Opening balance 100.00 75.00 56.25 42.19 31.64
Less: Depreciation -25.00 -18.75 -14.06 -10.55 -7.91
Closing balance 75.00 56.25 42.19 31.64 23.73

WN 3: Terminal flow
Particulars Amount
Sale value 20.00
Less: Book value -23.73
Capital loss 3.73
Tax saved (3.73 x 40%) 1.49
NSV (20 + 1.49) 21.49
Recapture of working capital 3.00
Total terminal flow 24.49

WN 4: Computation of NPV
Year Cash flow PVF @ 20% DCF

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0 -103 1 -103
1 54.40 0.83 45.15
2 51.90 0.69 35.81
3 50.02 0.58 29.01
4 48.62 0.48 23.34
5 72.05 0.4 28.82
NPV 59.13
The company is advised to replace the old machine since the NPV of the new machine is positive.

9. Capital Budgeting and Leverages [Sep 2024 MTP]

Mathangi Ltd. is a News broadcasting channel having its broadcasting Centre in Chennai. There are total
200 employees in the organisation including top management. As a part of employee benefit expenses, the
company serves tea to its employees, which is outsourced from a third-party. The company offers tea three
times a day to each of its employees. The third-party charges Rs. 10 for each cup of tea. The company works
for 200 days in a year.

Looking at the substantial amount of expenditure on tea, the finance department has proposed to the
management an installation of a master tea vending machine from Nirmal Ltd which will cost Rs. 5,00,000
with a useful life of five years. Upon purchasing the machine, the company will have to incur annual
maintenance which will require a payment of Rs. 25,000 every year. The machine would require electricity
consumption of 500 units p.m. and current incremental cost of electricity for the company is Rs. 24 per unit.
Apart from these running costs, the company will have to incur Rs. 8,00,000 for consumables like milk, tea
powder, paper cup, sugar etc. The company is in the 25% tax bracket. Straight line method of depreciation
is allowed for the purpose of taxation.

Nirmal Ltd sells 100 master tea vending machines. Variable cost is Rs. 4,50,000 per machine and fixed
operating cost is Rs. 25,00,000. Capital Structure of Mathangi Ltd and Nirmal Ltd consists of the following:
Particulars Mathangi Limited Nirmal Limited
Equity Share Capital (Face value Rs. 10 each) 40,00,000 40,00,000
Reserves & Surplus 25,00,000 50,00,000
12% Preference Share Capital 12,00,000 Nil
15% Debentures 20,00,000 40,00,000
Risk free rate of return = 5%, Market return = 10%, Beta of the Mathangi Ltd. = 1.9 You are required to
answer the following five questions based on the above details:
Question No.1: If sales of Nirmal Ltd are up by 10%, impact on its EBIT is
a. 30% b. 60% c. 5% d. 20%
Question No.2: Combined leverage of Nirmal Ltd is
a. 1.63 b. 2.63 c. 1.315 d. 2
Question No.3: Discount rate that can be applied for making investment decisions of Mathangi Ltd is
a. 12% b. 13.52% c. 15% d. 20%
Question No.4: Incremental cash flow after tax per annum attributable to Mathangi Ltd due to
investment in the machine is
a. Rs. 2,39,438 b. Rs. 1,98,250 c. Rs. 98,250 d. Rs. 1,31,000
Question No.5: Net present value of investment in the machine by Mathangi Ltd is
a. Rs. 6,88,522 b. Rs. 1,88,522 c. Rs. 9,91,250 d. Rs. 4,91,250
Answer:
Question No.1 and 2:
Leverage Analysis of Nirmal Limited
Particulars Calculation Amount
(in lacs)
Sales 100 x 5,00,000 500.00
Less: Variable cost 100 x 4,50,000 -450.00
Contribution 50.00

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Less: Fixed cost -25.00
EBIT 25.00
Less: Interest 40,00,000 x 15% -6.00
EBT 19.00
Operating leverage (Contribution/EBIT) 50 2.00
( )
25
Financial leverage (EBIT/EBT) 25 1.32
( )
19
Combined leverage (Contribution/EBT) 50 2.63
( )
19
Answers:
Question No.1 – 20%
• % Change in EBIT = % Change in Sales x Operating leverage = 10% x 2 =20%

Question No.2 – 2.63 Times

Question No.3 – 13.52%
Computation of WACC (Discount Rate) of Mathangi Limited
Source Cost Weight Product
Equity capital 14.50% 40,00,000 5,80,000
Reserves and Surplus 14.50% 25,00,000 3,62,500
Preference share capital 12.00% 12,00,000 1,44,000
Debentures 11.25% 20,00,000 2,25,000
Overall 13.52% 97,00,000 13,11,500
Note:
• Cost of equity = Rf + Beta x (Rm – Rf) = 5 + 1.9 x 5 = 14.50%
Question No.4 and 5:
• Question No.4 – 1,98,250 (WN 2)
• Question No.5 – 1,88,522 (WN 3)

WN 1: Initial outflow
Particulars Amount
Capital Expenditure -5,00,000
Working Capital 0
Initial outflow -5,00,000

WN 2: In-between flows
Particulars Calculation Amount
Saving in tea cost 200 employees x 3 times x 200 days x 10 12,00,000
Less: AMC -25,000
Less: Electricity cost 500 units x 24 x 12 months -1,44,000
Less: other costs -8,00,000
Less: Depreciation -1,00,000
PBT 1,31,000
Less: Tax @ 25% 1,31,000 x 25% -32,750
PAT 98,250
Add: Depreciation 1,00,000
CFAT 1,98,250
• No terminal flow

WN 3: Computation of NPV
Year Cash flow PVF @ 13.52% DCF
0 -5,00,000 1.000 -5,00,000
1 to 5 1,98,250 3.473 6,88,522
NPV 1,88,522

10. Investment decision [SM]

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A company wants to invest in a machinery that would cost Rs.50,000 at the beginning of year 1. It is
estimated that the net cash inflows from operations will be Rs.18,000 per annum for 3 years, if the company
opts to service a part of the machine at the end of year 1 at Rs.10,000. In such a case, the scrap value at the
end of year 3 will be Rs.12,500. However, if the company decides, not to service the part, then it will have
to be replaced at the end of year 2 at Rs.15,400. But in this case, the machine will work for the 4 th year and
also get operational case inflow of Rs.18,000 for the 4th year. It will have to be scrapped at the end of year 4
at Rs.9,000. Assuming cost of capital at 10% and ignoring taxes, will you recommend the purchase of this
machine based on the net present value of its cash flows? If the supplier gives a discount of Rs.5,000 for
purchase, what would be your decision? (The present value factors at the end of years 0, 1, 2, 3, 4, 5 and 6
are respectively 1, 0.9091, 0.8264, 0.7513, 0.6830, 0.6209 and 0.5644)
Answer:
WN 1: Identification of alternatives:
Alternative 1 – Servicing of part at end of year 1
Alternative 2 – Servicing of part at end of year 2

WN 2: Computation of NPV of alternative 1:

Year CF PVF @ 10% DCF
0 -50,000 1.0000 -50,000
1 8,000 0.9091 7,273
2 18,000 0.8264 14,875
3 30,500 0.7513 22,915
NPV -4,937
Note:
• Cash flow of year 1 = 18,000 of inflow – servicing cost of 10,000
• Cash flow of year 3 = 18,000 of inflow + salvage value of 12,500

WN 3: Computation of NPV of Alternative 2:

Year CF PVF @ 10% DCF
0 -50,000 1.0000 -50,000
1 18,000 0.9091 16,364
2 2,600 0.8264 2,149
3 18,000 0.7513 13,523
4 27,000 0.6830 18,441
NPV 477
Note:
• Cash flow of year 2 = 18,000 of inflow – servicing cost of 15,400
• Cash flow of year 4 = 18,000 of inflow + Salvage value of 9,000

Conclusion: The company should go ahead with alternative 2 and servicing part at end of year 2

WN 4: Revised analysis if supplier gives discount of 10%:

Particulars Alternative 1 Alternative 2
Existing NPV -4,937 477
Discount 5,000 5,000
Revised NPV 63 5,477
Life 3 years 4 years
PVAF 2.4868 3.1698
EAB 25 1,728
Conclusion: The company should choose alternative 2 as it has higher Equated Annual Benefit.

11. Modernization versus New machine [May 2021 RTP]

The General Manager of Merry Ltd. is considering the replacement of five-year-old equipment. The
company has to incur excessive maintenance cost of the equipment. The equipment has zero written down

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value. It can be modernized at a cost of Rs.1,40,000 enhancing its economic life to 5 years. The equipment
could be sold for Rs.30,000 after 5 years. The modernization would help in material handling and in
reducing labour , maintenance & repairs costs.

The company has another alternative to buy a new machine at a cost of Rs.3,50,000 with an economic life
of 5 years and salvage value of Rs.60,000. The new machine is expected to be more efficient in reducing
costs of material handling, labour, maintenance & repairs, etc.

The annual cost are as follows:

Particulars Existing Equipment Modernization New Machine
Wages and salaries 45,000 35,500 15,000
Supervision 20,000 10,000 7,000
Maintenance 25,000 5,000 2,500
Power 30,000 20,000 15,000
Total 1,20,000 70,500 39,500
Assuming tax rate of 50% and required rate of return of 10%, should the company modernize the
equipment or buy a new machine?
Answer:
WN 1: Initial outflow:
Particulars Modernization New machine
Capital expenditure -1,40,000 -3,50,000
Working capital 0 0
Initial Outflow 1,40,000 3,50,000

WN 2: In-between flows:
Particulars Modernization New machine
Saving in cost 49,500 80,500
[1,20,000 – 70,500] [1,20,000 – 39,500]
Less: Depreciation 22,000 58,000
[1,40,000-30,000]/5 [3,50,000-60,000]/5
PBT 27,500 22,500
Less: Tax @ 50% -13,750 -11,250
PAT 13,750 11,250
Add: Depreciation 22,000 58,000
CFAT 35,750 69,250

WN 3: Terminal flow:
Particulars Modernization New machine
Salvage value 30,000 60,000
Recapture of working capital 0 0
Total terminal flow 30,000 60,000

WN 4: Computation of NPV:
Cash flow DCF
Year Modernization New PVF @ 10% Modernization New
0 -1,40,000 -3,50,000 1.000 -1,40,000 -3,50,000
1 to 5 35,750 69,250 3.790 1,35,493 2,62,458
5 30,000 60,000 0.621 18,630 37,260
NPV 14,123 -50,282
Conclusion: The company should modernize its existing equipment and not buy a new machine because
NPV is positive in modernization of equipment.

12. Capital rationing [May 2019 MTP]

Prem Limited has a maximum of Rs.8,00,000 available to invest in new projects. Three possibilities have
emerged and the business finance manager has calculated NPV for each of the projects as follows:

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Investment Initial Cash Outlay NPV
Alpha 5,40,000 1,00,000
Beta 6,00,000 1,50,000
Gama 2,60,000 58,000
Determine which investment/combination of investments should the company invest in, if we assume that
the projects can be divided?
Answer:
Step 1: Check whether capital rationing exist:
Particulars Amount
Demand for money (5,40,000 +6,00,000 + 2,60,000) 14,00,000
Supply of money 8,00,000
Capital rationing exist as the demand for money is more than supply of money

Step 2: Statement of ranking:

Project Outflow NPV Profitability index Rank
Alpha 5,40,000 1,00,000 1.185 3
Beta 6,00,000 1,50,000 1.250 1
Gamma 2,60,000 58,000 1.223 2

Step 3: Statement of allocation:

Project Money invested Balance Money NPV
Beta 6,00,000 2,00,000 1,50,000
20/26 of Gamma 2,00,000 - 44,615
Total NPV 1,94,615
• NPV of Gamma Project = 58,000 x (20/26) = Rs.44,615

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Chapter 8: Dividend Decisions

Overview:
• Walter’s and Gordon’s model
• Dividend Re-investment and Buyback of Shares
• Graham & Dodd Model and Lintner’s model
• MM Approach

Part 1 – Walter’s and Gordon’s model

1. Walter’s Model [SM]

XYZ Ltd. earns Rs. 10/ share. Capitalization rate and return on investment are 10% and 12% respectively.
DETERMINE the optimum dividend payout ratio and the price of the share at the payout.
Answer:
Basic information:
• Cost of equity is 10% and return on investment is 12%. This is a case of growing firm and hence
optimum payout ratio is 0%
Particulars Amount
Dividend per share 0
Earnings per share 10.00
Return on Equity/Investment 12%
Cost of equity 10%

r 0.12
( 𝑥 (10 − 0))
D K e x (E − D) 0 0.10
Price = + = + = 0 + 120 = Rs. 120 per share
Ke Ke 0.10 0.10

2. Walter’s model [Nov 2020, May 2017, May 2022 MTP, May 2022 RTP, May 2024 MTP, SM]
The following figures are collected from the annual report of XYZ Ltd.:
Particulars Amount
Net Profit 30 lakhs
Outstanding 12% preference shares 100 lakhs
No. of equity shares 3 lakhs
Return on Investment 20%
Cost of Capital 16%
What should be the approximate dividend pay-out ratio so as to keep the share price at Rs.42 by using
Walter model?
Answer:
Basic information:
Particulars Amount
Dividend per share ?
Earnings per share 6.00
Return on Equity/Investment 20%
Cost of equity 16%

Note 1: Computation of EPS:

Particulars Amount
PAT 30,00,000
Less: Preference dividend -12,00,000
EAES 18,00,000

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No of equity shares 3,00,000
EPS 6.00

Computation of Dividend per share:

0.20
D x (6 − D) D + 1.25(6 − D)
42 = + 0.16 ; 42 =
0.16 0.16 0.16
0.78
42 x 0.16 = D + 7.50 − 1.25D; 6.72 = −0.25D + 7.50; 0.25D = 0.78; D = = 3.12 per share
0.25
DPS 3.12
Dividend Payout Ratio = x 100 = x 100 = 𝟓𝟐%
EPS 6

3. Walter’s Model [May 2018 RTP, Nov 2019 RTP, May 2020 RTP, Nov 2018, SM]
The following information relates to Navya Limited:
Earnings of the company Rs.20,00,000
Dividend Pay-out Ratio 60%
No of shares outstanding 4,00,000
Rate of return on investment 15%
Equity capitalization rate 12%
Required:
(i) DETERMINE what would be the market value per share as per Walter’s model.
(ii) COMPUTE optimum dividend pay-out ratio according to Walter’s model and the market value of
company’s share at that pay-out ratio.
Answer:
Basic information:
Particulars Amount
Dividend per share (5 x 60%) 3
Earnings per share (20,00,000/4,00,000) 5
Return on Equity/Investment 15%
Cost of equity 12%
r 0.15
( 𝑥 (5 − 3))
D K e x (E − D) 3 0.12
Price = + = + = 25 + 20.83 = Rs. 45.83 per share
Ke Ke 0.12 0.12

Revised market price with optimum dividend payout ratio:

• Cost of equity is lower than return on equity and hence optimum dividend payout ratio is 0%
r 0.15
x (E − D) ( 𝑥 (5 − 0))
D Ke 0 0.12
Price = + = + = 0 + 52.08 = Rs. 52.08 per share
Ke Ke 0.12 0.12

4. Walter’s model [Nov 2018 RTP]

The earnings per share of a company is Rs.10 and the rate of capitalisation applicable to it is 10 per
cent. The company has three options of paying dividend i.e.(i) 50%, (ii)75% and (iii)100%. Calculate the
market price of the share as per Walter’s model if it can earn a return of (a) 15, (b) 10 and (c) 5 per
cent on its retained earnings.
Answer:
r
D K e x (E − D)
Price = +
Ke Ke
Computation of price:
Particulars Payout of 50% Payout of 75% Payout of 100%
R = 15% 0.15 0.15 0.15
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10

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= 50 + 75 = Rs.125 = 75 + 37.50 = Rs.112.50 = 100 + 0 = Rs.100
R = 10% 0.10 0.10 0.10
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10
= 50 + 50 = Rs.100 = 75 + 25 = Rs.100 = 100 + 0 = Rs.100
R = 5% 0.05 0.05 0.05
5 x (10 − 5) 7.5 x (10 − 7.5) 10 x (10 − 10)
0.10 0.10 0.10
+ + +
0.10 0.10 0.10 0.10 0.10 0.10
= 50 + 25 = Rs.75 = 75 + 12.50 = Rs.87.50 = 100 + 0 = Rs.100

5. Walter’s Model [May 2021 RTP, May 2019 MTP, Nov 2012 RTP, SM]
The following information is supplied to you:
Amount
Total earnings Rs.2,00,000
No of equity shares (of Rs.100 each) 20,000
Dividend paid 1,50,000
Price/Earnings Ratio 12.5
❖ Ascertain whether the company is following an optimal dividend policy?
❖ Find out what should be the P/E ratio at which the dividend policy will have no effect on the value
of the share?
❖ Will your decision change, if the P/E ratio is 8 instead of 12.5?
Answer:
• Dividend policy is dependent on two important variables – Cost of equity and Return on equity
Total earnings 2,00,000
Return on equity = x 100 = x100 = 10%
Value of equity 20,000 x 100
• Question has three scenarios wherein dividend policy has been linked with PE Multiple.
• Cost of equity can be taken as inverse of PE Multiple if payout ratio is 100%. However, in this
question payout ratio is only 75%. However we still go ahead with the assumption due to lack of
information.

Original scenario:
• Cost of equity = (1/12.50) = 0.08 or 8%
• Return on equity = 10%
• The optimum payout ratio in this case is 0%. The company is paying 75% and hence it is not
following optimal dividend policy

Scenario b:
• Dividend policy will have no effect on share price if the cost of equity is equal to return on equity
• Return on equity = 10%. Hence cost of equity should also be 10%
• Cost of equity = (1/PE Multiple); 10% = (1/PE Multiple); PE Multiple = 10 Times (1/10%)
• Hence Dividend Policy will have no effect on share price if PE Multiple is 10 Times

Scenario c:
• PE Multiple = 8 Times; Cost of equity = (1/8) = 12.50%
• Return on equity = 10%
• Return on equity is lower than cost of equity. This would mean optimum payout ratio is 100%. The
company is currently paying 75% and hence not following optimal dividend policy

6. Walter’s model [Nov 2018, Nov 2019 RTP, May 2020 RTP, Nov 2019, May 2016 RTP, Nov 2014
RTP, May 2013 RTP, July 2021]
Following figures and information were extracted from the company A Limited:
Earnings of the company 10,00,000

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Price Earnings ratio 10
Dividend paid 6,00,000
Number of shares 2,00,000
Rate of return on investment 20%
You are required to calculate:
• Current market price of the share
• Capitalization rate of its risk class
• What should be the optimum pay-out ratio?
• What should be the market price per share at optimal pay-out ratio? (Use walter’s model)
Answer:
Basic information:
Particulars Amount
Dividend per share (6,00,000/2,00,000) 3.00
Earnings per share (10,00,000/2,00,000) 5.00
Return on Equity/Investment 20%
Cost of equity (1/PE Multiple) 10%
r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟐𝟎
𝟑 𝐱 (𝟓 − 𝟑)
𝐏𝐫𝐢𝐜𝐞 = + 𝟎. 𝟏𝟎 = 𝟑𝟎. 𝟎𝟎 + 𝟒𝟎. 𝟎𝟎 = 𝟕𝟎. 𝟎𝟎
𝟎. 𝟏𝟎 𝟎. 𝟏𝟎

• Capitalization rate (Cost of equity) = 10%

• Return on equity is higher than cost of equity. This is a case of growing firm and hence the optimum
payout ratio is 0%

Price at optimum payout ratio of 0%:

r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟐𝟎
𝟎 𝐱 (𝟓 − 𝟎)
𝐏𝐫𝐢𝐜𝐞 = + 𝟎. 𝟏𝟎 = 𝟎. 𝟎𝟎 + 𝟏𝟎𝟎. 𝟎𝟎 = 𝟏𝟎𝟎. 𝟎𝟎
𝟎. 𝟏𝟎 𝟎. 𝟏𝟎

7. Gordon’s model [May 2019 MTP, May 2019, May 2015]

The following information is collected from the annual reports of J Limited:
Particulars Amount
Profit before tax Rs.2.50 Crores
Tax rate 40 percent
Retention ratio 40 percent
Number of outstanding shares 50,00,000
Equity capitalization rate 12 percent
Rate of return on investment 15 percent
What should be the market price per share according to Walter and Gordon’s model of dividend policy?
Answer:
Basic information:
Particulars Amount
Dividend per share (3 x 60%) 1.80
Earnings per share 3.00
Return on Equity/Investment 15%
Cost of equity 12%

Note 1: Computation of EPS:

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Particulars Amount
PBT 2,50,00,000
Less: Tax -1,00,00,000
PAT 1,50,00,000
Less: Preference dividend 0
EAES 1,50,00,000
No of equity shares 50,00,000
EPS 3.00
r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟏𝟓
𝟏. 𝟖𝟎 𝟎. 𝟏𝟐 𝐱 (𝟑 − 𝟏. 𝟖𝟎)
𝐏𝐫𝐢𝐜𝐞 = + = 𝟏𝟓 + 𝟏𝟐. 𝟓𝟎 = 𝟐𝟕. 𝟓𝟎
𝟎. 𝟏𝟐 𝟎. 𝟏𝟐

Gordon’s model:
Particulars Amount
Dividend per share (3 x 60%) 1.80
Growth rate (IRR x Retention ratio) 6.00%
Cost of equity 12%
• It is assumed that DPS of Rs.1.80 is D1

D1 1.80 1.80
Price = = = = Rs. 30
K e − G 12% − 6% 6%

Alternate answer if DPS of Rs.1.80 is D0:

D1 1.80 + 6% 1.908
Price = = = = Rs. 31.80
K e − G 12% − 6% 6%

8. Gordon’s model [May 2018 MTP, SM]

A firm had been paid dividend at Rs.2 per share last year. The estimated growth of the dividends from the
company is estimated to be 5% per annum. Determine the estimated market price of the equity share if the
estimated growth rate of dividends (i) rises to 8% and (ii) falls to 3%. Also find out the present market price
of the share, given that the required rate of return of the equity investors is 15.5%
Answer:
WN 1: Computation of market price when growth rate is 5%:
D1 (2 + 5%) 2.10
Price = = = = Rs. 20
K e − G 15.50% − 5% 10.50%

WN 2: Computation of market price when growth rate is 8%:

D1 (2 + 8%) 2.16
Price = = = = Rs. 28.80
K e − G 15.50% − 8% 7.50%

WN 3: Computation of market price when growth rate is 3%:

D1 (2 + 3%) 2.06
Price = = = = Rs. 16.48
K e − G 15.50% − 3% 12.50%

9. Gordon’s model [Nov 2020 MTP, May 2019 RTP, Nov 2019 MTP, SM]
The following figures are collected from the annual report of XYZ Limited:
Particulars Amount
Net Profit 60,00,000
Outstanding 10% preference capital 100,00,000
No of equity shares 5,00,000

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Return on investment 20%
Cost of capital (Ke) 14%
Calculate price per share using Gordon’s model when dividend pay-out is
• 25%
• 50% and
• 100%
Answer:
WN 1: Computation of EPS:
Particulars Amount
Net Profit 60,00,000
Less: Preference Dividend -10,00,000
EAES 50,00,000
No of shares 5,00,000
EPS Rs.10

WN 2: Computation of market price at different payout ratio:

Payout ratio is 25%:
• Dividend per share = Rs.10 x 25% = Rs.2.50 per share
• Growth rate = 20% x 75% = 15%

D1 2.50 2.50
Price = = = = −250
K e − G 14% − 15% −1%

As per Gordon’s model of Dividend relevance model, the cost of equity should be greater than the growth
rate. In this case, growth rate is higher than cost of equity and hence price cannot be computed as per
Gordon’s model

Payout ratio is 50%:

• Dividend per share = Rs.10 x 50% = Rs.5.00 per share
• Growth rate = 20% x 50% = 10%

D1 5.00 5.00
Price = = = = Rs. 125
K e − G 14% − 10% 4%

Payout ratio is 100%:

• Dividend per share = Rs.10 x 100% = Rs.10.00 per share
• Growth rate = 20% x 0% = 0%

D1 10.00 10.00
Price = = = = Rs. 71.43
K e − G 14% − 0% 14%

10. Walter/Gordon Model

A company has a book value per share of Rs.137.80. Its return on equity is 15% and it follows a policy of
retaining 60% of its earnings. If the opportunity cost of capital is 18%, what is the price of share today?
Answer:
WN 1: Valuation of share as per Walter’s model:
Basic information:
Particulars Amount
Earnings per share (Return on equity x BVPS) 20.67
(137.80 x 15%)
Dividend per share (20.67 x 40%) 8.27
Cost of equity 18.00%
Return on equity 15.00%

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r
D K e x (E − D)
Price = +
Ke Ke
0.15
8.27 0.18 x (20.67 − 8.27)
Price = + = 45.94 + 57.41 = 103.35
0.18 0.18

WN 2: Valuation of share as per Gordon’s model:

Particulars Amount
Dividend per share (D1) 8.27
8.27 assumed as D1
Growth rate (IRR x Retention ratio) 9.00%
Cost of equity 18.00%

D1 8.27 8.27
Price = = = = Rs. 91.89
K e − G 18% − 9% 9%

Alternate answer (if 8.27 is assumed as D0):

D1 8.27 + 9% 9.01
Price = = = = Rs. 100.11
K e − G 18% − 9% 9%

11. Gordon’s Model [Nov 2023 RTP]

HM Ltd. is listed on Bombay Stock Exchange which is currently been evaluated by Mr. A on certain
parameters. Mr. A collated following information:
(a) The company generally gives a quarterly interim dividend. Rs. 2.5 per share is the last dividend
declared.
(b) The company’s sales are growing by 20% on a 5-year Compounded Annual Growth Rate (CAGR) basis,
however the company expects following retention amounts against probabilities mentioned as contention
is dependent upon cash requirements for the company. Rate of return is 10% generated by the company.
Situation Probability Retention Ratio
A 30% 50%
B 40% 60%
C 30% 50%
The current risk-free rate is 3.75% and with a beta of 1.2 company is having a risk premium of 4.25%. You
are required to help Mr. A in calculating the current market price using Gordon’s formula
Answer:
Note 1: Computation of cost of equity:
• Cost of equity = Rf + Beta x (Rm – Rf)
• Cost of equity = 3.75 + 1.20 x 4.25 = 8.85%

Note 2: Computation of Growth Rate:

• Retention Ratio = (30% x 50% + 40% x 60% + 30% x 50%) = 54%
• Growth Rate = ROE x Retention Ratio = 10% x 54% = 5.40%

Note 3: Valuation of Share:

D1 10 + 5.40%
P0 = = = Rs. 305.51
K e − G 8.85% − 5.4%

12. Gordon’s Model [Sep 2024 MTP]

Mr. A is thinking of buying shares at Rs. 500 each having face value of Rs. 100. He is expecting a bonus at
the ratio of 1:5 at the end of fourth year. Annual expected dividend is 20% and the same rate is expected to
be maintained on the expanded capital base. He intends to sell the shares at the end of seventh year at an
expected price of Rs. 900 each. Incidental expenses for purchase and sale of shares are estimated to be 5%

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of the market price. He expects a minimum return of 12% per annum. Should Mr. A buy the share? If so,
what maximum price should he pay for each share? Assume no tax on dividend income and capital gain
Answer:
WN 1: Decision on purchase of share:
Year Cash flow PVF @ 12% DCF
1 20 0.893 17.86
2 20 0.797 15.94
3 20 0.712 14.24
4 20 0.636 12.72
24
5 [20 x 1.2 shares] 0.567 13.61
6 24 0.507 12.17
7 24 0.452 10.85
7 1026 0.452 463.75
PV of future cash inflows 561.14
Less: Purchase price (500 x 1.05) (525)
Net gain 36.14
Note:
• Selling price at end of year 7 is Rs.900. Investor buying one share would get 1.2 shares and hence
the gross sale proceeds would be Rs.1080. Selling expenses are 5% and hence net selling price is
Rs.1,026
• Dividend of Rs.24 per share has been taken from year 5 as bonus issue is made at the end of fourth
year

13. Dividend discount model [May 2021 MTP, May 2018 MTP, May 2012, SM]
In December, 2011 AB Co.'s share was sold for Rs. 219 per share. A long term earnings growth rate of
11.25% is anticipated. AB Co. is expected to pay dividend of Rs.5.04 per share.
❖ What rate of return an investor can expect to earn assuming that dividends are expected to
grow along with earnings at 11.25% per year in perpetuity?
❖ It is expected that AB Co. will earn about 15% on book Equity and shall retain 60% of
earnings. In this case, whether, there would be any change in growth rate and cost of Equity?
Answer:
WN 1: Computation of rate of return an investor expects (Cost of equity) for original scenario:
Basic information:
Particulars Amount
Dividend per Share (D1) 5.04
Growth rate 11.25%
Cost of equity ?
Price 219
D1 5.04
Cost of equity = + Growth rate = + 0.1125 = 0.023 + 0.1125 = 0.1355 (or)13.55%
P0 219

WN 2: Rework scenario:
Note 1: Computation of DPS:
• The company will be earning 15% on book equity. Growth rate for revised scenario will be IRR x
Retention ratio = 15% x 60% = 9%
• Growth rate for the original scenario was 11.25%. This is further analyzed below:
Original scenario Analysis:
Growth rate = ROE x Retention ratio
11.25% = 15% x Retention ratio

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𝟏𝟏. 𝟐𝟓%
𝐑𝐞𝐭𝐞𝐧𝐭𝐢𝐨𝐧 𝐫𝐚𝐭𝐢𝐨 = = 𝟕𝟓%
𝟏𝟓%
Payout ratio in original scenario = 25%
5.04
EPS = = 20.16
25%
Revised DPS =20.16 x 40% = 8.064

D1 8.064
Cost of equity = + Growth rate = + 0.09 = 0.0368 + 0.09 = 0.1268 (or)12.68%
P0 219

14. Step-up growth model [Dec 2021, Nov 2023 MTP, SM]
X Ltd. is a multinational company. Current market price per share is Rs.2,185. During the F.Y. 2020-21, the
company paid Rs.140 as dividend per share. The company is expected to grow @ 12% p.a. for next four
years, then 5% p.a. for an indefinite period. Expected rate of return of shareholders is 18% p.a.
• Find out intrinsic value per share.
• State whether shares are overpriced or underpriced.
Answer:
WN 1: Computation of dividends till first year of stabilization phase [Year 5]
Year Growth Rate Dividend
1 12% 156.80
[140 + 12%]
2 12% 175.62
[156.80 + 12%]
3 12% 196.69
[175.62 + 12%]
4 12% 220.29
[196.69 + 12%]
5 5% 231.30

WN 2: Computation of MPS at beginning of stabilization phase [Year 4]

D5 231.30
P4 = = = 𝑅𝑠. 1,779.23
K e − G 18% − 5%

WN 3: Computation of intrinsic value:

Year Cash flow PVF @ 18% DCF
1 156.80 0.847 132.81
2 175.62 0.718 126.10
3 196.69 0.608 119.59
4 220.29 0.515 113.45
4 1,779.23 0.515 916.30
Intrinsic Value of Share 1,408.25
Intrinsic value of share is Rs.1,408.25 as compared to latest market price of Rs.2,185. Market price of share
is over-priced by Rs.776.75.

15. Step-up Growth Model [May 2024]

Vista Limited's retained earnings per share for the year ending 31.03.2023 being 40% is Rs. 3.60 per share.
Company is foreseeing a growth rate of 10% per annum in the next two years. After that the growth rate is
expected to stabilize at 8% per annum. Company will maintain its existing pay-out ratio. If the investor's
required rate of return is 15%, Calculate the intrinsic value per share as of date using Dividend Discount
model.
Answer:
WN 1: Computation of dividends till first year of stabilization phase [Year 3]
• Earnings of last year (D0) = 3.60/40% = Rs.9.00 per share
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• Dividends of last year = 9 x 60% = Rs.5.40 per share
Year Growth Rate Dividend
1 10% 5.94
[5.4 + 10%]
2 10% 6.534
[5.94 + 10%]
3 8% 7.05672
[6.534 + 8%]

WN 2: Computation of MPS at beginning of stabilization phase [Year 2]

D3 7.05672
P2 = = = 𝑅𝑠. 100.81
K e − G 15% − 8%

WN 3: Computation of intrinsic value:

Year Cash flow PVF @ 15% DCF
1 5.94 0.870 5.17
2 6.53 0.756 4.94
2 100.81 0.756 76.21
Intrinsic Value of Share 86.32

Part 2 – Dividend Re-investment and Buyback of shares

16. Dividend re-investment [SM]

Mr H is currently holding 1,00,000 shares of HM ltd, and currently the share of HM ltd is trading on
Bombay Stock Exchange at Rs. 50 per share. Mr A have a policy to re-invest the amount of any dividend
received into the shared back again of HM ltd. If HM ltd has declared a dividend of Rs. 10 per share, please
determine the no of shares that Mr A would hold after he re-invests dividend in shares of HM ltd.
Answer:
Particulars Amount
Dividend received [1,00,000 x 10] 10,00,000
Current market price (cum-dividend) Rs.50
Current market price (ex-dividend) Rs.40
No of shares received through reinvestment [10,00,000/40] 25,000
Revised number of shares [1,00,000 + 25,000] 1,25,000
• Share is currently quoted at Rs.50 and the same would decline to Rs.40 once the dividend is paid.
Re-investment of dividend would happen at ex-dividend share price of Rs.40

17. Buyback of shares [Sep 2024 MTP]

Paarath Limited had recently repurchased 20,000 equity shares at a premium of 10% to its prevailing
market price. The book value per share (after repurchasing) is Rs. 193.20. Other Details of the company are
as follows:
• Earnings of the company (before buyback) = Rs. 18,00,000
• Current MPS is Rs. 270 with a P/E Ratio of 18.
CALCULATE the Book Value per share of the company before the re purchase.
Answer:
WN 1: Computation of existing no of shares:
Particulars Calculation Amount
EAES 18,00,000
No of equity shares 18,00,000/15 1,20,000
EPS 270/18 15.00
PE Multiple 18.00
MPS 270.00

WN 2: Computation of Book value per share before repurchase

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Particulars Before buyback After buyback
Networth 2,52,60,000 1,93,20,000
[1,93,20,000 + (20,000 x 297)
[193.20 x 1,00,000]
No of equity shares 1,20,000 1,00,000
[1,20,000 – 20,000]
Book value per share 210.50 193.20
• Buyback size = 20,000 shares x [270 + 10%] = Rs.59,40,000
• Networth before buyback = Networth post buyback + 59,40,000 = 2,52,60,000

Part 3 – Graham & Dodd Model and Lintner’s Model

18. Graham & Dodd Model

RA Limited has earnings of Rs.12 per share this year. The dividend payout is 75%. A multiplier of 7 is
considered reasonable under current market conditions. What is the likely market price under G&D model?
Answer:
EPS 12
Price = Multiplier x (DPS + ( )) = 7 x (9 + ( )) = 7 x 13 = Rs. 91
3 3

19. Lintner’s model

Given the last year’s dividend is Rs.9.80, speed of adjustment = 45%, target payout ratio 60% and EPS of
current year = Rs.20. Calculate the current year’s dividend.
Answer:
Computation of Dividend per share as per Lintner’s model:
Particulars Amount
Dividend per share of last year 9.80
Target DPS of current year (20 x 60%) 12.00
Target increase in DPS 2.20
Actual increase in DPS (2.20 x 45%) 0.99
Final DPS of current year (9.80 + 0.99) 10.79

Part 4 – MM Approach

20. Modigilani Miller Model [Nov 2018 MTP, Nov 2014, Nov 2021 RTP, May 2023 MTP, May 2024
RTP, May 2024 MTP, SM]
MCO Ltd. has a paid-up share capital of Rs. 10,00,000, face value of Rs. 10 each. The current market price
of the shares is Rs.20 each. The Board of Directors of the company has an agenda of meeting to pay a
dividend of 25% to its shareholders. The company expects a net income of Rs. 5,20,000 at the end of the
current financial year. Company also plans for a capital expenditure for the next financial year for a cost of
Rs. 7,50,000, which can be financed through retained earnings and issue of new equity shares. Company’s
desired rate of investment is 15%.
Required
Following the Modigliani- Miller (MM) Hypothesis, DETERMINE value of the company when:
(i) It does not pay dividend and
(ii) (ii) It does pay dividend

Answer:
WN 1: Computation of market price as per MM Model:
P1 = P0 x (1 + Ke ) − 𝐷1

Dividend not declared:

P1 = P0 x (1 + Ke ) − D1 = 20 x (1 + 15%) − 0 = Rs. 23

Dividend is declared:
P1 = P0 x (1 + Ke ) − D1 = 20 x (1 + 15%) − 2.5 = Rs. 20.50

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WN 2: Valuation of Firm with/without dividend payout:

Particulars Dividend Paid Dividend not paid
1. Total earnings 5,20,000 5,20,000
-2,50,000
2. Dividends paid [1,00,000 x 2.50] 0
3. Retained earnings [2-1] 2,70,000 5,20,000
4. New investments to be made 7,50,000 7,50,000
5. Fresh capital to be raised [4-3] 4,80,000 2,30,000
6. Year-end share price 20.50 23.00
7. No of shares to be issued [5/6] 23,415 10,000
8. Closing shares [1,00,000 + item (7)] 1,23,415 1,10,000
9. Closing price 20.50 23.00
10. Value of firm at end of year [8 x 9] 25,30,008 25,30,000
• Value of firm is not impacted by Dividend Decision

(Closing shares x Closing price) − Investment + Earnings

Adjusted value at beginning of year =
1 + Ke
Dividends Paid:
(25,30,008) − 7,50,000 + 5,20,000
Adjusted value at beginning of year = = 20,00,000
1 + 0.15
Dividends not Paid:
(25,30,000) − 7,50,000 + 5,20,000
Adjusted value at beginning of year = = 20,00,000
1 + 0.15

21. Modigilani Miller Model [Nov 2018 MTP, May 2013, May 2023 RTP, Nov 2023 MTP]
M Ltd. belongs to a risk class for which the capitalization rate is 10%. It has 25,000 outstanding
shares and the current market price is Rs.100. It expects a net profit of Rs. 2,50,000 for the year and the
Board is considering dividend of Rs.5 per share. M Ltd. requires to raise Rs.5,00,000 for an approved
investment expenditure. Show, how the MM approach affects the value of M Ltd. if dividends are paid
or not paid. Also WHAT is the implied growth rate in dividends as per Gordon’s model, if expected
dividend payment is considered imminent?
Answer:
WN 1: Computation of market price as per MM Model:
P1 = P0 x (1 + Ke ) − 𝐷1

Dividend not declared:

P1 = P0 x (1 + Ke ) − D1 = 100 x (1 + 10%) − 0 = Rs. 110

Dividend is declared:
P1 = P0 x (1 + Ke ) − D1 = 100 x (1 + 10%) − 5 = Rs. 105

WN 2: Valuation of Firm with/without dividend payout:

Particulars Dividend Paid Dividend not paid
1. Total earnings 2,50,000 2,50,000
2. Dividends paid 1,25,000 -
3. Retained earnings [2-1] 1,25,000 2,50,000
4. New investments to be made 5,00,000 5,00,000
5. Fresh capital to be raised [4-3] 3,75,000 2,50,000
6. Year-end share price 105 110
7. No of shares to be issued [5/6] 3,571 2,273
8. Closing shares [25,000 + item (7)] 28,571 27,273
9. Closing price 105 110

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10. Value of firm [8 x 9] 29,99,955 30,00,030
• Value of firm is not impacted by Dividend Decision

Computation of growth rate:

D1 5 5
P0 = ; 100 = ; 10 − 100𝐺 = 5; 𝐺 = = 5%
Ke − G 0.10 − 𝐺 100

22. MM Approach (Nov 2022 RTP):

Ordinary shares of a listed company are currently trading at Rs. 10 per share with two lakh shares
outstanding. The company anticipates that its earnings for next year will be Rs. 5,00,000. Existing cost of
capital for equity shares is 15%. The company has certain investment proposals under discussion which
will cause an additional 26,089 ordinary shares to be issued if no dividend is paid or an additional 47,619
ordinary shares to be issued if dividend is paid.
Applying the MM hypothesis on dividend decisions, CALCULATE the amount of investment and
dividend that is under consideration by the company.
Answer:
Let us assume dividend per share to be A and amount of investment to be B
Particulars Dividend Paid Dividend Not Paid
1. Total earnings 5,00,000 5,00,000
2. Dividends paid 2,00,000A 0
3. Retained earnings 5,00,000 – 2,00,000A 5,00,000
4. Investment made B B
5. External equity issued B – (5,00,000 – 2,00,000A) B – 5,00,000
(Investment – Retained earnings)
6. Issue price (Closing price) 11.50 – A 11.50
[Opening price + 15% - Dividends]
7. No of shares issued B − 5,00,000 + 2,00,000A B − 5,00,000
11.50 − A 11.50

Computation of investment made:

Shares issued when dividend not paid = 26,089
B − 5,00,000
= 26,089
11.50
B − 5,00,000 = 3,00,024
Investment made = Rs.8,00,024

Computation of Dividend under consideration:

Shares issued when dividend paid = 47,619
8,00,024 − 5,00,000 − 2,00,000A
= 47,619
11.50 − A
3,00,024 + 2,00,000A = 5,47,618.50 − 47,619A
2,47,594.50 = 2,47,619A
2,47,594.50
A= = 1.00
2,47,619
Dividend per share = Rs.1
Total Dividends = 1 x 2,00,000 = Rs.2,00,000

Practice Questions

1. Walter’s Model [May 2023]

Following information are given for a company:
Earnings per share Rs.10
P/E Ratio 12.50
Rate of return on investment 12%
Market price per share as per Walter’s Model Rs.130

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You are required to calculate: (i) Dividend payout ratio. (ii) Market price of share at optimum dividend
payout ratio. (iii) P/E ratio, at which the dividend policy will have no effect on the price of share. (iv)
Market price of share at this P/E ratio. (v) Market price of share using Dividend growth model
Answer:
Note 1: Computation of Dividend Payout Ratio
• Cost of equity = (1/PE Multiple) = 1/12.50 = 8%
r 0.12
( x (10 − D))
D K e x (E − D) D 0.08
Price = + ; 130 = +
Ke Ke 0.08 0.08
D + 15 − 1.5D 4.60
130 = ; 10.40 = 15 − 0.5𝐷; 𝐷 = = 9.20
0.08 0.50
• Dividend Payout Ratio = (9.20/10) = 92%

Note 2: MPS at optimum Dividend Payout Ratio

• Cost of equity is lower than return on equity and hence optimum payout ratio is 0%

r 0.12
( x (10 − 0))
D K e x (E − D) 0 0.08
Price = + ; + = Rs. 187.50
Ke Ke 0.08 0.08

Note 3: PE Ratio at which the Dividend Policy will have no effect on the price of share and market
price at the PE Ratio
Cost of equity = Return on equity
1 1
= 12%; 𝑃𝐸 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 = = 8.33333 Times
𝑃𝐸 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑒 12%
Price of share at P/E ratio = 10 x 8.3333 = Rs.83.33

Note 4: Computation of market price as per Dividend Growth Model

D1 9.2 + 0.96%
P0 = = = Rs. 131.936
K e − G 8% − 0.96%
• Growth rate = ROE x Retention ratio = 12% x 8% = 0.96%

2. Walter/Gordon Model [Jan 2021, May 2021 MTP, Nov 2020 RTP, Nov 2019, Sep 2024 RTP, Sep
2024 MTP]
The following information is given for QB Ltd.
Net Profit for the year 30,00,000
12% preference share capital 1,00,00,000
Equity share capital (of Rs.10 each) 15,00,000
Retention ratio 75%
Cost of capital 18%
Internal Rate of Return on investment 22%
Calculate the market price per share using
❖ Gordon’s formula
❖ Walter’s formula
Answer:
Computation of EPS:
Particulars Amount
PAT 30,00,000
Less: Preference Dividend [1,00,00,000 x 12%] -12,00,000
EAES 18,00,000
No of equity shares (15,00,000/10) 1,50,000
Earnings per share [EAES/No of equity shares] 12
Dividend per share [12 x (100% – 75%)] 3

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Basic information:
Particulars Amount
Dividend per share 3.00
Earnings per share 12.00
Return on Equity/Investment 22%
Cost of equity 18%

r
D K e x (E − D)
Price = +
Ke Ke
𝟎. 𝟐𝟐
𝟑 𝐱 (𝟏𝟐 − 𝟑)
𝐏𝐫𝐢𝐜𝐞 = + 𝟎. 𝟏𝟖 = 𝟏𝟔. 𝟔𝟕 + 𝟔𝟏. 𝟏𝟏 = 𝟕𝟕. 𝟕𝟖
𝟎. 𝟏𝟖 𝟎. 𝟏𝟖

Gordon’s model:
Particulars Amount
Dividend per share 3.00
Payout ratio (3/12) 25%
Retention ratio (1 – Payout ratio) 75%
Growth rate (IRR x Retention ratio) 16.50%
Cost of equity 18%
• It is assumed that DPS of Rs.3.00 is D1
D1 3.00 3.00
Price = = = = Rs. 200
K e − G 18% − 16.5% 1.50%

Alternate answer if DPS of Rs.3.00 is D0:

D1 3.00 + 16.50% 3.495
Price = = = = Rs. 233
Ke − G 12% − 6% 6%

3. Gordon’s Model [SM]

Taking an example of three different firms i.e. growth, normal and declining, CALCULATE the share price
using Gordon’s model.
Factors Growth Normal Declining
r (rate of return on retained earnings) 15% 10% 8%
Ke (Cost of Capital) 10% 10% 10%
E (Earning Per Share) 10 10 10
b (Retained Earnings) 0.6 0.6 0.6
1 - b (Dividend Payout 0.4 0.4 0.4
Answer:
Growth rate = Rate of return x Retention ratio

Growth Company:
D1 10 x 0.40 4
Price = = = = Rs. 400.00
K e − G 10% − 9% 1%

Normal Company:
D1 10 x 0.40 4
Price = = = = Rs. 100.00
K e − G 10% − 6% 4%

Declining Company:
D1 10 x 0.40 4
Price = = = = Rs. 76.92
K e − G 10% − 4.8% 5.2%

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4. Gordon’s Model [Nov 2023]

INFO Ltd is a listed company having share capital of Rs. 2400 Crores of Rs. 5 each. During the year 2022-
23
• Dividend distributed = 1000%
• Expected Annual growth rate in dividend = 14%
• Expected rate of return on its equity capital = 18%
Required:
(a) Calculate price of share applying Gordon's growth Model.
(b) What will be the price of share if the Annual growth rate in dividend is only 10%?
(c) According to Gordon's growth Model, if Internal Rate of Return is 25%, then what should be the
optimum dividend payout ratio in case of growing stage of company? Comment
Answer:
Part (a)
D1 50 + 14%
P0 = = = Rs. 1,425
K e − G 18% − 14%

Part (b)
D1 50 + 10%
P0 = = = Rs. 687.50
K e − G 18% − 10%

Part (c)
If Internal rate of return, r = 25% and Ke = 18%. As per Gordon’s model, when r > Ke, optimum dividend
payout ratio is ‘Zero’. When IRR is greater than cost of capital, the price per share increases and dividend
payout decreases.

5. Buyback of Shares [SM]

Following information is given pertaining to DG ltd,
Particulars Amount
No of shares outstanding 1,00,000
Earnings Per share 25 per share
P/E Ratio 20
Book value per share 400 per share
If company decides to repurchase 25,000 shares, at the prevailing market price, what is the resulting book
value per share after repurchasing.
Answer:
Particulars Calculation Amount
Current Networth 1,00,000 x 400 4,00,00,000
Less: Reduction in NW due to buy-back 25,000 x 500 -1,25,00,000
Revised Networth 2,75,00,000
Revised number of shares 1,00,000 – 25,000 75,000
Revised Book value per share 𝟐, 𝟕𝟓, 𝟎𝟎, 𝟎𝟎𝟎 366.67
𝟕𝟓, 𝟎𝟎𝟎

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Chapter 9: Management of Working Capital

Overview:
• Liquidity versus profitability
• Working capital estimation using operating cycle method
• Working capital estimation using normal method
• Optimum cash balance
• Cash budget
• Relaxation/tightening of credit terms
• Factoring arrangement

Part 1 – Liquidity versus profitability

1. Investment Policies [SM]

A firm has the following data for the year ending 31st March, 2022:
Particulars Amount
Sales (1,00,000 @ Rs.20) 20,00,000
Earnings before interest and taxes 2,00,000
Fixed Assets 5,00,000
The three possible current assets holdings of the firm are Rs. 5,00,000, Rs. 4,00,000 and Rs. 3,00,000. It is
assumed that fixed assets level is constant, and profits do not vary with current assets levels. ANALYSE
the effect of the three alternative current assets policies.
Answer:
Particulars Conservative Moderate Aggressive
Sales 20,00,000 20,00,000 20,00,000
EBIT 2,00,000 2,00,000 2,00,000
Current Assets 5,00,000 4,00,000 3,00,000
Fixed assets 5,00,000 5,00,000 5,00,000
Total Assets 10,00,000 9,00,000 8,00,000
Return on Total Assets 20% 22.22% 25%
(EBIT/Total Assets)
Current Assets/Fixed Assets 1.00 0.80 0.60
The aforesaid calculation shows that the conservative policy provides greater liquidity (solvency) to the
firm, but lower return on total assets. On the other hand, the aggressive policy gives higher return, but low
liquidity and thus is very risky. The moderate policy generates return higher than Conservative policy but
lower than aggressive policy. This is less risky than aggressive policy but riskier than conservative policy.
It also reflects inverse relationship between Current Assets / Fixed Assets ratio and Return on Total Assets.

2. Financing policies – impact on profitability and liquidity [May 2021 RTP, May 2019 RTP, Nov
2018 RTP, Nov 2020 RTP]
A company is considering its working capital investment and financial policies for the next year. Estimated
fixed assets and current liabilities for the next year are Rs.2.60 crores and Rs.2.34 crores respectively.
Estimated Sales and EBIT depend on current assets investment, particularly inventories and book-debts.
The financial controller of the company is examining the following alternative Working Capital Policies:
Working capital policy Investment in current assets Estimated sales EBIT
Conservative 4.50 12.30 1.23
Moderate 3.90 11.50 1.15
Aggressive 2.60 10.00 1.00
After evaluating the working capital policy, the Financial Controller has advised the adoption of the
moderate working capital policy. The company is now examining the use of long-term and short- term
borrowings for financing its assets. The company will use Rs.2.50 crores of the equity funds. The
corporate tax rate is 35%. The company is considering the following debt alternatives.

Financing Policy Short-term Debt Long-term Debt

Conservative 0.54 1.12

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Moderate 1 0.66
Aggressive 1.5 0.16

Interest rate-Average 12% 16%

You are required to calculate the following:

• Working capital position for each investment policy:
o Net working capital position
o Rate of return on total assets
o Current ratio
• Analysis of financing policies for
o Net working capital position
o Rate of return on shareholders equity
o Current ratio
Answer:
WN 1: Analysis of working capital policies:
Particulars Conservative Moderate Aggressive
Current Assets 4.50 3.90 2.60
Fixed assets 2.60 2.60 2.60
Total Assets 7.10 6.50 5.20
Current liabilities 2.34 2.34 2.34
Net working capital (CA - CL) 2.16 1.56 0.26
Current ratio [Current Assets/Current Liabilities] 1.92 1.67 1.11
EBIT 1.23 1.15 1.00
Rate of return on total assets (EBIT/Total assets) 17.32 17.69 19.23
Note:
• We have analyzed the various working capital policies given in the question and the financing for
the same will be analyzed in the next working note

WN 2: Analysis of financing policies:

• The company has decided to go ahead with moderate working capital policy from assets side. We
will now analyze the three financing policies given in the question
Particulars Conservative Moderate Aggressive
Current Assets 3.90 3.90 3.90
Fixed assets 2.60 2.60 2.60
Total Assets 6.50 6.50 6.50
Equity share capital 2.50 2.50 2.50
Long term debt 1.12 0.66 0.16
Short term debt 0.54 1.00 1.50
Current liabilities 2.34 2.34 2.34
Total liabilities 6.50 6.50 6.50
Net working capital (CA - CL - short term debt) 1.02 0.56 0.06
Current ratio (CA/(CL+Short term debt)) 1.35 1.17 1.02
EBIT 1.1500 1.1500 1.1500
Less: Interest on short-term debt -0.0648 -0.1200 -0.1800
Less: Interest on long-term debt -0.1792 -0.1056 -0.0256
EBT 0.9060 0.9244 0.9444
Less: Tax @ 35% -0.3171 -0.3235 -0.3305
EAT/EAES 0.5889 0.6009 0.6139
Return on equity (EAES/Equity) x 100 23.56 24.04 24.56

Part 2 – Working Capital Estimation Using Operating Cycle Method

3. Operating Cycle [SM]

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From the following information of XYZ Ltd., you are required to CALCULATE: (a) Net operating cycle
period. (b) Number of operating cycles in a year.
Raw material inventory consumed during the yea 6,00,000
Average stock of raw material 50,000
Cost of Production for the year 5,00,000
Average work-in-progress inventory 30,000
Cost of goods sold during the year 8,00,000
Average finished goods stock held 40,000
Average collection period from debtors 45 days
Average credit period availed 30 days
No. of days in a year 360 days
Answer:
WN 1: Computation of operating cycle:
Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Particulars Calculation Amount
Average RM
x 360
RM consumed
50,000
= x 360
RM Days 6,00,000 30 days
Average WIP
x 360
Cost of Production
30,000
= x 360
WIP Days 5,00,000 21.60 days
Average FG
x 360
Cost of Goods Sold
40,000
= x 360
FG Days 8,00,000 18 days
Debtor days Given 45 days
Creditor days Given 30 days
84.60 days
Operating cycle (in days) 30 + 21.60 + 18 + 45 – 30 ~ 85 days
85 days = 1 operating cycle
Number of operating cycles 360 days = ? operating cycle 4.23 cycles

4. Estimation of working capital through operating cycle method [Jan 2021, May 2021 MTP, May
2020 MTP, May 2013, Nov 2023 MTP]:
The following information is provided by MNP Ltd. for the year ending 31st March, 2020:
Raw material storage period 45 days
Work-in-progress conversion period 20 days
Finished goods storage period 25 days
Debt collection period 30 days
Creditors payment period 60 days
Annual operating cost Rs.25,00,000
(including depreciation of Rs.2,50,000)
Assume 360 days in a year.
You are required to calculate:
a) Operating cycle period
b) Number of operating cycles in a year
c) Amount of working capital required for the company on cash cost basis
d) The company is a market leader in its product and it has no competitor in the market. Based on a
market survey it is planning to discontinue sales on credit and deliver products based on pre-
payments in order to reduce its working capital requirement substantially. You are required to
compute the reduction in working capital requirement in such a scenario.
e) Amount of increase in working capital requirement if all purchases are made on cash basis only

Answer:

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(a) Computation of operating cycle:
Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Operating cycle = 45 + 20 + 25 + 30 – 60 = 60 days

(b) and (c): Computation of number of operating cycles and amount of working capital requirement:
Particulars Calculation Amount
60 days = 1 operating cycle
Number of operating cycles 360 days = ? operating cycle 6 cycles
OC in days
Annual Cash operating cost x
365
60
Amount of working capital required = 22,50,000 x (360) Rs.3,75,000
Note: It is assumed that company is following cash cost approach for estimating the working capital
requirement.

(d): Reduction in working capital requirement due to discontinuation of credit:

• Revised operating cycle = 45 days + 20 days + 25 days + 0 days – 60 days = 30 days
• Amount of working capital required = 22,50,000 x (30/360) = Rs.1,87,500
• Reduction in working capital requirement = 3,75,000 – 1,87,500 = Rs.1,87,500

(e): Increase in working capital requirement due to all purchases being made in cash:
• Revised operating cycle = 45 days + 20 days + 25 days + 30 days – 0 days = 120 days
• Amount of working capital required = 22,50,000 x (120/360) = Rs.7,50,000
• Increase in working capital requirement = 7,50,000 – 3,75,000 = Rs.3,75,000

5. Calculation of Operating Cycle [Nov 2018, Nov 2022 RTP]

The Trading and Profit and Loss Account of Beta Ltd. for the year ended 31st March, 2011 is given below:
Particulars Amount Amount Particulars Amount Amount
To opening stock By sales (credit) 20,00,000
Raw material 1,80,000 By closing stock
Work in process 60,000 Raw material 2,00,000
Finished goods 2,60,000 5,00,000 Work in process 1,00,000
To Purchases (Credit) 11,00,000 Finished goods 3,00,000 6,00,000
To wages 3,00,000
To production expenses 2,00,000
To Gross Profit 5,00,000
26,00,000 26,00,000
To Administration expenses 1,75,000 By Gross Profit 5,00,000
To Selling expenses 75,000
To Net profit 2,50,000
5,00,000 5,00,000
The opening and closing balances of debtors were Rs.1,50,000 and Rs.2,00,000 respectively whereas
opening and closing creditors were Rs.2,00,000 and Rs.2,40,000 respectively.
You are required to ascertain the working capital requirement by operating cycle method.
Answer:
WN 1: Cost Sheet of Beta Limited for the year ended 31 st March 2011
Particulars Amount Amount
Direct Material:
Opening stock of RM 1,80,000
Purchases 11,00,000
Less: Closing stock of RM -2,00,000 10,80,000
Direct Labour 3,00,000
Direct expenses 0
Factory Overheads 2,00,000
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Gross works cost 15,80,000
Add: Opening WIP 60,000
Less: Closing WIP -1,00,000
Net works cost 15,40,000
Admin OH relating to production 0
Cost of Production 15,40,000
Add: Opening FG 2,60,000
Less: Closing FG -3,00,000
Cost of Goods sold 15,00,000
General and administrative overheads 1,75,000
Selling and distribution overheads 75,000
Cost of sales 17,50,000
Profit 2,50,000
Sales 20,00,000
• It is assumed that admin overheads is general and administrative overheads

WN 2: Computation of operating cycle:

Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Particulars Calculation Amount
Average RM
x 365
RM consumed
1,80,000 + 2,00,000
= 2 x 365
RM Days 10,80,000 64.21 days
Average WIP
x 365
Cost of Production
60,000 + 1,00,000
= 2 x 365
WIP Days 15,40,000 18.96 days
Average FG
x 365
Cost of Goods Sold
2,60,000 + 3,00,000
= 2 x 365
FG Days 15,00,000 68.13 days
Average Debtors
x 365
Credit sales
1,50,000 + 2,00,000
= 2 x 365
Debtor days 20,00,000 31.94 days
Average creditors
x 365
Credit Purchases
2,00,000 + 2,40,000
= 2 x 365
Creditor days 11,00,000 73 days
Operating cycle (in days) 64.21+18.96+68.13+31.94-73 110 days

WN 3: Amount of working capital required

Particulars Calculation Amount
OC in days
Annual operating cost x
365
110
Amount of working capital required = 17,50,000 x ( ) Rs.5,27,397
365

Part 3 – Working capital estimation using normal method

6. Working capital forecast, P&L and Balance Sheet [Nov 2021 MTP, SM]

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On 01st April, 2020, the Board of Director of ABC Ltd. wish to know the amount of working capital that
will be required to meet the programme they have planned for the year. From the following information,
PREPARE a working capital requirement forecast and a forecast profit and loss account and balance
sheet:
• Issued share capital = Rs.6,00,000
• 10% debentures = Rs.1,00,000
• Fixed assets = Rs.4,50,000
Production during the previous year was 1,20,000 units; it is planned that this level of activity should be
maintained during the present year. The expected ratios of cost to selling price are: raw materials 60%,
direct wages 10% overheads 20% Raw materials are expected to remain in store for an average of two
months before issue to production. Each unit of production is expected to be in process for one month. The
time lag in wage payment is one month. Finished goods will stay in the warehouse awaiting dispatch to
customers for approximately three months. Credit allowed by creditors is two months from the date of
delivery of raw materials. Credit given to debtors is three months from the date of dispatch. Selling price
is Rs.5 per unit. There is a regular production and sales cycle and wages and overheads accrue evenly
Answer:
WN 1: Preparation of Profit and Loss Account:
Particulars Amount Particulars Amount
To Material consumed 3,60,000 By Sales [1,20,000 x 5] 6,00,000
[1,20,000 x 3]
To Direct wages 60,000
[1,20,000 x 0.50]
To Overheads 1,20,000
[1,20,000 x 1.00]
To Gross Profit 60,000
Total 6,00,000 Total 6,00,000
To Debenture interest 10,000 By Gross Profit 60,000
[1,00,000 x 10%]
To Net profit 50,000
Total 60,000 Total 60,000

WN 2: Estimation of working capital:

Particulars Calculation Amount
Current Assets:
Stock of Raw material 2
(Based on RM Consumed) 3,60,000 x ( ) 60,000
12
Stock of WIP
(based on COP) Note 1 37,500
Stock of FG 3
(based on COGS) 5,40,000 x ( ) 1,35,000
12
Debtors 3
(based on credit sales) 6,00,000 x ( ) 1,50,000
12
Total Current Assets (A) 3,82,500

Current liabilities
Creditors 2
(Based on credit purchases) 3,60,000 x ( ) 60,000
12
Outstanding wages 1
(Based on total wages) 60,000 x ( ) 5,000
12
Total Current Liabilities (B) 65,000
Working capital (A-B) 3,17,500

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Note 1: Computation of WIP:
Particulars Calculation Amount
Cost of Production: 5,40,000
Direct Material 3,60,000
Other costs 1,80,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
1
Direct Material 3,60,000 x ( ) x 100% 30,000
12
1
Other costs 1,80,000 x ( ) x 50% 7,500
12
Overall stock of WIP 37,500

WN 3: Balance Sheet as on 31.03.2021:

Liabilities Amount Assets Amount
Issued share capital 6,00,000 Fixed assets 4,50,000
Profit and loss account 50,000 Current assets:
10% debentures 1,00,000 Stock of RM 60,000
Creditors 65,000 Stock of WIP 37,500
Bank OD (b/f) 17,500 Stock of FG 1,35,000
Debtors 1,50,000
Total 8,32,500 Total 8,32,500

7. Estimation of working capital [May 2021 MTP, Nov 2013 RTP, May 2024 MTP, SM]
The below information for Lever Ltd is provided on annual basis:
Particulars Amount
Sales at 3 months credit 48,00,000
Materials consumed (suppliers extend 2 months credit) 12,00,000
Wages paid (one month lag in payment) 9,60,000
Cash manufacturing expenses (paid on month in arrear) 12,00,000
Administrative expense (one month lag in payment) 3,60,000
Sales promotion expense (paid monthly in advance) 1,20,000
The Company sells its products at a gross profit of 20%. The Company keeps two months stock of raw
materials and two months stock of finished goods. Depreciation is considered as a part of cost of
production. Cash balance is retained at Rs. 1,00,000, Assuming a 15% margin, COMPUTE the working
capital requirements of the Company on cash cost basis. Ignore work-in progress.
Answer:
WN 1: Cost sheet of XYZ Company:
Particulars Calculation Amount
Direct material 12,00,000
Direct wages 9,60,000
Manufacturing expenses 12,00,000
Depreciation NA
GWC/NWC/COP/COGS 33,60,000
Administrative expenses 3,60,000
Selling expenses 1,20,000
Cost of sales 38,40,000

WN 2: Estimation of working capital under cash cost approach:

Particulars Calculation Amount

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Current Assets:
Debtors 3
(Based on cash cost of credit sales) 38,40,000 x ( ) 9,60,000
12
1
Prepaid sales promotion 1,20,000 x ( ) 10,000
12
Stock of Raw material 2
(Based on RM consumed) 12,00,000 x ( ) 2,00,000
12
Stock of FG 2
(Based on COGS) 33,60,000 x ( ) 5,60,000
12
Cash Given 1,00,000
Current Assets (A) 18,30,000

Current Liabilities
Creditors 2
(Based on credit purchases) 12,00,000 x ( ) 2,00,000
12
Outstanding wages 1
(Based on total wages) 9,60,000 x ( ) 80,000
12
1
Outstanding manufacturing expenses 12,00,000 x ( ) 1,00,000
12
1
Outstanding admin expenses 3,60,000 x ( ) 30,000
12
Current liabilities (B) 4,10,000
Working capital (A – B) 14,20,000
Add: Safety margin (15%) 14,20,000 x 15% 2,13,000
Final Working Capital 16,33,000

8. Working capital forecast for an existing entity [May 2019 RTP, May 2019, May 2020 MTP, Nov
2023, Nov 2023 MTP]
A proforma cost sheet of a Company provides the following data:
Particulars Amount
Raw material cost per unit 117
Direct labour cost per unit 49
Factory overheads cost per unit 98
(includes depreciation of Rs.18 per unit at budgeted level of activity)
Total cost per unit 264
Profit 36
Selling price per unit 300

Following additional information is available:

Average raw material in stock 4 weeks
Average work in process stock 2 weeks
DOC for material 80%
DOC for 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 1 week
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.
Required:
Prepare a statement showing estimate of working capital needed to finance a 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.
Answer:
• It is assumed that the company follows total approach for estimation of working capital

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WN 1: Cost sheet:
Particulars Calculation Amount
RM consumed/purchased 78,000 units x 117 91,26,000
Direct labour 78,000 units x 49 38,22,000
FOH other than depreciation 78,000 units x 80 62,40,000
Depreciation 78,000 units x 18 14,04,000
GWC/NWC/COP/COGS/COS 2,05,92,000
Profit 28,08,000
Sales 78,000 units x 300 2,34,00,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
4
Stock of raw material 91,26,000 x ( ) 7,02,000
52
Stock of WIP Note 1 5,45,400
3
Stock of FG 2,05,92,000 x ( ) 11,88,000
52
6
Debtors 2,34,00,000 x 80% x ( ) 21,60,000
52
Cash 2,50,000
Total Current Assets (A) 48,45,400
Current Liabilities:
8
Creditors 91,26,000 x ( ) 14,04,000
52
1
Outstanding wages 38,22,000 x ( ) 73,500
52
2
Overheads payable 62,40,000 x ( ) 2,40,000
52
Total Current Liabilities (B) 17,17,500
Working capital (A-B) 31,27,900

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 2,05,92,000
Direct Material 91,26,000
Other costs 1,14,66,000
Degree of Completion:
Direct Material 80%
Other costs 60%
Stock of WIP:
2
Direct Material 91,26,000 x ( ) x 80% 2,80,800
52
2
Other costs 1,14,66,000 x ( ) x 60% 2,64,600
52
Overall stock of WIP 5,45,400

9. Computation of working capital requirement (May 2021 RTP)

While applying for financing of working capital requirements to a commercial bank, TN Industries Ltd.
projected the following information for the next year:
Cost Element Per unit Per unit
Raw Material
X 30

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Y 7
Z 6 43
Direct Labour 25
Manufacturing and admin overheads
(excluding depreciation) 20
Depreciation 10
Selling overheads 15
113
Additional information:
• Raw Materials are purchased from different suppliers leading to different credit period allowed as
follows: X – 2 months; Y– 1 months; Z – ½ month
• Production cycle is of ½ month. Production process requires full unit of X and Y in the beginning
of the production. Z is required only to the extent of half unit in the beginning and the remaining
half unit is needed at a uniform rate during the production process.
• X is required to be stored for 2 months and other materials for 1 month.
• Finished goods are held for 1 month.
• 25% of the total sales is on cash basis and remaining on credit basis. The credit allowed by debtors
is 2 months.
• Average time lag in payment of all overheads is 1 months and ½ months for direct labour.
• Minimum cash balance of Rs.8,00,000 is to be maintained.

CALCULATE the estimated working capital required by the company on cash cost basis if the budgeted
level of activity is 1,50,000 units for the next year. The company also intends to increase the estimated
working capital requirement by 10% to meet the contingencies. (You may assume that production is carried
on evenly throughout the year and direct labour and other overheads accrue similarly.)
Answer:
WN 1: Preparation of cost sheet for 1,50,000 units under cash cost approach:
Particulars Calculation Amount
Direct Material:
X 1,50,000 x 30 45,00,000
Y 1,50,000 x 7 10,50,000
Z 1,50,000 x 6 9,00,000
Direct Labour 1,50,000 x 25 37,50,000
Manufacturing and administrative overheads 1,50,000 x 20 30,00,000
GWC/NWC/COP/COGS 1,32,00,000
Selling overheads 1,50,000 x 15 22,50,000
Cost of sales 1,54,50,000

WN 2: Estimation of working capital under cash cost approach:

Particulars Calculation Amount
Current Assets:
Raw Material
X 45,00,000 x (2/12) 7,50,000
Y 10,50,000 x (1/12) 87,500
Z 9,00,000 x (1/12) 75,000
Stock of WIP Note 1 4,00,000
Stock of FG (based on COGS) 1,32,00,000 x (1/12) 11,00,000
Debtors (based on cost of sales) 1,54,50,000 x 75% x (2/12) 19,31,250
Cash 8,00,000
Total Current Assets 51,43,750
Current Liabilities:
Creditors for raw material:
X 45,00,000 x (2/12) 7,50,000
Y 10,50,000 x (1/12) 87,500
Z 9,00,000 x (0.5/12) 37,500
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Outstanding overheads 52,50,000 x (1/12) 4,37,500
Outstanding wages 37,50,000 x (0.5/12) 1,56,250
Total Current Liabilities 14,68,750
Working capital 51,43,750 – 14,68,750 36,75,000
Add: Contingencies 36,75,000 x 10% 3,67,500
Final working capital 40,42,500

Note 1: Computation of WIP:

• WIP valuation is based on degree of completion. We normally take 100% degree of completion for
material and 50% for [Link], in this question DOC will be 100% for material X and Y
only.
• Only 50%of Material Z cost is incurred at the start (50%) and balance 50% is incurred evenly. Hence
relevant DOC for material Z will be original 50% and half of balance 50%. Relevant DOC = 50% +
(50%/2) = 75%
• For other costs relevant DOC will be taken as 50%
Particulars Amount
Cost of Material X and Material Y 55,50,000
Cost of Material Z 9,00,000
Other costs [37,50,000 + 30,00,000] 67,50,000
Relevant COP for WIP valuation 96,00,000
[55,50,000 + 75% of 9,00,000 + 50% of 67,50,000]
Stock of WIP [96,00,000 x (0.5/12)] 4,00,000

10. Working capital forecast [May 2023 RTP]

Kalyan limited has provided you the following information for the year 2021-22: By working at 60% of its
capacity the company was able to generate sales of Rs. 72,00,000. Direct labour cost per unit amounted to
Rs. 20 per unit. Direct material cost per unit was 40% of the selling price per unit. Selling price was 3 times
the direct labour cost per unit. Profit margin was 25% on the total cost.

For the year 2022-23, the company makes the following estimates:
• Production and sales will increase to 90% of its capacity. Raw material per unit price will remain
unchanged. Direct expense per unit will increase by 50%. Direct labour per unit will increase by
10%. Despite the fluctuations in the cost structure, the company wants to maintain the same profit
margin on sales.
• Raw materials will be in stock for one month whereas finished goods will remain in stock for two
months. Production cycle is for 2 months. Credit period allowed by suppliers is 2 months. Sales
are made to three zones:
Zone Percentage of Sales Mode of credit
A 50% Credit period of 2 months
B 30% Credit period of 3 months
C 20% Cash sales
There are no cash purchases and cash balance will be Rs. 1,11,000. The company plans to apply for a
working capital financing from bank for the year 2022 23. ESTIMATE Net Working Capital of the Company
receivables to be taken on sales and also COMPUTE the maximum permissible bank finance for the
company using 3 criteria of Tandon Committee Norms. (Assume stock of finished goods to be a core
current asset)
Answer:
WN 1: Cost sheet for 2021-22 and 2022-23:
Particulars 2021-22 2022-23
Calculation Amount Calculation Amount
Direct Material 1,20,000 x 60 x 40% 28,80,000 1,80,000 x 24 43,20,000
Direct Labour 1,20,000 x 20 24,00,000 1,80,000 x 22 39,60,000
Direct Expenses 1,20,000 x 4 4,80,000 1,80,000 x 6 10,80,000
PC/COP/COGS/COS 57,60,000 93,60,000
Profit 14,40,000 93,60,000 x ¼ 23,40,000
Sales 1,20,000 x 60 72,00,000 1,17,00,000
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Note for 2021-22
• Selling price in 2021-22 = 3 times of direct labour cost = 3 x 20 = Rs.60 per unit
• No of units = 72,00,000/60 = 1,20,000 units
• Profit margin is ¼ on cost and same would become 1/5 on sales. Hence profit is Rs.12 per unit and
cost is Rs.48 per unit
• Direct expenses per unit = 48 – 20 – 24 = Rs.4 per unit

Note for 2022-23

• No of units sold = 1,20,000 x (90/60) = 1,80,000 units

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
1
Stock of raw material 43,20,000 x ( ) 3,60,000
12
Stock of WIP Note 2 11,40,000
2
Stock of FG 93,60,000 x ( ) 15,60,000
12
Debtors
2
A 1,17,00,000 x 50% x ( ) 9,75,000
12
2
B 1,17,00,000 x 30% x ( ) 8,77,500
12
C Cash sales Nil
Cash 1,11,000
Total Current Assets (A) 50,23,500
Current Liabilities:
2
Creditors (Note 1) 44,40,000 x ( ) 7,40,000
12
Total Current Liabilities (B) 7,40,000
Working capital (A-B) 42,83,500
Note 1:
• Raw material Consumed = Opening stock of RM + Purchases – Closing stock of RM
• 43,20,000 = (28,80,000 x 1/12) + Purchases – 3,60,000
• Purchases = 44,40,000

Note 2: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 93,60,000
Direct Material 43,20,000
Other costs 50,40,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
2
Direct Material 43,20,000 x ( ) x 100% 7,20,000
12
2
Other costs 50,40,000 x ( ) x 50% 4,20,000
12
Overall stock of WIP 11,40,000

WN 3: Computation of Maximum Permissible Bank Finance as per Tandon Committee Lending Norms:
Method 1:
MPBF = 75% of Current Assets – 75% of Current Liabilities

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MPBF = (75% x 50,23,500) – (75% x 7,40,000) = Rs.32,12,625
Method 2:
MPBF = 75% of current assets – 100% of current liabilities
MPBF = (75% x 50,23,500) – (100% x 7,40,000) = Rs.30,27,625
Method 3:
MPBF = 75% of non-core current assets – 100% of current liabilities
Non-core current assets = Total Current assets – Core current assets = 50,23,500 – 15,60,000 = 34,63,500
MPBF = (75% x 34,63,500) – (100% x 7,40,000) = Rs.18,57,625

11. Estimation of Working Capital [Nov 2021 RTP, May 2017, SM]
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 Amount
Sales – Domestic at one-month credit 24,00,000
Sales - Exports at three months credit 10,80,000
(sales price 10% below domestic price)
Material used (suppliers extend two months credit) 9,00,000
Lag in payment of wages – 0.5 month 7,20,000
Lag in payment of manufacturing expenses (cash) – 1 month 10,80,000
Lag in payment of administration expenses – 1 month 2,40,000
Sales promotion expenses payable quarterly in advance 1,50,000
Income tax payable in four instalments of which one falls in the next financial year 2,25,000
• 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
Answer:
• It is assumed that the company follows total approach for working capital estimation:
WN 1: Cost sheet of MNP Company Limited:
Particulars Calculation Amount
Direct material 9,00,000
Direct wages 7,20,000
Manufacturing expenses 10,80,000
Other expenses Bal figure 1,80,000
GWC/NWC/COP/COGS 19,20,000 + 9,60,000 28,80,000
Admin expenses 2,40,000
Sales promotion 1,50,000
Cost of sales 32,70,000
Profit Bal figure 2,10,000
Sales 34,80,000

Note:
Note 1: Computation of COGS:
Particulars Domestic Export
Actual Sales 24,00,000 10,80,000
Adjusted sales 12,00,000
(adjusted for discount) 24,00,000 (10,80,000x 100/90)
COGS @ 80% of adjusted sales 19,20,000 9,60,000

WN 2: Estimation of working capital:

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Particulars Calculation Amount
Current Assets:
1
Debtors for domestic sales 24,00,000 x ( ) 2,00,000
12
3
Debtors for export sales 10,80,000 x ( ) 2,70,000
12
1
Prepaid sales promotion 1,50,000 x ( ) 37,500
4
Stock of FG 1
(Based on COGS) 28,80,000 x ( ) 2,40,000
12
Stock of RM 1
(based on RM consumed) 9,00,000 x ( ) 75,000
12
Cash 2,50,000 – 75,000 1,75,000
Total Current Assets (A) 9,97,500
Current Liabilities:
Creditors 2
(Based on RM Purchased) 9,00,000 x ( ) 1,50,000
12
Wages payable 0.5
(Based on total wages) 7,20,000 x ( ) 30,000
12
1
Outstanding manufacturing expenses 10,80,000 x ( ) 90,000
12
Outstanding admin expenses 1
2,40,000 x ( ) 20,000
12
1
Income tax payable 2,25,000 x ( ) 56,250
4
Total Current Liabilities (B) 3,46,250
Working capital (A-B) 6,51,250
Add: Contingencies @ 12% 78,150
Final working capital 7,29,400

12. Estimation of working capital [May 2022 MTP]

The following annual figures relate to manufacturing entity:
• Sales at one month credit = Rs.84,00,000
• Material consumption = 60% of sales value
• Wages (paid in a lag of 15 days) = Rs.12,00,000
• Cash Manufacturing Expenses = Rs.3,00,000
• Administrative Expenses = Rs.2,40,000
• Creditors extend 3 months credit for payment.
• Cash manufacturing and administrative expenses are paid 1 months in arrear
The company maintains stock of raw material equal to economic order quantity. The company incurs
Rs.100 as per ordering cost per order and opportunity cost of capital is 15% p.a. The optimum cash balance
is determined using Baumol’s model. The bank charges Rs.10 for each cash withdrawal. Finished goods
are held in stock for 1 month. The company maintains a bank balance of Rs.12,00,000 on an average.
Creditors are paid through net banking and all other expenses are incurred in cash which is withdrawn
from bank.

Assuming a 20% safety margin, you are required to ESTIMATE the amount of working capital that needs
to be invested by the Company.
Answer:
WN 1: Cost sheet:
• It is assumed that the company is following cash cost approach for estimating working capital
Particulars Calculation Amount
Material consumed 84,00,000 x 60% 50,40,000
Direct Wages 12,00,000
Manufacturing expenses 3,00,000
GWC/NWC/COP/COGS 65,40,000
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Admin expenses 2,40,000
Cost of Sales 67,80,000

WN 2: Estimation of working capital:

Particulars Calculation Amount
Current Assets
Stock of Raw material √(2 x 50,40,000 x 100 81,975
( )
0.15
Stock of finished goods 65,40,000 x (1/12) 5,45,000
Receivables 67,80,000 x (1/12) 5,65,000
Bank Balance 12,00,000
Cash balance √(2 x 17,40,000 x 10 15,232
( )
0.15
Total Current Assets 24,07,207
Current Liabilities:
Creditors for material 50,40,000 x (3/12) 12,60,000
Outstanding wages 12,00,000 x (0.5/12) 50,000
Outstanding manufacturing expenses 3,00,000 x (1/12) 25,000
Outstanding admin expenses 2,40,000 x (1/12) 20,000
Total Current liabilities 13,55,000
Working capital 10,52,207
Add: Safety margin @ 20% 2,10,441
Total working capital requirement 12,62,648

13. Working capital for new entity [May 2022 RTP, SM]
A newly formed company has applied for a loan to a commercial bank for financing its working capital
requirements. You are requested by the bank to prepare an estimate of the requirements of the working
capital for the company. Add 10% to your estimated figure to cover unforeseen contingencies. The
information about the projected profit and loss account of this company is as under:
Particulars Amount Amount
Sales 21,00,000
Less: Cost of goods sold 15,30,000
Gross Profit 5,70,000
Less: Administrative expenses 1,40,000
Less: Selling expenses 1,30,000 2,70,000
Profit before tax 3,00,000
Provision for tax 1,00,000
Cost of goods sold has been derived as follows:
Particulars Amount
Material used 8,40,000
Wages and manufacturing expenses 6,25,000
Depreciation 2,35,000
17,00,000
Less: Stock of finished goods (10%) 1,70,000
15,30,000
The figures given above relate only to the goods that have been finished and not to work in progress; goods
equal to 15% of the year’s production (in terms of physical units) are in progress on an average, requiring
full materials but only 40% of other expenses. The company believes in keeping two months consumption
of material in stock; Desired cash balance Rs.40000
Average time lag in payment of all expenses in 1 month; suppliers of materials extend 1.5 months credit;
sales are 20% cash; rest are at two months credit; 70% of the income tax has to be paid in advance in
quarterly installments.
You can make such other assumptions as you deem necessary for estimating working capital requirements
on cash cost basis
Answer:
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WN 1: Cost sheet of the company under cash cost approach:
Particulars Calculation Amount
Opening Raw material 0
Add: Purchases (b/f) 11,27,000
2
Less: Closing Raw material 9,66,000 x ( ) -1,61,000
12
Raw material consumed 9,66,000
Wages and manufacturing expenses 6,62,500
Depreciation (Nil due to cash cost) 0
Gross works cost 16,28,500
Add: Opening WIP 0
Less: Closing WIP -1,63,500
Net works cost/Cost of production 14,65,000
Add: Opening FG 0
Less: Closing FG 10% x 14,65,000 -1,46,500
Cost of Goods sold 13,18,500
Administrative expenses 1,40,000
Selling expenses 1,30,000
Cost of sales 15,88,500

Note:
Computation of RM consumed:
• The company has incurred Rs.8,40,000 as Raw material cost. This cost is incurred only for units
produced
• Let us assume that the company has produced 100 units. 15% of year’s production (in terms of
physical units) is closing WIP. Hence closing WIP is 15 units
• DOC of material for closing WIP = 100%
• Equivalent units produced (for computing RM cost) = 100 units of FG + 15 units of WIP = 115 units
• RM consumed = (8,40,000/100) x 115 = Rs.9,66,000

Computation of wages and manufacturing expenses:

• The company has incurred Rs.6,25,000 as wages and manufacturing expenses. This cost is incurred
only for units produced
• DOC of wages for closing WIP = 40%
• Equivalent units produced (for computing wages cost) = 100 units of FG + 6 units of WIP (15 x
40%) = 106 units
• Wages and manufacturing expenses = (6,25,000/100) x 106 = Rs.6,62,500

Closing WIP:
Particulars Equivalent units Value
Materials 15 1,26,000
(8,400 x 15)
Wages and manufacturing expenses 6 37,500
(6,250 x 6)
Total 1,63,500

WN 2: Working capital estimation under cash cost approach:

Particulars Calculation Amount
Current Assets:
Stock of RM WN 1 1,61,000

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Stock of WIP WN 1 1,63,500
Stock of FG WN 1 1,46,500
Cash 40,000
Debtors 2
(Based on cash cost of sales) 15,88,500 x 80% x ( ) 2,11,800
12
Total Current Assets (A) 7,22,800
Current Liabilities:
1.5
Creditors 11,27,000 x ( ) 1,40,875
12
1
Outstanding expenses 9,32,500 x ( ) 77,708
12
Income tax payable 1,00,000 x 30% 30,000
Current liabilities (B) 2,48,583
Working capital (A – B) 4,74,217
Add: Safety margin (10%) 47,422
Final Working Capital 5,21,639

14. Working capital estimation for two years [Nov 2019 RTP, May 2024 RTP, SM]
Marks ltd. is launching a new project for the manufacture of a unique component. At full capacity of 24,000
units, the cost per unit will be as follows;
Direct material 80
Labour and variable expenses 40
Fixed manufacturing and administrative expenses 20
Depreciation 10
Total cost 150
The selling price per unit is expected at Rs.200 and the selling expenses per unit will be Rs 10 – 80% being
variable.
In the first two years, production and sales are expected to be as follows:
Year Production units Sales units
1 15,000 14,000
2 20,000 18,000
To assess working capital requirement, the following additional information is given:
a. Stock of Raw material – 3 month’s average consumption.
b. Work in process – nil
c. Debtors – 1 month average cost of sales
d. Creditors for supply of materials – 2 months average purchases of the year
e. Creditors for expenses – 1 month average of all expenses during the year
f. Minimum cash balance desired – Rs.20000
g. Stock of finished goods is taken at average cost
You are required to prepare a projected statement of profitability and working capital requirement for two
years based on total approach.
Answer:
WN 1: Statement of Profitability of Marks Limited for two years:
Particulars Year 1 Year 2
RM Consumed
Opening Raw material - 3,00,000
Add: Purchases (b/f) 15,00,000 17,00,000
Less: Closing Raw material (RM consumed x 3/12) -3,00,000 -4,00,000
RM Consumed (units produced x 80) 12,00,000 16,00,000
Labour and variable expenses (units produced x 40) 6,00,000 8,00,000
Fixed Manufacturing and admin expenses (24,000 units x 20) 4,80,000 4,80,000
Depreciation (24,000 units x 10) 2,40,000 2,40,000
GWC/NWC/COP 25,20,000 31,20,000
Add: Opening FG - 1,68,000

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Less: Closing FG -1,68,000 -4,69,714
Cost of Goods sold 23,52,000 28,18,286
Selling expenses 1,60,000 1,92,000
Cost of sales 25,12,000 30,10,286
Profit 2,88,000 5,89,714
Sales 28,00,000 36,00,000
Note:
Note 1: Closing FG of year 1:
25,20,000
Closing FG = x 1,000 = Rs. 1,68,000
15,000

Note 2: Selling expenses:

• Selling expenses = (8 x units sold) + (2 x full capacity)
• Selling expenses of year 1 = (8 x 14,000) + (2 x 24,000) = Rs.1,60,000
• Selling expenses of year 2 = (8 x 18,000) + (2 x 24,000) = Rs.1,92,000

Note 3: Closing FG of year 2:

(31,20,000 + 1,68,000)
Closing FG = x 3,000 = Rs. 4,69,714
(20,000 + 1,000)

WN 2: Working capital estimation for two years:

Particulars Year 1 Year 2
Current Assets:
Stock of RM 3,00,000 4,00,000
Stock of FG 1,68,000 4,69,714
Debtors (based on cost of sales) 2,09,333 2,50,857
Cash 20,000 20,000
Total Current Assets (A) 6,97,333 11,40,571
Current liabilities
Creditors (based on purchases) 2,50,000 2,83,333
Creditors for expenses (based on all expenses) 1,03,333 1,22,667
Total current liabilities (B) 3,53,333 4,06,000
Working capital (A-B) 3,44,000 7,34,571

15. Working capital forecast for a new entity [Nov 2020 MTP, May 2018 MTP, Nov 2018 MTP, SM]
Aneja Limited, 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
projections for the current year:

Estimated level of activity: 1,04,000 completed units of production plus 4,000 units of work-in-
progress. Based on the above activity, estimated cost per unit is:
Raw material Rs.80 per unit
Direct wages Rs.30 per unit
Overheads (exclusive of depreciation) Rs.60 per unit
Total cost Rs.170 per unit
Selling price Rs.200 per unit
Raw materials in stock: Average 4 weeks consumption, work-in-progress (assume 50% completion
stage in respect of conversion cost) (materials issued at the start of the processing).
Finished goods in stock 8,000 units
Credit allowed by suppliers Average 4 weeks
Credit allowed to debtors/receivables Average 8 weeks
Lag in payment of wages Average 1.5 weeks
Cash at banks (for smooth operation) is expected to be Rs.25,000.
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Assume that production is carried on evenly throughout the year (52 weeks) and wages and overheads
accrue similarly. All sales are on credit basis only.
You are required to calculate:
(i) The net working capital required;
(ii) Maximum Permissible Bank Finance under three methods if core-current assets is 20% of total current
assets
Answer:
WN 1: Cost sheet of Aneja Limited:
Particulars Calculation Amount
RM Consumed:
Opening RM -
Add: Purchases b/f 93,04,615
Less: Closing RM 86,40,000 x (4/52) -6,64,615
RM consumed (1,04,000 x 80) + (4,000 x 80 x 100%) 86,40,000
Direct wages (1,04,000 x 30) + (4,000 x 30 x 50%) 31,80,000
Overheads (1,04,000 x 60) + (4,000 x 60 x 50%) 63,60,000
GWC 1,81,80,000
Add: Opening WIP -
Less: Closing WIP (4,000 x 80 x 100%) + (4,000 x 90 x 50%) -5,00,000
NWC/COP (1,04,000 units) 1,76,80,000
Add: Opening FG -
Less: Closing FG 8,000 units x 170 -13,60,000
COGS/COS 1,63,20,000
Profit 28,80,000
Sales 1,92,00,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM 6,64,615
Stock of WIP 5,00,000
Stock of FG 13,60,000
Debtors (1,92,00,000 x 8/52) 29,53,846
Cash 25,000
Total Current Assets (A) 55,03,461
Current Liabilities:
Creditors 93,04,615 x (4/52) 7,15,740
Wages payable 31,80,000 x (1.5/52) 91,731
Total current liabilities (B) 8,07,471
Working capital (A-B) 46,95,990

WN 3: Computation of maximum permissible bank finance under three methods:

Particulars Calculation Amount
= 75% of CA – 75% of CL
Method 1 = (75% x 55,03,461) – (75% x 8,07,471) 35,21,993
= 75% of CA – 100% of CL
Method 2 = (75% x 55,03,461) – (100% x 8,07,471) 33,20,125
= 75% of Non-core CA – 100% of CL
Method 3 = (75% x (80% x 55,03,461) – (100% x 8,07,471) 24,94,606
• Maximum Permissible Bank Finance (Lower of three methods) = Rs.24,94,606

16. Impact of double shift on working capital requirements [May 2021 RTP, SM]

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Samreen Enterprises has been operating its manufacturing facilities till 31.3.2017 on a single shift working
with the following cost structure:
Particulars Per unit
Cost of materials 6.00
Wages (out of which 40% fixed) 5.00
Overheads (out of which 80% fixed) 5.00
Profit 2.00
Selling price 18.00
Sales during 2016-17 – Rs.4,32,000
As at 31.3.2017 the company held:
Stock of raw material (at cost) 36,000
Work in progress (valued at prime cost) 22,000
Finished goods (valued at total cost) 72,000
Sundry debtors 1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift. It is
expected that a 10% discount will be available from suppliers of raw materials in view of increased volume
of business. Selling price will remain the same. The credit period allowed to customers will remain
unaltered. Credit availed of from suppliers will continue to remain at present level of 2 months. Lag in
payment of wages and expenses will continue to remain half a month.

You are required to assess the additional working capital requirements, if the policy to increase output is
implemented
Answer:
WN 1: Cost sheet for single shift and double shift:
Particulars Single Shift Double Shift
Calculation Amount Calculation Amount
Units sold 4,32,000 24,000 24,000 x 2 48,000
18
Raw material cost 24,000 x 6 1,44,000 48,000 x 6 x 90% 2,59,200
Variable wages 24,000 x 3 72,000 48,000 x 3 1,44,000
Fixed wages 24,000 x 2 48,000 48,000
Prime cost 2,64,000 4,51,200
Variable overheads 24,000 x 1 24,000 48,000 x 1 48,000
Fixed overheads 24,000 x 4 96,000 96,000
GWC/NWC/COP/COGS/COS 3,84,000 5,95,200
Profit 48,000 2,68,200
Sales 24,000 x 18 4,32,000 48,000 x 18 8,64,000

WN 2: Working capital estimation:

• It is assumed that company follows cash cost approach for working capital estimation
Particulars Single Shift Double Shift
Calculation Amount Calculation Amount
Current Assets:
Raw material 36,000 12,000 x 6 x 90% 64,800
Work-in-progress 22,000 4,51,200 18,800
2,000 x ( )
48,000
Finished goods 72,000 5,95,200 1,11,600
9,000 x ( )
48,000
Sundry debtors 3 96,000 3 1,48,800
3,84,000 x ( ) 5,95,200 x ( )
12 12
Total Current Assets (A) 2,26,000 3,44,000
Current Liabilities:
Creditors 2 24,000 2 43,200
1,44,000 x 2,59,200 x
12 12
Outstanding wages 0.5 5,000 0.5 8,000
1,20,000 x 1,92,000 x
12 12
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Outstanding expenses 0.5 5,000 0.5 6,000
1,20,000 x 1,44,000 x
12 12
Total Current Liabilities (B) 34,000 57,200
Working capital (A-B) 1,92,000 2,86,800
• Increase in working capital due to double shift = 2,86,800 – 1,92,000 = Rs.94,800

Note:
• The company current has raw material of 6,000 units (36,000/6). Raw material requirement will
double to 12,000 units with doubling of production
• The company currently has WIP of 2,000 units (22,000/11). WIP requirement will continue to be
2,000 units as double shift will not lead to increase in WIP
• The company currently has FG of 4,500 units (72,000/16). FG requirement will double with
doubling of production
• Debtor days = (1,08,000/4,32,000) x 12 = 3 months

Part 4 – Optimum cash balance

17. Optimum Cash Balance [Nov 2022]

K Ltd. has a Quarterly cash outflow of Rs. 9,00,000 arising uniformly during the Quarter. The company has
an Investment portfolio of Marketable Securities. It plans to meet the demands for cash by periodically
selling marketable securities. The marketable securities are generating a return of 12% p.a. Transaction cost
of converting investments to cash is Rs. 60. The company uses Baumol model to find out the optimal
transaction size for converting marketable securities into cash.
Consider 360 days in a year.
You are required to calculate (i) Company's average cash balance, (ii) Number of conversions each year
and (iii) Time interval between two conversions
Answer:
WN 1: Computation of optimum cash balance:
2 x annual demand for money x transfer cost
Optimum cash balance = √
Interest cost

2 x ( 4 x 9,00,000) x 60
Optimum cash balance = √ = 𝐑𝐬. 𝟔𝟎, 𝟎𝟎𝟎
0.12

WN 2: Solution:
Particulars Calculation Amount
Average cash balance OCB 60,000 Rs.30,000
=
2 2
Number of conversion each year 36,00,000 60 conversions
60,000
Time interval between two conversion 360 6 days
60

18. Computation of cash to be maintained [SM]

The following information is available in respect of sai trading company:
• On an average, debtors are collected after 45 days; inventories have an average holding period of
75 days and creditors payment period on an average is 30 days
• The firm spends a total of Rs.120 lakhs annually at a constant rate
• It can earn 10 percent return on investments

From the above information, you are required to calculate:

• The cash cycle and cash turnover
• Minimum amounts of cash to be maintained to meet payments as they become due
• Savings by reducing the average inventory holding period by 30 days
Answer:
Particulars Calculation Amount
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Cash cycle Inventory days + Debtors days – Creditor days 90 days
= 75 days + 45 days – 30 days
Cash Turnover (360 days /90 days) 4 cycles
Amount of cash to be maintained (120 lacs x 90/360) 30 lacs
Savings calculation:
Revised cash cycle 45 days + 45 days – 30 days 60 days
Revised cash (120 lacs x 60/360) 20 lacs
Reduction in cash 30 lacs – 20 lacs 10 lacs
Interest earned (savings) 10 lacs x 10% 1,00,000

Part 5 – Cash Budget

19. Cash Budget [SM]

Consider the balance sheet of Maya Limited as on 31 December, 2022. The company has received a large
order and anticipates the need to go to its bank to increase its borrowings. As a result, it has to forecast its
cash requirements for January, February and March, 2023. Typically, the company collects 20 per cent of
its sales in the month of sale, 70 per cent in the subsequent month, and 10 per cent in the second month
after the sale. All sales are credit sales.
Equity and Liabilities Amount Assets Amount
(in ‘000s) (in ‘000s)
Equity share capital 100 Net Fixed Assets 1,836
Retained earnings 1,439 Inventories 545
Long-term borrowings 450 Accounts Receivables 530
Accounts Payables 360 Cash and Bank 50
Loan from banks 400
Other liabilities 212
2,961 2,961
Purchases of raw materials are made in the month prior to the sale and amounts to 60 per cent of sales.
Payments for these purchases occur in the month after the purchase. Labour costs, including overtime, are
expected to be Rs. 1,50,000 in January, Rs. 2,00,000 in February, and Rs. 1,60,000 in March. Selling,
administrative, taxes, and other cash expenses are expected to be Rs. 1,00,000 per month for January
through March. Actual sales in November and December and projected sales for January through April are
as follows (in thousands):
Month Amount Month Amount Month Amount
November 500 January 600 March 650
December 600 February 1,000 April 750
On the basis of this information:
(a) PREPARE a cash budget and DETERMINE the amount of additional bank borrowings necessary to
maintain a cash balance of Rs. 50,000 at all times for the months of January, February, and March.
(b) PREPARE a pro forma balance sheet for March 31.
Answer:
WN 1: Cash budget for the month of January, February and March:
Particulars January February March
Opening cash 50,000 50,000 50,000
Add: Receipts
Collection from November month sales 50,000
Collection from December month sales 4,20,000 60,000 -
Collection from January month sales 1,20,000 4,20,000 60,000
Collection from February month sales - 2,00,000 7,00,000
Collection from March month sales - - 1,30,000
Total receipts 5,90,000 6,80,000 8,90,000
Payments:

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Payment to creditor 3,60,000 6,00,000 3,90,000
[Purchase made one month prior to Sales and payment made next
month. Hence this would be effectively equal to 60 percent of current
month sales
Labour costs 1,50,000 2,00,000 1,60,000
Selling expenses 1,00,000 1,00,000 1,00,000
Total Payments 6,10,000 9,00,000 6,50,000
Closing cash balance 30,000 -1,70,000 2,90,000
Minimum cash balance 50,000 50,000 50,000
Fresh borrowings 20,000 2,20,000 -2,40,000
WN 2: Proforma balance sheet as on 31 st March, 2023:
Liabilities Amount Assets Amount
Equity share capital 1,00,000 Net fixed assets 18,36,000
Retained earnings 15,29,000 Inventories 6,35,000
Long-term borrowings 4,50,000 Accounts receivables 6,20,000
Accounts payables 4,50,000 Cash at Bank 50,000
[March month purchase]
Loan from banks 4,00,000
[4,00,000 + 20,000 + 2,20,000 – 2,40,000]
Other liabilities 2,12,000
Total 31,41,000 Total 31,41,000

Retained earnings:
• Retained earnings = 14,39,000 + Sales – Material cost (60 percent of sales) – Labour costs – other
expenses
• Retained earnings = 14,39,000 + 22,50,000 – 13,50,000 – 5,10,000 – 3,00,000 = 15,29,000

Inventories
• Inventory = 5,45,000 + Total purchases for Jan to March – Total sales x 60%
• Inventory = 5,45,000 + (6,00,000 + 3,90,000 + 4,50,000) – (22,50,000 x 0.60) = 6,35,000

Accounts receivables:
• Debtors = 10 percent of Feb sales + 80 percent of march sales
• Debtors = 1,00,000 + 5,20,000 = Rs.6,20,000

20. Cash budget [Dec 2021]

A garment trader is preparing cash forecast for first three months of calendar year 2021. His estimated
sales for the forecasted periods are as below:
January February March
Total sales 6,00,000 6,00,000 8,00,000
• The trader sells directly to public against cash payments and to other entities on credit. Credit sales
are expected to be four times the value of direct sales to public. He expects 15% customers to pay
in the month in which credit sales are made, 25% to pay in the next month and 58% to pay in the
next to next month. The outstanding balance is expected to be written off.
• Purchases of goods are made in the month prior to sales and it amounts to 90% of sales and are
made on credit. Payments of these occur in the month after the purchase. No inventories of goods
are held.
• Cash balance as on 1st January, 2021 is Rs.50,000.
• Actual sales for the last two months of calendar year 2020 are as below:
November December
Total sales 6,40,000 8,80,000
You are required to prepare a monthly cash, budget for the three months from January to March, 2021.
Answer:
Monthly cash budget for the period of January to March 2021:

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Particulars January February March
Opening cash balance 50,000 1,74,960 2,89,680
Add: Inflows
Cash sales 1,20,000 1,20,000 1,60,000
Collection from customers 5,44,960 6,00,320 4,94,400
Total inflows 6,64,960 7,20,320 6,54,400
Less: Outflows
Payment to suppliers [Note 2] 5,40,000 5,40,000 7,20,000
Closing cash balance 1,74,960 3,55,280 2,89,680

Note 1: Computation of cash sales and collection from customers:

Particulars November December January February March Total
Total Sales 6,40,000 8,80,000 6,00,000 6,00,000 8,00,000
Cash sales 1,28,000 1,76,000 1,20,000 1,20,000 1,60,000
Credit sales 5,12,000 7,04,000 4,80,000 4,80,000 6,40,000
Collection in Jan 2,96,960 1,76,000 72,000 NA 5,44,960
Collection in Feb 4,08,320 1,20,000 72,000 6,00,320
Collection in Mar 2,78,400 1,20,000 96,000 4,94,400
• Credit sales are four times of cash sales. Cash sales + Credit sales = Total sales; Cash sales + 4
(cash sales) = Total sales; 5 (Cash sales) = Total sales; Cash sales = 20% of credit sales
• Credit sales collection = 15% in same month + 25% in next month and 58% in second month
• Collection in January for Nov month sales = 5,12,000 x 58%
• Collection in January for Dec month sales = 7,04,000 x 25%
• Other amounts are computed in similar manner

Note 2: Payment to suppliers:

• Purchase = 90% of previous month sales. Payment is made in the next month of purchases.
Hence, we can conclude that payment to suppliers is equal to 90% of sales of current month

21. Cash budget

The following details are forecasted by a company for the purpose of effective utilization and management
of cash:
Estimated sales and manufacturing costs:
Year and Month Sales Materials Wages Overheads
2010
April 4,20,000 2,00,000 1,60,000 45,000
May 4,50,000 2,10,000 1,60,000 40,000
June 5,00,000 2,60,000 1,65,000 38,000
July 4,90,000 2,82,000 1,65,000 37,500
August 5,40,000 2,80,000 1,65,000 60,800
September 6,10,000 3,10,000 1,70,000 52,000

Credit terms:
• Sales – 20 percent sales are on cash; 50 percent of the credit sales are collected next month and the
balance in the following month
• Credit allowed by suppliers is 2 months
• Delay in payment of wages is 0.5 months and of overheads is one month

Other information:
• Interest on 12 percent debentures of Rs.5,00,000 is to be paid half-yearly in June and December
• Dividends on investments amounting to Rs.25,000 are expected to be received in June 2010
• A new machinery will be installed in June 2010 at a cost of Rs.4,00,000 which is payable in 20
monthly installments from July 2010 onwards
• Advance income tax to be paid in August 2010 is Rs.15,000

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• Cash balance on 1st June, 2010 is expected to be Rs.45,000 and the company wants to keep it at the
end of every month around this figure. The excess cash (in multiple of thousand rupees) is being
put in fixed deposit

You are required to prepare monthly cash budget on the basis of the above information for four months
beginning from June 2010
Answer:
Cash budget for the period of June to September 2010:
Particulars June July August September
Opening cash 45,000 45,500 45,500 45,000
Add: Receipts:
Cash sales 1,00,000 98,000 1,08,000 1,22,000
Collection from April Month Sales 1,68,000
Collection from May Month Sales 1,80,000 1,80,000
Collection from June Month Sales 2,00,000 2,00,000
Collection from July Month Sales 1,96,000 1,96,000
Collection from August Month Sales 2,16,000
Collection from September Month Sales -
Dividends 25,000
Total Receipts (B) 4,73,000 4,78,000 5,04,000 5,34,000
Less: Payments
Payment to suppliers 2,00,000 2,10,000 2,60,000 2,82,000
Wages paid (half of previous month + 1,62,500 1,65,000 1,65,000 1,67,500
half of current month)
Overheads paid 40,000 38,000 37,500 60,800
Interest on debentures 30,000
Payment for machinery 20,000 20,000 20,000
Advance income tax 15,000
Total Payments (C) 4,32,500 4,33,000 4,97,500 5,30,300
Closing cash (A+B-C) 85,500 90,500 52,000 48,700
Fixed deposit created 40,000 45,000 7,000 3,000
Revised cash 45,500 45,500 45,000 45,700

22. Cash budget [SM]

From the following information relating to a departmental store, you are required to prepare for the three
months ending 31st March, 2017:
• Month-wise cash budget on receipts and payments basis
• Statement of sources and uses of funds for three-month period
It is anticipated that the working capital at 1st January, 2017 will be as follows:
Particulars Amount (in ‘000s)
Cash in hand and at bank 545
Short term investments 300
Debtors 2,570
Stock 1,300
Trade creditors 2,110
Other creditors 200
Dividends payable 485
Tax due 320
Plant 800
(in ‘000s)
Budgeted Profit Statement January February March

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Sales 2,100 1,800 1,700
Cost of sales 1,635 1,405 1,330
Gross Profit 465 395 370
Administrative, selling and distribution expenses 315 270 255
Net profit before tax 150 125 115

(in ‘000s)
Budgeted balances at the end of each months January February March
Short term investments 700 - 200
Debtors 2,600 2,500 2,350
Stock 1,200 1,100 1,000
Trade creditors 2,000 1,950 1,900
Other creditors 200 200 200
Dividends payable 485 - -
Tax due 320 320 320
Plant 800 1,600 1,550
Depreciation amount to Rs.60,000 is included in the budgeted expenditure for each month
Answer:
WN 1: Cash budget for the period of January to March 2007:
Particulars Jan Feb Mar
Opening cash balance (A) 5,45,000 3,15,000 65,000
Add: Receipts
Collection from customers (Note 1) 20,70,000 19,00,000 18,50,000
Sale of investments 7,00,000
Sale of Plant 50,000
Total receipts (B) 20,70,000 26,00,000 19,00,000

Payments
Creditors (Note 2) 16,45,000 13,55,000 12,80,000
Expenses 2,55,000 2,10,000 1,95,000
Capital expenditure 8,00,000
Payment of dividend 4,85,000
Purchase of investments 4,00,000 2,00,000
Total Payments (C) 23,00,000 28,50,000 16,75,000
Closing cash (A+B-C) 3,15,000 65,000 2,90,000

Note 1: Computation of collections from customers:

Particulars Jan Feb Mar
Opening debtors 25,70,000 26,00,000 25,00,000
Add: Sales 21,00,000 18,00,000 17,00,000
Less: Closing debtors -26,00,000 -25,00,000 -23,50,000
Collection from customers 20,70,000 19,00,000 18,50,000

Note 2: Payment to creditors:

Particulars Jan Feb Mar
Cost of sales 16,35,000 14,05,000 13,30,000
Add: Closing stock 12,00,000 11,00,000 10,00,000
Less: Opening stock -13,00,000 -12,00,000 -11,00,000
Purchases 15,35,000 13,05,000 12,30,000
Add: Opening creditors 21,10,000 20,00,000 19,50,000
Less: Closing creditors -20,00,000 -19,50,000 -19,00,000
Payment to creditors 16,45,000 13,55,000 12,80,000

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WN 2: Statement of sources and uses of funds:
Particulars Calculation Amount
Sources:
Fund from operations:
Net Profit 1,50,000 + 1,25,000 + 1,15,000 3,90,000
Depreciation 60,000 x 3 1,80,000
Sale of Plant 16,00,000 – 15,50,000 50,000
Decrease in working capital Note 3 6,65,000
Total Sources 12,85,000
Uses:
Purchase of Plant 16,00,000 – 8,00,000 8,00,000
Payment of dividends 4,85,000
Total Uses 12,85,000

Note 3: Computation of changes in working capital:

Particulars January 1, 2021 March 31, 2021
Current Assets:
Cash in hand and at bank 5,45,000 2,90,000
Short term investments 3,00,000 2,00,000
Debtors 25,70,000 23,50,000
Stock 13,00,000 10,00,000
Total Current Assets 47,15,000 38,40,000
Current Liabilities:
Trade creditors 21,10,000 19,00,000
Other creditors 2,00,00 2,00,000
Tax due 3,20,000 3,20,000
Total Current Liabilities 26,30,000 24,20,000
Working Capital 20,85,000 14,20,000
Decrease in working capital 6,65,000

23. Cash Budget [SM]

The following information relates to Zeta Limited, a publishing company:
• The selling price of a book is Rs. 15, and sales are made on credit through a book club and invoiced
on the last day of the month.
• Variable costs of production per book are materials (Rs. 5), labour (Rs. 4), and overhead (Rs. 2)

The sales manager has forecasted the following volumes:

Month No of Books
November 1,000
December 1,000
January 1,000
February 1,250
March 1,500
April 2,000
May 1,900
June 2,200
July 2,200
August 2,300

Customers are expected to pay as follows:

One month after the sales 40%
Two months after the sales 60%

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• The company produces the books two months before they are sold and the creditors for materials
are paid two months after production.
• Variable overheads are paid in the month following production and are expected to increase by
25% in April; 75% of wages are paid in the month of production and 25% in the following month.
A wage increase of 12.5% will take place on 1st March.
• The company is going through a restructuring and will sell one of its freehold properties in May
for Rs. 25,000, but it is also planning to buy a new printing press in May for Rs. 10,000. Depreciation
is currently Rs. 1,000 per month, and will rise to Rs. 1,500 after the purchase of the new machine.
• The company’s corporation tax (of Rs. 10,000) is due for payment in March.
• The company presently has a cash balance at bank on 31 December 2021, of Rs. 1,500.

You are required to PREPARE a cash budget for the six months from January to June, 2022.
Answer:
Cash budget for the period of January to June, 2022:
Particulars Jan Feb Mar Apr May Jun
Opening cash 1,500 3,250 1,500 -11,913 ##### 575
Add: Receipts
Collection from Nov month sales 9,000
Collection from Dec month sales 6,000 9,000
Collection from Jan month sales 6,000 9,000
Collection from Feb month sales 7,500 11,250
Collection from Mar month sales 9,000 13,500
Collection from Apr month sales 12,000 18,000
Collection from May month sales 11,400
Sale of building 25,000
Total receipts 15,000 15,000 16,500 20,250 50,500 29,400
Less: Payments
Payment to creditors
[2 months post incurrence] 5,000 6,250 7,500 10,000 9,500 11,000
Payment to labour
[75% of current month + 25% of previous
month] 5,750 7,500 8,413 9,563 9,900 10,238
Payment of variable OH
[Previous month paid in current month] 2,500 3,000 4,000 3,800 5,500 5,500
Purchase of printing press 10,000
Corporation tax 10,000
Total Payments 13,250 16,750 29,913 23,363 34,900 26,738
Closing balance 3,250 1,500 -11,913 -15,025 575 3,238

Note 1: Production cost

Particulars Nov Dec Jan Feb Mar Apr May Jun
Units produced 1,000 1,250 1,500 2,000 1,900 2,200 2,200 2,300
Material cost 5,000 6,250 7,500 10,000 9,500 11,000 11,000 11,500
Labour cost 4,000 5,000 6,000 8,000 8,550 9,900 9,900 10,350
Variable OH 2,000 2,500 3,000 4,000 3,800 5,500 5,500 5,750
Total cost 11,000 13,750 16,500 22,000 21,850 26,400 26,400 27,600
• Units produced are two months before the sale month. Hence production in November equal to
sales of January
• Material cost = Units x Rs.5
• Labour cost = Units x Rs.4 for the month of November to February and thereafter the per unit cost
increases to Rs.4.5 [4 + 12.5%]
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• Variable OH = Units x Rs.2 for the month of November to March and thereafter the per unit cost
increases to Rs.2.5 [2 + 25%]

24. Cleared Funds Forecast [SM]

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

Receipts from customers:

Credit Terms Payment Method 9 Aug 20x2 sales 9 Jul 20x2 sales
W Limited 1 Calendar Month BACS 1,50,000 1,30,000
X Limited None Cheque 1,80,000 1,60,000
(a) Receipt of money by BACS (Bankers' Automated Clearing Services) is instantaneous.
(b) X Ltd’s cheque will be paid into Prachi Ltd’s bank account on the same day as the sale is made and will
clear on the third day following this (excluding day of payment).

Payments to Suppliers:
Credit Terms Payment Method 9 Aug 20x2 9 Jul 20x2 9 Jun 20x2
Purchases Purchases Purchases
A Limited 1 Calendar Month Standing order 65,000 55,000 45,000
B Limited 2 Calendar Months Cheque 85,000 80,000 75,000
C Limited None Cheque 95,000 90,000 85,000
• Prachi Ltd has set up a standing order for Rs. 45,000 a month to pay for supplies from A Ltd. This
will leave Prachi’s bank account on 9 August. Every few months, an adjustment is made to reflect
the actual cost of supplies purchased (you do NOT need to make this adjustment).
• Prachi Ltd will send out, by post, cheques to B Ltd and C Ltd on 9 August. The amounts will leave
its bank account on the second day following this (excluding the day of posting).

Wages and Salaries:

July 20X2 August 20X2
Weekly Wages 12,000 13,000
Monthly Salaries 56,000 59,000
• Factory workers are paid cash wages (weekly). They will be paid one week’s wages, on 13 August,
for the last week’s work done in July (i.e. they work a week in hand).
• All the office workers are paid salaries (monthly) by BACS. Salaries for July will be paid on 9
August.

Other Miscellaneous Payments:

• Every Saturday morning, the petty cashier withdraws Rs. 200 from the company bank account for
the petty cash. The money leaves Prachi’s bank account straight away.
• The room cleaner is paid Rs. 30 from petty cash every Monday morning.
• Office stationery will be ordered by telephone on Sunday 10 August to the value of Rs. 300. This is
paid for by company debit card. Such payments are generally seen to leave the company account
on the next working day.
• Five new softwares will be ordered over the Internet on 12 August at a total cost of Rs. 6,500. A
cheque will be sent out on the same day. The amount will leave Prachi Ltd’s bank account on the
second day following this (excluding the day of posting).

Other Information:
The balance on Prachi’s bank account will be Rs. 200,000 on 9 August 20X2. This represents both the book
balance and the cleared funds.
PREPARE a cleared funds forecast for the period Saturday 7th August to Wednesday 13th August 20X2
inclusive using the information provided. Show clearly the uncleared funds float each day.
Answer:
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Particulars Aug-09 Aug-10 Aug-11 Aug-12 Aug-13
Cleared
W Limited 1,30,000
X Limited 1,80,000
A Limited -45,000
B Limited -75,000
C Limited -95,000
Wages -12,000
Salaries -56,000
Cash withdrawal -200
Stationery -300
Net cleared balance 28,800 - -1,70,300 1,80,000 -12,000
Opening balance 2,00,000 2,28,800 2,28,800 58,500 2,38,500
Closing balance 2,28,800 2,28,800 58,500 2,38,500 2,26,500
Uncleared
X Limited 1,80,000 1,80,000 1,80,000
B Limited -75,000 -75,000
C Limited -95,000 -95,000
Stationery -300
Software -6,500 -6,500
Net uncleared balance 10,000 9,700 1,80,000 -6,500 -6,500
Closing book balance 2,38,800 2,38,500 2,38,500 2,32,000 2,20,000

Part 6 – Relaxing/tightening of credit terms

25. Relaxing Credit terms

A company has prepared the following projections for a year:
Sales 21,000 units
Selling price per unit Rs.40
Variable cost per unit Rs.25
Total cost per unit Rs.35
Credit period allowed One month
The Company proposes to increase the credit period allowed to its customers from one month to two
months. It is envisaged that the change in the policy as above will increase the sales by 8%. The company
desires a return of 25% on its investment.
You are required to examine and advise whether the proposed Credit Policy should be implemented or not
assuming debtors are based on:
• Sales valuation
• Variable cost valuation
• Full cost valuation
Answer:
WN 1: Evaluation of credit policy if debtors are valued based on sales:
Particulars One month Two months
Sales 8,40,000 9,07,200
Less: Variable cost -5,25,000 -5,67,000
Less: Fixed cost -2,10,000 -2,10,000
Gross Benefit 1,05,000 1,30,200
Less: Interest cost (Note 1) -17,500 -37,800
Net Benefit 87,500 92,400

Note 1: Computation of interest cost:

Particulars One month Two months
Sales 8,40,000 9,07,200

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Debtors (Sales x CP/12) 70,000 1,51,200
Interest cost (Debtors x Return %) 17,500 37,800

Advise: The company should go ahead with higher credit period of 2 months as the same has led to higher
Net Benefit.

WN 2: Evaluation of credit policy if debtors are valued based on variable cost:

Particulars One month Two months
Sales 8,40,000 9,07,200
Less: Variable cost (Note 1) -5,25,000 -5,67,000
Less: Fixed cost -2,10,000 -2,10,000
Gross Benefit 1,05,000 1,30,200
Less: Interest cost -10,938 -23,625
Net Benefit 94,062 1,06,575

Note 1: Computation of interest cost:

Particulars One month Two months
Variable cost of Sales 5,25,000 5,67,000
Debtors (Variable cost x CP/12) 43,750 94,500
Interest cost (Debtors x Return %) 10,938 23,625

Advise: The company should go ahead with higher credit period of 2 months as the same has led to higher
Net Benefit.

WN 3: Evaluation of credit policy if debtors are valued based on full cost:

Particulars One month Two months
Sales 8,40,000 9,07,200
Less: Variable cost -5,25,000 -5,67,000
Less: Fixed cost -2,10,000 -2,10,000
Gross Benefit 1,05,000 1,30,200
Less: Interest cost (Note 1) -15,313 -32,375
Net Benefit 89,687 97,825

Note 1: Computation of interest cost:

Particulars One month Two months
Full cost of Sales (VC + FC) 7,35,000 7,77,000
Debtors (Cost of sales x CP/12) 61,250 1,29,500
Interest cost (Debtors x Return %) 15,313 32,375

Advise: The company should go ahead with higher credit period of 2 months as the same has led to higher
Net Benefit.

26. Evaluation of credit policy [May 2021 MTP, Nov 2020 MTP, May 2018 MTP, Nov 2018 MTP, Nov
2013, SM]
XYZ Corporation is considering relaxing its present credit policy and is in the process of evaluating two
proposed policies. Currently, the firm has annual credit sales of Rs.50 lakhs and accounts receivable
turnover ratio of 4 times a year. The current level of loss due to bad debts is Rs.1,50,000. The firm is required
to give a return of 25% on the investment in new accounts receivables. The company’s variable costs are
70% of the selling price.
Given the following information, which is the better option?
Particulars Present Policy Policy Option I Policy Option II
Annual credit sales 50,00,000 60,00,000 67,50,000
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Debtors turnover ratio 4 Times 3 Times 2.4 Times
Loss due to bad debts 1,50,000 3,00,000 4,50,000
Answer:
Evaluation of credit policy:
Particulars Present Option 1 Option 2
Sales 50,00,000 60,00,000 67,50,000
Less: Variable cost (70% of sales) -35,00,000 -42,00,000 -47,25,000
Less: Fixed cost - - -
Gross Benefit 15,00,000 18,00,000 20,25,000
Less: Interest cost (Note 1) -2,18,750 -3,50,000 -4,92,188
Less: Bad debt -1,50,000 -3,00,000 -4,50,000
Net Benefit 11,31,250 11,50,000 10,82,812
• The company should go ahead with option 1 as the same leads to higher net benefit.

Note 1: Computation of interest cost:

Particulars Present Option 1 Option 2
Full cost of Sales (VC + FC) 35,00,000 42,00,000 47,25,000
Debtors (Full Cost/DTR) 8,75,000 14,00,000 19,68,750
Interest cost (Debtors x Return %) 2,18,750 3,50,000 4,92,188
• Note: It is assumed that debtors are valued based on full cost of sales

27. Evaluation of various credit policies [May 2016, SM]

Radiance Garments Ltd. manufacturers readymade garments and sells them on credit basis through a
network of dealers. Its present sale is Rs.60 lakh per annum with 20 days credit period. The company is
contemplating an increase in the credit period with a view to increasing sales. Present variable costs are
70% of sales and the total fixed costs Rs.8 lakh per annum. The company expects pre-tax return on
investment @ 25%. Some other details are given as under:

Proposed credit Policy Average collection period Annual sales

(Days) ([Link])
I 30 65
II 40 70
III 50 74
IV 60 75
Required: Which credit policy should the company adopt? Present your answer in a tabular form. Assume
360 days in a year. Calculations should be made up-to two digits after decimal.
Answer:
Evaluation of credit policy:
(in lacs)
Particulars Present Policy 1 Policy 2 Policy 3 Policy 4
Sales 60.00 65.00 70.00 74.00 75.00
Less: Variable cost (70% of sales) -42.00 -45.50 -49.00 -51.80 -52.50
Less: Fixed cost -8.00 -8.00 -8.00 -8.00 -8.00
Gross Benefit 10.00 11.50 13.00 14.20 14.50
Less: Interest cost (Note 1) -0.70 -1.12 -1.58 -2.08 -2.52
Net Benefit 9.30 10.38 11.42 12.12 11.98
• The company should go ahead with Policy option 3 (Collection period of 50 days) as the same has
highest net benefit.

Note 1: Computation of interest cost:

Particulars Present Policy 1 Policy 2 Policy 3 Policy 4

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Full cost of sales (VC + FC) 50.00 53.50 57.00 59.80 60.50
Debtors (Full cost x CP/360) 2.78 4.46 6.33 8.31 10.08
Interest cost (Debtors x Return%) 0.70 1.12 1.58 2.08 2.52
• It is assumed debtors are valued on full cost of sales

28. Evaluation of credit policy [Nov 2020 RTP, May 2013 RTP, Nov 2014 RTP]
H Ltd. has present annual sales of 10,000 units at Rs.300 per unit. The variable cost is Rs.200 per unit and
the fixed costs amount to Rs.3,00,000 per annum. The present credit period allowed by the company is 1
month. The company is considering a proposal to increase the credit period to 2 months and 3 months and
has made the following estimates:
Particulars Existing Proposed 1 Proposed 2
Credit period 1 month 2 months 3 months
Increase in sales - 15% 30%
% of bad debts 1% 3% 5%
There will be increase in fixed cost by Rs.50,000 on account of increase of sales beyond 25% of present level.
The company plans on a pre-tax return of 20% on investment in receivables. You are required to calculate
the most paying credit policy for the company.
Answer:
Evaluation of credit policy:
Particulars Present Option 1 Option 2
Sales 30,00,000 34,50,000 39,00,000
Less: Variable cost -20,00,000 -23,00,000 -26,00,000
Less: Fixed cost -3,00,000 -3,00,000 -3,50,000
Gross Benefit 7,00,000 8,50,000 9,50,000
Less: Interest cost (Note 1) -30,000 -1,03,500 -1,95,000
Less: Bad debt (% of sales) -38,333 -86,667 -1,47,500
Net Benefit 6,31,667 6,59,833 6,07,500
• The company should go ahead with option 1 as the same leads to higher net benefit.

Note 1: Computation of interest cost:

Particulars Present Option 1 Option 2
Full cost of Sales (VC + FC) 23,00,000 26,00,000 29,50,000
Debtors (Full Cost x CP/12) 1,91,667 4,33,333 7,37,500
Interest cost (Debtors x Return %) 38,333 86,667 1,47,500
• Note: It is assumed that debtors are valued based on full cost of sales

29. Evaluation of credit policy [Nov 2018, SM]

Mosaic Limited has current sales of Rs.15 lakhs per year. Cost of sales is 75 per cent of sales and bad debts
are one per cent of sales. Cost of sales comprises 80 per cent variable costs and 20 per cent fixed costs, while
the company’s required rate of return is 12 per cent. Mosaic Limited currently allows customers 30 days’
credit, but is considering increasing this to 60 days’ credit in order to increase sales. It has been estimated
that this change in policy will increase sales by 15 per cent, while bad debts will increase from one per cent
to four per cent. It is not expected that the policy change will result in an increase in fixed costs and creditors
and stock will be unchanged.
Should Mosaic Limited introduce the proposed policy?
Answer:
Evaluation of credit policy:
Particulars Existing Revised
Sales 15,00,000 17,25,000
Less: Variable cost (sales x 75% x 80%) -9,00,000 -10,35,000
Less: Fixed cost (sales x 75% x 20%) -2,25,000 -2,25,000
Gross Benefit 3,75,000 4,65,000
Less: Interest cost (Note 1) -11,250 -25,200

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Less: Bad debt -15,000 -69,000
Net Benefit 3,48,750 3,70,800
• The company should go ahead with revised credit policy as the same leads to increase in net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 11,25,000 12,60,000
Debtors (Full Cost x CP/360) 93,750 2,10,000
Interest cost (Debtors x Return %) 11,250 25,200
Note:
• It is assumed that debtors are valued based on full cost of sales
• It is assumed that there are 360 days in a year

30. Receivables Management [July 2021]

Current annual sale of SKD Ltd. is Rs.360 lakhs. It's directors are of the opinion that company's current
expenditure on receivables management is too high and with a view to reduce the expenditure they are
considering following two new alternate credit policies:
Particulars Policy X Policy Y
Average collection period 1.5 months 1 month
% of default 2% 1%
Annual collection expenditure 12,00,000 20,00,000
Selling price per unit is Rs.150. Total cost per unit is Rs.120. Current credit terms are 2 months and
percentage of default is 3%. Current annual collection expenditure is Rs.8,00,000. Required rate of return
on investment of SKD Limited is 20%. Determine which credit policy SKD Limited should follow.
Answer:
Evaluation of credit policy:
Particulars Existing Policy X Policy Y
Sales 360.00 360.00 360.00
Less: Total Cost [360.00 x 120/150] -288.00 -288.00 -288.00
Gross Benefit 72.00 72.00 72.00
Less: Interest cost (Note 1) -9.60 -7.20 -4.80
Less: Bad debt -10.80 -7.20 -3.60
Less: Collection expenditure -8.00 -12.00 -20.00
Net Benefit 43.60 45.60 43.60
• Company should go ahead with Policy X as it has the highest net benefit

Note 1: Computation of interest cost:

Particulars Existing Policy X Policy Y
Full cost of Sales 288.00 288.00 288.00
Debtors (Full Cost x CP/12) 48.00 36.00 24.00
Interest cost (Debtors x Return %) 9.60 7.20 4.80
• It is assumed debtors are valued based on full cost of sales

31. Evaluation of credit policy [Nov 2014, SM]

A Company has sales of Rs.25,00,000. Average collection period is 50 days, bad debt losses are 5% of sales
and collection expenses are Rs.25,000. The cost of funds is 15%. The Company has two alternative
Collection Programmes:
Particulars Programme I Programme II
Average collection period reduced to 40 days 30 days
Bad debt loss reduced to 4% of sales 3% of sales
Collection expenses 50,000 80,000
Evaluate which Programme is viable.
Answer:

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Evaluation of collection programme:
Particulars Existing Option 1 Option 2
Collection expenses 25,000 50,000 80,000
Bad debt 1,25,000 1,00,000 75,000
Interest cost (Note 1) 52,083 41,667 31,250
Total cost 2,02,083 1,91,667 1,86,250
• Company should go ahead with collection programme 2 as the same leads to lowest cost

Note 1: Computation of interest cost:

Particulars Existing Option 1 Option 2
Sales 25,00,000 25,00,000 25,00,000
Debtors (Sales x CP/360) 3,47,222 2,77,778 2,08,333
Interest cost (Debtors x Return %) 52,083 41,667 31,250
• It is assumed year consist of 360 days

32. Incremental Approach:

QR Ltd. having an annual sales of Rs. 30 lakhs, is re-considering its present collection policy. At present,
the average collection period is 50 days and the bad debt losses are 5% of sales. The company is incurring
an expenditure of Rs. 30,000 on account of collection of receivables. Cost of funds is 10 percent.
The alternative policies are as under:
Particulars Alternative 1 Alternative 2
Average collection period 40 days 30 days
Bad debt losses 4% of sales 3% of sales
Collection expenses 60,000 95,000
DETERMINE the alternatives on the basis of incremental approach and state which alternative is more
beneficial.
Answer:
Evaluation of collection programme:
Particulars Existing Option 1 Option 2
Collection expenses 30,000 60,000 95,000
Bad debt 1,50,000 1,20,000 90,000
Interest cost (Note 1) 41,667 33,333 25,000
Total cost 2,21,667 2,13,333 2,10,000
Incremental benefit 8,334 11,667
Conclusion: From the analysis it is apparent that Alternative I has a benefit of Rs. 8,333 and Alternative II
has a benefit of Rs. 11,667 over present level. Alternative II has a benefit of Rs. 3,334 more than Alternative
I. Hence Alternative II is more viable.
Note 1: Computation of interest cost:
Particulars Existing Option 1 Option 2
Sales 30,00,000 30,00,000 30,00,000
Debtors (Sales x CP/360) 4,16,667 3,33,333 2,50,000
Interest cost (Debtors x Return %) 41,667 33,333 25,000
• It is assumed year consist of 360 days

33. Determination of degree of risk to get the required rate of return [May 2015, SM]
As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods
to a group of new customers with 10% risk of non-payment. This group would require one and a half
months credit and is likely to increase sales by Rs.1,00,000 p.a. Production and Selling expenses amount to
80% of sales and the income-tax rate is 50%. The company’s minimum required rate of return (after tax) is
25%. Should the sales manager’s proposal be accepted? Also find the degree of risk of non-payment that
the company should be willing to assume if the required rate of return (after tax) were (i) 30%, (ii) 40% and
(iii) 60%.
Answer:
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WN 1: Computation of actual post-tax return:
Particulars Amount
Sales 1,00,000
Less: Production and selling expenses -80,000
Gross Benefit 20,000
Less: Bad debt -10,000
Profit before tax 10,000
Less: Tax @ 50% -5,000
Profit after tax 5,000
Debtors (Full cost x 1.5/12) 10,000
Return on investment (PAT/Debtors x 100) 50%
• The company should go ahead with sales as actual return (50%) is higher than required return

WN 2: Computation of degree of risk of non-payment for required return:

Particulars Return = 30% Return = 40% Return = 60%
Sales 1,00,000 1,00,000 1,00,000
Less: Production and selling expenses -80,000 -80,000 -80,000
Gross Benefit 20,000 20,000 20,000
Less: Bad debt (bal figure) -14,000 -12,000 -8,000
Profit before tax (PAT/(1-Tax)) 6,000 8,000 12,000
Less: Tax @ 50% -3,000 -4,000 -6,000
Profit after tax (Debtors x ROI) 3,000 4,000 6,000
Debtors (Full cost x 1.5/12) 10,000 10,000 10,000
Return on investment (Given) 30% 40% 60%
Degree of risk of non-payment
(Bad debt/sales x 100) 14% 12% 8%
• The above table has been filled through reverse working

34. Determination of cash discount percentage

A firm is considering offering 30-day credit to its customers. The firm likes to charge them an annualized
rate of 24%. The firm wants to structure the credit in terms of a cash discount for immediate payment. How
much would the discount rate have to be?
Answer:
• The company wants to offer cash discount with annualized rate of 24 percent
• They want customers to make immediate payment as compared to normal credit period of 30 days
• Let us assume a customer purchases goods worth Rs.100. He will be paying Rs.X (post discount)
today and will not pay Rs.100 after 30 days
100 − X 365 36,50,000 − 36500X
Annualized discount = x x 100 = 24; = 24
X 30 30X
𝟑𝟔, 𝟓𝟎, 𝟎𝟎𝟎
36,50,000 − 36,500X = 720X; 37,220X = 36,50,000; 𝐗 = = 𝟗𝟖. 𝟎𝟔𝟓𝟔
𝟑𝟕, 𝟐𝟐𝟎

• Amount of cash discount =100 – 98.0656 = 1.9344

• % of cash discount = (1.9344/100) x 100 = 1.9344%

35. Decision on change in cash discount terms [Nov 2019, May 2012, May 2014 RTP, Nov 2017, Sep
2024 MTP]
The financial statements of Gurunath Ltd is furnished below –
Balance Sheet as at 31st March
Particulars Amount
Equity and Liabilities
Shareholders’ Funds 10,00,000
Non–Current Liabilities: 10% Debt 6,00,000
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Current Liabilities 1,56,000
Total 17,56,000
Assets
Non–Current Assets 16,56,000
Current Assets – Trade Receivables 1,00,000
Total 17,56,000
Additional information:
• The existing credit terms are 1/10, net 45 days and average collection period is 30 days. The current
bad debts loss is 1.5%. In order to accelerate the collection process further as also to increase sales,
the company is contemplating liberalization of its existing credit terms to 2/10, net 45 days.
• It is expected that sales are likely to increase by 1/3 of existing sales, bad debts increase to 2% of
sales and average collection period to decline to 20 days.
• Credit period allowed by the supplier is 60 days. Generally, operating expenses are paid 2 months
in arrears. Total Variable expenses of the company constitute Purchases of stock in trade and
operating expenses only.
• Opportunity cost of investment in receivables is 15%. 50% and 80% of customers in terms of sales
revenue are expected to avail cash discount under existing and liberalization scheme respectively.
The tax rate is 30%.
• The Company considers only the relevant or variable costs for calculating the opportunity costs on
the funds blocked in receivables. Assume 360 days in a year and 30 days in a month.
Should the company change its credit terms?
Answer:
WN 1: Computation of Sales and Operating Expenses:
ACP 30
Receivables = Sales x ( ) ; 1,00,000 = Sales x ( ) ; Sales = 12,00,000
360 360
ACP 2
Payables = Expenses x ( ) ; 1,56,000 = 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 𝑥 ( ) ; Expenses = 9,36,000
360 12

WN 2: Evaluation of change in credit policy:

Particulars Existing Revised
Sales 12,00,000 16,00,000
Less: Variable cost -9,36,000 -12,48,000
Less: Fixed cost - -
Gross Benefit 2,64,000 3,52,000
Less: Interest cost (Note 1) -11,700 -10,400
-6,000 -25,600
Less: Cash discount [12,00,000 x 50% x 1%] [16,00,000 x 80% x 2%]
Less: Bad debt -18,000 -32,000
Profit before tax 2,28,300 2,84,000
Less: Tax @30% -68,490 -85,200
Profit after tax 1,59,810 1,98,800
• Company should go ahead with liberalization scheme as the same leads to higher net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 9,36,000 12,48,000
Debtors (Full Cost x CP/360) 78,000 69,333
Interest cost (Debtors x Return %) 11,700 10,400

36. Extension of Credit Policy (May 2023, SM)

A company has current sale of Rs.12 lakhs per year. The profit-volume ratio is 20% and post-tax cost of
investment in receivables is 15%. The current credit terms are 1/10, net 50 days. 50% of customers in terms
of sales revenue are availing cash discount and bad debt is 2% of sales. In order to increase sales, the
company want to liberalize its existing credit terms to 2/10, net 35 days. Due to which, expected sales will
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increase to Rs.15 lakhs. Percentage of default in sales will remain same. 80% of customers in terms of sales
revenue are expected to avail cash discount under this proposed policy. Tax rate is 30%. ADVISE, should
the company change its credit terms. (Assume 360 days in a year.)
Answer:
Particulars Existing Revised
Sales 12,00,000 15,00,000
Less: Variable cost -9,60,000 -12,00,000
Less: Fixed cost - -
Gross Benefit 2,40,000 3,00,000
-6,000 -24,000
Less: Cash discount [12,00,000 x 50% x 1%] [15,00,000 x 80% x 2%]
Less: Bad debt -24,000 -30,000
Profit before tax 2,10,000 2,46,000
Less: Tax @ 30% -63,000 -73,800
Profit after tax 1,47,000 1,72,200
Less: Interest cost (Note 1) -12,000 -7,500
Net Gain 1,35,000 1,64,700
• Company should go ahead with liberalization scheme as the same leads to higher net benefit

Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 9,60,000 12,00,000
Credit Period 30 15
Debtors (Full Cost x CP/360) 80,000 50,000
Interest cost (Debtors x Return %) 12,000 7,500
• Average collection period for existing scenario = [10 x 50%] + [50 x 50%] = 30 days
• Average collection period of revised scenario = [10 x 80%] + [35 x 20%] = 15 days

37. Decision on providing credit [Nov 2019 RTP, Nov 2023 RTP, SM]
Slow Payers are regular customers of Goods Dealers Ltd., Calcutta and have approached the sellers for
extension of a credit facility for enabling them to purchase goods from Goods Dealers Ltd. On an analysis
of past performance and on the basis of information supplied, the following pattern of payment schedule
emerges in regard to Slow Payers:
Particulars Pattern of Payment Schedule
At the end of 30 days 15% of the bill
At the end of 60 days 34% of the bill
At the end of 90 days 30% of the bill
At the end of 100 days 20% of the bill
Non-recovery 1% of the bill
Slow Payers want to enter into a firm commitment for purchase of goods of Rs.15 lakhs in 2013, deliveries
to be made in equal quantities on the first day of each quarter in the calendar year. The price per unit of
commodity is Rs.150 on which a profit of Rs.5 per unit is expected to be made. It is anticipated by Goods
Dealers Ltd., that taking up of this contract would mean an extra recurring expenditure of Rs.5,000 per
annum. If the opportunity cost of funds in the hands of Goods Dealers is 24% per annum, would you as
the finance manager of the seller recommend the grant of credit to Slow Payers? Workings should form
part of your answer. Assume year of 365 days.
Answer:
Decision on providing credit to Slow Payers Limited:
Particulars Amount
Sales 15,00,000
Less: Variable Cost (15 lacs/150 x 145) -14,50,000
Less: Recurring cost -5,000
Gross Benefit 45,000
Less: Interest cost (Note 1) -68,787
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Less: Bad debt (15,00,000 x 1%) -15,000
Net Benefit -38,787
• The company should not provide credit to Slow Payers Limited as the net benefit is negative

Note 1: Computation of interest cost:

Particulars 15% of sales 34% of sales 30% of sales 20% of sales
Full cost of Sales (14,55,000 x %) 2,18,250 4,94,700 4,36,500 2,91,000
Collection period 30 60 90 100
Debtors (Full Cost x CP/365) 17,938 81,321 1,07,630 79,726
Interest cost (Debtors x Return %) 4,305 19,517 25,831 19,134
• Total interest cost = Rs.68,787

38. Evaluation of cash discount [May 2018 RTP]

A Ltd. is in the manufacturing business and it acquires raw material from X Ltd. on a regular basis. As per
the terms of agreement the payment must be made within 40 days of purchase. However, A Ltd. has a
choice of paying Rs.98.50 per Rs.100 it owes to X Ltd. on or before 10th day of purchase. Required:
EXAMINE whether A Ltd. should accept the offer of discount assuming average billing of A Ltd. with X
Ltd. is Rs.10,00,000 and an alternative investment yield a return of 15% and company pays the invoice.
Answer:
Annual benefit of availing discount:
1.50 365
Annual Benefit = x x 100 = 18.53%
98.50 30

• Annual benefit of availing cash discount is 18.53%. Opportunity cost is 15%. Hence the company
should go ahead with availing of cash discount

39. Decision making on acceptance of cash discount [SM]

The Dolce Company purchases raw materials on terms of 2/10, net 30. A review of the company’s records
by the owner, Mr. Gupta, revealed that payments are usually made 15 days after purchases are received.
When asked why the firm did not take advantage of its discounts, the accountant, Mr. Ram, replied that it
cost only 2 per cent for these funds, whereas a bank loan would cost the company 12 per cent.
(a) What mistake is Ram making?
(b) What is the real cost of not taking advantage of the discount?
(c) If the firm could not borrow from the bank and was forced to resort to the use of trade credit funds,
what suggestion might be made to Ram that would reduce the annual interest cost?
Answer:
Part a:
• Ram is confusing the percentage cost of using funds for 5 days with the cost of using funds for a
year. These costs are clearly not comparable. One must be converted to the time scale of the other

Part b:
2.00 365
Real cost of not using discount = x x 100 = 148.98%
98.00 5

Part c:
Assume that the firm has made the decision to not use the cash discount, it makes no sense to pay before
the due date. In this case, payment 30 days after purchases are received rather than 15 would reduce the
annual interest cost
2.00 365
Cost of not availing cash discount = x x 100 = 37.24%
98.00 20

40. Selection of Alternative [Nov 2021 RTP, May 2023 MTP, SM]
The Alliance Ltd., a Petrochemical sector company had just invested huge amount in its new expansion
project. Due to huge capital investment, the company is in need of an additional Rs.1,50,000 in working
capital immediately. The Finance Manger has determined the following three feasible sources of working
capital funds:

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(i) Bank loan: The Company's bank will lend Rs.2,00,000 at 15%. A 10% compensating balance will be
required, which otherwise would have been only Rs.5,000.
(ii) Trade credit: The company has been offered credit terms from its major supplier of 3/30, net 90 for
purchasing raw materials worth Rs.1,00,000 per month.
(iii) Factoring: A factoring firm will buy the company’s receivables of Rs.2,00,000 per month, which have a
collection period of 60 days. The factor will advance up to 75% of the face value of the receivables at 12%
on an annual basis. The factor will also charge commission of 2% on all receivables purchased. It has been
estimated that the factor’s services will save the company a credit department expense and bad debt
expense of Rs.1,250 and Rs.1,750 per month respectively.
On the basis of annual percentage cost, ADVISE which alternative should the company select? Assume 360
days year
Answer:
Cost of Bank Loan:
Since the compensating balance would not otherwise be maintained, the real annual cost of taking bank
loan would be:
• Real loan taken = 2,00,000 – (2,00,000 x 10% - 5,000) = 1,85,000
2,00,000 x 15%
Cost of Bank loan = x 100 = 16.22%
1,85,000

Cost of Trade Credit:

Amount upto Rs.1,50,000 can be raised within 2 months or 60 days. The real annual cost of trade credit
would be:
3 360
Cost of Trade Credit = x x 100 = 18.56%
97 60

Cost of Factoring:
Particulars Amount
Commission charges [2% x 24,00,000] 48,000
Less: Admin cost saving [1,250 + 1,750] x 12 -36,000
Net cost of factoring (excluding interest) 12,000
Annual Cost of Borrowing Rs.1,50,000 receivables through factoring would be:
(12% x 1,50,000) + 12,000 18,000 + 12,000
x 100 = 𝑥 100 = 20.00%
1,50,000 1,50,000

Conclusion: The company should select alternative of Bank Loan as it has the lowest annual cost i.e. 16.67%
p.a.

41. Computation of eligible lending [May 2019 MTP]

A bank is analysing the receivables of Jackson Company in order to identify acceptable collateral for a
short-term loan. The company’s credit policy is 2/10 net 30. The bank lends 80 percent on accounts where
customers are not currently overdue and where the average payment period does not exceed 10 days past
the net period. A schedule of Jackson’s receivables has been prepared. How much will the bank lend on
pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
Account Amount Outstanding in days Historical average payment period
74 25,000 15 20
91 9,000 45 60
107 11,500 22 24
108 2,300 9 10
114 18,000 50 45
116 29,000 16 10
123 14,000 27 48
1,08,800
Answer:
Computation of eligible accounts for funding:

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• The company provides a normal credit period of 30 days. Any accounts which are overdue (above
30 days) are not eligible for funding. This would mean Account No.91 and 114 is not eligible for
computing amount to be lent
• Average payment period should not exceed 10 days past the net period. This would mean average
payment period should not exceed 40 days. Account No.123 is not meeting this condition and
hence is not eligible for funding
• Accounts eligible for funding = 74, 107, 108 and 116

Computation of amount to be lent:

Account Amount 80% of amount Amount lent
74 25,000 20,000 18,000
107 11,500 9,200 8,280
108 2,300 1,840 1,656
116 29,000 23,200 20,880
Amount lent 48,816
• Final amount lent is 90% of column 3. This is because 10% is deducted for cash discount and returns

Part 7 – Factoring

42. Cost of factoring [Nov 2015, May 2017 RTP]

A Ltd. has total sales of Rs.3.2 crores and its average collection period is 90 days. The past experience
indicates that bad-debt losses are 1.5% on sales. The expenditure incurred by the firm in administering its
receivable collection efforts are Rs.5,00,000. A factor is prepared to buy the firm’s receivables by charging
2% commission. The factor will pay advance on receivables to the firm at an interest rate of 18% p.a. after
withholding 10% as reserve. Calculate the effective cost of factoring to the Firm. Take one year as 360 days.
Answer:
WN 1: Computation of amount lent by factor:
Particulars Calculation Amount
1. Credit sales 3,20,00,000
2. Average collection period 90 days
3. Amount of debtors 3,20,00,000 x (90/360) 80,00,000
4. Less: Reserve 80,00,000 x 10% -8,00,000
5. Less: Commission 80,00,000 x 2% -1,60,000
6. Amount eligible to be lent 70,40,000
7. Less: Interest 70,40,000 x 18% x (90/360) -3,16,800
8. Amount actually lent 67,23,200

WN 2: Computation of effective cost of factoring:

Particulars Calculation Amount
A. Costs:
Commission 3,20,00,000 x 2% 6,40,000
Interest 70,40,000 x 18% 12,67,200
Total Costs 19,07,200
B. Benefits
Saving in bad debt 3,20,00,000 x 1.5% 4,80,000
Saving in admin cost 5,00,000
Total benefits 9,80,000
Effective cost of factoring (in Rs.) 19,07,200 - 9,80,000 9,27,200
Amount lent by factor WN 1 67,23,200
Effective cost of factoring (in %) 13.79

• Effective cost of factoring = 13.79%

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• The above cost is compared with rate of interest on bank loan to decide whether we can go ahead
with factoring arrangement.
• If bank loan interest rate is higher than 13.79% then we will choose factoring option. Alternatively,
if interest is lower than 13.79% then we will choose bank loan

43. Decision on factoring [SM]

A Factoring firm has credit sales of Rs.360 lakhs and its average collection period is 30 days. The financial
controller estimates, bad debt losses are around 2% of credit sales. The firm spends Rs.1,40,000 annually on
debtors administration. This cost comprises of telephonic and fax bills along with salaries of staff members.
These are the avoidable costs. A Factoring firm has offered to buy the firm’s receivables. The factor will
charge 1% commission and will pay an advance against receivables on an interest @15% p.a. after
withholding 10% as reserve. What should the firm do? Assume 360 days in a year.
Answer:
WN 1: Computation of amount lent by factor:
Particulars Calculation Amount
1. Credit sales 3,60,00,000
2. Average collection period 30 days
3. Amount of debtors 3,60,00,000 x (30/360) 30,00,000
4. Less: Reserve 30,00,000 x 10% -3,00,000
5. Less: Commission 30,00,000 x 1% -30,000
6. Amount eligible to be lent 26,70,000
7. Less: Interest 26,70,000 x 15% x (30/360) -33,375
8. Amount actually lent 26,36,625

WN 2: Computation of effective cost of factoring:

Particulars Calculation Amount
A. Costs:
Commission 3,60,00,000 x 1% 3,60,000
Interest 26,70,000 x 15% 4,00,500
Total Costs 7,60,500
B. Benefits
Saving in bad debt 3,60,00,000 x 2% 7,20,000
Saving in admin cost 1,40,000
Total benefits 8,60,000
Effective cost of factoring (in Rs.) 7,60,500-8,60,000 -99,500
Amount lent by factor WN 1 26,36,625
Effective cost of factoring (in %) -3.77
• The company should go ahead with factoring arrangement as the effective cost of factoring is
negative.

44. Effective cost of factoring [May 2024]

Following is the sales information in respect of Bright Ltd:
Annual Sales (90 % on credit) 7,50,00,000
Credit Period 45 days
Average collection period 70 days
Bad debts 0.75%
Credit administration cost (out of which 2/5th is avoidable) 18,60,000
A factor firm has offered to manage the company's debtors on a non-recourse basis at a service charge of
2%. Factor agrees to grant advance against debtors at in interest rate of 14% after withholding 20% as
reserve. Payment period guaranteed by factor is 45 days. The cost of capital of the company is 12.5%. One
time redundancy payment of Rs. 50,000 is required to be made to factor. Calculate the effective cost of
factoring to the company. (Assume 360 days in a year)

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Answer:
WN 1: Computation of Amount lent by factor
Particulars Calculation Amount
1. Credit sales 6,75,00,000
2. Average collection period 45 days
3. Amount of debtors 6,75,00,000 x (45/360) 84,37,500
4. Less: Reserve 84,37,500 x 20% -16,87,500
5. Less: Commission 84,37,500 x 2% -1,68,750
6. Amount eligible to be lent 65,81,250
7. Less: Interest 65,81,250 x 14% x (45/460) -1,15,172
8. Amount actually lent 64,66,078

WN 2: Computation of effective cost of factoring:

Particulars Calculation Amount
A. Costs:
Commission 6,75,00,000 x 2% 13,50,000
Interest (65,81,250 x 14%) 9,21,375
Redundancy payment (note 1) 50,000
Total Costs 23,21,375
B. Benefits
Saving in bad debt 6,75,00,000 x 0.75% 5,06,250
Saving in admin cost 18,60,000 x (2/5) 7,44,000
70 − 45
Interest cost saved (6,75,00,000 𝑥 ) 𝑥 12.50% 5,85,938
360
Total benefits 18,36,188
Effective cost of factoring (in Rs.) 23,21,375 – 18,36,188 4,85,187
Amount lent by factor WN 1 64,66,078
4,85,187
x 100
Effective cost of factoring (in %) 64,66,078 7.504%
Advice: Since the rate of effective cost of factoring is less than the existing cost of capital, therefore, the
proposal is acceptable.

Note 1:
• Redundancy payment is one-time expenses and hence can also be considered as irrelevant.
Alternative solution taking redundancy payment as irrelevant is presented below:
Particulars Calculation Amount
A. Costs:
Commission 6,75,00,000 x 2% 13,50,000
Interest (65,81,250 x 14%) 9,21,375
Redundancy payment 0
Total Costs 22,71,375
B. Benefits
Saving in bad debt 6,75,00,000 x 0.75% 5,06,250
Saving in admin cost 18,60,000 x (2/5) 7,44,000
70 − 45
Interest cost saved (6,75,00,000 𝑥 ) 𝑥 12.50% 5,85,938
360
Total benefits 18,36,188
Effective cost of factoring (in Rs.) 22,71,375 – 18,36,188 5,35,187
Amount lent by factor WN 1 64,66,078
5,35,187
x 100
Effective cost of factoring (in %) 64,66,078 6.730%

45. Evaluation of factoring proposal [May 2019 MTP, Sep 2024 MTP]

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Sukrut Limited has annual credit sales of Rs. 75,00,000/-. Actual credit terms are 30 days, but its
management of receivables has been poor, and the average collection period is about 60 days. Bad debt is
1 per cent of total sales.

A factor has offered to take over the task of debt administration and credit checking, at an annual fee of 1.5
per cent of credit sales.

Sukrut Limited estimates that it would save Rs. 45,000 per year in administration costs as a result. Due to
the efficiency of the factor, the average collection period would come back to the original credit offered of
30 days and bad debts would come to 0.5% on recourse basis.

The factor would pay net advance of 80 percent to the company at an annual interest rate of 12 per cent
after withholding a reserve of 10%. Sukrut Limited is currently financing its receivables from an overdraft
costing 10 per cent per year and will continue to finance the balance fund needed (which is not financed by
factor) through the overdraft facility

If occurrence of credit sales is throughout the year, COMPUTE whether the factor’s services should be
accepted or rejected. Assume 360 days in a year.
Answer:
Cost benefit analysis of factoring arrangement:
Particulars Calculation Amount
A. Benefits
Saving in bad debt 75,00,000 x 0.5% 37,500
Saving in admin cost 45,000
Saving in interest on bank overdraft 75,00,000 x (60/360) x 10% 1,25,000
Total Benefits 2,07,500
B. Costs
Commission 75,00,000 x 1.5% 1,12,500
Interest cost:
To factor Note 1 53,100
To others (bank OD) Note 1 18,250
Total Costs 1,83,850
Net benefit of factoring 23,650
The company should go ahead with factoring arrangement as net benefit of factoring arrangement is
Rs.23,650

Note 1: Computation of interest cost with factoring arrangement:

Particulars Calculation Amount
Credit sales 75,00,000 x (30/360) 6,25,000
Less: Reserve @ 10% 6,25,000 x 10% -62,500
Less: Commission @ 1.5% 6,25,000 x 1.5% -9,375
Net amount eligible 5,53,125
Amount advanced by factor 5,53,125 x 80% 4,42,500
Interest cost to factor 4,42,500 x 12% 53,100
Interest cost on OD for balance debtors (6,25,000 – 4,42,500) x 10% 18,250
Total Interest cost under factoring arrangement 71,350

46. Evaluation of factoring proposal [Dec 2021]

A company is considering to engage a factor. The following information is available:
• The current average collection period for the company’s debtors is 90 days and 0.5 percent of
debtors’ default. The factor has agreed to pay money due after 60 days and will take the
responsibility of any loss on account of bad debts
• The annual charge for factoring is 2% of turnover. Administration cost saving is likely to be
Rs.1,00,000 per annum

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• Annual credit sales are Rs.1,20,00,000. Variable cost is 80% of sales price. The company’s cost of
borrowing is 15% per annum. Assume 360 days in a year.
Should the company enter into a factoring agreement?
Answer:
Particulars Calculation Amount
A. Benefits
Saving in bad debt 1,20,00,000 x 0.5% 60,000
Saving in admin cost 1,00,000
Interest saving Note 1 1,20,000
Total Benefits 2,80,000
B. Costs
Commission 1,20,00,000 x 2% 2,40,000
Net benefit of factoring 40,000
• Conclusion: The company should go ahead with factoring arrangement as benefits are higher than
costs.

Note 1: Computation of interest costs:

Particulars Existing Factoring
1. Sales 1,20,00,000 1,20,00,000
2. Variable cost of sales 96,00,000 96,00,000
3. Fixed cost - -
4. Full cost of sales 96,00,000 96,00,000
5. Average collection period 90 days 60 days
6. Debtors (Full cost of sales x CP/360) 24,00,000 16,00,000
7. Interest cost (Debtors x 15%) 3,60,000 2,40,000
8. Interest saving under factoring 1,20,000

47. Working capital estimation [May 2024 RTP]

ArMore LLP is a newly established startup dealing in manufacture of a revolutionary product HDHMR
which is a substitute to conventional wood and plywood. It is an economical substitute for manufacture of
furniture and home furnishing. It has been asked by a venture capitalist for an estimated amount of funds
required for setting up plant and also the amount of circulating capital required. A consultant hired by the
entity has advised that the cost of setting up the plant would be Rs. 5 Crores and it will require 1 year to
make the plant operational. The anticipated revenue and associated cost numbers are as follows:
• Units to be sold = 3 lakh sq metres p.a.
• Sale Price of each sq mtr = Rs. 1000
• Raw Material cost = Rs. 200 per sq mtr
• Labour cost = Rs. 50 per hour
• Labour hours per sq mtr = 3 hours
• Cash Manufacturing Overheads = Rs. 75 per machine hour
• Machine hours per sq mtr = 2 hours
• Selling and credit administration Overheads = Rs. 250 per sq mtr
Being a new product in the industry, the firm will have to give a longer credit period of 3 months to its
customers. It will maintain a stock of raw material equal to 15% of annual consumption. Based on
negotiation with the creditors, the payment period has been agreed to be 1 month from the date of
purchase. The entity will hold finished goods equal to 2 months of units to be sold. All other expenses are
to be paid one month in arrears. Cash and Bank balance to the tune of Rs. 25,00,000 is required to be
maintained.

The entity is also considering reducing the working capital requirement by either of the two options: a)
reducing the credit period to customers by a month which will lead to reduction in sales by 5%. b) Engaging
with a factor for managing the receivables, who will charge a commission of 2% of invoice value and will
also advance 65% of receivables @ 12% p.a. This will lead to savings in administration and bad debts cost
to the extent of Rs. 20 lakhs and 16 lakhs respectively.

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The entity is also considering funding a part of working capital by bank loan. For this purpose, bank has
stipulated that it will grant 75% of net current assets as advance against working capital. The bank has
quoted 16.5% rate of interest with a condition of opening a current account with it, which will require 10%
of loan amount to be minimum average balance

You being an finance manager, has been asked the following questions:
Question No.1: The anticipated profit before tax per annum after the plant is operational is ……….
a. 750 lacs b. 570 lacs
c. 370 lacs d. 525 lacs
Question No.2: The estimated current assets requirement in the first year of operation (debtors
calculated at cost) is ……….
a. Rs.9,42,50,000 b. Rs.2,17,08,333
c. Rs.7,25,41,667 d. Rs.67,08,333
Question No.3: The net working capital requirement for the first year of operation is ……….
a. Rs.9,42,50,00 b. Rs.2,17,08,333
c. Rs.7,25,41,667 d. Rs.67,08,333
Question No.4: The annualised % cost of two options for reducing the working capital is ……….
a. 18.18% and 16.92% b. 18.33% and 16.92%
c. 18.59% and 18.33% d. 16.92% and 19.05%
Question No.5: What will be the Maximum Permissible Bank Finance by the bank and annualised %
cost of the same?
a. 4,55,03,630 and 18.33% b. 5,44,06,250 and 18.33%
c. 4,45,86,025 and 18.59% d. 3,45,89,020 and 19.85%
Answer:
Part (i) Cost sheet of Armore LLP:
• Profit before tax = Rs.750 lacs
Particulars Calculation Amount
Direct Material:
Opening stock of Raw Material 0
Add: Purchases (b/f) 805.00
Less: Closing stock of Raw Material 700 x 15% -105.00
Raw Material Consumed 3.5 lac x 200 700.00
Labour cost 3.5 lac x 50 x 3 525.00
Manufacturing OH 3.5 lac x 75 x 2 525.00
Gross works cost/NWC/COP 1,750.00
Add: Opening FG 0.00
Less: Closing FG 0.5 lac x 500 -250.00
Cost of Goods Sold 1,500.00
Selling and distribution OH 3 lac x 250 750.00
Cost of Sales 2,250.00
Profit 750.00
Sales 3 lac x 1,000 3,000.00
• Units produced = Units sold + Closing stock
• Units Produced = 3,00,000 + (3,00,000 x 2/12) = 3,50,000

Part (ii) and (iii) Estimation of working capital

• Part (ii) answer = 9,42,50,000
• Part (iii) answer = 7,25,41,667
Particulars Calculation Amount
Current Assets:
Closing stock of Raw Material 105.00
Closing stock of FG 250.00
Debtors 3 562.50
2,250 𝑥
12
Cash 25.00
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Total Current Assets 942.50
Less: Current Liabilities
Creditors 1 67.08333
805𝑥
12
Outstanding expenses 1 150.00
(525 + 525 + 750)𝑥
12
Total Current Liabilities 227.08
Net working capital 725.41667

Part (iv): Computation of cost of two alternatives:

• Answer = 18.18% and 16.92%
Alternative 1 – Reduction in Credit Period:
Particulars Calculation Amount
Reduction in profit due to lower credit period 15,000 x 250 37,50,000
Old debtors 3 5,62,50,000
22,50,00,000 𝑥
12
New Debtors 2 3,56,25,000
22,50,00,000 𝑥 95% 𝑥
12
Reduction in debtors 2,06,25,000
Cost of Alternative 1 𝟑𝟕, 𝟓𝟎, 𝟎𝟎𝟎 18.18%
𝒙 𝟏𝟎𝟎
𝟐, 𝟎𝟔, 𝟐𝟓, 𝟎𝟎𝟎

Alternative 2 – Costs of factoring:

Particulars Calculation Amount
Commission 2% of 30 Crores 60,00,000
Interest (30 cr x 65% x 3/12 x 12%) 58,50,000
Saving in cost -36,00,000
Net cost (in Rs.) 82,50,000
Amount advanced 3 4,87,50,000
30 cr x 65% x
12
Cost of Alternative 2 82,50,000 16.92%
𝑥 100
4,87,50,000

Part (v)
• Answer = 5,44,06,250 and 18.33%
• MPBF = 75% x 7,25,41,667 = Rs.5,44,06,250
• Annualized cost = (16.50/90%) = 18.33%

Practice Questions

1. Calculation of operating Cycle [May 2018 RTP, Nov 2015 RTP, May 2022 MTP, SM]
Following information is forecasted by the CS Limited for the year ending 31st March, 2010:
Particulars Balance as on April 1, Balance as on March 31,
2009 2010
Raw material 45,000 65,356
Work in process 35,000 51,300
Finished goods 60,181 70,175
Debtors 1,12,123 1,35,000
Creditors 50,079 70,469
Annual purchase of raw material (all 4,00,000
credit)
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.

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You are required to calculate:

I. Net operating cycle period.
II. Number of operating cycles in the year.
III. Amount of working capital requirement
Answer:
WN 1: Computation of operating cycle:
Operating cycle = RM days + WIP days + FG days + Debtor days – Creditor days
Particulars Calculation Amount
Average RM
x 365
RM consumed
45,000 + 65,356
= 2 x 365
RM Days 45,000 + 4,00,000 − 65,356 53.05 days
Average WIP
x 365
Cost of Production
35,000 + 51,300
= 2 x 365
WIP Days 7,50,000 20.99 days
Average FG
x 365
Cost of Goods Sold
60,181 + 70,175
= 2 x 365
FG Days 9,15,000 25.99 days
Average Debtors
x 365
Credit sales
1,12,123 + 1,35,000
= 2 x 365
Debtor days 11,00,000 40.99 days
Average creditors
x 365
Credit Purchases
50,079 + 70,469
= 2 x 365
Creditor days 4,00,000 55 days
Operating cycle (in days) 53.05+20.99+25.99+40.99-55 86 days

WN 2: Amount of working capital required and number of operating cycles:

Particulars Calculation Amount
OC in days
Annual operating cost x
365
86
Amount of working capital required = 9,50,000 x ( ) Rs.2,23,836
365
86 days = 1 operating cycle
Number of operating cycles 365 days = ? operating cycle 4.24 ycles

2. Working capital forecast [SM]

PREPARE a working capital estimate to finance an activity level of 52,000 units a year (52 weeks) based on
the following data:
Particulars Amount
Raw Materials Rs.400 per unit
Direct Wages Rs.150 per unit
Overheads (Manufacturing) Rs.200 per unit
Overheads (Selling and distribution) Rs.100 per unit
Selling Price - Rs. 1,000 per unit, Raw materials & Finished Goods remain in stock for 4 weeks, Work in
process takes 4 weeks. Debtors are allowed 8 weeks for payment whereas creditors allow us 4 weeks.
Minimum cash balance expected is Rs.50,000. Receivables are valued at Selling Price.
Answer:
It is assumed that company is following total approach for estimation of working capital
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Cost sheet for 52,000 units:
Particulars Calculation Amount
Direct Material 400 x 52,000 2,08,00,000
Direct Wages 150 x 52,000 78,00,000
Manufacturing OH 200 x 52,000 1,04,00,000
Cost of Production/Cost of Goods Sold 3,90,00,000
Selling and distribution overheads 100 x 52,000 52,00,000
Cost of sales 4,42,00,000
Profit (b/f) 78,00,000
Sales 52,000 x 1,000 5,20,00,000

WN 2: Working capital forecast:

Particulars Calculation Amount
Current Assets:
Stock of Raw material 4
(Based on RM Consumed) 2,08,00,000 x 16,00,000
52
Stock of WIP
(based on COP) Note 1 23,00,000
Stock of FG 4
(based on COGS) 3,90,00,000 x ( ) 30,00,000
52
Debtors 8
(based on credit sales) 5,20,00,000 x ( ) 80,00,000
52
Cash 50,000
Total Current Assets (A) 1,49,50,000

Current liabilities
Creditors 4
(Based on credit purchases) 2,08,00,000 x ( ) 16,00,000
52
Total Current Liabilities (B) 16,00,000
Working capital (A-B) 1,33,50,000

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 3,90,00,000
Direct Material 2,08,00,000
Other costs 1,82,00,000
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
4
Direct Material 2,08,00,000 x ( ) x 100% 16,00,000
52
4
Other costs 1,82,00,000 x ( ) x 50% 7,00,000
52
Overall stock of WIP 23,00,000

3. Estimation of working capital [May 2017 RTP, Nov 2017 RTP, Nov 2020]
The following information has been extracted from the records of a Company:
Particulars Amount per unit
Raw material cost 45.00
Direct labour cost 20.00
Overhead cost 40.00
Total cost 105.00

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Profit 15.00
Selling price 120.00
I. Raw materials are in stock on an average of two months.
II. The materials are in process on an average for 4 weeks. The degree of completion is 50%.
III. Finished goods stock on an average is for one month.
IV. Time lag in payment of wages and overheads is 1½ weeks.
V. Time lag in receipt of proceeds from debtors is 2 months.
VI. Credit allowed by suppliers is one month.
VII. 20% of the output is sold against cash.
VIII. The company expects to keep a Cash balance of Rs.1,00,000.
IX. Take 52 weeks per annum.
X. The Company is poised for a manufacture of 1,44,000 units in the year.
You are required to prepare a statement showing the Working Capital requirements of the Company.
Answer:
• It is assumed that the company follows cash cost approach for estimation of working capital

WN 1: Cost sheet:
Particulars Calculation Amount
RM consumed/purchased 1,44,000 units x 45 64,80,000
Direct labour 1,44,000 units x 20 28,80,000
Factory overheads 1,44,000 units x 40 57,60,000
GWC/NWC/COP/COGS/COS 1,51,20,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
2
Stock of raw material 64,80,000 x ( ) 10,80,000
12
Stock of WIP Note 1 5,81,358
1
Stock of FG 1,51,20,000 x ( ) 12,60,000
12
2
Debtors 1,51,20,000 x 80% x ( ) 20,16,000
12
Cash 1,00,000
Total Current Assets (A) 50,37,538
Current Liabilities:
1
Creditors 64,80,000 x ( ) 5,40,000
12
1.5
Outstanding wages 28,80,000 x ( ) 83,077
52
1.5
Overheads payable 57,60,000 x ( ) 1,66,154
52
Total Current Liabilities (B) 7,89,231
Working capital (A-B) 42,48,307

Note 1: Computation of WIP:

Particulars Calculation Amount
Cost of Production: 1,51,20,000
Direct Material 64,80,000
Other costs 86,40,000
Degree of Completion:
Direct Material 50%
Other costs 50%
Stock of WIP:

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4
Direct Material 64,80,000 x ( ) x 50% 2,49,231
52
4
Other costs 86,40,000 x ( ) x 50% 3,32,307
52
Overall stock of WIP 5,81,358

4. WC forecast for a new entity [Sep 2024 RTP]

MN Limited is commencing a new project for manufacture of electric toys. The following cost information
has been ascertained for annual production of 60,000 units at full capacity:
Particulars Amount per unit Amount per unit
Raw material 20
Direct labour 15
Manufacturing overheads
Variable 15
Fixed 10 25
Selling and distribution overheads
Variable 3
Fixed 1 4
Total cost 64
Profit 16
Selling price 80
In the first year of operations, expected production and sales are 40,000 units and 35,000 units respectively.
To assess the need of working capital, the following additional information is available:
Stock of raw material 3 months consumption
Credit allowable for debtors 1.5 months
Credit allowable by creditors 4 months
Lag in payment of wages 1 month
Lag in payment of overheads 0.5 month
Cash in hand and bank (expected) 60,000
Provision for contingencies is required @ 10% of working capital requirement including that provision.
You are required to prepare a projected statement of working capital requirement for the first year of
operations. Debtors are taken at cost.
Answer:
It is assumed that company follows total approach for estimation of working capital

WN 1: Cost sheet of MN Limited:

Particulars Calculation Amount
RM Consumed:
Opening RM -
Add: Purchases b/f 10,00,000
3
Less: Closing RM 8,00,000 x ( ) -2,00,000
12
RM consumed 40,000 x 20 8,00,000
Direct wages 40,000 x 15 6,00,000
Variable manufacturing OH 40,000 x 15 6,00,000
Fixed manufacturing OH 60,000 x 10 6,00,000
GWC/NW/COP (40,000 units) 26,00,000
Add: Opening FG -
5,000
26,00,000 x ( )
Less: Closing FG 40,000 -3,25,000
COGS 22,75,000
Variable selling OH 35,000 x 3 1,05,000
Fixed selling OH 60,000 x 1 60,000
Cost of sales 24,40,000
Profit 3,60,000
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Sales 35,000 x 80 28,00,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM WN 1 2,00,000
Stock of FG WN 1 3,25,000
1.5
Debtors 24,40,000 x ( ) 3,05,000
12
Cash 60,000
Total Current Assets (A) 8,90,000
Current Liabilities:
4
Creditors 10,00,000 x ( ) 3,33,333
12
1
Wages payable 6,00,000 x ( ) 50,000
12
0.5
Creditors for expenses 13,65,000 x ( ) 56,875
12
Total current liabilities (B) 4,40,208
Working capital (A-B) 4,49,792
10
Provision for contingencies 4,49,792 x ( ) 49,977
90
Final working capital 4,99,769

5. Working capital estimation [SM]

The following data relating to an auto component manufacturing company is available for the year 2014:
Raw material held in storage 20 days
Receivables collection period 30 days
Conversion process period 10 days
Raw material – 100%
Other costs – 50%
Finished goods storage period 45 days
Credit period from suppliers 60 days
Advance payment to suppliers 5 days
Total cash operating expenses per annum Rs.800 lacs
75% of the total cash operating expenses are for raw material. 360 days are assumed in a year.
You are required to calculate:
• Each item of current assets and current liabilities
• The working capital requirement, if the company wants to maintain a cash balance of Rs.10 lacs at
all times
Answer:
• It is assumed that company follows cash cost approach for working capital estimation

WN 1: Cost sheet:
Amount
Particulars Calculation (in lacs)
Material consumed/purchased 800 lacs x 75% 600
Other costs 800 x 20% 200
GWC/NWC/COP/COGS/COS 800

WN 2: Working capital estimation:

Amount
Particulars Calculation (in lacs)
Current Assets:

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Stock of RM 20
(Based on RM Consumed) 600 x ( ) 33.33
360
Stock of WIP Note 1 19.45
Stock of FG 45
(Based on COGS) 800 x ( ) 100.00
360
Debtors 30
(Based on cost of Sales) 800 x ( ) 66.67
360
5
Advance to suppliers 600 x ( ) 8.33
360
Cash 10.00
Total Current Assets (A) 237.78
Current Liabilities:
Creditors 60
(Based on RM Purchased) 600 x ( ) 100.00
360
Total Current Liabilities (B) 100.00
Working capital (A-B) 137.78

Note 1: Computation of WIP:

Amount
Particulars Calculation (in lacs)
Cost of Production: 800.00
Direct Material 600.00
Other costs 200.00
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
10
Direct Material 600 x ( ) x 100% 16.67
360
10
Other costs 200 x ( ) x 50% 2.78
360
Overall stock of WIP 19.45

6. Estimation of working capital [Nov 2018, May 2020 MTP, May 2020 RTP, May 2018]
Day Limited, a newly formed company has applied to the private bank for the first time for financing its
working capital requirements. The following information is available about the projections for the current
year:
Estimated level of activity Completed units of production 31,200 plus units of work-in-
progress 12,000
Raw material cost 40 per unit
Direct wages cost 15 per unit
Overhead 40 per unit (inclusive of depreciation of Rs.10 per unit)
Selling price 130 per unit
Raw material in stock Average 30 days consumption
Work in progress stock Material 100% and Conversion cost 50%
Finished goods stock 24,000 units
Credit allowed by the supplier 30 days
Credit allowed to purchasers 60 days
Direct wages (lag in payment) 15 days
Expected cash balance 2,00,000
Assume that production is carried on evenly throughout the year (360 days) and wages and overheads
accrue similarly. All sales are on the credit basis. You are required to calculate the net working capital
requirements on cash cost basis.
Answer:
WN 1: Cost sheet:
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Particulars Calculation Amount
RM Consumed:
Opening RM -
Add: Purchases Bal figure 18,72,000
30
Less: Closing RM 17,28,000 x 1,44,000
360
RM consumed (31,200 x 40) + (12,000 x 40) 17,28,000
Direct wages (31,200 x 15) + (12,000 x 7.50) 5,58,000
Overheads (excluding depreciation) (31,200 x 30) + (12,000 x 15.00) 11,16,000
GWC 34,02,000
Add: Opening WIP -
Less: Closing WIP (12,000 x 40) + (12,000 x 22.50) -7,50,000
NWC/COP (31,200 units) 26,52,000
Add: Opening FG -
24,000
26,52,000 x
Less: Closing FG 31,200 -20,40,000
COGS/COS 6,12,000

WN 2: Working capital estimation:

Particulars Calculation Amount
Current Assets:
Stock of RM WN 1 1,44,000
Stock of WIP WN 1 7,50,000
Stock of FG WN 1 20,40,000
Debtors 60
(Based on Cost of Sales) 6,12,000 x ( ) 1,02,000
360
Cash 2,00,000
Total Current Assets (A) 32,36,000
Current Liabilities:
Creditors 30
(Based on RM Purchased) 18,72,000 x ( ) 1,56,000
360
Wages payable 15
(Based on total wages) 5,58,000 x ( ) 23,250
360
Total Current Liabilities (B) 1,79,250
Working capital (A-B) 30,56,750

Note 1: Computation of WIP:

Amount
Particulars Calculation (in lacs)
Cost of Production: 480.00
Direct Material 300.00
Other costs 180.00
Degree of Completion:
Direct Material 100%
Other costs 50%
Stock of WIP:
1
Direct Material 300 x ( ) x 100% 25.00
12
1
Other costs 180 x ( ) x 50% 7.50
12
Overall stock of WIP 32.50

7. Maximum permissible bank finance (May 2022)

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Balance sheet of X Ltd for the year ended 31st March,2022 is given below:
(in lacs)
Liabilities Amount Assets Amount
Equity shares of Rs.10 each 200 Fixed assets 500
Retained earnings 200 Raw materials 150
11% Debentures 300 WIP 100
Public Deposits (Short-term) 100 Finished Goods 50
Trade Creditors 80 Debtors 125
Bills Payable 100 Cash at Bank 55
980 980
Calculate the amount of maximum permissible bank finance under three methods as per Tandon
Committee lending norms. The total core current assets are assumed to be Rs. 30 lakhs.
Answer:
Computation of Maximum Permissible Bank Finance as per Tandon Committee Lending Norms:
Method 1:
MPBF = 75% of Current Assets – 75% of Current Liabilities
Current assets = 150 + 100 + 50 + 125 + 55 = Rs.480 lacs
Current Liabilities = 100 + 80 + 100 = 280 lacs
MPBF = (75% x 480) – (75% x 280) = 360 lacs – 210 lacs = Rs.150 lacs
Method 2:
MPBF = 75% of current assets – 100% of current liabilities
MPBF = (75% x 480) – (100% x 280) = 360 lacs – 280 lacs = Rs.80 lacs
Method 3:
MPBF = 75% of non-core current assets – 100% of current liabilities
Non-core current assets = Total Current assets – Core current assets = 480 lacs – 30 lacs = Rs.450 lacs
MPBF = (75% x 450 lacs) – (100% x 280 lacs) = Rs.337.50 lacs – Rs.280 lacs = Rs.57.50 lacs

8. Optimum cash balance [Nov 2019 MTP, May 2017, SM]

A firm maintains a separate account for cash disbursement. Total disbursements are Rs.2,62,500 per month.
Administrative and transaction cost of transferring cash to disbursement account is Rs.25 per transfer.
Marketable securities yield is 7.5% per annum. Determine the optimum cash balance according to William
J Baumol model.
Answer:
2 x annual demand for money x transfer cost
Optimum cash balance = √
Interest cost

2 x ( 12 x 2,62,500) x 25
Optimum cash balance = √ = 𝐑𝐬. 𝟒𝟓, 𝟖𝟐𝟔
0.075

9. Cash budget [May 2021 MTP, Nov 2019 MTP, May 2023 MTP, SM]
Prepare monthly cash budget for six months beginning from April 2017 on the basis of the following
information:
Estimated monthly sales:
Particulars Amount Particulars Amount
January 1,00,000 June 80,000
February 1,20,000 July 1,00,000
March 1,40,000 August 80,000
April 80,000 September 60,000
May 60,000 October 1,00,000

Wages and salaries:

Particulars Amount Particulars Amount
April 9,000 July 10,000
May 8,000 August 9,000
June 10,000 September 9,000

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Other information:
• Of the sales, 80% is on credit and 20% for cash. 75% of the credit sales are collected within one
month and the balance in two months. There are no bad debt losses
• Purchases amount to 80% of sales and are made on credit and paid for in the month preceding the
sales
• The firm has 10% debentures of Rs.1,20,000. Interest on these has to be paid quarterly in January,
April and so on
• The firm has to make and advance payment of tax of Rs.5,000 in July, 2017
• The firm had a cash balance of Rs.20,000 on April 1, 2017, which is the minimum desired level of
cash balance. Any cash surplus/deficit above/below this level is made up by temporary
investments/liquidation of temporary investments or temporary borrowings at the end of each
month (interest on these to be ignored)
Answer:
Cash budget for six months from April 2007:
Particulars Apr May Jun Jul Aug Sep
Opening cash balance (A) 20,000 20,000 20,000 20,000 20,000 20,000
Add: Receipts
Cash sales 16,000 12,000 16,000 20,000 16,000 12,000
Collections
Feb month sales 24,000
Mar month sales 84,000 28,000
Apr month sales 48,000 16,000
May month sales 36,000 12,000
June month sales 48,000 16,000
July month sales 60,000 20,000
August month sales 48,000
Total receipts (B) 1,24,000 88,000 68,000 80,000 92,000 80,000

Payments
Payment to suppliers
(80% of preceding month sales) 48,000 64,000 80,000 64,000 48,000 80,000
Wages and salaries 9,000 8,000 10,000 10,000 9,000 9,000
Interest on debentures 3,000 3,000
Advance tax 5,000
Total Payments (C) 60,000 72,000 90,000 82,000 57,000 89,000
Closing cash (A+B-C) 84,000 36,000 -2,000 18,000 55,000 11,000
New deposit/liquidation of deposit -64,000 -16,000 22,000 2,000 -35,000 9,000
Revised cash 20,000 20,000 20,000 20,000 20,000 20,000

10. Cash budget [SM]

From the information and the assumption that the cash balance in hand as on 1 st January 2004 is Rs.72,500,
prepare a cash budget.
Assume that 50 percent of total sales are cash sales. Assets are to be acquired in the months of February
and April. Therefore, provisions should be made for the payment of Rs.8,000 and Rs.25,000 for the same.
An application has been made to the bank for the grant of a loan of Rs.30,000 and is hoped that the loan
amount will be received in the month of May. It is anticipated that a dividend of Rs.35,000 will be paid in
June. Debtors are allowed one-month credit. Creditors for materials purchased and overheads grant one-
month credit. Sales commission at 3 percent on sales is paid to the salesman each month.
Month Sales Material Salaries and Production Office and selling
purchased wages overheads overheads
January 72,000 25,000 10,000 6,000 5,500
February 97,000 31,000 12,100 6,300 6,700
March 86,000 25,500 10,600 6,000 7,500

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April 88,600 30,600 25,000 6,500 8,900
May 1,02,500 37,000 22,000 8,000 11,000
June 1,08,700 38,800 23,000 8,200 11,500
Answer:
Cash budget for the months of January to June 2004:
Particulars Jan Feb Mar Apr May Jun
Opening cash balance (A) 72,500 96,340 1,21,330 1,55,650 1,51,292 2,05,767
Add: Receipts
Cash sales (50%) 36,000 48,500 43,000 44,300 51,250 54,350
Collection from customers - 36,000 48,500 43,000 44,300 51,250
Bank loan 30,000
Total receipts (B) 36,000 84,500 91,500 87,300 1,25,550 1,05,600

Payments
Payment to suppliers - 25,000 31,000 25,500 30,600 37,000
Salaries and wages 10,000 12,100 10,600 25,000 22,000 23,000
Production overheads - 6,000 6,300 6,000 6,500 8,000
Selling overheads - 5,500 6,700 7,500 8,900 11,000
Sales commission 2,160 2,910 2,580 2,658 3,075 3,261
Capital expenditure - 8,000 25,000
Dividend 35,000
Total Payments (C) 12,160 59,510 57,180 91,658 71,075 1,17,261
Closing cash (A+B-C) 96,340 1,21,330 1,55,650 1,51,292 2,05,767 1,94,106

11. Decision on Change in Cash Discount [May 2023 RTP]

River limited currently uses the credit terms of 1.5/15 net 45 days and average collection period was 30
days. The company presently having sales of Rs. 50,00,000 and 30% customers availing the discount. The
chances of default are currently 5%. Variable cost constitutes 65% and total cost constitute 85% of sales. The
company is planning liberalization of credit terms to 2/20 net 50 days. It is expected that sales are likely to
increase by Rs. 5,00,000, the default chances are 10% and average collection period will decline to 25 days.
There won't be any change in the fixed cost and 50% customers are expected to avail the discount. Tax rate
is 35%.
EVALUATE this policy in comparison with the current policy and recommend whether the new policy
should be implemented. Assume cost of capital to be 10% (post tax) and 360 days in a year
Answer:
• Existing credit terms are “1.5/15 net 45”. This would mean that company will give 1.5 percent cash
discount if payment is done in 15 days. And the normal credit period is 45 days if person does not
opt for cash discount
Particulars Existing Revised
Sales 50,00,000 55,00,000
Less: Variable cost -32,50,000 -35,75,000
Less: Fixed cost -10,00,000 -10,00,000
Gross Benefit 7,50,000 9,25,000
-22,500 -55,000
Less: Cash discount [50,00,000 x 30% x 1.5%] [55,00,000 x 50% x 2%]
Less: Bad debt -2,50,000 -5,50,000
Profit before tax 4,77,500 3,20,000
Less: Tax @ 35% -1,67,125 -1,12,000
Profit after tax 3,10,375 2,08,000
Less: Opportunity interest cost
[Note 1} -35,417 -31,771
Net Benefit after tax 2,74,958 1,76,229
• Company should reject the revised scheme as the same leads to lower net benefit

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Note 1: Computation of interest cost:

Particulars Existing Revised
Full cost of Sales (VC + FC) 42,50,000 45,75,000
Debtors (Full Cost x CP/360) 3,54,167 3,17,708
Interest cost (Debtors x Return %) 35,417 31,771

12. Cost of Factoring [May 2024 MTP]

NV Industries Ltd. is a manufacturing industry which manages its accounts receivables internally by its
sales and credit department. It supplies small articles to different industries. The total sales ledger of the
company stands at Rs. 200 lakhs of which 80% is credit sales. The company has a credit policy of 2/40, net
120. Past experience of the company has been that on average out of the total, 50% of customers avail of
discount and the balance of the receivables are collected on average in 120 days. The finance controller
estimated, bad debt losses are around 1% of credit sales.
With escalating cost associated with the in-house management of the debtors coupled with the need to
unburden the management with the task so as to focus on sales promotion, the CFO is examining the
possibility of outsourcing its factoring service for managing its receivables. Currently, the firm spends
about Rs. 2,40,000 per annum to administer its credit sales. These are avoidable as a factoring firm is
prepared to buy the firm's receivables. The main elements of the proposal are : (i) It will charge 2%
commission (ii) It will pay advance against receivables to the firm at an interest rate of 18% after
withholding 10% as reserve.
Also, company has option to take long term loan at 15% interest or may take bank finance for working
capital at 14% interest.
You were also present at the meeting; being a financial consultant, the CFO has asked you to be ready with
the following questions:
Consider year as 360 days.
Question No.1: What is average level of receivables of the company?
a. Rs.53,33,333 b. Rs.35,55,556
c. Rs.44,44,444 d. Rs.71,11,111
Question No.2: How much advance factor will pay against receivables
a. Rs.31,28,889 b. Rs.39,11,111
c. Rs.30,03,733 d. Rs.46,93,333
Question No.3: What is the annual cost of factoring to the company?
a. Rs.8,83,200 b. Rs.4,26,667
c. Rs.5,51,823 d. Rs.4,00,000
Question No.4: What is the net cost to the company on taking factoring service?
a. Rs.4,00,000 b. Rs.4,26,667
c. Rs.3,50,000 d. Rs.4,83,200
Question No.5: What is effective cost of factoring on advance received?
a. 16.09% b. 13.31%
c. 12.78% d. 15.89%
Answer:
Question No.1 b. Rs.35,55,556
Question No.2 c. Rs.30,03,733
Question No.3 a. Rs.8,83,200
Question No.4 d. Rs.4,83,200
Question No.5 a. 16.09%

WN 1: Computation of amount lent by factor:

Particulars Calculation Amount
1. Credit sales 200 lacs x 80% 1,60,00,000
2. Average collection period (40 𝑥 50% + 120 𝑥 50%) 80 days
3. Amount of debtors 1,60,00,000 x (80/360) 35,55,556
4. Less: Reserve 35,55,556 x 10% -3,55,556

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5. Less: Commission 35,55,556 x 2% -71,111
6. Amount eligible to be lent 31,28,889
7. Less: Interest 31,28,889 x 18% x 80/360 -1,25,156
8. Amount actually lent 30,03,733

WN 2: Computation of effective cost of factoring:

Particulars Calculation Amount
A. Costs:
Commission 1,60,00,000 x 2% 3,20,000
Interest 31,28,889 x 18% 5,63,200
Total Costs 8,83,200
B. Benefits
Saving in bad debt 1,60,00,000 x 1% 1,60,000
Saving in admin cost 2,40,000
Total benefits 4,00,000
Effective cost of factoring (in Rs.) 4,83,200
Amount lent by factor WN 1 30,03,733
Effective cost of factoring (in %) 16.09%

13. Evaluation of factoring proposal

The turnover of Sky Ltd. is Rs.90 lakhs of which 80 per cent is on credit. Debtors are allowed one month to
clear off the dues. A factor is willing to advance 80 per cent of the bills raised on credit for a fee of 2 per
cent a month plus a commission of 3 per cent on the total amount of debts. Sky Ltd. as a result of this
arrangement is likely to save Rs.22,800 annually in management costs and avoid bad debts at 1 per cent on
the credit sales.
A bank has come forward to make an advance equal to 80 per cent of the debts at an annual interest rate of
18 per cent. However, its processing fee will be at 2 per cent on the debts. Would you accept factoring or
the offer from the bank?
Answer:
Cost benefit analysis of factoring arrangement:
Particulars Calculation Amount
A. Benefits
Saving in bad debt 72,00,000 x 1% 72,000
Saving in admin cost Given 22,800
Saving in existing interest cost 72,00,000 x (1/12) x 80% x 18% 86,400
Saving in processing cost 72,00,000 x 2% 1,44,000
Total Benefits 3,25,200
B. Costs
Commission 72,00,000 x 3% 2,16,000
Interest cost:
To factor 72,00,000 x (1/12) x 80% x 24% 1,15,200
Total Costs 3,31,200
Net cost of factoring 6,000
• The company should not go ahead with factoring arrangement as benefits of factoring are lower
than cost

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APPENDIX

Future Value Interest Factor for Rs.1 per period at i% for n periods, FVIF (i,n)
(The compound Sum of One Rupee)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.090 1.100
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.835
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063 13.268 17.449
35 1.417 2.000 2.814 3.946 5.516 7.686 10.677 14.785 20.414 28.102
40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725 31.409 45.259
45 1.565 2.438 3.782 5.841 8.985 13.765 21.002 31.920 48.327 72.890
50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902 74.358 117.391

Future Value Interest Factor for Rs.1 per period at i% for n periods, FVIF (i,n)
(The compound Sum of One Rupee)
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.110 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200
2 1.232 1.254 1.277 1.300 1.323 1.346 1.369 1.392 1.416 1.440
3 1.368 1.405 1.443 1.482 1.521 1.561 1.602 1.643 1.685 1.728
4 1.518 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074
5 1.685 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488
6 1.870 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986
7 2.076 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583
8 2.305 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300
9 2.558 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160
10 2.839 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.695 6.192
11 3.152 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430
12 3.498 3.896 4.335 4.818 5.350 5.936 6.580 7.288 8.064 8.916
13 3.883 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699
14 4.310 4.887 5.535 6.261 7.076 7.988 9.007 10.147 11.420 12.839
15 4.785 5.474 6.254 7.138 8.137 9.266 10.539 11.974 13.590 15.407
16 5.311 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.172 18.488
17 5.895 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186

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Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
18 6.544 7.690 9.024 10.575 12.375 14.463 16.879 19.673 22.901 26.623
19 7.263 8.613 10.197 12.056 14.232 16.777 19.748 23.214 27.252 31.948
20 8.062 9.646 11.523 13.743 16.367 19.461 23.106 27.393 32.429 38.338
25 13.585 17.000 21.231 26.462 32.919 40.874 50.658 62.669 77.388 95.396
30 22.892 29.960 39.116 50.950 66.212 85.850 111.065 143.371 184.675 237.376
35 38.575 52.800 72.069 98.100 133.176 180.314 243.503 327.997 440.701 590.668
40 65.001 93.051 132.782 188.884 267.864 378.721 533.869 750.378 1051.668 1469.772
45 109.530 163.988 244.641 363.679 538.769 795.444 1170.479 1716.684 2509.651 3657.262
50 184.565 289.002 450.736 700.233 1083.657 1670.704 2566.215 3927.357 5988.914 9100.438

Present Value Interest Factor for Rs.1 per period at i% for n periods, PVIF (i,n)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239
16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 0.218
17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 0.198
18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180
19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 0.164
20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 0.149
25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 0.092
30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 0.057
35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 0.036
40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 0.022
45 0.639 0.410 0.264 0.171 0.111 0.073 0.048 0.031 0.021 0.014
50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 0.009

Present Value Interest Factor for Rs.1 per period at i% for n periods, PVIF (i,n)
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162

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Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065
16 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.054
17 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.045
18 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.038
19 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.031
20 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.026
25 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.010
30 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.004
35 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.002
40 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.001
45 0.009 0.006 0.004 0.003 0.002 0.001 0.001 0.001 0.000 0.000
50 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 0.000

Future Value Interest Factor of an ordinary Annuity of Re.1 per period at i% for n periods, FVIFA(i,n)
(The compound value of an Annuity of One Rupee)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.153 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950
17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545
18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599
19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159
20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275
25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347
30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.283 136.308 164.494
35 41.660 49.994 60.462 73.652 90.320 111.435 138.237 172.317 215.711 271.024
40 48.886 60.402 75.401 95.026 120.800 154.762 199.635 259.057 337.882 442.593
45 56.481 71.893 92.720 121.029 159.700 212.744 285.749 386.506 525.859 718.905
50 64.463 84.579 112.797 152.667 209.348 290.336 406.529 573.770 815.084 1163.909

Future Value Interest Factor of an ordinary Annuity of Re.1 per period at i% for n periods, FVIFA(i,n)
(The compound value of an Annuity of One Rupee)
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000

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Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
2 2.110 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200
3 3.342 3.374 3.407 3.440 3.473 3.506 3.539 3.572 3.606 3.640
4 4.710 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.368
5 6.228 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442
6 7.913 8.115 8.323 8.536 8.754 8.977 9.207 9.442 9.683 9.930
7 9.783 10.089 10.405 10.730 11.067 11.414 11.772 12.142 12.523 12.916
8 11.859 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499
9 14.164 14.776 15.416 16.085 16.786 17.519 18.285 19.086 19.923 20.799
10 16.722 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959
11 19.561 20.655 21.814 23.045 24.349 25.733 27.200 28.755 30.404 32.150
12 22.713 24.133 25.650 27.271 29.002 30.850 32.824 34.931 37.180 39.581
13 26.212 28.029 29.985 32.089 34.352 36.786 39.404 42.219 45.244 48.497
14 30.095 32.393 34.883 37.581 40.505 43.672 47.103 50.818 54.841 59.196
15 34.405 37.280 40.417 43.842 47.580 51.660 56.110 60.965 66.261 72.035
16 39.190 42.753 46.672 50.980 55.717 60.925 66.649 72.939 79.850 87.442
17 44.501 48.884 53.739 59.118 65.075 71.673 78.979 87.068 96.022 105.931
18 50.396 55.750 61.725 68.394 75.836 84.141 93.406 103.740 115.266 128.117
19 56.939 63.440 70.749 78.969 88.212 98.603 110.285 123.414 138.166 154.740
20 64.203 72.052 80.947 91.025 102.444 115.380 130.033 146.628 165.418 186.688
25 114.413 133.334 155.620 181.871 212.793 249.214 292.105 342.603 402.042 471.981
30 199.021 241.333 293.199 356.787 434.745 530.312 647.439 790.948 966.712 1181.882
35 341.590 431.663 546.681 693.573 881.170 1120.713 1426.491 1816.652 2314.214 2948.341
40 581.826 767.091 1013.704 1342.025 1779.090 2360.757 3134.522 4163.213 5529.829 7343.858
45 986.639 1358.230 1874.165 2590.565 3585.128 4965.274 6879.291 9531.577 13203.424 18281.310
50 1668.771 2400.018 3459.507 4994.521 7217.716 10435.649 15089.502 21813.094 31515.336 45497.191

Present Value Interest Factor of an ordinary Annuity of Re.1 per period at i% for n periods, PVIFA(i,n)
Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514
25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644

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Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.863
50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915

Present Value Interest Factor of an ordinary Annuity of Re.1 per period at i% for n periods, PVIFA(i,n)
Period 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.668 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.584 5.316 5.070 4.843
20 7.963 7.469 7.025 6.623 6.259 5.929 5.628 5.353 5.101 4.870
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
45 9.008 8.283 7.661 7.123 6.654 6.242 5.877 5.552 5.261 4.999
50 9.042 8.304 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999

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